Chapter 1: Development Of Accounting Principles And Professional Practice PDF

CHAPTER ONE DEVELOPMENT OF ACCOUNTING PRINCIPLES AND PROFESSIONAL PRACTICE 1  The Environment of Accounting The environment of accounting consists of:  social,  economic,  political,  legal conditions, and influences that v...

CHAPTER ONE DEVELOPMENT OF ACCOUNTING PRINCIPLES AND PROFESSIONAL PRACTICE 1  The Environment of Accounting The environment of accounting consists of:  social,  economic,  political,  legal conditions, and influences that vary from time to time. As a result, accounting objectives and practices are not the same today as they were in the past. 2  Global market World markets are becoming increasingly intertwined. The tremendous variety and volume of both exported and imported goods indicates the extensive involvement in international trade. In addition, due to technological advances and less onerous regulatory requirements,  investors are able to engage in financial transactions across national borders and 3  Global market 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. As a result, an increasing number of investors are holding securities of foreign companies. 4  Global market As indicated, capital markets are increasingly integrated and companies have greater flexibility in deciding where to raise capital. In the absence of market integration, there can be company-specific factors that make it cheaper to raise capital and list/ trade securities in one location versus another. 5  Global market With the integration of capital markets, the automatic linkage between the location of the company and location of the capital market is loosening. As a result, companies have expanded choices of where to raise capital, either equity or debt. The move toward adoption of global accounting standards has and will continue to facilitate this trend. 6  Cont.… Accounting theory and practices have evolved to meet changing demands and influences Three of which deserve special consideration are First, accounting recognizes that people live in a world of scarce resources ACCOUNTING - helps to identify efficient and inefficient users of resources. Accountants must measure performance accurately and fairly on a timely basis, 7  Cont…. To facilitate efficient capital allocation, investors need relevant information and a faithful representation of that information to enable them to make comparisons across borders. A single, widely accepted set of high-quality accounting standards is a necessity to ensure adequate comparability. 8  Cont.…. Second, accounting recognizes and accepts society’s current and ethical concepts of property and other rights when determining equity. » what property rights society protects, » what society recognizes as value, and » what society acknowledges as equitable and fair. 9  Cont… Third, accounting recognizes that in highly developed, complex economic systems, some (owners and investors) entrusts the custodianship of and control over property to others (managers). Thus, the function of measuring and reporting information to absentee investors (e.g. Shareholders) has been added to that of recording and presenting financial data for owner – manager use This development greatly increased the need for accounting standards (rules of practice governing the contents, measurements, and disclosures in financial statements). 10 Nature environment of financial accounting Financial accounting Accounting discipline Managerial(cost ) Accounting Tax Accounting Not for profit(public sector) Accounting 11  Users of Accounting Information These users of accounting information may be divided broadly into two groups as internal and external users. Internal Users: - use accounting information either for planning and controlling current operations and making major business decisions. – Managerial Accounting is the discipline that measures and reports information to internal users. 12  Cont’ External Users: - includes stockholders, bondholders, potential investors, bankers and other creditors, financial analysts, labor union and others who use accounting information to make various decisions on behalf of their own respective interest. – Financial Accounting is concerned with the provision of relevant financial information to various external users. 13  The IASB and its governance structure IFRS refers to set of accounting rules which specify in detail how companies must maintain their records and report their expenses and income. The main international standard-setting organization is called the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS), which is presently used or permitted in over 149 countries including Ethiopia and is rapidly gaining acceptance in other countries as well. 14  Cont.… 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)- Develop high quality and enforceable IFRS based on public interest 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  Interpretative body of the IASB  Responds to questions about the application of the Standards and does other work at the request of the Board. 15 The members of the Monitoring Board include, the relevant leaders of: The European Commission The Japanese Financial Services Agency The US Securities and Exchange Commission The Emerging Markets Committee of IOSCO The Technical Committee of IOSCO and 16 China ministry of finance  1.3. List of IASB pronouncements The IASB issues three major types of pronouncements: 1. International Financial Reporting Standards. 2. Conceptual Framework for Financial Reporting. 3. International Financial Reporting Standards Interpretations 17  Cont… 1. International Financial Reporting Standards 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 etc.. 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. 18  Cont.… 2. Conceptual Framework for Financial Reporting The Framework's purpose is to  Assist the IASB in developing and revising IFRSs that are based on consistent concepts,  To help preparers & develop consistent accounting policies for areas that are not covered by a standard or where there is choice of accounting policy, and  To assist all parties to understand and interpret IFRS. Three levels:  First Level: Objectives of Financial Reporting.  Second Level: Qualitative Characteristics and Elements of Financial Statements.  Third Level: Recognition, Measurement, and Disclosure Concepts. 19  ASSUMPTIONS PRINCIPLES CONSTRAINTS 1. Economic entity 1. Measurement 1. Cost 2. Going concern 2. Revenue recognition Third level 3. Monetary unit 3. Expense recognition The "how"— 4. Periodicity 4. Full disclosure implementation 5. Accrual QUALITATIVE CHARACTERISTICS ELEMENTS 1. Fundamental 1. Assets qualities 2. Liabilities Second level 3. Equity Bridge between 2. Enhancing qualities 4. Income levels 1 and 3 5. Expenses OBJECTIVE Provide information about the reporting entity that is useful First level to present and potential The "why"—purpose equity investors, of accounting lenders, and other creditors in their capacity as capital providers. 20  First Level: Basic Objective The objective of financial reporting is the foundation of the conceptual framework. The objective of 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. 21  Second Level: Fundamental Concepts The second level provides conceptual building blocks that explain the qualitative characteristics of accounting information and define the elements of financial statements. That is, the second level forms a bridge between the why of accounting (the objective) and the how of accounting 22 (recognition, measurement, and financial  Qualitative Characteristics of Accounting Information IASB identified the Qualitative Characteristics of accounting information that distinguish  better (more useful) information from  inferior (less useful) information for decision-making purposes. 23 Qualitative Characteristics Fundamental Quality—Relevance To be relevant, accounting information must be capable of making a difference in a decision. LO 2  Qualitative Characteristics Fundamental Quality—Relevance 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. LO 2  Qualitative Characteristics Fundamental Quality—Relevance Relevant information also helps users confirm or correct prior expectations. LO 2  Qualitative Characteristics Fundamental Quality—Relevance Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. LO 2 Materiality……. Example During the period in question, the revenues and expenses, and therefore the net incomes of Company A and Company B, are proportional. Each reported an unusual gain. In your view which company's operating income would be greatly distorted if unusual gain is merged with the regular operating income? 28  Qualitative Characteristics Fundamental Quality—Faithful Representation Faithful representation means that the numbers and descriptions match what really existed or happened. LO 2  Qualitative Characteristics Fundamental Quality—Faithful Representation Completeness means that all the information that is necessary for faithful representation is provided. LO 2  Qualitative Characteristics Fundamental Quality—Faithful Representation Neutrality means that a company cannot select information to favor one set of interested parties over another. LO 2  Qualitative Characteristics Fundamental Quality—Faithful Representation An information item that is free from error will be a more accurate (faithful) representation of a financial item. LO 2  Qualitative Characteristics Enhancing Qualities Information that is measured and reported in a similar manner for different companies is considered comparable. LO 2 Qualitative Characteristics Enhancing Qualities Verifiability occurs when independent measurers, using the same methods, obtain similar results. LO 2  Qualitative Characteristics Enhancing Qualities Timeliness means having information available to decision- makers before it loses its capacity to influence decisions. LO 2  Qualitative Characteristics Enhancing Qualities Understandability is the quality of information that lets reasonably informed users see its significance. LO 2 Basic Elements Elements of Financial Statements Asset A resource controlled by the entity as a result of past events and from Liability which future economic benefits are expected to flow to the entity. Equity Income Expenses LO 2 Basic Elements Elements of Financial Statements Asset A present obligation of the entity Liability arising from past events, the settlement of which is expected to Equity result in an outflow from the entity of resources embodying economic Income benefits. Expenses LO 2 Basic Elements Elements of Financial Statements Asset Liability Equity The residual interest in the assets of the entity after deducting all its Income liabilities. Expenses LO 2 Basic Elements Elements of Financial Statements Asset Liability Equity Increases in economic benefits during the accounting period in the form of inflows or Income enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions Expenses from equity participants. Basic Elements Elements of Financial Statements Asset Liability Equity Decreases in economic benefits during the accounting period in the form of Income outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those Expenses relating to distributions to equity participants. LO 2  ASSUMPTIONS PRINCIPLES CONSTRAINTS 1. Economic entity 1. Measurement 1. Cost 2. Going concern 2. Revenue recognition Third level 3. Monetary unit 3. Expense recognition The "how"— 4. Periodicity 4. Full disclosure implementation 5. Accrual QUALITATIVE CHARACTERISTICS ELEMENTS 1. Fundamental 1. Assets qualities 2. Liabilities Second level 3. Equity Bridge between 2. Enhancing qualities 4. Income levels 1 and 3 5. Expenses OBJECTIVE Provide information about the reporting entity that is useful First level to present and potential The "why"—purpose equity investors, of accounting lenders, and other creditors in their capacity as capital providers. 42  Third level Recognition, Measurement, and Disclosure Concepts These concepts explain how companies should recognize, measure, and report financial elements and events. Recognition, Measurement, and Disclosure Concepts ASSUMPTIONS PRINCIPLES CONSTRAINTS 1. Economic entity 1. Measurement 1. Cost 2. Going concern 2. Revenue recognition 3. Monetary unit 3. Expense recognition 4. Periodicity 4. Full disclosure 5. Accrual LO 3  Assumptions Economic Entity – requires that activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. Going Concern – assumes that the business will have a long life. Monetary Unit - requires that companies include in the accounting records only transaction data that can be expressed in terms of money. Periodicity – implies that a company can divide its economic activities into time periods (i.e., to report information periodically). Accrual Basis of Accounting – transactions are recorded in the periods in which the events occur.  Basic Principles of Accounting We generally use four basic principles of accounting to record and report transactions: i. measurement, ii. revenue recognition, iii. expense recognition, and iv. full disclosure.  Basic Principles of Accounting Measurement Principles  Historical Cost: IFRS requires that companies account for and report many assets and liabilities on the basis of acquisition price  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  Recently, IFRS has increasingly called for use of fair value measurements in the financial statements. LO 4 Revenue Recognition Principle: When a company agrees to perform a service or sell a product to a customer, it has a performance obligation.  Requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied (i.e., when the Co. performed the service). Expense Recognition – In practice, the approach for recognizing expenses is, “Let the expense follow the revenues.” This approach is the expense recognition principle.  Recognize expense when the work (service) or the product actually contributes to revenue.  Basic Principles of Accounting Full Disclosure Principle  Requires that companies disclose all circumstances and events that would make a difference to financial statement users. Provided through:  Financial Statements  Notes to the Financial Statements- e.g explain the items presented in the main body of the statements.  Supplementary information- e.g an expanded table containing the details  Cost Constraint Companies must weigh the costs of providing the information against the benefits that can be derived from using it.  Rule-making bodies and governmental agencies use cost- benefit analysis before making final their informational requirements.  In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it.  IFRS-based Financial Statements (IAS 1) IAS 1 Presentation of Financial Statements sets out the overall requirements for financial statements, including how they should be structured, the minimum requirements for their content and overriding concepts 50  Cont… Objective of financial statements The objective of general purpose financial statements is to provide information about the financial position, financial performance, and cash flows of an entity To meet that objective, financial statements provide information about an entity's: [IAS 1.9] Assets Liabilities Equity Income and expenses, including gains and losses Contributions by and distributions to owners (in their capacity as owners) Cash flows. 51  Components of financial statements A complete set of financial statements includes: [IAS 1.10] 1. A statement of financial position (balance sheet) at the end of the period 2. A statement of profit or loss and other comprehensive income for the period (Income statement) 3. A statement of changes in equity for the period 4. A statement of cash flows for the period 5. Notes to the financial statement, comprising a summary of significant accounting policies and other explanatory notes 6. Comparative information prescribed by the standard. 52 The End! 53