Unit One

Introduction to Financial Accounting

Unit Objectives
The main objective of this unit is introducing the basics of financial accounting.
Specifically, after completing this unit, students will be ableto:
» Identify the users and purpose of accountinginformation
» Understand how International Financial Accounting Standards (IFRS) areprepared
» Identify the elements of conceptual framework in IFRS
» Distinguish between cash base and Accrual baseaccounting
» Recognize ethics in accountingprofession
1.1 Accounting and Users of AccountingInformation
Accounting is the universal language of business. As a financial information system, accounting
is a process of three activities: identifying, recording, and communicating the economic events of
an organization (business or non-business) to interested users of the information. Thus, the
essential characteristics of accounting include (1) the identification, measurement, and
communication of financial information about (2) economic entities to (3) interested parties.
Several specialized fields in accounting have evolved as a result of the ever increasing rapid
technological advances and accelerated economic growth of which financial accounting is one

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. Financial statements are the
principal means through which a company communicates its financial information to those
outside it. 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 corporate 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, regulatory rule, or custom. Or, they may supply it because management wishes
to disclose itvoluntarily.

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The objective of general-purpose financial reporting is to provide financial information about the
reporting entity that is useful to present to 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. Information that is decision-useful to capital providers (investors) may also be useful to
other users of financial reporting who are not investors. Let‘s examine each of the elements of
thisobjective.

General-purpose financial statements provide financial reporting information to a wide variety of

users. For example, when Habesha Cement Share Company issues its financial statements, these
statements help shareholders, creditors, suppliers, employees, and regulators to better understand
its financial position and related performance. Habesha Cement Share Company users need this
type of information to make effective decisions. To be cost-effective in providing this
information, general-purpose financial statements are most appropriate. In other words, general-
purpose financial statements provide at the least cost the most useful information possible
.
The objective of financial reporting identifies investors and creditors as the primary user group
for general-purpose financial statements. Identifying investors and creditors as the primary user
group provides an important focus of general-purpose financial reporting. For example, when
Habesha Cement Share Company issues its financial statements, its primary focus is on investors
and creditors because they have the most critical and immediate need for information in financial
reports. Investors and creditors need this financial information to assess Habesha Cement Share
Company‘s ability to generate net cash inflows and to understand management‘s ability to
protect and enhance the assets of the company, which will be used to generate future net cash
inflows. As a result, the primary user groups are not management, regulators, or some other non-
investorgroup.

As part of the objective of general-purpose financial reporting, an entity perspective is adopted.

Companies are viewed as separate and distinct from their owners (present shareholders) using
this perspective. The assets of Habesha Cement Share Company are viewed as assets of the
company and not of a specific creditor or shareholder. Rather, these investors have claims on
Habesha‘s assets in the form of liability or equity claims. The entity perspective is consistent
with the present business environment where most companies engaged in financial reporting
have substance distinct from their investors (both shareholders and creditors). Thus, a
perspective that financial reporting should be focused only on the needs of shareholders often
referred to as the proprietary perspective is not consideredappropriate.

Investors are interested in financial reporting because it provides information that is useful for
making decisions (referred to as the decision-usefulness approach). As indicated earlier, when
making these decisions, investors are interested in assessing (1) the company‘s ability to generate

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 net cash inflows and (2) management‘s ability to protect and enhance the capital providers‘
investments. Financial reporting should therefore help investors assess the amounts, timing, and
uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the
sale, redemption, or maturity of securities or loans. In order for investors to make these
assessments, the economic resources of an enterprise, the claims to those resources and the
changes in them must be understood. Financial statements and related explanations should be a
primary source for determining this information. The emphasis on ―assessing cash flow
prospects‖ does not mean that the cash basis is preferred over the accrual basis of accounting.
Information based on accrual accounting generally better indicates a company‘s present and
continuing ability to generate favorable cash flows than do information limited to the financial
effects of cash receipts and payments.

1.2 International Financial Reporting Standard (IFRS)

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
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, United Kingdom, and is called the International Accounting
Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS),
which are used in many countries. IFRS is presently used or permitted in over 140 countries
including Ethiopia and is rapidly gaining acceptance in other countries as well.

The IASB was preceded by the International Accounting Standards Committee (IASC), which
came into existence on June 29, 1973, as a result of an agreement by professional accountancy
bodies in Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United
Kingdom and Ireland, and the United States. A revised agreement and constitution was signed in
November 1982 and has been updated most recently in 2009. The constitution mandates that all
standards and interpretations issued under previous constitutions continue to be applicable unless
and until they are amended or withdrawn. When the term IFRS is used in this module, it includes
standards and interpretations approved by the IASB, and International Accounting Standards
(IAS) and SIC interpretations issued under the previous constitutions.

The followings are the currently working 15 IFRS and 28 IAS standards, totally 43 which are
commonly called IFRS:

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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 theseorganizations.
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 financialstatements.
3. The IFRS Advisory Council (the Advisory Council) provides advice and counsel to the
IASB on major policies and technicalissues.
4. The IFRS Interpretations Committee assists the IASB through the timely identification,
discussion, and resolution of financial reporting issues within the framework ofIFRS.

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. The figure below shows the organizational structure for
the setting of international accountingstandards.

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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. To implement its
due process, the IASB follows specific steps to develop a typical IFRS, as shown in the figure
below.

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Furthermore, the characteristics of the IASB, as shown below, reinforce the importance of an
open, transparent, and independent due process.

Membership: The Board consists of 16 members. Members are well-paid and appointed for
five-year renewable terms. The 16 members come from different countries.
Autonomy: The IASB is not part of any other professional organization. It is appointed by and
answerable only to the IFRS Foundation.
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.
Voting: Nine of 16 votes are needed to issue a new IFRS. With these characteristics, the IASB
and its members will be insulated as much as possible from the political process, favored
industries, and national or cultural bias.

The IASB issues three major types of pronouncements:

1. International Financial Reporting Standards
Financial accounting standards issued by the IASB are referred to as International Financial
Reporting Standards (IFRS). The IASB has issued 15 of these standards to date, covering such
subjects as business combinations and share-based payments. 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 ofIFRS.

Qualitative Characteristics of Accounting Information

Qualitative characteristics are either fundamental or enhancing characteristics, 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.

5. FundamentalCharacteristics
A. 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, orboth.
1. Financial information has predictive value if it has value as an input to predictive
processes used by investors to form their own expectations about thefuture.
2. When relevant information also helps users confirm or correct prior expectations; ithas

11 Financial and Managerial Accounting

 confirmatoryvalue.
3. 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 discloseit.
B. 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. To be a faithful representation, information must be complete, neutral, and free of
material error.
1. Completeness: Completeness means that all the information that is necessary for
faithful representation is provided. An omission can cause information to be falseor
misleading and thus not be helpful to the users of financialreports.
2. 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 overridingconsideration.
3. Free from Error: An information item that is free from error will be a moreaccurate
(faithful) representation of a financialitem
2. Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more-useful information from less-useful
information. Enhancing characteristics, include; comparability, verifiability, timeliness, and
understandability.
1. 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. 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 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 thechange.
2. Verifiability: Verifiability occurs when independent measurers, using thesame
methods, obtain similarresults.
3. Timeliness: Timeliness means having information available to decision-makers before it
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 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 itsusefulness.
4. Understandability: Decision-makers vary widely in the types of decisions they make,
how they make decisions, the information they already possess or can obtain from other
sources, and their ability to process the information. For information to be useful there
must be a connection (linkage) between these users and the decisions they make. This
link, understandability, is the quality of information that lets reasonably informed users
sees its significance. Understandability is enhanced when information is classified,
characterized, and presented clearly andconcisely.

1.3 Cash Base Vs Accrual Base of Accounting

Most companies use accrual-basis accounting: They recognize revenue when the performance
obligation is satisfied and expenses in the period incurred, without regard to the time of receipt
or payment of cash. Some small companies and the average individual taxpayer, however, use a
strict or modified cash-basis approach. Under the strict cash basis, companies record revenue
only when they receive cash, and they record expenses only when they disperse cash.
Determining income on the cash basis rests upon collecting revenue and paying expenses. The
cash basis ignores two principles: the revenue recognition principle and the expense recognition
principle. Consequently, cash-basis financial statements are not in conformity withIFRS.

Illustration: Assume that Quality Contractor signs an agreement to construct a garage for
22,000. In January, Quality begins construction, incurs costs of 18,000 on credit, and by the end
of January delivers a finished garage to the buyer. In February, Quality collects 22,000 cash from
the customer. In March, Quality pays the 18,000 due to the creditors. The following tables show
the net incomes for each month under cash basis accounting and accrual-basis accounting.

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For the three months combined, total net income is the same under both cash-basis accounting
and accrual-basis accounting. The difference is in the timing of revenues and expenses. The basis
of accounting also affects the statement of financial position. The following table shows Quality
Contractor‘s statements of financial position at each month-end under the cash basis and the
accrual basis.

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 Analysis of Quality‘s income statements and statements of financial position
shows the ways in which cash-basis accounting is inconsistent with basic
accounting theory.

 The cash basis understates revenues and assets from the construction and
delivery of the garage in January. It ignores the 22,000 of accounts
receivable, representing a near-term future cashinflow.
 The cash basis understates expenses incurred with the construction of the
garage and the liability outstanding at the end of January. It ignores the
18,000 of accounts payable, representing a near-term future cashoutflow.
 The cash basis understates equity in January by not recognizing the
revenues and the asset until February. It also overstates equity in February
by not recognizing the expenses and the liability until March. In short,
cash-basis accounting violates the accrual concept underlying
financialreporting.

The modified cash basis is a mixture of the cash basis and the accrual basis. It is
based on the strict cash basis but with modifications that have substantial support,
such as capitalizing and depreciating plant assets or recording inventory. This
method is often followed by professional services firms (doctors, lawyers,
accountants, consultants) and by retail, real estate, and agricultural operations.

Conversion from Cash Basis to Accrual Basis

Not infrequently, companies want to convert a cash basis or a modified cash basis
set of financial statements to the accrual basis for presentation to investors and
creditors. To illustrate this conversion, assume that Dr. Diane Windsor, like many
small business owners, keeps her accounting records on a cash basis. In the year
2015, Dr. Windsor received 300,000 from her patients and paid 170,000 for
operating expenses, resulting in an excess of cash receipts over disbursements of
130,000 (300,000 -170,000). At January 1 and December 31, 2015, she has
accounts receivable, unearned service revenue, accrued liabilities, and prepaid
expenses as shown in tablebelow.

Service Revenue Computation

To convert the amount of cash received from patients to service revenue on an
accrual basis, we must consider changes in accounts receivable and unearned

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 service revenue during the year. Accounts receivable at the beginning of the year
represents revenues recognized last year that are collected this year. Ending
accounts receivable indicates revenues recognized this year that are not yet
collected. Therefore, to compute revenue on an accrual basis, we subtract
beginning accounts receivable and add ending accounts receivable, as the formula
below shows

Similarly, beginning unearned service revenue represents cash received last year
for revenues recognized this year. Ending unearned service revenue results from
collections this year that will be recognized as revenue next year. Therefore, to
compute revenue on an accrual basis, we add beginning unearned service revenue
and subtract ending unearned service revenue, as the formula belowshows

Therefore, for Dr. Windsor‘s dental practice, to convert cash collected from
customers to service revenue on an accrual basis, we would make the
computations shown in below

Operating Expense Computation

To convert cash paid for operating expenses during the year to operating expenses
on an accrual basis, we must consider changes in prepaid expenses and accrued
liabilities. First, we need to recognize as this year‘s expenses the amount of
beginning prepaid expenses. (The cash payment for these occurred last year.)
Therefore, to arrive at operating expense on an accrual basis, we add the beginning
prepaid expenses balance to cash paid for operating expenses. Conversely, ending
prepaid expenses result from cash payments made this year for expenses to be
reported next year. (Under the accrual basis, Dr. Windsor would have deferred
recognizing these payments as expenses until a future period.) To convert these
cash payments to operating expenses on an accrual basis, we deduct ending
prepaid expenses from cash paid for expenses, as the formula in belowshows.

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 Similarly, beginning accrued liabilities result from expenses recognized last year
that require cash payments this year. Ending accrued liabilities relate to expenses
recognized this year that have not been paid. To arrive at expense on an accrual
basis, we deduct beginning accrued liabilities and add ending accrued liabilities to
cash paid for expenses, as the formula below shows.

Therefore, for Dr. Windsor‘s dental practice, to convert cash paid for operating
expenses to operating expenses on an accrual basis, we would make the
computations shown in table below.

Using this approach, we adjust collections and disbursements on a cash basis to revenue
and expense on an accrual basis, to arrive at accrual net income. In any conversion from
the cash basis to the accrual basis, depreciation or amortization is an additional expense
in arriving at net income on an accrual basis.

Theoretical Weaknesses of the Cash Basis

The cash basis reports exactly when cash is received and when cash is disbursed. To
many people that information represents something concrete. Isn‘t cash what it is all
about? Does it make sense to invent something, design it, produce it, market and sell it, if
you aren‘t going to getcashforitintheend?Manyfrequently
say,―Cashistherealbottomline,‖andalso,―Cashis
theoilthatlubricatestheeconomy.‖Ifso,thenwhatisthemeritofaccrualaccounting?

Today‘s economy is considerably more lubricated by credit than by cash. The accrual
basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors,
creditors, and other decision-makers seek timely information about a company‘s future
cash flows. Accrual-basis accounting provides this information by reporting the cash
inflows and outflows associated with earnings activities as soon as these companies can
estimate these cash flows with an acceptable degree of certainty. Receivables and
payables are forecasters of future cash inflows and outflows. In other words, accrual-
basis accounting aids in predicting future cash flows by reporting transactions and other
events with cash consequences at the time the transactions and events occur, rather than
when the cash is received and paid.

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 1.4 Ethics in FinancialAccounting
In accounting, as in other areas of business, we frequently encounter ethical dilemmas.
Some of these dilemmas are simple and easy to resolve. However, many are not,
requiring difficult
choicesamongallowablealternatives.Companiesthatconcentrateon―maximizingthebottom
line,‖―facing the challenges of competition,‖and ―stressing short-term
results‖placeaccountantsinanenvironmentofconflictandpressure.Basicquestionssuchas,―Isth
iswayof communicatingfinancialinformationgoodorbad?‖―Isitrightorwrong?
‖and―WhatshouldI do in the circumstance?‖ cannot always be answered by simply
adhering to IFRS or following the rules of the profession. Technical competence is not
enough when encountering ethical decisions.

The followings are ethical principles to help sensitize you to the type of situations
you may encounter in the performance of your professional responsibility.

 Integrity: A professional accountant should be straightforward and honest in all

professional and businessrelationships
 Objectivity: A professional accountant should not allow bias, conflict of interest or
undue influence of others to override professional or businessjudgments.
 Professional Competence and Due Care: A professional accountant has a
continuing duty to maintain professional knowledge and skill at the level required to
ensure that a client or employer receives competent professional service based on
current developments in practice, legislation and techniques. A professional
accountant should act diligently and in accordance with applicable technical and
professional standards when providing professionalservices.
 Confidentiality: A professional accountant should respect the confidentiality of
information acquired as a result of professional and business relationships and should
not disclose any such information to third parties without proper and specific
authority unless there is a legal or professional right or duty to disclose. Confidential
information acquired as a result of professional and business relationships should not
be used for the personal advantage of the professional accountant or thirdparties.
 Professional Behavior: A professional accountant should comply with relevant laws
and regulations and should avoid any action that discredits theprofession
Unit Summery
 Accounting provides reliable, relevant, and timely information to managers,
investors, and creditors to allow resource allocation to the most efficient
enterprises. Accounting also provides measurements of efficiency
(profitability) and financial soundness. Companies most frequently provide (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
18 Financial and Managerial Accounting
 of changes in equity. 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. Information that is decision-useful to
investors may also be useful to other users of financial reporting who are
notinvestors.
 The International Accounting Standards Board (IASB) is the leading
international accounting standard-setting organization. Its mission is to
develop, in the public interest, a single set of high-quality and understandable
International Financial Reporting Standards (IFRS) for general-purpose
financial statements. Standards issued by the IASB have been adopted by over
140 countries worldwide, and all publicly traded European companies must use
IFRS. IFRS is comprised of (a) International Financial Reporting Standards,
(b) International Accounting Standards, and (c) interpretations issued by the
IFRS Interpretations Committee or the former Standing Interpretations
Committee (SIC). In the absence of a standard or an interpretation, other
accounting literature, including that contained in the Conceptual Framework
for Financial Reporting and recent pronouncements of other standard-setting
bodies that use a similar conceptual framework can beapplied.
 The accounting profession needs a conceptual framework to (1) build on and
relate to an established body of concepts and objectives, (2) provide a
framework for solving new and emerging practical problems, (3) increase
financial statement users‘ understanding of and confidence in financial
reporting, and (4) enhance comparability among companies‘ financial
statements. The conceptual framework prepared by IASB summarizes
objectives of financial reporting, qualitative characteristics, basic financial
statements, assumptions, principles and constraints.
 There are two basis of accounting in connection to revenue and expense
recognition. The accrual basis recognize revenue when the performance
obligation is satisfied and expenses in the period incurred, without regard to the
time of receipt or payment of cash. Under the strict cash basis, companies
record revenue only when they receive cash, and they record expenses only
when they dispersecash.
 The fundamental ethical standards that profession accounts should obey
include: Integrity, Objectivity, Professional Competence and due care,
Confidentiality and professional behavior.

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