CHAPTER I

BASIC CONCEPTS and FINANCIAL STATEMENTS

I. THE ENVIRONMENT OF ACCOUNTING
1.1 INTRODUCTION
Fair presentation of financial affairs is the essence of accounting theory and practice. With the increasing
size and complexity of business enterprises and the increasing economic role of government, the
responsibility placed on accountants is greater today than ever before. This theoretical structure must be
realistic in terms of the economic environment and must be designed to meet the needs of users of financial
statements.
1.2 ENVIRONMENTAL FACTORS THAT INFLUENCE ACCOUNTING
Accounting like other social science disciplines and human activities is largely a product of its environment.
Modern accounting is the product of many influences and conditions three of which deserve special
consideration.
First accounting recognizes that people live in a world of scarce resources. Second accounting recognizes
and accepts society’s current and ethical concepts of property and other rights when determining equity
among the varying interests in an enterprise or entity. Third accounting recognizes that in highly developed,
complex economic systems, some (owners and investors) entrust the custodianship of and control over
property to others (managers). One of the results of the corporate form of organization has been the
tendency in large enterprises to divorce ownership and management
1.3 NATURE AND ENVIRONMENT OF FINANCIAL ACCOUNTING
For purposes of study and practice, the discipline of accounting is commonly divided into the following
areas or subsets: financial accounting, managerial (cost) accounting, tax accounting, and not- for- profit
(public sector) accounting. Financial accounting has been characterized as “that branch of accounting
concerned with the classification, recording, analysis, and interpretation of the overall financial position
and operating results of an organization. Financial accounting encompasses the process and decisions that
culminate in the preparation of financial statements relative to the enterprise as a whole for use by parties
both internal and external to the enterprise. The following four environmental factors, although not as basic
as the three aspects described in environmental factors that influence accounting, shape financial accounting
to a significant extent:
The many users and uses that accounting serves
The nature of economic activity
The economic activity in individual business enterprises
The means of measuring economic activity

1.4 USERS OF ACCOUNTING INFORMATION

The users of accounting information may be divided into two broad groups: internal users and external
users.
Internal users: include all the management personnel of a business enterprise who use accounting
information either for planning and controlling current operations or for formulating long-range plans and
making major business decisions.

External users: of accounting information include stock-holders, bondholders, potential investors, bankers
and other creditors, financial analysts, economists, labor unions, and numerous government agencies. The
field of financial accounting is directly related to external reporting because it provides investors and other
outsiders with the financial information they need for decision making.

1
1.5 ORGANIZATIONS AND LAWS AFFECTING FINANCIAL ACCOUNTING
Certain professional organizations, governmental agencies, and legislature acts have been extremely
influential in shaping the development of the existing body of financial accounting theory. Among the most
important of these have been the International Accounting standards, the financial Accounting standards in
U.K., the American Institute of certified public Accountants, the Association of chartered certified
Accountants (ACCA) in U.K., the American Accounting Association etc.
In this course, we will depend on the laws or principles established by financial Accounting standards Board
(FASB). So, let us see what FASB is.
Financial Accounting standards Board (FASB)
The financial Accounting standard Board was established in 1972 to develop financial accounting standards
for business enterprises and nonprofit organizations. This independent body consisted of seven full- time
members and a large supporting staff.
II. CONCEPTUAL FRAMEWORK FOR FINANCIAL ACCOUNTING AND REPORTING
An accounting theory is not something that is discovered rather, it is created, developed, or decreed on the
basis of environmental factors, intuition, authority, and acceptability because the theoretical framework
accounting is difficult to substantiate objectively or by experimentation, arguments concerning it can
degenerate into quasi – religious dogmatism. As a result, the credibility of accounting rests upon its general
recognition and acceptance by preparers, auditors, and users of financial statements. Given this, the purpose
of this chapter is to examine the nature and usefulness of a conceptual framework for financial accounting,
and discuss its components
2.1 NATURE OF A CONCEPTUAL FRAMEWORK
A conceptual framework is like a constitution. A conceptual framework for financial accounting is “a
coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that
prescribes the nature, function, and limits of financial accounting and financial statements.”
Why is a conceptual framework necessary?
First to be useful, standard setting should build on and relate to an established body of concepts and
objectives. A soundly developed conceptual framework should enable the development and issuance of a
coherent set of standards and practices built upon the same foundation. Second a conceptual framework
should increase financial statement users’ understanding of and confidence in financial reporting.
Third such a framework should enhance comparability among the financial statements of different
companies. Similar events should be similarly accounted for and reported; dissimilar events should not be.
Fourth new and emerging practical problems should be solved more quickly by referring to an existing
framework of basic theory
2.2 DEVELOPMENT OF A CONCEPTUAL FRAMEWORK
One of the initial projects of the financial Accounting standards Board (FASB) was a study designed to
identify the “broad qualitative standards for financial reporting” After extensive work on the project, the
FASB decided to expand the scope of the project to include the entire conceptual framework of financial
accounting and reporting, including objectives, qualitative characteristics, and the needs of users of
accounting information. The purpose of the conceptual framework project was to provide a sound and
consistent basis for the development of financial accounting standards.
The expanded conceptual framework project undertaken by the FASB has resulted in the publication of the
following relating to financial reporting for business enterprises:
Statement of Financial Accounting concepts No.1 (SFAC No.1), “objectives of Financial Reporting by
business Enterprises” Presents the goals and Purposes of Accounting.
SFAC No.2, “Qualitative characteristics of Accounting Information” Examines the Characteristics that
make accounting information useful.

2
SFAC No. 3, “Elements of Financial Statements of Business Enterprises” Provides definitions of items that
financial statements comprise, such as assets, liabilities, revenues and expenses.
SFAC No. 5, “Recognition and measurement in financial Statements of Business enterprises” Sets forth
fundamental recognition and measurement criteria and guidance on what information should be formally
incorporate into financial statements and when.
SFAC No. 6, Elements of Financial Statements” Replaces SFAC No.3 and expands its scope to include not
–for-profit organizations.
These issues are discussed in three levels of conceptual framework.
First level: Objectives: SFAC No. 1
Second level: - Qualitative characteristics: SFAC No. 2

Elements of financial statements SFAC No. 6

Third level: Recognition and measurement concepts. SFAC No. 5
FIRST LEVEL: OBJECTIVES OF FINANCIAL REPORTING AND FINANCIAL STATEMENTS
In general, when providing information to users of financial statements, the accounting profession has relied
on general-purpose financial statements. The intent of these is to provide useful information to various user
groups at reasonable cost. This point is important because it means that when preparing financial
statements, accountants may assume that users have a reasonable level of competence; this has an impact on
the way and the extent to which information is reported.
The objectives established by the FASB were as follows:
Financial reporting should provide information that is useful to present and potential investors and creditors
and other users in making rational investment, credit, and similar decisions.
Financial reporting should provide information to help present and potential investors and creditors and
other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or
interest and the proceeds from the sale, redemption, or maturity of securities or loans.
Financial reporting should provide information about the economic resources of an enterprise, the claims to
those resources, and the effects of transactions, events, and circumstances that change resources and claims
to those resources.
Financial reporting should provide information about an enterprise’s financial performance during a period.
The primary focus of financial reporting is information about an enterprise’s performance provided by
measures of earnings and its components.
Financial reporting should provide information about how enterprise obtains and spends cash, about its
borrowing and repayment of borrowing, about its capital transactions, including cash dividends and other
distributions of enterprise resources to owners, and about other factors that may affect an enterprise liquidity
or solvency.
Financial reporting should provide information about how management of an enterprise has discharged its
stewardship responsibility to owners (stockholders) for the use of enterprise resources interested to it.
Financial reporting should provide information that is useful to managers and directors in making decisions.
SECOND LEVEL: FUNDAMENTAL CONCEPTS
The objectives (first level) are concerned with the goals and purposes of accounting. Later, we will discuss
the ways these goals and purposes are implemented (third level). Between these two levels it is necessary to
provide certain conceptual building blocks that explain the qualitative characteristics of accounting
information and define the elements that financial statements comprise. These conceptual building blocks
from bridge between the why (the objectives) and the how (recognition and measurement) of accounting.
2.5.1. Qualitative Characteristics of Accounting Information
Choosing an acceptable accounting method, the amount and type of information to be disclosed, and the
format in which information should be presented involves determining which of several possible
alternatives provide the best (i.e. most useful) information for decision – making purposes. Financial
3
reporting is concerned, in varying degrees, with decision making by financial statement users. As a
consequence, the overriding criterion by which accounting choices can be judged is that of decision
usefulness, that is, providing information that is most useful for decision-making. To help distinguish
superior (more useful) form inferior (less useful) information, the qualitative characteristics, which make
information useful, should be considered.
2.5.1.1 Decision Makers (Users) and Understandability
Decision makers vary widely in the types of decisions they make, the methods of decision making they
employ, the information they already possess or can obtain from other sources, and their ability to process
the information. Consequently, for information to be useful there must be a connection (linkage) between it
and the users and the decisions they make. This linkage is the understandability of the information. Under
stability of financial statements, however, depends not only on the accounting’s skills and abilities to
comprehend that information. In this regard, a user’s ability could vary from being simplistic to expert.
2.5.1.2 Primary Qualities
It is generally agreed that relevance and reliability are two primary qualities that make accounting
information useful for decision making. Each of these qualities is achieved to the extent that information
incorporates specific capabilities (ingredients)
A. Relevance
Relevance is the capacity of accounting information to make a difference to the external decision makers
who use financial reports. If certain information is disregarded because it is perceived to have no bearing on
a decision, it is irrelevant to that decision.
Relevance can be evaluated according to three qualitative criteria,
Timeliness – means available to decision makers before it loses its capacity to influence their decisions.
Accounting information should be timely if it is to influence decisions, like the news of the world; state
financial information has less impact than fresh information.
Predictive value – Accounting information should be helpful to external decision makers by increasing their
ability to make predictions about the outcome of future events. Decision makers working from accounting
information that has little or no predictive value are merely speculating. For example, information about the
current level and structure of asset holdings help users to assess the entity’s ability to exploit opportunities
and react to adverse situations
Feedback value: Accounting information should be helpful to external decision makers who are confirming
past predictions or making updates, adjustments, or corrections to predictions.
B. Reliability
Reliability means that users can depend on accounting information to represent the underlying economic
conditions or events that it purports to represent. Reliability of information is a necessity for individuals
who have neither the time nor the expertise to evaluate the factual content of financial statements. It is
especially important to the independent audit process. Like relevance, reliability must meet three qualitative
criteria.
Representational faithfulness – Accounting information should represent what it purports to represent and
should ensure that the selected method of measurement has been used without error or bias. This attribute is
sometimes called Validity: - Information must give a faithful picture of the facts and circumstances
involved. Accounting information must report the economic substance of transactions, not just their form
and surface appearance.
Verifiability:- Verifiability pertains to maintenance of audit trials to information source documents that can
be checked for accuracy. It also pertains to the existence of alternative information sources as backing.
Verification implies a consensus and implies that independent measures using the same measurement
methods would reach substantially the same conclusions.
Neutrality: - Accounting information must be free from bias regarding a particular view point,
predetermined result, or particular party. Preparers of financial reports must not attempt to induce a
predetermined outcome or a particular mode of behavior (such as to purchase a company’s stock).
4
Accounting information can not be selected to favor one set of interested parties over another. It should be
factual and truthful.
Secondary Qualities
The potential use of different acceptable methods by one enterprise in different years, or by different
companies in a given year, would make comparison of financial results difficult consequently, in order to
enhance the usefulness of accounting reports, the qualities of comparability and consistency are components
of the conceptual framework. They are considered to be secondary in our hierarchy to the qualities of
relevance and reliability. If information is to be useful, it must first be relevant and reliable, but achieving
these primary qualities may require foregoing the secondary qualities. Ideally, financial accounting
information would satisfy both qualitative levels
A. Comparability: - Information that has been measured and reported in a similar manner for different
enterprise in a given year, or for the same enterprise in different years, is considered comparable. Thus,
comparability is a characteristic of the relationship between two pieces of information rather than of a
particular piece of information in itself. Comparability enables to identify the real similarities and
differences in economic phenomena because these differences and similarities have not been obscured by
the use of non-comparable methods of accounting.
B. Consistency: - This characteristic is achieved by an enterprise when it uses the same selected accounting
policies from period to period; that is, these methods are consistently applied. Consistency results in
enhancing the comparability of financial statements of an enterprise from year to year.
Consistency doesn’t mean that a company can never switch from one method of accounting to another.
Companies can change methods, but the changes are restricted to situations in which it can be demonstrated
that the newly adopted method is preferable to the old. Then the nature and affect of the accounting change,
as well as the justification for it, must be fully disclosed in the financial statements for the period in which
the change is made.
Elements of Financial Statements
An important aspect of the theoretical structure is the establishment and definition of the basic categories of
items to be included in financial statements. At present, accounting uses many terms that have peculiar and
specific meaning in the language of business. It seems necessary, therefore, to develop a basic definitional
framework for the elements of accounting. Such definitions provide guidance for identifying what to
include and what to exclude from the financial statements.
SFAC No.6 defines 10 elements of financial statements as follows:
Assets
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events. They have three essential characteristics:
They embody a future benefit that involves a capacity, singly or in combination with other assets to
contribute directly or indirectly to future net cash flows.
The entity can control access to the benefit
The transaction or event-giving rise to the entity’s right to, or control of, the benefit has already occurred
(result of past transactions).
Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular
entity to transfer assets or provide services to other entities in the future as result of past transactions or
events. They have three essential characteristics.
They embody a duty or responsibility to others that entails settlement by future transfer or use of assets,
provision of services or other yielding of economic benefits, at a specified or determinable date, on
occurrence of a specified event, or on demand.
The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it.

5
The transaction or event obligating the entity has already occurred.
Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after deducting its
liabilities. While equity in total is a residual, it includes specific categories of items, for example, types of
share capital, contributed surplus and retained earnings
Investments by owners
Are increases in net assets of a particular enterprise resulting from transfers to it from other entities of
something of value to obtain or increase ownership interests (or equity) in it?
Investments by owners are characterized as:
Cash or other assets exchanged for stock
Service performance (sometimes called sweat equity) exchanged for stock
Conversion of liabilities to equity ownership
Distributions to owners
Are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or
incurring liabilities by the enterprise to owners? They are characterized as:
Cash dividend payments or declarations
Transfer of assets to owners
Liquidating distributions (asset sale proceeds)
Conversion of equity ownership to liabilities
Revenues
Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities (or
combination of both) during a period from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central operations. The two essential characteristics
of a revenue transaction are:
It arises from the company’s primary earning activity (main stream business lines) and not from incidental
or investment transactions (assuming that the entity is a non investment company).
It is recurring
Expenses
Expenses are outflows or other using up of assets or incurrence of liabilities (or combination of both) during
a period from delivering or producing goods, rendering services, carrying out other activities that constitute
the entities ongoing major or central operations.
The essential characteristic of an expense is that it must be incurred in conjunction with the company’s
revenue-generating process. Expenditures that do not qualify as expenses must be treated as assets (future
economic benefit to be derived), as losses (no economic benefit), or as distributions to owners.
Gains
Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all
other transactions and other events and circumstances affecting the entity during a period except those that
result from revenues or investments by owners.
Losses
Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from
all other transactions and other events and circumstances affecting the entity during a period except those
that result from expenses or distributions to owners.
Comprehensive Income
Is change in equity (net assets) of an entity during a period from transactions and other events and
circumstances from non owner sources, i.e., change in equity other than resulting from investment by
owners and distribution to owners. The FASB’s new comprehensive income incorporates certain gains and
losses in its computation that are not currently included in net income capital transactions are still excluded.

6
THIRDLEVEL: RECOGNITIONANDMEASUREMENT CONCEPTS.
SFAC No 5 published in 1984, provides a set of companion directives to those in SFAC No 2. The
statements are similar in that both are aimed at promoting consistency (in how accounting information is
communicated to interested parties). SFAC N o 5 addresses six specific topic areas: Recognition criteria,
measurement criteria, environmental assumptions, implementation principles, and implementation
constraints and general purpose financial statements.
Recognition Criteria:- recognition pertains to the point in time when business transactions are recorded in
the accounting system. The term recognition is broadly defined as the process of recording and reporting an
item as an asset, liability, revenue, expense, gain, loss or change in owners’ equity. Recognition of an item
is required when all four of the following criteria are met:
Definition: the item in question must meet the definition of an element of financial statements.
Measurability: The item must have a relevant quality or attribute that is reliably measurable (historical cost,
current cost, market value, present value or net realizable value).
Reliability:- The accounting information generated by the item must be representational faithful, verifiable
(Subject to audit confirmation or second – Source collaboration) and neutral (bias – free).
Relevance – The accounting information generated by the item must be significant, that is, capable of
making a difference to external users in making decision.
Measurement Criteria – SFAC No 5 reflects that all monetary measurements will be based on nominal units
of money. However, a change in the level of inflation, which leads to significant distortions, could lead
another, more stable measurement scale.
Basic Assumptions
Statements of financial Accounting concepts No5 addresses four basic environmental assumptions that
significantly affect the recording, measuring, and reporting of accounting information. They are:
Business entity Assumption – Accounting deals with specific, identifiable business entities, each considered
an accounting unit separate and apart from its owners and from other entities. A corporation and its
stockholders are separate entities for accounting purposes. Also partnership and sole proprietorships are
treated as separate from their owners, although this separation does not hold true in a legal sense.
Under the business entity assumption, all accounting records and reports are developed from the viewpoint
of a single entity, whether it is a proprietorship, a partnership, or a corporation. The assumption is that an
individual’s transactions are distinguishable from those of the business he or she might own.
Going – Concern (continuity) Assumption –under this assumption the business entity in question is
expected not to liquidate but to continue operations for the foreseeable future. That is , it will stay in
business for a period of time sufficient to carry out contemplated operations, contracts and commitments.
This non liquidation assumption provides a conceptual basis for many of the classifications used in account.
Assets and liabilities, for example, are classified as either current or long term on the basis of this
assumption. If continuity is not assumed, the distinction between current and long – term loses its
significance, all assets and liabilities become current. Continuity supports the measurement and recording of
assets and liabilities at historical cost.
Unit - of – measure Assumption – It states that the results of a business’s economic activities are reported in
terms of a standard monetary unit throughout the financial statements. Money amounts are the language of
accounting – the common unit of measure (yardstick) enables dissimilar items, such as the cost of a ton of
coal and an account payable, to be aggregated into a single total. Example, the unit of measure in the
United States is the dollar; in Japan it is the yen, in Ethiopia it is the birr.
Unfortunately, the use of a standard monetary unit for measurement purposes poses a dilemma unlike a
yardstick, which is always the same length, a currency experiences change in value. During periods of
inflation (deflation) dollars of different values are accounted for without regard to the fact that some have
greater purchasing power than others.

7
Time – period Assumption The operating results of any business enterprise can’t be known with certainty
until the company has completed its life span and ceased doing business. In the meantime, external decision
makers require timely accounting information to satisfy their analytical needs. To meet their needs, the time
period assumption requires that changes in a business’s financial position be reported over a series of
shorter time periods.
The time – period assumption recognizes both that decision makers’ need timely financial information and
that recognition of accruals and deferrals is necessary for reporting accurate information. If a demand for
periodic reports didn’t exist during the life span of a business, accruals and deferrals would not be
necessary.
2.6.2. Basic Principles
Accounting principles assist in the recognition of revenue, expense, gain, and loss items for financial
statement reporting purposes. Income is defined as revenues plus gains minus expenses and losses. The
cost principle, the revenue principle, and the matching concept are employed in practice in the process of
determining income.
The four principles are:
1. The cost principle: Normally applied in conjunction with asset acquisitions, the cost principle specifies
that the actual acquisition cost be used for initial accounting recognition purposes. The cash – equivalent
cost of an asset is used if the asset is acquired via some means other than cash.
The cost principle assumes that assets are acquired in business transactions conducted at arm’s length, that
is, transactions between a buyer and a seller at the fair value prevailing at the time of the transaction. For
non – cash transactions conducted at arm’s length the cost principle assumes that the market value of the
resources given up in a transaction provides reliable evidence for the valuation of the item acquired.
When an asset is acquired as a gift, in exchange for stock, or in an exchange of assets, determining a
realistic cost basis can be difficult. In these situations the cost principle requires that the cost basis be based
on the market value of the assets given up or the market value of the asset received, which ever value is
more reliably determined at the time of the exchange.
When an asset is acquired with debt, such as with a note payable given in settlement for the purchase, the
cost basis is equal to the present value of the debt to be paid in the future.
2. The revenue realization principle
This principle requires the recognition and reporting of revenues in accordance with accrual basis
accounting principles. Applying the revenue principle requires that all four of the recognition criteria –
definition, measurability, reliability and relevance must be met. More generally, revenue is measured as the
market value of the resources received or the product or service given, whichever is the more reliably
determinable.
The revenue principle pertains to accrual basis accounting, not to cash basis accounting. Therefore,
completed transactions for the sale of goods or services on credit usually are recognized as revenue for the
period in which the cash is eventually collected. Furthermore, related expenses are matched with these
revenues.
3. The matching Principle
Like the revenue principle, the matching principle is predicated on accrual basis accounting, but matching
refers to the recognition of expenses. The principle implies that all expenses incurred in earning the revenue
recognized for a period should be recognized during the same period. If the revenue is carried over
(deferred) for recognition to a future period, the related expenses should also be carried over or deferred
since they are incurred in earning that revenue.

8
Application of the matching principle requires carrying on the books as asset outlays that under cash basis
accounting would be expensed at the time cash is disbursed. These expenditure are for fixed assets,
materials, purchased services and the like that are used to earn future revenue. Only later, when the revenue
is recognized, would the asset accounts be expensed. In this way revenues and related expenses would be
matched across accounting period.
4. FULL – Disclosure Principle.
This principle stipulates that the financial statements report all relevant information bearing on the
economic affairs of a business enterprise. Many items, such as executory contracts, fail to meet the
recognition criteria but must still be disclosed for relevance and complete reporting.
Additionally, the full – disclosure principle stipulates that the primary objective is to report the economic
substance of a transaction rather than merely its form. This means that substance should not be blurred by
the way the transaction is presented. The aim of full disclosure is to provide external users with the
accounting information they need to make informed investment and credit decisions. Full disclosure
requires that the accounting policies followed be explained in the notes to the financial statements.
Accounting information may be reported in the body of the financial statements, in disclosure notes to these
statements, or in supplementary schedules and other presentation formats for events that fail to meet the
recognition criteria.
Constraints
Consistency in the application of accounting principles and uniformity of accounting practice within the
profession may not be achievable in all cases. Exceptions to GAAP are allowed in special Situations
categorized according to four constraints:
1. Cost –Benefit Constraint
Underlying the cost – benefit constrain is the expectation that the benefits derived by external users of
financial statements should outweigh the costs incurred by the preparers of the information. Although it is
admittedly difficult to quantify these benefits and costs, the FASB often attempts to obtain information from
preparers on the costs of implementing a new reporting requirement. It does not, however, try to estimate
indirect costs, such as the cost of any altered allocation of resources in the economy. The cost – benefit
determination is essentially a judgment call.
2. Materiality Constraint
Materiality is defined as “the magnitude of an omission or misstatement of accounting that, in the light of
surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the omission or misstatement”
The materiality constraint is also called a threshold for recognition. The assumption is that the omission or
inclusion of immaterial facts is not likely to change or influence the decision of a rational external user.
However, the materiality threshold does not mean that small items and amounts do not have to be accounted
for or reported. For example, Fraud is an important event regardless of the size of the amount.
Materiality judgments are situation specific. An amount considered immaterial in one situation might be
material in another. The decision depends on the nature of the item, its birr amount, and the relationship of
the amount to the total amount of income, expenses, assets, or liabilities, as the case may be. Because
materiality matters tend to be case – by – case judgments, the FASB has not specified general materiality
guidelines.
3. Industry peculiarities.
One of the overriding concerns of accounting is that the information in financial statements be useful. The
problem is that certain types of accounting information might be critical for decision making in one industry
setting but not in another.
Basically, every industry has its own way of doing things, its own business practices. Under the industry
peculiarities constraint, selective exceptions to GAAP are permitted, provided there is a clear precedent in
9
the industry. Precedent is based on the uniqueness of the situation, the usefulness of the information
involved, preference of substance over form, and any possible compromise of representational faith-
fullness.
4. Conservatism
The conservatism constraint holds that when two alternative accounting methods are acceptable and both
equally satisfy the conceptual and implementation principles set out by the FASB, alternatives having the
less favorable effect on net income or total assets is preferable. The reasoning is that investors prefer
information that does not unnecessary raise expectations.
Conservatism assumes that when uncertainty exists, the users of financial statements are better served by
under –statement of net income and assets. Prime examples include valuing inventories at the lower of cost
or current market and minimizing the estimated service life and residual value of depreciable assets.
III. CASH FLOWS AND INCOME MEASUREMENT
INTRODUCTION
Investors and creditors are interested in cash – flow information when evaluating investment opportunities.
Accrual information helps investors estimate future net cash flows and the risks associated with these flows.
It does so through the accruals included in the income statement and the balance sheet (such as the bad debt
allowance), and in general through the matching process that leads to the accrual and the deferral of
expenses and revenues.
Accountants assume that a business enterprise has continuous existence. Therefore, they record the prospect
of future cash inflows as increase in assets and as revenue whenever they have reliable evidence of the
amount of the future cash receipt. Cash inflows often occur before an enterprise has performed its part of a
contract. In this case, an increase in asset (cash) is recorded, but a liability is recognized instead of revenue.
The liability indicates an obligation on the part of the enterprise to perform in accordance with the contact.
When performance is completed the revenue is recognized i.e. a debit to liability and a credit to revenue is
recorded. Thus, cash inflows are closely related to revenue realization; however, the assumptions underlying
the timing of revenue realization do not always permit cash inflows and revenue to be recorded in the same
accounting period.
Similarly, cash outflows are closely related to expense of a business enterprise; however, cash outflows and
expenses may not be recorded in the same accounting period. For example, enterprises frequently acquire
for cash in one period asset that will be productive over several future periods; and assets that are productive
only during the current period often are acquired in exchange for a promise to pay cash in a future period.
ACCRUAL BASIS OF ACCOUNTING
Accrual basis of accounting is a system of accounting that requires an event that alters the economic status
of a firm as represented in its financial statements be recorded (recognized) in the period in which the event
occurs rather than in the period when cash changes hands.
When accrual basis of accounting is used, revenues are reported in the income statement when they are
earned and expenses are reported in the income statement when they are incurred, without regard to the
timing of cash receipt or payment. When we say revenues are earned it means the service is rendered or the
items are sold, and when we say expenses are incurred, it means that employees are engaged or services are
used or items are consumed.
Under the accrual basis of accounting, the accounting records are adjusted periodically to ensure that all
assets and liabilities (and thus revenue and expenses) are correctly stated. That is, the accrual basis of
accounting is in line with the matching principle therefore net income under this basis is determined as
realized revenue less incurred expenses.

10
The general rule for determining the cash flows received from any revenue or paid for any expenses (except
depreciation is to determine the potential cash payments or receipts and deduct the amount not paid or
received. The application of the general rule varies with the type of asset or liability account as shown
below:
Type of account Potential payment of Receipt not paid or received Result
Prepaid expense Ending balance + Expense for the period – Beginning balance = cash payment
for expenses

Unearned cash Receipts

Revenue Ending balance + Revenue for the period – Beginning balance = from revenues

Accrued Cash payment

Liability Beginning balance + Expense for the period – Ending balance = for expenses

Accrued Cash receipts

Receivable Beginning balance + revenue for the period – ending balance = from revenues.

For instance, assume that on May 31 a company had a balance of Br 480 in prepaid Insurance and that on
June 30 the balance was Br. 670. If the insurance expense during June was Br.120, the amount of cash
expended (paid) on insurance during June can be computed as follows:
Prepaid Insurance at June 30……………………………………..Br. 670
Insurance Expense during June………………………………….. 120
Potential cash payments for insurance…………………………....Br.790
Less: prepaid insurance at May 31……………………………….. 480
Cash payments for insurance during June………………………… 310
The beginning balance is deducted because it was paid in a prior accounting period. Note that the cash
payments equal the expense plus the increase in the balance of prepaid insurance account [Br. 120 +(Br. 670
– Br 480) = Br. 310]
CASH BASIS OF ACCOUNTING
It is an accounting system based on the timing of cash payments and receipts. Under the cash basis of
accounting revenue is recorded only when cash is received and expenses are recorded only when cash is
paid. Under the cash basis of accounting, net income is determined as collection of revenue minus payment
of expenses. Financial statements prepared under the cash basis of accounting do not represent the financial
position or operating results of an enterprise in conformity with GAAP since it is not compatible with the
matching principle. As a result, A strict cash basis of accounting seldom is found in practice, but a modified
cash basis (a mixed cash – accrual basis)
Under the modified cash basis of accounting, which is mostly used for income tax purpose, the entire cost of
property having an economic life of more than one year may not be deduced in the year of acquisition. It
must be treated as an asset to be depreciated over its economic life. Expenses such as rent or advertising
paid in advance also are regarded as assets and are deductible only in the year or years to which they apply.
Expenses paid after the year in which incurred are deductible only in the year paid. Revenue is reported in
the year received.
However, in any business enterprise on which the purchase, production, or sale of merchandise is a
significant factor, these transactions must be reported on the accrual basis (in the period earned or incurred).
Thus for a merchandising enterprise the revenue from sale, the cost of goods sold, and the gross profit on
sales will be the same under the accrual basis of accounting as under the modified cash basis of accounting.

11
 Illustration: The difference between the cash basis and accrual basis of accounting is illustrated below for
SKY Company, which maintains accounting records on a cash basis.
During year 10, SKY Co. collected Br. 150,000 from its clients and paid Br. 80,000 for operating expenses,
resulting in a cash basis net income of Br. 70,000. SKY company’s fees receivables, accrued liabilities, and
short –term prepayments on January 1 and on December 31,year 10, were as follows:
January 1,year 10 December 31,year 10.
Fees receivable …………………………Br. 18,200 Br. 37,000
Accrued liabilities…………………………….6,200 4,000
Short – term prepayments…………………….3,500 2,500
A working paper showing the necessary adjustments to restate SKY Company’s income statement from the
cash basis of accounting to accrual basis of accounting is illustrated below:

SKY Company
Working paper to restate Income Statement from cash basis to Accrual basis.
For the Year ended December 31, year 10
Income statement Adjustments to Income
under restate to statement
cash basis of Accrual basis under accrual
accounting of accounting Basis of
accounting
Added Deducted
Revenue from fees received in cash Br. 150,000
Add: Fee Receivables, Dec. 31,year 10 Br.37,000
Less: Fees receivable, Jan.1, year 10 Br. 18,200 Br. 168,800
Operating expenses paid in cash Br. 80,000
Add: Accrued liabilities, Dec.31,year 10 4,000
Short – term prepayments, Jan1,year10 3,500
Less: Accrued liabilities, Jan 1, year 10 6,200
Short – term prepayments, Dec 31, year 10 _______________ 2,500 78,800
Net income under cash basis of accounting Br. 70,000
Net income under accrual basis of accounting Br. 90,000
The adjustments to restate operating expenses and fees revenue from the cash basis of accounting to accrual
basis of accounting are explained below:
The amount of accrued liabilities on December 31, year 10, representing expenses incurred in year 10 that
will be paid in year 11, and the amount of short – term prepayments on January 1, year 10, represents
services paid for in year 9 that were consumed in year 10. Therefore, both amounts are added to the amount
of cash paid to restate the operating expenses for year 10 to the accrual basis of accounting.
The amount of accrued liabilities on January 1, year 10, represents expenses of year 9 paid for in year 10,
and the amount of short – term prepayments on December 31, year 10, represents cash outlays in year 10 for
services that will be consumed in year 11. Therefore, both amounts are deducted from the amount of cash
paid to restate the operating expenses for year 10 to the accrual basis of accounting.
Because the revenue from fees under the cash basis does not include the fees receivable on December 31,
which were realized in year 10, this amount is added to the cash collected in the restatement of revenue
from fees to the accrual basis of accounting. Because fees receivable on January 1 were realized in year 9
and collected in year 10, this amount is subtracted from cash collections in the restatement of revenue from

12
fees to the accrual basis of accounting. That is : Fees received (collected) + Ending Fees receivable =
Beginning receivable
= 150,000 + 37,000 – 18,200
=Br.168, 800 = Fees revenue under accrual basis of accounting.
General Illustration
A Summary of operating results for FENOTE Company for year 2 is presented below:
Cash collected from customers………………………………Br. 466,000
Cash paid for merchandise suppliers……………………………..268,200
Cash paid for operating expenses……………………………….... 79,400
The following data were taken form comparative balance sheets prepared on the accrual basis of accounting.
December 31, year1 December 31,year 2
Accounts receivable…………………………..Br. 52,400………………………Br. 48,600
Inventories………………………………………...75,000…………………………..72,100
Short – term prepayments………………………… 4,100……………………………9,500
Accounts payable (merchandise suppliers)………32,000…………………………..37,400
Accrued expense ……………………………….. 2,800 ………………………… 3,200
Accumulated depreciation (there were no
Disposal of plant assets during year 2)………… 50,000…………………………..74,000
Instructions:
Prepare income statement for FENOTE company for year 2 under
the accrual basis of accounting.
The modified cash basis of accounting where by operating expenses (other than depreciation) are computed
on the cash basis. FENOTE Company’s income is taxed at 45%

Solution: (a) FENOTE Company

Income statement
For the year ended Dec. 31, year 2
(a) (b)
Accrual basis Modified cash basis
of Accounting of accounting
Sales (46,600 + 48,600 – 52,400)………..Br. 462,200…………….. Br. 462,200
Cost of merchandise sold:
Beginning Inventory………………………………..Br. 75,000………………75,000
Add: Purchases (268,000 + 31,400 – 32,000)……… 273,600…………… 273,600
Cost of merchandise available for sale……………….348,600……………...348,600
Less: Ending inventory……………………………….(72,100)……………..(72,100)
Cost of merchandise sold…………………………....(276,500)…………….(276,500)
Gross profit on sales…………………………………Br. 185,700……………Br. 185,700
Operating Expense (79,400+4100 – 9500 +3200 – 2800)… 98,400..(79,400+24,000)..103,400
Income before income tax…………………………………..87,300…………………82,300
Income tax Expense………………………………………...39,285…………………37,035
Net income…………………………………………… Br. 48,015………………Br.45,265
N.B.
* Cash receipt form customers……………………………………XX
Plus: Cash discount…………………………………..XX
Sales returns and allowance…………………..XX
Accounts written – off………………………..XX
Ending Accounts receivable………………… XX……XX
13
Less: Beginning Accounts receivable…………………………(XX) Under accrual &modified
Gross sales……………………………………………………..XX cash basis
* Cash paid for merchandise suppliers……………………….. XX
Add: Ending Accounts payable………………………………..XX
Less: Beginning Accounts Payable………………………… (XX)
Purchase under accrual and modified cash basis………………………XX
*Cash paid for operating expenses…………………………….............XX
Add: Beginning prepaid expenses……………………………XX
Ending accrued expenses……………………………...XX
Less: Ending prepaid expenses……………………………….XX
Beginning accrued expenses…………………………..XX
Operating expenses under accrual basis……………………………….XX
Rent receipts…………………………………………………...XX
Add: Ending rent receivable…………………………………...XX
Beginning unearned rent…………………………………XX
Less: Ending unearned rent…………………………………….XX
Beginning rent receivable……………………………… XX
Rent revenue……………………………………………………XX
MODEL EXAMINATION QUESTIONS
I. Exercises
1. Cash paid by Life Corporation for operating expenses during the month of October, year 10, totaled Br.
16,480. Short –term prepayments and accrued liabilities were as follows:
October1,year 10 December 31,yeat 10
Short – term prepayments………………………..Br. 1,240……………………..Br. 1,690
Accrued liabilities……………………………………2,570…………………………1,820
Required: Compute LIFE Corporation’s operating expenses for the month of October,
Year 10, under the accrual basis of accounting
2. The following summarized data were taken from the records of Peppe Company at December 31, 1992,
end of the accounting year.
Sales: 1992 cash sales were Br. 150,000, and 1992 credit sales were Br. 120,000.
Cash collections during 1992: Br. 40,000 on 1991 credit sales, Br. 80,000
Expenses: 1992 cash expenses were Br 180,000, and 1992 credit expenses were Br. 70,000
Cash payments during 1992: Br. 20,000 for 1991 credit expenses, Br. 40,000 for 1992 credit expenses, and
Br. 9000 for 1993 expenses (paid in advance)

Required (1). Complete the following statements for 1992 as a basis for evaluating the
difference between cash and accrual accounting
Cash basis Accrual basis
Sales revenue………………………………….Br________ Br. _______
Expenses…………………………………………________ _______
Net income………………………………………_________ ________
(2) Which basis is in conformity with GAAP? Explain the reasons for your answer.
3. SOYN Company owns a small building with offices that it rents under contracts calling for payments
either monthly or yearly in advance. However, some tenants are delinquent in their rent payments. During

14
year, SOYN received Br. 20,000 form tenants. SOYN’S ledger account balances for year 2 included the
following.
Jan 1,year 2 DEC. 31, year 2
Rent Receivable…………………………….Br. 2,400………………Br. 3,100
Unearned Rent…………………………………8,000……………………6,000
Required: Complete SOYN Company’s rent revenue for year 2 under the accrual basis of accounting
Unearned revenue was Br.1,300 at the end of November, and Br.900 at the end of December. Service
revenue. Was Br. 5,100 for the month of December. How much cash was received for service provided
during December?
The income statement for Joy company included the following expenses for 1990
Rent Expense………………….Br. 5,200
Interest Expense………………….. 7,800
Salaries Expense………………….83,700
Listed below are the related balance sheet account balances at year end for last year (1989) and this year
(1990)
Last Year. This Year.
Prepaid rent……………………___ ………………..Br. 900
Interest payable……………..Br. 1,200 __
Salaries Payable………………...5,000………………….9,600
Required:
Compute the cash paid for rent during 1990
Compute the cash paid for interest during 1990.
Compute the cash paid for salaries during 1990.

15