LESSON 1

ACCOUNTING AND CONCEPTUAL FRAMEWORK

Introduction
In this first lesson, we will try to understand what is accounting, Framework of accounting,
objectives and purpose of accounting, Fundamental accounting concepts and limitations of
accounting.
1.2 Lesson Learning Outcomes
By the end of this lesson, you will be able to:
1.2.1 Explain the meaning of accounting and Usefulness of accounting
1.2.2 Discuss the conceptual framework of accounting
1.2.3 State the objectives of general purpose financial reporting
1.2.4 Describe the nature of financial statements and the reporting entity
1.2.5 Explain limitations of accounting.
1.2.1 Meaning of Accounting
Accounting is the process of identifying, measuring, and communicating economic
information to permit informed judgments and decisions by users of the information.
The accounting is the art of recording, classifying, reporting, and interpreting the financial
data of an organization.
Usefulness of Accounting
The main usefulness of accounting can be given as follows:
1. The accounting keeps a systematic and permanent record of all financial transactions of a
business.
2. The accounting keeps a record of revenues and expenses so that the net results of the
business can be quickly known for any period.
3. The accounting keeps a record of assets and liabilities projecting the financial position of
the business at any moment of time.
4. The accounting protects the property of the business by designing the required system of
accounting.
5. The accounting keeps a control on expenses to minimize the same.
6. The accounting provides Information for meeting various legal requirements such as
realization of the income tax purpose.

1.2.2 Conceptual Framework of Accounting

Conceptual framework is a statement of generally accepted theoretical principles which
form the frame of reference for financial reporting.
Also it is a constitution, 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.
The purpose of the Conceptual Framework is:
1. To assist the IASB in the development of future accounting standards and in its
review of existing accounting standards, ensuring consistency across standards.
2. To assist the IASB in promoting harmonisation of regulations, accounting standards
and procedures relating to the presentation of financial statements by providing a
basis for reducing the number of alternative accounting treatments permitted by
accounting standards.
3. To assist national standard-setting bodies in developing national accounting standards.
4. To assist preparers of financial statements in applying international financial reporting
standards and in dealing with topics that has yet to form the subject of an accounting
standard.
 5. To assist users of financial statements in interpreting the information contained in
financial statements prepared in compliance with international financial reporting
standards.
6. To assist auditors in forming an opinion on whether financial statements comply with
international accounting standards.
7. To provide those who are interested in the work of the IASB with information about
its approach to the formulation of accounting standards.

The Framework
Scope
The Framework addresses:
 The objective of general purpose financial reporting
 Qualitative characteristics of useful financial information
 Financial statements and the reporting entity
 the elements of financial statements
 recognition and de recognition
 measurement
 presentation and disclosure
 concepts of capital and capital maintenance

1.2.3 The Objective of general purpose financial reporting

The primary users of general purpose financial reporting are present and potential investors,
lenders and other creditors, who use that information to make decisions about buying,
selling or holding equity or debt instruments, providing or settling loans or other forms of
credit, or exercising rights to vote on, or otherwise influence, management’s actions that
affect the use of the entity’s economic resources.

The primary users need information about the resources of the entity not only to assess an
entity's prospects for future net cash inflows but also how effectively and efficiently
management has discharged their responsibilities to use the entity's existing resources (i.e.,
stewardship).

The IFRS Framework notes that general purpose financial reports cannot provide all the
information that users may need to make economic decisions. They will need to consider
pertinent information from other sources as well.

The IFRS Framework notes that other parties, including prudential and market regulators,
may find general purpose financial reports useful. However, these are not considered a
primary user and general purpose financial reports are not primarily directed to regulators or
other parties.

Information about a reporting entity's economic resources, claims, and changes in

resources and claims
Economic resources and claims
Information about the nature and amounts of a reporting entity's economic resources and
claims assists users to assess that entity's financial strengths and weaknesses; to assess
liquidity and solvency, and its need and ability to obtain financing. Information about the
claims and payment requirements assists users to predict how future cash flows will be
distributed among those with a claim on the reporting entity.
A reporting entity's economic resources and claims are reported in the statement of financial
position.
Changes in economic resources and claims
Changes in a reporting entity's economic resources and claims result from that entity's
performance and from other events or transactions such as issuing debt or equity
instruments. Users need to be able to distinguish between both of these changes.
Financial performance reflected by accrual accounting
Information about a reporting entity's financial performance during a period, representing
changes in economic resources and claims other than those obtained directly from investors
and creditors, is useful in assessing the entity's past and future ability to generate net cash
inflows. Such information may also indicate the extent to which general economic events
have changed the entity's ability to generate future cash inflows.
The changes in an entity's economic resources and claims are presented in the statement of
comprehensive income.
Financial performance reflected by past cash flows
Information about a reporting entity's cash flows during the reporting period also assists
users to assess the entity's ability to generate future net cash inflows and to assess
management’s stewardship of the entity’s economic resources. This information indicates
how the entity obtains and spends cash, including information about its borrowing and
repayment of debt, cash dividends to shareholders, etc.
The changes in the entity's cash flows are presented in the statement of cash flows.
Changes in economic resources and claims not resulting from financial performance
Information about changes in an entity's economic resources and claims resulting from
events and transactions other than financial performance, such as the issue of equity
instruments or distributions of cash or other assets to shareholders is necessary to complete
the picture of the total change in the entity's economic resources and claims.
The changes in an entity's economic resources and claims not resulting from financial
performance is presented in the statement of changes in equity.
Information about use of the entity’s economic resources
Information about the use of the entity's economic resources also indicates how efficiently
and effectively the reporting entity’s management has used these resources in its
stewardship of those resources. Such information is also useful for predicting how
efficiently and effectively management will use the entity’s economic resources in future
periods and, hence, what the prospects for future net cash inflows are.

1.2.4 Financial statements and the reporting entity

Objective and scope of financial statements
The objective of financial statements is to provide information about an entity's assets,
liabilities, equity, income and expenses that is useful to financial statements users in
assessing the prospects for future net cash inflows to the entity and in assessing
management's stewardship of the entity's resources.
This information is provided in the statement of financial position and the statement(s) of
financial performance as well as in other statements and notes.
Reporting period
Financial statements are prepared for a specified period of time and provide comparative
information and under certain circumstances forward-looking information.
Perspective adopted in financial statements and going concern assumption
Financial statements provide information about transactions and other events viewed from
the perspective of the reporting entity as a whole and are normally prepared on the
assumption that the reporting entity is a going concern and will continue in operation for the
foreseeable future.
The reporting entity
A reporting entity is an entity that is required, or chooses, to prepare financial statements. It
can be a single entity or a portion of an entity or can comprise more than one entity. A
reporting entity is not necessarily a legal entity.
Determining the appropriate boundary of a reporting entity is driven by the information
needs of the primary users of the reporting entity’s financial statements.
Consolidated and unconsolidated financial statements
Generally, consolidated financial statements are more likely to provide useful information
to users of financial statements than unconsolidated financial statements.
Underlying assumption
The IFRS Framework states that the going concern assumption is an underlying assumption.
Thus, the financial statements presume that an entity will continue in operation indefinitely
or, if that presumption is not valid, disclosure and a different basis of reporting are required.
The elements of financial statements
Financial statements portray the financial effects of transactions and other events by
grouping them into broad classes according to their economic characteristics. These broad
classes are termed the elements of financial statements.
The elements directly related to financial position (balance sheet) are:
 Assets
 Liabilities
 Equity
The elements directly related to performance (income statement) are:
 Income
 Expenses
The cash flow statement reflects both income statement elements and some changes in
balance sheet elements.
Definitions of the elements relating to financial position
 Asset. An asset is a resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to the entity.
 Liability. A liability is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.
 Equity. Equity is the residual interest in the assets of the entity after deducting all its
liabilities.
Definitions of the elements relating to performance
 Income. Income is increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.
 Expense. Expenses are decreases in economic benefits during the accounting period
in the form of outflows or depletions of assets or incurrences of liabilities that result
in decreases in equity, other than those relating to distributions to equity participants.
The definition of income encompasses both revenue and gains. Revenue arises in the course
of the ordinary activities of an entity and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties and rent. Gains represent other items that
meet the definition of income and may, or may not, arise in the course of the ordinary
activities of an entity. Gains represent increases in economic benefits and as such are no
different in nature from revenue. Hence, they are not regarded as constituting a separate
element in the IFRS Framework.
The definition of expenses encompasses losses as well as those expenses that arise in the
course of the ordinary activities of the entity. Expenses that arise in the course of the
ordinary activities of the entity include, for example, cost of sales, wages and depreciation.
They usually take the form of an outflow or depletion of assets such as cash and cash
equivalents, inventory, property, plant and equipment. Losses represent other items that
meet the definition of expenses and may, or may not, arise in the course of the ordinary
activities of the entity. Losses represent decreases in economic benefits and as such they are
no different in nature from other expenses. Hence, they are not regarded as a separate
element in this Framework.
Recognition of the elements of financial statements
Recognition is the process of incorporating in the balance sheet or income statement an item
that meets the definition of an element and satisfies the following criteria for recognition:
 It is probable that any future economic benefit associated with the item will flow to or
from the entity; and
 The item's cost or value can be measured with reliability.
Based on these general criteria:
 An asset is recognised in the balance sheet when it is probable that the future
economic benefits will flow to the entity and the asset has a cost or value that can be
measured reliably.
 A liability is recognised in the balance sheet when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present
obligation and the amount at which the settlement will take place can be measured
reliably.
 Income is recognised in the income statement when an increase in future economic
benefits related to an increase in an asset or a decrease of a liability has arisen that can
be measured reliably. This means, in effect, that recognition of income occurs
simultaneously with the recognition of increases in assets or decreases in liabilities
(for example, the net increase in assets arising on a sale of goods or services or the
decrease in liabilities arising from the waiver of a debt payable).
 Expenses are recognised when a decrease in future economic benefits related to a
decrease in an asset or an increase of a liability has arisen that can be measured
reliably. This means, in effect, that recognition of expenses occurs simultaneously
with the recognition of an increase in liabilities or a decrease in assets (for example,
the accrual of employee entitlements or the depreciation of equipment).
Measurement of the elements of financial statements
Measurement involves assigning monetary amounts at which the elements of the financial
statements are to be recognised and reported.
The IFRS Framework acknowledges that a variety of measurement bases are used today to
different degrees and in varying combinations in financial statements, including:
 Historical cost
 Current cost ( Fair Value)
 Net realisable (settlement) value
 Present value (discounted)
Historical cost is the measurement basis most commonly used today, but it is usually
combined with other measurement bases. The IFRS Framework does not include concepts
or principles for selecting which measurement basis should be used for particular elements
of financial statements or in particular circumstances. Individual standards and
interpretations do provide this guidance, however.
1.2.5 Limitations of Accounting
1. Historical in Nature:
Accounting is historical in nature and reflects the past position of business organization.
2. Records Only Monetary Transactions:
Accounting provides only incomplete information as accounting records only those
transactions which can be expressed and measured in terms of money. It is worth mentioning
that there are a lot of non-financial transactions that are important and have a significant
impact on the working of enterprise. Due to their non-financial nature, they do not get
recorded in books of accounts. For example, ineffective control prevailing in the
organization, inefficient employees, market conditions, change of government policies etc.
3. Price Level Changes:
The accounting statements do not show the effect of price level changes on the value of assets
since it is based on historical cost. Thus the financial position, as depicted by the Balance
Sheet may not come true in case of inflation or deflation.
4. Window Dressing:
Accounting principles are not static. Information contained in accounting may be
manipulated by the accountants. There are several methods of recording the value of unsold
stock or charging depreciation etc. By adopting different methods, the position of net profit or
assets can be increased or decreased depending on the requirement of the management. It
means accounting is subject to window dressing and it fails to depict the true financial
position of the enterprise if the accounts were not drawn properly.
5. Personal Biasedness:
In some cases, some events are measured on the basis of some estimates. In such cases,
judgment of the person who is estimating the events plays a vital role in accounting. For
example, charging of depreciation is based on mere estimates, useful life of the asset and
estimated scrap value of the asset. In this regard the judgment of the accountant may differ
from person to person. So we can say that accounting gets influenced by personal judgments.
6. Real Value not Known:
Accounting is based on various generally accepted accounting principles. Sometimes, the
records prepared in accounting fail to show a true and fair position of profitability and
financial soundness of the business enterprise. For example, fixed assets are recorded at their
cost price and as per the going concern concept, business always goes on.

1.3 Assessment Questions

Write a term paper on qualitative characteristics of financial statements.
1.4 References
1. Hoyle J.B, Schaefer T.F and Doupnik T.S (2009) Advanced accounting, 11th Edition,
Boston: Irwin McGraw-Hill
2. Wang’ombe, D. K. (2005). Advanced accounting: Theory and practice, Nairobi: Focus
Publishers
3. Lewis & Pendrill (2004). Advanced financial accounting (7th Ed.).
4. Frank Wood and Sangster (2005). Business accounting 2 (10th edition)