Materiality is a company-specific aspect of relevance.

Information is material if
omitting it or misstating it could influence decisions that users make on the basis of the
reported financial information. An individual company determines whether information
is material because both the nature and/or magnitude of the item(s) to which the
information relates must be considered in the context of an individual company’s financial
report. Information is immaterial, and therefore irrelevant, if it would have no
impact on a decision-maker. In short, it must make a difference or a company need not
disclose it.
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 the change.4 When a change in
accounting principles occurs, the auditor generally refers to it in an explanatory paragraph
of the audit report. This paragraph identifies the nature of the change and ref
Assumptions
The economic entity assumption means that economic activity can be identified with
a particular unit of accountability. In other words, a company keeps its activity separate
and distinct from its owners and any other business unit.6 At the most basic level,
the economic entity assumption dictates that Sappi Limited (ZAF) record the company’s
financial activities separate from those of its owners and managers. Equally important,
financial statement users need to be able to distinguish the activities and elements of
different companies, such as Volvo (SWE), Ford (USA), and Volkswagen AG (DEU). If
users could not distinguish the activities of different companies, how would they know
which company financially outperformed the other?
The entity concept does not apply solely to the segregation of activities among
competing companies, such as Toyota (JPN) and Hyundai (KOR). An individual,
department, division, or an entire industry could be considered a separate entity if we
choose to define it in this manner. Thus, the entity concept does not necessarily refer
to a legal entity. A parent and its subsidiaries are separate legal entities, but merging
their activities for accounting and reporting purposes does not violate the economic
entity assumption.7

Going Concern Assumption

Most accounting methods rely on the going concern assumption—that the company
will have a long life. Despite numerous business failures, most companies have a fairly
high continuance rate. As a rule, we expect companies to last long enough to fulfill their
objectives and commitments.
This assumption has significant implications. The historical cost principle would be
of limited usefulness if we assume eventual liquidation. Under a liquidation approach,
for example, a company would better state asset values at fair value than at acquisition
cost. Depreciation and amortization policies are justifiable and appropriate only if we
assume some permanence to the company. If a company adopts the liquidation approach,
the current/non-current classification of assets and liabilities loses much of its significance.
Labeling anything a long-lived or non-current asset would be difficult to justify. Indeed,
listing liabilities on the basis of priority in liquidation would be more reasonable.
The going concern assumption applies in most business situations. Only where
liquidation appears imminent is the assumption inapplicable. In these cases a total
revaluation of assets and liabilities can provide information that closely approximates
the company’s fair value. You will learn more about accounting problems related to a
company in liquidation in advanced accounting courses.
Monetary Unit Assumption
The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis.
That is, the monetary unit is the most effective means of expressing to interested
parties changes in capital and exchanges of goods and services. Application of this
assumption depends on the even more basic assumption that quantitative data are useful
in communicating economic information and in making rational economic decisions.
Furthermore, accounting generally ignores price-level changes (inflation and deflation)
and assumes that the unit of measure—euros, dollars, or yen—remains reasonably
stable. We therefore use the monetary unit assumption to justify adding 1985 pounds to
2015 pounds without any adjustment. It is expected that the pound or other currency,
unadjusted for inflation or deflation, will continue to be used to measure items recognized
in financial statements. Only if circumstances change dramatically (such as high inflation
rates similar to that in some South American countries) will “inflation accounting” be
considered.8
Periodicity Assumption
To measure the results of a company’s activity accurately, we would need to wait until
it liquidates. Decision-makers, however, cannot wait that long for such information.
Users need to know a company’s performance and economic status on a timely basis so
that they can evaluate and compare companies, and take appropriate actions. Therefore,
companies must report information periodically.
The periodicity (or time period) assumption implies that a company can divide its
economic activities into artificial time periods. These time periods vary, but the most
common are monthly, quarterly, and yearly.
The shorter the time period, the more difficult it is to determine the proper net
income for the period. A month’s results usually prove less reliable than a quarter’s

Accrual Basis of Accounting

Companies prepare financial statements using the accrual basis of accounting. Accrualbasis
accounting means that transactions that change a company’s financial statements
are recorded in the periods in which the events occur. [8] For example, using the accrual
basis means that companies recognize revenues when it is probable that future economic
benefits will flow to the company and reliable measurement is possible (the revenue
recognition principle). This is in contrast to recognition based on receipt of cash.
Likewise, under the accrual basis, companies recognize expenses when incurred (the
expense recognition principle) rather than when paid.
An alternative to the accrual basis is the cash basis. Under cash-basis accounting,
companies record revenue only when cash is received. They record expenses only when
cash is paid. The cash basis of accounting is prohibited under IFRS. Why? Because it
does not record revenue according to the revenue recognition principle (discussed in the
next section). Similarly, it does not record expenses when incurred, which violates the
expense recognition principle (discussed in the next section).
Financial statements prepared on the accrual basis inform users not only of past
transactions involving the payment and receipt of cash but also of obligations to pay
cash in the future and of resources that represent cash to be received in the future. Hence,
they provide the type of information about past transactions and other events that is
most useful in making economic decisions.

Basic principles

Measurement Principles
We presently have a “mixed-attribute” system in which one of two measurement principles
is used. The most commonly used measurements are based on historical cost and
fair value. Selection of which principle to follow generally reflects a trade-off between
relevance and faithful representation. Here, we discuss each measurement principle.
Historical Cost. IFRS requires that companies account for and report many assets and
liabilities on the basis of acquisition price. This is often referred to as the historical cost
principle. Cost has an important advantage over other valuations: It is generally
thought to be a faithful representation of the amount paid for a given item.
To illustrate this advantage, consider the problems if companies select current selling
price instead. Companies might have difficulty establishing a value for unsold
items. Every member of the accounting department might value the assets differently.
Further, how often would it be necessary to establish sales value? All companies close
their accounts at least annually. But some compute their net income every month. Those
companies would have to place a sales value on every asset each time they wished to
determine income. Critics raise similar objections against current cost (replacement cost,
present value of future cash flows) and any other basis of valuation except historical
cost.
What about liabilities? Do companies account for them on a cost basis? Yes, they do.
Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange for
assets (or services), for an agreed-upon price. This price, established by the exchange
transaction, is the “cost” of the liability. A company uses this amount to record the
liability in the accounts and report it in financial statements. Thus, many users prefer
historical cost because it provides them with a verifiable benchmark for measuring
historical trends.
Fair Value. Fair value is defined as “the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants at the
measurement date.” Fair value is therefore a market-based measure. [9] Recently, IFRS
has increasingly called for use of fair value measurements in the financial statements.
This is often referred to as the fair value principle. Fair value information may be more
useful than historical cost for certain types of assets and liabilities and in certain industries.
For example, companies report many financial instruments, including derivatives,
at fair value. Certain industries, such as brokerage houses and mutual funds, prepare
their basic financial statements on a fair value basis. At initial acquisition, historical cost
equals fair value. In subsequent periods, as market and economic conditions change,
historical cost and fair value often diverge. Thus, fair value measures or estimates often
provide more relevant information about the expected future cash flows related to the
asset or liability. For example, when long-lived assets decline in value, a fair value measure
determines any impairment loss.
The IASB believes that fair value information is more relevant to users than historical
cost. Fair value measurement, it is argued, provides better insight into the value of a
company’s assets and liabilities (its financial position) and a better basis for assessing
future cash flow prospects. Recently, the Board has taken the additional step of giving
companies the option to use fair value (referred to as the fair value option) as the basis
for measurement of financial assets and financial liabilities. [10] The Board considers
fair value more relevant than historical cost because it reflects the current cash equivalent
value of financial instruments. As a result, companies now have the option to
record fair value in their accounts for most financial instruments, including such items
as receivables, investments, and debt securities.
Use of fair value in financial reporting is increasing. However, measurement based on
fair value introduces increased subjectivity into accounting reports when fair value information
is not readily available. To increase consistency and comparability in fair value
measures, the IASB established a fair value hierarchy that provides insight into the priority
of valuation techniques to use to determine fair value. As shown in Illustration 2-4, the fair
value hierarchy is divided into three broad levels. As Illustration 2-4 indicates, Level 1 is the
least subjective because it is based on
quoted prices, like a closing share price in the Financial Times. Level 2 is more subjective
and would rely on evaluating similar assets or liabilities in active markets. At the most
subjective level, Level 3, much judgment is needed, based on the best information available,
to arrive at a relevant and representationally faithful fair value measurement.9
It is easy to arrive at fair values when markets are liquid with many traders, but fair
value answers are not readily available in other situations. For example, how do you
value the mortgage assets of a subprime lender such as New Century (USA) given that
the market for these securities has essentially disappeared? A great deal of expertise and
sound judgment will be needed to arrive at appropriate answers. IFRS also provides
guidance on estimating fair values when market-related data is not available. In general,
these valuation issues relate to Level 3 fair value measurements. These measurements
may be developed using expected cash flow and present value techniques, as
described in Chapter 6.
As indicated above, we presently have a “mixed-attribute” system that permits the
use of historical cost and fair value. Although the historical cost principle continues to
be an important basis for valuation, recording and reporting of fair value information is
increasing. The recent measurement and disclosure guidance should increase consistency
and comparability when fair value measurements are used in the financial statements
and related notes.
Revenue Recognition Principle
When a company agrees to perform a service or sell a product to a customer, it has a
performance obligation. When the company satisfies this performance obligation, it
recognizes revenue. The revenue recognition principle therefore requires that companies
recognize revenue in the accounting period in which the performance obligation is
satisfied.
To illustrate, assume that Klinke Cleaners cleans clothing on June 30 but customers
do not claim and pay for their clothes until the first week of July. Klinke should record
revenue in June when it performed the service (satisfied the performance obligation)
rather than in July when it received the cash. At June 30, Klinke would report a receivable
on its statement of financial position and revenue in its income statement for the
service performed. To illustrate the revenue recognition principle in more detail, assume
that Airbus (DEU) signs a contract to sell airplanes to British Airways (GBR) for
€100 million. To determine when to recognize revenue, Airbus uses the five steps shown
in Illustration 2-5.10
Many revenue transactions pose few problems because the transaction is initiated
and completed at the same time. However, when to recognize revenue in other certain
situations is often more difficult. The risk of errors and misstatements is significant.
Chapter 18 discusses revenue recognition issues in more detail.
Expense Recognition Principle
Expenses are defined as outflows or other “using up” of assets or incurring of liabilities
(or a combination of both) during a period as a result of delivering or producing goods and/or
rendering services. It follows then that recognition of expenses is related to
net changes in assets and earning revenues. In practice, the approach for recognizing
expenses is, “Let the expense follow the revenues.” This approach is the expense recognition
principle.
To illustrate, companies recognize expenses not when they pay wages or make a
product, but when the work (service) or the product actually contributes to revenue.
Thus, companies tie expense recognition to revenue recognition. That is, by matching
efforts (expenses) with accomplishment (revenues), the expense recognition principle
is implemented in accordance with the definition of expense (outflows or other using
up of assets or incurring of liabilities).11
Some costs, however, are difficult to associate with revenue. As a result, some
other approach must be developed. Often, companies use a “rational and systematic”

Full Disclosure Principle

In deciding what information to report, companies follow the general practice of
providing information that is of sufficient importance to influence the judgment and
decisions of an informed user. Often referred to as the full disclosure principle, it recognizes
that the nature and amount of information included in financial reports reflects
a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to disclose
matters that make a difference to users, yet (2) sufficient condensation to make the
information understandable, keeping in mind costs of preparing and using it.
Users find information about financial position, income, cash flows, and investments
in one of three places: (1) within the main body of financial statements, (2) in the
notes to those statements, or (3) as supplementary information.
As discussed in Chapter 1, the financial statements are the statement of financial
position, income statement (or statement of comprehensive income), statement of cash
flows, and statement of changes in equity. They are a structured means of communicating
financial information. An item that meets the definition of an element should be
recognized if (a) it is probable that any future economic benefit associated with the item
will flow to or from the entity; and (b) the item has a cost or value that can be measured
with reliability. [11]
Disclosure is not a substitute for proper accounting. As a noted accountant indicated,
“Good disclosure does not cure bad accounting any more than an adjective or
adverb can be used without, or in place of, a noun or verb.” Thus, for example, cashbasis
accounting for cost of goods sold is misleading, even if a company discloses
accrual-basis amounts in the notes to the financial statements.