Chapter One
Development of Accounting Principles and Professional
Practices
By: Tsegazeab T(MBAF)
4/10/2023
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The Environment of Accounting
 Fair presentation of financial affairs is the essence of accounting
theory and practice.
 The increasing size and complexity of business enterprises and the
increasing economic role of gov’t increase the responsibility of
accountant
 to meet these challenges framework is nedded
 Financial statements and reports prepared by accountants are vital to
the successful working of society.
 Different users rely on the product of accountants
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Environmental Factors that Influence Accounting
 accounting is the product of its environment
 Modern accounting is the product of many influences and conditions
such as;
Effective and efficient use of resources
Recognition on current and ethical concept of property
Recognition in corporate stewardship management
 Accounting is source of information for the absentee investors
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Nature and Environment of Financial Accounting
 Accounting: classification, recording, analysis, and interpretation of
the overall financial position and operating results of an organization
 Accounting categorized as




Financial accounting
Managerial (cost)accounting
Tax accounting
Not-for profit accounting
 Financial accounting: concerned with preparation of financial
statements relative to the enterprise as a whole for use by parties both
internal and external to the enterprise.
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Factors of Financial Accounting
Environmental factors that influence accounting;
 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
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Users of Accounting Information
 The users of accounting information may be
 internal users: use accounting information either for planning and
controlling current operations or for formulating long-range plans and
making major business decisions. Such as
 BOD
 All level managers
 external users: stockholders, bondholders, potential investors,
bankers and other creditors, financial analysts, economists, labor
unions, and numerous government agencies.
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Difference Between FA & C & MA
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IASB & its Governance Structure
 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.
2. The IASB develops, in the public interest, a single set of highquality, enforceable, and global international financial reporting
standards for general-purpose financial statements.
3. The IFRS Advisory Council provides advice and counsel to the
IASB on major policies and technical issues.
4. The IFRS Interpretations Committee assists the IASB through
the timely identification, discussion, and resolution of financial
reporting issues within the framework of IFRS.
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IASB & its Governance Structure
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Types of IASB Pronouncements
 The IASB issues three major types of pronouncements:
1. International Financial Reporting Standards:



2.
Conceptual Framework for Financial Reporting: sets



3.



the fundamental objective and
concepts that the Board uses in developing future standards
It is not the IFRS
International Financial Reporting Standards Interpretations:
issued by the IFRS Interpretations Committee
considered as authoritative and must be followed
Covers


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issued by the IASB
13 standards to date are issued
41 IAS are also issued previously
newly identified financial reporting issues not specifically dealt with in IFRS and
issues where unsatisfactory or conflicting interpretations have developed
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Hierarchy of IFRS
 The following hierarchy is used to determine what recognition,
valuation, and disclosure requirements should be used. Companies
first look to:
A. International Financial Reporting Standards, International
Accounting Standards and IFRS interpretations
B. The Conceptual Framework for Financial Reporting; and
C. Pronouncements of other standard-setting bodies
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The IASB’s Conceptual Framework For
Financial Reporting
 A conceptual framework
is a coherent system of interrelated
objectives and fundamentals that can lead to consistent rules and
prescribes the nature, function, and limits of financial accounting and
financial statements.
 The needs to have conceptual framework are;
 First, to be useful, rule making should build on and relate to an
established body of concepts and objectives.
 Second, the profession should be able to more quick solve new and
emerging practical problems by referring to an existing framework of
basic theory.
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Summary of IASB Conceptual Framework
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Objectives of Financial Reporting
 The 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.
 Specifically providing information or to maintain
 Equity Investors and Creditors
 Entity Perspective
 Decision-Usefulness
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Qualitative Characteristics of Accounting Information
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Fundamental Quality—Relevance
 To be relevance, the information should be posses
A. Predictive value: if it has value as an input to predictive
processes used by investors to form their own expectations about
the future.
B. Confirmatory value: helps to confirm or correct users’ past
predictions about that ability.
C. Materiality: a company-specific aspect and Information is
material if omitting it or misstating it could influence decisions that
users make on the basis of the reported financial information. It is
based on
I.
II.
Nature of the event or value and
Magnitude of the event
 Information is immaterial, and therefore irrelevant, if it would have no
impact on a decision-maker.
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Fundamental Quality—Faithful Representation
 Faithful representation means that the numbers and descriptions
match what really existed or happened.
 Faithful representation and related ingredients of this fundamental
quality like
Completeness: all the information that is necessary for faithful
representation is provided
2. Neutrality: means that a company cannot select information to favor
one set of interested parties over another.
If financial information is biased (rigged), the public will lose
confidence and no longer use it.
1. Free from error: An information item that is free from error will
be a more accurate (faithful) representation of a financial item.
1.
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Secondary Quality of Financial Information
 Secondary quality includes
1.
2.
Comparability: Information that is measured and reported in a similar
manner for different companies. consistency, is present when a
company applies the same accounting treatment to similar events, from
period to period.
Verifiability: occurs when independent measurers, using the same
methods, obtain similar results.Verifiability occurs when
A.
B.
3.
4.
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Two independent auditors count inventory and arrive at the same physical quantity
amount or direct verification
Two independent auditors compute inventory value at the end of the year using the
FIFO method of inventory valuation or indirect verification
Timeliness: having information available to decision-makers before it
loses its capacity to influence decisions.
Understand ability: must have a connection (linkage) between these
users and the decisions they make.
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Basic Elements
ASSET. 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.
B. LIABILITY. 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.
C. EQUITY. The residual interest in the assets of the entity after deducting
all its liabilities.
D. The elements of income and expenses are defined as follows.
E. INCOME. 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.
F. EXPENSES. Decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrence of
liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.
A.
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Third Level: Recognition, Measurement, And Disclosure
Concepts
 Basic Assumptions
1. economic entity:
 economic activity can be identified with a particular unit of
accountability.
 A company keeps its activity separate and distinct from its owners and
any other business unit.
 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.
going concern:
2.



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company will have a long life, despite of numerous business failures
Depreciation and amortization policies are indicators
Only where liquidation appears imminent is the assumption
inapplicable
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Third Level: Recognition, Measurement, And Disclosure Concepts
3. Monetary Unit Assumption
 money is the common denominator of economic activity
 provides an appropriate basis for accounting measurement and analysis.
 assume that quantitative data are useful in communicating economic
information
4. Periodicity Assumption:
 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 results
 the trade-off between relevance and faithful representation in preparing
financial data.
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Accrual vs Cash Bases of Accounting
Accrual basis accounting:
 transactions that change a company’s financial statements are recorded
in the periods in which the events occur.
 recognize revenues when it is probable that future economic benefits
will flow to the company and reliable measurement is possible
 recognize expenses when incurred (the expense recognition principle)
rather than when paid.
Cash Basis of Accounting
 record revenue only when cash is received.
 record expenses only when cash is paid.
 The cash basis of accounting is prohibited under IFRS.
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Basic Principles of Accounting
 We generally use four basic principles of accounting
1.
2.
3.
4.
Measurement,
Revenue Recognition,
Expense Recognition, And
Full disclosure
 Measurement Principle: The most commonly used measurements are
based on historical cost and fair value.
 Historical Cost. IFRS requires that companies account for and report many
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
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assets and liabilities on the basis of acquisition price.
It is generally thought to be a faithful representation of the amount paid for a
given item.
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.
Fair value information may be more useful than historical cost for certain types
of assets and liabilities and in certain industries like derivatives, brokerage,
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Revenue & Expense Recognition Principle
 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.
 Expense Revenue 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.
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Revenue & Expense Recognition Principle
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Revenue…………………
 Costs are generally classified into two groups: product costs and
period costs.
 Product costs, such as material, labor, and overhead, attach to the
product. Companies carry these costs into future periods if they recognize
the revenue from the product in subsequent periods.
 Period costs, such as officers’ salaries and other administrative expenses,
attach to the period.
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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.
2.
sufficient detail to disclose matters that make a difference to users, yet
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.
2.
3.
within the main body of financial statements,
in the notes to those statements, or
as supplementary information.
 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)
b)
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it is probable that any future economic benefit associated with the item will flow to or
from the entity; and
the item has a cost or value that can be measured with reliability.
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Full Disclosure Principle
 The notes to financial statements generally amplify or explain the
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items presented in the main body of the statements.
If the main body of the financial statements gives an incomplete picture
of the performance and position of the company, the notes should
provide the additional information needed.
Information in the notes does not have to be quantifiable, nor does it
need to qualify as an element. Notes can be partially or totally
narrative.
Examples of notes include descriptions of the accounting policies and
methods used in measuring the elements reported in the statements,
explanations of uncertainties and contingencies, and statistics and
details too voluminous for presentation in the financial statements.
The notes can be essential to understanding the company’s
performance and position.
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Full Disclosure Principle
 Supplementary information may include details or amounts that
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
present a different perspective from that adopted in the financial
statements.
It may be quantifiable information that is high in relevance but low in
reliability.
For example, oil and gas companies typically provide information on
proven reserves as well as the related discounted cash flows.
Supplementary information may also include management’s explanation
of the financial information and its discussion of the significance of that
information.
In each of these situations, the same problem must be faced: making sure
the company presents enough information to ensure that the
reasonably prudent investor will not be misled.
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Cost Constraint
 In providing information with the qualitative characteristics that make
it useful, companies must consider an overriding factor that limits
(constrains) the reporting.
 That is, companies must weigh the costs of providing the information
against the benefits that can be derived from using it.
 Rule-making bodies and governmental agencies use cost-benefit
analysis before making final their informational requirements.
 In order to justify requiring a particular measurement or disclosure,
the benefits perceived to be derived from it must exceed the costs
perceived to be associated with it.
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IFRS-Based Financial Statements
Objective of Financial Statement Presentation
 The general purpose of financial statements is to ensure comparability
both with the entity’s financial statements of previous periods and with
the financial statements of other entities.
 It sets out overall requirements for the presentation of financial
statements, guidelines for their structure and minimum requirements
for their content.
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Scope of Financial Statement Presentation
1.
2.
3.
4.
5.
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An entity shall apply IFRS in preparing and presenting general purpose
financial statements.
Other IFRSs set out the recognition, measurement and disclosure
requirements for specific transactions and other events.
This Standard does not apply to the structure and content of
condensed interim financial statements
This Standard uses terminology that is suitable for profit-oriented
entities, including public sector business entities.
Similarly, entities that do not have equity as defined in IAS 32 Financial
Instruments: Presentation (eg some mutual funds) and entities whose
share capital is not equity (eg some co-operative entities) may need to
adapt the financial statement presentation of members’ or unit
holders’ interests.
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Financial Statements in General
 Financial statements are a structured representation of the financial
position and financial performance of an entity.
 Financial statements also show the results of the management’s
stewardship of the resources entrusted to it.
 To meet this objective, financial statements provide information about an
entity’s:
 assets;
 liabilities;
 equity;
 income and expenses, including gains and losses;
 contributions by and distributions to owners in their capacity as owners; and
 cash flows.
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Statement of Financial Position
 As a minimum, the statement of financial position shall include line
items that present the following amounts:









property, plant and equipment;
investment property;
intangible assets;
financial assets
investments accounted for using the equity method;
biological assets;
inventories;
trade and other receivables;
cash and cash equivalents;
 The total of assets classified as held for sale and assets included in
disposal groups classified as held for sale in accordance with IFRS 5 Noncurrent Assets Held for Sale and Discontinued Operations;
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Statement of financial position
 As a minimum, the statement of financial position shall include line
items that present the following amounts:
 trade and other payables;
 provisions;
 financial liabilities
 liabilities and assets for current tax
 deferred tax liabilities and deferred tax assets
 liabilities included in disposal groups classified as held for sale
 non-controlling interest, presented within equity; and
 issued capital and reserves attributable to owners of the parent.
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Statement of financial position
 An entity shall present additional line items, headings and subtotals in the
statement of financial position when such presentation is relevant
 When an entity presents current and non-current assets, and current and noncurrent liabilities, it shall not classify deferred tax assets (liabilities) as current
assets (liabilities).
 In addition:
 line items are included when the size, nature or function of an item or aggregation are
relevant
 the descriptions used and the ordering of items or aggregation of similar items may be
amended according to the nature of the entity
 An entity makes the judgment about whether to present additional items
separately on the basis of an assessment of:
 the nature and liquidity of assets;
 the function of assets within the entity; and
 the amounts, nature and timing of liabilities.
 The use of different measurement bases for different classes of assets suggests
that their nature or function differs and, therefore, that an entity presents them
as separate line items.
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Current/non-current distinction
 An entity shall present current and non-current assets, and current and
non-current liabilities, as separate classifications in its statement of
financial position except when a presentation based on liquidity provides
information that is reliable and more relevant.
 When that exception applies, an entity shall present all assets and
liabilities in order of liquidity.
 An entity shall disclose the amount expected to be recovered or settled
after more than twelve months for each asset and liability line item that
combines amounts expected to be recovered or settled:
 no more than twelve months after the reporting period, and
 more than twelve months after the reporting period.
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Current vs Non-Current
Current Assets
 An entity shall classify an asset as current when:
1.
2.
3.
4.
it expects to realize the asset, or intends to sell or consume it, in its
normal operating cycle;
it holds the asset primarily for the purpose of trading;
it expects to realize the asset within twelve months after the reporting
period; or
the asset is cash or a cash equivalent unless the asset is restricted from
being exchanged or used to settle a liability for at least twelve months
after the reporting period.
An entity shall classify all other assets as non-current which include
tangible, intangible, and financial assets of a long-term nature.

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Current vs Non-Current
 The operating cycle of an entity is
 the time between the acquisition of assets for processing and their realization
in cash or cash equivalents.
 When the entity’s normal operating cycle is not clearly identifiable, it is
assumed to be 12 months.
 Current assets include assets (such as inventories and trade receivables) that
are sold, consumed or realized as part of the normal operating cycle even
when they are not expected to be realized within 12 months after the
reporting period.
 Current assets also include assets held primarily for the purpose of trading
((examples include some financial assets classified as held for trading in
accordance with IAS 39) and the current portion of non-current financial
assets.
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Current vs Non-Current
Current Liabilities
An entity shall classify a liability as current when:
a)
b)
c)
d)
it expects to settle the liability in its normal operating cycle;
it holds the liability primarily for the purpose of trading;
the liability is due to be settled within twelve months after the reporting
period; or
it does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting period.
 Terms of a liability that could, at the option of the counterparty, result
in its settlement by the issue of equity instruments do not affect its
classification.
 An entity shall classify all other liabilities as non-current.
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Current vs Non-Current
 Some current liabilities, such as trade payables and some accruals for employee
and other operating costs are classified as current liabilities even if they are due
to be settled more than twelve months after the reporting period.
 Other current liabilities are not settled as part of the normal operating cycle,
but are due for settlement within 12 months after the reporting period or held
primarily for the purpose of trading.
 Examples are some financial liabilities classified as held for trading such as





bank overdrafts,
the current portion of non-current financial liabilities,
dividends payable,
income taxes and
other non-trade payables.
 Financial liabilities that provide financing on a long-term basis and are not due
for settlement within 12 months after the reporting period are non-current
liabilities
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Current vs Non-Current
 An entity classifies its financial liabilities as current when they are due to
be settled within twelve months after the reporting period, even if:
a.
b.
the original term was for a period longer than twelve months, and
an agreement to refinance, or to reschedule payments, on a long-term
basis is completed after the reporting period and before the financial
statements are authorized for issue.
 If an entity expects, and has the discretion, to refinance or roll over an
obligation for at least twelve months after the reporting period under an
existing loan facility, it classifies the obligation as non-current
 When an entity breaches a provision of a long-term loan arrangement on
or before the end of the reporting period with the effect that the liability
becomes payable on demand, it classifies the liability as current.
 However, an entity classifies the liability as non-current if the lender
agreed by the end of the reporting period to provide a period of grace
ending at least twelve months after the reporting period
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Current vs Non-Current
 An entity shall disclose the following, either in the statement of financial
position or the statement of changes in equity, or in the notes:
A. for each class of share capital:
the number of shares authorized;
ii. the number of shares issued and fully paid, and issued but not fully paid;
iii. par value per share, or that the shares have no par value;
iv. a reconciliation of the number of shares outstanding at the beginning and
at the end of the period;
v. the rights, preferences and restrictions attaching to that class
vi. shares in the entity held by the entity or by its subsidiaries and
vii. shares reserved for issue under options and contracts for the sale of
shares, including terms and amounts; and
i.
B.
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a description of the nature and purpose of each reserve within equity.
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Statement of Comprehensive Income
An entity shall present all items of income and expense recognized in a period:
(a) in a single statement of comprehensive income, or
(b) in two statements: a statement displaying components of profit or loss and a
statement of comprehensive income
Information to be presented in the statement of comprehensive income
 As a minimum, the statement of comprehensive income shall include the ff
a. revenue;
b. finance costs;
c. share of the profit or loss of associates and joint ventures accounted for using the
equity method;
d. tax expense;
e. a single amount comprising the total of: the post-tax profit and the post-tax gain or
loss recognized on the measurement to fair value less costs to sell or on the disposal
f. profit or loss;
g. each component of other comprehensive income classified by nature (excluding
amounts in (h))
h. share of the other comprehensive income of associates and joint ventures accounted
for using the equity method; and
i. total comprehensive income.
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Statement of Comprehensive Income
 An entity shall disclose the following items
profit or loss for the period attributable to:
i. non-controlling interest, and
ii. owners of the parent.
B. Total comprehensive income for the period attributable to:
i.
non-controlling interest, and
ii. owners of the parent.
 An entity may present in a separate statement of comprehensive income
 An entity shall present additional line items in the statement of comprehensive
income and the separate statement of comprehensive income
 An entity shall not present any items of income or expense as extraordinary
items, in the statement of comprehensive income
A.
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Statement of Comprehensive Income
Profit or loss for the period
 An entity shall recognize all items of income and expense in a period in profit
or loss unless an IFRS requires or permits otherwise.
Other comprehensive income for the period
 An entity shall disclose the amount of income tax relating to each component
of other comprehensive income, including reclassification adjustments, either
in the statement of comprehensive income or in the notes.
 An entity may present components of other comprehensive income either:
 net of related tax effects, or
 before related tax effects
 An entity shall disclose reclassification adjustments relating to components of
other comprehensive income.
 An entity shall present an analysis of expenses recognized in profit or loss using
a classification based on either their nature or their function within the entity,
whichever provides information that is reliable and more relevant.
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Statement of Comprehensive Income
 The first form of analysis is the ‘nature of expense’ method.
 An entity aggregates expenses within profit or loss according to their nature (for example,
depreciation, purchases of materials, transport costs, employee benefits and advertising costs),
and does not reallocate them among functions within the entity.
 This method may be simple to apply because no allocations of expenses to functional
classifications are necessary.
 An example of a classification using the nature of expense method is as follows:
Revenue……………………………………………….………………………….…X
Other income………………………..………………………………………….….. X
Changes in inventories of finished goods and work in progress…………….….. X
Raw materials and consumables used ………………………………………….…X
Employee benefits expense ………………………………………...………………X
Depreciation and amortization expense…………………………………………… X
Other expenses ……………………………………………………………………..X
Total expenses ……………………………………………………………………...(X)
Profit before tax ……………………………………………………………………..X
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Statement of Comprehensive Income
 The second form of analysis is the ‘function of expense’ or ‘cost of sales’
method and classifies expenses according to their function as part of cost of
sales or administrative activities.
 At a minimum, an entity discloses its cost of sales under this method separately
from other expenses.
 An example of a classification using the function of expense method is as
follows:
Revenue ………………………………………………………………………………..X
Cost of sales …………………………………………………………………………..(X)
Gross profit …………………………………………………………………………….X
Other income …………………………………………………………………………..X
Distribution costs ……………………………………………………………………...(X)
Administrative expenses……………………………………………………………... (X)
Other expenses …………………………………………………………………………(X)
Profit before tax …………………………………………………………………………X
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Statement of Changes in Equity
Information to be presented in the statement of changes in
equity
 The statement of changes in equity includes the following
information:
 total comprehensive income for the period, showing separately the total
amounts attributable to owners of the parent and to non-controlling
interest;
 for each component of equity, the effects of retrospective application or
retrospective restatement recognized and
 for each component of equity, a reconciliation between the carrying amount
at the beginning and the end of the period, resulting from:
 profit or loss;
 other comprehensive income; and
 transactions with owners in their capacity as owners,
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CH-2 Fair Value Measurement &
Impairment
Fair Value Measurement
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Related Terms
 An active market is a market in which transactions for the asset or
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liability take place with sufficient frequency and volume to provide
pricing information on an ongoing basis.
Entry price refers to the price paid to acquire an asset or received to
assume a liability in an exchange transaction.
The exit price is the price that would be received to sell an asset or paid
to transfer a liability.
Fair value is 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.
Highest and best use refers to the use of a non-financial asset by
market participants that would maximize the value of the asset or the
group of assets and liabilities within which the asset would be used.
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Related Terms
 The income approach is a valuation technique that converts future
amounts (e.g. cash flows or income and expenses) to a single current
(i.e. discounted) amount. The fair value measurement is determined on
the basis of the value indicated by current market expectations about
those future amounts.
 The market approach is a valuation technique that uses prices and
other relevant information generated by market transactions involving
identical or comparable (i.e. similar) assets, liabilities or a group of assets
and liabilities, such as a business.
 The cost approach is a valuation technique that reflects the amount that
would be required currently to replace the service capacity of an asset
(often referred to as current replacement cost).
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Related Terms
 Inputs are the assumptions that market participants would use when
pricing the asset or liability, including assumptions about risk, such as the
following:
a)
b)
the risk inherent in a particular valuation technique used to measure fair
value (such as a pricing model); and
the risk inherent in the inputs to the valuation technique.
Inputs may be observable or unobservable.
 Observable inputs are inputs that are developed using market data, such
as publicly available information about actual events or transactions, and
that reflect the assumptions that market participants would use when
pricing the asset or liability.
 Unobservable inputs are inputs for which market data are not available
and that are developed using the best information available about the
assumptions that market participants would use when pricing the asset
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or liability.
Related Terms
 A market participant is a buyer and seller in the principal (or most
advantageous) market for the asset or liability that have all of the
following characteristics:
a)
b)
c)
d)
They are independent of each other
They are knowledgeable, having a reasonable understanding about the
asset or liability
They are able to enter into a transaction for the asset or liability.
They are willing to enter into a transaction for the asset or liability
 A principal market is a market with the greatest volume and level of
activity for the asset or liability.
 The most advantageous market maximizes the amount that would be
received to sell the asset or minimizes the amount that would be paid to
transfer the liability
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Definition of Fair Value
 Fair value is a market-based measurement, not an entity-specific
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measurement.
For some assets and liabilities, observable market transactions or market
information might be available.
For other assets and liabilities, observable market transactions and
market information might not be available.
However, the objective of a fair value measurement in both cases is the
same—to estimate the price at which an orderly transaction to sell the
asset or to transfer the
When a price for an identical asset or liability is not observable, an entity
measures fair value using another valuation technique that maximizes the
use of relevant observable inputs and minimizes the use of unobservable
inputs.
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 A fair value measurement is for a particular asset or liability. Therefore,
when measuring fair value an entity shall take into account the
characteristics of the asset or such as
a)
b)
the condition and location of the asset; and
restrictions, if any, on the sale or use of the asset.
 The asset or liability measured at fair value might be either of the
following:
1.
2.
a stand-alone asset or liability (e.g a financial instrument or a non-financial
asset); or
a group of assets, a group of liabilities or a group of assets and liabilities
 The transaction: A fair value measurement assumes that the asset or
liability is exchanged in an orderly transaction between market
participants to sell the asset or transfer the liability at the measurement
date under current market conditions.
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Measurement of FairValue
 A fair value measurement assumes that the transaction to sell the asset or
transfer the liability takes place either:
a)
b)
in the principal market for the asset or liability; or
in the absence of a principal market, in the most advantageous market for
the asset or liability.
 The price: Fair value is the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction in the principal (or
most advantageous) market at the measurement date under current
market conditions (i.e. an exit price) regardless of whether that price is
directly observable or estimated using another valuation technique.
 Market participants: An entity shall measure the fair value of an asset
or a liability using the assumptions that market participants would use
when pricing the asset or liability, assuming that market participants act
in their economic best interest.
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Application to non-financial assets
 Highest and best use for non-financial assets
 A fair value measurement of a non-financial asset takes into account a
market participant’s ability to generate economic benefits by using the
asset in its highest and best use or by selling it to another market
participant that would use the asset in its highest and best use.
 The highest and best use of a non-financial asset takes into
account the use of the asset, as follows:
 A use that is physically possible takes into account the physical characteristics
of the asset
 A use that is legally permissible takes into account any legal restrictions on
the use of the asset
 A use that is financially feasible takes into account whether a use of the asset
that is physically possible and legally permissible generates adequate income
or cash flows
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 A fair value measurement assumes that a financial or non-financial
liability or an entity’s own equity instrument is transferred to a
market participant at the measurement date.
 The transfer of a liability or an entity’s own equity instrument
assumes the following:
A. A liability would remain outstanding and the market participant
transferee would be required to fulfill the obligation.
B. An entity’s own equity instrument would remain outstanding
and the market participant transferee would take on the rights
and responsibilities associated with the instrument.
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Liabilities and equity instruments held by other
parties as assets:
 In such cases, an entity shall measure the fair value of the liability or
equity instrument held by other parties as follows:
1.
2.
Using the quoted price in an active market for the identical item held by
another party as an asset, if that price is available.
if that price is not available, using other observable inputs, such as the
quoted price in a market that is not active for the identical item held by
another party as an asset.
 if the observable prices in (1) and (2) are not available, using another
valuation technique, such as:
1.
2.
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an income approach;
a market approach
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Liabilities and equity instruments not held by other
parties as assets:
 An entity shall measure the fair value of the liability or equity instrument using
a valuation technique from the perspective of a market participant that owes
the liability or has issued the claim on equity.
 For example, when applying a present value technique an entity might take
into account either of the following:
a.
b.
the future cash outflows that a market participant would expect to incur in
fulfilling the obligation
the amount that a market participant would receive to enter into or issue an
identical liability or equity instrument
 When measuring the fair value of a liability, an entity shall take into account
the effects of its credit risk and any other factors that might influence the
likelihood that the obligation will or will not be fulfilled.
 The fair value of a financial liability with a demand feature (e.g. a demand
deposit) is not less than the amount payable on demand, discounted
from the
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first date that the amount could be required to be paid.
Application to financial assets and financial liabilities with offsetting
positions in market risks or counterparty credit risk (exception)
 An entity that holds a group of financial assets and financial liabilities is
exposed to market risks and to the credit risk of each of the
counterparties.
 If the entity manages that group of financial assets and financial liabilities
on the basis of its net exposure to either market risks or credit risk, the
entity is permitted to apply an exception to this Standard for measuring
fair value.
 That exception permits an entity to measure the fair value of a group of
financial assets and financial liabilities on the basis of the price that would
be received to sell a net long position (i.e. an asset) for a particular risk
exposure or paid to transfer a net short position (i.e. a liability) for a
particular risk exposure in an orderly transaction between market
participants at the measurement date under current market conditions.
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Application to financial assets ……
 Accordingly, an entity shall measure the fair value of the group of
financial assets and financial liabilities consistently with how market
participants would price the net risk exposure at the measurement date.
 An entity is permitted to use the exception only if the entity does all the
following:
manages the group of financial assets and financial liabilities on the basis of
the entity’s net exposure to a particular market risk (or risks) or to the
credit risk of a particular counterparty in accordance with the entity’s
documented risk management or investment strategy;
B. provides information on that basis about the group of financial assets and
financial liabilities to the entity’s key management personnel and
C. Is required or has elected to measure those financial assets and financial
liabilities at fair value in the statement of financial position
A.
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Fair Value at Initial Recognition
 When determining whether fair value at initial recognition equals the
transaction price, an entity shall take into account factors specific to the
transaction and to the asset or liability.
 For example, the transaction price might not represent the fair value of
an asset or a liability at initial recognition if any of the following
conditions exist:
The transaction is between related parties
B. The transaction takes place under duress or the seller is forced to accept
the price in the transaction.
C. The unit of account represented by the transaction price is different from
the unit of account for the asset or liability measured at fair value
D. The market in which the transaction takes place is different from the
principal market (or most advantageous market).
A.
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Valuation Techniques
 If the transaction price is fair value at initial recognition and a valuation
technique that uses unobservable inputs will be used to measure fair
value in subsequent periods, the valuation technique shall be calibrated
so that at initial recognition the result of the valuation technique equals
the transaction price.
 Factors in selecting techniques
a.
b.
c.
d.
e.
f.
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the information that is reasonably available to an investor;
the market conditions
the investment horizon and investment type
the life cycle of an investee
the nature of an investee’s business
the industry in which an investee operates.
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Valuation Techniques
 There are three valuation approaches
 Market approach: uses prices and other relevant information
generated by market transactions involving identical or comparable (i.e.
similar) assets, liabilities or a group of assets and liabilities, such as a
business
 Cost approach: reflects the amount that would be required currently
to replace the service capacity of an asset (often referred to as current
replacement cost).
 Income approach: converts future amounts (e.g. cash flows or income
and expenses) to a single current (i.e. discounted) amount. The fair value
measurement is determined on the basis of the value indicated by
current market expectations about those future amounts.
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Market Approach
 The market approach uses prices and other relevant information that
have been generated by market transactions that involve identical or
comparable assets.
 A number of techniques are consistent with the market approach. The
market approach techniques that are most commonly referred to for
valuing unquoted equity instruments are
1.
2.
3.
4.
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Comparable company valuation multiples
Adjusting valuation multiples: differences between an investee
and its comparable company peers
Adjusting valuation multiples and an investee’s performance
measure: normalization
Adjusting valuation multiples and an investee’s performance
measure: non-operating items
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Transaction price paid for an identical instrument of an investee
 When an investor has recently made an investment in an instrument that
is identical to the unquoted equity instrument being valued.
 factors that might indicate that the investor’s transaction price might not
be representative of fair value at the measurement date, such as
 a significant change in the performance of the investee compared with
budgets, plans or milestones;
 changes in expectation as to whether the investee’s technical product
milestones will be achieved;
 a significant change in the market for the investee’s equity or its products or
potential products;
 a significant change in the global economy or the economic environment in
which the investee operates;
 a significant change in the performance of comparable entities, or in the
valuations implied by the overall market;
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Income Approach
 The income approach converts future amounts (for example, cash flows
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or income and expenses) to a single current (ie discounted) amount.
This is typically done using a discounted cash flow (DCF) method, which
is applied to enterprise cash flows or, less frequently, to equity cash
flows.
Discounted cash flow (DCF) method
When applying the DCF method, investors are required to estimate the
future expected cash flows of an investee.
For practical purposes, when an investee is expected to have an indefinite
life, most models estimate cash flows for a discrete period and then
either use a constant growth model, apply a capitalization rate to the cash
flow immediately following the end of the discrete period or use an exit
multiple to estimate a terminal value.
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DCF method …………..
 When applying a DCF model, an investor would typically discount the
expected cash flow amounts (ie possible future cash flows multiplied by
their respective probabilities;
 In addition, an investor will need to define the relevant cash flow
measure.
 Equity instruments can be valued directly (equity valuation), using free
cash flow to equity (FCFE), or indirectly, by obtaining the enterprise value
using free cash flow to firm (FCFF) and then subtracting the fair value of the
investee’s debt net of cash.
 Although both of these approaches result in discounted expected cash
flows, the relevant cash flows and discount rates are different when using
each approach.
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Equity Value vs Enterprise Value
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Equity Value vs Enterprise Value
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Fair value Hierarchy
 Three levels
Level 1 inputs :are quoted prices (unadjusted) in active markets for identical
assets or liabilities that the entity can access at the measurement date.
Level 2 inputs: are inputs other than quoted prices included within Level 1 that
are observable for the asset or liability, either directly or indirectly.
 Level 2 inputs include the following:
A.
B.
C.
D.
quoted prices for similar assets or liabilities in active markets.
quoted prices for identical or similar assets or liabilities in markets that are not
active.
inputs other than quoted prices that are observable for the asset or liability, for
interest rates and yield curves observable at commonly quoted intervals; implied
volatilities; and credit spreads.
market-corroborated inputs
Level 3 inputs are unobservable inputs for the asset or liability when relevant
observable inputs are not available.
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A.
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Presentation and Disclosure
 An entity shall disclose information that helps users of its financial
statements assess both of the following:
for assets and liabilities that are measured at fair value on a recurring or
non-recurring basis in the statement of financial position after initial
recognition, the valuation techniques and inputs used to develop those
measurements.
B. for recurring fair value measurements using significant unobservable
inputs (Level 3), the effect of the measurements on profit or loss or other
comprehensive income for the period.
In the note to financial statement, the following should be disclosed
A.
(i) the fair value measurement at the end of the reporting period, and
for non-recurring fair value measurements, the reasons for the
measurement;
(ii) the level of the fair value hierarchy within which the fair value
measurements are categorized in their entirety (Level 1, 2 or 3);
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Presentation and Disclosure
(iii) categorized within Level 2 and Level 3 of the fair value hierarchy, a
description of the valuation technique(s) and the inputs used in the fair
value measurement.
(iv) categorized within Level 3 of the fair value hierarchy, a description of
the valuation processes used by the entity
(v) if the highest and best use of a non-financial asset differs from its
current use, an entity shall disclose that fact and why the non-financial
asset is being used in a manner that differs from its highest and best use.
(vi) a reconciliation from the opening balances to the closing balances,
disclosing separately changes during the period
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THE
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THE TIME FOR
READING ……..
END
CHAPTER
OF
2ND
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