Management Accounting. GMP A Brief Introduction to Mechanics & Principles of Recording Accounting Transactions Prof. Santosh Sangem XLRI, Finance Area
Management Accounting. GMP
A Brief Introduction to Mechanics & Principles of Recording Accounting
Transactions
Prof. Santosh SangemXLRI, Finance Area
Management Accounting. GMP
A coherent set of principles for recording transactions of business & non-business entities Focus on business entities
A business entity is an organization that manages productive resources to provide products and services to customers with the objective of earning profit
Types of business entities Sole proprietorship Partnership Corporation Limited Liability Corporation/Partnership
What is accounting all about?
Management Accounting. GMP
Business Stakeholders
Management Accounting. GMP
Accounting & Information Provides information to stakeholders
Decision making by management Investment decisions of investors Government & regulatory agencies Customers & providers of resources
Information relating to financing, investing, & operating activities of the business entity
Two branches of accounting Financial Accounting Management Accounting
Management Accounting. GMP
Financial Accounting A structured representation of the financial position and financial
performance of an entity (IAS – 1)
Principles for recording business transactions that affect financial position Ensuring comparability over time and across firms
Categorization of business transactions Operating Investing Financing
Management Accounting. GMP
Issues in recording business transactionsW
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Economic Transactions
Business transactions that affect financial position & performance
Economic Transactions
Valuation
Recognition
Classification
Management Accounting. GMP
Basic assumptions/concepts underlying accounting principles
Adequate DisclosureAdequate Disclosure
Accounting Period
Accounting PeriodEntityEntity
Unit of MeasureUnit of
Measure ObjectivityObjectivity
Historical Cost
Historical Cost
MatchingMatching
Going Concern
Going Concern
PrudencePrudence MaterialityMateriality
Fair ValueFair Value
Management Accounting. GMP
Entity The most basic of the basic concepts Only transactions related to the activities of the entity are to be
recorded That is, the entity is viewed as separate from its owners, creditors,
customers, or other entities Boundaries on transactions to be recorded Defines the nature of the transaction Examples: A computer purchased by a sole proprietor and used for both
business and personal purposes (largely the latter) cannot be treated as an asset of the business.
A sale made to a customer cannot be recorded in the books of the entity as a purchase made by the customer.
Management Accounting. GMP
Going Concern The assumption that the entity will continue in business forever Violation of assumption requires that all assets and liabilities be
recorded at current market value Examples A telecom company has been stripped of all operating licenses it
owned on the grounds of fraudulent conduct during the spectrum auction process. The company has also been barred from participating in spectrum auctions for the next 10 years.
A company has a large portion of its long-term debt falling due in the next 3 months. The company is in no position to raise the money required to repay the debt nor are the lenders willing to refinance/restructure the debt.
A company has failed to maintain the financial covenants set by its bankers leading them to request the court for its liquidation
Management Accounting. GMP
Accounting Period Financial statements are to be prepared periodically to help
external stakeholders to continuously evaluate the financial position of the entity
A typical accounting period is one year Different accounting periods make it difficult to compare financial
performance. Disclose reasons if statements prepared for a period different than
one year Examples: During the late 1990’s, many companies in India presented their
annual accounts for a period of either 9 months or 15 months on account of transition to the statutory requirement of presenting financial statements for April-March each year.
Management Accounting. GMP
Adequate Disclosure Requires that all relevant information needed by shareholders to
understand the financial statements and to evaluate financial performance be disclosed
Minimum disclosure requirements specified by the accounting standards in force
Central feature of corporate governance standards and regulatory principles
Examples: RG garments did not disclose the fact that during the year it was
required to pay Rs. 20 crores as penalty for violating the customs duty and forex laws.
A large number of companies in the US have at some time or the other not disclosed the true extent of their pension liabilities and obligations under derivative contracts.
Management Accounting. GMP
Objectivity Entries in accounting records & information presented in financial
statements must be based on objective or verifiable evidence Reduces the chance of fraudulent behavior Necessary to avoid subsequent legal liabilities Examples: At the beginning of the year, ABD Garments Ltd. recorded the
purchase of a second hand delivery vehicle for Rs.25 lakhs from DBA Garments Co., an entity owned by its managing director. At the end of the year, a physical inspection showed that the vehicle was not in the premises of ABD Garments and that the registration papers had also not been transferred.
Management Accounting. GMP
Unit of Measure All business transactions to be recorded in terms of money
Financial statements to be presented in a single currency Currency in country of residence Currency in country of listing Currency in country of substantial business
Choice of currency usually determined by regulatory requirements
Examples Infosys Ltd. presents its financial statements in Indian Rupees and
its Form 10K SEC filings in US dollars Mahindra Forgings Global Ltd. presents its financial statements in
both Indian Rupees and Euros
Management Accounting. GMP
Prudence (Conservatism) The concept of prudence requires that wherever estimates are to be
made for items in financial statements, the least optimistic value is to be used
Mainly applicable for provisions and assets where there is uncertainty as to the amount that will either be paid/recovered
Judgment as to values & their likelihood Examples: During the recent financial crisis, many US banks over-stated the
value of their derivative transactions despite the near absence of trading in their markets
During 2006-08, a number of US banks had made inadequate provisions for loan defaults by customers
Management Accounting. GMP
Historical Cost The principle that assets are to be initially recorded at their cost or
purchase price Some exceptions allowed
Asset impairment Hyper-inflationary conditions Occasional revaluation of long-term assets
Examples: ABC Publishing Ltd. purchased the land for its factory premises
for Rs. 5 crore in 2005. As on 31/03/2012, the land had a market value of Rs. 18 crore. The CEO of the company wishes to record the land at the market value of Rs. 18 crore.
Management Accounting. GMP
Materiality It is an expression of relative significance or importance of a
particular matter in context to financial statements Usually as a % of total assets, total revenues, or total profits
Primarily concerned with presentation of financial statements Not with recording of transactions
An item is considered material if it could influence the economic decisions of users of financial statements
All material items must be correctly classified & distinctly shown in the financial statements
Examples: Spending on stationary is usually treated as an expense rather than
as an asset Transactions with related entities or entities owned by directors
Management Accounting. GMP
Fair Value Central principle in IFRS and recent Accounting Standards Fair value 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 the value that could have been obtained/paid in an arm’s length (market-based) transaction
The fair value principle states that assets and liabilities should be reported at fair value
To put simply, transactions for assets, liabilities, incomes, and expenses are to be recorded at fair value rather than historical cost.
Fair Value a contentious concept Example Firms A & B are owned by the same set of partners. During the year, firm A has
billed firm B an amount of Rs. 40 lakh for goods sold (Rs. 1000 per unit). However, during the year, firm A sold the same product to its other customers at a price of Rs. 2500 per unit.
Management Accounting. GMP
Matching/Accrual Derives from the accounting period concept Expenses are to be matched against the revenues recorded during the
accounting period Revenues to be recorded when they are earned Examples: A garments outlet buys 10000 shirts for being sold to its customers
at Rs. 100 per shirt. At the end of the year, it finds that it has sold 9800 shirts. It will record only the cost of 9800 shirts (i.e. 9800*100) as the cost of shirts sold during the year.
A motor vehicle company provides its customers the option of purchasing a maintenance contract for a period of 5 years for a total sum of Rs. 50,000. It will record only Rs. 10,000 as revenue for each year
Management Accounting. GMP
Basic assumptions/concepts underlying accounting principles
Recording of Transactions Entity Objectivity Prudence Unit of Measure Matching
Presentation of Financial Statements Accounting Period Historical Cost Fair Value Going Concern Materiality Prudence Unit of Measure
Disclosures Adequate Disclosure Materiality
Management Accounting. GMP
Should we be so concerned about these basic concepts/assumptions?
Company Concept Violated Result
AdelphiaBusiness Entity Concept: Rigas family
treated the company assets as their own.
Bankruptcy. Rigas family members convicted of fraud and lost their
investment in the company.
AIG
Business Entity Concept: Compensation transactions with an off-shore company
that should have been disclosed on AIG’s books.
CEO (Chief Executive Officer) resigned. AIG paid $126 million in
fines.
EnronBusiness Entity Concept: Treated
transactions as revenue, when they should have been treated as debt.
Bankruptcy. Criminal charges against senior executives. Over $60 billion in
stock market losses.
Fannie Mae
Accounting Period Concept: Managing earnings by shifting expenses between
periods.
CEO and CFO fired. $9 billion in restated earnings.
TycoAdequate Disclosure Concept: Failure to disclose secret loans to executives that
were subsequently forgiven.
CEO forced to resign and was convicted in criminal proceedings.
Management Accounting. GMP
Should we be so concerned about these basic concepts/assumptions?
Company Concept Violated Result
WorldComMatching Concept: Improperly treated
expenses as assets
Bankruptcy. Criminal conviction of CEO and CFO. Over $100 billion in stock
market losses. Directors fined $18 million.
XeroxMatching Concept: Recognized $3 billion in revenue in periods earlier than should have
been recognized.
$10 million fine to SEC. Six executives fined $22 milliom
AOL and PurchasePro
Matching Concept: Back-dated contracts to inflate revenues
Civil charges filed against senior executives of both companies. $500
million fine.Computer Associates
Matching Concept: Fraudulently inflating revenues.
CEO and senior executives indicted. Five executives pled guilty. $225 million fine.
HealthSouthMatching Concept: $4 billion in false entries
to overstate revenues.Senior executives face regulatory and civil
charges.
QuestMatching Concept: Improper recognition of
$3 billion in revenue.
CEO and six other executives charged with “massive financial fraud.” $250
million SEC fine
And Many More….
Management Accounting. GMP
Basic Accounting Concepts-More Examples
A noted accountant once remarked, “If it becomes accepted or expected that accounting principles are determined or modified in order to secure purposes other than economic measurement, we assume a grave risk that confidence in the credibility of our financial information system will be undermined.” Which of the basic accounting principle(s) attempt(s) to ensure that such a situation will not occur?
You are required to select the most appropriate choice from belowA. Materiality, Matching & Unit of MeasureB. Going Concern, Fair Value & MatchingC. Objectivity, Matching & MaterialityD. Prudence, Historical Cost & Unit of MeasureE. Objectivity, Fair Value & Matching
Management Accounting. GMP
Duality Concept & the Accounting Equation Dual entry system of recording transactions Derives from the matching principle & the fundamental accounting
equation Every economic transaction has two aspects “a sacrifice” and “a
benefit” The Fundamental Accounting Equation
Assets = Liabilities + Owners Capital (general form)Alternatively
Assets = Liabilities + Owners Capital + Incomes – Expenses – Dividends (expanded form)
Method of recording transactions must ensure balance at all times
Management Accounting. GMP
Debits (Dr.) & Credits (Cr.)
Accounting tools that are used to describe changes in different accounts
Each transaction is broken up into two components – a debit component and a credit component
Total Amount of Debit component = Total Amount of Credit component for each transaction
Ensures equality of the fundamental equation at all times Transactions recorded in “Journal” & “Ledgers” The “Golden Rules” of Book-Keeping & the recording of debits
and credits
Management Accounting. GMP
The “Golden” Rules of Accounting
Real Accounts Debit what comes in Credit what goes out
Nominal Accounts Debit all expenses and losses Credit all incomes and gains
Personal Accounts Debit the benefit receiver Credit the benefit giver
Management Accounting. GMP
A Simpler Alternative
Debits Increase (hence credits decrease) Assets Dividends Expenses
Debits - ADE
Credits Increase (hence debits decrease) Owners Capital Income Liabilities
Credits - OIL
Hence Normal Balances in ADE called Debit Balances & Normal Balances in OIL called credit balances