Manac - Module 1

Management Accounting. GMP

A Brief Introduction to Mechanics & Principles of Recording Accounting

Transactions

Prof. Santosh SangemXLRI, Finance Area


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?


Business Stakeholders


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


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


Issues in recording business transactionsW

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Economic Transactions

Business transactions that affect financial position & performance

Economic Transactions

Valuation

Recognition

Classification


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


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.


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


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.


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.


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.


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


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


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.


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


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.


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


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


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.


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….


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


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


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


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


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

Documents

Manac - Module 1