A Brief Introduction to Mechanics &

Principles of Recording Accounting

Transactions
Prof. Santosh Sangem
XLRI, Finance Area

Management Accounting. GMP

What is accounting all about?

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

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Business Stakeholders

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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

Wh
Me at is
as u
r ed
?
?

Issues in recording business transactions

Economic Transactions
Business transactions that affect financial
position & performance
W
n?
he

How
Mu
c h?
?

Economic
Transactions
Recognition

Valuation
ch
hi ou
W Acc ??
s
nt

Classification

Management Accounting. GMP

Basic assumptions/concepts underlying

accounting principles
Entity

Going
Concern

Accounting
Period

Unit of
Measure

Adequate
Disclosure

Objectivity

Historical
Cost

Materiality

Prudence

Matching

Fair 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 1990s, 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 arms 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

Adelphia

Business Entity Concept: Rigas family

treated the company assets as their own.

Result
Bankruptcy. Rigas family members
convicted of fraud and lost their
investment in the company.

Business Entity Concept: Compensation

CEO (Chief Executive Officer)
transactions with an off-shore company
AIG
resigned. AIG paid $126 million in
that should have been disclosed on AIGs
fines.
books.
Business Entity Concept: Treated
Bankruptcy. Criminal charges against
Enron transactions as revenue, when they should senior executives. Over $60 billion in
have been treated as debt.
stock market losses.
Accounting Period Concept: Managing
Fannie
CEO and CFO fired. $9 billion in
earnings by shifting expenses between
Mae
restated earnings.
periods.
Adequate Disclosure Concept: Failure to
CEO forced to resign and was convicted
Tyco
disclose secret loans to executives that
in criminal proceedings.
were subsequently forgiven.
Management Accounting. GMP

Should we be so concerned about these basic

concepts/assumptions?
Company

Concept Violated

Result

WorldCom

Matching Concept: Improperly treated

expenses as assets

Bankruptcy. Criminal conviction of CEO

and CFO. Over $100 billion in stock
market losses. Directors fined $18 million.

Xerox
AOL and
PurchasePro
Computer
Associates
HealthSouth
Quest

Matching Concept: Recognized $3 billion in

$10 million fine to SEC. Six executives
revenue in periods earlier than should have
fined $22 milliom
been recognized.
Civil charges filed against senior
Matching Concept: Back-dated contracts to
executives of both companies. $500
inflate revenues
million fine.
Matching Concept: Fraudulently inflating CEO and senior executives indicted. Five
revenues.
executives pled guilty. $225 million fine.
Matching Concept: $4 billion in false entries Senior executives face regulatory and civil
to overstate revenues.
charges.
CEO and six other executives charged
Matching Concept: Improper recognition of
with massive financial fraud. $250
$3 billion in revenue.
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 below
A. Materiality, Matching & Unit of Measure
B. Going Concern, Fair Value & Matching
C. Objectivity, Matching & Materiality
D. Prudence, Historical Cost & Unit of Measure
E. 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
Management Accounting. GMP