Principles of Recording Accounting

Transactions

Prof. Santosh Sangem

XLRI, Finance Area
 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
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 (or Cost) Accounting

Accounting Standards and their role

 Why the Ind-AS (or IFRS)
 Global Harmonization of Financial Statements
 Information that is useful for Economic Decisions
 Changes in Business Environment, Practices, and Instruments
 Much Greater Complexity
 Usefulness of Financial Information for Decision Making

 Rule-Based vs. Principles Based

 Principles Based better suited in a complex environment

 Prudential Supervision as the predominant global philosophy

 Shift from “Regulatory Approach” to “Supervisory Approach”

 Ind-AS to achieve convergence with IFRS

 Convergence vs. Adoption
 Conceptual Framework of Ind-AS/IFRS
 Conceptual Framework
 A set of broad principles
 To provide guidance in development and application of Reporting Standards
(IFRS & Related Standards)
 Does not over-ride any specific standard
 Standards may provide exceptions to conceptual framework where justified

 What does the Conceptual Framework deal with?

 Objective of Financial Reporting
 Qualitative Characteristics of useful information
 Definition, Recognition, and Measurement of financial statement elements

 Revised Conceptual Framework in March 2018

 To be adopted in India soon
 Objective of Financial Reporting
 Underlying Theme
 To provide financial information about the entity to existing and potential
investors, lenders, and creditors
 Objective of enabling decisions involving buying, selling, and holding
equity, loans, and other forms of credit
 Financial Information is not an Exact Depiction
 Based on Estimates, Judgments & Models

 Financial reports prepared for users with a reasonable knowledge

of business and economic activities who review and analyze
information diligently [Point 2.36, March 2018 version]
 In practice, this translates to institutional investors, educated investors, and
entities providing specialized financial services
 Self-Discipline, Adequate Disclosure and Market Discipline Pillars of
Prudential Supervision
 What do Investors Need?
 Information to assess and evaluate future cash flow prospects
 Focus on Cash Flows & Not on Profits
 Implicit movement towards bridging the gap between profits & cash flows
 Financial Performance reflected by Cash Flows in addition to Profits

 More specifically
 Resources of the Entity
 Claims against the Entity
 Transactions that lead to changes in Resources & Claims
 Efficiency and Effectiveness of discharge of responsibilities by
Management and Governing Board
 Information to help estimate value of the entity
 Accrual Concept as guiding principle
 What do Investors Need?
 Why Information about Resources & Claims
 To Assess Liquidity & Solvency
 To Assess Needs for Additional Financing
 To Evaluate Success in Obtaining Financing
 Sources of Cash Flows
 To Predict Distribution of Future Cash Flows
 Non-Financial Performance Reasons for Change
 Financial Accounting
 A structured representation of the financial position and financial
performance of an entity (Ind AS – 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 transactions
Economic Transactions

Business transactions that affect financial

position & performance

Economic Transactions
Recognition

Valuation

Classification
Basic assumptions/concepts underlying
accounting principles
Historical Going
Entity Concern
Cost

Accounting Unit of Adequate

Period Measure Disclosure

Prudence Materiality
Objectivity

Matching Fair Value Neutrality

 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.
 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.
 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 (Reporting Currency)
 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
 Neutrality
 Critical for faithful representation
 A widely misunderstood concept
 No systematic bias in selection of financial information for
presentation (neutral towards good and bad news)
 Neutrality about choice of presentation and form
 Does not imply irrelevance of information
 Increases reliability of information provided

 Prudence and Neutrality seen as opposed to each other

 Neutrality in forefront in 2010 conceptual framework
 No explicit reference to Prudence in 2010 conceptual framework
 Heavily debated as being divergent from prudence concept
 Delayed adoption of IFRS across countries
 Prudence vs. Neutrality Debate
 Prudence applicable where estimates have to be made under
conditions of uncertainty
 Assets & Income should not be overstated
 Expenses & Obligations should not be understated
 Asymmetric impact of Prudence in practice (conservative bias)
 Prudence embedded in Ind-AS/IFRS

 The Clarification
 Neutrality relates to assumptions & estimations where prudence is applicable
 Neutrality mandates no asymmetry while applying prudence
 No understatement of Assets & Incomes
 No overstatement of Expenses & Obligations
 Emphasis on unbiased process and assumptions
 Is conservatism the best way to avoid imprudent practices??
 Prudence vs. Neutrality Debate
 A workable approach
 Is the event likely or not?
 Given the event, what is the most likely estimate of amount involved

 How to determine the above?

 Likelihood using probability of event happening (at least 50%)
 Use expected value (probability weighted mean) over the range of outcomes
 Possibility of using median or mode (risk of asymmetry with mode)
 No single measure of central tendency sufficient. Give information on
possible range of outcomes.
 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
 Expected Default Losses of Large Customers
 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
 Revenues to be recorded when they are earned
 Expenses are to be matched against the revenues recorded during the
accounting period
 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 5 year maintenance contract 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
Bankruptcy. Rigas family members
Business Entity Concept: Rigas family
Adelphia convicted of fraud and lost their
treated the company assets as their own.
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 AIG’s
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.
Should we be so concerned about these basic
concepts/assumptions?
Company Concept Violated Result
Bankruptcy. Criminal conviction of CEO
Matching Concept: Improperly treated
WorldCom and CFO. Over $100 billion in stock
expenses as assets
market losses. Directors fined $18 million.
Matching Concept: Recognized $3 billion in
$10 million fine to SEC. Six executives
Xerox revenue in periods earlier than should have
fined $22 milliom
been recognized.
Civil charges filed against senior
AOL and Matching Concept: Back-dated contracts to
executives of both companies. $500
PurchasePro inflate revenues
million fine.
Computer Matching Concept: Fraudulently inflating CEO and senior executives indicted. Five
Associates revenues. executives pled guilty. $225 million fine.
Matching Concept: $4 billion in false entries Senior executives face regulatory and civil
HealthSouth
to overstate revenues. charges.
CEO and six other executives charged
Matching Concept: Improper recognition of
Quest with “massive financial fraud.” $250
$3 billion in revenue.
million SEC fine
And Many More….