Chapter-1

Introduction to Financial accounting

1.Who is considered the father of modern accounting?

a) Luca Friar Pacioli
b) J.Betty
c)Henry Fayol
d) Gestonburg
Answer A
2.Who is considered the father of accounting in India?
a) Chankya
b) Aryabhatt
c)Sri Kalyan Subramani Aiyar
d) A.P.JAbdul Kalam
Answer C
3. Which of them is personal account?
a) Capital
b) Patents
c) Trademark
d) Copyright
Answer A
4. Which of them is real account?
a) Capital
b) Loan
c) Drawings
d) Patents
Answer D
5.Which of the following is not a real account?
a) Cash account
b) Stock account
c)Machinery account
d) Reserve for discount on creditors
Answer D
6. Which of the following is not a real account?
a) Patents account
b) Goodwill account
c) Petty cash account
d) Petty cash expenses account
Answer D
7.Which of the following is not a personal account?
a) Capital Account
b) Drawings Account
c)Bills Payable Account
d) Bills receivable Account
e) All of the above
Answer E
8. Which of the following is not a personal account?
a) Arihant Jewelers Ltd.
b) Punjab National Bank
c)Tinsukia College
d) Reserve for discount on creditors Account
Answer D
2. Which of the following statement is correct?
a) Book keeping is very old
b) The workof book-keeping is usually entrusted to junior employees
) Function of book- keeping is performed by the book-keeper
d) All of the above
Answer D
10. "Accounting is an art of recording, classifying and summarizing in a significant manner and in
terms of money, transactions and events which are of a financial character and interpreting the
result thereof: this definition is given by:
a) American Institute of Certified Public Accountants
b) J. Betty
c) Henry Fayol
d) Gestonburg
Answer A
11.A list of assets, liabilities and owner's equity of a business enterprise as of a specific date is:
a) Income Statement
b) Cash Flow Statement
c) Balance-Sheet
d) Proft& Loss Account
Answer C
12. The balance-sheet is related to the income statement in the same way that -
a) Apoint in time is related to period of time
b) A period of time is related to a point in time
c) Apoint in time is related to another point in time
d) Aperiod of time is related to another period of time
Answer B
13. The properties own by business enterprises are called:
a) Assets
b) Liabilities
Capital
d) Owner's Equity
Answer A
14. Which of the following is an important reason for studying accOunting?
a) The information provided by accounting is useful in making many economic decisions.
b) Accounting plays an important role in society
) The study of accounting could lead to challenging career
d) All of the above.
Answer A
15. Statement of changes in financial position shows:
a) Sources and uses of funds
b) Assets and Liabilities
c)Income and Expenses
d) Losses and Gains
Answer A
16. Which of the following statements is false?
a) Accounting is the language of business.
b) Accounting is as old as money itself.
c)Accounting is a service function.
d) Accounting involves only the recording of business transactions.
Answer D
17.Which of the following statements are false?
a) Accounting may be described as an information system which has its inputs, processing
methods and outputs.
b) Accounting records only those transactions and events which are of financial nature.
c) Accounting is both art and science.
d) Accounting means recording transactions and events, not their interpretation.
Answer B
18.Which of the following is not a characteristic of accounting information?
a) Relevance
b) Reliability
c) Comparability
d) Matching
Answer D
19.Which of the following is not a branch of accounting?
a) Financial accountin8
b) Cost accounting
c) Management Accounting
d) Responsibility accounting
Answer D
20.The last step in accounting process is:
a) ldentifying the business transactions and events
b) Recording of business transactions
c)Classifying the business transactions
d) Communication of financial statements
Answer D
21. If a trial balance totals do not agree, the difference must be entered in
A) The Profit and Loss Account
B) A Nominal Account
C) The Capital Account
D) A Suspense Account
Answer: D

22. If it is required to maintain fixed capitals then the partners’ shares of profits must be
A) Credited to capital accounts
B) Debited to capital accounts
C) Debited to partners’ current accounts
D) Credited to partners’ current accounts
Answer: D

23. Suppliers personal a/c are seen in the

A) Sales Ledger
B) Nominal ledger
C) Purchases Ledger
D) General Ledger
Answer: C

24. If you want to ensure that your money will be secured if cheques sent are wasted in the post,
you should
A) Always pay by cash
B) Cross your Cheques ‘Account Payee only, Not Negotiable.’
C) Always get the money in person
D) Not use the postal service in future
Answer: B

25. Discounts received are

A) Deducted by us when we pay our accounts
B) Deducted when we receive cash
C) Given by us when we sell goods on credit
D) None of these
Answer: A

26. Sales invoices are first entered in

A) The Cash Book
B) The Purchases Journal
C) The Sales Journal
D) The Sales Account
Answer: C

27. Entered in the Purchases Journal are

A) Discounts received
B) Purchases invoices
C) Payments to suppliers
D) Trade discounts
Answer: B

28. At the balance sheet date, the balance on the Accumulated Provision for Depreciation Account is
A) Transferred to Depreciation Account
B) Transferred to the Asset Account
C) Transferred to Profit and Loss Account
D) Simply deducted from the asset in the Balance Sheet
Answer: D

29. If we take goods for own use we should

A) Debit Drawings Account, Credit Purchases Account
B) Debit Drawings Account: Credit Stock Account
C) Debit Sales Account: Credit Stock Account
D) Debit Purchases Account: Credit Drawings Account
Answer:
30. When a petty cash book is kept there will be
A) No entries made at all in the general ledger for items paid by petty cash
B) The same number of entries in the general ledger
C) Fewer entries made in the general ledger
D) More entries made in the general ledger
Answer: C
Long Answer Type Questions
1. Who are the different users of accounting and explain their role?
Users of accounting are both internal and external to the organization.
Internal Users of Accounting
Internal users are the primary users of accounting.
Following are the 3 types of internal users and their information needs:
Owners
Owners need to assess how well their business is performing.
Financial statements provide information to owners about the profitability of the overall business as
well as individual products and geographic segments.
Owners are also interested in knowing how risky their business is.
Accounting information helps owners in assessing the level of stability in business over the years and
to what extent have changes in economic factors affected the bottom line of the business. Such
information helps owners to decide if they should invest any further in the business or if they should
use their financial resources elsewhere in more promising business ventures.

Managers
Managers need accounting information to plan, monitor and make business decisions Managers
need to allocate the financial, human and capital resources towards competing needs of the
business through the budgeting process.

Preparing and monitoring budgets effectively requires reliable accounting data relating to the
various activities, processes, products, services, segments and departments of the business.
Management requires accounting information to monitor the performance of business by
comparison against past performance, competitor analysis, key performance indicators and industry
benchmarks.
Managers rely on accounting data to form their business decisions such as investment, financing and
pricing decisions.
In case of investment decisions for example, managers would require the return on investment
calculation of a proposed project supported by reliable estimates of the costs and revenues.

Employees
For the employees operating in the finance department, using accounting information is usually part
of their job description. This includes for example preparing and reviewing various financial reports
such as financial statements.
Employees are interested in knowing how well a company is performing as it could have implications
for their job security and income.
Many employees review accounting information in the annual report just to get a better
understanding of the company’s business.
In recent years, the increase in number of shares and share options schemes for employees
particularly in startups has fostered a greater level of interest in accounting information by
employees.
Moreover, potential employees are also interested to learn about the financial health of the
organization they aspire to join in the future.

External Users of Accounting

External users are the secondary users of accounting.
Following are the 8 types of external users and their information needs:

Investors
Investors need to know how well their investment is performing. Investors primarily rely on the
financial statements published by companies to assess the profitability, valuation and risk of their
investment.

Investors use accounting information to determine whether an investment is a good fit for their
portfolio and whether they should hold, increase or decrease their investment.
Lenders
Lenders use accounting information of borrowers to assess their credit worthiness, i.e. their ability
to pay back any loan.
Lenders offer loans and other credit facilities on terms that are based on the assessment of financial
health of borrowers.
Good financial health is indicated by the borrower’s ability to pay its liabilities on time, high
profitability, substantial securable assets and liquidity.
Poor liquidity, low profitability, lack of assets that can be secured and an inability to pay liabilities on
time demonstrate poor financial health of borrowers.
On a lighter note, borrowers can only get a loan from lenders if they can prove that they don’t need
the money.

Suppliers
Just like lenders, suppliers need accounting information to assess the credit-worthiness of its
customers before offering goods and services on credit.
Some suppliers only have a handful of customers. These customers could be very large businesses
themselves. Suppliers need accounting information of its key customers to assess whether their
business is in good health which is necessary for sustainable business growth.

Customers
Most consumers don’t care about the financial information of its suppliers.
Industrial consumers however need accounting information about its suppliers in order to assess
whether they have the required resources that are necessary for a steady supply of goods or services
in the future. Continuity in supply of quality inputs is essential for any business.

Tax Authorities
Tax authorities determine whether a business declared the correct amount of tax in its tax returns.
Occasionally, tax authorities conduct audits of the tax returns filed by businesses in order to verify
the information with the underlying accounting records.
Tax authorities also cross reference accounting information of suppliers and consumers in order to
identify potential tax evaders.

Government
Government ensures that a company’s disclosure of accounting information is in accordance with
the regulations that are in place to protect the interest of various stakeholders who rely on such
information in forming their decisions.
Government defines and monitors accounting thresholds such as sales revenue and net profit to
determine the size of each business for the purpose of ensuring that it complies with the relevant
employee, consumer and safety regulations.

Auditors
External auditors examine the financial statements and the underlying accounting record of
businesses in order to form an audit opinion.
Investors and other stakeholders rely on the independent opinion of external auditors on the
accuracy of financial statements.

Public
General public may also be interested in accounting information of a company. These could include
journalists, analysts, academics, activists and individuals with an interest in economic developments.
 2. What are the different types and branches of accounting?
There are eight types of financial accounting. Each branch has come about thanks to technological,
economic or industrial developments and has its own specialized use. Accountants tend to specialize
in one branch.
1. Financial Accounting
Financial accounting involves recording and categorizing transactions for business. This data is
generally historical, meaning it’s from the past.

It also involves generating financial statements based on these transactions. All financial statements,
such a balance sheet and income statement, must be prepared according to the generally accepting
accounting principles (GAAP), according to Accountingverse.
Public companies have to follow a set of rules set out by the government (this is the Securities and
Exchange Commission in the U.S.).
Financial accounting is performed to conform to external regulations and is not for internal
employees to analyze and make financial decisions—managerial accounting is used for this purpose.

2. Cost Accounting
Cost accounting is considered a type of managerial accounting. Cost accounting is most commonly
used in the manufacturing industry, an industry that has a lot of resources and costs to manage. It is
a type of accounting used internally to assess a company’s operations.
Cost accounting concerns itself with recording and analyzing manufacturing costs. It looks at a
company’s fixed (unchanging and constant costs, like rent) and variable costs (changing costs, like
shipping charges) and how they affect a business and how these costs can be better managed,
according to Accounting Tools.

3. Auditing
There are two types of auditing: external and internal auditing. In external auditing, an independent
third party reviews a company’s financial statements to make sure they are presented correctly and
comply with GAAP.
Internal auditing involves evaluating how a business divides up accounting duties, who is authorized
to do what accounting task and what procedures and policies are in place. Internal auditing helps a
business zero in on fraud, mismanagement and waste or identify and control any potential
weaknesses in its policies or procedures, according to Accounting Tools.

4. Managerial Accounting
Also known as management accounting, this type of accounting provides data about a company’s
operations to managers. The focus of managerial accounting is to provide data that managers need
to make decisions about a business’s operations, not comply strictly with GAAP.
Managerial accounting includes budgeting and forecasting, cost analysis, financial analysis, reviewing
past business decisions and more. Cost accounting is a type of managerial accounting.
Fresh Books has simple online accounting software for small business that makes it easy to produce
these reports.

5. Accounting Information Systems

Known as AIS for short, accounting information systems concerns itself with everything to do with
accounting systems and processes and their construction, installment, application and observation.
This can include accounting software management and the management of bookkeeping and
accounting employees.

6. Tax Accounting
Tax accounting involves planning for tax time and the preparation of tax returns. This branch of
accounting aides businesses be compliant with regulations set up by the IRS.
Tax accounting also helps businesses figure out their income tax and other taxes and how to legally
reduce their amount of tax owing. Tax accounting also analyzes tax-related business decisions and
any other issues related to taxes.

7. Forensic Accounting
This specialized accounting service is trending in accounting and is becoming increasingly popular.
Forensic accounting focuses on legal affairs such as inquiry into fraud, legal cases and dispute and
claims resolution.
Forensic accountants need to reconstruct financial data when the records aren’t complete. This
could be to decode fraudulent data or convert a cash accounting system to accrual accounting.
Forensic accountants are usually consultants who work on a project basis, according to Accounting
Tools.

8. Fiduciary Accounting
This branch of accounting centers around the management of property for another person or
business. The fiduciary accountant manages any account and activities related to the administration
and guardianship of property.
Fiduciary accounting covers estate accounting, trust accounting and receivership (the appointing of a
custodian of a business’s assets during events such as bankruptcy).

Though there are eight branches of accounting in total, there are three main types of accounting,
according to McAdam & Co. These types are tax accounting, financial accounting and management
accounting.
Management accounting is useful to all types of businesses and tax accounting is required by the IRS.
Financial accounting is only relevant to larger companies.

TAX ACCOUNTING
In this type of accounting, all records and reports are made according to regulations established by
the tax authorities. Small businesses can hire a tax accountant who specializes in making sure the
accounting records are IRS-compliant and who transfers that information to the business tax return.
The IRS requires that businesses use one accounting system and stick to it (see below for an
exception). Whether they use the cash or accrual method determines when they report revenue and
expenses.

FINANCIAL ACCOUNTING
Financial accounting is performed with potential lenders and investors in mind, as well as GAAP
(generally accepted accounting principles). Using this standard accounting methods helps investors
and lenders get an accurate read on a business’s financial health if a company is looking to finance a
new purchase or venture.
It also helps businesses be transparent by reporting management’s income.
That said, small businesses usually aren’t required to use GAAP and its accrual method. Any business
that makes, buys or sells products must use GAAP, according to the IRS.
Larger businesses often employ accountants in-house to help them comply with these standard
accounting principles.

MANAGEMENT ACCOUNTING
This category of accounting doesn’t follow GAAP but it does follow standard accounting practices
taught in accounting school.
The focus here is on generating financial statements like budgets, product costings, cash flow
projections and business acquisition analysis reports. Standard reports like balance sheets, profit and
loss statements and cash flow statements are generated in a way to help managers analyze past
decisions and plan for the future.
Small businesses may only use cash projections. Larger companies, especially manufacturers, will use
many more reports.

3. Explain the advantages and disadvantages of financial accountitng.

he meaning of Financial Accounting can be defined as a procedure of documenting, encapsulating,
and reporting the multiple transactions resulting from trading operations over a timeframe. These
transactions are compiled in the preparation of financial statements, comprising the income
statement, balance sheet, and cash flow statement that record the enterprise’s operating
accomplishment over a particular period.
Financial accounting is a specific accounting branch that maintains a company’s financial activities.
With the help of regulated guidelines, all the transactions are entered, reviewed, and shown in a
financial statement or financial report.
Financial statements prepared by financial accounting takes into account the following aspects of
business viz. Expenses, Revenue, Asset, Equity, and Liability. Financial accounting has an important
role in increasing profitability and efficiency as it helps in managing all financial resources of the
business. It is statutorily required to practice financial accounting in their operations by every
business organization.

Few advantages of financial accounting are:

Maintain Business Record – Financial accounting records each and every transaction of business
organization. It systematically maintains a proper book of accounts of all monetary transactions.
Unlike human memory which has a limited capacity to remember things, financial accounting can
record large amounts of transactions.
Prevention And Detection Of Fraud – Avoidance, and detection of frauds or errors is an important
role played by financial accounting. It records all financial data fairly which is used by management
for analysis purposes. This data acts as proof and reduces the chances of any fraud or errors.
Present True Financial Position – Financial accounting reveals and interprets the true financial
position of organizations. It records each financial aspect and supplies it from time to time to the
internal management team. Managers get the real ideas of all financial resources of the organization
regularly through data supplied by financial accounting. It helps them in making proper decisions for
managing the overall financial position.
Helps In Preparing Financial Statements – Preparation of financial statements is a must for knowing
the true profit or loss and real worth of the organization. Financial accounting supplies all relevant
accounting data for the preparation of financial statements like profit and loss account and balance
sheet.
Comparison of Result – Financial accounting helps in comparing the performance of business
organizations. It systematically records and stores financial data for many accounting years. This way
comparison of present data with previous year’s data can be easily done.
Acts as Legal Evidence – Financial accounting serves as legal evidence of all data and helps in settling
of all business disputes. It prepares and maintains systematic books of accounts of all financial
transactions which can be used for avoiding any confusion or misunderstanding.
Assists The Management – Managers depend on financial accounting for various data for taking
managerial decisions. It provides the full information’s regarding all cash flows in an organization.
They can easily anticipate any surplus or deficit of funds in an organization and take decisions
accordingly.

Disadvantages of Financial Accounting –

Financial accounting is the only branch of accounting and it is not perfect. There are large numbers
of limitations which open a new way to use other tools of accounting. To know what are the main
limitations of financial accounting. It is very necessary for accountants. Accountants are often blind
to these limitations.

Financial accounting is of historical nature – Net effect of transactions are recorded in financial
accounting which has happened in the past. These accounts is just postmortem of all events of
business in the past. These records does not help for future planning and other managerial
decisions. Financial accounting shows the profitability of the business but it is a failure to tell that is
it good or bad. Financial accounting is also a failure to know the reasons of the low profitability
position.
Financial accounting deals with overall profitability – Accounts of business are made by a way which
shows only overall profitability. It does not show net profit per product, or per department or
according to job. Thus to find it difficult to all activities which do not give profit. So, it creates
inefficiency in business activities.
Absence of full disclosure of facts – In financial accounting, we record only those activities and
transactions which we can show or describe in money. There are many other facts of business which
are non-financial and non-monetary like efficient management, the demand of products of the firm,
good relations in industry, good working environments which cannot be known by financial
accounting.
Financial reports are interim report of business – Financial statements made by financial accounting
is the interim report of the firm’s all business work but financial position and profitability which are
shown in it is not fully true. Due to adopting cost concept, all transactions are recorded on it real
cost but by changing in the time; it is the need of time to adjust the cost of assets and liabilities
according to inflation of the market. Because financial accounting does not record according to
inflation so its result does not show the true position of the business.
Incomplete knowledge of costs – From a cost point of view, financial accounting is incomplete. In
financial accounting, the accountant does not calculate each and every product’s total cost. So,
financial accounting does not help to determine the price of the product of the business.
No provision of cost control – Financial accounting does not help business organization for
controlling the cost. Because there is no provision of controlling cost in it. In financial accounting, we
write cost, if we paid any expenses. Thus there is no provision of improvement in financial
accounting. Except for this, there is no other way to inspect all expenses.
Financial statements are affected from personal judgment – Many events of financial statements are
affected from personal judgment of the accountant. Method of calculating depreciation, rate of
provision of doubtful debts, and stock valuation method are decided by an accountant. Thus,
financial statements do not show true and fair view of business.
The financial statements are incorporated for external usage because it is given to people who are
not the employee of the company. The primary recipients of this statement are owners/stockholders
and few moneylenders. In the case of a corporation’s stock that is traded publicly, the financial
statements are circulated publicly such as customers, employees, labor organizations, competitors,
and investment analysts.

Chapter2. Accounting Process

Multiple Choice Questions
1. Balance sheets are prepared
A. Daily
B. Weekly
C. Monthly
D. Annually
Answer D
 2. The ratios that refer to the ability of the firm to meet the short term obligations out of its
short term resources
A. Liquidity ratio
B. Leverage ratio
C. Activity ratio
D. Profitability ratio
Answer A
3. The measure of how efficiently the assets resources are employed by the firm is called
A. Liquidity ratio
B. Leverage ratio
C. Activity ratio
D. Profitability ratio
Answer C
4. The following is (are) the current liability (ies)

A. Bills payable

B. Outstanding expenses

C. Bank Overdraft

D. All of the above

Answer D
5. Current ratio =

A. Quick assets/Current liabilities

B. Current assets/Current liabilities

C. Debt/Equity

D. Current assets/Equity
Answer B
6. Liquid or Quick assets =
A. Current assets - (Stock + Work in progress)
B. Current assets + Stock + Work in progress
C. (Current assets + Stock) + Work in progress
D. (Current assets + Work in progress) - Stock
Answer A

7. Lower the Debt Equity ratio

A. Lower the protection to creditors
B. Higher the protection to creditors
C. It does not affect the creditors
D. None of the above
Answer B
8. higher inventory ratio indicates
A. Better inventory management
B. Quicker turnover
C. Both A and B
D. None of the above
Answer C

9. Return on Investment Ratio (ROI) =

A. (Gross profit / Net sales) x 100
B. (Gross profit x Sales / Fixed assets) x 100
C. (Net profit / Sales) x 100
D. (Net profit / Total assets) x 100
Answer D
10. A low Return on Investment Ratio (ROI) indicates
A. Improper utilization of resources
B. Over investment in assets
C. Both A and B
D. None of the above
Answer C
11. Sales expenditure budget is prepared by estimating the expense(s) of
A. Advertisement
B. Market analysis
C. Salesman's salary
D. All of the above
Answer D
12. Budgeting is difficult to apply in the following cases
A. Products subjected to rapid changes
B. Job order manufacturing
C. Uncertain market condition
D. All of the above
Answer D

13. A Master Budget consists of

A. Sales budget
B. Production budget
C. Material budget
D. All of the above
Answer D

14. The accounting process involves recording

A. Quantifiable economic event
B. Non Quantifiable economic event
C. All of them
D. None of them
Answer A
15. In accounting, an economic event is referred to as
A. Cash
B. Bank statement
C. Transaction
D. Exchange of money
Answer C
16. Identify the correct sequence of accounting process
A. Communicating -> Recording -> Identifying
B. Recording -> Communicating -> Identifying
C. Identifying -> Communicating -> Recording
D. Identifying -> Recording -> Communicating
Answer D
17. Bookkeeping mainly consists of which part of accounting process?
A. Analysing
B. Preparing financial statements
C. Recording financial information
D. Auditing the books of accounts
Answer C
18. Auditing refers to
A. Reporting the financial information
B. Examination of financial information
C. Preparation of financial statements
D. Maintaining the ledger accounts
Answer B
19. Which of the following is the external user of financial statements?
A. Manager of the business
B. CEO of the business
C. Creditor of the business
D. Controller of the business
Answer C
20. Which of the following is the internal user of financial statements?
A. Creditor of the business
B. Government agency
C. Shareholder of the business
D. Manager of the business
Answer D
21. ________ is the first phase of accounting cycle
A. Identifying an economic event or transaction
B. Preparing Journal
C. Posting entries to Ledger accounts
D. Making decisions about business
Answer A
22. ______ is a separate legal entity whose total capital can be divided into many shares
A. Partnership
B. Sole Proprietorship
C. Company
D. Non-profit organization
Answer C
23. An asset possesses which of the following?
A. Future economic benefits for the business
B. All kinds of benefits for the business
C. Expenses for the business
D. Merits & Demerits for the business
Answer A
24. Liabilities are which of the following?
A. Resources
B. Obligations
C. Future benefits
D. Expenses
Answer B
25. _______ is the gross inflow of economic benefits
A. Assets
 B. Liabilities
C. Income
D. Expenses
Answer C
26. An asset must be ________ by the business to be shown as an asset in its balance sheet.
A. Possessed
B. Owned
C. Controlled
D. Used
Answer C
27. Which is the most important characteristic that all assets of a business have?
A. Long life of assets
B. Value of assets
C. Intangible nature of assets
D. Future economic benefits
Answer D
28. What is the basic accounting equation?
A. Capital + Liabilities = assets
B. Assets + Liabilities = Capital
C. Capital + Assets = Liabilities
D. Liabilities - Capital = Assets
Answer A
29. Which of the following is a liability?
A. Cash
B. Equipment
C. Debtors
D. Creditors
Answer D
30. What is equity?
A. Cash from the business
B. Liability of a business
C. Owner's claim on total assets
D. Owner's claim on total liabilities
Answer C
Long Answer Type Questions
1. What are the eight steps of accounting cycle?
The eight-step accounting cycle starts with recording every company transaction individually and
ends with a comprehensive report of the company’s activities for the designated cycle timeframe.
Many companies use accounting software to automate the accounting cycle. This allows accountants
to program cycle dates and receive automated reports.
Depending on each company’s system, more or less technical automation may be utilized. Typically,
bookkeeping will involve some technical support, but a bookkeeper may be required to intervene in
the accounting cycle at various points.
Every individual company will usually need to modify the eight-step accounting cycle in certain ways
in order to fit with their company’s business model and accounting procedures. Modifications for
accrual accounting versus cash accounting are usually one major concern.
Companies may also choose between single-entry accounting versus double-entry accounting.
Double-entry accounting is required for companies to build out all three major financial statements:
the income statement, balance sheet, and cash flow statement.

The 8 Steps of the Accounting Cycle

The eight steps of the accounting cycle include the following:

Step 1: Identify Transactions

The first step in the accounting cycle is identifying transactions. Companies will have many
transactions throughout the accounting cycle. Each one needs to be properly recorded on the
company’s books.
Recordkeeping is essential for recording all types of transactions. Many companies will use point of
sale technology linked with their books to record sales transactions. Beyond sales, there are also
expenses that can come in many varieties.

Step 2: Record Transactions in a Journal

The second step in the cycle is the creation of journal entries for each transaction. Point of sale
technology can help to combine steps one and two, but companies must also track their expenses.
The choice between accrual and cash accounting will dictate when transactions are officially
recorded. Keep in mind, accrual accounting requires the matching of revenues with expenses so
both must be booked at the time of sale.
Cash accounting requires transactions to be recorded when cash is either received or paid. Double-
entry bookkeeping calls for recording two entries with each transaction in order to manage a
thoroughly developed balance sheet along with an income statement and cash flow statement.
With double-entry accounting, each transaction has a debit and a credit equal to each other. Single-
entry accounting is comparable to managing a checkbook. It gives a report of balances but does not
require multiple entries.

Step 3: Posting
Once a transaction is recorded as a journal entry, it should post to an account in the general ledger.
The general ledger provides a breakdown of all accounting activities by account. This allows a
bookkeeper to monitor financial positions and statuses by account. One of the most commonly
referenced accounts in the general ledger is the cash account that details how much cash is
available.

Step 4: Unadjusted Trial Balance

At the end of the accounting period, a trial balance is calculated as the fourth step in the accounting
cycle. A trial balance tells the company its unadjusted balances in each account. The unadjusted trial
balance is then carried forward to the fifth step for testing and analysis.

Step 5: Worksheet
Analyzing a worksheet and identifying adjusting entries make up the fifth step in the cycle. A
worksheet is created and used to ensure that debits and credits are equal. If there are discrepancies
then adjustments will need to be made.
In addition to identifying any errors, adjusting entries may be needed for revenue and expense
matching when using accrual accounting.

Step 6: Adjusting Journal Entries

In the sixth step, a bookkeeper makes adjustments. Adjustments are recorded as journal entries
where necessary.

Step 7: Financial Statements

After the company makes all adjusting entries, it then generates its financial statements in the
seventh step. For most companies, these statements will include an income statement, balance
sheet, and cash flow statement.
Step 8: Closing the Books
Finally, a company ends the accounting cycle in the eighth step by closing its books at the end of the
day on the specified closing date. The closing statements provide a report for analysis of
performance over the period.
After closing, the accounting cycle starts over again from the beginning with a new reporting period.
At closing is usually a good time to file paperwork, plan for the next reporting period, and review a
calendar of future events and tasks.
The eight-step accounting cycle process makes accounting easier for bookkeepers and busy
entrepreneurs. It can help to take the guesswork out of how to handle accounting activities. It also
helps to ensure consistency, accuracy, and efficient financial performance analysis.

2. What is accounting transaction analysis with one example?

The accounting transaction analysis is the process of translating the business activities and events
that have a measurable effect on the accounting equation into the accounting language and writing
it in the accounting books. This is the first stage in the accounting cycle, which is the foundation of
accounting, regardless of the accounting type you are interested in. Businesses analyze to ensure
that the balance sheet equation stays in balance after each transaction is completed.
Six Steps of Accounting Transaction Analysis

1. Determine if the event is an accounting transaction

You first need to determine whether this transaction is a business nature transaction. An accounting
also transaction has to involve a monetary amount. So if the company signed a rental contract, there
is no accounting transaction. However, if it makes a payment under this contract, it will be an
accounting transaction because it has a monetary amount that the company will need to record.
Other examples include a purchase of equipment, sale of products, and salary payments.

2. Identify what accounts it affects

Your next step is to identify which accounts the transaction will affect. For example, Ellen invested
$38,000 in cash and a used truck with a market value of $8,500 in the business in exchange for the
company’s common stock. The cash and truck invested will be assets for that business, recorded
under Cash account and Truck account. In exchange for that investment, Ellen will get common
stock, so it will also affect the Common Stock account.

3. Determine what type of accounts they are

Every transaction leads to a measurable change in the accounting equation. Knowing whether the
account belongs to assets, liabilities, or equity will allow you to determine whether the account will
have a debit or credit normal balance. In the example above, we already decided that two accounts
will be Asset accounts, and the Common Stock account is the Owner’s Equity type account.

4. Determine which accounts are going up or down

A business records a transaction with an entry that has a debit and credit effect. This double-entry
procedure keeps the accounting equation in balance. So, when Ellen invested cash, the cash and
truck accounts will increase because the company will now have more money, and it now has a
truck. The Common Stock account will also increase.

5. Apply the rules of debits and credits to these accounts

One has to record each business transaction in two or more related but opposite accounts. We debit
one account and credit the other Account in the same transaction amount. Accounts on the left side
increase with a debit entry and decrease with a credit entry while accounts on the rise in the right
side with a credit entry and decrease with a debit. So, if the Cash and Truck accounts will increase,
and it is an asset account, the business will debit it. The Common Stock account is the Equity
account, which increases with a credit entry.
6. Find the transaction amount to be entered into each account
Your final step would be to determine the amount of the transaction from the business records, such
as receipts, invoices, and bank statements.

Accounting Transaction Analysis Table

When going through the six steps of the accounting analysis, it is much easier to analyze by filling out
an accounting transaction analysis table, such as one below. Let’s go over the example transaction,
explaining it step by step and filling the table.

 This is an accounting transaction because it involves a monetary amount and is a

business activity.
 The business bought supplies so that it will involve Supplies account. Since it purchased
them on account and not with cash, it will use the Account Payable account.
 Supplies are an asset the company acquired. Accounts Payable is a liabilities account
because the company still owes money for the amounts it purchased.
 Supplies’ account is increasing because the company has more amounts after this
transaction than before. Accounts Payable is also growing because it owes more money
than it did before the transaction.
 Supplies (asset) is debited to increase it. Accounts Payable (liability) is credited to
enlarge it.
 The company will record $300 for each account as the transaction amount.
Injection of Capital Transaction Example
Let’s review another example and use the table to summarize our analysis.

This is an accounting transaction because it involves a monetary amount and is a business activity.
The two accounts that will be used to record this transaction are Cash and Capital. The Cash account
is an asset type account, while the Capital is the owner’s equity. Both accounts are going up because
now there is more money, and the owner made a contribution. To increase the Cash (asset), the
company will debit it, and to increase Capital (owner’s equity), it will credit it. Both accounts will
increase by $97,000.
 3. What is accounting records and what are the different types?
Accounting records are all of the documentation and books involved in the preparation of financial
statements or records relevant to audits and financial reviews. Accounting records include records of
assets and liabilities, monetary transactions, ledgers, journals, and any supporting documents such
as checks and invoices.

Understanding Accounting Records

Rules and laws are generally in place to force accounting entities and accounting firms to retain
accounting records for a specified period of time. In the U.S., the Securities and Exchange
Commission (SEC) requires that accounting firms retain records from audits and reviews for at least
seven years and that they retain any records that support or cast doubt on the conclusions of an
audit.
There is no universal agreement as to which collection of business documents comprise a
comprehensive set of accounting records. Accounting records can be thought of as a catch-all term.
Different parties, such as creditors, equity investors, or groups interested in corporate governance
will have different, and often competing priorities; their demands or preferences for documentation
will continuously change.
At different points in the economic or business cycle, parties demanding accounting records will
alter their request for information based on the position in a cycle. For instance, at the start of an
upswing in a business cycle, requests for financial statements might be strong, as equity investors
are bullish. In contrast, during a dip in a business cycle, creditors might require more details
surrounding balance sheet items, as they become more hesitant to extend credit.
In short, accounting records and even methods of accounting are continuously evolving to keep pace
with the changing nature of business and the information demands of interested market
participants.

Types of Accounting Records

Accounting records generally come in two forms: single entry and double entry. By its name, single
entry is a much simpler method, which works better for smaller operations. The double entry
method is more complex and requires two entries, one credit and one debit, for every transaction a
business makes. The goal is to balance the books and account for the movement of cash through an
organization. This is primarily done in larger corporations, which helps with spotting errors and
potential fraud.
The specific types of accounting records that are reviewed consist of the transactions, journals,
general ledgers, trial balances, and financial statements of a company.

Transactions
The transaction is the starting point for any accounting record. It is the catalyst for the entire process
that shows any item bought or sold, depreciated, etc., that a business transacts.

Journals
Journals record all of the transactions that are made by a company. Journals can cover all of the
entire transactions of a company or there can be different journals for different areas of the firm.
The only necessity is that journals are kept up to date and that all the transactions are recorded in
some manner.

General Ledgers
The general ledger is the movement of transactions in the journal to designated places in the general
ledger that are outlined by the type of transaction. This makes it easier to comb through the
transactions and categorize them correctly in the preparation of the trial balance and ultimately the
financial statements.

Trial Balances
The trial balance is the summation of all credits and debits within the business cycle. Once this step
has been completed, all entries should balance out. If they do not, this can reveal an error that must
be corrected or possible fraud. It will be crucial to determine the disconnect.

Financial Statements
The financial statement is the final piece of document that comprises the components of all the
other accounting documents. The financial statements are what will be provided to the public and to
regulatory bodies for viewing. Investment analysts can review the financial statements to arrive at
their thoughts on the company. Regulatory bodies can request the accounting documents that the
financial statements were generated from to gain a deeper understanding of the company.

Chapter 3 - Financial Statemens

Question 1.
Which of the following is the element of financial statements?
(a) Balance Sheet
(b) Profit & Loss A/c
(c) Both (a) and (b)
(d) None of these
Answer: (c) Both (a) and (b)

Question 2.
Which of the following is not required to be prepared under the Companies Act:
(a) Statement of Profit & Loss
(b) Balance Sheet
(c) Anditor’s Report
(d) Fund Flow Statement
Answer: (c) Anditor’s Report

Question 3.
Equity ₹ 90,000 Liabilities ₹ 60,000 Profit of the year ₹ 20,000. Then total assets will be :
(a) ₹ 1.70,000
(b) ₹ 1,50,000
(c) ₹1,10,000
(d) ₹ 80,000
Answer: (a) ₹ 1.70,000

Question 4.
The reserve which is created for a particular (specific) purpose and which is a charge against revenue
is called:
(a) Capital Reserve
(b) General Reserve
(c) Secret Reserve
(d) Specific Reserve
Answer
Answer: (d) Specific Reserve

Question 5.
An Annual Report is issued by a company to its:
(a) Directors
(b) Authors
(c) Shareholders
(d) Management
Answer
Answer: (c) Shareholders

Question 6.
The profit and loss disclosed by the accounts of a company is:
(a) Transferred to share capital account
(b) Shown under the head of ‘Current liabilities’ and provisions
(c) Shown under the head ‘Reserves and Surplus
(d) None of these
Answer
Answer: (c) Shown under the head ‘Reserves and Surplus

Question 7.
The assets of a business can be classified as :
(a) Fixed and Non-fixed Assets
(b) Tangible and Intangible Assets
(c) Non-Current and Current Asset
(d) None of these
Answer
Answer: (c) Non-Current and Current Asset

Question 8.
The term financial statements includes :
(a) Statement of Profit & Loss
(b) Balance Sheet
(c) Statement of Profit & Loss and Balance Sheet
(d) None of these
Answer
Answer: (c) Statement of Profit & Loss and Balance Sheet

Question 9.
Balance Sheet is a :
(a) Account
(b) Statement
(c) Both (a) and (b)
(d) All the above
Answer
Answer: (b) Statement

Question 10.
Financial statements are the product of accounting process.
(a) First
(b) Second
(c) End
(d) None of these
Answer
Answer: (c) End

Question 11.
Financial statements disclose :
(a) Monetary information
(b) Qualitative information
(c) Non-monetary information
(d) All the above
Answer
Answer: (a) Monetary information

Question 12.
Statement of Profit & Loss is also called………:
(a) Operating Profit
(b) Balance Sheet
(c) Income Statement
(d) Trading Account
Answer
Answer: (c) Income Statement

Question 13.
Preliminary expenses are shown in the Balance Sheet under the head:
(a) Non-current assets
(b) Current assets
(c) Non-current liabilities
(d) Deducted from securities premium reserve
Answer
Answer: (d) Deducted from securities premium reserve

Question 14.
Debit Balance of Profit & Loss Statement will be shown on:
(a) Assets Side of Balance Sheet
(b) Liabilities Side of Balance Sheet
(c) Under the head Reserve & Surplus
(d) Under the head Reserves and Surplus as a negative item
Answer
Answer: (d) Under the head Reserves and Surplus as a negative item

Question 15.
Patents and copyrights fall under the category of:
(a) Current Assets
(b) Liquid Assets
(c) Intangible Assets
(d) None of these
Answer
Answer: (c) Intangible Assets
Question 16.
Goodwill falls under which category of assets:
(a) Current Assets
(b) Tangible Assets
(c) Intangible Assets
(d) None of the above
Answer
Answer: (c) Intangible Assets

Question 17.
Contingent Liabilities are exhibited under the heading:
(a) Fixed Liabilities
(b) Current Liabilities
(c) As a footnote
(d) None of these
Answer
Answer: (c) As a footnote

Question 18.
Provision for Provident Funds is shown in the Balance Sheet of a company under the head :
(a) Reserves and Surplus
(b) Non-current Liabilities
(c) Provision
(d) Contingent Liabilities
Answer
Answer: (b) Non-current Liabilities

Question 19.
Preliminary Expenses are shown in the Balance Sheet under which head ?
(a) Fixed Assets
(b) Reserves and Surplus
(c) Loans & Advances
(d) None of these
Answer
Answer: (d) None of these

Question 20.
Financial Statements are :
(a) Anticipated facts
(b) Recorded facts
(c) Estimated facts
(d) None of these
Answer
Answer: (b) Recorded facts

Question 21.
The term current assets includes :
(a) Stock
(b) Debtors
(c) Cash
(d) All of these
Answer
Answer: (d) All of these

Question 22.
Which of the following is not a part of financial statement of a company ?
(a) Profit & Loss A/c
(b) Balance Sheet
(c) Ledger Account
(d) Cash Flow Statement
Answer
Answer: (c) Ledger Account

Question 23.
Under which heading of Balance Sheet is general reserve shown:
(a) Miscellaneous Expenditure
(b) Share Capital
(c) Reserves & Surplus
(d) None of these
Answer
Answer: (c) Reserves & Surplus

Question 24.
Current Assets on the Assets side of Balance Sheet of a Company includes:
(a) Sundry Debtors
(b) Cash in hand
(c) Stock
(d) All of these
Answer
Answer: (d) All of these

Question 25.
As per provisions of Companies Act, 2013 under which Section, the final accounts of a company is
prepard :
(a) 128
(b) 210
(c) 129
(d) 212
Answer: (c) 129
Long Answers

Chapter 3 - Financial statements

1. What do you mean by the preparation of a Balance Sheet? What are the different
elements in which balance sheets are divided?
Ans: Originally, the balance sheet is included in the first part of the quarterly financial statements. It
represents a detailed image of the company’s financial status when published. The balance sheet
includes the company’s assets, liabilities and shareholders’ equity which gives a clear idea on its
book value. It is a known fact that it is not a good sign if the company’s liabilities outperformed its
assets because that means that its losses are more than its capital which could lead the company to
be unable to practice its business and maybe bankrupted. That’s not only what the company’s
balance sheet could explain; it can also point out the assets’ availability in it to the sufficient amount
that helps in expanding its business through the acquisition of another company or to develop a new
product or to resort to borrowing to maintain its operational activities. Reading the balance sheet
enables the investor to know if there is additional stock in excess of the market need as a result of
the inaccurate assumption of the management for the expected demand on the products. That
could be a strong indicator that the company handles its assets badly. Although the numbers shown
in the companies’ statement of financial position vary greatly, but the general framework of the
statements of all companies remain united. It means that it is possible to compare the performance
of two companies in two different trading fields. It is possible to summarize the three elements
which, as a whole, generate the balance sheet for a company as the following:
• Assets
• Liabilities.
• Shareholders’ Equity

Assets: Companies can own assets, just as the individual has assets of value, like real estate or
jewelry. One of the differences between an individual and a company’s assets is the company’s
obligation to publish what it owns to the public. Companies can own tangible assets such as
computers, machinery, money and real estate. It can also have intangible assets such as trademarks,
copyrights or patents.Generally a company’s assets are categorized according to the ability to
change it into cash in two types:

1. Current Assets: Cash and other properties owned by the company and could be easily converted
into cash in one year. It is an important indicator of the company’s financial status because it is used
to cover short term commitment of the company’s operations. If the company suffers from a decline
in its current net assets then that means it needs to find new means to finance its activities. One of
the answers to this is to issue extra stocks by the company. We can generally say that increasing the
company’s current net asset means an increase in the company’s opportunities in maintaining its
growth

2. Non-current Assets: an asset that the company owns and needs more than a year to convert to
cash or it is the asset that the company does not have a plan to convert to cash during the next year.
Fixed assets such as lands, buildings, machinery and so on, come under non-current assets. The
importance of the company’s non-current assets volume is based on its sector’s type. For instance,
companies in the banking sector don’t need (fixed) non-current assets compared to a company in
the industrial sector.

Liabilities: All companies- even those profitable- have debts. In the balance sheet, debts are called
Liabilities. A company’s management success is based on its ability in managing its various liabilities
which are considered a part of its business. Examples of a company’s liabilities:

• Debt of suppliers and shareholders

• Payable Expenses
• Long-term loans

1. Current Liabilities: The commitments the company should pay in no more than one year. The
company usually refers to liquidating some of its current assets to cover these expenses. Some of
the important types of current liabilities are:
• Payables
• Undistributed dividends
• Zakat.
• Installments of long-term loans

2. Long-term Liabilities: The commitments the company is not restricted to pay within at least one
year such as Long- term loans. Although theses debts are not to be paid through the next financial
year, but at the end it should be paid. It is important to keep that in mind when evaluating the
company.

Shareholders’ Equity: Shareholders’ equity is mentioned in the company’s balance sheet report.
Shareholder’s equity equals the invested money that was distributed as shares plus the
undistributed profits, which represents retained earnings held and re-invested by the company. They
are not distributed to shareholders. To make it simple, shareholders’ equity represent the main
source in financing the company’s business. The more equity the shareholders have, the size of the
company’s own operational money increases.

2. What is meant by the term ‘income statement’? Elaborate in detail.

Ans: The income statement is easier to understand and less complicated than the balance sheet. But
still, it is the most analyzed part of the quarterly financial statements. It is because it details the
company’s profit sources based on its performance in selling products, offering services or in its
investments’ income. To explain that, the income statement shows the company’s income out of its
sales and the outgoing cash to cover these expenses.
Reading the income statement is not only on deducting the total income expenses. In general, the
company has more than one source for income and several different kinds of expenses. The
company details the different sources for its income and expenses in the income statement and that
reflects a clear image of the company’s performance. Here are some of the main points in an income
statement:
• Income or sales
• Expenses
• Gross profit
• Net profit
• Operating profit “income from the company’s major operations”
• Gains and losses from other than the major operations
• Earnings per share
• Zakat

The investor can, when he understands what these numbers refer to and the relationship between
them, determine the company’s strengths and weaknesses. For instance, a troubled company –
which is obviously not a good investment- suffers from increasing expenses and decreasing income
which leads to a decrease in its total net profit.

Income and Expenses: As an individual gains profit through his work or his investments’ revenues,
the company can also profit from selling its products or services or its investments’ revenues. Some
companies have only one source for profits and others have more than one. The income statement
shows the company’s sales and incomes. By following the statement, the size of the company’s
financial profit could be accurately known. It can also let you know from which of the company’s
sources the profit is generating. Income: it is the company’s total funds which are gained from its
major activity that includes selling goods or the services it produces.

Total Profits (or losses): if any company can find a way to develop and manufacture products and
offer services without incurring any expenses, it would be the richest company in the world. Reality,
on the other hand, proves that spending money is important to gain more money. To calculate the
company’s total profits (or losses), a deduction should be made by deducting its direct expenses
from its income.

Operating Profit: production expenses are not the only expenses the company has to pay to succeed.
After the product is produced, it is supposed to be advertised and sold and this of course brings in
other and more expenses. In addition to marketing and advertising expenses, the company is
obligated to pay its employees’ salaries, office supplies and its management expenses. The
company’s operating profit (or loss) could be reached by deducting all the operating expenses
mentioned from the profits’ total.

Net Profit: in addition to operational expenses, the company has to pay other expenses such as the
Zakat. When the company deducts these expenses from the operational profit and add what income
it gains from outside its area, then what is left forms the company’s net profit. One of the clear
indicators that the company’s performance is doing good is the increase in the net profit from one
quarter to the next.

3. Outline in detail, the significance of financial statements and also explain the ways in
which they are useful to different users.

Ans: Financial analysis is the process of identifying the financial strengths and weaknesses of the
firm by properly establishing relationships between the various items of the balance sheet and the
statement of profit and loss. Financial analysis can be undertaken by management of the firm, or by
parties outside the firm, viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst. A technique
frequently used by an analyst need not necessarily serve the purpose of other analysts because of
the difference in the interests of the analysts. Financial analysis is useful and significant to different
users in the following ways:

(a) Finance manager: Financial analysis focuses on the facts and relationships related to managerial
performance, corporate efficiency, financial strengths and weaknesses and creditworthiness of the
company. A finance manager must be well-equipped with the different tools of analysis to make
rational decisions for the firm. The tools for analysis help in studying accounting data so as to
determine the continuity of the operating policies, investment value of the business, credit ratings
and testing the efficiency of operations. The techniques are equally important in the area of financial
control, enabling the finance manager to make constant reviews of the actual financial operations of
the firm to analyse the causes of major deviations, which may help in corrective action wherever
indicated.

(b) Top management: The importance of financial analysis is not limited to the finance manager
alone. It has a broad scope which includes top management in general and other functional
managers. Management of the firm would be interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are used most efficiently and that the
firm’s financial condition is sound. Financial analysis helps the management in measuring the success
of the company’s operations, appraising the individual’s performance and evaluating the system of
internal control.

(c) Trade payables: Trade payables, through an analysis of financial statements, appraises not only
the ability of the company to meet its short-term obligations, but also judges the probability of its
continued ability to meet all its financial obligations in future. Trade payables are particularly
interested in the firm’s ability to meet their claims over a very short period of time. Their analysis
will, therefore, evaluate the firm’s liquidity position.

(d) Lenders: Suppliers of long-term debt are concerned with the firm’s longterm solvency and
survival. They analyse the firm’s profitability over a period of time, its ability to generate cash, to be
able to pay interest and repay the principal and the relationship between various sources of funds
(capital structure relationships). Long-term lenders analyse the historical financial statements to
assess its future solvency and profitability.

(e) Investors: Investors, who have invested their money in the firm’s shares, are interested about the
firm’s earnings. As such, they concentrate on the analysis of the firm’s present and future
profitability. They are also interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the management and determine whether
a change is needed or not. However, in some large companies, the shareholders’ interest is limited
to decide whether to buy, sell or hold the shares.

(f) Labour unions: Labour unions analyse the financial statements to assess whether it can presently
afford a wage increase and whether it can absorb a wage increase through increased productivity or
by raising the prices.

(g) Others: The economists, researchers, etc., analyse the financial statements to study the present
business and economic conditions. The government agencies need it for price regulations, taxation
and other similar purposes.

Analysis of financial statements reveals important facts concerning managerial performance and the
efficiency of the firm. Broadly speaking, the objectives of the analysis are to apprehend the
information contained in financial statements with a view to know the weaknesses and strengths of
the firm and to make a forecast about the future prospects of the firm thereby, enabling the analysts
to take decisions regarding the operation of, and further investment in the firm.

Chapter 4 - Preparation of Financial Statements

1. Balance sheet of a company is required to be prepared in the format given in ………………………

(A) Schedule III Part II
(B) Schedule III Part I
(C) Schedule III Part III
(D) Table A
Answer: B

2. As per Companies Act, the Balance Sheet of a company is required to be presented in

………………………
(A) Horizontal Form
(B) Vertical Form
(C) Either Horizontal or Vertical Form
(D) Neither ofthe above
Answer: B

3. Which of the following is not required to be prepared under the Companies Act
(A) Statement of Profit and Loss
(B) Balance Sheet
(C) Report of Director’s and Auditor’s
(D) Funds Flow Statement
Answer: D

4. According to prescribed order of assets in a Company’s Balance Sheet ……………………… assets

should be shown first of all.
(A) Non-Current Assets
(B) Current Assets
(C) Current Investments
Answer: A

5. In a Company’s Balance Sheet …………………. appear under the head ‘non-current assets’.
(A) Goodwill
(B) Patents
(C) Vehicles
(D) All of the above
Answer: D

6. Calls in Arrears appear in a Company’s Balance Sheet under ………………..

(A) Reserve & Surplus
(B) Shareholder’s Funds
(C) Contingent Liabilities
(D) Short-term Borrowings
Answer: B

7. Calls in advance appear in a Company’s Balance Sheet under ………………..

(A) Share Capital
(B) Current Liability
(C) Long-term Borrowings
(D) Reserve & Surplus
Answer: B

8. Short-term Borrowings appear in a Company’s Balance Sheet under the head …………………..
(A) Current Assets
(B) Current Liabilities
(C) Non-Current Liabilities
(D) Non-Current Assets
Answer: B

9. Fixed Deposits appear in a Company’s Balance Sheet under :

(A) Current Assets
(B) Current Liabilities
(C) Long-term Provisions
(D) Long-term Borrowings
Answer: D

10. Goodwill appears in a Company’s Balance Sheet under the Sub-head ………………….
(A) Unamortized Assets
(B) Non-Current Investment
(C) Intangible Assets
(D) Tangible Assets
Answer: C

11. Share Forfeiture Account appears in a Company’s Balance Sheet under the Sub-head ……………….
(A) Share Capital
(B) Reserve & Surplus
(C) Contingent Liability
(D) Commitments
Answer: A

12. Expenses allowed on issue of shares appears in a Company’s Balance Sheet under :
(A) Share Capital
(B) Current Liability
(C) Unamortized Expenditure
(D) Contingent Liability
Answer: C

13. Securities Premium Reserve appears in a Company’s Balance Sheet under :

(A) Share Capital
(B) Long-term Provision
(C) Short-term Provision
(D) Reserve & Surplus
Answer: D

14. Prepaid Expenses appear in a Company’s Balance Sheet under the Sub-head ………………
(A) Other Current Assets
(B) Short-term Loans & Advances
(C) Intangible Assets
(D) Other Non-Current Assets
Answer: A

15. ……………… appear in a Company’s Balance Sheet under the Sub-head Short-term Provision
(A) Interest Accrued but not due on Borrowings
(B) Provision for Tax
(C) Unpaid Dividend
(D) Calls in Advance
Answer: B

16. Provision for Tax appears in a Company’s Balance Sheet under the Sub-head ……………………
(A) Short-term Provisions
(B) Reserves and Surplus
(C) Long-term Provisions
(D) Other Current Liabilities
Answer: A
17. Bills Receivables appear in a Company’s Balance Sheet under the Sub-head ……………………..
(A) Current Investments
(B) Cash Equivalents
(C) Trade Receivables
(D) Short term Loans and Advances
Answer: C

18. Trade Investments appear in a Company’s Balance Sheet under the Sub-head ………………….
(A) Current Investments
(B) Non-Current Investments
(C) Intangible Assets
(D) Short-term Loans and Advances
Answer: B

19. ‘Claims against the Company not acknowledged as debts’ is shown under the head ……………….
(A) Current Liabilities
(B) Non-Current Liabilities
(C) Commitments
(D) Contingent Liabilities
Answer: D

20. Unclaimed dividend appears in a Company’s balance Sheet under the Sub-head ………………
(A) Short-term Borrowings
(B) Trade Payables
(C) Other Current Liabilities
(D) Short-term Provisions
Answer: C

21. Interest accrued and due on debentures appear in a Company’s Balance Sheet under the Sub-
head ……………..
(A) Short-term Borrowings
(B) Trade Payables
(C) Other Current Liabilities
(D) Short-term Provisions
Answer: C

22. Interest accrued but not due on loans appear in a Company’s Balance Sheet under the Sub-head
………………
(A) Short-term Borrowings
(B) Trade Payables
(C) Other Current Liabilities
(D) Short-term Provisions
Answer: C

23. 6% Debentures appear in a Company’s Balance Sheet under the Sub-head ………………….
(A) Long-term Provisions
(B) Long-term Borrowings
(C) Other Current Liabilities
(D) Other Long-term Liabilities
Answer: B
24. Interest accrued on Investments appear in a Company’s Balance Sheet under the Sub-head
………………….
(A) Non-Current Investments
(B) Current Investments
(C) Other Current Assets
(D) Other Non-Current Assets
Answer: C

25. ‘Accumulated Dividend Arrears’ on preference shares is shown in the Company’s Balance Sheet
as :
(A) Current Liability
(B) Contingent Liability
(C) Commitments
(D) Short-term Provision
Answer: C
1.What is the nature of a financial statement, in terms of financial accounting?

Ans: The chronologically recorded facts about events expressed in monetary terms for a defined
period of time are the basis for the preparation of periodical financial statements which reveal the
financial position as on a date and the financial results obtained during a period. The American
Institute of Certified Public Accountants states the nature of financial statements as, “the statements
prepared for the purpose of presenting a periodical review of report on progress by the
management and deal with the status of investment in the business and the results achieved during
the period under review. They reflect a combination of recorded facts, accounting principles and
personal judgements”. The following points explain the nature of financial statements:
1. Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data
recorded in accounting books. The original cost or historical cost is the basis of recording
transactions. The figures of various accounts such as cash in hand, cash at bank, trade receivables,
fixed assets, etc., are taken as per the figures recorded in the accounting books. The assets
purchased at different times and at different prices are put together and shown at costs. As these
are not based on market prices, the financial statements do not show the current financial condition
of the concern.

2. Accounting Conventions: Certain accounting conventions are followed while preparing financial
statements. The convention of valuing inventory at cost or market price, whichever is lower, is
followed. The valuing of assets at cost less depreciation principle for balance sheet purposes is
followed. The convention of materiality is followed in dealing with small items like pencils, pens,
postage stamps, etc. These items are treated as expenditure in the year in which they are purchased
even though they are assets in nature. The stationery is valued at cost and not on the principle of
cost or market price, whichever is less. The use of accounting conventions makes financial
statements comparable, simple and realistic.

3. Postulates: Financial statements are prepared on certain basic assumptions (pre-requisites)

known as postulates such as going concern postulate, money measurement postulate, realisation
postulate, etc. Going concern postulate assumes that the enterprise is treated as a going concern
and exists for a longer period of time. So the assets are shown on a historical cost basis. Money
measurement postulate assumes that the value of money will remain the same in different periods.
Though there is a drastic change in purchasing power of money, the assets purchased at different
times will be shown at the amount paid for them. While preparing a statement of profit and loss the
revenue is included in the sales of the year in which the sale was undertaken even though the sale
price may be received over a number of years. The assumption is known as the realisation postulate.

4. Personal Judgements: Under more than one circumstance, facts and figures presented through
financial statements are based on personal opinion, estimates and judgements. The depreciation is
provided taking into consideration the useful economic life of fixed assets. Provisions for doubtful
debts are made on estimates and personal judgements. In valuing inventory, cost or market value,
whichever is less is being followed. While deciding either cost of inventory or market value of
inventory, many personal judgements are to be made based on certain considerations. Personal
opinion, judgements and estimates are made while preparing the financial statements to avoid any
possibility of over statement of assets and liabilities, income and expenditure, keeping in mind the
convention of conservatism. Thus, financial statements are the summarised reports of recorded
facts and are prepared following accounting concepts, conventions, accounting policies, accounting
standards and requirements of Law.

2. Outline the importance of Financial Statement from the economic point of view, and also
outline its limitations.

Ans: The users of financial statements include management, investors, shareholders, creditors,
government, bankers, employees and public at large. Financial statements provide the necessary
information about the performance of the management to these parties interested in the
organisation and help in taking appropriate economic decisions. It may be noted that the financial
statements constitute an integral part of the annual report of the company in addition to the
directors report, auditors report, corporate governance report, and management discussion and
analysis. The various uses and importance of financial statements are as follows:

1. Report on stewardship function: Financial statements report the performance of the management
to the shareholders. The gaps between the management performance and ownership expectations
can be understood with the help of financial statements.

2. Basis for fiscal policies: The fiscal policies, particularly taxation policies of the government, are
related with the financial performance of corporate undertakings. The financial statements provide
basic input for industrial, taxation and other economic policies of the government.

3. Basis for granting of credit: Corporate undertakings have to borrow funds from banks and other
financial institutions for different purposes. Credit granting institutions take decisions based on the
financial performance of the undertakings. Thus, financial statements form the basis for granting of
credit.

4. Basis for prospective investors: The investors include both short-term and long-term investors.
Their prime considerations in their investment decisions are security and liquidity of their
investment with reasonable profitability. Financial statements help the investors to assess long term
and short-term solvency as well as the profitability of the concern.

5. Guide to the value of the investment already made: Shareholders of companies are interested in
knowing the status, safety and return on their investment. They may also need information to make
decisions about continuation or discontinuation of their investment in the business. Financial
statements provide information to the shareholders in taking such important decisions.

6. Aids trade associations in helping their members: Trade associations may analyse the financial
statements for the purpose of providing service and protection to their members. They may develop
standard ratios and design a uniform system of accounts.

7. Helps stock exchanges: Financial statements help the stock exchanges to understand the extent of
transparency in reporting on financial performance and enables them to call for required
information to protect the interest of investors. The financial statements enable the Stock brokers to
judge the financial position of different concerns and take decisions about the prices to be quoted.
Limitations of Financial Statements

Though utmost care is taken in the preparation of the financial statements and provide detailed
information to the users, they suffer from the following limitations:

1. Do not reflect current situation: Financial statements are prepared on the basis of historical cost.
Since the purchasing power of money is changing, the values of assets and liabilities shown in
financial statement do not reflect current market situation.

2. Assets may not realise: Accounting is done on the basis of certain conventions. Some of the assets
may not realise the stated values, if the liquidation is forced on the company. Assets shown in the
balance sheet reflect merely unexpired or unamortised cost.

3. Bias: Financial statements are the outcome of recorded facts, accounting concepts and
conventions used and personal judgements made in different situations by the accountants. Hence,
bias may be observed in the results, and the financial position depicted in financial statements may
not be realistic.

4. Aggregate information: Financial statements show aggregate information but not detailed
information. Hence, they may not help the users in decision-making much.

5. Vital information missing: Balance sheet does not disclose information relating to loss of markets,
and cessation of agreements, which have vital bearing on the enterprise.

6. No qualitative information: Financial statements contain only monetary information but not
qualitative information like industrial relations, industrial climate, labour relations, quality of work,
etc.

7. They are only interim reports: Statement of Profit and Loss discloses the profit/loss for a specified
period. It does not give an idea about the earning capacity over time similarly, the financial position
reflected in the balance sheet is true at that point of time, the likely change on a future date is not
depicted.
3. What is the importance of including liabilities in the financial statements?

Ans :Liabilities Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in the future
as a result of past transactions or events. Three essential characteristics of an accounting liability
include the following:

1. A duty or obligation to pay exists.

2. The duty is virtually unavoidable by a particular entity.

3. The event obligating the enterprise has occurred. Liabilities are usually classified as current or
non-current liabilities. Current liabilities are those obligations whose liquidation is reasonably
expected to require the use of existing resources properly classified as current assets, or the creation
of other current liabilities. This definition emphasizes a short term creditors’ claim to working capital
rather than the due date for classification purposes. Current liabilities include
(1) trade accounts payable,

(2) short-term notes payable,

(3) current maturities of longterm liabilities,

(4) unearned revenues (collections in advance, e.g., rent, interest, and magazine subscription
revenues),

(5) accrued expenses for payrolls, interest, taxes, and others expenses. Unearned revenues arise
when assets are received before being earned; a liability called unearned revenue is created. After
the services are performed, revenue is earned and the liability is settled. Accrued liabilities are
liabilities that exist at the end of an accounting period but which have not yet been recorded. All
liabilities not classified as current are reported as long-term liabilities. Net working capital is the
excess of current assets over current liabilities. Adequate working capital is necessary for the
business if it is to pay its debts as they come due. Creditors often consider working capital to
constitute a margin of safety for paying short-term debts. Working capital assets are in a constant
cycle of being converted into cash. Cash is used to acquire inventories which, when sold, become
account receivable; receivables upon collection become cash; cash is used to pay current liabilities
and expenses and to acquire more inventories. Working capital does not appear as a specific item on
the balance sheet, but it can be computed as the difference between the reported current assets
and current liabilities.

Contingent liabilities arise from an existing situation or set of circumstances involving uncertainty as
to possible loss to an enterprise that will ultimately be resolved when one or more future events
occur or fail to occur.

Examples of contingent liabilities include product warranties and pending litigation. An estimated
loss from a loss contingency must be accrued in the accounts and reported in financial statements as
a charge against income and as a liability if both of the following conditions are met: 1. It is probable
that an asset has been impaired or a liability has been incurred at the date of the financial
statements. 2. The amount of the loss can be reasonably estimated.

A lease is a contractual agreement in which the owner of property (the lessor) allows another party
(the lessee) to use the property for a stated period of time in exchange for specified payments. The
major reporting problem for leases is whether the lease should be included in the financial
statements. A lease that transfers substantially all of the benefits and risks associated with
ownership of the property should be accounted for as the acquisition of an asset and the incurrence
of an obligation by the lessee and as a sale or financing by the lessor. According to FASB 13
(Accounting for Leases) (ASC 840-10-05, Leases: Overall.), the criteria used to classify a lease as a
capital lease for a lessee are the following four: 1. The lesser transfer ownership of the property to
the lessee by the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease
term is equal to 75 percent of the estimated economic life of the leased property. 4. The present
value at the beginning of the lease term of the minimum lease payments excluding that portion
representing executory costs equals or exceeds 90 percent of the fair market value of the property.

Chapter 5 - Financial Reporting Standards - I

1. Accounting Standards Board of India was established in the year:
a)
1970
b) 1972
c) 1973
d) 1977
Answer- d
2. Accounting Standard board of India was set up by ICAL(Institute of Chartered Accountants of
India).
a. True
b. Fals
Answer - a
3. How many mandatory accounting standards are there in India 2020?
a) 29
b) 32
c) 41
d) 12
Answer - a
4. Which one of the following accounting standard in not mandatory
a) AS 30- Financial Instruments: Recognition and Measurement
b) AS 31- Financial Instruments: Presentation
c) AS 32- Financial Instruments: Disclosures
d) All of the above
Answer - d
5. What is the aim of accounting standards in India?
a) To make financial statements more comparable.
b) To ensure uniformity in accounting policies.
c)To guide the judgement of professional accountants.
d) All of the above
Answer: d
6. As per Indian GAAP financial statements are presented at:
a) Market Value
b) Fair Value
c)Cost
d) None of the above
Answer: b
7. Which one of the following is not a consideration in selection of accounting policies?
a) Prudence
b) Substance over form
c)Materiality
d) Full disclosure
Answer: a
8. Which one of the following is a fundamental accounting assumption?
a) Going Concern Concept
b) Accrual Concept
c)Consistency Concept
d) All of the above
Answer: a
9. Total number of IFRS is:
a) 15
b) 16
c) 17
d) 18
Answer: b
10. International Accounting Standard Board (IASB) was established in the year:
a) 1977
b) 2001
c)2013
d) 2019
Answer: b
11. How many Indian AS are there in India 2020?
a)29
b) 32
c) 41
d) 10
Answer: b
12. The accounting standards are mandatory for:
a)Sole trader
b) Firms
c) Companies
d) Societies
Answer: c
13. Accounting standards cannot override the statute.
a)True
b)False
Answer: b
14. Premier body of accounting in India is ICAl.
a)True
b)False
Answer: a

15. Accounting standards and accounting principles are one and the same thing.
a)True
b)False
Answer: b

16. Which accounting standard is applicable for valuation of inventories?

(a) AS-1
(b) AS-2
(C) AS-3
(d)As-4
Answer : b
17. How many standards are issued by ICAI which are mandatory?
(a) 28
(b) 32
(C) 10
(d) None of these
Answer : b
18. Which accounting standard is applicable for fixed assets?
(a) AS-1
(D) )AS-1
(C) AS-19
(d)AS-18
Answer : b
19. Which accounting standard is applicable for intangible assets?
(a) AS- 10
(b) AS-6
(c) AS-26
(d)AS-3
Answer : c
20. Which accounting standard is applicable for depreciation accounting8
(a) As-6
(b) AS-9
(c)AS-1
(d)AS-3
Answer : a
21. Which accounting standard is applicable for revenue recognition?
a)AS-9
(b) AS-10
(c)AS-3
(d)AS-23
Answer : a
22. Which accounting standard is applicable for cash flow statement?
(a) AS- 1
(b) AS-100
(C) AS-19
(d)AS-5
Answer : d
24. Which accounting standard is applicable for contingencies and events occurring after the balance
sheet date?
(a) AS- 1
(b) AS-10
(C).AS-4
(d)AS-18
Answer : c
25.Which accounting standard is applicable for impairment of assets?
(a) AS-1
(b) AS-10
(c) AS-19
(d)AS-28
Answer : b
Long Answers

1. Explain the importance of Solvency in financial statement preparation.

Ans: Cash flow analysis should not be overlooked when evaluating the liquidity of a company. Cash
flow ratios need to be evaluated to determine a company's ability to satisfy its debts. It is useful in
predicting financial distress (or even bankruptcy). Cash flow to total debt appraises the adequacy of
available funds to meet debt obligations. Concern is also directed to how many times a company's
immediate liquid resources are sufficient to meet cash expenses. The cash flow-to-capital
expenditures ratio indicates a company's ability to maintain plant and equipment from cash
provided from operations, rather than by borrowing or issuing new stock. The purpose of the cash
flow adequacy ratio is to determine the degree to which an enterprise has generated sufficient cash
flow from operations to cover capital expenditures, net investment in inventories, and cash
dividends. Chapter 9 (Cash Flow Ratios) discusses how to analyze cash flows of a company and
evaluates more cash flow ratios. Note: In analyzing company performance, a high ratio of total
liabilities to total stockholders' equity (financial leverage) implies a great deal of risk because it may
be difficult for the company to satisfy its interest and principal payments and also obtain reasonable
levels of further financing. A high debt/equity ratio is an especially acute problem for companies
with cash problems, particularly during times when adverse business conditions exist. Carrying
excessive amounts of debt will result in less financial flexibility for the company since it is more
difficult to obtain funds in a tight money market. Also, having to pay high fixed interest charges can
also cause earnings instability. A favorable leverage situation occurs when the return on borrowed
funds exceeds the interest cost, provided that the firm is not in debt over its head. A desirable
debt/equity ratio depends on many variables, including the rates of other companies in the industry,
the access to further debt financing, and the stability of earnings. A ratio in excess of 1 for long-term
debt-to-stockholders’' equity indicates a higher long-term debt participation as compared to equity
capital. The debt ratio (total liabilities to total assets) shows the percentage of total funds obtained
from creditors. The ratio is an indicator of how much debt may be comfortably taken on, given the
company's situation. Creditors would rather see a low debt ratio because there is then a greater
cushion for creditor losses if the firm goes bankrupt. Potential creditors are reluctant to give
financing to a company with a high debt position; however, the size of debt taken on may be
satisfactory, depending on the nature of a particular business. For example, a utility can afford a
higher debt ratio than a manufacturer because its earnings can be controlled by rate adjustments.

The evaluation of the relative size of the different sources of funds of an enterprise is major factor in
determining the financial stability of the firm, including the risk of insolvency. As a source of funds,
debt has both advantages and disadvantages, especially as it relates to leverage. Since most long-
term debt involves interest, the importance of earning coverage of those charges can be
appreciated. Earnings are used as a measure of liquid resources that can be generated from
operations. Analysts must constantly monitor the ratios related to financial structure and solvency
so that changes in factors affecting these ratios will be detected.

2. What are tangible assets that are included in the preparation of a financial statement?

Ans: These are the physical facilities used in the operations of the business. The tangible assets of
land, buildings, machinery, and construction in progress will now be reviewed. Accumulated
depreciation related to buildings and machinery will also be reviewed. Land Land is shown at
acquisition cost and is not depreciated because land does not get used up. Land containing
resources that will be used up, however, such as mineral deposits and timberlands, is subject to
depletion. Depletion expense attempts to measure the wearing away of these resources. It is similar
to depreciation except that depreciation deals with a tangible fixed asset and depletion deals with a
natural resource. Buildings Structures are presented at cost plus the cost of permanent
improvements. Buildings are depreciated (expensed) over their estimated useful life. Machinery
Machinery is listed at historical cost, including delivery and installation, plus any material
improvements that extend its life or increase the quantity or quality of service. Machinery is
depreciated over its estimated useful life. Construction in Progress Construction in progress
represents cost incurred for projects under construction. These costs will be transferred to the
proper tangible asset account upon completion of construction. The firm cannot use these assets
while they are under construction. Some analysis is directed at how efficiently the company is using
operating assets. This analysis can be distorted by construction in progress, since construction in
progress is classified as part of tangible assets. To avoid this distortion, classify construction in
progress under long-term assets, other. Accumulated DepreciationDepreciation is the process of
allocating the cost of buildings and machinery over the periods benefited. The depreciation expense
taken each period is accumulated in a separate account (Accumulated Depreciation). Accumulated
depreciation is subtracted from the cost of plant and equipment. The net amount is the book value
of the asset. It does not represent the current market value of the asset. There are a number of
depreciation methods that a firm can use. Often, a firm depreciates an asset under one method for
financial statements and another for income tax returns. A firm often wants to depreciate slowly for
the financial statements because this results in the highest immediate income and highest asset
balance. The same firm would want to depreciate faster for income tax returns because this results
in the lowest immediate income and thus lower income taxes. Over the life of an asset, the total
depreciation will be the same regardless of the depreciation method selected. Three factors are
usually considered when computing depreciation: (1) the asset cost, (2) length of the life of the
asset, and (3) its salvage value when retired from service. The length of the asset’s life and the
salvage value must be estimated at the time that the asset is placed in service. These estimates may
be later changed if warranted.

3. What is meant by growing concern or continuity in financial accounting?

Ans: The going-concern assumption, that the entity in question will remain in business for an
indefinite period of time, provides perspective on the future of the entity. The going-concern
assumption deliberately disregards the possibility that the entity will go bankrupt or be liquidated. If
a particular entity is in fact threatened with bankruptcy or liquidation, then the going-concern
assumption should be dropped. In such a case, the reader of the financial statements is interested in
the liquidation values, not the values that can be used when making the assumption that the
business will continue indefinitely. If the going-concern assumption has not been used for a
particular set of financial statements, because of the threat of liquidation or bankruptcy, the
financial statements must clearly disclose that the statements were prepared with the view that the
entity will be liquidated or that it is a failing concern. In this case, conventional financial report
analysis would not apply. Many of our present financial statement figures would be misleading if it
were not for the going-concern assumption. For instance, under the going-concern assumption, the
value of prepaid insurance is computed by spreading the cost of the insurance over the period of the
policy. If the entity were liquidated, then only the cancellation value of the policy would be
meaningful. Inventories are basically carried at their accumulated cost. If the entity were liquidated,
then the amount realized from the sale of the inventory, in a manner other than through the usual
channels, usually would be substantially less than the cost. Therefore, to carry the inventory at cost
would fail to recognize the loss that is represented by the difference between the liquidation value
and the cost. The going-concern assumption also influences liabilities. If the entity were liquidating,
some liabilities would have to be stated at amounts in excess of those stated on the conventional
statement. Also, the amounts provided for warranties and guarantees would not be realistic if the
entity were liquidating. The going-concern assumption also influences the classification of assets and
liabilities. Without the going-concern assumption, all assets and liabilities would be current, with the
expectation that the assets would be liquidated and the liabilities paid in the near future. The audit
opinion for a particular firm may indicate that the auditors have reservations as to the going-concern
status of the firm. This puts the reader on guard that the statements are misleading if the firm does
not continue as a going concern.
Chapter 6 - Financial Reporting Standards - II
1. Within the EU, accounting standard setting evolved largely as a consequence of:
a)A lack of public confidence in the accounts after the accounting scandals
b) The Eastern European countries joining the EU
c) The formation of the International ACcounting Standards Committee
d) Company directors wanting to provide information consistent with their competitors
Answer : a
2. International Accounting Standards (IAS) have been developed by:
O The Financial Reporting Council
O The International Accounting Standards Committee
O The European Commission
O The International organisation of Securities Commission (10SCO)
Answer : b
3. The European Commission announced that International Financial Reporting Standards (IFRSs) had
to be adopted by 2005 by:
OAll companies in the EU
O All listed companies in the EU preparing their consolidated accounts
O Al listed companies in the Eu
d)All enterprises in the EU
Answer : b
4.The body that has superseded the International Accounting Standards Committee is the:
O International Accounting Standards Board
OInternational Financial Reporting Board
O International Accounting Standards Commission
O International Financial Reporting Council
Answer : a
5.According to the IASB Framework, the main purpose of financial reporting is to:
O Calculate taxable income
O Help the managers to run the Business
O Calculate prudential distributable profit
O Enable investors to make economic decisions
Answer : a
6. According to the IASB Framework:
O The relative importance of the characteristics in different cases is a matter of professional
judgement
b)Relevance and reliability must be maximized, with a trade-off when they conflict
c)Prudence overrides relevance
d)Relevance overrides reliability
e) Reliability overrides relevance
Answer : b
7. The convention of consistency refers to consistent use of accounting principles:
O Across accounting periods
O Throughout the accounting period
O Within industries
O Among enterprises belonging to different industries
Answer : c
8. The charging of depreciation expense over the life of an asset rather than the immediate full
expensing of its costs is an example of:
O Reliability
O Consistency
c)prudence
O Matching
Answer : c
9.Which of the following statements best describes the term 'going concern'?
O When current assets less current liabilities become negative
b)The potential to contribute to the flow of cash and cash equivalents to the entity
O The income less expenses or an entity are negative
O The ability of the entity to continue in operation for the foreseeable future
Answer : d
10. Which of the following statements is true of the qualitative characteristics of 'understandability'
in relation to information in financial statements?
OUsers are expected to have significant business knowledge
O Financial statements should exclude complex matters
OUsers should be willing to study the information with reasonable diligence
O Financial statements should be free from material error
Answer : c
11.Which of the following terms best describes information in financial statements that is neutral?
a)Relevant
b)Rellable
c)Understandable
d)Unbiased
Answer : d
12. Which of the following terms best describes financial statements whose basis of accounting
recognises transactions and other events when they occur?
O Accrual basis of accounting
O Cash basis of accounting
O Invoice basis of accounting
O Going concern basis of accounting
Answer : d
13. Which of the following is the best description of 'reliability' in relation to information in financial
statements?
O Comprehensibility to users
O Freedom from material error
O Including a degree of caution
d)Influence on the economic decisions of users
Answer : b
14. Which of the following terms best describes information that influences the economic decisions
of users?
O Relevant
O Reliable
O Understandable
OProspective
Answer : c
15. Which two of the following are listed in the IASB Framework as 'underlying assumptions'
regarding financial statements?
a)The enterprise can be viewed as a going concern
b)Any changes or accounting policy are neutral
c)The financial statements are reliable
d)The financial statements are prepared under the accrual basis
Answer : d
16. Financial statements include a balance sheet, an income statement and a statement of changes
in equity. Which two of the following are also included within the financial statements?
OA cash flow statement
b)A directors' report
OAccounting policies
d)An auditor's report
Answer : a
17. According to the TASB Framework, which two of the following characteristics are described as
principal qualitative characteristics that make the information provided in financial statements
useful to users?
a)Relevance
b)Accrual
c)Understandability
d) Growing concern
Answer : a
18. A series of reports that are time-consuming and expensive to prepare is presented to the board
of directors each month even though the reports are never used. Which of the following qualitative
characteristics of constraints IS VIOlated by this statement?
O Prudence
O Balance between benefit and cost
O Comparability
O Materiality
O Completeness
Answer : b
19. The most difficult to calculate is ____________.
A. the cost of equity capital.
B. the cost of preferred capital.
C. the cost of retained earnings.
D. the cost of equity and preference capital.
ANSWER: B
20. The required rate of return for an investment project should ____________.
A. leave the market price of the stock unchanged
B. increase the market price.
C. reduce the market price.
D. constant market price.
ANSWER: A
21. ICICI was formed in _______:
A. 1955
B. 1665
C. 1965
D. 1954
ANSWER: A
22. The principal objective to form ICICI was:
A. To create a development financial institution
B. To create a financial institution for providing medium-term and long term project
financing
C. Create a financial institution for providing medium-term and long term project financing
to Indian businesses
D. All of The Above
ANSWER: D
23. Headquarter of ICICI Bank is located at:
A. Mumbai
B. Hyderabad
C. Mysore
D. Bangalore
ANSWER: A
24. Fixed cost per unit ____________.
A. changes according to the volume of production
B. be flexible according to the rate of interest.
C. does not change with the volume of production.
D. remains constant.
ANSWER: C
25. The principal objective was to create a development financial institution for providing
______project
financing to Indian businesses:
A. Medium Term
B. Long Term
C. Medium Term and Long Term
D. short term
ANSWER: C

Long Answers :
1. Under Reporting standards, what is meant by statement of comprehensive income?
Ans: The statement of comprehensive income presents an entity’s performance over a
specific period. Entities have a choice of presenting this in a single statement or as two
statements. The statement of comprehensive income under the single-statement approach
includes all items of income and expense and includes each component of other
comprehensive income classified by nature. Under the two-statement approach, all
components of profit or loss are presented in an income statement, followed immediately
by a statement of comprehensive income. This begins with the total profit or loss for the
period and displays all components of other comprehensive income and ends with total
comprehensive income for the period. Items to be presented in statement of comprehensive
income The following items, as a minimum, are presented in the statement of
comprehensive income: • Revenue. • Finance costs. • Share of the profit
or loss of associates and joint ventures accounted for using the equity method. • Tax
expense. • Post-tax profit or loss of discontinued operations aggregated with any
post-tax gain or loss recognised on the measurement to fair value less costs to
sell (or on the disposal) of the assets or disposal group(s) constituting the discontinued
operation. • Profit or loss for the period. • Each component of other comprehensive
income is classified by nature. • Share of the other comprehensive income of associates and
joint ventures accounted for using the equity method. • Total comprehensive income. Profit
or loss for the period and total comprehensive income are allocated in the statement of
comprehensive income to the amounts attributable to noncontrolling interest and to the
parent’s owners. Additional line items and sub-headings are presented in this statement
when such presentation is relevant to an understanding of the entity’s financial
performance. Material items The nature and amount of items of income and expense are
disclosed separately, where they are material. Disclosure may be in the statement or in the
notes. Such income/expenses may include items such as restructuring costs; write-downs of
inventories or property, plant and equipment; litigation settlements; and gains or losses on
disposals of non-current .
● The objective of financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.
● Financial reporting requires policy choices and estimates. These choices and estimates
require judgment, which can vary from one preparer to the next. Accordingly,
standards are needed to ensure increased consistency in these judgments.
● Private sector standard setting bodies and regulatory authorities play significant but
different roles in the standard setting process. In general, standard setting bodies make
the rules, and regulatory authorities enforce the rules. However, regulators typically
retain legal authority to establish financial reporting standards in their jurisdiction.
● The IFRS framework sets forth the concepts that underlie the preparation and
presentation of financial statements for external users.
● The objective of fair presentation of useful information is the center of the IASB’s
Conceptual Framework. The qualitative characteristics of useful information include
fundamental and enhancing characteristics. Information must exhibit the fundamental
characteristics of relevance and faithful representation to be useful. The enhancing
characteristics identified are comparability, verifiability, timeliness, and
understandability.
● IFRS Financial Statements: IAS No. 1 prescribes that a complete set of financial
statements includes a statement of financial position (balance sheet), a statement of
comprehensive income (either two statements—one for net income and one for
comprehensive income—or a single statement combining both net income and
comprehensive income), a statement of changes in equity, a cash flow statement, and
notes. The notes include a summary of significant accounting policies and other
explanatory information.
● Financial statements need to reflect certain basic features: fair presentation, going
concern, accrual basis, materiality and aggregation, and no offsetting.
● Financial statements must be prepared at least annually, must include comparative
information from the previous period, and must be consistent.
 ● Financial statements must follow certain presentation requirements including a
classified statement of financial position (balance sheet) and minimum information on
both the face of the financial statements and in the notes.
● A significant number of the world’s listed companies report under either IFRS or US
GAAP.
● In many cases, a user of financial statements will lack the information necessary to
make specific adjustments required to achieve comparability between companies that
use IFRS and companies that use US GAAP. Instead, an analyst must maintain general
caution in interpreting comparative financial measures produced under different
accounting standards and monitor significant developments in financial reporting
standards.
● Analysts can remain aware of ongoing developments in financial reporting by
monitoring new products or types of transactions; actions of standard setters,
regulators, and other groups; and company disclosures regarding critical accounting
policies and estimates.

2. Give a brief outline of the International Financial Reporting Standards.

Ans: The International Accounting Standards Board (the Board) was established in 2001 and
is the independent standard-setting body of the IFRS Foundation, an independent, private
sector, not-for-profit organisation working in the public interest. Its principal objectives are:
● to develop, in the public interest, a single set of high quality, understandable,
enforceable and globally accepted international financial reporting standards (IFRS
Standards) based upon clearly articulated principles. These standards should require
high quality, transparent and comparable information in financial statements and
other financial reporting to help investors, other participants in the world's capital
markets and other users of financial information make economic decisions;
● to promote the use and rigorous application of those standards;
● in fulfilling the objectives associated with (1) and (2), to take account of, as
appropriate, the needs of a range of sizes and types of entities in diverse economic
settings; and
● to promote and facilitate adoption of IFRS Standards, being the standards and
interpretations issued by the Board, through the convergence of national accounting
standards and IFRS Standards.
The governance and oversight of the activities undertaken by the IFRS Foundation and its
standard-setting body rests with a geographically and professionally diverse body of
Trustees, who are also responsible for safeguarding the independence of the Board and
ensuring the financing of the organisation. The Trustees are publicly accountable to a
Monitoring Board of public authorities. The Board is an independent group of experts with
an appropriate mix of recent practical experience in setting accounting standards; in
preparing, auditing, or using financial reports; and in accounting education. Broad
geographical diversity is also required. Members are appointed by the Trustees through an
open and rigorous process that includes advertising vacancies and consulting relevant
organisations. The IASB has 14 full-time members. The Board develops and maintains a set
of accounting requirements collectively referred to as International Financial Reporting
Standards (IFRS Standards). IFRS Standards are a set of high quality, understandable,
enforceable and globally accepted Standards based up on clearly articulated accounting
principles. The Board has no authority to impose those Standards. However, entities that
wish, or are required by a particular jurisdiction, to assert compliance with IFRS Standards
must comply with all of the individual IFRSs Standards and IFRS Interpretations
(Interpretations) issued by the Board. IFRS Standards generally contain principles and
accompanying application guidance, both of which are mandatory and carry equal weight.
Some Standards also include illustrative examples or implementation guidance, neither of
which is part of IFRS Standards. They are therefore not mandatory. Each Standard and
Interpretation has a basis for conclusions that explains the Board's reasons for developing
the particular requirements. The basis for conclusions is not part of IFRS Standards and is
therefore also not mandatory. Additionally, the Board has a Conceptual Framework for
Financial Reporting (the Framework). This Framework is designed to help the Board develop
IFRS Standards. The Framework is also designed to help those applying IFRS Standards
address matters not covered by IFRS Standards. However, the Framework is not a Standard
and the accounting requirements in an IFRS Standards take precedence over the
Framework. The Board develops IFRS Standards in the public interest. Through the Board's
due process, it consults and engages with investors, regulators, business leaders and the
global accountancy profession at every stage of the process, whilst maintaining
collaborative efforts with the worldwide standard-setting community. In developing IFRS
Standards and Interpretations the Board publishes and seeks public comment on Discussion
Papers and Exposure Drafts. Those documents are not part of IFRS Standards. The IFRS
Interpretations Committee is the interpretative body of the Board. The Interpretations
Committee has 14 voting members appointed by the Trustees, and its members are drawn
from a variety of countries and professional backgrounds. The Interpretations Committee's
mandate is to review on a timely basis widespread accounting issues that have arisen within
the context of current IFRS Standards and to provide authoritative guidance (IFRIC
Interpretations) on those issues. The Interpretations Committee also develops proposals for
narrow scope amendments to IFRS Standards on behalf of the Board. In developing
Interpretations and narrow scope amendments, the Interpretations Committee follows a
transparent, thorough and open due process. However, it is the Board that issues
Interpretations and narrow scope amendments and the Board that considers and votes on
each Interpretation and narrow scope amendment before it is issued. As well as IFRS
Standards, the Board has issued an IFRS Standard for SMEs, to meet the needs and
capabilities of small and medium-sized entities (SMEs) and users of their financial
statements. Any company of any size is eligible to use the IFRS Standard for SMEs, provided
it does not have public accountability. An entity has public accountability if it is publicly
traded, or if it is a financial institution or similar entity. The IFRS Standard for SMEs is based
on IFRS Standards but is much less complex.

3. Briefly describe IAS 32 , IAS 39, IFRS 9 and IFRS 7 with concern to Accounting
standards.

Ans: IAS 32, IAS 39, IFRS 9 and IFRS 7 For periods beginning on or after 1 January 2018, IFRS
9 is required to be applied in full. But, when an entity first applies IFRS 9, as an accounting
policy choice, it can apply the hedge accounting requirements of IAS 39 instead of the hedge
accounting requirements included in IFRS 9. The objective of the four financial instruments
standards (IAS 32, IAS 39, IFRS 9 and IFRS 7) is to establish requirements for all aspects of
accounting for financial instruments, including distinguishing debt from equity, balance
sheet offsetting, recognition, derecognition, measurement, hedge accounting and
disclosure. The standards’ scope is broad. The standards cover all types of financial
instruments, including receivables, payables, investments in bonds and shares, borrowings
and derivatives. They also apply to certain contracts to buy or sell non-financial assets (such
as commodities) that can be net-settled in cash or another financial instrument. Financial
instruments are recognised and measured according to IAS 39/IFRS 9’s requirements and
are disclosed in accordance with IFRS 7.
For annual reporting periods beginning on or after 1 January 2018 IFRS 9 replaces IAS 39.
However for some preparers IAS 39 will remain relevant (for example insurers that apply the
IFRS 4 deferral of IFRS 9).
On transition to IFRS 9 entities may also continue to apply IAS 39 hedge accounting. In
addition, requirements for fair value measurement and disclosures are covered by IFRS 13.
IAS 32 establishes principles for presenting financial instruments as financial liabilities or
equity, and for offsetting financial assets and financial liabilities.
Financial instruments represent contractual rights or obligations to receive or pay cash or
other financial assets. A financial asset is cash; a contractual right to receive cash or another
financial asset; a contractual right to exchange financial assets or liabilities with another
entity under conditions that are potentially favourable; or an equity instrument of another
entity.
A financial liability is a contractual obligation to deliver cash or another financial asset; or to
exchange financial instruments with another entity under conditions that are potentially
unfavourable. An equity instrument is any contract that evidences a residual interest in the
entity’s assets after deducting all of its liabilities.
A derivative is a financial instrument that derives its value from an underlying price or
index; requires little or no initial net investment; and is settled at a future date.
IFRS 9 replaces the multiple classification and measurement models for financial assets in IAS 39
with a single model that has three classification categories: amortised cost; fair value through other
comprehensive income (OCI); and fair value through profit and loss. Classification under IFRS 9 is
driven by the entity’s business model for managing the financial assets and whether the contractual
characteristics of the financial assets represent solely payments of principal and interest. However,
at initial recognition an entity can irrevocably designate a financial asset as measured at fair value
through profit and loss, if doing so eliminates or significantly reduces an accounting mismatch The
new standard removes the requirement to separate embedded derivatives from financial asset
hosts. It requires a hybrid contract to be classified, in its entirety, at either amortised cost or fair
value if the contractual cash flows do not represent solely payments of principal and interest. IFRS 9
prohibits reclassifications, except in rare circumstances when the entity’s business model changes.
There is specific guidance for contractually linked instruments that leverage credit risk, which is
often the case with investment tranches in a securitisation. IFRS 9’s classification principles indicate
that all equity investments should be measured at fair value through profit and loss. However, an
entity has the ability to make an irrevocable election, on an instrument-by-instrument basis, to
present changes in fair value in other comprehensive income (OCI) rather than profit or loss,
provided that the instrument is not held for trading. IFRS 9 removes the cost exemption for
unquoted equities and derivatives on unquoted equities, but it provides guidance on when cost
might be an appropriate estimate of fair value. Under IFRS 9, financial liabilities continue to be
measured at amortised cost, unless they are required to be measured at fair value through profit or
loss or an entity has opted to measure a liability at fair value through profit or loss. However, IFRS 9
changes the accounting for those financial liabilities where the fair value option has been elected.
For such liabilities, changes in fair value related to changes in own credit risk are presented
separately in OCI.
Chapter 7 - Corporate financial Statements
1. Financial Management is mainly concerned with ____________.
A. arrangement of funds
B. all aspects of acquiring and utilizing financial resources for firms activities
C. efficient Management of every business.
D. profit maximization
ANSWER: B
2. In his traditional role the finance manager is responsible for ____________.
A. arrange of utilization of funds.
B. arrangement of financial resources.
C. acquiring capital assets of the organization.
D. effective management of capital.
ANSWER: D
3. The primary goal of the financial management is ____________.
A. to maximize the return
B. to minimize the risk.
C. to maximize the wealth of owners.
D. to maximize profit..
ANSWER: D
4. Capital budgeting is related to ____________.
A. long terms assets.
B. short term assets.
C. . long terms and short terms assets.
D. fixed assets.
ANSWER: A
5. A way to analyze whether debt or lease financing would be preferable is to:
A. compare the net present values under each alternative, using the cost of capital as the
discount rate.
B. compare the net present values under each alternative, using the after-tax cost of
borrowing as the
discount rate.
C. compare the payback periods for each alternative.
D. compare the effective interest costs involved for each alternative
ANSWER: B
6. The type of lease that includes a third party, a lender, is called a(n)
A. sale and leaseback.
B. direct leasing arrangement.
C. leveraged lease.
D. operating lease.
ANSWER: C
7. Future value interest factor takes ____________.
A. Compounding rate
B. Discounting rate.
C. Inflation rate.
D. Deflation rate.
ANSWER: A
8. Present value takes ____________.
A. Compounding rate.
B. Discounting rate.
C. Inflation rate.
D. Deflation rate.
ANSWER: B
9. Financial decisions involve ____________.
A. Investment, financing and dividend decisions.
B. Investment sales decisions.
C. Financing cash decisions.
D. Investment dividend decisions.
ANSWER: C
10. Traditional approach confines finance function only to ____________.
A. raising
B. mobilizing
C. utilizing
D. financing
ANSWER: A
11. The company’s cost of capital is called ____________.
A. Leverage rate
B. Hurdle rate.
C. Risk rate.
D. Return rate.
ANSWER: A
12. Market value of the shares are decided by ____________.
A. the respective companies.
B. the investment market.
C. the government.
D. shareholders.
ANSWER: D
13. Cost of retained earnings is equal to ____________.
A. Cost of equity.
B. Cost of debt.
C. Cost of term loans.
D. Cost of bank loan.
ANSWER: C
14. Beta measures the ____________.
A. Financial risk.
B. Investment risk rate.
C. Market risk.
D. Market and finance risk.
ANSWER: B
15. The expansion of CAPM is ____________.
A. Capital amount pricing model.
B. Capital asset pricing model.
C. Capital asset printing model.
D. a. Capital amount printing model.
ANSWER: B
16. Medium-term notes (MTNs) have maturities that range up to
A. one year (but no more)
B. two years (but no more).
C. ten years (but no more).
D. thirty years (or more)
ANSWER: D
17. Which one of the following is the main objective of Unit Trust of India?
A. To mobilize the savings of high-income groups.
B. To mobilize the savings to low and high-income groups.
C. To mobilize the savings of corporate.
D. To mobilize the savings of low and middle-income groups.
ANSWER: D
18. The first development financial institution in India that has got merged with a bank
A. IDBI
B. ICICI
C. UTI
D. SFC
ANSWER: B
19. The most difficult to calculate is ____________.
A. the cost of equity capital.
B. the cost of preferred capital.
C. the cost of retained earnings.
D. the cost of equity and preference capital.
ANSWER: B
20. The required rate of return for an investment project should ____________.
A. leave the market price of the stock unchanged
B. increase the market price.
C. reduce the market price.
D. constant market price.
ANSWER: A
21. ICICI was formed in _______:
A. 1955
B. 1665
C. 1965
D. 1954
ANSWER: A
22. The principal objective to form ICICI was:
A. To create a development financial institution
B. To create a financial institution for providing medium-term and long term project
financing
C. Create a financial institution for providing medium-term and long term project financing
to Indian businesses
D. All of The Above
ANSWER: D
23. Headquarter of ICICI Bank is located at:
A. Mumbai
B. Hyderabad
C. Mysore
D. Bangalore
ANSWER: A
24. Fixed cost per unit ____________.
A. changes according to the volume of production
B. be flexible according to the rate of interest.
C. does not change with the volume of production.
D. remains constant.
ANSWER: C
25. The principal objective was to create a development financial institution for providing
______project
financing to Indian businesses:
A. Medium Term
B. Long Term
C. Medium Term and Long Term
D. short term
ANSWER: C
26. Variable cost per unit ____________.
A. varies with the level of output.
B. remains constant irrespective of the level of output.
C. changes with the growth of the firm.
D. does not change with the volume of production
ANSWER: A
27. Financial leverage measures ____________.
A. sensitivity of EBIT with respect of 1% change with respect to output
B. 1% variation in the level of production
C. sensitivity of EPS with respect to 1% change in level of EBIT.
D. no change with EBIT and EPS.
ANSWER: A
28. Operating leverage measures ____________.
A. the business risk.
B. financial risk.
C. both risks.
D. production risk.
ANSWER: D
29. Financial leverage helps one to estimate ____________.
A. the business risk
B. the financial risk.
C. both risks
D. production risk.
ANSWER: C
30. Financial leverage is also known as ____________.
A. Trading on equity
B. Trading on debt.
C. Interest on equity.
D. Interest on debt.
ANSWER: A
Long Answers
 1. What is the difference between internal and external reconstruction?
2. Ans: Having decided who is to bear how much sacrifice of loss and having settled the
broad details of the scheme, and important question remains to be decided. Will the
reconstruction be internal or external? Internal reconstruction means that the
scheme will be carried out by liquidating the existing company and incorporating
immediately another company (with the name only slightly changed such as AB Ltd.,
to take over the business of the outgoing company. There are advantages in both,
but generally internal reconstruction is preferred. The advantages in its favour are:-

(a) Creditors, specially

bank over draft and debenture holders, may continue where as they may not if the
company is formally liquidated which will involve payment of claims to out siders, If
they do not continue, the company may suffer from want of financial assistance. This
is, however, only academic since no reconstruction scheme, even internal, will be
really formulated without the consent of the bank, debenture holders. etc.
(b) The company will be able to set off its past losses against future
profits for income-tax purposes. This will materially reduce the income-tax liability
depending on the losses suffered during the preceding eight years. Losses can be
carried forward for eight years provided the business is carried on.The business will
technically end when the company is liquidated. Hence, in case of external
reconstruction, losses cannot be carried forward for income tax purposes.
The arguments in favour of
external reconstruction are as under:- (a) External reconstruction may
be the only way to bring about speedy reconstruction because sometimes a few
people hold up the scheme by delaying tactics by means of legal objections.
(b) It may help in raising more finance by issuing to the existing shareholders
partly paid shares in the new company. It should be remembered that in internal
reconstruction fully paid up shares unless every share holder gives his assent in
writing. This may prove cumbersome. However, if share holders are willing to accept
partly paid shares in the new company, there is not much reason why they should
refuse to buy new shares under a scheme of internal reconstruction.
External Reconstruction • Reconstruction means
reorganization of a company’s financial structure. In reconstruction of a company,
usually the assets and liabilities of the company are revalued, the losses suffered by
the company are written off by a deduction of the paid-up value of shares and /or
varying of the rights attached to different classes of shares and compounding with
the creditors. It may be done without liquidating the company and forming a new
company in which case the process is called internal reconstruction. However, there
may be external reconstruction in which case the undertaking being carried on by
the company is transferred to a newly started company consisting substantially of
the same shareholders with a view to the business of the transferor company being
continued by the transferee company. An attempt is made that the newly started
company has a sound financial structure and a good set off assets and liabilities
recorded in the books of the transferee company at their fair values.
2.What is meant by consolidated financial statements and what are its scope?
Ans: The consolidated financial statements are prepared on the basis of financial statements
of parent and all enterprises that are controlled by the parent, other than those subsidiaries
excluded for the reasons set out in paragraph 11. Control exists when the parent owns,
directly or indirectly through subsidiary(ies), more than one-half of the voting power of an
enterprise. Control also exists when an enterprise controls the composition of the board of
directors (in the case of a company) or of the corresponding governing body (in case of an
enterprise not being a company) so as to obtain economic benefits from its activities. An
enterprise may control the composition of the governing bodies of entities such as gratuity
trust, provident fund trust etc. Since the objective of control over such entities is not to
obtain economic benefits from their activities, these are not considered for the purpose of
preparation of consolidated financial statements. For the purpose of this Standard, an
enterprise is considered to control the composition of:
(i) the board of directors of a company, if it has the power, without the
consent or concurrence of any other person, to appoint or remove all or a majority of
directors of that company. An enterprise is deemed to have the power to appoint a director,
if any of the following conditions is satisfied:
(a) a person cannot be appointed as director without the exercise in his favour by
that enterprise of such a power as aforesaid; or (b)
a person’s appointment as director follows necessarily from his appointment to a position
held by him in that enterprise; or (c) the director is
nominated by that enterprise or a subsidiary thereof.
(ii) the governing body of
an enterprise that is not a company, if it has the power, without the consent or the
concurrence of any other person, to appoint or remove all or a majority of members of the
governing body of that other enterprise. An enterprise is deemed to have the power to
appoint a member, if any of the following conditions is satisfied:
(a) a person cannot be appointed as member of the
governing body without the exercise in his favour by that other enterprise of such a power
as aforesaid; or (b) a person’s appointment as member of the governing body follows
necessarily from his appointment to a position held by him in that other enterprise; or (c)
the member of the governing body is nominated by that other enterprise.Explanation: It is
possible that an enterprise is controlled by two enterprises – one controls by virtue of
ownership of majority of the voting power of that enterprise and the other controls, by
virtue of an agreement or otherwise, the composition of the board of directors so as to
obtain economic benefits from its activities. In such a rare situation, when an enterprise is
controlled by two enterprises as per the definition of ‘control’, the first mentioned
enterprise will be considered as subsidiary of both the controlling enterprises within the
meaning of this Standard and, therefore, both the enterprises need to consolidate the
financial statements of that enterprise as per the requirements of this Standard.
Exclusion of a subsidiary from consolidation on the
ground that its business activities are dissimilar from those of the other enterprises within
the group is not justified because better information is provided by consolidating such
subsidiaries and disclosing additional information in the consolidated financial statements
about the different business activities of subsidiaries. For example, the disclosures required
by Accounting Standard (AS) 17, Segment Reporting, help to explain the significance of
different business activities within the group. The
parent’s portion of equity in a subsidiary, at the date on which investment is made, is
determined on the basis of information contained in the financial statements of the
subsidiary as on the date of investment. However, if the financial statements of a subsidiary,
as on the date of investment, are not available and if it is impracticable to draw the financial
statements of the subsidiary as on that date, financial statements of the subsidiary for the
immediately preceding period are used as a basis for consolidation. Adjustments are made
to these financial statements for the effects of significant transactions or other events that
occur between the date of such financial statements and the date of investment in the
subsidiary. If an enterprise makes two or more investments in another
enterprise at different dates and eventually obtains control of the other enterprise, the
consolidated financial statements are presented only from the date on which holding-
subsidiary relationship comes into existence. If two or more investments are made over a
period of time, the equity of the subsidiary at the date of investment, for the purposes of
paragraph 13 above, is generally determined on a step-by-step basis; however, if small
investments are made over a period of time and then an investment is made that results in
control, the date of the latest investment, as a practicable measure, may be considered as
the date of investment. Intragroup balances and intragroup transactions, including sales,
expenses and dividends, are eliminated in full. Unrealised profits resulting from intragroup
transactions that are included in the carrying amount of assets, such as inventory and fixed
assets, are eliminated in full. Unrealised losses resulting from intragroup transactions that
are deducted in arriving at the carrying amount of assets are also eliminated unless cost
cannot be.
The financial statements of the parent and its subsidiaries used in the preparation of
the consolidated financial statements are usually drawn up to the same date. When the
reporting dates are different, the subsidiary often prepares, for consolidation purposes,
statements as at the same date as that of the parent. When it is impracticable to do this,
financial statements drawn up to different reporting dates may be used provided the
difference in reporting dates is not more than six months. The consistency principle requires
that the length of the reporting periods and any difference in the reporting dates should be
the same from period to period. The results of operations of a subsidiary are included in
the consolidated financial statements as from the date on which parent-subsidiary
relationship came in existence. The results of operations of a subsidiary with which parent-
subsidiary relationship ceases to exist are included in the consolidated statement of profit
and loss until the date of cessation of the relationship. The difference between the proceeds
from the disposal of investment in a subsidiary and the carrying amount of its assets less
liabilities as of the date of disposal is recognised in the consolidated statement of profit and
loss as the profit or loss on the disposal of the investment in the subsidiary. In order to
ensure the comparability of the financial statements from one accounting period to the
next, supplementary information is often provided about the effect of the acquisition and
disposal of subsidiaries on the financial position at the reporting date and the results for the
reporting period.
3. Give a brief definition of Corporate Financial Statements and their reporting.
Ans: Corporate financial reporting is an essential activity for all businesses. This form of
accounting should provide investors and creditors with useful information that they can
employ in making lending or investment decisions. Since stockholders and lending
institutions rely on income or repayment from your business to accurately run their own
companies and estimate their cash flow, it’s essential that your company be able to present
accurate, timely information that speaks to the overall health of your company. Failure to
provide accurate information can not only lead to problems of reputation; it can cause legal
difficulties.
Corporate financial statements are essential for tax preparation and audit protection, as
well. When your business files monthly or quarterly reports that showcase the health of the
company, you may use that information in preparing other, more complex reports come tax
time or keep them on hand in case your company is ever subject to an audit.
In general, the primary goal of corporate financial reporting is to provide capital market
participants with information for financial decision making. It is not necessary to lower the
provided information to the level of a layperson, however. Investors, creditors and other
decision-makers are expected to possess a general understanding of accounting principles
and apply these to understand the reports furnished by your company. Corporate financial
reporting is important because it offers essential information to management, as well as
others with capital market interests in your business. This information is necessary for
making determinations about future investments, purchases or loans. For corporate leaders,
financial reports can be compared to past data to determine how certain decisions have
impacted the bottom line and whether similar choices should be made in the future. Also, a
high-level look at the company’s overall financial health is critical in determining whether to
bring on or reduce staffing, make financial or economic investments, pursue mergers and
acquisitions or raise or lower prices. They can also help you to determine the liquidity of
your business, which can indicate whether the company can continue as what is called a
“going concern,” or an entity that will remain in business for the foreseeable future.
For investors and creditors, corporate financial reports are useful because they disclose the
financial obligations of a business. This speaks to the potential for future economic
resources to ebb and flow and indicates whether it might be a good time to lend money or
invest in your company.
Principles for corporate financial reporting have been laid out by the Financial Accounting
Standards Board, which is the successor to the Accounting Principles Board, in existence in
the United States since 1973. All corporate financial reporting must follow the Generally
Accepted Accounting Principles so that information presented across industries can be
universally understood.
Corporate financial reporting can be used for decision-making purposes by internal and
external parties. Particularly for larger companies, in which many major players don’t
consistently have access to important financial data, these reports are essential in providing
the basis for decisions related to staffing, scaling and setting price levels.
Say, for instance, an automobile dealership is trying to decide whether or not to bring on 10
new employees. The past year has been very busy, with high sales figures. Extra staff on the
lot would go a long way to providing superior service for customers. However, the
dealership only sells cars from one automaker. The brand hasn’t released a new model in
some time, and the vehicles that are being delivered seem to have more and more
manufacturer defects. In this scenario, it would be hugely helpful for the car dealership to
know whether the automaker is struggling financially at the top and if this has been the
cause of less money spent on research and development or quality control.
If the local dealership had the opportunity to review corporate financial reports from the
automaker, it could showcase the brand’s income and expenses, as well as its overall assets,
liabilities and equity. All of this information might prove useful in determining whether the
dealership should scale up with new employees, or whether they should expect a slow
down in the future due to the brand’s failure to invest in itself.
Corporate financial reporting can also be helpful for creditors and investors who are on the
outside of the business itself. Let’s say the same auto dealership was looking for a loan to
expand to a second location. A local bank would need to review the dealership’s corporate
financial reports before it could determine if the company is a safe one to lend money to. In
addition, the bank would likely wish to review the financial reports of the auto
manufacturer, since they present a better depiction of the dealership’s growth potential if
they continue to sell just one brand of car.
As a consumer, corporate financial reports are useful when it comes to determining
whether you should make personal investments. Say, for instance, you are considering
purchasing stock in a telecommunications company. You are unsure which particular
telecommunications business would yield the highest dividends based purely on their
trading price and stock value history. Corporate financial reports play a critical role for you
as the investor, because they enable you to see how the company is performing overall. By
reviewing financial reports for multiple telecommunications companies, you should be able
to determine which is the best place to invest.
Also, once you hold stocks in a given company, it’s essential to continue to pay attention to
its financial reports. Over time, you may see growth trends that encourage you to invest
additional funds in their stock. Similarly, however, you might be concerned by something
that you see and elect to reallocate your investable income elsewhere.
Corporate financial reporting is only as good as the information it is based on. Careful,
meticulous statements must be kept for every transaction that is carried out by a company.
The day-to-day information must be tracked and fed into monthly and quarterly reports. In
turn, these must be accurate, so that semi-annual or annual financial reports are also
correct.
There is no substitute for careful bookkeeping. Not only is providing creditors and investors
accurate information essential from a moral standpoint, the failure to do so can cause
significant legal difficulties. Also, internal decision-makers must have access to up-to-date,
completely accurate financial information so that they can make informed choices to propel
the company forward.
As a decision-maker within a company, it’s important to review corporate financial
statements carefully. If anything seems amiss or out-of-place, report it to the appropriate
parties immediately. No matter how careful the accounting department might be, mistakes
do creep in from time to time. Staying vigilant and informing the powers that be of any
errors could go a long way in putting the company on the proper trajectory. In addition,
doing so could lead to a fix of the corporate reports before they enter the hands of investors
or creditors. Once an error reaches that point in the process, it will likely be far more
problematic.

Chapter 8 - Statements of Cash Flows

Question 1.
Preparation of cash flow statement is :
(a) Mandatory
(b) Recommendatory
(c) Required under the Companies Act
(d) None of these
Answer: (a) Mandatory

Question 2.
Issue of shares in consideration of purchase of plant and machinery results into :
(a) Inflow of Cash
(b) Outflow of Cash
(c) Neither Inflow nor Outflow
(d) None of these
Answer: (c) Neither Inflow nor Outflow

Question 3.
If net profit is 7 50,000 after writing off goodwill 7 10,000 then the cash flow from operating
activities will be:
(a) ₹ 60,000
(b) ₹ 40,000
(c) ₹ 50,000
(d) ₹ 30,000
Answer: (a) ₹ 60,000

Question 4.
If net profit is ₹ 35,000 after writing off good will ₹ 6,000 and loss on sale of furniture ₹ 1,000, cash
flow from operating activities will be :
(a) ₹ 35,000
(b) ₹ 42,000
(c) ₹ 29,000
(d) ₹ 28,000
Answer: (b) ₹ 42,000

Question 5.
Cash sales in :
(a) Operating Activity
(b) Investing Activity
(c) Financing Activity
(d) None of these
Answer: (a) Operating Activity

Question 6.
Cash from operating activities will decrease due to :
(a) Increase in Current Assets
(b) Decrease in Current Liabilities
(c) Neither of the two
(d) Both (a) and (b)
Answer: (d) Both (a) and (b)

Question 7.
Which of the following is an example of Cash Flow from Operating Activities ?
(a) Purchase of Machinery
(b) Issue of Shares
(c) Purchases of Inventory for Cash
(d) Purchases of Investment
Answer: (c) Purchases of Inventory for Cash

Question 8.
While calculating operating profit which will be added to net profit:
(a) Interest received
(b) Profit on sale of Asset
(c) Increase in General Reserve
(d) Refund of Tax
Answer: (c) Increase in General Reserve

Question 9.
While calculating cash flow from operating netivities which will be deducted ?
(a) Increase in Creditors
(b) Increase in Debtors
(c) Decrease in Debtors
(d) Decrease in Prepaid Expenses
Answer: (b) Increase in Debtors

Question 10.
While calculating cash flow from operating activities, which will be added ?
(a) Increase in Stock
(b) Increase in Creditors
(c) Decrease in Bills Payable
(d) Increase in Debtors
Answer: (b) Increase in Creditors

Question 11.
An example of Cash Flow from Investing Activities :
(a) Cash Sales
(b) Issue of Shares
(c) Payment of cash for purchase of machinery
(d) Payment of Dividend
Answer: (c) Payment of cash for purchase of machinery

Question 12.
An example of Cash Flows from Financing Activity is :
(a) Sale of goods
(b) Sale of Investment
(c) Cash receipts from issue of shares
(d) Interest received
Answer: (c) Cash receipts from issue of shares

Question 13.
How will you treat payment of ‘Interest of Debentures’ while preparing a Cash Flow Statement ?
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Cash Equivalents
Answer: (c) Cash Flow from Financing Activities

Question 14.
Where will you show purchase of goodwill in Cash Flow Statement:
(a) Cash Flow from Operating Activities
(b) Cash Flow from Investing Activities
(c) Cash Flow from Financing Activities
(d) Cash Equivalent
Answer: (b) Cash Flow from Investing Activities
Question 15.
Interest received by a finance company is classified under which kind of activity while preparing a
Cash Flow Statement ?
(a) Cash Flow from Operating Activities
(b) Investing Activities
(c) Financing Activities
(d) Cash Equivalent
Answer: (a) Cash Flow from Operating Activities

Question 16.
Which of the following item is considered as cash equivalents:
(a) Bank Overdraft
(b) Bills Receivable
(c) Debtors
(d) Short-term Investment
Answer: (a) Bank Overdraft

Question 17.
Which of the following items is not considered as cash equivalents ?
(a) Bank Overdraft
(b) Commercial Papers
(c) Treasury Bills
(d) Investment
Answer: (d) Investment

Question 18.
Cash payment to employees is a Cash Flow from:
(a) Operating Activities
(b) Investing Activities
(c) Finance Activities
(d) All the above
Answer: (a) Operating Activities

Question 19.
Which of the following is not a Cash in Flow ?
(a) Sale of Fixed Asset
(b) Purchase of Fixed Asset
(c) Issue of Debentures
(d) Sale of Goods for Cash
Answer: (b) Purchase of Fixed Asset

Question 20.
In cash flow statement, the item of ‘Interest’ is shown in:
(a) Operating Activities
(b) Investing Activities
(c) Financial Activities
(d) In both (d) & (c)
Answer: (d) In both (d) & (c)

Question 21.
Which of the following is not a Cash Outflow:
(a) Increase in Creditors
(b) Increase in Debtors
(c) Increase in Stock
(d) Increase in prepaid expenses
Answer: (a) Increase in Creditors

Question 22.
Cash from operation is equal to :
(a) Net Profit + Increase in Current Assets
(b) Net Profit + Decrease in Current Liabilities
(c) Operating Profit + Adjustment of Current Assets and Current Liabilities
(d) All of the above
Answer: (b) Net Profit + Decrease in Current Liabilities

Question 23.
Income tax refund is a cash of:
(a) Source
(b) Application
(c) Both (a) & (b)
(d) None of these
Answer: (a) Source

Question 24.
Cash Flow Statement in based upon:
(a) Cash basis of accounting
(b) Accrual basis of accounting
(c) (a) and (b) both
(d) None of these
Answer: (a) Cash basis of accounting

Question 25.
Cash Flow Statement is related to:
(a) AS-3
(b) AS-6
(c) AS-9
(d) AS-12
Answer: (a) AS-3
Long Answers
1. What is the importance of cash flow statements? And what are the elements that are
incorporated in a cash flow statement?
Ans: Information about the cash flows of an enterprise is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents
and the needs of the enterprise to utilise those cash flows. The economic decisions that are taken by
users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and
the timing and certainty of their generation. The Standard deals with the provision of
information about the historical changes in cash and cash equivalents of an enterprise by means of a
cash flow statement which classifies cash flows during the period from operating, investing and
financing activities. Users of an enterprise’s financial statements are interested in how the enterprise
generates and uses cash and cash equivalents. This is the case regardless of the nature of the
enterprise’s activities and irrespective of whether cash can be viewed as the product of the
enterprise, as may be the case with a financial enterprise. Enterprises need cash for essentially the
same reasons, however different their principal revenue-producing activities might be. They need
cash to conduct their operations, to pay their obligations, and to provide returns to their investors. A
cash flow statement, when used in conjunction with the other financial statements, provides
information that enables users to evaluate the changes in net assets of an enterprise, its financial
structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash
flows in order to adapt to changing circumstances and opportunities. Cash flow information is useful
in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to
develop models to assess and compare the present value of the future cash flows of different
enterprises. It also enhances the comparability of the reporting of operating performance by
different enterprises because it eliminates the effects of using different accounting treatments for
the same transactions and events.
Historical cash flow information is often used as an indicator of the amount, timing and
certainty of future cash flows. It is also useful in checking the accuracy of past assessments of future
cash flows and in examining the relationship between profitability and net cash flow and the impact
of changing prices. Cash
equivalents are held for the purpose of meeting short-term cash commitments rather than for
investment or other purposes. For an investment to qualify as a cash equivalent, it must be readily
convertible to a known amount of cash and be subject to an insignificant risk of changes in value.
Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity
of, say, three months or less from the date of acquisition. Investments in shares are excluded from
cash equivalents unless they are, in substance, cash equivalents; for example, preference shares of a
company acquired shortly before their specified redemption date (provided there is only an
insignificant risk of failure of the company to repay the amount at maturity).
Cash flows exclude movements between items that constitute cash
or cash equivalents because these components are part of the cash management of an enterprise
rather than part of its operating, investing and financing activities. Cash management includes the
investment of excess cash in cash equivalents. ELEMENTS : An
enterprise presents its cash flows from operating, investing and financing activities in a manner
which is most appropriate to its business. Classification by activity provides information that allows
users to assess the impact of those activities on the financial position of the enterprise and the
amount of its cash and cash equivalents. This information may also be used to evaluate the
relationships among those activities. A single transaction may include cash flows that are classified
differently. For example, when the instalment paid in respect of
a fixed asset acquired on deferred payment basis includes both interest and loan, the interest
element is classified under financing activities and the loan element is classified under investing
activities.Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which
is included in the determination of net profit or loss. However, the cash flows relating to such
transactions are cash flows from investing activities. An
enterprise may hold securities and loans for dealing or trading purposes, in which case they are
similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase
and sale of dealing or trading securities are classified as operating activities.
Similarly, cash advances and loans
made by financial enterprises are usually classified as operating activities since they relate to the
main revenue-producing activity of that enterprise.
Unrealised gains and losses arising from changes in
foreign exchange rates are not cash flows. However, the effect of exchange rate changes on cash
and cash equivalents held or due in a foreign currency is reported in the cash flow statement in
order to reconcile cash and cash equivalents at the beginning and the end of the period. This
amount is presented separately from cash flows from operating, investing and financing activities
and includes the differences, if any, had those cash flows been reported at the end-of-period
exchange rates. The
cash flows associated with extraordinary items are disclosed separately as arising from operating,
investing or financing activities in the cash flow statement, to enable users to understand their
nature and effect on the present and future cash flows of the enterprise. These disclosures are in
addition to the separate disclosures of the nature and amount of extraordinary items required by
Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies.
2. What is the influence of taxes on cash flow statements?
Ans: Cash flows arising from taxes on income should be separately disclosed and

should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities. Taxes on income arise
on transactions that give rise to cash flows that are classified as operating, investing
or financing activities in a cash flow statement. While tax expense may be readily
identifiable with investing or financing activities, the related tax cash flows are often
impracticable to identify and may arise in a different period from the cash flows of
the underlying transactions. Therefore, taxes paid are usually classified as cash flows
from operating activities. However, when it is practicable to identify the tax cash
flow with an individual transaction that gives rise to cash flows that are classified as
investing or financing activities, the tax cash flow is classified as an investing or
financing activity as appropriate. When tax cash flow are allocated over more than
one class of activity, the total amount of taxes paid is disclosed.
When accounting for an investment in an associate or a subsidiary or a joint
venture, an investor restricts its reporting in the cash flow statement to the cash
flows between itself and the investee/joint venture, for example, cash flows relating
to dividends and advances. The aggregate cash flows arising from acquisitions and
from disposals of subsidiaries or other business units should be presented separately
and classified as investing activities.
The separate presentation of the cash flow effects of acquisitions and
disposals of subsidiaries and other business units as single line items helps to
distinguish those cash flows from other cash flows. The cash flow effects of disposals
are not deducted from those of acquisitions.
Investing and financing transactions that do not require the use of
cash or cash equivalents should be excluded from a cash flow statement. Such
transactions should be disclosed elsewhere in the financial statements in a way that
provides all the relevant information about these investing and financing activities.
Many investing and financing activities do not have a direct impact on current cash
flows although they do affect the capital and asset structure of an enterprise. The
 exclusion of non-cash transactions from the cash flow statement is consistent with
the objective of a cash flow statement as these items do not involve cash flows in the
current period. The separate disclosure of cash flows that represent increases in
operating capacity and cash flows that are required to maintain operating capacity is
useful in enabling the user to determine whether the enterprise is investing
adequately in the maintenance of its operating capacity. An enterprise that does not
invest adequately in the maintenance of its operating capacity may be prejudicing
future profitability for the sake of current liquidity and distributions to owners.
Information from the statement of profit and loss and balance sheet is provided to
show how the statements of cash flows under the direct method and the indirect
method have been derived. Neither the statement of profit and loss nor the balance
sheet is presented in conformity with the disclosure and presentation requirements
of applicable laws and accounting standards. The working notes given towards the
end of this illustration are intended to assist in understanding the manner in which
the various figures appearing in the cash flow statement have been derived. These
working notes do not form part of the cash flow statement and, accordingly, need
not be.
3. Outline the limitations of cash flow statements. Also give examples.
Ans: Firstly, the possibility of ‘window-dressing’ in cash position is more than in the case of
working capital position of a business. The cash balance can easily be maneuvered by
deferring purchases and other payments, and speeding up collections from debtors before
the balance sheet date. The possibility of such maneuvering is lesser in respect of working
capital computation. Therefore, a funds-flow statement which shows reasons responsible
for the changes in the working capital presents a more realistic picture than in the cash-flow
statement. Secondly, the liquidity position of a business does not depend upon
cash position only. In addition to cash, it is also dependent upon those assets, which can be
converted into cash. Exclusion of these assets while assessing the liability of a business
obscures the true reporting of the ability of business in meeting its liabilities on due dates.
Thirdly,
equating cash generated from the operations of the business with the net operating income
of the business is not fair; while computing cash generated from business operations,
depreciation on fixed assets is excluded. This treatment leads to mis-match between the
expenses and revenues while determining the business results as no charge is made in the
profit and loss account for the use of fixed assets.
Fourthly, a relatively larger amount of cash
generated from business operations vis-à-vis net profit earned may prompt the
management to pay a higher rate of dividend, which, in turn, may affect the financial health
of the firm. Cash-flow statement shows the impact of various transactions on the cash
position of a firm. It is prepared with the help of financial statements, i.e. balance sheet and
profit and loss account and some additional information. A cash-flow statement starts with
the opening balance of cash - and balance of cash in hand and cash balance at bank - all the
inflows of cash are added to the opening balance and the outflows of cash are deducted
from the resultant total. The balance, i.e. opening balance of cash and bank balance plus
inflows of cash minus outflows of cash is reconciled with the closing balance of cash.
Additionally : (a) Fails to Present Net
Income: Cash Flow Statement actually fails to present the net income of a firm for a period
since it does not consider non-cash items which can easily be ascertained by an Income
Statement. It can be used as a supplement to Income Statement.
(b) Fails to Assess the Liquidity and Solvency
Position:Practically, cash flow statement does not help to assess liquidity or solvency position

of a firm. Proper liquidity position cannot be assessed from the cash flow statement which
presents only the cash position at the end of the period. It only helps how much amount of
obligation can be met, i.e. Cash Flow Statement does not represent the real liquidity
position.
(c) Neither a Substitute of Funds Flow Statement nor Income Statement: Neither a
Substitute of Funds Flow Statement nor Income Statement:
Cash Flow Statement is neither a substitute of Funds Flow Statement nor a substitute of
Income Statement. The functions which are performed by a Funds Flow Statement or
Income statement cannot be done by a Cash Flow Statement.
(d) Not to Assess Profitability:
Practically, cash flows from operation does not help to assess profitability of a firm since it
neither considers the costs nor revenues.
(e) Does not Conform with the Companies Act:
The provisions which are made by the Companies Act is in conformity with Profit and Loss
Account and Balance Sheet are not in conformity with Cash Flow Statement which is
prepared as per AS 3.
(f) Does not Assess Future Cash Flows:
Since Cash Flow Statement is prepared on the basis of historical cost and, as such, it does
not help to know the future/projected cash flows.
(g) Inter-Industry Comparison not Possible:
Since Cash Flow Statement does not measure the economic efficiency of a firm in
comparison with other inter-industry comparison is not possible, e.g. a firm having less
capital investment will have less cash flow than the firm which has more capital investment
having a higher cash flow.

Chapter 9 - Analysis of financial statements - I

Question 1.
Interpretation of Financial Statements includes:
(a) Criticisms and Analysis
(b) Comparison and Trend Study
(c) Drawing Conclusion
(d) All the above
Answer: (d) All the above

Question 2.
Horizontal Analysis is also known as :
(a) Dynamic Analysis
(b) Structural Analysis
(c) Static Analysis
(d) None of these
Answer: (a) Dynamic Analysis

Question 3.
Vertical Analysis is also known as :
(a) Static Analysis
(b) Dynamic Analysis
(c) Structural Analysis
(d) None of these
Answer: (a) Static Analysis

Question 4.
Comparative Statements are also known as :
(a) Dynamic Analysis
(b) Horizontal Analysis
(c) Vertical Analysis
(d) External Analysis
Answer: (b) Horizontal Analysis

Question 5.
Common-size Statement are also known as:
(a) Dynamic Analysis
(b) Horizontal Analysis
(c) Vertical Analysis
(d) External Analysis
Answer: (c) Vertical Analysis

Question 6.
The most commonly used tools for financial analysis are:
(a) Comparative Statements
(b) Common-size Statement
(c) Accounting Ratios
(d) All the above
Answer: (d) All the above

Question 7.
The analysis of financial statement by a shareholder is an example of:
(a) External Analysis
(b) Internal Analysis
(c) Vertical Analysis
(d) Horizontal Analysis
Answer: (a) External Analysis

Question 8.
For calculating trend percentages any year is selected as:
(a) Current year
(b) Previous year
(c) Base year
(d) None of these
Answer: (c) Base year

Question 9.
Tools for comparison of financial statements are :
(a) Comparative Balance Sheet
(b) Comparative Income Statement
(c) Common-size Statement
(d) All the above
Answer: (d) All the above

Question 10.
Trend ratios and trend percentage are used in :
(a) Dynamic analysis
(b) Static analysis
(c) Horizontal analysis
(d) Vertical Analysis
Answer: (c) Horizontal analysis
Question 11.
Comparative Financial Statements show:
(a) Financial position of a concern
(b) Earning capacity of a concern
(c) Both of them
(d) None of these
Answer: (c) Both of them

Question 12.
Comparative financial analysis process shows the comparison between the items of which
statement:
(a) Balance Sheet
(b) Profit & Loss Statement
(c) (a) and (b) both
(d) None of these
Answer: (c) (a) and (b) both

Question 13.
Which of these are not the method of financial statement analysis ?
(a) Ratio Analysis
(b) Comparative Analysis
(c) Trend Analysis
(d) Capitalisation Method
Answer: (d) Capitalisation Method

Question 14.
Common-size financial statements are mostly prepared:
(a) In proportion
(b) In percentage
(c) (a) and (b) both
(d) None of these
Answer: (b) In percentage

Question 15.
Tangible assets of company increased from T 4,00,000 to T 5,00,000. What is the percentage of
change ?
(a) 20%
(b) 25%
(c) 33%
(d) 50%
Answer: (b) 25%

Question 16.
A company’s shareholders fund was 7 8,00,000 in the year 2015. It because 7 12,00,000 in the year
2016. What is percentage of change ?
(a) 100%
(b) 25%
(c) 50%
(d) 33.3%
Answer: (c) 50%
Question 17.
A company’s net sales are ₹ 15,00,000; cost of sales is ₹ 10,00,000 and indirect expenses are ₹
3,00,000, the amount gross profit will be:
(a) ₹ 13,00,000
(b) ₹ 5,00,000
(c) ₹ 2,00,000
(d) ₹ 12,00,000
Answer: (c) ₹ 2,00,000

Question 18.
Sales less Cost of goods sold is called :
(a) Operating Profit
(b) Gross Profit
(c) Net Profit
(d) Total Profit
Answer: (b) Gross Profit

Question 19.
If total assets of a firm are 7 12,00,000 and its non of non-current assets to total assets ?
(a) 50%
(b) 75%
(c) 25%
(d) 80%
Answer: (b) 75%

Question 20.
If total assets of a firm are 7 10,00,000 and its non-current assets are 7 6,00,000, what will be the
percentage of current assets on total assets ?
(a) 60%
(b) 50%
(c) 40%
(d) 30%
Answer: (c) 40%

Question 21.
In a common-size Balance Sheet, total equity and liabilities are assumed to be equal to :
(a) 1,000
(b) 100
(c) 10
(d) 1
Answer: (b) 100

Question 22.
Break-even point refers to that point where :
(a) Total Costs are more than Total Sales
(b) Total Costs are less than Total Sales
(c) Total Costs are half of the Total Sales
(d) Total Cost are equal to total sales
Answer: (d) Total Cost are equal to total sales

Question 23.
Payment of Income Tax is considered as :
(a) Direct Expenses
(b) Indirect Expenses
(c) Operating Expenses
(d) None of these
Answer: (b) Indirect Expenses

Question 24.
Vertical Analysis is also known as :
(a) Fluctuation Analysis
(b) Static Analysis
(c) Horizontal Analysis
(d) None of these
Answer: (b) Static Analysis

Question 25.
Financial analysis is useful:
(a) For Investors
(b) For Shareholders
(c) For Debenture holders
(d) All the above
Answer: (d) All the above
Long Answers

Chapter 9

1. What do you mean by the preparation of a Balance Sheet? What are the different
elements in which balance sheets are divided?

Ans: Originally, the balance sheet is included in the first part of the quarterly financial statements. It
represents a detailed image of the company’s financial status when published. The balance sheet
includes the company’s assets, liabilities and shareholders’ equity which gives a clear idea on its
book value. It is a known fact that it is not a good sign if the company’s liabilities outperformed its
assets because that means that its losses are more than its capital which could lead the company to
be unable to practice its business and maybe bankrupted. That’s not only what the company’s
balance sheet could explain; it can also point out the assets’ availability in it to the sufficient amount
that helps in expanding its business through the acquisition of another company or to develop a new
product or to resort to borrowing to maintain its operational activities. Reading the balance sheet
enables the investor to know if there is additional stock in excess of the market need as a result of
the inaccurate assumption of the management for the expected demand on the products. That
could be a strong indicator that the company handles its assets badly. Although the numbers shown
in the companies’ statement of financial position vary greatly, but the general framework of the
statements of all companies remain united. It means that it is possible to compare the performance
of two companies in two different trading fields. It is possible to summarize the three elements
which, as a whole, generate the balance sheet for a company as the following:
• Assets
• Liabilities.
• Shareholders’ Equity
Assets: Companies can own assets, just as the individual has assets of value, like real estate or
jewelry. One of the differences between an individual and a company’s assets is the company’s
obligation to publish what it owns to the public. Companies can own tangible assets such as
computers, machinery, money and real estate. It can also have intangible assets such as trademarks,
copyrights or patents.Generally a company’s assets are categorized according to the ability to
change it into cash in two types:

1. Current Assets: Cash and other properties owned by the company and could be easily converted
into cash in one year. It is an important indicator of the company’s financial status because it is used
to cover short term commitment of the company’s operations. If the company suffers from a decline
in its current net assets then that means it needs to find new means to finance its activities. One of
the answers to this is to issue extra stocks by the company. We can generally say that increasing the
company’s current net asset means an increase in the company’s opportunities in maintaining its
growth

2. Non-current Assets: an asset that the company owns and needs more than a year to convert to
cash or it is the asset that the company does not have a plan to convert to cash during the next year.
Fixed assets such as lands, buildings, machinery and so on, come under non-current assets. The
importance of the company’s non-current assets volume is based on its sector’s type. For instance,
companies in the banking sector don’t need (fixed) non-current assets compared to a company in
the industrial sector.

Liabilities: All companies- even those profitable- have debts. In the balance sheet, debts are called
Liabilities. A company’s management success is based on its ability in managing its various liabilities
which are considered a part of its business. Examples of a company’s liabilities:

• Debt of suppliers and shareholders

• Payable Expenses
• Long-term loans

1. Current Liabilities: The commitments the company should pay in no more than one year. The
company usually refers to liquidating some of its current assets to cover these expenses. Some of
the important types of current liabilities are:
• Payables
• Undistributed dividends
• Zakat.
• Installments of long-term loans

2. Long-term Liabilities: The commitments the company is not restricted to pay within at least one
year such as Long- term loans. Although theses debts are not to be paid through the next financial
year, but at the end it should be paid. It is important to keep that in mind when evaluating the
company.

Shareholders’ Equity: Shareholders’ equity is mentioned in the company’s balance sheet report.
Shareholder’s equity equals the invested money that was distributed as shares plus the
undistributed profits, which represents retained earnings held and re-invested by the company. They
are not distributed to shareholders. To make it simple, shareholders’ equity represent the main
source in financing the company’s business. The more equity the shareholders have, the size of the
company’s own operational money increases.
 2. What is meant by the term ‘income statement’? Elaborate in detail.

Ans: The income statement is easier to understand and less complicated than the balance sheet. But
still, it is the most analyzed part of the quarterly financial statements. It is because it details the
company’s profit sources based on its performance in selling products, offering services or in its
investments’ income. To explain that, the income statement shows the company’s income out of its
sales and the outgoing cash to cover these expenses.
Reading the income statement is not only on deducting the total income expenses. In general, the
company has more than one source for income and several different kinds of expenses. The
company details the different sources for its income and expenses in the income statement and that
reflects a clear image of the company’s performance. Here are some of the main points in an income
statement:
• Income or sales
• Expenses
• Gross profit
• Net profit
• Operating profit “income from the company’s major operations”
• Gains and losses from other than the major operations
• Earnings per share
• Zakat

The investor can, when he understands what these numbers refer to and the relationship between
them, determine the company’s strengths and weaknesses. For instance, a troubled company –
which is obviously not a good investment- suffers from increasing expenses and decreasing income
which leads to a decrease in its total net profit.

Income and Expenses: As an individual gains profit through his work or his investments’ revenues,
the company can also profit from selling its products or services or its investments’ revenues. Some
companies have only one source for profits and others have more than one. The income statement
shows the company’s sales and incomes. By following the statement, the size of the company’s
financial profit could be accurately known. It can also let you know from which of the company’s
sources the profit is generating. Income: it is the company’s total funds which are gained from its
major activity that includes selling goods or the services it produces.

Total Profits (or losses): if any company can find a way to develop and manufacture products and
offer services without incurring any expenses, it would be the richest company in the world. Reality,
on the other hand, proves that spending money is important to gain more money. To calculate the
company’s total profits (or losses), a deduction should be made by deducting its direct expenses
from its income.

Operating Profit: production expenses are not the only expenses the company has to pay to succeed.
After the product is produced, it is supposed to be advertised and sold and this of course brings in
other and more expenses. In addition to marketing and advertising expenses, the company is
obligated to pay its employees’ salaries, office supplies and its management expenses. The
company’s operating profit (or loss) could be reached by deducting all the operating expenses
mentioned from the profits’ total.

Net Profit: in addition to operational expenses, the company has to pay other expenses such as the
Zakat. When the company deducts these expenses from the operational profit and add what income
it gains from outside its area, then what is left forms the company’s net profit. One of the clear
indicators that the company’s performance is doing good is the increase in the net profit from one
quarter to the next.
1. Q3. Outline in detail, the significance of financial statements and also explain theways in
which they are useful to different users.

Ans: Financial analysis is the process of identifying the financial strengths and weaknesses of the firm
by properly establishing relationships between the various items of the balance sheet and the
statement of profit and loss. Financial analysis can be undertaken by management of the firm, or by
parties outside the firm, viz., owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst. A technique
frequently used by an analyst need not necessarily serve the purpose of other analysts because of
the difference in the interests of the analysts. Financial analysis is useful and significant to different
users in the following ways:

(a) Finance manager: Financial analysis focuses on the facts and relationships related to managerial
performance, corporate efficiency, financial strengths and weaknesses and creditworthiness of the
company. A finance manager must be well-equipped with the different tools of analysis to make
rational decisions for the firm. The tools for analysis help in studying accounting data so as to
determine the continuity of the operating policies, investment value of the business, credit ratings
and testing the efficiency of operations. The techniques are equally important in the area of financial
control, enabling the finance manager to make constant reviews of the actual financial operations of
the firm to analyse the causes of major deviations, which may help in corrective action wherever
indicated.

(b) Top management: The importance of financial analysis is not limited to the finance manager
alone. It has a broad scope which includes top management in general and other functional
managers. Management of the firm would be interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are used most efficiently and that the
firm’s financial condition is sound. Financial analysis helps the management in measuring the success
of the company’s operations, appraising the individual’s performance and evaluating the system of
internal control.

(c) Trade payables: Trade payables, through an analysis of financial statements, appraises not only
the ability of the company to meet its short-term obligations, but also judges the probability of its
continued ability to meet all its financial obligations in future. Trade payables are particularly
interested in the firm’s ability to meet their claims over a very short period of time. Their analysis
will, therefore, evaluate the firm’s liquidity position.

(d) Lenders: Suppliers of long-term debt are concerned with the firm’s longterm solvency and
survival. They analyse the firm’s profitability over a period of time, its ability to generate cash, to be
able to pay interest and repay the principal and the relationship between various sources of funds
(capital structure relationships). Long-term lenders analyse the historical financial statements to
assess its future solvency and profitability.

(e) Investors: Investors, who have invested their money in the firm’s shares, are interested about the
firm’s earnings. As such, they concentrate on the analysis of the firm’s present and future
profitability. They are also interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the management and determine whether
a change is needed or not. However, in some large companies, the shareholders’ interest is limited
to decide whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess whether it can presently
afford a wage increase and whether it can absorb a wage increase through increased productivity or
by raising the prices.

(g) Others: The economists, researchers, etc., analyse the financial statements to study the present
business and economic conditions. The government agencies need it for price regulations, taxation
and other similar purposes.

Analysis of financial statements reveals important facts concerning managerial performance and the
efficiency of the firm. Broadly speaking, the objectives of the analysis are to apprehend the
information contained in financial statements with a view to know the weaknesses and strengths of
the firm and to make a forecast about the future prospects of the firm thereby, enabling the analysts
to take decisions regarding the operation of, and further investment in the firm.

Chapter 10 - Analysis of Financial Statements - II

Question 1
Analysis of financial statements involve :
(a) Trading A/c
(b) Profit & Loss statement
(c) Balance Sheet
(d) All the above
Answer: (d) All the above

Question 2
Financial analysis is significant because it:
(a) Ignores qualitative aspect
(b) Judges operational efficiency
(c) Suffers from the limitations of financial statements
(d) It is affected by personal ability and bias of the analysis
Answer: (b) Judges operational efficiency

Question 3.
What is shown by the Income Statement ?
(a) Accuracy of books of accounts
(b) Profit or loss of a certain period
(c) Balance of Cash Book
(d) None of these
Answer: (b) Profit or loss of a certain period

Question 4
What is shown by Balance Sheet ?
(a) Accuracy of books of accounts
(b) Profit or loss of a specific period
(c) Financial position on a specific date
(d) None of the above
Answer: (c) Financial position on a specific date

Question 5.
Which of the following is the purpose or objective of financial analysis ?
(a) To assess the current profitability of the firm
(b) To measure the solvency of the firm
(c) To assess the short-term and long-term liquidity position of the firm
(d) All the above
Answer: (d) All the above

Question 6.
Out of the following which parties are interested in financial statements ?
(a) Managers
(b) Financial Institutions
(c) Creditors
(d) All the these
Answer: (d) All the these

Question 7.
Which of the following is not a limitations of financial statement analysis ?
(a) To measure the financial strength
(b) Affected by window-dressing
(c) Do not reflect changes in price level
(d) Lack of Qualitative Analysis
Answer: (a) To measure the financial strength

Question 8.
Break-even Analysis shows:
(a) Relationship between cost and sales
(b) Relationship between production and purchases
(c) Relationship between cost and revenue
(d) None of these
Answer: (a) Relationship between cost and sales

Question 9.
Which of the following shows the actual financial position of nenterprise ?
(a) Fund Flow
(b) Balance Sheet
(c) P & L A/c
(d) Ratio Analysis
Answer: (b) Balance Sheet

Question 10.
The financial statements of a business enterprise include:
(a) Balance Sheet
(b) Profit & Loss Account
(c) Cash Flow Statement
(d) All the above
Answer: (d) All the above

Question 11.
An annual report is issued by company to its :
(a) Directors
(b) Auditors
(c) Shareholders
(d) Management
Answer: (c) Shareholders

Question 12.
Balance Sheet provides information about financial position of the enterprise :
(a) At a Point of Time
(b) Over a Period of Time
(c) For a Period of Time
(d) None of the above
Answer: (a) At a Point of Time

Question 13.
Profit & Loss Account is also called :
(a) Balance Sheet
(b) Income Statements
(c) Operating Profit
(d) Investment
Answer: (b) Income Statements

Question 14.
Which of the following statement is correct ?
(a) Assets = Liabilities + Shareholders funds
(b) Assets = Total funds
(c) Assets = Funds of outsiders .
(d) None of the above
Answer: (a) Assets = Liabilities + Shareholders funds

Question 15.
In which meeting of company directors report is presented ?
(a) Directors Meeting
(b) Annual General Meeting
(c) Manager’s Meeting
(d) All of the above
Answer: (b) Annual General Meeting

Question 16.
On the basis of process, which of the following is the type of financial analysis ?
(a) Horizontal Analysis
(b) Vertical Analysis
(c) Ratio Analysis
(d) (a) and (b) both
Answer: (d) (a) and (b) both

Question 17.
Which Of the following is limitation of financial analysis ?
(a) Window-dressing
(b) Basis of Valuation
(c) Lack of Accuracy
(d) All the above
Answer: (d) All the above

Question 18.
Which of the following is not the limitations of financial analysis ?
(a) Lack of Accuracy
(b) Based on Historical facts
(c) Basis of Valuation
(d) Information of Profit and Loss
Answer: (d) Information of Profit and Loss

Question 19.
When Financial Statements of two or more organisations are analysed, it is called :
(a) Intra-firm Analysis
(b) Inter-firm Analysis
(c) Vertical Analysis
(d) None of these
Answer: (b) Inter-firm Analysis

Question 20.
Which of the following statement correct ?
(a) Retained Earnings = Total Income
(b) Retained Earnings = Revenue-expenses
(c) Retained Earnings = Gross Profit
(d) None of the above
Answer: (b) Retained Earnings = Revenue-expenses

Question 21
Which of the following is a type of Financial Analysis on the basis of material used ?
(a) Internal Analysis
(b) External Analysis
(c) Internal Audit
(d) Both (a) and (b)
Answer: (d) Both (a) and (b)
Question 22
When the concept of ratio is defined in respected to the items shown in the financial statements, it
is termed as

a) Accounting ratio
b)Financial ratio
c) Costing ratio
d) None of the above
ANSWER: a) Accounting ratio
Question 23
The definition, “The term accounting ratio is used to describe significant relationship which exist
between figures shown in a balance sheet, in a profit and loss account, in a budgetary control system
or in a any part of the accounting organization” is given by

a) Biramn and Dribin

b) Lord Keynes
c) J. Betty
d) None of the above.

ANSWER: c) J. Betty
Question 24
The relationship between two financial variables can be expressed in:

a) Pure ratio
b) Percentage
c) Rate or time
d) Either of the above

ANSWER: d) Either of the above

Question 25

Liquidity ratios are expressed in

a) Pure ratio form

b) Percentage
c) Rate or time
d) None of the above

ANSWER: a) Pure ratio form

QUESTIONS
Q1:
1.What is the nature of a financial statement, in terms of financial accounting?

Ans: The chronologically recorded facts about events expressed in monetary terms for a defined
period of time are the basis for the preparation of periodical financial statements which reveal the
financial position as on a date and the financial results obtained during a period. The American
Institute of Certified Public Accountants states the nature of financial statements as, “the statements
prepared for the purpose of presenting a periodical review of report on progress by the
management and deal with the status of investment in the business and the results achieved during
the period under review. They reflect a combination of recorded facts, accounting principles and
personal judgements”. The following points explain the nature of financial statements:
1. Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data
recorded in accounting books. The original cost or historical cost is the basis of recording
transactions. The figures of various accounts such as cash in hand, cash at bank, trade receivables,
fixed assets, etc., are taken as per the figures recorded in the accounting books. The assets
purchased at different times and at different prices are put together and shown at costs. As these
are not based on market prices, the financial statements do not show the current financial condition
of the concern.

2. Accounting Conventions: Certain accounting conventions are followed while preparing financial
statements. The convention of valuing inventory at cost or market price, whichever is lower, is
followed. The valuing of assets at cost less depreciation principle for balance sheet purposes is
followed. The convention of materiality is followed in dealing with small items like pencils, pens,
postage stamps, etc. These items are treated as expenditure in the year in which they are purchased
even though they are assets in nature. The stationery is valued at cost and not on the principle of
cost or market price, whichever is less. The use of accounting conventions makes financial
statements comparable, simple and realistic.
3. Postulates: Financial statements are prepared on certain basic assumptions (pre-requisites)
known as postulates such as going concern postulate, money measurement postulate, realisation
postulate, etc. Going concern postulate assumes that the enterprise is treated as a going concern
and exists for a longer period of time. So the assets are shown on a historical cost basis. Money
measurement postulate assumes that the value of money will remain the same in different periods.
Though there is a drastic change in purchasing power of money, the assets purchased at different
times will be shown at the amount paid for them. While preparing a statement of profit and loss the
revenue is included in the sales of the year in which the sale was undertaken even though the sale
price may be received over a number of years. The assumption is known as the realisation postulate.

4. Personal Judgements: Under more than one circumstance, facts and figures presented through
financial statements are based on personal opinion, estimates and judgements. The depreciation is
provided taking into consideration the useful economic life of fixed assets. Provisions for doubtful
debts are made on estimates and personal judgements. In valuing inventory, cost or market value,
whichever is less is being followed. While deciding either cost of inventory or market value of
inventory, many personal judgements are to be made based on certain considerations. Personal
opinion, judgements and estimates are made while preparing the financial statements to avoid any
possibility of over statement of assets and liabilities, income and expenditure, keeping in mind the
convention of conservatism. Thus, financial statements are the summarised reports of recorded
facts and are prepared following accounting concepts, conventions, accounting policies, accounting
standards and requirements of Law.

2. Outline the importance of Financial Statement from the economic point of view, and also
outline its limitations.

Ans: The users of financial statements include management, investors, shareholders, creditors,
government, bankers, employees and public at large. Financial statements provide the necessary
information about the performance of the management to these parties interested in the
organisation and help in taking appropriate economic decisions. It may be noted that the financial
statements constitute an integral part of the annual report of the company in addition to the
directors report, auditors report, corporate governance report, and management discussion and
analysis. The various uses and importance of financial statements are as follows:

1. Report on stewardship function: Financial statements report the performance of the management
to the shareholders. The gaps between the management performance and ownership expectations
can be understood with the help of financial statements.

2. Basis for fiscal policies: The fiscal policies, particularly taxation policies of the government, are
related with the financial performance of corporate undertakings. The financial statements provide
basic input for industrial, taxation and other economic policies of the government.

3. Basis for granting of credit: Corporate undertakings have to borrow funds from banks and other
financial institutions for different purposes. Credit granting institutions take decisions based on the
financial performance of the undertakings. Thus, financial statements form the basis for granting of
credit.

4. Basis for prospective investors: The investors include both short-term and long-term investors.
Their prime considerations in their investment decisions are security and liquidity of their
investment with reasonable profitability. Financial statements help the investors to assess long term
and short-term solvency as well as the profitability of the concern.
5. Guide to the value of the investment already made: Shareholders of companies are interested in
knowing the status, safety and return on their investment. They may also need information to make
decisions about continuation or discontinuation of their investment in the business. Financial
statements provide information to the shareholders in taking such important decisions.

6. Aids trade associations in helping their members: Trade associations may analyse the financial
statements for the purpose of providing service and protection to their members. They may develop
standard ratios and design a uniform system of accounts.

7. Helps stock exchanges: Financial statements help the stock exchanges to understand the extent of
transparency in reporting on financial performance and enables them to call for required
information to protect the interest of investors. The financial statements enable the Stock brokers to
judge the financial position of different concerns and take decisions about the prices to be quoted.

Limitations of Financial Statements

Though utmost care is taken in the preparation of the financial statements and provide detailed
information to the users, they suffer from the following limitations:

1. Do not reflect current situation: Financial statements are prepared on the basis of historical cost.
Since the purchasing power of money is changing, the values of assets and liabilities shown in
financial statement do not reflect current market situation.

2. Assets may not realise: Accounting is done on the basis of certain conventions. Some of the assets
may not realise the stated values, if the liquidation is forced on the company. Assets shown in the
balance sheet reflect merely unexpired or unamortised cost.

3. Bias: Financial statements are the outcome of recorded facts, accounting concepts and
conventions used and personal judgements made in different situations by the accountants. Hence,
bias may be observed in the results, and the financial position depicted in financial statements may
not be realistic.

4. Aggregate information: Financial statements show aggregate information but not detailed
information. Hence, they may not help the users in decision-making much.

5. Vital information missing: Balance sheet does not disclose information relating to loss of markets,
and cessation of agreements, which have vital bearing on the enterprise.

6. No qualitative information: Financial statements contain only monetary information but not
qualitative information like industrial relations, industrial climate, labour relations, quality of work,
etc.

7. They are only interim reports: Statement of Profit and Loss discloses the profit/loss for a specified
period. It does not give an idea about the earning capacity over time similarly, the financial position
reflected in the balance sheet is true at that point of time, the likely change on a future date is not
depicted.

3. What is the importance of including liabilities in the financial statements?

Ans :Liabilities Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in the future
as a result of past transactions or events. Three essential characteristics of an accounting liability
include the following:

1. A duty or obligation to pay exists.

2. The duty is virtually unavoidable by a particular entity.

3. The event obligating the enterprise has occurred. Liabilities are usually classified as current or
non-current liabilities. Current liabilities are those obligations whose liquidation is reasonably
expected to require the use of existing resources properly classified as current assets, or the creation
of other current liabilities. This definition emphasizes a short term creditors’ claim to working capital
rather than the due date for classification purposes. Current liabilities include
(1) trade accounts payable,

(2) short-term notes payable,

(3) current maturities of longterm liabilities,

(4) unearned revenues (collections in advance, e.g., rent, interest, and magazine subscription
revenues),

(5) accrued expenses for payrolls, interest, taxes, and others expenses. Unearned revenues arise
when assets are received before being earned; a liability called unearned revenue is created. After
the services are performed, revenue is earned and the liability is settled. Accrued liabilities are
liabilities that exist at the end of an accounting period but which have not yet been recorded. All
liabilities not classified as current are reported as long-term liabilities. Net working capital is the
excess of current assets over current liabilities. Adequate working capital is necessary for the
business if it is to pay its debts as they come due. Creditors often consider working capital to
constitute a margin of safety for paying short-term debts. Working capital assets are in a constant
cycle of being converted into cash. Cash is used to acquire inventories which, when sold, become
account receivable; receivables upon collection become cash; cash is used to pay current liabilities
and expenses and to acquire more inventories. Working capital does not appear as a specific item on
the balance sheet, but it can be computed as the difference between the reported current assets
and current liabilities.

Contingent liabilities arise from an existing situation or set of circumstances involving uncertainty as
to possible loss to an enterprise that will ultimately be resolved when one or more future events
occur or fail to occur.

Examples of contingent liabilities include product warranties and pending litigation. An estimated
loss from a loss contingency must be accrued in the accounts and reported in financial statements as
a charge against income and as a liability if both of the following conditions are met: 1. It is probable
that an asset has been impaired or a liability has been incurred at the date of the financial
statements. 2. The amount of the loss can be reasonably estimated.

A lease is a contractual agreement in which the owner of property (the lessor) allows another party
(the lessee) to use the property for a stated period of time in exchange for specified payments. The
major reporting problem for leases is whether the lease should be included in the financial
statements. A lease that transfers substantially all of the benefits and risks associated with
ownership of the property should be accounted for as the acquisition of an asset and the incurrence
of an obligation by the lessee and as a sale or financing by the lessor. According to FASB 13
(Accounting for Leases) (ASC 840-10-05, Leases: Overall.), the criteria used to classify a lease as a
capital lease for a lessee are the following four: 1. The lesser transfer ownership of the property to
the lessee by the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease
term is equal to 75 percent of the estimated economic life of the leased property. 4. The present
value at the beginning of the lease term of the minimum lease payments excluding that portion
representing executory costs equals or exceeds 90 percent of the fair market value of the property.