Home Assignment 1

Question 1
Do the terms financial reporting and financial statements mean the same thing? Explain.

Answer:

Financial reporting is a broader term, which includes preparation of financial statements. Financial
reports may be created to cater to a wider range of users, both internal and external. Whereas,
financial statements are formal reports made by the management, on the basis of other financial
reports, primarily for the external users. For example, an annual report is a financial report, which
includes the four primary financial statements namely: 1) Balance Sheet; 2) Income statement; 3)
Cashflow statement and statement of changes in equity.

Question 2
Is externally reported financial information always precise and accurate?

Ethics and accounting principles suggest that the financial information presented must be
understandable, comprehensive and reliable so that it presents a fair view of the company. However
due to assumptions and approximations used in the preparation (example time period assumptions) the
information may not be 100% definite. Even the external Auditors do not “certify” the total accuracy of
fi nancial statements, but only opine on the reasonableness of the statements

Question 3
Why is the balance sheet a logical place to begin a discussion of financial statements?

1. For management, balance sheet is important as the company starts the period with balances in
items on the balance sheet.
2. For investors or other stakeholders, all four statements are important. They are interdependent and
may therefore be read in conjunction to form an overall view of the company. A prospective
investor or other user may however look at the Balance sheet first to determine the value of the
company (Asset – Liabilities) and company’s contrition to shareholder’s wealth.

Question 4
Why is a going concern assumption an important consideration in understanding financial statements?

As per the going concern principle it is assumed that the company will continue to operate in future. It
means that the company will not curtail its business; instead it will use assets to generate profits and
settle its liabilities in the normal course of business. If assumption doesn’t hold, assets cannot be
assumed to contribute towards profitable business; rather they will only be able to contribute to the
extent of their Forced sale values/ market value. This assumption also provides the basis of use of
principles of accounting pertaining to historical cost, accruals and prepayments.
Question 5
Explain the effect of operating profitability on the balance sheet of a business entity. Does it necessarily
enhance the size of balance sheet?

Operating profit is the profit of accompany before taking the impact of taxes and interest payments.
Therefore, if the operating profit is such that it can cover taxes and interest payments, it will result in a
net profit for the company. The net profit, net of dividend payments, flows into Balance sheet as part of
the retained earnings.

Question 6
Does net income represent supply of cash that could be distributed to shareholders in the form of
dividend? Explain.

Net income, may or may not translate into supply of cash. Profitable company can find itself in a liquidity
crunch if its payments get stuck in credit cycle. Net income does, however, contribute to retained
earnings, which are the source of dividend payment. If the company has retained earnings and cash, it
may issue dividend in cash form; however, where cash is short company may issue other forms of
dividends. The company may even decide to plough back the profit no pay dividends at all.

Question 7
When do accountants consider revenue to be realized? What basic question about recording revenue in
accounting records is answered by the realization principle?

As per the revenue recognition principle, revenue is recognized when it is both realized and earned. The
realization principle states that the revenue can only be realized when promised goods, against which
the revenue is booked, have been delivered or when the services promised against revenue have been
performed.

Question 8
Listed here are three common business situations involving revenue. At what point the business should
recognize revenue?
1. Airline ticket revenue – when the ticket is redeemed i.e. on the date of customer’s travel
2. Magazine Subscription revenue- on delivery date of the magazine to the reader.
3. Prepaid Telephone Card revenue – when the card is redeemed

Question 9
Listed below are four items that may or may not require disclosure in the notes that accompany
financial statements.
a. MC Ltd uses percentage of completion method to recognize revenue on long term construction
contracts. This is one of the two acceptable methods of accounting for such projects. Over the
 life of the project, both methods produce the same result; but annual results may differ
substantially.
b. One of the important employees is leaving the company and going to work for a competitor.
c. Shortly after the balance sheet date, but before the financial statements are issued, one the two
food processing plants was damaged in an earthquake. The plant will be out of service for at
least three months.
d. The management of Software Systems believes that the company has developed systems
software that make Windows virtually obsolete. If they are correct, the company’s profits could
increase by 10 fold or more.
For each case, explain what, if any, disclosure is required by the company in its financial statements.

Answers
a. Yes disclosure will be required. As per IAS 11 the company will be required to disclose the
following:
 Amount of contract revenue recognized;
 Method used to determine revenue; 
 Method used to determine stage of completion;
 For contracts in progress at balance sheet date.
 Aggregate costs incurred and recognised profit;
 Amount of advances received; 
 Amount of retentions.

b. Does not require disclosure

c. Disclosure is prudent. It seems that the potential financial impact would be material and
therefore a disclosure should be made regarding the nature of the event and its estimated
financial implications.
d. Should not be disclosed as there is no certainty to this claim. Company may, however, choose
to disclose that it has developed a new software without quoting its financial impact.

Question 10
Assume you have the opportunity to purchase some shares in OV Auto Ltd from a member of the
company. The member suggests that the company’s profitability is really stronger that closing numbers
indicate because advertising expense should have been capitalized. The member argues that the Rs.
13.9 million advertising cost will generate future revenues and showing it as an asset would have met
the requirements of matching principle. How would you respond?