Accounting for Managers End Term Examination

Prudhvi Pokuru
PGDM ABM
2021-23
Roll: 1339

1. Discuss the importance and purpose of ratio analysis. Explain the significance and how
the following ratios are calculated.

Ans:
The importance of ratio analysis is that to compare current with past records and/or the budget,
develop some operating standards, and to highlight deviations so that corrective action can be
pinpointed. By watching the gauges--the Income Statements; Balance Sheets, and the Ratios-
comparing their readings from year to year, management is able to control and to step in with the
right action at the right time to keep a downtrend from becoming a catastrophe; to keep an
uptrend.

Significance of Ratio analysis includes some crucial points like,

• Ratios taken alone mean very little. They should be compared with others ratios, norms,
standards, etc.
• Ratios help in understanding the strengths and weakness of a firm.
• The analyst should decide the ratios which are appropriate in a specific situation and what
combination of ratios to use.

a. Current Ratio: The current ratio is a liquidity ratio that measures a company's ability to
pay short-term obligations or those due within one year. It tells investors and analysts
how a company can maximize the current assets on its balance sheet to satisfy its current
debt and other payables. It is a comparison of current assets to current liabilities,
calculated by dividing your current assets by your current liabilities. Potential creditors
use the current ratio to measure a company’s liquidity or ability to pay off short-term
debts.
Current Ratio = Current Assets / Current Liabilities

b. Return on Net Worth: Return on Equity (RoE) or Return on Net Worth (RoNW) means
the amount of profit or earnings a company generates on the sheer strength of its
shareholders' equity. RoNW is calculated as follows:
Return on Net Worth =Annual Net worth of the company/ shareholders equity capital.
 c. Earnings per Share: Earnings per share (EPS) is calculated as a company's profit divided
by the outstanding shares of its common stock. The resulting number serves as an
indicator of a company's profitability. It is common for a company to report EPS that is
adjusted for extraordinary items and potential share dilution.
EPS (for a company with preferred and common stock) = (net income – preferred dividends) ÷
average outstanding common shares.

d. Total assets turnover ratio: The asset turnover ratio measures the efficiency of a
company's assets in generating revenue or sales. It compares the dollar amount of sales
(revenues) to its total assets as an annualized percentage. Thus, to calculate the asset
turnover ratio, divide net sales or revenue by the average total assets. Asset turnover rate
formula
 Asset Turnover = Net Sales / Total Assets.
 Net Sales = Gross Sales – Returns – Discounts – Allowances.
 Total Assets = Liabilities + Owner’s Equity.

2. Du Pont analysis allows an investor to determine what financial activities are

contributing the most to the changes in ROE’. Explain how the ratio is calculated and why
it is important for Companies.

Ans:
The DuPont analysis is a framework for analyzing fundamental performance popularized by the
US-based DuPont Corporation
DuPont Analysis is a technique that breaks ROA and ROE measures down into basic
components that determine a firm's profit efficacy, asset efficiency and leverage. DuPont analysis
is a useful technique used to decompose the different drivers of return on equity (ROE). A
DuPont analysis is used to evaluate the parts of a company's return on equity (ROE). This allows
an investor to determine what financial activities are contributing the most to the changes in
ROE. An investor can use an analysis like this to compare the operational efficiency of two
similar firms. Managers can use DuPont analysis to identify strengths or weaknesses that should
be addressed.

 It attempts to isolate the factors that contribute to the strengths and weaknesses in a
company's financial performance.
 The breaks down return on net worth (RONW) helps in reflecting the quality of earnings
along with possible risk levels.
 The process of calculation the ROE is shown below:

ROE = (Profit margin) x (Asset turnover) x (Equity multiplier)

= Net Profit x Sales x Assets

 Sales Assets Equity

= Net Profit
Equity
Where,
Net Profit Margin = Net Income/ Revenue

Asset Turnover = Sales/ Average Total Asset

Equity Multiplier = Average Total Asset / Average Shareholders’ Equity

The DuPont Analysis is a convenient and helpful tool that helps an investor look at the more
detailed aspects of a company's financial health and help them make more informed investment
decisions. The DuPont system is important because it provides a complete, overall picture of any
company's financial health and performance, as compared to the common and limited equity
valuation tools.

3. Explain any three accounting concepts and give their significance.

Ans: Accounting Concepts:

Accounting Concepts denote the accounting principles that is necessary assumptions and
conditions upon which accounting is based.
1. Business Entity concept
2. Going concern concept
3. Money measurement concept
4. Accounting period concept
5. Cost concept
6. Dual-aspect concept
7. Realization concept
8. Matching concept

Matching concept:
 It ensures that revenues and their associated expenses are recorded in the same
accounting period.
 Matching principal is based on accrual accounting method i.e., recognize revenues and
expenses when they occur.
Significance:
 It helps the businesses avoid misstating of profits for a period.
 It helps businesses adhere to the matching principle to ensure consistency in the financial
statements.
 It allows an asset to be distributed and matched over the course of its useful life in order
to balance the cost over a period.
Business entity concept:
Business and owner are 2 separate entities.
 Transactions related with business must be recorded separately from those of it’s owners
and other business. While recording we have to take into account only transaction that
affect business.
Significance:
 It ensures each and every business entity is taxed separately.
 Helps in assessing the financial position of each and every business separately on
particular date of accounting period.
 Is essential to separately measure the performance of a particular business in terms of
profitability and cash flows.

Dual-aspect concept:
 It states that every transaction has 2 sided effects to the extent of same amount.
Double entry system – one is receiver, one is giver
Assets= Liability + Equity
Significance:
Every transaction requires recording in two different accounts as per double entry system.
Example:
Purchased goods worth 500/- for cash means cash account is debited and assets accounted is
credited.
Simply cash is reduced
Assets are increased in this both cash and assets account is affected.

4. What are contingent assets and contingent liabilities? Elucidate and give examples to
illustrate your answer.
Ans:
1. Contingent asset

a. A contingent asset is a possible asset that may arise because of a gain that is contingent on future events
that are not under an entity's control.

b. According to the accounting standards, a business does not recognize a contingent asset even if the
associated contingent gain is probable.

c. A contingent asset becomes a realized (and therefore recordable) asset when the realization of income
associated with it is virtually certain.
d. In this case, recognize the asset in the period when the change occurs. This treatment of a contingent
asset is not consistent with the treatment of a contingent liability, which should be recorded when it is
probable

e. Auditors are particularly watchful for contingent assets that have been recorded in a company's
accounting records, and will insist that they be eliminated from the records before issuing an opinion on
its financial statements.

Example of a Contingent asset.

 The best example of both sides of a contingent asset is a lawsuit. Even if it is probable
that the plaintiff will win the case and receive a monetary award, it cannot recognize the
contingent asset until such time as the lawsuit has been settled. Conversely, the other
party that is probably going to lose the lawsuit must record a provision for the contingent
liability as soon as the loss becomes probable, and should not wait until the lawsuit has
been settled to do so.

2. Contingent Liability

a. A contingent liability is a liability or a potential loss that may occur in the future depending on the
outcome of a specific event.

b. Potential lawsuits, product warranties, and pending investigation are some are examples. Contingent
liability as a term does not apply only to companies and individual.

Example of Contingent Liability

 If we take an educational loan of Rs 10, 00,000 from bank to fund child’s higher studies.
That amount could well become a contingent liability if my child fails to make monthly
payments after getting a job. We might have to pay the amount because you have taken
the loan from your bank.
 Your company might be in the middle of a lawsuit and your lawyer thinks that the other
party has a strong case which could potentially lead to damages worth Rs 10 crore. In that
case, the company would book that amount as contingent liability on its balance sheet.