FINANCIAL ACCOUNTING AND ANALYSIS

Question: - 1
Answer: -Accounting is mainly concerned with recording of financial transactions,

summarising them and communicating financial information to varioususers. The users of

financial information are debtors, creditors, owners, stakeholders, government agencies,
bankers, etc.
There is no unanimity of opinions regarding theexact definition of accounting. Different
authorities have presenteddifferent perspective over the term. Below are some of the
generally accepted definitions given by various authorities :

 According to American Accounting Association (AAA):- Accounting is the process of

identifying, measuring and communication economic information to permit informed
judgments and decisions by users of the information.
 According to American Institute of Certified Public Accountants (AICPA):- Accounting
is the art of recording, classifying and summarising in a significant manner and in terms
of money; transactions and events which are part, in part at least, of a financial
character, and interpreting the results thereof.

In simple words, accounting is the process of collecting, recording, summarising and

communicating financial information to the users for decision-making.

Accounting Principles: Accounting principles are the rules and guidelines that every
organization needs to follow while recording accounting transactions.These are general rules
used with the theory and practices of accounting. These are the broad guidelines, and
adaptability of the same depends on the nature of the firm or business.In order to maintain
regularity and consistency in preparing and maintaining books of accounts, certain
rules/principles have been progressed. These standards, which work as the guidelines for
accounting for financial transactions and preparing financial statements, are known as the
“Generally Accepted Accounting Principles,” or GAAP. These principles are classified are
classified into two catagories:
 Accounting conventions
 Accounting concepts

Accounting conventions
Accounting conventions are the guidelines which helps theorganisationsin deciding how
to record certain business transactions that have not yet been fully addressed by
accounting standards. These procedures are not lawfully authoritative yet are commonly
acknowledged and accepted by accounting bodies. Mainly, they are intended to
promote consistency and help accountants overcome practical problems that can arise
when preparing financial statements.The generallyencountered convention is the
"historical cost convention". This expects transactions to be recorded at the price ruling
at the time, and for resources to be valued at their original cost. The other accounting
convention can be summarised as follows:

 Materiality: Accountant should record significant data and leave out

irrelevantdata because itwould influence the decision of the informed investor.
 Full disclosure: Full disclosureconventionmeansinvolves the disclosure of all
information, both favourable and unfavourable to a business enterprise, and
which are of material value to creditors and debtors.
 Consistency: Consistency conventions recommends the use of the same
accounting principles from one period of an accounting cycle to the next, so that
the same standards are applied to calculate profit and loss.
 Conservatism:According to this concept, financial transactions are recorded in
the books of accounting bytaking into consideration that, profit should never be
overvalued, and there should always be a provision for losses.

Accounting concepts
The Conceptsalludes to an idea, a general view or thought. Principles refer to a laws, the
process or a rule of conduct. Accounting principles are advanced over a period of time
through this procedure of development of concepts to standards and finally to principles.
Principles
are something built up for use when in doubt, planned to go about as premise of
comparison and reference. These are formations of planning and keeping up accounting
records. Accounting concepts are also undeniable statements or facts. These concepts have
been grown over the years from experience and they are universally accepted rules. In other
words, accounting concept refers to the basic assumptions and rules and principles which
work as the basis of recording of business transactions and preparing accounts.

Accounting concepts find wide acceptance across the world by accounting experts
and auditors. Below are some of the basic accounting concepts:

 Accounting period concept

 Separate entity concept
 Matching Concept
 Accounting Period Concept
 Cash and Accrual concept
 Money measurement concept

Accounting period concept: Accounting period concept is an important concept for

each organization as this periods refers to the period for which an organizations assesses
their financial positions. It covers the profit earned or loss incurred by the organization
during this period that is represented in the income statement. This period, is usually the
calendar year (January 1 to December 31) or the financial year (April 1 to March 31).
Generally most of the company adoptsone year as accounting period as it helps to take
corrective action, to absorb seasonal fluctuations, to pay income tax etc. Various financial
statements are prepared at the end of the accounting year such as balance sheet, income
statement and profit and loss account.
It is not compulsory to have calendar year as a default year. It’s simply the length of time
the financials cover.Variouscompanies with odd fiscal year-ends open and close their
accounting periods in the middle of a calendar year. For example: A company with a May
fiscal year would start its period on May 1stand end it on April31 of the following year.
Separate entity concept: As per this concepta business is considered as a separate
entity from the creditors, managers, proprietors and stakeholders.Because without such
distinctions the personal affairs will get mix with that of the firm and the true picture of the
firm will not be depicted. Therefore, even the proprietors is regarded as a creditors of
business. Let’s understand the concept of a separate entity with the help of suitable
example.
Example: Suppose Mr.Amarinvests Rs.50, 000 in his business, it will be deemed that the
owner has given that much of money to the business which will be shown as a ‘liability’ in
the books of account. In case the owner Amar withdraws Rs.10, 000 from the business, it
will be charged to him and the net amount payable by the business will be shown only
asRs.40, 000.

Question: - 2
Answer: - Ratio is define as an arithmetical expression of relationship between two

interdependent or related items. When ratioscalculated on the basis of accounting data, are
called Accounting Ratios. Accounting Ration may be describe as arithmetical relationship
between two accounting variables. Ratios can be divided on the basis of liquidity for
example current ratio, solvency ratio like debt-equity ratio, profitability ratio, gross profit
ratio and stock turnover ratio.
Ratio Analysis
Ratio analysis is describe as a process of determining and interpreting relationship between
the items of financial statements to provide a meaningful understanding of the performance
and financial position of an organisation. Ratio analysis is a technique of analysis and
interpreting various ratios for helping in making certain business decisions. It is apowerful
tools of analysing an organisations financial statements for determining the financial
strengths and weaknesses of the organisations.It provides financial statements in
comparative form. Ratio analysis is not limited to any one aspect but takes into
considerations of all aspects such as, financial obligation, liquidity and solvency aspects,
liquidity,profitability concepts and earning capacity of the firm. Further, Ratio analysis
provides important information to external management such as investor, creditor,
proprietors etc. to understand about how well business is performing and what areas needs
to be improved in future.

Objectives of Ratio analysis are as follows:

1. Ratio analysis are useful for understandings the financial positions of the
organizations. Different stakeholders in a business such as, investors, bankers,
creditors, etc. are uses this method to analyse various financial statements of an
organisations.
2. Ratio analysis simplifies, summarises and organized accounting data to make them
understandable.
3. Ratio analysis are also helpful for forecasting the financial positions and performance
of the organisation in the future.
4. Ratio analysis are useful in locating the weak areas of the business even though the
overall performance may be good. It will help management to remedial action to the
weakness.
5. Ratio analysis are useful for assessing the financial health and performance of an
organisation. It evaluates by evaluating, solvency, profitability, liquidity etc.

Five market ratios with their importance that should look into before undertaking any
investment decision are as follows:

1. Debt Equity Ratio: Debt equity ratio is financial ratio that is computed to assess long term
financial soundness of the organisations. The ratio shows the relationship between external
equities i.e., external debt and internal equities i.e. Shareholder’s funds .Debt Equity Ratio
reflects the relative claims of creditors and shareholders against the assets of the firm. Debt
Equity ratio measures the ratio of long term or total debt to shareholder’s equity. It can be
calculates as:
Debt-Equity Ratio = Debt (Total Liabilities)
Equity (Shareholder’sFunds)
 Debt = Long term borrowings + Long Term Provisions
 Equity (Shareholder’s Funds) = Share Capital + Reserves and Surplus
The Debt Equity Ratio is avital tool to assess the financial structure of a firm. The ratio
reflects the relative contribution of creditors and proprietorsof business in its financing. It is
a measure of the degree to which a company is financing its operations through debt
against wholly-owned funds. Specifically, it reflects the ability of shareholder equity to cover
all outstanding debts in the event of a business recession period.
Treatment of Preference Share Capital in Debt Equity Ratio: Additionor exclusion of
preference share capital is totally relies upon the purpose for which theDebt Equity Ratio is
calculated. If the objective is to examine the financial solvency of an organisation in terms of
its ability to avoid financial risk, preference capital should be clubbed with equity capital. On
the other hand, if Debt Equity Ratio is calculated to show the result of the use of fixed-
interest/dividend sources of funds on the earnings available to the ordinary shareholders,
preference capital should be clubbed with debt.

2. Return on Capital Employed or Return on Investment: Return on capital

employed/Return on Investment refers to long term funds supplied by the proprietors and
creditors of the organisation. The capital employed provides a test of profitability related to
the source of long-term funds. This ratio evaluates the overall performances of the
organisations. It measures, how efficiently the resources entrusted to the business are used.

ROCE/Return on investment= Profit before interest, Tax and Dividend EBIT x 100
Capital employed

3. Price-to-Earnings Ratio – P/E Ratio:Price-to-earnings ratio measures the organizations

current share to it’s per share earnings. This value is then compared to the P/E ratio for the
market or sector, as well as the historical range of the stock. Investors can use various
values for the denominator of the calculation based on their preferences. Benefits of this
method is that there is a certainty in earnings as the data is historical.

Price-to-earnings ratio = Market Value Per Share

Earnings Per share

4. Market to Book Ratio: TheMarket to Book ratio is used to compare a company’s market
price to its book value. The market value is the present stock price of all outstanding shares
for example the value that the market accepts the organization is worth. The book value is
the amount that would be left if the company liquidates all of its assets and repays all of its
liabilities. Market to Book Ratio is used to compare a business net resources that are
available in relation to the sales price of its stock. Market to book ratio is usually used by
investors to show the market’s perception of a particular stock’s value. This ratio is used to
shows how much equity investors are paying for each dollar in net assets.

Market to book ratio = Market capitalization

Total book value

5. Return on Equity: Return on Equity ratio measures the firm profitability by showing how
much profit business generates with the shareholder’s money. This ratio reviewer’s whether
the firm has earned a satisfactory return for its equity holders or not.

Return on Equity =Net profit after tax – Preference dividends x 100

Shareholders’ Equity

Question: - 3
Answer: -Cash Flow Statement is the statement that shows the flow of cash and cash
equivalents for a given reporting period. It is a statement which shows the change in cash
balances during a specific period. These are the inflows and outflows of cash and cash
equivalents. Any transactions that increase cash and cash equivalents are inflow of cash and
cash and cash equivalent or transactions that decreases cash and cash equivalents are
outflow of cash and cash equivalent. Cash flow statement provides essential information to
investors and allowing them to evaluate the changes in net assets of an organisations,
financial structure, solvency conditions, liquidity and organisations capacity to influence the
amounts and timing of cash flow.
(A)Cash flow from Operating Activities:

Operating activities are the primary revenue producing activities of the Organisation. Cash
flow from operating activities means cash flow from business. For instance, sale of goods
and services, purchase of goods and services and cash discount received, etc. The amount of
cash flows arising from operating activities is a key indicator of the extent to which the
operations of the organisation have generated sufficient cash flows to sustain the operating
capability of the organisation, pay dividends, repay loans and make new investments
without recourse to external source of financing. Cash flow from operating activities can be
calculatedthrough direct method or indirect method. In direct method, gross income and
gross cash payments for the major items are disclosed. Under the direct method data can be
taken from either accounting records of the organisations or by adjusting the sales. In
indirect method cash flow from operating activities is determined from statement of profit
and loss account.
Cash Inflows from operating activities:
 Payment received from sale of goods and services.
 Payment receipt from debtors and bills receivable
 Payment receipts from commissions, royalties and fees, etc.
Cash Outflows from operating activities:
 Payments to suppliers for purchase of goods and services.
 Payment of salaries and wages to employees.
 Cash payment to creditors and bill payables.

Cash flow from Operating Activities

Net Profit before taxation and extraordinary items: 50.00

Adjustments for

Depreciation (75*0.10) 7.50

Interest Income (150*0.115) 17.25

Dividend Income 1.00 25.75

Operating Profit before Working Capital changes 24.25

(+)Decrease in stock 95.00

Cash generated from operations 119.25

Income Tax Paid (24.25*0.30) (7.275)

Net Cash flow from Operating activities 111.975

(B) Cash Flow from Investing Activities

Cash flow from investing activities provides details of cash flows related to acquisition and
disposal of long term assets (Plant and equipment, Machinery, etc.) and other investments
not included in cash equivalents. Cash flows from investing activities signify the change in an
entities cash situation resulting from investments in the financial markets and operating
subsidiaries, and changes resulting from funds spent on investments in fixed assets such as
plant and equipment. Outflow of cash will be shown as minus and inflow of cash will be
added in cash flows. Cash flow from investing activities helps users to assess whether the
company is investing in such assets that may result in increased profits in the upcoming
years.

Cash inflows from investing activities:

 Proceeds from sale of fixed assets
 Proceeds from sale of shares, debt or equity instruments of other entities.
 Proceeds from repayments of advances and loans made to third parties
Cash Outflows from investing activities:
 Payments for purchased of fixed assets
 Payment for purchases of shares, debt or equity instruments of other entities.
 Loan given to third parties

Cash flows from investing activities

Purchase of Fixed Assets (75)

Loan given to Big Boy Company (150)

Shares purchased of a company (10)

Net cash flow from investing activities (235)