ACCOUNTING FOR MANAGEMENT 1) What do you mean by accounting? Explain the concepts & conventions on which accounting is based? Answer Accounting According to the American Institute of Certified public Accountant (AICPA), 1941, “accounting is an act of recording , classifying and summarizing in significant manner and in terms of money transactions and events which are in part, at least of a financial character and interpreting the results thereof”. Accounting concepts Accounting is based on few concepts which follows assumptions or rules for recording the transactions. Some important accounting concepts are as follows, i. Separate Entity Concept In accounting, proprietor treats its business as a separate entity so that his business transactions does not gets mixed up with his personal life. If business and personal activities are mixed up then it would be difficult to derive/draw meaningful accounting information. The separate entity concept is applicable to all forms of business organizations for the accounting purpose. Usually, this concept seems to be unreasonable but it is very useful in drawing out the accounting information. ii. Going Concern Concept In this concept, the proprietor assumes that business will continue for a longer period of time in future. There is no intention of winding up the business in the near future. In this concept accountant values the assets by calculating depreciation on the basis of expected life instead of the market values and he does not take into account the forced sale value of assets. iii. Money Measurement Concept This concept implies that only monetary transactions are taken into consideration at the time of preparation of accounting records. Books of account does not consider any transaction which cannot be expressed in terms of money even though it may be useful for business but it is not recorded in the books of account. iv. Cost Concept The cost concept is similar to going concern concept. This concept implies that, β Only the actual price of the asset is being recorded in books of accounts and, β This actual cost is considered as a basis for further calculations of asset. This concept explains that an asset is recorded at its cost at the time of purchase but as the time passes on its value gets reduced due to depreciation charged on it. The preparation and presentation of financial statements becomes flawless and impartial with the help of cost concept. v. Dual Aspect Concept The dual aspect concept is a primary concept of accounting, it implies that every business transaction has two-fold effect i.e., dual effect. The double effect of this concept can be expressed in form of an accounting equation as, Capital + Liabilities = Assets Or Capital = Assets – Liabilities This equation can also be written as, Equities = Assets Hence, accounting equation explains the relationship between equities and assets. It implies that every debit has a credit which is equal to the sum of the debit. vi. Accounting Period Concept This concept explains that even through the life of business is very long but proprietor must calculate its position regularly after certain period of time usually after one year, this is known as accounting period. At the end of every accounting period, accountant is supposed to prepare the income statement which displays the profit or loss earned during the accounting period ,and the balance sheet which shows the accounting period and the balance sheet which shows the financial condition of the business till the last day of the accounting period. During the preparation of the statement, the capital and revenue expenditures must be taken carefully. vii. Periodic Matching of Costs and Revenue Concept The matching concept is based on the accounting period concept. According to the accounting period concept. According to this concept, a business in order to achieve its prime objective of profit maximization should always maintain a match between the costs and revenue within the accounting period. The term ‘matching’ refers to the adequate association of related revenues and expenditures. viii. Realisation Concept According to this concept revenue is generated only through sales. The point of time when the property in goods is passes on to buyer and when he is legally entitled/liable to pay, it is considered as sales. The realisation concept is not applicable for hire-purchase and contracts accounts. Accounting Conventions According conventions involves those rituals and practices which helps the accountant in the preparation of accounting statements. Some of the important accounting conventions are, (a) Convention of Conservatism According to this convention, accountant must adopt the policy of playing safe and follow the rule “anticipate no profit but provide for all possible losses”. This implies that accountant must make a provision for all possible or expected losses but unearned or unrealized profit must not be included. When convention of conservatism is used inventory is valued at lower price , either at cost or market price and provision is made for bad or doubtful debts. The financial position of the company in order to show lower net income and understated assets and liabilities. (b) Convention of Full Disclosure According to the convention, financial statements must provide the complete and true information about the company. Financial statements must be prepared in accordance to the laws so that it can be effectively used by proprietors, present and potential creditors and investors. The convention of full disclosure add notes to the accounting statements. (c) Convention of Consistency According to this convention, a company must follow same accounting practices and methods from one period to another. Any changing the accounting practices would result in several problems in calculating the true financial position of the company. If suppose for calculating depreciation a company follows a straight line method in one year and diminishing reducing balance method in another year, it becomes difficult to evaluate and compare the true finance position of the company. If any advanced technique is introduced, it must be mentioned clearly in the financial statements. (d) Convention of Materiality According to this convention, the accountant must give importance to material details and must avoid unnecessary/unimportant details. Kohler defined “materiality means the characteristic attaching to a statement, fact or item whereby its disclosure or method of giving it expression would be likely to influence the judgment of a reasonable person”. 2) What are accounting standard? Explain their importance in global accounting environment? Accounting Standards According has certain rules and regulations which are to be followed while recording business transactions and preparing the financial statements. If in case a professional body makes these accounting rules mandatory in nature for recording transactions and preparing final Accounts, then they become ‘Accounting Standards’. Accounting Standards (AS) are written statements which are issued by the professional body and it contains uniform rules or practices which act as the basis for preparing Financial Statements. Need Accounting standards codify acceptable accounting practices. They act as the basic source of Generally Accepted Principles (GAAP) and are thus in the first position in the hierarchy of GAAP. Besides this other sources of GAAP are technical pronouncements provided by several professional bodies, regulating the accounting and auditing profession, that requires the accounting principles and methods. Different countries have different accounting standard setting bodies. In USA, it is called as SFAS (statement of Financial Accountant Standards ) which are given by the Financial Accounting Standards Board (FASB). In India, the accounting standards are given by the Institute of Chartered Accountants of India (ICAI). The International Accounting Standards Committee (IASC) was formed in 1973 in order to frame the International Accounting Standards (IAS). The accounting standards which are given by FASB is called as IFRS (International Financial Reporting Standards ). Importance /Significance/Rationale The following are the benefits of accounting standards 1. Uniformity Accounting standards maintain uniformity in the preparation and reporting of financing statements, so that the misleading deviations or changes in accounting treatment can be avoided while developing financial statements. 2. Comparability AS the accounting principles are uniform or consistent, the accounting standards can be used for comparing the financial statements of various organizations or various accounting periods of the same organization. 3. Reliability The firmness or steadiness of economic system relies on the trust and confidence which the users have on the fairness of financial statements. Accounting standards helps in developing such type of confidence by producing a standard framework within which the financial statements can be prepared. 4. Useful to Investors Accounting standards help the investors in analyzing the growth of different companies depending on the financial statements so that the best alternative is selected for taking investment decision. 5. Useful to Auditors Accounting standards must be followed while preparing financial statements as it helps the auditors to manage their clients. If clients are not following the accounting standards, then the auditor must specify this point in the report for avoiding different penal provisions under the Companies Act,1956. 6. Useful to Government The financial statements which are prepared by following accounting standards can be easily combined and used by government officials and others. Applicability Great efforts have been made by two accounting bodies namely, (a) International Accounting Standards Board (IASB) (b) Institute of Charted Accountants of India (ICAI). (a) International Accounting Standards Board (IASB) IASB was initially known as IASC (International Accounting Standards Committee ) in the year 1973. In the year 2001, after its restructuring IASC was changed to IASB. This organization aimed at framing and spreading the standards among the general public which were used in preparing financial statements. IASB also aims at promoting the accounting standards all over the world. Nearly 140 countries are its members. Till date, IASC has issued 41 standards, out of which 11 standards have been withdrawn and 30 standards have been in practice. IASB has also issued 7 standards to date. The standards issued by IASB wee initially called as International Accounting Standards (IASs) and now currently are known as International Financial Reporting Standards (IFRSs). IASB does not hold any power to mandate the compliance of its standards by its member countries but simultaneously plays an important role in effecting the accounting standards formulation on par with its country’s standards. (b) Institute of Chartered Accountants of India (ICAI) According to the revised preface of the para 2.3 with regards to the statements of accounting standards illustrates the role of ICAI in harmonizing the accounting standards. The para reads as under, “The ICAL, being a member of International Federation of Accountants (IFAC), is supposed, inter alia to develop the International Accounting Standards Boards (IASB) pronouncements in the nation with an aim to facilitate global harmonization of the accounting standards. Thus, during the formulation of accounting standards, ASB would greatly take into consideration IAS’s issued by the International Accounting Standards Committee or International Financial Reporting Standards (IFRS) which are issued by IASB, any one of these and would attempt to integrate them fully, in the light of the circumstances and practices existing in India’’. ICAI till date has issued 31 accounting standards 3) Explain the significance of accounting importance in business decision? Answer: Significance of accounting in modern organization Accounting is a theory or system which records and assess the business transactions and maintains them in the accounting books of a firm. Accounting records must be maintained in chronological order and must be summarized in a standardized format, so that financial position of business can be evaluated through sales, purchases and overhead. Inspite of the economic recession and decline in the job market, the importance of accounting has not declined and is greatly perceptible ever before as accounting is very useful in almost all the areas of the economy. Accounting is important in modern organization in the following ways, 1. The knowledge of accounting is important as it is applicable for any job opportunities. In a firm, from secretary to executive everyone makes use of the accounting information in order to analyze the financial position of the firm. 2. In present scenario, business world is going on exploring and practicing new financial laws. It is quite necessary for every worker of all businesses to hold atleast basic knowledge of accounting. 3. Accounting is useful in ascertaining the present and future economic stability of the organization. 4. Companies who applies/makes use of the effective accounting practices enjoys competitive advantage over their competitors and also makes good decisions. 5. Financial managers depends upon their accountants for gathering information which is essential/required for identifying the profitability and financial status of the firm. 6. Accounting involves cash flow statement which is an effective tool i.e., useful in monitoring and analyzing the factors which effects the cash flows of the firm. 7. Accounting is also useful in making effective decisions relating to cash utilization, efficient business operations/activities allocation of funds, financing of investment etc. 8. Accounting is not only useful to business firms but also to the common people their in day-to day life for evaluating the interest rates and to make effective investments. Hence , it is clear from the above points that accounting is important not only for the business people but also for the households. Eventhough accounting skills may not be that important in the future. 4) what are the different types of accounts? State the principles of recording transactions? Answer Types of accounts At the time of journalizing the transactions on the basis of double entry system, transactions are being classified into three accounts as follows. Accounts Personal Real Nominal Natural Tangible Expenses and losses Artificial Intangible Incomes and gains Representative Figure: Classification of Accounts 1. Personal Accounts Personal accounts includes all these transactions which are related to person with whom the business carries out its transactions. Personal accounts are further categorized into three different accounts as follows, (a) Natural Personal Accounts These are the accounts of human beings who are God’s creation i.e., they are natural and not artificial accounts. Example: Mahesh’s accounts, suman’s accounts, etc., (b) (c) Artificial Personal Accounts These are the accounts of corporate bodies or institutions which are considered as a person in business. Example: The account of a club, the account of an insurance company, the account of government, etc. Representative Personal Accounts 2. Usually these accounts are prepared when certain amount is due to a person or group of persons. Example: Outstanding salaries account is opened when salaries are due to employees. These accounts represents the individual or the group of individuals. The journalizing rule/principle personal accounts is “Debit the receiver, credit the giver”. Real Accounts Real accounts are those accounts which involves transactions relating to the properties and assets which the business holds. Real accounts are of two types. They are, (a) Tangible Real Account All the accounts which are related to assets that can be measured, thatched, viewed felt, etc., are categorized as tangible real accounts. Example: Cash stock account, building account, furniture account, etc. Bank account is not considered as a tangible real account because it is treated as an artificial person and is thus regarded as a personal account. (b) Intangible Real Accounts Intangible real accounts involves the accounts of those assets which can be measured in terms of money but are abstract in nature i.e., they cannot be touched. Example: Patent’s account, Goodwill accounts, etc. The journalizing rule for real accounts is “Debit-what comes in, credit-what goes out”. Example: When furniture is being purchased for cash then furniture must be debited and cash must be credited i.e., furniture account…dr. To cash account…cr. As furniture comes in and cash goes out. 3. Nominal Accounts Nominal accounts consists of the accounts related to expenses, losses, incomes and gains. Nominal accounts are imaginary in nature i.e., they are prepared to describe the nature of transactions and to keep record of all expenses incurred by the business . Example: Salaries, rent, commission, etc. These accounts do not exist in reality. For instance salary a/c , rent a/c, commission a/c, etc., are all nominal accounts which shows the way how the cash is being spent. The journalizing rule for nominal account is “Debit-All expenses and losses, Credit-All gains and incomes”. Principles of Recording Transactions There are some basic principles to be followed in order to enter the daily transactions in journal as follows, Step 1 Ascertain the two accounts involved in the business transactions. Step 2 Ascertain the nature of accounts involved. Step 3 Apply the golden rule of accounts for “Debit” and “Credit” and find out which is to be debited and which is to be credited. 5) Explain the provisions of the companies act regarding preparation of final accounts? Preparation and Presentation of Final Accounts The companies Act 1956 made it compulsory for every company to keep proper set of books for recording financial transactions and to prepare its annual statements in the prescribe from at the proper time. The Amendment Act, 1998 has made it obligatory on all companies to maintain accounts on accrual basis and according to the double entry system of accounting. The provisions governing the keeping of books and the publication of final accounts dealt are laid down under sections 209 to 223. The brief provisions are as follows: 1. Preparation of Final Statements Under Sec.210 it has been made compulsory to present the balance sheet and profit and loss accounts, at every annual general meeting. For every financial year one annual general meeting must be held. Between two agm’s it shall not exceed fifteen months, however that it may be to eighteen months with special permission with Registrar extended of companies. The responsibility for the preparation of final accounts and placing them before the annual general meeting is placed on the directors. In the case of companies not carrying on business for profit, an income and expenditure account will be prepared instead of profit and loss account. If the directors fail to company with the provision of this section, they are punishable under the provision of company Act 1956. 2. Form and Contents of Profit and Loss Account and Balance Sheet According to Sec. 211 every balance sheet and profit and loss account of a company and further, the balance sheet shall be in the form set out in the Schedule VI or as near there to as circumstances admit or in such other form as may be approved by the Central Government either generally or in any particular case. The set form for the preparation of balance sheet has been given in part I of the Schedule and the requirements for the preparation of the profit and loss account are given in the part II of that Schedule. 3. Disclosure of Interest in the Subsidiary Company As per Sec.212 if a company happens to be a holding company, the following documents relating to subsidiary company shall be attached to its balance sheet (a) A copy of the balance sheet (b) A copy of its profit and loss account (c) A copy of directors report (d) A copy of the reports of its auditors and (e) A statements of holding company’s interest in the subsidiary. 4. Report The auditor’s report (including separate, special or supplementary report, if any ) and directors report shall be attached to the balance sheet of the company. 5. Authentication of Balance Sheet and Profit and Loss As per Sec.215, every balance sheet and every profit and loss account of a company shall be signed on behalf of the board of directors by its manager or secretary, if any, and by not less than two directors of the company one of whom shall be a managing director where there is one. 6. Filling of Accounts Under Sec.220 within thirty days of the annual general meeting every company has to file with the Registrar three copies of balance sheet and profit and loss account and three copies of all documents which are required to be attached with the balance sheet. 6) Discuss different methods of Depreciation? Depreciation The process of spreading the cost of fixed asset is termed as depreciation. Depreciation is an expense in each of the accounting periods in which the asset provides service to the enterprise. Depreciation is the cost of lost usefulness or the cost of diminution or service yield from a fixed asset. “Depreciation is a measure of the wearing out, consumption of other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation is allocated so as to change a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is predetermined. Methods of Depreciation Following are various methods of calculating depreciation amount 1. Straight line method or fixed installment method 2. Declining charge method or Diminishing Balance Method (DBM) or reducing balance method or written down value method 3. 4. 5. 6. 7. 8. 9. Sum of year’s digit method Inventory or revaluation method Annuity method Depreciation fund method Insurance policy method or capital redemption policy method Depletion method Machine hour rate method. The choice of the method of allocating the cost of affixed asset over its economic useful life should depend upon the pattern of expected benefits to be obtained in each period from its use. 1. Straight Line Method or Fixed Installment Method Under this method the amount of depreciation is same throughout the life of the asset. The amount of depreciation is calculated by adopting the following formula. π·ππππππππ‘πππ = Cost of asset − Scrap value Estimated life asset Under this method, a fixed proportion of the original cost of the long- term asset is written off each year so that the asset account may be reduced to zero or its residual value at the end of its estimated economic useful life. The amount of depreciation is constant every year. It is assumed that depreciation is a function of time. This method can be usefully employed in case of assets like furniture and fixtures, office equipment, patents and short leases where small capital is invested and where time is the important factor in the exertion of the benefits obtainable from the use of the asset. If any additional assets are purchased during the year, they must be depreciated from the date of purchase. So, that at the close of accounting period when no date is mentioned, the depreciation is charged only on the opening balance of the asset, nothing on additions assuming that they were made on the last day of the year. If some assets are sold during the year, then depreciation should be calculated on those assets from the beginning of the year till the date of sale. The major advantage of this method is simple as arithmetical calculation are not at all complicated. i. ii. iii. iv. v. 2. The disadvantages are loss in market value of not properly reflected. The unevenness of the loss in the market value of an asset over several years is also considered. The amount of depreciation is same in all the years, which may not be correct. The total charge in respect of an asset will be equal from year to year. The assumption that the asset will be equal useful throughout its life seems to be illogical. Diminishing Balance Method(DBM) Under this method depreciation is charged at fixed rate on the reducing balance (i.e., cost less depreciation ) every year. π r = 1- √πΊ πͺ Where r stands for depreciation rate and S stands for salvage and C stands for cost of acquisition. The salient feature are, it tends to equalize the burden on profit and loss account in respect of depreciation and repairs. The written down value methods acts as a tax shield. Asset never becomes zero. This method can be applied only when there is some residual. This method is usually adopted in case of plants and machinery. Merits of Diminishing Balance Method The following are the merits of diminishing balance method of depreciation. i. ii. iii. iv. Depreciation and repairs charges continues to be uniform throughout the assets life. In the first year, depreciation amount is higher and repair charges are less, but at the end of the assets life depreciation is less and repair charges are more. It is easy and simple to understand this method. There is no need of fresh calculation of depreciation when new asset is purchased. It is recognized by tax authorities. Demerits of Diminishing Balance Method Diminishing balance method has the following disadvantages, i. ii. iii. 3 It takes longtime to bring down the asset value to scrap value. It is difficult to calculate depreciation rate. This method give more importance to historical cost. Sum of Years Digits Method In this method the amount of depreciation goes on decreasing in the coming years. The rate of depreciation is determined by fraction where the denominator is the sum of the digits representing the life of the asset and the numerators are individual digits used in the life of asset taken in reverse order. Example 3/6 x 1000, 2/6 x 1000, 1/6 x 1000 In case if the asset for three years. 4 Revaluation Method This method should be adopted only where the asset is represented by a large number of small and diverse items of small unit cost. 5 Annuity Method In this method the asset A/c is debited with interest which is ultimately created to P & L A/c and is credited with amount of depreciation which remains fixed year after year. The annual amount of depreciation is determined with the help of annuity table. The total amount of depreciation is determined by adding the cost of asset and interest there at an expected rate. This method considers interest on capital invested and it is scientific and this method is suitable to those assets that require considerable investment and frequent additions are not there. 6 Depreciation Fund Method The amount of depreciation goes on accumulating till the asset is completely worn out. This amount become readily available for the replacement of the asset. The depreciation amount is fixed and remains the same year after year and it is charged to P & L A/c through the creation of depreciation fund A/c. the amount of depreciation is invested outside the business every year in securities. The process of investing depreciation fund together with interest continuous till the time of replacement of asset. At this time all the securities will be sold and the new asset will be purchased. 7 Insurance Policy Method Under this method an insurance policy will be taken by the business to replace the asset when it is worn out. Premium will be paid every year. The amount will be accumulated with the insurance company at certain rate and on maturity of policy the amount will be received and new asset will be purchased. 8 Depletion Method This method is specially used for those assets which deplete with use. The cost of the assets is divided by total workable deposits. 9 Machine Hour Rate Method Under this method the life of machine is not estimated in year and it is estimated in hours. Proper records are maintained for running hours of the machine and depreciation is completed accordingly. Machine hour rate means the cost of running a machine per hour. 7) Explain briefly about the capital & revenue expenditure Distinguish between capital Expenditure & revenue Expenditure? Capital Expenditure Capital expenditure is the amount spent for acquiring or improving the long-term assets. For example, expenditure for extension or improvement of Land, Buildings, Machinery, Furniture, Motor Car etc. Revenue Expenditure Revenue expenditure is the amount spent for earning more income or revenue from the business. For example, expenditure for maintaining the business by purchasing goods for selling purpose. However, the expenses incurred to maintain the assets of the business are also referred as revenue expenditures. Difference between Capital and Revenue Expenditure Basis for difference Capital Expenditure 1. Meaning Capital expenditure is the amount spent for Revenue expenditure is the amount acquiring or improving the long term assets. spent for maintaining or earning more income from the business. 2. Nature Capital expenditure is non- recurring by nature. Revenue expense is recurring by nature. 3. Purpose Capital expenditure enhances the earning capacity of the firm. Revenue expenditure maintains the earning capacity of the firm. 4. Association Capital expenditure is associated with the acquisition of fixed assets for business purpose. Revenue expenditure is associated with day-to-day business activities. 5. Accounting treatments Capital expenditure does not have any effect on the business income of current period. Revenue expenditure is debited to Profit and Loss account. 6. Effect on income Capital expenditure does not have any effect on the business income of current period. Revenue expenditure reduces the business income of the current period. 7. Examples Purchase of additional plant, building, purchase of patents, copy rights, goodwill etc. Administrative expenses, manufacturing and selling expenses, interest on loans etc. 8) Revenue Expenditure What is trading account? What are its features? Show the format of trading account? Answer Trading Account Trading account is one of the financial statements which shows the results of buying and selling of goods and services during an accounting period. The purpose of preparing trading account is to know the gross profit or gross loss during the accounting period. The Trading Account is closed by transferring its balance to the Profit and Loss Account as gross profit/gross loss c/d. Features of Trading Account 1. It is based on the principle of nominal account. 2. 3. 4. 5. It involves all direct incomes and expenses. It shows all the purchase related expenditure on debit side and sales related expenditure on credit side. The balancing figure of trading account exhibits gross profit or gross loss which is further transferred to profit and loss account. It is the type of financial statement which is prepared at the end of accounting year. Format of Trading Account Trading Account of …for the period ending on... Dr. Cr. Particulars Amount ( βΉ ) Particulars To Opening stock a/c (finished Goods) To Purchases a/c xxxx Less : Returns outwards xxxx To Direct expenses a/c To Wages a/c To Freight inwards a/c To Carriage inwards a/c To Cartage inwards a/c To Gross profit c/d (Transferred to P & L A/c) xxxx By Sales a/c xxxx Less: return inwards xxxx By closing stock a/c (Finished goods) By Abnormal loss of stock a/c By Gross loss c/d (Transferred to P & L A/c) xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx Amount ( βΉ ) xxxx xxxx xxxx xxxx xxxx 9) What is financial statement analysis? Explain its need & various techniques for financial analysis? Answer The financial statements provides a rich information about the operational results of a business unit and much can be learn from a careful examination of these statements. A forecast of future earnings of a business can also be prepared based on the analysis and interpretation of financial statements. “Financial statements analysis “. According to Myers, is largely a study of relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements. In the words of W.B Meig, “financial statements “ are organized summaries of detailed information and are thus a form of analysis. Need for Financial Statement Analysis Financial statements play a vital role for analyzing the financial position of the concern. The primary need of financial statements is to assists decision-making. According to the Accounting Principles Board (APB) of America financial statements are needed for the following purpose, β To provide reliable financial information about economic resources and obligations of a business firm. β To provide other needed information about changes in such economic resources and obligations. β To provide reliable information about changes in net resources arising out of business activities. β To disclose, to the possible extent other information related to the financial statements which is relevant to the needs of the users of these statements. In this connection American Institute of Certified public Accounts states that, “Financial statements are prepared for the purpose of presenting a periodical review of report on progress by the management and deal with the status of investments in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgments”. Techniques of Financial Analysis The different methods and tools used in analysis of financial statements are, 1. Comparative Analysis As the very term signifies, comparative financial statements are statements of the financial position of a business so formulated as to focus on the elements contained therein and provide the necessary time perspective to it. Normally it is the balance sheet and profit and loss account which alone are prepared in a comparative form, since it is these two statements which are considered as important financial statements. Moreover, it is through these two statements the financial positional and the operational results of any business can be determined. Comparative financial statements are designed to disclose the following, i. ii. iii. Absolute data Increase or decrease in absolute data Increase or decrease in absolute data in terms of percentage. The analyst should also keep in mind the price level changes that have taken place between the dates of different transactions and that of preparation of financial statements. Where there is a substantial price fluctuation, the analyst must exercise great caution while interpreting the values. 2. Trend Analysis The financial statements for a series of years may be analyzed to determine the trend of the data contained there in. the trend percentages are also referred to as ‘trend ratios’. This method of analysis is adopted to determine the direction, upward or downward. This involves the computation of the percentage relationship that each item in the statement bears to the corresponding item contained in that of the base year. For this purpose the earliest year involved in comparison for any Intervening Yeah may be considered as the base year. The trend percentages emphasize changes in the financial data from year to year and facilitate horizontal comparison and study of the data. These trend ratios can be considered as index numbers showing relative changes in the financial data over a period of years. 3. Common Size Analysis The comparative financial statements and the calculations of trend percentages, as tools of financial analysis, have a common shortcoming in that they do not enable the analyst understand changes that have taken place from year to year in relation to total assets, total liabilities, capital or total net sales. This defect becomes more glaring when the analysis is made through comparison of two or more business units or off 1 unit with that of the industry as a whole, since there is no common base of comparison when dealing with absolute figures. But when the balance sheet and income statement items are shown in analytical percentages, i.e., the percentage as that each item bears to the total of the appropriate items such as total assets, total liabilities, capital and net sales, the common base for comparison is provided. The statements compiled in this from are termed as "common-size statements" . The common size statement sir also known as "component percentage" or "100 percent statement". Each statement is reduced to the total of hundred and is individual item contained there in is Express it as a percentage to the total 100.Thus, each percentage in this statement shows the relationship of individual item to its representative total. 4. Ratio Analysis Ratio analysis is a very important tool of financial analysis. It is the process of establishing a significant relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of a firm. Since, we are using the term 'ratio' in relation to financial statement analysis, it may properly mean 'An accounting Ratio' or 'Financial Ratio'. It may be defined as the mathematical relationship between two accounting figures. But these figures must be related to to each other (i.e., this triggers must have a mutual cause and effect relationship) to produce a meaningful and useful ratio. A ratio is a simple mathematical expression. It is a number expressed in terms of another number, expressing the quantitative relationship between the two. Ratio analysis is the technique of interpretation of financial statements with the help of various meaningful ratios. Ratios do not add Tu to any information that is already available, birthday show the relationship between two items in a more meaningful way which help us to draw time conclusion. Comparison with related facts is the basis of ratio analysis. Ratios may be used for comparison in any of the the following ways, (i) comparison of post data. (ii) comparison of one firm with another firm. (iii) comparison of an achieved performance with predetermined standards. (iv) comparison of one firm with the industry. (v) comparison of one department of a concern with other departments. 5. Statement of Changes in Working Capital This step involves to accepts namely, 1. Determination of working capital at the the commencement and at the end of the period covered by the funds flow statement. 2. Ascertainment of increase or decrease in working capital. Working capital is ascertained by deducting the total of Current assets from the total of Current liabilities. Working capital=Current Assets- Current liabilities. Increase or decrease in working capital over a period is ascertained by preparing schedule of changes in working capital. 10. Explain the utility of ratio analysis as a tool for financial analysis? Ratio Analysis Ratio analysis is a very important tool of financial analysis. It is the process of establishing a segment relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of a firm. Uses of Ratio Analysis Ratio analysis plays a significant role in ascertaining the financial performance of a concern. The following are the various users of ratio analysis. (i) Management Ratio analysis helps management to reap many managerial uses from it. They are a) Ratio analysis helps a management assess the financial position of the firm and making necessary decisions from the information available in the financial statement. b) It facilitates in financial forecasting and financial planning. c) It helps in communicating the financial strengths and weakness of a firm in a more easy and understandable form. d) It helps in the coordination of activities which is the most important functions of business management. e) It facilitates in effective control of the business by revealing the loopholes in it. f) Ratio analysis also serves many other purpose to the management by becoming an essential part in budgetary control and standard costing. (ii) Investors/Shareholders Ratio analysis helps and inventors are a shareholders to assess the financial position of the concern in which he is going to invest. It wants him in making up his mind whether the present financial position of the concern warrants him for further investment or not. The calculation of various ratios help him to do this. (iii) Creditors/Suppliers Ratio analysis helps the creditors are suppliers who extend short term credit to the concern to know whether the financial position of the concern warrants their payment at a specified time or not. (iv) Employees Ratio analysis also helps the employees who are interested in knowing the financial position of the concern. Various profitability e ratios facilitate them to know for the increase of their wages and other benefits. (v) Government β Ratio analysis aid the government in accessing the financial health of different industries and prepare its future policies. β With all the utilities to various uses, ratio analysis serves as a powerful tool for ascertaining the financial position of a concern. Advantages of Ratio Analysis 1. Ratio analysis simplifies the understanding of financial statements. 2. Ratio bring out the interrelationship among various financial figures and bring to light their financial significance and it is a device to analyze and interpret the financial health of the Enterprise. 3. Ratios contribute significantly towards effective planning and forecasting. 4. Ratios facilitate inter firm and intra firm comparison. 5. Ratio serve as effective control tools. 6. Ratios cater to the particular information need of a particular person. Limitations of ratio analysis 1. Ratio may not prove to be the ideal tool for interfirm comparisons. When two firms adopt different accounting policies. 2. A study of ratios in isolating, without studying the actual figures may lead to wrong conclusions. 3. Ratios can be calculated based on the data. If the original data is not reliable, then ratios will be misleading. 4. Ratio analysis suffers from lack of consistency. 5. In the absence of well accepted standards, interpretation of ratios become subjective. 6. Ratios fail to reflect the impact of price level changes, and hence can be misleading. 7. Ratios are only tools of quantitative analysis and fail to take into account the quantitative aspects of a business. 8. Ratios are based on past data and hence cannot be reliable guide to future performance. 9. Ratios are volatile and can be influenced by a single transaction with extreme value. 10. Ratios are only indicators. They need proper analysis by a Capital Management, they are only the means, and not an end, in the interpretation of financial statements. 11. Explain about different types of turnover ratio’s? Turnover ratios These ratios measure the effectiveness with which firm uses its available resources. Does ratios are also called "Turnover Ratios" since they indicate the speed with which the resources are being turned into sales. Usually, the following turnover ratios are calculated, 1. 2. 3. 4. 5. Capital turnover ratio Fixed assets turnover ratio Net working capital turnover ratio Stock turnover ratio Debtors turnover ratio 6. Creditors turnover ratio. These ratios may also be calculated with reference to cost of sales. 1. Capital turnover ratio a) Meaning This ratio establishes a relationship between net sales and capital employed. b) Objective The objective of computing this ratio is to determine the efficiency with which the capital employed is utilized. c) Components (i) Net sales: which means gross sales minus sales Returns. (ii) capital employed: which means long-term debit plus shareholder's funds. d) Competition This way this ratio is computed by dividing the net sales by the capital employed. This ratio is usually expressed as times. Formula Net sales πΆππππ‘ππ π‘π’ππππ£ππ πππ‘ππ = πΆππππ‘ππ ππππππ¦ππ e) Interpretation It indicates the firm’s ability to generate sales per rupee of capital employed. In general, higher the ratio,the more efficient the management and utilization of capital employed. 3. Working capital turnover ratio a) Meaning This ratio establishes A ratio relationship between net sales and working capital. b) Objective The objective of computing this ratio is to determine the efficiency with which the working capital is utilized. c) Components (i) Net sales which means gross sales minus sales returns. (ii) Working capital which means current assets minus current liabilities. d) Computation This ratio is computed by dividing the net sales by the working capital. This ratio is usually expressed Formula πππππππ πππππ‘ππ π‘π’ππππ£ππ πππ‘ππ = Net sales πππππππ πππππ‘ππ e) Interpretation It indicates the firm's ability to generate sales per rupee of working capital. In general, higher the ratio, the more efficient the management and utilization of working capital and vice versa. 4. Stock turnover ratio a) Meaning This ratio establishes a relationship between cost of goods sold and average inventory. b) Objective The objective of computing this ratio is to determine the efficiency with which the inventory is utilized c) Components Cost of goods sold which is calculated as under. Cost of goods sold= opening inventory+ net purchase+ direct expenses- closing inventory (or) = net sales- gross profit. Average inventory which is calculated as under Average inventory=( opening inventory+ closing inventory) /2 d) Computation This ratio is computed by dividing the cost of goods sold by the average inventory. This ratio is usually expressed as times. Formula πΊππππ ππππππππ πππππ = Cost of goods sold Average inventory e) Interpretation It indicates the speed with which the inventory is covered into sales. In general, a high ratio indicates efficient performance scenes and improvement in the ratio shows that they have the same volume of sales has been maintained with a lower investment in stocks, the volume of sales has increased without any increase in the amount of stocks. However, too high ratio and too low ratio call for further investigation. f) Stock velocity This well as it indicates the period for which cells can be generated with the help of an average stock maintained and is usually expressed in days. This velocity may be calculated as follows, Stock velocity, = π΄π£πππππ π π‘πππ Average daily costs of goods sold Or = 12Months/52weeks/365 ππ‘πππ π‘π’ππππ£ππ πππ‘ππ 5. Debited turnover ratio a) Meaning This ratio establish a relationship between net credit sales and average trade debtors. b) Objective The objective of computing this ratio is to to determine the efficiency with which the trade debtors are managed. c) Components (i)Net credit sales which means gross credit sales minus sales Returns (ii) average trade debtors which are calculated as under, Average trade debtors =( opening trader debited + closing Credit Debit in bill receivable debit) /2. d) Computation This ratio is computer by dividing the net credit sales by average trade debtors. This ratio is usually expressed as times. Net credit sales Formula: Debtors turnover ratio = Average trade debtors e) Interpretation It indicates the speed with which the debited turnover on an average each year. In general a high ratio indicates the shorter collection period which implies prompt payments by debtors and a low ratio indicates a longer collection period which implies delayed payment by debtors. However, too high ratio and too low ratio calls to further investigation. The ideal ratio may be 8 to 10 terms. f) Debit collection period This period shows an average period for which the credit sales remind outstanding and measure the quality of debtors. It indicates the rapidly are slowness with which the money is collected from debtors. This period may be calculated as under: Debit collection period, = Average trade debtors average net credit sales per day Average Credit Sales per day, Net credit sales for the year = Number of working days in the year 6. Creditors turnover ratio a) Meaning This ratio establishes relationship between net credit purchases and average trade creditors. b) Objective The objective of computing this ratio is to determine the efficiency with which the creditors are managed. c) Components (i) Net credit purchases which mean gross credit purchase minus purchase returns. (ii) average trade creditors which are calculated as under, Average trade creditors=( opening trade creditors + closing trade creditors include bills payable creditors) /2 d) Computation This ratio is computed by dividing the net credit purchase by average trade creditors full stop this ratio is usually expressed as times. Formula: Creditors turnover ratio, = Net credit purchases Average trade creditors e) Interpretation It includes the speed with which the creditors turnover on an average each year. In general, Yeh high ratio indicates the shorter payment period which implies that the availability of less credit or earlier payments and a low rates indicates a larger payment period which implies that the ability of more credit or delayed payments . f) Debit payment period for creditors velocity This period shows an average period for which the credit purchases remind outstanding are the average credit period actually availed of debit payment period, = Average trade creditors average net credit ourchases per day Average net credit purchases for the year, = 12. Net credit purchases for the year Number of working days in the year Explain the liquidity ratia’s & their significance? Liquidity ratios The term liquidity refers to the ability of your freedom to meet the short term obligations/ requirements as and when they arise. Various liquidity ratios are available that measure the short term solvency or financial position of a firm. These ratios are usually calculated to determine the short-term paying capacity of a concern or its ability to meet the current obligations. The various liquidity ratio are, 1. Current ratio 2. Liquid ratio 1. Current ratio Definition Current ratio is defined as the ratio/relationship between current assets and current liabilities current ratio is also called as 'working capital ratio’. Formula Current ratio = Current assets Current liabilities Components The two major components of current ratio or current assets and current liabilities. Current assets include cash in hand, cash at Bank, shorten marketable securities, short term Investments, bill receivable, sundry debtors, inventories/stocks, work in progress, prepaid expenses. Current liabilities include outstanding/accrued expenses, bills payable, sundry creditors, short term advance, Income Tax payable, dividends payable, bank overdraft. Interpretation Current ratio indicates the amount of current assets owned by a firm for each current liability. While interpret the current ratio is standard 2:1 called as arbitrary standard of liquidity are banker's rule of thumb be considered. If the result of the current ratio is greater than or equal to 2, then the firm is said to process may current assets then its current liabilities, indicating good liquidity position of the firm. Significance Current ratio measures the ability of the firm in meeting short-term obligations. Higher the ratio, greater the margin of safety to the ratio of creditors. It also provides the ratio of the credit assets and credit liabilities. 2. Liquid ratio Definition Liquid ratio is defined as the ratio/relationship between the quick/ liquid Assets and liquid current/liabilities. Liquid ratio is also called as quick ratio or acid test ratio. Formula Current assets current liabilities Liquid assets =Current assets-Stock Liquid ratio = Components Liquid ratio consists of two components liquid Assets and liquid liabilities. Liquid assets are obtained by executing stock from current assets. Interpretation While interpreting the quick/ liquid ratio is standard of 1:1 is taken as a rule of thumb. A high liquid ratio indicates that the firm is liquid and has enough liquid assets to meet the liquid liabilities on time. Significance The quick ratio plays a vital role in measuring the liquidity position of a firm. it measures bhi capacity of the firm to meet the current obligations. It is a more rigorous test of liquidity then the current ratio full stop a liquid ratio is usually used as a complementary to the current ratio.
