Chapter 3 Financial Statements of a Company Solutions
Question - 1 : - State the meaning of financial statements?
Answer - 1 : -
Financial statements of a company present a true and fair picture of the results of a company's operations to the various users of an accounting information. Financial Statements are the end products of the accounting process. These are the annual formal statements that are prepared by various enterprises or organisations for a particular accounting period.
Quoting the words of the American Institute of Certified Public Accountants (AICPA), "Financial statements are prepared for the purpose of presenting a periodical review or report on progress made by the management and deal with the status of investment in the business and the results achieved during the period under review."
Question - 2 : - What are limitations of financial statements?
Answer - 2 : -
The limitations of the financial statements are as follows:
- Historical Data- The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects. Thus, it can be concluded that financial statements reflect the data and information of historical nature.
- Ignorance of Qualitative Aspects- Financial statements do not reveal the qualitative aspects of a transaction. The qualitative aspects such as colour, size and brand position in the market, employees’ qualities and capabilities are not disclosed by the financial statements. These statements record only those transactions that are quantitative in nature and can be expressed in the monetary terms.
- Biased- Financial statements are based on the personal judgments regarding the use of methods of recording. For example, the choice of practice in the valuation of inventory, method of depreciation, amount of provisions, etc. are based on the personal value judgments, which may differ from person to person. Thus, the financial statements reflect the personal value judgments of the concerned accountants and experts.
- Inter-firm Comparison- Usually, it is difficult to compare the financial statements of two companies (either in the same business or in different businesses). This is basically because of the difference in the methods and practices followed by them in preparing their respective financial statements.
- Window Dressing- The possibility of window dressing is highly probable. This might be because of the motive of the company to overstate or understate its assets and liabilities to attract more investors or to reduce taxable profit. For example, Satyam showed high fixed deposits in the Assets side of its Balance Sheet for better liquidity that gave false and misleading signals to the investors.
- Difficulty in Forecasting- Since the financial statements is based on the historical data, so they fail to reflect the effect of inflation. This drawback makes the forecasting difficult.
Question - 3 : - List any three objectives of financial statements?
Answer - 3 : -
The financial statements are basically the accounts that are prepared for providing the true financial information to the internal as well as external users. These statements lay the base for the decision making process and policy designing by different users. The following are the various objectives for preparing financial statements.
- To Provide Information about Economic Resources- Financial statements provide adequate, accurate, reliable and periodical information about the employment of economic resources. It also specifies the obligation of a business to its external users who do not have the powers or authority to access the information directly.
- To Ascertain the Financial Position- These statements help to reveal the true financial position of an enterprise. In other words, it discloses the performance and position of an organisation in terms of their profitability, solvency, liquidity, financial viability, etc.
- To Ascertain the Earning Capacity- These statements are prepared with an objective of providing useful information to compare, predict and evaluate the earning capacity of a business firm. Thus, it helps in ascertaining the earning capacity of firms.
Question - 4 : - State the importance of financial statements to
(i) shareholders
(ii) creditors
(iii) government
(iv) investors
Answer - 4 : -
Importance of financial statements to its various users is given below.
(i) Shareholders- They are interested in assessing the profitability and viability of the capital invested by them in the business. The financial statements prepared by the business concerns enable them to have sufficient information to assess the financial performance and financial health of the business.
(ii) Creditors- These are those individuals and organisations to whom a business owes money on account of credit purchases of goods and services. Hence, the creditors require information about the credit worthiness and liquidity position of the business.
(iii) Government- It needs information to determine various macroeconomic variables such as national income, GDP, industrial growth, etc. The accounting information assist the government in the formulation of various policies measures and to address various economic problems such as unemployment, poverty, etc
(iv) Investors- These are the parties who have invested or are planning to invest in the business of an enterprise. Hence, in order to assess the viability and prospects of their investments, they need information about the profitability and solvency position of the business.
Question - 5 : - How will you disclose the following items in the Balance Sheet of a company:
(i) Loose Tools
(ii) Uncalled liability on partly paid-up shares
(iii) Debentures Redemption Reserve
(iv) Mastheads and publishing titles
(v) 10% debentures
(vi) Proposed dividends
(vii) Share forfeited account
(viii) Capital Redemption Reserve
(ix) Mining Rights
(x) Work-in-progress
Answer - 5 : - Disclosure of various items in the Balance Sheet of a company is given below.
| Items | Main Head | Sub-Head |
| (i) | Loose Tools | Current Assets | Inventories |
| (ii) | Uncalled liability on partly paid-up shares | Contingent Liability and Capital Commitments | Capital Commitments |
| (iii) | Debentures Redemption Reserve | Shareholders’ Funds | Reserve and surplus |
| (iv) | Mastheads and publishing titles | Non-Current Assets | Fixed Assets – Intangible assets |
| (v) | 10% debentures | Non-Current Liabilities | Long-Term Borrowings |
| (vi) | Proposed dividend | Current Liabilities | Short-Term Provisions |
| (vii) | Share forfeited account | Shareholders’ Funds | Subscribed Capital (to be added) |
| (viii) | Capital Redemption Reserve | Shareholders’ Funds | Reserve and surplus |
| (ix) | Mining Rights | Non-Current Assets | Fixed Assets – Intangible assets |
| (x) | Work-in-progress | Current Assets | Inventories |
Explain the nature of the financial statements.
Answer - 6 : -
The financial statements are the end-products of the accounting process. The financial statements not only reveal the true financial position of the company but also help various accounting users in decision making and policy designing process. The nature of the financial statements depends upon the following aspects like recorded facts, conventions, concepts, and personal judgment
1. Recorded facts- The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects.
2. Conventions- The preparation of financial statements is based on some accounting conventions like, Prudence Convention, Materiality Convention, Matching Concept, etc. The adherence to such accounting conventions makes financial statements easy to understand, comparable and reflects the true and fair financial position of the company.
3. Accounting Assumptions − These basic accounting assumptions like Going Concern Concept, Money Measurement Concept, Realisation Concept, etc are called as postulates. While preparing financial statements, certain postulates are adhered to. The nature of these postulates is reflected in the nature of the financial statements.
4. Personal Judgments- Personal value judgments play an important role in deciding the nature of the financial statements. Different judgments are attached to different practices of recording transactions in the financial statements. For example, recording stock either at market value or at the cost requires value judgment. Similarly, provision on various assets, method of charging depreciation, period related to writing off intangible assets depends on personal judgment. Thus, personal judgments determine the nature of the financial statements to a great extent.
Question - 7 : - Explain in detail about the significance of the financial statements.
Answer - 7 : -
The importance of financial statements is mentioned below.
1. Provides Information- Financial statements provide information to various accounting users both internal as well as external users. It acts as a basic platform for different accounting users to derive information according to varying needs. For example, the financial statements on one hand help the shareholders and investors in assessing the viability and return on their investments, while on the other hand, the financial statements help the tax authorities in calculating the amount of tax liability of the company.
2. Cash Flow- Financial statements provide information about the cash flows of the company. The financial statements help the creditors and other investors in determining solvency of company.
3. Effectiveness of Management- The comparability feature of the financial statements enables management to undertake comparisons like inter-firm and intra-firm comparisons. This not only helps in assessing the viability and performance of the business but also helps in designing policies and drafting policies. The financial statements enhance the effectiveness and efficacy of the management.
4. Disclosure of Accounting Policies- Financial statements provide information about the various policies, important changes in the methods, practices and process of accounting by the company. The disclosure of the accounting policies makes financial statements simple, true and enables different accounting users to understand without any ambiguity.
5. Policy Formation by Government- It needs information to determine national income, GDP, industrial growth, etc. The accounting information assist the government in the formulation of various policy measures and to address various economic problems like employment, poverty etc.
6. Attracts Investors and Potential Investors- They invest or plan to invest in the business. Hence, in order to assess the viability and prospectus of their investment, creditors need information about profitability and solvency of the business.
Question - 8 : - Explain the limitations of financial statements.
Answer - 8 : -
The following are the limitations of financial statements.
1. Historical Data- The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects.
2. Ignorance of Qualitative Aspect- Financial statements does not reveal the qualitative aspects of a transaction. The qualitative aspects like colour, size and brand position in the market, employee’s qualities and capabilities are not disclosed by the financial statements.
3. Biased- Financial statements are based on the personal judgments regarding the use of methods of recording. For example, the choice of practice in the valuation of inventory, method of depreciation, amount of provisions, etc. are based on the personal value judgments and may differ from person to person. Thus, the financial statements reflect the personal value judgments of the concerned accountants and clerks.
4. Inter- firm Comparisons- Usually, it is difficult to compare the financial statements of two companies because of the difference in the methods and practices followed by their respective accountants.
5. Window dressing- The possibility of window dressing is probable. This might be because of the motive of the company to overstate or understate the assets and liabilities to attract more investors or to reduce taxable profit. For example, Satyam showed high fixed deposits in the Assets side of its Balance Sheet for better liquidity that gave false and misleading signals to the investors.
6. Difficulty in Forecasting- Since the financial statements is based on historical data, so they fail to reflect the effect of inflation. This drawback makes forecasting difficult.
Question - 9 : - Prepare the format of statement of Profit and Loss and explain its items.
Answer - 9 : - Format of Statement of Profit and Loss- As per the REVISED SCHEDULE VI
| Statement of Profit and Loss for year ended... |
| S. No. | Particulars | Note No. | Figures for the Current Year | Figures for the Previous Year |
| I | Revenue from Operations | | | |
| II | Other Income | | | |
| III | Total Revenue (I + II) | | | |
| IV | Expenses: | | | |
| | Cost of Material Consumed | | | |
| | Purchase of Stock-in-Trade | | | |
| | Changes in inventories of finished goods | | | |
| | Work-in-progress and Stock-in-Trade | | | |
| | Employee Benefit Expenses | | | |
| | Finance Cost | | | |
| | Depreciation and Amortisation Expenses | | | |
| | Other Expenses | | | |
| | Total Expenses | | | |
| V | Profit before exceptional and extraordinary items and tax (III – IV) | | | |
| VI | Exceptional items | | | |
| VII | Profit before extraordinary item and tax (V – VI) | | | |
| VIII | Extraordinary Items | | | |
| IX | Profit Before Tax (VII – VIII) | | | |
| X | Tax Expenses | | | |
| | (1) Current Tax | | | |
| | (2) Deferred Tax | | | |
| XI | Profit/(Loss) for period from continuing operations (IX – X) | | | |
| XII | Profit/ (Loss) from discontinuing operations | | | |
| XIII | Tax expenses of discontinuing operations | | | |
| XIV | Profit/(Loss) from discontinuing operations (after Tax (XII – XIII) | | | |
| XV | Profit (Loss) for the period (XI + XIV) | | | |
| XVI | Earning Per Equity Shares | | | |
| | (1) Basic | | | |
| | (2) Diluted | | | |
| | | | | |
I. Revenue from Operations- It refers to the revenue earned from the basic operating business activities of an organization. For Non-financing companies, it consists of the following.
• Sale of Products
• Sale of Services
• Other Operating Revenues
For financing companies, revenue from operations includes the following.
• Interest
• Dividends
• Other Financial Services
II. Other Incomes- This income includes the income earned other than from the operating activities of a business. It comprised of the following incomes.
• Interest Income (in case of Non-Financing Company)
• Dividend Income (in case of Non-Financing Company)
• Net Gain or Loss on Sale of Investments
• Other Non-Operating Incomes (i.e. after deducting expenses directly related to such income)
III. Expenses- These can be bifurcated in the following given below types.
• Cost of Materials Consumed- It includes all the materials consumed during the process of manufacturing. It can also be calculated with the help of the given below formula.
Material Consumed = Opening Stock of Raw Material + Purchase of Raw Material – Closing Stock of Raw Material
• Purchase of Stock-in-Trade- It includes all the goods purchased by a trading concern with an intention of resell.
• Change in Inventories, Work-in-Progress and Stock-in-Trade- It is difference of opening and closing balance of inventories (stock), work-in-progress and stock-in-trade.
Prepare the format of balance sheet and explain the various elements of balance sheet.
Answer - 10 : - COMPANY'S BALANCE SHEET- As per REVISED SCHEDULE VI
| Name of the Company... BALANCE SHEET as at... |
| Particulars | Note No. | Figures as at the end of Current Year | Figures as at the end of the Previous Year |
| I. EQUITY AND LIABILITIES | | | |
| (1) Shareholders’ Funds | | | |
| (a) Share Capital | | | |
| (b) Reserves and Surplus | | | |
| (c) Money received against Share Warrants | | | |
| (2) Share Application Money Pending Allotment | | | |
| (3) Non-Current Liabilities | | | |
| (a) Long-Term Borrowings | | | |
| (b) Deferred Tax Liabilities (Net) | | | |
| (c) Other Long-Term Liabilities | | | |
| (d) Long-Term Provisions | | | |
| (4) Current Liabilities | | | |
| (a) Short-Term Borrowings | | | |
| (b) Trade Payables | | | |
| (c) Other Current Liabilities | | | |
| (d) Short-Term Provision | | | |
| | | | |
| TOTAL | | | |
| | | | |
| II. ASSETS | | | |
| (1) Non-Current Assets | | | |
| (a) Fixed Assets | | | |
| (i) Tangible Assets | | | |
| (ii) Intangible Assets | | | |
| (iii) Capital Work-in-Progress | | | |
| (iv) Intangible assets under development | | | |
| (b) Non-Current Investments | | | |
| (c) Deferred tax assets (net) | | | |
| (d) Long-Term Loans and Advances | | | |
| (e) Other Non-Current Assets | | | |
| (2) Current Assets | | | |
| (a) Current Investments | | | |
| (b) Inventories | | | |
| (c) Trade Receivables | | | |
| (d) Cash and Cash Equivalents | | | |
| (e) Short-Term Loans and Advances | | | |
| (f) Other Current Assets | | | |
| | | | |
| TOTAL | | | |
| | | | |
Items under the head Equity and Liabilities
1. Shareholders’ Funds
a. Share Capital:
i. Authorised Capital-
ii. Issued Share Capital-
iii. Subscribed Share Capital-
iv. Called-up Share Capital-
v. Paid-up Share Capital-
vi. Share Forfeiture Amount
b. Reserves and Surplus: It consists of the following items to be shown separately.
i. Capital Reserve
ii. Capital Redemption Reserve
iii. Securities Premium
iv. Debenture Redemption Reserve
v. Revaluation Reserve
vi. Other Reserves (such as General Reserve, Tax reserve, etc.)
vii. Proposed Additions to Reserves
viii. Sinking Fund
ix. Share Option Outstanding Amount
x. Surplus i.e. credit balance in Statement of Profit and Loss. However, in case of debit balance in Statement of Profit and Loss, it is deducted from the total of reserves.
c. Money received against warrants: A financial instrument that allows its holder to acquire equity shares is known as Share Warrant. Any amount received by the company on such share warrants is required to be disclosed under this head.
2. Share Application Money Pending Allotment
Amount received by the company on application of shares issued and the allotment on which is to be received after the date of balance sheet is shown under this head separately.
3. Non-Current Liabilities
These are comprised of the following items.
a. Long-Term Borrowings- It is further consists of the given below items.
• Debentures
• Bonds
• Term Loans from bank as well as from other parties
• Deposits
• Other Loans and Advances
b. Deferred Tax Liabilities (Net)
c. Other Long-Term Liabilities
d. Long-Term Provisions
4. Current Liabilities
Under this head the following items are disclosed.
a. Short-term Liabilities- It is further comprised of the given below items.
• Loan repayable on demands from bank as well as from other parties
• Deposits
• Other Loans and Advances
b. Trade Payables
c. Other Current Liabilities- It includes all those liabilities that are not covered in any of the mentioned above heads. Some examples are-
• Income received in advance
• Interest accrued but not due on borrowings
• Interest accrued and due on borrowings
• Unpaid Dividends
• Calls-in-Advance and interest thereon
• Other Payables etc.
d. Short-term Provisions- These are categorised as follows.
• Provision for Doubtful Debts
• Proposed Dividend
• Provision for Tax
• Provision for Employees Benefits
• Others
Items under the head Assets
Non-Current Assets and Current Assets are two titles that come under the heading of Assets.
1. Non-Current Assets
a. Fixed Assets- These are further classified s follows.
• Tangible Assets (such as, Building, Machinery, Furniture, etc.)
• Intangible Assets (such as Goodwill, Trademark, Copyrights, Mining Rights, etc.)
• Capital Work-in-Progress
• Intangible Assets under development
b. Non-current Investments- These are the investments that are not held for the purpose of resale.
c. Deferred Tax Assets
d. Long-term Loans and Advances
e. Other Non-Current Assets
2. Current Assets
Under this head the following items are shown.
a. Current Investments- Investments that are held for conversion into cash within a period of 12 months. These are further classified as follows.
• Investment in Equity Shares
• Investment in Preference Shares
• Investment in Government or Trust Securities
• Investment in Debentures or Bonds
• Investment in Mutual Funds
• Investment in Partnership Firms
• Other Investments
b. Inventories- It comprised of the given items.
• Raw Materials
• Work-in-Progress
• Finished Goods
• Stock-in-Trade (goods acquired for trading)
• Stores and Spares
• Loose Tools
c. Trade Receivables
d. Cash and Cash Equivalents- These are classified as follows.
• Cash on Hand
• Balances with Banks
• Cheques, Drafts on Hand
• Others
e. Short-term Loans and Advances
f. Other Current Assets (such as prepaid expenses, advance taxes, etc.)