UNIT-1

SHORT ANSWER QUESTIONS

1. Define accrual accounting and explain its significance in financial
reporting.

Answer:

Accrual Accounting:
• As per this concept, the actual cash received or the actual cash
payment for the current year shall be recorded in the books of
accounts.
• Outstanding expenses, Prepaid Expenses, etc shall be recorded
separately in books of accounts.
Importance in Financial Reporting/ Significance in Financial Reporting:

o Accuracy: Accrual accounting offers a more precise view of a

company’s current condition by combining current and future
cash inflows or outflows.
o Decision-Making: Stakeholders can make informed decisions
based on reliable and timely financial information.
o Standard Practice: Encouraged by International Financial
Reporting Standards (IFRS) and Generally Accepted Accounting
Principles (GAAP), accrual accounting is the standard practice for
most companies, except very small businesses and individuals.

2. Differentiate between a balance sheet and an income statement.

Answer:
Differences between a balance sheet and income statement:

Balance sheet Income statement

The income statement provides an
The balance sheet summarizes the
overview of the financial
Time financial position of a company at a
performance of the company over
specific point in time.
a given period.
It includes revenues, expenses and
It includes assets, liabilities and
Key items gains and losses realized from the
shareholder’s equity, further
sale or disposal of assets.
 categorized to provide accurate
information.
Ratios, such as gross margins,
It helps assess financial health using
operating margins, price-to-
Financial ratios, such as current ratio, debt-
earnings and interest coverage,
analysis to-equity ratio and return on
paint a picture of financial
shareholder’s equity.
performance.
Management, investors,
Investors and lenders use it to
shareholders and others use it to
Usage determine creditworthiness and
assess the performance and future
availability of assets for collateral.
prospects of a business.

3. What is the purpose of the accounting equation, and how does it relate
to the balance sheet?

Answer:

Accounting equation is referred to as the relationship between assets,

liabilities and capital of a business. The accounting equation is one of the
most important equations in accounting and is used for preparing balance
sheet. It can be represented by the following equation:

Assets = Liabilities + Capital (Owner’s equity)

Or

Capital = Assets – Liabilities

Or

Liabilities = Assets – Capital

The accounting equation sometimes is also referred to as the balance sheet

equation since the accounting equation shows the fundamental relationship
between the assets, liabilities and capital which are regarded as the most
components of a balance sheet.

The accounting equation states that at any given point in time, the resources
of the business entity (assets) must be equal to the claims of those who have
provided finance for those resources.
The claims can be either from proprietors (known as capital) and from
outsiders (known as liabilities).

4. Explain the concept of materiality in financial reporting.

Answer:

Materiality is a fundamental concept in financial reporting under IFRS

Standards. If an item is immaterial, IFRSs do not apply to it. An information is
considered material if its omission, misstatement or obscurity could
reasonably be expected to influence decisions made by the primary users of
financial statements.

Significance:

If a transaction or business decision is substantial enough to warrant

reporting to investors or other users of financial statements, that information
is considered "material" and cannot be omitted. Materiality ensures
transparency and accuracy in financial reporting.

Types of Information:

Material items can be financial (measurable in monetary terms) or non-

financial.

For instance, pending lawsuits, revenues, and even environmental, social,

and corporate governance (ESG) practices can all be material information,
depending on the context and business priorities.

5. Describe the purpose of the statement of cash flows.

Answer:

• The purpose of the statement of cashflows is to present cash

inflows and outflows for a reporting period to the reader of the
report.
• These inflows and outflows are further classified into operating,
investing, and financing activities.
• The information is used by the investment community to discern the
ability of an organization to generate cash, and how the funds are
then used.
 1. Operating Activities: This section includes cash flows related to the
core business operations, such as revenue, expenses, and working
capital changes (e.g., accounts receivable, accounts payable). It helps
assess the company’s day-to-day cash generation.
2. Investing Activities: Here, the statement highlights cash flows related
to investments in assets (e.g., property, equipment, acquisitions) and
dispositions (e.g., selling assets). It reflects the company’s capital
expenditure decisions.
3. Financing Activities: This section covers cash flows from financing
sources, including debt issuance, equity transactions, dividends, and
interest payments. It shows how the company raises capital and
manages its debt.

LONG ANSWERS

1. Discuss the importance of financial accounting in decision-making for

external users such as investors and creditors.

ANSWER:

1. Investors: They may be current investors, minority stakeholder,

potential future investors, etc.

o Investors rely on financial statements (such as the balance sheet,

income statement, and cash flow statement) to assess a
company’s financial health.
o These statements provide information about profitability,
liquidity, solvency, and overall performance.

They use it for

o Checking how the management is utilizing the equity invested in

the business.
o Decisions related to an increase in investment or to divest from
the business.
o Analysing their present investment in the business or the overall
financial health in case of a potential investor.
 2. Creditors: Banks and Non - banking financial companies which provide
loans in the form of cash or credit are termed as lenders.
o Creditors evaluate a company’s creditworthiness before
extending loans or providing credit.
o Evaluation of short-term and long-term financial stability of a
business.
o Financial accounting helps creditors assess the risk of lending
money to a business.
o They analyse financial ratios (e.g., debt-to-equity ratio, interest
coverage ratio) to gauge repayment capacity.
3. Transparency and Accountability:
o Proper financial accounting ensures transparency by disclosing
accurate and reliable financial information.
o External users can trust that the data is unbiased and adheres to
accounting standards.
4. Legal Compliance:
o Financial statements are legally required for publicly traded
companies.
o Compliance with accounting standards (e.g., GAAP or IFRS)
ensures fair representation of financial data.
5. Resource Allocation:
o Businesses use financial statements to allocate resources
effectively.
o For instance, they decide on capital investments, research and
development, or expansion based on financial data.

2. Explain the concept of accounting principles and discuss their

importance in financial reporting.
Answer:

1) Business entity concept:

(1) As per this concept, the business entity is treated as separate
party and the owners of that entity are treated as separate
party.
(2) Capital is treated as liability.
(3) Personal expenses are treated as drawings.
2) Double Entry System:
(1) All the business transactions are recorded in books of accounts
have two aspects (i.e. receiving benefit and giving benefit).
 (2) Equity + Liabilities=Assets
3) Going Concern Concept:
(1) It is assumed that the organisations will continue for a longer
period unless and until it enters to the stage of liquidation.
(2) This concept is not applicable for joint venture organisations.
4) Money Measurement Concept:
(1) All the transactions shall be recorded in monetary terms. • The
events or transactions which cannot expressed in monetary
terms shall not be recorded in books of accounts.
5) Cost Concept:
(1) According to this concept, the assets shall be recorded at
historical cost not at current value.
6) Accounting Period Concept or Periodicity:
(1) The accounting period is normally considered to be 12 Months
and the accounting books are closed at the end of every year ( i.e
31st March or 31st December).
7) Accrual Concept:
(1) As per this concept, the actual cash received or the actual cash
payment for the current year shall be recorded in the books of
accounts.
(2) Outstanding expenses, Prepaid Expenses, etc shall be recorded
separately in books of accounts.
8) Matching Concept:
(1) Revenue/Sales of current period should be matched with
expenditure incurred to generate that revenue.
(2) Profit = Revenue – Expenses
9) Realisation Concept:
(1) Revenue shall be recognised only when the revenue is actually
realised or when the revenue has become certain that it will be
realised.
10) Disclosure:
(1) All the material facts shall be disclosed in or below the financial
statements.
(2) This helps the users of financial statements to take rationale
decisions.
(3) All significant accounting policies, contingent liabilities and
events occurring after the balance sheet date shall be disclosed
as foot note to financial statements.
11) Materiality:
 (1) Materiality is a fundamental concept in financial reporting under
IFRS Standards. If an item is immaterial, IFRSs do not apply to it.
(2) An information is considered material if its omission,
misstatement or obscurity could reasonably be expected to
influence decisions made by the primary users of financial
statements.
12) Consistency:
(1) An accounting policy which is selected in first year of operation
of business shall be followed consistently year after year.
(2) This helps in comparison of financial statements.
(3) Change in accounting policy can be made only when it is
required under law or statute or it gives better presentation of
financial statements.
13) Conservatism or Prudence:
(1) All anticipated losses shall be considered to books of accounts and all
anticipated profits shall be ignored.
14) Cost Principle:

(1) Assets should be recorded at their historical cost (the amount paid to
acquire them), rather than their current market value.

15) Economic Entity Principle:

(1) Business transactions should be separate from personal transactions.
The business is treated as a distinct entity.

Importance of accounting principles in Financial Reporting:

1. Completeness, Consistency, and Comparability:

• The ultimate goal of accounting principles is to ensure that a
company's financial statements are complete, consistent, and
comparable.
• This consistency allows investors to analyse financial data effectively,
extract useful information, and identify trends over time.

2. Comparability:

• Accounting principles enable financial statement users to review

multiple companies' financials side by side, knowing that the same set
of standards has been followed.
• Without these rules, comparing financial statements among companies
would be extremely difficult, even within the same industry.

3. Mitigating Fraud and Increasing Transparency:

• By standardizing accounting practices, principles help mitigate

accounting fraud.
• They increase transparency, allowing red flags to be identified. When
everyone follows the same rules, inconsistencies and errors become
easier to spot.
UNIT-2

SHORT ANSWER QUESTION

1.Define and explain the significance of the current ratio.

ANSWER:

• The ratio that is used to derive a relation between the current

assets and current liabilities of a firm is called a Current Ratio.
• It is used to determine whether the current assets of a firm would
be sufficient to pay off its current obligations or not.
• In other words, it is used to depict the magnitude of current
assets against current liabilities of a concern.
• It is also known as Working Capital Ratio.
• Generally, a current ratio of 2:1 is considered ideal, which means
that the current assets must be twice the amount of current
liabilities.

Where,

✓ Current Assets = Cash in Hand + Cash at Bank + Short-term Investments

(Marketable Securities) + Trade Receivables (Less Provision) +
Inventories (Stock of Finished Goods + Stock of Raw Material + Work in
Progress) + Prepaid Expenses
✓ Current Liabilities = Bank Overdraft + Trade Payables + Provision of
Taxation + Proposed Dividends + Unclaimed Dividends + Outstanding
Expenses + Loans Payable within a Year

There can be three situations arising from the calculation:

1. If Current Assets > Current Liabilities, then Current Ratio > 1: This
implies that the organisation would still have some assets left even
after paying all the short-term debts and is a desirable situation to be
in.
2. If Current Assets = Current Liabilities, then Current Ratio = 1: This
means that the current assets are just enough to cover the short-term
obligations of the firm.
 3. If Current Assets < Current Liabilities, then Current Ratio < 1: This is not
an ideal situation to be in since it implies that the company does not
have enough resources to pay off short-term debts.

Significance:

1. Current Ratio is computed to know the ability of a firm to pay off the
short-term liabilities of a firm with the help of current assets.
2. It is assumed that all the current assets are likely to be converted into
cash to pay off the short-term liabilities of the firm.
3. In other words, this ratio is calculated to determine the short-term
solvency of a firm. 2:1 is considered an ideal current ratio.
4. That means the current assets should be double the current liabilities
of the firm.
5. But if the current ratio is very high, it is believed that the funds are
lying idle and the firm has poor control over its inventory or debtors
turnover is slow.

2. Discuss the importance of the price-to-earnings (P/E) ratio for investors.

ANSWER:

• The Price Earnings Ratio (P/E Ratio) is the relationship between the
stock price of a company and its earnings per share (EPS).
• It is a popular and widely accepted ratio that gives investors a better
vision about the value of the company.
• The P/E ratio shows what the markets are expecting and how much
investors must pay per unit of current earnings.
• Earnings of a company is an important parameter while valuing it’s
stock as investors would want to know how profitable a company is
and how profitable its future prospects are.
• The P/E ratio is used by investors to determine the market value of a
stock as compared to the company’s earnings.
• The P/E shows what the market is willing to pay today for a stock
based on its past or future earnings.
• A high P/E is an indicator that a stock’s price is high relative to earnings
and possibly overvalued.
• Conversely, a low P/E is a potential indicator that the current stock
price is low relative to its earnings.
 ➢ There are two major types of P/E Ratio which investors take into
consideration. They are forward P/E ratio and trailing P/E ratio. Both
types of the P/E Ratio depend on the nature or the timeframe of
earnings.

1. Forward P/E Ratio:

1) It is calculated by dividing the prices of a single unit of stock of a

company and the estimated earnings of a company derived from
its future earnings guidance.
2) It is also called an estimated P/E ratio as this ratio is based on
the future earnings of the company.
3) Investors use forward P/E ratio to assess how a company is
expected to perform in the future and its estimated growth rate.

2. Trailing P/E Ratio:

1) Trailing P/E Ratio calculates the past earnings of a company over

a period is considered.
2) It provides a more accurate and objective view of a company’s
performance as the picture drawn is more realistic.

➢ There are two more types of P/E ratios that help investors to
determine the ‘value’ and ‘performance’ of a company.

1. Absolute P/E Ratio:

• When the current stock price of a company is divided by either

its past or previous earnings.

2. Relative P/E Ratio:

• When the absolute ratio of a company is compared against a

benchmark P/E ratio of the sector or past price to earnings of
respective peers from the industry.

3.Explain the significance of analysing the statement of cash flows in financial

statement analysis.

ANSWER:
 1. A cash flow statement, when employed with other financial
reports, permits users to assess variations in net assets of a firm
and its economic system.
2. It involves liquidity and stability, the capability to influence the
amounts and timings of cash flows to adjust to varying
conditions and possibilities.
3. Cash flow data evaluate the capability of a firm to produce cash
and cash equivalents.
4. It permits users to generate models to assess and analyse the
existing value of the expected cash flows of various companies.
5. It also assists in stabilizing its cash inflow and outflow, following
in acknowledgement to the varying situation.
6. It is also essential in verifying the correctness of prior estimates
of anticipated cash flows and in exploring the association
between profitability and net cash flow and the result of varying
cost prices.

✓ The statement of cash flow gives insights, help an investor to

understand the status of a company’s operations, from where the
money is coming, and how efficiently the money is utilized.
✓ The statement is essential as it assists investors to understand whether
an organization financial status is reliable or not.
✓ On the other hand, creditors, use this statement to analyse how much
funds (liquid cash) a company has to support its operating
expenditures and pay the debts.

4.Calculate the inventory turnover ratio for Company XYZ using the following
information:

Beginning Inventory = Rs.100,000, Ending Inventory = Rs.80,000, Cost

of Goods Sold = Rs.500,000.

ANSWER:
5.A company has a net profit margin of 15% and total revenue of
Rs.2,000,000. Calculate the company's net income and discuss the
significance of this ratio in assessing the company's profitability.

ANSWER:

SIGNIFICANCE:
 1) Role in Assessing Operational Efficiency:

• A high ratio indicates that the company operates effectively and

optimally utilizes its resources to generate maximum profit.
• On the other hand, a low ratio demonstrates the company's
inefficiency, where a large portion of generated revenue is
consumed by operational costs.
• Therefore businesses strive to depict net profit margin at higher
level of operational efficiency.

2) Surfacing Profitability Indication:

• This measure provides valuable insights about a company by

representing the percentage of each Dollar of revenue that the
company retains as profit.
• It delineates the actual profit realized for every Dollar of sales,
depicting the true profitability status.
• So, higher percentages reflect better profitability, conversely,
lower percentages indicate trouble spots in terms of
profitability.

3) Evaluating Competitive Advantage:

• Companies with higher Net Profit Margins tend to have a

competitive edge, provided other attributes are relatively
equivalent.
• Investors often compare the Net Profit Margins of companies
within the same industry to identify the more competitive
players.
• This comparison gives them an understanding of the company's
pricing strategy, cost control, and financial health compared to
its competitors.
• Hence, a high net profit margin can be a sign of strong
competitive positioning.

LONG ANSWER QUESTIONS:

1. Calculate the return on equity (ROE) for Company XYZ given the
following information: Net Income = Rs.500,000, Total Equity =
Rs.2,000,000.
 ANSWER:

COMMENT:

• In this case, an ROE of 25% means that for every dollar of equity
invested by shareholders, the company generates Rs.0.25 in net
income.
• A higher ROE suggests stronger profitability and efficient use of
shareholders' funds, whereas a lower ROE may indicate less
effective utilization of equity or higher risk. Therefore, analysing ROE
helps investors assess the company's profitability, efficiency, and
overall performance relative to its equity capital.

2. Explain the limitations of ratio analysis in financial statement analysis.

ANSWER:

The limitations of financial ratios are listed below:

Diversified product lines:

• Many businesses operate a large number of divisions in quite different

industries.
• In such cases ratios calculated on the basis of aggregate data cannot be
used for inter-firm comparisons.

Financial data are badly distorted by inflation:

• Historical cost values may be substantially different from true values.

Such distortions of financial data are also carried in the financial ratios.
Seasonal factors:

• It may also influence financial data.

Differences in accounting policies and accounting period:

• It can make the accounting data of two firms non-comparable as also

the accounting ratios.

No standard set of ratios against which a firm’s ratios can be compared:

• Sometimes a firm’s ratios are compared with the industry average.

• But if a firm desires to be above the average, then industry average
becomes a low standard.
• On the other hand, for a below average firm, industry averages
become too high a standard to achieve.

Difficulty to generalise whether a particular ratio is good or bad:

• For example, a low current ratio may be said ‘bad’ from the point of
view of low liquidity, but a high current ratio may not be ‘good’ as this
may result from inefficient working capital management.

Financial ratios are inter-related, not independent:

• Viewed in isolation one ratio may highlight efficiency. But when

considered as a set of ratios they may speak differently.
• Such interdependence among the ratios can be taken care of through
multivariate analysis (analysing the relationship between several
variables simultaneously).

Financial ratios provide clues but not conclusions. These are tools only in the
hands of experts because there is no standard ready-made interpretation of
financial ratios.
UNIT-3

SHORT ANSWER QUESTIONS

1. Define the debt-to-equity ratio and provide an example calculation.

ANSWER:

It is calculated by dividing the total liabilities by the shareholder equity of the

company.

It shows the proportion to which a company is able to finance its operations

via debt rather than its own resources.

It is also a long-term risk assessment of the capital structure of a company

and provides insight over time into its growth strategy.

A high D/E ratio suggests that the company is sourcing more of its business
operations by borrowing money, which may subject the company to
potential risks if debt levels are too high.

A low D/E ratio shows a lower amount of financing by debt from lenders
compared to the funding by equity from shareholders.
 2.Calculate the inventory turnover ratio for a company that had
Rs.1,000,000 in sales and an average inventory of Rs.200,000. If the cost of
goods sold is Rs.600,000.

ANSWER:

3.Explain what the current ratio measures and how it is calculated.

ANSWER:

• The ratio that is used to derive a relation between the current assets
and current liabilities of a firm is called a Current Ratio.
• It is used to determine whether the current assets of a firm would be
sufficient to pay off its current obligations or not.
• In other words, it is used to depict the magnitude of current assets
against current liabilities of a concern.
• It is also known as Working Capital Ratio.
• Generally, a current ratio of 2:1 is considered ideal, which means that
the current assets must be twice the amount of current liabilities.

4. Define the price-to-earnings (P/E) ratio and discuss its significance.

ANSWER:
 • The Price Earnings Ratio (P/E Ratio) is the relationship between
the stock price of a company and its earnings per share (EPS).
• It is a popular and widely accepted ratio that gives investors a
better vision about the value of the company.
• The P/E ratio shows what the markets are expecting and how
much investors must pay per unit of current earnings.
• Earnings of a company is an important parameter while valuing
it’s stock as investors would want to know how profitable a
company is and how profitable its future prospects are.
• The P/E ratio is used by investors to determine the market value
of a stock as compared to the company’s earnings.
• The P/E shows what the market is willing to pay today for a stock
based on its past or future earnings.
• A high P/E is an indicator that a stock’s price is high relative to
earnings and possibly overvalued.
• Conversely, a low P/E is a potential indicator that the current
stock price is low relative to its earnings.

➢ There are two major types of P/E Ratio which investors take into
consideration. They are forward P/E ratio and trailing P/E ratio. Both
types of the P/E Ratio depend on the nature or the timeframe of
earnings.

1. Forward P/E Ratio:

a) It is calculated by dividing the prices of a single unit of stock of a

company and the estimated earnings of a company derived from
its future earnings guidance.
b) It is also called an estimated P/E ratio as this ratio is based on
the future earnings of the company.
c) Investors use forward P/E ratio to assess how a company is
expected to perform in the future and its estimated growth rate.

2. Trailing P/E Ratio:

a. Trailing P/E Ratio calculates the past earnings of a company over

a period is considered.
b. It provides a more accurate and objective view of a company’s
performance as the picture drawn is more realistic.
 ➢ There are two more types of P/E ratios that help investors to
determine the ‘value’ and ‘performance’ of a company.

1. Absolute P/E Ratio:

• When the current stock price of a company is divided by either its

past or previous earnings.

2. Relative P/E Ratio:

• When the absolute ratio of a company is compared against a

benchmark P/E ratio of the sector or past price to earnings of
respective peers from the industry.

5. Briefly explain the significance of the return on equity (ROE) ratio.

ANSWER:

1. Return on equity (ROE) is a measure of financial performance

calculated by dividing net income by shareholders' equity.
2. Because shareholders' equity is equal to a company’s assets minus its
debt, ROE is considered the return on net assets.
3. ROE is considered a gauge of a corporation's profitability and how
efficient it is in generating profits.
4. The higher the ROE, the more efficient a company's management is at
generating income and growth from its equity financing.
5. Significance:

o Profitability Gauge:

ROE reflects how efficiently a company converts equity financing

into profits. A higher ROE indicates better profitability.

o Investor Perspective:

Investors use ROE to evaluate management’s performance.

Maximizing ROE can positively impact share prices and dividend
growth.

o Capital Efficiency:

A high ROE suggests efficient use of capital to generate profits.

 6. Formula:

Return on Equity (ROE) = Net Income / Equity of the Shareholders

LONG ANSWER QUESTIONS

1. Discuss the limitations of ratio analysis in evaluating a company's

financial performance and provide examples.

ANSWER:

The limitations of financial ratios are listed below:

Diversified product lines:

• Many businesses operate a large number of divisions in quite different

industries.
• In such cases ratios calculated on the basis of aggregate data cannot be
used for inter-firm comparisons.

Financial data are badly distorted by inflation:

• Historical cost values may be substantially different from true values.

Such distortions of financial data are also carried in the financial ratios.
• For example, a company may have had high profitability ratios in the
past but faces declining sales and increasing competition in the future.

Seasonal factors:

• It may also influence financial data.

Differences in accounting policies and accounting period:

• It can make the accounting data of two firms non-comparable as also

the accounting ratios.

No standard set of ratios against which a firm’s ratios can be compared:

• Sometimes a firm’s ratios are compared with the industry average.

• But if a firm desires to be above the average, then industry average
becomes a low standard.
• On the other hand, for a below average firm, industry averages
become too high a standard to achieve.
 • For example, a debt ratio of 0.8 may be considered high for one
industry but low for another. Therefore, ratio analysis should be
supplemented with other qualitative and quantitative measures to
provide a comprehensive assessment of a company's financial health.

Difficulty to generalise whether a particular ratio is good or bad:

• For example, a low current ratio may be said ‘bad’ from the point of view
of low liquidity, but a high current ratio may not be ‘good’ as this may
result from inefficient working capital management.

Financial ratios are inter-related, not independent:

• Viewed in isolation one ratio may highlight efficiency. But when

considered as a set of ratios they may speak differently.
• Such interdependence among the ratios can be taken care of through
multivariate analysis (analysing the relationship between several variables
simultaneously).

Financial ratios provide clues but not conclusions. These are tools only in the
hands of experts because there is no standard ready-made interpretation of
financial ratios.

2. Explain how investors can use ratio analysis to make investment

decisions, considering both strengths and limitations.

ANSWER:

Strengths of Ratio Analysis:

Providing a Standard Basis for Comparison:

• Ratio analysis enables investors to compare the financial performance

and risk profile of different companies in a standardized way.

• This makes it easier to identify potential investment opportunities such

as companies with a high growth potential or stocks that
are undervalued compared to the business’s ability to outperform
competitors in the market.
Identifying Trends with Ratio Analysis:

• One of the advantages of financial ratio analysis is that investors

can identify certain trends in a company’s financial performance.

• This allows for an understanding of the general development, growth,

and revenue potential over the years compared to the company’s share
price.

Using Financial Ratio Analysis to Evaluate Company Performance:

• Financial ratios can be used to set benchmarks for evaluating a

company’s financial performance, which can help investors identify
companies that are outperforming their peers.

Identifying Potential Red Flags With Key Financial Ratios:

• By evaluating financial ratios, investors can identify potential red flags,

such as high debt levels or low profitability, which can help them avoid
potential investment risks.

Assessing a Company’s Financial Health

• A company’s financial health refers to its financial stability, profitability,

and ability to meet its financial obligations.

• A financially healthy company can generate sufficient profits to cover

its expenses and debts. By evaluating financial ratios such as
the current ratio, debt-to-equity ratio, and return on assets, investors
can assess a company’s risk profile.

Identify Companies With Strong Growth Potential:

 • By evaluating financial ratios such as revenue growth, earnings growth,
and return on investment, investors can identify companies that may
have strong growth potential.

Assessing Management Quality:

• Investors can gain an insight into a company’s management quality by

analysing financial ratios such as return on equity (ROE) and return on
assets (ROA).

• These ratios provide an indication of how effectively the company is

being run.

Limitations of Financial Ratio Analysis:

Diversified product lines:

• Many businesses operate a large number of divisions in quite different

industries.
• In such cases ratios calculated on the basis of aggregate data cannot be
used for inter-firm comparisons.

Financial data are badly distorted by inflation:

• Historical cost values may be substantially different from true

values. Such distortions of financial data are also carried in the
financial ratios.
• For example, a company may have had high profitability ratios in
the past but faces declining sales and increasing competition in
the future.

Seasonal factors:

• It may also influence financial data.

Differences in accounting policies and accounting period:

• It can make the accounting data of two firms non-comparable as

also the accounting ratios.
No standard set of ratios against which a firm’s ratios can be compared:

• Sometimes a firm’s ratios are compared with the industry

average.
• But if a firm desires to be above the average, then industry
average becomes a low standard.
• On the other hand, for a below average firm, industry averages
become too high a standard to achieve.
• For example, a debt ratio of 0.8 may be considered high for one
industry but low for another. Therefore, ratio analysis should be
supplemented with other qualitative and quantitative measures
to provide a comprehensive assessment of a company's financial
health.

Difficulty to generalise whether a particular ratio is good or bad:

• For example, a low current ratio may be said ‘bad’ from the point of view
of low liquidity, but a high current ratio may not be ‘good’ as this may
result from inefficient working capital management.

Financial ratios are inter-related, not independent:

• Viewed in isolation one ratio may highlight efficiency. But when

considered as a set of ratios they may speak differently.
• Such interdependence among the ratios can be taken care of through
multivariate analysis (analysing the relationship between several variables
simultaneously).

Financial ratios provide clues but not conclusions. These are tools only in the
hands of experts because there is no standard ready-made interpretation of
financial ratios.
UNIT-4

SHORT ANSWER QUESTIONS

1. Define budget variance and explain its significance in budgeting.

ANSWER:

• A budget variance is a periodic measure used by governments,

corporations, or individuals to quantify the difference between
budgeted and actual figures for a particular accounting category.
• A favourable budget variance refers to positive variances or gains; an
unfavourable budget variance describes negative variance, indicating
losses or shortfalls.
• Budget variances occur because forecasters are unable to predict
future costs and revenue with complete accuracy.
Significance of a Budget Variance
1. A variance should be indicated appropriately as "favourable" or
"unfavourable." A favourable variance is one where revenue comes in
higher than budgeted, or when expenses are lower than predicted.
2. The result could be greater income than originally forecast. Conversely,
an unfavourable variance occurs when revenue falls short of the
budgeted amount or expenses are higher than predicted.
3. As a result of the variance, net income may be below what
management originally expected.
4. If the variances are considered material, they will be investigated to
determine the cause. Then, management will be tasked to see if it can
remedy the situation.
5. The definition of material is subjective and different depending on the
company and relative size of the variance.
 6. However, if a material variance persists over an extended period of
time, management likely needs to evaluate its budgeting process.
2.Calculate the sales volume variance if the budgeted sales volume is 500
units, actual sales volume is 480 units, and the standard profit per unit is
Rs.10.
ANSWER:

3.Explain the difference between a flexible budget and a static

budget(Fixed Budget).
ANSWER:

4.Define zero-based budgeting and outline its advantages and

disadvantages.
• Zero-based Budgeting (ZBB) is defined as a method of budgeting
which requires each cost element to be specifically justified, though
 the activities to which the budget relates are not being undertaken
for the first time.
• The cost of each activity has to be justified and without justification,
the budget allowance is zero.
• ZBB is suitable for both corporate and non-corporate entities.
• In case of non-corporate entities like Government department, local
bodies, not for profit organisations, where these entities need to
justify the benefits of expenditures on social programmes like mid-
day meal, installation of street lights, provision of drinking water etc.
• In case of corporate entities, ZBB is best suited for discretionary costs
like research and development cost, training programmes,
advertisement etc.
Advantages of Zero-based Budgeting:
1) It provides a systematic approach for the evaluation of different
activities and rank them in order of preference for the allocation of
scarce resources.
2) It ensures that the various functions undertaken by the organization
are critical for the achievement of its objectives and are being
performed in the best possible way.
3) It provides an opportunity to the management to allocate resources
for various activities only after having a thorough cost-benefit-
analysis. The chances of arbitrary cuts and enhancement are thus
avoided.
4) The areas of wasteful expenditure can be easily identified and
eliminated.
5) Departmental budgets are closely linked with corporation objectives.
Disadvantages of Zero-Bases Budgeting:
1) The work involves in the creation of decision-making and their
subsequent ranking has to be made on the basis of new data. This
process is very tedious to management.
2) The activities selected for the purpose of ZBB are on the basis of the
traditional functional
departments. So, the consideration scheme may not be implemented
properly.
5.Calculate the materials usage variance if the standard quantity of materials
for production is 1,000 units, actual quantity used is 950 units, and the
standard cost per unit is Rs.5.
ANSWER:

LONG ANSWER QUESTIONS

1. Discuss the steps involved in the budgeting process and explain the
importance of each step.
ANSWER:
Preparing the Base for the Budget according to Funding
The first step in preparing a budget is to identify the budget goals and how
they will be achieved. Factors such as the business’s socioeconomic
surroundings, sales trends, etc., have to be taken into consideration for
setting goals. Also, these goals have to be set according to the economic
resources available to the company. A budget will be of no use without
proper funding.
Creating a Cost Buffer
The next step in a budget is to scrutinize the cost for the business. Also,
evaluating factors that can affect input costs during the budget period has
to be done. Revision of the compensation plans of the employees takes
place every year in most companies. To make the budget realistic and
achievable, proper provisions should be created for variations in these
costs and compensation plans.
Preparation of Revenue and Expenditure Budgets:
 Proper and realistic forecasts for the different types of budgets, such as
sales, production, cash, purchase, labour and overheads, selling, and
general and administrative expenses, have to be made. A realistic plan for
the sources of revenue is the need for the budget period. Planning of
expenditure should be done accordingly as the company cannot spend
more than what it earns. Thus, the revenue target decides and dictates the
expected quantum of expenses to achieve these revenue targets.
Changes in the Budget Model and Review
After finalizing all the above steps, a review of the assumptions as per the
budget model should be done. Also, a thorough review of the entire
budget is essential. If there is a need for any changes in the budget, it can
be done now.

Approval and Implementation

The budget will then go to the top management for approval. They will
check if it is proper. Makers will make any changes as per need. In case
everything is fine with the budget, they will give the go-ahead for
implementation.
Performance evaluation and feedback
Analysing variances, identifying areas for improvement, and providing
feedback to stakeholders for future budget cycles.
Each step is crucial for effective budgeting as it ensures that the budget
reflects organizational priorities, is based on accurate information, and
facilitates performance evaluation and feedback for continuous
improvement.
2.Calculate the direct labour efficiency variance if the standard labour hours
per unit are 5 hours, actual labour hours per unit are 4.5 hours, and the
standard labour rate is Rs.15 per hour.
ANSWER:
 UNIT-5

SHORT ANSWER QUESTIONS

1.Calculate the current ratio for a company with current assets of Rs.500,000
and current liabilities of Rs.200,000.
ANSWER:
2.Explain the concept of "double-entry accounting."
ANSWER:

Double Entry System:

1) All the business transactions are recorded in books of accounts have

two aspects (i.e. receiving benefit and giving benefit).
2) For example, when a company sells goods, it both increases the
revenue account and decreases the inventory account.
3) Debits (left side of an account) represent increases in assets or
expenses.
4) Credits (right side of an account) represent increases in liabilities,
equity, or revenue.
5) Equity + Liabilities=Assets
A) Assets: Resources owned by the company (e.g., cash,
inventory).
B) Liabilities: Obligations (e.g., loans, accounts payable).
C) Equity: Owner’s interest (e.g., common stock, retained
earnings).

6) Each transaction maintains the balance between debits and credits. If

the books don’t balance, there’s an error.
 7) Financial Statements: Double-entry accounting enables the creation of
accurate financial statements, including the balance sheet, income
statement, and cash flow statement.

3.Calculate the debt-to-equity ratio if a company has total debt of Rs.400,000

and total equity of Rs.600,000.

ANSWER:

4. Define the term "integrated reporting" in financial accounting.

ANSWER:

1. Integrated reporting is concise communication of an entity’s

governance strategies, performance, and prospects relevant to the
external environment that leads to developing criteria for financial and
non-financial value over the period.
2. It provides us with an understanding of how a business is affected by
its external environment and gives insights into how capital creates
value for a business over short-, medium- and long-term time.
3. These reports are based not only on the financial performance but
competence of the business to perform value-adding services and lead
to an overall enhancement of the business activities.
 4. So, these reports provide more comprehensive business details that
help potential shareholders in decision-making about the business.
5. An integrated reporting was introduced to allow businesses to focus
more on achieving long-term goals and help stakeholders in decision-
making related to longer aspects of the business.
6. Integrated Reporting (IR) involves the practice of critical thinking and
its application through the connectivity of information between
operations and functional units of the business organization.
7. The focus of integrated reporting is enhancing the culture of
accountability, trust, and stewardship.
8. IR connects the flow of information and business transparency brought
by technology in the modern-day business world.
9. It is an extension of corporate reporting and key focus areas are
conciseness, governance strategies, performance, and prospects.

5.What are the three pillars of ESG investing?

ANSWER:
Environmental, Social, and Governance (ESG) investing considers
environmental sustainability, social responsibility, and good governance
practices in investment decisions.
ENVIRONMENTAL PILLAR:
This pillar focuses on a company’s impact on the environment.
Investors can also consider environmental opportunity such as:
▪ Switching to renewable sources of energy or fuel.
▪ Utilising processes that conserve resources and minimise pollution.
▪ Adopting a carbon neutral stance or reducing carbon footprint.
▪ Planet restoration for example planting trees.
▪ Adopting clean energy initiatives.
SOCIAL PILLAR:
In this pillar we consider the effect of a company’s behaviour regarding social
issues.
▪ Employment equality and gender diversity
▪ Product safety concerns and liability
▪ Employee health and safety
▪ Training and development
▪ Animal testing
 ▪ Stance on various physical and mental health-related issues, such as
topics such as drug abuse, gambling and reproductive choice
▪ Supply chain transparency
▪ Human rights
▪ Privacy issues
GOVERNANCE PILLAR:
The governance pillar refers to how a company operates internally, its
corporate behaviour.
Other government issues that might be considered when evaluating a
company include:
▪ Compensation of employees and board executives
▪ Board and company diversity
▪ Tax strategy and accounting standards
▪ Bribery and corruption
▪ Fraud
▪ Ethics and values
▪ Transparency and anti-corruption
▪ Shareholder rights

LONG ANSWER QUESTIONS

1.Discuss the impact of blockchain technology on financial accounting

practices, including its advantages and challenges.
ANSWER:
1. Blockchain in accounting involves concepts such as blockchain,
knowledge of computer languages, and computer security systems.
2. If in normal accounting activities, an accountant needs to make double
entries, blockchain only requires one access to provide information to
all parties without worrying about authenticity.
3. Accounting records cannot be edited or changed once saved to the
blockchain, even if requested by the owner of the accounting system.
4. Because every daily transaction is recorded and authenticated on the
Blockchain platform, the integrity of financial records is guaranteed.
A. Advantages of Blockchain in Accounting:
• Decentralization and Transparency:
Blockchain operates on a decentralized network, ensuring transparency and
trust. Transactions are recorded in a tamper-proof manner, reducing the risk
of fraud.
• Verifiable Transactions:
Organizations can achieve more verifiable transactions with banks,
customers, and internal parties using blockchain.
• Enhanced Auditing:
Auditors can verify transactions by reviewing the transaction history in the
blockchain.
This improves the completeness and existence assertions in financial
statements.
• Efficiency:
Blockchain streamlines processes, reducing paperwork and manual
reconciliation efforts.
• Immutable Records:
Once data is added to the blockchain, it cannot be altered, ensuring data
integrity.

B. Challenges and Considerations:

• New Competencies:
Accountants and auditors need to acquire technical skills related to
blockchain evidence and its use in recording transactions.
• Scalability:
As blockchain adoption grows, ensuring scalability becomes crucial.
• Accounting Standard Reconciliation:
Aligning blockchain data with existing accounting standards can be
challenging.
• Reduced Demand for Traditional Accounting Work:
While blockchain enhances trust, accountants must adapt to new demands
and stay relevant.

2.Explain the importance of sustainability reporting for companies in the

current business environment, and discuss how it influences stakeholders'
perceptions and decisions.
ANSWER:
Sustainability reporting is based on two underlying fundamentals of a
business – trust and transparency. It is a broad concept and covers various
parameters such as environment, social and governance of business
performance.

Why Is Sustainability Reporting Important for Businesses?

1.Better decision-making:
• Sustainability reporting helps make the decision-making processes of
businesses more effective and relevant.
2.Achieving operational efficiency:
• The analysis of the business impact on sustainability issues enables
companies to better plan their resources, people and other materials
to achieve enhanced operational efficiencies.
3.Optimizing costs and savings:
• Corporate sustainability reporting provides a comprehensive analysis
of business and its impact areas.
• It also highlights areas where the funds are required and where they
need to be restricted.
• Therefore, it gives a holistic picture of the business indicating where to
optimize costs and savings, and where to reduce the spending.

1.Investor Perception:

• Influence: Prior research has shown that companies' sustainability

reporting, especially related to environmental, social, and governance
(ESG) disclosures, significantly influences investors' investment
decisions.
• Growing Interest: Interest in experimental research on sustainability
reporting perception has increased in recent years, highlighting its
relevance.

2. Credibility Factors:

Researchers have examined various factors that determine the credibility of

sustainability information:
 • Sustainability Performance: How well a company performs in terms of
ESG aspects.
• External Assurance: Independent verification of sustainability
disclosures.
• Disclosure Precision: The accuracy and specificity of reported
information.
• Inherent Plausibility: The believability of sustainability claims.

3. Future Research Directions:

• Investigate credibility factors more comprehensively.

• Explore new theories and heuristics related to sustainability
disclosures.
• Consider diverse experimental settings, including different investor
groups and company characteristics.

In summary, sustainability reporting shapes stakeholders' perceptions by

providing information on a company's ESG practices, and investors consider
this information when making decisions. As companies continue to report on
sustainability, understanding these dynamics becomes increasingly
important for both investors and organizations.