1) What do you understand by the concept of conservatism ?

Why is it also called the

concept of prudence? Why is it not applied as strongly today as it used to be in the Past ?
Concept of Conservatism:
Concept of Conservatism implies using conservatism while preparing financial statements i.e.
income should not be accounted for unless it has actually been earned but expenses, even if just
anticipated should be provided for. According to this concept, revenues should be recognized
only when they are realized, while expenses should be recognized as soon as they are reasonably
possible.
For instance, suppose a firm sells 100units of a product on credit for Rs.10, 000.
Until the payment is received, it will not be recorded in the accounting books. However, if the
firm receives information that the customer has lost his assets and is likely to default the
payment, the possible loss is immediately provided for in the firms books. The rule is to
recognize revenue when it is reasonably certain and recognize expenses as soon as they are
reasonably possible. The reasons for accounting in this manner are so that financial statements do
not overstate the companys financial position.
It is also called the concept of prudence as it essentially involves exercising prudence in
recording income and expenses/losses in the financial statements so that anticipated income are
not recorded whereas likely losses are provided for.
However, this concept is not applied as strongly today as it used to be in the past for the reason
that the modern world saw a considerable increase in corporate frauds e.g. Enron case in USA
and Satyam in India. Also, there is a decline in assuming corporate social responsibilities due to
superfluous issues of gaining publicity and brand building. These two major issues call for
increased transparency in financial statements and hence, the decline in use of age old concept of
conservatism.

2) What is a Balance Sheet ? How does a Funds Flow Statement differ from a Balance Sheet
? Enumerate the items which are usually shown in a Balance Sheet and a Funds Flow
Statement.
A Balance Sheet is a type of financial statement of an entity, indicating the financial position at a
given point of time. It is the statement of Assets and Liabilities as on a particular date. The
various items of a Balance Sheet can be grouped under two heads, viz: assets and liabilities.
Funds Flow statement determines the sources of cash flowing into the firm and the application of
that cash by the firm. The various items of a Funds Flow Statement can be grouped under two
heads, viz: inflow of funds (sources) or outflow of funds (applications).

While the Balance Sheet shows only the monetary value of each source and application of funds
at the end of the year, funds flow statement depicts the extent of changes in each source and
application of funds during the year. If we take the Balance Sheet for two consecutive years and
work out the change for each item, we are able to arrive at the Funds Flow Statement items.

The various items usually shown in a Balance Sheet are:

Assets side:
(1) Fixed assets
(a) Gross block
(b) Less depreciation
(c) Net block
(d) Capital work-in-progress
(2) Investments
3) Current assets, loans, and advances:
(a) Inventories
(b) Sundry debtors
(c) Cash and bank balances
(d) Other current assets
(e) Loans and advances
(4) Deferred Revenue Expenditure:
(a) Miscellaneous expenditure to the extent not written off or adjusted
(b) Profit and Loss account

Liabilities side:
(1) Shareholder's funds
(a) Capital
(b) Reserves and Surplus
(2) Loan funds
(a) Secured loans
(b) Unsecured loans

Current liabilities and provisions:

(a) Liabilities
Sundry Creditors
Outstanding expenses
Provision for tax

Similarly, items in a Funds Flow Statement are:

Inflow of funds:
A decrease in assets
An increase in liabilities
An increase in shareholders funds
Outflow of funds:
An increase in assets
A decrease in liabilities
A decrease in shareholders funds

Question 2b: Why do you understand by the term 'pay-out ratio'? What factors are taken into
consideration while determining pay-out ratio? Should a company follow a fixed pay-out ratio
policy? Discuss fully.
Answer:
Pay-out Ratio means the amount of earnings paid out in dividends to shareholders. Investors can
use the payout ratio to determine what companies are doing with their earnings. It can be
calculated as:
A very low payout ratio indicates that a company is primarily focused on retaining its earnings
rather than paying out dividends. The pay-out ratio also indicates how well earnings support the
dividend payment. The lower the ratio, the more secure the dividend because smaller dividends
are easier to payout than larger dividends.
The major factor to be considered in determining the payout ratio is the dividend policy of the
company. Young, fast-growing companies are typically focused on reinvesting earnings in order
to grow the business. As such, they generally sport low (or even zero) dividend payout ratios. At
the same time, larger, more-established companies can usually afford to return a larger

percentage of earnings to stockholders. Also, another factor to be considered is the type of

industry in which the company is operating. For example, the banking sector usually pays out a
large amount of its profits. Certain other sectors like real estate investment trusts are required by
law to distribute a certain percentage of their earnings.
Funds requirement of the company and its available liquidity is another factor which is
considered while determining the pay-out.
Some companies prefer to follow a fixed pay-out ratio policy irrespective of the earnings made.
This is a welcome policy from the point of view of the investors. But, the company should take
into account various important factors such as its need for future investment and growth, cash
requirements and debt obligations.
Question 2a: Discuss the importance of ratio analysis for inter-firm and intra-firm comparisons
including circumstances responsible for its limitations .If any
Answer:
Ratio analysis implies the systematic use of ratios to interpret the financial statements so that the
strength and weaknesses of a firm as well as its historical performance and current financial
position can be determined.
With the help of ratio analysis conclusion can be drawn regarding several aspects such as
financial health, profitability and operational efficiency of the undertaking.
Ratio analysis is very useful in making inter-firm comparison as it helps to draw a comparison
between the entities within the same industry or otherwise following the same accounting
procedure. It provides the relevant financial information for the comparative firms with a view to
improving their productivity & profitability.
Ratio analysis helps in intrafirm comparison by providing necessary data. An interfirm
comparison indicates relative position. It provides the relevant data for the comparison of the
performance of different departments. If comparison shows a variance, the possible reasons of
variations may be identified and if results are negative, the action may be initiated immediately
to bring them in line.
However, in spite of being such a useful tool, it is not free from its limitations. A single ratio is of
a limited use and it is essential to have a comparative study. The base used for ratio analysis viz:
financial statements have their own limitations. Also, they consider only the quantitative aspects
of business transactions where as there are various other non-quantitative aspects such as quality
of work force which considerably affect profitability and productivity. Also, ratio analysis as a
tool is also limited by changes in accounting procedures/policies.