Concept of Conservatism implies using conservatism while preparingfinancial statements i.e.

income
should not be accounted for unless it hasactually been earned but expenses, even if just anticipated
should beprovided for. According to this concept, revenues should be recognized onlywhen they are
realized, while expenses should be recognized as soon asthey are reasonably possible. For instance,
suppose a firm sells 100units of aproduct on credit for Rs.10, 000. Until the payment is received, it will not
berecorded in the accounting books. However, if the firm receives informationthat 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 isto recognize revenue when it is reasonably certain and recognize expensesas 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

Answer2: 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
a. Sundry Creditors
b. Outstanding Expenses
c. Provision for Tax
Similarly, items in a Funds Flow Statement are:

4 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 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

5
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.
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 3a: From the ratios and other data given below for Bharat Auto Accessories Ltd. indicate your
interpretation of the company's financial position, operating efficiency and profitability. Year I Year II Year
III Current Ratio 265% 278% 302% Acid Test Ratio 115% 110% 99% Working Capital Turnover (times)
2.75 3.00 3.25 Receivables Turnover 9.83 8.41 7.20

7
Average Collection Period (Days) 37 43 50 Inventory to Working Caital 95% 100% 110% Inventory
Turnover times 6.11 6.01 5.41 Income per Equity Share 5.10 4.05 2.50 Net Income to Net Worth 11.07
8.5% 7.0% Operating Expenses to Net Sales 22% 23% 25% Sales increase during the 10% 16% 23%
Cost of goods sold to Net Sales 70% 71% 73% Dividend per share Rs. 3 Rs.3 Rs.3 Fixed Assets to Net
Worth 16.4% 18% 22.7% Net Profit on Net Sales 7.03% 5.09% 2.0% Answer:
The financial position of a concern is mainly judged by its current ratio, acid test ratio, working capital
turnover ,fixed assets to net worth. In the given case of Bharat Auto Accessories Ltd, the current ratio has
gone up from 265% to 302% over a period of three years. It is a measure of the degree to which current
assets cover current liabilities (Current Assets / Current Liabilities). A high ratio indicates a good
probability the enterprise can retire current debts. However, the acid test ratio has gone down from 115%
to 99%, which is not a very good sign. It is a measure of the amount of liquid assets available to offset
current debt (Cash + Accounts Receivable / Current Liabilities). A healthy enterprise will always keep this
ratio at 1.0 or higher. Also, the fixed asset to net worth ratio is 16.4% for Yr. I and has gone up to 22.7%
for Yr. III. This ratio is a measure of the extent of an enterprise's investment in non-liquid and often over
valued fixed assets
(Fixed Assets / Liabilities + Equity). A ratio of .75 or higher is usually undesirable as it indicates possible
over-investment. The operating efficiency of a concern can be viewed by its receivables turnover, average
collection period, inventory turnover, operating expenses to net sales. The receivables turnover has gone
down from 9.83 to 7.20, reflecting that expenses as a percentage of revenue or earnings has gone down
over the three year period, which is a good sign. An increasing average collection period indicates that the
concern is offering too liberal credit terms and has inefficient credit collection. The inventory turnover has
gone down from 6.11 to 5.41 times indicating declining sales and excessive inventory which again reflects
poor operating efficiency. The operating expense to net sales has increased from 22% to 25% which
indicates that the organization has lowered its ability to generate profits in case of declining revenues.
The indicators of profitability are income per equity share, net income to net worth, and net profit on net
sales. All these ratios have declined considerably over the three year period. This indicates declining
profitability over the years. Thus, on a review of the various ratios, we conclude that Bharat Auto
Accessories Ltd does not have a strong financial position, is not very efficient in its operations and is
undergoing a period of declining profitability.
Question 4: Trading and Profit and Loss Account for the yr ended 31
st
Mar 2004 Answer)

Trading and Profit and Loss Account for the yr ended 31

st
Mar 2004
Dr. Cr.

9
PARTICULARS AMOUNT PARTICULARS AMOUNT
To opening stock 1,50,000 By Cash Sales 61,000 To purchases 3,69,000 By Credit Sales 7,80,000 To
wages 1,80,000 To salaries 1,50,000 By closing stock 1,40,000 To Sunday office expenses 1,08,750 To
Gross Profit c/d 23,250 TOTAL 9,81,000 TOTAL 9,81,000 To Discount allowed 7,000 By Gross Profit b/d
23,250 To Bad debts w/o 8,000 By Discount received 4,000 To Depreciation By misc income 2,000

Furniture @5% 2,000 By net loss c/d 26,750

36,500 To interest on loan from Dass 4,500 TOTAL 58,500 TOTAL 58,500
Balance Sheet as at 31
st
Mar 2004 LIABILITIES AMOUNT ASSETS AMOUNT
OWNERS CAPITAL FIXED ASSETS Op balance 5,16,000 Machinery 3,45,000 Less drawings 40,000
Less dep 34,500 Less loss 26,750
4,49,250
Net block 3,10,500 Furniture 40,000 UNSECURED LOAN Less dep 2,000 Dass @9%
1,00,000

Net block 38,000

3,48,500
INVESTMENTS CURRENT LIABILITIES & PROVISIONS CURRENT ASSETS,LOANS & ADVANCES
Sundry Creditors
1,25,000
Stock
1,40,000
Wages outstanding
20,000
Sundry Debtors
1,93,000
Interest on loan
4,500
Bank
16,000
Unexpired insurance
1,250 TOTAL 6,98750 TOTAL 6,98,750

10
WORKING NOTES:
1)

Opening balance of Owners capital = stock + debtors + bank + machinery + furniture sundry creditors =
1,50,000 +1,81,000+5,000 +2,50,000+40,000-1,10,000 =5,16,000
Question (5a) What procedure would you adopt to study the liquidity of a business firm? Answer:
Liquidity is the ability of the firm to convert assets into cash. It is also called marketability or short-term
solvency. In other words, it is the ability of the firm to meet its day-to-day obligations. In order to study the
liquidity of the firm, we need to thoroughly examine its asset structure, mainly the current assets. The

current assets, viz: stock, debtors, bank balance and other current assets need to be seen to determine at
what rate a firm can convert these into cash. A business that collects its accounts receivable in an
average of 20 days generally has more cash on hand than a business that requires 45 days. Similarly, a
business that turns over its inventory 15 times a year has more cash on hand than a company that turns
its inventory only 10 times a year. A business which keeps surplus cash or an idle bank balance may be
readily able to meet its short-term or daily obligations but it is not effectively utilizing its cash flow. Another
factor to determine the liquidity is to see the profitability of the firm. The more profitable the firm is, the
more cash resources it shall have. Last, but not the least, we use make use of certain financial ratios like
current ratio, quick or acid-test ratio, net working capital to determine the liquidity of the firm.

12
due within one year. In general, businesses prefer to have at least one dollar of current assets for every
dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current
ratio significantly higher than the industry average could indicate the existence of redundant assets.
Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.
Formula
Current Assets Current Liabilities
Acid Test or Quick Ratio
A measurement of the liquidity position of the business.

The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities.
The primary difference between the current ratio and the quick ratio is the quick ratio does not include
inventory and prepaid expenses in the calculation. Consequently, a business's quick ratio will be lower
than its current ratio. It is a stringent test of liquidity.
Formula
Cash + Marketable Securities + Accounts Receivable Current Liabilities
Cash Ratio

Indicates a conservative view of liquidity such as when a company has pledged its receivables and its
inventory, or the analyst suspects severe liquidity problems with inventory and receivables.

Formula

Cash Equivalents + Marketable Securities Current Liabilities

Working Capital

Working capital compares current assets to current liabilities, and serves as the liquid reserve available to
satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable
to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a
firm can pay its current liabilities when due.
Formula

13 Current Assets - Current Liabilities

14
Assignment - B Answer 1:
1)

Bank balance as per pass book of Priya & Co. as on 28

th
Feb.2008 : (Rs.) (Rs.) Cr. Balance as per cash book on 28
th
Feb 15,000 Less: interest charged by bank not recorded in cash book 500 Bank charges made by bank
not recorded in cash book 125 Cheques paid into bank but not yet credited 6,250

6,875 8,125 Add: Cheques issued but not yet presented 7,500 Dividends collected directly by bank 4,500
12,000 Bank balance as per pass book of Priya & Co as on 28
th
Feb 2008 20,125
Answer 2a:

Decision whether new product should be introduced Sale price of new product 2000@Rs.60 =
Rs.1,20,000 Less: Direct costs Direct material 2000@16 =Rs.32,000 Direct labour 2000@15
=Rs.30,000 Direct expenses 2000@1.5 =Rs. 3,000 Rs.65,000 Indirect costs-Variable factory overheads
2000@2.00 =Rs. 4,000 Variable selling & distribution overheads 2000@1.50 =Rs. 3,000 Rs. 7,000
Rs.72,000 CONTRIBUTION from new product = Rs.48,000
Answer 2b)
Profitability Profits from present production Sales 5,40,000 Direct material 96,000 Direct labour 1,20,000
Direct expenses 19,000 2,35,000 Variable factory ohds 25,000

17 Inventory should be valued at lower of cost or net realisable value. Inventory should be valued on
FIFO (First in First Out) method or weighted average method. [LIFO is not permitted]. According to AS-2,
inventory of raw materials should be valued at cost, without considering excise duty, as manufacturer has
availed credit of the same. However, this reduces value of stock and hence profits are lower.

18
CASE STUDY
Question 1: Describe the impact of different types of standards on motivations, and specifically, the likely
effect on motivation of adopting the labor standard recommended for Geeta & Company by the
engineering firm. Answer:
Different standards have different impact on motivation. In the given case, where the labor standard
recommended by the engineering firm is adopted by Geeta & company, the six-month operation period
showed a decline in production and an unfavourable quantity variance for each of the six months in the
said period. In the other case where the management used the internally set labour standard, there was a
favourable quantity variance for the first three months ; thereby implying that the actual production was
more than the standard producton. In the fourth month, there was no variance in production and in the
fifth and sixth month, there was an unfavourable variance, thereby implying that the actual production was
less than standard production. Thus, we see that the standard recommended by the engineering firm had
a negative impact on motivation as it was less than the standard production. But, in the case of internally
set standards, there was a positive impact on motivation for first three months; neutral in the fourth month;
and negative impact in fifth and sixth month.
Question 2: Please advise the company in reviewing the standards.

19
Answer:
The labour standard recommended by the consulting firm should not be used as a motivational device as
it is having a negative impact. The cost standard used for reporting had a positive or neutral impact for
greater part of the period and a negative impact for two months. Therefore, the company should try and
adopt labour standards similar to those ones.
Assignment - C
1 d) Assets are measured using the cost concept. 2 a) Overstatement of Capital d) Understatement of
Assets 3 d) Assets = Liabilities + Owners' Equity. 4 c) Net income increases retained earnings on the
statement of retained

earnings, which ultimately increases retained earnings on the balance sheet. 5 d) Journalizing 6 d) Most
likely an error was- made in posting journal entries to the general ledger or in preparing the trial balance 7
c) Supplies, Rs2, 300; Supplies Expense, Rs6, 500. 8 d) Fund decreases 9 a)Cash 10 a) All sources and
uses of resources 11 c) Interest expense 12 d) All of the above 13 b) Accommodate changes in activity
levels 14 d) One place that the reader of an annual report would be able to identify that a company
changed inventory methods is the footnotes to the financial statements. 15 b) Will be recorded in a contra
account, Discount on Notes Receivable, by Co 16 b)Balance sheet and statement of cash flows. 17 c)
Has no affect on working capital at all. 18 b) The company produced more sales in 2006 for each dollar
invested in assets. 19 a) Rs. 170 unfavorable

21 20 b) Standards are developed using past costs and are available at a relatively low cost.
21 c)
help in fixing selling price
.
22 c) Direct wages and production overheads. 23. b) Imputed cost. 24 c) Arise from additional capacity.
25 c) Recovered from the customer. 26 d) Nowhere in the Cash Book. 27 b) Rs.26, 220 28 c)
Commission. 29 b) Liabilities. 30 c) When the goods are transferred from the seller to the buyer. 31 a)
Petty cash. 32 d) both a and b above. 33 a) the corporation must have adequate retained earnings. 34 c)
Operating activities. 35 d) Additional information. 36 d) All of the above. 37 c) Nominal Accounts. 38 d)
Both (a) and (b) above. 39 c) Both (a) and (b) above. 40 d) All of the abov