1

Submitted to: Sir Kamal Mustaffa

ASSIGNMENT
Section: MBA-1B
Subject: Financial Accounting

Submitted by:

M. Qamar Adeel (FA09-MBA-105) Samra Riaz (FA09-MBA-143)

Kaynat Pervaiz:(FA09-MBA-210) Arsalan Mehmood (FA09-MBA-201)

Wafa Arshad (FA09-MBA-184) Syeda Anum Asim (FA09-MBA-165)

Samar Abdullah (FA09-MBA-159) Yusra Tariq (FA09-MBA-194)

Saqib Zubair (FA09-MBA-145) Sidra Irshad (FA09-MBA-152)

Muhammad Tayyab Saleem (FA09-MBA-113)

 2

We DEDECATE THIS ASSIGNMENT TO All of our

FAMILY
MEMBERS
WHO SUPPORTED us IN EVERY WAY OF LIFE AND DID NOT
LET us DOWN

&
Our teacher Kamal Mustaffa
 3

Acknowledgements

We have the only pearl of eyes to admire the blessing of the Compassionate and
Omnipotent because the words are bound, knowledge is limited and time is
short to express His dignity. All thanks are due only to Almighty Allah, most
gracious, the most merciful, who gave us the strength to do this job.Our special
praise for Holy Prophet Muhammad (Peace Be Upon Him) who is, for even
humanity as a whole.
It is a matter of great honor and pleasure for us to express our ineffable gratitude and
profound indebtedness to our venerable Teacher, Kamaal Mustaffa, we are much
impressed of his intellectual activities, inexhaustible energy to steer forth the
student. His sympathetic and sincerest attitude is highly qualified experience.
 4

Yusra Tariq (FA09-MBA-194)

QUESTION NO: 1 a) - Define what is mean by treasury stock?

A treasury stock is a stock which is bought back by the issuing company, reducing the
amount of outstanding stock on the open market ("open market" including insiders'
holdings). On the balance sheet, treasury stock is listed under shareholder equity as a
negative number. The accounts may be called equity reduction or contra-equity.

Limitations of treasury stock

• Treasury stock does not pay a dividend

• Treasury stock has no voting rights
• Total treasury stock cannot exceed the maximum proportion of total capitalization
specified by law in the relevant country

b) - Define the meaning and purpose of stock split?

A stock split is a decision by the company's board of directors to increase the number of
shares that are outstanding by issuing more shares to current shareholders
A stock split increases the number of shares in a public company. The price is adjusted
such that the market capitalization of the company remains the same after the split, so
that dilution does not occur.

Purpose of stock split:

Stocks split when the boards of directors of a company decide to split the stock to dilute
the shares.
A company feels its stock price is not where it should be, it can consider a stock split.
The number of outstanding shares is increased, while the price of each share decreases. In
a reverse split, the number of shares decreases, raising the value of each share.
A publicly traded company might decide to issue a stock split in the equity markets for
several reasons. If a stock price becomes prohibitively expensive for investors, a stock
split makes the security more affordable. A split also makes a stock easier to trade

c) - Define capital stock and different types of capital stock?

Capital stock:
 5

The common and preferred stock a company is authorized to issue, according to

their corporate charter is known as capital stock. Capital stock are normally listed on a
company's balance sheet.

In financial statement analysis, an increasing capital stock account tends to be a

sign of economic health since the company can use the additional proceeds to invest in
projects or machinery that will increase corporate profits and/or efficiency

Types of capital stock:

The two basic types of capital stock are common stock and preferred stock.

Common stock

A security that represents ownership in a corporation; holders of common stock exercise

control by electing a board of directors and voting on corporate policy. Common
stockholders are on the bottom of the priority ladder if a company fails. In the case of
liquidation, common shareholders get paid after bondholders, preferred shareholders, and
other debt holders.

Preferred stock:
A class of stock that usually pays a higher dividend than the common stock. However,
preferred stock is less liquid and usually doesn't have voting rights.Preferred stock is a
special class of shares that may have any combination of features not possessed by
common stock.
The following features are usually associated with preferred stock.

• Preference to assets in the event of liquidation

• Convertible into common stock.
• Callable at the option of the corporation.
• Nonvoting.
 6

Kaynat Pervaiz: (FA09-MBA-210)

Wafa Arshad (FA09-MBA-184)

QUESTION NO: 2. Explain the following terms in

detail:
MANGAMENT ACCOUNTING:

“Management or Cost accounting is a management

System which analysis data to provide information

as a basis for managerial action. The concern of a

Management accounting information in the form of

most helpful to management”.

The information needs of management go for beyond those of other

account users. Managers have the responsibility of planning and controlling
the resources of business. Therefore, they need much more detailed
information. They also need to plan for the future (e.g. Budgets, which
predict future revenue and expenditure.)

FINANCIAL ACCOUNTING:

“Financial accounting is mainly a method of reporting

the results and financial position of a business”.

 7

It is not primarily concerned with providing information towards the

more efficient running of the business. Although financial accounts

Are of interest to management, their principal function is to satisfy the

information needs of persons not involved in running the business. They
provide historical information.

FINANCIAL REPORTING:

“Financial reporting is a way of recording, analyzing

& summarizing financial data”.

FINANCIAL DATA:

“Financial data is the name given to the actual

Transactions carried out by a business e.g. sales

Of goods, purchases of goods, payments of expenses.”

The transactions are recorded in books of prime entry. The

transactions are analyzed in the books of prime entry and the totals are
posted to the ledger accounts.

Finally, the transactions are summarized in the financial statements.

ACCRUALS CONCEPT:

“In the accruals basis of accounting, items are recognized as assets,

liabilities, equity, income and expenses when they satisfy the definitions and
recognition criteria for those elements in the Framework”.
 8

Entities should prepare their financial statements on the basis that

transactions are recorded in them not as the cash is paid or, received, but as
the revenue or expenses are earned or incurred in the accounting period to
which they relate.

According to accrual assumption, in computing profit revenue earned

must be matched against the expenditure incurred in earning it. This is also
known as matching convention.
 9

Saqib Zubair (FA09-MBA-145)

Muhammad Tayyab Saleem (FA09-MBA-113)

QUESTION NO: 3

ICMA:
Institute of chartered and management
accounting.
ICMA is the professional and educational organization for chief
appointed managers, administrators, and assistants in cities, towns,
countries, and regional entities throughout the world. Since 1914, ICMA
has provided technical and management assistance, training, and information
resources to its members and the local government community. The
management decisions made by ICMA's 9,000 members affect nearly 185
million individuals in thousands of communities--from small towns with
populations of a few hundred to metropolitan areas serving several million.

HOW TO BECOME MEMBER:

The following persons shall be entitled to have to their names entered
in the Register, namely:-

Any person who has passed such examination and completed such
training as may be prescribed for membership of the Institute.

CIA:
Certified Internal Auditor:
A certified internal auditor (CIA) is an individual who has met the
requirements for certification as established by the Institute of Internal
Auditors (IIA). Requirements relate to education, experience, and successful
completion of an examination. Achieving the credential as a certified
internal auditor is tangible evidence of meeting professional qualifications
established by the IIA.
 10

The IIA, established in 1941 at a meeting in New York City, now has
a worldwide membership of more than 70,000 in more than 100 counties.
The CIA examination was first administered in 1974.

HOW TO BECOME MEMBER

CIA candidates must hold a bachelor’s degree (or higher degree) or its
educational equivalent from an accredited college-level institution.

Required Documentation
• Applicants must indicate their highest level of education on the CIA
application.

ACCA:
Association of Chartered Certified Accountants:
The Association of Chartered Certified Accountants (ACCA) is a
British accountancy body which offers the Chartered Certified Accountant
(Designatory letters ACCA or FCCA) qualification worldwide. It is one of
the world's largest and fastest-growing accountancy bodies with 131,500
members and 362,000 affiliates and students in 170 countries (as at February
2009). The Institute's headquarters are in London with the principal
administrative office being based in Glasgow. In addition the ACCA has a
network of nearly 80 staffed offices and other centres around the world.

Membership:
In the first instance, individuals register as student members to
undertake the Professional Scheme qualification. Upon successful
completion of the examinations, student members are automatically
transferred to Affiliate status.

For ACCA affiliates to gain admission to full membership, they must

demonstrate, on the application form that they have obtained a minimum of
three years of acceptable, supervised, practical experience in an accountancy
role (or roles) and have reached the required standard of competence.
 11

CAT:
Certified Accounting Technician:
The Certified Accounting Technician (CAT) qualification is offered
by the Association of Chartered Certified Accountants (ACCA). Upon
completion of the exams and required practical work experience the CAT
graduate will be able to apply to use the letters CAT after his or her name. In
addition, they will have the opportunity to join the CAT alumni.

Although CAT can be obtained as a stand-alone qualification, it is

often the case that individuals study for CAT as an introductionary
qualification in accountancy prior to training to become a Chartered
Certified Accountant through the ACCA Professional Scheme. It usually
takes one and a half years to complete the nine CAT exams. However, there
is no restriction on the number of papers that can be attempted in each
sitting.

CAT's rival is the Association of Accounting Technicians (AAT)

qualification. ACCA was a sponsor of the AAT before breaking its links in
the mid 1990s in order to form the CAT qualification. The rationale behind
this move was that it wanted a technician level qualification which followed
the same strategic direction of the ACCA qualification, ie. one with an
international profile.

The Certified Accounting Technician qualification (CAT) has now

been placed on the Qualifications and Curriculum Authority (QCA) National
Qualifications Framework, which means that publicly funded educational
institutions are now eligible for grants to help them train individuals towards
this qualification in the United Kingdom.
 12

ICAEW:
Institute of Chartered Accountants in England
& Wales:
The Institute of Chartered Accountants in England & Wales (ICAEW)
was established by a Royal Charter in 1880.It has over 130,000 members.
Over 15,000 of these members live and work outside the UK. The Institute
also has some 9,000 students.

The Institute is a member of the Consultative Committee of

Accountancy Bodies (CCAB), formed in 1974 by the major accountancy
professional bodies in the UK and Ireland. The fragmented nature of the
accountancy profession in the UK is in part due to the absence of any legal
requirement for an accountant to be a member of one of the many Institutes.
This is because the term accountant does not have the same legal protection
in the United Kingdom as that given to, say, doctors and lawyers. There are,
though, certain legal rights and duties which are available to professionally
qualified accountants. For example, individuals who operate in the areas of
audit and insolvency must be registered and only members of certain
accountancy bodies (such as the ICAEW) are eligible for such registration.
Likewise individuals who describe themselves as "chartered accountants"
must be a member of an accountancy body which holds a 'Royal Charter'
and if working in public practice these chartered accountants must comply
with additional regulations such as holding indemnity insurance and
submitting to regular and independent inspections.

The ICAEW has 2 offices; the main one is in Moorgate, London and
the other in Central Milton Keynes, in the newly built Hub:MK complex.

ADMISSION TO MEMBERSHIP:
To be admitted to membership of the ICAEW, applicants must
generally complete 450 days of relevant work experience (training) and pass
a series of examinations. The work experience lasts between three and five
years and must be with an employer or employers approved by the Institute
for training. The examinations are in two stages, professional stage
 13

(Twelve papers) and advanced stage (two papers and a case study, which
must be taken in the final year of training).

Existing members of CPA Australia (Subject to meet certain criteria),

ACCA, CIMA and CIPFA of over five years membership may be admitted,
subject to passing an Examination of Experienceand sponsorship by two
ICAEW members. Members of equivalent bodies in other European
Economic Area countries and Switzerland may also be admitted to
membership after passing an aptitude test, provided they are a citizen of an
EEA state or Switzerland.

ICAP:
Institute of chartered accountants of
Pakistan:
The Institute of Chartered Accountants of Pakistan is a
professional accountancy body in Pakistan. By 5 May, 2008, it has total
4393 members working in and outside Pakistan. The institute was
established on July 1, 1961 to regulate the profession of accountancy in
Pakistan. It is a statutory autonomous body established under the Chartered
Accountants Ordinance 1961. With the significant growth in the profession,
the CA Ordinance and Bye-Laws were revised in 1983.

In view of globalization of the accountancy profession, the Institute is

in the process of updating the Ordinance and Bye-Laws once again.

The course of ICAP involves a blend of theoretical education and

practical training which run concurrently for a period of three years and
equips a student with knowledge, ability, skills and other qualities required
of a professional accountant.

The head office of the institute is in Clifton, Karachi where it has its
own premises. The institute also has regional offices at Lahore, Islamabad,
Multan and Faisalabad.

HOW TO BECOME MEMBER:

 14

Those who have completed the prescribed training and have passed all
the prescribed examinations of the Institute will be eligible for Associate
Membership of the Institute. Please ensure the following is taken care of.

AAT:
HOW TO BECOME MEMBER:
There are no minimum entry requirements for the AAT's Education
and Training Scheme, or Diploma, although students are expected to have a
good standard of English.

CFA:
Chartered financial analyst:
Chartered Financial Analyst (CFA) is an international professional
designation offered by CFA Institute (formerly known as AIMR) to financial
analysts who complete a series of three examinations. To become CFA
Charterholder candidates must pass each of three six-hour exams, possess a
bachelor's degree (or equivalent, as assessed by CFA institute) and have 48
months of work experience in an investment decision-making position. CFA
charterholders are also obligated to adhere to a strict Code of Ethics and
Standards governing their professional conduct.

HOW TO BECOME MEMBER:

Based on applicant’s qualifications, CFA institute assigns one of three
types of membership:
• Meet CFA society requirements, which vary by society.

CPA:
Certified Public Accountant:
Certified Public Accountant (CPA) is the statutory title of qualified
accountants in the United States who have passed the Uniform Certified
Public Accountant Examination and have met additional state education and
experience requirements for certification as a CPA. Individuals who have
passed the Exam but have not either accomplished the required on-the-job
experience or have previously met it but in the meantime have lapsed their
continuing professional education are, in many states, permitted the
 15

designation "CPA Inactive" or an equivalent phrase.In most U.S. states, only

CPAs who are licensed are able to provide to the public attestation
(including auditing) opinions on financial statements. The exceptions to this
rule are Arizona, Kansas, North Carolina and Ohio where, although the
"CPA" designation is restricted, the practice of auditing is not.
 16

M. Qamar Adeel (FA09-MBA-105)

Arsalan Mehmood (FA09-MBA-201)

QUESTION NO: 4a) DEFINE THE ROLE AND IMPORTANCE OF

ACCOUNTING STANDARDS IN THE REPARATION OF
FINANCIAL STATEMENTS?

Accounting standards came to be developed from the mid sixties

onwards to promote the reliability of the accounting profession by way of
ensuring uniformity in the way accountants report transactions in their books
and also in their preparation of the final accounts of businesses. This is by
and large aimed at boosting the confidence of stakeholders, particularly
shareholders and potential investors in the accounting profession.

Good and useful information should have the essential characteristics

of understandability, comparability, relevance and reliability in order to play
its role effectively.

Accounting standards serve to promote the understandability,

comparability, relevance and reliability of financial reports.

Objective of accounting standards is to standardize the various

accounting policies and practices with a view to climinate to the level
possible the non-comparability of financial statements and the reliability to
the financial statements.

OBJECTIVES AND IMPACT OF ACCOUNTING

STANDARDS:-
At the firm level, Accounting standards improve the accountability of
individual business enterprises and their managements to investors and
creditors. By promoting accurate reporting, accounting standards assist the
management of a business entity to maximize the wealth of the entity and to
put in place effective and efficient corporate governance arrangements. At a
broader level, Accounting standards are central to the provision of accurate,
transparent and reliable information to the market as a whole. In this regard,
a well informed market will generally be an efficient one.
 17

Accounting standards that result in the provision of accurate and

comparable information about the true financial performance and position of
business entities promote investor confidence and market integrity, thereby
ultimately reducing the costs of capital throughout the economy. Public
confidence in the integrity of the financial reporting framework is central to
maintaining and expanding a sophisticated domestic capital market.

b). WHAT IS IFRS? HOW IFRS IS DIFFERENT FROM ICAP

ACCOUNTING STANDARDS?

An International Financial Reporting Standard (IFRS) is

an accounting standard set by the International Accounting Standards Board.
IFRS has replaced the older term International Accounting Standard (IAS).
IFRSs are compulsory for listed companies in the EU, and most national
accounting standards globally are also converging on IFRSs. IFRSs have
been adopted by many other national accounting standards bodies. In the
US, the Financial Accounting Standards Board is working towards
converging US GAAP with IFRSs. Japanese accounting standards have been
extensively revised to bring them into line with IFRSs. In the rest of the
world IFRSs are either being incorporated into national standards or national
standards are being gradually converged with IFRSs.
The advantages to investors are clear. IFRSs make it easier to
compare the accounts of companies in different countries. They also
incorporate many improvements on most current standards. As things stand,
the problem of differences in accounting standards will continue to exist for
some time.
US standards will take some years to fully converge with IFRSs and
some other countries will take even longer. IFRSs currently allow a number
of choices (alternative standards) that will need to be gradually eliminated to
provide true uniformity.

Major changes in the UK that resulted from the adoption of IFRSs

include.
The treatment of goodwill
The value of options issued as remuneration being shown as a cost on
the face of the P & L.
The use of fair value rather than book value for assets acquired in
a takeover
Valuation of embedded options.
 18

How IFRS different from ICAP accounting standards?

Adoption of IFRS are used in many parts of the world, including the
European Union, Hong Kong, Australia, Malaysia, Pakistan, GCC countries,
Russia, South Africa, Singapore and Turkey. As of 27 August 2008, more
than 11 countries around the world, including all of Europe, currently
require or permit IFRS reporting. Approximately 85 of those countries
require IFRS reporting for all domestic, listed companies.

GAAP IFRS

Principle of prudence IFRS/IAS F16

PROPERTY PLANT AND
EQUIPMENT

Principle of Going Concern IFRS/IAS 40

INVESTMENT PROPERTY

Principle of Full Disclosure/Materiality IFRS/IAS 10

EVENTS AFTER THE REPORTING
PERIOD

Principle of consistency IFRS/IAS 18

REVENUE

NAME OF FIVE ACCOUNTING STANDARDS

IAS 11 Construction Contracts
IAS 19 Employee Benefits (revised 2004)
IAS 28 Accounting for Investments in Associates (revised 2003, effective 2005)
IAS 40 Investment Property (revised 2003, effective 2005)
IAS 29 Financial Reporting in Hyperinflationary Economies
 19

Samar Abdullah (FA09-MBA-159)

Samra Riaz (FA09-MBA-143)

Syeda Anum Asim (FA09-MBA-165)

QUESTION NO: 5a) WHAT IS MEAN BY CREATIVE

ACCOUNTING? WHAT ARE THE MODES OF CREATIVE
ACCOUNTING?

Definition:

The use of aggressive and/or questionable accounting techniques in order to produce a

desired result, generally high earnings per share. Creative accounting may include selling
assets with a low cost basis, shipping unusually large quantities of product near the end of the
year, and failure to write down inventories that have declined in value.

The practice of recognizing revenue in a way that makes a company look better than it is
while still conforming to the GAAP. Creative accounting seeks to inflate stock prices, for
example, by selling assets at the end of a year to create a profit that offsets a loss. One could
argue that creative accounting hides a company's true financial state, but, unlike aggressive
accounting, creative accounting is generally legal. It is also called financial engineering

Creative accounting, also called aggressive accounting, is the manipulation of financial

numbers, usually within the letter of the law and accounting standards but very much against
their spirit and certainly not providing the “true and fair” view of a company that accounts
are supposed to.

A typical aim of creative accounting will be to inflate profit figures. Some companies
may also reduce reported profits in good years to smooth results. Assets and liabilities may
also be manipulated, either to remain within limits such as debt covenants, or to hide
problems.

Typical creative accounting tricks include off balance sheet financing, over-optimistic
revenue recognition and the use of exaggerated non-recurring items.

The term “window dressing” has similar meaning when applied to accounts, but is a
broader term that can be applied to other areas. In the US it is often used to describe the
manipulation of investment portfolio performance numbers. In the context of accounts,
“window dressing” is more likely than “creative accounting” to imply illegal or fraudulent
practices, but it need to do so.
 20

The techniques of creative accounting change over time. As accounting standards change,
the techniques that will work change. Many changes in accounting standards are meant to
block particular ways of manipulating accounts, which means those intent on creative
accounting need to find new ways of doing things. At the same time, other, well intentioned,
changes in accounting standards open up new opportunities for creative accounting (the use
of fair value is a good example of this).

Many (but not all) creative accounting techniques change the main numbers shown in the
financial statements, but make themselves evident elsewhere, most often in the notes to the
accounts. The market has been surprised before by bad news hidden in the notes, so a diligent
approach can give you an edge.

Earnings management usually involves

1. the artificial increase (or decrease) of

• revenues,
• profits,
• r earnings per share figures through aggressive accounting tactics. Aggressive
earnings management is a form of fraud and differs from reporting error.

The main forms of creative accounting are as follows:

• Unsuitable revenue recognition

• Inappropriate accruals and estimates of liabilities
• Excessive provisions and generous reserve accounting
• Intentional minor breaches of financial reporting requirements that aggregate to a
material breach.

b)- FACTORS GIVING RISE TO CREATIVE ACCOUNTING:

1.Management wishing to show earnings at a certain level or following a certain

pattern seek loopholes in financial reporting standards that allow them to
2. adjust the numbers as far as is practicable to achieve their desired aim
3. or to satisfy projections by financial analysts. These adjustments amount to
fraudulent financial reporting when they fall 'outside the bounds of acceptable
accounting practice'.
Drivers for such behaviour include market expectations, personal realisation of a bonus,
and maintenance of position within a market sector. In most cases conformance to
acceptable accounting practices is a matter of personal integrity. Aggressive earnings
management becomes more probable when a company is affected by a downturn in
business.
21
 22

Sidra Irshad (FA09-MBA-152)

Question No. 6:- Part (a)

I) Define authorized capital.

Answer:
It is the amount of capital with which the company is registered. This
capital is mentioned in the memorandum of association. A mention is also
made of the number of shares into which this total capital is divided, and the
par values of shares. In later years, if the company wants to either increase
or decrease this capital, certain legal requirements must be met. This capital
is also known as nominal capital or registered capital.
II) Define Issued capital.

Answer:
Shared offered to the general public for contribution are known
as shares issued. The total par value of such shares is called issued capital.
To begin with, a company seldom offers all of its shares for subscription.
Therefore, the amount of issued capital is generally less than the authorized
capital. If a company has an authorized capital of Rs. 10,00,000 divided into
10,000 shares of Rs. 100 each, it may decide to offer 5,000 shares to the
general public. In this case the issued capital is said to be Rs. 5, 00,000
divided into 5,000 shares of Rs. 100 each. The remainder, that is, the
difference between the authorized and issued capital is known as unissued
capital.
III) Define Called-up capital.

Answer:
A company may require payment of the par value either in
installments or in, lump sum. This amount is known as the called-up capital.
For example, for each of the 4,500 shares taken up by the public the
company may require a payment of Rs. 70 per share (the remainder Rs. 30
per share to be paid when asked for by the company. In this case the called-
up capital of the company is Rs. 3,15,000 (4,500 x Rs. 70 per share called-
up). The difference between the subscribed capital and the called-up capital
is known as un-called capital. In this case the un-called capital is Rs.
1,35,000 (Rs. 4,50,000 subscribed capital minus Rs. 3,15,000 called-up
capital or 4,500 shares subscribed x Rs. 30 per share
 23

un-called capital. According to Companies Ordinance, 1984, shares are

always issued at full price (full amount is called upon application).
Therefore, there is no difference between subscribed and called capital.

IV) Define Paid-up capital.

Answer: -
The total amount received by the company out of the total called-up
amount is known as the paid-up capital. Assuming that of Rs. 3,15,000
called-up capital the company received Rs. 3,00,000; the paid-up capital is
in the amount of Rs. 3,00,000. The remainder of Rs. 15,000 is known as
calls unpaid or calls in arrears. Now-a-days the total par value is collected at
the time of application and as such practically there are no calls in arrears.
Presently, therefore, the subscribed, called-up and paid-up capitals are in the
same amount.

Part (b)
I) What are the advantages of ratio analysis?

Answer: Ratio analysis is one of the techniques of financial analysis to

evaluate the financial condition and performance of a business concern.
Simply, ratio means the comparison of one figure to other relevant figure or
figures.

According to Myers, “Ratio analysis of financial statements is a study of

relationship among various financial factors in a business as disclosed by a
single set of statements and a study of trend of these factors as shown in a
series of statements."

Advantages of Ratio Analysis

There are various groups of people who are interested in analysis of

financial position of a company. They use the ratio analysis to workout a
particular financial characteristic of the company in which they are
interested. Ratio analysis helps the various groups in the following manner: -

1. To workout the profitability: Accounting ratio help to measure the

profitability of the business by calculating the various profitability
ratios. It helps the management to know about the earning capacity of
 24

the business concern. In this way profitability ratios show the actual
performance of the business.
2. To workout the solvency: With the help of solvency ratios, solvency
of the company can be measured. These ratios show the relationship
between the liabilities and assets. In case external liabilities are more
than that of the assets of the company, it shows the unsound position
of the business. In this case the business has to make it possible to
repay its loans.
3. Helpful in analysis of financial statement: Ratio analysis help the
outsiders just like creditors, shareholders, debenture-holders, bankers
to know about the profitability and ability of the company to pay them
interest and dividend etc.
4. Helpful in comparative analysis of the performance: With the help
of ratio analysis a company may have comparative study of its
performance to the previous years. In this way company comes to
know about its weak point and be able to improve them.
5. To simplify the accounting information: Accounting ratios are very
useful as they briefly summarise the result of detailed and complicated
computations.
6. To workout the operating efficiency: Ratio analysis helps to
workout the operating efficiency of the company with the help of
various turnover ratios. All turnover ratios are worked out to evaluate
the performance of the business in utilising the resources.
7. To workout short-term financial position: Ratio analysis helps to
workout the short-term financial position of the company with the
help of liquidity ratios. In case short-term financial position is not
healthy efforts are made to improve it.
8. Helpful for forecasting purposes: Accounting ratios indicate the
trend of the business. The trend is useful for estimating future. With
the help of previous years’ ratios, estimates for future can be made. In
this way these ratios provide the basis for preparing budgets and also
determine future line of action.
II) What are the Limitations of ratio analysis?

Answer: In spite of many advantages, there are certain limitations of the

ratio analysis techniques and they should be kept in mind while using them
in interpreting financial statements. The following are the main limitations
of accounting ratios:
 25

1. Limited Comparability: Different firms apply different accounting

policies. Therefore the ratio of one firm can not always be compared
with the ratio of other firm. Some firms may value the closing stock
on LIFO basis while some other firms may value on FIFO basis.
Similarly there may be difference in providing depreciation of fixed
assets or certain of provision for doubtful debts etc.
2. False Results: Accounting ratios are based on data drawn from
accounting records. In case that data is correct, then only the ratios
will be correct. For example, valuation of stock is based on very high
price, the profits of the concern will be inflated and it will indicate a
wrong financial position. The data therefore must be absolutely
correct.
3. Effect of Price Level Changes: Price level changes often make the
comparison of figures difficult over a period of time. Changes in price
affect the cost of production, sales and also the value of assets.
Therefore, it is necessary to make proper adjustment for price-level
changes before any comparison.
4. Qualitative factors are ignored: Ratio analysis is a technique of
quantitative analysis and thus, ignores qualitative factors, which may
be important in decision making. For example, average collection
period may be equal to standard credit period, but some debtors may
be in the list of doubtful debts, which is not disclosed by ratio
analysis.
5. Effect of window-dressing: In order to cover up their bad financial
position some companies resort to window dressing. They may record
the accounting data according to the convenience to show the
financial position of the company in a better way.
6. Costly Technique: Ratio analysis is a costly technique and can be
used by big business houses. Small business units are not able to
afford it.
7. Misleading Results: In the absence of absolute data, the result may be
misleading. For example, the gross profit of two firms is 25%.
Whereas the profit earned by one is just Rs. 5,000 and sales are Rs.
20,000 and profit earned by the other one is Rs. 10,00,000 and sales
are Rs. 40,00,000. Even the profitability of the two firms is same but
the magnitude of their business is quite different.
8. Absence of standard university accepted terminology: There are no
standard ratios, which are universally accepted for comparison
 26

purposes. As such, the significance of ratio analysis technique is

reduced.

References:
http://www.ifrsaccounting.com
http://www.ifrs.com
http://www.wikipedia.com
Question No.6
Part(a): Advanced Accounting written by M. Arif & Sohail Afzal
Part(b): Accounts Theory written by Naresh Khurana from website
http://www.universalteacher4u.com/cbse/xii/acctheory/main.htm