NCERT Class 12 Accountancy Chapter 7 Financial Statements of a Company

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NCERT Class 12 Accountancy Chapter 7 Financial Statements of a Company

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Financial Statements of a Company

Chapter: 7

PART – II

Short Answer Questions: 

1. State the meaning of financial statements?

Ans: Financial statements are the basic and formal annual reports through which the corporate management communicates financial information to its owners and various other external parties which include investors, tax authorities, government, employees, etc. These refer to, the balance sheet (position statement) as at the end of accounting period, the statement of profit and loss of a company and the cash flow statement. 

2. What are limitations of financial statements?

Ans: Limitations of Financial Statements: Financial statements are not free from limitations. They provide only aggregate information to satisfy the general purpose needs of the users. They are technical statements understood by only persons having some accounting knowledge. They reflect historical information but not current situation, which is essential in any decision making. In addition, one can get idea about the organisation’s performance in terms of quantitative changes but not in qualitative terms like labour relations, quality of work, employees satisfaction, etc. The financial statements are neither complete nor accurate as the flow of income and expenses are segregated using best judgement apart from accepted concepts. Hence, these statements need proper analysis before their use in decisionmaking.

3. List any three objectives of financial statements?

Ans: The specific objectives include the following: 

(i) To provide information about economic resources and obligations of a business: They are prepared to provide adequate, reliable and periodical information about economic resources and obligations of a business firm to investors and other external parties who have limited authority, ability or resources to obtain information. 

(ii) To provide information about the earning capacity of the business: They are to provide useful financial information which can gainfully be utilised to predict, compare and evaluate the business firm’s earning capacity. 

(iii) To provide information about cash flows: They are to provide information useful to investors and creditors for predicting, comparing and evaluating, potential cash flows in terms of amount, timing and related uncertainties.

4. State the importance of financial statements to: 

(i) shareholders.

Ans: Financial statements report the performance of the management to the shareholders. The gaps between the management performance and ownership expectations can be understood with the help of financial statements.

(ii) Creditors.

Ans: Corporate undertakings have to borrow funds from banks and other financial institutions for different purposes. Credit granting institutions take decisions based on the financial performance of the undertakings. Thus, financial statements form the basis for granting of credit.

(iii) government.

Ans: The fiscal policies, particularly taxation policies of the government, are related with the financial performance of corporate undertakings. The financial statements provide basic input for industrial, taxation and other economic policies of the government.

(iv) investors.

Ans: The investors include both short-term and long-term investors. Their prime considerations in their investment decisions are security and liquidity of their investment with reasonable profitability. Financial statements help the investors to assess long term and short-term solvency as well as the profitability of the concern.

5. How will you disclose the following items in the Balance Sheet of a company: 

(i) Current assets, inventory.

Ans: In balance sheet, Asset side.

(a) Current asset: Main head. 

(b) Inventory: Sub head.

(ii) Contingent liabilities in notes to accounts.

Ans: Main head in the notes to account.

(iii) Shareholders Funds, Reserve and Surplus.

Ans: In the balance sheet, Liabilities side.

(a) Shareholders Funds: Main head.

(b) Reserve and Surplus: Sub head. 

(iv) Fixed Assets, Intangible Assets.

Ans: (a) Fixed assets: Sub head.

(b) Intangible Assets: A part of the sub head.

Long Answer Questions

1. Explain the nature of the financial statements.

Ans: The following points explain the nature of financial statements: 

(i) Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books. The original cost or historical cost is the basis of recording transactions. The figures of various accounts such as cash in hand, cash at bank, trade receivables, fixed assets, etc., are taken as per the figures recorded in the accounting books. The assets purchased at different times and at different prices are put together and shown at costs. As these are not based on market prices, the financial statements do not show current financial condition of the concern. 

(ii) Accounting Conventions: Certain accounting conventions are followed while preparing financial statements. The convention of valuing inventory at cost or market price, whichever is lower, is followed. The valuing of assets at cost less depreciation principle for balance sheet purposes is followed. The convention of materiality is followed in dealing with small items like pencils, pens, postage stamps, etc. These items are treated as expenditure in the year in which they are purchased even though they are assets in nature. The stationery is valued at cost and not on the principle of cost or market price, whichever is less. The use of accounting conventions makes financial statements comparable, simple and realistic.

(iii) Postulates: Financial statements are prepared on certain basic assumptions (pre-requisites) known as postulates such as going concern postulate, money measurement postulate, realisation postulate, etc. Going concern postulate assumes that the enterprise is treated as a going concern and exists for a longer period of time. So the assets are shown on historical cost basis. Money measurement postulate assumes that the value of money will remain the same in different periods. Though there is drastic change in purchasing power of money, the assets purchased at different times will be shown at the amount paid for them. While, preparing statement of profit and loss the revenue is included in the sales of the year in which the sale was undertaken even though the sale price may be received over a number of years. The assumption is known as realisation postulate. 

(iv) Personal Judgements: Under more than one circumstance, facts and figures presented through financial statements are based on personal opinion, estimates and judgements. The depreciation is provided taking into consideration the useful economic life of fixed assets. Provisions for doubtful debts are made on estimates and personal judgements. In valuing inventory, cost or market value, whichever is less is being followed. While deciding either cost of inventory or market value of inventory, many personal judgements are to be made based on certain considerations. Personal opinion, judgements and estimates are made while preparing the financial statements to avoid any possibility of over statement of assets and liabilities, income and expenditure, keeping in mind the convention of conservatism.

2. Explain in detail about the significance of the financial statements.

Ans: The various uses and importance of financial statements are as follows: 

(i) Report on stewardship function: Financial statements report the performance of the management to the shareholders. The gaps between the management performance and ownership expectations can be understood with the help of financial statements. 

(ii) Basis for fiscal policies: The fiscal policies, particularly taxation policies of the government, are related with the financial performance of corporate undertakings. The financial statements provide basic input for industrial, taxation and other economic policies of the government.

(iii) Basis for granting of credit: Corporate undertakings have to borrow funds from banks and other financial institutions for different purposes. Credit granting institutions take decisions based on the financial performance of the undertakings. Thus, financial statements form the basis for granting of credit. 

(iv) Basis for prospective investors: The investors include both short-term and long-term investors. Their prime considerations in their investment decisions are security and liquidity of their investment with reasonable profitability. Financial statements help the investors to assess long term and short-term solvency as well as the profitability of the concern. 

(v) Guide to the value of the investment already made: Shareholders of companies are interested in knowing the status, safety and return on their investment. They may also need information to take decision about continuation or discontinuation of their investment in the business. Financial statements provide information to the shareholders in taking such important decisions. 

(vi) Aids trade associations in helping their members: Trade associations may analyse the financial statements for the purpose of providing service and protection to their members. They may develop standard ratios and design uniform system of accounts. 

(vii) Helps stock exchanges: Financial statements help the stock exchanges to understand the extent of transparency in reporting on financial performance and enables them to call for required information to protect the interest of investors. The financial statements enable the Stock brokers to judge the financial position of different concerns and take decisions about the prices to be quoted.

3. Explain the limitations of financial statements.

Ans: Though utmost care is taken in the preparation of the financial statements and provide detailed information to the users, they suffer from the following limitations: 

(i) Do not reflect current situation: Financial statements are prepared on the basis of historical cost. Since the purchasing power of money is changing, the values of assets and liabilities shown in financial statement do not reflect current market situation. 

(ii) Assets may not realise: Accounting is done on the basis of certain conventions. Some of the assets may not realise the stated values, if the liquidation is forced on the company. Assets shown in the balance sheet reflect merely unexpired or unamortised cost. 

(iii) Bias: Financial statements are the outcome of recorded facts, accounting concepts and conventions used and personal judgements made in different situations by the accountants. Hence, bias may be observed in the results, and the financial position depicted in financial statements may not be realistic. 

(iv) Aggregate information: Financial statements show aggregate information but not detailed information. Hence, they may not help the users in decision-making much. 

(v) Vital information missing: Balance sheet does not disclose information relating to loss of markets, and cessation of agreements, which have vital bearing on the enterprise. 

(vi) No qualitative information: Financial statements contain only monetary information but not qualitative information like industrial relations, industrial climate, labour relations, quality of work, etc. 

(vii) They are only interim reports: Statement of Profit and Loss discloses the profit/loss for a specified period. It does not give an idea about the earning capacity over time similarly, the financial position reflected in the balance sheet is true at that point of time, the likely change on a future date is not depicted.

4. Prepare the format of statement of profit and loss and explain its items upto the as certainment of profit before tax. 

Ans: 

	Particulars	Note. No.	Figure as at the end of current reporting period	Figure as at the end of previous reporting period.
(i)	Revenue from operations
(ii)	Other income
(iii)	Total Revenue (I+II)
(iv)	Expenses:  Cost of materials consumed  Purchases of stock-in-trade  Changes in inventories of finished goods  Work-in-progress and stock-in-trade  Employee benefits expense  Finance costs  Depreciation and amortisation expense  Other expenses  Total expenses
(v)	Profit before extraordinary items and tax (III-IV)
(vi)	Exceptional items
(vii)	Profit before extraordinary items and tax (V-VI)
(viii)	Extraordinary items
(ix)	Profit before tax (VII-VIII)
(x)	Tax expense: (1) Current tax (2) Deferred tax
(xi)	Profit/(Loss) for the period from continuing operations (IX-X)
(xii)	Profit/(Loss) from discontinuing operations
(xiii)	Tax expense of discontinuing operations
(xiv)	Profit/(Loss) from Discontinuing operations (after tax) (XII-XIII)
(xv)	Profit/(Loss) for the period (XI + XIV)
(xvi)	Earnings per equity share: (1) Basic(2) Diluted

5. Prepare the format of balance sheet and explain the various elements of balance sheet. 

Ans: 

Particulars	Note No.	Figure as at the end current reporting period	Figure as at the end of previous reporting period
I. EQUITY AND LIABILITIES
(1) Shareholder’s Funds (a) Share Capital (b) Reserves and Surplus (c) Money received against share warrants
(2) Share Application money pending allotment
(3) Non-current Liabilities (a) Long term borrowings (b) Deferred tax liabilities (net) (c) Other long term liabilities (d) Long term provisions
(4) Current Liabilities (a) Short-term borrowings (b) Trade payables (c) Other current liabilities (d) Short-term provisions
Total
II. ASSETS
(1) Non-Current Assets
(a) Fixed assets (i) Tangible assets (ii) Intangible assets (iii) Capital work-in-progress (iv) Intangible assets under development
(b) Non-current investments (c) Deferred tax assets (net) (d) Long-term loans and advances (e) Other non-current assets
(2) Current Assets
(a) Current investments (b) Inventories (c) Trade receivables (d) Cash and cash equivalents (e) Short term loans and advances (f) Other current assets
Total

6. Explain how financial statements are useful to the various parties who are interested in the affairs of an undertaking? 

Ans: The users of financial statements include management, investors, shareholders, creditors, government, bankers, employees and public at large. Financial statements provide the necessary information about the performance of the management to these parties interested in the organisation and help in taking appropriate economic decisions. It may be noted that the financial statements constitute an integral part of the annual report of the company in addition to the directors report, auditors report, corporate governance report, and management discussion and analysis. The fiscal policies, particularly taxation policies of the government, are related with the financial performance of corporate undertakings. Corporate undertakings have to borrow funds from banks and other financial institutions for different purposes. Credit granting institutions take decisions based on the financial performance of the undertakings.  Shareholders of companies are interested in knowing the status, safety and return on their investment. They may also need information to take decision about continuation or discontinuation of their investment in the business. Financial statements provide information to the shareholders in taking such important decisions. 

7. ‘Financial statements reflect a combination of recorded facts, accounting conventions and personal judgements’. Discuss. 

Ans: The chronologically recorded facts about events expressed in monetary terms for a defined period of time are the basis for the preparation of periodical financial statements which reveal the financial position as on a date and the financial results obtained during a period. The American Institute of Certified Public Accountants states the nature of financial statements as, “the statements prepared for the purpose of presenting a periodical review of report on progress by the management and deal with the status of investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgements”. Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books. The original cost or historical cost is the basis of recording transactions. The figures of various accounts such as cash in hand, cash at bank  trade receivables, fixed assets, etc., are taken as per the figures recorded in the accounting books. Certain accounting conventions are followed while preparing financial statements. The convention of valuing inventory at cost or market price, whichever is lower, is followed. The valuing of assets at cost less depreciation principle for balance sheet purposes is followed. The convention of materiality is followed in dealing with small items like pencils, pens, postage stamps, etc.

8. Explain the process of preparing income statement and balance sheet.

Ans: Important Features of Presentation: 

(a) It applies to all Indian companies preparing financial statement as per Schedule III to the Comapnies Act, 2013. 

(b) It does not apply to-

(i) Insurance or Banking Company

(ii) Company for which a form of balance sheet or income statement is specified under any other Act. 

(c) Accounting standards shall prevail over Schedule III of the Companies Act, 2013. 

(d) Disclosure on the face of the financial statements or in the notes are essential and mandatory.

(e) Terms in the revised Schedule III will carry the meaning as defined by the applicable accounting standards. 

(f) Balance to be maintained between excessive details that may not assist users of financial statements and not providing important information. 

(g) Current and non-current bifurcation of assets and liabilities is applicable.

(h) Rounding off requirements is mandatory (refer box 1). 

(i) Vertical format for presentation of financial statement is prescribed (refer Exhibit 3.1). 

(j) Debit balance in the statement of profit and loss to be disclosed as negative figure under the head “Surplus”. 

(k) Mandatory disclosure for share application money pending allotment. 

(l) ‘Sundry Debtors’ and ‘Sundry Creditors’ replaced by terms ‘Trade Receivables’ and ‘Trade Payables’.