Notes And Questions NCERT Class 12 Accountancy Chapter 3 Financial Statements of a Company

Please refer to Financial Statements of a Company Class 12 Accountancy notes and questions with solutions below. These revision notes and important examination questions have been prepared based on the latest Accountancy books for Class 12. You can go through the questions and solutions below which will help you to get better marks in your examinations.

Class 12 Accountancy Financial Statements of a Company Notes and Questions

Financial Statements

Meaning
The statements which are prepared to ascertain the profit earned or loss suffered and position of assets and liabilities at a particular date are known as financial statements. These are the final product of accounting process.
A set of financial statements as per Section 2(40) of the Companies Act, 2013 include
i. Balance sheet i.e. position statement
ii. Statement of profit and loss i.e. income statement
iii. Notes to accounts
iv. Cash flow statement
Section 129 of the Companies Act, 2013 requires the company to prepare its financial statements every year in prescribed form i.e. Schedule III of the Companies Act, 2013.

Characteristics of Financial Statements
i. Financial statements are historical documents as they relate to past period.
ii. Financial statements are prepared in monetary terms.
iii. Balance sheet reveals the financial position and statement of profit and loss shows the profitability of the business organisation.
Nature of Financial Statements
i. Recorded facts
ii. Accounting conventions
iii. Postulates

Objectives of Financial Statements
i. Financial statements provide the information about the earning capacity of the business.
ii. Financial statements provide the information about the economic resources and obligation of an en-terprise.
iii. Financial statements also provide the information about the cash flows.
iv. Financial statements supply the information useful for judging the management’s ability to utilise the resources of business effectively.
v. Financial statements have to report the activities of the business organisation affecting the society, which is important in its social environment.

Uses and Importance of Financial Statements
i. Report on stewardship function
ii. Basis for fiscal policies
iii. Basis of granting of credit
iv. Basis for prospective investors
v. Guide to the value of the investment already made
vi. Aids trade associations in helping their members

Financial statement analysis

Meaning:
Financial statement analysis is a judgmental process which aims to estimate current and past financial posi-tions and the results of the operation of an enterprise, with primary objective of determining the best possible estimates and predictions about the future conditions. It essentially involves regrouping and analysis of in-formation provided by financial statements to establish relationships and throw light on the points of strengths and weaknesses of a business enterprise, which can be useful in decision-making involving com-parison with other firms (cross sectional analysis) and with firms’ own performance, over a time period (time series analysis).

Features
1. To present the complex data contained in financial statements in simple and understandable form.
2. To classify the items contained in financial statements in convenient and rational groups
3. To make comparisons between various groups to draw variousconclusions.

Objectives:
– To assess the current profitability and operational efficiency of the firm as a whole as well as its different departments so as to judge the financial health of the firm.
– To ascertain the relative importance of different components of the financial position of the firm.
– To identify the reasons for change in the profitability/financial position of the firm.
– To judge the ability of the firm to repay its debt and assessing the short-term as well as the long-term liquidity position of the firm.

Importance:
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the various items of the balance sheet and the statement of profit and loss. Financial analysis can be undertaken by management of the firm, or by parties outside the firm, viz., owners, trade creditors, lenders, investors, labour unions, analysts and others. The nature of analysis will differ de-pending on the purpose of the analyst.
Financial analysis is useful and significant to different users in the following ways:

(a) Finance manager: Financial analysis focusses on the facts and relationships related to managerial performance, corporate efficiency, financial strengths and weaknesses and creditworthiness of the company. A finance manager must be well-equipped with the different tools of analysis to make rational decisions for the firm. The tools for analysis help in studying accounting data so as to deter-mine the continuity of the operating policies, investment value of the business, credit ratings and testing the efficiency of operations. The techniques are equally important in the area of financial control, enabling the finance manager to make constant reviews of the actual financial operations of the firm to analyse the causes of major deviations, which may help in corrective action wherever indicated.

(b) Top management: The importance of financial analysis is not limited to the finance manager alone. It has a broad scope which includes top management in general and other functional managers. Man-agement of the firm would be interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most efficiently and that the firm’s finan-cial condition is sound. Financial analysis helps the management in measuring the success of the company’s operations, appraising the individual’s performance and evaluating the system of internal control.

(c) Trade payables: Trade payables, through an analysis of financial statements, appraises not only the ability of the company to meet its short-term obligations, but also judges the probability of its con-tinued ability to meet all its financial obligations in future. Trade payables are particularly interested in the firm’s ability to meet their claims over a very short period of time. Their analysis will, there-fore, evaluate the firm’s liquidity position

(d) Lenders: Suppliers of long-term debt are concerned with the firm’s longterm solvency and survival. They analyse the firm’s profitability over a period of time, its ability to generate cash, to be able to pay interest and repay the principal and the relationship between various sources of funds (capital structure relationships). Long-term lenders analyse the historical financial statements to assess its future solvency and profitability.

(e) Investors: Investors, who have invested their money in the firm’s shares, are interested about the firm’s earnings. As such, they concentrate on the analysis of the firm’s present and future profitabil-ity. They are also interested in the firm’s capital structure to ascertain its influences on firm’s earning and risk. They also evaluate the efficiency of the management and determine whether a change is needed or not. However, in some large companies, the shareholders’ interest is limited to decide whether to buy, sell or hold the shares.

(f) Labour unions: Labour unions analyse the financial statements to assess whether it can presently afford a wage increase and whether it can absorb a wage increase through increased productivity or by raising the prices.

(g) Others: The economists, researchers, etc., analyse the financial statements to study the present busi-ness and economic conditions. The government agencies need it for price regulations, taxation and other similar purposes.

Limitations of Financial Analysis
Financial analysis helps the interested parties to make an assessment of the eaming capacity and financial soundness of a business enterprise. But such analysis has its own limitations. Such limitations should be kept in mind while using the informations provided by the financial analysis. Some of the limitations are as follows:

(1) Limitations of Financial Statements:
Financial analysis is based on financial statements. But financial statements themselves suffer from certain limitations, hence the limitations of financial statements are also the limitations of their anal-ysis. For example, (a) Sometimes the informations given in financial statements are incomplete and unauthentic, (b) Financial Statements are based on accounting concepts and conventions. As such, the utility of financial analysis is decreased due to the shortcomings of financial statements.

(2) Affected by Window-dressing:
Some firms resort to window-dressing their financial statements to cover up bad financial position on the eve of accounting date. For example, they may not record the purchases made at the end of the year or they may overvalue their closing stock. In such cases, the results obtained by analysis of financial statements will be misleading.
It is clear from the above mentioned limitations that the results analysis of financial should not be taken as the true in strength and weaknesses of the concern. The results obtained from and read carefully and cautiously. The limitations of analysis must be kept taking decisions based on the results obtained from such analysis.

(3) Do not Reflect Changes in Price Level:
Figures given in financial statements do not show the effect of changes in price level. As such, the comparison of past year figures with current year figures may lead to misleading conclusions. For example, if in 2021 a firm sells 10,000 metre of cloth for 10 lakhs and the same firm in 2022 sells the same type of 10,000 metre of cloth for 15 lakhs, it discloses an increase of 50% in sales, whereas, in actual, the sales have not increased at all. As such, sufficient adjustments must be made for changes in price level before making the analysis.

(4) Different Accounting Policies:
If two firms adopt different accounting policies, the comparison between the two will be unreliable. For example, one firm may provide depreciation on original cost method, whereas the other firm may adopt the written-down value method for providing the depreciation. Similarly, the method of valu-ation of closing stock may also differ from one firm to another. The results obtained from the com-parison of the financial statements of such firms may give misleading picture.

(5) Effect of Personal Ability and Bias of the Analyst:
Figures given in financial statements do not speak by themselves, hence, any conclusion can be drawn from these figures. Conclusions obtained from the analysis of these figures are affected to a great extent by the personal ability and knowledge of the analyst. For example, for calculating ‘return on capital’ one analyst may consider the profits after taxes, whereas, the other analyst may consider the profits before taxes. Similarly, the term “Capital’ may mean only the “Shareholder’s Funds’ for one analyst, whereas the other analyst may take the ‘Shareholder’s Funds and Long Term Debts’ as capital.

(6) Difficulty in Forecasting:
Financial statements are a record of past events and historical facts. In the fast changing and devel-oping modern business, the analysis of past information may not be of much use in future forecasting. Continuous changes take place in the demand of the product, policies adopted by the firm, the posi-tion of competition etc. As such, no estimate based on the analysis of historical facts can be made for future.

(7) Lack of Qualitative Analysis:
Financial statements record only those events and transactions which can be expressed in terms of money. Qualitative aspects of business units are omitted from the books at all as these cannot be expressed in monetary terms. Thus, changes in management, reputation of the business, cordial man-agement-labour relations, firm’s ability to develop new products, efficiency of management, satisfac-tion of firm’s customers etc. which have a vital bearing on the profitability of the company are all ignored and omitted from being recorded because all of these are qualitative in nature.

(8) Limited Use of Single Year’s Analysis of Financial Statements:
Results obtained from financial analysis assume significance only when compared with the figures of previous periods. For example, the profit of a firm to sales is 12%, whether this is satisfactory or not will depend upon the figures of previous years. If the firm earned 10% of sales as profit in the previous year, it may be considered to have done better this year. However, the financial statements of two years may not be comparable due to the changes in accounting policies.
It is clear from the above mentioned limitations that the results obtained from analysis of financial state-ments should not be taken as the true indicators of the strength and weaknesses of the concern. The results obtained from analysis must be read carefully and cautiously. The limitations of analysis must be kept in mind while taking decisions based on the results obtained from such analysis.
Tools for analysis of Financial Statements

Cash flow statement:
The Cash Flow Statement was previously known as the flow of Cash statement. Cash Flow Statement is a statement of inflow and outflow of cash and cash equivalents. The cash flow statement is divided into three parts namely: (1) Cash flow from operating activities; (2) Cash flow from investing activities; and (3) Cash flow from financing activities. Cash flow statement is helpful in knowing the movement of cash into the business and movement of cash out of the business.

Ratio Analysis:
Ratio Analysis is a study of relationship among various financial factors in a business. Ratio Analysis is a tool of Financial Statement Analysis that is used to know the firm’s financial performance. Ratio Anal-ysis is based on the availability of accounting information. The main objective of ratio analysis is the comparative measurement of financial data.

Format: As prescribed in Part I of Schedule III of the Companies Act, 2013, Balance Sheet is pre-pared as follows:

Question. Main objective of analysis of financial statements is:
(A) To know the financial strength
(B) To make a comparative study with other firms
(C) To know the efficiency of management
(D) All of the Above

Question. Financial analysis becomes significant because it:
(A) Ignores price level changes
(B) Measures the efficiency of business
(C) Lacks qualitative analysis
(D) Is effected by personal bias

Question. Main limitation of analysis of financial statements is
(A) Affected by window dressing
(B) Difficulty in forecasting
(C) Do not reflect changes in price level
(D) All of the Above

Question. According to prescribed order of assets in a Company’s Balance Sheet ……………………… assets should be shown first of all.
(A) Non-Current Assets
(B) Current Assets
(C) Current Investments
(D) Loans and Advances

Question. Calls in advance appear in a Company’s Balance Sheet under ………………..
(A) Share Capital
(B) Current Liability
(C) Long-term Borrowings
(D) Reserve & Surplus

Question. ………appear in a Company’s Balance Sheet under the Sub-head Short-term Provision
(A) Interest Accrued but not due on Borrowings
(B) Provision for Tax
(C) Unpaid Dividend
(D) Calls in Advance

Question. Change in Inventories means :
(A) Difference between Opening Inventories and Closing Inventories
(B) Difference between Closing Inventories and Opening Inventories
(C) Difference between Opening Inventories and Closing Inventories, if Opening Inventories are higher
(D) Difference between Closing Inventories and Opening Inventories, if Closing Inventories are higher.

Question. Which of the following points out nature of financial statements? (i) Financial statements are prepared on the basis of recorded facts. (ii) Certain accounting conventions are followed while preparing financial statements. (iii) Financial statements are prepared on certain basic assumptions (pre-requisites) known as postulates. (iv) Facts and figures presented through financial statements are based on personal opinion, esti-mates and judgements.
(a) Only (i)
(b) (i),and(ii)
(c) (i),(ii) and (iii)
(d) (i) ,(ii),(iii) and (iv)

Question. Bank overdraft and cash credit are treated as ‘short-term borrowings’ in the balance sheet of a company.
(a) True
(b) False
(c) Partially true
(d) Can’t say

Question.Amount provided for any known liability whose amount as yet isuncertain is known as:
(a) Liability
(b) Reserve
(c) Provision
(d) None of the above

Question. The assets which cannot be realised incash or from which no further benefit can be derived are known as:
(a) Tangible asset
(b) Fictitious asset
(c) Intangible asset
(d) None of the above

Question. Livestock is an item of……… under sub-head fixed asset and the major head non-current assets.
(a) tangible assets.
(b) inventories
(c) trade receivables
(d) intangible

Question. What will be the amount shown under the head current liabilities when the following data is given? Short-term borrowings=₹2,00,000 Trade Payables = 1,00,000 Other Current Liabilities = 1,50,000, Short-term Provisions=20,000
(a) ₹ 5,00,000
(b) 600,000
(c) 2,00,000
(d) 4,70,000

Question. Goodwill of a company amounting to 35,000 is shown on the assets side of the balance sheet under which of the following head?
(a) Non-current assets
(b) Current assets
(c) Non-current liabilities
(d) None of the above

Directions – There are two statements marked as Assertion (A) and Reason (R).

Read the statements and choose the appropriate option from the options given below:

(a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of As-sertion(A)
(b) Both Assertion (A) and Reason (R) are true but Reason (R) is not the correct explanation of Assertion (A)
(c) Assertion (A)is false, but Reason (R) is true (d) Assertion (A ) is true, but Reason (R) is false

Question. Assertion (A) Bills receivable are shown as trade receivables in the balance sheet of the com-pany.
Reason (R) Debtors and bills receivable forms the part of trade receivables.

Question. Assertion (A) The bank charges charged by the bank are included in finance cost.
Reason (R) Bank charges are an expense not incurred in connection with raising finance but for availing the services of the bank.

Question. Assertion (A) Analysis of financial statements is done to assess the managerial efficiency. 
Reason (R) Financial statement analysis helps to identify the areas where the managers have been efficient and the areas where they have been inefficient.

Direction : Read the following case study and answer questions 18 to 22 on the basis of the same. Care Ltd is a company that deals in manufacturing of pharmaceutical products. Dev has recently been hired as an assistant to the accountant of Care Ltd. The accountant of the firm Mr. Raj asks Dev to go for financial statement analysis to assess the financial position of the firm. To judge the knowledge and capabilities of Dev, Mr. Raj asked him to analyze the financial statements from the view point various parties interested in the firm like the management, the lenders, the inves-tors, government etc.

Question. Which of the following statements will primarily be utilised by Dev for the purpose of finan-cial statement analysis?
(a) Balance sheet and cash flow statement.
(b) statement of profit and loss and cash flow statement
(c) balance sheet and statement of profit and loss
(d) cash flow statement and fund flow statement.

Question. If Dev is to analyse the financial statements for the top management, what should he consider?
(a) Short-term liquidity of the firm.
(b) Ability to pay its long-term lenders.
(c) The resources of the firm are used most efficiently and that the firm’s financial condition is sound.
(d) None of the above

Question. If Dev is to analyse the financial statements for the short-term lenders, what should he consider?
(a) Short-term liquidity of the firm
(b) Long-term solvency of the firm
(c) The resources of the firm are used most efficiently and that the firm’s financial condition is sound
(d) None of the above

Question. If Dev is to analyse the financial statements for the investors, what should he consider?
(a) Firm’s present and future profitability
(b) Ability to pay its long-term lenders
(c) Firm’s capital structure
(d) Both (a) and (c)

Question. While analysing the financial statements, Dev should be conscious of which of the following?
(a) Changes in accounting policies of the firm
(b) Personal judgements
(c) Window dressing of financial statements
(d) All of the above

Question. Match the following:
a. Interest paid on debentures                              (i) depreciation
b. Fixed assets written off over their useful life      (ii) other expenses
c. cheques                                                         (iii) financial cost
d. discount allowed                                              (iv) other current liabilities
Answer. a(iii),b(i),c(iv),d(ii)

Question. Explain the importance of financial analysis for (i) labour unions, and (ii) creditors
Answer.(i) Importance for Labour Unions: Labour unions analyse the financial statements to assess whether it can presently afford a wage increase and whether it can absorb a wage increase through increased productivity or by raising the prices.
(ii) Importance for Creditors: Creditors through an analysis of Financial Statements appraises not only the ‘ ability of the company to meet its short term obligations but also judges the probability of its continued ability to meet its financial obligations in future.

Question. State the objectives of ‘Analysis of Financial Statements’.
Answer.Objectives of‘Financial Statements Analysis’:
1.Assessing the earning capacity or profitability of the firm as a whole as well as its different departments so as to judge the financial health of the firm.
2. Assessing the managerial efficiency by using financial ratios to identify favourable and unfavourable variations in managerial performance.

Question. State any four limitations of analysis of financial statements.
Answer.Limitations of ‘Financial Statements Analysis’:
(a) Different Accounting Principles and Practices. Financial analysis is subject to lim-itations inherent in the financial statements like following different accounting princi-ples or practices regarding depreciation methods, inventory valuation and pricing, etc.
(b) Ignores the Quality Elements. Financial statements contain only financial data and exclude from the preview of qualitative information, which cannot be expressed in money terms. Thus, analysis of such financial statements will also lack quality ele-ment.
(c) Ignores Price Level Changes. Transactions, in financial statements, are recorded on historical cost basis and generally no adjustment is made for price level changes. Thus, the analysis of financial statement will not yield comparable results due to lack of ad-justments for the price level changes.
(d) Affected by Window Dressing. Some firms may resort to window dressing (show-ing better picture) to cover-up bad financial position. For example, closing stock may be overstated. In such case, the results of analysis will also be misleading.

Question. State the importance of Financial Analysis?
Answer.Financial Analysis has great importance to various accounting users on various mat-ters. Income Statements, Balance Sheets and other financial data provides information about expenses and sources of income, profit or loss and also helps in assessing the financial position of a business. These financial data are not useful until they are ana-lysed. There are various tools and methods such as Ratio Analysis, Cash Flow State-ments that make the financial data to cater varying needs of various accounting users.
The following are the reasons that advocate in favour of Financial Analysis:
1. It helps in evaluating the profit earning capacity and financial feasibility of a busi-ness.
2. It helps in assessing the long-term solvency of the business.
3. It helps in evaluating the relative financial status of a firm in comparison to other competitive firms.
4. It assists management in decision making process, drafting various plans and also in establishing an effective controlling system.

Question.28 State under which major headings and sub-headings will the following items be presented in the BalanceSheet of a company as per Schedule-Ill, Part-I of the Companies Act, 2013. (i) Prepaid Insurance
(ii) Investment in Debentures
(iii) Calls-in-arrears
(v) Capital Reserve
Answer.

Question.29 Under which major heads and sub-heads will the following items be placed in the Balance Sheet of the company as per Schedule III, Part I of the Companies Act, 2013?
(i) Cheques and Bank Drafts in Hand
(iii) Securities Premium Reserve
(iv) Long-Term Investments with maturity period less than six months
(viii) Debtors
Answer.

Question.30 W Ltd was a company manufacturing geysers. As a part of its long term goal for expansions, the company decided to identify the opportunity in rural area. Initial plan was rolled out for Bhiwani village in Haryana. Since, the village did not have regular supply of electricity, the company de-cided to manufacture solar geysers. The core team consisting of the Regional Managers, Account-ant and the Marketing Manager was taken from the Head office and the remaining employee were selected from the village and neighbourhood area. At the time of preparation of financial statement the accountant of the company fell sick and the company deputed a junior accountant temporarily from the village for two months. The Balance Sheet prepared by the junior accountant showed the following items against the Major heads and sub-head mentioned which were not as per Schedule III of the Companies Act 2013. Items Major Head
– Loose Tools -Trade Receivable
– Cheque in Hand- Current Investment
– Term Loan from Bank- Other long Term Liabilities
– Computer Software -Tangible Fixed Assets Present the above items under the correct major head and sub-head as per the Schedule III of Companies Act 2013.
Answer.

Question.31 How would you show ‘Employee Benefit Expenses with the help of Notes to Accounts in the Statement of Profit &Loss. (i) Salaries & wages ₹ 5,20,000 (ii) Dividend received ₹ 5000, (iii) Leave encasement ₹ 400,000 (iv) Salaries to manages ₹ 10,00,000 (v) Depreciation on fixed assets ₹ 200,000 (vi) Contribution to provident fund ₹ 50,000.
Answer.

Question.32 K M Limited is a computer hardware manufacturing company. While preparing its accounting rec-ords it takes into consideration the various accounting principles and maintains transparency. At the end of the accounting year, the company follows the ‘Companies Act, 2013 and Rules there under’ for the preparation of its Financial Statements. It also prepares its Income Statement and Balance Sheet as per the format provided in Schedule III to the Act. Its Financial Statements depict its true & fair financial position. For the financial year ending March 31,2017, the accountant of the company is not certain about the presentation of the following items under relevant Major Heads & Sub Heads, if any, in its Balance Sheet: Present it correctly.
– Securities Premium Reserve
– Calls in Advance
– Stores & Spares
Answer.