.

(a) Explain the following accounting concepts (i) Money Measurement Concept (ii) Cost Concept (iii)
Conservatism Concept (iv) Periodicity Concept

(i) Money Measurement Concept

In accounting, only those facts which can be expressed in terms of money are recorded. As money is
accepted not only as a medium of exchange but also as a measuring rod of value, it has a very
important advantage since a number of widely different assets and equities can be expressed in
terms of a common denominator. Without this adding heterogeneous factors like five buildings, ten
machines, six trucks will not have much meaning.

Money measurement concept states that all transactions are to be recorded only in monetary terms
and record only those transactions, which can be measured in money terms. It ignores intangibles
like employee loyalty and customer satisfaction, as they cannot be expressed in money terms. It also
assumes records on the basis of a stable monetary unit.

(ii) Cost Concept

The resources (land, buildings, machinery, property rights, etc.) that a business owns are called
assets. The money values assigned to assets are derived from the cost concept. This concept states
that an asset is worth the price paid for, or cost incurred to acquire it. Thus, assets are recorded at
their original purchase price and this cost is the basis for all subsequent accounting for the assets.
The assets shown on the financial statements do not necessarily indicate their present market worth
(or market values). This is contrary to what is often believed by an uninformed person reading the
statement or report. The term ‘book value’ is used for the amount shown in the accounting records.

Cost Concept states that an asset is to be recorded in books of accounts at a price for, or at a cost
incurred to acquire it.

(iii) Conservatism Concept

Conservatism concept forbids the inclusion of unrealised gains but advocates provision for possible
losses.

iv) Periodicity Concept

Periodicity concept divides the life of a business into smaller time periods which are generally one
year, and the accountant is supposed to prepare necessary financial statements for each time
period.
Clearly explain the meaning and importance of Funds Flow Statement. How is Funds Flow Statement
prepared ?

A funds flow statement explains the changes in a company’s working capital. It considers the inflows
and outflow of funds (source of funds and application of funds) for a particular period. The
statement helps in analysing the changes in a company’s financial position between two balance
sheet periods.

The statement helps in determining how the funds are being used. As a result, analysts can assess
the company’s fund flow in the future.

Importance of a Funds Flow Statement

Financial Position: A profit and loss statement or balance sheet does not explain the reasons for the
change in a company’s financial position. The statement will give information about where the funds
have come (Source of Funds) and where the funds have been used (Application of Funds).

Company Analysis: Often, companies that are making profits end up in cash crunch scenarios. In such
scenarios, the funds flow statement offers a clear picture of the source and usage of funds.

Management: The funds flow statement assists management in determining its future course of
action and also serves as a management control tool.

Changes in Assets and Liabilities: The statement shows the reason behind the change in assets and
liabilities between two balance sheet dates. As a result, you can conduct an in-depth analysis of the
balance sheet.

Creditworthiness: Lending institutions use this statement of a company to analyse creditworthiness.

They compare the statement over the years before approving a loan. Therefore, the statement
depicts a company’s credibility in terms of fund management.

How to Prepare Fund Flow Statement?

Step 1

Prepare a Schedule of Changes in Working Capital. Consider the increase or decrease in the current
assets and current liabilities. The difference between the net current assets and net current liabilities
gives the net increase or decrease in working capital.

Step 2

Prepare the Adjusted P&L Account to find out Funds from Operations. It includes the funds used and
generated from operating activities of the business and not from investing and financing activities.
Here some adjustments that the company makes to the net profit for the year. They add back non-
cash expenses like depreciation and amortisation. They subtract any profit from the sale of
investments and fixed assets to arrive at the actual fund generated from operating activities.

Step 3

To create the fund flow statement; you need to identify the Sources of Funds (Inflows) and
Application of Funds (Outflows). Identify the source of funds or application of funds (increasing or
decreasing) from the balance sheet to create a fund flow statement. And also net increase or
decrease in working capital and funds from operations to complete the statement.

What do you understand by Ratio Analysis ? How would you calculate various Activity Ratios ?
Discuss their significance.
Ratio analysis is referred to as the study or analysis of the line items present in the financial
statements of the company. It can be used to check various factors of a business such as
profitability, liquidity, solvency and efficiency of the company or the business.
Ratio analysis is mainly performed by external analysts as financial statements are the primary
source of information for external analysts.
The analysts very much rely on the current and past financial statements in order to obtain
important data for analysing financial performance of the company. The data or information thus
obtained during the analysis is helpful in determining whether the financial position of a company
is improving or deteriorating.

1 Current Ratio = Current Assets/Current Liabilities

2 Quick Ratio = Quick Assets/Current Liabilities Quick Assets = Current Assets –

Inventory – Prepaid Expenses
3 Absolute Liquid Ratio = Cash + Marketable Securities/Current Liabilities

 Helps in forecasting and planning by performing trend analysis.

 Helps in estimating budget for the firm by analysing previous trends.
 It helps in determining how efficiently a firm or an organisation is operating.
 It provides significant information to users of accounting information regarding the
performance of the business.
 It helps in comparison of two or more firms.
 It helps in determining both liquidity and long term solvency of the firm.

Critically examine the various methods of evaluating capital expenditure proposals. Discuss their
advantages and disadvantages.

Various methods for doing this exist:

• payback period (expected time to recoup the investment)
• accounting rate of return (forecasted return from the project as a portion of
total cost)
• net present value (expected cash outflows minus cash inflows)
• internal rate of return (average anticipated annual rate of return)

Advantages :
It is easy to understand and calculate.

It takes into account the time value of money.

It takes into account the entire series of cash flows for analysis.

Selection of project under mutually exclusive projects is easy under NPV

Considers cash inflows and cash outflows over the entire life of the project.

In case of mutually exclusive projects, it helps select a project very easily.\

It provides a single rate and thus avoids confusion

Disadvantages:

It is difficult to understand.

It involves lengthy and tedious calculations.

It involves lengthy and tedious calculations.

Sometimes a project may have multiple IRR which confuses users.

Projects selected on the basis of higher IRR may not be profitable in all cases.

In comparison to traditional method, it is slight difficult to understand and calculate.

Selection of the discount rate for discounting of cash inflows is another problem of
NPV.

It does not take into account the cash inflows that occur after the payback period.

Selection of appropriate rate for discounting the cash flows is another problem.
What are the motives for holding cash? Explain the Baumol model for optimum
cash balance.

Transaction Motive: The transaction motive refers to the cash required by

a firm to meet the day to day needs of its business operations. In an
ordinary course of business, the firm requires cash to make the payments
in the form of salaries, wages, interests, dividends, goods purchased, etc.

Precautionary Motive: The precautionary motive refers to the tendency of

a firm to hold cash, to meet the contingencies or unforeseen circumstances
arising in the course of business.

Speculative Motive: The firms hold cash for the speculative purposes to

avail the benefit of bargain purchases that may arise in the future. For
example, if the firm feels the prices of raw material are likely to fall in the
future, it will hold cash and wait till the prices actually fall.

Baumol model is an approach to establish a firm’s optimum cash balance

under certainty. As such, firms attempt to minimise the sum of the cost of
holding cash and the cost of converting marketable securities to cash.

Baumol model of cash management trades off between opportunity cost or

carrying cost or holding cost and the transaction cost.

The Baumol model is based on the following assumptions:

The firm is able to forecast its cash requirements in an accurate way.

The firm’s payouts are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with
time.
The firm will incur the same transaction cost for all conversions of securities
into cash.
Cash balances are refilled and brought back to normal levels by the sale of
securities. The average cash balance is C/2. The firm buys securities as
and when it has above-normal cash balances. This pattern is explained in
figure