CHAPTER 1 (Pages 22 – 23)Analytical questions

1. Equity capital is called risk capital because it is exposed to business risks. The claim of

equity holders is residual. In a situation of liquidation the amount realised from the sale

of assets is first distributed to debt holders and other creditors and if any cash is left, it is

distributed to equity holders.

If debt capital is 80 per cent of the total capital employed, the debt is exposed to business

risks because of the thin margin. Therefore in that situation it is inappropriate to say that

the debt capital is exposed to credit risk only.

Yes, the notion of ‘safe debt level’ is appropriate in determining the capital structure. By

borrowing either from the public (by issuing corporate bonds like debentures) or from

financial institutions a firm commits to repay the principal and to pay interest as per

agreed terms. This firm financial commitment reduces the flexibility to respond to market

changes particularly when the going is bad. Therefore, firm limits financial commitments

and set out the ‘safe debt level’. The ‘safe debt level’ is fixed taking into account the

proportion of fixed costs in the total cost of delivering value to customers.

2. ‘Snap shot’ in photography refers to capturing of a moment by a hand-held camera at

the snap of the camera shutter. The balance sheet captures the financial position at the

balance sheet date. It is a stock statement that lists out assets and claims on those assets at

the balance sheet date. Therefore the photographic analogy for balance sheet is ‘snap

shot’. Profit and loss account presents flow (i.e. movement) of income and expenses

during the period covered by the financial statements. Similarly cash flow statement

presents flow (i.e. movement) of cash during the period covered by the financial

statements. Therefore the analogy for profit and loss account and cash flow statement is

‘motion picture’.

3. ‘Decision usefulness’ is the overriding principle in the preparation and presentation of

financial statements. Transparency is the corner stone of financial reporting. Therefore

management should include information that is relevant for forecasting future cash flows

that the firm is expected to generate in future and hence for the valuation of the firm. It is

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possible that information may be relevant but it cannot be estimated reliably. For example

market value of investment in an investment property (e.g. property not being used in

operation) located in a remote corner of a village is relevant but cannot be measured

reliably. In that situation the firm does not measure the investment property at market

value. It measures the same at the historical cost (i.e. cost of acquisition). Accountants

always balance between the relevance and reliability to ensure that the information is

relevant but not misleading. In fact, while formulating accounting standards, standard

setters balance relevance and reliability and stipulate accounting principles and methods.

4. Note

Investors aim to optimise their investment in terms of risk and return by constructing a

diversified portfolio of securities. An investor constructs her portfolio based on her risk-

appetite. Institutional investors offer variety of schemes (read portfolios) from which an

investor can choose one that matches with her investment needs. Capital moves across

the globe when investors including institutional investors look for investment

opportunities across the globe. Accounting is the business language. Mobility of funds

gets restricted if entities domiciled in different territories provide information in different

business languages as the mobility of tourists or job seekers is restricted by lack of

understanding of each others’ languages (people of different territories speak in different

languages). When different entities use different business languages investors fail to

estimate the risk of investment in securities of entities domiciled in different territories.

Another factor that accentuates the problem is that comparability of performance and

financial position of firms operating in different territories is lost. All these restrict the

mobility of funds across the globe. Therefore, harmonization of accounting practices

across the globe is a pre-requisite for movement of capital across the globe.

5. Financial statements present a true and fair view when it is free from material fraud

and error. As an auditor I know that a fraud is being investigated. I should carefully

understand the nature of the fraud and its impact on financial statements. If, according to

my assessment the fraud is a major fraud and its impact will be significant on the

financial statements, I shall issue a disclaimer. I shall express my inability to give an

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opinion on whether the financial statements present a true and fair view until the

investigation is complete. However, If, I assess that the impact of the fraud on financial

statements might not be material, I shall formulate my opinion on the true and fairness of

financial statements based on my audit results and shall disclose in my audit report that a

financial fraud, which is under investigation, might impact the financial position and

operating result presented in financial statements.

6. Internal control provides reasonable assurance regarding achievement of the objectives

of the firm in the following categories:

(a) Effectiveness and efficiency of operations, including risk management

(b) Reliability of financial reporting

(c) Compliance with applicable rules and regulations

It does not ensure success because success of a firm depends on the formulation of the

right strategy and its implementation. Moreover, in a competitive environment there will

always be winners and losers. Therefore, the question of relative performance arises.

Internal control cannot ensure success. But, if we include board process as a part of

internal control, it definitely signals weaknesses much earlier than failures in the market

place and reviews the strategy in terms of chances for success and compatibility with

corporate mission and vision. This significantly enhances the chance for success.

In a sense there is an expectation gap between what the investor is looking for and what

internal control can offer.

7. Accounting standards are formulated by bodies represented by all stakeholders

including investors, preparers of financial statements, auditors and regulators. Every

stakeholder group has its own objectives, which may not be conflicting but definitely not

compatible in all respect. For example, investors and regulators may look for complete

transparency on corporate financial reporting while prepares may be unwilling to disclose

sensitive information. Similarly, preparers might over-emphasise difficulties in

implementation of accounting principles while others may underplay the same. Therefore

in a sense, formulation of accounting standards is a bargaining process. In that sense,

‘politics is inherent to the accounting standard setting process’.

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