Q.1. How do accounting
methods influence decisions in an organization?
Should accounting outcomes drive decision making?
Explain your reasoning.
Accounting has been called the language of business.
As such, the purpose of accounting is to formalize
data and numbers in such a manner that it aids
in financial planning and decision making. While
book keeping refers to just the manner of organizing
and keeping records i.e. books of accounts, accounting
goes a step further in that it is used to analyze
the data or information. And the purpose of this
analysis is to make inferences or plans based
on trends or assumptions. The result of the book-keeping
process are three main financial statements, the
Income Statement, the Balance Sheet and the Cash
Flow or Funds Flow Statement. The income statement
shows whether the business operations have been
successful or not i.e. whether they have resulted
in a Profit or Loss. If we look at these carefully
and try to analyze our total revenues, costs and
expenses we can learn a lot. Once we have worked
on these three determinants i.e. revenues, costs
and expenses, we then have an idea of the role
each plays in the determination of our profits.
Our goal would be to increase Profits either by
increasing Revenues or controlling and decreasing
Costs and Expenses. In a similar manner, the Balance
Sheet is a picture of the Assets, Liabilities
and Owners Equity of a business on a particular
date, being the end of the accounting year for
that firm. Assets are the resources used by the
firm while Liabilities and Owner’s Equity
are both sources of funds; they show whether the
resources used by the business belong to the owners
themselves (Owners Equity) or are borrowed from
other sources (Liabilities). By analyzing the
breakup of total assets, liabilities and owners
equity, we can determine whether the business
is solvent, debt-heavy etc. The cash flow statement
shows how cash was generated and how it was spent
in the business. The collective information from
all three statements in tandem will definitely
aid in decision making. Using ratio analysis,
trend analysis and other measures, we can set
the tone for future business goals.
(Source:Robert Meigs: Accounting: The Basis For
Business Decisions. (Irwin/McGraw-Hill [11th ed.]).
Q.2. What are the implications of using financial
leverage and how does leverage impact the value
of bonds? What are some of the other factors that
would influence the value of bonds?
Financial leverage refers to the degree to which
a business is utilizing borrowed money. Companies
that are highly leveraged may run the risk of
being bankrupt if they are unable to make the
necessary principal and interest installments
on their debt. Being defaulters, they are regarded
a credit risk and may also be unable to find new
lenders in the future.
Financial leverage is not always bad, however.
One may invest and do business with borrowed funds,
earn a profit on the same and out of these, make
interest payments to the bondholders and dividend
payments to the shareholders. Other than this,
interest being a fixed cost is also tax deductible-
therefore there is a tax advantage of using debt
rather than equity to finance the business. However
the capital structure of the firm must be carefully
decided- the total value of the firm at any point
is the sum of the value of debt plus equity in
the capital structure. The capacity of the firm
to absorb debt and meet the debtors fixed obligations
will have to be determined, before launching a
bond flotation. A firm having a strong equity
base will be regarded more favorably by the prospective
bondholder- as he is sure that there are enough
assets and profits to cover interest and principal
repayments. These bonds will be rated as first
class debt securities and may even be offered
at a premium. Conversely, if a business is already
debt heavy, its bonds will have to be floated
at a discount to face value, thereby increasing
its yield and making it favorable for the bondholder.
This is the principle behind deep discount bonds.
Other factors that may influence the value of
the bonds are the availability of credit in the
economy, the short and long term structure of
interest rates, the number of issues already in
the market, the firm’s business plans and
its value in the eyes of the stakeholders.
(Source: www.investorwords.com/1952/financial_leverage.html
and Ramesh Rao (1992) Financial Management: Concepts
and Applications, 2nd edition, Macmillan)
Q.3. What exactly are off balance sheet liabilities
and how do they impact users of financial statements?
Use either your company’s own annual report
or that of another public company to cite examples
as well as their impact.
Off balance sheet liabilities or contingent liabilities
refer to debts that may occur or become due based
upon the happening or non-occurrence of some specific
event in the future. The principle of adequate
disclosure in financial reporting requires that
all contingent assets and liabilities also be
reported on the Balance Sheet. This helps a potential
stakeholder form a more complete and lucid opinion
on the company. The effect on the company’s
financial stature must also be included; this
is usually reported in the Notes to the Accounts
section of the Company’s annual reports.
The potential of partial or total loss from a
particular venture or event must be noted and
accounted for. Often, the non-reporting of such
items can have serious consequences. A recent
example is the Enron scandal. In the wake of this,
Section 401(a) of the Sarbanes-Oxley Act requires
the reporting of "all material off-balance
sheet transactions, arrangements, obligations
(including contingent obligations), and other
relationships of the issuer with unconsolidated
entities or other persons, that may have a material
current or future effect on financial condition,
changes in financial condition, results of operations,
liquidity, capital expenditures, capital resources,
or significant components of revenues or expenses."
In this context, the following are some examples
of contingent or off balance sheet liabilities:
i) Any obligation under a direct or indirect
guarantee.
ii) A retained or contingent interest in liabilities
transferred to an unconsolidated entity.
iii) Derivatives, to the extent that the fair
value thereof is not fully reflected as a liability
in the financial statements.
In some instances where a liability is probable,
a company can reasonably estimate a range of losses.
A company may determine that one amount within
the range is more probable than any other amount
within the range. In that situation, a company
should accrue its best estimate within the range
and disclose in the notes to the financial statements
the additional exposure to loss if there is at
least a reasonable possibility of loss in excess
of the amount accrued.
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