Question 1 a): What do you understand by the concept of conservatism?

Why it is also called the concept of prudence? Why it is not applied as

strongly today as it used to be in the Past?
Answer: Concept of Conservatism implies using conservatism while preparing
financial statements i.e. income should not be accounted for unless it has
actually been earned but expenses, even if just anticipated should be
provided for. According to this concept, revenues should be recognized only when
they are realized, while expenses should be recognized as soon as they are
reasonably possible. For instance, suppose a firm sells 100units of a product on
credit for Rs.10, 000. Until the payment is received, it will not be recorded in the
accounting books. However, if the firm receives information that the customer
has lost his assets and is likely to default the payment, the possible loss is
immediately provided for in the firms books. The rule is to recognize revenue
when it is reasonably certain and recognize expenses as soon as they are
reasonably possible. The reasons for accounting in this manner are so that
financial statements do not overstate the companys financial position.
Under the conservatism principle, if there is uncertainty about incurring a loss, you
should tend toward recording the loss. Conversely, if there is uncertainty about
recording a gain, you should not record the gain.
Under the prudence concept, do not overestimate the amount of revenues
recognized or underestimate the amount of expenses. You should also be
conservative in recording the amount of assets, and not underestimate liabilities.
The result should be conservatively-stated financial statements. Concept of
Conservatism is also called the concept of prudence as it essentially involves
exercising prudence in recording income and expenses/losses in the financial
statements so that anticipated income are not recorded whereas likely losses are
provided for.
However, this concept is not applied as strongly today as it used to be in the past
for the reason that the modern world saw a considerable increase in
corporate frauds e.g. Enron case in USA and Satyam in India. Also, there is a decline
in assuming corporate social responsibilities due to superfluous issues of
gaining publicity and brand building. These two major issues call for increased
transparency in financial statements and hence, the decline in use of age old
concept of conservatism.
Question 1 b): What is a Balance Sheet? How does a Funds Flow
Statement differ from a Balance Sheet? Enumerate the items which
are usually shown in a Balance Sheet and a Funds Flow Statement.
Answer: A Balance Sheet is a type of financial statement of an entity,
indicating the financial position at a given point of time. It is the statement of

Assets and Liabilities as on a particular date. The various items of a Balance

Sheet can be grouped under two heads, viz: assets and liabilities.
Funds Flow statement determines the sources of cash flowing into the firm
and the application of that cash by the firm. The various items of a Funds
Flow Statement can be grouped under two heads, viz: inflow of funds
(sources) or outflow of funds (applications).
While the Balance Sheet shows only the monetary value of each source and
application of funds at the end of the year, funds flow statement depicts the extent
of changes in each source and application of funds during the year. If we take the
Balance Sheet for two consecutive years and work out the change for each
item, we are able to arrive at the Funds Flow Statement items.
The main differences between balance sheet and fund flow statement are as below:
1. Meaning
Balance Sheet: Balance sheet is a statement of assets, liabilities and capital.
Funds Flow Statement: Funds flow statement is a statement if changes in assets,
liabilities and capital accounts.
2. Objective
Balance Sheet: Balance sheet is prepared to ascertain the financial position of a
firm.
Funds Flow Statement: It is prepared to ascertain the sources and application of
funds.
3. Preparation
Balance Sheet: It is prepared with the help of trial balance.
Funds Flow Statement: It is prepared with the help of balance sheets of two
subsequent dates.
4. Information
Balance Sheet: It provides static view of financial affairs.
Funds Flow Statement: It provides the changes in assets, liabilities and capital
accounts.
The various items usually shown in a Balance Sheet are:
Assets side:
(1) Fixed assets
(a) Gross block
(b) Less depreciation
(c) Net block
(d) Capital work-in-progress

(2) Investments
(3) Current assets, loans, and advances:
(a) Inventories
(b) Sundry debtors
(c) Cash and bank balances
(d) Other current assets
(e) Loans and advances
(4) Deferred Revenue Expenditure:
(a) Miscellaneous expenditure to the extent not written off or adjusted
(b) Profit and Loss account
Liabilities side:
(1) Shareholder's funds
(a) Capital
(b) Reserves and Surplus
(2) Loan funds
(a) Secured loans
(b) Unsecured loans
Current liabilities and provisions:
(a) Liabilities
Sundry Creditors
Outstanding expenses
Provision for tax
Similarly, items in a Funds Flow Statement are:
Inflow of funds:
A decrease in assets
An increase in liabilities

 An increase in shareholders funds

Outflow of funds:
An increase in assets
A decrease in liabilities
A decrease in shareholders funds