Question

1) Describe the purpose of the balance sheet. What are the major limitations of the balance sheet as a source of information?

2) What is the purpose of a Statement of Cash Flows ? Differentiate between operating activities, investing activities and financing activities.

Answer 1

Answer 1)
The most important purpose of the balance sheet is to reveal the financial status of an organization. The purpose of the balance sheet is to reveal the financial status of a business as of a specific point in time. The statement shows what entity owns (assets) and how much it owes (liabilities), as well as the amount invested in the business (equity). This information is more valuable when the balance sheets for several consecutive periods are grouped together, so that trends in the different line items can be viewed.
LImitations:
1. Valuation of Internally Generated Assets: The major limitation of the balance sheet is that only acquired assets are accounted for. Hence, when the assets are developed internally by going through research and development works, these assets are not recognized at market value, rather at a cost which tends to generally lower than the value or sometimes higher than the market value.
2. Mis-stated Long-term assets: Long term assets are expected to last more than one year and include plant and machinery, building, etc. The Balance Sheet records the value of the assets at historical or book value. The depreciation that has been calculated is for tax purposes or is reliably estimated as per accepted policies. However, this does not reflect the true wear and tear of assets.
3. Snapshot at a particular date: As a balance sheet depicts financial position as on a particular date, the management or the owners want a balance sheet as healthy as possible. Businesses can manipulate the cash, debtors and creditors data so as to manipulate the lenders.
4. Needs Comparison: To make complete usage of all the items in the balance sheet, one must compare the business balance sheet with that of competitors and their own balance sheet over the various accounting periods

Answer 2) The primary purpose of the statement of cash flows is to provide information about cash receipts, cash payments, and the net change in cash resulting from the operating, investing, and financing activities of a company during the period.

Operating activities include the production, sales, and delivery of the company’s product as well as collecting payments from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.

Investing activities are purchases or sales of assets (land, building, equipment, marketable securities, etc.), loans made to suppliers or received from customers, and payments related to mergers and acquisitions.

Financing activities include the inflow of cash from investors, such as banks and shareholders and the outflow of cash to shareholders as dividends as the company generates income. Other activities that impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement.