Financial Accounting & Analysis April 2026

Q.1: A firm has the following simplified financials before any capital restructuring: EBIT Rs.600,000, existing interest expense Rs.100,000, corporate tax rate 30%, net income therefore currently Rs.350,000; total equity book value is Rs.2,000,000 and there are 50,000 ordinary shares outstanding; the market price per share is quoted at Rs.140; management proposes to borrow Rs.500,000 at an annual interest rate of 10% and use the full proceeds to repurchase shares at the market price (assume the repurchase is executed immediately at Rs.140 per share and repurchased shares are cancelled for book purposes, reducing book equity by the cash consideration equal to the market purchase price); ignore transaction costs; required: (1) compute current EPS and return on equity (ROE) before the transaction, (2) compute the number of shares repurchased and the new shares outstanding after the repurchase, (3) compute new interest expense and the new net income after tax (account for the interest tax shield), (4) compute post-repurchase EPS and ROE (use net income divided by new shares for EPS and net income divided by new book equity for ROE where new book equity equals old book equity minus cash paid for repurchase plus the increase in debt), (5) analyze numerically whether the buyback improves EPS and ROE and comment on the trade-off between higher EPS/ROE and increased financial leverage specifying the change in interest coverage ratio (EBIT divided by interest) and the percentage change in EPS.

Answer:

Introduction:

Using capital restructuring through debt refinancing (increasing debt borrowings) along with equity buybacks (repurchasing shares) is a fundamental financial management decision impacting Earnings per Share (EPS), Return on Equity (ROE) and financial leverage. In this example, the firm currently earns an EBIT of Rs. 600,000, has interest payments of Rs. 100,000 and pays a corporate tax rate of 30%. The firm has 50,000 shares outstanding; the book value of the company’s equity is Rs. 2,000,000 and the current market price per share is Rs. 140. The firm intends to borrow Rs. 500,000 at a 10% interest rate and use the entire amount to purchase back shares from the public market at the current market price.

This decision does not change earnings from operations (EBIT), but changes the amount of debt (by increasing debt) and reducing the amount of equity in the company's capital structure. This decision will therefore result in an increase in interest expense, a larger tax shield, a reduction in the number of the company’s shares outstanding, and an increased financial risk to the shareholders. This analysis will determine the EPS and ROE of the firm, both with and without the effect of the repurchase of shares, provide quantitative analysis of the impact of the share buyback on the financial performance to shareholders, and evaluate the benefits of increased financial leverage to generate higher returns to shareholders while determining how the increased financial risk to shareholders compares to their ability to cover interest expense with EA Entitlements.

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Q.2: A production entity uses a normal costing system where variable manufacturing cost per unit is Rs.650 and fixed production overhead is absorbed at Rs.120 per unit based on normal capacity of 75,000 units per year. During Year 1 the entity produced 68,000 units and sold 60,000 units for total revenue Rs.52,800,000. At the end of Year 1 work-in-progress (WIP) comprises 4,000 units that are 50% complete for conversion costs and 100% complete for materials; opening WIP was negligible. There is also a routine manufacturing scrap rate expected at 1% of units started which is sold for negligible proceeds and expensed to cost of goods sold; actual scrap was 3% of units started. Additionally, a large sales contract contains a right of return: historical return probability is estimated at 6% of units sold and estimated future return cost per returned unit to the company is Rs.2,000. The company capitalized fixed overhead using normal capacity method and did not adjust for abnormal scrap or returns in the accounting records. Prepare a full computation to determine the Year 1 profit under accrual accounting after adjusting for (i) abnormal production loss (excess scrap) and (ii) estimated sales returns and their cost, showing how inventory valuation for finished goods and WIP changes and the resulting effect on profit; compute sensitivity of Year 1 profit to a ±2 percentage point change in the estimated return probability (report the two profit outcomes).

Answer:

Introduction:

This issue will explore how profitable accrual accounting ultimately changes based on the proper recognizing of production inefficiencies and obligations to create a successful sales return. The company follows a regular costing method where their variable cost of each unit manufactured is Rs.650 and Rs.120 worth of overhead expense is applied to factories; this is based off the assumption that they will manufacture 75,000 compatible units per annum. For 12 months at the start of the first year, the business was only able to produce 68,000 units and after the first 12 months, they have made sales of only 60,000 units during this time frame, therefore, they have incurred fixed overhead that was not absorbed (under-absorbed), they have incurred abnormally low quality costs for manufacturing due to loss of inventory and as a company, they have created anticipated costs of purchasing inventory for non-purchases (expected sales returns).

It is important to recognize the following principles of accrual accounting:

Q.3 (A):

Using the direct method compute (a) cash receipts from customers, (b) cash paid to suppliers and employees (show derivation of purchases from COGS and inventory movements and adjust payables and salaries outstanding), and (c) net cash provided by operating activities after deducting interest paid and income taxes paid. Explain in one sentence for each adjustment how opening and closing balances are used in the direct-method computations. Show stepwise calculations.

Answer:

Introduction:

The cash flow from operating activities is prepared under the direct method by focusing on the actual cash inflows and outflows, rather than the accrual based figures contained in an income statement. With the direct method, it is necessary to adjust each income statement line item to determine cash from operating activities, using both opening and closing balances of related current assets and current liabilities. In the example provided, because all revenue was earned on account, it is necessary to adjust for changes in debtors, inventory, accounts payable, outstanding salaries, and income tax payable. This process allows an individual to determine (a) the amount of cash received from customers, (b) the amount of cash paid to suppliers and employees, and (c) net cash provided by operating activities after interest and taxes.

Q.3(B): Aarti Enterprises applied to a bank for a term loan and submitted a management- prepared balance sheet. The bank required an audited balance sheet; the auditor noted overlooked year-end adjustments such as incorrect inventory valuation, missing provisions and accruals. The bank’s lending policy requires a minimum current ratio of 1.5 and quick ratio of 1.0, so corrected presentation is critical for loan approval. Design an audit-adjustment checklist and reclassification model that a chartered accountant could apply to Aarti Enterprises submitted balance sheet to identify and quantify year-end adjustments (inventory valuation, provisions, accruals, prepayments), produce required journal entries, and demonstrate impact on current and quick ratios so the firm can meet bank lending criteria.

Answer:

Introduction:

Aarti Enterprises submitted a balance sheet prepared by management when applying for a term loan. The bank requested an audited balance sheet because lending decisions will be made based on reliable financial statements. Upon review, the auditor found errors in the balance sheet: incorrect inventory valuation; missing provisions; unrecorded accruals; and prepaid expenses. These changes directly affect both working capital and liquidity ratios. As per bank lending directly specifies ratio's for minimum current ratios of 1.5/quick ratio of 1.0. Therefore, in order to ensure that the company presents its financial and operating performance's in agreement with U.S. Generally Accepted Accounting Principles ("GAAP"), maintains compliance with bank lending criteria, and complies with prudent reporting practices, a structured audit adjustment checklist and reclassification model must be developed for future presentation of the company's financial statements.