Question

please explian and show the formulas

Question 2 (10 Marks) An airline company just released its annual reports for fiscal year 2016-2017. Working as a financial analyst, you carefully read the reports and try to analyse the company's performance and financial risk. 1. You notice that in 2016 the company reported retained earnings of -100 million. Please provide TWO possible explanations for the negative retained earnings. (4 marks) 2. On the balance sheet, the company reported "Revenue received in advance" of 3,685 million, which accounts for more than half of current liabilities. (a) Explain why revenue received in advance is a liability. (3 marks) (b) Explain how the profitability ratios and liquidity ratios will be affected if 200 million of "revenue received in advance" has been mistakenly recognized as "revenue". (3 marks)

Answer 1

Question 2:

Answer 1: In 2016, an airline company reported negative retained earnings of $100 million. Two possible reasons behind negative retained earnings could be:-

1. Accumulated losses:- There might be a possibility that the company has profits for the previous year and has incurred huge losses in 2016. When the amount of losses incurred in the current year are more than the surplus available or profits earned in the previous years, the retained earnings will be netted to negative. Thus, if the company is reporting a negative retained earnings of $100 million, there might be a possibility that the company has incurred huge losses in the year 2016.

2. Borrowing money:- The company might have borrowed money to cover the accumulated losses of the company. If the company would have issued shares, then the equity funding would create positive balance in the shareholders’ equity. Since the balance is negative, then there might be a possibility that the company has borrowed money to cover the accumulate losses as it is a debt and would be considered as liability even if losses are covered by the money borrowed.

Answer 2: The company reported “Revenue received in advance” amounting to $3,685 million as liability.

1. The revenue received in advance is the liability for the company as this is the revenue which is not earned by the company. The company is yet to offer the services against the unearned revenue. This advance cannot be recognized as the income since it is not accrued. It represents that the company owes services etc. to the customers. The company has the obligation to offer services against such advance. Therefore, unearned revenue is a liability for the company.

2. If the company mistakenly recognizes the unearned revenue of $200 million as “revenue” it will increase the current assets of the company. This will in turn increase the working capital of the company. By increase in it, the liquidity ratio of the company will go high even if the company is in a tight position. Similarly, this would lead in reporting of high profitability ratio by the company as there would be no or lesser expense against such unearned revenue. This would result in higher profit margin.