MF 0010 Security Analysis and Portfolio Management

Set- 1
Q.1 Frame the investment process for a person of your age group.

Ans. As investors, we would all like to beat the market handily, and we would all like to pick "great" investments on instinct. However, while intuition is undoubtedly a part of the process of investing, it is just part of the process. As investors, it is not surprising that we focus so much of our energy and efforts on investment philosophies and strategies, and so little on the investment process. It is far more interesting to read about how Peter Lynch picks stocks and what makes Warren Buffett a valuable investor, than it is to talk about the steps involved in creating a portfolio or in executing trades. Though it does not get sufficient attention, understanding the investment process is critical for every investor for several reasons: 1. The investment process outlines the steps in creating a portfolio, and emphasizes the sequence of actions involved from understanding the investors risk preferences to asset allocation and selection to performance evaluation. By emphasizing the sequence, it provides for an orderly way in which an investor can create his or her own portfolio or a portfolio for someone else. 1. The investment process provides a structure that allows investors to see the source of different investment strategies and philosophies. By so doing, it allows investors to take the hundreds of strategies that they see described in the common press and in investment newsletters and to trace them to their common roots. 1. The investment process emphasizes the different components that are needed for an investment strategy to by successful, and by so doing explain why so many strategies that look good on paper never work for those who use them. The best way of describing this book is by noting what it does not do. It does not emphasize individual investors or push an investment philosophy. It does not focus heavily on coming up with strategies that beat the market, though there is reference to some of them in the course of the book. Instead, it talks about the process of investing and how this process is the same no matter what investment philosophy one might have. The book is built around the investment process. The process always starts with the investor and understanding his or her needs and preferences. For a portfolio manager, the investor is a client, and the first and often most significant part of the investment process is understanding the clients needs, the clients tax status and most importantly, his or her risk preferences. For an individual investor constructing his or her own portfolio, this may seem simpler, but understanding ones own needs and preferences is just as important a first step as it is for the

portfolio manager. The next part of the process is the actual construction of the portfolio, which we divide into three sub-parts. The first of these is the decision on how to allocate the portfolio across different asset classes defined broadly as equities, fixed income securities and real assets (such as real estate, commodities and other assets). This asset allocation decision can also be framed in terms of investments in domestic assets versus foreign assets, and the factors driving this decision. The second component is the asset selection decision, where individual assets are picked within each asset class to make up the portfolio. In practical terms, this is the step where the stocks that make up the equity component, the bonds that make up the fixed income component and the real assets that make up the real asset component are picked. The final component is execution, where the portfolio is actually put together, where investors have to trade off transactions cost against transactions speed. While the importance of execution will vary across investment strategies, there are many investors who have failed at this stage in the process. The final part of the process, and often the most painful one for professional money managers, is the performance evaluation. Investing is after all focused on one objective and one objective alone, which is to make the most money you can, given the risk constraints you operate under. Investors are not forgiving of failure and unwilling to accept even the best of excuses, and loyalty to money managers is not a commonly found trait. By the same token, performance evaluation is just as important to the individual investor who constructs his or her own portfolio, since the feedback from it should largely determine how that investor approaches investing in the future. These parts of the process are summarized in Figure 1, and we will return to this figure to emphasize the steps in the process as we move through the book. The book is built around the same structure. It begins with a chapter that provides an overview of investment management as a business. The first major section is on understanding client needs and preferences, where we look at not only how to think about risk in investing but also at how to measure an investors willingness to take risk. The second section looks at the asset allocation decision, while the third section examines different approaches to selecting assets. The fourth section takes a brief look at the execution decision, and the fifth section develops different approaches to evaluating performance.

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated. Ans. Introduction SENSEX, first compiled in 1986, was calculated on a "Market Capitalization-

Weighted" methodology of 30 component stocks representing large, wellestablished and financially sound companies across key sectors. The base year of SENSEX was taken as 1978-79. SENSEX today is widely reported in both domestic and international markets through print as well as electronic media. It is scientifically designed and is based on globally accepted construction and review methodology. Since September 1, 2003, SENSEX is being calculated on a freefloat market capitalization methodology. The "free-float market capitalizationweighted" methodology is a widely followed index construction methodology on which majority of global equity indices are based; all major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the free-float methodology. The growth of the equity market in India has been phenomenal in the present decade. Right from early nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the 'TMT' sectors. More recently, real estate caught the fancy of the investors. SENSEX has captured all these happenings in the most judicious manner. One can identify the booms and busts of the Indian equity market through SENSEX. As the oldest index in the country, it provides the time series data over a fairly long period of time (from 1979 onwards). Small wonder, the SENSEX has become one of the most prominent brands in the country. Index Specification: Base Year 1978-79 01-01-1986 of Launched on full market capitalization method and effective September 01, 2003, calculation method shifted to free-float market capitalization.

Base Index Value 100 Date of Launch Method calculation

Number of scrips 30 Index Constituents Click here for list of constituents

Index calculation Real Time frequency Index calculation Click here for Index calculation and maintenance and Maintenance Index Reach Click here for scrip-wise, sector wise market capitalization, weightage etc.

Market Click here for market capitalization and turnover coverage Capitalization and Turnover

. scrips suspended on the last day of the month prior to review date. wherein. at which latest trades are executed. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions.Scrip Selection Criteria 1. the level of index at any point of time reflects the free-float market value of 30 component stocks relative to a base period. An exception may be granted to one month. Dollex-30 BSE also calculates a dollar-linked version of SENSEX and historical values of Dollex series of BSE indices') this index are available since its inception. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of SENSEX is 1978-79 and the base value is 100 index points. Equities of companies listed on Bombay Stock Exchange Ltd. replacement of scrips etc. (excluding companies classified in Z group. if the average free-float market capitalization of a newly listed company ranks in the top 10 of all companies listed at BSE. Price to Book Value ratio and Dividend Yield % of Index Historical Notices Click to search Historical Notices on Index Replacements Historical Replacements Click here for historical replacements SENSEX Calculation Methodology SENSEX is calculated using the "Free-float Market Capitalization" methodology. are used by the trading system to calculate SENSEX on a continuous basis.Coverage Historical Values Index. SENSEX . The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. The calculation of SENSEX involves dividing the free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. a minimum listing history is not required. 2. In the event that a company is listed on account of a merger / demerger / amalgamation. Price Earnings. This is often indicated by the notation 1978-79=100. scrips objected by the Surveillance department of the Exchange and those that are traded under permitted category) shall be considered eligible Listing History: The scrip should have a listing history of at least three months at BSE. prices of the index scrips. During market hours. listed mutual funds.

Companies that have reported revenue in the latest four quarters from its core activity are considered eligible.50% shall be excluded All remaining companies will be sorted on sector and sub-sorted in the descending order of rank on free-float market capitalization. 6. Any company having a weight within this filtered constituent list of <0. 5. the top 75 companies based on free-float market capitalisation (avg. 3 months). Freefloat market capitalization takes into consideration only those shares issued by the company that are readily available for trading in the market. Industry/Sector Representation: Scrip selection will generally attempt to maintain index sectoral weights that are broadly in-line with the overall market. The scrip should have been traded on each and every trading day in the last three months at BSE. so long as the remaining list has more than 30 scrips. 3 months). 3 months) are selected as well as any additional companies that are in the top 75 based on full market capitalization (avg. 10. sorted list created in Step 6 that has Cumulative Turnover of >98%. 7. From the list of constituents selected through Steps 1-4. It generally excludes promoters' holding. The filtered list calculated in Step 7 is then sorted by free float market capitalization. Track Record: In the opinion of the BSE Index Committee. 4. all companies included within the SENSEX should have an acceptable track record. government holding. Any company in the filtered. Understanding Free-float Methodology Concept Free-float methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in the index. Exceptions can be made for extreme reasons like scrip suspension etc. 9. strategic holding and other .3. are excluded. 8. The filtered list of constituents selected through Step 5 (which can be greater than 75 companies) is then ranked on absolute turnover (avg. 11.

A Free-float index aids both active and passive investing styles. a leading global index provider.QQQ is based on the Free-float • • • • . companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. which is followed by Foreign Institutional Investors (FIIs) to track Indian equities. The MSCI India Standard Index. Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. FTSE. Major advantages of Free-float Methodology  A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market. Subsequently all BSE indices with the exception of BSE-PSU index have adopted the free-float methodology. under the Free-float Methodology. the market capitalization of each company in a free-float index is reduced to the extent of its readily available shares in the market. the underlying index to the famous Exchange Traded Fund (ETF) . shifted all its indices to the Free-float Methodology in 2002. It aids active managers by enabling them to benchmark their fund returns vis-Ã -vis an investible index. Globally. Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. MSCI. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers.locked-in shares that will not come to the market for trading in the normal course. is also based on the Free-float Methodology. S&P and STOXX have adopted the same. the Free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI. under a Full-market capitalization methodology. This improves market coverage and sector coverage of the index. However. For example. since only the free-float market capitalization of each company is considered for index calculation. Being a perfectly replicable portfolio of stocks. a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. it becomes possible to include such closely-held companies in the index while at the same time preventing their undue influence on the index movement. In other words. NASDAQ-100.

55 means that only 55% of the market capitalization of the company will be considered for index Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. (Format available on www. The remaining shareholders fall under the Free-float category. it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. Definition of Free-float Shareholding of investors that would not.Methodology. Determining Free-float Factors of Companies BSE has designed a Free-float format. in the normal course come into the open market for trading are treated as 'Controlling/ Strategic Holdings' and hence not included in free-float. Specifically. the following categories of holding are generally excluded from the definition of Free-float: • • • • • • • • Shares held by founders/directors/ acquirers which has control element Shares held by persons/ bodies with "Controlling Interest" Shares held by Government as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings) Equity held by Employee Welfare Trusts Locked-in shares and shares which would not be sold in the open market in normal course. A Free-float factor of say 0. which is filled and submitted by all index companies on a quarterly basis. BSE determines the Free-float factor for each company based on the detailed information submitted by the companies in the prescribed format. Once the Free-float of a company is determined. Free-float Bands: .bseindia.

90% >90 .45 0.30 0.50% Free-Float Factor 0.40 0.80 0. If a SENSEX constituent has not traded in the last 30 minutes. fund managers.65 0.75 0.20 0.05 0. On-Line Computation of the Index .25% >25 .70% >70 . additional issue of capital and other corporate announcements like 'rights issue' etc. The base year value adjustment ensures that replacement of stocks in Index.55 0.45% >45 .20% >20 .95 1.30% >30 .90 0.85% >85 .35 0.00 Index Closure Algorithm The closing SENSEX on any trading day is computed taking the weighted average of all the trades on SENSEX constituents in the last 30 minutes of trading session. do not destroy the historical value of the index.100% Free-Float Factor 0.95% >95 . The BSE Index Committee comprises of capital market expert. then its last day's closing price is taken for computation of Index closure.15% >15 . market participants and members of the BSE Governing Board. the last traded price is taken for computation of the Index closure.35% >35 .65% >65 .50 % Free-Float >50 .10% >10 . The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values.85 0.15 0. The BSE Index Cell ensures that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. Maintenance of SENSEX One of the important aspects of maintaining continuity with the past is to update the base year average.10 0. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value. The BSE Index Cell does the day-to-day maintenance of the index within the broad index policy framework set by the BSE Index Committee.5% >5 .75% >75 .55% >55 .60 0.80% >80 .% Free-Float >0 . If a SENSEX constituent has not traded at all in a day.25 0.40% >40 .70 0.60% >60 .

This is done automatically on the basis of prices at which trades in Index constituents are executed. only the 'number of shares' in the formula is updated. suppose a company issues right shares which increases the market capitalization of the shares of that company by say. Rights and Newly Issued Capital SENSEX calculation needs to be adjusted for issue of Bonus or Rights shares If no adjustments were made. included in the compilation of the index. issues bonus shares. • Adjustments for Rights Issues When a company.During trading hours. The existing Base Market capitalization (Old Base Market capitalization). which is used to alter market capitalization of the component stocks to arrive at the SENSEX value.100 crores. Other Issues Base Market capitalization adjustment is required when new shares are issued by way of conversion of debentures. mergers. spin-offs etc. Adjustments for Bonus Issue When a company. there is no change in the Base Market capitalization. issues right shares. say. the base value is adjusted. the market capitalization of that company does not undergo any change. Base Market capitalization Adjustment • • • The formula for adjusting the Base Market capitalization is as follows: New Base Market capitalization = Old Base Market capitalization x New Market capitalization / Old Market capitalization To illustrate. Adjustment for Bonus. An offsetting or proportionate adjustment is then made to the Base Market capitalization (see 'Base Market capitalization Adjustment' below). is Rs. the free-float market capitalization of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. Therefore. a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. included in the compilation of the index. corporate restructuring etc.2450 crores and the aggregate market capitalization of all the shares included in the . value of the Index is calculated and disseminated on real time basis. The BSE Index Cell keeps a close watch on the events that might affect the index on a regular basis and carries out daily maintenance of all BSE Indices. or when equity is reduced by way of buy-back of shares. At the BSE Index Cell . Rs.

which had been achieved in April 2007. industrial sector in India had recorded a growth of 7 percent. In core infrastructural industries. 2501.2501. In case of a revision in the Index constituents.5 percent and for electricity sector. Measures that have been taken by Reserve Bank of India.3 Perform an economy analysis on Indian economy in the current situation. Q. India economic analysis provides various inputs on economic condition of this south-east Asian country.index before the right issue is made is.4 percent and 8. It can be done both at a microeconomic as well as a macroeconomic level. Mining sector has been comparatively better off as it has managed to grow at a rate of 8 percent in April 2008 compared to 2.= Rs. rate of development stood at 1. India economic analysis could also be described as being an explanation of various economic phenomena going on in this country. there has been deceleration as well.24 crore will be used as the Base Market capitalization for calculating the index number from then onwards till the next base change becomes necessary.4 percent in April 2008. For manufacturing sector it was 7. However. this figure is lesser than 11 percent development. Manufacturing and electric sector have suffered as well in recent times. rates of interest and prices of goods and services.24 crores 4781 This figure of Rs. The "New Base Market capitalization " will then be: 2450 x (4781+100) -------------------------.4781 crore. Their growth rates have come down too. Growth in April 2008 . Recent macroeconomic developments in India In April 2008. say Rs. raw materials. like upward revision of repo rate and CRR. In case of manufacturing sector much of this slump could be attributed to increase in input costs like expenses of oil. This rate is significantly low when compared to statistics of April 2007. Index Review Frequency The BSE Index Committee meets every quarter to discuss index related issues. the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision of the Index.7 percent respectively. have also contributed to decrease in industrial production. but it is still better off compared to non infrastructural industries in India. when rates of development for manufacturing and electricity were 12. Much of this critical condition could be attributed to an increase in prices of oil. Ans.6 percent that was achieved in April 2007.

This indicator measures short-term momentum as compared to longer term momentum and .6 percent. A moving average. a smoother line is produced. which is less than 5. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. finished steel and cement have performed better than April 2007.4 Identify some technical indicators and explain how they can be used to decide purchase of a company’s stock.66 percent. the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. say the closing prices of a stock for 3 days are Rs. while others incorporate volume and open interest into their formulae. as the name suggests. Ans. Some indicators may use only the closing prices. By averaging the data. low or closing price over a period of time. 43 and Rs. When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go above it. making it much easier to view the underlying trend. A 9-day moving average is generally used as a trigger line. The new total is then divided by the total number of days (10) and the resultant average computed. The price data is entered into the formula and a data point is produced. A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. high. 41.9 percent achieved in April 2007. Inflation in India In financial year 2007-08. Q. A moving average filters out random noise and offers a smoother perspective of the price action. Moving average convergence divergence (MACD) : MACD is a momentum indicator and it is made up of two exponential moving averages. Each day. Price data can be any combination of the open. Rs. The purpose of the moving average is to track the progress of a price trend. Some of the technical indicators are discussed below for the purpose of illustration of the concept : Moving average : The moving average is a lagging indicator which is easy to construct and is one of the most widely used. represents an average of a certain series of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. electricity and petroleum refinery have been performing below expectations but coal. A number of technical indicators are in use. 43. it’s a bullish signal. For example. High prices of oil were responsible for proportionately high rate of inflation in 2008-09. That high rate of inflation had to be controlled by banning a number of necessary commodities as well as various financial steps. Industries like crude oil production. average inflation in India was around 4. The moving average is a smoothing device. fiscal high prices of food items were primary cause behind high rates of inflation. In 2007-08. This rate was lower than average inflation of financial year 2006-07.has been around 3.

and in practice. Ans: In economics and finance. it is the possibility of a risk-free profit at zero cost. RSI is plotted in a range of 0-100. People who engage in arbitrage are called arbitrageurs (IPA: /ˌɑrbɨtrɑːˈʒɜr/)— such as a bank or brokerage firm. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. RSI helps to signal overbought and oversold conditions in a security. Traders use the MACD for indicating trend reversals. while a reading below 30 suggests that is oversold. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. In downtrends. as in merger arbitrage. the more is the selling pressure. a reading above 70 suggests that a security is overbought. In academic use. The idea behind this indicator is that in an uptrend. signaling upward momentum in the security. In principle and in academic use. it is also used to refer to differences between similar assets (relative value or convergence trades). an arbitrage is risk-free.5 Compare Arbitrage pricing theory with the Capital asset pricing model. The price should be closing near the highs of the trading range. some major (such as devaluation of a currency or derivative). and the closer the closing price is to the period’s low. Stochastic Oscillator : The stochastic oscillator is one of the most recognized momentum indicators. Relating Strength Index : The relative strength index (RSI) is another of the well-known momentum indicators. the price should be closing near the lows of the trading range. as in statistical arbitrage. some minor (such as fluctuation of prices decreasing profit margins). in common use. arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance. signaling downward momentum. there are always risks in arbitrage. an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state. Q. though losses may occur. When used by academics. in common use. This indicator helps traders to identify whether a security’s price has been unreasonably pushed to its current levels and whether a reversal may be on the way. an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows. The term is mainly applied to trading in . the higher is the buying pressure. This indicator provides information about the location of a current closing price in relation to the period’s high and low prices. The closer the closing price is to the period’s high. the profit being the difference between the market prices.signals the current direction of momentum. in simple terms. it may refer to expected profit.

Conditions for arbitrage Arbitrage is possible when one of three conditions is met: 1. such as bonds. derivatives. This type of price arbitrage is the most common. commodities and currencies. Traders may. particularly arbitrage mechanics. 3. "True" arbitrage requires that there be no market risk involved. and other factors. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London. and even then. storage. this is generally only possible with securities and financial products which can be traded electronically. for a profit of ¥200. In reality. See rational instruments. purchase the good. as such. The same asset does not trade at the same price on all markets ("the law of one price"). Examples • Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6.[note 1] In the simplest example. when each leg of the trade is executed the prices in the market may have moved. but this simple example ignores the cost of transport. this condition holds for grain but not for securities). Where securities are traded on more than one exchange. stocks. for example. arbitrage occurs by simultaneously buying in one and selling on the other. Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. Mathematically it is defined as follows: and where Vt means a portfolio at time t. risk. and transport it to another region to sell at a higher price. 2. this "triangle arbitrage" is so simple that it almost . The transactions must occur simultaneously to avoid exposure to market risk. would be arbitrage. In practical terms. or the risk that prices may change on one market before both transactions are complete. for example. the asset does not have negligible costs of storage. for further discussion. any good sold in one market should sell for the same price in another. find that the price of wheat is lower in agricultural regions than in cities. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'. Two assets with identical cash flows do not trade at the same price.

such as when a business outsources its bookkeeping to an accounting firm. One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. This profit would typically be between 1% and 5% but can be much higher. by taking the best odds offered by each bookmaker. The activity of other arbitrageurs can make this risky. Different bookmakers may offer different odds on the same outcome of a given event. known as a Dutch book. in order to remain competitive their margins are usually quite low. At present. many such jobs appear to be flowing towards China. outsourcing always involves subcontracting jobs to a different company. the odds of making an 'arb' usually last for less than an hour . and that company can be in the same country as the outsourcing company. Because the differences between the prices are likely to be small (and not to last very long). One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule. a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit. this is referred to as offshoring. Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. one can buy the less expensive one and sell it to the more expensive market. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually. Unlike offshoring.) Sports arbitrage – numerous internet bookmakers offer odds on the outcome of the same event. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync. However. though some which require command of English are going to India and the Philippines. which means "to subcontract from an outside supplier or source".• • • never occurs. such as the spot-forward arbitrage (see interest rate parity) are much more common. (Note that "offshoring" is not synonymous with "outsourcing". As bookmakers become more proficient. In popular terms. But more complicated foreign exchange arbitrages.

An ETF may trade at a premium or discount to the value of the underlying assets. Furthermore.S. represents pure profit. 11 APT can be extended to multifactor models. while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value. dollar debt and local currency debt of a foreign country. 14 Be aware that correlation does not imply causality. For example. Rather than exploiting price differences between identical assets. rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. a fund may see that there is a substantial difference between U. Comparison between APT & CAPM 8 APT applies to well diversified portfolios and not necessarily to individual stocks. and sell them in the open market. an arbitrageur will buy the underlying securities. 13 Empirical methods are based less on theory and more on looking for some regularities in the historical record. When a significant enough premium appears. When a discount appears. and enter into a series of matching trades (including currency swaps) to arbitrage the difference. assets and derivatives with similar characteristics. the arbitrageur makes a lowrisk profit. an arbitrageur will do the reverse. the belief is that there remains some difference which.• • and typically only a few minutes. ETFs trade in the open market.not lie on the SML. Some types of hedge funds make use of a modified form of arbitrage to profit. convert them to shares in the ETF. 15 Related to empirical methods is the practice of classifying portfolios by . In this way. Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself. 10 APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit. huge bets on one side of the market also alert the bookies to correct the market. with prices set by market demand. while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk. even after hedging most risk. 9 With APT it is possible for some individual stocks to be mispriced . and hedge any significant differences between the two assets. There are alternatives. they will purchase and sell securities. 12 Both the CAPM and APT are risk-based models.

Relation between sources determined by no Arbitrage condition. Ans.g. e. v CAPM is simpler to communicate. the unsystematic risks of the individual securities offset each other.6 Discuss the different forms of market efficiency. Important for hedging in portfolio formation. 19 Empirical models try to capture the relations between returns and stock attributes that can be measured directly from the data without appeal to theory. all public information and all private information) refers to the strong form version of market efficiency. A fully diversified portfolio has no unsystematic risk. information that is public information and information that is private information. . information that consists of past prices and all public information refers to the semi-strong version of market efficiency and all information (past prices. v CAPM difficult to find good proxy for market returns. different answers to these questions give rise to different versions of market efficiency. 21 Difference in Application v APT difficult to identify appropriate factors. 20 Difference in Methodology v CAPM is an equilibrium model and derived from individual portfolio optimization. A financial market displays informational efficiency when market prices reflect all available information about value. v APT shows sensitivity to different sources. v APT is a statistical model which tries to capture sources of systematic risk. o Value portfolio o Growth portfolio 16 The APT assumes that stock returns are generated according to factor models such as: 17 As securities are added to the portfolio. since everybody agrees upon. This definition of efficient market required answers to two questions : ‘what is all available information?’ & ‘what does it mean to reflect all available information ?’. 18 The CAPM can be viewed as a special case of the APT. Information about past prices refers to the weak form version of market efficiency. What information are we talking about? Information can be information about past prices.

using the available information. the semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. and other market-generated information. volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. trading volume data. EMH asserts that stock prices cannot be predicted with any accuracy. the semi-strong form suggests that fundamental analysis is also fruitless. are zero NPV activities. the strong form the EMH suggests that stock prices reflect all information.“Prices reflect all available information” means that all financial transactions which are carried out at market prices. The current prices fully reflect all security-market information. whether it be public (say in SEBI filings) or private (in the minds of the CERO and other insiders). In sum. So even with material non-public information. knowing what a company generated in terms of earnings and revenues in the past will not help you determine what the stock price will do in the future. rates of return. then technical analysis is fruitless in generating excess returns. Lastly. It would mean that if the weak form of EMH is correct. . The weak form the EMH states that all past prices. “OLD” information then is already discounted and cannot be used to predict stock price fluctuations. This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions. including the historical sequence of prices. This implies that past rates of return and other market data should have no relationship with future rates of return.

The scope of mergers and acquisition set the tone for the nature of mergers and acquisition activities and in turn affects the factors which have significant influence over these activities. staff and line personnel have important Responsibilities in the strategic decision making processes. Organization. Formulation of the missions. Formulation of long range strategy programs 9. goals and polices 6.MF 0011 Mergers and Acquisitions Set. industry. Assessment of changes in the organization environment 2. Review and evaluation of all the processes In each of these activities. Formulation of internal organizational performance measurements 8. Proper identification of different phases and related activities smoothen the process of involved in merger . Development of sensitivity to critical external environmental changes 7. Formulation of mid-range programmes and short-run plans 10. domestic economy and international economies 5. Analysis of company. Some of the essential elements in strategic planning processes of mergers and acquisitions are as listed here below : 1.1 What are the basic steps in strategic planning for a merger? Ans. Basic steps in Strategic planning in Merger : Any merger and acquisition involve the following critical activities in strategic planning processes. This can be seen by observing the factors considered during the different stages of mergers and acquisition activities. competitors.1 Q. Information flow and feedback system for continued repetition of all essential elements and for adjustment and changes at each stage 12. funding and other methods to implement all of the proceeding elements 11. Evaluation of company capacities and limitations 3. Assessment of expectations of stakeholders 4.

which should result in higher margins and operating income. allowing the combined firm to become more cost-efficient and profitable. 3. An example of limiting competition to increase pricing power is the acquisition of universal luggage by Blow Plast. Combination of different functional strengths. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so. Both the banks after combination can expect to cut costs considerably on account of sharing of their resources and thus avoiding duplication of facilities available. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. This synergy is also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in the business. When there are more firms in the industry ability of firms to exercise relatively higher price reduces and in such a situation the synergy does not seem to work as desired. Another example is the acquisition of Tomco by Hindustan Lever. 2. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of cost reducing operating synergy. The phenomenon can be understood in cases where one company with an established brand name lends its reputation to a company with upcoming product line or a company. Economies of scale that may arise from the merger. Economics of scales can be seen in mergers of firms in the same business For example : two banks combining together to create a larger bank. increase growth or both. Sources of Operating Synergy Operating synergies are those synergies that allow firms to increase their operating income.2 What are the sources of operating synergy? Ans.Q. We would categorize operating synergies into four types: 1. . Greater pricing power from reduced competition and higher market share. combination of different functional strengths may enhance the revenues of each merger partner thereby enabling each company to expand its revenues. In other words the two companies should get the advantage of the combination of their complimentary functional strengths. After the acquisition blow past acquired a strong hold on the market and operated under near monopoly situation.

In the realm of increased globalized economy. This can be understood with the following example Example : Consider a situation where there are two firms A and B.4. This would be case when a US consumer products firm acquires an emerging market firm. Such acquisitions need huge amount of finance to be provided. unrated or low rated debt known as junk bond financing is utilized. Bank loans are typically structured in up to three trenches : A. Modes of purchase There are a number of types of financing which can be used in an LBO. and uses these strengths to increase sales of its products. Ans. Higher growth in new or existing markets. Q. mergers and acquisitions have assumed significant importance both with the country as well as across the boarders. note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one. These include : Senior debt : this is the debt which ranks ahead of all other debt and equity capital in the business. which means the lender can automatically acquire these assets if the company breaches its . the concept of Leverage Buyout (LBO) has emerged. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). The leveraged buyout are cash transactions in nature where cash is borrowed by the acquiring firm and the debt financing represents 50% or more of the purchase price. with an established distribution network and brand name recognition. B and C. a proportionate amount of the long term financing is secured with the fixed assets of the firm and in order to raise the balance amount of the total purchase price. Operating synergies can affect margins and growth. Generally the tangible assets of the target company are used as the collateral security for the loans borrowed by acquiring firm in order to finance the acquisition. Some times. for example here A can invest its resource in the opportunities available to B. The debt is usually secured on specific assets of the company. If A and B combine with each other both can utilize each other strengths. Synergy results from complementary activities. LBO is a financing technique of purchasing a private company with the help of borrowed or debt capital. arising from the combination of the two firms.3 Explain the process of a leveraged buyout. and through these the value of the firms involved in the merger or acquisition. In search of an ideal mechanism to finance and acquisition.

This integration process has three dimensions: the technical. Mezzanine finance : This is usually high risk subordinated debt and is regarded as a type of intermediate financing between debt and equity and an alternative of high yield bonds. The question of whether loan stock is tax deductible should be investigated thoroughly with the company’s advisers. Subordinated debt : This debt ranks behind senior debt in order of priority on any liquidation. often listed on Indian markets. The technical integration is similar to the capability transfer discussed above. therefore it has the lowest cost of debt. political and cultural. Ordinary shares : This is the riskiest part of a LBOs capital structure. Ans. ordinary shareholders will enjoy majority of the upside if the company is successful. The integration of social interaction and political relationships represents the informal processes and systems which influence people’s ability and motivation to perform. Repayment is usually required in one ‘bullet’ payment at the end of the term. At the time of integration.obligations under the relevant loan agreement. The terms of the subordinated debt are usually less stringent than senior debt. Loan stock : This can be a form of equity financing if it is convertible into equity capital. Q.4 What are the cultural aspects involved in a merger. They are fixed rate. Typically. Since subordinated debt gives the lender less security than senior debt. The bank loans are usually held by a syndicate of banks and specialized funds. An increasingly important form of subordinated debt is the high yield bond. The value chains of the acquirer and the acquired. Give sufficient examples. An enhanced return is made available to lenders by the grant of an ‘equity kicker’ which crystallizes upon an exit. High yield bonds can either be senior or subordinated securities that are publicly placed with institutional investors. the acquirer should have regard to these political . A form of this is called a PIK. and generally includes an attached equity warrant. Preference share : This forms part of a company’s share capital and usually gives preference shareholders a fixed dividend and fixed share of the company’s equity. lending costs are typically higher. need to be integrated in order to achieve the value creation objectives of the acquirer. However. or rolled up into the principal. which reflects interest ‘paid in kind’. These obligations are usually quite stringent. publicly traded. long term securities with a looser covenant package than senior debt though they are subject to stringent reporting requirements. the terms of senior debt in an LBO will require repayment of the debt in equal annual installments over a period of approximately 7 years.

relationships, if acquired employees are not to feel unfairly treated. An important aspect of integration is the cultural integration of the acquiring and acquired firms. The culture of an organization is embodied in its collective value systems, beliefs, norms, ideologies myths and rituals. They can motivate people and can become valuable sources of efficiency and effectiveness. The following are the illustrative organizational diverse cultures which may have to be integrated during post-merger period: Strong top leadership versus Team approach · Management by formal paper work versus management by wandering around · Individual decision versus group consensus decision · Rapid evaluation based on performance versus Long term relationship based on loyalty · Rapid feedback for changes versus formal bureaucratic rules and procedures · Narrow career path versus movement through many areas · Risk taking encouraged versus ‘one mistake you are out’ · Risky activities versus low risk activities · Narrow responsibility arrangement versus ‘Everyone in this company is salesman (or cost controller, or product quality improver etc.)’ · Learn from customer versus ‘We know what is best for the customer’ The above illustrative culture may provide basis for the classification of organizational culture. There are four different types of organizational culture as mentioned below: · Power - The main characteristics are: essentially autocratic and suppressive of challenge; emphasis on individual rather than group decision making · Role - The important features are: bureaucratic and hierarchical; emphasis on formal rules and procedures; values fast, efficient and standardized culture service · Task/achievement - The main characteristics are: emphasis on team commitment; task determines organization of work; flexibility and worker autonomy; needs creative environment · Person/support

- The important features are: emphasis on equality; seeks to nurture personal development of individual members Poor cultural fit or incompatibility is likely to result in considerable fragmentation, uncertainty and cultural ambiguity, which may be experienced as stressful by organizational members. Such stressful experience may lead to their loss of morale, loss of commitment, confusion and hopelessness and may have a dysfunctional impact on organizational performance. Mergers between certain types can be disastrous. Differences in culture may lead to polarization, negative evaluation of counterparts, anxiety and ethnocentrism between top management teams of the acquired and acquiring firms. In assessing the advisability of an acquisition, the acquirer must consider cultural risk in addition to strategic issues. The differences between the national and the organizational culture influence the cross-border acquisition integration. Thus, merging firms must consciously and proactively seek to transform the cultures of their organizations. Q.5 Study a recent merger that you have read about and discuss the synergies that resulted from the merger. Ans. Synergy is the additional value that is generated by the combination of two or more than two firms creating opportunities that would not be available to the firms independently. There are two main types of synergy : 22 Operating synergy 23 Financial synergy Operating Synergy Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. We would categorize operating synergies into four types: 1. Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. Economics of scales can be seen in mergers of firms in the same business For example : two banks combining together to create a larger bank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of cost reducing operating synergy. Both the banks after combination can expect to cut costs considerably on account of sharing of their resources and thus avoiding duplication of facilities available. 2. Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income. This synergy is also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in the business. When there are more firms in the industry ability of firms to exercise relatively higher price reduces and in such a situation the synergy does

not seem to work as desired. An example of limiting competition to increase pricing power is the acquisition of universal luggage by Blow Plast. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. After the acquisition blow past acquired a strong hold on the market and operated under near monopoly situation. Another example is the acquisition of Tomco by Hindustan Lever. 3. Combination of different functional strengths, combination of different functional strengths may enhance the revenues of each merger partner thereby enabling each company to expand its revenues. The phenomenon can be understood in cases where one company with an established brand name lends its reputation to a company with upcoming product line or a company. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so. In other words the two companies should get the advantage of the combination of their complimentary functional strengths. 4. Higher growth in new or existing markets, arising from the combination of the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products. Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition. Synergy results from complementary activities. This can be understood with the following example Example : Consider a situation where there are two firms A and B. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). If A and B combine with each other both can utilize each other strengths, for example here A can invest its resource in the opportunities available to B. note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one. Financial Synergy With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate). Included are the following: 24 A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that were taken with the

technology. joint ventures are becoming an increasingly common way for companies to form strategic alliances. two or more “parent” companies agree to share capital. and other expenses. how to value it. This synergy is likely to show up most often when large firms acquire smaller firms. if so. in turn. The existence of synergy generally implies that the combined firm will become more profitable or grow at a faster rate after the merger than will the firms operating separately. as we show later in this chapter. Q. technology. there is potential for synergy in many mergers. a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. risks and rewards in a formation of a new entity under shared control. the important reasons for forming a joint venture can be presented below: Internal Reasons to Form a JV 27 Spreading Costs: You and a JV partner can share costs associated with marketing. product development. Clearly. This. Alternatively. a firm that is able to increase its depreciation charges after an acquisition will save in taxes. however. allows them to borrow more than they could have as individual entities. reducing your financial burden. human resources. It is thus a weak test of the synergy hypothesis. explain with an example of a joint venture.As there are good business and accounting reasons to create a joint venture with a company that has complementary capabilities and resources. because when two firms combine. The more important issues are whether that synergy can be valued and. or take the form of a lower cost of capital for the combined firm. or finance. This result has to be interpreted with caution.6 What are the motives for a joint venture. after takeovers. In a joint venture. or when publicly traded firms acquire private businesses. and increase its value. . Broadly. 25 Debt capacity can increase. which creates a tax benefit for the combined firm. such as distribution channels. Thus.excess cash that otherwise would not have been taken. On this test. 26 Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of net operating losses to shelter income. including under valuation and a change in corporate control. since the increase in the value of the combined firm after a merger is also consistent with a number of other hypotheses explaining acquisitions. A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth) relative to their competitors. This tax benefit can either be shown as higher cash flows. many mergers fail. their earnings and cash flows may become more stable and predictable. Ans:.

etc. and innovation. 30 Improving Access to New Markets: You and a JV partner can combine customer contacts and together even form a joint product that accesses new markets. development of diverse products. Diversification . and distribution resources. you and a JV partner can get your joint product to market faster and more efficiently. 33 Improve Speed to Market: With shared access to financial. technological. Sharing innovative and proprietary technology can improve products. diversify the innovative working force. 35 Share and Improve Technology and Skills: Two innovative companies can share technology to improve upon each other's ideas and skills. 31 Help Economies of Scale: Together you and a JV partner can develop products or services that reduce total overall production expenses.28 Opening Access to Financial Resources: Together you and a JV partner might have better credit or more assets to access bigger resources for loans and grants than you could obtain on your own.There could be many diversification reasons: access to diverse markets. Don't let a JV opportunity pass you by because you don't think it will fit in . as well as your own understanding of technological processes. Strategic Reasons 34 Synergistic Reasons: You may find a JV partner with whom you can create synergy. External Reasons to Form a JV 32 Develop Stronger Innovative Product: Together you and a JV partner may be able to share ideas to develop a product that is more competitive in your industry. which produces a greater result together than doing it on your own. or vice versa. Strategic Move Against Competition: A JV may be able to better compete against another industry leader through the combination of markets. Bring your product to market cheaper where the customer can enjoy the cost savings. technology. 29 Connection to Technological Resources: You might want access to technological resources you couldn't afford on your own.

Small and big companies alike can benefit from the reasons listed above. and strategically. externally. Analyze how your company can benefit internally. . and then find a joint venture partner that will fit with your needs.with your own small business.

Lands were sold for only 20% of their real values and the balance 80% given in cash out of the tax evaded monies. It came to light that none of the taxpayers concerned declared for taxation purposes anything more than 25% of their true incomes after 1999. In view of the facts set out so far. Considering the extent of Indian monies stacked in Swiss Bank Accounts. an attempt was made to determine the extent of tax evasion in the Mumbai Income Tax charge.1 Q. economy and the country. How does it affect the Indian economy and the growth prospects? Ans. There are companies which have camouflaged their capital investments and shown it in the books as if it is explained capital for income tax purposes. which collected about 35% of the Income Tax collections of the country and 43% of the corporate tax collections. Not a single protest was received from any of the taxpayer. ever since 1947. it appears that the real income admitted for taxation purposes is less than 25% . The said figure was thereafter cited for some more time. there appears 10 to be higher tax evasion in the case of companies. But later on when the tax rates were lowered to . The study was made on the basis of results of the survey and search cases for all the years covered by such cases. Though many estimates of black money have been coming forth. every reason to believe this estimate. Some of the companies have shown their entire capital as having come from the countries regarded as Tax Havens. The Indian Scenario . it becomes necessary to look at the extent of compliance of tax laws in India. including companies. However. The figure arrived at was given to the press specifying the basis on which it was so calculated. and bank accounts of the developed countries. There was. The extent of evasion appears to be very much higher in the case of companies as the companies have resorted to evolution of tax evasion devices in the accounts and such methods have not yet been properly investigated by the Income Tax Department. and comparing the same with the annual income tax collections of the Central Government.1 Tax evasion is a menace to the people. therefore. In the wake of recent Swiss bank account scandal give your views on the following: a. and even thereafter no protest was received.Peculiar problems of tax evasion : It will be appropriate at this stage to highlight some of the key problems from the view point of computerisation in India : (a) Investments in Real Estate : The one field where black monies have been invested on the largest scale is that of real estate properties.MF 0012 Taxation Management Set.

They have ability to give extensive bribes to protect business and other interests. But it is common knowledge that the black monies invested in land have been reinvested in bank accounts. in fact. 80. (c) Shares. as all the transactions relating to sale of real estate properties are now recorded in computers maintained by the Registration Offices all over the country. Further. suggested for adoption on the U. unaccounted cash holdings etc.000 crores a year. Like-wise. It is now confirmed knowledge that in regard to buildings constructed. huge unaccounted cash balances and gold and diamond jewellery have been found in the bank lockers maintained by tax payers in bogus names and in their own names. and if the same data is brought on the computers of the Income Tax Department. shares and in other properties. Mutual Funds. the black portion got reduced to 40% . it would have come from the traders themselves. it is necessary to introduce a law requiring them to transact only through bank cheques and issue computerized bills. it should be possible to know many owners of property who have not filed their tax returns at all so far. only 40% of the cost is shown to income tax. All such practices would varnish once fear is caused among the tax payers about the use of . pattern for India. travelers’ cheques. They are also giving vouchers to the effect that raw gold has been given by the customers. d) Undisclosed Stock in-trade held by companies and traders : Many firms and individuals have also a tendency to keep undisclosed business assets like cars and private assets. There is also the data generated in the computers of the organizations in charge of demat of shares. The Mumbai Stock Exchange is having a separate computer system with complete data on daily transactions and the Income Tax Department has so far not made use of such data. In India.. The data regarding company shares and other investments mentioned can be easily transferred to the computer system of the Income Tax Department. It is possible to detect such investment by analysis of the data obtained from the trade and industry governing commodities used for construction of buildings. Gold and diamond traders are mostly keeping their transactions outside bank accounts. mutual funds and the primary bonds issued by the Reserve Bank of India. In the searches conducted by the Income Tax Department. Therefore. though. It may be a difficult task to trace such black transactions through the computer system. etc : There are vast investments in shares and debentures. the data on post office savings and other accounts is easy to be brought on the computers of the tax department for verification with the individual returns. and thus a large number of people with taxable income have evidently chosen not to file income tax returns.30% for individuals and 35% for companies. to facilitate proper flow of information to the computer system of the tax department. there are only 3 crores of tax assessees at present. silver and diamonds may now reach about Rs.S. purchases of gold. apart from real estate property. At current market rates. which are available with the Government itself. (b) Gold and Jewellery Holdings : India is having the largest private holdings of gold and diamond jewellery among all the countries of the world.

smuggling. Such practices enable payment of secret trade commissions in foreign currency and unaccounted funds in Indian currency to those contesting general elections. The gap between the haves and the have nots is widening every day. They display it in ostentatious living and wasteful luxuries.computerized data for taxation purposes. The black money has already created a serious problem in our country. and benami shares will have to be traced sometimes by extensive studies to be conducted by teams of revenue officers. there are additions to the Swiss Bank Account holdings. It is the result of hoarding. This problem requires comprehensive study because it is peculiar to the Indian Taxation System. It is difficult to form an exact idea of the amount of black money in circulation in the country. the prices continue to rise in spite of all government efforts to control them. b. Does black money cause Inflation? Ans. It has been beyond the control of the Government. The large amounts of Swiss Bank deposits have. The poor go on becoming poorer while the rich go on becoming richer. Thus the entire social structure comes to be badly polluted. Illegally earned money is called black money. which are held in foreign currency. Black money is used by the rich in various evil activities. It has given rise to parallel economy operating in the country. Several major companies have converted Swiss Account holdings into benami shares and debentures. been utilized and every year. They purchase political bosses and control the strings of the Government. The Indian economy stands badly shattered because of the huge amount of this tainted wealth lying in the coffers of the rich. Searches and raids by Income Tax authorities are conducted from time to time. (f) Swiss Bank and other undisclosed bank accounts held abroad: Swiss Bank Accounts are shrouded in secrecy and hence no information will be available to the computer system of the Income Tax Department. Most of the offenders use all their money and . (e) Benami Investments : Benami investments are typical of the Indian economy. have been utilised by big companies and other taxpayers in India to import huge machineries at vastly underinvoiced prices. Even big companies have indulged in such practices to impart total secrecy to their undisclosed accounts. They use this money for corrupting and demoralizing social and political life. tax evasion and dealing in immovable property for which the consideration is paid in black. at times. cleverer than the Government. They bribe Government officers and lead them to corruption and dishonesty. It may be difficult to determine whether the investment found in the computers of the income tax department is benami or not. They seek the aid of the best legal brains and get the law twisted in their favour. Such raids yield crores of rupees. The amounts in Swiss Bank Accounts. But the people are. As a result. thus.

At different times. All steps to weed the black money out of circulation must be taken as early as possible.2 Detail death cum retirement gratuity under Sec 17(1)iii of IT Act. black-marketeers and hoarders. Any death-cum-retirement gratuity received under the revised Pension Rules of the Central Government or. It is to a great extent responsible for a great rise in prices because the purchasing power of the people has increased. 1972. A number of steps have been taken. Is commutation of pension a viable option in terms of tax planning? Ans. The black money. at various times. These schemes have proved successful to a very limited extent. Smugglers and black-marketeers can no longer be tolerated. the Central Civil Services (Pension) Rules. tax evaders. The vested interests always stand in the way of effective measures and get them diluted. 10. according to some reliable estimates has gone up to Rs. What has come to the surface is believed only to be the tip of the huge iceberg lying hidden underneath. There has been some success. They are striking at the very roots of our democratic structure. Black money is a curse. Taxation structure and system have been made easier. announced some voluntary disclosure schemes for unearthing the black money. Q. The Government has. as the case may be. People having black money are leading a life of luxury whereas the poor people are leadinng a miserable life. the government has brought forward several schemes and asked the people to declare their wealth. Some leading economists of the country have suggested stringent measures to the government to unearth black money but successive governments have been rejecting those measures. A lot soil remains to be done. Death-cum-retirement gratuity or any other gratuity which is exempt to the extent specified from inclusion in computing the total income under clause (10) of Section 10. The 1997 Voluntary Disclosure Scheme announced by the Government of India unearthed a big amount of black money as the tax rate in this scheme had been reduced to thirty per cent. or under any similar scheme applicable to the members of the civil services of the Union or holders of posts connected with defence or of civil posts under the Union (such members or holders being persons not governed by the said Rules) or to the members of the all-India services or to the members of the civil services of a State or holders of civil posts under a State or to the employees of a local authority or any payment of retiring gratuity received under the Pension Code or Regulations applicable to the .000 crores in our country. The government of the day appears to be doing its best to unearth black money.influence and go scot free whenever they are caught. It must be rooted out from public life.The government must come down with a heavy hand on smugglers. It must be clear to all that the nation cannot shut her eyes to this state of affairs.

children or dependants on his death is exempt subject to certain conditions. in respect of private sector employees gratuity received on retirement or on becoming incapacitated or on termination or any gratuity received by his widow. As regards payments in commutation of pension received under any scheme of any other employer.State or Provincial Act. under the Union. is exempt under sub-clause (i) of clause (10A) of Section 10.50. . Gratuity received in cases other than above on retirement. namely: (a) Where the employee received any gratuity. the commuted value of one-third of the pension which he is normally entitled to receive. The maximum amount of exemption is Rs. However.. any death-cum-retirement gratuity of a government servant is completely exempt from income tax. the commuted value of half of such pension.000. 3. Thus. termination etc is exempt up to the limit as prescribed by the Board. the least of these items is exempt from income tax under Section 10(10). Under the provisions of Section 10(10) of the IT Act. Any payment in commutation of pension received under the Civil Pension(Commutation) Rules of the Central Government or under any similar scheme applicable to the members of the civil services of the Union. Of course. The entire amount of any payment in commutation of pension by a government servant or any payment in commutation of pension from LIC [Get Quote] pension fund is exempt from income tax under Section 10(10A) of IT Act.or civil posts under a State. It may be noted here that the monthly pension receivable by a pensioner is liable to full income tax like any other item of salary or income and no standard deduction is now available in respect of pension received by a tax payer. or. calculated on the basis of average salary for the 10 months immediately preceding the year in which the gratuity is paid or 20 months' salary as calculated. or to the members of the All India Services/Defence Services. any payment in commutation of pension received from a Regimental Fund or Non-Public Fund established by the Armed Forces of the Union referred to in Section 10(23AAB) is exempt under sub-clause (iii) of clause (10A) of Section 10.members of the defence service. exemption will be governed by the provisions of sub-clause (ii) of clause (10A) of section 10. However. this is further subject to certain other limits like the one half-month's salary for each year of completed service. in respect of private sector employees. or holders of civil posts/posts connected with defence. only the following amount of commuted pension is exempt. to the employees of a local authority or a corporation established by a Central. and (b) In any other case. Also.

Ans. Position of Firm under the Income Tax Act Legally. While computing the income of the firm under the head “Profits and gains of business or profession”. but no deduction by way of payment of interest. salary. Assessment of firm From point (5) stated above. 5. 2. besides the deductions which are allowed u/ss 30 to 37. Share of profit which a partner receives from the firm (after deduction of remuneration and interest allowable) shall be fully exempt in the hands of the partner. salary etc while computing its income under the head business and profession). a firm can be of two types: 1. commission or remuneration. made to the partner.Q. it will be subject to the maximum of the limit specified under Section 40(b) 2. bonus. it is subject to certain limits laid down u/s 40 (b). no deduction shall be allowed to . a partnership firm does not have a separate entity from that of the partners constituting the firm as the partners are the owners of the firm. salary. However. However. The firm will be taxed at a flat rate of 30% plus education cess @ 3% plus for the financial year 2010-11. a firm is treated as a separate tax entity under the Income Tax Act.and the firm shall be eligible for deduction on account of interest. However. Firm assessed as firm (provided conditions mentioned u/s 184 are satisfied).’ 4. commission or remuneration shall not be chargeable to income tax in the hands of the partner. only that part of the interest and remuneration which was allowed as a deduction to the firm shall be taxable in the hands of the partners in their individual assessment under the head ‘profits and gains of business or profession. it can be concluded that for taxation purposes. the firm will be assessed as affirm.3 Explain the essential conditions to be satisfied by a firm to be assessed as firm under Section 184. Salient features of the assessment of a firm are as under: 1. If the prescribed conditions are not satisfied. bonus. 3. A firm is treated as a separate tax entity. The firm will be assessed as a firm provided conditions mentioned under Section 184 are satisfied. In case these conditions are not satisfied in a particular assessment year. However. special deduction is allowed to the firm on account of remuneration to working partners and interest paid to the partners. by whatever name called. shall be allowed in computing the income chargeable under the head “profits and gains of business or profession” and such interest.

bonus. it shall be assessed in the same capacity for every subsequent year if there is no change in the constitution of the firm or the share of the partners. (c) Certified copy of partnership deed must be filed: A certified copy of the said instrument of partnership shall accompany the return of income in respect of the assessment year for which the assessment as a firm is first sought.the firm on account of such interest. the firm shall furnish a certified copy of the revised instrument of partnership along with the return of income for the assessment year relevant to such previous year. salary. Once the firm is assessed as firm for any assessment year. Where certified copy is not filed with the return there is no provision for condonation of delay.e. In the first assessment year: The firm will be assessed as a firm. Essential conditions to be satisfied by a firm to be assessed as firm (Section 184) 1. salary and bonus etc if there is failure on the part of the firm as is mentioned in Section 144 (relating to Best Judgment Assessment) and where the firm does not comply with the three conditions mentioned under Section 184. Where any such change had taken place in the previous year. [Section 184(5)] The firm will be assessed as a firm but shall not be eligible for any deduction on account of interest. also known as ‘Firm Assessed as Such’ (FAAS) if the following conditions are satisfied: (a) Partnership is evidenced by an instrument i. . (b) The individual share of the partners is specified in that instrument. In the subsequent assessment years: If the above three conditions are satisfied the firm will be assessed as such (FAAS) in the first assessment year. Circumstance where the firm will be assessed as a firm but shall not be eligible for deduction on account of interest. bonus etc. Further Delhi ITAT in the case of Ishar Dass Sahini & Sons v CIT held that where uncertified Photostat copy of the instrument of partnership is submitted along with the return of income and the certified copy is produced at the time of assessment. salary. 2. etc. there is a written document giving the terms of partnership. Read the box for some important points to be considered in this regard. However where the return itself is filed late then there is no problem if the certified copy is filed along with such return as the condition that it shall accompany the return of income is satisfied. it will satisfy this condition.

. These incomes are excluded only to the extent of the limits specified in the Act. some incomes are partially exempt from income-tax e. Rental income is taxable under the head “Income from house property”. Agricultural income.Exclusion of income not chargeable to tax There are certain income which are wholly exempt from income-tax e. Step 1 – Determination of residential status The residential status of a person has to be determined to ascertain which income is to be included in computing the total income. The residential status of a person determines the taxability of the income. List out the steps to compute total income. the duration for which he is present in India determines his residential status. he may be (a) resident and ordinarily resident. or (c) nonresident. (b) resident but not ordinarily resident.4 Ans. Step 4 .g.g. Also. income earned outside India will not be taxable in the hands of a non-resident but will be taxable in case of a resident and ordinarily resident. Step 2 – Classification of income under different heads The Act prescribes five heads of income.Q. The fifth head of income is the residuary head under which income taxable under the Act. will be taxed. Education Allowance. The balance income over and above the prescribed exemption limits would enter computation of total income and have to be classified under the relevant head of income. The residential statuses as per the Income-tax Act are shown below – In the case of an individual. These are shown below – HEADS OF INCOME SALARIES INCOME FROM PROFITS AND GAINS CAPITAL INCOME HOUSE PROPERTY OF BUSINESS OR GAINS FROM OTHER PROFESSION SOURCES These heads of income exhaust all possible types of income that can accrue to or be received by the tax payer. For e. Income derived from carrying on any business or profession is taxable under the head “Profits and gains from business or profession”. Based on the time spent by him. Step 3 . Profit from sale of a capital asset (like land) is taxable under the head “Capital Gains”. House Rent Allowance. pension earned is taxable under the head “Salaries”.g. The tax payer has to classify the income earned under the relevant head of income. These income have to be excluded and will not form part of Gross Total Income. but not falling under the first four heads.Computation of income under each head . Salary.

Step 6 – Set-off or carry forward and set-off of losses An assessee may have different sources of income under the same head of income. Step 7 – Computation of Gross Total Income. Step 8 – Deductions from Gross Total Income There are deductions prescribed from Gross Total Income. income-tax is levied on a slab system on the total income. He might have profit from one source and loss from the other. while calculating income from house property. There are provisions in the Income-tax Act for allowing inter-head adjustment in certain cases. minor child etc. Some taxpayers in the higher income bracket have a tendency to divert some portion of their income to their spouse. It should be rounded off to the nearest Rs. The tax system is progressive i. There are deductions and allowances prescribed under each head of income. losses which cannot be set-off in the current year due to inadequacy of eligible profits can be carried forward for set-off in the subsequent years as per the provisions contained in the Act. Similarly. after claiming the above deductions from the Gross Total Income is known as the Total Income. Income from house property and profits under another head of income. Profits and gains of business or profession. an assessee may have profit from his textile business and loss from his printing business. after allowing the deductions. as the income increases. 10. . minor child etc. These deductions are of three types. an assessee can have loss under one head of income. Similarly. The final figures of income or loss under each head of income. In case of individuals. allowances and other adjustments. This loss can be set-off against the profits of textile business to arrive at the net income chargeable under the head “Profits and gains of business or profession”.) have to be included in the income of the person who has diverted his income for the purpose of computing tax liability. Step 9 – Total income The income arrived at. deductions and allowances are prescribed under other heads of income. there is a charging section which defines the scope of income chargeable under that head. to minimize their tax burden. It is also called the Taxable Income. These deductions etc. say. minor child etc. to arrive at the gross total income. say. municipal taxes and interest on loan are allowed as deduction. are then aggregated.Income is to be computed in accordance with the provisions governing a particular head of income. after giving effect to the provisions for clubbing of income and set-off and carry forward of losses.e. have to be considered before arriving at the net income chargeable under each head Step 5 – Clubbing of income of spouse. In order to prevent such tax avoidance. Under each head of income. under which income arising to certain persons (like spouse. For instance. Further. clubbing provisions have been incorporated in the Act. For example. the applicable rate of tax increases.

The tax rates have to be applied on the total income to arrive at the income-tax liability.00. in the case of salary income. Such deduction should be made either at the time of accrual or at the time of payment. At present. is to be further increased by an additional surcharge called education cess@2%. At present. This is payable by all assesses who are liable to pay income-tax irrespective of their level of total income. 1. The highest rate is 30%. In certain cases. the obligation of the employer to deduct tax at source arises only at the time of payment of salary to the employees.000. the basic exemption limit is Rs.000 @ 10% and so on.000. 1. The Education cess on incometax is for the purpose of providing universalised quality basic education. HUFs etc. tax is required to be paid in advance in certain installments on the basis of estimated income.00.000 have to pay tax on their total income in excess of Rs.50. This means that no tax is payable by individuals with total income of up to Rs. For individuals. 10 lakhs. Step 11 – Surcharge Surcharge is an additional tax payable over and above the income-tax.5%. as increased by the surcharge. Such tax deducted at source has to be remitted to the credit of the Central Government through any branch of the RBI.00.50.Advance tax and tax deducted at source Although the tax liability of an assessee is determined only at the end of the year. At present. If any tax is still due on the basis of return of income. For firms and companies.. the rate of surcharge for firms and domestic companies is 10% and for foreign companies is 2. 1. which is attracted in respect of income in excess of Rs. after adjusting advance tax and tax deducted at source. Surcharge is levied as a percentage of income-tax. there is a slab rate and basic exemption limit. Step 12 – Education cess The income-tax. as prescribed by the Act. surcharge would be levied @10% only if their total income exceeds Rs.000 but less than Rs. 1. 1. the assessee has to pay such tax (called self-assessment tax) at the time of filing of the return Taxation . the rate is 30% on the whole of their total income. 2. SBI or any authorized bank. Step 13 . tax is required to be deducted at source from the income by the payer at the rates prescribed in the Act. Taxation For individuals.00. For example.000 for individuals. Those individuals whose total income is more than Rs. a flat rate of tax is prescribed.The process of computation of total income is shown hereunder – Step 10 – Application of the rates of tax on the total income The rates of tax for the different classes of assesses are prescribed by the Annual Finance Act.

1-1 Assets Assets are defined in Section 2(ea) as follows. and a Mutual fund specified under section 10(23D) of the Income-tax Act [section 45] Net wealth = Value of assets [as defined in section 2(ea] plus deemed assets (as defined in section 4) less exempted assets (as defined in section 5).Assessment year means a period of 12 months commencing from the first day of April every year falling immediately after the valuation date [Section 2(d)] All. Ans. 30. valuation date is 31st March every year. It is not on income but payable only because a person is wealthy. residential house or commercial building . Debt should have been incurred in relation to the assets which are included in net wealth of assessee.The following are treated as “assets” .000 is chargeable to wealth-tax @ 1 per cent (on surcharge and education cess). Wealth tax is a socialistic tax. Net wealth in excess of Rs. (Till 31-3-2009. Assessment year . or by any other name) or a cantonment board [Section 2(ea)(i)] A residential house is not asset. As per Section 2(q). any social club. No wealth-tax is chargeable in respect of net wealth of any company registered under section 25 of the Companies Act. if it is meant exclusively for residential purposes . any co-operative society. HUF and company.5 Detail the important provisions under Wealth tax Act. the limit was Rs 15 lakhs).Q. Wealth tax is not a very important or high revenue tax in view of various exemptions. Guest house. Only debt owed on date of valuation is deductible. It is payable by every individual.). Tax rate is 1% on amount by which ‘net wealth’ exceeds Rs 30 lakhs from AY 2010-11. less debt owed [as defined in section 2(m)].00. municipal corporation. any political party. 1956. In case of residents of India. assets outside India (less corresponding debts) are also liable to wealth tax.(a) Any building or land appurtenant thereto whether used for commercial or residential purposes or for the purpose of guest house (b) A farm house situated within 25 kilometers from the local limits of any municipality (whether known as a municipality. No surcharge or education cess is payable. only assets located in India including deemed assets less corresponding debts are liable to wealth tax [section 6]. In case of non-residents and foreign national. Wealth tax is payable on net wealth on ‘valuation date’.

000. Any house which the assessee may occupy for the purposes of any business or profession carried on by him is not treated as “asset”. bullion. utensils or other article or worked or sewn into any wearing apparel. silver.e. jewellery. 5. 50. [Section 2(ea)(iii)] . platinum or any other precious metal or any alloy containing one or more of such precious metals. Any house (may be residential house or used for commercial purposes) which forms part of stock-in-trade of the assessee is not treated as “asset”. etc.) is used by an assessee as stock-in-trade.of employee who is in whole-time employment and the gross annual salary of such employee. furniture.. Where any of the above assets (i. Cash in hand . officer or director is less than Rs.Motor car is an “asset”.Jewellery. bullion. boats and aircrafts . Yachts. In the case of a leasing company. utensils of gold.In case of individual and HUF. Jewellery.00. and also precious or semi-precious stones.000 according to the last preceding census.000 is an ‘asset’. Land occupied by any building which has been constructed with the approval of the appropriate authority is not ‘asset’. utensils of gold. whether or not set in any furniture. Any property in the nature of commercial establishments or complex is not treated as an “asset”.Urban land is an “asset” [Section 2(ea)(v)] Urban land means land situated in the area which is comprised within the jurisdiction of a municipality and which has a population of not less than 10. Any unused land held by the assessee for industrial purposes for a period of 2 years from the date of its acquisition by him is not an asset. Motor cars .(a) motor cars used by the assessee in the business of running them on hire (b) motor cars treated as stock-in-trade [Section 2(ea)(ii)]. platinum or any other precious metal or any alloy containing one or more of such precious metals are treated as “assets” [Section 2(ea)(ii)] For this purpose. boats and aircrafts (other than those used by the assessee for commercial purposes) are treated as “assets” [Section 2(ea)(iv)] Urban land . motor car is an asset. silver.Yachts. “jewellery” includes ornaments made of gold. A residential property which is let out for a minimum period of 300 days in the previous year is not treated as an “asset”. utensils and any other article made wholly or partly of gold. etc. bullion. cash in hand on the last moment of the valuation date in excess of Rs. any amount not recorded in books of account is ‘asset’ [Section 2(ea)(vi)] . Any land held by the assessee as stock-in-trade for a period of 10 years from the date of its acquisition by him is also not an asset. then such asset is not treated as “assets” under section 2(ea)(iii). but not the following . silver. In case of companies.

If the asset is transferred by an individual after May 31. directly or indirectly. directly or indirectly. under an agreement to live apart. a person transfers his assets in name of others to reduce his liability of wealth tax. provision of ‘deemed asset’ has been made. Assets held by minor child . directly or indirectly. his or her spouse. it will be treated as ‘deemed asset’ of the transferor [Section 4(1) (a)(vi)]. under a revocable transfer is ‘deemed asset’ of transferor [Section 4(1)(a)(iv)] Assets transferred to son’s wife [Section 4(1)(a)(v)] . To stop such tax avoidance. 1956 to a person or an association of person. 1973.1-2 Deemed assets Often. interest of partner/member in the firm or association of persons should be determined in the manner laid down in . Interest of partner.The asset is transferred by an individual after March 31. the following assets will be included as deemed assets u/s 4. without adequate consideration. otherwise than for adequate consideration. to a person or an association of the immediate or deferred benefit of son’s wife. whether directly or indirectly. is ‘deemed asset’ of transferor [Section 4(1)(a)(iii)] Assets transferred under revocable transfers . to son’s wife. for the benefit of the transferor.In computing the net wealth of an individual. The expression “to live apart” is of wider connotation and even the voluntary agreements to live apart will fall within the exceptions of this sub-clause.Where the assessee (may or may not be an individual) is a partner in a firm or a member of an association of persons. without adequate consideration or not in connection with an agreement to live apart will be ‘deemed asset’ [Section 4(1)(a)(i)] If an asset is transferred by an individual to his/her spouse. the provisions of section 4(1)(a)(i) are not applicable. 1973. there shall be included the value of assets which on the valuation date are held by a minor child (including step child/adopted child but not being a married daughter) of such individual [Section 4(1)(a)(ii)] The net wealth of minor child will be included in the net wealth of that parent whose net wealth [excluding the assets of minor child so includible under section 4(1)] is greater. Assets transferred by one spouse to another . without adequate consideration will be ‘deemed asset’ of transferor [Section 4(1)(a)(iv)] Assets transferred for the benefit of son’s wife . For this purpose. the value of his interest in the assets of the firm or an association shall be included in the net wealth of the partner/member. 1956. Assets transferred to a person or an association of persons . 1956 to his or her spouse. In computing the net wealth of an assessee.The asset is transferred by an individual to a person or an association of person after March 31.An asset transferred by an individual after March 31.The asset transferred by an individual after May 31.

Admission of minor to benefits of the partnership firm . 1882.2]. The above rules are also applicable if the assessee is a member of a company or an association of persons [Section 4(7)] Property held by a person in part performance of a contract [Section 4(8)] A person who is allowed to take or retain possession of any building or part thereof in part performance of a contract of the nature referred to in section 53A of the Transfer of Property Act.If an individual is a member of a Hindu undivided family and he converts his separate property into property belonging to his Hindu undivided family. the value of such gift will be included in the net wealth of the person making the gifts. or by an individual. any outstanding instalments. Gifts by book entries . is deemed to be the asset of the transferor and is includible in his net wealth.If a minor is admitted to the benefits of partnership in a firm. directly or indirectly.For the purpose of the Wealth-tax Act. or a body of individuals with whom he has business connection. by virtue of transaction as is referred to in section 269UA(f) of the . the converted or transferred property or any part thereof.Where a gift of money from one person to another is made by means of entries in the books of account maintained by the person making the gift. unless he proves to the satisfaction of the Wealth-tax Officer that the money had actually been delivered to the other person at the time the entries were made [Section 4(5A)] Impartible estate . which is received by the spouse of the transferor. Similarly. in or with respect to any building or part thereof. or a Hindu undivided family. or a firm or an association of persons. Conversion by an individual of his self-acquired property into joint family property . are deductible as debt owed by the assessee. or if he transfers his separate property to his Hindu undivided family. a person can acquire any rights. the converted or transferred property shall be deemed to be the property of the individual and the value of such property is includible in his net wealth [Section 4(1A)] If there was such transfer and if the converted or transferred property becomes the subject-matter of a total or a partial partition among the members of the family. the holder of an impartible estate shall be deemed to be the owner of all the properties comprised in the estate [Section 4(6)] Property held by a member of a housing society . without adequate consideration. It will be determined in the manner specified in Schedule III. payable by the assessee to the society towards the costs of such house. excluding any rights by way of a lease from month to month or for a period not exceeding one year. the value of his interest in the firm shall be included in the net wealth of parent of minor in accordance with the provisions of section 4(1)(a)(ii) [see para 546. the assessee is deemed to be the owner of such building and the value of such building is includible in computing his net wealth. In determining the value of such building.Schedule III to the Wealth-tax Act [Section 4(1)(b)].Where the assessee is a member of a co-operative housing society and a building or part thereof is allotted or leased to him.

Coparcenary interest in a Hindu undivided family . Reasonable facilities shall be allowed to any officer of the Government. fund or trust specified in sections 10(23B) or 20(23C) of the Income-tax Act. Reasonable steps shall be taken for keeping that jewellery substantially in its original shape. as per section 5. Property held under a trust . [Section 5(i)]. Residential building of a former ruler .(a) where the business is carried on by a trust wholly for public religious purposes and the business consists of printing and publication of books or publication of books or the business is of a kind notified by the Central Government in this behalf in the Official Gazette (b) the business is carried on by an institution wholly for charitable purposes and the work in connection with the business is mainly carried on by the beneficiaries of the institution (c) the business is carried on by an institution. the assets are taxable in the hands of beneficial owners. Business assets held in trust.Jewellery in possession of a former ruler of a princely State. Any other business assets of a public charitable/religious trust is not exempt. In above cases. which are exempt . his interest in the family property is totally exempt from tax [Section 5(ii)].The following business assets held by as assessee under a trust for any public charitable/religious trust are exempt from tax . in the same manner in which they are taxed under the Income-tax Act : 1-3 Assets which are exempt from tax The following assets are exempt from wealth-tax. not being his personal property which has been recognised as a heirloom is totally exempt from tax [Section 5(iv)] The jewellery shall be permanently kept in India and shall not be removed outside India except for a purpose and period approved by the Board. .Any property held by an assessee under a trust or other legal obligation for any public purpose of charitable or religious nature in India is totally exempt from tax. to examine the jewellery as and when necessary.The value of any one building used for the residence by a former ruler of a princely State is totally exempt from tax [Section 5(iii)] Former ruler’s jewellery .If the assessee is a member of a Hindu undivided family. or authorised by the Board.Income-tax Act.

COST OF ACQUISITION Cost of Acquisition (COA) means any capital expense at the time of acquiring capital asset under transfer. meters in area is exempt. After his return to India. is exempt. a house or a part of house. regardless of the fact whether the house is self-occupied or let out. cost of acquisition of an asset is the value for which it was acquired by the assessee. Full value of consideration means & includes the whole/complete sale price or exchange value or compensation including enhanced compensation received in respect of capital asset in transfer. who was ordinarily residing in a foreign country and who has returned to India with intention to permanently reside in India. A house is qualified for exemption. expenses incurred up to acquiring date in the form of registration. or a plot of land not exceeding 500 sq.e. The following points are important to note in relation to full value of consideration. to include the purchase price. exemption is available to each co-owner of the house [Section 5(vi)] Q.6 What is meant by Full value of consideration? How short term capital gains and long term capital gains are computed using full value of consideration? Ans. 40 The consideration must be actual irrespective of its adequacy. A person shall be deemed to be of Indian origin if he. following shall not be chargeable to tax for seven successive assessment years .(a) moneys brought by him into India (b) value of asset brought by him into India (c) moneys standing to the credit of such person in a Non-resident (External) Account in any bank in India on the date of his return to India and (d) value of assets acquired by him out of money referred to in (a) and (c) above within one year prior to the date of his return and at any time thereafter [Section 5(v)] One house or part of a house . expenses incurred on completing transfer. .Assets (as given below) belonging to assessee who is a person of Indian origin or a citizen of India. i.. 37 The consideration received in kind is valued at its fair market 38 value. Expenses of capital nature for completing or acquiring the title are included in the cost of acquisition. storage etc.Assets belonging to the Indian repatriates . In other words.In the case of an individual or a Hindu undivided family. 39 It may be received or receivable. or either of his parents or any of his grand-parents. 36 The consideration may be in cash or kind. In case a house is owned by more than one person. was born in undivided India.

cost of improvement includes all those expenditures. Fin.81 then the indexation will also be done as per the CII of 1981 and not as per the year of acquisition. It also includes any expenditure incurred in protecting or curing the title. which are incurred to increase the value of the capital asset.4. If asset is purchased before 1st April we consider the fair market value. If assesses chooses the value as on 1.4. COST OF IMPROVMENT Cost of improvement is the capital expenditure incurred by an assessee for making any addition or improvement in the capital asset. The fair market value of asset on 1st April 1981 will certainly include the improvement made in the asset.4. Year Inflation Index 1 1981-82 100 15 1995-96 2 1982-83 109 16 1996-97 3 1983-84 116 17 1997-98 4 1984-85 125 18 1998-99 5 1985-86 133 19 1999-2000 6 1986-87 140 20 2000-01 7 1987-88 150 21 2001-02 8 1988-89 161 22 2002-03 9 1989-90 172 23 2003-04 10 1990-91 182 24 2004-05 11 1991-92 199 25 2005-06 12 1992-93 223 26 2006-07 13 1993-94 244 27 2007-08 14 1994-95 259 Cost Inflation Index 281 305 331 351 389 406 426 447 463 480 497 519 551 If capital assets were acquired before 1.No. the assesses has the option to have either actual cost of acquisition or fair market value as on 1. In other words.81 as the cost of acquisition. Provisions for computation of Capital Gain . asset should have been purchased before 1st April 1981. The reason behind it is that for carrying any improvement in asset before 1st April 1981. Indexed Cost of improvement = COA X CII of Year of transfer CII of Year of improvement Any cost of improvement incurred before 1st April 1981 is not considered or it is ignored. Year Cost S. Fin.81.No.Indexed Cost of Acquisition = COA X CII of Year of transfer CII of Year of acquisition The indices for the various previous years are given below: S.

deduct 46 Expenditure incurred wholly and in exclusively connection with the transfer 47 Indexed cost of acquisition of asset 48 Indexed cost of any improvement of asset .Provisions under section 48 The income under the head “Capital Gains” shall be computed by deducting the following from the full value of the consideration received or accrued as a result of the transfer of the capital asset : 41 Expenditure incurred wholly and exclusively in connection with such transfer. deduct 43 Expenditure incurred wholly and in exclusively 44 Cost of acquisition 45 Cost of any improvement of asset Computation of Long Term Capital Gains From full value of consideration. Computation of Short Term Capital Gains From full value of consideration. 42 The cost of acquisition of the asset and the cost of any improvement thereto.

people and management information systems.g. At the organizational level.g. the Control one of the . work and authority flows.. how to ensure the organization's payments to third parties are for valid services rendered.. reputation or intellectual property such as trademarks). Ans. with one set of bureaucrats charged with collecting taxes and another with supervising them. and measured. internal control objectives relate to the reliability of financial reporting.) Internal control procedures reduce process variation.[1] It is a means by which an organization's resources are directed. leading to more predictable outcomes. monitored. Internal controls within business entities are also referred to as operational controls. It plays an important role in preventing and detecting fraud and protecting the organization's resources.2 Q.MF 0013 Internal Audit and Control Set. Internal control is a key element of the Foreign Corrupt Practices Act (FCPA) of 1977 and the Sarbanes–Oxley Act of 2002. internal control is defined as a process effected by an organization's structure. which required improvements in internal control in United States public corporations. Internal controls have existed from ancient times.[2] In the Republic of China. both physical (e.. At the specific transaction level. internal control refers to the actions taken to achieve a specific objective (e.g. and compliance with laws and regulations. In accounting and auditing. machinery and property) and intangible (e.1 Why Internal check in necessary? Choose an organization of your choice and find out how internal checks are put in place. timely feedback on the achievement of operational or strategic goals. designed to help the organization accomplish specific goals or objectives. In Hellenistic Egypt there was a dual administration.

procedures. 2. Controls have unique characteristics – for example. review and approval authorizations.. COSO defines internal control as having five components: 1. safeguarding and accountability of assets. capture. Definitions There are many definitions of internal control. A control may exist within a designated function or activity in a process. which is composed of many individual control procedures. segregation of duties. Monitoring-processes used to assess the quality of internal control performance over time. influencing the control consciousness of its people. forming a basis for how the risks should be managed 3. Risk Assessment-the identification and analysis of relevant risks to the achievement of objectives.a specific set of policies. A control’s impact.. a widely-used framework in the United States. preventing or detecting error or fraud. and exchange of information in a form and time frame that enable people to carry out their responsibilities 4.five branches of government. or controls are defined by the SEC as: ". and activities designed to meet an objective. and other personnel. management. Control Activities-the policies and procedures management directives are carried out. and c) Compliance with laws and regulations. It is the foundation for all other components of internal control. internal control is broadly defined as a process. Under the COSO Internal Control-Integrated Framework. effected by an entity's board of directors.. Information and Communication-systems or processes that support the identification. those designed to . Controls within a process may consist of financial reporting controls and operational controls (that is. as it affects the various constituencies (stakeholders) of an organization in various ways and at different levels of aggregation. The COSO definition relates to the aggregate control system of the organization. reconciliations. Control Environment-sets the tone for the organization. they can be: automated or manual.may be entity-wide or specific to an account balance. designed to provide reasonable assurance regarding the achievement of objectives in the following categories: a) Effectiveness and efficiency of operations. is an investigatory agency that monitors the other branches of government. b) Reliability of financial reporting. class of transactions or application.. that help ensure 5. Discrete control procedures.

there needs to be in place circumstances ensuring that the aforementioned procedures will be performed as intended: right attitudes. Control built within a process is internal in nature. the chief executive fulfills this duty by providing leadership and direction to senior managers and reviewing the way they're controlling the business. In a large company. setting objectives. and policies and procedures. often an owner-manager. Control itself exists to keep performance or a state of affairs within what is expected. In a smaller entity. a manager is effectively a chief executive of his or her sphere of responsibility. assign responsibility for establishment of more specific internal control policies and procedures to personnel responsible for the unit's functions. the chief executive sets the "tone at the top" that affects integrity and ethics and other factors of a positive control environment. Roles and responsibilities in internal control According to the COSO Framework. Virtually all employees produce information used in the internal control system or take other actions needed to affect control.[4] The concepts of corporate governance also heavily rely on the necessity of internal controls. whose control activities cut across. allowed or accepted. Internal control structure is a plan determining how internal control consists of these elements. which . the influence of the chief executive. More than any other individual. Internal controls help ensure that processes operate as designed and that risk responses (risk treatments) in risk management are carried out. information necessary in control. everyone in an organization has responsibility for internal control to some extent.such as social environment effecting behavior of employees. integrity and competence. all personnel should be responsible for communicating upward problems in operations.achieve operational objectives). Of particular significance are financial officers and their staffs. noncompliance with the code of conduct. Senior managers. and monitoring by managers. in turn. Board of Directors: Management is accountable to the board of directors. or other policy violations or illegal actions. plans and other expectations establish criteria for control. as well as up and down. Also. the operating and other units of an enterprise."[3] Context More generally. Each major entity in corporate governance has a particular role to play: Management: The Chief Executive Officer (the top manager) of the organization has overall responsibility for designing and implementing effective internal control. in a cascading responsibility. budgets. It takes place with a combination of interrelated components . In addition. In any event. is usually more direct.

implemented and working effectively. These factors are outside the scope of internal control. but cannot guarantee their achievement. They also have a knowledge of the entity's activities and environment. capable and inquisitive. There are laws and regulations on internal control related to financial reporting in a number of jurisdictions. They may also review Information technology controls. 5 and SEC guidance. Management may be in a position to override controls and ignore or stifle communications from subordinates. They assess whether the controls are properly designed. legal and internal audit functions. whether an organization achieves operational and strategic objectives may depend on factors outside the enterprise. who are required to opine on the internal controls of the company and the reliability of its financial reporting.provides governance. they are tested by the external auditor (the organization's public accountants). particularly when coupled with effective upward communications channels and capable financial. not absolute. Guidance on auditing these controls is specified in PCAOB Auditing Standard No. Objective categorization Internal control activities are designed to provide reasonable assurance that . guidance and oversight. is often best able to identify and correct such a problem. A strong. The concept of reasonable assurance implies a high degree of assurance. constrained by the costs and benefits of establishing incremental control procedures. these regulations are specifically established by Sections 404 and 302 of the Sarbanes-Oxley Act. which relate to the IT systems of the organization.S. effective internal control provides only timely information or feedback on progress towards the achievement of operational and strategic objectives. such as competition or technological innovation. However. enabling a dishonest management which intentionally misrepresents results to cover its tracks. Describing Internal Controls Internal controls may be described in terms of: a) the objective they pertain to. further discussed in SOX 404 top-down risk assessment. Effective board members are objective. Effective internal control implies the organization generates reliable financial reporting and substantially complies with the laws and regulations that apply to it. Auditors: The internal auditors and external auditors of the organization also measure the effectiveness of internal control through their efforts. To provide reasonable assurance that internal controls involved in the financial reporting process are effective. assurance that the objectives of an organization will be met. and make recommendations on how to improve internal control. active board. therefore. and commit the time necessary to fulfill their board responsibilities. Limitations Internal control can provide reasonable. and b) the nature of the control activity itself. In the U.

in financial auditing. Reasonableness-transactions or results appears reasonable relative to other data or trends. . 6.. 7. Internal auditors perform their audits to evaluate whether the controls are designed and implemented effectively to address the relevant objectives. 5. The specific target used to determine whether a control is operating effectively is called the control objective. Presentation & Disclosure (Classification): Components of financial statements (or other reporting) are properly classified (by type or account) and described. These include (but are not limited to): • Segregation of duties . as of a given date. no omissions) 4. 3. Rights & Obligations: Assets represent the rights of the company. Completeness: All transactions are processed that should be (i. Activity categorization Control activities may also be explained by the type or nature of activity. and liabilities its obligations. Management is responsible for implementing appropriate controls that apply to transactions in their areas of responsibility. or related progress understood. and vendor invoice prior to authorizing payment. and record keeping roles of fraud or error by one person. For example.[5] but broader frameworks are helpful to also capture operational and compliance aspects: 1. Occurrence (Cutoff): Transactions occurred during the correct period or were processed timely.separating authorization. Control objectives fall under several detailed categories." This is a validity objective.e. Existence (Validity): Only valid or authorized transactions are processed (i.e. Valuation: Transactions are calculated using an appropriate methodology or are computationally accurate.particular objectives are achieved. they relate to particular financial statement assertions. A typical control procedure designed to achieve this objective is: "The accounts payable system compares the purchase order. a control objective for the accounts payable function may be stated as: "Payments are made only for authorized products and services received.. custody. receiving record." Multiple controls may be applicable to achieve a given control objective with a reasonable level of assurance. no invalid transactions) 2.

that is. management and the external auditors are required to identify and test controls that mitigate the risks.maintaining documentation to substantiate transactions.observation or review of ongoing operational activity. • • • Control precision Control precision describes the alignment or correlation between a particular control procedure and a given control objective or risk. Top-level reviews-analysis of actual results versus organizational goals or plans. This involves making judgments regarding both precision and sufficiency of controls required to mitigate the risks.usage of cameras. etc. locks. accounting for transactions in numerical sequences. Physical safeguards . and other key performance indicators (KPIs). Examples include edit checks of data entered. Controls over information processing-A variety of control activities are used in information processing. comparing file totals with control accounts. Precision is distinct from sufficiency. and controlling access to data. After identifying specific financial reporting material misstatement risks. metrics. access logs. to ensure access restricted to authorized personnel. etc. Risks and controls may be entity-level or assertion-level under the PCAOB guidance.[6] Later guidance by the PCAOB regarding small public firms provided several factors to consider . to protect property. multiple controls with varying degrees of precision may be involved in achieving a control objective or mitigating a risk. of particular transactions by an appropriate person. files and programs. Precision is an important factor in performing a SOX 404 top-down risk assessment. A control with direct impact on the achievement of an objective (or mitigation of a risk) is said to be more precise than one with indirect impact on the objective or risk.• • • • • Authorization of transactions . IT Security . Entity-level controls are identified to address entity-level risks. and established objectives. The PCAOB set forth a three-level hierarchy for considering the precision of entity-level controls. Retention of records . Supervision or monitoring of operations . However. physical barriers. a combination of entity-level and assertion-level controls are typically identified to address assertion-level risks. periodic and regular operational reviews. Top level reviews-Management review of reports comparing actual performance versus plans.usage of passwords. such as merchandise inventory.

continuous controls monitoring provides assurance on financial information flowing through the business processes. the traditional notion of separation of duties does not always apply. separation of duties prevents of detects errors and irregularities. then an important opportunity is assessing precision. this program is performing functions that in a manual systems would be considered incompatible. the following implementation of internal control : problems arise in the 49 Separation of duties : In a manual system. For example. recording transactions. In a minicomputer and microcomputer environments.[7] Fraud and internal control Internal control plays an important role in the prevention and detection of fraud. as program may reconcile a vendor invoice against a receiving document and print a cheque for the amount owed to a creditor.[10] The risk that senior management might override important financial controls to manipulate financial reporting is also a key area of focus in fraud risk assessment. separate individuals are responsible for initiating transactions. particularly in regard to effectiveness and efficiency. Q.[11] The AICPA. and ACFE also sponsored a guide published during 2008 that includes a framework for helping organizations manage their fraud risk. Thus.[12] Internal Controls and Improvement If the internal control system is implemented only to prevent fraud and comply with laws and regulations. separation .[9] This typically involves identifying scenarios in which theft or loss could occur and determining if existing control procedures effectively manage the risk to an acceptable level. however. The same internal controls can also be used to systematically improve businesses. Ans.[8] Under the Sarbanes-Oxley Act. IIA. companies are required to perform a fraud risk assessment and assess related controls. Used in conjunction with continuous auditing. In a computer system. and custody of assets.2 Detail the specific problems of electronic data process relating to Internal control. In an EDP system. As a basic control.[13] Continuous Controls Monitoring Advances in technology and data analysis have led to the development of numerous tools which can automatically evaluate the effectiveness of internal controls.

the existence of competent and trustworthy personnel becomes even more important when computer systems are used to process an organization’s data. High turnover in the data processing industry has been the norm. modify. it is not always easy to trace who is responsible for corrupting the data and who is responsible for identifying and correcting the error. well trained and experienced data processing personnel have been in short supply. When multiples users have access to the same data and integrity of the data is somehow violated. . maintain and operate today’s computer systems. Some minicomputers and microcomputers allow users to change programs and data easily. In a computer system. For example. one of the objectives of using a database management system is to provide multiple users with access to the same data. it Is not always easy for an organization to assess the competence and integrity of its EDP staff. assuring that an organization has competent and trustworthy data processing personnel has been a difficult task. Unfortunately. Thus. This user assumes ultimate responsibility for the integrity of the data.of incompatible functions may be even more difficult to achieve. however. since a relatively small number of individuals assume major responsibility for the integrity of the data. Historically. It may be difficult to determine whether incompatible functions have been performed by system users. Moreover. Therefore. Highly skilled personnel are needed to develop. Some organizations have attempted to overcome these problems by designating a single user as the owner of data. delegating authority and responsibility in an unambiguous way may be difficult because some resources are shared among multiple users. furthermore. 50 Delegation of authority and responsibility : A clear line of authority and responsibility is an essential control in both manual and computer systems. If the minicomputer or microcomputer does not have an inbuilt capability to provide a secure record of changes. thereby reducing the control problems that arise with maintaining redundant data. organizations sometimes have been forced to compromise in their choice of staff. and the rapid evolution of technology inhibits management’s ability to evaluate an employee’s skills. 51 Competent and trustworthy personnel : The technology of data processing is now exceedingly complex much more complex than in the days of manual systems. they provide no record of these changes.

54 Physical control over assets and records : Physical control over access to assets and records is critical in both manual . Some minicomputer and microcomputer software packages for example. when evaluating the adequacy of authorization procedures. execution and recording of some transactions. Thus. 53 Adequate documents and records : In a manual system. no visible audit or management trail may be available to trace the transaction. acquisitions of major capital assets may have to be approved by the board of directors. In a well designed computer systems. When this situation is coupled with a decreased ability to separate incompatible functions. documents may not be used to support the initiation. auditors have to examine not only the work of employees but also the veracity of program processing. The absence of a visible audit trail is not a problem for the auditor provided that systems have been designed to maintain a record of all events and there is a means of accessing these records. For example. Similarly. General authorizations establish policies for the organization to follow. Audit trails are often more extensive than those maintained in manual systems. serious control problems can arise. a fixed price list is issued for personnel to use when products are sold. authorization procedures often are embedded within a computer program.52 System of authorizations : Management issues two types of authorizations to execute transactions. provide inadequate access controls and logging facilities to ensure preservation of an accurate and complete audit trail. In a computer system. some transactions may be activated automatically by a computer system : for example. auditors evaluate the adequacy of procedures for authorization by examining the work of employees. the order entry module in a sales system may determine the price to be charged to a customer. adequate documents and records are necessary to provide an audit trail of activities within the system. an inventory replenishment program may initiate purchase orders when stock levels fall below a set amount. For example. In a manual system. in an online order entry system customers orders received by telephone may be entered directly into the system. Specific authorizations apply to individual transactions : for example. Unfortunately. not all computer systems are well designed. Thus. In computer systems. For example.

independent staff prepares the basic data used for comparison purposes. For example.3 Explain the principal considerations in internal control on: a. data communications may be used to enable employees to be closer to the customers they service. This concentration of data processing assets and records also increases the loss that can arise from computer abuse or a disaster. Q. programs are used to prepare this data. In a computer system. Purchases and creditors b. it may be unable to continue operations. data and the assets that the data purports to represent should be compared to determine whether incompleteness or inaccuracies in the data exist or shortages in the assets have occurred. If unauthorized modifications occur to the programs or data files that the programs use. the perpetrator does not have to go to physically distance locations to execute the fraud. Computer systems differ from manual systems. Fixed assets Ans. a fire that destroys a computer room may result in the loss of all major master files in an organization. however. in the way they concentrate the data processing assets and records of an and computer systems. In a manual system. For example. 56 Comparing recorded accountability with assets : Periodically. an irregularity may not be discovered. If the organization does not have suitable backup. a person wishing to perpetrate a fraud may be maintained at a single site the data processing installation. Thus. Thus. however. supervision of employees may have to be carried out remotely. 55 Adequate management supervision : In a manual system. management supervision of employee activities is relatively straight forward because managers and employees are often at the same physical location. Supervisory controls must be built into the computer system to compensate for the controls that usually can be exercised through observation and inquiry. in a manual system. programs may sort an inventory file by warehouse location and prepare counts by inventory item at different warehouses. In computer systems. however. For example. Purchases and creditors Basic considerations for having an effective internal control system for Purchase and creditors are as follows : . a.

62 The goods receipt documents should be cross checked with final purchase order. 69 Capital expenditure budget should be prepared regularly. . documents regarding purchase returns. maintenance of ledger accounts and reconciliation of statements sent by suppliers. purchase records. 59 The preparation and authorization of purchase orders should be under a senior manager. 67 The accounts of various suppliers should be confirmed periodically from statements received from them. Serial numbers should be allotted to each item for easy identification. 63 An authorize official from the accounts department should be made responsible for checking suppliers’ invoices. 61 Documents showing the receipt and acceptance of goods should also be send to the accounts department. and other similar adjustments. discounts on account of inferior quality of goods. 70 Fixed assets registers should be maintained showing brief particulars of all items. payment documents duly authorized by a senior official.57 The procedure for issuing purchase requisitions should be specified. showing that the goods have been received as specified in the purchase order should be verified by the accounts department. 66 Lawful policies and procedures should be implemented with regard to purchases from the companies under the same group and from the employees. 65 Adequate procedures should be established with regard to purchase returns. payments to suppliers. b. 72 Proper accounting records should be maintained for expenditure during the construction period distinguishing carefully between capital and revenue expenditure. 71 Fixed assets should be physically verified periodically. the procedure for opening and acceptance thereof should be laid down. Fixed assets Basic considerations for having an effective internal control system for Fixed Assets are as follows : 68 Payments for fixed assets should be made only after authorization of the top management. 60 Predetermine guidelines should exist for inspection of goods received. 64 Before payments are made to suppliers. 58 Where tenders are invited. especially with regard to quantity and quality.

he may have to rely on direct observations and inquiry only. maintain a detailed written record of his observations on the internal controls system. and flow charts etc. need to be tested through compliance procedures. if the flow chart prescribes that the detail terms and condition of each order of customer has to be verified by a particular manager. Thus. let us discuss the steps of evaluating internal control system which are as follows: i) Understanding the system: At first the auditor should understand the internal control system with the purpose to have an idea of the flow of transactions and the various controls procedures. scrapping. Sometimes. the auditor would see whether the transaction has taken place as stipulated in the flow chart or in the procedure manual. The receipts from such disposals should be properly accounted for. For example. The auditor can also discuss with different officials of organization. It is important to test the application of internal controls in practice. The different steps undertaken by the auditor for evaluating the system of internal control has been illustrated through Figure: 11. The auditor should also ascertain whether the internal controls were effective and efficient throughout the period under audit. or write off of fixed assets should be allowed only under proper authorization of the top management.73 Sale. procedure manuals. The auditor should. Organization charts. it may be useful to choose a few transactions through the system. an auditor may take up a few sales bills at random and examine all the related documents right from the order of the customer to the payment received from the customer. 74 Depreciation rates should be properly authorized. therefore. ii) Test through compliance procedures: Having reviewed the system.1 (adapted from ‘Contemporary Audit’ by Kamal Gupta) below: Study and Evaluation of Internal Controls an Illustration Now. job description. are some of the tools to have an idea about internal controls system. or reliance on which may not be cost effective. the auditor may select the specific controls on which he intends to rely and which. . He may decide not to rely on certain internal controls which are defective in design. especially in the case of first audit.4 Explain the steps of evaluating internal control system using flow chart Ans. At each stage. Q. To understand the internal control system. This will help him to pinpoint those internal controls on which he might base in doing his audit. the auditor should examine whether or not this has been done in practice.

Since this is a material item. The auditor should carry out such tests in case of all procedures on which audit reliance is intended to be placed. The nature and extent of the procedures performed by the auditor to obtain an understanding of the accounting and internal control systems generally depend on : 75 76 77 78 79 Nature of policies or kind of procedures. Q. Let us suppose he finds weaknesses in the system of maintaining debtors’ ledger. Way of documentation of business operations. Ans. In context with this case. This is essentially a question of individual judgment in a particular situation.The objective of compliance tests is to provide a fair confidence to the auditor that the internal controls procedures are being effective as prescribed. the auditor has to make an estimate of how far he can depend on various internal controls. Size and complexity of the business. he should ask for independent confirmations from the debtors. drastic losses in its stock and devaluation of its assets.5 Lehman Brothers Holding filed for Chapter 11 bankruptcy protection following the massive exodus of most of its clients.Were the necessary procedures complied with? . Thus. he should have a reasonable confidence that the system is such that the errors and fraud can be discovered automatically. he should try to evaluate the impact of the same on various transactions. Normally. the auditor’s evaluation of internal control system will determine the nature. If he finds certain errors or weaknesses in the system. Changes in operating environment.By whom they were complied with? iii) Evaluating the system: Based on his observation during the tests made by him. He has to ascertain whether the control procedures as designed to implement are in practice and competent in preventing or detecting material errors and fraud in the accounting system. examine internal control and risk assessment system. Auditor’s assessment of inherent risk. timing and extent of his substantive procedures.How were they complied with? . Tests of compliance are concerned primarily with the following questions: . The auditor should make a study of internal control relevant for his .

the auditor may have obtained evidence about the effectiveness of bank reconciliation process through inquiry and observation. Inherent risk signifies the chances that recording of transactions have been done either erroneously or under the influence of management fraudulent activity. the auditor should consider the initial assessment of control risk to determine the appropriate detection risk to accept for the financial statement assertions. It is the judgment of auditor to decide whether a control individually or in combination with other is relevant for audit or not. Some of the procedures performed to obtain understanding of the accounting and internal control systems may not have been specifically planned as tests of control but they may provide evidence about the effectiveness of both the design and operation of policies and procedures relevant to certain assertions and.audit. Relationship between the assessments of inherent and control risks : In many cases. the auditor should make an initial assessment of control risk for the appropriate assertions in the financial statements. serve as tests of control e. When planning the audit approach. Although most controls related to audit are relevant for financial reporting but all controls relevant for financial reporting may not be relevant for audit. in obtaining understanding of the system pertaining to cash. After having a basic idea of the accounting and internal control system. if the auditor attempts separately to . Auditor normally classified audit risk for assessment into control risk and inherent risk. Control risk signifies that a material misstatement could occur but would not be prevented or detected by internal control system. inherent risk and control risk are highly interrelated. Also management often reacts to inherent risk situations by designing accounting and internal control systems to prevent and detect misstatements in such situations. consequently.g. Assessment of control risk Assessing control risk is the process of evaluating the effectiveness of an entity’s accounting an internal control systems in preventing or detecting material mis-statements in the financial statements.

if this if not practicable.6 Explain the importance of working papers. administering and review of the work. As a result. regardless of the assessed levels of inherent and control risks the auditor should perform some substantive procedures. the more assurance the auditor must obtain from the performance of substantive procedures.assess inherent and control risk when they are highly interrelated. They also provide a proof that generally accepted auditing standards and practices have been duly followed in the conduct of work. Q. there is a possibility of inappropriate risk assessment. assertion or . influences the nature. even if fairly simple and unsophisticated. When both inherent and control risks are assessed at a high level. withdraw from the engagement. organizing. needs reasonable assurance that transactions are properly recorded in the accounting records and that transactions have not been omitted. Ans. They are the supporting evidence that the audit was conducted as per the generally accepted. timing and extent to substantive procedures to be performed to reduce detection risk to an acceptable level. The auditor’s control risk assessment. The auditor. auditing standards and practices. in forming his opinion on financial information. control and review of audit work : Working papers provide a means of planning. may contribute to the reasonable assurance the auditor seeks. 81 Basis of auditor’s opinion : Working papers are the basic documents for the report of the auditor. the auditor should also consider whether substantive procedures will provided sufficient assurance to reduce detection risk to an acceptable level. Internal controls. The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any substantive procedure for significant account balance and transaction classes. organization. If the validity of the auditor’s opinion. audit risk may be more appropriately determined in such situation by making a combined assessment. together with the inherent risk assessment. The higher the assessment of inherent and control risk. controlling. When the auditor determines that detection risk cannot be reduced to an acceptable level. he should either qualify or disclaim the opinion or. The importance of working papers is due to following reasons : 80 Planning. Consequently.

and vice versa. 82 Division of labor : Working papers help in appropriate division of work among the audit stag. 83 Use as permanent record : Working papers constitute a permanent record of auditing procedure employed. 86 Basis for evaluation and training of audit staff : Working papers provide a means to test whether the auditor and his staff have done their jobs as per the required standards. working papers facilitate an in-depth review of the internal control system. from the original records to the financial statements. The client can make use of these. which forms the basis of recommending suitable changes therein. leaving no question raised therein unanswered. or separate audit programmes may be prepared for each place. The progress of the work can thus be effectively monitored even where the audit work extends to different offices or branches of monitored. They serve as an index to the auditor’s ability to plan and organize the audit. he has to take decision as to the nature of evidence to be obtained and the . 84 Bridge between original transactions and financial statements : Working papers provide an important link between original transactions and the financial statements. and then working papers prepared at each place may be complied at the central office to have an overall view of the work. working papers can be produced as an evidence to establish the said opinion or assertion. though on a sample basis. in the sense that different working papers may be made the responsibility of different audit clerks under the supervision of a senior clerk or the auditor himself.recommendation as to the financial statements is later questioned. the audit programmes may be divided into so many parts. The auditor should therefore ensure that the working papers are conclusive and complete in every respect. Working papers also constitute the basis for making rectification and adjustment entries. 85 Basis for review and revision of internal controls : Internal control questionnaires form part of the working papers. Comments as to the working of the internal control system will also be found in working papers relating to audit tests in respect of each aspect of the enterprise. Even where the audit work extends to different offices or branches of the client. and the financial records examined. because at teach stage of audit. Thus. This is because an auditor’s work mostly consists in tracing the business transactions. in case his own records are lost.

Review of the past year’s working papers and reports submitted by senior audit clerks can also be used as a basis to provide the required training to the staff. being outside the purview of his report. 87 Basis for further work : In the course of his examination. Thus. the auditor may come across certain situations or conditions in the pattern of management of the client’s business which. . though not directly connected with his work and. therefore. may nevertheless be useful in future planning.tests to which evidence should be subjected. the notes and analysis prepared by the auditor as part of his working papers may also prove useful to the client in several other areas.

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