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The following transactions must be entered in the books of accounts of the company which must be kept at its registered office :-
a. all sums of money received and expended by the company and the matters in b. c. d.
respect of which the respect of which the receipt and expenditure took place; all sales and purchases of goods by the company; and the assets and liabilities of the company. in the case of a company engaged in production, processing, manufacturing or mining activities, such particulars relating to utilisation of material or other items of cost as may be prescribed relating to certain class of companies as the Central Government may require.
The books of accounts must comply with the following conditions :-
1. The books must give a true and fair view of the state of affairs of the company
or the branch office, if any, and explain its transaction.
2. The books must be kept on accrual basis and according to double entry
system of accounting. Every company must keep its books of account at its registered office. However, some of the books of account may be kept at such other place in India as the Board of Directors may decide, provided a notice in writing giving full address of that other place alongwith requisite filing fee is filed with the Registrar of Companies within seven of such decision. If the company has a branch office, the books of account relating to transactions at the branch office may be kept at that branch office, but proper summarised reports and statements must be sent to the registered office or such other place where the books are kept, at intervals of not more than three months. The books of account of the branch must give a true and fair view of the affairs of the branch and clearly explain its transactions. They must not conceal any transaction and also not disclose any transaction which is fictitious. The books of accounts and other documents and records are open to inspection by any director during business hours. Similarly, they are open to inspection by the Registrar of Companies or an officer authorised by the Central Government. These books and papers together with the vouchers pertaining to entries made must be maintained for at least 8 years. It has been clarified by the Department of Company Affairs in their Circular No. 2/83 dated 2/3/1983 that the books of account should be prepared and maintained in indelible ink (and not in pencil). The following persons are responsible for maintaining the books of accounts of a company :-
1. The managing director or manager; 2. If the company has neither a managing director nor manager, then every
director of the company;
3. Every officer and other employee who has been authorised and to whom
responsibility to maintain the books has been alloted by the Board of Directors. If any of the persons referred to above fails to take all reasonable steps to maintain proper books of accounts or has by his own willful act been the cause of any default by the company in this respect, he is punishable with imprisonment up to six months or with fine which may extend to Rs. 1,000 or with both. However, no person can be sentenced to imprisonment unless it is proved that the contravention was committed by him wilfully. Preparation of Balance Sheet and Profit and Loss Account The company has to prepare its balance sheet and profit & loss account from the books of account maintained by it. Every Balance Sheet of a company must give a true and fair view of the state of affairs of the company as at the end of the financial year and must be in the prescribed format. If the responsible for maintaining proper books of account fails to take all reasonable steps to secure compliance by the company with the requirement of law relating to the form and contents of the balance sheet, he is liable for each offence to imprisonment for a term extending up to six months or to fine up to Rs.1,000/- or to both. Form of Balance Sheet, Part 1 to Schedule VI of the Companies Act, 1956 gives the format in which the balance sheet is to be prepared. The schedule specifies 2 types of formats, the horizontal format and the vertical format. A company can prepare its balance sheet in either of the 2 formats. In the horizontal format, the liabilities including the share capital are placed on the left side and assets of all types on the right. The main heads in this form are arranged as under: (a) Share Capital (a) Fixed assets (b) Reserves and surplus (b) Investments (c) Loans (c) Current assets, loans and advances Current liabilities and (d) Miscellaneous (d) expenditure to the provisions extent not written off or adjusted (e) Profit & Loss Account ----------- ----------Total ----------- ----------In the vertical format, the various heads of liabilities and assets are arranged vertically and current liabilities are shown as deduction, from current assets. Whatever information which is required to be given in the horizontal format must also be given in the vertical format. Summarised prescribed vertical form of balance sheet is given below: I. Sources of Funds
(1) Shareholders' funds (2) Loan funds ---------------------Total ---------------------II Application of Funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances Less: Current liabilities & provisions (4) (a) Miscellaneous expenditure to the extent not written off or adjusted (b) Profit & Loss Account ---------------------Total ---------------------The Central Government may, on the application or with the consent of the Board of Directors of the company, by order, modify in relation to that company, any of the requirements as to matters to be stated in the company's balance sheet or profit and loss account for adapting them to the circumstances of the company. Contents of Profit and Loss Account Though no format has been prescribed for the profit and loss account, Part II to Schedule VI of the Companies Act, 1956 gives a list of items which must be disclosed in every profit & loss account. Every profit and loss account of a company must give a true and fair view of the company's profit or loss for the financial year for which it is drawn up. Adoption of Balance Sheet and Profit & Loss Account The Board of directors must present to the shareholders of the company, the balance sheet and a profit and loss account for the financial year at every annual general meeting. In the case of companies which are not commercial organisations such as Section 25 companies, instead if the profit & loss account, an income & expenditure account may be prepared. The profit and loss account to be placed in the FIRST annual general meeting should relate to a period beginning with the incorporation of the company and ending with a day, the interval between which and the date of the meeting does not exceed nine months. In case of subsequent annual general meetings, the profit and loss account should relate to a period beginning with a day immediately after the period for which the preceding profit & loss account was made and ending with a day, the interval between which and the date of the meeting should not exceed six months. The financial year may be more or less than a calendar year, but it must not exceed 15 months or with the special permission of the Registrar, 18 months.
If any director fails to take all reasonable steps to comply with the aforesaid requirements he is, in respect of each offence liable to be punished with imprisonment up to six months or with fine up to Rs.1,000/- or with both. Authentication of Balance Sheet and Profit & Loss Account The balance sheet and profit & loss account of a company must be signed on behalf of the Board of directors by two directors out of whom one must be the managing director, where there is one and the manager, or secretary, if any. The balance sheet and profit and loss account must be approved by the Board of directors before they are submitted to the auditors for the purpose of audit. The report of the auditors must be attached to the balance sheet and profit & loss account. The company and every officer of the company who is in default with the above provisions shall be punishable with the fine which may extend to Rs.500/-, if:
a. any copy of balance sheet and profit and loss account is issued, circulated or
published, without being signed as required ; or
b. any copy of balance sheet is issued, circulated or published, without there
being annexed or attached thereto, a copy each of the following :-
1. the profit and loss account; 2. any accounts, reports or statements pertaining to subsidiary companies which 3. 4.
are required to be attached to the balance sheet, the auditors' report; and the Report of the Board of Directors
Circulation of Balance Sheet and Auditors' Report A copy of every balance sheet, profit and loss account, auditors' report and every other document required to be annexed or attached to the balance sheet must be sent not less than twenty-one days before the general meeting to every member, to every trustee for debenture holders, and to all other persons who are entitled to have a notice of general meetings. In the case of a company not having a share capital, the above documents need not be sent to a member, or debenture holder who is not entitled to have notice of general meetings. In case of listed companies, the company may keep the aforesaid documents available for inspection at its registered office during working hours for a period of twenty-one days before the meeting and send to every member and trustee for debentureholders only a summarised statement containing the salient features of these documents in the prescribed format. Filing of Annual Accounts with the Registrar Every company must file with the Registrar within 30 days from the day on which the annual accounts, auditor’s report and the director’s report were presented at the annual general meeting, three certified copies of these documents signed by the managing director, manager or secretary of the company or if there be none of these by a director of the company. These accounts may be inspected and copies thereof may be obtained by any member of the public at the Registrar of Companies on payment of the requisite fee. However, no person other than a member of the company is entitled to inspect, or
obtain copies, of the profit and loss account in the case of the following types of companies :-
1. a private company which is not a subsidiary of public company; 2. a private company whose entire paid-up capital is held only by one or more
bodies corporate incorporated outside India; or
3. a private company which is deemed to be a public company by virtue of
Section 43A, if the Central Government directs that it is not in the public interest that any person other than a member of the company should be entitled to inspect or obtain copies of the profit and loss account of the company. In case the annual general meeting of a company for any year has not been held, , 3 copies of the balance sheet and profit and loss account, duly signed, within thiry days from the latest day on or before which that meeting should have been held in accordance with the provisions of the Act must be filed with the Registrar of Companies. If for any reason, the annual general meeting before which a balance sheet is laid does not adopt it, or is adjourned without adopting the balance sheet or if the annual general meeting of a company for any year has not been held, a statement of the fact and reasons thereof must also be annexed to the balance sheet and to the copies thereof to be filed with the Registrar. If default is made in complying with the above provisions, then the company and every officer of the company who is in default shall be punishable with fine which may extend to Rs.50 for every day during the period the default continues. Directors' Report The report of the Board of Directors must be attached to every balance sheet prsented at the annual general meeting. The report must contain information regarding the following matters :-
1. The state of affairs of the company 2. The amount, if any, which it proposes to carry to any reserves in such balance
3. The amount of dividend recommended 4. Details of any material changes and commitments, if any, affecting the
financial position of the company which have occurred between the end of the financial year of the company to which the balance sheet relates and the date of the report Conservation of energy, technology absorption, foreign exchange earnings and outgo. Names, designations and other particulars of all employees drawing more than Rs. 50000/- p.m. in the company Details necessary for a proper understanding of the state of the company's affairs and which are not, in the Board's opinion, harmful to the business of the company or of any of its subsidiaries, in respect of changes which have occured during the financial year :in the nature of company's business;
5. 6. 7.
in the company's subsidiaries or in the nature of the business carried on by them; and generally in the classes of business in which the company has an interest
Auditors of Company Auditors of Government Companies The auditor of a Government company is appointed or re-appointed by the Central Government on the advice of the Comptroller and Auditor-General of India provided that the audit would be within the number of acceptable audits available to each auditor. The Comptroller & Auditor General of India has the power :-
a. to direct the manner in which the company's accounts are to be be audited by b.
the auditor so appointed and to give such auditor instructions in regard to any matter relating to the performance of his functions as such to conduct supplementary or test audit of the company's accounts by such person or persons or persons as he may authorise in this behalf; and for the purpose of such audit, to require additional information to be furnished to any person or persons so authorised, on such matters, by such person or persons, and in such form, as the Comptroller and Auditor-General may, by general or special order, direct.
The auditor must submit a copy of his audit report to the Comptroller and AuditorGeneral of India who shall have the right to comment upon or supplement, the audit report in such manner as he may think fit. Any such comments upon, or supplement to, the audit report must be placed before the annual general meeting of the company at the same time and in the same manner as the auditors' report. Auditors of Other Companies It is the duty of the auditor conduct the audit of the books of accounts of the company and to make his report to the members of the company on the accounts examined by him, and on every balance sheet, every profit and loss account and on every other document declared by the Act to be part of or annexed to the balancesheet or profit and loss account and laid before the company in general meeting during his tenure of office. The auditor’s report, besides other things necessary in any particular case, must expressly state-
1. whether, in his opinion and to the best of his information and according to 2. 3. 4.
explanation given to him, the accounts give the information required by the Act and in the manner as required; whether the balance-sheet gives a true and fair view of the company's affairs as at the end of the financial year and the profit and loss account gives a true and fair view of the profit or loss for the financial year; whether he has obtained all the information and explanations required by him for the purposes of his audit; whether in his opinion, the profit & loss account and balance sheet refered to in his report comply with the accounting standards recommended by the Institute of Chartered Accountants of India;
5. whether, in his opinion, proper books of account as required by law have been 6.
kept by the company, and proper returns for the purposes of his audit have been received from the branches not visited by him; whether the company's balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and returns.
In case any of the above matters is answered in the negative or with a qualification, the auditor's report must state the reason for the same. Where the auditor is unable to express any opinion in answer to a particular question, his report shall indicate such fact together with the reasons why it is not possible for him to give an answer to such question. The Central Government is empowered to issue orders requiring the auditor to include in his report a statement on such matters as may be specified. In exercise of this power the Central Government has issued an order called "The Manufacturing and other Companies (Auditor's Report) Order, 1975. It is the duty of the auditor to comply with this order when making his report to the shareholders. Only the person appointed as auditor of the company or where a firm of auditors is so appointed, only a partner of that the firm practising in India, can sign the auditor's report or sign or authenticate any other document of the company required by law to be signed or authenticated by the auditor. =================================================== ======================= Inter Corporate Loans and Investments A company cannot :-
i. ii. iii.
make any loan to any other body corporate give guarantee or security in connection with any loan made by any person to another body corporate acquire, by subscription, purchase or in any other manner, securities in any other body corporate
exceeding 60 % of its paid up share capital and free reserves or 100 % of its free reserves, whichever is more, unless approved by a special resolution passed at a general meeting of members. The Board of the company may give a guarantee without being previously authorised by a special resolution of members if all the following conditions are satisfied :-
i. ii. iii.
a Board resolution is passed to this effect there exist exceptional circumstances which prevent the company from obtaining previous authorisation by special resolution the Board resolution is confirmed within 12 months in a general meeting or its next Annual general meeting, whichever is earlier.
Notice of such resolution must clearly indicate the specific limits, the particulars of the body corporate in which the investment / loan / guarantee / security is proposed, the purpose of the investment / loan / guarantee / security, sources of funding, etc. No investment / loan / guarantee / security may be made or given unless the Board resolution sanctioning it is with the consent of all directors present at the meeting and prior approval of the public financial institution ( if any term loan is outstanding ) is obtained. Approval of the public financial institution is not required if the investment / loan / guarantee / security is with the 60 % limit as mentioned above and there has been no default in repaying the term loan and / or interest thereon. No loan can be made at a rate of interest lower than the bank rate prescribed by the Reserve Bank of India. A company which has defaulted in repaying public fixed deposits cannot make or give any investment / loan / guarantee / security unless the fixed deposit is fully repaid along with interest due as per the terms and conditions of the fixed deposit. A register of such inter-corporate loans and investments must be maintained giving the relevant details. The above provisions do not apply to :-
Any loan / guarantee / security made or given by :-
a. a banking company or an insurance company or a housing finance
company in the ordinary course of its business or a company established with the object of financing industrial enterprises or providing infrastructural facilities a company whose principal business is the acquisition of shares, stocks, debentures or other securities a private company unless it is a subsidiary of a public company
b. c. ii. iii. iv. v.
Investment made under Rights issue of securities Loan made by holding company to its wholly subsidiary company Guarantee or security given by a holding company for loan to its wholly owned subsidiary Acquisition of securities by a holding company in its wholly owned subsidiary
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All the Inventory transactions will look for the valuation class and the corresponding GL Accounts and post the values in the G.L accounts. 1) For Example: during Goods Receipt Stock Account - Dr G/R I/R Account - Cr Freight Clearing account - Cr Other expenses payable - Cr 2) During Invoice Verification G/R I/R Account - Dr Vendor - Cr 3) When the Goods are issued to the Production Order the following transactions takes place: Consumption of Raw Materials - Dr Stock A/c - Cr 4) When the Goods are received from the Production Order the following transactions takes place: Inventory A/c - Dr Cost of Goods Produced - Cr Price difference - Dr/Cr (depending on the difference between standard cost and actual cost) 5) When the Goods are dispatched to customer through delivery the following transactions takes place: Cost of Goods Sold - Dr Inventory A/c - Cr 6) When the Goods are issued to a Cost Center or charged off against expenses the following transactions takes place: Repairs and Maintenance/Expenses - Dr Inventory A/c - Cr 7) When the Goods are stock transferred from one plant to another, the following transactions takes place: Stock A/c - Dr (Receiving location) Stock A/c - Cr (Sending location) Price difference - Dr/Cr (due to any difference between the standard costs between the two locations) 8) When the stocks are revalued, the following transactions take place: Stock A/c - Dr/Cr Inventory Revaluation A/c - Cr / Dr 9) When the Work in Progress is calculated the following transaction takes place:
Work in Progress A/c - Dr Change WIP A/c - Cr
1. Investment Basics
What is Investment?
The money you earn is partly spent and the rest saved for meeting future expenses. Instead of keeping the savings idle you may like to use savings in order to get return on it in the future. This is called Investment.
Why should one invest?
One needs to invest to: earn return on your idle resources generate a specified sum of money for a specific goal in life make a provision for an uncertain future One of the important reasons why one needs to invest wisely is to meet the cost of Inflation. Inflation is the rate at which the cost of living increases. The cost of living is simply what it costs to buy the goods and services you need to live. Inflation causes money to lose value because it will not buy the same amount of a good or a service in the future as it does now or did in the past. For example, if there was a 6% inflation rate for the next 20 years, a Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why it is important to consider inflation as a factor in any long-term investment strategy. Remember to look at an investment's 'real' rate of return, which is the return after inflation. The aim of investments should be to provide a return above the inflation rate to ensure that the investment does not decrease in value. For example, if the annual inflation rate is 6%, then the investment will need to earn more than 6% to ensure it increases in value. If the after-tax return on your investment is less than the inflation rate, then your assets have actually decreased in value; that is, they won't buy as much today as they did last year.
When to start Investing?
The sooner one starts investing the better. By investing early you allow your investments more time to grow, whereby the concept of compounding (as we shall see later) increases your income, by accumulating the principal and 7 the interest or dividend earned on it, year after year. The three golden rules for all investors are: Invest early Invest regularly Invest for long term and not short term
What care should one take while investing?
Before making any investment, one must ensure to: 1. obtain written documents explaining the investment 2. read and understand such documents 3. verify the legitimacy of the investment 4. find out the costs and benefits associated with the investment 5. assess the risk-return profile of the investment 6. know the liquidity and safety aspects of the investment
7. ascertain if it is appropriate for your specific goals 8. compare these details with other investment opportunities available 9. examine if it fits in with other investments you are considering or you have already made 10. deal only through an authorised intermediary 11. seek all clarifications about the intermediary and the investment 12. explore the options available to you if something were to go wrong, and then, if satisfied, make the investment. These are called the Twelve Important Steps to Investing.
What is meant by Interest?
When we borrow money, we are expected to pay for using it – this is known as Interest. Interest is an amount charged to the borrower for the privilege of using the lender’s money. Interest is usually calculated as a percentage of the principal balance (the amount of money borrowed). The percentage rate may be fixed for the life of the loan, or it may be variable, depending on the terms of the loan.
What factors determine interest rates?
When we talk of interest rates, there are different types of interest rates rates that banks offer to their depositors, rates that they lend to their borrowers, the rate at which the Government borrows in the 8 Bond/Government Securities market, rates offered to investors in small savings schemes like NSC, PPF, rates at which companies issue fixed deposits etc. The factors which govern these interest rates are mostly economy related and are commonly referred to as macroeconomic factors. Some of these factors are: Demand for money Level of Government borrowings Supply of money Inflation rate The Reserve Bank of India and the Government policies which determine some of the variables mentioned above
What are various options available for investment?
One may invest in: Physical assets like real estate, gold/jewellery, commodities etc. and/or Financial assets such as fixed deposits with banks, small saving instruments with post offices, insurance/provident/pension fund etc. or securities market related instruments like shares, bonds, debentures etc.
What are various Short-term financial options available for investment?
Broadly speaking, savings bank account, money market/liquid funds and fixed deposits with banks may be considered as short-term financial investment options: Savings Bank Account is often the first banking product people use, which offers low interest (4%-5% p.a.), making them only marginally better than fixed deposits. Money Market or Liquid Funds are a specialized form of mutual funds that invest in extremely short-term fixed income instruments and thereby provide easy liquidity. Unlike most mutual funds, money
market funds are primarily oriented towards protecting your capital and then, aim to maximise returns. Money market funds usually yield 9 better returns than savings accounts, but lower than bank fixed deposits. Fixed Deposits with Banks are also referred to as term deposits and minimum investment period for bank FDs is 30 days. Fixed Deposits with banks are for investors with low risk appetite, and may be considered for 6-12 months investment period as normally interest on less than 6 months bank FDs is likely to be lower than money market fund returns.
What are various Long-term financial options available for investment?
Post Office Savings Schemes, Public Provident Fund, Company Fixed Deposits, Bonds and Debentures, Mutual Funds etc. Post Office Savings: Post Office Monthly Income Scheme is a low risk saving instrument, which can be availed through any post office. It provides an interest rate of 8% per annum, which is paid monthly. Minimum amount, which can be invested, is Rs. 1,000/- and additional investment in multiples of 1,000/-. Maximum amount is Rs. 3,00,000/- (if Single) or Rs. 6,00,000/- (if held Jointly) during a year. It has a maturity period of 6 years. A bonus of 10% is paid at the time of maturity. Premature withdrawal is permitted if deposit is more than one year old. A deduction of 5% is levied from the principal amount if withdrawn prematurely; the 10% bonus is also denied. Public Provident Fund: A long term savings instrument with a maturity of 15 years and interest payable at 8% per annum compounded annually. A PPF account can be opened through a nationalized bank at anytime during the year and is open all through the year for depositing money. Tax benefits can be availed for the amount invested and interest accrued is tax-free. A withdrawal is permissible every year from the seventh financial year of the date of opening of the account and the amount of withdrawal will be limited to 50% of the balance at credit at the end of the 4th year immediately preceding the year in which the amount is withdrawn or at the end of the preceding year whichever is lower the amount of loan if any. Company Fixed Deposits: These are short-term (six months) to medium-term (three to five years) borrowings by companies at a fixed rate of interest which is payable monthly, quarterly, semi10 annually or annually. They can also be cumulative fixed deposits where the entire principal alongwith the interest is paid at the end of the loan period. The rate of interest varies between 6-9% per annum for company FDs. The interest received is after deduction of taxes. Bonds: It is a fixed income (debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with a fixed rate of interest on a specified date, called the Maturity Date. Mutual Funds: These are funds operated by an investment company which raises money from the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated set of
objectives. It is a substitute for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints. Benefits include professional money management, buying in small amounts and diversification. Mutual fund units are issued and redeemed by the Fund Management Company based on the fund's net asset value (NAV), which is determined at the end of each trading session. NAV is calculated as the value of all the shares held by the fund, minus expenses, divided by the number of units issued. Mutual Funds are usually long term investment vehicle though there some categories of mutual funds, such as money market mutual funds which are short term instruments.
What is meant by a Stock Exchange?
The Securities Contract (Regulation) Act, 1956 [SCRA] defines ‘Stock Exchange’ as any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. Stock exchange could be a regional stock exchange whose area of operation/jurisdiction is specified at the time of its recognition or national exchanges, which are permitted to have nationwide trading since inception. NSE was incorporated as a national stock exchange.
What is an ‘Equity’/Share?
Total equity capital of a company is divided into equal units of small denominations, each called a share. For example, in a company the total equity capital of Rs 2,00,00,000 is divided into 20,00,000 units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is 11 said to have 20,00,000 equity shares of Rs 10 each. The holders of such shares are members of the company and have voting rights.
What is a ‘Debt Instrument’?
Debt instrument represents a contract whereby one party lends money to another on pre-determined terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower to the lender. In the Indian securities markets, the term ‘bond’ is used for debt instruments issued by the Central and State governments and public sector organizations and the term ‘debenture’ is used for instruments issued by private corporate sector.
What Is Capital?
Let's imagine that you decide to start up your own ice cream shop business. You will need to invest in equipment, food supplies and property. All the money that you invest to start your business is called capital. Essentially, the capital of a business consists of all of its assets (or items to assist in the creation of wealth). What if it dawns on you that you don't have enough cash to buy all the needed assets? Let's see how new businesses and companies deal with this problem. Top
Equity vs. Debt
To start a new business (or fund a new project) a company can raise money in two ways - by selling shares of equity or by incurring debt. If the owner of our ice cream parlor invested all their own savings to buy the materials necessary to start the business, they made an equity investment in the company. Equity is simply ownership of a corporation. Typically, ownership
units in a corporation are referred to as stock. However, if our owner did not have necessary funds to start their own business they could finance their operation in one of two ways: 1. Issue stock (or certificates of partial ownership in his company) to people who may be interested in helping their venture out in return for a proportional share of the profits that the company might generate. 2. Borrow money that will need to be paid back with interest. So, what are the advantages of selling stock? Top
Why Do Corporations Issue Stock?
Businesses issue stock to raise capital. Advantages of issuing stock: 1. A Company can raise more capital than it could borrow. 2. A Company does not have to make periodic interest payments to creditors. 3. A Company does not have to make principal payments. Disadvantages of Issuing Stock: 1. The principal owners have to share their ownership with other shareholders. 2. Shareholders have a voice in policies that affect the company operations. Top
Advantages for Stockholders
As part owner of a corporation, you may be entitled to share in the profits of the company. There is also a chance that the company will grow and the price of the stock may rise. If the company achieves economic success, the stock value will go up and stockholders will benefit. For example, if you invested $1,000 to buy 100 shares of a company at $10 each and the shares rose to $13 each you would gain $300. This is equivalent to a 30% return. In cases like this, both the stockholders and the business would be pleased.
Initial Public Offerings (IPOs)
The very first sale of stocks to the public is called an initial public offering (IPO), and occurs on the primary market. This tutorial will cover the following factors involved in initial public offerings: __ The Process of Issuing Securities __ The Basics of Underwriting __ Types of Underwriting Arrangements __ The Prospectus __ Ways a Stock May Be Advertised Before it is Sold __ Newly Issued Stocks: Getting the Names Straight
The Process of Issuing Securities
Corporations sell stock to the public as one way to raise capital. Before it can issue new stock, a corporation must first file registration statements with the Securities and Exchange Commission (SEC) www.sec.gov. A twenty-day wait is required before it can sell the stocks. The issuing company may make their registration statement public with a preliminary prospectus called a red herring that summarizes the registration statement. Basic information about the new offering is also provided, including how many shares are being offered and which brokerage companies will distribute the stock to the public. At the time of issue, a final prospectus is presented. This includes the price of the stock (its offering price). Top
The Basics of Underwriting
A Corporation going public hires an investment banker to help it sell its stock. This process is called underwriting. The investment banker functions as an intermediary between the issuing corporation and the public. In most cases, the underwriter (investment banker) purchases the stocks from the company for resale to the public. To reduce its own risk, the investment banker may form an underwriting syndicate of other investment bankers to co-purchase the shares. The underwriting syndicate forms a selling group to sell specified allotments of the issue. The investment banker (underwriting syndicate) then marks up the price of the offering. This markup represents the fee for the syndicate's service. The difference between the price the underwriter
pays and the price the public pays is called the underwriting spread. The syndicate manager may bid on the stock in the offering to "stabilize" the price. This bid must be less than or equal to the offering price. By law, the prospectus must make this attempt to stabilize the stock price known to the public. The SEC also requires the underwriter to investigate the issuing company-particularly any audits, how it uses proceeds, its financial statements and the management team. This process is called due diligence. Top
Types of Underwriting Arrangements
A stock issue can be underwritten by several methods. The underwriter can act as an agent, in which it tries to sell as much of the issue as it can at market prices. This is a best effort arrangement. The issuing company can also agree to issue new stock on the condition that all of it is sold. If all of the stock is not sold, then it will withdraw the issue. This is an all-or-none arrangement. A negotiated underwriting is when the issuer and the corporation negotiate the terms of the issue, the price, the size and other details. The issue may be subject to competitive bids from investment bankers. The top bidder underwrites the issue and resells it to the public. When a public company issues more of its stock, it must first offer that stock to existing shareholders; that is their preemptive right. A standby is the public sale of whatever stock the existing shareholders have not yet purchased. A firm commitment arrangement is when an investment banker buys all of the stock from the corporation and then resells it to the public at a higher price. A private placement is an offering in which the company sells to private investors and not to the public. Private placements do not have registration fees. Top
Prospectuses are legal documents that explain the financial facts important to an offering. They must precede or accompany the sale of a primary offering. The law requires companies selling primary offerings to send prospectuses to anyone who wants to buy a primary offering. Prospectuses may also be used to solicit orders. Customers should read a prospectus carefully before purchasing any primary offering. Prospectuses include but are not limited to the following: __ Offering price __ Legal opinions about the issue __ Underwriting method __ The history of the company __ Other costs related to investing in the stock __ The management team __ The handling of proceeds The prospectus must be provided to customers before they complete any transactions. It must also include the SEC's disclaimers that it does not approve or disapprove of the stock being offered, and that it does not judge the prospectus' statements for accuracy. Top
Ways an Issue May Be Advertised Before it is Sold
A new issue of stock is allowed to be advertised before it is actually sold, although it may not be sold during the actual registration period. Registered representatives are allowed to accept oral solicitations from clients. They are not allowed to sell any shares of the new stock. Neither are they allowed to affirm any offers of sale. Registered representatives may send red herrings, or preliminary prospectuses, to clients. Information in these documents will discuss why the stock is being sold and the offering timetable. Red herrings are only issued for information purposes. Tombstone advertisements are ads that announce the new stock. Their sole purpose is to function as communication. They are not prospectuses. They are called tombstones because they provide prospective buyers with the "bare bones" information: the name of the stock, the
issuer and how to obtain a red herring. Top
Newly Issued Stocks: Getting the Names Straight
Two aspects of IPOs deserve special attention: hot issues and the so-called "when, as, and ifissued" stocks. A hot issue is a security sold by broker-dealers on the secondary market just after it is first issued. New stock may not be sold until after the registration period has expired. If the stock has not been issued by that time, it may be sold conditionally as a "When, as, and if-issued" stock. Should it fail to be issued, all buys, sells, earnings and losses will be canceled. This concludes the introductory tutorial on initial public offerings. For more information on investing in IPOs check out the tutorial titled Investing in Initial Public Offerings.
Stock Market Players
As an investor, you need to be familiar with the different players in the investment arena and how they buy and sell securities. Broker-dealers, registered representatives and the others have specific roles in clearing the way for commerce in securities. This tutorial will cover the following topics: __ Broker-Dealers __ What Broker-Dealers Are Not Allowed to Do __ Other Broker Services __ Registered Representatives, Market Makers and Specialists
A broker is a person or firm that facilitates trades between customers. A broker acts as a gobetween and, in doing so, does not assume any risk for the trade. The broker does, however, charge a commission. A dealer is a person or firm that buys and sells for his or her own inventory of securities and for others. A dealer therefore assumes risk for the transactions. Dealers may mark securities up or down to make a profit on their transactions. Many publications or websites use the term broker-dealer. A broker-dealer is allowed to operate in either role, but never as both at the same time. To be involved in the buying, selling or trading of securities, a person or firm must be registered with the National Association of Securities Dealers (NASD). The NASD is a self-regulatory organization created by the Securities and Exchange Commission (SEC). Brokers and dealers must follow all rules of the NASD and SEC, including the NASD's Conduct Rules and its rules for arbitration, complaints and dealings with the public. Broker-dealer status can be revoked for freely breaking securities rules; for having been expelled or suspended from any self-regulatory organization; for making misleading statements to the SEC or the NASD; or for having committed felonies or misdemeanors in the securities industry. Top
What Broker-Dealers Are Not Allowed to Do
The following are practices that broker-dealers are forbidden to do: __ Churning: Excessive trading of a client's discretionary account to increase the broker's commissions. __ Use deception or manipulation to trade securities, or failing to state material facts __ Recommending low-priced, speculative securities without determining whether they are suitable for the customer __ Make unauthorized transactions __ Guarantee that loss will not occur __ Try to talk clients into buying mutual funds inappropriate for their means and goals __ Use fictitious accounts to disguise trades __ State that the SEC has approved or judged positively either the security or the broker __ Not promptly transmitting the client's money or securities Broker-dealers convicted of any of these actions may be expelled or suspended by the NASD. Because brokers have so much control over other people's money, their activities are highly
Other Broker Services
Brokers, when authorized by the client, may set up discretionary accounts. These accounts allow brokers to buy and sell securities for a client's account without contacting the client for each transaction. The authorized broker may determine the security traded, how much of it may be traded, the price and the time of transaction. Brokers may lend funds to customers who have margin accounts. With margin accounts, customers can buy additional securities with money borrowed from a broker. Top
Registered Representatives, Market Makers and Specialists
Registered Representatives A registered representative is an individual who has passed the NASD's registration process and is therefore licensed to work in the securities industry. The process includes an examination that tests the candidate's knowledge of securities and markets. Further, the registration agreement requires that the candidate agree to follow the rules of the NASD. Registered representatives sell to the public; they do not work on exchange floors. Market Makers Market makers are firms that maintain a firm bid and offer price in a given security by standing ready to buy or sell at publicly-quoted prices. The Nasdaq is a decentralized network of competitive market makers. Market makers process orders for their own customers, and for other NASD broker/dealers; all NASD securities are traded through market maker firms. Market makers also will buy securities from issuers for resale to customers or other broker/dealers. About 10 percent of NASD firms are Market Makers; a broker/dealer may become a Market Maker if the firm meets capitalization standards set down by the NASD. Specialists Specialists keep markets for securities orderly and continuous. This means they must buy when there are others selling without buyers, and they must sell when others are buying without sellers. They must maintain their own inventories of securities that are large enough for sizable trades. Specialists both buy and sell out of these inventories and mediate between other customers. Specialists work on the exchanges where they hold seats. Among their duties is buying and selling odd-lots (trades of less than 100 shares) for exchange members. To trade a security, a specialist must be able to keep a position on it with at least 5,000 shares. Specialists, like others, who buy and sell for the public, are subject to rules and regulations. Specialists often choose to keep inventories in multiple securities, often in more than one market sector. This conclude s our tutorial on brokers, specialists and market makers
Q.1. What is meant by Comparison of Financial Statements? Answer: "Comparison of Financial Statements is primarily an analytical study of the different items shown in the Income Statement and Position Statement (Balance Sheet) over a period of time. It may refer to: 1. Financial statements of an enterprise for two or more accounting years. 2. Financial statements of different enterprises for the same accounting year.
Q.2. What is meant by Comparative Income Statement? Why is it prepared?
Answer: The Profit & Loss Account reveals the trading results of a concern i.e. its profit or loss during the year. But the Comparative Income Statement presents a review of two or more years. It shows the absolute change from one period to another. Comparative Income Statement is prepared: 1. To study increase or decrease in ‘Sales’. 2. To study the increasing or decreasing tendency of ‘Cost of Goods Sold’. 3. To study the increase or decrease in Gross Profit, Net Profit and Operating Profits. 4. To analyse the various items of incomes.
Q.3. What are the purposes of Comparative Financial Statement? Explain. Answer: The basic objectives of Comparative Financial Statements are as under: a. Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise. b. These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise. c. These statements help the management in making forecasts for the future. Q.4. What are the various methods of presenting Comparative Financial Statements? Answer: The various methods of presenting Comparative Financial Statements are: 1. 2. 3. 4. 5. 6. 7. Ratio Analysis Funds Flow Statement Cash Flow Statement Comparative Income Statement Comparative Position Statement Common Size Statement Trend Percentage
Q.5. What is the meaning and objective of "Trend Analysis"? Answer: Trend analysis is an important tool of horizontal financial analysis. This is helpful in making a comparative study of the financial statements for several years. Under this method trend percentages are calculated for each item of the financial statements taking the figure of base year as 100. The starting year is taken as the base
year. The trend percentages show the relationship of each item with its preceding year’s percentages. These percentages can also be presented in the form of Index Numbers showing relative change in the financial date of certain period. This will exhibit the direction to which the concern is proceeding. The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern. These are calculated only for major items instead of calculating for all items in the financial statements.
Q.1. What do you mean by the term ‘Debenture’? What are the kinds of Debentures? Answer: When a company desires to borrow a considerable sum of money for its expansion, it invites the general public to subscribe to its debentures. A debenture is a certificate issued by the company acknowledging the debt due by it to its holders and is issued by means of a prospectus in the same manner as shares. Kinds of Debentures: The following are the various types of debentures issued by a company: 1. Security Point of View i. Secured Debentures a. Fixed Charge: A fixed charge is created on certain specified assets generally immovable such as land and building, plant and machinery, long term investments and the like. So it is equivalent to mortgage. When the charge is fixed, the company can only deal with the property subject to the charge, that is, a fixed charge allows the company to retain possession of the assets but prevents the company from selling, leasing etc., of the assets without the consent of the charge holders. The property identified remains so identified during the period for which the charge is created. b. Floating Charge: A floating charge is generally in respect of movables, that is, properties which are constantly changing. It does not amount to mortgage of property. A charge on the stock-in-trade from time to time of a business is a floating charge. When an item is sold out of the stock, the charge ceases to attach to it and the buyer cannot be asked to pay the debt. When a new item is added to it the charge automatically attaches to it without further new agreement. So the property is certainly identified at the time of creation of charge; its very identification goes on changing and the final identification is at the point of time when the charge crystallizes or becomes fixed after which the company can mortgage or sell that property subject the
charge. The charge will continue to attach only so long as the item remains unsold. i. Unsecured Debentures: When debentures are issued without any charge or security, they are termed as unsecured or naked debentures. Holders of unsecured debentures are ordinary unsecured creditors and do not enjoy any special rights. 1. Tenure Point of View i. ii. Redeemable Debentures: Such debentures are redeemable at par or premium after the expiry of a particular period or under a system of periodical drawings. Perpetual Debentures: Debentures may be made irredeemable or in other words perpetual. Such debentures are redeemable either on the happening of a contingency or when the company is wound up or when the company decides to redeem. 1. Mode of Redemption Point of View i. Convertible Debentures: Debentures may be convertible into equity or preference shares of the company on certain dates or during certain periods on the basis of an agreement between company and debenture holders. a. Fully Convertible Debentures: When the full amount of debentures is converted into shares of the company at agreed terms and conditions. The conversion is to be made at or after 18 months from the date of allotment but before 36 months. b. Partly Convertible Debentures: When only a part of the amount of debentures is convertible into shares at a specified time and remaining part of debenture is redeemable on agreed terms. i. Non-Convertible Debentures: Such debentures are not convertible into equity or preference shares.
1. Coupon Rate Point of View: Usually the debentures are issued with a specified rate of interest, which is called as coupon rate. The specified rate may either be fixed or floating. The floating interest rate is usually tagged with the bank rate and yield on Treasury bond plus a reward for risk. Since the bank rate and yield on treasury securities keep on fluctuating over a period of time any change is compensated in the risk premium. The rate of interest in such a case is quoted as "PLR + 50 basis points". In this case if it is assume a PLR of 9% the rate of interest would 9.5%. The "+ basis points" is determined in relation to risk involved. A zero coupon bond is one which does not carry a specified rate of interest. In order to compensate the investors such bonds are then issued at a substantial discount. The difference between the face value and issue price is the total amount of interest related to the duration of the bond. In order to calculate the periodic charge of interest, the amount is calculated by using the following formula:
BO = MV/(1+ i)n Where BO = Value of zero coupon bond. MV = Maturity value of zero coupon bond. n = Life of zero coupon bond. i = Required rate of return. In the above formula the value of (1 +i)n is easily computed by dividing issue price in the maturity value of the bond. To find out the interest rate applicable to such bonds, we need to look for present value interest factor tables across the period equal to 'n' and find out the value near the above computed value. The interest rate in that column will be the interest on bonds. Thus, if we know the interest rate, years to maturity and the issue price, then the maturity value can be computed. In the same manner, if interest rate, years to maturity and maturity value are known, then the issue price can be computed. Present value interest factor for i rate of interest and 'n' years is written as PVIF,i.n and are given in present value of Re. 1 table shown in the appendix. BO = MV x PVIF,i,n MV= BO/PVIF, i. n PVIFi.n = BO/ MV Q.2. Briefly explain the following concepts: 1. 2. 3. 4. Debentures Bond Charge Debenture Stock
Answer: 1. Debentures: The word ‘Debenture’ is used to signify the acknowledgement of a debt, given under the seal of the company and containing a contract for the repayment of the principal sum at a specified date and for the payment of interest (usually half yearly) at a fixed rate until the principal sum is repaid and it may or may not give a charge on the assets of the company as security for the loan. Section 2 (12) of the Companies Act states that "a debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not".
2. Bond: Bond is similar to that of debenture both in terms of contents and texture. Traditionally government issued the bonds, but now these are also issued by semi-government and non-government organizations. The significant difference between bonds and debentures is with respect to the issue condition i.e., bonds can be issued without predetermined rte of interest. 3. Charge: A charge is created on certain specified assets generally immovable such as land and building, plant and machinery, long term investments and the like. So it is equivalent to mortgage. When the charge is fixed, the company can only deal with the property subject to the charge, that is, a fixed charge allows the company to retain possession of the assets but prevents the company from selling, leasing etc., of the assets without the consent of the charge holders. The property identified remains so identified during the period for which the charge is created. 4. Debenture Stock: Debenture stock is a document representing the loan capital of the company consolidated into one single composite debt which may be divided into the transferable in convenient units of fixed amount. This sum may be of any amount and may include fraction of a rupee. Certificates are issued to each debenture stockholder indicating the amount of his contribution or holding. The debenture stock must be fully paid. Debenture is always for a fixed sum and is transferable only in its entirety by a debenture stock may be the consideration of the several debenture amounts and a single certificate issued covering many debenture. Similarly debenture stock may be transferable in parts if articles so permit.
Q.3. Distinguish between Shares and Debentures. Answer: Basis of Difference 1. Capital Shares Debentures
A share is a part of equity or A debenture is a part of loan capital of the preference share capital of a company. The holder of a debenture is the company. The holders of the shares creditor of the company. may be described as part owner of the company. Return on share is known as dividend. A company declares dividend only when there are profits and its rate may vary from year to year. Return on a debenture is known as interest and the company compulsorily pays it at a fixed rate whether there are profits or losses.
Dividend is an appropriation of profit Interest on debenture is a charge against and is therefore debited in Profit & profits and is therefore debited in Profit & Loss Appropriation Account. Loss Account. Shares do not create any charge on the assets of the company. Debentures create a charge on the asset of the company.
4. Charge on Property
Normally the share capital is not returned during the lifetime of the company.
The amount of debentures has to be returned after a stipulated period of time as per the conditions of issue.
6. Discount on Issue
Shares can be issued at discount only There are no restrictions on issue of when the conditions lay down in debentures at a discount. Section 79 of the Companies Act 1956 are fulfilled. The premium received on issue of Premium received on issue of debentures shares can be utilised by the company can be utilised by company in any manner subject to the conditions given in it likes. Section 78 of the Companies Act 1956. A company cannot purchase its own shares Shares cannot be converted into debentures. A company can purchase own debentures from the open market. Debentures can be converted into shares according to the conditions of issue of debentures.
7. Premium on Issue
8. Purchase 9. Convertibility
A shareholder has the right to control A debenture holder does not have any the affairs of the company by right to control the affairs of the company. exercising his right to attend the general meeting of the company and by exercising his voting right. At the time of winding up the shareholders are paid their capital at the end. Debenture holders have a priority as to return of amount received from them in the event of winding up of the company.
11. Winding up
Q.4. Explain the meaning of debentures issued as collateral security by a company. Show its treatment in the Balance Sheet. Answer: When debentures are issued as security in addition to any other security against a loan or bank overdraft such an issue of debentures is known as issue of debentures as collateral security. The idea of such an issue is that if the company does not repay the loan and the interest and the main security is not sufficient, the bank will be entitled to sell the debentures in the market or the bank may keep the debentures with it. If the company repays the loan, the bank will return the debentures issued as collateral security to the company. No entry needs to be passed in the books of the company because debentures are issued only as a collateral security. Debentures become alive only when loan is not repaid. The fact of such an issue of debentures must be clearly stated in the Balance Sheet by way of a note under the loan and debentures as shown below: Balance Sheet of --- Co. Ltd.
As on--Liabilities Secured Loans Bank Loan (secured by issuing 6,000 12% Debentures of Rs. 100 each) Alternatively, the following entry may be passed in books of the company: Date Particulars L.F. Debit Rs. Bank A/c Dr. To Bank Loan A/c (For loan borrowed from bank) Debentures Suspense A/c Dr. To 12% Debentures A/c (For 6,000 Debentures of Rs. 100 each issued as collateral security) Balance Sheet of --- Co. Ltd. as on--Liabilities Secured Loans Bank Loan 12% Debentures (6,000 12% Debentures of Rs. 100 each issued as collateral security) Q.5. Briefly explain the meaning of Trust Deed. Who can be a Trustee? What the duties of a Trustee? Answer: When a series of debentures are issued to numerous debenture holders, it is not a practical 5,00,000 6,00,000 Rs. Assets Miscellaneous Expenditures Debentures Suspense A/c 6,00,000 Rs. 6,00,000 6,00,000 5,00,000 5,00,000 Credit Rs. Rs. Assets 5,00,000 Rs.
proposition to create a number of separate charges on the properties of the company in favour of individual debenture holders. And it is practically impossible for the debenture holders also to keep a watch on the assets of the company in order to safeguard their own interests. It is thus becomes necessary to execute trust deed by which properties of the company are charged by way of mortgage to the trustees. A trust deed is therefore a contract between the company and the trustees for the debenture holders. Generally trust deed has to be executed before the debentures are offered for public subscriptions so that the prospective investors may satisfy themselves as to the contents of the trust deed and credibility of the trustees selected by the company to look after their interest. A trust deed is also a mortgage deed between the company and the trustees for debenture holders. The debenture holders are merely beneficiaries under the trust deed. Section 118 of the Companies Act gives the right to obtain the copies and inspect trust deed by any member of the company. The advantages of creating a trust deed are: i. ii. iii. iv. The trustees can act expeditiously and effectively in safeguard interests of the debenture holders and enforcing the security on their behalf. They will act as watchdogs in seeing and insisting that company’s obligations under the trust deed are carried out properly. They are generally empowered to settle and adjust matters of dispute with the company. In cases of doubt or difficulty they can convene meetings and enable the debenture holders to meet and discuss and authorize the trustees to pursue any course of action to be beneficial to the debenture holders as a whole.
Who can be Trustees? Only the following are eligible to be debenture trustee: a. A scheduled bank carrying on commercial activity. b. A public financial institution within the meaning of sections 4A (1) of the Companies Act 1956. c. Insurance Company. d. Body Corporate. Who can not be a Trustee? No person can be appointed as a trustee if he: a. Beneficially holds share in the company. b. Beneficially entitle to receive money, which are to be paid to/the by the company to the debenture trustee. c. Has entered into any guarantee in respect of principal debts, secured by debenture or interest thereon.
Duties of Trustees a. b. c. d. Call for periodic reports from the body corporate Take possession of trust property in accordance with the provisions of the trust deed Enforce security in the interest of debenture holders The charge created against the assets under debenture trust deed should be completed within 30 days of the issue of allotment letter and dispatch of debenture certificate.
A debenture trustee who fails to comply with any conditions, contravenes any of the provisions of the Act, rules or regulations, the Companies Act or rules made thereunder, may disqualify him to act as trustee.
Q.1. What do you mean by Cash Flow Statement? Answer: A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current liabilities are taken into consideration. But in a cash flow statement only those sources of funds are taken which provide cash and only the uses of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored. A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash. Q.2. What are the objectives of Cash Flow Statement? Answer: A Cash Flow Statement provides very useful help to financial management of a business enterprise. It summarises the sources from where the cash may be obtained and the specific uses to which the cash may be applied during a particular period of time. A Cash Flow Statement has the following uses: Helpful in short-term financial planning: Cash Flow Statement provides useful information to a business enterprise to make decision for its short-term financial planning. Helpful in preparing Cash Budget: A Cash Budget is an estimate of cash receipts and disbursement for a future period of time. Cash Flow Statement provides help to the management to prepare Cash Budget. A comparison of cash budget and cash flow statement reveals the extent to which the sources of the business were generated and used as per the plans of the business.
Helps to understand liquidity: Liquidity means ability of a business enterprise to pay off its liabilities when due. Cash Flow Statement helps to know about the sources where from the cash will be available to pay off the liabilities. Prediction of sickness: With the help of preparing cash from operation a business enterprise may come to know about cash losses in operation. It helps to predict this type of sickness. Dividend decisions: Dividend is paid within 42 days, when company declares it. Cash Flow Statement helps the management to know about the sources of cash to pay off dividend.
Q.3. What are the sources and uses of Cash? Answer: The major sources of cash are as under: Cash from Operation Issue of Equity Share Capital for cash Issue of Preference Share Capital for cash Raising long term loans for cash Sale of Investments Sale of Fixed Assets Premium on Issue of Shares / Debentures etc. The major uses of cash are as under: Redemption of Preference Share Capital for cash Redemption of Debentures/ Repayment of Long-term Loans Purchase of Investment Purchase of Fixed Assets Premium on Redemption of Preference Share/Debentures Dividend Paid
Taxes Paid etc. Q.4. Differentiate between a cash flow statement and a funds flow statement. (CBSE) Answer: Difference between Funds Flow Statement and Cash Flow Statement Basis of Difference 1. Basis of Analysis Funds Flow Statement Funds flow statement is based on broader concept i.e. working capital. Funds flow statement tells about the various sources from where the funds generated with various uses to which they are put. Cash Flow Statement Cash flow statement is based on narrow concept i.e. cash, which is only one of the elements of working capital. Cash flow statement stars with the opening balance of cash and reaches to the closing balance of cash by proceeding through sources and uses.
Funds flow statement is more Cash flow statement is useful in useful in assessing the long-range understanding the short-term financial strategy. phenomena affecting the liquidity of the business.
Schedule of Changes In funds flow statement changes in In cash flow statement changes in in Working Capital current assets and current current assets and current liabilities are liabilities are shown through the shown in the cash flow statement itself. schedule of changes in working capital. Causes Funds flow statement shows the causes of changes in net working capital. Cash flow statement shows the causes the changes in cash.
Principal of Accounting
Funds flow statement is consonant In cash flow statement data obtained on with the accrual basis of accrual basis are converted into cash accounting. basis.
Q.1. Give major headings of the assets and liabilities-side of a company’s balances sheet as per Schedule VI, Part I. Answer: Major headings of Assets side i. ii. iii. iv. v. Fixed Assets Investments Current Assets, Loans and Advances: Current Assets, Loans and Advances Miscellaneous Expenditures Profit & Loss Account (Loss in Business)
Major headings of Liabilities side i. ii. iii. iv. v. Share Capital Reserves and Surplus Secured Loans Unsecured Loans Current Liabilities and Provisions a. Current Liabilities b. Provisions Q.2. What is contingent liability? Mention four examples of contingent liabilities. Where is it shown in the balance sheet? (CBSE Delhi 1999) Answer: A possible future liability, which depends on the happenings of certain uncertain event, is called contingent liability. These liabilities are not shown in the total of liability side, but are shown as a footnote to the balance sheet. The following are some examples of contingent liabilities: i. ii. iii. iv. v. Uncalled liabilities on partly paid shares Liabilities under Guarantee Arrears of dividends on cumulative preference shares Claim against the company now acknowledged as debts Liabilities on Bills Receivable discounted but not matured.
Q.3. Under what headings will you show the following items in the balance sheet of a company: i. ii. iii. iv. Goodwill Unclaimed Dividends Provision for Tax Share Premium Account
Loose Tools (CBSE 1996)
Answer: Items Goodwill Unclaimed Dividend Provision for Tax Loose Tools Headings Fixed Assets Current Liabilities and Provisions Current Liabilities and Provisions Current Assets, Loans and Advances Sub-headings --Current Liabilities Provisions --Current Assets
Share Premium A/c Reserves and Surplus
Q.4. Give the headings under which the following items will be shown in a company’s balance sheet as per Schedule VI, Part I: i. ii. iii. iv. v. Sundry Creditors Debentures Sinking Fund Bills Receivable Discount on Issue of Debentures Motor Car
Answer: Items Sundry Creditors Debentures Sinking Fund Bills Receivable Discount on Issue of Debentures Motor Car Headings Current Liabilities and Provisions Reserves and Surplus Current Asset, Loans and Advances Miscellaneous Expenditures Fixed Assets Sub-headings Current Liabilities --Loans and Advances -----
Q.5. Give the headings under which any four of the following items will be shown in Company’s Balance Sheet. i. ii. iii. Debentures Interest accrued on investment Goodwill
Preliminary Expenses Bills of Exchange (CBSE 1991 (Foreign))
Answer: Items Debentures Goodwill Preliminary Expenses Bills of Exchange Headings Secured Loans Fixed Assets Miscellaneous Expenditures Current Assets, Loans and Advances Sub-headings --Current Assets ----Loans and Advances
Interest accrued on Investment Current Assets, Loans and Advances
Q.6. Give the Performa of balance sheet in horizontal form according to the requirements of Schedule VI of the Companies Act 1956. Solution: Balance Sheet of---Co. Limited As at---Figures for the previous year Liabilities Rs. Rs. (1) Share Capital Authorised Capital: XXX … Shares of Rs. … each Issued Capital: XXX … Equity Shares of Rs. … each XXX … Preference Share of Rs. … each Subscribed Capital: … Equity Shares of Rs. … each Rs. … Called up XXX … Preference Share of Rs. … each Rs. … Called up XXX Less Calls Unpaid XXX (i) By directors XXX (ii) By Others XXX XXX Add Forfeited shares XXX (2) RESERVES AND SURPLUS: XXX 1. Capital Reserve, not available for Dividend XXX XXX XXX XXX XXX 1. Goodwill 2. Land 3. Building 4. Leaseholds 5. Railway Sidings 6. Plant and Machinery 7. Furniture and Fittings 8. Development of Property 9. Patents, Trade Marks and Designs 10. Live Stocks 11. Vehicles etc. (2) INVESTMENTS: (3) CURRENT ASSETS, LOANS AND ADVANCES: (A) Current Assets: Rs. Rs. Rs. (1) FIXED ASSETS: Figures Figures for the for the current previous year year Assets Rs. Figures for the current year
XXX 2. Capital Redemption Reserve XXX 3. Share Premium Account XXX 4. Other Reserves specifying the nature of reserve and the amount in respect thereof. Less: Debit balance in Profit & Loss account (if any) XXX 5. Surplus, that is balance in Profit and Loss account after providing for proposed allocation namely: Dividend, Bonus or Reserves XXX 6. Proposed addition to reserves XXX 7. Sinking Funds
XXX XXX XXX
1. Interest accrued on investments 2. Stores and Spare parts 3. Loose Tools
4. Stock in trade
5. Work in progress 6. Sundry Debtors: a. Debts outstanding for a period exceeding 6 months b. Other Debts Less: Provision
(3) SECURED LOANS:
7. (a) Cash balance in hand (b) Bank balance: i. ii. With scheduled Banks With others
XXX 1. Debentures XXX 2. Loans and Advances from Banks.
(B) Loans and Advances: 8. (a) Advances and loans to subsidiaries (b) advances and loans to partnership firms in which the Company or any of its subsidiaries is a partner
XXX 3. Loans and Advances from
9. Bills of Exchange
subsidiaries XXX 4. Other Loans and Advances XXX 10. Advances recoverable in cash or in kind (e.g. Rates, Taxes, Insurance, etc. prepaid) 11. Balances with customs, Port Trusts, and excise authorities etc. (4) MISCELLANEOUS EXPENDITURE: XXX XXX 1. Preliminary Expenses 2. Expenses, including commission or Brokerage on under writing of Shares or Debentures 3. Discount allowed on the issue of Shares or Debentures
XXX 5. Interest accrued and due on secured loans (4) UNSECURED LOANS: XXX 1. Fixed Deposits XXX 2. Loans and Advances from subsidiaries
XXX 3. Short Term Loans and Advances a. From Banks b. From Others XXX 4. Other Loans and Advances a. From Banks b. From Others (5) CURRENT LIABILITIES AND PROVISIONS: (A) Current Liabilities: XXX 1. Acceptances
4. Interest paid out of capital during construction period
5. Development expenditure not adjusted 6. Other sums (specifying nature) XXX 5. PROFIT & LOSS ACCOUNT: (This is shown only when its debit balance count not be written off out of others reserves)
XXX 2. Sundry Creditors XXX 3. Subsidiary Companies XXX 4. Unclaimed Dividends
XXX XXX XXX
XXX 5. Interest accrued but not due on loans XXX 6. Advance payments and unexpired discounts for the portion for which value has still to be given, e.g. in the case of the following classes of companies: Newspaper, Fire Insurance, Theatres, Clubs, Banking, Steamship Companies etc. XXX 7. Other Liabilities (if any) (B) Provisions: XXX 8. Proposed Dividends XXX 9. Provision for Taxation XXX 10. Provision for Contingencies XXX 11. Provision for Provident Fund schemes XXX 12. Provision for insurance, pension and similar staff benefit schemes. XXX 13. Other Provisions (6) CONTINGENT LIABILITIES (by way of foot- note only): 1.Uncalled liabilities on partly paid shares 2.Liabilities under Guarantee 3.Arrears of dividends on cumulative preference shares 4.Claim against the company now acknowledged as debts 5.Liabilities on Bills Receivable discounted but not matured. XXX
XXX XXX XXX XXX XXX XXX
Q.1. Define Company. Mention its main characteristics. Also explain the different kinds of shares, which a public company can issue. Answer: " A Company is an association of many persons who contribute money or money’s worth to a common stock and employ it for a common purpose. The common stock so contributed is denoted in money and is capital of the company. The persons who contribute it or to whom it belongs are members. The proportion of capital to which each member is entitled is his share." The company is an artificial legal person created by law. A Company has a right to sue and can be sued, can own property and has banking account in its own name, own money and be a creditor. A Company has a separate legal entity, which is distinct from its shareholder. According to Section 3 (1) of Indian Companies Act 1956 " Company means a company formed and registered under this Act." According to Professor Haney " A Company is an artificial person, created by law having a separate entity with a perpetual succession and a common seal." Characteristics of a Company: 1. Artificial Person: A company is an artificial person, which exists only in the eyes of law. The company carries business on its own behalf. It has a right to sue and can be sued, can have its own property and its own bank account. It can also own money and be a creditor. 2. Created by law: A company can be formed only with registration. It has to fulfill a lot of formalities to be registered. It has also to fulfill a lot of legal formalities in order to be dissolved. 3. Perpetual succession: A company has a continuous existence. Its existence does not affected by admission, retirement, death or insolvency of its members. The members may come or go but the company may go forever. Only law can terminate its existence 4. Limited Liability: The liability of every member is limited to the face value of shares, held by him. 5. Voluntary Association: A company is a voluntary association. It can not compel any one to become its member or shareholder. 6. Capital Structure: A company has to mention its maximum capital requirements in future in its memorandum of association. Its capital is divided into shares, which are easily transferable from person to person. 7. Common Seal: As a company is an artificial person, so it can sign any type of contracts.
For this purpose its requires a common seal which acts as the official signatories of the company. All the contracts prepared by its directors must bear seal of the company. 8. Democratic Ownership: The directors of a company are elected by its shareholders in a democratic way. Q.2. Distinguish between Partnership Firm and Joint Stock Company. Answer: Partnership 1. Partnership Firm is formed under Indian Partnership Act 1932. Joint Stock Company 1. A Joint Stock Company is formed under Indian Companies Act 1956.
2. Minimum number of partners are 2 and 2. Minimum number of members are 7 in case of maximum 10 in case of banking business and 20 a public company and maximum no limit. In a in other kind of business. private limited company minimum number of members are 2 and 50 are maximum. 3. Liability of a Partnership firm is unlimited. 4. Every partner can take active part in the management of the firm. 5. Auditing of books is not compulsory. 6. A Partnership firm can do the business as agreed upon by the partners. 7. A partnership firm do not have a separate legal entity 8. Insolvency of a Partnership firm means insolvency of all partners. 3. Liability of members is limited to extent of shares held by him. 4. Boards of Directors manage a company. 5. Auditing of books is compulsory. 6. A company can do only that business which is stated in Memorandum of Association. 7. A company has a separate legal entity. 8. Winding up of a company does not mean insolvency of its members.
Q.3. Distinguish between Equity Shares and Preference Shares. (CBSE 1991, 1993) Answer: Equity Share: According to Indian Companies Act 1956 " an equity share is share which is not preference share". An equity share does not carry any preferential right. Equity shares are entitled to dividend and repayment of capital after the claims of preference shares are satisfied. Equity shareholders control the affairs of the company and have right to all the profits after the preference dividend has been paid. Preference Share: A share that carries the following two preferential rights is called ‘Preference Share’:
Preference shares have a right to receive dividend at a fixed rate before any dividend given to equity shares. Preference shares have a right to get their capital returned, before the capital of equity shareholders is returned. in case the company is going to wind up.
Difference between Preference Share and Equity Share Basis of Difference Right of Dividend Preference Share Equity Share
Preference shares are paid dividend Equity shares are paid dividend out of before the Equity shares. the balance of profit after the dividend paid to preference shareholders. Preference shares are given dividend at a fixed rate. Dividend on Equity shares depend on the balance of profit left after the payment of dividend to preference shares. Equity shareholders carry the right to interfere in management of the company due to investigating risk of capital in the company.
Rate of Dividend
Preference shareholders do not carry the right to participate in the management of the company.
Preference shareholders do not Equity shareholders carry the right to carry the voting right. They can vote in all circumstances. vote only in special circumstances. Equity shares capital is refundable only at the time of winding up of the company. Equity shareholders are paid their capital if there is some balance left after the payment of preference shareholders.
Redemption of Share In case the preference shares are Capital redeemable, the amount of capital will be refunded to shareholders after a certain period. Refund of Capital At the time of dissolution of the company, preference share capital is paid before the payment of Equity share capital.
Q.4. What is meant by ‘Share Capital’? Explain the different categories of share capital. Answer: The capital of a joint stock company is divided into shares and called ‘Share Capital’. The share capital may be classified as below: 1. Nominal/Authorised/Registered Capital: This is the amount of the capital which is stated in Memorandum of Association and with which the company is registered. Nominal capital is the maximum amount which the company is authorised to raise from the public.
2. Issued Capital: This is the nominal amount of shares actually issued to the public. In other words, issued capital is that part of the nominal capital, which is offered to the public for subscription. The balance of the nominal capital, which is not offered to the public for subscription, is called unissued capital. 3. Subscribed Capital: This is the nominal amount of the shares taken up by the public. In other words, subscribed capital is that part of the issued capital, which is applied for by the public. The balance of the issued capital, which is not subscribed for by the public is called, unsubscribe capital. 4. Called up Capital: This is the amount of the capital that the shareholders have been called to pay on the shares subscribed for by them. The nominal amount of the shares is usually collected from the shareholders in installments and it is possible that the entire amount of the subscribed capital may not have been called. The amount of the subscribed capital, which is not called, is known as uncalled capital. 5. Paid up Capital: This represents that part of the called up capital, which is actually received by the company. The amount of the called-up capital, which not paid by the shareho0lders, is called as unpaid capital or calls in arrears. 6. Reserve Capital: A company may by special resolution determine that any portion of its share capital which has not been already called up, shall not be capable of being called-up, except in the event of winding up of the company. Such type of share capital is known as reserve-capital. Q.5. Give the meaning of ‘Issuing the shares at Premium’. For what purpose, the amount of Securities Premium can be utilized? (CBSE 1996, 1997) Or State the provision of Section 78 of the Company Act 1956, regarding the utilisation of Securities Premium. Or State any three purposes for which the balance of Securities Premium account can be utilized. (CBSE 1998, 2001(Outside Delhi) Answer: If Shares are issued at a price, which is more than the face value of shares, it is said that the shares have been issued at a premium. The Company Act 1956 does not place any restriction on issue of shares at a premium but the amount received, as premium has to be placed in a separate account called Security Premium Account. Under Section 78 of the Company Act 1956, the amount of security premium may be used only for
the following purposes: 1. To write off the preliminary expenses of the company. 2. To write off the expenses, commission or discount allowed on issued of shares or debentures of the company. 3. To provide for the premium payable on redemption of redeemable preference shares or debentures of the company. 4. To issue fully paid bonus shares to the shareholders of the company. Q.6. Can a company issue shares at discount. Or What condition must a Company satisfy for issuing shares at a discount? (CBSE 1996) Or Explain Section 79 of the Company Act 1956. Answer: As a general rule, a company cannot ordinarily issue shares at a discount. It can do so only in cases such as ‘reissue of forfeited shares’ and in accordance with the provisions of Companies Act. But according to Section 79 of company act 1956, a company is permitted to issue shares at discount provided the following conditions are satisfied: a. The issue of shares at a discount is authorised by an ordinary resolution passed by the company at its general meeting and sanctioned by the Company Law Board. b. The resolution must specify the maximum rate of discount at which the shares are to be issued but the rate of discount must not exceed 10 per cent of the nominal value of shares. The rate of discount can be more than 10 per cent if the Government is convinced that a higher rate is called for under special circumstances of a case. c. At least one year must have elapsed since the company was entitled to commence the business. d. The shares are of a class, which has already been issued. e. The shares are issued within two months from the date of sanction received from the Government.
Q.1. Explain briefly the various methods of redemption of debentures. Answer: Repayment or discharge of liability on account of debentures is called redemption of debentures. The method of debenture redemption adopted determines to a very large extent, the actual accounting for redemption as well as the marshalling of resources for the same. There are broadly four methods for the redemption of debentures which are as follows: 1. Lump-sum payment method: In this method, redemption of debentures is done by repayment in one lump sum after the expiry of a stipulated period. The total amount payable to debenture holders is decided at the time of issue of debentures (i.e. debentures will be redeemed at par or at premium). Usually a company creates sinking fund or an insurance policy fund for the redemption of debentures. 2. Drawings of Lots method: In order to reduce the liability of debentures, company may repay the debentures in some instalments. A certain amount of debentures is redeemed at regular interval of time during the lifetime of the debentures by drawings of lots. 3. Purchase in the Open Market: The company from the open market can purchase its own Debentures. Debentures so purchased may be cancelled immediately or may be kept as an investment, which will be cancelled later. It may beneficial for the company if it purchases its own debentures at a discount from the open market. 4. Conversion Method: Usually debentures are redeemed in cash but sometimes debenture holder are given an option to get their debentures converted either in shares or for new debentures of the company. The redemption of debentures by means of shares or new debentures is known as redemption by conversion. Debentures, which carry such right, are called ‘Convertible Debentures’. Q.2. Distinguish between redemption of debentures out of capital and out of profit. Answer: Redemption out of Capital: When debentures are redeemed out of capital, no transfer is made to general reserve or debenture redemption reserve account. In this method it is assumed that the company has sufficient funds to redeem the debentures. So the profits are not utilised to replace the debentures. It affects adversely to the Working Capital of the company. The following entries are passed when debentures are redeemed out of capital: 1. For amount of debentures due to Debenture holders: (a) when debentures are redeemable at par: % Debentures A/c Dr. To Debenture holders A/c (b) when debentures are redeemable at premium:
% Debentures A/c Dr. Premium on Redemption of Debentures A/c Dr. To Debenture holders A/c 2. For payment to Debenture holders: Debenture holders A/c Dr. To Bank A/c Redemption out of Profit: When it is intended to redeem the debentures out of profits, a part of profits available for distribution of dividends is withheld by the company every year to be used for redemption purposes as and when the need arises for the same. There are two alternatives available to the company in this regard namely: (a) the amount of divisible profits withheld by the company may be retained in the business itself as a source of internal financing. (b) The amount of divisible profits withheld from distribution as dividend may be invested either (i) in readily marketable securities or (ii) in taking out insurance policy to provide funds when required. The following entries are passed when debentures are redeemed out of profit: 1. For amount of debentures due to Debenture holders: (a) when debentures are redeemable at par: % Debentures A/c Dr. To Debenture holders A/c (b) when debentures are redeemable at premium: % Debentures A/c Dr. Premium on Redemption of Debentures A/c Dr. To Debenture holders A/c 2. For payment to Debenture holders: Debenture holders A/c Dr. To Bank A/c 3. For profit transferred to General Reserve Profit & Loss Appropriation A/c Dr. To General Reserve A/c
Q.3. Explain with the help of journal entries, how Sinking Fund Method for redemption of Debentures is used? (A.I.S.S.C.E. 1987) Answer: A sinking fund may be defined as a fund created by a charge against or appropriation of profits and represented by specific investments. The accounting entries for creating a Sinking Fund would be as under: I. First Year: On the date of issue of Debentures: 1. For issue of Debentures Bank A/c Dr. To % Debentures A/c At the end of first year: 2. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c Profit & Loss Appropriation A/c Dr. To Sinking Fund A/c 3. For Investments made for the amount of sinking fund Sinking Fund Investment A/c Dr. (with the amount of sinking fund) To Bank A/c II. At the end of second and subsequent years during the life of the debentures excepting last year: 1. For receipt of interest on investment Bank A/c Dr. To Interest on Sinking Fund Investment A/c 2. For interest on investment t/f to sinking fund Interest on Sinking Fund Investment A/c Dr. To Sinking Fund A/c 3. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c Profit & Loss Appropriation A/c Dr. To Sinking Fund A/c 4. For Investments made for the amount of sinking fund
Sinking Fund Investment A/c Dr. (with the total amount of annual sinking fund + interest) To Bank A/c III. Last year: 1. For receipt of interest on investment Bank A/c Dr. To Interest on Sinking Fund Investment A/c 2. For interest on investment t/f to sinking fund Interest on Sinking Fund Investment A/c Dr. To Sinking Fund A/c 3. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c Profit & Loss Appropriation A/c Dr. To Sinking Fund A/c 4. For sale of investment Bank A/c Dr. To Sinking Fund Investment A/c 5. For gain on sale of investment Sinking Fund Investment A/c Dr. To Sinking Fund A/c Or For loss on sale of investment Sinking Fund A/c Dr. To Sinking Fund Investment A/c 6. For amount of debentures due to Debenture holders: (a) when debentures are redeemable at par: % Debentures A/c Dr. To Debenture holders A/c (b) when debentures are redeemable at premium: % Debentures A/c Dr. Premium on Redemption of Debentures A/c Dr.
To Debenture holders A/c 7. For payment to Debenture holders: Debenture holders A/c Dr. To Bank A/c 8. For transfer of Sinking Fund to General reserve Sinking Fund A/c Dr. To General Reserve A/c Q.4. Explain the concept of compulsory creation of Debenture Redemption Reserve. Answer: The amount required for the redemption of debentures is usually very large. It creates a great difficulty for the company to arrange this large amount to pay off its debentures. In case this large amount is paid out of company’s working capital, it may affect the routine working of the company and that will affect the profitability of the company also. So in order to avoid this difficulty a company needs funds to repay its debentures. According to a notification of Government of India issued by Controller of Capital Issue as on 1-1-1987, it is compulsory for all companies to create a Debenture Redemption Reserve up to at least 50% of the amount of debentures issued before the commencement of redemption of debentures. The effect of such a notification is that a Company cannot redeem its debentures purely out of capital or purely out of current profits.
Q.1. Define Partnership. Enumerate the essential elements of partnership. (Delhi 1987, 92, 93, 97) Answer: In India, Partnership firm is governed by the Indian Partnership Act 1932. Section 4 of this act defines partnership as: " The relationship between persons, who have agreed to share the profits of a business carried on by all or any one of them acting for all." According to Prof. Haney, partnership is "the relation between persons competent to make contract who agree to carry on a lawful business in common with a view to private gain." Partnership in this way is an agreement, between two or more persons to carry on legal business with profit motive, carried on by all or any one of them acting for all. In this way, partnership has the following characteristics: (i) Contract: Partnership is the result of contract between the partners and their relation of partnership arises from contract and not from status. The relationship between the
members of a Joint Hindu Family (governed by the Mitakshara School of Hindu Law) is determined by birth and not by agreement. Therefore, a Joint Hindu Family firm is not a partnership under the act. (ii) Number of Persons: In a partnership firm there must be at least two person to form the business. Partnership Act 1932, does not specifies the maximum numbers of persons, but the Indian Company Act 1956, restricts the number of Partners to 10 for a partnership carrying on banking business and 20 in case of other kinds of business. (iii) Business: Business must be carried on by all or any one of them acting for all. This is the cardinal principle of the working of the partnership firms. An act of one partner in the course of the business of the firm is in fact an act of all the partners. Each partner carrying on the business is the principle as well as the agent for all the other partners. (iv) Motive: For a partnership firm there must be motive to earn profit. A partnership firm cannot be formed with service motive. (v) Legality of the Business: The business to be carried on by the partners must be legal. There should be lawful consideration and the business should not be illegal in the eyes of law.
Q.2. What is a partnership deed? State the main contents of the partnership deed. Ans. A partnership is formed by an agreement. This agreement may be oral or in writing. Though the law does not expressly require that the partnership agreement should be in writing, it is desirable to have it in writing. A document, which contains the terms of partnership, as agreed to by the partners is called ‘Partnership Deed.’ Contents of the Deed: 1. 2. 3. 4. 5. 6. 7. Name of the firm and its permanent address. Names and addresses of the partners. Nature of Business. Methods of evaluating of assets and liabilities. Date of commencement of partnership. Amount of capital to be contributed by each partner. Interest of Capital: According to section 13 of Partnership Act 1932, a partner is not entitled to interest on capital as a matter of right, but if there is an agreement that partner would receive interest on capital, it is paid at the agreed rate but such interest is payable only out of profits. 8. Drawings by the partners. 9. Interest on Drawings: The partnership deed must specifically mention whether interest on drawings will be charged, or not. If the interest is to be charged, rate of
interest should also be specified. 10. Accounting Period of the Firm: -The period after which the final accounts of the firm are to be prepared. Whether yearly or half-yearly and the date on which accounts are to be closed every year. 11. Profit and loss sharing ratio: Partners must agree as to the ratio in which they will be distributing profit or loss. In the absence of any agreed ratio profit or loss will be shared equally 12. Partner’s salary: If any partner is allowed salary, it should be mentioned in the partnership deed and the amount of salary should also be specified. 13. Duration of partnership: The period for which the partnership has established and the mode of dissolution of partnership. 14. Valuation of goodwill: Method of valuation of goodwill in case of admission or retirement of a partner should also be mentioned. 15. Auditing: Whether the firm’s books will be audited or not? If so, the mode of auditor’s appointment. 16. Operation of Bank Account: -The deed should mention the name of partner or partners, authorised to operate Bank Account, i.e., who is authorised to sign on cheque. 17. Application of the Decision of Garner vs. Murray: -The partnership deed should specify whether accounts will be closed as per the decision of Garner Vs. Murray in case of dissolution of the firm caused by the insolvency of the partners. 18. Settlement of Disputes:-In case of dispute among the partners, how the dispute will be solved.
Q.3. What are the Duties and Rights of a Partner? Answer. Duties (Obligations ) of a Partner: a. Devotion of time and attention: It becomes duty to each partner to devote his full attention and time to the firm. b. To carry on the business with the greatest common advantage and diligently. No partner is allowed any salary unless the deed provides. c. To act within the authority and to be just and faithful to other partners. d. Not to engage in competition against the firm. If he does so, he must account for the profits made in the competing business. e. To hold and use of property of the firm only for the firm. In case the partner makes use of the property of the firm for his personal use and earns, he will have to hand over the profit so earned to the firm. If the partner suffers loss, the firm will not be liable for it. f. To make good the loss that may have been caused by his willful neglect or breach of trust.
Rights of a Partner: a. b. c. d. Every partner has a right to part in the conduct and management of the business. Every partner has a right to be consulted in the matters of the partnership. Every partner has a right to share profits (or losses) with others in the agreed ratio. Partners have a right of free access to all records, books of accounts and also to examine and copy them. e. A partner who has advances loan to the firm is entitled to receive interest. In case the rate of interest is not agreed, he will be given it @ 6% p.a. f. Every partner has the right to prevent the introduction and admission of a new partner. g. After giving a proper notice every partner has the right to retire from the business. Q.4. State the main provisions of the Partnership Act relating to partnership accounts if there is no partnership agreement. (All India, 1993, 94,Delhi 94, 94 C, 99 C) Answer: According to Indian Partnership Act 1932 (sec. 4), the following provision are applicable in the absence of partnership deed: 1. Profit Sharing Ratio: In the absence of partnership deed all partners will share Profit or losses in equal ratio. 2. Interest on Capital: No interest will be given to any partner on his capital. In case, there is a partnership deed, which allows interest on capital, it will be allowed in case of profit but not in case of loss in the business. 3. Interest on Drawings: No interest will be charged on drawing in the absence of partnership deed. 4. Partner’s Salary: No salary or commission will be given to any partner in the absence of partnership deed. 5. Interest on Partner’s Loan: Interest on partner’s loan will be given @ 6% p.a. In case of partnership deed interest will be allowed at the agreed rate. Q.5. What is a Joint Life Policy? What is the purpose of taking joint life policy by a partnership firm? Answer: A Joint Life Policy is an assurance policy taken on the joint lives of the partners. On the death of a partner, the firm becomes liable to pay the executors of deceased partner his capital, interest on capital, his share of profit from the closing of the previous year to the date of death and his share of reserves, goodwill etc. The total amount thus becoming due to the executors is usually significant and immediate payment of such heavy amount out of firm’s resources is likely to affect firm’s finances very adversely.
The above problem can be tackled if the firm takes policy on the lives of all the partners jointly from the Life Insurance Corporation of India. According to the firms of the policy, the premium is paid, periodically by the firm to the L. I. C. of India who undertakes to pay the sum assured to the firm either on the death of any partner or on the maturity of the policy whichever is earlier. The amount received is credited to all the partners including the deceased in their profit sharing ratio, while the amount received enables the firm to make the payment to the executors without affecting adversely the financial position of the firm.
Q.1. What is meant by admission of a Partner? What is the purpose of admission of a Partner? Answer: Sometimes, it becomes difficult to run the partnership business due to lack of sufficient capital or managerial help or both. In this case a firm may decide to admit a new partner into the firm. But according to Indian Partnership Act 1932, no partner can be admitted into the firm without the consent of all the existing partners. A person who is admitted, as a partner into the firm does not thereby becomes liable for any act of the firm, done before his admission. A partner is admitted for any one or more of the following reasons: i. ii. iii. iv. v. In order to acquire more capital for the business. In order to have more managerial skill, a competent and experienced person is needed. In order to expand and boost up the business. In order to increase the goodwill by admitting a well-reputed person into the business. In order to reduce the competition.
Q.2. State the two main rights acquired by a New Partner. Answer: Rights of a New Partner: i. ii. Sharing in the assets of the firm: - In order to acquire the right of becoming the owner of a part of assets of the firm, new partner has to contribute towards the amount of capital into the business. Sharing in the future profits or losses of the firm: - In order to have right to share in profit in future new partner has to pay for the amount of goodwill into the business.
Q.3. Mention various matters that need adjustment at the time of admission of a partner. (D.H.S.E.) Answer: Required adjustments at the time of admission of a Partner: i. ii. Calculation of New Profit Sharing Ratio. Revaluation of Assets and Liabilities of the firm.
iii. iv. v.
Treatment of Goodwill. Adjustment of Accumulated Reserves and Profits /Losses. Adjustment of Capital (if agreed).
Q.4. Explain the accounting treatment of Goodwill at the time of admission of a Partner. Answer: Accounting treatment of goodwill at the time of admission of a partner is classified in four parts: (1) When new partner pays amount of goodwill privately: In this case no entry will be passed in the books of the firm. (2) When new partner brings his share of goodwill in Cash or kind. In this case the following entries are passed: i. For amount of Capital + Goodwill brought in by new partner Cash / Bank/ Assets A/c Dr. To New Partner’s Capital A/c (for amount of capital) To Premium A/c (for amount of goodwill) ii. For amount of goodwill brought in by new partner credited to Old Partner’s Capital A/cs in their Sacrificing Ratio. Premium A/c Dr. To Old Partner’s Capital A/cs iii. When old partners withdraw the amount of goodwill.
Old Partner’s Capital A/c Dr. To Cash/Bank A/c Condition: When new partner brings his share of goodwill in cash, in this case no goodwill should already appear in the books. In case goodwill already appears in the books it should be written off in old ratio. Entry will be: Old Partner’s Capital A/cs Dr. To Goodwill A/c Example: A and B are partners sharing profit and losses in the ratio of 5:3. C is admitted as a
new partner for 1/5th share. C brings Rs. 15,000 as his Capital and necessary amount of his share of goodwill in cash. Total goodwill of the firm is Rs. 60,000. Goodwill already appears in the Balance Sheet of A and B is Rs. 20,000. Pass necessary journal entries. Solution: Journal S. No. Particulars L.F. Dr. Rs. 27,000 Cr. Rs. 15,000 12,000 12,000 7,500 4,500
Cash A/c Dr. To C’s Capital A/c To Premium A/c (For amount of Capital and Goodwill brought in by C) Premium A/c Dr. To A’s Capital A/c To B’s Capital A/c (For amount of goodwill brought in by C credited to A and B in their Sacrificing Ratio, which is 5:3) A’s Capital A/c Dr. B’s Capital A/c Dr. To Goodwill A/c (For existing goodwill written off in Old Ratio)
12,500 7,500 20,000
Workings: C’s Share of Goodwill = 1/5 x Rs. 60,000 = Rs. 12,000
(3) When new partner does not bring his share of goodwill in cash. In this case new partner’s share of goodwill is charged to his capital account and t/f to old partner’s capital accounts in their sacrificing ratio. Entries for this will be: (i) For amount of capital brought in by new partner Cash / Bank/ Assets A/c Dr. To New Partner’s Capital A/c (ii) For new partner’s share of goodwill credited to old partner’s capital accounts in their sacrificing ratio
New Partner’s Capital A/c Dr. To Old Partner’s Capital A/cs (iii) When old partners withdraw the amount of goodwill. Old Partner’s Capital A/c Dr. To Cash/Bank A/c Condition: No goodwill should already appear in the books. In case goodwill already appears in the books it should be written off in old ratio. Entry will be: Old Partner’s Capital A/cs Dr. To Goodwill A/c Example: A and B are partners sharing profits and losses in the ratio of 5:3. C is admitted as a new partner for 1/5th share. C brings Rs. 50,000 as his capital but he is not able to bring his share of Goodwill in cash. Total Goodwill of the firm is Rs. 60,000. Pass necessary journal entries when in the books of A and B: a. No Goodwill already appears. b. Goodwill already appears at Rs. 24,000. Solution: Journal Date Particulars L.F. Debit Rs. 50,000 Credit Rs. 50,000 12,000 7,500 4,500
Bank A/c Dr. To C’s Capital A/c (For amount of capital brought in by C) C’s Capital A/c Dr. To A’s Capital A/c To B’s Capital A/c (For C’s share of goodwill credited to A’s and B’s Capital A/cs in their sacrificing ratio.) Bank A/c Dr. To C’s Capital A/c
(For amount of capital brought in by C) C’s Capital A/c Dr. To A’s Capital A/c To B’s Capital A/c (For C’s share of goodwill credited to A’s and B’s Capital A/cs in their sacrificing ratio.) A’s Capital A/c Dr. B’s Capital A/c Dr. To Goodwill A/c (For existing goodwill in the books written off in old ratio)
12,000 7,500 4,500
15,000 9,000 24,000
(4) When new partner brings only a part of his share of goodwill in cash or kind. In this case amount brought in by new partner as his share of goodwill t/f to old partner’s capital accounts in their sacrificing ratio and the amount that is not brought in by him is charged to his capital account and is also t/f to old partner’s capital accounts in their sacrificing ratio. Entries will be in following manner: 1. For amount of Capital + Goodwill brought in by new partner Cash / Bank/ Assets A/c Dr. To New Partner’s Capital A/c (Amount of Capital) To Premium A/c (Amount of Goodwill brought in by new partner) 2. For amount of goodwill brought in by new partner credited to old partner’s capital accounts in their sacrificing ratio. Premium A/c Dr. To Old Partner’s Capital A/cs 3. For amount of goodwill not brought in by new partner charged to his capital account and credited to old partner’s capital accounts in their sacrificing ratio. New Partner’s Capital A/c Dr. To Old Partner’s Capital A/cs Condition: No goodwill should already appear in the books. In case goodwill already appears in the books it should be written off in old ratio. Entry will be:
Old Partner’s Capital A/cs Dr. To Goodwill A/c Example: A and B are partners sharing profits and losses in the ratio of 5:3. C is admitted as a new partner for 1/5th share. C brings Rs. 50,000 as his capital and brings only 60% of his share of Goodwill in cash. Total Goodwill of the firm is Rs. 60,000. Pass necessary journal entries when A and B withdraw 50% of the amount brought in by C as his share of goodwill in cash. Goodwill already appears in the books at Rs. 16,000. Solution: Journal Date Particulars L.F. Debit Rs. 57,200 Credit Rs. 50,000 7,200 7,200 4,500 2,700
Bank A/c Dr To C’s Capital A/c To Premium A/c (For amount of capital and goodwill brought in by C) Premium A/c Dr. To A’s Capital A/c To B’s Capital A/c (For amount of goodwill brought in by credited to old partner’s capital account in their sacrificing ratio) C’s Capital A/c Dr. To A’s Capital A/c To B’s Capital A/c (For amount of goodwill not brought in by C charged to his capital A/c and credited to old partner in their sacrificing ratio) A’s Capital A/c Dr. B’s Capital A/c Dr. To Bank A/c (For amount of goodwill withdrawn by old partners) A’s Capital A/c Dr. B’s Capital A/c Dr. To Goodwill A/c (For existing goodwill in the books written off in old ratio)
4,800 3,000 1,800
2,250 1,350 3,600 10,000 6,000 16,000
Workings: C’s Share of Goodwill = 1/5 x Rs. 60,000 = Rs. 12,000. But C brings only 60% of his share of goodwill in cash i.e. Rs. 12,000 x 60/100 = Rs. 7,200. C does not bring 40% of his share of goodwill in cash i.e. Rs. 12,000 x 40/100 = Rs. 4,800.
Recommendation of Accounting Standard 10 (AS-10) – Issued by The Institute of Chartered Accountants of India According to AS – 10 goodwill should be recorded in the books only when some consideration in money or money’s worth has been paid for it. Thus, in case of admission or retirement/death of a partner or in case of change in profit sharing ratio among partners, goodwill, following the accounting standard should not be raised in the books of the firm because no consideration in or money worth is paid for it. If any partner brings any premium over and above his capital should be distributed to other existing partners. If goodwill is evaluated at the time of change in the constitution of the firm (by way of admission/retirement/death/change in profit sharing ratio), goodwill should not be brought in books since it is inherent goodwill. If it is raised then it should be immediately written off.
Q.1. Distinguish between dissolution of a partnership and dissolution of a firm. (CBSE 1991(Delhi) (C)) Answer: The dissolution of the partnership is not the dissolution of a partnership firm. Any type of change in the partnership agreement is called dissolution of partnership. A partnership may also be dissolved at the time of admission of a new partner into the firm or at the time of retirement or death of a partner. In this case a new partnership agreement is formed, this is why the old partnership comes to an end and a new partnership begins. However, dissolution of a firm means discontinuation of the firm’s business and the relationship between the partners. According to Sec. 39 of Indian Partnership Act 1932, " Dissolution of firm means a dissolution of partnership between all the partners in the firm." Therefore when a firm is dissolved, assets of the firm are disposed off, liabilities are
paid off and the accounts of all the partners are also settled. Q.2. Distinguish between Revaluation Account and Realisation Account. (DSSE 1987, AISSE 1988,1989 CBSE 1992) Answer: Revaluation Account (1) Revaluation account is prepared at the time of admission, retirement of death of a partner. (2) Revaluation account is prepared in order to work out the profit or loss on revaluation of assets and liabilities at the time of admission, retirement or death of a partner. (3) Revaluation profit or loss is distributed only among the old partners of the firm in their profit sharing ratio. (4) After preparing the revaluation account the firm’s business gets going with the same set of books. Realisation Account This account is prepared at the time of dissolution of a partnership firm. This account is prepared to work out the profit or loss on realisation of assets and payment to liabilities at the time of dissolution of the firm. Realisation profit or loss is distributed among all the partners in their profit sharing ratio. After preparation of this account the firms business comes to an end.
Q.3. Explain the provisions of Sec. 48 of the Indian Partnership Act 1932 dealing with settlement of accounts the time of the dissolution of firm. (DSSE 1991,1992) Answer: Sec. 48 of Indian Partnership Act 1932 lays down the following rules regarding the settlement of accounts: (i) Losses including deficiencies of capital shall be paid: a. first out of profits; b. then out of capitals; and c. lastly, if necessary by the partners individually in their profit sharing ratio. (ii) The amount realised from the assets of the firm including any sums of money contributed by the partners to make up deficiencies of capital shall be applied in the following order: a. b. c. d. First of all in paying the debts of the third party. Secondly to pay off partner’s loan. Then to refund partner’s capital balances. The surplus, if any distributed among the partners in their profit sharing ratio.
In case a partner has provided loan to the firm has debit balance of capital, first the debit
balance of capital will be completed by his loan, thereafter, if there is a balance in loan account, it will be paid before the payment of other partner’s capital.
Q.4. Enumerate the circumstances under which a firm is dissolved. Answer: According to Sec. 40 to Sec. 44 of the Indian Partnership Act 1932, the firm is dissolved in the following ways: 1. Dissolution by Agreement: When all the partners give their intention to dissolve the partnership firm. 2. Compulsory Dissolution: i. ii. iii. iv. v. When all the partners or all except one partner is declared insolvent. When the partnership business becomes illegal. When all the partners except one decide to retire from the firm. When one of the partner is the citizen of an enemy country. When specific purpose or the venture of the partnership firm is completed. 1. Dissolution by Notice: When the partnership is at will, any partner may dissolve the firm by giving notice in writing to the other partners. 2. Dissolution by Court: i. ii. iii. iv. v. vi. vii. When one of the partner becomes unsound mind. When the business of the firm cannot be carried on save at loss. When a partner becomes permanently incapable of performing his duties as a partner. When a partner is guilty of misconduct, which is likely to affect the firms business. When a partner intentionally commits breach of agreement. When a partner transfers whole of his interest in the firm to a third party. When the court is satisfied on any just and equitable ground.
Q.5. Distinguish between firm’s debts and private debts. Answer: Firm’s Debts: When a firm owes to an outsider, this debt is called firm’s debt. The firm is basically responsible to pay these debts. At the time of dissolution of the firm these debts are paid first out of the money realised. Private Debts: When a partner owes some amount from an outsider this debt is called his private debt. The
firm is basically not responsible for these types of debts. Such debts are paid off from the money realised by selling the private property of the partner. If private property of partner exceeds the amount of his private debt, surplus is used to settle the firm’s debts. Q.6. All the partners want to dissolve the firm. C, a partner, wants that his loan of Rs. 30,000 must be paid off before the payment of capitals to the partners. But A and B, other partners want that capital must be paid before the payment of C’s loan. State who is correct? Answer: C is correct because according to Sec. 48 of Indian Partnership Act 1932, partner’s loan is repaid before the payment of capitals of partners.
Q.1. What is meant by accounting ratios? How are they useful? Answer: A relationship between various accounting figures, which are connected with each other, expressed in mathematical terms, is called accounting ratios. According to Kennedy and Macmillan, "The relationship of one item to another expressed in simple mathematical form is known as ratio." Robert Anthony defines a ratio as – "simply one number expressed in terms of another." Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. Absolute figures are useful but they do not convey much meaning. In terms of accounting ratios, comparison of these related figures makes them meaningful. For example, profit shown by two-business concern is Rs. 50,000 and Rs. 1,00,000. It is difficult to say which business concern is more efficient unless figures of capital investment or sales are also available. Analysis and interpretation of various accounting ratio gives a better understanding of the financial condition and performance of a business concern. Q.2. What do you mean by ratio analysis? What are the advantages of such analysis? Also point out the limitations of ratio analysis. Answer: Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures. According to Myers, " Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements
and a study of trend of these factors as shown in a series of statements." Advantages and Uses of Ratio Analysis There are various groups of people who are interested in analysis of financial position of a company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner: 1. To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way profitability ratios show the actual performance of the business. 2. To workout the solvency: With the help of solvency ratios, solvency of the company can be measured. These ratios show the relationship between the liabilities and assets. In case external liabilities are more than that of the assets of the company, it shows the unsound position of the business. In this case the business has to make it possible to repay its loans. 3. Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc. 4. Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them. 5. To simplify the accounting information: Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. 6. To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources. 7. To workout short-term financial position: Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it. 8. Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years’ ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action. Limitations of Ratio Analysis In spite of many advantages, there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them in interpreting financial statements. The following are the main limitations of accounting ratios:
1. Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm. Some firms may value the closing stock on LIFO basis while some other firms may value on FIFO basis. Similarly there may be difference in providing depreciation of fixed assets or certain of provision for doubtful debts etc. 2. False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct. 3. Effect of Price Level Changes: Price level changes often make the comparison of figures difficult over a period of time. Changes in price affects the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison. 4. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis. 5. Effect of window-dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way. 6. Costly Technique: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it. 7. Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000. Even the profitability of the two firms is same but the magnitude of their business is quite different. 8. Absence of standard university accepted terminology: There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.
Q.3. Classify the various profitability ratios. Also explain the meaning, method of calculation and objective of these ratios. Answer: Classification of various profitability ratios: a. Gross Profit Ratio (CBSE Outside Delhi 2001, Delhi 2002)
b. c. d. e.
Net Profit Ratio Operating Net Profit Ratio Operating Ratio (CBSE Outside Delhi 2001) Return on Investment or Return on Capital Employed (CBSE 1998, 2000, Outside Delhi 2001) f. Return on Equity (CBSE 1999) g. Earning Per Share (CBSE Outside Delhi 2001) Meaning, Objective and Method of Calculation: a. Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: Gross Profit Ratio = Gross Profit/Net Sales x 100 Where Gross Profit = Net Sales – Cost of Goods Sold Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock And Net Sales = Total Sales – Sales Return Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. The gross profit ratio of current year is compared to previous years’ ratios or it is compared with the ratios of the other concerns. The minor change in the ratio from year to year may be ignored but in case there is big change, it must be investigated. This investigation will be helpful to know about any departure from the standard markup and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other such reasons. However it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business. b. Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: Net Profit Ratio = Net Profit/Net Sales x 100 Where Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non
Operating Incomes. And Net Sales = Total Sales – Sales Return Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern. c. Operating Profit Ratio: Operating Profit means profit earned by the concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, Interest on Investment etc. are added and all non-operating expenses are deducted. So, while calculating operating profit these all are ignored and the concern comes to know about its business income from its business operations. Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: Operating Profit Ratio = Operating Profit/Net Sales x 100 Where Operating Profit = Gross Profit – Operating Expenses Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes And Net Sales = Total Sales – Sales Return Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not. d. Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses. Operating Ratio = Operating Cost/Net Sales x 100 Where Operating Cost = Cost of goods sold + Operating Expenses Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock Operating Expenses = Selling and Distribution Expenses, Office and
Administration Expenses, Repair and Maintenance. Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit. e. Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit. Return on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital Employed x 100 Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets Or Capital Employed = Fixed Assets + Current Assets – Current Liabilities Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is. f. Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds. Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100 Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets Objective and Significance: Return on Equity judges the profitability from the point of view of equity shareholders. This ratio has great interest to equity
shareholders. The return on equity measures the profitability of equity funds invested in the firm. The investors favour the company with higher ROE. g. Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares. Earning Per Share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares Objective and Significance: Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.
Q.1. What do you mean by Goodwill? What are the different methods of calculating goodwill? Discuss every method with suitable examples. (CBSE 1982,85,87,88,89,98; All India 1986,1990) Answer: Goodwill is a thing which is not so easy to describe but in general words goodname, reputation and wide business connection which helps the business to earn more profits than the profit could be earned by a newly started business. The monetary value of the advantage of earning more profits is known as goodwill. Goodwill is an attractive force, which brings in customers to old place of business. Goodwill is an intangible but valuable asset. In a profitable concern it is not a fictitious asset. Prof. Dicksee has defined goodwill as " When a man pays for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts." According to J. O. Magee " The capacity of a business to earn profits in future is basically what is meant by the term goodwill." According to Lord Lindley " The term goodwill is generally used to denote benefit arising from connections and reputation." Lord Eldon has defined goodwill as " Goodwill is nothing more than the probability, that the old customers will resort to the old place." In the words of Lord Macnaghten, " Goodwill is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and
connections of a business. It is the attractive force, which brings in customers. It is one thing which distinguishes an old established business from a new business at its first start." In the words of Dr. Canning, "Goodwill is the present value of a firm’s anticipated excess earnings." Methods of Valuation of Goodwill The following are the methods of valuation of goodwill of a firm: i. ii. iii. iv. v. vi. Average Profit Method Weighted Average Profit Method Super Profit Method Capitalization of Average Profit Method Capitalization of Super Profit Method Present Value of Super Profits Method
1. Average Profit Method: Under this method goodwill is calculated on the basis of the average profit of previous years. The average profit is multiplied by the number of year’s purchase. Goodwill = Average Profit x Number of Years Purchase Example: Calculate goodwill at twice the average profits of last four years’ profits. The profits of the last four years were: 2001. 2002. 2003. 2004. Rs. 27,000 Rs. 39,000 Rs. 16,000 (Loss) Rs. 40,000
Solution: Total Profit for last four years = Rs. 27,000+ Rs. 39,000-Rs. 16,000+Rs. 40,000 = Rs. 80,000 Average Profit = Rs. 80,000/4 = Rs. 20,000. Goodwill = Rs. 20,000 x 2 = Rs. 40,000. 2. Weighted Average Profit Method: This method is a modified version of the average profit method. Under this method the respective number of weights i.e. 1,2,3,4 multiplies profit of every year, in order to find out value product and the total of products is then divided by the total of weights in order to ascertain the weighted average profits.
Goodwill = Weighted Average Profits x No. of years Purchase Weighted Average Profit = Total of Products of Profits/ Total of Weights Example: Calculate goodwill at twice the weighted average profits of last four years’ profits. The profits of the last four years were: 2001. Rs. 37,000 2002. Rs. 29,000 2003. Rs. 26,000 2004. Rs. 40,000 Solution: Years 2001 2002 2003 2004 Total Profits Rs. 37,000 29,000 26,000 40,000 Weight 1 2 3 4 10 Product Rs. 37,000 58,000 78,000 1,60,000 3,33,000
Weighted Average Profit = Rs. 3,33,000/10 = Rs. 33,300 Goodwill = Rs. 33,300 x 2 = Rs. 66,600
3. Super Profit Method: When the actual profit is more than the expected profit or normal profit of a firm, it is called ‘Super Profit.’ Under this method goodwill is to be calculate of on the following manner: Goodwill = Super Profit x Number of Years Purchase Example: The books of a business showed that the capital employed on January 1, 2001 was Rs. 4,50,000 and the profits for the last five years were as follows: 2001-Rs. 40,000; 2002 -Rs. 50,000; 2003 - Rs. 60,000; 2004 -Rs. 70,000 and 2005 -Rs. 80,000. You are required to find out the value of goodwill, based on three years’ purchase of the super profit of the business given that the normal rate of return is 10%. Solution: Total Profit of last five years = Rs. 40,000 + Rs. 50,000 + Rs. 60,000 + Rs. 70,000
+ Rs. 80,000 = Rs. 3,00,000 Average Profit = Rs. 3,00,000/5 =Rs. 60,000 Normal Profit = Rs. 4,50,000 x 10/100 = Rs. 45,000 Super Profit = Actual/Average Profit – Normal Profit Super Profit = Rs. 60,000 – Rs. 45,000 = Rs. 15,000 Goodwill = Rs. 15,000 x 3 = Rs. 45,000. 4. Capitalization of Average Profit Method: Under this method goodwill is difference between the total Capitalized value of the firm and the net assets of the firm. Goodwill = Capitalized Value the firm – Net Assets Capitalized Value of the firm = Average Profit x 100/ Normal Rate of Return Net Assets = Total Assets – External Liabilities Example: A firm earns Rs. 65,000 as its average profits. The usual rate of earning is 10%. The total assets of the firm amounted to Rs. 6,80,000 and liabilities are Rs. 1,80,000. Calculate the value of goodwill. Solution : Total Capitalized value of the firm = Rs. 65,000 x 100/10 = Rs. 6,50,000 Net Assets = Rs. 6,80,000 – Rs. 1,80,000 = Rs. 5,00,000 Goodwill = Total Capitalized value of the firm – Net Assets Goodwill = Rs. 6,50,000 – Rs. 5,00,000 = Rs. 1,50,000. 5. Capitalization of Super Profit Method: a. Calculate Capitalized value of the firm b. Calculate required profit on capital employed by using the following formula: Normal Profit = Capital Employed x Required Rate of Return/100 c. Calculate average profit d. Calculate super profit Goodwill = Super Profit x 100/Normal Rate of Return
Example: Verma Brothers earn a profit of Rs. 90,000 with a capital of Rs. 4,00,000. The normal rate of return in the business is 15%. Use Capitalization of super profit method to value the goodwill. Solution: Normal Profit = Rs. 4,00,000 x 15/100 = Rs. 60,000 Super Profit = Rs. 90,000 – Rs. 60,000 = Rs. 30,000 Goodwill = Super Profit x 100/Normal Rate of Return = Rs. 30,000 x 100/15 = Rs. 2,00,000 6. Present Value of Super Profit: Under this method, goodwill is estimated as the present value of the future super profits. The following steps are taken: a. b. c. d. e. Calculate the future super profits for next years Choose the required rate of return Calculate present value factors Multiply present value factors with future super profits The sum of product of present value factors and super profits is the value of goodwill.
Example: A firm has the forecasted profits for the coming 4 years as follows: Years 1 2 3 4 Profits Rs. 80,000 1,00,000 90,000 1,20,000
The total assets of the firm are Rs. 9,00,000 and outside liabilities are Rs. 3,00,000. The present value factors at 10% are as follows: Years 1 2 3 4 Calculate the Value of goodwill. Present Value Factor .9279 .8029 .7056 .6978
Solution: Net Assets = Total Assets – Liabilities = Rs. 9,00,000 – Rs. 3,00,000 = Rs. 6,00,000 Normal Profit = 10/100 x Rs. 6,00,000 = Rs. 60,000 Years Profits (Rs.) Normal Profit Super Profit Present Value Factor Present Value of Super Profit 1 80,000 60,000 20,000 .9279 18,558 2 1,00,000 60,000 40,000 .8029 32,116 3 90,000 60,000 30,000 .7056 21,168 4 1,20,000 60,000 60,000 .6978 41,868
Goodwill = Rs. 18,558 + Rs. 32,116 + Rs. 21,168 + Rs. 41,868 = Rs. 1,13,710.