MASTER OF BUSINESS

ADMINISTRATION (MBA)

III YEAR (FINANCE)

PAPER III

CORPORATE FINANCIAL
ACCOUNTING

BLOCK 2

COMPANY’S ACCOUNTS AND CONCEPTS

WRITTEN BY
SEHBA HUSSAIN

EDITTED BY
PROF. SHAKOOR KHAN
 PAPER I

CORPORATE FINANCIAL ACCOUNTING

BLOCK 2

COMPANY’S ACCOUNTS AND CONCEPTS

CONTENTS

Page number

Unit 1 Accounts of Holding and Subsidiary companies and

Cash Flow Basis Accounting 4

Unit 2 Concepts of Profit, Reconstruction and Amalgamation 38

Unit 3 Double Accounting System and Electricity Supply 65

Companies

Unit 4 Accounts of Banking, Insurance and Companies in 80

Liquidation

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BLOCK 2 COMPANY’S ACCOUNTS AND
CONCEPTS

In previous block you have recalled some basic concepts of corporate financial
accounting. This block presents to you the accounting concepts and practices belong to
various types of organisations and situations.

First unit deals with the accounts and concepts of holding companies and subsidiary
companies. Consolidated financial statements and cash flow basis accounting will be
discussed in detail in this unit.

Unit 2 focuses on profit concept and its relevance in companies act 1956. profit measures
will be explained followed by discussion on reconstruction of companies and related
schemes. Various issues pertaining to amalgamation and absorption of companies will be
dealt with the help of suitable illustrations.

Unit third is about double entry accounting system with special reference to electricity
companies. Main features of double accounting system and books of accounts of
electricity supply companies will be highlighted with focus on returns in those
companies.

Last unit that is unit 4 discusses accounting for banking, insurance and companies in
liquidation. Bank statements will be discussed and accounting for insurance claim
settlements will be explained. Other areas of concern of this unit are: fire insurance;
accounting for marine insurance; company in liquidation; accounts of companies in
liquidation and company’s liquidation account rules 1965

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 UNIT 1

ACCOUNTS OF HOLDING AND SUBSIDIARY

COMPANIES AND CASH FLOW BASIS ACCOUNTING
Objectives

After studying this unit you should be able to:

 Discuss the relevance of holding companies

 Understand the concept of subsidiary companies

 Know the importance and problems of holding and subsidiary companies

 Explain the consolidated financial statements and accounts

 Describe cash flow basis accounting

 Have the knowledge of cash flow statement and various methods of preparing
these statements.

Structure

1.1 Introduction
1.2 Holding companies
1.3 Subsidiary companies
1.4 Consolidated financial statements
1.5 Cash flow basis accounting
1.6 Cash flow statements
1.7 Summary
1.8 Further readings

1.1 INTRODUCTION

Financial accounts of holding and subsidiary companies are concerned with classifying,
measuring and recording the transactions of their business. At the end of a period
(typically a year), the following financial statements are prepared to show the
performance and position of the business:

 Describing the trading performance of the business over the accounting period

 Statement of assets and liabilities at the end of the accounting period (a

"snapshot") of the business

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  Describing the cash inflows and outflows during the accounting period

 Additional details that have to be disclosed to comply with Accounting Standards

and the Companies Act

 Description by the Directors of the performance of the business during the

accounting period + various additional disclosures, particularly in relation to
directors' shareholdings, remuneration etc

Financial accounts are geared towards external users of accounting information. To

answer their needs, financial accountants draw up the profit and loss account, balance
sheet and cash flow statement for the company as a whole in order for users to answer
questions such as:

o "Should I invest my money in this company?"

o "Should I lend money to this business?"
o "What are the profits on which this company must pay tax?"

Company Law Requirements for Financial Accounts

Every Indian company registered under the Companies Act 1956, is required to prepare a
set of accounts that give a true and fair view of its profit or loss for the year and of its
state of affairs at the year end. Annual accounts for Companies Act purposes generally
include:

 A directors’ report
 An audit report
 A profit and loss account
 A balance sheet
 A statement of total recognised gains and losses
 A cash flow statement
 Notes to the accounts

If the company is a "parent company", (in other words, the company also owns other
companies - subsidiaries) then "consolidated accounts" must also be prepared. Again
there are exceptions to this requirement.

Comparative figures should also be given for almost all items and analysis given in the
year end financial statements. Exceptions to this rule are given individually. For example,
there is no requirement to give comparative figures for the notes detailing the movements
in the year on fixed asset or reserves balances.

Let us now discuss holding and subsidiary companies to have deeper understanding of
accounts and problems related to these companies.

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1.2 HOLDING COMPANIES

A holding company is a company or firm that owns other companies' outstanding stock. It
usually refers to a company which does not produce goods or services itself; rather its
only purpose is owning shares of other companies. Holding companies allow the
reduction of risk for the owners and can allow the ownership and control of a number of
different companies. In the U.S., 80% or more of stock, in voting and value, must be
owned before tax consolidation benefits such as tax-free dividends can be claimed.

Sometimes a company intended to be a pure holding company identifies itself as such by

adding "Holdings" or "(Holdings)" to its name, as in Sears Holdings.

In fact, A holding company is a parent company that owns enough voting stock in a
subsidiary to dictate policy and make management decisions. This is generally done
through influence of the company's board of directors.

This doesn't mean that the holding company owns all of the subsidiary's stock, or even a
majority of it. However, holding companies that control 80% or more of the subsidiary's
voting stock gain the benefits of tax consolidation, which include tax-free dividends for
the parent company and the ability to share operating losses.

1.2.1 Advantages of Holding Companies

Acquiring a controlling interest in a subsidiary as a holding company has certain
advantages over a merger:

 The ability to control operations with a small percentage of ownership and, thus,
smaller up-front investment

 Holding companies can take risks through subsidiaries, and limit this risk to the
subsidiary alone rather than placing the parent company on the line

 Expansion can happen through simple stock purchases in the public market,
which avoids the difficult step of gaining approval from the subsidiary's board of
directors

Through a holding company operation, a firm may buy 5, 10, or 50 percent of the stock
of another corporation. Such fractional ownership may be sufficient to give the holding
company effective working control over the operations of the company in which it has
acquired stock ownership. Working control is often considered to entail more than 25
percent of the common stock, but it can be as low as 10 percent if the stock is widely
distributed. One financier says that the attitude of management is more important than the

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number of shares owned: “If management thinks you can control the company, then you
do.” In addition, control on a very slim margin can be held through relationships with
large stockholders outside the holding company group.

Because the various operating companies in a holding company system are separate legal
entities, the obligations of any one unit are separate from those of the other units.
Therefore, catastrophic losses incurred by one unit of the holding company system may
not be translatable into claims on the assets of the other units. However, we should note
that while this is a customary generalization, it is not always valid. First, the parent
company may feel obligated to make good on the subsidiary’s debts, even though it is not
legally bound to do so, in order to keep its good name and to retain customers.

An example of this was American Express’s payment of more than Rs.100 million in
connection with a swindle that was the responsibility of one of its subsidiaries.

Second, a parent company may feel obligated to supply capital to an affiliate in order to
protect its initial investment; General Public Utilities’ continued support of its
subsidiaries’ Three Mile Island nuclear plant after the accident at that plant is an example.

And, third, when lending to one of the units of a holding company system, an astute loan
officer may require a guarantee by the parent holding company. To some degree,
therefore, the assets in the various elements of a holding company are not really separate.
Still, a catastrophic loss, as could occur if a drug company’s subsidiary distributed a batch
of toxic medicine, may be avoided

1.2.2 Problems of Holding Companies

The holding company model has the following problems:

1. If less than 80% of the subsidiary is owned by the parent, the holding company pays
multiple taxes on the federal, state, and local levels.

Provided the holding company owns at least 80 percent of a subsidiary’s voting stock, the
IRS permits the filing of consolidated returns, in which case dividends received by the
parent are not taxed. However, if less than 80 percent of the stock is owned, and then tax
returns cannot be consolidated. Firms that own more than 20 percent but less than 80
percent of another corporation can deduct 80 percent of the dividends received, while
firms that own less than 20 percent may deduct only 70 percent of the dividends received.
This partial double taxation somewhat offsets the benefits of holding company control
with limited ownership, but whether the tax penalty is sufficient to offset other possible
advantages is a matter that must be decided in individual situations.

2. A holding company can be forced to dissolve more easily than a single merged
operation. It is relatively easy to require dissolution by disposal of stock ownership of a
holding company operation found guilty of antitrust violations. For instance, in the 1950s

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Du Pont was required to dispose of its 23 percent stock interest in General Motors
Corporation, acquired in the early 1920s.

Because there was no fusion between the corporations, there were no difficulties from an
operating standpoint in requiring the separation of the two companies. However, if
complete amalgamation had taken place, it would have been much more difficult to break
up the company after so many years, and the likelihood of forced divestiture would have
been reduced.

3. A holding company may expand through the use of leverage or debt, building a
complex corporate structure that can include unrealized values, and creating a risk if
interest rates on debt or the valuation of the assets posted as collateral for loans change
dramatically.

1.3 SUBSIDIARY COMPANIES

A subsidiary, in business matters, is an entity that is controlled by a separate higher entity.

The controlled entity is called a company, corporation, or limited liability company; and
in some cases can be a government or state-owned enterprise, and the controlling entity is
called its parent (or the parent company). The reason for this distinction is that a lone
company cannot be a subsidiary of any organization; only an entity representing a legal
fiction as a separate entity can be a subsidiary. Contrary to popular belief, a parent
company does not have to be the larger or "more powerful" entity; it is possible for the
parent company to be smaller than a subsidiary, or the parent may be larger than some or
all of its subsidiaries (if it has more than one).

The parent and the subsidiary do not necessarily have to operate in the same locations, or
operate the same businesses, but it is also possible that they could conceivably be
competitors in the marketplace. Also, because a parent company and a subsidiary are
separate entities, it is entirely possible for one of them to be involved in legal
proceedings, bankruptcy, tax delinquency, indictment and/or under investigation, while
the other is not.

The most common way that control of a subsidiary is achieved, is through the ownership
of shares in the subsidiary by the parent. These shares give the parent the necessary votes
to determine the composition of the board of the subsidiary, and so exercise control. This
gives rise to the common presumption that 50% plus one share is enough to create a
subsidiary. There are, however, other ways that control can come about, and the exact
rules both as to what control is needed, and how it is achieved, can be complex (see
below). A subsidiary may itself have subsidiaries, and these, in turn, may have
subsidiaries of their own. A parent and all its subsidiaries together are called a "group",
although this term can also apply to cooperating companies and their subsidiaries with
varying degrees of shared ownership.

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Subsidiaries are separate, distinct legal entities for the purposes of taxation and
regulation. For this reason, they differ from divisions, which are businesses fully
integrated within the main company, and not legally or otherwise distinct from it.

Subsidiaries are a common feature of business life, and most if not all major businesses
organize their operations in this way. Examples include holding companies such as
Berkshire Hathaway as in this listing of its subsidiaries, Time Warner, or Citigroup; as
well as more focused companies such as IBM, or Xerox Corporation. These, and others,
organize their businesses into national or functional subsidiaries, sometimes with multiple
levels of subsidiaries.

An operating subsidiary is a business term frequently used within the United States
railroad industry. In the case of a railroad, it refers to a company that is a subsidiary but
operates with its own identity, locomotives and rolling stock.

In contrast, a non-operating subsidiary would exist on paper only (i.e. stocks, bonds,
articles of incorporation) and would use the identity and rolling stock of the parent
company

1.3.1 Types of Subsidiaries

Three types of Subsidiaries can be formed namely:

 Public Limited Liability

 Minimum Capital - Must be paid by the founders (minimum two members)

 Shares - Can issue nominative or bearer shares

 Management - Should have at least three directors. One director should be a

permanent resident of the country

 Private Limited Liability

 Minimum Capital - Must be paid by the founders

 Shares - Shares need to be nominative. Bearer shares cannot be subscribed

 Management - Managed by one or more managers

 Co-operative Company with limited liability

 Minimum Capital - Three partners are needed. One quarter of capital contribution
must be paid-in

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  Shares - Shares are nominative

 Management - A co-operative company with limited liability and managed by one

or more managers

1.3.2 Parent Company - Subsidiary Relation

It is important that the subsidiary is recognized as an independent corporation managed

by the board of directors even though it was incorporated by the parent company. This
does not mean that the subsidiary is uncontrolled. The parent company has the legal
authority to hold the subsidiary accountable to meet the financial objectives.

For the Parent company to control the independent subsidiary it should be:

 The sole shareholder

 Include voting control provisions in subsidiary article

 Prepare bylaws defining the authority of the officers, their term in the office and
removal

 Prohibit bylaws amendment without shareholder's approval

1.3.3 Advantages and Problems of Subsidiary

Advantages

 Considerable tax advantages and legal protections

 Ability to offset profits and losses of one part of a business with another

 Some countries allow subsidiaries to file tax returns on the profits obtained in that
country

 Liabilities and credit claims are locked in that subsidiary and cannot be passed on
to the parent company

 Allows for joint ventures with other companies with each owning a portion of the
new business operation

Problems of subsidiaries

 Legal Risks: As long as the parent company holds its subsidiary accountable for
the expectations of its board of directors there is little risk for the parent to be

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 found liable for the wrong doings of the subsidiary. But, if the parent company
exercises excessive control for example has the same board of directors, use of
common letterhead, in such case the parent company and the subsidiary are
treated as one and the parent company is responsible for the subsidiaries debts etc.

 Legal paperwork involved with creating a subsidiary can be lengthy and

expensive

 Control also becomes an issue when a subsidiary is partially owned by another

outside organization

There are a few vital points that act against the concept of setting up a wholly owned
subsidiary. Once can even consider these points as major problems of going ahead and
setting up a subsidiary.

The first and foremost point to be considered while setting up a subsidiary is the huge
amount of initial investment capital. The firm will have no other option but to bear all of
the establishment costs for setting up the subsidiary on foreign land and operational costs
to cover the global operations of this subsidiary.

The second and most dangerous problem is that there is the risk associated with
becoming a subsidiary. This risk is the risk of failure. The situation can go out of the
hand, especially if a foreign subsidiary rushes ahead recklessly without trying to get
familiarized with the cultural aspects and market swings in the host country. Often, it is
seen that the subsidiary comes down crashing in no time. The main cause behind the
failure of a subsidiary on foreign land is the fact that a subsidiary ends up being ignorant
of the host country’s market situation and fluctuating market trends. The subsidiaries
often end up misjudging the host country’s market situation and make erroneous
decisions.

Especially when you consider the huge amount of capital to be invested, setting up a
wholly owned subsidiary seems to be all the more risky. Such a high amount of
investment coupled with a high degree of risk of failure often discourages people from
opting for a wholly owned subsidiary.

1.4 CONSOLIDATED FINANCIAL STATEMENTS

Consolidated financial statements are financial statements that factor the holding
company's subsidiaries into its aggregated accounting figure. It is a representation of how
the holding company is doing as a group. The consolidated accounts should provide a
true and fair view of the financial and operating conditions of the group. Doing so
typically requires a complex set of eliminating and consolidating entries to work back
from individual financial statements to a group financial statement that is an accurate
representation of operations.

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A group of companies is required to prepare accounts for the group as a whole as well as
the company. These consolidated accounts are almost always what matter to investors.

Initial announcements of results usually contain consolidated results and annual reports
always have both company and consolidated accounts. The consolidated accounts are
often called group accounts.

The consolidated P & L includes the profits of subsidiaries and the company's share of
profits made by associates and joint ventures. If any subsidiaries are not fully owned then
a deduction will be made further down the P & L for the profits attributable to minority
interests.

The consolidated balance sheet similarly shows the amounts of assets and liabilities of
the company and all its subsidiaries. It also shows The value of holdings in associates and
joint ventures.

In contrast the company balance sheet and P & L only shows only shows the value of
assets, liabilities and profits of the company itself. The impact of subsidiaries, associates
and joint ventures is limited to the value of shares in them and dividends paid by them.

1.4.1 How to prepare consolidated financial statements

A consolidated profit and loss account is prepared so that shareholders and other
interested parties can see the results of the group for a period as though it were a single
entity. It will also show how much of the profit accrues to the shareholders of the
parent company and how much to the minority and how the directors will distribute
the profit accruing to the shareholders.

A parent company which is not a wholly-owned subsidiary must publish:

• Its own balance sheet

• A consolidated balance sheet
• its own profit and loss account
• A consolidated profit and loss account

However a parent company may, and many do, take advantage of a dispensation
offered by CA 85 - the ability not to publish its own profit and loss account if group
accounts have been prepared in line with CA 85 and its own profit is disclosed in a
note to the balance sheet.

1 METHOD OF PREPARATION

TURNOVER TO PROFIT AFTER TAX

Amounts for parent and subsidiary are aggregated regardless of percentage owned by
the parent – as long as control has been established.

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DIVIDENDS AND INTEREST RECEIVABLE

Dividends from subsidiaries are excluded. The part attributable to the minority is
included in their share of the profit as the owners of the group are only interested in
the amount of profit due to the minority – not how it is distributed to them. Intragroup
interest should be eliminated on consolidation.

MINORITY INTEREST

This is the profit after tax due to the minority.

DIVIDENDS

This is the figure for dividends paid and payable by the holding company only.

RETAINED PROFITS

This is the same calculation as that required for the balance sheet.

MID-YEAR ACQUISITIONS

Pre-acquisition items should be excluded from group figures. It is most usual for
profits to accrue evenly throughout a period although this might not be the case with
seasonal trades

2 INTER-COMPANY TRADING

Where there has been trading between group companies it is necessary to take out
these transactions from sales and cost of sales, which would be inflated if this were not
done. It is also necessary to take out any unrealised profit from the closing stock
figure, as was done in the balance sheet section.

3 PREFERENCE DIVIDENDS

When the holding of preference shares is a different percentage to that of ordinary

shares the relevant percentage for preference shares must be applied to the preference
dividend for minority interest purposes. In calculating the minority interest the whole
of the preference dividend is deducted from the subsidiary’s profit after tax, the
resulting figure being the profit available for ordinary shareholders. The minority’s
share of profits is computed from this figure in the normal way and the minority’s
percentage of the preference dividend added to it.

4 PRE-ACQUISITION DIVIDENDS

ACCOUNTING TREATMENT

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These are dividends paid to a parent company by a subsidiary out of pre-acquisition
profits. There are two possible accounting treatments:

• Treat the dividend as part of the cost of investment – i.e. as a reduction to the
carrying value of the investment

• Treat the dividend as investment income.

The Companies Acts do not specify which treatment is preferable. However FRS 6
states that the carrying value of the investment should be reduced to the extent that the
payment of the dividend represents a diminution in the investment’s value.

CALCULATION

There are two ways of apportioning a dividend between the pre- and post-acquisition
periods:

• Time apportionment – traditional method and theoretically correct

• Pre-acquisition dividend is the portion that cannot have been paid out of
post acquisition

Reserves – minimises pre-acquisition dividends.

5 TRANSFERS OF FIXED ASSETS

When fixed assets have been transferred between group companies adjustments need
to be done on consolidation to show the profit and loss account as if the transfer had
not taken place. Profit or loss arising on the transfer must be eliminated and
depreciation must be adjusted so that it is based on the cost of the asset to the group.
For a fixed asset sold to a group company at a profit the accounting entries are:
Profit on transfer

1.4.2 Consolidated Balance Sheet

Under Indian Company Act, there is no need to prepare combined or consolidated final
accounts of holding and subsidiary company in the books of holding company but
holding company attaches the copy of balance sheet, one copy of profit and loss account
and one copy of audit report of subsidiary company with his final accounts. But for
showing true financial position, often holding company prepare consolidated balance
sheet.

It is easy to understand that consolidated balance sheet is a balance sheet in which all the
assets and liabilities of holding company and subsidiary company are added with each
other but practically, it is tough to make consolidated balance sheet of holding and
subsidiary company.

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Steps for preparing consolidated balance Sheet of the holding company and its
subsidiary-company.

1st-Step

Add all the assets of subsidiary company with the assets of holding company. But
Investment of holding company in Subsidiary company will not shown in consolidated
balance sheet because, investment in subsidiary company will automatically adjust with
the amount of share capital of subsidiary company in holding company.

2nd-step

Add all the liabilities of subsidiary company with the liabilities of holding company. But
Share capital of subsidiary company in holding company will not shown in the
consolidated balance sheet in the books of holding company. Because, this share capital
automatically adjust with the amount of the investment of holding company in to
subsidiary company .

3rd-Step

Calculate of Minority Interest

First of all we should know what minority interest is. Minority interest is the shareholder
but there is not holding company’s shareholder. So, when holding company shows
consolidated balance sheet, it is the duty of accountant to show minority interest in the
liability side of consolidated balance sheet.

We can calculate minority interest with following formula

Total share capital of Subsidiary company = XXXXX

Less Investment of Holding company in to subsidiary company = - XXXX

------------------------------------------------------------------------

Add proportionate share of the subsidiary company‘s profit and

Reserves or increase in the value of assets + XXXX
-----------------------------------------------------------------------------

Less proportionate share of the subsidiary company’s loss and decrease

In the value of total assets of company - XXXXX
------------------------------------------------------------------------------
Value of Minority Interest XXXXX
-------------------------------------------------------------------------------

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4th Step

Calculate cost of capital / Goodwill or Capital Reserve

If holding company purchases shares of subsidiary company at premium, then the value
of premium will be deemed as goodwill or cost of capital and shows as goodwill on the
assets side of consolidated balance sheet.

But if holding company purchases the shares of subsidiary company at discount, then this
value of discount will be capital reserve and show in the liability side of consolidated
balance sheet.

5th Step

Treatment of Pre – Acquisition of reserve and profit

Pre – acquisition profit and reserve of subsidiary company will be shown as capital
reserve in consolidated balance sheet but the value of minority interest’s profit or reserves
deducts from it and add in minority interest value.

Total profit before acquisition of subsidiary company = XXXX

Less share of minority interest - XXXX

Value of profit X minority interest’s value of shares in subsidiary company / total share
capital of subsidiary company.
_____________________________________________________

Pre – acquisition profit and reserve shown as capital reserve XXX

--------------------------------------------------------------------------------------

6th Step

Calculate post acquisition profits

After the date of purchasing the shares of subsidiary company , profit of subsidiary
company will also deem of holding company and it include in the profit of holding
company and we also separate the part of profit of minority interest and add in minority
interest’s value and shown in liability side .

7th Step

Elimination of common transactions

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All common transaction between holding company and subsidiary company will not
show in the consolidated balance. There following common transaction:

1. Goods sold and goods purchase on credit and the value of debtor or creditor either
subsidiary company or holding company will not show in consolidated balance sheet

2. Value of bill payable or bill receivable of holding company on subsidiary company will
also not shown but if some bills value is discounted from third party then either of both
company’s payable value shown as liability in the consolidated balance sheet .

8th Step

Treatment of Unrealized profit

If subsidiary company sells the goods to holding company or holding company sells the
goods to subsidiary company at profit and if such goods will not sold in third party , then
the profit will not realized , so such unrealized profit will not credited to profit and loss
account . At this time a stock reserve account is opened and all amounts of unrealized
profit transfers to this account and this accounts total amount is deducted from closing
stock of consolidated balance sheet.

Suppose

Closing stock of H 50000

Closing stock of S 50000
_________________________

100000

Less stock reserve

2000
----------------------------------

98000
----------------------------------

If subsidiary company has also other outsider’s shares then holding company makes
reserve up to his shares proportion.

9th Step

Treatment of Dividends

if holding company gets the dividends from subsidiary company, then this will divide into
two parts. If subsidiary company declare dividend out of capital profits, then this will add

17
in capital reserves in consolidated balance sheet. But, if subsidiary company has declared
the profit out of revenue gains, then this dividend will add in general profit and loss
account and will shown in the liability side of consolidated balance sheet.

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Figure 1

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Example

On 1 October 1999 Hedley plc acquired 80% of the ordinary share capital of Smedley plc
by way of a share exchange. Hedley plc issued five of its own shares for every two shares
it acquired in Smedley plc. The market value of Hedley plc’s shares on 1 October 1999
was Rs.3 each. The share issue has not yet been recorded in Hedley plc’s books. The
summarised financial statements of both companies are:

Profit and loss accounts: Year to 31 March

Hedley plc Smedley plc
2000
Rs.000 Rs.000 Rs.000 Rs.000
Turnover 1,200 1,000
Cost of sales (650) (660)
Gross profit 550 340
Operating expenses (120) (88)
Debenture interest nil (12)
Operating profit 430 240
Taxation (100) (40)
Profit after tax 330 200
Dividends – interim (40) NIL
– final (40) (80) (60) (60)
Retained profit for the year 250 140
Retained profit brought forward 160 500
Retained profit carried forward (per balance
410 540
sheet)
Hedley Smedley
Balance Sheets: as at 31 March 2000
plc plc
Rs.000 Rs.000 Rs.000 Rs.000
Fixed Assets
Land and buildings 400 150
Plant and Machinery 220 510
Investments 20 10
640 670
Current Assets
Stock 240 280
Debtors 170 210
Bank 20 40
430 530
Creditors: amounts falling due within one year
Trade creditors 170 155
Taxation 50 45
Dividends 40 60
(260) (260)

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Net Current Assets 170 270
810 940
Creditors: amounts falling due after more than one
year
8% Debentures nil (150)
Net Assets 810 790
Capital and reserves
Ordinary shares of Rs.1 each 400 150
Profit and loss account 410 640
810 790

The following information is relevant:

1. At the date of acquisition, the fair values of Smedley plc’s assets were equal to
their book values with the exception of its land and an item of plant. These had
fair values of Rs.125,000 and Rs.50,000 respectively in excess of their book
values. The plant had a remaining life of five years, depreciation is charged to
cost of sales.

2. In the post acquisition period Hedley plc sold goods to Smedley plc at a price of
Rs.100, 000, this was calculated to give at mark-up on cost of 25% to Hedley plc.
Smedley plc had half of these goods in stock at the year-end.

3. Consolidated goodwill is to be written off as an operating expense over a five-

year life. Time apportionment should be used in the year of acquisition.

4. Hedley plc’s policy is to include only post acquisition dividends in income.

Profits and dividends are deemed to accrue evenly over the year. Hedley plc has
not accounted for the proposed dividend of Smedley plc.

5. The current accounts of the two companies disagreed due to a cash remittance of
Rs.20,000 to Hedley plc on 26 March 2000 not being received until after the year-
end. Before adjusting for this, Smedley plc’s debtor balance in Hedley plc’s books
was Rs.56,000.

Required: Prepare a consolidated profit and loss account and balance sheet for
Hedley plc for the year to 31 March 2000

Answer

The principle underlying the preparation of a consolidated profit and loss account is to
aggregate the results of the parent and the subsidiary from the point in time at which

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control is achieved. In this case, this is the date of acquisition of 1 October 1999. The
question gives the results of the subsidiary for a full year to 31 March 2000.

Thus 6/12 of the subsidiary’s results should be included in the consolidated profit and
loss account. Even though Hedley plc only owns 80% of Smedley plc, FRS 2 requires
that the whole of its (post acquisition) results should be included in the profit and loss
account line items (i.e., on a line-by-line basis) with the minority interest of 20% being
shown as a deduction after the profit after tax figure. Intra group sales and cost of sales
(in this case Rs.100,000), together with any related unrealised profits (in this case
Rs.10,000), are eliminated.

Common errors are:

 Eliminating different figures for sales and cost of sales (what is a sale to one
member of the group is a purchase to the other member);

 To consolidate only 80% of the subsidiary’s results (this is effectively

proportional consolidation);

 To consolidate a full year’s results (instead of 6 months);

 To show the subsidiary’s dividend as a group dividend;

 To incorrectly calculate the post acquisition period (e.g., as 5 or perhaps 7

months).

Note: as the acquisition occurred during the current year the retained profits brought
forward will not contain any profits relating to the subsidiary.

The calculation of the minority interest is based on the post acquisition after tax profit of
Smedley plc as adjusted for the depreciation adjustment i.e., (((200 x 6/12) – 5) x 20%).

Balance sheet

The principle involved in preparing a consolidated balance sheet is similar to that in the
profit and loss account i.e., the parent and subsidiary’s assets and liabilities are
aggregated together to form the group balance sheet. 100% of the subsidiary’s figures are
included, with the minority interest being shown as a deduction in arriving at the net
assets. Another way of looking at this (at the time of the acquisition) is to view the parent
company’s investment in the subsidiary as being eliminated and replaced by the
subsidiary’s underlying assets and liabilities acquired (at fair value at the date of
acquisition). The difference between these two is effectively consolidated goodwill.

As in the profit and loss account the effects of intra group trading are eliminated
(unrealised profits in stock and inter company debtors and creditors – after allowing for
cash in transit). Common errors are:

22
  Failing to record the acquisition correctly (particularly the share premium);

 The incorrect use of proportional consolidation;

 Ignoring the fair value adjustments;

 Incorrect treatment of dividends paid out of pre-acquisition profits.

Workings

Note: there are many methods of presenting the working schedules for consolidated
accounts. No method is considered to be either inferior or superior to another. All correct
workings will be marked consistently. For illustration, workings (ii) to (iv) are presented
with an alternative style.

(i) Cost of sales

Rs.000
Hedley plc 650
Smedley plc (660 x 6/12) 330
Additional depreciation (see below) 5
Intra-group sales (100)
URP in stock (see below) 10
895

As the plant is a depreciating asset, its fair value adjustment will create an additional
depreciation charge in the subsidiary’s cost of sales (and subsequent profits) of Rs.5,000.
This is based on six months of the remaining life of 5 years i.e., Rs.50,000/5 x 6/12. The
unrealised profit (URP) in stock is calculated as:

Intra-group sales of Rs.100,000 of which one half is in stock at the year end = Rs.50,000

This has been sold at a mark-up of 25% on cost therefore the URP in stock is Rs.50,000 x
25/125 = Rs.10,000

(ii) Goodwill/Cost of control in Smedley plc

Hedley plc issued 5 shares for every 2 shares it acquired in Smedley plc.

Therefore Hedley plc issued ((150,000/2 x 5) x 80%) = 300,000 shares at a value of Rs.3
each for a total consideration of Rs.900,000. This would be recorded in Hedley plc’s
books as ordinary share capital of Rs.300,000 and share premium of Rs.600,000.

23
Pre-acquisition dividends

These refer to dividends that have been paid by a subsidiary out of profits that were made
prior to the acquisition. The treatment of these is relatively controversial. Many
companies treat them in the same way as a dividend paid out of post acquisition profits
i.e., they include them in the group’s profits. However an alternative view is that they
represent a partial return of the investment paid to acquire the subsidiary and as such they
should be deducted from the cost of the investment (as in this answer).

Where dividends are immaterial the former method is probably acceptable, but where
pre-acquisition dividends are material this treatment can lead to creative accounting.
Effectively a parent company would be buying the profits of another company (a
subsidiary) that have been made in the period before the subsidiary was acquired. These
would be reported as group post acquisition profits in the year the pre acquisition
dividends are paid (in this case in the current year). The requirements of the question
make it clear that in this case pre-acquisition dividends are not to be included in income.

Pre and post-acquisition profits

Smedley plc’s adjusted profits (for additional depreciation) are Rs.635,000 (Rs.640,000 –
Rs.5,000). The acquisition occurred half way through the year therefore the pre-
acquisition profits are Rs.570,000 (Rs.500,000 b/f + Rs.140,000 x 6/12) and the post
acquisition profits are Rs.65,000 (Rs.635,000 – Rs.570,000).

Note: questions in Paper 10 and the new Paper 2.5 on group accounts will not involve
more than one subsidiary, piecemeal acquisitions of subsidiaries or disposals of
subsidiaries. However, questions may include one subsidiary and one associate or one
joint venture.

Final thoughts – Criticisms of consolidated financial statements Whilst there is no

denying that consolidated financial statements are of great value to analysts and
investors, they are not without their critics. Some commentators feel that consolidated
financial statements ‘average’ group performance. This may mean for example that
within the consolidated profit and loss account, the results of a poorly performing
subsidiary (i.e., low profits or losses) may be offset by the results of a subsidiary that is
performing well.

A similar argument applies to balance sheet aspects, poor liquidity or near insolvency of
some subsidiaries may be ‘hidden’ by healthy ratios of other subsidiaries.

It has also been said the consolidated financial statements give the impression that all the
assets of the group are available to discharge all the liabilities of the group. This is not the
case. These criticisms or limitations arise from the fact that a group is not a legal entity, it
is the parent and the individual subsidiaries that are legal entities. Thus, the liabilities of
one subsidiary will only be paid from the assets of that subsidiary. For this reason it is
important to appreciate that if you are considering offering credit or a loan to a subsidiary

24
within a group, the decision must be based on the information given in its entity financial
statements, not the consolidated financial statements.

That said, there are circumstances where a parent company may guarantee the liabilities
of a subsidiary, perhaps to maintain the value of goodwill. Clearly if this is the case the
consolidated financial statements would provide useful information.

To a certain extent the criticisms of the ‘aggregation’ problems of consolidated financial

statements are addressed by the provision of segmental information. This enables the user
of the financial statements to assess those segments that are performing well and those
that may be performing badly, but segmental information is not a complete answer. There
is a common misconception that the separate segments of a group are separate
subsidiaries; this is not the case. One subsidiary may have its results included in more
than one segment, and several subsidiaries’ results may be included in the same segment.
Thus segmental information does not (usually) provide information on individual
subsidiaries.

1.4.3 LAYOUTS FOR CONSOLIDATED PROFIT AND LOSS

ACCOUNTS AND BALANCE SHEETS

The consolidated profit and loss account should be drawn up according to the following
format:

CONSOLIDATED PROFIT AND LOSS ACCOUNT

1. Commission income

2. Net income from securities transactions and foreign exchange dealing

(a) Net income from securities transactions
(b) Net income from foreign exchange dealing

3. Income from equity investments

4. Interest income
5. Other operating income

6. NET INCOME FROM INVESTMENT SERVICES

7. Commission expenses
8. Interest expenses
9. Administrative expenses

(a) Staff costs

(aa) Salaries and fees
(ab) Staff-related costs
(aba) Pension costs
(abb) Other staff-related costs

25
(b) Other administrative expenses

10. Depreciation and write-downs on tangible and intangible assets

11. Other operating expenses
12. Loan and guarantee losses
13. Write-downs on securities held as financial fixed assets
14. Share of profit/loss of undertakings included in the consolidated accounts using
the equity method

15. NET OPERATING PROFIT (LOSS)

16. Extraordinary items

(a) Extraordinary income
(b) Extraordinary expenses

17. PROFIT (LOSS) BEFORE APPROPRIATIONS AND TAXES

18. Income taxes

(a) Taxes for the financial year and previous financial years
(b) Change in imputed taxes due

19. Other direct taxes

20. Share of profit/loss for the financial year attributable to minority interests

21. PROFIT (LOSS) FOR THE FINANCIAL YEAR

The consolidated balance sheet should be drawn up according to the following layout:

CONSOLIDATED BALANCE SHEET

ASSETS

1. Liquid assets
2. Claims on credit institutions
3. Claims on the public and public sector entities

4. Debt securities
(a) On public sector entities
(b) Other

5. Shares and participations

6. Participating interests
7. Shares and participations in group undertakings

8. Intangible assets

26
(b) Goodwill
(c) Other long-term expenditure

9. Tangible assets
(a) Real estate and shares and participations in real estate corporations
(b) Other tangible assets

10. Claims in respect of share, investment share capital and original fund issues
11. Own retained shares and participations
12. Other assets
13. Accrued income and prepayments
14. Imputed tax claims

LIABILITIES

A. LIABILITIES

1. Liabilities to credit institutions

2. Liabilities to the public and public sector entities
3. Debt securities issued to the public
(a) Bonds
(b) Other

4. Other liabilities
5. Accrued expenses and deferred income

6. Compulsory provisions
(a) Pension provisions
(b) Provisions for taxes
(c) Other provisions

7. Subordinated liabilities
8. Imputed taxes due
9. Negative consolidation difference
10. Minority interests

B. EQUITY CAPITAL

11. Share capital

12. Share premium account
13. Revaluation reserve

14. Other restricted reserves

(a) Reserve fund
(b) Reserves provided for by the articles of association
(c) Other reserves

27
15. Capital loans

16. Non-restricted reserves

(a) Reserve for own retained shares
(b) Other reserves

17. Profit (loss) brought forward

18. Profit (loss) for the financial year

OFF-BALANCE SHEET COMMITMENTS

1. Commitments given to a third party on behalf of a customer

(a) Guarantees and pledges
(b) Other

2. Irrevocable commitments given in favour of a customer

(a) Securities repurchase commitments
(b) Other

3. Undelivered securities transactions

1.5 CASH FLOW BASIS ACCOUNTING

An accounting system that doesn't record accruals but instead, recognizes income (or
revenue) only when payment is received and expenses only when payment is made.
There's no match of revenue against expenses in a fixed accounting period, so
comparisons of previous periods aren't possible.
The cash method is simple in that the business's books are kept based on the actual flow
of cash in and out of the business. Income is recorded when it's received, and expenses
are reported when they're actually paid. The cash method is used by many sole
proprietors and businesses with no inventory. From a tax standpoint, it's sometimes
advantageous for a new business to use the cash method of accounting. That way,
recording income can be put off until the next tax year, while expenses are counted right
away.
The cash method may also continue to be appropriate for a small, cash-based business or
a small service company. You should consult your accountant when deciding which
accounting method would be best for your company.
In other words, when transactions are recorded on a cash basis, they affect a company's
books only once a completed exchange of value has occurred; therefore, cash basis
accounting is less accurate than accrual accounting in the short term.

For example, let's say a construction company secures a major contract in a given year,

28
 but will only be paid for its efforts upon completion of the project. Using cash basis
accounting, the company will only be able to recognize the revenue from its project at its
completion, while it will record the project's expenses as they are being paid out. If the
project's time span is greater than one year, the company's income statements will be
misleading: the company will incur large losses one year and then great gains the next.

Cash basis accounting is simpler and cheaper to perform than accrual accounting, but it
can make obtaining financing more difficult due to its inaccuracy.

1.5.1 Accrual versus Cash-Basis Accounting

Most businesses use one of two accounting methods to keep track of their transactions.
These accounting methods consist of rules that are used to determine when and how
revenues and expenses are reported.

With the accrual basis of accounting, used by all publicly traded companies and most
large businesses, revenues are recorded when they are earned and expenses are recorded
when they are incurred. With the cash basis of accounting, used primarily by smaller
businesses, revenues are recorded when they are received and expenses are recorded
when they are paid. Individuals generally use cash basis accounting when they file their
income tax returns.

Some important differences between these two methods are:

 There are no receivables or payables in a cash basis balance sheet.

 For small businesses that are within certain income tax limits, there may not be
inventory on a cash basis balance sheet.

 Only the cash amounts that are collected from sales and other revenue activities
are shown as revenue in cash basis reports. On accrual basis reports, revenue
includes both collected and uncollected amounts.

 Only the cash paid to vendors and others are shown as expenses in cash basis
reports, whereas on accrual basis reports, expenses include both paid and unpaid
amounts.

The following are examples that use an accrual basis system:

 Revenue is recognized before cash is received and is described as accrued

revenue. It is categorized as a current asset. The most common example is
accounts receivables that result from sales to customers.

 Cash is received before the revenue is earned and is described as deferred

revenue. It is categorized as a current liability. For example, a customer might pay
you a deposit for a service. However, you do not recognize the revenue until you

29
 have performed the service. Another example might be prepaid rental income. A
tenant might pay you on a quarterly basis for rent, but you only recognize each
month’s rent as it occurs.

 Expense is recognized before cash is paid and is described as accrued expense.

The most common example is accounts payables that result from purchases from
vendors. Another example would be paying interest on a bank loan on a quarterly
basis but recording the accrued interest on a monthly basis.

 Cash is paid before the expense is incurred and is described as deferred or prepaid
expense. It is categorized as a current asset. For example, you might pay your
auto insurance every six months, but you only recognize one month of expense at
a time.

When you open reports in Microsoft Office Accounting 2008, the reports display, by
default, either a cash basis view or an accrual basis view, depending on what you selected
in the Preferences section of Company Setup. To change your selection, on the Company
menu, click Preferences to open the Preferences dialog box.

Cash discounts that you offer your customers and the write off of uncollectible customer
amounts both represent a reduction in the cash to be collected from sales. Similarly, the
discounts you take when paying vendors represent a reduction in the cash paid on
purchases. The reporting of these items in sales and income tax returns is different from
state to state. The Office Accounting 2008 cash basis reports display these amounts so
you can properly report them on your tax return if your state or other tax agency permits
these items to be deductions.

Actually, there are two ways companies can keep their accounting books - Accrual and
Cash-Basis. The accrual basis is used by most companies; only very small businesses
use cash-basis.
Under the accrual method, expenses and revenue are recognized in the period they occur
regardless of whether a cash transaction has occurred. For example, if a sale is made in
January but payment is not expected until February, the revenue from the sale would be
recognized in January (when it was earned) and the amount due to the company is
recorded (accrued) in accounts receivable. Below are the Journal entries for the "sale on
account" and the "payment on account".

General Journal Page: 1

Date Ref
Account Titles/Explanation Debit Credit
Accounts Receivable
2008 5 Sales Revenue 450.00 450.00

30
 Sale on Account
Jan
Feb Cash 450.00
5 Accounts Receivable 450.00
Payment on Account

Notice that the first entry above recognizes the sale in January, when it actually
occurred. This method matches the revenue from the sale to the expenses incurred
during the same period.
On the other hand, under the cash-basis method, the revenue would not be recorded until
February when the cash is actually received, as in the example journal entry below.

General Journal Page: 1

Date Ref
Account Titles/Explanation Debit Credit
Cash
2008 5 Sales Revenue 450.00 450.00
Feb Received Cash from Sale

While this method is easier and requires fewer journal entries, the sale revenue would
not be matched-up to the expenses the company incurred to make the sale possible. For
example, consider the salesperson's salary who made the sale. Assume payroll expense is
recorded in January. Since the revenue is not recognized until the next period (month),
the accounting records do not portray a true picture of what actually occurred.

Under the cash-basis method, this mismatching of expenses and revenues would also
occur if payment was received right away (in January), but the salesperson's salaries
where not paid until February.

Generally Accepted Accounting Principles (GAAP) require that all public companies use
accrual accounting. One reason for this is that a truer indication of a companies financial
stability and income generating activities is reported giving investors and other
interested parties better information to make informed decisions.

1.6 CASH FLOW STATEMENT

The balance sheet, income statement, and cash flow statement are the three generally
accepted financial statements used by most businesses for financial reporting. All three
statements are prepared from the same accounting data, but each statement serves its own
purpose. The purpose of the cash flow statement is to report the sources and uses of cash
during the reporting period.

31
The cash flow statement is used to analyze the cash income and expenditures during a
designated time period. There are three major components of cash flow: operations,
investing and financing.

If you regularly do a monthly profit and loss (income) statement, you will be aware that
there are certain items that may not affect your profit and loss statement for some time,
such as:

 Substantial increase in inventory purchases;

 Increase in accounts receivable (money owed to you by customers);
 Reduction of credit by suppliers;
 Purchase of equipment;
 Unrecognized obsolescence of inventory (stale items);
 Bank's refusal to renew or extend loan; and
 Lump sum payment of debt.

A cash flow statement will highlight these activities in a way that an income statement
will not. And certainly your banker will want to see a cash flow statement showing how
you have used the funds from a previous loan before they approve an extension or a new
one. Without the cash flow statement, you will have an incomplete picture of your
business.

To determine operating cash flow, you start with net income and add back expenses
which did not result in inflows or outflows of cash. The most common non-cash expense
is depreciation. When working with historical figures, adjusting net income with
depreciation and other non-cash expenses is much simpler than determining all the
revenues and expenses which require or provide funds. Next, you identify all the balance
sheet accounts that are associated with operations and determine the change in the
account from the end of the last period to the end of the current period.

Purchasing inventory or paying salaries is an obvious use of cash. In accounts receivables

when you collect from your customers, you will receive cash, so a decrease is a source of
cash. The opposite is true when you increase accounts receivable; it is a decrease in cash.
Growing businesses need to closely watch their inventory and receivables so they don't
find themselves in a cash crunch at a time when business is booming.

Operating cash flow will include all the balance sheet accounts that are a part of normal
operations. Trade receivables and payables as well as accrued expenses, prepaid expenses
and other current assets that are a part of day-to-day operations are included in operating
cash flow.

The remaining balance sheet accounts will either be investing activities or financing
activities. You need to determine the change in each balance sheet account from the
beginning of the period to the end of the period, and tally them up. That completes all the
information that is needed to put together the cash flow statement.

32
1.6.1 Structure of the Cash Flow Statement

The most commonly used format for the cash flow statement is broken down into three
sections: cash flows from operating activities, cash flows from investing activities, and
cash flows from financing activities.

Cash flows from operating activities are related to your principal line of business and
include the following:

 Cash receipts from sales or for the performance of services

 Payroll and other payments to employees
 Payments to suppliers and contractors
 Rent payments
 Payments for utilities
 Tax payments

Investing activities include capital expenditures – disbursements that are not charged to
expense but rather are capitalized as assets on the balance sheet. Investing activities also
include investments (other than cash equivalents as indicated below) that are not part of
your normal line of business. These cash flows could include:

 Purchases of property, plant and equipment

 Proceeds from the sale of property, plant and equipment
 Purchases of stock or other securities (other than cash equivalents)
 Proceeds from the sale or redemption of investments

Financing activities include cash flows relating to the business’s debt or equity financing:

 Proceeds from loans, notes, and other debt instruments

 Installment payments on loans or other repayment of debts
 Cash received from the issuance of stock or equity in the business
 Dividend payments, purchases of treasury stock, or returns of capital

Cash for purposes of the cash flow statement normally includes cash and cash
equivalents. Cash equivalents are short-term, temporary investments that can be readily
converted into cash, such as marketable securities, short-term certificates of deposit,
treasury bills, and commercial paper. The cash flow statement shows the opening balance
in cash and cash equivalents for the reporting period, the net cash provided by or used in

33
each one of the categories (operating, investing, and financing activities), the net increase
or decrease in cash and cash equivalents for the period, and the ending balance.

There are two methods for preparing the cash flow statement – the direct method and the
indirect method. Both methods yield the same result, but different procedures are used to
arrive at the cash flows.

1.6.2 Direct Method

Under the direct method, you are basically analyzing your cash and bank accounts to
identify cash flows during the period. You could use a detailed general ledger report
showing all the entries to the cash and bank accounts, or you could use the cash receipts
and disbursements journals. You would then determine the offsetting entry for each cash
entry in order to determine where each cash movement should be reported on the cash
flow statement.

Another way to determine cash flows under the direct method is to prepare a worksheet
for each major line item, and eliminate the effects of accrual basis accounting in order to
arrive at the net cash effect for that particular line item for the period. Some examples for
the operating activities section include:

Cash receipts from customers:

 Net sales per the income statement

 Plus beginning balance in accounts receivable
 Minus ending balance in accounts receivable
 Equals cash receipts from customers

Cash payments for inventory:

 Ending inventory
 Minus beginning inventory
 Plus beginning balance in accounts payable to vendors
 Minus ending balance in accounts payable to vendors
 Equals cash payments for inventory

Cash paid to employees:

 Salaries and wages per the income statement

 Plus beginning balance in salaries and wages payable

34
  Minus ending balance in salaries and wages payable
 Equals cash paid to employees

Cash paid for operating expenses:

 Operating expenses per the income statement

 Minus depreciation expenses
 Plus increase or minus decrease in prepaid expenses
 Plus decrease or minus increase in accrued expenses
 Equals cash paid for operating expenses

Taxes paid:

 Tax expense per the income statement

 Plus beginning balance in taxes payable
 Minus ending balance in taxes payable
 Equals taxes paid

Interest paid:

 Interest expense per the income statement

 Plus beginning balance in interest payable
 Minus ending balance in interest payable
 Equals interest paid

Under the direct method, for this example, you would then report the following in the
cash flows from operating activities section of the cash flow statement:

 Cash receipts from customers

 Cash payments for inventory
 Cash paid to employees
 Cash paid for operating expenses
 Taxes paid
 Interest paid
 Equals net cash provided by (used in) operating activities

35
Similar types of calculations can be made of the balance sheet accounts to eliminate the
effects of accrual accounting and determine the cash flows to be reported in the investing
activities and financing activities sections of the cash flow statement.

1.6.3 Indirect Method

In preparing the cash flows from operating activities section under the indirect method,
you start with net income per the income statement, reverse out entries to income and
expense accounts that do not involve a cash movement, and show the change in net
working capital. Entries that affect net income but do not represent cash flows could
include income you have earned but not yet received amortization of prepaid expenses,
accrued expenses, and depreciation or amortization. Under this method you are basically
analyzing your income and expense accounts, and working capital. The following is an
example of how the indirect method would be presented on the cash flow statement:

 Net income per the income statement

 Minus entries to income accounts that do not represent cash flows
 Plus entries to expense accounts that do not represent cash flows
 Equals cash flows before movements in working capital
 Plus or minus the change in working capital, as follows:

o An increase in current assets (excluding cash and cash equivalents) would

be shown as a negative figure because cash was spent or converted into
other current assets, thereby reducing the cash balance.
o A decrease in current assets would be shown as a positive figure, because
other current assets were converted into cash.
o An increase in current liabilities (excluding short-term debt which would
be reported in the financing activities section) would be shown as a
positive figure since more liabilities mean that less cash was spent.
o A decrease in current liabilities would be shown as a negative figure,
because cash was spent in order to reduce liabilities.

The net effect of the above would then be reported as cash provided by (used in)
operating activities.

The cash flows from investing activities and financing activities would be presented the
same way as under the direct method.

1.6.4 Cash Control technique

36
Cash control is a control technique (q.v.) that aims to keep the amount of cash
immediately available to an organisation within desired limits.

If a company is unexpectedly short of cash the result can be anything from mildly
annoying to disastrous. For example, the company may have to seek an immediate
alteration in the overdraft limit, or it may unable to pay salaries. If it has an unexpected
surplus, again money is likely to be lost since insufficient time is available to plan the
most profitable way to dispose of it. Consequently it is important to be able to forecast
the cash flows of the company reasonably accurately in the short, medium and long term.

The technique consists of two component parts.

1. there are the various methods of cash forecasting; this is of crucial importance
(e.g. the Balance Sheet Projection Method);
2. There is the daily, weekly and monthly cycle of activity needed to invest
surpluses, to borrow to meet shortages and to mobilise cash from investments.

Illustration

A cash-only grocer has a much simpler problem than an international manufacturing

company. It is not just a matter of scale but of complexity. The latter has to make
dividend payments, allow for devaluations, finance debtors, have cash available for
capital expenditure and so on. In a large company the cash sums handled may be so large
that it becomes necessary to appoint full-time specialists to prepare forecasts and co-
ordinate day to day and month to month action on investments and cash mobilisation.

Activity 1

1. Distinguish between holding and subsidiary companies. Discuss the advantages

and disadvantages of both.

2. What do you understand by consolidated financial statements? Why consolidated

balance sheets are prepared?

3. What is the rationale behind cash flow basis accounting?

4. Discuss the direct and indirect methods of preparing cash flow statements

1.7 SUMMARY

This unit throws light on holding and subsidiary companies and accounts these
companies prepare to show their financial positions. The first area of discussion of this
unit was holding company which was discussed as a company which does not produce
goods or services itself; rather its only purpose owns shares of other companies. Problems
and advantages of holding companies also dealt in this section. Subsidiary company then

37
described as a company that is controlled by another company through a parent child
relationship. A company is only said to be a subsidiary company if the parent has
controlling interest by owning over 50% of the issued share capital. Another area of
consideration of unit was preparation of consolidated financial statements which was
discussed with the help of suitable illustrations. Finally cash flow basis accounting and
cash flow statements were explained with different methods and techniques.

1.8 FURTHER READINGS

 Helfert, Erich A. (2001). "The Nature of Financial Statements: The Cash Flow
Statement". Financial Analysis - Tools and Techniques - A Guide for Managers.
McGraw-Hill

 Bodie, Zane; Alex Kane and Alan J. Marcus (2004). Essentials of Investments, 5th
ed. McGraw-Hill Irwin

 Wild, John Paul. Fundamental Accounting Principles (18th edition ed.). New
York: McGraw-Hill Companies.

 Watanabe, Izumi: The evolution of Income Accounting in Eighteenth and

Nineteenth Century Britain, Osaka University of Economics

UNIT 2

38
 CONCEPTS OF PROFIT, RECONSTRUCTION AND
AMALAGAMATION

Objectives

Upon successful completion of this unit, you should be able to:

 Understand the concept of profit in financial accounting

 Absorb various measures to calculate and show profits in books of accounts
 Know the methods of determination and disposal of profit under companies act
1956
 Discuss the approaches to reconstruction of companies and reconstruction
schemes
 Have understanding of various issues pertaining to amalgamation of companies.

Structure

2.1 Introduction to profit concept

2.2 Profit measures
2.3 Profit determination and disposal under companies act 1956
2.4 Reconstruction of companies
2.5 Reconstruction schemes
2.6 Amalgamation and absorption issues
2.7 Summary
2.8 Further readings

2.1 INTRODUCTION TO PROFIT CONCEPT

In accounting, profit is the difference between price and the costs of bringing to market
whatever it is that is accounted as an enterprise (whether by harvest, extraction,
manufacture, or purchase) in terms of the component costs of delivered goods and/or
services and any operating or other expenses.

There is several important profit measures in common use which will be explained in the
following. Note that the words earnings, profit and income are used as substitutes in
some of these terms, thus inflating the number of profit measures.

Gross profit equals sales revenue less Cost of Goods Sold (COGS), thus removing only
the part of expenses that can be traced directly to the production of the goods. Gross
profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest
expense, taxes and extraordinary items.

39
Operating profit equals gross profit less all operating expenses. This is the surplus
generated by operations. It is also known as Earnings Before Interest and Taxes EBIT,
Operating Profit Before Interest and Taxes OPBIT or simply Profit Before Interest and
Taxes PBIT.

(Net) Profit before Tax (PBT) equals operating profit less interest expense (but before
taxes). It is also known as Earnings before Tax (EBT), Net operating income before taxes
or simply Pretax Income.

Net profit equals Profit After Tax (unless some distinction about the treatment of
extraordinary expenses is made). In the US the term Net Income is commonly used.
Income before extraordinary expenses represents the same but before adjusting for
extraordinary items.

Net income less dividends becomes retained earnings.

2.2 PROFIT MEASURES

There are several additional important profit measures, notably EBITDA and NOPAT.

To accountants, economic profit, or EP, is a single-period metric to determine the value

created by a company in one period - usually a year. It is the net profit after tax less the
equity charge, a risk-weighted cost of capital. This is almost identical to the economist's
definition of economic profit.

There are commentators who see benefit in making adjustments to economic profit such
as eliminating the effect of amortized goodwill or capitalizing expenditure on brand
advertising to show its value over multiple accounting periods. The underlying concept
was first introduced by Schmalenbach, but the commercial application of the concept of
adjusted economic profit was by Stern Stewart & Co. which has trade-marked their
adjusted economic profit as EVA or Economic Value Added.

Some economists define further types of profit:

 Abnormal profit (or supernormal profit)

 Subnormal profit
 monopoly profit (super profit)

2.2.1 Optimum Profit

This is the "right amount" of profit a business can achieve. In business, this figure takes
account of marketing strategy, market position, and other methods of increasing returns
above the competitive rate.

Accounting profits should include economic profits, which are also called economic
rents. For instance, a monopoly can have very high economic profits, and those profits

40
might include a rent on some natural resource that firm owns, where that resource cannot
be easily duplicated by other firms.

2.2.2 Gross profit

Gross profit or sales profit is the difference between revenue and the cost of making a
product or providing a service, before deducting overhead, payroll, taxation, and interest
payments. Note that this is different from operating profit (earnings before interest and
taxes).

Net sales are calculated:

Net sales = Gross sales - Sales of returns and allowances.

Gross profit is found by deducting the cost of goods sold:

Gross profit = Net sales - Cost of goods sold.

Gross profit should not be confused with net income:

Net income = Gross profit - Total operating expenses.

Cost of goods sold is calculated differently for merchandising business than for a
manufacturer

2.2.3 Net profit

In accounting, net profit is equal to the gross profit minus overheads minus interest
payable plus/minus one off items for a given time period (usually: accounting period).

A common synonym for "net profit" when discussing financial statements, (which
include a balance sheet and an income statement) is the bottom line. This term results
from the traditional appearance of an income statement which shows all allocated
revenues and expenses over a specified time period with the resulting summation on the
bottom line of the report.

In simplistic terms, net profit is the money left over after paying all the expenses of an
endeavor. In practice this can get very complex in large organizations or endeavors. The
bookkeeper or accountant must itemise and allocate revenues and expenses properly to
the specific working scope and context in which the term is applied.

Definitions of the term can however vary between the UK and US. In the US, net profit is
often associated with net income or profit after tax (see table below).

The net margin percentage is a related ratio. This figure is calculated by dividing net
profit by turnover, and it represents profitability, as a percentage.

41
Example

Here is how you reach net profit on a P&L (Profit & Loss) account:

1. Sales Revenue = Price (of product) X Quantity Sold

2. Gross profit = sales revenue - cost of sales and other direct costs
3. Operating profit (EBIT, earnings before interest and taxes) = Gross profit -
overheads and other indirect costs
4. Pretax Profit (EBT, earnings before taxes) = operating profit - one off items and
redundancy payments, staff restructuring - interest payable
5. Net profit= Pre-tax profit - tax
6. Retained earnings = Profit after tax – Dividends

2.2.4 Rate of return

In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit
or sometimes just return, is the ratio of money gained or lost (whether realized or
unrealized) on an investment relative to the amount of money invested. The amount of
money gained or lost may be referred to as interest, profit/loss, gain/loss, or net
income/loss. The money invested may be referred to as the asset, capital, principal, or the
cost basis of the investment. ROI is usually expressed as a percentage rather than a
fraction.

The initial value of an investment, , does not always have a clearly defined monetary
value, but for purposes of measuring ROI, the expected value must be clearly stated along
with the rationale for this initial value. The multiple value of an investment, , also
does not always have a clearly defined monetary value, but for purposes of measuring
ROI, the final value must be clearly stated along with the rationale for this final value.

The rate of return can be calculated over a single period, or expressed as an average over
multiple periods.

Single-period

1. Arithmetic return

The arithmetic return is:

is sometimes referred to as the yield. See also: effective interest rate, effective
annual rate (EAR) or annual percentage yield (APY).

42
2. Logarithmic or continuously compounded return

The logarithmic return or continuously compounded return, also known as force of

interest, is defined as:

It is the reciprocal of the e-folding time.

Multiperiod average returns

1. Arithmetic average rate of return

The arithmetic average rate of return over n periods is defined as:

2. Geometric average rate of return

The geometric average rate of return, also known as the time-weighted rate of return,
over n periods is defined as:

The geometric average rate of return calculated over n years is also known as the
annualized return.

3. Internal rate of return

The internal rate of return (IRR), also known as the dollar-weighted rate of return,
is defined as the value(s) of that satisfies the following equation:

where:

 NPV = net present value of the investment

43
  = cashflow at time

When the rate of return is smaller than the IRR rate , the investment is
profitable, i.e., . Otherwise, the investment is not profitable.

4. Return on assets

The return on assets (ROA) percentage shows how profitable a company's assets are in
generating revenue.

ROA can be computed as:

This number tells you what the company can do with what it has, i.e. how many dollars
of earnings they derive from each dollar of assets they control. It's a useful number for
comparing competing companies in the same industry. The number will vary widely
across different industries. Return on assets gives an indication of the capital intensity of
the company, which will depend on the industry; companies that require large initial
investments will generally have lower return on assets.

Return on assets is an indicator of how profitable a company is before leverage, and is

compared with companies in the same industry. Since the figure for total assets of the
company depends on the carrying value of the assets, some caution is required for
companies whose carrying value may not correspond to the actual market value.

Return on assets is a common figure used for comparing performance of financial

institutions (such as banks), because the majority of their assets will have a carrying
value that is close to their actual market value. Return on assets is not useful for
comparisons between industries because of factors of scale and peculiar capital
requirements (such as reserve requirements in the insurance and banking industries).

Return on assets is one of the elements used in financial analysis using the Du Pont
Identity.

5. Return on equity

Return on Equity (ROE, Return on average common equity, return on net worth, Return
on ordinary shareholders' funds) (requity) measures the rate of return on the ownership
interest (shareholders' equity) of the common stock owners. It measures a firm's
efficiency at generating profits from every unit of shareholders' equity (also known as net
assets or assets minus liabilities). ROE shows how well a company uses investment funds
to generate earnings growth.

44
The formula

[1]

ROE is equal to a fiscal year's net income (after preferred stock dividends but before
common stock dividends) divided by total equity (excluding preferred shares),
expressed as a percentage. with many financial ratios, ROE is best used to compare
companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined
by earnings per share (EPS), you will be paying twice as much (in Price/Book terms)
for a 20% ROE Company as for a 10% ROE company. The benefit comes from the
earnings reinvested in the company at a high ROE rate, which in turn gives the
company a high growth rate.

ROE is presumably irrelevant if the earnings are not reinvested.

 The sustainable growth model shows us that when firms pay dividends, earnings
growth lowers. If the dividend payout is 20%, the growth expected will be only
80% of the ROE rate.

 The growth rate will be lower if the earnings are used to buy back shares. If the
shares are bought at a multiple of book value (say 3 times book), the incremental
earnings returns will be only 'that fraction' of ROE (ROE/3).

 New investments may not be as profitable as the existing business. Ask "what is
the company doing with its earnings?"

 Remember that ROE is calculated from the company's perspective, on the

company as a whole. Since much financial manipulation is accomplished with
new share issues and buyback, always recalculate on a 'per share' basis, i.e.,
earnings per share/book value per share.

2.2.5 The DuPont formula

The DuPont formula, also known as the strategic profit model, is a common way to break
down ROE into three important components. Essentially, ROE will equal the net margin
multiplied by asset turnover multiplied by financial leverage. Splitting return on equity
into three parts makes it easier to understand changes in ROE over time. For example, if
the net margin increases, every sale brings in more money, resulting in a higher overall
ROE. Similarly, if the asset turnover increases, the firm generates more sales for every
unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial
leverage means that the firm uses more debt financing relative to equity financing.

45
Interest payments to creditors are tax deductible, but dividend payments to shareholders
are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher
ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments
increases. So if the firm takes on too much debt, the cost of debt rises as creditors
demand a higher risk premium, and ROE decreases. Increased debt will make a positive
contribution to a firm's ROE only if the matching Return on assets (ROA) of that debt
exceeds the interest rate on the debt.

Rate of profit

The profit rate is the relative profitability of an investment project, of a capitalist

enterprise, or of the capitalist economy as a whole. It is similar to the concept of the rate
of return on investment.

In Marxian political economy, the rate of profit (r) would be measured as

r = (surplus-value)/(capital invested).

where surplus-value corresponds to unpaid labor in the production process or to profits,

interest, and rent (property income).

2.2.6 Historical cost vs. market value

The rate of profit depends on the definition of capital invested. Two measurements of the
value of capital exist: capital at historical cost and capital at market value. Historical cost
is the original cost of an asset at the time of purchase or payment. Market value is the re-
sale value, replacement value, or value in present or alternative use.

To compute the rate of profit, replacement cost of capital assets must be used to define
the capital cost. Assets such as machinery cannot be replaced at their historical cost but
must be purchased at the current market value. When inflation occurs, historical cost
would not take account of rising prices of equipment. The rate of profit would be
overestimated using lower historical cost for computing the value of capital invested.

On the other side, due to technical progress, products tend to become cheaper. This in
itself should raise rates of profit, because replacement cost declines.

2.2.7 A prisoner's dilemma

If, however, firms achieve higher sales per worker the more they invest per worker, they
will try to increase investments per worker as long as this raises their rate of profit. If

46
some capitalists do this, all capitalists must do it, because those who do not will fall
behind in competition.

This, however, means that replacement cost of capital per worker invested, now
calculated at the replacement cost necessary to keep up with the competition, tends to be
increased by firms more so than sales per worker before. This squeeze, that investments
per worker tend to be driven up by competition more, so than before sales per worker
have been increased, causes the tendency of the rate of profit to fall. Thus, capitalists are
caught in a prisoner's dilemma or rationality trap.

This "new" rate of profit (r'), which tends to fall, would be measured as

r' = (surplus-value)/(capital to be invested for the next period of production in

order to remain competitive).

Numerical example

At the beginning of a "year" (possibly another length of time period, in this case other
numerical values will arise) the capitalist has to invest an amount of capital.

For example, he must invest:

 100 Rs. for wages (variable capital v)

Furthermore he must invest for constant capital c:

 100 Rs. for “production material”
 100 Rs. for “instruments” (life span 2 years)
 100 Rs. for “machines” (life span 4 years)
 100 Rs. for “equipment” (life span infinity).

In total he invests at the beginning of the year 500 Rs..

Now, it is assumed that during the year the capitalist can produce and sell
commodities at a total price of 300 Rs.. Volume of sales, therefore, is 300 Rs..

From volume of sales costs of the year must be deducted. Costs of circulating capital
are expenses for “production material” and for labour power; both of them are
consumed in production during the year (that is the definition of “circulating
capital”):

 100 Rs. wage costs (variable capital) - see assumption above.

 100 Rs. expenses for material - see assumption above.
 Costs of fixed capital (depreciation).

Fixed capital are those means of production, which are in use for more than one year: The
capitalist must take into account, that “instruments” and “machines” do not live forever,

47
but must finally be replaced after usage. From sales he must take aside certain sums of
money (depreciation) to be able to replace “instruments” and “machines” at their end of
life. For “instruments”, the depreciation expense per year is 50 Rs. (100 Rs. purchase cost
divided by lifespan of 2 years, straight-line depreciation assumed) and for “machines” 25
Rs. (100 Rs. purchase cost divided by 4 years). For “equipment” there is no depreciation
expense, because, in this example, it is assumed, that equipment hold forever, there is no
wear and tear for equipment.

In total costs are 275 Rs.

Sales of 300 Rs. minus costs of 275 Rs. gives a profit of 25 Rs.. 25 Rs. in relation to
an initial capital investment of 500 Rs. gives a rate of profit of 5 %. From year to
year capital can grow at a rate of 5 %, if all profits are invested or accumulated.

2.3 PROFIT DETERMINATION AND DISPOSAL UNDER

COMPANIES ACT 1956

Final accounts are the final product of accounting work done during the accounting
period i.e. quarterly, half yearly or annually. By this the accounting information is
communicated to the external users. It includes two basic financial statements namely:

(i) Profit and Loss Account

(ii) Balance Sheet.

Although the general principles of preparing the final accounts of joint stock companies
are the same as in the case of the sole proprietorship or partnership firms, but in addition
to these principles, a joint stock company must confirm to certain legal provisions as
given in the Indian Companies Act 1956.

Every company must prepare final accounts every year. At every annual general meeting
of a company, the Board of Directors of the company shall lay before the company:-

(a) A Balance Sheet as at the end of period

(b) A Profit and Loss Account for that period.

In case, a company is not carrying on business for profit, an Income and Expenditure
Account shall be laid before the company at its annual general meeting instead Profit and
Loss Account. The report of Auditor and Board of Directors should be attached to every
Profit and Loss Account and Balance Sheet. Enterprises having a turnover in excess of
Rs. 50 crores have to attach Cash Flow Statement and Segment Report with the annual
accounts. Disposal of profits of the company are basically shown by p & l account.

 A Balance Sheet is a statement of assets and liabilities indication the financial

position of an enterprise at a given date.

48
  A Profit and Loss Account shows the net result of business operations during an
accounting period.

 A Profit and Loss Appropriation Account shows how the profit for the year has
been distributed or appropriated.

 Schedules have the details of amounts in the Balance Sheet and Profit and Loss
Account, while the notes are the statements of accounting polices adopted and
explanation of material information.

Application of Schedule VI of the Companies Act 1956:

The form and contents of Balance Sheet and Profit and Loss Account are governed by
Section 211 of the Companies Act 1956.

Section 211 (1): According to this section every Balance Sheet must give true and fair
view of the state of affairs of the company as at the end of the financial year and to be in
the form set out in Part I of Schedule VI or as near thereto as circumstances permit or in
such form as may be approved by the Central Government.

Section 211 (2): According to this section every Profit and Loss Account must give true
and fair view of the profit or loss of the company for the financial year and shall comply
to with the requirement of Part II of Schedule VI, so far they are applicable.

Note: It must be noted here that Schedule VI has prescribed a form in which Balance
Sheet is to be prepared; it has not prescribed any form for Profit and Loss Account. The
Companies Act, 1956 has not recognised Trading Account and Profit and Loss
Appropriation Account, yet there is no bar to prepare these accounts. It is so because
Schedule VI has not prescribed any form for Profit and Loss Account. But, it must be
remembered that the Trading Account, Profit and Loss Account and Profit and Loss
Appropriation Account must comply with the requirements of Part II of Schedule VI of
Companies Act, 1956.

2.3.1 Profit and loss account

The starting point in understanding the profit and loss account is to be clear about the
meaning of "profit".

Profit is the incentive for business; without profit people wouldn’t bother. Profit is the
reward for taking risk; generally speaking high risk = high reward (or loss if it goes
wrong) and low risk = low reward. People won’t take risks without reward. All business
is risky (some more than others) so no reward means no business. No business means no
jobs, no salaries and no goods and services.

49
This is an important but simple point. It is often forgotten when people complain about
excessive profits and rewards, or when there are appeals for more taxes to pay for eg
more policemen on the streets.

Profit also has an important role in allocating resources (land, labour, capital and
enterprise). Put simply, falling profits (as in a business coming to an end eg black-and-
white TVs) signal that resources should be taken out of that business and put into another
one; rising profits signal that resources should be moved into this business. Without these
signals we are left to guess as to what is the best use of society’s scarce resources.

People sometimes say that government should decide (or at least decide more often) how
much of this or that to make, but the evidence are those governments usually doing a bad
job of this e.g. the Dome.

Part II of the Schedule VI of the Companies Act, 1956 deals with the Profit and Loss
Account. It has not prescribed the form in which the profit and loss account is to be
prepared but, has instead prescribed the particulars and information to be given in the
Profit and Loss Account. As a result, in practice, it is prepared in different forms based on
the needs of the business and type of industry. What ever may be the form of Profit and
Loss Account but it must exhibit a true and fair view of the profit or loss of the company
during the year under reference.

In case of a company, it is not necessary to split the Profit and Loss Account into three
sections i.e., Trading Account, Profit and Loss Account and Profit and Loss Appropriation
Account. Only Profit and Loss Account may be prepared which may cover items appearing
in Trading Account and Profit and Loss Appropriation Account. However, the splitting of
Profit and Loss Account into three sections is not forbidden (prohibited) by the Act. It is
desirable to split the Profit and Loss Account into three sections so that gross profit, net
profit and surplus carried to the balance sheet may be ascertained separately.

However, in case of in case of a company, instead of the heading of Trading Account and
Profit & Loss Account, the heading is only Profit & Loss Account. Items relating to
Trading Account are shown in its first part and the items relating to Profit and Loss
Account appear in its second part.

2.3.2 Profit and Loss Appropriation Account

An appropriation account shows the various ways that company funds have been used.
For example funds may have been split between investment, tax payments, making
external loans or distribution of dividends

After calculation and ascertainment of profit, question of its distribution or appropriation

arises. Generally the Articles of Association of the Company empower the directors to
decide the amount of profit to be transferred to reserves and the quantum of dividends.
The directors may decide to retain a certain amount of profit to strengthen the financial
position of the company, which is done by transferring the amount to various reserves, or

50
even by keeping as balance. A part of the profits may also be distributed as dividend. The
account showing the disposal of profit is called ‘Profit and Loss Appropriation Account ‘

For a limited company they have may appropriate profit. Any inappropriated profit will
be carried forward as a balance on the profit and loss account. It appears in the balance
sheet at the end of the period, as part of reserves and will be carried forward as the
opening balance on the appropriation account for the next period.

Profit and Loss Account (Debit balance): If there is net loss in a company and other
reserves is given, then first of all such loss will be deducted from such reserves and if
such reserve is not given or the amount of reserve is not sufficient to cover the total
amount of loss then the balance amount of net loss will be shown under this head.

Some specific terms

1. Provision

The term ‘Provision’ refers to any of the following amounts:

 The amount written off or retained by way of providing depreciation, renewals or

diminution in the value of assets; or

 The amount retained by way of providing for any known liability of which the
amount cannot be determined with substantial accuracy.

 If the amount of liability can be ascertained with substantial accuracy, or is set

aside out of profit for any known liability, it is termed as liability.

Following are the examples of provisions:

(i) Provision for Bad and Doubtful Debts.

(ii) Provision for Discount on Debtors.

(iii) Provision for Taxation.

(iv) Provision for Repairs and Renewals.

2. Reserves

Reserve means amount set aside out of profit, to meet out either an expected or an
unexpected future liability or loss. Other words any amount set aside out of profit and
other surpluses, which are not earmarked (assign) in any way to meet any particular
liability, known to exist on date of the Balance Sheet.

51
It is provided for meeting prospective losses or liabilities, creation of reserves to increase
the working capital in the business and strengthen its financial position. Provision in
excess of the amount considered necessary for the purpose for which it was created is
treated as reserve. Examples of reserves are General Reserves, Capital Reserve, Dividend
Equalisation Reserves, and Contingency Reserves etc.

Characteristics of Reserves

Reserves have got the following special features:

(i) They are appropriated out of profits. When there is no profit, no reserve may be
created.

(ii) Reserves are created to strengthen the financial position of the concern.

(iii) Reserves are not earmarked in any way to meet any liability or diminution in the
value of assets.

(iv) If the amount of reserves is invested outside the business in securities, it is called the
(Name of reserve) Fund.

(v) Since a reserve is a part of profit, hence the proprietor has claim over it. He may use it
in any manner he likes.

Importance or Purpose of Reserves

The purpose, for which the amount is so set aside, may be any one of the following:

(i) To strengthening the financial position: Improvement of the financial position of the
business by keeping back a portion of profits and thus conserving the resources which
would have otherwise been distributed to the owners.

(ii) Meeting future unanticipated loss: Arrangement for meeting unforeseen abnormal
losses irrespective of their nature

(iii) Normal rate of dividend: Equalisation of dividend by allowing its balance to be

drawn upon during periods of inadequate profits.

(iv) Fulfilling some specific purpose: Sometimes, a reserve is created for a specific
purpose such as ‘Debenture Sinking Fund’ for redemption of debentures.

Important term related to Profit and Loss Appropriation Account

1. Interim Dividend

52
Dividend paid by the company before the ascertainment of the profit is called ‘Interim
Dividend’. This dividend is declared by the directors at any time during the year if they
think that company will earn more profit than what is expected. It is paid before the final
dividend and in between the two annual general meetings, without the sanction from the
shareholders. However, if an interim dividend is paid and it is found subsequently that the
company’s profits are inadequate to cover the interim dividend, it amounts to payment of
dividend out of capital and hence the directors will be liable to make good the amount.

2. Proposed Dividend

After ascertainment of profit directors fix the rate of dividend which is to be paid to the
shareholders. This is a type of proposal by the directors on which the consent of the
shareholders is required. Hence it can be defined as the dividend which fixed by the
shareholders on which consent of shareholders is not received.

3. Final Dividend

Dividend proposed by the directors is declared by shareholders at the annual general

meetings. After the declaration the proposed dividend is termed as final dividend.
Shareholders cannot increase the rate of dividend fixed by the directors but they can
decrease it if they think fit.

4. Additional dividend

If after the normal dividend any extra dividend is paid to the shareholders, such a
dividend is termed as additional dividend. This dividend is paid when any surplus profit
is left out of the profit set aside for distribution of the normal dividend.

5. Divisible profits

All profits are not divisible profits. Only those profits which are legally available to
shareholders for dividend are known as divisible profits. In normal course, divisible
profits are the profits left after meeting all expenses, losses, depreciation on fixed assets,
and fall in the price of current assets, taxation, and writing off past losses and after
transferring a reasonable amount to reserves. Divisible profits should not include capital
profits. Dividends cannot be declared except out of divisible profits.

2.4 RECONSTRUCTION OF COMPANIES

The need for reconstruction arises when a company has accumulated losses or when a
company finds itself overcapitalized which means either that the value placed on assets is
too much as compared to their earning capacity or that their profits as a whole are
insufficient to pay a proper dividend. Reconstruction is of two types’ External
reconstruction and internal reconstruction.

2.4.1 External reconstruction

53
Under external reconstruction the ailing company is liquidated and a new company
(consisting substantially the same shareholders) is formed to acquire the business of the
old company.

An attempt is made that the newly started company has a sound financial structure and a
good set of assets and liabilities recorded in the books of the transferee company at their
fair values. When the reconstruction involves the creation of a new company, two main
accounts are needed to liquidate the old company:

a) A purchaser’s account, and

b) A realization and reconstruction account. (The realization section is similar to that

used to dissolve a partnership, and the reconstruction section is similar to the
capital reduction account.)

PURCHASER’S ACCOUNT

Realization and Reconstruction a/c Trade Payables a/c

(amt. of purchase consideration) xxxxx - shares issued in part satisfaction xxxx
- cash paid in part satisfaction xxxx
Debenture a/c
- shares and debentures issued
in satisfaction xxxx
Preference Shareholders’ a/c xxxx
Ordinary Shareholders’ a/c xxxx
- issue of shares in New company to
shareholders of old co.
Realization and Reconstruction a/c
- costs paid by new company xxxx
-------- ---------
xxxxx xxxxx
===== =====

REALIZATION & RECONSTRUCTION A/C

Sundry Assets (at book values) xxx Purchaser’s a/c (amt. of purchase consid.) xxx
Balance c/d xxx
----- -----
xxxx xxxx
==== ====
Balance b/d xxx Preference shareholders a/c xxx
Retained Earnings a/c – Dr. Balance xxx Ord. Shareholders a/c xxx
Trade Payables a/c } premium if any xxx - remaining balances on a/c after adjusting
Debenture a/c } premium if any xxx for reconstruction
Purchaser’s a/c – cost paid by new co. xxx
----- -----
xxxx xxxx
==== ====

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Legal position

Section 494 of the Companies Act permits the liquidator of a company to transfer the
whole or any part of the company business or property to another company and receive
from the transferee company (by way of compensation or part compensation) shares etc.
in the transferee company fro distribution among the shareholders of the company under
liquidation.

The liquidator must obtain the sanction of the company by a special resolution. Any sale
or arrangement in pursuance of this section is binding on the members of the transferor
company. But a share holder who has not voted for the special resolution may, within
seven days of the resolution, serve a notice on the liquidator expressing his dissent and
requiring the liquidator either, to abstain from carrying the resolution into effect or to
purchase his interest at the price to be determined by agreement or arbitration.

Distinction between External reconstruction and Amalgamation

1. Number of existing companies: In external reconstruction only one existing

company is involved in amalgamation; there are at least two existing companies which
amalgamate.

2. New Company In external reconstruction: a new company is certainly formed in

amalgamation a new company is formed or one of the existing companies may take over
the other amalgamating company and no new company may be formed.

3. Objective: The objective is to reorganize the financial structure of the company. The
objective is to cut the competition

2.4.2 Internal Reconstruction

Internal reconstruction is undertaken by companies that have surplus capital or

companies whose capital has been eroded by trading losses. Under this scheme the capital
of company is reduced. Section 100 of Companies Act 1956, deals with reduction of
capital. According to it reduction of capital may take the following forms: -

(a) Extinguishing or reducing the liability on any of the shares in respect of the unpaid
amount.

(b) Cancelling any paid up shares capital (writing off) which is lost or unrepresented by
available assets together with or without extinguishing or reducing liability on shares.

(c) Paying off capital (already paid up) which is in excess of needs of the company
(again together with or without extinguishing or reducing liability on shares).

Cancellation of Paid up Share capital which is Lost: - A company intending to reduce the
capital have following features:-

55
1. Heavy debit balance in the Profit & Loss A/c.

2. Unwritten off fictitious assets in the Balance Sheet such as Preliminary expenses;
underwriting commission; etc.

3. Existence of Goodwill in the Balance Sheet.

4. Over valued assets, because company due to losses charges inadequate depreciation.
General Provisions: -

The Company wishing to reduce their capital need to comply with the following
requirements as laid down in the Companies Act, 1956.

1. The capital reduction scheme must be confirmed by the Honorable Court.

2. The Articles of Association must provide for the reduction of capital.

3. A special resolution must be passed by the company. 4. If any creditor has any
objection to the scheme of capital reduction, his outstanding amount should either be paid
or secured as directed by the Honorable Court. Notes: -

Following point must be taken into consideration.

 Goodwill account appearing in the Balance Sheet is written off completely

because a company which has been incurring losses can not be said to be enjoying
any goodwill.

 When the losses are heavy Preference Shareholders may also made to make a
sacrifice. To compensate them for their sacrifice to some extent, the rate of their
dividend for the future may be increased, although as far as arrears of dividend
are concerned they may be made to forgo them.

 If the losses to write off are very heavy, even Trade Creditors and debenture
holders may be persuaded to make a sacrifice. In such case Capital Reduction
Account is not opened it must be either Reorganisation Account or Reconstruction
Account.

 Also when assets are revalued there may be appreciation in the value of a few
assets for example usually there is an appreciation in the value of Land &
Building Such an appreciation is also available for writing off losses. Similarly
there may be capital profits like profits prior to incorporation which may also be
used to write off losses under a scheme of reconstruction.

 The Honorable Court may direct the company to add the word ‘And Reduced’ to
its name for such period as it thinks fit. The Hon. Court may also requires the
company to publish such statement, in the press, in regard to the reduction of

56
 capital, as the Hon. Court may think expedient, with a view to giving proper
information to the public.

A special account, called a capital reduction account, is opened, through which are passed
the amounts written off assets and share capital, accumulated losses etc as shown by the
following table of entries.
DR CR
1. Amount written off assets revalued Capital Reduction Individual asset account
2. Adverse/Dr balance on Reserve A/C’s Capital Reduction Individual reserve A/C
3. Surplus on revaluation of Fixed Assets Individual F.A. a/c Capital Reduction
4. Amt. written off share capital Individual S/C A/c Capital Reduction
5. Reduction in liabilities/any other reserves Liability a/c Capital Reduction
5. Settlement of Liab. By an issue of shares Individual liabilities Share capital; share

premium
6. Waiver of preference dividend arrears
by an issue of shares/loan capital Capital Reduction Share capital/loan

capital
7. Replacement of one class of shares
by shares of a different class Share capital capital reduction
(replaced shares)
capital reduction share capital
(replacement shares)
8. Capitalization of surplus on
Capital reduction account capital reduction capital reserve

Accounting Entries Used In Capital Reduction Where Capital Is Not Represented By Available
Assets

(1) Being Amount Written Off From Share Capital Account

Debit Credit
Share Capital Account XXX
Capital Reduction Account XXX

(2) Being Reserves Utilized For Capital Reduction Scheme

Debit Credit
Reserve Account XXX
Capital Reduction Account XXX

(3) Being Amount Written Off From Accumulated Losses

Debit Credit
Capital Reduction Account XXX

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 Profit & Loss Account XXX

(4) Being Amount Written Off On Assets On Revaluation

Debit Credit
Capital Reduction Account XXX
Various Relevant Assets XXX

(5) Being Surplus Upon Revaluation Of Assets

Debit Credit
Various Relevant Assets XXX
Capital Reduction Account XXX
(6) Being shares issued to settle liabilities
Debit Credit
Various Relevant Liabilities XXX
Capital Reduction Account XXX
(7) Being new shares issued in lieu of preference dividends in
arrears
Debit Credit
Capital Reduction Account XXX
Share Capital Account XXX
(8) Being expenses incurred during the Capital Reduction.
Debit Credit
Capital Reduction Account XXX
Cash/Bank Account XXX
(9) Being difference(rounding) re: net credits transferred to
Capital Reserve Account.
Debit Credit
Capital Reduction Account XXX
Capital Reserve Account XXX

2.5 RECONSTRUCTION SCHEMES

A capital reconstruction is the alteration of the capital structure of a company.

Reconstruction may be carried out for a variety of reasons, such as:

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a) To increase the share capital by means of a bonus issue;
b) To reorganize a company following a merger or takeover agreement;
c) To restore a company to profitability in a rescue operation.

A reconstruction for reasons (b) and (c) might be carried out with a reorganization of the
existing company, or it might involve the creation of a new company out of the old one
(with assets transferred from the old to the new company.)

Our main interest in reconstructions lies with rescue operations to prevent a company
going into liquidation.

a) An external reconstruction involves the creation of a new company to take over

all or part of the assets and liabilities of the company which is in trouble. Short-
term creditors should expect to be paid in full by the new company, but debenture
holders will be offered a new deal in the newly-formed company.

Y PLC --------becomes----------- Z PLC

b) An internal re-organization involves a scheme of arrangement or scheme of

capital reduction which is an agreement between a company’s shareholders and
its creditors, in which the various interested parties agree to give up some of their
immediate legal rights in order to allow the company to survive. They will do so
only if there are reasonable prospects that the company will get out of trouble and
start to make profit again, so that they will get a bigger payment by letting the
company survive than by forcing the company into liquidation.

N PLC N PLC
(Before reorganization)-------------becomes--------- (after reorganization )

That is, the existing company retains its identity after reorganization, but with a trimmed
down capital structure reflecting the written off losses, borne by the shareholders.
Therefore, in a scheme of arrangement, the existing company continues to trade and no
new company is formed.

In an external reconstruction, i.e., the formation of a new company to take over the assets
and liabilities of the old company, the debt of every creditor will be paid in full by the
new company.

In a scheme of arrangement – i.e., re-organization of the existing company – creditors

might agree to accept less than their full due in order to keep the company going.

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2.5.1 S425 Scheme of Arrangement
A Companies Act 1985 procedure enabling a compromise or Arrangement between
companies and its creditors, it’s members or any class of them, subject to ratification by
the Court. Generally, an expensive procedure due to high level of Court involvement
utilise more often than not in respect of larger public quoted companies. The court on
application of the company, any creditor orders the calling of meeting of creditors or
members or clauses thereof as it so directs.

Notice of the relevant meetings must contain a statement explaining the effect of the
compromise or arrangement being sought and a declaration of any material interests of
the directors in the company and the effect of the proposed Arrangement on those
interests so far as it is different than the effect on other creditors or members. It should
also give note as to the effect on the rights of debenture holders.

The above notice must be advertised and where the advert does not include a statement
regarding the effects on the directors and debenture holders, a location where the
creditors and members may obtain the relevant details.

If a majority in number representing 75% in value of the creditors and members or

classes thereof voting in person or by proxy agree to the Arrangement, upon receiving
court sanction in the form of an Order being made and filed at the Registrar of
Companies in Cardiff, the Arrangement becomes binding on all creditors or members or
classes thereof. A copy of the Order should also be annexed to every copy of the
company’s memorandum after the Order has been made.

2.6 AMALGAMATION AND ABSORPTION ISSUES

The term “amalgamation” is not defined by the Companies Act, 1956. But section 2(1B)
of the Income-tax Act, 1961, defines the term “amalgamation” for the purposes of the
income tax law.

Amalgamation is the merger of one or more companies with another company or the
merger of two or more companies to form one company. In views of the Companies Act,
1956, the terms, “amalgamation” and “merger”, has the same meaning. Amalgamation is
not a process that can be completed within few days.

It is a lengthy process. It has its own procedures which contains critical processes. It may
take one year period or more to complete. The period that may be required to complete an
amalgamation process is depends upon the cases of the companies involved therein

Amalgamation is not a mere contract that can be executed by the companies themselves.
The law requires involvement of the Courts in the cases of amalgamation.

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2.6.1 Issues pertaining to amalgamation and absorption of firms

Section 390 to 395 of Companies Act, 1956 deal with arrangements, amalgamations,
mergers and the procedure to be followed for getting the arrangement, compromise or the
scheme of amalgamation approved. The business people or the MBA students look at the
issue of mergers in a different angle to that of legal professionals. It is very often been
criticized by legal professionals that the sections providing for amalgamation etc. are
being misused and it may be true to some extent, but, its not wholly true. But, when we
discuss the issue of mergers with business people, then, they talk about business
strategies like market penetration strategy etc. Its true that when a company is not doing
well and its financial position is weak, then, the Act itself guides the Company to go for
settlement with creditors or go for some arrangement instead of winding-up the
Company. The Act can not force the company to go for compulsory merger or settlement
and it all depends upon the commercial wisdom and viability of a Company.

While the Act facilitates the arrangement or settlement with creditors etc. when the
Company is not doing well, it is for the creditors and other stake-holders to decide as to
whether they agree for settlement etc. or not. The act facilitates arrangement, settlement,
amalgamation and merger etc. If it is a private company or a public limited company, the
Company has to follow the procedure laid down under the Companies Act apart from the
Central Government rules in this regard. If it is a listed public company, then, the
company has to comply with the SEBI regulations too and its all in the nature of giving
prior relevant information to the stake holders/public or giving further material
information when the deal is over.

Dealing with the issue of mergers and amalgamations elaborately is a bigger and
complicated affair.

Here we would like to deal with, in brief, as to whether it is right to say that the
amalgamation provisions as provided in the Act are being misused and the procedure to
be followed while getting the scheme of amalgamation approved under the provisions of
Companies Act, 1956.

Is it correct to say that the provisions dealing with the arrangement and
amalgamations will be useful for the unscrupulous as an escape route?

There is a general assumption that the provisions of Act especially provisions providing
for compromise, arrangement or amalgamation, are getting misused. Even though, there
is nothing in law even by implication to suggest that the provisions will get misused, it is
general thought that the persons charged with will take the plea that the application has
been filed for sanctioning the scheme and the proceedings will automatically get abated.
Law is very clear in this regard that the criminal proceedings against the persons
connected with the affairs of the company will not get abated just because an application
seeking sanction of scheme is filed or scheme is being implemented.

61
Only the proceedings, to some extent, sought to be stayed when a scheme is filed and
implemented. It is based on the logic that if the civil proceedings are going on
simultaneously when the scheme is being approved, then, the scheme could not be
worked out. Dealing with the same, the High Court of Bombay, in State of Tamilnadu Vs.
Uma Investments Pvt. Ltd (1977) 47 Com Cases 242, was pleased to observe that “it is in
respect of these classes of creditors that a proposal is put forward by the company for a
compromise or arrangement.

The compromises or arrangements are, therefore, concerned with civil liabilities where a
creditor will accept a lesser payment or receive less on distribution or grant time or waive
interest and work out other kindred things. It is not possible to take the view that section
391 is meant for freezing criminal proceedings which may be instituted either by a
creditor or a member of a company or by the State either against the company or its
officers. The section does not provide an umbrella to a company or its directors and
officers for a thing which is an offence or an infringement or violation of any law, rule or
regulation punishable by imprisonment or fine or both. Such criminal proceedings can be
commenced or continued notwithstanding the fact that a scheme for compromise or
arrangement has been initiated under section 391”.

Procedure to be followed while approving the scheme of amalgamation

The procedure to be followed while getting the scheme of amalgamation is approved will
depend upon sections 391 to 394A. Though, section 391 deals with the issue of
compromise or arrangement which is different from the issue of amalgamation as deal
with under section 394, as section 394 too refers to the procedure under section 391 etc.,
all the section are to be seen together while understanding the procedure of getting the
scheme of amalgamation approved. Again, it is true that while the procedure to be
followed in case of amalgamation of two companies is wider than the scheme of
compromise or arrangement though there exist substantial overlapping. The procedure to
be followed while getting the scheme of amalgamation and the important points, are as
follows:

(1) Any company, creditors of the company, class of them, members or the class of
members can file an application under section 391 seeking sanction of any scheme of
compromise or arrangement. However, by its very nature it can be understood that the
scheme of amalgamation is normally presented by the company. While filing an
application either under section 391 or section 394, the applicant is supposed to disclose
all material particulars in accordance with the provisions of the Act.

(2) Upon satisfying that the scheme is prima facie workable and fair, the Tribunal
order for the meeting of the members, class of members, creditors or the class of
creditors. Rather, passing an order calling for meeting, if the requirements of holding
meetings with class of shareholders or the members, are specifically dealt with in the
order calling meeting, then, there won’t be any subsequent litigation. The scope of
conduct of meeting with such class of members or the shareholders is wider in case of

62
amalgamation than where a scheme of compromise or arrangement is sought for under
section 391.

(3) The scheme must get approved by the majority of the stake holders viz., the
members, class of members, creditors or such class of creditors. The scope of conduct of
meeting with the members, class of members, creditors or such class of creditors will be
restrictive some what in an application seeking compromise or arrangement.

(4) There should be due notice disclosing all material particulars and annexing the
copy of the scheme as the case may be while calling the meeting.

(5) In a case where amalgamation of two companies is sought for, before approving
the scheme of amalgamation, a report is to be received form the registrar of companies
that the approval of scheme will not prejudice the interests of the shareholders.

(6) The Central Government is also required to file its report in an application
seeking approval of compromise, arrangement or the amalgamation as the case may be
under section 394A.

(7) After complying with all the requirements, if the scheme is approved, then, the
certified copy of the order is to be filed with the concerned authorities.

Legal & Tax Issues - Transferor Company

1. Capital Gains

The Income-tax Act provides for capital gains tax exemption to a company being
amalgamated into another company, and also to the shareholders of the amalgamating
company on the fulfillment of specified conditions.

2. Depreciation

1. The transferor company would be eligible for depreciation up to the date of

amalgamation.
2. Amendment to Software Technology Park of India (STPI) and Customs approvals
3. Applications would have to be made for seeking amendments to the STPI and
Customs approvals obtained by the transferor company for its Export Oriented
Undertakings (EOU) unit, to reflect the change in the legal entity.

3. Stamp duty

Stamp duty would be levied on the documents executed for the transfer of properties,
based on the value of the properties conveyed by the documents. The rates would depend
upon the nature of the property and its location.

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4. Sales tax

Transfer of assets as part of a merger should not be liable to sales-tax.

Legal & Tax Issues - Transferee Company

1. Income tax – depreciation

The Act provides that * where any assets are transferred by an amalgamating company to
an amalgamated company, in a scheme of merger, and the merged company is an Indian
company, the actual cost of the transferred capital asset to the amalgamated company
would be the same as it would have been if the amalgamating company has continued to
hold the capital asset for the purposes of its own business.

* Explanation 7 to section 43(1) of the Income-tax Act, 1961.

Further, where any block of assets is transferred by the amalgamating company to the
amalgamated company in a scheme of amalgamation, the actual cost of the block of
assets in the hands of the amalgamated company would be the written down value of the
block of assets in the hands of the amalgamating company for the immediately preceding
previous year as reduced by the amount of depreciation actually allowed during the year
of transfer.

Availability of tax losses of the amalgamating company to the amalgamated company

the following conditions need to be complied with.

The amalgamating company must have been engaged in the business in which the
accumulated loss occurred or depreciation remains unabsorbed, for three or more years.

The amalgamated company must: -

1. Held continuously on the date of the amalgamation at least three-fourths of the

book value of fixed assets held by it two years prior to the date of amalgamation.

2. Hold continuously for a minimum period of five years from the date of the
amalgamation at least three-fourths of the book value of fixed assets of the
amalgamating company acquired in a scheme of amalgamation.

3. Continue the business of the amalgamating company for a minimum period of

five years from the date of amalgamation.

4. Fulfill such other conditions as may be prescribed to ensure the revival of the
business of the amalgamating company or to ensure that the amalgamation is for
genuine business purpose.

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Activity 2

1. Discuss various measures of profit. What is the relevance of concept of profit in

business?

2. Explain determination of profit and its disposal under companies act 1956.

3. Distinguish between internal and external reconstruction. What do you understand

by S425 Scheme of Arrangement?

4. Describe various issues associated with amalgamation of companies.

2.7 SUMMARY

Unit 2 focuses on concept of profit and its provisions under company’s acts 1956. Unit
also discusses issues related to reconstruction and amalgamation of companies.
Introduction to profit concept was first given followed by measures to ascertain and show
profits in financial statements of companies. Various types of profits including optimum
profit, gross profit and net profit are discussed in detail. Reconstruction of companies was
the next area of discussion. The need for reconstruction arises when a company has
accumulated losses or when a company finds itself overcapitalized which means either
that the value placed on assets is too much as compared to their earning capacity or that
their profits as a whole are insufficient to pay a proper dividend. External and internal
reconstruction was described as two types of reconstruction and schemes of
reconstruction with special reference to S425 scheme of arrangement were highlighted.
Finally various measures related to amalgamation of companies were discussed in great
detail.

2.8 FURTHER READINGS

 Carl S. Warren, James M. Reeve, Philip E. Fess. Corporate Financial Accounting

(Corporate Financial Accounting). South-Western College

 Elliot, Barry & Elliot, Jamie: Financial accounting and reporting, Prentice Hall,
London 2004

 Katuri Nageswara Rao 2002 Asset Reconstruction Companies- Concepts and

Country Experiences Book Description. Icfai university press

 Pyle, William W., and Kermit D. Larson (1981). Fundamental Accounting

Principles. Homewood, Illinois: Richard D. Irwin

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 UNIT 3

DOUBLE ACCOUNTING SYSTEM AND ELECTRICITY

SUPPLY COMPANIES

Objectives

After completing this unit, you should be able to:

 Understand the concept of double accounting system and its main features
 Become aware of the books of accounts under double accounting system

 Understand the process of book keeping

 Know the receipt and payment on capital account and general balance sheet of an
electricity company

 Discuss the reasonable returns in electricity supply companies

Structure

3.1 Introduction
3.2 Double entry accounting system
3.3 Main features of double accounting system
3.4 Books of accounts
3.5 Book keeping process
3.6 Receipt and payment on capital account and general balance sheet of Electricity
Company
3.7 Returns in electricity supply companies
3.8 Summary
3.9 Further readings

3.1 INTRODUCTION

The double-entry bookkeeping system was codified in the 15th century and refers to a set
of rules for recording financial information in a financial accounting system in which
every transaction or event changes at least two different accounts. In modern accounting
this is done using debits and credits within the accounting equation: assets = liabilities +
equity. The accounting equation serves as a kind of error-detection system: if at any point
the sum of debits does not equal the corresponding sum of credits, an error has occurred.

66
Since several different types of errors result in equal sums for debits and credits, double-
entry accounting is not a guarantee that no errors have been made.

Double-entry bookkeeping has been considered a fundamental innovation and a

cornerstone of Capitalism by such thinkers as Werner Sombart and Max Weber, Sombart
writing in "Medieval and Modern Commercial Enterprise" that:

"The very concept of capital is derived from this way of looking at things; one can
say that capital, as a category, did not exist before double-entry bookkeeping.
Capital can be defined as that amount of wealth which is used in making profits
and which enters into the accounts."

3.2 DOUBLE ENTRY ACCOUNTING SYSTEM

An accounting system records, retains and reproduces financial information relating to

financial transaction flows and financial position. Financial Transaction Flows encompass
primarily inflows on account of incomes and outflows on account of expenses. Elements
of financial position, including property, money received, or money spent, are assigned to
one of the primary groups i.e. assets, liabilities, and equity.

Within these primary groups each distinctive asset, liability, income and expense is
represented by its respective "account". An account is simply a record of financial
inflows and outflows in relation to the respective asset, liability, income or expense.
Income and expense accounts are considered temporary accounts, since they represent
only the inflows and outflows absorbed in the financial-position elements on completion
of the time period.

3.2.1 Account types (nature)

Type Represent Examples

Tangibles - Plant and Machinery,
Physically tangible things in the real Furniture and Fixtures, Computers and
Real world and certain intangible things not Information Processing Equipment etc.
having any physical existence Intangibles - Goodwill, Patents and
Copyrights
Individuals, Partnership Firms,
Corporate entities, Non-Profit
Personal Business and Legal Entities Organizations, any local or statutory
bodies including governments at
country, state or local levels
Temporary Income and Expenditure
Accounts for recognition of the
Nominal implications of the financial Sales, Purchases, Electricity Charges
transactions during each fiscal year till
finalisation of accounts at the end

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Example: A sales account is opened for recording the sales of goods or services and at the
end of the financial period the total sales are transferred to the revenue statement account
(Profit and Loss Account or Income and Expenditure Account).

Similarly expenses during the financial period are recorded using the respective Expense
accounts, which are also transferred to the revenue statement account. The net positive or
negative balance (profit or loss) of the revenue statement account is transferred to
reserves or capital account as the case may be.

3.2.2 Account types (periodicity of flow)

The classification of accounts into real, personal and nominal is based on their nature i.e.
physical asset, liability, juristic entity or financial transaction.

The further classification of accounts is based on the periodicity of their inflows or

outflows in the context of the fiscal year.

Income is immediate inflow during the fiscal year.

Expense is the immediate outflow during the fiscal year.

An asset is a long-term inflow with implications extending beyond the financial period
and by the traditional view could represent unclaimed income. Alternatively, an asset
could be valued at the present value of its future inflows.

Liability is long term outflow with implications extending beyond the financial period
and represents unamortised expense as per the traditional view. Alternatively, a liability
could be valued as the present value of future outflows.

Type of Long term Long term Short term Short term

accounts inflows outflows inflows outflows
Real accounts Assets
Personal
Assets Liability
accounts
Nominal
Incomes Expenses
accounts

Items in accounts are classified into five broad groups, also known as the elements of the
accounts: Asset, Liability, Equity, Revenue, Expense.

The classification of Equity as a distinctive element for classification of accounts is

disputable on account of the "Entity concept", since for the objective analysis of the
financial results of any entity the external liabilities of the entity should not be
distinguished from any contribution by the shareholders.

3.2.3 Accounting entries

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  The double-entry accounting system records financial transactions in relation to
asset, liability, income or expense related to it through accounting entries.
 Any accounting entry in the-double entry accounting system has two effects: one
of increasing one account, the other of decreasing another account by an equal
amount.
 If the accounting entries are recorded without error, at any point in time the
aggregate balance of all accounts having positive balances will be equal to the
aggregate balance of all accounts having negative balances.
 The double-entry bookkeeping system ensures that the financial transaction has
equal and opposite effects in two different accounts.
 Accounting entries use terms such as debit and credit to avoid confusion
regarding the opposite effect of the accounting entry e.g. If an accounting entry
debits a particular account, the opposite account will be credited and vice versa.
 The rules for formulating accounting entries are known as "Golden Rules of
Accounting".
 The accounting entries are recorded in the "Books of Accounts".

3.3 MAIN FEATURES OF “DOUBLE ACCOUNTS” SYSTEM

Double accounts system is the name given to the system of preparing the final accounts
of certain statutory companies formed by special Acts of parliament, usually public utility
undertakings (for example Electricity Companies). The double accounts system is not a
special method of keeping accounts, rather a special method of presenting accounts
which are kept under the normal double entry system. Under this system, separate
accounts in respect of capital and revenue are prepared in order to show clearly the
capital receipts and the manner in which the amounts thereof have been invested. The
final accounts prepared under the double accounts system normally consist of :

(i) Revenue Account

(ii) Net Revenue Account
(iii) Capital Account (Receipts and Expenditure on capital account)
(iv) General Balance Sheet.

The Revenue account is analogous to the Profit & Loss Account of a company with some
exceptions. The Net Revenue Account resembles with appropriation portion of the Profit
& Loss Account of a company. The Balance Sheet is presented in two parts namely
Capital Account and General Balance Sheet. The Capital Account shows the total amount
of capital raised and its sources and also the manner and extent to which this capital has
been applied in the acquisition of fixed assets for the purpose of carrying on the business.
The General balance sheet includes the other items.

The Double accounts system in its pure form does no longer exist but the statements
submitted to State Governments by electricity companies generally follow the principle
of double accounts system. It may be noted that for presenting accounts to the
shareholders, electricity companies normally follow Schedule VI of the Companies Act,
1956.

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3.4 BOOKS OF ACCOUNTS

It does this by ensuring that each individual financial transaction is recorded in at least
two different nominal ledger accounts within the financial accounting system. The two
entries have equal amounts and opposite signs, so that when all entries in the accounts are
summed, the total is exactly the same: the accounts balance. This is a partial check that
each and every transaction has been correctly recorded. The transaction is recorded as a
"debit entry" (Dr.) in one account, and a "credit" (Cr.) entry in the other account. A debit
entry generally means that value has been added to the account, and a credit entry means
that value is being subtracted from the account. The debit entry will be recorded on the
debit side (left-hand side) of a nominal ledger account and the credit entry will be
recorded on the credit side (right-hand side) of a nominal ledger account. A nominal
ledger has a Debit (left) side and a Credit (right) side. If the total of the entries on the
debit side is greater than the total on the credit side of the nominal ledger account, that
account is said to have a debit balance.

An example of an entry being recorded twice for double-entry bookkeeping would be a

supplier's invoice for stationery costing Rs.100. The expense or Debit entry is Stationery
Nominal Ledger a/c Rs.100 Dr (showing that Rs.100 has been spent on stationery) and
the Credit entry is to the Supplier's Control Nominal Ledger a/c Rs.100 Cr (showing that
we now owe the supplier Rs.100). This transaction has now been recorded twice in the
financial accounting system and the total value is Rs.100 for both Debit and Credit
values.

Double entry is used only in nominal ledgers. It is not used in daybooks, which normally
do not form part of the nominal ledger system. The information from the daybooks will
be used in the nominal ledger and it is the nominal ledgers that will ensure the integrity of
the resulting financial information created from the daybooks (provided that the
information recorded in the daybooks is correct).

(The reason for this is to limit the number of entries in the nominal ledger: entries in the
daybooks can be totaled before they are entered in the nominal ledger. If there are only a
relatively small number of transactions it may be simpler instead to treat the daybooks as
an integral part of the nominal ledger and thus of the double-entry system.)

However as can be seen from the examples of daybooks shown below, it is still necessary
to check, within each daybook, that the postings from the daybook balance.

The double entry system uses nominal ledger accounts. From these nominal ledger
accounts a Trial balance can be created. The trial balance lists all the nominal ledger
account balances. The list is split into two columns, with debit balances placed in the left
hand column and credit balances placed in the right hand column. Another column will
contain the name of the nominal ledger account describing what each value is for. The
total of the debit column must equal the total of the credit column.

70
From the Trial balance the Profit and Loss Statement and the Balance Sheet can then be
produced. The Profit and Loss statement will contain nominal ledger accounts that are
Income or Expense type nominal ledger accounts. The Balance Sheet will contain
nominal ledger accounts that are Asset or Liability accounts.

3.5 BOOKKEEPING PROCESS

The bookkeeping process refers primarily to recording the financial effects of financial
transactions only into accounts. The variation between manual and any electronic
accounting system stems from the latency between the recording of the financial
transaction and its posting in the relevant account. This delay, absent in electronic
accounting systems due to instantaneous posting into relevant accounts, is not replicated
in manual systems, thus giving rise to primary books of accounts such as Sales Book,
Cash Book, Bank Book, Purchase Book for recording the immediate effect of the
financial transaction.

In the normal course of business, a document is produced each time a transaction occurs.
Sales and purchases usually have invoices or receipts. Deposit slips are produced when
lodgements (deposits) are made to a bank account. Cheques are written to pay money out
of the account. Bookkeeping involves, first of all, recording the details of all of these
source documents into multi-column journals (also known as a books of first entry or
daybooks).

For example, all credit sales are recorded in the Sales Journal; all Cash Payments are
recorded in the Cash Payments Journal. Each column in a journal normally corresponds
to an account. In the single entry system, each transaction is recorded only once. Most
individuals who balance their cheque-book each month are using such a system, and most
personal finance software follows this approach.

After a certain period, typically a month, the columns in each journal are each totaled to
give a summary for the period. Using the rules of double entry, these journal summaries
are then transferred to their respective accounts in the ledger, or book of accounts.

For example the entries in the Sales Journal are taken and a debit entry is made in each
customer's account (showing that the customer now owes us money) and a credit entry
might be made in the account for "Sale of Class 2 Widgets" (showing that this activity
has generated revenue for us). This process of transferring summaries or individual
transactions to the ledger is called posting. Once the posting process is complete,
accounts kept using the "T" format undergo balancing, which is simply a process to arrive
at the balance of the account.

As a partial check that the posting process was done correctly, a working document called
an unadjusted trial balance is created. In its simplest form, this is a three column list. The
first column contains the names of those accounts in the ledger which have a non-zero
balance. If an account has a debit balance, the balance amount is copied into column two
(the debit column). If an account has a credit balance, the amount is copied into column

71
three (the credit column). The debit column is then totaled and then the credit column is
totaled. The two totals must agree - this agreement is not by chance - because under the
double-entry rules, whenever there is a posting, the debits of the posting equal the credits
of the posting. If the two totals do not agree, an error has been made either in the journals
or during the posting process. The error must be located and rectified and the totals of
debit column and credit column recalculated to check for agreement before any further
processing can take place.

Once the accounts balance, the accountant makes a number of adjustments and changes
the balance amounts of some of the accounts. These adjustments must still obey the
double-entry rule. For example, the "Inventory" account asset account might be changed
to bring them into line with the actual numbers counted during a stock take. At the same
time, the expense account associated with usage of inventory is adjusted by an equal and
opposite amount.

Other adjustments such as posting depreciation and prepayments are also done at this
time. This result in a listing called the adjusted trial balance. It is the accounts in this list
and their corresponding debit or credit balances that are used to prepare the financial
statements.

Finally financial statements are drawn from the trial balance, which may include:

 the income statement, also known as the statement of financial results, profit and
loss account, or P&L
 the balance sheet, also known as the statement of financial position
 the cash flow statement
 the statement of retained earnings, also known as the statement of total recognised
gains and losses or statement of changes in equity

3.6 “RECEIPT AND PAYMENT ON CAPITAL ACCOUNT” AND

“GENERAL BALANCE SHEET” OF ELECTRICITY COMPANY

Under the double accounts system, which is followed by a public utility concern, the
balance sheet is split into two parts : (a) Receipt and payment on capital account and (b)
General Balance Sheet.

The main purpose of the former is to show (i) the total amount of capital raised its
sources and (ii) the manner and the extent to which this capital has been applied in the
acquisition of fixed assets for the purpose of carrying on the business of the undertaking.
It thus discloses the receipt and expenditure on capital account, that is, the receipts from
issue of shares, debentures and loans and the expenditure, out of such receipts, on
acquisition of and addition to fixed assets.

The receipt and expenditure on capital account is shown in a columnar form. There are
three money columns: (a) one showing the amount at the commencement of the period;

72
(b) another disclosing the amount received or spent during the period; and (c) the third
showing the balance left at the end of the period.

The other part (called general balance sheet) contains other assets and liabilities and the
balance of the receipt and expenditure on capital account. It is drawn up in the usual way,
showing on the liabilities side–reserves, depreciation fund, current liabilities and other
credit balances and total receipts as per capital account, on the assets side–total of
expenditure as per capital account, floating assets and other debit balances.

3.7 RETURNS IN ELECTRICITY SUPPLY COMPANIES

The law seeks to prevent an electricity undertaking from earning too high a profit. For
this purpose, “reasonable return” has been defined as consisting of :

(a) A yield at the standard rate which is Reserve Bank rate plus two percent on the capital
base as defined below;

(b) Income derived from investment except investment made against Contingencies
Reserve;

(c) An amount equal to 1/2% on loans advanced by the Electricity Board;

(d) An amount equal to 1/2% on the amounts borrowed from organisations or institutions
approved by the State Government;

(e) An amount equal to 1/2% on the amount raised by the issue of debentures;

(f) An amount equal to 1/2% on balance of Development Reserve; and

(g) Such other amounts as may be allowed by the Central Government having regard to
the prevailing tax structure in the country.

The term “Capital Base” used above can be defined as:

(a) The original cost of fixed assets available for use and necessary for the purpose of the
undertaking less contributions, if any made by the consumers for construction of service
lines and also amounts written off;

(b) The cost of intangible assets;

(c) The original cost of work in progress;

(d) The amount of investments compulsorily made against contingencies reserve; and

73
(e) The monthly average of the stores, materials, supplies and cash and bank balances
held at the end of each month of the year of account not exceeding in the aggregate an
amount equal to one quarter of the expenditure.

Less:

(i) The amount written off or set aside on account of depreciation of fixed assets and
amounts written off in respect of intangible assets in the books of the undertaking;

(ii) The amount of any loans advanced by the Board;

(iii) The amount of any loans borrowed from organisations or institutions approved by the
State Government;

(iv) The amount of any debentures issued by the licensee;

(v) The amount of security deposits held in cash;

(vi) The amount standing to the credit of the Tariffs and Dividends Control Reserve;

(vii) The amount set apart for the development reserve; and

(viii) The amount carried forward in the accounts of the licensee for distribution to the
consumers.

Illustration 1

Electric Supply Ltd. rebuilt and re-equipped one of their Mains at a Cash Cost of Rs. 40,
00,000. The old Mains thus superseded cost Rs. 15,00,000. The capacity of the new Main
is double that of the old Main. Rs. 70,000 was realised from sale of old materials. Four
old motors valued at Rs. 2,00,000 salvaged from the old Main were used in the
reconstruction. The cost of Labour and Materials is respectively 30% and 25% higher
now than when the old Main was built. The proportion of Labour to Materials in the
Main then and now is 2: 3.

Show the Journal entries for recording the above transactions, if accounts are maintained
according to Double Account System.

74
75
Illustration 2

Power Electric Company decides to replace one of its old plant by an improved plant
with larger capacity. The cost of the new plant is Rs. 16,00,000. Materials and Labour
earlier and now are in the ratio of 4: 6. Original cost of the old plant is Rs. 3,00,000.
Materials cost has gone up by 2½ times and Labour cost by 3 times since then. Old
materials worth Rs. 10,000 were used in the construction of the new plant and Rs. 20,000
were realised from the sale of old materials.

Give the necessary Journal Entries for recording the above transactions.

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Illustration 3

‘H’ Electricity Company earned a profit of Rs.60,00,000 (after tax) after paying
Rs.48,000 at 12% interest on debentures for the year ended 31.3.2007. The following
further information is supplied to you:

Rs.
Share Capital 2,50,00,000
Reserve Fund Investment (invested in 8% Government Securities at par) 60,00,000
Contingencies Reserve Fund Investment (7%) 25,00,000
Loan from State Electricity Board 50,00,000
Development Reserve 16,00,000
Fixed Assets 6,00,00,000
Depreciation Reserve on Fixed Assets 60,00,000

77
Security Deposits of customers 80,00,000
Amount contributed by consumers towards cost of Fixed Assets 4,50,000
Intangible Assets 17,50,000
Tariffs and Dividends Control Reserve 22,00,000
Monthly average of Current Assets 31,00,000

Show, how the profits of the company will be dealt with under the provisions of the
Electricity Act, assuming the bank rate of the year was 8%. All working notes should
form part of your answer.

78
Activity 3

1. Explain in detail the concept of double accounting system.

2. What are the main features of double accounting system?

79
 3. Write short notes on the book keeping process and books of accounts in double
entry system.

4. X Electricity Company Limited decides to replace one of its old plants with a
modern one in April, 2006. The plant when installed in the year 2000, costed the
company Rs.26 lakhs, the components of materials and labour being in the ratio
of 7:3. It is ascertained that the cost of labour and materials have risen by 30%
and 25% respectively. The cost of new plant is Rs.66 lakhs and in addition old
materials worth Rs.92,000 are reused. Old materials worth Rs.1,68,000 are sold.

Under double account system compute the following:

(i) The amount to be written off to Revenue A/c.

(ii) The amount to be capitalized.
(iii) Draw up the necessary Journal entries.
(iv) Draw up the Replacement Account.

3.8 SUMMARY

The unit focuses on discussing double accounting system with special reference to
electricity companies. Double accounting system is an accounting system that records,
retains and reproduces financial information relating to financial transaction flows and
financial position. The next area of discussion was main features of double accounting.
Books of accounts were discussed followed by book keeping process. The bookkeeping
process refers primarily to recording the financial effects of financial transactions only
into accounts. Now focus turned to the accounts of electricity companies. Under the
double accounts system, which is followed by a public utility concern, the balance sheet
is split into two parts: (a) Receipt and payment on capital account and (b) General
Balance Sheet. Returns in electricity supply companies finally were dealt in detailed
manner.

3.9 FURTHER READINGS

 Subhi Y. Labib (1969), "Capitalism in Medieval Islam", the Journal of Economic

History

 G. A. Lee (1977), "The Coming of Age of Double Entry: The Giovanni Farolfi
Ledger of 1299-1300", Accounting Historians Journal

 Livio, Mario (2002). The Golden Ratio. New York: Broadway Books

 Woodford, William; Wilson, Valerie; Freeman, Suellen; Freeman, John (2008).

Accounting: A Practical Approach (2 ed.). Pearson Education

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 UNIT 4
ACCOUNTS OF BANKING, INSURANCE AND
COMPANIES IN LIQUIDATION
Objectives

After reading this unit, you should be able to:

 Understand the concept of bank accounting

 Know the formulation of bank statements
 Discuss the accounting for insurance claim settlements
 Know the meaning of fire insurance
 Identify the calculation of the value of stock lost due to fire
 Have deep understanding of accounts of marine insurance
 Explain the companies in liquidation and their accounts
 Describe the companies liquidation account rules 1965

Structure

4.1 Introduction to bank accounting

4.2 Bank statements
4.3 Accounting for insurance claim settlements
4.4 Fire insurance
4.5 Calculating the value of stock lost due to fire
4.6 Accounting for marine insurance
4.7 Company in liquidation
4.8 Accounts of companies in liquidation
4.9 Companies liquidation account rules 1965
4.10 Summary
4.11 Further readings

4.1 INTRODUCTION TO BANK ACCOUNTING

Bank accounting consists in making written, permanent records of every transaction.

Every penny must be accounted for. The statement of the bank shows the general, or
control, accounts of the bank, and the various books of the bank show the detail of
specific items. It would not be impossible, but it would be entirely impractical, to enter
every figure directly on the statement of condition. We might imagine an enormous sheet
on which the capital is entered as to the ownership of each share of stock. Instead of total
deposits, the balance of each depositor would appear opposite his name. On the other
side, instead of loans and discounts, there would be an itemized list of the loans with the
names of the borrowers. With such a sheet spread out over a floor space of great area, we
might imagine the clerks crawling up and down the columns like flies making debits and

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credits. This is, of course, absurd, but it is precisely what happens, except that the entries
are made on books, loose leaves or cards, and the final results are posted on the statement
of condition which is thus altered day by day.

As in other matters we have mentioned, banks are also alike with respect to bank
accounting, the same principles govern whether the bank is large or small, national bank
or trust company. All the books are a part of the general books, and the extent to which
they are divided depends on the size of the bank. Division is made to fit the capacity of
the clerk. When any part of the work becomes too burdensome for one man, he may be
given an assistant or the books and records will be further divided, so that two men can
do the same thing without conflicting. In very large banks a clerk may spend all his time
listing checks upon a sheet, or adding up certain columns of figures or doing any one of a
thousand things that must be done in the process of keeping accounts. Unless he is
studious and observant, he loses sight of the fact that his work is a part of the whole, he
becomes mechanical, falls into a rut and banking, instead of being an interesting
employment full of possibilities, is to him mere drudgery. He is standing so close to the
machinery that he allows it to master him instead of broadening his vision by study and
thus mastering his task.

The first principle in bank accounting, as in all other bookkeeping, is that for every debit
there must be a credit, and vice-versa. In accordance with this fundamental theory the
books must always be in balance. As we have seen with respect to the statement, every
dollar of liabilities is accounted for by another dollar of resources. This is true of every
bank. If the institution is large enough to be divided into departments, such departments
are charged with all funds passing through their hands, and they must show on their
records what has become of every penny.

Similarly each clerk, bookkeeper or teller accounts at the end of the day for each item of
cash he has handled. When he has done, he is said to have "settled," "balanced" or "struck
a proof." Every bank clerk has had the experience of remaining at his desk until a late
hour at night checking up his day's work searching for a difference of a few cents. Often
he becomes embittered at what seems to him a tyranny when the small sum of money
involved is considered. The reason he must settle, however, is not on account of the
possible loss of ten cents, but because the most important principle in bank accounting is
involved. "Accuracy first" is a motto that should be framed, figuratively at least, upon the
wall of every banking room.

The books used by a bank are of various kinds and their purpose is indicated by name. A
ledger is a book used to keep a record of balances. To "post" means to enter in the proper
columns either the debits or credits on the ledger, and the difference between them
represents the balance either due by or to the bank. Most banks are doing away with
bound books, especially ledgers, and substituting cards or loose leaves. This plan enables
several men to work on the same records, which would be impossible if they were bound
in a single book. Alphabetical division is also easier of adjustment and "inactive"
accounts can be readily separated from "active" accounts. Totals of balances can be listed

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upon adding machines for proof more easily from loose sheets than from bound books.
But whether bound or not, records of balances are kept upon ledgers.

A journal is a book in which daily transactions are listed in regular order as to accounts,
and the total debit or credit is then posted on the ledgers. Journals, too, may be loose
sheets so that they can be inserted in the carriage of an adding machine; indeed, machines
have been invented upon which both debits and credits may be written and the machine
will automatically subtract or add and print the new balance. The journal, then, is merely
a subdivision of the ledger.

A depositor of the bank wishes his account to be charged and the money paid to a named
payee. The piece of paper upon which he writes this order is a "check." If he deposits
money, he writes the memorandum of the amount upon a ruled slip of paper and this is
the "deposit ticket." Bookkeepers enter debit and credit records upon their journals
directly from these items. Money, however, may change hands or from one account to
another, in other ways; by letter, telegram or other debit and credit advice. In such cases a
"charge ticket" or "credit slip," as the case may be, is signed or initialed by an officer of
the bank, and entry with full explanation is made upon a book from which record the
bookkeeper makes his entries. This book is known as a "scratcher," "tickler" or a
"blotter." The terms mean practically the same thing. A book upon which a complete
description of a negotiable instrument or transaction is made for a permanent record or
for reference, is called a register. For example, bond register, collection register, etc.

All other books, cards, sheets of whatever nature are a part or subdivisions of these
books. Often they become known among the clerks by some other name descriptive of
their general appearance. For instance, the general ledger scratcher in one bank is known
as the "red book," while the collection department scratcher is the "black book." These
names have stuck through generations of clerks, and a young man going into another
bank has been known to ask for the "black book," and being untrained in accounting, he
had difficulty in making himself understood. Similarly, in New York City banks the
pigeonholed desk where checks are assorted for the clearing house is generally known as
the "clearing house rack." A New York bank clerk visiting a Philadelphia institution and
asking to see the "rack" would probably be shown a hat room.

The records made by one clerk upon one set of books, in a well-appointed accounting
system, go to check the records of another clerk upon a different set of books. For
instance, the paying teller and the receiving teller will each keep a record of checks
cashed or deposited payable within the bank. The debit postings of the individual
bookkeeper would agree with the teller's figures. Skillful accounting lies in making the
fullest possible use of original entries, at the same time having a check on all figures to
guard against either error or fraud. Many young bank men have materially increased their
salaries and rate of promotion by devising improved accounting methods.

As has been said, every transaction ultimately affects the bank's statement of condition by
debit or credit.. A deposit of Rs.1,000.00 is made, consisting of Rs.200.00 cash, and
checks as follows: Rs.200.00 on the bank itself and Rs.600.00 payable in another city. At

83
the end of the day (assuming this to be the only deposit), on the liabilities side there is an
increase of Rs.800.00, all of which appears in the item "deposits" being the total
Rs.1,000.00, less the check for Rs.200.00 which is charged to the account of the drawer.
On the resource side, then, we must have a corresponding increase of Rs.800.00, and this
is made up by an increase in the cash of Rs.200.00 and an increase of Rs.600.00 in the
item "due from banks." Or a transaction may appear on one side of the statement only.
The bank has sold Rs.5,000.00 of the bonds it owns.

The bond item of resources would show a reduction of this amount, and either "cash" or
"due from banks" would be increased, depending whether payment was made in cash or
by check. If payment for the bonds is made with a check on the bank itself, both sides of
the statement are affected, a corresponding reduction in deposits taking place.

4.2 BANK STATEMENTS

With this explanation of the various items, we can now use an outline of our bank
statement to show how the institution "works."

Assets Liabilities

Loans........Rs.400,000.00 Capital........ Rs.100,000.00

Bonds........ 100,000.00 Surplus....... 75,000.00

Due from banks 50,000.00 Circulation.......... 75,000.00

Banking house. 50,000.00 Deposits...... 450,000.00

Cash......... 100,000.00

Rs.700,000.00 Rs.700,000.00

Assuming that the bank has started with capital fully paid in and with some deposits, a
building is secured, a few loans made, bonds purchased and the proper proportion of cash
or reserve is placed in the vaults. Accounts are opened with other banks, a part of the
earnings is set aside in the surplus fund and the bank finally grows to the dimensions
shown in the statement. Now let us reverse the process, and see what happens if a panic
should occur or the depositors want their money. We must keep in mind the fact that both
sides of the statement are always equal. As the deposits begin to fall, the cash is the first
resource available to meet the drain. Then the amount due from banks is called upon and
other institutions pay this amount with cash which helps to keep the bank going.

84
Loans are falling due, and as they are paid, this money also goes to the depositors. Then
perhaps the bonds are sold and so until all the resources are realized upon and the
depositors are paid off. In actual practice, however, when trouble starts, all the depositors
want their money at the same time and they want it right away. They do not know that
basis-of - credit money or deposits cannot be converted into medium-of - exchange
money at short notice. When this situation arises, banks are compelled to suspend specie
payments because there is not enough specie to go around. Making use of the note issue
function, the bank would pay the depositors with its own notes or promises to pay which
circulate as money. Now we see why note issue is such an important matter. Bank notes
to be useful, as money, must enjoy the confidence of the people or they will not be
accepted. Now let us apply the Federal Reserve Act to our bank statement. Under this Act
the bank, instead of being obliged to suspend payment to its depositors, can take a part of
its loans and discounts to the Federal Reserve Bank and the Reserve Bank will give its
own notes in payment. In the statement this reduces the bank's loans and increases its
cash.

The public, knowing that these great banks must keep a large gold reserve, will accept the
notes and the panic or demand for money slowly subsides. The scare being over, and
having no use for the money as a medium of exchange, the people redeposit it in the
banks, the banks deposit the Federal Reserve notes in the reserve banks and they are then
cancelled and retired from circulation.

Let us suppose our bank has made some "bad loans" that are not paid when due. This
reduces the assets so that they will not equal the liabilities. What happens? The bank
reduces the surplus fund the same amount so that there is no loss to the depositors. If,
however, the bad loans are larger than the surplus, the bank will be closed by the Banking
Department or the Comptroller of the Currency, and the stockholders are then liable for
an assessment equal to the amount of stock they hold to make up the loss.

Illustration 1

Balance sheet and income statement of a bank

Balance sheet

2005 2006 2007 2008 2009

Balance sheet
Rs. millions
Assets 1,649,313 1,842,356 2,059,366 2,445,855 2,354,769
Cash and deposits 39,599 41,547 46,452 51,023 51,469
Accounts receivable and accrued
revenue 5,462 5,798 8,105 8,643 7,769

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Investments and accounts with
affiliates 85,561 98,906 101,245 140,637 131,657
Portfolio investments 316,657 375,345 416,860 461,805 501,855
Loans 1,041,937 1,154,075 1,271,897 1,343,049 1,382,449
Mortgage 515,635 557,342 611,799 618,057 646,398
Non-mortgage 526,302 596,733 660,098 724,992 736,051
Allowance for losses on
investments and loans -7,427 -6,438 -6,094 -7,435 -8,647
Bank customers' liabilities under
acceptances 39,434 52,936 60,822 65,922 49,496
Net capital assets 9,222 9,669 10,290 10,829 9,273
Other assets 118,868 110,513 149,788 371,380 229,445
Liabilities 1,536,139 1,711,991 1,922,424 2,270,988 2,170,649
Deposits 1,141,463 1,248,120 1,398,581 1,528,586 1,548,588
Actuarial liabilities of insurers 0 0 0 0 0
Accounts payable and accrued
liabilities 11,722 15,143 17,501 19,771 16,536
Loans and accounts with affiliates 11,466 11,373 17,231 16,967 15,627
Borrowings 33,446 37,317 44,614 54,104 54,337
Loans and other borrowings 7,805 9,007 13,220 14,120 17,322
Bankers' acceptances and paper 0 0 0 0 0
Bonds and debentures 25,495 28,059 31,255 39,634 37,010
Mortgages 145 251 138 351 4
Future income tax 322 335 253 260 -2,679
Bank customers' liabilities under
acceptances 39,310 52,936 60,888 65,963 49,555
Other liabilities 298,410 346,766 383,355 585,336 488,685
Equity 113,173 130,364 136,943 174,867 184,120
Share capital 42,018 44,145 48,274 73,190 79,367
Contributed surplus and other 9,410 10,128 7,454 10,043 6,500
Retained earnings 61,745 76,091 81,215 91,634 98,252

86
4.3 ACCOUNTING FOR INSURANCE CLAIM SETTLEMENTS

Insurance is a necessity in any business. Businesses cover themselves against losses such
as fire, theft and unexpected natural disasters. It is with the bookkeeping or accounting
that owners get it wrong.

On successful insurance claims, a payment is normally made to the insured. Experience

has led many to believe that small businesses have no clue, as to how, to account for
insurance settlements. Most businesses reflect the payment as income.

Not only would this be deceptive but also violates International Accounting Standards.
Since the transaction has everything to do with assets and nothing to do with income, it
should be adjusted against assets. Erroneous accounting for assets might prejudice the
business further in future, if similar insurance claims are made.

Insurance companies settle claims on assets, on its book value and not its costs. (And yet
the asset was insured on its cost at date of purchase). Whereas this principle might vary
from country to country, book value is widely accepted as the norm. Since most small
businesses fail to maintain proper fixed assets registers, insurance companies perform
"desk top valuations", or make an "estimate", on the book value, mostly much lower than
its "real" book value. Without proper records, the claimant cannot debunk the assessor's
final conclusions.

If an asset is on the books at least, without the asset register, but business has no purchase
date, and this asset is lost due to theft, no accurate wear and tear can be furnished.
Furthermore, if a claim is settled, and reflects as "income", what happens to the asset that
was stolen, but still reflects on your books?

The method used to account for insurance claims is the "disposal method". Any asset
subject to an insurance claim should be transferred to a "Disposal Account". Depreciation
on the asset for the relevant period is calculated, and credited to the disposal account with
the insurance settlement. The cost, less depreciation equals book value. Any settlement
amounts over or under book value, will result in a loss or profit on disposal.

An insurance claim, wrongly entered as "income", can be adjusted by transferring the

amount to the disposal account. After effecting these entries, the disposal account should
balance to zero. new records would reveal, the loss or profit on claim (income statement),
settlement in bank account, fixed assets less the stolen/lost asset, and a lower depreciation
estimate for the year.

This is the accountant's job; however this is the duty of management to provide accurate
records. But how many businesses continue to pay, the same insurance premiums on the
assets, since purchase date, when they, entitled to a lower premium, due to a lower asset
value (Prior to any asset losses).

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Also, a precarious asset situation in the books, might lead to problems in tax affairs.

4.4 FIRE INSURANCE

Fire insurance is a contract between the insurance company and the policy-holder
wherein the insurance company undertakes in exchange for a premium to indemnify the
loss or damage caused to the specified property of the insured by fire or lightning. The
contract will be for a specified period of time and the company will compensate for the
actual loss caused by fire which in no case exceeds the maximum limit of the insured
amount.

4.4.1 Essentials of a Fire Insurance Contract

The main essentials of fire Insurance contract ar as follows:

1. Contract of indemnity

Fire insurance like the marine insurance is a contract of indemnity. The insured can
claim the actual loss caused to the property by fire, remaining of course within the
insured amount. The insured cannot make a profit from contract. A policy-holder cannot
get an overvalued fire

2. policy of his property

This will encourage the insured to get his property burned to ashes and then claim the full
insured amount and make a profit out of it.

3. Prescribed period

The fire insurance contract is for a specified period of time usually for one year. It is
annually renewed by the payment of a fresh premium.

4. Claim the market value of the property

The claim is determined by measuring the actual loss or damage. The amount which
appears on the face value of the policy expresses the limit of liability of the company.

5. Payment of the claim

The payment of the insured property damaged by fire as per contract is made to the
person or persons named in the policy as insured.

6. Interest of the policy.

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If the fire insurance contract covers the building, then the claim in the even of loss will be
met of the building only. If the policy gives a "Package" or multi-insurance coverage in
one policy, covering fire, theft, burglary, car liability, etc. etc.. and only one premium is
paid for this 'package policy', then in the event of loss, the policy holder is indemnified
(paid) for the total loss remaining within the limit of the liability of the money.

7. Assignment of Policy

The insured under the contract cannot assign his interest in the policy to any third party
without getting prior consent of the company. The assignment without the consent of the
company is void at law.

8. Consequential loss

The consequential loss (business interruption unless specifically covered under the
contract are not a part of fire loss.

9. Direct loss and damage

The fire insurance contract also says that loss to be covered by the policy must be a direct
loss i.e... The fire must be immediate cause of the loss

10. Insurable Interest

In a fire insurance contract, the insured must have interest in the subject matter of the
policy failing which the contract is void at law. Insurable interest is created when in the
event of a loss, the insured a financial loss himself and when compensated by the
company, he is financially restored to his previous position.

11. Absolute good faith

The insurer and the insured will place all the cards at the table and will not willfully
conceal or misrepresent any material fact from each other. The concealment or fraud
before or after a loss will make the policy void at law.

4.4.2 The fire claim and its settlement

1. Claim Form

The insurance company on receipt of the notice will supply a claim form to the insured.
The policy-holder is required to furnish a complete inventory of the destroyed, damaged,
undamaged property, showing in details quantities, costs, actual cash value and the
amount of loss claimed.

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2. Evidence

The insured should try to produce the documentary proof of the actual loss as far as
possible to the company. The books of account, bills etc .if attached with the claim help
the company in the early settlement of claims.

3. Proof of loss

In order to determine the insurer's liability, the policyholder is also required to furnish a
signed and sworn statement of the (1) time and origin of loss (2) the interest of the
insured (3) the cash value of the loss (4) any change in the title of the property insured (5)
by whom and for what purpose the building was occupied at the time of loss etc. etc.

4. Inspection and assessment of loss

The insurance company sends its specialized surveyor to examine and determine the loss
in the light of documents and forms received from the policy-holder.

5. Time limit of paying claims

The insurer is to pay the actual loss, remaining within the limits of the insured policy. The
amount shall be payable sixty days after proof of loss is received from the policy-holder.

6. Time Limit for bringing suit

If there is a dispute in the settlement of claim, the parties involved in the insurance
contract, can file a suit within the time limit prescribed in the contract.

7. Arbitration

The insurance companies normally avoid filing a suit in the court in case of disagreement
between the parties. The contract usually provides a clause that in case of a dispute, the
matter shall be referred to a Board of arbitration containing one nominee of the insurer
and one of the insured. The award given by the board is binding on both the parties. In
case there is disagreement among the arbitrators, the case is referred to the umpire whose
judgment shall be final.

4.4.3 Fire Insurance policy and its types

A fire insurance policy is a contact of indemnity. It may be defined as "a contract by

which the insurer in consideration of premium paid by the insured agrees to indemnify
him against any accidental property due to fire, up to the sum agreed upon with him in
the fire policy.

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The main types of insurance policies are as follows:

1. Specific Policy

In case of specific policy, the insurance .make good the loss to the insured to the
maximum extent of the face value of policy. For instance, a house valuing Rs. 5 lac is
insured for Rs. 3 lac only if the houses catches fire and is burnt to ashes, the insured can
claim Rs. 3 lac only it cannot realise more amount from the company.

2. Valued Policy

A valued policy is one in which the insurer has to pay the full value of the subject matter
(goods, securities etc)- If the building is destroyed by fire, the insured has not to prove
the actual value of the loss. The valued policy is against the principle of indemnity and so
is not commonly issued.

3. Floating policy

A floating policy is that which covers several items of goods lying in different localities
under one sum and for one premium. The floating policy is taken by big manufacturers
whose goods are stored in different localities.

4. Average Policy

An average policy is that which contains an average clause. The average clause lays
down that if the property is under insured, the insurer will bear only that part of actual
loss as his insurance bears to the total value of the property.

For example, a property is insured for Rs. 40 thousand as against its value of Rs. 80
thousand. If the loss due to fire is assessed at Rs, 20 thousand: the claim will be settled as
under:

Insured amount x Actual loss Value of property

40000 x 20000Claim = 80000 = Rs" 10<000
In this case, the insured is penalized for under insurance.

5. Comprehensive policy

In comprehensive policy all types of risks such as fire, burglary, riots, strikes, explosion,
lightning, etc are covered Blanket policy. Under blanket policy, both fixed and current
assets of the business are covered under one insurance.

6. Loss of profit policy

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Under this policy, the insured is indemnified against' the loss of profits caused by any
interruption of business by fire.

7. Reinstatement of policy

Under this policy, the insurer pays the amount which is required to reinstate the assets or
property destroyed. The insurer while calculating the amount of claim does not deduct the
amount of depreciation from the original value of the asset.

4.5 CALCULATING THE VALUE OF STOCK LOST DUE TO FIRE

For getting the amount of loss of stock from insurance company, it is very essential to
ascertain the value of loss of stock by fire. The procedure is given as follows:

Statement Form – Ist way

Particular Amount
Stock in the beginning of the year xxxx
Add : purchase from the beginning of accounting
Year to the date of fire (+) xxxx
------------------------------------------------------------------
XXXX
Less : cost of goods sold from the beginning of
Accounting year to the date of fire (-) XXXX
-----------------------------------------------------------------
Value of stock on the date of fire XXXXX
Less : Stock of Salvaged or saved from fire (-) XXXX
-----------------------------------------------------------------
Value of stock lost due to fire XXXXX
----------------------------------------------------------------

Or

You can make memorandum trading accounting - 2nd Way

“Memorandum trading account is not part of final account but it is just part of working
notes for calculating the net value of stock due to fire.”

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Remembering pin –point

1. From both above two methods we must need to calculate gross profit rate. There are
following way to calculate gross profit of business. There are following way to calculate
gross profit of business

i) Average of old year gross profit method

ii) Previous gross profit method

G.P. Rate = Previous year Gross profit / Sale of previous year X 100

2. Average Clause

“ Average clause means insurance company will pay only insurance in the proportion of
actual loss . Before this rule businessman used to take insurance policy below the actual
amount of his asset. So , Now under this method his claim will be reduced . "

Formula of Calculating of Claim of loss of stock =

Amount of policy X stock destroyed

----------------------------------------------
Stock on the date of fire

Suppose, xyz Co. got the insurance policy of Rs. 10000 but his stock value is Rs. 20000
and actual loss is Rs. 5000. Now we will calculate claim under average clause

Claim accept = 5000 X 10000/ 20000 = Rs.2500

Some time, information of opening stock , purchase and sale is not give by businessmen ,
so calculating correct value of loss due to fire it is very necessary to make total debtor
account , total creditor account and previous year trading account .

4.5.1 Calculating loss of profit

Many finance students are confused about how to calculate loss of profit. They know
that businessman can take loss of profit, due to dislocation of business after fire to
concern. It can also take with fire insurance policy. But for getting claim , the
businessman want to calculate exact loss of net profit from the date of fire to that day in
which business becomes normal .

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Computation of Claim:- This requires the determination of the basis on which profit
depends, In some cases, profit my be related to output in which case it would be proper to
determine the loss of output and then ascertain the amount of the profit lost. This is usual
in the case of flour mills, breweries, etc. In some other cases, the loss my be calculated
with reference to the loss in production, capacity, for example, spindles installed in case
of a cotton spinning mill.

Taxes (other than taxes which form part of net profit), Salaries to Permanent Staff and
wages to Skilled Employees, Boarding and Lodging of Resident Director and/or
Manager, Directors' Fees, Auditor, Fees, Traveling- and Expenses, Licenses, Insurance
Premiums, Advertising, Sundry Unspecified standing Charges (not exceeding 5% of the
amount recoverable in respect of the Specified standing charges. )

* Usually these are not covered by the meaning of fire in case of policies on stock or
other assets, However, mostly profit depends on sales and usually y loss of profit the is
computed by first ascertaining how much sales have suffered because of the fire. In this
respect, the following definitions contained in standar5d consequential loss policies
should be understood.

Gross Profit:- The sum produced by adding to the Net Profit the amount of the Insured
Standing Charges, or if there be no Net Profit the amount of the Insured Standing
Charges less such a proportion of any net trading loss as the amount of the Insured
Standing Charges bears to all the standing charges of the business.

Net Profit:- The net profit (exclusive of all capital receipts and accretions and all outlay
properly chargeable to capital) resulting from the business of the Insured at the premises
after due provision has been made for all standing and other charges including
depreciation.

Insured Standing Charges :- Interest on Debentures, Mortgages, Loans and Bank

Overdraft, Rent, Rates and

Indemnity Period. The period beginning with the occurrence of the Damage and ending
not later than twelve months thereafter during which the results of the business shall be
affected in consequent of the Damage.

Illustration 1

From the following information, calculation the amount of claim for consequential loss :-

(i) The policy is for Rs. 49 lakh with six month period of
indemnity.

(ii) A fire broke out on 1st October, 2000 and consequently, sales
for the ensuing three months were affected sales for 3 months

94
 ended 31st December, 1999 were Rs. 10 lakh, sales for 3
months ended 31st December, 2000 were only Rs. 4 lakh.

(iii) Sales for 12 months ended 30th September, 2000 amounted to

Rs. 50 lakh.

(iv) Sales for the year ended 31st March, 2000 amounted to Rs. 45
lakh.

(v) After debiting insured standing charges, Rs. 2,50,000 the net
profit for the eyar ended 31st March, 2000 amounted to Rs. 20
lakh.

(vi) A sum of Rs. 10,000 was spent as additional expenses to

mitigate the loss due to fire.

(vii) Accounts are closed every year on 3st March.

Solution 1

(i) Short sales :

Standard sales i.e. sales for 3 months Rs.
ended 31st December, 1999 10,00,000
Less: Actual sales during 3 months ended 31st December,2000 4,00,000
6,00,000

(ii) Gross profit rate for the year 1999-2000 :

Gross profit rate = Net profit+ Insured standing charges

Sales X 100

= 20,00,000+2,50,00
45,00,000 X 100 = 50%

(iii) Loss of profit = Short sales x gross profit rate

100

= Rs. 6,00,000 x 50
100 Rs. 3,00,000

(iv) Gross Claim : Rs.

Loss of Profit 3,00.000
Add; Additional expenses incurred 10,000

3,10,000

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(v) Net Claim :
Gross profit for 12 months prior to the date of fire = Rs.

50,00,000 X 50 = Rs. 25,00,000.

100
As the amount of the policy Rs. 49 lakh is not less than this amount of gorss profit, the
question of application of average clause does not arises

Hence, net claim = Rs. 3,10,00.

Illustration 2

From the following details, determine the amount of claim under a loss of profit policy:

Indemnity Period ... 6 months

Date of fire ... 1.4.2000
Dislocation continued upto ... 1.8.2000
... Rs.
Sum insured ... 6,00,000
Sales for the last accounting year ... 24,00,000
Net profit for the last accounting year ... 3,40,000
Standing charges fro the last accounting ...
year, all insured ... 2,60,000
Sales for the dislocation period i.e. ...
1.4.2000 to 1.8.2000 ... 3,00,000
Sales for the year 1.4.1999 to 31.3.2000 ...
Sales for the corresponding period in the ... 32,00,000
preceding year, i.e. 1.4.1999 to 1.8.1999 ... 10,00,000

The policy contains 'special circumstances clause' which stipulates for increases of
turnover (standard and annual) by 10% as there is an upward trend in the business.

[ Adapted C.S. (Inter) June, 1995 ]

Solution :

(i) Loss of turnover in the dislocation period : Rs.

Sales for the corresponding period in the preceding year. i.e.

1.4.1999 to 1.8.1999 10,00,000

Add : Agreed increase of 10% for upward trend 1,00,000

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 Standard turnover 11,00,000
Less : Actual turnover in the dislocation period 3,00,000
8,00,000

(ii) Gross profit ratio for the last accounting year :

Gross profit ratio = Net Profit +Insured standing cahrges
Turnover X 100

= 3,40,000+ 2,60,000
24,00,000 X 100

= 6,00,000
24,00,00 X 100 = 25%

(iii) Loss of profit = Loss of turnover X Gross profit ratio

= Rs. 8,00,000 X 25 = Rs. 2,00,000
100
(vi) Net Claim : Rs.
Annual turnover preceding the date of fire 32,00,000
Add : Agreed increase of 10% for upward trend 3,20,000
Adjusted annual turnover 35,20,000

Policy should have been taken for = Rs. 35,20,000 X 25 = Rs. 8,80,000
100

But the the policy has been taken for Rs. 6,00,000 only.
Hence, average clause will be applied.

Net Claim = Loss suffered x Sum insured

Insurable Value

Rs. 2,00,000 x 6,00,000 Rs. 1,36,364

8,80,000

Alternatively, the amount of claim may be calculated as follows :

Loss of turnover = Rs. 8,00,000

Amount of claim will be restricted to the lower of the two percentages calculated
below:

(i) Net profit +Insured standing charges

Turnover of the previous year X 100

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 = 3,40,000+2,60,000
X 100
24,00,000

(ii) Amount of policy

Standard turnover in the 12 months preceding the date of fire.

= 6,00,000
X 100= 17.045%
35,20,000

Hence, Claim = 17.045% of Rs. 8,00,000 = Rs. 1,36,364.

Steps of calculating loss of profit

Ist step

Calculate gross profit ratio:-

As the starting point of this procedure you have to determine the value of gross profit
because loss of profit is easy to calculate by multiplying Gross profit with short of sale in
that disturbance period .

Net profit xxxx

Add Insured standing
Charges of lass year (+) xxxx
-------------------------------------
Gross profit of last year xxxx
-------------------------------------

Gross profit ratio = Gross profit / sale of last year X 100

2nd step

Calculate shortage in sale due to loss of fire

Actual sale of same period of loss xxxx

Add any increase in thrend of sale (+)xxxx
------------------------------------------------
xxxxx
Less actual sale in dislocation period (-) xxxx
--------------------------------------------------
Shortage of sale in dislocation period xxxx
==================================

3rd step

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Calculation of loss of profit

Loss of profit = shortage of sale X G.P. rate / 100

4th Step

Total amount for claim of loss of profit

Loss of gross profit xxxx

Add increase in cost of working (+) xxxx
---------------------------------------------
xxxx
Less saving in standing charges
---------------------------------------------
Amount of claim xxxx
===================================

5th step

Apply average clause

Amount of claim = policy value / amount to be insured

Important notes

1. We will use of only less rate from following rates for calculating correct amount of loss
pf profit

Net profit + Insured standing charges of last accounting year

-------------------------------------------------------------------------- X 100
Sale for the last accounting year

Or

Policy value / sale of 12 months immediately proceeding fire as adjusted for trend .

2. The Indemnity period or dislocation period which will small, that period will be fixed
for calculation of claim.
3. We will calculate loss of sale on the base of future trend of sale.
4. Insured standing charges means all expenses which are mentioned in the policy of loss

99
 of profit. Businessman wants to get these expenses in the case of mishappening. We can
make its list

 Traveling expenses
 Rent, rate and taxes not related with profit of business
 Advertising
 Interest on debentures and loans.
 Auditors fee
 Salaries of permanent staff
 Directors’ fee
 Salaries of permanent staff
 Wages of skilled workers
 All not described expenses must not more than 5% of described standing expenses
.
illustration 3

From the following information, find out the claim under loss of profit policy :-

2007 – net profit for the year Rs. 10000

2007- Standing charges insured Rs. 6000
Rs. sales for 2007 Rs. 160000
Date of fire 1.1.2008
Period of dislocation 3 months
Sales from 1.12007 to 31.3.2007 Rs. 54000
Sales from 1.1.2008 to 31.3.2008 Rs. 19400
Indemnity period 6 months
Policy subject to average clause Rs. 11000
Trend in annual sales 10% increase

Solution
Ist step
Calculation of gross profit ratio

Net profit + Insured standing charges of last yea

100
----------------------------------------------------------- X 100
Sale of last year

10000+6000
---------------------- X 100
160000
= 10%
2nd step
Shortage of sale

Last year’s sale from 1.12007 to 31.3.2007 Rs. 54000

Add 10% for upward trend Rs. 5400
---------------------------------------------------
Rs. 59400
Less actual sale during dislocation period Rs. 19400
-----------------------------------------------------
Shortage of sale Rs. 40000
=====================================
3rd step
Calculate of loss of profit

Loss of sale X G.P. rate /100

40000 X 10/100 = 4000
4th step
Total amount for claim of loss of profit

Loss of gross profit 4000

Add increase in cost of working (+) nil
Less saving in standing charges nil
Amount of claim Rs.4000
5th step
Average clause

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Since the policy is subject to average clause, it is necessary to find out whether expected
profit of the current year was fully insured or not .

Expected sale for current year

Last year sale Rs. 160000

Add :Increase in current year 10% = Rs. 16000
--------------------------------------------
Total sale of current year = 176000
---------------------------------------------
Profit rate 10%
the profit of current year = 176000 X 10% = Rs.17600

But we take the policy of Rs. 11000

This is a case of under insurance. It means insurance company pays Rs. 110 of every
Rs.176 loss

Claim = insurance policy / insurable profit X profit lost

= 11000 / 17600 X 4000 = Rs. 2500

So, amount of claim would be Rs. 2500

4.6 ACCOUNTING FOR MARINE INSURANCE

4.6.1 Losses under marine insurance

The losses in Ocean Marine Insurance are generally of two types Loss (1) Total loss (2)
Partial Loss.

1. Total Loss:

Total loss is subdivided into (i) Actual total loss (ii) constructive total loss.

Actual Total Loss

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The actual total ocean marine loss occurs when the ship carrying the goods sinks in the
sea, catches fire and is burnt to ashes, the pirates take away the ship and remain missing,
and then it is said to be the actual total loss.

Constructive Total Loss

A constructive total loss is said to have taken place when the actual loss appears to be
unavoidable and the expenditure incurred on the repair of ship or the recovery of goods
exceed their total value. Under the above circumstances, the company abandons the
attempt of repairing the ship, or recovering of the cargo and makes the claims of the
policy holders for indemnification.

2. Partial Loss.

Partial Loss technically called average is also subdivided into two categories (a) General
Average (b) Particular Average.

a) General Average

If the ship suffers a loss or damage at sea and the loss is of a general nature which has
been undertaken to preserve the ship or the cargo, then the loss is to be borne by all the
underwriters in the vessel.

b) Particular Average

Particular average is the loss of a particular interest which may be in the ship alone or
cargo alone and is incidentally caused by a peril insured against. In particular average the
loss is partial and is not voluntary.

For instance, a ship may strike against a rock and is partially damaged. The insurer in
such a case will make good the partial loss suffered by the ship.

4.6.2 Types of Marine Insurance

There are three types of marine insurance (i) Cargo insurance (ii) Hull insurance and (iii)
Freight insurance c.

1. Cargo insurance: It is an insurance of the goes shipper.

2. Hull insurance: it is an insurance of ship itself against sea perils.

3. Freight insurance: In many cases, freight is paid on the arrival of at the port of
destination. If the cargo is damaged or lost, the ship company will lose the freight.

103
Freight is, therefore, also covered in marine policy.

4.6.3 Types of Marine Policies

The main types of marine policies based on variety of risks covered are as under:

1. Time policy

This a policy in which the subject matter is insured for a specified period of time say
from April 1997 to Dec. 25, 1997.

2. Voyage policy

The policy is meant to insure the subject matter for a particular voyage say from Karachi
to London.

3. Mixed policy

This policy is meant to cover the subject matter on a particular voyage and for a specified
period of time say from Karachi to London for a period of 4 months.

4. Valued policy

In this policy, the value of the goods insured is agreed upon between the insurer and the
insured and is written in the policy.

5. Unvalued policy

A policy which does not indicate the value of the subject matter is called open or
unvalued policy. The value is assessed when the loss actually takes place.

6. Composite policy

It is a policy which is underwritten by more than one underwriter. The liability of each
underwriter is distinct and separate.

7. Blanket policy

It is a policy which is taken for a certain amount but on the beginning of the policy, the
premium is paid on the whole of it. The adjustment is made at the end of the term of the
policy.

8. Floating policy

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It is a policy which is used by the cargo owners. They insure the shipment expected to be
made during a certain period by one policy. When the goods are loaded and the ship is on
sea, an actual value of the shipment is declared and the actual value of policy is reduced
or increased by that amount.

9. Port policy

It is a policy to cover the vessel when it is anchored in a port.

10. Fleet insurance policy

It is designed to insure a whole fleet of steamers or liners of a company

2.6.4 Essentials of Ocean Marine Insurance Contract

"A contract of marine insurance is a contract whereby the insurer undertakes to indemnify
the insured, in manner and to the extent thereby agreed, against the losses incidental to
marine adventure". The essentials of ocean marine insurance contract are (1) Insurable
interest (2) Disclosure of facts (3) Seaworthiness of the ship (4) Legality of voyage (5)
Non deviation.

1. Insurable Interest

The insured must have insurable interest in the property insured. In the event of loss, if
the facts are found otherwise, the contract will be void at law.

2. Disclosure of all facts

An essential feature of the marine insurance contract is that every contract or insurance
must disclose all the facts. If the principle of 'Utmost Good Faith' is not observed by
either party, the affected party may sue and declare the contract void,

3. Seaworthiness of the ship

The-insurer shall promise to the insured that the ship is in a good condition and can face
the ordinary perils of the sea.

4. Legality of voyage

The insured must also get a guarantee that the voyage of the ship is lawful. The illegality
of the venture makes the contract of insurance void.

105
5. Non-Deviation

The policy holder should also get a guarantee from the insurance company that the ship
will not part or deviate from the prescribed route

4.7 COMPANY IN LIQUIDATION

In law, liquidation is the process by which a company (or part of a company) is brought
to an end, and the assets and property of the company redistributed. Liquidation is also
sometimes referred to as winding-up or dissolution, although dissolution technically
refers to the last stage of liquidation. The process of liquidation also arises when customs,
an authority or agency in a country responsible for collecting and safeguarding customs
duties, determines the final computation or ascertainment of the duties or drawback
accruing on an entry.

Liquidation may either be compulsory (sometimes referred to as a creditors' liquidation)

or voluntary (sometimes referred to as a shareholders' liquidation, although some
voluntary liquidations are controlled by the creditors).

4.7.1Compulsory liquidation

The parties who are entitled by law to petition for the compulsory liquidation of a
company vary from jurisdiction to jurisdiction, but generally, a petition may be lodged
with the court for the compulsory liquidation of a company by:

1. the company itself

2. any creditor who establishes a prima facie case
3. contributories
4. the Secretary of State (or equivalent)
5. the Official Receiver

Grounds

The grounds upon which one can apply for a compulsory liquidation also vary between
jurisdictions, but the normal grounds to enable an application to the court for an order to
compulsorily wind-up the company are:

1. the company has so resolved

2. the company was incorporated as a public company, and has not been issued with
a trading certificate (or equivalent) within 12 months of registration
3. it is an "old public company" (i.e., one that has not re-registered as a public
company or become a private company under more recent companies legislation
requiring this)

106
 4. it has not commenced business within the statutorily prescribed time (normally
one year) of its incorporation, or has not carried on business for a statutorily
prescribed amount of time
5. the number of members has fallen below the minimum prescribed by statute
6. the company is unable to pay its debts as they fall due
7. it is just and equitable to wind up the company

In practice, the vast majority of compulsory winding-up applications are made under one
of the last two grounds.

An order will not generally be made if the purpose of the application is to enforce
payment of a debt which is bona fide disputed.

A "just and equitable" winding-up enable the ground to subject the strict legal rights of
the shareholders to equitable considerations. It can take account of personal relationships
of mutual trust and confidence in small parties, particularly, for example, where there is a
breach of an understanding that all of the members may participate in the business, or of
an implied obligation to participate in management. An order might be made where the
majority shareholders deprive the minority of their right to appoint and remove their own
director.

The order

Once liquidation commences (which depends upon applicable law, but will generally be
when the petition was originally presented, and not when the court makes the order),
dispositions of the company's property are generally void, and litigation involving the
company is generally restrained.

Upon hearing the application, the court may either dismiss the petition, or make the order
for winding-up. The court may dismiss the application if the petitioner unreasonably
refrains from an alternative course of action.

The court may appoint an official receiver, and one or more liquidators, and has general
powers to enable rights and liabilities of claimants and contributories to be settled.
Separate meetings of creditors and contributories may decide to nominate a person for the
appointment of liquidator and possibly of supervisory liquidation committee.

4.7.2 Voluntary liquidation

Voluntary liquidation occurs when the members of the company resolve to voluntarily
wind-up the affairs of the company and dissolve. Voluntary liquidation begins when the
company passes the resolution, and the company will generally cease to carry on business
at that time (if it has not done so already). If the company is solvent, and the members
have made a statutory declaration of solvency, the liquidation will proceed as a members'
voluntary winding-up. In such case, the general meeting will appoint the liquidator(s). If
not, the liquidation will proceed as a creditor's voluntary winding-up, and a meeting of

107
creditors will be called, to which the directors must report on the company's affairs.
Where a voluntary liquidation proceeds by way of creditor's voluntary liquidation, a
liquidation committee may be appointed.

Where a voluntary winding-up of a company has begun, a compulsory liquidation order

is still possible, but the petitioning contributory would need to satisfy the court that a
voluntary liquidation would prejudice the contributories.

In addition, the term liquidation is sometimes used when a company wishes to divest
itself of some of its assets. This is used, for instance, when a retail establishment wishes
to close stores. They will sell to a company that specializes in store liquidation instead of
attempting to run a store closure sale themselves.

4.7.3 Misconduct

The liquidator will normally have a duty to ascertain whether any misconduct has been
conducted by those in control of the company which has caused prejudice to the general
body of creditors. In some legal systems, in appropriate cases, the liquidator may be able
to bring an action against errant directors or shadow directors for either wrongful trading
or fraudulent trading.

The liquidator may also have to determine whether any payments made by the company
or transactions entered into may be voidable as a transaction at an undervalue or an unfair
preference.

4.7.4 Priority of claims

The main purpose of a liquidation where the company is insolvent is to collect in the
company's assets, determine the outstanding claims against the company, and satisfy
those claims in the manner and order prescribed by law.

The liquidator must determine the company's title to property in its possession. Property
which is in the possession of the company, but which was supplied under a valid retention
of title clause will generally have to be returned to the supplier. Property which is held by
the company on trust for third parties will not form part of the company's assets available
to pay creditors.

Before the claims are met, secured creditors are entitled to enforce their claims against
the assets of the company to the extent that they are subject to a valid security interest. In
most legal systems, only fixed security takes precedence over all claims; security by way
of floating charge may be postponed to the preferential creditors.

Claimants with non-monetary claims against the company may be able to enforce their
rights against the company. For example, a party who had a valid contract for the
purchase of land against the company may be able to obtain an order for specific

108
performance, and compel the liquidator to transfer title to the land to them, upon tender
of the purchase price.

After the removal of all assets which are subject to retention of title arrangements, fixed
security, or are otherwise subject to proprietary claims of others, the liquidator will pay
the claims against the company's assets. Generally, the priority of claims on the
company's assets will be determined in the following order:

1. Firstly, the costs of the liquidation are met out of the company's remaining assets
2. Secondly, the preferential creditors under applicable law are paid
3. Thirdly, in many legal systems, the claims of the holders of a floating charge will
be paid; other claims may also fit into this layer
4. Fourthly, if there is anything left, the unsecured creditors are paid out pari passu
in accordance with their claims. In many jurisdictions, a portion of the assets
which would otherwise be caught by a floating charge are reserved for the
unsecured creditors.
5. In the very rare instances where the unsecured creditors are repaid in full, any
surplus assets are distributed between the members in accordance with their
entitlements.

4.7.5 Dissolution

Having wound-up the company's affairs, the liquidator must call a final meeting of the
members (if it is a members' voluntary winding-up), creditors (if it is a compulsory
winding-up) or both (if it is a creditors' voluntary winding-up). The liquidator is then
usually required to send final accounts to the Registrar and to notify the court. The
company is then dissolved.

However, in most jurisdictions, the court has discretion for a period of time after
dissolution to declare the dissolution void to enable the completion of any unfinished
business.

4.7.6 Striking off the Register

In some jurisdictions, the company may elect to simply be struck off the Register as a
cheaper alternative to a formal winding-up and dissolution. In such cases an application is
made to the Registrar, and they may strike off the company if there is reasonable cause to
believe that the company is not carrying on business or has been wound-up and, after
enquiry, no case is shown why the company should not be struck off.

However, in such cases the company may be restored to the Register if it is just and
equitable so to do (for example, if the rights of any creditors or members have been
prejudiced).

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In the event the company does not file an annual return or annual accounts, and the
company's file remains inactive, in due course, the Registrar at Companies House will
strike the company off the register.

4.7.7 Fresh Start Options for Limited Companies (Ltd)

In the UK, many companies in debt decide it's more beneficial to "start again". This is
often called in the UK a "Phoenix". To enact a phoenix effectively means to die and then
come alive again. In business terms this will mean liquidating a company as the only
option and then resuming under a different name with the same customers, clients and
suppliers. In some circumstances it can be ideal for the company. It can be a way to start
trading profitably having left unfavourable lease agreements and historic debt behind.

4.8 ACCOUNTS OF COMPANIES IN LIQUIDATION

The officers and directors of a company under liuqidation must, according to section 454
read with section 511A, make out and submit, within 21 days of the Tribunal's order (or
within such ext5ended time, not exceeding 3 months, as the liquidator or the Tribunal
may allow), a statement showing the following :-

 The assets of the company, stating separately the cash balance inv hand at bank if,
any, and the negotiable securities, if any, held by the company.

 Its debts and liabilities:

 The names, residences and occupation of its creditors, stating separately the
amount of secured and unsecured debts and in the case of secured debts,
particulars of the securities given, whether by the company or its officers, their
value and the dates on which they were given.

 The debts due to the company and the names, residences and occupations of the
persons from whom they are due and the amount likely to be realised on account
therof:

 Such further or other information as may be prescribed, or as the Official

Liquidator may require.

 The statement has to be prepared even in case of voluntary winding up

The statement has to properly verified by an affidavit. It is has to be open for inspection
by any person stating himself in writing it be a creditor of the company, on payment of
prescribed fee. The person concerned can also acquire a copy or extract from it. The form
in which it has to be made out has been prescribed by the Supreme Court: it is given
below:

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 Form No. 57
In the High Court at ...............................(or) in the District Court at ...............
Original Jurisdiction ............................in the matter of Companies Act, 1956
In the matter of .......................................Ltd.
Company Petition No.......................................of 20.....
Statement of Affairs under section 454 Statement of affairs of the above -named as on the
............................... day of .............................20......... the date of the winding-up order
appointing Provisional Liquidator of the date directed by the Official Liquidator).
I/We.......................................................of ............................................. do solemnly affirm
and say that statement made overleaf and the several list hereunto annexed marked 'A' to
'H' are to the best of my/our knowledge and belief, a full, true and complete statement as
to the affairs of the above named company, on the......................................day
of .................20.............. the date of the winding-up order (or the order appointing
Provisional Liquidator or the date directed by the official Liquidator), and that the said
company carries/carried on the following business:
(Here set out nature of company 's business)
Signature (s)

Solemnly affirmed .................................. this .........day of .........20......, before me.

The Commissioner is particularly requested, before swearing the affidavit, to ascertain
that the full name, address and description of the deponents are stated, , and to initial any
crossing -out other alterations in the printed form. A deficiency in the affidavit in any of
the above respects will entail its refusal by the Court, and will necessitate its being re-
sworn.

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Note:- The several lists annexed are not exhibits to the affidavit.

Statement of Affairs and Lists to be Annexed

Statement as to the affairs of ............................Ltd, on the ..................day

of ............20 ..........being the date of the winding-up order (or order appointing
Provisional Liquidator or the date directed by the Official Liquidator, as the case may be )
showing assets at estimated realisable values and liabilities expected to rank :-
Assets not specifically pledged ( as per list 'A')

Estimated realisable
Values
Balance at Bank ... .... .... ....
Cash in Hand ... .... .... ....
Marketable Securities ... .... .... ....
Bills Receivable ... .... .... ....
Trade Debtors ... .... .... ....
Loan & Advances ... .... .... ....
Unpaid Calls ... .... .... ....
Stock in Trade ... .... .... ....
.............................. ... .... .... ....
.............................. ... .... .... ....
Freehold Property, Land & Building ... .... .... ....
Leasehold Property ... .... .... ....
Plant & Machinery ... .... .... ....
Furniture, Fittings, Utensils, etc ... .... .... ....
Investments other than marketable ... .... .... ....
securities
Livestock ... .... .... ....
Other property, etc.
.............................. ... .... .... ....

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 .............................. ... .... .... ....

(a) (b) (c) (d)

*Assets specifically Estimated Due to Deficiency Surplus
pledged realisable secured ranking as carried to last
( as per list 'B') values creditors unsecured column

Freehold property Rs. Rs. Rs. Rs.

....................
....................
Rs. Estimated surplus from assets specifically pledged ---------------
Estimated total assets available for preferential creditors
debenture holders secured by a floating charge, and unsecured
creditors (carried forward ) Rs. ---------------

Summary of Gross Assets (d)

Rs.
Gross reliable value of assets specifically pledged ---------------
Other Assets ..... .... .... ..... ---------------
Gross Assets Rs ---------------

Estimated total assets available for preferential creditors.

Debenture holders secured by a floating charge, and unsecured
Creditors (brought forward)
(e) Liabilities
Gross Liabilities (to be adducted from surplus or added to deficiency as the case my be )
Rs.

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 Secured creditors (as per list'B') to the extent to which claims are
estimated to be covered by assets specifically pledged [item (a)
or (b) as above, whichever is less ]
( insert in ' Gross Liabilities ' Column only )
Preferential creditors ( as per list 'C')
Estimated balance of assets available for Debentureholder -------
secured by a floating charge and unsecured creditors**
Debenture holder secured by a floating charge
(as per list 'D') -------
Estimated Surplus/Defiance as regard Debentureholder
Unsecured Creditors (as per list 'E') :
Estimated unsecured balance of claims if creditors partly secyred
on specific assets, brought from preceding page (c)
Trade Creditors
Bills Payalbe
Outstanding Expense
....................................
Contingent Liabilities (state name )
...................................
Rs. Estimated Surplus/Deficiency as regards Creditors [ being deference
between Gross Assets brought from preceding page (d) and Gross Liabilities as
per column (e) ]
Issued and Called-up-Capital :
..........................Preference Shares of each,
Rs.........................called-up (as per list 'F')
.............................Equity Shares of ....................each,
Rs.............................called-up ( as per list 'G' )
Estimated Surplus/Deficiency as regards Members ---------------
(as per List 'H')
Rs. ---------------

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 List A to G containing details of assets and liabilities and supplementary
schedules are not given.
List A given the list of assets which are specifically pledged with creditors both
fully secured and partly secured.
List B gives the list of assets which are specifically pledged with creditors both
fully secured and partly secured.
List C is list of preferential creditors and the amounts due.
List D is a list of debenture holders having a floating charge.
List of E contains names of unsecured creditors and the amounts due.
List of F gives the names and holdings of preference shareholders.
List G is a list of equity shareholders together with the amount of the shares
held.
List H is a statement showing how the surplus or deficiency in the statement of
affairs arose as a result of the profits and losses of the company (form given below .
List 'H' - Deficiency or Surplus Account
The period covered by this Account must commence on a date not less than three
years before the date of the winding- up order (or the order appointing Provisional
Liquidator, or the date director by the Official Liquidator) or, if the company has not been
incorporated for the whole of that period, the date of formation of the company, unless
the Official Liquidator otherwise agrees.
Items contributing to Deficiency (or reducing Surplus ) :-
Rs.
1. Excess ( if any ) of Capital and Liabilities over Assets on the...............
20........at shown by Balance Sheet (copy annexed ).
2. Net dividends and bonuses declare during the period from .......20........
to the date of the statement.
3. Net trading losses (after charging items shown in note to follow) for the
same period.
4. Losses other than trading losses written off or which provision has been made in
the books during the same period (given particulars or annex schedule.)

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5. Estimated losses now written off or for which provision has been made for the
purpose of preparing the statement (given particulars or annex schedule)
6. Other items contributing to Deficiency or reducing Surplus .................
Items reducing Deficiency (or contributing or Surplus ) :-
7. Excess (if any ) of Assets over Capital and Liabilities on the ............
20..... to the date of statement.
9. Profits and income other than trading profits during the same period (given
particulars or annex schedule)
10. Other items reducing Deviancy or contributing to Surplus : -------
Rs.
Deficiency/Surplus (as shown by the statement of Affairs ). -------
Note as to Net Trading Profits and Loses : Rs. -------
Particulars are to be inserted here (so as applicable) of the items mentioned below, which
are to be taken into account in arriving at the amount of net trading profits or losses
shown in account :-
Provisions for depreciation, renewals or diminution in value of fixed assets.
Charges for India income-tax and other Indian taxation on profits.
Interest on debentures and other fixed loans, payments to directors made by the Company
and
required by law to be disclosed in the accounts:- ---------------
Exceptional or non-recurring expenditure: ---------------
..............................
Less Exceptional or recurring expenditure
.................................
Balance , being other trading profits or losses
Net trading profits or losses as shown in Deficiency or Surplus
Account Above .......................................................... ---------------
Signature
Dated...............................
Briefly, the scheme statement of affairs is as follows :-
Put down the "free" assets (assets not specifically pledge) at their realisable values.

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Add any surplus expected from securities in the hands of the creditors.
Deduct unsecured together with unsatisfied balance of partly secured creditors.
Deduct Share Capital.
If at any stage the deduction to be made is more than the amount available , deficiency
appears; otherwise there is a surplus.
In preparing the statements, the discounted by the company is contingent ; any amount
expected
(a) Liability in respect of the bills discounted by the company is contingent ;
any amount expected to be paid in respect of bills discounted should be included in List
E. This applies to all contingent liabilities.
(b) Bills payable are creditors and should be included in the appropriate lists
according to the securities held by the holders of the bills. Generally, Bills Payable are
included in unsecured creditors (List E).
(c) Debentures should be assumed have a floating charge if nothing is mentioned
regarding the security held by the debentured holders
(List D).
(d) Unclaimed dividends should bee included in unsecured creditors.
(e) Uncalled capital should not be treated as an asset but calls in arrear should
be treated as an asset. (List A)
(f) Uncalled capital should not be be ignored.
The student should not be afraid of a surplus appearing in the statement as
often prosperous companies are wound up. A company which is being wound up is
not necessarily insolvent.

LIQUIDATOR'S FINAL STATEMENT OF ACCOUNT

The liquidator's task is to realise the assets and disburse the amounts among those who
have a rightful claim to itl in every case the liquidator has to prepare a statement showing
how much he realised and how the amount was distributed. The following is the order in
which disbursements will be made by the liquidator:-

A) Secured creditors up to their claim or up to the amount realised by sale of

securities held by them, whichever is less. The creditors themselves may sell the

117
 securities they will pay to the liquidator any surplus after meeting their claims.
Only the surplus is shown as a receipt ; the payment to secured creditors is not
shown in the liquidator's final statement of account. The balance left unsatisfied
-that is when the claims of the creditors are more than the amount realised by sale
of securities- wil be added to unsecured creditors. Workmen's dues will rank parri
passu with the secured creditors. These are called overriding preferential
payments.
(b) Legal Charges.
(c) Remuneration to the liquidator
(d) Costs of winding up.
(e) Preferential creditors.
(f) Debenture holders or other having a floating charge on the
assets of the company (While preparing the Liquidator's
Statement of Account, payment to preferential creditors is
shown, however, after the payment to debenture
holders having a floating charges)
(g) unsecured creditors (This may include liability in respect of
dividends or amounts due to shareholders on account of profits.
In this case, the amount in respect of dividends, ets., shall
be paid only after the outsiders are satisfied.)
(h) Preference shareholders.
(i) Equity shareholders. Unless the articles contain provisions to
the effect that preference shareholders are entitled to participate
in the surplus left after meeting the claims of the equity
shareholders in full. Whole of the amount left after
payment to preference shareholders will go to equity
shareholders.

The various claims have priority in the order mentioned above. Hence, if the amount
available is exhausted after paying, say, the preferential creditors, payment cannot be
made to unsecured creditors or anybody else coming after the preferential creditors. The
form prescribed by the Supreme Court is given later.

While preparing the Liquidator's Statement of Account, it should be remembered that

there is no double entry involved. It is only a statement although presented in the form of
an account. (It is really summary o f the Cash Book after the start of liquidation.)

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Liquidator's Remuneration: In case of compulsory winding up, the remunerations fixed
by the Court and the amount is payable to the Court since the official liquidator is a
salaried employee of the Government. In case of voluntary winding up, the remuneration
is fixed by the meeting which appoints the liquidator. The remuneration once fixed
cannot be increased.

Usually, the remuneration consists of a commission on assets realised plus a commission

on the amount paid to unsecured creditors. Unsecured creditors include preferential
creditors unless otherwise stated. The commission on unsecured creditors is on the
amount paid and hence care should be exercised in calculating the commission. If the
commissions 2% on amount paid to unsecured creditors, a payment of Rs. 100 to the
unsecured creditors will entail a commission of Rs. 2 to the liquidator, thus absorbing Rs.
102. Hence, if the amount available is insufficient to pay the unsecured creditors fully, the
commission due to the liquidator will be 2/102 of the amount available ; the balance will
be paid to the unsecured creditors.

Illustration 4

Suppose, the amount realised by sale of assets is Rs. 3,00,000 and the amount due is Rs.
3,40,000 including Rs. 10,000 as preferential creditors. Then, if the liquidator is entitled
to a creditors, his remunerating will be calculated as follows :-
Rs
3% on amount realised by sale if assets, of viz., Rs. 3,00,000........... 9,000
2% on preferential creditors, Rs. 10,000.................................. 200
2/102 of the amont remaining viz, Rs. 2,80,8000.................... 5,506
(Rs. 3,00,000-- 9,000--200--10,000)
Or 2% on the amount paid to unsecured creditors, viz.
Rs. 2,80,800--5,506 or Rs. 2,75,294 14,706

If the amount available is sufficient to pay all the creditors, the calculation of the
remuneration to the liquidator is simple. Suppose, the liquidator is to get 2% on amount
distributed among the unsecured creditors whose claims are Rs. 60,000; the amount
available, say is Rs. 80,000. The creditors will be paid Rs. 60,000. The liquidator will get
% of this figure, viz, Rs. 1,200. The reaming amount (Rs. 80,000--1,200) will be paid to
the shareholders.

Illustration 5
The Ultra Optimist Ltd. went into liquidation. Its assets realised Rs. 3,50,000exculding
amount realised by sales of securities held by the secured creditors. The following was
the position :-

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 Rs.
Share Capital : 50,000 shares of Rs. 10 each

Secured Creditors (securities realised Rs. 40,000) 35,000

Preferential Creditors............................................... 6,000

Unsecured Creditors ................................................ 1,40,000

Debentures having a floating charge on the assets of the company 2,50,000

Liquidator's Expense ............................................ 5,000
Liquidator's Remuneration ................................... 7,500
Prepare the Liquidator's Final Statement of Account,

THE ULTARA OPTMIST LTD.

Liquidator's Final Statement of Account

Rs. Rs.
Assets
Liquidator's Remuneration 7,500
Realised:
"Other"assets 3,50,000 Liquidator's Expenses 5,000
Surplus from
5,000 Debentures having a floating charge 2,50,00
Securities
Preferential Creditors Unsecured Creditors- 6,000
61.79% of Rs. 1,40,000* 86,500
3,55,000 3,55,000

Since the amount is not sufficient to pay the unsecured creditors fully, nothing can be
paid to the shareholder.

4.9 COMPANIES LIQUIDATION ACCOUNTS RULES, 1965

In exercise of the powers conferred by sub-section (3) of section 555, read with sub-
section (1) of section 642 of the Companies Act, 1956 (1 of 1956), the Central
Government hereby makes the following rules namely :-

1. Short title

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These Rules may be called The Companies Liquidation Account Rules, 1965.

2. Definitions

In these rules, unless the context otherwise requires,-

(a) "Act" means the Companies Act, 1956 (1 of 1956);
(b) "Liquidator", means the liquidator of a company appointed under the Act or the
Banking Companies Act, 1949 (X of 1949);
(c) "Reserve Bank" means the Reserve Bank of India and includes its branches and
agencies;
(d) "Annexure" means an annexure to these rules.

3. Head of account

All moneys representing unpaid dividends or undistributed assets in the hands or under
the control of the liquidator which, under sub-sections (1) and (2) of section 555 of the
Act, are required to be paid into public account of India, shall be paid into the Reserve
Bank within a period of fourteen days from the date on which the moneys become so due
to the credit of the Company's Liquidation Account (hereinafter referred to as "the said
Account") under the major head "Civil Deposits" in section 'T'-Deposits and advances-
Part II- Deposits not bearing interest- (c) Other Deposits Accounts-Departmental and
Judicial Deposits". The said moneys shall be paid into an office of the Reserve Bank
situated in the State in which the registered office of the company in liquidation is
situated:

Provided that in respect of the amounts paid under sub-section (2) of section 17 of the
Deposit Insurance Corporation Act, 1961 (47 of 1961), and any provision for unpaid
amounts made under section 20 of that Act by the Deposit Insurance Corporation, the
liquidator shall make payment to the Corporation as required by clause (a) of sub-section
(2) of section 21 of the Act.

4. Payment of investment and deposits

Any money belonging to a company under liquidation which the liquidator has invested
or deposited at interest shall, when such money forms part of the unclaimed dividends or
undistributed assets of the company, be realized, or, as the case may be, be withdrawn
and paid to the credit of the said account.

5. Operation of the account

The said account shall be operated by the Registrar of Companies of the State in which
the registered office of the company in liquidation is situated.

6. Maintenance of account by the Registrar

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The Registrar of Companies shall cause to be maintained in his office separate accounts
in respect of each company whose unpaid dividends or undistributed assets are deposited
in the said account

7. Statement to Registrar

The liquidator shall, when making any payment to the credit of the said Account furnish
to the Registrar of Companies concerned a statement in the form set out in Annexure I
containing the particulars specified in sub-section (3) of section 555 of the Act.

8. Claims for payment through court

Any person who claims to be entitled to any money paid into the said account and who
makes an application to the court under clause (a) of sub-section (7) of section 555 of the
Act, for payment of such money, shall state whether he has made any application to the
Central Government for the payment of the money and if so, the result of the application.

9. Claims for payment through Central Government

(1) Any person applying to the Central Government under clause (b) of sub-section (7) of
section 555 of the Act, shall make such application under his own signature or through a
power of attorney-holder, giving details of the amount and the name of the company from
which the amount is due to him.

(2) Every such application shall be accompanied by a treasury Challana in token of

payment of fees chargeable for the amount of the claims in terms of the Companies (Fees
on Applications) Rules, 1968. Such fees shall be deposited into the Government Treasury
under the head ["104-Other General Economic Services-Regulation of Joint Stock
Companies-Fees realized by the Central Government on applications made to it under the
Companies Act, 1956"].

(3) The application received by the Central Government shall be sent to the Registrar of
Companies concerned, who shall verify from his records and certify whether the claimant
is entitled to money claimed by him and whether according to the records with the
Registrar, no application from the claimant is pending in any court for payment of the
money.

(4) The Central Government may direct the Registrar of Companies concerned to obtain
from the liquidator of the company, in case the company has not been finally would-up, a
report certifying whether the claimant is or is not entitled to the whole or any part of the
amount claimed, and on receipt of a communication from the Registrar in that regard, the
liquidator shall submit a report to the Central Government through the Registrar
specifying the amount, if any, to which the claimant is entitled.

(5) Where the claimant's title to the aforesaid money has been established to the
satisfaction of the Central Government, that Government shall direct the claimant (not

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being the Central Government itself, a State Government, a Government company within
the meaning of section 617 of the Act or a local authority) to execute an indemnity bond
with or without surety in the form set out in Annexure II or as near thereto as may be on a
non-judicial stamp paper of the value payable in the State of execution or acceptance.

(6) On receipt of the report referred to in sub-rule (4) and the indemnity bond, if any, duly
executed by the claimant, the Central Government shall issue a payment order
sanctioning the payment of the amount due to the claimant.

(7) Notwithstanding anything in sub-rule (4) or sub-rule (5), the Central Government
may, where the amount claimed is not more than 2[one thousand rupees] and the claimant
establishes his title to the money to its satisfaction, issue an order sanctioning the
payment of the amount due to the claimant.

(8) The claimant, on receipt of the order under sub-rule (6) or sub-rule (7), shall obtain
payment of the amount from the Registrar of Companies concerned or such other
Registrar of Companies as may be specified in that order after delivering to him a
stamped receipt bearing the signature of two witnesses.

(9) The Registrar of Companies concerned shall, in the accounts maintained by him,
because a note to be made therein of any payment having been made.

Activity 4

1. Discuss the relevance of bank accounting. What do you understand by bank

statements? Discuss how bank statements are different from financial statements
of other firms?

2. Distinguish between voluntary and compulsory liquidation. Discuss fresh start

options for limited companies.

3. The following information was extracted from the books of a limited company on
31st March, 2001 on which date a winding up order was made :

Equity Share Capital-20,000 Shares of Rs. 10 each Rs

14% Preference Share Capital-30,000 Shares of Rs.10 each 2,00,000
Calls in arrear on Equity Shares(estimated it realise Rs.2,000) 3,00,000
14% First Mortgage Debentures secured by a floating charge
on the whole of the assets of the company (interest paid to date) 2,00,000
Creditors having a mortgage on the Freehold Land and Building 85,000
Creditors having a second charge on Freehold Land and Building 90,000

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Trade Creditors 2,70,000
Bills Discounted (of theses bills for 15,000 are expected to 40,000
be dishonored)
Unclaimed Dividends 6,000
Bills Payable 10,000
Income-tax due 25,000
Salaries and Wages (for five months) 40,000
Bank Overdraft secured by a second charge on the Whole of the
assets of the company 20,000
Cash in hand 1,200
Debtors (of these Rs. 60,000 are good; Rs. 15,000 are doubtful, estimated to realise Rs.
5,000 and the rest bad) 90,000
Bills of Exchange (considered good) 35,000
Freehold Land Buildings (estimated to realise Rs. 1,65,000) 1,50,000
Plant and Machinery (estimated to produce Rs. 90,000) 1,20,000
Fixtures and Fittings (estimated to produce Rs. 8,000) 12,000
Stock in trade (estimated to produce Rs. 25% less) 80,000
Patents (estimated to produce Rs. 45,000) 70,000

On 31st March, 1995, the company's share capital stood at the same figures as on 31st
March, 2001 but in addition, there was General Reserve of Rs. 65,000 In 1995-96 the
company earned a profit of Rs. 1,43,00 but thereafter it suffered trading losses totalling in
all Rs. 4,67,000. In 1997-98 a speculation loss or Rs. 91,000 was incurred . Preference
dividend was paid for 1995-96 and 1996-97 and on equity shares a dividend of 15% was
paid for 1995-96 only.

Excise authorities imposed a penalty of Rs. 1,60,000 for evasion of excise and income tax
authorities imposed a penalty of Rs. 60,400 for evasion of tax. Prepare the Statement of
Affairs and the Deficiency Account.

6. A company went into liquidation on 31st March, 2001 when the following
balance sheet was prepared:-

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 Liabilities Rs. Assets Rs.
Share Capital Goodwill 50,000
Subscribed and paid up capital Leasehold Property 48,000
19,500 shares of Rs. 10 each 1,95,000 Plant and Machinery 65,500
Sundry Creditors Stock 58,800
Rs.
Preferential 24,200
Partly secured 55,310 Rs. Rs.
unsecured 99,890 Sundry Debtors 64,820.
Bank Overdraft (unsecured) Cash 2,500
1,79,300 Profit and Loss Account 98,680
12,000

3,86,300 3,86,300

The liquidator realised the assets as follows :-

Rs.
Leasehold Property which was used in the first instance to pay
the partly secured creditors pro rata............................................. 35,000
Plant and Machinery ................................................................... 51,000
Stock ........................................................................................... 39,000

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Sundry Debtors........................................................................... 58,000
Cash .......................................................................................... 2,500

The expenses of liquidation amounted to Rs. 1,000 and the liquidator's remuneration was
agreed at 2.5% on the amount realsed, including cash, and 2% on the amount paid to the
unsecured creditors.
You are required to prepare the Liquidator's Final Accounts showing the distribution.

Note: goodwill valued at Rs. 50000 in books is value less.

(Adapted from C.A. Final)
4.10 SUMMARY

This unit discusses accounting for banking, insurance and companies in liquidation. First
area of discussion was an introduction to bank accounting. The statement of the banks
were discussed as they shows the general, or control, accounts of the bank, and the
various books of the bank show the detail of specific items. Next area of concern was the
accounting for insurance claim settlement. Insurance companies settle claims on assets,
on its book value and not its costs. Whereas this principle might vary from country to
country, book value is widely accepted as the norm. Fire insurance and related concepts
of accounting were explained in the later section. Another important topic which unit
explains was accounting for marine insurance, various types of marine insurance, marine
insurance policies were discussed in a detailed manner. Finally accounts of companies in
liquidation were focussed with company’s liquidation account rules 1965.

4.11 FURTHER READINGS

 Carl S. Warren, James M. Reeve, Jonathan E. Duchac. 2008. Corporate Financial

Accounting. South-Western Publications

 Don A. Egginton January 1977 Accounting for the Banker . Longman Publishing
Company.

 David H. Marshall, Wayne W. McManus, Kenneth N. Scoles January 2001

Accounting and Finance for Insurance Professionals. American Institute for
CPCU

 Ernst & Young 1994 Ernst & Young Guide to Performance Measurement for
Financial Institutions: Methods for Managing Business Results Probus Pub
Company.

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Solutions to the activities

Activity 3

Solution 3

Activity 4

Solution 3

Deficiency as shown by the statement of affairs 7,87,800

Solution 5

Balance sheet total 1,51,000

127