B.COM.

Sem-5
Advanced Accounting Intellect – I
UNIT-1

Insurance – Insurance is a contract under which the insurer (insurance company) in consideration of
a sum of money paid (premium) by the insured (the person whose risk is insured) required all the
essentials of a valid contract according to the law of contract.

Policy – It is the instrument containing the contract of insurance.

Characteristics of Insurance
 It is a cooperative device
 It is sharing or transfer of risk
 Large number of insurance persons & properties
 Payment of happening of a specified event
 It is preceded by evaluation of risk
 It is a protection against risk
 The amount of compensation depends on amount of loss
 Contractual Relationship
 Contract of insurance is a contract of indemnity
 It is a means of converting uncertainty into certainty
 It is neither a charity nor gambling
 It is regulated under certain law
 Minimum two parties

Purpose of Insurance
 Reduction of worries
 Reimbursement of losses
 Opportunity for investment
 Credit enhancement
 Opportunity for employment
 Regular savings
 Retirement
 Promotion of efficiency and motivation

Importance of Insurance
 Protection against possible uncertainties.
 Eliminates risks and losses are shared.
 Reduces the impact of losses.
 It helps in uninterrupted business operations and facilitates smooth trade.
 It serves as an agency of capital formation.

Principles of Insurance
  Principle of insurable interest
 Principle of Utmost Good Faith (Uberrimae Fidei)
 Principle of indemnity
 Principle of Subrogation
 Principle of Contribution
 Principle of Causa Proxima

Classification of Insurance
 Life Insurance
 Non-life Insurance (General Insurance)
o Marine Insurance
o Fire Insurance
o Personal Accident Insurance
o Motor Vehicle Insurance
o Fidelity Guarantee Insurance
o Crop Insurance
o Burglary Insurance
o Cattle Insurance
o Cash in transit Insurance

Insurance Claims -
Business, in the course of its operation, confronts several types of risks which may result in huge
losses. No business can overcome such risks and it is necessary that such risks are insured.
Business suffers heavy loss of assets on account of happening of certain events such as fire,
earthquake, flood, theft, etc. To cover up the risk of loss against these uncertain events, the business
enterprises take insurance policy with insurance company.
Whenever a business enterprise suffers a loss from an insured event, it files a claim of compensation
against such losses. Such claims are known as Insurance Claims.
All insurance except life insurance are contract of indemnity. In such contract the claim accepted by
the insurance company is restricted to the lower of the actual loss or policy value.
Sometimes business enterprises get themselves insured against the loss of profit which is known as
Loss of Profit Policy or Consequential Loss Policy.

The types of risks that are common to the business are:

a. Risk of fire, which can destroy stocks and/or fixed assets. Insurance companies are ready to cover
such risks by issuing fire insurance policies.
b. Consequent to fire, business gets dislocated and results in loss of profits which could have,
otherwise, been made had there been no such interruption. Insurance companies covers sc=uch risk
by issuing loss of profit policies.
c. Business employs workmen and if due to accidents workers suffers injuries or die, compensation
has to be paid to under Workmens Compensation Act 1923. The business can free itself from such
payments by taking such insurance policies.
Types of Insurance Claims
1. Claims for loss of stock and fixed assets
2. Claims for loss of profit

1. Claims for Loss of Stock and fixed assets

Every business entity keeps sufficient stock as per the need and size of its respective business for
smooth running of the business, but at the same time risk of loss by fire or by means is also there. To
safeguard the businesses from any unforeseen circumstantial loss, most of the business entities buy
insurance policy, which covers loss of stock (by fire) — is known as stock policy.
In consideration of the premium, insurance company takes the responsibility to compensate — if any
loss occurs by fire or by other means, applicable under the insurance terms. It is in the best interest
of the firm to take fire insurance policy because it covers wide range of losses (by fire) including
Building damage, Furniture and Fixture loss, Plant & Machinery destruction, etc.
A fire insurance contract provides for indemnification by the insurer, of any financial loss suffered by
the insured, as a result of damage or destruction of the insured property by fire or other specified
perils.
The contract is for a specified period, usually for a year and the consideration for the promise by the
insurer is the premium paid by the insured.
Stocks of all kind are important items of property for any business to insure and more so for a trading
concern. A substantial part of the working capital, in any business, is locked up in stocks and working
capital mostly comes from out of borrowings. Therefore, if stocks are destroyed or damaged by fire,
it will very much affect the financial solvency of the business. Insurance of stocks will help business to
cover this risk adequately.

Average Clause – Some unscrupulous businessman may resort to under-insurance of stocks in order
to save some amount of premium. Under-insurance means insuring for lesser value. It is resorted to
because usually the loss will not be total and therefore in spite of under-insurance, the businessman
can cover his loss. To prevent misuse of insurance, the policy incorporates an ‘average clause’.
By inserting average clause, the insured is called upon to bear a portion of loss himself in the event of
under-insurance. The main object of this clause is to discourage under-insurance and encourage full
insurance and to accurately value the property before insurance.

Value of claim = (Policy Value X Loss of Stock) / (Value of stock of the date of fire)

Illustration 1
Goods of Rs. 1,60,000 of M/s. R & Sons are insured for Rs. 1,40,000. Loss due to fire is assessed for
Rs. 32,000. Calculate the claim of M/s. R & Sons against the insurance company. The policy is subject
to average clause.
Solution
Value of claim = (1,40,000 * 32,000) / (1,60,000)
= Rs. 28,000

Illustration 2
Value of insurance policy is Rs. 15,00,000 and at the date of fire, value of stock in hand is Rs.
18,00,000, out of which approx. worth of 12,00,000 of stock is destroyed. The policy is subject to
average clause. Calculate the value of the claim admitted.
Solution
Value of Claim = (15,00,000 * 12,00,000) / 18,00,000
= Rs. 10,00,000

Deductible or Excess - With respect to each type of policy, the insurance company may deduct a
specified amount at the time of paying claim. This is known as ‘deductible’ or ‘excess’.

Survey Expenses - When a claim is made on the occurrence of a loss, the insurance company
appoints a surveyor to assess the loss, so that the claim may be admitted and eventually paid. He has
to be paid fees, which, in some cases is paid by the insured in the first instance and later reimbursed
by the insurer.

Journal Entries

a. When premium is paid

Insurance Premium A/c. Dr.
To Bank A/c.
b. When premium paid is transferred to Profit and Loss Account
Profit & Loss A/c. Dr.
To Insurance Premium A/c.
c. When loss of stock/asset occurs
Loss of Stock / Asset A/c. Dr.
To Stock / Asset A/c.
d. When fees of surveyor is paid
Surveyor Fees / Insurance Co. Dr.
To Bank A/c.
e. When fees of surveyor is reimbursed
Bank A/c. Dr.
To Insurance Co.
f. When fees of surveyor is not reimbursed by insurance company
Profit & Loss A/c. Dr.
To Surveyor Fees
g. When claim is admitted by the insurance company
Insurance Co. Dr
To Loss of Stock / Asset A/c.
h. When claim amount is received from insurance company
Bank A/c. Dr.
To Insurance Co.
i. When claim admitted is less than the loss
Profit & Loss A/c. Dr.
To Loss of Stock / Asset A/c.
Calculation of total stock and claim on the date of fire - Claim for loss of stock depends upon actual
loss of stock due to fire. Actual loss of stock is equal to “Total stock on the date of fire less stock
salvaged”. Therefore in order to lodged the claim it is essential to calculate
a. Total stock on the date of fire
b. Stock salvaged

Sometime information about total stock is not available, which can be calculated by preparing
Memorandum Trading Account
(for the period ending…….)
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening Stock ---- By Sales ----
To Purchases ---- By Stock on the date of fire ----
(Balancing figure)
To Direct Expenses (If any) ----
To Gross Profit ----
---- ----

OR
Computation of Loss Stock on the date of fire
Stock in the beginning of the accounting year (Opening Stock) -----
Add: Purchases from the beginning of the accounting year till the date of fire -----
Less: Cost of Goods Sold (from the beginning of the accounting year till the date of fire) -----
Value of the stock on the date of fire -----
Less: Salvaged Value of stock (---)
Value of stock due to fire -----
Value of Salvaged Stock
Value of stock as calculated from above will be reduced by the value of salvaged stock to arrive at the
value of Insurance Claim.

Remember
 Gross Profit can be calculated with the help of sales and rate of gross profit which are given in
the question or preceding year’s rate can also be considered.
 In case, where gross profits of the last several years are given, average gross profit should be
taken to determine the gross profit of the current year.
 In case, where stock is not valued at the cost, first it will be valued at the cost in the last year
trading account and then in the memorandum account of the current year.
 Cost of the sample given free of cost or withdrawal of stock by proprietor or partner of the
firm for personal use, it should be adjusted in the Trading Account of the last year as well as
in the current year’s memorandum trading account.
 An average clause will be applied when the value of insurance policy is less than the value
of stock on the date of fire.

Illustration 3
On 30th November, 2019 a fire occurred in the premises of a firm which carried on the business of
general merchandise. From the various books, which were saved from fire, it was ascertained that
Sales from 1st April to 30th November Rs. 12,80,000
st th
Purchases from 1 April to 30 November Rs. 8,40,000
st
Stock on hand on 31 March, 2019 Rs. 2,36,000
Gross profit for the past five years had averaged at 35% on sales.
The value of salvaged stock was agreed at Rs. 30,000. Calculate the amount of claim. There was no
average clause in policy.
Solution
Memorandum Trading Account
(for the period ending 30th November, 2019)
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening Stock 2,36,000 By Sales 12,80,000
To Purchases 8,40,000 By Stock on the date of fire 2,44,000
(Balancing figure)
To Gross Profit 4,48,000
(12,80,000*35) / 100
15,24,000 15,24,000

Amount of Insurance Claim (estimated)

Stock on 30th November 2,44,000
Less: Salvaged Stock (30,000)
Claim 2,14,000
Illustration 4
Asia Traders have taken out a fire policy of Rs. 80,000 covering its stock. A fire occurs on 30 th June,
2020 and stock was destroyed with the exception of the value of Rs. 20,680. Following particulars are
available from the books of account of the firm:
Stock as on 31st March 2020 Rs. 30,000
Purchases till the date of fire Rs. 1,30,000
Sale to the date of fire Rs. 90,000
Commission paid to the Purchase Manager on purchases 2%
Carriage paid on purchases Rs. 800
Average gross profit on cost 50%
The policy was subject to average clause. You are required to arrive at the (i) Total loss of stock (ii)
amount of insurance claim
Solution
Asia Traders
Memorandum Trading Account
(for the period ending 30th June, 2020)
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening Stock 30,000 By Sales 90,000
To Purchases 1,33,400 By Stock on the date of fire 1,03,400
(1,30,000 + 2% of 1,30,000 (Balancing figure)
+ Rs. 800)
To Gross Profit 30,000
 (90,000*50) / (100+50)
1,93,400 1,93,400

Stock as on the date of fire = 1,03,400

Less: Salvaged Value = (20,680)
Loss of Stock 82,720

Value of Insurance Claim (estimated)

= (80,000 * 82,720) / 1,03,400
= Rs. 64,000

Illustration 5
Fire occurred on the business premises of ‘Fashion India’ on 30 th June, 2020 and most of the stock
destroyed. Please ascertain the insurance claim from the following given particulars –
Amount Amount
Particulars
(Year 2019) (01 April to 30 Jun 2020)
Sale 25,00,000 7,50,000
Purchases 18,00,000 3,50,000
Opening Stock (01-04-2019) 2,70,000
Closing Stock (31-03-2020) 4,98,750
Direct Expenses (Freight & wages) 1,50,000 30,000
 Stock as on 01-04-2019, valued 10% less at the cost.
 Stock as on 31-03-2020 value 5% more at the cost.
 Value of stock salvaged Rs. 45,000.
 Insurance policy (for fire) was for Rs. 3,00,000.
Solution
Fashion India
Trading Account
(for the period ending 31st March, 2020)
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening Stock 3,00,000 By Sales 25,00,000
(2,70,000 * 100) / (100-10)
To Purchases 18,00,000 By Stock 4,75,000
(4,98,750 * 100) / (100+5)
To Direct Expenses 1,50,000
To Gross Profit (29%) 7,25,000
(7,25,000 * 100)/25,00,000
29,75,000 29,75,000

Memorandum Trading Account

(for the period ending 30th June, 2020)
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening Stock 4,75,000 By Sales 7,50,000
To Purchases 3,50,000 By Stock on the date of fire 3,22,500
(Balancing figure)
 To Direct Expenses 30,000
To Gross Profit 2,17,500
(7,25,000 * 29)/ 100
10,72,500 10,72,500

Value of stock = 3,22,500

Less: Salvaged Stock = (45,000)
Loss of stock 2,77,500

Value of Insurance Claim (estimated)

= (3,00,000 * 2,77,500) / 3,22,500
= Rs. 2,58,140
Here an average clause will be applied because the value of insurance policy (Rs.300,000) is less than
the value of stock (Rs. 322,500) on the date of fire.

Illustration 5
A fire occurred in the premises of Hiren on 25th Nov, 2019 where as a large part of stock was
destroyed. Salvage was Rs. 15,000. He gives you the following information for the period April 1,
2019 to Nov 25, 2019:
Purchases Rs. 85,000; Sales Rs. 90,000; Goods costing Rs. 5,000 was taken by Hiren for personal use;
Cost price of stock on April 1, 2019 was Rs. 40,000.
Over the past few years, Hiren has been selling goods at a consistent gross profit margin of 33.33%.
The insurance policy was for Rs. 50,000 including average clause.
Hiren asks you to find out the amount of claim to be made on the insurance company.
Solution

Memorandum Trading Account of Mr. Hiren

(for the period ending 25th Nov, 2019)
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening Stock 40,000 By Sales 90,000
To Purchases 80,000 By Stock on the date of fire 60,000
(Purchases – Drawings of (Balancing figure)
Goods)
To Gross Profit 30,000
(90,000 * 33.33)/ 100
1,50,000 1,50,000

Value of stock = 60,000

Less: Salvaged Stock = (15,000)
Loss of stock 45,000

Value of Insurance Claim (estimated)

= (50,000 * 45,000) / 60,000
= Rs. 37,500
Here an average clause will be applied because the value of insurance policy (Rs.50,000) is less than
the value of stock (Rs. 60,000) on the date of fire.

2. Claims for loss of profit

Fire Insurance provides coverage only for material damage or destruction occurring to stock or assets
which results in total or partial loss/stoppage of business. The fire insurance policy does not provide
cover for such losses. In order to give complete protection to the business, a new type of insurance,
known as “Loss of Profits Insurance” or “Consequential Loss Insurance” has come into vogue.
A normal fire policy only indemnifies loss of stock or assets, and fails to insure any loss of profit
suffered by the concerned business. Therefore, a consequential loss policy should be taken to cover
the Loss of profit, Loss of Fixed expenditure, etc.
Consequential loss is the loss of profit suffered which the business would have earned otherwise,
because, for some time, the business is disorganised or has to be discontinued.

Difference between Fire Insurance and Loss of Profit Insurance

Fire Insurance Loss of Profit Insurance
Tangible Intangible
Covers material property Covers earning capacity
Insurance against losses of assets Insurance against trading loss
Covers capital losses Covers revenue losses
Usually no stoppage of business Stoppage of business

Under this insurance, the insurer pays the following amounts:

a. Loss of gross profit due to reduced turnover
b. Increased working expenses

Important terms related to Loss of Profit Insurance

Standing Charges − Salaries to staff, Rent rates & Taxes, Wages to skilled workers, Auditors’ fees,
Directors’ fees, Advertisement Expenses, Travelling Expenses, Interest on debentures, Interest on
Mortgage loan, interest on bank overdraft, boarding and lodging of resident directors/managing
directors, and unspecified expenses (not more than 5% of the specified expenses) are the charges
that have to mention on the policy form at the time of buying policy (so that all charges get insured).
Indemnity Period – It refers to the period beginning with the occurrence of the damage and ending
not later than 12 months, thereafter during which the results of the business shall be affected in
consequence of the damage. This period is selected by the insured himself. It is not necessary that
the policy to cover the entire indemnity period. But, it is essential that the policy must in force during
the period of consequence.
Turnover − Turnover includes sold goods or services for which amount is payable; it also needs to be
insured.
Indemnity Period Turnover (IPT) - It is the sale during the period when the business is disorganized
or discontinued.
Standard Turnover (ST) – It is the turnover during that period in the twelve months immediately
before the date of the damage which corresponds with the indemnity period. It also needs to be
adjusted to notice the trend during the accounting year, in which incident took place.
Reduced Turnover or short Sale – Short sale means loss of sale due to the incident of fire and
subsequent dislocation of the business. It is the difference between standard turnover and actual
turnover.
Annual turnover (AT) – It is the turnover during the twelve months immediately before the date of
damage.
Net Profit − Profit (excluding tax), insured standing charges, other charges, depreciation, and other
provisions of such kind need to be adjusted.
Loss due to short sales = It is calculated by applying the rate of gross profit to the amount of short
sales.

Example
Date of fire = 1.5.2020 and period of dislocation = 5 months
IPT = 1.5.2020 to 1.10.2020
ST = 1.5.2019 to 1.10.2019
AT = 1.5.2019 to 30.4.2020

Steps for Claim under Loss of Profit Policy

1. Amount of Gross Profit = Net Profit + Insured standing charges
Amount of Gross Loss = Insured Standing charges – Net Loss

2. Rate of Gross Profit/Loss

Rate of Gross Profit = Gross Profit Amount * 100 / Net Turnover (Sales)
Rate of Gross Loss = Gross Net Loss * 100 / Net Turnover (Sales)

Note − All figures given above are related to the last accounting year.

3. In case where all the standing charges are not insured, amount of net loss need to reduce as –
= (Insured Standing Charges * Net Loss) / All standing charges

4. Loss due to short/reduced sale

= (Short Sale * Rate of Gross Profit) / 100

5. Increased Cost of Working − Increased cost of working means, certain additional expenses those
have to be incurred by insured person to keep the business in running condition during the indemnity
period.
Least of following figures will be considered as increased cost of working
= (Net Profit + Insured Standing Charges) * (Increased Cost of Working) / (Net Profit + All
Standing Charges)

6. Calculation of ITP, ST, AT and Short Sales

Loss of profit = Loss of Net Profit + Standing Charges + Increased cost of working

Amount of Claim = Loss of profit – saving in standing charges

Illustration 1
X Ltd. has insured itself under a loss of profit policy for Rs. 3,63,000. The indemnity period under the
policy is six months. On 1st September, 2019 a fire occurred in the factory of X Ltd. and the normal
business was affected up to 1st March, 2020. The following information is compiled for the year
ended on 31st March, 2019:
Rs.
Sales 20,00,000
Insured standing charges 2,40,000
Uninsured standing charges 20,000
Net profit 1,20,000
Following further details of turnover are furnished.
(a) Turnover during the period of 12 months ending on the date of fire was 22,00,000.
(b) Turnover during the period of interruption was Rs. 2,25,000.
(c) Actual turnover during the period from 1.9.2018 to 1.3.2019 during the preceding year
corresponding to the indemnity period was Rs. 7,50,000.
X Ltd. spent an amount of Rs. 40,000 as additional cost of working during the indemnity period. On
account of this additional expenditure:
(a) There was a saving of Rs. 15,000 in insured standing charges during the period of indemnity.
(b) Reduced turnover avoided was Rs. 1,00,000 i.e. but for his expenditure, the turnover after the
date of fire would have been only Rs. 1,25,000.
A special clause in the policy stipulates that owing to the reasons acceptable to the insurer under the
special circumstances the following increases are to be made:
(a) Increase of turnover standard and actual by 10%.
(b) Increase in rate of gross profit by 2% from previous year’s level.
X Ltd. asks you to compute the claim for loss of profit. All calculations should be to the nearest rupee.
Solution
Computation of loss of profit for insurance claim
(1) Rate of gross profit
Net profit for the last financial year + Insured standing charges
*100
Turnover for the last financial year

Rs.1,20,000 + Rs. 2,40,000

= *100 = 18%
Rs, 20,00,000
Add: Adjustment for increase in gross profit rate = 2%
20%
(2) Calculation of short sales: Rs.
Turnover from 1.9.2018 to 1.3.2019 7,50,000
Add: Adjustment for increase in turnover _75,000
Adjusted turnover 8,25,000
Less: Actual turnover from 1.9.2019 to 1.3.2020 2,25,000
Short sales 6,00,000
(3) Additional expenses: Rs.
(i) Actual expenses 40,000
(ii) Gross profit on sale generated by additional expenses
[(20/100) x Rs. 1,00,000] 20,000
 Additional expenses * Gross profit on annual adjusted turnover
Gross profit on annual adjusted turnover + Uninsured standing charges
= Rs.40,000 * 20% on Rs. 24,20,000 *
(20% on Rs. 24,20,000) + Rs. 20,000

= Rs. 40,000 x Rs. 4,84,000

Rs.5,04,000

= Rs. 38,413
Least of the above three figures i.e. Rs. 20,000 is allowable.

(4) Amount of claim before application of average clause Rs.

Gross profit on short sales (20% on Rs. 6,00,000) 1,20,000
Add: Allowable additional expenses 20,000
1,40,000
Less: Saving in insured standing charges 15,000
1,25,000

(5) Application of average clause Rs.

Annual turnover i.e. turnover from 1.9.2018 to 31.8 2019 22,00,000
Add: Adjustment for increase in turnover (10% of Rs. 22,00,000) 2,20,000
24,20,000
Gross profit on annual adjusted turnover (20% on Rs. 24,20,000) 4,84,000
Loss of profit policy value 3,63,000
Since the policy-value is less than gross profit on adjusted annual turnover, the average clause is
applicable.
Hence the amount of claim = Rs. 1,25,000 x (Rs. 3,63,000/Rs. 4,84,000) = Rs. 93,750

Also refer to:

 Advanced Accountancy by S.N. Maheshwari & S.K. Maheshwari (Vol. 1) Vikas
publishing house
 Advanced Accountancy (theory, Method & Application) by R.L. Gupta & M.
Radhaswamy Sultan Chand & Sons