IC-46

GENERAL INSURANCE ACCOUNTS

PREPARATION AND REGULATION OF
INVESTMENT
Acknowledgement:
This course based on new syllabus has been prepared with the assistance of
Ratan Chandra Guria,
Asoke Kumar Chakraborty
A.R. Sekar
Brahmananda Pani
www.irdaexam.in
We also acknowledge Get Through Guides, Pune for their contribution in
preparing the study material.

NOT FOR SALES COPY

INSURANCE INSTITUTE OF INDIA

G- Block, Plot No. C-46,
Near Dhirubhai Ambani International School,
Bandra Kurla Complex,
Bandra (E), Mumbai – 400 051.
 GENERAL INSURANCE ACCOUNTS
PREPARATION AND REGULATION OF
INVESTMENT

IC-46

First Edition-2010

All Rights Reserved

This course is the copyright of the Insurance Institute of India, Mumbai. In
no circumstances may any part of the course be reproduced.

Published by Sharad Shrivastva, Secretary-General, Insurance Institute

of India, G- Block, Plot C-46, Banra Kurla Complex, Bandra (E)Mumbai
– 400 051 and printed at ……
 PREFACE

This course is designed for the use of candidates appearing for the Associateship
(Non Life) examination of the Insurance Institute of India.

The course gives an overview of the General Insurance Financial Accounting and
Investment Regulations in five chapters subdivided into twenty units presented in
a logical manner. This covers, inter alia, Accounting Principles, Standards,
Processes and Methods of Finalisation of accounts applicable to business entities
in general as well as Methods, Processes and Techniques of Non-life Insurance
Financial Accounting separately. Besides, Investment Accounting & Regulations,
Internal Audit processes and techniques, Statutory Audit requirements and salient
aspects of International Financial Reporting Standard –IFRS 4 having impact on
the presentation of financial statements and Disclosure of Accounting
Information of Non-life insurance companies have been dealt with distinctly in
order to get the students familiarized and equipped with the latest knowledge in
the subject. Discussions in almost all the units have been accompanied by a
number of examples explaining the intricacies of financial accounting. The
subject matter has also been accompanied by the relevant extracts of the financial
statements published in the Annual Reports of The New India Assurance
Company Limited in appendix 1 to demonstrate and explain the complexities and
technicalities in preparation, presentation and analysis of financial statements of
a non-life insurance company. It has been the endeavor of the Institute to provide
a unified and integrated study material in Financial Accounting, Audit and
Investment Accounting & Regulation to enable the students to obtain
comprehensive knowledge on the subject in one go. The study material has been
prepared and presented in such a manner that a student who has no prior
knowledge of the fundamentals of financial accounting can prepare and analyze
financial statements of general insurance business without any difficulty after his
thorough study of this study material.

Although the course covers the syllabus prescribed for the examination, it is
desirable that candidates should supplement their knowledge by additional
reading materials such as recommended Text Books, relevant Regulations issued
by IRDA, Office Manuals on Accounts, Audit and Investments. The books
recommended here are 1) Financial Accounting by R. L. Gupta & V.K. Gupta, 2)
Financial Accounting by S. N. Maheshwari, 3) Advanced Accounts by M. C.
Shukla, T. S. Grewal & S. C. Gupta and 4) Financial Management & Insurance
Accounting by K.C. Mishra and R. C. Guria (National Insurance Academy)

In today’s competitive insurance business, finance, accounting & investment

have assumed critical significance. Financial Accounting has become all the
more important today in the business world in view of use of cross-border capital
and foreign investment in insurance business requiring implementation of
International Financial Reporting Standards and stringent disclosure norms for
protection of the interests of various stakeholders of the insurance. Sound
knowledge on Financial Accounting, Financial Statement Analysis, Investment
Accounting with Regulations, Internal Audit Procedures, Statutory Audit
Requirements and standards, Regulatory and Statutory requirements for
Disclosures are very essential in insurance business management. The candidates
therefore should keep themselves abreast of the latest trends in the market, which
are constantly changing. More importantly, this being a practical paper, requires
the students to obtain comprehensive theoretical knowledge and thorough
practice from this Study Material as also from the recommended books to attain
proficiency and confidence in preparation and presentation of Non-life Insurance
Financial Statements and Accounting Analysis.

To enhance the learning and to make it rich, each chapter in the study text has
specific learning outcomes listed at the beginning of the chapter and a summary
at the end of the chapter followed by self-test questions and answers. Within the
study text there are a number of features like case studies, extensive use of
examples, diagrams, tables, MCQs, tips etc. to add life to learning and to make it
interesting for the candidate.

To supplement the study text, key notes have been provided. Key notes include
topics presented in the same order as the study text and aid revision by giving
clear, visual emphasis to key points. Key notes are quite handy as they are
portable and concise, ideal for last minute revision on the move.

Although sufficient care has been taken in publishing the study material, the
possibility of errors, omissions and discrepancies cannot be ruled out. Should
there be any discrepancy, error or omission noted in the study material, the
Institute shall be liable for issue of necessary corrigendum in the study material.
The Institute would welcome suggestions to improve the quality of the present
course of materials. The candidates are recommended to collect and study
specimen forms used in offices. This will provide a practical basis for their
studies. Suggestions for improvement are most welcome.

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 CONTENTS

Chapter No. Title Page No.

Accounting Scope, Concepts, Principles and
Chapter 1
Standards
Unit-1 Financial Accounting- Meaning and Scope 1
Accounting Concepts, Principles and
Unit-2 24
Convention
Accounting Standards- Objectives and
Unit-3 50
Interpretation
Unit-4 Accounting Policies 124
Accounting Process, Methods & Control and
Chapter 2
Finalisation of Accounts
Unit-5 Accounting Process 143
Unit-6 Accounting Methods & Control 167
Unit-7 Depreciation Accounting 203
Unit-8 Bank Reconciliation Statement 252
Unit-9 Introduction to Company Accounts 277
Non-Life Insurance Business Accounting
Chapter 3
Methods, Techniques & Process
Accounting Process & Techniques of General
Unit-10 391
Insurance Business
Unit-11 Accounting Regulations 429
Preparation & Presentation of Financial
Unit-12 487
Statements
Unit-13 Reinsurance Accounting 547
Accounting Methods & Process of Special
Chapter 4
Accounting Transactions
Unit-14 Investment Regulations 595
Unit-15 Investment Accounting 615
Annual Reports, Audit & International
Chapter 5
Financial Reporting Standards
Unit-16 Annual Reports 648
Unit-17 Statutory Audit in Insurance Business 670
Unit-18 Internal Audit in Insurance Business 705
International Financial Reporting Standard-
Unit-19 751
IFRS 4- Insurance Contracts
 1

CHAPTER 1

ACCOUNTING SCOPE, CONCEPTS,

PRINCIPLES AND STANDARDS
UNIT 1

FINANCIAL ACCOUNTING – MEANING AND

SCOPE
Chapter Introduction
This chapter aims to provide you with an understanding of basic financial
accounting.

a) Give a brief introduction to the concept of financial accounting and

explain its meaning.
b) Describe the objectives and functions of accounting.
c) Discuss the limitations of financial accounting.
d) Identify the books of accounts.

For Mock Test Visit:

https://irdaexam.in/

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 2

1. Give a brief introduction to the concept of financial

accounting and explain its meaning.
[Learning Outcome a]

1.1 Introduction

The term ‘accounting’ is a derivative of the word ‘account’ which, as per

Chambers 21st Century Dictionary means, among other things, “an explanation,
especially of one’s behaviour”.

Each activity in our everyday life must have some accountability. Similar is the
case with economic activity that constitutes the fulcrum of our economic life.

Financial Accounting is thus concerned with the accountability of economic

activities or activities related to finance. It shows the ways, manner, methods and
techniques to account for the economic or financial activities for preparation of
meaningful information for those who are concerned with those activities in any
capacity.

Every aspect of economic activity requires proper recording of all transactions

and financial events to obtain adequate financial information as an aid to decision
making. Financial Accounting has been developed to serve this purpose, which
has universal application for recording transactions and events with a view to
presenting suitable information in the matter of decision-making.

Every business enterprise has to maintain books of account in a systematic

manner for recording all such financial transactions on a daily basis. Such
financial transactions include:

9 purchases and sales of goods,

9 payment of wages,
9 payment of administrative expenses,
9 receipts of other income,
9 introduction of capital,
9 purchase of plant / machinery,
9 distribution of profits,
9 payment of taxes and so on.
 3

Financial accounting methods followed by business houses depend on the types

of business and the statutes or business laws applicable to them. There are two
systems of recording transactions –single entry system and double entry system.
A sole proprietor may maintain his books and accounts on a single entry basis
that generates incomplete records only, while a company registered under the
Company’s Act 1956 is required to maintain accounts on double entry system for
preparation of its financial statements and for mandatory disclosure of
information to the stakeholders of the company.

In practice, however, ‘Double Entry’ system is being practiced universally at

present barring a few small traders and shopkeepers.

Financial Accounting is required not only by business enterprises, but also by

Government Departments.

A Municipal Corporation has to maintain books of accounts for recording

financial transactions to account for sources and utilisation of funds.

Financial transactions on sources of funds generally include receipts of govt.

grants, collection of municipal taxes, raising funds from public or financial
institutions etc. while financial transactions for utilisation of funds include
payments for expenses incurred for road development and repairs, maintenance
of sanitation and cleanliness of the municipal wards, municipality upkeep and
public welfare, establishment and staff welfare etc. All such financial
transactions are required to be recorded in the books of accounts in accordance
with the accounting standards, accounting policies and procedures applicable to
municipalities.

Financial accounting in financial institutions like banks, insurance companies and

others are special in nature and type, as they are required to follow regulatory
norms and requirements of statutes over and above compliance with the
provisions of the Companies Act, 1956 as amended and the accounting standards
issued by The Institute of Chartered Accountants of India (ICAI). Accounts of
these business organisations are popularly called ‘Form Accounts’ in financial
accounting parlance. The Financial accounting of banks is based on RBI
regulations and the provisions of the Banking Regulation Act, 1949, in addition
to compliance with the relevant provisions of the Companies Act, 1956 and the
Indian Accounting Standards as referred to above.
 4

Insurance accounting is a systematic and analytical process of financial

accounting that requires compliance with the requirements of the Companies Act
1956, the provisions of the Insurance Act, 1938, the directives contained in the
IRDA Regulations on accounts and the Accounting Standards (AS) issued by the
ICAI (or the requirements of the relevant IFRS which will be applicable to the
insurance sector also very soon).

Insurance accounts are very specific in nature, in consideration of legal

requirements and also considering the information requirement for different
classes of stakeholders like policyholders, shareholders, financial institutions,
reinsures, co-insurers, regulators, the Government and the society at large.

Financial accounting methods followed by business houses depend on:

A The type of business

B The statutes
C Business laws applicable to them
D All of the above

1.2 Meaning of Accounting

Accounting is the process of recording and reporting of financial transactions

including the origination of the transaction, its recognition, processing and
summarisation in the financial statements.
The New York State Society of CPAs

The American Institute of Certified Public Accountants(AICPA) has defined

accounting as “an art of recording, classifying and summarising in a significant
manner and in terms of money, transactions, and events which are, in part at least
of financial character and interpreting the results thereof”.
 5

Accounting is thus the process of recording, classifying, summarising, analysing

and interpreting financial transactions and communicating the results thereof to
the interested parties.

Interested parties are the users of the financial statements namely, shareholders,
investors, employers, suppliers, trade creditors, customers, lenders, regulators,
Government Authorities, so on and so forth. Accounting involves the art of
presenting information systematically to the users of accounts. In the current era
of Information Technology, both business processes and financial transactions
have become very complex in nature and character, making the accounting
process more complex and critical for determining the result of operations,
preparation of general financial statements and presenting them to the different
interested group of stakeholders of the business entity. With Indian companies
going global in the open economy, the Accounting Standards, treated as the
foundation and guiding factor of accounting being followed now in our country,
are going to be converged with the International Financial Reporting Standards
(IFRS).

Implementation of IFRS on convergence of national accounting standards with

IFRS is the requirement not only in India, but also in 140 other countries in the
world, who have agreed to adopt IFRS already.

In that perspective, the meaning of accounting would not be limited to national

practices and conventions but would stretch beyond our country to have
standards at par with other countries for uniformity. Truly enough, accounting
would become international in character when IFRS would be adopted by most
of the countries.

Soon, an accountant would be expected to be conversant with the entire

accounting methods prevalent in other countries and be versatile enough to
prepare, present and interpret financial statements of any other country having
IFRS. This will necessitate grasping the conventional concepts of accounting,
continuous honing of the knowledge and skill acquired and being updated with
the various applicable legislations and statutes that are undergoing rapid change
every time.
 6

The paradigm shift would be according to the intention of the legislators as to

how they want to protect the interests of different types of stakeholders of any
business entity and thus require financial statements to be presented for the
purpose. Here lies the true meaning of accounting.

The very basic unit of accounting is a ‘transaction’ that differs from a general
event or an occurrence. An event which is measurable in terms of money and
which changes the financial position when it occurs gives rise to a transaction. To
put in the form of a corollary, it can be said that all transactions are events but
all events are not transactions.

Transactions are recorded first in the primary books of accounts known as

Journals including Cash Book and then transferred to Ledgers in the form of
Ledger Accounts. Balancing is done for all the ledger accounts including for
cash balance at a particular point of time. A summary of ledger balances is
prepared, known as ‘Trial Balance’, from which final accounts or financial
statements as on a particular date and for a particular period are prepared.

This, in short, is the meaning of accounting for the preliminary stage of learning.
Each of the above concepts is elaborated in subsequent units.

Which of the following are users of financial statements?

A Financial analysts
B Tax authorities
C Shareholders
D All of the above
 7

2. Describe the objectives and functions of accounting.

[Learning Outcome b]
There are two prime objectives of financial accounting:
1. to report on the financial position of an entity (e.g. a business, an
organisation); and
2. to show how the entity has performed (financially), particularly over an
accounting period. The most common measurement of "performance" is
profit.

2.1 Objectives of accounting

Diagram 1: The main objectives of accounting

The idea and objectives of accounting may well be appreciated with reference to
the concept of joint stock company operations where management is separated
from ownership.
A joint stock company or public limited company is treated as an artificial
juridical person having a separate identity and perpetual succession. A number of
interested parties are involved in such a joint stock company. To protect various
stakeholders including shareholders, investors, financiers, customers, suppliers,
employees, regulators, the Government and the society at large, there must be
proper financial accounting for every joint stock company.
 8

For every business enterprise, the society is a major group of stakeholders in

consideration of the social costs incurred by and social benefits created by the
enterprise through its business operations. No one can do business without the
participation of the society as a whole.

When an entity earns profits, it is supposed to incur many social costs like use of
the resources of the society, pollution etc. So the business enterprise is expected
to create social benefits like employment, availability of quality products at an
affordable price etc. As a result, the society is also interested to know the results
of the business operations of an enterprise.

Thus, financial accounting has the social responsibility to communicate results

and information to the society. Let us now elaborate on these objectives for better
understanding.

1. Recording of financial transactions

Book keeping, i.e. keeping records systematically is the first objective of

accounting.

Recording refers to the actual writing of the transactions that take place in words
and figures so that reliable information regarding the position of the business can

recorded are known as the books of originalNOT FOR SALES COPY

be made available at any point of time. The books where this information is
entry. The transactions are recorded
in the books of accounts on the basis of documents such as invoices, receipts,
vouchers, bank statements, etc.

Jadhav has started a business as a sole trader selling tables that he buys from a
craftsman’s shop called Table Crafters. He started the business in January 2012
and the following transactions took place during the year:

i) He deposited Rs. 50,000 cash into a bank account exclusively for the
business
ii) Jadhav bought 10 round wooden tables at Rs. 2,000 each from Table crafters
LLC.
iii) Jadhav sold all the tables during the year at Rs. 3,500 each for cash.
 9

The following are the documents on the basis of which the above transactions
and events could be recorded.

i) The business bank statements confirm the receipt and payment of cash into
the business account

ii) Purchase invoice issued by Table Crafters will be used to record the
purchases made

iii) Sales invoices issued by Jadhav will document the sales made.

The recorded transactions are then classified, summarised and analysed logically
for the purpose of preparation of financial statements in accordance with legal
and regulatory norms or provisions. The two end products of financial accounting
being Profit & Loss Account and Balance Sheet reveal profitability on one hand
and financial soundness on the other.

Therefore, transactions need to be summarised in a structured manner in order to

understand an entity’s financial position and performance at the end of a period.

2. Ascertainment of results of recorded transactions

The ultimate objective of accounting is preparation of financial statements, i.e.

Balance Sheet, Profit & Loss Account and other peripheral statements.
9 Profit and Loss Account is prepared to ascertain the net result i.e. operating
surplus or loss from the aggregate of all financial transactions effected by the
enterprise for a particular period – say, a year.

9 While Profit & Loss Account is prepared in a commercial organisation to

determine the result being either profit or loss, Income and Expenditure
Account is prepared for the same purpose for a non-profit seeking
organisation, the term being either surplus or deficit.

9 In General Insurance business, such results are determined by Revenue

Accounts followed by Profit and Loss Account.
 10

3. Assessment and analysis of financial health of the enterprise

A businessman is concerned not only with the profitability of the business
operations, but also with the growth and solvency of the entity. Due to some
windfall gain, the business may earn a hefty profit in a particular period of
accounting. Conversely, the business may incur a huge loss due to some
catastrophic event in any particular year. Such abnormal gain or accidental loss
should not be a deciding factor for a business’ decision for growth or expansion
plans.

Interested parties like present and prospective shareholders, investors, debenture-

holders, depositors, creditors, employees, regulators, taxation authorities and so
on are interested equally in annual profits, financial health as well as solvency of
the organisation, although from different angles.

For this purpose, a balance sheet, the final and conclusive part of financial
statements, is prepared to ascertain the financial position consisting of the total
assets and liabilities, net worth and net working capital of the organisation.
There are various tools and techniques to analyse the financial position of a
business as on a particular date such as Ratio Analysis, Fund Flow Analysis,
Cash Flow Analysis and others depending on the purpose of the analysis and the
parties who seek to analyse.

In insurance business, a lot of emphasis is directed towards solvency and

liquidity apart from net worth in measuring financial health. Solvency is the
capacity to pay liability and borrowings. The regulator may not allow an
insurance company to do business, or increase business without the requisite
solvency ratio which is computed with reference to RSM (Required Solvency
Margin) and ASM (Available Solvency Margin).

9 RSM is determined with reference to the nature and volume of business

operations and the incurred claims on such business operations.

9 ASM is calculated with reference to Net Worth being excess of assets over
liabilities in both the policyholders’ funds and the shareholders’ fund.

The balance sheet is the basis of ASM while Revenue Accounts provide the
required information for computation of RSM. This ratio is determined as per
IRDA (Assets, Liabilities and Solvency Margin of Insurers) Regulations, 2000.
 11

4. Communicating results to stakeholders for decision making

Accounting as a language of business communicates the financial results and

required information of the enterprise to various stakeholders by means of
financial statements. Such financial results and information on the financial
health of the enterprise help the interested group of stakeholders to take various
rational, financial and investment decisions with respect to the enterprise. In the
case of certain categories of companies, publication of periodic operational
results is mandatory as per the provisions of the relevant statute. An insurance
company prepares, presents and publishes an annual report every year containing
the financial statements as required by the Insurance Act, the IRDA Regulations
and other statutory provisions.

The Annual Report also contains Directors’ report, Management Report and
Audit Reports providing financial results, financial health and other particulars
for the information of all stakeholders. Pertinently, the objectives of financial
accounting as enumerated above (which are the subject matter of this study
course) are different from those of Cost Accounting, Management Accounting
and Human Resource Accounting.

In insurance business, a lot of emphasis is directed towards ____________ and

____________ apart from net worth in measuring financial health.

A Profitability, revenue
B Expenditure, revenue
C Solvency, liquidity
D Profit and loss account, balance sheet

2.2 Functions of Accounting

Functions of accounting stem from objectives of accounting, as discussed above.

The American Institute of Certified Public Accountants (AICPA) has regarded

accounting as a service activity. Its functions are “to provide quantitative
information, primarily financial in nature, about economic entities, that is
intended to be useful in making economic decisions, in making choices
among alternative courses of actions”.

Accounting includes several branches like Financial Accounting, Managerial

Accounting, Cost Accounting, Government Accounting etc.
 12

Diagram 2: The main functions of accounting

Here, we will concentrate on the main functions of financial accounting, which

are discussed below in brief.

1. Performance Measurement: financial accounting measures and determines

the past performance of the business entity and the current financial position
or the state of affairs through the financial statements. In general insurance
business, financial performance being profitability, solvency and liquidity of
the insurer is measured by Revenue Accounts, Profit &Loss Account,
Balance Sheet and Receipts & Payments Accounts (Fund Flow/Cash Flow
statements).

2. Forecasting and Trend Analysis: accounting results and past performance

analysis help in forecasting the future performance or trend analysis of
profitability and solvency of the enterprise based on the past data.

3. Providing Data for Decision Making: as mentioned earlier, accounting

provides not only accounting results, but also various financial information
and data for the users of the financial accounting statements, helping them in
rational decision making in respect of the enterprise.

4. Comparison and analysis: financial information, data and results contained

in the financial statements enable intra-company and inter-company
comparison and analysis for making informed decisions for the stakeholders
of the enterprise.
 13

5. Control: financial accounting also aids in exercising accounting control as

well as administrative control through maintenance of various books, records
and registers. For example, Premium Register, Co-insurance Register,
Advance Register etc. play very important roles in accounting control and
administrative control.

6. Government Regulations and Taxation: financial accounting and financial

statements provide the required information and particulars to various govt.
departments and regulators for their assessment and collection of various
taxes, revenues and fees.

In general, financial accounting helps to determine the reasonableness of the cost

for which funds are arranged and the manner in which such funds are employed
to exploit maximum returns.

3. Discuss the limitations of financial accounting.

[Learning Outcome c]
Financial accounting is not free from limitations. Following are the major
limitations of financial accounting.

Diagram 3: The limitations of financial accounting

 14

1. Financial Accounting permits alternative treatment

Financial accounting allows scope for alternative treatment of the same

transactions in certain cases based on accounting concepts, policies, principles
and assumptions that might be followed by different accountants. Accounting
follows GAAP - Generally Accepted Accounting Principles.

As there exists more than one principle for the treatment of any particular item,
treatment may vary from one entity to another depending upon their concept and
accounting policy. Thus, alternative treatment is permitted within the framework
of generally accepted principles followed by entities. However, complications
may crop up from this flexibility, specifically in the matter of comparability of
financial statements of different organisations.

The closing stock of a business house may be valued by any of the methods such
as FIFO (First-in- First-out), LIFO (Last-in-First-out), Weighted Average Price,
Average Price, Standard Price etc. As per Accounting Standard-2 issued by ICAI
only two methods i.e. First in First Out and Weighted Average are permitted.

If two different entities follow different methods of stock valuation, their

accounting results are not directly comparable.

However, in General Insurance accounting in India, the scope of alternative

treatment by different insurers has been reduced with the introduction of
mandatory observance of IRDA regulations in regard to recognition of income
and expenditure, valuation of investment and assets, determination of liability
etc. Yet, such regulations are not applicable to insurance companies in other
countries implying lack of feasibility of comparison with the financial statements
of companies in those countries. This type of difficulty is expected to be
curtailed, if not eliminated, with the implementation of IFRS.

2. Financial Accounting is influenced by personal judgments

Though the ‘Convention of objectivity' is followed in financial accounting,

estimates are required to be made to record certain events or transactions. Such
estimates are influenced by personal judgment in many cases. Consequently, it
becomes very difficult to maintain uniformity and accuracy in estimation, and
thus, objectivity suffers.
 15

In general insurance accounting, estimation of liability for outstanding claims

greatly differs in view of opinions and personal judgment of surveyors, stage of
survey, availability of relevant information and examination as also perception of
the underwriter concerned. Thus the so-called 'Convention of objectivity' is not
truly observed in estimation of liability for outstanding claims due to the fact that
estimates are influenced by personal judgments.

3. Financial Accounting ignores important non-monetary information

Financial accounting does not take into account transactions of non- monetary
nature such as efficiency of employees, input-output analysis, R&D application
and results and the like.

However, in accordance with AS 17 of the ICAI, segment reporting provides

detailed information about the different types of products and services as also the
geographical areas in which an enterprise may operate. Such detailed information
helps the users of financial statements to understand the performance, assess the
risks and returns of the enterprise in a better way and also make better
judgements about the enterprise. This AS has been made mandatory w.e.f.
01.04.2004 for certain specified companies and also applies to companies
carrying on general insurance business.

The IRDA (Preparation of Financial Statements and Auditor’s Report of

Insurance Companies) Regulations, 2002 also provide for applicability of
segment reporting as per AS 17 issued by the ICAI. Accounting software is being
devised to provide additional information on rural business (lives covered etc.).

4. Financial Accounting does not provide timely information

Financial accounting is designed to supply information in the form of financial

statements (Balance Sheet and Profit and Loss Account) usually for a period of
one year. For listed companies, half yearly accounts are prepared.

In general, financial statements of insurance companies are prepared and

presented for a period of one year, which are audited. Apart from the annual
financial statements, half-yearly accounts are also prepared and reviewed. In this
way, financial accounting is completed periodically, only on 'post-mortem' basis
from the past transactions. But business management requires live information at
frequent intervals to enable the management to design a strategy for expansion
 16

and take corrective action on adverse results, where such periodical financial
account closing and financial statements may not help much.

Instant and proactive decisions may not be feasible for want of current
information. However, as of now, financial accounting is done through
sophisticated software in all insurance companies, where timely information is
readily available for various management decisions. At present, this limitation
has been overcome to a large extent and is not noticed much in financial
accounting of general insurance companies. With the use of computer software,
Financial Accounting displays monthly profit and loss account and balance sheet
to overcome this limitation in the present day scenario in other sectors as well.

5. Financial Accounting does not provide technical details

The information supplied by the financial accounting and financial statements

prepared in accordance with the relevant legal provisions or regulatory
framework is aggregated in a summarised form from the financial transactions
occurred during the course of the year.

Such aggregates, although enabling the users to study the overall results of the
business transactions, do not provide such information product-wise, leaving
other incidental information for collection from other sources.

In general insurance business, Miscellaneous Revenue Account may reveal a net

result being either operating surplus or operating loss of all the products covered
under the Miscellaneous Department, which may include more than 100
products.

Though much of such details are taken care of through Segment Accounting,
complete details are not available in the case of motor insurance regarding class-
wise vehicles.
 17

6. Financial Accounting does not disclose the present value of the business

In financial accounting, the financial position of the business as on a particular

date is shown by a statement known as 'Balance Sheet'. In a Balance Sheet, the
assets are shown on the basis of the "Continuing Entity Concept”. Thus, it is
presumed that the business will have a relatively longer life and will continue to
exist indefinitely. Hence, the asset values are 'going concern values’ based on
historical cost.

The 'market value’ or ‘realisable value' of each asset is not ascertainable from the
financial statements for management decisions including those related to internal
reconstruction or external reconstruction like merger, amalgamation and others.

7. Financial Accounting does not provide classification of cost

Financial accounting does not classify costs into direct and indirect, fixed and
variable, controllable and uncontrollable, normal and abnormal etc. It only
allocates expenditure into two categories: as Capital and Revenue. Because of
such limitations, management decisions cannot be taken without the application
of Management Accounting that gathers information available from both
financial accounting and cost accounting.

8. Financial Accounting does not help in fixing price

Financial accounting does not provide adequate information for fixing the
selling prices of the products produced or services rendered by the business
concern. Financial accounting also does not provide a proper system of
controlling various elements of cost like materials, labour and management
expenses. A cost control procedure may be adopted by setting of standards,
which financial accounting lacks.

In general insurance, financial statements are prepared and presented for a period
of __________, which are audited.

A One year
B Two years
C Half year
D Quarter year
 18

4. Identify the books of account.

[Learning Outcome d]

Accounting entries are recorded in the ‘Books of Account’. Each individual

financial transaction is recorded at least through two different ledger accounts
within the financial accounting system.

Books of account broadly include Journals and Ledgers, termed the Primary
Books of Account and Final Books of Account respectively.

When an accounting transaction relating to a business is entered in the

accounting records for the first time, these records are called books of prime
entry or books of original entry. Books of prime entry are the books in which
transactions are recorded for the first time. These are also called basic / primary /
original accounting books.

While transactions are recorded initially in Journals through journal entries,

ledgers incorporate individual ‘Accounts’ under which details of such
transactions related to a particular account are available. These ledger accounts
display the balance as on a particular date, implying the net amount of all
transactions accounted under them.

9 Journals include Cash Book and Subsidiary Books or Day Books depending
on the volume of the business such as Sales Day Book, Purchase Day Book,
Return Inward Book, Return Outward Book, Bills Receivable Book, Bills
Payable Book and so on.

9 Ledgers include Cash Book also as it, like any other ledger account, displays
cash or bank balance as on a particular date. Besides, all cash transactions are
primarily recorded in the cash book. The Cash Book includes Bank Book
also. Hence, cash book is called both a journal and a ledger.
 19

The following table summarises the differences between journal and ledger:

Journal
Books of prime entry
As soon as transaction originates it
is recorded in the journal
Transactions are recorded in the
order of occurrence i.e. strictly in a
chronological order
Debit and credit amounts of a
transaction are recorded in adjacent
columns
Journal is not balanced
Final accounts can't be prepared
directly from the journal
Ledger
Books of final entry
Transactions are posted in the ledger
after they have been recorded in the
journal
Transactions are classified according to
their nature and are grouped in the
concerned accounts
Debit and credit amounts of a
transaction are recorded on two different
sides of two different accounts
Every account in the ledger is balanced
at the appropriate time
Ledger is the basis of preparing the final
accounts

Sec. 209 of the Companies Act 1956 requires Books of Accounts to be kept by a
company.

In general insurance companies, books of account maintained at operating offices

are different from the books of account maintained at the Head office level.

At present, books of account are maintained through computer systems as the

manual system of financial accounting has been almost discarded.
However, the following books of account are required to be maintained at the
operating office level of a general insurance company.

9 Cash Receipt Book 9 Sub-Ledger

9 Cash Disbursement Book
9 Petty Cash Register
9 Premium Register
9 Refund Premium Register
9 Cheque Dishonoured Book
9 Claims Disbursement Register*
9 Bank Transfer Sheet Journal
9 Journal or Journal Register
9 Cover Note Control Register
9 General Ledger
9 Salvage Register
9 Claims Intimation Register
9 Claims Recovery Register
9 Assets Register
9 Policy Stamp Register
9 Revenue Stamp Register
9 Co-insurance Register
9 TDS Register
9 Service Tax Register
9 Stationery Register
 20

* Claims disbursement is done from the same bank account at present along with
other payments, in contrast with the earlier system of maintaining a separate bank
account for making payment of a claim.

____________ is considered a ledger as well as a journal.

A Cash book
B Sales day book
C Return inward book
D Bills receivable

Summary
¾ Accounting is the process of recording, classifying, summarising, analysing
and interpreting the financial transactions and communicating the results to
its users.
¾ All transactions are events but all events are not transactions.
¾ The main objective and function of accounting is to report on the financial
position of the entity and highlight its performance for an accounting period.
¾ In insurance business, the balance sheet is the basis of ASM while Revenue
Accounts provide the required information for the computation of RSM.
¾ In general insurance companies, books of account maintained at the
operating offices are different from the accounts maintained at the head
office level.

Answers to Test Yourself

Answer to TY 1
The correct option is D.
Financial accounting methods followed by business houses depend on the types
of business and the statutes or business laws applicable to them.

Answer to TY 2
The correct option is D.
The users of financial statements include the shareholders, investors, employers,
suppliers, trade creditors, customers, lenders, regulators, Government
Authorities, tax authorities, financial analysts, etc.
 21

Answer to TY 3

The correct option is C.

In insurance business, for measuring the financial health, a lot of emphasis is

directed towards solvency and liquidity, apart from the net worth.

Answer to TY 4
The correct option is A.
In general insurance, financial statements are prepared and presented for a period
of one year, which are audited.

Answer to TY 5
The correct option is A.
Ledgers include Cash Book also as it, like any other ledger account, displays
cash or bank balance as on a particular date. Besides, all cash transactions are
primarily recorded in the cash book. Cash Book includes Bank Book also. Hence,
the cash book is called both a journal and a ledger.

Self Examination Questions

Question 1
For a municipal corporation, financial transactions on sources of funds generally
include:
A Collection of municipal taxes
B Amount incurred for road development and repairs
C Sale of goods
D Amount spent on public welfare

Question 2
Which of the following accounting system of recording transactions is being
practised universally?
A Single entry system
B Double entry system
C Balance sheet method
D Profit and loss account method
 22

Question 3

Insurance accounting requires compliance with the requirements of the

Companies Act __________, the provisions of the Insurance Act ________ and
the directives contained in the _________ Regulations.

A 1938, 1956, AS
B 1956, 2000, IFRS
C 1956, 1938, IRDA
D 1938, 2002, ICAI

Question 4

In general insurance business, financial results (profitability) are determined by

the _____________.

A Profit and loss account

B Revenue accounts
C Income and expenditure account
D Receipts and Payments account

Question 5

The ‘realisable value' of each asset is not ascertainable from the financial
statements for management decisions because of which of the following
limitations of financial accounting?

A Does not provide technical details

B Does not provide classification of cost
C Does not disclose present value of the business
D Does not help in price fixation

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is A.

Options B and D indicate utilisation of funds.

Option C indicates revenue income.
 23

Answer to SEQ 2

The correct option is B.

In practice, the ‘Double Entry’ system is being applied universally at present,

barring a few small traders and shopkeepers. A sole proprietor may maintain his
books of accounts on a single entry basis, which generates incomplete records
only.

Answer to SEQ 3

The correct option is C.

Insurance accounting is a systematic and analytical process of financial

accounting that requires compliance with the requirements of the Companies Act
1956, the provisions of the Insurance Act, 1938 and the directives contained in
the IRDA Regulations on accounts and the Accounting Standards (AS) issued by
ICAI or the requirements of the relevant IFRS which will be applicable to the
insurance sector also very soon.

Answer to SEQ 4

The correct option is B.

In General Insurance business, financial results are determined by Revenue

Accounts followed by Profit and Loss Account.

Answer to SEQ 5

The correct option is C.

The 'market value’ or ‘realisable value' of each asset is not ascertainable from the
financial statements for management decisions including those related to internal
reconstruction or external reconstruction like merger, amalgamation and others as
financial statements are based on the historical cost and do not disclose the
present value of the business.
 24

CHAPTER 1

ACCOUNTING SCOPE, CONCEPTS,

PRINCIPLES AND STANDARDS
UNIT 2

ACCOUNTING CONCEPTS, PRINCIPLES AND

CONVENTION
Chapter Introduction
Financial statements of different entities in a particular industry should be
prepared on a uniform basis to communicate proper financial information
regarding financial accounting to the stakeholders to enable them to make
informed decisions. To achieve uniformity for this purpose, financial accounting
- a language of business - must be within the framework of GAAP (Generally
Accepted Accounting Principles). The term ‘GAAP’ is used to describe general
rules, conventions and practices of Financial Accounting as also preparation of
Financial Statements accepted by the accounting fraternity and users of financial
statements in a particular country.

These rules of financial accounting comprise Accounting Concepts, Principles

and Conventions. Accounting Principles are the basic norms and assumptions on
which the whole system of financial accounting is established. However, the
GAAP of one country may differ from that of another country, although the main
principles remain undistorted. Thus, US GAAP may differ from Indian GAAP
and with the GAAP of any other country.

The proposed IFRS is expected to eliminate these differences among those

countries who would adopt it.

a) Discuss the various accounting concepts.

b) Discuss the various accounting principles.
c) State the elements of financial statements.
 25

1. Discuss the various accounting concepts.

[Learning Outcome a]

Accounting concepts are the fundamental ideas and assumptions in

accounting.

These are the fundamental rules that must be followed while preparing the
financial statements. A clear disclosure must be made in the financial statements
if these are not followed.

Accounting concept refers to the basic assumptions and rules which work as the
basis of recording business transactions, maintaining accounts and preparation of
financial statements.

These concepts are assumed and accepted in accounting to provide uniform

structure, rules and logic to the accounting process.

The accounting transactions and financial statements are interpreted in the light
of accounting concepts, which have universal application.

Accounting concepts provide the basic assumptions and postulates that lay the
foundation on the basis of which the accounting principles are formulated.

The accounting concepts, with their universal application, enable maintaining

uniformity and consistency in accounting records as well as in interpreting
financial statements in the same meaning and sense.

All the concepts have been developed over the years from experience before they
have been universally accepted as rules.

For Mock Test Visit:

https://irdaexam.in/
 26

Diagram 1: Important accounting concepts

These are elaborated in the following paragraphs.

1. Business Entity Concept
This concept states that the business entity and its owner(s) are two separate
independent entities for the purpose of accounting. Thus, business transactions
and personal transactions of the owner of a business are separately entered in the
business’ books of account and in personal books of record respectively.
For example, when an owner invests money in the business, it is recorded as a
liability of the business entity to the owner either as capital or as a loan. It is
shown on the liability side of the Balance Sheet. Similarly, when the owner
draws cash or goods for his personal use from the business, it is treated as
drawings, not as business expense. Let us take an example.

Mr. Arora started his business investing Rs. 10,00,000. He purchased plant &
machinery of Rs. 3,00,000, furniture & fixture for Rs. 1,00,000, and goods for
Rs. 5,00,000, keeping Rs. 1,00,000 in hand.
Plant & machinery, furniture & fixture, stock of goods and cash in hand are
assets of the business, and not of the owner according to the business entity
concept. Rs. 10,00,000 will be treated by the business entity as capital, i.e. as a
liability of the business towards Mr. Arora.
 27

2. Money Measurement Concept

This concept assumes that all business transactions must be measurable in terms
of money, that is, in the currency of a country.

In our country, such transactions are measured in terms of Rupee that has gained
a new symbol of its own in July, 2010. It has been waiting for international
recognition from Unicode Consortium to be the fifth currency in the world to
have a distinctive identity. The symbol has been reproduced on the very first
page of this book.

Thus, as per the money measurement concept, transactions that can be expressed
in terms of money are recorded in the books of account.

Purchase of goods for Rs.10,00,000, sale of goods worth Rs. 20,00,000, wages
paid Rs.5,00,000, rent paid Rs.1,00,000 and salary paid Rs.1,00,000 in a business
enterprise for the year 2009-10 are all transactions.

These transactions are expressed in terms of money, and hence they can be
recorded in the books of account to determine the profit earned or loss incurred
by the entity. It naturally follows that transactions which cannot be expressed in
monetary terms are not transactions and hence, are not recorded in the books of
account. Another aspect of this concept is that records of the transactions are to
be kept not in physical units or in quantitative terms, but in monetary units.
Quantitative particulars may be required for the purpose of reconciliation.

For example, a general insurance company issued 10-lakh personal accident (PA)
policies covering 1-crore persons. Such transactions will not find a place in the
financial books of account, unless premium collection from all such PA policies
are measured or calculated. Details such as number of policies issued and persons
covered may be entered in other registers or records. Thus under this concept, the
insurance transactions which can be expressed in terms of money only are
recorded in the account books.

This concept guides accountants what to record and what not to record. It helps
in recording business transactions uniformly. It also facilitates comparison of
performance of two different periods of the same firm or of two different firms
for the same period.
 28

3. Going Concern Concept

This concept states that an entity will continue to carry on its business activities
for an indefinite period of time. It means that transactions are recoded and
financial statements are prepared on an assumption that the business entity has
continuity of life and will not be dissolved in the near future. This is an important
assumption of accounting, as it provides a basis for showing the value of assets in
the balance sheet.

For example, an insurance company spent Rs.50 crore for installation of new
computers for its 300 operational units in 2009-10. The new computers each have
a life span of 5 years. Applying this concept, certain percentage (say 20%) of the
total cost of computers will be considered business expenses as ‘Depreciation on
Computer’ and the balance amount will be shown as an item of assets i.e.
Computers in the Balance Sheet as at 31.03.2010.

Under this concept, if an amount is spent for acquiring an asset which will be
used in business for many years, it will not be proper to charge the entire amount
to the revenue of the firm for the year in which the item is acquired. Therefore,
only a part of the value is shown as expense in the year of purchase and the
remaining balance is shown as an asset. On the basis of this concept,
depreciation, being the cost of the annual use of an asset, is charged on the fixed
assets and the balance is carried over for the remaining useful life in the books of
the business concern.

4. Accounting Period Concept

All transactions are recorded in the books of account on the assumption that
financial results of such transactions are to be ascertained for a specified period
known as the accounting period, which is usually one year. This concept requires
that the financial statements, like the balance sheet and profit & loss account,
should be prepared periodically – e.g. annually, half yearly or quarterly as the
case may be. This is necessary for different purposes like calculation of profit,
determination of financial position, tax computation, various performance
analyses etc. In general insurance business, financial statements are prepared on
quarterly basis as per legal and regulatory norms, in addition to half yearly and
annual accounts, for which statutory audit is carried out.

According to the accounting period concept, all the transactions are recorded in
the books of account for an accounting period as stated above.
 29

Goods purchased and sold during a particular period and rent, salaries and other
expenses incurred and paid for that period are accounted for in that period only.

In general insurance business, premium income is accounted for on “Net

Premium Earned” basis, and not on “Gross Premium Collected” basis. Similarly,
Claims are accounted for as “Incurred Claim”, and not as “Claims Paid”.

This implies that income is to be considered for a particular period only even
when it is received in excess or in advance or may be accrued but not yet
received. Only that portion of the income is to be incorporated which pertains to
the particular period under consideration, whether received fully or not and
whether accrued but not received as also whether received in excess or in
advance. A similar principle applies in the case of expenses also.

The methods of computation of “Net Premium Earned” and “Incurred Claim” are
discussed elaborately in Unit 10.

This concept helps not only in determining the correct result of all financial
transactions that occur in the accounting period, but also in predicting the future
prospects of the business from the financial accounting viewpoint. It helps in
calculating the appropriate tax liability on business income calculated for a
particular time period and in determining the correct amount of profits to be
distributed as dividend for the period. It also helps all stakeholders to assess and
analyse the performance of a business for a particular period.

5. Accounting Cost Concept

Accounting cost concept states that all assets are recorded in the books of
accounts on the basis of historical cost or at their purchase price that includes
cost of acquisition, transportation and installation, and not at the market price. It
means that fixed assets like building, plant and machinery, furniture, etc. are
recorded in the books of accounts at the price paid for them.
 30

A building was purchased by XYZ Insurance Co. Ltd for Rs. 50,00,000 in May
2009.

An amount of Rs. 5,00,000 was spent for further development and elevation
coupled with another Rs. 5,00,000 for registration of charges in the same year.

On 31st March 2010, the market value of the said building was found to be Rs.
70,00,000. The total amount at which the building is to be recorded in the books
of accounts would be Rs. 60,00,000 (50 Lac+5 Lac + 5 lac), and not
Rs.70,00,000.

The accounting cost concept is also known as historical cost concept.

The effect of this concept is that if the business entity does not pay anything for
acquiring an asset, that asset would not appear in the books of account. Thus,
goodwill appears in the accounts only if the entity has purchased this intangible
asset for a price.

6. Dual Aspect Concept

Dual aspect concept is the foundation of double entry book-keeping system.

Under this concept, every transaction or event has two aspects.

If we consider this concept in regard to an item of assets having been involved in

a transaction, it may result in any of the under mentioned alternatives.

9 It increases one asset and simultaneously decreases another asset.

9 It increases an asset and simultaneously increases/creates a liability.
9 It decreases one asset and decreases a liability.
9 It increases one liability and decreases another liability.
 31

Following is an extract of the balance sheet as at 31st March 2010 of X Insurance

Co.

Balance Sheet as at 31-03-2010

Liability Rs in Asset Rs in
crores crores
Capital 200 Investments 11,000
Reserves & Surplus 5,000 Fixed Assets 200
Borrowings NIL Current Assets (including 300
Cash & Bank Balance)
Current Liabilities 6,300
(Including O/S Claims
Rs.4200cr. & Unexpired
Reserve Rs.2100cr.)
11,500 11,500

Prepare the balance sheet of the company as at 1st April 2010, assuming that there
is only one transaction of settlement of one O/S claim for Rs.100 crores.

The balance sheet as at 1.4.2010 will be as follows:

Balance Sheet as at 01-04-2010

Liability Rs in Asset Rs in
crores crores
Capital 200 Investments 11,000
Reserves & Surplus 5,000 Fixed Assets 200
Borrowings NIL Current Assets (including 200
Cash & Bank Balance)
Current Liabilities 6,200
(Including O/S Claims Rs.
4,100cr. & Unexpired
Reserve Rs. 2,100cr.)
11,400 11,400

Thus, a decrease in the Current Liability (O/s Claim) by Rs. 100 crores has
reduced the current asset value by Rs.100 crores.
 32

This concept assumes that every transaction has a dual effect, i.e. it affects two
accounts on opposite sides. Therefore, the transaction should be recorded at two
places. It means that both the aspects of the transaction must be recorded in the
books of account. Thus, the duality concept is commonly expressed in terms of
the fundamental accounting equation:

Assets = Liabilities + Capital

Diagrammatically, it can be presented as:

The above accounting equation states that the assets of a business are always
equal to the claims of the owner/owners and the outsiders. This claim of the
owner(s) is termed capital or owners’ equity and that of outsiders as liabilities or
creditors’ equity.
7. Realisation Concept / Revenue Recognition Concept
This concept states that revenue from any business transaction should be
included in the accounting records only when it is realised. The term realisation
means creation of legal right to receive money. While selling goods is realisation
amounting to a transaction, receiving an order is not a transaction to be recorded
in the books of account. Here, revenue is said to have been realised when cash is
received or the right to receive cash has been accrued on the sale of goods or
services or both.

X Insurance Co Ltd received a fire insurance proposal for the insurance of a

factory for its plant, machinery, building and stock worth Rs. 5 crores. The
business proposal was accepted by the branch manager for a premium of Rs. 5
lakh on 30th March 2010, but the premium cheque was received on 6th April,
2010.
This transaction would be entered in the books of account when the premium
cheque was received on 6th April 2010 and the insurance coverage would be
operative from that date only, i.e. w.e.f. 6th April 2010.
 33

This is in accordance with the provisions of Section 64VB of the Insurance Act,
1938 which is a special requirement in the matter of receipt of insurance
premium.

P & Co sold goods on credit for Rs. 50,000 during the year ending 31st March
2010. The goods have been delivered in March 2010 but the payment was
received only in April 2010.

Here, P & Co’s revenue of Rs. 50,000 would be entered in the books in March
2010 because the goods have been delivered to the customer in March 2010 and
revenue became due in March 2010 itself.

In the above example, revenue is realised when the goods were delivered to the
customers. The concept of realisation states that revenue is realised at the time
when goods or services are actually delivered or rendered. In short, realisation
occurs when the goods and services have been sold or rendered either for cash or
on credit. It also refers to inflow of assets in the form of receivables.

An insurance transaction for premium income recognition being at the time of

receipt of cash differs from a transaction of income belonging to a commercial
organisation. This difference can be understood from the examples stated above.

8. Accrual Concept

Accrual concept requires revenue to be recognised when it is realisable or

realised, and expenses to be recognised when they become due and payable,
without having regard to the time of cash receipt for goods delivered or services
rendered and the time of cash payment for goods or services received.

It means that revenues are recognised when they become receivable whether cash
is immediately received or not and the expenses are recognised when they
become payable whether cash is immediately paid or not. Both the transactions
are to be recorded in the accounting period to which they relate.

Therefore, the accrual concept makes a distinction between the actual receipt of
cash and the right to receive cash as regards revenue and actual payment of cash
and obligation to pay cash as regards expenses.
 34

The accrual concept assumes that revenue is realised at the time of sale of goods
or services rendered, irrespective of the time when the cash is actually received.

A firm sold goods for Rs. 50,000 on 25th March 2010, but the payment was not
received until 10th April 2010.

The amount of sale proceeds was receivable by the firm on the date of sale, i.e.
25th March 2010. It must be entered in the books of account as revenue for the
year ending on 31st March 2010.

Similarly, expenses are to be recognised at the time when goods are purchased or
services are received, irrespective of the time of actual payment.

Under this concept, all insurance claims are registered and entered in the books
of account by an insurance company on receiving claim intimation from the
policyholders.

However, the accrual concept is not applicable to general insurance companies in

the matter of revenue from premium in view of the mandatory provisions of
Section 64VB of the Insurance Act, 1938 (as mentioned elsewhere in this unit).

A provision is created for unexpired risk to cover the risks associated with receipt
of premium, insurance coverage of which extends beyond the accounting period
in which the premium was received.

9. Matching Concept

The matching concept states that the revenue and the expenses incurred to earn
the revenue must belong to the same accounting period.

Hence, once the revenue is realized, the next step is to allocate it to the relevant
accounting period and the expenses related to such revenue are also to be
identified in the same accounting period.

The Matching concept follows the Accrual concept discussed earlier.

 35

Let us study the following transactions of a business during the year 2009-10.

9 Sales are Rs. 10,000 (cash Rs. 6,000 and credit Rs. 4,000). Book Debt is Rs.
3,000 as on 31.3.10.
9 Paid for Purchase, Rs. 5,000.
9 Wages & Salaries paid, Rs. 2,000. Salary &Wages Outstanding Rs. 1,000 on
31.3.10.
9 Commission paid Rs. 1,000 including the amount paid in excess, Rs. 500.

In the above example, expenses would be matched with revenue when the
accountant calculates “expenses incurred” instead of amount paid for expenses.

Continuing with the previous example

Here, total revenue for the year is Rs. 10,000, while total Incurred Expenses are
Rs. 8,500 though total expenses paid amount to Rs. 8,000.
Under the matching concept, profit for the year will be Rs. 1,500 i.e.
Rs. [10,000 - {(5,000) + (2,000 + 1,000) + (1,000 – 500)}].
Workings
W1 Expenses paid

Rs.
Purchases 5,000
Wages and salary 2,000
Commission 1,000
8,000

W2 Expenses incurred

Rs. Rs.
Purchases 5,000
Wages and salary 2,000
Add: Outstanding 1,000 3,000
Commission 1,000
Less: Prepaid 500 500
8,500
 36

If the Matching Concept is not followed, Profit will Rs. 2,000 [Revenue Rs.
10,000-(Expenses Rs. 5,000 + Rs. 2,000 + Rs. 1,000), which will not be a true
and fair view of profit for the year.

Therefore, the matching concept implies that all revenues earned during an
accounting year, whether received or not during that year and all cost incurred,
whether paid or not during the year should be taken into account while
ascertaining the profit or loss for that year.

This concept shows how the expenses should be matched with revenue for
determining the exact profit or loss for a particular period. It is very helpful for
the management, investors and shareholders to know the exact amount of profit
or loss of the business.

In general insurance business, the Matching Concept is applied in

recognition of income and expenses.

For example:

9 Premium income is recognised as income over the contract period or the

period of risk, whichever is appropriate.

9 Unearned premium and premium received in advance which do not

represent premium income relating to the current accounting period are
treated and disclosed separately in the financial statements.

9 A Reserve for Unearned Premium is created against that part of premium

written which is attributable to the subsequent accounting periods.

Match the following:

(i) Business entity concept
(ii) Money measurement
concept
(iii) Going concern concept
(iv) Accounting period
concept
(a) Health of director is not recorded in the
books of accounts
(b) Owner’s personal expenses are recorded as
drawings in the books of accounts
(c) Order received for supply of goods is not
recorded
(d) Fixed assets are shown in the books at their
cost
 37

(v) Accounting cost concept (e) Transaction should be recorded at two places
(vi) Dual aspect concept (f) Goodwill appears in the accounts only if the
entity has purchased this intangible asset for
a price
(vii) Realisation concept (g) Goods purchased and sold during the period,
rent, salaries etc. paid for the period are
accounted for and against that period only
(viii) Accrual concept (h) Income is the excess of revenues over
expenses
(ix) Matching concept (i) Revenue is recognised when it is realised and
expenses are recognised when they become
due / payable

2. Discuss the various accounting principles.

[Learning Outcome b]

2.1 Accounting principles

Accounting principles are a body of doctrines commonly associated with the

theory and procedures of accounting, serving as an explanation of current
practices and as a guide for selection of conventions or procedures, where
alternatives exist.

Financial accounting provides information that is assembled and reported

objectively in accordance with universally accepted principles. The users of
financial statements who rely on such information have a right to be assured that
the data and information contained in the financial statements are free from bias
and inconsistency. For this purpose, financial accounting is based on certain
standards or rules that are called "Generally Accepted Accounting
Principles" (GAAP).

Principles derive from tradition, practice and concepts as discussed earlier.

“Generally Accepted Accounting Principles" (GAAP) are a guide to the
accounting profession in the choice of accounting techniques and preparation of
financial statements. GAAP are not static in nature, but change in response to
changes in the socio-economic conditions, new inventions, knowledge and
technology.
 38

Accounting principles have been developed over the years from experience,
research, usage, conventions and concepts. They are judged on their general
acceptability rather than on universal acceptability to the makers and the users.
Therefore they are called Generally Accepted Accounting Principles or GAAP.
The structure and manifestation of GAAP is done through Accounting Concepts,
Accounting Assumptions and conventions. Different committees, regulators and
institutes have pronounced or issued the principles of accounting from time to
time after considering the findings of their research or study on the subject. The
IRDA has prescribed Accounting Principles for preparation of financial
statement in Part 1 of Schedule B to IRDA (Preparation of Financial
Statements and Auditor’s Report of Insurance Companies) Regulations,
2000. These principles are separately discussed in Unit 12. All insurance
companies in India are required to follow the said principles.

As stated above, Accounting Principles are usually developed by professional

bodies like the American Institute of Certified Public Accountants in the US, the
Institute of Chartered Accountants of England and Wales (in the UK), the
Institute of Chartered Accountants of India in India, and the like.

However, following are the basic principles.

1. Accrual Principle
2. Matching Principle
3. Realisation Principle
4. Continuity Principle or Going Concern Principle
5. Periodicity principle
6. Consistency Principle
7. Prudence Principle
8. Materiality/ Disclosure Principle

The first five principles have been discussed in the earlier Learning Outcome on
Accounting Concepts and the other three principles are briefly discussed
hereafter.

1. Principle of consistency
The principle of consistency requires that the financial statements be prepared in
the same manner, period after period.
This principle states that when a business has once fixed a method or principle
for accounting an item, it must adopt the same method or principle for all similar
items that would follow in exactly the same way. There will not be any change in
the accounting policy.
 39

Shivam Co valued its stock under the last in first out method (LIFO) until 2010.
But AS 2 Inventories does not permit the LIFO method of inventory valuation
and is applicable to the accounting periods in 2005. Therefore, the company has
to follow a different method for valuing inventory from 2005.

In case of any change, the necessity and impact of such change must be disclosed
in the financial statements for the information of users.

Until 2009, Raghunath Traders followed the reducing balance method (RBM) for
charging depreciation on assets. However, in 2010, the company calculated
depreciation according to the straight line method (SLM). Here, Raghunath
Traders has not followed the principle of consistency.

If Raghunath Traders wants to change its accounting policy, the necessity and
impact of the change in the depreciation amount must be disclosed in the notes to
the financial statements.

2. Principle of prudence / conservatism

This principle aims at showing the state of affairs on “as is" basis; there should
not be any attempt to make things look better or healthier than they actually are.

The concept of prudence implies that the profit should not be over-stated but all
anticipated losses should be recognised. The implication of this is that all
anticipated losses should be recognised and recorded immediately. But profits
should be recognised and recorded in the books of account only when realised
(this need not necessarily be in cash).

The following are the examples of the principle of prudence:

9 Bad debt expense is recorded in the books of accounts to avoid net income
being overstated.
9 Stock is recorded at the lower of cost and net realisable value.
9 Contingent liabilities are recorded, but contingent assets are not recorded in
the books of accounts.
 40

3. Principle of Materiality/ Principle of Disclosure

Materiality means relative importance. Material items are important items that
the users of the financial statements must be aware of. The financial statements
should show all the material items separately. The concept of materiality relates
to the time, efforts and the cost of accounting in relation to the usefulness of the
data generated. Materiality requires that only those items which have a bearing
on the determination of financial position and computation of profit and loss
during the accounting period should be recorded and disclosed in the financial
statements.

All information and values pertaining to the financial position of a business must
be recorded and disclosed in the financial statements. Pertinently, the materiality
depends not only on the amount of the item, but also on the value, size and
importance of the information. What is material is a question that depends on the
situation and related matters of the issue.

Manoj Group of Industries, a large manufacturing firm, has a total of company’s

debtor accounts for the year 2011 as Rs. 9,50,000.

One of the company’s stationery providers to whom Rs. 100 was given as
advance, closed his business. It was clear that the company would not be able to
recover the advance.

Here, considering the company’s scale of operations, Rs. 100 is not a material
amount. Hence, Manoj Group of Industries need not adjust the total debtors’
amount immediately. The financial statements would still be fair.

The materiality concept does not apply to cash transactions.

Which of the following statements are incorrect?

(i) In accounting, all the business transactions are recorded based on the concept
of dual aspect.
(ii) Accrual concept implies accounting on cash basis.
(iii) Revenues are matched with the expenses in accordance with the matching
principle.
(iv) In accordance with the principle of conservatism, the accountant should
provide for all possible losses, but should not provide for anticipated income.
 41

A All of the above

B Only (i) and (ii)
C Only (iii) and (iv)
D Only (ii) and (iii)

3. State the elements of financial statements.

[Learning Outcome c]

3.1 Accounting assumptions

Financial accounting is based on the following fundamental accounting

assumptions:
9 Economic Entity or Separate Entity
9 Going Concern
9 Accrual
9 Consistency
9 Money Measurement or Money Unit

All the above stated fundamental assumptions have been discussed in earlier
Learning Outcomes. If nothing is mentioned about accounting assumptions
adopted in the preparation of financial statements, it is assumed that the
preparation of financial statements is based on the fundamental assumptions as
detailed above.

3.2 Financial Statements

The main objectives of financial accounting are:

i) to keep systematic records for all financial transactions of an entity;

ii) to ascertain financial results and financial position; and
iii) to communicate the relevant financial information to all stakeholders of the
entity.

The financial statements are the basic documents through which financial
information is communicated to the stakeholders.
The financial statements generally include:
i) Balance Sheet;
ii) Profit & Loss Account; and
iii) Notes to Accounts.
 42

Preparation of financial statements is based on the aforesaid accounting

principles, assumptions, and relevant rules in compliance with the requirements
of the applicable Accounting Standards issued by the Institute of Chartered
Accountants of India. The financial statements of a company must be prepared in
accordance with the provisions of the Companies Act 1956 and the relevant
regulations applicable to the entity apart from compliance with the requirements
of the applicable Accounting Standards issued by the Institute of Chartered
Accountants of India.

For example, the Financial Statements of a bank will be prepared as per specific
regulations issued by the RBI; the financial statements of an insurance company
are governed by the specific accounting regulations issued by the IRDA. The
provisions of various sections, particularly sec.198, s.205, s.211, s.212, s.349,
s.350 are to be complied with in preparation of the financial statements of a
company.

As per the IRDA regulations, the following financial statements of an insurance

company are prepared as per specified formats and in accordance with
Accounting Principles and General Instructions for preparation of financial
statements described in the said regulations over and above the compliance with
the requirements of the Companies Act, 1956, the Insurance Act, 1938 and the
applicable Accounting Standards (AS).

9 Balance Sheet
9 Revenue Accounts
9 Profit and Loss Account
9 Receipts and Payments Account – Cash Flow Statement

These financial statements primarily show the financial position and financial
performance of an enterprise. The financial position of a business as reflected in
the Balance Sheet covers the following aspects as on a particular date.

a) Assets

Resources controlled by the enterprise as a result of contribution from the

promoters, shareholders and past performances from which future economic
benefits are expected to arise to the enterprise.
 43

Examples include:

9 Fixed assets
9 Stock in trade
9 Cash and Bank (debit) Balance

b) Liabilities

Obligations of the enterprise arising from the borrowings made by the promoters,
shareholders and past performances, the settlement of which is expected to make
use of the enterprises' resources, i.e., assets.

Examples include:
9 Creditors
9 Bank loan
9 Outstanding expenses

c) Equity
It refers to owners’ capital or residual interest in the assets of the enterprise after
deducting all the liabilities. This is also called the Net Worth of the enterprise.

Examples include:

9 Owners’ contribution
9 Retained earnings

3.3 The financial performance of an enterprise is primarily provided in Revenue

Accounts prepared for three departments followed by an Income Statement
or Profit and Loss Account covering the following aspects.
a) Revenues
It refers to increases in economic benefits during an accounting period in the
form of inflows or increase of assets and decrease in the liabilities. However, it
does not include the contributions made by the equity participants, i.e.,
proprietor, partners and shareholders.
 44

Examples include:

9 Sales revenue
9 Income from investments
9 Dividends received

b) Expenses

It refers to decreases in economic benefits during an accounting period in the

form of outflows or depletion of assets or appreciation in liabilities that result in
decreases in equity.

Examples include:

9 Wages and salaries paid

9 Interest on borrowings
9 Office maintenance

The financial statements must disclose all reliable and relevant information.
The disclosure should be full, fair and final so that the users can correctly assess
the financial position of the enterprise. The disclosures of all the major
accounting policies and other information are to be provided in the form of
‘Notes to the Financial Statements’.

Which of the following items represents income?

A Interest received
B Share capital
C Cash received from sale of machinery
D Salaries and wages paid to employees
 45

Summary
¾ Generally Accepted Accounting Principles refer to the rules or guidelines
adopted for recording and reporting of business transactions in order to bring
uniformity in the preparation and presentation of financial statements. These
principles are also referred to as concepts and conventions.
¾ The important accounting concepts are business entity, money measurement,
going concern, accounting period, cost, dual aspect, realisation, accrual, and
matching concepts.
¾ Business entity concept assumes that for accounting purposes, the business
enterprise and its owner(s) are two separate entities.
¾ Money measurement concept states that only those transactions and
happenings in an organisation that can be expressed in terms of money are to
be recorded in the books of accounts. Also, records of the transactions are to
be kept not in physical units, but in monetary units.
¾ Going concern concept states that a business firm will continue to carry on
activities for an indefinite period of time.
¾ Accounting period concept states that all the business transactions are
recorded in the books of accounts on the assumption that profits of
transactions is to be ascertained for a specified time period.
¾ Accounting cost concept states that all assets are recorded in the books of
accounts at their cost price (not at the market price).
¾ Dual aspect concept states that every transaction has a dual effect. It is
commonly expressed in terms of the fundamental accounting equation Assets
= Liabilities + Capital
¾ Revenue recognition concept requires that the revenue for a business
transaction is considered to be realised when a legal right to receive it arises.
¾ Matching concept emphasises that expenses incurred in an accounting
period should be matched with revenues during that period. It follows from
this that the expenses incurred to earn this revenue must belong to the same
accounting period.
¾ Consistency concept states that accounting policies and practices followed
by an entity should be uniform and consistent so that results are comparable.
¾ Conservatism (prudence) concept requires that business transactions
should be recorded in such a manner that profits are not overstated. All
anticipated losses should be accounted for but all unrealised gains should be
ignored.
¾ Materiality concept states that accounting should focus on material facts. If
the item is likely to influence the decision of a reasonably prudent investor or
creditor, it should be regarded as material, and should be disclosed in the
financial statements.
 46

Answers to Test Yourself

Answer to TY 1
(i) Business entity (b) Owner’s personal expenses are recorded as
drawings in the books of accounts
(ii) Money measurement (a) Health of director is not recorded in the books
concept of accounts
(iii) Going concern (d) Fixed assets are shown in the books at their cost
concept price
(iv) Accounting period (g) Goods purchased and sold during the period,
concept rent, salaries etc. paid for the period are
accounted for and against that period only
(v) Accounting cost (f) Goodwill appears in the accounts only if the
concept entity has purchased this intangible asset for a
price
(vi) Dual aspect (e) Transaction should be recorded at two places
(vii) Realisation concept (c) Order received for supply of goods is not
recorded
(viii) Accrual concept (i) Revenue is recognised when it is realised and
expenses are recognised when they become due
/ payable
(ix) Matching concept (h) Income is the excess of revenue over expenses

Answer to TY 2
The correct option is D.
Statement (ii) is incorrect because the accrual concept implies accounting on
accrual basis. Statement (iii) is incorrect because expenses are matched with
revenue in accordance with the matching principle.

Answer to TY 3
The correct option is A.
Interest received is income. Share capital will be included in equity; salaries and
wages to employees are expenses of the business.
While cash has been received in exchange for an asset; the income in this
transaction would be the amount received over the fair value (value) of the asset.
This amount would be known as gain on sale of asset.
 47

Self Examination Questions

Question 1

According to which of the following accounting concepts / assumptions will

sincerity, loyalty and honesty of employees not be recorded in the books of
accounts?

A Business entity
B Going concern
C Dual aspect
D Money measurement

Question 2

Which of the following concepts states that a business entity will not be closed
down in the near future?

A Money measurement concept

B Going concern concept
C Accounting cost concept
D Realisation concept

Question 3

According to which of the following assumptions / concepts are transactions

between the owner and business recorded separately?

A Business entity
B Historical cost
C Accounting period
D Accrual

Question 4

Business concerns must prepare financial statements at least once in a year: this
is based on the ___________ assumption.
A Consistency
B Accounting period
C Dual aspect
D Business entity
 48

Question 5

Stock in trade is to be recorded at cost or market price whichever is lower; this is

based on the _____________ principle.

A Materiality
B Going concern
C Prudence
D Consistency

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is D.

In accordance with the money measurement concept, transactions which can be

expressed in terms of money are recorded in the books of accounts.

Hence, the factors which cannot be measured in terms of money (e.g. sincerity,
honesty etc.) are not recorded in the books of accounts.

Answer to SEQ 2

The correct option is B.

This concept states that an entity will continue to carry on its business activities
for an indefinite period of time.

Answer to SEQ 3

The correct option is A.

According to the business entity assumption, for accounting purposes, the

business enterprise and its owners are two separate, independent entities.
 49

Answer to SEQ 4

The correct option is B.

Business concerns must prepare financial statements at least once in a year: this
is based on the accounting period assumption.

Answer to SEQ 5

The correct option is C.

Stock in trade is to be recorded at cost or market price whichever is lower: this is

based on the prudence / conservatism principle.
 50

CHAPTER 1

ACCOUNTING SCOPE, CONCEPTS,

PRINCIPLES AND STANDARDS
UNIT 3

ACCOUNTING STANDARDS - OBJECTIVES

AND INTERPRETATION
Chapter Introduction
Accounting standards play a major role in the study of accounting discipline.
They help the user of financial statements to appreciate and fully grasp the
information presented. The following chapter intends to discuss the principles,
procedures and techniques with respect to the accounting standards followed in
India.

a) Explain the meaning of Accounting Standards and their applicability to

insurance companies.
b) Explain the objectives of Accounting Standards.
c) Discuss briefly about International Accounting Standards and IFRS and
the convergence of Indian Accounting Standards (AS) with the IFRS.
d) Explain the significant differences between Indian Accounting standards
and IFRS.
e) Provide a brief overview of the Indian Accounting Standards.
 51

1. Explain the meaning of Accounting Standards and their

applicability to insurance companies.
[Learning Outcome a]
1.1 Indian Accounting Standards - An Introduction
'Accounting Standards' mean the standards of accounting recommended by the
ICAI and prescribed by the Central Government in consultation with the National
Advisory Committee on Accounting Standards (NACAs) constituted under sec
210(1) of the Companies Act, 1956. Accounting Standards deal with the
following issues to ensure transparency, consistency, comparability, adequacy
and reliability of the financial statements, as well as financial reporting.
Diagram 1: Essence of accounting standards

Accounting Standards are written policy documents issued by an expert

accounting body or some regulatory body or the Government of a country. These
are issued in order to address the above three important aspects and to bring
uniformity in their handling in an entity’s financial statements. Accounting
Standards provide systems, standards, yardsticks principles and procedures to
bring about financial discipline, control and accountability at various stages of
accounting functions of an organization especially where management is
separated from ownership and direct control.
In India, Accounting standards are issued under the authority of the council of
ICAI (Institute of Chartered Accountants of India) being the authorised body
for regulation of the profession of accountancy in the country. The
Accounting Standards Board (ASB) constituted by the council considers the
following aspects while formulating the standards:
9 International Accounting Standards (IAS) and International Financial
Reporting Standards (IFRS)
9 Laws applicable within India
9 Customs and traditions in India
9 Specific business environment in India
 52

The ICAI has so far formulated and issued thirty two Accounting Standards to
standardize the accounting principles and policies of various industries and
organizations. These Accounting Standards (AS) provide accounting framework
and accounting policies including guidelines as described in diagram 1 above to
make the financial statements of different organisations comparable for proper
decision making of investors and other stakeholders. At present, majority of these
Accounting Standards have been made mandatory as to their applicability.

1.2 Broad classifications of AS

Diagram 2: Broad classifications of AS

1.3 Applicability of Accounting Standards in Insurance industry

Section 209 of the Companies Act requires that accounts shall be prepared to
comply with all the mandatory Accounting Standards (AS) issued by the ICAI.
The IRDA (Accounts and Audit) Regulations 2002 provide that the Balance
Sheet, Revenue Accounts, Receipts and Payments Account and Profit and Loss
Account shall be in conformity with all accounting standards issued by the ICAI
except AS 13. AS 17 shall apply to all insurers irrespective of the requirements
prescribed by the ICAI for its applicability.
 53

Diagram 3: Applicability of Accounting Standards in Insurance industry

For insurance companies, compliance with accounting standards issued by the

ICAI is:

A Recommendatory
B Mandatory
C Not applicable since IRDA can issue their own accounting standards
D Approved by the IRDA.

2. Explain the objectives of Accounting Standards.

[Learning Outcome b]
2.1 Objectives of Indian Accounting Standards
The Accounting Standards issued by the ICAI prescribe ethical guidelines
and standards of accounting process, highlighting the need for greater vigilance,
security and transparency in the working of business organizations.
Transparency, consistency, comparability, adequacy and reliability of the
financial statements are the other objectives.

The users of financial statements expect the following characteristics to be

inherently present in the said statements.
 54

Diagram 4: Features of Accounting Statements

An investor of an insurance company would like to choose between two

insurance companies ‘A’ and ‘B’. The investor would select an appropriate
insurer based on its past financials.

While analysing the financial statements, the investor notices that the method of
depreciation followed by ‘A’ is a unique one (not in accordance with the
accounting standards). This method of depreciation would make it impossible to
compare the financial statements of A with any other insurer. Thus,
comparability of financials would be difficult.

On the other hand if ‘B’ follows a method of depreciation which is in accordance

with AS 16, but the method of depreciation is not consistently applied year after
year, then the preparation of financial statements would be inconsistent and again
not comparable year after year.
 55

In order to overcome the above mentioned difficulties and to inculcate

comparability, consistency, reliability, transparency and accuracy, a standardised
pattern of measurement, presentation and disclosure of the accounting
information needs to be followed. Accounting standards were developed with the
above objective in mind.

In India, the Central Government, vide section 211 of the Companies Act, 1956
have empowered the ICAI to issue the generally applicable accounting standards.
The Central Government can consult with the National Advisory Committee on
Accounting Standards (NACAS) and can amend/modify/set aside the accounting
standards issued by the ICAI.

This simply means that though ICAI issues and regulates the Accounting
Standards in India, it cannot override Central Government’s (MCA) notifications
on accounting standards.

Which of the following is one of the important purposes of accounting standards?

A Helping government to take punitive actions.

B Helping users of financial statements to compare different companies
C To establish financial supremacy of a nation.
D To hold as evidence against the company in the court.

3. Discuss briefly about International Accounting

Standards and IFRS and the convergence of Indian
Accounting Standards (AS) with the IFRS.
[Learning Outcome c]
3.1 International Accounting Standards and IFRS
Every country has its own GAAP including accounting rules, regulations and
Accounting Standards. Need for implementation of a single and common
accounting language termed as IFRS (International financial reporting standards)
was felt since long, in order to have uniformity in the preparation of financial
statements and presentation of financial results in view of cross border business
operations and overseas investments. Globalization of economic activities in
recent times has warranted this inevitability more pertinently.
 56

Suppose an insurance company wants to invest in an insurance project in the

U.K. In order to procure investor’s confidence, it is also seeking to get listed on
the U.K stock exchange. Now, the stock exchange in the U.K wants the insurance
company to make its financials in accordance with the U.K accounting standards.
It ignores the financial statements of the insurance company prepared in
accordance with the Indian Standards. This would unnecessarily be a waste of
time and resources. Instead, if the insurer prepared its financial statements in
accordance with the international accounting standards, and the UK stock
exchange also accepted such financial statements then making global investments
would be easier.

Liberalisation and globalisation have now made it a matter of urgency to have

one single global accounting standard.

Statutory bodies involved in setting accounting standards

In the year 1973, an International Accounting Standards Committee (IASC) was
set up to standardise global accounting standards. International Accounting
Standards (IAS) were issued by this committee to attain the standardization
objective.

In the year 2001, the committee was renamed as International Accounting

Standards Board (IASB), the objective being establishing International Financial
Reporting Standards (IFRS).

Diagram 5: Single Global Accounting Standards

 57

3.2 Convergence of Indian Accounting Standards (AS) with the IFRS

As mentioned earlier, in order to have uniformity in presentation of financial

performance and state of affairs of business entities, almost the whole business
world has agreed to adopt one single and common accounting language i.e. IFRS.

Since the need for having one single language of business is gaining momentum,
more than 140 countries have now decided to adopt IFRS. A meeting of the Core

Group constituted by the Ministry of Corporate Affairs for convergence of Indian

Accounting Standards with International Financial Reporting Standards (IFRS)
from the year 2011 was held on 29th March, 2010. The meeting was attended by
the officials from Ministry of Finance, SEBI, RBI, IRDA, C&AG, PFRDA,
ICAI, Industry representatives and other experts.

The convergence would to be applicable to business organizations including

Insurance Companies, Banking Companies and Non-Banking Finance
Companies.

All insurance companies will convert their opening balance sheet as at 1st April,
2012 in compliance with the converged Indian Accounting Standards.

The Indian regulatory authorities have decided to converge the Indian GAAP
with the IFRS considering the prevailing legal and business conditions in India.

The said converged standards will be termed as Ind AS and are being drafted by
the Accounting Standards Board of ICAI. It needs to be noted at this juncture that
Ind AS would be differing with IFRS in certain matters considering the specific
situations in India.
 58

3.3 Applicability to entities other than insurance companies

9 In case of banking companies, the converged Indian accounting standards

would be applicable to all scheduled commercial banks and to those urban
co-operative banks whose net worth exceeds 300 crores. Such entities will
have to convert their opening balance sheets as at 1st April, 2012 by applying
the converged standards.

9 Urban co-operative banks having net worth exceeding 200 crores will have to
convert their opening balance sheets with the converged standards, as on 1st
April, 2014.

9 The converged standards will overrule the existing management policies and
some existing laws and hence this calls for some significant amendments to
various statutes like the Income Tax Act, The Companies Act etc.

The name of the body which issues IFRS is:

A ICAI
B IASC
C IASB
D IRDA

4. Explain the significant differences between Indian

Accounting Standards and IFRS.
[Learning Outcome (d)]

4.1 Significant differences between Indian Accounting Standards and

IFRS

There are certain conceptual differences between Indian Accounting Standards

and the IFRS. Knowledge and understanding about ASs are the prerequisites to
appreciating their differences compared to the IFRS. However, at this level, the
student needs to know the following critical ones. These differences are
important to be understood to fully appreciate the latest IFRS.
 59
Sr. Area of Indian Accounting
no difference Standards
1. Valuation These give more importance
to historical costs for
valuation
2 Scope for AS are generally rule based
Judgments and are less flexible as
compared to IFRS.
3 Basis It is accepted in India that
Law overrides standards.
4 Directions No directions and definitions
for setting standards as to the
needs of the users.
5 Presentation Although AS-1 mentions
disclosure requirements, it
does not provide the format as
such. One has to take the aid
of the Schedule VI of
Companies Act
6 Extra- AS 5 requires separate
ordinary disclosure of such items
Items
7 Reports Schedule VI to the Companies
Act, 1956 requires the
following to be reported:
i) Balance Sheet
ii) Profit and Loss A/c and
iii) Notes to Accounts.
As per IRDA regulations,
insurance companies are
required to present Cash Flow
Statement.
8 Depreciation Here, Schedule XIV of the
Companies Act is expected to
be followed which provides
minimum rates
IFRS
These consider “fair
values” of the assets for
valuation purposes.
IFRS provides scope for
judgement. The substance
is given more importance
than the rule
Usage by investors or
other users is of prime
consideration.
IFRS framework provides
directions for setting
standards and defines
components of Asset,
Liability, Equity, Revenue
etc.
IAS 1 takes adequate steps
to provide guidelines for
presentation of the
disclosure requirements
IAS 1 disallows any
extraordinary items to be
presented separately.
IAS 1 specifies 5
statements to be presented
and reported:
i) Balance Sheet
ii) Income statement
iii) Cash Flow Statement
iv) Statement of changes
in Equity and
v) Notes to Accounts.
IAS 16 provides for
charging depreciation on
Property, Plant and
Equipment on the basis of
useful life of the asset
 60

The above differences are extremely important since they would be relevant and
frequently used in accounting of the insurance industry.

4.2 List of Indian Accounting Standards issued by the ICAI

Following is the list of the Accounting Standards issued by the ICAI. The ICAI
has regularly amended the standards and have modified certain aspects to bring
them in line with the International Accounting Standards.

No. AS Title Applicability

1 Disclosure of Accounting
Policies
2 Valuation of Inventories
3 Cash Flow Statements
4 Contingencies and Events
Occurring after the Balance
Sheet Date (Stands withdrawn
pursuant to AS 29 except those
relating to impairment of assets
not covered by any other AS)
5 Net Profit or Loss for the
Period, Prior Period Items and
Changes in Accounting Policies
6 Depreciation Accounting
7 Construction Contracts
8 Accounting for Research and
Development
9 Revenue Recognition
10 Accounting for Fixed Assets
11 The Effects of Changes in
Foreign Exchange Rates
12 Accounting for Government
Grants
13 Accounting for Investments
14 Accounting for Amalgamations
Mandatory for all companies
Mandatory for all companies
Mandatory for specified companies
but encouraged for others. Direct
method is adopted for General
Insurance Companies as per
IRDA regulations.
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Stands withdrawn pursuant to AS 26
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies other
than General Insurers.
Mandatory for all companies.
 61

No. AS Title Applicability

15 Accounting for Retirement Mandatory for all companies
Benefits
16 Borrowing Costs Mandatory for all companies
17 Segment Reporting Mandatory for specified companies
including general insurance
companies.
18 Related Party Disclosures Mandatory for listed/specified
companies.
19 Leases Mandatory for all companies subject
to exclusion of certain paragraphs in
respect of specified companies.
20 Earnings Per Share All companies are required to
calculate and disclose EPS as per
guidelines.
21 Consolidated Financial Mandatory pursuant to requirement
Statements of any statute/ regulation or in the
cases of voluntary preparation.
22 Accounting for Taxes on Mandatory for listed/specified
Income companies.
23 Accounting for Investments in Mandatory pursuant to requirement
Associates in Consolidated of any statute/ regulation or in the
Financial Statements cases of voluntary preparation.
24 Discontinuing Operations Mandatory for listed/specified
companies.
25 Interim Financial Reporting Mandatory for listed/specified
companies.
26 Intangible Assets Mandatory for listed/specified
companies.
27 Financial Reporting of Interests Mandatory pursuant to requirement
in Joint Ventures of any statute/ regulation or in the
cases of voluntary preparation.
28 Impairment of Assets Mandatory for all companies with
variation of meaning of a term in
respect of specified companies.
29 Provisions, Contingent Mandatory for all companies subject
Liabilities and Contingent to exclusion of certain paragraph(s)
Assets in respect of specified companies.
30 Financial Instrument; Mandatory for all entities w.e.f
Recognition and Measurement 01.04.11
 62

No. AS Title Applicability

31 Financial Instruments; Same as above
Presentation
32 Financial Instruments; Same as above
Disclosures

Valuation under IFRS is more of:

A Historical cost based

B Equity based
C Future value based
D Fair value based.

5. Provide a brief overview of the Indian accounting

standards.
[Learning Outcome e]
We will be now going into more detail with respect to Indian Accounting
Standards. Presently, there are 32 Accounting Standards which have been issued
by the ICAI. We will be introducing all the said standards. However, we will go
into more detail only for those standards which are relevant and frequently used
in the financial statements of Insurance Companies. Relevant conceptual and
numerical examples have been provided at appropriate places to make the topic
lucid and easy to understand.

5.1 Accounting Standard (AS) – 1: Disclosure of Accounting Policies

1. Purpose of Accounting Standard – 1

9 Disclosure of significant accounting policies and the manner of disclosure in

the financial statements, so as to promote better understanding by the user.
9 Consistency and uniformity in the nature and extent of disclosure.
9 Facilitating comparison and deriving meaningful conclusions from the
financial statements.
Before we proceed, let us learn some important definitions
 63

9 Accounting Policies refer to significant accounting principles and the

methods of applying those principles, adopted by the enterprise in the
preparations of the financial statements
9 Prudence refers to being conservative in approach. Recognise the expected
losses immediately even if they have not actually incurred but do not
recognize the expected profits unless they are actually realized.
9 Materiality refers to relative importance of an item in a company’s financial
statements.

As per AS – 1, only material items should be considered for designing and

disclosing the accounting policies.

Suppose there are two insurance companies, A Ltd and B Ltd. It may happen that
both these companies may adopt different accounting policies for a given
financial item. It may also happen that the policies followed by these companies
are different for different accounting periods. If this happens, different users of
the financial statements of these said companies will evaluate the companies
differently. However, if meaningful and consistent conclusions are to be drawn
then a proper disclosure of significant accounting policies of both these
companies is must.

Diagram 6: Areas where different accounting policies may be followed by

different companies
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Disclosure requirements of AS –
9 While selecting an accounting policy, consideration must be given to:
(a) Prudence (b) Materiality (c) Substance over form
At this stage, the term substance over form must be understood as giving
importance to the real nature of the transaction rather than how it is made to
appear.
9 All significant accounting policies adopted in preparation and presentation of
financial statements must be disclosed.
9 All the disclosures will be considered to be a part of the financial statements
9 Any changes in the accounting policies which bring a material effect in the
current or the future period should be disclosed along with the impact of
change. If the impact cannot be calculated, then it should be disclosed as
such.
9 If a fundamental accounting assumption is not followed, then it must be
disclosed as such (See the tip below).

a) Fundamental accounting assumptions are:

b) Going Concern – A concern continuing its business for the foreseeable
future. No hint of the business being closed down
c) Consistency – Accounting policies are consistent from one period to another
d) Accrual – Revenue and costs are recognized on due basis and not on
receipt/payment basis.

Papillion Ltd. changed its method of depreciation from SLM to WDV. The said
change will not have any impact on current year’s profit but will impact the
future year’s profit. Should this changed be disclosed?

Yes – since it is having an impact on the future period’s profit.

5.2 Accounting Standard (AS) – 2 : Valuation of inventories

AS – 2 deals with determination of inventory value which appears in the

financial statements of a business entity.

According to this standard, inventory is the value which is the lower of:
a) Historical cost of the inventory
b) Net Realisation Value.
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This standard also conforms to the prudence and conservative principles of

accounting. Any unrealized profits included in the inventory are removed before
valuing them. The financial statements should also disclose the accounting
policies adopted in measuring the inventories. The relevant cost formula adopted
(FIFO or Weighted Average formula. LIFO is expressly prohibited in AS – 2)
should also be disclosed.

AS – 2 has very limited applicability in the insurance business, since inventory is

not of major significance in the financial statements of an insurance company.

5.3 Accounting Standard (AS) – 3: Cash Flow Statements

AS- 3 deals with the cash flow statements of a business entity. A typical cash
flow statement refers to a statement which shows changes in the position of cash
and cash equivalents within an organization during the said accounting period.
There are two methods of preparing a cash flow statement.
a) Direct Method
b) Indirect Method
Diagram 7: Disclosure requirements for a cash flow statement
 66

In accounting of insurance companies, a cash flow statement is called Receipts

and Payment account. As per the IRDA regulations on accounts and audit, every
insurance company must mandatorily prepare a cash flow statement by using the
Direct Method.

Cash flows arising from transactions in a foreign currency should be recorded in

an enterprise’s reporting currency by applying the exchange rate to the amount of
foreign currency.

It needs to be noted that the difference in methods (Direct and Indirect) is

applicable only for the purpose of calculating the Cash from operating
activities.
Other sources of cash are:

a) Cash from investing activities

b) Cash from financing activities

Padmaja Ltd provides you the following information. Prepare a cash flow
statement using the direct method:

Particulars Amount
(In Rs.)
Sales for the year Rs. 50,00,000 (All sales in cash) 50,00,000
Cash paid to suppliers during the year 30,00,000
Selling and Administrative expenses paid in cash 2,00,000
Tax paid during the year 1,00,000
Cost of new Plant acquired and paid 4,00,000
Payment of Dividend 1,50,000
Opening cash balance 80,000
Closing cash balance 12,30,000
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Cash flow statement for the period (direct method)

Amount Amount
Particulars
(In Rs.) (In Rs.)
A. Cash flow from operating activities
Cash from sales of goods 50,00,000
Less: Payments to suppliers (30,00,000)
Less: Selling and Admin Expenses (2,00,000)
Less: Payment of tax (1,00,000)
Net cash flow from operating activities 17,00,000

B Cash from investing activities

Purchase of plant (4,00,000)
Net cash flow from investing activities (4,00,000)

C. Cash from financing activities

Payment of dividend (1,50,000)
Net cash flow from financing activities (1,50,000)

D. Net Increase/(Decrease) in cash 11,50,000

(A)+(B)+(C) (Figures in brackets indicate
negative figures)

E. Opening balance of cash and cash 80,000

equivalents
F Closing Balance of cash and cash 12,30,000
equivalents
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5.4 Accounting Standard (AS) – 4: Events Occurring after the balance

sheet date

This standard is mandatory for all types of entities (including the insurance
companies.). Before the year 2004, this standard was titled “Contingencies and
Events occurring after the balance sheet date”. On 1.04.2004, a new Accounting
Standard – 29 ‘Provisions, Contingent Liabilities and Contingent Assets was
introduced, and all paragraphs relating to contingencies were withdrawn from AS
– 4.

Events occurring after the balance sheet date include those events (both
favourable and unfavourable), that occur between the balance sheet date and the
date on which the financial statements are approved by the Board of Directors in
case of a company, and, by the corresponding approving authority, in case of
other organizations.

Diagram 8: Identification of events after the end of the reporting period

Suppose the date of balance sheet is 31st March 2011 and the accounts would be
approved by the board of directors at its meeting on 15th August 2011. Any event
occurring between these said two dates is an “event occurring after the balance
sheet date.
There are two types of events according to this accounting standard:

a) Adjusting event
b) Non-adjusting event
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Diagram 9: Events after the end of the reporting period

Any event occurring after the balance sheet date which represents a material
change affecting the financial statements should be disclosed as (a) nature of
event and (b) financial impact of the said event and the reason if such impact
cannot be quantified.

The disclosures of AS – 4 need to be made in the director’s report.

5.5 Accounting Standard (AS) – 5: Net Profit or loss for the period,
prior period items and changes in accounting policies.
This standard is mandatory for all entities and is very much relevant for
insurance companies.
This standard should be applied to:
9 presenting profit or loss from ordinary activities, extraordinary items and
prior period items in the statement of profit and loss,
9 accounting for changes in the accounting estimate, and
9 disclosure of changes.
`
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9 Extra ordinary items are those items of incomes and expenses which are
clearly distinct from the ordinary activities of the business. They are not
expected to recur in the future periods.
9 Ordinary activities are those activities which are carried out by a business
entity as a part of its business operations and include any incidental activities
undertaken to further the main ordinary activity.
9 Prior period items are those items of incomes or expenses which arise in the
current period owing to errors or omissions in the preparation of the financial
statements of one or more prior periods.
9 Accounting policies are the specific accounting principles and the methods
of applying those principles adopted by an enterprise in the preparation and
presentation of financial statements.

All items of income and expenses, which are recognised in a period, should be
included in the determination of net profit or loss for the period unless an
Accounting Standard requires or permits otherwise.

Disclosure requirements
9 Extraordinary items should be disclosed in the statement of profit and loss, as
a part of net profit or loss for the period. The nature and the amount of each
extraordinary item should be separately disclosed in the statement of profit
and loss in a manner that its impact on current profit or loss can be perceived.
9 The nature and amount of prior period items should be separately disclosed
in the statement of profit and loss in a manner that their impact on the current
profit or loss can be perceived.
9 The nature and amount of a change in an accounting estimate, which has a
material effect in the current period or which is expected to have a material
effect in subsequent periods, should be disclosed. If it is impracticable to
quantify the amount, this fact should be disclosed.
9 Any change in an accounting policy, which has a material effect should be
disclosed. The impact of, and the adjustments resulting from such change, if
material, should be shown in the financial statements of the period in which
such change is made, to reflect the effect of such change.
 71

Akanksha Ltd received Rs.10,00,000 as compensation from a party against

whom litigation was filed by the company around 5 years back. This
compensation was received in the year 2010-11 and Akanksha Ltd. clubbed this
amount as a part of its net profit. Is this treatment valid?

Solution

No. This treatment is not valid as per AS – 5.

The said compensation received by the company is an extra-ordinary item,

since it is distinct from the normal activities and is expected to be non-
recurring. It needs to be separately disclosed in the Profit and Loss Account.

5.6 Accounting Standard (AS) – 6: Accounting for Depreciation

This standard deals with depreciation accounting and applies to all depreciable
assets, except to certain specified items to which special considerations will
apply. Different accounting policies for depreciation are adopted by different
enterprises. Disclosure is to be made of the accounting policy for depreciation
that is followed by an enterprise.

Depreciable amount is the historical cost of a depreciable asset minus the

estimated residual value.

Depreciation is a measure of wearing out, consumption or other loss of value of

a depreciable asset, arising from use, effluxion of time or obsolescence through
technology and market changes. It is charged as a fair proportion of the
depreciable amount in each accounting period during the expected useful life of
an asset.

Useful life is either (a) the period over which a depreciable asset is expected to
be used by the enterprise or (b) number of production units expected to be
obtained from the use of an asset by the enterprise.
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9 The depreciation method selected should be applied consistently from period

to period. A change from one method of providing depreciation to another
should be made only if the adoption of the new method is required by statute
or for compliance with an accounting standard or if it is considered that the
change would result in a more appropriate preparation or presentation of the
financial statements of the enterprise. When such a change in the method of
depreciation is made, depreciation should be recalculated in accordance with
the new method from the date of the asset coming into use. The deficiency or
surplus arising from retrospective computation of depreciation in accordance
with new method should be adjusted in the accounts in the year in which the
method of depreciation is changed. Such a change should be treated as a
change in accounting policy and its effect should be quantified and disclosed.

9 The useful life of a depreciable asset should be estimated after considering i)

expected physical wear and tear ii) obsolescence and iii) legal and other
limits on the use of the asset.
9 Where the depreciable assets are revalued, the provisions for depreciation
should be based on the revalued amount and on the estimate of the remaining
useful lives of such assets. In case the revaluation has a material effect on the
amount of depreciation, the same should be disclosed separately in the year
in which revaluation is carried out.
9 If any depreciable asset is disposed of, discarded, demolished or destroyed,
the net surplus or deficiency, if material, should be disclosed separately.

Disclosure requirements

Details of disclosure Disclosed in

Historical cost, total depreciation and
accumulated depreciation for each class
of asset
Depreciation methods and rates
Effect of change in depreciation method
Depreciation amount in case of
revaluation of assets
Net Surplus or deficiency in case any
depreciable asset is sold off or discarded
Profit and Loss A/c and Balance
Sheet
Profit and Loss A/c and Balance
Sheet and notes to accounts
Profit and Loss A/c and notes to
accounts
Profit and Loss A/c and notes to
accounts
Profit and Loss A/c
 73

5.7 Accounting Standard (AS) – 7: Construction Contracts

This standard is not applicable to an insurance company. However,

knowledge of this standard will help you to appreciate the financial statements of
policyholders and or claimants belonging to the category of contractors
especially to ensure proper settlement of claims, if any.

Construction Contract is a contract specifically negotiated for the construction

of an asset or a combination of assets.
Cost plus contract is a construction contract in which the contractor is
reimbursed for allowable or other defined costs plus a percentage of these costs
or a fixed fee.
Fixed price contract: It is a construction contract in which the contractor agrees
to a fixed contract price or a fixed rate per unit of output.

Other important aspects of the accounting standard:

9 In accounting for construction contracts in financial statements, either the
‘percentage of completion method’ or the ‘completed contract method’ may
be used. When a contractor uses a particular method of accounting for a
contract, then the same method should be adopted for all other contracts
which meet similar criteria.
9 The percentage of completion method can be used if the outcome of the
contract can be reliably estimated.
9 In the fixed price contracts, the degree of reliability would be provided if the
following conditions are satisfied; i) total contract revenues to be received
can be reliably estimated ii) both the costs to complete the contract and the
stage of contract performance completed at the reporting date can be
reasonably estimated and iii) the costs attributable to the contract can be
clearly identified so that actual experience can be compared with prior
estimates.
9 Profit in case of ‘fixed price contracts’ normally should not be recognized
unless the work on a contract has progressed to a reasonable extent.
9 In the case of ‘Cost plus Contract’, this degree of reliability would be
provided only if both the following conditions are satisfied; i) cost
attributable to the contract can be clearly identified and ii) costs other than
those that are specifically reimbursable under the contract can be reliably
estimated.
 74

Disclosure requirements
In the financial statements, there should be disclosure of:
9 the amount of construction work-in-progress
9 progress payments received and advances and retentions on account of
contracts included in construction work-in-progress and
9 the amount receivable in respect of income accrued under costs plus
contracts not included in the construction work-in-progress.

If both ‘the percentage of completion method’ and ‘the completed contract

method’ are simultaneously used by the contractor, the amount of contract work
described above should be analyzed to disclose separately the amount attributable
to contracts accounted for under each method.

5.8 Accounting Standard (AS) – 8: Accounting for research and

development

All the provisions with respect to accounting for research and development have
been adequately incorporated in AS – 26 ‘Accounting for intangible assets’. AS –
8, hereby, stands withdrawn. Currently, there is no accounting standard at serial
no. 8 of the accounting standards.

5.9 Accounting Standard (AS) – 9: Revenue Recognition

This standard deals with the bases for recognition of revenue in the statement of
profit and loss of an enterprise.

Revenue is the gross inflow of cash, receivables or other consideration arising in

the course of the ordinary activities of an enterprise from the sale of goods, from
the rendering of services, and from the use by others of the resources of the
enterprise yielding interest, royalties and dividends.
 75

Revenue is measured by the charges made to customers or clients for goods

supplied and services rendered to them.
This statement does not deal with the following aspects of revenue recognition to
which special considerations apply:
9 Revenue arising from construction contracts
9 Revenue arising from hire purchase or lease agreements
9 Revenue arising from Govt. grants and other similar subsidies
9 Revenue of insurance companies
Very Important Aspect

A key criterion for recognition of revenue from transaction of sale of goods is

transfer of property in the goods to the buyer for a consideration. Revenue from
services is recognized as the service is performed, either by the proportionate
completion method or by the completed service contract method.

5.10 Accounting Standard (AS) – 10: Accounting for Fixed Assets

Following are some important definitions of terms used in the accounting
standard.

Fixed Asset is an asset held with the intention of being used for the purpose of
producing or providing goods or services and is not held for sale in the normal
course of business
Fair market value is the price that would be agreed to in an open and
unrestricted market between knowledgeable and willing parties dealing at arm’s
length who are fully informed and are not under any compulsion to transact.
Gross book value of a fixed asset is its historical cost or other amount
substituted for historical cost in the books of account or financial statements.
When this amount is shown net of accumulated depreciation, it is termed as net
book value.

The standard does not deal with:

9 Forests, plantations and other natural resources
9 Wasting assets like mineral rights and expenditure on explorations of oil,
natural gas etc.
9 Expenditure on real estate development
9 Livestock (Domesticated animals)
 76

AS – 10 does not cover inflation accounting, that is specialized aspects of fixed

assets that arise under a comprehensive system reflecting the effects of changing
prices. (Only historical cost accounting is considered in AS – 10)

Other special considerations are as follows:

9 The gross value of fixed assets should be either historical cost or a

revaluation computed in accordance with the standard.

9 The cost of fixed assets should comprise its purchase price and any
attributable cost of bringing the asset to the working condition for its
intended use. Refer to example of Daffodils given below.

9 When a fixed asset is acquired in exchange or in part exchange for another

asset, the cost of the asset acquired should be recorded either at fair market
value or at the net book value of the asset given up.

9 Subsequent expenditure related to an item of fixed asset should be added to

its book value, only if they increase the future benefits from the existing asset
beyond its previously assessed standard of performance.

9 Fixed asset should be eliminated from the financial statements on disposal or

when no further benefit is expected from its use and disposal.

9 Losses arising from the retirement or gains or losses arising from disposal of
fixed asset which is carried at cost, should be recognized in the profit and
loss statement.

9 When a fixed asset is revalued in the financial statements, an entire class of

assets should be revalued, or selection of assets for revaluation should be
made on a systematic basis, which is to be disclosed.

9 An increase in net book value arising on revaluation of fixed assets should be

credited to ‘Owners’ Interests’ under the head ‘Revaluation Reserves’.

9 Goodwill should be recorded in the books only when some consideration in

money or money’s worth has been paid for it. Whenever a business is
acquired, for a price which is in excess of the value of the net assets of the
business taken over, the excess should be termed as goodwill.
 77

Daffodils Perfumeries Enterprise purchased a machine for Rs.135,000. It spent

Rs.4,000 on freight and Rs.3,500 on installation. It spent materials worth
Rs.3,000 and wages Rs.1,200 on the trial run. Owing to low capacity utilisation,
it incurred initial losses of Rs.10,000 for the first year. It spent Rs.7,000 on
launching the new product.

The cost of the machinery is to be calculated as below:

Details Rs.
Purchase price 135,000
Freight 4,000
Installation 3,500
Trial run costs 4,200
Total 146,200

Administration and other general overhead expenses are usually excluded from
the cost of fixed assets because they do not relate to a specific fixed asset.

Therefore office rent is not considered in the cost of the machinery.

Disclosure requirements

Details of disclosure Disclosed in

Gross and net book values of fixed assets along with Balance Sheet
additions and deletions thereto
Any expenditure incurred in order to make the fixed Balance Sheet
asset usable and occurring in the course of construction
Revalued amounts substituted for historical costs of Balance Sheet
fixed assets, the method adopted to compute the
revalued amounts, the nature of indices used, the year of
any appraisal made and whether an external valuer was
involved in cases where fixed assets are stated at
revalued amounts.
 78

5.11 Accounting Standard (AS) – 11: The Effects of Changes in

Foreign Exchange Rates
This standard deals with the issues involved in accounting for foreign currency
transactions or foreign operations. Many organizations carry on foreign
operations or foreign currency transactions.

The principal issues in accounting for foreign currency transactions and foreign
branches are to decide which exchange rate to use and how to recognize the
financial effect of changes in exchange rates in the financial statements.

An insurance company may have transactions in foreign currencies or it may

have foreign branches. The foreign currency transactions should be expressed in
the company’s reporting currency, and the financial statements of foreign
branches should be translated into the company’s reporting currency in order to
include them in the financial statements of the company.

Let us now see some important terms and definitions:

9 Reporting Currency is the currency used in presenting the financial

statements. For an Indian insurance company, the reporting currency will be
‘rupee’.
9 Foreign currency is the currency other than the reporting currency of an
enterprise.
9 Monetary items are money held and assets and liabilities to be received or
paid in fixed or determinable amounts of money.
9 Non-monetary items are assets and liabilities other than the monetary items.
9 Fair value is the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable and willing parties in an arm’s length
transaction.
9 Exchange difference is the difference resulting from reporting the same
number of units of a foreign currency in the reporting currency at different
exchange rates.
9 Closing rate is the exchange rate at the balance sheet date.
9 Average rate is the mean of the exchange rates in force during a period.
 79

Following are the important points to be remembered:

9 A transaction in a foreign currency should be recorded in the reporting

currency by applying to the foreign currency amount the exchange rate
between the reporting currency and the foreign currency at the date of
transaction except in the inter-related transactions.

9 For reporting effects of changes in exchange rates subsequent to initial

recognition, monetary items denominated in a foreign currency should be
reported using the closing rate.

9 Non-monetary items other than fixed assets which are carried in terms of
historical costs denominated in a foreign currency should be reported using
the exchange rates at the date of the transactions.

9 Non- monetary items other than fixed assets, which are carried in terms of
fair value or other similar valuation should be reported using the exchange
rates that existed when the values were determined.

9 Exchange differences arising on foreign currency transactions should be

recognized as income or as expense in the period in which they arise.

9 Exchange differences arising on repayment of liabilities incurred for the

purpose of acquiring fixed assets, which are carried in terms of historical
costs, are to be adjusted in the carrying amount of the respective fixed assets.

9 The carrying amounts of fixed assets, which are carried in terms of revalued
amounts, are also to be adjusted in the manner described in the paragraph
above.

9 Where the carrying amounts of depreciable assets has undergone a change

for the reasons mentioned above, the depreciation on the revised unamortized
depreciable asset shall be provided for as per AS 6.

9 The financial statements of a foreign branch are to be translated into

reporting currency of the reporting company as per guidelines prescribed in
this AS –11.

The above points can be summarized using the following chart:

Initial recognition i.e. the date on which the transaction first qualifies for
recognition in accordance with International Financial Reporting Standards.
 80

Recognised in FS = Foreign currency amount x Spot exchange rate between the

functional currency and the foreign currency as on the date of the transaction

Subsequent translation (ST)

The monetary and non-monetary items are recognised in the balance sheet in the
following manner:

Item Rate used for subsequent translation

Monetary items Spot exchange rate as on the date of the balance
sheet or date of settlement, if earlier
Non-monetary items Rate of exchange as on the date of the original
recognised at cost transaction i.e. on the date of purchase / acquisition
of the non-monetary item
Non-monetary item Rate of exchange as on the date on which the fair
recognised at fair value value was determined

Disclosure requirements

Details of disclosure Disclosed in

Amount of exchange difference Profit and Loss A/c
Net exchange difference accumulated in foreign Balance Sheet and
Currency translation reserve Notes to accounts
Reasons for change in the reporting currency Notes to accounts
Effects on monetary items due to exchange rate Notes to accounts
Fluctuations after the balance sheet date

5.12 Accounting Standard (AS) – 12: Accounting for Government

Grants.

This standard deals with accounting for government grants. Government grants
include subsidies, cash incentives, duty drawbacks etc.

This statement does not deal with

9 special problems arising in accounting for government grants in financial
statements reflecting effects of changing prices or in supplementary
information of a similar nature,
9 government assistance other than in the form of govt. grants,
9 Govt. participation in the ownership of the enterprise.
 81

Government refers to the government, government agencies and similar bodies

whether local, national or international.
Government grants are assistance by government in cash or kind to an
enterprise for past or future compliance with certain conditions. They exclude
those forms of government assistance which cannot reasonably have a value
placed upon them and transactions with government which cannot be
distinguished from the normal trading transactions of the enterprise.

Government grants should be recognized only if there is a reasonable assurance

that:
9 the grant will be actually received; and
9 the receiving entity will actually comply with the conditions attached to the
grant.

Following are the three important modes of receiving government grants

a) In the nature of promoter’s contribution – Capital in nature

b) Relating to specific fixed assets – Capital in nature
c) Received as a regular income stream – Revenue in nature

9 If the government grant is received in the nature of promoter’s contribution,

then it should be credited to capital reserve.

9 Govt. grants related to fixed assets should be presented in the balance sheet
by showing the grant as a deduction from the gross value of the assets
concerned in arriving at their book value. Where the grant related to a
specific fixed asset equals the whole of the cost of the asset, asset should be
shown in the balance sheet at a nominal value. This is one method of
presentation of Grants related to Specific Fixed Assets.

9 Govt. grants related to depreciable fixed assets may be treated as deferred

income, which should be recognized in the profit and loss statement over the
useful life of the asset. This is another way of such presentation.

9 Govt. grants related to non-depreciable fixed assets should be credited to

Capital Reserve.
 82

Certain government grants are given by the government on refund basis. This
means that the grant needs to be refunded after a certain specific time or after
completion of the requisite conditions.

9 Govt. grants that become refundable should be accounted for as an

extraordinary item.

9 Grants related to revenue may be presented as a credit to the profit and loss
statement either separately or under ‘Other Income’. Alternatively, they may
be deducted in reporting the related expense.
Disclosure requirements

Details of disclosure Disclosed in

Accounting policies adopted for government Notes to accounts
grants along with the methods of presentation
in the financial statement
Nature and extent of government grants Profit and Loss A/c,
Recognized in the financial statements including Balance Sheet and
Grants of non-monetary assets given at a Notes to accounts
concessional rate or free of cost

5.13 Accounting Standard (AS) – 13: Accounting for Investments

(Refer AS – 30 , 31, and 32 for recent amendments and updates)

This standard deals with accounting for investment in the financial statements of
enterprises and related disclosure requirements.

Accounting Standards 30, 31 and 32 have been made mandatory with effect from
01.04.2011 for certain business entities including the insurance companies.

Hence, provisions in AS – 13, relating to investments in financial

instruments, are not applicable to such entities. Only those provisions which
are in respect of investment in immovable properties which have been covered in
AS -13 would be applicable to insurance companies.
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9 Investment property is an investment in land or buildings that are not

intended to be occupied substantially for use by, or in the operations of the
investing enterprise. It is always treated as long term investment.
9 Long term investment is an investment other than the current investment.
9 Current investment is an investment that is by its nature readily realisable
and is intended to be held for not more than one year from the date on which
such investment is made.

Apart from the above mentioned amendment, this accounting standard does
not apply to:
9 interest, dividend, and rentals earned on investments which are covered by
Accounting Standard 9
9 Operating or finance leases
9 Investments of retirement benefit plans of Life Insurance enterprises
9 Investments of General Insurance business
9 Mutual funds and venture capital funds and/or the related asset management
companies, banks, and public financial institutions.

Following are other important provisions of this accounting standard

9 The cost of an investment should include acquisition charges such as
brokerage, fees and duties.

9 When an investment is acquired or partly acquired, by the issue of shares and

other securities, the acquisition cost should be the fair value of the securities
issued.

9 When an investment is acquired in exchange for another asset, the acquisition

cost of the investment should be determined with reference to the fair value
of the asset given up or the acquisition cost of the investment, whichever is
more clearly evident.

9 Investments classified as current investments should be carried in the

financial statements at the lower of cost and fair value determined either on
an individual investment basis or by category of investment.

9 Investments classified as long-term investments should be carried in the

financial statements at cost.
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9 On disposal of an investment, the difference between the carrying amount

and the net disposal proceeds should be charged or credited to the profit and
loss statement.

Disclosure requirements

Aspects of disclosure Disclosed in

Any income on investments and profit or loss Profit and Loss
From disposal of investments Account
Classification of investments into Government or trust Balance Sheet
Securities, shares, debentures or bonds, investment
Properties and others
Significant restrictions on the right of ownership, Notes to accounts
realisability of investments or remittance of Income
and proceeds of disposal
Other disclosures Notes to accounts

5.14 Accounting Standard (AS) – 15: Employee Benefits

This Accounting Standard is applicable to an insurance company which will

consider the following aspects for assessing and accounting employee benefits.

It prescribes rules for accounting and disclosure for all employee benefits, except
employee share-based payments.

Following are some of the categories of employee benefits:

9 Short-term employee benefits such as wages, salaries and social security

contributions (e.g., contribution to an insurance company by an employer to
pay for medical care of its employees), compensated absences or paid annual
leave, profit sharing and bonuses (if payable within twelve months of the end
of the period) and non-monetary benefits (such as medical care, housing, cars
and free or subsidized goods or services) for current employees;

9 Post-employment benefits such as gratuity, pension, other retirement

benefits, post-employment life insurance and post-employment medical care;
 85

9 Other long-term employee benefits, including long-service leave or

sabbatical leave, jubilee or other long-service benefits, long-term disability
benefits and if they are not payable wholly within twelve months after the
end of the period, profit-sharing, bonuses and deferred compensation; and

9 Termination benefits.

Following are various aspects with respect to recognition and measurement

9 This Standard requires an enterprise to recognize the undiscounted amount of

short-term employee benefits when an employee has rendered service in
exchange for those benefits. Such benefits expected to be paid should be
shown as a liability after adjustment for paid amount. Amount paid in excess
should be shown as an asset as prepaid expense.

9 Post-employment benefit plans are classified as either ‘defined contribution

plans’ or ‘defined benefit plans’. Under defined contribution plans, the
enterprise’s obligation is limited to the amount that it agrees to contribute to
the fund and in consequence, actuarial risk (that benefits will be less than
expected) and investment risk (that assets invested will be insufficient to
meet expected benefits) fall on the employee.

9 The Standard requires that when an employee has rendered service to an

enterprise for a period, the enterprise should recognize the contribution
payable to a defined contribution plan in exchange for that service as a
liability after adjustment for paid amount. Amount paid in excess should be
shown as an asset as prepaid expense. Alternatively, it may be recognized as
an expense unless another AS requires or permits the inclusion of the
contribution in the cost of an asset.

9 All other post-employment benefit plans are defined benefit plans. Defined
benefit plans may be unfunded, or they may be wholly or partly funded.
Under these plans, i) the enterprise’s obligation is to provide the agreed
benefits to current and former employees and ii) actuarial risk (that benefits
will be less than expected) and investment risk (that assets invested will be
insufficient to meet expected benefits) fall on the enterprise.
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Diagram 10: Post employment benefit plans

Following are the principles of accounting used and determination of value

of Defined Benefit plans:
It is a complex process in view of the necessity of actuarial assumptions.
For accounting and determination of value the enterprise should do the
following:
9 To account not only for its legal obligation under the formal terms, but also
for any other obligation that arises from the enterprise’s informal practices.
9 To determine the present value of defined benefit obligations and the fair
value of any plan assets with sufficient regularity so that the amounts
recognised in the financial statements do not differ materially from the
amounts that would be determined at the balance sheet date.
9 To use Projected Unit Credit Method to measure its obligations and related
costs
9 To attribute benefit to periods of service under the plan’s benefit formula,
unless an employee’s service in later years will lead to a materially higher
level of benefit than in earlier years.
 87

9 To use unbiased and mutually compatible actuarial assumptions about

demographic assumptions (such as mortality, employee turnover) and
financial assumptions (such as discount rate, future salary and benefit levels.)
Financial assumptions should be based on market expectations, at the balance
sheet date for the period over which the obligations are to be settled;

9 To determine the discount rate by reference to market yields at the balance

sheet date on government bonds of a currency and terms consistent with the
currency and estimated term of the post-employment benefit obligations;

9 To deduct the fair value of any plan assets from the present value of the
defined benefit obligation at the balance sheet date. Certain reimbursement
rights that do not qualify as plan assets are treated in the same way as plan
assets except that they are presented as a separate asset rather than as a
deduction from the obligation;

9 To limit the carrying amount of a defined benefit asset so that it does not
exceed the present value of any economic benefit available in the form of
refunds from the plan or reductions in future contributions to the plan;

9 To recognize past service cost as an expense on a straight-line basis over the

average period until the benefits become vested. To the extent that the
benefits are already vested immediately following the introduction of, or
changes to, a defined benefit plan, an enterprise should recognize past service
cost immediately;

9 To recognize gains or losses on the curtailment or settlement of a defined

benefit plan when the curtailment or settlement occurs;

9 To recognize immediately actuarial gains and losses in the statement of profit

and loss as income or expense.

Diagram 11: Determination of present value (PV) of defined benefit

obligation (DBO) and current service cost
 88

Digram 12: Accounting for DBP

Disclosure requirements

Details of disclosure Disclosed in

Amount of Long-term employee benefits Profit and Loss A/c
Amount of defined contribution plans Profit and Loss A/c
Amount of defined benefit plans Describing the accounting policy
used and a general description
 89

5.15 Accounting Standard (AS) – 18: Related party disclosures

This standard is applied in reporting related party relationship and transactions

between a reporting enterprise and its related parties. The requirements of these
statements apply to the financial statements of each reporting enterprise as also to
consolidate financial statement presented by a holding company.

Related party transaction is a transfer of resources or obligation between related

parties regardless of whether or not a price is charged.

Following are treated as related parties

i) Enterprises that directly or indirectly control (through subsidiaries) or are

controlled in respect of which reporting enterprise is an associate or a joint
venture for example LICHFL is Associate of LIC of India.

ii) Associates, Joint ventures of the reporting entity: Investing party or venturer
in respect of which reporting enterprise is an associate or a joint venture

iii) Individuals owning voting power giving control or significant influence.

iv) Key management personnel and their relatives.

Here, key management personnel are those persons who have the authority and
responsibility for planning directing and controlling the activities of the reporting
enterprise. Relative means spouse, son, daughter, brother, sister, father and
mother.

Para 3 of this accounting standard specifies certain relationships, which are

termed ‘related parties’. The related party relationships between various
enterprises are determined on the following basis:

9 Control aspect
9 Associate/Joint Venture
9 Ownership
9 Key management personnel and (e) Significant influence
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Diagram 13: Related party relationship

Remember, while determining whether a party is related or not, substance of the

relationship should be considered and not merely the legal form. This means that
to become a related party, the party should be in a position to influence the
decision making power of the reporting entity.

Relative in relation to an individual means the spouse, son, daughter, brother,

sister, father and mother, who may be expected to influence, or be influenced by
that individuals in his dealings with the reporting enterprise.

Related party is a party which has the ability to control the other party or
exercise significant influence over the other party in making financial and/or
operating decisions.

Control means (a) direct or indirect ownership of more than 50% voting power
of an enterprise (b) control of the composition of the board of directors or any
corresponding governing authority in an enterprise, or (c) a substantial interest in
voting power and the power to direct, by statute or agreement, the financial and
operating policies of an enterprise

Significant influence means participation or authority to participate in the

financial and operating decisions of an enterprise, but not the control of those
policies. Significant influence is presumed to exist if the holding of voting power
is 20% or more.
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Key management personnel include those persons who have the authority and
responsibility for planning, directing and controlling the activities of the
reporting enterprise.

The transactions which may occur with related parties:

9 Purchase or Sale of goods
9 Purchase or Sale of Fixed Assets
9 Rendering or receiving of services
9 Agency arrangements
9 Leasing or Hire purchase arrangements
9 Transfer of research and development
9 Licence Agreements
9 Finance including loans/ equity contributions
9 Guarantees and collaterals
9 Management contracts including for deputation of employees

Following are not considered related parties:

9 Common directors of two or more companies

9 Economic dependence on a single customer or supplier
9 Participation in decision making by trade unions, government departments
etc.

Disclosure requirements
Details of disclosure Disclosed in
The name of the transacting related party Notes to accounts
Description of the relationship between the parties Notes to accounts
Description of the nature of transactions Notes to accounts
Any other elements necessary for an understanding of Notes to accounts
financial statements
Amount or appropriate proportion of outstanding items Notes to accounts
or provisions of doubtful debts due from such related
parties at balance sheet date
Volume of the transaction Notes to accounts
Outstanding amounts and bad debts written off Notes to accounts
Or written back
 92

5.16 Accounting Standard (AS) – 20: Earnings per Share

Scope of the accounting standard

This standard prescribes principles for the determination and presentation of

earning per share, which enables comparison of performance among different
enterprises for the same period and amongst different accounting periods for the
same enterprise. It has very important impact on enhancement of quality financial
reporting and financial management.

Diagram 14: Earnings per share (EPS)

The information required by this standard should be presented in consolidated

financial statements on the basis of consolidated information. This applies to
inter alia, enterprises whose equity or potential equity shares are listed on a
recognized stock exchange in India, and banks and financial institutions
including insurance companies.

Presentation

The various terms expressed in the standard are presented as follows:

The companies to whom this standard applies should present basic and diluted
earnings per share on the face of the statement of profits and loss of each class of
equity shares that has a different right to share in the net profit for the period and
also with equal prominence for all periods presented. The requirement is
mandatory even if the disclosure turns to be negative, implying a loss per share.
 93

Before proceeding, we will see some important definitions

9 Equity share is a share other than a preference share

9 Preference share is a share carrying preferential rights to dividends and

repayment of capital

9 Financial instrument is any contract that gives rise to both, a financial asset
of one enterprise and a financial liability or equity shares of another
enterprise

9 Option or share warrants are financial instruments that give the holder the
right to acquire equity shares.

9 Potential equity share is a financial instrument or other contract that entitles

or may entitle its holder to equity shares.

Computations of Basic Earnings per share (Basic EPS) and Diluted

Earnings per share (Diluted EPS)

Basic Earnings per Share should be calculated by dividing the net profit or loss
for the period attributable to equity shareholders by the weighted average number
of equity shares outstanding during the period.

Net profit or loss for the period:

9 includes all items of income and expenses, including extra ordinary and prior
period items
9 deducts preference dividend and dividend distribution tax thereon
9 apportion to different classes of equity shares, if any based on dividend rights

The Weighted average number of equity shares:

It is the number of equity shares outstanding at the beginning of the period,

adjusted by the number of equity shares bought back or issued during the period
multiplied by the time-weighting factor. Time-weighting factor is the number of
days for which specific shares are outstanding as a proportion of the total number
of days in the period.
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Calculation of Weighted Average Number of Shares

Date Particulars No of No of Share No of Shares

Shares bought outstanding
issued back
01.04.09 Balance at Beginning 3,000 3,000
30.09.09 Shares Issued for cash 600 3,600
01.02.10 Buy Back 300 3,300
31.03.10 Balance at the end 3,600 300 3,300

Now computation of Weighted Average will be as under:

12 months 6 months 2 months

3,000 × + 600 × - 3,00 ×
12 months 12 months 12 months

= 3250 shares

(Explanation: Balance of shares is to be multiplied by remaining period of

holding them. Buy back of shares is a reduction from the number of shares.)

There is a special computation principle applying to bonus shares:

When the number of equity shares outstanding is increased without any increase
in resources because of bonus issue, the number of equity shares outstanding
before the event is adjusted for the proportionate change in the number of equity
shares outstanding as if the event had occurred at the beginning of the earliest
period reported.

Diagram 15: Basic EPS

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Bonus Issue and Adjusted Earnings per Share

Net Profit for 2008-09 Rs.72,00,000

Net Profit for 2009-10 Rs.1,20,00,000
No of equity Shares up to 30.6.09 40,00,000
Bonus issue on 1.7.09-2equity for1 80,00,000
existing
Earnings per share 2009-10 `1,20,00,000/1,20,00,0 shares =Re.1
Adjusted Earnings per share 2008-09 `72,00,000/1,20,00,000 shares= Re.0.6

Since the bonus issue is an issue without consideration, the issue is treated as if it
had occurred prior to the beginning of the year 2009-10, the earliest period
reported.

Diluted Earnings per share

For the purpose of calculating diluted Earnings per Share, the net profit or loss
for the period attributable to equity shareholders and the weighted average
number of shares outstanding during the period should be adjusted for the effects
of all dilutive potential equity shares. Dilutive potential equity shares are those
equity shares which being potential in nature, decrease net profit per share from
continuing operations when get converted to equity shares actually.
Diagram 16: Diluted EPS

Net profit for the purpose of computing diluted earnings is adjusted as

follows:
For the purpose of calculating diluted Earnings per Share, the net profit or loss
for the period attributable to equity shareholders and the weighted average
number of shares outstanding during the period should be adjusted for the effects
of all dilutive potential equity shares. Dilutive potential equity shares are those
equity shares which being potential in nature, decrease net profit per share from
continuing operations when get converted to equity shares actually.
 96

The existing number of ordinary shares of Zanco Ltd is 80,000. Bonds worth
Rs.1,00,000 are to be converted in future into 20,000 ordinary shares. For the
purpose of calculation of the number of shares, these potential shares are added
and the total number is 80,000 + 20,000 = 1,00,000.

Diagram 17: Adjustments to denominator – no. of ordinary shares (OS)

Following is the statement showing appropriation of profits of Y Insurance

Co Ltd. for 2009-10. Calculate Diluted Earnings per Share on conversion of
Debentures.

Particulars
Net Profit for 2009-10 Rs.4,00,00,000
No of equity shares outstanding 2,00,00,000
10% -100000 Convertible Debentures of Rs100 each Rs.1,00,00,000
Interest expenses for the current year for Debenture Rs.10,00,000
Tax element on Interest Expense Rs.3,00,000
Basic Earnings Per Share Rs.2.00

Calculation of Diluted Earnings Per share on conversion of debentures:

Particulars Amount-Rs.
Interest Exp. For Debenture 10,00,000
Tax on Interest 3,00,000
Adjusted Net Profit (`40000000+`1000000—`300000) 4,07,00,000
No of Equity Shares considered (200,00,000 2,10,00,000
shares+10,00,000 shares)
Diluted Earnings Per Share (`4,07,00,000 /2,10,00,000 1.94 per share
shares)
 97

Important considerations

If the equity shares issued on account of an ‘option’ are issued at a price less than
the fair value, then the option is a dilutive option.

If there is more than one class of equity shares, then EPS will have to be
calculated by first apportioning the net profits amongst the different classes. The
base used for apportionment would be the dividend rights of those equity shares.

Disclosure requirements

Details of disclosure Disclosed in

Basic and diluted EPS for each class of Shares Profit and Loss A/c
Adjusted EPS for the previous reporting periods in Profit and Loss A/c
case of bonus issue
Amount used as numerators in calculating the Basic Profit and Loss A/c and
and diluted EPS and reconciliation of those notes to accounts
amounts with the net profit for the period
Weighted average number of equity shares used as Profit and Loss A/c and
denominator in calculating basic and diluted EPS notes to accounts
Nominal value of shares along with EPS figures Profit and Loss A/c and
notes to accounts.

Disclosure requirement of weighted average number of equity shares

Let us now refer to the published accounts for 2010-11 of United India Insurance
Co. Ltd, with the following extracts:

No Particulars Current Year Previous Year

Rs. Rs.
1 Net Profit attributable to Shareholders 13054 70779
Weighted Average Number of Equity
2 Shares issued (in Nos.) 15,00,00,000 15,00,00,000
3 Basic earnings per Share of 10/- each 8.7 47.19

The Company does not have any outstanding dilutive potential equity shares.
Consequently, the basic and diluted earnings per share of the company remains
the same.
 98

5.17 Accounting Standard (AS) – 21: Consolidated Financial

Statements

AS - 21 is applied in the preparation and presentation of consolidated financial

statements for a group of enterprises under the control of a parent and in
accounting for investments in subsidiaries in the separate financial statement of a
parent.

An Insurance Company having foreign or domestic subsidiary is required to

comply with this accounting standard.

This accounting standard does not consider the following:

a) Methods of accounting for amalgamation (covered by AS 14)

b) Accounting for investments in associates (covered by AS 13) and
c) Accounting for investments in joint ventures (covered by AS 13).

9 A parent is an enterprise that has one or more subsidiaries.

9 A subsidiary is an enterprise that is controlled by another enterprise known

as the parent.

9 A group is a parent and all its subsidiaries. In other words, the holding
enterprise and its subsidiaries together constitute a group.

9 Minority Interest is that part of the net results of operations and of the net
assets of a subsidiary attributable to interests which are not owned directly or
indirectly by the parent.

9 Equity is the residual interest in the assets of an enterprise after deducting all
its liabilities.

9 Consolidated financial Statements are the financial statements of a group

presented as those of a single enterprise.
(Source: ICAI compendium)
 99

Now we will see some of the aspects with respect to presentation of the
consolidated financial statements.

a) Consolidated Financial Statements normally include the following

9 Consolidated Balance Sheet
9 Consolidated Statement of Profit and Loss
9 Consolidated Cash Flow Statement

b) A parent company shall present consolidated financial statements in

addition to its own separate financial statement in the same format to the
extent possible.

c) A subsidiary is excluded from consolidation when control is temporary

exclusively with a view to its subsequent disposal in the near future.
Investment in such subsidiary is to be accounted for in accordance with AS
13. Reasons for such exclusion of subsidiary financial statement must be
justified and disclosed in the consolidated financial statements. For example
exclusion of a subsidiary on the ground that its business activities are
dissimilar from those of the other enterprises within the group is not justified
because the disclosures under AS 17 will explain the significance of different
business activities within the group.

Following is the consolidation procedure in brief:

9 In preparing the consolidated financial statement, the financial statements of

the parent and its subsidiaries should be combined on a line by line basis by
adding together like items of assets, liabilities, income and expenses so that
the consolidated statements present financial information about the group as
that of a single enterprise. For this purpose, following steps need to be
adopted.

9 The cost of investment of the parent in the subsidiary and its portion of
equity in each subsidiary is eliminated.

9 The excess of the costs to the parent of its investment in a subsidiary over the
parent’s portion of equity of the subsidiary is to be taken as Goodwill and to
be treated as an asset in the Consolidated Financial Statements.

9 The excess of the parent’s portion of equity over the cost of investment is to
be treated as Capital Reserve in the Consolidated Financial Statements.
 100

Treatment of Minority Interest (MI)

9 Minority Interest in the net income of consolidated subsidiaries should be
identified and adjusted against the group in order to arrive at the net income
attributable to the owners of the parent.
9 Minority Interest in the net assets of consolidated subsidiaries has to be
identified and presented in the consolidated balance sheet separately from
liabilities and equity of the parent’s shareholders.

Consolidated financial statements should be prepared using uniform accounting

policies for like transactions and events in similar circumstances.
Accounting for investments in subsidiaries in parent’s separate balance sheet
should be accounted for in accordance with AS 13 - Accounting for Investment.

Diagram 18: Treatment of Minority Interest (MI)

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Disclosure requirements

Details of disclosure Disclosed in

Minority interest and treatment of reserves Consolidated Financial
Statements
Names of all the subsidiaries, residence and country Notes to accounts
of incorporation
Proportion of ownership and interest Notes to accounts
Voting power Notes to accounts

5.18 Accounting Standard (AS) – 22: Accounting for taxes on income

This statement is applied in accounting for taxes on income. This includes
determination of the amount of the expense or saving related to taxes on income
in respect of an accounting period and the disclosure of such an amount in the
financial statement.

9 Taxable income is the amount of income/loss for a period, determined in

accordance with the tax laws, based upon which income tax
payable/refundable is computed.

9 Accounting income is the net profit/loss for a period, as reported in the

statement of profit and loss, before deducting income tax expense or adding
income tax saving.

9 Current tax is the amount of income tax determined to be payable

(refundable) in respect of taxable income/loss for a period.

9 Deferred tax is the tax effect of timing differences.

9 Tax expense is the aggregate of current tax and deferred tax charged or
credited to the statement of profit and loss for the period.

9 Permanent difference is the difference between taxable income and

accounting income for a period that originate in one period and do not
reverse subsequently.

9 Timing differences are the differences between taxable income and

accounting income for a period that originate in one period and are capable
of reversal in one or more subsequent periods.
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As per the matching concept of accounting, taxes on income are accrued in the
same period as the revenue and expenses to which they relate. In insurance
business, this accounting standard is essential/mandatory both for accounting and
disclosure purpose.

Applicability

Enterprises whose equity or debt securities are listed on a recognised stock

exchange in India and enterprises that are in the process of issuing equity or debt
securities that will be listed on recognized stock exchanges in India as evidenced
by the Board of Directors’ resolution in this regard come, among others, within
the purview of mandatory application.

9 Differences between items of revenue and expenses as shown in the financial

statements including Profit and Loss Account and the items considered
revenue or expenditure or deduction for tax purposes are one of the reasons
attributable to divergence between taxable income and accounting income.

9 As per this statement, taxes on income include domestic and foreign taxes,
which are based on taxable income.

This statement does not specify when or how, an enterprise should account for
taxes that are payable on distribution of dividends and other distributions made
by the enterprise.

Following are some of the aspects with respect to recognition of taxes as per
the accounting standard:

9 Tax expenses for the period, comprising current tax and deferred tax, should
be included in the determination of the net profit or loss for the period

9 Deferred tax should be recognized for all the timing differences subject to the
consideration of prudence in respect of deferred tax assets.
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9 Deferred tax assets should be recognized and carried forward only to the
extent that there is a reasonable certainty that sufficient future taxable income
will be available against which such deferred tax assets can be realized.

9 Where an enterprise has unabsorbed depreciation or carry forward of losses

under tax laws, deferred tax assets should be recognized only to the extent
that there is virtual certainty supported by convincing evidence that sufficient
future taxable income will be available against which such deferred tax assets
can be realized

9 At each balance sheet date, an enterprise reassess unrecognized deferred tax

assets to the extent that it has become reasonably certain or virtually certain
as the case may be that sufficient future taxable income will be available
against which such differed tax assets can be realized. For example, product
development or effective underwriting policy may make it reasonably certain
that the insurance company will be able to generate sufficient taxable income
in near future.

9 Deferred tax assets and liabilities should be measured using the tax rates and
tax laws.

9 Deferred tax assets and liabilities should not be discounted to their present
value.

Disclosure requirements

Details of disclosure Disclosed in

Offsetting of current tax and deferred tax assets and Balance Sheet
liabilities if permissible under the accounting standard
Deferred tax asset and deferred tax liability Balance sheet
distinguished from current assets/liabilities
Break-up of deferred tax asset and deferred tax liability Notes to accounts
into major classes
Evidence supporting DTA/DTL Notes to accounts
 104

5.19 Accounting Standard (AS) – 23: Accounting for investment in

associates in consolidated financial statements

An enterprise that prepares and presents consolidated financial statements should

account for investments in associates in the consolidated financial statements in
accordance with this standard. This statement does not deal with accounting for
investments in associates in the preparation and presentation of separate financial
statements by investors.

Equity means residual interest in the assets of an enterprise after deducting all its
liabilities.

Group is a parent and all its subsidiaries.

Significant influence refers to participation or power to participate in the

financial and operating policy decisions of an enterprise, but not control of those
policies. It is evidenced by:
9 Representation on the board of directors or governing body of the investee
9 Participation in policy making processes
9 Material transactions between the investors and the investee
9 Interchange of managerial personnel
9 Provision of essential technical information.

Equity method of accounting is a method whereby the investment is initially

recorded at cost, identifying any goodwill/capital reserve arising at the time of
acquisition. The carrying amount of the investment is adjusted thereafter for the
post acquisition change in the investor’s share of net assets of the investee. The
consolidated statement of profit and loss reflects the investor’s share of the
results of operations of the investee.

An associate is an enterprise in which the investor has significant influence and

which is neither a subsidiary nor a joint venture of the investors.
 105

It is to be noted that accounting for investments in associates in the consolidated

financial statements should be done using the equity method of accounting.

Following are the exceptions where equity method cannot be used:

(Accounting Standard – 30 is applicable in such cases now. Initially, AS – 13
was applicable)

9 Investment is acquired and held exclusively with a view to its subsequent

disposal in the near future or

9 The associate operates under severe long-term restrictions that significantly

impair its ability to transfer funds to the investors.

Equity method needs to be discontinued under the following circumstances:

9 Investor ceases to have significant influence in an associate but retains, either

in whole or in part, its investment.

9 Use of equity method no longer serves the purpose because the associate
operates under severe long term restrictions that significantly impair its
ability to transfer funds to the investor.

Disclosure requirements

Details of disclosures Disclosed in

Goodwill/capital reserve, investment in Associates Consolidated Balance
and the contingent liabilities if any Sheet
Investor’s share of the profits or losses of Investment Consolidated Profit
in associates and Loss A/c
Description about the associate, reasons for not Using Notes to accounts.
the equity method etc.
 106

5.20 Accounting Standard (AS) – 25: Interim financial reporting

This standard prescribes minimum content of an interim financial report and the
principles of recognition and measurement in a complete or condensed financial
statement for an interim period. Timely and reliable interim financial reporting
improves the ability of the investors, creditors and others to understand the
enterprise’s capacity to generate earnings and cash flows, its financial conditions
and liquidity.

Diagram 19: Interim financial statements

In insurance accounting, where interim reports are required to be made, its use is
all the more important for shareholders for their subsequent decision about
investments and for the policyholders to decide for their next insurance policy of
a major risk with a particular insurer in view of its liquidity and solvency.

This statement does not mandate which enterprise is required to prepare interim
financial reports, how frequently or at what interval. But if an enterprise is
required by the regulator or any statute, or elects to do so, it should comply with
this standard.

Minimum contents of interim financial statements are:

9 Condensed Balance Sheet

9 Condensed statement of Profit and loss
9 Condensed Cash Flow statements and d) Selected Explanatory Notes.
 107

Forms and contents of interim financial statements (relevant for insurance

sector companies)

9 If an enterprise prepares and presents a complete set of financial statements

in its interim financial report, the form and contents of those statements
should conform to the requirements as applicable to the annual complete set
of financial statements. In the case of an insurance company, the form and
contents of interim financial statements must conform to the forms and
contents furnished in PART V of Schedule A and Schedule B in IRDA
(Accounts and audit) Regulations, 2002 which have been discussed in
previous chapters.

9 If an enterprise presents Basic and diluted earnings per share in its annual
report in accordance with AS 20, the same should also be presented for the
interim period on the face of the statement of profit and loss, complete or
condensed.

9 If an enterprise’s annual financial report includes the consolidated financial

statements in addition to the parent’s separate financial statements, the
interim financial report should also include both the consolidated financial
statements and separate financial statements, complete or condensed.

Diagram 20: Recognition and measurement principles for interim FS

Disclosure requirements

Details of disclosures Disclosed in

Statement that the same accounting policies have been Notes to accounts
followed in interim reporting as in final Reporting
Nature and amount of significant change in the Notes to accounts
Estimates in interim financial reporting
Explanatory comments about the seasonality of Interim Notes to accounts
operations
 108

5.21 Accounting Standard (AS) – 28: Impairment of Assets

AS 28 prescribes the procedures for accounting for impairment of all assets.

Following are the exceptions:

9 Inventories (AS 2 applies)
9 Assets arising from construction contracts (AS 7 applies)
9 Investments that are included in the scope of AS 13
9 Deferred Tax assets (AS 22 applies)
9 Financial assets

It is mandatory for enterprises carrying on insurance business.

9 Impairment Loss is the amount by which the carrying amount of an asset

exceeds its recoverable amount.

9 Carrying amount is the amount at which an asset is recognized in the

balance sheet after deducting any accumulated impairment losses thereon.

9 Recoverable amount is the higher of an asset’s net selling price and its
value in use.

9 Value in use is the present value of estimated future cash flows expected to
arise from the continuing use of an asset and from its disposal at the end of
its useful life.

9 An active market means a market where the items traded within the market
are homogenous, willing buyers and sellers can normally be found at any
time and prices are available to the public.

Identifying assets for impairment:

9 An asset is impaired when the carrying amount of the asset exceeds its
recoverable amount
9 An enterprise should assess at each balance sheet date whether there is any
indication that an asset may be impaired. The following indications from
external and internal sources may be considered for this purpose.
 109

Indications of impairment from external sources of information

9 The asset’s market value has declined significantly more than normal or
expectation.

9 Significant changes with an adverse effect on the enterprise have taken place
in respect of technology, market, economic or legal environment, to which
the asset is dedicated.

9 Market interest rates or other market rates of return on investments have

increased during the period and those increases are likely to affect the
discount rate used in calculating an asset’s value in use and decrease the
asset’s recoverable amount materially.

9 The carrying amount of the net assets is more than its market capitalization.

Indications of impairment from internal sources of information

9 Evidence of obsolescence or physical damage.

9 Internal reporting that the economic performance of an asset is or will be

worse than expected.

9 Evidence of changes with adverse effect on the organization due to some

strategy or plans to discontinue or restructure the operations to which an
asset belongs.

Measurement of Recoverable Amount:

9 This standard defines recoverable amount as the higher of asset’s net selling
price and value in use.

9 If either asset’s net selling price or its value in use exceeds the asset’s
carrying amount, the asset is not impaired and it is not necessary to estimate
the other amount.

9 If it is not possible to determine the net selling price because there is no basis
for making reliable estimate of the amount obtainable from the sale of the
asset in arm’s length transaction, the recoverable amount will be its value in
use.
 110

9 Net selling Price is a price in a binding sale agreement in arm’s length

transaction, adjusted for incremental costs that would be directly attributable
to the disposal of the asset.

9 If there is no binding sale agreement, but there is an active market for an

asset, the net selling price is the asset’s market price less the costs of
disposals.

9 If there is no binding sale agreement but an asset is traded in an active

market, net selling price is the asset’s market price less the cost of disposal.

9 If there is no binding sale agreement, or no active market for an asset, the net
selling price is based on the best information available to reflect the amount
that the enterprise can obtain at the balance sheet date.

9 Value in use is estimated on the basis of future cash flows and outflows
arising from continuing use of the asset and from its ultimate disposal.

9 Future cash flows are discounted by applying appropriate discount rate.

Recognition and measurement of an Impairment Loss:

9 If the recoverable amount of an asset is less than its carrying amount of the
asset, the carrying asset should be reduced to its recoverable amount and
such reduction is an impairment of loss.

9 Such impairment loss shall be recognized as an expense in the Profit and

Loss Account immediately unless the asset is carried at revalued amount in
accordance with another Accounting Standard i.e. AS 10. Under AS 10, an
impairment loss of a revalued asset should be treated as a revaluation reserve.

9 Impairment loss on a revalued asset is recognized directly against any surplus

for the asset to the extent that the impairment loss does not exceed
revaluation surplus while Impairment loss beyond above amount to a
revalued asset is recognised as an expense in Profit and Loss Account.
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Diagram 21: Measurement of Impairment Loss

Disclosure requirements

Details of disclosure Disclosed in

Amount of impairment losses and the reversals Profit and loss A/c, Balance
thereof sheet and Notes to accounts.
Main classes of assets affected by impairment Notes to accounts
losses
Main events leading to impairment losses Notes to accounts

5.22 Accounting Standard (AS) – 29: Provisions, Contingent

Liabilities and Contingent Assets

This Statement ensures that appropriate recognition criteria and measurement

bases are applied to provisions and contingent liabilities and that sufficient
information is disclosed in the notes to the financial statements to enable users to
understand their nature, timing and amount. The objective of this Statement is
also to lay down appropriate accounting for contingent assets. This is a standard
that is mandatory for the enterprises carrying on insurance business

Following are the exceptions with respect to provisions, contingent assets

and contingent liabilities, according to this accounting standard:
9 those resulting from financial instruments that are carried at fair value;
9 those resulting from executor contracts;
9 those arising in insurance enterprises from contracts with policy-holders;
9 those covered by another Accounting Standard.
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Provision is a liability which can be measured only by using a substantial degree

of estimation.

Possible obligation is an obligation whose existence at the balance sheet date,

based on the available evidence, is considered not probable.

Restructuring is a programme that is planned and controlled by management

and materially changes either the scope of a business undertaken by an enterprise
or the manner in which the business is conducted.

Contingent asset is a possible asset that arises from past events the existence of
which will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the asset.

Contingent asset should never be recognised considering prudence and

principle of conservatism.

Contingent liability is (a) a possible obligation that arises from past events and
the existence of which will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly within the control
of the enterprise, or (b) a present obligation that arises from past events but is not
recognised because it is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation or a reliable estimate
of the amount of the obligation cannot be made.

Following is the recognition criteria for provisions:

9 The enterprise should have a present obligation as a result of a past event.

9 It should be probable that an outflow of resources embodying economic
benefits will be required to settle the obligation.
9 A reliable estimate can be made of the amount of the obligation.

Following is the recognition criteria for contingent liabilities

An enterprise should not recognise a contingent liability

Students may remember that recognition is different from disclosure. A

provision needs to be recognised as well as disclosed. A contingent liability
should not be recognised but only disclosed.
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Contingent liabilities should be periodically reviewed by the enterprise. If it is

found that its nature is changed and there is a probable outflow of resource, then
it will be recognised as a provision, and treated accordingly.

Following is the recognition criteria for contingent assets

An enterprise should not recognise a contingent asset as this may result in

recognition of income that may never be realised.

Also, contingent assets should not be disclosed in the financial statements but
they may be disclosed in the report of the board of directors.

Disclosure requirements

Details of disclosure Disclosed in

For each class of provision:
9 Carrying amount at the beginning and end Balance Sheet
of the period.
9 Additional provision made Profit and Loss A/c
9 Unsued provisions reversed Profit and Loss A/c
A brief description of contingent liability Notes to accounts
General nature of dispute with respect to Notes to accounts
Contingent liability

5.23 Accounting Standard (AS) – 30: Financial instruments:

Recognition and measurement.

The objective of this Standard is to establish principles for recognising and

measuring financial assets, financial liabilities and some contracts to buy or sell
non-financial items.

Requirements for presenting information about financial instruments are in

Accounting Standard (AS) 31, Financial Instruments: Presentation. Requirements
for disclosing information about financial instruments are in AS 32, Financial
Instruments: Disclosures.
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AS 30 shall be applied by all entities to all types of financial

Instrument except:

9 Those interests in subsidiaries, associates and joint ventures that are

accounted for under AS 21, AS 23 and AS27.

9 Rights and obligations under leases to which AS 19 Leases applies.

9 Employers’ rights and obligations under employee benefit plans, to

which AS 15, Employee Benefits applies.

9 Financial instruments issued by the entity that meet the definition of an

equity instrument in AS 31, Financial Instruments Presentation, (including
options and warrants).

9 Rights and obligations arising under an insurance contract as defined in the

Accounting Standard on Insurance Contracts.

9 Contracts for contingent consideration in a business combination. This

exemption applies only to the acquirer.

9 Contracts between an acquirer and a vendor in a business combination to buy

or sell at a future date.

9 Loan commitments other than those loan commitments described in

paragraph 3. An issuer of loan commitments should apply AS 29.

9 Financial instruments, contracts and obligations under share-based payment

transactions.

9 Rights to receive payments as reimbursement of expenditure that the entity is

required to make, to settle a liability that it recognises as a provision in
accordance with AS 29.

The following loan commitments are within the scope of this Standard.

9 Loan commitments that the entity designates as financial liabilities at fair

value through profit or loss.

9 Loan commitments that can be settled net in cash or by delivering or issuing

another financial instrument.

9 Commitments to provide a loan at a below-market interest rate.

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This Standard should be applied to contracts to buy or sell a non-financial item

that can be settled net in cash or another financial instrument, or by exchanging
financial instruments, as if the contracts were financial instruments, with the
exception of contracts that were entered into and continue to be held for the
purpose of receipt or delivery of a non-financial item according to the entity’s
expected purchase, sale or usage requirement.

Disclosure requirements

Details of disclosures Disclosed in

It is to be noted that disclosure requirement with Respect to
financial instruments, which is the Subject matter of ---------------------
accounting standard – 30, has been handled in a separate
accounting standard – 32

Contingent liabilities:
A Are shown on the liabilities side of the balance sheet
B Are shown in the notes to accounts
C Are disclosed only in the director’s report
D Are neither recognised nor disclosed

Compliance with Accounting Standards in case of a General Insurance

Company

Following is the extract of Disclosure on Significant Accounting Policies

forming Part of Financial Statements for 2010-11 of United India Insurance Co, a
general insurance company in India.

a) Employee Benefits

The Company has adopted the policy of accounting employee benefits in

accordance with Accounting Standard 15 (Revised) issued by Institute of
Chartered Accountants of India.
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b) Intangible Assets
Intangible Assets are stated at cost of development / acquisition less accumulated
amortisation. The same is amortised over a period of three years on straight line
basis. Software development / acquisition costs, except those which meet the
recognition criteria as laid down in Accounting Standard 26 (AS 26), are charged
to revenue.
c) Related party disclosures: AS 18
Name of the Related Party and their relationship with the Company:
i) Subsidiary: Zenith Securities and Investments Limited
ii) Associate Companies:
9 India International Insurance Pvt. Ltd. Singapore
9 Ken India Assurance Co. Ltd., Kenya

Details of Transactions:
India International Ken India Assurance
Insurance Pvt. Ltd. Co. Ltd.
Sl.
No. Particulars 2010-11 2009-10 2010-11 2009-10
Investment in
Equity (No. of
1 Shares) 5000000 5000000 332790 332790
(Amount in Lakhs)
Rs. Rs. Rs. Rs.

Dividend received
2 during the year 126.48 123.36 0 10.3
3 Reinsurance transactions:
- Due to - Direct 0 115.91 0 0
Due from- Direct 103.67 1.44 0 0
Other Dues
4 receivable 0 0 0 0
Directors'
5 Remuneration 0 0 1.25 1.1
Since the company and its subsidiary are State controlled, no disclosures are
made pertaining to the transactions with them in accordance with the
requirements of the Accounting Standard AS-18.
 117

List of International Accounting Standards:

The following IFRS statements including IAS have been issued.

IFRS 1 First time Adoption of International Financial Reporting Standards

IFRS 2 Share-based Payment
IFRS 3 Business Combinations
IFRS 4 Insurance Contracts
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
IFRS 6 Exploration for and Evaluation of Mineral Resources
IFRS 7 Financial Instruments: Disclosures
IFRS 8 Operating Segments
IFRS 9 Financial Instruments
IAS 1 Presentation of Financial Statements.
IAS 2 Inventories
IAS 7 Cash Flow Statements
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
IAS 10 Events After the Balance Sheet Date
IAS 11 Construction Contracts
IAS 12 Income Taxes
IAS 14 Segment Reporting (superseded by IFRS 8 on 1 January 2008)
IAS 16 Property, Plant and Equipment
IAS 17 Leases
IAS 18 Revenue
IAS 19 Employee Benefits
IAS 20 Accounting for Government Grants and Disclosure of Government
Assistance
IAS 21 The Effects of Changes in Foreign Exchange Rates
IAS 23 Borrowing Costs
IAS 24 Related Party Disclosures
IAS 26 Accounting and Reporting by Retirement Benefit Plans
IAS 27 Consolidated Financial Statements
IAS 28 Investments in Associates
IAS 29 Financial Reporting in Hyperinflationary Economies
IAS 31 Interests in Joint Ventures
IAS 32 Financial Instruments: Presentation (Financial instruments
disclosures are in IFRS 7 Financial Instruments: Disclosures, and
no longer in IAS 32)
IAS 33 Earnings Per Share
 118

IAS 34 Interim Financial Reporting

IAS 36 Impairment of Assets
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
IAS 38 Intangible Assets
IAS 39 Financial Instruments: Recognition and Measurement
IAS 40 Investment Property
IAS 41 Agriculture

Summary
¾ Accounting Standards are written policy documents issued by an expert
accounting body or some regulatory body or the Government of a country.
¾ In India, Accounting standards are issued under the authority of the council
of ICAI (Institute of Chartered Accountants of India) being the authorised
body for regulation of the profession of accountancy in the country.
¾ The Accounting Standards issued by ICAI prescribe ethical guidelines and
standards of accounting process highlighting the need for greater vigilance,
security and transparency in the working of business organizations.
Transparency, consistency, comparability, adequacy and reliability of the
financial statements are the other objectives.
¾ There are certain conceptual differences between Indian Accounting
Standards and the IFRS.
¾ As per AS – 1, only material items should be considered for designing and
disclosing the accounting policies.
¾ As per the IRDA regulations on accounts and audit, every insurance
company must mandatorily prepare a cash flow statement by using the Direct
Method.
¾ The principal issues in accounting for foreign currency transactions and
foreign branches are to decide which exchange rate to use and how to
recognize the financial effect of changes in exchange rates in the financial
statements.
¾ Disclosures under Accounting Standard (AS) – 20: Earnings per Share
have a very important impact on the enhancement of quality financial
reporting and financial management.
¾ Consolidated financial statements should be prepared using uniform
accounting policies for like transactions and events in similar circumstances.
¾ Recognistion is different from disclosure. A provision needs to be
recognised as well as disclosed. A contingent liability should not be
recognised, but only disclosed.
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Answers to Test Yourself

Answer to TY 1

The correct answer is B.

Accounting standards issued by ICAI are mandatory for insurance companies.

Answer to TY 2

The correct answer is B.

Comparability of financial statements of different companies is an important

purpose of accounting standards.

Answer to TY 3

The correct answer is C.

IASB issues IFRS. ICAI is the accounting regulatory body in India and issues the
Indian accounting standards. IASC is the old name of IASB. It has issued IAS.
IRDA is the insurance regulatory body in India.

Answer to TY 4

The correct answer is D.

Valuation under IFRS is more of fair value based, unlike in Indian GAAP, which
is historical cost based.

Answer to TY 5

The correct answer is B.

Contingent liabilities are never recognised but they are disclosed as a note in
‘notes to accounts’.
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Self Examination Questions

Question 1

Following is one of the fundamental accounting assumptions as per

Accounting Standard – 1.

A Prudence
B Substance over form
C Materiality
D Consistency

Question 2

________ is used for preparing cash flow statements of an insurance

company.

A Percentage of completion method.

B Historical cost method
C Direct method
D Indirect method

Question 3

JD Paints Plc earned Rs.1,00,000 during the year 2008. The number of ordinary
shares on the balance sheet date i.e. 31 December 2008 is 100,000, including
60,000 shares it issued on 1 June 2008, and excluding 10,000 shares it
repurchased on 1 October 2008.

Determine the EPS.

A 1.29
B 1
C 1.15
D 1.21
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Question 4
Which of the following is true for accounting for investments as per AS –
13?
A It is not applicable to investment in financial instruments
B It is not applicable to investment in immovable property
C It is applicable to operating lease but not to financial lease
D It is applicable only to short term investments.
Question 5
Which of the following statements relating to AS 2 is correct?
A Inventory items are normally to be valued at the higher of cost and net
realisable value
B The Last In First Out method may be used to determine the cost of inventory
C The First In First Out or weighted average method may be used to determine
the cost of inventory
D AS – 2 deals with the method of physical verification of inventory

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is D.

Prudence, substance over form and materiality are considerations for designing
accounting policies for an organization whereas going concern, consistency and
accrual are fundamental accounting assumptions.

Answer to SEQ 2

The correct answer is C.

There are basically two methods of preparing cash flow statements, (a) Direct,
and (b) Indirect. Out of these, the direct method is specifically used in the case of
accounting for insurance companies.
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Answer to SEQ 3

The correct option is D.

Weighted average of the shares held and EPS

Treasury shares Shares

Shares issued
repurchased outstanding
1Jan 2008 Balance 50.000 - 50,000
1June 2008 Issued 60,000 - 110,000
1Oct 2008 Repurchased - 10,000 100,000
31Dec 2008 Balance 110,000 10,000 100,000

Weighted average based on the balance

In this case, the period for which the balance remained unchanged is used in the
calculation of weighted average. For example, the balance of 50,000 shares was
constant from 1 January to 31 May 2008, i.e. 5 months. Therefore, a weight of 5
will be attached to the balance of 50,000:

50,000 x 5/12 = 20,833

110,000 x 4/12 = 36,667
100,000 x 3/12 = 25,000
Weighted average = 82,500

Now, it is easier to calculate the EPS:

Profit or loss attributab le to ordinary equity holders of the parent entity

EPS =
Weighted average number of ordinary shares outstandin g

100,000
=
82,500

= $1.21
 123

Answer to SEQ 4

The correct answer is A.

AS – 13, as amended, is no longer applicable to investment in financial assets.

AS – 30, AS - 31 and AS - 32 have been issued for the same. AS – 13 is not
applicable to leases, operating as well as finance. AS – 13 is applicable to
investment in immovable property and is also applicable to long term
investments.

Answer to SEQ 5

The correct option is C.

Option A is incorrect. Inventory should be valued at the lower of cost or net

realisable value.

Option B is incorrect as Last in-first out method of inventory valuation is not

permitted in AS 2.

Option D is incorrect as AS-2 deals with the valuation of inventories.

 124

CHAPTER 1

ACCOUNTING SCOPE, CONCEPTS,

PRINCIPLES AND STANDARDS
UNIT 4

ACCOUNTING POLICIES
Chapter Introduction
In this chapter, we discuss the fundamental accounting policies and concepts
which should be followed while preparing financial statements.

a) Explain what accounting policies are and state their objectives.

b) Discuss the selection of and changes to accounting policies.
c) List the accounting policies applicable to non-life insurance business.
 125

1. Explain what accounting policies are and state their

objectives.
[Learning Outcome a]

1.1 Accounting policies

Accounting policies refer to specific accounting principles and the methods of

application of those specific principles adopted by the enterprise in the
preparation and presentation of financial statements of the enterprise.

Accounting policies are based on various accounting concepts, conventions,

assumptions and principles, which have been discussed in Unit 2.

Accounting policies of one enterprise may differ from those of another,

depending on the nature, type and structure of the enterprises.

Accounting policies followed by insurance companies are different from those

followed by banking companies.

Also, accounting policies followed by life insurance companies are different

from those followed by non-life insurance companies.

Again, accounting policies followed by a domestic general insurance company

may differ to some extent from the accounting policies followed by a
multinational general insurance company.

There is no single set of accounting policies, which are strictly followed by all
enterprises in all circumstances, although all accounting policies are governed by
the fundamental accounting principles, concepts, assumptions and conventions.

Enterprises operate in diverse environmental situations with different products

having different structure and legal status. Hence, accounting policies tend to
vary in different types of enterprises. Besides, interpretation of financial
statements largely depends on the selection of accounting policies adopted by the
enterprise.
 126

Selection of appropriate accounting policies calls for considerable judgment and

experience of the management of the enterprise, having regard to nature, type,
product, operation and structure of the enterprise.

The Institute of Chartered Accountants of India has been incessantly trying to

reduce the difference in the adoption of accounting policies by different entities
through issuance of ‘Guidance Notes’ and ‘Accounting Standards’ in
consultation with the Government and various regulatory bodies.

1.2 Objectives of Accounting Policies

The main objectives of accounting policies are shown in the diagram below and
further elaborated in the following paragraphs:
Diagram 1: Objectives of accounting policies

1. To maintain quality of financial statements: the use of appropriate

accounting policies helps in maintaining the essential quality of the
information provided in the financial statements. As the accounting policies
are judiciously decided by the management in consideration of the
fundamental accounting principles, accounting norms and regulations, these
policies help in maintaining the quality of information that is provided in the
financial statements for the users.
2. To ensure reliability: information contained in the financial statements, to
be useful to the users, must be reliable and free from material error and bias.
In the absence of appropriate accounting policies, the financial accounting,
statements and information provided therein might pose a risk of material
misstatement or erroneous statement leading to wrong decisions being made
by the users and investors of the organisation.
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3. To maintain consistency: the principle of consistency is ensured through

consistency in application of a specific set of accounting policies.
Accounting policies are followed consistently from one period to another and
a change in accounting policies is made only in exceptional circumstances.
This facilitates comparison and maintenance of uniformity of useful
information.

4. To bring about comparability of financial statements: users of financial

statements need to compare the financial statements of one enterprise with
those of other enterprises or compare financial statements of the same
enterprise of one period with another period (in other words inter comparison
and intra comparison) to make a comparative analysis of the financial
position, performance and cash flows. It is possible only when the same set
of accounting policies are consistently followed by the enterprise(s) over the
period.

5. To ensure full, fair and adequate disclosure: a change in accounting

policies brings about a material effect on the financial results and
performance reflected in the financial statements. So, a change in the
accounting policies is permitted only in exceptional circumstances with full,
fair and adequate disclosure of such change and the impact thereof by way of
inclusion in ‘Notes to accounts’.

The term "accounting policies" refers to:

A The measurement bases used by an entity

B The accounting concepts and conventions adopted by an entity
C The accounting principles applied by an entity
D All of the above
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2. Discuss the selection of and changes to accounting

policies.
[Learning Outcome b]

2.1 Selection of accounting policies

As mentioned earlier, the choice of accounting policies is an important and

judicious decision of the management keeping in view the requirements of law,
regulations and accounting standards. Choice of accounting policies greatly
affects measurement or assessment of the financial position and performance of a
business entity.

Wrong selection of accounting policies may lead to overstatement or

understatement of the financial position and performance of the enterprise
leading to various adverse consequences such as errors in computation of tax
liability, payment of dividend, decision for product development or other
important managerial decisions. Therefore, the management should take due care
and exercise caution in the selection of accounting policies.

It is also a known fact that no single set or exhaustive list of accounting policies
could be recommended for all entities in all circumstances. Hence, certain factors
should be kept in mind for selection of accounting policies by the competent
authority. The important factors are Prudence, Substance and Materiality.
These aspects do not require further elaboration, as all these aspects have already
been discussed in Unit 2.

Following are the areas where accounting policies of one enterprise may differ
from those of other enterprises.

9 Methods of Depreciation
9 Valuation of Inventories
9 Valuation of Investments
9 Valuation of Fixed Assets
9 Treatment of Goodwill
9 Recognition of Income
9 Recognition of Expenditure
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Inventories may be valued at either ‘cost’ or ‘market price’, whichever is lower.

Alternatively, they may be valued at cost except for the finished goods and by-
products.

Finished goods may be valued at net realisable value.

All these depend on which accounting policies are selected by the enterprise.

Again, for determination of the cost price, the enterprise may adopt any of the
methods like FIFO, LIFO, Average Price or Weighted Average Price etc.

2.2 Change in accounting policies

As mentioned earlier, accounting policies are followed consistently from one

period to another and a change in the accounting policies is made only in
exceptional circumstances.

An enterprise generally makes changes in accounting policies in the following

circumstances:
9 To bring the books of accounts in accordance with the Accounting Standards
9 To comply with the provisions of law
9 To ensure that the changed circumstances or methods will reflect a truer and
fairer view of the financial statements

For any change in the accounting policy, there must be a full, fair and adequate
disclosure of such change and the impact thereof in the ‘Notes on accounts’ as
per AS 1.

2.3 Disclosure of Accounting Policies

The requirement for disclosure of significant accounting policies followed by a

company in preparing and presenting financial statements to ensure that the true
and fair view of the state of affairs and of the profit or loss are reflected by the
financial statements is contained in Accounting Standard 1 (AS 1).

As per this Standard, all significant accounting policies adopted for the
preparation of financial statements should be disclosed. The disclosure of the
significant accounting policies forms part of the financial statements, and all the
significant accounting policies should normally be disclosed in one place.
 130

This statement further provides that any change in the accounting policies, which
has a material effect in the current period or which is reasonably expected to have
a material effect in later periods, should be disclosed.

In the case of a change in accounting policies, which has a material effect in the
current period, the amount by which any item in the financial statements is
affected by such a change should also be disclosed to the extent ascertainable.

Where such amount is not ascertainable, wholly or in part, the fact should be
disclosed.

This can be summarised in the form of a diagram:

Diagram 2: Disclosure requirements in case of change in accounting policy

If the fundamental accounting assumptions, viz. Going Concern, Consistency and

Accrual are followed in the financial statements, specific disclosure is not
required.

However, if a fundamental accounting assumption is not followed, the fact

should be disclosed.

When can an entity change one of its accounting policies?

A Whenever it wishes to do so
B If this would result in the provision of reliable and more relevant information
C If this would reduce the cost of preparing the financial statements
D Never
 131

3. List the accounting policies applicable to non-life

insurance business.
[Learning Outcome c]
For a better understanding of the accounting policies adopted by non-life
insurance companies, an extract of the significant accounting policies forming
part of financial statements published in the Annual Report of a PSU Non-life
insurance Company for the financial year ended 31st March 2010 is appended
below.

3.1 Accounting convention

The Financial Statements are drawn up in accordance with the provisions of

section 11 (1) of the Insurance Act, 1938, regulations framed under Insurance
Regulatory Development Act, 1999, read with the provisions of sub-sections (1),
(2) and (5) of Section 211, sub-section (5) of Section 227 of the Companies Act,
1956. The said statements prepared on the historical cost convention and on
accrual basis, comply with accounting standards referred in Section 211 (3C) of
the Companies Act, 1956 to the extent applicable, and conform to practices
prevailing in the general insurance industry except as otherwise stated.

3.2 Basis of incorporation

1. Reinsurance Accepted

Reinsurance returns have been incorporated for the advices received up to the
date of finalisation of accounts.

2. Reinsurance Ceded

Reinsurance cessations are accounted for on the basis of actuals - or estimates

wherever actuals are not available.
3. Outstanding Claims
i) Estimated liability for outstanding claims at the year-end are based on survey
reports, information provided by clients and other sources, past experience
and other applicable laws and includes:
9 in respect of direct business, claim intimations received up to the year end;
9 in respect of reinsurance accepted, advices received as of different dates of
subsequent year and
 132

9 provision for Claims Incurred but not Reported(IBNR) and provision for
Claims Incurred But not Enough Reported (IBNER), as certified by
Appointed Actuary.

ii) All the outstanding claims for direct business are provided net of salvage (if
any).

iii) In respect of Motor Third Party Claims where court summons have been
served on the Company without adequate policy particulars to establish
liability of the Company, provision is made as under:

9 100% of the estimated liability, where such claims are outstanding for more
than one year.
9 1/3rd of the estimated liability, for all such claims for which court summons
have been served on the company during the year.

iv) Interest on Motor Accident Claims Tribunal is provided based on the

prevailing trends in the Motor Third Party Claim Awards.

3.3 Premium recognition

Premium income is recognised on assumption of risk.

3.4 Reserve for unexpired risks

Reserve for unexpired risk is made at 100% of net premium for marine business
and 50% of net premium for other classes of business.

3.5 Foreign currency transactions

i) Revenue transactions of re-insurance in foreign currencies are converted at

the average of buying and selling rates of exchange of each quarter in which
they are accounted for.

ii) Foreign Operations

9 As per the Accounting Standard (AS) 11 “The Effects of changes in Foreign

Exchange Rates” (revised 2003) foreign branches / agencies are classified as
‘Non-integral foreign operations’.
9 The assets and liabilities (including contingent liabilities), both monetary and
non-monetary of the non-integral foreign operations are translated at the
closing rate.
 133

9 Income and expense items of the non-integral foreign operations are

translated at the average exchange rate of the year.
9 Provision for outstanding claims of non-integral foreign operations is
converted at the closing rate.
9 Depreciation on fixed assets held in foreign branches and agencies is
provided on written down rupee value at the year end.
9 All resulting exchange difference is accumulated in a Foreign Currency
Translation Reserve until the disposal of the net investment.

iii) Foreign investment transactions during the year are converted at the
exchange rates prevailing as on the last day of the month of purchase or sale.

iv) Other assets and liabilities in foreign currencies are converted at the average
of buying and selling rates of exchange prevailing at the year end.

v) The exchange gain/loss due to conversion of foreign currencies other than

relating to non-integral foreign operations is taken to revenue.

3.6 Fixed assets

1. Fixed assets are stated at cost less depreciation.

2. The fixed assets are assessed for any indication that the assets are impaired.
In case the recoverable amount of the fixed assets is lower than their carrying
amount, a provision is made for the impairment loss.

3.7 Intangible assets

Software Development / Acquisition cost is charged to revenue.

3.8 Expenses of management

1. Depreciation

9 Depreciation on fixed assets is charged on written down value method at the

rates prescribed in schedule XIV of the Companies Act, 1956. However,
where corresponding rates are higher under the Income Tax Rules, 1962, the
same are adopted. In the case of leasehold properties, amortisation is done
over the lease period.
9 Depreciation is provided at 50% of the applicable rates as above on additions
made to fixed assets, which are put into use for less than six months. No
depreciation is provided on assets sold/ discarded/destroyed during the year.
 134

2. Retirement benefit of employees

9 Liability for gratuity, pension and leave encashment at the year-end is

accounted for based on actuarial valuation.
9 Ex-gratia payable and additional actuarial liability, net of tax benefits, for
pension, gratuity and leave encashment on account of Special Voluntary
Retirement Scheme during 2003-04 is being amortised over a period of five
years.

3. Basis for apportionment of management expenses

Expenses of management, including provision for bad and doubtful debts and
exchange gain/ loss, are apportioned to the revenue accounts on the basis of gross
direct premium plus reinsurances accepted giving weightage of 75% for marine
business and 100% each for fire and miscellaneous business.

3.9 Premium deficiency

Premium Deficiency (if any) is provided for the three major segments viz., Fire,
Marine and Miscellaneous as directed by the Insurance Regulatory and
Development Authority vide circular no. F & A/cIR/017/MAY-04 dated 18th
May 2004.

3.10 Basis for apportionment of income from investments

Investment income (net of expenses) is apportioned between Shareholders’ Fund

and Policyholders’ Fund in proportion to the opening balance of these funds at
the beginning of the year. Investment income (net of expenses) belonging to
Policyholders is further apportioned to Fire, Marine and Miscellaneous
Departments in proportion to respective Technical Reserves Balance at the
beginning of the year.

Shareholders’ Funds for this purpose consist of Share Capital, General Reserves,
Capital Reserves and Investment Reserves. Policyholders’ Funds consist of
Technical Reserves i.e. Unexpired Risks Reserve plus Outstanding Claims.

3.11 Salvage / claim recoveries

Recoveries of claims and sale proceeds on disposal of salvage are accounted for
on realisation and credited to claims.
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3.12 Loans and investments

1. Short Term Money Market Instruments such as Commercial Papers and

Certificates of Deposit, are shown at their discounted value and the
difference between the acquisition cost and the redemption value is
apportioned on time basis and recognised as accrued income.

2. Contracts for purchase and sale of shares, bonds and debentures are
accounted for as “Investments” as on the date of transaction.

3. The cost of investments includes premium on acquisition, expenses like

brokerage, transfer stamps, transfer charges, etc., and is net of incentive/ fee
if any, received thereon.

4.
9 Dividend is accounted for as income in the year of declaration. Dividend on
shares/interest on debentures under objection/pending delivery is accounted
for on realisation. Interim dividend is accounted for where the warrants are
dated 31st March or earlier.
9 Dividend on foreign investments is accounted for net of withholding tax.

5. Profit/Loss on realisation of investments is computed by taking weighted

average book value as cost of investments, except :

9 In respect of Govt. Securities/Debentures/Bonds under Trading Portfolio, the

profit/loss is worked out scrip-wise.
9 In respect of Govt. Securities sold from the Investment Portfolio, the
profit/loss is worked out on First-In-First-Out (FIFO) Basis.

6. The company follows the prudential norms prescribed by the Reserve Bank
of India as applicable to Term Lending Institutions as regards asset
classification, recognition of income and provisioning pertaining to loans /
advances.

7. Investment in Govt. Securities, Debt Securities and Redeemable Preference

Shares are considered to be held till maturity and valued at cost. However, in
terms of the Insurance Regulatory & Development Authority Regulations,
the premium paid at the time of acquisition of securities is amortised over the
residual period of maturity.
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8.
9 Investments in Mutual Fund/s / Venture Fund/s are valued at Net Asset
Value (NAV) at the year-end and the difference between cost/book value and
NAV is accounted for in Fair Value Change Account. However, if there is
impairment in value, it is charged to revenue and the book value of
investment is reduced accordingly. Any reversal of impairment loss earlier
recognised is taken to revenue to the extent of reduction in impairment
recognized earlier.

9 In case of non-availability of NAV as at the Balance Sheet date, investment

is shown at cost.

9.
9 Investment Portfolio in respect of Equity/Equity related instruments is
segregated into Actively Traded and Thinly Traded as prescribed by the
Insurance Regulatory & Development Authority Regulations. The shares are
treated as thinly traded by taking into consideration transactions in the month
of March on both National Stock Exchange (NSE) and Bombay Stock
Exchange (BSE).

9 Actively Traded Equity / Equity related instruments are valued at the lower
of the last quoted closing price in March at the National Stock Exchange
(NSE) or Bombay Stock Exchange (BSE). If the shares are traded / listed
only on either of the stock exchanges then the quotation available on the
respective stock exchange is considered. The difference between the
weighted average cost and quoted value is accounted for in the Fair Value
Change Account.

10. Investment in thinly traded Equity Shares and unlisted Equity Shares are
shown at cost. However, the difference between the cost and break-up value
is provided for as diminution in value. If the break- up value is negative then
the provision is made for the entire cost. Furthermore, if the published
accounts of an unlisted company are not available for the last three
accounting years ending on or immediately preceding the date of working out
the diminution in value, then provision is made for the entire cost.

11. In the case of investment in Listed Equity / Equity Related Instruments /

Preference Shares, where the value has been impaired on or before
31.03.2000, the historical/weighted average costs are not available with the
company. As a consequence, the carrying value of such investments on
01.04.2000 is presumed to be the historical / weighted average cost.
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12.

i) Investment in Listed Equity/Equity Related Instruments/Preference Shares

made in those companies that are making losses continuously for the last 3
years and where capital is eroded, are considered to have impairment in
value. Furthermore, if the published accounts of a company are not available
for the last three accounting years ending on or immediately preceding the
date of working out impairment in value, it is presumed that the value of
investment is fully impaired and is written off to a nominal value of Re.1/-
per company.

Valuation of such investments is done as under:

9 In respect of Actively Traded Equity Shares: - Least of Cost Price, Market

Price or Break-up Value, provided the Break-up Value is positive. However,
if the Break-up Value is negative, the nominal value is taken at Rs. 1/- per
company.

9 In respect of Other Than Actively Traded Equity Shares: - Lower of Cost

Price or Break-up Value provided the Break-up Value is positive. However,
if Break-up Value is negative, the nominal value is taken at Rs. 1/- per
company.

9 In respect of Preference Shares, if the dividend is not received for the last
three years: - The preference shares are written down to a value which will
bear to its face value, the same proportion as the value taken / which would
have been taken for writing down equity shares bears to the face value of the
equity shares. However, if the equity shares are written down to Re.1/- per
company, Preference Shares are also written down to a nominal value of Re.
1/- per company.

ii) Once the value of investment in listed Equity/Equity Related

Instruments/Preference Shares is impaired in accordance with the above
mentioned policy, then the reversal of such impairment losses are recognised
in Revenue/Profit & Loss Account only when the accumulated losses of such
investee companies are completely wiped out as per the latest available
published accounts on or immediately preceding the date of working out the
reversal. However, in respect of investments where the historical or weighted
average cost is not available as mentioned in Policy No.11, reversal of
impairment loss is carried out and recognized only to the extent of
impairment losses accounted for after 31st March, 2000.
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13. Reverse Repo Transactions are treated as secured lending transactions and
accordingly disclosed in the financial statements. The difference between
total consideration at the 1st and 2nd leg of the transaction is treated as interest
income.

14. “Collateralised Borrowing and Lending Obligation”(CBLO), which is issued

at Discount to the Face Value, is treated as Money Market Instrument as per
the Reserve Bank of India Notification. Discount earned at the time of
lending through CBLO is shown as income, which is apportioned on time
basis.

15.
9 Unrealised gain, losses arising due to changes in the fair value of listed
equity shares other than those enumerated in Accounting Policy No 11 are
taken under the head “Fair Value Change Account” and on realization,
reported in the profit and loss account.

9 Pending realisation, the credit balance in the “Fair Value Change Account” is
not available for distribution.

3.13 Tax liability on income

1. Tax Liability in India

9 Tax expense for the year comprises current tax and deferred tax. A provision
is made for the current tax based on the tax liability computed in accordance
with the relevant tax rates and tax laws. A provision is made for deferred tax
for all timing differences arising between taxable income and accounting
income at currently enacted tax rates.

9 Deferred tax assets are recognised only if there is virtual certainty that they
will be realised and are reviewed for the appropriateness of their respective
carrying values at each balance sheet date.

2. Tax Liability in Foreign Countries.

Tax liability in foreign countries is accounted for on actual payment basis.

 139

Reserve for unexpired risk is made at ____________ for marine business and
________ for other classes of business.

A 100% of net premium, 50% of the net premium

B 50% of the net premium, 100% of the net premium
C 100% of the claims accepted, 50% of the claims accepted
D 50% of the claims accepted, 100% of the claims accepted

Summary
¾ Accounting policies are based on various accounting concepts, conventions,
assumptions and principles.
¾ Accounting policies of various organisations depend on the nature, type and
structure of the enterprises and hence policies of one organisation may differ
from those of another organisation.
¾ The main objectives of the accounting policies are to maintain the quality and
consistency ensure reliability and bring about comparability of the financial
statements, and to ensure full, fair and adequate disclosure.
¾ Appropriate selection of accounting policies is very important as wrong
selection may lead to overstatement or understatement of the financial
position and performance of the enterprise.
¾ Any changes to the accounting policies should be made only in exceptional
circumstances. For any change in an accounting policy, there must be full,
fair and adequate disclosure of such change and the impact thereof in the
‘Notes on accounts’, as per AS 1.
¾ The financial statements of non-life insurance companies are drawn up in
accordance with the provisions of section 11 (1) of the Insurance Act, 1938,
and the Regulations framed under the Insurance Regulatory Development
Act, 1999.
¾ These financial statements are prepared on the historical cost convention and
accrual basis.

Answers to Test Yourself

Answer to TY 1

The correct option is D.

All of the above

 140

Answer to TY 2

The correct option is B.

An entity may change its accounting policy if this would result in the provision
of reliable and more relevant information.

Answer to TY 3

The correct option is A.

Reserve for unexpired risk is made at 100% of the net premium for marine
business and 50% of the net premium for other classes of business.

Self Examination Questions

Question 1

For all changes in accounting policy, the entity concerned must disclose:

A The title of the international standard that has caused the change to occur
B The reasons which suggest that the change will provide reliable and more
relevant information
C The nature of the change
D The fact that the change has been accounted for in accordance with
transitional provisions specified in the applicable standard

Question 2

A change in an accounting policy which does not result from the initial
application of an international standard must normally be accounted for:

A Retrospectively
B Prospectively
C Either retrospectively or prospectively
D Prospectively, unless it is impracticable to account for impact of change
 141

Question 3

In which of the following areas can accounting policies of one enterprise differ
from other enterprises?

A Valuation of current assets

B Valuation of inventories
C Valuation of shares
D Valuation of debentures

Question 4

In foreign currency transactions, the assets and liabilities (including contingent

liabilities) of the non-integral foreign operations, both monetary and non-
monetary, are translated at ______________.

A The opening rate

B The closing rate
C The average rate
D The economy rate

Question 5

A provision is made for _________for all timing differences arising between

taxable incomes and accounting income at currently enacted tax rates.

A Deferred tax
B Current tax
C Total tax
D 50% tax of the net profit

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is C.

For all changes in accounting policy, the entity concerned must disclose the
nature of the change.
 142

Answer to SEQ 2

The correct option is A.

A change in an accounting policy which does not result from the initial
application of an international standard must normally be accounted for
retrospectively.

Answer to SEQ 3

The correct option is B.

Accounting policies of one enterprise may differ from other enterprises in:
Methods of Depreciation, Valuation of Inventories, Valuation of Investments,
Valuation of Fixed Assets, Treatment of Goodwill, Recognition of Income, and
Recognition of Expenditure.

Answer to SEQ 4

The correct option is B.

The assets and liabilities (including contingent liabilities) of the non-integral

foreign operations, both monetary and non-monetary, are translated at the closing
rate.

Answer to SEQ 5

The correct option is A.

A provision is made for deferred tax for all timing differences arising between
taxable incomes and accounting income at currently enacted tax rates.
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CHAPTER 2

ACCOUNTING PROCESS, METHODS AND

CONTROL AND FINALISATION
OF ACCOUNTS
UNIT 5

ACCOUNTING PROCESS
Chapter Introduction
This chapter aims to provide you with an understanding of the accounting
process. You will also learn about the different types of accounts, the golden
rules of accounting and how transactions are classified on the basis of these rules.

a) Understand the accounting process.

b) Get introduced to double entry system of bookkeeping.
c) Learn about classification of accounts.
d) Understand the golden rules of accounting.
e) Get introduced to principle books and subsidiary books.
 144

1. Understand the accounting process.

[Learning Outcome a]
1.1 Accounting Process
Financial accounting is the process of identifying, measuring, classifying,
recording, summarising, analysing, interpreting and reporting the financial
performance and the financial position of the enterprise through financial
statements. The process stated above is called Accounting Process.
Diagram 1: Accounting Process
 145

Accounting process is based on certain:

9 Accounting Concepts
9 Accounting Principles and
9 Accounting Standards comprising accounting policies
for preparation and presentation of financial statements

To be precise, accounting process refers to the process of book keeping as well

as process of preparation of final accounts, that is, preparation of financial
statements.

Steps or stages of accounting process

Diagram 2: Stages of accounting process

From the above diagram we can see that accounting process covers the entire
process of commencing from obtaining information from source documents up to
the final stage of preparation of financial statements for communication of
financial results of all financial transactions effected and recorded by the
enterprise for a particular period.
 146

The stages of accounting process involve preparation of trial balance, profit &
loss account and _______

A Spread sheet
B Balance sheet
C Income sheet
D Profitability sheet

2. Get introduced to double entry system of bookkeeping.

[Learning Outcome b]

2.1 Bookkeeping

Bookkeeping is the foundation of financial accounting.

Bookkeeping is an activity that involves recording of financial data from

financial transactions relating to business operations in a systematic and
chronological order.

It covers procedural aspects of financial accounting and record keeping function.

Some people are mistaken in referring to ‘bookkeeping’ and ‘accounting’ as
synonymous terms. Accounting is a broad subject of which bookkeeping is the
small part but groundwork on which huge spectrum or edifice of financial
accounting rests.

2.2 Accounting systems

Diagram 3: Systems of accounting

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Single entry system

Single entry system is an accounting system for recording financial information

in which only one aspect of the transaction is recorded.

Single entry system of accounting does not follow any fixed set of rules. In this
system
9 some transactions are recorded on both sides
9 some transactions are recorded on one side
9 some transactions are not recorded at all
Hence single entry system of accounting is nothing but a mix of double entry,
single entry and no entry.
Single entry system of accounting is an incomplete form of recording financial
transactions. This system mainly maintains cash book and personal accounts of
debtors and creditors. It does not take into consideration nominal accounts and
real accounts except for cash. Hence single entry system of accounting does not
give a correct picture of the financial position of the business.

Individual and small shops or sole-proprietary business entities generally use

single entry system of bookkeeping and do most of their personal financial
accounting following this approach.

Double entry system

Double entry system of bookkeeping is used in almost all financial accounting

software for corporate houses including all insurance businesses. The double
entry bookkeeping system, which has emerged in the process of evaluation of
various accounting techniques, was codified in the 15th century by an Italian
named Lucas Pacioli.

Every financial transaction has two aspects – a debit leg and a credit leg.
Double entry system is
9 an accounting system of book keeping
9 based on a set of rules (golden rules of accounting)
9 for recording financial information
9 related to both (debit and credit) aspects of the transaction
9 in such a way that both sides are equally balanced
 148

A financial transaction may have

9 one debit and one credit (one-to-one) or
9 one debit and multiple credits (one-to-many) or
9 multiple debits and one credit (many-to-one) or
9 multiple debits and multiple credits (many-to-many)
In double entry system when a financial transaction is recorded, irrespective of
the number of debits or credits it may have, the total of both the sides is always
balanced.

In double entry system, two aspects are recorded for every transaction and hence
the name ‘double entry’ for this system of book keeping. The set of rules which
form the basis for classifying the aspects of a transaction are known as golden
rules of accounting.

The two aspects of every transaction are

DEBIT
and
CREDIT

The double entry accounting system records financial transactions in relation to

asset, liability, income or expense through accounting entries.
1. Asset: it is something that the company owns and adds value to the
company. Assets can generate revenue for the company or can be used for
utility purpose.
Examples: cash, land, machinery, goods, vehicle etc.
2. Liability: it is something that a company owes to others. It can be
obligations or payments due to others.
Examples: bank loans, creditors etc.
3. Income: it is the revenue earned by the business from its core activity of
selling products or offering services or from other sources.
Examples: profit earned selling products or offering services, income from
sale of assets, income from investments like bank FDs, dividend from shares
etc.
4. Expense: it is the amount spent by the business for running the day-to-day
operations of the business, marketing expenses for selling of goods and
services.
Examples: salaries paid to employees, rent paid for premises; interest paid
on loan, office expenses like printing, postage, stationery etc.
 149

An accounting entry in double entry bookkeeping system has two effects:

9 one of increasing account and the other of decreasing another account by
an equal amount or
9 increasing of both accounts or
9 decreasing of both accounts

i) A business purchases machinery worth Rs 2,50,000 in cash.

ii) In this case there will be increase in the machinery (asset) account by Rs
2,50,000 and decrease in cash or bank balance (asset) by the same amount of
Rs 2,50,000.
iii) The transaction has two effects. These two effects on purchase of an asset in
cash will be recorded as
9 Asset account – debit and
9 Cash account – credit
iv) The transaction will be recorded both in asset register / ledger and in cash
book.
v) In both the accounts i.e. asset account and cash account, the balances will be
modified by an equal amount after recording the single transaction i.e.
purchase of asset by cash.
vi) Now let us assume the same machinery (as mentioned in the above case) is
purchased on credit.
vii) In this case there will be increase in machinery (asset) account and also
increase in liability account or creditor’s account by an equal amount of Rs
2,50,000.
viii) When the creditor is paid off, there will be decrease in both, creditor’s
account and in cash or bank account by an equal amount of Rs 2,50,000.

Advantages of double entry system

Double entry system of accounting has some distinct advantages over the single
entry system. The advantages are as under:

1. The arithmetical accuracy of financial accounting is established through trial

balance, a summary of balances of all the ledger accounts including that of
cash and bank on a particular date.
 150

2. The financial results including performance of transactions recorded and the

consequent changes in the financial positions of the enterprise can be
measured and assessed systematically and logically through preparation of
financial statements including:
9 Trading A/c
9 Profit & loss A/c
9 Balance sheet
9 Income statement

3. Accounting done using double entry system provides detailed information for
analysis and management decision making.

4. Double entry system is based on a set of rules and principles and hence the
results and positions shown by financial systems are considered more
authentic and reliable. It exhibits a higher degree of true and fair view of the
financial position of the entity through financial statements.

5. Double entry system is globally and extensively used in business firms and is
based upon laid down principles and standards and hence the financial
statements of various firms in an industry are comparable both nationally and
internationally.

In which type of accounting system some transactions are recorded on both sides,
some on one side and some transactions are not recorded at all?

A Unique entry system

B Single entry system
C Double entry system
D Dual entry system
 151

3. Learn about classification of accounts

[Learning Outcome c]

3.1 Classification of accounts and accounting transactions

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 depicting the state of affairs
encompass assets such as land & building, plant & machinery, cash & bank
balances as ‘Property & Assets’ and sundry creditors, borrowings and capital as
‘Liability & Equity’. Each distinctive asset, liability, income or expense is
represented by its respective ‘account’.

1. An account is simply a record of financial inflows and outflows in relation to

the respective asset, liability, income or expense.
2. Income and expense accounts represent only the inflows and outflows
absorbed in the financial-position elements on completion of time period.
3. For the convenience of logical and systematic order of bookkeeping and for
preparation of financial statements, all transactions are recorded in the books
of accounts through the accounts of assets, liabilities, income and
expenditures.
4. Accounts are classified as
9 personal accounts
9 real accounts and
9 nominal accounts

Diagram 4: Classification of Accounts

 152

3.2 Personal Accounts

Personal accounts relate to:

9 individuals
9 partnership firms
9 corporate entities
9 local or statutory bodies including governments or other legal entities

Company ABC has purchased some office equipment from M/s X & Co. on
credit. So M/s X & Co. is a creditor on account of supply of goods to business
(Company ABC). M/s X & Co. is personal A/c.

When goods are sold on credit, debtor A/c is debited and sales A/c is credited.
For example Company ABC sells goods on credit to Company XYZ. In this case
Company XYZ becomes a debtor for Company ABC. This debtor A/c is personal
account in the books of the business for Company ABC.

Capital account is the account of proprietor and so it is a personal account. For

example Ajay starts a business by contributing an initial amount of Rs 25,000.
This initial Rs 25,000 will be credited to capital A/c which is a personal account
as it belongs to Ajay.

Personal accounts are of three types

1. Natural personal accounts: it relates to transactions of human beings such

as Ram A/c, X A/c, John A/c etc.

2. Artificial personal accounts: for business and financial accounting,

business entities are treated as separate legal entities. Examples: firms,
companies, co-operative societies etc.

3. Representative personal accounts: these are not in the name of any persons
or organisation but represented as persons. Examples: capital ac or drawings
A/c is a representative personal A/c.
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3.3 Impersonal Accounts

Real accounts: these relate to assets of the firm. For example accounts regarding
land, building, investment, furniture and cash & bank balance are real accounts.

Nominal accounts: these accounts relate to expenses, losses, gains, revenue etc.
like salary, wages, printing & stationery, interest paid, interest received,
commission, premium received, claims paid A/c etc.

Classification of Accounts

Account Nature Examples

Personal Business entities and Natural:
individual 9 Individuals
Artificial:
9 Firms
9 Corporate entities
9 Banks
9 Insurance companies
9 Statutory bodies etc.
Representative:
9 Capital
9 Drawings
Real Tangible assets and Tangible:
intangible assets 9 Cash
9 Bank balance
9 Plant & machinery
9 Furniture & fixtures
9 Stock
Intangible:
9 Patents
9 Goodwill
9 Copyrights
Nominal Elements of income, Income:
gains, revenue, profits, 9 Investment income
expenditure, losses etc. 9 Dividend
9 Interests on deposits
Expenditure:
9 Rent
9 Wages & Salary
9 Commission
9 Stationery etc.
 154

Goodwill will be classified under which type of account?

A Personal Account
B Unreal Account
C Real Account
D Nominal Account

4. Understand the golden rules of accounting

[Learning Outcome d]

4.1 Golden rules of accounting

A transaction is recorded as a ‘debit entry’ (Dr.) in one account and a ‘credit
entry (Cr)’ in the other account. The process of debiting and crediting accounts is
governed by golden rules of accounting. These golden rules imply the rules of
debit and credit for recording transactions in the books of accounts under double
entry system.

4.2 Application of rules of accounting

Type of account Debit rule Credit rule
1. Personal Debit the receiver Credit the giver
account
2. Real account Debit what comes in Credit what goes out
3. Nominal Debit all expenses and Credit all incomes,
account losses profits and gains

Personal Account: Accounting Rule:

Debit the receiver
Credit the giver

Company ABC sold goods worth Rs. 5000 to Company XYZ on credit.
In this case Company XYZ is the receiver of goods and hence as per the
accounting rule for personal account, (debit the receiver) in the books of
accounts of Company ABC, the account of Company XYZ will be debited for
Rs. 5000. The second aspect of this transaction is that goods are going out of the
company. Hence as per the accounting rule for real accounts (credit what goes
out) goods account will be credited for Rs. 5000.
 155

After 1 month, Company XYZ makes a cash payment of Rs. 5000 to Company
ABC. In this case Company XYZ is the giver of Rs. 5000 and hence as per the
accounting rule for personal account (credit the giver) in the books of accounts
of Company ABC, the account of Company XYZ will be credited for Rs. 5000.
The second aspect of this transaction is that cash of Rs. 5000 is coming into
Company ABC. Hence as per the accounting rule for real accounts (debit what
comes in) cash account will be debited for Rs. 5000.

Real Account: Accounting Rule:

Debit what comes in

Credit what goes out

Let us take the same example that we took for personal account

Company ABC sold goods worth Rs.5000 to Company XYZ on credit.

In this case goods worth Rs. 5000 are going out of the company.

Hence as per the accounting rule for real account, (credit what goes out) in the
books of Company ABC, goods account will be credited for Rs.5000.

After 1 month, Company XYZ makes a cash payment of Rs.5000 to Company

ABC. In this case cash of Rs.5000 is coming into Company ABC.

Hence as per the accounting rule for real account, (debit what comes in) in the
books of Company ABC, cash account will be debited for Rs.5000.

Nominal Account: Accounting Rule:

Debit all expenses and losses

Credit all incomes, revenue and gains

Company ABC paid Rs.1000 as telephone bill.

In this case, telephone bill is an expense for the company.

Hence as per the accounting rule for nominal account, (debit all expenses and
losses) in the books of Company ABC, telephone account will be debited for
Rs.1000.
 156

Company ABC received Rs.1000 as interest on bank deposit.

In this case, interest is an income for the company. Hence as per the accounting
rule for nominal account, (credit all incomes, revenue and gains) in the books
of Company ABC, interest account will be credit for Rs.1000.

Students should also note following fundamental aspects for better understanding
of golden rules of accounting.
1. In real account, when there is an increase in the amount of an asset, such
asset A/c is to be debited and the related account which gets reduced in
amount for the transaction is to be credited.
Example: a firm purchases a computer and makes payment by cheque for
Rs. 40,000. In this case computer A/c will be debited for Rs. 40,000 and bank
A/c will be credited for the same amount.
2. If the firm purchases the computer on credit from a firm called M/s
Electronic Systems, computer A/c will be debited for Rs.40,000 and M/s
Electronic Systems A/c (giver of the transaction) will be credited for the
same amount.
3. When M/s Electronic Systems A/c will be paid off for the price of the
computer purchased, M/s Electronic Systems (receiver of the payment) will
be debited for Rs.40,000 and bank A/c (giver of the transaction) will be
credited for the same amount.
4. According to the said rule, all expenses or losses are debited while incomes
and gains are credited. If there is reduction of expenses, expense A/c will be
credited. Similarly, if there is reduction of gains or incomes, income A/c will
be debited.

Example 1: Goods worth Rs 1000 are found defective and returned to the
supplier. Here purchase A/c will be credited and supplier A/c will be debited.
Example 2: In 2009-10, M/s PP Insurance Company ceded 20% of the total fire
premium collection of Rs 100 crores to RR Re-insurer and recovered from them
20% of the total fire claims paid for Rs.50 lakhs for the year as per reinsurance
treaty. In the books of PP Insurance Company, fire premium A/c will be debited
and M/s RR Reinsurer A/c will be credited for Rs.20 crores for cession of
premium, while re-insurer will be debited and fire claims A/c will be credit Rs 10
lakhs for recovery of claims from the reinsurer.
 157

To sum up, the under mentioned points deserve to be looked into:

1. Bookkeeping and accounting are done in respect of transactions

2. Transactions are different from events involving no monetary value

3. A transaction means an event which is measureable in terms of money and

causes a change in the financial position of a person, business entity and
others who maintain accounts.

4. All transactions are events while all events are not transactions.

5. Recording of a transaction consists, primarily of identification of individual

accounts involved in the transaction followed by ascertainment of debit and
credit, further followed by making journal entries in a book called ‘Journal’.

6. Records of individuals ledger accounts are kept in a book called ‘Ledger’.

7. Journal entries from ‘Journal’ are posted to the individual ledger accounts
maintained in the ‘Ledger’.

8. Balancing is done for each and every ledger account periodically, specifically
at the end of the accounting period.

9. Trial balance is prepared taking balances from the ‘ledger’ and also from the
cash and bank balances of cash book. It ensures arithmetical accuracy to
confirm the dual aspect of transactions. If the trial balance gets agreed, it
would mean that there have been corresponding credits for all the debits of
equal monetary value.

10. Adjustment entries or rectification entries and closing entries are prepared.

11. Some of the individual ledger balances from the trial balance are used for the
preparation of income statement such as profit & loss A/c while others along
with the result being either balance of loss or profit emanating from the
income statement are utilised for preparation of balance sheet or statement of
affairs.

12. Searching information through six questions serially as mentioned below can
make identification of individual ledger accounts involved in a transaction.
 158

a) What comes in?

b) What goes out?
c) What is the expense or loss incurred?
d) What is the income or gain made?
e) Who gives to the entity?
f) Who takes from the entity?

The questions are to be made on behalf of the entity whose accounts are being
recorded and owner’s identity must be treated as separate from the entity.

Paid Rs 300 to Pratip as his wages for Dec 2009

9 What comes in? – nothing
9 What goes out? – Cash (to be treated as one account involved)
9 What is the expense or loss? – wages (to be treated as another account)

One account is to be debited and the other account is to be credited. There may
be more than two accounts in a single transaction also. Alternatively, it may be
effected through more than one journal entry. No more questions are necessary if
prima facie minimum two accounts of equal monetary value are available that
complete the transaction. Hence the accounts are cash A/c and wages A/c and not
Pratip A/c.

13. Rules for ascertaining debit and credit may be elaborated for comprehensive
understanding which are stated below:

Rules for ascertaining debit and credit

Personal Accounts
Debtor or receivable Increases Debit
Decreases Credit

Creditor or payable Increases Credit

Decreases Debit

Real Accounts
Asset Increases Debit
Decreases Credit

Liability Increases Credit

Decreases Debit
 159

Nominal Accounts
Expense or loss Increases Debit
Decreases Credit

Income or gain Increases Credit

Decreases Debit

Company ABC paid Rs.1000 as telephone bill. What will be the accounting entry
in this case?

A Telephone account will be credited by Rs.1000 and company account will be

debited by Rs.1000
B Telephone account will be debited by Rs.1000 and cash account will be
credited by Rs.1000
C Cash account will be debited by Rs.1000 and telephone account will be
credited by Rs.1000
D Cash account will be credited by Rs.1000 and company account will be
debited by Rs.1000

5. Get introduced to principal books and subsidiary books.

[Learning Outcome e]

5.1 Principal books and subsidiary books

In business, separate registers are maintained for each and every class of
transactions for
9 purchase
9 sales
9 receipts and
9 payments of cash

Such registers or books are called ‘books of prime entry‘ or ‘books of original
entry’ or ‘subsidiary books’ as the transactions are recorded there initially. They
are nothing but journals. Ledgers where individual accounts are maintained are
called ‘principle books’ or ‘final books of account’.
 160

Diagram 5: Principal Books and Subsidiary Books

Following subsidiary books are commonly maintained in business firms.

1. Sales day book: records credits sales on a daily basis

2. Purchase day book: records credit purchases on daily basis

3. Cash book: records receipts and disbursements of cash or bank account

transactions on daily basis

4. Bank receipts day book: records all receipts of cheques and deposits into
banks where banking transactions are not recorded in cash book

5. Sales return book: records return of goods sold. This book is also referred to
as return inward book.

6. Purchases return book: records return of goods purchase. This book is also
referred to as returns outward book
7. Bills receivable book: records all receipts of bills, promissory notes
8. Bills payable book: records commitments for bills accepted
i) In insurance business, subsidiary books are:
9 premium register
9 claim payment register
9 commission register (both accrual and payment)
9 cheque dishonor register etc.
 161

ii) In insurance, primary books are:

9 general ledger for premium account
9 claims paid account
9 commission account
9 bank account etc

5.2 Concepts of capital & revenue: expenditure and receipts –

treatment

1. Capital and revenue

Business results can be properly ascertained if proper distinction is made

between capital and revenue transactions.

Capital transaction
A capital transaction is one, benefit of which is extended beyond one accounting
period.

Revenue transaction
A revenue transaction is one, benefit of which is exhausted within one
accounting period.

2. Receipt and expenditure

A capital transaction may either be capital receipt or capital expenditure.

Capital receipt
A capital receipt is converted into liability or capital contribution or which results
from disposal of an asset.
Capital expenditure
A capital expenditure gives rise to an item of asset usually enhancing earning
capacity.
Revenue receipt
A revenue receipt can be an income or gain
Revenue expenditure
A revenue expenditure gives rise to an expense
 162

Both capital receipts and capital expenditure appear in the balance sheet while
both revenue receipts and revenue expenditure appear in the profit & loss A/c.

The distinction between capital vs. revenue expenditure and capital vs. revenue
receipts is required for placing the items in the appropriate financial statements
i.e. profit & loss account of the balance sheet. Importantly, capital expenditure is
also ultimately taken into profit & loss account, but not in the year of spending. It
is spread over the period of use for generation of revenue.

Sales return book is also known as _______.

A Returns inward book

B Returns indoor book
C Returns outward book
D Returns outdoor book

Summary
¾ Accounting process refers to the process of identifying, measuring,
classifying, recording, summarising, analysing, interpreting and reporting the
financial performance and the financial position of the enterprise through
financial statements.
¾ Stages of accounting process include juournalising transactions, ledger
posting, balancing ledger; preparing trial balance, profit & loss account and
balance sheet.
¾ Accounting systems are of two types: single entry system and double entry
system.
¾ Accounts are classified into two main types: personal and impersonal
¾ Personal accounts can be natural, artificial and representative
¾ Real accounts can be tangible and intangible
¾ Nominal accounts include all expenses and losses, incomes and gains
¾ Golden rules of accounting:
9 Personal: debit the receiver and credit the giver
9 Real: debit what comes in and credit what goes out
9 Nominal: debit all expenses and losses and credit all incomes and gains
¾ Subsidiary books maintained in business include: sales book, purchase book,
cash book, bank receipts book, sales return book, purchase return book, bills
receivable, bills payable
 163

Answers to Test Yourself

Answer to TY 1

The correct answer is B.

The stages of accounting process involve preparation of trial balance, profit &
loss account and balance sheet.

Answer to TY 2

The correct answer is B.

In single entry system of accounting, some transactions are recorded on both

sides; some on one side and some transactions are not recorded at all.

Answer to TY 3

The correct answer is C.

Goodwill will be classified under real account.

Answer to TY 4

The correct answer is B.

Telephone account will be debited by Rs. 1000 and cash account will be credited
by Rs. 1000.

Answer to TY 5

The correct answer is A.

Sales return book is also known as returns inward book.

 164

Self-Examination Questions

Question 1

In bookkeeping, in systematic recording of financial transactions, which is the

first step?

A Journalising transactions with debit and credit

B Balancing of ledger accounts
C Preparation of profit & loss account
D Preparation of balance sheet

Question 2

Company ABC bought goods worth Rs 1000 from Company XYZ on cash. In
this transaction cash will be classified as which type of account?

A Personal account
B Real account
C Nominal account
D Normal account

Question 3

As per the golden rules of accounting, from the below, which one is applicable to
personal accounts?

A Debit all expenses and losses and credit all incomes and gains
B Debit what comes in and credit what goes out
C Debit the receiver and credit the giver
D Debit what goes out and credit what comes in

Question 4

Returns of purchased goods are recorded in which book?

A Returns inward book

B Returns indoor book
C Returns outdoor book
D Returns outward book
 165

Question 5

Bank paid interest Rs 1000 to Company XYZ, as interest on bank deposit. In this
case cash account will be _____ and interest account will be ______ in the books
of Company XYZ

A Debited, credited
B Credited, debited
C Debited, no effect
D Credited, no effect

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is A.

In bookkeeping, in systematic recording of financial transactions, the first step is

journalising transactions with debit and credit.

Answer to SEQ 2

The correct answer is B.

Company ABC bought goods worth Rs 1000 from Company XYZ on cash. In
this transaction cash will be classified as real account.

Answer to SEQ 3

The correct answer is C.

As per the golden rules of accounting, for personal accounts – Debit the receiver
and credit the giver.

Answer to SEQ 4

The correct answer is D.

Returns of purchased goods are recorded in returns outward book.

 166

Answer to SEQ 5

The correct answer is A.

Bank paid interest Rs 1000 to Company XYZ, as interest on bank deposit. In this
case cash account will be debited and interest account will be credited in the
books of Company XYZ.
 167

CHAPTER 2

ACCOUNTING PROCESS, METHODS,

CONTROL AND FINALISATION OF
ACCOUNTS
UNIT 6

ACCOUNTING METHODS AND CONTROL

Chapter Introduction
In this unit we will study the methods and procedures through which financial
data and information flow from the source documents to the stage where final
accounts are prepared.

The accounting methods and procedures include:

1. Methods of Journalising
2. Methods of Ledger Posting
3. Methods of Trial Balance Preparation and
4. Methods of Preparation of Final Accounts or Financial Statements.

Thus, to arrive at the final stage of financial accounting, an accountant has to

complete the various stages as mentioned above.

a) Explain Journals.
b) Explain how Cash Book is prepared.
c) Learn the objectives, rules and process of preparation of the trial balance.
d) Demonstrate the preparation of Final Accounts.
 168

1. Explain Journals.
[Learning Outcome a]
For recording and analysing business transactions of a financial nature, they are
classified into various types of accounts such as assets, liabilities, capital,
revenue and expenses. These are either debited or credited in accordance with the
rules of debit and credit applicable to the specific accounts. Applying dual aspect,
one account is debited and the other account is credited. Every transaction can be
recorded in the journal. This process of recording transactions in the journal is
known as ‘Journalising’.

The journal is the book in which transactions are recorded for the first time. It is
also known as the ‘Book of Original Record’ or ‘Book of Primary Entry’.

The following flow chart shows how journal plays an important role in the
preparation of financial statements.

Diagram 1: Important role of journal in the preparation of financial

statements

Journals are prepared in a particular form, as shown below:

JOURNAL
Date Particulars L.F Debit Credit
Amount Amount
 169

At the end of the journal entry, a narration or an explanation of the entry is given.

In a computer system, sometimes transactions may be directly posted in the

respective ledger account from source
documents, but posting of items in Journal proper is meant for
ledger or sub-ledger follow the rules recording all such transactions for
of journalising the transactions for which no special journal has been
accounting treatment. In a maintained in the business. E.g.
computerised system, journal machinery purchased on credit,
proper is maintained for closing outstanding expenses, pre-received
adjustment entries or rectification of income, etc.
mistakes etc.

Generally, in small business houses, one Journal Book is maintained in which all
the transactions are recorded. However, in the case of big business houses, the
transactions are quite large in number, and so the journal is divided into various
types of books called Special Journals in which transactions are recorded
depending upon the nature of transaction.

The following chart will help you to understand the different types of journals:

Diagram 2: Types of journals

 170

Journal entries can be either on single entry basis (one Debit A/c and one Credit
A/c) or compound entry basis (one debit and two or more credits or vice versa).
But in both the cases, the total of debits must equal the total of credits.

A firm purchased goods for Rs. 40,000 and made the payment partly in cash, Rs.
10,000, and the balance by cheque.

The journal entries for this transaction will be as follows:

Purchase A/c Dr Rs. 40,000

To Cash A/c Rs. 10,000
To Bank A/c Rs. 30,000
(Being goods purchased)

We will discuss the journalising process through examples for better

understanding.

Journalise the following transactions in the books of the business started by Mr.
Rajesh in April 2010.

1. 1st April: Mr. Rajesh commenced a business dealing in stationery with Cash
Rs.1,00,000.
2. 2nd April: he opened a bank account and deposited Rs.80,000.
3. 4th April: he purchased furniture in cash Rs.10,000.
4. 5th April: he purchased a computer for Rs.30,000 and paid by cheque.
5. 7th April: he purchased goods for Rs. 40,000 and paid by cheque.
6. 8th April: he sold goods for cash Rs.5000.
7. 9th April: he deposited Rs 5000 into the bank.
8. 10th April: he sold goods for Rs.10000 to M/s Unique Stationers who made
the payment by cheque which was deposited into the bank immediately.
9. 15th April: he purchased goods worth Rs.50000 on credit from M/S XYZ Ltd.
10. 20th April: he sold goods worth Rs.40000 to M/S P B Stores on credit.
11. 25th April: M/S P B Stores paid Rs 25000 through cheque, which was
deposited into the bank.
12. 26th April: M/S XYZ Ltd was issued a cheque for Rs.30,000 as part payment
for dues.
 171

13. 28th April; he withdrew Rs 15,000 from the bank and paid rent for Rs 5000
by cheque.
14. 29th April: he paid salary Rs 5000 to his staff.
15. 30th April: he drew Rs 5000 for personal use.
Pass the necessary journal entries in the books of the business.
Solution
Journal
In the books of the business of Rajesh
(Amount in Rs.)
Date Particulars LF Dr Cr
01.04.2010 Cash A/c Dr 1,00,000
To Capital A/c 1,00,000
(Being business commenced
with cash)
02.04.2010 Bank A/c Dr 80,000
To Cash A/c 80,000
(Being cash deposited into bank
account)
04.04.2010 Furniture A/c Dr 10,000
To Cash A/c 10,000
(Being furniture purchased)
05.04.2010 Computer A/c Dr 30,000
To Bank A/c 30,000
(Being cheque no. issued for
computer purchased)
07.04.2010 Purchase A/c Dr 40,000
To Bank A/c 40,000
(Being cheque no. issued for
goods purchased)
08.04.2010 Cash A/c Dr 5,000
To Sales A/c 5,000
(Being goods sold on cash)
09.04.2010 Bank A/c Dr 5,000
To Cash A/c 5,000
(Being cash deposited into
bank)
 172

In the books of the business of Rajesh

(Amount in Rs.)
Date Particulars LF Dr Cr
10.04.2010 Bank A/c Dr 10,000
To Sales A/c 10,000
(Being cheque for sales
proceeds deposited)
15.04.2010 Purchase A/c Dr 50,000
To M/S XYZ Ltd A/c 50,000
(Being goods purchased on
credit)
20.10.2010 M/S P.B. Stores A/c Dr 40,000
To Sales A/c 40,000
(Being goods sold on credit)
25.10.2010 Bank A/c Dr 25,000
To M/s P. B. Stores A/c 25,000
(Being cheque collected from
debtor and deposited)
26.10.2010 XYZ Ltd A/c Dr 30,000
To Bank A/c 30,000
(Being cheque no..issued to
creditor)
28.10.2010 Cash A/c Dr 15,000
To Bank A/c 15,000
(Being cash withdrawn from
bank)
28.10.2010 Rent A/c Dr 5,000
To Bank A/c 5,000
(Being rent paid by cheque)
29.10.2010 Salary A/c Dr 5,000
To Bank A/c 5,000
(Being salary paid to staff for
April 2010)
30.10.2010 Drawings A/c Dr 5,000
To Cash A/c 5,000
(Being cash drawn by
proprietor from business)
 173

In another example, we shall discuss how transactions in a general insurance

business are recorded in journals.

The following transactions took place in May 2010 in the business of Yong
General Insurance Co. Ltd:

1. Premium collected Rs. 10,000 in Fire Dept, Rs. 30,000 in Motor Dept, Rs.
10,000 in Marine Dept
2. Commission accrues on all types of business @ 10%.
3. Commission Rs. 6,000 accrued in April was paid in May, 2010 which
includes Rs. 1,000 for Fire Dept, Rs. 2,000 for Motor Dept, Rs. 1,000 for
Marine Dept and Rs. 2,000 for Misc. dept. 10%TDS on commission was
deposited.
4. Fire Claims paid for Rs. 20,000.
5. Marine Claims reported for Rs. 2,00,000.

Solution

In the books of Yong General Insurance Co Ltd: Journal

(Amount in Rs.)
Date Particulars LF Dr Cr
May 2010 Bank A/c Dr 50,000
To premium Control 50,000
A/c
(Being total premium collected
in May 2010)

May 2010 Premium Control A/c Dr 50,000

To Fire Premium A/c 10,000
To Motor Premium A/c 30,000
To Marine Premium 10,000
A/c
(Being premium collected in
May booked in respective
Dept.)
 174

In the books of Yong General Insurance Co Ltd: Journal

(Amount in Rs.)
Date Particulars LF Dr Cr
May 2010 Commission on Fire Dr 1,000
Business A/c
Commission on Motor Dr 3,000
Business A/c
Commission on Marine Dr 1,000
Business A/c
To Commission 5,000
Control A/c
(Being commission accrued in
May 2010 booked)

May 2010 Commission Control A/c Dr 6,000

To Bank A/c 5,400
To TDS on commission 600
A/c
(Being commission for April’10
paid)

May 2010 TDS on Commission A/c Dr 600

To Bank A/c 600
(Being TDS on April
Commission deposited)

May 2010 Fire Claims Paid A/c Dr 10,000

To Bank A/c 10,000
(Being fire claims paid)

May 2010 Marine Claims Outstanding Dr 2,00,000

at the End A/c
To Outstanding 2,00,000
Liability for Claims A/c
(Being marine claims in May)
 175

Journalising transactions is advantageous to the accountant in the following

ways:

9 Transactions are recorded in a chronological order; one can get complete

information about the nature and process and period of transactions occurred
as the entries in the journals are supported by proper narrations.

9 Journals facilitate proper posting of entries easily and systematically in

ledger accounts as they provide a basis for posting.

Which of the following statements related to the recording of journal entries is

correct?

A For any given journal entry, credits must exceed debits.

B Usually, credits are recorded on the left side and debits on the right side.
C The chart of accounts discloses the amount taken to the debit and credit of
the affected accounts.
D Journalisation is the process of converting transactions and events into a
debit-credit format.

2. Explain how Cash book is prepared.

[Learning Outcome b]
Cash transactions are straightway recorded chronologically in the Cash Book. On
the basis of records or entries in the cash book – on Debit and Credit sides for
receipts and payments of cash respectively - the cash book is prepared as a
Ledger Account.

The Cash Book is balanced like other accounts and the net balance is calculated
and placed in the trial balance and final statement of accounts. Though cash
book is a subsidiary book, it serves as Cash Account and Bank Account.
Thus, the Cash Book is both a subsidiary book and a principal book serving
the purpose of both types of books.

A cash book may be either the Main Cash Book or Petty Cash Book.
 176

Diagram 2: Types of Main Cash Book

2.1 Simple Cash Book

It is a single column cash book providing only one amount column on each side.
The left-hand side keeps the records of cash receipts while the right-hand side
amount column records the cash payments. Both the columns are totalled and the
balance is determined. The receipts column (debit side) is always higher than the
payments column (credit side). The excess balance on the debit side is written on
the credit side as ‘By balance c/d’, which is then taken to the Debit Side as ‘’To
Balance b/d” after the total to show the cash balance in hand at the beginning of
the next period. The following illustration will explain the concept better.

Enter the following transactions that occurred in July 2010 in a simple cash book
maintained by Mr. X for his sole proprietor business:
2010 Rs.
1 July Cash in hand 12,000
5 July Received from Rahim, a debtor 3,000
8 July Sold goods for Cash 3,000
10 July Purchased goods for cash from Prakash 2,000
15 July Sold goods to Mr. Z on credit 5,000
20 July Purchased furniture for cash 10,000
25 July Sold goods for cash 12,000
28 July Paid rent in cash 1,000
30 July Paid salary in cash 1,000
31 July Cash withdrawn for personal use 2,000
 177

Solution

Dr Cash book Cr
Date Particulars LF Amount Date Particulars LF Amount
2010
July
1 To Balance b/d 12,000 10 By Purchase 2,000
5 To Rahim 3,000 20 By Furniture 10,000
8 To Sales 3,000 28 By Rent 1,000
20 To Sales 12,000 30 By Salary 1,000
31 By Drawings 2,000
31 By Balance c/d 14,000
30,000 30,000
2010
August
1 To Balance b/d 14,000

Note: The transaction for 15 July, for sold goods to Mr. Z on credit, Rs. 5000
will not be recorded in the cash book.

2.2 Double Column Cash Book

In a double column cash book, both Cash account and Bank account are
prepared simultaneously and the double entry related to cash and bank
transactions is made in the book with a facility for cross verification at any time,
especially for reconciliation of cash and bank transactions.

Following is the format of Double Column Cash Book:

Dr Cash Book Cr
Dt Particulars L Cash Bank Dt Particulars L Cash Bank
F F

In this book, chances of errors in respect of banking transactions are reduced to

the minimum. The information regarding Cash in hand and Balance at Bank can
be obtained easily without any separate ledger of a particular bank account. In
double-column Cash Book, the following points must be kept in mind:
 178

1. All receipts are written on the receipts side—Cash in the Cash Column and
Cheques in Bank column. In the particulars column, the name of the account
in respect of which payment has been received is to be entered.

2. All payments are entered on the payment side, cash payment in the cash
column and payment by cheques in the bank column.

3. Contra Entries are made for transactions relating to cash withdrawn from
bank for office use and on cash deposited into bank. For cash withdrawn
from bank, the amount is entered in the bank column on the payment side
and in the cash column on the receipt side. Conversely, for cash deposited
into bank, the amount is entered in the bank column on the receipt side and in
the cash column on the payment side. For such contra entries, the letter “C”
should be entered in the L.F column to indicate that these are contra entries.

4. Entries for cheques dishonoured are made on the payment side of the bank
column with the name of the related party in the particulars column.

5. Closing Balance of Cash in hand and the Balance at Bank is obtained

through balancing of the Cash Account and Bank Account – which involves
determining the excess of the receipt side over the payment side for both cash
column and bank column.

The following example explains the method of preparation of the double-column

cash book.

In the books of the sole proprietor, Mr. Ramesh, prepare a double column cash
book.

2010 Rs.
1 Aug Cash in hand 22,000
Balance at Bank 25,000
5 Aug Received a cheque from Rahim, a debtor 30,000
6 Aug Cheque deposited into bank
8 Aug Sold goods for Cash 30,000
9 Aug Deposited cash into bank 20,000
10 Aug Purchased goods for cash from Prakash 20,000
15 Aug Sold goods to Mr. Z on credit * 50,000
 179

2010 Rs.
20 Aug Purchased furniture; paid in cash 10,000
and balance by cheque 20,000
25 Aug Sold goods for cash 12,000
28 Aug Paid rent by cheque 10,000
29 Aug Cash withdrawn from bank 20,000
30 Aug Paid salary in cash 10,000
31 Aug Cash withdrawn for personal use 2,000

Dr Cash Book Cr
Dt Particular L Cash Bank Dt Particulars L Cash Bank
s F F
1 To Balance 22,000 25,000 6 By Cash C 30,000
b/d A/c
5 To Rahim 30,000 9 By Cash C 20,000
A/c A/c
6 To Cash C 30,000 10 By Purchase 20,000
A/c A/c
8 To Sales 30,000 20 By 10,000 20,000
A/c Furniture
A/c
9 To Cash C 20,000 28 By Rent A/c 10,000
A/c
25 To Sales 12,000 29 By Cash C 20,000
A/c A/c
29 To Bank C 20,000 30 By Salary 10,000
A/c A/c
31 By 2,000
Drawings
A/c
31 By Balance 22,000 25,000
c/d
1,14,000 75,000 1,14,000 75,000

* 15 Aug: sold goods to Mr. Z on credit – this transaction will not be recorded in
the Cash Book as it is a credit transaction.

Note: in a Cash book, Cash A/c will always have a debit balance but Bank A/c
may have either a debit or a credit balance. Credit balance in a Bank A/c
represents Bank Overdraft.
 180

The following transactions occurred in July 2010 (up to 10th July) in Lucknow
Branch I of Good Luck General Insurance Company. The premium collected for
a day is deposited into the bank the very next day.

Rs.
1 July Cash in hand 22,000
Balance at Bank 4,50,000
2 July Premium Collection (Cash Rs. 20,000 & Cheques Rs. 2,20,000
200,000)
5 July Premium Collection (Cash Rs. 30,000 & Cheques Rs. 4,30,000
400,000)
6 July Premium Collection (Cash Rs. 50,000 & Cheque Rs. 4,50,000
400,000)
7 July Premium Collection (Cash Rs. 40,000 & Cheques Rs. 5,40,000
500,000)
7 July Remittance sent to Head Office 10,00,000
8 July Commission for June disbursed by cheque after deducting 1,44,000
TDS Rs. 16,000
8 July Premium Collection (Cash Rs. 20,000 & Cheques Rs. 5,20,000
500,000)
9 July TDS on Commission deposited 16,000
9 July Premium Collection (Cash Rs. 60,000 & Cheques Rs. 5,60,000
500,000)
10 July Remittance sent to Head Office 14,40,000
Premium Collection (Cash Rs 40000 & Cheques Rs 300,000) 3,40,000
Festival Advance paid to staff 15,000
Cash withdrawn from bank 10,000

Prepare the Cash Book and show the closing balance as on 10-07-2010. Verify
the closing balance of the Cash A/c and Bank A/c as on 10-7-2010.
Solution

Dr Cash Book Cr
Dt Particulars L Cash Bank Dt Particulars L Cash Bank
F F
1 To Balance 22,000 4,50,000 5 By Bank C 2,20,000
b/d A/c
 181

Dr Cash Book Cr
Dt Particulars L Cash Bank Dt Particulars L Cash Bank
F F
2 To 2,20,000 6 By Bank C 4,30,000
Premium A/c
control A/c
5 To Cash C 2,20,000 7 By Bank C 4,50,000
A/c A/c
To 4,30,000 By Head 10,00,000
Premium Office A/c
control A/c
6 To Cash C 4,30,000 8 By Bank C 5,40,000
A/c A/c
To 4,50,000 By Agency 1,44,000
Premium Commissio
control A/c n A/c
7 To Cash C 4,50,000 9 By Bank C 5,20,000
A/c A/c
To 5,40,000 By TDS on 16,000
Premium commission
control A/c A/c
8 To Cash C 5,40,000 10 By Bank C 5,60,000
A/c A/c
To 5,20,000 By Head 14,40,000
Premium Office A/c
control A/c
9 To Cash C 5,20,000 By Cash C 10,000
A/c A/c
To 5,60,000 By Festival 15,000
Premium Advance
control A/c A/c
10 To Cash C 5,60,000 By Balance 3,57,000 5,60,000
A/c c/d
To 3,40,000
Premium
control A/c
To Bank C 10,000
A/c
30,92,000 31,70,000 30,92,000 31,70,000
Note: sometimes in the cash book a short narration is given for every transaction.
 182

2.3 Triple Column Cash Book

Along with columns for Cash and Bank Accounts on the debit and credit side of
cash books showing cash receipts and payments and bank receipts (deposits) and
payments (withdrawals), another additional column may be added on both the
sides to record the transactions of ‘Cash Discount Allowed’ and Cash Discount
Received’.

9 ‘Cash Discount Allowed’ is related to the receipt or collection of recoveries.

When cash discount is allowed to customers, the amount collected is shown
in the Cash or Bank column as the case may be on the debit side, and the
amount of discount allowed is shown in the Discount Column on the debit
side.

9 Conversely, ‘Cash Discount Received’ is related to cash payment to

creditors. When Cash Discount is received on making payment to creditors,
the net payment is shown in the Cash Column and the discount amount is
shown in the Discount column.

Remember that unlike Cash and Bank Columns, Discount Columns are not
balanced. Debit Column of Discount is Discount Allowed A/c which is an
expense while Credit Column of Discount represents Discount Received A/c
which is an income. As Expenditure Account and Income Account are to be
shown separately, one cannot be adjusted with the other to determine the net
balance.
The total debits and total credits are shown in the monthly Trial Balance.

Following is the format of Triple Column Cash Book:

Dr Three Columnar Cash Book Cr

L L
Date Receipts Disc Cash Bank Date Payments Disc Cash Bank
F F
 183

Transactions in the books of M/S ABC & CO for the month of August 2010:

2010 Rs.
1 Aug Cash in hand 2,000
Balance at Bank 5,000
5 Aug Received cheque from Rina, a debtor, after discount of Rs. 50 2,550
6 Aug Cheque deposited into bank
8 Aug Sold goods for Cash 30,000
9 Aug Cash deposited into bank 20,000
10 Aug Purchased goods for cash from Prakash 10,000
15 Aug Sold goods to Mr. Z on credit* 50,000
20 Aug Purchased furniture and paid by cheque 10,000
25 Aug Sold goods for cash 12,000
28 Aug Paid rent by cheque 10,000

Prepare a Triple column Cash Book for the month of August 2010
Cash Book
L L
Date Receipts Disc Cash Bank Date Payments Disc Cash Bank
F F
Aug- Aug-
10 10
To Balance
1 b/d 2,000 5,000 6 By Bank C 2,550
5 To Rina 50 2,550 9 By Bank C 20,000
By
6 To Cash C 2,550 10 Purchase 10,000
By
8 To Sales 30,000 20 Furniture 10,000
9 To Cash C 20,000 28 By Rent 10,000
By
Balance
25 To Sales 12,000 31 c/d 14,000 7,550
50 46,550 27,550 46,550 27,550

* 15 Aug: sold goods to Mr. Z on credit – this transaction will not find a place in
the Cash Book.
 184

2.4 Petty cash book

There could be certain transactions such as payment for postage, local transport
or food and refreshments for the staff that may not be paid for by cheque. These
payments have to be made in cash as these are of small amounts. There may also
be a lack of systems at the receiver’s side to process such small amounts.

As indicated by the literal meaning of the word ‘petty’ i.e. insignificant or small,
petty cash transactions mean small cash transactions. Petty cash refers to the cash
that is held by the entity for small expenses.

The petty cash book has a number of columns for amount on the payment side.
Each of the amount columns is allotted to specific, common expenses. The last
column is allotted for miscellaneous expenses. At the end of the period, all
amount columns are totalled. The total of the amount paid shown in column 5 is
deducted from column 1 to calculate the petty cash balance.

Format of petty cash book

Dr Petty Cash Book Cr

Particulars

Amount Amount
Date

Voucher
received paid Analysis of Payments
No.
(Rs) (Rs)
& Telegram

Conveyance
Telephone

Stationery

Expenses
Postage

Misc.

1 2 3 4 5 6 7 8 9 10

Which of the following statements concerning the triple column cash book is
correct?

A The ledger folio column represents the third column of the cashbook
B The discount column totals should be the same to enable balancing
C The bank column can have either a debit or a credit balance
D The cash column can have a credit balance at the end of the period
 185

3. Learn the objectives, rules and process of preparation of

the trial balance.
[Learning Outcome c]
Under the double entry system, for every debit entry, there is a corresponding
credit entry of the same amount when we record a transaction for financial
accounting. Consequently, the total amount of all the debit entries should be
equal to the total of all credit entries for any particular period of accounting.

A statement showing all debit items and all credit items is prepared periodically
to verify whether the two totals i.e. the debit total and the credit total are equal.
Such debit items and credit items are taken from the general ledger after
balancing. The debit items are shown in one column and the credit items are
shown in another. This statement is called a trial balance.

Generally, a monthly trial balance is prepared to verify the arithmetical accuracy

of the recording of transactions in financial accounting.

There are two methods of preparing a trial balance.

1. Trial Balance prepared with the gross totals of the debit side and the credit
side of each ledger account and
2. Trial Balance prepared with the net balance of each ledger account. The
former is called Gross Trial Balance while the latter is called Net Trial
Balance.

Generally, Net Trial Balance is adopted in almost all cases. Trial balance
contains the net balances of Personal Accounts and Real Accounts while
Nominal Accounts are shown with gross debit totals and gross credit totals.

Financial statements are prepared on the basis of the trial balance. Nominal
Accounts are taken into Trading and Profit &Loss Account, while the balances of
Personal Accounts and Real Accounts are shown in the Balance Sheet.

Debit Balances of Personal Accounts and Real Accounts are shown on the Asset
Side and Credit Balances of these accounts are shown on the Liability Side of the
Balance Sheet.

Thus, Trial Balance is the foundation of financial statements.

 186

Diagram 2: Steps to prepare trial balance

The following example will help you to understand the method of preparation of
Trial Balance.

From the following balances of accounts of a sole proprietor business, prepare a

Trial Balance as on 31.3.2010

Rs. Rs.
Purchase of goods 3,10,000 Furniture and fittings 22,000
Sales of goods 4,20,000 Advertising & publicity 10,000
Discount on sales 20,000 Printing & stationery 10,000
Opening stock 50,000 Motor car 48,000
Cash in hand 2,100 Bad debts 2,000
Cash at bank 12,000 Cash discounts 4,000
Proprietor’s capital 2,88,600 General expenses 14,000
Drawings 4,000 Carriage inwards 22,000
Rent, rates and taxes 5,000 Carriage outwards 10,000
Salaries 32,000 Wages 20,000
Postage and telephones 11,500 Sundry creditors 40,000
Commission paid to 35,000 Sundry debtors 96,000
salesmen
Insurance premium 9,000
 187

Solution
Trial Balance as on 31.03.2010
(Amount in Rs.)
Dr Cr
Purchase of goods 3,10,000
Sales of goods 4,20,000
Discount on sales 20,000
Opening stock 50,000
Cash in hand 2,100
Cash at bank 12,000
Proprietor’s capital 2,88,600
Drawings 4,000
Rent, rates and taxes 5,000
Salaries 32,000
Postage and telephones 11,500
Commission paid to salesmen 35,000
Insurance premium 9,000
Furniture and fittings 22,000
Advertising & publicity 10,000
Printing & stationery 10,000
Motor car 48,000
Bad debts 2,000
Cash discounts 4,000
General expenses 14,000
Carriage inwards 22,000
Carriage outwards 10,000
Wages 20,000
Sundry creditors 40,000
Sundry debtors 96,000
7,48,600 7,48,600

Note: If the totals of the two amount columns of the trial balance do not agree, it
means there is some mistake in the ledger posting, and the difference is taken to
the suspense account to temporarily agree the trial balance.

A trial balance is prepared in order to:

1. confirm the arithmetical accuracy of the ledger accounts
2. help in locating errors
3. provide a basis for preparing the final accounts / financial statements
 188

A credit balance in which of the following accounts would indicate a likely

error?

A Premium received
B Share capital
C Claims incurred
D Accumulated depreciation

4. Demonstrate the preparation of Final Accounts.

[Learning Outcome d]
Preparation of Final Accounts or Financial Statements is the concluding stage of
financial accounting. Final Accounts include Trading and Profit & Loss Account
and Balance Sheet, which are drawn at the end of the accounting or trading
period to ascertain the trading or operating results and to present the state of
affairs of the business at the end of a year, after adjustment of operating results
including profit or loss during the period.

4.1 The Trading Account

The Trading Account determines the gross profit which is the difference between
the sales price of goods sold and the cost of goods sold. Gross profit represents
the difference between the sale price and the cost price of goods or services sold.

It is calculated not so much for the amount itself, as for the usefulness of
knowing the ratio the gross profit bears to the turnover (i.e. the total of sales less
returns), and the value of the ratio for comparison with similar information from
preceding business years.

The ratio of gross profit to turnover should remain fairly constant from year to
year. Fluctuations in the ratio call for an enquiry into the causes. The method of
preparation of gross profit can be easily understood from the examples shown
hereinafter.

4.2 The Profit and Loss Account

The purpose of the profit and loss account is to determine the net profit i.e., final
operating surplus available for its distribution to government, the proprietors or
partners or shareholders as the case may be.
 189

The method of preparation is briefly described as under:

1. The account is credited with the gross profit (or debited with gross loss) from
the trading account and debited with all the charges incurred in the course of
the business other than those which have already been taken to the trading
account.

2. It is also credited with any gain which is made apart from trading, such as
rent from any premises sublet interest on investments, profit on sale of
capital assets etc. The difference is the net profit or net loss, as the case may
be, for the trading period. This represents the amount available for
distribution to the proprietors of the business or other stakeholders as
mentioned above.

3. The items which are shown in a profit and loss account are grouped, with
subtotals, under rational headings, so that the trends shown by a succession
of accounts may be followed more easily. The expenses may be placed
broadly under heads such as Administrative expenses, Selling expenses,
Distribution expenses and General expenses.

4. The disposal/ distribution of the net profit varies according to the nature of
ownership of the business. In the case of a proprietorship or partnership
concern, it is transferred to the capital account(s) of the proprietor or partners
as the case may be. In the case of a limited company, however, profit and
loss account is maintained as an open account and appears separately in the
balance sheet.

5. Expenses which are virtually appropriation of profits, such as salary to

partners, interest on capital, commission to partners etc. should not be
debited to profit and loss account. These are debited to profit and loss
appropriation account. Similarly, interest on drawings is credited to profit
and loss appropriation account. The profit and loss appropriation account
begins with the closing balance of profit and loss account, i.e., net profit or
net loss.

6. The trading account, profit and loss account and profit and loss
appropriation account are usually prepared together, that is, they are
drawn as one account with three distinct parts – the first part showing the
gross profit, the second part, the net profit and the third part the distribution
of profit.
 190

The above mentioned procedure can be summarised as shown below:

Diagram 3: Procedure of preparing Profit and Loss A/c

Which of the following is NOT debited to the profit and loss account?

A Gross loss
B Net loss
C Salary paid
D Interest on loan

4.3 Balance Sheet

The last stage of final accounts is the balance sheet.

The purpose of the balance sheet is to show the financial position or state of
affairs of the business entity as at the end of the accounting period. The financial
position is exhibited by a statement of assets and liabilities.
 191

A balance sheet is drawn up from the balances of those ledger accounts (Real &
Personal Accounts) which remain open after the accounts relating to revenue and
expenses have been closed by transferring their balance to the trading and profit
and loss accounts. Such balances are relating to assets or liabilities. Thus, a
balance sheet is not an account forming part of the double entry system; it is a
statement prepared from the balances of accounts. The balances are not
transferred to the balance sheet. They remain in the accounts to appear as
opening balances of the next trading period.

The balance sheet may be regarded as a statement which shows, on one hand, the
sources from which the funds of an enterprise have been obtained and, on the
other, the ways in which these funds are used/ applied.

The Balance Sheet in a vertical form shows the sources and application of funds
during the trading period. The Funds may be derived from various sources such
as investment of the owners, borrowings, sale of assets, decrease in working
capital, profit from operation, etc. and they may be applied in the purchase of
fixed assets, drawings by owners, distribution of profits, payment of loans or
borrowings, increase in working capital, operating loss etc. The Balance Sheet
exhibits all such sources and application of funds in proper form and order to
enable the users of the Balance sheet to understand the information.

From another point of view, the balance sheet is regarded as setting out, on one
hand, the rights and properties (or assets) which an enterprise owns or possesses
and, on the other, the financial liability to be paid by the enterprise.

The balance sheet has acquired the status of a highly important accounting report,
because it serves as a valuable source of information to owners and other
stakeholders. It sets out in summary a picture of the financial position of the
business. It provides a reasonable basis for an analytical study for necessary
interpretation and critical examination of the assets and liabilities of the entity on
a particular date. If, along with the current year balances, the same assets and
liabilities as at previous balance sheet date are shown, the net changes can be
easily seen and the use of the statement as a mirror of results and as a
determinant of trading policy is enhanced. From the following illustrations, you
will see how balance sheet is prepared from the trial balance after preparation of
the Trading and Profit& Loss account.

Final Accounts of companies is discussed in unit no 9 and final accounts of

general insurance companies is discussed in unit 12.
 192

The following examples will help you understand the method of preparation of
Final Accounts.

Final accounts can be prepared from the Trial Balance illustrated in the example
given in Learning Outcome 3 along with the following information:

The following adjustments are to be made:

a) Stock on 31st March, 2010 was valued at Rs.145000.

b) The owner has taken out for personal use goods costing Rs. 5000 out of
purchases during the year.
c) Furniture purchased for Rs. 10000 was wrongly included in purchases.
d) Rs. 5000 due from a debtor included in sundry debtors has become bad.
e) Creditors include a balance of Rs. 4000 to the credit of Mr. Ram in respect of
which it has been settled that only Rs.1000 is to be paid to him.
f) Provision for bad debts to be created at 5% on sundry debtors.
g) Depreciate furniture and fittings by 10% and motor car by 25%.
h) The salesmen are entitled to a commission of 10% on sales.

Solution
Trading and Profit & Loss Account For the
Dr year ended 31st March 2010 Cr
Rs. Rs.
To Opening 50,000 By Sales 4,40,000
stock
To Purchases 3,10,000 Less: Discount 20,000 420,000
Less: Personal 5,000 By Closing stock 1,45,000
use
Less: Furniture 10,000 2,95,000
To Wages 20,000
To Carriage 22,000
inwards
To Gross Profit 1,58,000
c/d
5,45,000 5,45,000
To Rent, rates 5,000 By Gross Profit 1,58,000
and taxes b/d
To Salaries 32,000 By Discount 3,000
from Creditors
 193

Trading and Profit & Loss Account For the

Dr year ended 31st March 2010 Cr
To Postage and 11,500
telephones
To 35,000
Commission to
salesmen
Add: 5,000 40,000
Outstanding
To Insurance 9,000
premium
To Advertising 10,000
and publicity
expenses
To Printing and 10,000
stationery
To Bad debts 7,000
(2,000 + 5,000)
To cash 4,000
discounts
To General 14,000
expenses
To Carriage 10,000
outwards
To Provision 4,550
for bad debt
To
Depreciation
Motor car 12,000
Furniture and 3,200 15,200 By Net Loss 11,250
fittings transferred to
Capital A/c
1,72,250 1,72,250
 194

Balance Sheet as at 31st March 2010

Capital and Liabilities Rs. Assets Rs.
Capital Account Fixed Assets
Opening balance 2,88,600 Motor Car 48,000
Less: Net loss 11,250 Less: 12,000 36,000
Depreciation
277,350 Furniture & 22,000
fittings
Less: Drawings 9,000 2,68,350 Add: Addition 10,000
(5,000 + 4,000) during year
32,000
Less: 3,200 28,800
Depreciation
Current Current Assets
liabilities
Sundry Creditors 37,000 Stock in trade 1,45,00
(40,000 – 3,000) 0
O/s Salesman 5,000 Sundry Debtors 91,000
Commission (96,000 – 5,000)
Less: 5% 4,550 86,450
Provision for
bad debts
Cash at Bank 12,000
Cash in hand 2,100
310350 310350
 195

Prepare Trading and Profit & Loss Account and Balance Sheet as at 31st March
2010 from the following trial balance as on 31.3.2010 in the books of Mr X
Agarwal
Trial Balance as on 31.3.2010
(Amount in Rs.)
Particulars Dr Cr
Opening stock 50,000
Purchases 1,25,000
Bills receivable 13,200
Sales 2,60,000
Sales return 2,000
Purchase return 1,200
Discounts 300 250
Carriage outwards 500
Salaries 10,000
Insurance 1,200
Rent 3,000
Sundry debtors 45,000
Sundry creditors 20,000
Income-tax 900
Cash and bank 5,000
Furniture and fittings 5,000
Bad debts 2,000
Plant and machinery 80,000
Freight and duty 1,500
Wages 15,000
Provision for bad debts 1,750
Capital 81,400
Drawings 5,000
3,64,600 3,64,600
Additional information
a) Stock on 31st March, 2010 was valued at Rs. 60,000.
b) The provision for bad debts is to be maintained at 5% on sundry debtors.
c) Total bad debts to be written off during the year Rs. 3,200.
d) Outstanding liabilities for Salaries Rs. 2,000 and Wages Rs. 3,000.
e) Rent and insurance paid during the year were for 15 and 18 months
respectively.
f) Depreciate:
9 Furniture and fittings by 5%.
9 Plant and machinery by 10%.
 196

Solution:
X Agarwal
Trading and Profit & Loss Account for the year ended 31st March 2010

Dr Cr
Rs. Rs.
To Opening stock 50,000By Sales 2,60,000
To Purchases 1,25,000 Less: Returns 2,000 2,58,000
Less: Returns 1,200 1,23,800By Closing stock 60,000
To Freight and duty 1,500
To Wages 15,000
Add: Outstanding 3,000 18,000
To Gross Profit c/d 1,24,700
3,18,000 3,18,000
To Discount 300By Gross Profit b/d 1,24,700
Allowed
To Carriage 500By Discount 250
Outwards Received
To Salaries 10,000
Add: Outstanding 2,000 12,000
To Insurance 1,200
Less: Prepaid (6/18 400 800
months)
To Rent 3,000
Less: Prepaid (3/15 600 2,400
months)
To Provision for 2,190
Bad Debts 5% on
Rs.43800
Add: Bad debts 3,200
written off
5,390
Less: Existing 1,750 3,640
Provision
To Depreciation:
Plant & Machinery 8,000
Furniture & Fittings 250 8,250
To Net Profit 97,060
transferred to
Capital
1,24,950 1,24,950
 197

X Agarwal
Balance Sheet As At 31st March 2010

Capital and Liabilities Rs. Assets Rs.

Capital Account Fixed Assets
Capital A/c Op 81,400 Plant & 80,000
Balance Machinery
Add: Net Profit 97,060 Less: depreciation 8,000 72,000
1,78,460 Furniture& 5,000
Fittings
Less: Drawings 5,000 Less: depreciation 250 4,750
Less: Income tax 900 1,72,560Current Assets
Current liabilities Stock in trade 60,000
Sundry creditors 20,000Sundry debtors 45,000
Outstanding Less: Bad debt 1,200
expenses written off Rs.
(3,200 – 2,000)
Wages 3,000 43,800
Salaries 2,000 5,000Less: Provision 2,190 41,610
for bad debts
Bills Receivable 13,200
Cash and Bank 5,000
Prepaid Expenses
Insurance 400
Rent 600 1,000
1,97,560 1,97,560

Which of the following is not an element of the balance sheet?

A Income
B Assets
C Liabilities
D Equity
 198

Summary
¾ The flow of accounting from the time a transaction takes place to its
recording in the ledger may be illustrated as follows:

¾ A journal is a book of accounts in which all day-to-day transactions are

recorded in the order of their occurrence.
¾ In big business houses, a journal is classified into various special journals
which record transactions of similar and repetitive nature. All those
transactions which arise occasionally or do not find a place in any of the
special journals are recorded in the Journal proper.
¾ Do not confuse a journal entry and a journal (i.e. journal proper). A journal
entry is a way of recording a transaction in a debit / credit form. A journal
proper is a book of special transactions, which are not otherwise recorded in
the books of prime entry. These are generally the adjustment entries such as
provisions for doubtful debts, income receivable, expense payable etc.
¾ The Cash Book records all transactions related to receipts and payments
made in cash only.
¾ The Cash Book itself is a Cash Account, and hence, no separate cash account
will be maintained in the ledger.
¾ When there is a transaction that relates to both cash and bank, this will be
written on one side of the Bank Column and on other side of the Cash
Column. Such transactions are known as ‘Contra entries’.
¾ A separate cash book to record small transactions is called a petty cash book.
 199

¾ The Trial Balance may be defined as a statement containing balances of all

ledger accounts on a particular date.
¾ The Trial Balance helps to determine the arithmetical accuracy of posting in
the ledger.
¾ Final Accounts (Financial statements) are the statements that are prepared at
the end of the accounting period, which is generally one year. These include
the income statement i.e. Trading and Profit & Loss Account and Balance
Sheet.
9 Trading Account is prepared to ascertain the results, gross profit or gross
loss, of the trading activities of the business.
9 Profit and Loss Account is prepared to find out the Net Profit/Net Loss.
9 Balance Sheet is prepared to ascertain the financial position of a firm on
a particular date.

Answers to Test Yourself

Answer to TY 1

The correct option is D.

Journalisation is the process of converting transactions to their debit / credit form

and recording them in the general journal.

Option A is incorrect because for any given journal entry, whether single or
compound, debits must equal credits.
Option B is incorrect because traditionally, debits are recorded on the left side
and credits on the right side.
Option C is incorrect because the chart of accounts is a listing of accounts in use
(and their corresponding reference number).

Answer to TY 2
The correct option is C.
Bank column can have either a debit or a credit balance. Credit balance in the
Bank column is regarded as Bank overdraft.

Answer to TY 3
The correct option is C.
Claims incurred are expenses and should have debit balance.
 200

Answer to TY 4

The correct option is B.

Net loss will be recorded on the credit side of the P&L A/c as it indicates excess
of expenses over income.

Answer to TY 5
The correct option is A.
Income is an element of profit and loss account. All other items are elements of
the balance sheet.

Self Examination Questions

Question 1
A contra entry in the cashbook would include:
A Totalling up the bank and cash columns at the end of each month
B Transferring the discounts to the accounts in the general ledger
C Transferring cash into the petty cash box
D Withdrawing cash from the bank account

Question 2
The amount of cash discount allowed on a transaction will initially be recorded in
the:
A Sales day book
B Sales invoice only
C Cash book (receipts side)
D Cash book (payment side)

Question 3
A transaction which does not involve payroll, cash or credit is likely to be
recorded in:
A The journal
B The purchase day book
C The cash book
D The petty cash book
 201

Question 4

Which of the following items would appear in the trial balance as a credit
balance?

A Carriage inwards
B Carriage outwards
C Returns inwards
D Returns outwards

Question 5

Which of the following errors will not affect the arithmetical accuracy of the
Trial Balance?

A Wrong balancing of an account

B Writing an amount in the wrong account but on the correct side
C Wrong totalling of an account
D None of the above

Answers to Self Examination Questions

Answer to SEQ 1
The correct option is D.
Contra entries are:
1. Cash deposited into the bank account
2. Cash withdrawn from the bank account

Answer to SEQ 2
The correct option is C.
The amount of cash discount allowed on a transaction will initially be recorded in
the discount column on the receipts side of the cash book.

Answer to SEQ 3
The correct option is A.
A transaction which does not involve payroll, cash or credit is likely to be
recorded in the journal.
 202

Answer to SEQ 4

The correct option is D.

Return outwards i.e. purchase returns (reduction in purchases) would appear in

the trial balance as a credit balance. All other items are expenses and hence will
have a debit balance.

Answer to SEQ 5

The correct option is B.

Writing an amount in the wrong account but on the correct side will not affect the
arithmetical accuracy of the Trial Balance.
 203

CHAPTER 2

ACCOUNTING PROCESS, METHODS AND

CONTROL, AND FINALISATION OF
ACCOUNTS
UNIT 7

DEPRECIATION ACCOUNTING
Chapter Introduction
In the foregoing units, the overall concepts of preparation of final accounts and
financial statements have been discussed. That included depreciation also,
although in brief and only to the extent required. In this unit, we shall deliberate
on accounting for depreciation in detail under the captioned Learning Outcomes.

a) Define depreciation and give a brief introduction of AS 6 issued by the

ICAI.
b) Explain briefly the objectives of providing for depreciation.
c) Describe the various methods of providing for depreciation.
d) Elaborate the impact of change in the depreciation method.
e) Discuss the disposal of depreciable assets and its accounting treatment.
f) Explain the method of revaluation of depreciable assets.
 204

1. Define depreciation and give a brief introduction of AS 6

issued by the ICAI.
[Learning Outcome a]
The very basic idea that requires to be invariably kept in mind is that
depreciation is an expense chargeable to Profit and Loss Account and is
related to Fixed Assets.

In this context, the ideas of capital expenditure and revenue expenditure are
relevant to have an in-depth knowledge of depreciation. ‘Expense’ or
‘expenditure’ is nothing but the cost of the business. This cost may either be
periodic, that is pertaining to a particular accounting period, or may result in the
creation of an asset to be carried forward to the subsequent accounting periods.

1. The former or the periodic cost is referred to as ‘revenue expenditure’

which is charged to the Profit and Loss Account for writing off. Examples
are Salary, Wages, Conveyance, Travelling etc. Usually, the term ‘expense’
is used while referring to revenue expenditure.

2. The latter is called ‘capital expenditure’. Capital expenditure results in

assets such as Plant and Machinery, Furniture and Fixture, Computer and
Peripherals etc. Assets, which are subject to depreciation, are termed
‘Depreciable Assets’.

Capital expenditure increases the value of fixed assets and includes expenses
that provide benefits of an enduring nature i.e. for more than one accounting
period.

Revenue expenditure maintains property or wealth, and is incurred to acquire or

maintain current / trading assets. It includes all expenditure that provides current
benefits i.e. benefits which can be potentially realised within the accounting
period.

The difference between capital and revenue expenditure is explained with the
help of the following example:
 205

Sheilja owns a motor car. She decided to fit an AC in the car. For this, she
incurred Rs. 50,000. After a month’s time, the mud flap of the car was damaged.
She gave it for repairing; the repair charges were Rs. 500.

Here, she has incurred two types of expenses.

Rs. 50,000 for fitting the AC in car is capital expenditure because it increases
the utility of the car and the repair charge of Rs. 500 is revenue expenditure
because it is incurred to maintain the car in working condition.

The result of operations of any business or profit or loss can be ascertained only
when all the items of expenses are considered. The relevance of depreciation
assumes utmost importance in this context. It can be well appreciated that the
effective lives of assets start decreasing, once put to use. This means that after the
lapse of a certain period, the assets will cease to be useful for the business,
which, as a corollary, indicates decline in the value of the assets. This further
implies that the concerned business incurs unforeseen expenses through loss in
the value of the assets. If this expense is not taken into account, the result of
operations of the business will not reflect the true picture. Hence, this type of
expense is accounted for as “Depreciation.”

On the other hand, diminution in the value of assets will necessitate fresh capital
expenditure to keep the operations of the business running. Hence, unless some
provision is made, a time will come when the business might face lack of
capacity to replace the assets. From both aspects discussed above, providing for
depreciation has been thought of as a prudent as well as an inevitable principle in
determining the profit /loss of the business.

Let us consider one known but very important point as an eye-opener regarding
treatment of expenditure of any business organisation. One may look at it as
either an inference or a conclusion. This is nothing but the idea or view that all
expenditure is chargeable to Profit and Loss account, be it revenue or capital.
Profit and loss account, in this context, includes Manufacturing and Trading
Accounts also.

The only difference in the treatment between revenue expenditure and capital
expenditure in the matter of depreciation is that revenue expenditure is instantly
identified as a charge against profit whereas capital expenditure is written off
over a number of years, depending on the life of the asset.
 206

Primarily, assets cannot be an item of cost for a particular accounting period. But
ultimately, a capital expenditure giving rise to an asset turns into an element of
chargeable cost in instalments over a number of years, except capital expenditure
relating to land and intangible assets like goodwill etc.

Depreciation is, thus, a gradual conversion of the cost of an asset into

revenue expense to be accounted for in the accounts of a particular
accounting period.

However, capital expenditure is definitely not a ‘Deferred Revenue

Expenditure’ that is also written off over a period of years. Such ‘Deferred
Revenue Expenditure’ does not create any asset.

Deferred Revenue Expenditure is basically a revenue expenditure of higher value

and is charged against profit, not in a single accounting period, but over a period
of more than one in order to avoid distortion in the financial result for a particular
period as well as to spread the utility of the Deferred Revenue Expenditure
logically over the subsequent periods to which it extends its benefit.

Examples of deferred revenue expenditure include heavy advertisement

expenditure, underwriting commission, discount on issue of shares and
debentures, brokerage paid on purchase of shares and debentures, research
expenses and development expenses.

An organisation expects to get benefit from an advertisement for 10 years; the

advertisement cost Rs. 5,00,000.

Here, Rs. 5,00,000 is divided by 10 years and Rs. 50,000 will be shown as
revenue expenses in the profit and loss account and the balance amount of Rs.
4,50,000 will be shown in the balance sheet.

Every year, one tenth of the original and total advertising expenses will go to the
profit and loss account.

This deferred revenue account will close in the 10th year when there will be no
balance on the assets side of the balance sheet.
 207

Now, let us define depreciation in a formal way. Depreciation may be defined as

the reduction, decrease or diminution in the value of an asset during a particular
accounting period owing to various reasons such as wear and tear, efflux of time,
obsolescence and a host of others depending on the nature of the asset and its use.
While the cost of an asset is treated as a capital expenditure, the loss in the value
of the said asset during a particular period is considered revenue expenditure for
charging to Profit and Loss Account.

Extracts from Accounting Standard (AS) 6 issued by The Institute of

Chartered Accountants of India (ICAI) (that has been made mandatory for all
commercial organisations)

In its introduction, it states,

“This statement deals with depreciation accounting and applies to all depreciable
assets, except the following items to which special considerations apply:
9 Forests, plantations and similar regenerative natural resources;
9 Wasting assets, including expenditure on the exploration for and extraction
of minerals, oils, natural gas and similar non-generative resources;
9 Expenditure on research and development;
9 Livestock.

This statement also does not apply to land unless it has a limited useful life for
the enterprise.”

Definitions provided in this AS 6 are also given here for you to know the views
of the ICAI, which is the regulatory body in our country for regulation of the
profession of accountancy. The concepts will be strengthened and consolidated
by going through the following excerpts from the ICAI.

“Depreciation is a measure of the wearing out, consumption or other loss of

value of a depreciable asset arising from use, effluxion of time or obsolescence
through technology and market changes.

Depreciation is allocated so as to charge a fair portion of the depreciable amount

in each accounting period during the expected useful life of the asset.

Depreciation includes amortisation of assets whose useful life is predetermined.”

 208

“Depreciable assets are assets which are:

9 expected to be used during more than one accounting period;
9 and have a limited useful life;
9 and are held by an enterprise for use in the production or supply of goods and
services, for rental to others, or for administrative purposes;
9 and not for the purpose of sale in the ordinary course of business.”

“Useful life is
1. either the period over which a depreciable asset is expected to be used by the
enterprise;
2. or the number of production or similar units expected to be obtained from the
use of the asset by the enterprise.”

“Depreciable amount of a depreciable asset is its historical cost, or other

amount substituted for historical cost in the financial statement, less the estimated
residual value.”

To conclude this Learning Outcome, let us sum up - depreciation is an

inevitable constituent of revenue expenditure forming cost of operation of
any business where fixed assets are utilised. Depreciation accounting thus deals
with different aspects of providing for depreciation including policy, methods,
rates, and of course, the ultimate action for bringing it into the accounts of any
business organisation.

In accordance with AS 6, which of the following assets does not fit into the
definition of a depreciable asset?

A Land
B Machinery
C Building
D Coal mine
 209

2. Explain briefly the objectives of providing for

depreciation.
[Learning Outcome b]

The idea or the perception about depreciation as stated by the American Institute
of Certified Public Accountants (AICPA) deserves to be mentioned in order to
understand the primary objective of providing for depreciation in the accounts.

It runs as quoted herein.

“The cost of a productive facility is one of the costs of the services during its
economic life.

Generally accepted accounting principles require that this cost be spread over the
expected useful life of the facility in such a way as to allocate it as equitably as
possible to the periods during which services are obtained from the use of the
facility.

This procedure is known as depreciation accounting; a system of accounting

which aims to distribute the cost or other basic value of tangible capital
assets, less salvage (if any), over the estimated useful life of the unit (which
may be a group of assets) in a systematic and rational manner.

It is a process of allocation, not of valuation.”

The concept as stated above is so simple and self-explanatory that hardly any
aspect is left out for comprehension of the basic objective of accounting for
depreciation.

1. Productive facility here means an asset arising out of any capital

expenditure.

2. Another matter that merits mention here is that the incidental cost of
creation of any asset is to be added to the cost of the asset.

For Mock Test Visit:

https://irdaexam.in/
 210

The installation cost of a machine is to be added to the cost price of the machine
to determine the actual total cost of the machine. To put this in another way, the
acquisition cost till an asset is put to use is to be incorporated in arriving at the
total actual cost price of the particular asset.

3. Cost here means historical cost. Hence, market value has no relevance in
depreciation accounting. It may not even consider the physical deterioration
of the asset as depreciation is simply the allocation of the cost of any asset to
the periods over which the benefits are obtained from such an asset.

In short, the objectives of providing for depreciation can be summarised as

follows:

Diagram 1: Objectives of providing for depreciation

 211

1. The main objective is to allocate the used up cost of an asset in the

accounting periods in which the services of the said asset are utilised. This
will ensure recovery of the cost of the asset over its useful life from the profit
earned, treating it as a part of the cost of business operation.

2. If depreciation is not taken into account, the correct picture of profit or loss
cannot be ascertained. In the absence of depreciation, the asset will show
more value than what it stands for.

3. Provision for depreciation is also necessary to arrange for replacement of the

asset that is adopted as a policy of the management. Although depreciation is
an expenditure, it is not an outflow of cash; the provision amount saved
every year can be utilised for replacing / purchasing a new asset at the end of
the useful life of the old asset.

4. In accordance with the Companies Act, it is mandatory for a joint stock

company to provide for depreciation on fixed assets before distributing
profits for dividends.

5. By providing depreciation on fixed assets, the amount saved because of the

provision will be the retention of the expired cost of fixed assets. The
reduced amount of the asset will be retained in the business in the form of
provision for depreciation.

The main objective of providing depreciation is:

A To calculate the true profit

B To show the true financial position
C To reduce tax
D To provide funds for replacement
 212

3. Describe the various methods of providing for

depreciation.
[Learning Outcome c]
Before we discuss the various methods of providing for depreciation, three
factors on which the amount of depreciation depends must be mentioned.

For better understanding, it is relevant to quote a few lines from the

‘Explanation’ to AS 6.

‘Assessment of depreciation and the amount to be charged tin respect thereof in

an accounting period is usually based on the following three factors:

1. Historical cost or other amount substituted for the historical cost of the
depreciable asset when the asset has been revalued;
2. Expected useful life of the depreciable asset; and
3. Estimated residual value of the depreciable asset’

At least four steps emanate from the explanation as quoted above to determine
the amount of depreciation in respect of a particular asset for a particular
accounting period. These are:

1. Determination of the historical cost of the asset that will include capital
investment in the asset in the form of money or its equivalent, cost of
acquisition, cost of installation, cost of commissioning till the asset is put to
use and other costs related to additions or improvement to the asset.

2. Making an estimate of the salvage, scrap or resale value of the asset at the
end of the useful life depends on a number of factors. Experience plays a
vital role in this matter as the nature of the asset, its use and market situation
relating to the scrap are to be considered too.

3. The next step is the determination of the difference between historical

cost as clarified earlier and the estimated salvage value.

4. The last step is the distribution of this difference over the period of its
useful life by a method that will suit the requirement of the business as per
the decision of the management.
 213

However, statutory requirements are to be kept in mind also, such as the

provisions of Companies Act, 1956 and The Income Tax Act, 1961 as amended,
and others, if any.

Coming to the core issue of methods of depreciation, there are several methods of
providing for depreciation out of which two methods are very common: the
Straight Line Method and the Diminishing Balance Method.

In selecting a method, the principle of equitable distribution of the cost of the

asset should be given essential consideration although a secondary thought of
replacement of the asset should also be kept in mind in a given situation. The
implications of profit, tax, dividend and cash flow are the important
considerations while choosing a method of depreciation.

The various methods are listed below:

Diagram 2: Methods of depreciation

As stated earlier, the first two methods are commonly used, while others are
employed in special circumstances. But the Depreciation Fund or Sinking Fund
Method is very important where the main consideration remains the replacement
of asset. Depreciation is expressed as a rate per cent per annum.

Let us deal with the accounting procedure here before elaborating the methods
with examples. Whatever method is employed, there is another important issue
that requires our attention. This is regarding the manner of reflection of the asset
in the books of account. The particular asset account may be maintained at the
Written Down Value (WDV) when depreciation is charged against the asset
account. In that case, the original cost price of the asset will not be available. In
 214

the alternative, depreciation may be charged against ‘Provision for Depreciation

Account’ in which case the original cost will remain intact but the WDV can also
be obtained by deducting the accumulated depreciation from the original cost of
the asset at a particular point of time. Examples will demonstrate the matter to
clear the concept.

Journal Entries for Depreciation Accounting

Purchase price
1. Entry when any asset is purchased:

Asset Account (Name of the Asset) Dr X

To Bank/Cash Account (Amount paid in cash or by cheque) X
To Supplier’s Account (Amount due to Party, if purchased on X
credit)
(Being asset purchased in cash/by cheque or on credit)

2. Entry for providing depreciation at the end of the accounting period or

for a particular period:

Depreciation Account Dr X
To Asset Account (If Asset is desired to be maintained at X
WDV) OR
To Provision for Depreciation Account (If original cost of the X
asset is desired to be maintained)
(Being depreciation provided on asset @ …% on … method for the
year/period ending on …)

3. Entry for transferring depreciation to Profit and Loss Account at the

end of the accounting period:

Profit and Loss Account Dr X

To Depreciation X
(Being depreciation for the accounting period transferred to Profit
and Loss Account)

4. Entry for sale/disposal of asset on loss:

Bank/Cash/Party’s Account (Amount of sale of goods) Dr X

Loss on Sale of Asset A/c (Difference between WDV and Sale Dr X
Proceeds)
To Asset Account (WDV on the date of sale/disposal) X
(Being sale proceeds of asset and loss incurred on sale accounted
for)
 215

5. Entry for transfer of loss on sale of asset to Profit and Loss Account:

Profit and Loss Account Dr X

To Loss on Sale of Asset X
(Being loss incurred on sale of asset transferred to Profit and Loss
Account)

6. Entry for sale/disposal of asset on profit:

Bank/Cash/Party’s Account (Sale proceeds) Dr X

To Asset Account (WDV on the date of sale) X
To Profit on Sale of Asset Account X
(Being asset sold and profit earned taken into account)

7. Entry for transfer of profit on sale of asset to Profit and Loss Account:

Profit on Sale of Asset Account Dr X

To Profit and Loss Account X
(Being profit earned on sale/disposal of asset transferred)

Instead of debiting the amount of loss on Sale of Asset (in case loss is incurred)
or crediting Profit on Sale of Asset (in case profit is earned), Profit and Loss
Account may be debited or credited for the amount of loss or profit on sale
respectively.

Working: Profit/Loss on Sale of Asset

Particulars Amount
(Rs.)
Cost Price of the Asset X
Less: Accumulated Depreciation on the date of disposal (X)
A: Value of the Asset → WDV on the date of sale X
B: Sale Price X
C: Profit/Loss on Sale of Asset X / (X)
 216

Notes

1. If B>A, there is profit. Conversely, if A>B, there is loss.

2. If Depreciation Fund Method is applied, ‘Provision for Depreciation
Account’ will be replaced by ‘Depreciation Fund Account’.
3. If Asset account is maintained at cost, the accumulated depreciation under
‘Provision for Depreciation Account’ or ‘Depreciation Fund Account’ is to
be transferred to Asset Account on the date of sale/disposal so as to reduce
the value of the asset to WDV for ascertaining the loss or profit on sale of the
asset.

3.1 Straight Line Method

It is considered the simplest of all the methods. Depreciation is arrived at by

deducting the salvage value from the historical cost and then dividing the
difference thus determined by the number of years of useful life. It can also be
expressed as a percentage per annum of the historical cost.

To translate into a formula, the under mentioned symbols can be used.

D = Depreciation,
HC = Historical Cost,
SV = Scrap/Salvage Value,
N = No. of years of useful life,
RD = Rate of Depreciation
Then,
D = HC- SV/N
RD = D/HC x 100

Although the Straight Line Method has a number of advantages, it suffers from
one major shortcoming. In the later years, the charge against profit becomes
disproportionate to the increasing cost of repairs. Hence, this method is not
suitable for exhausting assets like Plant and Machinery, Vehicles etc. Rather, it is
suitable for assets prone to depreciate for lapse of time such as Patents and assets
having comparatively small values like Furniture and Fixtures etc.
 217

A machine purchased for Rs. 60,000 on 01.04.2005 is expected to have a life of

five years. Estimated salvage/scrap value after the expiry of five years is Rs.
10,000. Depreciation is considered under the Straight Line Method.

Show necessary accounts.

a) If the asset account is maintained at written down value

Dr Machine Account Cr
Date Particulars Rs. Date Particulars Rs.
By
01.04.2005 To Bank A/c 60,000 31.03.2006 Depreciation 10,000
A/c
31.03.2006 By Balance c/d 50,000
60,000 60,000
By
To Balance
01.04.2006 50,000 31.03.2007 Depreciation 10,000
b/d
A/c
31.03.2007 By Balance c/d 40,000
50,000 50,000
By
To Balance
01.04.2007 40,000 31.03.2008 Depreciation 10,000
b/d
A/c
31.03.2008 By Balance c/d 30,000
40,000 40,000
By
To Balance
01.04.2008 30,000 31.03.2009 Depreciation 10,000
b/d
A/c
31.03.2009 By Balance c/d 20,000
30,000 30,000
By
To Balance
01.04.2009 20,000 31.03.2010 Depreciation 10,000
b/d
A/c
By Bank A/c -
31.03.2010 sale proceeds 10,000
of salvage
20,000 20,000
 218

Dr Depreciation Account Cr
Date Particulars Rs. Date Particulars Rs.
To Machine By Profit and
31.03.2006 10,000 31.03.2006 10,000
A/c Loss A/c
10,000 10,000
To Machine By Profit and
31.03.2007 10,000 31.03.2007 10,000
A/c Loss A/c
10,000 10,000
To Machine By Profit and
31.03.2008 10,000 31.03.2008 10,000
A/c Loss A/c
10,000 10,000
To Machine By Profit and
31.03.2009 10,000 31.03.2009 10,000
A/c Loss A/c
10,000 10,000
To Machine By Profit and
31.03.2010 10,000 31.03.2010 10,000
A/c Loss A/c
10,000 10,000

Balance Sheet (Extract): Assets side only

Balance Sheet As on 31.03.2006

Liabilities Rs. Assets Rs.
Machine 60,000
Less: Depreciation 10,000 50,000

Balance Sheet As on 31.03.2007

Liabilities Rs. Assets Rs.
Machine 50,000
Less: Depreciation 10,000 40,000

Balance Sheet As on 31.03.2008

Liabilities Rs. Assets Rs.
Machine 40,000
Less: Depreciation 10,000 30,000
 219

Balance Sheet As on 31.03.2009

Liabilities Rs. Assets Rs.
Machine 30,000
Less: Depreciation 10,000 20,000

Balance Sheet As on 31.03.2010

Liabilities Rs. Assets Rs.
Machine 20,000
Less: Depreciation 10,000
10,000
Less: Sold at
10000 NIL
salvage value

b) If the asset account is maintained at historical cost

Machine Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2005 To Bank A/c 60,000 31.03.2006 By Balance c/d 60,000
60,000 60,000
01.04.2006 To Balance b/d 60,000 31.03.2007 By Balance c/d 60,000
60,000 60,000
01.04.2007 To Balance b/d 60,000 31.03.2008 By Balance c/d 60,000
60,000 60,000
01.04.2008 To Balance b/d 60,000 31.03.2009 By Balance c/d 60,000
60,000 60,000
31.03.2010
60,000 By Provision for
01.04.2009 To Balance b/d 50,000
Depreciation A/c

31.03.2010 By Bank A/c 10,000

60,000 60,000
 220

Dr Provision for Depreciation Account Cr

Date Particulars Rs. Date Particulars Rs.
31.03.2006 To Balance c/d 10,000 31.03.2006 By Depreciation 10,000
A/c
10,000 10,000
31.03.2007 To Balance c/d 20,000 01.04.2006 By Balance b/d 10,000
31.03.2007 By Depreciation 10,000
A/c
20,000 20,000
31.03.2008 To Balance c/d 30,000 01.04.2007 By Balance b/d 20,000

31.03.2008 By Depreciation 10,000

A/c
30,000 30,000
31.03.2009 To Balance c/d 40,000 01.04.2008 By Balance b/d 30,000
31.03.2009 By Depreciation 10,000
A/c
40,000 40,000
31.03.2010 To Machine A/c 50,000 01.04.2009 By Balance b/d 40,000
31.03.2010 By Depreciation 10,000
A/c
50,000 50,000

Depreciation Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.03.2006 To Provision for 10,000 31.03.2006 By Profit and 10,000
Depreciation A/c Loss A/c
10,000 10,000
31.03.2007 To Provision for 10,000 01.04.2006 By Profit and 10,000
Depreciation A/c Loss A/c
10,000 10,000
31.03.2008 To Provision for 10,000 01.04.2007 By Profit and 10,000
Depreciation A/c Loss A/c
10,000 10,000
31.03.2009 To Provision for 10,000 01.04.2008 By Profit and 10,000
Depreciation A/c Loss A/c
10,000 10,000
31.03.2010 To Provision for 10,000 01.04.2009 By Profit and 10,000
Depreciation A/c Loss A/c
10,000 10,000
 221

Balance Sheet (Extract): Assets side only

Balance Sheet as on 31.03.2006

Liabilities Rs. Assets Rs Rs.
Machine 60,000
Less: Provision for
10,000 50,000
Depreciation

Balance Sheet as on 31.03.2007

Liabilities Rs. Assets Rs Rs.
Machine 60,000
Less: Provision for
20,000 40,000
Depreciation

Balance Sheet as on 31.03.2008

Liabilities Rs. Assets Rs Rs.
Machine 60,000
Less: Provision for
30,000 30,000
Depreciation

Balance Sheet as on 31.03.2009

Liabilities Rs. Assets Rs Rs.
Machine 60,000
Less: Provision for
40,000 20,000
Depreciation

Balance Sheet as on 31.03.2010

Liabilities Rs. Assets Rs Rs.
Machine 20,000
Less: Provision for
10,000
Depreciation
10,000
Less: Sold at salvage
10000 NIL
value
 222

Workings

W1 Depreciation

HC= Rs. 60,000, SV= Rs. 10,000, N= 05 years

Hence,
Historical cost − Salvage value
Amount of annual depreciation =
Estimated useful life (years)
Rs. 60,000 - Rs. 10,000
=
5 years
= Rs. 10,000

W2 Rate of Depreciation

Rate of Depreciation = D/HC x100

= 10,000/60,000 x100
= 16.66% p.a.

3.2 Diminishing balance method / Reducing balance method

This method is widely used in commercial organisations. Like any other method,
it has its merits and limitations also. However, this system is more equitable than
the Straight Line Method. Since the amount of depreciation goes on decreasing
with increase in the amount of repairs, the charge against profit turns out to be a
balanced or constant figure every year. It is calculated on the cost of the assets as
reduced by the amount of annual depreciation or in other words, on the written
down value (WDV) and not on the historical original cost as in the case of
Straight Line Method. Depreciation under this method is expressed as a rate per
cent per annum on the WDV of the asset.

This method is useful for exhausting and costly assets like Plant and Machinery,
Electronic Equipment etc.
 223

A machine purchased for Rs. 30,000 on 01.04.2007 depreciates at 10% p.a. under
the Diminishing Balance method. Write up the necessary accounts for three
years.

Machine Account
Dr Cr
Date Particulars Amount Date Particulars Amount
Rs. Rs.
01.04.2007 To Bank A/c 30,000 31.03.2008 By Depreciation 3,000
A/c
31.03.2008 By Balance c/d 27,000
30,000 30,000
01.04.2008 To Balance b/d 27,000 31.03.2009 By Depreciation 2,700
A/c
31.03.2009 By Balance c/d 24,300
27,000 27,000
01.04.2009 To Balance b/d 24,300 31.03.2010 By Depreciation 2,430
A/c
31.03.2010 By Balance c/d 21,870
24,300 24,300

Depreciation Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.03.2008 To Machine A/c 3,000 31.03.2008 By Profit and 3,000
Loss A/c
3,000 3,000
31.03.2009 To Machine A/c 2,700 31.03.2009 By Profit and 2,700
Loss A/c
2,700 2,700
31.03.2010 To Machine A/c 2,430 31.03.2010 By Profit and 2,430
Loss A/c
2,430 2,430
 224

Working

W1 Calculation of annual depreciation

Particulars Amount
(Rs.)
Cost of the Machine 30,000
Less: Depreciation for the year 2007-08 ending on 31.03.2008 3,000
WDV as on 01.04.2008 27,000
Less: Depreciation for the year 2008-09 ending on 31.03.2009 2,700
WDV as on 01.04.2009 24,300
Less: Depreciation for the year 2009-10 ending on 31.03.2010 2,430
WDV as on 01.04.2010 21,870

As with the Straight Line Method, ‘Provision for Depreciation Account’ can
be maintained alternatively; this is not repeated for the sake of brevity.

Comparison between straight-line method and reducing balance method

Straight-line method Reducing balance method

It is simple to understand and operate.
It charges a fixed amount each year to
the statement of comprehensive
income.
It is suitable for assets which give the
same efficiency year after year e.g. a
building is used in the same way over
the years.
If repairs increase in later years, the
charge of depreciation plus repairs
increases each year (since the
depreciation is constant).
It is relatively difficult to understand
and operate.
It charges a higher amount during
the initial years when the machine is
new and efficient and a lower amount
in later years.
It is suitable for assets which give a
higher efficiency in earlier years and
a lower efficiency in later years e.g.
machinery used in various
manufacturing processes.
The charge of depreciation plus repairs
is expected to be the same over the
years. In the initial years when repairs
are low, the depreciation is high - and
in the later years when repairs are high,
the depreciation is low.
 225

In the previous examples, simple accounts are given assuming no purchase and
sales during the period.

However, in practice, there can be a different scenario. For example, assets can
be sold during the year or some can be purchased during the year. In such cases,
depreciation should be calculated on the usage of that asset not for the whole
accounting year, but for the part of the year corresponding to its use. It means if
an asset is purchased on 1 June and accounting year ends on 31 December,
depreciation will be computed for 7 months only. Likewise, if an asset is sold on
1 June, depreciation will be computed for 5 months only.

3.3 Depletion Method

This method is also known as ‘Unit Charging Method’ or ‘Output Method’.

Usually, this method is applied in the case of assets of a wasting nature as well
as intangible assets like patents, copyrights, leaseholds etc. The rate of
depreciation per unit is determined by dividing the total cost by the expected
number of output in contrast to the number of years. Annual depreciation is
obtained by multiplying the output or the number of units by the rate per unit.

The example stated below will clarify the manner of maintaining the particular
asset account.

XYZ Collieries Ltd acquired a coal mine for Rs. 9,00,000 on 01.04.2007.
Estimated output of coal is Rs. 20,00,000 tons. Expected raising of coal is 75%.
Output obtained in the years 2007–08, 2008-09 and 2009-10 are 27,000, 48,000
and 69,000 tons of coal respectively.

Prepare the coal mines account for three years.

 226

In the books of XYZ Collieries Ltd

Coal Mines Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2007 To Bank A/c 9,00,000 31.03.2008 By Depreciation 16,200
A/c
31.03.2008 By Balance c/d 8,83,800
9,00,000 9,00,000
01.04.2008 To Balance b/d 8,83,800 31.03.2009 By Depreciation 28,800
A/c
31.03.2009 By Balance c/d 8,55,000
8,83,800 8,83,800
01.04.2009 To Balance b/d 8,55,000 31.03.2010 By Depreciation 41,400
A/c
31.03.2010 By Balance c/d 8,13,600
8,55,000 8,55,000
Workings
W1 Calculation of annual depreciation
Total coal (weight): 20,00,000 tons
Actual raising: 75% of 20,00,000 = 20,00,000 x 75/100
= 15,00,000 tons
W2 Rate of depreciation per ton
Rs. 9,00,000/15,00,000 tons = Rs. 0.60 per ton
Depreciation for the year 2007-2008: Rs. 27,000 x 0.60 =Rs. 16,200
Depreciation for the year 2008-2009: Rs. 48,000 x 0.60 =Rs. 28,800
Depreciation for the year 2009-2010: Rs. 69,000 x 0.60 =Rs. 41,400

3.4 Annuity Method

The annuity method takes into consideration the interest lost by the owner - the
interest that could have been earned if the amount would have been invested in
interest earning securities. Therefore, under the annuity method, the cost of the
asset and the interest at a given rate is written down every year by fixed amount.
This annual amount is determined with the help of annuity tables. The asset is
debited with the amount of interest on the diminishing value of the asset and the
amount of depreciation is ascertained with reference to the present value of the
capital investment or the original cost of the asset, usually with the help of the
Logarithmic Table. A formula can also be used to ascertain the present value.
This method is useful for long term leases.
 227

A lease was acquired with a premium of Rs. 2,00,000 on 01.04.2006 for 4 years.
Depreciation under annuity system at 5% p.a. interest is charged. Rupee 1 is the
present value of 0.282012 payable over 4 years @ 5% p.a.
Prepare Lease Account.
Lease Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2006 To Bank A/c 200,000 31.03.2007 By Depreciation 56,402
A/c
31.03.2007 To interest A/c 10,000 31.03.2007 By Balance c/d 153,598
210,000 210,000
01.04.2007 To Balance b/d 153,598 31.03.2008 By Depreciation 56,402
A/c
31.03.2007 To Interest A/c 7,680 31.03.2008 By Balance c/d 104,876
161,278 161,278
01.04.2008 To Balance b/d 104,876 31.03.2009 By Depreciation 56,402
A/c
31.03.2009 To Interest A/c 5,244 31.03.2009 By Balance c/d 53,718
110,120 110,120
01.04.2009 To Balance b/d 53,718 31.03.2010 By Depreciation 56,402
A/c
31.03.2010 To Interest A/c 2,684
56,402 56,402

Workings

W1 Interest (Rate: 5% p.a.)

1st year on Rs. 2,00,000 = 200000 x 5/100 = Rs. 10,000
2nd year on Rs. 1,53,598= 153598 x 5/100 = Rs. 7,680 rounded off (r/off)
3rd year on Rs. 1,04,876= 104876 x 5/100 = Rs. 5,244 r/off
4th year on Rs. 53,718= 53718 x 5/100 = Rs. 2,684

Rs. 2,686 has been r/off to balance the lease account as the amount of annual
depreciation is Rs. 56,402 and the opening balance is Rs. 53,718 in the 4th year
 228

W2 Annual depreciation

Present Value: Re.1 and Annual Depreciation: 0.282012

Hence, if present value is Rs. 2,00,000, then annual depreciation is:

= Rs. 2,00,000 x 0.282012
= Rs. 56,402 r/off.

3.5 Depreciation Fund or Sinking Fund Method

This is a very important method especially for Plant and Machinery of very high
value where replacement is desired at the end of its effective life in order to keep
the liquidity position of a fund favourable.

An equal amount of depreciation that is computed either with the help of Annuity
Table or Logarithm Table is credited to Depreciation Fund/Sinking Fund instead
of Asset Account by debiting Depreciation Account or Profit and Loss Account
directly.

An equal amount is invested in interest earning securities in such a manner that

the annual investment together with the compound interest becomes equal to the
original cost of the asset.

At the end of the useful life of the asset, this earmarked investment is realised for
replacing the asset.

PQR Company Ltd obtained a machine for Rs. 3,00,000 with a useful life of 4
years on 01.04.2006. Replacement was to be done after 4 years by setting up a
depreciation fund, and an annual investment of Rs.70,647 would be required to
earn interest @ 4% p.a.

Prepare necessary ledger accounts assuming that the depreciation fund

investment realised Rs. 2,20,800 at the end of four years.
 229

In the books of PQR Company Ltd

Machine Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2006 To Bank A/c 3,00,000 31.03.2007 By Balance c/d 3,00,000
3,00,000 3,00,000
01.04.2007 To Balance b/d 3,00,000 31.03.2008 By Balance c/d 3,00,000
3,00,000 3,00,000
01.04.2008 To Balance b/d 3,00,000 31.03.2009 By Balance c/d 3,00,000
3,00,000 3,00,000
01.04.2009 To Balance b/d 3,00,000 31.03.2010 By Depreciation 3,00,268
Fund A/c
31.03.2010 To Profit and 268
Loss A/c
3,00,268 3,00,268

Depreciation Fund Account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.03.2007 To Balance c/d 70,647 31.03.2007 By Depreciation 70,647
A/c
70,647 70,647
01.04.2007 By Balance b/d 70,647
31.03.2008 By Depreciation 70,647
A/c
31.03.2008 To Balance c/d 1,44,120 31.03.2008 By Interest A/c 2,826
1,44,120 1,44,120
01.04.2008 By Balance b/d 1,44,120
31.03.2009 By Depreciation 70,647
A/c
31.03.2009 To Balance c/d 2,20,532 31.03.2009 By Interest A/c 5,765
2,20,532 2,20,532
01.04.2009 By Balance b/d 2,20,532
31.03.2010 By Depreciation 70,647
A/c
31.03.2010 By Interest A/c 8,821
31.03.2010 To Machine 3,00,268 31.03.2010 By Depreciation 268
A/c Investment A/c
3,00,268 3,00,268
 230

Depreciation Fund Investment Account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.03.2007 To Bank A/c 70,647 31.03.2007 By Balance c/d 70,647
70,467 70,467
01.04.2007 To Balance b/d 70,647 31.03.2008 By Balance c/d 1,44,120
31.03.2008 To Bank A/c 73,473
(70,647 + 2,826)
1,44,120 1,44,120
01.04.2009 To Balance b/d 1,44,120 31.03.2009 By Balance c/d 2,20,532
31.03.2009 To Bank A/c 76,412
(70,647 + 5,765)
2,20,532 2,20,532
01.04.2010 To Balance b/d 2,20,532 31.03.2010 By Bank A/c 2,20,800
31.03.2010 To Depreciation 268
Fund A/c
2,20,800 2,20,800

The following three methods are used in special circumstances.

3.6 Revaluation Method

This method is selected in the case of assets in respect of which usual

depreciation methods are not applied e.g. loose tools, packages, patents,
copyrights, farmers’ livestock etc. This method is generally used by printing
press and similar business concerns. Here, depreciation is not calculated on the
original cost of an asset. Revaluation is done both at the beginning and at the
close of the accounting period. The difference thus arrived at is written off as
depreciation through Profit and Loss Account.

Depreciation = (Value of asset at the beginning + Any new purchases) – Value of

asset at the end

On April 01, 2009, Sitar Ltd commenced a business of repairing and servicing,
electronic appliances, with small tools having an estimated cost of Rs. 50,000 as
part of the opening capital.

During the year, small tools costing Rs. 15,000 were purchased on credit. On 31
March, 2010, Sitar Ltd revalued the cost of small tools at Rs. 63,000.
 231

Under the revaluation method of depreciation, depreciation charge on small tools

for the year 2009-10 will be calculated as follows:

Rs.
Opening estimated cost of small tools 50,000
Add: Purchases during the year 15,000
75,000
Less: Closing estimated cost of small tools 63,000
Depreciation for the year 2009-10 12,000

If book value / opening cost is higher than the revaluation amount, the difference
is charged to Profit and Loss account as depreciation. However, if book value /
opening cost is lower than the revaluation amount, the excess amount is ignored
and no depreciation will be charged to profit and loss account.

3.7 Insurance Policy Method

This method is similar to the sinking fund method. Under this method, premiums
are paid on a policy taken out with an insurance company. When the policy
matures, funds become available for replacement of the asset.

The policy is made usually for a period equal to the useful life of the asset and
for a sum assured that is expected to provide fund for replacement of the asset. If
annual interest is desired to be accounted for, surrender value of the policy at the
particular year-end is referred to. This is adopted in the cases of vehicles for the
uncertainty of their useful lives.

Journal entries under this method are as follows:

For the first year and subsequent years:

Insurance Policy Account Dr X

To Bank Account X
(Being premium paid at the beginning of the year)

Profit and Loss Account Dr X

To Depreciation fund Account X
(Being depreciation equal to premium charged)
 232

For the last year:

Bank Account Dr X
To Insurance Policy Account X
(Being amount of the policy received on maturity)

Insurance Policy Account Dr X

To Depreciation fund Account X
(Being transfer of the excess amount received over the total
premiums)

Depreciation fund Account Dr X

To Asset Account X
(Being depreciation fund account closed and transferred to asset
account)

Bank Account Dr X
To Asset Account X
(Being sale of scrap, if any)

Shyam Ltd took a building worth Rs. 80,000 on lease for four years, starting
from 01 January 2010. Shyam Ltd has decided to make a provision for
replacement of the lease by means of an insurance policy purchased for an annual
premium of Rs. 18,300.

Prepare the necessary accounts.

Leasehold building account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.01.2010 To Bank A/c 80,000 31.12.2010 By Balance c/d 80,000
80,000 80,000
01.01.2011 To Balance b/d 80,000 31.12.2011 By Balance c/d 80,000
80,000 80,000
01.01.2012 To Balance b/d 80,000 31.12.2012 By Balance c/d 80,000
80,000 80,000
01.01.2013 To Balance b/d 80,000 31.12.2013 By Depreciation 80,000
fund A/c
80,000 80,000
 233

Depreciation fund account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.12.2010 To Balance c/d 18,300 31.12.2010 By Profit and 18,300
Loss A/c
18,300 18,300
01.01.2011 By Balance b/d 18,300
31.12.2011 To Balance c/d 36,600 31.12.2011 By Profit and 18,300
Loss A/c
36,600 36,600
01.01.2012 By Balance b/d 36,600
31.12.2012 To Balance c/d 54,900 31.12.2012 By Profit and 18,300
Loss A/c
54,900 54,900
01.01.2013 By Balance b/d 54,900
31.12.2013 By Profit and 18,300
Loss A/c
31.12.2013 To Building A/c 80,000 31.12.2013 By Depreciation 6,800
fund policy A/c
80,000 80,000

Depreciation fund policy A/c

Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.01.2010 To Bank A/c 18,300 31.12.2010 By Balance c/d 18,300
18,300 18,300
01.01.2011 To Balance b/d 18,300
To Bank A/c 18,300 31.12.2011 By Balance c/d 36,600
36,600 36,600
01.01.2012 To Balance b/d 36,600
To Bank A/c 18,300 31.12.2012 By Balance c/d 54,900
54,900 54,900
01.01.2013 To Balance b/d 54,900
To Bank A/c 18,300
To Depreciation 6,800 31.12.2013 By Bank A/c 80,000
fund A/c
80,000 80,000
 234

Comparison between the sinking fund method and the insurance policy method:

Sinking fund method Insurance policy method

Annual investments are made at the
end of the year.
The amount to be received on
maturity is not certain as it depends
upon the nature of the investments
made and the market conditions.
Annual premium is paid at the
beginning of the year.
The amount to be received on
maturity is certain.

3.8 Machine Hour Rate Method

This method, also known as service hour method, is chosen for machines where
productivity is relevant and for machines having a high cost. Depreciation is
charged on the basis of number of hours for which any particular machine is
utilised in the production process.

This method is similar to the ‘Depletion Method’, as depreciation is not charged

based on time, but on utilisation; i.e., the volume of production.

Rate per hour is calculated by dividing the historical original cost after deducting
salvage value by the expected total number of hours of the effective/useful life of
the asset.

Original cost of the asset − Scrap value

Depreciation per hour =
Life of the asset (in hours)

Suhana Co purchased a machine worth Rs. 100,000. Its estimated life is 25,000
hours and at the end of its useful life, scrap value would be Rs 10,000. In the year
2010-11, the machine runs for 6,000 hours.

Here,
Original cost of the asset − Scrap value
Depreciation per hour =
Life of the asset (in hours)
= (Rs. 100,000 – Rs. 10,000)/25,000 hours
= Rs. 3.60 per hour

Annual depreciation for the year 2010-11 = 6,000 hours x Rs. 3.60
= Rs. 21,600
 235

The amount of depreciation charged on a machine will be debited to:

A Machinery account
B Depreciation account
C Cash account
D Repair account

If the equipment account has a balance of Rs. 45,000 and its accumulated
depreciation account has a balance of Rs. 28,000, the book value of the
equipment will be:

A Rs. 45,000
B Rs. 28,000
C Rs. 17,000
D Rs. 73,000

4. Elaborate the impact of change in the depreciation

method.
[Learning Outcome d]
This is a very important aspect of depreciation accounting. The moot point is
whether any business organisation is at a liberty to switch over from one method
of depreciation to another at its own discretion. This issue and other incidental
matters connected with change in the method of depreciation have been dealt
with by Accounting Standard 6 (AS 6) issued by The Institute of Chartered
Accountants of India.

The relevant guidelines are quoted below.

 236

‘The method of depreciation is applied consistently to provide comparability of

the results of the operations of the enterprise from period to period. A change
from one method of providing depreciation to another is made only if the
adoption of the new method is required by statute or for compliance with an
accounting standard or if it is considered that the change would result in a more
appropriate preparation or presentation of the financial statements of the
enterprise. When such a change in the method of depreciation is made,
depreciation is recalculated in accordance with the new method from the date of
the asset coming into use. The deficiency or surplus arising from retrospective re-
computation of depreciation according with the new method is adjusted in the
accounts in the year in which the method of depreciation is changed. In case the
change in the method results in deficiency in depreciation in respect of past
years, the deficiency is charged in the statement of profit and loss. In case the
change in the results in surplus, the surplus is credited to the statement of profit
and loss. Such a change is treated as a change in accounting policy and its effect
is quantified and disclosed.’

The above stated guidelines leave no ambiguity as to when and how to effect any
change in the method of depreciation. It is, hence, necessary to implement any
change in the method of depreciation with retrospective effect. Evidently, the
difference between depreciation under existing method and the changed method
will have to be ascertained and necessary entries have to be incorporated.

The example given below will make the position clear:

On 01.04.2004, a firm purchased machinery for Rs.116400 and spent Rs.3600 on

its erection. On 01.10.2004, additional machinery costing Rs. 40000 was
purchased. On 1st October 2006, the machinery purchased on 01.04.2004, having
become obsolete, was auctioned for Rs. 57200, and on the same date, new
machinery was purchased at a cost of Rs.80000.

Depreciation was provided annually on 31st March every year @ 10% p.a. on
WDV. In 2007-08, however, the firm changed this method of providing
depreciation and adopted the method of providing 5% depreciation p.a. on the
original cost of the machinery.

Prepare Machinery Account as it would stand at the end of each year from 2004-
05 to 2007-08.
 237

Machinery Account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2004 To Bank A/c – 1,16,400 31.03.2005 By Depreciation 14,000
cost A/c

01.04.2004 To Bank A/c- 3,600 31.03.2005 By balance c/d 1,46,000

Erection
01.10.2004 To Bank A/c - 40,000
Addition
1,60,000 1,60,000
01.04.2005 To Balance b/d 1,46,000 31.03.2006 By Depreciation 14,600
A/c
31.03.2006 By Balance c/d 1,31,400
1,46,000 1,46,000
01.04.2006 To Balance b/d 1,31,400 01.10.2006 By Depreciation 4,860
A/c
- On 1st Machine
01.10.2006 To Bank A/c - 80,000 01.10.2006 By Bank A/c 57,200
Addition
31.03.2007 By Profit and 35,140
Loss A/c
- Loss on Sale
31.03.2007 By Depreciation 7,420
A/c
31.03.2007 By Balance c/d 1,06,780
2,11,400 2,11,400
01.04.2007 To Balance b/d 1,06,780 31.03.2008 By Depreciation 6,000
A/c - 5% of
(40,000 + 80,000)
31.03.2008 To Profit and 6,220 31.03.2008 By Balance c/d 1,07,000
Loss A/c
- Excess
depreciation
written Back
(W3)
1,13,000 1,13,000
 238

Workings

W1 Calculation of Depreciation @ 10% p.a. on Diminishing Balance method

and Loss on sale of Machinery

Particulars Machine I Machine II Machine

Rs. Rs. III Rs.
Cost 1,20,000 40,000 80,000
Less: Depreciation for 2004-05 12,000 2,000 -
WDV as on 31.03.2005 1,08,000 38,000 -
Less: Depreciation for 2005-06 10,800 3,800 -
WDV as on 31.03.2006 97,200 34,200 -
Less: Depreciation for 2006-07 4,860 3,420 4,000
WDV as on1.10.06 for Machine I/ 92,340 30,780 76,000
31.03.2007 for others
Sale Proceeds 57,200 - -
Loss on sale of Machine I 35,140

W2 Calculation of Depreciation @ 5% p.a. on Straight Line Method and

WDV thereof

Particulars Machine II Machine

Rs. III Rs.
Cost 40,000 80,000
Depreciation – Machine II for 2 and ½ years 5,000 ---
Depreciation – Machine III for ½ year --- 2,000
WDV as on 31.03.2007 35,000 78,000

W3 Amount to be written back to Profit and Loss Account to restore the

WDV of two machines as on 31.03.2007 based on Depreciation @ 5% p.a. on
Straight Line method.

Particulars Rs.
WDV as on 31.03.2007 as per changed method (35,000 + 78,000) 1,13,000
Less: WDV as on 31.03.2007 as per earlier method (30,780 + 1,06,780
76,000)
WDV as on 31.03.2007 6,220
 239

Diagram 3: Impact of change in the method of depreciation

5. Discuss the disposal of depreciable assets and its

accounting treatment.
[Learning Outcome e]

Disposal of depreciable assets means sale, removal, destruction or exchange of

any particular asset usually when the usefulness of that asset ceases. It is sold as
an item of salvage or scrap. Sometimes, it may be exchanged for a part of the
cost with payment being made for the remaining cost.
 240

AS 6 issued by the ICAI provides for requirement of disclosure of certain

information in the financial statements. The relevant text is quoted below.
‘Where depreciable assets are disposed of, discarded, demolished or
destructed, the net surplus or deficiency, if material, is disclosed separately.’

The accounting procedure for this has been stated in Learning Outcome 3 under
the head Journal Entries for Depreciation Accounting.

Journal entries 4 to 7 represent the accounting entries required to be made in the

case of sale of assets.

However, entry nos. 4 and 6 are meant to be made when asset account is
maintained at WDV.

Entry nos. 5 and 7 are applicable to both systems of maintaining asset account.

Additional entry required to be incorporated at the time of disposal when asset

account is maintained at historical original cost are mentioned below.

Tip appended after Journal Entries under Learning Outcome 3 is to be read

with this section also.

8. Entry for transferring accumulated depreciation under ‘Provision for

Depreciation Account’ to particular asset account

Provision for Depreciation Account (Depreciation Fund A/c) Dr X

To Asset Account (Amount paid in cash or by cheque) X
To Supplier’s Account (Amount due to Party, if purchased on X
credit)
(Being accumulated depreciation in respect of the asset sold
transferred)

This entry is to be followed by either entry no.4 when the asset is sold at a loss or
entry no. 6 when the asset is sold at a profit. Furthermore, for transfer of loss on
sale of asset, entry no.5 and for transfer of profit on sale of asset, entry no.7 are
to be recorded.

When no profit or no loss is made, entry no. 4 to entry no. 7 are to be modified
by removing Profit and Loss Account from the entries. Besides, if no
money/return is obtained by any process of disposal other than sale, value of sale
proceeds is to be treated as NIL and the entire WDV is to be treated as loss on
disposal of the particular asset.
 241

Previous examples show how the accounts have been prepared in the case of
disposal by way of sale. Therefore, no example is given here.

In this context, excerpts from the contents of AS 10 of ICAI in the matter of

‘Retirement and Disposals’ of Fixed Assets are worthy of reference for
guidance:

“14.1 An item of fixed asset is eliminated from the financial statements on

disposal.

14.2 Items of fixed assets that have been retired from active use and are held for
disposal are stated at the lower of their net book value and net realizable value
and are shown separately in the financial statements. Any expected loss is
recognized immediately in the profit and loss statement.

14.3 In historical cost financial statements, gains or losses arising on disposal are
generally recognized in the profit and loss statement.

14.4 On disposal of a previously revalued item of fixed asset, the difference

between net disposal proceeds and the net book value is normally charged or
credited to the profit and loss statement except that, to the extent such a loss is
related to an increase which was previously recorded as a credit to revaluation
reserve and which has not been subsequently reversed or utilized, it is charged
directly to that account. The amount standing in revaluation reserve following the
retirement or disposal of an asset which relates to that asset may be transferred to
general reserve.”

This Learning Outcome may be read with the next Learning Outcome about
revaluation of depreciable assets.

6. Explain the method of revaluation of depreciable assets.

[Learning Outcome f]
Revaluation of depreciable assets is done at the discretion and decision of the
management of any business organisation. It should not be confused with the
‘Revaluation Method’ of charging depreciation.

Revaluation is necessitated when it is felt that the depreciation cost is not correct;
rather, it is understated or overstated so as to distort the financial picture of any
 242

business organisation. This usually happens when the market value of any asset
goes downward or upward substantially. Insufficiency in the amount of
depreciation or excess depreciation turns into the reason for not reflecting the
correct result of the business operation.

Ashiyana Ltd has purchased a builidng worth Rs. 25,00,000 at the start of the
year 2009. The company has a policy to charge 10% depreciation using the
diminishing value method on its fixed assets.

At the end of 2012, the builidng has a book value of Rs. 16,40,250. However, its
market value on the same date has been appreciated to Rs. 45,00,000.

In such cases, Ashiyana may decide to revalue its building.

Moreover, replacement of any asset might be difficult. In such a situation, the

assets of the entity may be revalued. However, it is exclusively a matter of policy
of any business entity.

Usually, revaluation is done after appraisal by competent valuers and also

by indexation and reference to current prices with periodical checking by
the appraisal method.
Unlike changes in the method of depreciation, depreciation is charged on the
revalued figure of any asset with prospective effect.
The only matter to be kept in mind is that depreciation is charged on the
revalued amount of the asset only from the date of its revaluation.

AS 6 issued by the ICAI does not deal with the treatment of the revaluation
difference arising out of substitution of historical cost by the revalued figure of
any asset. But it recognises charging of depreciation on revalued amount of any
asset. Besides, it provides for a disclosure requirement which is quoted below.

‘In case the depreciable assets are revalued, the provision for depreciation is
based on the revalued amount on the estimate of the remaining useful life of such
assets. In case the revaluation has a material effect on the amount of depreciation,
the same is disclosed separately in the year in which revaluation is carried out.’

To learn how the accounting treatment for revaluation of depreciable assets is

done, it is better to quote the relevant portion of the Accounting Standard 10 (AS
10) on ‘Accounting for Fixed Assets’ issued by the Institute of Chartered
Accountants of India (ICAI), which contains clear guidelines in this matter.
 243

‘An increase in net book value arising on revaluation of fixed assets is normally
credited directly to owner’s interests under the heading of revaluation reserves
and is regarded as not available for distribution. A decrease in net book value
arising on revaluation of fixed assets is charged to profit and loss statement
except that, to the extent that such a decrease is considered to be related to a
previous increase on revaluation that is included in revaluation reserve, it is
sometimes charged against that earlier increase. It sometimes happens that an
increase to be recorded is a reversal of a previous decrease arising on revaluation
which has been charged to profit and loss statement in which case the increase is
credited to profit and loss statement to the extent that it offsets the previously
recorded decrease.’ It is also advisable to go through the contents of AS 10 on
“Retirements and Disposals’ mentioned earlier.

Saujanya Textile Mill purchased an office building worth Rs. 30,00,000 on 1

April 1995; the estimated useful life of the building is 40 years. Depreciation is
provided on straight line basis.

The office building was revalued on 30 September 2012 at Rs. 20,00,000 and the
revaluation effects were incorporated in the books of accounts.

Calculation of surplus / deficit on revaluation

Amount (Rs.)
Cost on 1 April 1995 30,00,000
Less: Depreciation till 30 September 2012 13,12,500
(30,00,000/40 years x 17.5 years)
Book value on 30 September 2012 16,87,500
Revaluation amount on 30 September 2012 20,00,000
Surplus on revaluation 3,12,500

This surplus of Rs. 3,12,500 should be credited directly to owners’ interests

under the heading Revaluation Reserve as per the requirement of AS 10.

Depreciation charged in the Profit and Loss Account of 2012-13

Depreciation on historical cost from 1 April 2012 to 30 Rs. 3,750

September 2012 (Rs. 3,00,000/40 years x 0.5 years)
Depreciation on revalued amount from 1 October 2012 to 31 Rs. 44,444
March 2013 (Rs. 20,00,000/22.5 years x 0.5 years)
Total depreciation of 2012-13 Rs. 48,194
 244

To sum up, an increase on revaluation of a depreciable asset is credited to

revaluation reserve that is not available for distribution. If, however, such
increase occurs as a result of earlier decrease on revaluation, it is to be credited to
Profit and Loss Account to the extent of the earlier decrease. A decrease on
revaluation is debited to Profit and Loss Account. Again, if such decrease
happens on account of earlier increase and is included in the revaluation reserve,
it may be charged to revaluation reserve. Journal entries to record this are given
below.

9. When there is any increase in the net book value of an asset or profit:

Asset Account (Amount of increase in the net Book Value) Dr X

To Revaluation Reserve Account X
(Being profit on revaluation transferred to revaluation reserve)

10. When there is any increase on revaluation which is related to previous

decrease:

Asset Account (Amount of increase in the net Book Value) Dr X

To Profit and Loss Account (Amount of earlier decrease) X
To Revaluation Reserve Account (Total increase-Amount of
X
earlier decrease)
(Being profit on revaluation adjusted against previous decrease on
revaluation and balance transferred to revaluation reserve account)

11. If there is decrease on revaluation:

Profit and Loss Account (Amount of decrease) Dr X

To Asset Account X
(Being loss on revaluation transferred to Profit and Loss Account)

12. If there is decrease on revaluation that is related to previous increase

included in Revaluation Reserve Account:

Revaluation Reserve Account (Amount of previous increase) Dr X

Profit and Loss Account (Total decrease-Previous increase) Dr X
To Asset Account (Total amount of decrease) X
(Being loss on revaluation adjusted against previous increase and
balance transferred to Profit and Loss Account)
 245

The purpose of revaluation varies from organisation to organisation. Different

bases may be used in the same financial year also.

At the end of this chapter, one much debatable and frequently asked question
related to Cash Flow and Fund Flow Statements is whether depreciation is a
source of funds.

In fact, depreciation is an operating cost, which should be allocated over the

period of the useful life of an asset. Had it been a source of funds, it would mean
more inflow of funds if more depreciation is charged, which is not at all true.
Hence, it is not a source of funds.

However, there are two reasons for considering depreciation to be a source of

funds, to some extent.

1. If depreciation is not charged, an amount equal to depreciation may be

distributed as dividend.

2. Secondly, depreciation retains the original historical cost of assets within the
business and thus adds to the working capital.

It is to be noted that India is going to adopt the International Financial Reporting

Standards (IFRS) with effect from April 01, 2011. Effort is already in progress
for convergence of Accounting Standards with IFRS. For this, necessary
guidelines have to be obtained from IFRS.

Which of the following accounting standard deals with the treatment of the
revaluation difference arising out of replacement of historical cost revaluation
amount?

A AS 6
B AS 1
C AS 10
D AS 2
 246

Summary
¾ Depreciation is a gradual conversion of the cost of an asset into revenue
expense to be accounted for in the accounts of a particular accounting period.
AS 6 has made it mandatory for all commercial organisations.
¾ Depreciation is based on the following three factors:
9 Historical cost
9 Expected useful life
9 Estimated salvage / residual value
¾ In order to ascertain the correct picture of profit or loss, depreciation should
be taken into account.
¾ Accounting treatment
9 Either by charging directly to Asset Account
9 Or by creating provision for depreciation
¾ Depreciation methods:
9 Straight line method: annual depreciation is calculated on the historical
cost of the asset and hence remains uniform - suitable for assets prone to
depreciate for lapse of time, such as patents.
9 Diminishing value method: annual depreciation is calculated on the
opening balance of the Asset Account and hence reduces year by year;
this method is suitable for exhausting and costly assets like plant and
machinery, vehicles, etc.
9 Depletion method: applied to assets of wasting nature and intangible
assets like mines, patents, copyrights, leaseholds, etc.
9 Annuity method: takes into account the opportunity cost of interest, had
the monetary outlay in the asset been invested elsewhere.
9 Sinking fund method: the amount of depreciation is invested in interest
earning securities in such a manner that the annual investment together
with compound interest becomes equal to the original cost of the asset.
9 Revaluation method: depreciation is calculated as the difference between
the revalued opening balance of the asset account and closing balance of
the asset account. Suitable for assets such as loose tools, packages,
livestock, etc.
9 Insurance policy method: resembles Sinking Fund Method; the major
difference being that annual investment is made by contribution to an
Insurance Policy as premium instead of investment in securities.
9 Machine hour rate method: chosen for machines where productivity is
relevant in their performance and in the case of machines with high cost.
¾ Change in depreciation method is permitted as per AS 6. Depreciation has to
be calculated from the date the asset comes into use.
 247

¾ Where depreciable assets are disposed of, discarded, demolished or

destructed, the net surplus or deficiency, if material, is disclosed separately.
¾ Revaluation of assets is necessitated when it is felt that the depreciation cost
is not correct; rather, it is understated or overstated so as to distort the
financial picture of any business organisation.
¾ Whether depreciation is a source of funds is a controversial and debatable
question. The most acceptable answer is – it is not a source of funds.

Answers to Test Yourself

Answer to TY 1

The correct option is A.

Land is not a depreciable asset unless it has a limited useful life for the
enterprise.

Answer to TY 2

The correct option is A.

The main object of providing depreciation is to calculate true profit. Other

options are also objectives, but they are subsidiary ones.

Answer to TY 3

The correct option is B.

The amount of depreciation charged on a machine will be debited to depreciation

account and credited to machinery account.

Answer to TY 4

The correct option is C.

Book value of an equipment = Opening balance – Accumulated depreciation

= Rs. 45,000 – Rs. 28,000
= Rs. 17,000
 248

Answer to TY 5

The correct option is C.

AS 10, Accounting for Fixed Assets, deals with the treatment of the revaluation
difference arising out of substitution of historical cost by the revaluation amount
of any asset.

Self Examination Questions

Question 1

On which of the following factors are the assessment of depreciation and the
amount to be charged for it in an accounting period based on?

(i) Historical cost of the depreciable asset

(ii) Market value of the depreciable asset
(iii) Purchase date of the depreciable asset
(iv) Estimated useful life of the depreciable asset
(v) Estimated salvage value of the depreciable asset

A All of the above

B (i), (ii) and (v)
C (iii) and (iv)
D (i), (iv) and (v)

Question 2

A mine was purchased at Rs. 3,00,000 and estimated quantity of mineral in the
mine is 10,000 tonnes. In the year 2010-11, a total of 1,700 tonnes of ore was
mined. Depreciation for 2010-11 will be:

A Rs. 3,00,000
B Rs. 51,000
C Rs. 10,000
D None of the above
 249

Question 3

Sukh-Sagar Ltd owns some land and buildings for which the following details are
available:

Cost of land Rs. 50,000

Cost of buildings Rs. 1,00,000
Estimated life of buildings 20 years
Estimated residual value of buildings Rs. 2,000
Estimated residual value of land Rs. 50,000

The company uses the straight line depreciation method. Which is the correct
annual depreciation charge for this asset?

A Rs. 4,000
B Rs. 4,900
C Rs. 7,400
D Rs. 7,500

Question 4

Shivam Corporation purchased a machinery of Rs. 50,000 on 1 January 2011and

incurred an installation charges of Rs. 10,000. The depreciation is calculated at
10% on a straight line basis.

On 30 June 2013, the machinery was sold for Rs. 42,500.

If the depreciation is calculated by written down value method, the book value of
the machinery on 30 June 2013 will be more by:

A Rs. 1,170
B Rs. 3,000
C Rs. 2,500
D Rs. 2,430
 250

Question 5

Parmar Group of Industries, which has a calendar year accounting period,

purchased a new machine for Rs. 1,20,000 on April 1, 2006. At that time Parmar
Group of Industries expected to use the machine for nine years and then sell it for
Rs. 12,000. The machine was sold for Rs. 66,000 on 30 September 2011.

Assuming straight-line depreciation, no depreciation in the year of acquisition,

and a full year of depreciation in the year of withdrawal, the gain to be
recognised at the time of sale would be:

A Rs. 12,000
B Rs. 9,000
C Rs. 6,000
D NIL

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is D.

Assessment of depreciation and the amount to be charged for it in an accounting

period are based on the following three factors:
9 Historical cost of the depreciable asset
9 Estimated useful life of the depreciable asset
9 Estimated salvage value of the depreciable asset

Answer to SEQ 2

The correct option is B.

Rate of depreciation = Rs. 3,00,000/10,000 tonnes = Rs. 30 per tonne

Annual depreciation = 1,700 tonnes x Rs. 30 = Rs. 51,000

Answer to SEQ 3

The correct option is B.

Land is not depreciated, so the depreciation charge for the building will be:
Rs. 1,00,000 – Rs. 2,000/20 = Rs. 4,900 p.a.
 251

Answer to SEQ 4
The correct option is A.
Difference = Rs. 46,170 – Rs. 45,000 = Rs. 1,170

SLM WDV
Method Method
Purchase price on 01 January 2011 50,000 50,000
Add: Installation cost 10,000 10,000
Cost of the machinery on 01 January 2011 60,000 60,000
Less: Depreciation on 31 December 2011 6,000 6,000
Book value of the machinery on 01 January 2012 54,000 54,000
Less: Depreciation on 31 December 2012 6,000 5,400
Book value of the machinery on 01 January 2013 48,000 48,600
Less: Depreciation on 30 June 2013 (6 months) 3,000 2,430
45,000 46,170
Answer to SEQ 5
The correct option is C.
Profit on sale of machinery
SLM
Method
Purchase price on 01 April 2006 1,20,000
Less: Depreciation on 31 December 2006 NIL
Book value of the machinery on 01 January 2007 1,20,000
Less: Depreciation on 31 December 2007 12,000
Book value of the machinery on 01 January 2008 1,08,000
Less: Depreciation on 31 December 2007 12,000
Book value of the machinery on 01 January 2009 96,000
Less: Depreciation on 31 December 2009 12,000
Book value of the machinery on 01 January 2010 84,000
Less: Depreciation on 31 December 2010 12,000
Book value of the machinery on 01 January 2011 72,000
Less: Depreciation on 30 September 2011 12,000
Book value of the machinery on 30 September 2011 60,000
Selling price of machinery 66,000
Profit on sale of machinery 6,000
W1 Annual Depreciation = (Rs. 1,20,000 – Rs. 12,000)/9 years = Rs.12,000
 252

CHAPTER 2

ACCOUNTING PROCESS, METHODS AND

CONTROL, AND FINALISATION OF
ACCOUNTS
UNIT 8

BANK RECONCILIATION STATEMENT

Chapter Introduction
Every person has a bank account. The entries of deposits and withdrawals are the
key components of bank transactions. All the transactions relating to the bank
have to be monitored properly because this helps in identifying any differences
between the cash book and bank statement. It also helps to make sure that
nobody has been stealing money directly from your bank account!
Generally, there should be no difference between the balances shown on the bank
statement and in the cash book, because all the entries should appear in both. It
may happen that on a particular date some entries are recorded in the cash book
but are not shown on the bank statement. Entities usually have a policy of
entering cheques received from any party immediately in the cash book; it
usually takes 3-4days to be processed by the bank, before it appears on the bank
statement. Similarly cheques issued by Entities are immediately entered in the
Bank Book but are presented to bank after 3-4 days. So, this is the most common
reason why there are differences between the cash book and the bank statement.
It is therefore necessary to prepare a bank reconciliation statement to discover the
differences between the bank statement and the cashbook. This will help to keep
a check on the accounts maintained by the entities and the transactions recorded
by the bank. Most organisations prepare monthly bank reconciliations to
maintain proper records.

Error!
a) Define Bank Reconciliation Statement and highlight its importance.
b) Mention the possible reasons for a difference in the cash book balance
and pass book balance.
c) Explain how Bank Reconciliation Statement is prepared.
 253

Look at the scenario

Sunil’s cash book showed a balance of Rs. 20,000, whereas the balance per the
bank statement (i.e. pass book) was Rs. 15,000. Sunil wondered why there was a
difference in the cash book balance and bank statement.

When he prepared the bank reconciliation statement, he found that he had

recorded a receipt of Rs. 5,000 from one of his customers but this transaction was
not reflected in the bank account.

So, by preparing the reconciliation statement, he located the missing amount and
was reassured about the accuracy of accounts.

1. Define Bank Reconciliation Statement and highlight its

importance.
[Learning Outcome a]
1.1 Bank reconciliation statement (BRS)

Bank Reconciliation Statement is the statement prepared by an entity that

reconciles the difference between the bank balance shown by the pass book and
the cash book balance.

The bank usually provides bank statements periodically, e.g. fortnightly,

monthly, quarterly, etc. It is prepared by an entity on a particular day (mostly
month-end) when the bank sends a bank statement. Ideally, there should not be
any difference between the two balances if all entries are recorded properly and
timely in both the books.

But there are several occasions where certain entries are recorded in any of the
books or errors of omission or commission that arise in recording entries in the
books. Some entries may have been recorded in the cash book, but not in the pass
book and vice versa at a particular point of time and recorded in the other book
subsequently.

Again, certain entries recorded in one book are not at all recorded in the other or
recorded at a different value in the other book. For all such reasons, the balance
in one book may not agree with that of the other book.
 254

Thus difference between the two books may

be classified into two groups: These differences are briefly
1. Timing Difference and covered in the next Learning
2. Difference due to errors in Outcome.
recording.
It is the bank reconciliation statement that provides a systematic process of
identifying the reasons for the difference between the balances of two books and
reconciling the difference giving reasons for necessary accounting and
administrative action.
In insurance business, 99% of transactions are carried out through the bank and
the differences between the two book balances are sometimes found to run into
crores of rupees, causing great concern to the accounts department, which has to
spend considerable time preparing the bank reconciliation statement.

1.2 Importance of BRS

1. Bank reconciliation statement is an important tool for internal control over
both administration and accounting.
2. It helps to detect many discrepancies and irregularities in financial
transactions apart from reconciliation of the two balances due to mere time
difference or errors of omission or commission.
3. Most of the scams may remain undetected for a long time. Satyam Scam and
Enron Scam are two instances of this sort. Mistakes may be intentional and
unintentional.
4. When mistakes are deliberate or intentional, the difference between the two
balances may be due to financial irregularities and fraud.
5. Proper bank reconciliation is the first and foremost tool to detect and control
fraud.

A bank reconciliation statement is:

(i) prepared by the bank and sent to its account holders
(ii) a statement sent by a bank to those customers who do not maintain a
minimum balance
(iii) not a part of the double entry system
(iv) prepared by the entity to find discrepancies
A (i)
B (ii) and (iii)
C (iii) and (iv)
D (ii) and (iv)
 255

2. Mention the possible reasons for a difference in the cash

book balance and pass book balance.
[Learning Outcome b]
As mentioned in the previous Learning Outcome, a difference in balances
between the two books, Cash Book and Pass Book, may arise due to many
reasons, which may be broadly classified into two groups:
1. Timing Difference
2. Difference due to errors in recording

Diagram 1: Reasons for differences in the balances between Cash Book and
Pass Book
 256

2.1 Timing Difference

1. Cheques paid into bank but not credited or collected by the bank

Entries are made on the debit side of the Cash Book in the bank column
immediately after the cheques are sent to the bank for deposit, but the bank
generally gives credit to the customer's account for the said deposits only after
the bank receives collections on the cheques being cleared. Thus, there will be
difference in balances of the two books at a particular point of time.

2. Cheques issued but not presented for payment

Immediately after issuing cheques, entries are made on the credit side of the Cash
Book in the Bank Column, but no entry is passed by the bank till such cheques
are presented and payment is made by the bank. Such difference of timing for
entry in two books causes difference in balances of the two books.

3. Direct payments and remittances by bank

Sometimes, banks may make payments according to standing orders on various

items such as insurance premium and remittance to some other accounts or
persons, which the customer enters in his cash book only after he receives advice
from the bank. With such entries being made in the Cash Book and Pass Book on
different dates, there arises a difference between two balances at a particular
point of time.

4. Direct deposits by customers into bank

Direct payments into bank by clients or others may remain unrecorded in the
cash book till this comes to the knowledge of the account holder. In such case,
entries are made in the Cash Book and Pass Book on different dates, creating the
timing difference.

5. Dishonour of bills

When discounted bills are dishonoured and the bank fails to collect payments on
the discounted bills or promissory notes, debit entries are passed by the bank, but
these are not entered in the cash book till it comes to the knowledge of the
account holder.
 257

6. Bills or income collected by the bank

Sometimes, the bank directly collects bills or other incomes such as dividends,
rents, interest on securities etc. on behalf of its customer’s standing instructions,
and passes credit entries in the customers' account. However, account holders
pass the entries only after they receive advice from the bank.

7. Interest or expenses debited by the bank

Banks pass the necessary debit entries in the pass book for overdraft interest or
loan interest or other expenses; the accountholders pass the necessary entries
afterwards, when they receive particulars and documents thereof.

8. Interest allowed by the bank

When the bank allows interest on deposit, a credit entry is recorded in the pass
book, but no debit entry is passed by the accountholder in his cash book, until
intimation is received by the customer (accountholder).

2.2 Difference due to errors in recording

Errors in recording entries may occur both in the Cash Book and the Pass Book.
Generally, errors arise in recording entries in the Cash Book. Banks rarely make
mistakes in recording transactions. Even if they make mistakes, their system of
preparing a daily balance sheet helps in the detection of errors and mistakes on a
daily basis, unless the mistakes are deliberate. Errors are found to occur mostly in
recording of entries in the cash book.

The following are a few examples of errors that cause a difference between
the balances of Cash book and Pass Book.

1. Cheques or cash paid into the bank and credited in the pass book but
omitted to be recorded in the cash book.

2. Up-country cheques paid into bank and credited in the pass book subject to
collection charge, but not entered in the cash book.

3. Charges, expenses and interest on overdraft debited in the pass book but
not recorded in the cash book.
 258

4. Interests on deposits allowed by the bank credited in the pass book but not
recorded in the cash book.

5. Errors in casting, balancing or carry forward either in the cash book or in

the pass book or in both.

6. Cheques dishonoured, entered in the pass book, but not entered in the cash
book

7. Recording of entries on the wrong side of the Cash Book or Pass Book

Which of the following does not cause a difference between the cash book and
the bank statement?

A Interest on bank overdraft debited in the bank account

B Cheques received and entered in the cash book, but not yet paid in to the
bank for collection
C Cheques issued and presented for payment
D A customer directly deposited a certain amount in to the bank

A cheque was issued by Matrix Ltd to Jack (supplier), it has not yet appeared on
the bank statement. This cheque is known as ________

A A dishonoured cheque
B A standing order
C An outstanding cheque
D A credit transfer
 259

3. Explain how Bank Reconciliation Statement is prepared.

[Learning Outcome c]

A statement is prepared to reconcile the difference that exists between the cash
book and the pass book. This statement is known as the Bank Reconciliation
Statement.

Diagram 2: Bank reconciliation

For preparation of a bank reconciliation statement, entries appearing in the bank

column of the cash book are compared with those appearing in the pass book.
More precisely, the entries appearing on the debit side of the cash book will be
compared with the entries appearing on the credit side (deposit column) of the
pass book and vice versa.

It should be remembered that entries appearing both in the cash book and the
pass book will cause no difference at all and hence, should be ignored.

One of the balances is taken up as the starting point and is adjusted considering
how the balance would have changed if the same entries were made in the two
books. This enables the management of business concerns to check the accuracy
of the entries made in the cash book and also to keep track of cheques either sent
to the bank for collection and remaining unclear or issued to the clients by the
customer and remaining unpresented, for an unreasonably long period.
Ultimately, the management can ascertain the cause for delay and take timely
action.
 260

Preparation of a bank reconciliation statement

Take the Cash Book Balance or Pass Book Balance as the starting point and then
check what has been done or has not been done in the other Book. For instance if
we take the Pass Book Balance as the starting Point, we would check carefully
what has been done or not done in the Cash Book and ascertain if the entries
passed in the Cash Book are also passed in the Pass Book and also if the entries
not finding a place in the Cash Book are removed from the Pass Book.
Step 1
Compare the debit side of the cash book with the deposits column of the pass
book, item by item. Note down the following:
9 cheques deposited into the bank account (appearing in the cash book)
which are not credited by the bank
9 interest credited by the bank for which there is no corresponding entry in
the cash book
9 Cheques dishonoured (not recorded in the cash book)
9 Direct credits by customers (appearing in the pass book) for which there
is no corresponding entry in the cash book
Step 2
Compare the credit side of the cash book with the withdrawals column of the
pass book. Note the following:
9 cheques issued during the period which have not been presented for
payment
9 bank charges debited by the bank for which there is no corresponding
entry in the cash book
9 Standing order payments (appearing in the pass book) for which there is
no corresponding entry in the cash book
9 Interest debited by the bank for which there is no corresponding entry in
the cash book
Step 3
Fill up the proforma of the bank reconciliation statement.

The following proforma can be used to reconcile the balances of cash book
and bank statement.

Let us see the proforma of the same in two different ways.

1. When we move from cash book balance to bank statement balance.
2. When we move from bank statement balance to cash book balance.
 261

Proforma of bank reconciliation statement when we move from cash book

balance to bank statement balance

Bank Reconciliation Statement

Rs.
Balance according to cash book X
Add: Cheque issued but not presented X
Add: Bank interest X
Add: Direct credit by customers X
X
Less: Standing order (X)
Less: Cheques deposited in bank but not credited (X)
Less: Cheques dishonoured (not recorded in cash book) (X)
Less: Bank charges (X)
Balance according to bank statement X

Proforma of bank reconciliation statement when we move from bank

statement balance to cash book balance
Bank Reconciliation Statement

Rs.
Balance according to bank statement X
Add: Cheques deposited in bank but not credited X
Add: Bank charges X
Add: Cheques dishonoured X
Add: Standing order X
X
Less: Cheque issued but not presented (X)
Less: Direct credit by customers (X)
Less: Bank interest (x)
Balance according to cash book X

The method of comparison of entries in the Cash Book with those found in the
Pass Book will be clear from the following:

Following is an extract from the Pass Book and the bank column of the Cash
Book of M/S Young & Old for the month of September 2010.
 262

Cash Book (Bank Column only)

Dr Cr
Date Particulars Amount Date Particulars Amount
2010 2010
Sept Sept
1 To Balance b/d 40,000 3 By M/s D Electronics 6,000
2 To M/S P & Co 3,500 7 By M/s Arora & Co 10,000
6 To M/S B& Co 7,600 17 By M/s Tonk & Sons 12,500
8 To Cash 3,000 24 By M/s Dilip & Sons 7,300
16 To M/s Raj & Co 4,300 25 By Cash 5,000
23 To M/S T & CO 10,500 28 By M/S B& Co 7,800
29 To M/S D & Sons 3,400 30 By Balance c/d 23,700
72,300 72,300

Pass Book (Bank of India)

Date Withdrawal Deposit/
Balance
(2010 /Debit Credit
(Rs.)
Sept) (Rs.) (Rs.)
1 Balance 40,000
5 To M/s D Electronics 6,000 34,000
8 By Cash 3,000 37,000
9 To M/s Arora & Co 10,000 27,000
10 By M/S P & CO 3,500 30,500
18 To M/s Tonk & Sons 12,500 18,000
18 By M/S B& Co 7,600 25,600
20 By M/s Raj & Co 4,300 29,900
25 To Cash 5,000 24,900
29 By Interest Collected from Govt. 2,000 26,900
Securities
30 Insurance Premium as per S/order 2,600 24,300

On examination of the Cash Book and Pass Book entries for the month of
September 2010, we find that although Cash Book and Pass Book have started
with the same balance of Rs 40000, the closing balances of both the books differ
from each other due to the following timing differences and differences arising
from errors in recording certain transactions:

1. Bank’s direct collection - Interest from Govt. Securities - and one direct
payment - Insurance Premium as per Standing Order on 29th and 30th Sept for
Rs. 2,000 and Rs. 2,600 respectively - have not been recorded in the Cash
Book by the end of the month.
 263

2. Two deposits on 23rd and 29th Sept for Rs 10500 and Rs. 3,400 respectively
have not been entered in the pass book; two cheques issued for Rs. 7,300 and
Rs. 7,800 on 24th and 28th Sept respectively have not been presented by 30th
Sept.
3. Now to prepare the Bank Reconciliation, start with one balance, then adjust
this balance with the above noted items of difference and then arrive at the
other balance.
Let us prepare the Bank Reconciliation Statement with the above-mentioned
extract from the Cash Book and Pass Book of an organisation:
M/S Young & Old
Bank Reconciliation Statement for the month of September 2010
Amount
Particulars
(Rs.)
Balance as per Cash Book 23,700
Add:
Interest Collected by bank, but not entered in Cash Book 2,000
Cheque issued to M/s Dilip & Sons, but not yet presented
7,300
to bank
Cheque issued to M/S B& Co, but not yet presented to
7,800 17,100
bank
40,800
Less:
Insurance Premium paid by bank, but not entered in Cash
2,600
Book
Cheque deposited into bank, but not encashed (M/S T &
10,500
CO)
Cheque deposited into bank, but not encashed (M/S D
3,400 16,500
&Sons)
Balance as per Pass Book 24,300

From the above illustration, we find that Bank Reconciliation is nothing but a
method to reconcile the Cash Book Balance and Pass Book Balance with
adjustment for differences being identified on the verification of Cash Book and
Pass Book.

9 If we start with the Cash Book Balance, our objective will be arriving at the
Pass Book Balance as shown above.
9 If we start with the Pass Book Balance, our objective will be arriving at the
Cash Book Balance after adjustment of all differences.
 264

To make the above aspect clearer, let us prepare a bank reconciliation statement
with the Pass Book Balance as the starting point, instead of the Cash Book
balance.

M/S Young & Old

Bank Reconciliation Statement for the month of September 2010
Amount
Particulars
(Rs.)
Balance as per Pass Book 24,300
Less:
Interest Collected by bank, but not entered in Cash Book 2,000
Cheque issued to M/s Dilip & Sons, but not yet presented
7,300
to bank
Cheque issued to M/S B& Co, but not yet presented to
7,800 17,100
bank
7,200
Add:
Insurance Premium paid by bank, but not entered in Cash
2,600
Book
Cheque deposited into bank, but not encashed (M/S T &
10,500
CO)
Cheque deposited into bank, but not encashed (M/S D
3,400 16,500
&Sons)
Balance as per Cash Book 23,700

From the above illustration, we find that if we start the bank reconciliation taking
the Cash Book Balance, we will adjust the differences following the entries
recorded in Pass Book. If we start the bank reconciliation taking the Pass Book
Balance as the starting point, we will adjust the differences following the entries
recorded in the Cash Book.

Salient aspects to be considered for preparation of Bank Reconciliation

Statement (BRS)

1. Bank Reconciliation can be started using any of the following four balances;

9 Dr Balance in Cash Book (Favourable Balance)

9 Cr. Balance in Cash Book (Adverse/ Overdraft Balance)
9 Dr Balance in Pass Book (Adverse/ Overdraft Balance)
9 Cr. Balance in Pass Book (Favourable Balance)
 265

2. When one balance is more than the other due to certain reasons already
known or not yet identified, the accountant shall verify one book with
reference to the other book.

The Debit Side of the Cash Book will be identified with the entries on the
Credit side of the Pass Book and the entries on the credit side of the Cash
Book will be compared with those on the Debit side of the Pass Book by way
of placing a tick mark before the entries.

The unticked items will be the cause of the difference.

3. The unticked items will be added to or subtracted from one balance to arrive
at the other balance in the manner mentioned in the diagram below.

Diagram 3: Causes of difference between two balances and their treatment

in BRS
 266

With the following illustrations, the above guidelines on treatments of various

causes of difference between Cash Book balance and Pass Book Balance have
been applied for preparation of bank reconciliation statements

ABC & Co’s Cash Book shows an overdraft balance of Rs. 6,34,000 on 30th June
2010, while the Pass Book balance on that date is Rs. 6,33,200.

On examination of the Cash Book and Bank statement (Pass Book), the
following discrepancies are noticed:
1. Rs. 16,000 Interest on Overdraft for the last 6 months appearing in the Bank
Statement is not entered in the Cash Book
2. Rs. 3,000 Bank Charges are not entered in the Cash Book
3. Two cheques for Rs. 1,00,000 and Rs. 16,800 issued by the firm have not
been presented to the bank.
4. Two cheques for Rs. 2,00,000 and Rs. 17,000 deposited on 29.6.10 have not
been credited in the Pass Book.
5. Rs. 1,20,000 interest on investments has been collected and credited by the
bank on 30.6.10, but is not entered in the Cash Book.

Prepare Bank Reconciliation Statement on the basis of the above

particulars.

Solution
Bank Reconciliation Statement as on 30th June 2010

Particulars Amount
Overdraft balance as per Cash Book 6,34,000
Add:
i) Overdraft Interest debited in Pass book, not entered 16,000
in Cash Book
ii) Bank Charges debited in Pass book, not entered in 3,000
Cash Book
iii) Cheques issued, but not yet presented 2,17,000 2,36,000
8,70,000
Less:
i) Cheques issued, but not yet presented 1,16,800
ii) Investment interest credited in pass book, not entered 1,20,000 2,36,800
in Cash book
Balance as per Pass Book 6,33,200
 267

XYZ & CO’s Cash Book shows a bank balance of Rs. 46,100 on 30th June 2010,
which does not agree with the Bank Statement Balance.

On examination of the Cash Book and Bank statement (Pass Book), the
following discrepancies are observed.

1. Three cheques for Rs. 40,000, Rs. 20,000 and Rs. 3,000 are credited in the
Cash Book, but are not presented before the bank.
2. Two cheques totalling Rs. 25,000 are deposited on 29.6.10, but are credited
in the Pass Book on 2.7.10.
3. Dividend Rs. 3,800 directly collected and credited in the pass book on
28.6.10 is intimated on 2.7.10.
4. Two cheques totalling Rs. 7,300, dishonoured by the bank are duly debited in
the Pass Book; dishonour intimation received by the firm on 3.7.10.
5. Bank Charges of Rs. 4,200 and one direct payment of Rs. 1,000 to Trade
Association is debited in the Pass Book, but not yet entered in the Cash
Book.
6. Bank wrongly debited a cheque of Rs. 2,700, which was not issued by XYZ
& CO.

You are required to:

(a) Prepare Bank Reconciliation Statement with given bank balance as per Cash
Book.
(b) Adjust Cash Book (Bank Column) and prepare Bank Reconciliation
Statement with bank balance as per Adjusted Cash Book.

Solution

Bank Reconciliation Statement is prepared directly with the given bank balance
as per Cash Book or Pass Book, as the case may be. Sometimes, Cash Book is
adjusted/ corrected for the mistakes and then the Bank Reconciliation Statement
is prepared. In this example, BRS with the given bank balance is shown in (a)
and BRS with the bank balance as per Adjusted Cash Book is shown in (b). But
in both the cases, bank balance as per Pass Book is the same, i.e. Rs. 72,700.
 268

(a) Bank Reconciliation Statement starting with the given bank balance as
per Cash Book

XYZ & CO’s

Bank Reconciliation Statement as on 30th June 2010

Particulars Amount Amount

Rs Rs
Bank Balance as per Cash Book 46,100
Add:
Three cheques credited in the cash book but not presented 63,000
(40,000 + 20,000 + 3,000)
Dividend directly collected by bank but not recorded in 3,800 66,800
cash book
1,12,900
Less:
Two cheques deposited into bank but not credited in Pass 25,000
book
Two cheques deposited into bank has been dishonoured by 7,300
bank but not recorded in cash book
Bank charge debited in Pass book but not recorded in Cash 4,200
Book
Paid by bank to Trade Associated but not recorded in Cash 1,000
Book
Cheque was not issued but wrongly debited by bank in Pass 2,700 40,200
Book
Bank Balance as per Pass Book 72,700

(b) Adjust Cash Book (Bank Column) and prepare Bank Reconciliation
Statement with bank balance as per Adjusted Cash Book
Dr Adjusted Cash Book (Bank Column) Cr
Date Particulars Amount Date Particulars Amount
30.6.10 To Balance B/d 46,100 30.6.10 By Cheque 7,300
dishonoured
To Dividend 3,800 By Bank Charges 4,200
By Trade 1,000
association
By Balance C/d 37,400
49,900 49,900
 269

Bank Reconciliation Statement (with bank Balance of adjusted Cash Book)

As on 30th June 2010
Particulars Amount Amount
Bank Balance As per Adjusted Cash Book 37,400
Add:
i) Cheques Issued, but Not presented (40,000 + 20,000 + 63,000 63,000
3,000)
1,00,400
Less:
i) Cheques Deposited, but not credited in Pass Book 25,000
ii) Cheques was not issued, but wrongly debited in Pass 2,700 27,700
Book
Bank Balance as per Pass Book 72,700

The cash balance of Krupa Traders was Rs. 700 (debit). The bank statement
showed a credit balance of Rs. 1,600 on 31 March 2011. The difference was
caused due to the following transactions

(i) Cheques of Rs. 500 issued, but not presented in the bank for payment
(ii) A cheque received amounted to Rs. 200, but was entered as Rs. 20
(iii) Payment of Rs. 250 from a customer was directly received by the bank
(iv) The cash book was overstated by Rs. 30

What will be the revised balance in the cash book after revising the above
transactions?

A Rs. 750
B Rs. 850
C Rs. 550
D Rs. 690

Which of the following is a timing difference that reduces the balance according
to the cash book in bank reconciliation?

A Cheques deposited but not cleared

B Cheques issued but not presented
C Bank charges
D Bank interest
 270

Summary
¾ Cash book is the record of cash and bank transactions, which is prepared by
the entity, and the pass book is the statement of accounts prepared by the
bank.
¾ Pass Book is a book issued by the Bank to an account holder. It is almost a
copy of the account of the customer / entity in the books of the bank.
¾ There can be various reasons due to which the balances of the cash book and
the pass book do not match.
¾ These reasons can be either timing differences or errors in recording.
¾ Hence, bank reconciliation statement is prepared to reconcile both the
balances.
¾ Bank reconciliation statement is a statement, not an account.
¾ Bank reconciliation statement eases checking of errors and detection of
frauds in the cash books and pass books.

Answers to Test Yourself

Answer to TY 1

The correct option is C.

The bank reconciliation statement is prepared by an entity to find discrepancies

in the cash book and the bank statement. It is a statement and not an account and
hence is not a part of the double entry system.

Answer to TY 2

The correct option is C.

Cheques issued, but not presented for payment will cause the difference between
the cash book and the bank statement.

Answer to TY 3

The correct option is C.

It is a cheque issued to Jack for payment but not yet cashed by him.
 271

Answer to TY 4

The correct option is B.

(ii) and (iv) are the errors in the cash book.

The correction in the cash book is made as follows:

Cash Book
Dr Cr
Date Receipts Rs. Date Payments Rs.
To Balance b/d 700 Overstated 30
Cheque entered with a
wrong amount (Rs.
200 - Rs. 20) 180 By Balance c/d 850
880 880

Answer to TY 5

The correct option is A.

Cheques deposited but not cleared.

Self Examination Questions

Question 1

The following information of Suraj Traders is available for the month of July
2011:
1 July Balance as per Cash Book 1,50,000
2 July Cheques paid into Bank in July 2011 but credited by the 8,000
bank in August 2011
3 July Cheques issued in July 2011 but cashed in August 2011 12,000
4 July Cheques entered in the Cash Book in July 2011 but paid 5,000
into bank in August 2011
5 July Interest allowed by the bank 3,000
6 July Interest charged by the bank 900
 272

From the above details, prepare a bank reconciliation statement as on 31st July
2011, and find out the Balance as per pass book.

A Rs. 1,50,000 balance

B Rs. 1,51,100 overdraft
C Rs. 1,51,100 balance
D Rs. 1,50,000 overdraft

Question 2

The cash book of a sole trader, Jayprakash, showed an overdraft of Rs. 3,000, but
it was not matching with the balance as per pass book on the same date. The
following reasons were revealed on the comparison of the cash book and the pass
book.
(i) Cheques of Rs. 200, Rs. 100 and Rs. 250 respectively had not been presented
for payments
(ii) Cheque of Rs. 800 paid into account had not been cleared.

The balance as per the pass book will be:

A Rs. 2,200
B Rs. 4,350
C Rs. 3,250
D Rs. 2,750

Question 3

Rishita’s cash book shows a credit balance of Rs. 8,700 for the month of January.
The balance of the bank statement does not match with that of the cash book, due
to the following reasons.

(i) Interest on an overdraft of Rs. 500 had been debited by the bank but not
recorded in the cash book.
(ii) Cheques of Rs. 5,000 issued during the month, but were not presented in the
bank until 31 January 2007. Cheques of Rs. 3,500 were deposited but not
cleared.
(iii) Interest on investments of Rs. 1,000 was directly collected by the bank.
(iv) The bank had wrongly debited Rs. 800.
 273

The balance per the bank statement is:

A Rs. 7,500 (debit)
B Rs. 9,500 (debit)
C Rs. 5,900 (credit)
D Rs. 7,500 (credit)

Question 4
The following is a bank reconciliation statement prepared by a trainee accountant
of Surya Ltd:

Rs.
Overdraft per bank statement 40,000
Add: Deposits not credited 45,000
85,000
Less: Outstanding cheques Overdraft per cash book 6,000
79,000

Assuming the bank statement balance of Rs. 40,000 to be correct, what should
the cash book balance be?
A Rs. 79,000 overdrawn
B Rs. 6,000 overdrawn
C Rs. 1,000 overdrawn
D Rs. 6,000 cash at bank

Question 5
Debit balance as per Cash Book of Shrinath Enterprises as on 31.3.2012 is Rs.
1,500.
(i) Cheques deposited but not cleared amount to Rs. 100 and cheques issued but
not presented amount to Rs. 150.
(ii) The bank allowed interest amounting Rs. 50 and collected dividend of Rs. 50
on behalf of Shrinath Enterprises.
Balance as per pass book should be:
A Rs. 1,600
B Rs. 1,450
C Rs. 1,850
D Rs. 1,650
 274

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is B.

Pass book will show overdraft (debit balance) of Rs. 1,51,100.

Bank Reconciliation Statement as on July 31, 2011

Particulars Amount Amount
Balance as per Cash Book 1,50,000
Add:
Cheques issued but not cashed 12,000
Interest allowed by bank 3,000 15,000
1,65,000
Less:
Cheques deposited into bank but not yet credited 8,000
Cheques entered into Cash Book but not paid by Bank 5,000
Interest charged by Bank 900 13,900
Balance as per Pass Book 1,51,100

Answer to SEQ 2

The correct option is C.

Rs.
Credit balance as( overdraft) per cash book 3,000
Add: Cheque deposited but not cleared 800
3,800
Less: Cheques issued but not presented for payment
(200 + 100 + 250) 550
Balance as per Pass Book 3,250
 275

Answer to SEQ 3

The correct option is A.

Rs. Rs.
Overdraft balance per Cash Book 8,700
Add:
Interest on overdraft not entered in cash book 500
Cheques deposited but not cleared 3,500
Wrong debit by bank 800 4,800
13,500
Less:
Cheque issued but not presented 5,000
Interest on investment directly collected by bank 1,000 6,000
Overdraft balance per Bank Statement 7,500

Answer to SEQ 4

The correct option is C.

Here, balance according to bank statement is overdraft balance. So, Rs. 40,000 is
to be taken as (Rs. 40,000) and then we have to proceed to find the cash book
balance.

A bank reconciliation statement is prepared as follows:

Rs.
Overdraft per Bank Statement 40,000
Add: Outstanding cheques Overdraft per cash book 6,000
Less: Deposits not credited 45,000
Overdraft as per Cash Book 1,000
 276

Answer to SEQ 5

The correct option is D.

Rs. Rs.
Debit balance as per cash book 1500
Add:
Cheques issued but not presented 150
Bank allowed interest 50
Dividend collected on behalf of Shrinath 250
Enterprises 50
1,750
Less:
Cheque deposited but not cleared 100 100
Balance as per pass book 1650
 277

CHAPTER 2

ACCOUNTING PROCESS, METHODS &

CONTROL AND FINALISATION OF
ACCOUNTS
UNIT 9

INTRODUCTION TO COMPANY ACCOUNTS

Chapter Introduction
In this chapter we will discuss various aspects relating to company accounts. This
would include discussion pertaining to relevant provisions of Companies Act
regarding maintenance of proper books, issuing shares, debentures, preference
shares, underwriting of shares, calculating managerial remuneration and
preparing final accounts.
 278

a) State the legal requirements relating to preparation and presentation of

financial statements as per the provisions of the Companies Act 1956.
b) Learn about a company, along with various types of companies,
including the salient features.
c) State the provisions of the Companies Act relating to maintenance of
proper books of account.
d) Discuss the accounting treatment of share capital with respect to issue,
reissue and forfeiture.
e) Discuss buy-back of shares and study the condition for buy back of
shares.
f) Discuss the various Employee Stock Option Plans (ESOP) issued by
companies, along with their accounting treatment.
g) Discuss the accounting treatment of redemption of preference shares.
h) Discuss the treatment of issue, underwriting and redemption of
debentures.
i) Discuss the concept of bonus shares along with accounting treatment and
related provisions under the Companies Act.
j) Discuss the form and content of financial statements as required by
statute and prepare financial statements in accordance with the formats.
k) Discuss taxation and its accounting treatment in the final accounts.
l) Discuss and calculate managerial remuneration in accordance with the
provisions of the Companies Act 1956.
 279

1. State the legal requirements relating to preparation and

presentation of financial statements as per the provisions
of the Companies Act 1956.
[Learning Outcome a]
In India, the financial statements of a company are prepared in accordance with
the Indian GAAP. The Indian GAAP comprises the provisions of the Companies
Act 1956 (as amended), the mandatory Accounting Standards issued by the ICAI,
and the specific guidelines or regulations issued by any other regulatory authority
like SEBI, RBI or IRDA. In accordance with the Indian GAAP, a complete set
of financial statements of a company include the following:

9 Balance Sheet
9 Income Statement/ Profit & Loss Account
9 Cash Flow Statement
9 Notes comprising a summary of accounting policies and other explanatory
notes
9 Consolidated Financial Statements (listed companies) in accordance with AS
21 and AS 23

The said financial statements also known as general purpose financial statements
are furnished along with the auditors’ report and the Board’s report in the Annual
Report published by the company for public communication and especially for
various stakeholders including shareholders, the regulator, customers, financiers
and the Government.

1.1 Laying of annual accounts at the Annual General Meeting (AGM)

Under Section 210 of the Companies Act 1956, at every annual general meeting
of a company held in pursuance of the Section 166, the Board of Directors of the
company shall lay before the company

9 Balance Sheet as at the end of the financial year and

9 Profit& Loss account for the financial year

Under section 216 of the Companies Act, the Statement of Profit and Loss shall
be annexed to the Balance Sheet and the auditor’s report shall be attached
thereto. Section 217 provides that there shall be attached to every balance sheet
laid before a company in general meeting a report by its Board of Directors, with
respect to the following matters along with many other aspects specified therein:
 280

9 The state of affairs of the company

9 The amount, if any, which the company proposes to carry to any reserves
9 The amount, if any, which it recommends, should be paid by way of
dividend
9 Material changes and commitments, if any, affecting the financial position of
the company, which have occurred in between the date of balance sheet and
the date of report.

1.2 Form and content of a Balance Sheet and Statement of Profit and
Loss

Form and content of a Balance Sheet and Statement of Profit and Loss is
governed by the provision under Companies Act 1956, Schedule VI

Schedule VI to the Companies Act, 1956 has recently been revised and is became
applicable to all companies for the preparation of financial statements beginning
on or from 1 April 2011.

In accordance with Section 211 of the Companies Act, every balance sheet and
statement of profit and loss of a company shall give a true and fair view of the
state of affairs and profit and loss of the company for the financial year and shall
comply with the requirements of the Revised Schedule VI. The contents of
balance sheet and Statement of Profit and Loss are discussed in detail in Learning
Outcome 10.

Salient features of Revised Schedule VI:

a) The Revised Schedule VI requires that if compliance with the requirements

of the Act and / or the notified Accounting Standards requires a change in the
treatment or disclosure in the Financial Statements as compared to that
provided in the Revised Schedule VI, the requirements of the Act and / or the
notified Accounting Standards will prevail over the Schedule.

b) The Revised Schedule VI has eliminated the concept of ‘Schedule’ and such
information is now to be furnished in the Notes to Accounts.

c) All items of assets and liabilities are to be bifurcated between current and
non-current portions and presented separately on the face of the Balance
Sheet.
 281

An asset shall be classified as current when it satisfies any of the following

criteria:

a) it is expected to be realized in, or is intended for sale or consumption in, the

company’s normal operating cycle
b) it is held primarily for the purpose of being traded;
c) it is expected to be realized within twelve months after the reporting
d) date; or
e) it is cash or cash equivalent unless it is restricted from being exchanged or
used to settle a liability for at least twelve months after the reporting date.

All other assets shall be classified as non-current.

d) There is an explicit requirement to use the same unit of measurement

uniformly throughout the financial statements and notes thereon.

It should be noted that the requirements of the Revised Schedule VI however, do

not apply to companies as referred to in the proviso to Section 211 (1) and
Section 211(2) of the Act, i.e., any insurance or banking company, or any
company engaged in the generation or supply of electricity or to any other class
of company for which a form of Balance Sheet and statement of Profit and Loss
has been specified in or under any other Act governing such class of company.

Thus, company accounts are to be prepared, presented and analyzed in pursuance

of the applicable Accounting Standards and relevant regulatory norms and more
specifically, the provisions of the Companies Act, which have been discussed
more elaborately in subsequent Learning Outcomes.

At every annual general meeting the financial statements are presented to the
shareholders by the:

A Statutory Auditors
B Internal Auditors
C Company Secretary
D Board of Directors
 282

2. Learn about a company, along with various types of

companies, including the salient features.
[Learning Outcome b]

2.1 Meaning of Company

To study and appreciate company accounts properly, one needs to know what a
company stands for legally, how it differs from a firm and what are the legal
requirements to be complied with for preparation and presentation of its financial
statements.

Sec. 3(1)(i) of the Companies Act, 1956 defines the company as:

A company formed and registered under this Act or any existing company
formed and registered under any of the previous company laws specified in
Section 3(i)(ii).

A company defined in this section may mean either a private company or a

public company.

Under Section 3(i)(iii), private company means a company which has a minimum
paid-up capital of one lakh rupees or such higher capital as may be prescribed by
its articles.

Under Section 3(1)(iv), a public company means a company which:

a) is not a private company,

b) has a minimum paid-up capital of five lakh rupees or such higher paid-up
capital as may be prescribed and
c) is a private company which is a subsidiary of a company which is not a
private company.

Companies (Amendment) Act 2003 states that if a company fails to enhance its
minimum paid-up capital up to Rs.1 lakh in case of private company and Rs.5
lakhs in case of a public company, each director or manager or shareholder will
have unlimited liability.
 283

2.2 Types of companies

The various types of companies are discussed below:

1. Registered Company: is of two types- Public Company and Private

Company. A public company may be a listed company or unlisted company.
Listed companies are those which get their securities listed in any recognized
Stock Exchange in India. An unlisted company is one whose securities are
not listed on any recognized stock exchange. Private companies don’t
involve participation of public in general for funding capital. So the shares of
private companies are not listed in any stock exchange.

2. Statutory Company: Companies that come into existence and operate under
the special act passed by the State Legislature or the Parliament are called
statutory companies. Unit Trust of India, Life Insurance Corporation of India,
General Insurance Corporation of India, Reserve Bank of India. Such
companies are not required to use the word ‘Limited’ or ‘Ltd’ as part of their
name.

3. Government Company: In accordance with Section 617 of the Companies

Act 1956, a Government company is a company in which not less than 51%
of the paid capital is held by the central Government or state Governments or
by both of them jointly.

The New India Assurance Company Limited, National Insurance Company

Limited, United India Insurance Company Limited and the Oriental Insurance
Company Limited are all government companies as they are fully owned by the
Government of India.

4. Foreign Company: A foreign company is one that is incorporated or

registered outside India but is having place of business or operations in India.
LG, Samsung, Dell, Goldman Sachs, Google are all foreign companies
having their place of operations in India.

5. Holding Company: In accordance with Section 4(4) of the Companies Act

1956, a company is deemed to be a holding company if the other company is
its subsidiary company. A company shall be deemed to be a subsidiary of
another if the composition of its board of directors is controlled by that other
company.
 284

Pertinently, types of company as outlined above determine the legal requirements

and their proper compliance in respect of preparation, presentation of financial
statements, and the obligation of the board of directors for disclosures and
management report.

Diagram 1: Types of companies

2.3 Salient Features of a company

Before we proceed to discuss company accounts, it is advisable that you must

know the following salient features of a company:

1. Incorporation: a company, which is regarded as an artificial legal person

comes into existence only through the operation of law. It must be
incorporated and registered under the Companies Act to obtain its legal
personality.

2. Separate Entity: a company is a distinct legal entity separate from its

members, management and shareholders. Having a separate and distinct
entity or legal personality, it can contract, sue or be sued in its own
incorporated name and capacity.

3. Perpetual Succession: a company enjoys continuous existence and its

continuance is not affected by the death, insolvency, mental or physical
incapacity of its members. It is created under the provisions of company law
and can be wound up in accordance with the provisions of company law
alone.
 285

4. Common Seal: as a company is an artificial person, it cannot sign

documents or contracts as a natural person. A company therefore has a
common seal, which is the signature of that company and signifies common
consent of all the members. The company's seal is affixed on all the
documents executed for and on its behalf.

5. Distinction between Ownership and management: shareholders or

members who are very large in number and scattered over the country or
even over the world cannot participate in the day-to day management of the
company. So the members elect the board of directors and managers for
management of the company.

6. Limited Liability: the significance of the word “limited” or “Ltd” signifies

that the liability of every shareholder is either limited by shares or by
guarantee. The liability of its members is limited to the amount remaining
unpaid on the shares subscribed by them. Thus, in case of fully paid-up
shares, the members cannot be asked to contribute any further, if the
company goes into liquidation.

7. Transferability of Shares: a Company’s Capital is raised from the

shareholders through their subscription in shares issued by the company.
Such shares are transferable by its members except in case of private
companies where there are certain restrictions for such transfer.

8. Maintenance of Books of Accounts: a company registered under the Act is

required by law to maintain a prescribed set of books of accounts as
discussed hereinafter and any failure in this regard attracts statutory
penalties.

9. Annual Audit: a limited company is required by the Act to get its annual
accounts audited by the Chartered Accountants appointed by the shareholders
in the annual general meeting on the recommendation of the board of
directors.

10. Access to information and books: The Articles of Association govern the
shareholders’ right to inspect the company’s books of accounts with the
exception of books open for inspection under statute. Shareholders have the
right to seek information from the directors through participation in the
meeting and through the periodic reports as stipulated by the statute.
 286

Diagram 2: Salient features of a company

A foreign company is one that is:

A Incorporated or registered in India but has a place of business or operations

outside India
B Incorporated or registered outside India and has a place of business or
operations outside India
C Incorporated or registered outside India but has a place of business or
operations in India
D None of the above
 287

3. State the provisions of the Companies Act relating to

maintenance of proper books of account
[Learning Outcome c]

3.1 Legal Requirements of Company Accounts

In order that the students may be able to appreciate the provisions for statutory
books to be maintained by a company, the manner the financial statements to be
prepared and presented, the students should thoroughly study the specific chapter
dedicated to Accounts in the Companies Act 1956 (as amended now). In this
Learning Outcome, only the important requirements of the Act as regards
maintenance of accounts are discussed. In this regard the provisions of following
sections Sec. 209, S.210, S. 211, S.212, deserve special mention.

Section Particulars
Section 209 Books of account to be kept by company
Section 210 Annual accounts and Balance Sheet
Section 211 Form and contents of Balance Sheet and Statement of Profit
and Loss
Section 212 Balance sheet of holding company to include certain
particulars as to its subsidiaries

3.2 Books of Accounts to be kept by company (Section 209)

Section 209 of the Companies Act 1956 prescribes the books of accounts to be
maintained by every company at its registered office. In accordance with Section
209 of the Act every company shall keep at its registered office proper books of
accounts regarding:

a) all sums of money received and expended by the company and the matters in
respect of which the receipt and expenditure take place
b) all sales and purchases of goods of the company
c) the assets and liabilities of the company
d) such other particulars as may be required by the Central Government to
include in the books of accounts in case of a company pertaining to any class
of companies engaged in production, processing, manufacturing or mining
activities.
 288

3.3 Time limit for preservation of books of account

The sub section 4A of Section 209 requires that these books of account along
with relevant vouchers must be preserved in good order for a minimum period of
8 years in the case of existing companies. However if any company which is less
than 8 years old, books of accounts need to be preserved for the entire period
from the previous year.

3.4 Responsibility of maintaining books of account

The primary responsibility of maintenance of books of account is that of the

Managing Director or Manager and all officers or other employees who have
been given the responsibility by the Board of Directors. If the company has
neither a Managing Director nor a Manager, then all the directors are collectively
responsible.

As per Companies Act 1956, for existing companies, books of account along
with relevant vouchers must be preserved in good order for a minimum period of:

A 5 years
B 7 years
C 8 years
D 10 years

4. Discuss the accounting treatment of share capital with

respect to issue, reissue and forfeiture.
[Learning Outcome d]

The prospectus issued under Section 56 of the Companies Act, 1956 must specify
the following matters in regard to capital structure of the company as specified in
Schedule II:

a) Authorized, issued, subscribed and paid-up capital

b) Size of present issue-preferential allotment to promoters and others.
c) Paid up capital-After present issue and after conversion of debentures, if any
d) Terms of the present issue-terms of payment, terms of application and special
tax benefits
 289

4.1 Issue of shares and accounting entries

A company is required to pass the following accounting entries in the financial

books on the various stages of issue of shares.

Particulars Debit A/c Credit A/c Amount

1. Receipt of share Bank A/c Share Amount
application money application received
A/c
2. Allotment of i) Share Share Capital Total amount.
Shares Application A/c due on
A/c application
ii) Share and allotment
Allotment A/c
3. Receipt of Bank A/c Share Amount
application money Allotment A/c received
4. on Refund of Share Bank A/c Amount
application Application A/c refunded
money*
5. Allotment of a part Share Share Amount held
of shares applied-- Application A/c Allotment A/c in credit to
in case of over & Calls -in- these A/c s
subscription Advance A/c
6. On a Call being Share Call A/c Share Capital Call amount
made A/c
7. Adjustment of Calls-in- Share Call A/c Amount held
money in Calls in Advance A/c to the credit of
advance Calls in Adv.
8. Receipt of Call Bank Account Share Call A/c Amount
Amount received

Note:

* When an issue is oversubscribed, some of the application will be rejected and

application money may be refunded

+ Sometimes separate Application A/c and Allotment A/c are not prepared and
entries relating to share application and share allotment monies are passed
through a combined account called Share Application and Allotment Account.
 290

Issue of Equity Shares – Beauty Soaps Ltd

In January 2010, Beauty Soaps Ltd. invited applications for 1,50,000 equity
shares of Rs.10 each issued at Rs.12 including premium of Rs.2 payable as
follows:

On application by 1 March 2010 Rs.6 per share

On allotment by 31 March 2010 (including premium) Rs.4 per share
On First & Final Calls Rs.2 per share

The company received 1,80,000 applications and made allotment of shares in

compliance with the provisions of Section 73 of the Companies Act 1956 in the
following manner in arrangement with the authorities of a recognized stock
exchange. The Company completed the allotment process and intimated the
applicants as per Board’s Resolution dated 10 May 2010.

i) To reject applications for 8,000 shares as ineligible / incomplete

ii)To make full allotment for applications for 22,000 shares
To make pro-rata allotment for remaining applications
iii)
iv)To utilize the surplus money received on applications against the amounts
due on allotments.
v) All allotment money was received in time. The company has not yet made
First and Final Calls.

Required:

Pass the necessary journal entries to record the above financial transactions on
issue of shares. Also show the Share Application and Allotment A/c, Equity
Share Capital and Bank Account as on 31st March 2010.
 291

Solution
Beauty Soap Ltd
Journal Entries

Debit Credit
Date Particulars
Amount Amount
2010 Bank A/c Dr 10,80,000
To Share Application and
March 1 10,80,000
Allotment A/c
(Being Application money received on
1,80,000 shares @Rs.6 per share)

March 10 Share Application and Allotment A/c Dr 15,00,000

To Equity Share Capital A/c 12,00,000
To Securities Premium A/c 3,00,000
(Being application and allotment money
on 1,50,000 shares @ Rs.8 and Rs.2
being transferred to Share capital and
Securities premium respectively vide
Board’s resolution dt.10.5.2010)

March 10 Share Application and Allotment A/c Dr 48,000

To Bank Account 48,000
(Being Application money refunded on
8,000 shares as per Board’s Resolution
dt.10.5.10)

March 31 Bank A/c Dr 468,000

To Share Application and
468,000
Allotment A/c
(Being Allotment money received on
1,50,000 shares @ Rs.4 per share less
Rs,1,32,000 received in advance on
22,000 shares as application
money@Rs.6 each)

For Mock Test Visit:

https://irdaexam.in/
 292

Bank Account
Dr Cr
Date Date
By Share
To Share
Application
Application
March 1 10,80,000 March 10 and 48,000
and Allotment
Allotment
A/c
A/c
To Share
Application By Balance
March 1 4,68,000 March 31 15,00,000
and Allotment C/D
A/c

15,48,000 15,48,000
To Balance
15,00,000
B/D

Share Application and Allotment A/c

Dr Cr
Date Particulars Amount Date Particulars Amount
To Share By Bank
March 10 12,00,000 March 1 10,80,000
Capital A/c A/c
To Securities By Bank
March 10 3,00,000 March 31 4,68,000
Prem. A/c A/c
March 10 To Bank A/C 48,000

15,48,000 15,48,000

Equity Share Capital A/c

Dr Cr
Date Particulars Amount Date Particulars Amount
By Share
Application
By Balance
March 31 12,00,000 March 10 and 12,00,000
C/d
Allotment
A/c
12,00,000 12,00,000
By Balance
12,00,000
B/D
 293

Securities Premium A/c

Dr Cr
Date Particulars Amount Date Particulars Amount
By Share
Application
By Balance
March 31 3,00,000 March 10 and 3,00,000
C/d
Allotment
A/c
3,00,000 3,00,000
To Balance
3,00,000
B/D

4.2 Forfeiture of shares

In case any shareholder fails to pay any call money on the day appointed for
payment, the directors of the company may, with the express provisions in its
articles, proceed to forfeit the shares held by such defaulting shareholders after
serving them with prior notice in this regard.

When shares are forfeited, the defaulting shareholder’s name is removed from the
Register of members.

a) Procedure for forfeiture of shares

The authority to forfeit shares is given to the Board of Directors in the Articles of
Association of the company. The Board of Directors has to give at least fourteen
days’ notice to the defaulting members calling upon them to pay the outstanding
amount with or without interest as the case may be before the specified date. The
notice must also state that if the shareholders fail to remit the amount mentioned
therein within the stipulated period, their shares will be forfeited. If they still fail
to pay the amount within the specified period of time, the Board of Directors of
the company may decide to forfeit such shares by passing a resolution.

The decision regarding the forfeiture of shares is then communicated to the

concerned allottees and they are asked to return the allotment letters and share
certificates of the forfeited shares to the company.
 294

b) Treatment of Securities Premium A/c on forfeiture

If the shares are issued at premium, the premium amount so collected is treated in
accordance with the provisions of Section 78 of the Companies Act 1956.
According to the said provisions, premium once collected cannot be cancelled
even if that share is forfeited later on. However if a share on which premium has
become due, but has not been received, is forfeited, and then any credit given to
Securities Premium A/c is to be reversed.

James, a shareholder holding 100 shares of Rs.10 each, has paid application
money of Rs.2 per share and allotment money of Rs.3 per share, but has failed to
pay the first call of Rs.2 per share and second call of Rs.3 per share. His shares
were forfeited.
Required
Make the journal entry to record the forfeiture of shares.
Solution:

Share Capital A/c (100 × Rs.10) Dr. Rs.1,000

To Share forfeited A/c (100 × Rs.5) Rs.500
To Share First Call A/c (100 × Rs.2) Rs.200
To Share Second and Final Call A/c (100 × Rs 3) Rs.300
(Being forfeiture of 100 shares)

4.3 Reissue of forfeited shares

Furthermore, shares forfeited on non-payment of call money can be re-issued by
the company as per the provisions of the Articles. The company can reissue such
forfeited shares at any price it likes. But in no case the amount so collected on the
re-issue of shares plus the amount already collected from the defaulting member
shall be less than the amount credited as paid up on re-issue of shares.
a) Accounting treatment for reissue of forfeited shares
The forfeited shares are reissued as fully paid and at a discount. The amount of
discount allowed cannot exceed the amount that had been received on forfeited
shares on their original issue, and that the discount allowed on reissue of forfeited
shares should be debited to the ‘Share Forfeited Account’. The balance, if any,
left in the Share Forfeited Account, should be treated as capital profit and
transferred to Capital Reserve Account.
 295

PQR Ltd forfeits 200 shares of Rs.10 each on which Rs.600 had been received; it
can allow a maximum discount of Rs.600 on their reissue. An amount of Rs.600
is credited to Share Forfeited A/c. Assuming that the company reissues these
shares for Rs.1,800 as fully paid, the discount on issue of shares of Rs.200 is
provided from Share Forfeited A/c and the balance of Rs.400 is transferred to
Capital Reserve A/c.

b) Accounting entries on Forfeiture and Re-issue of shares

Particulars Debit A/c Credit A/c Amount

Forfeiture Share Capital A/c Called-up
of Shares amount
Share Calls A/c Amount due,
Share Forfeited A/c but not paid
Amount
already
collected
Re-issue of i. Bank A/c Amount
shares(On ii. Sh. Forfeited A/c actually
Discount) received
Discount
Amount
Share Capital A/c Amount paid-
up
Transfer of Share Forfeited A/c Balance in
Balance in Capital Reserve A/c Share
Share Forfeiture to
Forfeiture Capital Reserve
to Capital A/c
Reserve
A/c

Taking the same data as in the previous example of Beauty Soaps Ltd, pass the
journal entries assuming that the company called for First & Final call money on
31st May 2010. The company realized all call monies except from the member to
whom 400 shares were allotted. His shares were forfeited 30 June 2010 by the
Board of Directors as per the provisions of the Articles. These shares were
reissued at Rs. 9 per share on 30 July 2010.
 296

Solution

Journal Entries in the books of Beauty Soaps Ltd

Debit Credit
Date Particulars
Amount Amount
2010
May 31 Share First and Final Call A/c Dr 3,00,000
To Equity Share Capital A/c 3,00,000
Being amount due on 150,000 shares in
respect of First & Final Call as per
Board’s resolution
May 31 Bank A/c Dr 2,99,200
To Share First and Final Call 2,99,200
A/c
Being First &Final call money received
on 1,49,600 shares @ Rs.2 per share
June 30 Equity Share Capital A/c Dr 4,000
To Share First and Final Call 800
A/c 3,200
To Share Forfeited A/c
Being 400 shares forfeited for non-
payment of First & Final call as per
Board’s Resolution
July 30 Bank A/c Dr 3,600
Share Forfeited A/c Dr 400
To Equity Share Capital A/c 4,000
Being 400 shares reissued @ Rs.9 per
share
July 30 Share Forfeited A/c Dr 2,800
To Capital Reserves 2,800
Being balance in the Shares Forfeited
A/c Transferred to Capital Reserve
 297

4.4 Forfeiture of shares allotted on a pro-rata basis

If the shares issued by the company are over-subscribed, the company may allot
shares to applicants in the ratio of shares for which applications are entertained
by the company for allotment and the number of shares the company has offered
for subscription. This is called allotment of shares on pro-rata basis. In case of
pro-rata allotment the excess money received on applications is transferred to
Share Allotment A/c from Share Application A/c. In case a shareholder fails to
make payment on allotment and call money of shares held by him/her, the unpaid
amount will be calculated as under:

i) Number of shares applied for allotment =

Total No. of shares applied x Shares allotted to defaulter

Total shares allotted

ii) Calculate excess applications received = Number of shares applied for (as per
step i) – number of shares allotted

iii) Calculate excess application money received = Excess number of applied

shares x money called per share on application

iv) Amount unpaid on allotment = Amount due on allotment – excess

application money adjusted towards allotment

Re-issue of Shares forfeited, in case of pro-rata allotment

Super Computer Ltd issued a prospectus inviting application for 10,000 equity
shares of Rs.100 each to be issued at a premium of Rs.20 per share.
On 1 January 2009, the company received 24,000 applications. The Board
rejected 4,000 shares and refunded the application money on 1 February, 2009
when the remaining applicants were allotted shares on pro rata basis on the
following terms of payments specified in the prospectus:

On Application Rs.30
On Allotment (including premium) Rs.40
On First Call Rs.25
On Final Call Rs.25
 298

Allotment money was received in full on 15 February 2009. First Call was made
on 15 April, 2009 and received on 2 May 2009 for all but 50 shares allotted to
Mr. X. He was served the notice for payment of the amount due on allotment, but
he failed to pay on the stipulated time. His shares were forfeited on 1 September
2009 and reissued on 15 September at Rs.100 per share. Final Call was made on
1 October and received on 15 October 2009 for all but 200 shares held by Y.
Required:
Pass necessary journal entries and also show Share Capital A/c
Solution
Super Computer Ltd
Journal Entries
(Amount in Rs.)
Date Particulars Debit Credit
2009
Jan.1 Bank A/c Dr 7,20,000
To Share Application A/c 7,20,000
(Being application money received
on received 24,000 applications @
Rs.30 per share)
Feb. 1 Share Application A/c Dr 7,20,000
To Equity Share Capital A/c 3,00,000
To Share Allotment A/c 3,00,000
To Bank A/c 1,20,000
(Being Share Application money
for10,000shares transferred to
Equity Share Capital A/c, money for
10,000 shares adjusted towards
allotment money and balance money
on 4,000 shares refunded)
Feb. 1 Share Allotment A/c Dr 4,00,000
To Equity Share Capital A/c 2,00,000
To Security Premium A/c 2,00,000
(Being Allotment money of Rs.40
per share including share premium
of Rs.20 per share due on 10,000
shares)
Feb.15 Bank A/c Dr 1,00,000
To Share Allotment A/c 1,00,000
(Being Allotment money after
adjustment received in full)
 299

Super Computer Ltd

Journal Entries
(Amount in Rs.)
Date Particulars Debit Credit
2009
April 15 Share First Call A/c Dr 2,50,000 2,50,000
To Equity Share Capital A/c
(Being Share first Call money at
Rs.25 per share due on First call
made on 10,000 shares)
May 2 Bank A/c ………………………. Dr 2,48,750
Calls-in-Arrear A/c ……………. Dr 1,250
To Share First Call A/c … 2,50,000
(Being First call money received in
full except for 50 shares)
Sept 1 Equity Share Capital A/c Dr 3,750
To Calls in Arrear A/c 1,250
To Share Forfeited A/c 2,500
(Being 50shares forfeited for non-
payment of First Call money)
Sept 15 Bank A/c Dr 5,000
To Equity Share Capital A/c 3,750
To Securities Premium A/c 1,250
(Being 50shares reissued @ Rs.100
each)
Forfeited share A/c Dr 2,500
To Capital Reserve A/c 2,500
(Being profit on re-issue of forfeited
shares transferred to capital reserve)
Oct. 1 Share 2nd& Final Call A/c Dr 2,50,000
To Equity Share Call A/c 2,50,000
(Being Final Call money at Rs.25
per share due on final call made on
10,000 shares)
Oct 15 Bank A/c Dr 2,45,000 2,50,000
Calls in Arrear A/c Dr 5,000
To Share 2nd& Final Call
A/c
(Being Final Call money received in
full except of 200 shares)
 300

The balance in Share Forfeited Account after the reissue of forfeited shares is
transferred to:
A General reserve A/c
B Capital redemption reserve A/c
C Capital reserve A/c
D Revenue reserve A/c

5. Discuss buy-back of shares and study the condition for

buy back of shares
[Learning Outcome e]
5.1 Meaning of buy-back of shares

Buy-back of shares means repurchase by the company of its own shares.

Buy-back may take place either at par or premium or discount in compliance

with the provisions of Sec.77A and Sec.77B of the Companies Act 1956. With
the repurchase, the par value of shares repurchased is reduced from the equity
capital. Any excess paid on repurchase is to be debited to Reserves & Surplus
A/c.

5.2 Advantages of buy-back of shares

1. Buy–back of shares reduces equity value and increases earnings per share
(EPS) or Dividend per share (DPS).

2. It facilitates managing the surplus cash and maintaining target capital by

way of the returning the same to investors.

3. Sometimes buy-back of shares is adopted to maintain the share price in the

share market and keep the sentiments of the investors high. For example,
Bajaj Auto went on a massive buy-back in 2000 and recently Reliance Ltd
also bought back some shares to keep the sentiments of the investors high.

4. A company buys back its shares when the prices are low and reissues shares
at a later date at good prices, thus making profit.
 301

5.3 Resources of buy-back

The Companies Amendment Act 1999 under section 77A prescribes for
the sources of buying back of shares or other specified securities by a
company, which are as follows:

1. Free reserves- a company may buy back out of its free reserves but a
sum equal to the nominal value of the shares so purchased must be
deposited in the capital redemption reserves account.
2. Securities premium account
3. The proceeds of any shares or specified securities.

No buy back of any shares or securities shall be made out of the proceeds
of an earlier issue of the same kind of shares or same kind of securities.

5.4 Conditions for a buy-back

Sub clause (2) of Section 77A enshrines the conditions for a buy back, which are
as follows:

a) It should be authorised by the articles of association of the company.

b) A special resolution has been passed at the general meeting of the company
authorising the buy back.

c) If the buy-back is equal to or less than 10 percent of the total paid up equity
share capital, a resolution at the general meeting is not needed to be passed;
rather, a simple board resolution is enough.

d) Provided that no offer of buy back shall be made within three sixty five days
reckoned from the date of proceeding offer of buy back.

e) The buy-back is equal to or less than 25 percent of the total paid up equity
share capital and free reserves

f) The ratio of debt owned by the company is not more than twice the capital
and its free reserves after such buy back.

g) All the shares or other specified securities for buy back are fully paid up.
 302

h) A company cannot issue the same kind of shares or security for a period of
24 months after completion of buy-back

i) Money borrowed from bank or financial institution cannot be utilized for buy
back purpose

j) A company having defaulted in repaying fixed deposits or interest thereon or

in redemption of preference shares or debentures cannot buy back its shares.

k) A company having defaulted in filing annual returns, in preparation of

financial statements or whose accounts have failed to exhibit.

l) The buy-back of shares or other specified securities listed on any recognised

stock exchange is in accordance with the regulations made by the Securities
and Exchange Board of India in this behalf.

m) The buy back in respect of shares and other specified securities other than
those specified in the aforesaid clause is in accordance with the guidelines
specified.

5.5 Accounting Entries on Buy-Back

Particulars Debit A/c Credit A/c Amount

Shares Bought Share Capital A/c Bank A/c Nominal
Back Value of
shares bought
back
Premium Paid on Free Reserves/ Bank A/c Premium
buy back Security Premium Amount
A/c
Discount on buy- Share Capital Capital Discount
back Reserve Amount
Transfer of free Free Reserves CRR Nominal
Reserves Account value of
shares bought
back
Expenses on Buy- Buy-back Expenses Bank A/c
back
 303

Following is the Balance Sheet of Good Luck Ltd as at 31 March 2010

Balance Sheet of Good Luck Ltd as at 31 March 2010

Rs. Rs.
Authorized Capital 10,00,000 equity Shares 100,00,000
of Rs.10each
Equity and liabilities
Shareholders’ funds
Share capital 100,00,000
Subscribed& Paid-up Capital 10,00,000
equity Shares of Rs.10each -fully paid

Reserves & Surplus

Revenue reserves 2,20,00,000
Capital reserves 20,00,000
Security premium 20,00,000 2,60,00,000

Current liability 40,00,000

Total equity and liabilities 4,00,00,000

Assets
Non-current assets
Gross value 2,00,00,000
Less: depreciation (1,00,00,000) 1,00,00,000
Investments (Market Value Rs200,00,000) 50,00,000

Current assets
Trade receivables 40,00,000
Stock 50,00,000
Cash and bank balance 1,60,00,000 2,50,00,000
Total assets 4,00,00,000

The company bought back 5,00,000 equity shares of Rs.10 each at Rs.20
per share as per board resolution dated 15 April 2010 in view of huge
unutilized cash & Bank Balance.
 304

Required:

You are required to give the necessary journal entries. Also prepare the
Balance Sheet after the buy-back transactions are recorded.

Solution:

Journal Entries on Buy-back

In the books of Good Luck Company

Debit Credit
Date Particulars
Amount Amount
15/04/10 Equity Share Capital A/c ---- Dr 50,00,000
Revenue Reserves A/c ---- Dr 50,00,000
To Bank A/c 1,00,00,000
Being 5,00,000 equity shares of
Rs.10 each bought back at Rs.20
per share as per board resolution
dt.15.4.2010
15/04/10 Revenue Reserves A/c ---- Dr 50,00,000
To Capital Redemption 50,00,000
Reserves
Being transfer of free Reserves
to capital redemption Reserve to
the extent of nominal

Balance Sheet of Good Luck Ltd as at 15 April 2010 (After Buy-back)

Rs. Rs.
Authorized Capital 10,00,000 equity Shares of 100,00,000
Rs.10each
Equity and liabilities
Shareholders’ funds
Share capital 50,00,000
Subscribed& Paid-up Capital 5,00,000 equity
Shares of Rs.10each -fully paid

Reserves & Surplus

Revenue reserves 1,20,00,000
 305

Rs. Rs.
Capital reserves 20,00,000
Security premium 20,00,000
Capital redemption reserve 50,00,000 2,10,00,000

Current liability 40,00,000

Total equity and liabilities 3,00,00,000

Assets
Non-current assets
Gross value 2,00,00,000
Less: depreciation (1,00,00,000) 1,00,00,000

Investments (Market Value Rs.200,00,000) 50,00,000

Current assets
Trade receivables 40,00,000
Stock 50,00,000
Cash and bank balance 60,00,000 1,50,00,000
Total assets 3,00,00,000

According to Sub clause (2) of section 77A, one of the conditions of buyback is:

A The buy-back is equal to or less than 25% of the total paid up equity share
capital and free reserves
B The buy-back is more than 25% of the total paid up equity share capital and
free reserves
C The buy-back is equal to or less than 10% of the total paid up equity share
capital and free reserves
D The buy-back is more than 10% but less than 25 % of the total paid up equity
share capital and free reserves
 306

6. Discuss the various Employees Stock Option Plan

(ESOP) issued by companies, along with their accounting
treatment.
[Learning Outcome f]

Employee Stock Option Plan (ESOP)

6.1 Meaning

Employee Stock Option Plan known as ESOPs is an employee compensation

system providing for sharing of corporate wealth and profit by the employee.
Under the scheme an employee is given an option to buy shares of the company
at less than the market price and the employee gets the benefit when the share
prices rise. ESOPs give right to the employee to buy shares at the specified price
during specified period.

6.2 Definition

Sec 2(15A) defines the employees stock options as “ the option given to the
whole-time director, officers, or employees of the company, which gives right to
directors, officers, or employees of the company to purchase or subscribe at a
future date the securities offered by the company at a predetermined price’

Under the Employee Stock Option Scheme, a right but not an obligation is
granted to the employees to apply for the shares of the company at a pre-
determined price.

There are several ways in which employees buy shares through ESOS – they may
purchase shares out of their own funds or they borrow money from the company
to purchase shares.

In this regard the SEBI has issued detailed guidelines called SEBI (Employee
Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines 1999.
The said guidelines are applicable to all companies having their shares listed on
any recognized stock exchange in India.
 307

The guidelines provide for two schemes namely

Diagram 3: Employee stock option & stock purchase scheme

6.3 Why do companies set up ESOPs for Employees?

There are several reasons for issuing ESOPs. The major reasons include:

a) ESOPs act as a motivator to the employee and can get employees highly
involved in their jobs and focused on corporate performance.
b) ESOPs play a vital role in attracting and retaining employees, and fostering
long term attitudes.

c) As a compensation tool, ESOPs offer rewards that can exceed the

expectations of employees but are still affordable to the company as they are
highly performance driven.

d) ESOPs are also used for granting retirement benefits to employees and as
succession plan for owners.

e) Strategically, economically, financially or philosophically ESOPs are a win-

win combination.

6.4 Employee Stock Option Scheme (ESOS)

Eligibility to participate in ESOS- An employee shall be eligible to participate

in ESOS of the company (whether working in India or out of India). But
employees who are promoters or who belong to the promoter group shall not be
eligible to participate in ESOS. A director who either by himself or through
anybody corporate, directly or indirectly holds more than 10% outstanding shares
of the company is not eligible for participation in the scheme.
 308

Shareholders’ approval - The shareholders must approve the scheme by passing

a special resolution in the general meeting.

Pricing and lock-in period - The company granting ESOS will have the
freedom to determine the exercise price. There shall be a period of at least one
year between the grant of options and vesting of options. Vesting means the
process by which the employee is given right to apply for the shares of the
company in pursuance of the scheme. The option granted to the employee is
neither transferable nor can be pledged or hypothecated or mortgaged.

Accounting for ESOS

Schedule I of the SEBI (Employee Stock Option Scheme and Employee Stock
Purchase Scheme) guidelines, 1999 provides the accounting policies to be
followed for ESOS. These are discussed below:

a) The accounting value of options shall be treated as employee compensation

in the financial statements.

b) The accounting value is aggregate of the fair value of the options of all
employee stock options granted during the financial year.

c) Fair value means option discount.

d) Option discount means the excess of the market price of the share at the date
of grant of option over the exercise price of the option.

e) The accounting value of options as employee compensation shall be

amortized on a straight line basis over the vesting period.

f) When an unvested option lapses due to non-vesting of the employees, after

accounting value of the option has already been accounted for as employee
compensation, the said accounting treatment is to be reversed by credit to the
employee compensation expenses equal to the amortized portion of the
accounting value of the options thus lapsed.

g) When a vested option lapses on the expiry of the exercise period, after the
fair value of the options is accounted for employee compensation, this
accounting treatment shall be reversed by credit to employee compensation
expenses.
 309

ABC Ltd offered 1000 options for ESOS on 01 January 2007 at Rs.50 for each
share of Rs.10 each when the market price of equity was Rs.150. The vesting
period for the said ESOS is two and a half years and the maximum exercise
period is one year. 600 options have been exercised on 15 February 2010. 100
options vested but lapsed at the end of the exercise period.

Required:

Show journal entries. Also show Employee Stock Options Outstanding Account
and Deferred Employees Compensation Expenses Account.

Solution

Accounting Value of the option= Total Option Discount x No of options = 1000

(i.e. 150 - 50) x 1,000 options = Rs.1,00,000
(Amount in Rs.)
Date Particulars Debit Credit
01/01/07 Deferred Employee Compensation Dr 1,00,000
Expenses A/c
To Employee Stock Options 1,00,000
outstanding A/c
(Being grant of 1,000 options at a
discount of Rs.100 each)
31/12/07 Employee Compensation Expenses Dr 40,000
A/c
To Deferred Employee 40,000
Compensation Expenses A/c
(Being amortization of deferred
employee compensation over two
and a half years on straight line basis)
31/12/08 Employee Compensation Expenses Dr 40,000
A/c
To Deferred Employee 40,000
Compensation Expenses A/c
(Being amortization of deferred
employee compensation over two
and a half years on straight line basis)
 310

Date Particulars Debit Credit

01/02/09 Employee Stock Options outstanding A/c Dr 30,000
To Employee Compensation
Expenses A/c 24,000
To Deferred Employee
Compensation Expenses A/c 6,000
(Being reversal of employee
compensation expenses on lapse of 300
unvested options)
30/06/09 Employee Compensation Expenses A/c Dr 14,000
To Deferred Employee
Compensation Expenses A/c 14,000
Being amortization of deferred employee
compensation over two and a half years
on straight line basis
31/03/10 Cash/ Bank A/c Dr 30,000
Employee Stock Options outstanding A/c Dr 60,000
To Equity Capital A/c
To Security Premium A/c 6,000
(Being exercise of 600 options at the 84,000
specified exercise price of Rs.50 each at
accounting value of Rs.150 each)
01/07/10 Employee Stock Options outstanding A/c Dr 10,000
To Employee Compensation
Expenses A/c 10,000
(Being reversal of Compensation
accounting on lapse of 100 vested
options)

Employee Stock Options Outstanding Account

Dr. Cr.
Date Particulars Amount Date Particulars Amount
01.02.09 To Employee 24,000 1-1-07 By Deferred 1,00,000
Compensation Employee
Exp A/c Compensation
Expenses A/c
To Deferred 6,000
Employee
Compensation
Expenses A/c
 311

Dr. Cr.
Date Particulars Amount Date Particulars Amount
31.03.10 To Equity 60,000
Share Capital
&Security
Prem. A/c
01.07.10 To Deferred 10,000
Employee
Compensation
Expenses A/c
100,000 1,00,000

Deferred Employees Compensation Expenses Account

Dr. Cr.
Date Particulars Amount Date Particulars Amount
01.01.07 ESO* 1,00,000 31.12.07 Employee 40,000
outstanding Compensation
A/c Exp.
31.12.08 Employee 40,000
Compensation
Exp.
01.02.09 ESOS 6,000
Outstanding
30.6.09 Outstanding 14,000
Employee
Compensation
1,00,000 1,00,000

*ESO – Employee Stock Options

6.5 Employee Stock Purchase Scheme (ESPS)

In this scheme the company offers shares to the employees as a part of public
issue or otherwise. The criteria for eligibility, lock-in period, pricing,
shareholders’ approval as applicable to ESOS is also applicable to ESPS.
Accounting for ESPS
Schedule II of the SEBI (Employee Stock Option Scheme and Employee Stock
Purchase Scheme) guidelines, 1999 provides the accounting policies to be
followed for ESPS. These are discussed below:
a) The accounting value of the shares so issued shall be also treated as another
form of employee compensation in the financial statements of the company.
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b) The accounting value of the shares so issued shall be equal to the aggregate
of price discount over all shares issued under ESPS. For this purpose price
discount means the excess of the market price of the shares on the date of
issue over the price at which they are issued.

BC Ltd issued 1,000 options on 1 April 2010 for ESPS at Rs.50 for each
share of Rs.10 each when the market price of equity was Rs.150.

Solution

Accounting Value of the option = Total Option Discount x No of options

= 100 (i.e.150-50) x 1,000 options = Rs.1,00,000

Journal Entries
(Amount in Rs.)
Date Particulars Debit Credit
01.04.10 Cash/Bank A/c 50,000
Employee Compensation Expense A/c 1,00,000
To Equity Capital (paid-up) A/c 10,000
To Security Premium A/c 1,40,000
Being issue of 1,000 under ESPS at the
price of Rs.50 each while market value
being Rs.150 each

The accounting value of options granted under an Employee Stock Option Plan
shall be:

A Treated as shares issued on discount

B Treated as employee compensation in the financial statements
C Reduced from share premium account
D Reduced from Share Capital Account
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7. Discuss the accounting treatment of redemption of

preference shares.
[Learning Outcome g]
In this Learning Outcome, we will discuss in brief:

9 Process and purpose of issuing redeemable preference shares

9 Legal provisions in respect of redemption of redeemable preference shares
9 Methods of redemption and
9 Accounting treatment

7.1 Process and purpose of issuing redeemable preference shares

A company limited by shares if so authorised by its Articles, may issue

preference shares which at the option of the company, are liable to be redeemed.
However, there should be proper compliance of the legal aspects emerging from
various provisions of the Companies Act 1956 (as amended) while issuing
redeemable preference shares.

A company sometimes may issue redeemable preference shares for raising funds
in a dull primary market when it faces difficulty in raising equity capital. The
potential investors who are hesitant in investing in equity shares of the company
may invest in redeemable preference shares having preferential treatment of
distribution of surplus of the company over the equity shares. Such redeemable
preference shares are redeemed when the company finds surplus of capital
(overcapitalization) and cannot utilize such surplus funds in the business for a
profitable purpose.

7.2 Legal Provisions with respect to issue of preference shares

Issue and redemption of preference shares are governed by Section 80 of the

Companies Act, 1956, which provides that:

1. A company limited by shares, if authorized by its Articles, may issue

preference shares, which at the option of the company are liable to be
redeemed.
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2. No shares can be redeemed except out of profit of the company, which would
otherwise be available for dividend or out of proceeds of fresh issue of shares
made for the purpose of redemption.

3. No such shares can be redeemed, unless they are fully paid.

4. The premium, if payable on redemption, must be provided for out of the

profits of the company or out of the Share Premium Account of the company.

5. Where any such shares are redeemed, otherwise than out of the proceeds of a
fresh issue, there shall, out of profits, which would otherwise have been
available for dividends, be transferred to a Reserve Account called “Capital
Redemption Reserve, a sum equal to the nominal amount of the shares
redeemed.

As per the Companies (Amendment) Act 1996, a company cannot issue any
preference share, which is irredeemable or is redeemable after the expiry of a
period of twenty years from the date of its issue.

7.3 Methods of Redemption

Redemption of preference shares means repayment of the amount obtained by a

company on issuance of preference shares in compliance with the provisions of
the Companies Act 1956.

Redemption of preference shares can be done either by fresh issue of shares or

out of distributable profits being retained and transferred to Capital Redemption
Reserve Account.

Section 80 of the Companies Act 1956 deals with the process and rules of
redemption of redeemable preference shares. The underlying objective of the
legal provisions for redemption is to ensure that there is no reduction in
shareholders’ fund and outsiders’ interests are not impaired due to redemption.

The legal provisions as discussed above precisely show that redemption of

redeemable preference shares can be effected in any of the following three
methods:
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Diagram 4: Methods of Redemption

7.4 Accounting treatment

Accounting entries depend on the methods of redemption. We have to discuss

separately the accounting entries for each of the methods.

a) Redemption by fresh issue of shares

A fresh issue of share may be on three situations:

9 Issue at par
9 Issue at a Premium and
9 Issue at a discount

Furthermore redemption may be on two situations:

9 Redemption at par and
9 Redemption at a premium

Let us discuss here accounting entries for redemption of preference shares

keeping in view the above situations.

1 Fresh Issue at par

(a) Bank A/c Dr ….
To Share Capital Account …..
Being issue of ……shares of Rs…. each at par for
redemption of preference shares as per Board
Resolution No. dated……
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or Fresh Issue at a Premium

(b) Bank A/c Dr. ….
To Share Capital Account …..
To Security Premium Account …..
Being issue of…shares of Rs…. each at a premium
Rs...for redemption of preference shares as per Board
Resolution No. dated
or Fresh Issue at a Discount
(c) Bank A/c ……… Dr ….
Discount Account …………………… Dr ….
To Share Capital Account ……………… …..
(Being issue of…shares of Rs…. each at discount Rs.
for redemption of preference shares as per Board
Resolution No. dated…)
2 Redemption of preference share at par Dr
(a) Redeemable Preference Share Capital A/c -----
To Preference Shareholders Account ……… ------
or Redemption of preference share at a Premium
Redeemable Preference Share Capital A/c Dr ----
(b) Premium on Redemption of Pref. Shares A/c Dr ----
To Preference Shareholders Account ------
3 Payment to preference shareholders
Preference Shareholders Account ------------------------ Dr -----
To Bank A/c --------------------------------------- -------
4 Adjustment of Premium on Redemption
Profit & Loss Account -------------------------------- Dr -----
Security Premium Account ……………………… Dr -----
To Premium on Redemption of Pref. Shares ------
A/c---------

Redemption of Preference Share with fresh issue at a Premium

A Ltd decided to redeem its 10,000 10% Redeemable Preference shares of Rs.10
each fully paid by issue of sufficient number of equity shares of Rs.10 each at a
premium of Rs.2 each. Redemption will be at par.
Required:
Pass the necessary journal entries.
 317

Solution:
(Amount in Rs.)
Debit Credit
Bank A/c Dr. 1,20,000
To Equity Share Capital Account 1,00,000
To Security Premium Account 20,000
Being issue of 10,000shares of Rs.10 each at
a premium Rs.2 for redemption of preference
shares as per Board Resolution No. dated….
Redeemable Preference Share Capital A/c Dr. 1,00,000
To Preference Shareholders Account 1,00,000
Being amount payable on redemption of
preference shares
Preference Shareholders Account -------------- Dr. 1,00,000
To Bank A/c 1,00,000
Being amount paid on redemption of
preference shares

Note:
Amount required for redemption is Rs.100,000. Thus the face value of equity
shares to be issued for the purpose must be equal to Rs.100,000 as premium
received on such new share issue cannot be utilized for redemption of preference
shares.

In accordance with the Companies Act 1956, Share Premium account is utilized
for certain specific purposes such as:
i) Issue of bonus share
ii) Writing off Preliminary Expenses
iii) Writing off expenses or discount allowed on any issue of shares or
debentures of the company and
iv) In providing for the premium payable on the redemption of any redeemable
preference shares or debentures of the company.

Redemption of Preference Share with fresh issue at a Discount

A Ltd decided to redeem its 10,000 10% Redeemable Preference shares of Rs.10
each fully paid by issue of sufficient number of equity shares of Rs.10 each at a
discount @10%. Redemption will be at par.
 318

Required:
Pass the necessary journal entries.
Solution:
(Amount in Rs.)
Debit Credit
Bank A/c ………… Dr. 1,00,008
Discount Account ………………… Dr. 11,112
To Share Capital Account 1,11,120
Being issue of 10,000shares of Rs10 each at
discount @20%.for redemption of preference
shares as per Board Resolution No. dated…
Redeemable Preference Share Capital A/c Dr 1,00,000
To Preference Shareholders Account … 1,00,000
Being amount payable on redemption of
preference shares
Preference Shareholders Account …………… Dr 1,00,000
To Bank A/c --------------------------------- 1,00,000
Being amount paid on redemption of preference
shares

Note: When shares are redeemed by issuing shares at a discount, the proceeds
from new issue must be sufficient to cover the face value of shares redeemed.
Here the value of preference shares to be redeemed is Rs100,000.
The proceeds from each share are Rs.9 (Rs.10 less 10% Discount). Therefore the
number of shares to be issued will be calculated as:
Rs.100,000 / Rs.9 = 11,111.11 shares (Rounded off to 11,112 shares) and value
Rs.1,11,120

Calculation of Minimum Fresh Issue

The minimum number of fresh issue of shares should be calculated keeping in

view of the provisions of Section 80 of the Companies Act 1956. For this
purpose following four steps are generally followed:

1. Availability of Maximum Amount of Reserves and Surplus - Maximum

Amount of Reserves and Surplus available for redemption is to be
ascertained taking into consideration the balances of such items appearing in
the Balance Sheet and the additional information thereon before redemption
 319

2. Adjustment of Premium Payable on Redemption: Necessary adjustment

for premium payable on redemption is to be made out of profits. The adjusted
balance is then compared with the nominal value of shares to be redeemed.
After comparison, the minimum proceeds of fresh issue of shares are
determined. The minimum proceeds of fresh issue of shares = Nominal
Value of Preference Shares to be redeemed less Maximum amount of
Reserves & Surplus
3. Determination of Minimum Number of shares to be issued: Minimum
Number of shares to be issued is determined by dividing minimum proceeds
as determined above by the proceeds of one share. Minimum Number of
Shares = Minimum Proceeds complying Sec.80 of Companies Act / Proceeds
of one Share
4. Adjustment for Fractions in Minimum Number: If minimum number of
shares shows some fraction, it is to be adjusted to the next higher value, as
fraction of a share cannot be issued.
Redemption of Preference Shares with Minimum Fresh Issue

The following is the balance sheet of AVG Ltd on 30 September 2010:

Rs. Rs.
Equity and Liabilities
Equity
20,000 10% Preference Shares of Rs.100 each 20,00,000
50,000 Equity Shares of Rs.100 each 50,00,000 70,00,000
Reserves & Surplus
General Reserves 4,00,000
Profit &Loss A/c 5,00,000
Securities premium A/c 1,00,000 10,00,000
Shareholders fund 80,00,000
Non-current liabilities 20,00,000
Total equity and liabilities 1,00,00,000
Assets
Non-current assets
Fixed assets 70,00,000
Investments 20,00,000 90,00,000
Current assets
Trade receivables 4,00,000
Closing Stock 5,00,000
Cash & Bank Balance 1,00,000 10,00,000
Total assets 1,00,00,000
 320

Required:

Pass the necessary journal entries keeping in view the decision of the board for
redemption of all preference shares at 10% premium. Also prepare Balance Sheet
after redemption assuming that entire process has been completed on or before 31
October 2010.

1. Sale of 50% investments for Rs.11,00,000.

2. Issuance of minimum number of equity shares of Rs.100 each at 10%

premium.

Solution:

1. Calculation of minimum number of Equity Shares to be issued

a) Nominal Value of preference 20,00,000

shares
b) Premium payable on redemption 10% of Rs20,00,000 2,00,000
c) Security Premium as per Balance 1,00,000
Sheet
d) Security premium on fresh issue 1,10,000
e) Premium on redemption payable Nil
out of profits
f) Reserves& Surplus available for 9,00,000
redemption
g) Minimum Proceeds (a- f) (20,00,000 - 9,00,000 ) 11,00,000
h) Minimum number of shares 11,00,000 / 100 11,000shares
 321

2. Journal Entries
(Amount in Rs.)
Particulars Debit Credit
Bank A/C…………………………….. Dr 11,00,000
To Investment A/c………………. 10,00,000
To Profit on Sale of Investment…… 1,00,000
(Being Sale of 50% investments for
Rs.11,00,000)
Bank A/c Dr. 12,10,000
To Share Capital Account ………… 11,00,000
To Security Premium 1,10,000
Account………
(Being issue of 11,000shares of Rs.100each
at a premium Rs.10 for redemption of
preference shares as per Board Resolution
No.dated…)
Redeemable Preference Share Capital A/c … Dr 20,00,000
Premium on Redemption of Pref. Shares A/c Dr 2,00,000
To Preference Shareholders Account 22,00,000
(Being amount payable to Preference
Shareholders on redemption of preference
shares at premium)
Security Premium Account ……………… Dr 2,00,000
To Premium on Redemption of Pref. 2,00,000
Shares A/c------
(Being adjustment of Premium on
Redemption of Pref. Shares with Security
Premium Account)
Preference Shareholders Account 22,00,000
To Bank A/c……………………… 22,00,000
(Being payment to Preference Shareholders
for redemption)
General Reserves A/c……………………… Dr 4,00,000
Profit & Loss A/c …………………………. Dr 5,00,000
To Capital Redemption Reserves A/c 9,00,000
(Being transfer of Reserves & Surplus A/c
utilized for redemption to Capital
Redemption Reserves A/c)
 322

AVG Ltd

Balance Sheet As at 31 October 2010

Rs. Rs.
Equity and Liabilities
Equity
61,000 Equity Shares of Rs.100 each 61,00,000
Reserves & Surplus
Capital Redemption Reserve 9,00,000
Securities premium Account 10,000
Profit on Sale of Investment 1,00,000 10,10,000
Shareholders fund 71,10,000
Non-current liabilities 20,00,000
Total equity and liabilities 91,10,000
Assets
Non-current assets
Fixed assets 70,00,000
Investments 10,00,000 80,00,000
Current assets
Trade receivables 4,00,000
Closing Stock 5,00,000
Cash & Bank Balance (1,00,000+11,00,000 + 2,10,000 11,10,000
12,10,000 – 22,00,000)
Total assets 91,10,000

b) Redemption by Capitalisation of Undistributed Profits

The Companies Act also provides for redemption of preference shares by

capitalization of undistributed profits in place of fresh issue of shares as shown in
the earlier example. We need to know the provisions of the Companies Act in
regard to redemption of preference shares. The Companies Act provides that
“when any such shares are redeemed otherwise than out of the proceeds of a
fresh issue , there shall, out of profits which would otherwise have been
available for dividend, be transferred to a Reserve Fund to be called “the
Capital Redemption Reserve Account” for the sum equal to the nominal
amount of the shares redeemed”. The accounting entries have been almost
covered in the earlier illustration. From the following illustration, the accounting
entries for redemption of preference shares by Capitalization of Undistributed
Profits will be further clear to the students.
 323

Redemption of Preference Shares by Capitalization of Profits

The following is the balance sheet of XYZ Ltd on 30 September 2010

Rs. Rs.
Equity and Liabilities
Equity
10,000 7% Preference Shares of Rs.100 each 10,00,000
2,00,000 Equity Shares of Rs.10 each 20,00,000 30,00,000
Reserves & Surplus
General Reserve 8,00,000
Profit and loss A/c 1,00,000
Investment Allow. Reserve 1,00,000*
Security Premium 1,20,000 11,20,000
Shareholders fund 41,20,000
Non-current liabilities 3,80,000
Total equity and liabilities 45,00,000
Assets
Non-current assets
Fixed assets 20,00,000
Investments 10,00,000 30,00,000
Current assets
Trade receivables 2,00,000
Closing Stock 2,00,000
Cash & Bank Balance 11,00,000 15,00,000
Total assets 45,00,000

*(50% Investment Allow. Reserves is not a distributable profit)

It has been decided by the Board of Directors that 7% Preference Shares shall be
redeemed at a premium of 10%. For this purpose, a fresh issue of equity shares
will be made at par after utilizing the amount of undistributed reserves and
surplus keeping a balance of Rs.2,00,000 in General Reserves Account.

Required:

Pass necessary journal entries and prepare the Balance Sheet after redemption of
preference shares.
 324

Solution:

Computation of Minimum number of Shares to be issued:

Nominal value of preference shares to be 10,00,000

redeemed
Less: Profits Available for Distribution:
i) General Reserves (8,00,000 – 2,00,000) 6,00,000
ii) Profit & Loss A/c 1,00,000
iii) Investment Allowance Reserve 50,000
(100,000 – 50,000) 7,50,000
Proceeds for Minimum Fresh Issue 2,50,000
Number of fresh issue (2,50,000/ 10) 25,000 shares

Journal Entries on redemption of preference share

In the books of XYZ Ltd:
(Amount in Rs.)
Date Particulars Debit Credit
Bank A/c Dr 2,50,000
To Share Capital A/c 2,50,000
(Being 25,000 shares of Rs.10each
issued redemption of preference
shares as per Board Resolution No.
dated…)
Redeemable Preference Share 10,00,000
Capital A/c Dr
Premium on Redemption of Pref. 1,00,000
Shares A/c Dr 11,00,000
To Preference Shareholders
Account
(Being amount payable to
Preference Shareholders on
redemption of preference shares at
premium 10%)
Security Premium A/c Dr 1,00,000
To Premium on 1,00,000
Redemption of Pref. Shares
A/c
(Being adjustment of Premium on
Redemption of Pref. Shares with
Security Premium A/c)
 325

Journal Entries on redemption of preference share

In the books of XYZ Ltd:
(Amount in Rs.)
Date Particulars Debit Credit
Preference Shareholders A/c Dr 11,00,000
To Bank A/c 11,00,000
(Being payment to Preference
Shareholders for redemption)
General Reserves A/c Dr 6,00,000
Profit & Loss A/c Dr 1,00,000
Investment Allowance Reserves A/c Dr 50,000
To Capital Redemption 7,50,000
Reserves A/c
(Being transfer of Reserves &
Surplus A/c utilized for redemption
to Capital Redemption Reserves
A/c)

Balance Sheet of XYZ Ltd as at 31 October 2010

Rs. Rs.
Equity and Liabilities
Equity
2,25,000 Equity Shares of Rs10each 22,50,000
Reserves & Surplus
General Reserve 2,00,000
Capital Redemption Reserve 7,50,000
Investment Allow. Reserve 50,000
Security Premium 20,000 10,20,000
Shareholders fund 32,70,000
Non-current liabilities 3,80,000
Total equity and liabilities 36,50,000
ASSETS
Non-current assets
Fixed assets 20,00,000
Investments 10,00,000 30,00,000
Current assets
Trade receivables 2,00,000
Closing Stock 2,00,000
Cash & Bank Balance(11,00,000 +2,50,000 – 2,50,000 6,50,000
11,00,000)
Total assets 36,50,000
 326

The premium, if payable on redemption, must be provided for out of:

(i) Profits of the company

(ii) Share Premium Account
(iii) Capital Reserve Account
(iv) Revaluation Reserve Account

A (i) and (ii)

B (ii) and (iii)
C (iii) and (iv)
D Only (i)

8. Discuss the treatment of issue, underwriting and

redemption of debentures
[Learning Outcome h]
In the previous Learning Outcomes we studied the issue of share capital and
preference shares as a means of raising funds or capital for financing business
and business expansion. In this Learning Outcome we will study issue of
debentures and its accounting.

Debentures are one of the most commonly used debt instruments for raising
funds and supplementing capital requirements of corporates.

8.1 What is a Debenture?

Debenture is a bond issued by a company under its seal acknowledging its debt
and obligation for repayment along with the conditions and provisions for
repayment of the principal amount and interest.

More precisely, debentures are issued with or without charge created on the
assets of the company. If a charge is created on any or entire assets of the
company, the nature of charge and the assets charged are described to specify the
obligation of the company for repayment of debt.
 327

8.2 Characteristics of Debentures

i) Debenture is a document evidencing borrowings by a company.

ii) It is a fixed interest-bearing security where interest is payable at a

predetermined fixed rate on specific dates

iii) It is issued with or without charge created on assets of the company as

security

iv) It is traded on the Stock Exchange as per market availablity.

v) Debentures can classified into various types such as:

9 Secured or Unsecured
9 Redeemable or Irredeemable
9 Convertible or Non-convertible
9 Registered or Unregistered
9 First Mortgage or Second Mortgage.

Debentures issued by a company are classified on the basis of Security,

Convertibility, Permanence, Negotiability, Priority etc.

8.3 Issue of debentures

The procedure for the issue of debentures is the same as that for the issue of
shares. The intending investors apply for debentures on the basis of the
prospectus issued by the company. The company may either ask for the entire
amount to be paid on application or by means of installments on application, on
allotment and on various calls. Debentures can be issued at par, at a premium, or
at a discount. They can also be issued for consideration other than cash or as a
Collateral Security.

8.4 Accounting Entries on issue of Debentures

When a company issues debentures, it usually mentions the terms on which they
will be redeemed at their maturity. Redemption of debentures means discharge of
liability on account of debentures by repayment made to the debenture holders.
Accounting entries on issue of debentures depends on nature or types of issues.
 328

Generally debentures are issued on any of the following terms or conditions:

9 Debentures at par and redeemable at par

9 Debentures at par and redeemable a discount
9 Debentures at a discount and redeemable at par
9 Debentures at a discount and redeemable at a discount
9 Debentures at a premium and redeemable at par
9 Debentures at a premium and redeemable at a discount
9 Debentures at par and redeemable at premium
9 Debentures at discount and redeemable at a premium

Here accounting entries are discussed as illustrations.

1. Accounting Entries for Debentures at par and redeemable at par:

a) Receipt of Application Money

Bank A/c …………………………………………..…Dr
To Debenture Application and Allotment Money A/c

b) Transfer of Application money to Dentures A/c on allotment

Debenture Application and Allotment Money A/c… Dr
To Debentures A/c

8.5 Underwriting of shares and debentures

Underwriting is a contract entered by a company with certain parties, whereby

the underwriters undertake that in case of the whole or an agreed portion of the
shares or debentures are not subscribed by the public, then they will themselves
take up the shares or debentures in consideration of a commission.

Underwriting means undertaking a responsibility or giving a guarantee that the

shares or debentures offered to the public will be subscribed for in full. The
persons or institutions that give such guarantee are called underwriters.
For this service underwriters charge a commission which is generally calculated
at a specified rate on the issue price of the whole of the shares or debentures
underwritten
An underwriter may be an individual, partnership firm or company and the
underwriting commission is payable on the amount of shares or debentures
underwritten by them.
 329

In India the business of underwriting is carried on by certain specialised

institutions, some of them include:

9 Industrial Development Bank of India (IDBI)

9 Unit Trust of India (UTI)
9 Life insurance Corporation of India (LIC)
9 Industrial Finance Corporation of India (IFCI)
9 Various Nationalised banks

8.6 Legal provisions relating to underwriting commission

The consideration payable to underwriters for underwriting the issue of shares or

debentures of a company is called underwriting commission. It may be paid in
cash or in fully paid shares or debentures. Underwriting commission is generally
calculated at a specified rate on the issue price of the whole of the shares or
debentures underwritten. Section 76 of Companies Act 1956 lays down certain
conditions relating to the payment of underwriting commission which must be
complied with. These are as follows:

a) The payment of the underwriting commission must be authorized by the

Articles of Association.

b) The amount of commission paid or agreed to be paid should not exceed 5%

of the issue price and in the case of debentures it should not exceed 2.5% of
the issue price.

c) The names and addresses of the underwriters, the number of shares and
debentures underwritten by each of them and commission payable to them
should be disclosed in the Prospectus or Statement in Lieu of Prospectus.

d) A copy of the contract for the payment of underwriting commission should

be delivered to the Registrar along with the Prospectus or Statement in Lieu
of Prospectus for registration.

Underwriting is a nature of insurance against the possibility of inadequate

subscription and it is of great economic significance as it provides an assurance
to the company regarding its investment programme. The Central Government
has also permitted certain financial institutions to render various services
including underwriting of shares and debentures to help the companies for raising
funds. The prominent institutions providing this service are Industrial Finance
Corporation of India (IFCI) and Life Insurance Corporation of India.
 330

8.7 Important terminology

Before we study the underwriting process, let us understand the following terms:

a) Marked application: These applications bear the stamp of the underwriter

and the credit for these applications is given to the individual underwriter.

b) Unmarked application: These applications don’t bear the stamp of the

underwriter and are given directly to the company.

8.8 Determination of liability in respect of an underwriting agreement

Determination of liability of underwriters depends upon the nature of

underwriting agreement. The 3 main types of underwriting agreements are:

Diagram 5: Types of underwriting agreement

a) Complete underwriting

If the whole of the issue has been underwritten by one person, the underwriter is
responsible to subscribe for all the shares or debentures that have not been
subscribed by the public. In such a case, it is not necessary to ascertain the
number of applications that originated through the underwriter and those that
came directly to the company.

X Ltd issues 1,00,000 equity shares of Rs.10 each at par. The whole of the issue
is underwritten by IDBI. This is a case of full/complete underwriting.
 331

b) Partial underwriting

In case where only a part of an issue has been underwritten, or where there are a
number of underwriters, a difficulty may arise in determining the liability of each
of the underwriters. Such a difficulty may arise in deciding the basis on which
the unmarked applications are to be allotted. In this case, the applications which
have directly come to the company should be allocated among the different
underwriters.

X Ltd issues 1,00,000 equity shares of Rs.10 each at par. 80% of the issue is
underwritten by IDBI. This is a case of partial underwriting.

This can be done in two ways.

9 In one method, the unmarked applications are allotted in the proportion of

gross amount of capital underwritten.

9 Alternatively these are allocated in proportion to the gross amount of capital

underwritten as reduced by the marked applications.

By following one or the other method, the liability of the underwriter or writers
can be ascertained. This is explained with the help of the following example:

Young & Old Co Ltd of Kolkata issued 100,000 equity shares. These were
underwritten by underwriters being A, B &C; A for 40%, B 35% and C for 25%.

In all, applications for 80,000 shares were received; applications for 20,000
shares bear the stamp of A; those for 10,000 shares that of B, and those for
20,000 shares that of C.

There were also applications for 30,000 shares which did not bear any stamp. It is
decided that credit for unmarked applications is given to A, B, and C in
proportion to their gross liability.

Required:

Determine the liability of each of the underwriters.

 332

Solution:

Particulars \ Underwriters A B C
Gross Liability 40,000 35,000 25,000
Less: 30,000 unmarked applications in (12,000) (10,500) (7,500)
40:35:25
28,000 24,500 17,500
Less: Marked applications (20,000) (10,000) (20,000)
Balance 8,000 14,500 (2,500)
Credit to A & B for C’s Surplus (Ratio (1,330) (1,170) 2,500
40:35)
Actual Liability 6,670 13,330 Nil

Alternatively

The unmarked applications are allocated in proportion to the gross amount of

capital underwritten as reduced by the marked applications.

In the given case, the unmarked applications should be credited to different

underwriters in the ratio of liability after credit for marked applications has been
given - the position will be as follows:

Particulars \Underwriters A B C
Gross Liability 40,000 35,000 25,000
Less: Marked applications (20,000) (10,000) (20,000)
20,000 25,000 5,000
Less: Unmarked applications in 20:25:5 (12,000) (15,000) (3,000)
Actual Liability 8,000 10,000 2,000

Note- Under the alternative method, the underwriters’ liability in can also be
determined by simply apportioning the total number of shares yet to be
subscribed (20,000 in the above case) in the proportion of the balance of the
liability after credit for marked forms has been given.

Since the liability of each underwriter may vary widely if one or the other
method is followed, the underwriting contract should specify the method to be
followed.
 333

c) Firm Underwriting

Under firm underwriting, the underwriter provides for definite commitment to

accept a specified number of shares irrespective of the number of shares
subscribed by the public.

In such case, unless it has been otherwise agreed, the underwriter’s liability is
determined without taking into account the number of shares taken up by him.

X Ltd issues 1,00,000 equity shares of Rs.10 each at par. 80% of the issue is
underwritten by the IDBI with the definite commitment to take up 10,000 shares.
This is firm underwriting.

Firm underwriting is explained with the help of the example given below.

Global Steel Ltd came up with an issue of 2,00,000 equity shares of Rs.100 each
at par. Amounts payable on application and allotment are Rs.25 and Rs.20 per
share and the balance on call. 50,000 shares were issued to the promoters and the
balance which was offered to the public was underwritten by Asoke, Raja and
Varun equally with firm underwriting of 5,000shares.

The underwriting commission is agreed @5%. Unmarked applications are to be

credited to the underwriters equally.

Subscriptions were received for 1,29,700 shares, including the following marked
applications:

Asoke 42,500 shares

Raja 45,000 shares
Varun 35,000 shares

The underwriters applied for the number of shares as per contract on firm
underwriting.
 334

Required:
You are now required to pass journal entries for
i) Allotment of shares to the underwriters
ii) Commission due to each of them
iii) The Net Cash paid or received
Solution:
Journal Entries in the books of Global Steel Ltd
(Amount in Rs.)
Debit Credit
Bank A/c Dr 3,75,000
To Share Application A/c 3,75,000
(Being application money received on firm application
of 5,000shares @ Rs.25 per share from Asoke, Raja &
Varun)
Asoke A/c Dr 1,00,000
Raja A/c Dr 1,00,000
Varun A/c Dr 3,38,500
Share Application A/c Dr 3,75,000
To Share Capital A/c 9,13,500
(Being allotment of shares as calculated in working
note –5,000shares to Asoke,5,000shares to
Raja,10,300 shares to Varun)
Underwriting Commission A/c Dr 7,50,000
To Asoke A/c 2,50,000
To Raja A/c 2,50,000
To Varun A/c 2,50,000
(Being Underwriting Commission @5% payable on
amount of shares underwritten)
Asoke A/c Dr 1,50,000
Raja A/c Dr 1,50,000
To Bank 3,00,000
(Being amount paid to Asoke and Raja in final
settlement of commission after adjustment of amount
receivable on shares allotted to them)
 335

Journal Entries in the books of Global Steel Ltd

(Amount in Rs.)
Debit Credit
Bank A/c …….. Dr 88,500
To Varun A/c 88,500
(Being amount received from Varun in final
settlement of commission after adjustment of amount
receivable on shares allotted to him)
Workings:
1) Calculation of the liability of underwriters;
Particulars Asoke Raja Varun
Liability (No of Shares) 50,000 50,000 50,000
Less: Firm Underwriting -5,000 -5,000 -5,000
45,000 45,000 45,000
Less: Marked Application -42,500 -45,000 -35,000
2,500 NIL 10,000
Less: Unmarked Application (equally) 3,600 3,600
1,100 -6,400
Adjustment of Anand Surplus -1,100 -1,100
Net Liability excluding Firm
NIL 5,300
Underwriting
Add: Firm Underwriting 5,000 5,000 5,000
Gross Liability 5,000 5,000 10,300
Unmarked Application = 129,700- 42,500- 45,000- 35,000 = 7,200
2) Calculation of Amount payable by underwriters
Asoke Raja Varun
Gross Liability (No of Shares) as
5,000 5,000 10,300
calculated above
Amount payable @ Rs.45 per share on
2,25,000 2,25,000 4,63,500
Gross Liability
Less: Amount paid on Firm
1,25,000 1,25,000 1,25,000
application for 5,000 shares@Rs25
Balance payable 1,00,000 1,00,000 3,38,500
Underwriting Commission 2,50,000 2,50,000 2,50,000
Amount paid 1,50,000 1,50,000 -------
Amount received by the Company 88,500
 336

As this study material is intended to give special coverage on investment

accounting and investment regulations, the students must understand essential
aspects of shares and debenture issue, and underwriting thereof for developing an
integrated idea of financing as well as investment activities of the corporate
business houses, including insurance firms.

Commitment provided to accept a specified number of shares irrespective of the

number of shares subscribed by the public are known as:

A Redemption
B Full underwriting
C Firm underwriting
D None of the above

9. Discuss the concept of bonus shares along with

accounting treatment and related provision under the
Companies Act.
[Learning Outcome i]

9.1 Bonus Shares

A company may decide to distribute past undistributed profit, when there is large
amount of accumulated reserves, by way of issuing shares free of cost to its
existing shareholders. Such shares are called Bonus Shares.

Bonus shares are issued to the existing members in proportion to their

shareholding in the company. The issue of bonus shares help in ploughing back
the of profits of the company, bringing about proper balance between paid up
capital and accumulated reserves, elicit good public response to equity issue of
the public company and improves the market image of the company.
Accounting for issue of bonus shares is one of the important aspects of company
accounts. It requires compliance of lot statutory requirements and accounting
formalities, which are being discussed in brief hereunder.
 337

9.2 Provision of the Companies Act 1956 for issue of Bonus Shares
The following provisions of Companies Act need to be adhered:
a) Bonus shares can only be issued when there is a provision to this effect in the
Articles of Association (AoA) of the company. If the articles do not contain
such a provision, the company must first pass a special resolution in the
general meeting of the shareholders and make such a provision in the articles.
b) For issuing bonus shares, a resolution should first be passed by the Board of
Directors and it should then be approved by shareholders in their general
meeting.
c) The bonus issue is not made until the partly paid shares are made fully paid-
up.
d) Guidelines issued by Securities and Exchange Board of India (SEBI) must be
complied with. (discussed in detail below)

Bonus shares can be issued from following:

9 General reserves
9 Capital reserves realized in cash
9 Securities premium realized in cash

9.3 SEBI Guidelines for Issue of Bonus Shares

Securities and Exchange Board of India (Disclosure and Investor Protection)

Guidelines, 2000 contains the guidelines for bonus issue. These are discussed in
detail below:

a) No issue within 12 months - No bonus issue shall be made within 12

months of any public/right issue.

b) Out of free reserves: The bonus issue shall only be made out of free
reserves built out of genuine profits or securities premium collected in cash
only. However, SEBI guidelines relating to debentures provide that
Debenture Redemption Reserve shall be considered as general reserve for
consideration of bonus issue proposals.
 338

c) Revaluation reserve: reserves created by revaluation of fixed assets cannot

be used for issuing bonus shares. If assets are subsequently sold and the
profits are realized, such reserves could be utilised for capitalisation.

d) Bonus issue not to be in lieu of dividend: The declaration of bonus issue, in

lieu of dividend, should not be permitted.

e) Partly paid shares: The bonus issue is not made unless the partly- paid
shares, if any, existing, are made fully paid-up.

f) No default in respect of deposit/debentures: the company should not have

defaulted in payment of any interest or principal in respect its fixed deposits
and interest on debentures or redemption of debentures.

g) Statutory dues of the employees: The company should not be defaulted in

payment of its statutory dues to the employees such as contribution to PF,
gratuity, bonus, minimum wages, workmen’s compensation, retrenchment,
payment to contract labour etc.

h) Implementation of proposal : The bonus issue shall be implemented within

a period of 15 days after the date of approval of the BoD; it does not require
the shareholders’ approval for capitalisation of profits or reserves for making
bonus issue as per the AoA of the company. However, if the company is
required to get the shareholders’ approval as per AoA of the company for
capitalisation of profits or reserves, the bonus issue shall be implemented
within 2 months from the date of the meeting of the BoD

i) Provision in AoA: There should be a provision in the Articles of Association

of the company for capitalization of reserves, and, if not, the company shall
pass a resolution at its general body meeting making provisions in the
Articles of Association for capitalization.

j) Authorised capital: Consequent to the issue of bonus shares, if the

subscribed and paid-up capital exceeds the authorized share capital,
resolution shall be passed by the company at its general body meeting for
increasing the authorized capital.

k) Right of FCD/PCD holders: No company shall, pending conversion of

FCDs/PCDs, issue any shares by way of bonus unless similar benefit is
extended to the holders of such FCDs/PCDs, through reservation of shares in
proportion to such convertible part of FCDs or PCDs. The shares so reserved
may be issued at the time of conversion of such debentures on the same
terms on which the bonus issues were made.
 339

l) Reporting to SEBI: The company should file with SEBI a statement of the
bonus issue conveying the details of the bonus issue and certifying that the
bonus issue is being made as per the guidelines.

m) Certificate: The statement, as aforesaid, should be accompanied by a

certificate from the statutory auditors of the company or by a practicing
company secretary to the effect that bonus guidelines have been duly
complied with.

Journal entries

Sanction of an issue of bonus shares

Profit and Loss Account (or reserve) Dr XX
General reserve account Dr XX
Capital reserve account (realized in cash only) Dr XX
Securities premium account Dr XX
Capital redemption reserve account Dr XX
To Bonus to Shareholders Account XX

Entry for issue of shares

Bonus to Shareholders Account Dr XX
To Share Capital Account XX

AB Ltd had an issued and subscribed capital of 100,000 equity shares of Rs 10

each and the details of the reserves and surplus are as follows as on 31March,
2009

Reserves & Surplus Rs

General Reserve 1,20,000
Capital Reserve 1,00,000
Securities Premium 25,000
Profit and Loss Account 2,00,000

On 31 May, the company decided to capitalize its reserves by way of bonus at the
rate of 1 share for every 4 shares held.

Required:

Show the necessary journal entries for the bonus issue.

 340

Solution:

Bonus issue of 1 share for every 4 share = 1,00,000 shares x ¼ = 25,000 shares.

Share capital to be issued = 25,000 shares x Rs. 10 = Rs.2,50,000

Journal Entries in the books of AB Ltd

Date Particulars Debit Credit

Amount Amount
31 May Capital Reserve A/c Dr 1,00,000
Securities Premium A/c Dr 25,000
General Reserve A/c Dr 1,20,000
Profit and Loss A/c Dr 5,000
To Bonus to Shareholders A/c 2,50,000
Being bonus issue @ one share for every four shares held

31 May Bonus to Shareholders A/c Dr 2,50,000

To Equity Share Capital A/c 2,50,000
Being Capitalisation of profit

Bonus shares can be issued from following:

(i) General reserves

(ii) Securities premium realized in cash
(iii) Revaluation Reserves

A Only (i)
B Only (ii)
C (ii) and (iii)
D (i) and (ii)
 341

10.Discuss the form and content of financial statements as

required by statute and prepare financial statements in
accordance with the formats.
[Learning Outcome j]

10.1 Preparation of Financial Statements

The financial statement of a company must be prepared in accordance with the

provisions of the companies Act 1956, and the relevant regulations applicable to
a company and in compliance with the requirements of the applicable
Accounting Standards issued by the Institute of Chartered Accountants of India.

For example the financial statements of a bank will be prepared as per specific
regulations issued by the RBI and the financial statements of an insurance
company are governed by the specific accounting regulation issued by the IRDA.

The provisions of various sections particularly Section198, 205, 211, .212, 349,
350 are to be complied with in preparation of the financial statements of a
company. Besides above regulatory and legal requirements, the accounting
policy and accounting assumptions followed by the company shall not be
deviated without proper disclosure and the impact of such deviation must be
specified in the accounting notes.

It is mandatory under the Companies Act for all types of companies to maintain
their accounts on accrual basis and according to double entry system of
accounting As required by Accounting Standard (AS) -1 on “Disclosure of
Accounting Policies , there must be proper disclosure if fundamental accounting
assumptions viz. Going Concern, Consistency and Accrual basis are not
followed.

Similarly there are many legal requirements in preparation of financial statements

of a company. For example Section 212 of the Companies Act provides that the
balance sheet of holding company shall be accompanied by the following
documents of its subsidiary/subsidiaries:

a) a copy of the Balance Sheet of the subsidiary

b) a copy of its Statement of Profit & Loss
c) a copy of the report of its Board of Directors
d) a copy of the Report of its Auditors
e) a statement of holding company’s interest in the subsidiary
 342

While preparing the financial statements of a company the following aspects

should be kept in mind:

9 Requirements of Revised Schedule VI

9 Other statutory requirement
9 Indian Accounting Standards issued by the ICAI or IFRS as and when
applicable
9 Statements and Guidance Notes issued by the ICAI in regard to various
accounting treatment, valuation of assets or disclosure requirements.

a) Form and Contents of Balance Sheet and Profit & Loss Account
(Sec.211)

As provided by Section 211, every Balance Sheet of a company shall give a true
and fair view of the state of affairs of the company as at the end of the financial
year and shall be in the form set out in Part I of the Schedule VI or as near
thereto as circumstances admit or such other form as may be approved by the
Central Government. In preparing the balance sheet due regard shall be had to the
general instructions contained in the ‘Notes” at the end of the said Part I, for
preparation of balance sheet under.

Pertinently the aforesaid provisions of Section.211 shall not apply to any

insurance company, banking company or any company engaged in the
preparation or supply of electricity or any other class of company for which form
of balance sheet has been specified in the Act governing such class of company.

Section 211(2) further provides that every statement of profit & Loss of a
company shall give a true and fair view of the profit or loss of a company for the
financial year and shall comply with the requirements of Part II of the Schedule
VI, so far as they are applicable thereto. But the said provisions of this section
shall not apply to any insurance company or banking company engaged in
generation or supply of electricity or any other class of company for which form
of balance sheet has been specified in the Act governing such class of company.

Every statement of profit and loss account and balance sheet of the company
shall comply with the accounting standards. Here Accounting Standards mean
the standards of accounting issued by the Institute of Chartered Accountants of
India.
 343

b) Preparation of financial statements

i) Balance sheet

The Balance Sheet can now be prepared only under the vertical form as per the
revised Schedule VI. While preparing balance sheet, the companies not only
conform to the format, but also notes and general instructions given in the
Schedule VI.

ii) Statement of Profit and Loss

The name has been changed to “Statement of Profit and Loss” as against ‘Profit
and Loss Account’ as contained in the Old Schedule VI. Unlike the Old
Schedule VI, the Revised Schedule VI lays down a format for the presentation of
Statement of Profit and Loss. This format of Statement of Profit and Loss does
not mention any appropriation item on its face. Further, the Revised Schedule VI
format prescribes such ‘below the line’ adjustments to be presented under
“Reserves and Surplus” in the Balance Sheet.

The formats of balance sheet and Statement of Profit and Loss as per
Revised Schedule VI are given below:

Schedule VI
(See Section 211)

GENERAL INSTURCTIONS FOR PREPARATION OF BALANCE

SHEET AND STATEMENT OF PROFIT AND LOSS OF A COMPANY IN
ADDITION TO THE NOTES INCORPORATED ABOVE THE HEADING
OF BALANCE SHEET UNDER

GENERAL INSTRUCTIONS

1. Where compliance with the requirements of the Act including Accounting

Standards as applicable to the companies require any change in treatment or
disclosure including addition, amendment, substitution or deletion in the
head/sub-head or any changes interest, in the financial statements or
statements forming part thereof, the same shall be made and the requirements
of the Schedule VI shall stand modified accordingly.
 344

2. The disclosure requirements specified in Part I and Part II of this Schedule

are in addition to and not in substitution of the disclosure requirements
specified in the Accounting Standards prescribed under the Companies Act,
1956. Additional disclosures specified in the Accounting Standards shall be
made in the notes to accounts or by way of additional statement unless
required to be disclosed on the face of the Financial Statements. Similarly, all
other disclosures as required by the Companies Act shall be made in the
notes to accounts in addition to the requirements set out in this Schedule.

3. Notes to accounts shall contain information in addition to that presented in

the Financial Statements and shall provide where required:
a) narrative descriptions or disaggregation of items recognized in those
statements and
b) information about items that do not qualify for recognition in those
statements.

Each item on the face of the Balance Sheet and Statement of Profit and Loss
shall be cross-referenced to any related information in the notes to accounts.
In preparing the Financial Statements including the notes to accounts, a
balance shall be maintained between providing excessive detail that may not
assist users of financial statements and not providing important information
as a result of too much aggregation.

4. Depending upon the turnover of the company, the figures appearing in the
Financial Statements may be rounded off as below:

Turnover Rounding off

a) less than one hundred To the nearest hundreds, thousands,
crore rupees lakhs or millions, or decimals thereof.
b) one hundred crore rupees To the nearest, lakhs, millions or crores,
or more or decimals thereof.

Once a unit of measurement is used, it should be used uniformly in the

Financial Statements.

5. Except in the case of the first Financial Statements laid before the Company
(after its incorporation) the corresponding amounts (comparatives) for the
immediately preceding reporting period for all items shown in the Financial
Statements including notes shall also be given.

6. For the purpose of this Schedule, the terms used herein shall be as per the
applicable Accounting Standards.
 345

Notes

This part of Schedule sets out the minimum requirements for disclosure on the
face of the Balance Sheet, and the Statement of Profit and Loss (hereinafter
referred to as “Financial Statements” for the purpose of this Schedule) and Notes.
Line items, sub-line items and sub-totals shall be presented as an addition or
substitution on the face of the Financial Statements when such presentation is
relevant to an understanding of the company’s financial position or performance
or to cater to industry/sector-specific disclosure requirements or when required
for compliance with the amendments to the Companies Act or under the
Accounting Standards.

PART I - FORM OF BALANCE SHEET

Name of the Company……………
(Rupees
Balance Sheet as at ……………… in……..)
Figures as Figures as at
at the end of the end of
Note
Particulars current previous
No.
reporting reporting
period period
1 2 3 4
I. Equity and Liabilities

(1) Shareholders' Fund

a) Share Capital
b) Reserves and Surplus
c) Money received against
share warrants

(2) Share application money

pending allotment

(3) Non-current liabilities

a) Long-term borrowings
b) Deferred tax liabilities(Net)
c) Other Long-term liabilities
d) Long-term provisions
 346

(4) Current liabilities

a) Short-term borrowings
b) Trade payables
c) Other current liabilities
d) Short-term provisions

Total
II. Assets

(1) Non-Current Assets

a) Fixed Assets
i) Tangible assets
ii) Intangible assets
iii) Capital work-in-
progress
iv) Intangible assets under
development
b) Non-current investments
c) Deferred tax assets (net)
d) Long-term loans and
advances
e) Other non-current assets

(2) Current assets

I Current investments
II Inventories
III Trade receivables
IV Cash and cash
equivalents
V Short-term loans and
advances
VI Other current assets

Total - -

Refer Revised Schedule VI of the Companies Act 1956 for the general
instructions for preparation of balance sheet
 347

PART II - FORM OF STATEMENT OF PROFIT AND LOSS

Name of the Company ………..
Profit and loss statement for the year ended…………….
(Rupees
in……)
Figures Figures
for the for the
current previous
Note reporting reporting
Particulars No. period period
I Revenue from operations
II Other Income
III Total Revenue (I + II)
IV Expenses:
Cost of materials consumed
Purchase of Stock-in-trade
Changes in inventories of finished
goods work in progress and Stock-in-
trade
Employee Benefits expense
Finance Costs
Depreciation and amortization
expense
Other Expenses
Total Expenses
V Profit before exceptional and
extraordinary items and tax (III -
IV)
VI Exceptional Items
VII Profit before extraordinary items
and tax (V-VI)
VIII Extraordinary items
IX Profit before tax (VII-VIII)
X Tax Expense
(1) Current tax
(2) Deferred Tax
XI Profit (Loss) for the period from
continuing operations (IX-X)
XII Profit/(loss) from discontinuing
operations
 348

XIII Tax expense of discontinuing

operations
XIV Profit/(loss) from discontinuing
operations (after tax) (XII - XIII)
XV Profit (Loss) for the period (XI +
XIV)
XVI Earnings per equity share:
(1) Basic
(2) Diluted

Refer Revised Schedule VI of the Companies Act 1956 for general

instructions for preparation of statement of profit and loss

Presentation of Final Accounts in a Summary Form

It is another form in which final statements of account are prepared. Presently

this form of financial statements is often used. Under this method assets and
liabilities and incomes and expenditure are grouped under main heads and are
shown in the balance sheet and profit and loss account respectively and other
information requiring disclosure are also disclosed in a summarised form to
comply with the requirements of Section 219(1)(b) of the Companies Act 1956.

Consequently, the statement of profit and loss accounts and balance sheet are not
loaded with details. The Balance Sheet and statement of Profit & Loss Account
can be prepared in the abridged form for the use of members and others who do
not need full statements.

Such abridged accounts are to be prepared as per form 23AB of Companies

(Central Government‘s) General Rules and Forms, 1956. The statement shall be
approved by the Board of Directors and signed on behalf of them.
 349

Form of Abridged Balance Sheet (Form no 23-AB) As per Sec 219(1) (b)
Name of the Company
Abridged Balance sheet as at …….

Particulars Figures at the end of

C/Y Fin. P/Y Fin.
Year year
I Sources of Funds
1. Shareholders’ Funds
(a) Capital
(i) Equity
(ii) Preference
(b) Reserves & Surplus
(i) Capital Reserves
(ii) Revenue Reserves
(iii) Revaluation Reserve
(iv) Surplus in Profit & Loss Account
(v) Share Premium Reserve
(vi) Investment Allowance Reserve

2. Loans Funds
(i) Debentures (Amount of convertible and
partly convertible debenture
(ii) Public Deposits
(iii) Secured Loans (Other than debentures)
(iv) Unsecured Loans
Total of (1) and (2)
II Application of Funds
1. Fixed Assets
(a) Net Block (original cost less depreciation)
(b) Capital Work in Progress
2. Investments
(a) Government securities
(b) Investment in subsidiary companies
(i) Quoted
(ii) Unquoted
(c) Others
(i) Quoted
(ii) Unquoted
 350

3. Current Assets, Loans and Advances

(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balances
(d) Other Current Assets
(e) Loans and Advances
Less: Current Liabilities
(a) Liabilities
(b) Provisions

4. Miscellaneous Expenditure to the extent not

written off

5. Profit and Loss Account

Total (1 to 5)

Performa of Abridged Profit and Loss Account for the year ended…….

Name of the Company

Profit and Loss Account for the year ended…….

Particulars Figures as at the end

of ……
C/Y P/Y
I. Income
Sales/ Services rendered (Details as per annexure)
Dividend
Interest
Other Income (Refer Note 5)

II. Expenditure
Cost of Goods Consumed/ Sold
i) Opening Stock
ii) Purchase
Less: Closing Stock

Manufacturing Expenses
Salaries, Wages, and Other Employee Benefits
Managerial Remuneration
 351

Interest
Depreciation
Auditors’ Remuneration
Provisions for i) Doubtful Debts and
ii) Other Contingencies (to be specified)
Any Other Expenses (refer point no.5)

III. Profit / Loss before Tax (PBT)

IV. Provision for Taxation

V. Profit/ Loss After Tax

VI. Proposed Dividend;

i) Preference Share
ii) Equity Share

VII. Transfer to Reserves

Notes to the Abridged Balance Sheet and the Abridged Profit & Loss
Account

1. The amounts to be shown here should be the same as shown in the

corresponding aggregated heads in the accounts as per Schedule VI or as
close to it as possible.

2. The total amount of contingent liabilities and that of Capital commitments

should be shown separately

3. All notes forming part of the accounts as per schedule VI to which specific
attention has been drawn by the auditors or which form a subject matter of
audit qualification should be reported

4. If fixed assets are revalued, the amount of revaluation, should be shown

separately for the first five years subsequent to the date of revaluation
 352

5. Any item which constitutes 20% or more the total income or expenditure
(including provisions) should be shown separately.

6. Amount, if material, by which any items shown in the profit and loss account
are affected by any change in the basis of accounting, should be disclosed
separately.

7. If no provision is made for depreciation, the fact that no depreciation has

been made shall be stated along with the quantum of arrears of depreciation
computed in accordance with sec 205 of the Act

8. Market value of quoted investments (both of current year and also of

previous year) to be mentioned

9. Any note forming part of the accounts as per Schedule VI which is in the
nature of any explanation regarding compliance with any law should be
reproduced

10. Important ratio performance such as sales/ total assets ratio, operating profit/
capital employed ratio, return on net worth, profit/sales ratio should be
disclosed

11. Details of installed capacity and productivity of main items should be

disclosed

12. Notes in abridged balance sheet should be given the same number as in the
main balance sheet

Above stated salient features of balance sheet and the profit and loss account
should be authenticated in the same manner as the main accounts are to be
authenticated.
 353

Preparation of Financial statements

From the following Trial Balance of M/S Ma Durga Chemical Ltd prepare
financial statements for the year ended 31 March 2010.
Trial Balance as on 31 March 2010
(Amount in Rs.)
Debit Credit
Equity Shares Capital
Goodwill 26,50,000 250,00,000
(Shares of Rs100each)
Land & Building 1,54,60,000 12% Debenture
Plant & Machinery 86,00,000 Bank Loans 50,00,000
Furniture & Fixtures 55,00,000 Bills Payable 64,50,000
Trade receivables 28,70,000 Trade payables 12,50,000
Bills Receivable 15,30,000 Sales 15,60,000
Stock in Trade 68,00,000 Rent Received 447,90,000
Profit &Loss Account
Tools & Equipment’s 26,00,000 5,60,000
B/F
Loans to Directors 8,00,000 13,90,000
Discount Allowed 4,00,000
Bad Debts 3,50,000
Advertisement &
2,00,000
Publicity
Commission &
12,00,000
Brokerage
Purchases 2,31,90,000
Rent, rates & Taxes 2,50,000
Balance in Current
4,50,000
A/c
Cash in Hand 80,000
Interest on bank Loan 11,60,000
Preliminary expenses 1,00,000
Wages 90,00,000
Consumables 8,40,000
Transit Insurance 3,00,000
Trade Expenses 930,000
Freight 540,000
Debenture Interest 2,00,000
8,60,00,000 8,60,00,000
 354

Additional aspects to be considered in preparation of Financial Statements are;

9 Closing Stock is Rs.70,00,000 as on 31. 03.2010

9 Depreciation to be provided as follows; Machinery @10%, Land & Building
@5%, Furniture& Fixtures @10% and Tools & Implements @ 5%
9 Dividend proposed and declared @ 10%
9 Provision for Taxation to be made @ 30% of net profit

Solution;
M/S Ma Durga Chemical Ltd
Balance Sheet as at 31st March 2010 (In Vertical Form)
Particulars Note No Amount Rs Amount Rs
Equity and liabilities
Shareholders’ funds
(a) Share capital 1 2,50,00,000
(b) Reserves and surplus 2 21,63,900
Shareholders’ funds 2,71,63,900

Non-current liabilities
(a) Secured Loans 3 1,14,50,000 1,14,50,000

Current Liabilities
Liabilities 6 28,10,000
Provisions 7 39,03,100 67,13,100

Total Equity and liabilities 4,53,27,000

ASSETS
Non-current assets
1) Fixed Assets;
Gross block 4 3,48,10,000
Less: Depreciation (23,13,000)
Net Block 3,24,97,000 3,24,97,000

Current assets
a) Inventories 70,00,000
b) Trade Receivables 28,70,000
c) Cash and Bank Balances 5,30,000
 355

M/S Ma Durga Chemical Ltd

Balance Sheet as at 31st March 2010 (In Vertical Form)
Particulars Note No Amount Rs Amount Rs
d) Other Current Assets ---Bills
23,30,000
Receivable
e) Loans and Advances 5 1,00,000
f) Miscellaneous Esp. the extent not
1,28,30,000
written off
Total assets 1,28,30,000

4,53,27,000

M/S Ma Durga Chemical Ltd

Statement of Profit & loss Account for the year ended 31 March 2010
Note Amount Amount
Particulars
No Rs. Rs.
Income
Sales 4,47,90,000
Other Income 8 5,60,000
Expenditure 4,53,50,000
Purchases 9 2,38,30,000
Manufacturing and other expenses 10 1,31,70,000
Depreciation 11 23,13,000
Interest and other Financial Charges 12 13,60,000 (4,06,73,000)
Profit before tax (PBT) 46,77,000
Tax expense (14,03,100)
Profit for the period from
32,73,900
continuing operations

Note 1 Capital
Subscribed &Paid-up capital;
(250,000 shares of Rs.100 each) Rs.2,50,00,000
Note 2 Reserves & Surplus

Rs.
Profit for the period from continuing operations 32,73,900
Balance of profit & Loss brought forward 13,90,000
Less: Proposed Dividend (25,00,000)
Transfer to Reserves Nil
Balance carried to Balance Sheet 21,63,9000
 356

Note 3 Secured Loans

Rs.
11% Debentures 50,00,000
Loans From Bank 64,50,000
1,14,50,000

Note 4 Fixed Assets

Rs.
Gross Block
Goodwill 26,50,000
Land &Buildings 1,54,60,000
Plant & Machinery 86,00,000
Furniture &Fixture 55,00,000
Tools& Equipment 26,00,000
3,48,10,000
Less: Depreciation
Land &Building 7,73,000
Plant& Machinery 8,60,000
Furniture & Fixture 5,50,000
Tools & Equipment 1,30,000
23,13,000
Net Block 3,24,97,000

Note 5 Loans & Advances

Rs
Loans To Directors 8,00,000
Bills Receivable 15,30,000
23,30,000

Note 6 Current Liabilities

Rs.
Bills Payable 12,50,000
Trade payables 15,60,000
28,10,000
 357

Note 7 Provisions

Rs.
Provisions for Taxation 14,03,100
Proposed Dividend 25,00,000
39,03,100

Note 8 Other Income

Rs.
Rent Received Rs.5,60,000
Others Nil
5,60,000

Note 9 Purchase

Rs.
Purchase 231,90,000
Consumable Stores 8,40,000
2,40,30,000
Add: Opening Stock 68,00,000
Less: Closing Stock 70,00,000
2,38,30,000

Note 10 Manufacturing & Other Expenses

Rs.
Wages 90,00,000
Bad Debts 3,50,000
Discount Allowed 4,00,000
Rent, rates & Taxes 2,50,000
Commission & Brokerage 12,00,000
Advertisement & Publicity 2,00,000
Transit Insurance 3,00,000
Trade Expenses 9,30,000
Freight 5,40,000
1,31,70,000
 358

Note 11 Depreciation

Rs.
Land &Building; 7,73,000
Plant& Machinery 8,60,000
Furniture & Fixture 5,50,000
Tools& Equipment 1,30,000
23,13,000

Note 12 Interest & Other Financial Charges

Rs.
Interest on bank Loan 11,60,000
Debenture Interest 2,00,000
13,60,000

Certain Special items in Trial Balance

1. Calls in-Arrear

When this item generally appears in the Trial Balance, it represents the amount
not paid by the shareholders on the calls made by the company on shares. This
needs adjustment to be shown in Balance sheet. In the liability side this amount is
deducted from the Called-Up and Paid-Up Capital.

2. Unclaimed Dividend

It represents the amount of dividend not collected by the shareholders. It is to be

shown on the liability side of Balance Sheet under the head “Current Liabilities”

3. Interim Dividend

This item in Trial Balance represents dividend paid by a company before the
Annual General Meeting and generally on the basis of financial results shown by
the half-yearly accounts. Since there is no profit and loss appropriation account
under the revised Schedule VI, all appropriations including interim dividends are
shown as a movement in “Reserve and Surplus Account”
 359

4. Proposed Dividend

This item represents dividend proposed and declared by the company in the
General Meeting, which is to be paid in accordance with the provisions of sec
205 of the Companies Act 1956. This is to be shown on the liability side of
Balance Sheet under the heading “provisions”

5. Dividends Received

This represents dividend received on company’s investments in shares. If

‘dividend received’ shown in Trial Balance is the net dividend amount (net of
tax) received by the company. But this is to be adjusted for gross amount i.e
dividend plus tax deducted at source (TDS) by the company disbursing the
dividend under sec 194 of the Income Tax Act 196. For example; in the trial
balance of X Ltd, there is a credit balance of Dividend Received A/c is Rs,1,790
paid by Y Ltd after deducting tax @10% and surcharge thereupon @5%. X Ltd is
required to show the gross amount of Dividend Received in the final accounts.

Here Gross Dividend is Rs.2,000, Tax is Rs.200 and Surcharge is Rs10. To show
the gross amount, the following entry is to be passed;

Tax Deducted at Source A/c Dr Rs.210

To Dividend Received A/C Rs.210

With this adjustment entry, Dividend Received will be Rs.2000, which will be
shown in the statement of profit and loss account and Tax Deducted at Source
A/c for Rs.210 will appear on the asset side of the Balance Sheet till the same is
adjusted against total tax liability of the company.

However, at present dividends are not subject to tax at the hands of the
shareholders. The company declaring dividends pays a dividend distribution tax
along with applicable surcharge and education cess.

6. Interest Received

As in the case of Dividend Received A/C, same adjustment entry is required to

be passed for “Interest Received A/C if shown in Trial balance for the net amount
(net of tax).

Under sec.194A of the Income Tax Act 1961, banks are required to deduct tax
@20% and surcharge 5% on interest payable to a domestic company.
 360

X Ltd. received Interest from bank deposits for Rs15,800 after deduction of Tax
at source for Rs.4,200.

X Ltd is required to pass the following adjustment entry to show the gross
amount of Interest Received A/C in the final accounts if Trial Balance shows the
net amount of Rs15,800.

Tax Deducted at Source A/c Dr Rs.4,200

To Interest Received A/C Rs.4,200

With this adjustment entry, Interest Received A/c will be Rs.20,000, which will
be shown in the statement of profit and loss account and Tax Deducted at Source
A/c for Rs.4,200 will appear on the asset side of the Balance Sheet till the same is
adjusted against total tax liability of the company.

7. Interest on Debentures Issued

When a company pays interest on Debentures, it is required to deduct tax at

source.

Suppose TDS on interest is @20% and surcharge 5% . So if X Ltd pays interest

on debenture for Rs.1,00,000/- for 2009-10, it is required to deduct tax with
surcharge for Rs.21,000/- which is to be deposited by the company as per the
provisions of the Income Tax Act.

The accounting entry for payment of debenture interest for Rs.1,00,000/- will be
as under

Interest on debenture A/c Dr Rs1,00,000

To Bank A/c Rs79,000
To Income Tax Payable A/c / Tax Deducted at Source A/c Rs21,000

With this entry, Interest on Debenture A/c will be Rs100,000, which will be
shown in the statement of profit and loss account as expenses and tax deducted
at source A/c for Rs21,000 will appear on the liability side of the Balance Sheet
till the same is deposited.
 361

8. Discount & Cost of Issue of Debenture A/c

This represents Discount, Commission and other expenses incurred on issue of

debentures. This appears on the asset side of the Balance Sheet under the head
“Miscellaneous Expenditure” till the same is fully written off.

This expenditure is written off prudently over the period of the life of debentures.

This expenditure written off is shown in the Statement of Profit & Loss Account
with the following adjustment entry;

Profit & Loss A/c Dr (amount written off) XXX

To Discount & Cost of Issue of Debenture A/c XXX

The balance amount unwritten off will appear in the balance sheet.

The form and contents of Balance Sheet and Statement of Profit and loss is for
companies are prescribed by:

A Schedule VI of Companies Act

B Accounting Standards issued by ICAI
C Reserve Bank of India
D No format prescribed
 362

Financial Statements of Banks - The following are the balances (Rs in Crores) in the General ledger of Welcome Bank
Ltd as at 31st March 2010.
Particulars C/Yr 2010 P/Yr 2009 C/Yr 2010 P/Yr 2009
Cash & Bank Balances Capital & Reserves
Cash In Hand 636 686 Equity Share Capital 3,000 3,000
Cash With RBI 800 850 Reserve Fund& Reserves 2,000 1,500
Balance with Other Bank: Balance in Profit &Loss A/c 681 484
On Fixed Deposit 500 550 Deposits & Borrowings
Current Accounts 500 550 Fixed Deposits 12,000 11,000
Money at Call & Short Notice 100 100 Savings Bank Deposits 8,000 7,000
Investments Current Accounts 20,000 19,000
Securities of State Govt 1,000 1,000 Borrowings from Other Banks 1,510 1,202
Securities of State Govt 500 1,550 Other Liabilities
Shares in Listed Companies 1,900 1,950 Bills Payable 500 550
Debenture in Companies 400 400 Rebate on Bills Discounted 400 450
Investments in Gold 100 141 Unclaimed Dividend 54 16
Balances- in both Assets &
Loans & Advances:
Liabilities
Bills For Collection being Bills
Loans, Cash Credit & O/Draft 25,000 21,000 500 600
Receivable
Liabilities for Acceptances,
Bills Discounted &Purchased 14,036 13,156 700 500
Endorsements, other Obligation
Other Assets
Premises Less Depreciation 1,100 1,200
Furniture & Fixtures 373 469
Computer & Net Working 1,200 600
 363

Prepare Balance Sheet of Welcome Bank Ltd as at 31st March 2010 from the above balances

Welcome Bank Ltd

Balance Sheet as at 31st March 2010

Capital & liabilities 2010 2009 Property & Assets 2010 2009
Capital & Reserves Cash & Bank Balances
Equity Share Capital 3,000 3,000 Cash In Hand 636 686
Reserve Fund& Reserves 2,000 1,500 Cash With RBI 800 850
Balance in Profit &Loss A/c 681 484 1,436 1,536
5,681 4,984
Deposits &Borrowings Balance with Other Bank
Fixed Deposits On Fixed Deposit 500 550
Savings Bank Deposits 12,000 11,000 Current Accounts 500 550
Current Accounts 8,000 7,000 Money at Call & Short Notice 100 100
Borrowings from Other Banks 20,000 19,000 1,100 1,200
1,510 1,202 Investments
41,510 38,202 Securities of State Govt 1,000 1,000
Other Liabilities Securities of State Govt 500 1550
Bills Payable 500 550 Shares in Listed Companies 1,900 1,950
Rebate on Bills Discounted 400 450 Debenture in Companies 400 400
Unclaimed Dividend 54 16 Investments in Gold 100 141
954 1016 3,900 5,041
 364

Welcome Bank Ltd

Balance Sheet as at 31st March 2010

Capital & liabilities 2010 2009 Property & Assets 2010 2009
Bills For Collection being Bills
500 600 Loans &Advances
Receivable as per contra
Loans, Cash Credit & O/Draft 25,000 21000
Liabilities for Acceptances,
Endorsements, other Obligation as 700 500 Bills Discounted &Purchased 14,036 13,156
per contra
39,036 34,156
Other Assets
Premises Less Depreciation 1,100 1,200
Furniture & Fixtures 373 469
Computer & Net Working 1,200 600
2,673 2269
Bills For Collection being
600
Bills Receivable; contra 500

Liabilities for Acceptances,

Endorsement contra 700 500
49,345 45,302 49, 345 45,302
 365

11.Discuss taxation and its accounting treatment in the final

accounts.
[Learning outcome k]
While recording transactions and preparing financial statements, an accountant
has to deal accounting for taxation in the books of accounts of a company.
Therefore it is necessary that you should understand the implication of the same
and necessary accounting treatments or adjustments thereof
With respect to taxation the below mentioned items are explained to show as to
how they will be dealt with in the preparation of the final accounts:
9 Tax Deducted at Source
9 Advance Payment of Tax
9 Income Tax (Corporate Tax)
9 Provisions for Taxation
9 Deferred Tax
11.1 Tax Deducted at Source
In accordance with the provisions of Income Tax Act 1961, it is the duty of the
payer of salary, interest, dividend, etc. to deduct tax at the prescribed rates and
to deposit the tax collected to the credit of Central Government within a
specified time.
When tax is deducted by the company as per the provisions of Income Tax Act,
the following entry is passed:
Salaries/Dividends/Interest A/c Dr XXX
To Bank A/c XXX
To Tax Deducted at Source A/c XXX
(Being Salaries/Dividends/Interest paid)

X Ltd paid interest to the debenture holders of Rs.15,800 after deduction of Tax
at source for Rs.4,200/-. X Ltd is required to pass the following adjustment entry
to show the gross amount of interest paid in the final accounts.

Rs. Rs.
Interest paid A/c Dr 20,000
To Bank A/c 14,200
To Tax Deducted at Source A/c 4,200
Being interest paid after deducting tax at source
 366

Credit balance of Tax Deducted at Source A/c for Rs.4,200 will appear on the
credit side of the Trial Balance and will be shown as a current liability in the
Balance Sheet.

11.2 Advance Payment of Tax

Under Section 207 of the Income Tax Act 1961, the assesse are liable to pay
advance tax when the income exceeds a certain limit and for companies the limit
is Rs. 2,500. When advance tax is paid, following entry is passed;

Advance Payment of Tax A/c Dr XXX

To Bank A/c XXX

In the trial balance it will be shown on the debit side and in the Balance Sheet it
will appear as a current asset.

11.3 Income Tax

This represents the amount of tax payable on the assessed income. As mentioned
earlier, Advance Payment of Tax and Tax Deducted Source Tax are adjusted
deducted from the total tax payable on the assessed income and then the net
amount is paid.

The tax payable on the assessed income of the X Ltd for the financial year is
Rs100,000 while it has already paid tax in advance for Rs70,000 and has had
TDS balance with certificate for Rs10,000/- . Now the company will pay the
balance amount of Rs20000/- for which following entry will be passed

Rs. Rs.
Income Tax A/c Dr 1,00,000
To Advance Payment of Tax A/c 70,000
To Tax Deducted at Source A/c 10,000
To Bank A/c 20,000

Both Advance Payment of Tax A/c and Tax Deducted at Source A/c will appear
in the Balance Sheet under the head ‘Loans & Advances’ till assessment is
completed.
 367

11.4 Provisions for Taxation

As it takes time to get income assessed in consideration of admissibility of all

payments and taxability of all incomes, company is required to provide for tax
liability on the profits at the current rates. After determining the tax liability
based on self-assessment, the company is required to pass the following journal
entry:

Profit and Loss Account Dr XXX

To Provision for Taxation XXX

Provision for taxation appears in the liability side of the balance sheet under the
head “Provisions” in the broad head “Current Liabilities and Provisions”

Advance Payment of Tax and Provision for Taxation

Trial Balance of X Ltd as on 31 March 2009 shows Debit Balance in Advance

Payment of Tax A/c for Rs.2,00,000 and Credit Balance in Provision for
Taxation for Rs.1,30,000 for the year ended 31 March 2008.

You are provided with following information:

9 Advance Payment of Tax A/c for Rs.2,00,000 includes Rs.1,20,000 for 2007-
08
9 Actual Tax Liability for 2007-08 is Rs.1,40,000/-
9 Provisions for Taxation for 2008-09 is to be made for Rs.1,50,000

Required:

You are required to pass necessary journal entries and show relevant Ledger
Accounts Also show as to how these items will appear in the Profit and Loss
Account and the Balance Sheet as 31 March 2009.
 368

Solution

Debit Credit
Date Rs. Rs.
31-03-09 Provisions for Taxation A/c (2007- Dr 1,30,000
08)
Profit & Loss Appropriation A/c Dr 10,000
To Income Tax A/c 1,40,000
(Being tax liability for 2007-08
adjusted against Provisions for
Taxation A/c (2007-08) and tax in
excess of provision debited to Profit
& Loss Appropriation A/c)

31-03-09 Income Tax A/c Dr 1,40,000

To Advance Payment of Tax 1,20,000
A/c
To Tax Payable A/c 20,000
(Being tax liability for 2007-08
adjusted against Advance Payment of
Tax A/c and balance tax payable A/c)

31-03-09 Profit &Loss Loss A/c Dr 1,50,000

To Provisions for Taxation 1,50,000
A/c (2008-09)
(Being provisions for Taxation made
2008-09)

Provisions for Taxation A/c (2007-08)

Rs. Rs.
To Income Tax A/c 1,30,000 By Balance B/D 1,30,000
(2007-08)
1,30,000 1,30,000

Provisions for Taxation A/c (2008-09)

Rs. Rs.
To Balance C/d 1,50,000 By Profit &Loss 1,50,000
Appropriation A/c
1,50,000 1,50,000
 369

Advance Payment of Tax A/c

Rs. Rs.
To Balance b/d 2,00,000 By Income Tax A/c 120,000
By Balance c/d 80,000
2,00,000 2,00,000

Income Tax A/c

Rs. Rs.
To Advance Payment of 1,20,000 By; Provisions for Taxation 1,30,000
Tax A/c A/c (2007-08)

To Tax Payable A/c 20,000 By Profit & Loss 10,000

Appropriation A/c
1,40,000 1,40,000

Tax Payable A/c

Rs. Rs.
To Balance C/d 20,000 By Income Tax A/c 20,000
20,000 20,000

Profit &Loss A/c

Rs. Rs.
To Income Tax A/c 2007-08 10,000 By Net Profit C/d 1,60,000
To Provision for Taxation A/c 1,50,000
(2008- 09)
1,60,000 1,60,000

X Ltd
Balance Sheet as at 31 March 2009

Rs. Rs.
Capital and Liability Assets
Capital XX Fixed Asset XX
Reserves & surplus XX Investments
Current Liabilities & Current Assets Loans &
Provisions Advances
A. Current Liabilities 20,000 Advance Payment of Income 80,000
Tax Payable A/c 2007-08 Tax
B. Provisions for Tax 1,50,000
2008-09
XXX XXX
 370

11.5 Deferred Taxes –Assets and Liabilities

Current Tax

As mentioned earlier after preparation of profit and Loss Account, Tax on profit
is estimated and provided in the profit and loss appropriation account. Generally
provisions for taxation are made on current taxable income. Tax calculated on
taxable income is called ‘Current Tax’. Tax can be also calculated on accounting
income.

Taxable income is the income determined in accordance with the tax laws
(Income Tax Act 1961 and Income Tax Rules), based on which income tax is
payable for a period. Accounting income is different from taxable income.
Accounting income is the net profit for a period as reported in Profit and Loss
Account.

Tax Expenses and Deferred Tax

The difference between tax on accounting income and taxable income is called
‘Deferred tax’. Deferred tax is the effect of timing differences. The tax to be
charged to Profit and loss account is ‘Tax Expenses’ which include Current Tax
plus Deferred Tax. Deferred Tax arising out of timing difference included in the
tax expenses is shown in the Balance Sheet as ‘Deferred Tax Assets or Deferred
Tax Liabilities, as the case may be.
Deferred Tax Assets
A deferred tax asset comes into existence when taxable income is more than
accounting income and this is due to time difference. There could be many
reasons for such difference. One of the major reasons for this mismatch is the
fact that certain expenses may be deducted as per accounting principles and
practice, but they are not considered by tax authorities as deductible or
admissible expenditure. The most common example is Provision for Bad Debt in
Profit & Loss Account showing the accounting income, but such item is not
deductible as per tax laws until and unless it crystallizes. Following example will
clarify the accounting treatment of deferred tax asset.

Accounting income of a company after making provision for bad debt of Rs10-
lacs is Rs90-lacs in 2009-10, while taxable income at the end of the financial
year will be Rs1-crore. Tax authorities will allow Bad Debt as Admissible
Expenses when it will be actually established or crystallized. Tax rate is 35%.
Pass journal entry for provisions for taxation for the year 2009-10.
 371

Solution

9 Accounting Income is Rs. 90-lacs; Tax @35% on Accounting Income is Rs

31,50,000
9 Taxable income is Rs1 crore; Tax @35% on Taxable Income is Rs.
35,00,000.
9 Current Tax is Rs 35,00,000 while Tax Expenses for 2009-10 is
Rs31,50,000.

This difference of Rs 3,50,000 is deferred tax for which following adjustment

entry needs to be passed.
(Amount in Rs.)
Date Particulars Debit Credit
31.3.2010 Profit and Loss A/c 31,50,000
Deferred Tax Asset A/c 3,50,000
To Provision for Taxation A/c 35,00,000

Deferred Tax Liability

Deferred Tax Liability arises when taxable income is less than accounting
income. There could be many reasons for Taxable income to be less than
accounting income. One of the major reasons is depreciation on assets. As per
income tax laws, depreciation is charged on fixed assets on WDV basis, while in
accounts it may be on straight-line method.

In the financial statement of M/S XYZ Ltd. depreciation on fixed assets, which is
charged to Profit & Loss A/c on straight line method is Rs. 10,00,000/- while
depreciation allowed on fixed assets as per tax laws at the specified rate amounts
to is Rs. 12,00,000 in 2009-10. Accounting income is Rs. 20,00,000.
Required:
Pass necessary journal entry assuming tax rate to be 35%.
Solution
9 Accounting income is Rs. 20,00,000 Tax on Accounting income is Rs.
7,00,000.
9 Taxable income is Rs. 18,00,000; and therefore the Current Tax is Rs.
630,000.
9 Thus current tax is Rs. 6,30,000, while tax expense is Rs. 7,00,000.
 372

This time difference of Rs. 70,000/- is Tax liability for future, for which the
following journal entry will be passed
(Amount in Rs.)
Date Particulars Debit Credit
31.03.10 Profit and Loss A/c Dr 7,00,000
To Provision for Taxation A/c 6,30,000
To Deferred Tax Liability A/c 70,000
(Being tax expenses of Rs.7,00,000 with
current tax of Rs.6,30,000 provided for)

Deferred Tax - Situations and treatment

Deferred tax due to time difference originates in the current year and reverses in
the subsequent years with the difference cease to exist. There are many situations
where such time difference arises. Following are the few instances of such
situations or cases:

i) Depreciation accounting

a) Difference in rates of depreciation in financial accounting and tax laws

b) Difference in depreciation methods in financial accounting and tax laws
c) Difference in consideration of costs of asset in financial accounting and tax
laws

ii) Difference in recognition and treatment of expenditure

Certain expenses are debited to Profit & Loss Account on accrual basis, but
allowed by tax authorities for the purpose of computation of tax liability in
subsequent years as and when the expenses are paid. For example Excise duty,
cess, fees etc.

iii) Difference in recognition and treatment of Income

Sometimes incomes are recognized in accounts over the years according to

periodicity of earning and expenditure applying matching principles, but for
taxation purpose, it is considered and recognized in the year of receipt.
Sometimes certain incomes are credited to Profit & loss A/c, but taxed in the
subsequent years
 373

iv) Provisions for contingencies

Provisions for contingencies such as provision for bad debts are debited in the
profit & loss Account, but they are considered admissible as and when
crystallized.

v) Amortization of expenses

Certain expenditure like expenditure on research and development are fully

considered in one year, while in financial accounting it is spread over a period.

When taxable income is more than accounting income it gives rise to

A Deferred tax asset

B Deferred tax liability
C Current tax
D Extraordinary income

12.Discuss and calculate managerial remuneration in

accordance with the provisions of the Companies Act
1956.
[Learning Outcome l]

12.1 Managerial Remuneration

As per section 309 of the Act, the remuneration payable to the directors shall be
determined –

9 By the Articles of Association or

9 By Ordinary resolution or
9 By special resolution where AoA so require

Calculation of Managerial Remuneration and computation of profits as a base for

calculation of Managerial Remuneration are important aspects in financial
accounting. Schedule XIII contains detailed provision regarding calculation of
managerial remuneration.
 374

Schedule XIII is divided in three parts:

9 Part I deals with ‘Appointments’

9 Part II deals with ‘Remuneration’ and
9 Part III deals with ‘Provisions applicable to Part I and Part II of this
schedule’.

In this Learning Outcome we will discuss calculation of managerial remuneration

and determining net profits for calculation of managerial remuneration.

12.2 Legal provisions for payment of Managerial Remuneration

a) Remuneration not to exceed 11% - As per Section 198 of the Companies

Act 1956, the total remuneration payable to its directors and managers in
respect of any financial year shall not exceed 11% of the net profits.

b) Quantum of remuneration- As per Sch. XIII of the Act such remuneration

shall not exceed 5% of the net profits for a single managerial personnel. If
the company has more than one managerial personnel. Then such
remunerations shall not exceed 10% of the net profits. This limit can be
increased with the approval of Central Government only.

c) Remuneration to non-executive directors – Except with the approval of the

central Government, the remuneration of the non-executive directors shall
not exceed:

d) 1% of the net profits if a company has employed a managing director or a

whole time director or a manager

e) 3% of the net profits, if the company has not employed a managing director
or a whole time director or a manager

f) The aforesaid percentage shall be exclusive of any sitting fees payable to

directors. In other words sitting fees is not considered while computing any
of the limits of managerial remuneration. However if sitting fees is paid to
the whole time director or a managing director, then it will be considered as a
payment of remuneration to directors.

g) The net profits shall be computed in the manner laid down in Section 349 of
the Act.

h) Remuneration shall not be deducted from the gross profits.

 375

i) In case of absence of profits or inadequacy of profits, such remuneration

shall not exceed a ceiling limit of Rs. 24,00,000 per annum or Rs. 2,00,000
per month but within the limits of scale based on the effective capital of the
company as provided in the Schedule XIII of the Act.

Where the effective capital of the Monthly remuneration

Company is payable to each
managerial person shall
not exceed (in Rs.)
A Less than Rs.1 Crore 75,000
B Between Rs.1 Crore and Rs.5 Crore 1,00,000
C Between Rs.5 Crore and Rs.25 Crore 1,25,000
D Between Rs.25 Crore and Rs.50 Crore 1,50,000
E Between Rs.50 Crore and Rs.100 Crore 1,75,000
F Rs.100 Crore or more 2,00,000

Summary of different limits based on Net profits of the company is given

below:

Sr. Managerial personnel % of net

No profit
1 Whole time director or managing director (where there is 5%
one)
2 Whole time director or managing director (where there is 10%
more than one)
3 Manager 5%
4 Non-executive directors
(i) If the company has managing director or a whole time 1%
director or manager
(ii) In other case 3%
5 All managerial personnel’s together 11%

Computation of profits as a base for calculation of Managerial

Remuneration

Net profit for the purpose of calculation of Managerial Remuneration profits

should be computed as per provisions of Section 349 of the Companies Act 1956.
 376

Section 349 requires that in computing the net profits of a company in a financial
year:

i) Credits shall be given for the items specified in sub-section (2) and Credits
shall not be given for the items specified in Sub-section (3)
ii) The sums specified in sub-sec. (4) shall be deducted and those specified in
sub-sec (5) shall not be deducted.

In view of the items as specified in sub-sec (2), (3) (4), (5), profits for the
purpose can be computed in the following manner:

Computation of profit for the puprose of managerial remuneration

under Section 349 of the Companies Act.

(Please note that this is not an exhaustive list)

Sl No. Particulars Amount

(Rs)
Profit before tax as per Profit & Loss account
ADD The following if debited to the Profit & Loss account bef
arriving at the profit before tax
1 Managerial Remuneration
2 Provision for Doubtful Debts
3 Loss on Sale/disposal/discarding of Assets
4 Loss on sale of Investments
5 Write off of Investment
6 Provision for diminution in the value of Investments
7 Unserviceable Fixed Assets Written off
8 Fall in the value of Foreign Currency Monetary Assets
9 Loss on cancellation of Foreign Exchange Contracts
10 Provision for Contingencies and Unascertained Liabilities
11 Provision for loss of Subsidiary Companies
12 Lease Premiums Written off
13 Provisions for Warranty Spares/Supplies
14 Infructuous Project Expenses Written Off
15 Provision for anticipated loss in case of Contracts
16 Loss on sale of Undertaking
17 Provision for Wealth Tax
18 Voluntary Compensation Paid under VRS
 377

Sl No. Particulars Amount

(Rs)
19 Depreciation as provided in the Books
LESS The following if credited to the Profit & Loss account
for arriving at profits before tax
1 Capital Profit on sale/disposal of Fixed Assets
2 Profit on sale of Undertaking/any part thereof
3 Profit on Buy-back of Shares
4 Profit/discount on redemption of Shares or debentures
5 Profit on sale of Investments
6 Compensation received on “Non-Compete” Agreements
7 Write back of Provision for doubtful debts
8 Write back of Provision for doubtful Advances
9 Appreciation in the value of Investments
10 Compensation received on surrender of Tenancy Rights
11 Profit on Sale of Undertaking
12 Consideration received on assignment of Operating License
13 Write back of Provision for contingencies
14 Write off Bad debts against the Provision created earlier.
15 Write back of Provision for diminution in the value of
Investments
16 Excess of Expenditure over Income, i.e Loss of earlier
years computed in accordance with Sec.349.
17 Profit on sale of forfeited Shares
18 Depreciation as provided in the Books of Account
19 Profit on sale of Shares of Subsidiary /Associate
Companies

Besides the above:

a) Certain Extraordinary Items as required under Accounting Standard-5 are

shown after arriving at Profits before Tax. Such items also need to be
considered for arriving at the Profit under Section 349 of the Companies Act.

b) Bounties and Subsidies received from any Government or any Public

Authority constituted or authorised by any Government shall also be added
notwithstanding the fact that they may have been directly credited to Capital
Reserves.
 378

M/S XYZ Manufacturing Co. Ltd with authorized capital of Rs.60,00,000

consisting of 5,00,000 equity shares of Rs.10 and 1,00,000 6% preference shares
of Rs.10 each has prepared following trial balance as 31 March 2010:
Trial Balance as on 31 March 2010
(Amount in Rs.)
Dr Cr
Goodwill & patents 50,000 Equity Share Capital 50,00,000
(Rs10each)
Land & building 33,45,000 Pref. Share Capital (Rs. 5,00,000
100 each)
Plant & machinery 27,24,500 General Reserve 5,00,000
Interim dividend 1,00,000 10% Debentures 7,00,000
Calls in arrear 4,000 Trade payables 4,43,900
Preference dividend 30,000 Depreciation: Land & 74,000
Building
Investment: In quoted 4,08,000 Depreciation: Plant& 4,00,400
Share Machinery
Work-In Progress 2,00,000 Provision for Doubtful 12,700
Debts
Stock 6,74,000 Profit & Loss Account 1,35,000
01/04/2009
Trade Receivables 8,70,000 Provision for taxation 172,000
for 2008-09
Cash in hand 12,000 Sales 52,56,000
Cash at Bank 5,00,000 Income from 28,500
Investments
Preliminary expenses 7,500 Proceeds from reissue of 10,000
shares forfeited due to
calls in arrear
Discount on debenture 16,000
Debenture interest (6 35,000
months)
Works overhead 15.06,500
Direct materials purchased 18,94,800
Direct labour paid 7,11,900
Administrative expenses 71,000
Remuneration Paid to MD 41300
Directors’ Fees 4,000
Loan to Employees 27,000
1,32,32,500 1,32,32,500
 379

Following additional information is provided for preparation of financial

statements of the company for 2009-10:

1. Closing Stock valued on 31 March 2010 - Rs.6,50,000

2. Closing Work in-progress on 31 March 2010 – Rs.7,50,000

3. In 2009-10, land and building was revalued at Rs.40,00,000. New value is to

be taken into financial statement. Depreciation on land and building is to be
provided for Rs. 40,000. Depreciation on plant and machinery is to be
provided for Rs.2,00,000. But Depreciation admissible under section 350 of
the Companies Act is Rs. 2,68,000 on Plant & Machinery and Rs. 60,000 on
land &Building

4. Preliminary expenses and discount are to be written off fully in the current
financial year.

5. Directors declared a final dividend of 4% on equity shares and decided to

transfer to general reserve Rs.1 lakh.

6. Market value of investments are Rs.5,10,000

7. Taxation Liability for 2008-09 has been decided by the Tax Authority as per
Assessment order for Rs.1,70,000 which was paid off on 15 April 2010.

8. Other Provisions to be made for

a) Director Fees Rs.20,000
b) Bad Debt Rs.15,000
c) Debenture Interest to be provided for the balance 6 months
d) Auditors’ Remuneration Rs.15,000
e) Provisions for taxation to be made @35% of the current profit
f) Outstanding Liability Managerial remuneration to be provided for in
accordance with the provisions of Companies Act and the agreement in
this regard.
g) Contingent Liability against a legal action by a customer for defect in the
product causing property damage of Rs.50,000.

You are required to prepare Manufacturing Account and Profit& Loss Account
and the Balance Sheet in the prescribed format (horizontal)
 380

Solution;
M/S XYZ Manufacturing Co. Ltd
Manufacturing and Profit & Loss Account
For the year ended 31st March 2010

Particulars Rs. Particulars Rs.

To Opening Work in-progress 2,00,000 By Closing Work in-progress 7,50,000
To Direct Materials Purchased 18,94,800
By P & L Account: Cost of Goods
To Direct Labour Paid for 7,11,900 37,63,200
produced
To Works overhead 15.06,500
To Depreciation;
Plant & Machinery 200,000
Total 45,13,200 Total 45,13,200

To Stock in Trade 6,74,000 By Sales 52,56,000

To Manufacturing A/c (Cost of Goods
37,63,200 By Closing Stock 6,50,000
produced)
To Administrative Overhead 71,000 By Investment Income 28,500
To Director Fess (4000+20000) 24,000
To Debenture Interest; 70,000
(Paid Rs. 35,000 + OS Rs.35,000)
To Depreciation; Land &Building 40,000
To Provision for Bad Debt 15,000
To Auditors’ Remuneration 15,000
 381

M/S XYZ Manufacturing Co. Ltd

Manufacturing and Profit & Loss Account
For the year ended 31st March 2010

Particulars Rs. Particulars Rs.

To Discount on debentures 16,000
To Preliminary Expenses 7,500
To Managerial Remuneration
Amount Paid Rs.41,300
Add: Outstanding Liability Rs.18,565 (see
59,865
Note 2)

To Net Profit C/D 11,78,935

Total 59,34,500 Total 59,34,500

To Provisions for Taxation 4,12,627 By Balance as per last A/c 1,35,000

To Preference Dividend 30,000 By Net Profit b/d 11,78,935
To Interim Dividend 1,00,000 By Excess of Provision over 2,000
To Proposed Dividend 2,00,000 Tax Liability for 2008-09
To Transfer to General Reserve 1,00,000
To Balance transfer to Balance Sheet 4,73,308
Total 13,15,935 Total 13,15,935
 382

M/S XYZ Manufacturing Co. Ltd

Balance Sheet as at 31st March 2010

Rs. Rs.
Authorized Capital 50,00,000
5,00,000 equity shares of Rs10 each 1,00,000
6% Preference Shares of Rs10 each 10,00,000

Equity and Liabilities

Share Capital 50,00,000
Subscribed &Paid-up capital
5,00,000 equity shares of Rs10 each
6% Preference Shares of Rs10 each 5,00,000
Reserves and Surplus
Capital reserves
- On revaluation 6,55,000
- On reissue of share 6,000
6,61,000
General reserve
- Previous balance 5,00,000
- Current transfer 1,00,000
6,00,000
Profit and Loss 4,73,308 17,34,308
Total shareholders fund 72,34,308

Non-current liabilities
10% Debentures 7,00,000

Current liabilities
Trade payables 4,43,900
Tax liability (08-09) 1,70,000
Debenture interest 35,000
Outstanding Directors’ fees 20,000
Outstanding Directors’ remuneration 18,565
Outstanding audit fees 15,000
Provision for tax (2009-10) 4,12,627
Dividend outstanding 2,00,000 13,15,092
Total Equity and Liabilities 92,49,400
Assets
Non-current asset
Goodwill 50,000
 383

M/S XYZ Manufacturing Co. Ltd

Balance Sheet as at 31st March 2010
Rs. Rs.
Land &Buildings 33,45,000 38,86,000
Add: Revalution 6,55,000
40,00,000
Less: Depreciation
Previous Balance 74,000
Current 40,000
1,14,000
Plant &Machinery 27,24,500 21,24,100
Less: Depreciation
Previous Balance 4,00,400
Current 2,00,000
6,00,400
Quoted Shares in companies 4,08,000
Total non-current assets 64,68,100

Current liabilities
Work in progress 7,50,000
Finished stock 6,50,000
Trade receivables 8,70,000
Less: Prov for Bad debts (27,700) 8,42,300
Balance at Bank 5,00,000
Cash in hand 12,000
Loans to employees 27,000
Total current assets 27,81,300
Total assets 92,49,400

Notes to accounts
Contingent liability- Liability against legal Action by customer due to defect in
product causing damage to property of customer I estimated as Rs.50, 000
Workings:
W1 Computation of Profit for calculation of Managerial Remuneration
Particulars Rs. Rs.
Profit before Tax & Managerial Remuneration 12,38,800
Add:
(i) Depreciation as per P&L A/c (2,00,000 + 2,40,000
40,000)
(ii) Provision for bad debts 15,000
 384

Particulars Rs. Rs.

(iii) Director fees 24,000
(iv) Preliminary expenses written off 7,500 286,500
15,25,300
Less: Depreciation allowed U/S 350 (3,28,000)
(2,68,000+60,000)
Profit for Managerial Remuneration 11,97,300

Managerial Remuneration 5% of Rs11,97,300 59,865

W2 Provisions for Outstanding Liability

Rs
Managerial Remuneration payable to MD as per agreement 59,865
Less: Amount Already Paid 41,300
Liability to be provided for managerial remuneration 18,565

The total remuneration payable to its directors and managers in respect of any
financial year shall not exceed:

A 11% of the net profits

B 5% of the net profits
C 3% of the net profits
D None of the above

Summary

¾ Form and content of a Balance Sheet and Statement of Profit and Loss is
governed by the provision under Companies Act 1956, Schedule VI
¾ Schedule VI to the Companies Act, 1956 has recently been revised and is
became applicable to all companies for the preparation of financial
statements beginning on or from 1 April 2011.
¾ A company formed and registered under this Act or any existing company
formed and registered under any of the previous company laws specified in
Section 3(i)(ii).
 385

¾ Section 209 of the Companies Act 1956 prescribes the books of accounts to
be maintained by every company at its registered office. The primary
responsibility of maintenance of books of account is that of the Managing
Director or Manager and all officers or other employees who have been
given the responsibility by the Board of Directors.
¾ In case of any default for payment of call money the directors of the
company may, with the express provisions in its articles, proceed to forfeit
such shares with prior notice in this regard.
¾ The balance, if any, left after reissue of forfeited shares in the Share Forfeited
Account, should be treated as capital profit and transferred to Capital
Reserve Account.
¾ Buy-back of shares means repurchase by the company of its own shares.
Buy-back can be done provided conditions mentioned in Sub clause (2) of
Section 77A are adhered.
¾ There are several ways in which employees buy shares through ESOS – they
may purchase shares out of their own funds (known as ESPS) or they borrow
money from the company to purchase shares (known as ESOS)
¾ Issue and redemption of preference shares are governed by Section 80 of the
Companies Act, 1956. Method of redemption of preference shares include: a)
Fresh issue of shares, b) Capitalisation of undistributed profit or c)
Combination of both
¾ Underwriting means undertaking a responsibility or giving a guarantee that
the shares or debentures offered to the public will be subscribed for in full.
The persons or institutions that give such guarantee are called underwriters
¾ A company may decide to distribute past undistributed profit, when there is
large amount of accumulated reserves, by way of issuing shares free of cost
to its existing shareholders. Such shares are called Bonus Shares
¾ Provision for taxation appears in the liability side of the balance sheet under
the head “Provisions” in the broad head “Current Liabilities and Provisions”
¾ The difference between tax on accounting income and taxable income is
called ‘Deferred tax’. Deferred tax is the effect of timing differences.
¾ Schedule XIII contains detailed provision regarding calculation of
managerial remuneration.
 386

Answers to Test Yourself

Answer to TY 1

The correct option is D.

At every annual general meeting the financial statements are presented to the
shareholders by the Board of Directors.

Answer to TY 2

The correct option is C.

A foreign company is one that is incorporated or registered outside India but has
a place of business or operations in India.

Answer to TY 3

The correct option is C.

In case of existing companies, books of account along with relevant vouchers

must be preserved in good order for a minimum period of 8 years.

Answer to TY 4

The correct option is C.

The balance in Share Forfeited Account after the reissue of forfeited shares is
transferred to capital reserve account.

Answer to TY 5
The correct option is A.
According to Sub clause (2) of section 77A, buy-back of shares is equal to or less
than 25% of the total paid up equity share capital and free reserves

Answer to TY 6
The correct option is B.
The accounting value of options granted under an Employee Stock Option Plan
shall be treated as employee compensation in the financial statements.
 387

Answer to TY 7

The correct option is A.

The premium, if payable on redemption, must be provided for out of the

profits of the company or the share premium account.

Answer to TY 8

The correct option is C.

Commitment provided to accept a specified number of shares irrespective of the

number of shares subscribed by the public are known as firm underwriting.

Answer to TY 9

The correct option is D.

Answer to TY 10

The correct option is A.

The form and contents of Balance Sheet and Statement of Profit and loss is for
companies are prescribed by Schedule VI of the Companies Ac.

Answer to TY 11

The correct option is A.

When taxable income is more than accounting income, it gives rise to

Deferred Tax Asset.

Answer to TY 12

The correct option is A.

The total remuneration payable to its directors and managers in respect of

any financial year shall not exceed 11% of the net profit.
 388

Self-Examination Questions

Question 1

The Securities Premium Account is shown under

A Share Capital
B Current liabilities
C Current Assets
D Reserves and Surplus

Question 2

The excess price received over the par value of share, should be credited to:

A Calls-in-advance account
B Share Capital account
C Capital Reserve A/c
D Securities Premium A/c

Question 3

The maximum amount beyond which a company is not allowed to raise

funds by issue of shares is:

A Issued Capital
B Authorised Capital
C Paid Capital
D Subscribed Capital

Question 4

Nominal share capital is:

A that part of the authorised capital which is issued by the company.

B the amount of capital which is actually applied for by the prospective
shareholders.
C the maximum amount of share capital which a company is authorised to
issue.
D the amount actually paid by the shareholders.
 389

Question 5

A public company means a company which:

(i) is not a private company

(ii) has a minimum paid-up capital of 5 lakh rupees or such higher paid-up
capital as may be prescribed
(iii) is a private company which is a subsidiary of a company which is not a
private company

A Only (i)
B (i) and (ii)
C (ii) and (iii)
D (i), (ii) and (iii)

Question 6

If a company has employed a managing director or a whole time director or a

manager, the maximum remuneration payable to non-executive director shall be:

A 1% of the net profit

B 5% of the net profit
C 10% of the net profit
D None of the above

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is D.

The Securities premium Account is shown under reserves and surplus in the
Balance Sheet.

Answer to SEQ 2

The correct option is D.

The excess price received over the par value of share is referred to as Securities
Premium and should be credited to the Securities Premium Account
 390

Answer to SEQ 3

The correct option is B.

The maximum amount beyond which a company is not allowed to raise funds by
issue of shares is the authorised capital

Answer to SEQ 4

The correct option is C.

Nominal share capital is the maximum amount of share capital which a company
is authorised to issue.

Answer to SEQ 5

The correct option is D.

All the three points are applicable for a public company

Answer to SEQ 6

The correct option is A.

If a company has employed a managing director or a whole time director or a

manager, the maximum remuneration payable to non-executive director shall be
1% of the net profit.
 391

CHAPTER 3

NON-LIFE INSURANCE BUSINESS

ACCOUNTING METHODS, TECHNIQUES &
PROCESS
UNIT 10

GENERAL INSURANCE ACCOUNTING

PROCESS & TECHNIQUES
Chapter Introduction
Accounting Process & Techniques of General Insurance Business comprise
regulatory aspects and technical aspects of accounting. This unit deals with the
fundamentals of general insurance accounting with special emphasis on
accounting framework, certain definitions and interpretations of various terms
and techniques used in the accounting process. The regulatory aspects have been
discussed specifically in the next unit.

a) Discuss the accounting framework with reference to insurance business.

b) Explain the definition and interpretations of various terms and techniques
used in the insurance accounting process.
c) Discuss what is meant by Co-insurance.
d) Discuss the financial reporting requirement for non-life insurance
business, including the requirement to prepare consolidated financial
statements.
 392

1. Discuss the accounting framework with reference to

insurance business.
[Learning Outcome a]

1.1 Accounting Framework in General Insurance Business

The legal aspects of insurance accounting in India are addressed by the primary
legislations which include:

Diagram 1: Primary Legislations

The technical aspects of insurance accounting are addressed by the Accounting

Standards, Accounting Conventions, Accounting Process discussed earlier.

The aforesaid legal and technical aspects are taken together for forming the
Accounting Framework or Indian GAAP (Generally Accepted Accounting
Principles) for insurance accounting in India. Accounting Standards mentioned
here are Accounting Standards issued by the Institute of Chartered Accountants
of India. Pertinently, the Accounting Standards issued by the ICAI will be
converged with International Financial Reporting Standards with effect from
2012.
Section 11 of the Insurance Act 1938 provides that every insurer, on or after the
commencement of the IRDA Act, 1999 in respect of insurance business
transacted by him and in respect of his shareholders’ fund, shall at the expiration
of each financial year, prepare:
9 Balance Sheet,
9 Profit and Loss account,
9 Separate Account of Receipts and Payments (Cash Flow Statement),
9 Revenue Accounts in accordance with the regulations made by the Authority.
 393

Every Insurer shall keep separate accounts relating to funds of shareholders and
policyholders.

The IRDA (Preparation of Financial Statements and Auditor’s Report of

Insurance Companies) Regulations, 2002 provide that an insurer carrying on
general insurance business shall prepare financial statements in compliance with
the requirements of Schedule ‘B’ to the said regulations. They must thoroughly
understand the requirements of the Regulations before they proceed to prepare
financial statements of a general insurance company.

The format of financial statements as prescribed by Schedule B of IRDA

(Preparation of Financial Statements and Auditor’s Report of Insurance
Companies) Regulations, 2002 is covered in detail in Unit 11.

1.2 Accounting Basis; Annual Basis vs. Fund Basis

There are several bases of accounting for insurance transactions. However, most
commonly used bases are Annual basis and Fund Basis. These bases refer to the
way in which profit is recognised in the accounting period.

Fund Basis of accounting – This basis is adopted where it takes a long time to
determine the underwriting result with a reasonable degree of certainty. Under
this basis, a fund is created for each underwriting year. Premiums on business
written during the year and related claims or expenses are posted to the fund. The
fund for each underwriting year will remain open until there is enough
information to determine the underwriting results. No profit is recognized for
open years until information is reasonably certain, but provisions are usually
made for any anticipated losses.

Annual Basis of accounting: This basis is used where it is possible to determine

the underwriting result of an insurance business written in an accounting period
at the end of that period. The profits and losses of business written during the
financial year are recognised at the end of that financial year by setting up
provisions for outstanding claims, unearned premiums and unexpired risk
provisions, and by deferring an appropriate portion of acquisition costs.
 394

Comparison of Fund basis and Annual Basis of accounting

General insurance business can be accounted for both on Annual basis and Fund
basis. But in most cases, general insurance accounting is prepared on annual
basis with appropriate estimation for outstanding claims made at the balance
sheet date. The estimation for outstanding claims must be appropriate to comply
with the requirement of the Companies Act that the financial statements shall
give a true and fair view of profit or loss of the insurance company for the
accounting period and a true and fair view of the state of affairs of the company
at the end of the year.

Compared to the fund basis, the annual basis is a better indicator of current
profitability since profits and losses pertain to underwriting decisions and
investment decisions. In certain circumstances such as in marine, aviation and
liability business, where abnormal delays occur in the receipt of information on
claims, the accounts prepared on the annual basis may not be much meaningful.
In such cases the use of the fund basis may be more meaningful. However, in
general, annual basis of accounting is followed in general insurance business
with appropriate adjustments or provisions for ‘Outstanding Claims’ and
‘Reserves for Unexpired Risks’. Where the fund basis of accounting is adopted,
the reasons for such adoption should be disclosed together with the categories of
business accounted for in this way and the period before which any underwriting
profit is recognized in respect of an underwriting year.

In India, only annual basis is adopted for insurance accounting for determination
of underwriting results for all departments of business including Fire, Marine,
Motor, Engineering and Miscellaneous.
 395

Diagram 2: Fund basis and Annual basis of accounting

In accordance with the Indian GAAP, the basis adopted for insurance accounting
for determination of underwriting results is:

A Fund Basis
B Annual Basis
C Either Fund Basis or Annual Basis
D None of the above
 396

2. Explain the definitions and interpretations of various

terms and techniques used in the insurance accounting
process.
[Learning Outcome b]

2.1 Underwriting Results

The prime consideration of the insurer, also called the underwriter, is

underwriting results of his insurance business. Underwriting results are
determined on an annual basis by deducting all costs or expenses incurred for the
particular year from the ‘Earned Premium’ in the year.

Costs include:

9 Incurred Claim Net

9 Commission Net (Acquisition Costs) and
9 Operating Expenses

Underwriting results provide the basic foundation for deciding underwriting

policy of the company. The corporate management examines and analyses
underwriting results of each and every product for review of underwriting policy
for every product or product-mix or the total underwriting policy. For this
purpose underwriting results for each department are separately determined
through preparation of Revenue Account for each department. Revenue Account
determines underwriting results as well as Revenue Account Surplus after
adjustment of Investment Income on Policyholders’ fund.

The Fire Department of ABC General Insurance Co Ltd gives the following
details for 2009-10:

9 Earned Premium is Rs. 900 crore

9 Incurred Claim Net Rs. 600crore
9 Commission Net Rs. 100 crore
9 Operating Expenses Rs.190 crore
9 Investment Income on Policyholders’ fund (fire) Rs. 210 crore

Compute Underwriting Results and Revenue Account Surplus for Fire Dept.
 397

Solution

Computation of Underwriting Results and Revenue Account Surplus

Rs in crores Rs in crores
Earned Premium 900
Less: Incurred Claim Net 600
Commission Net 100
Operating Expenses 190 890

Underwriting Results 10
Add: Investment Income on Policyholders’ 210
fund (fire)
Revenue A/c Surplus 220

Note: Underwriting Results and Revenue Account Surplus are determined from
the Revenue Account forming part of Financial Statements, discussed in unit 12.

2.2 Premium Income

Premium income is the consideration received from the insured by the insurance
company in accordance with the contract of insurance. This forms a primary
source of income for any insurance company.

In accordance with Part I of Schedule B of IRDA (Preparation of Financial

Statements and Auditor’s Report of Insurance Companies) Regulations, 2002,
“Premium shall be recognised as income over the contract period or the
period of risk, whichever is appropriate”

Premium income means Net Premium Earned which is determined after

necessary adjustments shown in the below table. Earned premium is the
proportion of written premiums (including, where relevant, those of prior
accounting periods) attributable to the risks borne by the insurer during the
accounting period.

Net Premium Earned is determined after adjustment for ‘Reinsurance Premium’,

‘unearned premium’ and ‘Premium Received in Advance’ from Written Premium
in the year. Written premiums under annual basis comprise all premiums relating
to policies incepting in the accounting period.
 398

They will include the premium for the whole of the period of risk covered by the
policies, regardless of whether or not these are wholly due for payment in the
accounting period. Written premiums are also subject to adjustments for the
premium pertaining to unexpired risks. Department-wise ‘Net Premium Earned’
is calculated in the following manner for the purpose of its consideration in the
respective Revenue Account:
Net Premium Earned Account (to be shown in Revenue A/c)

Rs. Rs.
Gross premium received on risks undertaken during XX
the year (direct & re-insurance accepted)
Add: Receivable at the end of year (direct & re- XX
insurance accepted)
Less: Receivable at the beginning of year (direct & re- (XX)
insurance accepted)
Less: Premium on re-insurance ceded:
- Paid during the year XX
- Add: Payable at the end of year XX
- Less: Payable at the beginning of year (XX) (XX)
Net premium income (XXX)

The Fire Department of ABC General Insurance Co Ltd gives the following
details for 2009-10:
9 Gross Direct Premium Income Rs. 981crore
9 Premium on Reinsurance Accepted Rs. 343crore
9 Premium on Reinsurance Ceded Rs. 437 crore
9 Net Premium for 2008-09 Rs. 913 crore
Calculate Net Premium Account
Solution

(Rs. in crores)
Gross Direct Premium Income 981
Add: Premium on Reinsurance Accepted 343
Less: Premium on Reinsurance Ceded (437)
Net Premium 887
*Adjustment: Change in Reserve in Unexpired Risks 50% (-)13
(913-887)
Net Premium Earned (2009-10) 874
 399

*Note: In accordance with the provisions of section 64 V(1) (ii) (b) of The
Insurance Act 1938, reserve for unexpired risks shall be created in respect of fire
and miscellaneous business at 50%.

2.3 Technical Reserves / Unexpired risk reserves

Technical reserves are also referred to as reserves for Unexpired Risk. Most of
the general insurance policies are annual policies, which are issued throughout
the year. The technical reserves are created in respect of such policies that extend
beyond the reporting date into the following years during which the coverage of
risk continues. In other words, this reserve is created to meet the claims which
arise when the policies mature in the subsequent years.

Per Section 64 V(1) (ii) (b) of The Insurance Act 1938, on the reporting date, a
liability for unexpired risk reserve is created for the policies which extend
beyond the reporting date. A provision for unexpired risks is made normally at
50% in the case of Fire Insurance and 100% of in the case of Marine Insurance.
This reserve is based on the net premium income earned by the insurance
company during the year.

In addition to this, if unearned premium exceeds such reserve for unexpired risks
calculated as per the provisions of the Act, the difference is to be accounted for
as unearned premium.

The following is the information pertaining to New Imperial Insurance Co. Ltd:

i) On 31.12.2010 the reserves for unexpired risk were as follows:

9 Marine insurance business - Rs. 22.5 crores

9 Fire insurance business - Rs. 30.0 crores
9 Miscellaneous insurance business - Rs. 7.5 crores

ii) It is the accounting policy of the company to create reserves in accordance

with Section 64 V (1) (ii) (b) of The Insurance Act 1938.

iii) During 2011, the following business was conducted :

 400

Marine Fire Miscellaneous

Rs in Rs in Rs in crores
crores crores
Premia collected from :
(a)Insured in respect of policies 27.0 64.5 18.0
issued
(b)Other insurance companies 10.5 7.5 6.0
in respect of risks undertaken
Premia paid/payable to other 10.0 6.4 10.5
insurance companies on business
ceded

Required:

Show the accounting treatment of Unexpired risks reserve for the year ended
December 2011.

Solution

Rs in Rs in
crores crores
Marine Revenue A/c Dr. 5.0
To Unexpired risk reserve 5.0
Being the difference between closing provision of Rs. crores (27.0 + 10.5 –
10.0) and opening provision of Rs.22.5 crores charged to marine revenue
account

Fire Revenue A/c Dr. 2.8

To Unexpired Risks Reserve A/c 2.8
Being the difference between closing provision of Rs.21.85 crores [(64.5
+ 7.5 – 6.4)/2] and opening provision of Rs.30 crores charged to fire
revenue account

Unexpired Risks Reserve A/c Dr. 0.75

To Miscellaneous Revenue A/c 0.75
Being the excess of opening balance of Rs.7.5 crores over the required
closing balance of Rs. 6.75 crores [(18.0 + 6.0 – 10.5)/2] credited to
miscellaneous revenue account
 401

Unexpired Risks Reserve A/c

(Rs in crores)
Marine Fire Misc. Marine Fire Misc.
To - - 0.75 Balance 22.5 30.0 7.5
Revenue b/d
A/c
To 27.5 32.8 6.75 By 5.0 2.8 -
Balance Revenue
c/d A/c

27.5 32.8 7.5 27.5 32.8 7.5

Instead of calculating the differential for the unexpired risk reserve account, the
opening balances of unexpired risk reserves may be reversed at the start of the
year by transferring the entire balance in the reserve account to the revenue
account and then providing for fresh reserve of the full required amount at the
end of the year.

International practices (UK) in respect of recognition of premium income:

9 Written premiums should comprise the total premiums receivable for the
whole period of cover provided by a policy during an accounting period
together with certain adjustments arising in the accounting period to such
premiums receivable in respect of business written in prior accounting
periods.

9 If premiums are receivable in installments (especially in project insurance)

during the period of risk covered by insurance contracts, any amount
receivable on the balance sheet date by the insurer in terms of contract may
be treated as a debtor.

9 Written premiums sometimes may include an estimate of pipeline premiums,

where contracts have been entered into providing for intermediaries to accept
business on behalf of underwriters (for example: binding covers and line-slip
arrangements). The estimate of pipeline premiums shall relate only to those
contracts of insurance where the period of cover has commenced prior to the
balance sheet date.
 402

9 If written premiums are subject to a reduction, an adjustment for such a

reduction shall be made as soon as it can be foreseen. Where written
premiums are subject to a retrospective increase (for example; in case of
declaration of higher sums insured or on increase in claims experience),
recognition of such increases in premium income should be deferred until the
additional amount can be ascertained with reasonable certainty.
9 Where a claim event causes a reinstatement premium to be paid (for
example; on claim payment in fire policy), the recognition of the
reinstatement premium and the effect on the initial premium should reflect
the respective incidence of risk pertaining to that premium in determining
that proportion earned and unearned at the balance sheet date.
2.4 Claim Expenses
Claim Expenses mean ‘Incurred Claim’. Incurred Claim is the major cost in a
general insurance business. Claim expenses generally amount to more than 70%
of premium income. A claim is incurred when the event giving rise to a claim
has occurred. Under Annual Basis accounting, ‘claims incurred’ include paid
claims plus outstanding claims at the end of the year minus outstanding claims at
the beginning of the year. Claim expenses also include all internal and external
expenses incurred in the handling of claims in connection with surveys,
inspection, negotiation and settlement. Outstanding claims include amounts
provided to cover the estimated ultimate cost of settling claims arising out of
events which have occurred by the balance sheet date, including IBNR claims.
The provision for gross outstanding claims is disclosed as Technical reserves
(also referred to as reserve for unexpired risks which are discussed above).
Incurred Claim considered in the Revenue Account is Claims Incurred Net,
which is calculated after adjustment of Claims on Reinsurance and Outstanding
Claims with Paid Claims.
The format to calculate claim expenses is:
Rs.
Claims settled during the year—direct & re-insurance accepted XX
(including legal fees, survey charges etc.)
Add: Payments to co-insurers XX
Less: Received from co-insurers and re-insurers (XX)
Net payment XXX
Add: Estimated liability at the end of the year (After deducting XX
recoverable from co-insurers and re-insurers)
Less: Estimated liability at the beginning of the year (after (XX)
deducting recoverable from co-insurers and re-insurers)
Claims expense XXX
 403

The Fire Department of ABC General Insurance Co. Ltd gives the following
details for 2009-10:
9 Fire Claims Paid Rs.705 crore
9 Claims on Reinsurance Accepted Rs.144 crore
9 Claims on Reinsurance ceded Rs.292 crore
9 Claims outstanding as on 01/04/2009 Rs.756 crore
9 Claims outstanding as on 31/03/2010 Rs.800 crore
Calculate Claims Incurred Net, which have been shown in the Revenue
Account for the year ended 31st March 2010.
Solution
Fire Claims Incurred Net

(Rs. in Crore)
Fire Claims Paid 705
Add: Claims on Reinsurance Accepted 144
Less: Claims on Reinsurance ceded 292
Net Claims Paid 557
Add: Claims Outstanding as on 31.3.2010 800
Less: Claims outstanding as on 1.4.2009 756
Claims Incurred Net 601

In accordance with the convention of conservatism, the claims intimated are

taken at par with claims intimated and accepted but not paid. Thus, while
calculating the claims outstanding at the end of the reporting period, both claims
intimated, and claims intimated and accepted are considered. The adjustment
entry to record this would be as follows:
Claims account Dr.
To Claims intimated and accepted but not paid
To Claims intimated but NOT accepted and paid
At the start of the next year, the credit part of the entry gets reversed once these
claims intimated are paid by the insurance company. The claim account of this
year will not have an impact due to the payment of claims. If the insurance
company rejects the claim made by the insured, the amount is transferred to the
Insurance fund account and not to the claims account.
 404

From the following, you are required to calculate the total claims incurred to be
shown in the revenue account for the year ending 31st March, 2011:

Claim intimated in Claim admitted in Claim paid in Rs

the year the year the year
2010 2010 2011 30,000
2011 2011 2012 20,000
2009 2010 2010 10,000
2009 2010 2011 24,000
2011 2012 2012 16,000
2011 2011 2011 2,04,000

Claim on account of reinsurance ceded was Rs. 50,000.

Solution: Schedule 2 is prepared in accordance with IRDA

(Preparation of Financial Statements and Auditor’s
Report of Insurance Companies) Regulations,
Schedule 2
2002. This is covered in detail in Unit 11.

Rs
Particulars Fire
Claims paid in 2011 -
Direct (2,04,000 + 24,000 + 30,000) 258,000
Add: Re-insurance accepted -
Less: Re-insurance ceded 50,000
Net claims paid 208,000
Add: Claims outstanding at the end of the year i.e. intimated in
2011 whether accepted in 2011 or in 2012 (20,000 + 16,000) 36,000
Less: Claims outstanding at the beginning of the year i.e.
intimated in 2010 or earlier whether accepted in 2010 or accepted
in 2011 (30,000 + 24,000) (54,000)
Total claims incurred 190,000
 405

International practices (UK) in respect of claims:

9 Provision is made at the balance sheet date for the expected ultimate cost of
settlement of all claims incurred in respect of events up to that date, whether
reported or not, together with related claims handling expenses, less amounts
already paid. If a liability is known to exist but there is uncertainty as to its
actual assessment amount, necessary provision should be made.

9 The claims provisions also known as technical provisions should be such that
no adverse runoff deviation is envisaged. This should satisfy the requirement
of the regulatory norms and should be sufficient at all times to cover any
liabilities arising out of insurance contracts so far as can reasonably be
foreseen.

9 In determining the sufficiency of provisions and the ability to measure claims

costs, the insurer shall take all reasonable steps to ensure that it has
appropriate information with regard to its claims exposure.

9 The quantum of claims provision should be assessed having regard to the

range of uncertainty as to the eventual outcome for the category of business
involved. In some cases there will be considerable uncertainty concerning
future events (e.g. liability business). In these circumstances, a degree of
caution will be necessary in the exercise of the judgment required for making
provisions such that liabilities are not understated.

9 The provision for gross outstanding claims should be disclosed within

technical provisions in the balance sheet, and amounts expected to be
recoverable under reinsurance arrangements in respect of claims incurred
should be recognized separately in the balance sheet. In other words,
reinsurers’ share of technical provisions in respect of claims outstanding
should be disclosed separately.

2.5 Acquisition Cost

Acquisition costs, if any, shall be expensed in the period in which they are
incurred. Acquisition costs are those costs that vary with, and are primarily
related to, the acquisition of new and renewal insurance contracts. The most
essential test is the obligatory relationship between costs and the execution of
insurance contracts (i.e. commencement of risk).
 406

Costs incurred for procurement of business or for conclusion of insurance

contracts with clients through agents, brokers, corporate agents, bank under
bancassurance or other intermediaries are called acquisition costs.

In general insurance business, acquisition costs are all direct costs incurred on
obtaining or renewing insurance contracts. They include expenses like
commission and brokerage. Furthermore, indirect costs such as advertising costs
or administrative costs also form part of acquisition costs.

'Bancassurance' is a term used to describe the relationship between a bank and an

insurance company whereby the insurance company takes the help of banking
Channels to sell insurance products

Acquisition costs pertaining to renewal of insurance contracts shall be:

A Expensed in the period in which they are incurred

B Deferred for a period of 2 years
C Deferred for a period of 3 years
D Capitalised in the period in which they are incurred

2.6 Insurance Commission

Commission includes agency commission, brokerage, and corporate agency
commission. Commission/ brokerage becomes payable as soon as business is
underwritten. For the purpose of preparation of Revenue Account, Commission
Net is considered. Commission Net is calculated in the following manner:

Commission paid Rs.

Direct
Add: Re-insurance Accepted
Less: Commission on Re-insurance Ceded
Net Commission

The applicable service tax on commission paid is borne by the insurer and paid
timely to the excise authorities. Tax needs to be deducted at source in accordance
with the provisions of the Income Tax Act and is deposited in the Government
account within the prescribed time limit.
 407

By virtue of the power vested in the Authority under Section 14 of the IRDA Act,
1999 and in terms of the provisions of Sections 40(1), 40A (3) and Section 42E
of the Insurance Act, 1938, IRDA has issued a circular that specifies the
maximum percentage of premium that can be paid by way of commission or
brokerage on a general insurance policy.

Maximum percentage of
premium payable as
Class of Business agency commission or
brokerage (% of final
premium excluding
service tax)
S. Agency
Brokerage
No. Comm.
1 Fire, IAR and Engineering insurances 10% 12.50%
i. General
ii. Risks treated as large risks under 5% 6.25%
para 19(v) of File & Use Guidelines
Motor insurance business (OD portion),
2 WC/EL & statutory Public Liability 10% 10%
Insurance
3 Motor Third Party insurance Nil Nil
4 Marine Hull insurance 10% 12.50%
5 Marine Cargo business 15% 17.50%
6 All other business 15% 17.50%

Ref: IRDA Circular No 011/ IRDA/ Brok-Comm/ Aug-08

Note:

i) No payment of any kind, including “administration or servicing charges” is

permitted to be made to the agent or the broker in respect of the business in
respect of which he is paid agency commission or brokerage.

ii) No brokerage can be paid in respect of an insurance where agency

commission is payable and likewise, no agency commission can be paid in
respect of an insurance where brokerage is payable.
 408

In accordance with the IRDA circular prescribing maximum agency and

brokerage commission, the maximum agency commission permissible for Marine
cargo business is:

A 10.0%
B 12.5%
C 15.0%
D 17.5%

2.7 Operating or Management Expenses

Management expense is a major cost component related to insurance business.

Management expenses are generally accounted for under the following heads
separately, before they are clubbed together for the purpose of the Revenue
Account.

9 Employees’ remuneration and welfare expenses

9 Traveling & Conveyance Expenses
9 Vehicle Running Expenses
9 Rent, Rates & Taxes
9 Repairs & maintenance
9 Printing & Stationery
9 Communication Expenses
9 Legal & Professional Charges
9 Advertisement & Publicity
9 Interest & Bank Charges
9 Depreciation
9 Audit Fess
9 Provision for Bad & Doubtful Debts
9 IT & EDP Expenses
9 Others.

For all cases, incurred expenses are considered.

Incurred Expenses are expenses paid plus expenses outstanding minus prepaid
expenses.
 409

These expenses are first aggregated and then apportioned to each class of
business on a reasonable and equitable basis i.e. between:

9 Fire revenue account

9 Marine revenue account
9 Miscellaneous revenue account

Any major expenses (Rs.5-lacs or in excess of 1% of net premium, whichever is

higher) are required to be shown separately. Section 40C of the Insurance Act,
1938 prohibits an insurer to incur expenses of management in excess of the limits
prescribed in the Act.

An adequate provision for outstanding expenses is made in the accounts at the

end of the financial year. A provision for leave encashment, gratuity etc. at the
end of each financial year is made on actuarial basis.

2.8 Outstanding Claims

A liability for outstanding claims is provided by the insurer at the reporting date
for the estimated cost of all claims not settled at that date including claims
handling expenses, less amounts already paid.

The provision for claims outstanding at the end of the period would include the
insurer's estimated liability in respect of:

9 notified claims,
9 claims incurred but not reported (IBNR) including inadequate reserves
[sometimes referred to as Claims Incurred But Not Enough Reported
(IBNER)] and
9 claims handling expenses

Whilst general insurance policies will normally specify the type of risks insured
against and the cover provided, the amount of a claim under such a policy will
not be certain but will depend upon the circumstances giving rise to the claim. In
the interim period, it will be necessary to make estimates, and the provision for
claims outstanding will necessarily be the result of a series of estimates which
would be based on surveyors’ assessment and recommendations, statistical
calculations and management decisions as considered appropriate. The provision
would be determined as accurately as possible, having regard to prudent
assumptions about the final amount for which claims are expected to be settled.
 410

The factors considered in estimation of outstanding claims are:

9 previous experience in claims notification patterns,

9 changes in the nature and amount of business written
9 trends in claims frequency and severity
9 inflation rate and
9 other relevant data or information available from post-claim inspection report

Diagram 3: Outstanding claims

At the end of each financial year, as required by IRDA, the actuarial valuation of
the claims liability of an insurer is made by the appointed actuary, and the
shortfall, if any, is provided as IBNR/IBNER.

2.9 Discounting

Discounting refers to an accounting practice which places a present day value on

a claim outstanding provision.

When determining the amount of provision for claims outstanding on the balance
sheet, there is also a view that the amount will not necessarily be the full amount
of the liability, especially in liability claims in consideration of the fact that
income may be earned on the fund made by such provisions for the period before
the liability is settled.
 411

Therefore, in the case of general insurance business, for claims outstanding

where a delay is expected before the claims are settled, there is an argument that
the provision would be discounted to take account of the investment income on
the funds held to meet the liabilities.
In practice, the time taken to determine and settle a claim in property claims can
vary in weeks, although in liability claims, it takes sometimes a year or two
depending upon court judgments and the nature of liability policy with reference
to jurisdiction of the court of law- national or international.
Furthermore, some claims in certain classes of liability business (occurrence
based Commercial General Liability (CGL) Policy or public liability policy or
employers’ liability policy) give rise to liabilities payable at regular intervals
over many years. In Motor Own Damage claims which are settled within 2/3
months, discounting may not have a significant financial effect, while in Motor
Third Party Claims involving death and personal injury to third party,
discounting might have a significant financial effect. In the case of Motor TP
claims, the notification of claims, judgment in the court of law and their
agreement and settlement are spread over a considerable period of time; the
effect is more likely to be material. Therefore, there is a case for discounting
these liabilities to reflect anticipated future investment income from claims
outstanding provisions.

If there are inherent uncertainties in estimating future liabilities and the timing of
their payment, discounting would be imprudent.

Discounting of Claims Provisions requires compliance of the following

conditions:
9 Notification of claims and their agreement and settlement are spread over a
considerable period of time.
9 There is adequate past experience on which a reasonable model of the timing
of the run-off of the liability can be constructed to facilitate appropriate
provisioning of claims based on evaluation of the likely amounts and timing
of claim payments having regard to the effects of inflation and other factors
in establishing the claim liabilities to be discounted.
9 The assumptions used in the discounting of the provision for claims
outstanding would include an appropriate risk factor to take into account the
uncertainties regarding the expected timing of payments, the ultimate claims
liability and the expected returns on investment.
 412

Diagram 4: Discounting of Claims Provisions requires compliance of

conditions

Assumptions used in discounting

The assumptions used in the discounting of the provision for claims outstanding
would include an appropriate risk factor to take into account the uncertainties
regarding:

9 expected timing of payments,

9 ultimate claims liability and
9 expected investment return.

Also the effect of inflation needs to be factored in the assumptions, in order to

determine the ultimate claims liability.

2.10 Reinsurance

An arrangement where one party called the‘re-insurer’, in consideration for a

premium, agrees to indemnify another party called the cedant or reinsured
against an agreed part of the liability assumed by the cedant in the event of claim
admissible under a policy or policies of insurance.

Reinsurance may be decided by the Insurer and the Re-insurer on the basis of
Facultative arrangement for individual risks or under Treaty Arrangement for
groups of risks. Re-insurance accounting has been discussed separately in Unit
13 for better understanding of the students.
 413

2.11 Investment Accounting

Investments are treated as assets held by an insurer for earning income by way of
dividends, rent and interest or for capital appreciation or for other benefits to both
policyholders and shareholders.

An insurance company makes investment for the following purposes:

Diagram 5: Purposes of investment of an insurance company

In an insurance company there are mainly two sources of investible funds viz.
surplus funds arising out of the business and funds arising from income, being
interest and dividends on existing investments.

IRDA Regulations on Investments and the Insurance Act, 1938 provide specific
rules and norms for investment of funds by an insurance company. The
procedure and norms as laid down in the IRDA (Preparation of Financial
Statements and Auditor’s Report of Insurance Companies) Regulations, 2002,
Regulations for valuation of investments have been discussed in Unit 11.
Furthermore, the IRDA has also issued detailed guidelines under IRDA
(investment) (amendment) Regulations, 2008 for investments by the insurer,
which have been discussed in Unit 14.
Accounting entries involved for buying/selling investments, receipts / accrued
and outstanding interest, dividends, rent, and recording impairments, write off
and write down of certain investments etc. have been discussed in Unit 15 for
better analysis.
 414

3. Discuss what is meant by co-insurance.

[Learning Outcome c]

3.1 Co-insurance

An arrangement whereby two or more insurers enter into a single contract with
the insured to cover a risk in agreed proportions at a specified premium.

At times, it may happen that the risk being insured is large and therefore such
large risks are shared between two or more insurers at agreed percentages under
co-insurance arrangements. Under a co-insurance arrangement, the leading
insurer issues the documents, collects premium and settles claims. Statements of
Account are rendered by the leading insurer to the other co-insurers.

The accounting treatment of premium, claims, commission, etc. under co-

insurance arrangement is done in the same manner as that of the direct business.

Process of co-insurance

In Co-insurance, the lead insurer collects the full premium along with service tax
and pays it to the respective excise authorities. The lead insurer accounts for its
own share as premium income and balance is shown as payable to other co-
insurers. Similarly in case of a claim, the entire claim amount is paid by the lead
insurer to the insured (claimant), but only his own share is accounted for as
‘claims expense’ and the balance is shown as amount due from the coinsurer.

Coinsurance account balances are finally settled as per the agreement between
the coinsurers. Usually, there is a provision for charging of interest for delayed
settlement of the coinsurance account balance. At the end of the financial year, if
a provision for outstanding claims is required to be made, the lead insurer
accounts for its own share and informs the co-insurers of their respective share of
outstanding claim provisions to be booked by them. At the end of each financial
year, balance confirmation certificates are exchanged by all co-insurers for
accounting records and verification by auditors.
 415

Diagram 6: Accounting in a co-insurance arrangement

A fire insurance policy was issued by New India to M/S ABC Automobile Co
Ltd on 01/04/2010 for a sum insured (SI) of Rs.400 crore with a premium @ Re
0.50/Rs.1000 SI under an arrangement that New India is the lead insurer with
40% share of business and other three PSUs (National Insurance, United
Insurance and Oriental Insurance) are co-insurers with 20% shares each.

On 01/04/2010, New India collected the entire premium. On 10/07/2010, a fire

accident occurred and a claim for Rs.1.20 crore was lodged for accidental
damage under this policy. The surveyor assessed the loss as Rs. 99 lakhs on
31/08/10. New India paid the entire claim and also survey fees for Rs.1.0 lakh on
15/09/10.

Required:

Pass journal entries in the books of New India and show the Co-insurance
Account as on 30/09/2010 assuming that Co-insurance balance has been settled
on 15/10/10, 16/10/10 and 18/10/10 by National Insurance, United Insurance and
Oriental Insurance respectively.
 416

Solution
Date Particulars Debit Credit
Amount Amount
01/04/10 Bank A/c Dr 20,00,000
To Premium Control A/c 20,00,000
(Being fire insurance premium collected under co-insurance
arrangement)
01/04/10 Premium Control A/c Dr 20,00,000
To Fire Premium A/c 8,00,000
To National Ins. Co A/c 4,00,000
To United Ins. Co A/c 4,00,000
To Oriental Ins. Co A/c 4,00,000
(Being fire insurance premium booked under co-insurance
arrangement)
31/08/10 Fire Claims A/c Dr 40,00,000
National Ins. Co A/c Dr 20,00,000
United Ins. Co A/c Dr 20,00,000
Oriental Ins. Co Dr 20,00,000
To Claims Payable to ABC 99,00,000
Automobile Co A/c
To Survey fees Payable to 1,00,000
Surveyor A/c
(Being claims and survey fees payable as per survey report)
15/09/10 Claims Payable to ABC Automobile 99,00,000
Co A/c Dr
To Bank 99,00,000
(Being claim paid in full and final settlement)
15/09/10 Survey fess Payable to Surveyor A/c 1,00,000
To Bank A/c 1,00,000
(Being survey fees paid)
15/10/10 Bank A/c Dr 16,00,000
To National Ins. Co A/c 16,00,000
(Being co-insurance balance settled by National Ins)
16/10/10 Bank A/c Dr 16,00,000
To United Ins. Co A/c 16,00,000
(Being co-insurance balance settled by United Ins)
18/10/10 Bank A/c Dr 16,00,000
To Oriental Ins. Co A/c 16,00,000
(Being co-insurance balance settled by Oriental Ins)
 417

Co-Insurance A/c
Rs in Lakhs
National United Oriental National United Oriental
31.08.10 20 20 20 01.04.10 40 40 40
To By
Claim Premium
Payable Control
A/c A/c

30.09.10 16 16 16
By
Balance
c/d
20 20 20 20 20 20

Such Co-Insurance balances will appear in the Balance Sheet as at 30/09/2010 on

the Asset Side under the head “Amount Due from Other Insurers”.

An arrangement whereby two or more insurers enter into a contract with the
insured to cover a risk in agreed proportions at a specified premium is termed:

A Co-insurance
B Bancassurance
C Re-insurance
D Joint assurance
 418

4. Discuss the financial reporting requirement for non-life

insurance business, including requirement to prepare
consolidated financial statements.
[Learning Outcome d]

4.1 Financial Statements

Presentation and preparation of financial statements are in accordance with IRDA

(Preparation of Financial Statements and Auditor’s Report of Insurance
Companies) Regulations, 2002. The students must have thorough knowledge of
the regulations on insurance accounts to appreciate the legal aspects of financial
accounting in general insurance business.

As per the said regulation, the financial statements of an insurer include:

9 Revenue Accounts,
9 Profit & Loss Account,
9 Balance Sheet and
9 Cash Flow Statements

The regulatory requirements for Presentation and preparation of financial

statements are discussed in the following unit, Unit 11, and the illustrations on
Presentation and preparation of financial statements are given in Unit 12.

Along with the regulatory aspects of Presentation and preparation of financial

statements, we need to know certain fundamental aspects on financial statements
for insurance business with reference to international practice.

4.2 Income statement and Revenue Account

i) Details of the underwriting results for the reporting period would be

presented in the Revenue Account, with the net underwriting result being
transferred to the income statement.

ii) It is necessary that a revenue account is prepared for each class of business.

iii) The net underwriting result would be combined with the net result from
investments and other shareholder activities to determine the net profit (loss)
of the insurer.
 419

iv) An allocation of the investment results may be made between the revenue
account and the income statement, distinguishing the investment results
derived from the investment of policyholders’ funds from those derived from
shareholders' funds.

v) The following additional disclosures are made on the face of the income
statement:

a) Underwriting results transferred from the revenue account (if separately

prepared);
b) Expenses not related to underwriting activities; and investment income
arising from investments not supporting technical provisions.
c) If the income statement and revenue accounts are to be prepared on a
combined basis, the disclosure set out below relating to the revenue account
would be included on the face of the income statement.

In relation to the revenue account, separate disclosure would be made on the

following:

9 Gross Premiums written, Premiums on Reinsurance Ceded &Accepted, and

Net Premiums Written
9 Movement in the unearned premiums, as an addition to or deduction from net
premiums written
9 Net premiums earned;
9 Acquisition costs incurred relating to gross premiums written, commissions
earned on business ceded and net acquisition costs;
9 Movement in deferred acquisition costs, as an addition to or deduction from
net acquisition costs;
9 Gross claims paid, and reinsurance and other recoveries receivable;
movement in claims outstanding, as an addition to or deduction from the net
claims paid;
9 Net claims incurred;
9 Indirect claims handling costs incurred in the period;
9 Maintenance costs and other underwriting expenses;
9 Investment income (net of investment expenses) attributable to the
investments that have been allocated to support the technical provisions;
9 Underwriting result;
9 Income and expenses relating to non-underwriting activities; and
9 Net investment income relating to the assets held, which is not supporting the
technical provisions.
 420

Diagram 7: Revenue & Income account

4.3 Disclosure Requirement for Balance sheet

In relation to the balance sheet, separate disclosure would be made of the

following:

9 Amount of unearned premium;

9 Amount of deferred acquisition costs;
9 Provision for premium deficiency;
9 Liability for claims outstanding which includes claims incurred but not
reported
9 Provision for claims handling expenses;
9 Reinsurance amount applicable
9 Reinsurance recoveries receivable
9 Premiums receivable (net of commission receivable)
9 Insurance balances receivable;
9 Premium payables; and
9 Insurance balances payable.
 421

4.4 Foreign Operations and Insurance Accounting

Foreign branch accounts of insurance companies are merged with the Indian
operations to present a global financial position and the state of affairs in the
financial statements.

In addition to the Indian statutory or regulatory requirements, these offices have

to comply with the local laws for preparation of financial statements and get the
accounts audited by the Indian firms of auditors. These accounts which are
prepared in local currencies are converted in Indian currency as per the specific
Accounting Standard -AS11, and merged with Indian accounts. The requirements
of AS 11 have been discussed in Unit 3.

4.5 Consolidation

The accounts of a large insurance company having a number of offices in India

and abroad are consolidated at the head office level of the company.

i) The accounts of the operating offices in India are prepared by the respective
offices as per corporate guidelines and are audited by the branch auditors.

ii) These are consolidated at various regional / zonal offices and the
consolidated accounts for the whole region are submitted to the head office.

iii) At the head office, separate accounts are prepared for the re-insurance and
investment operations.
iv) If the company has foreign branches, their accounts are prepared at their
level and are audited by the local statutory auditors or the central statutory
auditors. Their accounts are converted into Indian currency and merged with
the Indian accounts as mentioned in Para 4.4 above.
v) The central accounts department at the head office is responsible for the
consolidation of all regional office accounts and preparation and
reconciliation of reinsurance accounts, investment accounts and foreign
operation accounts.
vi) The consolidation is done today through appropriate consolidation software
for preparation of financial statements including Fire Revenue Account,
Marine Revenue Account, Miscellaneous Revenue Account, Profit and Loss
Account and Balance Sheet along with all required schedules in specified
forms and formats given in Part V of the IRDA Regulations for the financial
statements.
 422

vii) The final accounts are audited by the statutory auditors appointed by the
shareholders (by C&AG in case of a Government company) and presented in
the Annual General Meeting for approval.

Diagram 8: Process of preparing consolidated financial statements

 423

While preparing final accounts with consolidation at the head office level, the
following aspects are globally determined and accounted for:

Sr. No
9 In view of Section 64V(1)(ii) of the Insurance
Act, 1938 providing specific percentage of net
premium as Reserve for unexpired risks, which
is minimum and mandatory requirement.
Unexpired
1 9 In addition to this, if unearned premium
Risk Reserve
exceeds such reserve for unexpired risks
calculated as per the provisions of the Act, the
difference is to be accounted for as unearned
premium.

In view of requirements of AS 15 for recognition of

a liability for employee benefits to be paid in future,
Provision for
provision for leave encashment, gratuity, pensions,
terminal
2 and termination benefits such VRS etc. payable to
benefits of the
the employees on superannuation is made on
employees
actuarial basis at the head office.

Reserve for After doing age-wise analysis of the debtors, a

Bad and suitable provision is made at the Head
3
Doubtful Office.
Debts
Tax liability of an insurance company is governed
by the special provisions contained in section 44 of
Provision for the Income tax Act. Adequate provision for tax
4
taxation liability (including wealth tax) is made at Head
Office.

An adequate provision is made for proposed

Provision for dividend as per the board resolution at head office
5 proposed keeping in view the relevant provisions of the
dividend Companies Act 1956.

Such provision is made as per the advice of the

IBNR/IBNER appointed actuary by increasing the outstanding
6
provision claims reserve.
 424

Provision of IBNR/IBNER is based on the advice of:

A Management
B Actuary
C Shareholders
D Auditors

Summary
¾ The legal aspects of insurance accounting in India is addressed by The
Insurance Act 1938, The Companies Act 1956 and the IRDA (Preparation of
Financial Statements and Auditor’s Report of Insurance Companies)
Regulations, 2002.
¾ In India, only annual basis is adopted for insurance accounting for
determination of underwriting results for all departments of business
including Fire, Marine, Motor, Engineering and Miscellaneous.
¾ Premium income is the consideration received from the insured by the
insurance company in accordance with the contract of insurance.
¾ A provision for unexpired risks is made normally at 50% in case of Fire
Insurance and 100% in case of Marine Insurance which is in accordance with
Section 64 V(1) (ii) (b) of The Insurance Act 1938.
¾ Under Annual Basis accounting, ‘claims incurred’ include paid claims plus
outstanding claims at the end of the year minus outstanding claims at the
beginning of the year.
¾ Acquisition costs, if any, shall be expensed in the period in which they are
incurred.
¾ The agency commission and brokerage are goverened by the IRDA circular
issued in August 2008 which prescribes the maximum permissible
percentage of premium that can be paid by way of commission or brokerage
on a general insurance policy.
¾ Section 40C of the Insurance Act, 1938 prohibits an insurer to spend as
expenses of management in excess of the limits prescribed in the Act.
¾ At the end of each financial year, as required by IRDA, the actuarial
valuation of the claims liability of an insurer is made by the appointed
actuary, and the shortfall, if any, is provided as IBNR/IBNER.
¾ Discounting refers to an accounting practice which places a present day value
on a claim outstanding provision. Discounting requires compliance of certain
mandatory conditions.
 425

¾ Co-insurance is an arrangement whereby two or more insurers enter into a

single contract with the insured to cover a risk in agreed proportions at a
specified premium.
¾ Presentation and preparation of financial statements are in accordance with
IRDA (Preparation of Financial Statements and Auditor’s Report of
Insurance Companies) Regulations, 2002.
¾ Consolidated financial statements of Indian and Foreign operations are
prepared in accordance with IRDA regulations which are then audited by the
statutory auditors.

Answers to Test Yourself

Answer to TY 1

The correct option is B.

In accordance with the Indian GAAP, the basis adopted for insurance accounting
for determination of underwriting results is Annual Basis.

Answer to TY 2

The correct option is A.

Acquisition costs pertaining to renewal of insurance contracts shall be expensed

in the period in which they are incurred.

The correct option is C.

Answer to TY 3

The correct option is A.

In accordance with the IRDA circular prescribing maximum agency and

brokerage commission, the maximum agency commission permissible for Marine
cargo business is 10.0%.
 426

Answer to TY 4

The correct option is A.

An arrangement whereby two or more insurers enter into a contract with the
insured to cover a risk in agreed proportions at a specified premium is termed
Co-insurance.

Answer to TY 5

The correct option is B.

Provision of IBNR/IBNER is based on the advice of the actuary.

Self-Examination Questions

Question 1

At the end of each financial year, the actuarial valuation of the claims liability of
an insurer is made by:

A An accountant
B An auditor of the company
C Management
D An actuary

Question 2

In accordance with the IRDA circular prescribing agency and brokerage

commission structure, the maximum agency commission or brokerage payable by
any insurer is:

A 5.0%
B 10.0%
C 17.5%
D 20.0%
 427

Question 3

In accordance with the IRDA circular prescribing agency and brokerage

commission structure, agency commission payable for motor third party
insurance is:

A 5.00%
B 6.25%
C 10.00%
D None of the above

Question 4

In case of a Government Insurance company, the accounts are audited by:

A Statutory auditors
B Comptroller and Auditor General
C Insurance and Regulatory Development Authority
D None of the above

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is D.

At the end of each financial year, the actuarial valuation of the claims liability of
an insurer is made by an actuary.

Answer to SEQ 2

The correct option is C.

In accordance with the IRDA circular prescribing agency and brokerage

commission structure, the maximum agency commission or brokerage payable by
any insurer is 17.5%.
 428

Answer to SEQ 3

The correct option is D.

In accordance with the IRDA circular prescribing agency and brokerage

commission structure, agency commission is not payable for motor third party
insurance.

Answer to SEQ 4

The correct option is B.

In case of a Government Insurance company, the accounts are audited by the

Comptroller and Auditor General (C&AG).
 429

CHAPTER 3

NON-LIFE INSURANCE BUSINESS

ACCOUNTING METHODS, TECHNIQUES &
PROCESSES
UNIT 11

INSURANCE ACCOUNTING REGULATIONS

Chapter Introduction
In 1999, the IRDA Act was passed, the Insurance Regulatory and Development
Authority was established and conferred upon the powers to regulate and
promote orderly growth of the insurance sector.

With the advent of private players in the business of insurance, regulation was
needed with respect to the financial statements and audit reports being prepared
by the insurance companies, to protect the interests of policyholders and all other
stakeholders involved. With the above objective, the IRDA passed the IRDA
(Preparation of Financial Statements and Auditor's Report of Insurance
Companies) Regulations in 2002.

In this unit, we will discuss the various provisions of these regulations.

a) Discuss the accounting regulations pertaining to non-life insurance

methods, techniques and processes, along with the formats of financial
statements.
b) Prepare financial statement extracts for a non-life insurance business in
accordance with the appropriate regulatory requirements.
 430

1. Discuss the accounting regulations pertaining to non-life

insurance methods, techniques and processes, along with
the formats of financial statements.
[Learning Outcome a]
1.1 Indian GAAP on Insurance Accounting
Indian GAAP on Insurance Accounts comprises specific regulations which
include:
9 Relevant provisions of the Insurance Act 1938
9 The Companies Act, 1956
9 Relevant Accounting Standards issued by the Institute of Chartered
Accountants of India.
In this regard, the IRDA has issued a detailed accounting and audit regulation
called the Insurance Regulatory and Development Authority (Preparation of
Financial Statements and Auditor’s Report of Insurance Companies) Regulations,
2002.
The following financial statements of an insurance company are required to be
prepared as per specified formats and in accordance with the Accounting
Principles and General Instructions for preparation of financial statements
specified in the said regulations over and above compliance of the requirements
of the Companies Act, 1956 and the Insurance Act, 1938 and applicable
Accounting Standards (AS).
9 Balance Sheet
9 Revenue Accounts
9 Profits and Loss Account
9 Receipts and Payments Account

1.2 Regulations for Insurance Accounting

In exercise of the powers conferred by section 114A of the Insurance Act, 1938
and in suppression of The Insurance Regulatory And Development Authority
(Preparation Of Financial Statements And Auditor’s Report Of Insurance
Companies) Regulations, 2000, the Insurance Regulatory and Development
Authority in consultation with the Insurance Advisory Committee, has framed
the Regulations called “IRDA (Preparation of Financial Statements and Auditor’s
Report of Insurance Companies) Regulations, 2002” for the purpose of
accounting of insurance business. These regulations superseded the regulations
made in the year 2000.
 431

The said Regulations provide that:

1. An insurer carrying on life insurance business, after the commencement of

these Regulations, shall comply with the requirements of Schedule A.

2. An insurer carrying on general insurance business, after the

commencement of these Regulations, shall comply with the requirements of
Schedule B.

3. The report of the auditors on the financial statements of every insurer and
reinsurer shall be in conformity with the requirements of Schedule C, or as
near thereto as the circumstances permit.

4. The Authority may, from time to time, issue separate directions/ guidelines
in the matter of appointment, continuance or removal of auditors of an
insurer or reinsurer, as the case may be, and such directions/ guidelines
may include prescriptions regarding qualifications and experience of
auditors, their rotation, period of appointment, etc. as may be deemed
necessary by the Authority.

This Unit provides the relevant extract of the Schedule B to Regulations for
Preparation of financial statements, management report and auditor’s report in
respect of general insurance business. Schedule B deals with accounting
regulations under the following heads:

Part I- Accounting Principles for Preparation of Financial Statements

Part II- Disclosures forming part of Financial Statements
Part III- General Instruction for preparation of Financial Statements
Part IV- Contents of Management Report
Part V- Preparation of Financial Statements

Section 2(6B) of the Insurance Act defines “General insurance business as fire,
marine or miscellaneous insurance business whether carried on singly or in
combination with one or more of them.”

Some common types of miscellaneous insurance includes automobile insurance,

health insurance, burglary insurance, fidelity insurance, cash in transit insurance,
workmen’s compensation insurance, exchange risk insurance, etc.
 432

1.3 Extracts of financial statements

In accordance with Regulation 3 of the Insurance Regulatory and Development

Authority of India Regulations, 2000, an insurer carrying on general insurance
business shall comply with the requirements of Schedule B of the IRDA
(Preparation of Financial Statements and Auditor’s Report of Insurance
Companies) Regulations, 2002. This pronouncement issued by the IRDA gives
extensive guidance on the formats to be adhered to by insurance companies while
preparing their financial statements.

Which part of Schedule B of The Insurance Regulatory and Development

Authority (Preparation Of Financial Statements and Auditor’s Report Of
Insurance Companies) Regulations, 2000 deals with “Contents of management
Report”?

A Part I
B Part II
C Part III
D Part IV

Diagram 1: Overview of Schedule B

 433

PART I - Accounting principles for preparation of financial statements

1. Applicability of Accounting Standards

Every Balance Sheet, Receipts and Payments Account [Cash Flow statement]
and Profit and Loss Account [Shareholders’ Account] of the insurer shall be in
conformity with the Accounting Standards (AS) issued by the ICAI, to the extent
applicable to the insurers carrying on general insurance business, except that:

i) Accounting Standard 3 (AS 3) – Cash Flow Statements – Cash Flow Statements

shall be prepared only under the Direct Method.
ii) Accounting Standard 13 (AS 13) – Accounting for Investments, shall not be
applicable.
iii) Accounting Standard 17 (AS 17) - Segment Reporting– shall apply to all insurers
irrespective of the requirements regarding listing and turnover mentioned therein.

2. Premium Recognition
Premium shall be recognised as income over the contract period or the period of risk,
whichever is appropriate. Premium received in advance, which represents premium
income not relating to the current accounting period, shall be disclosed separately in the
financial statements.

A reserve for unexpired risks shall be created as the amount representing that part
of the premium written which is attributable to, and to be allocated to the
succeeding accounting periods and shall not be less than as required under
section 64 V(1) (ii) (b) of the Act.

In accordance with the provisions of section 64 V(1) (ii) (b) of The Insurance Act
1938, reserve for unexpired risks shall be created in respect of:
i) fire and miscellaneous business - 50 per cent
ii) marine cargo business - 50 percent
iii) marine hull business - 100 percent of the premium, net of re-insurances,
during the preceding twelve months

Premium Received in Advance, which represents premium received prior to the

commencement of the risk, shall be shown separately under the head ‘Current
Liabilities’ in the financial statements.
 434

3. Premium Deficiency: Premium deficiency shall be recognised if the sum of

expected claim costs, related expenses and maintenance costs exceed the
related reserve for unexpired risks.

4. Acquisition Costs: Acquisition costs, if any, shall be expensed in the period

in which they are incurred.

Acquisition costs are those costs that vary with, and are primarily related to,
the acquisition of new and renewal insurance contracts. The most essential
test is the obligatory relationship between costs and the execution of
insurance contracts (i.e. commencement of risk).

5. Claims: The components of the ultimate cost of claims to an insurer

comprise the claims under policies and specific claims settlement costs.
Claims under policies comprise the claims made for losses incurred, and
those estimated or anticipated under the policies following a loss occurrence.

A liability for outstanding claims shall be brought to account in respect of

both direct business and inward reinsurance business. The liability shall
include:

i) Future payments in relation to unpaid reported claims;

ii) Claims Incurred But Not Reported (IBNR) including inadequate reserves
[sometimes referred to as Claims Incurred But Not Enough Reported
(IBNER)],

which will result in future cash/asset outgo for settling liabilities against
those claims. Change in estimated liability represents the difference between
the estimated liability for outstanding claims at the beginning and at the end
of the financial period. IBNR and IBNER are to be provided on the basis of
estimates worked out by the appointed actuary and approval from IRDA.

The accounting estimate shall also include claims cost adjusted for estimated
salvage value if there is sufficient degree of certainty of its realisation.

Actuarial Valuation of claim liability – in some cases

Claims made in respect of contracts where the claims payment period

exceeds four years shall be recognised on an actuarial basis, subject to
regulations that may be prescribed by the Authority. In such cases, certificate
from a recognised actuary as to the fairness of liability assessment must be
obtained. Actuarial assumptions shall be suitably disclosed by way of notes
to the accounts.
 435

6. Procedure to determine the value of investments: An insurer shall

determine the values of investments in the following manner:

i) Real Estate: Investment Property: Investment Property shall be measured

at historical cost less accumulated depreciation and impairment loss, residual
value being considered zero and no revaluation being permissible.

The Insurer shall assess at each balance sheet date whether any impairment
of the investment property has occurred.

An impairment loss shall be recognised as an expense in the Revenue/Profit

and Loss Account immediately.

Fair value as at the balance sheet date and the basis of its determination shall
be disclosed in the financial statements as additional information.

ii) Debt Securities: Debt securities including government securities and

redeemable preference shares shall be considered to be “held to maturity”
securities and shall be measured at historical cost subject to amortisation.

iii) Equity Securities and Derivative Instruments that are traded in active
markets: shall be measured at fair value as at the balance sheet date. For the
purpose of calculation of fair value, the lowest of the last quoted closing
price of the stock exchanges where the securities are listed shall be taken.

The insurer shall assess on each balance sheet date whether any impairment
of listed equity security / derivative instruments has occurred.

An active market shall mean a market where the securities traded are
homogenous, availability of willing buyers and willing sellers is normal and
the prices are publicly available.

Unrealised gains/losses arising due to changes in the fair value of listed

equity shares and derivative instruments shall be taken to equity under the
head ‘Fair Value Change Account’. The ‘Profit on sale of investments’ or
‘Loss on sale of investments’, as the case may be, shall include accumulated
changes in the fair value previously recognised in equity under the heading
Fair Value Change Account in respect of a particular security and being
recycled to Profit and Loss Account on actual sale of that listed security.

For the removal of doubt, it is clarified that balance or any part thereof shall
not be available for distribution as dividends. Also, any debit balance in the
said Fair Value Change Account shall be reduced from the profits/free
reserves while declaring dividends.
 436

The insurer shall assess, at each balance sheet date, whether any impairment
has occurred. An impairment loss shall be recognised as an expense in
Revenue/Profit and Loss Account to the extent of the difference between the
remeasured fair value of the security/ investment and its acquisition cost as
reduced by any previous impairment loss recognised as expense in
Revenue/Profit and Loss Account. Any reversal of impairment loss earlier
recognised in Revenue/Profit and Loss Account shall be recognised in
Revenue/Profit and Loss Account.

iv) Unlisted and other than actively traded Equity Securities and Derivative
Instruments: Unlisted equity securities and derivative instruments and listed
equity securities and derivative instruments that are not regularly traded in
active market will be measured at historical costs. Provision shall be made
for diminution in value of such investments. The provision so made shall be
reversed in subsequent periods if estimates based on external evidence show
an increase in the value of the investment over its carrying amount. The
increased carrying amount of the investment due to the reversal of the
provision shall not exceed the historical cost.

For the purposes of this regulation, a security shall be considered being not
actively traded, if as per guidelines governing mutual funds laid down from
time to time by SEBI, such a security is classified as “thinly traded”.

7. Loans: Loans shall be measured at historical cost subject to impairment

provisions.

The insurer shall assess the quality of its loan assets and shall provide for
impairment. The impairment provision shall not be lower than the amounts
derived on the basis of guidelines prescribed from time to time by the
Reserve Bank of India that apply to companies and financial institutions.

8. Catastrophe Reserve: Catastrophe reserve shall be created in accordance

with norms, if any, prescribed by the Authority. Investment of funds out of
the catastrophe reserve shall be made in accordance with prescription from
the Authority.
 437

Diagram 2: Accounting principles for preparation of financial statements

 438

PART II - Disclosures forming part of Financial Statements

A The following shall be disclosed by way of notes to the Balance Sheet:

1. Contingent Liabilities:
a) Partly-paid up investments
b) Underwriting commitments outstanding
c) Claims, other than those under policies, not acknowledged as debts
d) Guarantees given by or on behalf of the company
e) Statutory demands/liabilities in dispute, not provided for
f) Reinsurance obligations
g) Others (to be specified).

2. Encumbrances to assets of the company in and outside India.

3. Commitments made and outstanding for Loans, Investments and Fixed

Assets.

4. Claims, less reinsurance, paid to claimants in/outside India.

5. Actuarial assumptions for determination of claim liabilities in the case of

claims where the claims payment period exceed four years.

6. Ageing of claims – distinguishing between claims outstanding for more than

six months and other claims.
7. Premiums, less reinsurance, written from business in/outside India.
8. Extent of premium income recognised, based on varying risk pattern,
category-wise, with basis and justification therefore, including whether
reliance has been placed on external evidence.
9. Value of contracts in relation to investments, for:
(a) Purchases where deliveries are pending;
(b) Sales where payments are overdue.
10. Operating expenses relating to insurance business: basis of allocation of
expenditure to various classes of business.
11. Historical costs of those investments valued on fair value basis.
12. Computation of managerial remuneration.
13. Basis of amortisation of debt securities.
 439

14.
a) Unrealised gain/losses arising due to changes in the fair value of listed equity
shares and derivative instruments are to be taken to equity under the head
‘Fair Value Change Account’ and on realisation reported in profit and loss
Account.

b) Pending realisation, the credit balance in the ‘Fair Value Change Account’ is
not available for distribution.

15. Fair value of investment property and the basis therefor.

16. Claims settled and remaining unpaid for a period of more than six months as
on the balance sheet (BS) date.

B The following accounting policies shall form an integral part of the

financial statements:

1. All significant accounting policies in terms of the accounting standards

issued by the ICAI, and significant principles and policies given in Part I of
Accounting Principles and any other accounting policies followed by the
insurer shall be stated in the manner required under Accounting Standard 1
issued by the ICAI.

2. Any departure from the accounting policies as aforesaid shall be separately

disclosed with reasons for such departure.

C The following information shall also be disclosed:

1. Investments made in accordance with any statutory requirement should be

disclosed separately together with its amount, nature, security and any special
rights in and outside India.
2. Segregation into performing/ non performing investments for purpose of
income recognition as per the directions, if any, issued by the Authority.
3. Percentage of business sector-wise.
4. A summary of financial statements for the last five years, in the manner as
may be prescribed by the Authority.
5. Accounting Ratios as may be prescribed by the Authority.
6. Basis of allocation of Interest, Dividends and Rent between Revenue
Account and Profit and Loss Account.
 440

Diagram 3: Balance sheet (BS) contains

contingent liabilities

encumbrances to assets of
company

outstanding for loans, investments

& fixed assets

claims less reinsurance paid

outside India

actuarial assumptions for

determination of claim liabilities

ageing of claims

premium, less reinsurance, written

from business outside India

premium income recognised, based

on varying risk pattern

Balance sheet (BS) contains

value of contracts in relation to
investments

operating expenses relating to

insurance business

historical costs of investments

computation of managerial
remuneration

basis of amortisation of debt

securities

unrealised gain / loss arising due

to changes in fair value of financial
instruments

fair value of investment property

claims settled & remaining unpaid

for more than 6 months as on BS
date
 441

Part III - General Instruction for Preparation of Financial Statements

1. The corresponding amounts for the immediately preceding financial year for
all items shown in the Balance Sheet, Revenue Account and Profit and Loss
Account should be given.

2. The figures in the financial statements may be rounded off to the nearest
thousands.

3. Interest, dividends and rentals receivable in connection with an investment

should be stated at gross value, the amount of income tax deducted at source
being included under 'advance taxes paid'.

4. Income from rent shall not include any notional rent.

5.
a) For the purposes of financial statements, unless the context otherwise
requires –

i) the expression ‘provision’ shall, subject to note II below mean any amount
written off or retained by way of providing for depreciation, renewals or
diminution in value of assets, or retained by way of providing for any known
liability or loss of which the amount cannot be determined with substantial
accuracy;

ii) the expression "reserve" shall not, subject to as aforesaid, include any
amount written off or retained by way of providing for depreciation, renewals
or diminution in value of assets or retained by way of providing for any
known liability;

iii) the expression capital reserve shall not include any amount regarded as free
for distribution through the profit and loss account; and the expression
"revenue reserve" shall mean any reserve other than a capital reserve;

iv) The expression "liability" shall include all liabilities in respect of expenditure
contracted for and all disputed or contingent liabilities.

b) Where:

i) any amount written off or retained by way of providing for depreciation,

renewals or diminution in value of assets, or
 442

ii) any amount retained by way of providing for any known liability is in excess
of the amount which in the opinion of the directors is reasonably necessary
for the purpose, the excess shall be treated for the purposes of these accounts
as a reserve and not as a provision.

6. The company should make provisions for damages under lawsuits where the
management is of the opinion that the award may go against the insurer.

7. Extent of risk retained and reinsured shall be separately disclosed.

8. Any debit balance of Profit and Loss Account shall be shown as deduction
from uncommitted reserves and the balance if any, shall be shown separately.

Diagram 4: Instruction for preparation of financial statement

disclose comparative information

for previous year

round off figures to nearest

thousands

show rental / interest income at

gross value, & include TDS under
advance tax paid

Instruction for preparation of do not include any notional rent

financial statements under rental income

make provisions for damages

under lawsuits

disclose extent of risk retained

& reinsured separately

deduct debit balance of P & L from

uncommitted reserves & show
balance separately
 443

PART IV - Contents of Management Report:

There shall be attached to the financial statements, a management report

containing, inter alia, the following duly authenticated by the management:

1. Confirmation regarding the continued validity of the registration granted by

the Authority;

2. Certification that all the dues payable to the statutory authorities have been
duly paid;

3. Confirmation to the effect that the shareholding pattern and any transfer of
shares during the year are in accordance with the statutory or regulatory
requirements;

4. Declaration that the management has not directly or indirectly invested

outside India the funds of the holders of policies issued in India;
5. Confirmation that the required solvency margins have been maintained;
6. Certification to the effect that the values of all the assets have been reviewed
on the date of the Balance Sheet and that in his (insurer’s) belief the assets
set forth in the Balance-sheets are shown in the aggregate at amounts not
exceeding their realisable or market value under the several headings – “
Loans”, “ Investments”, “Agents balances”, “Outstanding Premiums”,
“Interest, Dividends and Rents outstanding”, “Interest, Dividends and Rents
accruing but not due”, “Amounts due from other persons or Bodies carrying
on insurance business”, “ Sundry Debtors”, “ Bills Receivable”, “ Cash” and
the several items specified under “Other Accounts”;
7. Disclosure with regard to the overall risk exposure and strategy adopted to
mitigate the same;
8. Operations in other countries, if any, with a separate statement giving the
management’s estimate of country risk and exposure risk and the hedging
strategy adopted;
9. Ageing of claims indicating the trends in average claim settlement time
during the preceding five years;
10. Certification to the effect as to how the values, as shown in the balance sheet,
of the investments and stocks and shares have been arrived at, and how the
market value thereof has been ascertained for the purpose of comparison with
the values so shown;
 444

11. Review of asset quality and performance of investment in terms of portfolios,

i.e., separately in terms of real estate, loans, investments, etc.

12. A responsibility statement indicating therein that:

i) in the preparation of financial statements, the applicable accounting

standards, principles and policies have been followed along with proper
explanations relating to material departures, if any;

ii) the management has adopted accounting policies and applied them
consistently and made judgements and estimates that are reasonable and
prudent so as to give a true and fair view of the state of affairs of the
company at the end of the financial year and of the operating profit or loss
and of the profit or loss of the company for the year;

iii) the management has taken proper and sufficient care for the maintenance of
adequate accounting records in accordance with the applicable provisions of
the Insurance Act 1938 (4 of 1938) / Companies Act, 1956 (1 of 1956), for
safeguarding the assets of the company and for preventing and detecting
fraud and other irregularities;

iv) the management has prepared the financial statements on a going concern
basis;

v) the management has ensured that an internal audit system commensurate

with the size and nature of the business exists and is operating effectively.

13. A schedule of payments, which have been made to individuals, firms,

companies and organisations in which Directors of the insurer are interested.
 445

Diagram 5: Contents of management report

confirmation for validity granted by

authority

certification for dues paid

confirmation for transfer of shares

declaration from management that

no funds invested outside India

confirmation regarding
maintenance of solvency margins

certificate to confirm the value of

assets being reported

disclosure for overall risk exposure

and related strategy
Contents of management report
separate statements for risk &
exposure in other countries along
with hedging strategy

ageing of claims

certification to ascertain the

procedure for deriving value of
stock, and investment

review of asset quality

& performance of investment in
terms of portfolio

responsibility statement indicating

adoption of accounting policies

schedule of payments
 446

PART V - Preparation of Financial Statements

1. An insurer shall prepare the Revenue Account, Profit and Loss Account
[Shareholders’ Account] and the Balance Sheet in Form B-RA, Form B-PL,
and Form B-BS, or as near thereto as the circumstances permit.

Provided that an insurer shall prepare Revenue Accounts separately for fire,
marine, and miscellaneous insurance business and separate schedules shall be
prepared for Marine Cargo, Marine – Other than Marine Cargo and the
following classes of miscellaneous insurance business under miscellaneous
insurance and accordingly application of AS 17 – Segment Reporting - shall
stand modified.

a) Motor
b) Workmen’s Compensation/Employers’ Liability,
c) Public/Product Liability,
d) Engineering
e) Aviation ,
f) Personal Accident,
g) Health Insurance,
h) Others

2. An insurer shall prepare separate Receipts and Payments Account in

accordance with the Direct Method prescribed in AS 3 – “Cash Flow
Statement” issued by the ICAI.
 447

FORM B-RA

Name of the Insurer:

Registration No. and Date of Registration with the IRDA

REVENUE ACCOUNT FOR THE YEAR ENDED 31ST MARCH,

20___.

Particulars Schedule Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. Premiums earned (Net) 1
2. Profit/ Loss on sale/redemption of
Investments
3. Others (to be specified)
4. Interest, Dividend & Rent – Gross
TOTAL (A)

1. Claims Incurred (Net) 2

2. Commission 3
3. Operating Expenses related to 4
Insurance Business
TOTAL (B)
Operating Profit/(Loss) from
Fire/Marine/Miscellaneous Business
C= (A - B)
APPROPRIATIONS

Transfer to Shareholders’ Account

Transfer to Catastrophe Reserve
Transfer to Other Reserves (to be
specified)
TOTAL (C)

Note: See Notes appended at the end of Form B-PL

 448

FORM B-PL

Name of the Insurer:

Registration No. and Date of Registration with the IRDA

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST

MARCH, 20___.

Particulars Schedule Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. OPERATING PROFIT/(LOSS)
(a) Fire Insurance
(b) Marine Insurance
(c) Miscellaneous Insurance
2. INCOME FROM INVESTMENTS
(a) Interest, Dividend & Rent – Gross
(b) Profit on sale of investments
Less: Loss on sale of investments
3. OTHER INCOME (To be specified)
TOTAL (A)

4. PROVISIONS (Other than taxation)

(a) For diminution in the value of
investments
(b) For doubtful debts
(c) Others (to be specified)
5. OTHER EXPENSES
(a) Expenses other than those related
to Insurance Business
(b) Bad debts written off
(c) Others (To be specified)
TOTAL (B)
Profit Before Tax
Provision for Taxation
 449

Particulars Schedule Current Previous

Year Year
(Rs.’000) (Rs.’000)
APPROPRIATIONS
(a) Interim dividends paid during the
year
(b) Proposed final dividend
(c) Dividend distribution tax
(d) Transfer to any Reserves or Other
Accounts (to be specified)
Balance of profit/ loss brought
forward from last year
Balance carried forward to Balance
Sheet

Notes: to Form B-RA and B- PL

a) Premium income received from business concluded in and outside India shall
be separately disclosed.
b) Reinsurance premiums whether on business ceded or accepted are to be
brought into account gross (i.e. before deducting commissions) under the
head reinsurance premiums.
c) Claims incurred shall comprise claims paid, specific claims settlement costs
wherever applicable and change in the outstanding provision for claims at the
year-end,
d) Items of expenses and income in excess of one percent of the total premiums
(less reinsurance) or Rs.5,00,000 whichever is higher, shall be shown as a
separate line item.
e) Fees and expenses connected with claims shall be included in claims.
f) Under the sub-head "Others” shall be included items like foreign exchange
gains or losses and other items.
g) Interest, dividends and rentals receivable in connection with an investment
should be stated as gross amount, the amount of income tax deducted at
source being included under 'advance taxes paid and taxes deducted at
source”.
h) Income from rent shall include only the realised rent. It shall not include any
notional rent.
 450

FORM B-BS

Name of the Insurer:

Registration No. and Date of Registration with the IRDA

Balance Sheet As At 31ST March, 20___

Schedule Current Previous

Year Year
(Rs.’000) (Rs.’000)
Sources of Funds

Share Capital 5
Reserves and Surplus 6
Fair value change account
Borrowings 7
Total
Application of funds
Investments 8
Loans 9
Fixed Assets 10
Current Assets
Cash and Bank Balances 11
Advances and Other Assets 12
Sub-Total (A)
Current Liabilities 13
Provisions 14
Sub-Total (B)
Net Current Assets (C) = (A - B)
Miscellaneous Expenditure (to the extent 15
not written off or adjusted)
Debit Balance in Profit and Loss Account
Total
 451

CONTINGENT LIABILITIES

Particulars Current Previous

Year Year
(Rs.’000). (Rs.’000).
1. Partly paid-up investments
2. Claims, other than against policies, not
acknowledged as debts by the company
3. Underwriting commitments outstanding (in
respect of shares and securities)
4. Guarantees given by or on behalf of the Company
5. Statutory demands/ liabilities in dispute, not
provided for
6. Reinsurance obligations to the extent not provided
for in accounts
7. Others (to be specified)
TOTAL

SCHEDULES FORMING PART OF FINANCIAL STATEMENTS

SCHEDULE 1 – PREMIUM EARNED [NET]

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
Premium from direct business written
Add: Premium on reinsurance accepted
Less : Premium on reinsurance ceded
Net Premium
Adjustment for change in reserve for unexpired risks
Total Premium Earned (Net)

Notes: Reinsurance premiums whether on business ceded or accepted are to be

brought into account, before deducting commission, under the head of
reinsurance premiums.
 452

SCHEDULE 2 - CLAIMS INCURRED [NET]

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
Claims paid
Direct
Add: Re-insurance accepted
Less: Re-insurance Ceded
Net Claims paid
Add: Claims Outstanding at the end of the year
Less: Claims Outstanding at the beginning
Total Claims Incurred

Notes:

a) Incurred But Not Reported (IBNR), Incurred but not enough reported
[IBNER] claims should be included in the amount for outstanding claims.
b) Claims includes specific claims settlement cost but not expenses of
management
c) The surveyor fees, legal and other expenses shall also form part of claims
cost.
d) Claims cost should be adjusted for estimated salvage value if there is a
sufficient certainty of its realisation.

SCHEDULE 3 - COMMISSION

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
Commission paid
Direct
Add: Re-insurance Accepted
Less: Commission on Re-insurance Ceded
Net Commission

Note: The profit/ commission, if any, are to be combined with the Re-insurance
accepted or Re-insurance ceded figures.
 453

SCHEDULE 4 - OPERATING EXPENSES RELATED TO INSURANCE

BUSINESS

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. Employees’ remuneration & welfare benefits
2. Travel, conveyance and vehicle running expenses
3. Training expenses
4. Rents, rates & taxes
5. Repairs
6. Printing & stationery
7. Communication
8. Legal & professional charges
9. Auditors' fees, expenses etc
(a) as auditor
(b) as adviser or in any other capacity, in respect
of
(i) Taxation matters
(ii) Insurance matters
(iii) Management services; and
(c) in any other capacity
10 Advertisement and publicity
.
11 Interest & Bank Charges
.
12 Others (to be specified)
.
13 Depreciation
.
TOTAL

Note: Items of expenses and income in excess of one percent of the total
premiums (less reinsurance) or Rs.5,00,000 whichever is higher, shall be shown
as a separate line item.
 454

SCHEDULE 5 - SHARE CAPITAL

Particulars Current Previous

Year Year
(Rs.’000). (Rs.’000).
1. Authorised Capital
Equity Shares of Rs..... each
2. Issued Capital
Equity Shares of Rs. .....each
3. Subscribed Capital
Equity Shares of Rs.......each
4. Called-up Capital
Equity Shares of Rs. .....each
Less : Calls unpaid
Add: Equity Shares forfeited (Amount
originally paid up)
Less: Par Value of Equity Shares bought back
Less: Preliminary Expenses
Expenses including commission or
brokerage on
Underwriting or subscription of shares
TOTAL

Notes:

a) Particulars of the different classes of capital should be separately stated.

b) The amount capitalised on account of issue of bonus shares should be
disclosed.
c) In case any part of the capital is held by a holding company, the same should
be separately disclosed.
 455

SCHEDULE 5A - SHARE CAPITAL

PATTERN OF SHAREHOLDING
[As certified by the Management]

Shareholder Current Year Previous Year

Number of % of Number of % of
Shares Holding Shares Holding
Promoters
(a) Indian
(b) Foreign
Others
TOTAL

SCHEDULE 6 - RESERVES AND SURPLUS

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. Capital Reserve
2. Capital Redemption Reserve
3. Share Premium
4. General Reserves
Less: Debit balance in Profit and Loss Account
Less: Amount utilized for Buy-back
5. Catastrophe Reserve
6. Other Reserves (to be specified)
7. Balance of Profit in Profit & Loss Account
TOTAL

Note:

Additions to and deductions from the reserves should be disclosed under each of
the specified heads.
 456

SCHEDULE 7 - BORROWINGS

Particulars Current Previous

Year Year
(Rs.’000). (Rs.’000).
1. Debentures/ Bonds
2. Banks
3. Financial Institutions
4. Others (to be specified)

TOTAL

Notes:

a) The extent to which the borrowings are secured shall be separately disclosed
stating the nature of the security under each sub-head.
b) Amounts due within 12 months from the date of Balance Sheet should be
shown separately

SCHEDULE 8 - INVESTMENTS

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
Long Term Investments
1. Government securities and Government
guaranteed bonds including Treasury Bills
2. Other Approved Securities
3. Other Investments
(a) Shares
(aa) Equity
(bb) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/ Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
4. Investments in Infrastructure and Social Sector
5. Other than Approved Investments
 457

Short Term Investments

1. Government securities and Government
guaranteed bonds including Treasury Bills
2. Other Approved Securities
3. Other Investments
(a) Shares
(aa) Equity
(bb) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/ Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
4. Investments in Infrastructure and Social Sector
5. Other than Approved Investments
TOTAL

Notes:

a) Investments in subsidiary/holding companies, joint ventures and associates

shall be separately disclosed, at cost.

i) Holding company and subsidiary shall be construed as defined in the

Companies Act, 1956:

ii) Joint Venture is a contractual arrangement whereby two or more parties

undertake an economic activity, which is subject to joint control.

iii) Joint control - is the contractually agreed sharing of power to govern the
financial and operating policies of an economic activity to obtain benefits
from it.

iv) Associate - is an enterprise in which the company has significant influence

and which is neither a subsidiary nor a joint venture of the company.

v) Significant influence (for the purpose of this schedule) - means participation

in the financial and operating policy decisions of a company, but not control
of those policies. Significant influence may be exercised in several ways, for
example, by representation on the board of directors, participation in the
policymaking process, material inter-company transactions, interchange of
managerial personnel or dependence on technical information.
 458

Significant influence may be gained by share ownership, statute or

agreement. As regards share ownership, if an investor holds, directly or
indirectly through subsidiaries, 20 percent or more of the voting power of the
investee, it is presumed that the investor does have significant influence,
unless it can be clearly demonstrated that this is not the case. Conversely, if
the investor holds, directly or indirectly through subsidiaries, less than 20
percent of the voting power of the investee, it is presumed that the investor
does not have significant influence, unless such influence is clearly
demonstrated. A substantial or majority ownership by another investor does
not necessarily preclude an investor from having significant influence.

b) Aggregate amount of company's investments other than listed equity

securities and derivative instruments and also the market value thereof shall
be disclosed.

c) Investments made out of Catastrophe reserve should be shown separately.

d) Debt securities will be considered as “held to maturity” securities and will be

measured at historical cost subject to amortisation.

e) Investment Property means a property [land or building or part of a building

or both] held to earn rental income or for capital appreciation or for both,
rather than for use in services or for administrative purposes.

f) Investments maturing within twelve months from balance sheet date and
investments made with the specific intention to dispose of within twelve
months from balance sheet date shall be classified as short-term investments

SCHEDULE 9 – LOANS

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. SECURITY-WISE CLASSIFICATION
Secured
(a) On mortgage of property
(aa) In India
(bb) Outside India
(b) On Shares, Bonds, Govt. Securities
(c) Others (to be specified)
Unsecured
TOTAL
 459

2. BORROWER-WISE CLASSIFICATION
(a) Central and State Governments
(b) Banks and Financial Institutions
(c) Subsidiaries
(d) Industrial Undertakings
(e) Others (to be specified)
TOTAL
3. PERFORMANCE-WISE CLASSIFICATION
(a) Loans classified as standard
(aa) In India
(bb) Outside India
(b) Non-performing loans less provisions
(aa) In India
(bb) Outside India
TOTAL
4. MATURITY-WISE CLASSIFICATION
(a) Short Term
(b) Long Term
TOTAL

Notes:

a) Short-term loans shall include those, which are repayable within 12 months
from the date of balance sheet. Long term loans shall be the loans other than
short-term loans.
b) Provisions against non-performing loans shall be shown separately.

c) The nature of the security in case of all long term secured loans shall be
specified in each case. Secured loans for the purposes of this schedule,
means loans secured wholly or partly against an asset of the company.

d) Loans considered doubtful and the amount of provision created against such
loans shall be disclosed.
 460

SCHEDULE 10 - FIXED ASSETS

(Rs.’000)
Particulars Cost/ Gross Block Depreciation Net Block

Opening Additions Deductions Closing Upto For On Sales/ To As Previous

Last The Adjustments Date at Year
Year Year year
end
Goodwill
Intangibles (specify)
Land-Freehold
Leasehold Property
Buildings
Furniture & Fittings
Information Technology
Equipment
Vehicles
Office Equipment
Others (Specify nature)
TOTAL
Work in progress
Grand Total
PREVIOUS YEAR

Note: Assets included in land, building and property above exclude Investment Properties as defined in note (e) to
Schedule 8.
 461

SCHEDULE 11 - CASH AND BANK BALANCES

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. Cash (including cheques, drafts and stamps)
2. Bank Balances
(a) Deposit Accounts
(aa) Short-term (due within 12 months)
(bb) Others
(b) Current Accounts
(c) Others (to be specified)
3. Money at Call and Short Notice
(a) With Banks
(b) With other Institutions
4. Others (to be specified)
Total

Balances with non-scheduled banks included in

2 and 3 above

Note : Bank balance may include remittances in transit. If so, the nature and
amount should be separately stated.

SCHEDULE 12 - ADVANCES AND OTHER ASSETS

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
Advances
1. Reserve deposits with ceding companies
2. Application money for investments
3. Prepayments
4. Advances to Directors/Officers
5. Advance tax paid and taxes deducted at source
(Net of provision for taxation)
6. Others (to be specified)
Total (A)
 462

Other Assets
1. Income accrued on investments
2. Outstanding Premiums
3. Agents’ Balances
4. Foreign Agencies Balances
5. Due from other entities carrying on insurance
business
(including reinsurers)
6. Due from subsidiaries/ holding co.
7. Deposit with Reserve Bank of India
[Pursuant to section 7 of Insurance Act, 1938]
8. Others (to be specified)
Total (B)
Total (A+B)

Notes:

a) The items under the above heads shall not be shown net of provisions for
doubtful amounts. The amount of provision against each head should be
shown separately.
b) The term ‘officer’ should conform to the definition of that term as given
under the Companies Act, 1956.
c) Sundry Debtors will be shown under item 9(others)

SCHEDULE 13 - CURRENT LIABILITIES

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. Agents’ Balances
2. Balances due to other insurance companies
3. Deposits held on re-insurance ceded
4. Premiums received in advance
5. Unallocated Premium
6. Sundry creditors
7. Due to subsidiaries/ holding company
8. Claims Outstanding
9. Due to Officers/ Directors
10. Others (to be specified)
Total
 463

SCHEDULE 14 - PROVISIONS

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1 Reserve for Unexpired Risk
2 For taxation (less advance tax paid and taxes
deducted at source)
3 For proposed dividends
4 For dividend distribution tax
5 Others (to be specified)
Total

SCHEDULE 15 - MISCELLANEOUS EXPENDITURE

(To the extent not written off or adjusted)

Particulars Current Previous

Year Year
(Rs.’000) (Rs.’000)
1. Discount Allowed in issue of shares/ debentures

2. Others (to be specified)

Total

Notes:

a) No item shall be included under the head “Miscellaneous Expenditure” and

carried forward unless:

i) some benefit from the expenditure can reasonably be expected to be received

in future, and
ii) the amount of such benefit is reasonably determinable.

b) The amount to be carried forward in respect of any item included under the
head “Miscellaneous Expenditure” shall not exceed the expected future
revenue/other benefits related to the expenditure.
 464

SCHEDULE C
(See Regulation 3)
AUDITOR’S REPORT

The report of the auditors on the financial statements of every

insurer shall deal with the matters specified herein:

1.
a) That they have obtained all the information and explanations which, to the
best of their knowledge and belief were necessary for the purposes of their
audit and whether they have found them satisfactory;

b) Whether proper books of account have been maintained by the insurer so far
as appears from an examination of those books;

c) Whether proper returns, audited or unaudited, from branches and other

offices have been received and whether they were adequate for the purpose
of audit;

d) Whether the Balance sheet, Revenue account , Profit and Loss account and
the Receipts and Payments Account dealt with by the report are in agreement
with the books of account and returns;

e) Whether the actuarial valuation of liabilities is duly certified by the appointed

actuary including to the effect that the assumptions for such valuation are in
accordance with the guidelines and norms, if any, issued by the Authority,
and/or the Actuarial Society of India in concurrence with the Authority.

2. The auditors shall express their opinion on:

a)
i) Whether the balance sheet gives a true and fair view of the insurer’s affairs as
at the end of the financial year/period;

ii) Whether the revenue account gives a true and fair view of the surplus or the
deficit for the financial year/period;

iii) Whether the profit and loss account gives a true and fair view of the profit or
loss for the financial year/period;

iv) Whether the receipts and payments account gives a true and fair view of the
receipts and payments for the financial year/period;
 465

b) The financial statements stated at (a) above are prepared in accordance with
the requirements of the Insurance Act, 1938 (4 of 1938), the Insurance
Regulatory and Development Authority Act, 1999 (41 of 1999) and the
Companies Act, 1956 (1 of 1956), to the extent applicable and in the manner
so required.

c) Investments have been valued in accordance with the provisions of the Act
and these Regulations.

d) The accounting policies selected by the insurer are appropriate and are in
compliance with the applicable accounting standards and with the accounting
principles, as prescribed in these Regulations or any order or direction issued
by the Authority in this behalf.

3. The auditors shall further certify that:

a) they have reviewed the management report and there is no apparent mistake
or material inconsistencies with the financial statements;

b) the insurer has complied with the terms and conditions of the registration
stipulated by the Authority.

4. A certificate signed by the auditors [which shall be in addition to any other

certificate or report which is required by law to be given with respect to the
balance sheet] certifying that:–

a) they have verified the cash balances and the securities relating to the
insurer’s loans, reversions and life interests (in the case of life insurers) and
investments;

b) to what extent, if any, they have verified the investments and transactions
relating to any trusts undertaken by the insurer as trustee; and

c) no part of the assets of the policyholders’ funds has been directly or

indirectly applied in contravention of the provisions of the Insurance Act,
1938 (4 of 1938) relating to the application and investments of the
policyholders’ funds.

Ref: IRDA Order F.No. IRDA/Reg/03/2002

 466

Which of the following is/are the criterion/criteria for an item of expenditure to

be included under the head “Miscellaneous Expenditure” in accordance with
Schedule B of The IRDA (Preparation of Financial Statements and Auditor’s
Report of Insurance Companies) Regulations, 2002?

(i) Future benefit from the expenditure can reasonably be expected.

(ii) The amount of such benefit is reasonably determinable.

A Both (i) and (ii)

B Only (i)
C Only (ii)
D Either (i) or (ii)

In accordance with Schedule B of The IRDA (Preparation of Financial

Statements and Auditor’s Report of Insurance Companies) Regulations, 2002,
Revenue Accounts need to be separately prepared for which of the following
insurance businesses?

A Fire, marine, and miscellaneous

B Fire and marine
C Marine and miscellaneous
D Only miscellaneous

Which one of the following comes under “Miscellaneous Insurance”?

A Marine insurance
B Motor Insurance
C Fire Insurance
D None of the above
 467

2. Prepare financial statement extracts for a non-life

insurance business in accordance with the appropriate
regulatory requirements.
[Learning Outcome b]
Before we actually prepare the financial statements for non-life insurance
business in accordance with Schedule B, we will discuss some important terms
used.

2.1 Premium income

The payment made by the insured as consideration for the grant of insurance is
known as premium. The amount of premium income to be credited to the revenue
account for a year is calculated as follows:

Rs. Rs.
Premium received on risks undertaken during the year XX
(direct & re-insurance accepted)
Add: Receivable at the end of year (direct & re- XX
insurance accepted)
Less: Receivable at the beginning of year (direct & re- (XX)
insurance accepted)
Less: Premium on re-insurance ceded:
- Paid during the year XX
- Add: Payable at the end of year XX
- Less: Payable at the beginning of year (XX) (XX)
Premium income (XXX)

2.2 Claim expenses

A claim occurs when a policy falls due for payment on the occurrence of an
insured event. In the case of general insurance business, a claim arises only when
the loss occurs or the liability arises. The amount of claim to be charged to the
revenue account is calculated as:
 468

Rs.
Claims settled during the year—direct & re-insurance accepted XX
(including legal fees, survey charges etc.)
Add: Payments to co-insurers XX
Less: Received from co-insurers and re-insurers (XX)
Net payment XXX
Add: Estimated liability at the end of the year (After deducting XX
recoverable from co-insurers and re-insurers)
Less: Estimated liability at the beginning of the year (after (XX)
deducting recoverable from co-insurers and re-insurers)
Claims expense XXX

2.3 Commission expenses

The IRDA Act, 1999 regulates the commission payable on policies to agents.
Commission expense to be charged to the revenue account is computed as follow

Rs.
Commission paid (direct & re-insurance accepted) XX
Add: Commission payable at the end of the year (direct & re- XX
insurance accepted)
Less: Commission payable at the beginning of the year (direct & (XX)
re-insurance accepted)
Commission expense XXX

2.4 Reinsurance

In simple terms, reinsurance is insurance for insurance companies. It is a means

by which insurance companies can protect itself from the risk. The company who
request for the cover is called the cedant and the reinsurer is called the ceded.
When a risk is shared, the first insurer cannot himself retain the entire premium
collected from the policy holders. Depending upon the share of risk undertaken
by the second insurer, proportionate premium must be ceded by the first insurer.
Further, if the policy matures, the claim will also have to be shared by both the
insurers in the agreed ratio. The ceding company, which gives business to re-
insurance company is to receive commission from later – which is known as
commission or re-insurance ceded.

Note - Reinsurance accounting will be covered in detail in Unit 13.

 469

2.5 Catastrophic reserve

It means a reserve which is meant for meeting losses arising from entirely
unexpected set of events & not for any specific known purpose. A catastrophe
could cause a serious financial strain unless adequate reserves are built
systematically over a period of time to meet such contingencies. Catastrophe
losses include losses caused due to storms, floods, tornadoes, earthquakes,
tsunamis, etc.
The IRDA has provided for the regular creation of a catastrophe reserve in the
prescribed format of accounts. However, the norms for maximum annual
transfers to such a reserve have not been specified. The precise utilisation of this
reserve in case of adverse financial results of the insurer caused by a catastrophe
has not been specified.

The following are the details of Premier Ltd, a fire insurance company for the
year ending 31 March 2009:

Particulars Rs.
Claim admitted but not paid (as on 31/03/2009) 3,30,000
Commission paid 3,15,000
Commission on reinsurance received 78,000
Share transfer fees 27,000
Management expenses 4,68,000
Bad debts 16,500
Claims paid 1,35,000
Profit and loss appropriation account 58,500
Premium received less reinsurance 18,67,500
Reserve for unexpired risks as on 01/04/2008 7,05,000
Additional reserve as on 01/04/2008 1,42,500
Claims outstanding as on 01/04/2008 1,53,000
Dividend on share capital 1,05,000
Premium outstanding on 01/04/2008 2,10,000
Premium outstanding on 01/04/2009 2,25,000

The company maintains 50% of the Net Premium towards Reserve for unexpired
Risks, and 10% of the Net premium as Additional Reserve.
Required:
Prepare the Fire Insurance Revenue A/c as per IRDA regulations for the year
ended 31st March, 2009.
 470

Form B-RA - Revenue Account for the year ended 31 March 2009

Particulars Schedule Rs.

Premium Earned (Net) 1 16,00,500
Profit / Loss on sale or redemption of Investments -
Other (to be specified) -
Interest, dividend and rent - Gross -
Total - A 16,00,500

Claim incurred (Net) 2 3,12,000

Commission 3 2,37,000
Operating expenses relating to Insurance business -
Total - B 5,49,000
Operating Profit from Fire Insurance = A - B 10,51,500

Form - B-PL- Profit and Loss Account for the year ending 31 March 2009

Particulars Schedule Rs.

1 Operating Profit from Fire Insurance 10,51,500
2 Income from investment
3 Other income - share transfer fee 27,000
Total - A 10,78,500
4 Provision (other than taxation)
5 Expenses of Management 4,68,000
6 Other expenses - Bad debts written off 16,500
Total - B 4,84,500
Profit before tax = A - B 5,94,000
Less: Provision for taxation -
Profit for the year before appropriation 5,94,000
Less: Appropriation - Dividend on equity
share capital (1,05,000)
Profit for the year after appropriation 4,89,000
Add: Balance of profit/loss Brought forward
from last year 58,500
Balance carried forward to Balance sheet 5,47,500
 471

Schedules forming part of Revenue Accounts

Schedule 1 - Premium received

Particulars Rs.
Premium received less Reinsurance premium 18,67,500
Add: Outstanding premium as on 31/03/2009 2,25,000
Less: Outstanding premium as on 31/03/2008 (2,10,000)
Net premium received before adjustment for Unexpired
Risk reserve and Additional Reserve 18,82,500
Less: Adjustment for change in unexpired Risk Reserve = 50%
of Net premium Less Opening Balance in Unexpired Risk
Reserve = 50% of Rs. 18,82,500 - Rs. 7,05,000) (2,36,250)
Less: Adjustment for change in Additional reserve = 10% of
Net Premium Less Opening Balance in Additional Reserve =
10% of Rs. 18,82,500 - Rs. 1,42,500) (45,750)
Total Premium Earned (Net) 16,00,500

Schedule 2 - Claims incurred (Net)

Particulars Rs.
Claims Paid 1,35,000
Add: Claims outstanding at the end of the year 3,30,000
Less: Claims outstanding at the beginning of the year (1,53,000)
Total claims incurred 3,12,000

Schedule 3 - Commission Expenses

Particulars Rs.
Commission Paid 3,15,000
Less: Commission Earned on re-insurance ceded (78,000)
Net Commission 2,37,000

The following are the balances of Zenith Insurance Co. Ltd as on 31 March 2009:
Particulars
Capital (Shares Rs 10 each)
Balance of Funds as on
01/04/1995
- Fire Insurance
- Marine Insurance
- Miscellaneous Insurance
Unclaimed dividend
Amount due to other
insurance companies
Sundry creditors
Deposit and suspense
account (Cr)
Profit and loss account (Cr)
Agent balance (Dr)
Interest accrued but not due
(Dr)
Due from other insurance
Companies
Cash on hand
Balance on current account
with bank
Furniture and fixture WDV
(Cost Rs. 150,00)
Stationery stock
Expenses of Management
- Fire Insurance
- Marine Insurance
- Miscellaneous Insurance
- Others
Foreign taxes - Marine
Outstanding premium
Donation paid to NGO (No
80G benefit)
472
Rs.000's Particulars Rs.000's
4,80,00 Transfer fee 1,50
Income tax refund received
during the year 45,00
12,00,00 Reserve for bad debts 17,55
14,25,00 Income tax paid 1,80,00
3,27,97 Mortgage Loans (Dr) 14,62,50
12,75 Sundry debtors 37,50
Government securities
51,75 deposited with RBI 55,50
108,75 Government securities 15,30,00
34,20 Debentures 6,98,25
Equity shares of joint Stock
1,20,60 Companies 3,37,50
2,02,50 Claims Less Re-insurance
33,75 - Fire Insurance 6,75,00
96,75 - Marine Insurance 5,38,35
5,25 - Miscellaneous Insurance 1,02,00
Premium Less Re-
1,12,20 insurance
87,00 - Fire Insurance 26,43,75
2,10 - Marine Insurance 15,33,75
- Miscellaneous Insurance 3,93,38
Interest and dividends
4,20,00 received on investments 87,75
Tax deducted at source on
2,40,00 Interest 17,55
60,00 Commission
45,00 - Fire Insurance 7,50,00
12,00 - Marine Insurance 5,25,00
1,23,00 - Miscellaneous Insurance 1,20,00
15,00
 473

You are required to make the following provisions:

1. Depreciation on furniture - 10% of original cost

2. Depreciation on investment of joint stock companies’ shares Rs. 15,00,000.

3. Transfer to general reserve Rs.15,00,000.

4. Outstanding claims as on 31/03/2009

- Fire Insurance - Rs. 300,00,000
- Marine Insurance - Rs. 75,00,000
- Miscellaneous Insurance - Rs. 48,75,000

5. Provision for tax @ 50%

Proposed dividends @ 20%

6. Provision for unexpired risk is to be made as follows:

(a) On Marine Policies 100% Premium Less reinsurance
(b) On Other Policies 50% Premium Less reinsurance

7. The shares of the company are fully held by Indian promoters.

Required:

You are required to prepare Revenue and Profit and Loss Account for the year
ended 31 March 2009 and Balance Sheet as on that date.
 474

Form B - RA - Revenue account for the year ended 31 March 2009

Rs.000 Rs.000 Rs.000

Particulars Schedule Fire Marine Misc.
1 Premium earned (Net) 1 25,21,88 14,25,00 5,24,66
2 Profit / Loss on sale or redemption of Investments - - -
3 Other (to be specified) - - -
4 Interest, dividend and rent - Gross - - -
Total - A 25,21,88 14,25,00 5,24,66
1 Claims incurred (Net) 2 9,75,00 6,13,35 1,50,75
2 Commission 3 7,50,00 5,25,00 1,20,00
3 Operating expenses relating to Insurance business 4 4,20,00 2,52,00 60,00
Total - B 21,45,00 13,90,35 3,30,75
Operating Profit from Insurance business= A - B 3,76,88 34,65 1,93,91
Appropriations
1 Transfer to shareholder's Account 3,76,88 34,65 1,93,91
2 Transfer to Catastrophe Reserve - - -
3 Transfer to other reserves (to be specified) - - -
Total - C 3,76,88 34,65 1,93,91
 475

Form B-PL - Profit and Loss account for the year ending 31 March 2009

Schedule Rs.000
1 Operating Profit
(a) Fire Insurance 3,76,88
(b) Marine Insurance 34,65
(c) Miscellaneous Insurance 1,93,91
2 Income from investment
(a) Interest, dividend and rent - Gross 87,75
(b) Profit on sale of investment -
3 Other income - Transfer fees 1,50
Total - A ( 1 + 2 + 3) 6,94,69
4 Provision (other than taxation)
(a) For decrease in value of investment -
(b) For doubtful debts -
(c) Others (to be specified) -
5 Other expenses
(a) Depreciation of fixed assets 15,00
(b) Depreciation on Joint stock companies
shares 15,00
(c) Expenses of Management 45,00
(d) Donations 15,00
Total - B (4 + 5) 90,00
Profit before tax (A - B) 6,04,69
Less: Provision for taxation (WN 1) (3,09,84)
Profit after tax 2,94,85
Appropriations
(a) Interim dividends paid during the year -
(b) Proposed final dividend 96,00
(c) Dividend distribution tax -
(d) Transfer to reserve - General Reserve 15,00
Balance after appropriations 1,83,85
Add: Balance of profit / Loss brought
forward from last year 1,20,60
Add: Income tax refund received 45,00
Balance carried forward to balance sheet 3,49,45
 476

Form - B-BS - Balance Sheet as at 31 March 2009

Sources of funds Schedule Rs.000

Share capital 5 4,80,00
Reserve and surplus 6 3,97,00
Fair value change account -
Borrowings 7 -
Total sources of funds 8,77,00

Application of funds Rs.000

Investments 8 26,21,25
Loans 9 14,62,50
Fixed assets 10 72,00
Current assets
- Cash and Bank balances 11 1,17,45
- Advances and other assets (4,93,50 + 2,10) 12 4,95,60
Sub-Total - A 47,68,80
Current liabilities 13 6,31,20
Provisions 14 3,26,060
Sub-Total - B 38,91,80
Net current assets C = A - B 8,77,00
Miscellaneous expenditure (to the extent not
written off or adjusted) 15 -
Debit balance in profit and loss account -
Total application of funds 8,77,00

Note: The corresponding amounts for the preceding financial year have not been
shown in the above case study due to lack of information in the question.
 477

Schedules forming part of financial statements:

Schedule 1 - Premium earned

Rs.000 Rs.000 Rs.000

Particulars Fire Marine Misc.
Premium from direct business written
Add: Premium on reinsurance accepted
Less: Premium on reinsurance ceded
Net premium (given directly in
question) 26,43,75 15,33,75 3,93,38
Add/ (Less): Adjustment for change in
Reserve for unexpired risk (1,21,87) (1,08,75) (1,31,28)
Total premium earned (net) 25,21,88 14,25,00 5,24,66

Note: Amount to be transferred to / from Unexpired Risk Premium = Balance

required as on 31 March 2009 Less Balance in Unexpired Risk Reserve Account

a) Fire Insurance = Balance required as on 31 March 2009 50% of the net

premium Rs. 26,43,75 less Opening balance in Unexpired Risk Reserve
Account Rs.1,200,00 = Rs.13,21,87 - Rs.1,200,00 = Rs.1,21,87.

b) Marine Insurance = Balance required as on 31 March 2009 100% of the net

premium Rs. 15,33,75 less Opening balance in Unexpired Risk Reserve
Account Rs.14,25,00 = Rs.1,08,75

c) Miscellaneous Insurance = Opening balance in Unexpired Risk Reserve

account Less balance required as on 31 March 2009 50% of the net premium
Rs.3,93,38 = Rs.3,27,97 - Rs. 1,96,69 = Rs.1,31,28.
 478

Schedule 2 - Claims incurred (Net)

Rs.000 Rs.000 Rs.000

Particulars Fire Marine Misc.
Claims paid - - -
Direct - - -
Add: Re-insurance accepted - - -
Less: Re-insurance Ceded - - -
Net claims paid 6,75,00 5,38,35 1,02,00
Add: Claims outstanding at the end of the
year 3,00,00 75,00 48,75
Less: Claims outstanding at the beginning
of the year - - -
Total claims incurred 9,75,00 6,13,35 1,50,75

Schedule 3 - Commission expenses

Rs.000 Rs.000 Rs.000

Particulars Fire Marine Misc.
Commission paid 7,50,00 5,25,00 1,20,00
Net commission 7,50,00 5,25,00 1,20,00

Schedule 4 - Operating expenses related to insurance business

Rs.000 Rs.000 Rs.000

Particulars Fire Marine Misc.
1 Rent rates and taxes (foreign taxes) - 12,00 -
2 Other expenses of management 4,20,00 2,40,00 60,00
Total operating expenses 4,20,00 2,52,00 60,00
 479

Schedule 5 - Share capital

Particulars Rs.000
Authorised capital - Equity shares of
1 Rs….each -
Issued, subscribed, called up and
paid up capital - 48 lakhs shares of
2 Rs 10 each 4,80,00

Schedule 5A - Pattern of shareholding

Shareholder Current year Previous year

No of % of No of % of
shares holding shares holding
1 Promoters
(a) Indian 48 lakhs 100% 48 lakhs 100%
(b) Foreign - - - -
2 Others - - - -
Total 48 lakhs 100% 48 lakhs 100%

Schedule 6 - Reserve and Surplus

Particulars Rs.000
1 General reserve 15,00
2 Other reserve
(a) Reserve for bad debts 17,55
(b) Fluctuation reserve account [Depreciation of
Investment in shares of Joint Stock Co] 15,00
3 Balance in profit and loss account 3,49,45
Total 3,97,00

Schedule 7 – Borrowings

Borrowings - NIL
 480

Schedule 8 – Investments

Particulars Rs.000
Long term investments 15,30,00
Govt. securities and government guaranteed bonds
1 including treasury bills 55,50
2 Other approved securities deposited with RBI
3 Other investments 3,37,50
(a) Equity shares 6,98,25
(b) Debenture bonds
Short term investments -
Total investments 26,21,25

Schedule 9 – Loans

Particulars Rs.000
1 Security wise classification
Secured
(a) On mortgage of property 14,62,50
(b) On shares, bond, government securities, etc. -
(c) Others (to be specified) -
Unsecured -
Total 14,62,50
2 Borrower wise classification 14,62,50
3 Maturity wise classification 14,62,50

Note - in the absence of information, borrower-wise and maturity-wise

classification is not provided.
 481

Schedule 10 - Fixed assets

Particulars Cost / Gross Block Accumulated depreciation Net Block

Opening Addn. Deduction Closing Opening For the year Sales/adj. Closing Closing Opening
Furniture and fixture 1,50,00 - - 1,50,00 63,00 15,00 - 78,00 72,00 87,00

Schedule 11 - Cash and bank balance

Particulars Rs.000
Cash (including cheques, drafts and stamps) 5,25
Bank balance - current account 1,12,20
Total 1,17,45

Schedule 12 - Advances and other assets

Particulars Rs.000
Other assets
1 Income accrued on investments 33,75
2 Outstanding premium 1,23,00
3 Agent's balance 2,02,50
Due from other entity carrying on insurance
4 business (including re-insurers) 96,75
5 Other - stationery stock 2,10
6 Other - sundry debtor 37,50
Total 4,95,60
 482

Schedule 13 - Current liabilities

Particulars Rs.000
1 Balance due to other insurance companies 51,75
2 Deposit and suspense account 34,20
3 Sundry creditor 1,08,75
Claims outstanding (Rs.3,00,00 + Rs.75,00 +
4 Rs.48,75) 4,23,75
5 Unclaimed dividend 12,75
Total 6,31,20

Schedule 14 – Provisions

Particulars Rs.000
1 Reserve for unexpired risk
(a) Fire Refer to notes 13,21,87
(b) Marine to Schedule 4 15,33,75
(c) Miscellaneous 1,96,69
For taxation (Less advance tax paid and taxes
2 deducted at source) (W2) 1,12,29
3 For proposed dividends 96,00
Total provisions 32,60,60

Schedule 15 - Miscellaneous expenditure

NIL

Workings
W1 Calculation of provision for taxation

Particulars Rs.000
Net profit before tax 6,04,68
Add: Donation not allowed as a deduction u/s 80G of
Income tax act 15,00
Taxable profit 6,19,68
Provision for tax at 50% 3,09,84
 483

W2 Provision for taxation account

Particulars Rs.000 Particulars Rs.000

By profit and loss
To Bank A/c 1,80,00 A/c 3,09,84
To Tax deducted at source A/c 17,55
To balance c/d - Balancefigure 1,12,29
3,09,84 3,09,84

Summary
¾ An insurer carrying on general insurance business shall comply with the
requirements of Schedule ‘B’ to prepare financial statements.
¾ General insurance includes life insurance, marine insurance and fire
insurance.
¾ Insurance companies are required to maintain their financial accounts i.e.
revenue account, profit and loss account and balance sheet in accordance
with the provisions of the IRDA (Preparation of Financial Statements and
Auditor's Report of Insurance Companies) Regulations, 2002.
¾ General insurance companies should comply with the requirements of
Schedule B. Schedule B is broadly divided into the following parts:
9 Part l - Accounting principles for preparation of financial statements
9 Part II- Disclosures forming part of financial statements
9 Part III - General instructions for preparation of financial statements.
9 Part IV - Contents of management report.
9 Part-V - Preparation of financial statements.
¾ Premium shall be recognised as income over the contract period or the period
of risk, whichever is appropriate.
¾ Acquisition costs, if any, shall be expensed in the period in which they are
incurred.
¾ A liability for outstanding claims shall be brought to account in respect of
both direct business and inward reinsurance business.
¾ Loans shall be measured at historical cost subject to impairment provisions.
¾ Catastrophe reserve shall be created in accordance with norms, if any,
prescribed by the authority.
 484

Answers to Test Yourself

Answer to TY 1

The correct option is D.

Answer to TY 2

The correct option is A.

Both the conditions need to be satisfied in order to include an item of expenditure

under the head “Miscellaneous Expenditure”.

Answer to TY 3

The correct option is A.

Answer to TY 4

The correct option is B.

Marine and fire insurance are separate categories under general insurance. Motor
insurance needs to be classified under miscellaneous insurance.

Self Examination Questions

Question 1

An item of income and expense can be shown in the Revenue Account of a Fire /
Marine insurance company as a separate line item only if:

A It is in excess of 1% of the premium or Rs.50,000, whichever is higher

B It is in excess of 1% of the premium or Rs.50,000, whichever is lower
C It is in excess of 1% of the premium or Rs.5,00,000, whichever is higher
D It is in excess of 1% of the premium or Rs.5,00,000, whichever is lower
 485

Question 2

General insurance includes:

A Life insurance, marine insurance and fire insurance

B Marine insurance and fire insurance
C Marine insurance, fire insurance and miscellaneous insurance
D Only miscellaneous insurance

Question 3

An insurance company carrying on general insurance business is required to

prepare balance sheet, revenue account and profit and loss account in accordance
with:

A Schedule A
B Schedule B
C Schedule C
D Schedule D

Question 4

For a company engaged in general insurance business, premium is recognised:

A When due
B Over the contract period or period of risk
C On receipt basis
D None of the above

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is C.

In accordance with the notes to B-RA and B-PL, items of expenses and income
in excess of one per cent of the total premiums (less reinsurance) or Rs.5,00,000
whichever is higher, shall be shown as a separate line item.
 486

Answer to SEQ 2

The correct option is C.

General insurance includes Fire, Marine and Miscellaneous Insurance.

Answer to SEQ 3

The correct option is B.

The general insurance companies need to comply with Schedule B of IRDA

(Preparation of Financial Statements and Auditor's Report of Insurance
Companies) Regulations, 2002.

Answer to SEQ 4

The correct option is B.

In accordance with Part I of Schedule B, premium is recognised as income over

the contract period or the period of risk, whichever is appropriate.
 487

CHAPTER 3

NON-LIFE INSURANCE BUSINESS

ACCOUNTING METHODS, TECHNIQUES AND
PROCESS
UNIT 12

PREPARATION AND PRESENTATION OF

FINANCIAL STATEMENTS
Chapter Introduction
In the previous unit, accounting regulations are discussed for the general
insurance business. In this unit, we discuss how and which different financial
statements are prepared and presented.

a) Briefly list the regulatory requirements for financial statements for

general insurance business and present the specified formats of the
required financial statements.
b) Explain how Revenue Accounts, Profit and Loss Accounts and Balance
sheets are prepared in the general insurance business.
c) Demonstrate the preparation and presentation of cash flow statement in
general insurance business.
d) Briefly explain how analysis of financial statements is done using ratio
analysis.
e) Highlight the legal aspects of general insurance accounting.
 488

1. Briefly list the regulatory requirements for financial

statements for general insurance business and present
the specified formats of the required financial
statements.
[Learning Outcome a]
1.1 Financial statements - regulatory requirements
In India, Financial Statements of a general insurance business are drawn up in
accordance with the provisions of section 11 (1) of the Insurance Act 1938, the
requirements of regulations called IRDA (Preparation of Financial Statements
and Auditors Report of Insurance Companies) Regulations 2002, read with
provisions of Sec.211 and Sec.227 of the Companies Act, 1956.
The said statements are also prepared in compliance with accounting principles
and conventions discussed earlier and on accrual basis.
The said financial statements shall also be in conformity with Accounting
Standard (AS) issued by the ICAI to the Extent applicable to the insurers
except Accounting Standard 13 (AS 13) and Accounting Standard 17 (AS17).

As discussed earlier, the financial statements in general insurance business

include:
i) Balance Sheet,
ii) Revenue Accounts,
iii) Profit and Loss Account and
iv) Receipts and Payments Account (Cash flow Statement).

Financial Statements shall be prepared in the formats specified in the

Regulations.
9 Revenue Account shall be prepared in Form B- RA, Profit and Loss Account
in Form B-PL and Balance Sheet in Form B-BS as specified in Part V in
schedule B of Reg.3.
9 The said Financial Statements will be prepared in accordance with General
Instructions for preparations as per Part 111.
9 The said Financial Statements shall be supported by Disclosures Forming
Part of Financial Statements and the comments of Management report as per
Part 11 and Part 1V of the Schedule B to the IRDA (Preparation of Financial
Statements and Auditors Report of Insurance Companies) Regulations 2002.
 489

The financial statements in general insurance business does not include:

A Revenue Account
B Profit and Loss Account
C Receipts and Payments Account
D Trading Account

1.2 Specified Forms of financial statements

There are 15 schedules, the first four relate to Revenue A/c and the
remaining eleven schedules relate to Balance Sheet.

1. Balance Sheet

BALANCE SHEET as on…………..

Schedule Current Previous
year year
SOURCES OF FUNDS
Share capital 5
Reserves and surplus 6
Fair value change account
Borrowings 7
TOTAL
APPLICATION OF FUNDS
Investments 8
Loans 9
Fixed assets 10
Current assets
Cash and Bank Balances 11
Advances and Other Assets 12
Sub-Total (A)
Current liabilities 13
Provisions 14
Sub-Total (B)
Net current assets (c) = (a - b)
Miscellaneous expenditure (Not written 15
off )
Debit Balance in P& L Account
TOTAL
 490

The above financial statements are to be prepared according to the General

instruction for preparation of Financial Statements as specified in Part 111 of the
IRDA regulation. Again, said financial statements will be supported by specific
disclosure forming part of Financial Statements as specified by Part 11 and
Comments of Management Report specified by Part 1V of Schedule B of the
Regulation.
It should also mention about the contingent liability in respect of the following
items:
9 Partly-paid up investments
9 Underwriting commitments outstanding
9 Claims, other than those under policies, not acknowledged as debts
9 Guarantees given by or on behalf of the company
9 Statutory demands/liabilities in dispute, not provided for
9 Reinsurance obligations to the extent not provided for in accounts

2. Revenue account (Form B – RA)

Particulars Schedule Current Previous

year year
1. Premium earned (Net) 1
2. Profit/loss on sale/redemption of
investments
3. Others (to be specified)
4. Interest, Dividend & Rent—Gross
Total (A)
1. Claims Incurred (Net) 2
2. Commission 3
3. Operating Expenses related to 4
Insurance business
Total (B)
Operating profit/loss from
Fire/Marine/ Misc. Business
C=(A--B)
Appropriations
9 Transfer to Shareholders’ Account
9 Transfer to Catastrophe Reserve
9 Transfer to other Reserves (to be
specified)
Total (C)
 491

3. Profit and Loss A/c (Form B-PL)

Particulars Schedule Current Previous

year year
1. Operating profits/loss
a) Fire Insurance
b) Marine Insurance
c) Miscellaneous Insurance
2. Income from investments
a) Interest, Dividends & \Rents—
Gross
b) Profit on Sale of Investments
3. Other income (To be specified)
Total (A)
4. Provisions (Other than taxation)
a) For diminution in value of
investment
b) For doubtful debts
c) Others (to be specified)
5. Other expenses
a) Expenses other than those related to
Ins. Business
b) Bad Debts written off
c) Others (To be specified)
Total (B)
Profit Before Tax
Provisions for Taxation
Appropriations
a) Interim Dividend Paid during the
year
b) Proposed Final Dividend
c) Dividend distribution tax
d) Transfer to any Reserve or Other
Account
Balance of profit / loss brought
forward from last year
Balance carried forward to Balance
Sheet
 492

Revenue Account shall be prepared in Form B- RA, Profit and Loss Account in
Form B-PL and Balance Sheet in Form B-BS as specified in ___________.

A Part V in schedule B of Reg.3

B Part 111 of the IRDA regulation
C Part IV of Schedule B
D The Companies Act 1956

2. Explain how Revenue Accounts, Profit and Loss

Accounts and Balance sheets are prepared in the general
insurance business.
[Learning Outcome b]
The following examples will help you to understand the preparation and the
presentation of Revenue Accounts, Profit and Loss Accounts and Balance Sheets
in general insurance business.

2.1 Revenue A/c

The main purpose of preparing Revenue A/c is to show a summary of income

and expenditure relating to fire insurance, marine insurance and miscellaneous
insurance during an accounting period.

General insurance companies are required to prepare separate Revenue accounts

for fire insurance business, marine insurance business and miscellaneous
insurance business.

The books of accounts of Golden General Insurance Co Ltd show the following
closing balances as on 31st March 2010 in respect of Fire Dept.

Rs. (in Lakhs)

Premium from Direct Business 98,139
Premium on Reinsurance Accepted 34,363
Premium on Reinsurance Ceded 43,732
Net Premium for 2008-09 1,05,292
Interest Dividend & Rent - Gross 10,619
 493

Claim Paid Direct 70,511

Claims on Reinsurance Ceded 14,435
Claims on Reinsurance Accepted 29,228
Outstanding Claims at the end (net) 80,000
Outstanding Claims at the Beginning (net) 75,558
Commission Paid Direct 10,721
Commission on Reinsurance Accepted 6,292
Commission on Reinsurance Ceded 6,990
For Dept. Foreign Taxes paid for 2
Amortisation Write off provision on Investments 8

From the above closing balances, prepare Fire Revenue Account for the year
ended 31st March 2010 in consideration of the Management Expenses
apportioned for fire dept. of Rs. 19,611 lakh.

Solution
Golden General Insurance Co Ltd
Fire Insurance Revenue Account for the year ended 31st March 2010
Particulars Schedule Rs in
Lakhs
1. Premium earned (Net) 1 97,031
2. Profit on sale or redemption of investments 10,490
(policyholders)
3. Others Nil
4. Interest, Dividend & Rent—Gross* 10,619
Total (A) 1,18,140
1. Claims Incurred (Net) 2 60,160
2.Commission 3 10,023
3. Operating Expenses related to insurance business** 4 19,611
4. Others:
Taxes 2
Amortisation, Write off, provisions - Investments 8
Total (B) 89,804
Operating profit/loss Business C=(A-B) 28,336
Appropriations
Transfer to Shareholders’ A/C (P&L Account) 28,336
Transfer to Catastrophic Reserve --
Transfer to other Reserves --
Total (C) 28,336
 494

Note

9 * Apportionment of Income from Investment: as per accounting policy of

an insurance company, Investment Income (Net of Expenses) is apportioned
between Shareholders’ Funds and policyholders’ fund in proportion to the
balance of these funds at the beginning of the year. Investment Income (Net
of Expenses) pertaining to policyholders’ funds is further apportioned to Fire,
Marine and Miscellaneous departments in proportion to respective technical
reserves balance at the beginning of the year. Shareholders’ funds for this
purpose consist of Share Capital, General Reserves, Capital Reserves, and
Foreign Currency Transaction Reserves. Policyholders’ funds consist of
Technical Reserves including Unexpired Risks Reserves and Provisions for
outstanding claims

9 ** Apportionment of Management Expenses: Management Expenses or

Operating Expenses related to insurance business are apportioned to Revenue
Account (Fire, Marine and Miscellaneous departments) on the basis of Gross
Direct Premium plus Reinsurance Accepted giving weightage- generally
75% for marine business and 100% each for Fire and Miscellaneous
business.

Schedules to Fire Insurance Revenue Account For the year ended 31st
March 2010

Schedule 1: Fire Premium Earned (Net) (Rs. in Lakhs)

Particulars 2009-10
50% of the net
Premium From Direct Business 98,139
Add: Premium on Reinsurance Accepted premium 34,363
Less: Premium on Reinsurance Ceded 43,732
Net Premium 88,770
Adj. For Change in Reserve in Unexpired Risks (44,385-52,646) 8,261
Net Premium Earned (Net) 97,031
 495

Schedule 2: Fire Claim Incurred (Net) (Rs. in Lakhs)

Particulars 2009-10
Claim Paid Direct 70,511
Add: Claims on Reinsurance Accepted 14,435
Less: Claims on Reinsurance Ceded 29,228
Net Claims Paid 55,718
Add: Outstanding Claims at the end (net) 80,000
Less: Outstanding Claims at the Beginning (net) 75,558
Incurred Claims Net 60,160

Schedule 3: Fire Commission (Net) (Rs. in Lakhs)

Particulars 2009-10
Commission Paid Direct 10,721
Add: Commission on Reinsurance Accepted 6,292
Less: Commission on Reinsurance Ceded 6,990
Net Commission 10,023

Lets understand the Revenue Account for marine insurance business with the
help of the following example.

The books of accounts of Golden General Insurance Co Ltd show the following
closing balances as on 31st March 2010 in respect of Marine Dept.:

Rs. (in Lakhs)

Premium from Direct Business 49,483
Premium on Reinsurance Accepted 1,536
Premium on Reinsurance Ceded 27,842
Net Premium (2008-09) 18,857
Claim Paid Direct 15,380
Claims on Reinsurance Ceded 1,095
Claims on Reinsurance Accepted 3,751
Outstanding Claims at the end (net) 21,099
Outstanding Claims at the Beginning (net) 17,999
Commission Paid Direct 4,982
Commission on Reinsurance Accepted 318
Commission on Reinsurance Ceded 2,631
Profit on sale/redemption of investments 3,016
Interest, Dividend & Rent—Gross 3,053
 496

Taxes 1
Amortisation, Write off, provisions—Investments 2
Operating Expenses relating to Marine Dept. 5,663
Net Premium for 2008-09 18,857

Prepare Marine Insurance Revenue Account for the year ended 31st March 2010
with all schedules.
Solution
Marine Insurance Revenue Account for the year ended 31st March 2010
(Rs. in Lakhs)
Particulars Schedule 2009-10
1. Premium earned (Net) 1 18,857
2. Profit on sale/redemption of investments 3,016
3. Interest, Dividend & Rent—Gross 3,053
Total (A) 24,926
1. Claims Incurred (Net) 2 15,824
2.Commission 3 2,670
3. Operating Expenses 4 5,663
4. Others
Taxes 1
Amortisation, Write off, provisions—Investments 2
Total (B) 24,160
Operating profit/loss Business C=(A-B) 766
Appropriations
Transfer to Shareholders’ A/c (P&L Account) 766
Transfer to Catastrophe Reserve -
Total (C) 766

Schedules to Marine Insurance Revenue Account for the year ended 31st
March 2010
Schedule 1: Marine Premium Earned (Net) (Rs. in Lakhs)

Particulars 2009-10
Premium From Direct Business 49,483
Add: Premium on Reinsurance Accepted 1,536
Less: Premium on Reinsurance Ceded 27,842
Net Premium 23,177
Less: Adj. For Change in Reserve in Unexpired Risks (23177- 4,320
18,857)
Net Premium Earned (Net) 18,857
 497

Schedule 2: Marine Claim Paid (Net) (Rs. in Lakhs)

Particulars 2009-10
Claim Paid Direct 15,380
Add: Claims on Reinsurance Accepted 1,095
Less: Claims on Reinsurance Ceded 3,751
Net Claims Paid 12,724
Add: Outstanding Claims at the end (net) 21,099
Less: Outstanding Claims at the Beginning (net) 17,999
Incurred Claims Net 15,824

Schedule 3: Marine Commission (Net) (Rs. in Lakhs)

Particulars 2009-10
Commission Paid Direct 4,982
Add: Commission on Reinsurance Accepted 318
Less: Commission on Reinsurance Ceded 2,631
Net Commission 2,669

Lets understand the Revenue Account for miscellaneous insurance business with
the help of the following example.

The books of accounts of Golden General Insurance Co Ltd show the following
closing balances as on 31st March 2010 in respect of Miscellaneous Dept.:

Rs. (in Lakhs)

Operating Expenses 76,637
Taxes 66
Amortisation Write Off 40
Premium From Direct Business 4,67,524
Premium on Reinsurance Accepted 50,278
Premium on Reinsurance Ceded 1,38,322
Net Premium for 2008-09 3,51,027
Claim Paid Direct 3,70,421
Claims on Reinsurance accepted 2,467
Claims on Reinsurance ceded 61,648
Outstanding Claims at the end (net) 5,12,889
Outstanding Claims at the Beginning (net) 4,82,365
Commission Paid Direct 46,819
Commission on Reinsurance Accepted 6,346
Commission on Reinsurance Ceded 19,934
 498

Solution

Miscellaneous Insurance Revenue Account for the year ended 31st March
2010
Particulars Schedule 2009-10
(Rs in Lakhs)
1. Premium earned (Net) 1 3,65,254
2. Profit on sale/redemption of investments 53,827
3. Interest, Dividend & Rent - Gross 54,493
Total (A) 4,73,574
1. Claims Incurred (Net) 2 3,41,765
2.Commission 3 33,231
3. Operating Expenses 4 76,637
4. Others:
Taxes 66
Amortisation, Write off, provisions - 40
Investments
Total (B) 451,739
Operating profit/loss Business C=(A-B) 21,835
APPROPRIATIONS
Transfer to Shareholders’ A/c (P&L Account) 21,835
Transfer to Catastrophe Reserve
Total (C) 21,835

Schedules to Misc. Insurance Revenue Account for the year ended 31st
March 2010

Schedule 1: Miscellaneous Premium Earned (Net) (Rs. in Lakhs)

Particulars 2009-10
Premium From Direct Business 4,67,524
Add: Premium on Reinsurance Accepted 50,278
Less: Premium on Reinsurance Ceded 1,38,322
Net Premium 3,79,480
Adj. For Change in Reserve in Unexpired Risks (3,79,480- 14,226
3,51,027)
Net Premium Earned (Net) 3,65,254
 499

Schedule 2: Miscellaneous Claim Paid (Net) (Rs. in Lakhs)

Particulars 2009-10
Claim Paid Direct 3,70,421
Add: Claims on Reinsurance accepted 2,467
Less: Claims on Reinsurance ceded 61,648
Net Claims Paid 3,11,240
Add: Outstanding Claims at the end (net) 5,12,889
Less: Outstanding Claims at the Beginning (net) 4,82,365
Incurred Claims Net 3,41,764

Schedule 3: Miscellaneous Commission (Net) (Rs. in Lakhs)

Particulars 2009-10
Commission Paid Direct 46,819
Add: Commission on Reinsurance Accepted 6,346
Less: Commission on Reinsurance Ceded 19,934
Net Commission 33,231

The following example highlights the adjustments in calculating the amount to be

shown as claims incurred (net).

Preparation of Revenue Account with the following balances extracted from the
books of Miscellaneous Dept. of DLF General Insurance Company for the year
ended 31st March 2010, show the amount of claim as it would appear in the
Revenue Account.

Rs. In (000)
Claims paid to Claimants 4,08,90,000
Survey Fess paid 2,153
Claims paid on Reinsurance Accepted 11,57,699
Claims Payable on Reinsurance Accepted as on 31.3.10 3,00,000
Claims Payable on Reinsurance Accepted as on 31.3.09 2,00,000
Claims Received on Reinsurance ceded 84,86,973
Claims Receivable on Reinsurance ceded as on 31.3.10 5,00,000
Claims Receivable on Reinsurance ceded as on 31.3.09 3,00,000
Claims outstanding as per OS Register as on 31.3.10 5,58,06,788
Claims outstanding as per OS Register as on 31.3.09 5,13,88,921
 500

Solution

In the Revenue Account claims are shown as “Claims Incurred (Net)” which
will be calculated as under;

Claims Incurred (Net) ...Miscellaneous

Particulars Rs. In (000)

Claims Paid Direct (W1) 4,08,92,153
Add: Claims on Reinsurance Accepted 11,57,699
Less: Claims Received on Reinsurance ceded 84,86,973
Net Claims Paid 3,35,62,879
Add: Claims outstanding at the end (Net) (W2) 5,56,06,788
Less: Claims outstanding at Beginning (Net) (W3) 5,12,88,921
Incurred Claims Net 3,78,80,746

Workings
(Rs in 000)
W1 Claims Paid Direct

Claims paid to Claimants 4,08,90,000

Survey Fess paid 2,153
4,08,92,153

W2 Claims outstanding at the end (Net)

Claims outstanding as per OS Register as on 31.3.10 5,58,06,788

Less: Claims Receivable on Reinsurance ceded as on 31.3.10 5,00,000
Add: Claims Payable on Reinsurance Accepted as on 31.3.10 3,00,000
55,606,788

W3 Claims outstanding at Beginning (Net)

Claims outstanding as per OS Register as on 31.3.09 5,13,88,921

Less: Claims Receivable on Reinsurance ceded as on 31.3.09 3,00,000
Add: Claims Payable on Reinsurance Accepted as on 31.3.09 2,00,000
5,12,88,921
 501

From the following information, calculate the amount of Net Premium Earned in
fire insurance business.

Premium from Direct Business 1,20,000

Premium on Reinsurance Accepted 40,000
Premium on Reinsurance Ceded 50,000
Net Premium for the previous year 1,30,000

A 1,00,000
B 1,20,000
C 1,10,000
D 1,30,000

2.2 Profit and Loss Account / Income statement

After Revenue Accounts, the Income Statement (Profit and Loss A/c) is prepared
with net underwriting result being transferred from Revenue Accounts. Net
underwriting result is combined with the net result from investments and
financing activities of the shareholder to determine the net profit or loss of the
insurer for a particular financial year.

As discussed earlier, Profit and Loss Account starts with Underwriting or

Operating Profits / Losses and then the investment incomes are taken into
consideration. After determining the aggregate income, Provisions and Expenses
that are incurred are deducted from the total income to determine the net profit.

General insurance companies doing more than one business e.g., fire, marine, etc.
need to prepare separate Revenue A/c for each business. Thereafter, the profit /
loss disclosed by each Revenue A/c will be transferred to the Profit and Loss A/c,
where expenses and incomes which do not relate to any specific business are
recorded.

In brief, the direct expenses and incomes applicable to a particular business are
recorded in the Revenue A/c and common / general expenses and incomes are
recorded in the Profit and Loss A/c.
 502

A Profit and Loss Account is prepared in the IRDA specified format FORM
B-PL.

Continuing with the previous example of Golden General Insurance Co

Prepare a Profit and Loss Account of Golden General Insurance Co for the year
ended 31st March 2010 in consideration of the underwriting results shown in the
previous examples and the following information:

Rs. (in Lakhs)

Interest, Dividend and Rent (gross)—Shareholders 49,866
Profit on Sale of Investments 49,256
Misc. Receipts; Credit Balance Written Back 2,102
Amortization, Provisions for thinly traded shares 493
Doubtful Debts ……………Investments (-) 426
Diminution in value of investment (-) 30
Service Tax-on Interest Income 1
Loss on Sale of assets 27
Penalty for Breach of Tariff 5
Current Tax 9,179
Fringe Benefit Tax 1,550
Deferred Tax 3,040
Earlier Year Tax 1,785
Wealth Tax 48
Interim Dividend Paid during the year 10,000
Proposed Dividend 18,300
Dividend Distribution Tax 4,810
Transfer to General Reserve 1,07,003

Solution

Profit and Loss A/c for the year ended 31st March 2010
Particulars Schedule Amount
(Rs. in Lakhs)
Incomes (A)
Underwriting or Operating Profits/ Losses
Fire Insurance 11814
Marine Insurance 766
Miscellaneous Insurance 21,835
Income from investments
 503

Profit and Loss A/c for the year ended 31st March 2010
Particulars Schedule Amount
(Rs. in Lakhs)
Interest, Dividends & \Rents (Gross)— 49866
Shareholders
Profit on Sale of Investments —Shareholders 49256
Other Income
Misc. Receipts; Credit Balance Written Back 2102
Total (A) 1,35,639
Provisions & Expenses (B)
Provisions (Other than taxation) for
Amortisation, Provisions for thinly traded 493
shares
Doubtful Debts ……………Investments (426)
Diminution in value of investment (30)
Other Expenses (other than those related to Ins.
Business )
Service Tax-on Interest Income 1
Loss on Sale of assets (27)
Penalty for Breach of Tariff 5
Total (B) 16
Profit Before Tax (A-B) 1,35,623
Provisions for Taxation
Current Tax 9,179
Fringe Benefit Tax 1,550
Deferred Tax 3,040
Earlier Year Tax (1,785)
Wealth Tax 48
12,032
Profit after Tax 1,23,591
Appropriations
Interim Dividend Paid during the year 10,000
Proposed Final Dividend 18,300
Dividend distribution tax 4,810
Transfer to any Reserve or Other Account 90,481
Balance of profit / loss brought forward from Nil
last year
Balance carried forward to Balance Sheet Nil
 504

It should be noted that appropriations are accommodated in the Profit and Loss
A/c.

2.3 Balance Sheet

Balance Sheet containing the closing balances of assets and liabilities at the close
of the year shows the state of affairs at the end of the accounting year.

The Balance Sheet of a General Insurance Company is prepared in Form B-BS as

specified in Part V in schedule B to the IRDA (Preparation of Financial
Statements and Auditors Report of Insurance Companies) Regulations 2002 and
also keeping in view the requirements of the Companies Act 1956 and the
following regulatory aspects as mentioned in the aforesaid Regulations:

9 Accounting Principles for Preparation of Financial Statements (Part. 1 of

Reg.)
9 Disclosures forming part of Financial Statements (Part.11 of Reg.)
9 General Instruction for preparation of Financial Statements (Part.111 of
Reg.)

The above regulatory aspects have been discussed in Unit 11.

The format of Balance Sheet has also been shown earlier in this unit. It is not out
of place to mention that all financial statements are to be presented with figures
for the current year as well for the previous year. Here, all financial statements
have been illustrated with current figures only. In the Appendix, it is presented in
the correct form.

The students should go through the financial statements in the appendix for better
understanding.

Continuing with the previous example of Golden General Insurance Co

Prepare a Balance Sheet as at 31st March 2010 of M/S Golden General Insurance
Co from the following statement of balances (Trial Balance) after preparation of
Revenue Accounts and Profit & Loss illustrated in the above example
 505

Statement of Balances as on 31.03.2010

Closing Balances of Assets and Liabilities Debit Credit
Rs in Lakh Rs in Lakh
Share capital
Authorised/ Paid Up Capital 2,000lac 20,000
Equity shares of Rs. 10 each
Reserves and Surplus
Capital Reserves 6
General Reserves (Balance on 5,70,214
1.4.2009)
Add: Transfer from P& L Account 1,07,003 6,77,217
Catastrophe Reserves NIL
Foreign Currency as on 31.3.2010 57
(After Adjustment)
Fair Value Change Account 13,95,928
Borrowings NIL
Investments; Long Term
Government Securities
Central Govt. Securities 3,15,513
State Govt. Securities 1,18,133
Foreign Govt. Securities 19,359
Other Approved Investments 7,416
Other Investments
Equity Shares 15,55,688
Preference Shares 8,334
Debentures In India 87,015
Debentures Outside India 4,378
Investment in Subsidiaries 5,956
Investment in Infrastructure 1,65,948
Investment in Housing Bonds 66,149
Other Approved Investments 69,763 2,423,662
Investments; Short Term
Government Securities
Central Govt. Securities 3,565
State Govt. Securities 6,710
Foreign Govt. Securities
Other Approved Investments 2,023
Other Investments
Equity Shares 6,619
Preference Shares
Debentures In India
 506

Closing Balances of Assets and Liabilities Debit Credit

Rs in Lakh Rs in Lakh
Debentures Outside India
Investment in Subsidiaries
Investment in Infrastructure
Investment in Housing Bonds 12,356
Other Approved Investments 8,252 39,625
Loans :
Secured Loans:
Housing Loan to Employees 20,000
Vehicle Loans to Employees 5,000
Computer Loans to Employees 361
25,361
Other Term Loans to Various Firms 15,297
Loans to State Govt. 23,206
Unsecured Terms Loans or Bridge 1,912 65,776
Loans;
Fixed Assets: Gross Block
Land & Building 12,992
Furniture & Fixtures 6,476
I T Equipment 17,468
Vehicles 5,170
Other Equipment 1,156 43,262
Depreciation on Fixed Assets:
Land & Building 6,484
Furniture & Fixtures 5,433
I T Equipment 15,870
Vehicles 2,942
Other Equipment 1,009 31,738
Cash and Bank Balances
Cash In-hand 19,029
Bank Deposits (Short Terms & 2,27,980
Others)
Bank Balances in current Accounts 38,784 2,85,793
Deferred Tax Assets 1,016
Advances & Other Assets:
Advances
Deposits with Ceding Companies 1,808
Application Money for Investments 3,784
Advance Tax &TDS (Net) (255,149 - 1,15,036
140113)
Other Advances 7,388 1,28,016
 507

Closing Balances of Assets and Liabilities Debit Credit

Rs in Lakh Rs in Lakh
Other Assets
Income Accrued On Investments 26,583
Outstanding Premium 274
Agents Balances 10,578
Amount Recoverable From Various 12,613
Agencies
Amount due From Others Carrying 1,61,059
on Insurance Business
Amount due From Subsidiaries 4
Deposit with RBI 1,075
Other Accrued Income 4,098
Amount due From Sundry Debtors 22,718 2,39,002
Current Liabilities
Agents Balances 3,086
Balances Due to Other Insurance 87,025
Companies
Deposits with Reinsurers 632
Premium Received In Advance 7,677
Sundry Creditors 61,616
Service Tax Payable 431
Claims Outstanding 6,13,988
Others 1,753 7,76,208
Provisions
Reserves for Unexpired Risks 2,57,302
Provisions for Taxation (1,40,113 ---
adjusted with Adv. Tax)
Provision for Proposed Dividend 28,300
Provision for Proposed Dividend Tax 4,810
Reserves for Bad & Doubtful Debt 34,336
Provisions in Diminution in value of 250 3,24,998
Thinly Traded Shares
32,26,151 32,26,151
 508

Solution

M/S Golden General Insurance Co Balance Sheet as at 31st March 2010

Schedule Current Previous
year (Rs. year (Rs.
In Lakhs) In
Lakhs)
Sources of Funds
Share capital 20,000
Reserves and surplus 6,77,280
Fair value change account 13,95,928
Borrowings Nil
TOTAL 20,93,208
Application of Funds
Investments 8 24,63,287
Loans 9 65,776
Fixed assets 10 11,524
Deferred Tax Assets 1,016
Current assets
a Cash and Bank Balances 11 2,85,793
b Advances and Other Assets 12 3,67,018
Sub-Total (A) 6,52,811
c Current liabilities 13 7,76,208
d Provisions 14 3,24,998
Sub-Total (B) 11,01,206
Net current assets (c) = (a +b-c- -4,48,395
d)
Miscellaneous expenditure (Not 15 NIL
written off )
TOTAL 20,93,208

Note: Schedules to Balance Sheet, though numbered as per the specified format
in above balance sheet, are not prepared here. The students should try to prepare
them in the forms and with the particulars as shown in the schedules forming the
part of the balance sheet illustrated under the example of M/S Good Luck
Insurance Co hereinafter.
 509

Preparation of Balance Sheet in the forms and with the particulars as shown
in the schedules

Prepare a Balance Sheet as at 31st March 2010 of M/S Good Luck Insurance Co
from following statement of balances after preparation of Revenue Accounts and
Profit & Loss

Statement of Balances (After P&L Account) as on 31st March 2010

Closing Balances of Assets and Liabilities Debit Credit

Rs (000) Rs (000)
Share capital
Authorised / Paid Up Capital 20,00,000
2,000 Lakh Equity shares of
Rs. 10 each
Reserves and Surplus
Capital Reserves Nil
General Reserves (as on 6,77,22,294
1.4.2009)
Addition during the year 12,65,476 6,89,87,770
(Transferred from P&L A/c)
Contingency Reserves 4,49,500
Catastrophe Reserves Nil
Foreign Currency Translation 17,84,249
Reserve (Opening Balance
5,741)
Fair Value Change 7,41,72,943
Account
Borrowings Nil
Investments: Long Term
Government Securities
Central Govt. Securities 2,99,85,499
State Govt. Securities 1,09,56,967
Foreign Govt. Securities 22,33,531
Other Approved 3,72,474
Investments
Other Investments
Equity Shares 9,45,24,937
Preference Shares 7,95,319
 510

Closing Balances of Assets and Liabilities Debit Credit

Rs (000) Rs (000)
Debentures In India 79,87,138
Debentures Outside India 1,23,866
Investment in Subsidiaries 5,95,564
Investment in Infrastructure 1,66,73,417
Investment in Housing 47,80,646
Bonds
Other Approved Investments 41,78,175 17,32,07,533
Investments; Short Term
Govt. Securities
Central Govt. Securities 3,28,001
State Govt. Securities 8,55,253
Foreign Govt. Securities 84,299
Other Approved 4,73,461
Investments
Other Investments
Equity Shares 0
Preference Shares 0
Debentures In India 0
Debentures Outside India 0
Investment in Subsidiaries 0
Investment in 11,43,322
Infrastructure & Social
Sector
Investment in Housing 15,83,856 44,68,192
Bonds
Other Approved 0
Investments
Borrowings Nil
Loans
Secured Loans
Housing Loan to Employees 24,51,200
Vehicle Loans to Employees 13,75,848
Computer Loans to 6,740
Employees
Loans to State Govt. Housing 19,21,643
(HUDCO)
Unsecured Loans: Other 1,83,193 59,38,624
Term Loans, Bridge Loans
 511

Closing Balances of Assets and Liabilities Debit Credit

Rs (000) Rs (000)
etc.
Fixed Assets: Gross Block
Intangible 4,14,693
Land & Building (Land 13,05,406
14,892 &Building 12,90,514)
Furniture & Fixtures 6,78,682
IT Equipment 20,88,299
Vehicles 5,85,395
Other Equipment 1,16,685 51,89,160
Depreciation on Fixed
Assets
Intangible 1,03,673
Land & Building 6,87,741
Furniture & Fixtures 5,67,219
IT Equipment 18,12,730
Vehicles 3,34,516
Other Equipment 1,01,575 36,07,454
Cash and Bank Balances
Cash In-hand 14,23,502
Bank Deposits (Short 2,54,89,278
Terms & Others)
Bank Balances in current 39,72,118
Accounts
Money at Call & Short 23,23,479 3,32,08,377
Notice
Deferred Tax Assets 2,33,054
Advances & Other Assets
Advances
Deposits with Ceding 1,59,704
Companies
Pre-Payments 3,17,912
Advance Tax &TDS (Net) 1,21,45,088
(2,55,149 -1,40,113)
Other Advances 1,82,151 1,28,04,855
Other Assets
Income Accrued On 25,03,584
Investments
Outstanding Premium 8,98,644
Agents Balances 7,80,800
Amount Recoverable From 11,61,296
 512

Closing Balances of Assets and Liabilities Debit Credit

Rs (000) Rs (000)
Various Agencies
Amount due from Reinsurers 2,96,26,214
& Co-insurers
Amount due From 524
Subsidiaries
Deposit with RBI 1,07,520
Other Accrued Income 6,10,319
Amount due from Sundry 21,76,407 3,78,65,308
Debtors
Current Liabilities
Agents Balances 5,58,061
Balances Due to Other 1,22,09,338
Insurance Companies
Deposits with Reinsurers 60,224
Premium Received In 7,47,151
Advance
Sundry Creditors A/c Service 74,12,130
Taxes & Others
Amount Due to Subsidiaries/ 60,780
Holding Company
Claims Outstanding 6,81,84,534
Others 5,28,865 8,97,61,083
Provisions
Reserves for Unexpired 2,82,40,313
Risks
Provision for Proposed 4,50,000
Dividend
Provision for Proposed 76,478
Dividend Tax
Reserves for Bad &Doubtful 33,57,710
Debt
Provisions in Diminution in 27,603 3,21,52,104
value of Thinly Traded
Shares
27,29,15,103 27,29,15,103

Prepare Balance Sheet as at 31st March 2010 with Schedules as per IRDA format
and requirements specified in IRDA (Accounts & Audit) Regulations 2002.
 513

Solution
M/S Good Luck General Insurance Co Ltd
Balance sheet as at 31st March 2010
Particulars Schedule Current Previous
Year Year
Rs (000) Rs (000)
A. Sources of Funds
1. Share Capital 5 & 5A 20,00,000
2. Reserves and Surplus 6 7,12,21,519
3. Fair Value Change Account 7,41,72,943
4. Borrowings 7 0
Total A 14,73,94,462
B. Application of Funds
1. Investments 8 17,76,75,725
2. Loans 9 59,38,624
3. Fixed Assets 10 15,81,706
4. Deferred Tax Assets 11 2,33,054
5. Current Assets 12
a. Cash and Bank Balances 3,32,08,377
b. Advances and Other Assets 5,06,70,163
Subtotal (a + b) 8,38,78,540
c. Current Liabilities 13 8,97,61,083
d. Provisions 3,21,52,104
Subtotal (c + d) 12,19,13,187
Net Current Assets (a + b – c – d) (3,80,34,647)
6. Miscellaneous Expenditure (to the 15 0
extent not written off or adjusted)
Total B 14,73,94,462
Significant accounting policies and notes to accounts are not mentioned here.
Students should refer Appendix 1. The Schedules referred to above form integral
part of the Balance Sheet are numbered as per IRDA specified formats
Schedule 5: Share Capital
Particulars Current
Year
(Rs. in 000)
1. Authorised capital: 30,00,00,000 Equity shares of Rs 10 each 30,00,000
2. Issued capital: 20,00,00,000 Equity shares of Rs 10 each 20,00,000
3. Subscribed capital: 20,00,00,000 Equity shares of Rs10 each 20,00,000
4. Called up capital: 20,00,00,000 Equity shares of Rs 10 each 20,00,000
 514

Schedule 5A: Pattern of Shareholding: (As Certified by Management)

Numbers % of Holding
Promoters - Indian 20,00,00,000 100
Foreign Nil
Others Nil
20,00,00,000 100

Schedule 6: Reserves and surplus

Rs in 000 Rs in 000
Capital Reserves Nil
General Reserves (As on 1.4.2009) 6,77,22,294
Addition during the year (Transferred from P&L A/c) 12,65,476 6,89,87,770
Contingency Reserves 4,49,500
Catastrophe Reserves Nil
Foreign Currency Translation Reserve 17,84,249
7,12,21,519

Schedule 7: Borrowings

Particulars Rs in 000
1. Debentures / bonds ---
2. Banks ---
3. Financial institutions ---
4. Others ---
Nil

Schedule 8: Investments

Particulars Rs in 000
Government Securities
Central Govt. Securities 2,99,85,499
State Govt. Securities 1,09,56,967
Foreign Govt. Securities 22,33,531
Other Approved Investments 3,72,474
Other Investments
Equity Shares 9,45,24,937
Preference Shares 7,95,319
Debentures In India 79,87,138
Debentures Outside India 1,23,866
Investment in Subsidiaries 5,95,564
 515

Particulars Rs in 000
Investment in Infrastructure 1,66,73,417
Investment in Housing Bonds 47,80,646
Other Approved Investments 41,78,175
Total long-term investments 17,32,07,533
Govt. Securities
Central Govt. Securities 3,28,001
State Govt. Securities 8,55,253
Foreign Govt. Securities 84,299
Other Approved Investments 4,73,461
Other Investments
Equity Shares 0
Preference Shares 0
Debentures In India 0
Debentures Outside India 0
Investment in Subsidiaries 0
Investment in Infrastructure 11,43,322
Investment in Housing Bonds 15,83,856
Other Approved Investments 0
Total short-term investments 44,68,192
Total Investment (Long Term & Short Term) 17,76,75,725
Schedule 9: Loans
Particulars Rs in 000
Secured Loans
Housing Loan to Employees 24,51,200
Vehicle Loans to Employees 13,75,848
Computer Loans to Employees 6,740
Loans to State Govt. Housing (HUDCO) 19,21,643
Unsecured Loans
Other Term Loans, Bridge Loans etc. 1,83,193
Total 59,38,624
 Gross block Depreciation Net Block

De
Opn Add Opn Additi Deletio
leti Clg Bal Clg Bal
Bal ition bal on n
on
During
1.4.09 31.3.10 1.4.09 During the year 31.3.10 31.3.10 31.3.09
the year

Intangibles 4,14,693 1,03,673

Land
14,892
Freehold

Buildings 12,90,514 6,87,741

Schedule10: Fixed Assets (Rs. In 000)

Furniture
516

6,78,682 5,67,219
& Fittings
IT
20,88,299 18,12,730
Equipment

Vehicles 5,85,395 3,34,516

Office
1,16,685 1,01,575
Equipment

51,89,160 36,07,454 15,81,706

 517

In the absence of data for Opening Balance, Addition & Deletion during the year,
both for Gross Block and Depreciation, the above schedule has not been
completed here in all respects. For complete information, students should refer to
the unit on Depreciation earlier.

Schedule 11: Cash and Bank Balances

Particulars Rs in 000
Cash In-hand 14,23,502
Bank Deposits (Short Terms & Others) 2,54,89,278
Bank Balances in current Accounts 39,72,118
Money at Call & Short Notice 23,23,479
Total 3,32,08,377

Schedule 12: Advances & Other Assets

Particulars Rs in 000
Advances
Deposits with Ceding Companies 1,59,704
Pre-Payments 3,17,912
Advance Tax &TDS (Net) (2,55,149 -1,40,113) 1,21,45,088
Other Advances 1,82,151 1,28,04,855
Other Assets
Income Accrued On Investments 25,03,584
Outstanding Premium 8,98,644
Agents Balances 7,80,800
Amount Recoverable From Various Agencies 11,61,296
Amount due from Reinsurers & Co-insurers 2,96,26,214
Amount due From Subsidiaries 524
Deposit with RBI 1,07,520
Other Accrued Income 6,10,319
Amount due From Sundry Debtors 21,76,407 3,78,65,308
Total 5,06,70,163
 518

Schedule 13: Current Liabilities

Particulars Rs in 000
Agents Balances 5,58,061
Balances Due to Other Insurance Companies 1,22,09,338
Deposits with Reinsurers 60,224
Premium Received In Advance 7,47,151
Sundry Creditors A/c Service Taxes & Others 74,12,130
Amount Due to Subsidiaries/ Holding Company 60,780
Claims Outstanding 6,81,84,534
Others 5,28,865
Total 8,97,61,083

Schedule 14: Provisions

Particulars Rs in 000
Reserves for Unexpired Risks 2,82,40,313
Provision for Proposed Dividend 4,50,000
Provision for Proposed Dividend Tax 76,478
Reserves for Bad &Doubtful Debt 33,57,710
Provisions in Diminution in value of Thinly Traded Shares 27,603
3,21,52,104

3. Demonstrate the preparation and presentation of cash

flow statement in general insurance business.
[Learning Outcome c]
3.1 Cash flow statement
Cash Flow Statement is useful in providing users of financial statements with a
basis to assess the ability of the firm to generate cash and cash equivalent,
and the needs of the firm to utilise those cash flows. The financial decisions
that are taken by users require an evaluation of the ability of the firm to generate
cash and cash equivalent and the timing and certainty of their generation. In the
insurance industry, the cash flow statement is of prime importance to the users of
the financial statements as the insurance companies carry on risk taking business
dealing with an intangible product i.e. promise to indemnify loss in future as and
when accidents occur, in consideration of premium collected currently. The
insurer needs to have both solvency and liquidity sufficient to pay off its liability
for claims at the time of accident i.e. occurrence of perils. Thus an insurer should
always prepare a cash flow statement and should present it for each period for
which financial statements are presented as per regulatory norms and forms.
 519

In accordance with IRDA regulations, Cash Flow statement in an insurance

company is to be prepared using the Direct Method where AS 3 will not be
applicable.

A cash flow statement, if used in conjunction with other financial statements,

provides information that enables the user to evaluate the charges in the net
assets of the insurance company and its financial structure (including its liquidity
and solvency).

For the purpose of preparation of cash flow statement in an insurance company,

the following terms need to be defined for proper interpretation and use.

1. Cash comprises on hand and demand deposits with banks of the corporate
office and all operational units, including overseas ones.
2. Cash Equivalents are short term, highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an
insignificant risk of changes in value.
3. Cash Flows are inflows and outflows of cash and cash equivalents.
4. Operating Activities are the principal revenue-producing activities of a firm
(insurer) and other activities that are not investing or financing activities. In
insurance company cash flow from operating activates ( insurance activities)
is a key indicator of the extent to which the operations of the enterprise have
generated sufficient cash flows to maintain the operating capability of the
insurers, pay claims, commission, management expenses and pay dividends
and repay loans and borrowings
5. Investing Activities are the acquisition and disposals of long term assets and
other investments not included in cash equivalents
6. Financing Activates: are activities that result in changes in the size and
composition of the shareholders’ funds and policy holders’ funds (in case of
an insurance company) and borrowings of the firm.
7. Preparation of Cash Flow statement: the cash flow statements should be
prepared and presented by classifying and segregating Operating, Investing
and Financing activities.
 520

Diagram 1: Cash flows from different activities

An enterprise should report cash flows from operating activities using either:
9 the direct method, whereby major classes of gross cash receipts and gross
cash payments are disclosed; or
9 the indirect method, whereby net profit or loss is adjusted for the effects of
transactions of a non-cash nature, any deferrals or accruals of past or future
operating cash receipts or payments, and items of income or expense
associated with investing or financing cash flows.
AS 3 Para 18

Cash flows from investing activities and financing activities will be the same
under the direct and also the indirect method.

1. Direct Method Cash Flow Statement (Paragraph 18 (a))

Particulars Amount Amount

(Rs.) (Rs.)
Cash flows from operating activities
Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Income taxes paid
Cash flow before extraordinary item
Proceeds from earthquake disaster settlement
Net Cash from operating activities (A)
Cash flows from investing activities
Purchase of fixed assets
Proceeds from sale of equipment
Interest received
 521

Particulars Amount Amount

(Rs.) (Rs.)
Dividends received
Net cash from investing activities (B)
Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Repayment of long-term borrowings
Interest paid
Dividends paid
Net cash used in financing activities (C)
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period

Diagram 2: Direct method of cash flow statement

2. Indirect Method Cash Flow Statement (Paragraph 18(b))

Particulars Amount Amount

(Rs.) (Rs.)
Cash flows from operating activities
Net Profit before taxation, and extraordinary item
Adjustments for:
Depreciation
Foreign exchange loss
Interest income
Dividend income
Interest expense
Operating profit before working capital changes
Increase in sundry debtors
Decrease in inventories
Decrease in sundry creditors
 522

Particulars Amount Amount

(Rs.) (Rs.)
Cash generated from operations
Income tax paid
Cash flow before extraordinary item
Proceeds from earthquake disaster settlement
Net Cash from operating activities (A)
Cash flows from investing activities
Purchase of fixed assets
Proceeds from sale of equipment
Interest received
Dividend received
Net Cash flows from financing activities (B)
Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long term borrowings
Repayment of long-term borrowings
Interest paid
Dividend paid
Net cash used in financing activities (C)
Net increases in cash and cash equivalents
Cash and cash equivalents at beginning of
period
Cash and cash equivalents at end of period

Diagram 3: Indirect method of cash flow statement

 523

Diagram 4: General rule to compute the cash flow by the indirect

method

The above Accounting Statements and Cash Flow statements have been given to
enable the students to prepare the Financial Statements in specified formats for
an insurance company.

In the subsequent units, with some more illustrations and examples, it will be
shown how these financial statements will be used for financial management and
managerial decisions.

Receipt & Payment Account/ Cash Flow Statement for the period 01.04.2008
to 31.03.2009
Amount in Amount in
Rs.(000) Rs.(000)
Description
Current Previous
Year Year
Operating Activities
Profit Appropriate to General Reserve 12,65,475 1,07,00,322
Adjustment for Non- Cash Items
Deferred Expenses 0 4,76,070
Unexpired Risks Reserves 25,10,091 10,28,499
Special Contingency Reserves for URR 4,49,500 0
Additional Provisions for Outstanding
Claims 67,85,764 38,06,514
Depreciation 4,81,854 3,56,358
Provision for Dividend and Dividend Tax 5,26,478 33,10,959
Provision for Tax - India 4,10,100 9,55,668
 524

Provision for Tax - Foreign 3,45,666 0

Deferred Tax (1,31,491) 3,04,037
Reserve for Doubtful Debts 1,08,320 (11,027)
Foreign Currency Translation Reserve 17,78,508 (7,84,146)
General Reserve Adjustment for AS 15 0 (3,89,700)
Other Provisions 8,02,682 (1,96,797)
Prepaid Expenses (1,16,966) 0
Profit on sale of Assets (4,970) (2,674)
Balance Written Back (5,64,923) 2,10,201
1,46,46,088 1,97,64,284
Items Considered Separately
Investment Items - Interest, Dividend, Rent
& Provisions (1,23,07,648) (2,34,60,453)
Investment Items - Profit on sale of
Investments (45,60,616) 0
(22,22,176) (36,96,169)
Net Increase in Current Assets (79,61,987) (50,86,648)
Net Cash Flow from Operating Activities
Before Tax (1,01,84,163) (87,82,817)
Net Tax Expenses – Indian (16,99,977) (95,29,798)
Net Cash Flow from Operating Activities
After Tax (A) (1,18,84,140) (1,83,12,615)
Investing Activities
Interest, Dividend & Rent 1,23,62,688 1,18,49,662
Net Increase / Decrease in Investments 77,28,648 61,38,560
Net Increase / Decrease in Loans 6,39,023 8,76,886
Net Addition to Assets (9,06,159) (1,79,649)
Net Cash Flow from Investing Activities
(B) 1,98,24,200 1,86,85,459
Financing Activities
Dividend Paid (33,10,959) (34,16,300)
Net Cash Flow from Financing Activities
© (33,10,959) (34,16,300)
Increase/Decrease in Cash &Bank Balances
during the year (A+B+C)=D 46,29,101 (30,43,456)
Cash & Bank Balances as per Schedule at
the beginning of period (E) 2,85,79,676 3,16,22,732
Cash & Bank Balances as per Schedule at
the end of period (D+E)= F 3,32,08,377 2,85,79,276
 525

Identify the classification of the following activities in order to prepare a

statement of cash flows.
(i) Issue of share capital for cash
(ii) Issue of share capital other than cash, for acquisition of business
(iii) Payment to suppliers
(iv) Depreciation
(v) Purchase of a plant
(vi) Dividend paid
(vii) Taxes on income
A (ii) and (iv) are financing activities
B (i), (iii) and (v) are operating activities
C (iii) and (vi) are investing activities
D None of the above statements are true

From the following information, determine the cash flow from investing
activities.
Sale of building: carrying value Rs. 2,80,000 at a profit of Rs. 38,000.
Sale of long-term investment: carrying amount Rs. 3,40,000 at a loss of Rs.
17,000.
Purchase of car: Rs. 5,40,000 out of which Rs. 3,00,000 is outstanding
Interest paid: Rs. 45,000
A Rs. 4,01,000
B Rs. 3,56,000
C Rs. 7,01,000
D Rs. 6,41,000

Which of the following statements is incorrect?

A Cash flow from operating activities can be calculated by using the direct as
well as the indirect method
B An increase in assets is cash inflow from investing activities
C A decrease in liabilities is cash outflow from investing activities
D Depreciation should be added back to the book profit so as to calculate the
cash flow from operating activities under the indirect method
 526

4. Briefly explain how analysis of financial statements is

done using ratio analysis.
[Learning Outcome d]

4.1 Analysis of Financial Statements - Why Ratio Analysis?

Users of financial statements cannot form any opinion on any of the trends of the
company for their economic decisions only on the basis of financial statements
unless they use various ratio analysis, trend analysis with comparative and
classified Accounting or Financial Statements. In using the Financial Statement
including balance Sheet, Income statements along with the required disclosure
and management report and computing percentage change, trend change,
component percentages, and ratios as exemplified in annexure, the finance
manager and analyst constantly search for some standard of comparison to
establish whether the information and relationship they have found are
favourable or adverse for their future economic decisions.

Generally, two standards of comparison used by financial analysts are:

a) past performance of the company and
b) position of the company with respect to industry performance in the country
and overseas

The Insurance business is carried on with international processes, principles and

perspectives because of its very nature of international character. So, its trend
analysis or trend percentage need be compared with industry data and
international standard to judge the company’s position in respect of growth,
profitability, liquidity, solvency etc.

4.2 Ratio Analysis for Analysis of Financial statements

These Ratios are the most vital tools of financial analysis in management
accounting. The corporate management will take a lot of financial decisions for
their strategic issues. With this accounting information, many more analysis like
the following can be done.

From Balance Sheet, Revenue Account and Profit & Loss Account many
Accounting Ratios can be obtained for Financial Management.
 527

For non-life insurance companies, disclosure of the analytical ratios under

FORM NL-30 is mandatory, in which the following fifteen ratios are disclosed.
1. Gross Premium Growth Rate
2. Gross Premium to Shareholders' Fund Ratio
3. Growth Rate of Shareholders ‘Fund
4. Net Retention Ratio
5. Net Commission Ratio
6. Expense of Management to Gross Direct Premium Ratio
7. Combined (Claim & Mgmt. Exp.)Ratio
8. Technical (Unexpired) Reserves to Net Premium Ratio
9. Underwriting Balance Ratio
10. Operating Profit Ratio
11. Liquid Assets to Liabilities Ratio
12. Net Earnings Ratio
13. Return on Net Worth Ratio
14. Available Solvency Margin Ratio to Required Solvency Margin Ratio
15. NPA Ratio (non-performing advances)

Ratio Description of ratio

1 Gross Direct GDPI (CY) - GDPI(PY)
Premium
GDPI (PY)
Growth Rate
Where, Gross Direct premium Income is net of service
tax for both the years
2 Gross Direct GDPI (CY)
Premium to
Shareholders' funds
shareholders'
Where,
fund ratio
Gross Direct premium Income is net of service tax for
both the years
Shareholders’ funds = Paid up capital + Free reserves
3 Growth rate of Shareholders' funds (CY) - Shareholders' funds(PY)
shareholders’
Shareholders' funds (PY)
fund
4 Net Retention Net Premium
Ratio
Gross Direct Premium Income (CY)
(Net premium divided by gross direct premium net of
service tax - Total gross premium i.e., without
considering reinsurance business)
 528

5 Net Gross Commission Paid (net of reinsurance commission)

Commission Gross Direct Premium Income (CY)
Ratio
6 Expense of Expenses of Management
Management to Gross Direct Premium Income (CY)
Gross Direct Where,
Premium Ratio Expenses of Management are operating expenses
related to insurance business plus direct commissions
paid
7 Combined Ratio Insured Claims + Expenses of Management
Gross Direct Premium Income (CY)
8 Technical Reserve for (Unexpired Risk + Premium Deficiency
Reserves to net + Outstanding Claims)
premium ratio Net Premium
Where,
Outstanding claims include IBNR and IBNER (IBNR =
incurred but not reported, IBNER = Incurred but not
enough reported
9 Underwriting Underwriting profit / loss
balance ratio: Net Premium
Where,
Underwriting profit = Net earned premium - Net
incurred claims - Net commissions - Operating
expenses relating to insurance business
1 Operating profit Underwriting profit / loss + Investment income
0 ratio Net Premium

1 Liquid Assets to Liquid Assets

1 liabilities ratio Policyholders' liabilities
Where,
Liquid assets = Short Term Investments + Short Term
Loans + Cash & Bank Balances of the insurer
Policyholders’ liabilities = Claims outstanding +
Reserve for unexpired risk and Premium Deficiency
1 Net earnings Profit after tax
2 ratio Net Premium
 529

1 Return on net (profit after tax divided by net worth )

3 worth ratio Profit after tax
Net Worth

1 Actual Solvency Ratio of actual solvency margin for the quarter to the
4 to required solvency margin required to be maintained as per
solvency margin regulations; to be taken from solvency margin reporting
ratio requirements
1 NPA ratio Data taken from Section 11 table 11.5 which provides
5 the NPA ratio separately for policyholders' funds and
shareholders' funds
1 Reinsurance Risks reinsured
6 ratio Gross Direct Premium Income (CY)

In the following examples, certain performance analysis has been done with
some hypothetical figures just to show how Accounting information is used for
trend analysis.

Ratio Analysis

From the financial statements of ABC General Insurance Company Ltd, the
following data has been collected:

Data from Financial Statements for 2005-06 & 2004-05 (Rs in lakhs)

Information 2005-06 2004-05

1 Gross Direct Prem. 6,151 5,937
2 Shareholders’ funds 6,973 5,973
5 Net Premium 4,914 4,752
6 Unexpired Risks Reserves 2,573 2,470
Outstanding Claims 6,140 5,759
7 Risks Reinsured 2,099 1,654
8 Incurred Claims 4,177 3,644
9 M/ Exp. 1,019 1,153
10 Commission 459 390
11 Investment Income 2,365 2,267
12 Provision Tax 120 154
12 Net Worth 6,973 5,972
 530

Difference of URP 103

Gross Profit (PBT) (-844+2365) 1,521
PAT / Net profit 1,401

From the above data, compute the following accounting ratios for analysis of
financial statements vis-à-vis Performance Analysis for 2005-06 ABC General
Insurance Company:

1. Gross Premium to Shareholders’ funds

2. Growth Rate of Shareholders’ Funds
3. Management Expenses to Gross Premium Ratio
4. Net Commission Ratio
5. Technical Reserves to Net Premium
6. Combined Ratio
7. Operating Profit Ratio
8. Net Earnings Ratio
9. Return on Net Worth
10. Reinsurance Ratio

Solution

Performance Analysis based on Accounting Ratios

2005-06
Accounting Ratios Formula / Calculation (rounded
off)
Gross Direct Premium
Gross Premium to = x 100
1 Shareholders' funds 103.00%
Shareholders’ funds
= 6,151/5,973 x 100
Closing Shareholders' funds
Growth Rate of = x 100
2 Opening Shareholde rs' funds 116.74%
Shareholders’ Funds
= 6,973/5,973 x 100
Management Expenses
Mgmt. Expenses to = x 100
3 Gross Direct Premium 16.57%
Gross Premium Ratio
= 1,019/6,151 x 100
Commission
Net Commission = x 100
4 Net Premium 9.34%
Ratio
= 459/4,914 x100
 531

2005-06
Accounting Ratios Formula / Calculation (rounded
off)
Technical Reserves
= x 100
Net Premium
= 8,713/4,914 x 100
Technical Reserves
5 Where, 177.31%
to Net Premium
Technical Reserves = Unexpired Risks
Reserves + Outstanding Claims
= 2,573 + 6,140
= 8,713
Incurred Claims + Expenses
= x 100
6 Combined Ratio Gross Direct Premium 84.47%
= (4,177 + 1,019)/6,151 x100
Operating profit
Operating Profit = x 100
7 Net Premium 30.95%
Ratio
= 1,521/4,914 x 100
Net profit
= x 100
8 Net Earnings Ratio Net Premium 28.51%
= 1,401/4,914 x 100
Net profit
= x 100
9 Return on Net Worth Closing Shareholders' Funds 20.09%
= 1,401/6,973 x 100
Risks reinsured
= x 100
10 Reinsurance Ratio Gross Direct Premium 34.12%
= 2,099/6,151 x 100

Reinsurance premium ceded – expense

Financial Statement analysis

The balance Sheet as at 31.3.2006 of M/s XYZ General Insurance Co. Ltd is
given below along with the figures of the previous year for financial statement
analysis.
 532

M/s XYZ General Insurance Co. Ltd.

Balance Sheet as at 31.3.06
(Rs. in million)
Particulars Schedule Current Previous
year year
A. Sources of Funds
1. Share Capital 200.00 150.00
2. Reserves and Surplus 4,608.03 4,166.41
3. Fair Value Change Account 12,211.27 6,846.97
4. Borrowings Nil NIL
Total (A) 17,019.30 11,163.38

B. Application of Funds
1. Investments 20,665.26 14,575.23
2. Loans 786.52 874.13
3. Fixed Assets 121.06 114.41
4. Deferred Tax Assets 61.75 84.07
5. Current Assets
a. Cash and Bank Balances 3,059.71 2,286.09
b Advances and Other Assets 2,230.12 1,738.56
Total Current assets (a + b) 5,289.83 4,024.65
c. Current Liabilities 7,134.74 6,085.25
d. Provisions 2,871.54 2,578.57
Total Current Liabilities (c + d) 10,006.28 8,663.82
Net Current Assets (a + b – c – d) 4,716.45 4,639.17
6. Miscellaneous Expenditure (to the 101.16 154.72
extent not, written off or adjusted)
7. Debit Balance in Profit and Loss A/c Nil Nil …
Total (B) 17,019.30 11,163.38

From the above balance sheet and certain additional data collected from the
books of accounts, the following ratio analysis and schedule of investments are
prepared for appreciation of accounts.

9 Gross Premium to Shareholders’ Funds Ratio

9 Net Retention ratio
9 Ratio between Shareholders’ Fund and Policyholders’ Fund
 533

1. Gross Premium to Shareholders’ Funds Ratio

2005-06 2004-05
Gross Premium 5,675.54 5,103.16
Shareholders’ Fund 4,161.69 3,735.22
Ratio (times) 1.36 1.37 (Growth)

The better the ratio, the greater is the capacity utilisation, and better will be the
return. However, again, this ratio must be within the permissible limits laid down
by regulators.

2. Net Retention ratio

Gross Premium Net Premium Retention Ratio Previous Year

Retention Ratio
Fire 1,103.49 830.76 75.28% 78.12 %
Marine 349.33 164.38 47.05% 55.97%
Misc. 4,222.73 3,347.52 79.27% 77.46%
Total 5,675.54 4,342.65 76.52% 76.33%

3. How to calculate Shareholders’ Fund & Policyholders’ Fund

Shareholders’ Fund (2005-06)

Share Capital… 200.00
Capital Reserve 0.06
General Reserve 4622.79
Misc. Reserve (-)14.82 4808.03
Policyholders’ Fund (2005-06)
Unexpired Reserves 2253.51
Outstanding Claims 5505.40 7758.91
Total Funds 12566.94

Ratio between Shareholders’ Fund and Policyholders’ Fund

4808.03:7758.91= 38:62
 534

Which of the following ratios is an important indicator that helps to judge

whether an insurer is strong enough to pay claims to policy holders as scheduled?

A Net earnings ratio

B Gross premium growth ratio
C Solvency margin ratio
D All of the above

5. Highlight the legal aspects of general insurance

accounting.
[Learning Outcome e]

5.1 Legal Aspects of General Insurance Accounting

The students should keep in mind that “financial accounting demands not only
technical knowledge comprising knowledge on
i) Accounting principles,
ii) Accounting Standard,
iii) Accounting Process,
iv) Accounting Conventions,

but also through knowledge on legal aspects of financial accounting

So here, the legal aspects of financial accounting are discussed in detail.

1. Some relevant provisions of the Insurance Act, 1938

The Companies Act 1956 (Amended), The Insurance Act, 1938, the Insurance
Rules, 1939, IRDA Act 1999 and IRDA Regulations on Accounts set out the
legal provisions; regulatory requirements provide legal aspects to accounts and
audit of general insurance companies. Certain major regulatory and legal
provisions are outlined below to identify the legal aspects of general insurance
accounting.

Though after the nationalisation of General Insurance Business, a few provisions

contained in the Act have become irrelevant, but the following statutory and
regulatory provisions are to be followed in preparation of financial statements
and audit thereof for general insurance business.
 535

9 The Section 11(1) of the Act requires that every insurer in respect of all
insurance business shall prepare (a) a balance sheet in accordance with
regulations contained in part I of the First Schedule and in the form set forth
in Part II of that schedule, (b) a profit and loss account in accordance with
the regulations contained in part I of the second schedule and in the forms set
forth in part II of that schedule, and (c) a revenue account in accordance
with the regulations and in the forms set forth in Third Schedule in respect of
each class or sub- class of insurance business.

9 It has been the general practice in general insurance companies to indicate in

their notes to the accounts that the balance sheet, the Profit and Loss
Account, the Profit and Loss Appropriation Account and Revenue Accounts
are drawn up in accordance with the provisions of section 11 (1) of the
Insurance Act, 1938, read with provisions of sub-sections (1), (2) and (5) of
section 211 and sub-section (5) of section 227 of the Companies Act, 1956.

9 The Act also provides that the accounts of the Companies carrying on
general insurance business be audited as per the requirements of the
Companies Act, 1956.

9 Section 14 of the Act requires that every insurer shall maintain a register or
record of policies showing in respect of every policy, the names and
addresses of policy holders, the date when the policy was effected and record
of any transfer, assignment or nomination of which the insurer has notice.
Every insurer must also maintain a register or record of claims in which shall
be entered, every claim made, date of the claim, the name and address of the
claimant and the date on which the claim was discharged, or, in the case of a
claim which is rejected, the date of rejection and the grounds therefor.

9 Apart from the above records required to be maintained under the Act, Rule
39 of the Insurance Rules, 1939 also provides for maintenance of certain
other records.

9 Section 15 of the Act prescribes that the Audited accounts and statements
shall be printed and four copies thereof shall be furnished as returns to the
controller within six months from the end of the period to which they refer.

9 Section 17 of the Act provides that the balance sheet and the profit and loss
account prepared in accordance with section 11 of the Act, and filed with the
Registrar of Companies, will be a sufficient compliance with the provisions
of section 220 of the Companies Act, 1956.
 536

9 Section 27B of the Act requires that no insurer carrying on general insurance
business shall invest any part of his assets otherwise than in the approved
investments listed in this section.

9 According to Section 28B of the Act, every General Insurance Company

shall submit a return of investments in the prescribed form to the controller,
indicating therein the changes in the investments, within the stipulated
period. A statement containing various encumbrances on assets must also
accompany the aforesaid return.

9 Section 40 of the Act prohibits payment of commission to any person other

than an authorised agent for soliciting or procuring business, subject to a
maximum of 15 per cent of the premium.

9 Section 40A (3) of the Act deals with limits of expenditure by way of
commission which normally ranges between 5 per cent and 15 per cent
subject to review thereof by the General Insurance Corporation.

9 Section 40C of the Act lays down provisions regarding limits on expenses of
management in general insurance business. Rule 17E of the Insurance Rules,
1939, prescribes the various limits in detail.
Now, the students also need to know Relevant Amendments in Insurance Act,
1938 after enactment of Insurance Regulatory And Development Authority
Act, 1999 in respect of financial accounting for General Insurance Company

2. Amendments made by IRDA Act, 1999 in the Insurance Act, 1938

The IRDA Act 1999 has made certain amendments to the Insurance Act, 1938;
the amendments relevant for financial statements of general insurance business
are outlined below for ready reference of the students.
Section 11
a) In sub-section (1) for ‘calendar year’, ‘substitute financial year’.
b) After sub- section (1) insert the following:-
“(1A) notwithstanding anything contained in sub-section (1), every insurer. On or
after the commencement of the Insurance Regulatory and Development
Authority Act, 1999, in respect of insurance business transacted by him and in
respect of his shareholders’ funds, shall at the expiration of each financial year,
prepare with reference to that year, a balance sheet, a profit and loss account, a
separate account of receipts and payments, a revenue account in accordance with
the regulations made by the authority.
 537

(1B) every insurer shall keep separate accounts relating to funds of shareholders
and policy holders”

Section 27

After section 27B, IRDA Act, 1999 has inserted the following sections in the
Insurance Act, 1938-

i) “27C, Providing for prohibition of investment of the policy-holder’s funds

outside India

ii) 27D, Manner and conditions of Investment-

9 Without prejudice to anything contained in section 27, 27A and 27B, the
authority may, in the interest of policy-holders, specify by the regulations
made by it, the time, manner and other conditions of investment of assets
held by an insurer for the purposes of this Act.

9 The Authority may give specific directions for the time. Manner and other
conditions subject to which the funds of the policy-holders shall be invested
in the infrastructure and social sector as may be specified by regulations
made by the Authority and such regulations shall apply uniformly to all the
insurer carrying on the business of life insurance, general insurance, or re-
insurance in India on or after the commencement of the Insurance Regulatory
and Development Authority Act, 1999.

9 The Authority may after taking into account the nature of business and to
protect the interest of the policy-holders, issue to an insurer the directions
relating to the time, manner and other conditions of investment assets to be
held by him:

iii) Provided that no direction under this sub-section shall be issued unless the
insurer concerned has been given a reasonable opportunity of being heard.”

In section 28A and 28B in sub-section (1), for “31st day of December,” IRDA
Act has substituted “31st day of March”

iv) Section 40A, in sub-section (3), for the portion beginning with the word “an
amount exceeding” and ending with the words “ten per cent of the premium
payable on the policy”, IRDA Act has substituted “an amount not exceeding
fifteen per cent of the premium payable on the policy where that policy
relates to fire or marine insurance or miscellaneous insurance”.
 538

9 Every insurer shall furnish to the Authority with his returns under section 15
or section 16, as the case may be, a statement certified by a principal officer
approved by the authority in respect of general insurance business, or an
actuary approved by the Authority in respect of life insurance business, as the
case may be, of his assets and liabilities assessed in the manner required by
this section as on the 31st day of March of the preceding year.

9 Every Insurer shall value his assets and liabilities in the manner required by
this section and in accordance with the regulations which may be made by
the Authority in this behalf”.

v) In the case of an insurer carrying on general insurance business, the required

solvency margin, shall be the highest of the following amounts:-

9 Fifty crores of rupees (one hundred crores of rupees in case of re-insurer); or

9 A sum equivalent to twenty per cent of net premium income; or
9 A sum equivalent to thirty per cent of net incurred claims, subject to credit
for re-insurance in computing net premiums and net incurred claims, being
actually determined by the regulations not exceeding fifty per cent.

vi) “Net incurred claims” means the average of net incurred claims during the
\specified period of not exceeding three preceding financial years.

Which of the following sections of the Act requires that every insurer in respect
of all insurance business shall prepare Balance Sheet, Profit and Loss A/c and
Revenue A/c?

A Section 11
B Section 14
C Section 15
D Section 17
 539

Summary
¾ General insurance includes:
9 Fire insurance,
9 Marine insurance and
9 Miscellaneous insurance
¾ An item of expense to be shown in the Revenue Account of a fire / marine
insurance company separately if it is in excess of 1% of premium or Rs.
5,00,000 whichever is higher.
¾ Premium, a primary source of income, is the consideration received by the
insurance company from the insured as per the insurance contract. Net
premium earned is calculated as follows:

Particulars Amount
Premium From Direct Business X
Add: Premium on Reinsurance Accepted X
Less: Premium on Reinsurance Ceded (X)
Net Premium X
Add: Adj. For Change in Reserve in Unexpired Risks (50% X
of the net premium of the last year – 50% of the net premium
of current year)
Net Premium Earned (Net) X

¾ Any amount payable by the insurance company is regarded as claim. Net

claim payable is calculated as follows:

Particulars Amount
Claim Paid Direct X
Add: Claims on Reinsurance Accepted X
Less: Claims on Reinsurance Ceded (X)
Net Claims Paid X
Add: Outstanding Claims at the end (net) X
Less: Outstanding Claims at the Beginning (net) X
Incurred Claims Net X

¾ When an insurer insures the risk undertaken by him with another insurer, it is
called reinsurance.
¾ The premium payable by the original insurer to the reinsurer is called
reinsurance premium ceded and the premium receivable by the reinsurer
from the original insurer is known as premium on reinsurance accepted.
 540

¾ Commission on re-insurance ceded is an income to the company, which

has ceded or transferred the reinsurance business, so it should appear on the
credit side of the concerned revenue account. Commission on re-insurance
accepted is an expense for the company which has accepted the re-insurance
business. So it should be entered on the debit side of the concerned revenue
account.
¾ In other words, Commission, being an expense, commission on reinsurance
ceded is deducted from the commission paid and commission on
reinsurance accepted is added to derive the net amount of commission paid.
¾ A reserve for unexpired risks shall be created as the amount representing
that part of premium written which is attributable to, and allocated to the
succeeding accounting periods shall not be less than as required under
64V(1)(ii)(b) of the Act. As per the provisions of section 64V(1)(ii)(b),
reserve for unexpired risks shall be created in respect of— (i) fire and
miscellaneous business, 50 per cent (ii) marine cargo business, 50 per cent,
and (iii) marine hull business, 100 per cent of the premium, net of re-
insurances, during the preceding twelve months.
¾ The direct expenses and incomes applicable to a particular business (i.e. fire,
marine or misc.) are recorded in the respective Revenue A/c, whereas
common / general expenses and incomes are recorded in the Profit and Loss
A/c.
¾ Cash flow statement can be prepared using either the direct method or the
indirect method. It classifies cash receipts and payments as operating,
investing and financing activities.
¾ In accordance with IRDA regulations, Cash Flow statement in an insurance
company is to be prepared using the Direct Method.
¾ There are several specialised ratios used to analyse an insurance company’s
financial condition. They are:
9 Gross Premium and Growth 9 Technical Reserves to Net
Rate Premium Ratio
9 Gross Premium to 9 Underwriting Balance Ratio
Shareholders Funds Ratio 9 Operating Profit Ratio
9 Growth Rate of 9 Liquid Assets to Liabilities
Shareholders Funds Ratio
9 Net Retention Ratio 9 Net Earnings Ratio
9 Net Commission Ratio 9 Return on Net Worth
9 Management Expenses to 9 Reinsurance Ratio
Gross Premium 9 Solvency ratio
9 Combined Ratio 9 NPA ratio
 541

Answers to Test Yourself

Answer to TY 1

The correct option is D.

The financial statements in general insurance business include

i) Balance Sheet,
ii) Revenue Accounts,
iii) Profit and Loss Account and
iv) Receipts and Payments Account (Cash flow Statement).

Answer to TY 2

The correct option is A.

Revenue Account shall be prepared in Form B- RA, Profit and Loss Account in
Form B-PL and Balance Sheet in Form B-BS as specified in Part V in schedule B
of Reg.3

Answer to TY 3

The correct option is B.

Particulars 2009-10
Premium From Direct Business 1,20,000
Add: Premium on Reinsurance Accepted 40,000
1,60,000
Less: Premium on Reinsurance Ceded 50,000
Net Premium 1,10,000
Adj. for Change in Reserve in Unexpired Risks (55,000- 10,000
65,000)
Net Premium Earned (Net) 1,20,000
 542

Answer to TY 4
The correct option is D.

Transactions
(i) Issue of share
capital for cash
(ii) Issue of share
capital other than
cash, for acquisition
of business
(iii) Payment to
suppliers
(iv) Depreciation
(v) Purchase of plant
(vi) Dividend paid
(vii) Taxes on income
Classification
Financing activities
Not a cash flow item, although needs separate
disclosure (section 2e)
Operating activities
It is a non-cash item. Not included in the cash flow.
In the indirect method, it is added back since the
starting net profit is after depreciation.
Investing activities
Either as a finance activity or as an operating
activity. (The IAS allows flexibility to the entities
to decide how to classify interest and dividends,
depending upon circumstances and the judgement
of the management).
Operating activities unless they can be specifically
identified with financing and investing activities.

Answer to TY 5
The correct option is A.

Rs.
Sale of building (2,80,000 + 38,000) 318,000
Sale of long-term investment (3,40,000 - 17,000) 323,000
Purchase of car (5,40,000 – 3,00,000) (240,000)
Net cash flow from investing activities 401,000

Interest paid will come under financing activities.

Answer to TY 6
The correct option is B.
Increase in assets indicates cash outflow from investing activities. This is because
an increase in assets means purchase of a new asset.
 543

Answer to TY 7

The correct option is C.

Solvency margin ratio is an important indicator that helps to judge whether an

insurer is strong enough to pay claims to policy holders as scheduled. It results
from the division of net assets by the required retained earnings.

Answer to TY 8

The correct option is A.

Section 11(1) of the Act requires that every insurer in respect of all insurance
business shall prepare Balance Sheet, Profit and Loss A/c and Revenue A/c.

Self Examination Questions

Question 1
From the following information, calculate the amount of Net Claims Incurred for
marine insurance:

Rs.
Claim Paid Direct 20,000
Claims on Reinsurance Ceded 1,500
Claims on Reinsurance Accepted 4,500
Outstanding Claims at the end (net) 25,000
Outstanding Claims at the Beginning (net) 16,000

A Rs. 17,000
B Rs. 23,000
C Rs. 26,000
D Rs. 32,000

Question 2
Which of the following statements are correct?
(i) In general insurance business, separate Profit and Loss Accounts are
prepared for fire insurance, marine insurance and miscellaneous insurance.
(ii) Reserve for unexpired risk is compulsorily created, in spite of it not being
mentioned in the question - 100% of the net premium in case of marine
insurance and 50% of the net premium in case of all other types of insurance.
 544

A Only (i)
B Only (ii)
C Both (i) and (ii)
D None of the above

Question 3

Survivor General Insurance Co Ltd provides the following information relating to

re-insurance business.

Rs.
Commission received during the year 2012-13 27,000
Commission receivable on 1 April 2012 2,000
Commission receivable on 31 March 2013 1,000

Which of the following amounts will reflect in the Revenue A/c of Survivor as
Commission on re-insurance ceded for the year ended 31 March 2013?

A Rs. 26,000
B Rs. 27,000
C Rs. 28,000
D None of the above

Question 4

Use the following information to calculate the cash flow from operating
activities:

Rs.
Book profit 11,664
Depreciation charges 2,916
Proceeds of sale of fixed assets 486
Increase in stock 495
Increase in creditors 550

A Rs. 14,525
B Rs. 14,635
C Rs. 8,803
D Rs. 15,625
 545

Question 5

Which of the following statements are incorrect in regards of the amendments

made by the IRDA Act, 1999 in the Insurance Act, 1938?

(i) Every insurer shall keep separate accounts relating to funds of shareholders
and policy holders
(ii) In section 28A and 28B in sub-section (1), for “31st day of March,” the IRDA
Act has substituted “31st day of December”

A Only (i)
B Only (ii)
C Both (i) and (ii)
D None of the above

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is C.

Particulars 2009-10
Claim Paid Direct 20,000
Add: Claims on Reinsurance Accepted 1,500
Less: Claims on Reinsurance Ceded 4,500
Net Claims Paid 17,000
Add: Outstanding Claims at the end (net) 25,000
Less: Outstanding Claims at the Beginning (net) 16,000
Incurred Claims Net 26,000

Answer to SEQ 2

The correct option is B.

Statement (i) is incorrect because, in general insurance business, separate

Revenue Accounts are prepared for fire insurance, marine insurance and
miscellaneous insurance but only one Profit and Loss A/c is prepared at the end
of the period in the prescribed form B given in schedule B of the Insurance Act,
1938.
 546

Answer to SEQ 3

The correct option is A.

Rs. 26,000 will be credited to the Revenue A/c.

Rs.
Commission received during the year 2012-13 27,000
Less: Commission receivable on 1 April 2012 2,000
25,000
Add: Commission receivable on 31 March 2013 1,000
26,000

Answer to SEQ 4

The correct option is B.

Rs.
Book profit 11,664
Add: Depreciation charge 2,916
Less: Increase in stock (495)
Add: Increase in creditors 550
Cash flow from operating activities 14,635

Increase in stock indicates that more cash is locked in stock and therefore should
be deducted. Increase in creditors indicates that a longer credit period is given by
suppliers and therefore added to the cash flow.

Answer to SEQ 5

The correct option is B.

Statement (ii) is incorrect as in section 28A and 28B in sub-section (1), for “31st
day of December,” the IRDA Act has substituted “31st day of March”.
 547

CHAPTER 3

NON-LIFE INSURANCE BUSINESS

ACCOUNTING METHODS, TECHNIQUES &
PROCESS
UNIT 13

REINSURANCE ACCOUNTING
Chapter Introduction
This unit aims to provide a fundamental understanding about the process of
reinsurance, various types of reinsurance arrangements, need for reinsurance and
the accounting for reinsurance arrangement.

a) Explain what is meant by reinsurance, along with the various terms and
definitions used.
b) Discuss the various types of reinsurance arrangements.
c) Learn about reinsurance accounting.
d) Discuss surplus treaty reinsurance and excess loss treaty reinsurance.
e) Discuss the reinsurance regulations in India.
 548

Introduction
Just as individuals transfer risk to insurance companies, insurance companies can
also transfer some of their risk to other insurance companies. Insurance
companies have to pay claims as and when they occur. They cannot be certain as
to when claims would occur and how big the claims would be. They do have
estimates based on probabilities, but there can be huge variances between the
estimates and the actual amount of claims as there can be no certainty regarding
perils. Insurers normally have enough funds to pay claims, however, events such
as earthquakes or tsunamis can put a strain on the funds of the insurer as there
would be thousands of claims amounting to extremely large sums of money. In
much the same way as an individual transfers their risk; insurers too can transfer
their risk to other insurers.

However, insurers do not transfer all the risk. They retain some of it themselves
(up to a certain level) and transfer the rest to another insurance company known
as the reinsurer. These transfers of risk are called “Reinsurance” and this allows
the burden of paying claims to be shared by the primary insurer and the reinsurer.

1. Explain what is meant by reinsurance, along with the

various terms and definitions used.
[Learning Outcome a]

1.1 Definition

An arrangement where one party (the reinsurer or assuming company), in

consideration for a premium, agrees to indemnify another party (the cedant or
reinsured) against part or all of the liability assumed by the cedant under a
policy or policies of insurance. Reinsurance may be on the basis of individual
risks (facultative) or groups of risks (treaty).

In other words, reinsurance is insurance for insurance companies. It is a transfer

of part of the risks that a direct insurer assumes by way of primary insurance
contract, to a second insurance carrier called Re-insurer.

For such transfer of risks, the reinsured and the reinsurer share premium and
claims as per the treaty or facultative arrangements.
 549

1.2 Purpose of Reinsurance

The purpose of reinsurance can be precisely enumerated as under:

M/S XYZ Ltd (referred to as insured) insured its textile operations with the
Insurer M/S Fortune General Insurance Company for Rs.100 million. However,
currently M/S Fortune can sustain risks of up to Rs.10 million only in view of its
financial capacity (capital and reserves & surplus).

Therefore it is decided to transfer any risks beyond Rs.10 million to some other
company. M/S Fortune enters into an arrangement that any fire policy beyond
Rs.10 million will be transferred to M/S RI International.

In this scenario, RI International is the re-insurer. The total risks assumed by M/S
Fortune are Rs.100 million, its retention is Rs.10 million and transfer to M/S RI
International is Rs.90 million, which is referred to as “Cession”. The contract
between M/S Fortune General Insurance Company and M/S RI International is a
contract of reinsurance.
 550

1.3 Reinsurance fundamentals

The transfer of risk from one insurance company to another is called reinsurance.
Catastrophic events such as earthquakes or oil tankers spilling oil into the sea can
generate claims that could place a considerable financial burden on the insurer.
To ensure that they can fulfil their promise to pay claims, insurers transfer a part
of their risk to another insurer. Should one of the above events happen, the
primary insurer would pay a part of the claim and the reinsurer would pay the
rest.

Insurers retain risk up to a certain limit (retention limit) and transfer the rest to
the reinsurer. There are insurance companies that deal exclusively in reinsurance
although reinsurance can be done with any insurer.

Reinsurance is not a simple business; it is complex and can be arranged in

numerous ways. Some of which are:

9 Reinsurance brokers act as intermediaries and find a reinsurer willing to

accept the risk.
9 Treaties between the insurance company and the reinsurer specify retention
limits for various risks and agree to reinsure any amount above the retention
limit on terms specified in the treaty.
9 Treaties may specify that reinsurance would be a certain proportion of the
risk underwritten by the insurance company.
9 The reinsurer may or may not have the option to refuse particular risks.
9 In some treaties, when the loss exceeds a certain limit the reinsurer gets
involved.

Reinsurance Brokers
Reinsurance brokers act as an intermediary between the primary insurer and
reinsurers. The percentage commission paid by the reinsurers to the reinsurance
brokers is relatively small in comparison to the commission paid to the insurance
brokers.

When there are reinsurance brokers, the premium payments and loss payments as
well as premium refunds pass through them. The primary insurer may take help
from the reinsurance brokers when they do not have the expertise to place
reinsurance directly. Reinsurance brokers obtain their commission from the
reinsurers. They have a duty to observe the principle of utmost good faith, which
means they must reveal to the reinsurers all material facts concerning the risks
after obtaining business from the primary insurers.
 551

Diagram 1: Reinsurance

1.4 Specific terms used in reinsurance

When the primary insurer passes risk on to a reinsurer,
and the reinsurer accepts the business, the primary insurer
Ceding
is called the “ceding company” and the company that
takes on the risk is called the “reinsurer”.
A reinsurer reinsures with another reinsurer or insurance
Retrocession company. Such process of transfer is called
“retrocession”.
Agreements between the ceding company (primary
insurer) and the reinsurer containing terms and conditions
Treaties on which risks shall be reinsured. Such treaties are valid
for a specific period and can be renewed on the same or
different terms based on experience.
This is when the reinsurer has the right to decide whether
they should accept the risk or not. In other words, the
Facultative
reinsurer negotiates with each risk, whether to take it on or
reinsurance
not. This may happen in treaty cases also, where risk is not
within the terms of the treaty.
 552

Surplus Agreement requires reinsurance beyond the retention limit

reinsurance of the primary insurer.
Quota share A proportion of all businesses to be reinsured.
An arrangement wherein the reinsurer steps in only if there
is a loss that exceeds the specified limit.
Insurance companies may have several excess of loss
Excess of loss treaties with second and third reinsures set at different
limits that come into effect when the loss is in excess of
the limit for the primary insurer and the first reinsurer.
These are called “first”, “second” etc. excess of loss.
When net claims ratios of the insurer exceed specified
Excess of loss
limits in a financial year, excess of loss ratio becomes
ratio
operational.
A number of insurers agree to pool all premiums received
Pool
and claims are paid from that pool. Expenses and profits
arrangement
are shared as per agreed interests of the pool members.

Accounting for reinsurance arrangements

Before we proceed to discuss reinsurance accounting, we need to discuss

reinsurance methods, because reinsurance accounting is directly associated with
methods and forms of reinsurance contracts which are either Facultative or
Treaty in nature and character.

An accountant handling reinsurance accounting must have thorough knowledge

about each and every reinsurance contract and its terms and conditions, which
provides the basis of reinsurance accounting.

The various types of reinsurance arrangements and their accounting have been
discussed in detail in the subsequent Learning Outcomes.

In reinsurance terms, a treaty condition stating that the insurer’s loss must exceed
a certain limit for the reinsurer to get involved is called ________________.

A Excess of loss
B Quota share
C Ceding
D Pool arrangement
 553

2. Discuss the various types of reinsurance arrangements.

[Learning Outcome b]
Reinsurance arrangements are broadly divided into:

1. Facultative reinsurance and

2. Treaty Reinsurance.

Both these reinsurance arrangements are discussed below:

1. Facultative Reinsurance

Facultative Reinsurance is the reinsurance of a single insurance policy, which

may cover a schedule of risk in different locations.

Facultative reinsurance is negotiated separately for each insurance contract that is

reinsured. It is optional to both the parties, (i.e. insurance company and the re-
insurer) to offer or not to accept or reject the offer. The re-insurer may accept the
business on revised rates, terms and conditions. The reinsurer has the option of
either accepting or declining a proposal.
A direct reinsurer turns to facultative reinsurance generally in the following two
cases:
9 When he is left with the sum remaining to be insured after both his retention
and obligatory reinsurance capacity is exhausted
9 When a policy contains risks that are excluded from his obligatory
reinsurance cover

Indus Insurance Co Ltd’s retention is Rs.3 crores for any fire policy. It does not
require any Reinsurance protection as long as the sum insured (SI) of any fire
policy is within the range of Rs 3 crores.
If the sum insured under any policy exceeds Rs.3 crores, the insurance company
needs to take a re-insurance cover on facultative basis or a particular contract of
reinsurance for a particular risk underlying the original policy for amount
exceeding the retention capacity i.e. Rs.3 crores.
The risks which are outside the scope of the treaty are generally taken care of in
Facultative Reinsurance.
 554

2. Treaty Reinsurance

A treaty is an automatic re-insurance facility which covers a portfolio of risks.

Treaty reinsurance is an obligatory arrangement between an Insurance Company

(also referred to as ceding company) and Reinsurance Company.

Under treaty reinsurance, the insurance company wishes to reduce its exposure
on any branch of business and the reinsurance company agrees to automatically
accept the business. Under a Treaty RI, the reinsured (or referred to as ceding
company) is under obligation to cede the agreed portion of premium to the
Reinsurance Company (or referred to as reinsurer) in accordance with the
agreement between them and the reinsurer is obliged to accept without any
choice. The reinsurer then covers all the insurance policies coming within the
scope of that contract.

There are two basic types of treaty reinsurance:

a) Proportional treaty is one whereby the reinsurer receives a predetermined

proportion or share of the premium and pays the same proportion or share of
loss. It is also referred to as pro-rata insurance. In proportional reinsurance,
the insurer and the reinsurer share the risks and premiums pro-rata.

The two common types of proportional reinsurance are:

Diagram 2: Proportional reinsurance

 555

Note: Surplus treaty is explained further in detail in Learning Outcome 4.

Quota share treaties are especially suitable for young emerging insurance
companies or for those companies who are new to a certain class of business. As
their loss experience is limited, they often face difficulties in defining the correct
premium to be collected from the insurance written. With quota share treaties, the
insurer takes the risk of any incorrect estimates.

Example of Quota share treaty

Let us say, if there is a loss of Rs. 1,00,000 under a 40 percent quota share
reinsurance treaty, the cedant will bear Rs. 60,000 of the loss and the reinsurer
concurrently will bear Rs.40,000 of the loss.
Example of Surplus share treaty

Where the policy limit is Rs.1,50,000, and the cedant’s retention is Rs.25,000,
the amount ceded to the reinsurer is Rs.125,000 and the ratio of what is ceded to
what is retained is 5:1. Losses, therefore, will be shared in that proportion.
Therefore, in the case of claim of Rs.1,00,000, the cedant is responsible for
Rs.16,667 and the reinsurer pays Rs.83,333.

Reinsurers limit the amount of risk ceded to them which is described in terms of
“No. of lines”. The amount of the insurer’s retention is considered one line. A
reinsurer may be said to accept, for example, a five-line surplus reinsurance
contract, meaning risks up to five times the primary insurer’s retention.

b) Non-proportional Treaty

In non-proportional treaty reinsurance, there is no such pre-determined ratio for

dividing the premiums and losses between the direct insurer and the reinsurer.

The re-insurer is liable to only those losses which have exceeded the specified
amount, called the attachment point or excess point e.g. excess of loss treaty.
 556

There are different types of reinsurance treaties. Reinsurance accounting process

and preparation of accounting statements follow the nature and type of
reinsurance and reinsurance policy wording in the treaty.
Let us summarise this learning outcome by understanding the basic differences
between facultative and treaty reinsurance:

Facultative Reinsurance Treaty Reinsurance

Facultative reinsurance is a contract Treaty reinsurance involves a pre-
only covering all or part of a single existing commitment by the reinsurer
specific policy of insurance to cover a predetermined class and
amount of coverage that will be sold
by the primary insurer.
Under a facultative reinsurance, the Under treaty reinsurance, the
reinsurance company is not under any reinsurance company is under an
obligation to provide reinsurance obligation to provide reinsurance
protection. protection.
Facultative reinsurance is commonly Treaty insurance is generally
purchased for large, unusual or purchased to cover risks which are
catastrophic risks. pre-determined and are out of scope of
the Primary Insurer
Generally entered for short term and Generally treaties are long term
for a specified period of time. contracts or risks pertaining to certain
risky business segments.

When the business is not covered by the insurer’s reinsurance treaty, or the
amount of insurance needed exceeds the net treaty capacity of the primary
insurer, the primary insurer can transfer that excess to a facultative reinsurer.

Orion Insurance Company has purchased from Artis Reinsurance Company a

quota share treaty with retention of 20 percent and a cession of 80 percent with a
limit of Rs. 10,00,000. The details of three policies to be ceded are as follows:

Policy No Sum Insured Premium Loss

111 4,00,000 1,600 100,000
112 6,00,000 3,000 160,000
113 8,00,000 3,400 180,000
 557

Required:

Show how the sum insured, premiums and losses under these policies will be
divided between the primary insurer and the reinsurer under a quota share treaty.

Orion insurance company has purchased from Artis Reinsurance Company a ten
line surplus share treaty with retention of Rs.4,00,000 and a limit of Rs.
40,00,000. Use the details of the policies to be ceded given in Test Yourself 1.

Required:

Show how the sum insured, premiums and losses under these policies will be
divided between the primary insurer and the reinsurer under a surplus share
treaty.

3. Learn about reinsurance accounting.

[Learning Outcome c]
In this section we will discuss the following broad areas:

3.1 Characteristics of reinsurance accounting

3.2 Need for reinsurance accounting
3.3 Basis of Reinsurance Programme
3.4 Principles & Prerequisites of reinsurance accounting
3.5 Provisions for Reinsurance Recoverable

3.1 Characteristics of reinsurance accounting

Reinsurance accounting is a process of identifying, analyzing and reporting

financial data and results for the various groups of people interested in
reinsurance transactions for their various decisions.
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Characteristics:

1. Reinsurance accounting deals with not only financial aspects but also
technical and legal aspects of reinsurance.

2. Reinsurance Accounting process and methods are based on class of business,

types & methods of reinsurance, types of arrangements or treaties i.e. Quota
Share Treaties, Surplus Treaties or excess of Loss treaties.

3. Reinsurance accounting is done by the purchaser of the product (the

reinsured) for the use of the sellers (reinsurers) and other users such as
shareholders, Management, employees, Regulatory Authorities &Taxation
Authorities, Brokers, Financial analysts etc.

4. Reinsurance Accounts are maintained mainly to provide important statistical

analysis of financial as well as technical data such as premium, incurred
claims, commission, premium reserves, Claims Reserves, Cash calls, various
commissions (normal, profit or overriding commission), Taxes &
management expenses.

3.2 Need for reinsurance accounting

1. Commissions and settlements

The reinsured earns commission from reinsurers for ceding premium with
reinsurers at various rates and terms. Reinsurance accounting forms the basis for
determining the commissions to be received / paid between the ceding company
and the reinsurer during the year.

2. Profitability

With reinsurance accounts, the reinsured and reinsurer determine profitability for
each and every reinsurance treaty or facultative transactions so that they can
decide the future reinsurance cover with the best possible rates and terms.

3. Periodical settlement

It facilitates all periodical reconciliations and settlement of quarterly or periodical

balances to avoid undue gains or losses due to fluctuations of exchange rates.

4. Ageing analysis

It also provides proper mechanism for age-wise analysis of the recoverables.

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5. Decision making

Appreciation and analysis Reinsurance Accounting gives rise to the following

queries, which need to be considered before forming any opinion or taking any
decision.

9 Is profit earned on insurance business is really profit?

9 Is Profit on Reinsurance Accounts not a reserve against some future
catastrophic liability?
9 If one major catastrophic loss in 30 years wipes out the entire profits, what
should be the treatment of taxes?

3.3 Basis of Reinsurance Programme

We have already discussed the purpose of reinsurance in Learning Outcome 1.

Reinsurance programme benefits the direct insurer in many ways, which include:

9 stabilizing the direct insurer’s balance sheet by transferring a major part of

risks,
9 reducing the probability of his insolvency by assuming catastrophic risks,
9 enlarging his underwriting capacity by accepting a proportional share of risks
and
9 enhancing his efficiency with the reinsurer’s services such as compiling and
presenting underwriting data from sources around the world, evaluating and
assessing special risks, providing loss adjustment support etc.

A reinsurance programme cannot be standardised for each and every insurance

company. Every insurance company is in a unique situation with regard to loss
exposure, financial standing, management culture and future plans. Thus each
company needs a unique reinsurance programme, which is tailored to suit the
requirements of the company.

The service provided by the reinsurer is only possible due to the availability of
accounting records of financial and technical data identified which are analysed
and reviewed for reinsurance treaty formation, renewal and settlement.
Therefore, without proper reinsurance accounts, reinsurance service that is
international in character, practice and perspectives in risk transfer technology
cannot be properly utilized. Furthermore, management decisions in framing
reinsurance policy and programme and choosing the method to account for
reinsurance treaties depend on reinsurance accounting and results analysis.
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In accordance with IRDA (General Insurance - Reinsurance) Regulations,

2000, the Reinsurance Programme shall be guided by the following objectives to:
9 maximise retention within the country
9 develop adequate capacity
9 secure the best possible protection for the reinsurance costs incurred
9 simplify the administration of business
3.4 Principles & Pre-requisites of reinsurance accounting
There is neither any accounting principle, nor any accounting standard that is
internationally accepted for reinsurance. Principally, reinsurance accounting and
its procedures follow the foundation of reinsurance treaty. This includes learning
the following fundamental areas of reinsurance accounts:
1. Reinsurance Accounting format
2. Reinsurance Accounting systems
3. Reinsurance portfolios
4. Accounting entries with reference to general accounts and final statement of
accounts.
5. Reinsurance Commission and Profit Commission
1. Reinsurance Accounting Formats
There is no standard format for reinsurance accounts that has been globally
accepted. Over the years, a number of attempts have been made to standardize
the reinsurance accounts to a global acceptance, but limited success has been
achieved so far. Certain examples of accounts are shown hereinafter in regard to
various Accounts formats commonly followed for reinsurance accounting all
over the world. The reinsurance accounts formats include various treaty accounts,
Profit and Loss Statement or Profit Commission Statement, which are discussed
in detail below.
2. Reinsurance Accounting Systems
It is said that “Treaty is blind” because everything is decided based on the results
revealed by the Accounts. The Accounting System is one of the fundamental
aspects that help to analyze and interpret the reinsurance results through
reinsurance accounts. The type of reinsurance accounting system plays an
important role in accounting for reinsurance arrangement. It forms the basis in
each specific case before we proceed to prepare accounts and statistics.
Generally, the account system chosen is specified in the reinsurance treaty
concerned. If the accounting system is not specified in the treaty, an accounting
system, which is common in the relevant class of business, will have to be
selected. But once an accounting system is chosen, it should not be changed in
order to maintain uniformity and consistency.
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Need for accounting systems

9 Accounting systems help to determine the amount and manner of recognizing
premiums or losses, which should go into accounts in accordance with the
reinsurance treaty.
9 While preparing accounting statements such as Reinsurance Treaty Account,
Profit Commission Statement etc., the accounting system determines as to
how premium reserves, loss reserves and profit commissions should be
determined.
There are three major reinsurance accounting systems:
Diagram 3: Reinsurance accounting system

a) Reinsurance Accounting Year System

In this system, the premiums and losses are entered in the accounts according to
the treaty criteria for the relevant accounting year without any break up of
income (premium) and expenditure (claims/commission) by year of occurrence
or underwriting year.
Premium is booked as per the due date or premium paid, and claims as per the
date of payment. While preparing Profit Commission Statement and Reinsurance
Treaty Accounts on accounting year basis, all transactions are accounted for in
the same treaty period with the following debits and credits without reference to
the underwriting year:

Debit Items Credit Items

Claims, Commissions Premium Reserve B/F
Miscellaneous Charges Loss Reserve B/F
Loss Reserve C/f Premiums etc.
Premium Reserve C/f
Allowance for Re-insurer’s Expenses B/f
Allowance for Re-insurer’s Expenses B/f
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The reserves mentioned here are not cash reserves, but technical reserves that the
ceding insurer may retain from the reinsurer although the same may be replaced
by portfolio transfers. Losses payable to the reinsured company are divided
between losses already paid by the ceding company and loss reported but unpaid
by ceding company. Unearned premium reserves held by the reinsured are
similar to loss recoverable from the reinsurer. If reinsurer cancels treaty or
becomes insolvent, the unearned premium reserves must be adjusted by ceding
company against loss.

b) Reinsurance Accounting -Occurrence System

In this system, premiums and losses are recorded in the accounts according to
treaty terms for the relevant year of occurrence with breakdown of losses by year
of occurrence. Here, premium is booked as per due date or premium paid, but
losses are booked according to the date of occurrence, which is clearly defined
for each class of business in the treaty.

c) Reinsurance Accounting- Underwriting Year System

Under this system, the premiums and losses are entered in the accounts according
to the treaty terms for the relevant underwriting years (breakdown of premium
and losses by underwriting years). For calculation of profit for profit commission
of the underwriting year and determination of closing balances for periodical
settlement, all transactions of an underwriting year are accounted for in the same
u/w year without reference to accounting year. Premium and paid losses are
accounted according to the policy period. Generally the preparation of the first
statement is deferred until at least one year after the end of the u/w year.

Readjustment statements are then rendered in accordance with treaty terms until
all liabilities have expired and been accounted for. Sometimes, the treaty may
provide for closing of accounts after a specified period in order to account for
liability and transfer of any outstanding liability to the next open underwriting
year.

Thus, all subsequent transactions for claims or liabilities relating to the preceding
underwriting years are then included in the profit commission statement and for
settlement of periodical balances under Underwriting Year System. Pertinently,
no premium reserve or no loss reserve will be brought forward or carried forward
unlike calculation of profit commission under accounting year basis to determine
the profit commission.
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3. Reinsurance Portfolio
Direct insurers minimize their risk by ceding certain risks in the form of
facultative reinsurance. However, some direct insurers may opt to cede a
portfolio of risk - for example, all the risk contained in business segment of fire,
motor or marine insurance policies written. These insurance portfolios may be
covered by blanket agreements (also referred to as obligatory reinsurance
treaties). Insurance portfolios based on the reinsurance treaty include huge
individual risks of distinct classes covered by the treaty. Different portfolios are
constructed for different classes of business such as motor, fire, marine,
engineering etc. The said portfolio that provides data on premium, risk, risk date,
loss, date of loss and date of payments is the basic foundation of reinsurance
accounting. An insurance portfolio is constructed in many ways. It may be a
Balanced or an Un-balanced portfolio.
a) Balanced Portfolio

Balanced portfolio is one based on many similar and equivalent risks, balancing
of portfolio losses collectively and distributing proportionately as per terms of
treaty.

To be considered a balanced portfolio, an insurance portfolio should include

many similar and equivalent risks. In this way, losses can be balanced
collectively, meaning that the direct insurer will need little or no reinsurance.

One of the business lines for Lumini Ltd is the insurance of motor vehicles. If
such a portfolio includes enough individual risks (say 200,000 automobiles) the
law of large numbers should apply, meaning that the loss ratio (the ratio of
claims to premiums) should fluctuate only minimally from year to year.

b) Unbalanced portfolio
Examples of such unbalanced portfolios are those of nuclear power or aviation
insurance risks. Here, huge risk exposures arise from a relatively small number of
objects insured through accumulation of sums insured under property, hull,
liability and accident coverage. Such risks cannot be possibly borne by a single
insurance or reinsurance company. It necessitates setting up national pools,
which retain part of risk exposures for national insurance companies, collectively
enabling the balance to be reinsured. The following example of a marine
portfolio gives some basic ideas and concepts about how reinsurance portfolio
serves as basis for reinsurance accounts.
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Table 1 - Reinsurance Portfolio (Marine)

Vessels Sum Period Due date Premium Loss Date Loss Payment
Insured date
Asoke 2,00,000 01/01/05 to 31/12/05 01/01/05 5,000 - NIL -
01/10/05 5,000
Victor 4,00,000 01/02/05 to 31/01/06 01/02/05 20,000 07/4/05 5,000 02/08/05
Calcutta 7,50,000 01/04/05 to 31/03/06 01/04/05 37,500 6/12/05 7,500 01/02/06
Bombay 10,00,000 01/07/05 to 31/12/05 01/07/05 25,000 8/10/05 20,000 20/10/05
01/10/05 25,000
Madrid 14,00,000 01/09/05 to 31/08/06 01/09/05 28,000
Madras 18,00,000 01/01/06 to 30/06/06 01/01/06 36,000 07/4/06 150,000 03/03/07
Singapore 20,00,000 01/01/06 to 31/12/06 01/01/06 40,000
01/07/06 10,000
Hongkong 20,00,000 01/01/06 to 31/12/06 01/01/06 10,000 4/03/06 40,000 7/04/06
01/07/06 40,000
Total Rs2,81,500 Rs2,22,500

Note: Table 1 will also be used below to understand further examples.

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4. Accounting entries with reference to general accounts and final

statement of accounts

Accounting entries vary with Methods and Types of reinsurance. Methods are
two - Facultative and Obligatory. The types are also two - Proportional and Non-
proportional. Let us examine the standard accounting entries to be passed for
reinsurance accounts.

Accounting Entries for Reinsurance Transactions

Accepted /
Transaction Debit A/c Credit A/c
Ceded
Premium for Current Year Accepted Cedant Premium
Premium for Current Year Ceded Premium Reinsurer
Commission Accepted Commission Cedant
Commission Ceded Reinsurer Commission
Brokerage Accepted Brokerage Broker
Brokerage Ceded Brokerage Broker
Claims Paid Accepted Claims Cedant
Claims Paid Ceded Reinsurer Claims
Portfolio reinsurance
Portfolio Premium Entry Accepted Cedant Premium
Portfolio Premium Entry Ceded Premium Reinsurer
Outstanding
Portfolio Loss Entry Accepted Cedant
Claims
Outstanding
Portfolio Loss Entry Ceded Reinsurer
Claims
Portfolio Premium Withdrawal Accepted Premium Cedant
Portfolio Premium Withdrawal Ceded Reinsurer Premium
Outstanding
Portfolio Loss Withdrawal Accepted Cedant
Claims
Outstanding
Portfolio Loss Withdrawal Ceded Reinsurer
Claims
Profit Commission Accepted Commission Cedant
Profit Commission Ceded Reinsurer Commission
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c) Facultative Reinsurance Accounting

Under Facultative Reinsurance, the risks are reinsured on individual basis, where
the insurer has no obligation to cede a risk in a primary insurance contract and
the reinsurer also has the option of accepting or declining each proposal. When
reinsuring facultatively, the insurer may obtain reinsurance coverage before
accepting risks of the insured. Facultative reinsurance may be either proportional
or non-proportional. Accounting entries will be the same, irrespective of the
methods and types of reinsurance.
What is to be specially considered in facultative reinsurance is the distribution of
premium and claims as per arrangement. Generally, premium is booked under
this method on net of commission basis. However, Facultative Obligatory treaty
may provide for some commission, which is substantially less than the quota
share and surplus treaty because of the simple fact that premium paid under this
treaty is very less compared to the loss exposure.
d) Quota Share Treaty and Reinsurance Accounting
The quota share treaty is an automatic reinsurance whereby the ceding company
is bound to part with a fixed percentage of every risk written by it. The same
percentage is applied to each and every risk to determine cession in the class of
insurance as reinsured. It is immaterial how large or small is the sum insured or
how good or bad the risk is. This is different from surplus method where the
percentage reinsured varies with each risk according to the underwriter’s decision
in determining the surplus for reinsurance.

Distribution of Premium
Primary Insurer (PI) entered into 80% Quota Share Treaty with Reinsurer (RI)
with respect of all the fire businesses written by the company in India. A treaty is
agreed to distribute premium between PI and RI for the following fire businesses
written in India. A premium of Re1 per Rs.1000 (Sum Insured) is charged for all
business written in India.
During the year the following businesses were written:

Business Date Sum Insured

(Rs.)
A 01/09/10 5,00,000
B 02/09/10 10,00,000
C 03/09/10 20,00,000
D 04/09/10 40,00,000
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Required:
Prepare a statement showing the distribution of Premium.
Solution
Statement showing distribution of Premium

Business A B C D
Sum-insured 100% 5,00,000 10,00,000 20,00,000 40,00,000
Premium Total 100% 500 1000 2,000 4,000

Ceding Company 20% 100 200 400 800

Reinsurer 80% 400 800 1600 3,200

Let us now examine how claims will be distributed in a Quota Share treaty.

Distribution of Sum Insured, Premium and Claims in Quota Share Treaty

Primary Insurer (PI) entered into a 20% quota share treaty with reinsurer (RI) for
2009 with maximum cession of Rs. 90,00,000.
The following are the details of premium rate and business written during the
year:
(i) Premium rate 1%
(ii) Sum insured of Rs. 50,00,000 with claim of Rs. 44,00,000
(iii) Sum insured of Rs. 110,00,000 with claim Rs. 1,000 only
(iv) Sum insured of Rs. 600,00,000 with claim Rs. 6,00,000
Required:
Calculate retention and reinsurance cessions.
Solution
Accounting Statement showing distribution of SI, Premium and Claims
1. SI Distribution

SI Retention Quota Cession Fac SI

a) 50,00,000 40,00,000 -80% 10,00,000 -20% NIL
b) 110,00,000 88,00,000-80% 22,00,000-20% NIL
c) 600,00,000 480,00,000-80% 90,00,000-15% 30,00,000-5%
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2. Premium Distribution

Total Retention Cession Fac Share

Premium
a. 50,000 40,000- 80% 10,000-20% NIL
b. 1,10,000 88,000-80% 22,000-20% NIL
c. 6,00,000 4,80,000-80% 90,000 – 15% 30,000

3. Claim Distribution

Total Claim Retention Cession Fac Share

a. 40,00,000 32,00,000-80% 8,00,000-20% NIL
b. 1,000 800– 80% 200 - 20% NIL
c. 6,00,000 480000-80% 90,000-15% 30,000-5%

Quota Share Reinsurance Accounting

Let us now prepare Quota Share Reinsurance Accounting of XYZ Insurer Ltd.
Mumbai, for the accounting transactions with Bharat Reinsurer Ltd, Mumbai (as
reflected in Reinsurance Portfolio specified in Table 1 shown earlier) using
following Quota Share Treaty

Marine Quota Share Treaty

Portfolio As per Insurance Portfolio specified in Table 1

Treaty Inception 01/01/2005
Reinsurance share 40% with Bharat Reinsurer, 40% others; 20% retention
by XYZ
Proportional Sum-insured 20,00,000; Bharat Reinsurer max. liability
Cover 8,00,000
Management Exp. 5%
Commission 22.5%
Profit Sliding Scale Profit Commission
Commission 30% Profit Commission on profit upto 10% of premium
booked
40% Profit Commission on profit 10% - 20% of premium
booked
50% Profit Commission on rest of profit.
Losses carried forward to extinction
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Accounts Underwriting Year Basis; Half-yearly account’s

Statement
Closing of books on 31 December
Deadlines- 60 days; Confirmation – 30 days
Settlement; 30 days by both parties;
Accounting Currency and Payment Currency- INR
Set-off permitted with all balances
Loss Reserves 100%
Solution
A statement of account for the 1st half year of 2005 may be prepared in the
following format taking premium and claims specified in earlier Table 1
In the books of XYZ Insurance Co Ltd (insurer)
A statement of account for the 1st half year of 2005 for Reinsurance Treaty with
Bharat Reinsurer Ltd, Mumbai (Reinsurer)
Reinsurance Treaty Marine Quota Share
Accounting Period 1st Half Year, 2005
Accounting System Underwriting Year
Accounting Currency INR
100% figures accounted for
Particulars Treaty Year Debit Credit
Amount Amount
Premiums 2005 - 62,500.00
(5,000+20,000+37,500)
Commission 22.5% 2005 14,062.50
Paid Claims
48,437.50 -
62,500.00 62,500.00
Bharat’s 40% reinsurance share 40% 19,375.00
In the books of XYZ Insurance Co. Ltd
A statement of Account for the 2nd half year of 2005 for Reinsurance Treaty with
Bharat Reinsurer Ltd, Mumbai, Reinsurer
Re-insurer Bharat Reinsurer Ltd, Mumbai
Reinsurance Treaty Marine Quota Share
Accounting Period 2nd Half Year, 2005
Accounting System Underwriting Year
Accounting Currency INR
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100% figures accounted for

Particulars Treaty Debit Credit
Year Amount Amount
Premiums 2005 - 83,000.00
(5,000+25,000+25,000+28,000)
Commission 22.5% 2005 18,675.00
Paid Claims (Payment-2.8.05& 2005 25,000.00
11.10.05)
Balance 39,325.00 -
83,000.00 83,000.00
Bharat’s 40% reinsurance Share 40% 15,730.00
In the books of XYZ Insurance Co. Ltd
A statement of account for the 1st half year of 2006 for Reinsurance Treaty with
Bharat Reinsurer Ltd, Mumbai, Reinsurer
Re-insurer Bharat Reinsurer Ltd, Mumbai
Reinsurance Treaty Marine Quota Share
Accounting Period 1st Half Year, 2006
Accounting System Underwriting Year
Accounting Currency INR
100% figures accounted for
Particulars Treaty Year Debit Credit
Amount Amount
Premiums 2006 - 86,000.00
Commission 22.5% 2006 19,350.00
Paid Claims (Payment--1.2.06) 2005 7,500.00
Balance 59,150.00 -
86,000.00 86,000.00
Bharat’s 40% reinsurance 40% 23,660.00
Share
In the books of XYZ Insurance Co. Ltd
A statement of Account for the 2nd half year of 2006 for Reinsurance Treaty with
Bharat Reinsurer Ltd, Mumbai, Reinsurer
Re-insurer Bharat Reinsurer Ltd, Mumbai
Reinsurance Treaty Marine Quota Share
Accounting Period 2nd Half Year, 2006
Accounting System Underwriting Year
Accounting Currency INR
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100% figures accounted for

Particulars Treaty Year Debit Credit

Amount Amount
Premiums 2006 - 50,000.00
Commission 22.5% 2006 11,250.00
Paid Claims 2006 40,000.00
Balance 1,250.00
51,250.00 51,250.00
Bharat’s 40% reinsurance 23,660.00
Share

Prepare Profit and Loss statement

Now let us prepare Profit and Loss statement as at 31/12/2005 on the basis of
reinsurance accounts transactions recorded in the above noted Half-yearly
Accounts (following data specified in Table. 1 and Quota Share Treaty shown
above):
In the books of XYZ Insurance Co. Ltd
Profit and Loss statement as at 31/12/2005
(As per premium and claims specified in earlier Table .1)

Reinsurance Treaty Marine Quota Share

Accounting Period 2005
Accounting System Underwriting Year
Accounting Currency INR

100% figures accounted for

(Amount in Rs.)
Debit Credit
Premiums 145,500.00
Commission 32,737.50
Paid Claims 25,000.00
Loss Reserves 100% 7,500.00
Management Expenses 5% 7,275.00
Profit 72,987.50
145,500.00 145,500.00
Calculation of Profit Profit Debit Credit
Commission
30% profit commission upto 14,550 4,365.00
10% of Premium
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Debit Credit
40% profit commission for 14,550 5,820.00
another 10% of premium
50% profit commission for the 43,887.50 21,944.00
balance profit
Profit Commission 32,129.00
32,129.00 32,129.00

Preparation of Profit and Loss statement for 2006

Now let us prepare Profit and Loss statement as at 31.12.2006 on the basis of
reinsurance accounts transactions recorded in the above noted Half-yearly
Accounts (following data specified in Table. 1 and Quota Share Treaty shown
above)

Profit and Loss statement as at 31/12/2006

Reinsurer
Reinsurance Treaty
Accounting Period
Accounting System
Accounting Currency
Bharat Reinsurer Ltd, Mumbai
Marine Quota Share
2006
Underwriting Year
INR

100% figures accounted for

Dr. Amount Cr. Amount
Premiums 1,45,500.00
Commission 32,737.50
Paid Claims 40,000.00
Loss Reserves 100%
Mgmt. Expenses 5% 7,275.00
Profit 65,487.50
1,45,500.00 1,45,500.00
Calculation of Profit Profit Debit Credit
Commission
30% profit commission upto 14,550 4,365.00
10% of Premium
40% profit commission for 14,550 5,820.00
another 10% of premium
50% profit commission for the 36,387.50 18,194.00
balance profit
Profit Commission 28,379.00
28,379.00 28,379.00
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Note: As in the 2006 transactions, there is no change other than paid claims
which correspond with the aggregate of paid claims and Loss reserves
(25000+7500)

Profit & Loss Statement as at 30/06/03

Reinsurer M/s Universal Reinsurance Co Ltd

Portfolio Premium Entry (35%) Ceded Rs.80,00,000
Portfolio Loss Entry (O/S Claims) Rs.50,00,000
Premium for Current Half Rs.4,00,00,000
Reinsurance Commission 40%
Claims Paid Rs.60,00,000
Expenses of Management 2.5%
Portfolio Loss Withdrawal Rs.70,00,000
Profit Commission 20%

Required:

Prepare Half Yearly Profit & Loss Statement as on 30/06/03.

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Solution
Reinsurer—M/s Universal Reinsurance Co Ltd
Half Yearly Profit & Loss Statement As on 30.6.03
Reinsurance Treaty: Quota Share; Treaty Year: 1st Half ‘03
Accounting System --Underwriting Year Class of Business –Marine

Particulars % Debit Amount Credit Amount Remarks

Portfolio Premium Entry 35 Ceded 80,00,000 Debit-Premium A/c
Portfolio Loss Entry Outstanding claim 50,00,000 Debit-Outstanding claim
Premium for Current year* 4,00,00,000 Debit-Premium A/c
Commission 40 Premium 1,60,00,000 Credit-Commission A/c
Claims Paid 60,00,000 Credit-Claim A/c
Credit -Bank
Expenses of Management 2.5 Premium 10,00,000 Credit- Management
Expenses
Portfolio Premium Withdrawal 35 Premium 1,40,00,000 Credit-Premium A/c
Portfolio Loss Withdrawal Outstanding claim 70,00,000 Credit-Outstanding Claim
Balance being profit 90,00,000
5,30,00,000 5,30,00,000
Profit b/d 80,00,000
Profit Commission 20 16,00,000

*Premium: Refer Table 1 for Portfolio. Total of first four items

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5. Reinsurance Commission and Profit Commission

a) Reinsurance commission

Reinsurance Commission is paid by the re-insurer to the ceding (direct) insurer

and is decided as a percentage of premium for reimbursement of acquisition cost
(agency commission) & management expenses.

Reinsurance Commission is calculated by applying the agreed percentage of

commission to the premium ceded less returns and cancellation. Different rates
are decided for different classes of business.

Reinsurance commission may be fixed either on a:

i) fixed scale or
ii) sliding scale

These are discussed below in detail:

i) Fixed scale commission

This is very easy to operate as the commission payable is calculated by applying

an agreed percentage to the premiums ceded (less returns and cancellations). If a
treaty has business emanating from different geographical areas, there may be
different rates of commission applying to different locations.

ii) Sliding scale commission

This method has been developed to allow the ceding company to receive more
commission when the treaty is profitable and to minimize the loss to the reinsurer
in unprofitable years.

The rate of commission is based on the loss ratio of the treaty during any one
treaty year or during any one underwriting year. The loss ratio is usually
calculated as the percentage that incurred losses bear to earned premiums, as
follows:
Incurred Losses
× 100
EarnedPremiums
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If incurred claim is Rs. 50,000 and premium is Rs. 100,000, loss ratio is 50%. A
treaty may provide the following type of sliding scale commission:

Rate of commission 30% if Loss ratio is 65% or more

” ” 35% ” ” is below 65%
” ” 36% ” ” is below 64%
” ” 37% ” ” is below 63%
” ” 38% ” ” is below 62%
” ” 39% ” ” is below 61%
” ” 40% ” ” is below 60%
” ” 41% ” ” is below 59%. And so on.

9 Commission on Reinsurance Accepted: the reinsurer generally allows

commission to the ceding company on a part of business ceded. This is
treated as expense of the reinsurer company.

9 Commission on Reinsurance ceded: the ceding company generally gets

commission for giving business under a reinsurance contract. It appears as
income in the revenue account of the ceding company.

b) Profit Commission

Profit commission is an additional commission percentage payable to a ceding

insurer on profitable treaties in accordance with an agreed formula. It is
therefore an incentive for ceding insurers to produce profitable business.

There are two types of profit commission statements:

9 Statements on Accounting Year basis and
9 Statements on Underwriting Year basis

Fire and Accidental proportional treaties are usually on an accounting year basis
while Marine and aviation, on underwriting year basis. Generally, only
proportional treaties provide for profit commission and non-proportional treaties
rarely contain a profit commission clause. When a treaty provides for profit
commission, the ceding insurer must prepare profit commission statement to see
whether the treaty is showing a profit or a loss.
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i) Profit Commission on Accounting Year Basis

A profit commission on Accounting Year basis requires all transactions for the
same treaty period without reference to the underwriting year, to be accounted
for in the same profit commission statement.
A typical example would include the Debit Items like Claims, Commissions,
Miscellaneous Charges, Premium Reserve Carried Forward, Loss Reserve
Carried Forward, allowance for Re-insurer’s Expenses and Credit Items like
Premium Reserve Brought Forward, Loss Reserve Brought Forward, Premiums
etc. A profit commission on an accounts year basis would not be adjusted in
subsequent years, as long as the treaty remains current.

Specimen Profit Commission statement on accounting year basis

Profit Commission statement on accounting year basis 01/01/03 to 31/12/03
First Surplus Fire Treaty with Y Re-insurer

Particulars Debit Credit

Premium Reserve B/f (Portfolio entry) as on 80,00,000
01/01/03
Loss Reserve B/F (Portfolio entry) as on 70,00,000
01/01/03
Premium 2,00,00,000
Commission (45% of premium) 90,00,000
Claims Paid 60,00,000
Taxes & Charges 5,00,000
Management expenses (2.5% of premium) 5,00,000
Premium Portfolio Withdrawal 35% as on 70,00,000
31/12/03
Loss Portfolio Withdrawal 35% as on 31/12/03 80,00,000
Profit for the year 2003 40,00,000
3,50,00,000 3,50,00,000
Calculation of profit commission
Average Profit
Profit for 2003 40,00,000
Profit for 2002 40,00,000
Profit for 2001 10,00,000
Average Profit 30,00,000
Profit Commission say 20% of average profit 6,00,000
(as per treaty)
 578

ii) Profit Commission on Underwriting Year Basis

A profit commission on an underwriting year basis requires all figures for the
same underwriting year, irrespective of the account year in which these are
included, to be related back to the same year for the purposes of determining the
profit of that underwriting year.

When this sort of commission statement is considered, the preparation of the first
statement is deferred until one year after the end of the underwriting year.
Readjustment statements are then rendered in accordance with treaty terms for
various liabilities occurred. Every treaty contains detailed provisions regarding
the close of the accounting books after a specified period and transfer of any
outstanding liability to the next open underwriting year so as to cover all
subsequent transactions relating to all preceding underwriting years for
determining profit commission.

Aggregate Annual Profit: Where a treaty covers more than one currency or
class of business, it is a normal practice to combine the results of each section of
the treaty or the results of more than one treaty to determine the aggregate annual
profit for calculation of profit commission.

Specimen Profit Commission statement on underwriting year basis

X Insurance Company Ltd.

Marine Quota Share Treaty with Y Re-insurer
Profit Commission Statement for the period from 01/01/04 to 31/12/04

Particulars Debit Credit

Premium Reserve B/f (Portfolio entry) as on 7,000
01/01/04
Loss Reserve B/F (Portfolio entry) as on 01/01/04 1,000
Premium 15,000
Commission (45% of premium) 6,750
Claims Paid 2,500
Taxes & Charges 500
Management expenses (5% of premium) 750
Premium Portfolio Withdrawal 50% as on 7,500
31/12/04
Loss Portfolio Withdrawal as on 31/12/04 3,000
Profit for the year 2004 2,000
23,000 23,000
 579

Statement of profit commission

30% profit commission - up to 10% of premium Rs.
10% on Premium 1,500
@30% on above - A 450
40% of Balance
Profit 2,000
Less : 10% Premium 1,500
Balance 500
@40% on Balance - B 200
Profit Commission (A+B) 650

Calculate profit commission from the following data:

Rs.
Premium for 2009 66,00,000
Claims paid in 2009 24,00,000
Portfolio entry:
- Premium 22,00,000
- Loss 40,00,000
Portfolio withdrawal:
- Premium 23,10,000
- Loss 40,00,000
Rate of Commission 40%
Management expenses 5%
Profit commission 25%

XYZ Insurance Ltd

Market Fire insurance pool

Profit as at 31/03/2004 20,25,000

Premium 35,37,000
Profit commission terms 15% Pc on Profit Up to 10% of Premium
& 75% of balance

Required:
Calculate profit commission.
 580

3.5 Provisions for Reinsurance Recoverable

Statutory accounting imposes "provisions” for Reinsurance Recoverable in

respect of:

9 Unsecured Recoverable from unauthorized reinsurers,

9 Unsecured Recoverable from slow-paying (authorized) reinsurers,
9 Overdue Recoverable from both authorized and unauthorized reinsurers, and
9 Recoverable others in dispute from unauthorized reinsurers and from non-
slow-paying Authorized Reinsurers.

On the statutory balance sheet, Reinsurance Recoverable on paid losses and

loss adjustment expenses are shown as an asset. Reinsurance Recoverable on
unpaid losses and loss adjustment expenses are shown as a contra-liability to
gross unpaid losses and loss adjustment expenses. Ceded unearned premium
reserves are shown as a contra-liability to gross unearned premium reserves. The
provision for reinsurance is a liability that relates to all of these items.

4. Discuss surplus treaty reinsurance and excess loss treaty

reinsurance.
[Learning Outcome d]

4.1 Surplus treaty reinsurance

Under the surplus treaty, the ceding insurer (direct insurer) decides the limit of
liability which he wants to retain on any one risk or class of risk. This limit is
called retention limit. If the sum insured under the policy is within the net
retention of the company, there will be no cession to the reinsurer. The surplus
over and above this retention is allotted to one or more insurers.

Surplus treaty insurance is usually arranged in terms of the number of lines of

retention. The amount retained by the the primary insurer (ceding company) is
also referred to as a line. The surplus treaty may thus be of ten or twenty lines
capacity. This means that the ceding company can assume cover on risks with
sums insured ten or twenty times its own retained line.
 581

A ceding insurer’s maximum retention limit may be Rs. 2,00,000/- on fire

insurance covering all cotton mills, jute mills and flour mills. Distribution of sum
insured between direct insurer & re-insurer will be as follows.

Computation of Reinsurance share under Surplus Treaty

Risk Total SI Ceding company’s share Reinsurance share

ABC 1,00,000 100.00% 1,00,000 0.00% Nil
BCD 2,00,000 100.00% 2,00,000 0.00% Nil
CDE 3,00,000 66.67% 2,00,000 33.33% 1,00,000
DEF 4,00,000 50.00% 2,00,000 50.00% 2,00,000
EFG 5,00,000 40.00% 2,00,000 60.00% 3,00,000
FGH 6,00,000 33.33% 2,00,000 67.67% 4,00,000
GHI 10,00,000 20.00% 2,00,000 80.00% 8,00,000
HIJ 20,00,000 10.00% 2,00,000 90.00% 18,00,000

Second Surplus Treaty

Generally, the amount ceded to a surplus treaty is expressed in terms of the

number of lines.

For example the ceding company’s retention limit is equal to one line. If the
ceding company eneters into a 5 line surplus treaty on the basis of a maximum
retention limit of Rs.1,00,000/-, it means that the total capacity of the treaty to
accept the liability over and above the retention limit would be Rs. 5,00,000 (5
lines x Rs. 1,00,000).

In other words, the ceding insurer would have the treaty protection for policy
having sum insured upto Rs. 6,00,000/.

If due to any reason the sum insured exceed the limits of the treaty i.e. Rs.
6,00,000, the ceding company has the option to bear the balance on its own
account (in addition to existing retention of Rs. 1,00,000) - or it may affect
further reinsurance. This further reinsurance may be effected through
facultatively reinsurance or by any other surplus treaty automatically. This
further surplus treaty is called Second Surplus treaty.

Surplus Treaty accounting incorporating the above example is framed in the

following manner under the accounting year system.
 582

Any Insurance Co may present the following terms under surplus treaty:
Portfolio
Treaty inception
Reinsurance share
Proportional cover
Commission
Profit commission
Rendering of accounts
Unearned premium reserve
Loss reserves
Marine as mentioned above
01/01/2004
5 lines surplus treaty
5,00,000 and 1,00,000 = 1 line
30%+ 0.5% if loss ratio < 42.5%
+ up to 7.5% if loss ratio < 28.5%
Difference: 0.5% commission for 1.0% loss ratio
Provisional commission during the year: 32.5%
Management expenses 3%
Profit commission 20%
Closing of books at 31 December
Deadlines: rendering of accounts 60 days,
Accounting currency INR
Payment currency INR
40%
Are entered at 100%

Let us understand the concept of surplus treaty with the help of a comprehensive
example:

Pristine insurance company entered into two surplus treaty contracts with
reinsurers.

9 The first surplus treaty consisted 10 lines with a maximum liability of Rs.
25,00,000.
9 The second surplus treaty consists of 20 lines with a maximum liability of
Rs. 45,00,000.

Risk Gross Sum Retention Applicable

Insured (Rs.) (Rs.)
1 4,00,000 2,00,000
2 14,00,000 3,00,000
3 28,00,000 4,00,000
4 70,00,000 2,00,000

Calculate the cessions to first surplus treaty.

Calculate the cessions to second surplus treaty.
 583

Risk Gross Sum Retention Cession to 1st Cession to

Insured (Rs.) (Rs.) Surplus 2nd Surplus
Treaty (Rs.) Treaty (Rs.)
1 4,00,000 2,00,000 2,00,000 Nil
2 14,00,000 3,00,000 11,00,000 Nil
3 28,00,000 4,00,000 24,00,000 Nil
4 70,00,000 2,00,000 20,00,000 40,00,000

In case of risk 4:

9 1st Surplus treaty being ten line, maximum risk transferred is Rs.20,00,000.
9 2nd Surplus treaty being 20 line, maximum risk transferred is Rs.40,00,000.
9 Balance of Rs. 8,00,000 has to be arranged through facultative reinsurance.

Reinsurance Premium: Premium is determined as per local practice, terms of

contract, class of business etc. In some, market premium means gross premium
and expenses, and fees taxes are accounted for separately while in other cases
(marine & aviation business) it is accounted for on a net basis. Consequently,
commission amount becomes relatively less in the second case.

4.2 Excess of Loss Treaty

Excess of loss treaty is also referred to as non-proportional reinsurance
arrangements. These treaties are characterized by a distribution of liability
between the primary insurer (or referred to as the cedant) and the reinsurer on the
basis of losses rather than sums insured. Unlike proportional treaties which focus
on sharing the size of risk, the focus of excess of loss treaties is on the size of the
loss.
Under an excess of loss treaty, the reinsurer only receives a part of the original
premium. Reinsurance premium is worked out on the basis of exposure and past
loss experience.

PQR Ltd has a capacity of retention of loss upto Rs.10,00,000 and purchases a
layer of reinsurance of Rs.40,00,000 in excess of its retention of Rs.10,00,000.
If a loss of Rs.30,00,000 were to occur, PQR Ltd would retain Rs.1 million of the
loss and would recover Rs.2 million from its reinsurer. Furthermore, PQR also
retains any loss exceeding Rs.50,00,000 unless it has purchased a further excess
layer of reinsurance.
 584

There are three general classes of excess of loss treaties:

1. Per Risk Excess Treaty

Risk excess treaties are generally entered into to reinsure loss in respect of
property claims. The retention and limit are decided separately for each risk
insured by the primary insurer.

PQR Ltd has issued a policy to insure commercial property risks for its clients
with policy limits of up to Rs.10 lakhs. PQR Ltd then buys per risk reinsurance
of Rs.5 lakhs with retention of Rs.5 lakhs. In case there is a loss of Rs.6 lakhs on
the policy, PQR Ltd can recover Rs.1 lakh from the reinsurer. In this way, PQR
Ltd can safeguard itself from individual risk by entering into per risk treaty
reinsurance.

2. Per occurrence excess

These treaties are designed to protect the reinsured against catastrophic events
that involve more than one policy. These treaties gives the primary insurer the
indemnity against loss sustained in excess of their net retention, subject to the
reinsurance limit. Unlike per risk excess treaty, these treaties cover all the risks
involved in respect of one accident, event or occurrence. This kind of reinsurance
when applied to property coverage is called catastrophe excess and when applied
to liability coverage is called clash cover.

An insurance company issues property policies with individual limits of these

policies up to Rs.5,00,000. It then buys catastrophe reinsurance of Rs.40,000,000
(in excess of Rs.30,00,000). In this case, the insurance company would be able to
recover from reinsurers in the event of multiple policy losses in one event (i.e.
due to catastrophes such as hurricane, earthquake, flood, etc.).
 585

3. Aggregate excess

Such treaties provide indemnity to reinsurers on an aggregate basis. The reinsurer

pays when a single loss or series of losses arising from a single event exceeds a
certain figure. Thus if all the claims which occur during a given year exceed a
certain percentage of the ceding company's premium, the reinsurer will pay all
amounts exceeding this figure.

Aggregate excess treaties also referred to as excess of loss ratio or stop loss
treaties

Excess of Loss Treaty for Rs.9,50,000 (excess Rs.50,000)

Year Premium Claims to be accounted for

(Rs)
2000 8,00,000 1 claim of Rs.60,000/- paid. Rs.10,000/- loss to treaty

2001 9,00,000 1 of 2000 of which Rs. 30,000/- paid and Rs. 90,000/-
outstanding. i.e. Rs. 70,000/- to treaty
1 of 2001 Rs. 70,000/- paid i.e. Rs.20,000 to treaty

2002 10,00,000 1 of 2000 estimated Rs. 2,40,000/- i.e. Rs. 1,90,000/- to

treaty
3 of 2001 estimated to Rs.80,000/- Rs.1,25,000/- &
Rs.1,80,000/- i.e. Rs.30,000/-, Rs.75,000/- &
Rs.1,30,000/- to treaty

2003 12,00,000 1 of 2000 estimated loss Rs.1,00,000/- i.e. Rs.50,000/- to

treaty
2 of 2001 estimated loss Rs.2,90,000/- & Rs.1,25,000/-
i.e. Rs.2,40,000/- & Rs.75,000/- to treaty
1 of 2002 estimated loss Rs.180000/- i.e. Rs.130000/- to
treaty

2004 15,00,000 1 of 2001 estimated loss Rs.170000/- i.e. Rs.120000/- to

treaty
2 of 2002 estimated loss Rs.3,10,000/- & Rs.1,80,000/-
i.e. Rs.2,60,000/- & Rs.1,30,000/- to treaty
1 of 2003 estimated loss Rs.1,90,000/- i.e. Rs.1,40,000/-
to treaty
 586

Prestige Ltd enters a 4 line first surplus treaty and 5 line second surplus treaty in
respect of their commercial property business. The company’s retention is
Rs.4,00,00,000 on any risk. The sum insured is given as follows:

Risks Sum Insured

1 4,00,000
2 14,00,000
3 40,00,000
4 70,00,000
Required:
Calculate the cessions to first surplus treaty.
Calculate the cessions to second surplus treaty.

4.3 Rating for excess of loss covers

The concept of “Burning Cost” is often used in the calculation of the rate for
excess of loss covers (either per risk or per policy).

This is arrived at by taking a fixed period and computing the ratio of claims paid
and outstanding for the share of the excess of loss to the gross net premium
income of the company for the period.

The burning cost ratio (or percentage) is used for determining premium rates for
excess of loss reinsurance.

Sometimes, an average is taken of these ratios (or percentages) and loading is

added to cover the reinsurance expenses and profit. Sometimes, reinsurance
accounts based on the above percentage may not consider certain aspects such as:

9 Claims still outstanding

9 IBNR Claims (incurred but not reported)
9 Increasing court awards and
9 Inflationary effect

Therefore, while computing the burning cost, all these aspects should be
considered with due adjustments to the accounting results.
 587

5. Discuss the reinsurance regulations in India.

[Learning Outcome e]
The placement of reinsurance business (both life and non-life) from the Indian
market is governed by IRDA (General Insurance - Reinsurance) Regulations,
2000 framed by the IRDA. The objective of the regulation is to maximize the
retention of premiums within the country.

Major guidance given in this regulation includes the following:

1. Every insurer should retain risk proportionate to its financial strength and
business volumes.

2. Every insurer shall cede such percentage of the sum insured on each policy
for different classes of insurance written in India to the Indian reinsurer as
may be specified by the Authority in this regard in accordance with the
Insurance Act, 1938.
3. The reinsurance programme will begin at the start of each financial year and
has to be submitted to the IRDA forty-five days before the start of the
financial year.

4. The Authority may call for further information or explanations in respect of

the reinsurance programme of an insurer and may issue necessary directions.

5. Within 30 days of the commencement of the financial year, every insurer

shall file with the Authority a photocopy of every reinsurance treaty slip and
excess of loss cover note in respect of that year together with the list of
reinsurers and their shares in the reinsurance arrangement.

6. Insurers must place their reinsurance business in excess of limits defined

outside India with only those reinsurers who have a rating of at least BBB
(with Standard & Poor or equivalent international rating agency) for the
preceding five years.

7. The treaty and balance risk after automatic capacity are to be first offered to
other insurance companies in the market before offering it to international re-
insurers.

8. Not more than 10% of reinsurance premium is to be placed with one re-
insurer.
 588

9. Every insurer shall be required to submit to the Authority statistics relating to

its reinsurance transactions in specified forms together with its annual
accounts.

For further details about these regulations, students may also refer to IRDA
(General Insurance - Reinsurance Regulations, 2000) issued by the IRDA in July
2000.

Summary
¾ Reinsurance is insurance for insurance companies.
¾ The purpose of reinsurance is to provide greater financial capacity to the
primary insurer to assume more risks.
¾ Reinsurance brokers act as an intermediary between the primary insurer and
reinsurers.
¾ Reinsurance arrangements are broadly divided into: Facultative reinsurance
and Treaty Reinsurance.
¾ When the business is not covered by the insurer’s reinsurance treaty, or the
amount of insurance needed exceeds the net treaty capacity of the primary
insurer, the primary insurer can transfer that excess to a facultative reinsurer.
¾ Reinsurance accounting is a process of identifying, analyzing and reporting
such financial data and results for the various groups of people interested in
reinsurance transactions for their various decisions.
¾ There are three major reinsurance accounting systems: Accounting Year
System, Occurrence Year System and Underwriting Year System.
¾ Reinsurance Commission is paid by the re-insurer to the ceding (direct)
insurer. Reinsurance commission may be fixed either on a: fixed scale or
sliding scale.
¾ Profit commission is an additional commission percentage payable to a
ceding insurer on profitable treaties in accordance with an agreed formula.
¾ Under the surplus treaty, the ceding insurer (direct insurer) decides the limit
of liability which he wants to retain on any one risk or class of risk. Surplus
treaty insurance is usually arranged in terms of number of lines of retention.
¾ Excess of Loss treaties are characterized by a distribution of liability between
the primary insurer (referred to as the cedant) and the reinsurer on the basis
of losses rather than sums insured. There are three general classes of excess
of loss treaties: Per Risk Excess, Per Occurrence Excess and Aggregate
Excess.
¾ The placement of reinsurance business (both life and non-life) from the
Indian market is governed by IRDA (General Insurance - Reinsurance)
Regulations, 2000 framed by the IRDA.
 589

Answers to Test Yourself

Answer to TY 1

The correct option is A.

Excess of loss describes a treaty condition stating that the insurer’s loss must
exceed a certain specified limit for the reinsurer to get involved.

Answer to TY 2

Division of sum insured, insurance premium and losses under a quota share
treaty

Orion Insurance Artis Total (Rs.)

Co.(Rs.) Reinsurance
Company (Rs.)
20% 80%
Policy 111
Sum Insured 80,000 320,000 400,000
Premium 320 1,280 1,600
Loss 20,000 80,000 100,000

Policy 112
Sum Insured 120,000 4,80,000 6,00,000
Premium 600 2,400 3,000
Loss 32,000 128,000 160,000

Policy 113
Sum Insured 160,000 6,40,000 8,00,000
Premium 680 2,720 3,400
Loss 36,000 144,000 180,000
 590

Answer to TY 3

Division of sum insured, insurance premium and losses under a surplus

share treaty

Orion Insurance Artis Reinsurance Total

Co. (Rs.) (%) Company (% ceded) (Rs.) (Rs.)
Policy 111
Sum Insured 400,000 (100%) NIL 400,000
Premium 1,600 NIL 1,600
Loss 100,000 NIL 100,000

Policy 112
Sum Insured 4,00,000 (66.67%) 2,00,000 (33.33%) 6,00,000
Premium 2,000 1,000 3,000
Loss 106,666 53,334 160,000

Policy 113
Sum Insured 4,00,000 (50%) 4,00,000 (50%) 8,00,000
Premium 1,700 1,700 3,400
Loss 90,000 90,000 180,000

Answer to TY 4

Profit commission account

Rs Rs
Commission @ 40% premium 26,40,000 Premium 66,00,000
Claims paid 24,00,000 Portfolio entry
Portfolio withdrawal - Premium 22,00,000
- Premium 23,10,000 - Loss 40,00,000
- Loss 40,00,000
Management expense @ 5% 3,30,000
Profit 11,20,000
Total 1,28,00,000 1,28,00,000

Profit Commission @ 25% on the profit of Rs.11,20,000 = Rs.2,80,000.

 591

Answer to TY 5

Calculate Profit Commission

Rs.
15% PC up to 10% on Premium
10% on Premium 3,53,700
@15% on above - A 53,055 (A)
75% of Balance
Profit 20,25,000
Less : 10% Premium 3,53,700
Balance 16,71,300
@75% on Balance - B 12,53,475(B)
Commission (A+B) 13,06,530

Answer to TY 6

Risk Gross Sum Retention Cession to 1st Cession to 2nd

Insured (Rs.) (Rs.) Surplus Surplus Treaty
Treaty (Rs.) (Rs.)
1 4,00,000 4,00,000 Nil Nil
2 14,00,000 4,00,000 10,00,000 Nil
3 40,00,000 4,00,000 16,00,000 20,00,000
4 70,00,000 4,00,000 16,00,000 20,00,000

In case of Risk 4, balance of Rs.30,00,000 has to be arranged through facultative

reinsurance.

Self Examination Questions

Question 1

A reinsurance contract under which the ceding company has the option to cede
and the reinsurer has the option to accept risk of a specific business line is called
______________

A Facultative reinsurance
B Treaty reinsurance
C Proportional reinsurance
D Optional reinsurance
 592

Question 2

Which of the following are the commissions involved in a reinsurance

transaction?

(i) Ceding commission

(ii) Brokerage commission
(iii) Settlement commission
(iv) Profit commission

A (i), (ii) and (iv)

B (i), (ii) and (iii)
C (i) and (ii)
D Only (i)

Question 3

The amount of liability the ceding company (primary insurer) keeps for its
account on a risk is known as:

A Retention
B Cession
C Retrocession
D None of the above

Question 4
The amount of retention of a Direct Insurer is also referred to as:
A Cession
B Retrocession
C Line
D None of the above

Question 5
Reinsurers also may reinsure some of the loss exposures they assume under
reinsurance contracts. Such a transaction is known as
A Cession
B Reinsurance portfolio
C Retrocession
D Pool arrangements
 593

Question 6

A reinsurance contract under which the reinsured company agrees to cede and the
reinsured agrees to assume a particular class or classes of Insurance business
automatically is referred to as:

A Inward reinsurance
B Retrocession
C Treaty
D None of the above

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is A.

A reinsurance contract under which the ceding company has the option to cede
and the reinsurer has the option to accept a risk of a specific business line is
called Facultative Reinsurance.

Answer to SEQ 2

The correct option is A.

Answer to SEQ 3

The correct option is A.

The amount of liability the ceding company (primary insurer) keeps for its
account on a risk is known as Retention.

Answer to SEQ 4

The correct option is C.

The amount of retention of a Direct Insurer is also referred to as Line.

 594

Answer to SEQ 5

The correct option is C.

Reinsurers also may reinsure some of the loss exposures they assume under
reinsurance contracts. Such a transaction is known as Retrocession.

Answer to SEQ 6

The correct option is C.

A reinsurance contract under which the reinsured company agrees to cede and the
reinsured agrees to assume a particular class or classes of Insurance business
automatically is referred to as Treaty.
 595

CHAPTER 4

ACCOUNTING METHODS AND PROCESS OF

SPECIAL ACCOUNTING TRANSACTIONS
UNIT 14

IRDA (INVESTMENT) REGULATIONS 2008

Chapter Introduction
Insurance companies deal with public funds. Therefore, insurers rely on the trust
of their policy holders. Hence, the investments of the insurance sector are
stringently monitored by the regulatory framework. The regulations aim to work
towards promoting the prevention of fraudulent practices and acting in the
interest of the policy holders. The Insurance Act, 1938 and the IRDA Act, 1999
are the fundamental legislations which deal with the insurance business in India.

This unit deals with only the regulatory aspects of investment functions of
general insurance companies, while investment accounting methods and
processes are discussed in the subsequent chapter (chapter 15).

a) Understand the manner in which General Insurance Companies make

investments.
b) Study the regulatory directives for investments by insurance companies.
c) Study the Exposure / Prudential Norms for investments by insurance
companies.
d) Explain the reporting requirements relating to investments.
e) Describe the constitution of the investment committee and its role.
f) List the approved investments under Schedule II to IRDA(Investment).
 596

The following is an extract from the annual report of IRDA, which relates to
the pattern of investments followed by non-life insurance

Non-Life insurers contributed to the extent of only 5 per cent of total investments
held by the insurance industry. The total investments of the sector, as on31st
March, 2011, stood at Rs. 82,520 crores. During2010-11, the net increase in
investments was Rs. 16,148 crores (24.33 per cent growth over previous year), up
from Rs. 66,372 crores in 2009-10.

Total Investments of Non-Life Insurers : Instrument-Wise

(As on 31st March)
Amount in Cr
Pattern of Investments 2010 2011
Total Percentage Total Percentage
Central Govt. Securities 16,038 24.16 19,865 24.07
State govt. and other
approved securities 6,971 10.5 8,191 9.93
Housing and Loans to State
Govt. for Housing and FFE 4,790 7.22 6,973 8.45
Infrastructure Investments 10,373 15.63 12,216 14.8
Approved Investments 24,256 36.55 31,769 38.5
Other Investments 3,944 5.94 3,506 4.25
Total 66,372 100 82,520 100

Note:

1. The Figures of 2010-11 are based on Provisional Returns filed with IRDA
2. Investments of CHNHB Association, ECGC and AIC of India have not been
included.
3. FFE: Fire Fighting Equipment.

(Source:http://www.irda.gov.in/)
 597

1. Understand the manner in which General Insurance

Companies make investments
[Learning Outcome a]

1.1 Regulators of Insurance business in India

Every insurer carrying on insurance or reinsurance business in India shall invest

and at all times keep invested his total assets as per provisions of Sec 27 or Sec
27A of the Insurance Act, 1938 and in the same manner as set out in specific
regulations framed by the IRDA.

In exercise of the powers conferred by sections 27A, 27B, 27D and 114A of the
Insurance Act, 1938, the Authority (IRDA) in consultation with Insurance
Advisory Committee, makes these regulations on Investments of insurance
companies. The Regulations originally framed by the IRDA are called the IRDA
(Investment) Regulations 2000, which have been amended now into IRDA
(Investment) (Fourth Amendment) Regulations 2008. Here we will discuss only
those regulatory aspects which are applicable to general insurance business. The
said regulation is meant for both life insurance business and non-life insurance
business.

1.2 Manner of Investments by General Insurance Companies

1. Investment assets mean all investments made out of shareholders’ funds

representing solvency margin and policyholders’ funds at their carrying value
as shown in its balance sheet drawn as per the IRDA (Preparation of
Financial Statements and Auditors’ Report of Insurance Companies)
Regulations 2002.

Solvency margin = Assets of an insurer - Liabilities

2. As per Regulation 4 (1) of the IRDA (Investment) (Fourth Amendment)

Regulations 2008, every insurer carrying on general insurance business shall
invest and keep invested their investment assets in the following manner;
 598

No Type of Investments Percentage

i) Government Securities Not less than
20% of
investment
assets
ii) Govt. Securities and other approved securities incl. i) Not less than
above 30% of
investment
assets
iii) Investments as specified in sec27B of the Insurance Act
1938 and Schedule II subject to Exposure / Prudential
Norms specified in Regulations 5;

a) Approved Investments and Other Investments Not exceeding

(out of ‘(iii)a’ ‘Other investments specified under 55%
27B(3) of the Act, shall not exceed 25% of the
Investment Assets)

b) Housing and Loans to State Govt for Housing and Not exceeding
Fire Fighting equipment by way of subscription or 5%
purchase of ;
1. Bonds/ debentures of HUDCO (Housing and
Development Corporation Limited) and National
Housing Bank
2. Bonds/debentures of Housing Finance Companies
either duly accredited by National Housing Banks
for house building activities or duly guaranteed by
Government or carrying current rating of not less
than ‘AA’ by a credit rating agency registered under
SEBI (Credit Rating Agencies) Reg,1999
3. Asset Backed Securities with underlying housing
loans , satisfying the norms specified in the
guidelines issued under these regulations

c) Investment in Infrastructure; Not less than

(Subscription or purchase of Bonds /Debentures, Equity 10%
and Asset Backed Securities with underlying
infrastructure assets would qualify for the purpose of
this requirement, Infrastructure facility shall have the
same meaning as given in IRDA (Registration of Indian
Insurance Companies) Amendment Regulations 2008)
 599

Clarifications on some important matters discussed in the table above

a) Government securities mean securities created and issued by the Central
Government or a State Government for the purpose of raising a public loan in
a form specified in the Public Debt Act 1944.
b) Approved securities include:
i) Government securities and other securities:
9 charged on the revenue of the Central / State Government or
9 guaranteed fully as regards principal and interest by the Central / State
Government
ii) Debentures / other securities for money issued under the authority of any
Central Act / Act of a State Legislature by or on behalf of a port trust /
municipal corporation / city improvement trust in any Presidency-town
iii) Shares of a corporation established by law and guaranteed fully by the
Central Government or the Government of a State as to the repayment of the
principal and the payment of the dividend
iv) Securities issued or guaranteed fully as regards principal and interest by the
Government of any Part B State and specified as approved securities for the
purposes of this Act by the Central Government by notification in the
Official Gazette
c) Infrastructure facility shall include roads, bridges, rail system, highway
projects, ports, water supply systems, telecommunication services.
3. Reinsurance Business
Reinsurance business functions on the same lines as direct insurance. In order to
spread risks, the insurer reinsures its own risks with reliable insurers.
Every insurer carrying on reinsurance business shall invest and at all times keep
invested his investment assets in the same manner as set out in 4(1) mentioned in
2 above, until such time separate regulations in this behalf are formed by the
Authority.

Solvency margin relates to:

A Liabilities of an insurer – Assets
B Assets of an insurer – liabilities
C Assets of an insurer
D Liabilities of an insurer
 600

2. Study the regulatory directives for investments by

insurance companies.
[Learning Outcome b]
The following are the regulatory directives for investments by insurance
companies:
1. Investments to be based on credit ratings
All investments in assets or instruments, which are capable of being rated
according to market practice, shall be made on the basis of credit rating of such
assets or instruments.

Investments shall not be made in instruments, which are not rated,

although they are capable of being rated.

2. Approved credit rating agencies

The rating should be carried out by a credit rating agency registered under SEBI
(Credit Rating Agencies) Regulations1999. For example CRISIL (India) and
ICRA are well known rating agencies.

Following is the list of various ratings provided by the agencies (for long term
instruments:

Rating Explanation
AAA Highest safety: lowest credit risk
AA High safety: very low credit risk
A Adequate safety: low credit risk
BBB Moderate safety: moderate credit risk
BB Moderate risk of default relating to timely servicing of financial
obligations
B High risk of default relating to timely servicing of financial
obligations
C Very high risk of default regarding timely servicing of financial
obligations
D Default / expected to be in default soon
Rating scale for short-term instruments: A1, A2, A3, A4 and D1
 601

3. Credit ratings to qualify as approved investments

Investments will be considered ‘approved investments’ if they meet the following

rating parameters:

Type of investment Minimum rating

Corporation bond / Debentures AA

Short term bonds, debentures, certificate of deposits and P1

commercial paper

Debt instrument issued by All India Financial Instruments AA

recognised as such by RBI

4. Other investments

Approved Investments which are downgraded below the minimum rating

prescribed should be automatically re-classified under “Other Investments”.

5. Parameters relating to investment in equity shares

Investments in equity shares listed on a registered stock exchange should be

made only if they are actively traded and liquid instruments i.e. equity shares
other than those defined as thinly traded as per SEBI regulations and guidelines
governing mutual funds issued by SEBI from time to time.

6. Rating parameters for debt securities

At least 75% of debt instruments excluding Government and Other Approved

Securities and Investment Assets shall have a rating of:

9 ‘AAA’ or equivalent rating for long-term and

9 PI+ or equivalent for short term investments

 602

7. Risk analysis and financial risk management

It is emphasized that rating should not replace appropriate risk analysis and
financial risk management process on the part of the insurer. The insurer should
conduct risk analysis commensurate with complexity of the products and the
materiality of their holding or could also refrain from such investments.

Investments in short term bonds will be considered ‘approved investments’ if

they have the minimum rating of:

A P1
B AA
C AAA
D A

3. Study the Exposure / Prudential Norms for investments

by insurance companies.
[Learning Outcome d]
Without prejudice to anything contained in Sec.27A and 27B of the Insurance
Act, 1938 every insurer shall limit his investments based on the following
exposure norms:

Exposure norms for life (including Unit linked business), General insurance
(including reinsurance) business for both approved investments as per the
Insurance Act, 1938, and as per provisions contained in Schedule I and II of
these regulations and other investments as permitted under 27A(2) and 27A(3) of
the Insurance Act, 1938.
 603

The exposure norms to be followed by both life insurance business and

general insurance business are as follows:

Type of Limit for Limit for entire Limit for

Investment Investee group of industry
Company Investee
Company
a) Investment in: 10% of:
9 Equity, 9 outstanding Investment by
9 Preference equity share the insurer in
Shares, (face value) any industrial
9 Convertible or; Not more than sector shall not
Debenture 9 investment 10% of exceed 10% of
asset, investment in its total
whichever is assets (including exposure to the
less in gen. reinsurer) industry sector
insurance

b) Investments in: 9 10% of the

9 Debts, paid-up share
9 Loans, and capital, free
9 Other reserves,
investment debenture,
permitted by bonds of
Act / investee
Regulation company or
9 10% of
investment
assets in
General
Insurance;
whichever is
less
 604

Diagram 1: Special notes on exposure norms

The exposure limit for the financial sector:

A Should be 25% of investment assets for general insurance business and 30%
for life insurance business
B Should be 25% of investment assets for all insurers
C Should be 30% of investment assets for all insurers
D Should be 30% of investment assets for general insurance business and 25%
for life insurance business
 605

4. Explain the reporting requirements relating to

investments.
[Learning Outcome d]
Investment returns to be submitted by insurers
Reg.6 of the Investment Regulation provides that the quarterly investment
returns should be submitted by every insurer to the Regulator.
Such quarterly investment returns shall be duly verified/ certified by CEO/ chief
of investment.
Diagram 2: Investment returns to be submitted by insurers

___________ investment returns are to be submitted by every insurer to the

regulator.

A Monthly
B Quarterly
C Annual
D Half yearly
 606

5. Describe the constitution of the investment committee

and its role.
[Learning Outcome e]
Reg.7 provides for the Constitution of the Investment Committee and its role,
which are briefly discussed below:

1. Members of the investment committee

Every insurer shall constitute an investment committee which shall consist of a

minimum of two non-executive directors, the CEO, chief of finance, chief of
investment decision and the appointed actuary.

2. Investment policy

Every insurer shall draw up, annually, an investment policy and place the policy
before the board of directors for approval.

3. Compliances relating to investment policies

While framing such policies, the board shall ensure compliance with the
following:

a) Adherence to regulations

The provisions of the Insurance Act 1938 and the IRDA (Investments)
Regulations 2000, guidelines and circulars in this respect need to be adhered to
on matters relating to:

9 liquidity
9 prudential norms
9 exposure limits
9 stop loss limits
9 security trading
9 management of investment risks
9 management of assets and liabilities
9 scope of concurrent and internal audit of investments and investment
statistics and
9 all other internal control of investment operations
 607

b) Aim of the policy

The policy must ensure adequate return on policyholders’ funds and

shareholders’ funds consistent with the protection, safety and liquidity of such
funds.

c) Invesment of funds

The funds of the insurer shall be invested and continued to be invested in equity
shares, equity related instruments and debt instruments keeping in view the
requirements of the Insurance Act 1938 and IRDA (Investments) Regulations
2008.

4. Implementation of investment policies

The investment policy as approved by the board shall be implemented by the

investment committee, which shall keep the board informed about its activities
and fund performance.

5. Periodicity of review of investment policies

The Board shall review the investment policy and its implementation on a half
yearly basis or at such short intervals as it may decide and make such
modification to the investment policy as is necessary to bring it in line with
investment provisions laid down in the Insurance Act and in investment
regulations.

6. Auditor’s role relating to investment policies

The details of the investment policy or its review as periodically decided by the
board shall be made available to the concurrent or internal auditor. The auditor
shall comment on such review and its impact on investment operations.
 608

7. Efficient internal control of investment functions and operations

In order to ensure proper internal control of investment functions and operations,

the insurer shall segregate the functions and operations of the front office, mid
office and back office.

8. Information to IRDA

The Authority may call for further information from time to time as it deems
necessary and in the interest of the policyholders.

The Board shall review the investment policy and its implementation on:

(i) a half yearly basis

(ii) an annual basis
(iii) at such short intervals as it may decide

A (i)
B (ii)
C (i) or (iii)
D (ii) or (iii)

6. List the approved investments under Schedule II to

IRDA (Investment) Regulations
[Learning Outcome f]
Schedule II of the IRDA (Investment) Regulation provides the following list of
approved investments for general insurance business for the purpose of sec 27B
of the Act:
 609

Diagram 3: Approved investments

The list of investments approved by IRDA under the powers vested in it

Under Section27B(i)(j) excludes:

A Loans secured under the Insurance Act

B Money market instrument defined in regulation 29cc)
C Short term bonds having a minimum credit rating of AA
D Commercial papers issued by a company
 610

Summary
¾ Every insurer carrying on insurance or reinsurance business in India shall
invest and at all times keep invested his total assets as per provisions of Sec
27 or Sec 27A of the Insurance Act, 1938 and in the same manner as set out
in specific regulations framed by the IRDA
¾ Solvency margin = Assets of an insurer – liabilities
¾ All investments in assets or instruments, which are capable of being rated
according to market practice, shall be made on the basis of credit rating of
such assets or instruments.
¾ Investments in equity shares listed on a registered stock exchange should be
made only if they are actively traded and liquid instruments.
¾ Exposure norms for life (including Unit linked business), General insurance
(including reinsurance) business for both approved investments as per the
Insurance Act, 1938, and as per provisions contained in Schedule I and II of
these regulations and other investments as permitted under 27A(2) and
27A(3) of the Insurance Act, 1938.
¾ Reg.6 of the Investment Regulation provides that the quarterly investment
returns should be submitted by every insurer to the Regulator.
¾ Such quarterly investment returns shall be duly verified/ certified by CEO/
chief of investment.
¾ Every insurer shall constitute an investment committee which shall consist of
a minimum of two non-executive directors, the CEO, chief of finance, chief
of investment decision and the appointed actuary.
¾ Every insurer shall draw up, annually, an investment policy and place the
policy before the board of directors for approval.
¾ The investment policy as approved by the board shall be implemented by the
investment committee
 611

Answers to Test Yourself

Answer to TY 1

The correct option is B.

Solvency margin = Assets of an insurer - liabilities

Answer to TY 2

The correct option is B.

Investments will be considered ‘approved investments’ if they meet the following

rating parameters:

Type of investment Minimum rating

Long term corporation bond / debentures AA
Short term bonds, debentures, certificates of deposit and P1
commercial paper
Debt instrument issued by All India Financial AA
Instruments recognised as such by RBI

Answer to TY 3

The correct option is B.

Answer to TY 4

The correct option is B.

Reg.6 of the Investment Regulation provides that the quarterly investment returns
should be submitted by every insurer to the Regulator.

Answer to TY 5

The correct option is D.

The Board shall review the investment policy and its implementation on a half
yearly basis or at such short intervals as it may decide.
 612

Answer to TY 6
The correct option is C.

The list of investments approved by the IRDA includes Short term bonds having
a minimum credit rating of P1 rather than AA.

Self-Examination Questions
Question 1
Which of the following are not the regulators of insurance business (relating to
investments) in India?

(i) The Insurance Advisory Committee

(ii) The IRDA
(iii) The Insurance act 1938
(iv) The IRDA (Investment) (Fourth Amendment) Regulations 2008

A (i) and (ii)

B (ii) and (iii)
C (ii) and (iv)
D (i) and (iv)

Question 2
Investment in infrastructure by an insurer carrying on general insurance business:

A Should not be less than 20% of investment assets

B Should not less than 30% of investment assets
C Should not be less than 10% of investment assets
D Should not exceed 5% of investment assets

Question 3
An investment policy should be drawn up by every insurer___________. The
same should be placed before the ______________ for approval.

A Once a year; board of directors

B Once a year; the CEO
C Once in five years; the chairman
D Once in six months; the board of directors
 613

Question 4

Every insurer carrying on general insurance business shall invest and keep
invested _________________ of its investment assets in government securities.

A At least 20%
B More than 20%
C More than 15%
D At least 30%

Question 5

The ratings on investments should be carried out by:

A A credit rating agency registered under SEBI (Credit Rating Agencies)

Regulations1979
B A credit rating agency registered under SEBI (Credit Rating Agencies)
Regulations1999
C Any credit rating agency
D A credit rating agency registered under The Insurance Act 1938

Answers to Self-Examination Questions

Answer to TY 1

The correct option is A.

In exercise of the powers conferred by sections 27A, 27B, 27D and 114A of the
Insurance Act, 1938, the Authority (IRDA) in consultation with the Insurance
Advisory Committee, makes these regulations on Investments of insurance
companies.

Points (iii) and (iv) contain regulations which provide guidance on investments
made by insurance business in India.
 614

Answer to TY 2

The correct option is C.

Investment in infrastructure by an insurer carrying on general insurance business

should not be less than 10% of investment assets.

9 Option A relates to Government securities.

9 Option B relates to Govt. Securities and other approved securities.
9 Option D relates to investments in housing and Loans to State Government
for Housing and Fire Fighting equipment.

Answer to TY 3

The correct option is A.

Every insurer shall draw up, annually, an investment policy and place the policy
before the board of directors for approval.

Answer to TY 4

The correct option is A.

Every insurer carrying on general insurance business shall invest and keep
invested not less than 20% of its investment assets in government securities.

Answer to TY 5

The correct option is B.

The rating should be carried out by a credit rating agency registered under SEBI
(Credit Rating Agencies) Regulations1999.
 615

CHAPTER 4

ACCOUNTING METHODS AND PROCESS OF

SPECIAL ACCOUNTING TRANSACTIONS
UNIT 15

INVESTMENT ACCOUNTING
Chapter Introduction
We have seen that investments are major assets in the balance sheet of an insurance
company. There is a specific regulation called IRDA (Investment) Regulations
2000 modified in August 2008. Keeping in view the major changes in the nature
and forms of investment of insurance companies in the open market, the regulator
has thoroughly amended the said investment regulation. At present, the regulation
in force is IRDA (Investment) (Fourth Amendment) Regulations 2008.

Accounting for investments in insurance business is governed by two Regulations

– one is IRDA (Investment) (Fourth Amendment) Regulations 2008 and the other
is IRDA (Preparation of Financial Statements and Auditor’s Report of Insurance
Companies) Regulations, 2002. Investment Accounting in other companies is
governed by Accounting Standard (AS)-13. Though AS13 is not applicable to
insurance business, for better understanding of investment accounting, the students
must have knowledge in respect of general accounting treatment of investment
governed by AS 13, in addition to thorough knowledge of the regulatory aspects
for investment process and accounting principles applicable to insurance
companies.

The Regulatory requirements for investment functions and accounting thereof are
discussed separately in unit 14. This unit deals with general investment accounting
with reference to the requirements of AS 13.
 616

a) Briefly explain classification of investments.

b) Explain how accounting of investments is done according to AS 13
Guidelines.
c) Show the preparation of investment account.
 617

1. Briefly explain classification of investments.

[Learning Outcome a]

As per AS 13, investments are assets which are held by an enterprise for earning
income by way of interest, dividends and rentals, for capital appreciation, or for
other benefits to the investing enterprise.

1.1 Classification of Investments and Valuation thereof

As per AS-13, investments may be either current Investments or long-term

Investments.

1. Current investments

Current investment is an investment which by its nature is readily realisable and

intended to be held for not more than one year from the date when such
investments are made.

These investments shall be carried in the financial statements at the lower of cost
and fair value. Market Value or Net Realisable Value (NRV) provides the base
for fair value.

Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s
length transaction. Under appropriate circumstances, market value or net
realisable value provides an evidence of fair value.

Market value is the amount obtainable from the sale of investments in an open
market, net of expenses.
 618

2. Long-term Investments

These are investments other than current investments. Long-term Investments are
held for more than one year from the date of their acquisition.

These are always valued at cost. However, if there is a decline of permanent nature
in the value of long-term investments, their carrying amount is to be reduced to the
declined value.

The carrying amount of long-term investments is always determined on an

individual basis, with reference to their market value, underlying assets of the
investee, and expected cash-flows from investments.

Any reduction in the carrying amount of investment is charged or debited to Profit

and Loss Account. Similarly, reversal of such reductions is credited to Profit and
Loss Account.

Investment valuation vis-à-vis determination of fair market value largely depends

on restrictions on distribution of income or disposable of investments.

Diagram 1: Classification of investments to be held

 619

2. Explain how accounting of investments is done according

to AS 13 Guidelines.
[Learning Outcome b]

Investments are assets held by an enterprise for earning income by way of

dividends, interest, rentals for capital appreciation, or for other benefits to the
enterprise.

Investments are either current investments or long-term investments. Long-term

investments may also include investment in property.

AS 13 provides the following guidelines in regard to investment accounting:

1. An enterprise shall disclose current investments and long-term investments

distinctly in the financial statements.

2. Further classification of current and long-term investments should be as per

norms specified in the statute or regulations as applicable to the enterprise. In
the absence of statutory or regulatory requirements, the investments shall be
further classified as:

a) Investments in Govt. or Trust Securities

b) Shares, Debentures and Bonds
c) Investment Property
d) Others-Specifying nature

3. Cost of an investment shall include acquisition charges such as brokerage,

fees and duties.
 620

Ishan Industries sought the advice of an Investment Advisor for investment of its
surplus funds worth Rs. 25,00,000. He advised investing in the shares of
Supreme Ltd and charged fees worth Rs. 8,000. Accordingly, Ishan Industries
invested in the 20,000 shares at the rate of Rs. 120 each and paid brokerage 2%.

The cost of acquisition will be calculated as follows:

Rs.
Prime Cost of shares (20,000 shares x Rs. 120) 24,00,000
Add: 2% brokerage (2% of Rs. 24,00,000) 48,000
Total Cost of shares 24,48,000
Add: Investment Advisor’s fees 8,000
Total cost of acquisition / cost of investment 24,56,000

If an investment is acquired by the issue of shares or other securities, the

acquisition costs shall be fair value of the securities. Again, acquisition cost varies
with the mode of acquisition of investment, for example, investment can be
acquired either through IPO or private placements, or through exchange.

When the investment or the shares are acquired through IPO (fresh issue of share
by the company), the acquisition cost will be the fair value of the securities, which
is equivalent to issue price as indicated or specified by the authority or issuer.

Market forces do not have any impact on the fair value of the securities acquired by
the IPO. However, when the shares are acquired in the secondary market, the fair
value of securities is decided by the exchange rate.

A separate investment account is made for each scrip purchased to determine the
profit and loss on that particular scrip.

4. Investment properties shall be accounted for as Long-term Investment.

5. Current Investments shall be carried in the financial statements at cost.

However, provision for diminution shall be made to recognise decline, if not
temporary.
 621

6. Reclassification of investments

Where investments are classified from current to long-term, transfers are made
at the lower of cost and fair value at the date of transfers. Where investments
are classified from long-term to current, transfers are made at the lower of cost
and carrying amount at the date of transfers.

Any reduction in the carrying amount or any reversal thereof should be

charged or credited to Profit and Loss Account.

7. When a part of investment is disposed of, the carrying amount is allocated to

the part on the basis of the average carrying amount of the total holding of the
investment, and the difference between the carrying amount and the disposable
proceeds is determined. Such difference, net of expenses, is recognised in the
Profit and Loss Account.

8. As the securities including shares, debentures etc. are held as stock in trade,
the costs of stock disposed of may be determined by applying appropriate
costing methods like FIFO, Average Price etc. which are used for valuation of
inventories as per AS 2 “Valuation of Inventories’.

9. Interests, Dividends and rentals received and receivable in connection with

an investment are recognised as income, being the return on investment. When
dividends declared on equity are declared from pre-acquisition profits, such
dividends shall be credited to the investment account.

10. Cost of Right Shares is added to the carrying amount of the original holding.
If rights are not subscribed for, but sold in the market, the sale proceeds are
taken to the Profit and Loss Account through Investment Account.

Investment properties shall be accounted for as _______________.

A Current investment
B Short-term investment
C Long-term investment
D Either current investment or long-term investment
 622

Which of the following statements are correct with regard to guidelines issued by
AS 13?

A An enterprise shall disclose current investments and long-term investments

jointly in the financial statements
B Cost of an investment does not include acquisition charges such as
brokerage, fees and duties
C Any reduction in the carrying amount of investments or any reversal thereof
should be charged or credited to Profit and Loss Account
D Long-term Investments shall be carried in the financial statements at cost

3. Show the preparation of investment account.

[Learning Outcome c]
Investment Accounting is done through maintaining a separate Investment
Account for each scrip purchased for holding and sale as trading.

The scrips purchased are divided into two classes:

1. Fixed- Income Bearing Securities (Scrips) and
2. Variable Income Bearing Securities (Scrips)

1. Fixed- Income Bearing Securities

Such securities are Govt. securities, bonds, foreign govt. securities, debentures etc.
In this type of scrip, the interest accrued from the date of the last payment to the
date of the transaction is calculated.

In case of transaction on “Ex-interest basis”

the amount of interest accrued till the date of Ex- interest and cum-
transaction has to be paid in addition to the price interest are discussed
of the security. In the Investment Account, the below in this Learning
amount of accrued interest from the date of the last Outcome, Paragraph 3.2
payment to the date of sale is credited in the Income Column.

2. Variable income bearing securities

These investments are also known as marketable investments. They include

investment in equity shares of a company.
 623

3.1 Investment Account

The investment account shows three components –Nominal Value, Capital or

Cost and Income on investment which are shown in three columns, Nominal
Column, Capital / Cost Column and Interest / Income Column in the Investment
Account.

1. Nominal Column: for recording the nominal value of investments

purchased, sold, bonus etc.

2. Cost/Capital column: for recording the costs of acquisition or purchase of

investments and sale proceeds of the investments sold and the profit or loss
on sale of investments.

3. Income / Interest Column: for recording the interest paid at the time of
purchase (Ex-interest / Cum-interest), Interest or Income received or
receivable on investments.

Diagram 2: Components of Investment A/c

 624

Format of investment account

Books of _ _ _ _ _ _ _ _ _

Investment Account for the period from _ _ _ _ _ _ _ to _ _ _ _ _ _ _

Security _ _ _ _ _ _ _ _ _ _ _ Interest due date/s _ _ _ _ _ _ _ _ _

Face value Rs. _ _ _ _ _ _ _ _

Dr Cr
Cost / Interest / Nominal / Cost / Interest /
Nominal /
Capital / Income / Face Capital / Income /
Date Particulars Face value Date Particulars
Principal Revenue value Principal Revenue
Rs.
Rs. Rs. Rs. Rs. Rs.
To Balance X X X By Bank sale / X X
b/d interest A/c
To Bank X X By Interest X
purchases A/c accrued on
investment A/c
To Profit and X X X By Balance c/d X X X
loss A/c
Total X X X Total X X X
 625

3.2 Other aspects, terms and procedures followed in the preparation of

investment account are discussed below in brief:

1. Opening balance

The investments in hand at the beginning of the year are to be shown as opening
balance on the debit side with Nominal value in the Nominal column and cost in
the cost column. Accrued interest, if any, up to the last closing date is to be brought
down in the Income Column.

The accrued interest arises only when the closing date does not coincide with the
date of payment of interest and such accrued interest is calculated on the closing
balance of the investment of the last period.

2. Cum-interest Purchase

Here, the price paid for acquisition includes the accrued interest on the securities
purchased for the period commencing from the last date of payment of interest to
the date of the transaction. So the investor is required to find out the cost of
investment and accrued interest due thereupon.

The transaction is to be recorded on the debit side with nominal value in the
Nominal column, accrued interest in the Income column and the cost in the Cost
column.

Journal entries

1. Investment A/c Dr (Quoted price – accrued interest)

Interest on investments A/c Dr (Accrued interest)
To Bank A/c (Quoted price)
(Being purchase cum-interest)

2. Bank A/c Dr
To Interest on investments A/c
(Being first interest received after
purchase)

3. Ex-interest Purchase

Brokerage and expenses are to be added to the price to ascertain the cost. The
nominal value is to be debited in the Nominal value column and the cost is to be
 626

debited in the Cost column. Simultaneously, for the interest from the date of
transaction to the next date of payment of interest less tax (if any), a contra entry
is to be passed (to capitalise the interest forgone) by debiting the cost column and
crediting the Income column.

Journal entries

1. Investment A/c Dr (Quoted price)

Interest on Investment A/c Dr (Accrued interest)
To Bank A/c (Quoted price + Accrued
(Being purchase ex-interest)

2. Bank A/c Dr
To Interest on Investment
(Being first interest received on
due date after purchase)

4. Cum-interest sale

Brokerage and expenses are to be first deducted from the price, then the accrued
interest from the last date of payment to the date of transaction less tax (if any) will
have to be deducted to ascertain the cost (i.e., capital income). The nominal value
and the cost are to be credited to the Nominal value column and Cost column
respectively, while the accrued interest less tax (if any) is to be credited to the
Income column.

Journal entry

1. Bank A/c Dr (Quoted price)

To Investment A/c (Quoted price – accrued interest)
To Interest (Accrued interest)
(Being sale of investment)

5. Ex-interest sale

Brokerage and expenses are to be deducted from the price to find out the cost or
capital income. The Nominal value and the capital income are to be credited to the
Nominal value column and cost column respectively.

The interest on investment from the date of transaction to the next date of payment
of interest less tax (if any) is to be treated as the capital income of the seller and
 627

hence, a contra entry is to be passed simultaneously, debiting the Income column

and crediting the cost column.

Disposal of Investments: in case the transaction is on ex-interest basis, the entire

sale proceeds are credited in the capital column and the amount of accrued interest
to the date of sale will be taken to the credit side in the income column.

Journal entries

1. Bank A/c Dr (Quoted price + Accrued interest)

To Investment A/c (Quoted price)
To Interest on Investment A/c (Accrued interest)
(Being sale of investments ex-
interest)

Profit on sale of investments

Investment A/c Dr
To profit on sale of (Ex-interest price (net) – Cost price)
investments
(Being profit on sale of
investments)

Loss on sale of investments

Loss on sale of investment A/c Dr (Cost price – Ex-interest price (net))
To Investment A/c
(Being loss on sale of investments)

6. Interest received

Whenever any interest is received less tax (if any), it has to be credited to the
Income Column.

While calculating the amount of interest, it must be seen that interest in respect of
ex- interest purchase before this interest-date but after the previous interest-date
shall not be received, while interest on ex- interest sale before this interest-date but
after the previous interest-date shall be received.

7. Accrued interest on the closing date

When the date of interest does not coincide with the closing date, the question of
accrued interest arises.
 628

Suppose the last date of interest was 31st October while the closing date is 31st
December. Interest on the closing balance of investment for November and
December less tax (if any) is the accrued interest on the closing date. This has to be
credited to the Income column on the closing date and brought down to the next
period in the debit side of the Income column.

8. Closing of Investment Transactions

a) After recording the various transactions as mentioned above, the closing

balance of the investment is to be valued.

b) The value of the closing balance is to be credited to the investment ledger

with nominal value and cost in the respective columns and these are to be
brought down at the beginning of the next period.

c) The Nominal value columns on both the sides will not agree; the difference
in the total of income columns (always credit balance) represents revenue
income to be transferred to the general Interest A/c or to the Profit and Loss
A/c.

d) Difference between the totals of the Cost columns represents profit or loss on
sale of investment (Dr Balance is loss and Cr balance is profit) to be
transferred to Profit and Loss A/c.

e) In the above discussion, we have mentioned that the closing balance of the
investment is to be valued.

The valuation may be done on any of the following principles:

9 At specific cost where the closing balance represents a specific
purchased investments.
9 At specific cost on the basis of FIFO i.e., investments purchased first are
sold first.
9 On average cost.
 629

Diagram 3: Ex-interest price and cum-interest price

While closing the investment account, what does the difference in the cost
column represent?

A Revenue income
B Profit or loss on sale of investment
C Balance of the Investment A/c
D None of the above

3.3 Investment in shares and Certain Transactions

1. Bonus shares received

Sometimes an investor in shares of a company receives bonus shares from the

company on the basis of his holding. Since bonus shares cost nothing to the
investor, the nominal value of such shares will have to be debited to the Nominal
value column and nothing will be debited to the Cost column.

The effect of the bonus shares received will be the reduction in the value of the
closing balance of investment.
 630

If a company has 10,000 equity shares each of Rs. 125 (i.e. Rs. 12,50,000) and it
receives bonus shares of 2,000, the closing balance of the investment would be
12,000 equity shares worth Rs. 12,50,000 only.

2. ‘Right shares’ purchased

Sometimes the investor (investing in shares) enjoys the right of purchasing some
new shares of the company through letters of right. He has an option to exercise
or not to exercise the right.

If he exercises the right, i.e. if he purchases some or all of the shares offered, the
total nominal value of the shares purchased will be debited to the Nominal value
column at the time of allotment while the cost is debited to the Cost column as and
when paid by instalment.

3. Surrender and acquisition of ‘Right’ to/from third parties

Sometimes the investor (in shares of a company), on receiving the letters of right,
sells some or all of the rights to a third party, who can, on authority of such letters
of right, purchase the shares offered by the company. Such transfer is a capital
income on the part of the investor and hence it has to be credited to the cost column
of his investment ledger. If, however, the investor purchases similar rights from
third parties, the price paid has to be capitalised by debiting the cost column of the
Investment ledger.

Investment in Equity Shares

On 1 April 2009, M/s. X Ltd purchased 10,000 equity shares of face- value of
Rs.100 each in ABC Ltd @ Rs.110 each from a broker who charged 2%
brokerage. 72 paise per Rs.100 as cost of share transfer stamps was incurred.

On 31 December 2009, Bonus was declared in the ratio of 2:1.

On 31 March 2010, M/s. X Ltd sold the bonus shares @ Rs. 90 per share to a
broker, who charged 2% brokerage.
 631

In The Books of M/S. X Ltd

Investment in Equity Shares in ABC Ltd A/c

Dr Cr
Date Particulars No. of Nominal Cost Date Particulars No. of Nominal Cost
shares Rs. Rs. shares Rs. Rs.
01.04.2009 To Bank 10,000 10,00,000 11,30,000 31.03.2010 By Bank 5,000 5,00,000 4,41,000
31.12.2009 To Bonus Shares 5,000 5,00,000 31.03.2010 By Balance c/d 10,000 10,00,000 7,53,333
31.03.2010 To Profit and Loss A/c 64,333
15,000 15,00,000 11,94,333 15,000 15,00,000 11,94,333

Workings

W1Cost of Acquisition of Shares

Rs.
Nominal Value 110.00
Brokerage 2% 2.20
Stamp Duty ( 0.72% of Rs. 110) 0.792
112.992
(Rounded off to Rs. 113)
Cost of 10,000 equity shares = 10,000 x Rs. 113 11,30,000

Note: Brokerage and stamp duty should be calculated on the nominal value / face value of the investment.
 632

W2 Sale Proceeds of Bonus Shares

Brokerage will be
Rs. deducted at the
Unit Price 90.00 time of sale.
Less: Brokerage @2% 1.80
88.20
Total Sales Price ( 5,000 shares x Rs. 88.82) 4,41,000
Bonus shares =
W3 Calculation of Profit on Sale of Bonus Shares 10,000 x ½ = 5,000

Rs.
Sales Proceeds 4,41,000
Less: Cost of Sales(11,30,000/ 15,000 x 5,000) 3,76,667
Profit on Sale 64,333

W3 Valuation of Closing Stock i.e. 10,000 Equity Shares on 31.03.2010

= Rs. 11,30,000/15,000 shares x 10,000 shares

= Rs. 7,53,333

Purchase and Sale of Debentures

On 1.4.2009, 9% 1500 Debentures of Rs 100 each in P and Y Ltd were held as

investment by XYZ Ltd at the cost of Rs 160000. Interest is payable on 30th Sept
and 31st December. On 1.8.2009, Debentures of Rs 60000 were purchased for Rs
52000 Ex-Interest and Rs 30000 at Rs 30600 Ex-Interest on 1.1.2010. On
1.3.2010, Debentures for Rs 20000 were sold for Rs 20300 ex-interest.

Show the Investment Account in the books of XYZ Ltd assuming that Accounts
are closed on 31st March 2010 every year.
 633

Solution

In The Books of M/S XYZ Ltd

Investment in Debentures of Rs100 each in P and Y Ltd A/c

Dr Cr
Date Particulars Nominal Capital Interest Date Particulars Nominal Capital Interest
1.4.2009 To Balance 1,50,000 1,60,000 1.8.09 By Interest (C) 900
1.8.2009 To Bank 60,000 52,000 30.6.2009 By Bank 6,750
1.8.2009 To Interest (C) 900 1.1.2010 By Interest (C) 675
1.1.2010 To Bank 30,000 30,600 By Bank Sale 20,000 20,300
1.1.2010 To Interest (C) 675 1.3.2010 By Interest 150
1.3.2010 To Capital (C) 102 31.3.2010 By Bank 9,450
Interest-6mths
31.3.2010 To Profit on Sale of 150 31.3.2010 By Balance c/d 2,20,000 2,23,827
Deb (Profit and
Loss)
To Profit and Loss 17,625
2,40,000 2,44,277 17,775 2,40,000 2,44,277 17,775

Workings

W1 1-8-2009 Ex-Interest Purchase for Rs. 60,000

Additional Cost being interest on Rs.60,000 for two months (1.8.09 to 30.9.09) debited to Capital column and credited to
Interest Column by Contra Entry for Rs. 900/-
 634

W2 30.6.09 Half-yearly Interest

9% on Rs. 1,50,000 = Rs. 6,750

No Interest on Ex-Interest purchase of Rs. 6,000 on 1.8.09 will be received

W3 1-1-10; Ex-Interest Purchase for Rs. 30,000 (nominal)

Additional Cost being interest on Rs 30000 for two months (1.1.10 to 31.3.10)
debited to Capital column and credited to Interest Column by Contra Entry for Rs
675/-

W4 1.3.10; Sale of Rs.20,000 - Debentures for Rs. 20,300 Ex-interest

Additional proceeds for interest for one month; Rs 150/-

W5 31.310; Half-yearly Interest: 9% on Rs 210000 (150000 +60000)= Rs 9450

No Interest on Ex-Interest purchase of Rs 20000 on 31.3.10 will be received.

Interest on Rs 20000 Debentures sold on 1.3.10 included in Interest on Rs 210000

W6 Valuation of closing Stock

Cost of Rs 240000 Debentures (150000+60000+30000) is Rs 244175; Cost of

balance Rs 220000 debentures is Rs 223827

Investment in Equity Shares

On 1.4.05, XYZ Ltd were holding 10000 equity shares of Rs 100each in M/s
ABC Ltd with acquisition cost of Rs 1250000. On 15.8.05 M/s ABC Ltd made a
Bonus issue of 1 fully paid share for every 2 held on 15.8.05. In addition, on the
same day, it declared a Right Issue of 3 for every 5 held on that date at a
premium of Rs 30; Rs70 to be paid on application and the balance in one call
after a month. Rights were exercised for 2000 shares. The balance shares were
sold on 25-8-05 @ Rs 20 per share. The shares were not eligible for dividend for
the year ended 31st March 2005. M/s ABC Ltd declared dividend @20% for the
year ended 31st March 2005.

Prepare the Investment Account in the books of XYZ Ltd

 635

Solution
In the books of XYZ Ltd
Investment Account –Equity Shares of M/s ABC Ltd

Dr Cr
Date Particulars Nominal Capital Income Date Particulars Nominal Capital Income
01.04.2005 To Balance b/d 10,00,000 12,50,000 25.08.2005 By Bank –Sale 80,000
of Rights (4000
@20)
15.08.2005 To Bonus Share 5,00,000 15.01.2006 By Bank – 2,00,000
Dividend 20%
on Rs1000000
15.08.2005 To Bank Right 2,00,000 1,40,000 31.03.2006 By Balance c/d 14,00,000 14,30,000
issue Appl Money
@70- 2,000shares
15.09.2005 To Bank Right 1,20,000
issue - Call
Money @60
15.09.2005 To Profit and Loss 2,00,000
A/c
Investment
income
17,00,000 15,10,000 2,00,000 17,00,000 15,10,000 2,00,000
 636

Workings

Total Rights: 10,000 x 2/5 6,000 shares

Rights Exercised 2,000 shares
Right Sold 4,000
shares

Investment in Equity Shares

Investments of M/s RCG Ltd in Equity Shares of LGS Ltd for 2008-09 are given
below:

9 1-4-08; had 2500 equity shares of Rs 100 with investment of Rs 200000

9 16-4-08; Sold for 500 shares for Rs 56000 cum-dividend
9 15-5-08; Received an interim dividend @ 2-1/2%
9 15-6-08; LGS Ltd made a bonus issue of 1:8 for shares held on 31.5.08
9 15-6-08; LGS Ltd resolved Right Issue of 1:10 on shares held on 31.5.08 for
Rs100 per share
9 For Right Issue, Rs 60 was payable on 26.7.08 with application and balance
on 26th Sept
9 Also resolved that shares under Bonus Issue or Right Issue are not eligible
for dividend for the year ending 31st March 2008.
9 Half of the Right Issue was utilized by making payments on scheduled dates
9 16-8-08; Other half of Rights has been sold for Rs 15 per share.
9 10-3-09; Final dividend @7-1/2% received
9 22-3-09; 750 shares sold for Rs 40000

Show Investment Account in the books of M/s RCG as on 31.3.2009.

 637

Solution
Investment Account; Equity Shares of LGS Ltd

Dr Cr
Date Particulars Nominal Capital Income Date Particulars Nominal Capital Income
1-4-08 To Balance b/d 2,50,000 2,00,000 16-4-08 By Bank-Sale of 50,000 56,000
500sh Cum-div
16-4-08 To Profit and 16,000 15-5-08 By Dividend 5,000
Loss A/c-Profit 2.5% on Rs 2
on sale of Invest lakhs
26-6-08 To Bonus Share; 25,000 16-8-08 By Bank - Sale of 1,500
250 shares Rights; Rs15 for
100shares
26-7-08 To Bank Right 10,000 6,000 10-3-09 By Bank; 15,000
Issue Appl. Dividend 7.5% on
Money Rs60 for Rs200000
100 share
26-9-08 To Bank- Call 4,000 22-3-09 By Bank-Sale of 75,000 40,000
money Rs 40per Investment
share
By Profit and 13,780
Loss A/c - Loss
on Sale
31-3-09 To Profit and 20,000 31-3-09 By Balance c/d 1,60,000 1,14,720
Loss A/c
Income for2008-
09
2,85,000 2,26,000 20,000 2,85,000 2,26,000 20,000
 638

Workings

W1 Profit on Sale of Investments on 16.4.2008: 500 Shares

Rs.
Sales Price 56,000
Less: Cost (2,00,000/ 2,50,000 x 50,000) 40,000
Profit 16,000

W2 Loss on Sale of 750 shares on 22-3-09 for Rs 40,000/-

Number of Shares before sale (2,500 – 500 + 250 + 100) 2,350 shares
Rs.
Nominal Value of 2350 Shares: 2,350 x 100 2,35,000
Cost of 2,350 Shares (2,00,000 - 40,000 + 10,000 – 1,500) 1,68,500
Average Cost of 750 shares (1,68,500/2,350 x750) 53,780
Less: Sales Price 40,000
Loss on sale 13,780

Investment in Equity shares

Investments of M/s RP Ltd in Equity Shares of LGI Ltd in 2008-09 are given
below:
9 1-4-08; had 2000 equity shares of Rs 100 with book value of Rs 320000
9 1-6-08; 500 shares purchased with a premium of Rs 40per share
9 2-8-08; LGI Ltd made a bonus issue of 1:5 for shares held
9 10-8-08; LGI Ltd declared Right Issue of 1:3 @ Rs150 per share
9 30-9-08; 50% of Rights exercised and balance sold for Rs 15per share on 20-
10-08
9 30-10-08; Received dividend @15% for 2007-08
9 1-11-08 Sold 2000 shares with a premium of 30 per share
 639

Solution
In the books of M/s RP Ltd
Investment Account- Equity Shares in LGI Ltd

Dr Cr
Date Particulars Nominal Capital Income Date Particulars Nominal Capital Income
1-4-08 To Balance b/d 2,00,000 3,20,000 20-10-08 By Bank –Sale 7500
2000 shares of Rights 500s
1-6-08 To Bank; 50,000 70,000 30-10-08 By Bank - 30,000
Purchase of Dividend@15%
500sh
2-8-08 To Bonus Share 50,000 1-11-08 By Bank -Sale 2,00,000 2,60,000
500s of 2000 shares
30-09-08 To Bank–Right 50,000 75,000 1-11-08 By Profit and 1,429
issue 500 shares Loss A/c -Loss
@ Rs. 150 on Sale
31-3-09 To Profit and 30,000 31-3-09 By Balance c/d 1,50,000 1,96,071
Loss A/c
3,50,000 4,65,000 30,000 3,50,000 4,65,000 30,000
 640

Workings

Rs.
Average Cost of 3500 shares (4,65,000 - 7,500)/3,500 130.71
Average Value of 2000 Shares sold (Stock in hand) 2,61,429.00
Less: Sales Price of 2000 shares 2,60,000.00
Loss on Sale 1,429.00

On 1.4.2012, Shatrujit Industries had 25,000 equity shares of Janta Ltd at a book
value of Rs. 15 per share (Face value Rs. 10). On 20.6.2012, he purchased
another 5,000 shares of Janta Ltd at Rs. 16 per share.

The directors of Janta Ltd announced a bonus and rights issue. No dividend was
payable on these issues. The terms of the issue are as follows:
9 Bonus basis 1:6 (Date 16.8.2012).
9 Rights basis 3:7 (Date 31.8.2012) Price Rs. 15 per share.
9 Due date for payment 30.9.2012

Shareholders can transfer their rights in full or in part. Accordingly, Shatrujit

Industries sold 1/3rd of his entitlement to Saroj for a consideration of Rs. 2 per
share.

Dividends: Dividends for the year ended 31.3.2012 at the rate of 20% were
declared by Janta Ltd and received by Shatrujit Industries on 31.10.2012.
Dividends for shares acquired by him on 20.6.2012 are to be adjusted against the
cost of purchase.

On 15.11.2012, Shatrujit Industries sold 25,000 equity shares at a premium of Rs.

5 per share. Assume that the books are closed on 31.12.2012 and shares are
valued at average cost.
 641

In the books of Shatrujit Industries

Equity shares of Janta Ltd

Dr Cr
Date Particulars No. Amount Date Particulars No. Amount

01.04.2012 To Balance b/d 25,000 3,75,000 30.09.2012 By Bank (Sale of Rights) 10,000

20.06.2012 To Bank – new shares 5,000 80,000 31.10.2012 By Bank (dividend on shares 10,000
purchased acquired on 20/6/2010)

16.08.2012 To Bonus 5,000 15.11.2012 By Bank (Sale of shares) 25,000 3,75,000

30.09.2012 To Bank (right shares) 10,000 1,50,000 31.12.2012 By Balance c/d 20,000 2,60,000

15.11.2012 To Profit 50,000

45,000 6,55,000 45,000 6,55,000

 642

Workings

W1 Bonus shares = (25,000 + 5,000)/6 =

5,000 shares Hence, rights shares of only
W2 Right shares = (25,000 + 5,000 + 10,000 will be debited to
5,000)/7 x 3 = 15,000 shares Investment A/c @ Rs. 15 and
W3 Right shares renounced = 15,000 x the amount of Rs. 10,000 will
1/3 = 5,000 shares be credited to Investment A/c
W4 Dividend received = 25,000 shares x Rs. 10 x 20% = Rs. 5,000
Dividend on shares purchased on 20.6.2012 = 5,000 shares x Rs. 10 x 20%
= Rs. 10,000 (adjusted to Investment A/c)
W5 Cost of shares on 31.12.2012

3,75,000 + 80,000 + 1,50,000 − 10,000 − 10,000

= x 20,000
45,000
= Rs. 2,60,000

Summary
¾ Investments may be classified as either current Investments or long-term
Investments in accordance with AS 13.
¾ Valuation
9 Current investments: lower of cost or fair value / NRV
9 Long-term investments: at cost
¾ Reclassification
9 Current investments to long-term investments: valuation at cost or fair
value / NRV, whichever is lower
9 Long-term investments to current investments: valuation at cost or
carrying amount, whichever is lower
¾ Any dividend received out of pre-acquisition profit is credited to Investment
A/c in the “cost column” only. However, dividend received out of post-
acquisition profit is credited to the “income column”.
¾ On disposal of investment, the difference between the carrying amount and
the net disposal proceeds should be charged or credited to the profit and loss
A/c.
¾ When rights shares offered are subscribed for, the cost of right shares is
added to the carrying amount of the original holding.
¾ Where an investment is acquired by way of issue of bonus shares, no amount
is entered in the capital column of investment account since the investor does
not have to pay anything.
 643

Answers to Test Yourself

Answer to TY 1

The correct option is C.

Investment properties shall be accounted for as Long-term Investment.

Answer to TY 2

The correct option is C.

Option A is incorrect because an enterprise shall disclose current investments and

long-term investments separately in the financial statements.
Option B is incorrect because cost of an investment shall include acquisition
charges such as brokerage, fees and duties.
Option D is incorrect because Current Investments shall be carried in the
financial statements at cost.

Answer to TY 3

The correct option is B.

Difference between the totals of the Cost columns represents profit or loss on
sale of investment (Dr Balance is loss and Cr balance is profit) to be transferred
to Profit and Loss A/C.

Self Examination Questions

Question 1

When dividends declared on equity are declared from pre-acquisition profits, such
dividends shall be ___________.

A Debited to Profit and Loss A/c

B Debited to Investment A/c
C Credited to Profit and Loss A/c
D Credited to Investment A/c
 644

Question 2

Profit on disposal of investment is:

A Credited to Investment A/c

B Credited to Revaluation Reserve
C Credited to Investment Fluctuation Fund
D Credited to Profit and Loss A/c

Question 3

Dividend received from pre-acquisition profit will _______ the average cost of
shares, and dividend received from post-acquisition profit will _______ the
income.

A Increase, reduce
B Reduce, increase
C Reduce, reduce
D Increase, increase

Question 4

Mr. Shah purchased 500 equity shares of Rs. 100 each in Parekh Ltd for Rs.
62,500, inclusive of brokerage and stamp duty.

At the end of six years, the company decided to capitalise its profits and to issue
to the shareholders of equity shares, one equity bonus share for every share held
by them.

Prior to capitalisation, the shares of Parekh Ltd. were quoted at Rs. 180 per share.
After the capitalisation, the shares were quoted at Rs. 92.50 per share. Mr. Shah
sold the bonus shares and received Rs. 90 per share.

What will be the cost of the closing investment (on average cost basis)?

A Rs. 46,250
B Rs. 50,000
C Rs. 31,250
D Rs. 45,000
 645

Question 5

On 1.4.2010, Ms. Kavita Puri purchased 1,000 equity shares of Rs. 100 each in
Tibco Ltd @ Rs. 120 each from a Broker, who charged 2% brokerage. She
incurred 50 paise per Rs. 100 as cost of share transfer stamps.

On 31.1.2011, Bonus was declared in the ratio of 1 : 2. Before and after the
record date of bonus shares, the shares were quoted at Rs. 175 per share and Rs.
90 per share respectively.

On 31.3.2011, Ms. Kavita Puri sold bonus shares to a Broker, who charged 2%
brokerage. Ms. Kavita Puri held the shares as Current assets, and the closing
value of investments shall be calculated at Cost or Market value whichever is
lower.

What will be the amount transferred to the Profit and Loss A/c?

A Rs. 3,100
B Rs. 11,100
C Rs. 4,000
D Rs. 900

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is D.

When dividends declared on equity are declared from pre-acquisition profits, such
dividends shall be credited to the investment account, in the capital column.

Answer to SEQ 2

The correct option is D.

Profit on disposal of investment is credited to Profit and Loss A/c.

 646

Answer to SEQ 3
The correct option is B.

Dividend received from pre-acquisition profit will reduce the average cost of
shares, and dividend received from post-acquisition profit will increase the
income.

Answer to SEQ 4
The correct option is C.
Investment A/c
Dr Cr
Particulars Nominal Cost Particulars Nominal Cost
To Bank 50,000 62,500 By Bank - sales 50,000 45,000
To Bonus shares 50,000 By Balance c/d 50,000 31,250
To Profit and 13,750
Loss A/c
1,00,000 76,250 1,00,000 76,250

The total cost of 1,000 equity shares (including 500 bonus shares) is Rs. 62,500
Hence,
The total cost of the closing investment: 500 equity shares = Rs. 31,250
Market price of the closing investment: 500 equity shares = Rs. 46,250

Cost being lower than the market price, shares are carried forward at cost.

Answer to SEQ 5
The correct option is A.

Date Particulars Nominal Cost Date Particulars Nominal Cost

2010-11 2010-11
1 Apr To Bank 1,00,000 1,23,000 31 Mar By Bank - 50,000 44,100
sales
31 Jan To Bonus 50,000 31 Mar By Balance 1,00,000 82,000
shares c/d
31 Mar To Profit 3,100
and Loss
A/c
1,50,000 1,26,100 1,50,000 1,26,100
 647

Workings

W1 Cost of equity shares purchased on 1 April 2010

Rs.
1,000 shares x Rs. 120 1,20,000
Add: 2% of Rs. 1,20,000 2,400
Add: 0.5% of Rs. 1,20,000 600
Cost of shares 1,23,000

W2 Sale proceeds of equity shares sold on 31 March 2011

Rs.
500 shares x Rs. 90 45,000
Less: 2% of Rs. 45,000 900
44,100

W3 Profit on sale of bonus shares on 31 March 2011

Rs.
Sale proceeds 44,100
Less: Average cost (1,23,000 x 50,000/1,50,000) 41,000
3,100

W4 Valuation of equity shares on 31 March 2011

Rs.
Cost (1,23,000 x 1,00,000/1,50,000 82,000
Market value (1,000 shares x Rs. 90) 90,000
Closing balance (lower of cost and market value) 82,000
 648

CHAPTER 5

ANNUAL REPORTS, AUDIT AND

INTERNATIONAL FINANCIAL REPORTING
STANDARDS
UNIT 16

ANNUAL REPORT OF A GENERAL

INSURANCE COMPANY
Chapter Introduction
For listed companies where ownership and control are generally separated,
shareholders have, in effect, delegated the running of the company to the
directors as their agents.

Good corporate governance is underpinned by good communication with

shareholders. This communication can be done formally through the AGM, the
annual report and through meetings with major and institutional shareholders.

The board of directors presents the annual report containing a report of the board
of directors along with audited financial statements, performance analysis and
projection for future to the members of the company. The report of the board is
presented in accordance with the provisions of Sec.217 of the Companies Act
1956 (Amendment).

The annual reports of insurance companies are of great use not only to members,
but also to policyholders, prospective customers, government, regulators,
reinsurers, other market players for various purposes including ascertaining the
financial strength and capacity, solvency margin, growth trend, combined ratio,
profitability, projections of the company and so on.

In this unit we will study the annual reports of general insurance companies.
 649

a) Understand the annual report and statutory provisions for general

insurance companies.
b) List the contents of an annual report.
c) List the disclosures to be made in the directors’ report in the annual
report.
 650

The following is an extract of the Director’s report from the annual report
of General Insurance Company for the period 2010 – 11
To the Members,
The Directors have the pleasure of presenting the Thirty-Ninth Annual Report on
the working and affairs of the Corporation and the audited statements of account
for the year ended 31st March, 2011.

Financial Results:

The highlights of the financial results for the year under review are as under:

(in Crores) (in Crores)

2010-11 2009-10 2010-11 2009-10

1 Net Premium 10,512.57 8,776.87 11 Distribution of 0.00 0.00

LPA Assets

2 Net Earned 9,544.03 8,076.43 12 Interest on 2.18 0.47

Premium Service Tax

3 Net Incurred 8,625.77 6,856.39 13 Profit before 1,189.35 1,290.20

Claims Tax (7+8+9-
10-11-12)

90.4% 84.9%

4 Net 1,926.35 1,930.25 14 Income-tax 155.94 (484.40)

Commission Deducted at
Source and
Provision for
tax incl.
deferred taxes

20.2% 23.9%
 651

5 Operating 96.43 69.98 15 Profit after 1033.41 1774.60

Expenses and Tax (13- 14)
Other Outgo
less
Other Income 1.0% 0.9%
6 Investment 1337.11 1211.17 16 Balance of 0.06 0.01
Income Profit b/f
Apportioned to from
Revenue less previous
expenses year
7 Total 232.59 430.98 17 Profit 1033.47 1774.61
Profit/Loss available for
(-)(2+6-3-4-5) appropriatio
n
8 Interest, 880.08 902.06 18 Proposed 240.68 411.16
Dividends and Dividend
Rents (gross) incl.
Dividend
Tax
9 Other Income 169.94 (18.75) 19 Transferred 792.73 1363.39
less Other to General
Outgo Reserves
10 Reserve for 91.08 24.09 20 Balance of 0.06 0.06
Doubtful Debts Profit carried
and Investment forward
incl. (15+16-18-
Amortisation of 19)
Investments
Written off

(Net Earned Premium is arrived at after adjustments for Reserve for Unexpired
Risks)
(Percentages relate to the net earned premium of the corresponding year)
 652

1. Understand the annual report and statutory provisions

for general insurance companies.
[Learning Outcome a]

Section 217 of The Companies Act 1956 provides guidance on the annual reports
and other statutory provisions for general insurance companies.

The following are the provisions:

Refer to case Study
1. Contents of report by board of directors of GIC provided at
the start of the unit!
There shall be, attached to every balance sheet laid
before a company in a general meeting, a report by
its Board of Directors with respect to the following;

a) The state of company’s affairs

b) The amounts, if any which it proposes to carry to any reserves in such
balance sheet.
c) The amount, if any which it recommends should be paid by way of dividend.
d) The material change and commitments, if any, affecting the financial position
of the company which have occurred between the end of the financial year of
the company to which the balance sheet relates and the date of the report.
e) The conservation of energy, technology, absorption, foreign exchange
earnings and outgo.

2. The Boards Report shall, so far as is material for the appreciation of the state
of company’s affairs by its members and will not in the Board’s Opinion be
harmful to the business of the company or of any of its subsidiaries, deal with
any changes, which have occurred during the financial year:
9 In the nature of company’s business
9 In the company’s subsidiaries or in the nature of business carried on by
them
9 And generally in the classes of business in which the company has an
interest.
 653

a) The Board’s Reports shall also include a statement showing the name of
every employee of the company who:

i) if employed throughout the financial year was in receipt of remuneration for

that year which, in the aggregate was not less than such sum as may be
prescribed; or

ii) If employed for a part of the financial year, was in receipt of remuneration
for any part of the year at a rate which, in the aggregate, was not less than the
sum as may be prescribed; or

iii) if employed throughout the financial year or part thereof, was in receipt of
remuneration in that year which, on the aggregate, or as the case may be, at a
rate which, in the aggregate, is in excess of that drawn by the managing
director or whole-time director or manager and holds by himself or along
with his spouse and dependent children, not less than two per cent of the
equity shares of the company.

b) The statement referred to in clause (A) shall also indicate:

i) whether any such employee is a relative of any director or manager of the

company and if so, the name of such director, and
ii) such other particulars as may be prescribed.

Explanation.—“Remuneration” has the meaning assigned to it in the explanation

to section 198.

Prescribed amounts dicussed above relate to:

9 Rs 2400000 (or more) per annum: for employees of the company employed
throughout the financial year, and were in receipt of remuneration for that
year,
9 Rs 200000 per month: for employees of the company employed for a part of
the financial year,
 654

Following is an extract relating to dividend, from the annual report of GIC

Housing Finance Ltd for the period 2010 – 11

None of the employees of the company were in receipt of remuneration in excess

of the limits as laid down under section 217(2A) of the Companies Act, 1956
read with Companies (Particulars of Employees) Rules, 1975 as amended from
time to time.

[(2AA) The Board’s report shall also include a Director’s Responsibility

Statement, indicating therein:

i) That in the preparation of the annual accounts, the applicable accounting

standards had been followed along with proper explanation relating to
material departures;

ii) That the directors had selected such accounting policies and applied them
consistently and made judgments and estimates that are reasonable and
prudent so as to give a true and fair view of the state of affairs of the
company for that period;

iii) That the directors had taken proper and sufficient care for the maintenance of
adequate accounting records in accordance with the provisions of this Act for
safeguarding the assets of the company and for preventing and detecting
fraud and other irregularities;

iv) That the directors had prepared the annual accounts on a going concern basis.
 655

Following is an extract of the Director’s responsibility statement from the annual

report of General Insurance Corporation for the year 2010 – 11:

Pursuant to the provisions of Section 217 (2AA) of the Companies Act, 1956, the
Directors confirm that:

1. In the preparation of the annual accounts, the applicable Accounting

Standards have been followed along with proper explanations relating to
material departures;

2. Appropriate accounting policies have been selected and have been applied
consistently, and judgments and estimates have been made that are
reasonable and prudent so as to give a true and fair view of the state of affairs
of the Corporation at the end of the financial year 2010-11 and of the profit
or loss of the Corporation for that period;

3. Proper and sufficient care has been taken for the maintenance of adequate
accounting records in accordance with the provisions of this Act for
safeguarding the assets of the Corporation and for preventing and detecting
fraud and other irregularities;

4. The annual accounts have been prepared on a going concern basis.

[(2B) The Board’s report shall also specify the reasons for the failure, if any, to
complete the buy-back within the time specified in sub-section (4) of section
77A]

1. The Board shall also be bound to give the fullest information and
explanations in its report aforesaid, or, in cases falling under the proviso to
section 222, in an addendum to that report, on every reservation, qualification
or adverse remark contained in the auditors’ report.

The diagram below mentions the various audit opinions and the causes for
modified reservation mentioned above:
 656

Diagram 1: Types of audit opinion

The above diagram can be summarised as follows:

9 When the audit opinion is true and fair, the auditor provides an
unmodified audit opinion.
9 When the audit opinion is not true and fair, the audit opinion is said to
have reservation, qualification or be adverse.

2. The Board’s report and any addendum thereto shall be signed by its chairman
if he is authorized in that behalf by the Board; and where he is not so
authorized, shall be signed by such number of directors as are required to
sign the balance sheet and the profit and loss account of the company by
virtue of sub-sections (1) and (2) of section 215.
 657

The balance sheet and profit and loss account of a company must be signed on
behalf of the Board of directors by two directors:

9 the managing director, (where there is one) and

9 the manager / secretary (if any).

The balance sheet and profit and loss account must be approved by the Board of
directors before they are submitted to the auditors for the purpose of audit. The
report of the auditors must be attached to the balance sheet and profit and loss
account.

3. If any person, being a director of a company, fails to take all reasonable steps
to comply with the provisions of sub-sections (1) to (3), or being the
chairman, signs the Board’s report otherwise than in conformity with the
provisions of sub-section (4), shall, in respect of each offence , be punishable
with imprisonment for a term which may extend to six months, or with fine
which may extend to [twenty] thousand rupees, or with both:

9 Provided that no person shall be sentenced to imprisonment for any such

offence unless it was committed wilfully:
9 Provided further that in any proceedings against a person in respect of
an offence under sub-section (1), it shall be a defence to prove that a
competent and reliable person was charged with the duty of seeing that
the provisions of that sub-section were complied with and was in a
position to discharge duty.

4. If any person, not being a director, having been charged by the Board of
directors with the duty of seeing that the provisions of sub-sections (1) to (3)
are complied with, makes default in doing so, he shall, in respect of each
offence, be punishable with imprisonment for a term which may extend to six
months, or with fine which may extend to [twenty] thousand rupees, or with
both, provided that no person shall be sentenced to imprisonment for any
such offence unless it was committed wilfully.
 658

Diagram 2: Provisions of section 217 of The Companies Act 1956 (in brief)
 659

Every balance sheet of an insurance company which is laid in the general

meeting contains:

(i) The state of company’s affairs

(ii) The amount paid by way of dividend
(iii) The details relating to conservation of energy
(iv) The details of all changes which occurred during the financial year in
respect of the nature and class of business of the company or its subsidiary

A (i), (ii), (iii) and (iv)

B (i), (ii) and (iii)
C (ii), (iii) and (iv)
D (i), (iii) and (iv)

2. List the contents of an annual report.

[Learning Outcome b]
An annual report contains information about the operation as well as the financial
performance of a company.

An annual report of a general insurance company generally includes the

following documents, data and particulars:
 660

Diagram 3: Contents of annual report

The information contained in an annual report of a general insurance company

contains:

A Information relating to the operations of a company

B Information relating to the financial performance of a company
C Information relating to the operations as well as the financial performance of
a company
D Information related to internal audit reports
 661

3. List the disclosures to be made in the directors’ report in

annual report.
[Learning Outcome c]
Directors Report of an insurance company generally furnishes the following
information specifically as per the above requirements of the Companies Act
1956:
1. Audited Financial Statements
2. Comparative Performance Analysis of the company:
9 Gross Direct Premium and percentage of growth over previous year
9 Net Incurred Claims
9 Reinsurance Premium Ceded
9 Reinsurance Accepted
9 Net Premium and percentage of growth over previous year
9 Increase in Unexpired Risks Reserve and percentage to net premium
9 Net Commission ; Net Premium Earned Percentage
9 Net Incurred Claims and percentage to Net Premium
9 Underwriting Results; Percentage to Net Premium
9 Investment Income apportioned; Percentage to Net Premium
9 Surplus/Deficit (-) in policyholders’ account; Percentage to Net
Premium
9 Profit –Before Tax and After Tax
9 Proposed Dividend
9 General Reserves and Current Year transfer of profit to that General
Reserve
9 Total Assets and contribution of increase of Fair value Change Account
9 Total Investments; composition /portfolio; increase over the last year
9 Solvency Margin and its change over the previous year
9 Compliance with Sec.40c in regard to prescribed percentage of expenses
9 Unexpired Risk Reserves; Percentage to Net Premium
3. Foreign operation details
4. Plans, Projections and Budget for the next year
5. Organizational Structure both domestic and foreign
6. Business Strategy (department wise)
7. Loss Control Measures
8. Claim Settlement and Age-wise Analysis of Outstanding Claims
9. Rural and Social Insurance schemes and performance
10. Customer Service
11. Grievance redressal
12. Reinsurance Policy and Programme
13. Information technology- Development and Projection
 662

14. HRM activities on Recruitment Training, social welfare activities, industrial

relation, etc.
15. Foreign Exchange Earnings and Outgo
16. Financial Rating
17. Corporate Governance with various Committee Reports such as Audit
committee, Investment committee, Remuneration committee.
18. Particulars of employees under section 217 (2A) of the Companies Act,1956
19. Adoption of the Accounts by Shareholders
20. Director’s Responsibility Statement

The following is an extract of the ‘Report of The Board of Directors’ of United

India Insurance for the period 2010 – 11:
Class-Wise Performance Summary
(in crores)
Year Fire Marine Misc. Total
Gross In India 2010-11 805.33 501.53 5069.80 6376.66
Direct
Premium
Percentage 23.47% 10.58% 22.66% 21.71%
Growth
2009-10 652.25 453.56 4133.24 5239.05
13.87% 34.62% 22.72% 22.47%
Outside 2010-11 0.00 0.00 0.00 0.00
India
2009-10 0.00 0.00 0.00 0.00
Total 2010-11 805.33 501.53 5069.80 6376.66
23.47% 10.58% 22.66% 21.71%
2009-10 652.25 453.56 4133.24 5239.05
13.87% 34.62% 22.72% 22.47%
Reinsurance In India 2010-11 68.00 12.35 625.30 705.65
Premium
Accepted
2009-10 37.25 11.04 509.75 558.04
Outside 2010-11 14.34 5.98 8.33 28.65
India
2009-10 18.25 7.65 5.06 30.96
Total 2010-11 82.34 18.33 633.63 734.30
2009-10 55.50 18.69 514.81 589.00
 663

Year Fire Marine Misc. Total

Reinsurance In India 2010-11 274.66 123.18 1243.03 1640.87
Premium
Ceded
2009-10 213.11 96.03 1032.18 1341.32
Outside 2010-11 102.93 147.55 102.67 353.15
India
2009-10 88.98 125.25 82.34 296.57
Total 2010-11 377.59 270.73 1345.70 1994.02
2009-10 302.09 221.28 1114.52 1637.89
Net In India 2010-11 598.67 390.70 4452.07 5441.44
Premium
Percentage 25.67% 6.01% 23.30% 22.12%
Increase
over
previous
year
Percentage 74.34% 77.90% 87.82% 85.33%
to Gross
Premium
2009-10 476.39 368.57 3610.81 4455.77
(2.39%) 36.58% 22.75% 20.44%
73.04% 81.26% 87.36% 85.05%
Outside 2010-11 (88.59) (141.57 (94.34) (324.50)
India )
25.25% 20.38% 22.09% 22.18%
0.00% 0.00% 0.00% 0.00%
2009-10 (70.73) (117.60 (77.28) (265.61)
)
1.84% 51.33% 83.91% 40.40%
0.00% 0.00% 0.00% 0.00%
Total 2010-11 510.08 249.13 4357.73 5116.94
25.74% (0.73%) 23.33% 22.12%
63.34% 49.67% 85.95% 80.24%
2009-10 405.66 250.97 3533.53 4190.16
(3.09%) 30.61% 21.86% 19.36%
62.19% 55.33% 85.49% 79.98%
 664

Corporate Governance report along with various Committee Reports is a part of

the disclosure to the:

A Director’s report
B Annual report
C External audit report
D Internal audit report

Summary
¾ Section 217 of The Companies Act 1956 provides guidance on the annual
reports and other statutory provisions for general insurance companies.

¾ There shall be, attached to every balance sheet laid before a company in a
general meeting, a report by its Board of Directors with respect to the
following;

9 The state of company’s affairs

9 The amounts, if any which it proposes to carry to any reserves in such
balance sheet.
9 The amount, if any which it recommends should be paid by way of
dividend.
9 The material change and commitments, if any, affecting the financial
position of the company which have occurred between the end of the
financial year of the company to which the balance sheet relates and the
date of the report.
9 The conservation of energy, technology, absorption, foreign exchange
earnings and outgo.

¾ An annual report contains information about the operation as well as the

financial performance of a company.

¾ Directors Report of an insurance company generally furnishes information

specifically as per the above requirements of the Companies Act 1956.
 665

Answers to Test Yourself

Answer to TY 1

The correct option is B.

Points (i), (ii) and (iii) include valid matters laid out in the general meeting along
with the balance sheet.

Point (iv) is incorrect as material changes, if occurred during the financial year in
respect of the nature and class of business of the company or its subsidiary, are to
be laid out in the general meeting along with the balance sheet.

Answer to TY 2

The correct option is C.

An annual report contains information about the operation as well as the financial
performance of a company.

Internal audit reports are management tools for ensuring efficient internal
controls. Therefore they are not part of public documents. However, if matters
contained in internal audit reports are important and relevant for the users of
financial statements, the external audit reports will contain such matters.

Answer to TY 3

The correct option is A.

 666

Self Examination Questions

Question 1

Annual reports of a Government company do not include:

(i) Tax audit reports
(ii) Segment reporting section
(iii) Minutes of all board meetings
(iv) Capital expenditure budget
(v) CAG reports

A (ii), (iii), (v)

B (i), (iii), (iv)
C (i), (ii), (iv)
D (ii), (iv), (v)

Question 2

Director’s reports are prepared:

A Monthly
B Quarterly
C Annually
D Half-yearly

Question 3

Guidance on the annual reports and other statutory provisions for general
insurance companies is provided in:

A Section 198 of The Companies Act 1956

B Section 217 of The Companies Act 1956
C Section 215 of The Companies Act 1956
D Section 77A of The Companies Act 1956
 667

Question 4

The Directors’ Responsibility Statement contains which of the following

matters?

A Proper explanations relating to all departures in the application of

accounting policies in the preparation of the annual accounts
B The results and estimates are absolute and correct so as to give a true and fair
view of the state of affairs of the company at the end of the financial year
C The reasons for the failure, if any, to complete the buy back within the time
specified in Sec.77A of the Act.
D The explanations of all important reservations, qualifications or adverse
remarks contained in the auditors’ report

Question 5

When the auditor provides a modified opinion, the opinion cannot be:

A Adverse
B Qualified
C A disclaimer of opinion
D True and fair

Question 6

If the financial statements of a general insurance company are not authorised by

officials mentioned in The Companies Act; the directors can be punished with
which of the following?
(i) imprisonment for a term which may extend to six months
(ii) fine which may extend to [twenty] thousand rupees

A (i)
B (ii)
C None of the above
D (i) and / or (ii)
 668

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is B.

Tax audit reports and capital expenditure budgets are not a part of annual reports.
Furthermore, only important matters discussed in the board meeting may be a
part of matters contained in the annual reports.

Answer to SEQ 2

The correct option is C.

Directors Report of an insurance company is prepared annually.

Answer to SEQ 3

The correct option is B.

Section 198 provides an explanation of ‘remuneration’.

Section 215 relates to the officials who are required to sign the financial
statements.

Section 77A relates to the timelines available for reporting reasons to complete
the buy-back.

Answer to SEQ 4

The correct option is C.

The other options are incorrect as the directors’ responsibility statement must:

9 Mention that in the preparation of the annual accounts, the applicable

accounting standards have been followed along with proper explanations
relating to material departure,
9 Mention that the results and estimates are reasonable and prudent so as to
give a true and fair view of the state of affairs of the company at the end of
the financial year and of the profit or loss of the company for that period,
9 Provide the fullest explanation on every reservation, qualification or adverse
remarks contained in the auditors’ report.
 669

Answer to SEQ 5

The correct option is D.

When the auditor provides an unmodified opinion, the opinion is true and fair.

Answer to SEQ 6

The correct option is D.

If the financial statements of a general insurance company are not authorized by

officials mentioned in The Companies Act; the directors can be punished with
imprisonment for a term which may extend to six months, or with fine which
may extend to [twenty] thousand rupees, or with both.
 670

CHAPTER 5

ANNUAL REPORTS, AUDIT AND

INTERNATIONAL FINANCIAL REPORTING
STANDARDS
UNIT 17

STATUTORY AUDIT IN GENERAL INSURANCE

BUSINESS
Chapter Introduction
Audit starts when accounts end. Insurance Business is subject to various audits
such as Statutory Audit, Internal Audit, Concurrent Audit, Operational Audit,
Underwriting Audit, Investment Audit etc.

Each of these audits has a role and objectives in:

9 improving the quality of insurance accounting and

9 exercising financial control over the fund management and financial
management of the insurance company

In PSU organisations, another important audit called CAG audit is also carried
out in addition to the above audits.

Therefore, the accountant must know the requirements of various audits to

ensure:
9 quality of accounts
9 complete accounts without audit objections, audit qualifications and
9 compliance with statutory and regulatory requirements in financial
accounting as well as in preparation and presentation of financial statements
keeping in view the interests of all users of financial statements.

This unit discusses the various aspects of statutory audit which will enable you to
carry out your function as an accountant even more effectively.
 671

Internal Audit is discussed in Unit 18. Again, International Financial Reporting

Standard (IFRS) 4 relating to accounting and auditing requirement has also been
discussed in brief in unit 19 in order to highlight the requirements of audit and
the quality of accounts.

a) Explain the management’s responsibilities towards financial statements.

b) Explain the auditor’s responsibilities towards financial statements.
c) Explain the specific areas where auditors are required to express
opinions.
d) Explain briefly the work of branch auditors.
e) Provide detailed audit programmes in the areas of:
i. Premium income
ii. Claim expenses
iii. Management expenses
iv. Investments
f) Understand the contents of audit reports.
For Mock Test Visit:
https://irdaexam.in/
 672

This unit discusses the content of audit reports (main report and long form audit
report). The following case study contains the main audit report of United India
Insurance Company Limited for the year 2010 -11.

Audit Report To The Shareholders Of United India Insurance Company

Limited

We have audited the attached Balance Sheet of United India Insurance Company
Limited as at 31stMarch 2011, the Fire, Marine and Miscellaneous Insurance
Revenue accounts, the Profit and Loss Account and Cash Flow Statement for the
year ended on that date annexed thereto, in which are incorporated accounts and
returns of 26 Regional Offices, 7 Large Corporate and Brokers Cells (LCBs) and
384 Divisional Offices audited by other firms of Chartered Accountants and an
Overseas run-off operations audited by an Overseas Auditor.

The Balance Sheet, the Revenue Accounts, the Profit and Loss Account and the
Cash Flow Statement have been drawn in accordance with Insurance Act, 1938,
Insurance Regulatory and Development Authority (IRDA) (Preparation of
Financial Statements and Auditor's Report of Insurance Companies) Regulations
2002 read with Section 211 of the Companies Act, 1956.

These financial statements are the responsibility of the Company's Management.

Our responsibility is to express an opinion on these financial statements based on
our audit. We conducted our audit in accordance with auditing standards
generally accepted in India. These standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatements. An audit includes examining, on a test basis, of
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis for
our opinion.

We report that:

We have obtained all information and explanations, which, to the best of our
knowledge and belief were necessary for the purpose of audit and found them to
be satisfactory;
 673

In our opinion, proper books of accounts as required by law have been kept by
the Company so far as appears from our examination of those books;
In our opinion, proper returns of Regional Offices, Divisional Offices, LCBs and
Overseas run-off operations, have been received and these were considered
adequate for the purpose of audit;

The Reports of the Auditors on the accounts of Regional Offices, Divisional

Offices, LCBs and Overseas run-off operations and such other particulars and
information thereon have been taken into consideration;

The Balance Sheet, Revenue Accounts, Profit and Loss Account and Cash Flow
Statement (Receipts and Payments Account) dealt with by our report are in
agreement with the books of accounts and returns;

The accounting policies of the Company are in accordance with the Accounting
Standards referred to in Sub-section (3C) of Section 211 of the Companies Act,
1956, to the extent applicable and with the accounting principles as prescribed by
the IRDA (Preparation of Financial Statements and Auditor's Report of Insurance
Companies)Regulations, 2002;

Section 274(1)(g) of Companies Act is not applicable as all Directors are

Government nominated directors;

The Company has valued its investments in accordance with the provisions of
IRDA (Preparation of Financial Statements and Auditor's Report of Insurance
Companies) Regulations 2002;

The actuarial valuation of Claims Incurred But Not Reported (IBNR) and Claims
incurred But Not Enough Reported (IBNER) has been duly certified by the
appointed actuary. The appointed actuary has certified to the Company that the
assumptions used for such estimate are appropriate and are in accordance with
the requirement of the Insurance Regulatory and Development Authority (IRDA)
and Actuarial Society of India in concurrence with IRDA. We have relied on the
appointed actuary's certificate in this regard.

In our opinion and to the best of our information and according to the
explanations given to us, the said accounts read with Significant Accounting
Policies and Notes thereon give the information as required by the Insurance Act,
1938, the Insurance Regulatory and Development Authority Act, 1999 and the
Companies Act, 1956 to the extent applicable in the manner so required, give a
 674

true and fair view in conformity with the Accounting principles generally
accepted in India.

In the case of the Balance Sheet, of the state of affairs of the Company as at 31st
March 2011;

In case of the Revenue Accounts, of the surplus/ (deficit) for the year ended 31st
March 2011;

In the case of the Profit and Loss Account, of the profit for the year ended 31st
March 2011; and

In the case of the Cash Flow Statement, of the receipts and payments for the
financial year ended 31stMarch 2011.

Emphasis of Matter

Without qualifying our opinion, we draw attention to Note No. 24 to the financial
statements, which describes unrecognized and unamortized Gratuity liability to
the extent of Rs.11280 Lakhs for the year ended 31-3-2011 pursuant to the option
granted by the Insurance Regulatory and Development Authority to all the
Insurance and Re-insurance Companies vide Circular No. IRDA/FandA/c
IR/ACT/069/04/2011 dated 18-04-2011 on the subject “Accounting Treatment of
Enhanced Provision of Gratuity”.

Further, we certify that:

We have reviewed the Management Reports and there is no apparent mistake or

material inconsistency with the financial statements.
The Company has complied with terms and conditions of the registration
stipulated by the IRDA.

To the best of our information and explanations given to us and representations

made by the Company, the Company is not the trustee of any trust.

We have verified cash and bank balances, investments and securities relating to
loans by actual inspection or by production of certificates and other documentary
evidences except in the case of investment referred to in Note No.10.
 675

The Company has complied with the instructions issued by the IRDA in relation
to the business transacted on account of motor third party commercial vehicles
pools and the investment of funds from that pool.

To the best of our information and explanations given to us and representations

made by the Company, no part of the assets of the Policyholders' Funds has been
directly or indirectly applied in contravention of the provisions of the Insurance
Act, 1938 (4 of 1938) relating to the application and investments of the
Policyholders' Funds.

For Anand and Ponnappan

ICAI FRN: 000111S
Chartered Accountants

For Kalyanasundaram and Co.

ICAI FRN:001676S
Chartered Accountants

For Manohar Chowdhry and Associates

ICAI FRN:001997S
Chartered Accountants

CA R. PonnappanPartner
(Membership No. 21695)

CA K.Rameshkumar, Partner
(Membership No.23962)

CA G.R.Hari, Partner
(Membership No.206386)

Chennai
28th April 2011
 676

1. Explain the management’s responsibilities towards

financial statements.
[Learning Outcome a]
Management is responsible for preparation and presentation of financial
statements that give a true and fair view of the state of affairs, results of
operation, and cash flows of the company in accordance with the required
provisions of the Companies Act, 1956, the Insurance Act, 1938, the IRDA
(Preparation of Financial Statements and Audit Report) Regulations 2002, and
the applicable Accounting Standards passed by the Institute of Chartered
Accountants of India.

The term “true and fair” is not defined in the Companies Act, but if the accounts
of an entity are prepared in accordance with the facts, correct principles and
applicable / accepted standards, the accounts are said to be true and fair.

In simple terms, we can say that truth means something factually correct and fair
means just, equitable and not misleading. So, the auditor needs to ensure that the
financial statements are not only factually correct but are also just and equitably
presented so as to be open and understandable, and in accordance with
accounting principles and standards.

Grand Insurers has had its accounts audited by its auditor. The motor car has
been depreciated over a period of ten years.

Mathematically, the auditor has made the calculations correctly but the useful life
of the motor car has not been estimated correctly. The useful life of the motor car
cannot be more than five years. Therefore, the financial statements are true but
are not fair - though arithmetically accurate; they mislead users about the position
of the motor cars.
 677

Diagram 1: Management’s responsibilities towards financial statements

The process and requirements of preparation of financial statements have been

discussed in detail in the foregoing units. Here we will discuss the process and
requirements of various audits in respect of financial statements of general
insurance companies.
 678

The financial statements prepared by the management must adhere to the

provisions of:

(i) The Companies act, 1956,

(ii) The Insurance act, 1938,
(iii) The IRDA (preparation of financial statements and audit report) regulations
2002
(iv) The applicable accounting standards passed by the ICAI

A (i), (iii) and (iv)

B (i), (ii) and (iii)
C (ii), (iii) and (iv)
D (i) to (iv)

2. Explain the auditor’s responsibilities towards financial

statements.
[Learning Outcome b]

2.1 Basic responsibility

An auditor’s responsibility is to express his opinion on the financial statements

based on audit examinations including vouching, verification, and examination of
the financial statements in accordance with various Auditing Assurance
Standards or Standard of Auditing issued by the Institute of Chartered
Accountants of India and keeping in view the requirements of the above-
mentioned statutes and regulations.

The auditor performs tests to obtain evidence of individual debits and credits that
make up an account in order to reach a conclusion about the account. The tests
can be made through tracing and vouching of transactions.
 679

Diagram 2: Vouching and tracing

Diagram 3: Auditor’s basic responsibilities

2.2 Statutory Auditor’s responsibility

The Statutory Auditors report to the members of the company in the specified
manner.

Statutory Audit is performed in accordance with the provisions of:

9 The companies Act, 1956,
9 The IRDA (Preparation of Financial Statements and Audit Report)
Regulations 2002 and
9 The Accounting Standards and Auditing Assurance Standards passed by the
Institute of Chartered Accountants of India.
 680

The statutory auditor verifies that insurance accounting has been completed in
accordance with the provisions of the above statutes and regulations. Insurance
audit is a special type of audit where the auditor is required to follow a set of
regulatory requirements and the relevant provisions of:
9 the Insurance Act 1938 as well as
9 the provisions of the Companies Act on accounts and audit.

2.3 Powers and duties of auditors in accordance with The Companies

Act 1956

Sec.227 of the Companies Act, 1956 provides the powers and duties of auditors.

Under the provisions of Section 227, every auditor shall:

1. inquire into the areas and aspects as specified by sub-section (IA) (for
example on the loans and advances made by the company).

2. report to the members of the company on:

9 the accounts examined by him and on every balance sheet (BS) and
profit and loss account (P and L A/c) and
9 on every other document declared by this Act to be part of or annexed to
the balance sheet or profit and loss account, which are laid before the
company ( for example whether BS and Pand L A/c are in accordance
with the Companies Act).

3. ensure that his report provides information and particulars as per regulatory
norms (for example whether the financial statements are true and fair)

2.4 Regulatory requirements (Schedule C of IRDA regulations) for

audit reports of insurance companies

This has been explained in detail in the next learning outcome.

Which of the following options contains inappropriate audit procedures?

A Vouching
B Verification
C Preparation of financial statements
D Examination of the financial statements in accordance with various auditing
assurance standards
 681

3. Explain the specific areas where auditors are required to

express opinions.
[Learning Outcome c]
The regulatory requirements for audit report in accordance with schedule C of the
Regulation called IRDA (Preparation of Financial Statements and Auditor’s
Report of Insurance Companies) Regulations 2002 are detailed below.

3.1 Specific Areas where auditors are required to express opinions

The auditors are required to express their opinions

on the financial statements including Balance Sheet, As mentioned above
Revenue Accounts, Profit and Loss Account and the the preparation of
Receipts and Payments Account of the insurance financial statements
company for the year ended, in which are audited by them is
incorporated a) Returns and Records of Regional the responsibility of
or Zonal Offices, b) Divisional Offices c) the company’s
Branch Offices, d) Foreign Branches as the case management!
may be, audited by the other auditors appointed by
the competent authority.

An auditors’ responsibility is to express an opinion on the financial statements

based on their audit.

The auditors shall express their opinion specifically on the following aspects as
required by the IRDA in the specified regulations and as required by the
provisions of the Sec.227 0f the Companies Act 1956.

1. Obtaining sufficient information and explanation

Whether they have obtained all the information and explanation, which, to the
best of their knowledge and belief, was necessary for the purposes of their audit
and found them satisfactory

2. Maintenance of proper books of account

Whether the insurer has maintained proper books of account so far as appears
from an examination of those books
 682

Proper books of account shall not be deemed to be maintained:

a) if books of accounts which are necessary to give a true and fair view of the
state of the affairs of the company (or branch office) are not maintained and
b) If books of account are not maintained on accrual basis and according to the
double entry system of accounting.

3. Agreement of financial statements with books of accounts and returns

The balance sheet, revenue accounts, profit and loss account and receipts and
payments account are in agreement with the books of accounts and returns.

4. Receipt of proper returns

Whether proper returns, audited or un-audited, from branches and other offices
have been received and whether they were adequate for the purpose of audit

5. True and fair view

9 Whether the balance sheet gives a true and fair view of the insurer’s affairs
as at the end of the financial year / period;
9 Whether the revenue account gives a true and fair view of the surplus or the
deficit for the financial year / period;
9 Whether the profit and loss account gives a true and fair view of the profit
and loss or the financial year / period;
9 Whether the receipts and payments account gives a true and fair view of the
receipts and payments for the financial year / period.

6. Preparation of financial statements in accordance with regulations

Whether the financial statements are prepared in accordance with the

requirements of the Insurance Act, 1938, the Insurance Regulatory and
Development Act, 1999 and the Companies Act, 1956, to the extent applicable
and in the manner so required

7. Valuation of investments in accordance with regulations

Whether investments have been valued in accordance with the provisions of the
Act and the specified Regulations
 683

8. Appropriateness and correctness of accounting policies

Whether the accounting policies selected by the insurer are appropriate and in
compliance with the applicable accounting standards and with the accounting
principles, as prescribed in the Regulations or any order or direction issued by the
IRDA in this behalf

The IRDA regulations require insurance companies to adhere to the following

accounting policies:
9 all accounting standards issued by the ICAI
9 all accounting policies mentioned under AS-1 issued by the ICAI

The following is an extract of the significant accounting policies of General

Insurance Corporation of India for the year 2010-11

Reserve for unexpired risk

Reserve for Unexpired Risk in respect of Marine Insurance and Terrorism Risk
Business (included in Fire and Engineering) is made at 100% of Net Premium,
while for all other classes of insurance, is made at 50% of Net Premium and for
London Branch as per local practice. Any additional provision as required by
IRDA shall be provided for foreign branches.

It is important to note that knowledge of the client’s accounting policies and the
laws and regulations applicable to the entity is vital to the auditor because the use
of inappropriate accounting policies leads to manipulations of the financial
statements. Without an adequate understanding of the laws and accounting
policies, the auditor is unable to judge whether or not the financial statements
give a true and fair view of the position of the entity.

9. Certification of review of management report

The auditors shall further certify that they have reviewed the management report
and there is no apparent mistake or material inconsistencies with the financial
statements; and that the insurer has complied with the terms and conditions of the
registration stipulated by the authority.
 684

The matters contained in the management reports of insurance companies relate

to whether the entity has complied with matters contained in Part IV of Schedule
B of The Insurance Regulatory and Development Authority (Preparation of
Financial Statements and Auditor’s Report of Insurance Companies) Regulations,
2002.

An illustration of points included in the report are provided in para 3.3.

It is a common notion that auditors are responsible for providing an opinion

relating to whether the financial statements are true and fair. However, we also
need to remember that the auditor needs to also take responsibility for matters
contained in the management reports.

10. Certification of verification of cash balances and securities

The auditors specifically certify that: they have verified the cash balances and the
securities relating to the insurer’s loans, reversions and life interests (in the case
of life insurers) and investments.

11. Verification of investment transactions

Generally, the following aspects are specified in their report after verification of
assets and liabilities and vouching of revenue and expenditure of the insurance
company:
9 they have verified the investments and transactions relating to any trusts
undertaken by the insurer as trustee; and
9 no part of the assets of the policyholders’ funds has been directly or
indirectly applied in contravention of the provisions of the Insurance Act,
1938 relating to the application and investments of the policyholders’ funds.

12. Compliance and application of accounting policies with regulations

In their opinion, the accounting policies selected by the company are appropriate
and are in compliance with the applicable accounting standards and with the
accounting principles, as prescribed in the IRDA Regulations.
 685

Diagram 4: Regulatory requirements (Schedule C of IRDA regulations) for

audit reports of insurance companies

The auditor shall express an opinion on:

(i) True and fair view of the financial position of the entity
(ii) The compliance of the terms and conditions of registration by the insurer
(iii) Selection of appropriate accounting policies by the insurer
(iv) The verification of cash balances
(v) Preparation of financial statements in accordance with regulations
(vi) Valuation of investments in accordance with regulations
(vii) The review of the management report

A (i),(ii),(iv) and (v)

B (i), (iii), (v) and (vi)
C (ii),(iv),(vi) and (vii)
D (iii), (v),(vi) and (vii)
 686

4. Explain briefly the work of branch auditors.

Provide detailed audit programmes in the areas of:
i. Premium income
ii. Claim expenses
iii. Management expenses
iv. Investments
[Learning Outcomes d and e]

4.1 Statutory Audit in Branch Office or Divisional Office

Branch auditor

According to the provisions of Sec.228 of The Companies Act 1956, where a

company has a branch office, the accounts of that office shall be audited by:
9 the company’s auditor appointed under section 224; or
9 a person qualified for appointment as auditor of the company under section
226.
Furthermore, where the branch office is situated in a country outside India, the
branch auditor could also be an accountant duly qualified to act as an auditor of
the accounts of the branch office in accordance with the laws of that country.

4.2 Major matters to be examined and commented upon by Branch

Auditor

The following are the important aspects which the branch auditor must consider
when devising an audit programme for the statutory audit of Branch/ Divisional
Office:
Premium income
a) Verification of recognition of premium income,
collection and accounting thereof keeping in view is discussed in
the corporate policy and regulatory norms. detail in Unit 10
Detailed audit procedures are explained in Para 3.3.

The auditor needs to confirm that:

9 premium income is accounted for on “ Net Premium Earned” basis and not
on “Gross Premium Collected” basis.
9 premium income is recognised at the time of receipt of cash.
 687

b) Verification of commission expenses incurred and accounting thereof

keeping in view the corporate policy and regulatory norms: For example, the
auditor confirms the adherence to TDS norms (with the provisions of Income
tax Act 1961) in respect of commission expenses incurred.

c) Verification of Claims Paid, Claims Outstanding and Claims Incurred, IBNR

(Intimated, but not reported) Claims and IBNER (Intimated, but not
sufficiently reported) claims.

“Incurred Claim”, ‘claims outstanding’ and ‘IBNR are discussed in detail in

Unit 10.

In respect of IBNRs, the auditor needs to check the records for the subsequent
period in order to confirm that adequate provisions have been created for such
claims.

d) Verification of settled claims with reference to settled claims files.

e) Verification of claims outstanding with reference to outstanding claims

register, survey report and management note on status of the outstanding
claims and also age-wise analysis of claims.

f) Verification of Management Expenses and accounting thereof.

Management expenses are explained in detail in unit 10. The auditor must
ensure that expenses of management should fall within the limits prescribed
by section 40C of the Insurance Act, 1938.

g) Appropriate treatment of capital expenditure and revenue expenditure. The

auditor needs to ensure that capital receipts and capital expenditure appear in
the Balance Sheet while revenue receipts and revenue expenditure appear in
the Profit and Loss A/c.

h) Budgetary Control

The establishment of budgets relating the responsibilities of executives to the

requirements of a policy, and the continuous comparison of actual with budgeted
results, either to secure by individual action the objective of that policy, or to
provide a basis for its revision.
The Institute of Cost and Management Accountants (CIMA)
 688

The auditors can pay extra attention to audit of cost centres and revenue
centres where unfavourable variances are noticed.

i) Reconciliation of inter-office balances and availability of balance

confirmations for their necessary comments on certain balances on the
financial statements.

j) Availability or verification of the historical / weighted average cost of listed

and unlisted equity/equity related instruments / preference shares, the value
of which was impaired on or before 31.03.2000 and the consequent impact of
impairment losses recognized in profit and loss / revenue account.

k) Availability or verification / reconciliation of reinsurers’ balances and

balance confirmations and its consequent impact on the financial statements.

l) The accounting of Tax Liability in Foreign Countries is proper and in

accordance with the Accounting Standard

m) Adequacy of Internal Audit and Control System and corporate governance

(Internal audit is discussed in detail in unit 18).

n) Procedure followed for amortization of expenses on account of pension,

gratuity and leave encashment under voluntary retirement schemes if any,
and whether in accordance with Accounting Standard 15.

o) Whether there is any change in Accounting policy; If yes, the impact of such
policy on the financial results exhibited by the Financial Statements during
the year

p) Written representation from the management with respect to any fraud

attempted / detected during the year under audit.

q) Examination of written representation obtained from the management.

r) Examination of the confirmation certificate of all bank balances (both

operative as well as non-operative).

s) Customer balance confirmation certificate with respect to receivables.

t) Verification of loans and advances given to employees and recovery thereof

in the year under audit.
 689

u) Audit Of Investments – acquisition, sale, valuation and returns as pre

regulatory norms, requirements and statutory provisions. Audit of
investments is discussed in the next learning outcome.

v) Valuation methods adopted for real estate investment. Real estate property is
valued at historical cost less accumulated depreciation and impairment loss.

w) Physical verification report of fixed assets if any conducted by the

management during the period under audit.

x) Verification of amounts payable in respect of provident fund, income tax,

investor education and protection dues, employees state insurance, wealth
tax, sales tax, service tax, custom duty, excise duty and any other material
statutory dues outstanding for more than 6 months from the date on which
they become payable.

y) Verification of details of related party transactions, if any, entered into during

the year. Related party transactions are explained in detail in unit 3.

4.3 Detailed audit programme on important areas of insurance

business which are required to be conducted by the Branch or DO
auditor

1. Examination of premium income

Purpose of procedure Audit procedure (in respect of premium income

booked by the operating office (OO))
Adhere to matching Whether premium has been recognized by OO as
principles as well as income over the contract period of risk or the period
proper cut-off of revenue. of risks, whichever is appropriate.

Whether a ‘reserve for unexpired risks’ has been

created as the amount representing that part of the
premium written which is attributable to, and to be
allocated to the succeeding accounting periods
Whether unearned premium has been shown
separately as Current Liabilities; importantly,
premium received in advance shall not be included
in the unearned premium.
 690

Purpose of procedure Audit procedure (in respect of premium income

booked by the operating office (OO))
Classification under Whether unearned premium received in advance,
appropriate which represents premium income not relating to the
headings in the FS current accounting period, has been disclosed
separately in the financial statements.

Whether premium received in advance, which

represents premium received prior to the
commencement of the risk, has been separately
shown under the head ‘Current Liabilities’ in the
financial statements.
Appropriate valuation Whether necessary changes based on actuarial/
and accounting of technical evaluation has been made to the liability
liability for contracts exceeding four years.

Whether Premium Deficiency has been recognized

when the sum of expected claim costs, related
expenses and maintenance costs exceeds related
unearned premiums.

2. Examination of claim expenses

Purpose of procedure Audit procedure

Classification and a) To confirm that:
accounting under i) the components of the ultimate cost of claims to
appropriate an insurer comprise:
headings in the FS 9 the claims under policies and
9 specific claims settlement costs
ii) claims under policies comprise:
9 the claims made for losses incurred, and
9 those estimated or anticipated under the
policies following a loss occurrence

iii) all claims relating to Health/ Mediclaim are

transferred from Float account and booked in
claims ledger account

b) the float account shows only the deposit amount.

The auditor needs to verify that steps have been
taken to reconcile at the year end
 691

Purpose of procedure Audit procedure

Completeness of liability c) Whether the liability for outstanding claims in
account respect of both direct business and inward
reinsurance business has been brought to
account
d) Whether all the claims have been recorded in the
books of accounts and not kept outside the
books for any reason whatsoever
e) Whether reserves have been made for IBNR
(Claims Incurred, but not Reported) and IBNER
(Claims Incurred, but not Enough Reported)
f) Whether the TPA claims provisions have been
made as per the statements received from the
TPA
Accuracy of expenses g) Whether the accounting estimate includes claims
cost adjusted for estimated salvage value if there
is sufficient degree of certainty of its realization
h) Whether estimate of claims made in respect of
contracts exceeding four years have been
recognised on an actuarial basis.

3. Examination of Management Expenses

Purpose of procedure Audit procedure

Accuracy of expenses a) To confirm that the competent authority has
approved all management expenses
Classification and b) To confirm that:
accounting under 9 the items of management expenses in excess of
appropriate one per cent of net premium or Rs500000 (or
headings in the FS any other amount as per corporate policy )
whichever is higher have been shown separately
9 any expense of revenue nature has not been
incorrectly recorded as capital expenditure
9 all expenses incurred, but not paid have been
duly accounted for under the relevant head and
shown separately as current liabilities
 692

4. Investments audit

Purpose of procedure Audit procedure

To verify existence of To verify the certificates or other documents
ownership evidencing the ownership of securities.
Appropriateness of To confirm that:
method of accounting 9 the method of accounting (e.g. cost or market
value) is appropriate, having regard to the
requirements of the company
9 the method of accounting is consistently applied
9 the financial statements disclose the method of
accounting followed
Valuation of investments
a) Real Estate- To confirm that:
Investment Property 9 investment property has been measured at
historical cost less accumulated depreciation and
impairment loss (residual value being considered
zero and no revaluation being permissible)
9 the Insurer has assessed at each balance sheet
date any impairment of the investment property
occurred
9 impairment losses are recognized as expenses in
the Revenue / Profit and Loss Account
immediately
9 Whether the Fair value as at the balance sheet
date and the basis of its determination has been
disclosed in the financial statements as
additional information
b) Debt Securities To confirm that the debt securities including
government securities and redeemable preference
shares have been considered “ held to maturity”
securities and have been measured at historical cost
subject to amortisation
c) Equity Securities and To confirm that:
Derivative 9 the listed equity securities and derivative
Instruments that are instruments that are traded in active markets
traded in active have been measured at fair value as at the
markets balance sheet date
9 the insurer has assessed on each balance sheet
date whether any impairment of listed equity
security / derivative instruments has occurred
(an active market shall mean a market where the
 693

securities traded are homogenous, availability of

willing buyers and willing sellers is normal and
the prices are publicly available)
9 the unrealized gains/ losses arising due to
changes in the fair value of listed equity shares
and derivative instruments have been taken to
equity under the head ‘ Fair Value Change
Account’
9 the profit on sale of investments or loss on sale
of investments, as the case may be, includes
accumulated changes in the fair value previously
recognised in equity under the heading fair value
change account in respect of a particular security
and being recycled to profit and loss account on
actual sale of that listed security
9 the debit balance in the said fair value change
account has been reduced from the profits / free
reserves while declaring dividends
9 the insurer has assessed, at each balance sheet
date, whether any impairment has occurred
9 the impairment loss has been recognised as an
expense in revenue / profit and loss account to
the extent of the difference between the
remeasured fair value of the security /
investment and its acquisition cost as reduced by
any previous impairment loss recognised as
expense in revenue / profit and loss account to
the extent of the difference between the
remeasured fair value of the security /
investment and its acquisition cost as reduced by
any previous impairment loss recognized as
expense in the revenue/ profit and loss account
9 any reversal of impairment loss, earlier
recognised in revenue / profit and loss account
has been recognised in revenue / profit and loss
account
d) Unlisted and other To confirm that:
than actively traded 9 the unlisted equity securities, derivative
Equity Securities and instruments and listed equity securities and
Derivative derivative instruments that are not regularly
Instruments : traded in the active market have been measured
at historical costs.
 694

Management Report for Statutory Auditor

Management Report, Year 2009-10

By the Regional or Divisional Head in ABC General Insurance Company

1. We confirm that all the dues payable to the Statutory Authorities have been
duly paid;

2. We certify that the values of all the assets have been reviewed on the date of
preparation of Trial Balance and that in our belief the assets set forth in the
Trial Balance are shown in the aggregate at amounts not exceeding their
realisable or market value under the several headings- “Loans”,
“Investments”, “Agents balances”, “Outstanding Premiums”, “Interest,
Dividends and Rents outstanding”, “Interest, Dividends and Rents accruing
but not due”, “Amounts due from other persons or Bodies carrying on
insurance business”, “Sundry Debtors”, “Bills Receivable”, “Cash” and the
several items specified under “Other Accounts”.

3. Statement of ageing of claims indicating the trends in average claim

settlement time during the financial year has been prepared and enclosed.

4. It is hereby confirmed:

i) That in the preparation of financial statements, the applicable Accounting

Standards, principles and policies have been followed along with proper
explanations relating to material departures, if any;

ii) That the management has adopted accounting policies and applied them
consistently and made judgments and estimates that are reasonable and
prudent so as to give a true and fair view of the state of affairs of the
Divisional Office at the end of the financial year and of the operating
profit or loss of the Divisional Office for the year.

iii) That the management has taken proper and sufficient care for the
maintenance of adequate accounting records in accordance with the
applicable provisions of the Insurance Act, 1938 (4 of 1938)/Companies
Act, 1956 (1 of 1956), for safeguarding the assets of the company and for
preventing and detecting fraud and other irregularities;
 695

iv) That the management has prepared the financial statements on a going
concern basis.

v) That the management has ensured that an internal audit system

commensurate with the size and nature of the business exists and is
operating effectively.

Date Divisional/ Regional In-Charge

Real Insurers carries out non-life insurance business. The company is an Indian
company having branches in Sri Lanka and Bangladesh. J.K. Shah can be
appointed as the auditor for the Bangladesh branch if:

(i) He is the companies auditor appointed under section 224 of the Companies
Act

(ii) He is qualified for appointment as auditor of the company under section 226

(iii) He is qualified for appointment as auditor of the company in accordance with

the laws of Bangladesh

(iv) He is qualified for appointment as auditor of the company in accordance with

international laws

A (i) or (ii) or (iii)

B (i) or (ii)
C (i) or (iii)
D (i) or (ii) or (iii) or (iv)
 696

5. Understand the contents of audit reports.

[Learning Outcome f]
Audit Reports

Audit reports are prepared and submitted by the Branch Auditor or Statutory
auditor keeping in view statutory, regulatory and auditing standards. Audit
Reports are of basically two types:
9 Main Reports and
9 Long-form Reports.

5.1 Main Reports

Main reports are prepared in certain specified formats with expression of the
auditor’s opinion on true and fair view of operating results as shown by income
statement and true and fair view of the profits and losses.

Main Audit Report

1. AUDITORS’ REPORT (Main Report) generally given by Branch Auditors

(Chartered Accountants) appointed by CAG is given below as an example

Name of Chartered Accountants Firm Date of Report

Contents of Report (Example)

We have audited the attached Financial Statements and Schedules of -------

Divisional / Branch Office of ABC Insurance Co. Ltd., as at 31st March 2011
and obtained all the information and explanations, which to the best of our
knowledge and belief were necessary for the purposes of our audit and found
them satisfactory.

We conducted our audit in accordance with auditing standards generally accepted

in India. These standards required that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by the
management as well as evaluating the overall financial statements presentation.
We believe that our audit provides a reasonable basis for our opinion.
 697

We report that:

a) We have obtained all the information and explanations, which to the best of
our knowledge and belief were necessary for the purposes of our audit and
found them satisfactory;
b) Proper books of account as required by law have been maintained by the
Company, so far as appears from our examination of those books.
c) Proper returns, audited or un-audited, from branches and other offices have
been received and they were adequate for the purposes of our audit.
d) The financial statements, receipts and payments accounts, trial balance along
with schedules dealt with by the Report are in agreement with the books of
account and returns which are extracted from the books of account of the
Divisional Office and are prepared in accordance with the requirements of
the Insurance Act, 1938 (4 of 1938), the Insurance Regulatory and
Development Act, 1999 (41 of 1999) and the Companies Act, 1956 (1 of
1956) to the extent applicable and in the manner so required and the closing
circular of the Head office of the Company.
2. Subject to our observation mentioned hereunder, proper provisions have been
made for all known liabilities including claims at the closing date. (List of
observation)
3. The accounting policies selected by the Company are appropriate and are in
compliance with the applicable accounting standards and with the accounting
principles, as prescribed in IRDA Regulations or any order or directions
issued by the Authority in this behalf.
4. We have reviewed the management report and there is no apparent mistake
or material inconsistencies with the financial statements.
5. We have verified the cash balance during the course of our audit.
6. Disclosures forming part of financial statements have been duly verified by
us.
7. Subject to our observation mentioned in point No.2 above in our opinion and
to the best of information and according to the explanations given to us:
a) The financial statements dealt with by this Report read together with
schedules, significant accounting policies and disclosures give a true and fair
 698

view in conformity with the accounting principles generally accepted in India

as applicable to Insurance Companies.
9 the state of affairs of the Divisional/ Branch Office as at 31st March
….and
9 the operations of Divisional /Branch Office for the year ended 31st
March….
b) The receipts and payments account gives a true and fair view of the receipts
and payments for the year ended 31st March …….
Date …………………….. Signature of Auditor
Chartered Accountants

5.2 Long-form Report by Branch

Auditors; Branch audit
means ‘other than
Long-form reports (LFAR) provide information audit by statutory
on process lapses including underwriting, claims, auditor in HO’.
accounts, internal control, investments etc.

Long-form Report by Branch Auditors generally provides information or

auditors’ observations on the following aspects:

9 Observation on non-compliance by Divisional / Branch Office, of accounts

closing circular, in connection with annual closing of accounts with Cases of
non-compliance or partial compliance.
9 Cases of cheques dishonoured where the relevant risks covered have not been
cancelled from inception
9 Cases where there have been violations of Sec.64VB of the Insurance Act,
1938.
9 Status of large Outstanding claims—with cause-wise and year-wise analysis
9 Comments on satisfactory provisions on MACT Claims
9 Observations on Bank Reconciliations. Whether all bank accounts have been
reconciled with bank statements with balance confirmation certificate
9 Comments on stale cheques; cheques issued which are outstanding for more
than six months are required to be transferred to stale cheques account.
9 Comments on inter-office reconciliation; mentioning the inter office
Accounts not reconciled.
9 Comments on adequacy of Internal Audit and adequate internal control
systems for proper functioning of operations of divisional office and
branches.
 699

9 Comments on action taken on the qualifications given in the previous

statutory audit report
9 Comments on service tax recovery and deposits; whether the service tax
amount is recovered each month on all taxable policies with the required in
the specified format.
9 Comments on submission of underwriting returns in the specified formats as
per instructions issued by head office technical department from time to time
for reinsurance being dealt at head office level.
9 Whether the total of premium, claims paid and outstanding claims reflected
in the underwriting returns and forms of various department tallies with the
figures mentioned in the audited accounts of premium, claims paid for the
year and claims outstanding at the year end.
9 Whether the figures of premium, claims paid for the year and claims
outstanding at the year-end are properly bifurcated viz. IBNR, IBNER, etc. in
the underwriting returns and forms for reinsurance accounting being dealt at
head office level
9 Comments on adequacy of provision made for all outstanding claims at the
year end
9 Comments on disposal of salvage system-whether salvage register has been
updated; whether there is an effective control system of collecting,
accounting and disposal of salvage within reasonable time
9 Whether co-insurance balances from / to other companies are reconciled
9 Whether the fixed assets register is updated
9 Was there an impairment of assets as per Accounting Standard 28
“Impairment of Assets? If yes, particulars / details relating to assets impaired
are to be furnished.
9 Whether the Divisional / Branch Office has complied with Accounting
Standard 29 “Provisions, Contingent liabilities and Contingent Assets”. If
yes, details regarding provisions, contingent liabilities or contingent assets
are to be furnished
There may be many other aspects which may find a place in LFAR of Insurance
Branch Audit.

Information relating to process lapses including underwriting, claims, accounts,

internal control, investments etc. is provided in:
A Internal audit reports
B Long-form reports (LFAR)
C Main audit reports
D Management reports
 700

Summary
¾ Management is responsible for preparation and presentation of financial
statements that give a true and fair view of the state of affairs, results of
operation, and cash flows of the company.
¾ An auditor’s responsibility is to express his opinion on the financial
statements based on audit examinations of the financial statements in
accordance with various Auditing Assurance Standards.
¾ Every auditor shall report to the members of the company on the financial
records examined by him and ensure that his report provides information and
particulars as per regulatory norms.
¾ Where a company has a branch office, the accounts of that office shall be
audited by the company’s auditor appointed under section 224 or a person
qualified for appointment as auditor of the company under section 226.
¾ Audit reports are prepared and submitted by the Branch Auditor or Statutory
auditor keeping in view statutory, regulatory and auditing standards.
¾ Main reports are prepared in certain specified formats with expression of the
auditor’s opinion on true and fair view of operating results as shown by
income statement and true and fair view of the profits and losses.
¾ Long-form reports (LFAR) provide information on process lapses including
underwriting, claims, accounts, internal control, investments etc.

Answers to Test Yourself

Answer to TY 1

The correct option is D.

Management is responsible for preparation and presentation of financial

statements that give a true and fair view of the state of affairs, results of
operations, and cash flows of the company in accordance with the required
provisions of the Companies Act, 1956, the Insurance Act, 1938, the IRDA
(Preparation of Financial Statements and Audit Report) Regulations 2002, and
the applicable Accounting Standards issued by the Institute of Chartered
Accountants of India.
 701

Answer to TY 2

The correct option is C.

Management is responsible for preparation and presentation of financial
statements that give a true and fair view of the state of affairs.

Answer to TY 3

The correct option is B.

Points (ii), (iv) and (iv) contain matters which are certified by the auditor.

Answer to TY 4

The correct option is A.

According to the provisions of Sec.228 of The Companies Act 1956, where a
company has a branch office, the accounts of that office shall be audited by: the
company’s auditor appointed under section 224; or a person qualified for
appointment as auditor of the company under section 226.
Furthermore, where the branch office is situated in a country outside India, the
branch auditor could also be an accountant duly qualified to act as an auditor of
the accounts of the branch office in accordance with the laws of that country.

Answer to TY 5
The correct option is B.

Long-form reports (LFAR) provide information on process lapses including

underwriting, claims, accounts, internal control, investments etc.

Self Examination Questions

Question 1

Financial statements are said to be true when they are:

A Just
B Factually correct
C Equitable
D Not misleading.
 702

Question 2

An auditor performing insurance audit is required to follow a set of regulatory

requirements and the relevant provisions of which of the following?

(i) The Insurance Act 1938

(ii) The provisions of the Companies Act on accounts and audit
(iii) The Accounting Standards passed by the ICAI.

A (i) and (ii)

B (i) to (iii)
C (ii) and (iii)
D (i)and (iii)

Question 3

Accounting policies of insurance companies must adhere to:

(i) All accounting standards issued by ICAI

(ii) All auditing standards issued by ICAI
(iii) All accounting policies mentioned under AS-1 issued by ICAI
(iv) All accounting standards issued by IAASB

A (i) and (ii)

B (i) and (iii)
C (i), (ii) and (iii)
D (i) to (iv)

Question 4

While auditing debt securities, in order to confirm the correctness of the

valuation, the auditor confirms that securities have been measured:

A At historical cost less accumulated depreciation and impairment loss

B At historical cost subject to amortisation
C At fair value as at the balance sheet date
D At historical cost
 703

Question 5

Which of the following options contains matters found in Long-form reports

(LFAR)?

(i) Cases of cheques dishonoured where the relevant risks covered have not been
cancelled from inception
(ii) Status of large Outstanding claims—with cause-wise and year-wise analysis
Comments on adequacy of provision made for all outstanding claims at the
year end
(iii) Certification that all the dues payable to the statutory authorities have been
duly paid
(iv) Confirmation that the required solvency margins have been maintained
(v) Adequacy of Internal Audit and Control System

A (ii), (iii), (iv) and (v)

B (iii), (iv), (v) and (vi)
C (i), (ii), (iii) and (vi)
D (i), (iii), (v) and (vi)

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is B.

Financial statements are said to be true when they are factually correct, and said
to be fair when they are just, equitable and not misleading.

Answer to SEQ 2

The correct option is A.

Insurance audit is a special type of audit where the auditor is required to follow a
set of regulatory requirements and the relevant provisions of:
9 the Insurance Act 1938 as well as
9 the provisions of the Companies Act on accounts and audit

Point (iii) is inappropriate as adherence to the Accounting Standards passed by

the ICAI is required on the part of the insurer. The auditor only confirms whether
the FS adhere to the Accounting Standards passed by the ICAI.
 704

Answer to SEQ 3

The correct option is B.

The IRDA regulations require insurance companies to adhere to the following

accounting policies:

9 all accounting standards issued by ICAI

9 all accounting policies mentioned under AS-1 issued by ICAI

Answer to SEQ 4

The correct option is B.

Debt securities including government securities and redeemable preference

shares have to be considered “held to maturity” securities and need to be
measured at historical cost subject to amortisation.

Option A relates to valuation of real estate investment property.

Option C relates to the measurement of equity securities and derivative

instruments that are traded in active markets

Option D relates to the measurement of unlisted and other than actively traded
equity securities and derivative instruments.

Answer to SEQ 5

The correct option is C.

The matters mentioned in points (iv) and (v) are contained in the management
report.
 705

CHAPTER 5

ANNUAL REPORTS, AUDIT AND

INTERNATIONAL FINANCIAL REPORTING
STANDARDS
UNIT 18

INTERNAL AUDIT IN GENERAL INSURANCE

BUSINESS
Chapter Introduction
In addition to being profitable, organisations today are also expected to be
responsible. They are expected to ensure that the activities they engage in are not
only profitable but also in line with the best interests of their various
shareholders.

For this to be achieved, organisations need to implement systems of internal

controls and corporate governance. Such systems will help ensure the efficiency
and effectiveness of operations and compliance with all relevant laws and also
ensure that organisations are properly governed and controlled.

However, designing and implementing appropriate and adequate internal controls

is only the first step. These controls have to be tested on an on-going basis to
ensure that they are effective and still relevant for the business operations of the
organisation.

This is where the function of internal auditing comes into effect. Internal auditors
are the internal “checkers” of an organisation. They are responsible for
determining if the organisation’s activities and management are operating in
accordance with its prescribed policies and procedures. Note, however, that not
every organisation will have an internal audit department, nor may it be required
to have one.
 706

As an employee of an insurance company, you will inevitably become involved

with the internal audit function at some point in your career. You will either be
involved with carrying out this function or find yourself on the “other side of the
fence” and have your work checked by an internal auditor. Therefore, it is
important that you understand the concept behind internal audit and all that it
involves.

a) Explain the meaning and scope of internal audit.

b) Explain the objectives of internal audit.
c) Explain the relationship between the statutory and the internal auditors.
d) Explain the major considerations for devising internal audit systems in
general insurance business.
e) List the common internal audit queries in general insurance business.
f) Provide detailed audit programmes to be carried out by internal audit and
inspection function in the areas of
i. Premium income, refund premium and commission
ii. Claims and estimated liabilities for outstanding claims
iii. Commission
iv. Coinsurance
v. Bank transactions and bank reconciliation
vi. Fixed assets
vii. Advances
viii. Investment audit
g) Explain the reporting systems for internal auditors.
h) Explain the standards on internal audits (SIA).
 707

1. Explain the meaning and scope of internal audit.

[Learning Outcome a]

1.1 Meaning

Internal Audit is a thorough examination of the financial transactions as well as

the system of accounting.

Internal audit is aimed at reassuring the management that:

9 all financial transactions are taking place according to the corporate policy,
rules and directives
9 all transactions are being recorded in accordance with accounting principles,
accounting standards, and accounting policies
9 the system of accounting provides adequate safeguards to check the wastage
of revenue and misappropriation of property of the organisation

Internal audit is a managerial control function –devising and implementing both

accounting control and administrative control. Though the aims and objectives of
internal audit are the same, the nature, scope and process of internal audit widely
vary from one organisation to other depending upon their nature, size and
geographical jurisdiction.

The scope of internal audit varies from assignment to assignment

If an internal auditor is appointed to evaluate the effectiveness of the internal

control system of the claims settled, their scope will be limited to evaluation of
the effectiveness of the system relating to the claims settled i.e. the auditors will
verify the corporate manual, financial order, delegation of financial authority and
power and whether claims settlement policies have been strictly followed for
settlement of all claims.

However, if they are appointed to review the whole internal control system,
they will not confine themselves to a specific function, and instead, will look into
the effectiveness of the whole internal control system of the entity i.e. they will
verify the internal control systems of premium income, commission, refund
premium, liability for outstanding claims, etc.
 708

Though the routine process of internal audit is the same as is followed in a

statutory audit, its depth and coverage (regarding checking and examination) are
more than for statutory audit.

When statutory audit is primarily concerned with the statutory or legality of the
business transaction, internal audit is mainly concerned with the propriety and
validity of the transaction for the purpose and the maximum profitability of the
entity.

Statutory audit in non-life insurance business aims at ensuring compliance with

the provisions of:

i) the Insurance Act,

ii) the Companies Act,
iii) the IRDA Act and
iv) other relevant statutes and the IRDA regulations in regard to accounts and
audit.

Internal audit is also required to ensure that various functions mentioned below
are carried out in accordance with the various corporate policies, laid-down rules
and manuals for:

i) Underwriting,
ii) Claims settlement,
iii) Financing and Investment,
iv) Financial Accounting,
v) Reinsurance Accounting

The concept and standards of internal audit have undergone major changes in
modern times. To understand the modern concept of internal auditing, it is
worthwhile to quote the following definition of Internal Auditing as specified by
the Institute of Internal Auditors (USA):
 709

Internal auditing is an independent appraisal function, established within an

organisation to examine and evaluate its activities as a service to the
organisation. The objective of internal auditing is to assist members of the
organisation in the effective discharge of their responsibilities. To this end,
internal auditing furnishes them with analyses, appraisals, recommendations,
counsel and information concerning the activities reviewed.

Internal Auditing is an independent, objective assurance and consulting activity

designed to add value and improve an organisation’s operations. It helps an
organisation accomplish its objectives by bringing a systematic, disciplined
approach to evaluate and improve the effectiveness of risk management, control
and governance process.

1.2 Scope of internal audit

The above definition indicates that the scope of internal audit is wide and
includes:
9 The operational audit of various operating activities in the organisation
9 The audit of management itself.

The definition also emphasises the role of internal audit in achieving the
maximum organisational effectiveness.

Internal audit, which is considered an integral part of an organisation, finds its

base in financial accounting.

Internal audit also plays a very important role in improving the quality of
financial accounting of an organisation.

Nowadays there is growing tendency in the corporate world to make internal

auditors responsible directly to the Board of Directors for the maintenance of:
9 adequate accounting procedure,
9 preparation of financial statements and
9 reports as regards various business activities.
 710

The definition clearly implies that the scope of internal audit is not confined to
routine checking of the accounting records but also includes an appraisal of the
various operational functions together with providing advice and
recommendations on the activities and operations reviewed.

The Institute of Internal Auditors defines the scope of internal auditing as:
9 the examination and evaluation of the adequacy and effectiveness of the
system of internal control
9 the quality of performance in carrying out assigned responsibilities

Traditionally, an internal audit was a review on behalf of management to ensure

that:
9 Existing internal controls are adequate and effective.
9 Financial and operating information is reliable.
9 The laws and regulations and the policies of the management are complied
with.
9 Assets of the entity are safeguarded.

Accordingly, the scope of internal audit should include, but not necessarily
be limited to:

1. Examination and evaluation of the adequacy and effectiveness of the internal

control system of an entity

In order to conduct an internal audit of fixed assets, the internal auditor will
evaluate the fixed assets management system by looking into the documentation
and physical verification processes and determining whether or not the system
itself prevents any fraud or error.

2. Review of reliability, integrity, adequacy, timeliness of the financial and

operating information and also the mechanism employed for identifying,
measuring, classifying and reporting such information

An internal auditor checks outstanding claims and age-wise analysis of claims in

order to ascertain the reliability, integrity, adequacy and timeliness of the
information regarding claims.
 711

3. Review of the system established for ensuring compliance with the

applicable laws and regulations and also management policies

An internal auditor needs to check whether the laws relating to maximum

working hours, minimum wages, etc. are complied with while engaging and
paying employees.

4. Review of the system for ensuring that the assets of the entity are
safeguarded from various losses like damage, fire, misappropriation etc.

An internal auditor needs to check the safety and security measures of the assets
of an insurance company in order to assure himself that the assets are
safeguarded from various losses.

5. Determination of the effectiveness, efficiency and also the economy of the

operations of the entity

According to the definition of internal audit given by the Institute of Internal

Auditors, suggestions of improvements to the entity’s operations are also
expected from the internal auditor. This can be achieved by evaluating and
improving the effectiveness of the following:

a) Risk management

Risk management refers to the set of activities that involve:

9 identifying and assessing any and all relevant risks that the organisation
may face while conducting its daily operations; and

9 then identifying and implementing a set of policies and procedures that

will help the organisation to mitigate these risks.
 712

Sun Insurance Co carries out general insurance business. It has invested in new
sophisticated financial accounting software, which is based on the double-
entry accounting system. The software has been tailor-made for the company.

The terms of the purchase order for the software are that:
9 The company will test the software during the various stages of its
development

9 Payments to the supplier will be made at each stage of development e.g. the
module for recording assets and expenses will be tested after completing the
module. If the module operates according to the requirements of the
company, the company will accept the software and make payment to the
software company.

Therefore, the risk of failure of the software is reduced through a combination of

testing and contractual terms.

Risk management is important in supporting the achievement of company

objectives. Corporate collapses and failures have often been linked to excessive
risk taking or risky business models. Risk management systems and internal
controls provide an essential check and balance, particularly when combined
with corporate governance mechanisms for executives, managers and staff.

For example, risk management systems facilitate:

9 safeguarding shareholders’ investment and the company’s assets.
9 the effectiveness and efficiency of operations.
9 ensuring the reliability of external and internal reporting.
9 ensuring compliance with laws and regulations.
9 ensuring the effectiveness of financial controls.
9 a thorough evaluation of the risks which the company is exposed to.

To provide the directors with assurance that the controls have been properly
designed and implemented and are working effectively, it is necessary to
conduct internal audits. Risk management also includes proper reporting of
risks and internal controls to management and obtaining assurance from internal
audit reports. The risk committee and audit committee can bring non-executive
directors into the control process to provide an independent and unbiased opinion
on the internal controls of the company.
 713

b) Internal control process

The internal auditor’s primary duty is to examine and evaluate the adequacy and
effectiveness of the system of internal control and to assess the quality of
performance in carrying out assigned responsibilities.

While performing an internal audit of debtors, the internal auditor needs to

ensure that the debtors on a particular date reconcile with the debtors at the
beginning of the year, taking into consideration the total amount of billing made
and the amount collected with respect to the debtors’ accounts under
consideration. If the balances reconcile, it gives him some assurance about the
effectiveness of the internal control over debtors. In order to be more confident
about the effectiveness of the internal control system, an internal auditor may
carry out an ageing analysis of the debtors’ accounts with large outstanding
amounts.

c) Corporate governance

Corporate governance consists of four elements, namely, the external auditor, the
audit committee, management, and the internal audit function. The internal audit
function serves as a resource for each of the other three parties responsible for
corporate governance. Accordingly, the nature and value of corporate governance
depends on the quality of the internal audit function.

The internal audit function provides an insight into the effectiveness and quality
of operations of an organisation. If the internal audit function is not performed
appropriately, it may provide misleading or insufficient information about the
functioning of the organisation, causing the objective of corporate governance to
be defeated.

Section 40C of the Act lays down provisions regarding limits on expenses
of management in general insurance business. Therefore, some expenses of
management may be recorded under other account heads. If the internal auditor
cannot bring this problem to the attention of the audit committee, the whole
purpose of corporate governance may be defeated.
 714

Diagram 1: Meaning, scope and aim of internal audit

Traditionally, an internal audit was a review on behalf of management to ensure

that:
(i) Existing internal controls are adequate and effective
(ii) Review and analysis of risk management activities is done
(iii) Financial and operating information is reliable
(iv) Review of corporate governance arrangements is done
(v) The laws and regulations and the policies of the management are complied
with
(vi) Assets of the entity are safeguarded
A (i), (ii), (iii), (v)
B (ii), (iv), (v), (vi)
C (i), (iii), (v), (vi)
D (i), (ii), (iii), (v), (vi)
 715

2. Explain the objectives of internal audit.

[Learning Outcome b]

As mentioned above, internal audit is fundamentally concerned with identifying,

analyzing, and evaluating risks associated with management functions to realize
the objectives of an organisation. It is an integral part of enterprise risk
management.

Enterprise risks include financial risks, operational risks, technology risks,

market risks, and so on. Thus, the role of the internal auditor is to identify,
analyze and evaluate the above risks and also provide assurance to management
that all key risks are being managed effectively. He will evaluate the quality of
risk management processes, systems of internal control and corporate governance
processes across all parts of an organisation and report on these aspects directly
and independently to the most senior level of management.

Objectives of internal audit

The objectives of internal audit can be outlined on the following points:

1. Examination of financial accounting

To examine the accuracy and authenticity of financial accounting, statistical data

and records presented to the management for various managerial decisions, for
example, internal auditors would review the entire process of preparing annual
budgets.

2. Ascertain the effectiveness of accounting policies

To ascertain that the accounting policies and practices followed by the

organisation are sound, effective and fault-free

For example, insurance companies could adopt different accounting policies

(based on guidance from accounting standards) for depreciating fixed assets.
Internal auditors will ascertain whether the accounting polices used are
appropriate (i.e. in line with the accounting standards) and consistently applied
year after year. Furthermore, if the accounting policies are changed, then the
auditor would confirm that the impact of the change in application of the
accounting policies is correctly reflected in the financial statements.
 716

3. Ensure observance of financial orders

To ensure observance of financial orders prescribing limits of exercising

financial power, authority for any business approval both revenue earning and
disbursement of expenditure, acquisition and disposal of fixed assets or capital
expenditure

4. Confirm existence of proper authority for all business decisions

To establish that there is a proper authority for any decision on business

acquisition, strategic alliance, merger and restructuring

5. Confirm genuineness of liabilities

To confirm that liabilities have been incurred or amount is expended only for the
purpose of the organisation and its best interests

6. Improve internal control system

To improve and analyze the internal check and control system: The main aim of
internal audit reporting should be to increase the risk awareness, minimise the
shortcomings and loopholes in the existing internal control systems and suggest
actions that will improve internal controls.

7. Review accounting system

To review the accounting system and related accounting control by way of

establishing adequate accounting system and related records.

8. Analyse various risk factors

To identify, analyze and evaluate various risk factor in organisational activities

and report there upon to the top management.

9. Physical verification of assets

To ensure physical examination and verification of the existence and condition of

the various assets and property of the organisation
 717

10. Detect and prevent fraud

To facilitate the detection and prevention of frauds and financial irregularities

While vouching expenses incurred during the year, the internal auditor of an
insurance company discovers that certain managers are using their corporate
credit cards to pay their personal bills. This matter is reported by the internal
auditor to the audit committee through their monthly reports.

11. Ensure protection of interest of all stakeholders

To ensure protection of interest of all stakeholders in the organisation

Internal auditors review the salary paid to employees to ensure that the entity
does not pay any employee a wage that is below the legal minimum wage for the
country that it operates in.

12. Carry out special investigation

To carry out special investigation in case of occurrence of any irregularity or for

enabling the management for any strategic action: For example, the scope of
internal audit of an insurance company would include an investigation of the
suspense account, long pending cases of cheques deposited, cheques deposited
but not credited, high value claim settlement, off-balance sheet transactions etc.

13. Reviewing various organizational activities

To review the various organisational activities including operational financing

and investment and to report to the top management about the review results
 718

Diagram 2: Objectives of internal audit

Which of the following options contain the primary objective of internal audit?

A Performing audit procedures so that the cost of statutory audit can be

minimised
B Providing an opinion on the true and fair nature of financial statements
C Identifying fraud
D Identifying, analyzing, and evaluating risks associated with management
functions to realize the objectives of an organisation
 719

3. Explain the relationship between statutory and internal

auditors.
[Learning Outcome c]

The function of an internal auditor being an integral part of the system of internal
control, it is obligatory for a statutory auditor to examine the scope and
effectiveness of the work carried out by the internal auditor.

Under the Companies (Auditor’s Report) Order, 2003 issued under section
227(4A) of the Companies Act, the statutory auditor is required to comment (as
amended in Nov, 2004) on the internal audit system.

For the purpose, the statutory auditor should examine:

1. The organisation of the Internal Audit Department

2. Skill, qualifications, strength and efficiency of the internal audit staff
3. The internal audit procedures
4. The scope and extent of internal audit examination with reference to internal
audit reports
5. Points raised therein and the subsequent actions taken by management on the
internal audit queries.
6. Independence: The extent of independence exhibited by the internal auditor
in the discharge of his duties and his status in the organisation are important
factors for the statutory auditor to determine the effectiveness of internal
audit commensurate with the size and nature of the organisation.

Little LLP, an audit firm, is the ERP consultant of RSA Technologies from 2004
to 2005. John, an employee of Little LLP, was involved in setting up the ERP
systems in RSA Technologies. In January 2011, Little LLP has been appointed as
the internal auditors of RSA Technologies. Little proposes to assign the internal
audit task to John.

In this situation, John would be required to review the controls in the ERP which
were set up by him. This causes a threat to the auditor’s independence because he
could face a conflict of interest, i.e. if John notices some irregularities in the
controls of the ERP, he may not report the matter.
 720

7. Co-ordination with external auditors: In a large business, it has been

recognised that if examination functions of internal auditors and those of
statutory auditors are integrated, the statutory auditors may not find it
necessary to examine and go over the same facts and figures as have been
previously examined and reported by competent and efficient internal
auditors.

Thus, internal audit examination and checking carried out by the internal
auditors efficiently and exhaustively are of great assistance to statutory
auditors and considered one of the most important factors for devising the
statutory audit programme.

If the statutory auditor is satisfied with the adequacy and the effectiveness of
the internal audit, he often curtails his audit work by dispensing with certain
detailed checking and verification. Therefore, working in close co-
ordination with the external auditors will ensure that the functions of
internal and external audits are not duplicated and the cost of external
audit is minimized.

8. Regulatory need for internal audit function: The CARO (Companies Auditors
Report Order 2003) requires that companies which meet any of the
parameters mentioned below have the internal audit system as a part of the
internal control system. The parameters are as follows:

9 listed companies or

9 companies having a paid-up capital of Rs.50-lakhs or

9 companies having an average annual turnover in excess of Rs. 5 crores

for a period of three consecutive financial years immediately preceding
the financial year concerned

This is also an aspect that the statutory auditor has to examine and comment
upon.
 721

Diagram 3: Matters relating to internal audit; to be examined by the

statutory auditor

Which of the following options contain the parameters set by CARO (Companies
Auditors Report Order 2003) that make it mandatory for entities to have the
internal audit system as a part of the internal control system?
(i) Listed companies
(ii) Trusts
(iii) Companies having a paid-up capital of Rs.50-lakhs
(iv) Companies having a paid-up capital of Rs.40-lakhs
(v) Companies having an average annual turnover in excess of Rs. 5 crores for a
period of three consecutive financial years immediately preceding the
financial year concerned
(vi) Companies having an average annual turnover in excess of Rs 4-crores for a
period of five consecutive financial years immediately preceding the
financial year concerned
A (i) or (ii) or (iv) or (vi)
B (i) or (iii) or (v)
C (i) or (iii) or (vi)
D (i) or (iv) or (vi)
 722

4. Explain the major considerations for devising internal

audit systems in general insurance business.
[Learning Outcome d]
Every insurance company must have a sound system of internal audit for the
obvious reasons mentioned above.

In order to ensure effectiveness and adequacy of the internal audit system, the
insurance company generally considers the following aspects while devising an
internal audit system.

1. Internal Audit Manual

An insurance company must have an exhaustive and well-defined audit manual

prescribing policy, principles and procedure of internal audit, keeping in view the
underwriting policy, risk inspection policy, reinsurance policy, investment
policy, accounting policy etc. Internal audit can be conducted efficiently if
internal auditors have a good understanding of company policies and internal
audit procedures which relate to insurance business.

2. Professional Approach

The head of the audit and inspection department at the head office should be
preferably a professional, senior and experienced person who could report
directly to the chairman on the performance, prospects and problems of various
departments and discuss on possible ways of improvement in the internal control
system. The officers in this department should have sufficient experience and
exposure in all department functions, through knowledge on corporate rules and
manuals on various aspects and also on various regulatory norms and
requirements.

3. Periodicity of Audit

The periodicity of the internal audit for every operational unit should be at least
once in a year, and preferably unannounced, or without intimation (i.e. having a
surprise element).

4. Coverage of Audit

The coverage of internal audit should be made comprehensive so that statutory

auditors get satisfied with the adequacy and effectiveness of internal audit and
that all fraud or financial irregularities are detected by internal audit inspection.
 723

The inspection / audit officials should also critically analyse and study in-depth
all fraud-prone areas such as:

9 acceptance of bad or declined risks,

9 settlement of fraudulent claims,
9 functions in establishment and estate department ,
9 financing and investment activities,
9 loans and advances to employees,
9 inter-related parties’ transactions,
9 balancing of books,
9 reconciliation of inter-branch accounts,
9 third party claim settlements etc.

5. Special Investigation

The internal auditor should scrutinise the suspense account, long pending cases
of Cheques Deposited, but Not Credited, High Value Claim Settlement, Off-
balance sheet transactions etc.

6. Supplementary Short Inspections

The annual internal inspection should be supplemented by surprise short

inspections at irregular intervals, particularly of large branches on certain specific
transactions like incentive payment to development officers, arrear payments on
revision of salaries, MACT claims, HRM functions, payment of non-core
benefits etc.

7. Revenue Audit

Besides annual internal audit and short inspections, there should be a regular
system of revenue audit or underwriting audit including verification of practice
of risk acceptance – whether on proper risk-inspection as per laid down norms,
observance of laid-down norms in case of a break in insurance or in case of
acceptance of large and complicated risks.

8. EDP Audit

Internal audit is conducted to ensure that the EDP applications have resulted in a
consistent and reliable system for inputting of data, processing and generation of
output. For this purpose, various tests to identify erroneous processing, to assess
the quality of data, to identify inconsistent data and to compare data with
physical forms should be introduced by the internal auditor in his system of audit.
Entire domain of EDP activities (from policy formulation to implementation)
should be brought under close scrutiny of Inspection and Audit Department.
 724

9. Audit Compliance Cell

There must be an audit compliance cell responsible for review compliance of

audit queries raised by the internal auditor and review the implementation of the
guidelines issued by the internal auditor in view of the procedural lapses in order
to improve the performance of the unit itself and various departments functioning
in the unit.

10. Audit Committee of Board (ACB)

ACB provides direction and oversees the operations of the total audit function in
insurance. The total audit function includes the organisation, operation and
quality control of internal audit and inspection within the organisation and
follow-up on the statutory audit of the company, CandAG and Regulator. It may
review the follow up action on the internal inspection reports, particularly of
"unsatisfactory" branches and branches classified by the IRDA as non-
compliance branches. It should also specially focus on the follow up on inter-
branch adjustment accounts, un-reconciled long outstanding entries in inter-
branch accounts, suit claims, MACT claims etc.

The head of the Audit and Inspection Department at the Head Office should
preferably:

(i) Be a professional
(ii) Be an employee of the company
(iii) Be a practicing professional
(iv) Report to the CEO
(v) Report to the chairman
(vi) Be a topper in the professional course
(vii) Be an experienced professional

A (i), (ii), (iv) (vii)

B (i), (iii), (v), (vi) and (vii)
C (i), (v), (vii)
D (i), (iii), (v) and (vii)
 725

5. List the common internal audit queries in general

insurance business.
[Learning Outcome e]
The accountant and other officers must have adequate knowledge about the
common queries (relating to financial accounting) in the internal audit report,
which lead to qualifications to the statutory audit report afterwards.

Some of the common internal audit queries in a general insurance business

are as follows:

1. Inappropriate revenue recognition

Inappropriate revenue recognition occurs due to overstatement of premium

income, booking of advance premium as current premium, recording fictitious
income by way of excess booking of premium in co-insurance arrangement etc.

2. Incorrect expenses recognition

Incorrect expenses recognition occurs due to treating:

9 revenue expenses as capital expenditure or vice-versa,
9 personal expenses of officers as business expenses,
9 excess payment of motor car running expenses,
9 excess payment of incentive and non-core expenses to development officers,
9 personal tour treated as official tour,
9 wrong fitment of salary etc.

3. Understatement of outstanding claims liability

Understatement of outstanding claims liability occurs either in the form of claims

‘reported but not registered” (RBNR) or reported but not enough registered”
(RBNER) to project higher solvency and inflated profits.

4. Overstatement of Assets

Overstatement of Assets occurs from avoiding impairment or proper depreciation

of assets.
 726

5. Misappropriation of assets

Misappropriation of assets occurs due to fraudulent conduct by management in

the incorrect booking of premium or settlement of fraudulent / false claims.

6. False accounting entries

False accounting entries by way of window dressing i.e. wrong valuation of

investments or other asset.

Diagram 4: Common internal audit queries

Collections made before 31st March in respect of risks commencing on or after

1st April of the next year are accounted for as premium income in the accounting
year. This is an example of:

A Incorrect expense recognition

B Inappropriate revenue recognition
C Misappropriation of assets
D False accounting entries
 727

6. Provide detailed audit programmes to be carried out by

internal audit and inspection function in the areas of:
i. Premium income, refund premium and commission
ii. Claims and estimated liabilities for outstanding
claims
iii. Commission
iv. Coinsurance
v. Bank transactions and bank reconciliation
vi. Fixed assets
vii. Advances
viii. Investment audit
[Learning Outcome f]

The most important areas of work carried out by internal audit relate to the
review the internal control systems. Therefore, most of the internal audit queries
pertain to system and procedural lapses. Generally, procedural or system lapses
result into financial irregularity, frauds and loss of revenue for the company.
Therefore, the internal auditors should always take serious view of system and
procedural lapses and report them. Following are the areas where system lapses
may arise and cause financial loss of revenue to the company or insurance fraud
in some cases.

9 Premium Income, Refund Premium and Commission

9 Claims and estimated liabilities for Outstanding Claims
9 Commission
9 Coinsurance
9 Bank Transactions and Bank Reconciliation
9 Fixed Assets
9 Advances
9 Investment Audit

The salient points of audit inspection for such cases are also briefly discussed
with special reference to financial accounting.
 728

6.1 Premium Income, Refund Premium and Commission

In auditing Premium Income, Refund of Premium and Commission expenses, the

internal auditor is to examine the following aspects:

1. All policies for risks commencing in the year are accounted for in the same
year. There should not be any instances of carry-over of premium to the next
accounting year in respect of risks commencing in the year. This will ensure
that the matching principle of recording income and the related expenses
during the same period will be ensured.

2. Collections made before 31st March in respect of risk commencing on or

after 1st April of the next year should not be accounted for as premium
income in the accounting year and such collections are to be credited to
“Premium Received in Advance A/c. This will be in line with the accrual
system of accounting.

3. In Marine Hull and other Engineering policies allowing collection of

premium on installment (like MCE policies), instalments received within the
accounting year are duly accounted for. The accounting aspect of bifurcating
Marine and Engineering portions in case of MCE policies has to be followed.

4. In all Declaration Policies expiring before March, premium should be

reworked, and refund endorsements, if any, have to be passed before closing
the books of accounts.

5. Bhavishya Arogya Premium has to be accounted for with all particulars in

the register and schedules under direct supervision and control of Regional
Office.

6. All dishonoured cheques returned by banks up to 31st March are to be duly

accounted for and cancellation endorsements are to be passed by the office
immediately.
 729

7. Co-sharing of business amongst two or more operating offices: the

following instructions are to be strictly followed by the operating offices”

9 The policy issuing office will account for 100% of premium, claims and
outstanding claims.

9 Co-sharing office will show notional credit of premium in its statistical

returns.

9 IBD at regional office / head office will monitor the sharing arrangement
and pass on necessary notional credit to the sharing offices at the year-
end.

8. Premium as per accounts is to be reconciled with the gross direct premium

(GDP). In case of any variance, the branch-in-charge and divisional-in-
charge has to inform the higher offices about the reasons for the variance, if
any, and send supplementary statistical returns to tally with the accounted
figures.

9. Excess collections to be refunded are shown in a register with complete

details.

10. Short collections, if any, are to be verified with subsequent collection

particulars.

11. Collections due for documents to be allotted are to be verified. As far as

possible, it should be ensured that no collection remains outstanding under
this head as all collections for which risk is commencing in the year have to
be accounted for in the same year and should not be carried over to the next
year. Similarly, collection for which risk is commencing on or after 1st April
should be transferred to ‘premium received in advance account’.

12. Bank Guarantee Account should show client-wise balances mentioning

clearly the bank guarantee limit, expiry date and subsequent collection
particulars.
 730

Diagram 5: Audit procedures for premium income

6.2 Claims and estimated liabilities for Outstanding Claims

While checking claims paid and estimated liabilities for outstanding claims, the
internal auditor may look into the following aspects:

1. Claims Settled:

The auditor should examine whether the settlement of all claims are in
accordance with:
9 the corporate manual,
9 the financial order delegating financial authority; and
9 power for claims settlement
 731

Furthermore, the auditor will examine whether the legal and technical aspects
have been duly taken into consideration by the authority approving the settlement
of claims as per the financial limits.

2. Liabilities for Outstanding claims

The auditor is to verify that:

a) Liabilities for outstanding claims are determined after review of outstanding

claims by the department. Outstanding claims must be made with reference
to:
9 policy terms and terms and conditions,
9 nature and damages described in claim intimation,
9 survey report,
9 post-claim inspection, if any, by officers etc.

b) Outstanding claims statements are to be verified with reference to the claims

file and the latest review report.

c) In respect of coinsurance business where the company is the leader, provision

for outstanding claims has to be made only for its share. Full particulars of
the claims registered by the company should be sent to the co-insurers for
enabling them to make necessary provisions in their books of account.

d) In the case of coinsurance business where the company is not the leader,
provision should be made for its share of claim as intimated by the leader
company. In respect of incoming coinsurance, the concerned branch /
divisional office should address a letter to the lead insurer seeking
information / confirmation regarding claims outstanding at the end of the
year.

e) While providing for third party outstanding claim, it is to be ensured that

interest has been provided from the date of petition as per the rates advised
by the corporate office technical department. Each year, the provision should
be revised taking into account the rate of interest for the current year, as per
the corporate circular.

f) Estimated liabilities for outstanding claims of the motor department are

booked on net of salvage basis.

g) Deposits paid to courts as per the award have been debited to the claim
account directly and not to sundry advance account or sundry deposit account
or suspense account. Outstanding claim provision to the extent of the deposit
made should be reduced.
 732

h) If the amount is placed in a fixed deposit in the company’s name and the
receipt is deposited in the court, full provision has to be made in the
outstanding claims statement.

Diagram 6: Audit procedures for outstanding claims

6.3 Commission

1. Commission control account should be verified with reference to:

9 premium register, and
9 commission payment register.

2. Statement of outstanding commission prepared at the year-end showing

agent-wise balances should be also examined.

3. If any agents’ account shows debit balances, the balances should be

recovered from the agent. Similarly, the corporate agency commission
account and brokerage control accounts are to be examined with reference to
the statement showing corporate agent / broker wise details.
 733

6.4 Coinsurance

Coinsurance settlement is one of the major items of internal audit check and
verification.

1. It is to be ensured that:
9 all co-insurance premium has been booked as per the agreement with the
client and the co-insurers
9 nothing has been omitted
9 there is excess booking to bolster income and for window dressing in the
accounts by the operating units
9 all claims booked in the Co-insurance Account are supported by claim
details and details of payment, if made by the leader.

2. Settlement of all coinsurance balances by the year end should be stressed

upon to reduce the possibility of wrong booking and padding of premium
income.

3. However, if coinsurance balances are not settled by the year end, then
outstanding balances should be supported by written confirmation from the
other co-insurers concerned.

4. In the case of premium recoverable from other insurers, the policy number
and other details of the leader should be verified.

5. Subsequent adjustment / settlement particulars are to be verified.

6.5 Bank Transactions and Bank Reconciliation

1. The internal auditor is to thoroughly scrutinize reconciliations of all bank

accounts and should see that reconciliations of all bank accounts, including
inoperative bank accounts, are up to date, keeping in mind that delay in bank
reconciliations may lead to lot many irregularities such as accounting frauds,
issuance of policies without the requisite premium received in-advance etc.

2. To verify that there is no long-pending case for “Cheques Deposited, but Not
Credited” in BRS, proper follow up with banks on a regular basis is
necessary to ensure that cheques deposited with banks are credited to our
account within the time-limit as per the RBI guidelines.
 734

3. The bank balance in the disbursement account should be minimum one. The
Branch office / DO should estimate their fund requirements up to 31st
March, and excess funds in the disbursement account are to be transferred to
the DO / HO or are to be placed in F.Ds as per the corporate guidelines so
that no unutilized funds remain in the Branch or DO bank accounts.

4. Under no circumstances should the book balance be overdrawn.

Diagram 7: Audit procedures for bank transactions and reconciliations

BRS: Bank reconciliation statements

 735

6.6 Fixed Assets

1. Ensure maintenance of fixed asset register

The Internal Auditor is to verify that the establishment department at the

divisional office / branch office has maintained a fixed assets register. The
register has to be updated every year for verification by the statutory auditors.
Non-maintenance of fixed assets register generally leads to serious audit
qualification in the Statutory Auditor’s report. Physical verification of inventory
should be done at the branch / division at every year-end with the statement of
assets maintained by the accounts department.

2. Reconciliation of fixed asset register

Fixed Asset Register must be reconciled with Accounts schedules forming part of
the financial statements of the insurance company.

3. Correct updates of register

The Internal Auditor shall verify that:

9 the location of each asset is specifically mentioned, and should there be a
change in location, the same should be promptly recorded in the Assets
register.
9 accounting entries are recorded in the respective office’s books of account to
give effect to such transfer in accounts.
9 necessary details for sale / transfer of assets are entered into the assets
register.

4. Appropriate entries relating to depreciation

Depreciation on Assets has to be provided in the books of accounts on all the

assets.

On an asset, depreciation can be provided under the following conditions only.

9 Assets purchased and put to use (commissioned) during the year.
9 Assets purchased and ready for putting to use (ready for commissioning)
during the year (even though not put to use during the year).
9 Payment for purchase of assets made or not made during the year: this does
not have any bearing on providing depreciation on assets.
 736

9 When an asset is transferred from one office to another, written down value
(WDV), depreciation fund and depreciation charged as per the Income Tax
Act or corporate guidelines should also be simultaneously informed to the
transferee office for tax audit purpose. This should be done along with the
book balance of WDV, depreciation fund balance and the depreciation
charged in the books.

The auditor needs to examine the following matters (in addition to the matters
mentioned above) relating to depreciation:

9 Depreciation on assets purchased up to 30th September should be provided

as per the rates applicable. Depreciation on assets purchased on or after 1st
October should be provided at half the rates applicable.
9 All assets purchased during the year (April to March) costing up to Rs.5,000
may be written off completely during the year (i.e. debited to Revenue A/c)
as per the corporate accounting policy. For ascertaining the amount of
Rs.5,000 the cost of individual assets should be
considered.
Please note: Assets up to Rs.5,000 should not
be debited to the asset account directly.

If ten chairs each costing Rs. 4,000/- are purchased at a time, the entire amount of
Rs.40,000 will be written off as the cost of each chair is less than Rs.5,000,
although the total amount paid for all chairs is Rs.40,000. However, for the sake
of identification, Re.1/- will be assumed as the cost of each asset. For accounting
these assets, the assets’ code is to be debited for the full cost and then 100%
depreciation is to be provided on the assets, leaving Re.1 for each asset.

9 Depreciation on Assets has to be

provided for in the books of accounts
at the rates applicable as per the
Companies Act, 1956 or the Income-
Tax Act, 1961, whichever is higher.
9 No depreciation has to be provided for
assets sold during the year.
Schedule of depreciation
rates as per the Companies
Act and the Income-tax Act
will be sent along with the
tax audit circular.
 737

Diagram 8: Conditions to be fulfilled before charging depreciation on assets

6.7 Advances

The audit procedures relating to advances are as follows:

1. All advances have been sanctioned by appropriate authority for the required
purpose.

2. The Internal Auditor is to examine that all advances paid to employees in

respect of travelling, LTS and other advances have been settled as per the
norms and procedures laid down by the company.

3. In case advances are overdue, they must be deducted from salaries.

4. Advance register must be examined thoroughly for each advance and

settlement thereof.
 738

6.8 Investment Audit

Investments constitute a significant portion of total assets in insurance business

as we have discussed in detail in the earlier chapters.

Investments of policyholders’ funds and shareholders’ funds are assets held by

insurance companies for earning income by way of:
9 dividends
9 interests
9 rentals
9 capital appreciation for the benefit of both policyholders and shareholders.

With substantial investment income, almost all insurance companies manage to

set off underwriting loss and survive in a de-tariff market today. So auditors are
required to verify investments very sincerely so as to ensure survival and growth
of business. The auditors shall verify both current investments and long-term
investments. As we have discussed earlier, investment accounting follows the
regulatory norms specified by IRDA Investment Regulation (as discussed in unit
15).

Therefore, the auditor should particularly consider the following aspects in

regard to investment audit:

1. Internal control over acquisition, accretion and disposal of investment

The auditor should verify that the acquisition and disposal of investments are
approved by the appropriate authority and are made in accordance with the
regulatory requirements.

2. Safeguarding of investments

The auditor should verify that all investments have been made in the name of the
entity only, and there exists a proper system for the safe custody of all scripts and
other documents of title to investment belonging to the company.

3. Control relating to title to investment

The auditor should verify that the title to all investments has passed on to the
organisation immediately on acquisition. If it is not transferred immediately after
acquisition, it must pass on to the insurance company within the shortest period
of time with all benefits.
 739

4. Information control

Internal auditors shall give special emphasis on information control in respect of

acquisition, disposal, accretion and valuation. They should verify the detailed
records regarding acquisition and disposal etc. of the investment along with
proper documentation.

5. Physical verification of investments

The auditors shall verify the physical existence of all investments as per records
and register and verify valuation as per the regulatory norms with reference to the
IRDA Regulations on Accounts and Audit.

The verification of investments may be carried out by auditors by employing the

following procedures:

9 Verification of investment transaction

9 Physical inspection of investment in the form of shares, debentures and other

securities.

9 Examination of valuation and disclosure as per the regulatory requirement.

9 Analytical review of income derived from investment with reference to the

total value and volume of the investment.

Conclusion

In this chapter, we have discussed the internal audit procedures and techniques
only for a few selected items of income, expenditure and assets with a view to
highlight the fact that financial accounting and internal audit are inter-related and
inter-woven. Without proper internal audit system and control, the financial
statements of an entity will never exhibit true and fair view of profit or loss and
the state of affairs of the entity, which is the ultimate objective of financial
statements.
 740

Which of the following instructions are to be strictly followed by the operating

offices in respect of co-sharing of business between two operating offices?

(i) The policy issuing office will account for 100% of premium, claims and
outstanding claims
(ii) The co-sharing office will account for 100% of premium, claims and
outstanding claims
(iii) The co-sharing office will show notional credit of premium in its statistical
returns.
(iv) The policy issuing office will show notional credit of premium in its
statistical returns
(v) IBD at RO/HO will monitor the sharing arrangement and pass on necessary
notional credit to the sharing offices at the year-end.

A (i), (iv) and (v)

B (ii), (iii) and (v)
C (i), (iii) and (v)
D (i) and (iii)

7. Explain the reporting systems for internal auditors.

[Learning Outcome g]
There are no formal standards set for the reporting systems for the internal audit
function. However, best practices recommend the following reporting system for
internal auditors:

1. The Internal auditors will report to the top management with their
recommendations for necessary improvements in case of deficiencies and
actions for irregularities and fraud.
2. They should also verify that management has taken immediate action for
rectification of mistakes, wrongs and irregularities reported.
3. If the reported mistakes, wrongs and irregularities are not rectified within a
reasonable period of time, these may be reported to the CEO.
4. There must be a system of annual review of the working of concurrent audit.
 741

Which of the following statements is incorrect?

A There are formal standards set for the reporting systems for the internal audit
function
B The Internal auditors should report to the finance manager.
C The internal auditors should verify that management has taken immediate
action for rectification of mistakes, wrongs and irregularities reported
D There must be a system of bi-annual review of the working of concurrent
audit

8. Explain the standards on internal audits (SIA)

[Learning Outcome h]
It is often found that the age-old internal audit practices and procedures are
followed by the department without having regard to the changes in the other
department. Such age-old practice brings non-integration of the systems of
internal audit with the operational systems.

The following standards on internal audit are in force:

1. Integration of internal audit system with other systems of internal

control and accounting control

While instituting the internal audit system in insurance companies, attempt

should be made by the head of the department to integrate it with other systems
of internal control and accounting control in respect of all operational activities
which change with changes in market conditions, technology, product
development and regulatory requirements.

Recently (since the end of 2009), online selling of insurance policies has started.
This involves having the necessary technology in place in order to carry out such
transactions. However, the use of IT technology can also result in leakage of
revenue if internal controls are not in place. Therefore, insurers need to have staff
who are aware of the working of the system, in addition to the internal control
systems of the company. This will enable them to understand the sufficiency of
internal controls (like restricted access to various staff working on the system)
and also its integration with the accounting systems. Internal audit staff will then
be able to effectively audit the design as well as the implementation of the
internal control systems for this kind of transactions.
 742

2. Documentation of system of internal audit and inspection

It is necessary that the entire system of internal audit and inspection is properly
documented.

3. Standards of internal audit

Considering the ever-increasing importance of internal audit in contemporary

business, the Institute of Chartered Accountants has brought out certain standards
of internal audits (SIA). At present, there are about seventeen standards of
internal audits, on various aspects such as Reporting, Sampling, Analytical
procedures, Quality Assurance, Terms of engagement, Evidence, Communication
with management, Correlation with External Authority Auditors and
responsibility for detection of frauds. These standards, codifying the best
practices of internal audit, may provide the benchmark for internal audits in any
organisation. The internal audit department in insurance companies may apply
these standards to the extent as relevant to make the internal audit system more
effective and responsive to the needs of the insurance business to improve quality
of financial accounting.

4. IRDA regulations

The IRDA has also amended its regulation to provide that:

9 every insurer having Assets under Management (AUM) not more than
Rs.1000 crore shall have a Quality Internal Audit and

9 insurers having AUM above Rs.1000 crores should appoint a Chartered

Accountant Firm for concurrent Audit.
 743

Diagram 9: Standards on internal audit

Traditionally, the head of the internal audit department (in insurance companies)
integrated the internal control systems with other systems of internal control and
accounting control in respect of all operational activities which change with
changes in market conditions, technology, product development and regulatory
requirements.

The above statement is:

A True
B False
 744

Summary
¾ Internal Auditing is an independent, objective assurance and consulting
activity designed to add value and improve an organisation’s operations. It
helps an organisation accomplish its objectives by bringing a systematic,
disciplined approach to evaluate and improve the effectiveness of risk
management, control and governance process.
¾ The definition clearly implies that the scope of internal audit is not confined
to routine checking of the accounting records but also includes an appraisal
of the various operational functions, and providing advice and
recommendations on the activities and operations reviewed.
¾ Internal audit is fundamentally concerned with identifying, analyzing, and
evaluating risks associated with management functions to realize objectives
of an organisation. It is an integral part of enterprise risk management.
¾ Under the Companies (Auditors Report) Order, 2003 issued under section
227(4A) of the Companies Act, the statutory auditor is required to comment
(as amended in Nov, 2004) on the internal audit system
¾ In order to ensure effectiveness and adequacy of the internal audit system,
the insurance company generally considers the following aspects while
devising an internal audit system:
9 Internal audit manual
9 Professional approach
9 Periodicity of audit
9 Coverage of audit
9 Special investigation
9 Supplementary short inspections
9 Revenue audit
9 EDP audit
9 Audit compliance cell
9 Audit committee of board (ACB)
¾ There are no formal standards set on the reporting systems for the internal
audit function.
¾ While instituting the internal audit system in insurance companies, attempt
should be made by the head of the department to integrate it with other
systems of internal control and accounting control in respect of all
operational activities which change with changes in market conditions,
technology, product development and regulatory requirements.
 745

Answers to Test Yourself

Answer to TY 1

The correct option is C.

Traditionally, an internal audit was a review on behalf of management to ensure

that:
(i) existing internal controls are adequate and effective
(ii) financial and operating information is reliable
(iii) the laws and regulations and the policies of the management are complied
with
(iv) assets of the entity are safeguarded

Answer to TY 2

The correct option is D.

Internal audit is fundamentally concerned with identifying, analyzing, and
evaluating risks associated with management functions to realize objectives of an
organisation. It is an integral part of enterprise risk management.

Option A is incorrect as working in co-ordination with statutory auditors will

minimize the cost of statutory audit. However, this is not the primary objective of
internal audit.
Option B is incorrect as providing an opinion on the true and fair nature of
financial statements is the primary objective of statutory audit.
Identifying and preventing fraud is the primary responsibility of management.

Answer to TY 3

The correct option is C.

The CARO (Companies Auditors Report Order 2003) requires that companies
which meet any of the parameters mentioned below have the internal audit
system as a part of the internal control system. The parameters are:
9 the companies are listed companies or
9 the companies have paid-up capital of Rs.50-lakhs or
9 companies have an average annual turnover in excess of Rs. 5 crores for a
period of three consecutive financial years immediately preceding the
financial year concerned

For Mock Test Visit:

https://irdaexam.in/
 746

Answer to TY 4

The correct option is C.

The head of the Audit and Inspection Department at the Head Office should be
preferably a professional, senior and experienced person who would report
directly to the Chairman on the performance, prospects and problems of various
departments and discuss possible ways to improve the internal control system.

Answer to TY 5

The correct option is B.

Inappropriate revenue recognition occurs due to overstatement of premium

income.

Answer to TY 6

The correct option is C.

In the case of co-sharing of business amongst two or more operating offices,
the instructions mentioned under this option are to be strictly followed by the
OOs.

Answer to TY 7

The correct option is C.

Option A is incorrect as there are no formal standards set on the reporting

systems for internal audit function.

Option B is incorrect as internal auditors should report to the top management.

Option D is incorrect as there must be a system of annual review of the working

of concurrent audit.

Answer to TY 8

The correct option is B.

The age-old internal audit practices and procedures followed by entities were
without having regard to the changes in the other department.
 747

Self Examination Questions

Question 1

The audit compliance cell is responsible for:

(i) Reviewing compliance of audit queries raised by internal audit

(ii) Providing direction and oversee the operations of the total audit function in
insurance
(iii) Reviewing the implementation of the guidelines issued by the Internal
Auditor in view of procedural lapses
(iv) Focusing on the follow up on Inter-branch adjustment accounts

A (i) and (iii)

B (i), (ii) and (iii)
C (ii), (iii) and (iv)
D (i) and (iv)

Question 2

Fraud-prone areas in general insurance business include:

(i) High value claim settlement

(ii) Off-balance sheet transaction
(iii) Acceptance of bad or declined risks,
(iv) Loans and advances to employees
(v) Balancing of books,
(vi) Reconciliation of inter-branch accounts,
(vii) Third party claim settlement

A (i), (ii), (iii)

B (iii), (iv), (v), (vi) (vii)
C (i), (iv), (v), (vi)
D (iii), (v) and (vii)
 748

Question 3

The following transactions relate to G R Insurers. Which of the following

options correctly describes the correct accounting treatment followed by its
accountant?

A GR purchased a printer for Rs. 7,500 on 31st December 2011. The accountant
has charged depreciation as per the rates applicable
B GR purchased a motor car for Rs. 3,40,000 on 15 Feb 2012. The accountant
has charged depreciation for one and half months at the rates applicable
C All assets purchased during the year (April to March) costing up to Rs.5,000
each have been written off keeping a balance of Re.1 for each asset. The
amount written off is debited to asset account.
D No depreciation has been provided for assets sold during the year

Question 4

Which of the following statements relating to advances is incorrect?

A The internal auditor examines all advances paid to employees in respect of

travelling, LTS and other advances
B All advances need to be deducted from salaries
C Advance register should be examined thoroughly (by the internal auditor) for
each advance and settlement thereof
D All advances need to be sanctioned by the appropriate authority

Question 5

Proper internal audit system and control will ensure that the financial statements
of an entity will exhibit:

A A true and fair view of profit or loss and state of affairs of the entity
B A correct and accurate view of profit or loss and state of affairs of the entity
C A correct and fair view of profit or loss and state of affairs of the entity
D A true and accurate view of profit or loss and state of affairs of the entity
 749

Answers to Self Examination Questions

Answer to SEQ 1

The correct option is A.

The audit compliance cell is responsible for review compliance of audit queries
raised by internal auditors and reviewing the implementation of the guidelines
issued by the Internal Auditor in view of the procedural lapses in order to
improve the performance of the unit itself and also of the various departments
functioning in the unit.

Points mentioned under (ii) and (iv) are applicable to the Audit Committee of the
Board. Therefore, the other options are incorrect.

Answer to SEQ 2

The correct option is B.

Fraud-prone areas in general insurance business include acceptance of bad or

declined risks, settlement of fraudulent claims, functions in establishment and
estate dept, Financing and Investment Activities, Loans and Advances to
employees or Inter-related parties’ transactions, balancing of books,
reconciliation of inter-branch accounts, Third Party Claim Settlement etc.

Answer to SEQ 3

The correct option is D.

No depreciation has to be provided for assets sold during the year.

Option A is incorrect as depreciation on assets purchased up to 30th September

should be provided as per the rates applicable.

Option B is incorrect as depreciation on assets purchased on or after 1st October

should be provided at half the rates applicable.

Option C is incorrect as amounts written off relating to assets up to Rs.5,000 each

should be debited to the depreciation account.
 750

Answer to SEQ 4

The correct option is B.

Only advances which are overdue must be deducted from salaries.

Answer to SEQ 5

The correct option is A.

With a proper internal audit system and control, the financial statements of an
entity will exhibit a true and fair view of profit or loss and state of affairs of the
entity.
 751

CHAPTER 5

ANNUAL REPORTS, AUDIT AND

INTERNATIONAL FINANCIAL REPORTING
STANDARDS
UNIT 19

INTERNATIONAL FINANCIAL REPORTING

STANDARD-IFRS 4
Chapter Introduction
India Incorporation has started to prepare financial statements in accordance with
Accounting Standards prepared by ICAI in convergence with the IFRS. The
convergence is being carried out by entities in a phased manner from 1 April
2011. The IFRS roadmap requires insurance companies to start preparation of
financial statements in accordance with IFRS 4 –Insurance Contracts, with effect
from 1 April 2012. It is expected that more than 150 countries, including the
USA, will move to IFRS for various classes of companies by 2015.

Therefore, students studying financial accounting now must know the salient
features of IFRS as that is going to be the future accounting norms. Students for
this paper in III should be familiar with IFRS 4- Insurance Contracts as all
insurance companies will convert their opening balance sheet as at 1st April, 2012
in compliance with the converged Indian Accounting Standards.

a) Explain the important aspects of IFRS 4.

b) Explain the disclosure requirements under IFRS 4.
c) Explain the key issues on adoption of Insurance Accounting Standards-
IFRS 4.
 752

Introduction

With the adoption of IFRS by all companies in more than 150 countries, there
will be truly one single language of financial accounting in the business world
enabling comparability of financial statements all over the world and facilitating
more cross-border movements of all capital in various sectors. The newly formed
IASB adopted all of the standards that had been prepared by the IASC and new
accounting standards produced by the board will be known as International
Financial Reporting Standards (IFRS). The term IFRS is understood in this report
to refer to both these new standards that will emerge over time and those set by
the IASB’s predecessor organization.

The ICAI is of the view that IFRS will be advantageous in many respects such
as:
9 saving in cost of capital,
9 saving in cost for preparation of separate set of financial statements,
9 easy comparability of Financial Statements in various sectors over the world

There are many IFRS such as IFRS 1—First-time Adoption of International

Financial Reporting, IFRS 2 Share Based Payment, IFRS 3 Business
Combinations, IFRS 4 Insurance Contracts etc. Here we will discuss a few
important aspects of IFRS 4 Insurance Contracts applicable to insurance
companies. There are over 10,000 Indian companies, including banks and
financial institutions, which will adopt IFRS by 2014.

1. Explain the important aspects of IFRS 4.

[Learning Outcome a]

There will be many changes in accounting treatment for preparation of Financial

Statements in insurance companies on adoption of IFRS 4. The following
changes are the few requirements that have already been published by IASB and
further developments are expected.

1. Compliance with IFRS 4

When IFRS will be applicable, the consolidated accounts of all listed insurance
companies will have to be prepared in compliance with IFRS 4 Insurance
Contracts.
 753

2. More disclosure and greater consistency

With adoption of IFRS-4 Insurance Contracts the financial statements will be

more transparent and comparable across regions. Due to easy comparability of
financial statements across the globe, it will become easier for insurers to find
international investors. It is also believed by various accounting bodies and
regulators that adoption of IFRS-4 Insurance Contracts will bring enhanced
disclosure and greater consistency in insurance accounting.

3. Move towards Fair Value

The IASB has observed that the overall objective of new insurance standards is
to move towards fair value accounting (i.e. recording both assets and liabilities at
the “amount for which an asset could be exchanged or a liability settled).

Apple Insurers purchased a building for Rs. 35 Crores on 15 Dec 2011. Shortly
after it purchased the building, there was an increase in price, and now on 31
March 2012, an equivalent building can be purchased for Rs. 40 crores.

Therefore the entity will recognise the building on 15 Dec 2011 at 35 crores in its
books of account. However on 31 March the fair value of the building is $40
crores, being the amount that would have to be paid if the same or an equivalent
building was acquired currently. Therefore the building will be recognised at 40
crores on 31 March 2012. The increase in the fair value will be recorded as a
revaluation reserve in the books of account.

4. Definition of Insurance Contract

Insurance contract has been defined by IFSR 4 as “A contract under which one
party (the insurer) accepts significant insurance risk from another party (the
policyholder) by agreeing to compensate the policyholder if a specified uncertain
event (the insured event) adversely affects the policyholder.”
 754

Examples of insurance contracts

9 Insurance against theft or damage to property.
9 Insurance against product liability, professional liability, civil liability or
legal expenses
9 Life insurance, prepaid funeral plans (in this case although death is certain, it
is uncertain when death will occur or, for some types of life insurance,
whether death will occur within the period covered by the insurance).

5. Substance of Economic Transactions

The above definition has focused on the substance of economic transactions
rather than the legal form and helped to standardize the treatment of insurance
contracts across industries. The definition will also mean that certain contracts
that are written by insurers will no longer be classified as insurance contracts.

Following are examples of items that are not insurance contracts:

9 Weather derivatives that require a payment based on a climatic, geological or
other physical variable that is not specific to a party to the contract are
financial instruments rather than insurance contracts
9 Certain financial reinsurance contracts and policies with a low degree of risk
transfer (e.g. certain finite risk contracts) will not meet the above definition
and therefore be required to be treated as deposits
9 Hedges

Diagram 1: Classification of contracts

 755

6. Separation between Investment and Insurance

It brings about a requirement to separate the investment and insurance
components of a contract to account for embedded derivatives at fair value, with
movements in their values being recorded in the income statement. IFRS 4
requires the insurer to account for the deposit component of insurance contracts
separately from the insurance contracts. This accounting treatment will ensure
that the balance sheet discloses all assets and liabilities. Furthermore, the deposit
component is to be accounted for in accordance with the provisions of IFRS 9.

7. Life products
Embedded derivatives that will have to be recorded at fair value include life
products offering a guarantee of minimum equity returns on surrender or
maturity, like guaranteed NAV plans.

8. Claims reserves
The IASB takes the view that claims reserves are only permissible to the extent
that they relate to actual liabilities (for a “present obligation arising from past
events, which is expected to result in an outflow of resources embodying
economic benefits). Equalisation and catastrophe reserves do not fulfil this
required definition and so will no longer be permitted.

9. Treatment of Investments
Changes to the treatment of investments will be one of the most important
changes of accounting standard when they adopt IFRSs for the first time. The
measurement and recognition of financial instruments is addressed under IFRS 9.

At the time of initial recognition itself the financial assets and financial liabilities
must be classified as per IFRS 9, as their classification determines the valuation
principles to be followed.

More precisely, the classification of financial assets and financial liabilities

determines whether the gain or loss should be recognised immediately in the
income statement or initially in other comprehensive income** i.e. equity with a
subsequent transfer to income statement.

**Other comprehensive income is a component of equity. It contains details of

incomes and expenses that are not included in the SOCI (i.e. not considered
while calculating the profit or loss), for example, gains on property revaluations
and foreign exchange differences. In short it contains gains and losses that are not
realised.
 756

a) Classification of financial assets

IFRS 9 classifies financial instruments as provided in the following diagram.
Diagram 2: Classification of financial instruments

OCI: Other comprehensive income

Other comprehensive income includes details of incomes and expenses that are
not included in the SOCI (i.e. not considered while calculating the profit or loss),
for example, gains on property revaluations and foreign exchange differences.
Note- Available-for-sale financial assets and Held-to-maturity investments
categories were available under the old standard IAS 39, but have been
eliminated in IFRS 9.

i) Those measured at amortised cost

A financial asset at amortised cost is a financial asset other than an equity

instrument that meets the following conditions:

9 The asset is held within a business model whose objective is to hold assets in
order to collect contractual cash flows.
9 The contractual terms of the financial asset give rise to cash flows on specific
dates that are solely payments of principal and interest on the principal
amount outstanding.
9 The entity has not invoked the fair value option for measurement of financial
assets to reduce an accounting or measurement mismatch.
 757

Guidance for determining the business model

The entity’s business model does not depend on management’s intentions for an
individual instrument. Accordingly, this condition is not an instrument-by-
instrument approach to classification and should be determined on a higher level
of aggregation. Furthermore, a single entity may have more than one business
model for managing its financial instruments. Therefore, classification need not
be determined at the reporting entity level. For example, an entity may hold a
portfolio of investments that it manages in order to collect contractual cash flows
and another portfolio of investments that it manages in order to trade and realise
fair value changes.

ii) Financial assets measured at fair value

A financial asset shall be measured at fair value unless it is measured at

amortised cost.

Option to designate a financial asset at fair value through profit or loss:

As stated in the above paragraph, even for the instruments satisfying the
requirements of being classified as at amortised cost, an entity may, at initial
recognition, irrevocably designate a financial asset as measured at fair value
through profit or loss if doing so eliminates or significantly reduces a
measurement or recognition inconsistency (sometimes referred to as ‘accounting
mismatch’) that would otherwise arise from measuring assets or liabilities or
recognising the gains and losses on them on different bases. This decision once
made is irrevocable.

Following investments are classified at fair value through profit or loss:

9 All investments in equity instruments and contracts on those instruments

9 Investments in unquoted equity instruments (and contracts on those

investments that must be settled by delivery of the unquoted equity
instruments)

In the case of an equity instrument not held for trading, an entity has
additional choice as follows:

9 At initial recognition, an entity may make an irrevocable election to present

in other comprehensive income subsequent changes in the fair value of an
investment
 758

b) Classification of financial liabilities is in accordance with the above

diagram

i) Financial liabilities measured at amortised cost

An entity shall classify all financial liabilities as subsequently measured at

amortised cost using the effective interest method, except for financial liabilities
at fair value through profit or loss, as stated below.

Generally, deposits from customers and issued debt instruments are classified
under this category.
ii) Financial liabilities at fair value through profit or loss

IFRS 9 provides for an option to measure financial liability at fair value through
profit or loss. This option is exercisable if:

9 On using this option, recognition inconsistency (referred to as an 'accounting

mismatch') that would arise on measuring or recognising gain or loss on
financial liability on some different basis is either eliminated or significantly
reduced; or

9 The liability is part or a group of financial liabilities or financial assets and

financial liabilities that is managed and its performance is evaluated on a fair
value basis, in accordance with a documented risk management or
investment strategy, and information about the group is provided internally
on that basis to the entity's key management personnel.

10. Deferred acquisition costs

Deferred acquisition costs will be permitted for insurance contracts and

whichever GAAP that companies currently use will continue to prevail on the
accounting of costs for insurance contracts.

11. Equalisation and catastrophe reserves

Equalisation and catastrophe reserves will not be allowed to be classified as

liabilities following implementation of IFRS 4. However, IFRS 4 does not
prohibit the reporting of equalization reserves as a component of equity.
 759

12. Goodwill

Goodwill will not be amortized (although it will require an annual impairment

test).

13. Move to fair values

As previously mentioned, the move to fair values (also known as prospective

provisioning) will bring an end to the deferral of acquisition costs and the
spreading of premiums over the duration of the contract.

In the case of non-life contracts where a single premium is paid at the start of the
contract, the following accounting treatment is to be followed:

Both premiums and expenses will be recognized immediately as a contract is

signed, with the accounting focused on the present value of expected future cash
flows.

For example, on writing a new policy, all present and future expected cash flows
will be recorded.

9 The net present value (NPV) of relevant contractual premiums will be

recorded as assets and premium income;

9 whilst the future expected cash flows for claims and expenses will be
discounted to their NPV and recorded as liabilities (and claims/expenses)

But the concept is complex for policies where premiums may be received over a
long period (e.g. life assurance policies).

The IASB has indicated that future premiums will be able to be recognised if
policyholders have “non-cancellable continuation or renewal rights that
significantly constrain the insurer’s ability to re-price the contract to rates that
would apply for new policyholders whose characteristics are similar to those of
the existing policyholder” and that “those rights will lapse if the policyholders
stop paying premiums.”
 760

For example, insurers would typically charge lower premium rates on an existing
life assurance policy compared with a new policy for an individual of the same
age. Assuming that the definitions included above are met, the insurer would
recognise the expected cash flows (including premium and payments) allowing
for projected lapse experience.

14. Market value margin (MVM)

The insurers will have to maintain a market value margin (MVM). This margin
aims to take total reserves to the level that would be sufficient to encourage a
third party to accept the relevant liabilities and therefore represent a proxy for
fair value in the absence of a liquid market.

15. Minimum liability adequacy test

The standard lays down that insurers carry out a minimum liability adequacy test
under which a comparison of recognised insurance liabilities will be made
against estimated cash flows.

16. Reinsurance assets will have to be tested for impairment.

Move towards fair value accounting means:

A Recording assets at fair values

B Recording initial cost of assets at fair values
C Recording subsequent cost of assets at cost
D Recording subsequent cost of assets and liabilities at fair values

2. Explain the disclosure requirements under IFRS 4.

[Learning Outcome b]
Experts believe that increased disclosure is one of the most important aspects of
IFRS 4, which will support the move to improve transparency as well as
consistency.

IFRS 4 requires significantly more detailed quantitative and qualitative

information on risk exposures.
 761

The required disclosures include the following important aspects:

1. Explanation of Reported Amounts

This disclosure category will include information on:

9 accounting policies
9 derivation of significant assumptions and material changes to insurance
liabilities, reinsurance assets etc.
9 whether margins are built into the assumptions
9 whether margins are derived from actual data
9 how margins relate to recent experience
9 any gains or losses that have been made in buying reinsurance to aid
comparison between companies

The above mentioned information will help to identify and understand the
amounts in the insurer’s financial statements that arise from insurance contracts.

2. Amount, timing and uncertainty of future cash flows

This will require the disclosure of:

9 risk management policies
9 terms and conditions that have a material impact on the amount, timing and
uncertainty of the insurers’ cash flows
9 information on insurance risk

Information on insurance risk helps users of financial statements to assess the

insurers’ capacity, liquidity and solvency ‘through the eyes of management’, as
well as additional information on insurance, interest rate and credit risks.

3. Disclosures on insurance risk will include information on :

9 concentrations/ accumulation of insurance risk,
9 the sensitivity of profit or loss and
9 equity to variables and claims development data
These disclosures will assist the users of financial statements:
9 in assessing the insurance risk associated with an insurer,
9 to assess the accuracy of reserving practices and
9 to appreciate the company’s financial position, state of affairs and the
underlying economic reality
 762

4. Disclosure of Inflation Assumptions

In the application of discounting, experts want disclosure of the inflation
assumptions that have been used and, in particular, the assumed link between
interest rates and inflation rates. The risk is that higher interest rates lead to a
reduction in discounted claims reserves but inflation anticipation may not be
adequately reflected in claims reserves.

If an increase in interest rate is due to higher actual or anticipated inflation, then

expected nominal cash outflows are likely to increase – a factor that should be
incorporated into reserve calculations.

Disclosure of inflation assumptions would assist users in assessing the degree of

conservatism that has been applied and ensure that insurers do not take additional
credit for reserve discounting when the impact is likely to be offset by greater
cost inflation.
5. Disclosure of market value margin (MVM)
Experts also expect that it will be important for the MVM to be disclosed, so that:
9 users of the accounts are able to clearly identify the best estimate of liabilities
and the margin that has been built into the estimate
9 users of the accounts can make a comparative study
9 analysts can establish likely future profitability and also identify the degree
of confidence that actuaries are able to apply to the reserves set
9 analysts have the option of considering MVMs either as additional capital
above a ‘best-estimate’ of reserves or as a prudential reserve to counter any
uncertainties or bias in reserve calculations

In highlighting the importance of disclosure, the experts desire the issue of

performance presentation in addition to ‘footnote’ disclosures. According to them
the way the income statement and balance sheet have been structured and
presented can significantly enhance the usefulness of the financial data.
 763

Diagram 3: Disclosures under IFRS 4

Disclosures on insurance risk will assist the users of financial statements to:

A Assess the accuracy of reserving practices

B Identify and understand the amounts in the insurer’s financial statements that
arise from insurance contracts
C Assess the accuracy of reserving practices
D Assess the degree of conservatism that has been applied and ensure that
insurers do not take additional credit for reserve discounting when the impact
is likely to be offset by greater cost inflation

3. Explain the key issues on adoption of Insurance

Accounting Standards- IFRS 4.
[Learning Outcome d]
Some of the key issues arising from the implementation of Insurance IFRS as
analysed by experts from implementation in other countries are outlined below:
 764

1. Increase in Volatility

Volatility associated with results is expected to increase as a result of IFRS,

particularly for those entities that currently employ a national GAAP that records
investments at amortised historic cost. The increased volatility will largely stem
from:

9 Financial instruments being valued at market value rather than at amortized

historic cost.

9 The removal of claims equalisation or catastrophe reserves which act to

smooth reported profits.

9 The calculation of fair values (e.g. for embedded derivatives and claims
reserves) will be dependent on a number of assumptions and external
variables that can vary significantly. Fair values may be sensitive to small
changes in these assumptions.

9 The fact that premiums and costs will no longer be smoothed over time
(through deferred acquisition costs and an unearned premium reserve) would
be expected to increase volatility in results. The degree of profit-smoothening
over time will depend on the calculation of MVMs and other factors as
observed by experts.

9 Removal of prudential margins which have historically been used by many

insurers to reduce profit in the good years and enhance profit in the bad
years.

9 Experts opine that volatility in results will be a particular factor following

phase 1 stage of implementation, but may be overcome on subsequent
recording liabilities at fair value.

Following the introduction of fair values and the subsequent discounting on

reserves, changes in the value of assets due to interest rate movements will be
counterbalanced by changes to the valuation of reserves like an increase in
interest rates will lead to a fall in the value of bond assets but also a fall in the
discounted value of reserve liabilities.
 765

2. Cost of capital does remain a possibility

Experts believe that an impact on the cost of capital does remain a possibility but
there is little evidence that the cost of capital would change to levels inconsistent
with the actual risk associated with insurers. As the IASB has noted, many of the
insurers with access to the capital markets already report assets at market value
with the volatility to profit or shareholders’ equity that this entails. In addition, to
the extent that transparency is improved and risk reduced by the proposed new
reporting, and this is rewarded by the markets, there could be some offsetting
benefit to the cost of capital.

3. Economic volatility stemming from accounting

The experts also opine that in considering volatility, it is important to make the
distinction between that resulting from economic mismatch (‘economic
volatility’) and that stemming from accounting mismatch (‘accounting
volatility’). Economic volatility reflects the underlying economic reality of the
business and does have informational content. According to them accounting
volatility may stem from asymmetrical accounting treatment (e.g. the use of a
different accounting basis for assets and liabilities).

Diagram 4: Key issues on adoption of IFRs 4

 766

Which of the following statements is true?

A Economic volatility reflects the underlying economic reality of the business

and does have informational content.
B Economic volatility may stem from asymmetrical accounting treatment.
C Economic volatility may stem from the use of a different accounting basis for
assets and liabilities
D Volatility associated with results is expected to increase as a result of IFRS,
particularly for those entities that currently employ a national GAAP that
records investments at fair values

Appendix 1
For better understanding of the students on preparation of financial statements of
a non-life insurance company in compliance with regulatory norms and
requirements in this regard, the extract of financial statements of the United India
Insurance Company, a non-life insurance company in India is given below. The
said financial statements are taken from the published annual report for 2010 -11
of the United India Insurance Company. The extract of Significant Accounting
Policies and Notes forming part of Financial Statements as on 31st March, 2011
of the company are also appended below for complete understanding of financial
statements. For other accounting information such as Segment Accounting,
Disclosure of details of Employee Benefits required under Accounting Standard
15, etc the students should study annual report of any insurance company.
 767

Annual Report 2010 - 2011

United India Insurance Company Limited
Registration No. : 545, Date of Renewal with IRDA : 10th March 2010
Fire Insurance Revenue Account for the year ended 31 March 2011

Current Year Previous Year

Particulars Schedule
(Rs'000) (Rs'000)
Premium earned (Net) 1 45,29,122 41,04,549
Profit/Loss on sale/redemption of Investments
5,53,879 6,49,112
(Net)
Sundry Balances written back (Net) 18 60,015
Exchange Loss/Gain (837) (1,496)
Interest, Dividend and Rent – Gross 4,77,237 5,58,214
Total (A) 55,59,419 53,70,394
Claims Incurred (Net) 2 31,13,836 19,80,730
Commission 3 24,022 (44,141)
Operating Expenses related to Insurance
4 21,80,889 14,09,531
Business
Others
Expenses relating to Investments 1,345 1,680
Amortisation of Premium on Investments 14,573 21,214
Amount written off in respect of depreciated
11,125 18,080
investments
 768

Current Year Previous Year

Particulars Schedule
(Rs'000) (Rs'000)
Provision for Bad and Doubtful Debts (16,229) (14,838)
Provision for diminution in the value of other
(4,219) 664
than actively traded Equities
Total (B) 53,25,342 33,72,920
Operating Profit / (Loss) C = (A-B) 2,34,077 19,97,474

Appropriations
Transfer to Shareholder's account 2,34,077 19,97,474
Transfer to Catastrophe Reserve
Transfer to Other Reserves (to be specified)
Total ( C ) 2,34,077 19,97,474

The Schedules referred to above form integral part of the revenue account.
 769

Marine Insurance Revenue Account for the year ended 31 March 2011

Current Year Previous Year

Particulars Schedule
(Rs'000) (Rs'000)
Premium earned (Net) 1 24,52,070 21,17,009
Profit/Loss on sale/redemption of
3,03,740 2,42,396
Investments (Net)
Sundry Balances written back (Net) 8 30,031
Exchange Loss/Gain 53 (445)
Interest, Dividend and Rent – Gross 2,61,711 2,08,452
Total (A) 30,17,582 25,97,443
Claims Incurred (Net) 2 21,71,195 21,85,154
Commission 3 1,34,669 2,28,209
Operating Expenses related to Insurance
4 9,60,401 7,12,165
Business
Expenses relating to Investments 738 628
Amortisation of Premium on Investments 7,991 7,922
Amount written off in respect of depreciated
6,101 6,752
investments
Provision for Bad and Doubtful Debts (8,900) (5,542)
Provision for diminution in the value of
(2,314) 248
other than actively traded Equities
Total (B) 32,69,881 31,35,535
 770

Current Year Previous Year

Particulars Schedule
(Rs'000) (Rs'000)
Operating Profit / (Loss) C= (A-B)

Appropriations
Transfer to Shareholders' Account (2,52,299) (5,38,092)
Transfer to Catastrophe Reserve
Transfer to other Reserves (to be specified)
Total (C ) (2,52,299) (5,38,092)

Miscellaneous Insurance Revenue Account for the year ended 31 March 2011

Current Year Previous Year

Particulars Schedule
(Rs'000) (Rs.'000)

Premium earned (Net) 1 3,94,95,117 3,21,60,390

Profit/Loss on /sale/redemption of Investments
50,46,451 46,76,331
(Net)
Sundry Balances written back (Net) 112 3,94,332
Transfer fees, etc. 10,097 8,530
Exchange Loss/Gain 277 (128)
Interest, Dividend and Rent– Gross 45,96,453 40,21,486
Total (A) 4,91,48,507 4,12,60,938
 771

Current Year Previous Year

Particulars Schedule
(Rs'000) (Rs.'000)
Claims Incurred (Net) 2 3,85,71,363 2,91,26,546
Commission 3 25,56,694 21,45,378

Operating Expenses related to Insurance Business 4 1,41,12,553 94,48,250

Others
Expenses relating to Investments 12,254 12,104
Amortisation of Premium on Investments 1,32,771 1,52,833
Amount written of in respect of depreciated
1,01,361 1,30,249
investments
Provision for Bad and Doubtful Debts (1,47,864) (1,06,899)
Provision for diminution in the value of other than
(38,436) 4,787
actively traded Equities
Total (B) 5,53,00,695 4,09,13,248
Operating Profit / (Loss) C= (A-B) (61,52,188) 3,47,693

Appropriations (61,52,188) 3,47,693

Transfer to Shareholders' Account
Transfer to Catastrophe Reserve
Transfer to Other Reserves (to be specified)
Total ( C ) (61,52,188) 3,47,693
 772

Profit and loss account for the year ended 31 March 2011

Current Year Previous Year

Particulars Schedule
(Rs.'000) (Rs.'000)
Operating Profit / (Loss)
Fire Insurance 2,34,077 19,97,474
Marine Insurance (2,52,299) (5,38,092)
Miscellaneous Insurance (61,52,188) 3,47,693
Income from Investments
Interest, Dividend and Rent - Gross 34,65,527 30,19,042
Profit on sale of investments 40,22,072 35,10,652
Other Income
Profit / Loss on sale of assets and other income 38,996 36,627
Total (A) 13,56,185 83,73,396
Provisions (other than taxation)
For diminution in the value of investments (30,634) 3,594
For doubtful debts (1,17,849) (80,252)
Other Expenses
Expenses other than those related to Insurance
9,767 9,087
Business
Bad debts written off 0 0
 773

Current Year Previous Year

Particulars Schedule
(Rs.'000) (Rs.'000)
Amortisation of Premium on Investments 1,05,820 1,14,736
Amount written off in respect of depreciated
80,785 97,782
investments
Total (B) 47,889 1,44,947
Profit before Tax ( C ) = (A-B) 13,08,296 82,28,449
Provision for Taxation 7,000 11,60,000
Taxation relating to earlier ears (4,152) (9,453)
Profit After Tax (D) 13,05,448 70,77,902
Appropriations
Interim dividends paid during the year 0 0
Proposed final dividend 3,00,000 14,20,000
Dividend distribution tax 48,555 2,41,211
Transferred to General Reserve 9,56,893 54,16,691
Balance of profit brought forward from last year 0
Balance carried forward to Balance Sheet
Basic and diluted earnings per share (Rs.) 8.7 47.19

Refer Significant accounting policies and notes to accounts

The Schedules referred to above form integral part of the Profit and Loss Account
 774

Balance Sheet As at 31 March 2011

Particulars Schedule Current Year (Rs.'000) Previous Year (Rs.'000)
Sources of Funds
Share Capital 5 15,00,000 15,00,000
Reserves and surplus 6 4,09,79,332 4,00,24,458
Fair value change account 4,71,62,518 4,80,84,542
Borrowings 7 0 0
Total 8,96,41,850 8,96,09,000
Application of funds
Investments 8 15,26,67,223 13,44,82,953
Loans 9 40,36,716 45,35,649
Fixed Assets 10 8,64,213 10,83,782
Current Assets
Cash and bank balances 11 98,77,966 84,37,558
Advances and other assets 12 1,93,32,354 2,35,57,734
Sub Total (A) 2,92,10,320 3,19,95,292
Current Liabilities
Provisions 13 6,73,12,969 5,36,08,200
Sub Total (B) 14 2,98,23,653 2,88,80,476
Net Current Assets (C ) = (A-B) 9,71,36,622 8,24,88,676
Miscellaneous expenditure (67926302) (50493384)
Debit balance in profit and loss
15 0 0
account
Total 8,96,41,850 8,96,09,000

Significant accounting policies and notes to accounts 1

The Schedules referred to above form integral part of the Balance Sheet
 775

Contingent Liabilities

Sr. Current Year Previous Year

Particulars
No. (Rs.'000) (Rs.'000)

1 Partly paid-up Investments 21,402.00 0.00

Claim other than those under
2 policies, not acknowledged as 1,008,040.68 706,850.15
debts
Underwriting commitments
3 outstanding (in respect of Shares NIL NIL
and securities)
Guarantee given by or on behalf
4 NIL NIL
of the company
Statutory demands / liabilities in
5 2,737,794.45 3,821,893.00
dispute, not provided for
Reinsurance obligations to the
6 NIL NIL
extent not provided for
Letters of credit given on behalf
7 NIL NIL
of the company
Total 3,767,237.13 4,538,743.18
 776

Schedules to Fire Insurance Revenue Account

For the year ended 31st March, 2011

Current Previous
Particulars
Year Year

Schedule 1 - Fire Premium Earned (net)

Premium from Direct business written 8,053,252 6,522,542

Add: Premium on Reinsurance accepted 823,453 554,952
Less: Premium on Reinsurance ceded 3,775,878 3,020,913
Net Premium 5,100,827 4,056,584
Adjustment for change in reserve for
(571,705) 47,968
unexpired risks
Total Premium Earned (Net) 4,529,122 4,104,549

Schedule 2 – Fire Claims Incurred (Net)

Claim Paid
Direct Business 4,235,414 3,503,991
Add: Reinsurance accepted 238,215 395,227
Less: Reinsurance ceded 1,404,029 1,012,152
Net Claims Paid 3,069,604 2,887,066
Add: Claims outstanding at the end of the
8,198,487 6,923,448
year - Direct
Add: Claims outstanding at the end of the
404,043 520,076
year - RI accepted
Less: Claims outstanding at the end of the
4,975,948 3,861,174
year - RI ceded
Add: Claims outstanding at the end of the
3,626,582 3,582,350
year - Net
Less: Outstanding claims at the beginning of
6,923,448 6,523,900
the year - Direct
Less: Claims outstanding at the beginning of
520,076 747,772
the year - RI accepted
 777

Current Previous
Particulars
Year Year
Add: Claims outstanding at the beginning of
3,861,175 2,782,986
the year - RI Ceded
Less: Claims outstanding at the beginning of
3,582,350 4,488,686
the year - Net
Claims incurred (Net) 3,113,836 1,980,730

Schedule 3- Fire Commission (Net)

Commission Paid
Direct 473,634 402,782
Total (A) 473,634 402,782
Add: Commission on Reinsurance accepted 93,363 90,458
Less: Commission on Reinsurance ceded 542,975 537,381
Net Commission 24,022 (44,141)

Break-up oth the expenses (Gross)

incurred to procure business

Agents 275,073 239,756

Brokers 70,997 60,826
Corporate Agency 119,529 100,716
Referral 8,065 1,484
Total (B) 473,634 402,782
 778

Schedules to Marine Insurance Revenue Account

For the year ended 31st March 2011

Current Previous
Particulars
Year Year

Schedule 1 – Marine Premium Earned

(Net)

Premium from Direct business written 5,015,288 4,535,619

Add: Premium on Reinsurance accepted 183,338 186,848
Less: Premium on Reinsurance ceded 2,707,284 2,212,752
Net Premium 2,491,342 2,509,715
Adjustment for change in reserve for
(39,272) (392,706)
unexpired risks
Total Premium Earned (Net) 2,452,070 2,117,009

Schedule 2 – Marine Claims Incurred (Net)

Claim Paid
Direct Business 2,450,786 2,776,437
Add: Reinsurance accepted 1,760,203 123,776
Less: Reinsurance ceded 2,406,298 963,241
Net Claims Paid 1,804,691 1,936,972
Add: Claims outstanding at the end of the
5,166,270 4,869,284
year - Direct
Add: Claims outstanding at the end of the
369,095 293,007
year - RI accepted
Less: Claims outstanding at the end of the
3,434,674 3,428,104
year - RI ceded
Add: Claims outstanding at the end of the
2,100,692 1,734,187
year - Net
Less: Outstanding claims at the beginning of
4,869,284 4,436,211
the year - Direct
 779

Current Previous
Particulars
Year Year
Less: Claims outstanding at the beginning of
293,007 364,354
the year - RI accepted
Add: Claims outstanding at the beginning of
3,428,103 3,314,560
the year - RI Ceded
Less: Claims outstanding at the beginning of
1,734,187 1,486,005
the year - Net
Claims incurred (Net) 2,171,195 2,185,154

Schedule 3 – Marine Commission (Net)

Commission Paid
Direct 351,031 378,971
Total (A) 351,031 378,971
Add: Commission on Reinsurance accepted 24,242 26,489
Less: Commission on Reinsurance ceded 240,605 177,251
Net Commission 134,669 228,209

Break-up of the expenses (Gross) incurred

to procure business

Agents 186,648 161,124

Brokers 161,452 215,202
Corporate Agency 2,830 2,626
Referral 101 18
Total (B) 351,031 378,971
 780

Schedules to Misc. Insurance Revenue Account

For the year ended 31st March 2010

Current Previous
Particulars
Year Year

Schedule 1 – Miscellaneous Premium

Earned (Net)

Premium from Direct business written 50,698,033 41,332,367

Add: Premium on Reinsurance accepted 6,336,262 5,148,087
Less: Premium on Reinsurance ceded 13,457,016 11,145,186
Net Premium 43,577,279 35,335,268
Adjustment for change in reserve for unexpired
(4,082,162) (3,174,878)
risks
Total Premium Earned (Net) 39,495,117 32,160,390

Schedule 2 – Miscellaneous Claims Incurred

(Net)

Claim Paid
Direct Business 36,538,596 32,656,935
Add: Reinsurance accepted 3,006,266 1,405,806
Less: Reinsurance ceded 7,943,435 5,774,209
Net Claims Paid 31,601,428 28,288,532
Add: Claims outstanding at the end of the year
39,979,259 37,478,669
- Direct
Add: Claims outstanding at the end of the year
16,807,089 9,906,287
- RI accepted
Less: Claims outstanding at the end of the year
15,427,780 12,996,323
- RI ceded
Add: Claims outstanding at the end of the
41,358,568 34,388,632
year - Net
Less: Outstanding claims at the beginning of
37,478,669 39,789,744
the year - Direct
 781

Current Previous
Particulars
Year Year
Less: Claims outstanding at the beginning of
9,906,287 6,005,163
the year - RI accepted
Add: Claims outstanding at the beginning of
12,996,323 12,244,287
the year - RI Ceded
Less: Claims outstanding at the beginning of
34,388,634 33,550,619
the year - Net
Claims incurred (Net) 38,571,363 29,126,456

Schedule 3 –Misc. Commission (Net)

Commission Paid
Direct 3,374,635 3,075,837
Total (A) 3,374,635 3,075,837
Add: Commission on Reinsurance accepted 339,211 614,932
Less: Commission on Reinsurance ceded 1,157,152 1,545,391
Net Commission 2,556,694 2,145,378

Break-up of the expenses (Gross) incurred

to procure business

Agents 2,338,468 2,117,346

Brokers 753,597 684,405
Corporate Agency 262,580 257,131
Referral 19,990 16,955
Total (B) 3,374,635 3,075,837
 782

Other Schedules for the year ended 31st March, 2010

Schedule– 4;Operating expenses related to insurance business

Current Previous
Particulars
Year Year

Employees' remuneration and welfare

1,39,46,626 86,01,307
benefits
Travel, conveyance and vehicle
4,34,598 3,84,393
running expenses
Training Expenses 30,527 22,316
Rents, rates and taxes 3,79,945 3,42,165
Repairs 1,26,745 1,04,761
Printing and stationery 1,50,565 1,40,630
Communication 1,83,240 1,98,584
Legal and professional charges 39,138 24,099
Auditor's fees Expenses etc
a) as Auditor 21,653 20,743
b) As Advisor or in any other capacity,
in respect of
1. Taxation matters
2. Insurance matters
3. Management services and
C) Any other capacity 1,614 1,284
Advertisement and publicity 1,92,989 1,42,419
Interest and Bank charges 28,360 36,993
Service Tax on Premium A/c 589
Others 14,01,516 11,14,793
Depreciation 3,15,736 4,35,459
Total 1,72,53,842 1,15,69,946
 783

Balance Sheet Schedules for the year ended 31st March, 2010
Schedule – 5; Share Capital
Current Previous
Particulars
Year Year
Authorised Capital
200000000 Equity Shares of Rs. 10/- each 2,000,000 2,000,000
Issued Capital
150000000 Equity shares of Rs. 10/- each
(includes 14,63,74,857 Equity Shares of
Rs. 10/- each issued as Bonus Shares by 1,500,000 1,500,000
Capitalisation of General Reserve and
Share Premium Account)
Subscribed Capital
150000000 Equity shares of Rs. 10/- each
(includes 14,63,74,857 Equity Shares of
Rs. 10/- each issued as Bonus Shares by 1,500,000 1,500,000
Capitalisation of General Reserve and
Share Premium Account)
Called up Capital
150000000 Equity shares of Rs. 10/- each
(includes 14,63,74,857 Equity Shares of
Rs. 10/- each issued as Bonus Shares by 1,500,000 1,500,000
Capitalisation of General Reserve and
Share Premium Account)
Less: Calls unpaid
Add: Equity Shares forfeited (Amount
originally paid up)
Less: Per Value of Equity Shares bought
back
Less: Preliminary Expenses
Less: Expenses including commission or
brokerage on Underwriting or subscription
of shares
Total 1,500,000 1,500,000

Note: Of the above 19,61,49,366 shares are issued as fully paid up bonus shares
by capitalisation of General Reserves.
 784

Schedule 5A; Pattern of Shareholding

(As Certified by Management) Numbers in (000)

Current Year Previous Year

Shareholder No, of % of No, of % of
Shares Holding Shares Holding
Promoters
Indian
Government of India 149,999,970 149,999,970
Nominees of Govt. of
30 100 30 100
India
Total 150,000,000 100 150,000,000 100

Schedule 6; Reserves and surplus

Particulars Current Year Previous Year

Capital Reserve 13,589 13,589

Capital Redemption Reserve
Share Premium
General Reserve 39,988,852 34,572,161
Add: Transfer from Profit and
956,893 5,416,691
Loss Account
40,945,745 39,988,852
Catastrophe Reserve
Other Reserves - Investment
8,744 8,628
Reserve
Foreign Currency Translation
13,390 41,528
Reserve - Opening
Additions during the year (2,136) (28,138)
Closing Balance 11,254 11,390
Balance of Profit in Profit and loss
account
Total 40,979,332 40,024,458
 785

Schedule 7: Borrowings

Particulars Current Year Previous Year

Debentures / Bonds 0 0
Banks 0 0
Financial Institutions 0 0
Others (to be specified) 0 0
Total 0 0

Schedule 8: Investments

Current Previous
Particulars
Year Year

Investments
Long Term Investment
Government securities and Govt. guaranteed 33,110,086 26,755,764
bonds including Treasury Bills)
Other Approved Securities 10,475 10,475
 786

Current Previous
Particulars
Year Year
Other Investment
(a) Shares
(aa) Equity 62,904,103 60,126,401
(bb) Preference 8,045 3,072
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures and bonds 15,501,877 11,993,236
(e) Other Securities
(f) Subsidiaries 762 762
(g) Investment Properties - Real Estate
78,414,787 72,123,470
Investments in Infrastructure and Social sector 31,069,435 26,584,526
Other than Approved Investments 3,966,253 4,103,479
Sub Total 146,571,036 129,577,715
Short term Investments
Govt Securities and Govt Guaranteed bonds
2,763,086 2,381,205
including Treasury Bills
Other Approved Secuerities - -
Other Investments
 787

Current Previous
Particulars
Year Year
(a) Shares
(aa) Equity
(bb) Preference 4,973
(b) Mutual Funds 642,597 50,005
(c) Derivative Instruments
(d) Debentures and bonds 1,104,000 213,977
(e) Other Securities - Commercial Papers 145,707 188,748
(f) Subsidiaries
(g) Investment Properties - Real Estate
1,892,304 457,703
Investments in Infrastructure and Social Sector 1,436,517 1,055,439
Other than Approved Investments 4,280 1,010,892
Sub Total 6,096,187 4,905,239
Total 152,667,223 134,482,954

Aggregate amount of Company's Investment

other than listed equity securities and derivative
instruments
Book Value 78,100,752 59,448,863
Market Value 78,236,991 60,764,211
 788

Schedule 9: Loans
Current Previous
Particulars
Year Year
Loans
Security-wise classification
Secured
(a) On mortgage of properties
(aa) In India 488,993 534,445
(bb) Outside India
(b) On Shares, Bonds, Govt. Securities
(c) On others (Govt. Guaranteed Loans) 3,284,944 3,630,519
Unsecured 262,779 370,685
Total 4,036,716 4,535,649
Borrower-wise Classification
(a) Central and state Govt 1,619,043 1,768,034
(b) Banks and financial institutions 75,000
(c) Subsidiaries - -
(d) Industrial undertakings 751,772 830,130
(e) Loans to HUDCO 32,000 100,000
(f) Employees Housing Loan 1,633,901 1,762,485
Total 4,036,716 4,535,649
Performance-wise classification
(a) Loans classified as standard
(aa) In India 3,603,616 3,863,468
(bb) Outside India
(b) Non-performing loans less provisions
(aa) In India 23,618 20,623
(bb) Outside India
Provisions 409,482 651,558
Total 4,036,716 4,535,649
Maturity-Wise Classification
(a) Short term 54,809 25,849
(b) Long Term 3,981,907 4,509,800
Total 4,036,716 4,535,649

Note:
1) Provisions against non-performing loans – Rs. 409482
2) Loans considered doubtful are Rs. 433,100/- and amount of provision created
against such loans – Rs. 409,482/-
 789

Schedule 10; Fixed Assets in ` (000)

Cost / Gross Block Depreciation Net Block

On
Particulars Additions Deducti
Upto last For the sales / As at Previous
Opening / ons/Tra Closing To date
Year year adjustm year end Year
Transfers nsfers
ents
Goodwill
Intangibles 152,442 10,401 35,800 127,043 36,141 30,528 8,329 58,340 68,703 116,301
Land -
3,694 - - 3,694 - - - - 3,694 3,694
freehold
Land-
2,642 - - 2,642
Leasehold 616 38 - 654 1,988 2,026
Leasehold
114,415 970 1,514 113,871 47,217 1,408 - 48,625 65,246 67,198
Properties
Building 571,350 17,509 1,848 587,011 340,282 14,534 - 354,816 232,195 231,068
Furniture
250,238 14,400 1,649 262,989 216,691 10,764 1,055 226,400 36,589 33,547
and fittings
Information
Technology 1,720,011 80,474 34,712 1,765,773 1,507,178 169,998 34,519 1,642,657 123,116 212,833
Equipment
Vehicles 317,621 50,650 52,792 315,479 105,720 60,944 34,638 132,026 183,453 211,901
Office
92,163 6,954 2,661 96,456 68,754 4,687 2,143 71,298 25,158 23,409
Equipment
Others -
Electrical 347,066 10,856 1,142 356,780 251,386 16,867 1,031 267,222 89,558 95,680
Equipments
Other Assets 108,039 13,641 2,769 118,911 80,742 6,020 2,364 84,398 34,513 27,297
Total 3,679,681 205,855 134,887 3,750,649 2,654,727 315,788 84,079 2,886,436 864,213 1,024,954
 790

Cost / Gross Block Depreciation Net Block

On
Particulars Additions Deducti
Upto last For the sales / As at Previous
Opening / ons/Tra Closing To date
Year year adjustm year end Year
Transfers nsfers
ents
Work-in-
58,828 - 58,828 - - - - - - 58,828
progress
Grand
3,738,509 205,855 193,715 3,750,649 2,654,727 315,788 84,079 2,886,436 864,213 1,083,782
Total
Previous
3,895,958 668,055 825,504 3,738,509 2,656,319 435,457 437,049 2,654,727 1,083,782 1,239,639
Years
 791

Receipts and Payments Account/cash flow statement

Current Previous
Particulars
Year Year

I. A. Cash flow from Operating Activities

Premium received from policyholders,
including advance receipts, net of 63,533,341 52,782,705
coinsurance
Other Receipts 176,831 318,413
Payments to reinsurers, net of commission
5,003,051 (4,292,214)
and claims
Payments to coinsurers, net of claims
1,078,049 821,706
recovery
Payments of claims (43,224,797) (38,937,363)
Payments of commission and brokerage (4,070,913) (3,821,132)
Payments of other operating expenses (17,129,433) (9,056,126)
Deposits, advances and staff loans 129,700 108,104
Income tax paid (net) (665,745) (1,313,842)
Service tax paid (net ) (436,738) 172,824
Other payments / collections (net) 644,269 72,140
Gain / loss on Foreign Exchange fluctuations 4,029 19,405
Cash flow before extraordinary activities 5,041,646 (3,125,380)
Extraordinary activities - -
Cash flow after extraordinary activities 5,041,646 (3,125,380)
Net cash flow from the operating activities 5,041,646 (3,125,380)
II. Cash flow from the Investing Activities
Purchase of fixed assets (142,330) (631,787)
Proceeds from sale of fixed assets 19,818 15,742
Purchase of investments (net ) (122,897,279) (116,049,084)
Sale value of Investments 113,627,756 116,971,501
Rents/ Interests / Dividends received 7,480,766 6,224,183
Expenses relating to investments (28,759) (27,089)
Net Cash Flow from Investing Activites (1,940,027) 6,503,466
 792

Current
Particulars Previous Year
Year

III. Cash flow from the financing Activities

Proceeds from issuance of share capital - -
Proceeds from borrowing - -
Repayments of borrowings - -
Interest / Dividends paid (1,661,211) (1,123,034)
Net cash flow from the Financing Activities (1,661,211) (1,123,034)
Net increase in cash and cash equivalents 1,440,408 2,255,052
Cash and cash Equivalents at the beginning
8,437,558 6,182,506
of the year
Cash and cash Equivalents at the end of the
9,877,966 8,437,558
year

Significant Accounting Policies and

Notes Forming Part of Financial Statements
as on 31st March 2011

I. Significant Accounting Policies

1. Accounting Convention

The Balance Sheet, the Profit and Loss Account, Revenue Accounts, Schedules
and Cash Flow Statement are drawn in accordance with the provisions of Section
11 (1A) of the Insurance Act, 1938, read with provisions of Sub-section (5) of
Section 227 of the Companies Act, 1956 and the Insurance Regulatory and
Development Authority (IRDA) Act, 1999 along with the instructions issued by
IRDA from time to time.

The said statements are prepared on historical cost convention and on accrual
basis of accounting, comply with the Accounting Standards referred to in Section
211(3C) of the Companies Act, 1956 to the extent applicable, and also with the
Insurance Regulatory and Development Authority (Preparation of Financial
Statements and Auditor's Report of Insurance Companies) Regulations 2002, and
conform to the practices prevailing in the General Insurance Industry in India
except as otherwise stated.
 793

2. Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amount of assets, liabilities, revenues and expenses and
disclosure of contingent liabilities on the date of the financial statements. Actual
results may differ from those estimates and assumptions. The estimates and
assumptions used in the accompanying financial statements are based upon
management's evaluation of the relevant facts and circumstances as on the date of
the financial statements. Any revision to accounting estimates is recognized
prospectively in current and future periods.
3. Premium
3.1 Direct Business
9 Premium income is recognised on assumption of risk. A reserve for unearned
premium for each segment representing that part of the recognized premium
attributable to the succeeding accounting periods, calculated on time
apportionment basis is created. This forms part of the unexpired risk
reserves.
9 Premium refunds are accounted on the basis of endorsements passed during
the year.

3.2 Reinsurance
9 The returns from foreign reinsurance companies to the extent received up to
31st March and the returns from Indian Reinsurers received up to finalisation
of accounts of the relevant accounting year are incorporated.
9 Reinsurance cessions are made on the basis of advices / returns received from
the operating offices. Wherever full particulars are not available, reinsurance
cessions are estimated on the basis of information available.
9 Pool Cessions / Acceptances: Premium, Claims, Service charges, Investment
income and expenses in respect of Terrorism Pool retro and Motor TP Pool
retro are accounted as per the statements received from GIC (Pool
Administrator) up to finalisation of accounts. Premium, Claims, Service
charges and expenses of our cessions in respect of Terrorism Pool /Motor TP
Pool are accounted up to 31 March.
3.3 Reserve for Unexpired Risk
The Reserve for unexpired risk are made at 50% of net premium except in the
case of Marine Hull business and Terrorism, where it is made at 100% of net
premium.
 794

4. Claims

4.1 Direct Business

9 Estimated Liability for outstanding claims at the year-end are based on

survey reports, advices of Leaders, information provided by clients and other
sources up to the date of finalisation of accounts, past experience and other
applicable laws.

9 All expenses directly attributable to claims including exchange fluctuations

are debited to claims.

9 In respect of unidentified motor third party claims outstanding for more than
one year, provision is made at the rate of 100% of the estimated liability. In
other cases, provision is made at the rate of 1/3rd of the estimated liability.

4.2 Reinsurance

Liability for outstanding claims in respect of Foreign Inward acceptances is

based on Actuarial Valuation and actual returns received up to finalisation of
accounts.

4.3 Claims Incurred but Not Reported (IBNR) and Incurred but Not Enough
Reported (IBNER) is made on the basis of actuarial valuation.

4.4 Salvage and other Recoveries

Recoveries under claims and disposal of salvage are accounted on realisation and
are credited to claims.

5. Expenses of management

d) Apportionment of expenses

Expenses of Management are apportioned to the Revenue Accounts on the basis

of gross direct premium plus reinsurance accepted, giving weightage of 75% for
Marine business and 100% for Fire and Miscellaneous business. Expenses
relating to policy stamps and reinsurance are directly taken to respective Revenue
Accounts. Expenses relating to Investment, such as safe custody, collection of
interest/dividend, bank charges etc., are apportioned between Revenue Accounts
and Profit and Loss Account based on policyholders' and shareholders' funds as
at the beginning of the year.
 795

e) Depreciation

9 Depreciation on fixed assets (except Software considered under intangible

assets), is charged on written down value method at the higher of the rates
specified in the Income Tax Rules, 1962and those specified in Schedule XIV
to the Companies Act, 1956.

9 Depreciation is provided at 50% of the applicable rates on additions to fixed

assets held for less than 180 days. No depreciation is provided on assets sold,
discarded or destroyed during the year.

9 Depreciation is provided on Land and Building as a whole where separate

costs are not ascertainable.

9 Assets whose actual cost does not exceed five thousand rupees are written off
in the year of acquisition, by retaining 1rupee per asset as book value.

9 Cost of Lease Hold properties have been amortised over the period of Lease.

f) Employee Benefits

The Company has adopted the policy of accounting employee benefits in

accordance with Accounting Standard 15 (Revised) issued by Institute of
Chartered Accountants of India as under:

9 Provident Fund

Provident Fund is a defined contribution scheme as the Company pays fixed

monthly contribution at pre-determined rates to a separate trust. The obligation of
the Company is limited to such fixed contribution.

9 Post-Employment Benefits

Pension and Gratuity liabilities are defined benefit obligations and are provided
for on the basis of an actuarial valuation made at the end of the financial year.
The schemes are funded by the Company and are managed by separate Trusts.

9 Encashment of Earned Leave

Accumulated Earned Leave (EL), which is encashable at the time of retirement,

is provided for based on actuarial valuation.
 796

9 Short Term Benefits

Short term employee benefits which fall due wholly within twelve months after
the end of the period in which the employees render the related service such as
Leave Travel Subsidy (LTS), Medical Benefits, etc., are provided on the basis of
estimates.

6. Translation/Conversion of Foreign Currencies

6.1 Items of income and expenditure, Monetary items as at the Balance Sheet
date of foreign branch and foreign currency transactions in Indian operations
are translated as under:

9 Items of income and expenditure at the quarterly average rates.

9 Monetary items as at the Balance Sheet date are converted at the exchange
rates prevailing at that date.

6.2 Exchange differences on account of translation of the balances relating to

foreign branch (non-integral) is accumulated in a Foreign Currency
Translation Reserve until the closure of the operation. On the closure of this
non-integral foreign operation, the cumulative amount of the exchange
differences which have been deferred will be recognized as income or as
expenses in the year of such closure.

6.3 The difference in translation arising out of foreign currency transaction in

Indian operations is recognized in the relevant Revenue Accounts / Profit and
Loss Account as applicable.

7. Loans and investment

7.1 Purchase and sale of shares, bonds and debentures are accounted for on the
date of contract (Trade Date).

7.2 The cost of investment includes Securities Transaction Tax (wherever

applicable), premium on acquisition and other direct expenses incurred for
the acquisition of the investment and is net of commission/fee earned
thereon.

7.3 Investments maturing within 12 months from the Balance Sheet date are
classified as Short Term Investments except in respect of Equity Shares
 797

which are treated as Long Term Investments. All other investments are
classified as Long Term Investments.

7.4 Money market instruments such as Certificate of Deposit, Commercial

Papers and CBLO which are discounted at the time of contract, are accounted
at their discounted value.

7.5 Investments in debt securities including Government Securities and

redeemable Preference Shares are shown at cost subject to amortisation. The
premium, based on weighted average cost is amortised over the residual
period of maturity, including the years of investment and excluding the year
of redemption, by considering put/call option.

7.6 Investment in Equity shares that are actively traded, are valued at lower of
the last quoted prices in NSE / BSE, in the month of March. Investments in
Equity shares of companies outside India that are quoted and actively traded
are valued at last quoted price at London Stock Exchange. The unrealised
gains/losses are recognised in Fair Value Change account.

7.7 Investments in Unlisted/Thinly traded equity shares including shares held in

companies incorporated outside India are valued at cost and provision is
made for diminution in value of such investments when break-up value is
lower than the cost. In case the break-up value is negative, provision is
made@100% of book value.

7.8 Investment in units of Mutual funds, are valued at Net Asset Value as at the
Balance Sheet date as declared by the funds and unrealized gains / losses are
recognized in Fair Value Change Account.

Investments in Venture Capital Fund are valued at cost. Provision is made for
diminution in value of such investments where Net Asset Value as at the
Balance Sheet date is lower than cost. Wherever Net Asset Value as on
Balance Sheet date is not available, latest available Net Asset Value nearer to
Balance Sheet date is considered.

7.9 Impairment is recognised in

9 Equity shares of companies which have been continuously incurring losses

during three immediately preceding years and the capital of which has been
partially or fully eroded, or where the audited annual accounts for the three
immediately preceding years are not available.
 798

9 Investments are written down as under:

a) Equity shares which are actively traded are written down to their market
value.

b) Equity shares other than actively traded, are written down to the breakup
value and where the breakup value is negative, are written down to 1/-
rupee per company.

9 The Company follows the prudential norms prescribed by the Insurance

Regulatory and Development Authority as regards asset classification,
recognition of income and provisioning pertaining to loans / advances /
debentures.

9 In respect of preference shares other than those in the nature of advances,

provision for permanent diminution is made to the extent of 100%.

The permanent diminution in respect of preference shares is reckoned as

follows:

a) The preference dividend is not paid for three consecutive years (or)

b) The maturity proceeds have not been received for three consecutive years
(or)

c) The company has incurred losses in three immediately preceding years

and the capital of which has been partially or fully eroded.

d) Where the audited annual accounts for the three immediately preceding
years are not available.

7.10 Profit or Loss on realisation/sale of investment is computed by taking

weighted average book value of each investment.

7.11 Dividend income (other than interim dividend) is accounted for as income in
the year of declaration. Interim dividends are accounted on the basis of
declaration in the Board Meeting held on or before 31st March of the
financial year and realized subsequently. Income from shares and
debentures, which are under objection / pending delivery, is accounted for
on receipt basis.
 799

7.12 Revenue with respect to Venture Capital Funds is recognised on Receipt

basis.

7.13 Amounts received towards compensation for future loss of interest is

recognized as income only to the extent attributable to the accounting year
and the balance is kept in interest received in advance account for
apportionment in the relevant years.

7.14 Investment income, profit/loss on sale/realisation of investment, expenditure

relating to investments, amortisation of premium on investments, amount
written off/written down in respect of depreciated investments, provision for
non-performing investment/diminution in value are apportioned to Revenue
Accounts and Profit and Loss Account on the basis of Policyholders' Fund
and Shareholders' Fund as at the beginning of the year.

8. Assets

8.1 Fixed Assets

Fixed Assets are stated at cost less depreciation.

8.2 Intangible Assets

Intangible Assets are stated at cost of development / acquisition less

accumulated amortisation. The same is amortised over a period of three years on
straight line basis. Software development / acquisition costs, except those which
meet the recognition criteria as laid down in Accounting Standard 26 (AS 26),
are charged to revenue.

9. Taxation

9.1 Provision for taxation is made after due consideration of the applicable
judicial pronouncements and opinions from the Company's counsel. Disputed
taxes are shown under 'Contingent Liabilities' in notes forming part of
accounts.

9.2 Deferred tax is recognised, subject to the consideration of prudence, on

timing differences, being the difference between taxable incomes and
accounting income that originate in one period and are capable of reversal in
one or more subsequent periods.
 800

10. Provisions and Contingencies

10.1 The Company creates provision based on a reliable estimate for the present
obligation of a past event that might cause outflow of resources in future.

10.2 Disclosure for a contingent liability is made when there is a possible

obligation or a present obligation that may or may not require an outflow of
resources.

10.3 Contingent assets are neither recognized nor disclosed in the financial
statements.

II. Notes to Accounts

(Previous year's figures, wherever necessary, have been shown in brackets)

1. (a) Contingent Liability

(Amount in lakhs)
31.03.2011 31.03.2010
Rs. Rs.
On partly paid shares 214.02 0
Claims other than those under policies, not
acknowledged as debts 10,080.41 7,168.5
Guarantees given by or on behalf of the
Company 0 0
Statutory demands / liabilities in dispute,
not provided for 27,377.94 38,218.93

Note: Statutory demands include a sum of Rs 26207.73 lakhs in respect of

income tax. The Income Tax authorities have suo motto adjusted the refund due
to the company amounting to Rs 26222.65 lakhs.

1(b) The Service Tax Department has disallowed cenvat credit availed by the
company on bills raised on authorised service stations' for the earlier years up to
2008-09 and the same have been appealed against. In the event of disallowance
by the Service Tax authorities for the year 2009-10, a sum of Rs. 119.31 lakhs
would be disallowed towards Cenvat Credit. For 2010-11, the return is yet to be
filed.
 801

2. (a) Encumbrances to Assets of the Company in and outside India

(Amount in lakhs)
31.03.2011 31.03.2010
Rs. Rs.
Deposits towards margin money for issue of
letters of credit / bank guarantee 70 70
Deposits made in court as per orders
/attachments of bank accounts for claims 514.02 571.21
Deposits made to comply with Overseas
Statutory requirements 0 22.18

(b)Investments / Deposits made in accordance with statutory requirements

(Amount in lakhs)
31.03.2011 31.03.2010
Rs. Rs.
Deposit with Bombay Stock Exchange
towards Margin Money for trading in Capital
Market as per SEBI Circular dated 19.3.08
regarding Margin of Institutional Trades in
the Cash Market 500 500
Deposit with National Stock Exchange
towards Margin Money for trading in Capital
Market as per SEBI Circular dated 19.3.08
regarding Margin of Institutional Trades in
the Cash Market 1000 1000
10.70% GOI 2020 deposited with HDFC
Bank in accordance with Section 7 of
Insurance Act 1938, to adhere to minimum
deposit requirement of Insurance Regulatory
and Development Authority - FV Rs.1200.10
lakhs 1257.61 1263.99
10.70% GOI 2020 deposited with Clearing
Corporation of India for CBLO operation -
FV Rs.100 lakhs 104.79 105.32
Margin money deposited with Clearing
Corporation of India for CBLO operations 1 1
 802

3. Commitments made and outstanding on account of loans, investments

and fixed assets
(Amount in lakhs)
31.03.2011 31.03.2010
Rs. Rs.
Loans and Investment 6027.63 3556.86
Core Insurance Project - Software and Hardware 14573.56 11415.74
Construction at Learning Centre 27.14 0
Commitments for EDP 18.34 0
Stamp duty and Registration charges and
Interest on properties in dispute and pending
conveyance (estimated at) 178.54 152.05

4. Claims less reinsurance, paid to claimants in/outside India

(Amount in lakhs)
Business In India Outside India
Rs. Rs.
29697.96 998.08
Fire (27755.14) (1115.51)
1912.73 16134.18
Marine (19155.54) (214.18)
315541.68 472.60
Miscellaneous (281853.84) (1031.48)

5. Age-wise outstanding claims statements for five years are enclosed.

6. Premium less reinsurance written from business in/outside India

(Amount in lakhs)
Business In India Outside India
Rs. Rs.
49574.62 1433.65
Fire (38741.03) (1824.78)
24315.09 598.33
Marine (24332.51) (764.64)
434940.26 832.53
Miscellaneous (352846.87) (505.81)

7. In respect of Purchases of Investments no deliveries are pending and in

respect of sale of investment, no payments are overdue as on 31-3-2011.
 803

8. In accordance with the regulation prescribed by IRDA, unrealised gains (net)

amounting to Rs. 471625.18 lakhs (Rs. 480845.42 lakhs) arising due to
changes in the fair value of listed equity shares and mutual funds are taken to
fair value change account. The historical cost of such investments amounted
to 267613.56 lakhs (269495.47 lakhs). Pending realisation, the credit balance
in the fair value change account is not available for distribution.
Break up of Market value and historical costs which have been valued on fair
value basis is as follows:
(Amount in lakhs)
Fair value
Market Value Historical Cost change
Rs. Rs. Rs.
Equity Shares of 184128.72 93053.03 91075.69
PSU (181154.12) (85025.47) (96128.65)
Equity Shares of
Companies other 554931.65 174560.21 380371.44
than PSU (560390.26) (175860.96) (384529.30)
Equity Shares 178.37 0.32 178.05
outside India (187.54) (0.31) (187.23 )
6425.97 6425.97 0.00
Mutual Fund (8608.97) (8608.73) (0.24)
745664.71 274039.53 471625.18
Total (750340.89) (269495.47) (480845.42)

9. Investments amounting to 0.12 lakhs (3.96 lakhs) have not been registered in
the name of the company as they are under objection.
10. Unidentified Quantitative differences in Investments, arising out of
reconciliation between the book figures and the year-end certificate received
from SHCIL (Custodian of the Company's investments) are tabulated as
under:
(Amount in lakhs)
Book Value Book Value
Particulars (2010-11) (2009-10)
Rs. Rs.
Equity and
Preference Shares Short Book Value 0 3.62
Debentures Short Book Value 56.2 56.2
Total Short Book Value 56.2 59.82
Equity and
Preference shares Excess Book Value 19.29 20.64
 804

11. Out of the total investment assets of 1124757.38 lakhs (925421.90 lakhs),
7913.77 lakhs (10130.10 lakhs) is considered as non-performing assets in
terms of Insurance Regulatory and Development Authority guidelines. The
aggregate amount of income not recognised for the current accounting year
on NPA (net of waiver/collections) as per related IRDA guidelines is 2277.60
lakhs [ (-)5752.77 lakhs] and up to31stMarch 2011 is 41771.22 lakhs
(39493.62 lakhs).

12. Restructured Assets

Rs. Rs. Rs.

Total amount of assets NIL 728.46 728.46
1 subjected to restructuring (2,601.71) (NIL) (2,601.71)
The amount of standard
assets subjected to NIL NIL NIL
2 restructuring (1,000.00) (NIL) (1,000.00)
The amount of Sub-
Standard assets subjected to NIL NIL NIL
3 restructuring (NIL) (NIL) (NIL)
The amount of Doubtful
and other assets subjected NIL 728.46 728.46
4 to restructuring (1,601.71) (NIL) (1,601.71)

13. (i) As per Part I of Schedule B of IRDA (Preparation of financial statements

and Auditors Report of Insurance Companies) Regulations, 2002, Debt
Securities shall be considered as 'Held to Maturity Securities' and shall be
measured at historical costs subject to amortisation.

The company in line with IRDA Regulations is also treating debt securities
as 'Held to Maturity'. However, amortisation of premium is done over the
remaining period of maturity (including the year of investment and excluding
the year of redemption)/up to the date of put/call option-where such option is
available, consistently on a conservative basis.
(ii) The Company does not have Real Estate Investment Property.

14. Being a Government Company, the Company is exempted from computation

of managerial remuneration in terms of Notification No. 235 dated 31
January 1978 u/s.620 of the Companies Act, 1956.

15. Barring disputed cases, no settled insurance claim remained unpaid for more
than six months as on the Balance Sheet date.
 805

16. Depreciation on Fixed Assets is provided as per the Accounting Policy of the
Company at the following rates

i. Furniture and Fixtures 18.10%

ii. Motor Cars 25.89%
iii. Computer and WAN Equipments 60.00%
iv. Freehold Buildings Office 10.00%
v. Freehold Buildings Residence 5.00%
vi. Bicycles 20.00%
vii. Electrical fittings and equipment etc. 15.00%

17. Fixed Assets include Land and House Properties valued at Rs. 1849.42 lakhs
(Rs.1689.47 lakhs) which are pending Conveyance and Registration. This
includes properties under dispute worth Rs.111.46 lakhs (Rs.111.46 lakhs),
properties purchased from TAC and LPA (Rs.159.95 lakhs and properties
acquired from erstwhile insurance units Rs.3.37 lakhs).

18. Motor Third Party Pool:

a) The Company is a member of the Indian Motor Third Party Insurance Pool
(IMTPIP) which is created under the regulation of IRDA to share all motor
third party insurance business underwritten on or after 1st April 2007, in
respect of commercial vehicles with GIC as Pool Administrator. The
Company’s share of inward premium, claims, expenses and interest income
have been accounted as per the unaudited financial statements received from
the Pool Administrator, covering the period from 01.03.2010 to 28.02.2011.
The IMTPIP accounts have been drawn in accordance with the IRDA Order
No. IRDA /NL / ORD /MPL / 046 / 03 / 2011 dated 12.03.2011, under
Section 14 of the IRDA Act read with Section 64VAof Insurance Act, 1938.
b) During the year the company has made a tentative additional provision
towards difference of ultimate liability @ 153% of the earned premium for
each of the three years from 2007-08 to 2009-10 over the existing provisions
and@153% of the earned premium for 2010-11 for IMTPIP losses in respect
of Motor TP Pool business as per the order under Section 14 of IRDA Act
read with Section 64VA of the in Insurance Act, 1938. The total liabilities of
94867 lakhs resulting out of the order are now recognized in the accounts.
However the outcome of ultimate liability will be quantified only on
completion of peer review by an independent actuary appointed by the
Authority.
 806

c) During the year, the Company has received Rs. 92793 lakhs from GIC
Motor Third Party Insurance Pool towards settlement of balances in respect
of T P Pool Inward business for the period from 01.04.2007 to 31.03.2010.
In accordance with Point No. 5 of IRDA Circular dated 31.03.2010, the
amount has been invested by the Company as per IRDA Investment
Regulations.

d) The business transacted by Company on account of the Third Party Motor

Pool for the current financial year is as detailed below:

Premium.......................................…. Rs. 57,943 lakhs

Claims Paid....................................... Rs. 27,959 lakhs

The surplus of Rs.29984 lakhs is invested by the Company, in accordance

with the IRDA Regulations.

19. Terrorism Pool retro figures received from GIC (Pool Administrator)
accounted in 2010-11 include figures for the 3 quarters of the current year,
fourth quarter of 2009-10 and also a sum of Rs. 973.10 lakhs towards
premium and Rs. 4.19 lakhs towards claims paid and Rs. 114.37 lakhs
towards service charges of fourth quarter of 2008-09 which was not
accounted in 2009-10.

20. The Company’s Agency at Hong Kong ceased underwriting operations with
effect from 01.04.2002 and the transactions relating to run off operations
have been accounted. Pending final IBNR/IBNER report, the NIL Provision
as given in Actuary’s report for the previous year has been considered for
current year.

21. Reconciliation of Inter-Office accounts is in progress and in the opinion of

the Company the effect of the same will not be material.

22. Confirmation of amounts has been received in respect of balances due from /
Due to other persons or bodies carrying on Insurance business, except in a
few cases, where reconciliation is in progress.

23. a) Accounting Ratios as prescribed by IRDA are enclosed.

b) Segmental reporting in the format prescribed by IRDA is given along with
Schedules.
c) A summary of financial statements for the last five years is attached.
 807

24. During the year, the Company has incurred an additional liability in gratuity
on account of enhancement in the prescribed limit from Rs. 3,50,000 to Rs.
10,00,000 as well as the revision in pay scale payable to employees. As a
result, the gratuity liability of the Company has increased by Rs. 16,366
lakhs.

In terms of the requirement of the Accounting Standard AS 15 (Revised) on

Employees' Benefits the entire amount of 16,366 lakhs is required to be
charged to the Profit and Loss Account.

However, the Insurance Regulatory and Development Authority, vide its

Circular No. IRDA/FandA/cIR/ACT/069/04/2011 dated 18.4.2011, has
permitted the insurers to amortize the additional liability over a period of five
years starting from financial year 2010-11 subject to a minimum of 1/5th of
the total amount involved every year. Accordingly, the details of amortisation
for 2010-11 are as follows:

Total Amount Amortised in Unrecognised and

Amount 2010-11 Unamortised Gratuity
Liability
Rs. 14,100 Rs. 2820 Rs. 11,280

The unrecognized and unamortised liability of 11280 lakhs does not include
any amount relating to separated / retired employees.

The profit of the Company would have been lower by 11280 lakhs and the
liability would have been more by11280 lakhs had the Company recognized
the entire liability during the year in accordance with the requirements of AS
15.

In line with the accounting policy and as per the Accounting Standard AS-
15(Revised), the summarized position of post-employment benefits is
recognized in the Profit and Loss A/c and Balance Sheet as under:
 808

A. Changes in the defined benefit obligations

Leave
Pension Gratuity Encashment
Particulars (funded) (Funded) (Funded)
Rs. Rs. Rs.
Present value of defined benefit
obligation as at 1st April 2010 1,14,885 35,910 15,130
Interest Cost 9,191 2,873 1,210
Current service cost 4,862 1,496 795
Past Service Cost (due to
increase in gratuity ceiling and
pay revision) 0 141 0
Less: Benefits paid 11,788 2,945 0
Actuarial loss/ (gain) on
obligations 29,850 2,266 1,025
Present value of defined benefit
obligation as at 31st March
2011 1,47,000 53,700 18,160

B. Changes in the Fair Value of Plan Assets

Leave
Pension Gratuity Encashment
Particulars (Funded) (Funded) (Unfunded)
Rs. Rs. Rs.
Fair Value of Plan Assets as at
1st April 2010 1,14,885 37,228 15,130
Expected return of Plan Assets 9,191 2,978 0
Employer's Contribution
(Regular) 34,712 5,179 3,030
Less: Benefits paid 11,788 2,945 0
Actuarial loss / (gain) 0 0 0
Fair Value of Plan Assets as at
31st March 2011 1,47,000 42,440 18,160
Actual return on Plan Assets - - NA
 809

C. Net Actuarial loss / (gain)

Leave
Pension Gratuity Encashment
Particulars (Funded) (Funded) (Unfunded)
Rs. Rs. Rs.
Actuarial loss / (gain) on
obligation …. (A) 29,850 2,266 1,025
Actuarial loss / (gain) on Plan
Assets …. (B) NIL NIL NIL
Net Actuarial loss / (gain) (A)
+(B) (29,850) (2,266) (1,025)
Actuarial loss / (gain)
recognized in the period (29,850) (2,266) (1,025)
Unrecognized actuarial loss /
(gain) at the end of the year NIL NIL NIL

D. Amount recognized in Balance Sheet

Leave
Pension Gratuity Encashment
Particulars (Funded) (Funded) (Unfunded)
Rs. Rs. Rs.
Present value of defined
benefit obligation as at 31st
March 2011 1,47,000 53,700 18,160
Less: Fair Value of Plan
Assets as at 31st March 2011 1,47,000 42,440 18,160
Funded in Advance NIL NIL NIL
Unrecognised transitional
liability NIL 11,280 NIL
Unfunded net liability / (asset)
recognised in Balance Sheet NIL 20 0
 810

E. Expenses recognized in the Profit and Loss Account

Leave
Pension Gratuity Encashment
Particulars (Funded) (Funded) (Unfunded)
Rs. Rs. Rs.
Current service cost 4,862 1,496 795
Interest cost 9,191 2,873 1,210
Transitional liability
recognised during the year NIL 2,820 NIL
Less: Expected return on plan
assets and contribution 9,191 2,978 0
Net Actuarial loss/(gain)
recognised in the year -29,850 -2,266 -1,025
Net benefit expense 34,712 6,477 3,030

F. Movements in the Liability recognized in the Balance Sheet

Leave
Pension Gratuity Encashment
Particulars (Funded) (Funded) (Unfunded)
Rs. Rs. Rs.
Opening Net Liability 0 0 0
Net Benefit Expense 34,712 6,477 3,030
Contribution paid 34,712 5,179 3,030
Closing Net Liability 0 1,298 0

G. Investment percentage maintained by the trust

Pension Gratuity
Particulars (Funded) (Funded)
Rs. Rs.
Central Government and State Government
securities 55 55
Investment in Corporate Bonds 40 40
Other investments 5 5
 811

H. Principal Actuarial assumption at the Balance Sheet date (expressed as

weighted average)

Leave
Pension Gratuity Encashment
Particulars (Funded) (Funded) (Unfunded)
Rs. Rs. Rs.
Discount rate 8.5 8.5 8.5
Expected rate of return on plan
assets 8.5 8.5 8.5
Rate of escalation in salary 3.5 3.5 3.5
Employee turnover Not significant
Mortality LIC (1994-96) table of mortality rates
Method used Projected Unit Credit Method

I. Basis of Actuarial assumption considered

Particulars Basis of assumption

Discount rate Yield on 10 Year Government Securities
Expected rate of return
One year Interest rate
on plan assets
The estimates of future salary increase considered
Rate of escalation in in actuarial valuations taking into account inflation,
salary seniority, promotion and other relevant factors,
such as supply and demand in employment market.
Employee turnover NOT SIGNIFICANT

25. In terms of IRDA Circular 067/IRDA/FandA/cIR/MAR-08 dated 28.03.08,

expenses incurred under the following heads are disclosed :
i) Outsourcing expenses – 11342.86 lakhs ( 6705 lakhs)
ii) Business Development – 3790.98 lakhs ( 2387 lakhs)
iii) Marketing Support – NIL (NIL)
26. Related party disclosures: AS 18
Name of the Related Party and their relationship with the Company:
a) Subsidiary: Zenith Securities and Investments Limited
b) Associate Companies:
1. India International Insurance Pvt. Ltd. Singapore
2. Ken India Assurance Co. Ltd., Kenya
 812

Details of Transactions

India International Ken India Assurance

Insurance Pvt. Ltd. Co. Ltd.
Sl.
No. Particulars 2010-11 2009-10 2010-11 2009-10
Investment in
Equity (No.
1 of Shares) 5000000 5000000 332790 332790
(Amount in Lakhs)
Rs. Rs. Rs. Rs.
Dividend
received
during the
2 year 126.48 123.36 0 10.3
3 Reinsurance transactions:
- Due to -
Direct 0 115.91 0 0
- Due from-
Direct 103.67 1.44 0 0
Other Dues
4 receivable 0 0 0 0
Directors'
5 Remuneration 0 0 1.25 1.1

Since the Company and its Subsidiary are State controlled, no disclosures are
made pertaining to the transactions with them in accordance with the
requirements of the Accounting Standard AS-18.

c) Key Management Personnel:

Sri G. Srinivasan, Chairman-cum-Managing Director

Sri.MilindAKharat, Director and GeneralManager
Sri.V.Harshavardhan, Director and General Manager

d) Nature of Transactions:
1. Salaries, allowances and contributions –Rs. 50.35 lakhs (Rs. 37.03 lakhs)
2. Loan Balances due as on 31.03.2011 - NIL (NIL)
 813

27. Disclosure as per AS 20 "Earnings Per Share

Sl.No. Particulars Current Year Previous Year
Rs. Rs.
1 Net Profit attributable to Shareholders 13,054 70,779
Weighted Average Number of Equity
2 Shares issued (in Nos.) 15,00,00,000 15,00,00,000
3 Basic earnings per Share of 10/- each 8.7 47.19
The Company does not have any outstanding dilutive potential equity shares.
Consequently, the basic and diluted earning per share of the Company remains
the same.
28. The effect of timing difference is not material. Hence recognition of Deferred
Tax Asset/Liability in terms of Accounting Standard AS-22 is not required
for the year.
29. In the opinion of the management, there is no impairment of assets of the
Company that require any adjustment to be made in terms of Accounting
Standard AS-28.
30. Prior period items have been included in the respective heads and consist of
the following:
Particulars 2010-11 2009-10
Prior period income Rs. 17.39 Rs. 920.16
Prior period expenses Rs. 936.16 Rs. 2686.81
31. Details of Provisions
Provision for
Leave Provision for
Provision for Encashment Bad and Doubtful
Particulars Income Tax (Long Term) Debts
2010-11 2009-10 2010-11 2009-10 2010-11 2009-10
Rs. Rs. Rs. Rs. Rs. Rs.
Opening
balance 22107.34 15061.99 15130 14989 19143.92 21291
Additions 70 11600 3030 752 475.08 396.87
Utilisation 33.47 27.06 0 0 0 0
Reversals 6029.4 4527.59 0 611 3389.79 2543.95
Closing
balance 16114.47 22107.34 18160 15130 16229.21 19143.92
 814

Summary
¾ The insurance contract has been defined by IFRS 4 as “A contract under
which one party (the insurer) accepts significant insurance risk from another
party (the policyholder) by agreeing to compensate the policyholder if a
specified uncertain event (the insured event) adversely affects the
policyholder.”
¾ IFRS 4 requires the insurer to account for the deposit component of insurance
contracts separately from the insurance contracts.
¾ According to IFRS 9, financial assets are classified under the following two
categories:
i. at amortised cost
ii. at fair value:
9 through OCI
9 through profit and loss

¾ Equalisation and catastrophe reserves will not be allowed as liabilities.

¾ In the case of non-life contracts where a single premium is paid at the start of
the contract, both premiums and expenses will be recognized immediately as
a contract is signed, with the accounting focused on the present value of
expected future cash flows.

Answers to Test Yourself

Answer to TY 1

The correct option is D.

The move towards fair value accounting means recording both assets and
liabilities at the “amount for which an asset could be exchanged or a liability
settled”.

Assets are always recorded initially at cost. Subsequently, the assets are recorded
at fair values.
 815

Answer to TY 2

The correct option is A.

Option B relates to explanation of Reported Amounts.

Option C relates to Disclosures on insurance risk.

Option D relates to Disclosure of inflation assumptions.

Answer to TY 3

The correct option is A.

Self Examination Questions

Question 1

Which of the following statements is true?

(i) Claims reserves can be maintained only to the extent that they relate to actual
liabilities
(ii) Claims reserves will no longer be permitted
(iii) Equalisation reserve is permissible
(iv) Catastrophe reserve is permissible
(v) Equalisation reserve is a component of equity

A (i), (iii), (iv)

B (i), (v)
C (ii), (iii) (v)
D Only (i)

Question 2

Minimum liability test involves:

A A comparison of recognised insurance liabilities against estimated assets

B A comparison of recognised insurance liabilities against estimated cash flows
C A comparison of all insurance liabilities against estimated cash flows
D A comparison of all insurance liabilities against estimated assets
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Question 3
Under what circumstances can an entity classify financial assets that meet the
amortised cost criteria as at FVTPL?
A Where the financial asset passes the contractual cash flow characteristics test
B Where the instrument is held to maturity
C If doing so eliminates or reduces an accounting mismatch
D Where the business model approach is adopted

Question 4
IFRS 9 gives a variety of approaches for the measurement of financial assets and
liabilities.
Which of the following measurement methods are acceptable under IFRS 9?
A Amortised cost, fair value and net realisable value
B Amortised cost, fair value and depreciated replacement cost
C Amortised cost, fair value and replacement cost
D Amortised cost and fair value

Question 5
Which of the following options contains matters disclosed under ‘explanation of
reported amounts’?
(i) Accounting policies,
(ii) Risk management policies
(iii) Derivation of significant assumptions and material changes to insurance
liabilities, reinsurance assets etc.
(iv) Whether margins are built into the assumptions,
(v) Terms and conditions that have a material impact on the amount, timing and
uncertainty of the insurers’ cash flows.
(vi) Disclosure of market value margin
(vii) Whether margins are derived from actual data
(viii) How margins relate to recent experience.
(ix) Disclosure of the inflation assumptions
(x) Information on insurance risk
A (i), (iii), (iv), (v), (viii)
B (ii), (v), (ix), (x)
C (i), (iii), (iv), (vii), (viii)
D (i), (ii), (iv), (vi), (vii)
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Answers to Self Examination Questions

Answer to SEQ 1

The correct option is B.

Equalisation and catastrophe reserves will not be allowed as liabilities following

implementation of IFRS 4. However, IFRS 4 does not prohibit the reporting of
equalisation reserves as a component of equity.

The IASB takes the view that claims reserves are only permissible to the extent
that they relate to actual liabilities.

Answer to SEQ 2

The correct option is B.

IFRS 4 lays down that insurers carry out a minimum liability adequacy test under
which a comparison of recognised insurance liabilities will be made against
estimated cash flows.

Answer to SEQ 3

The correct option is C.

In accordance with Para 4.2.2 of IFRS 9 “An entity may, at initial recognition,
irrevocably designate a financial asset as measured at fair value through profit or
loss if it eliminates or significantly reduces a measurement or recognition
inconsistency (sometimes referred to as ‘an accounting mismatch’) that would
otherwise arise from measuring assets or liabilities or recognising the gains and
losses on them on different bases”

Answer to SEQ 4

The correct option is D.

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Answer to SEQ 5

The correct option is C.

This disclosure category will include information on:

9 accounting policies,
9 derivation of significant assumptions and material changes to insurance
liabilities, reinsurance assets etc.
9 whether margins are built into the assumptions,
9 whether margins are derived from actual data
9 how margins relate to recent experience
9 any gains or losses that have been made in buying reinsurance to aid
comparison between companies

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