XII Accountancy Notes All Chapters MR - Mohan H Baksani

Chapter: Accounting for Partnership Firms – Fundamentals
Partnership is defined by Indian Partnership Act, 1932, Section 4 as follows:
“Partnership is the relation between persons who have agreed to share the profits
of a business carried on by all or any of them acting for all.”
The persons who have entered into a partnership with one another individually are
called partners and collectively a firm. The name under which the business is carried
is called firm name.
➢ Features / Characteristics of Partnership:

1. Two or More Persons: There must be at least two persons to form a partnership and all
such persons must be competent to contract.
According to Indian Contract Act, 1872, every person except the following is
competent to contract:
(i) Minor
(ii) Persons of unsound mind
(iii) Persons disqualified by law
Section 464 of the Companies Act, 2013 empowers the Central Government to
prescribe maximum number of partners in a firm but the number of partners so
prescribed cannot be more than 100. The Central Government has prescribed
maximum number of partners in a firm to be 50 vide Rule 10 of Companies
(Miscellaneous) Rules, 2014. Thus in effect, a partnership firm cannot have more
than 50 members.
2. Agreement: Partnership comes into existence by an agreement, either written or oral.

The written agreement among the partners is known as Partnership Deed.
3. Lawful Business: The agreement among partners must be for carrying on some lawful
business and to earn profit. Mere joint ownership of some property is not a business.
They are co-owners and not partners and their motive is not to earn profit on recurring
basis.
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4. Profit – sharing: The agreement between the partners must be to share profits and
losses of the business. It is not essential that all the partners must share losses also.
There may be a provision in the Partnership Deed that a particular partner or partners
shall not bear the losses.
5. Business can be carried on by all or Any of the Partners Acting for All:
Business of the partnership can be carried on by all the partners or by any of them
acting for all the partners. In other words, partners are agents as well as the
principals. As an agent, he represents other partners and thereby, binds the other
partners through his acts. As a principal, he is bound by the act of other partners.
➢ Rights of Partners:
1. Right to participate in the management of the business.
2. Right to be consulted about the affairs of the business.
3. Right to inspect the books of account and have a copy of it.
4. Right to share profits or losses with others in the agreed ratio.
5. Right to receive interest on loan (if advanced to firm) at an agreed rate of interest.
In case the rate of interest is not agreed upon, interest is paid at the rate provided
in the Indian Partnership Act, 1932, i.e. @ 6 % p.a.
6. Right not to allow the admission of a new partner.
7. Right to retire from the firm (after giving proper notice)
8. Right to get reimbursement of the expenses paid on behalf of the firm.
➢ Duties of Partners:
1. Every partner should devote due time in the business.
2. Every partner should carry on the business of the firm diligently.
3. No partner should engage himself in competitive business.
4. Every partner should act within the authority.
5. It is the duty of a partner to indemnify the firm for his wilful negligence.
6. It is the duty of each partner to use the property of the firm for the partnership
firm.

➢ PARTNERSHIP DEED:
Partnership is based on agreement. It is, therefore, necessary that terms conditions of
the partnership be agreed upon among all the partners. These terms and conditions may
either be oral or written. Both are equally enforceable by law, however, the written
agreements are always better to resolve the misunderstanding and dispute, if any at a
later date. Such a written agreement signed by all the partners and duly stamped as per
Stamp Act, 1889 is called ‘Partnership Deed’ of ‘Articles of Partnership’. Contents
of Partnership Deed:
(1) Name and address the Firm (2) Name and address of Partners
(3) Nature of Business (4) Capital Contribution
(5) Interest on Capital (6) Interest on Drawings
(7) Profit – sharing ratio (8) Interest on Partner’s Loan
(9) Salary / Commission (10) Accounting period
(11) Rights and duties of Partners (12) Auditing of Accounts
(13) Operation of Bank Account (14) Valuation of Goodwill
(15) Valuation of Assets (16) Duration of Partnership
(17) Settlement of Dispute
(18) Settlement in case of dissolution of firm
(19) Settlement of accounts in case of retirement or death of partner
(20) Rules to be followed while admitting a partner

➢ In case Partnership Deed does not exist, provisions of the Indian Partnership Act,
1932 will be applied. Provisions Affecting Accounting Treatment in the Absence of
Partnership Deed:
Matters Provisions of the Indian Partnership Act, 1932
1. Sharing of Profit/Losses Profits/Losses are shared equally by the partners.
2. Interest on Capital Interest on capital is not allowed to partners.
3. Interest on Drawings Interest on drawings is not charged from partners.
4. Interest on Partner’s Interest on loan is paid @ 6 % p.a. Interest on
Loan partner’s loan is charge against profit. It means
interest is payable even if there is a loss.
5. Remuneration to Partners Remuneration (salary / commission) is not allowed to
any partner.
6. Admission of a Partner No new partner can be admitted without the consent of
the existing partners.
➢ Some other Provisions of Partnership Act. 1932.

1. Registration of Firm: The registration of partnership firm is optional. It is not
compulsory as per Partnership Act. 1932.
2. Minor as a Partner:- A minor can be admitted as a partner with the consent of all the
existing partners.
3. Liability of Partners:- In case of partnership the liability of each partner is unlimited.
It means that loss of partnership firm will be met first of all by the partners out of their
capital and thereafter out of their personal property.
4. Sleeping Partner: - In a partnership firm, it is not necessary that all the partners remain
active. One or more partners may be admitted as sleeping partners. They will
contribute their capital for agreed share of profit.
5. Interest on capital of Partners:- Interest on capital is paid to partners provided it is
provided in partnership deed and firm is earning profit. Interest on capital is never
paid if the firm is incurring loss even though it is permissible in partnership deed. If the
profit is inadequate to pay interest on capital, it will be paid to the extent of profit in
the ratio of interest due to partners.

6. Following persons cannot be admitted as a partner:
(i) Persons of unsound mind / lunatic
(ii) Insolvent persons
(iii) Any individual disqualified by law
(iv) Minor in normal course
➢ Profit and Loss Appropriation Account:

A partnership firm prepares Profit and Loss Appropriation Account to which net profit
or net loss as per the Profit and Loss Account is transferred to show its appropriation.
This account is an extension of the Profit and Loss Account.
Appropriation of profit is made up to the amount available for distribution. Thus,

if after transfer of net loss and credit of interest charged on drawings to Profit and Loss
Appropriation Account, the balance is loss, appropriation is not made. But if it results in
profit, appropriation is made up to the amount of profit.
➢ Features of Profit and Loss Appropriation Account:

(1) It is a nominal account.
(2) It is an extension of profit and Loss Account to depict the appropriation of
profit among the partners.
(3) It is prepared by partnership firms.
(4) It discloses the appropriation of accounting profit among partners of the firm.
(5) The entries shown in Profit and Loss Appropriation Account are either based on
partnership deed or based on Indian Partnership Act, 1932.

Dr. Specimen of the Profit and Loss Appropriation Account Cr.
Particulars ` Particulars `
To Profit and Loss A/c …… By Profit and Loss A/c ……
(Net loss transferred from Profit (Net Profit transferred from
and Loss Account) Profit and Loss Account)
To Interest on Capital: By Interest on Drawings:
A …… A ……
B …… …… B …… ……
To Partners’ Salaries ……
To Partners’ Commission ……
To Reserve ……
To Profit transferred to:
A’s Capital ……
B’s Capital …… ……
…… ……
➢ Journal Entries relating to the Profit and Loss Appropriation Account
Date Particulars L.F. Debit (`) Credit (`)

(i) Transfer of profit from Profit and Loss Account:
Profit and Loss A/c Dr. ……
To Profit and Loss Appropriation A/c ……
(ii) Transfer of loss from Profit and Loss Account:
Profit and Loss Appropriation A/c Dr. ……
To Profit and Loss A/c ……
(iii) For allowing Interest on Capitals:
Interest on Capital A/c Dr. ……
To Partners’ Capital A/c ……
To close Interest on Capital Account
To Interest on Capital A/c ……

(iv) For Charging Interest on Drawings:
Partners’ Capital A/c Dr. ……
To Interest on Drawings A/c ……
To close Interest on Drawings Account
Interest on Drawings A/c Dr. ……
To Profit and Loss Appropriation A/c ……
(v) For Partners’ Salaries / Commission:
Partners’ Salaries / Commission A/c Dr. ……
To close Partners’ Salaries / Commission
To Partners’ Salaries / Commission A/c ……
(vi) For Transfer to Reserve out of Profit:
To Reserve A/c ……
(vii) For Transfer of Credit Balance of Profit and Loss Appropriation Account
(Divisible Profit):
➢ Liabilities of Partners:
Subject to agreement among the partners:
1. If a partner carries on a business that is similar to that of the firm in competition

with the firm and earns profit from it, the profit earned from such business shall
be paid to the firm.
2. If a partner earns profit for self from any transaction of the firm or from the use of
firm’s property or business connection, the profit so earned shall be paid to the
firm.

➢ Interest on Partners’ Loan to the firm: Every partner is entitled to interest on loan
provided by him at an agreed rate. In the absence of partnership deed, interest on loan
given by any partner be allowed @ 6 % p.a. whether there is profit or loss in the
partnership firm. [ Section 13 (d)]
Interest on partner’s loan is a Charge against profit and not an appropriation out of
profits. Thus, interest on partner’s loan has to be paid whether firm is earning profit or
not. Interest on partner’s loan is an expense for the firm so it should be debited to
Profit and Loss A/c.
Partner has given loan to the firm so interest on loan is an income of the concerned
partner as a lender of the money. Hence, interest on loan is credited to Partner’s
Loan A/c and not to his Capital A/c.
The entries passed are:

(i) To provide on Interest on Partner’s Loan:
Interest on Partner’s Loan A/c Dr. ……
To Partner’s Loan A/c ……
(ii) To close the Interest on Partner’s Loan A/c:
To Interest on Partner’s Loan A/c ……
➢ It is important to distinguish Loan Account and Capital Account of Partner

because
1. As per the provisions of Indian Partnership Act, 1932 partner’s loan is repayable
on dissolution before payment of capital to partners; and
2. In the absence of any agreement, partners are entitled to get interest @ 6 % p.a.
on loan advanced whereas they are not entitled to interest on capital.

➢ Rent Paid to a Partner:
Rent paid to partner, like interest on loan by a partner, is a charge against the
profit and not an appropriation of profit. It is a charge on profit because of the reason
that rent is paid to a partner for using his or her property for business purpose. It is,
therefore, debited to Profit and Loss account (not to the Profit and Loss
Appropriation Account) and credited to Rent Payable Account.
➢ Manager is an employee of the firm. Commission payable to him / her is in the nature
of salary. Therefore, it is debited to Profit and Loss Account to determine net profit.
➢ Appropriations are more than Available Profit:

If total amount of appropriation is more than the amount of profit available for
appropriation, profit available for distribution among partners is distributed in
the ratio of appropriation to be made.
The ratio of appropriation is determined as follows:
(i) Determine the amount payable as appropriation to each partner as per the
Partnership Deed (ignoring the profit available for distribution among partners).
For example, salary payable, commission payable and interest on capital, etc.,
payable to each partner is determined.
(ii) Total the amount of appropriation (as per step (i) above) for each partner
separately.
(iii) Ratio of the Appropriations (as per step (ii) above) to be made to each partner is
the ratio in which profit is appropriated.
It should be kept in mind that no particular item like salary, commission,
interest on capital, etc. has priority over other items of appropriation.
➢ Charge against Profits:

Charge against profit means that the amount should be paid or credited to Partner’s
Capital Account whether the firm earns profit or not. Whereas appropriation means that
it is allowed only when the firm earns profit. Interest on Partner’s Loan and rent
payable to a partner is a charge against profit and not an appropriation.

➢ Difference between Charge against Profit and Appropriation of Profit
Basis Charge Against Profit Appropriation of Profit
1. Nature It means deduction from Revenue to It means distribution of net profit for
determine net profit or loss of the the year among partners under
firm. different heads as per the Partnership
Deed.
2. When In the event of loss also expenses Appropriation s made when there is
made that are a charge on profit are a profit.
accounted.
3. Recording It is debited to Profit and Loss It is debited to Profit and Loss
Account. Appropriation Account.
4. Priority It is done before appropriation of It is done after accounting for all
profit. expenses.
5. Example Rent paid to Partner, Interest on Salary to partners, interest on
Partner’s Loan. capital, transfer of profit to general
reserve.
➢ Difference between Profit and Loss Account and Profit and Loss Appropriation
Account
Basis Profit and Loss A/c Profit and Loss Appropriation A/c
1. Stage It is prepared after Trading Account. It is prepared after Profit and Loss
Account.
2. Objective To determine net profit earned or net To show appropriation of net profit
loss incurred during the year. i.e. distribution of Net Profit for the
accounting period among the
partners.
3.Nature of It is debited with the expenses It is debited with the items of
Items (charge against profit) and credited appropriation of profit such as
with the income, not being business salary/commission to partners,
income to determine net profit for interest on capital and transfer to
the accounting period. reserve, etc. It is credited with the
items of income being debited to
Partners’ Capital Accounts or
Current Accounts such as interest on
drawings.
4. Prepared This account is prepared by all the It is prepared by partnership firms.
by business concerns.
5. Matching While preparing this account, While preparing this account,
Principle Matching Principle is followed. Matching Principle is not followed.

➢ INTERST ON PARTNERS’ CAPITALS: Interest on capital is allowed to
compensate a partner for contributing a capital to the firm in excess of the profit-
sharing ratio. It is computed at the agreed rate with reference to the time capital has
been used in the business. Interest on capital is computed on the opening balance of the
partner’s capital.
If additional capital is introduced during the year, interest is allowed on it for the period
it has remained in business, i.e. from the date of additional capital is introduced till the
end of the accounting year. Similarly, if capital is withdrawn by a partner during the
year, interest is not allowed on the amount of capital withdrawn.
Interest on Capital when Profit Available for Appropriation is Inadequate

The profit of the firm may be less than the amount of interest on capital allowable to the
partners. In such a situation, interest on capitals of the partners is calculated and the
profit is distributed among the partners in the ratio of interest on capital.
In case, besides the interest on capital, appropriation is to be made for salary and
commission, etc., to partners, total appropriation for each partner is determined and
amount of profit is distributed among the partners in the ratio of the
appropriations to be made to each partner.
Interest as a charge means interest on capital is to be allowed whether the firm has
earned profit or incurred loss. Profit and Loss Appropriation Account should not be
prepared because interest on capital is treated as charge against profit.
Opening Capital: Interest on capital is allowed on the Opening Capital of the

partner. In case, opening capital is not given, it is determined by adding those items
which have already been subtracted (e.g. Share of Loss, Drawings, Interest on
Drawings) and by subtracting those items which have already been added to the capital
(e.g. Additional Capital, Interest on Capital, Profit already credited).
For calculating opening capital, drawings are added. However, if drawings of partners
appear in Balance Sheet, it means that their Capital Accounts have not been
adjusted with respect to their drawings. So drawings will not be added back.
PROVISIONS RELATING TO INTEREST ON CAPITAL
Case Provisions
1. When the Partnership Deed does Interest on capital is not allowed.
not exist or Partnership Deed
does not have a clause as to
interest on capital.
2. When the partnership deed Interest on capital is treated as appropriation of
provides for interest on capital profit. Interest on capital is allowed only if there is
but is silent as to the treatment of profit.
interest as a charge or There are three possible situations:
appropriation (i) In case of Loss Interest on capital is not
allowed.
(ii) In case, profit Interest on capital is
before interest allowed at the agreed rate.
is equal to or
more than the
interest.
(iii) In case, profit Interest is allowed only to
before interest the extent of profit in the
is less than the ratio of interest on capital
interest. of each partner.
3. When the partnership Deed Interest on capital is allowed whether there is profit or
provides for interest on capital as loss.
a charge (i.e. to be allowed
whether there are profits or loss)

DRAWINGS & INTEREST ON DRAWINGS
Drawings mean the amount withdrawn, in cash or in kind, by partners for their personal
use. Drawings may be out of capital or against profit. Drawings out of capital means
withdrawal of part of capital while drawings against profit means withdrawal of amount
against profit earned during the year by the firm.
➢ Difference between Drawings Against Profit and Drawings Against Capital:

Basis Drawings Against Profit Drawings Against Capital
1. Debited to Debited to Drawings Account. Debited to Capital Account.
2. Part Part of Expected Profit. Part of Capital.
3. Effect It does not reduce capital. It reduces capital.
4. Int. on It is considered for calculating It is not considered for

Drawings Interest on Drawings. calculating Interest on Drawings.
5. Int. on It is not considered for calculating It is considered for calculating

Capital Interest on Capital. Interest on Capital.
➢ Drawings by a Partner:
Drawings by a partner may be broadly divided into:
(i) Irregular Drawings: It means drawings of same amount or different amounts at
irregular intervals; and
(ii) Regular Drawings: It means drawings of same amount at regular intervals.
➢ Interest on Drawings
When drawings are made at irregular period or of different amounts, Product
Method of calculating interest is followed. And when drawings are made of same
amount at regular intervals, interest on drawings is calculated using Average Period
Method.

➢ Product Method: Under this method, the amount of drawings is multiplied with the
number of months or number of days (as the case may be) it has been used.
The product so obtained is totaled and interest is calculated thereon for one month, if
the period taken is in months and for one day if the period taken is in days.
Formula:
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝟏 𝟏
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒐𝒏 𝑫𝒓𝒂𝒘𝒊𝒏𝒈𝒔 = 𝑻𝒐𝒕𝒂𝒍 𝒐𝒇 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 𝑿 𝑿 𝒐𝒓
𝟏𝟎𝟎 𝟏𝟐 𝟑𝟔𝟓
➢ Average Period Method: This method is used when there is regular drawings or when
the amount of drawings is uniform and the time interval between the two drawings
is also uniform.
Formula:
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒐𝒏 𝑫𝒓𝒂𝒘𝒊𝒏𝒈𝒔
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒆𝒓𝒊𝒐𝒅
= 𝑻𝒐𝒕𝒂𝒍 𝑫𝒓𝒂𝒘𝒊𝒏𝒈𝒔 𝑿 𝑿
𝟏𝟎𝟎 𝟏𝟐
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒆𝒓𝒊𝒐𝒅
𝑴𝒐𝒏𝒕𝒉𝒔 𝒍𝒆𝒇𝒕 𝒂𝒇𝒕𝒆𝒓 𝑭𝒊𝒓𝒔𝒕 𝑫𝒓𝒂𝒘𝒊𝒏𝒈𝒔 + 𝑴𝒐𝒏𝒕𝒉𝒔 𝒍𝒆𝒇𝒕 𝒂𝒇𝒕𝒆𝒓 𝑳𝒂𝒔𝒕 𝑫𝒓𝒂𝒘𝒊𝒏𝒈𝒔
=
𝟐
Average Period to be taken:

Amount Withdrawn In the Beginning In the Mid At the End
Every Month 6.5 6 5.5
Every Quarter 7.5 6 4.5
Every Month
3.5 3 2.5
(for six months only)
Every Month
(for first six months only) 9.5 9 8.5
Interest calculated on 31.3.
Every Six Months 9 6 3

Every Month Beg Mid End
(Six months only)
If interest is calculated after first six months (1st Apr to 30th Sep.)
First 1.4 6 15.4 5.5 30.4 5
Last 1.9. 1 15.9 0.5 30.9 0
7/2 6/2 5/2
3.5 3 2.5
If interest is calculated at the end of the year (1st Apr to 30th Sep.)
First 1.4 12 15.4 11.5 30.4 11
Last 1.9. 7 15.9 6.5 30.9 6
19/2 18/2 17/2
9.5 9 8.5
• If the date of withdrawal is not given, then interest on total drawings for the
year is calculated for six months on the average basis.
• If the date of drawings is not given and accounting period is less than 12
months, then the interest on Total Drawings is calculated for half of the
accounting period.
• When the rate of interest is given without the word ‘per annum’ (p.a.),
interest is charged without considering the time factor.

PAST ADJUSTMENTS
(ADJUSTMENTS FOR INCORRECT ADJUSTMENTS IN PAST AFTER
CLOSING THE BOOKS)
Sometimes after closing the accounts of a partnership firm some errors or

omissions in the accounts of earlier years are found. For example, interest on capital
or drawings is omitted, allowed or charged at higher or lower rate, profits or losses are
distributed among the partners in a wrong ratio and so on. These errors and omissions
are rectified by adjusting the Capital Accounts of the affected partners by passing
(a) an adjustment entry, or (b) adjustment entries.
Usually, following types of mistakes may take place:
(i) Interest on Capital is omitted
(ii) Interest on Drawing is omitted
(iii) Salary / Commission payable to a partner is omitted
(iv) Error in the profit sharing ratio
(v) Profit sharing ratio is changed with retrospective effect
Guarantee of Profit
A new partner (or partners) may be admitted in the firm with minimum guaranteed
profit from the business. The profit may be guaranteed to an existing or incoming (new)
partner by:
(a) All the remaining partners in an agreed ratio; or
(b) One or more of the existing or old partners
When the guaranteed partner’s share of profit is more than the guaranteed amount, his
actual share of profit is given to him instead of the guaranteed amount of profit.
Accounting treatment of Guarantee of minimum profit to a partner in case of
Loss: It is possible that the firm has incurred loss but minimum guaranteed profit is to
be paid to the partner who has been guaranteed minimum profit. In such case,
adjustment is made through Partners’ Capital Accounts in the following manner:
(i) Distribute loss among the partners in their profit-sharing ratio.
(ii) Capital Account of the guaranteed partner is credited with guaranteed
minimum profit plus the amount of loss. This amount is debited to remaining
partners in their profit sharing ratio or to the debit of the partner who has
guaranteed minimum profit.
Minimum Earnings guaranteed by a partner: A partner (or partners) may guarantee

minimum earnings to the firm. In such a situation, shortfall in earnings is debited to the
concerned partner’s Capital Account or Current Account (if capitals are fixed).

Chap: Reconstitution of Partnership Firm
Any change in the partnership agreement gives rise to change in the relationship
among the partners. It is called reconstitution of partnership firm. As a result, the
existing agreement comes to an end and a new agreement comes into existence. It
always leads to change in the profit sharing ratio among the partners.
The reconstitution of the firm takes place in the following circumstances:
(i) Change in the profit sharing ratio among the existing partners.
(ii) Admission of a new partner
(iii) Retirement of an existing partner
(iv) Death of a Partner
(v) Amalgamation of two partnership firms.
➢ Change in the profit sharing ratio among the existing partners: The partners of an
existing firm may decide to change their profit sharing ratio as a result of change in
their capital contributions, due to ill health, old age of a partner, due to inability to
discharge duties of firm.
Following issues must be considered carefully due to change in the profit sharing
ratio:
(i) Determination of Sacrificing ratio
(ii) Determination of Gaining ratio
(iii) Accounting Treatment of Goodwill
(iv) Accounting Treatment of Accumulated Profits and Reserves
(v) Revaluation of Assets and Re-assessment of Liabilities
(vi) Adjustment of Capitals
❖ Sacrificing Ratio: During change in the profit sharing ratio, some partners will
surrender a portion of their share of profit in favour of other partner. The ratio in which
the partners have agreed to sacrifice their share in profit in favour of other
partner/partners, is called as sacrificing ratio.
Sacrificing Ratio = Old Ratio of a Partner – New Ratio of a Partner
S=0-N
The sacrificing ratio is computed to find out the amount of compensation to be paid by
the gaining partner to the sacrificing partner.
The compensation is usually paid on the basis of proportionate amount of
goodwill, share in accumulated profits and reserves, profit and loss on revaluation
of assets and liabilities.
❖ Gaining Ratio: Due to change in the profit sharing ratio, one or more partners will gain
their share of profit, it is called gaining ratio.
Gaining Ratio = New Ratio of a Partner – Old Ratio of a Partner
❖ Goodwill:
In general usage, goodwill refers to reputation of a business which enables it to earn
relatively more profit as satisfied customers will come again and again in future.
Thus, goodwill of a firm enables it to earn higher profits in comparison to normal
profits earned by the similar firms in the same trade.
It can also be defined as excess amount paid for a business over and above its net
worth.
Nature of Goodwill:
Goodwill is a fixed asset but not a tangible asset like plant, building, etc. It is an
intangible asset but not a fictitious asset.
Characteristics / Features of Goodwill:

(i) Intangible Asset
(ii) Valuable when business is sold
(iii) Goodwill is subject to constant fluctuation
(iv) Exact value of goodwill is not possible
(v) Subjective valuation
(vi) Valuable Asset

Factors affecting value of Goodwill:
(i) Location of Business
(ii) Nature of Business
(iii) Management
(iv) Longevity of Business
(v) Possession of Licence and Patents
(vi) Quality of Products
(vii) Degree of Competition
(viii) Capital Requirement
(ix) Incentives
Need for valuation of Goodwill: The valuation of Goodwill is needed whenever the
mutual rights of partners’ change. Thus, need of valuation of goodwill in case of a
partnership business arises in the following cases:
1. Change in the profit sharing ratio among existing partners
2. Admission of a partner
3. Retirement or death of a partner
4. Sale of business
5. Amalgamation of two firms
➢ Methods of Valuation of Goodwill:

Following methods are usually followed for valuation of goodwill:
1. Simple Average Profit Method: Under this method of valuation of goodwill, average
of past years’ profits of a number of years is calculated and is multiplied by agreed
number of years to find out the value of goodwill. Steps:
𝑻𝒐𝒕𝒂𝒍 𝑷𝒓𝒐𝒇𝒊𝒕
(i) 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒇𝒊𝒕 =
𝑵𝒐. 𝒐𝒇 𝒚𝒆𝒂𝒓𝒔
(ii) 𝑮𝒐𝒐𝒅𝒘𝒊𝒍𝒍 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑥 𝑁𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 ′ 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒

The past profits should be adjusted in view of future expectations in the following
light:
(i) Abnormal loss of a particular year be added back and abnormal income be
deducted to arrive at the profit of a normal year.
(ii) Income from investment be deducted as it is not an operating income of the
business.
(iii) Normal expenses if not deducted from the past profit should be deducted and
normal income if not added in the past should be added now.
• Logic behind number of years’ purchase: A buyer of a business will earn entirely due
to seller’s efforts for few years as buyer’s effort will start yielding results after few
years. So buyer compensates the seller for few years’ profit which he yields due to past
efforts of the seller.
2. Weighted Average Profit Method: In this method, each year’s profit is assigned a
weight in a manner so that the recent year’s profit is given highest weight and the least
weight is given to starting year. Steps:
(i) Abnormal Profits/losses are adjusted to find out the normal profit of that year.
(ii) Normal profits are multiplied with respective weights.
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
(iii) Thereafter, Weighted Average Profit is computed as,
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝑊𝑒𝑖𝑔ℎ𝑡𝑠
(iv) Goodwill: 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑋 𝑁𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 ′ 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒
Note: This method is preferred when profits depict a rising or falling trend over given
period of time.
3. Super Profit Method: Super Profits refer to excess profit earned by a firm in
comparison to normal profit earned. Thus, if firm has no excess profit, it will not have
goodwill. Steps:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝑋 𝑁𝑜𝑟𝑚𝑎𝑙 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛
(i) 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 =
100
(ii) 𝑆𝑢𝑝𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑟 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡

(iii) 𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = 𝑆𝑢𝑝𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 𝑋 𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 ′ 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒
4. Capitalisation of Average Profit Method: In this method, value of business is
ascertained by capitalising the profit earned on the basis of normal rate of return. This
capital is known as capitalised value of average profits. Steps:
𝐴𝑣𝑒𝑟𝑔𝑎𝑒 𝑃𝑟𝑜𝑓𝑖𝑡
(i) 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑋 100
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛
(ii) Compute Capital Employed

(iii) 𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = 𝐶𝑎𝑝𝑖𝑡𝑙𝑖𝑠𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐴𝑐𝑡𝑢𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙.
If net tangible assets exceed the capitalised value of average profit, there will be no
goodwill.
5. Capitalisation of Super Profit Method: In this method, Super profit is computed.

Thereafter goodwill is computed as
𝑆𝑢𝑝𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = 𝑥 100
𝑁𝑜𝑟𝑚𝑎𝑙 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑟𝑒𝑡𝑢𝑟𝑛
Note: The amount of goodwill calculated by either of the two methods of capitalisation
will always remain the same.
ACCOUNTING STANDARD – 26 (AS – 26)

Treatment of Goodwill issued by Institute of Chartered Accountants of India:
According to AS – 26, goodwill should be recorded in the books of accounts only when
some consideration in money or money’s worth has been paid for it.
AS – 26 deals with intangible assets, Para 35 states that internally generated goodwill
should not be recognised as an asset as it is not identifiable resource controlled by the
enterprise, that can be measured reliably at cost. Thus, following AS -26, goodwill
should not be raised in the books of accounts in case of :
- Admission of a partner
- Retirement of a partner
- Death of a partner
- Change in profit sharing ratio among existing partners

This is so as no consideration in money or money’s worth is paid for it. However, if any
partner brings premium over and above his share of capital at the time of admission,
such premium should be distributed among the other partners in their sacrificing ratio.
If goodwill is evaluated at the time of change in the constitution of the firm (by way of
admission/retirement/death/change in profit sharing ratio), goodwill would not be
brought in the books. The value of goodwill should rather be adjusted through
partners’ capital accounts.
❖ Accounting Treatment of Goodwill when profit sharing ratio of existing partners’

change:
If the existing partners of the firm decide to change their profit sharing ratio, the gaining
partner must compensate the sacrificing partner in gaining ratio towards share of firm’s
goodwill sacrificed by the sacrificing partner.
Entries:
(i) When capital of Partners’ is Fluctuating:
Gaining Partners’ Capital A/c Dr. ……
To Sacrificing Partners’ Capital A/c ……
(In their gaining and sacrificing ratio)
(ii) When capital of Partners’ is Fixed:
Gaining Partners’ Current A/c Dr. ……
To Sacrificing Partners’ Current A/c ……
(iii) Goodwill appearing in the books be written off :
Existing Partners’ Capital/Current A/c Dr. ……
To Goodwill A/c ……
(In their existing/old ratio)

❖ Accounting Treatment of Accumulated Profits and Reserves: If a firm has
undistributed portion of profits and reserves at the time of reconstitution of a
partnership, it can be adjusted in two ways, namely
(i) Profits and reserves be cancelled
(ii) Profits and reserves are not to be cancelled
(i) Profits and Reserves be cancelled: The undistributed profits and reserves belong to
partners before the reconstitution of firm, so these should be cancelled amongst partners
in their old profit sharing ratio.
Entry:
Profit and Loss A/c (cr.) Dr. ……
Reserves A/c Dr. ……
To Existing Partners’ Capital A/c ……
(In their old ratio)
Similarly, undistributed losses and deferred revenue expenditure if exist before

reconstitution of partnership, it should also be cancelled amongst partners in their old
profit-sharing ratio.
Entry:
Existing Partners’ Capital/Current A/c Dr. ……
To Profit and Loss A/c (dr.) ……
To Deferred Revenue Expenditure A/c ……
(In their existing/old ratio)

(ii) Profit and Reserves not to be cancelled: If it is decided amongst the partners that
profits and reserves would continue to appear in the books at the same figure despite the
reconstitution of partnership, an adjustment entry will be passed.
This is due to the fact that profits and reserves belong to partners in their old ratio but in
future, they agreed to share profits and losses in new ratio so the gaining partners’ must
compensate the sacrificing partners’ for the share they have gained by reconstitution of
partnership.
Entries:
For Accumulated Profits / Reserves:
Gaining Partners’ Cap./Current A/c Dr. ……
To Sacrificing Partners’ Cap./Current A/c ……
For Accumulated Losses:
Sacrificing Partners’ Cap./Current A/c Dr. ……
To Gaining Partners’ Cap./Current A/c ……
(In their sacrificing and gaining ratio)

❖ Accounting Treatment for Revaluation of Assets and Re-assessment of Liabilities:
It is necessary to revalue assets and liabilities at the time of change in the profit sharing
ratio among the existing partners.
Any loss or profit arising due to revaluation upto the date of change in the profit sharing
ratio should be divided amongst the partners in their old profit sharing ratio.
For this purpose, Revaluation Account or Profit and Loss Adjustment Account is
prepared. It is similar to Nominal Account.
Entries:
Decrease in value of asset:
Revaluation A/c Dr ……
To Asset A/c ……
Increase in value of asset:
Asset A/c Dr ……
To Revaluation A/c ……
Increase in value of Liabilities:
To Liabilities A/c ……
Decrease in value of Liabilities:
Liabilities A/c Dr ……
Profit on Revaluation:
To Partners’ Capital/Current A/c ……
Loss on Revaluation:
Partners’ Capital A/c Dr ……
According to this method, the revised values of assets and liabilities will be recorded
in the books of accounts.

❖ When Revised values of Assets and Liabilities are not be recorded in the books OR
Adjustments are made through Partners’ Capital Account.
If partners have agreed to record the net effect of revaluation of assets and reassessment
of liabilities through their capital accounts without affecting the valuation of assets and
liabilities, a single adjustment entry is passed based on partners’ gain / sacrifice.
Entries:
For Profit on Revaluation:
Gaining Partners’ Capital/Current A/c Dr. ……
To Sacrificing Partners’ Capital/Current A/c ……
For Loss on Revaluation:
Sacrificing Partners’ Capital/Current A/c Dr. ……
To Gaining Partners’ Capital/Current A/c ……
(In their sacrificing and gaining ratio)
❖ Adjustments of Capitals: Sometimes, reconstitution of partnership firm may also

require that capital of partners be reconstituted in their profit-sharing ratio. So
adjustment in capitals is also required. Following steps are followed:
(i) Prepare capital accounts of partners’ by adjusting their old capital accounts.
(ii) Calculate total capital of the new firm. (if not given)
(iii) Allocate firm’s capital in new profit-sharing ratio.
(iv) Find surplus/deficiency in capital in cash or by opening partners’ current
accounts if they have fixed capitals.

Chap: Admission of a Partner
Section 31 of the Indian Partnership Act, 1932 provides that a new partner shall not
be admitted into a firm without the consent of all the existing partners. The
person so admitted as a partner shall not be liable for the past acts of the firm. A new
partnership deed is prepared on admission of a partner in place of old partnership
deed.
❖ Effects of Admission of a Partner:

(i) On admission of a partner, old partnership agreement comes to an end and a new
agreement is entered into.
(ii) New partner is entitled to share in the future profits of the firm.
(iii) New partner contributes an agreed amount as capital in the firm.
(iv) Since the old partners have sacrificed their share of profit in favour of the
incoming partner so the incoming partner will compensate the old partners
by giving his share of goodwill to them in their sacrificing ratio.
(v) The incoming partner introduces agreed amount of capital in cash or in kind and
acquires ownership right on assets and becomes liable for liabilities of the firm.
(vi) The assets are revalued and liabilities are reassessed and adjustment of
profits/losses is made among the old partners’ capital accounts.
❖ Adjustments made at the time of Admission of a Partner:

(i) Calculation of new profit-sharing ratio
(ii) Sacrificing ratio of old partners
(iii) Accounting treatment of Goodwill
(iv) Adjustment of Profit / Loss on revaluation of assets and re-assessment of
liabilities
(v) Adjustment of Accumulated Profits / Losses and Reserves
(vi) Adjustments of Capital

(i) Calculation of New Profit Sharing Ratio:
The calculation of New Profit Sharing Ratio will depend on the manner in which the
new partner has acquired his share of profit from the existing partners. So, the new
profit sharing ratio of existing partners will be computed as :
New Profit Share = Old Share – Sacrifice of a Partner
Case:1
When incoming partner acquires his share from old partners in their old profit
sharing ratio: If nothing specific is stated, it is assumed that incoming partner has
acquired his share of profit from the old partners in their old profit sharing ratio. Thus,
the old partners will continue to share the balance profit in their old profit sharing
ratio. Steps:
(i) Let the total profit be 1.
(ii) Deduct new partners share.
(iii) Balance Profit = 1 – New Partner’s Share
(iv) Divide balance profit among old partners’ in their old profit sharing ratio.
Case:2
When old partners agreed to share the remaining profit in the agreed ratio: In
this case, the balance profit is shared by the old partners in the agreed ratio and thus
new profit-sharing ratio is ascertained.
Case:3
When incoming partner purchases his share of profit from old partners’ in a
particular ratio: Sometimes, the incoming partner acquires his share of profit from
the old partners in a particular ratio, the new ratio in such cases is computed by
deducting the sacrifice made by the old partners from their old ratio.
Case:4
When Old Partners’ sacrifice is expressly given: In such cases, old partner’s
sacrifice is deducted from his old ratio to ascertain his new share of profit.

Case:5
When a new partner acquires his share by surrender of a particular fraction of
share by old partners: In such cases, share surrendered by old partners in favour of
incoming partner is added to find the share of incoming partner. The share surrendered
by old partners is deducted from their ratio to find their new profit share.
(ii) Sacrificing Ratio of Old Partners: Sacrificing ratio is the ratio in which old partners
have surrendered their share of profit in favour of incoming partner. It is computed as
Sacrifice Ratio = Old Share – New Share
The purpose of computing sacrificing ratio is to determine the amount of
compensation paid by the incoming partner to the old partners in the form of goodwill.
The compensation depends upon sacrifice in profit made by the old partners.
Case:1
When Old and New Profit Sharing Ratio of Partners are given: In such a situation,
sacrifice of old partners are determined by deducting new share of profit from the old
share of profit of partners.
Case:2
When share of New Partner is given without the detail of sacrifice made by old
partners: In such cases, it is assumed that old partners have sacrificed their share
in their old ratio itself.
Case:3
When old partners agree to share the balance profit in agreed ratio: In such cases,
first new ratio be computed and thereafter, sacrificing ratio is ascertained.
Case:4
When old partners sacrifice fraction of their share to incoming partner: In such
case, share of profit surrendered by old partners’ are computed and added to find the
share of incoming partner. New profit sharing ratio of old partners is computed by
deducting their sacrifice from their old profit share ratio.
Case:5
When Sacrifice made by Old Partners’ is given in the question: In such case,
sacrificing share of old partners is given so sacrificing ratio can be determined easily.
However, new profit-sharing ratio is computed by deducting the sacrifice made by a
partner from his old profit-sharing ratio.
Case:6
When there is a gain to existing partner: Sometimes, admission of a new partner
also results in gain to the existing partner also. Thus, negative sacrifice of an old
partner results in gain to that partner.
Accounting Treatment of Goodwill:

As per AS-26, goodwill is recorded in the books of accounts only when
consideration in the form of money or money’s worth has been paid for it. Thus
goodwill should not be raised in the books of the firm.
If the incoming partner brings premium for goodwill in cash besides share of capital
contribution, such premium should be distributed among the existing partners in
the ratio of their sacrifice.
If the goodwill is not brought in cash at the time of admission, it should be adjusted
through partners’ capital / current accounts.
Goodwill of the firm is the result of efforts made by the existing partners of the firm in
the past. Thus, the incoming partner who acquires share in the future profits of
the firm must compensate the existing partners who have sacrificed their existing
profit share in favour of incoming partner in the form of premium (goodwill).
Following are the situations pertaining to treatment of goodwill:

(i) Goodwill (Premium) is paid by the incoming partner Privately:
No Journal Entry is required in the books of accounts.

(ii) Incoming partner brings his share of goodwill in cash:
When the incoming partner brings his share of goodwill or premium in cash, it is
distributed among the old partners in their sacrificing ratio. The goodwill share
received by the existing partner may either be (i) retained in the firm or (ii) may be
withdrawn by the old partners from the firm. The accounting entries passed are as
under:
Date Particulars L.F. Debit ` Credit `

(a) When amount of goodwill is retained in the business:
Cash A/c Dr. ……
To Premium for Goodwill A/c ……
To New Partner’s Capital A/c ……
(Cash brought in by new partner for capital and
goodwill)
Premium for Goodwill A/c Dr. ……
To Old Partners’ Capital A/c ……
(On distribution of amount of goodwill among
old partners in their sacrificing ratio)
(b) When the amount of goodwill is withdrawn by old partners:

Cash A/c Dr. ……
To New Partner’s Capital A/c ……
(Cash brought in by new partner for capital and
goodwill)
(On distribution of amount of goodwill among
old partners in their sacrificing ratio)
Old Partners’ Capital A/c Dr. ……
To Cash/Bank A/c ……
(For amount of goodwill withdrawn by old
partners)
Note: If old partners withdraw amount of goodwill partly, entry should be passed
with the withdrawn amount only.

❖ When Goodwill already appears in the books: If the amount of goodwill already
appears in the books, the existing goodwill must be written off in the old ratio of old
partners by making the following entry:
Old Partners’ Capital A/c Dr. ……
(For amount of goodwill written off
amongst old partners in their old ratio)
(iii) Incoming partner brings his share of goodwill/premium in kind:

Assets A/c Dr. ……
(In their sacrificing ratio)
(iv) Incoming partner does not bring his share of goodwill in cash: If the incoming
partner is unable to bring his share of premium (goodwill) in cash, it is adjusted
through partner’s capital / current accounts.
New Partner’s Capital / Current A/c Dr. ……
To Old Partners Capital/Current A/c ……
(v) Incoming partner bring in only part of his goodwill / premium share in cash:
If incoming partner brings his share of goodwill partly in cash, cash portion will be
adjusted among old partners in their sacrificing ratio. For rest of the portion of
goodwill share, adjustment will be made as if he did not bring his share of goodwill in
cash.

(vi) Gain received by old partner also besides the incoming partner:
During admission of a partner, profit sharing ratio changes. It may result in gain to
even an old partner besides incoming partner. The goodwill brought in by an
incoming partner is shared by the sacrificing partners. Similarly, the old partner who
has gained due to reconstitution of firm should also compensate the sacrificing
partners for goodwill share.
(vii) Hidden or Inferred Goodwill:

Sometimes, goodwill share brought in by the incoming partner is not given in the
question. Goodwill in such cases is computed on the basis of an inferred method of
profit-sharing ratio or by using capitalisation method. Following steps are used to find
the value of hidden goodwill:
(a) Find the total (expected) capital of new firm: Capital of the new firm if
computed on the basis of incoming partner’s capital and his share in profit. eg.
C is admitted as a partner, contributing ` 40,000 for 1/5th share in profit. So
capital of new firm will be
𝟓
𝟒𝟎, 𝟎𝟎𝟎 𝑿 = 𝟐, 𝟎𝟎, 𝟎𝟎𝟎
𝟏
(b) Find the actual capital of the firm including incoming partner’s capital: A :
B, 3: 2. Capitals ` 60,000 and ` 50,000 respectively. C is admitted for 1/5th share
contributing ` 40,000 as capital. Actual Capital will be
60,000 + 50,000 + 40,000 = 1,50,000
Note: If on date of admission some reserves appear in the books, then reserves
are also to be taken into consideration for calculating actual capital of the firm.
(c) Find Goodwill of the firm: The amount of difference between expected capital
and actual capital will be the amount of goodwill.
Expected Capital : ` 2,00,000
Less: Actual Capital : ` 1,50,000
Goodwill of the firm : ` 50,000

❖ Adjustment of Profit / Loss on Revaluation of Assets and Re-assessment of
Liabilities: It is essential to revalue the assets and re-assess the liabilities of the firm at
the time of admission of a partner as with the passage of time, the value of some assets
might have gone up and value of other assets might have gone down. Thus, the
revaluation of assets may result into profit or loss. It must be allocated among the
existing partners in their old profit sharing ratio as the incoming partner has
nothing to do with profit or loss arising before his induction into the firm. For this
purpose, Revaluation Account or Profit and Loss Adjustment Account is prepared.
This account is similar to nominal account i.e. all losses be debited and gains be
credited.
By doing this, assets and liabilities will be recorded in the books of accounts at their
revised values and profit/loss on revaluation will be shared by the old partners in their
old profit sharing ratio.
❖ Accounting Treatment of Accumulated Profits/Losses and Reserves:

(a) Accumulated Profit: A firm may have balance of undistributed profits and reserves
such as Reserve Fund, General Reserve, Credit balance of Profit and Loss Account
etc. at the time of admission of partner. All these profits and reserves belong to old
partners in their old profit sharing ratio. Entry:
Reserve Fund A/c Dr. ……
General Reserve A/c Dr. ……

(b) Specific Funds:
(i) The firm may also have specific funds like – Investment Fluctuation Fund/Reserve,
Workmen Compensation Fund, etc. If there is no liability against these funds, these
should also be credited to old partners’ capital / current Account in their old profit-
sharing ratio. Entry:
Investment Fluctuation Fund A/c Dr. ……
Workmen’s Compensation Fund A/c Dr. ……
(ii) If there is a liability against Workmen Compensation Fund, it should be first

charged against Workmen Compensation Fund and balance be distributed among old
partners in their old profit-sharing ratio. The entry passed will be:
To Claim against Workmen Comp. Fund A/c ……
(iii) If the liability against Workmen Compensation Fund exceeds the amount of fund,
the excess amount be charged with revaluation A/c. The entry passed will be:
Revaluation A/c Dr. 4,000
Workmen’s Compensation Fund A/c Dr. 10,000
To Claim against Workmen Comp. Fund A/c 14,000
(c) Accumulated Losses: Accumulated losses like Debit Balance of Profit and Loss
Account, Advertisement Suspense Account, Deferred Revenue Expenditure, etc. are
losses and belong to old partners. So these items should also be written off against
capital or current account of old partners in their old profit sharing ratio.
Old Partner’s Capital / Current A Dr. ……
To Advertisement Suspense A/c ……

❖ Adjustment of Capital Accounts in Proportion of Profit Sharing Ratio:
Sometimes, partners decide at the time of inducting a new partner that their capitals
should also be adjusted in their profit sharing ratio. The adjustment in capital is made
in 2 ways:
(i) Determination of capital of new partner on the basis of old partners’ capital: If the
incoming partner has to bring in the proportionate capital, his capital is determined on
the basis of capital of old partners (after all adjustments) and new profit sharing ratio
of old partners.
(ii) Adjustment of old partners’ capital on the basis on new partner’s capital: Sometimes,
the capital of incoming partner is given and capital of old partners is computed on the
basis of new profit sharing ratio of partners. Thus, the existing capital of old partners’
be adjusted in 2 ways:
(a) Cash Basis: If the new capital is more than the existing capital of a partner, he will
bring it in cash. On the other hand, if new capital is less than the existing capital of old
partners, excess capital is returned back.
(i) If capital of old partner falls short, he will bring it in cash:
Cash/Bank A/c Dr.
To Partner’s Capital A/c
(ii) If capital of old partner has a surplus, he will withdraw it in cash:
Partner’s Capital A/c Dr.
To Cash/Bank A/c
(b) By Opening Current A/cs of Partners: The excess or short fall of old partners’
capital can also be adjusted by opening current account of partners in case they have
fixed capitals.
(i) If capital of old partner is more:
Partner’s Capital A/c Dr.
To Partner’s Current A/c
(ii) If capital of old partner is less:
Partner’s Current A/c Dr.
To Partner’s Capital A/c
❖ Important points to remember:
(i) When New partner brings proportionate capital but unable to bring his share of
Goodwill in cash: In normal usage when the new partner is unable to bring his share
of goodwill in cash, the journal entry passed is
New Partner’s Capital A/c Dr. ……
To Old Partners Capital A/c ……
(New partner’s share of goodwill will be
adjusted in sacrificing ratio of existing
partners)
Thereafter, proportionate capital of new partner will be computed eg. It is ` 50,000.

But his capital account has been debited for adjustment of his goodwill share (say
` 10,000). Thus, his ultimate capital remains in the business is `40,000 which is not
equivalent to his share of proportionate capital. Hence, this accounting treatment is
technically wrong. Suggested Accounting Treatment:
New Partner’s Current A/c Dr. ……
To Old Partners Capital A/c ……
(New partner’s share of goodwill will be
adjusted in sacrificing ratio of existing
partners)
Note: The suggested treatment of goodwill share of new partner be followed in the
following cases
(i) When he is unable to bring his share of goodwill in cash:
(ii) When capital of old partners’ is adjusted based on new partner’s capital.

❖ Important points to Remember:
While solving questions of admission of a partner, following rules be observed:
Items Treatment
1. Balance of General Reserve, Reserve Transfer to old partners in their old profit sharing
Fund, Profit & Loss A/c (Dr. or Cr. ratio
Balance)
2. Goodwill appearing on Assets Side Written off among old partners in their old profit
sharing ratio
3. Revaluation of Assets and Liabilities Transfer to old partners in their old profit sharing
(loss/profit) ratio
4. Capital and goodwill of new partner Cash A/c Dr.
brought in cash To Premium for Goodwill A/c
To New Partner’s Capital A/c
5. Transfer of goodwill share brought Premium for Goodwill A/c Dr.
in by the new partner among old To Old Partners’ Capital A/c
partners in their sacrificing ratio
6. If goodwill share is not brought in New Partner’s Capital / Current A/c Dr.
cash by the new partner (share of goodwill)
To Old Partners Capital/Current A/c

❖ When Assets and Liabilities are not to be shown at the Revised Values or
Preparation of Memorandum Revaluation Account:
Assets are usually revalued and liabilities re-assessed at the time of admission of a new
partner but sometimes, partners may decide that assets and liabilities will continue to be
shown at their existing values. In such a case, Memorandum Revaluation Account is
prepared to record the increase or decrease in the values of assets and liabilities. This
account is divided into two parts:
In the first part, increase or decrease in the values of assets and liabilities are recorded
in the usual way and profit or loss is transferred among the old partners in their old
profit sharing ratio.
In the second part, entries of the first part are reversed and profit or loss is transferred
to all the partners, including incoming partners in their new profit sharing ratio.
❖ Memorandum Balance Sheet: In case of admission of a partner, sometimes Balance

Sheet of old firm is not given. We are given incomplete information. Thus we cannot
prepare Balance Sheet of new firm unless and until old Balance sheet is given. Thus,
preparation of Balance Sheet of old partners with incomplete information is called
Memorandum Balance Sheet. The balancing figure on the assets side may be cash
balance or debit balance of Profit and Loss Account. Similarly, balancing figure on the
liabilities side may be capital of old partners or credit balance of Profit and Loss
Account.

Chap: Retirement of a Partner
Retirement of a partner refers to discontinuation of a partner from partnership firm.

Thus, a partner leaving the firm is known as a retiring partner or an outgoing partner.
As per Indian Partnership Act, 1932, a partner may retire from the firm:
(i) With the consent of all the partners.

(ii) As per agreement to that effect
(iii) By giving notice in writing to all other partners, if partnership is at will.
On retirement of a partner, old partnership comes to an end, however, the remaining

partners will enter into a new agreement and the partnership firm will continue.
❖ Entitlement of a Retiring Partner:

(i) Share in reserves and profits or losses
(ii) Share in revaluation of assets and reassessment of liabilities
(iii) Share in goodwill
(iv) Right to get back his capital
❖ Adjustments needed at the time of retirement of a partner:

(i) Calculation of new profit-sharing ratio and gaining ratio of continuing partners.
(ii) Accounting treatment of Goodwill.
(iii) Accounting treatment of Revaluation of Assets and Re-assessment of Liabilities
(iv) Accounting treatment of Accumulated Profits/Losses.
(v) Settlement of amount due to Retiring Partner.
(vi) Preparation of Balance Sheet
(vii) Preparation of Loan Account of the Retiring Partner
(viii) Adjustment of Capitals of Continuing Partners.

(i) New Profit Sharing Ratio of Continuing Partners and Gaining Ratio:
New Ratio = Old Share + Acquired Share from Retiring Partner
Case: 1
When a partner retires and nothing is stated about the new ratio of continuing
partners: If nothing specific is stated, the profit sharing ratio of continuing partner
will not change with the retirement of a partner. For eg. A:B:C profit sharing ratio
3:2:1. A retires. Therefore, New Ratio of B and C will be 2:1.
Case:2
When remaining partners’ purchase the retiring partner’s share in a specific
proportion: The continuing partners’ may prefer to take the retiring partner’s share in
a specific ratio. In such case, exact share of gain is computed for the continuing
partners. Their new ratio will be computed by adding the gain obtained in their
previous ratio.
Case: 3
When retiring partner surrenders his share of profit to remaining partners in a
specific ratio
❖ Gaining Ratio: The ratio in which continuing partners acquire the profit share of
retiring or deceased partner’s share, is called the gaining ratio. Thus, gaining ratio is
computed at the time of retirement or death of a partner.
Gaining Ratio = New Ratio – Old Ratio
Case:1
When no agreement is entered into: If no agreement is entered among the continuing

partners at the time of retirement of a partner, it is assumed that the continuing
partners have gained their share in the ratio which existed before the retirement of the
partner. (i.e. Old Ratio)

Case:2
When New Profit Sharing is given: If profit sharing ratio before retirement / death of
a partner and after retirement / death has been given, the gaining ratio will be the
difference between their new and old profit-sharing ratio.
Case:3
Gaining ratio is expressly given: Sometimes, after the retirement of a partner,

gaining ratio between continuing partners’ is given so gaining ratio is computed in such
cases.
❖ DISTINCTION BETWEEN SACRIFICING RATIO AND GAINING RATIO

Basis Sacrificing Ratio Gaining Ratio
1. Meaning It is the ratio in which old partners It is the ratio in which remaining
sacrifice their share of profit in partners acquire share of profit from
favour of new partner. the outgoing partners.
2. Need It is used during admission of a It is used during retirement/death of
partner. a partner.
3. Purpose It is computed to find out the It is computed to find out the
amount of premium (goodwill) to be amount given to the retiring partner
paid to old partners by the incoming for goodwill share by the continuing
partner. partners.
4. Calculation Sacrificing Ratio Gaining Ratio
= Old Share – New Share = New Share – Old Share
(ii) Accounting treatment of Goodwill as per AS – 26 :

Goodwill of a firm is the result of the combined effort of all the partners in the past.
Therefore, at the time of retirement / death of a partner, the outgoing partner must be
compensated by the continuing partners in their gaining ratio. AS – 26 issued by ICAI
states that goodwill is recorded only when consideration in money or kind has been
paid. It also states that internally generated goodwill should not be recognised as an
asset as it is not an identifiable resource that can be measured reliably at cost.

Following AS – 26, goodwill should not be raised in the books of account at the time
of retirement / death as no consideration has come in cash rather value of goodwill
should be adjusted through partners’ capital accounts.
Accounting Treatment:
(a) The retiring / deceased partner must be compensated in the form of premium
(goodwill) for share of profit sacrificed in favour of the continuing partners in the ratio
of gain obtained by them through partners’ capital accounts. Entry:
Continuing / Gaining Partner(s) Capital A/c Dr. ……

To Retiring/Deceased Partner’s Capital A/c ……
(b) If goodwill already appeared in the books of accounts, it should be written off among
all the partners in their profit sharing ratio. Entry:
All Partners’ Capital A/c Dr. ……

(in their old profit sharing ratio)
❖ Sacrifice made by Continuing Partner besides Retiring Partner: It may be

possible that at the time of retirement / death of a partner, a continuing partner may
also sacrifice in favour of remaining continuing partners besides the retiring / deceased
partner. Thus, the gaining partner must compensate both the retiring partner and the
other continuing partner who is also sacrificing his profit share in favour of gaining
partner / partners. Entry:
Continuing Partners’ Capital A/c Dr. (Gaining)

To Retiring/Deceased Partner’s Cap. A/c ……
To Continuing Partner’s Capital A/c (Sacrificing)
(iii) Revaluation of Assets and Re-assessment of Liabilities: At the time of retirement /

death of a partner, all the assets be revalued and liabilities be re-assessed and loss /
profit be distributed among all the partners including retiring / deceased partner in their
old profit sharing ratio.
(iv) Accounting Treatment of Accumulated Profits / Losses: All the accumulated
profits / losses be allocated among all the partners including retiring / deceased partner
as profits / losses have taken place when they were also partners in the firm. Entries:
For Reserve Fund A/c Dr. ……

Acc. General Reserve A/c Dr. ……
Profits Profit and Loss A/c Dr.
To All Partners Capital/Current A/c
For All Partners’ Capital / Current A/c Dr. ……

Acc. To Profit and Loss A/c (dr.) ……
Losses To Advertisement Suspense A/c ……
Specific Reserves: If specific reserves like Workmen Compensation Fund, Investment

Fluctuation Reserve, etc. are more in value than the actual liability, the excess portion
of these should be distributed among all the partners including the outgoing partner in
their old profit sharing ratio as it belongs to all of them. Entry:
Investment Fluctuation Fund A/c Dr. ……

To All Partners Capital/Current A/c ……
(v) Settlement of amount due to the Retiring Partner: On the retirement of a partner
from the firm, the amount due to the retiring partner is computed as per the provisions
of partnership deed.
The amount due to him is either paid in cash or is transferred to his loan account and
the balance of loan is shown on the liabilities side of the Balance Sheet.
The amount of loan may be paid in various instalments along with interest or may be
paid in a single instalment as per terms of agreement.

If full amount due to retiring partner is paid in cash:
Retiring Partner’s Capital A/c Dr. ……

To Cash / Bank A/c ……
If the amount due to retiring partner is paid partly in cash and the balance
amount due is transferred to his loan account:

To Retiring Partner’s Loan A/c ……
Important points to remember:

• In the absence of any written agreement, the amount due to a retiring partner is
transferred to his loan account.
• In the absence of an agreement, the retiring partner is entitled to get interest @ 6 %
p.a. on his loan account. Alternatively, the retiring partner at his option may take
share of profit that has been earned by the new firm by the use of amount due to
him u/s 37 of Partnership Act, 1932.
(vi) Preparation of Balance Sheet of Firm after Retirement of a Partner

After the retirement of a partner from the firm, Balance Sheet is prepared in the usual
manner. However, following points be taken care of:
(i) If retiring partner is paid in cash, the amount due to him shall be deducted from Cash
A/c / Bank A/c.
(ii) If the retiring partner is not paid in cash, amount due to him will be transferred to his
Loan A/c and it will be shown on the liability side of the balance sheet.
(iii) If the retiring partner is paid partly in cash, the balance due to him represents his Loan
A/c and it will be shown on the liabilities side f the balance sheet. However, cash paid
will be deducted from Cash A/c / Bank A/c on the assets side of the balance sheet.
(iv) Other items of assets and liabilities will be shown in the balance sheet in the usual
manner at their revalued amount.
(vii) Preparation of Loan Account of the Retiring Partner: If the retiring partner is not
paid in cash, the mount due to him is transferred to his Loan A/c and it is shown on the
liabilities side of the balance sheet. Thereafter, retiring partner is usually paid the sum
due to him in agreed instalments along with interest at the agreed rate or at 6 % p.a. in
absence of agreement. Entries:
1. For transfer of partner’s capital to partner’s loan account:

2. For interest due on due date:
Interest on Partner’s Loan A/c Dr. ……

3. For payment of instalment on due date:
Retiring Partner’s Loan A/c Dr. ……

(viii) Adjustment of Capital of Continuing Partners: In partnership business, partners

may or may not contribute their capital in proportion to their profit share but at the time
of retirement / death of a partner, the continuing partners may decide that their
capital will be in proportion to their profit sharing ratio in future.
In such circumstances, capital of the firm is ascertained and it is divided among
partners in their profit sharing ratio, if they so desire.
The desired capital is compared with the actual capital of the partners and excess or
deficit in capital may either be adjusted in cash or may be adjusted by opening the
current account of the partners. Following entries are passed:
(i) If capital of a partner is less:
Cash / Bank A/c Dr. ……

To Concerned Partner’s Capital A/c ……

(ii) If capital of a partner is more:
Concerned Partner’s Capital A/c Dr. ……

OR
(i) If the surplus in their capital accounts is transferred to their current accounts:
Concerned Partner’s Capital A/c Dr. ……

To Concerned Partner’s Current A/c ……
(ii) If the deficit in their capital accounts is transferred to their current accounts:
Concerned Partner’s Current A/c Dr. ……

To Concerned Partner’s Capital A/c ……
Note: In the absence of any specific instruction any surplus or deficiency be adjusted
in cash and not by transferring to current account of partners.
❖ Retirement during the Accounting Year: It is possible that retiring partner may
retire during the accounting year as well. In such a situation, the retiring partner is also
entitled for the profit share till the date of his retirement besides his share of
goodwill, reserves, revaluation of assets and reassessment of liabilities etc. His share
of profit during the intervening period is computed either as per the provisions of the
Partnership Deed or as per mutual consent of old partners. Usually profit share of
retiring partner is computed on the basis of last year profit or on the basis of
average profit of past few years.
Steps followed are as under:
(i) Average profit or last year profit is reduced to profit of firm till his retirement e.g.
= Profit of last year x 3/12 = `……… (Say if retired after three months)
(ii) Profit share of retiring partner based on his old profit sharing ratio
(iii) Journal entry passed is
Profit and Loss Suspense A/c Dr. ……

To Retiring Partner’s Capital A/c ……

Notes:
(i) Profit and Loss Suspense A/c is written as profit share of retired partner is not based
on actual profit till the date of his retirement. It is written on the asset side of the
Balance Sheet on the date of retirement.
(ii) At the end of accounting year, Profit and Loss Suspense A/c is transferred to Profit
and Loss Appropriation A/c.
(iii) Balance Profit is shared by the remaining partners in their profit sharing ratio
provided remaining partners have not changed their profit sharing ratio.
(iv) If the remaining partners have changed their old profit sharing ratio, the profit
share of retired partner is not debited to Profit and Loss Suspense A/c rather it is
debited to remaining partners in their gaining ratio. The entry passed is
Continuing Partner’s Current A/c Dr. ……

To Retired Partner’s Capital A/c ……

Chap: Death of a Partner
A partnership is dissolved with the death of a partner, however, the firm will continue
among remaining partners. The continuing partners will acquire the deceased partner’s
share of profit.
On the death of a partner, the legal heirs of deceased partner are entitled to all rights
which have been discussed in respect of retirement of a partner i.e.
(i) Amount of capital to the credit of deceased partner

(ii) Share in accumulated profits and losses
(iii) Revaluation of assets and re-assessment of liabilities
(iv) Share in Goodwill
But in case of death of a partner, the Executor’s of deceased partner are also
entitled to the following additional items:
(a) Share of profit earned or loss share from beginning of year till the date of
death.
(b) Interest on capital till death.
(c) Drawings and interest thereon till death.
(d) Salary / Commission, if any till death.
All above adjustments are incorporated in the capital account of deceased partner and
thereafter, it is transferred to account opened in the name of his executors’ or legal
representatives. Entry
Deceased Partner’s Capital A/c Dr. ……

To Deceased Partner’s Executors A/c ……
On Payment in Full / Part:
Deceased Partner’s Executors A/c Dr. ……

To Bank A/c ……

Note: If the executors of deceased partner are to be paid in instalments, his legal heirs
are entitled to interest @ 6 % p.a. unless agreed otherwise proportionate share of profit
earned by using deceased partner’s capital. The executors may opt any of these two
options as per section 37 of Indian Partnership Act, 1932.
❖ Computation of Share of Profit till the date of death of a Partner:

• The executors of deceased partner are entitled to share in the profit till the death
of a partner.
• The actual amount of profit can be ascertained only when books are closed.
• It is certainly a inconvenient mode so the partnership deed generally provides that
profit share till date of death of a partner may be ascertained on the basis of last
year’s / average profit either on time basis or on turnover basis.
• Since profit share of deceased partner is not based on actual profit of the firm
so the estimated profit share is termed as Profit and Loss Suspense Account.
Entry:
(i) When profit sharing ratio of remaining partners does not change:

To Deceased Partner’s Capital A/c ……
Profit and Loss Suspense A/c is shown on the assets side of the Balance Sheet. At
the end of accounting year, Profit and Loss Suspense A/c is debited to Profit and Loss
Appropriation A/c.
(ii) When profit sharing ratio of remaining partners’ change:
Continuing Partners’ Capital A/c Dr. ……

(gaining partners to sacrificing partners)
At the end of the accounting year, whole profit of the year is shared by the remaining
partners in their new profit-sharing ratio.

❖ Basis of Share of Profit till the date of death of a Partner:
(a) Time Basis: It is assumed that profit accrue on uniform basis during each month.
Partnership Deed may provide that either last year’s profit or the average profit of last
few years may be taken as basis for determining the share of profit of deceased partner.
𝑃𝑟𝑜𝑓𝑖𝑡 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝑑𝑒𝑐𝑒𝑎𝑠𝑒𝑑 𝑃𝑎𝑟𝑡𝑛𝑒𝑟
= 𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑓 𝐹𝑖𝑟𝑚 𝑡𝑖𝑙𝑙 𝑑𝑎𝑡𝑒 𝑜𝑓 𝑑𝑒𝑎𝑡ℎ 𝑋 𝑃𝑟𝑜𝑓𝑖𝑡 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑑𝑒𝑐𝑒𝑎𝑠𝑒𝑑 𝑝𝑎𝑟𝑡𝑛𝑒𝑟
(b) Profit on the basis of Turnover (Sales): When business is seasonal in nature, profit of
different months will not remain uniform. In such case, share of profit of deceased
partner will be computed on the basis of sales till the death of a partner and the profit
and sales of last year. Firm’s profit is computed on sales basis, and therefore
𝑃𝑟𝑜𝑓𝑖𝑡 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝐷𝑒𝑐𝑒𝑎𝑠𝑒𝑑 𝑝𝑎𝑟𝑡𝑛𝑒𝑟
𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑓 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟
= 𝑋 𝑆𝑎𝑙𝑒𝑠 𝑡𝑖𝑙𝑙 𝑑𝑎𝑡𝑒 𝑜𝑓 𝑑𝑒𝑎𝑡ℎ 𝑋 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝑑𝑒𝑐𝑒𝑎𝑠𝑒𝑑 𝑝𝑎𝑟𝑡𝑛𝑒𝑟
𝑆𝑎𝑙𝑒𝑠 𝑜𝑓 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟
❖ Accounting Treatment of Goodwill: The accounting treatment of deceased partner’s

share of goodwill is similar to the treatment shown in case of retirement of a partner. It
has already been discussed in detail in case of retirement of partner that as per AS – 26
goodwill cannot be raised in the books. However, it is adjusted through capital account
of partners.
Entry:
Continuing Partners’ Capital A/c Dr.

To Deceased Partner’s Capital A/c
(gaining partners’ compensating the
deceased partner for share of goodwill)
❖ Revaluation of Assets and Re-assessment of Liabilities: The revaluation of assets and

re-assessment of liabilities at the time of retirement and death of a partner is alike. The
profit / loss on revaluation is divided among all the partners including retiring /
deceased partner in their old profit sharing ratio.

❖ Preparation of Capital Account of Deceased Partner: Capital Account of deceased
partner is prepared in the usual manner as it is prepared at the time of retirement of a
partner. Following items comes into it.
(1) Amount of Capital to the credit of deceased partner.
(2) Share in Accumulated Profits/Losses
(3) Share of Revaluation of Assets and Re-assessment of Liabilities
(4) Share in Goodwill
Deceased partner is also entitled to the following additional items:

(a) Share of profit earned or loss share from beginning of year till the date of death.
(b) Interest on capital till death.
(c) Drawings and interest thereon till death.
(d) Salary / Commission, if any till death.
❖ Proforma of Capital Account of Deceased Partner

Deceased Partner’s Capital Account
Particulars ` Particulars `
To Accumulated Losses …… By Balance b/d ……
(Share of loss) …… By Interest on Capital A/c ……
To Revaluation A/c …… By Salary/Commission A/c ……
(Share of loss) By Accumulated Profit ……
To Goodwill A/c …… (Share of Profit) ……
(Share of goodwill written off) …… By Revaluation A/c (Share of Profit) ……
To Drawings A/c …… By Gaining partner’s Capital A/c
To Interest on Drawings …… (Share of goodwill) ……
To P & L Suspense A/c By P & L Suspense A/c
(Share of loss)* (Share of profit)*
To Deceased Partner’s Executor’s
A/c (Balancing figure)
…… ……
Note: *If profit sharing ratio of continuing partners does not change

❖ Accounting treatment of amount due to Deceased Partner: The capital account of
deceased partner is maintained on the pattern of capital account of a retiring partner.
Since the deceased is not alive so the amount due to him is transferred to deceased
partner’s executors account. Entry:
Deceased Partner’s Capital A/c Dr. ……

To Deceased Partner’s Executors A/c ……
❖ Preparation of Balance Sheet of firm after the Death of a Partner:

After the death of a partner, the Balance Sheet of the firm will be prepared in the usual
manner except the following points:
(i) Since deceased partner is not alive so the amount due to him is transferred from
his capital account to his executor’s account. It is shown in the Balance Sheet on
the liabilities side.
(ii) Profit share of deceased partner till his death is based on last year’s profit /
average profit of past several years. So entry passed is:

Debit Balance of Profit and Loss Suspense Account is shown on the assets side of
the Balance Sheet.
❖ Settlement of Deceased Partner’s Executor’s Account in Instalments: In case of

death of partner, the settlement of account of a deceased partner in various instalments
is similar to settlement of account in case of retirement of partner. The only difference
is that we prepare Loan Account of retiring partner while in case of death, we have to
prepare Executor’s A/c of deceased partner as he not alive.

Chap: Dissolution of Partnership Firm
The term dissolution with reference to partnership refers to discontinuation of business

relations among partners. Since partnership is based on agreement so any change in the
original agreement amounts to dissolution of partnership. Dissolution of partnership
firm refers to complete close down of the business.
❖ Dissolution of Partnership: Dissolution of partnership refers to change in the

economic relationship among partners without affecting the continuation of business.
Thus, existing firm is reconstituted without affecting the dissolution of firm. This may
happen in the following circumstances:
(i) Change in the profit-sharing ratio among the existing partners
(ii) Admission of a Partner
(iii) Retirement of a Partner
(iv) Death of a Partner
(v) Amalgamation of two Partnership Firms
It is pertinent to note that in all the above cases, the existing partnership comes to an
end and a new agreement is entered into while the firm will continue to run its business
under its firm name.
❖ Dissolution of Partnership Firm: Dissolution of partnership firm refers to complete

close down of the business of the firm. Thus all the assets are disposed off and all the
liabilities are paid off. Thereafter, the account of partners are settled and paid.
❖ A firm is dissolved under the following circumstances:

(i) All the partners of the firm give their consent.
(ii) Firm’s business becomes unlawful.
(iii) All partners or all partners except one, become insolvent.
(iv) In case the partnership is at will, if any partner give notice.
(v) Dissolution of firm under order of court.

❖ Dissolution of Partnership and Dissolution of Partnership Firm
Basis Dissolution of Partnership Dissolution of Partnership Firm

1. Meaning Dissolution of partnership refers to Dissolution of firm refers to
change in the existing agreement complete close down of the
among partners. business.
2. Continuation Firm continues with dissolution of Dissolution of firm means
of business partnership. dissolution of partnership as well.
3. Books of Same books of accounts will Books of accounts are also closed
Accounts continue in future. with the dissolution of firm.
4. Dissolution It may or may not involve Dissolution of firm always
of dissolution of firm. involves dissolution of partnership.
Partnership
5. Assets and Assets and outside liabilities are Assets are disposed off and
outside revalued. liabilities are paid off.
Liabilities
6. Existence It involves reconstitution of firm, It involves complete winding up of
however, firm will continue to firm.
exist.
❖ Modes of Dissolution of Partnership Firm:

1. Dissolution without the Order of Court:
(i) With the consent of all the partners.
(ii) When all the partners or all the partners except one become insolvent.
(iii) When business becomes unlawful.
(iv) On completion of venture
(v) Dissolution by giving notice if the partnership is at will.
(vi) On expiry of term of the firm.

2. Dissolution by Court:
(i) If a partner becomes man of unsound mind.
(ii) If a partner is guilty of misconduct.
(iii) If a partner transfers his interest in the business without the consent of existing
partners.
(iv) If a partner consistently and deliberately commits breach of agreement
(v) If court finds that the dissolution of firm is justified.
(vi) If a partner is permanently incapable of performing his duties as a partner.
❖ Settlement of Accounts on Dissolution of Firm (Sec 48): Section 48 of Indian

Partnership Act, 1932 deals with settlement of accounts at the time of dissolution of
partnership firm. These rules are:
(a) Treatment of Losses: The amount of loss including deficiency of capital shall be paid
first out of profit, then out of capital, and lastly, if necessary be realised from partners in
their profit-sharing ratio.
(b) Application of Assets: The amount realised from sale of assets, including any sum of
money contributed by any partner to make up the deficiency of his capital, shall be
applied in the following order:
(i) Debts due to third parties
(ii) Partners’ loans and advances rateably (proportionately)
(iii) Partners’ capital rateably.
(iv) Balance left be distributed among partners in their profit-sharing ratio.
❖ Payment of Firm’s Debts and Private Debts: Following provisions shall apply in
connection with payment of firm’s debts and partners’ private debts.
(a) Firms’ property shall be used to pay firm’s debt and if there is any surplus, it is
distributed among partners in their profit-sharing ratio.
(b) The private property of each partner shall be used to pay off his/her private debts and
surplus, if any, be used to pay off firm’s debts.

❖ Accounting Treatment on Dissolution of Partnership Firm: Following accounts are
opened in the books of the firm to complete this process:
1. Realisation A/c 2. Partner’s Loan A/c
3. Partners’ Capital A/c 4. Bank / Cash A/c
1. Realisation A/c: Realisation A/c is opened in the books of the firm to dispose off all the
assets and to pay off all the outside liabilities. It is a nominal account. It is prepared to
determine the profit or loss arising on realisation of assets and payment of liabilities.
Profit or loss on realisation is transferred to partners’ capital account in their profit-
sharing ratio.
Following steps are followed while preparing this account:
(i) For closing the assets accounts: All the assets except Cash, Bank, debit balance of
Partner’s Capital / Current A/c, Loan to partners, deferred revenue expenditure (like
advertisement suspense account) and debit balance of Profit and Loss A/c are
transferred to Realisation A/c at their book values. Entry:
Realisation A/c Dr. ……

To Various Assets A/c (by name) ……
Note:
1. If an asset has provision or reserve appearing on the liabilities side of the balance
sheet, such reserve / provision is also transferred to Realisation A/c eg. Provision
for doubtful debts, Provision for discount on debtors, Investment Fluctuation
Reserve, etc.
2. These reserves / provisions are not to be paid off after realisation of assets as these
do not denote outside liabilities of the firm.

To Plant A/c ……
To Investment A/c ……
To Debtors A/c ……

Provision for Depreciation A/c Dr. ……
Investment Fluctuation Reserve A/c Dr. ……
Provision for Doubtful Debt A/c Dr. ……
To Realisation A/c ……
(ii) For closing Outside Liabilities: All outside liabilities except accumulated profits
(Profit and Loss A/c, General Reserve, Reserve Fund, Contingency Reserve, etc.), loan
due to partners are transferred to realisation account. Entry:
Various Liabilities A/c (by name) Dr. ……

For Unrecorded Assets and Liabilities: During the course of dissolution of firm, there
may be unrecorded assets in the firm (Plant written off completely). Similarly, a firm
may also have unrecorded liabilities. These unrecorded assets / liabilities are never
recorded in the Realisation A/c as they do not appear in the Balance Sheet.
However, the payment realised from unrecorded assets and payment of unrecorded
liabilities are recorded in the Realisation A/c.
(iii) For Realisation of Assets (Whether recorded or not):

(a) Assets sold for cash:
Cash A/c (realised value) Dr. ……

(b) Assets taken over by Partner (Whether recorded or not):
Partner’s Capital A/c (agreed price) Dr. ……

(c) Assets given away to a creditor: NO ENTRY is required.

❖ Sometimes, a creditor may accept payment partly in cash and part of his payment by
taking over an asset, in such a case there may be two situations:
(i) When a creditor accepts an asset whose value is less than the amount due to him,
balance will be paid in cash and entry will be

To Bank A/c ……
(for rest of the payment made to creditors)
(ii) When a creditor accepts an asset whose value is more than the amount due to
him, he will pay cash and entry will be
Bank A/c Dr. ……

(for excess amount of asset over creditors
received)
(iv) Payment of Liabilities (Whether recorded or not):

(a) On payment of Liability:

To Bank A/c ……
(b) Liability taken over by a partner (Whether recorded or not):

To Partner’s Capital A/c ……
Note:
(i) Liabilities are paid in full if nothing is stated about them.

(ii) Fixed Assets to be realised at its book value in case of absence of any
information.
(iii) Realised value of each asset must be given at the time of dissolution.

(iv) If Workmen Compensation Fund has a liability to be met, the amount equivalent
to liability is transferred to credit side of Realisation A/c and it is paid.
Remaining amount of workmen compensation fund is transferred to Partners’
Capital / Current Account.
(v) Payment of Realisation Expenses: Usually realisation expenses of assets are paid by
the firm as it is an expense of the firm. But often, it is paid by a partner as well.
Sometimes, a partner gets commission so he bears expenses in lieu of commission.
Thus, it is pertinent to see who is paying the expenses and who is bearing the
burden of the expenses. Following entry is passed in each circumstance:
Sr. No. Borne By Paid By Journal Entry

Dr. Cr.
1. FIRM FIRM Realisation A/c Dr.
To Bank A/c
2. FIRM MOHAN Realisation A/c Dr.
(Partner) To Mohan A/c
3. MOHAN FIRM Mohan A/c Dr.
(Partner) To Cash A/c
4. MOHAN SOHAN Mohan A/c Dr.
(Partner) (Partner) To Sohan A/c
5. MOHAN MOHAN
NO ENTRY
(Partner) (Partner)
Note:
(i) In the absence of specific treatment given, entry no. 1 will follow i.e. expenses
paid and borne by firm.
(ii) In case, realisation expenses are borne by a partner, clear indication should
be given regarding payment thereof.

(vi) For closing the Realisation Account:
The realisation account will either reveal profit or loss. The profit or loss is transferred
to partners’ capital / current accounts in their profit-sharing ratio.
When realisation account shows profit:

To Partner’s Capital / Current A/c ……
When realisation account shows loss:
Partner’s Capital / Current A/c Dr. ……

❖ PARTNER’S LOAN ACCOUNT:

If a partner has advanced loan besides his capital to the firm, loan will have credit
balance. It will be paid after the payment of outside liabilities but before the
payment of capital of partners. The partner’s loan account is prepared separately and
is paid by passing the following entry:
Partner’s Loan A/c Dr. ……

Note: The loan taken from a relative of a partner including his wife is a part of
outside liability and will be paid through the realisation account itself. However,
Partner’s Loan has a priority over the repayment of partner’s capital.
❖ Partners’ Capital Account: The balances of partners’ capital and current accounts are
recorded in these accounts. If a partner has taken over asset of the firm, it will be
recorded on the debit side of the account. Similarly, if any liability of the firm is taken
over by a partner, it is recorded on the credit side of his capital account.

❖ Reserves, accumulated profits are transferred to capital account of partners in
their profit sharing ratio. Entry:
Reserve Fund A/c Dr. ……

General Reserve A/c Dr. ……
Contingency Reserve A/c Dr. ……
Workmen Compensation Fund A/c Dr. ……
To Partners Capital/Current A/c ……
❖ In case of debit balance of Profit and Loss A/c and Deferred Revenue Expenditure.
Entry:
Old Partner’s Capital / Current A/c Dr. ……

To Advertisement Suspense A/c ……
To Deferred Revenue ExpenditureA/c ……
❖ Final settlement with Partners:

(i) If a partner’s capital account shows debit balance, he shall bring it in cash.
Cash / Bank A/c Dr. ……

(ii) If a partner’s capital shows credit balance,
Partner’s Capital A/c Dr. ……

❖ Bank / Cash Account: If the firm has both the accounts i.e. Cash A/c and Bank A/c,
open only one account and deposit the balance of other in the former account.
❖ Bank Overdraft: If Bank Overdraft is given along with Cash A/c or Bank A/c, it would
be preferred to consider it as an outside liability. It is therefore, transferred to the credit
side of Realisation A/c. On the other hand, if Bank Overdraft balance is given without
having Cash / Bank A/c, it would be better to open Bank A/c and BOD balance be
shown in it as a credit balance. Thus, BOD will not be credited to Realisation A/c. As
soon as the assets are realised, BOD will be settled automatically.

❖ Accounting Treatment of Partners’ Current Account: If the partnership firm is
maintaining fixed capitals of partners, we will also be having partners’ current accounts.
All the items like accumulated profits (General Reserve, Reserve Fund, Profit and Loss
Account, Contingency reserve, etc.) and accumulated losses (like debit balance of Profit
and Loss A/c, Deferred Revenue Expenditure) will be transferred to Current Account of
Partners. Assets / Liabilities taken over by partners will also be transferred to Partners’
Current A/c. Profit or loss arising from Realisation A/c is also transferred to Partners
Current A/c. Current A/c is ultimately closed by transferring balance to Partners’
Capital A/c.
If Current A/c shows credit balance
Partner’s Current A/c Dr. ……

If Current A/c shows debit balance
Partner’s A/c Capital Dr. ……

To Partner’s Current A/c ……
Thereafter, if capital account reveals credit balance, payment will be given to partner
and if capital account depicts debit balance, the partner will bring it from his personal
assets.
❖ Commission or remuneration Payable to a Partner: With the consent of all the

partners, a partner may be asked to realise all the assets and pay the liabilities of the
firm. For providing these services, he is often given remuneration or commission in
many ways:
(i) Commission in lump sum
(ii) Commission as a certain percentage on assets realised.
(iii) Commission by way of percentage on capital returned to other partners.
Generally, when commission is offered to a partner, the expenses of dissolution are

borne by such partner’s personally or as per terms of agreement.

Chap: Accounting for Share Capital
❖ Meaning of a Company: “A company is an artificial person created by law, having

separate entity with perpetual succession and a common seal”.
❖ Characteristics of a Company:
(i) Incorporation: The most essential feature of a company is that it is formed and
registered under the law i.e. the companies Act, 2013. The law considers it as an
artificial legal person.
(ii) Separate Legal Entity: A company is a separate legal entity and it is distinct
from its members (shareholders). It can enter into contracts, issue share capital,
conduct business, sue any body and can also be sued.
(iii) Perpetual Existence: The existence of a company is not affected due to
bankruptcy, death or lunacy of its members or shareholders. A company is
incorporated by law so also it is wound up as per provisions of companies Act,
2013.
(iv) Limited Liability: The liability of shareholders is limited up to the face value of
shares eg. Mohan holds 100 shares of a company of a face value of Rs.10 each
but Rs.7 paid up. He can be called upon to pay Rs.3 per share. Thus, the liability
of its members is confined upto the face value of shares only.
(v) Transferability of Shares: The shares of a public company are freely
transferable while the shares of a private company can be transferred subject to
fulfilment of certain conditions.
(vi) Common Seal: Since the company is an artificial person created by law having
no physical existence so it acts through its directors. All the documents prepared
by directors must also bear seal of the company along with their signatures.
(vii) Separation of Ownership from the Management: A company is owned by the
shareholders but they are not allowed to participate in the day-to-day activities of
the company. In real practice, company is being managed by the directors who
are elected representatives of the shareholders. These directors are collectively
called as ‘Board of Directors’ and they manage the company on behalf
ofshareholders.

❖ SHARES
Meaning: The capital of the company is divided into certain indivisible units of a fixed
amount. These units are called shares. ‘Share’ means a share in the share capital of a
company. The persons who hold the shares in their names are the shareholders.
Nature of shares: The shares of a company shall be movable property, transferable in

the manner provided by the Articles provided by the Articles of the company Section
44. They can be bought, sold, hypothecated and even bequeathed. (to leave by will).
❖ Stock and Shares: Stock is the aggregate of fully paid up shares, consolidated and
divided, for the purpose of convenient holding into different parts. A company limited
by shares may, if authorised by its Articles, by passing an ordinary resolution, convert
its fully paid up shares into stock.
Stock and Shares Distinction: Following are the important points of distinction
between the two:
(i) A share has a face value while stock has no face value.
(ii) Stock is always fully paid up whereas shares may be of unequal amounts.
(iii) All the shares are of equal denomination while stock may be of unequal amounts.
(iv) Stock is transferable in small fractions while share can be transferred in round
numbers.
(v) Shares can be directly issued to the public by a company while only the fully paid
shares can be converted into stock.
❖ Types or Classes or Kinds of Shares: A company may issue two types of shares,
namely
1. Preference Shares 2. Equity Shares

1. Preference Shares: Preference Shares are those shares which carry the following two
rights:
(i) Preferential right of dividend at a fixed rate before any dividend is paid to the
equity shareholders.
(ii) At the time of winding up of the company, they have a preferential right to
return of capital over equity shareholders.
Besides the above rights, preference shares may also carry rights such as right to
participate in the excess profit after making the payment of dividend to equity
shareholders at a specified rate and right to participate in the surplus amount left
after making the payment to equity shareholders at the time of liquidation of the
company.
❖ Types of Preference Shares:

(i) On the basis of Dividend:
Cumulative Preference Shares: Cumulative Preference Shares are those preference
shares which carry right to receive the payment of arrear of dividend before the
payment of dividend to the equity shareholders. It means that if a company is either
running into losses or is having insufficient profit to make the payment of dividend to
the preference shareholders, the dividend will continue to accumulate and will be paid
in the year in which company has earned sufficient profits.
Non-cumulative Preference Shares: Non-cumulative preference shares do not enjoy
right to receive arrear of dividend of the past period.
(ii) On the basis of Participation in Profits:

Participating Preference Shares: The Articles of Association of the company may
have a provision that preference shareholders after getting dividend at a fixed rate, will
further participate in the surplus profits, if any, after making payment of dividend to
equity shareholders at a specified rate.
Non-Participating Preference Shares: Such preference shares get dividend at a fixed
rate.

(iii) On the basis of Redemption:
Redeemable Preference Shares: The amount of such shares will be returned by the
company to shareholders in accordance with the term of their repayment or at an earlier
date. The repayment of amount is called redemption.
Irredeemable Preference Shares: As per Sec 55 (1) of Co. Act 2013, no company
limited by shares shall, after the commencement of this Act, issue any Preference
Shares which are irredeemable.
(iv) On the basis of Conversion: The holders of such preference shares have the right to
get these shares converted into equity shares as per terms of the issue.
Non-convertible Preference Shares: These shareholders do not carry right of
conversion of preference shares into equity shares.
❖ Equity Shares: Equity shares are those shares which are not preference shares. Thus,
these shares do not enjoy any preferential right. They are paid dividend only after
making the payment of dividend to preference shareholders. As regards the repayment
of their capital is concerned, they will be paid at the time of winding up of the company
if surplus remains after making payment to preference shareholders. Keeping in view
the risk involved in equity share capital, it is also called as ‘Risk Capital’.

❖ Difference Between Preference Share and Equity Share
Basis Preference Shares Equity Shares

1. Rate of They are paid dividend at a fixed The rate of dividend on equity
Dividend rate. share is not fixed. It varies from
year to year depending upon the
profitability position of the
company.
2. Preferential Preference shares have preferential Equity shares do not have any
right to right to dividend. preferential right to dividend. They
dividend are paid dividend only after the
payment of dividend to preference
shareholders.
3. Redemption Preference shares can be redeemed A company may buy back its equity
as per requirements of Section 55 shares upto 25 % of its paid up
(2). capital and free reserves as per Sec.
68(2) of companies Act, 2013.
4. Convertibility They can be converted into equity Equity shares are not convertible.
shares, if the terms of the issue
permits.
5. Voting Right Normally, they do not have voting They enjoy voting right in all
right but they have it only in special circumstances.
circumstances.
6. Arrear of If dividend is not paid by the Dividend on equity shares never
Dividend company on these shares in the accumulate.
past, the arrear of dividend may
accumulate.
7. Right to These shareholders do not have Shareholders have right the right to
participate in right to participate in the participate in the management of
Management management of the company. the company.

❖ Share Capital of a Company: Every company limited by shares requires capital to
meet its financial requirements. The company raises its capital by issuing shares so it is
called share capital.
❖ Types / Classification of Share Capital: From accounting point of view, share capital
can be classified as under:
(i) Authorised Share Capital: It is the maximum amount of share capital which a
company can issue during its life span. It is also called as registered or nominal
capital of the company.
(ii) Issued Share Capital: Issued Share Capital is that part of authorised share capital
which is issued by the company from time to time for subscription. It cannot
exceed the authorised share capital of the company.
(iii) Subscribed Share Capital: Subscribed Capital is that part of issued capital which
has been subscribed for by the investors. It cannot exceed the issued capital of the
company, however, it can be equal to issued capital.
(iv) Called up Share Capital: It is not necessary for the company to call the whole
amount / face value of share in one lot. Usually, shareholders are asked to make
payment of shares in instalments. The portion of face value of share called by the
company during the accounting year is called as called up capital.
(v) Paid up Capital: Paid up capital is that part of the called up capital which has
actually been paid by the shareholders. Thus, paid up capital is equivalent to
amount of called up capital less calls-in-arrears.
❖ Reserve Capital: As per Section 65 of the Companies Act, 2013, an unlimited

company having a share capital may by passing a resolution for registration as a limited
company may have a reserve capital by doing the following things:
(a) This can be created by increasing the nominal amount of its share capital, subject
to the condition that no part of the increased capital shall be capable of being
called-up except in the event and for the purpose of the company being wound up.
(b) Company may also provide that a specified portion of its uncalled capital shall not
be capable of being called-up except in the event of company being wound up.

❖ Capital Reserve: All those profits of the company which are not earned by it in the
normal course of business are called capital profits or capital reserves. Capital Reserve
cannot be used for distribution of dividend among shareholders, however it can be used
to meet the capital losses or to issue the bonus shares among the equity shareholders.
Major Sources of Capital Reserve:
(i) Premium on issue of shares and debentures
(ii) Profit on redemption of debentures
(iii) Balance of share forfeiture account left after reissue of forfeited shares.
(iv) Pre-incorporation profit
❖ Difference Between Reserve Capital and Capital Reserve
Basis Reserve Capital Capital Reserve

1. Meaning As per Sec. 65 of Companies Act, It is that part of profit which is not
2013 an unlimited company having earned by the company in the
share capital may by passing a normal course of business e.g.
resolution for registration as a profit earned on sale of assets,
limited company may have reserve profit on redemption of debentures,
capital. etc.
2. Special A special resolution by the No special resolution is required for
Resolution company is required for its creation. its creation.
3. Time for its It can be used only at the time of It can be used during life span of
use winding up of the company. the company.
4. Disclosure It is not shown in the Balance It is shown in the Balance Sheet
in Balance Sheet. under the head, ‘Reserves and
Sheet Surplus’.
5. Mandatory It is not mandatory to create It is mandatory to create Capital
Reserve Capital. Reserve if the company has earned
capital profits.
6. Creation It is created either by increasing the It is created out of capital profits of
nominal amount of share capital by the company.
increasing face value of each share
with condition that it can be called-
up in case of winding up of
company or by specifying a portion
of uncalled capital to be called only
on winding up of the company.

❖ Preliminary Expenses: Expenses incurred by the company during the process of its
formation are called as ‘Preliminary Expenses’. It is also termed as Incorporation
Expenses, Formation Expenses or Promotion Expenses. It includes the following
expense:
(i) Expenses incurred on preparation and printing of documents pertaining to
registration of company.
(ii) Registration fee paid to the registrar of companies.
(iii) Legal expenses
(iv) Underwriting Commission
(v) Cost of Common Seal and Preliminary Books
(vi) Fee charged by Accountant or valuer if company has been formed to purchase the
running business.
Accounting Treatment: As per para 20 of AS-26 and as per Guidance Note on

Audit of Miscellaneous Expenditure of ICAI, preliminary expenses will be written
off in the year in which it is incurred first from Securities Premium Reserve A/c and
balance out of Statement of Profit and Loss. The entry passed shall be:
Securities Premium Reserve A/c Dr. ……

Statement of Profit and Loss Dr. ……
To Preliminary Expenses A/c ……
Even if there is no credit balance in Statement of Profit and Loss still the entry be
passed and debit balance of Statement of Profit and Loss be shown under head
Reserves and Surplus as a negative item as per requirement of the of the Schedule III
of Companies Act, 2013.

❖ ISSUE OF SHARES
(i) For Cash – by Public Subscription
(ii) For Consideration other than cash
(iii) For Cash – by Private Placement of Shares
(i) Issue of Shares for Cash – by Public Subscription: Following steps are followed by
a company for issuing shares for cash.
(i) Issue Prospectus (ii) Receive Applications
(iii) Allotment of Shares (iv) Make call on Shares
Note:
a) As per Sec 39(2), the amount payable on application on each share should not be
less than 5 % of face value of share. However as per SEBI guidelines, the
minimum application money payable must be at least 25 % of the issue price of
each share. The application money must be deposited by the company in a
‘Scheduled Bank’ till the certificate to commence business is obtained or till the
full amount of minimum subscription has been received by the company.
b) Minimum Subscription: A public company cannot make any allotment of shares
unless the amount of minimum subscription stated in the prospectus has been
subscribed and sums payable on application has been received by the company.
[Sec39(1)]
But as per SEBI guidelines, no listed company can make allotment of shares unless
a minimum of 90 % subscription is received by the company against the entire
issue. As per Sec 39(3), if the stated minimum subscription has not been received
within a period of 30 days from the date of issue of prospectus or such other time
as may be specified by SEBI, company cannot proceed to allotment of shares and
shall return the whole amount within the 15 days failing which interest @ 15 %
will be paid for the delayed period.

Minimum subscription refers to the amount which in the opinion of directors, must be
raised by issue of shares in order to provide for the following:
(i) For purchasing necessary assets of the company
(ii) For making payment of preliminary expenses and underwriting commission
(iii) To meet the working capital requirement
(iv) To repay money borrowed for above purposes
The purposes of minimum subscription is to ensure that no company is allowed to

commence business without raising sufficient amount of capital.
c) Basis of Allotment: Shares are allotted by the Board of Directors to all eligible
applicants provided minimum subscription of 90 % of issue size of shares is
received by the company. But in case of over-subscription, the basis of allotment
of shares is decided by the Board of Directors in consultation with the concerned
Stock Exchange and following courses of action are taken:
(i) Full Allotment: The company may reject the excess applications and to allot in
full to other applications.
(ii) Pro-rata Allotment: The Company may prefer to allot shares in proportion to
shares applied.
(iii) Any combination of above two alternatives:
❖ Provisions of Articles of Association given in Schedule I, Table-F of Companies

Act, 2013 are as under:
(i) No call shall exceed 25 % of the nominal or face value of the shares.
(ii) There must be atleast one month gap between two calls.
(iii) Atleast 14 days notice must be given to members to make the payment of call.
(iv) A call may be revoked or postponed by the Board of Directors.
As per SEBI guidelines, the calls must be designed in a manner so that the entire
subscription money is called within 12 months from the date of allotment of shares.

❖ Issue of shares at Par: The shares are said to be issued at par when the issue price of
shares is equal to its face value.
Issue of Shares for Cash: Journal Entries
Amount received on application:

Bank A/c Dr. ……
To Share Application A/c ……
On Transfer of Share Application Money:
Share Application A/c Dr. ……
To Share Capital A/c ……
On return of Application Money:
To Bank A/c ……
On Allotment of Shares:
Share Allotment A/c Dr. ……
On Receipt of Allotment Money:
Bank A/c Dr. ……
To Share Allotment A/c ……
On Share First / Final Call:
Share First / Final Call A/c Dr. ……
On Receipt of First / Final Call Money:
Bank A/c Dr. ……
To Share First / Final Call A/c ……

❖ Issue of shares at Premium (Sec 52): Shares may be issued at a price which is more
than its face value. The excess over share capital will be called as premium on share.
There is no legal restriction on the company to issue shares at premium.
The amount of premium on shares is a capital profit so it is credited to a separate
account called ‘Securities Premium Reserve A/c’. It is shown in the Balance Sheet
under the head ‘Reserves and Surplus’.
Accounting Treatment: A company may call the amount of Securities Premium either
in lump sum or in instalments. It may prefer to collect the premium on share
application, share allotment or even on calls. If question is silent with regard to receipt
of amount of premium, it is assumed that amount of securities premium becomes due on
allotment money.
If amount of premium is received on application:
Bank A/c Dr. ……

To Share Application A/c ……
To Securities Premium Reserve A/c ……
If amount of premium is received on allotment:
Share Allotment A/c Dr. ……

Bank A/c Dr. ……
Presentation of Securities Premium Account in Balance Sheet: The amount of

Securities Premium Reserve Account will be shown directly under the head ‘Reserves
and Surplus’ and in Notes to Accounts, it will be shown under the sub head, “Securities
Premium Reserve”.

Note: Share issue expenses are capital losses and securities premium reserve is a capital
profit. Even if nothing is stated, the share issue expenses must be set off against
securities premium reserve account, if it exists.
❖ Utilisation of Securities Premium: As per Section 52(2) of the Companies Act 2013,
securities premium reserve account may be applied for the following purposes:
(i) For writing off the preliminary expenses
(ii) For writing off expenses, discount on issue of debentures, underwriting
commission paid on issue of shares or debentures.
(iii) For issuing fully paid bonus shares to equity shareholders.
(iv) For providing for the payment of premium payable on redemption of preference
shares or debentures.
(v) For buy back of its own shares.
❖ Calls in Arrears: Often some shareholders fail to make payment of allotment or calls
on due date. It is known as calls in arrears. There are two ways of recording the amount
of Calls-in-arrears.
(i) Without Opening Calls-in-arrears A/c: No calls-in-arrears account is opened under
this method. The actual amount received on calls is recorded in this method. The
difference between amount due on calls and actual amount received represents Calls-in-
Arrears.
(ii) By Opening Calls-in-arrears A/c: Under this method of recording, amount due on call
but not received is debited to Calls-in-Arrears Account.
Without opening Calls-in-arrears A/c By opening Calls-in-arrears A/c
For share first call due For share first call due
Share First Call A/c Dr. Share First Call A/c Dr.
To Share Capital A/c To Share Capital A/c
On receipt of first call On receipt of first call
Bank A/c Dr. Bank A/c Dr.
To Share First Call A/c Calls-in-arrears A/c Dr.
To Share First Call A/c

Accounting Treatment: The debit balance of Calls-in-arrears is shown in Notes to
Accounts to balance sheet as deduction from Subscribed but not fully paid capital on the
equity and liabilities side of the Balance Sheet.
Interest on Calls-in-arrears: [Not in Syllabus]: If sum due on share is not paid by the
shareholder before or on the appointed date of payment, company is authorised to
charge interest on calls-in-arrears from the appointed date of payment till the actual date
of payment @ 10 % p.a. or at lower rate, if any, determined by the Board of Directors.
(Schedule I, table F, Rule – 16 of Companies Act, 2013)
❖ Calls in Advance: If a shareholder prefer to make payment of calls which have not
been called upon by the company from him, it is called as ‘Calls-in-advance’.
Accounting Treatment: Whenever calls in advance is received by the company, a
separate account called “Calls in Advance A/c” is opened when call is really due, ‘Calls
in Advance A/c’ is adjusted. In Balance Sheet, it is shown under the head, current
liabilities, under sub head Other Current Liabilities. The entries passed are as under:
On receipt of calls in advance at the time of Allotment:

Bank A/c Dr. ……
To Calls in Advance A/c
Adjustment of calls in advance:
Bank A/c Dr. ……
Calls in advance A/c Dr. ……
To Share Calls A/c (First/Final) ……
❖ Interest on Calls in Advance [Not in Syllabus]: A Company can pay interest on calls
in advance if it is authorised by its articles. If company has not prepared its own articles
or it is silent with regards to rate of interest payable on calls in advance, Company shall
pay interest @ 12 % p.a. or @ such lower rate which is determined in its general
meeting on Calls-in-advance. Interest on calls in advance is a charge against profits.
So it is payable even if the company has either no profit or running into losses.

However, no dividend is payable on calls in advance as it is not a part of share capital.
(Table F of Schedule I –Rule 18) Entry:
Interest on Call in Advance A/c Dr. ……

To Bank A/c ……
Notes:
(i) In the absence of interest on calls in advance, it will be payable @ 12 % p.a.
(Table – F)
(ii) In case advance money is received at the time of application, interest will be
calculated from the date of allotment till the date of call due and not from the date
of application as a person becomes shareholder only when shares are allotted to
him.
❖ Difference between Calls-in-arrears and Calls-in-advance
Basis Calls-in-Arrears Calls-in-Advance

1. Meaning Calls-in-arrears is that portion of Calls-in-advance is the amount paid
the share capital which has been by the shareholder in excess of the
called up but not yet paid by the amount due from him.
shareholders.
2. Interest Interest is charged on calls-in- Interest is allowed by the company
arrears from shareholders as an on calls-in-advance as an expense.
income of the company.
3. Rate of As per Schedule I, Table F, Rule As per Schedule I, Table F, Rule
interest No.16 of Companies Act, 2013, No.18 of Companies Act, 2013,
company may charge interest on company may pay interest on Calls-
Calls-in-Arrears @ 10 % p.a. or @ in-Advance @ 12 % p.a. or @ such
such lower rates which is lower rates which is determined by
determined by the Board. the Board in its general meeting.
4. Disclosure Calls-in-arrears is shown in the It is shown as current liability of the
in Balance balance sheet as deduction from company under sub-head, other
Sheet subscribed but not fully paid capital current liabilities.
in Notes to Accounts.
❖ Under Subscription of shares: Sometimes, the company receives applications or lesser
number of shares than it has issued, it is called Under Subscription of Shares. The
Under Subscription of issue should not fall below the minimum subscription of shares
(90 % as per SEBI guidelines), otherwise the amount received on application must be
returned within stipulated period of time to the applicants. In such cases, entries are
passed on the basis of number of shares applied for by the applicants.
❖ Over Subscription of Shares: A company may receive applications for a large number
of shares than offered by it to public for subscription. Such a situation is termed as over
subscription. However, a company cannot allot more shares than it has offered to public
for subscription. Under these circumstances, the board of directors have three
alternatives namely:
(i) First Alternative: The Company can make full allotment to some applicants and
can reject the excess applications and their money is returned.
(ii) Second Alternative: The company can make pro-rata allotment among all
applicants i.e. no application is rejected and all the applicants are allotted shares on
pro-rata basis. The excess application money paid by shareholders is adjusted on
share allotment and on subsequent calls.
(iii) Third Alternative: The Company may also prefer to use combination of first two
alternatives. Company may accept some applications in full, some applications
may be rejected and pro-rata allotment is made among remaining applicants.
Accounting Treatment of Surplus Application Money in Case of Pro-rata

Allotment of Shares
Generally it is stated in the given question that surplus application money will be
adjusted on:
(i) Share allotment only (ii) Share allotment and on subsequent calls
However, if question is silent with regard to treatment of surplus application money, it

is to be adjusted against allotment and surplus if any be refunded.

Accounting Treatment concerning Over Subscription:
1. If surplus applications are rejected, their application money received is returned.

The entry passed is:

To Bank A/c ……
2. Pro-rata Allotment:

To Calls in Advance A/c ……
To Bank A/c ……
❖ Issue of shares for Consideration Other than Cash:

❖ On Purchase of Assets:
To Vendors A/c ……
When Shares are issued at PAR:
Vendors A/c Dr. ……
When Shares are issued at PREMIUM:
Vendors A/c Dr. ……
𝑨𝒎𝒐𝒖𝒏𝒕 𝑷𝒂𝒚𝒂𝒃𝒍𝒆
𝑵𝒐. 𝒐𝒇 𝑺𝒉𝒂𝒓𝒆𝒔 =
𝑰𝒔𝒔𝒖𝒆 𝑷𝒓𝒊𝒄𝒆
❖ When Shares are issued to Promoters:
Goodwill / Incorporation Expenses A/c Dr. ……

❖ Calculation of Goodwill or Capital Reserve: Sometimes assets and liabilities are
acquired from the vendor and purchase consideration is pre-determined. In such cases,
if the credit side exceeds the debit side items, difference is put to Goodwill A/c as a
balancing figure and if the debit side exceeds the credit side, the difference is put to
Capital Reserve A/c as a balancing figure. The payment of purchase consideration can
be made by issuing shares, cheque or even by accepting bill of exchange drawn by the
vendor.
❖ Private Placement of Shares: According to Section 42 of Companies Act, 2013,

private placement of shares refer to issue and allotment of shares to a selected group of
persons in place of public issue. No fresh offer under private placement of shares shall
be made unless the allotments made earlier under this scheme have been completed.
The process of allotment of shares under private placement of shares be completed
within 60 days from the receipt of application money falling which the application
money so received be returned within next 15 days otherwise it shall be liable to pay
interest @ 12 % p.a. from the expiry of 60 days. Company is also required to file a
return to registrar for allotment of such shares.
These allottees of shares are deprived from selling these shares for period of three years
from the date of allotment called ‘lock in period’. These allottees include promoters,
their friends, mutual funds, financial institutions, etc.
❖ Employees Stock Option Plan (ESOP): As per Section 62(1-b) a company can allot
shares to its employees under a scheme of employees’ stock option by passing a special
resolution. The scheme is intended to retain high Caliber employees or to give them a
sense of belonging in the company so a company may offer them equity shares at a pre-
determined price which is lower than the market price of the shares. The option is given
to whole time directors, officers or employees which give them right to purchase or
subscribe shares at a future date. The basic objective of ESOP is:
(i) to inspire the employees of the company.
(ii) to attract, retain and to motivate the efficient employees of the company.
(iii) to create long term wealth for the employees.

ESOP is a contract between company and employees that gives employees of the
company right, but not the obligation, for a specified period to purchase or subscribe to
the specified number of equity shares of the company at a fixed determined price, called
as exercise price.
Thus, employees gain on exercise date if the market price of these shares is more over
the exercise price. Naturally, option is not exercised by the employees if the market
price of shares falls below the exercise price.
❖ Terminology used in ESOP:

(i) Grant Option means giving an option to employees to subscribe to the shares
of the company.
(ii) Vesting: Vest means entitlement. It is a process by which employees are given
right to apply for shares of the company against option given to them for
purchase of ESOP.
(iii) Vesting Conditions area the conditions laid down by the company which must
be satisfied by the employees for their entitlement for getting shares e.g.
completion of specific period of service, meeting out the prescribed target, etc.
(iv) Vesting Period: It is a time period during which vesting of option granted to
employees take place.
(v) Option means right but not an obligation granted to employees to apply for
shares at a predetermined price.
(vi) Exercise Period is the time period after vesting period within which employees
should exercise their right to apply to apply for share against option vested to
them.
(vii) Exercise Price: It is the price payable per share by the employees for exercising
option granted to them.
(viii) Benefit Value is excess of market price over exercise of option.

❖ Forfeiture of Shares: If any shareholder of a company fails to pay the sum due on
allotment or on any call, company ay exercise its power to forfeit those shares as per
terms of Articles of Association or as per requirements of rules laid down in Table F of
Schedule I of Companies Act, 2013. The company must give 14 days’ notice to the
defaulting shareholder requiring him to pay the unpaid amount on shares together with
accrued interest thereon, by the specified date failing which his shares are liable to be
forfeited. On forfeiture, such shares are cancelled and share capital is reduced with the
called-up amount on shares and not by the nominal value of share. The amount already
paid by the shareholder is forfeited and not returned to him. His name is removed from
‘Register of Members’.
Entry on Forfeiture of shares when shares are issued at PAR:
Share Capital A/c Dr. (Called up capital)

To Share Allotment A/c (Amount not received)
To Share Calls A/c (Amount not received)
To Share Forfeiture A/c (Amount not received)
Disclosure: The balance of share forfeiture account is added to subscribed capital on

the equity and liabilities side of the balance sheet.
Entry on Forfeiture of shares when shares are issued at PREMIUM:
If amount of premium has been received:

If amount of premium has not been received:
Securities Premium Reserve A/c Dr. (Premium not received)

If the amount of premium has not been paid by shareholders, ‘Securities Premium
Reserve A/c’ will be debited at the time of forfeiture of share so that securities premium
account credited at the time of entry of due is cancelled.
❖ Reissue of Forfeited Shares: The Company can reissue the forfeited shares at Par, at
premium or even at a discount but the amount of discount on reissue of shares should
not exceed the amount paid by the original shareholders. (i.e. the amount of share
forfeiture account). This discount on reissue of forfeited shares has nothing to do with
Sec. 53 which prohibit to issue fresh issue of shares at a discount. The entries will be:
Reissue of shares at Par:

Bank A/c Dr. ……
Reissue of shares at a Premium:
Bank A/c Dr. ……
Reissue of shares at a Discount:
Bank A/c Dr.
Share Forfeiture A/c Dr.
To Share Capital A/c
Notes:
(i) Balance amount of share forfeiture account will be transferred to Capital

Reserve A/c as it is a capital profit. But if company has reissued only part of
the forfeited shares, the proportionate amount of balance of share forfeiture
account will remain in the share forfeiture account till they are reissued. The
entry of capital reserve will be
Share Forfeiture A/c Dr.

To Capital Reserve A/c
(ii) Capital Reserve A/c will be shown on the liabilities under the head, ‘Reserves
and Surplus’.
(iii) Shares forfeited first shall be reissued first.

❖ Reissue of Forfeited Shares which were Originally Issued at Premium: When
shares are issued at premium, there may be three situations, at the time of forfeiture of
shares, namely:
(i) The amount of premium is due but not received: The Securities Premium
Reserve A/c in such case is debited at the time of forfeiture of shares as entry for
Securities Premium Reserve A/c stands credited at the time of due. Thus, entry
passed for premium amount due will be cancelled.
(ii) Amount of premium is received on forfeited shares: If a shareholder has paid
the amount of premium, it is not cancelled at the time of forfeiture of such
shares. It is treated as income of the company and it is used as per provisions of
Section 52 (2) of Companies Act, 2013.
(iii) Partial amount of premium received: The amount of actual premium received
is not cancelled at the time of share forfeiture, however, portion of premium due
but not received is cancelled at the time of forfeiture of shares.

Chap: Issue of Debentures
A debenture is an instrument issued by the company under its common seal as
acknowledgement of a debt. It contains the face value or nominal value of debenture,
rate of interest, mode of payment of interest, tenure and terms of redemption.
According to Section 2(30) of the Companies Act, 2013, ‘Debenture includes debenture
stock, bonds and any other security of a company whether constituting a charge on
assets of the company or not’.
❖ Features or Characteristics of Debentures:
• Document acknowledging the debt
• Issued under a common seal
• Constitutes long term borrowing
• Payment of debenture interest is a charge against profit
• Normally, interest is paid on half yearly basis at a fixed rate, called ‘Coupon Rate’.
• Secured by charge on fixed assets of the company.
• On maturity, paid in cash or they may be converted.
• Do not carry any voting right
❖ Minimum Subscription: As per Sec. 39(1) a company cannot make allotment of nay
securities unless the amount stated in the prospectus as minimum amount has been
subscribed.
Thus, Companies Act, 2013 do not specify the quantum of minimum subscription
needed in case of public issue (both equity and debt), but only requires disclosure in
the offer document. But as per SEBI rules, minimum subscription for public issue of
debt securities has been specified as 75 % [Circular No.12 of 2014 of SEBI].

❖ Types or Kinds of Debentures:
1. From the point of view of Redemption:
Redeemable Debentures: Redeemable debentures are those debentures which are
issued by the company for a fixed period. Its amount is repaid at the end of a
specific period or by instalments during the tenure of debentures.
Irredeemable Debentures: These debentures are not repayable during the life span of
the company. They are repaid only at the time of liquidation of the company. They are
also called as perpetual debentures.
2. On the basis of Security:

Secured Debentures: Debentures are called secured when some assets of the company
are charged in favour of debenture holders. It they are secured on a particular asset of
the company it is called as fixed charge. If they are secured on all assets of the
company in general, it is called floating charge. They are also called ‘mortgaged
debentures’.
Unsecured Debentures: Unsecured debentures are those debentures which do not carry
any security in respect of repayment of their debt.
3. On the basis of Convertibility:

Convertible Debentures: On the date of maturity, such debentures are converted into
equity shares or preference shares or into other debentures. These debentures may be
fully or partly convertible.
Non-convertible Debentures: Such debentures cannot be converted into shares, so
these have to be redeemed in cash on due date.
4. On the basis of Record (transfer):

Registered Debentures: A register of debenture holders is maintained for registered
debentures. Thus, they are not freely transferable. The payment of interest and
principal amount is paid to person whose name appears in the register of the
company.

Bearer Debentures: The payment of interest or principal amount is payable to
bearer or to the holder debenture. They are transferable by mere delivery. Coupons
are attached with these debentures and interest is paid by the specified bank on
the production of such coupons.
5. On the basis of Interest Rate:

Coupon Rate Debentures: A coupon rate is the rate of interest at which interest is
payable on debentures. When the rate of interest is fixed, they are called
debentures with fixed coupon rate.
Zero Coupon Rate: A zero coupon rate bond is one which does not carry a specified
rate of interest. Such bonds are issued at a substantial discount to compensate the
investors. The difference between face value and issue price is the amount of
interest for the entire period of bond. These bonds are also called as deep discount
bonds.
❖ Debenture Trust Deed: A debenture trust deed is a document created by the company
where by trustees are appointed to protect the interest of debenture holders before the
debentures are offered for public subscription. A company is required to appoint one
or more debenture trustees before issue of prospectus or letter of offer of debentures to
the public and not later than 60 days after the allotment of debentures. A trust deed
grants the trustees a charge over the properties of the company.

❖ Distinction between a Share and a Debenture:
Basis Share Debenture
1. Ownership A share represents owned capital of A debenture represents debt taken
the company. by the company.
2. Return Dividend is paid on shares. Interest is paid on debentures.
3. Rate Rate of dividend varies from year Rate of interest is fixed on
to year. debentures.
4. Security Shares are never secured on any Debentures are generally secured on
asset of the company. assets of the company in the form of
charge.
5. Conversion Shares are never converted into Debentures can be converted into
debentures. share if the term so permits.
6. Issue at a Shares cannot be issued at a There are no such restrictions for
discount discount except Sweat Equity issuing debentures at a discount.
Shares.
7. Redemption Preference shares can be redeemed Debentures can be redeemed as per
as per requirement of Sec 55, terms of agreement.
however, company can also buy
back its equity shares upto 25 % as
per requirements of Sec 68.
8. Winding up In case of winding up of the During winding up of the company,
company, payments of share capital payment of debentures is made
is paid after the payment of before the payment of share capital.
debentures.
9. Forfeiture Shares can be forfeited for non- Debentures cannot be forfeited for
payment of allotment or call non-payment of call money.
money.

Issue of Debentures
The debentures are issued in the same manner which is used for issuing shares of the
company. Debentures cannot be forfeited for the non-payment of allotment or call
money as the debenture holders have provided debt to the company. Company may,
however, recover the calls in arrears through Court of Law. Debentures can also be
issued at par or at premium or at a discount. However, there is no restriction for
issuing debentures at a discount.
❖ Accounting Treatment:
The journal entries passed for issuing debentures are practically the same as are
followed in case of issue of shares. The only difference is that “ % Debentures A/c” is
used in place of ‘Share Capital A/c’.
On receipt of Debenture application money:
Bank A/c Dr. ……
To Debenture Application A/c ……
On Transfer of Debenture Application Money to Debenture A/c:
Debenture Application A/c Dr. ……
To 10 % Debenture A/c ……
On Allotment of Debentures:
Debenture Allotment A/c Dr. ……
On Receipt of Debenture allotment Money:
Bank A/c Dr. ……
To Debenture Allotment A/c ……
First / Final Call money due on Debentures:
Debenture First / Final Call A/c Dr. ……
On Receipt of Debenture First / Final Call Money:
Bank A/c Dr. ……
To Debenture First / Final Call A/c ……

❖ Calls in Advance and Calls in Arrears: Calls in advance and calls in arrears may also
take place in case of issue of debentures. Such problems are treated in the same manner
as they are treated in case of issue of shares.
❖ Over Subscription and Allotment of Debentures: Such problems are treated in the
same manner as they are treated in case of issue of shares.
❖ Under Subscription and Allotment of Debentures: As per SEBI guidelines vide

Circular No. 12 of June 2014, under subscription of debentures can be accepted
provided it is atleast 75 % of the size of issue of public subscription of debt securities
failing which the application money shall be returned by the Company within 12
days of closure of issue otherwise 15 % interest will have to be paid for the
delayed period.
❖ Debentures issued at Premium: Treated in the same manner as they are treated in case
of issue of shares.
❖ Debentures issued at a Discount: The debenture issued at a discount means that they
are issued at a price which is less than the face value of debenture. There is no
restriction on issuing debentures at a discount as per Companies Act, 2013. Discount
on issue of Debentures A/c or Discount on Debentures A/c is a capital loss and It is
written off with Securities Premium Reserve A/c or from Statement of Profit and Loss.

❖ Issue of Debentures for Consideration other than Cash: Often a Company purchases
some assets from the vendor and its payment is made by the company by issuing
debentures, shares or by cheque. If the payment is made by issue of debentures, it is
called issue of debentures for consideration other than cash. Such debentures may be
issued to vendor at par, at a premium or at a discount. Following entries are passed for
this purpose:
On Purchase of Assets:
To Vendor’s A/c ……
On issuing debentures to the vendor at PAR:
Vendor’s A/c Dr. ……
To 10 % Debentures A/c ……
On issue of debentures at PREMIUM:
To Debentures A/c ……
On issue of debentures at DISCOUNT:
Discount on Issue of Debentures A/c Dr. ……
To Debentures A/c ……
𝑵𝒐. 𝒐𝒇 𝑫𝒆𝒃𝒆𝒏𝒕𝒖𝒓𝒆𝒔
𝑨𝒎𝒐𝒖𝒏𝒕 𝑷𝒂𝒚𝒂𝒃𝒍𝒆
=
𝑰𝒔𝒔𝒖𝒆 𝑷𝒓𝒊𝒄𝒆
❖ Calculation of Goodwill or Capital Reserve: Sometimes assets and liabilities are

acquired from the vendor and purchase consideration is pre-determined. In such cases,
if the credit side exceeds the debit side items, difference is put to Goodwill A/c as a
balancing figure and if the debit side exceeds the credit side, the difference is put to
Capital Reserve A/c as a balancing figure.
The payment of purchase consideration can be made by issuing debentures, shares,
cheque or even by accepting bill of exchange drawn by the vendor.

❖ Issue of Debentures as Collateral Security: A company often takes loan either from a
bank, financial institution or from other party and issues debentures as collateral
security in addition to the principal security. Thus, a collateral security refers to
secondary security besides the principal security.
On default in the repayment of loan, the lender will realise money first from the
sale of Principal Security and becomes a debenture holder for the balance amount
due.
The lender of the money will not be entitled for payment of any interest on such
debentures as lender is entitled to get interest on the original amount of loan.
On the other hand if the borrower makes the payment of loan to the lender, he will take
back his debentures which were issued as a collateral security.
• Accounting Treatment:
1. First Method: Only entry of bank loan is passed and no entry is passed for
debentures issued as collateral security as debentures are not actually issued to the
lender rather they are given as collateral security only. Entry:
Bank A/c Dr. ……
To Bank Loan A/c ……
Accounting Treatment in Balance Sheet:
(i) Bank Loan will be shown on the Equity and Liabilities side of Balance Sheet
under the head
“ Non-current Liabilities” under sub-head, ‘Long-term Borrowings’.
(ii) In Notes to Accounts, details of long term borrowings be given as:
Bank Loan Rs.5,00,000
(Secured against collateral security of 6,000 Debentures of Rs.100 each)

2. Second Method: In this method, entry for bank loan and debentures issued as collateral
security is also passed. Entries:
For Bank Loan Taken:
Bank A/c Dr. ……
To Bank Loan A/c ……
For Issue of Debentures as Collateral Security:
Debentures Suspense A/c Dr. ……
To 10 % Debentures A/c ……
NOTES:
(i) Debentures issued as collateral security carry no interest as lender of money is
entitled for interest payment on the amount of loan due.
(ii) The debentures issued against collateral security are not to be redeemed as these
have been lodged as Collateral Security.
(iii) At the time of maturity of loan, the entry for debentures is reversed and
entry for repayment of loan is passed.
(iv) However, in case of default in payment of loan, debentures are enforced and
entry passed is:
Bank Loan A/c Dr. ……
To Debenture Suspense A/c ……

❖ Issue of Debentures with terms of Redemption:
1. Issued at PAR, redeemable at PAR:
Bank A/c Dr. 100
To Debenture Appl. & Allot. A/c 100
Issue
Debenture Appl. & Allot. A/c Dr. 100

To % Debentures A/c 100
% Debentures A/c Dr. 100
Redemption
To Debenture Holders A/c 100

Debenture Holders A/c Dr. 100
To Bank A/c 100
2. Issued at PREMIUM, redeemable at PAR:

Bank A/c Dr. 105
Issue

To Securities Premium Reserve A/c 5
Redemption

To Bank A/c 100
3. Issued at DISCOUNT, redeemable at PAR:

Bank A/c Dr. 95
Issue

Debenture Discount A/c Dr. 5
Redemption

To Bank A/c 100

4. Issued at PAR, redeemable at PREMIUM:
Bank A/c Dr. 100
Issue
Loss on issue of Debentures A/c Dr. 10

To Premium on Redemption A/c 10
Redemption
Premium on Redemption A/c Dr. 10

To Bank A/c 110
5. Issued at DISCOUNT, redeemable at PREMIUM:

Bank A/c Dr. 95
Issue
Debenture Discount A/c Dr. 5

Redemption

To Bank A/c 110

6. Issued at PREMIUM, redeemable at PREMIUM:
Bank A/c Dr. 105
Issue

To Securities Premium Reserve A/c 5
Redemption

To Bank A/c 110
❖ Notes:
(i) Securities Premium Reserve A/c: If debentures are issued at a premium, it
means that debenture holder is paying more amount than its face value. This
amount is treated as ‘Securities Premium Reserve A/c’ and it is shown under the
head ‘Reserves and Surplus’.
(ii) Premium on Redemption A/c: If debentures are issued at par or at a discount or
at a premium but redeemable at premium, premium payable is a liability at the
time of redemption, so it is shown under the head ‘Other Long-term Liabilities’.
(iii) Loss on issue of Debentures and Discount on issue of Debentures A/c:
Basically, discount on issue of debentures is a loss at the very time of issue of
debentures while loss on issue of debentures represents loss to the company at the
time of redemption of debentures. Both of these items be written off in the year
of its occurrence.

❖ Interest on Debentures: Interest on Debentures is always fixed and it is usually
payable on half yearly basis. Interest on debentures is always payable on the face value
of the debentures irrespective of the fact that debentures are issued at par, at premium or
at discount. Since debentures are debt of the company so interest must be paid on
debentures even though company does not earn profit.
Interest on debentures is a charge against profit and must be paid and debited to
Statement of Profit & Loss.
Entries:
For Interest Due:
Interest on Debentures A/c Dr. ……
To Debenture holders A/c ……
Interest Paid to Debenture Holders:
Debentures Holders A/c Dr. ……
To Bank A/c ……
On transfer of interest to Statement of Profit & Loss:
Statement of Profit & Loss Dr. ……
To Interest on Debentures A/c ……
❖ Some important points concerning Debenture Interest:

(i) Interest on debentures is always paid on face value despite the fact that they are
issued at par, premium or discount.
(ii) Interest on debentures is a charge against profit. It is payable irrespective of fact
that company has earned profit or not during the year.
(iii) Interest is not paid id debentures are issued as collateral security.
(iv) Interest Accrued and Due: If interest on debentures is due but it is not paid on
the date of accounting period, it is called interest outstanding. It is shown under
the head ‘Other Current Liability’.
(v) Interest Accrued but not Due: If the date of interest payment differs with the
date of accounting period, it is called interest accrued but not due. It is called as
interest accrued and it is shown under the head ‘Other Current Liability’.

❖ Writing Off Discount / Loss on Issue if Debentures: When debentures are issued at
discount but redeemable at premium, the Loss on Issue of Debentures is the sum total of
discount on issue of debentures plus amount of premium payable on redemption of such
debentures. Both discount/loss on issue of debentures are capital losses and it must be
written off.
Accounting Treatment of Discount/Loss on Issue of Debentures

In the absence of Securities Premium Reserve, discount/loss on issue of debentures is
written off out of the Statement of profit and Loss. The entry passed is:
Securities Premium Reserve A/c Dr. ……
Statement of Profit & Loss A/c Dr. ……
To Discount/Loss on Issue of Deb. A/c

Chapter: Financial Statements of a Company
Meaning: Financial Statements are those statements of a company that depict the
financial position and result of business activities at the end of the accounting period.
Financial Statements of a company are also called Annual Reports, Annual Accounts
or Published Accounts.
Financial Statements are prepared following the accounting principles, practices and the
accounting standards. Section 129 of the Companies Act, 2013 prescribes that Balance
Sheet and Statement of Profit and Loss are prepared in form prescribed in Schedule III
of Companies Act, 2013. A set of financial statements as per Section 2(40) of the
Companies Act, 2013 includes:
1. Balance Sheet: It is a statement of Assets, Liabilities and Equity of the company
at a given date. It shows the financial position of a business by detailing its
assets, equity and liabilities. It is also known as Position Statement.
2. Statement of Profit and Loss: It shows the financial performance i.e. result of
business operations during an accounting period. It is also known as Income
Statement.
3. Notes to Accounts: Balance Sheet and Statement of Profit and Loss are
supported by the notes to accounts giving details of items in the Balance Sheet
and Statement of Profit and Loss.
4. Cash Flow Statement: It is prepared as per Accounting Standard-3 (Revised)
and it must be published as per requirements of Section 2 (40) of the Companies
Act, 2013.
Format of the Balance Sheet: The format of Balance Sheet prescribed in Part I of
Schedule III of the Companies Act, 2013 is as follows:

Name of the Company
Balance Sheet as at 31st March.…
Figures as at Figures as at
Note the end of the end of
Particulars
No Current Previous
year ` year `
I EQUITY AND LIABILITIES
1. Shareholders’ Funds
(a) Share Capital …… ……
(b) Reserve and Surplus …… ……
(c) Money Received against Share Warrants …… ……
2. Share Applications 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 …… ……
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 / Property, Plant & Equipment and
Intangible Assets: …… ……
(i) Tangible Assets / Property, Plant & …… ……
Equipment …… ……
(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
(a) Current Investments …… ……
(b) Inventories …… ……
(c) Trade Receivables …… ……
(d) Cash And Cash Equivalents …… ……
(e) Short-Term Loans and Advances …… ……
(f) Other Current Assets …… ……
Total …… ……

Equity and Liabilities: Equity is the liability towards owners / shareholders and is
termed as Shareholders’ Funds. It includes Share Capital, Reserves and Surplus and
Money Received against Share Warrants.
The term Liabilities means external liabilities of the company i.e. liabilities towards
outsiders. It is shown as Non-current Liabilities and Current Liabilities.
In between Shareholders’ Funds and Non-current Liabilities, ‘Share Application Money
Pending Allotment’ is shown.
Shareholders’ Funds includes three items i.e. (a) Share Capital (b) Reserves and Surplus
and (c) Money Received against Share Warrants.
(a) Share Capital: Share Capital means amount received by the company against
shares issued for subscription and also shares issued for consideration other than
cash. Share Capital includes both Equity Share Capital and Preference Share Capital.
Schedule III of the Companies Act, 2013 requires the Balance Sheet to disclose i.e.
show authorized capital, issued capital, subscribed capital, amount called-up by the
company and paid-up by the shareholders. Details required by the schedule are given in
the Notes to Accounts. The details required to be given for share capital are:
Authorised Capital or Nominal Capital: Authorised Capital or Nominal Capital or

Registered Capital is the maximum capital that a company can issue for subscription
under each class of Share Capital. The amount of Authorised Capital is shown in the
Notes to Accounts on Share Capital for information only. It is not added to the
liability.
Issued Capital: Issued Capital is that part of authorized capital which the company has
issued for subscription up to the date of Balance Sheet. It should be kept in mind that
Issued Capital can be equal to or less than the Authorised Capital. Like Authorised
Capital, amount of Issued Capital is shown in the Notes to Accounts on Share Capital
for information only. It is not added to the liability.

Subscribed Capital: Subscribed Capital is that part of the Issued Capital which
has been subscribed. Amount received by the company, whether in cash or kind, as
Subscribed Capital is shown as Share Capital on the face value of the Balance Sheet.
Subscribed Capital is classified i.e. shown under the following two heads:
(a) Subscribed and fully paid-up capital: Shares are shown as ‘Subscribed and fully paid-
up’when both the following conditions are met:
(i) the company has called the full nominal (face) value of the share and
(ii) the company has received the amount called-up.
For example: X Ltd. issued 10,000 Equity Shares of ` 10 each. ` 10 per share has been
called and it has also been paid by all the shareholders.
(b) Subscribed but not fully paid-up: Shares are shown as ‘Subscribed but not fully paid-
up’ under the following two situations:
(i) When the Company has called the full Nominal (Face) Value of the share but
not received the amount called-up. For example: X Ltd. has issued 30,000
shares of ` 10 each. Company has called up ` 10 per share. All money is received
by the company except final call of ` 2 on 10,000 shares.
(ii) When the Company has not called the full Nominal (Face) Value of the share.
For example: X Ltd. issued 10,000 Equity Shares of ` 10 each, ` 8 called up.
Called-up Share Capital: Called up capital means such part of the capital, which has
been called for payment by the company. It is not necessary for the company to call the
whole face value of share in one lot. The portion of the face value of share called by the
company during the accounting year is called as Çalled-up Capital.
Paid-up share capital: Paid up capital means such aggregate amount of money
credited as paid up as is equivalent to the amount received as paid up in respect of
shares issued, but does not include any other amount received in respect of such share,
by whatever name called.

Calls-in-arrears: it refers to the amount not paid by the shareholder(s) against the
amount called-up by the company. Calls-in-arrears is always shown as deduction from
the “Subscribed but not fully paid” capital.
Calls-in-advance: A company may receive the amount of call(s) on shares not yet
made by the company. The amount so received is termed as Calls-in-advance. It is
shown in the Balance Sheet as ‘Other Current Liabilities’ under the head “Current
Liabilities” along with interest thereon if any.
Share Forfeited A/c: If shareholder(s) fails to pay the amount called on shares, the
company can forfeit these shares after compliance of procedure given in the law. The
amount paid by the shareholder on such shares is forfeited and it is added to the
“Subscribed Capital” at the end.
(b) Reserves and Surplus: Reserve and surplus shall classified as follows
(a) Capital Reserves (b) Capital Redemption Reserve
(c) Debenture Redemption Reserve (d) Securities Premium
(e) Revaluation Reserve (f) Share Options Outstanding Account
(g) Other Reserves (restricted to General Reserve only)
(h) Surplus i.e. balance in Statement of Profit & Loss
Even if Statement of Profit and Loss has a negative balance (i.e. loss), it has to be
shown in notes to accounts under the head ‘Reserves and Surplus’ as a negative
item. Even if the overall balance of ‘Reserves and Surplus’ remains negative, it will
continue to be shown as negative item under this head.
(c) Money received against share warrants: Generally, share warrants are issued to
promoters and others as per SEBI guidelines as preferential issue in case of listed
companies. AS-20 defines share warrants as financial instruments which give its
holder right to acquire equity shares at a future date. Thus, shares are yet to be
allotted against the share warrants so it is not shown directly as a part of ‘Share
Capital’.
❖ Share Application Money Pending Allotment: Application money pending allotment
is a separate item. If company has issued shares but date of allotment falls after the
balance sheet date, such application money pending allotment will be shown in the
following manner:
(i) Share application money not exceeding the issued capital and to the extent
not refundable is to be disclosed under this line-item.
(ii) Share Application Money Pending Allotment as Current Liability. Share
application money to the extent refundable or where minimum subscription is
not met, such amount shall be shown separately under, sub head “other current
liabilities” of head, Current Liabilities.
❖ Non-Current Liabilities: As per schedule III, Non-current Liabilities are those

liabilities which are not Current Liabilities. Thus, liabilities payable after 12 months or
after the operating cycle (whichever is more) are termed as non-current liabilities.
Long-term borrowings: Long-term borrowings shall be classified as:

(a) Bonds / Debentures;
(b) Term loans; • from banks; • from other parties;
(c) Public Deposits;
(e) Other loans and advances (specify nature).
Bonds/debentures (along with the rate of interest and particulars of redemption or

conversion, as the case may be) shall be stated in descending order of maturity or
conversion, starting from farthest redemption or conversion date, as the case may be.
Where bonds/debentures are redeemable by installments, the date of maturity for this
purpose must be reckoned as the date on which the first installment becomes due.
Current maturities of long-term debts shall be shown under the head, “Short-term
Borrowings” along with interest accrued on it.

Other Long-term liabilities: This should be classified into:
a. Trade payables (payables after 12 months from Balance Sheet date or operating
cycle); and
b. Others – like Premium on Redemption of Debentures / Preference Shares
Long-Term Provisions: Provision refers to amount set aside to meet the future liability
whose amount cannot be ascertained with substantial accuracy. It includes items as
(i) provision for employee benefits (Retirement benefits)
(ii) Others – Provision for Warranties, Provision for Workmen Compensation Claim
(iii) Provision for Gratuity and Provision for Earned Leave, etc.
❖ Current Liabilities
a. Short-term borrowings refer to borrowings payable within 12 months from the date of
Balance Sheet or within the period of operating cycle whichever is more. It includes
items like
(a) Loans repayable on demand - from banks; from other parties.
(b) Bank Overdraft or Cash Credit from Banks
(c) Current maturities of long-term debts
(d) Loans and advances from related parties;
(e) Deposits;
(f) Other loans and advances (specify nature).
b. Trade Payables: It includes Creditors and Bills Payables on account of goods or

services acquired in normal course of business.
c. Other current liabilities: The amounts shall be classified as:

(a) Interest accrued but not due on borrowings;
(b) Interest accrued and due on borrowings;
(c) Income received in advance;
(d) Unpaid dividends / unclaimed Dividend;
(e) Application money received for allotment of securities and due for refund and
interest accrued thereon;
(f) Unpaid matured deposits and interest accrued thereon;
(g) Unpaid matured debentures and interest accrued thereon;
(h) Calls-in-advance and interest thereon.
(i) Other payables – (specify nature).
Note: Provident Fund Contribution is to be deposited by the company to

Government Statutory Provident Fund so, it is always part of Other Current
Liability.
(d) Short-term provisions: Short-term provisions are those provisions against which
liability is expected to arise within 12 months from the date of Balance Sheet or
within the operating cycle which ever is longer. The amounts shall be classified as:
(a) Provision for employee benefits;
(b) Provision for Expenses
(c) Provision for Tax
(d) Other Provisions
Non-Current Assets:
❖ Property, Plant and Equipment and Intangible Assets: Property, Plant and
Equipment and Intangible Assets are those assets which are acquired for permanent use
in the business to earn profit. They are not meant for resale purposes. These may be
(a) Property, Plant and Equipment
(b) Intangible assets
(c) Capital work-in-progress
(d) Intangible Assets Under Development
a. Property, Plant and Equipment:

(i) Classification shall be given as:
(a) Land. (b) Buildings.
(c) Plant and Equipment. (d) Furniture and Fixtures.
(e) Vehicles. (f) Office equipment. (g) Others (specify nature).

b. Intangible assets
(i) Classification shall be given as:
(a) Goodwill. (b) Brands /trademarks.
(c) Computer software. (d) Mastheads and publishing titles.
(e) Copyrights, and patents and other intellectual property rights, services and
operating rights.
(f) Recipes, formulae, models, designs and prototypes.
(h) Licenses and franchise. (i) Mining rights
❖ Non-current investments: Investments made by the company with a view to retain

them for more than 12 months from the balance sheet date are termed as non-current
investments. They are further classified as trade investments and other investments.
Trade Investments are investments made by a company in shares or debentures of
another company to promote its own trade and business. They are further classified as:
• Investment in property; • Investments in Debentures or
• Investments in Equity Instruments; Bonds;
• Investments in Preference shares • Investments in Mutual Funds;
• Investments in Government or Trust • Investments in Partnership Firms
Securities; • Other Investments (Specify
nature)
Note: The portion of long-term investments as per AS-13 which is expected to be

realised in 12 months from balance sheet date are to be shown as current investments.
Long-term loans and advances:

(i) Long-term loans and advances shall be classified as:
(a) Capital Advances – for purchase of capital goods – plant
(b) Other loans and advances – (Specify the nature)

Other Non-current Assets
Other non-current assets shall be classified as:
(a) Security Deposits – for electricity meter, dealership security, etc.
(b) Long-term Trade Receivables
(c) Insurance Claim Receivable
(d) Others (specify nature)
❖ Current Assets:
a. Current Investments
(i) Current investments shall be classified as:
(a) Investments in Equity Instruments;
(b) Investment in Preference Shares
(c) Investments in Government or Trust Securities;
(d) Investments in Debentures or Bonds;
(e) Investments in Mutual Funds;
(f) Investments in Partnership Firms
(g) Other Investments (specify nature).
b. Inventories:
(i) Inventories shall be classified as:
(a) Raw materials;
(b) Work-in-progress;
(c) Finished goods;
(d) Stock-in-trade (in respect of goods acquired for trading);
(e) Stores and spares;
(f) Loose tools;
(g) Others - Goods-in-transit

c. Trade Receivables – includes debtors and Bills Receivables maturing within 12
months from the date of Balance Sheet or within the operating cycle whichever is
more. Trade receivables shall be sub-classified as:
(a) Secured, considered good;
(b) Unsecured considered good;
(c) Doubtful.
Note: Provision for doubtful debts are shown under the head, Short-term Provisions.
d. Cash and Cash Equivalents:

(i) Cash and cash equivalents shall be classified as:
(a) Balances with banks;
(b) Cheques, drafts on hand;
(c) Cash on hand;
(d) Others (specify nature).
(ii) Earmarked balances with banks (for example, for unpaid dividend) shall be
separately stated.
(iii) Balances with banks to the extent held as margin money or security against the
borrowings, guarantees, other commitments shall be disclosed separately.
(iv) Bank deposits with more than 12 months maturity shall be disclosed
separately.
e. Short-term loans and advances

(i) Short-term loans and advances shall be classified as:
(a) Loans and advances to related parties (giving details thereof);
(b) Others (specify nature).
(ii) The above shall also be sub-classified as:
(a) Secured, considered good;
(b) Unsecured, considered good;
(c) Doubtful.
f. Other current assets – it includes: Prepaid expenses, Income receivables, Advance

Tax, etc.
❖ General Instructions for Preparation of Balance Sheet
CURRENT ASSETS
An asset shall be classified as current when it satisfies any of the following criteria:
(a) it is expected to be realised 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 realised within twelve months after the reporting date; or
(d) 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.
OPERATING CYCLE
An operating cycle is the time between the acquisition of assets for processing and their
realisation in cash or cash equivalents. Where the normal operating cycle cannot be
identified, it is assumed to have duration of 12 months.
CURRENT LIABILTY
A liability shall be classified as current when it satisfies any of the following criteria:
(a) it is expected to be settled in the company’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is due to be settled within twelve months after the reporting date; or
(d) the company does not have an unconditional right to defer settlement of the
liability for at least twelve months after the reporting date. Terms of a liability
that could, at the option of the counterparty, result in its settlement by the issue of
equity instruments do not affect its classification. All other liabilities shall be
classified as non-current.
A receivable shall be classified as a ‘trade receivable’ if it is in respect of the amount

due on account of goods sold or services rendered in the normal course of business.

A payable shall be classified as a ‘trade payable’ if it is in respect of the amount due
on account of goods purchased or services received in the normal course of business.
A company shall disclose the following in notes to accounts:
Contingent liabilities and Commitments (to the extent not provided for)
(i) Contingent Liability: A liability the happening of which is uncertain is called
contingent liability. Since the liability is uncertain so it is disclosed in Notes to
Accounts below the balance sheet of a company for the information of the users. It
includes items such as :
(a) Claims against the company not acknowledged as debt;
(b) Guarantees;
(c) Other money for which the company is contingently liable
eg. Case of workmen compensation pending in court
(d) Proposed Dividend for current and previous years are also disclosed as
contingent liability as it will be proposed by the Board of Directors of the
company in the Annual General Meeting (A.G.M.) and approved by the
shareholders. Till it is approved by the shareholders in A.G.M., it will be
treated as Contingent Liability. [AS – 4 (Revised)].
(ii) Commitments shall be classified as:

(a) Uncalled liability on partly paid shares
(b) Dividend on cumulative preference shares
(c) B/R discounted not yet due
(d) Other commitments (specify nature).
❖ Preliminary Expenses: As per As-26, it is to be written off in the year in which it is

incurred first from Securities Premium Reserves U/S 52(2) and balance from Statement
of Profit and Loss.

STATEMENT OF PROFIT AND LOSS
Statement of Profit and Loss depicts the operating performance of the company during
the accounting period. Schedule III, Part II has prescribed a vertical format for it. Profit
and Loss A/c is called as “ Statement of Profit & Loss”.
Format of Statement of Profit and Loss

Statement of Profit and Loss
for the year ending 31st March,...
Figures for Figures for
the the
Note
Particulars current previous
No
reporting reporting
period period
` `
I Revenue from Operations ….. …..
II Other Income ….. …..
III Total Income (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
Employees Benefit Expenses ….. …..
Finance Costs ….. …..
Depreciation and Amortisation Expenses ….. …..
Other Expenses ….. …..
Total Expenses ….. …..
V Profit before tax (III – IV ) ….. …..
VI Less: Tax ….. …..
VII Profit after Tax (V – VI ) ….. …..

INSTRUCTIONS FOR PREPARATION OF STATEMENT OF PROFIT AND LOSS
Total of all major heads of Statement of Profit and Loss are to be shown directly and
detail of their sub-heading be shown in Notes to Accounts.
Terms Meaning
I. Revenue from Operations : This item is shown in notes as:
It refers to revenue earned (a) Sale of products
from the business activities of (b) Sale of services
the company. (c) Other operating revenue (i.e. sale of scrap)
Other income shall be classified as:
II. Other Income: (a) Interest income
It refers to income earned (b) Dividend income
from sources other than its (c) Net gain on sale of investments
business activities. (d) Profit on sale of Fixed Assets
III. Expenses: Expenses are incurred to earn income:
(a) Cost of Material Consumed: Term is used for manufacturing companies i.e.
Raw material (Opening + Purchases –
Closing)
(b) Purchase of Stock-in-Trade Term is used for Trading Companies. It refers to
goods purchased for selling.
(c) Change in inventories of work Difference between opening and closing stock of
in progress, finished goods work-in-progress, finished goods and stock-in-
and stock in trade trade.
(d) Employees benefit expenses The term includes the following expenses:
(i) Salaries and Wages, leave encashment
(ii) Contribution to provident fund and other
funds
(iii) Staff welfare expenses

(e) Financial Costs It includes:
(i) Interest expenses
(ii) Other borrowing costs
(iii) Net gain / loss on foreign currency
transactions
(iv) Discount / Loss on Issue of Debentures
(f) Depreciation and Depreciation is charged on fixed assets – tangible
Amortisation Expenses while intangible assets are amortised (written off)
(g) Other Expenses All other expenses which are not classified under
above heads will be classified here:
DIRECT EXPENSES
(i) Consumption of stores and spare parts
(ii) Power and fuel, Carriage, Freight, etc.
OPERATING EXPENSES
(iii) Rent, Printing & Stationery, Postage and
Call
(iv) Repairs to building
(v) Repairs to machinery
(vi) Insurance
(vii) Rates and Taxes
NON-OPERATING EXPENSES
(viii) Loss on sale of Investments & Fixed Assets
❖ Explanation of Important Items of Statement of Profit and Loss

I. Revenue from Operations (for other than finance company) : refers to revenue
earned by the company from the business activities of the company i.e. sales made by
the manufacturing or trading company, sale of services made by the service company.
Revenue from Operation (for finance company) : refers to revenue from interest and
dividend received and revenue earned from other financial services.

Important Relationship of Items of Statement of Profit and Loss at a glance
Sr. No. Items Components of Items
1. Net Revenue from Gross Revenue from Operations – Revenue from
Operations Operations Return
2. Cost of Revenue from Cost of Material Consumed + Purchase of stock in
Operations or Cost of goods trade + Change in Inventories (Finished goods,
sold (CoGS) work in progress & Stock-in-trade + Direct
Expenses
3. Direct Expenses 1. Wages and P.F. Contribution (Employees
Benefit Expenses)
2. Fuel and Power, Carriage inwards, Cartage,
Factory rent, Manufacturing expenses etc.
(Other Expenses)
4. Operating Expenses 1. Salary and P.F. Contribution (Employees
Benefit Expenses)
2. Interest on short-term loans (Finance Cost)
3. Depreciation and Amortisation
4. Rent, Printing and Stationery, Postage &
Call, Repair, Insurance Rates & Tax, Selling
& Distribution expenses etc.,
(other expenses)
5. Non-operating Expenses 1. Interest on long-term borrowings and other
borrowing costs (Finance Cost)
2. Loss on sale of Investments & Fixed Assets
6. Non-operating Incomes (Other Incomes)
1. Interest on Investment
2. Dividend Received
3. Gain on sale of Investments / Fixed Assets
4. Rent Received (other incomes)
7. Other Operating Incomes (Other Incomes)
1. Commission received
2. Provision for Discount on Creditors
8. Gross Profit Revenue from Operations – Cost of Revenue from
Operations
9. Operating Profit Gross Profit + Other Operating Incomes –
Operating Expenses
10. Net Profit (after tax) Gross Profit + Other incomes – Indirect Expenses
and losses – Provision for tax

USERS OF FINANCIAL STATEMENTS OR
PARTIES INTERESTED IN THE FINANCIAL STATEMENTS
Various users of financial statements and their objectives are:
1. Shareholders and potential investors: Shareholders are the owners of the company so
they are exposed to every type of risk. They are interested in knowing the profitability
position of the company, return on capital employed, safety of their investments and
growth potential in future.
2. Debenture holders, bankers, financial institutions and lenders are also interested in
the long-term solvency to ensure safety of their debt and short-term solvency of company
to ensure ability of the business to pay interest payment in the short-term on regular basis.
3. Creditors or suppliers are also interested in getting their payment as and when it
becomes due so they are more interested in the short-term solvency position of the
enterprise.
4. Customers: They are also interested enterprise remains a going concern as customers
buy their requirements from it. Alternatively, they will have to find alternate source of
supply.
5. Management is also interested in the financial performance and soundness of the
enterprise. It has to deal with management of cash, Trade Receivables, Trade Payables,
inventory, fixed assets, capital structure, etc.
6. Employees and trade union: They are also interested in knowing about the financial
position of the enterprise so that it may pay salary to employees in time, ability of the
company to pay bonus and ability to deposit provident fund contribution in time and to
give promotion, etc.
7. Government and other agencies: Various government departments like income tax,
sales tax, excise department are interested in the collection of various types of taxes. This
s possible only when growth of the company is satisfactory over the period of time.
8. Stock exchange: They also use financial statements to find out the profitability position
and financial health of the company.

Chapter: Financial Statements Analysis
Meaning of Financial Statement Analysis: Analysis of financial statements refers to
critical examination of financial information contained in financial statements. i.e.
Balance Sheet and Income Statement.
The complex information is divided into simple parts to yield valuable relations from
same or from different financial statements. The process of establishing relationship and
interpretation of different components of financial statements so as to understand about
the operating and financial position of a business is called analysis of financial
statements.
Types or Methods of Financial Statement Analysis: Financial Statements analysis

may be of two types: (i) On the basis of material used
(ii) On the basis of modus operandi (i.e. technique used)
(i) On the basis of Material Used: On this basis, financial statements analysis may be of
two types:
(a) External Analysis
(b) Internal Analysis
(a) External Analysis: The external analysis is conducted by those who do not have access
over books of accounts. This group consists of equity shareholders, preference
shareholders, debenture holders, financial institutions, bankers, creditors, public
depositors, trade unions, Government, researchers, etc. They solely rely upon published
accounts, directors’ report and auditor’s report and they have no control over its
preparation. The external end-users of business are interested in financial statements as
aids to determine the financial condition and results of operations of such enterprise for
specific period of time, usually, one year.
(b) Internal Analysis: This type of analysis is made by those who have access to the books
of accounts and other information. It is conducted by the management with a view to
knowing the operational and financial efficiency of the enterprise. The management is
also interested in using it for planning and control purposes against the planned
performance.
(ii) On the basis of Modus Operandi (i.e. technique used). On this basis, financial
statement analysis can also be of two types:
(a) Horizontal Analysis
(b) Vertical Analysis
(a) Horizontal (or Dynamic) Analysis: When an analyst analyses the financial statements
of an enterprise over a number of years, the analysis is called horizontal or dynamic
analysis. The emphasis, here, is on change and not on status. Financial data of several
years is compared with a selected base year to study the weakness, profitability and
financial strength of the business.
It includes the use of analytical tools like comparative statements, trend ratios, ratio
analysis, cash flow statement, fund flow statement, etc.
This type of analysis is useful for knowing the trends of the business. The technique
of analysis is also called as ‘dynamic analysis’ as it is based on several years data rather
than one year data.
(b) Vertical Analysis or Static Analysis: When the analyst uses only single set of
financial statements in the process of analysis, it is called vertical analysis.
The emphasis in this type of analysis is on status and not on change.
It involves the use of analytical tools like common size statement, ratio analysis, etc.
Normally such an analysis is useful for making comparison of performance of several
enterprises in the same industry or divisions in the same enterprise.
It involves study of quantitative relationship among various items of Income Statement
and Balance Sheet of a single year. Since this analysis is based on single year so the
analysis is also called static analysis.

❖ Difference Between Horizontal Analysis and Vertical Analysis
Basis Horizontal Analysis Vertical Analysis
Period It needs financial statements of It needs financial statements of
two or more accounting periods. one accounting period.
Item Comparison of same item over a It deals with different items of
period of time is made. financial statements of same
period.
Utility It is used for making time series It is used for cross sectional
analysis. analysis of a single year.
Nature of It is used for making dynamic It is used for making static
Analysis analysis / horizontal analysis. analysis / vertical analysis.
Information Information is provided in both Information is expressed in
money form and percentage percentage or ratio form.
form.
❖ Difference Between Intra-firm Analysis and Inter-firm Analysis

Intra-firm Analysis: If the different financial variables of a single firm are analysed
and compared over a period of time, it is called intra-firm analysis. It is also called as
Time Series Analysis or Trend Analysis. It is used to depict trends of various
financial variables by the management and external users.
Inter-firm Analysis: It involves comparison of financial statements of two or more

business firms. Various external end users of financial statements are interested in
making analysis of two or more firms to determine the comparative analysis. If single
set of financial statements of two or more firms are compared, it is called as Cross-
Section Analysis.

❖ Objectives of Financial Statement Analysis
1. To know the earning capacity or profitability: The profitability position and earning
capacity of the business may be computed on the basis of financial statements which is
an indicator of efficiency and success of a business enterprise. All the external end users
of financial statements including investors and potential investors are interested in
knowing the earning capacity of the business. Besides this, they may also forecast the
future earning capacity of the concern and may assess the future prospects of the
company.
2. To know the solvency position: Solvency of an enterprise refers to ability of an
enterprise to pay back its short term and long-term liabilities well in time. Debenture
holders and lenders are interested in judging the long-term solvency with the help of
debt-equity ratio and proprietary ratio while the trade creditors are interested in knowing
the short-term solvency position of an enterprise with the help of current ratio and liquid
ratio.
3. To know the managerial efficiency: The analysis of financial statements has the
ability to point out the areas of managerial efficiency and inefficiency. For instance
operating ratio, expense ratio, turnover ratios pin point the ability of ability of
managerial efficiency or inefficiency.
4. Facilitates inter-firm comparison: We can analyse and compare the financial
statements of similar enterprises with our own enterprise. Thus, inter-firm comparison
facilitates areas of efficiency and inefficiency of our enterprise with other similar
enterprises.
5. Facilitates intra-firm comparison: We can analyse the financial statements of a firm
over a period of time. It is called time series analysis. It helps to point out the areas of
efficiency or inefficiency of an enterprise in relation to previous periods. We can also
come to know about the growth potential of an enterprise by making intra-firm
comparison.
6. Facilitates preparation of budgets: Analysis of intra-firm comparison of past financial
statements are the basis for preparing budgets for the future sales , earning capacity, etc.

7. To know the financial strength: The object of financial analysis is to investigate the
future potential of the concern. For this, analysis helps in providing answers to the
following questions:
(i) Whether funds are required for modernization and expansion of the business will
be available from internal resources or not.
(ii) How much funds can be raised from external resources on the basis of goodwill?
8. To know the capability of payment of interest and dividend: By analysing the
financial statements, we can know about the capability of the company to pay interest
payment in time and capacity to pay dividend to shareholders at a higher rate.
❖ Significance of Financial Statement Analysis to Various Users: All the users are
using the financial statement analysis to suit their objectives so different
interpretations will develop from the same set of analysis depending upon the
objects of a particular user.
1. Significance for Management: The basic objective of the management is to judge the
efficiency and performance of the company so that their appointment may be renewed.
Its objective is to review how effectively capital is used, how well credit standards are
observed, whether capitalization is fair or not.
2. Significance for Shareholders and Potential Investors: Investors include equity
shareholders, preference shareholders and prospective shareholders. They are not only
interested in the safety of their capital but they are also interested in the appreciation of
their capital. They would also like to know the profitability of the company. In other
words, investors and shareholders analyse the profitability and long-term solvency of
the business concern.
They intend to know about the financial soundness and operating performance of the
company so as to decide whether they should continue to remain with the company or
they should dispose off their present holding and should buy the shares of another
company where prospects are better.
3. Significance for Creditors or Suppliers: Creditors are mainly interested in the short-
term solvency of the company. They are also interested in the profitability because
profit is viewed as the main source of payment of amount due to them. Thus, on the
basis of short-term solvency, they decide whether they should allow credit to an
enterprise or not.
4. Significance for Financial Institutions: All financial institutions which provide loan to
the industries such as Banks, Insurance Companies, Y.T.I., etc. are interested in
knowing about the profit earning capacity of the business and its long-term solvency.
They want to know about the present position and future prospects of the concern.
5. Bankers and Lenders: Bankers and lenders of money in the form of debentures are
interested in the regularity of interest payment in the short run and repayment of loan in
the long run on maturity
6. Significance for Government: Financial statement analysis provides useful
information to various government departments like Income Tax, Sales Tax, Excise etc.
to determine tax liability of the concern. On the basis of analysis of financial statements,
the Government can determine tax policy, import-export policy, industry policy, etc.
7. Significance for Employees and Trade Unions: Employees can judge the profitability
of the business enterpises on the basis of analysis of financial statements. They can
compute as to how much bonus and increase in their wages are possible from the profits
of the business concern. Financial analysis also helps the trade union in negotiating
wages agreements.
8. Customers: Customers are also interested in the analysis of financial statements as they
are interested in the continuance of supply of goods from the business entity on regular
basis. This is possible only when firm remains a profitable venture.
9. Tax Authorities: Tax authorities collect various types of taxes from business entities
like corporate tax, GST, etc. They are interested in the growth of the business entities so
that they may collect the desired amount of taxes in future.
10. Significance to Regulatory Authorities: Regulatory authorities like SEBI, Company
Law Board, Stock Exchanges, etc. would like to ensure that financial statements are
prepared in conformity with the laws of the nation and they have been prepared to
safeguard the interest of various users.
11. Significance for Other Parties: Some other parties are also interested in the analysis of
financial statements from their own point of view such as Research Institutions,
Newspaper, Economists, etc.

Limitations of Financial Statements Analysis
1. Limitations of Financial Statements: The analysis is directly based upon financial

statements. Whatever limitations financial statements have, those automatically apply to
the analysis also. For eg. Incomplete Information, Different Accounting Policies,
Qualitative Factors.
2. Affected by Window Dressing: Some business concerns use window dressing for their
financial statements to show better financial position on the date of final accounts. For
eg. They may not enter in the books the purchases made at the end of accounting year or
they may over value the closing stock. In such cases, the results obtained by financial
statement analysis will be misleading.
3. Unreliable Comparison: Financial statements reflect the accounting policies. These
keep on changing sometimes. More ever, different concerns have different accounting
policies which render inter-firm comparison unreliable.
4. Difficulty in Forecasting: Financial statements disclose data which is basically
historical in nature i.e. it tells what has happened in the past. These statements do not
give future projections. Since continuous changes take place in the demand of product,
trade policies, position of competition etc. but no estimate based on the analysis of
historical data can be made for future.
5. Lack of Qualitative Analysis: Financial statements record only those transactions and
events which can be expressed in terms of money. But, there are many factors which are
qualitative in nature and cannot be expressed in monetary terms. These non-monetary
factors do not find any place in the financial statements such as reputation of business,
cordial management-labour relations, efficiency of management, satisfaction of
customers, advertisement policy etc. even though they materially affect the profitability
of a business.
6. Limited use of Single Year’s Analysis of Financial Statements: The analysis of
financial statements assume significance only when they are compared with the data of
previous years. For eg. Net profit to sales is 13 %, whether this conclusion is
satisfactory or not will depend upon the conclusion of previous years. If the concern had
earned 11 % net profit on sales in the previous year, it may be treated to have performed
better this year.

7. Do not reflect Price Level Changes: The recording in financial statements is done on
the basis of actual cost, whereas the value of money goes on changing. As such, the
comparison of previous year figures with current year figures may lead to misleading
conclusions. Therefore, necessary adjustments must be made for changes in price level
while making the analysis.
8. Effect of Personal Ability and bias of the Analyst: Accounting data are dumb, any
conclusion can be drawn from these data. Thus, conclusions are influenced to a certain
extent by the personal judgement of the analyst. For eg. For calculating ‘Return on
Capital Employed’, one analyst may treat the profits after taxes, whereas the other
analyst may treat the profits before taxes.

Chap: Tools for Financial Statement Analysis
Financial Statements are prepared annually to depict the financial position and operating
performance of a business enterprise. They compromise Balance Sheet, Statement of
Profit and Loss supported by the information through Notes to Accounts, Directors’
Report, Auditor’s Report and Cash Flow Statement.
The numerical data contained in financial statements (i.e. Income Statement or

Statement of Profit and Loss and Balance Sheet) are not of much use to analyst or
decision maker. These data are to be analysed over a long period of time so that
meaningful conclusions can be drawn concerning the operating performance and
financial soundness of the business entity. Analysis of financial statements require the
use of analytical tools to find out the hidden facts. The analytical tools used for financial
analysis re as follows:
(i) Comparative Statements

(ii) Common Size Statements
(iii) Trend Ratios (not in syllabus)
(iv) Ratio Analysis
(v) Funds Flow Statement (not in syllabus)
(vi) Cash Flow Statement
1. Comparative Statements: Comparative Statements refer to the comparative study of

the components of balance sheet and income statement over a period of two or more
years both in absolute and in percentage form. It is a horizontal type of analysis.
2. Common Size Statements: Common Size Statements refers to study of percentage

relationship of ingredients of income statement with revenue from operations (sales) as
100 in case of income statement and study of percentage relationship of ingredients of
assets and equity and liabilities with the total of assets or equity and liabilities as 100
in case of balance sheet. These statements can be studied both vertically and
horizontally.

3. Ratio Analysis: Ratio analysis is a process of studying financial statements using
ratios on income statement and balance sheet of a business entity so as to draw
meaningful conclusions in respect of operating performance and financial soundness
of an enterprise. The tool is used vertically but applied horizontally to yield useful
results.
4. Cash Flow Statement: Cash Flow Statement refers to a statement that shows flow of
cash and cash equivalents during a specific period. The transactions of cash flow
statement are broadly classified into three activities, namely:
(i) Operating Activities
(ii) Investing Activities
(iii) Financial Activities
It reveals inflow and outflow of cash and cash equivalents during a specified period
from various activities mentioned above. It is also a horizontal analytical tool.
Types and Tools of Analysis of Financial Statements
Financial analysis is of two types, namely horizontal analysis and vertical analysis.
In horizontal type of analysis, financial statements of a company are analysed over a

number of years. In fact, it is a time series analysis. This type of analysis is done with a
view to knowing the weakness, profitability and financial strength of the business. It
includes the use of analytical tools like comparative statements, trend ratios, funds flow
statement, cash flow statement etc.
In vertical type of analysis, analyst uses only a single set of financial statements. It
involves the use of analytical tools like common size statement, ratio analysis, etc.
Normally this type of analysis is useful for making comparison of performance of
several companies in the same industry i.e. inter-frim comparison.
Both horizontal and vertical analysis are complementary in nature. There is no conflict
between the two techniques as both serve different purpose. The former analysis is used
for making intra-firm comparison (comparison of one firm over a period of time) while
the later form of analysis is used for making inter-firm comparison (comparison of one
firm with similar firms during same period of time).
Tools for Comparison of Financial Statements
Comparative Financial Statements are of two types namely:
(i) Comparative Balance Sheet

(ii) Comparative Income Statement
Comparative Balance Sheet
Objectives:
(i) To analyse the movement of current assets and current liabilities over a period of
two or more years both in absolute and in percentage form.
(ii) To analyse the movement of fixed assets over a period of two or more years.
(iii) To analyse the movement of shareholders’ fund over a period of two or more
years.
(iv) To analyse the movements of Non-current Liabilities i.e. (long-term debts) over a
period of two or more years.
Preparation of Comparative Balance Sheet
A format of comparative balance sheet possesses the following columns:
(i) Particulars
(ii) Data of previous years’ balance sheet
(iii) Data of current years’ balance sheet
(iv) Absolute change (i.e. increase or decrease) in the data column 2 and 3. (Column 3
– Column 2 in `)
(v) Percentage change (i.e. increase or decrease) of each item is calculated taking
previous year’s amount as base i.e.
𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐶ℎ𝑎𝑛𝑔𝑒
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 = 𝑋 100
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟

Format of Comparative Balance Sheet
Comparative Balance Sheet
as on 31st March 2022 and 2023
Figures Figures Absolute Percentage
as at the as at the change change
Note
Particulars end of end of (Increase (Increase or
No
Previous Current or Decrease)
year year Decrease)
` ` ` %
(1) (2) (3) (4) (5)
I. EQUITY AND LIABILITIES
(a) Share Capital …… …… …… ……
(b) Reserve and Surplus …… …… …… ……
(a) Long-term Borrowings …… …… …… ……
(b) Long-term Provisions …… …… …… ……
(a) Short-term Borrowings …… …… …… ……
(b) Trade Payables …… …… …… ……
(c) Other Current Liabilities …… …… …… ……
(d) Short-term Provisions …… …… …… ……
Total …… …… …… ……
II. ASSETS
(a) Fixed Assets (PPE)
(i) Tangible Assets - PPE …… …… …… ……
(ii) Intangible Assets …… …… …… ……
(b) Non-Current Investments …… …… …… ……
(c) Long-term Loans and Adv. …… …… …… ……
2. Current Assets
(a) Current Investments …… …… …… ……
(b) Inventories …… …… …… ……
(c) Trade Receivables …… …… …… ……
(d) Cash And Cash Equivalents …… …… …… ……
(e) Short-Term Loans and Adv. …… …… …… ……
(f) Other Current Assets …… …… …… ……
Total …… …… …… ……

Comparative Statement of Profit and Loss or Income Statement
Objectives:
(i) To analyse revenue from operation (i.e. sales) and Cost of Revenue from
Operation of two or more years both in money terms and in percentage terms.
(ii) To analyse various components of expenses like cost of material consumed,
change in inventories, employees benefit expenses, finance cost, depreciation
and amortisation expense and other expenses of two or more years in monetary
and in percentage form.
(iii) To analyse income of two or more years both in money and percentage form.
(iv) On the basis of past-performance, managerial control can be exercised
effectively and efficiently during current and future years so as to keep the cost
and expenses under control.
Preparation of Comparative Income Statement
A comparative income statement also contains five columns like comparative balance
sheet. These columns are
(i) Particulars: In this column, all the items of Statement of Profit and Loss are
written.
(ii) Data of previous year’s Income Statement
(iii) Data of current year’s Income Statement
(vi) Absolute change of column 3 over 2; (Column 3 – Column 2 in `)
(iv) Percentage change (increase or decrease) of column 4 in relation to column 2.
𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐶ℎ𝑎𝑛𝑔𝑒
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 = 𝑋 100
𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝐹𝑖𝑔𝑢𝑟𝑒 𝑜𝑓 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟

Format of Comparative Income Statement
for the year ending 31st March, 2022 and 2023
Figures Figures Absolute Percentage

for the for the change change
Note
Particulars previous current (Increase (Increase or
No
reporting reporting or Decrease)
period period Decrease)
` ` ` %
I. Revenue from Operations ….. ….. ….. …..
II. Other Income ….. ….. ….. …..
III. Total Income (I + II) ….. ….. ….. …..
IV. Expenses:
(a) Cost of Materials Consumed ….. ….. ….. …..
(b) Purchase of Stock-in-Trade ….. ….. ….. …..
(c) Changes in Inventories of ….. ….. ….. …..
Finished Goods, Work-in-
Progress and Stock-in-Trade
(d) Employees Benefit Expenses ….. ….. ….. …..
(e) Finance Costs ….. ….. ….. …..
(f) Depreciation and Amortisation ….. ….. ….. …..
Exp.
(g) Other Expenses ….. ….. ….. …..
Total Expenses ….. ….. ….. …..
V. Profit before tax (III – IV) ….. ….. ….. …..
Less: Provision for Tax ….. ….. ….. …..
VI. Profit after Tax ….. ….. ….. …..

Common Size Income Statement
Objectives:
(i) Common Size income statement helps in establishing relationship among various
components of income statement with the Revenue from Operations. i.e. net sales
(ii) The relationship among various components of income statement with Revenue
from Operations i.e. net sales are analysed to draw useful conclusions over a
period of time.
(iii) If the relationship among various components of income statements with Revenue
from Operations i.e. net sales of two or more firms are compared, it facilitates to
find out the relative efficiency of two or more firms.
Format:
(i) Record the items of income statement in Column I.

(ii) Enter the amount of different components of income statement of previous year in
Column II.
(iii) Enter the amount of different components of income statement of current year in
Column III.
(iv) Find out the percentage relation of various item of previous year with the
Revenue from Operations i.e. net sales of previous year in Column IV.
(v) Similarly, find out the percentage relation of various items of current year with
the Revenue from Operations i.e. net sales of the current year in Column V.

Format of Common Size Income Statement
for the year ending 31st March, 2022 and 2023
Percentage of
Note Revenue from
Particulars Absolute Amounts
No Operations
(Net Sales)
2022 ` 2023 ` 2022 % 2023 %
(1) (2) (3) (4) (5)
I. Revenue from Operations ….. ….. 100 100
(Net Sales)
II. Other Income ….. ….. ….. …..
III. Total Income (I + II) ….. ….. ….. …..
IV. Expenses:
(a) Cost of Materials Consumed ….. ….. ….. …..
(b) Purchase of Stock-in-Trade ….. ….. ….. …..
(c) Changes in Inventories of Finished ….. ….. ….. …..
Goods, Work-in-Progress and
Stock-in-Trade
(d) Employees Benefit Expenses ….. ….. ….. …..
(e) Finance Costs ….. ….. ….. …..
(f) Depreciation and Amortisation Exp. ….. ….. ….. …..
(g) Other Expenses
Total Expenses ….. ….. ….. …..
….. ….. ….. …..
V. Profit before tax (III – IV) ….. ….. ….. …..
Less: Provision for Tax ….. ….. ….. …..
VI. Profit after Tax ….. ….. ….. …..

Common Size Balance Sheet
A statement in this form is known as a common size, or 100 percent statement, since
the total of assets and also that of the liabilities and capital is 100 percent, and, because
this would be true of all statements so constructed, they are of a common size.
Objectives:
(i) It is prepared to analyse the changes in items of assets and equity and liabilities
of balance sheet.
(ii) We can establish trend of items of assets or equity and liabilities with the total
assets or liabilities side of the balance sheet as their total is the same.
(iii) If common size balance sheet is prepared for two or more firms, we can come to
know about the strategy adopted by different firms in the industry.
Format: The following columns are prepared in common size balance sheet
(i) Name of Equity and Liabilities and Assets

(ii) First of all, items of different equity and liabilities and assets of the balance
sheet of previous year are recorded in the absolute money terms.
(iii) Thereafter, all items of equity and liabilities and assets of current year balance
sheet are recorded in the absolute money terms.
(iv) After assuming total of equity and liabilities or assets of previous year Balance
Sheet as 100, all the items of equity and liabilities and assets are expressed in
percentage form.
(v) Thereafter, total of equity and liabilities or assets of current year Balance Sheet
is assumed as 100 and all the items are expressed in percentage form.

Format of Common Size Balance Sheet
as on 31st March, 2022 and 2023
Note Percentage of
Particulars Absolute Amounts
No Balance Sheet Total
2022 ` 2023 ` 2022 % 2023 %
(1) (2) (3) (4) (5)
I. EQUITY AND LIABILITIES
(a) Share Capital …… …… …… ……
(b) Reserve and Surplus …… …… …… ……
(a) Long-term Borrowings …… …… …… ……
(b) Long-term Provisions …… …… …… ……
(a) Short-term Borrowings …… …… …… ……
(b) Trade Payables …… …… …… ……
(c) Other Current Liabilities …… …… …… ……
(d) Short-term Provisions …… …… …… ……
Total …… …… 100 100

II. ASSETS
(a) Fixed Assets
(i) Tangible Assets …… …… …… ……
(ii) Intangible Assets …… …… …… ……
(b) Non-Current Investments …… …… …… ……
(c) Long-term Loans and Advances …… …… …… ……
2. Current Assets
(a) Current Investments …… …… …… ……
(b) Inventories …… …… …… ……
(c) Trade Receivables …… …… …… ……
(d) Cash And Cash Equivalents …… …… …… ……
(e) Short-Term Loans and Advances …… …… …… ……
(f) Other Current Assets …… …… …… ……
Total …… …… 100 100

Chap: 14 ACCOUNTING RATIOS
Accounting ratio is a numerical relationship between, two accounting variables

of financial statements. i.e. Income Statement and Balance Sheet. These ratios
assume significance only when they are used to present meaningful relationship
between individual items or group of items in the balance sheet and income
statement. For instance, there is a significant relationship between profit and capital
employed but there is no significant relationship between the amount of turnover
and capital employed.
Cross Sectional Analysis: In cross sectional analysis, ratios of the firm are
compared either with the ratios of the industry average or with the ratios of certain
selected firms in the same industry which are producing similar products by using
similar technique of production. Such an analysis is very useful for making
comparative analysis of financial and operating soundness of the firm.
Time Series Analysis: Comparison of ratios of a firm with its past ratios is
generally referred as time series analysis or trend analysis. Such type of analysis is
needed to know whether the financial and operating performance of the firm has
improved or deteriorated in comparison to past performance. Such an analysis yields
good result provided no significant change has taken place in the accounting policy,
government policy, technological development etc.

LIQUIDITY RATIOS (SHORT – TERM SOLVENCY RATIOS)
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
1. 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 𝐎𝐑 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐑𝐚𝐭𝐢𝐨 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒍𝒊𝒕𝒊𝒆𝒔
Current ratio is computed to measure the short term financial position of the firm. It
is a relationship between current assets to current liabilities.
Current Assets: All those assets which are likely to be converted into cash or cash
equivalents within 12 months from the balance sheet date or within the period of
operating cycle, are called current assets.
Current Assets Include:
• Current Investments
• Inventories excluding loose tools and stores and spares.
• Trade Receivables (i.e. B/R and sundry debtors less provision for doubtful
debts)
• Cash and Cash Equivalents (Cash in hand, Cash at Banks, Cheques & Drafts in
hand only)
• Short term loans and advances and
• Other-current Assets (Prepaid Expenses + Accrued Income + Advance Tax.)
Current Liabilities: Liabilities payable within 12 months from Balance Sheet date
or within the period of operating cycle are called Current Liabilities.
Current Liabilities Include:
• Short-term Borrowings (current maturities of long term debts, Loan repayable
on demand, Bank overdraft, cash credit etc.)
• Trade Payables (B/P and sundry creditors)
• Other-current Liabilities (interest accrued whether due or not on borrowings,
Unclaimed Dividend, O/s Expenses, Calls-in-advance, etc.)
• Short-term Provisions (i.e. Provision for Tax, Provision for Warranties)
Note: Provision for Doubtful Debt is a part of Short-term provision but is shown as
deduction from debtors while computing current ratio so it will not be counted
as component of current liabilities.
Significance: This ratio is computed to assess the ability of the firm to meet its
short-term liabilities. Current ratio of 2:1 is assumed as ideal ratio. However,
it is based on rule of thumb which varies from industry to industry.
𝑳𝒊𝒒𝒖𝒊𝒅 𝑨𝒔𝒔𝒆𝒕𝒔
2. 𝐋𝐢𝐪𝐮𝐢𝐝 𝐑𝐚𝐭𝐢𝐨 / 𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 / 𝐀𝐜𝐢𝐝 𝐓𝐞𝐬𝐭 𝐑𝐚𝐭𝐢𝐨 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Quick ratio tries to ascertain the liquidity position of a firm. Liquidity refers to
ability of the firm to convert current assets into cash and cash equivalents in a
very short period.
Liquid Assets Include:
• Current Investments
• Trade Receivables (net)
• Cash and Cash Equivalents
• Short Term Loans and Advances
• Income Receivables (Under Other Current Assets)
Liquid Assets = Current Assets – Inventories – Prepaid Expenses – Advance Tax

• Current Liabilities = Total Debts – Long Term Loans OR
• Current Liabilities = Current Assets – Working Capital OR
• Current Assets = Working Capital + Current Liabilities OR
• Working Capital = Current Assets – Current Liabilities
Significance: A quick ratio of 1:1 tries to assess the short-term solvency of the
firm. The ratio provides a more rigorous test of liquidity than the current ratio. It
provides a better view of firm’s ability to meet its current liabilities when used
in conjunction with current ratio.

SOLVENCY RATIOS (LONG – TERM SOLVENCY)
𝑫𝒆𝒃𝒕𝒔
1. 𝐃𝐞𝐛𝐭𝐬 𝐭𝐨 𝐄𝐪𝐮𝐢𝐭𝐲 𝐑𝐚𝐭𝐢𝐨 =
𝑬𝒒𝒖𝒊𝒕𝒚
𝑫𝒆𝒃𝒕𝒔 (𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔)
=
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′ 𝑭𝒖𝒏𝒅𝒔 𝒐𝒓 𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒐𝒓𝒔′ 𝑭𝒖𝒏𝒅𝒔 𝒐𝒓 𝑵𝒆𝒕−𝑾𝒐𝒓𝒕𝒉
The Debt-Equity ratio is computed to find out the long-term financial soundness of
the enterprise. The ratio indicates the relationship between long-term debts and
shareholders’ fund.
Long Term Debts: It includes all long-term liabilities of the enterprise maturing
after 12 months or after the period of operating cycle. As per Schedule III, all
long-term debts are stated under the head, “Non-current Liabilities”.
Components of Non-current Liabilities:

(a) Long-term Borrowings: Bonds, Debentures, Term Loans, Deposits, Loans
and Advances, etc.
(b) Long-term Provisions: Provision for Employees Benefits, Provision for
Warranties (payable after one year).
Note: Current maturity of Long-term Borrowings is a part of Short – term
Borrowings.
Shareholders’ Fund / Proprietors’ Fund / Net Worth: Components of

Shareholders’ Fund:
(a) Share Capital: Equity Share Capital, Preference Share Capital (stated in Notes to
Accounts under the head “Subscribed Capital”.
(b) Reserves and Surplus: Capital Reserve, Capital Redemption Reserve, Securities
Premium reserve, D.R.R., General Reserve, Statement of P & L (Dr. / Cr.) Balance
OR

Components of Shareholders’ Fund: Non-current Assets (Fixed Assets + Non-
current Investments + Long-term Loans and Advances) + Working Capital –
Non-current Liabilities (Long-term Borrowings + Long-term Provisions)
OR
Shareholders’ Fund = Total Assets – Total Debts
Significance: Debt equity ratio tells the proportion between long term borrowings
and shareholder’s fund. Debt – Equity Ratio of 2:1 is considered ideal. A low
debt equity ratio means more use of owner’s fund. This implies greater safety
margin to creditors. On the other hand, high debt-equity ratio means more risk to
lenders or low safety margin to lenders of money. The ratio indicates soundness of
long – term financial position and indicates the dependence of firm on outsider’s
funds.
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
2. 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 𝐭𝐨 𝐃𝐞𝐛𝐭 𝐑𝐚𝐭𝐢𝐨 =
𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
Total Assets: Non-current Assets + Current Assets

Non-current Assets = Tangible Assets + Intangible Assets + Non-current
Investments + Long-term Loans and Advances
Current Assets = Current Investments + Inventories (Including Loose Tools and
Stores and Spares) + Trade Receivables + Cash and Cash Equivalents + Short-term
Loans and Advances + Other Current Assets
Long-term Debts = Long-term Borrowings + Long-term Provisions
Significance: It shows the extent to which long term loans are covered by the total
assets of the business entity. A higher ratio represents more security to lenders
of long-term debts and vice versa. A low ratio indicates more dependence of
enterprise on long-term borrowed fund.

𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒐𝒓′𝒔 𝑭𝒖𝒏𝒅/𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′ 𝑭𝒖𝒏𝒅/𝑵𝒆𝒕 𝑾𝒐𝒓𝒕𝒉
3. Proprietary Ratio =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Significance: The ratio indicates the proportion of total assets financed by the
proprietor’s fund. A higher ratio is considered good from the point of view of
financial soundness of the company. A lower proprietary ratio implies that
insecurity to long-term lenders of money. A ratio below 50 is not considered
good for lenders as it signifies lower margin of safety to them.
𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑻𝒂𝒙

4. Interest Coverage Ratio / Debt Service Ratio =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒐𝒏 𝑳𝒐𝒏𝒈−𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
The ratio establishes relation between (Net) Profit before Interest and Tax to interest
payable on long-term debts. Since interest is a charge against profit so net profit
before interest and tax is considered for computation of this ratio.
Profit before Interest and Tax or EBIT: It includes profit of the enterprise before
providing for interest on long term loans and before charging tax provisions.
Interest on Long-term Debts: It includes all interest payments on long term loans
i.e. Debentures, Long term Loans, Bank Loans, Loan from Financial Institutions,
Public Deposits, Term Loan etc.
Significance: The ratio is computed in number of times. For a normal business, 6

to 7 times ratio is considered as ideal. A weak ratio indicates problem in raising
additional fund.
𝑳𝒐𝒏𝒈−𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
5. Debt to Capital Employed Ratio:
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 (𝒐𝒓 𝑵𝒆𝒕 𝑨𝒔𝒔𝒆𝒕𝒔)
This ratio establishes a relationship between Long-term Debt and Capital Employed
or Net Assets. Capital Employed is total of Long-term Funds which are
Shareholders; Funds and Long-term Debts. There are two components of this ratio
as follows:

(i) Debt: Debt means long-term debt, i.e. Non-current Liabilities (Long-term
Borrowings and Long-term Provisions) like debentures, bonds, term loans from
banks and financial institutions, long-term loans and advances, long-term
provisions, which are expected to be settled after 12 months or after the period
of Operating Cycle from the date of the balance sheet.
(ii) Capital Employed: Capital Employed is computed following either Liabilities
Side Approach or Assets Approach. It should be noted that whichever approach
is followed, the amount of capital employed will be same.
When Liabilities Side Approach is followed: It is computed by adding:

(i) Shareholders’ Funds (i.e., Share Capital, Reserves and Surplus)
In case, Surplus, i.e. balance in Statement of Profit & Loss has a debit
balance, it is deducted to calculate Shareholders’ Fund.
(ii) Non-current Liabilities (i.e. Long-term Borrowings and Long-term
Provisions).
Following are deducted to determine Capital Employed:
(i) Goodwill (ii) Non-Trade Investments (iii) Fictitious Assets
When Assets Side Approach is followed: It is computed by adding:

(i) Non-current Assets i.e.
(a) Fixed Assets (Tangible Fixed Assets and Intangible Fixed Assets
except Goodwill);
(b) Non-current Trade Investments (It is assumed that all Non-current
Investments are Trade Investments, unless specified to be Non-Trade
Investments); and
(c) Long-term Loans and Advances
(ii) Working Capital i.e. Current Assets – Current Liabilities
Objective and Significance:

The ratio shows the amount of long-term debts in capital employed. Low ratio
means more security to lenders and high ratio means lesser security to lenders.
High ratio helps the management in trading on equity.
TURNOVER / ACTIVITY / PERFORMANCE RATIOS
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑺𝒐𝒍𝒅

(𝒊.𝒆.𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔)
1. Stock Turnover Ratio (Inventory Turnover) =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒕𝒐𝒄𝒌 ( 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)
It tells the efficiency with which stock is used to generate sales. The stock turnover
is computed on the basis of cost of sales i.e. Cost of Revenue from Operations
If cost of Revenue from Operations (Cost of Goods Sold) cannot be computed, ratio
should be computed on the basis of Revenue from Operations (i.e. Sales)
Cost of Revenue from Operations or Cost of Goods Sold can be computed in 3
ways:
Cost of Revenue from Operations = Cost of Materials Consumed + Purchase of
Stock-in-Trade + Change in Inventories of Finished Goods, Work-in-progress and
Stock-in-Trade + Direct Expenses (like Wages, Carriage, Freight, Power & Fuel,
etc.)
OR
Cost of goods sold = Opening Stock + Purchases (net) + Direct Expenses (Wages,
Carriage, Freight, etc) – Closing Stock
OR
Cost of goods sold = Revenue from Operations (Net Sales) – Gross Profit
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑆𝑡𝑜𝑐𝑘

Average Sock =
2
Direct Expenses: As per Schedule III of Companies Act, 2013, direct expenses
may be shown in notes to accounts along with indirect expenses under the following
2 heads so direct expenses be separated from these two heads:
(i) Employees Benefit Expenses: Wages, Bonus to Workers, P.F.Contribution
of Workers, etc.
(ii) Other Expenses: Fuel and Power, Carriage Inward, Freight, Cartage, etc.

Note:
(i) Information containing Direct Expenses may be given as additional
information. In the absence of specific information, it may be assumed as no
direct expenses.
(ii) In case of Trading Company, you will be given Purchase of Stock-in-Trade.
Employees Benefit Expenses in such cases will not include wages as it is not
a manufacturing company.
Significance: The basic objective of computing stock (inventory) turnover is to

ascertain whether investment in stock has been judiciously used by the
management or not. Higher turnover ratio is considered better as it signifies more
sales per rupee of investment in stock. Thus, low stock turnover will mean either
over investment in stock or inefficient use of investment in stock.
❖ If COGs is not available or not given and if sales is given.

𝑺𝒂𝒍𝒆𝒔
Stock Turnover Ratio =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒕𝒐𝒄𝒌 𝑶𝑹 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
❖ In case average stock is not given:-

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑺𝒐𝒍𝒅
Stock Turnover Ratio =
𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑺𝒕𝒐𝒄𝒌
𝑫𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓 𝒐𝒓 𝑴𝒐𝒏𝒕𝒉𝒔 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓
Average Holding Period or Stock Velocity =
𝑺𝒕𝒐𝒄𝒌 𝒐𝒓 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑺𝒂𝒍𝒆𝒔 (𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔)

2. Debtors Turnover Ratio =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 (𝒊.𝒆.𝑫𝒆𝒃𝒕𝒐𝒓𝒔+𝑩𝒊𝒍𝒍𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆)
Net Credit Sales = Total Sales – Sales Return – Cash Sales

𝑂𝑝𝑒𝑛𝑖𝑛𝑔 (𝐷𝑒𝑏𝑡𝑜𝑟𝑠 + 𝐵/𝑅) + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 (𝐷𝑒𝑏𝑡𝑜𝑟𝑠 + 𝐵/𝑅)
Average Trade Receivables =
2
NOTE –
(i) If only closing balances are given then Debtors Turnover Ratio will be
calculated only on the basis of closing balances.
(ii) Similarly, if the credit sales (net credit revenue from operations) are not
available, we may use the value of net sales (Revenue from Operations).

(iii) Provision for Doubtful debts are never deducted from debtors as our
main objective is to know about the number of days for which sales are
tied up rather than to know the realisable value of debtors.
Significance: The ratio explains the speed with which amount is collected from
accounts receivable. Thus, it reveals the efficiency of the collection department of
the enterprise. A high ratio is considered better as it will mean quick collection from
the accounts receivables.
Average Collection Period: It indicated the days with in which accounts

receivables are converted into cash. By comparing the average collection period of
current year with the previous year, we can assess the efficiency of management in
collecting payment from debtors and B/R.
𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑫𝒂𝒚𝒔 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓 𝒐𝒓 𝑴𝒐𝒏𝒕𝒉𝒔 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓

Average Collection Period (in days) =
𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆

3. Creditors Turnover Ratio / Payable Turnover Ratio =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 (𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 + 𝐵/𝑃) + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 (𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 + 𝐵/𝑃)
Average Payables =
2
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑌𝑒𝑎𝑟
Average Payment Period (in days) =
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜
Significance: A higher creditor’s turnover ratio signifies the creditors are paid
quickly. It increases the creditworthiness of the firm.
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 𝒐𝒓 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔

4. Working Capital Turnover Ratio = =..times
𝑵𝒆𝒕 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
The ratio points out how effectively working capital has been used for generating
sales.
• Working Capital = Current Assets – Current Liabilities
• Working Capital = Net Capital Employed – Net Fixed Assets

Significance: A higher working capital turnover ratio is considered good. It is better
than stock turnover ratio as it points out the efficiency of entire working capital
rather than the efficiency of stock alone which is merely a part of it.
NOTE: If sales is not given, ratio can also be computed on the basis of cost of
goods sold as well.
5. 𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 𝒐𝒓 𝑵𝒐𝒏 − 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐

Fixed Assets Turnover Ratio is the ratio that analyses the relationship between Net
Fixed Assets and Revenue from Operations i.e. the number of times net fixed
assets are used or turned around for earning revenue from operations during the
year. It is computed as follows:
𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 (𝒏𝒆𝒕)
Objective and Significance: It shows the efficiency with which the fixed assets
have been used in earning revenue from operations during the year. A high ratio
means efficient use of fixed assets while low ratio means inefficient use of fixed
assets.
6. 𝑵𝒆𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 𝒐𝒓 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐

Net Assets Turnover ratio is the ratio that analyses the relationship between Net
Assets or Capital Employed and Revenue from Operations. It shows the number of
times net assets or capital employed is used or turned around in earning
revenue from operations during the year. It is calculated as
𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
𝑵𝒆𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 / 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Objective and Significance: Net Assets Turnover ratio (or Capital Employed
Turnover Ratio) is the analysis in respect of Revenue from Operations i.e. the
number of times net assets or capital employed is rotated or used in generating
revenue from operations. Higher turnover ratio means better and efficient
utilisation of net assets or capital employed and thus, higher profitability and
liquidity.
PROFITABILITY RATIOS
𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕
1. Gross Profit Ratio = × 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔
• Net Sales = Total Sales – Sales Return

• Net Revenue from Operations = Cash Revenue from Operations + Credit
Revenue from Operations – Revenue from Operations Return
• Gross Profit = Sales – Cost of Goods Sold (COGS)
• Gross Profit = Net Revenue from Operations – Cost of Revenue from
Operations
• Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing
Stock
Significance: Gross Profit Ratio measures the profit margin on sales. Higher ratio
indicates increase in the profit margin. The gross profit should be enough to cover
he operating expenses (administrative, selling and distribution expenses), interest
on borrowings, depreciation, fixed charges, dividends and for creation of reserves.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔 + 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔

2. Operating Ratio = × 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 (𝑵𝒆𝒕 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔)
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒐𝒔𝒕
Operating Ratio = × 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 (𝑵𝒆𝒕 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒔)
Operating expenses = Employees Benefit Expenses + Depreciation and

Amortisation + Other Expenses
Employees Benefit Expenses includes wages, Salary, Staff Welfare Expenses etc.
(Office and Administration Expenses)
Other Expenses include selling & distribution expenses like advertisement,
discount, bad debts etc. + Office & Administration Expenses like postage
stationery, printing charges, insurance, repairs etc. (Loss on Sale of Asset /
Investment is included in other expenses but it is Non-Operating Loss)

Note:
(i) The ratio excludes non-operating incomes like interest received from
Investments, profit from sale of fixed assets, rent received, etc.
(ii) It also excludes non-operating expenses / losses which have no relation to
production and sales e.g. loss on sale of fixed assets.
(iii) Finance cost i.e. interest on long term Borrowings is also not a part of
operating expenses so it is not considered.
(iv) Finance cost includes interest on short-term borrowing which is a part of
operating expenses.
Significance: The ratio measures the operational efficiency of the business. A

lower operating ratio is considered better as it will mean higher operating income.
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕
3. Operating Profit Ratio = × 𝟏𝟎𝟎
Operating Profit Ratio = 100 – Operating Ratio
Operating Profit = Net Revenue from Operations – Operating Cost OR

= Net Sales – [Cost of Goods Sold + Operating Expenses] OR
= Gross Profit – Operating Expenses (i.e. Administrative Expenses, Selling
Expenses, Depreciation, Bad debts, Interest on short term loans, etc.) + Other
Operating Incomes (i.e. Discount received, commission received, etc)
= Net Profit Before Tax + Non-operating Expenses or Losses – Non-operating
Incomes
Non-operating Expenses = Finance Cost like Debenture Interest, Interest on long-

term loans, Other Non-operating Expenses / Loss like loss on Sale of Assets /
Investments etc.
Non-operating Income = Interest received on investment, Profit on Sale of Asset /
Investments, etc.

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝑻𝒂𝒙
4. Net Profit Ratio (before tax) = × 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙
Net Profit Ratio (after tax) = × 𝟏𝟎𝟎
Net Profit (before tax) = Revenue from Operations (Sales) – (Cost of Revenue
from Operations + Operating Expenses) + Non-operating Income – Non-operating
Expenses / Losses
Net Profit (after tax) = Net Profit before Tax – Provision for Tax
Significance: The ratio is computed to measure overall profitability of the business.

Higher ratio in relation to previous years is always desirable as there is no
standard ratio for it.
𝑷𝑩𝑰𝑻
5. Return on Investment / Return on Capital Employed = × 𝟏𝟎𝟎
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅
PBIT = Net Profit (Earnings) before Interest and Taxes

PBIT Net Profit (Earnings) before Interest and Taxes = …
Less: Interest on Long Term Loans / Debts = …
Profit before Tax = …
Less: TAX @ -- % = …
Profit after Tax = …
Less: Preference Dividend = …
Profit Available for Equity Share Holders = …
• Capital Employed = Shareholders’ Fund + Long-term Debt

• Shareholders’ Fund = Share Capital + Reserves and Surplus
• Long-term Debts = Long-term Borrowings + Long-term Provisions
Significance: Return on Capital Employed or Return on Investment (ROI) reveals

the efficiency of the business in using long-term capital fund by the company
for operating purposes.

Notes:
Capital Employed can be computed from both the sides of Balance Sheet.
1. Capital Employed based on Liabilities Approach:
Shareholders’ Fund + Long-term Debts – Non-trade Investment (Under Non-current
Investments)
2. Capital Employed based on Asset Approach:
Fixed Assets (Tangible and Intangible) + Non-current Investment (Trade
Investments only) + Long-term Loans & Advances + Working Capital (Current
Assets – Current Liabilities)
3. Capital Employed (i.e. Long-term Fund) is invested by the company in Non-current
Assets and in Working Capital (i.e. Current Assets – Current Liabilities)
4. Investments of Company in Non-current Investments may be (i) Trade Investments
(ii) Non-trade Investments. Thus Non-trade Investments should be considered as
Non-operating objective of the company so portion of investments in ‘Non-trade
Investments’ be ignored.
5. Since Non-operating assets like Non-trade Investments are excluded while
computing Capital Employed so income from investment should also be excluded
from the profit before Interest & Tax.
“The components of formulae for accounting ratio are restricted to those

‘Heads’, and ‘Sub-Sub heads’ of Financial Statements, which shall be
evaluated in Board Examination”. – C.B.S.E. Circular No.43 of July 2, 2013.

Chapter: Cash Flow Statement
Meaning: Cash Flow refers to inflows and outflows of cash (i.e. movement of cash and
cash equivalents). The transactions which result in an increase in cash and cash
equivalent are inflows of cash while the transactions resulting in decrease in cash and
cash equivalent are termed as outflows of cash.
The transactions of cash flow statement are classified into three activities, namely:
(i) Cash Flow from Operating Activities
(ii) Cash Flow from Investing Activities
(iii) Cash Flow from Financing Activities
The Institute of Chartered Accountants of India (I.C.A.I) issued Accounting Standard

AS-3 (revised) for preparation of cash flow statement. With the introduction of
Companies Act, 2013, preparation of Cash Flow Statement is mandatory for every type
of companies except One Person Company (O.P.C.) vide Section 2 (40).
Objectives of Cash Flow Statement

The basic objectives of preparing a Cash Flow Statement are:
(i) To ascertain the various sources of activities from which cash and cash
equivalent have been generated during the specified period.
(ii) To ascertain the various uses of activities in which cash and cash equivalents
have been used by an enterprise during the specified period.
(iii) To ascertain the ultimate net change in cash and cash equivalents during the
specified period and to ascertain the changes in the components of cash flow
statement.
Terminology used in Cash Flow Statement

The following terms are used while preparing cash flow statement:
(i) Cash: It includes cash in hand and demand deposits with banks.
(ii) Cash Equivalents: Short-term highly liquid investments which are readily convertible
into known amount of cash having insignificant risk, are called cash equivalents.
Investments having maturity period of three months or less from date of acquisition
are termed as cash equivalents eg. treasury bills, commercial papers etc. Preference
Shares of a company purchased shortly before date of redemption can also be treated as
cash equivalents provided there is no risk failure of payment by the company. Thus it
includes:
(a) Short-term Deposits / Short-term Investments
(b) Marketable Securities / Treasury Bills
(c) As per syllabus contents, Current Investments are to be taken as marketable
Securities unless otherwise specified.
(iii) Cash Flows: It refers to inflows and outflows of cash and cash equivalents. AS – 3
(Revised) requires that cash flow statement be prepared in a manner that it reveals
inflows and outflows of cash and cash equivalents from Operating Activities, Investing
Activities and Financing Activity.
It is pertinent to note that movements in the components of Cash and Cash Equivalents
ate the part of cash management of the business entity rather than the part of its
operating, investing and financial activity. The examples of movements of Cash and
Cash equivalents are
(i) Cash deposited into bank
(ii) Cash withdrawn from bank for the business
(iii) Purchase and sale of short-term marketable securities. These are parts of
cash equivalents.
(iv) Cash Flow from Operating Activities: The operating activities refer to principal
revenue producing activities of an enterprise and all those activities which are neither
investing nor financing activities. They include all those which are helpful in
ascertaining net profit or net loss of an enterprise.
(v) Cash Flow from Investing Activities: Investing activities of an enterprise refer to
purchase and sale of fixed assets and investments which are not held for resale
purposes. It also includes Current Investments which are not held for resale purposes. It
also includes Current Investments other than marketable securities.

(vi) Cash Flow from Financing Activities: All those activities of an enterprise which
results in the change of capital and borrowing, are referred to as financial activities.
Note: For Financial Institutions:

(i) For financial institutions like banks, finance companies, mutual funds, etc.
transactions related to purchase and sale of securities will be considered as
Operating Activities as it is a part of their operating activities.
(ii) Cash paid for interest and cash received for interest and dividend will also be
operating activity of a financial enterprise.
Classification of Business Activities in Brief (AS – 3)

depicting Cash Inflow and Cash Outflow
Operating Activities
Cash Inflows Cash Outflows
1. Cash Sales 1. Cash Purchases
2. Cash received from Debtors and B/R 2. Cash paid to Creditors and B/P
3. Cash received from Royalty, Fees and 3. Payment of Operating Expenses like
Commission wages, salary, rent, etc.
4. Insurance claim received for loss of 4. Tax paid (unless identified with
Stock investing or financing)
Cash Inflows for Financial Companies Cash Outflows for Financial Companies
5. Interest and Dividend Received 5. Interest paid in cash
6. Sale of Securities 6. Purchases of Securities
7. Loan and Advances repaid by third 7. Loan and Advances to third parties
parties

Investing Activities
1. Sale of Fixed Assets 1. Purchase of Fixed Assets (Tangible or
2. Sale of Investments (Non-current and Intangible)
current other than Marketable 2. Purchase of Investment (Non-current
Securities) and current other than Marketable
3. Interest, Dividend and rent received Securities)
4. Insurance claim received for 3. Payment of Capital Gain Tax
destruction of Fixed assets 4. Loan and Advances to third parties
5. Repayment of Loans and Advances
received
Financing Activities
1. Issue of Shares (for Cash) 1. Payment of Loans
2. Issue of Debentures (for Cash) 2. Redemption of Preference Shares
3. Issue of Bonds (for Cash) 3. Buy-back of Equity Shares
4. Proceeds from Long-term or Short- 4. Redemption of Debentures for Cash
term Borrowings 5. Decrease in balance of Bank Overdraft
5. Increase in Bank Overdraft or Cash or Cash Credit A/c
Credit A/c 6. Payment of Interest and Dividend
7. Payment of Dividend Tax
Financing Activities will not include the following as these do not involve cash:
(i) Issue of bonus / bonus shares
(ii) Conversion of debentures into shares
(iii) Issue of share capital / debentures against purchase of fixed assets.

Format of Cash Flow Statement (Indirect Method)
for the year ended ……..
[As per AS – 3 (Revised)]
Sr. Particulars Details Amount
No. (`) (`)
A. Part A:
Cash Flow from Operating Activities:
Net Profit before Tax and Extra-ordinary items [Note No.1] …..
Adjustments for:
Add: Items to be added
- Depreciation …..
- Goodwill, Computer Software, Branding and …..
Trademark Amortised
- Preliminary Expenses / Discount on issue of …..
Debentures, Loss on Issue of Debentures, Share issue
expenses, Under-writing Commission written off
- Interest on Bank Overdraft and Cash Credit …..
- Interest on Borrowings (Short-term / Long-term) & …..
Debentures
- Loss on Sale of Fixed Assets / Investments …..
….. …..
Less: Items to be deducted
- Interest Income …..
- Dividend Income …..
- Rental Income …..
- Profit on Sale of Fixed Assets / Investments …..
….. (…..)
Operating Profit before Working Capital Changes …..
Part B:
Add:
(i) Decrease in Current Assets (Value of Assets) …..
(ii) Increase in Current Liabilities (Value of Liability) …..
Less:
(i) Increase in Current Assets (Value of Individual Assets) (…..)
(ii) Decrease in Current Liabilities (Value of Individual (…..)
Liabilities) …..
Cash Generated from Operations …..
Less: Income Tax Paid (Net of Tax Refund Received) …..
Net Cash from (or used in) Operating Activities (A) …..

B. Cash Flow from Investing Activities
- Proceeds from Sale of Tangible Fixed Assets …..
- Proceeds from Sale of Intangible Fixed Assets …..
- Proceeds from Sale of Investments (Other than …..
Marketable Securities)
- Interest and Dividend Received (for Non-financial …..
Companies only)
- Rent Income …..
- Purchase of Tangible Fixed Assets (…..)
- Purchase of Intangible Fixed Assets (…..)
- Purchase of Investments (Other than Marketable (…..)
Securities)
Net Cash from (or used) in Investing Activities (B) …..
C. Cash Flow from Financing Activities:
- Proceeds from Issue of Shares and Debentures …..
- Proceeds from Other Long-term Borrowings …..
- Increase / Decrease in Bank O/D and Cash Credit ….
- Payment of Dividend of Previous Year (…..)
- Interim Dividend Paid (…..)
- Interest on Debentures and Loans (Short-term / Long- (…..)
term) Paid
- Repayment of Loan (…..)
- Redemption of Debentures / Preference Shares (…..)
Net Cash from (or used) in Financing Activities (C) …..
Net Increase or Decrease in Cash and Cash Equivalents (A + B + …..
C)
Add: Cash and Cash Equivalents in the Beginning …..
Cash and Cash Equivalents at the end of the year …..

Note No. 1: Calculation of Net Profit before tax and Extra-ordinary Item
Particulars
Net Profit of current year (difference between Closing Balance and Opening …..
Balance of Statement of Profit and Loss)
Add:
- Proposed Dividend of Previous Year (Paid during the year) …..
- Interim Dividend paid during the year …..
- Transfer to Reserves (all transfer to reserves from balance of the …..
Statement of Profit and Loss)
- Provision for Tax made during the Current Year …..
- Extra-ordinary item (debited to Statement of Profit and Loss) …..
Less:
- Refund of tax Credited to Statement of Profit and Loss (…..)
- Extra-ordinary item (credited to Statement of Profit and Loss) (…..)
Net Profit before tax and Extra-ordinary item …..
Treatment of Special Items as per AS – 3 (Revised)

(1) Interest and Dividend Received: It is treated as cash inflow from investing activities.
(2) Interest, Dividend and Interim Dividend Paid: It is treated as cash outflow from
financing activities.
(3) Tax Paid: It is treated as cash outflow from operating activity as it is paid on operating
income of the company.
(4) Dividend Tax: Tax paid on dividend should also be classified as financing activity
along with dividend paid.
(5) Capital Gain Tax: If capital gain tax is paid on profit from sale of fixed assets, it is
classified under investing activity.
(6) Extra-ordinary incomes: (i) Insurance claim received for loss of stock is an operating
activity. (ii) Insurance claim received for destruction of fixed assets is an investing
activity.

Extra-ordinary Items and their Treatment
Extra-ordinary Items: All those transactions of an enterprise which are distinct from
its routine activities, are called extra-ordinary items. Thus, these items are not expected
to arise on regular basis eg. Insurance claim received due to loss by fire, payment of
compensation paid to employees who have taken V.R.S. These items may pertain to
Operating or Investing Activities.
Operating Activities: Insurance claim received against goods lost by fire,

compensations paid to employees under V.R.S.
Investing Activities: Insurance claim received against damages of fixed assets.
Treatment of Extra-ordinary Items in Cash Flow Statement

(i) As Income Received: Such extra-ordinary incomes are credited to Statement of Profit
and Loss so these are deducted from Net Profit before Tax and Extra-ordinary
Items and then shown as inflow from Extra-ordinary item in Operating / Investing
Activity (to which it relates)
(ii) As Expense: Such extra-ordinary expenses are debited to Statement of Profit and Loss
so these are added back to Net profit before tax and Extra-ordinary Items and then
shown as outflow to Operating / Investing Activity (to which it relates)
Treatment of Proposed Dividend as per AS-4 (Revised) and as adopted by CBSE

w.e.f. Session 2019-20 onwards.
As per AS-4 (Revised), Proposed Dividend is not shown in the Balance Sheet under
sub-head, Short-term Provisions of Current Liability as it is considered as Occurrence of
Events after Balance Sheet Date and is now disclosed in Notes to Accounts as
Contingent Liability.
Proposed Dividend is payable when it is proposed by the Board of Directors in Annual

General Meeting (A.G.M.) of the company and is also approved by the Shareholders of
the Company.
Thus, last year proposed dividend will only be approved by the shareholders in A.G.M.
and current year proposed dividend will be approved only in the next A.G.M. so it will
continue to be disclosed as Contingent Liability.
Note: As per AS-4 (Revised), proposed dividend of previous year will become
liability of the company on approval by the shareholders in the A.G.M. It is payable
within 30 days from the A.G.M.
Effect of AS-4 (Revised) on Cash Flow Statement:

(i) Proposed Dividend of Previous Year: It will be approved in A.G.M. of current year so
it is appropriated as well as paid to the shareholders.
(a) It will be added to Net Profit before Tax of current year
(b) It will be shown as outflow of Cash from Financing Activities.
(ii) Proposed Dividend of Current Year: It will be shown in Notes to Accounts as

Contingent Liability. No further treatment is required in the Cash Flow Statement of the
current year.
Operating Activities:
➢ If Profit made during year is given: Profit during the year is computed after charging
all operating and non-operating incomes and expenses along with provision for tax.
Items pertaining to appropriation of profits like transfer to General Reserve, Reserve
Fund, Debenture Redemption reserve, Proposed Dividend of previous year, Interim
Dividend etc. are never charged to arrive at profit during the year as these are
appropriation of profits and not charge against profit.
Thus, while computing Net Profit before Tax and Extra-ordinary items, these
appropriations of profits are never adjusted if Net Profit made during the year is
given.
However, extra-ordinary items like insurance claim against loss of goods by fire is
adjusted as it is an extra-ordinary operating income shown to arrive at Net profit during
year.

➢ If Statement of Profit and Loss of Current Year is given: Statement of Profit and
Loss contains items up to Provision for Tax. It does not contain appropriation of profit
like transfer to reserves, proposed dividend of previous year, interim dividend etc. Thus,
these items are not adjusted to arrive at Net Profit before Tax and Extra-ordinary items.
Only non-cash and non-current items like depreciation, amortisation of intangible assets
are added back and non-cash incomes or cash from non-operating incomes (i.e., interest
/ dividend received, Profit from Sale of Fixed assets / Investments etc.) are deducted to
arrive at Net Profit before tax and Extra-ordinary items.
➢ If Balance Sheet and Notes to Accounts are given: While computing Cash Flow from
Operating Activities from the contents of Balance Sheets, following points be taken care
of :
Reserves and Surplus: The difference between opening and closing balance of
Statement of Profit and Loss reveals profit/loss during year after all adjustments for
non-cash, items related to non-current items like depreciation, amortisation of intangible
assets and non-cash incomes or cash incomes pertaining to non-operating incomes like –
interest and dividend received, profit on sale of fixed assets. So all these items be
adjusted.
Short-term Provisions: It contains items like Provision for Tax, Provision for Doubtful
Debts, etc.
Provision for Tax: Current year figure is merely book entry during year and it will be
paid during next year. So current year provisions is added to Net Profit before Tax and
Extra-ordinary items and last year amount is paid during current year so it is shown as
last items while computing Net Cash Flow from Operating Activities.
Interim Dividend: It is paid during current year over and above the proposed dividend
of previous year so it is assumed that amount of provision and payment is same. It is
added to Net Profit before Tax and Extra-ordinary item and is also shown as a part of
financing activity.

Short-term Borrowings: It contains items like bank overdraft, cash credit, short-term
loans etc. So these are part of financing activities of the enterprise. These are ignored
while computing Cash Flow from Operating Activity.
Current Investments: As per syllabus contents, current investments are to be taken as
marketable securities unless otherwise specified. So these are part of cash equivalents
and ignored while computing Cash Flow from Operating Activity.
Interest on Borrowings: Interest on Debentures, Bonds, Bank Overdraft and Cash
Credit are added to Net Profit before Tax and Extra-ordinary item and are part of
financing activity.
Interest on Non-current Investments: It is deducted from Net Profit before Tax and
Extra-ordinary items as it is income from non-operating source. It is then added to Cash
Flow from Investing Activities.
➢ If Operating Profit is given: Since we are given Operating Profit, it means all non-
operating losses like loss on sale of fixed assets / investments, Preliminary Expenses
written off are not charged to arrive at Operating Profit.
Similarly, non-operating incomes like profit on sale of fixed assets / investments,
interest and dividend received are also not shown.
It means that appropriation of profits like profit transferred to General Reserve,
proposed dividend of previous year, interim dividend etc. are also not shown.
Since all items mentioned above are not shown to arrive at operating profit so these
items need not be adjusted to arrive at Cash Flow from Operating Activities.
Preparation of Accounts of Fixed Assets: Fixed assets account can be kept either on
(i) original cost basis or on (ii) written down value basis
(i) Fixed Assets Account (Original Cost Basis): Fixed assets are maintained or original
cost basis if “Accumulated Depreciation” or “Provision for Depreciation” accounts is
also given on liabilities side along with account of fixed asset. The fixed asset account
reveal information of asset purchased and sold during the period while provision for
depreciation account will reveal the amount of provision of depreciation for the period
concerned.
(ii) Fixed Assets Account (Written Down Value Method): Fixed assets account are
maintained on written down value method if Accumulated Depreciation / Provision for
Depreciation account is not given. Only fixed asset account will be prepared to find out
the information concerning purchase, sale and depreciation on asset during the year.
Some adjustments of Cash Flow Statement

1. Interest on Long-term Borrowings: Long-term borrowings include bonds, debentures,
deposits, loans etc. If rate of interest on borrowing is given, it should be assumed that
interest on the opening balance has been paid and addition or repayment of loan has
taken place at the close of accounting year in the absence of specific date given in the
question.
Accounting Treatment: Interest on long-term borrowing is added in Net Profit before
Tax and Extra-ordinary items in Operating Activities as payment of interest is non-
operating in nature and it is shown as payment in financing activities as it is a part of
financing activities.
2. Interest and Dividend on Non-current Investments: Non-current Investments

includes Bonds, Debentures, Equity Shares, Preference Shares, Deposits, Mutual Funds
etc. Thus interest / dividend received on investment on the opening balance be treated as
receipt and deducted from operating activity as income is non-operating in nature and
again it should be treated as income from investing activities. The addition / sale of
investment be assumed at the end of accounting period in the absence of specific date.
3. Profit on Sale of Investments is non-operating income so it should be deducted from

Net profit before Tax and loss on sale of investment and loss on sale of investment be
added to Net Profit before Tax and Extra-ordinary item as it is non-operating loss.
4. Depreciation on Fixed Assets: Fixed Asset’s account be opened in working notes.

Depreciation if given be charged.
(i) Depreciation charged be added to Net Profit before Tax as it is non-cash item in
the Cash Flow from Operating Activities.
(ii) Loss on sale of fixed asset should also be added to Net Profit before Tax as it is
non-operating loss.
(iii) Profit on sale of fixed asset should be deducted from Net Profit before Tax as it is
non-operating income.
(iv) Purchase of fixed asset is a use and sale of fixed asset is source of cash under
investing activities.
5. Provision for Taxation:

(i) If tax paid is given in adjustment only, it will be assumed that provision for tax and tax
paid remains same. So once it will be added to Profit before Tax in Operating Activities
and it will also be shown as tax paid in operating activities as last item.
(ii) If provision for tax is given under the head ‘Short-term Provisions’.
(a) Provision for tax for the last year is treated as tax paid during current year. It is
deducted from cash from operating activities.
(b) Provision for tax for the current year is added back to net profit as it is merely a
book entry during the current year and it will be paid only during next year.
Moreover, net profit before taxation and Extra-ordinary item is shown under the
head ‘Cash flow from Operating Activities’.
6. Proposed Dividend of Previous Year: As per AS-4 (Revised) on 6th April, 2016 and
adopted by the CBSE from the academic session 2019-20, proposed dividend becomes
liability of the company only when it is proposed by the Board of Directors in the
Annual General Meeting of the company and approved by the shareholders. It is
payable within 30 days from the date of approval in A.G.M. The A.G.M. of current year
will take place in next accounting year. Thus, proposed dividend of previous year will
only be approved by the shareholders in the A.G.M. during current accounting year.
Thus, due to amendment in AS-4 (Revised), proposed dividend of current and previous
year will not be shown in Balance Sheet under the head, current Liability under sub-
head, Short-term Provisions. It is now disclosed in Notes to Accounts as Contingent
Liability.
In the A.G.M. of Current year, proposed dividend on both equity shares and preference
shares of previous year is approved so it is appropriated as well as paid during current
year.
Treatment:
(i) Proposed Dividend of Previous Year is added to Net Profit before Tax and Extra-
ordinary items under the head, Cash Flow from Operating Activities and is also shown
as outflow of cash in Financing Activities. However, if Unclaimed Dividend is given
under the head, Current Liabilities under sub-head, Other Current Liabilities, dividend
payable less unclaimed dividend will only be treated as outflow of cash under Financing
Activities.
(ii) Proposed Dividend of Current Year is ignored and will continue to be shown in
Notes to Accounts as Contingent Liability.
(iii) Interim Dividend refers to dividend declared and paid by the Board of Directors during
the current year besides the Proposed Dividend of Previous Year approved by the
Shareholders in A.G.M.
(iv) Dividend Paid: If word dividend paid is given in additional information, it should be
treated s interim dividend paid i.e. added to Net Profit before Tax and shown as
payment of dividend in Financing Activities.
Dividend and Dividend Tax: As per law, dividend to shareholders is tax free and it is
the liability of the company to pay dividend tax to the government. Dividend tax will be
included in the provision for tax. Thus, its treatment will be
(i) Provision for tax of current year is added to Net Profit.
(ii) Last year provision for tax is divided into 2 parts – (a) provision for tax (b) dividend
tax. Dividend Tax is a part of financing activity along with dividend paid and provision
for tax is a part of operating activity.

XII Accountancy Notes All Chapters MR - Mohan H Baksani

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Chapter: Accounting for Partnership Firms – Fundamentals

Partnership is defined by Indian Partnership Act, 1932, Section 4 as follows:

➢ Features / Characteristics of Partnership:

2. Agreement: Partnership comes into existence by an agreement, either written or oral.

YOUTUBE CHANNEL: ACCOUNTANCY DIL SE… Page 1 of 176

YOUTUBE CHANNEL: ACCOUNTANCY DIL SE… Page 2 of 176

(3) Nature of Business (4) Capital Contribution

(5) Interest on Capital (6) Interest on Drawings

(7) Profit – sharing ratio (8) Interest on Partner’s Loan

(9) Salary / Commission (10) Accounting period

(11) Rights and duties of Partners (12) Auditing of Accounts

(13) Operation of Bank Account (14) Valuation of Goodwill

(15) Valuation of Assets (16) Duration of Partnership

(17) Settlement of Dispute

(18) Settlement in case of dissolution of firm

(19) Settlement of accounts in case of retirement or death of partner

(20) Rules to be followed while admitting a partner

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➢ Some other Provisions of Partnership Act. 1932.

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➢ Profit and Loss Appropriation Account:

Appropriation of profit is made up to the amount available for distribution. Thus,

➢ Features of Profit and Loss Appropriation Account:

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➢ Journal Entries relating to the Profit and Loss Appropriation Account

Date Particulars L.F. Debit (`) Credit (`)

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1. If a partner carries on a business that is similar to that of the firm in competition

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Date Particulars L.F. Debit (`) Credit (`)

➢ It is important to distinguish Loan Account and Capital Account of Partner

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➢ Appropriations are more than Available Profit:

The ratio of appropriation is determined as follows:

➢ Charge against Profits:

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Interest on Capital when Profit Available for Appropriation is Inadequate

Opening Capital: Interest on capital is allowed on the Opening Capital of the

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➢ Difference between Drawings Against Profit and Drawings Against Capital:

2. Part Part of Expected Profit. Part of Capital.

3. Effect It does not reduce capital. It reduces capital.

4. Int. on It is considered for calculating It is not considered for

5. Int. on It is not considered for calculating It is considered for calculating

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Average Period to be taken:

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Sometimes after closing the accounts of a partnership firm some errors or

Minimum Earnings guaranteed by a partner: A partner (or partners) may guarantee

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Characteristics / Features of Goodwill:

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➢ Methods of Valuation of Goodwill:

(ii) 𝑮𝒐𝒐𝒅𝒘𝒊𝒍𝒍 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑥 𝑁𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 ′ 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒

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(iv) Goodwill: 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝑋 𝑁𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 ′ 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒

(ii) 𝑆𝑢𝑝𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑜𝑟 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡

(ii) Compute Capital Employed

5. Capitalisation of Super Profit Method: In this method, Super profit is computed.

ACCOUNTING STANDARD – 26 (AS – 26)

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