Finantial Accounting Mca14

MCA-14-Financial Accounting: I. Financial Statements Financial Statements- meaning-Usefulness-Trading Account – Manufacturing AccountProfit and Loss A/c- Balance Sheet- Distinction between Fixed Assets and Current Assets-Tangible Assets and Intangible Assets- Distinction between Trading and Profit and Loss Account and a Balance Sheet-Distinction between a Trial Balance and a Balance Sheeet Introduction: Financial statements give detailed information about the firm. Financial statements are organized summaries of detailed information and are thus a form of analysis. The type of statement, the accountants prepares, the way they arrange items on these statements, and their standard of disclosure are all influenced by a desire to provide information in a convenient form. A financial statement is an organized collection of data according to logical and consistent accounting procedures. Its purpose is to convey financial information to concerned party. It may show the financial position of the business as on a particular day as in the case of balance sheet or disclose a series of activities during a given period, as in case of income statement or profit and loss account. The focus of financial analysis is on key figures contained in the financial statement. Financial statements are indicators of two significant factors, namely: a) Profitability b) Financial soundness Meaning of Final accounts of company : Section 209 of the Companies Act requires every company to maintain proper Books of accounts and section 210 has made it mandatory on the company to lay before its shareholders, at every annual general meeting, a balance sheet and profit and Loss account. Therefore every company is under legal obligation to present its accounts in the prescribed manner. The final accounts of a joint stock company refer to profit and loss account (Income Statement) and Balance Sheet (Position statement) prepared at the end of every year. Though the Act mentions only profit and loss account and Balance sheet, in practice Profit and Loss account is divided into Trading account, Profit and Loss account and profit and Loss Appropriation account. Trading account shows the result of trading by disclosing Gross Profit/Loss and Profit and Loss account shows the Net Profit/loss of the business.

Trading and Profit and Loss Account The Trading and Profit and Loss Account shows operating expenses and other expenses incurred by the company during the accounting period.It contains items as detailed below. Format of Trading and Profit and Loss account: Trading and Profit and Loss Account for the year ended.... Dr

TRADING ACCOUNT

Cr

--------------------------------------------------------------------------------------------------------PARTICULARS

Rs

PARTICULARS

Rs

To Opening stock

xxxx

By Sales

xxxx

xxxx

xxxx

less: sales returns

xxx

xxxx

By Closing Stock

Wages

xxxx

By Gross loss c/d

Fuel and power

xxxx

Coal,gas and water

xxxx

Freight

xxxx

Import duty

xxxx

Excise duty

xxxx

Octroi

xxxx

Royalty paid

xxxx

Other direct expenses

xxxx

To Gross profit c/d

xxxx

To Purchases Less purchase returns

xxx

xxxx xxx

To Direct/Mfg.expenses xxxx

.......

PROFIT AND LOSS ACCOUNT PARTICULARS

Rs

PARTICULARS

To gross loss b/d

xxxx

By gross profit b/d

xxxx

By interest received

xxxx

To Office/Admn. expenses

Rs

Salaries

xxxx

By discount received

xxxx

Rent,rates and taxes

xxxx

By commission received

xxxx

Printing &Stationery

xxxx

By rent received

xxxx

Postage & telegrams

xxxx

By dividend received

xxxx

Insurance

xxxx

By transfer fees

xxxx

Legal charges

xxxx

By Miscellaneous incomes

xxxx

Telephone charges

xxxx

By Net loss transferred to

Audit fees

xxxx

P&L Appn.account

Bank Charges

xxxx

General expenses

xxxx

Director’s fees

xxxx

Miscellaneous exps. xxxx To Selling &Distribution Expenses Advertising

xxxx

Travelling expenses

xxxx

Commission paid

xxxx

Discount allowed

xxxx

Carriage/freight outwards

xxxx

Bad debts etc. To financial expenses: Interest on loan

xxxx

Interest on debentures

xxxx

To provision for: Bad & doubtful debts

xxxx

Depreciation

xxxx

Repairs & maintenance

xxxx

Managerial remuneration

xxxx

To any other expenses

xxxx

To Net profit transferred To P&L Appropriation a/c

xxxx

--------------------------------------------------------------------------------------------------------xxxx xxxx

Profit and Loss Appropriation Account

xxxx

The Profit and Loss Appropriation account is prepared in order to show how the profits of the company are appropriated or allocated for various purposes such as payment of dividend, transfer to vaious reserves etc. Format of Profit and Loss Appropriation account Name of the company....... Dr

Profit and Loss appropriation account for the year ended....

Cr

--------------------------------------------------------------------------------------------------------Particulars To Balance b/d

Rs xxxx

Particulars

Rs

By balance b/d

(losses b/d from previous year)

(profit b/d from previous year)

To Net loss transferred

By net profit transferred

xxxx

from P&L a/c of current year

xxxx

from P&L a/c of current year

xxxx

To transfer to funds

xxxx

By transfer from any fund

xxxx

(Reserve fund, Sinking fund

By balance carried to

Dividend Equalization Fund etc.)

to assets side of the Balance sheet

To Dividend paid

xxxx

To Interim dividend

xxxx

To Proposed dividend

xxxx

To Balance carried to liabilities side of the balance sheet

xxxx

--------------------------------------------------------------------------------------------------------xxxx

xxxx

Differences between Profit and Loss account and Profit and Loss Appropriation account 1. Profit and loss account is prepared for recording expenses, losses, and gains of the current uear, whereas profit and loss appropriation acount is prepared for recording the appropriation of profit i.e how the profits are utilized for various purposes such as payment of dividend, etc. 2. Profit and Loss account is always prepared whereas the profit and loss appropriation account is prepared only when there is appropriation of profits. 3. The balance of profit and loss accounti.e net profit or loss is transfered to profit and loss appropriation account. On the other hand the balance of Profit and Loss Appropriation account is carried forward from year to year. 4. Profit and loss accunt discloses the net profit or net loss before appropriation whereas the closing balance of profit and loss appropriation account represents net

xxxx

profit appropriation.

or

net

loss

after

Balance sheet Section 211 provides that the balance Sheet shall give a true and fair value of the state of affairs of the company as at the end of the financial year and shall be in the prescribed form set out in part I of schedule VI. The balance Sheet is prepared in order to indicate the financial position of the company as on the last date of the trading period. The Balance sheet of a company can be drawn either in horizontal form or in vertical form. In the horizontal form of presentation assets are shown on the right hand side and liabilities are shown on the left hand side. In the vertical form, the liabilities are shown under the “Sources of funds” and assets are shown under the heading “Application of funds” given below are the two forms of Balance Sheet: Horizontal form: Name of the company Balance Sheet as at.... --------------------------------------------------------------------------------------------------------Liabilities Rs Assets

Rs

-------------------------------------------------------------------------------------------------------1. Share capital

1. Fixed Assets

Authorized: Shares of Rs... each

a) Goodwill

.....

Issued: Shares of Rs...each

b) Land

.....

Subscribed: Shares of Rs...each

c) Building

.....

Called up: Shares of Rs...each

d) Leaseholds

.....

Rs....called up

.....

e) Railway Sidings

.....

Less calls unpaid

.....

f) Plant and Machinery

.....

.....

g) Furniture and fittings

.....

.....

h) Development of property

.....

i) Patents, Trade marks & designs

.....

j) Live stock

.....

k) Vehicles

.....

Add: Forfeited Shares Paid up capital

.....

2. Reserves and Surplus 1) Capital Reserve

.....

2) Capital Redemption Reserve

.....

3) Securities premium a/c

.....

4) Other Reserves Less Debit balance in

......

2. Investments: 1) In Government Securities 2) In Shares, Debentures,

P& L Account, if any

.....

5) P & L Appropriation a/c

3) In immovable Properties .....

3) Current Assets, Loans

6) Proposed Addition to reserve

& Advances

7) Sinking Funds

A) Current Assets

3. Secured Loans:

1) Interst accured on investments

.....

2) Stores and Spare parts

.....

3) Loose Tools

.....

4) Stock in Trade.....

.....

5) work in progress

.....

1) Debentures

.....

2) Loans and advances from Banks

.....

3) Loans and Advances from subsidiaries

.....

6) Sundry Debtors

.....

4) Other Loans and Advances

.....

7) Cash Balance on hand

.....

8) Bank Balance

.....

4. Unsecured loans 1) Fixed Deposits

.....

B) Loans and Advances

2) Loans and Advances

9) Loans and Advances

3) Short-term loans & Advances:

to subsidiaries

a) From Bank

.....

10) Bills of exchange ie.,Bills

b) From Others....

Receivable .....

11) Prepaid expenses

5. Current Liabilites

4. Miscellaneous Expenditure

and Provisions

1) Preliminary expenses

(A) Current Liabilites

2) Expenses including commission

1) Acceptances (B/P)

.....

or brokerage on underwriting of

2) Sundry Creditors

.....

Shares or Debentures

3) Outstanding expenses

.....

4) Income recieved in advance

.....

3) Discount allowed on

5) Unclaimed Dividends

.....

issue of shares

6) Other Liabilities

.....

or debentures

(B) Provisions

4) Development expenditure

7) Provision for Taxation

.....

not adjusted

8) Proposed dividends

.....

5) Other sums

9) Provision for Contingencies

.....

5. Profit & Loss Account

10) Provision for Insurance,

Debit balance of profit

Pension and Similar Staff

and loss accounts

..... ....

Benefit Scheme

.....

which could not be deducted

11) Other Provision

.....

from free reserves, if any

Total ..... Total..... ---------------------------------------------------------------------------------------------------------

Vertical form of Balance Sheet: Balance sheet as on.......... --------------------------------------------------------------------------------------------------------Schedule No. Figures as ath the Figures as at the End of the current end of the previous Financial Year Financial year --------------------------------------------------------------------------------------------------------Rs. Rs. I Sources of Funds 1. Shareholders Funds a) Capital b) Reserves and Surplus 2. Loans Funds: a) Secured Loans b) Unsecured Loans Total II Application of Funds: 1. Fixed Asets: a) Gross Block b) Less Depreciation c) Capital Work-in-progress 2. Investments 3. Current Assets, Loans and Advances: a) Inventories b) Sundry Debtors c) Cash and Bank balances e) Loans and Advances Less: Current Liabilities and Provisions a) Liabilities

.....

b) Provisions Net Current Assets 4. a) Miscellaneous expenditure (to the extent not written off or adjusted) b) Profit and Loss account (Debit Balance) -------------------------------------------------------------------------------------------------Total ------------------------------------------------------------------------------------------------Details under each of the above items are to be given by way of a separate schedule. The schedule incorporates all the information required. TRIAL BALANCE: Trial Balance is a statement showing Debit and Credit Balances of Accounts obtained after balancing them. It contains two separate sides called debit side and credit side. The totals of both debit side and credit side of the trial balance should be equal keeping in conformity with the basic rule of double entry book keeping that every debit should have a corresponding credit. There are mainly two methods of preparing the trial balancenamely; The Balances method and the totals method. Under the Balances method only balances obtained by balancing various accounts will be listed. Under the totals method, the totals of accounts are listed. A third method of showing both totals and balances is also used rarely. Differences between Trial Balance and Balance sheet: .1. A trial Balance shows balances of all the accounts maintained where as a balance sheet shows the balances of Assets and Liabilities only. 2. A trial balance may be prepared in any format as long as debit and credit balances are shown. It is not a statutory document. Balance sheet has to be prepared keeping in mind the provisions of companies act. 3. A trial Balance has debit and credit columns where as a Balance sheet has Liabilities and Assets columns. 4. A trial Balance shows only balances of various accounts, whereas a Balance sheet shows financial position of a company as at the end of an accounting period.

Important points to be considered while preparing the final accounts of companies Treatment of some items while preparing final accounts:

1.Outstanding or Accrued Expenses: Expenses which have been incurred during the year, the benefit out of which has been derived during the year, but the payment in respect of which the payment has not been made is called accrued expense. It is shown on the debit side of the profit and loss account. It will also be shown in the Balance sheet on the liability side. 2.Accrued or outstanding income: These are incomes or benefits which have been earned but not yet received in cash during the year. It will be shown on the credit side of the Profit and Loss account and it also appears on the Asset side of the Balance sheet. 3.Prepaid or unexpired expenses: In some cases the benefits of payment made during the previous year will be available in the next year also. It is shown in the balance sheet as an asset. It is shown as a deduction from the account concerned on the debit side of the profit and loss account. 4.Capital and Revenue expenditure: Of the total expenditure incurred by a company during a year, two types are there, viz.Capital Expenditure and Revenue Expenditure. Revenue expenditure are shown in the Profit and loss account. The benefit derived from revenue expense are having benefits during a short period. The capital expenses are shown in the balance sheet and the benefits derived from capital expenditure are long range. Viewed from this angle, the profit and loss account is called Revenue Account. 5.. Calls in arrears: Calls-in-arrears represent the amount not paid by the shareholders on the calls made by the company. This items usually appears on the debit side of the trial balance and in the balance sheet it should be shown by the way of deduction from called-upcapital. 6. Calls in advance: Calls in advance represent the amount received from the shareholders before calls are made by the company. It is shown separately as an item under the heading ‘share capital’. It should not be added to called up or paid up capital. 7. Forfeited shares: It represents shares forfeited by the company for the non payment of allotment money or/and call money.It is shown on the liabilities side of the balance sheet by way of addition to the paid up capital. 8. Preliminary expenses: They represents expenses incurred in the formation of a company. They are entered on the assets side of the balance sheet under the heading ‘Miscellaneous expenditure’ However, preliminary expenses written off should be debited to profit and loss account. 9. Dividend: Dividend refers to that portion of profits of a company distributed among the shareholders. If it appears in the trial balance (debit balance) it should be shown on the

debit side of the profit and loss appropriation account. On the other hand, if it appears in the adjustment, first it should be shown on the debit side of the profit and loss appropriation account and secondly it should be shown as a liability under the heading ‘provisions’ in the balance sheet. 10. Interim dividend: It is the dividend declared by the directors of company in the middle of the year in anticipation for the profits of the current year. It should be shown on the debit side of the profit and loss appropriation account. 11. Final dividend: It is the dividend recommended by the directors and approved in the annual general meeting by the shareholders. When the final dividend is declared, the interim dividend already declared and paid should not be adjusted against the final dividend, unless otherwise instructed. Final dividend appearing in the adjustments should be first entered on the debit side of the profit and loss appropriations account and secondly it should be recorded as a liability in the balance sheet under the head “Provisions”. 13. Proposed dividend: it is dividend proposed by the directors and it is usually given in the adjustment. Therefore it should be recorded on the debit side of profit and loss appropriation account and also shown as a liability in the balance sheet under the heading “provisions”. Further when dividend is to be calculated as a percentage on share capital, it should be calculated only on paid up capital (i.e, called up capital less calls in arrears) 14. Unclaimed dividend: It represents dividend not collected by the shareholders from the company. Therefore it is a liability and shown under the heading “current liabilities” in the balance sheet. 15. Dividend received: It represents income of the company on investments made by it in the shares of other companies. It appears as a credit balance in the trial balance and hence recorded on the credit side of the profit and loss account. Illustration -1 From the following information of Ajantha limited, prepare Trading and profit and loss account for the year ended 31-12-2005 Opening stock

16,000

Purchases

28,600

Sales

50,900

Purchases returns

600

Sales returns

900

Wages

2,400

Salaries

2,800

Directors Fees

2,000

Gas and water

1,100

Carriage inwards

1,600

Trade expenses

2,000

Rent, rates and insurance

1,100

Discount allowed

400

Discount received

200

Bad debts

1,200

Audit fees

1,400

Interim dividend

2,800

Preliminary expenses written off

400

Profit and Loss appropriation a/c (cr)

3,000

Adjustments: Closing stock

16,000

Transfer to general reserve

2,200

Depreciation on machinery

1,300

Solution Trading and profit and loss Account for the year ended 31-12-2005 Dr.

Cr.

--------------------------------------------------------------------------------------------------------Particulars

Rs

To opening stock To Purchases

16,000 28,600

Particulars By Sales Less sales returns

To Carriage inwards

1,600

To Wages

2,400

To Gas and water

1,100

To Gross profit c/d

16,900

Rs 50,900 900

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

50,000

66,000

66,000

--------------------------------------------------------------------------------------------------------To Salaries

2,800

By Gross profit b/d

To Trade expenses (Gen expenses)

2,000

By Discount received

To Rent, rates and insurance

1,100

To Directors Fees

2,000

To Audit Fees

1,400

To Prel.expenses written off

400

To Discount allowed

400

To Bad debts

1,200

To Depreciation on machinery

1,300

16,900 200

To Net profit transferred to profit and loss appropriation a/c

4,500

--------------------------------------------------------------------------------------------------------17,100

17,100

--------------------------------------------------------------------------------------------------------Dr.

Profit and Loss Appropriation account for the year 31-12-2005

Particulars

Rs

Particulars

Cr. Rs

To Interim dividend

2,800

By bal c/d (last year’s bal)

3,000

To Transfer to Gen. reserve

2,200

By current year’s profit b/d

4,500

To Balance carried to Balance sheet

2,500

--------------------------------------------------------------------------------------------------------7,500

7,500

--------------------------------------------------------------------------------------------------------Illustration - 3 From the following balances of the Bahubali Trading company Ltd., for the year ended 31-12-2005, prepare profit and Loss appropriation Account and Balance sheet after transferring Rs. 20,000 to reserve fund, Rs. 10,000 to Dividend Equalization Fund and Rs. 6,000 to Insurance Fund from the current year’s profit. Rs. Share Capital

20,000

Reserve Fund

34,000

Dividend Equalization Fund

16,000

Insurance Fund

8,000

Land & Buildings

1,00,000

Profit & Loss Appropriation A/c (Cr)

14,000

Profit & Loss Account (Current year Net profit)

42,000

Machinery

12,000

Interim dividend paid

12,000

Stock

48,000

Debtors

50,000

Creditors

20,000

Cash

30,000

Security premium A/c

2,000

Forfeited Shares A/c

4,000

Calls in Arrears

20,000

Solution - 3 Bahubali Trading Co., Ltd., Profit and Loss Appropriation A/c for the year ended 31-12-2005 Dr.

Cr.

--------------------------------------------------------------------------------------------------------Particulars

Rs

Particulars

Rs

To Interim Dividend

12,000

by Balance B/d

14,000

To Transfer to reserve fund

20,000

By Current years Net profit

42,000

To Transfer to Dividend Equalization fund To Transfer to Insurance fund

10,000 6,000

To Balance carried to Balance sheet

8,000

--------------------------------------------------------------------------------------------------------56,000

56,000

Bahubali Trading Co., Ltd., Balance sheet as on 31-12-2005 Liabilities

Rs

Assets

Rs

--------------------------------------------------------------------------------------------------------1. Share Capital

1. Fixed Assets

Authorised capital

2,00,000

Land & Buildings

Issued & Subscribed

2,00,000

Machinery

Called up Less calls in arrears

2,00,000

1,00,000 80,000

2. Investments------------------------

20,000

3. Current assets and--------------------

1,80,000

Loans and Advances--------------------

Add forfeited Shares

4,000

Paid up capital

A. Current Assets 1,84,000

2.Reserve & Surplus: Reserve Fund

34,000

Add Addition -

20,000

54,000

Dividend

Stock

48,000

Debtors

50,000

Cash

30,000

B. Loans & Advances 4. Miscellaneous Expenditure---------

Equalisation Fund

16,000

Add Additions

10,000

Insurance Fund

8,000

Add. Additions

6,000

26,000 14,000

Security premium

2,000

Profit & Loss Appropriation A/c

8,000

3. Secured Loans

-

4. Unsecured Loans

-

5. Current Liabilities & Provisions: A. Current Liabilities Creditors

20,000

B. Provisions --------------------------------------------------------------------------------------------------------3,08,000 ----------------------------------------------------------------------------------------------------------

3,08,000

Illustration Following is the trial balance of Cheman Company Ltd”. As on 31st December, 2004 Prepare trading account, Profit and loss account, profit and loss appropriation account and balance sheet. -----------------------------------------------------------------------------------------------------Particulars

Dr.

Cr.

Rs.

Rs.

-------------------------------------------------------------------------------------------------------Capital

-

2,00,000

1,30,000

-

Investments

60,000

-

Machinery

15,000

-

Furniture

4,000

-

Bills receivable

6,400

-

Carriage inwards

2,500

-

Wages

21,000

-

Salary

8,500

-

-

5,000

60,000

1,10,000

Returns

2,000

1,000

Rent and rates

1,800

-

Preliminary expenses

6,000

-

Debtors and Creditors

42,000

15,000

2,500

10,000

-

14,000

30,000

-

Insurance

1,300

-

Discount

2,000

-

-

40,000

(2500 shares of Rs. 100 each on which Rs. 80 called up Land and Buildings

Bills payable Purchases and Sales

Advertising & Reserve Fund Profit and Loss a/c Stock (1-1-94)

5% debentures

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

3,95,000

3,95,000

--------------------------------------------------------------------------------------------------Adjustments: a) Write off Rs. 2,000 from preliminary expenses b) Transfer Rs. 10,000 to reserve fund c) Stock on 31-12-2004 Rs. 65,000 d) Provide for dividend on share capital at 10% e) Debentures interest is outstanding for one year Solution -4 Cheman Company Ltd., Dr.

Trading and Profit and Loss Account for the year ended 31-12-2004

Cr.

--------------------------------------------------------------------------------------------------------Particulars

Rs

Particulars

To Opening stock

30,000

By Sales

To Purchases

60,000

Less Purchase returns

1,000

To Carriage inwards

Less sales returns 59,000

Rs 1,10,000 2,000

By Closing stock

1,08,000 65,000

2,500

To Wages

21,000

To Gross profit c/d

60,500

--------------------------------------------------------------------------------------------------------1,73,000 To Salaries

8,500

To Rent & rates

1,800

To Advertising

2,500

To Insurance

1,300

To Discount

2,000

To Preliminary exp.written off

2,000

To Interest due on Debentures

2,000

[4,000x5/100] To Net profit transferred to profit and loss appropriation a/c

40,400

1,73,000 By Gross profit b/d

60,500

--------------------------------------------------------------------------------------------------------60,500

60,500

--------------------------------------------------------------------------------------------------------Dr.

Profit and Loss appropriation A/c for the year 31-12-2004

Cr.

--------------------------------------------------------------------------------------------------------Particulars

Rs

Particulars

Rs

--------------------------------------------------------------------------------------------------------To Transfer to Reserve fund

10,000

By BalanceB/d

14,000

(Last year’s profit) To Proposed dividend

20,000

By Current year’s Net profit

40,400

[2,00,000x10/100] To Balance carried to Balance sheet

24,400

------------------------------------------------------------------------------------------------54,400

54,400

Balance Sheet as on 31-12-2004 -----------------------------------------------------------------------------------------------Liabilities

Rs

Assets

Rs

-----------------------------------------------------------------------------------------------1. Share Capital Authorised capital

1. Fixed Assets 2,50,000

Land & Buildings

2,500 share of Rs. 100 each

Machinery

Issued & Subscribed 2,500

Furniture

shares of Rs. 100 each

2. Investments

Called up and paid up

2,50,000

15,000 4,000 60,000

3. Current Assets &

2500 shares of Rs.100

Loans and Advances

each, 80 called up and paid up

A. Current Assets

2,00,000

1,30,000

Stock

65,000

Debtors

42,000

B. Loans and Advances

Bills Receivable

6,400

2. Reserves & Surplus: Reserve Fund

10,000

Add. Additions

10,000

4. Miscellaneous Expenditure 20,000

Profit and Loss Appropriation A/c

Preliminary Exps.

6,000

Less written off

2,000

4,000

24,400

3. Secured Loans 5% Debentures

40,000

Add interest due

2,000

42,000

4. Unsecured Loans 5. Current Liabilities and Provisions A. Current Liabilities Creditors Bills payable B. Provision: Proposed Dividend

15,000 5,000 20,000

------------------------------------------------------------------------------------------------------3,26,400 ---------------------------------------------------------------------------------------------------------****************

3,26,400

2. Consignment Accounts CONSIGNMENT Consignment: Sometimes businessmen appoint their agents at distant place to sell their products or goods with a view to increase the sales and earn larger profits. Goods are sent to these agents who sell them on commission on account and risk of the principal. The Word “consignment” is derived from these types of principal agent relationships and implies sending of goods to another person without transferring the ownership to that other person. In such a case, if the goods do not fetch the required price or are destroyed, the loss will be borne by the person who sends them. In consignment business, generally there are two parties-the consignor and the consignee. The person who sends the goods to the agent for sale is called the consignor. The person to whom the goods are sent for sale is called the consignee. The consignee sells the goods and remits the proceeds to the consignor after deducting his expenses.

Consignment Terminology 1. Consignment A/c. : A consignment account is separately prepared which is debited with the cost of goods supplied and expenses incurred both by the consignor and the consignee. It is credited by the sales proceeds and the stock of unsold gods. Consignment account reveals profit or less on consignment which is transferred to profit and loss A/c. Goods sent to an agent for the purpose of sale cannot be treated as sales. The transfer of such goods is credited to Goods sent on Consignment A/c and debited to Consignment A/c. 2. Account Sales. This is a statement of account prepared and sent by the agent to the principal. After a certain period of time, the agency (consignee) prepares the account sales which show the quantity and description of goods sold, sales proceeds realized, the expenses incurred by consignee, his commission and the balance amount payable by him to the principal. The account sales is rent to the consignor, who makes entries in Consignment A/c and consignee’s A/c and ascertains the amount of profit or loss on consignment. (A specimen of Account sales is given below.) Account Sales of 200 Transistor received from and sold on behalf And at the risk of M/s Shri Sounds, Bangalore. ------------------------------------------------------------------------------------------------------Date

Particulars

Amount

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

Total

1976 Sept.30

150 Transistors Sold @ Rs.150 each 50 Transistors Sold @ Rs.180 each Less: Expenses Incurred: Cartage and Freight Insurance Godown rent Commission @ 10% of sales

22,500 9,000

31,500

250 150 100 3,150

Less Bill accepted by us Bank Draft enclosed

3,650 27,850 10,000 17,850

--------------------------------------------------------------------------------------------------------E.& O.E. For Shri Sounds Ramesh, Partner

3. Consignee’s Commission. Commission is the remuneration paid to the consignee by the cosignor is consideration of the services provided by him in selling the goods consigned. This is given over and above the amount of expenses incurred by consignee on sale of goods. Commission is paid at an agreed percentage over the sales proceeds. It thus depends on the amount of sales done by the consignee. 4. Del Credere Commission. Sometimes the consignor expects that the consignee should himself recover all the debts and bear the loss, on account of bad debts, if any. In order to compensate him from this type of loss, some extra commission is paid to him. This extra commission is called Del Credere commission and is calculated on the total amount of sales unless there is a special agreement that it is to be paid only on the amount of credit sales. Payment of this commission imposes extra liability on the consignor and induces him to deal in a prudent and cautions manner became otherwise loss on account of bad debts will be borne by him. 5. Proforma Invoice. As already stated, goods sent on consignment cannot be treated as sale therefore invoice can’t be prepared in respect of such goods. Therefore, the consignor sends a proforma invoice (invoice for form’s sake to the consignee so as to inform him about the cost of goods supplied, expenses incurred and a minimum sale price to be charged by him on sales. A proforma invoice also includes information about the quantity and description of goods, the number and weight, mark, packing of the containers of goods and so on.

A proforma invoice may reflect (i) actual cost and expenses incurred by the consignee or it may be prepared at (ii) inflated price of goods so that consignee may not know the actual cost of the goods. The main object for which inflated proforma invoice is prepared is to ensure a minimum margin of profit over the cost of goods supplied to the consignee. 6. The Consignee. The consignee does not become the owner of goods on receiving the consignment. H remains as an agent of the consignor. The law of agency applies between consignor-consignee relationships. The consignee is to sell the goods consigned to him. If he has incurred some expenses, such as advertisement, insurance, godown rent, salesmen’s salaries etc., he can recover them from the amount of sales proceeds received by him. We can also charge his commission, including del Credere commission out of the sales proceeds. He is not liable to make payment to the consignor until the goods are sold. When goods are sold out or after a certain period of time, he sends an account sales to the consignor giving details of the goods sold, his expenses and commission and the balance payable by him to the consignor. Difference between a Consignment and a Sale: 1. In a sale, the relationship between the parties is that of a buyer and seller whereas in a consignment, the relationship is that of an agent and principal. 2. Where a sale is complete, the buyer becomes the debtor of the seller but in a consignment, the consignee does not become debtor of the consignor on receipt of the consignment. 3. In case of a sale, the legal ownership and title of goods sold of transferred to the buyer whereas in a consignment, the legal ownership and title over goods remains with the consignor. 4. Goods can’t be returned after the sale is complete. But in the case of consignment, the consignee can return the unsold goods to the consignor. 5. In case of a sale, expenses incurred by the buyer on goods after sale are to be borne by the buyer himself. But in a consignment, consignee can recover the amount of expenses incurred by them on the goods consigned. 6. If goods are destroyed after sale, buyer only will suffer the Loss, because he becomes the owner of goods, after sale. But in case of consignment, risk attached to the goods is borne by the consignor and not the consignee. ACCOUNTING TREATMENT Accounting Treatment. Journal entries in the books of the consignor and the consignee relating to the transactions of consignment will be made in the manner discussed below:

1. When goods are sent to the consignee. As consignment of goods can’t be treated as sales of goods, sales account will not be credited in the books of the consignor. In its place, an account entitled goods sent on consignment account will be credited. The following entry will be recorded: Consignor’s Books Consignee’s Books Consignment Account Dr. No Entry To Goods sent on Consignment Account The entry in consignor’s books will be made with the cost of the goods consigned. If consignments have been sent to more than one consignees, the consignment accounts may be distinguished by adding the names of the place or the consignees along with the Consignment A/s, (for example Consignment to Bombay A/c, Consignment to Ramesh A/c etc.) It may be noted that no entry will be passed by the consignee. 2. Consignor’s Expenses. All expenses incurred by the consignor on consignment of goods to the consignee are debited to the consignment account and are thus added to cost of goods consigned. The following entry will be recorded in this connection. Consignor’s Books Consignment Account To Cash Account

Dr.

Consignee’s Books No Entry

It may be noted that no entry will be recorded in the books of the consignee in this respect. 3. Advance Remittance by Consignee. Usually the consignee remits a certain sum of money either by way of cash, bank draft or accepting a bill of exchange as a security against the goods received by him on consignment. The amount of advance can’t be treated as sales proceeds and therefore should not be credited to the consignment account. The following journal entries will be recorded in this connection:

or or

Consignor’s Books Cash Account Bank Account Bills Receivable Account To Consignee

Dr. Dr. Dr.

Consignee’s Books Consignor To Cash Account or To Bank Account or To Bills Payable

Dr.

4. On discounting the bill, If consignor gets the bill receivable discounted from his bankers, the following entry will be recorded in his books: Consignor’s Books Bank Account Dr. Discount Account Dr. To Bills Receivable Account

Consignee’s Books No Entry

The amount of discounts is not debited to Consignment Account. 5. Consignee’s Expenses. Sometimes the consignee also has to incur some expenses either on the upkeep and maintenance of the goods in safe condition or on their sale. These expenses may be freight, cartage, godown rent, advertisement, insurance

charges etc. All such expenses are to be borne by the consignor. The following entries will be recorded in the books in this connection: Consignor’s Books Consignment Account To Consignee’s A/c

Consignee’s Books Consignor Dr. To Cash Account

Dr.

6. Goods sold by Consignee: When the goods are sold out or after a certain period of time, the consignee will send an account sales to the consignor, intimating him the total sales and the amount of his expenses and commission, with the amount of total Gross sales, the following entries will be recorded in books of the consignor and the consignee: Consignor’s Books Consignee’s A/c To Consignment Account

Consignee’s Books Dr. (i) For Cash Sales: Cash or Bank Account Dr. To Consignor’s A/c (ii) For Credit Sale: Consignment Debtors Account Dr. To Consignor’s A/c (iii) When Cash received from Debtors: Cash or Bank Account Dr. To Consignment Debtors Account 7. Consignee’s Commission: The consignee is entitled to commission at an agreed rate on the gross sales proceeds. The Commission is paid in consideration of the services provided by him in selling the goods. Commission paid to consignee is debited to consignment account in consignor’s books. To the consignee, the amount of commission is an item of income therefore commission account is credited for it. The following entries are recorded: Consignor’s Books Consignment Account Dr. To Consignee’s A/c (commission)

Consignee’s Books Consignor A/c Dr. To Commission Account

8. Goods returned by Consignee: Sometimes defective or obsolete goods are returned by the consignee to the consignor. When such goods are received book the consignor records this transaction by making the following journal entry: Consignor’s Books Goods sent on Consignment Account

Consignee’s Books Dr.

To Consignment A/c

No Entry

It may be noted that no entry will be recorded in the books of the consignee for this transaction as he is not required to maintain accounts for goods received on consignment. 9. Bad Debts: When Del Credere commission is paid. Del Credere commission is paid to the consignee, if he undertakes to bear the bad debits himself. In case, some debits are not recorded from consignment debtors, the following entries will be recorded in the books: Consignor’s Books No Entry

Consignee’s Books Bad Debts Account To Consignment Debtors Account

Dr.

10. Remittance by Consignee in settlement of account. Out of the sales proceeds collected by the consignee, the following items are deducted: expenses incurred by consignee, his commission (ordinary and del Credere) and the advance remittance made by him. The balance made by him. The balance amount will have to be remitted by the consignee to the consignor in settlement of the account. The following entries, in this connection, will be recorded: Consignor’s Books Cash or Bank Account To Consignee’s A/c

Dr.

Consignee’s Books Consignor A/c Dr. To Cash or Bank Account

11. Unsold stock with the Consignee. It at the end of the accounting period, some goods remain unsold with the Consignee, the value of such goods be ascertained. The value is ascertained should be shown in the asset side of the consignor’s balance sheet. Valuation of stock. The unsold stock with the consignee is to be valued like ordinary stock. The method of valuation of unsold stock is cost or market price whichever is lower. Cost price of the unsold stock must included proportionate expenses incurred by the consignor as well as the consignee relation to the goods sent on consignment. But consignee’s commission selling expenses, salesmen’s salaries, advertisement etc. Should be included in such expenses. It may be expressed in simple terms like this: “All expenses which of incurred up to the point of time; the goods are received into the godown after consignee should be included in valuation of stock. But expenses incurred after the goods have been put into consignee’s godown should not be included in the cost of unsold stock because such expenses usually do not increase the value of the goods.” The following expenses, which are of non-recurring nature, should be proportionately added to the value of the unsold stock: Carriage, Freight,

Custom Duty, Loading and unloading charges, Insurance, Dock Charges, Import duty, Normal loss etc, The Following expenses, which are of recurring nature, should not be included in the value of the unsold stock: Advertisement, Godown Rent, Godown Insurance, Selling expenses, Travelling expenses of Salesmen, Free Samples, Abnormal loss etc. The following entry is passed to record the value of unsold stocks: Consignor’s Books Consignee’s Books Consignment Stock Account Dr. To Consignment Account No Entry. 12. Normal loss of goods.: In consignment business, Normal loss of goods is that part of loss which is unavoidable. Normal loss occurs because of some inherent, natural or unavoidable reasons. Examples of normal loss are: loss of coal in loading and unloading, loss of spirit or petrol due to evaporation, loss of timber in cutting it into pieces and so on. Suppose 100 tons of atta at the rate of Rs. 80 per ton was consigned to the consignee who received 95 tons of coal and the remaining 5 tons of atta was wasted in loading and unloading. It can legitimately be said that the cost of 95 tons of atta is Rs. 7600 (95 Tons X Rs.80 per ton). Loss of normal type should be apportioned on the amount of unsold stock in the proportion of the above example,if 10 tons of atta was left unsold with the consignee, it will be valued like this: 7600 X 10= Rs.800. 95 In the case of normal loss of goods, no entry is to be passed in the books of the consignor as well as the consignee. 13. Abnormal loss of goods. Abnormal loss is that loss which could have been avoided. It occurs because of negligence, carelessness, theft, mischief fraud of employees or inefficiency. Examples of abnormal loss are destruction of goods by fire theft, breakage, leakage, loss of goods because of mishandling etc. Loss of this nature is to be treated separately. It is not to be apportioned on the amount of unsold stock. The cost of goods lost because of abnormal or avoidable reasons is ascertained din the same manner as cost of unsold stocks is ascertained. This value is debited to abnormal loss account and credited to consignment Account. The following entry is passed to record abnormal loss of goods:

Consignor’s Books Abnormal Loss Account Dr. To Consignment Account

Consignee’s Books No Entry

It is to be noted here that abnormal loss account is finally closed by debiting the balance of this account to the profit and loss account after giving credit for any amount received from the insurance company. 14. Profit or Loss on Consignment. The balance of the consignment account in the books of the consignor will now show the amount of profit or loss on consignment. The following journal entries are recorded in the connection: Consignor’s Books Consignee’s Books (i) In case there is profit Consignment Account Dr. No Entry To Profit & Loss Account (ii) In case there is loss: Profit and Loss Account Dr. No Entry To Consignment A/c After making this entry, the consignment account will be closed. 17. Closing Entry for Goods sent on Consignment Account. When the goods have been sold out by the consignee, they can be treated as sales and may be credited either to Purchases account or trading account at the end of the period. The entry to close goods sent on consignment account is given below: Consignor’s Books Goods Sent on Consignment account Dr. To Trading Account

Consignee’s Books No Entry

Consignment Account A Consignment account is prepared by the consignor of goods to the consignee, All transactions such as cost of goods supplied, expense incurred by consignor or consignee, consignee’s commission, sales, unsold stock, profit or loss on consignment are to be recorded through this account. This account presents a summary of the transactions that have taken place between the consignor and the consignee. The consignment account reveals profit or loss on consignment and is thus a mini trading and profit and losses account Consignment account is a nominal account. Therefore the following items are debited to this account: 1) Cost of goods sent on Consignment 2) Expenses incurred by the consignor 3) Expenses incurred by the consignee

4) Consignee’s commission. 5) Bad debts when Del Credere commission is not paid. 6) Profit on consignment. The following items are credited to the consignment account: 1. Sales proceeds. 2. Returns of goods by consignee. 3. Abnormal loss of goods. 4. Unsold Stock with the consignee. 5. Loss on consignment (if any). Performa of a consignment account is given below:

Consignment Account Consignment to ………………….Account ----------------------------------------------------------------------------------------------------------Date Particular Amount Date Particulars Amount Rs. To Goods sent on Consignment A/c” !! Cash (Expenses Incurred by consignor)” !! Consignee (consignee’s

Expenses)”

Rs. By Consignee(Sales Proceeds)” !! Goods sent on Consignment (Returns of goods by consignee)”

!! Consignee (Commission)”

!! Abnormal Loss A/c”

!! Consignee (Bad Debts)” Profit &

!! Consignment Stock A/c

Loss A/c ( Profit on consignment

stock) (By Profit & Loss A/c)

(unsold

transferred to Profit & Loss A/c)

(Loss on consignment, if any, transferred to Profit & Loss A/c)

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

METHODS OF ACCOUNTING There are three different method of preparing accounts relating the consignment of goods. These are: 1.

Cost Price Method

2.

Invoice Price Method

3.

Memorandum Columns Method

1. Cost Price Method: Under this Method entries relating to consignment in the books of consignor or passed with the actual cost of goods and amount spent or expenses incurred by him. The journal entries already mentioned in a previous question will be passed in the books of consigner under this method. 2. Invoice Price Method (When consigned goods are invoiced at higher than actual cost price). Sometimes the consigner sends a Performa invoice to the consignee. In a Performa invoice goods are generally priced at higher than actual cost say cost plus 20 percent. This may be done with any of the following objective. 1. Not to disclose actual cost of goods to the consignee 2. Suggesting the consignee a minimum cost price which already includes some profit margin. 3. To ensure minimum amount of profit and consignment. 4. To Provide for all the expenses and consignee’s commission in the invoice price. 5. To discourage consignee from starting competing business. If the goods are invoiced at cost plus 10per cent and the cost of goods is Rs. 20,000, these will be invoiced at Rs.22,000 in the Performa invoice. A difference of Rs. 2,000 will then arise in the books of accounts. In order to nullify the effect of such difference, some entries are passed by the consignor in his books of accounts. 1. Recording Performa Invoice Price. Referring to above example when goods are invoiced at higher then cost price, the following entry will be recorded by the consignor on consignment of goods: Consignment A/c

Dr. Rs.22, 000

To Goods sent on Consignment

22,000

2. Recording the difference of invoice & cost price. In order to nullify the difference of Rs.2,000 between invoice and cost price, the following entry is recorded by the consignor in his books of accounts: Goods sent on Consignment A/c To Consignment A/c

Dr.Rs.2, 000 2,000

The effect of this entry is to show the actual cost of goods consigned in the consignment account so that profit or loss on consignment can be properly calculatedly. This entry is in one sense an adjusting entry which adjusts both the consignment account and the goods sent on consignment account. Goods sent on consignment account are to be transferred to the trading account at the end of the year. Therefore unless this account is adjusted, trading account will not show correct figures of profit or loss.

3. Unsold Stock. The unsold amount of stock in the hands of the consignee is to be valued at invoice price plus the proportionate share of expenses includable in the value of goods. For example, if in the above example, 25% goods are buying unsold and proportionate expenses on these 25% goods are Rs. 300, the amount of unsold stock will be calculated as under: Invoice price of goods

Rs.22, 000

Value of 25% goods

Rs. 5,500

Add Proportionate expenses

Rs.

Value of unsold stock

Rs. 5,200

300

The following entry will be passed to record this value of unsold stock: Consignment stock A/c

Dr.

.5,200

To Consignment A/c

. 5200

4. Recording the difference of invoice and cost price of unsold stock. The value of closing stock must be ascertained by the consignor at cost or Market value whichever is lower, But the value of closing stock, recorded above does not conform to this principle. In the above example, the cost of 25% unsold stock is Rs. 5,000 (25% of Rs.20,000) but the invoice price of 25% unsold stock is Rs. 5,500 (25% of Rs.22,000), the difference of Rs.500 in the valuation of closing stock has got to be adjusted by passing the following entry: Consignment stock A/c To Consignment Stock Suspense A/c

Dr.

Rs.500 Rs.500

This entry will be adjusting the excess of invoice price over cost price of unsold stock. Consignment stock suspense is deducted from consignment stock account to ascertain the cost of unsold stock with the consignee. It is important to note here that there is no difference in the entries to be passed in the books of the consignee. 5. Memorandum Columns Method: It is a combined method recording transactions at both the invoice and the cost price. For this purpose, separate columns are provided for Invoice prices and cost price in the following accounts: 1. Consignment A/c 2. Goods sent on consignment A/c 3. Consignment stock A/c Columns relating to invoice price are called memorandum columns. They are not to taken into consideration while preparing the final accounts but are useful to compare profit on consignment on the basis of Invoice and cost price. A proforma of consignment account with memorandum columns is given below:

Consignment Account -----------------------------------------------------------------------------------------------------------Date Particulars Invoice Actual Date Particulars Invoice Actual Price Price Price Price --------------------------------------------------------------------------------------------------------

Illustration: (i) The firm of Delta & Co., Of Delhi consigned to Premier & Co. of Rangoon 50 cases of Piece goods valued at Rs. 350 each. (ii) The consignors paid freight and insurance thereon Rs. 1800, (iii) They received as an advance from Premier & Co Rs. 8000. (iv) Received an Account Sales from Premier & Co. giving particulars as under: Gross proceeds Rs. 28000, expenses of Warehousing, Carriage, Dock Dues, etc, Incurred by them amounted to Rs. 900. and their commission to Rs. 1000. (v) Received a Bank Demand Draft of the balance due by them on the consignment. From the above particular, prepare the necessary Ledger Accounts in the books of the Consignors and those of the Consignees. Solution In the Books of Delta&Co., Consignment Account -------------------------------------------------------------------------------------------------------Rs. To Goods sent on consignment a/c To Cash A/c (Freight and Insurance) To Premier & Co. (Exp.)

17,500

By Premier & Co.

Rs. 28,000

1,800 900

To Premier & Co. (Com.)

1,000

To Profit and loss A/c

6,800

-------------------------------------------------------------------------------------------------------28,000

28,000

Premier & Co’s Account Rs.

Rs.

To Consignment A/c

28,000

By Cash (Advance)

8,000

By Consignment a/c (Exp)

900

By Consignment a/c (Com.)

1,000

By Bank A/c. 28,000

18,000 28,000

In the Books of Premier & Co, Delta & Co’s Account -------------------------------------------------------------------------------------------------------Rs. To Cash (Advance)

8,000

To Cash (Expenses)

900

To Commission To Bank

Rs. By Cash (Sales) A/c

28,000

1,000 18,100 28,000

3. Accounting for Partnership Accounts Fundamentals Partnership. Partnership is the relation which subsists between persons carrying on business in common with a view of profit. The Indian Partnership Act 1932 vide its section 4 defines the term Partnership as under. “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”. According to this definition the essential features of partnership form of business organisation are : 1. Two or more persons. None can be a partner with himself. There must be at least two or more persons to form a partnership. The term person does not include firms and joint stock companies and as such only partners on firms or members of joint stock companies can enter into a Partnership agreement provided the number of partners remains within statutory limit. The maximum number is ten in case of banking firms and twenty in all other business. 2. Agreement. Partnership arises out of an agreement only. It does not arise out of status or by operation of law. There must be an agreement among the partners of the firm.

28,000

3. Business. Partners must carry some lawful business and not for any other purpose. Business includes any trade, occupation and profession. 4. Profit Motive and Sharing of Profits. Partners must enter into partnership agreement with a motive to earn and distribute among themselves profits of a business in an agreed ratio. Clubs, building societies or any other associations, religious or charitable are not partnerships as there is no motive to earn profit. Agreement to share profit inplies agreement to share losses also. 5. Application of law of Agency. According to the definition, partnership business may be carried on by all or any of them acting for all. This implies that partnership is based on law of agency. Each partner acts as an agent as well as principal of other partners. Thus every partner can bind other partners and the firm by his own acts and be bound by the acts of the other partners. This means that a partner has implied authority to bind other partners for the acts done by him in the course of the business. Legal points affecting Partnership: 1. Members. The maximum number of partners in a partnership is limited to 10 in the case of banking business and 20 in the case of other business. A minor can’t become full fledged member of a partnership but a female can be. A minor however can be admitted to the benefits of partnership with the consent of other partners. 2. Liability. In partnership, liability of partners is unlimited. 3. Admission. No new partner can be introduced in the partnership save with the unanimous consent of all partners. 4. Death of a partner. Death of a partner will bring about the dissoulution of the partnership unless the partnership agreement provides otherwise. 5. Dissolution. In case of partnership at will, Partnership may be dissolved at the desire of any partner ant at any time by giving a notice in writing to other partners. 6. Registration. Registration of the partnership is not compulsory but the law has indirectly made registration compulsory because an unregistered firm suffers from many disabilities like :(a) A partner of an unregistered firm cannot file a suit against the firm or any partner thereof for the purpose of enforcing a right arising from contact or right conferred by the Partnership Act. (b) No suit can be filed on behalf of an unregistered firm against any third party for the purpose of enforcing a right arising from a contract. (c) An unregistered firm cannot claim a set off in a suit against the firm by a third party to enforce a right arising from a contract (where the claim of set off is above Rs. 100).

7. The rights and liabilities of the partners are governed by the Indian Partners Act, 1932. 8. Firm and firm name. Persons who have entered into partnership with one another are called individually partners and collectively a firm and the name under which the business is carried on is called the firm name.

Legal point affecting Partnership Accounts. 1. Partners are entitled to share profits equally, and must likewise bear losses equally irrespective of the amount of their respective capital accounts unless agreed otherwise. 2. Partners are not entitled to Interest on capital, salaries or remuneration, unless otherwise agreed. 3. Partners who advance loan to the partnership firm over and above the amount of capital contributed by them are entitled to charge interest thereon, at the rate of 6 percent per year, unless otherwise agreed. 4. No interest is charged to the partners in respect of their drawings, unless otherwise agreed. 5. Generally, an outgoing partner is entitled to have his proper share of the net assets (i.e.,) asset less liabilities), including goodwill, as they exist at the date of his retirement, quite apart from their book values. 6. A partner is entitled to be indemnified for expenses properly incurred by him on behalf of the partnership firm.

Partnership Deed According to the definition of partnership under the Indian Partnership Act, there must be an agreement between the partners of a partnership firm. The agreement may be express or implied. It may be a written or oral agreement. In most of the cases, these agreements are drawn up in writing. These written agreements are called by various names such as partnership deed, partnership agreement, constitution of partnership or Articles of partnership etc. The exact terms of the partnership deed (or agreement) will depend upon circumstances but, generally partnership deeds contain the following points : 1. 2. 3. 4.

The name of the firm and business to be carried on under that name. Address (s) of business place (s) Nature and scope of the Business. Commencement and duration of partnership.

5. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

The capital and the contribution made by each partner.6. Provision for further capital and loans by partners to the firm. Partner’s Drawings. Interest on capital, loans, drawings and current account. Salaries, commission and remuneration to partners. Profit )or loss) sharing ratio of partners. The keeping of proper books of accounts, inspection and audit, Bank Accounts and its operation The accounting period and the date on which final accounts are to be prepared. Rights, power and duties of partners. Whether, and in what circumstances, notice of retirement or dissolution can be given by a partner. Provision that death or retirement of a partner will not bring about dissolution of partnership. Valuation of goodwill on retirement, death dissolution etc. The method of valuation of assets (and liabilities) on retirement or death of any partner. Provision for expulsion of a partner. Provision regarding the allocation of business activities to be performed by individual partners. The arbitration clause for the settlement of disputes.

It may be noted that the exact terms of the partnership deed will a depend upon the circumstances of each case. The Rights of partners in a partnership firm are as follows : 1. Every partner is entitled to take active part in the management of the business. 2. Every partner has an inherent right to be consulted in all matters affecting the partnership. 3. Every partner has a right to have access to the accounts of the firm and he can have a copy of the books of the firm. 4. Every partner is entitled to share profits equally with other partners unless otherwise agreed. 5. If a partner contributes in excess of the amount he is supposed to subscribe, he is entitled to receive an interest on that amount @ 6% per annum out of profits of the firm. 6. Every partner has a right to use for the dissolution of the firm.

7. Every partner has a right to be indemnified by the firm in respect of payments made and liabilities incurred by him (a) in the conduct of the business and (b) in doing such act in an emergency for the purpose of protecting the firm from loss, as would be done by a person of ordinary prudence in his own case, under similar circumstances. 8. Every partner has a right to retire : (a) with the consent of all the partners, of (b) in accordance with an express agreement by the partners, or (c) where the partnership is at will, by giving a notice in writing to all partners of his intention to retire. 9. Every partner has a right not to be expelled from the partnership. Obligations : The following are the main obligations of the partners : 1. Every partner is bound to act honestly, faithfully and diligently for the greatest common advantage of the firm’s business. 2. Every partner is bound to render true, proper and correct accounts of partnership and allow other partners to inspect and copy them. 3. If due to negligence or fraud of a partner, the firm suffers losses, the partner responsible for such acts shall make good the loss. 4. Every partner is bound to use the property of the business for the purpose of the business only. 5. Every partner must share losses equally, unless agreed otherwise. 6. Every partner is under an obligation to account for private profits made by him from any use of partnership property, name of business connection. 7. Every partner is bound not to carry on competing business to the firm, during his stay in the partnership firm. 8. Every partner must act within the scope of his authority and where he exceeds, he must compensate other partners for any loss unless such act is ratified. 9. Every partner is liable severally and jointly with all other partners, for all acts of the firm done while he is a partner. Kinds of Partners : Partners can be divided into the following categories :

1. General Partners. All partners, if there is no specific agreement otherwise, are basically general partners and their liability is unlimited. 2. Active Partners. Those partners who take active part in the management of the business are known as active partners. 3. Sleeping Partners. Partners who though subscribe their share of capital but do not take active part in the management of the business are called as sleeping partners. 4. Secret Partners. Certain persons, though become partners, want to remain behind the screen. Such partners are called Secret Partners. The liability of such partners is unlimited. 5. Nominal Partners. Sometimes persons of credit or importance lend their name to the firm but neither they invest nor share the profits. But such partners can’t escape liability towards third person. 6. Partners by Estoppel. Some persons, though not partners, mislead other persons by saying that they are partners in a certain firm. Such persons are known as partners by estoppel. They are liable to third parties for their acts done in inducement of the statements given by such person. 7.Sub-Partner. Where a partner agrees to share his profits derived from a firm with a third person that third person is known as a sub-partner. He is not connected with the firm is any way and has no right or obligations towards the firm.

Goodwill The Goodwill of a business is the advantage which a person gets by continuing to carry on, and being entitled to represent to the outside world that he is carrying on a business, which has been carried on for some time in the past. Goodwill is a thing very easy to describe, very difficult to define. (It is the benefit and advantage of the good name. reputation and connection of a business). It is the attractive force which brings in customers to the business. It is the one thing which distinguishes an old established business from a new business at the first start. Goodwill is composed of a variety of elements. It differs in its composition in different trades and in different business in the same trade. We may describe Goodwill as an intangible asset arising out of super profit earning capacity of a concern. The existence of Goodwill of a firm distinguishes the same from others. If a firm being situated in a comparable position with others and doing the same nature of trade earns extra profit, then there is some factor favorable in the firm for bringing more and more customers to that particular firm. In economic sense, marginal firms have no goodwill but super marginal (above marginal) firms enjoy goodwill upto the value they are away from marginal firm.

But Goodwill, in the sense of attracting customers, has little significance unless it is valuable in the sense of having a saleable value. The Goodwill possessed by a firm may be due to the following elements of the business : 1. Favorable Location of the Business premises. 2. Quality of firm’s products or services. 3. Personal reputation of the partners. 4. The possession of efficient and contented employees. 5. The possession of well known Trade Marks, patents etc. 6. The possession of favorable contracts or monopoly 7. The continuity of advertisement. 8. Flexibility and development of business with charging conditions. 9. Freedom from legislative restrictions. Although a firm may possess goodwill, it is not always necessary to raise a goodwill account in the books of accounts except to the extent that cash or other assets of the firm have been used to pay for it. Because if payment is made for goodwill but is not recorded in the books, the capital accounts of the partners of the firm are understated to the extent of the value of goodwill account is opened, it is not always adjusted to give effect to every fluctuation in its value. Valuation of Goodwill There are various methods of valuation of goodwill much as 1. Average Profit Basis. In this case the profits of the past few years are averaged and adjusted (multiplied) for any charge that is expected to occur in the near future. The average is multiplied (adjusted) by a certain number. This is expressed, for example as 3 years of five years profits, suppose the profits for last 5 years are 10,000, 15,000, 20,000, 25,000,30,000 Goodwill will amount to 10,000 + 15,000 + 20,000 + 25,000 + 30,000 ----------------------------------------------------5 If there was a loss in the 2nd year of Rs. 15,000 then Goodwill would have been Rs. 42,000 2. Super Profit Basis. The super profits of a business are the profits which can be expected in the future over and above those necessary to pay a fair return upon the capital invested in the business, having regard to the risk involved in that particular business and a fair remuneration for the services of the partners who work thereon. Super Profits-Net Profits-(Normal rate of Int. on Cap. + Reasonable Salary to Partners)

Super profits multiplied by the number of years purchase agreed upon gives goodwill. thus Goodwill = Super Profits x No. of years purchase. Illustration Suppose Annual profits expected is Average Capital employed Expected Interest rate on Cap. 10%

Rs. 10,000 Rs. 50,000

Remuneration to Purchase Rs. 2,500

Profits Interest -Remuneration Super Profits

Goodwill = 2,500 X ‘x’ No. of years purchase. 3. Capitalisation Method. According to this method, the value of the business as a running concern is ascertained, and from the figure arrived at the value of the tangible assets is deducted, the difference being taken to represent Goodwill. The value of the business may be found out by the formula. Profit ----------------------------------Reasonable Return on Cap. and goodwill may be calculated by deducting the capital employed from the figure of the value of the business. In the above example. Estimated annual Profit Rs. 10,000 Less Partner’s remuneration Rs. 2,500 __________ Available for Interest on Capital employed Rs. 7,500 Value of Business =

7,500 ------- X100=75,000 10%

Goodwill

75,000-50,000 (Cap. employed)=Rs. 25,000

=

Adjustment in Goodwill Account : Whenever there is a change in the constitution of the firm or the business, value of the business fluctuates and Goodwill account needs some adjustment. In each of the following cases, a change in the profit sharing ratio takes place, and therefore, unless a Goodwill account already stands in the books at its correct value, some adjustment must be made. 1. Upon the Admission of a partner. 2. On the death or retirement of a partner.

10,000 5,000 2,500 ______ 2,500

3. Upon an agreement between partners to change the profit sharing ratio between themselves.

Distinction between Partnership & Co., The following are the main points of distinction between a partnership firm and a joint stock company : 1. Registration. A company comes into existence only after registration under the companies Act. In case of partnership registration is not compulsory. 2. Legal Status. A company is a legal person and regarded by law as a single person. A partnership is a collection of individuals. 3. Minimum number of members. The minimum number required to form a company is two in case of private limited companies and seven in case of public limited companies. The minimum number of persons required to form partnership is two. 4. Liability of members. The liability of the members of a company is limited where as the liability of the partners for the debts of a firm is unlimited. Partners are also personally liable for the debts of a firm. 5. Transferbility. A shareholder can transfer his share without the consent of other share-holders. In case of partnership, a partner cannot transfer his share without the consent of other partners. 6. Maximum number of members. A public company may have any number of members. In case of a private company the maximum number cannot be more than 50. In a trading partnership the maximum number of members is twenty, in a banking partnership ten. 7. Contractual capacity. The shareholders of the company can enter into contract with the company and can be an employee of the company. Partners can contract with other partners but not with the firm. 8. Duration of existence. The death or retirement or a partner dissolves the partnership. But a company having legal existence can continue, inspite of death or retirement of a member. It has thus perpetual succession. 9. Statutory obligations. A company is required to comply with various statutory obligations regarding management, e.g. filing of balance sheet, maintaining of prescribed registers etc. In case of partnership there are no such statutory obligations. 10. Authority of members, (a) In case of companies, management vest in the hands on a few directors, elected from amongst the share holders. A share holder as such cannot participate in the management. All the partners are entitled to share in the management of the firm.

11. Each partner is prima face the agent of the other partners and can bind hem for the acts done in the course of the partnership business. Shareholders in the company are not the agents of one another.

Capital Accounts Capital Accounts. The amount of contribution by each partner in the partnership firm is called his capital and is credited to his Capital Account Capital accounts of the partners may be either fixed or fluctuating. Fixed Capital Accounts. If the capital accounts of partners are to remain intact (expect under exceptional circumstances mentioned in the partnership agreement during the continuance of the partnership, the capital accounts will be called as fixed capital accounts, In the case of fixed capital accounts, no adjustments are made in the capital account and the balance on each such account will remain at the same figure year after year, representing the amount of capital briginally contributed. Where fixed capital accounts are maintained, capital and share of profits etc., are to be recorded in an account called as current account is shown quite separately in the Balance Sheet. If the current account shows a credit balance, it represents the surplus of profits and salaries etc., over drawings and on the other hand, if it shows a debit balance it represents account being overdrawn and the debit balance will be shown on the asset side of the Balance Sheet. This if capitals of partners are to be kept fixed, the following two accounts will be opened for each partner. 1. Capital Account. 2. Current Account. Fluctuating Capital Accounts. When the partners agree upon the employment of capital account only, for each partner, it will contain all transactions relating to the amount of capital contributed, drawings, interest on capital and drawings, salary, commission or remuneration and the share of profit or loss etc. It is, therefore, that the balance of this account will fluctuate from year to year the account is called as fluctuating capital account. In the case of fluctuating capital accounts, current accounts are not maintained. :

Interest on Capital (i) Interest on Capital. According to the provisions of the Act, no partner is entitled to Interest on capital unless otherwise agreed. If Interest is agreed to be payable, it is payable only out of profits of the business, when allowed, Interest account is debited and partner’s capital accounts are credited Subsequently the amount of interest is debited to the profit and loss account of the firm. Generally interest on capital is provided in the following cases : (i) When capitals are unequal but profit sharing ratios are equal. (ii) When capitals are unequal and profit sharing ratios are also unequal.

Interest on capital in the above instances reduces the inequalities in the distribution of profits amount the partners. The following journal entries are recorded for interest on capital. 1.

2.

When interest is allowed. Interest Account To Capital Account

Dr.

When interest account is closed at the end of the year. Profit and loss Account To Interest Account.

Dr.

(ii) Interest on Drawngs. Just like interest is allowed on capitals, partners may decide to charge interest on drawings also. Interest charged on drawings in an item of income and is credited to the profit and loss account. The amount of interest thus adds to the profits of the business which is further distributed among the partners. The following entries are passed for interest on drawings. (i)

(ii)

When interest is charged on drawings Capital Account To Interest Account

Dr.

Closing entry for Interest account. Interest Account. To Profit and loss Account

Dr.

Calculation of Interest on Drawings It may be noted that the interest on drawings is charged for the time period which lapses between the date of withdrawal and the end of accounting year. Problem arises when many withdrawals have been made on different dates during the year. The interest on drawing in such caes may be calculated after calculating an average date for all the withdrawals. The following illustration will calrify the point : Illustration : A, a partner has withdrawn the following sums of money : Rs. On 1st March 1976 On 1st April 1976 On 1st uly 1976 On 1st November 1976 Calculate interest @ 6 per cent per annum if the accounts are closed on 31st December every year.

500 400 600 300

Solution Interest Rs. On 500 On 400 On 600 On 300

Rs. 25 18 18 1.50 _______

for 10 months for 9 months for 6 months for 2 months Total Interest

62.50 _______

Alternatively. Interest can be calculated in the following manner : Amount

Months Rs. 500 400 600 300

Product Rs. 5,000 3,600 3,600 600 _______ 12,800 _______

10 9 6 2

1,800

Interst on Rs. 12,800 for one month @ 6% p.a. is Rs. 62.50 (iii) Salary to Partner. Sometimes, a partner who devotes more time and efforts towards the business of the firms than the other partners is allowed a certain amount of salary or commission for services rendered by him. This amount is adjusted to the profit and loss account and is credited to the capital account of the Active partner (to whom salary or commission is payable). The following entry is passed in the books of accounts. Profit and loss Account To Capital Account (Concerned)

Dr.

Profit or loss arrived at after making the adjustments relating to interest on capitals or drawings, salaries or commission etc, is distributed among the partners in their profit sharing ratio. The following entry is recorded for the distribution of profits : Profit and loss Account To all Partners Capital Accounts (in their profit sharing ratio) A reverse entry will be passed in case of loss in business.

Dr.

(iv) Adjustments of closed Partnership Accounts. After the preparation of final accounts for a certain period, if it is discovered that some errors or omissions were committed in the accounts, the closed partnership accounts will have to be readjusted. The errors or omissions may relate to the following. 1. 2. 3. 4.

Charging a very high (or low) rate of interest on capitals or drawings. Distributing profits or loss in a ratio different than that agreed upon. Wrong payment of salary to any partner. Not debiting the capital account in respect of drawings and so on.

Adjustment entries required to correct any such error or omission will have to be made in the usual manner.

4. Accounting for Partnership Accounts ADMISSION OF A PARTNER Goodwill on Admission of a new Partner : Goodwill is the attractive force that brings in customers. It is the benefit of a good name, reputation and connection of a business. It is one thing that distinguishes an old established business with a new bussiness at its first start. It is the benefit that attaches to the ownership of a successful business. It is therefore but natural to think that the owners of a successful business will nto like it to be shared by any one else. It is therefore that whenever a new person is admitted to the partnership, he is charged some amount of premium over and above his share of capital for the participation in the profits and the reputation established by the hard work, character, industry, enterprise and business capacity of the old partners. This amount of premium is called the price of Goodwill. Goodwill is dealt with on the admission of a new partner as follows : (A) Premium Method : This method is used when the new partner brings in the amount of Goodwill as cash. Under this method, the receipt of Goodwill is dealt with in the following ways : 1. As a Private Transaction. When the amount of Goodwill is received by old partners privately and outside the business in cash. In such a case, no entry will be made in the books of the firm. 2. As a firm’s Transaction ; The cash being Immediately withdrawn In such a case the receipt of Goodwill money is recorded in the books of the firm and transferred to the capital accounts of the old partners in their Profit Sacrifions also. The amount thus transferred is immediately withdrawn by the old partners. The following entries are recorded in firm’s books in the above case. (i) For the amount of Goodwill received in cash.

Cash Account To New Partner’s Capital Account

Dr.

Note. The above entry is made with the amount of Capital plus Goodwill brought in by the new partner. For example if X brings in Rs. 10,000 as capital and Rs. 2,500 as Goodwill, the above entry will be made with Rs. 12,500). (ii) For the distribution of goodwill among old partners. New Partners’ Capital, Account To Old Partner’s Capital Account

Dr.

Note. The above entry is made with the amount of Goodwill only brought in by new partner. The amount of Goodwill is to be shared by old partners in their profit sacrificing ratio). (iii) For the amount of Goodwill withdrawn by old partners : Old Partner’s Capital Accounts

Dr.

To Cash Account It is emphasised here again that the amount of Goodwill is to be distributed among the old partners in their Profit sacrificing ratio and not in their Profit sharing ratio. For example, if A and B are partners sharing profits in the ratio of 2:1. They admit O who brings in Rs. 10,000 as capital and Rs. 4,000 as Goodwill and they now become equal partners, the profit sacrificing ratio will be calculated as under : Old Profit Sharing Ratio New Profit Sharing Ratio Profit Sacrificing Ratio

=

A 2/3 1/3

B 1/3 1/3

2/3-1/3 1/3

1/3-1/3 = Nil

C 1/3

In the above example, the entire amount of Goodwill (Rs. 4,000) will be taken by A and B will get nothing as he is not sacrificing anything out of his share of firm’s profits. 3. As a firm’s Transaction-the cash being retained in the business. The entries in this case will be similar to the entries passed in 2nd method above except that the entry no (iii) for cash withdrawal will not be passed in the firm’s books. In this case, the cash is retained within the business and becomes a part of the working capital. (B) Memorandum Revaluation Methos. Sometimes new partner may not be in a position to bring in Goodwill as cash or it may be agreed among the partners that the goodwill account may be created or adjusted in the books of accounts. The created or adjusted Goodwill is credited to the old partners in their old profit sharing ratio and then again the same amount is debited to all the partners (including the new partner) in their new profit sharing ratio.

The following entries are recorded under the above method. (i) When Goodwill account is raised with full value Goodwill Account Dr. To Old Partner’s Capital Accounts (ii) When Goodwill account is written off. All Partners’ Capital Accounts Dr. To Goodwill Account [Note : If Goodwill is not written off, it will remain in the books and will be shown on the Asset side of the Balance Sheet]. (C) Revaluation Method. Sometimes, it so happens that Goodwill account exists in the books of the firm at the time of admission of the new partner. In such a case the Goodwill of the firm is revalued according to any of the following methods : (i) Goodwill based on average profits basis. (ii) Goodwill based on share of Incoming Partner or (iii) Goodwill on super profit basis. The amount of Goodwill so valued is compared with the amount shown in the Goodwill account. The excess of the revaluation over the existing amount of Goodwill is credited to the old partners capital accounts. The following Journal entry is passed under this method : Goodwill account To Old Partners’ Capital Accounts. [Note. This entry is made with the difference of Revalued amount and existing Goodwill]. If the amount of Goodwill already appearing int he account books is in excess of the revalued amount, the following entry is passed to bring down the value of Goodwill at its new value. Old partners’ Capital Accounts To Goodwill Account

Dr.

[Note. This entry is passed with difference of the amount of Goodwill existing in accounts and the revalued amount]. It may be noted that in the above entry old partner’s capital accounts will be credited or debited (as the case may be) in their Old profit sharing ratio. Illustration : A and B are equal partners. They admit C into partnership firm, C paying Rs. 10,000 as his Capital and Rs. 2,000 for Goodwill. The new profit sharing ratio is 2 : 2 : 1.

Pass Journal entries in the firm’s books : (i) When Goodwill is received as a private transaction. (ii) When Goodwill is received as a Firm’s t5ransaction, the amount being retained in the business. (iii) When Goodwill is received as a Firm’s t5ransaction, the amount being immediately withdrawn by the old partners. Solution (i) When Goodwill is received as a Private Transaction ; Rs. 10,000

Cash Account Dr. To C’s Capital Account [Note. No entry will be passed for the amount of Goodwill]. (ii) When Goodwill is received as a firm’s Transaction, the amount being retained in the business : Rs. (a) Cash Account Dr. 12,000 To C’s Capital Account (For the amount of Goodwill and Capital Credited to C’s Capital Account) Rs. (b) C’s Capital Account Dr. 2,000 To A’s Capital Account To B’s Capital Account (For the amount of Goodwill distributed between Old Partners) (iii) When Goodwill is received as a firms transaction, the amount being immediately withdrawn by old partners : Rs. (a) and (b) as above (c) A’s Capital Account Dr. 1,000 B’s Capital Account Dr. 1,000 To cash Account (For the amount withdrawn by Old Partners)

Rs. 10,000

Rs. 12,000

Rs. 1,000 1,000

Rs.

2,000

Distribution of Goodwill A

B

Old Profit Sharing Ratio

1/2

1/2

New Profit Sharing Ratio

2/5

2/5 :

C 1/5

Profit Sacrificing Ratio =

(1/2-2/5)

(1/2-2/5)

1/10

1/10

As the profit sacrificing ratio is equal, the amount of Goodwill is to be shared equally viz. Rs. 1,000 each. Question. How the following adjustments are recorded in the books of the firms (a) Adjustments in the Book values of Assets and Habilities. (b) Adjustments in the values of Accumulated profits, reserves or losses. (c) Adjustments regarding Capitals. Answer Revaluation of Assets and Liabilities on an Admission : The most important adjustment necessitated by the admission of a partner are those of revaluation of the assets and liabilities at their actual values in place of book values. It is to be carefully seen that the new partner does not get any benefit form any appreciation in the values of assets nor does he suffer any loss from the increase in the value of liabilities. It is therefore that the all assets and liabilities are revalued on the admission of a new partner and the resalt of such revaluation is to be enjoyed or suffered by the old Partners in their old profit sharing ratio. The adjustments in the values of assets and liabilities are recorded in the following ways : (Values to be altered in the Books) : 1st METHOD If the assets and liabilities are to be recorded in the books at their adjusted values, upon the admission of a new partner, the following entries will be recorded in the books of accounts. 1. Revaluation Account Dr. To Assets Account (For the book values of assets debited to Revaluation Account) 2.

Assets Account To Revaluation Account (For the revised values of assets recorded in the assets Accounts)

3.

Liabilities Account To Revaluation Account (For the book values of liabilities Credited to Revaluation Account)

4.

Revaluation Account Dr. To Liabilities Account (For the revised values of Liabilities recorded in the liabilities Account)

5.

The Balance of Revaluation Account is treated as Profit or Loss : In case of Profit : Revaluation Account Dr. To Old Partners’ Capital Accounts

(In their Old Profit Sharing Ratio) In case of Loss : Old Partners’ Capital Accounts Dr. To Revaluation Account [Note. A Profit and Loss Adjustment may also be opened in place of Revaluation Account]. 2ND METHOD : Alternatively, the entries may be made as under : 1. Revaluation Account Dr. To Liabilities To Assets (For Increased Liabilities and Decreased Assets Transferred to Revaluation Account) 2.

Liabilities Dr. Assets Dr. To Revaluation Account (For Decreased Liabilities and Increased Assets Transferred to Revaluation Account) 3.

The Balance of Revaluation is Treated as Profit or Loss In case of Profit : Revaluation Account Dr. To their Old partners Capital Accounts (In their Old Profit Sharing Ratio) In Case of Loss : Old Partners Capital Accounts Dr. To Revaluation Account

When Values are not to be altered in the books 3RD METHOD : When the new firm desires to keep the book values of assets and liabilities unchanged in the books, the following steps will be taken to record the adjustments in their values. 1. A Memorandum Revaluation Account is opened. This account is debited with all decreases in the value of assets or increases in the values of liabilities. The account is also credited with all increases in the values of assets or decreases in the values of liabilities. 2. The difference in the totals of debits and credits is then transferred to the old partners caital accounts in the old profit sharing ratio.

3. The items (adjustments in the book values of assets and liabilities) are again recorded in the memorandum revaluation account but on the opposite sides. 4. The difference now is transferred to all partners capital accounts in new profit sharing ratio. The system mentioned above is illustrated with the help of imaginary figures as given on next page. Memorandum Revaluation Account Rs. 1975 Dec. 31

To Decrease in the values of Assets : Debtors Land and Buildings To increase in the values of liabilities

1975 Dec. 31

1,500 3,000 1,000

Rs. By balance in value of Assests Investments By Capital Accounts A (½) B (½)

4,000 750

750

5,500 1976 Jan. 1

To Increase in Values of Assets Investments

To Capital Accounts A(½) B(½ C(½)

4,000

5,500 1976 Jan.1

500 500 500 7,500

By Decrease in values of Assets Debtors Land and Buildings

1,500 3,000

By Decrese in values of liabilities

1,000

7,500

Capital Accounts A

B

C

A

B

C

Rs.

Rs.

Rs.

Rs. --

Rs. --

Rs. --

500

500

500

500

500

500

Loss on Revaluation

750

750

--

To Balance

--

--

--

750

750

Accumulated Reserves, Profits or Losses :

By Balance By loss on Revaluation (written back)

If the accounts relating to accumulated reserves, profits or losses appear in the partnership business at the time of admission of a new partner, these should always be distributed among the old partners in their old profit sharing ratio. The followingm entries are recorded in this respect. (i)

(ii)

For reserve Account or reserve fund Reserves To old partner’s Capital Accounts

Dr.

For P. and L. Account (Credit balance). Profit and Loss Account To old Partner’s Capital Accounts

Dr.

(iii)

For P. and L Account (Debit balance) Old Partner’s Capital Account Dr. To Profit and Loss Account [Note. In the examination, if any of these items appear in the question, it is to be distributed among old partners, even though the question is silent over this issue]. Adjustments regarding capitals : In connection with the problems regarding adjustments of capital accounts, the following cases may arise. 1.

Capitals, may be adjusted on the basis of new partners contribution or

2. New partner may be asked to contribute the amount of capital in proportion to his share in the firm. In the first case, the total capital of the firm is calculated on the basis of capital contributed by new partner and share of profit allowed to him. For example if C is admitted to a partnership firm of A and B, and brings in Rs. 10,000 as his capital and is given 1/3rd share in the firm, the total capital of the firm (A, B and C) would be Rs. 30,000. The old partners capitals will be adjusted accordingly. Thus if in this example A and B were equal partners having capital balances of Rs. 11,000 and Rs. 8,000 respectively and are again equal partners with C, their capital accounts will be adjusted to show balances Rs. 10,000 in each account, thereby making payment of Rs. 18,000 to A and receiving a sum of Rs, 2,000 from B. In the second case, the amount of capital contribution may be calculated by taking the profit proportion and deducting fro the denominator the figure of the numerator e.g. one fourth becoming one third, one sixth becoming one fifth, two sevenths becoming two fifths and so on. This fraction will be multiplied to the total capitals of the old partners (aftef making all adjustments regarding revaluation of assets and liabilities, profits, reserves, losses etd.) so as to give the amount of capital, the new partner may be asked to bring in.

In the above example, if the adjusted capitals of A and B shows balancel of Rs. 14,000 and Rs. 11,000 respectively and C is given one third share, capitals contribution by C will be calculated as under. C’s share in Profits

=

rd

C’s Contribution

=

of A+B’s adjusted capitals

=

X (14,000+11,000)

C’s Capital = Rs. 12,500

5.

Accounting for Partnership Accounts

RETIREMENT & DEATH OF A PARTNER RETIREMENT OF A PARTNER: A partner may retire from the partnership firm with the unanimous consent of all the partners. In the case of partnership at will, he may retire at any time on giving a written notice to the other partners of his intention to retire from the firm. Retirement of a partner involves following accounting problems 1.

Treatment of Goodwill

2.

Revaluation of assets and liabilities.

3.

Distribution of accumulated reserves, Profits or losses.

4.

Adjustments in capitals and profit sharing ratio of the remaining partners.

5.

Payment of the dues to the outgoing partner.

To a large extent, these problems are similar to those arising at the admission of a new partner. A detailed discussion of each one of these is given belwo. 1. Goodwill. Just as an incoming partner is supposed to bring in some amount of Goodwill, an outgoing partner, in the similar way, becomes entitled to his share of goodwill at the time of his retirement. The calculation of the value of goodwill is done in the same way as is done in the case of admission of a partner. The share of goodwill of the outgoing partner is calculated by multiplying the value of goodwill to his profit sharing ratio. For example, if the profit sharing of goodwill of the firm is arrived at Rs. 30,000 and C, the retiring partner has a one-third share in the profits of the firm, his share

of goodwill will be Rs. 10,000 (Rs. 30,000X1/3rd share), C is entitled to the payment of Rs. 10,000 as his share of Goodwill. Adjustments regarding Goodwill may be made in either of the following ways. 1. When Goodwill is raised with the share of retiring partner and is allowed to appear in the books. In such a case the following entry will be made in the books of accounts. Goodwill Account To Retiring Partner’s Capital Account

Dr.

2. When Goodwill is raised with the share of retiring partner and is immediately written off : The following entries will be made in such a case, (a) Goodwill Account Dr. To Retiring Partner’s Capital Account (b) Remaining Partner’s Capital Account Dr. To Goodwill Account It may be noted that Goodwill is written off in the gaining ratio of the remaining partners. 3. When Goodwill is raised at full value and is allowed to appear in the books. Goodwill Account Dr. To All Partnor’s Capital Accounts. The above case, capital accounts of all partners (including the retiring partner) will be credited in the profit sharing ratio. 4. When Goodwill is raised at full value and is immediately written off : The following entries will be passed : (a) Goodwill Account Dr. To All Partner’s Capital Accounts (b) Remaining Partner’s Capital Accounts Dr. To Goodwill Account [Note : In the first entry, Goodwill is credited to the capital accounts of all partners (including the retiring partner) in their profit sharing ratio before retirement. In the second entry, capital accounts of only the remaining partners are to be debited in their new profit sharing ratio). Revaluation of Assets and Liabilities. If partnership deed provides for revaluation of assets and liabilities on retirement of any partner, the revaluation should be done

exactly in a similar manner as was done in case of admission of a partner. A revaluation account is opened. It is credited with the amount of increased liabilities or decreased assets and is credited with the amount of decreased liabilities or increased assets. The balance of revaluation (or Profit and loss adjustment) account is treated as profit or loss and is transferred to the capital accounts of all the Partners in their profit sharing ratio before retirement. The assets and liabilities will then appear at adjusted values in the Balance Sheet. But if the book values of the assets and liabilities are not to be altered, a memorandum revaluation account will be opened. The profit or loss of the first part of this account is transferred to the capital accounts of all the partners including the retiring partner) but the profit or loss of the second part is transferred to the capital accounts of only the remaining partners in their new profit sharing ratio. 3. Accumulated Reserves, Profits or Losses. The retiting partner is also entitled to his share in the accumulated reserves representing undistributed profits and is also liabile to share accumulated losses. Adjustment in this respect may be made in either of the following two ways : 1. The entire amount of undistributed profits or reserves is transferred to the capital accounts of all the partners in their profit sharing ratio before retirement. The following entry will be made. Reserve Account

Dr.

Or Profit and loss account To All partner’s Capital Accounts

Dr.

If previous losses appear in the balance sheet, the above entry will be reversed. 2. Only the share of retiring partner in the undistributed profits and/or reserves is calculated and the amount is credited to his capital account, thereby reducing the balance of undistributed reserves, profits or losses. The following entry will be made. Reserve Account

Dr.

Or Profit and loss account To Retiring partner’s Capital Account

Dr.

If previous losses appear in the books, the above entry will be reversed. 4. Adjustments in Capitals or Profit sharing ratios of the remaining partner. When a partner retires from a firm, the profit sharing ratio of the remaining partner changes. For example, if A, B and C are equal partners in a firm, where from C retires and A and B agree to share future profits equally. The effect of C’s retirement will be that A and B

(both) will be getting one. half of profits (each) instead of previous one third ratio of profit. Unless there is an agreement to the contrary, or if the examination question is silent over it, the remaining partners will continue to share between themselves profits or losses in the ratio which existed before the retirement. For example if A, B and C were sharing profits in the ratio 2:1:1 and C retires. A and B will now be sharing profits in the ratio of 2:1. But if new ratios for the remaining partners are given, the gaining ratio can be calculated by deducting the old ratio from the new ratio. Calculation of gaining ratio is important as the amount of Goodwill payable to retiring partner will be shared by the remaining partners in their ratios. Further, the capital accounts of the remaining partners may be adjusted according to their new profit sharing ratio and any excess of capital may be paid or shortage demanded from the partners. 5. Payment of the dues to the Retiring Partner. The total amount payable to the retiring partner is calculated and paid to him in any of the following manners : 1. In lump sum or 2. In annual Instalments or 3. In the form of Annuities. The following entries are made to recored the transaction of payments in the firm’s books. 1. When a lump sum payment is made. In such a case, retiring partner’s capital account is closed by making the following entry : Retiring Partner’s capital Account Dr. To Cash Account 2. When payment is made in annual instalments. In such a case, the balance of capital account of the retiting partner is first transferred to his loan Account. Interest at agreed rate is paid on the balance of the loan account eac year till the last instalment is paid and the loan account is closed. The following entries aremade in this respect : (a) Transferring the balance of capital Account to loan Account Retiring Partner’s Capital Account Dr. To Retiting Partner’s Loan Account (b) For Interest on loan. Interest Account To Retiring Partner’s loan Account

Dr.

(c) For payment of Instalment. Retiring Partner’s Capital Account To Cash Account

Dr.

It may be noted that the balance of the Retiring Partner’s loan Account is shown on the liabilities side of the Balance Sheet till the last instalment is paid to him. 3. When payment is made in the form of Annuities. Under this method an annual payment is made to the retiring partner in lieu of his capital in the firm. The balance due to the retiring partner is transferred to Annuity Suspense Account and the entries for interest and payment are made out of this account. Balance of this account is shown on the liabilities side till exhausted. An important point to note here is that annuities are paid to the retired partner every year irrespective of the fact that the balance in the account has exhausted or not. If the retiring partner dies and any balance is left in Annuity Suspense Account, it is treated as a profit and transferred to partner’s capital accounts in their profit sharing ratio. However, if the retiring partner lives even after the exhaustion of the balance of Annuity Suspense Account the payment will be treated as loss and will be debited to the profit and loss account every year.

The following entries are recorded : (a) Transferring the amount due to Annuity suspense Account. Retiring Partner’s Capital Account Dr. To Annuity Suspense Account (b) For the amount of Interest. Interest Account To Annuity Suspense Account (c) For payment Annuity Suspense Account To Cash Account

Dr.

Dr.

(d) If retired partner dies and any balance is left in Annuity Suspense Account Annuity Suspense Account Dr. To Partner’s Capital Accounts (e) If Annuity Suspense Account has been exhausted and payment is made. (i) Profit and oss Account Dr. To Annuity Suspense Account (ii) Annuity Suspense Account

Dr.

To Cash Account

DEATH OF A PARTNER Accounting problems arising on the death of a partner in the partnership firm are similar to those arising in the case of retirement. These problems are to be dealt with in a manner exactly similar to that followed in the case of retirement of a partner. However, the following points may be noted : 1. Death of a partner may occur at any time during the accounting period. If a partner dies after the last date of an accounting year, it becomes necessary to calculate his share for that period in respect of the following : (a) Profit or loss (b) Interest on capital (c) Salary, commission, remuneration etc., (if any) (2) The total amount due to the deceased partner is to be transferred to his Executor’s Account (Account of his legal representatives). The amount to transferred will include the following: (a) (b) (c) (d) (e) (f) (g) (h)

Deceased Partner’s capital in the firm. His share of goodwill. Profit or loss on revaluation of Assets and liabilities. His share of undistributed profits, reserves or losses. His share of Profit (upto the date of his death) Interest on capital Salary, remuneration etc., upto the date of his death. Any other amount payable.

Computation of Deceased Partner’s share of profit ; If a partner dies during the course of an accounting year, he will be entitled in the ordinary way to his share of Profit to the dae of death. This may be ascertained in any of the following manners, subject of course to the terms of the partnership agreement : 1.

Computation of Profits on the basis of current years working. (a) By drawing up accounts to the actual date of death or (b) By drawing up account for the full normal accounting year and splitting them into the (i) pre-and (ii) Post death period. 2.

Computation of Profits on the basis of last years working : (a) on Time Basis (b) on Turnover Basis

Out of the above methods, method (1) (a) is most satisfactory but circumstances may prevent this being carried out. Method (1) (b) may be put to use on any of the two basis viz. (i) The time basis or (ii) The turnover basis. Time Basis. Under the method, the amount of the share of profits of the deceased partner is calculated on the basis of time elapsed from the last Balance Sheet. Thus, if it is to base on last year’s profits the following formula may be used : Deceased Partner’s share of Profit =

X Number of Days upto the date of death. X Profit sharing ratio of the deceased Partner.

For example, if last year’s profits were Rs. 15,000 and C, the deceased partner enjoys one-third share out of profits and he dies 73 days after the date of last balance sheet, his (c’s) share of profit for the period (73 days) will be computed as under :

C’s Share of Profit =

x 73 days 1/3rd share = 3000 x 1/3 = Rs. 1,000

C’s capital account is to be credited by Rs. 1,000 as his share of profit upto the date of his death. Turnover Basis. Under thismethod, Profit is calculated on the basis of sales upto the date of his death and the figure of last year’s sales. The following formula may be used.

Deceased Partner’s share of Profit = Last year’s Profits X Total Sales uptot the date of death Last year’s Total Sales X Profit shareing Ratio of deceased partner. For example if last year’s sales figure was Rs. 3 lacs, Profits Rs. 30,000 and sales upto the date of death of C, a one - third partner in the firm amounts to Rs. 60,000 then c’s share of profit will be calculated as under : C’s share of Profit =

X 60,000

X 1/3

C’s Shae of Profit = Rs. 2,000 If deceased partner’s share of Profit upto the date of his dealth is calculated on the basis of last year’s figures, the following entry will be recorded : Profit and loss suspense Account Dr.

To Deceased Partner’s Capital Accounts At the end of the accounting period the profit and loss Suspense Account will be closed by transferring the balance to the debit of profit and Loss Account.

JOINT LIFE POLICY A joint life policy involves the insurance of two or more lives smiultaneously. The policy money is payable upon the death of any one of the lives assured and the assured sum will be payable to the surivor or survivors. In partnership firms, mostly joint life polices are taken to provide funds for : (i) Payment to the legal representatives of the deceased person. (ii) Payment to the retiring partner, if the policy is an endowment policy. The object behind taking of a joint life policy is generally to avoid under pressure on the working capital of the business, in the case of death of a partner, when payment is to be made to his legal representatives. It is also possible that separate policies are taken on the lives of cash of the partners but the accounting treatment is similar in both the cases. Transactions relating to joint life policy are dealt with in three ways. mentioned below: 1. When payment of premium is considered as a business expenditure. under this method, the amount of premium is charged off to Profit and Loss account each year and the amount received from the insurance company on the death of any partner is treated as income and is credited to all partner’s capital accounts in their profit sharing ratio. The following entries are recorded. (a) On Payment of Premium Insurance Premium Account To Cash Account

Dr.

(b) Closing entry for Insurance Premium Account Profit and Loss Account To Insurance Premium Account

Dr.

(c) On the death of a partner, when Policy money is received : Cash/Bank Account To Joint Life Policy Account

Dr.

(d) Amount received in (3) above transferred to Partner’s capital Accounts Joint Life Policy Account Dr. To All Partner’s capital Accounts

2. When Payments of Premium are treated as an Investment up to the amount of surrender value. The following entries are made under this method : (a) On Payment of Premium Joint Life Policy Account To Cash Account

Dr.

(b) When Excess of Premium over surrender value is written off Profit and Loss Account Dr. To Joint life Policy Account (c) When policy money is received on the dealth of a Partner Cash/Bank Account To Joint life Policy Account

Dr.

(d) When the balance of Joint life Policy Account (which is treated as an income) is transferred to capital accounts Joint Life Policy Account Dr. To All Partner’s Capital Accounts 3. When Payments of Premium are treated as Investment and a Reserve Account is opened : (a) On Payment of Premium Joint Life Policy Account To Cash/Bank Account (b) On creation of Reserve Profit and Loss Account To Joint life policy Reserve Account

Dr.

Dr. Dr.

(c) When Joint Life Policy Account is written down to its surrender value Joint Life Policy Reserve Account Dr. To Joint Life Policy Account (d) On receiving the policy money on death of a partner Bank Account To Joint Life policy Account

Dr.

(e) On transferring the balance of Joint Life Policy Reserve Account to the Joint Life Policy Account Joint Life Policy Reserve Account Dr. To Joint Life Policy Account (f) On transferring the balance among partner’s capital Accounts

Joint Life Policy Account To all Partner’s Capital Accounts.

Dr.

6. SHARES AND DEBENTURES Definition of Company : A company is a voluntary Association of persons formed for some common purpose, with capital divisible into parts, known as shares and with a limited liability. It is a creation of law and is sometimes known as an artificial person with a perpetual succession and a common seal. Features of a company (a) It is a Voluntary Association of persons (b) It is an artificial person (c) It enjoys separate legal entity (d) Liability of its members is limited (e) It has perpetual succession and common seal (f) Shares of the company are transferable (g) Large capital can be mobilised by company (h) Large Profits are earned Types of companies (1) On the basis of incorporation: companies are classified as(a) Chartered company : These are the companies which are incorporated under a special charter granted by the King or Queen. eg. The East India Company. (b) Statutory Companies : These are the companies which are created by a special Act of the legislature. eg. Reserve Bank of India, LIC etc. (c) Registered Companies: These are the companies which are formed and registered under the companies Act of 1956.

(2) On the Basis of Liability : Companies are classified as(a) Companies with limited liability (b) Companies with unlimited liability Companies limited liability may be(a) Companies limited by shares: Where the liability of the members of a company is limited to the amount unpaid on the shares. (b) Companies limited by Gurantee : Where the liability of the members of a Company is limited to a fixed amount which the members undertake to contribute to the assets of the company in case of its winding up. (c) Unlimited Companies : A Company without limited Liability is known as an unlimited company. It may or may not have a share capital and there is no limit on the liability of its members. (3) On the Basis of number of members: Companies are classified as (a) a Private Company (b) a Public Company. (a) A Private Company : Means a Company which by its articles, (i) Restricts the rights to transfer its shares if any (ii) Limits the number of its members to 50 and (iii) Prevents the public to subscribe for any shares in or debentures of the company. (b) A Public Company : Means of a company which is not a Private Company. In other words, a public company is a company which by its articles does not (i) Restricts the right to transfer its shares. (ii) Limit the number of its members and (iii) Prohibit any invitation to the public to subscribe for any shares in or debentures of the company. (4) On the Basis of Control: Companies may be classified into (a) Holdig companies (b) Subsidiary Companies. (a) Holding Company : a Company is deemed to be the holding Co. of another if, but only that other is its subsidiary. (b) A company is known as a subsidiary of another company when control is exercised by the latter over the former, called subsidiary company. (5) On the basis of ownership: Company may be a Government Company or a Non Government company.

(a) Government company means any company in which at least 51% of the paid-up share capital is held by the central government or by any State Government or partly by the Central Government and partly by one or more State Governments. (b) Foreign Company is any company incorporated outside India but which has a place of business in India. FORMATION OF A COMPANY Formation of any public Company involves different stages like: (a) Promotion Stage (b) Incorporation Stage (c) Capital Subscription Stage (d) Commencement of business stage Promotion stage: It invloves doing the necessary preliminary work incidental to the formation of the company. The persons who undertake the work incidental to the formation of a company are called as promoters. Incorporation Stage: This is the stage of registration of the company. The Promoters have to take certain steps for getting the certificate of incorporation from the Registrar of companies(a) Memorandum of Association (b) Articles of Association (c) The address of the registered office of the company. (d) A list of directors with their names, addresses and occupations (e) Consent in writing of the directors to act as directors (f) The statutory declaration Memorandum of Association: The Memorandum of Association is the most important document of the company. It sets out the constitution of a company and as such it is a charter. It defines the co’s relation with the outside world & the scope of its activities. Its purpose isto enable the shareholders, creditors as well as those who deal with the compay to know the company’s activities. It contains important clause & Association & Subscription clause. The Memorandum has to be divided into paragraphs, consecutively numbered and printed. It must be signed by the subscribrs... Articles of Association Articles of Association contains rules and regulations for inner managment. It provides rules for the conduct of the day-to day administration of the company. It

regulates the relationship between the company & its members and employees. Articles must be printed, divided into paragraphs, numbered consecutively & signed by each subscriber of the memorandum and filed with the registrar.They lay down the powers of the directors, shareholders & officers. It contains rules and regulations regarding share capital, lien on shares, calls on shares, transfer, transmission, forfeiture and surrender of shares, issue of share warrant, voting powers, borrowing powers, proceedings at the board and generalbody meetings, dividend & reserves, appointment, powers, duties, qualification and remuneration of directors, managing directors, secretary and auditors, maintenance of books of a/c s winding up procedures etc.

Prospectus A Public Company invites the public to subscribe for its shares or debentures through issue of a document known as prospectus. The companies Act of 1956 defines Prospectus as Prospectus, notice, circular, advertisement or other document inviting offers from the public for the subscription of any shares or debentures of a body corporate. The main objects of the prospectus are (a) to inform the public about the forming of a new company (b) to include the investors to invest in its shares & debentures & (c) to make the directors responsible for the statement in the prospectus. Statement in lieu of prospectus: If the promoters intend to secure capital from their relatives andfriends without public subscription, they need not issue prospectus but instead can prepare a statement containing similarinformationfor filing with the Registrar which is known as Statement in lieu of the prospectus. Listing of Shares Entering the shares of a company in the official list of stock exchanges for the purpose of trading is known as listing of shares. Some of the advantage of listing are (a) It provides a continuous market for securities (b) It enhances the prestige of the company and (c) It provides an indirect check against manipulation by the management. Underwriting Agreement: The act of ensuring the sale of shares or debentures of a company, even before offering to the public, is called underwriting and those engaged in such ativities are called underwriters. The terms and conditions under which the underwriters agree to underwrite the shares are embodied in a document known as underwriting agreement. Minimum Subscription

The minimum subscription is the minimum amount of capital which is in the opinion of the directors, is required to commence business. In case of a public company the registrar will issue the certificate to commence business only when the amount raised by alloting shares,is not less than the amount equivalent to the minimum subscription mentioned in the prospectus. Share Capital It is the capital raised by a company by the issue of shares. It can be raised by the company at the time of its formation and later on for the purpose of meeting the requriements of its expansion.

Classses of Capital (a) Authorised or Nominal or Registered Capital : This is the maximum amount which thecompany is authorised to raise by issuing shares. This is the sum stated in the memorandum of association as the nominal capital of the company. This capital is also known as registered capital becuase it is the amount of capital with which the company registered or incorporated. This amount is usually fixed by the company taking into account the present as well as its future needs for finance. Ex. Nominal capital may be Rs.10,00,000 dividend into 1,00,000 equity shares of Rs. 10 each. (b) Issued Capital : It is that part of the authorised or nominal capital which the company needs for the time being and has been issued to public for subscription. Ex: Out of Rs. 10,00,000 nominal capital,the company may decide to issue for public subscription Rs. 8,00,000 divided into 80,000 equity shares at Rs. 10 each. (c) Subscribed Capital : That part of the issued capital which is subscribed by thepublic is known as subscribed capital. In other words the amount of the issued capital which has been taken up by the public is known as subscribed capital. Ex: out of 80,000 equity shares issued for subscription only 70,000 shares may be taken up by the public. Thus the subscribed capital will be Rs. 7,00,000 (d) Called up Capital : The company often does not need the full amount of its subscribed capital. In which case it calls up only, part of the amount of the face value of shares immediately and later makes further calls as necessary. Ex: if the company decided to call Rs.5 per share out of its nominal value of Rs.10, it is called up capital. (e) Uncalled capital: The difference between the subscribedcapital and called up capital is known as uncalled capital. (f) Paid up Capital: The amount actually paid by the shareholders is known as paid-up capital.

(g) Reserve Capital: It is that part of the uncalled capital of a company which shall not be called up except at the time of winding up of the company. The purpose of creating reserve capital is to protect the interest of creditors and to create public cofidence in the company. (h) Fixed Capital: It is that part of the capital which is invested in fixed assets. Eg. Land and Building, Plant and Machinery. (i) Working Capital : It is the capital which is used for the purpose of day to day business of the co. In other words this capital is used again and again Eg. buying raw materials goods etc. Shares Share is a share is the share capital of a company. It is nothing but a company’s owned capital which is divided into a large number of equal parts. Kinds of Shares

 Preferences Shares





Ordinary/Equity Shares Deferred/ Founders

 (a) Cumulative & non Cumulative (b) Participating & non participating (c) Redeemable & irredeemable Preference Shares Preference shares are those shares which carry preferential rights in respect of dividend and the return of capital. The rate of divident on the shares is fixed & the dividend must be paid to them before paying any dividend on other shares. They provide long term and medium term finance. (a) Cumulative Preference Share: Cumulative preference shares enjoys rights over arrears of dividend on shares to be paid out of future profits, in case profits are inadequate in any year. (b) Non-cumulative Preference Share: Non Cumulative preference shares do not receive any dividend incase profits are nil in any year. In other words, in case the profits are inadequate i.e. the arrears of dividends do not accumulate and hence any unpaid dividend in any year will not be paid out of future profits. (c) Participating Preference Share: These shares have the right to participate in dividends if there is any balance after paying dividendon equity shares at a certain rate.

(d) Non Participating Share: These shares do not have the right to participate in dividends if there is any balance after paying dividend on equity shares. (e) Redeemable Preference Share: Redeemable Preference Shares are those shares where the company undertakes to return the amount paid on them subject to certain conditions like shares must be fully paid, shares must be redeemed only out of the dividable profits, & articles of the company must authorise for the issue of shares. Equity Shares: Equity Shares or Ordinary Shares are not preference shares. They receive dividend only after preference dividends are paid. They enjoy voting rights. Equity shares have the chance of receiving high dividend. They participate in the management. They are not subject to redemption during the life time of the company. It is also called as risk capital of the company. They provide only long term finance.

Deferred Shares/Founder’s Share Only private companies are allowed to issue deffered shares. These shares are held by the promoters. They enjoy differential voting rights and enable the promoters to have control over the company. Distincition between preference shares and equity shares. Preference shares

Equity Shares

(1) They are entitled for first

(1) They preference

rank

next

to

preference in receiving dividend

shares in receiving dividend

(2) For receiving back their capital, capital

(2) They receive back their

they enjoy first preference. are paid.

only after preference shares

(3) Rate of dividend is fixed by the articles. fixed.

(3) Rate of dividend is not It fluctuates according to the

earning power of the company. (4) They enjoy voting rights only

(4) They enjoy normal voting rights.

under exceptional circumstances. (5) Their rights are limited in the control of management

(5) They enjoy full control of management.

(6) Face Value is relatively much higher

(6) Face value is neither too high nor too low

(7) They can be redeemed reemption

(7) They are not subject to

during the lifetime of the company company.

during the lifetime of the

(8) They provide long term

(8) They provide only long

and medium term capital

term finance

(9) This is called rentier capital

(9) This is called risk capital

Subscription of Shares: There may be (a) Over subscription , (b) Equal subscription, (c) Under subscription. When the company receives application for more number of shares than issued, it is known as over subscription. When the company receives application for the same number of shares as issued, it is known as equal subscription and when the company receives application for less than the number of shares issued it is known as under subscription. Issue of Shares: The company may issue shares (a) at par, (b) at premium or (c) at discount. If the shares are issued at the face value, it is known as issue at par. Ex. Face value is Rs.100 per share issued at Rs. 100. If the shares are issued at more than the face value, it is known as issue at premium, Ex: face value is 100 per share issued at 110, Rs.10 is premium. If the shares are issued at less than face value, it is known as issue at discount. Ex. Face value being Rs. 100, issued at Rs. 90, Rs. 10 is discount. Allotment of shares Allocation of shares to applicants is known as allotment of shares. Methods of allotment (a) First cum first served basis (b) Giving preference for application for smaller number of shares. (c) Pro-rate allotment/ Proportionate allotment. (d) Lottery method. Procedure for recovering the amount of shares. The company may receive the amount on shares allotted ininstalments. It may be received at different stages like Application, Allotment etc., The instalment amount payable on application is called application money. The instalment amount payable on allotment of share is called allotment money and the instalment amount payable on demand in future is called calls on shares.

Calls in arrears : The amount of call money not paid by the shareholder by due date is called call-in-arrears. Such calls are subject to a charge of interest at 6% p.a. Calls in Advance : Payment of money on the shares by the share holders before the call is made is known as call in advance. Such amount is entitled to get 6% p.a. interest. Forfeiture of shares : Cancellation of shares for no-payment of call money due is known as forfeiture of shares. The amount paid by the shareholder on the forfeited shares will not be returned. The forfeiture of shares take place only for no-payment of call money and not for any other reason. Surrender of shares : Returning of shares by the shareholder to the company on account of inability to pay call money is known as surrender of shares. Here shareholder himself pleads his inability to pay the call money. Surrender V/s forfeiture (1) Surrender is a voluntary action taken by a shareholder where as forfeiture is a compulsory action taken by the company. (2) In case of surrender, the company may exempt the holder from paying the outstanding call amount and interest & return a part of te amount already paid on the shares. But no such concession is allowed in case of forfeiture of shares. Lien on shares : Lien is the right of a person to retain some property of another person until the claims of the person is possession of the property are satisfied. The company may exercise a right of lien on shares of a shareholder who has failed to pay his debts to the company. Lien V/s Forfeiture (a) Lien is a right to retain the possession of shares till due amount is paid where as forteiture is a right to cancell the shares for no-payment of call amount. (b) Lien does not be lead to reduction in capital but forfeiture may lead to reduction in capital. Re-issue of shares : Issuing again the forfeited shares is known as re-issue of shares. Capital Reserve : The balance remaining in the forfeited shares account after reissue is transferred to an account known as capital reserve. The balance in this account canot be used for any other purpose, other than for issue of Bouns shares. Journal Entries for share transaction

(1) For receipt of application money Bank A/c............................. Dr. To Share application a/c (2) For transfer of application money on allotment Share application a/c.............Dr. To Share capital a/c (3) For return of application money on rejected applications Share application a/c ............... Dr. To Bank a/c (4) For allotment money due Share allotment a/c ........... Dr. To Share capital a/c (5) For receipt of allotment money Bank a/c ............. Dr. To Share allotment a/c (6) For first call money due Share first call a/c ......... Dr. To Share Capital a/c (7) For first call money received Bank a/c ............. Dr. To share first call a/c (8) For second & final call money due Share second & final call a/c .......... Dr. To Share capital a/c (9) For second and final call money received Bank a/c .................... Dr. To share second and final call a/c. Sometimes shares are issued at premium and the premium amount is received along with application money. In such a case, the following jurnial entry is passed as receipt of application money. Bank A/c ..................Dr. To Share appliation a/c The following journal entry is passed to transfer the application money on allotment of shares.

Share application a/c ................. Dr. To Share capital a/c To Share Premium a/c Sometimes shares are issued at premium and the premium amount is received at allotment stage. In such a case, the following jurnial entry is passed. Share allotment a/c .............Dr. To Share capital a/c To Share premium a/c Sometimes shares are issued at discount and the discount amount is adjusted in allotment stage. In such a case, the following jurnial entry is passed. Share allotment a/c ............. Dr. Discount on issue of shares a/c ......... Dr. To share capital a/c (10) For forfeiture of shares Share capital a/c (called up amount) ........Dr. To share allotment a/c (amount not received) To Share calls a/c (amount not recevied) To Share forfeiture a/c (Balancing figure) (11) For re-issue of forfeited shares Bank a/c.............. Dr. Share forfeiture a/c ...........Dr. To Share capital a/c (12) For transfer of balance in share forfeiture a/c Share forfeiture a/c.........Dr. To Capital reserve a/c Illustration-1 Red Star Ltd. invited Application for 10,000 shares of Rs. 10 each payble Rs. 2/- on application, Rs. 3/- on allotment, Rs. 2/- on 1st call & Rs. 3/- on second & final call. 12,000 Applications are received. The directors rejected 2000 applications and accepted the remaining applications. All the calls were made & all the shares were fully paid up. Give journal entries & prepare ledger a/cs. Solution - 1

Journal Entries -----------------------------------------------------------------------------------------------------------Particulars (1) Bank a/c..............Dr,

L/F

Debit Rs.

Credit Rs.

24,000

To Share Application a/c

24,000

(Being application amount received on 12,000 shares at Rs. 2/(2) Share Application a/c....... Dr.

4,000

To Bank a/c

4,000

(Being refund of application money on 2000 rejected application) (3) Share Application a/c ..........Dr.

20,000

To Share capital a/c

20,000

(Being application amount transferred to share capial a/c) (4) Share Allotment a/c..............Dr,

30,000

To Share Capital a/c

30,000

(Being allotment amount due at Rs. 3/- on 10,000 Shares) (5) Bankd a/c ...................Dr

30,000

To Share allotment a/c

30,000

(Being allotment amount received at Rs.3/- on 10,000 shares) (6) Share 1st Cal a/c............Dr

20,000

To Share Capital a/c

20,000

(Being 1st call amount due on 10,000 shares at Rs.2/- shares) (7) Bank a/c......................Dr

20,000

To Share 1st call amount received on 10,000 shares

20,000

at Rs.2/- shares) (8) Share 2nd & final call a/c.............Dr

30,000

To share capital a/c

30,000

(Being 2nd & final call amount due on 10,000 shares at Rs.3/- shares) (9) Bank a/c...................Dr

30,000

To share 2nd & final call a/c

30,000

(Being final call amount received on 10,000 shares at 3/- share) --------------------------------------------------------------------------------------------------------Dr

Share Application a/c

Cr

--------------------------------------------------------------------------------------------------------Particulars

Amount

Particulars

Amount

--------------------------------------------------------------------------------------------------------To share Capital20,000 To Bank a/c

By Banka/c

24,000

4,000

--------------------------------------------------------------------------------------------------------24,000

24,000

--------------------------------------------------------------------------------------------------------Dr To Share capital a/c Dr. To Share capital a/c

Dr. To Share capital

Dr. Particulars

Share Allotment a/c 30,000

By Bank a/c

Share first call a/c 20,000

Cr 30,000 Cr.

By Bank a/c

Share 2nd & Final call a/c 30,000

By Bank a/c

Bank Account Amount

20,000

Cr. 30,000

Cr. Particulars

To Share Application

24,000

By Share Application

To Share Allotment

30,000

By Balance c/d

To Share 1st Call

20,000

To Share 2nd & Final Call

30,000

Amount 4,000 1,00,000

--------------------------------------------------------------------------------------------------------1,04,000

1,04,000

Dr.

Share capital A/c

Cr.

--------------------------------------------------------------------------------------------------------Particulars

Amount

Particulars

Amount

--------------------------------------------------------------------------------------------------------To Balance c/d

1,00,000

By Share application

20,000

By Share Allotment

30,000

By Share 1st Call

20,000

By Share 2nd & Final Call

30,000

--------------------------------------------------------------------------------------------------------1,00,000

1,00,000

Illustration-2 The Gold Ltd. having nominal capital of 2000 preference shares of Rs.100 each, issued 1000 preference shares of Rs. 110 each, payable Rs.10 on application, Rs.20 on allotment Rs.35 on 1st call and Rs.35 on final call. 2000 application were received & 400 applications were rejected. All the calls were made & money was duly received except 1st call money on 50 shares & final call money on 100 shares Pass journal entries, prepare ledger a/cs, and show the Balance Sheet. Solution - 2 Journal Entries Particulars (1) Bank A/c..............Dr.

L/F

Debit Rs.

Credit Rs.

20,000

To Preference share application a/c

20,000

(Being application amount received on 2000 shares at Rs.10/-) (2) Preference Shares Application a/c....... Dr.

10,000

To Preference share capital a/c

10,000

(Being application amount transfered to Share capital a/c on1,000 shares at Rs. 10/- share) (3) Preference Share Application a/c ..........Dr.

4,000

To Bank a/c

4000

(Being refund of application money on 400 shares rejected ) (4) Preference Share Allotment a/c..............Dr,

20,000

To Preference Share Capital a/c

20,000

(Being allotment amount due on 1,000 shares at Rs.20 each) (5) Preference Share Application a/c ...................Dr

6,000

Bank a/c ...............Dr

14,000

To Preference Share allotment a/c

20,000

(Being allotment received on allotment and adjustment of application money) (6) Preference Share 1st Cal a/c............Dr

35,000

To Preference Share Capital a/c

35,000

(Being 1st call amount due on 1,000 shares at Rs.35/- shares) (7) Bank a/c......................Dr

33,250

To Preference Share 1st call a/c (Being 1st call amount received on 950 shares at Rs.35/- )

33,250

(8) Preference shares final call a/c.............Dr

35,000

To Preference share capital a/c

35,000

(Being final call amount due on 10,000 shares at Rs.35/-) (9) Bank a/c...................Dr

31,500

To Preference Share final call a/c

31,500

(Being final call amount received on 900 shares at 35/-) Dr

Share Application a/c

Particulars

Amount

To Pref. share Capital a/c

10,000

To Bank a/c

4,000

To Pref. Share Allotment a/c

6,000

Cr Particulars

Amount

By Bank a/c

20,000

20,000 Dr To Pref. share capital a/c

20,000

Preference Share Allotment a/c 20,000

Cr

By Bank a/c

14,000

By Pref. Share Application a/c

6,000

20,000 Dr To Pref. share capital a/c

20,000

Preference Share 1st call a/c 35,000

Cr

By Bank a/c

33,250

By Balance c/d

1,750

35,000 Dr To P/S capital a/c

35,000

Preference Share final call a/c 35,000

By Bank a/c

Cr 31,500

By Balance c/d

3,500

35,000 Dr

35,000

Preference Share capital a/c

To Balance c/d

1,00,000

Cr

By Pref. Share Application

10,000

By Pref. Share Allotment

20,000

By Pref. Share 1st call a/c

35,000

By Pref. share Final call a/c

35,000

1,00,000

Dr

1,00,000

Bank a/c

Cr

To Pref. Share application

20,000

By Pref. Share

4,000

To Pref. Share Allotment

14,000

By Balance c/d

94,750

To Pref. Share 1st call

33,250

To Pref. share Final call

31,500 98,750

98,750

Balance sheet of Gold Ltd. as on ................ Liabilities

Rs.

Nominal Capital 2000 Preference Shares of Rs. 100/- issued &

Assets Cash at Bank

Rs. 94,750

2,00,000

Subscribed Capital 1,000 pref. shares of 100 each

1,00,000

Called up capital 1,000 pref Shares of 100 each 1,00,000 Less “Calls in arrears Paid up capital

5,250 94,750 94,250

94,250

Illustration - 3 The Bharat Co. Ltd. issued 1,00,000 equity shares of Rs. 10 each payable Rs. 2 on application, Rs. 3/- on allotment Rs. 3 on 1st call & Rs. 2 on final call. Application were

received for 80,000 shares which were fully alloted & allotment money received on 75,000 shares. When the 1st call was made, the amount was received in full along with balance of allotment money. Pass Journal entries for the books of the company Solution -3 Journal Entries Particulars

L/F 1. Bank a/c...............Dr

Debit Rs.

Credit Rs.

1,60,000

To Equity share application a/c (Being application amount

1,60,000

received on 80,000 shares at Rs.2 each) 2. Equity share application a/c.........Dr

1,60,000

To equity share capital a/c

1,60,000

(Being application money transferredto share capital a/c) 3. Equity share allotment a/c............Dr

2,40,000

To equity share capital a/c (Being allotment amound due

2,40,000

on 80,000 shares at Rs. 3 each) 4. Bank a/c.................Dr

2,25,000

To Equity Share allotment a/c (Being allotment money on

2,25,000

75,000 shares at Rs. 3 each) 5. Equity share 1st call a/c..........Dr

2,40,000

To Equity share capital a/c (Being 1st call & final call money

2,40,000

due on 80,000 shares at Rs. 2 each) 6. Bank a/c.............Dr

4,15,000

To Equity Share 1st call a/c

2,40,000

To Calls in Advance a/c

1,60,000

To Equity share allotment a/c (Being 1st call money & final call money received on 80,000 shares at 2 each and allotment money received on Balance of 5,000 shares at Rs. 3 each)

15,000

ACCOUNTING FOR DEBENTURES: Issue of Debenture Meaning : A debenture is a mere acknowledgement of a debt. It may be defined as an instrument in writing issued by a company under its common seal acknowledging a debt and setting forth the terms under which it is issued and to be repaid. Generally debentures are issued in fixed denominatins. They carry a fixed percentage of interest. The Debentures holders are not entitiled toparticipate in the profits of the company. They get only interest at a fixed rate. They are only creditors of the company. Classes of Debentures The debentures issued by a company may be calssified as under: (1) On the basis of title & transfarability- Debentures can be Register Debenture & Bearer Debentures. (a) Registered Debentures and (b) Bearer Debentures. In case of Registered debentures, the names of the debentures holders are entered in the books of the company & for transfring them regular transfer deed has to be prepared. In case of Bearer Debentures the names of the holders of bearer debentures are not registered in the books of the company and therefore, for transfering them , there is no need for preparing transfer deed. They can be transferred by mere delivery. (2) On the basis of Security: Debentures can be simple or naked or unsecured debentures and secured or mortgage debentures. Simple/ naked/ unsecured debenturesare issued with merely a promise to pay the holder interrest and alos to repay the principal without any charge on any assets of the company. Secured / morgage debentures are issued with charge on the company’s assets as security. (3) On the basis of Redeemability: debentures may be redeemable debentures, irredeemable or perpetual debentures and convertable debentures. In case of Redeemable debentures, the company reserves the right of off the principal on or after a specified date. In case of irredeemable debentures the company reserves the right not of on the principal as long as the company is a going concern & does not make default in the payment of interest.

convertable debentures are convertable into shares at the option of the holders after a special period. Issue of debentures Debentures can be issued at Par, at a Premium, or even at a Discount. Similarly, debentures can be redeembed at Par, or at premium but redumption of debentures at a discount is not allowed. A public Company can issue debentures only after getting the certificate of commencement of business but a private company can issue debentures immediately after incorporation.The articles usually empower the board of directors to issue debentures. Distinctions between debentures and shares Debentures

Shares

1. Debentures from capital creditorship securities

1. Shares form ownership

2. It receive interest

2. It receives Dividend

3. Debentures holders are creditors of the company

3. Share holders are owners of the company

4. Debentures are issued later

4. Shares are issued intially

5. Debentures can be converted into shares

5. Shares can not be converted into debentures

6. Debentures are secured by a charge on the asset of the company

6. Shares cannot be secured by a charge on the assets of the company

7. Debentures are issued for cash only

7. Shares may be issued for for cash of kind

8. Debentures are always paid up fully

8. Shares may be fully or partly paid up

Illustration - 1 ABC Co. issued 10,000 debentures of Rs. 100/- each at a discount of 10% payable Rs. 20 on application, Rs.20/- on allotment and Balance on first and final call. Pass the necessary journal entries. Journal entries Particulars 1. Bank a/c...............Dr

L/F

Debit Rs. 2,00,000

Credit Rs.

To Debenture Application a/c (Being application amount

2,00,000

received on 10,000 shares at Rs.20/- each) 2. Debentures application a/c.........Dr

2,00,000

To Debentures a/c

2,00,000

(Being application money transferredto Debentures a/c) 3. Debenture allotment a/c............Dr

2,00,000

Discount on debentures a/c..........Dr.

1,00,000

To Debenture a/c (Being allotment amound due

3,00,000

on 10,000 debentureincluding discount) 4. Bank a/c.................Dr

2,00,000

To Debenture allotment a/c

2,00,000

(Being Debenture allotment money received) 5. Debenture 1st & final call a/c........

5,00,000

To Debenture a/c (Being 1st & final call money

5,00,000

due on 10,000 debentures at Rs. 50 each) 6. Bank a/c .................Dr

5,00,000

To Debenture 1st & final call a/c

5,00,000

(Being final call money received) Balance sheet as on............. Liabilities 10,000 debenture at 100 each

Rs. 10,00,000

Assets

Rs.

Cash at Bank

9,00,000

Discount on Debentures

1,00,000

10,00,000

10,00,000

Illustration - 2 Star Ltd. issued 5,000 8% Debenture of Rs. 100/- each at a premium of Rs. 10/repayable at the end of 20yrs at Par. The amount was payable as follows: Rs. 10 on Application, Rs.30 on Allotment (including Premium) Rs.30 on 1st Call & Rs.40 on final call. Pass the necessary Journal Entries Journal entries Particulars 1. Bank a/c...............Dr To Debenture Application a/c (Being application amount

L/F

Debit Rs.

Credit Rs.

50,000 50,000

received on 5,000 shares at Rs.10/-per share) 2. Debentures application a/c.........Dr

50,000

ToDebentures a/c (Being application money transferred)

50,000

3. Debenture allotment a/c............Dr

1,50,000

To Debenture a/c

1,00,000

To Debenture premium a/c (Being allotment amound due

50,000

on 5,000 debenture at Rs.30/- per debenture) 4. Bank a/c.................Dr

1,50,000

To Debenture allotment a/c

1,50,000

(Being Debenture allotment money received) 5. Debenture 1st call a/c..........Dr

1,50,000

To Debenture a/c

1,50,000

(Being 1st call money due on 5,000 debentures at Rs. 30 each) 6. Bank a/c...................Dr

1,50,000

To Debenture 1st call a/c (Being 1st call money received

1,50,000

on 5,000 debenture at Rs.40 each) 7. Debenture Final call a/c............Dr

2,00,000

To Debenture a/c

2,00,000

(Being final call money due on 5,000 including premium) 8. Bank a/c................Dr

2,00,000

To Debenture final call a/c

2,00,000

(Being final call amount received) Distinction between shareholder and debenture holder Share holders

Debenture Holders

1. Share holder is

1. Debenture holder is a

owner of the company

creditor of the company

2. Share holder cannot receives any entitled to

2.

dividend unless the company of

receive interest irrespective

makes a profit company

the profit or loss of the

3. Capital except in the case

3. A Debenture loan can be

Debenture

holder

is

of redeemable preference shares,

liquidated.

cannot be repaid unless legal formalities for capital redemption are observed. 4. In the event of winding up of the

4. Debentures holder are paid

company, share holders are paid

first in the event of

only after debentures are paid

winding up of the company.

5. Shares can be issued at discount,

5. Debentures can be issued

or at a premium only subject

at par or at a premium easily

tocertain conditions laid down by the Companies Act 6. Share holder has a right to vote holder has no

6.

Generally

at the meeting of the company.

voting right.

Debenture

Illustration - 3 AB Ltd. issued 5,000 5%debentures of Rs. 100 each payable Rs. 30 on application, Rs.30 on allotment & Rs. 40 on final call. 6,000 applications were received & 4,000 applications accepted is full & 500 applications were rejected & remaining debentures were issued to remaining applicants. Give the Journal Entries & show Bank a/c & Debentures account Journal entries Particulars 1. Bank a/c...............Dr

L/F

Debit Rs.

Credit Rs.

1,80,000

To Debenture Application a/c (Being application amount

1,80,000

received on 6,000 shares at Rs.30/-per share) 2. Debentures application a/c.........Dr

1,50,000

To Debentures a/c (Being application money transferred

1,50,000

to5,000 debentures at Rs.30 each) 3. Debenture Application a/c............Dr

15,000

To Bank a/c (Being refund of application money

15,000

on 500 debentures at Rs. 30 each) 4. Debenture Allotment a/c................Dr To debenture a/c (Being allotment amount due

1,50,000 1,50,000

on 5,000 debentures at Rs.30 each) 5. Bank a/c............Dr

1,35,000

Debentures application a/c .......Dr

15,000

To Debentures allotment (Being cash on allotment &

1,50,000

adjustment of debenture application received) 6. Debenture final call a/c.............Dr

2,00,000

To Debenturea/c (Being final call amount due on 5,000

2,00,000

debentures at Rs. 40 each) 7. Bank a/c.................Dr

2,00,000

To Debenture final call a/c (Being final call amount received) Dr.

2,00,000

Bank Account

Cr.

To Debenture application

1,80,000

By Debenture application

To Debenture allotment

1,35,000

By Balance c/d

To Debenture final call

2,00,000

5,00,000

5,15,000 Dr. To Balance c/d

15,000

5,15,000

Debenture Account 5,00,000

Cr.

By Debenture Application

1,50,000

By Debenture Allotment

1,50,000

By Debenture final call

2,00,000

5,00,000

5,00,000

Illustration -4 The Hindustan Co. Ltd. issued 10,000 debenture of Rs. 100 each at a premium of Rs.20 each, payable as follows- Rs. 30 on application, Rs. 50 on allotment including premium, Rs. 40 on first & final call. All the debenture were fully subscribed & the money duly received by the Co. Give Journal Entries to record the above transactions. Solution - 4 Journal entries Particulars 1. Bank a/c...............Dr To Debenture Application a/c (Being application amount

L/F

Debit Rs.

Credit Rs.

3,00,000 3,00,000

received on 10,000 shares at Rs.30/-per share) 2. Debentures application a/c.........Dr

3,00,000

To Debentures a/c

3,00,000

(Being application money transferred to Debentures a/c) 3. Debenture allotment a/c............Dr

5,00,000

To Debenture a/c

3,00,000

To Debenture premium a/c

2,00,000

(Being allotment amound due along with premium) 4. Bank a/c.................Dr

5,00,000

To Debenture allotment a/c (Being Debenture allotment

5,00,000

money received along with premium) 5. Debenture final call a/c................Dr

4,00,000

To Debenture a/c

4,00,000

(Being final call amount due on 10,000 debentures) 6. Bank a/c...................Dr

4,00,000

To Debenture final call a/c

4,00,000

(Being final call amount received) Illustration - 5 The ‘X’ Co Ltd. issued 1,000 12% Debentures of Rs. 1,000 each at a premium of Rs. 200 per debenture payable as under; on application Rs. 200, on allotment Rs. 500 (including premium) on final call Rs. 500 All the debentures were fully subscribed called up and paid up. Pass necessary Journal Entries.

Solution- 5 Journal entries Particulars 1. Bank a/c...............Dr

L/F

Debit Rs. 2,00,000

To Debenture Application a/c (Being application amount

2,00,000

received on 1,000 shares at Rs.200/-) 2. Debentures application a/c.........Dr

Credit Rs.

2,00,000

To Debentures a/c (Being application amount due)

2,00,000

3. Debenture allotment a/c............Dr

5,00,000

To Debenture a/c

3,00,000

To Debenture premium a/c (Being allotment amound due

2,00,000

on 1,000 debentures along with premium) 4. Bank a/c.................Dr

5,00,000

To Debenture allotment a/c

5,00,000

(Being Debenture allotment money received) 5. Debenture call a/c................Dr

5,00,000

To Debenture a/c (Being final call amount due )

5,00,000

6. Bank a/c...................Dr

5,00,000

To Debenture final call a/c (Being final call amount received)

5,00,000

Illustration -6 Sriram Co. Ltd. issued 20,000 12% debentures of Rs.100 each at discount of 10% payable in full on application . Application received for 23,000 debentures. It was alloted only to the extent of issued & the excess was refunded. Pass Journal entries, show ledger a/c & B/s Solution - 6 Journal entries Particulars

L/F

1. Bank a/c...............Dr

Debit Rs.

Credit Rs.

20,70,000

To Debenture Application a/c (Being application amount

20,70,000

received on 23,000 debenture at Rs.90/-per share) 2. Debentures application a/c.........Dr

1,80,000

Discount on Debenture a/c..............Dr

20,000

To Debentures a/c (Being Allotment of 20,000 debentur at

20,00,000

Rs.100 each at a discount of Rs. 10 each) 3. Debenture Application a/c.............Dr To Bank a/c

2,70,000 2,70,000

(Being the excess money on 3,000 Debenture refunded) Dr.

Debenture Application A/c

Cr.

To Debentures a/c

18,00,000

To Bank a/c

By Bank a/c

20,70,000

2,70,000 20,70,000

20,70,000

Dr.

Debenture Account

To Balance c/d

20,00,000

By Debenture Application

18,00,000

By Discoun on Debenture

2,00,000

20,00,000 Dr.

20,00,000

Discount on Debenture a/c

To Debenture a/c

2,00,000

By Balance c/d

2,00,000 Dr.

20,70,000

Cr. 2,00,000 2,00,000

Bank Account

To Debenture Application a/c

Cr.

Cr.

By Application

2,70,000

By balance c/d

18,00,000

20,70,000

20,70,000

Balance Sheet as on............. Liabilities

Rs.

Share capital secured loans 12% debentures

Assets Bank

20,00,000 20,00,000

Discount on debenture

Rs. 18,00,000 2,00,000 20,00,000

8. RATIO ANALYSIS Meaning of Ratio :Ratios are nothing but one set of figures compared with another set. It explains the relationship between the two. It is a method to understand the financial position of a business unit. According to Accountant's Handbook by Wixon, Kell and Bedford, a ratio "is an expression of the quantitative relationship between two numbers". In simple language .ratio is one number expressed in terms of another and can be worked out by dividing one number to the other. For example, the ratio of two figures 100 and 50 may be expressed in any of the following ways: (a) 2:1

(b) 2

(c) 2/1 (d) 2 to 1

(e) 200%

In all these cases the inference is that the first figure is double, 200%, or 2 times than that of the second. Nature of Ratio Analysis : Quantitative ratio analysis does not provide solution for all the problems faced by financial analyst, unless several ratios, each of which related to the other are compiled and analysed in a proper perspective. There are a number of ratios, which can be computed from a single set of financial statements. But only a few can be used in a particular situation. The ratio to be computed depends upon the purpose for which such ratios are required. Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. It involves four steps: i)

ii) iii)

iv)

Selection of relevant data from the financial statements depending upon the Objective of the analysis. Calculation of appropriate ratios from the above data. Comparison of the calculated ratios with the ratios of the same firm in the past, or the ratios developed from projected financial statements or the ratios of some other firms or the comparison with the ratios of the industry to which the firm belongs. Interpretation of the ratios.

The interpretation of ratios should be done by taking into analysis a group of related ratios in sufficient number. Some times an individual ratio may also give some information. But a comprehensive analysis can be made only when a set of inter related ratios are analysed.

Ratios provide clues to the financial position of a concern. These are the points or indicators of financial strength, soundness, position or weakness of an enterprise. One can draw conclusions about the exact financial position of a concern with the help of ratios. Advantages of Ratio Analysis Following are some of the advantages of Ratio analysis: 1. Simplifies financial statement: Ratio analysis simplifies the comparison of financial statements. 2. Inter-firm comparison: It facilitates inter-firm and intra-firm comparison. 3. It provides the management the area of weakness and strength. So, that it can concentrate on improving the weak point. 4. Helps in planning: Ratio can help the management in its basic function of planning and forecasting. Over a period of time, the firm/industry can develop certain norms, which may indicate future success or failure. Limitations of Ratio analysis. Following are the limitations of Ratio analysis. 1. Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with the past results of the business or with the results of the similar business. However, such a comparison only provides a glimpse of the past performance. But forecast for future may not be correct, because there are several other factors like market condition, management policy etc., may affect future operations. 2, Limitations of Financial Statement: Ratios are based only on the information which has been recorded in the financial statements. A change in the management may have a change in the operations of the firm. 3. Only quantitative aspects: Ratios gives only the quantitative aspect of the firm. For example, a current ratio of 4:1 indicates the company’s liquidity position is very good. But for an outsider, not only the capacity of the firm but its attitude is also important. Courtesy, Promptness, punctuality and decency in dealing with the customers depends upon attitude of the persons occupying the helm of affairs. Those aspects are not disclosed by the ratio analysis. 4. Window dressing: The term window dressing means manipulation of accounts in such a way so as to conceal vital facts. Financial statements may be presented in a way to show a different position, than what it is. In such a situation the ratios developed from such figures may not disclose the actual facts.

5. Problems of price level changes: Financial analysis based on accounting ratios may be misleading if the effect of change in the price level is not taken into account. 6. No fixed standard: No fixed standard has been laid down for ideal changes. For example, if the current assets are twice the current liability, the liquidity position is satisfactory. But when a company has established a good rapport with their bankers, to provide additional finance, then even if the current ratio is lesser, still the liquidity position may be good. Therefore, it may be concluded that ratio analysis , if done mechanically is not only misleading but also dangerous. It is indeed a double edged sword which requires a great deal of understanding. Ratio analysis is an aid to management in taking correct decision. Ratios if discriminately calculated and widely interpreted can be a useful tool of financial analysis.

CLASSIFICATION OF RATIOS Various accounting ratios can be classified as follows: 1) Classification according to statement from which they are derived. In this case, classification is made depending upon the statement from which the data is collected. This is the convenient mode of classification. In this type ratios are developed on the following three lines: a) Revenue statement ratios: These ratios are also known as operating ratios. These establish relationship between two items of a group of items which are taken from the revenue statements. b) Balance Sheet ratios or Financial ratios: These are the ratios which deal with the relationship between any two items or a group of items given in the balance sheet. c) Combined ratios: These ratios portray the relationship between items, one of which is taken from revenue statement and the other from the balance sheet. Traditional Classification or Statement Ratios

Balance Sheet Ratio OR Position Statement Ratios 1. Current Ratio. 2. Liquid Ratio (Acid test or Quick Ratio). 3. Absolute Liquidity Ratio. 4. Debt Equity Ratio. 5. Proprietary Ratio. 6. Capital Gearing Ratio.

Profit and Loss Account Ratios OR Revenue / Income Statement Ratios 1. Gross Profit Ratio. 2. Operating Ratio. 3. Operating Profit ratio. 4. Net Profit ratio 5. Expense Ratio 6. Interest coverage Ratio

Composite / Mixed Ratio OR Inter – Statement Ratios

1. Stock Turnover ratio. 2. Debtors Turnover ratio. 3. Payables Turnover ratio. 4. Fixed Assets Turnover Ratio. 5. Return on Equity Capital.

Some important types of ratios are as follows: 1. Liquidity Ratios, 2. Solvency Ratios, 3. Profitability Ratios. 4. Activity Ratios

1.LIQUIDITY RATIOS These ratios indicates about the financial position of the company. A company is deemed to be financially sound if it is in a position to carry on its business smoothly and meet all its obligations – both long term and short term without strains. Thus, the financial position has to be judged from two angles – long term as well as short term. It is a sound principle of finance that long term requirements of funds should be met out of long term funds. Short term requirements shall be met out of sort term funds. For example, if fixed assets are purchased out of funds provided by bank overdraft, the company will face the problem, when it has to repay bank overdraft. It cannot sell fixed asset for repaying bank overdraft. The following are some of the important financial ratios. 1. SHORT TERM LIQUIDITY. The smooth day to day working of the company depends upon its capacity to pay all its short term obligations. To judge the company’s capacity to pay all its obligations on time, the following ratios have to be examined. 1) CURRENT RATIO: It is the most important ratio for measuring short term liquidity. Since it is related to working capital analysis, it is also called working capital ratio. Current ratio express the relationship between current assets and current liabilities. Current ratio is the ratio of total current assets to total current liability. It is calculated by dividing current assets by current liability. Current ratio = Current assets Current liability Current assets are those that can be converted into cash within a very short period. They include cash in hand, cash at bank, sundry debtors, bills receivable, stock, prepaid expenses, outstanding income etc., Current liabilities are those that are to be paid within a short period of time. They include sundry creditors, bills payable, bank overdraft, outstanding expenses and any other short term liabilities. Importance of Current Ratio The current ratio of a firm measures the short term solvency i.e. its ability to meet its short term obligations. The excess of current assets over current liability, becomes working capital. Therefore, higher the current ratio, the higher will be the amount of working capital available to the firm for conducting day to day operation and safer will be the position of the creditors. In a financially sound business, a current ratio of 2:1 is considered to be ideal i.e. current assets shall be twice the amount of current liability. In the rarest situation, if all the

current liabilities are paid, there should be sufficient working capital left over in the business. However, all current assets do not have same amount of liquidity. For example, for cash sales, lower margin may be sufficient but for credit sale higher margin is required because all debtors may not pay in time. Current ratio is an index of firm’s financial stability i.e. an index of technical solvency and strength of working capital. In brief, the current ratio has the following significance. a) Current ratio indicates the firm’s ability to pay its current liability. b) It shows short term financial strength. c) It indicates strength and solvency of the firm. d) A higher current ratio shows effective financial and operational efficiency of the firm. Precautions: In determining the current ratio, it is important that all current assets and current liabilities should be properly valued, over valuation of inventory, un-saleable inventory included in stock, sufficient provision not being made for bad and doubtful debts etc., may mislead the current ratio. Short term investment in marketable securities, shall be included in current assets but fictitious assets shall be excluded. Similarly, every long term liabilities, if it is due for payment within a year shall be included in current liabilities. Regarding bank overdraft, unless it is mentioned as permanent arrangements, shall be included in current liability. Problems of window dressing: The financial analyst shall be very careful, while examining the current assets (on account of window dressing i.e. practice of manipulating the current assets and current liability). Many firms, may show excess value of current assets, by inflating inventory value, not making provision for doubtful debts, advance received for next year as cash receipt etc., similarly short term liability may be treated as long term liability. Illustration 1 The following information are taken from the Balance sheet of a firm. Rs. Creditors 80,000 Cash Bills Payable 20,000 Debtors Bank Overdraft 50,000 Bills Receivable Outstanding expenses 25,000 Marketable Securities Inventories Prepaid Expenses Total Current Liability 1,75,000 Total Current Assets

Rs. 1,00,000 80,000 20,000 80,000 60,000 10,000 3,50,000

Current Ratio = Current Assets Current Liability = 350000 175000 = 2:1 It means for every Re. 1 current liability, there are Rs. 2 Current assets. Assume that full amount of outstanding expenses and Rs. 25000 creditor are paid then there is a reduction in cash by Rs. 50,000 i.e. current asset is reduced to Rs. 3,00,000. Similarly current liability is reduced by Rs. 50,000 i.e. current liability is Rs. 1,25,000. Then, the current ratio is 300000 = 2.4:1 125000

Therefore, when current liabilities are paid, out of cash the current ratio has increased from 2:1 to 2.4:1. LIQUID RATIO This ratio is also called as “Acid Test Ratio” or “Quick ratio”. This ratio indicates the relationship between the liquid assets (assets which are immediately convertible into cash) to liquid liability. All current assets except stock and prepaid expenses are considered as liquid assets. All current liability except bank overdraft is known as liquid liability. Normally, the banker will not demand back he amount of overdraft so long as payment of interest is made promptly. Liquid Ratio = Liquid Assets Liquid Liabilities On the basis of illustration no. 4.10 the liquid asset will be Rs. 3,50,000-60000 (Stock) – 290000. The liquid liability will be Rs. 175000-50000(bank overdraft) = Rs. 1,25,000. Therefore, the liquid ratio is 290000 = 2.32:1 125000 The main defect of current ratio is that it fails to distinguish between inventory and receivables. A firm may have a huge amount of inventory compared to receivables and other current assets. Then even with a very high current ratio, it may not be in a position to pay its liabilities in time. In so far as eliminating inventory is concerned while calculating acid test ratio, it is a rigorous test of liquidity. It gives a better picture of firm’s ability to meet its short term obligations. When a business has 1:1 liquid ratio, then the liquidity position of the firm is supposed to be satisfactory. A comparison of the current ratio to quick ratio indicates the inventory hold-ups, for example, if two units have the same current ratio but different liquid ratio, it indicates over stocking by the firm, which has low liquid ratio. Absolute liquidity ratio: The superiority of liquid ratio, over the current ratio is on account of inventory. It may take a longer period to convert inventory into stock. Similarly, conversion of account receivable into cash may also take longer period and the total amount may not be received full due to bad and doubtful debts. Therefore, absolute liquidity ratio relates to the sum of cash and marketable securities to the total quick liabilities. It gives more meaningful measure of liquidity when used in comparison with current and acid test ratios. However, this ratio is not much in use. Long term liquidity: These ratios indicate the long term solvency of the company. Every trading company has implied power to borrow. This borrowing power is generally limited to the amount of paid up capital and free reserves. It means, if a company has Rs. 100 paid-up capital, Rs. 50 reserves i.e. total Rs. 150, then it can borrow up to Rs. 150, 50% may be short term borrowing and another 50% long term borrowings. This is supposed to be an ideal borrowing.

2.SOLVENCY RATIOS: The following are the important ratios that determines the long term solvency of the firm. 1. Debit Equity Ratios. The financing of the total assets of a business is done by owners equity (also known as internal equity) as well as outside debt (also known as external equity). How much fund has been provided by the owners and how much by outsiders in the purchase of total asses is very significance factor in deciding the long term solvency of the firm. In other words, the relationship between, the sorrowed fund and owners funds is a popular measure of long term financial solvency of a firm. This relationship is shown by the debtequity ratio. This is also known as external-internal equity ratio. This calculated by the following formula. Debt equity Ratio = External Equities Internal Equities The term external equity includes debentures and other long term loans. Internal equities, include equity share capital, preference share capital and undistributed profits and reserves. The following additional formula is used. i) Debt equity ratio = Total Long term debt Total long term funds ii) Debt equity ratio = Share holders funds Total long term debt iii) Debt equity ratio = Total long term debt Share holders funds Method iii is very popular. Whatever the way, the debt equity ratio is calculated, it shows the extent to which debt financing has been used in the business. A high ratio shows that the claim of the creditors are greater than those of owners. It is unfavourable from the company’s point of view because creditors will interfere in the company’s administration. A low debt-equity is favourable as owners have greater say in the administration and creditors are more secured. Illustration 2 From the following information calculate the debt equity ratio. Rs. Preference share capital 2,00,000 Equity share capital 4,00,000 Capital Reserve 1,00,000 Profit and Loss account 1,00,000 12% Mortgage Debentures 2,00,000 Unsecured loan 1,00,000 Sundry Creditors 80,000 Bills payable 40,000 Provision for taxes 20,000 Provision for dividends 40,000

The debt equity ratio is calculated in any one of the following methods, depending upon the purpose for which the information is required. i)

ii)

iii)

Debt Equity Ratio = External Equities Internal Equities = 480000 800000 = 0.6:1 Debt Equity Ratio = Total Long Term Debt Total Long Term Funds = 3,00,000 (Debentures + Unsecured Loan) 11,00,000 (Share holders funds + Long term loans) = 0.27:1 Debt Equity Ratio = Share Holders Funds Total Long Term Funds

= 8,00,000 11,00,000 = 0.73:1 iv) Debt Equity Ratio = Long Term Debt Share Holders Funds = 3,00,000 8,00,000 = 0.375:1 The fourth method is very commonly used. A ratio of 0.5:1 is said to be satisfactory. It indicates the proportion of owner’s stake in the business. Excessive liabilities tend to cause overstrain on the business. This ratio shows to what extent, the firm depends on outsider for its survival. Too much dependency is dangerous.

3.PROFITABILITY RATIOS: It is an indication of the efficiency with which the operations of the business are carried on. A lower profitability may be the result of under sales or over expenditure. Bankers, financial institutions and other creditors look at the profitability ratios as an indicator of the capacity of the firm to pay interest. Owners are interested to know the profitability as it indicates the return on their investments. Profit is the engine that drives the business enterprise. It is an index of economic progress. Profits are the test of efficiency and a measure of control to the management. It is a source of fringe benefits to the employees. Profit is a measure of tax paying capacity to the government. It is a hint for a price cut to the customers. Finally the profitability ratios judge the overall efficiency of the business. Most of the profitability ratios are expressed a percentage on sales. Profitability ratio may be broadly be classified into two types. A) Those ratios that indicates the operational efficiency of the business. B) Those ratios that indicate the return on investment. The following are the important profitability ratios for judging operational efficiency.

A) Gross Profit Ratios: It is also known as Gross Margin Ratios. The difference between the cost of goods sold and net sales is known as gross profit. It is very useful as a test of profitability. It is generally believed that the margin of gross profit should be sufficient enough to cover all operating expenses and to leave adequate amount as net sales. Opening Stock + Purchases + All direct expenses = Cost of goods sold This amount is deducted from sales + Closing Stock to get the Gross Profit. Gross Profit Ratio

= Gross Profit X 100 Net Sales Generally the gross profit ratio should remain same from year to year, because cost of sales will normally vary in direct proportion to the sales. Higher the ratio, greater will be the profitability. The Finance Manager must be able to detect the causes of a decrease in Gross margin and initiate action to improve the situation. There is no fixed standard percentage of gross profit to sales. It depends upon the nature of productions and type of goods. However a ratio of 25% to 35% may be considered reasonable. A higher gross profit ratio may indicate: a) Increase in selling price. b) Reduction in cost of goods sold or both. c) Under valuation of opening stock or over valuation of closing stock. B) Operating Ratio: This ratio establishes the relationship between total operating expenses and sales. Total operating expenses includes cost of goods sold, administration expenses, financial expenses and selling expenses. Cost of goods sold is also known as direct operating expenses and the rest are known as other operating expenses. This ratio is also expressed as a percentage on sales. Operating Ratio = (Cost of Goods sold + Operating Expenses) X 100 Net Sales i) Cost of Goods sold = Opening Stock + Purchases – Closing Stock ii). Operating expenses = Administration Expenses + Financial Expenses + Selling Expenses. This ratio shows the operating efficiency of the firm. Lower operating ratio indicates higher operating profit and vice-versa. C) Expenses ratio: This is a supporting ratio to operating ratio. It becomes imperative that each aspect of cost of goods sold and/or operating expenses should be analysed in detail. Just to find out as how for the firm is able to save or is making over expenditure in respect of different items of expenses. In order to know which item of expenditure is more, it is very essential to find out the ratio of each item of expenditure to net sales. The following are the four important expenses ratio: a) Factory Expenses Ratio = Factory Expenses X 100 Net Sales

b) Administrative Expenses Ratio

= Administrative Expenses Net Sales

c) Selling Expenses Ratio = Selling Expenses X 100 Net Sales d) Any other particular expenses Ratio = Particular Expenses Net Sales

X 100

X 100

D) Operating Profit Ratio: This ratio indicates the operating profit to net sales. It shows the overall operational efficiency of the firm. Although there is no fixed standard, 12% to 15% of net sales is supposed to be a reasonable operating profit. Operating Profit Ratio = Operating Profit Net Sales

X 100

E) Net Profit Ratio: The Profit margin is an indictor of management ability to operate the business with sufficient success, not only to recover from revenues of the cost but also to leave a reasonable margin. Net Profit Ratio = Net Profit Net Sales

X 100

The following are the profitability ratio which indicates the return on investments. The profitability of the firm is also measured in relation to investments. The term investment may refer to total assets, capital employed or owner’s equity. The efficiency of an enterprise has to be judged not only on the profit earned in relation to sales, but also the profit earned in relation to the total investments made in the business. Investments are represented by those assets, which are acquired for conducting the business operations. The size of the investments certainly affects the volume of profits. The following are the important ratios in this type. a) Return on Total Assets: Profitability can be measured in terms of relationship between the Net profit and total assets. The overall profitability can be measured by using the following formula. Return on Asset = Net Profit X 100 Total Assets b) Return on Capital employed: This is a ratio which establishes the relationship between the operating profit and capital employed. The Prime objective of making investment in any business is to get satisfactory return on capital invested. The following formula is used. X 100 Return on Investment = Operating Profit Capital Employed The term Capital employed refers to the long term funds supplied by the creditor and owners of the firm. Capital employed is to be found out by long term liabilities plus owners’ equity. Alternatively, it is also equivalent to net working capital plus fixed

assets. Thus, the capital employed basis provides a test of profitability related to the long term funds. A comparison of this ratio with similar firms and with the industrial average would provide information regarding the efficiency of long term funds. Higher the ratio, more is the efficient use of long term funds. c) Return on Share holder’s equity: This ratio establishes the relationship between the net profit and the shareholders funds. In this context, Net profit means net income, after interest and tax, including non-operating income. It is the final income available for distribution as dividends to shareholders. Share holders funds include both equity share capital and preference share capital and all reserves and surplus belonging to shareholders. Return on Share holders equity = Net Profit X 100 Share holder’s funds. d) Return on Equity share holders Funds: Profitability from the equity share holders point of view will be judged after taking into account the amount of dividends payable to preference share holders. X 100 Return on Equity = Net Profit Equity Share holders funds. e) Earning per share (E.P.S.) In order to avoid confusion on account of different meaning of the capital employed, the overall profitability can also be judged by calculating earning per share by using the following formula. EPS = Net Profit (after preference dividends) No. of Equity Share The EPS helps in determining the market price of equity shares of the company. A comparison of EPS of the company with similar other company will also help in deciding whether the equity share capital is being effectively used or not. It also helps in estimating the company’s capacity to pay dividend to it’s equity share holders. f). Price Earning Ratio: This ratio indicates the number of times the earning per share is covered by it’s market price. This is calculated by using the following formula. Price Earning Ratio = Market price per equity share Earning per share For example, the market price is Rs. 100. The EPS is Rs. 20, then price earning ratio = 100/20, = 5 It means the market value of every Re. 1 earning is 5 times.

2.. Proprietary Ratio: It is a variant of debt equity ratio. It establishes relationship between proprietors funds (Shareholders funds) and total tangible assets. The ratio

provides a margin of safety to creditors. It tells the owner the extent to which they can gain the benefit or maintain the control with a limited investment. It is found out by using the following formula. Proprietary Ratio = Share holders funds Total Tangible assets Illustration No. 3 From the following particulars, calculate the proprietary ratio. Liabilities Rs. Assets Rs. Preference Share Capital 4,00,000 Fixed Assets 8,00,000 Equity Share Capital 8,00,000 Current Assets 4,00,000 Reserves and Surplus 2,00,000 Good Will 1,80,000 Debentures 4,00,000 Investments 6,00,000 Creditors 2,00,000 Preliminary Expenses 20,000 20,00,000 20,00,000 Solution: Proprietary Ratio

= Share holders funds Total Tangible assets = 14,00,000 18,00,000 = 0.77:1

4.ACTIVITY RATIOS: These ratios are intended to measure the effectiveness of the employment of resources. They not only analyse the use of the total resources of the firm but also the use of the component of the total assets. Activity analysis together with the degree of leverage employed by the firm is a key factor in determining the profitability. (Shareholders funds includes preference share capital + Equity Share Capital +Reserves and Surplus Tangible Assets, All assets excluding goodwill and preliminary expenses) This ratio focuses the attention on the general financial strength of the business enterprise. This ratio has particular importance to creditor as it helps them to find out the proportion of the shareholders funds in the total assets of the company. Higher ratio indicates the secured position of the creditor. It shows the long term solvency of the firm. Capital Gearing Ratio: This is also known as Capitalisation ratio or leverage ratio. This ratio is mainly used to analyse the capital structure of the firm. The term capital gearing normally refers to the proportion between fixed interest or dividend bearing funds to equity shareholders funds. Capital Gearing Ratio = Fixed Interest Bearing Funds Equity Share Holders Funds The Capital gearing shows the relationship between the fixed interest bearing funds to non-fixed interest (dividend) bearing funds. This proportion is leverage. Strictly, leverage means the effect of pressure applied in one end on the other. In the context of capital structure of the company, the effect o fixed interest bearing funds to

non-fixed interest bearing funds. The extent to which the capital is geared shows the speed with which the firm is accelerating towards the corporate goal. Further, high gearing means trading in this equity and low gearing means trading in thick equity. Highly geared capital structure may be indicative of under capitalisation which means that the amount of capital is far less than the needs measured by the volume of activity. A low capital gearing ratio indicates over-capitalisation. It must be very carefully planned to avoid both over and under capitalisation. There should be a balanced capital structure. 1) Equity Capital = Loan Capital = Even Gear 2) Equity Capital > Loan Capital = Low Gear = Over Capitalisation 3) Equity Capital < Loan Capital = High Gear = Under Capitalisation Therefore, an analysis of capital gearing ratio helps for balanced capital structure of the company. Illustration No. 4 Find out the capital gearing from the following details

Equity Share capital 10% Preference Share Capital 12% Debentures 15% Long Term Loans Current Liabilities General Reserve

Rs. 1,00,000 50,000 80,000 14,000 30,000 80,000

Solution: Capital Gearing Ratio = Fixed Interest and Dividends bearing funds Equity Share holders funds = 1,44,000 (Preference shares + Debentures + Long term loans) 1,80,000 (Equity Share capital + Reserves = 0.8:1 Since, it is less than one, it is low geared. Illustration No.5 From the following balance sheet of a company, you are required to calculate current ratio and solvency ratio Share Capital 5,00,000 Fixed Assets 6,00,000 Fixed Liabilities 2,50,000 Current Assets 4,00,000 Current Liabilities 2,50,000 10,00,000 10,00,000 Solution: 1) Current Ratio = Current Assets Current Liability = 4,00,000 2,50,000 = 1.6:1

2) Solvency Ratio = Outsiders Liability X 100 Total Assets = 5,00,000 X 100 10,00,000 = 50% Although, the current ratio is slightly less than standard, the solvency ratio is very good. The Total assets are 200% of outsiders liability. It means, the company is fully capable of paying all outsiders liability, out of its assets. Illustration No. 6 The following is the summarised Profit and Loss Account of Progress Ltd., for the year ended 31.03.2003. To Opening Stock To Purchases To Direct Expenses To Gross Profit To Administration Expenses To Selling Expenses To Finance Expenses To Loss on Sale of Assets To Net Profit

1,99,000 10,90,500 28,500 6,80,000 19,98,000 3,00,000 60,000 30,000 8,000 3,00,000 6,98,000

By Sales By Closing Stock

17,00,000 2,98,000

By Gross Profit b/f By Interest on investment By Profit on sale of shares

19,98,000 6,80,000 6,000 12,000

Balance Sheet as on 31.03.2003 Liabilities Rs. Assets Share Capital 4,000 Shares of Land and Building Rs. 100 each 4,00,000 Machinery Reserves 1,80,000 Stock in Trade Profit and Loss account 2,80,000 Sundry Debtors Debentures 2,00,000 Cash and Bank balances 40,000 Bank Overdraft Other current Liability 60,000 11,60,000

6,98,000

Rs. 5,00,000 1,60,000 2,98,000 1,42,000 60,000

11,60,000

Re-arrange the above statement in a suitable form for proper analysis and calculate the following ratios. a) Gross Profit Ratio, b) Operating Ratio, c) Operating Expenses Ratio, d) Operating Profit Ratio, e) Net Profit Ratio, f) Return on Total resources Ratio, g) Return on Capital employed Ratio, h) Earning per share ratio, i) Current Ratio, j) Liquid Ratio, k) Debt equity Ratio, l) Proprietary Ratio, m) Solvency Ratio, n) Stock turn over ratio, and o) Fixed Asset turnover ratio.

Solution: Progress Ltd., Income Statement for the year ended 31.03.2003 Sales

17,00,00 0

Less: Cost of goods sold Opening Stock Purchases Direct Expenses

1,99,000 10,90,50 0 28,500 13,18,00 0 2,98,000

Closing Stock

Gross Profit Less: Operating Expenses

10,20,00 0 6,80,000

A. Administration Expenses B. Selling Expenses C. Finance Expenses Operating Profit ADD: Non Operating Income Interest on Investment Profit on sale of shares

b) Operating Ratio

c) Operating Expenses Ratio

3,90,000 2,90,000

6,000 12,000 18,000

Less Non Operating Expenses Loss on sale of assets Net Profit a) Gross Profit Ratio

3,00,000 60,000 30,000

8,000

10,000 3,00,000

= Gross Profit X 100 Net Sales = 6,80,000 X 100 17,00,000 = 40% = (Cost of Goods + Operating Expenses) X 100 Net Sales = (10,20,000+3,90,000)X100 17,00,000 = 82.90% = Operating Expenses X 100 Net Sales

= 3.90,000 X 100 17,00,000 = 22.9% d) Operating Profit Ratio = Operating Profit X 100 Net Sales = 2,90,000 X 100 17,00,000 = 17.05% e) Net Profit Ratio = Net Profit X 100 Net Sales = 3,00,000 X 100 17,00,000 = 17.64% f) Return on Total Resources Ratio = Net Profit X 100 Total Assets = 3,00,000X 100 11,60,000 = 25.86% e) Return on Capital Employed Ratio = Net Profit X 100 Capital Employed = 3,00,000 X 100 8,60,000 (Equity Capital + Reserve + Profit and Loss Account) = 34.88% h) Earning per Share ratio = Net Profit No. of Equity Shares = 3,00,000 4,000 = Rs. 75 per Share i) Current Ratio = Current Assets Current Liability = 5,00,000 1,00,000 = 5:1 Ratio j) Liquidity Ratio = Liquid Assets Liquid Liability = 2,02,000 60,000 = 3.36:1 k) Debt Equity Ratio = Long Term Debt Equity Shareholders funds = 2,00,000 8,60,000 = 0.23:1 l) Proprietary Ratio = Share Holders funds Total Assets

m) Solvency Ratio

n) Stock Turnover Ratio

= 8,60,000 11,60,000 = 0.74:1 = Outsiders liability X 100 Total Assets = 3,00,000 X 100 11,60,000 = 25.86% = Cost of Goods Sold Average Stock] = 10,20,000 2,48,500(Opening Stock + Closing Stock) 2

o) Fixed Assets Turn Over Ratio

= =

4.1 Times Sales Fixed Assets = 17,00,000 6,60,000 = 2.5 Times

9. FUND FLOW STATEMENT Introduction: Trading Account, Profit and Loss Account and Balance Sheet are the basic financial statements. They give sufficient information about profitability and financial position of a company. But these statements do not disclose some vital information regarding the changes in current assets and current liabilities that have taken place during the year. As such, the usefulness of these statements to the financial analyst is limited. For financial analysis and planning, the financial managers shall know how the financial position of the firm has changed during the financial year. It was felt that an additional statement was required to indicate the changes in financial position. As a result of this, an additional statement was prepared which was called “Where got, where gone” statement. Later it was called “Statement showing the changes in financial position”. But these names were not well accepted by the business community. Now, it is commonly known as “Fund Flow Statement”. Meaning of Fund The term “fund” has a variety of meaning. There are people who believe that fund is equal to cash; others say that cash and marketable securities constitute the Fund. In this context, either cash or those that can be converted into cash become fund. Though there were ambiguities in them beginning, now the “working capital” concept is

commonly accepted for fund. There are further two concepts –‘ Gross working capital’ and ‘Net working capital’. The totals of current assets is called ‘Gross Working Capital’, where as the total of current assets minus current liability is called’ Net working capital’. Current Assets: The term “current assets” includes assets, which are acquired with the intention of converting them into cash during the normal business operation of the company, with in a calendar year. The following items are included in current assets in this connection: a. Cash and Bank balance including fixed deposits with banks. b. Accounts Receivable i.e. Debtors and bills receivables. c. Inventory i.e. raw material, work-in-progress, finished goods, stores and spares. d. Advances given to various persons including government agencies. e. Prepaid expenses. f. Short-term investments and marketable securities. g. Income earned but not received.

Current Liabilities: The term ‘current liabilities’ is used for those liabilities, which require to be paid within a short period, say about a year. In other words, current liabilities refer to those obligations that are to be paid during the operating cycle of the business with in a calendar year. The mere fact that the amount is due within a year does not make it current liability unless it is payable out of existing current assets or creation of additional current liabilities. For example, debentures due for redemption within a year will not be taken as current liabilities, if they are to be paid out of the proceeds of fresh issue of shares/debentures or out of the proceeds of the sale of debenture redemption fund investments. The following items are included in current liabilities. a. Account payable i.e. Bills payable and trade creditors. b. Outstanding expenses i.e. expense for which services has been received by the business but for which payment has not been made. c. Bank overdraft. d. Short term loans i.e. loans which are payable within a year. e. Advances received by the business for the services to be rendered or goods to be supplying during the next accounting cycle. f. Provisions against current assets i.e. provision for doubtful debts, discount on debtor etc., are treated as current liability since, they reduced the amount of current assets. Non-Current Assets

All assets other than current assets specified as above are termed as ‘non current assets’. Such assets include Fixed Assets like Good will, Land, Building, Machinery, Furniture, Patents, Trade Mark, Debit balance of Profit and Loss account, Discount on issue of shares and Debentures, Preliminary expenses etc., Non-Current Liability All liabilities, other than current liabilities are called as non-current liabilities. They include Long Term Liabilities like Share capital, Long term loans, Debentures, Share Premium, Revenue reserves, Capital reserves, Credit balance of Profit and Loss account, any other undistributed profit in any form (like debenture redemption fund, dividend equalization fund etc.,) Treatment of provision for taxation and proposed dividends a) Provision for taxation: There is a debate regarding the treatment of this item. Some accountants are treating it as current liability and others non-current liability. It may either be treated as a current liability or as a non-current liability. If it is treated as a current liability, then it is taken to the schedule of charges in working capital. Then payment of tax is not regarded as “application of fund”. Tax provision is not debited to adjusted profit and loss account. When provision for tax is treated as a current liability, for creating tax provision, profit and loss account is debited and provision for tax account is credited (which is a current liability). In this case, when tax is paid, there is no change in working capital as there is a reduction in one current liability with a corresponding reduction in one current asset. However, there is a clear difference between provision and liability. The amount set aside for a likely payment, which may or may not be paid during the accounting cycle is a provision, where as the amount to be paid within the next accounting cycle is a current liability. In this context, taxation provision is to be treated as ‘non current liability’. Then the provision for taxation is debited to adjusted profit and loss account and the amount of tax paid is treated as “application of fund”. This is a stronger view, which is more commonly accepted. b) Proposed Dividend Whatever, has been said about “taxation provision” is applicable for “proposed dividends” also. It can also be dealt in two ways. a) Proposed dividend may be taken as a current liability, since acceptance of dividends by shareholders, declared by the directors is only a formality, once it is accepted by general meeting; it has to be paid with in the stipulated time as per law. (42days). In this case, the proposed dividend will be shown in the schedule of changes in working capital. When it is paid, it will not be shown as application of fund. b) The difference in figures of proposed dividends cannot be treated as additional dividends proposed, because as already said, when the director proposes the dividends and it is shown in the appropriation account, the payment is bound to be made, as the acceptance by share holders is only a formality. In such a case, proposed dividend for the current year shall be added back to the current year profit in adjusted profit and loss

account, to determine the fund received from business operations. amount of dividend paid is shown as application of fund.

Then the actual

Meaning of Fund Flow statement. Flow of fund means, the change in the amount of fund. When there is a business transaction, there is a flow of fund i.e. either there may be inflow of fund or outflow of fund. When there is inflow of fund, it is considered as a source of fund. When there is outflow of fund, it is shown as application of fund. Therefore, a fund flow statement is a statement of sources and uses of fund. In other words it is a statement, which shows how the net working capital is obtained and how it is used. Uses of Fund flow statement: Fund flow statement is very useful tool for the financial managers. The following are the uses of fund flow statement for different parties. 1.Fund flow statement determines the financial consequences of business operations. Finance managers can know how the firm has obtained the fund and how it is has been used. 2.The management can formulate its financial policies on the basis of the information provided by Fund flow statements. 3.It serves a control mechanism, when compared with the budgeted figures. It helps for taking corrective actions. 4.It enables the creditors, bankers and other financial institutions in assessing the degree of credit involved in granting credit to the business. 5.The management can formulate more effective financial policy, with the help of fund flow statement. 6.It tells whether the sources of fund are increasing, decreasing or constant. 7.The statement compared with the budgeted figures will show to what extent the resources were used according to plans. Limitations of Fund flow statements: A fund flow statement suffers from the following limitations. 1.The fund flow statement ignores the non-fund item which has a greater impact on the working of the firm. As a result, it becomes a crude device. 2.The information used for preparing the fund flow statement is basically historical in nature. As a result, it fails to give proper guidance for future planning. 3.Fund flow statement discloses the changes in the working capital in the summarized form. Individual changes are not disclosed. 4.The statement lacks originality, because all information is taken from the other financial statements. 5.When both aspects of transactions are current or when both aspects are non-current, they are excluded from fund flow statement. Preparation of Fund flow statement.

The following four steps are involved in preparation of fund flow statement. 1. Schedule of changes in working capital. For preparing the fund flow statement two years Balance sheet of the firm are given, from these balance sheets, the changes in the current assets and current liabilities have to be recorded. Increase or decrease of each item of current assets and current liabilities are recorded. The object of preparing this statement is to ascertain the increase or decrease in net working capital. The following pro-forma may be used.

Particulars

Schedule of changes in working capital Effect on Working capital Previous Current Year Year Increase Decrease Rs. Rs. Rs. Rs.

Current Assets Cash in hand Cash at Bank Bills Receivable Sundry Debtors Marketable Securities Inventories Prepaid Expenses Outstanding Income Total Current Assets (C.A.) Current Liabilities Trade Creditors Bills Payable Outstanding Expenses Bank Overdraft Advance Received Total Current Liabilities (C.L.) Working Capital (C.A. – C.L.) Increase/Decrease in working capital Total Hints: 1) The above schedule is prepared with the help of current assets and current liabilities given with in the two years balance sheet. 2) Additional information given outside the balance sheet has no effect on the above statement. 3) Increase in current asset or decrease in current liability increases the working capital. 4) Decrease in current asset and increase in current liability reduces the working capital. 5) Increase in working capital becomes the uses of fund and decrease in working capital becomes the sources of fund.

2) The second step in preparation of fund flow statement is to find out the funds received from business operations (Funds from operation) The amount received from business operation is the single largest source of fund. The cash received from debtors or from sales cannot be taken as fund received because it has to be spent for purchases and for other payments. The net profit, as disclosed from profit and loss account cannot also be taken as fund received during the year, as profit and loss account includes a number of non-fund item. Non-fund item means those items in which neither the fund is received, nor the fund is given. These items are only book adjustments. Therefore, in order to find out the fund received from business operations these items have to be excluded. For example, depreciation on fixed asset. For the amount of depreciation profit and loss account is debited and the amount is deducted from the asset. In this case neither fund is received nor the fund goes out. Therefore, in order to adjust a number of non-fund items, an adjusted profit and loss account is prepared.

Particulars To Opening debit balance of profit and loss account To Depreciation To Good will written off To Preliminary Expenses written off To Underwriting commission written off To Discount on issue of shares and debentures written off

To Premium paid on redemption of preference shares or debentures To Loss on sale of assets To Profit transferred to reserve To Bonus shares issued To Dividends proposed To Taxation provision To Balance c/f (Profit and loss account credit balance at the end of the year) To Fund lost in business operations (when credit side is more)(Balancing figure)

Adjusted profit and loss account Rs. Particulars By Opening balance of Profit and loss appropriation account By Profit on sale of assets or appreciation of assets. By Non trading income By Balance c/f (Profit and loss account debit balance at the end of year) By Fund received from business operations (when debit side is more)Balancing figure

Rs.

3) Ascertainment of hidden transactions: Sometimes, certain items required for fund flow statement may not be given directly. They have to be found out by preparing various assets account. The third step

involved in preparation of various fixed assets accounts to find out either depreciation on fixed assets, profit or loss on sale of fixed assets or purchase of fixed assets. Fixed Assets Account Particulars Rs. Particulars Rs. To Opening balance b/f By Depreciation on fixed c) To Bank: - purchase of fixed a) assets assets By Bank: – sale of fixed assets d) To Profit and loss account b) By Profit and loss account e) (Profit on sale of fixed assets) (loss on sale of fixed assets) By Closing balance c/f Hint: The opening and closing balance of fixed assets are always given. The remaining items i.e. a to e may or may not be given. They are the missing items to be found out. Similarly, provision for taxation account is to be prepared. The opening and closing balances are always given. Either tax paid or provision for tax paid or provision for tax created during the year is given. The balance will be either tax paid or provision made during the year. Depreciation Fund account: There are two methods of charging depreciation on fixed assets. Normally, the amount of depreciation is debited to profit and loss account and deducted from the respective assets. Alternatively, the amount of depreciation may be charged to Profit and loss account and credited to depreciation fund account. Then asset will be shown at its full value in the balance sheet. But, when the asst is sold, for the amount of depreciation on the asset sold, depreciation fund account is debited and asset account credited. 4) After following all the above three steps, the final step is the preparation of fund flow statement. It is similar to cash account, where in the left side is used for showing the sources of fund and the right side is used for showing the application of fund. Fund Flow statement Sources Rs. Applications Rs. 1. Redemption of preference shares 1. Issue of shares 2. Redemption of debentures 2. Issue of Debentures 3. Repaying loans to 3. Borrowing loans from institutions institutions 4. Purchase of fixed assets 4. Sale of Fixed assets 5. Purchase of investments 5. Sale of investments 6. Fund lost in business 6. Fund received from business operations operations 7. Increase in working capital 7. Decrease in working capital 8. Non trading payment 8. Non trading receipt

Is depreciation a source of fund? There is a debate going on, whether depreciation is a source of fund. While preparing the adjusted profit and loss account, the amount of depreciation is added back to the profit, which increases, the fund received from business operations. Higher the amount of depreciation charged, higher will be the fund received from business operations. Therefore, depreciation may be considered as a source of fund. Besides, depreciation is charged on fixed assets. Fixed assets are used to generate the revenue. If there is no fixed assts, then the particular assets have to be hired for which hire charges are to be paid. Depreciation, which is charged on the fixed asset, prevents fund from going out of business. Fund saved become fund earned. Therefore, depreciation may be treated as a source of fund. Depreciation is debited to profit and loss account, which reduces the amount of profit. Since profit is reduced on account of depreciation, to that extent tax liability is also reduced. Therefore, the amount of depreciation reduces the fund from going out as tax. Hence, it is taken as a source of fund. The question is, whether the depreciation can really be considered as a source of fund? If it were to be so, all firms would have charged higher amount of depreciation and increase their sources of fund. But it is not so, because depreciation is only a book adjustment. PRACTICAL PROBLEMS Illustration No. 2.1 From the following Balance sheets, make out 1. Statement of changes in working capital 2 funds flow statement. BALANCE SHEET Liabilities

Assets 1989 Rs.

1990 Rs.

1989 Rs.

1990 Rs.

Share Capital

300000

400000 Goodwill

100000

80000

8% Redeemable Preference shares

150000

100000 Building

200000

170000

20000 Plant

80000

200000

20000

30000

140000

170000

Capital reserve

-

Gen Reserve

40000

50000 Investment

P & L A/c

30000

48000 Debtors

Proposed Divd.

42000

50000 Stock

77000

109000

Sundry Creditors

25000

47000 B/R

20000

30000

B/P

20000

16000 Cash

15000

10000

O/S. Exp.

30000

36000 Bank

10000

8000

Provn. For Tax.

40000

50000 Preliminary Exp.

15000

10000

677000

817000

677000

817000

Other information: i. A portion of the building was sold in 1990 and the profit has been transferred to Capital Reserve. ii. Written down value of a machine was Rs. 12000. it was sold for Rs. 10000. Depreciation of Rs. 1000 is charged in 1990. iii. Dividend on investment received in 1990 Rs. 3000. iv. An interim dividend paid in 1990 was Rs. 20000.

Solution: Statement showing change in working capital : Liabilities 1990

1989 Current Assets Stock Debtors B/R Cash in hand Cash in bank Less current Liabilities Creditors B/P Liability for Exp

Increase

Decrease

Rs.

Rs.

Rs.

77,000 1,40,000 20,000 15,000 10,000

1,09,000 1,70,000 30,000 10,000 8,000

32,000 30,000 10,000

2,62,000

3,27,000

72,000

25,000 20,000 30,000

47,000 16,000 36,000

Rs.

5,000 2,000 7,000 22,000 4,000 6,0000

76,000

35,000 41,000

76,000

76,000

Increase in Working capital

Plant A/c: Rs. To Op. Balance To Plant Purchased (Bal. Figure)

80,000 1,33,000

Rs. By Depreciation By Cash sales By Loss on Sales By Closing Balance

2,13,000 Goodwill A/c: By P & L A/c 1,00,000 By closing Bal.

To Opening balance

1,00,000 Building A/c : By Sales To Opening Bal 2,00,000 By Closing Bal To Capital Reserve 20,000 2,20,000

1,000 10,000 2,000 2,00,000 2,13,000

20,000 80,000 1,00,000

50,000 1,70,000 2,20,000

Investment A/c: To Opening Bal. To Purchases

20,000 10,000 By Closing Bal.

30,000

30,000

30,000

Proposed Dividend: Closing Bal Add. L.Y’s Paid this year

50,000 42,000

92,000 Less Opening Bal.

42,000

Current Provis ion

50,000

Gen. Reserve: Closing Bal. Less Opening Bal.

50,000 40,000

Provision during the year 10,000 Tax Provision : Closing Bal. Less Opening Bal. Provision during the year

50,000 40,000 10,000

Preliminary expenses : Opening Bal. Less Opening Bal. Written during the year

15,000 10,000 5,000

i) Adjusted Profit and Loss A/c: To General Reserve Propose dividend Int. Dividend Tax. Reserve Goodwill Depreciation on plant Loss on plant Preliminary

By Opening Balance 10,000 Dividend 50,000 Funds from operation 20,000 10,000 20,000 1,000 2,000

30,000 3,000 1,33,000

expenses Closing Balance

5,000 48,000 1,66,000

1,66,000

Funds Flow Statement: Sources Equity Capital Sale of land Sale of plant Div on investment Fund from Operation

Applications Rs. 1,00,000 50,000 10,000 3,000 1,33,000

2,96,000

Increase in Working Capital Pref. shares Int. Div. Paid Plant Purchased Investment Dividend Paid

Rs. 41,000 50,000 20,000 1,33,000 10,000 42,000 2,96,000

Illustration No. 2.2 From the following balance sheets of Y Ltd., as on 31st December 2001 and 2002. You are required to prepare a) A Schedule of changes in working capital b) A fund Flow Statement. Liabilities 2001 2002 Rs. Rs. 1,00,000 1,00,000 Share Capital General Reserve 14,000 18,000 Profit and Loss Account 16,000 13,000 Sundry Creditors 8,000 5,400 Bills payable 1,200 800 Provision for taxation 16,000 18,000 Provision for doubtful debts 400 600

1,55,600 1,55,800 Assets 2001 2002 Goodwill 12,000 10,000 Building 40,000 36,000 Plant 37,000 36,000 Investments 10,000 11,000 Stock 30,000 23,400 Debtors 18,000 19,000 Bills receivables 2,000 5,200 Cash at Bank 6,600 15,200 1,55,600 1,55,800 The following additional information has been given: 1) Depreciation charged on plant was Rs. 4,000 and on building was Rs. 4,000 2) Provision for taxation of 19,000 was made during the year 2002. 3) Interim (1/2 year) dividend of Rs. 8,000 was paid during the year 2002. Solution:

Schedule of charges in working capital Effect on working capital

Particulars Current Assets Stock Debtors Bills receivables Cash at Bank Total of Current Assets (CA) Current Liability Sundry Creditors Bills payable Provision for Doubtful debts Total of Current Liability (CL) Working Capital (CA-CL) Increase in Working Capital

Sources Fund Received Business Operation

from

2001

2002

30,000 18,000 2,000 6,600 56,600

Increase Rs.

23,400 19,000 5,200 15,200 62,800

6,600 1,000 3,200 8,600

8,000 5,400 2,600 1,200 800 400 400 600 9,600 6,800 47,000 56,000 9,000 56,000 56,000 15,800 Fund Flow Statement Rs. Application 38,000 Purchase of:a) Plant b) Investment Tax paid Interim Dividends paid Increase in working capital

38,000

Decrease Rs.

200

9,000 15,800 Rs. 3,000 1,000 17,000 8,000 9,000 38,000

Working Note: To Balance b/f

Building Account 40,000 By Depreciation

4,000

By Balance c/f

To Balance b/f To Bank: Purchase of Plant (Balancing figure)

To Balance b/f To Bank Purchase (Balancing figure)

40,000 Plant Account 37,000 By Depreciation 3,000 By Balance c/f 40,000 Investment Account 10,000 By Balance c/f 1,000

11,000 Provision for Taxation Account To Bank Tax paid 17,000 By Balance c/f (Balancing figure) 18,000 By Profit and Loss A/c To Balance b/f (Provision made during the year) 35,000 Adjusted Profit and loss Account To Depreciation By Balance b/f a) Plant 4,000 By Fund Received from b) Building 4,000 business operation To Good will written off 2,000 (Balancing figure) To Taxation provision 19,000 To General Reserve 4,000 To Interim Dividend 8,000 To Balance c/f 13,000 54,000 Note: Tax provision is treated as non-current liability. Illustration No. 2.3 From the following Balance sheets of Bharath Ltd., make out: a) Statement of changes in working capital b) Fund Flow Statement. Liabilities 1999 2000 Rs. Rs. Equity share capital 30,000 40,000 8% Redeemable preference 15,000 10,000 shares Capital reserve 2,000 General reserve 4,000 5,000 Profit and Loss account 3,000 4,800 Proposed dividend 4,200 5,000 Creditors 2,500 4,700 Bills payable 2,000 1,600 Liabilities for Exps. 3,000 3,600 Provision for tax 4,000 5,000

36,000 40,000 4,000 36,000 40,000 11,000

11,000 16,000 19,000

35,000 16,000 38,000

54,000

67,700 1999 10,000 20,000 8,000 2,000 14,000 7,700 2,000 1,500 1,000 1,500 67,700

Assets Goodwill Land and Buildings Machinery Investments Sundry debtors Stock Bills receivable Cash balance Bank balance Preliminary expenses

81,700 2000 8,000 17,000 20,000 3,000 17,000 10,900 3,000 1,000 800 1,000 81,700

You are informed that: a) A piece of land has been sold out in 2000 and profit on sale has been credited to capital reserve. b) A machine has been sold for Rs. 1000. Written Down Value (W.D.V.) of the machine was Rs. 1200. The Depreciation of Rs. 1000 was charged on machinery in 2000. c) Dividends received on investments Rs. 200. d) An Interim dividend of Rs. 2000 was paid in the year 2000.

Solution: Schedule of changes in working capital Effect on working capital

Particulars Current Assets Sundry Debtors Stock Bills receivable Cash balance Bank balance Total of Current Assets (CA) Current Liability Sundry Creditors Bills payable Liability for Exp, Provision for Tax

1999

2000

14,000 7,700 2,000 1,500 1,000 26,200

17,000 10,900 3,000 1,000 800 32,700

2,500 2,000 3,000 4,000

4,700 1,600 3,600 5,000

Increase Rs.

Decrease Rs.

3,000 3,200 1,000 500 200

2,200 400 600 1,000

Total of Current Liability (CL) Working Capital (CA-CL) Increase in Working Capital

Sources Issue of Equity shares Fund received from business operations Dividends received Sale of Land Sale of Machinery

11,500 14,700 3,100 17,800

14,900 17,800 17,800

7,600

Fund Flow Statement Rs. Application 10,000 Purchase of:13,300 a) Machinery b) Investments 200 Preference shares 5,000 redeemed 1,000 Dividends paid (1999) Interim dividends paid Increase in working capital 29,500

3,100 7,600

Rs. 14,200 1,000 5,000 4,200 2,000 3,100 29,500

Working Note: To Balance b/f To Capital Reserve

To Balance b/f To Bank -Purchase

To Balance b/f To Bank Purchase

To Balance c/f

To Bank – preference shares redeemed To Balance c/f

Land and Building Account 20,000 By Bank – 2,000 (3000+2000) By Balance c/f 22,000 Machinery Account 8,000 By Bank – Sales 14,200 By Loss on sale By Depreciation By Balance c/f 22,200

Sale

Investment Account 2,000 By Balance c/f 1,000 3,000 Equity share capital Account 40,000 By Balance b/f By Bank – issue of share (Balancing figure) 40,000 8% Preference share capital Account 5,000 By Balance b/f 10,000 15,000

5,000 17,000 22,000 1,000 200 1,000 20,000 22,200

3,000

3,000 30,000 10,000 40,000 15,000

15,000

To Depreciation on Machinery To Loss on sale of Machinery To Interim Dividend paid To General Reserve To Dividends proposed (2000) To Goodwill written off To Preliminary expenses written off To Balance c/f

Adjusted Profit and loss Account 1,000 By Balance b/f By Dividends received 200 on investment By Fund received from 2,000 business operations 1,000 (Balancing figure) 5,000

3,000 200 13,300

2,000 500 4,800 16,500

16,500

Tutorial Note: 1) Tax provision has been taken as current liability 2) Dividends proposed in 1999 is paid in 2000 3) Profit on sale of land is not taken to adjusted profit and loss account because it has not been added to profit. 4) Dividends received on investment is a non-trading income.

Illustration No. 2.4 The Balance Sheets of Sri Mookambika Company Ltd. as at the end of 2001 and 2002 are given below: Liabilities 2001 2002 Rs. Rs. Equity share capital 1,00,000 1,50,000 Share premium 5,000 General reserve 50,000 60,000 Profit and Loss Account 10,000 17,000 6% Debentures 70,000 50,000 Provision for depreciation of plant and machinery 50,000 56,000 Provision for depreciation of furniture 5,000 6,000 Provision for taxation 20,000 30,000 Creditors 86,000 95,000

3,91,000 4,69,000 Assets 2001 2002 Plant and Machinery at cost 1,04,000 1,00,000 Furniture at cost 7,000 9,000 Investments at cost 1,60,000 1,80,000 Debtors 30,000 70,000 Stock 60,000 65,000 Cash 30,000 45,000 3,91,000 4,69,000 A Plant which had been purchased for Rs. 4,000 (Accumulated depreciation Rs. 2,000) was sold for cash Rs. 800 on 30.09.2002. On 30.06.2002 an item of furniture was purchased for Rs. 2,000. These were the only transactions concerning Fixed Assets during 2002. Depreciation on Plant was provided at 8% p.a. on original cost (the sold out item is not taken into consideration) and on Furniture at 12 ½ % p.a. on average cost. A dividend of 22 ½ % on original shares was paid. Prepare a statement showing sources and destination (uses) of Fund during 2002. Solution: Schedule of charges in working capital Effect on working capital

Particulars Current Assets Debtors Stock Cash Total of Current Assets (CA) Current Liability Creditors Provision for taxation Total of Current Liability (CL) Working Capital (CA-CL) Increase in Working Capital

Sources Issue of shares Premium collected Fund received business operations Sale of Machinery

from

1999

2000

30,000 60,000 30,000 1,20,000

70,000 65,000 45,000 1,80,000

86.000 20,000 1,06,000 14,000 41,000 55,000

95,000 30,000 1,25,000 55,000 55,000

Fund Flow Statement Rs. Application 50,000 Purchase of:5,000 a) Furniture b) Investments 49,700 Debentures repaid 800 Dividends paid Increase in working capital 1,05,500

Increase Rs.

Decrease Rs.

40,000 5,000 15,000

9,000 10,000

60,000

41,000 60,000

Rs. 2,000 20,000 20,000 22,500 41,000 1,05,500

Working Note: Depreciation Fund on Plant and Machinery Account To Machinery A/c 2,000 By Balance b/f To Balance c/f 56,000 By Depreciation (Balancing figure) 58,000 Plant and Machinery Account To Balance b/f 1,04,000 By Depreciation By Cash – Sale By Loss on Sale By Balance c/f 1,04,000 Investment Account To Balance b/f 1,60,000 By Balance c/f To Bank: - Purchase 20,000

To Balance c/f

To Balance b/f To Cash: - Purchase

To Depreciation a) Machinery b) Furniture To Loss on sale of Machinery To General Reserve To Dividends (22.5% on 1,00,000) To Balance c/f

1,80,000 Depreciation on Furniture Account 6,000 By Balance b/f By Depreciation (Balancing figure) 6,000 Furniture Account 7,000 By Balance c/f 2,000 9,000

Adjusted Profit and loss Account By Balance b/f 8,000 By Fund received from 1,000 business operations

50,000 8,000 58,000 2,000 800 1,200 1,00,000 1,04,000 1,80,000

1,80,000 5,000 1,000 6,000 9,000 9,000

10,000 49,700

1,200 10,000 22,500 17,000 59,700

59,700 Tutorial Notes: 1. Tax provision is taken as current liability. 2. Difference in share capital is to be taken as issue of additional shares. 3. Reduction in debentures to be treated as debentures re-paid. 4. Under the depreciation fund system, when the asset is sold, for the amount of depreciation on the asset sold, fund is account to be debited and asset account credited.