ACG 102
ADVANCED ACCOUNTING - II
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Msharashtra
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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Vice-Chancellor : Dr. M. M. Salunkhe
Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh
State Level Advisory Committee
Dr. Pandit Palande
Hon. Vice Chancellor
Dr. B. R. Ambedkar University
Muaaffarpur, Bihar
Dr. Suhas Mahajan
Ex-Professor
Ness Wadia College of Commerce
Pune
Dr. V. V. Morajkar
Ex-Professor
B.Y.K. College, Nashik
Dr. Mahesh Kulkarni
Ex-Professor
B.Y.K. College, Nashik
Dr. J. F. Patil
Economist Kolhapur
Dr. Ashutosh Raravikar
Director, EDMU,
Ministry of Finance
New Delhi
Dr. A. G. Gosavi
Professor
Modern College, Shivaji Nagar, Pune
Dr. Madhuri Sunil Deshpande
Professor
Swami Ramanand Teerth Marathwada
University, Nanded
Dr. Prakash Deshmukh
Director (I/C)
School of Commerce & Management
Y.C.M.O.U., Nashik
Dr. Parag Saraf
Chartered Accountant Sangamner
Dist. AhmedNagar
Dr. S. V. Kuvalekar
Associate Professor and
Associate Dean (Training)(Finance )
Dr. Surendra Patole
Assistant Professor
School of Commerce & Management
National Institute of Bank Management ,
Y.C.M.O.U., Nashik
Pune
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Author
Editor
Instructional Technology Editing &
Programme Co-ordinator
1) Dr. Suhas Mahajan
Research Guide,
NessWadiaCollege ofCommerce,
Pune - 411 001.
2) Dr. Mahesh A. Kulkarni
Research Guide,
BYK College of Commerce,
Nashik - 422 005.
Prof. V. V. Morajkar
10, Vidya Society, Shikhare Wadi,
Nashik Road - 422 101.
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Production
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Manager, Print Production Centre
Y.C.M. Open University, Nashik - 422 222.
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
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Topic 1
CONTENTS
Accounts of Holding Companies
Unit 1 Meaning, Definition, Legal Conditions and Principles of Consolidation 1-22
1.0 Introduction 1.1 Unit Objectives 1.2 Meaning and Definitions 1.3 Legal Conditions for preparation of Balance
Sheet of a Holding Co. 1.4 Principles of Consolidation 1.5 Financial year of the Holding Co. and its Subsidiary 1.6
Illustrations 1.7 Summary 1.8 Key Terms 1.9 Questions and Exercises 1.10 Further Reading
Unit 2 Preparation of Consolidated Balance-sheet of Holding Company
23-46
2.0.Introduction 2.1 Unit Objectives 2.2 Preparation of Consolidated Balance Sheet of Holding Co. with one
Subsidiary only 2.2.1 Purpose 2.2.2 Advantages 2.2.3 Disadvantages 2.2.4 Procedure 2.3 Basic Rules for preparing
a Consolidated Balance Sheet 2.4 Miscellaneous Adjustments 2.5 Illustrations 2.6 Summary 2.7 Key Terms 2.8
Questions and Exercises 2.9 Further Reading
Unit 3 AS-21 and Preparation of Consolidated Financial Statements
47-74
3.0 Introduction 3.1 Unit Objectives 3.2 AS-21 and Preparation of Consolidated Financial Statements 3.2.1 Objectives
3.2.2 Notable Terms 3.2.3 Format of Consolidated Financial Statement 3.3. Scope of Consolidated Financial Statement
3.4 Consolidation Procedure 3.5 Unrealised Losses 3.6 Disclosure 3.7 Practical Examples related to AS-21 3.8.
Illustrations 3.9. Summary 3.10. Key Terms 3.11. Questions and Exercises 3.12. Further Reading
Topic 2
Human Resource Accounting
Unit 4 Meaning, Objectives and Measurements in Human Resources
Accounting
75-92
4.0 Introduction 4.1 Unit Objectives 4.2 Meaning and Concept of HRA 4.2.1 Objectives of HRA 4.4.2 Purpose
of HRA 4.3 Need of HRA 4.4 Historical Development of HRA Concept 4.5 Importance in HRA 4.6 Measurements
in HR Accounting (A) Cost Approach. (a) Original or Historical Cost Approach. (b) Opportunity Cost Approach (c)
Replacement Cost Approach (d) Adjusted Present Value 4.7 Illustrations 4.8 Summary 4.9 Key terms 4.10
Questions and Exercise 4.11 Further Reading
Unit 5 Measurement in HRA - Economic Value Approach
93-106
5.0 Introduction 5.1 Unit Objectives 5.2 Economic Value Approach 5.2.1 Lev and Schwart 2 Model 5.2.2
Likert’s Behaviour Model 5.2.3 Flamholtz’s Model of Individual Value 5.2.4 Stochastic process with service Model
5.2.5 Hekimian and Jones competitive Bidding Model 5.2.6 Hermanson’s unpurchased Goodwill Model 5.3 Other
- Non-monetary Models 5.4 Illustrations 5.5 Summary 5.6 Key Terms 5.7 Questions and Exercises 5.8 Further
Reading
Unit 6 Human Resource Accounting In India
107-116
6.0 Introduction 6.1 Unit Objectives 6.2 Human Resource Accounting in India 6.2.1 Frame work of Corporate
Reporting in India 6.3 Human Resource Valuation models selected by Indian Companies 6.4 General consideration
in working of HRA concept by Indian companies 6.5 Usefulness of HRA practice 6.6 Problems in HR Accounting
6.7 Summary 6.8 Key Terms 6.9 Questions and Exercises 6.10 Further Reading
Topic 3
Valuation of Goodwill and Valuation of Shares
Unit 7 Meaning, Need, Valuation of Goodwill - Average Profit Method
117-136
7.0 Introduction 7.1 Unit Objectives 7.2 Meaning and Definition of Goodwill 7.3 Need for Valuation of Goodwill 7.4
Elements of Goodwill 7.4.1 Distinguishing Features of Goodwill 7.4.2 Type of Goodwill 7.5 Factory Affecting
Valuation of Goodwill 7.6 Methods of Valuation of Goodwill 7.6.1 Average profit Method 7.7 Illustrations 7.8 Summary
7.9 Key Terms 7.10 Questions and Exercises 7.11 Further Reading
Unit 8 Valuation of Goodwill - Super Profit Method
137-154
8.0 Introduction 8.1 Unit Objectives 8.2 Super Profit Method 8.3 Accounting Treatment 8.4 Calculation of Average
Profit, Super profit and Goodwill 8.5 Sliding -Scale Valuation of Super Profit 8.6 Illustrations 8.7 Summary 8.8 Key
Terms 8.9 Questions and Exercises 8.10 Further Reading
Unit 9 Valuation of Goodwill - Capitalisation and Annuity Methods
155-166
9.0 Introduction 9.1 Unit Objectives 9.2 Capitalisation of Profit method 9.3 Annuity Method 9.4 Illustrations 9.5
summary 9.6 Key Terms 9.7 Questions and Exercises 9.8 Further Reading
Unit 10 Valuation of Shares - Need, Methods of Valuation of Shares
167-185
10.0 Introduction 10.1 Unit Objectives 10.2 Valuation of shares 10.2.1 Factors Affecting the value of shares 10.2.2
Need for Valuation of Shares 10.3 Methods of Valuation of Shares 10.3.1 Asset - Backing Method 10.3.2 YieldBasis Method (i) On Profit Basis (ii) On Dividend Basis 10.4 Illustrations 10.5 Summary 10.6 Key Terms 10.7
Questions and Exercises 10.8 Further Reading
Unit 11 Valuation of Shares - Fair Value Method, Value of Right and
Preference Shares
187-208
11.0 Introduction 11.1 Unit Objectives 11.2 Fair Value Method 11.3 Valuation of Right Shares 11.4 Valuation of
Preference Shares 11.5 Valuation of Bonus Shares 11.6 Illustrations 11.7 Summary 11.8 Key Terms 11.9 Questions
and Exercises 11.10 Further Reading
Topic 4
Hotel Accounting
Unit 12 Visitor’s Ledger and Preparation of Final Accounts
209-218
12.0 Introduction 12.1 Unit Objectives 12.2 Visitor’s Ledger 12.3 Preparation of Final Accounts 12.4 Illustrations
12.5 Summary 12.7 Key Terms 12.8 Questions and Exercises 12.9 Further Reading
Unit 13 Introduction, Accounting Treatment in Hotel Accounting
219-228
13.0 Introduction 13.1 Unit Objectives 13.2 Hotel Accounting 13.2.1 Type of Hotels and Restaurants 13.3 Accounting
Treatment in Hotel Accounting 13.4 Fixation and Charging of Room Rate 13.4.1 Method for ascertaining RoomRate 13.4.2 Calculation of Room Occupancy Rate 13.5 Illustrations 13.6 Summary 13.7 Key Terms 13.8 Questions
and Exercises 13.9 Further Reading
INTRODUCTION
This book of self - instructional material is based on the syllabus for the
subject Advanced Accounting (M.Com ACG 102), This book is written as per the
revised syllabus prescribed for M.Com. Part I students of Yashwantrao Chavan
Maharashtra Open University, Nashik from June, 2015. We do hope that this
book will definitely help to meet the emmerging and growing requirements of
distance education students of Advanced Accounting from the School of
Commerce. This book adopts a moderate and novel approach towards the study
of Advanced Accounting in view with the specific and upcoming requirements of
the readers and practitioners of this subject.
All the topics included in the revised syllabus are explained in simple but apt
language. Equal stress is also given for neccessary basic accounting theory and
wide variety of practical problems. Authors have taken appropriate care to
incorporate basic accounting concepts, accounting control techniques and tabular
representation of classified accounting statements and reports. Proper emphasis
has also being given on graphical presentation to simplify the accounting theories
and modern practices. This book has been designed to serve as a self sufficient
text for M.Com students. Nevertheless, we do not rule out the possibility of certain
shortcomings or misprints still remaining, we will be greatful to the reader if such
errors are pointed out from time to time. Any criticism or valuable suggestions for
further improvement of this book will be greatfully acknowledged and highly
appreciated.
The authors have also kept in mind the fact that the students concerned are
the distance education students, spread over a large territory, different environment
and do not have regular interaction with the teachers. Thereofore, authors have
taken ulmost efforts to simplify the matter without affecting scientific quality and
precision.
The editor and authors are greatful to the authorities of YCMOU for valuable
guidence and whole hearted co-operation.
Editor
Authors
Topic 1
Accounts of Holding Companies
Unit 1
Meaning, Definition, Legal
Conditions and Principles of
Consolidation
Unit 2
Preparation of Consolidated
Balance-sheet of Holding
Company
Unit 3
AS-21 and Preparation of
Consolidated Financial Statements
Unit 1
Meaning, Definition, Legal
Conditions and Principles of
Consolidation
Structure
1.0
Introduction
1.1
Unit Objectives
1.2
Meaning and Definitions
1.3
Legal Conditions for preparation of Balance Sheet of a Holding Co.
1.4
Principles of Consolidation
1.5
Financial Year of the Holding Co. and its Subsidiary
1.6
Illustrations
1.7
Summary
1.8
Key Terms
1.9
Questions and Exercises
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
1.10 Further Reading
1.0
Introduction
A company may acquire either the whole or the majority of shares of another
company so as to have a controlling interest in such a company or companies.
The controlling company is knows as the Holding Company and the company
so controlled is known as a Subsidiary and both together are knows as the Group.
The purpose of getting control over another company may be to gain advantages
such as elimination of competition, enjoying economies of large-scale production,
ensuring a smooth supply of quality raw materials, getting an assured market for
the products of the company etc.
It also means that a company which has controlling interest by virtue of
acquisition of shares or otherwise is known as a Holding Company and the
company whose shares have been acquired is known as a Subsidiary Company.
Therefore, one of the common ways of acquiring a controlling interest is to acquire
more than half in nominal value of the equity shares of another company.
Advanced Accounting - II
1
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
1.1
Unit Objectives
After studying this unit you should be able to :
NOTES
•
Know the meaning of ‘Holding Company’ and ‘Subsidiary Company’.
•
Identify the Legal conditions for preparation of Balance Sheet of a Holding
Co.
•
Understand the Basic Principles of Consolidation.
•
Understand the legal definition of a Holding and Subsidiary Company.
•
Explain financial year of the Holding Company and its Subsidiary.
•
Describe the right of Holding Company’s Representative and Members.
1.2
Meaning and Definition
There are two ways by which one company can gain control over other
companies.
i) One way is to acquire all the assets and liabilities of the companies
concerned thereby securing control by ownership of such assets and liabilities.
This arrangements is termed as ‘Absorption’.
ii) Another way is to acquire all or the majority (50% and above) of the
voting shares of these companies. The company acquiring the shares is known
as Holding Company; the company whose shares have been acquired is known
as Subsidiary Company of the Holding Company.
Different ways of control over other Companies is shown in Figure 1.1 on
next page.
Legal Definition of a Holding Company and Subsidiary Company :
(1) Holding Company has been indirectly defined by section 4 of the Companies
Act, 1956 in the context of the definition of the Subsidiary Co. According to this
section a company shall be deemed to be a subsidiary of another company only
if :
a) that other company controls the composition of its Board of Directors, or
b) that other i)
2
Advanced Accounting - II
When the first mentioned company is an existing company in respect
of which the holders of Preference Shares issued before the
commencement of this Act have the same voting rights in all respects
as the holders of Equity Shares, exercises or controls more than half of
the total voting power of such company,
HH Co.
Ltd.
invests in
SS
Co.
Ltd.
HH Co.
Ltd.
invests in
SS
Co.
Ltd.
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
Acquires
net assets
of
SS Co.
Ltd.
Acquires
majoroty shares
of
SS Co.
Ltd.
Record as
Absorption
(SS Co. Ltd. will
be liquidated)
Recorded as Stock
Acquisition and
operates as
Subsidiary
Fig. 1.1 : Different ways of control over other Companies
ii)
c)
where the first mentioned company is any other company, holds more
than half in nominal value of its equity share capital, or
the first mentioned company is a subsidiary of any company which is that
other’s subsidiary.
Examples :
a)
B Co. Ltd. has a Share Capital of ` 1,00,000 divided into Shares of ` 10
each. Therefore, the number of Shares are 10,000. If A Co. Ltd. acquires
6,000 Shares in B Co. Ltd., then A Co. Ltd. will be called the Holding Co.
and B Co. Ltd. will be the Subsidiary of A Co. Ltd.
b)
X Co. Ltd. purchased 4,000 shares in Y Co. Ltd. The share Capital of the Y
Co. Ltd. consists of 10,000 shares of `10 each. In this case, since the
share holdings of X Co. Ltd. is only 40%, the relationship of Holding Co.
and Subsidiary Co. is not established.
c)
F. Co. Ltd., is holding 5,000 Shares out of 10,000 shares of ` 10 each of Q
Co. Ltd., since the holding in nominal value is not more than 50%, again the
relationship of Holding Co. and Subsidiary Co. is not established.
(2) For the purpose of sub- section (1), the composition of a company’s
Board of Directors shall be deemed to be controlled by another company if,
but only if, that other company by the exercise of some power exercisable by it at
Advanced Accounting - II
3
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
its discretion without the consent or concurrence of any other person, can appoint
or remove the holders of all or a majority of the directorships; but for the purposes
of this provision that other company shall be deemed to have power to appoint a
directorship with respect to which any of the following condition is satisfied, viz.
a) that a person cannot be appointed thereto without the exercise in the
favour by that other company of such a power as aforesaid;
NOTES
b) that a person’s appointed thereto follows necessarily from his appointment
as director, managing agent, secretaries and treasurers, or manger, or
to any other office or employment in, that other company; or
c) that the directorship is held by an individual nominated by that other
company or a subsidiary thereof.
(3)
In determining whether one company is a subsidiary of another a) any shares held or power exercisable by that other company in a fiduciary
capacity shall be treated as not or exercisable by it;
b) subject to the provisions of clauses c) and d), any shares held or power
exercisable :
i ) by any person as a nominee for that other company (except where
that other is concerned only in a fiduciary capacity); or
ii) by, or a nominee for, a subsidiary of that other company, not being a
subsidiary which is concerned only in a fiduciary capacity; shall be
treated as held or exercisable by that other company;
c) any shares held or power exercisable by any person virtue of the provision
of any debentures of the first-mentioned company or of a trust deed for
securing any issue of such debentures shall be disregarded.
d) any share held or power exercisable by, or a nominee for, that other
company or its subsidiary (not being held or exercisable as mentioned
in clause) (c) shall be treated as not held or exercisable as mentioned in
ordinary business of that other or its subsidiary, as the case may be,
includes the lending of money and the shares are held or the power is
exercisable as aforesaid by way of security only for the purposes of a
transaction entered into in the ordinary course of that business.
4
Advanced Accounting - II
(4)
For the purposes of this Act, a company shall be deemed to be the Holding
Company of another, if, but only if, that other is its Subsidiary.
(5)
In this section, the expression “Company” includes any body corporate and
the expression “Equity Share Capital” has the same meaning as sub-section
(2) of Section 85.
(6)
In the case of a body corporate which is incorporated in a country outside
India, a Subsidiary of Holding Co. of the body corporate under the law of
such country shall be deemed to be the Subsidiary of Holding Co. of the
body corporate within the meaning and for the purpose of this Act, also
whether the requirement of this section are fulfilled or not.
(7)
1.3
A private company, being a subsidiary of a body corporate incorporated
outside India, which if incorporated in India, would be a public company
within the meaning of this Act, shall be deemed for the purpose of this Act
to be a subsidiary of a public company if the entire share capital in that
private company is not held by that body corporate whether alone or together
with one or more other bodies incorporated outside India.
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
Legal Conditions for preparation of Balance
Sheet of a Holding Company
Section 212 of the Companies Act stipulate the conditions regarding the
manner in which the Balance Sheet of the Holding Co. should be prepared. The
provisions of the Section are given below :
(1)
These shall be attached to the Balance Sheet of a Holding Company
having a subsidiary or subsidiaries at the end of the financial year as
at which the Holding Co.’s Balance Sheet is made out, the following
document in respect of such subsidiary or of each such subsidiary, as the
case may be :
a) a copy of the Balance Sheet of the subsidiary;
b) a copy of its Profit and Loss Account;
c) a copy of the Report of its Board of Directors;
d) a copy of the Report of its Auditors;
e) a statement of the Holding Co.’s interest in the subsidiary as specified
in sub-section (3);
f) the statement referred to in sun-section (5) if any; and
g) the report referred to in sub-section (6) if any.
(2)
a) The Balance Sheet referred to in clause (a) of sub-section (1) shall be
made out in accordance with the financial year of the Holding Co.
i) as at the end of the financial year of the subsidiary, where such
financial year coincides with the financial year of the Holding Co.
ii) as at the end of the financial year of the subsidiary last before that of
the Holding Co. where the financial year of the subsidiary does not
coincide with that of the Holding Co.
b) The Profit and Loss Account and the Report of the Board of Directors
and the Auditors, referred to in clauses b), c) and d) of sub-section (1),
shall be made out, in accordance with the requirements of this Act for
the financial year of the subsidiary referred to in clause (a).
Advanced Accounting - II
5
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
c) Where the financial year of its subsidiary does not coincide with that of
its Holding Co., the financial year aforesaid of the subsidiary shall not
end on a day which precedes the day on which the Holding Co.’s financial
year ends by more than six months.
d) Where the financial year of a subsidiary is shorter in durationthan that
of its Holding Co., references to the financial year of the subsidiary in
clauses b), c) and a) shall be construed as references to two or more
financial years of the subsidiary the duration of which, in the aggregate,
is not less than the duration of the Holding Co.’s financial year.
NOTES
(3)
The statement referred to in clause (e) of sub-section (1) shall
specify
a) the extent of the Holding Co.’s interest in the subsidiary at the end of
financial year or of the last financial year of the subsidiary referred to in
sub-section (2);
b) the net aggregate amount, so far as it concerns members of the Holding
Co. and is not dealt with in the company’s accounts, of the subsidiary
profits after deducting its losses or vice-versa.
i) for the financial year or years of the subsidiary aforesaid; and
ii) for the previous financial year of the subsidiary since it became the
Holding Co.’s subsidiary;
c) the net aggregate amount of the profits of the subsidiary after deducting
its losses or vice versa.
i) for the financial year or year of the subsidiary aforesaid ; and
ii) for the previous financial year of the subsidiary since it became the
Holding Co.’s subsidiary;
so far as those profit are dealt with, or provision is made for those losses,
in the company’s accounts.
4)
Clauses (o) and (c) of sub-section (3) shall apply only to profits and
losses of the subsidiary which may properly be treated in the Holding
Co.’s accounts as revenue profits or losses, and the profits or losses
attributable to any shares in a subsidiary for
the time being held by the
Holding Co. or any other of its subsidiaries shall not (for that or any other
purpose) be treated as aforesaid so faras they are profits or losses for the
period before the date on or as from which the shares were acquired by the
company or any of its subsidiaries, except that they may be in a proper case
be so treated where
a) the company is itself the subsidiary of another body corporate; and
6
Advanced Accounting - II
b) the shares were acquired from that body corporate or a subsidiary of
it; and for the purpose of determining whether any profits or losses are
to be treated as profits or losses for the said period, the profit or loss
for any financial year of the subsidiary may , if it is not practicable to
apportion it with reasonable accuracy by reference to the facts, be
treated as accruing from day-to-day during that year and be apportioned
accordingly.
(5)
Whether the financial year or years or a subsidiary referred to in
sub-section (2) do not coincide with the financial year of the Holding
Co., a statement containing information on the following matters shall also
be attached to the Balance Sheet of the Holding Co. :
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
a) Whether there has been any, and if so , that change in the Holding
Co.’s interest in the subsidiary between the end of the financial year or
of the last of the financial years of the subsidiary and the end of the
Holding Co.’s financial year;
b) details on any material changes which have acquired between the end
of the financial year or of the last of the financial years of the subsidiary
and the end of the Holding Co’s financial year in respect of i)
the subsidiary’s fixed assets;
ii)
its investments;
iii)
the money lent by it;
iv) the money borrowed by it for any purpose other than that of meeting
current liabilities.
(6)
If, for any reason, the Board of Directors of the Holding Co.’s is unable
to obtain information on any of the matters required to be specified by
subsection (4) a report in writing to that effect shall be attached to the
Balance Sheet of the Holding Co.
(7)
The documents referred to in clauses (c), (f) and (g) of sub-section (1)
shall be signed by the person by whom the Balance Sheet of the Holding
Co. is required to be signed.
(8)
The Central Government may, on the application or with the consent of the
Board of Directors of the company, direct that in relation to any subsidiary,
the provisions of this section shall not apply, or shall apply only to such
extent as may be specified in the direction.
(9)
If any such person as is referred to in sub - section (6) of Section 209 fails
to take all reasonable steps to comply with the provisions of this Section, he
shall, in respect of each offence, be punishable with imprisonment for a
term which may extent to six months, or with a fine which may extend to
one thousand rupees, or with both :
Provided that no person shall be sentenced to imprisonment for any such
offence unless it was committed wilfully.
Advanced Accounting - II
7
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
1.4
Principles of Consolidation
The basic principles to be remembered in the preparation of a consolidated
Balance Sheet are as follows :
NOTES
8
Advanced Accounting - II
(1)
The shares in the Subsidiary Co. held by the Holding Co. as investments
represent the share of ownership of Holding Co. in the equity or net assets
of the Subsidiary Co. Therefore, while preparing the consolidated Balance
Sheet, the investments of the Holding Co. in the subsidiary are replaced by
proportionate net assets of the Subsidiary Co.
(2)
Assets and liabilities of the Holding Co. and its subsidiary will be aggregated
with the exception of the following :
a)
The share capital of the Holding Co. alone will be considered in
consolidation and not aggregated with that of Subsidiary Co.
b)
Investment in the Subsidiary Co. as appearing on the asset side of
the Holding Co. balance will not be aggregated as the same has
been considered in the wording of the cost of control.
c)
The Profit and Loss Account and reserves of the Subsidiary Co.
will not be aggregated as they have been considered in working of
cost of control, minority interest and consolidated Profit and Loss
Account.
(3)
All the inter - company owing should be eliminated from both the sides of
the consolidated Balance Sheet.
(4)
The interest of minority shareholders will appear on the liabilities side of the
consolidated Balance Sheet.
(5)
The cost of control or goodwill calculated will be shown on the asset side
of the Balance Sheet. If it is a capital reserve it will be shown on the liability
side of the Balance Sheet.
(6)
Consolidated Profit and Loss Account will consist of the Profit and Loss
Account of Holding Co. along with its share in the revenue profits of the
Subsidiary Co.
(7)
Unrealised profit to the extent of Holding Co.’s share will be deducted from
the figure of consolidated Profit and Loss Account and the figure of total
stock.
1.5
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
Financial Year of the Holding Co. and its
Subsidiary
Section 213 of the Companies Act provides :
(1)
Where it appears to the Central Government desirable for a Holding Co. or
a Holding Co.’s subsidiary, to extent its financial year so that the subsidiary’s
financial year may end with that of the Holding Co., and for that purpose to
postpone the submission of the relevant accounts to a general meeting, the
Central Government may, on the application or with the consent of the
Board of Directors of the company whose financial year is to be extended,
direct that in the case of that company, the submission of accounts to a
general meeting, the holding of an an nual general meeting the making of
an annual return, shall not be required to be submitted, held or made, earlier
than the dates specified in the direction, notwithstanding anything to the
contrary in this Act or in any other Act for the time being in force.
(2)
The Central Government shall, on the application of the Board of Directors
of a Holding Co. or a Holding Co.’s subsidiary exercise the powers conferred
on that Government by sub-section (1) if it necessary to do so, in order to
secure that the end of the financial year of the subsidiary does not precede
the end of the holding company’s financial year by more than six months,
where that is not the case at the commencement of this Act, or at the date
on which the relationship of the holding company and subsidiary comes into
existence where that date is later than the commencement of this Act’.
NOTES
Rights of Holding Co.’s Representatives and Members :
Section 214 of the Companies Act states :
(1)
(2)
A Holding Co. may, by resolution, authorise representatives named in the
resolution to inspect the books of account kept by any of its subsidiaries;
and the books of accounts of any such subsidiary shall be open to inspection
by those representatives at any time during business hours`
The rights conferred by Section 235 upon members or a company may be
exercised, in respect of any subsidiary , by members of the Holding Co. as
if they alone were members of the subsidiary.’
The Principles of Consolidation can be understood with the help of following
illustrations :
Check Your Progress
i)
What do you understand
by the term ‘Holding
‘Company’
and
‘Subsidiary Company’ ?
ii) State the ‘Principles of
Consolidation’.
Advanced Accounting - II
9
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
1.6
Illustrations
ILLUSTRATION 1
A Ltd., acquired 16,000 Equity Shares of B Ltd., of `10 each on 31st March,
2014. The summarised Balance Sheet of A Ltd., and B Ltd., as on that date were
as under :
Balance Sheet as on 31-3-2014
Liabilities
A Ltd.
B Ltd.
`
`
Assets
A Ltd.
B Ltd.
`
`
Share Capital :
Land and Buildings
1,50,000 1,80,000
Equity Shares of
Plant and Machinery
2,40,000 1,09,400
`10 each
5,00,000 2,00,000 Investment in shares
General Reserve
2,40,000 1,20,000 in B Ltd. (at cost)
Profit and Loss
57,200
Bank Overdraft
80,000
Bills Payable
(including ` 3,000
payable to A Ltd.)
Sundry Creditors
-
47,100
3,40,000
-
1,20,000
36,000
44,000
40,000
8,400 Bills Receivables
(including ` 3,000
From B Ltd.)
15,800
-
9,000 Cash at Bank
14,500
8,000
36,000 Stock
- Sundry Debtors
9,24,300 3,73,400
9,24,300 3,73,400
You are supplied with the following information :
i) The directors are advised that Land and Buildings of B Ltd., are
undervalued by `20,000 and Plant and Machinery of B Ltd., are
overvalued by ` 10,000. Their assets have to be adjusted accordingly.
ii) Sundry Creditors of A Ltd., include `12,000 due to B Ltd.
You are required to prepare the Consolidated Balance Sheet as at 31-3-2014
alongwith necessary workings.
SOLUTION
Working Notes :
1)
A Ltd., acquired Equity Shares of B Ltd., on 31st March, 2014.
2)
Share of A Ltd., in B Ltd.
=
=
=
10
Advanced Accounting - II
Shares acquired by A Ltd.
Shares issued by B Ltd.
16,000 shares
20,000 shares
4
5
3)
Statement of Capital Profit :
`
General Reserve on 31-3-2014
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
1,20,000
Add : Profit and Loss Account (Cr.) on 31-3-2014
36,000
Add : Undervaluation of Land and Buildings of B Ltd. (+) 20,000
NOTES
1,76,000
Less :Overvaluation of Plant and Machinery of B Ltd. (-) 10,000
 Capital Profit
1,66,000
Capital Profit
`1,66,000
A Ltd.
Minority
(4/5)
(1/5)
` 1,32,800
` 33,200
(Goodwill)
Since the shares have been acquired on the date of Balance Sheet i.e
31-3-2014, all profits shown in the Balance Sheet of B Ltd. as on that date are to
be treated as Capital Profits.
4)
Statement of Minority Interest :
`
Face Value of shares held by Minority
(4000 shares X ` 10)
Add : Capital Profit
 Minority Interest
5)
Statement of Goodwill :
Cost of shares acquired by A Ltd.
40,000
(+) 33,200
73,200
`
3,40,000
Less : Face Value of shares acquired
(16,000 shares x ` 10)
(-) 1,60,000
1,80,000
Less : A Ltd.’s share in Capital Profit
 Goodwill
(-) 1,32,800
47,200
Advanced Accounting - II
11
Consolidated Balance Sheet of A Ltd., and its Subsidiary B ltd., as on 31-3-2014
Liabilities
Share Capital :
• Equity Shares of ` 10 each
Genral Reserve
Profit and Loss
Minority Interest
Bank Overdraft
A Ltd.
B Ltd.
`
`
5,00,000
2,40,000
57,200
73,200
80,000
(+)
Bills Payable
A Ltd.
B Ltd.
(+)
Less : Inter-company owings
(-)
80,000
NIL
5,400
NIL
8,400
8,400
3,000
44,100
(+)
Less : Inter-company owings
(-)
2,00,000
3,39,400
2,40,000
1,09,400
(-) 10,000
99,400
12,800
(+)
Debtors
A Ltd.
B Ltd.
47,100
9,000
56,100
12,000
`
47,200
3,50,000
1,50,000
1,80,000
(+) 20,000
Less : Inter-company owings
Creditors
A Ltd.
B Ltd.
`
Assets
Goodwill
Land and Buildings
A Ltd.
B Ltd.
Add : Increase
Plant and Machinery
A Ltd.
B Ltd.
Less : Decrease
Bills Receivables
A Ltd.
B Ltd.
(-)
15,800
NIL
15,800
3,000
72,000
(-)
44,000
40,000
84,000
12,000
(+)
1,20,000
36,000
(+)
14,500
8,000
(+)
Less : Inter-company owings
Stock
A Ltd.
B Ltd.
Cash at Bank
A Ltd.
B Ltd.
1,56,000
22,500
9,99,900
9,99,900
ILLUSTRATION 2
On 1st October, 2013 S Ltd., purchased 5,500 shares of `10 each fully paid
in W Ltd., for `20 each. At that time, it was estimated that the tangible assets and
liabilities of W Ltd., might be taken at book valuation except the Buildings which
were undervalued by `25,000.
Each Company prepares a Balance Sheet as on 31-3-2014 which can be
condensed as follows :
Liabilities
Share Capital :
S Ltd.
W Ltd.
`
`
2,00,000
Sundry Assets
50,000
6,000 Debtors
1-4-2013
Creditors
Shares in W Ltd.
15,000
5,000
Balance on 1-4-2013
25,000
8,000
Profit for the year
40,000
12,000
S Ltd. W Ltd.
`
60,000 Buildings
• Shares of `10 each
General Reserve on
Assets
`
1,50,000 65,000
50,000 11,000
20,000 15,000
1,10,000
-
Profit and Loss
3,30,000 91,000
12
Advanced Accounting - II
The debtors of S Ltd. included ` 5,000 due from W Ltd.
3,30,000 91,000
Prepare a consolidated Balance Sheet as on 31-3-2014 showing your
working notes clearly.
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
SOLUTION
Working Notes :
1)
S Ltd., purchased 5,500 shares of W Ltd., on 1st October, 2013.
2)
Share of S Ltd., in W Ltd. :
Shares purchased by S Ltd.
=
Shares issued by W Ltd.
5,500 shares
=
6,000 shares
11
=
3)
NOTES
12
`
Statement of Capital Profit :
i)
General Reserve on 1-4-2013
6,000
ii)
Profit and Loss (Cr.) on 1-4-2013
8,000
iii) Profits earned from 1-4-2013 to 1-10-2013
6,000
1/2 X (Profits for the year ` 12,000)
iv) Appreciation in the value of Buildings of W Ltd., being
undervaluation on 1-10-2013
(+) 25,000
 Capital Profit
45,000
Capital Profit
` 45,000
S Ltd.
Minority
(11/12)
(1/12)
` 41,250
` 3,750
(Goodwill)
4)
`
Statement of Revenue Profit :
Profits earned from 1-10-2013 to 31-3-2014
= 1/2 x (Profits for the year ` 12,000)

Revenue Profit
6,000
(+)
6,000
Advanced Accounting - II
13
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
Revenue Profit
` 6,000
NOTES
S Ltd.
Minority
(11/12)
(1/12)
`5,500
` 500
(Consolidated Profit and Loss)
5)
`
Statement of Minority Interest :
Face value of shares held by minority
(500 shares x `10)
Add : Capital Profit
5,000
(+) 3,750
8,750
Add : Revenue Profit

6)
Minority Interest
Statement of Goodwill :
Cost of shares purchased by S Ltd.
(+) 500
9,250
`
1,10,000
Less : Face value of shares purchased
(5,500 shares x ` 10)
(-) 55,000
55,000
Less : S Ltd.s’ share in Capital Profit
 Goodwill
7)
Statement of Consolidated Profit and Loss Account :
`
25,000
Add : Profits for the year
40,000

Advanced Accounting - II
13,750
Profit and Loss (Cr.) Balance on 1-4-2013
Add : S Ltd.s’ share in Revenue Profit
14
(-) 41,250
Profit and Loss (Cr.)
(+) 5,500
70,500
Consolidated Balance Sheet of S Ltd., and its Subsidiary W Ltd., as on 31-3-2014
`
Liabilities
Share Capital :
• Shares of ` 10 each
Genral Reserve as on 1-4-2013
Profit and Loss
Minority Interest
Creditors
S Ltd.
W Ltd.
(+)
Less : Inter-company owings
(-)
`
2,00,000
50,000
70,500
9,250
15,000
15,000
5,000
20,000
5,000
`
Assets
Goodwill
Buildings
S Ltd.
W Ltd.
Add : Appreciation
Debtors
S Ltd.
W Ltd.
13,750
2,40,000
1,50,000
65,000
(+) 25,000
Less : Inter-company owings
Sundry Assets
S Ltd.
W Ltd.
3,44,750
`
90,000
30,000
(-)
20,000
15,000
35,000
5,000
(+)
50,000
11,000
(+)
61,000
3,44,750
ILLUSTRATION 3
The Balance Sheet of S Ltd. and P Ltd. as on 31-3-2014 is as follows.
Balance Sheet as on 31-3-2014
Liabilities
S Ltd.
P Ltd.
`
`
Share Capital :
• Shares of 10 each
Assets
P Ltd.
`
`
60,000
20,000
Goodwill
10,00,000 4,00,000 Machinery
General Reserve
1,50,000
Profit and Loss
1,42,000
60,000 Debtors
Creditors
1,82,000
87,000 Cash
Bills Payable
S Ltd.
20,000
7,32,000 2,72,000
- Stock
1,80,000
90,000
2,95,000 1,23,000
35,000
27,000
- Investment :
24,000 Shares of
P Ltd. at Cost
1,92,000
Bills Receivable
14,94,000 5,47,000
-
15,000
14,94,000 5,47,000
Other Information :
i)
S Ltd., acquired the shares in P Ltd., on 1st October, 2013.
ii)
The Profit and Loss Account of P Ltd., showed a debit balance of ` 20,000
on 1-4-2013.
iii)
Included in the stock of P Ltd., are goods of ` 20,000 which were supplied
by S Ltd., at cost plus 25 %.
iv)
The bills payable in S Ltd., represented ` 15,000 issued in favour of P Ltd.
Prepare a Consolidated Balance Sheet as on 31-3-2014.
Advanced Accounting - II
15
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
SOLUTION
Working Notes :
1)
S Ltd., acquired shares of P Ltd., on 1st October, 2013.
2)
Share of S Ltd., in P Ltd. :
Shares acquired by S Ltd.
=
Shares issued by P Ltd.
24,000 shares
=
40,000 shares
3
=
3)
5
`
Statement of Capital Profit :
i) General Reserve as on 1-4-2013
NIL
ii) Profit and Loss (Dr.) on 1-4-2013 i.e. Loss
(-) 20,000
iii) Profits earned from 1-4-2013 to 1-10-2013
(+) 40,000
1
x
2
General Reserve + Profit and Loss i.e. Profit
NIL
`80,000)
 Capital Profit
Capital Profit
20,000
` 20,000
S Ltd.
Minority
(3/5)
(2/5)
` 12,000
`8,000
(Goodwill)
4)
`
Statement of Revenue Profit :
Profits earned from 1-10-2013 to 31-3-2014
1
x
=
2
General Reserve + Profit & Loss i.e. Profit
` 80,000
NIL
 Revenue Profit
(+) 40,000
40,000
Revenue Profit
` 40,000
16
Advanced Accounting - II
S Ltd.
(3/5)
Minority
(2/5)
` 24,000
`16,000
(Consolidated Profit and Loss)
5)
`
Statement of Minority Intrest :
Face value of shares held by Minority
(16,000 shares x `10
1,60,000
Add : Capital Profit
(+)
8,000
1,68,000
Add : Revenue Profit
NOTES
(+) 16,000
 Minority Intrest
6)
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
1,84,000
`
Statement of Goodwill :
Cost of shares acquired by S Ltd.
1,92,000
Less : Face value of acquired
(24,000 shares x ` 10)
(-) 2,40,000
 Capital Reserve
48,000
Add : S Ltd.’s share in Capital Profit *
(+)
 Capital Reserve
12,000
60,000
Add : Balance in Goodwill as per Balance Sheet
S Ltd.
`60.000
P Ltd.
+
` 20,000
(+)
 Goodwill
80,000
20,000
* Note : This item is added and not deducted since the resulting figure (i.e. `
1,92,000 - ` 2,40,000) is negative `48,000 which is capital reserve.
7)
Calculation of Unrealised Profit :
S Ltd., supplied goods to P Ltd., for ` 20,000 at cost plus 25%

SP =
CP + P
125 =
100 + 25
P
SP
=
25
125
=
1
5
x 20,000
=
` 4,000 x
=
` 2,400
3
5
Hence, unrealised profit of ` 2,400 will be deducted from the Stock of
P Ltd. and from the Consolidated Profit and Loss of S Ltd., in the Consolidated
Balance Sheet.
Advanced Accounting - II
17
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
8)
`
Statement of Consolidated Profit and Loss Account
Profit and Loss (Cr.)
1,42,000
Add : S Ltd.’s share in Revenue Profit
(+)
24,000
1,66,000
NOTES
Less : Unrealised Profit

(-)
Profit and Loss (Cr.)
2,400
1,63,600
Consolidated Balance Sheet of S Ltd., and its Subsidiary P Ltd.,
as on 31-3-2014
`
Liabilities
`
Share Capital
`
Assets
10,00,000 Goodwill
• Shares of ` 10 each
20,000
Machinery
10,04,000
Profit and Loss
1,63,600
S Ltd.
7,32,000
General Reserve
1,50,000
P Ltd.
(+) 2,72,000
Creditors
2,69,000 Debtors
S Ltd.
P Ltd.
(+)
S Ltd.
2,95,000
87,000
P Ltd.
(+) 1,23,000
1,84,000 Bills Receivables
Bills Payble
5,000
S Ltd.
P Ltd.
4,18,000
1,82,000
Minority Interest
20,000
(+)
Less : Inter-Co.’s Owing(-)
S Ltd.
P Ltd.
`
NIL
NIL
(+)
NIL
15,000
15,000
20,000
Less : Inter-Co.’s
15,000
Owings
(-)
15,000
Stock
2,67,600
S Ltd.
P Ltd.
1,80,000
(+)
90,000
2,70,000
Less : Unrealised
Profit
(--)
2,400
Cash
62,000
S Ltd.
P Ltd.
17,71,600
1.7
18
Advanced Accounting - II
35,000
(+)
27,000
17,71,600
Summary
•
A company may acquire either the whole or majority of shares of another
company so as to have a controlling interest in such a company or companies.
The controlling company is known as the “Holding Company” and the
company so controlled is known as a “Subsidiary” and both together are
known as the “Group”.
•
There are two ways by which one company can gain control over other
companies. One way is termed as “Absorption”. Another way is to acquire
all other majority (50% and above) of the voting share of these companies.
•
Holding Company has been indirectly defined by Section 4 of the Companies
Act, 1956 in the context of the definition of Subsidiary Company.
•
Section 212 of the Companies Act,1956, stipulates the conditions regarding
the manner in which the Balance Sheet of the Holding Company should be
prepared.
1.8
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
NOTES
Key Terms
(1) Holding Company :
It is one which acquires all or working majority of the equity shares of any
other company with a view to control the operations of such other company called
a subsidiary.
(2) Subsidiary Company :
A company which is being controlled by another company (i.e. Holding
Company) because of the latter having acquires majority of the shares or the
power to appoint majority of the directors of the former company.
(3) Absorption :
One way is to acquire all assets and labilities of the companies concerned
thereby security control by ownership of such assets and liabilities. This
arrangement is termed as “ Absorption”.
1.9
Questions and Exercises
I - Objective Questions
(A) Multiple Choice Questions :
(1)
Consolidations of financial statements helps to understand the financial ---- of the group as one business unit.
(a) strength
(b) solvency
(c) liquidity
(d) viability
(2)
One of the common ways of acquiring a controlling interest is to purchase
more than ----- in nominal value of the equity shares of another company
(a) forty percent
(b) fifty percent
Advanced Accounting - II
19
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
(c) forty five percent
(d) forty nine percent
(3)
NOTES
The company is a subsidiary of any company which is that other company’s
-----(a) holding
(b) parent
(c) subsidiary
(d) vendor
(4)
A ----- is a parent and all its subsidiaries.
(a) firm
(b) vendor
(c) association
(d) group
Ans : (1-a), (2- b), (3-c), (4-d)
II - Long Answer Questions :
20
Advanced Accounting - II
(1)
Define ‘Holding Company’ Explain in brief the important points to be kept
in mind while consolidating a Balance Sheet.
(2)
Define the term i) a parent , ii) a subsidiary and iii) a group as per AS-21.
(3)
Explain the legal conditions involved in determining whether one company
is a subsidiary of another.
(4)
What do you understand by ‘Holding Company’ ? Explain the basic principles
of consolidation.
(5)
What is ‘Holding Company’ ? How it differs from a Subsidiary Company?
III - Practical Problems :
(1)
The following are the summarised Balance Sheet of H Ltd. and S Ltd. as
on 31st March, 2014
Meaning, Definition, Legal
Conditions & Principles of
Consolidation
Balance Sheet as on 31st March, 2014
Liabilities
Share Capital
H Ltd.
S Ltd.
C
H Ltd.
S Ltd.
`
`
`
1,80,000 1,00,000 Buildings
50,000
40,000
80,000
20,000
Shares of ` 10 each
Assets
Machinery
Creditors
40,000
20,000 Furniture
60,000
20,000
Bills Payable
20,000
10,000 Debtors
50,000
25,000
Bank Overdraft
20,000
- Investments
55,000
-
Profit and Loss
35,000
- Profit ans Loss
(8,000 Equity Shares
-
25,000
-
25,000
NOTES
in S Ltd.
Profit ans Loss
2,95,000 1,30,000
2,95,000 1,30,000
Additional Information :
i)
Debtors include `10,000 due from S Ltd.
ii)
H Ltd. acquired shares of S Ltd. on 1st April, 2013 when S Ltd. had a debit
balance of ` 40,000 in its Profit and Loss Account.
Prepare a Consolidated Balance-Sheet as on 31st March, 2014.
1.10 Further Reading
•
Shukla M.C., Grewal T. S. and Gupta S.C. - Advanced Accounts - New
Delhi - S Chand & Co. Pvt.Ltd., 2013
•
Sehgal Ashok - Taxman’s Fundamentals of Corporate Accounting - New
Delhi - Taxmann Publications Pvt. Ltd., - 2012
Advanced Accounting - II
21
Unit 2
Preparation of Consolidated
Balance-Sheet of Holding Company
Preparation of Consolidated
Balance-Sheet of Holding
Company
Structure
NOTES
2.0.
Introduction
2.1.
Unit Objectives
2.2
Preparation of Consolidated Balance Sheet of Holding Co. with one
Subsidiary only
2.2.1
Purpose
2.2.2
Advantages
2.2.3
Disadvantages
2.2.4
Procedure
2.3
Basic Rules for preparing a Consolidated Balance Sheet
2.4
Miscellaneous Adjustments
2.5
Illustrations
2.6
Summary
2.7
Key Terms
2.8
Questions and Exercises
2.9
Further Reading
2.0
Introduction
The financial position and operating results reported through the consolidated
statement are portrayed from the standpoint of the interest of the members of
Holding Co.. In practice, users of the financial statements of a parent are usually
concerned with, and need to be inform about the financial position and results of
operations of not only the enterprise itself ‘ but also of the group as a whole. This
need is served by providing the users separate financial statement of the parent
and consolidated financial statements. which present financial information in
detailed about the group as that of a single enterprise without regard to the legal
boundaries of the separate legal entities.
Consolidated financial statements normally include consolidated Balance
Sheet consolidated Profit and Loss and notes, other statements and explanatory
material that from an integral part thereof. The consolidated financial statements
are presented to the extend possible in the same format as that adopted by the
Advanced Accounting - II
23
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
parent for its separate financial statements. Consolidated financial statements are
presented by a parent ( i.e by Holding Enterprise) to provide financial information
about the economic activities of its group.
2.1
Unit Objectives
After this unit you should able to :
•
Prepare Consolidated Balance Sheet of Holding Company with a Subsidiary
Company.
•
Understand the Basic Rules for preparing a Consolidated Balance Sheet.
•
Calculate Minority Interest.
•
Calculate Goodwill or Capital Reserve on consolidation.
•
Understand various miscellaneous adjustments related to Consolidated
Balance Sheet.
•
Acquainted with treatment of issue of bonus shares by the Subsidiary Co.
•
Discuss the advantages and disadvantages of Consolidated Financial
Statement.
2.2
Preparation of Consolidated Balance Sheet of
Holding Co. with one Subsidiary only
2.2.1 Purpose
The purpose of a consolidated Balance Sheet and Profit and Loss Account
is to show the financial position and operating results of a group consisting of a
Holding Co. and one or more subsidiaries. The consolidated statements are reports
of a notional accounting entity which subsist on the view that the holding and
subsidiary companies are to be treated as one economic unit. The financial position
and operating results, reported through the consolidated statements are portrayed
from the standpoint of the interest of the members of Holding Co.
24
Advanced Accounting - II
Shareholders of a Holding Co. hand over share capital to the directors of
the company for carrying out an agreed business in the most efficient way.
Directors, with a view to discharging their responsibilities fully, present detailed
accounts and reports. If the directors have invested a part of this capital in
purchasing, controlling shares in some other company, thus making that company
a subsidiary company, it becomes obligatory to explain the position of the subsidiary
also. Since the shareholders of the Holding Co. are interested in the Subsidiary
Co. only to the extent of the shares held in it, a full Balance Sheet of the Subsidiary
may not be of much interest to them. They are interested only to the extent they
Preparation of Consolidated
Balance-Sheet of Holding
Company
are entitled to the assets of Subsidiary Co. But many shareholders being laymen
may not be able to make out anything from separate Balance Sheets of the Holding
Co. and the Subsidiary Co.’s. Therefore, in order to enable them to understand
their interest better, it is advisable to give the Consolidated Balance SCeet of the
group.
NOTES
2.2.1 Advantages :
The advantages of Consolidation of Financial Statements are as follows.
a)
The Holding Co. with its subsidiary constitute one business units although
they function as separate legal entities. Hence, one Balance Sheet is desirable
through consolidation.
b)
The shareholders of Holding Co. get a complete and full disclosure of t h e
interest of the Holding Co. in its subsidiary Co.
c)
The shareholders get a better idea and picture of their investment in the
subsidiary which is represented by the net assets position of Subsidiary Co.,
the investment item appearing on the assets side is represented by the net
assets of the subsidiary to the extent of their interest in subsidiary.
d)
It helps in judging the efficiency and performance of the group as a whole.
e)
It helps to understand the financial strength of the group as a one business
unit.
2.2.2 Disadvantages :
The following are the main disadvantages of Consolidation of Financial
Statements :
a)
Aggregating the results of Holding Co. and its subsidiary may conceal
important information from shareholders when the companies differ in respect
to profitability, business risk and growth potential.
b)
Consolidation may mislead the shareholders if the activities of the subsidiary
are very dissimilar from those of other companies within the group.
2.2.3 Procedure :
Check Your Progress
It becomes imperative for consolidation to arrive at the following figures to
present a Consolidated Balance Sheet disclosing the interest in the subsidiary.
Hence, the following workings are necessary :
a)
Determination of the share of the Holding Co. in subsidiary and the share
of minority in subsidiary
b)
Analysis of profits of Subsidiary Co. into pre and post acquisition period.
c)
Calculation of Minority Interest.
d)
Calculation of Cost of Control.
i)
Explain the basic purpose
of
preparing
a
Consolidated Balance
Sheet of Holding Co.
ii) How consolidation of
Financial Statements is
advantageous to Holding
Co. ?
Advanced Accounting - II
25
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
e)
Calculation of Consolidated Profit and Loss Account.
f)
Working of unrealised profit in unsold closing stock.
g)
Elimination of inter company indebtedness.
h)
Finally, the Consolidated Balance Sheet is prepared as per the rules of
consolidation explained below.
2.3
Basic Rules for Preparing a Consolidated
Balance Sheet
Rule 1 : Cancellation of Investment and Share Capital :
A Consolidated Balance Sheet can be prepared by simply combining all the
assets and liabilities of the Holding Co. and its subsidiary. It will certainly balance,
but it is not a consolidated Balance Sheet. This is because the inter-company
balance have first to be eliminated. The “Investment in Subsidiary Co.” by the
Holding Co. should cancel out the share Capital of the Subsidiary Co. consider the
following example :
The simplest example is a case where the Holding Co. is holding all the
shares of the subsidiary. Suppose, H Ltd. acquires all the shares of S Ltd. on
April 1, 2009 on which date the Balance Sheet of the two companies are as
follows :
Balance Sheet as on April 1, 2009
Liabilities
Share Capital
H Ltd.
S Ltd.
`
`
10,00,000 2,00,000 Sundry Assets
(Share of `10 each)
Creditors
Assets
Investments
2,00,000
H Ltd.
S Ltd.
`
`
10,00,000
2,50,000
2,00,000
-
50,000 (20,000 Shares of `10
each at cost)
12,00,000 2,50,000
12,00,000 2,50,000
Since, in the above example, all the shares of S. Ltd. are held by H Ltd., all
the assets and liabilities of S Ltd. belong only to the Holding Co. and the consolidated
Balance Sheet will be as follows :
Consolidated Balance Sheet of H Ltd. and S Ltd. as on April 1, 2009
`
Liabilities
Share Capital :
10,00,000 Sundry Assets :
Creditors :
26
Advanced Accounting - II
`
Assets
H Ltd.
2,00,000
S Ltd.
(+) 50,000
H Ltd.
10,00,000
S Ltd.
(+) 2,50,000
12,50,000
2,50,000
12,50,000
12,50,000
Thus, in the above example, the investment in the Holding Co. is replaced
by the assets and liabilities of the subsidiary; the Share Capital of S Ltd. being
cancelled against the Investments in H Ltd.
Preparation of Consolidated
Balance-Sheet of Holding
Company
Rule 2 : Calculation of Minority Interest :
When the Holding Co. acquires all the shares of the Subsidiary Co., the
latter co. becomes a wholly owned subsidiary. In our previous example , S Ltd.
is a wholly owned subsidiary of H Ltd. But when the Holding Co. acquires more
than half but less than all the shares of the Subsidiary Co., those shareholders who
have a minority share are referred to as Minority Shareholders. The interest of
the Minority Shareholders, known as Minority Interest must be accounted
separately in the Consolidated Balance Sheet.
NOTES
A minority interest is the proportion of the subsidiary company’s net assets/
shareholders fund which belongs to the minority shareholders. Therefore, the value
of the minority interest is the portion of the share capital and reserves at the date
when the Holding Co. acquires its controlling interest and the share of income
after acquisition.
The minority interest is calculated as follows :
`
Paid-up value of the shares held by outsiders
------
Add : (+) Proportionate share in the company’s profits and reserves -----(+) Proportionate share in the increase in the value of the
assets of the subsidiary
(+) ------
Less : (-) Proportionate share in the loss of the subsidiary, if any
------
(-) Proportionate share in the decrease in the value of assets
of the subsidiary
 Minority Interest
(-) -----------
If preference shares are held by outsiders, the face value of such shares
with the dividend due thereon (if there are profits) will be included in the minority
interest. If the Subsidiary Co. does not have any profit and the preference shares
are cumulative, then the dividend due will be shown by way of a note. The
proportionate share of the outsiders in the profits or losses will be shown by way
of a note. The proportionate share of the outsiders in the profits or losses will be
calculated only with reference to the equity shares held by them since the profit
and reserves, if any, belong only to the equity shareholders.
Rule 3 : Goodwill or Capital Reserve on Consolidation :
i)
Goodwill on Consolidation :
If value of “Investment in Subsidiary” in the Holding Co.’s Balance Sheet
is more than the book value of the net assets acquired, the difference represents,
Advanced Accounting - II
27
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
“Goodwill on Consolidation”. In this case, Investment in Subsidiary will not
cancel out against the share capital of the subsidiary unless a goodwill equal to
the difference of the two items is shown on the assets side of the Consolidated
Balance Sheet.
ii)
Capital Reserve on Consolidation :
If the value of Investment in Subsidiary is less than the book value of the
net assets acquired, the difference represents Capital Reserve on Consolidation.
In this case also, Investment in Subsidiary will not cancel out against the share
capital of the subsidiary unless a capital reserve equal to the difference of the two
items is shown on the liabilities of the Consolidated Balance Sheet.
To calculate goodwill or capital reserve, the value of the net assets acquired
by the Holding Co. in the Subsidiary Co. must be compared with the cost of the
investment. This value can be ascertained by adding together with proportionate
share capital and reserve of the subsidiary.
Calculation of Cost of Control of Goodwill :
The shares acquired by the Holding Co. appear under the head “Investment
in Subsidiary Co.”, in the Balance Sheet of the Holding Co. This figure appears at
the cost at which it has been acquired or the purchase cost. This is therefore the
price actually paid for purchasing the share in the Subsidiary Co. This price is
paid against the nominal value of the shares as well as the profits or losses already
existing in the Balance Sheet of the Subsidiary Co. on the date of acquisition.
These profits or losses already existing in the Balance Sheet of the Subsidiary Co.
are therefore known as pre-acquisition profits or losses. When the price paid is
more than the nominal value of the shares acquired and pre-acquisition profits (or
losses ) put together, then the differential amount represents the excess price
paid and therefore called as Goodwill. If on the other hand, the price paid is less
than the total of nominal value of shares and pre-acquisition profits or losses, then
the total of nominal value of shares and pre- acquisition profits or losses, then the
resulting figure is known as Capital Reserve. This is explained in the following
format.
`
Investment in the Subsidiary Company
..........
(Cost of acquiring the shares or the price paid for shares)
Less : Nominal value of shares acquired
..........
Less : Pre-acquired profits (including reserves)
(Capital profits)
(-)
 Cost of Control or Goodwill (Capital Reserve)
28
Advanced Accounting - II
1. If the figure work out to be negative, then the amount is known as
Capital Reserve, since what has acquired is more than what has been
paid for.
2. Pre-acquisition losses are added instead of deducting those (shown
above) as in case of pre- acquisition profits.
Preparation of Consolidated
Balance-Sheet of Holding
Company
Rule 4 : Pre-acquisition or Capital Profits :
The profits of the subsidiary may be divided into Capital Profit; and Revenue
Profit . Profit existing , or earned by, the subsidiary company upon the date of
acquisition of shares by the Holding Company are Capital Profits or (pre-acquisition
profits) and the Holding Company’s share or the same is to be calculated and
shown separately under the heading ‘Capital Reserve’ or adjusted against the
cost of control. The profits earned by the subsidiary company after the purchase
of shares by the Holding Company are Revenue Profits (or post-acquisition
profits) and the holding company’s share of it is to be added to the profits of the
Holding Company. The share in the capital profit and revenue profit of the minority
shareholders are added to the minority interest.
NOTES
Any increase in the value of fixed assets of the Subsidiary Company whether
before or after the date of acquisition will also be treated as Capital Profit and if
there is reduction in the value of fixed assets as on the date of acquisition, it must
be treated as Capital Loss and deducted from the Capital Profits. But if the fall in
the value of the assets occurs after the date of acquisition, the loss is treated as an
ordinary revenue loss.
Thus, to decide whether profits or losses and reserve of the Subsidiary
Company are Capital Profits or Revenue Profits, the date of purchase of shares
by the Holding Company is the deciding factor.
Similarly, the losses of the Subsidiary Company up to the date of acquisition
is treated as a Capital Loss and subsequent to the acquisition as a Revenue Loss.
Rule 5 : Cancellation of Inter-company Debts and Acceptances :
It is very common that member companies have business dealings not only
with outsiders but also with each other. Inter-company transactions may lead to
inter company debts and acceptances. At the time of consolidation, inter-company
debts and acceptances which are part of the group, are to be cancelled out as
follows :
(i) Debtors and Creditors : These relate to sale and purchases of goods
on credit between the holding and subsidiary company. This results in
the mutual indebtedness in the form of debtors in the books of the
company selling the goods and creditors in the Balance Sheet of the
purchasing company on credit basis. The amount of debtors and creditors
are eliminated by deducting the common owing amount from the total
of the debtors and creditors in the consolidated Balance Sheet.
(ii) Bill Receivable an Bill Payable : Bill of Exchange drawn by the
company on another company appears as an assets in the Balance
Sheet of the company drawing the bill whereas the same amount will
appears as Bill Payable on the liabilities side in the Balance Sheet of
the company accepting the bills. The mutual indebtedness is eliminated
Advanced Accounting - II
29
Preparation of Consolidated
Balance-Sheet of Holding
Company
by deducting the common amount of bills. receivable and bills payable
from the total of the bills receivable and total of bills payable in the
consolidated Balance Sheet.
Rule 6 : Cancellation of Inter- company Loans and Advances :
NOTES
Usually, a Current Account is used to record inter-company loans and
advances. When a loan is provided by either of the companies to the other, a
current account will exist between the Holding Co. and its subsidiary.
Inter company transactions refers to those transactions between the holding
and subsidiary with regard to loans given and taken or sales and purchases of
goods effected between the two entities. Sale and purchase of goods on credit
basis result in debtors and creditors relationships between the two companies.
Since it amounts to purchase and sale of goods by the same company or loans
given or taken by the same company, the transactions deserve eliminations.
Rule 7 : Contingent Liability on Bill Discounted :
Contingent Liability is an uncertain liability which materialises on the
happening of a particular event. Till then it is not an actual liability and therefore
cannot appear on the face of the Balance Sheet. However, it appears as a note at
the foot of the Balance Sheet.
If the company has discounted any of its bills receivable with its bankers
and the transaction involved is between the company in the group and outside
third party, it will appear as a note to the Balance Sheet of the company as a
contingent liability to the extent of the bills discounted. But if the contingent liability
is in respect of a transaction between the holding and subsidiary companies, it will
disappear from the footnote of individual company, Balance Sheet, as it appears
as actual liability in the consolidated Balance Sheet.
Rule 8 : Revaluation of Assets :
Certain assets may be revalued on the date of acquisition of shares by the
Holding Co. Any such revaluation of the assets results in capital profit or capital
losses. If there is an increase in the value of asset, it results in capital profit. If
there is a decrease in the value of the asset, it results in capital loss. The
proportionate share of Holding Co. will be adjusted against the cost of control
thereby reducing or increasing the amount of goodwill or resulting in capital reserve
as the case may be. The minority shareholders would be entitled to their
proportionate share in capital profits or capital reserves.
Further, for adjustment for depreciation on the increase or decrease in the
value of assets should be made in the Profit and Loss Account of the subsidiary.
It may be noted that for revaluation profit (due to increase in the value of the
assets), higher depreciation provision will be necessary, on the other hand, for
revaluation loss (due to decrease in the value of assets ) excess depreciation
provisions should be written back.
30
Advanced Accounting - II
Rule 9 : Adjustment of Bank Balances :
Bank accounts may be held by the Holding Co. and its subsidiary at different
banks. While some balances are favourable, others are overdrawn balances they
should appear in the Consolidated Balance Sheet as assets and liabilities
respectively. It would be incorrect to adjust the overdraft balances against credit
balances for the purpose of the Consolidated Balance Sheet.
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
Rule 10 : Unrealised Profit on Fixed Assets :
A member company may transfer fixed assets or stock which becomes
fixed assets of the transferee company at a profit . In this case, a similar problem
arises as that seen in connection with trading stock transfer. At the time of
consolidation, unrealised profits should be deducted from consolidated profit as
well as aggregate value of fixed assets.
2.4
1)
Miscellaneous Adjustments
Unrealised Profit on Unsold Stock :
It is quite possible that the Holding Company can buy goods from the
Subsidiary Company which sells it at costs plus certain margin of profits. Such
goods purchased by the Holding Company may still remain in its closing stock as
unsold as on the date of Balance Sheet. In such a case, it becomes necessary to
eliminate the profit of the Subsidiary Company to the extent of the Holding
Company’s share, since such profits have not yet been earned to the extent to
which it has been included in the closing stock. Therefore, a proportionate share
of the Holding Company’s profits included in the stock of the goods remaining
unsold is elimination from the figure of closing stock of the Holding Company
along with simultaneous elimination of such unrealised profits from the profit of
the Subsidiary Company. It may be noted that the minority interest remains
unaffected in this regards, since for them profit has already been earned on the
sale effected by the subsidiary to the Holding Company. It is only the share of the
Holding Company in the profits of the subsidiary on such sale which matters,
since the same has not been earned as long as it remains in the closing stock of
the Holding Company as unsold.
Similarly, if the Holding Company has sold goods to the Subsidiary Company
and the closing stock of the Subsidiary Company still contains such goods as
unsold stock, such elimination effects of profits is necessary. Since the Holding
Company has not earned profits till the goods are sold by the subsidiary, the
unrealised profits including in such goods to the extent lying in closing stock requires
elimination. Such unralised profits to the extent of Holding Company share is
eliminated both from the closing stock of Subsidiary Company as well as from the
profit of the Holding Company. Some authors have argued in favour of elimination
of the full provision of unrealized profits. However, as a matter of normal practice
and as per the standards prescribed by well known authors on the subject, it is
considered prudent to eliminate only to the extent of Holding Company’s share.
Advanced Accounting - II
31
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
All problems solved in this book have, therefore, been given treatment accordingly.
For example, a Subsidiary Company may sell to the Holding Company goods
of the value of `30,000 on which the subsidiary has put a profit of 20% on the
selling price and the entire goods may remain unsold at the date of consolidation.
Supposing the Holding Company holds, 3,000 shares of the subsidiary’s 4,000
shares, the stock reserve would be :
a) ` 30,000 x 1/5 x 3/4 = ` 4,500 (only to the extent of the Holding
Company’s share).
b) ` 30,000 x 1/5 = ` 6,000
The modern practice is to create the whole of the unrealised profit as Stock
Reserve without adjusting the share of the minority shareholders. The Stock
Reserve is created whether the goods are sold by the Holding Company to the
Subsidiary Company or vice-versa at a profit. The amount of unrealised profit
(Stock Reserve) is deducted from the stock on the asset side and also from the
Profit and Loss Account on the liability side of the consolidated Balance Sheet.
Thus, stock will be shown at its true cost and the Profits and Loss Account will
show only realised profit.
2)
Issue of Bonus Shares :
Treatment of issue of bonus shared by the subsidiary will depend upon the
source from which bonus shares are issued. Bonus shares may be issued out of
pre-acquisition profits or reserves or post acquisition profits or reserves.
i) Issue of bonus shares out of pre-acquisition profits : In this case,
there will be no effect on the consolidated balance because while
calculating the cost of control, the Holding Company’s shares in the
pre- acquisition profit is reduced (because of capitalisation of profit)
while on the other hand, the paid-up value of shares held increases. So
the cost of control or goodwill will remain the same as it was before the
issue of bonus shares.
ii) Issue of shares out of Post-acquisition Profits : If a subsidiary
company issues bonus shares out of post - acquisition profit, it will have
a direct effect on the Consolidated Balance Sheet. In such a situation,
the Holding Company’s share of revenue profit in the Subsidiary
Company will be reduced and the paid - up value of the shares held by
the Holding Company in its subsidiary will be increased because of the
issue of bonus shares. This will reduce the value of goodwill or increase
the value of capital reserve. The portion of the bonus shares of the
minority interest will be added to the minority interest, as before.
3)
32
Advanced Accounting - II
Preference Shares held by the Holding Company :
When preference shares are issued by a Subsidiary Company and are held
by the Holding Company (whether wholly or partly), it should be treated in the
same way as equity shares. If the Holding Company acquires the preference
shares at par, the cost of investment of the Holding Company cancels out the
shares shown on the Balance Sheet of the subsidiary. When the preference shares
are acquired at a premium or a discount, the balance is carried to goodwill or
capital reserve in the Consolidated Balance Sheet. The portion of the preference
shares owned by the minority shareholders are added to minority interest.
4)
Preparation of Consolidated
Balance-Sheet of Holding
Company
Debentures of the Holding Company :
The debentures of the Holding Company will appear on the liability side of
the Consolidated Balance Sheet, just like equity or preference share capital.
Debentures issued either by the Holding Company or the subsidiary and held by
others should be cancelled out when they are acquired at par. When at par. When
part of the debenture are held by the minority shareholders, it should appear in the
liability side of the Consolidated Balance Sheet. The holding company’s “ investment
in debentures in the subsidiary” will cancel out against the nominal value of
debentures shown in the subsidiary company’s Balance Sheet.
NOTES
If the debentures are acquired at a premium or at a discount, the difference
between cost and nominal value is adjusted against goodwill or capital reserve in
the Balance Sheet.
5) Inter-company Dividends :
Check Your Progress
Holding Company owns majority of the shares of its subsidiary . When a
dividend is paid out of profit of the Subsidiary Company, the Holding Company is
likely to receive a majority portion of it as a shareholders. It should be noted that
such dividend may be paid out of pre-acqusition profit or post-acquisition profit .
If any dividend received by the Holding Company from its subsidiary come
out of pre-acquisition profits, such dividend should be treated as a return on capital
to the Holding Company, since it transfers to the Holding Company part of the net
assets in the Subsidiary Company that have been paid for. In this situation, the
correct accounting treatment is to deduct such dividend from the cost of investment
in the subsidiary for calculating goodwill or capital reserve.
The procedure followed in the preparation of Consolidated Balance Sheet
of Holding Company with one subsidiary only can be understood with the help of
following illustrations :
1 . How would you treate
investment in Subsidiary
Co. by Holding Co. and
Share
Capital
of
Subsidiary Co. ?
2 . Explain the accounting
adjustments to be made
while
computing
Minority Interest.
3 . Define the term Goodwill
on Consolidation and
Capital Reserve on
Consolidation.
4 . How Capital Profits
differs from Revenue
Profits ?
5 . What are Inter-Company
Debts and Acceptances ?
Advanced Accounting - II
33
Preparation of Consolidated
Balance-Sheet of Holding
Company
2.5
Illustrations
ILLUSTRATION 1
NOTES
The following is the summarised Balance Sheet of H Ltd., and S Ltd., as
on 31-3-0214
Liabilities
H Ltd.
`
Share Capital
Reserve as on 1-4-13
S Ltd.
Assets
`
S Ltd.
`
`
2,00,000
50,000 Sundry Assets
1,80,000
1,20,000
30,000
10,000 Share in S Ltd.
2,30,000
-
20,000
10,000
4,30,000
1,30,000
Profit and Loss
Cash at Bank
(Balance as on 1-4-13)
60,000
30,000
Profits for the year
40,000
10,000
1,00,000
30,000
Creditors
H Ltd.
4,30,000 1,30,000
H Ltd., acquired 80% of the shares in S Ltd., on 1st October, 2013. Included
in the assets of H Ltd., there is ` 30,000 Loan to S Ltd., shown as Creditors of S
Ltd. Sundry Assets of S Ltd., include Furniture and Fittings of ` 40,000 to be
revalued at ` 50,000 being over depreciated as at 1-10-2013.
Prepare a Consolidated Balance Sheet of H Ltd., as at 31-3-2014
SOLUTION
Working Notes :
1) H Ltd., acquired 80% shares of S Ltd., on 1st October, 2013.
2) Share of H Ltd., in S Ltd. :
=
=
=
Shares acquired by H Ltd.
Shares issued by S Ltd.
40,000 shares
50,000 shares
4
5
3) Statement of Capital Profit :
i)
Reserves as on 1-4-2013
10,000
ii)
Profit and Loss (Cr.) on 1-4-2013
30,000
iii)
Profit earned from 1-4-2013 to 1-10-2013
1
x
2
iv)
34
Advanced Accounting - II
`
Profits for the year
` 10,000
Appreciation in the value of Sundry Assets
(i.e. Furniture and Fittings) of S Ltd., being
over depreciation on 1-10-2013

Capital Profit
5,000
(+)10,000
55,000
Preparation of Consolidated
Balance-Sheet of Holding
Company
Capital Profit
` 55,000
H Ltd.
Minority
(4/5)
(1/5)
` 44,000
` 11,000
NOTES
(Goodwill)
`
4) Statement of Revenue Profit :
Profits earned from 1-10-2013 to 31-3-2014
1
x
2

Profits for the year
` 10,000
Revenue Profit
(+) 5,000
5,000
Revenue Profit
` 5,000
H Ltd.,
Minority
(4/5)
(1/5)
` 4,000
` 1,000
(Consolidated Profit and Loss)
5) Statement of Minority Interest :
Face Value of shares held by Minority
( 20% of ` 50,000 )
Add : Capital Profit
`
10,000
(+) 11,000
21,000
Add : Revenue Profit

Minority Interest
6) Statement of Goodwill :
Cost of shares acquired by H Ltd..
Less : Face value of shares acquired
(80 % of ` 50,000)
(+) 1,000
22,000
`
2,30,000
(-) 40,000
1,90,000
Less : H Ltd.’s share in Capital Profit

Goodwill
(-) 44,000
1,46,000
Advanced Accounting - II
35
Preparation of Consolidated
Balance-Sheet of Holding
Company
7) Statement of Consolidated Profit and Loss Account :
`
Profit and Loss (Cr.) balance on 1-4-2013
60,000
Add : Profits for the year
40,000
Add : H Ltd.’s share in Revenue Profit
NOTES

(+) 4,000
Profit and Loss (Cr.)
1,04,000
Consolidated Balance Sheet of H Ltd., and its Subsidiary S Ltd.,
as on 31-3-2014
`
Liabilities
Share Capital
`
`
Assets
2,00,000 Goodwill
`
1,46,000
Reserves as on
1-4-2013
30,000 Cash at Bank
Profit and Loss
Minority Interest
Creditors
H Ltd.
22,000
S Ltd.
(+)
1,00,000
H Ltd.
30,000
S Ltd.
1,30,000
(+)
10,000
2,80,000
1,80,000
1,20,000
Add : Appreciation in
Less: InterCompany Loan
20,000
1,00,000 Sundry Assets
H Ltd.
S Ltd.
1,04,000
30,000
Furniture and Fittings
(-)
30,000
(+)10,000
1,30,000
(+) 3,10,000
Less: InterCompany Loan
4,56,000
(-)
30,000
4,56,000
ILLUSTRATION 2
A Ltd., holds 80% of the Equity Shares Capital of B Ltd., which was
acquired on 31st March, 2013 when the latter company had a credit balance on
Profit and Loss Account of ` 15,000 and General Reserve of ` 20,000. Stock
held by A Ltd., include ` 5,000 for goods supplied by B Ltd., at a profit of 20% on
the selling price.
From the following Balance Sheet, prepare a consolidated Balance Sheet
as on 31-3-2014.
36
Advanced Accounting - II
Preparation of Consolidated
Balance-Sheet of Holding
Company
Balance Sheet as on 31-3-2014
Liabilities
A Ltd.
B Ltd.
`
`
Assets
Share Capital :
Fixed Assets
Equity Shares
Investments:
of ` 10 each
5,00,000
Capital Reserve
1,00,000
General Reserve
1,20,000
Profit and Loss
40,000
Creditors
1,49,700
Bills Payable
Bank Overdraft
A Ltd.
B Ltd.
`
`
2,45,500
23,000
NOTES
1,00,000 8,000 Shares
- of B Ltd.
1,20,000
-
4,14,000
1,23,000
10,000 Debtors
87,000
37,400
36,000 Cash
64,500
-
9,31,000
1,83,400
30,000 Stock
21,300
1,000
-
6,400
9,31,000
1,83,400
SOLUTION
Working Notes :
1) A Ltd., acquired 80% of Equity Shares of B Ltd., on 31st March, 2013
2) Shares of A Ltd., in B Ltd. :
=
=
=
Shares acquired by A Ltd.
Shares issued by B Ltd.
8,000 shares
10,000 shares
4
5
3) Statement of Capital Profit :
i)
Profit and Loss (Cr.) on 31-3-2013
ii)
General Reserve on 31-3-2013

Capital Profit
`
15,000
(+) 20,000
35,000
Capital Profit
` 35,000
A Ltd.
Minority
(4/5)
(1/5)
` 28,000
` 7,000
(Goodwill)
Advanced Accounting - II
37
Preparation of Consolidated
Balance-Sheet of Holding
Company
4)
`
Statement of Revenue Profit :
Profit earned from 31-3-2013 to 31-3-2014
(i)
Profit and Loss i.e. Loss
(-) 5,000
(ii) General Reserve
NOTES

(+) 10,000
Revenue Profit
5,000
Revenue Profit
` 5,000
A Ltd.
Minority
(4/5)
(1/5)
` 4,000
` 1,000
(Consolidated Profit and Loss)
5)
`
Statement of Minority Interest :
Face value of shares held by Minority
(2,000 shares x ` 10)
20,000
Add : Capital Profit
(+) 7,000
27,000
Add : Revenue Profit

(+) 1,000
Minority Interest
28,000
`
6) Statement of Goodwill :
Cost of shares acquired by A Ltd.
1,20,000
Less :Face value of shares acquired
(8,000 shares x ` 10)
(-)
80,000
40,000
Less : A Ltd’s share in Capital Profit

(-)
Goodwill
28,000
12,000
This Goodwill of ` 12,000 is adjusted against Capital Reserve of A
Ltd. , in the consolidated Balance Sheet.
7) Calculation of Unerealised Profit :
B Ltd., supplied goods to A Ltd., for ` 5,000 at a profit of 20% on
selling price.

38
Advanced Accounting - II
SP
=
CP + P
100
=
80 + 20
P
SP
20
=
100
1
=
5
x ` 5,000
Preparation of Consolidated
Balance-Sheet of Holding
Company
4
=
` 1,000 x
=
` 800
5
Hence, unrealised profit of ` 800 will be deducted from the stock of A
Ltd., and from the Consolidated Profit and Loss Account of A Ltd., in
Consolidated Balance Sheet.
`
8) Statement of Consolidated Profit and Loss Account :
Profit and Loss (Cr.)
NOTES
40,000
Add : A Ltd’s share in Revenue Profit
(+) 4,000
44,000
Less :Unrealised Profit

(-)
Profit and Loss (Cr.)
800
43,200
Consolidated Balance Sheet of A Ltd., and its Subsidiary B Ltd.,
as on 31-3-2014
`
Liabilities
Share Capital
`
5,00,000 Fixed Assets
Equity Shares of
A Ltd.
` 10 each
B Ltd.
Capital Reserve
1,00,000
(-)
1,20,000
23,000
A Ltd.
4,14,000
B Ltd.
(+) 1,23,000
43,200
Creditors
5,37,000
1,85,700 Less: Unrealised
A Ltd.
1,49,700
(+)
Profit
36000
800
(-)
22,300 Debtors
A Ltd.
(+)
21,300
A Ltd.
1,000
B Ltd.
Minority Interest
1,24,400
87,000
(+)
37,400
28,000 Cash
Bank Overdraft
6,400
A Ltd.
B Ltd.
(+)
5,36,200
12,000
Profit and Loss
B Ltd.
2,45,500
Stock
General Reserve
B Ltd.
Bills Payable
`
2,68,500
88,000
Less:Goodwill
adjusted
`
Assets
NIL
(+)
64,500
A Ltd.
B Ltd.
64,500
(+)
NIL
6,400
9,93,600
9,93,600
Advanced Accounting - II
39
Preparation of Consolidated
Balance-Sheet of Holding
Company
ILLUSTRATION 3
H Ltd., acquired Equity Shares in S Ltd., as on 1st April, 2013. Their Balance
Sheet as on 31-3-2014 was as follows :
Liability
NOTES
Share Capital :
H Ltd.
S Ltd.
`
`
2,50,000
Assets
50,000 Land and Buildings
• Equity Shares of
Plant and Machinery
`100 each, fully paid
Investments :
General Reserve
50,000
20,000 400 Shares in S Ltd.,
(as on 1-4-2013)
H Ltd.
S Ltd.
`
`
1,00,000
20,000
1,50,000
30,000
50,000
-
40,000
25,000
30,000
15,000
30,000
10,000
(at cost)
Profit and Loss
70,000
Creditors
30,000
25,000 Stock
5,000 Debtors
Cash
4,00,000 1,00,000
4,00,000 1,00,000
Additional Information:
i)
Sundry Debtors of H Ltd. , include ` 5,000 due from S Ltd.
ii) Stock of S Ltd., includes goods purchased from H Ltd., for ` 20,000
on which H Ltd., made a profit of 25% on Sales.
iii) On 1-4-2008 the Profit and Loss of S Ltd., showed a credit balance of
` 5,000.
Prepare a Consolidated Balance Sheet of H Ltd., and its Subsidiary S Ltd.,
as on 31-3-2014
SOLUTION
Working Notes :
1) H Ltd., acquired Equity Shares of S Ltd., on 1st April ,2013.
2) Shares of H Ltd., in S Ltd :
=
=
=
Shares acquired by H Ltd.
Shares issued by S Ltd.
400 shares
500 shares
4
5
3) Statement of Capital Profit :
(i)
General Reserves as on 1-4-2013
(ii)
Profit and Loss (Cr.) on 1-4-2013 i.e. Profit

40
Advanced Accounting - II
Capital Profit
`
20,000
(+) 5,000
25,000
Preparation of Consolidated
Balance-Sheet of Holding
Company
Capital Profit
` 25,000
H Ltd.
Minority
(4/5)
(1/5)
` 20,000
` 5,000
NOTES
(Goodwill)
4) Statement of Revenue Profit :
`
Profits earned from 1-4-2013 to 31-3-2014
(i) General Reserve
NIL
(ii) Profit and Loss i.e. Profit

Revenue Profit
(+) 20,000
20,000
Revenue Profit
` 20,000
H Ltd.
Minority
(4/5)
(1/5)
` 16,000
` 4,000
(Consolidated Profit and Loss)
`
5) Statement of Minority Interest :
Face value of shares held by Minority
(100 shares x ` 100)
10,000
Add : Capital Profits
(+) 5,000
15,000
Add : Revenue Profits

Minority Interest
6) Statement of Capital Reserve :
Cost of shares acquired by S Ltd.
(+) 4,000
19,000
`
50,000
Less : Face value of shares acquired
(400 shares x ` 100)
(-) 40,000
10,000
Less : H Ltd.’s share in Capital Profit

Capital Reserve
(-) 20,000
10,000
Advanced Accounting - II
41
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
7) Calculation of Unralised Profit :
H Ltd., sold goods to S Ltd., for ` 20,000 at a Profit of 25% on Sales.

SP
=
CP + P
100
=
75
P
SP
+ 25
25
=
100
=
1
` 5,000 x
=
x
4
4
5
` 20,000
=
` 4,000
Hence, unrealised profit of ` 4,000 will be deducted from Stock of S Ltd.,
and from the Consolidated Profit and Loss of H Ltd., in the Consolidated
Balance Sheet.
`
8) Statement of Consolidated Profit and Loss Account :
Profit an d Loss (Cr.)
70,000
Add : H Ltd.’s shares in Revenue Profit
(+) 16,000
86,000
Less : Unrealised Profit

(-) 4,000
Profit and Loss (Cr.)
82,000
Consolidated Balance Sheet of H Ltd. and its Subsidiary S Ltd.,
as on 31-3-2014
`
Liabilities
`
Share Capital :
`
Assets
Land and Buildings
• Equity Shares of
2,50,000
`100 each, fully paid
1,20,000
H Ltd.
S Ltd.
1,00,000
(+)
Profit and Loss
82,000 Plant and Machinery
Capital Reserve
10,000
H Ltd.
General Reserve
50,000
S Ltd.
as on 1-4-2013
30,000
H Ltd.
S Ltd.
30,000
Minority Interest
1,80,00
1,50,000
(+)
30,000
(+)
61,000
H Ltd.
S Ltd.
40,000
(+)
25,000
5,000
65,000
35,000
Less: Unrealised Profit (-) 4,000
Less: Inter-Co.’s
owing
20,000
Stock
Creditors
Debtors
(-)
5,000
40,000
H Ltd.
19,000
S Ltd.
`
30,000
(+)
15,000
45,000
Less: Inter-Co.’s
owings
(-)
5,000
Cash
40,000
H Ltd.
S Ltd.
42
Advanced Accounting - II
4,41,000
30,000
(+)
10,000
4,41,000
2.6 Summary
•
Consolidated financial statement normally include consolidated Balance
Sheet. Consolidated Profit and Loss Account notes, other statements and
explanatory material that form an integral part therefor.
•
The purpose of a consolidated Balance Sheet and Profit and Loss Account
is to show the financial position and operating result of a group consisting of
a Holding Co. and one or more subsidiaries.
•
Basic Rules for preparing a Consolidated Balance Sheet :
Rule 1.
Cancellation of Investment and Share Capital
Rule 2.
Calculation of Minority Interest .
Rule 3.
Goodwill or Capital Reserve on Consolidation
Rule 4.
Pre-requisition or Capital Profit.
Rule 5.
Cancellation of Inter company Debts and Acceptances
Rule 6.
Cancellation of Inter - company Loans and Advances
Rule 7.
Contingent Liability on Bills Discounted
Rule 8.
Revaluation of Assets
Rule 9.
Adjustment of Bank Balances
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
Rule 10. Unrealised Profit on Fixed Assets.
•
Miscellaneous Adjustment :
(1) Unrealised Profit on Unsold Stock
(2) Issue of Bonus Shares
(3) Preferences Shares hold by the Holding Co.
(4) Debentures of Holding Co.
(5) Inter-company Dividends.
2.7
Key Terms
(1)
Minority Interest :It is that part of the net results of the operations and
of the net assets of a subsidiary attributable to interests which are not
owned, directly or indirectly through subsidiary or subsidiaries by the parent.
(2)
Capital Profit : Capital Profit are the pre-acquisition profits earned by the
Subsidiary Company till the date of acquisition of shares by the Holding
Company.
(3)
Revenue Profit : Revenue profit are the post-acquisition profits earned
Advanced Accounting - II
43
Preparation of Consolidated
Balance-Sheet of Holding
Company
by the Subsidiary Company in the post acquisition period.
(4)
Capital Reserve : If the cost incurred by the Holding Co. is less than the
benefits derived by it, is treated as Capital Reserve.
(5)
Goodwill : If the cost incurred by the Holding Company is more than the
benefit s derived by it, is treated as Goodwill.
(6)
Consolidated Balance Sheet : It is a consolidated statement of the financial
position of the Holding as well as Subsidiary Companies.
(7)
Gross Holding : A situation where the Holding and Subsidiary Companies
own shares in each others.
(8)
Wholly - owned subsidiary : A subsidiary company whose all shares
owned by the Holding Company or companies of the same group.
(9)
Partly - owned subsidiary : A subsidiary in which the Holding Company
or the group does not hold all the shares.
NOTES
2.8
Questions and Exercises
I - Objective Questions
(A) Multiple Choice Questions
(1)
Consolidation of financial statements may mislead the ......... if the activities
of the subsidiary are very dissimilar from those of other companies within
the group.
(a) Shareholders
(b) Customers
(c) Bankers
(d) Suppliers
(2)
As per ......... consolidated financial statements are the financial statements
of a ‘group’ presented as those of a single enterprise.
(a) AS - 24
(b) AS-18
(c)AS-21
(d) AS -16
(3)
Section 212 of the Companies Act,1956 requires that the published accounts
of Holding Co. must be accompanies by ..............
(a) the recent Balance Sheet
44
Advanced Accounting - II
(b) the Profit and Cost Account
(c) the Board of Directors Report
(d) all of the above
(4)
That part of the net results of operations and of the net assets of a subsidiary
attributable to interests which are owned, directly or indirectly through
subsidiary by the parent is termed as -------
Preparation of Consolidated
Balance-Sheet of Holding
Company
NOTES
(a) Majority Interest
(b) Operational Interest
(c) Minority Interest
(d) Parential Interest
Ans : (1 - a) , (2 - c), (3 - d),(4 - c)
II - Long Answer Questions
(1)
What are ‘Consolidated Financial Statement ?’ Explain in brief the need of
consolidated financial statements.
(2)
Explain in brief the advantages and disadvantages of consolidation of
financial statement .
(3)
Explain the neccesary steps involved in the preparation of consolidated
financial statements.
(4)
What is ‘ Minority Interest ?’ Explain the procedure for calculation of minority
interest.
(5)
How would you differentiate between Goodwill and Capital Reserve on
Consolidation ?
(6)
Write Short Notes on :
(a) Minority Interest
(b) Goodwill or Cost of Capital
(c) Inter Company Indebtedness
(d) Need of Consolidated Financial Statements
III - Practical Problems
(1) Prepare a Consolidated Balance Sheet with necessary working notes from
the Balance Sheet of H Ltd. and S Ltd. and the additional information given below
as on 31st March, 2014
Advanced Accounting - II
45
Preparation of Consolidated
Balance-Sheet of Holding
Company
Balance Sheet as on 31st March 2014
Liabilities
Share Capital
NOTES
H Ltd.
S Ltd.
`
`
5,00,000
Machinery
General Reserve
40,000
Profit and Loss
70,000
Bills Payable
50,000
1,40,000
H Ltd. S Ltd.
`
3,00,000 Buildings
share of ` 100each
Creditors
Assets
10,000 Investment
`
2,00,000 1,00,000
1,50,000 2,00,000
2,97,000
-
25,000 Stock
40,000
30,000
60,000 Debtors
50,000
60,000
63,000
10,000
5,000 2,700shares in S Ltd.
Bills Receivable
8,00,000 4,00,000
8,00,000 4,00,000
Additional Information :
i)
On the date of purchase of shares there was no balance in General Reserve
and Profit and Loss Account showed a debit balance of `10,000 in the
books of S Ltd.
ii)
Debtors of S Ltd. include Rs. 40,000 due from H Ltd.
iii)
Bills Payable of S Ltd. include ` 18,000 in favour of H Ltd. which has
discounted ` 3,000 of them .
2.9 Further Reading
46
Advanced Accounting - II
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand and Co. Pvt. Ltd., 2013
•
Sehgal Ashok - Taxman’s Fundamentals of Corporate Accounting - New
Delhi - Taxman Publications Pvt. Ltd., 2012.
UNIT 3 AS-21 and preparation of
Consolidated Financial Statements
AS-21 & Preparation Of
Consolidated Financial
Statements
Structure
NOTES
3.0
Introduction
3.1
Unit Objectives
3.2
AS-21 and preparation of Consolidated Financial Statements
3.2.1
Objectives
3.2.2
Notable Terms
3.2.3
Format of Consolidated Financial Statement
3.3.
Scope of Consolidated Financial Statement
3.4
Consolidation Procedure
3.5
Unrealised Losses
3.6
Disclosure
3.7
Practical Examples related to AS-21
3.8
Illustrations
3.9
Summary
3.10 Key Terms
3.11 Questions and Exercises
3.12 Further Reading
3.0. Introduction
AS-21 deals with the preparation of Consolidated Financial Statement with
an intention to provide information about the activities of a group. This statement
should be applied in preparation and presentation of Consolidated Financial
Statements for a group (parent company and companies under its control referred
as subsidiary companies) of enterprises under the control of a parent. In a parent’s
separate financial statements investments in subsidiaries should be accounted for
in accordance with accounting standard (AS)13 Accounting for Investments.
Consolidated Financial Statement normaly include Consolidated Balance Sheet,
Consolidated Profit and Loss Account and related notes. The Consolidated
Financial Statements under AS-21 mean a complete set of financial statements
even if this means a repetition of notes already disclose in the individuals entity
financial statement. AS 21 requires Consolidated Financial Statements to include
Advanced Accounting - II
47
AS-21 & Preparation Of
Consolidated Financial
Statement
NOTES
notes and other statements and explanatory material that form an integral part
thereof. ICAI has issued ASI 15 on the subject of presentation and disclosure,
which concentrated on certain principles should be observed in respect of notes
and other explanatory material. It means, in the preparation of consolidated financial
statements, other mandatory accounting standards also apply in the same manner
as they apply to separate financial statements.
In preparing consolidated financial statements, the financial statements of
the parent and its subsidiaries should be combined on a line by line basis adding
together like items of assets, liabilities, income and expenses. Further balances
and transactions among members of the group must be eliminated. The effect of
this is to show transaction that have been communicated with outside parties only.
3.1
Unit Objectives
After studying this unit you should able to
•
Understand how AS-21 deals with the preparation of Consolidated Financial
Statement.
•
Interprete the various notable terms related to AS-21.
•
Express the exceptions to AS-21.
•
Discuss the terms “negative minority interest”
•
Understand the accounting treatment for unrealised losses from inter group
transactions.
•
Give the practical examples related to AS-21.
3.2
AS-21 and preparation of Consolidated
Financial Statements
AS-21, deals with the preparation of Consolidated Financial Statements
with an intention to provide information about the activities of a group (Parent
Company and companies under its control referred to as Subsidiary Companies.)
3.2.1. Objectives :
48
Advanced Accounting - II
The objectives of this statement is to present financial statement of a parent
and its subsidiary as a single economic entity. In other words, the Holding Company
and its subsidiary are treated as one entity for the preparation of these Consolidated
Financial Statements. Consolidated Profit or Loss Account and Consolidated
Balance Sheet are prepared for disclosing the total profit or loss of the group and
total assets and liabilities of the group. As per this accounting standard, the
consolidated Balance Sheet if prepared should be prepared in the manner prescribed
by this statement.
3.2.2. Notable Terms :
AS-21 & Preparation Of
Consolidated Financial
Statement
a) Parent :
A parent is an enterprise that has one or more subsidiaries.
b) Subsidiary :
NOTES
A subsidiary is an enterprise that is controlled by another enterprise
known as parent.
c) Control :
Control can be exercised directly or indirectly (through a subsidiary) by
purchasing more than 50% of the voting power of an enterprise or by
controlling composition of board of directors or governing body. Generally,
it is done by purchasing more than 50% of the equity shares (voting
power) of an enterprise.
3.2.3 Format of Consolidated Financial Statements :
These are prepared or presented in the same format as that followed by
the parent for preparation of its separate financial statements.
Application of other accounting standards in preparation of Consolidated
Financial Statements :
As per the accounting standard while preparing the Consolidated Financial
Statement, the other accounting standard shall apply in the same manner as they
apply in preparing the separate financial statements.
Accounting for investments made by parents in its subsidiary(ies) while
preparing separate financial statements:
A parent should account for the investment in subsidiary(ies) in accordance
with AS-13, “Accounting for Investment”. As per AS-13, the investment made
by a parent in subsidiary(ies) should be recorded at cost.
Consolidated Financial Statements are no substitute for separate financial
statements :
Consolidated Financial Statements are not the substitute for separate
financial statements of a parent and its subsidiary(ies). In other words, a parent
and its subsidiary(ies), shall prepare separate financial statements as per governing
law. The consolidated financial statement made by a parent is in addition to the
separate financial statements
.
Advanced Accounting - II
49
AS-21 & Preparation Of
Consolidated Financial
Statement
3.3. Scope of Consolidated Financial Statement
A parent, which is required to prepare the Consolidated Financial Statement,
should consolidate the financial statement of all its subsidiary(ies), whether domestic
or foreign.
NOTES
Exceptions:
Consolidated Financial Statements are not required to be prepared even if
parent subsidiaries relationship exists when :
•
a parent acquires the control (investment in subsidiary), which is intended
to be temporary as the investment (control) is to be disposed in the near
future.
•
the subsidiary operates under severe long-term restrictions and due to this
its ability to transfer the funds to parent is significantly weakened.
Dissimilar activities of parent and the its subsidiaries cannot be the ground
for non-consolidation of financial statements.
3.4. Consolidation Procedure
In preparing Consolidated Financial Statements the financial statements
(Balance Sheet and Profit and Loss Account) of the parent and its subsidiaries
should be combined or added on line by line basis by adding the like items of
assets, like items of liabilities, like items of income and expense.
•
The Cost of Investment of parent in each subsidiary should be cancelled
or eliminated with parent’s portion of equity of each subsidiary on the
date on which the investment was acquired in each subsidiary. Parents
portion of equity of means share of parent (holding), in equity share
capital of subsidiary (+) share in reserve and surplus of the subsidiary on
the date of acquisition of share. In other words, parent’s portion of equity
in each subsidiary(ies) on the date of acquisition is paid up share capital
held by holding (+) Share of pre-acquisition profits.
•
If cost of investment in a subsidiary exceeds the parent’s (holding) portion
of equity i.e. paid up capital held by the holding plus share of pre-acquisition
profit on the date of consolidation, the excess is Goodwill, and such goodwill
arising due to consolidation procedure should be shown as an asset in
consolidated financial statement.
•
When the cost of investment in subsidiary is less than the paid up equity
capital held by holding (parent) plus share of pre-acquisiton profits, the
difference is credited Capital Reserve and this capital reserve is shown
in consolidated financial statement under the head ‘Reserve and Surplus’.
•
Minority Interest should be calculated and shown in the consolidated
financial statements separately under separate heads. Minority interest
means the portion of net assets of subsidiary on the date of consolidation
Check Your Progress
1 . What is AS-21 ?
2 . Define the terms Parent, Subsidiary and
Control as per AS-21.
3 . State the procedure of
consolidation.
50
Advanced Accounting - II
not controlled by the parent, itself or through its subsidiary. Minority
interest = Paid up equity capital held by an outsider (outside the group)
plus share of ‘reserve and surplus’ on the date of consolidation. Preference
share capital not held by parent or group is also shown along with minority
interest.
•
While calculating minority interest, share of minority in net profit of
consolidated subsidiaries for the reporting period should be calculated
and charged against the consolidated profit consequently balance profit
after charging minority interest represents the parent (holding company)
share in profit which he shown under the head ‘Reserves and Surplus’ in
consolidated Balance Sheet.
•
Intra - Group Balances and transactions i.e. inter-company debtor or
creditors, inter-company purchase or sales and resulting unrealise profit
shall be eliminated in full.
AS-21 & Preparation Of
Consolidated Financial
Statement
NOTES
3.5. Unrealised Losses
Unrealised Losses from intra-group transactions should also be eliminated
if recoverable amount is more than the cost of transactions, e.g., if X Ltd. (holding
company), sells goods costing ` 5,00,000 to its subsidiary, Y Ltd. at `4,00,000 and
on the date of consolidation. The goods are lying in stock of Y Ltd. This recoverable
amount of stock is ` 5,50,000; as the recoverable amount is more than the cost of
the transaction, the unrealised loss of ` 1,00,000 should be eliminated by adding
to stock and adding to consolidated Period and Loss Account in consolidated
Balance Sheet.
It should be noted that if unrealised losses are on account of intra-group
sale or purchase of assets, the recoverable amount shall have the meaning as
described in accounting standard on ‘Impairment of Assets’.
Consolidation when different reporting Date :
Financial statement of parents and its subsidiary used for consolidation are
generally of same date, however when reporting dates are different and it is not
practical to prepare the financial statement of subsidiary of the same date, the
different reporting date financial date financial statement can be consolidated
making adjustment for the effects of significant transactions that occur between
those dates and parent financial statements provided difference is not more than
six months. If parent and its subsidiaries are following different accounting policies,
the consolidated financial statement should be prepared using uniform accounting
policies, if it is not practicable, then the items in which different accounting have
been followed should be disclosed.
Disposal of investment in a subsidiary :
The difference between the proceeds front the disposal of investments in
a subsidiary and the carrying amount of its assets less liabilities as of the date of
disposal is recognized in the consolidated statement of profit and loss on the
disposal of the investment in a subsidiary.
Advanced Accounting - II
51
AS-21 & Preparation Of
Consolidated Financial
Statement
NOTES
Successive purchase of shares in a subsidiary by the parent :
If all enterprise purchases two or more the investment of other enterprise
and eventually obtains control of the other enterprise, the consolidated financial
statement is prepared from the date on which holding subsidiary relationship is
established. Further, in such cases goodwill or capital reserve on consolidation
should be determined on a step by step basis, however if small investments are
made over a period of time, then the date of latest major investment which resulted
in control, should be considered as date of investment for all successive purchases
and, accordingly calculation of goodwill/capital reserve should be made.
Minority interest is in Negative :
When minority interest comes in negative (minus), this should be adjusted
against majority interest. In other words, negative minority interest will not shown
in consolidated Balance Sheet. If the subsidiary subsequently reports profits, all
such profits should be allocated to majority interest until minority share of losses
previously absorbed by the majority has been recovered.
Arrears of Cumulative Preference Sheet of a subsidiary :
If the subsidiary has arrears of, cumulative preference shares which are
held outside the group, then the holding company share of profit is calculated after
charging the arrear of cumulative preference dividend of a subsidiary, whether
declared or not.
3.6
Disclosure
Following disclosure should be made in Consolidated Financial Statements
Check Your Progress
•
List of all subsidiaries.
•
Proportion of ownership interest.
•
Nature of relationship between parent and subsidiary whether direct control
or control through subsidiaries.
•
Name of the subsidiary of which reporting dates are different.
•
The fact for different accounting policies applied for preparation of
consolidated financial statement.
•
If consolidation of particular subsidiary has not been made as per the grounds
allowed in accounting standards the reason for not consolidating should be
disclosed.
1 . Define
the
term
‘Unrealised Losses’.
2 . What disclosures should
be made in Consolidated
Financial Statements ?
52
Advanced Accounting - II
AS-21 also focuses on the following points :
•
Interpretations issued by the ICAI.
•
Transactional provisions.
•
Significant differences among AS, IFRS/and US GAAP.
3.7
Practical Examples related to AS-21
AS-21 & Preparation Of
Consolidated Financial
Statement
EXAMPLE 1
What are the exceptions to AS-21 ?
ANSWER
NOTES
AS-21 does not deals with :
i) Method of accounting for amalgamations and their effects on
consolidation, including goodwill arising on amalgamation (see AS-14,
Accounting for Amalgamations);
ii) Accounting for investments in associates (at present governed by
AS-23, Accounting for Investments in Associates in Consolidated
Financial Statements) and
iii) Accounting for investments in joint ventures (governed by AS - 27,
Financial Reporting of Interests in Joint Ventures).
EXAMPLE 2
If A is holding 60% in B is holding 60% in C, will C be consolidated in B
and ultimately in A ?
ANSWER
Consolidation is required when there is ownership of more than one-half of
voting power directly or indirectly through subsidiaries. In this case though effective
ownership of , A is 36%, A is able to exercise more than one - half of the voting
power in C through its majority holding in B.E.g. of a resolution is put to vote
in C,A because of its control over B will be able to pass or veto that resolution .
Hence, C will be consolidated in B, and consequently in A.
EXAMPLE 3
Parent Co. A owns 100% of subsidiary B and 49% of C. Subsidiary B in
turn, owns 10% of C Parent Co. A controls C through direct and indirect ownership
and would therefore consolidate it.
ANSWER
Parent Co. A owns 51% of subsidiary B, which in turn owns 51% of
subsidiary C. Again parent Co. A control subsidiary C and would consolidate it.
On the other hand , if parent company A owned only 49% of B, Control would
not result. If company A does not control company B, company B’s investment
in company C is irrelevant to whether company A controls company C.
EXAMPLE 4
X Ltd. is Textile Manufacturing Co., it has purchased 75% equity shares
of Y Ltd., which is a Software Company. X Ltd, did not consolidate the accounts
of Y Ltd., on the pretext that subsidiary business is entirely different and it does
Advanced Accounting - II
53
AS-21 & Preparation Of
Consolidated Financial
Statement
not make sense to consolidate the subsidiary Y Ltd., accounts. Comment.
ANSWER
Contention is not correct as per AS-21.
NOTES
EXAMPLE 5
While consolidating the financial statement the Minority Interest was
calculated as minus ` 50,000. The accountant wants to show it in assets side of
consolidated Balance Sheet.
Comment.
ANSWER
` 50,000 to be adjusted with Majority Interest.
3.8
Illustrations
The preparation of consolidated financial statements as per AS-21 can be
understood with the help of following illustration :ILLUSTRATION 1
The following is the condensed Balance Sheet of A Ltd., and its Subsidiary
B Ltd., as on 31-3-2014.
Balance Sheet as on 31-3-2014
Liabilities
A Ltd.
B Ltd.
`
`
Assets
A Ltd.
B Ltd.
`
`
5,58,000
3,45,000
2,00,000
1,35,000
2,85,000
1,55,000
1,50,000 B Ltd., at cost
3.90,000
-
Cash at Bank
5,000
45,000
14,65,000
6,80,000
Share Capital:
Fixed Assets
Sh. of `10 each
11,00,000
Share Premium
1,30,000
General Reserve
Profit and Loss
Sundry Creditors
1,40,000
95,000
4,00,000 Stock
- Sundry Debtors
1,00,000 Investments :
30,000 36,000 Shares in
14,65,000 6,80,000
You are required to prepare a Consolidated Balance Sheet as on 31-3-2014
with necessary workings, having regard to the following :
i) On the date, when A Ltd. acquired the Shares of B Ltd., the latter
Company had a General Reserve of `25,000 and a credit balance on
Profit and Loss of `5,000.
ii) B Ltd. had purchased goods from A Ltd., of which ` 70,000 are still in
Stock A Ltd., sells to B Ltd., at cost plus 25%.
54
Advanced Accounting - II
AS-21 & Preparation Of
Consolidated Financial
Statement
SOLUTION
Working Notes :
1) It is assumed that A Ltd., acquired Shares of B Ltd. on 1st April, 2013.
2) Shares of A Ltd., in B Ltd.
=
=
=
Shares acquired by A Ltd.
NOTES
Shares issued by B Ltd.
36,000 shares
40,000 shares
9
10
3) Statement of Capital Profit :
(i)
General Reserve as on 1-4-2013
(ii)
Profit and Loss (Cr.) on 1-4-2013 i.e. Profit

Capital Profit
`
25,000
(+) 5,000
30,000
Capital Profit
` 30,000
A Ltd.
(9/10)
` 27,000
(Goodwill)
Minority
(1/10)
` 3,000
4) Statement of Revenue Profit :
`
Profit earned from 1-4-2013 to 31-3-2014
(i)
General Reserve
(ii)
Profit and Loss (Cr.) i.e. profit

75,000
Revenue Profit
(+) 25,000
1,00,000
Revenue Profit
` 1,00,000
A Ltd.
(9/10)
` 90,000
(Consolidated Profit and Loss)
Minority
(1/10)
` 10,000
Advanced Accounting - II
55
AS-21 & Preparation Of
Consolidated Financial
Statement
`
5) Statement of Minority Interest :
Face value of shares held by Minority
(4,000 shares x `10)
Add :
40,000
Capital Profit
(+) 3,000
NOTES
43,000
Add :
Revenue Profit

(+) 10,000
Minority Interest
53,000
`
6) Statement of Goodwill :
Cost of shares acquired by A Ltd.
Less :
3,90,000
Face value of shares acquired
(36,000 shares x `10)
(-) 3,60,000
30,000
Less :

A Ltd.’s share in Capital Profit
(-) 27,000
Goodwill
3,000
7) Calculation of Unrealised Profit :
A Ltd., sold goods to B Ltd., for `70,000 at cost plus 25%

SP
= CP + P
125
= 100 + 25
P
25
=
SP
125
=
1
x ` 70,000
5
= ` 14,000 x
9
= ` 12,600
10
Hence, Unrealised Profit of `12,600 will be deducted from Stock of B
Ltd., and from the Consolidated Profit and Loss of A Ltd., in the Consolidated
Balance Sheet.
8) Statement of Consolidated Profit and Loss Account
Profit and Loss (Cr.)
Add :
A Ltd.’s share in Revenue Profit
`
1,40,000
(+) 90,000
2,30,000
Less :
Unrealised Profit
Profit and Loss (Cr.)
56
Advanced Accounting - II
(-) 12,600
2,17,400
AS-21 & Preparation Of
Consolidated Financial
Statement
Consolidated Balance Sheet of A Ltd. and its Subsidiary B Ltd.,
as on 31-3-2014
`
Liabilities
Share Capital :
`
`
Assets
`
11,00,000 Goodwill
• Sh. of `10 each
3,000
Fixed Assets
9,30,000
Share Premium
1,30,000
A Ltd.,
5,85,000
Profit and Loss
2,17,400
B Ltd.,
(+) 3,45,000
Minority Interest
NOTES
53,000 Stock
Sundry Creditors
2,45,000
A Ltd.
95,000
B Ltd.
(+) 1,50,000
3,22,400
A Ltd.,
2,00,000
B Ltd.,
(+) 1,35,000
3,35,000
Less: Unrealised
Profit
(-)
12,600
Sundry Debtors
4,40,000
A Ltd.
2,85,000
B Ltd.
(+) 1,55,000
Cash at Bank
50,000
A Ltd.
B Ltd.
5,000
(+)
45,000
17,45,400
17,45,400
ILLUSTRATION 2
The Balance Sheet of two companies as at 31-3-2014 is as follows.
Liabilities
A Ltd.
C Ltd.
`
`
Share Capital :
Assets
Land and Buildings
A Ltd.
C Ltd.
`
`
2,00,000
1,50,000
3,00,000
3,00,000
75,000
50,000
50,000
60,000
5,00,000
-
10,000
5,000
1,55,000
1,60,000
Equity Shares of
` 10 each
General Reserve
10,00,000
1,00,000
5,00,000 Machinery
1,00,000 Stock
(as on 1-4-2013)
Profit and Loss
Sundry Debtors
50,000
30,000 Investment at cost in
(as on 1-4-2013)
the Shares of C Ltd.
Profit for the year
Bills Receivable
(2013-2014)
60,000
40,000 Cash at Bank
Sundry Creditors
70,000
50,000
Bills Payable
10,000
5,000
12,90,000 7,25,000
12,90,000 7,25,000
Additional Information :
i) A Ltd. acquired 40,000 Equity Shares of C Ltd. on 1st April, 2013.
Advanced Accounting - II
57
AS-21 & Preparation Of
Consolidated Financial
Statement
ii) Bills Receivable of A Ltd., include ` 3,000 accepted by C Ltd.
iii) Sundry Debtors of A Ltd., include `10,000 due from C Ltd.
iv) Stock of C Ltd., includes goods purchased from A Ltd., for `30,000
which were invoiced by A Ltd., at a profit of 25% on the invoice price.
NOTES
Prepare a Consolidated Balance Sheet of A Ltd. and its Subsidiary C Ltd.
as at 31-3-2014
SOLUTION
Calculation and Notes :
1) A Ltd. acquire Equity Shares of C Ltd., on 1st April, 2013.
2) Share of A Ltd., in C Ltd.
=
=
=
3)
Shares acquired by A Ltd.
Shares issued by C Ltd.
40,000 shares
50,000 shares
4
5
Statement of Capital Profit :
`
i)
General Reserve on 1-4-2013
ii)
Profit and Loss (Cr.) on 1-4-2013 i.e. Profit
+ 30,000

1,30,000
Capital Profit
1,00,000
Capital Profit
` 1,30,000
A Ltd.
(4/5)
` 1,04,000
(Goodwill)
Minority
(1/5)
` 26,000
4) Statement of Revenue Profit :
Profits earned from 1-4-2013 to 31-3-2014 i.e.
Profit for the year 2013-2014 i.e. Profit

Revenue Profit
`
NIL
(+) 40,000
40,000
Revenue Profit
` 40,000
58
Advanced Accounting - II
A Ltd.
(4/5)
` 32,000
(Consolidated Profit and Loss Account)
Minority
(1/5)
` 8,000
`
5) Statement of Minority Interest :
Face value of shares held by Minority
1,00,000
AS-21 & Preparation Of
Consolidated Financial
Statement
(10,000 shares x ` 10)
Add : Capital Profit
(+) 26,000
1,26,000
Add : Revenue Profit

(+) 8,000
Minority Interest
NOTES
1,34,000
`
6) Statement of Capital Reserve :
Cost of shares acquired by A Ltd.
5,00,000
Less : Face value of shares acquired
(40,000 shares x ` 10)
(-) 4,00,000
1,00,000
Less : A Ltd.’s share in Capital Profit

(-) 1,04,000
Capital Reserve
4,000
7) Calculation of Unrealised Profit :
A Ltd., invoiced goods to C Ltd., for ` 30,000 at a profit of 25% on the
invoice price.
SP
=
100 =

P
SP
CP + P
75
+ 25
25
=
100
1
=
4
4
= ` 6,000
5
Hence, Unrealised Profit of ` 6,000 will be deducted from Stock of C Ltd.,
and from the Consolidated Profit and Loss of A Ltd., in Consolidated Balance
Sheet.
=
` 7,500 x
x ` 30,000
8) Statement of Consolidated Profit and Loss Account :
`
Profit and Loss (Cr. ) on 1-4-2013
50,000
Add :
60,000
Profit for the year 2013-2014
Add : A Ltd.’s share in Revenue Profit
(+) 32,000
1,42,000
Less:
Unrealised Profit

Profit and Loss (Cr.)
(-)
6,000
1,36,000
Advanced Accounting - II
59
AS-21 & Preparation Of
Consolidated Financial
Statement
Consolidated Balance Sheet of A Ltd. and its Subsidiary C Ltd.,
as on 31-3-2014
`
Liabilities
Share Capital :
NOTES
`
`
Assets
10,00,000 Land and Buildings
3,50,000
Equity Shares of
A Ltd.
2,00,000
Rs.10 each
C Ltd.
(+) 1,50,000
Capital Reserve
4,000 Machinery
General Reserve
1,00,000
on 1-4-2013
3,00,000
C Ltd.
(+) 3,00,000
1,36,000 Sundry Debtors
Sundry Creditors
1,10,000
A Ltd.
70,000
C Ltd.
(+)
10,000
owings
Minority Interest
10,000
12,000
A Ltd.
C Ltd.
10,000
(+)
5,000
5,000
15,000
15,000
Less: Inter-Co. (-)
(-)
Bills Receivable
12,000
(+)
60,000
Less:Inter-Co.
10,000
Bills Payable
C Ltd.
(+)
1,10,000
owings
A Ltd.
50,000
50,000
Less: Inter-Co.
(-)
1,00,000
A Ltd.
C Ltd.
1,20,000
owing
6,00,000
A Ltd.
Profit and Loss
`
Less : Inter-Co.
3,000
(-)
3,000
owings
1,34,000
Stock
A Ltd.
C Ltd.
1,19,000
75,000
(+)
50,000
1,25,000
Less :Unrealised
Profit
6,000
Cash at Bank
14,96,000
60
Advanced Accounting - II
3,15,000
A Ltd.
1,55,000
C Ltd.
(+) 1,60,000
14,96,000
ILLUSTRATION 3
From the following information, prepare a Consolidated Balance Sheet of
H Ltd., and its Subsidiary S Ltd., as at 31-3-2014 giving detailed working notes :
AS-21 & Preparation Of
Consolidated Financial
Statement
Balance Sheet as on 31-3-2014
Liabilities
H Ltd.
S Ltd.
`
`
NOTES
Share Capital :
Equity Share of ` 10 each
4,00,000
2,00,000
General Reserve
2,00,000
60,000
Profit and Loss
1,00,000
40,000
6% Debentures
-
1,00,000
Loan from H Ltd.
-
10,000
Sundry Creditors
1,00,000
40,000
50,000
30,000
8,50,000
4,80,000
Bills Payable
Assets
H Ltd.
S Ltd.
`
`
Goodwill
1,00,000
Fixed Assets
2,00,000
2,50,000
2,00,000
-
60,000
-
-
50,000
1,00,000
40,000
Sundry Debtors
80,000
40,000
Bills Recevable
40,000
-
Bank Balance
60,000
1,00,000
Loans to S Ltd.
10,000
-
8,50,000
4,80,000
Investments :
i)
16,000 Shares of ` 10 each in S Ltd., at cost
ii) 6% Debentures of S Ltd., (Face value ` 60,000)
iii) Government Securities
Stock
Additional
Information :
i) Sundry Creditors of H Ltd., include ` 20,000 due to S Ltd.
ii) The Closing Stock of H Ltd., includes stock worth ` 30,000 supplied by
S Ltd., which had invoiced at cost plus 20% profit on cost.
iii) Bills Payable of S Ltd., include Rs.24,000 issued in favour of H Ltd.,
which was discounted but yet matured ` 4,000 of them.
iv) H Ltd., acquired 16,000 Equity Shares in S Ltd., on 1st April, 2013 on
which date the Balance Sheet of S Ltd., showed General Reserve at
Advanced Accounting - II
61
AS-21 & Preparation Of
Consolidated Financial
Statement
` 20,000 and Profit and Loss Account credit balance of ` 10,000.
v) H Ltd., revalued Fixed Assets of S Ltd., as on 1-4-2013 at ` 2,60,000.
SOLUTION
NOTES
Working Notes :
1)
H Ltd., acquired shares in S Ltd., on 1st April, 2013.
2)
Share of H Ltd., in S Ltd. :
Shares acquired by H Ltd.
Shares issued by S Ltd.
16,000 shares
20,0000 shares
4
5
=
=
=
3)
Statement of Capital Profit :
(i)
`
General Reserves as on 1-4-2013
20,000
Add : Profit and Loss (Cr.) as on 1-4-2013
10,000
Add : Increase in value of Fixed Assets of S Ltd.,
as on 1-4-2013

(+) 10,000
Capital Profit
40,000
Capital Profit
` 40,000
H Ltd.
(4/5)
` 32,000
(Goodwill)
4)
Minority
(1/5)
` 8,000
Statement of Revenue Profit :
`
Profit earned from 1-4-2013 to 31-3-2014
i) General Reserve
40,000
ii) Profit and Loss (Cr.)

(+) 30,000
Revenue Profit
70,000
Revenue Profit
` 70,000
62
Advanced Accounting - II
H Ltd.
(4/5)
` 56,000
(Consolidated Profit and Loss)
Minority
(1/5)
` 14,500
`
5) Statement of Minority Interest :
Face value of shares held by Minority
40,000
AS-21 & Preparation Of
Consolidated Financial
Statement
(4,000 shares x ` 10 )
Add : Capital Profit
8,000
Add : Revenue Profit

(+) 14,000
Minority Interest
62,000
NOTES
`
6) Statement of Goodwill :
Cost of Shares acquired by H Ltd.
2,00,000
Less : Face value of shares acquired
(16,000 Shares x `10)
(-) 1,60,000
40,000
Less : H Ltd.’s share in Capital Profits
(-) 32,000
8,000
Add : Goodwill as per Balance Sheet
(-)1,00,000
(H Ltd., ` 1,00,000)

Goodwill
7) Calculation of
1,08,000
Unrealised Profit :
The Closing Stock of H Ltd., includes Stock worth ` 30,000 supplied by S
Ltd. invoice at cost plus 20%.
SP = CP
+ P
120 = 100 + 20

P
SP
20
=
120
1
=
6
x
` 30,000
4
= ` 5,000 x
5
= ` 4,000
Therefore, ` 4,000 being unrealised profit will be deducted from the Closing
Stock of S Ltd., and from the Consolidated Profit and Loss Account of H Ltd., in
Consolidated Balance Sheet.
8) Statement of Consolidated Profit and Loss Account :
Profit and Loss as on 31-3-2014
Add : H Ltd.’s share in Revenue Profit
`
1,00,000
(+) 56,000
1,56,000
Less : Unrelised Profit

Profit and Loss (Cr.)
(-) 4,000
1,52,000
Advanced Accounting - II
63
AS-21 & Preparation Of
Consolidated Financial
Statement
Consolidated Balance Sheet of H Ltd., and its Subsidiary S Ltd.,
as on 31-3-2014.
`
Liabilities
NOTES
`
Share Capital :
Goodwill
• Equity Shares of
Fixed Assets
` 10 each
4,00,000
H Ltd.
General Reserve
2,00,000
S Ltd.
Profit and Loss
1,52,000 Investments
6% Debentures
1,00,000
Less : held by H Ltd. (-)
60,000
Minority Interest
2,00,000
(+)
2,60,000
4,60,000
50,000
40,000 (ii) 6% Debenture
60,000
62,000 Less: Held by
10,000
H Ltd.
Less :Inter-Company
owings(-)
10,000
NIL Stock
H Ltd.
Sundry Creditors
S Ltd.
H Ltd.
(-)
(+)
Less : Inter-Company
owings
(-)
40,000
(+)
Profit
(-)
Sundry Debtors
20,000 1,20,000
H Ltd.
(+)
50,000
Contingent Liability for
4,000
1,36,000
80,000
40,000
1,20,000
30,000
Less:Inter -
80,000
Company owings(-)
Less: Inter-Company
(-)
40,000
Less: Unrealised
S Ltd.
(+)
NIL
1,40,000
Bills Payable
H Ltd.
60,000
1,00,000
1,00,000
1,40,000
owings
1,08,000
Securities
Loan from H Ltd.
S Ltd.
`
(i) Government
S Ltd.
S Ltd.
`
Assets
20,000
1,00,000
Bills Receivable
20,000
60,000
H Ltd.
-
S Ltd.
40,000
(+)
Bills Recevable discount
NIL
40,000
by H Ltd., ` 4,000
Less :Inter Company owings (-) 20,000
20,000
Bank Balance
H Ltd.
S Ltd.
60,000
(+)
Loan to S Ltd.
1,00,000
1,60,000
10,000
Less : Inter Company owings(-)
10,34,000
64
Advanced Accounting - II
10,000
NIL
10,34,000
ILLUSTRATION 4
The summerised Balance Sheet of H Ltd., and M Ltd., as on 31-3-2014
were as follows :
Liabilities
H Ltd. M Ltd.
`
Share Capital :
Assets
`
2,50,000 1,00,000 Premises
H Ltd.
M Ltd.
`
`
75,000
90,000
Equity Shares of
Plant
1,20,000
54,700
` 100 each
Investment
1,70,000
-
70,000
18,000
21,000
20,000
4,200 Account
1,000
-
4,000 Cash at Bank
7,250
4,000
7,900
-
Capital Reserve
-
AS-21 & Preparation Of
Consolidated Financial
Statement
NOTES
60,000 (Sh. in M Ltd.,
at cost)
General Reserve
1,20,000
Profit and Loss
28,600
Bank Overdraft
50,000
Bills Payable
-
Creditors
23,550
H Ltd.’s Current A/C
-
- Stock
18,000 Debtors
- M Ltd.’s Current
500 Bills Receivable
4,72,150 1,86,700
4,72,150 1,86,700
H Ltd., acquired 800 Equity Shares of `100 each in M Ltd., on
30th March, 2013.
i)
Creditors of H Ltd., include ` 6,000 due to M Ltd.
ii) ` 1,500 of the bills are drawn by H Ltd., on M Ltd.
iii) The directors are advised that the Premises of M Ltd. are undervalued
by `10,000 and its Plant is overvalued by ` 5,000.
iv) A cheque for ` 500 sent by M Ltd., to H Ltd., on 30-3-2014 was
receivable H Ltd., on 3-4-2014.
Prepare a Consolidated Balance Sheet on 31-3-2014.
SOLUTION
Working Notes :
1)
H Ltd., acquired Equity Shares in M Ltd., on 30th June, 2013.
2)
Share of H Ltd., in M Ltd. :
=
=
=
Shares acquired by H Ltd.
Shares issued by M Ltd.
800 Shares
1,000 Shares
4
5
Advanced Accounting - II
65
AS-21 & Preparation Of
Consolidated Financial
Statement
3) Statement of Capital Profit :
Capital Reserve
`
60,000
Add : Profits earned from 1-4-2013 to 30-6-2013
3
NOTES
Profits for the year 2013-2014
x
12
4,500
` 18,000
Add : Undervaluation of Premises of M Ltd.
(+) 10,000
74,500
Less : Overvaluation of Plant of M Ltd.

Capital Profit
(-) 5,000
69,500
Capital Profit
` 69,500
H Ltd.
(4/5)
` 55,600
(Goodwill)
Minority
(1/5)
` 13,900
4) Statement of
Revenue Profit :
`
Profit earned from 1-7-2013 to 31-3-2014
9
12
x

Profits for the year 2013-2014
` 18,000
Revenue Profit
(+) 13,500
13,500
Revenue Profit
` 13,500
H Ltd.
(4/5)
` 10,800
(Consolidated Profit and Loss)
5) Statement of Minority Interest :
Minority
(1/5)
` 2,700
`
Face Value of shares held by Minority
(200 Shares x ` 100)
Add : Capital Profit
20,000
(+) 13,900
33,900
Add : Revenue Profit

66
Advanced Accounting - II
Minority Interest
(+) 2,700
36,600
`
6) Statement of Goodwill :
Cost of Shares acquired by H Ltd.
1,70,000
AS-21 & Preparation Of
Consolidated Financial
Statement
Less : Face value of shares acquired
(800 shares x ` 100)
(-) 80,000
90,000
Less : H Ltd.’s shares in Capital Profit

(-) 55,600
Goodwill
34,400
7) Statement of Consolidated Profit and Loss Account :
Profit and Loss (Cr.)
`
28,600
Add : H Ltd.’s share in Revenue Profit

NOTES
(+) 10,800
Profit and Loss(Cr.)
39,400
Consolidated Balance Sheet of H Ltd., and its Subsidiary M Ltd.,
as on 31-3-2014
`
Liabilities
Share Capital :
• Equity Shares of
` 100 each
General Reserve
Profit and Loss
Minority Interest
Bank Overdraft
Bills Payable
H Ltd.
M Ltd.
`
Assets
2,50,000 Goodwill
`
`
34,400
Premises
(+)
NIL
4,200
4,200
Less :Inter company owings
Creditors
H Ltd.
M Ltd.
(-)
1,500
(+)
23,550
4,000
27,550
Less : Inter - Co.
owings
(-)
6,000
H Ltd.
75,000
1,20,000
M Ltd.
90,000
39,400 Add :
36,600 Increase
+10,000 1,00,000 1,75,000
50,000 Plant
1,20,000
2,700
H Ltd. 54,700 (+)
M Ltd.(-)5,000
49,700 1,69,700
Less: Decrease
Bills Receivable
H Ltd.
7,900
M Ltd.
(+)
NIL
21,550
7,900
Less :Inter - Co.
owings
(-)
1,500
6,400
Debtors
H Ltd.
21,000
M Ltd.
(+) 20,000
41,000
Less: Inter - Co.
owings
(-)
6,000
35,000
Cash in Transit*
500
Stock
H Ltd.
70,000
M Ltd.
(+) 18,000
88,000
Cash at Bank
H Ltd.
7,250
M Ltd.
(+)
4,000
11,250
5,20,250
5,20,250
Advanced Accounting - II
67
AS-21 & Preparation Of
Consolidated Financial
Statement
•
N.B. : Cash in Transit represents ` 500 cheque sent by M Ltd., to H
Ltd., on 30-3-2014, but received by H Ltd., on 3-4-2014 i.e. after the date of
Balance Sheet as on 31-3-2014. Hence, shown as Cash in Transit as on the date
of Balance Sheet i.e. 31-3-2014. This reflects the difference in the Current Account
Balance of both the companies which gets squared off against each other.
NOTES
3.9
Summary
•
AS-21 deals with the preparation of consolidated financial statement with
an intention to provide information about the activities of group.
•
The objectives of this statement is to preset financial statement of a parent
and its subsidiaries as a single economic entry.
•
A parent and its subsidiary shall prepare separate financial statements as
per governing law. The consolidated financial statement made by a parent
is in addition to the separate financial statement.
•
‘Minority Interest’ should be calculated and shown in the consolidated
financial statements separately under separate heads.
•
Unrealised Losses from intra-group transaction should also be eliminated if
recoverable amount is more than the cost of transaction.
•
When minority interest comes in negative (minus) this should be adjusted
against majority interest .
•
AS - 21 also focuses on the following points:
a) Interpretations issues by the ICAI
b) Transactional provisions
c) Significant differences among AS, IFRS/IAS and USGAAP.
3.10 Key Terms
68
Advanced Accounting - II
(a) Parent :
A parent is an enterprise that has one or more
subsidiaries (Also known as Holding Enterprise)
(b) Subsidiary :
A subsidiary is an enterprise that is controlled by another
enterprise known as parent.
(c) Control :
Control can be exercise directly or indirectly (through
a subsidiary) by purchasing more than 50% of the
voting power of an enterprise or by controlling
composition of board of directors or governity body.
(d) Minority Interest : Minority Interest means the portion of net assets of
subsidiary on the date of consolidation not controlled
by the parent it self or through it subsidiary.
Minority Interest : Paid up equity capital held by an outsider (out side the
group) plus share of reserves and surplus on the date
of consolidation (Are forever share capital not held by
parent or group is also shown along with minority
interest.)
AS-21 & Preparation Of
Consolidated Financial
Statement
NOTES
(e) Consolidated Financial Statement : These statements are intended to
present financial information about a parent and its
subsidiaries as a single economic entity to shown the
economic resources controlled by the group.
3.11 Questions and Exercises
I. Objective Questions
(A) Multiple Choice Questions
(1)
AS-21 deals with the preparation of consolidated financial statement with
an intention to provide information about the activities of a ..........
(a) group
(b) association
(c) holding co.
(d) subsidiary co.
(2)
The holding company and its subsidiary are treated as are.......for the
preparation of consolidated financial statement
(a) business
(b) entity
(c) organisation
(d) group
(3)
A parent should account for the investment in subsidiary in accordance
with ..........
(a) AS - 21
(b) AS - 17
(c) AS - 13
(d) AS - 9
(4)
When the cost of investment in subsidiary is less than the paid-up equity
capital held by holding plus share of pre-acquisition profits, the difference is
credited to ---------- Account.
Advanced Accounting - II
69
AS-21 & Preparation Of
Consolidated Financial
Statement
(a) Secret Reserve
(b) Revenue Reserve
(c)Investment fluctuation Reserve
(d) Capital Reserve
NOTES
Ans : (1-a), (2-b), (3-c), (4-d)
II . Long Answer Questions
(1)
What is AS-21? Explain the objective and scope of AS-21
(2)
Explain in brief the application of other accounting standards in the
preparation of consolidated financial statements.
(3)
While preparing a consolidated Balance Sheet how would you deals with
a) Arrears of cumulative preference share of a subsidiary
b) Minority interest is in negative
c) Successive purchase of shares in a subsidiary by the parent
(4)
Define a ‘Subsidiary Company’ as per AS-21. How a subsidiary can be
controlled by a parent company.
(5)
Write short notes on :
(a) Objective of Consolidated Financial Statements
(b) Consolidation Procedure
(c) Unrealised Losses
(d) Impairment of Assets
70
Advanced Accounting - II
AS-21 & Preparation Of
Consolidated Financial
Statement
III. Practical Problems :
1) The Balance Sheet of K Ltd., and P Ltd., as on 31-3-2014 were as under :
Liabilities
Share Capital :
K Ltd.
P Ltd.
`
`
2,00,000
50,000 Buildings
30,000
K Ltd.
P Ltd.
`
`
60,000
-
- Plant
2,00,000
-
10,000 Stock
40,000
85,000
Shares of ` 10 each
Reserve Fund
Assets
Profit and Loss
Debtors
10,000
30,000
Balance as on
Bank
10,000
10,000
65,000
-
-
10,000
1-4-2013
40,000
20,000 3,000 shares in P Ltd.
Profit for the year
Bills Receivable
2013-2014
50,000
25,000
Creditors
30,000
30,000
Bank Overdraft
20,000
-
Bills Payable
15,000
-
3,85,000 1,35,000
NOTES
3,85,000 1,35,000
K Ltd., purchased Shares of P Ltd. on 1st October, 2013 at a cost of
` 65,000. The Bills Payable of K Ltd., included bills amounting to `10,000 drawn
by P Ltd., and payable to P Ltd. The Debtors of P Ltd., included the debts due
from K Ltd., in respect of goods supplied to them for `6,000.
Prepare a Consolidated Balance Sheet as on 31-3-2014.
2) The following are the Balance Sheet of M Ltd., as on 31-3-2014. M Ltd.,
acquired the shares in N Ltd., at a cost of ` 2,10,000 on 1st April, 2013.
Liabilities
Share Capital :
M Ltd.
N Ltd.
`
`
7,00,000
90,000 Premises
Shares of ` 10each
General Reserve
Plant
2,00,000
4,000 Shares inN Ltd.
(1-4-2013)
Profit and Loss
Creditors
Assets
M Ltd.
N Ltd.
`
`
3,30,000
56,000
1,40,000
52,000
2,10,000
-
1,24,000
36,000
70,000
28,000
1,26,000
22,000
(at cost)
1,80,000
20,000
72,000 Stock
28,000 Debtors
Cash
11,00,000 1,94,000
11,00,000 1,94,000
The Creditors include ` 10,000 due to N Ltd., for purchases on which the
latter Company made a profit of ` 2,000. The stock includes ` 3,000 of the
above purchases from N Ltd.
Prepare a Consolidated Balance Sheet as on 31-3-2014.
Advanced Accounting - II
71
AS-21 & Preparation Of
Consolidated Financial
Statement
3) The following are the Balance Sheet of X Ltd., and Y Ltd., as on 31-3-2014.
Liabilities
X Ltd.
Y Ltd.
`
`
Assets
Eq. Share Capital :
NOTES
Equity Shares of
X Ltd.
Y Ltd.
`
`
7,00,000
3,00,000
1,80,000
80,000
1,20,000
60,000
1,20,000
-
in Y Ltd. at cost
2,40,000
-
Cash
1,50,000
50,000
-
2,00,000
Fixed Assets
10,00,000 4,00,000 Stock
` 100 each
Debtors
General Reserve
2,00,000
- Investments -
Profit and Loss
1,90,000
- i) 6%Debentures
Creditors
1,20,000
6% Debentures
90,000 in Y Ltd.
- 2,00,000 ii) 3,000 Shares
Profit and Loss
15,10,000 6,90,000
15,10,000 6,90,000
X Ltd., acquired the Shares in Y Ltd., on 1st October, 2013. The Profit and
Loss of Y Ltd., showed a debit balance of ` 3,00,000 on 1-4-2013. Creditors of
Y Ltd., include ` 40,000 for goods supplied by X Ltd., made a profit of ` 4,000.
Half of the goods were still in Stock on 31-3-2014.
Prepare a Consolidated Balance Sheet as on 31-3-2014.
4) S Ltd., acquired 8,000 Equity Shares of V Ltd., on1st April ,2013. The following
are the Balance Sheets of the two companies as at 31-3-2014.
Liabilities
Shares Capital
S Ltd.
V Ltd.
`
Assets
S Ltd.
V Ltd.
`
`
`
20,00,000 10,00,000 Buildings
5,00,000
3,00,000
Equity Shares of
Machinery
5,00,000
6,00,000
` 100 each
Stock
1,50,000
1,00,000
General Reserve
Debtors
1,00,000
1,20,000
(1-4-2013)
4,00,000
2,00,000 Investments in
Profit and Loss
1,00,000
60,000 shares of V Ltd.
10,00,000
-
(1-4-2013)
Bills Recevable
80,000
-
Profit for the year
Cash and Bank
5,00,000
3,30,000
2013-2014
2,00,000
80,0000
Creditors
1,00,000
1,00,000
30,000
10,000
Bills Payable
28,30,000 14,50,000
28,30,000 14,50,000
Other information is an follows :
72
Advanced Accounting - II
i)
Bills Recevable of S Ltd., includes ` 10,000 by V Ltd.
ii)
Debtors of S Ltd., include ` 50,000 due from V Ltd.
iii)
Stock of V Ltd., includes goods purchased from S Ltd., for ` 60,000 which
were invoiced by S Ltd., at a Profit of 25% on cost.
AS-21 & Preparation Of
Consolidated Financial
Statement
Prepare a Consolidated Balance Sheet of S Ltd., and its Subsidiary V Ltd.,
as on 31-3-2014.
5) The Balance Sheet of A Ltd., and B Ltd., as on 31-3-2014 were as follows :
Liabilities
Share Capital :
A Ltd.
B Ltd.
`
`
10,00,000
Assets
2,50,000 Goodwill
A Ltd.
B Ltd.
`
`
1,00,000
50,000
Equity Shares of
Land
2,00,000
1,00,000
Rs10 each
Plant
5,00,000
2,00,000
80,000 Stock
2,00,000
1,00,000
3,40,000
-
30,000
-
50,000
20,000
2,40,000
70,000
General Reserve
2,00,000
(1-4-2013)
Profit and Loss
Investments
60,000
60,000 Bills Receivable
(1-4-2013)
Cash at Bank
Profit for the year
Debtors
ended 31-3-2014
1,50,000
50,000
Creditors
2,50,000
1,30,000
16,60,000 5,70,000
NOTES
16,60,000 5,70,000
The following information is given :
A Ltd., acquired 15,000 Equity Shares of B Ltd., for ` 1,90,000 on 1st April, 2013.
Debtors of A Ltd., include `30,000 due from B Ltd.
Bills Receivable of B Ltd., include ` 10,000 due from A Ltd.
The Stock of B Ltd., Include goods purchased from A Ltd. of `10,000 which
includes profit charged by A Ltd., at 25% on cost.
Prepare a Consolidated Balance Sheet as on 31-3-2014.
Advanced Accounting - II
73
Topic 2
Human Resource Accounting
Unit 4
Meaning, Objectives and
Measurements in Human
Resources Accounting
Unit 5
Measurement in HRA - Economic
Value Approach
Unit 6
Human Resource Accounting In India
Unit 4
Meaning, Objectives and Measurements
in Human Resources Accounting
Meaning Objectives &
Measurements In Human
Resources Accounting
Structure
NOTES
4.0
Introduction
4.1
Unit Objectives
4.2
Meaning and Concept of Human Resource Accouting
4.2.1
Objectives of Human Resource Accounting
4.4.2
Purpose of Human Resource Accounting
4.3
Need of Human Resource
4.4
Historical Development of Human Resource Accounting Concept
4.5
Importance in Human Resource Accounting
4.6
Measurements in Human Resource Accounting
(A)
Cost Approach
(a) Original or Historical Cost Approach
(b) Opportunity Cost Approach
(c) Replacement Cost Approach
(d) Adjusted Present Value
4.7
Illustrations
4.8
Summary
4.9
Key terms
4.10 Questions and Exercise
4.11 Further Reading
4.0
Introduction
Human resources are the chest important assets of an organisation and
their effective management is the key to its success. HRA (Human Resource
Accounting) means accounting for people as the organisational resource. Human
Resource Accounting is the measurement of the cost and value of people to
organisation and involves measuring the costs incurred on recruitment selecting,
living, training and developing employees and judging their economic value to the
organisation. Human Resource Accounting can be very useful in decision making.
Human Resource Accounting can provide data pertaining to turnover cost, the
Advanced Accounting - II
75
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
cost of employee absence and its the process of recruitment and selection Human
Resource Accounting can provide an estimate of the cost involves in the process
of recruitments and selection or replacement of an employee.
Human Resource Accounting is a means of measuring the cost and value
of people. It is one of the modern developments in the area of accounting. Though
a good amount of research has been rapidly accumulated in the science of human
resource managing the measurement aspect of human resources is touched very
peripherally. The frame work of human resource accounting is concerned with
the efforts of the accounting research to prepare human resource investment and
value analysis for managerial planning an control. It is acknowledged that human
Resource Accounting will represent one of the major innovations in behavioral
aspects of accounting and control system in the decades to come. Applying
accounting tools and techniques to the area of human Resource management is a
challenging responsibility.
4.1
Unit Objectives
After studying this unit you should be able to :
•
Understand the concept of Human Resource Accounting.
•
Recognise the need for human resource accounting.
•
Determine the importance of human resource accounting.
•
Find out the different approaches and models for valuation of human
resources.
•
Explain the meaning of certain key terms used in Human Resource
Accounting.
•
Explain the Historical Development of Human Resource Accounting
concept.
4.2
Meaning and Concept of Human Resource
Accounting
According to Emch & Arnold F,
76
Advanced Accounting - II
Human resource system in an organisation operates with production as the
central processing function. The human resource input influence on the production
activity result in actual human output. This is compared with the preplanned human
output and significant deviations are investigated and rectified through the
adjustments of input factors. The effectiveness of human organisation depends
upon the continuous improvement of productive interaction between human inputs
and production process. The greater the degree of productive interaction the greater
will be the human recourse effectiveness and vice versa. As such, the relation
between human input and human output is vitally dependant on adaptation of
production planning and control to the planning and control of human inputs.
The behaviour of human resource inputs is to be adjusted for improving the
quality of human resource output. In other words, the influence of human resource
inputs on production activity would result in a set of human resource output
variables. These output variables are : (i) Magnitude resource investments, (ii)
Efficiency of human resource investments, (iii) Magnitude of human resource
value and (iv) Relative efficiency of human resources.’
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
The American Accounting Association’s Committee on Human Resource
Accounting (1973) has defined Human Resource Accounting as “the process
of identifying and measuring data about human resource and communicating this
information to interested parties”. Human Resource Accounting, thus, not only
involves measurement of all the costs/investments associated with the recruitment
placement, training and developments of employees, but also the quantification of
the economic value of the people in an organisation.
Flamholtz (1971) too has offered a similar definition for Human Resource
Accounting. They define Human Resource Accounting as “the measurements
and reporting of the cost and value of people in organizational resources”.
Mr. Woodruff Jr. president of R.G. Barry Corporation, defines is as follows:
“Human resources accounting is an attempt to identify and report investments
made in human resources of an organisation that are presently not accounted for
in conventional accounting practice. Basically it is an information system that tells
the management what changes over time are accruing to the human resources of
the business”.
In simple words, “Human resource accounting is the art of valuing recording
and presenting the worth of human resources in the books of accounts of an
organisation. Accordingly, human resources accounting is an information system.
It involves measuring the costs incurred by business to recruit, select, train and
develop personnel, evaluate their economic value, and report to management the
changes occurring in this asset management may use of this information for
planning, budgeting and control of human resources.
Thus, human resource accounting is primarily involved in measuring the
various aspects related to human asses. Its basic purpose is to facilitate the effective
management of human resources by providing information to acquiring, develop,
retain, utilize, and evaluate human resources.
4.2.1. Objectives of Human Resource Accounting
The objectives of human resource accounting are as follows :
(i)
To provide cost value date for managerial decisions regarding acquiring,
developing, allocating and maintaining human resource so as attain cost
effective organizational objectives.
Advanced Accounting - II
77
Meaning Objectives &
Measurements In Human
Resources Accounting
(ii)
To provide information for effectiveness of human resources utilization.
(iii)
To provide information for determining the status of human asset whether it
is conserved properly: it is appreciating or depleting.
(iv)
To assist in the development of effective human resource Management
practices by classifying the financial consequences of these practices.
(v)
To Develope new measures of effective manpower utilisation & better
human resource planning.
NOTES
4.2.2
Purposes of Human Resource Accounting
According to Likert (1971), Human Resource Accounting serves the
following purposes in an organisation:
(a)
It furnishes cost/value information for making management decisions about
acquiring allocating, developing and maintaining human resources in order
to attain cost-effectiveness.
(b)
It allows management personnel to monitor effectively the use of human
resources;
(c)
It provides a sound and effective basis of human asset control, that is,
whether the asset is appreciated, depleted or conserved;
(d)
It helps in the development of management principles by classifying the
financial consequences of various practices.
Basically, Human Resource Accounting is a management tool which is
designed to assist senior management in understanding the long term cost and
benefit implications of their HR decisions so that better business decisions can be
taken.If such accounting is not done,then the management runs the risk of taking
decisions that may improve profits in the short run but may also have severe
repercussions in future.
4.3
Need of Human Resource Accounting
Dr. Prubhakara rao, in his book “Human Resource Accounting” stated that
The human output can be recognised as the manual or mental, creative or
technical services rendered by the employees. Very often the effectiveness of
human resource system would directly of indirectly interact with the effectiveness
of the total system. Human Resource Accounting is the need the of the day to
measure the human input/output behaviour and to provide useful information for
human resource planning and control operations.
78
Advanced Accounting - II
The basic premises underlying the theory of Human Resource Accounting
are many. Among them the contemporary thoughts on human resource cost and
value variables and their changes. Dominated the thinking of researchers from a
number of disciplines. In fact, the area is a multi-disciplinary one, demanding
pragmatic and relevent thoughts from accounting as well as economics coupled
with the management of human resources.
The need of human resource accounting is felt because of the vitality of
manpower as an asset of the modern enterprise. It is people who employ, plan,
promote and produce to accomplish the organsational goals. The preponderance
of people as the most valuable assets, has been acknowledged since times
immemorial. The organisational climate that provides an opportunity of making
the fullest contribution of its people is said to be effective. Man is not a substitute
of subordinate to the inanimate assets as well as advancements is production
methods and systems. The so-called sophisticated and scientific work study,
technological exacerbations and innovative adaptations as well as organisational
manifestations can be antiproductive unless they are recognised to be a broad set
of guidelines within which the individual literally performs his job.
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
The skills and abilities of human beings are included in the concept of fixed
capital by Adam Smith. He has attributed the variances in wage-rates to the
corresponding differences in the level of education and training of people. Alfred
Marshall has also acknowledged that the investment in man is similar to investment
in plant and machinery, Schultz has stated that human capital may be accumulated
through imparting knowledge and skills and also through the experience on the
job. Schultz has argued that the human resource investments do not exactly
represent the value of human capital. Many scholars have opined that the
capitalisation of wage or salary may be an agreed basis for valuing people. Thurow
has added that when the value of marginal product is not equal to the earnings of
the employees, the capitalisation of earnings stream method may not hold good
for valuing people”
Check Your Progress
In addition to facilitating internal decision making processes, Human
Resource Accounting also enables critical external decision makers, especially
the investors in making realistic investment decisions. Investors make investment
decisions based on the total worth of the organisation. Human Resource Accounting
provides the investors with a more complete and accurate account of the
organisation total worth, and therefore, enables better investment decisions.
Furthermore, in a business environment where corporate social responsibility
is rapidly gaining ground, Human Resource Accounting reflects the extent to which
organisation contributes to society’s human capital by investing in its development.
1 . What is Human Resource
Accounting’ ?
2 . State the basic objectives
of Human Resource
Accounting.
3 . What purposes are served
by Human Resource
Accounting according to
‘Likert’ ?
Advanced Accounting - II
79
Meaning Objectives &
Measurements In Human
Resources Accounting
4.4
Historical Development of Human Resource
Accounting Concept
1960-66
NOTES
1
1980
onwards
Development
of
5
2
Human Resource Accounting
in
Five Stages
4
3
The development of Human Resource Accounting as a systematic and
detailed academic activity, according to Eric G Falmholtz (1999) began in sixties.
He divides the development into five stages. These are :
First stage (1960-66) : This makes the beginning of academic interest in the
area of HRA. However, the focus was primarily on deriving Human Resource
Accounting concepts from other studies like the economic theory of capital
psychological theories of leadership effectiveness, the emerging concepts of human
resources as different from personnel or human relation; as well ad the
measurement of corporate goodwill.
Second stage (1966-71) : The focus here was more on developing and validating
different models for Human Resource Accounting. These models covered both
costs and the monetary and non-monetary value of HR. The aim was to develop
some tools that would help the organisations in assessing and managing their human
resource/asset in a more realistic manner. One of the earliest studies here was
that of Roger Hermanson, who as part of his Ph. D. studied the problem of
measuring the value of human assets as an element of goodwill. Inspired by his
work, a number of research projects were undertaken by the researchers to develop
the concepts and methods of accounting for human resource.
Third stage (1971-76) : This period was marked by a widespread interest in the
field of Human Resource Accounting leading to a rapid growth of research in the
area. The focus in most cases was on the issues of application of Human Resource
Accounting in business organisation. R.G. Barry experiments contributed
substantially during this stage. (R.G. Barry Corporation : 1971)
80
Advanced Accounting - II
Forth Stage (1976 - 1980) : This was a period of decline in the area of HRA
primarily because the complex issues that needed to be explored required much
deeper empirical research than was needed for the earlier simple models. The
Organisation, however, were not prepared such research. They found the idea of
HRA interesting but did not find much use in pumping in large sums or investing
lot of time and energy in supporting the research.
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
Fifth Stage (1980 Onwards) : There was a sudden renewal of interest in the
field of Human Resource Accounting partly because most of developed economics
has shifted from manufacturing to service economics and realized the criticality
of human asset for their organisations. Since the survival, growth and profits of
the organisations were perceived to be dependent more on the intellectual assets
of the companies more than on the physical assets, the need was felt to have
more accurate measures for HR costs, investments and value.
An important outcome of this renewed interest was that unlike the previous
decades, when the interests were mainly academic with some practical applications,
from mid 90s the focus has been on greater application of Human Resource
Accounting to business management.
Different types of models to suit the specific requirements of the organisations
have been developed incorporating both the tangible and the intangible aspects.
Also, larger number of organisations actually began to use Human Resource
Accounting as part of their managerial and financial accounting practice.
Today, human and intellectual capital are perceived to be the strategic
resources and therefore, clear estimation of their value has gained significant
importance. The increased pressures for corporate governance and the corporate
code of conduct demanding transparency in accounting have further supported
the need for developing methods of measuring human value.
4.5
Importance of Human Resource Accounting
Human Resource Accounting helps decision making process. It is more
useful for internal decision making specially while discharging personnel function.
Brummet and others observed that managerial decisions will be made differently
if human resource accounting information is considered. A study conducted by
Flamholtz to examine the effects of human resource cost data and value data on
personnel allocation decision, revealed significant differences. The impact of
learning costs on productivity showed significant correlation proving the hypothesis
that learning cost is essentially an investment in Human Assets. For decisions on
employee turnover, positional replacement costs have been considered. The
positional replacement costs consist of direct and indirect costs on acquisition,
learning and human resource turnover. Woodruff argued that human resource
accounting data has many applications in improving planning and controlling of
human resource investments.
The necessary investments needed to meet the expected human resource
Advanced Accounting - II
81
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
requirements, the rate to return on such investments and the decisions relating to
allocation of human resources for must profitable areas of operation, will be guided
by the information generated from a system of human resource accounting.
Investment allocation decisions on human or non-human activities can be examined
in the light of relative efficiency. The decisions on employee turnover may be
investigated with the help of turnover analysis provided by human resource
accounting.
4.6
Measurements in Human Resource Accounting
The two main approaches usually employed for valuation of human
resources.
1
The Cost
Approach
The Economic 2
Value
Approach
Monetary
Models
Composite
Models
Non
Monetary
Models
Two approaches for Valuation of Human Resources :
I) The cost approach which involves methods based on the costs incurred
by the company, with regard to an employee.
II) The economic value approach which includes methods based on the
economic value of the human resources and their contribution to the
company’s gains. This approach looks at human resources as assets
and tries to identify the stream of benefits flowing from the asset.
(I)
The Cost Approach : Cost is a sacrifice incurred to obtain some anticipate
benefit of service. All costs have two portions, viz, the expense and assets
portions. The expense portion is that which provides benefits during the
current accounting period, where as the asset portion is that which is
expected to give rise to benefits in the future.
1)
Original or Historical Cost Approach :
Two types of costs are of special importance in Human Resource
Accounting. These are original or historical cost, and replacement cost. The
historical cost of human resources is the sacrifice that was made to acquire and
develop the resource. These include the costs of recruiting, selection, hiring,
placement, orientation, and on the job training. While some of the costs like salaries,
for instance, are direct costs, other costs like the time spent by the supervisors
during induction and training, are indirect costs.
82
Advanced Accounting - II
Original Cost Model :
The original cost model is proposed by Brummet and others to measure a
firm’s investment in human resources. They argued that human resource costs
are current sacrifices for obtaining future benefits and can be obviously treated as
assets. They suggested. therefore, to capitalise firm’s expenditure on recruitment,
selection, orientation, training and development of people and treat them as assets
for the purposes of human resource accounting. The amounts so capitalised are
to be shown in the Balance-sheet as human assets as distinguished from other
physical assets. However, accounting practices of amortisation and write-off would
usually apply to assets alike. This original cost model has been followed by R.G.
Barry Corporation.
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
Historical cost is based on actual cost incurred on human resources. Such
a cost may be two types - acquisition cost and learning cost. Acquisition cost is
the expense incurred on recruitment, selection, and placement. While calculating
the cost of recruitment and selection, entire cost is taken into consideration including
hose who are not selected. Learning cost involves expenses incurred on training
and development. This method is very simple in its application but it does not
deflect the true value of human assets. For example, an experienced employee
may not require much training and, therefore, his value may appear to below
though his real value is much mode than will is suggested by historical cost method.
2)
Opportunity Cost Approach
Sometimes, opportunity cost method, that is, a calculation of what would
have been the returns if the money spent on HR was spent on something else, is
also used. However, this method is seen to be not as objective as desired. Hence
its use is restricted to internal reporting and not external reporting.
It means that the opportunity cost is linked with scarcity. The value of an
employee is determined according to his alternative use. Human resources are
evaluated under this method by making an estimate of their alternative use.
It has specifically excluded from its purview those employees who are not
scarce or are not being bid by other department. This is likely to result in lowering
morale and productivity of the employees, who are not covered by the competitive
bidding process.
Opportunity Cost Model :
Hekimian and Jones advanced an opportunity cost model to value the
employees. The computation of monetary value and allocation of people are
considered as the central points of emphasis. They have suggested opportunity
cost as the best means to value employees. They have relied upon the availability
of alternatives to allocate people to the most promising economic activity. To
assess the opportunity cost of key employees they have suggested competitive
bidding among investment centres. It us emphasised that this system would facilitate
more optional allocation of key employees and argued that it would also act as a
quantitative base for planning and controlling the activities of personnel function.
The only contention is that key employees are assigned with tasks, the contribution
Advanced Accounting - II
83
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
of which is much less than it would have been if they are employed in more
dynamic jobs.
The Method roughly works as shown below. Suppose a division’s target
ROI is 15%. It has capital base of `1,00,00,000 but its profit is only `13,00,000
i.e., `2,00,000 short of the target. It is felt that if it can acquire the services of a
particular executive, its profits can improve by ` 90,000 i.e., the profit will be
`15,90,000. ` 90,000 more than `15,00,000 `90,000 capitalised at 15% comes
to ` 6,00,000. The division certainly may bid up to ` 6,00,000 for the services of
the executive. Actually, the maximum bid may even be the capitalised value of
` 2,90,000 the extra profit likely to be generated by the executive’s availability.
The method can work for some of the people but, surely. quite a few people,
specially those at the top, will not be available for the auction. It also ignores
people that are not scarce.
Opportunity cost method is also known as competitive Bidding Method.
Opportunity costs is determined by a process of competitive bidding in which
various division are departments bid for the services of various officers.
3)
Replacement Cost Method :
The replacement cost of human resources is the cost that would have to
be incurred if present employees are to be replaced. For instance, if an employee
were to leave today, several costs of recruiting, selection, hiring, placement,
orientation, and on the job training would have to be incurred in order to replace
him. Such costs have two dimensions-positional replacement costs or the costs
incurred to replace the services rendered by an employee only to a particular
position; and personal replacement cost or the cost incurred to replace all the
services expected to be rendered by the employee at the various positions that he
might have occupied during his work like in the organisation.
Replacement Cost Model :
This approach was developed by Rensis Likert and Eric G-Flamholtz.
Since accountants first undertook the task of putting a value on human
resources, it was natural for them to first turn to the historical cost method which
has been the traditional method of valuing physical or intangible assets for the
purpose of financial statements. In the case of human resources, cost would
comprise.
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Advanced Accounting - II
(i)
the amount spent on processes leading upto selection and placement in
position;
(ii)
the cost of formal training imparted to the selected people; and
(iii)
the cost of informal training, the loss incurred because of the mistakes
committed, due to their being new on the job and becasue of the time taken
to reach the normal level of efficiency.
In cost accounting labour turnover cost has been computed in this manner.
To compute a figure which is more up-to-date, one can imagine that everyone
would leave and then arrive at the cost of replacing all members of the present
strength.
Replacement cost is generally much higher than the historical cost. For
example, Friedman has estimate that the replacement cost of an executive in
middle management level is about 1.5 to 2 times the current salary paid in that
position. Replacement cost is much better indicator of value of human assets
though it may present certain operational problems. For example, true replacement
of a person may not ne found easily with whose cost the valuation is done.
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
Standard Cost : Instead of using historical or replacement cost, many
companies use standard cost for the valuation of human assets just as its used for
physical and financial assets. For using standard cost, employees of an organization
are categorized into different groups based on the hierarchical positions. Standard
cost is fixed for each category of employees and their value is calculated. This
method is simple but does not take into account differences in employees put in
the same group. In many cases, these differences may be quite vital.
5)
Adjusted Present Value Method :-
The method attempts to bring in the question of effectiveness but the ratio
of ROI of the firm to the ROI of the industry, based on past performance, assumes
that there were no unusual or extraneous factors - that the performance was
entirely due to the efforts of the employees and executives of the firm. If the past
returns on investment can be suitably adjusted to remove the effect of all factors
beyond the firm’s control, the method may approximate to value somewhat.
Adjusted Present Value Model Hermanson has suggested that human resource must be reported as asset
in the financial statements. He has proposed an Adjusted Present Value model to
quantify the value of human capital of a company. The first stage is to compute
the present value of future wage payments for five years. The next step is to find
out the efficiency ratio.
Hermanson used efficiency ratio to adjust the discounted future wage stream.
The equation is :
5(RF0)
4(RE1 )
3(RF2 )
+
+
(RF0)
4(RE1 )
3(RF2 )
+
2(RF3 )
2(RF3 )
+
(RF4 )
(RF4 )
/15
Where RF indicates firm’s return, RE indicates economy’s rerurn.
This ratio is applied to adjust the present value of the future wage payments.
The resultant figure is the value of human (Operational) assets. He categorised a
highly trained sales force as an example for ‘operational assets’ differentiating
them from legally owned assets. Hermanson also suggested an entry to record his
theory in the books of accounts.
If the efficiency ratio is one (1), the value of both credit and debit will be
same as follows :
Advanced Accounting - II
85
Meaning Objectives &
Measurements In Human
Resources Accounting
Human Resources (Operational Assets )
Dr.
xx
xx
To Future Wages payable
NOTES
But more than one (>1) efficiency ratio denotes excess worth and less than
one (<1) efficiency ratio indicates inefficiency. Then entry for a situation
where the efficiency ratio is more than one will be :
Human Resources (Operational Assets)
Dr.
xx
xx
To Future Wages payable
To Excess worth created by relatively
xx
efficient human resources
The entry for less than one efficiency ratio will be :
Human Resources (Operational Assets )
Dr. xx
Reserve for Future Human Resource
Inefficiency
To Future Wages Payable
Dr. xx
xx
Check Your Progress
The amount of future wages payable represents a liability, while the Human
Resources (or operational assets s. an assets in the Balance-sheet.
1 . Which are the different
steps involved in the
development of ‘Human
Resource
Accounting
concept’?
Alternatively, Hermanson also suggested unpurchased Goodwill Method to
value Human Resources. Under this method, the superior earnings on physical
and financial assets are capitalised at normal rate or return to establish a case for
Human Assets for Balance - sheet purposes.
2 . Explain the importance
of Human Resourch
Accounting.
3 . Explain
the
‘Cost
Approach’ employed for
valuation of human
resources.
Adjusted present value model has two variables. One is the present value
of future wage payments for the next five years and the other is the efficiency
ratio derived from the relative performance of the firm and the economy as a
whole. The product of the present value of future wages and the efficiency ratio
unfolds the relative efficiency of the firm’s resources in relation to the performance
of the economy’s total human resources.
The cost approach employed for education human resources can be
understood with the help of following illustrations.
4.7. Illustrations
ILLUSTRATION 1
Escorts Ltd. Ernakulam employed seven skilled employers of the same age
group with similar educational qualifications who expect to work for the period of
near eighteen years. The costs incurred for the same were as under :
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Advanced Accounting - II
Recruitment
:
` 12,000
Selection
:
` 15,000
Training
:
` 19,000
Orientation
:
` 26,000
Meaning Objectives &
Measurements In Human
Resources Accounting
Calculate the value of human resource after a period of seven years as per
Historical Cost Method.
NOTES
SOLUTION
1)
Calculation of Total Capital Investments made in Human Resource :
Capital
Recruitment
=
+
Invested
cost
= ` 12,000
+
= ` 72,000
2)
+
Total Capital
Investment in
Human Resourse
=
` 72,000
=
` 28,000
x
•
Orientation
cost
+ ` 26,000
+
Specific Period of Valuation
Estimated Working period
7 years
18 years
x
Calculation of Value of Human Resource :
Value of Human
Total Capital Investments
=
Resource
in Human Resource
= ` 72,000
= ` 44,000
4.8
Training
cost
` 19,000
+
Calculation of total amortisation and written off amount over seven years :
Total Amortization =
& Written off Amts
3)
Selection
cost
` 15,000
-
Amortization and
Written off Amount
` 28,000
Summary
Human Resource Accounting is a means of measuring the cost and value
of people. It is one of the neoteric developments in the area of accounting.
Though a good amount of research has been rapidly accumulated in the
science of human resource management, the measurement aspect of human
resources is touched very peripherally. Now the success of all organisations
is contingent on the quality of their Human Resource its knowledge, skills,
competence, motivation and understanding of the organisational culture in
knowledge-driven economics therefore, it is imperative that the humans be
recognised as an integral part of the total worth of an organisation. However,
in order to estimate and project the worth of the human capital, it is necessary
that some method of quantifying the worth of the knowledge, motivation,
skills, and recruitment, selection, training etc. which are used to build and
support these human aspects, is developed Human Resource Accounting
(Human Resource Accounting) denotes just this process of quantification/
measurement of the Human Resource.
Advanced Accounting - II
87
Meaning Objectives &
Measurements In Human
Resources Accounting
•
There are a number of human resource valuation models. Hermanson has
developed Adjusted Present Value Model, to quantify the value of human
capital of a company. He has used a technique, called Efficiency Ratio to
adjust the present value of future wage payments to arrive at the relative
efficiency of particular firm’s human assets compared to that of the
economy’s human assets.
•
Likert has established a relationship among causal, intervening and end result variables for assessing the productive capabilities of human
organisation and the associated changes over a period of time.
•
Likert has linked the management system and the resultant influence on the
efficiency of human resources in his model.
•
Hekimian and Jones have advocated an Opportunity Cost model to value
the firm’s important people and suggested competitive bidding among
investment centres to find out the monetary value.
•
Flamholtz and other have concentrated on original cost model and argued
that investment expenditure on human resource having future benefits may
be capitalised to establish a basis for the human assets. Lev and Schwartz
have considered compensation as a possible measure of employees’ value
to an undertaking.
•
Historical Development of Human Resource Accounting concept : The
development of Human Resource Accounting as a systematic and details
economic activity, according to Eric G. Flamholtz began in sixties. He divided
development in his 5 stages.
NOTES
(i) First stage (1960-66) (ii) Second stage (1966-71), (iii) Third stage (197176), (iv) Forth stage (1976-80) & (v) stage Five 1980 onwords.
•
The two main approaches usually employed for valuation of human resources
(i) The cost Approach and (ii) The Economic value Approach.
(i)
Cost approach which is involves methods buses on the costs
incurred by the company, with regard to an employee.
(ii) The economic value approach which includes method buses on
the economic value of the human resources and their contribution
to the company’s gains.
4.9
(1)
Key Terms
Capitalization of compensation
The capitalisation method involves capitalizing a person’s salary and using
it as a surrogate measure of human value. This value may be ascertained
for group as well as individuals. The value of the group is essentially the
aggregate value of the individuals compromising the group.
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Advanced Accounting - II
Capitalization of compensation method is not considered an ideal method of
group valuation because it ignores the possible effects of synergy. However,
this method may be used to arrive at an approximation of a group value to
the firm.
(2)
Meaning Objectives &
Measurements In Human
Resources Accounting
Replacement cost valuation
The replacement cost of group is defined as the sacrifice that would have
to be incurred today to recruit, select, hire, train and develop a substitute
group capable of providing a set of services equivalent to that of a group
presently employed.
NOTES
This method involves considerable subjective estimates, which reduce its
validity and replicability.
(3)
Original cost valuation
The original cost valuation method involves estimation of the original cost
of recruiting, selecting, hiring, training and developing a firm’s existing human
organisation.
(4)
Adjusted Present Value Method
In his book, “ Accounting for Human Assets.” Hermanson advocated that
earning for the next five years be estimated and than discounted, the resulting
figure being multiplied by an “Efficiency Factor” - the 5 years weighted
average of the return on investment of the firm divided by a similar average
of the return on investment of the firm divided by a similar average for the
concerned industry [(REO)/ RFO)].
(5)
Opportunity Cost Method
An interesting method advocated by Hekimain and Jones, called opportunity
cost method, is that divisional heads may bid for the services to various
people whose services they may require and then include the bid price in
the investment base.
(6)
Human Resource Accounting “The process of identifying and measuring data about human resources
and communicating this information to interested parties”. Human Resource
Accounting, thus not only involves measurement of all the costs/investments
associated with the recruitment, placement, training and development of
employees, but also the qualification of the economic value of the people in
the organisation.
4.10 Questions and Exercises
I - Objective Questions
(A) Multiple choice Questions
Advanced Accounting - II
89
Meaning Objectives &
Measurements In Human
Resources Accounting
(1)
Accounting for people as the organisational resource is termed as ......
(a) Human Resource Accounting.
(b) Social Responsibility Accounting.
(c) Environmental Accounting.
NOTES
(d) Financial Accounting.
(2)
Human Resource Accounting provides cost/value information about
acquiring, allocating, developing and maintaining human resources in order
to attain cost ........
(a) measurement
(b) allocation
(c) effectiveness
(d) classification
(3)
The first attempt to value the human beings in monetary terms was made
by ....
(a) William Far
(b) Earnest Engle
(c) William Petty
(d) William Pyle
(4)
For valuation of human resources the ............ approach follows the traditional
accounting concept of matching cost with revenue.
(a) replacement cost
(b) opportunity cost
(c) standard cost
Ans - (1-a), (2-c), (3-c), (4-d)
II - Long Answer Questions
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Advanced Accounting - II
(1)
Define the term ‘Human Resource Accounting’. Explain in brief the
objectives of Human Resource Accounting.
(2)
Explain the concept of ‘Human Resource Accounting’. State the purposes
served by human Resource Accounting.
(3)
What is ‘Human Resource Accounting’? Explain the need of Human
Resource Accounting.
(4)
Explain in detail the historical development of ‘Human Resource Accounting’
concept.
(5)
What do you understand by ‘Human Resource Accounting’? State the
importance of Human Resource Accounting.
(6)
Briefly describe the following method employed for valuation of human
resources under cost approach.
(a) Original Cost Model
Meaning Objectives &
Measurements In Human
Resources Accounting
NOTES
(b) Opportunity Cost Model
(c) Replacement Cost Model
(d) Adjusted Present Value Model
III) Practical Problems
1)
Bokaro Ltd., Baroda employed ten skilled employees of the same age group
with similar educational qualifications who except to work the period of next twenty
year. The costs incurred for the same were as under :
Recruitment - ` 32,000, Selection - 28,000, Training - ` 16,000 and
Orientation - ` 24,000.
Calculate value of Human Resource after a period of eight years as per
Historical Cost Method.
4.11 Further Reading
•
Shukla M. C., Grewal T.S. , and Gupta S.C. - Advanced Accounts - New
Delhi S. Chand & Co. Pvt. Ltd. - 2013
•
Bapat varadraj and Raithatha mehul - Financial Accounting a managerial
perspective - New Delhi - Tata Mcgraw Hill Education Pvt. Ltd. - 2012
Advanced Accounting - II
91
Unit 5
Measurement in Human Resource
Accounting - Economic Value
Approach
Structure
NOTES
5.0
Introduction
5.1
Unit Objectives
5.2
Economic Value Approach
5.2.1
Lev and Schwart 2 Model
5.2.2
Likert’s Behaviour Model
5.2.3
Flamholtz’s Model of Individual Value
5.2.4
Stochastic process with service Model
5.2.5
Hekimian & Jones competitive Bidding Model
5.2.6
Hermanson’s unpurchased goodwill Model
5.3
Other - Non-monetary Models
5.4
Illustrations
5.5
Summary
5.6
Key Terms
5.7
Questions and Exercises
5.8
Further Reading
5.0
Measurement In HRA Economic Value Approach
Introduction
It has been widely accepted fact that success of any business house, to a
great extend depends upon the quality, calibre character and tallent of people
working in it. The importance of human asset as productive resources was ignored
by accounting authorities. But during 1960’s, as a result of various research
conducted by different experts in the field of accounting and finance a new branch
of accounting known as “Human Resources Accounting” has come into being.
In the last unit (i.e. in unit) we have seen that the two main a approaches
usually employes for valuation of human resources i.e. (i) The cost Approach and
(ii) The Economic Value Approach. In this unit we are going discuss the economic
value approach which includes methods based on the economic value of the human
resources and their contribution to company’s gains. On one hand, the cost approach
which involves methods based on the costs incurred by the company, with regard
to an employee. On the other hand, the economic value approach looks at human
resources as assets and tries to identify the stream of benefits flowing from the
asset.
Advanced Accounting - II
93
Measurement In HRA Economic Value Approach
5.1
Unit Objectives
After studying their unit your should able to :
NOTES
•
Understand the meaning and importance of “Economic Value Approach”.
•
Discuss “Human Capital Model” developed by Lev and Schwartz.
•
Explain “Likert’s Behaviour Model”.
•
Classify “Human Variables” with the help of Likert’s Model.
•
Discuss “Flamholtz Model of Individual Value”.
•
Explain “three factors - (i) productivity (ii) transferability and (iii)
promotability
•
Explain “Service Rewards Model.”
•
Discuss “ Competitive Bidding Model.”
•
Know ‘Other Non-Monetary Methods for assessing the Economic Value
of HRS’.
5.2
Economic Value Approach
The value of an object in economic terms, is the present value of the services
that it expected to render in future. This may be the value of individuals groups or
the total human organisation. The methods for calculating the economic value of
individuals may be classified into monetary, non - monetary methods and compos
methods.
Human Resource Accounting models can be classified into three categories,
viz. (i) Monetary models, (ii) Non-monetary models, and (iii) Composite models.
The models that are constructed mainly with monetary variables are monetary
models while those which are dominated by behavioral variables are called as
non-monetary models. The models which consider both monetary and behavioural
variables may be known as composite models.
5.2.1 Lev and Schwartz Model
Lev and Schwartz developed a model which known as “Human Capital
Model.”
Lev and Schwartz have valued human capital in a different way. The value
of human capital is the present value of the future earning of people till retirement.
A mathematical model was developed to quantify the value of human capital. The
model considers employee compensation as the reasonable measure of individual’s
value to an organisation.
94
Advanced Accounting - II
Lev and Schwartz advocate the estimation of future earning during the
remaining working life of the employees, taking into account the possibility of
early death and than arriving at the present value by discounting the estimated
earnings at the firm’s cost of capital. Replacement cost may be either (a) positional
replacement cost or (b) personal replacement cost.
Vx =
T
t=x
Measurement In HRA Economic Value Approach
x
I (T) (t)
(1 + r) t - x
NOTES
Where,
v*
= the human capital value of a person x years old.
I x(t) = the person’s expected future annual earnings upto retirement.
r =
a discount rate specific to the person.
T=
retirement age.
The above equation ignores the possibility of death prior to retirement; but
that can be easily taken care of by visualising ‘t’ as the age at which the employee
may die, if that is before retirement. Mortality tables can help in this regard.
The method ignores the possibility of a person moving from one career to
another and the possibility of early exit. The most important defect of the method
is that it assumes remuneration of an employee as being equal to his value; further,
the synergistic effect is totally ignored.
This method of accounting is basically oriented towards measuring changes
in the employees ‘value rather than employers’ gain from the employees. Unless
the employees’ payments are directly linked to employee productivity or the
company performance, the changes in the value of employees will not reflect the
changes in the employees’ contribution.
The Lev and Schwartz model is the basic model employed by different
Indian companies.
The basic theme of Lev and Schwartz model is to compute the present
value of the future direct and indirect payments to their employees as a measure
of their human resource value. While doing so, the common assumptions set by
the Indian companies are the pattern of employee compensation, normal career
growth and weightage for efficiency. Moreover companies adapt this model to
their practical requirements by making necessary alterations. For instance, different
organisations use different discount rates for ascertaining the present value for
future cash flows.
According to D. Prabhakara Rao in his book ‘Human Resource
Accounting’,
“The human capital model is mainly dependant on present value of annual
earning until retirement, adjusted with the death probability of the individual. This
model also invariably considers the value as its basis. But the model suffers from
the main drawback that it does not consider the effect of employee mobility
before death on the earnings.”
Advanced Accounting - II
95
Measurement In HRA Economic Value Approach
NOTES
5.2.2 Likert’s Behaviour Model :
Likert developed a model to diagnose the changes in human organisation
over a period of time. He has classified certain human variables into three
categories, viz, (i) Causal variables (ii) intervening variables, and (iii) End-result
variables.
Casual Variables
ing
en
erv les
Int riab
Va
2
Classification of
Human
Variables
3
En
dVa Resu
ria
ble lt
1
The interaction between causal and intervening variables has been shown
to effect the job satisfaction, costs, productivity and earnings, the end-result
variables. Some of the end-result variables are monetary in nature. Likert
established a very concrete relationship between these variables and the
organisational performance. For assessing the change in value of the productive
capability of the human organisation form time to time, Likert designed a model
reflecting a good amount to numerical support. Managerial leadership determines
organisational climate which in turn influence the subordinate satisfactions and
subsequently the total productive efficiency. Time lag of two years or more, often
exist between a change in causal variables and the resultant changes in the endresult variables.
Likert identified four systems of Management, viz., (a) System I to represent
exploitative style of management, (b) System II for Benevolent style of
management, (c) System III for Consultative style of management and (d) system
IV for participative Management style, Likert, R., The human Organisation : Its
Management and Value, Mc Graw-Hill Kogakusha Ltd., Tokyo, 1967.
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Advanced Accounting - II
Likert observes that a firm in which the causal variables display the
characteristics of participative management style will generate more effective
intervening variables and consequently end-result variables and consequently more
effective intervening variables and consequently more desirable end - result variable.
He argues that the philosophy and practice of conventional accounting concentrate
on a few end-result variables which are consistent with the exploitative type of
management. He opines that by over-emphasising short-run profits and cost savings
the present accounting system penalises managers who are making the greatest
long-run contribution to the organisation. For example, a manager can achieve
apparent gains in production volume cost reduction and profitability by liquidating
the human assets.
Although these human assets are as important to the future growth and
survival of organisation as any physical assets, their loss is not immediately
noticeable. Therefore, the existing accounting system will reflect the supposed
gains of the system I manager, but fails to record the real costs that are incurred.
However, the decrease in human assets will eventually be reflected in the
accounting reports as profits begin to fall.
Measurement In HRA Economic Value Approach
NOTES
In his book “Human Resource Accounting” D.Prabhakra Rao observed
that The behavioural model is dominated by the human actions and reactions.
These are termed as the non-monetary variables. While the construction of the
model is based in non-monetary variables, the working of the model has vital
influence in the monetary variables also. The model implicity explains: (i) an
interaction of causal and intervening variables, the non-monetary measures in
themselves, and (ii) the interaction of the effect of non-monetary variables on the
magnitude of manetary variables. It is stated that the monetary reflections may
involve time lags of two years of more. Likert thus emphasised the importance of
accounting for the human resources on a continuing basis. Horngren accepts
Likert’s suggestion and opines that the major formal performance measurement
system (the accounting system) is the best way to portray of results of the human
resource utilisation for the benefit of the organisation.
5.2.3 Flamholtz’s Model of Individual Value :
According to Flamholtz, the value of an individual is the present worth of
the services that he is likely to render to the organisation in future. As ad individual
moves from one position to another, at the same level of at different levels, the
profile of the services provided by him is likely to change. The present cumulative
value of all the possible services that may be rendered by him during his/ her
association with the organisation, is the value of the individual.
Pr
1
2
ity
bil
era
nsf
Tra
od
uc
ti
Pe
o
r fo r vity
rm
an
ce
Typically, this value is uncertain and has two dimensions. The first is the
expected conditional value of the individual. This is the amount that the organisation
could potentially realize from the services of an individual during his/her productive
service life in the organization. It is composed of three factors which are shown in
figure 5.1 as follows :
3
Promotability
Fig. 5.1 : Elements of Conditional Value
Advanced Accounting - II
97
Measurement In HRA Economic Value Approach
1)
Productivity : Which involved in creation of goods and services to produce
weather value. Productivity of performance (set of services that an
individual is expected to provide in his/her present position.)
2)
Transferability : Which involved an activity to carry, remove or shift from
one position or place to another. Transferability (set of services that he/she
is expected to provide if any when he/she is in different position at the same
level.)
3)
Promotability : Which involved the qualities needs for advancing to a
higher position of rank. Promotability (set of services that are expects
when an individual is in higher level positions.)
NOTES
Flamholtz seeks to remove the defects of Lev and Schwartz model and
value the human resources on the basis of their discounts earnings in the future
taking in to account charges in their service status and the possibility of early
retirement.
Productivity, transferability and promotability, these three factors depends,
to a great extend on individual determinants activation level of the individual and
organisational determinants like opportunity to use these skills or roles and the
reward system.
The another dimension of an individual value is the expected realizable
value, which is a function of the expected conditional value, and the probability
that the individual will remain in the organisation of the duration of his/her productive
service life. Since individuals are not owned by the organisation and are free to
leave, ascertaining the probability of their turnover becomes important.
The interaction between the individual and organizational determinants
mentioned above, leads to job satisfaction. The higher is the level of job satisfaction,
the lower is the probability of employee turnover. Therefore, higher is the expected
realizable value.
5.2.4 Stochastic Process with Service Rewards Model :
Flamholtz developed a model for measuring a person’s value to the
organisation with the help of stochastic process. He has considered the movement
of employees from one position to another position over a time period. He has
used statistical probability estimates to forecast the person’s association with a
particular position in each of the time period. He has established the value of an
individual. It is equal to the present value of future rewards adjusted with the
probability of mobility and separation.
The expected conditional value is computed with the following equation.
n
m-1
E(CV) =
Ri . P(Ri)
t=1 i=1
(1 + r)t
98
Advanced Accounting - II
Where E (CV) is the expected conditional value; Ri is the positional value; P(Ri)
is the person’s probability to occupy the service state i, t is the time period; m is
the state of exit and (1+r)t is Discount Factor.
Finally the present value of future rewards is being adjusted with the
probability of separation. The resultant figure represents the expected realisable
value of a person to the organisation. The equation for computing expected
realisable value is given below.
n
E (RV) =
t=1
Measurement In HRA Economic Value Approach
NOTES
m
Ri . P(Ri)
i=1
(1 + r)t
Ref. Flamholtz, Eric, A Model for Human Resource Valuation : A Stochastic
Process with Service Rewards, The Accounting Review, American Accounting,
U.S.A., April 1971, pp. 253-67.
The Stochastic Process with Service Rewards model is called as a composite
model of human resource accounting. It consists of both monetary and non-monetay
variables, for the monetary value of an individual depends upon many qualitative
(non-monetary) variables. The models links the competence and activation levels
of employees with rewards system that affect productivity and work - satisfaction
as well. The variables of promotability and organisational membership are also
considered with the help of statistical probability estimates to determine the
realisable value of an employee to the organisation.
Use of this model necessitates the following information :
1.
The set of mutually exclusive states that an individual may occupy in the
system during his/her career;
2.
The value of each state, to the organisation;
3.
Estimates of a person’s expected tenure in the organisation.
4.
The probability that in future, the person will occupy each state for the
specified time.
5.
The discount rate to be applied to the future cash flows.
A person’s expected conditional value and expected realizable value will be
equal, if the person is certain to remain in the organisation, in the predetermined
set of states, throughout his expected service life.
The movement of progress of people through organizational ‘states’ or roles
is called a stochastic process. The Stochastic Rewards Model is a direct way of
measuring a person’s expected conditional value and expected realizable value. It
is based on the assumption that an individual generates value as he occupies and
moves along ogranizational roles, and renders service to the organisation. It
presupposes that a person will move from one state in the organisation, to another,
during a specified period of time. In this model, exit is also considered to be a
state.
Advanced Accounting - II
99
Measurement In HRA Economic Value Approach
NOTES
The main drawback of his model, however, is the extent of information
required to make the necessary estimates of the values of the service states, the
expected tenure, and the probability that the individual will occupy the state for
the specified period of time. However, if this information can be made available,
this model emerges as one of the most sophisticated models for determining the
value if individuals.
5.2.5 Hekimian & Jones Competitive Bidding Model :
In this method, an internal market for labour is developed and the value of
the employees is determined by the managers. Managers bid against each other
for human resources already available within the organisation. The highest bidder
‘Wins’ the resource. There is no criteria on which the bids are based. Rather, the
managers rely only on their judgement.
5.2.6 Hermanson’s Unpurchased Goodwill Model :
According to Hermanson, the unpurchased goodwill notion is based on the
premise that ‘the best available evidence of the present existence of un-owned
resources is the fact that a given firm earned a higher than normal rate of income
for the most recent year. Here Hermanson is proposing that supernormal earning
are an indication of resources not shown on the balance sheet, such as human
assets. Even though his method of valuing human resources is explicitly intended
for use in a company’s published financial statements rather than for internal
consumption, this would necessarily involve forecasting future earnings and
allocating any excess above normal expected earnings to human resources of the
organization. However, the assumptions would be subject to the uncertainties
involved in any forecast of future events.
5.3
Other Non-Monetary Methods for assessing
the Economic Value of human resources :
There are some behavioral measurement techniques which can be used to
assess the benefits gained from Human Resource of an organisation.
These techniques are as under :-
100 Advanced Accounting - II
(i)
Performance evaluation measures used in Human Resource Accounting
include ratings, and rankings. Ratings reflect a person’s performance in
relation to a set of scales. They are scores assigned to characteristics
possessed by the individual. These characteristics include skills, judgment,
knowledge, interpersonal skills, intelligence etc. Ranking is an ordinal form
of rating in which the superiors rank their subordinates on one or more
dimensions, mentioned above.
(ii)
Assessment of potential determines a person’s capacity for promotion and
development. It usually employs a trait approach inwhich the traits essential
for a position are identified. The extent to which the person possesses these
traits is then assessed.
(iii)
Attitude measurements are used to assess employees’ attitudes towards
their job, pay, working conditions, etc. in order to determine their job
satisfaction and dissatisfaction.
(iv)
The skills or capability inventory is a simple listing the education.
knowledge, experience and skills of the firm’s human resources.
(v)
The results-oriented appraisals are based on the concrete performance
targets which are usually established by superior and subordinates jointly.
This procedure has been known as MBO. CMBO management by
objectives.
The concept of individual value in Human Resource Accounting can be
understood with the help of following illustrations.
5.4
Measurement In HRA Economic Value Approach
NOTES
Check Your Progress
1 . Define
the
term
‘Economic Value’.
2 . How to classify ‘Human
Variables’ according to
‘Likert’ ?
3 . State the elements of
Conditional
Value
according to ‘Flamholtz’.
Illustrations
4 . What is
Process’ ?
ILLUSTRATION 1
‘Stochastic
Aakruti Enterprises has started their business on 15th April, 2013 and
transacted the following transactions for the year ended 31st March, 2014.
a) Started business with initial capital amazing to ` 2,50,000.
b) The firm has purchased machinery worth ` 75,000 and Buildings
`1,00,000 for cash.
c) The firm has utilised ` 50,000 as working capital.
d) During the year the total expenses incurred on recruitment, training and
development of human resources amounted to ` 25,000
e) The value of human resources is assessed at ` 1,00,000.
You are required to prepare the Balance Sheet of the firm as on
31st March, 2014 inclusive of Human Resource Accounting information attached
to the financial statements.
SOLUTION
In the books of Aakruti Enterprise
Balance-sheet as on 31st March, 2014
(inclusive of Human Resource Accounting information)
Liabilities
`
Capital :
Assets
Machinery
i) Cash
2,50,000 Buildings
ii) Human Assets
1,00,000 Current Assets
`
75,000
1,00,000
50,000
Human Assets :
i) Value of Individuals
ii) Value of Firm’s investment
3,50,000
1,00,000
25,000
3,50,000
Advanced Accounting - II
101
Measurement In HRA Economic Value Approach
5.5
Summary
•
The Economic Value Approach : The economic value of human resources
is the present worth of the services that they are likely to render in future.
This may be the value of individuals, group of the total human organisation.
The methods for calculating the economic value of individuals may be
classified into monetary and non-monetary methods.
•
The Lev and Schwartz Model :
NOTES
As mentioned earlier, the Lev and Schwartz model is the basic model
employed by Indian organisations. According to this model, the value of
human capital embodied in a person who is ‘y’ years old, is the present
value of his/her future earning from employment and can be calculated by
using the following formula
E(Vy)
Py ( t I)
T Y
Where
I (T) / (I R)
t y
T
E (V y) = expected value of a ‘y’ year old person’s human capital
T = the person’s retirement age
py (t) = probability of the person leaving the organisation
I (t) = expected earning of the person in period I
r = discount rate
•
Expected Realizable Value :Expected realizable value is based on the assumption. That there is no
direct relationship between cost incurred on an individual and his value to
organization can be defined as the present worth of the set of future services
that he is expected to provide during the period he remains in the organization.
Flamholtz has given the variables affecting an individual’s expected realizable
value (IERV) : individual conditional values and his like hood of remaining
in the ogranization. The former is a function of the individual’s abilities and
activation level. While the later is a function of such variables as job
satisfaction, commitment, motivation, and other factors.
Likert’s Behaviour Model : Likert developed a model to diagnose the changes
in human organisation over a period of time . He has classified certain human
variables in to three categories, viz (i) causal variables, (ii) Interveating variables
and (iii) eco-result variables.
Flamholtz’s Model of Individual Value : According to Flamoltz, the value of
an individual is the present worth of the services that he is likely to render to the
organisation in future. The present cumulative value of all possible services that
may be rendered by him during his/her association with the organisation, is the
value of the individual.
102 Advanced Accounting - II
Stochastic process with service Rewards Model : Flamholtz developed a
model for measuring a person’s value to the organisation with the help of stochastic
process. He has established the value of an individual. It is equal to the present
value of future rewords adjusted with the probability of mobility and separation.
Measurement In HRA Economic Value Approach
Hekimian and Jones competitive Bidding Model : In this model, an internal
market for labour is developed and the value of the employees is determines by
the managers.
Hermanson is proposing that super normal earning are an indication of resources
not shown on the balance-sheet, such as human assets.
NOTES
There are some behavioural measurement techniques which can be used to asses
the benefits gains from Human Resource of an organisation.
5.6
Key Terms
(1)
Monetary and Non Monetary Models :- The models that are constructed
mainly with monetary variables are monetary models while those which
are dominated by behavioural variables are called as non- monetary models.
(2)
Composite Models :- The models which consider both monetary and
behavioural variables may be known as composite models.
(3)
Likert has classifies human variables into three categories viz (i) causal
variables, (ii) Intervening variables and (iii) Eco-result variables.
(4)
“Value of an Individual” is the present worth of the services that he is
likely to render to the organisation in future.
(5)
Expected Realisable Value” : Which is a function of the expected
conditioned value and the probability that the individual will remain in the
organisation for the duration of his / her productive service life.
(6)
“Stochastic Process” - The movement of progress of people through
organisational “states” or roles is called a stochastic process.
(7)
MBO :- The result-oriented appraised are based on the concrete
performance targets which are usually established by superior and
subordinates jointly. This procedure has been known as MBO ( Management
by Objectives)
5.7
Questions and Exercises
Advanced Accounting - II
103
Measurement In HRA Economic Value Approach
I - Objective Questions
A) Multiple choice Questions
(1)
The complete disclosure of the value of human resource in the final accounts
is made as a ...........
NOTES
(a) part of final accounts
(b) legal obligation
(c) supportive information
(d) compulsory part
(2)
Tax laws do not recognise human beings as ...........
(a) physical assets
(b) intangible assets
(c) wasting assets
(d) current assets
(3)
Human capital Model has been developed by ............ in 1971.
(a) Hekimian and Jones
(b) Lev and schwartz
(c) Likert and Flamholtz
(d) David watson
(4)
According to chakraborty the cost incurred for recruitment hiring, selection,
development and training of each employee should be recorded separately
and treated as ..................... .
(a) capital expenditure
(b) revenue expenditure
(c) deferred revenue expenditure
(d) accrued expenditure
Ans : (1 - c), (2 - a), (3 - b), (4 - d)
II - Long Answer Questions
104 Advanced Accounting - II
1)
What is ‘Economic Value’ ? Classify the Human Resource Accounting
models in different categories.
2)
Define the concept of ‘Human Capital’. Explain the formula developed by
Lev and Schwartz for calculating the value of an employee.
3)
Classify human variables according to a model developed by Likert.
4)
What is ‘Individual value’? Explain in brief the elements of ‘Conditional
Value’ according to Flamholtz.
5)
What is ‘Stochastic Process’. Explain the composite model of human
resource accounting developed by Flamholtz.
6)
Explain in brief the competitive Bidding model developed by Hekimian and
Jones.
Measurement In HRA Economic Value Approach
NOTES
III - Practical Problems
1)
From the following accounting data provided by Barua and co. for the year
ended 31st March, 2014 prepare the Balance Sheet of the firm as on that date
inclusive of human resource accounting information attached to the financial
statements.
a)
Started business with initial capital of ` 4,00,000 of which ` 1,00,000 were
borrowed from Dena Bank.
b)
The firm has utilised ` 1,00,000 as circulating capital.
c)
The firm has also purchased factory premises worth ` 1,25,000 and
machinery ` 1,00,000.
d)
During the year the total expenses incurred on training, development and
recruitment of human resources amounted to ` 75,000.
e)
The value of human resources is assessed of ` 1,00,000.
5.8
Further Reading
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts- New
Delhi : S. Chand & Co. Pvt. Ltd., 2013.
•
Bapat Varadraj and Raitha tha Mehul - Financial Accounting A Managerial
Perspective - New Delhi - Tata Mc Graw Hill Education Pvt. Ltd. - 2012.
Advanced Accounting - II
105
Unit 6
Human Resource Accounting in India
Human Resource
Accounting In India
Structure
6.0
Introduction
6.1
Unit Objectives
6.2
Human Resource Accounting in India
6.2.1
NOTES
Frame work of corporate reporting in India
6.3
Human Resource valuation models selected by Indian Companies
6.4
General consideration in the working of Human Resource Accounting
concept by Indian companies
6.5
Usefulness of Human Resource Accounting practice
6.6
Problems in Human Resource Accounting
6.7
Summary
6.8
Key Terms
6.9
Questions and Exercises
6.10 Further Reading
6.0
Introduction
In India, AS-26 does not allow Human Resource Assets to be recognised in
the balance sheet for the following reasons.
(a) Self generates intangibles such as human resource asset are not
recognised in the balance sheet.
(b) There is no control over future economic benefit in the case of Human
Resource Asset. They can leave on organisation or may continue to
remain in the organisation, but may not perform.
(c) The cost of Human Resource Assect can not be because reliably. For
example salaries paid to office staff cannot be spilt with realiability into
current cost and those that would be provided benefit in future.
Under the constraints under which the financial statements are prepared as
per the companies Law in India, there is no scope for showing any significant
information about human resource is financial statements except the remuneration
paid to them and the human employees getting high rate of salaries and
remuneration. However, there is nothing to prohibit the companies to attach
information about the worth of human resources and the result of their performance
Advanced Accounting - II
107
Human Resource
Accounting In India
NOTES
during the accounting period in notes or schedules.
In India, the concept of Human Resource Accounting is yet to gain
momentum. Bharat Heavy Electrical is a pioneer in this direction. few more
organisation like Minerals and Metals Trading corporation of India, Oil & Natural
cost commission, southern petrochemical Indian’s corportion and Ney Lignite
corportion are adopted this concept. But the concept is adopted as additional
information.
6.1
Unit Objectives
After studying this unit you should be able to:
•
Understand the framework of corporate reporting in India.
•
Describe Human Resource Valuation Models selected by Indian companies.
•
Discuss general consideration in the working of the Human Resource
Accounting concept by Indian companies.
•
Illustrates Indian companies adopting Human Resource Accounting concept
in India.
•
Discuss problem in Human Resource Accounting.
6.2
Human Resource Accounting in India
6.2.1 Framework of corporate reporting in India
In India corporate reporting has been mandatory and is governed by the
framework enshrined in sections 209, 210, 211, 212, 213, and 617 of the Companies
Act 1956. The statutory format for a balance sheet is prescribed in schedule VI
of the said act. Where as rules for reporting on banking, insurance, and electricity
companies are prescribed in the respective acts and laws and rules made there
under. However, no specific legislation exists for extraction, plantation, oil, and
gas and agribusiness companies. These companies are required to follow the
general principles as laid down in the Companies Act 1956 and to the extent the
specific law does not provide for, the provisions of company law prevail. Company
law directs that the financial statements should give a “true and fair view” of the
affairs that the company. The overarching framework does not specify the nuts
and bolts of corporate reporting and hence leaves greater scope for professional
judgement to be applied in determining as to what constitutes a “true and fair
view”. This has given rise to (a) statutory versus voluntary disclosures and (b)
mandatory versus voluntary but creative reporting, Creative reporting may be
classified into two categories: (a) voluntary and creative and (b) highly creative
but forensic in character.
108 Advanced Accounting - II
The Companies Act 1956 does not explicitly provide for the disclosure on
human assets in the financial statements of companies. The Institute of Chartered
Accountants of India has not issued an accounting standard for the measurement
and reporting of the human resources of an organisation. Therefore, it is up to the
organisation to decide how much information, what information and in which form
they want to disclose voluntarily in their annual financial reports or elsewhere.
However, accepting the arguments raised in favour of human resource accounting
(Human Resource Accounting) many companies have voluntarily started valuation
and disclosure regarding their human resources.
Human Resource
Accounting In India
NOTES
In India, human resource accounting has not been introduced so far as a
system. But its importance as a managerial tool has been recognised. The annual
reports of some companies contain information regarding the manpower employed,
manhours lost and the associated loss of production, the human resource
productivity, etc. The monetary value of human resources has been reported by
M/s. Bharat Heavy Electrical Limited.
M/s. Bharat Heavy Electrical Limited is engaged in world-wide business in
the area of Electrical / Mechanical Engineering equipment for the generation,
transmission and the utilisation of energy. The company made it a point to put
human resource development as one of the corporate objectives.
The company introduced a system of human asset reporting from 1974-75
in the capacity of image-projection. The Lev and Schwartz. Human Capital model
is consulted for evaluating the human assets. The employees future earning are
considered as a reasonable measure of the human asset value. The employees of
the company are divided into six categories - (i) Executives, (ii) Supervisors, (iii)
Supporting Technical Staff, (iv) Skilled Artisans, (v) Unskilled and semi-skilled
workers and (vi) Clerical Stall. The weighted average salary of the concerned
group of employes is computed and the future earning of the employees of each
group are calculated depending on the general promotion policy. Finally, the annual
earning are adjusted at 12 percent discount factor to determine the human capital
value. The computation of these values assume that pay-scales and the promotion
policy are constant. The ratios of value of production per rupee of human asset
and value added per rupee of human asset have been computed at 1.4 and 0.8
respectively for the year 1978-79 as against 1.1 and 0.6 in 1974-75, the year
system’s inception. The increase in the ratios indicate the improvement in the
efficiency level of the company’s human resources.
(Bharat Heavy Electrical Limited, Annual Reports, for the years 1974-75 and
1978-79)
Advanced Accounting - II
109
Human Resource
Accounting In India
NOTES
6.3
Human Resource Valuation Models Selected
by Indian Companies
Companies like ACC, CCI, EIL, MRL, OIL, and PEC have adopted the
economic valuation concept and accepted the model suggested by Lev and Schwartz
with refinements suggested by Flamholtz, Jaagi and Lau. Companies like CFSL,
GTL, HPCL, HZL, IDPL, INFOSYS, KRL, MECON, MMTC, NTPC, ROLTA,
SAIL, SATYAM, SPIC and STC have adopted the Lev and Schwartz model
(1971) of economic value and have used an employee’s anticipated future earnings
as a surrogate of his value, whereas a company like BHEL has developed its own
valuation model considering the original model of Lev and Schwartz as a base.
The model used by BHEL is as follows:
Human ResourceV = P x 12 x N x E x I/F
Where,
N = Number of employees in the grade
E = Efficiency factor
I = Imcremental factor, future expected increments
f = Discount factor, which is constant at 12 percent being a risk free rate of
return
Most of the Indian companies following the economic valuation method
considering human resources as a human capital. The charge in the discount rate
would a effect the human Resource value without a change in any other material
condition of the business.
In order to evolute the quality of disclosure relates to profitability and
efficiency made by each company, ratios were identified from the literatare survey
and the annual reports of the companies which have been following the human
resource accounting practices. As there is no compulsion by any statutroy bodies
regarding human resource accounting disclosure, different companies follow
different practice for the valuation and reporting of human resources. Following
efficiency and profitability indicator ratio commonly discloses by the Indian
Companies
Check Your Progress
1 . What is the Framework
of corporate Reporting in
India ?
2 . State the various ratios
computed by Indian
Companies to indicate
efficiency
and
profitability.
110 Advanced Accounting - II
(i)
Ratio of human resource value to the number of employees.
(ii)
Ratio of Human Resource to fixed assets.
(iii)
Ratio of turnover to Human Resources.
(iv)
Ratio of turnover to total resources.
(v)
Ratio of employee cost to Human Resources Value
(vi)
Ratio of return on Human Resource Value
(vii) Ratio of value added to Human Resource Value.
(viii) Ratio of value added to total resources.
(ix)
6.4
Human Resource
Accounting In India
Ratio of net value added to total resources.
General Consideration in the Working of
Human Resource Accounting Concept by
Indian Companies
NOTES
The following are the general considerations in the working of the Human
Resource concept by the organisation in India.
(i)
Only internal human organisation (employees) is considered. External
organisation like customers are not considered.
(ii)
At categories of employees are includes. The value of employee’s potential
services is considered.
(iii)
Human Resource value is worked out - on the Lev and Schewartz model
(iv)
A 12 percent discount rate is adopted.
(v)
Employees are classified according to age and pay scales under six
categories - executives, supervisors, supporting technical staff, skilled
artisans, unskilled and semi skilled workers and clerical staff.
(vi)
Weighted average is calculated for each group on information of total number
of employees at each incremental stage and in each grade
(vii) Future number of employees is worker out on the basis of general promotion
policy.
(viii) Employee considerations include direct and indirect benefits.
6.5
Usefulness of Human Resource Accounting
Practices
In favour of Human Resource Accounting, behavioural scientists as well as
professionals made number of arguments such as following:
(i)
Human Resource Accounting helps in decision making.
(ii)
Human Resource Accounting provides input to the internal as well as external
decision makers.
(iii)
Human Resource Accounting works as a motivational factor to the
employees.
(iv)
It helps in giving valuable information to the management of effective
planning and managing human resources.
Advanced Accounting - II
111
Human Resource
Accounting In India
(v)
It helps in measurement of standard cost of recruiting, selecting, hiring and
training people and organization can select a person with highest expected
realizable values.
(vi)
Human resource accounting can change the attitude of managers completely,
thereby, they would try to maximize the expected value of human resources
and effective use of human resources in the organization.
NOTES
(vii) It also provides necessary data to devise suitable promotion policy congenial
work environment and job satisfaction to the people.
Human Resource Accounting information, if property developed, will be
useful to managers at all levels regarding costs of turnover and inefficient utilization
of human resources. Such information will help managers to make better decisions
regarding personnel. Such information also helps these organization to understand
the costs involved in fulfilling social responsibilities such as training to the unemployed
and retrenched personnel. Data could also be useful to investors to judge the
future performances of enterprise.
6.6
Problems in Human Resource Accounting
The major operational problems involves in Human Resource Accounting are of
the following type :(i)
Human being cannot be owned like other assets. thus they cannot command
any value therefore subjective factor may play crucial role.
(ii)
There is no well-set standard accounting practice for measuring the value
of human resources. In the case of financial accounting, there are certain
specified standards which every organization follows. However, in the case
of human resource accounting, there are on such standards.
Therefore, various organization that adopt human asset valuation use their
own models with the result, value of human assets of two organization may
not be comparable. models with tax laws do not recognise human being as
asset. Assets depreciate in value for various reasons but human assets
appreciated in value because of experience efficiency etc.
Check Your Progress
1 . State
the
general
consideratons in the
working
of
Human
Resource
Accounting
Concept.
2 . How Human Resource
Accounting is useful in
actual practices ?
3 . What are the major
operational
problems
involved in Human
Resource Accounting ?
112 Advanced Accounting - II
(iii)
The valuation of human assets is based on the assumption that the Employees
may remain with the organization for certain specified period. However,
this assumption may not hold in the today’s context because of increased
human resource mobility.
(iv)
There is a possibility that human resource accounting may leas to the
dehumanization in the organization if the valuation is not done correctly or
results of the valuation are not utilised properly. Hence salaries cannot be
predicted with precision and accuracy. If is difficult to obtain reliable data
for detemining the value derived by an organisation during the period a
person occupies a particular position.
(v)
There is also possibility that trade unions may oppose the use of human
resource accounting. They may want parity of wages/salaries and value of
employees.
However many of these problems are of operational nature or of attitudinal
nature. These may be overcome by developing suitable organizational climate and
culture.
6.7
Human Resource
Accounting In India
NOTES
Summary
•
In India the concept of Human Resource Accounting is yet to gain
momentum. There are a few organization. however, that do recognize the
value of their human resources, and furnish the related information in their
annual reports. In India, some of these companies are : Infosys, Bharat
Heavy Electrical Ltd (BHEL) ; the steel Authority of India Ltd. (SAIL) the
Minerals and Metals Trading Corporation of India Ltd, (MMTC), the
Southern petrochemicals Industries Corporation of India(SPIC), the
Associated Cement Companies Ltd, Madras Refineries Ltd., the Hindustan
Zinc Ltd,. Engineers India Ltd, the Oil and Natural Gas Commission, Oil
India Ltd. the Cement Corporation of India Ltd. etc.
•
Most of the Indian companies following the economic valuation method
considering human resources as a human capital. Some Indian companies
like BHEL has developed its own valuation model considering the original
model of ‘Lev & Schwartz” as a base.
•
Human Resource Accounting information, if properly developed, will be
useful to managers at all levels regarding with of turnover and inefficient
utilization of human resources.
•
There are some operational problems involved in Human Resource
Accounting, however many of these problems are of attitudinal nature.
these can solves by developing suitable organisational climate and culture.
6.8
Key Terms
(1) ‘BHEL’ valuation model : Human ResourceV = Px12xNxExI/F
Where, N = Number of employees in the grade
E = Efficiency Factor
I = Increments factor, future expected increments
F = Discount factor, which is at conduct 12% being a risk free rate of
return.
(2) ‘Lev and Schwartz’ model : The basic theme of Lev, Schwartz model is
to compute the present value of the future direct and indirect payment to their
employees as a measure of their human resource value.
Advanced Accounting - II
113
Human Resource
Accounting In India
6.9
Questions and Exercises
I - Objective Questions
A) Multiple choice Questions
NOTES
(1)
In India AS-26 does not allow ---------- assets to be recognised in the
Balance-sheet.
(a) Human Resource
(b) capital
(c) Non-wasting
(d) contingent
(2)
The companies Act, 1956 does not explicity provide for the disclosure of ----- assets in the financial statements of companies.
(a) capital
(b) human
(c) wasting
(d) contingent
(3)
Indian companies are generally following human resource accounting
according to model as developed by -------------.
(a) Likert,
(b) Flamholtz,
(c) Hermanson,
(d) lev and schwartz
(4)
Among all the corporate enterprise in India ------------- is the pioneer in the
field of human resource accounting since -1970.
(a) Bajaj Auto Ltd.
(b) Bharat Heavy Electrical Ltd.,
(c) Tata motors Ltd,
(d) Hindustan unilever Ltd.
Ans. (1 - a), (2 - b), ( 3 - d), ( 4 - b)
II - Long Answer Questions
(1)
114 Advanced Accounting - II
What is Human Resource Assets? Why in India As 26- does not allow
Human Resource Assets to be recognised in the Balance Sheet.
(2)
State in brief the general considerations in the working of the human resources
concept by Indian companies.
(3)
Explain in brief the usefulness of Human Resource accounting practices
followed in India.
(4)
Explain the major problems involved in Human Resource Accounting
practices followed in India.
(5)
“Conventional accounting practices in India ignore human resources
altogether”. Explain.
(6)
Explain in brief the progress made by Indian companies so far in the field of
human resource accounting.
Human Resource
Accounting In India
NOTES
6.10 Further Reading
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand Co. Pvt. Ltd,. - 2013
•
Bapat varadraj and Raithatha Mehul - Financial accounting - A managerial
prospective - New Delhi - Tata Mc Graw Hill Education Pvt. Ltd,. 2012.
Advanced Accounting - II
115
Topic 3
Valuation of Goodwill and Shares
Unit 7
Meaning , Need, Valuation of
Goodwill - Average Profit Method
Unit 8
Valuation of Goodwill - Super Profit
Method
Unit 9
Valuation of Goodwill - Capitalisation
and Annuity Methods
Unit 10
Valuation of Shares - Need, Methods
of Valuation of Shares
Unit 11
Valuation of Shares - Fair Value
Method, Value of Right and
Preference Shares
Unit 7
Meaning , Need, Valuation of
Goodwill - Average Profit Method
Meaning, Need,
Valuation of Goodwill Average Profit Method
Structure
NOTES
7.0
Introduction
7.1
Unit Objectives
7.2
Meaning and Definition of Goodwill
7.3
Need for Valuation of Goodwill
7.4
Elements of Goodwill
7.4.1
Distinguishing Features of Goodwill
7.4.2
Type of Goodwill
7.5
Factory Affecting Valuation of Goodwill
7.6
Methods of valuation of Goodwill
7.6.1
Average profit Method
7.7
Illustrations
7.8
summary
7.9
Key Terms
7.10 Questions and Exercises
7.11 Further Reading
7.0
Introduction
When a business is able to earn profits at a rate higher than that at which a
similar business earns, the former is said to possess goodwill. Every businessman
tries to establish their goodwill because to enables them to earn more profit. Goodwill
is a valuation asset if the concern is profitable, it is valueless if the concern is a
losing concern. Goodwill refers to a measure of the capacity of a business to earn
above the normal profits. It is an attractive force which beings in customers.
Goodwill refers to a measure of the capacity of a business to earn above
normal profits. It is the benefit and advantage of a good name, reputation and
connection of a business. It is the attractive force which brings in customers. It is
the one thing which distinguished an old and established business from a new
business at start. It is an intangible but a real asset.
Goodwill is a term used in accounting for intangible assets usually measured
Advanced Accounting - II
117
Meaning, Need,
Valuation of Goodwill Average Profit Method
by the difference between the price paid for a going concern and its book value.
If a firm is sold with a “good name” or large set of customers or clients likely to
remain after the sale, these are part of the firm’s goodwill. There are several
ways by which an accountant can compute goodwill. Here, we will outline some
of the various methods available for valuation of goodwill.
NOTES
7.1
Unit Objectives
After studying this unit to should be able to :
•
Understand the need of valuation of goodwill
•
Recognise the factors that effect the value of goodwill
•
Determine the elements of goodwill
•
Explain various methods of valuation of goodwill
•
Calculate valuation of goodwill as per average profit method.
7.2
Meaning and Definition of Goodwill
Meaning :
Goodwill is an asset which has countless definitions. Accountants,
Economists, Engineers and the Counts have defined Goodwill in a number of
ways from their respective angles. As such they have suggested different methods
for its nature and valuation. No doubt, it is an intangible real asset and not a
fictitious one. ‘It is perhaps the most intangible of intangibles’.
Goodwill is a most valuable asset if the concern is profitable, on the other
hand, it is valueless if the concern is a losing one. Therefore, it can be stated that
Goodwill is the value of the representative firm, judged in respect of its earning
capacity. However, some of the definitions are discussed here under:
Definitions :
Prof. Dicksee : “ The present value of a firm’s anticipated excess
earning”. When a man pays for goodwill, he pays for something which puts him
in a position of being also to earn more than he would be able to do by his own
unaided efforts.
Goodwill is thus, the extra saleable value attached to a prosperous business
beyond the intrinsic value of net assets.
118 Advanced Accounting - II
From a different angle, goodwill may be viewed as a more or less permanent
impression created in the minds of the customers of a particular organisation who
continue to patronise that organisation despite the high price of its products which
enables the organisation to earn super-profits. So goodwill is the outcome of an
impression created in the mind of each customer. It can exist only among competitive
businesses.
Lord Lindley :
“ The term Goodwill can hardly be said to have any precise significance.
It is generally used to denote the benefit arising from connection and
reputation and its value is what can be got for the change of being able to
keep that connection and improve it. Upon the sale of an established business
its goodwill has a marketable value, whether the business is that of a
professional man or any other person. But it is plain that goodwill has no
meaning except in connection with a continuing business, and the value of
the goodwill of any business to a purchaser depends in some cases entirely,
and in all very much, on the absence of competition on the part of those by
whom the business has been previously carried on”.
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
Wilson :
“Goodwill has been very ably divided into three types - cat, dog an rat
- in view of the peculiar habits of these three animals. The cat tends to stick
to the abode, cat goodwill is therefore that which will adhere to the business
which is being transferred and is the most valuable. The dog follows his
master, dog goodwill is difficult to transfer and is correspondingly less
valuable. The rat is a migrant, rat goodwill is practically valueless, as it
represents those customers who have no specialities either to the business or
its properties and who may be here today and gone tomorrow. Summed up,
cat goodwill is adherent; dog personal and rat fugitive. Adherent goodwill
is only valuable as attaching to the business; personal goodwill is unsaleable,
fugitive goodwill in only valuable in that as one fugitive goes another may
arrive”.
In the word of Spicer and Pegler, “Goodwill may be said to be that
element arising from the reputation, connection, or other advantages
possessed by a business which enables it to earn greater profits than the
return normally to be expected on the capital represented by the net tangible
assets employed in the business”.
Goodwill may be described as the aggregate of those intangible attribute of
a business which contribute to its superior earning capacity over a normal return
on investment. It may arise from such attributes of a business as good reception,
a favorable location, the ability and skill of its employees and management, nature
of its products, etc.
Lord Machaghten :
‘What is goodwill ? It is a thing very easy to describe, very difficult to
define. It is the benefit and advantages of the good name, reputation in connection
with a business. It is the attractive force which brings is customers. It is a thing
which distinguishes an old established business from a new business at its first
start’.
Lord Eldon :
“Goodwill is nothing more than the probability that the old customers
will resort to the old place”.
Advanced Accounting - II
119
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
Hatfield :
“The value of business connections, the value of the probability that
present customers will continue to buy inspite of the allurements of competing
dealers”.
Walton :
“The element of an established business which makes the business as
a going concern worth more than its book value, that is, its net worth as
shown by the books”.
Wildman :
“It is the influence that the proprietor or his organisation has upon
the purchasing public through which he is enabled to attract and retain
patronage”.
7.3
Need for Valuation of Goodwill
There are various circumstances when it may be necessary to value goodwill.
Some of the circumstances are as under.
(1)
In the of individuals, goodwill is valued for purpose of Estate Duty, Death
Duty, etc. on the death of a person.
(2)
In the case of a sole trader, goodwill is valued at the time of selling the
business, to decide the purchase consideration.
(3)
In the case of a partnership, when there is an admission, retirement, death
or amalgamation, or a change in profit sharing ratio takes place, valuation
of goodwill become necessary.
(4)
In the case of a company, when two or more companies amalgamate or
one company absorbs another company, or one company wants to acquire
controlling interest in another company of with the Government takes over
the business, valuation of goodwill becomes necessary.
7.4
Check Your Progress
1 . What is ‘Goodwill’ ?
Elements of Goodwill
R.H. Nelson suggests that goodwill generally consists of the following
elements:
2 . Why it is necessary to
value ‘Goodwill’ ?
(a) Customer lists;
3 . State the Elements of
Goodwill.
(b) Organisation costs;
(c) Development costs;
(d) Trademarks, trade names and brands;
120 Advanced Accounting - II
Meaning, Need,
Valuation of Goodwill Average Profit Method
(e) Secret processes and formulae;
(f) patents;
(g) Copyrights;
(h) Licenses;
NOTES
(i) Franchises; and
(j) Superior earning power.
7.4.1 Distinguishing Features of Goodwill
Following are the factors distinguishing goodwill from most of the other
assets.
(a) It is the earning power of the business.
(b) It is intangible in nature.
(c) It represents a non-physical value over and above the physical assets.
(d) It cannot have an existence separate from the business and therefore,
cannot be realised separately.
(e) It is difficult to place a cost on goodwill as the value may fluctuate from
day-to-day as a result of internal and external circumstances, i.e.
changing fortunes of the company’s business.
(f) The amount or value of the goodwill and the assessment of its actual
existence is highly dependent on the subjective judgement of the valuer.
7.4.2 Types of Goodwill
Generally, the types of goodwill can be shown as indicated in Figure 7.1
Purchased
Goodwill
Types of Goodwill
NonPurchased
Goodwill
Fig. 7.1 : Types of Goodwill
a)
Purchased Goodwill:
Purchased Goodwill arises when one business buys another and the purchase
consideration paid is more than the value of the net tangible assets received. It
can never exist in a new business except by purchase.
It is accepted practice to recognise only the purchased goodwill in the
Advanced Accounting - II
121
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
accounting system.Therefore, goodwill should enter into the books of accounts of
a business only in connection with a valuation ascribed to it in the acquisition price
of a business. Purchased goodwill is recognised in financial statements. Mostly, it
arises on an acquisition.
b)
Non-Purchased or Inherent Goodwill:
Non-Purchased or inherent goodwill is referred to as internally generated
goodwill and it arises when a business may over the years generate its own
goodwill. Inherent goodwill is never recognised in financial statements. It is not
demonstrated by a purchase consideration. It is internally generated.
7.5
The Various Factors affecting valuation of
goodwill are shown belows in figure 7.2
A
Internal
Factors
External
Factors
B
Factors Affecting
Valuation of
Goodwill
Fig 7.2 Factors affecting valuation of goodwill
There are many other factors which are taken into consideration for valuation
of goodwill. Those factors - internal and external-which contribute to the goodwill
of a business and the important ones are listed below :
(A) Internal Factors :
122 Advanced Accounting - II
1)
If risk is less in a business, then the amount of goodwill will be more than
those business in which risks are more.
2)
If quality of goods manufactured is better, there will be more goodwill.
3)
If more profits are made in a business, no doubt, goodwill increases.
4)
If more profits can be derived by investing comparatively less capital, then
value of goodwill increases.
5)
The better the relations between employer and employees more will be
goodwill.
6)
The profits of the past years play an important role in determination of
goodwill.
7)
If a firm has established reputations for a patent or trade - mark. it will have
goodwill due to it.
8)
If the increasing trend of profits can be maintained in future, without risk,
the amount of goodwill will be more.
9)
Some place are famous for certain products. If a business is carried on at
these place, goodwill is created. if it is located in a very prominent place it
can attract more customers.
10)
If management expenses are less, comparing with the profits, goodwill
increases.
11)
The efficient management may also help to increase the value of goodwill
by increasing profits through proper planned production, distribution &
services.
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
(B) External Factors :
1)
If customers’ point of view is good about the business, goodwill will be
more and vice versa.
2)
The position of the business in relation to its competitors is an important
factor.
3)
Popularity of products in terms of quality and effective after-sales-services.
4)
Availability of raw materials is also one of the factors influencing the value
of goodwill.
5)
If a business is enjoying political protection or it is expected to enjoy political
protection, the value of goodwill will be more.
6)
Effective advertising to establish brand popularity.
7)
Good industrial relations with other industries, as well as good labour relations.
8)
Research and Development efforts.
9)
Technical collaborations with established companies.
10)
Customers’ favourable attitude and customer satisfaction.
11)
Favourable money market condition help to increase the value of goodwill.
12)
Effective government policies and peace and security in the country help
to increase the value of goodwill. Favourable Tax polices are also helping.
13)
Time dimention is another important factor which influences the value of
goodwill.
Advanced Accounting - II
123
Meaning, Need,
Valuation of Goodwill Average Profit Method
7.6
Methods of Valuation of Goodwill
The Various Methods of valuation of Godwill are shown below in figure 7.3 -
s doht e
Myti un
nA
vA
gar a s doht e M
e
P
ti f or
NOTES
hods
t Met
i
f
o
r
rP
Supe
Methods of
Valuation of
Goodwill
Capitalis
ation Me
thods
Fig. 7.3 Methods of Valuation of Goodwill
7.6.1 Average Profit Method
This method takes into account the average profit for the last few years
and fixes the value of the goodwill as so many years of purchase of this amount.
Formulae :
Total Profit Less Loss, if any
(i) Average Profit
=
Number of Years
(ii) Valuation of Goodwill = Average Profit x Number of Years purchase
Calculation of Average Profit :
124 Advanced Accounting - II
Under this method, at first, average profit is calculated on the basis of the
past few years’ profits. At the time of calculating average profit, precaution must
be taken in respect of any abnormal items of profit or loss which may be based on
simple average or weighted average.
Valuation of Goodwill : After calculating average profit, it is multiplied by
a number (3 or 4 i.e. three or four years), as agreed. The product will be the value
of the goodwill, ?If the weighted average profit is taken for the last four years, the
last year should be given a weightage of 4, the previous year a weightage of 3, the
prior to that a weight of 2 and so on. To obtain the weighted average profit, the
profit of the year must be multiplied by its weightage and the grand total should be
divided by the aggregate number of weights.
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
Since goodwill figures rely on a series of estimates and assumptions,
different weightings would produce different end results.
EXAMPLE
Ashoka Ltd. Ahmednagar agreed to purchase business of a sole trader. For
that purpose, goodwill is to be valued at 3 year’s purchase of the average profits
of last 5 years.
Years
`
2007 - 2008
80,000
2008 - 2009
90,000
2009 - 2010
72,000
2010 - 2011
92,000
2011 - 2012
1,00,000
Calculate the value if Goodwill by following Average Profit Method
ANSWER
` 80,000 + 90,000 + `72,000 + ` 92,000 + `1,00,000
Average profit =
5 Years
` 4,34,000
=
5Yeras
= ` 86,800
Goodwill
= 3 Years purchase of average profit of last 5 years
= ` 86,800 x 3
= ` 2,60,400
ACCOUNTING TREATMENT
Average Profit Method involves two steps to follow in computation of
goodwill
Advanced Accounting - II
125
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
(a) The profit for an agreed number of years preceding the valuation are
averaged so as to arrive at the average annual profit earned during the period.
This will have to be adjusted in the light of future possibilities and the average
future maintainable profit determined.
If the profit have been fluctuating, a simple average is used. If profits show
a steadily increasing or decreasing trend, appropriate weights are used giving
greater weightage for profits of the last years.
(b) The average future maintainable profit is multiplied by certain number
of years to find out the value of goodwill. The number of years selected for this
purpose are based on the expectation of the number of years’ benefit to be derived
in the future from the past association.
The Average Profit Method has the following advantages and limitations.
Advantages :
(i)
This method is very simple for calculations.
(ii)
The net profit earned in the past over the desired period forms the suitable
base for computation of goodwill.
(iii)
Income-Tax department uses this method of valuation of goodwill because
of its simplicity and universal applicability.
Limitations :
(i)
The main disadvantage of this method of valuing goodwill is that any trend
in the level of profitability is not reflected in the valuation of goodwill. If the
simple average is used, i.e. each year’s profits are given the same weightage,
no discrimination is made between a business that has rising profits and one
that has falling profits. To overcome this,it is necessary to give more
weightage to the profits of recent years.
(ii)
Difficulty of finding out the right number of years’ purchase of profits as it
depends on many factors and situations.
Check Your Progress
(iii)
It does not consider the capital investment which has been made to earn
the profits.
1 . What are the important
‘Features of Goodwill’ ?
(iv)
This method relies upon historical data.
(v)
It is not a scientific method.
2 . Differentiate between
Purchased Goodwill and
Non-Purchased Goodwill.
3 . State the internal and
external factors affecting
the
‘Valuation
of
Goodwill.’
4 . Explain the advantages
and
limitations
of
Average Profit Method of
Valuation of Goodwill.
126 Advanced Accounting - II
The Average Profit Method of valuation of goodwill can be understood
with the help of following illustrations.
7.7
Meaning, Need,
Valuation of Goodwill Average Profit Method
Illustrations
ILLUSTRATION 1
Eastern India Ltd., Edalbad earned the following amount of profits:
Year
Profit
NOTES
`
2011
22,000
2012
23,500
2013
21,000
2014
25,500
It is decided to value Goodwill of the company at two years purchase of the
average profits of the four years.
Calculate of the amount of Goodwill as per Average Profit Method.
SOLUTION
(a) Calculation of the Average profit :
Year
Profit
`
2011
22,000
2012
23,500
2013
21,000
2014
25,500
 Total
92,000
Total Profit
Average Profit
=
Number of Years
` 92,000
=
4 Years
= ` 23,000
(b) Calculation of Goodwill of the firm :
Goodwill
= 2 years’ purchase of Average Profit
= Average Profit x 2
= ` 23,000 x 2
= ` 46,000
Hence, Goodwill of the company is to be valued at ` 46,000
Advanced Accounting - II
127
Meaning, Need,
Valuation of Goodwill Average Profit Method
ILLUSTRATION 2
Femina and Co., Faridabad wish to value Goodwill of their firm. They have
decided to value Goodwill as three years’ purchase of the average profit earned
by them in last five years. The profit earned are as under :
NOTES
Year
Profit/Loss
`
2010
32,000
2011
12,500 (Loss)
2012
27,800
2013
25,900
2014
35,300
Calculate the amount of Goodwill as per Average Profit Method.
SOLUTION
(a) Calculation of the Average profit:
Year
Profit/Loss
`
2010
32,000
2011
12,000 (Loss)
2012
27,800
2013
25,900
2014
(+)
Total Profit
35,300
1,09,000
Total profit
Average Profit
=
Number of Years
` 1,09,000
=
5 Years
= ` 21,800
(b) Calculation of the Goodwill :
Goodwill
= 3 years’ purchase of Average profit
= ` 21,800 x 3
= ` 65,400
128 Advanced Accounting - II
Hence, Goodwill of the film is to be valued of ` 65,400
ILLUSTRATION 3
The partnership firm of M/s Gemini and Sons, Goregaon wishes to value
goodwill of the firm. It is decided to use average profit method for this purpose
and the basis to be used is two years’ purchase of the average profits for preceding
four years. The profit and losses for the last four years are as follows:
Year
Profits/Loss
Meaning, Need,
Valuation of Goodwill Average Profit Method
NOTES
`
2011
8,700 (Loss)
2012
10,850
2013
14,380
2014
17,070
Calculate the amount of Goodwill as per Average Profit Method.
SOLUTION
(1)
Calculation of the Average Profit :
Year
Profit/Loss
`
2011
8,700 (Loss)
2012
10,850
2013
14,380
2014
(+) 17,070
 Total Profit
33,600
Total Profit
Average Profit
=
Number of Years
` 33,600
=
4 Years
= ` 8,400
(b)
Calculation of Goodwill
Goodwill
=
2 years’ purchase of Average profit
=
` 8,400 x 2
=
` 16,800
Hence, Goodwill of the film is to be valued of ` 16,800
Advanced Accounting - II
129
Meaning, Need,
Valuation of Goodwill Average Profit Method
ILLUSTRATION 4
M/s Hira - panna and Co. Haridwar wish to find out the value of the Goodwill
of the firm. Goodwill is decided to be valued at two years’ purchase of the average
profit for last five years. The profits and losses of the five years as under:
NOTES
`
Year ended 31st March, 2010
14,580
Year ended 31st March, 2011
11,210
Year ended 31st March, 2012
8,350 (Loss)
Year ended 31st March, 2013
9,460
Year ended 31st March, 2014
12,810
Calculate the value of the Goodwill of the firm as per Average Profit Method.
SOLUTION
(1) Calculation of the Average profit:
Particulars
Profits/Loss
Year ended 31st March, 2010
14,580
Year ended 31st March, 2011
11,210
Year ended 31st March, 2012
8,350 Loss
Year ended 31st March, 2013
(+) 9,460
Year ended 31st March, 2014
12,810
Total Profit
39,710
Total profit
Average Profit
=
Number of Years
` 39,710
=
5 Years
= ` 7,942
(2) Calculation of the Goodwill :
Goodwill
= 2 years’ purchase of Average profit
= ` 27,942 x 2
= ` 15,884
Hence, Goodwill of the company is to be valued of ` 15,884
130 Advanced Accounting - II
ILLUSTRATION 5
A Partnership firm in which Mahesh, Suresh and Bhaegsh are the partners,
has earned profits in the last five years as under:
Year
Meaning, Need,
Valuation of Goodwill Average Profit Method
Profit
`
NOTES
2010
27,750
2011
32,225
2012
33,465
2013
28,640
2014
30,360
The partners have decided to value Goodwill at 3 years’ purchase of the
average profit for last 5 years.
SOLUTION
(1) Calculation of Average profits:
Year
Profit
`
2010
29,750
2011
32,225
2012
33,645
2013
28,640
2014
30,360
Total Profit
1,54,440
Total profit
Average Profit
=
Number of Years
` 1,54,440
=
5 Years
= ` 30,888
(2) Calculation of Goodwill of the firm:
Goodwill
= 3 years’ purchase of Average profit
= ` 30,888 x 3
= ` 92,664
Hence, Goodwill of the film is to be valued of ` 92,664
Advanced Accounting - II
131
Meaning, Need,
Valuation of Goodwill Average Profit Method
7.8
Summary
(1)
Goodwill is the value of the reputation of a business in respect of profits
expected in future over and above the normal level of profits earned by
undertakings belonging to the same class of business.
(2)
Goodwill is the term used in accounting for intangible assets, but not fictitious,
usually measured by the difference between the price paid for a concern
and its book value.
(3)
In case of a partnership firm, when there is an admission, retirement, death
of a partner. amalgamation or sale of a firm, or a change in profit sharing
ratio takes place, valuation of Goodwill becomes necessary.
(4)
Goodwill is the earning power of business with intangible nature.
(5)
Purchased Goodwill and Inherent Goodwill are generally the two types of
Goodwill arises in a partnership.
(6)
Average profit Method takes into account the average profit for the last
few years and fixes the value of Goodwill as to many years of purchase of
this amount.
NOTES
7.9
Key Terms
(1)
Goodwill : Goodwill is the extra saleable value attaches to a prosperous
business beyond the intrinsic value of net assets.
(2)
Purchased Goodwill : Purchased Goodwill arises when one business buys
another and the purchase consideration paid is more than the value of the
net tangible assets received.
(3)
Non-purchased or Inherent Goodwill : Non-purchased or inherent
goodwill is referred to as internally generated goodwill and it arises when a
business may over the years generate its own goodwill.
(4)
Average Profit
Total profit Less Loss, if any
=
Number of Years
(5)
Valuation of Goodwill = Average profit x Number of Years purchase
(6)
Average profit may be computed in the following manners :
(1) Simple Average; and
(2) Weighted Average
(1)
Simple Average :
It is nothing but the simple average profit for the last few years.
132 Advanced Accounting - II
Total profit of all the years
Average Profit
=
Number of years
(2)
Meaning, Need,
Valuation of Goodwill Average Profit Method
Weighted Average :
Actual profit is being multiplied by the respective number of weights (say,
1,2,3, and 4 ..........) in order to get the amount of product.
NOTES
Total Product
Average Profit
=
No. of weights
(Note : Weighted average profit is considered when the trend of profits is raising.)
7.10 Questions and Exercises
I - Objective Questions
(A) Multiple choice Questions
(1)
A measure of the capacity of a business to earn above normal
profits in accounting term is referred to as ------- .
(a) Goodwill
(b) Reputation
(c) Creditstandings
(d) Prestige
(2)
Goodwill is an ----------- real assets and not a fictitious one.
(a) Intangible
(b) tangible
(c) wasting
(d) non-wasting
(3)
In case of a sole trader goodwill is valued at the time of selling the business
to decide upon the ----------- .
(a) selling price
(b) inflated price
(c) purchase consideration
(d) loaded price
(4)
Income - Tax department uses ------------ method of valuation of goodwill
because of its simplicity and universal applicability
Advanced Accounting - II
133
Meaning, Need,
Valuation of Goodwill Average Profit Method
(a) super profit
(b) capitalisation
(c) annuity
(d) average profit
NOTES
Ans :- (1-a), (2 - b), (3 - c), (4 - d)
II - Long Answer Questions
1)
What is ‘Goodwill’ ? Explain the need for valuation of goodwill.
2)
Define ‘Goodwill’. Explain in breif the elements of goodwill.
3)
What do you understand by ‘Goodwill’? State the distinguishing features of
Goodwill.
4)
What is ‘Goodwill’? Explain in brief the types of goodwill viz.
a) Purchased Goodwill and b) Inherent goodwill
5)
Explain in brief the factors affecting the valuation of goodwill.
6)
What is ‘Average profit’? State the advantages and limitations of Average
profit method of valuation of Goodwill.
III - Practical Problems
1) The profits of Aarohi Enterprises for the last four years are ` 27,500, ` 19,300.
` 23,200 and ` 14,000 respectively. The goodwill of the firm is equal to two years
purchase of the average profits for the last for years. Calculate the Goodwill as
per Average profit method.
2) Goodwill of Bristol adn co. is to be valued at three times of the average profits
for the last five years. The profits were .....
Year
`
2010
20,400 profits
2011
11,700 profits
2012
6,900 profits
2013
8,700 profits
2014
19,700 profits
Find out the value of Goodwill as per Average profit method.
134 Advanced Accounting - II
3) Goodwill of chandan Bros. is to be calculated as two years purchased of the
average profits of last three years. The profits for the first year was ` 10,000.
The profits for the second and third year was twice the profits of the previous
year.
Meaning, Need,
Valuation of Goodwill Average Profit Method
Find out the value of Goodwill as per Average profit method.
7.11 Further Reading
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd., 2013.
•
Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - New
Delhi - Taxmann Publications Pvt. Ltd., 2012.
NOTES
Advanced Accounting - II
135
Unit 8
Valuation of Goodwill - Super Profit
Method
Valuation of Goodwill Super Profit Method
Structure
NOTES
8.0
Introduction
8.1
Unit Objectives
8.2
Super Profit Method
8.3
Accounting treatment
8.4
Calculation of Average Profit, Super Profit and Goodwill
8.5
Sliding -Scale Valuation of Super Profit
8.6
Illustrations
8.7
Summary
8.8
Key Terms
8.9
Questions and Exercises
8.10 Further Reading
8.0
Introduction
Goodwill, in general is recorded in the books only when some consideration
in money or money’s worth has been paid for it. Whenever a business is acquired
for a price (payable either in cash in shares or otherwise) which is in excess of the
value of the net assets of the business taken over, the excess is termed as
“goodwill”. In previous Unit, we have discussed various methods of valuation of
goodwill. Another common method of valuation of goodwill is the “Super Profit
Method”. Under this method, super profits is taken as the basis for calculating
goodwill in place of average profit. Like average profit method, this value is also
computed by applying a general rule acceptable in the trade e.g. three or four
years purchase of super profit.
Advanced Accounting - II
137
Valuation of Goodwill Super Profit Method
8.1
Unit Objectives
After studying this unit you should be able to :
NOTES
•
Understand the meaning of Average profit, Normal profit & super profit.
•
Calculate Average profit, super profit and goodwill as per super profit method.
•
Know the concept of Normal rate of Return.
•
Ascertain ‘Average capital Employed”.
•
Explain “Sliding -Scale valuation of super profit”.
8.2
Super Profit Method
Under this method, super profits is taken as the basis for calculating goodwill
in place of average profit. Like the previous method, this value is also computed
by applying a traditional rule acceptable in the trade, e.g. three or four years’
purchase of super profit.
Strictly speaking, goodwill can be attached only to a business which is earning
above normal profits or super profits. If there are no anticipated excess earnings
over normal earnings, there can be no goodwill. Such excess profit is known as
super profit and it is difference between the average profit earned by the business
and the normal profit based on the normal rate of return. For ascertaining the
super profits the following information will be required.
(i) The estimated average future profits of the firm.
(ii) The normal rate of return on investment and
(iii) The fair value of average capital employed in the business.
These essentials are depicted in following figure. 8.1
Capital
Employed
1
Average
maintainable
profit
138 Advanced Accounting - II
3
Esentials
of
Superprofit
Method
2
Normal Rate
of
Return
Fig. 8.1 Essential of super profit method.
Valuation of Goodwill Super Profit Method
Formulae :
Total Profit Less Loss, if any
(i) Average Profit
=
Number of years
(ii) Normal Profit = Capital Employed x Normal Rate of Returns
NOTES
(iii) Super Profit = Average Profit - Normal Profit.
(iv) Valuation of Goodwill = Super Profit x Number of years purchase.
8.3
Accounting Treatment
Normal Rate of Return : The normal rate of return refers to the rate of
earning which investors in general expect on their investments in a particular type
of industry. It varies depending upon general factors like the bank rate, general
economic conditions, political stability, etc. and specific factors like period
investment, risk attached to the investment, etc.
Average Capital Employed : The average capital employed in the business
may be ascertained in the following ways:
(i) Asset Side Approach and
(ii) Liabilities side Approach.
(i)
Asset Side Approach :
Assets (other than non-trading assets, goodwill and past
expenses and losses) at market value, at the Balance Sheet
date.
Less :Liabilities to outsiders at revised values, if any
xxx
(-)
Average Capital employed for the year.
(ii)
xxx
xxx
Liabilities Side Approach :
Add : •
Equity Share Capital
xxx
•
Preference Share Capital
xxx
•
Reserves and Surplus
xxx
•
Profit on revaluation of assets and labilities
(+)
xxx
* Losses and past expenses not yet written off
xxx
* Loss on revaluation
xxx (-)
xxx
Less : * Goodwill (Book Value)
xxx
Capital employed at the end of the year
Less : 1/2 of the profit
Average Capital employed for the year
xxx
(-)
xxx
xxx
Advanced Accounting - II
139
Valuation of Goodwill Super Profit Method
NOTES
In short, super profit is the excess of actual profit over the normal of an
enterprise. A common method of valuation of goodwill is the super-profit method.
A business unit may posses some advantages which enable it to make extra profits
over and above the amount that would be earned it the capital of the business was
invested elsewhere with similar risks. These extra profits, generally expressed as
super profit, can be valued, and goodwill is the value of the few years’ purchase
of super profit.
8.4
Calculation of Average Profit, Super profit and
Goodwill
For calculating goodwill, the different steps are as follows :
Step 1:
Calculate capital employed (it is the total of shareholders equity plus
long-term debt or fixed assets plus net current assets).
Step 2:
Calculate normal return by multiplying capital employed with
normal rate of return.
Step 3:
Calculate average maintainable profit of the business.
Step 4:
Calculate the difference between the average maintainable profit
and normal return as calculated above.This difference is called
super profit (if it is positive).
Step 5:
Multiply that super profit by the number of years’ purchase. The
product is the value of the goodwill.
EXAMPLE
The following particulars are available in respect of the business of Colgate
and Co., Cochin.
(i)
Capital employed - ` 50,000.
(ii)
Trading profit (after tax) :
2009 - ` 10,000;
2010 - ` 17,200;
2011 - ` 2,000 (Loss); and
2012 - ` 21,000
140 Advanced Accounting - II
(iii)
Market rate of interest on investment - 8%.
(iv)
Rate of risk return on capital invested in business - 2%.
(v)
Remuneration from alternative employment of the proprietor (if not engaged
in business) amount to ` 3,600 p.a.
You are required to compute the value of goodwill on the basis of three
years purchase of super profit of the business calculated on the average profit of
the last four years.
Valuation of Goodwill Super Profit Method
ANSWER
(1)
Calculation of Average Profit :
Particulars
`
2009 - Profit
10,000
2010 - Profit
17,200
2011 - Loss
2,000
2012 - Profit
NOTES
(+) 21,000
Total Profit
46.200
Average Profit =
` 46,200
11,550
4 Years
(2)
Calculation of Super Profit :
`
Particulars
Average Profit
Less :
11,550
Remuneration from alternative employment
(-)
Average Trading Profit
Less :
Normal Profit @ 10% on ` 50,000
Super Profit
Goodwill
3,600
7,950
(-)
5,000
2,950
= 3 Years purchase of super profit
= ` 2,950 x 3
= ` 8,850
EXAMPLE
The net profit of Dorabjee and Co., Dombivali after providing for taxation
for the past five years as under:
2007 - 08 - ` 80,000; 2008-09 - ` 85,000; 2009-10 ` 92,000; 2010-11 ` 1,05,000 and 2011-12 - ` 1,18,000. The capital employed in the business is
` 8,00,000. The normal rate of return expected in this type of industry in 10%. It
is expected that the company will be able to maintain its super profit for the next
5 years.
Calculate the value of goodwill on the five years’ purchase of super profit
method.
Advanced Accounting - II
141
Valuation of Goodwill Super Profit Method
ANSWER
(1)
Calculation of Average Profit and Super Profit:
Average Profit =
Total Profits
Number of Years
NOTES
`
Profit for 5 Years,
(` 80,000 + ` 85,000 + ` 92,000 + ` 1,05,000 + ` 1,18,000)
4,80,000
Average Profit (` 4,80,000/5)
96,000
Less : Normal Profit (` 8,00,000 x 10/100)
(-) 80,000
Super Profit
2)
16,000
Calculation of Goodwill as per Purchase of Super Profit Method:
Goodwill
8.5
Check Your Progress
1 . What is ‘Super Profit’ ?
2 . Explain the essentials of
Super Profit Mehtod of
valuation of Goodwill.
3 . What is ‘Normal Rate of
Return’ ?
4 . Define the term ‘SlidingScale Valuation of Profit’.
=
Super Profit x 5 Years
=
` 16,000 x 5
=
` 80,000
Sliding -Scale Valuation of Super Profit
This method of valuation of goodwill is a slight variation of the purchase of
super profit method. It has been advocated by AE. Cutforth. It is based on the
logic that the greater is the amount of super profits, the more difficult it is to
maintain it. Higher profit will naturally attract competition and soon the firm’s
ability to make super profit is curtailed. Hence, instead of multiplying the whole
super profit by a certain number of years, a grading scale is adopted. According to
Culforth , super profit is divided into two or three divisions. Each of these be
multiplied by a different number of year’s purchase, in desceding order from the
first division. Thus, for example, if super profit is estimated at ` 15,000, the goodwill
will be calculated as under:
First ` 5,000 at, say, 5 years purchase
` 25,000
Second ` 5,000 at, say 4 Years purchase
` 20,000
Third ` 5,000 at, say 3 Years purchase
` 15,000
Total value of goodwill
` 60,000
The super profit method of valuation of goodwill can be understood with
the help of following illustrations.
142 Advanced Accounting - II
Valuation of Goodwill Super Profit Method
ILLUSTRATION 1
Indian Chemicals Ltd., Indore has earned profits in the last four years as
under:
Year
Profit
`
2011
9,200
2012
12,300
2013
14,700
2014
15,800
NOTES
Investments made in the firm is ` 90,000. Other firms carrying on similar
business give a return @ 10% of the investment made in them.
It is decided to value the Goodwill of the firm on super profit basis using
five years’ purchase of the average super profit method.
Calculate the amount of Goodwill of the firm.
SOLUTION
(1)
Calculation of Average profits:
Year
Profit
`
2011
9,200
2012
12,300
2013
14,700
2014
(+) 15,800
 Total Profit
52,000
Total profit
Average Profit
=
Number of Years
` 52,000
=
4 Years
= ` 13,000
(2)
Calculation of Normal Profit :
Normal profit is 10% of the investments made.
Normal Profit
= ` 90,000 x 10%
= ` 9,000
Advanced Accounting - II
143
Valuation of Goodwill Super Profit Method
(3)
Calculation of Super Profit :
Super Profit
= Average Profit - Normal Profit
= ` 13,000 - ` 9,000
= ` 4,000
NOTES
(4)
Calculation of Goodwill according to five years’ purchase of super
profit method :
Goodwill
= Super Profit x Number of Years purchase
= ` 4,000 x 5 Years
= ` 20,000
Hence, Goodwill of the company is to be valued at ` 20,000.
ILLUSTRATION 2
M/s Jindal and Sons. Jamner have earned the following amount of profits in
the last five years.
Year
Profit
`
2010
25,300
2011
28,560
2012
26,200
2013
29,440
2014
35,500
Investment made in the firm amounts to ` 1,20,000. Other firms carrying
on similar business give return at 15% on the investment made in them.
Calculate the Goodwill of the firm on super profit basis using four years’
purchase of the Super Profit Method.
SOLUTION
(1)
Calculation of Average profits:
Year
Profit
`
2010
25,300
2011
28,560
2012
26,200
2013
29,440
2014
144 Advanced Accounting - II
 Total Profit
(+)
35,500
1,45,000
Valuation of Goodwill Super Profit Method
Total profit
Average Profit
=
Number of Years
` 1,45,000
=
5 Years
NOTES
= ` 29,000
(2)
Calculation of Normal Profit :
Normal profit is 15% of the investments made.
Normal Profit
= ` 1,20,000 x 15%
= ` 18,000
(3)
Calculation of Super Profit :
Super Profit
= Average Profit - Normal Profit
= ` 29,000 - ` 18,000
= ` 11,000
(4)
Calculation of Goodwill according to four years’ purchase of super
profit method.
Goodwill
= Super Profit x Number of Years purchase
= ` 11,000 x 5 Years
= ` 55,000
Hence, Goodwill of the firm is to be valued at ` 55,000.
ILLUSTRATION 3
M/s Kirloskar Bros., Kalyan have earned the profits in the last four years
as under.
Year
Profit/Loss
`
2011
7,000 (Loss)
2012
32,000
2013
36,000
2014
47,000
Investment made in M/s Kirloskar Bros., ` 1,20,000. Other firm carrying
on similar business give return at 18% on the amount of investment made in them.
You are required to calculate the Goodwill M/s Kirlsokar Bros. using three
years’ purchase of the Super Profit Method.
Advanced Accounting - II
145
Valuation of Goodwill Super Profit Method
SOLUTION
(1)
Calculation of Average profits:
Year
Profit/Loss
`
NOTES
2011
7,000 (Loss)
2012
32,000
2013
36,000
2014
(+) 47,000
Total Profit
1,08,000
Total profit
Average Profit
=
Number of Years
` 1,08,000
=
4 Years
= `27,000
(2)
Calculation of Normal Profit :
Normal Profit
= Normal profit is 18% of the
investments made.
= ` 1,20,000 x 18%
= ` 21,600
(3)
Calculation of Super Profit :
Average Super Profit
= Average Profit - Normal Profit
= ` 27,000 - ` 21,600
= ` 5,400
(4)
Calculation of Goodwill according to three years’ purchase of Super
Profit Method :
Goodwill
= Super Profit x Number of Years purchase
= ` 5,400 x 3 Years
= ` 16,200
Hence, Goodwill of the firm is to be valued at ` 16,200.
146 Advanced Accounting - II
Valuation of Goodwill Super Profit Method
ILLUSTRATION 4
M/s Larson and Co., Lasagaon have earned following amount the profits in
the last five years.
2010 - ` 38,750;
2011 - ` 41,900;
2013 - ` 39,020;
2014 - ` 44,050.
2012 - ` 36,280;
NOTES
Investment made in Larson and Co. amount to ` 3,25,000.
Other firms doing similar business earn a return of 10% on their investments.
Calculate the Goodwill of M/s Larson and Co. on super profit using four
years’ purchase of the Super Profit Method.
SOLUTION
(1)
Calculation of Average profits:
Year
Profit
`
2010
38,750
2011
41,900
2012
36,280
2013
39,020
2014
(+)
 Total Profit
44,050
2,00,000
Total profit
Average Profit
=
Number of Years
` 2,00,000
=
5 Years
= `40,000
(2)
Calculation of Normal Profit :
Normal profit is 10% of the investments made.
Normal Profit
= ` 3,25,000 x 10%
= ` 32,500
(3)
Calculation of Super Profit :
Super Profit
= Average Profit - Normal Profit
= ` 40,000 - ` 32,500
= ` 7,500
Advanced Accounting - II
147
Valuation of Goodwill Super Profit Method
(4)
Calculation of Goodwill according to four years’ purchase of Super
Profit :
Goodwill
= Super Profit x Number of Years purchase
= ` 7,500 x 4 Years
NOTES
= `30,000
Hence, Goodwill of the firm is to be valued at ` 30,000.
ILLUSTRATION 5
M/s Manik - Moti and Co., Malegaon, a partnership firm in which ` 60,000
are invested has earned ` 14,200; ` 18,400 and ` 16,300 ad profits in the last
three years. Other firms doing similar firms earn 16% returns on the amount
invested in them.
Reference to Annuity Table shown that the annuity of ` 1 for 3 years @
16% is 2.246.
You are required to calculate Goodwill of the firm on super profit using two
years’ purchase of the Super Profit Method.
SOLUTION
(1)
Calculation of Average profits:
Year
Profit
`
1st Year
14,200
2st Year
18,400
3st Year
(+) 16,300
Total Profit
48,900
Total profit
Average Profit
=
Number of Years
` 48,900
=
3 Years
= `16,300
(2)
Calculation of Normal Profit :
Normal profit is 16% of the investments made.
Normal profit
= ` 60,000 x 16%
= ` 9,600
148 Advanced Accounting - II
(3)
Calculation of Super Profit :
Super Profit
Valuation of Goodwill Super Profit Method
= Average Profit - Normal Profit
= ` 16,300 - ` 9,600
= ` 6,700
(4)
Calculation of Goodwill according to two years’ purchase of Super
Profit Method :
Goodwill
NOTES
= Super Profit x Number of Years purchase
= ` 6,700 x 2 Years
= ` 13,400
Hence, Goodwill of the firm is to be valued at `13,400.
8.7
•
Summary
A common method of valuation of goodwill is the “Super Profit Method”.
Under this method, super profits is taken as the basis for calculating goodwill
is place of average profit. For ascertaining the super profit the following
informations in will be required.
(i)
The estimated average future profit.
(ii) The Normal rate of return on investment &
(iii) The fair value of average capital employed in the business.
•
For calculating goodwill as per super profit method following steps are
follows (1) Calculate capital employed.
(2) Calculate normal rate of return.
(3) Calculate average maintainable profit.
(4) Calculate difference between the average maintainable profit & normal
return. This differences called “ Super Profit”.
(5) Multiply the super profit by number of years purchase. The product is
the value of the goodwill.
•
Sliding Scale Valuation of Super Profit - It has been advocates by AE Cutforth.
It is bused on the logic that the grater is the amount of super profits, the
more difficult it is to maintain it. Here, super profit is divided in to two or
three division.
Advanced Accounting - II
149
Valuation of Goodwill Super Profit Method
8.8
Key Terms
(1) Capital Employed :
NOTES
At the time of calculating the goodwill of a firm, It is very important to
ascertain the value of Capital employed, since the profit of a firm can be justified
in terms of capital employed only. Capital employed may be computed with the
help of the following :
Capital Employed = Fixed assets (at revalued figure but excluding non-trading
assets, like investment) + Current Assets(at market value)
- Current Liabilities.
Alternatively, Capital Employed = Fixed Assets + Working Capital.
OR
Capital Employed = Share Capital + Reserve and Surplus + Long-term Debts Preliminary Expenses, Discount on issue of Shares and
Debentures.
Capital Employed may be divided into :
(a) Gross Capital Employed
= Total Fixed Assets + Total Current Assets.
(b) Net Capital Employed
= Total Fixed Assets + Total Current Assets Total Current Liabilities (stated above).
(c) Proprietor’s Capital Employed = Total Fixed Assets + Total Current Assets External Liabilities.
(Note : Usually, the term “Capital Employed” indicates Net Capital employed.)
(2) Average Capital Employed :
It is the modified version of capital employed. Average capital employed
may be computed by adding the closing capital employed with the opening capital
employed and dividing the same by two:
Opening Capital Employed + Closing Capital Employed
Average Capital Employed =
2
Alternatively : Average Capital Employed = Capital Employed - 1/2 Current Year’s
Profit.
(3) Normal Rate of Return or Standard Rate of Return :
150 Advanced Accounting - II
Valuation of goodwill is greatly affected by the rate of earning which is
expected by the investors from their investments - since normal level of profit is
ascertained from the above expectation of the said investors. The return which
satisfies a general investor on his investment in business or industry is said to be
the Normal Rate of Return. It is also known as Average Rate of Return. Normal
Rate of Earnings, Yeild, Reasonable Rate of Return, Rate of General Expectations,
Standard Rate of Return etc.
8.9
Questions and Exercises
Valuation of Goodwill Super Profit Method
I - Objective Questions
(A)
Multiple Choice Questions
(1)
The difference between the average profit earned and the normal profit
based on the normal rate of return is termed as-----.
NOTES
(a) super profit
(b) capital profit
(c) revenue profit
(d) maintainable profit
(2)
The rate of earnings which investors in general expect on their investments
in a particular type of industry is termed as ----- rate of return.
(a) average
(b) normal
(c) general
(d) super
(3)
Sliding scale valuation of super profit method of valuation of goodwill has
been advocated by -----(a) Spicer
(b) Dicksee
(c) Cutforth
(d) Wilson
(4)
Capital Employed during the year = opening capital (+) 1/2 of ------ profit.
(a) Capital
(b) revenue
(c) super
(d) annual
Ans. : (1-a), (2-b), (3-c), (4-d)
II - Long Answer Questions
(1)
What is ‘super profit’? state the essentials of super profit method of valuation
of goodwill.
Advanced Accounting - II
151
Valuation of Goodwill Super Profit Method
(2)
Explain and illustrate the super profit method of valuation of goodwill.
(3)
Define the term ‘Super Profit’, Explain the concepts of average profit and
normal profit in the computation of super profit.
(4)
Explain in brief ‘sliding scale valuation of super profit’ method of valuation
of goodwill.
(5)
What is ‘super profit’? state the advantages and limitations of super profit
method of valuation of goodwill.
NOTES
III - Practical Problems
(1)
The following is the Balance sheet of Rakesh and Yogesh as on 31st March
2012
Balance Sheet as on 31-3-2012
`
Liabilities
Capitals:
Assets
Machinery
`
50,000
• Rakesh
90,000 Buildings
41,000
• Yogesh
70,000 Furniture
10,000
General Reserve
44,000 Investments
30,000
Sundry Creditors
30,000 Stock
10,000
Bills Payable
8,000 Sundry Debtors
Cash at Bank
2,42,000
66,000
35,000
2,42,000
The net profit of the firm for last few years were as follows:
Year
Profit
`
2008-09
15,000
2009-10
25,000
2010-11
26,000
Ascertain the value of Goodwill at two years purchase of the super profit
for 3 years, taking the normal rate of return on capital employed as 10%.
(2)
The present average net profit of M/s Pradip and Sudip before deducting
partners remuneration is ` 27,000 p.a. The capital employed in the business
by the partners were.
Pradip ` 1,00,000 and Sudip ` 50,000. The profit expected from the
total capital invested is 10% p.a. The total remuneration of the partners is
estimated to be ` 6,000 p.a. Find out the value of Goodwill on the basis of
two years purchases of super profits.
(3)
152 Advanced Accounting - II
Calculate the value of Goodwill of M/s Pratik and Co.,Pune from the following
information :
(a) Total capital employed in the business ` 4,00,000.
Valuation of Goodwill Super Profit Method
(b) Net profit of the firm for the three years were :
Year
Profit
`
2010
53,800
2011
43,350
2012
56,250
NOTES
(c) Normal rate of return at 10%.
(d) Goodwill is to be valued at three years purchase of super profit.
(4)
M/s Deshpande and Sons, Dapoli have earned following amount of profits
in the last 4 years :
2009 - ` 15,450;
2010 - ` 18,600;
2011 - `22,250;
2012 - ` 23,700.
Investments made in the firm is ` 1,60,000.
Other firms carrying on similar business earned 10% return on their
investments.
Calculate Goodwill of the firm according to two years’’ purchase of the
super profit method.
(5)
M/s Jay and Parajay, Jalgaon has given you the result of its working for last
5 years as under :
2008 - ` 19,050
2011 - ` 22,200
profit, 2009 - ` 4,800 loss, 2010 - ` 18,750 profit,
profit, 2012 - ` 25,200 profit.
Investments made in the firm is ` 75,000. Other firms engaged in similar
business show earnings @ 14% on amount invested in them.
Calculate the amount of Goodwill of the firm using three years’ purchase of
the super profit method.
(6)
Calculate the amount of Goodwill of M/s Ravi-shankar bros, Ranjangaon,
from the following details provided to you :
(1) Profit earned by the firm in the firm in the last 3 years :
2010 - ` 48,900 ; 2011 - ` 56,400 ; 2012 - ` 44,700.
(2) Investment ,made in the firm amounted to ` 2,25,000.
(3) Rate of earnings of other firms carrying similar business is 20% on
investment.
Goodwill to be calculated by using two years purchase of the super profit
method.
Advanced Accounting - II
153
Valuation of Goodwill Super Profit Method
(7)
M/s Pannalal and Keshavalal, Panchgani have earned profits and losses in
the last 5 years as follows :
Year
Profit /Loss
`
NOTES
2008
40,820
Profit
2009
44,150
Profit
2010
6,300
Loss
2011
32,700
Profit
2012
38,130
Profit
Investments made in the firm is ` 1,50,000. Other firms carrying similar
business earn 15% profit on the amount invested in them.
Calculate Goodwill of M/s Pannalal & Keshavlal using three years purchase
of the super profit method.
(8)
M/s Bhave, Surve and Co., Badalapur earned profits in the last 4 years as
under :
2009 - ` 52,390; 2010 - ` 64,830; 2011 - ` 78,080;
2012 - ` 72,600.
Investments made in the firm is ` 5,00,000. Other firms carrying on
similar business earn profit @ 10% on their investment.
You are requested to calculate Goodwill of the firm using three years
purchase of the super profit method.
8.10 Further Reading
154 Advanced Accounting - II
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd. - 2013.
•
Bapat Varadraj and Raithatha Mehul - Financial Accounting : An Managerial
Prospective - New Delhi - Tata Mc Graw Hill Education Pvt. Ltd. - 2012.
Unit 9
Valuation of Goodwill - Capitalisation
and Annuity Methods
Valuation of Goodwill Capitalisation & Annuity
Method
Structure
NOTES
9.0
Introduction
9.1
Unit Objectives
9.2
Capitalisation of Profit method
9.3
Annuity Method
9.4
Illustrations
9.5
Summary
9.6
Key Terms
9.7
Questions and Exercises
9.8
Further Reading
9.0
Introduction
Goodwill arise only if a firm earns extra profits, which is called super profits.
There are two factors relates to valuation of goodwill; (i) When one buys a business,
he will be able to get profits in future only and is not concerned with the past
profits at all. (ii) Goodwill is paid for the ability to earn super profits and not for
ordinary profits. Goodwill is the value of reputation of a firm in respect of profits
expected in future over and above the normal profits The value of goodwill depends
upon such factors as nature of the business, reputation if the firm, location of the
business, pleasing sevice, superior quality of its product managerial efficiency etc.
The excess over the normal profit, called super profit, is the tangible factor of
goodwill. In last Unit, we have discussed super profit Method. In this unit we are
going to learn the another inportant methods of valuation of goodwill i.e.
capitalisation method and Annunity Method. In the capitalisation of profit method,
the total value of the business is found out by capitalising the expected profits on
the basis of normal rate of return. The value of goodwill is the difference between
the value of the business so foundout and the actual capital employes in the business.
On the other work, Annuity method is bused an the logic that the purchaser should
pay for goodwill only the present value of super profits calculated at a proper rate
of interest. It means, goodwill in case of annuity method is the discounted value of
the total amount calculated as per purchase of super profit method.
Advanced Accounting - II
155
Valuation of Goodwill Capitalisation & Annuity
Method
9.1
Unit Objectives
After studying this unit you should be able to :-
NOTES
•
Understand the meaning of capitilisation of profit method.
•
Ascertain value of goodwill as per capitalisation of super profit method.
•
Calculate value of goodwill as per capitalisation of Average profit method.
•
Understand the meaning and process of Annuity Method.
•
Calculate value of goodwill as per annuity method.
9.2
Capitilisation of Profit Method
In this method the total value of the business house is found out by capitalising
the expected average profits on the basis of normal rate of return. As per this
method, the value of goodwill is the difference between the value of the business
so found out and the actual capital employed in the business. The Capitatisation of
Profit Method is further classified in to : (a) Capitalisation of Super profit and (b)
Capitalisation of Average profit as shown below in figure 9.1
Capitalisation of
Super Profit
Method
Capitalisation
of
Profit
Method
Capitalisation of
Average Profit
Method
Fig. 9.1 : Classification of Capitatisation of Profit Method.
(a) Capitalisation of Super Profit
Under this method, it is estimated as to how much capital will be required to
earn super profit at normal rate of profit. This capitalised value of super profit is
treated as goodwill.
(b) Capitalisation of Average Profit
Under this method, the average annual profit is to be ascertained after
providing for reasonable management remuneration. This profit should be capitalised
at the rate of reasonable return to find out the total value of the business. Now the
value of goodwill will be the total value of the business minus its net assets. If,
however the net asset is greater, there will be no goodwill but badwill.
PROFIT (ADJUSTED)
CAPITALISED VALUE OF PROFIT
=
X 100
NORMAL RATE OF RETURN
156 Advanced Accounting - II
VALUE OF GOODWILL = CAPITALISED VALUE OF PROFIT LESS NET TANGIBLE
ASSETS
Under the Capitalisation method the average profit is capitalised in the basis of
normal rate of return and than excess of this capitalised amount over the net
assets of the firm is goodwill.
Valuation of Goodwill Capitalisation & Annuity
Method
Average Profit x 100
Goodwill
=
- Net Asset
Percentage of normal return
EXAMPLE
NOTES
The average profit if a firm is ` 9,000. The firm’s is ` 60,000 and
the normal return on business is expected at 10%. Calculate the
goodwill amount as per capitalisation method.
Average profit x 100
ANSWER
Goodwill
=
percentage of normal returns
- Net Assets.
(9,000 x 100 )
=
- ` 60,000
10
= 90,000 - 60,000
= ` 30,000
Alternatively : Super profit = ` 9,000 - 6,000 = ` 3,000
= Normal Return 10%
Capital value = 3,000/10% = 3,000 x 100/10 = ` 30,000
EXAMPLE
The net profits of a Company, after providing for taxation. for the past five
years are ` 42,000; ` 47,000; ` 45,000; ` 39,000 and ` 47,000. The capital
employed in the business is ` 4,00,000 on which a reasonable rate of return of
10% is expected, Calculate the goodwill under (a) Capitalisation of Average Profit
Method and (b) Capitalisation of Super Profit Method.
SOLUTION
(a) Average Profit
=
Total profits of 5 years
5
=
` 42,000 + 47,000 + 45,000 + 39,000 + 47,000
5
=
` 2,20,000
= ` 44,000
5
Advanced Accounting - II
157
Valuation of Goodwill Capitalisation & Annuity
Method
Capitalised value of the business at 10% = ` 44,000 x 100 = ` 4,40,000
10
Less : Capital employed (given)
4,00,000
Value of goodwill :
40,000
NOTES
(b) Average Profit (as above )
44,000
Less : Normal return on capital employed
(at 10% on ` 4,00,000)
40,000
Super Profit
4,000
The normal rate of return is 10%.
Hence Capital Value
= ` 4,000
10%
= ` 4,000 x 100
10
= ` 40,000
9.3
Annuity Method
Annuity Method of super profit is bused on the logic that the purchaser
should pay for goodwill only the resent value of super profits calculated at a
proper rate of interest. Under this method goodwill is the discounted value of the
total amount calculated as per purchase of super profit method.
The value of goodwill as per this method is calculated as follows Average Annual Super Profit x Annuity Rate
EXAMPLE
In ABC firm, average annual super profit ` 5,000, rate of Interest 10%.
Supposed, goodwill is to be valued at 3 years, purchase of the average annual
super profit reference will have to be made to the annuity table for finding out the
present -value of one rupee paid annually for 3 years at 10% interest. Annuity
table shows the ` 2.48685 is the present-value of an annuity of ` 1 for three
years.
ANSWER
The Value of Goodwill = ` 5,000 x 2,48685 = ` 12434 or
(say ) ` 12500.
158 Advanced Accounting - II
Formula of Annuity Method :
Under this method, Super - Profit(excess of actual profit over normal profit)
is being considered as the value of annuity over a certain number of years and, for
this purpose, compound interest is calculated at a certain respective percentage.
The present value of the said annuity will be the value of goodwill.
Value of Goodwill, V
=
a
i
(1 -
Valuation of Goodwill Capitalisation & Annuity
Method
NOTES
1
)
(1 + i)n
Check Your Progress
Where,
V
=
Present value of Annuity
a
=
Annual Super Profit
n
=
Number of Years
i
=
Rate of Interest
1 . Explain
the
term
‘Capitalisation of Profit.’
2 . Differentiate between
capitalisation of average
profit and capitalisation
of super profit.
EXAMPLE
From the following particulars, compute the value of Goodwill under ‘Annuity
Method’ :
` 10,000
Super - Profit
Number of years over which Super-profit is to be paid
Rate percent per annum
5
5%
ANSWER
V =
a
i
(1 -
1
)
(1 + i)n
Or, V = ` 10,000
(1 05
1
)
(1 +0.5)n
Where,
a = ` 10,000
1 = 5%, or .05
n = 5.
Or, V = ` 43,260 or, say, ` 43,300
The capitalisation of profit method and Annuity Method of valuation of
goodwill can be understood with the help of following illustrations.
Advanced Accounting - II
159
Valuation of Goodwill Capitalisation & Annuity
Method
9.4
Illustrations
ILLUSTATION 1
NOTES
Prestige Ltd., Pune are selling their business to Howking Ltd., Haridwar.
The net profits of prestage Ltd., Pune after providing for taxation. For the past
five years are as follows.
Year
Profits
`
2010
1,80,000
2011
2,05,000
2012
1,90,000
2013
1,95,000
2014
2,30,000
The value of the net tangible assets of the business at the proposed date of
sale amounted to ` 20,50,000 and a reasonable rate of return of 8% is expected
on capital invested.
Calculate the value of Goodwill as per capitalisation of Average profit Method
and capitalisation of super profit method.
SOLUTION
1) Calculation of Average Profits :Year
Profits
`

2010
1,80,000
2011
2,05,000
2012
1,90,000
2013
1,95,000
2014
2,30,000
Total Profit
10,00,000
Total Profits
Average profit
=
Number of years
` 10,00,000
=
5 Years
= ` 2,00,000
160 Advanced Accounting - II
Valuation of Goodwill Capitalisation & Annuity
Method
(2) Calculation of Capitalised value of Profit :
Capitalised value
of Profit
Adjusted profit
x 100
=
Normal Rate of Return
= ` 2,00,000 x 100
NOTES
8
= ` 25,00,000
(3) Calculation of the value of Goodwill as per capitalisation of Average
Profit Method :`
Capitalised value of profit
25,00,000
Less : net tangible Assets

(-) 20,50,000
Value of Goodwill
4,50,000
Hence the Goodwill of the Company is to be valued at ` 4,50,000
`
1) Calculation of super profit :Average profit
2,00,000
Less Normal Return on capital Employed
( 8% on ` 20,50,000)
(-) 1,64,000
Super profit
36,000
2) Calculation of the value of Goodwill as per capitalisation of Super Profit
Method :Capitalised Value
of Super Profit
Super Profit
=
Rate of Return
=
` 36,000
8%
= ` 36,000 x
100
8
= ` 4,50,000
Hence, Goodwill of the Company is to be valued at ` 4,50,000
Advanced Accounting - II
161
Valuation of Goodwill Capitalisation & Annuity
Method
ILLUSTRATION 2
Rotex and Co. decides to purchase the business of Bata and Co. as on 31st
December, 2014. The profits of Bata and Co. for the last five years as follows.
Year
Profit
NOTES
`
2010
15,900
2011
17,800
2012
18,200
2013
16,800
2014
21,300
The value of the net tangible assets of Bata and Co. as on the date of sale
amounted to ` 1,50,000 on which the normal rate of return is expected to be 8%.
Calculate the value of Goodwill of the business of Bata and co. as per
Annuity Method taking the present value of annuity of one rupee for five years @
8% interest as ` 2.45.
SOLUTION
1) Calculation of Average Profit
Year
Profit
`
2010
15,900
2011
17,800
2012
18,200
2013
16,800
2014
21,300
 Total Profit
90,000
Total Profits
Average Profit
=
Number of years
` 90,000
=
5 Years
= `18,000
162 Advanced Accounting - II
`
(2) Calculation of Super Profit :
Average Profit
18,000
Valuation of Goodwill Capitalisation & Annuity
Method
Less: Normal Return on Net
Tangible Assets (8% on ` 1,50,000)

(-) 12,000
Super Profit
6,000
NOTES
(3) Calculation of the value of Goodwill as per Annuity Method :if ` 1 Annuity
= ` 2.45 present value
` 6,000
= ?
= ` 6,000 x ` 2.45
1
= ` 14,700 .
Hence, Goodwill of the firm is to be valued of ` 14,700
9.5
•
Summary
Capitalisation Method :- The average profit is capital on the basis of
normal rate of return and the excess of this capitalises amount over the net
assets of the firms is goodwill.
Goodwill
=
Average profit x 100
Percentage of normal return
- net Assets.
•
The capitalisation of profit method of valuation of Goodwill is further classify
in to : (a) capitalisation of super Profit & (b) Capitalisation of Average
Profit Method.
•
Under Annuity method of Super Profit goodwill is the discounted value of
the total amount calculates as per purchase of super profit method.
Goodwill = Average Annual Super Profit x Annuity Rate
Advanced Accounting - II
163
Valuation of Goodwill Capitalisation & Annuity
Method
9.8
Key - Terms
(1) Under capitalisation Method :Goodwill
=
NOTES
Average profit x 100
- net Assets.
Percentage of normal return
(2) Annuity Method :-Goodwill = Average Super Profit x Annuity Rate
(3) Formula of Annuity Method = Value of goodwill = a
i
Where
(1 -
1
)
(1 + i)n
v = Present Value of Annuity
a = Annual Super Profit
n = Number of years
i = Rate of Interest
9.9
Questions and Exercises
I - Objective Questions
(A) Multiple Choice Questions
(1)
According to lord Linaley -------------- is the profit earned due to relations
and reputations.
(a) Goodwill
(b) Creditworthyness
(c) Prestige
(d) Value of Confidence
(2)
The time value of money is considered basically under ------------ of valuation
of Goodwill.
(a) Average Profit Method
(b) Annuity Method
(c) Super Profit Method
(d) capitalisation Method
(3)
While calculating the value of Goodwill under --------- method, average
capital investment is subtracted from the capitalised value of business.
(a) Annuity method
(b) Super Profit Method
164 Advanced Accounting - II
Valuation of Goodwill Capitalisation & Annuity
Method
(c) Capitalisation Method
(d) Average Profit Method
(4)
Goodwill, in case of professionals like cost are accountants chartered
accountants is usually valued on the basis of ------------- years purchase of
fees earned.
NOTES
(a) two
(b) three
(c) four
(d) one
Ans: (1-a), (2 - b), ( 3 - c), ( 4 - d)
II - Long Answer Questions
(1)
What is ‘Capitalisation of Profit’? State the advantages and limitation of
capitalisation of Average profit method of valuation of Goodwill.
(2)
Explain the term ‘Capitalisation of Profit’ State the advantages and limitations
of capitalisation of super profit method of valuation of Goodwill.
(3)
Differentiate clearly between capitalisation of Average profit method and
capitalisation of super profit method.
(4)
Explain the advantages and limitations of Annuity method of valuation of
Goodwill.
III - Practical Problems
(1) Bosco Enterprises provides the following accounting information four years
ended on 31st December, 2014.
Year
Profit
`
2011
10,200
2012
13,700
2013
14,400
2014
9,700
The firm has average capital investment of ` 50,000. The rate of return on
investment is 15% calculate the value of Goodwill as per capitalisation of Average
profit Method and capitalisation of super profit method
Advanced Accounting - II
165
Valuation of Goodwill Capitalisation & Annuity
Method
(2) Chirag and co. provides the annual results of their trading business carried out
for last four years ended on 31st December, 2014.
Year
Profit
`
NOTES
2011
36,900
2012
48,100
2013
59,200
2014
63,800
The normal rate of on investment is 10% p.a. The firm has average capital
investment of ` 3,00,000. The present value of an annuity of one rupee for four
years @ 10% is ` 3.78.
You are required to calculate the value of Goodwill of the business of chirag
and co. as per Annuity Method
9.8
166 Advanced Accounting - II
Further Reading
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd. - 2013.
•
Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - New
Delhi - Taxmann publications Pvt. Ltd. - 2012.
UNIT 10 Valuation of Shares - Need, Methods
of Valuation of Shares
Valuation of Shares Need, Methods of
Valuation of Shares
Structure
NOTES
10.0 Introduction
10.1 Unit Objectives
10.2 Valuation of shares
10.2.1 Factors Affecting the value of shares
10.2.2 Need for valuation of Shares
10.3 Methods of Valuation of Shares
10.3.1 Asset - Backing Method
10.3.2 Yield-Basis Method
(i) On Profit Basis
(ii) On Dividend Basis
10.4 Illustrations
10.5 Summary
10.6 Key Terms
10.7 Questions and Exercises
10.8 Further Reading
10.0 Introduction
Generally shares quotes on a recognised stock exchange prices are taken
as the basis for the valuation of those shares. However, the stock exchange
quotation are not acceptable when a large block of company’s shares is involved.
Actually the exchange price it determines on the interactions of demand and supply
of business cycles. In this regard, the council of the London stock exchange has
also passed the following remark.
“The stock exchange may be linked to a scientific recording instrument
which registers, not its own actions and opinions but the actions and opinions of
private institutional investors all over the country and indeed the world. These
actions and opinions are result of fear, guess work, intelligent or otherwise, good
or bad investment policy and many other considerations. The quotations that result
definitely do not represent valuation of a company by reference to its assets and
its earning potential”.
Advanced Accounting - II
167
Valuation of Shares Need, Methods of
Valuation of Shares
NOTES
In practice stock exchange quotations are not form a fair and equitable or
rational basis for compensation. Therefore accountants of business houses are
frequently required to place a proper value on the shares in a company.
The shares of joint stock company quoted on the stock exchange have a
value different from the face value. The shares of private companies are not
freely purchased and sold to the public. Only the share of public limited companies
are freely transferable and hence their valuation is absolutely necessary. In this
unit we will also discuss some important methods for valuation of shares.
10.1 Unit Objectives
After studying this unit you should be able to:
•
Understand factors affecting the value of shares.
•
Explain in need for valuation of shares.
•
Discuss various methods of valuation of shares.
•
Explain Asset Backing Method of valuation of shares.
•
Understand Yield Basis Method of valuation of shares
•
Focus on profit Basis and Dividend Basis for calculation of yield.
10.2 Valuation of Shares
Share capital of a company is spilt up in to a large number of equal parts or
units each of part is called a “share”. e.g. the total capital of a company may
consist of `1,00,000 divided in to 10,00,000 share or parts of ` 10 each.
According to section 2(46) of the companies Act 1956,
“ Share” means a share in the share capital of a company and includes
stock except where a distraction between. stock and share is expressed or implied”.
A share is a fructional part of the : Capital of the company which forms the
basis of ownerships of certain rights and interests of a subscriber in the company.
A share is the interest of a shareholder in a definite portion of the capital. If
expressed proprietory relationship between the company and the shareholder.
Equity capital is a term which denoted the capital contributed by owners of
the company Different values are attached to equily share which are: (a) par
value (b) Book value (c) Market value and (d) Issue price. In fact, all these prices
does not ... represent the true value of intrinsic value of the share. Under the
circumstances, the valuation of share may be only necessary even if the same
are quoted in the stock-Exchange. Practical in the case of Amalgamation or
Absorption valuation of share is because necessary.
168 Advanced Accounting - II
While valuing the share an accountant has to depend upon the following
assumptions:
(i)
The purchaser of shares does not like to pay a higher price in comparison
with the reasonable or market price of the shares.
(ii)
The seller does not want to sell his shares due to his urgent need &
(iii)
Sufficient number of buyers and sellers of the shares are available in the
market.
10.2.1
Valuation of Shares Need, Methods of
Valuation of Shares
NOTES
Factors affecting the Value of Shares
The value of a share is greatly affected by the economic, political and
social factors such as:
(i)
The nature of the company’s business;
(ii)
The economic conditions of the country;
(iii)
Other political and economic factor (e.g., possibility of nationalisation, excise
duty on goods produced etc.);
(iv)
The demand and supply of shares;
(v)
Proportion of liabilities and capital;
(vi)
Rate of proposed dividend and past profit of the company;
(vii) Yield if other related shares of the Stock Exchange etc.
(viii) Dividend declared by company in the past,
(ix)
Net tangible asset of the company
(xi)
Restrictions on investment
(xii) Pease and security of company
(xii) Goodwill of the company
(xix) Capacity of Directors
(xx) Type of Management
10.2.2
Need for valuation of shares
The necessity for valuation of a share arises in the following circumstances:
(i)
For Estate Duty and Wealth Tax purpose;
(ii)
For Amalgamation and Absorption schemes;
(iii)
For Gift Tax purposes;
(iv)
For Nationalisation of companies compensation made to a company.
(v)
In case of trust finance or investment trust companies.
(vi)
For grunting loans on the basis of security of shares.
(vii) For discharge of debts and liabilities, in exceptional nature;
(viii) Purchasing shares for control;
(ix)
For selling shares of a shareholder to a purchaser (Which are not quoted in
the stock Exchange) ;
(x)
For the conversion of one class of share to another class.
Advanced Accounting - II
169
Valuation of Shares Need, Methods of
Valuation of Shares
10.3 Methods of Valuation of shares
The Methods of Valuation of Shares are shown in figure 10.1 as follows :
NOTES
Asset-backing Method; or
Asset-Basis Method; or
Intrinsic Value Method; or,
Real Value Basis Method; or,
Break-uo Value Method; or
Net Asset Method; or
Balance-sheet Method.
a
b
Methods
of
Valuation
of
shares
Yield-basis Method; or
Market Value Method; or,
Earning Capacity Method
Profit/Income Basis Method
c
Fair Value Method; or,
Average of Asset-Backing
and
Yield-basis Method
Fig. 10.1 : Methods of Valuation of Shares.
(a) Asset Baking Method; (b) Yield Basis Method, & (c) Fair Value Method
10.3.1
Asset-Backing Method
Since the valuation is made on the basis of the assets of the company, it is
known as Asset-Basis or Asset-Backing Method. At the same time, the shares
are valued on the basis of real internal value of the assets of the company and that
is why the method is also termed Intrinsic Value Method or Real Value Basis
Method. This method may be made either (i) on a going \ continuing concern
basis; and (ii) break-up value basis.
Here the emphasis is on the safety of investment as the investors always
need safety for their investments. Under this method, net assets of the company
are divided by the number of share to arrive at the net asset value of each share.
The following points may be borne in mind:
170 Advanced Accounting - II
(1)
The value of goodwill will be ascertained.
(2)
Fixed assets of the company, disclosed or undisclosed n Balance Sheet, are
taken at their realisable value.
(3)
Floating assets are to be taken at market value.
(4)
Remember to exclude fictitious assets, such as Preliminary Expenses,
Accumulated Losses etc.
(5)
Provision for depreciation, bad debts provision etc. must be considered.
(6)
Find out the external liabilities of the company payable to outsiders including
contingent liabilities.
Valuation of Shares Need, Methods of
Valuation of Shares
NOTES
Thus the value of net asset is;
Total of realisable value of assets - Total of external liabilities = Net Assets
(Intrinsic value of asset)
Total value of Equity shares = Net Assets - Preference share capital
Net Assets - Preference share capital
Value of one Equity share
=
Number of Equity shares
The following chart will make the above points clear :
Computation of Net Assets
`
Net Assets
Fixed Assets (Market Value)
xx
Investments (Market Value)
xx
Current Assets (Market Value)
xx
Goodwill, any (Market Value)
xx
xx
Less :
Current Liabilities
xx
Debentures
xx
Pref. Share Capital (with arrear Dividend)
xx
Net Assets /Funds available for Equity Shareholders
--xx
Funds available for equity shareholders
Intrinsic Value of each share =
Number if Equity shares
Alternatively Net Assets = Share Capital + Reserves and surplus - Miscellaneous Expenditure
+ Profit on Revaluation - Loss on Revaluation
Advanced Accounting - II
171
Valuation of Shares Need, Methods of
Valuation of Shares
EXAMPLE
From the following information compute the ‘Intrinsic Value’ of an Equity
share of Sumana Ltd.
Balance Sheet as at 31.03.2013
NOTES
`
Liabilities
`
Assets
1,000 Equity Share
Land and Buildings
40,000
of ` 100 each fully
Plant and Machinery
40,000
paid-up
1,00,000 Sundry Debtors
5,000
100, 6% Perference Share
Stock
20,000
of ` 100 each,
Cash at Bank
25,000
fully paid
10,000 Investment in
Reserves and Surplus
25,000 5% Govt. Securities
10,000
Cash in hand
10,000
10,000 Preliminary Expenses
10,000
5,000
100, 5%Debentures
of ` 100each
Sundry Creditors
1,55,000
1,55,000
(i)
Fair return on capital employed in this type of business is around 10% p.a..
(ii)
Goodwill is to be taken at 5 years’ purchase value of super profits.
(iii)
Average of the profits (after deduction of preliminary expenses) for the last
seven years is ` 19,000. Preliminary expenses to the extent of ` 1,000
has been written-off every year for the last seven years. Profit is more or
less stable over years and the same trend is expected to be maintained in
the near future. Ignore tax.
ANSWER
`
1) Computation of Goodwill :
Capital Employed:
40,000
Land and Building
40,000
Plant and Machinery
5,000
Sundry Debtors
Stock
20,000
25,000
Cash at Bank
10,000
Cash in Bank
10,000
1,40,000
Less : Liabilities
5% Debentures
10.000
Creditors
10.000
Capital Employed:
172 Advanced Accounting - II
Normal Profit ` 1,20,000 x
20,000
1,20,000
10
100
= ` 12,000
Super Profit
` 19,000
Average Profit
Less : Non-trading income
Valuation of Shares Need, Methods of
Valuation of Shares
500
Interest on Investment
@ 5% on ` 10,000
Super Profit
18,500
=
Average Profit - Normal Profit
=
` 18,500 - ` 12,000 = ` 6,500
NOTES
Value of Goodwill = ` 6,500 x 5 = ` 32,500
Computation of Intrinsic Value of Equity Share :
` 1,40,000
Total Assets (as above)
Add : Investment
10,000
Add : Goodwill
32,500
1,82,500
Less : Liabilities (as above)
20,000
1,62,500
Less : Preference Share Capital
10,000
Funds available to equity Shareholders:
 Intrinsic Value of Equity Share =
` 1,52,500
1,52,500
= ` 152.50
1,000 sh.
10.3.1
Utility Asset - Backing Method
(i)
This method highly applicable if liquidation takes place although the net
realisable value of the asset is to be taken into account. But the best method
is to prepare a statement of affairs supported by independent valuation of
different fixed assets after making proper provision for cost of liquidation.
(ii)
The permanent investors determine the value of share under this method at
the time of purchasing the share.
(iii)
The method is particularly applicable when the share are valued at the time
of Amalgamation. Absorption and Liquidation of companies; and
(iv)
This method is also applicable when shares are acquired for control motives.
10.3.2
Yield-Basis Method
Yield is the effective rate of return on investments which is invested by the
investors. It is always expressed in terms of percentage. Since the valuation of
shares is made on the basis if Yield, it is called Yield-Basis Method. For example,
an investor purchases one share of `100 each (face value and paid-up value) at
` 150 from a stock Exchange on which he receives a return(dividend)@ 30%. In
that case, yield of the said investor will be :
Advanced Accounting - II
173
Valuation of Shares Need, Methods of
Valuation of Shares
NOTES
Yield
=
30 x 100
=
20%
150
Practically, yield may also termed as: Expected Yield Normal Rate of Return/
Earning, Rate of Fair Return, Rate of General Expectations, Estimated Rate for
Capitalisation etc.
Yield may be calculated as under :
Normal Profit
Yield
x 100
=
Capital employed
Under Yield-Basis Method, valuation of shares is made on (i) Profit Basis;
or on (ii) Dividend Basis.
Yield-Basis Method
On
Dividend Basis
On
Prodit Basis
Profit Basis should be followed in the
case of Majority Holding.
(The shareholders holding maximum
number of shares.)
Dividend Basis should be followed
in the case of Minority Holding.
(The shareholders holding minimum
number of shares.)
(i) Profit Basis :
Under this method, at first, profit should be ascertained on the basis of
past average profit. There after, capitalised value of profit is to be determined on
the basis of normal rate of return, and the same (capitalised value of profit) is
divided by the number of share in order to find out the value of each share. The
following procedure may be adopted.
Profit
Capitalised Value of Profit
x 100
=
Normal rate of return
Capitalised Value of Profit
Value of each Equity Share
=
Number of shares
174 Advanced Accounting - II
Profit
x100
or, Value of each equity share =
Normal rate of return x Number of Equity shares
1.
Here, profit means and includes Future Maintainable Profit, i.e. the rate of
profit which is expected in be earned in future. “ It is to be remembered that the
analysis of profit that is made in order to determine future annual maintainable
profit must seek a profit that is capable of distribution as dividend.” - Yorston,
Smyth and Brown, Advance According.
Valuation of Shares Need, Methods of
Valuation of Shares
NOTES
The following principle should be kept in mind while ascertaining maintainable
profit.
(i)
Average profit for the last few years should be taken as base.
(ii)
Average profit should be properly adjusted such as:
(a) Proper depreciation on assets should be deducted;
(b) Appreciation in Fixed Assets should not be included whereas
appreciation in current assets should, however, be included;
(c) Income from non-trading assets should be excluded.
(d) Non-recurring expenses, which may not be incurred in future, are
not to be included;
Check Your Progress
(e) Any casual income (Which is not expected in future) should not to
be included;
1 . Explain
the
term
‘Valuation of Shares’.
(f) provision should be made for taxation;
2 . What are the factors
affecting Value of Shares ?
(g) If any reserve is created, the same should be deducted; and
3 . Explain the need for
‘Valuation of Shares’.
(h) Preference dividend should always be deducted form profit.
4 . What is ‘Asset Backing
Method’ ?
EXAMPLE
5 . Explain in brief ‘Yield Basis
Method’.
Two companies, A Ltd. and B. Ltd,. are found to be exactly similar as to
their assets, reserve and liabilities except that their share capital structures are
different.
The Share Capital of A. Ltd is `11,00,000, divided into 10,000, 6%
Preference Shares of `100 each and 10,000 Equity Share of `10 each.
The Share Capital of B. Ltd is also `11,00,000, divided into 1,000, 6%
Preference Shares of `100 each and 1,00,000 Equity Share of `10 each.
The fair yield in respect of the Equity Share of this type of companies is
ascertained at 8%.
The profits of the two companies for 2013, and 2012 are found to be
` 1,10,000 and `1,50,000, respectively.
Calculate the value of the Equity Share of each of these two companies on
31.12.2012 on the basis of this information only. Ignore taxation.
Advanced Accounting - II
175
Valuation of Shares Need, Methods of
Valuation of Shares
ANSWER
`
A. Valuation of Shares
of A Ltd.
of B Ltd.
Average profit of two years
NOTES
`
Valuation of Shares
1,30,000 Average profit
(` 1,10,000 + ` 1,50,000)
1,30,000
Less: Pref.Dividend
6% on ` 1,00,000
2
Less: Preference Dividend
6,000
Maintainable profit:
6% on ` 10,00,000
1,24,000
60,000 Capitalised Value of profit:
Maintainable Profit
70,000
Capitalised Value of Profit
=
` 70,000
` 1,24,000
x 100
8
8,75,000
Value of each Equity Share
=
x 100
8
=
15,50,000
Value of each Equity Share
` 8,75,000
x ` 87.50
10,000 Equity Share
=
` 15,50,000
x ` 15.50
1,00,000 Equity Share
(ii) Dividend Basis
Valuation of shares may be made either (a) on the basis total amount of dividend,
or (b) on basis of percentage or rate of dividend.
(a) On the basis of total amount of Dividend:
Divisible Profit i.e. Total amount of Dividend
x 100
Capitalised Value of Profit =
Normal Rate of Return i.e. Yield
Capitalised Value of Profit
Value of each Equity Share =
Number of Equity Shares
Divisible Profit x 100
Or, Value of each Equity Share =
Normal Rate of Return x No. of Equity Share.
(b) On the basis of percentage or Rate of Dividend:
Value of each Equity Share
Rate of Dividend
=
x Paid-up value of each Equity Share
Normal Rate of Return x No. of Equity Share
When the Rate of Dividend is not given:
Profit
Rate of Dividend =
176 Advanced Accounting - II
x 100
Equity Share Capital (paid-up)
EXAMPLE
On December 31, 2012, the Balance Sheet of xyz Ltd,. Disclosed the
following position :
`
Liabilities
Share Capital 40,000 Equity
`
Assets
4,00,000 Fixed Assets
Shares of ` 10 each
5,00,000
Current Assets
Reserves and Surplus
90,000 Goodwill
Profit and Loss Account
20,000
5% Debentures
Valuation of Shares Need, Methods of
Valuation of Shares
1,50,000
NOTES
40,000
1,00,000
Current Liabilities
80,000
6,90,000
6,90,000
The Net Profit for the three years were.
Year
`
2010
51,150
2011
50,300
2012
53,800
On which 20% was placed to Reserve, this proportion being considered
reasonable in the industry in which the company is engaged and where a fair
investment return may be taken at 10%.
Compute the value of the company’s share under yeild-basis method.
ANSWER
Average Profit =
` 51,150 + ` 50,300 + ` 53,800 ` 1,55,250
=
= ` 51,750
3
3
= ` 10,350
Less : Transfer to Reserve @ 20%
= ` 41,400
Maintainable Profit
Here, the rate ofdividend is not given, the same can be found out with the help of
the following :
Profit
Rate of Dividend
x 100
=
Paid up Equity Capital
` 41,400
x 100 = 10.35 %
=
` 4,00,000

Value of each Equity Shares
Rate of Dividend
x
=
Normal Rate of Return
Paid -up Value of each Equity
Share
Advanced Accounting - II
177
Valuation of Shares Need, Methods of
Valuation of Shares
` 10.3
10
=
NOTES
x ` 10
=
` 10.35
EXAMPLE
Form the following information supplied to you ascertain the value per share
of AMCO Ltd. on Dividend Basis.
1)
2,50,000 Equity Shares of ` 1 each fully paid-up .
2)
The annual net earnings of the company normally amounts to ` 35,000.
3)
The normal rate of return on paid-up value of Equity share capital is 7%.
ANSWER
1) Calculation of Rate of Dividend :
Profit
Rate of Dividend
x 100
=
Paid-up Equity share Capital
` 35,000
x 100
=
` 2,50,000
= 14%
2) Calculation of value per Equity Share :
Value Per Equity Share =
Rate of Dividend
Normal Rate of Return
14
=
x v1
7
=`2
x Paid up value of
each Equity Share
The Asset Backing Method and yield Basis Method of Valuation of shares
can be understood with the help of following illustrations.
178 Advanced Accounting - II
Valuation of Shares Need, Methods of
Valuation of Shares
10.4 Illustrations
ILLUSTRATION 1
From the following information relating to Adwani Ltd., Ahmednagar,
Compute the ‘Intrinsic Value’ of each Equity Share.
NOTES
Balance Sheet as on 31st March 2014
Liabilities
`
Assets
`
Share Capital :
Goodwill
35,000
Issued and Paid-up Capital
Land and Buildings
95,000
•
Plant and Machinery
20,000 Equity Shares of
` 10 each
•
2,00,000 Investments
13,000 Preference Share
1,35,000
55,000
Stock in Trade
65,000
` 10 each
1,30,000 Trade Debtors
36,000
Reserve Fund
60,000 Cash in Hand
24,000
Trade Creditors
45,000 Underwriting Commission
15,000
Bills Payable
20,000
Taxation Provision
5,000
4,60,000
4,60,000
For the purpose of valuing the equity shares of the company, various assets
were revalued as under :
•
Book Debts realised 100% of book value
•
Stock-in-Trade realised at a profit of ` 15,000
•
Investments
- ` 60,000
•
Goodwill
- ` 50,000
•
Land and Building
- ` 1,10,000
•
Plant and Machinery
- ` 1,40,000
SOLUTION
1) Computation of Total Net Assets :
Total Assets
`
•
Goodwill
50,000
•
Land and Buildings
1,10,000
•
Plant and Machinery
1,40,000
•
Investments
60,000
•
Stock-in-Trade
80,000
•
Trade Debtors
36,000
•
Cash in hand
(+) 24,000
5,00,000
Advanced Accounting - II
179
Valuation of Shares Need, Methods of
Valuation of Shares
NOTES
Less : Current Liabilities
70,000
•
Trade Creditors
45,000
•
Bills Payable
20,000
•
Taxation Provision
(+) 5,000 (-)
Total Net Assets
4,30,000
2) Computation of Funds available for equity shareholders :
`
Total Net Assets
Less : Preference Share Capital
4,30,000
(-) 1,30,000
 Fund available for Equity Shareholders
3,00,000
3) Computation of Intrinsic Value of each Equity Share :
Funds available for Equity Shareholders
=
Number of Equity Shares
` 3,00,000
=
20,000 Equity Shares
=
` 15
ILLUSTRATION 2
Bremain Ltd., Bareli issued 50,000 Equity Shares of ` 10 each fully calledup and paid-up respectively. The company has earned sizable amount of net profit
during the last five years which as follows:
Year
Net Profit
`
2009
55,390
2010
57,820
2011
60,140
2012
61,280
2013
65,370
Of the profits so earned 20% was transferred to General Reserve, this
proportion being considered reasonable in the manufacturing industry in which the
company is engaged and where a fair investment return may be taken at 10%.
You are required to compute the value of company’s Equity Share in the
Yield Basis Method under Dividend Basis and Profit Basis separately.
180 Advanced Accounting - II
Valuation of Shares Need, Methods of
Valuation of Shares
Solution
1) Calculation of average expected future Profits:
` 55,390 + ` 57,820 + Rs.60,140 + ` 61,280 + `65,370
Average Profit =
5
NOTES
` 3,00,000
=
5
=
` 60,000
2) Calculation of Maintainable Profit:
=
Average Profit Less 20% of Transfer to General Reserves
=
` 60,000 - 20% of ` 60,000
=
` 60,000 - ` 12,000
=
` 48,000
3) Calculation of Rate of Dividend:
Rate of Dividend
Maintainable Profit
=
x 100
Equity Share Capital (paid-up)
` 48,000
x 100 = 9.60 %
=
` 5,00,000
4) Calculation of value of each Equity Share under Yield Basis Method :
A) On Dividend Basis:
Value of each
Rate of Dividend
Equity Share
Paid up value of
x
=
Normal Rate of Return
each Equity Share
9.60
x ` 10
=
10
=
` 9.60
B) On Profit Basis :
i) Calculation of Capitalised Value of Maintainable Profit :
Capitalised Value
Profit
x
=
of Profit
100
Normal Rate of Return
=
` 48,000
x 100
10
= ` 4,80,000
Advanced Accounting - II
181
Valuation of Shares Need, Methods of
Valuation of Shares
ii) Calculation of value of each Equity Share :
Value of
Capitalised Value of Profit
=
Equity Share
Number of Equity Share
` 4,80,000
NOTES
=
50,000 Equity Shares
=
` 9.60
10.5 Summary
•
The valuation of Shares may be broadly be classified as (i) Assets - backing method, (ii) Yield base method & (iii) Fair value method.
•
Fair value method which is the mean of intrinsic value and yield value method
and the same provides a better indication about the value of shares than the
other method.
•
Profit Basis should be followed in the case of majority Holding and Dividend
Basis should be followed in the case of minority Holding.
•
Since the valuation is made on the basis of the assets of the company, it is
known as Assets Basis or Assets-Backing method.
•
Yield is the effective rate of return on investment of which is invested by
the investors. It is always expressed in terms of percentage. Since the
valuation of share is made on the basis of yield, it is called Yield - Basis
Method.
10.6 Key Terms (Valuation of Share)
(i)
Future Maintainable Profit that is, the rate of profit which is expected to
be earned in future. “It is to be remembered that the analysis of profit that
is made in order to determine future annual maintainable profit must seek a
profit that is capable of distribution as dividend.”
(ii)
Calculation of Expected Return :
Expected Profits
Expected Return
x
=
100
Equity Capitals
(iii)
Calculation of Yield value of Share :
Expected Rate
x Paid up value of share
Value of share =
Normal Rate
182 Advanced Accounting - II
(iv)
Valuation of Shares Need, Methods of
Valuation of Shares
Calculation of Rate of Earning
Profit earned
Rate of Earning
x 100
=
Capital Employed
(v)
Calculation of fair value
NOTES
Intrinsic Value + Yield value
Fair value
=
2
(vi)
Calculation of Capitalised value of profit
Profit
Capitalised value of profit
=
x 100
Normal Rate of Return
(vii) Value of Right Share :
Value of Right
Number of Right shares
share
(Market value
x
=
Total Holdings (i.e. holding% + New)
- Issue price)
10.7 Questions and Exercises
I - Objective Questions
(A) Multiple Choice Questions
(1)
The need for valuation of shares arises in circumstances for assessments
under --------- .
(a) estate duty
(b) Wealth tax
(c) gift tax
(d) all of the above
(2)
The value of share of a company is affected by -------------- backing of the
company.
(a) current asset
(b) non- current asset
(c) net - asset
(d) gross - asset
(3)
The value of an equity share based on net assets is known as ----------value of a share.
(a) current
(b) intrinsic
Advanced Accounting - II
183
Valuation of Shares Need, Methods of
Valuation of Shares
(c) face
(d) market
(4)
Under Balance-Sheet method of valuation of shares -------------- assets
are excluded as they have no realisable value.
NOTES
(a) fictitious
(b) non - wasting
(c) fixed
(d) current
Ans :- (1 - d), (2 - c), (3 - b), (4 - a)
II - Long Answer Questions :
(1)
What is ‘Valuation of Shares’? State the factors affecting the value of
shares.
(2)
Define the term ‘Share’. Explain in brief the important assumptions while
making valuation of shares.
(3)
Explain the term ‘Valuation of Shares’. What is the need for valuation of a
share?
(4)
‘The value of the share is greatly affected by the economic, political and
social factors’ Discuss Valuation of share.
(5)
Explain in brief the various methods of valuation of share.
(6)
What is ‘Asset Backing Method’ of valuation of shares. State the entire
procedure for computation of a value of share under this method.
(7)
Explain in brief the utility of Asset-Backing method of valuation of shares.
(8)
What is ‘Yield Basis Method’? State the procedure for computation of a
value of share under profit Basis Method.
(9)
How do you ascertain the value of a share under Dividend Basis Method.
III - Practical Problems :
(1) Calculate the value of each equity share. by Intrinsic value Method from
the following accenting information made available by AMCO. Ltd,. as on 31st
March, 2014.
184 Advanced Accounting - II
Balance - Sheet as on 31st March, 2014.
`
Liabilities
3,000 Equity Shares of
Assets
`
3,00,000 Goodwill
32,000
3,00,000 Buildings
1,67,000
Valuation of Shares Need, Methods of
Valuation of Shares
of ` 100 each fully paid
3,000 8% preference shares
of Rs.100 each fully paid
Reserve fund
machinery
3,05,000
1,20,000 Investments
NOTES
76,000
creditors
40,000 Stock in Trade
1,10,000
Bills payable
25,000 Debtors
90,000
Bank Overdraft
15,000 cash at Bank
10,000
under writers commission
8,00,000
10,000
8,00,000
The assets were revalued for the purpose of valuation of shares of the
company as follows:
Goodwill - ` 72,000, Buildings - ` 2,27,000, machinery - ` 2,65,000, Investments
of Book value, stock - ` 1,70,000, Debtors less ` 8,000.
(2)
The issued capital of Bokaro Ltd., is ` 10,00,000 divided into 1,00,000
Equity shares of ` 10 each. The net profits of the company for the last five years
were as fallows:
Year
Net Profit
`
2010
72,000
2011
97,000
2012
1,16,000
2013
1,41,000
2014
1,74,000
Every year 20% of the profits were transferred to General Reserve. The
normal rate of return in respect of equily shares of this type of companies is 10%.
Calculate the value of the equity shares of Bokaro Ltd. by Yield Basis
Method.
10.8 Further Reading
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd. - 2013.
•
Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - New
Delhi - Taxmann publications Pvt. Ltd. - 2012.
Advanced Accounting - II
185
Unit 11 Valuation of Shares - Fair Value
Method, Value of Right and
Preference Shares
Structure
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
NOTES
11.0 Introduction
11.1 Unit Objectives
11.2 Fair Value method
11.3 Valuation of Right Shares
11.4 Valuation of Preference Shares
11.5 Valuations of Bonus Shares
11.6 Illustrations
11.7 Summary
11.8 Key Terms
11.9 Questions and Exercises
11.10 Further Reading
11.0 Introduction
A share in a company is one of the units in to which the total share capital
of a company is divided. Share are two types, (i) Preference share (ii) Equity
share. Preference share are those which carry the following preferential right
over other classes of shares: (a) a preferential right in respected of fixed dividend
(b) a preferential right to repayment of capital in the event of a companies winding
up.
In case of joint stock companies generally the shareholders are given the
pre-emptive right either by their charter or by the Act applicable to them. This
pre-emptive right gives holders of equity shares the first option to purchase additional
issued of common stock. CAS per section 81 of the companies Act,1956)
Preference share valuation is generally on “Dividend Basis” according to
the following formula:
Paid-up value x Average maintainable dividend rate ÷ Normal Rate of Return
Value of right share will be the difference between the result that is obtained
and market value of shares.
Advanced Accounting - II
187
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
NOTES
A company may capitalise its profits or reserves by issuing fully paid bonus
share to existing members. The intrinsic value of each equity share will always be
less after the bonus issue.
In this unit, we are going to discuss Fair value method of valuation if shares
valuation of Right issue shares and preference share.
11.1 Unit Objectives
After studying this unit should be able to :
•
Understand meaning of Right issue share and its valuation.
•
Ascertain the value of preference share.
•
Discuss the Fair value method of valuation of shares.
•
Know the meaning of Bonus issues and its valuation.
11.2 Fair Value Method
Some Accountant prescribed the “Fair Value Method” as the mean of
Intrinsic value and Yield Value Method. The result from the same provides better
indication about the value of shares then the earlier two method. In short, Fair
Value Method is a combination of Intrinsic value method & Yield Method which
calculate the ‘Mean’ of these two methods.
Fair Value
=
Intrinsic Value + Yield Value
2
EXAMPLE
The following is the Balance Sheet of X Co. Ltd as on 31.12.2012.
Liabilities
`
Share Capital :
Equity Shares of ` 10 each
50,000
1,00,000 Buildings
1,50,000
Plant
60,000 (Market value of 52,000)
Profit and Loss
40,000 Normal Value ` 50,000
creditors
1,00,000 Stock
80,000 Debtors
4,80,000
188 Advanced Accounting - II
1,00,000
1,00,000 Investment in 10% stock
General Reserve
15% Debentures
`
Goodwill
12% Pref. Shares of
` 100 each
Assets
48,000
60,000
40,000
Cash
10,000
Preliminary Expenses
22,000
4,80,000
Ascertain the value of each equity share under Fair Value Method on the
basis of the information given below.
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
Assets are revalued as follows :
Building ` 3,20,000, Plant ` 1,80,000; Stock ` 45,000 and Debtors ` 36,000.
Average profit of the company is ` 1,20,000 and 12 1/2% of profit is
transferred to General Reserve. Rate of taxation being 50%. Normal dividend
expected on Equity Shares is 8% whereas fair return on capital employed is 10%.
Goodwill may be valued at 3 year’s purchase of super profit.
NOTES
ANSWER
Computation Goodwill :
Total Net Assets :
`
Buildings
3,20,000
Plant
1,80,000
Stock
45,000
Debtors
36,000
Cash
10,000
5,91,000
Less : Current Liabilities :
Creditors
80,000
Capital Employed

5,11,000
Normal Profit ` 51,100
i.e. ` 5,11,000 x
10
100
Actual Profit
Average Profit
`
1,20,000
Less : Non-trading Income
(i.e. income from investment)
@ 10% on ` 50,000
(-) 5,000
1,15,000
Add : Debenture Interest
(-) 15,000
1,30,000
Less :Preference Dividend @ 12 % of ` 1,00,000
(-) 12,000
1,18,000
Less :Taxation @ 50% of ` 1,18,000
(-) 59,000
59,000
Advanced Accounting - II
189
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
Less :Transfer to Reserve @ 12 1/2 %
(-) 7,375
51,625
Super Profit
= Actual Profit - Normal Profit
= ` 51,625 x ` - ` 51,000
NOTES
= ` 525
Goodwill is to be valued at three years purchase of Super Profit.
 Value of Goodwill
` 525 x 3 = ` 1,600
=
Valuation of Shares :
`
Assets-Backing Method
Sundry Assets (as above)
5,11,000
Add : Investments
48,000
Add : Goodwill
1,600
Funds available for Equity Shareholders
Intrinsic Value of Share
=
5,60,000
R 5,60,600
10,000
=
` 56.06
Yield - Basis :
Rate of Dividend
Value of share =
x Paid up value of each share
Normal Rate of return
8
=
10
x ` 10
= ` 8
Fair Value :
Fair value
=
Intrinsic Value + Yield Basis
2
` 56.06 + ` 8.00
=
2
= ` 32.03
11.3 Valuation of Right Shares
190 Advanced Accounting - II
On a right issue being made, the existing shareholders have the privilege of
either applying for the share offering within a fixed period or to renounce their
right to apply for these shares in favour of some other person. He may sell this
right with or without selling his existing shareholding. The price of the shares may
of two type viz. Cum-right price or ex-right price which is shown below in figure
11.1 -
Cum-Right Price
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
Ex-Right Price
Right Issue
Price
NOTES
Fig 11.1 : Classification of Right Issue Price
i)
The “Cum-right price” gives the buyer, besides the ownership of the shares
already held, the right to apply for new shares offered by the company.
ii)
The “ex-right price” gives the buyer only the ownership of the existing
shares held by the seller and not the right to apply for additional shares
offered by company.
Ex-right price is quoted either after the right shares have already been
allotted by the company or the time to apply for right share has already expired.
The Cum-right price is higher than the ex-right price of the share since the
former includes the value of the right also.
(i) Cum - right Price
The value of the right can be calculated by applying the following formula
M-S
R =
N+I
Where; R = Value of one right
M = Cum - right market price of a share
S = Subscription price for a new share
N = Number of old shares required to purchase one new share.
EXAMPLE
X Ltd., has a share capital of 5,000 equity shares of `10 each, having
number price of ` 15 new share . The company wants to raise additional funds of
` 12,000 old offers to existing sharesholders the right to apply for a new share at
` 12 for every five shares held.
You are required to ascertain the value of right.
ANSWER
M-S
R
=
N+I
Advanced Accounting - II
191
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
` 15 - ` 12
`
=
`3
=
`5+ `1
= ` 0.50
`6
The value of one right is therefore ` 0.50
NOTES
ii) Valuation of a share ex-right
The ex-right value of a share can be calculated by deducting the value of
right form the cum-right market price of the share.
Formula :-
MN + S
P =
N+I
Where :
P = The orefical market value of a share ex-right
M = Cum - Market price
N = Number of old shares entitling purchase of one new share
S = Subscription price for a new share.
EXAMPLE
In the Example given above, the ex-right value of a share would be as
follows ` 14.50 (i.e. ` 15 - ` 0.50)
ANSWER
On the basis of the data given in the above example, the theoretical ex-right
value of a share will be as follows :
MN + S
P =
N+I
` 15 x ` 5 + ` 12
P =
` 75 + ` 12
= ` 14.50
=
5+1
6 Shares
Alternatively the value of right by this method also come to ` 0.50 (i.e. `
15 - ` 14.50)
Value of Right Shares
According to Sec. 81 of the Compare Act, 1956, a company, if it so desires
can increase its share capital by issuing new shares. In that case, the existing
shareholders must be given the priority of purchasing those shares according to
their paid-up value. Since the existing shareholders have got such right to purchase
the newly issued shares, they are called Right Shares.
192 Advanced Accounting - II
In order to make a proper valuation of right relating to Right Shares, the
market value of the old holding and the total issue price of the new holdings must
be added and the same must be divided by the total number of new and old
holdings. Value of right will be the difference between the result that is obtained
and market value of shares. Hence,
Value of Right
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
=
Number of Right Shares
x (Market Value - Issue Price)
=
Total Holdings (i.e. holdings = Old + New)
NOTES
EXAMPLE
The face value of the Equity shares of a company is ` 10 and the current
market price ` 17. The company issues “Right” shares at the rate of 3 Equity
shares for every 5 existing Equity shares held, the “Right” shares being priced at
` 13.
Calculate the value of “Right”
ANSWER
Number of Right Shares
Value of Right =
(Market Value (x)
Total Shares (old + new holdings)
Issue Price
3 shares
Value of right
x ( ` 17 - `13)
=
shares (5+3)
3 shares
x `4
=
= ` 1.50
8 shares
Alternatively :
Market value of 5 existing holdings
= ` 17 x 5 shares =
` 85
Add : Issue price of 3 new holdings
= ` 13 x 3 shares =
` 39
Value of holding =
` 124
` 124
= ` 15.50
Value of each share =
8 shares
Value of Right
=
` 17.00 - ` 15.50 = Rs. 1.50
11.4 Valuation of Preference Shares
i)
In the case if Non-participating Preference Shares :
When Preference Shares are Non-Participating, they are to be treated as
outside creditors and, hence, the same will be deducted from the total net assets.
Therefore, value of each preference share in this case will be only of its face
value plus arrear dividend (if any).
Advanced Accounting - II
193
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
NOTES
(ii) In the case of Participating Perference Shares:
When Preference Shares are Participating, they will take part in Surplus.
The surplus will be distributed among the equity and preference shareholders in
the ratio of paid-up capital; therefore, value of each preference share will be of its
face value plus surplus (of each share), plus arrear dividend (if any). The surplus
may be computed as under:
`
Sundry Assets (at market value)
Less : Current Liabilities
(-)
.
Less : Preference Share Capital
Arrear Preference Dividend
Or, Proposed Prefeference Dividend
Less : Equity Share Capital
Surplus
Now the “Surplus” will be distributed between equity and perference
shareholders in the ratio of their paid-up capital.
Value of each Equity Share
= Face value of each equity share + Surplus
of each equity share.
Value of each Preference Share
= Face value of each equity share + Surplus
of each equity share + Arrear Div. (if any)
11.5 Valuation of Bonus Shares
Check Your Progress
1 . Explain
‘Fair
Value
Method’ of valuation of
shares.
2 . Differentiate
between
‘Cum-Right Price’ and ‘ExRight Price’.
3 . How would you make
‘Valuation of Preference
shares’ ?
4 . Explain in brief the
‘Valuation
of
Bonus
Shares’.
194 Advanced Accounting - II
The company issues new shares to existing shareholders which is known
“Bonus Shares - instead of paying a dividend in cash. After the bonus issue, there
will be increase in the number of equity shears without a correoponding increase
in the available net assets to the equity shareholders. As a result, the intrinsic
value of each equity share will always be less after be less after the bonus issue.
The other method of valuation of shares can be understood with the help of
following illustrations.
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
11.6 Illustrations
ILLUSTRATION 1
On 31st December, 2013 the Balance Sheet of Dolphin Ltd., Delhi disclosed
the financial position as follows :
`
Liabilities
`
Assets
Share Capital
Goodwill
i) Issued and subscribed
Business Premises
2,70,000
Machinery
2,20,000
Capital:
• 40,000 Equity Shares of
` 10 each fully paid
42,000
Furniture and Fixtures
18,000
4,00,000 Trade Debtors
2,75,000
Reserve
2,02,000 (all considered good)
Profit and Loss
1,08,000 Stock- in- trade
1,05,000
7% Debentures
1,00,000 Cash - in- Hand
20,000
Trade Creditors
90,000
Bills payable
50,000
NOTES
9,50,000
9,50,000
The additional information as on 31st December, 2013 made available to
you which is as follows.
`
i) Assets were valued as follows.
•
Business Premises
1,95,000
•
Machinery
1,35,000
•
Furniture and Fixture
•
Goodwill
•
Stock - in - Trade
20,000
50,00
1,05,000
ii) The Net Profits for the last three years were as follows:
Year
Net Profit
`
2011
1,13,000
2012
1,21,000
2013
1,26,000
Of which 20% were transfer to reserve, this proportion being considered
reasonable in the industry in which the company is engaged and where a fair
return on investment may be taken at 20%.
You are required to calculate the valuation of each Equity Share separately,
ingnoring taxation as per Fair Value Method.
Advanced Accounting - II
195
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
SOLUTION
A)
Net Assets Method :
`
1) Calculation of Total Net Assets
Total Assets
NOTES
• Goodwill
50,000
• Business Premises
1,95,000
• Machinery
1,35,000
• Furniture and Fixture
20,000
• Trade Debtors
2,75,000
• Stock - in - Trade
1,05,000
• Cash-in-Hand
(+) 20,000
8,00,000
Less :
• 7% Debentures
1,00,000
• Trade Creditors
90,000
• Bills Payable
(+) 50,000 (-) 2,40,000
 Total Net Assets
5,60,000
2) Calculation of funds available for Equity Shareholders:
`
Total Net Assets
5,60,000
Less : Preference Share Capital
(-)
Funds available for Equity Shareholders
NIL
5,60,000
3) Calculation of Intrinsic Value of each Equity Shareholders:
Funds available for Equity Shareholders
=
Number of Equity Shareholders
` 5,60,000
=
40,000 Equity Shares
= ` 14
B) Yield Basis Method (on Profit Basis):
1) Calculation of Average Expected Future Profits :
Average Profit
=
` 1,13,000 + ` 1,21,000 + ` 1,26,000
3
=
` 3,36,000
3
196 Advanced Accounting - II
= ` 1,20,000
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
2) Calculation of Maintainable Profit :
=
Average Profit Less 20% Transfer to Reserve
=
` 1,20,000 - 20% of ` 1,20,000
=
` 1,20,000 - ` 24,000
=
` 96,000
NOTES
3) Capitalised Value of Maintainable Profit:
Profit
Capitalised Value of Profit
=
x 100
Normal Rate of Return
` 96,000
=
x 100
20
= ` 4,80,000
4) Calculation of Yield Value of each Equity Share :
Capitalised value of Profit
Value of Equity Share
=
=
Number if Equity Share
` 4,80,000
40,000 Equity Shares
= ` 12
C) Fair Value Method :
1) Valuation of Shares as per Fair Value Method:
Intrinsic Value (+) Yield Value
Valuation of each Equity Share =
2
`14 + ` 12
=
2
` 26
=
2
= ` 13
Advanced Accounting - II
197
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
ILLUSTRATION 2
Following is the Balance Sheet of Camin Ltd., Chennal as on 31st December,
2013.
`
Liabilities
NOTES
`
Assets
Share Capital
Freeholds Premises
50,000
i) Issued and Subscribe
Machinery
70,000
Capital
Furniture
14,000
10,000 Equity Shares of
Stock-in-Trade
20,000
•
` 10 each, fully paid
1,00,000 Book Debts
Reserve Fund
50,000 Bank Balance
Profit and Loss
16,000 Formation Expenses
Creditors
45,000
Bills Payable
15,000
44,000
26,000
2,000
2,26,000
2,26,000
Additional Information:
i) Assets are valued as under:
`
•
Goodwill
•
Freehold Premises
•
Machinery Premises
72,000
•
Furniture
24,000
•
Stock -in- Trade
25,000
•
Debtors
39,000
44,000
1,30,000
ii) The Profits of the company amounted to,
Year
Profit
`
2011
45,000
2012
49,000
2013
50,000
iii) It is the practice of the company to transfer one-fourth of profit to
Reserve Fund.
iv) The fair Yield in respect of Equity Share of similar type of companies is
ascertained at 10%.
Find out the value of each Equity Share under Fair Value Method.
198 Advanced Accounting - II
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
SOLUTION
A)
Intrinsic Value Method :
1)
Computation of Total Net Assets :
`
Total Assets
•
Goodwill
•
Freehold Premises
•
Machinery
72,000
•
Furniture
24,000
•
Stock - in - Trade
25,000
•
Debtors
39,000
•
Bank Balance
44,000
NOTES
1,30,000
(+) 26,000
3,60,000
Less Current liabilities:
•
Creditors
•
Bills Payable
60,000
45,000
(+) 15,000 (-)
 Total Net Assets
3,00,000
2) Computation of funds available for Equity Shareholders:
`
Total Net Assets
3,00,000
Less : Preference Share Capital
(+) NIL
Funds available for Equity Shareholders
3,00,000
3) Computation of Intrinisic Value of each Equity Share :
Funds available for Equity Shareholders
=
Number of Equity Shareholders
` 3,00,000
=
=
B)
10,000 Equity Shares
` 30
Yield Basis Method (on Profit Basis):
1) Computation of Average Expected Future Profits :
Average Profit
=
` 45,000 + ` 49,000 + ` 50,000
3
=
` 1,44,000
3
= ` 48,000
Advanced Accounting - II
199
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
2) Computation of Maintainable Profit :
= Average Profit Less one fourth transfer to Reserve Fund
= ` 48,000 - 1/4 of ` 48,000
= ` 48,000 - ` 12,000
NOTES
= ` 36,000
3) Computation of Capitalised Value of Maintainable Profit :
Profit
Capitalised Value of Profit
=
=
x 100
Normal Rate of Return
` 36,000
x 100
10
= ` 3,60,000
4) Computation of Yield Value of each Equity Share :
Capitalised Value of Profit
Value of Equity Share
=
Number of Equity Shares
` 3,60,000
=
10,000 Equity Shares
= ` 36
C) Fair Value Method:
1) Valuation Share as per fair Value Method :
Intrinsic Value + Yield Value
Value of each equity Share
=
2
` 30 + ` 36
=
2
` 66
=
=
200 Advanced Accounting - II
2
` 33
ILLUSTRATION 3
The Following is the Balance Sheet of Domino Ltd., Durgapur as on 31st
December, 2013.
Liabilities
`
Assets
Share Capital:
Goodwill
• 30,000 Equity Shares of
Freehold Premise
` 100
3,00,000 Plant and Machinery
Profit and Loss Account-2013
Motor Vehicles
`
18,000
1,22,800
57,900
65,000 Trade Receivable
54,300
Trade Payable
50,000 Stock - in - Trade
41,600
Bills Payable
45,000 Bills Receivable
6,700
Income tax Payable
30,000 Cash at Bank
8,700
5,00,000
NOTES
1,80,000
Debentures
10,000 Preliminary Expenses
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
10,000
5,00,000
The following additional information are given to you :
i)
The company’s prospects for 2014 are equally good.
ii)
The profits for the past three years have shown as increase of ` 15,000
annually.
iii)
Goodwill is taken at ` 32,000.
iv)
The value of Freehold Premises to be raised by ` 27,200 whereas Motor
Vehicles are to be reduced by ` 7900.
v)
Plant and Machinery are worth 20% above their book values.
vi)
Book Debts amounting to Rs.4,300 are totally bad and hence to be writtenoff.
vii)
All other assets and liabilities are worth at their book value as shown in the
Balance Sheet above.
viii)
It is the practice of the company to transfer Rs.5,000 every year to General
Reserve.
ix)
Similar companies give a yield of 10% on the market value of shares.
x)
Dhansukhlal desires to invest ` 34,655 in equity shares, seeks your valuable
advice as to the fair value of shares.
Determine the number of shares which he should purchase, separately.
Advanced Accounting - II
201
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
SOLUTION
A) Net Assets Method :
`
1) Calculation of Total Net Assets
NOTES
•
Goodwill
•
Free Premises
1,50,000
•
Plant and Machinery
2,16,000
•
Motor Vehicles
•
Trade Receivable
5,000
•
Bills Receivable
6,700
•
Stock - in - Trade
•
Cash at Bank
32,000
50,000
41,600
(+)
8,700
5,55,000
Less :
1,35,000
•
Debentures
50,000
•
Trade Payable
45,000
•
Bills Payable
30,000
•
Income Tax Payable
10,000

Total Net Assets
(-)
4,20,000
`
2) Calculation on funds available for Equity Shareholders
Total Net Assets
4,20,000
Less : Preference Share Capital
 Funds available for Equity Shareholders
NIL
4,20,000
3) Calculation of Intrinsic Value of each Equity Share :
Funds available for Equity Shareholders
=
Number of Equity Shares
` 4,20,000
=
=
3,000 Equity Shares
` 140
B) Yield Basis Method (on Profit Basis):
1) Calculation of Yearly Profits :
Profits for 2013 - ` 65,000 (as per Balance Sheet)
202 Advanced Accounting - II

Profits for 2012 - ` 50,000 (` 15,000 less than for 2013)

Profits for 2011 - Rs.35,000 (` 15,000 less than for 2012)
Average Profit
=
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
` 65,000 + ` 50,000 + ` 35,000
3
=
` 1,50,000
3
= ` 50,000
NOTES
2) Calculation of Maintainable Profit :
= ` 50,000 Less ` 5,000 Transfer to General Reserve
= ` 45,000
3) Calculation of Capitalised Value of Maintainable Profit :
 Capitalised Value of Profit
Profit
=
x 100
Normal Rate of Return
` 45,000
=
x 100
10
` 4,50,000
=
4) Calculation of Yield Value of each Equity Share:
Capitalised Value of Profit
Value of Equity Share
=
Number of Equity Share
` 4,50,000
=
3,000 Equity Shares
= ` 150
C) Fair Value Method :
1) Valuation of Shares as per Fair Value Method:
Intrinsic Value + Yield Value
Value of each Equity Share =
2
`140 + ` 150
=
2
= ` 145
Valuable Advice :
Number of Equity Shares
to be purchased
=
Funds available to Invest in Equity share
Fair value of Equity Share
=
` 34,655
` 145
=
` 239 Equity Shares
Hence it is advisable that Dhansukhlal should invest the available funds of
` 34,655 for purchasing 239 Equity Shares of Domino Ltd., Durtapur.
Advanced Accounting - II
203
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
11.7 Summary
•
Fair Value Method :- Fair Value Method is a combination of Intrinsic value
method and Yield value method which calculate the “Mean” of these two
methods.
NOTES
Intrinsic value + Yield value

•
Fair value =
2
The price of the shares may be of two type Viz. Cum-right price and exright price.
(i) Cum-right price give the buyer, besides the ownership of the shares
already held, the right to apply for new shares offered by the co.
(ii) Ex-right price given the buyer only the ownership of the existing share
held by the seller and not the right to apply for additional shares offered
the co.
•
Valuation of Preference Shares : Their valuation is generally on “Dividend
Basis” According to the formula:
Paid-up Value x Average maintainable dividend rate ÷ Normal rate of return
In case dividend on cumulative perference shares is in arrears the present
value of such value of a preference share calculated as above.
In case of Participating Perference Shares of companies in liquidation
their share in the surplus assets remaining after payment to the equity
shareholders is taken on to account.
11.8 Key Terms
(1)
Preference Shares Valuation (Dividend Basis) :
= Paid up value x Average maintainable dividend rate ÷ Normal rate of
return.
(2)
Fair Value
=
Intrinisic value + Yield Value
2
(3)
Valuation of Cum-right price
R =
M-S
N+1
(4)
Valuation of Ex-right Price
P =
MN + S
N+I
(5)
Value of Right =
=
Number of Right Shares
Total Holding (i.e. holding = old + New)
204 Advanced Accounting - II
x Market value - Issue price.
11.9 Questions and Exercises
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
I - Object Questions
A) Multiple choice Question
1)
A simple average of net assets value and Yield value is termed as --------value of a shares.
NOTES
(a) Fair,
(b) intrinisic,
(c) earning,
(d) future.
(2)
The value of a non participating preference share is equivalent to its ----value, provided there are sufficient net assets available to settle the amount
payable to preference shareholders.
(a) intrinsic,
(b) face,
(c) fair,
(d) future
(3)
The ------------- givers the buyer, besides the ownership of the shares already
held, the right to apply for new shares, offered by the company.
(a) ex-right price
(b) Selling price
(c) Cum- right price
(d) inflated price
(4)
The ------------ gives the buyer only the ownership of the existing shares
held by the seller and not the right to apply for additional shares by the
company.
(a) Cum-right price
(b) loaded price
(c) invoice price
(d) ex- right price.
Ans :- (1 - a), (2 - b), (3 - c), (4 - d).
Advanced Accounting - II
205
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
II - Long Answer Questions
1)
What is ‘ Fair Value Method’ of Valuation of Shares? Explain in brief the
procedure involved in calculation of fair value of each equity share.
2)
What is ‘Right Share’? Classify the right issue price.
3)
What is ‘Cum - Right price’? How if differs from Ex- Right price?
4)
Explain in brief the method of Valuation of Shares in case of participating
and non-participating preference shares.
5)
How would you make the valuation of bonus shares?
6)
Write Short notes on :
NOTES
a) Fair Value Method of Valuation of Shares.
b) Value of Right Share
c) Valuation of preference Shares.
d) Valuation of Bonus Shares.
III - Practical Problems
1)
On 31st December, 2013 the Balance Sheet of Activa Ltd., Amarnath
disclosed the Following position:
`
Liabilities
Equity Share Capital:
Goodwill
• 40,000 Equity Shares of
Plant and Machinery
` 10 each
`
Assets
40,000
3,00,000
4,00,000 Land and Buildings
2,00,000
General Reserve
40,000 Sundry Debtors
80,000
Profit and Loss Account
15,000 Stock - in - Trade
70,000
10% Debentures
1,00,000 Cash at Hand
Sundry Creditors
85,000
Bills Payable
60,000
7,00,000
10,000
7,00,000
Additional information:
a) Independent valuation made of fixed assets shows the details as follows:
`
b)
206 Advanced Accounting - II
•
Goodwill
•
Plant and Machinery
2,50,000
•
Land and Buildings
1,00,000
50,000
The net profits for the last three years were : 2011 - ` 34,100. 2012 ` 42,600, 2013 - ` 47,300 of which 10% was transferred to General Reserve
annually, this proportion being considered reasonable in the industry in which
the company is engaged and where a fair investmentreturn may be taken
as 10%.
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
Find out the value of each Equity Share under Fair Value Method.
2)
The following financial details are available in relation to Bedaux Ltd.,
Badalapur as on 31st December. 2013.
NOTES
a) Share Capital comprises of
i) 450, 8% Preference Shares of `100 each fully paid-up and
ii) 4,500 Equity Shares of ` 10 each fully paid-up
b) Third Party Liabilities - ` 7,500
c) General Reserve - ` 3,500.
d) The average expected profit after taxation earned by the company
- ` 8,500.
e) The normal profit earned on the market value of equity shares of the
same type of company is 9%.
f) 10% profit after tax of each year is transmitted to General Reserve.
g) Out of the total assets, assets amounting to ` 350 are fictitious.
You are require to calculate the value of each equity share as per fair value
method.
3)
On 31st December, 2013 the Balance Sheet of Ekebana Ltd., Ellora shows
the financial position as Follows:
Liabilities
`
Assets
Share Capital:
Plant and Machinery
•
Land and Buildings
20,000 Equity Shares of
` 10 each fully paid-up
`
1,15,000
85,000
2,00,000 Motor Car
69,000
General Reserve Fund
45,000 Furniture
61,000
Profit and Loss Account
27,000 Patents
Debentures
1,00,000 Trade Debtors
5,000
90,000
Trade Creditors
67,000 Bills Receivable
50,000
Bank (Cr.)
11,000 Cash in Hand
25,000
Bills Payable
50,000
5,00,000
5,00,000
The following additional information is also provided on 31st December, 2013.
a)
The independent valuator valued the various assets as follows: Plant and
machinery ` 1,30,000, Land and Buildings ` 1,05,000. Motor Car ` 45,000,
Furniture ` 37,000, Patents are worthless, Trade Debtors are estimated to
realise 10 % less than the book value, Goodwill at ` 24,000.
Advanced Accounting - II
207
Valuation of Shares Fair Value Method, Value of
Right & Preference Shares
b)
The net profit for the last three years indicates the financial performances
as follows:
Year
Profit
`
NOTES
2011
25,350
2012
30,630
2013
34,020
c)
It is the practice of the company to transfer 20% of profit to General Reserve
Fund.
d)
Similar companies give a yield of 10 % on the market value of equity share.
You are require to calculate the fair value of each Equity Share.
11.10 Further Reading
208 Advanced Accounting - II
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd. - 2013.
•
Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - New
Delhi - Taxmann Publications Pvt. Ltd. - 2012.
Topic 4
Hotel Accounting
Unit 12 Visitor’s Ledger and Preparation of Final
Accounts
Unit 13 Introduction, Accounting Treatment in
Hotel Accounting
Unit 12 Visitor’s Ledger and Preparation of
Final Accounts
Visitor’s Ledger &
Preparation Of Final Accounts
Structure
NOTES
12.0 Introduction
12.1 Unit Objectives
12.2 Visitor’s Ledger
12.3 Preparation of Final Accounts
12.4 Illustrations
12.5 Summary
12.7 Key Terms
12.8 Questions and Exercises
12.9 Further Reading
12.0 Introduction
Hotel industries are required to follows the double entry system for recording
their business activity. However, it will be advantageous for them to follow tabular
system of book-keeping because most of their transactions are of regular and
uniform type. This requires maintenance of proper columns in different books of
accounts.
The following are the main books of accounts which a hotel may kept on
tabular system.
(a) Cash Book : This book records all cash transaction of the hotel. This book
may be maintained by having proper columns (as per the requirement of the hotel)
both on the receipts and payments side.
(b) Purchase Book : It records all credit purchase.
(c) Sale Book : It records all credit sale, transactions. It may have separate
columns for food, beverages drinks etc.
(d) Visitors or Guest Ledger : This ledger contains an account of each guest
staying in the hotel. It is also kept in a tabular analytical form so as to provide
ready information of different items or services provides to the visitors.
Advanced Accounting - II
209
Visitor’s Ledger &
Preparation Of Final Accounts
12.1 Unit Objectives
After studying this unit you should be able to :
NOTES
•
Understand the formats of visitor’s ledger
•
Classify the item included in visitor’s ledger.
•
Prepare visitor’s Ledger.
•
Prepare final accounts of a hotel. (i.e. Profit and Loss A/c and Balance
Sheet)
•
Explain How and Why the visitor’s ledger is maintained by a hotel.
12.3 Visitor’s Ledger
Visitors (Guest) Ledger is the main record of hotel accounting. This will
help them in maintaining accounts property.
In this visitors ledger every day’s transactions are maintained in a separate
page together with a column for each visitor. The room numbers are indicated
against each and every visitor. The amount brought down in each column indicated
the balance due at the commencement of the day from the concerned visitor. At
the time of settlement of the account, the amount receives from the visitor is
recorded as creditors it is observed that, there will be no balance in the account
which will be carried down in the next day’s page. On the other hand if there is
any due at any date form a visitor, the same account is transferred to a personal
ledger.
While closing the visitor’s ledger the daily total of each heading both debit
and credit sides are recorded in the total column on the right hand side of the
visitor’s ledger accounts. The same is transferred to a summary ledger of general
ledger for the purpose of obtaining the periodically totals (say for monthly quarterly,
or half yearly).
The items included in visitor’s ledger are depending on the services provided
by the restaurant of hotel.
A format of visitor’s Ledger is as given below:-
210 Advanced Accounting - II
1
A
`
Room No.
Names and Address
Credits
Cash
Allowances
Personal A/c
Balance C/D
Balance B/D
Lodging and
Boarding etc.
Breakfast/snacks
Lunches
Dinners
Tea. Coffee,etc.
Wines
Spirit
Beer
Minerals
Cigaretters, Cigars, etc.
Laundry
Carriage
Sundries etc.
Debits
Total `
Total `
B
`
2
C
`
3
D
`
4
E
`
5
F
`
6
G
`
H
`
Visitor’s Ledger
7
8
Debits
Balance B/D
Lodging and
Boarding etc.
Breakfast/snacks
Lunches
Dinners
Tea. Coffee, etc.
Wines
Spirit
Beer
Minerals
Cigaretters, Cigars, etc.
Laundry
Carriage
Sundries etc.
Total `
Credits
Cash
Allowances
Persnonal A/c
Balance C/D
Total `
Names and Address
Room No.
`
Total
Visitor’s Ledger &
Preparation Of Final Accounts
NOTES
Advanced Accounting - II
211
Visitor’s Ledger &
Preparation Of Final Accounts
Visitors’ Ledger (Total Account)
Dr.
Cr.
Particulars
NOTES
`
To Balance B/D
***
By Cash - Debit Cash Book
To Lodging - Credit, Lodging
***
By Allowance - Debit -
To Boarding etc. Boarding etc. A/c
***
***
Allowance
***
By Balance C/D.
***
***
To Balance B/D.
`
Particulars
***
***
12.4 Preparation of Final Accounts
Check Your Progress
1 . Explain the various books
of
accounts
to
be
maintained under Hotel
Accounting.
2 . State the basic need of
maintaining Visitors Ledger
under Hotel Accounting.
3 . Explain the accounts and
statements prepared by
Hotel Business relating to
their Final Accounts.
Trading accounts is of maintained in the hotel accounting. Therefore items
relates to trading accounts are to be recording first (i.e. at the top) while preparing
profit and loss Account. The Profit and Loss Account shall set out the various
items relating to the income and expenditure of the hotel industry arranged under
most convenient heads. The Balance-Sheet to be prepared at the end of stipulated
period (generally annually) in prescribed form. In practice all the accounting
principles applicable to a hotel industry are the same as in the case of any
commercial organisation.
The concept of visitors Ledger and preparation of finals Accounts of Hotel
Business can be understood with the help of following illustrations.
12.5 Illustrations
ILLUSTRATION 1
From the following particulars pertaining to four rooms in a hotel draw up a
suitable columunar ledger :
212 Advanced Accounting - II
(i)
Room rent for each room ` 5000 + 15% tax.
(ii)
Room 1 : Breakfast ` 450 Laundry ` 500 Local Phone calls ` 150.
(iii)
Room 2 : Lunch ` 850 S.T.D. Calls ` 1250 Wine ` 600 Previous day’s
outstanding amount ` 1,2500
(iv)
Room 3 : Private Taxi hired form hotel ` 4000 S.T.D. calls ` 35000 Dinner
` 1250. Whisky ` 1,000 Deposited ` 3,5000 with the hotel.
(v)
Room 4 : Opening due from the guest ` 5750 Laundry ` 300 Lunch `
1200.
(vi)
The guest in Room 3 is a regular visitor and is entitled to a discount of 20%
on room rent.
All the foregoing transactions pertain to a single day.
Visitor’s Ledger &
Preparation Of Final Accounts
SOLUTION
Visitors’ Ledger
Total
Particulars
`
1
2
3
4
`
`
`
`
NOTES
Balance B/D
18,250
-
12,500
-
5,750
Lodging
19,000
5,000
5,000
4,000
5,000
Tax on Lodging
3,000
750
750
750
750
Boarding
3,750
450
850
1,250
1,200
Loundry
800
500
-
-
300
Telephones
4,900
150
1,250
3,500
-
Private Taxi
4,000
-
-
4,000
-
Alcohonlic Drinks
1,600
-
600
1,000
-
55,300
6850
20,950
14,500
13,000
Credit Cash Received
35,000
-
-
3,5000
-
Balance C/D
20,300
6850
20,950
(-) 20,500
13,000
Total
55,300
6850
20,950
14,500
13,000
Total Debits
* ` 5,000 Less 20% discount
ILLUSTRATION 2
The following are the balances from the ledger of Ameet Hotel on
31 December 2012.
st
Particulars
`
Share Capital
56,865
Freehold Premises
46,800
Furniture and Fittings
8,934
Glass and China
1,101
Linen
840
Cutlery and Plate
390
Rates, Taxes and Insurances
1,713
Salaries
2,400
Wages
4,304
Stock on 1.1.2012
Wines ` 1,239, Spirits ` 378, Beer ` 165,
Mineral Water ` 147, Cigars and Cigarettes ` 114,
Sundry Provisions and Stores ` 183, Coal ` 150
Advanced Accounting - II
213
Visitor’s Ledger &
Preparation Of Final Accounts
Purchases
Meat ` 3,627, Fish and Poultry ` 3,960, Sundry Provisions
and Stores ` 5,220, Wines ` 1,881, Spirits ` 2,190,
Beers ` 1,152, Mineral Water `1,000,
NOTES
Cigars and Cigarettes ` 240.
Laundry
951
Coal and Gas
2,160
Electric Light
1,128
General Expenses
1,710
Sales
Wines ` 3,870, Spirits ` 4,338, Beer ` 1,863,
Minerals ` 2,160, Cigars and Cigarettes ` 390.
Charges
Meals ` 23,829, Room ` 9,375, Fires in bedrooms ` 582,
Washing Charges ` 219.
Repairs, Renewals and Depreciations
Premises ` 348, Furniture and Fittings ` 660,
Glass and China ` 609, Linen ` 390, Cutlery
and Plate ` 207.
Cash Book - Debit Balances
Bank ` 8,148, In hand ` 219, Visitor’s Account
` 1,348, Sundry Creditors ` 2,569
Prepare Final Account for the year ended 31st December 2012.
Stock on 31-12-2012 : Wines ` 1,197, Spirits ` 333, Beers ` 174, Minerals
` 357, Cigars and Cigarettes ` 69, Sundry Provisions and Stores ` 141, Coal
` 99.
214 Advanced Accounting - II
Visitor’s Ledger &
Preparation Of Final Accounts
SOLUTION
In the books of Ameet Hotel
Profit and Loss Account for the year ended 31st December, 2012.
Dr.
Cr.
Particulars
`
`
To Materials Consumed
• Wines
1,923
• Spirits
(378 + 2,190 - 333)
2,235
1,143
840
• Spirit
4,335
• Beers
1,863
• Minerals
2,160
390 12,618
• Meals
23,829
• Rooms
9,375
• Fires in
285
Bedrooms
To Provision and Stores
(183 + 5,220 - 141)
3,870
By Charges
• Cigars and Cigarettes
( 114 + 240 - 69)
NOTES
• Wines
Cigarettes (+)
• Minerals
(147 + 1,050 - 357)
`
• Cigars and
• Beers
(165 + 1,152 - 174)
`
By Sales
(opening + purchase - closing)
(1,239 + 1,881 - 1,197)
Particulars
• Washing (+)
5,262
Meat
3,627
Fish and poultry (+)
3,960
582
219
34,005
To Wages
19,275
To Salaries
4,305
To Rent, Rates and
Insurance
1,713
To Laundry
951
To Coal and Gas :
(150 + 2,160 - 99)
2,211
To Electric Light
1,128
To General Expenses
1,710
To Repairs and Renewals
and Depreciation on :
• Freehold premises
348
• Furniture and Fitting
660
• Glass and China
609
• Linen
390
• Cutlery and Plated (-)
207
To Net Profit C/D
2,214
10,716
46,623
46,623
Advanced Accounting - II
215
Visitor’s Ledger &
Preparation Of Final Accounts
In the books of Ameet Hotel
Balance Sheet as on 31st December 2012
Labilities
`
Share Capital :
NOTES
• Freehold Premises
56,865
Reserve and Surplus
Profit and Loss
46,800
• Furniture and Fitting
8,934
Current Assets :
10,716 Visitor’s A/c
Current Liabilities :
Sundry Creditors
`
Fixed Assets :
Authorised, Issued and
Subscribed :
`
Assets
1,345
Stocks :
2,569
• Wines
1,197
• Spirits
333
• Beers
174
• Minerals
357
• Cigars and Cigarettes
69
• Provisions and Stores
141
• Coal
(+)
99
2,370
Cash - at Bank
70,150
8,148
Cash - in - Hand
219
Glass and China
1,101
Linen
840
Cutlery and Plates
390
70,150
12.6 Summary
The main business of a hotel is to provide food and accomonodation. There
are some big hotels who provide different type of service such as recreation
entertain meats, business facilities, motals etc.
The accounting treatment in hotel industry will depend on the nature and
side of a hotel and its requirement. The principal of accounting will be the same as
like other business activities.
An analytical Purchase Book, Cash Book and Sale Book may be maintained
for recording business transactions. A Ledger column must also be made in cash
Book for recording the disbursement made for visitors. Cash Book will incorporate
two other ledgers Viz. visitors ledger and Personal Ledger.
While preparing final accounts, special attention must be made for adjustment
entries relating meals, lunch, accommolation etc.
216 Advanced Accounting - II
12.7 Key Terms
(1)
(2)
Visitors Ledger : This ledger contains an account of each guest staying in
the Hotel. The ledger is maintained in a loose leaf form. Separate sheets
are used for each day. It is kept in a tabular form so as to provide ready
information of different items or services provided to the guests.
Visitor’s Ledger &
Preparation Of Final Accounts
NOTES
Food staffs and Beverages (F & B) : are the two important items of
sales in a hotel.
12.8 Questions and Exercises
I - Objective Questions
A) Multiple choice Questions
(1)
Hotel industries follows the ------- system for recording their business
activities.
(a) double entry,
(b) Cash,
(c) Single entry,
(d) mixed-system
(2)
The ledger kept in a tabular analytical form, on account of each guest staying
in the hotel, which provide ready information of different items or services
provided to them is termed as --------(a) analytical ledger,
(b) principal ledger,
(c) Visitors ledger,
(d) Debtors ledger
(3)
The final accounts of hotel business includes ----------(a) Trading Account , Profit and Loss Account and Balance - Sheet.
(b) Profit and Loss Account and Balance - Sheet.
(c) Trading Account and Balance - Sheet.
(d) Manufacturing Account, Profit and Loss Account and Balance-Sheet.
(4)
An effective system of -------- is used by every hotel to check leakage of
revenue wastage of materials or facilities
(a) internal audit,
(b) internal check,
Advanced Accounting - II
217
Visitor’s Ledger &
Preparation Of Final Accounts
(c) internal control,
(d) internal verification.
Ans. : (1-a), (2-c), (3-b), (4-c).
NOTES
II - Long Answer Questions
(1)
What is ‘Tabular System of Book-Keeping’ ? Explain in brief the important
books of accounts maintained under Hotel Accounting.
(2)
What is ‘Visitors Ledger’? Explain the need of maintaining visitors ledger
by Hotel Business.
(3)
Define the term ‘Visitors Ledger’. State the importance of visitors ledger
as a basic record in Hotel Accounting .
(4)
What are ‘Final Accounts’ of Hotel Business ? Explain in brief the need
and importance of preparing final accounts in Hotel Accounting.
III - Practical Problems
(1)
From the following particulars relating to five rooms in Hotel sadanand
prepare a visitors ledger in columner form.
a)
Room Rent for each room ` 5,500 (+) 12% Tax
b)
Room 1 : Breakfast ` 390, Laundry ` 210, Local Phone Calls ` 100
c)
Room 2 : Lunch ` 1280, STD Calls ` 550, Wine ` 900, Outstanding f or
previous bill ` 270
d)
Room 3 : Hiring for Taxi ` 720, Local Phone Calls ` 240, Dinner `1,240
e)
Room 4 : Outstanding at the beginning ` 470, Laundry ` 230, Lunch `1,100
f)
Room 5 : Breakfast ` 410, Laundry Rs.240, Lunch ` 1,400.
g)
The guest in room 3 is regular visitor and is allowed to a discount of 8% on
room rent.
12.9 Further Reading
218 Advanced Accounting - II
•
Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd. - 2013.
•
Maheshwari S.N. and Maheshwari S.K. corporate Accounting - New Delhi
- Vikas publications Pvt. Ltd. - 2013.
Unit 13 Introduction, Accounting Treatment
in Hotel Accounting
Introduction, Accounting
Treatment In Hotel Accounting
Structure
NOTES
13.0 Introduction
13.1 Unit Objectives
13.2 Hotel Accounting
13.2.1 Type of Hotels and Restaurants
13.3 Accounting Treatment in Hotel Accounting
13.4 Fixation and charging of Room Rate
13.4.1 Method for ascertaining Room-Rate
13.4.2 Calculation of Room Occupancy Rate
13.5 Illustrations
13.6 Summary
13.7 Key Terms
13.8 Questions and Exercises
13.9 Further Reading
13.0 Introduction
The hotel business is basically a service industry. With the growth of tourism,
the hotel business is becoming a highly profitable venture for the entrepreneurs.
The accounting rules and principles to a hotel industry are the same as in the case
of any commercial organisation. In this regard, the provision of companies Act,
1956 for maintenance of account are also applicable to a hotel company. Hotel
industry provided services like, accommodation, food and beverage professional
and technical services to customers. Hence, the accounting system and control
devices are to some extent different form those applicable to other commercial
organisations. It is therefore necessary to get familiar with certain special services
and facilities concerning hotel business as discussed in this unit.
It may be noted that rent form rooms and sale of food and beverages (i.e.
provide breakfast, lunch, dinner guests and visitors) are the primary source of
revenue of a hotel. Other minor operating services like Telephone/fax services,
business centre, health club facilities, guest loundry, and beauty parlors etc. which
earn revenue for a hotel.
Advanced Accounting - II
219
Introduction, Accounting
Treatment In Hotel Accounting
13.1 Unit Objectives
After study this unit you should be able to.
NOTES
•
Understand the nature of a hotel business.
•
Identify the different type of hotels and restaurants.
•
Explain the accounting treatment for hotel business.
•
Explain the important points for fixation of room rate.
•
Determine Room occupancy rate.
13.2 Hotel Accounting
Restaurants and hotels provides their customers good services and value
for money and potential business transaction for the former. They provide quality
food to those who enjoy eating in these places. Today, restaurants and hotels have
become an essential part of living. Not only in cities, but also in towns and in the
rural areas. Many hotels are emerging, particularly near bus stands, railway stations
and in the market places. But there are some big hotels who provide other comforts
recreations, eutertainments, business facitilies, transport facilities, caterer services
etc. Therefore, the scheme of accounting will depend on the nature and size of a
hotel and its requirement although the principal of book keeping and accounting
will be the same.
Hotel Accounting is a particular system of accounting which accumulates,
communicates and interpretes historical and projects economic data that are useful
for the purpose of ascertaining the financial position and gaining results of a
restaurant or hotel. The types of hotels and restaurants is equally important to the
users of internal services of the hotel and external parties. In hotel industry,
accounting is nothing but an information of charging for various services provided
by the hotel or restaurant.
220 Advanced Accounting - II
Introduction, Accounting
Treatment In Hotel Accounting
13.2.1 Types of Hotels and Restaurants :
Ordinary
Hotels
(Snanck Centres)
2
Amruttulya
Bhavan
(Tea Stalls)
1
Types of
Restaurants
and
Hotels
NOTES
3
Udupi Hotels
4
Restaurants
1)
Amruttulya Bhavan (Tea Stalls) :- Provides only tea, coffee, colddrinks
etc. These hotels are the first in the various types of hotels.
2)
Ordinary Hotels :- These hotels also serve tea coffee, cold drinks and
delicious snacks and are gaining financially to a large extent.
3)
Udupi Hotels :- These hotels are found it cities and towns. They provide
south Indian snacks and other delicious eateries. These hotels are normally
run by the Udipi community and who strongly advocate vegtarianisum.
4)
Restaurants :- Restaurants have established them selves in cities, towns
and on highway carrying to the demands of quality foods by people through
a varied menu - from various Indian states and satisfying those who
appreciate social drinking. Restaurants are rates us 3 Star, and 5 star,
depending or the quality of their services, by attracting tourists and high
profile corporate clients. Some restaurants and hotel provides different types
of services which are classified as under.
(i) Inn :-
A loading house serving food and drinks to the travellers.
(ii) Hotel :-
A Hotel for motorists, with room adjoining a parking area.
13.3. Accounting treatment in Hotel Accounting
A hotel may have different provisions for serving of refreshments or for
serving of lunches and dinners including the arrangement of bar. Hotels may have
separate sections for catering at different places on different social occasions.
For this purpose, they maintained separate accounts for purchase of various types
of items and sales of various types of items.
Advanced Accounting - II
221
Introduction, Accounting
Treatment In Hotel Accounting
An analytical Purchase or Bought Book, Sales Book and Cash Book may
be maintained in Hotel Accounting.
(i)
A purchase book have a separate column for each and every purchase and
expenses i.e. Column for Wine, Minerals, Groceries and Provisions, Cutlery,
Glass, Plates, etc., Bedding and Lineus, Establishments, Furniture & Fixtures
etc.
(ii)
A ‘Ledger Column’ must be made in Cash Book for recording the
disbursement made for visitors, Cash Book will also incorporate two other
ledgers viz, “Visitors Ledger” and “Personal Ledger”.
(iii)
A Sales Book have a analysis column - such as Breakfast, Lunches and
Dinners, Bar, Cigarettes and cigurs etc., Carriages (If any) etc. The receipt
side of Cash Book must have similar analysis columns which are
incorporated in Sales Book.
(iv)
Beside the above, the Stock Ledger has to be maintained in details so that
direct control must be exercises regarding purchases, sales and other
consumable items.
(v)
Separate account have to be maintained for receipts like wines, Beer and
Spirits etc. and payments made against these items, the balance being transfer
to Profit and Loss Account.
(vi)
Proper Adjustments are also to be made for Meals, Loundry etc. between
the staff and the owner for ascertaining correct profit in Hotel Accounting.
(Salaries and wages (for staff) and Drawing Account (for owner) will be
debited and particular account say, Loundry will be credited)
NOTES
(vii) All kinds of transfer from one section to another section is to be maintained
systematically.
(viii) Open working accounts for various sections of Bar, Accommodation,
Restaurant, Lunch, Dinner etc. (When collection are made Accommodation
Account is credited on the other hand rates, taxes, repairs to building,
depreciation on bedding, attendents, wages, proportionate establishment
charges etc. are to be debited to Accommodation Account)
222 Advanced Accounting - II
(ix)
Cost and expenses relating to meat, eggs, fish, poultry, groceries provisions
etc. should be apportioned between Restaurants and Lunches and Dinners.
(x)
It becomes necessary to prepare separate accounts for Internet connection,
Billiards Room, Bunquet Hall, Laundry etc.
(xi)
While preparing Final Accounts, special attention must be made for all
adjustment entries, as well as closing entries relating to various types of
services provided by the hotel. All relating expenses are to be apportined
among the different sections in an appropriate manner and, consequently
the same will be adjusted in Profit and Loss Account.
Introduction, Accounting
Treatment In Hotel Accounting
13.4 Fixation and charging of Room Rate
While fixing room rate following points should be taken in to consideration
(a)
Location of the Hotel.
(b)
Availability of rooms in the hotel.
(c)
Capital and Revenue Expenditure.
(d)
Expected Rate of return on investments.
(e)
Availability of various facilities and services attached.
(f)
Location of the particular room.
(g)
Occupancy Rate.
(h)
Suitable season of tourists.
NOTES
13.4.1 Method for ascertaining Room-Rate :
For calculating room-rate, normally the total estimated revenue expenditure
plus estimated rate of return on investment is divided by the number of rooms
which are available for letting out purposes. The charges for single Room, Double
Room, South facing Room will be quite different than the other.
Room Occupancy Rate is calculated as :
Number of Rooms occupied
Room Occupancy Rate=
x 100
Number of Rooms available for letting out
(Note : Double Bedded Room is taken as two rooms.)
Double Occupancy Rate :
Total number of Guests - Number of Rooms occupied
x100
=
Number of Rooms occupied
(Note : Number of beds should be taken instead of number of Rooms.) OR
Estimates cost of operation + Expected fair return on investment
Room
=
rate
No. of available Room that can be let out.
13.4.2 Calculation of Room Occupancy Rate :
Usually for a 24-hour stay one day’s charge is take n, i.e., the occupant is
allowed to stay for 24 hours from the time of arrival to the time of departure. The
occupant is to pay one day’s charge even if he stays for less than 24 hours. It is
interesting to note that check-out time is followed in some hotels which is usually
fixed at 12 noon. For this, full charge is to be paid by the occupant from the time
of occupying the room to the check-out time which usually is less than 24 hours.
Check Your Progress
1 . State
the
types
of
Restaurants and Hotels
requiring
appropriate
system
of
Hotel
Accounting.
2 . State the important factors
to be considered while
fixing a room-rate.
3 . State the method of
calculating
Room
Occupancy Rate.
Advanced Accounting - II
223
Introduction, Accounting
Treatment In Hotel Accounting
NOTES
For Example, X occupied a room in a hotel at 7.00 a.m. in the morning on Monday
where check out time was fixed at 12.00 a.m.. He left the hotel on Tuesday at
4.00 p.m. He should pay 3 days charges (i.e., from 7.00 a.m. to 12 a.m. on Monday
+ 12 noon of Monday to 12 noon of Tuesday + 12 noon of Tuesday to 4 p.m. of
Tuesday.)
The concept of room occupancy rate can be understood with the help of
following illustrations.
13.5 Illustrations
ILLUSTRATION 1
A five - star hotel in Chennai has 320 lettable rooms on a particular day, 240
rooms are occupied by 300 guests. Calculate Double Occupancy Rate.
SOLUTION
Number of Guests - Number of Rooms Occupied
x100
Double Occupancy Rate =
Number of Rooms Occupied
300 Guest - 240 Rooms
x 100
=
240 Rooms
60 Guest
x 100
=
240 Rooms
= 25%
ILLUSTRATION 2
A five - star hotel has 660 rooms in all, out of which 52 rooms are used for
operational purposes and 8 rooms are used by the departmental managers.
If 480 rooms are occupied by the guests on any day, calculate the room
occupancy rate.
SOLUTION
Number of Rooms occupied
Room Occupancy Rate
x 100
=
Number of rooms available for letting out
480 Rooms
=
x 100
660 Rooms - 44 Rooms (52 Rooms - 8 Rooms)
480 Rooms
x 100
=
616 Rooms
224 Advanced Accounting - II
= 78 %
Introduction, Accounting
Treatment In Hotel Accounting
ILLUSTRATION 3
Mr. A arrives in Nagpur and check into a room in a five-star hotel at 4.p.m.
on 1 June 2012 at ` 500 per day plus 10% for service charges on European
Plan. Check out time in the hotel is 12 noon.
st
Calculate the amount payable by Mr. A in each of the following circumstance:
NOTES
(i) If Mr. A checks out at 10 p.m. on the same day
(ii) If Mr. A checks out at 9 a.m. on 2nd June 2012
(iii) If Mr. A checks out at 6 p.m. on 2nd June 2012
(iv) If Mr. A checks out at 4 p.m. on 3rd June 2012
Show also the amount payable by Mr. A if the charges were leviable @
` 500 for a stay of every 24 hours or part there of plus service charges at 10%
SOLUTION
Based on 12 Noon Check-out Time
Particulars
Number of
Rate Amount Tax@10%
`
Days
Check out at 10 p.m.
`
`
Total
Amounts
payable `
1
500
500
50
550
`` `` `` 9 a.m. on 2nd June
1
500
500
50
550
`` `` `` 6 a.m. `` `` ``
2
500
1,000
100
1,100
`` `` `` 4 p.m. on 3rd June
3
500
1,500
150
1,650
1
500
500
50
550
1
500
500
50
550
`` `` `` 6 p.m. on 2 June
2
500
1,000
100
1,100
`` `` `` 4 p.m. on 3rd June
2
500
1,000
100
1,100
on the same day
Based on 24 Noon Check-out Time
Check out at 10 p.m. on the
same day
`` `` `` 9 a.m. on the same day
nd
13.6 Summary
•
Hotel business is basically a service industry. Hence the accounting system
is some extent different from those applicable to other type of businesses.
•
Following services are provided by a hotel.
(i)
Accommodation to customer.
(ii) Food & beverages.
(iii) Professional and technical services.
(iv) Other facilities like, shopping centre, beauty parlors, hair dressing
saloons etc.
Advanced Accounting - II
225
Introduction, Accounting
Treatment In Hotel Accounting
•
Rent from rooms and sales of food and beverages are the primary sources
of revenue of a hotel.
•
Generally room rate is fixed taking into consideration the following important
factors :
NOTES
(i) Number of Rooms which can be hired out during a particular period.
(ii) The estimated cost of operation for the same period.
(iii) The expected fair return on the investment.
However the following additional factors which are important while fixing
the room rate by a hotel.
(i) Location of the hotel, (ii) Location of the room,
(iii) Facilities provided in the room & (iv) occupancy rate.
13.7 Key Terms
Name of Room Occupied
i) Room Occupancy Rate =
x 100
Number of Rooms Available for letting out
No. of Guest - No. of Room Occupied
x 100
ii) Double Occupancy Rate =
No. of Rooms Occupied
iii) Room Rate :- It is the rate at which a guest is to be charge for accommodation
provided to him by the hotel.
13.8 Questions and Exercises
I - Objective Questions
A) Multiple Choice Questions
(1)
The hotel business is basically a -------------(a) serving industry
(b) trading concern
(c) manufacturing organisation
(d) commercial enterprise
(2)
The primary source of revenue for a Hotel Business is ----------(a) rent from room - accommodations
(b) sale of food and beverages
226 Advanced Accounting - II
(c) health club facilities
(d) all of the above
(3)
Introduction, Accounting
Treatment In Hotel Accounting
The compilation of various information of charging for various services
provided by the hotel is termed as ----------(a) Services Accounting
(b) Hotel Accounting
NOTES
(c) Business Accounting
(d) Corporate Accounting
(4)
The percentage of beds occupied by the guests to the total beds available in
the hotel is termed as --------------(a) Single Occupancy Rate
(b) Double Occupancy Rate
(c) Bed Occupancy Rate
(d) Room Occupancy Rate
Ans. : (1 - a), (2 - d), (3 - b), (4 - c).
II - Long Answer Questions
(1)
What is ‘Hotel Accounting’? Explain the types of Hotels and Restaurants.
(2)
Define ‘Hotel Accounting’. State the importance of Purchase Book, Sales
Book and Cash Book maintained in Hotel Accounting.
(3)
What is ‘Room Rate’ ? Explain in brief the important points to be considered
while fixing room-rate.
(4)
What is ‘Room Occupancy Rate’? Explain the method for calculating Room
occupancy Rate.
III - Practical Problems
(1)
Hotel Blue Diamond, a three star hotel in Pune has 500 lettable rooms, of
which 300 rooms are single bed rooms and 200 are double bed rooms. On
26th January, 2014 200 single rooms and 100 double rooms are occupied by
the guests. Calculate the Bed Occupancy Rate for 26th January,2014.
Advanced Accounting - II
227
Introduction, Accounting
Treatment In Hotel Accounting
NOTES
228 Advanced Accounting - II
13.9 Further Reading
•
Shukla M.C., Grewal T. S. and Gupta S. C. - Advanced Accounts - New
Delhi - S. Chand & Co. Pvt. Ltd. - 2013
•
Maheshwari S. N. and Maheshwari S. K. - Corporate Accounting - New
Delhi - Vikas Publishing House Pvt. Ltd. - 2013