CHARTERED ACCOUNTANCY PROFESSIONAL (CAP) -II
STUDY MATERIAL
Advanced Accounting
August 2020
Education Division
The Institute of Chartered Accountants of Nepal (ICAN)
PREFACE
This study material on the subject of “Advanced Accounting” has been exclusively
designed and developed for the students of Chartered Accountancy Professional [CAP]II Level. It aims to provide the required knowledge to the students so as to enable the
candidates to understand the principles, methods and procedures of accounting as
followed by different entities and understand the relevant laws, principles and practices
for the presentation and presentation of financial statements of companies. It also
focuses on understanding of the tools and techniques followed in the analysis and
interpretation and presentation of financial statements of companies.
It broadly covers the chapters of Accounting Standards, Accounting for Special
Transactions, Preparation & presentation of financial statements for company,
Partnership Accounts, Preparation and presentation of financial statements of special
organizations, Incomplete Accounts, Government Accounting and Analysis and
interpretation of financial statements. Numbers of practical problems are included at the
end of each chapter which can be useful to the students for their self-assessment about
the progress evaluation after thoroughly reading the material.
Students are requested to accustom with the syllabus of the subject and read each topic
thoroughly for understanding on the chapter. We believe this material will be of great
help to the students of CAP-II. In addition to the study material provided, they should
update themselves and refer recommended text-books given in the CA Education
Scheme and Syllabus along with other relevant materials in the subject.
Last but the most, we acknowledge the efforts of CA. Ranjit Kumar Yadav, who has
meticulously assisted for updating this study material and CA. Prawin Karki, who has
reviewed this study material for building in this comprehensive shape.
Due care has been taken to make every chapter simple, comprehensive and relevant for
the students. In case students need any clarification, creative feedbacks or suggestions
for further improvement on the material, they may be forwarded to the Education
Division of the Institute.
August, 2020
Education Division
The Institute of Chartered Accountants of Nepal
TABLE OF CONTENTS
Chapter I
Accounting Principles, Concepts & Standards
Unit 1
Accounting Principles, Concept and Theory
1.1 Introduction
1.2 Bussiness Entity Concept
1.3 Money Measurement Concept
1.4 Going Concern Concept
1.5 Accounting Period Concept
1.6 Accounting Cost Conpcet
1.7. Dual Aspect Conpect
1.8 Realisation Concept
1.9 Accrual Concept
1.10 Matching Concept
2
3
3
4
4
5
5
6
6
7
7
Unit 2
Historical and Fair Value Concept of Preparation of Financial Statement
2.1 Introduction
2.2 Historical Cost Accounting
2.3 Fair Value Accounting
9
10
10
11
Unit 3
Effect of Price Level Changes and Financial Reporting
3.1 Introduction
3.2 Effect of Price Change
3.3 Conceptual Issue
3.4 Accounting Income
3.5 Economic Income
3.6 Purpose of the Comparison
3.7 The Conflict–Historical Cost Versus Fair Value
3.8 The Ultmate Question
3.9 Comprehensive Income
3.10 Value Change
3.11 The Problem
3.12 A Paradigm Shift
3.13 The Theory of Income
3.14 Conclusion
16
17
17
17
19
20
20
20
21
21
21
22
22
23
23
Unit 4
Financial Reporting Standards
4.1 Introduction to Accouning Standards Board (ASB)
4.2 Need of Accounting Standards
4.3 Standards Setting Process
25
26
26
27
4.4 Need of Convergence with Global Standards
4.5 Standards Issued by ASB
– NAS 01 Presentation of Finalcial Statement
– Nas 02 Inventories
– NAS 8 Accounting Policy, Changes in Accounting Estimates and Errors
– NAS 16 Property, Plant and Equipment
– NAS 17 Leases
– NAS 18 Revenue
– NAS 20 Accounting for Government Grants and Disclosure of
Government Assistances
– NAS 21 The Effects of Changes in Foreign Exchange Rates
– NAS 37 Provisions, Contingent Liabilities and Contingent Assests
– NFRS 3 Business Combination
28
29
30
35
45
55
68
77
86
91
98
107
Chapter II
Accounting for Special Transactons
Unit 1
Accounting for Leas
1.
Background
2. Types of Leases
3. Sale and Lease Back Transactions
112
113
115
117
Unit 2
Hire Purchage and Installlment Transactions
1.
Hire Purchage Transaction
1.1 Introduction of Hire-Purechase System
1.2 Calculaion of Cash Price, if Cash Price is not Given
1.3 Calculation of Amount of Intersest
1.4 Accounting in the Books of Hire-Purchaser
1.5 Accounting in the Books of Hire-Vendor
1.6 Repossession
1.7 Calculation of Missing Figures
2. Installment Payment System
3. Difference Between Hire Purchase Agreement and Installment Payment Agreement
122
123
123
124
126
130
135
147
150
151
152
Unit 3
Goods on Sale or Return
1.
Introduction
2. Methods for Recording Goods Sold on Approval Basis
2.1 Recording of Few Transaction
2.2 Recording of Considerable Number of Transactions
2.3 Recording of many Transactions
157
158
158
158
159
160
Unit 4
Contract Accounting
1.
Introduction of Construction Contract
164
165
2.
3.
4.
5.
6.
7.
8.
Contract Revenue
Contract Costs
Recognition of Contract Revenue and Expenses
Contract Work in Progress
Recognttion of Expected Losses
Disclosure Requirement in Case of construction Contraction
Traditional Method for Accounting or Contract
8.1 Ascertainment of Notional Profit
8.2 Calculation of Profit from the Notional profit
9. Contract Account with Statement of financial Position
10. Estimated Contract Account
11. Escalation Clause
166
167
168
171
171
171
173
173
174
181
186
191
Unit 5
Branch Accounting
1.
Introduction
2. Branch Not Keeping Full System of Accounting
2.1 Debtors Method
2.2 Final Account Method
2.3 Stock and Debtors System
2.4 Wholesale Branch
3. Branch Keeping Full System Accounting
3.1 Accounting Entries for Various Transaction between Head office & Branch
3.2 Adjustment and reconciliation of Branch and Head Office Accounts
3.3 Incorporation of Branch Balance in Head Office Books
3.4 Incomplete Information in Branch Books
4. Foreign Branches
4.1 Accounting For Foreign Branches
4.2 Change In Classification
4.3. Techniques for Foreign Currency Translation
194
195
195
196
205
210
225
227
227
229
232
242
245
245
247
247
Unit 6
Departmental Accounting
1.
Introduction
2. Division of Subsidiary Books
3. Allocation of Expenses
4. Calculation of Departmental Purchases
5. Calculation of Remuneration of Departmental Managers
6. Inter- Departmental Transfers- At Cost Price
255
256
256
256
258
260
262
Unit 7
Computation of Insurance Claims For Loss of Stock and Profit
1.
Meaning of Fire
2.
Claim for Loss of Stock
2.1 Average Clause
2.2 Deductible or excess
286
287
287
287
288
2.3 Survey expenses
2.4 Journal Entries
2.5 Calculation of total stock and claim on the date of fire
Claim for Loss of Stock
3.1 Scope and Coverage
3.2 Explanation of Certain Terms
288
289
290
295
295
296
Unit 8
Investment Accounts
1.
Background
2.
Application of Nepal Accounting Standard (NAS/NFRS)
3.
Financial Instrument
4.
Financial Asset
4.1 Held for Trading Investment
4.2 Held to Maturity Investment
4.3. Available for Sale Investment
5
Measurement of The Investment
6. Effective Interest Rate
7. Recognition of Income
8. Recognition of Gain and Losses
9. Impairment Loss
310
311
311
312
312
312
313
313
313
314
316
316
317
3.
Chapter III
Preparation and Presentation of Financial
Statements for Company
Unit 1
Accounting of Share Capital
1. Meaning of Company and Its Formation
2. Shares of The Company and its Type
3. Presentation of Share Capital in the Statement of Financial Position
4. Met Hod of Raising Share Capital
5. Regulation of Public Issues
6. Procedure for Allotment
7. Accounting Entries
7.1. Issue of Shares At Par
7.2 Issue of Shares at Premium
7.3 Issue of Shares at Discount
7.4 Issue of Shares for Consideration Other Than Cash
7.5 Forfetture of Shares
7.6 Re-Issue of Forfeited Shares
7.7 Forfeiture of Shares When There is an Over Subscription and
Pro-Rata Allotment
7.8 Right Issue
7.9 Bonus Share
7.10 Buy Back of Shares
325
326
328
331
333
333
336
338
344
346
348
350
353
355
359
360
370
Unit 2:
Redeemable Preference Shares
1. Itroduction
2. Types of Preference Shares
3. Conditions for Issue and Redemption of Redeemable Preference Shares
4. Accounting Entreies Necessary for Redemptions
5. Use of Equation for Determining the Amount
375
275
375
378
384
Unit 3:
Debentures: Issue and Redemption
1. Meaning and Nature of Debentures
2. Diffferences Between Shares and Debentures
3. Purposes of Issueing Debentrues
4. Types of Debentures
5. Stages of Debentures
6. Issue of Debentures
7. Provision for Redemption of Debentures
8. Redemption of Debentures–Different Methods
9. Ex-Interest and Cum-Interest Quotations
393
393
394
394
395
395
410
415
424
UNIT 4:
Underwriting of Shares and Debenture
1. Meaning of Underwriing
2. Importance of Underwriting
3. Types of Underwriting Agreement
4. Marked and Unmarked Applictions
5. Accounting Treatment Under Pure Underwriting
i. When the entire issue is underwritten
ii. When the issue is partially underwritten
6. Firm Underwriting
444
444
445
445
446
446
449
451
Unit 5:
Preparation of Financial Statements
1. Introduction
2. Legal Provision Relating to Books of Account & Financial Statements
3. Components of Financial Statements
3.1 Statement of Financial Position (A Balance Sheet)
3.2 Statement of Profit or Loss Account and Other Comprehensive
Income ( An Income Statement)
3.3 Interpretation of items of financial statement
3.4 Statement of Changes in equity
3.5 Cash flow statement
3.6 Notes to the financial statements
UNIT 6:
Winding up of Companies
460
460
463
463
466
468
484
486
486
1.
2.
3.
4.
5.
Meaning of Winding up
Voluntary Liquidation of Company
Insolvency Proceedings
Additional Disclosure and Comments on 'Going Concern' In
Relation to Winding up
Order of Settlement of Liabilities
493
394
495
499
500
UNIT 7:
Amalgamation, Absorption and Reconstruction
1. Meaning of business Combination
2. Legal Procedure for Business Combination
3. Purchase Consideration
3.1 Net Payments Method
3.2 Net Assets Method
3.3 Share Exchange method
4. Method of Accounting for Amalgamations
5. Accounting in the Books of Transferor Company
6. Accounting in The Books of Transferee Company
7. Treatment of Fractional Shares
8. Difference Between the Purchase and Pooling of Interest Method
9. Disssenting Shareholders
10. Inter Company Owings
10.1 Cancellation of Common Debts
10.2 10.2 Cancellation of Unrealized Profits
11. Intercompany Holding of Shares
11.1 When Purchasing Company Holds Shares in Vendor Company
11.2 When Vendor Company Holds Shares in Purchasing Company
11.3 When Shares are held by both the Companies in each other
12. Discounted Cashflow Model
13. Entries in Case of Internal Reconstruction
505
506
507
508
509
509
511
512
515
520
530
531
531
534
534
534
537
537
546
548
551
553
UNIT 8:
Statement of Cash Flows
1. Introduction
2. Use of Cashflow Information
3. Cash and Cash Equivalents
4. Cashflow Activities
4.1 Operating activities
4.2 Financing activities
4.3 Investing activities
4.4 Reporting Cash from Investing and Financing Activities
5. Foregn Currency Cash Flows
6. Special Considerations for Cash Flow
7. Disclosures
565
566
566
567
567
567
570
570
571
572
572
575
UNIT 9:
Application of Nepal Accounting Standards in the Preparation of Financial
Statements for General Purpose
1. Intruduction
2. Purpose of General Purpose financial Reporting
3. Users of General Purpose Financial Reports
4. Purposes for Which User Groups Require Financial Information
4.1 Resource providers
4.2 Recipients of goods and services
4.3 Parties performing a review or oversight function
5. Objective of General Purpose Financial Reporting
6. Types of Information Relevant to Users' Needs
7. Format of General Purpose Financial Statements
8. Conformity With Nepal Accounting Standards
9. Responsibilities of Memebers of ICAN in Respect of General
Purpose Financial statements
10 Responsibilities of Memebers in Respect of special Purpose Financial Statements
587
588
589
590
591
591
591
592
592
592
595
595
595
596
CHAPTER IV
Partnership Accounts
1.
2.
3.
4.
4.1
4.2
5.
6.
7.
8.
9.
1.
2.
3.
4.
Basic Concepts
Nature of Partnership
Parnership Deed
Parmer's Capital and Current Accounts
Fluctuating Capital Method
Fixed Capital Method
Distribution of Profit
Goodwill
6.1 Factors giving rise to Goodwill
6.2 Need for Valuation of Goodwill
6.3 Methods of Valuation of Goodwill
6.4 Accounting Treatment of Goodwill
Change in Profit Sharing Ratio
Joint Life Policy
Past Adjustments
598
598
599
600
600
600
605
611
611
612
612
616
616
618
619
ACCOUNTING FOR ADMISSION OF PARTNER
Basic Concepets
Deciding New Profit Sharing Ratio
Sacrificing Ratio
3.1 Incoming partner acquires his share of profit from all the existing partners
3.2 Incoming partner may acquire his share from one of the partners
Treatment of Goodwill
4.1 Goodwill (premium) paid privately
4.2 Goodwill/premium brought in cash by the new partner and retained
621
621
622
622
622
622
623
6.
7.
8.
in the business
Premium (Share of Goodwill) brought in kind
Goodwill/Premium brought by the new partner and the same withdrawn
by the old partners fully or partly.
4.5 When only a portion of the goodwill/premium is brought by the new
Partner in cash.
4.6 When the new partner is not able to bring his share of goodwill in cash
4.7 Hidden Goodwill
Adjustment of Joint Life Policy
5.1 When premium paid was considered as revenue expenditure
5.2 When premium paid was considered as capital expenditure
Adjustments for Reserves and Accumulated Profit and Loss Account
Revaluation of Assets and Reassessment of Liabilities
Determination/Adjustment of Capitals
624
624
625
625
625
625
626
626
627
1.
2.
3.
4.
5.
6.
7.
8.
ACOUNTING FOR RETIREMENT OF PARTNER
Basic Concept
New Profit Sharing Ratio and Gaining Ratio
Treatment of Goodwill
Revaluation of Assets and Liabilities
Treatment of Profit, Accumulated Reserves and Undistributed Profit
Settlement of Retiring Partner's Claim
Adjustment of Remaining Partner's Capital
Death of a Partner
632
632
634
634
635
636
637
640
1.
2.
3.
4.
5.
6.
7.
8.
9.
DISSOLUTION OF PARTNERSHIP FIRM
Introduction
Mode of Settlement of Account between Partners
Treatment of assets and Liabilities
Treatment of Accumulated Reserves and Profit/Loss
Treatment of Unrecorded Assets and Liabilities
Payment of Realization Expenses
Closing of Realization Account
settlement of Partners' Capital Accounts
Preparaion of Cash/Bank Account
645
646
646
647
648
649
649
650
651
4.3
4.4
5.
623
623
624
MERGER OF PARTNERSHIP AND CONVERSION OF PARTNERSHIP INTO COMPANY
1. Merger of Partnership Firms
666
CHAPTER V
Preparation and Presentations of Financial Statements of Special Organizations
676
UNIT 1:
Preparation and Presentations of Financial Statements of Banks and Financial Institutions677
1. Meaning of Banking Company
678
2. Types of Bank
678
3.
4.
5.
6.
7.
8.
9.
10.
11,
12,
13.
Capital of the Banks and Financial Institution
Capital Fund
General Reserve Fund
Exchange Equalization Fund
Restriction on Distribution of Dividends
Accounts and Audit
Unclaimed Deposits or Dividends
Statistical Returns to Be Submitted
Discounting and Collection of Bills
Rebate on Bills Discounted
Acceptance and Endorsement of Bill
678
679
679
680
680
680
681
681
682
683
685
UNIT 1.2: CAPITAL ADEQUACY NORMS
1.
2.
3.
4.
5.
6.
Regulation of Bank and Financial Institutions
Capital Adequacy Norms
Maintenance of Minimum Capital Fund
Capial Fund
4.1 Core Capital/Primary Capital (Tier I Capital)
4.2 Supplementary capital
Capital Fund Ratio and Its Determination Formula
Supervisory Review and Response on Capital Adequacy Assessment Process
686
686
688
688
688
690
690
692
1.
2.
3.
UNIT 1.3: Classification of Loan and Advances and Loan Loss Provisions
Provisions Relating to Classification of Loans/Advances and Loan Loss Provisions
Provision to be Maintained for Loan Loss
Loss Provisions and Auction of Non-Banking Assets
703
704
706
1,
2.
3.
4.
5.
6.
7.
UNIT 1.4: PROVISIONS RELATING TO ACCOUNTING POLICIES
AND FORMAT OF FINANCIAL STATEMENTS
Guidelines Relating to Financial Statements
Principal Accounting Policies
Notes on Accounts
Statement of Changes in Equity
Cash Flow Statement
Statement of Mortgage of Promoters Shares
Disclosure of Defered Tax Assets and Liabilities
711
712
714
715
715
715
715
UNIT 1.5: PROVISIONS RELATED TO COMPULSORY RESERVE RATIO ( CRR) AND
STATUTORY LIQUIDITY RATIO (SLR)
1.
Provisions Relating to Compulsory Reserve Ratio
732
2. Provisions Relating to Statutory Liquidity Ratio (SLR)
732
UNIT 2
Preparation and Presentation Of Financial Statements of Co-operative Societies
1. Introduction
2. Collection of Capital of Cooperative Societies
735
736
737
3.
4.
5.
6.
7.
8.
9.
Power to Undertake Banking Business
Distribution of Savings
Accounts and Audit
Income Recognigion
Loan Loss Provisions
Provisions Relating to Liquidity Management
'Pearls' System of Monitoring the Cooperative
Unit 3:
Accounts of Insurance Companies
1. Introduction and Meaning of Insurance
2. Types of Insurance
3. Directives of Insurance Board
4. Accounting Policy of Insurer
4.1 Recognition of Premium Income
4.2 Claim Payment
4.3 Agent Commission
4.4 Re-insurance Commission and Profit Commission on Re-insurance
4.5 Insurance Service Charge
4.6 Management Expenses:
5. Distribution of Management Expense
6. Distribution of Investment Income
7. Distribution of Income Tax
8. Insurance Fund
8.1 Life Insurance Fund
8.2 Other Compulsory Reserve Fund
9. Fixed Assets
10 Loan
11. Investment
1. Investment Criteria of Life Insurance Business
2. Investment Criteria of Non Life Insurance
Unit 4:
Agricultural Farm Accounting
1. Introduction
2. Unpopularity of Farm Accounting
3. Objective of Farm Accounting
4. Peculiar Features of Farm Accounting
5. Recording of Transactions
6. Recognition and Measurement of Specialized Nature of Transaction in
Farm Accounting
6.1 Biological Asset or Agricultural Produce
6.2 Land Development Expense
6.3 Insurance
6.4 Drawing
6.5 Wages
737
738
738
739
739
739
740
754
755
755
755
758
758
758
758
758
758
758
760
763
766
767
768
769
770
770
772
775
794
795
795
795
796
796
797
797
797
798
798
798
7.
Preparation of Financial Statements
7.1 Single Entry Method
7.2 Double Entry System
798
798
802
CHAPTER VI
ACCOUNTING FROM INCOMPLETE RECORDS
1.
2.
3.
4.
5.
6.
7.
8.
9.
10
Introduction
Features of Incomplete Records Accounting
Ascertainment of Profit or Loss by Preparing the Statement of Affairs
Accounts From Incomplete Records
Derivation of Information From Cash Book
Analysis of Debtors and Creditors Ledger
Stock and Work in Progeress
Provisions, Transfers nd Year-End Adjstments
Distincion Between Business Expenses and Drawings
Fresh Investment by Proprietors/Partners
812
812
812
815
816
817
817
818
818
819
CHAPTER VII
GOVERNMENT ACCOUNTING
1.
2.
3.
4.
5.
6.
7.
Concept of Government Accounting System
Salient Features of Government Accounting System
Difference Between Government Accounting and Busness Accounting
Basis of Government Accounting
Accounts Classification
Forms Used in Government Accounting
Nepal Public Sector Accounting Standard (NPSAS)
7.1 Scope of the Standard
7.2 Cash Basis of Accounting
7.3 Components of the Financial Statements
7.4 Information to be presented in the Statement of Cash Receipts and Payments
7.5 Payments by third parties on behalf of the entity
7.6 Accounting Policies and Explanatory Notes
7.7 Treatment of Foreign Currency Cash Receipts, Payments and Balances
7.8 Presentation of a Comparison of Budget and Actual Amounts
859
859
860
861
862
863
864
865
865
866
866
866
867
867
868
CHAPTER 8
Analysis and Interpretation of Financial Statements
UNIT 1:
Analysis and Interpretation of Financial Statements
1.1 Introduction
2.1 Methods of Analysis and Interpretation of Financial Statement
1.2.1 Financial Ratios
1.2.2 Sources and Uses of Funds – Fund Flow Statement
1.2.3 Percentage and Trend Analysis
870
871
871
872
872
872
1.2.4 Comparative Analysis
1.2.5 Fundamental Analysis
1.3 Analysis and Interpretation of Financial Statements Under NAS, Las And Ifrs
873
873
874
UNIT 2:
OPERATING SEGMENT
1. Introduction
2. Accounting Standard
877
878
878
UNIT 3:
Ratio Analysis
1. Meaniging of Ratio Analysis
1.1 Leverage Ratios
1.2 Liquidity Ratios
1.3 Efficiency Ratios
1.4 Profitability Ratios
1.5 Market Value Ratios
886
887
887
888
889
891
892
UNIT 4:
Related Party Disclosure
1. Introduction
2. Nepal Accounting Standard
3. Disclosure
916
917
917
919
CHAPTER IX
Accounting for NPOs
1.
2.
3.
4.
5.
6.
7.
Introduction
Nature of Receipts and Payments account
Sources of Income in NPOs
Fund Based Accounting
Income and Expenditure Account
Statement of Financial Position
Receipt and Expenditure Account
924
924
926
929
932
935
937
CHAPTER X
Public Financial Management
1.
2.
3.
4.
5.
Concepts
Public Financial Management System in Nepal
Public Expenditure and Financial Accountability (PEFA)
Strengthening PFM System in Nepal
The PFM REFORM Initiatives1000
a. Government Financial Statistics (GFS)
b. Treasury Single Account (TSA)
c. Strengthening Accounting and Financial Reporting
954
954
955
955
956
957
957
958
ICAN – Advanced Accounting – CAP II- CHAPTER I
CHAPTER I
Accounting Principles, Concepts & Standards
UNIT 1:
Accounting Principles, Concept and Theory
UNIT 2:
Historical and Fair Value Concept of Preparation of Financial Statements
UNIT 3:
Effect of Price Level Changes and Financial Reporting
UNIT 4:
Financial Reporting Standards
UNIT 1: Accounting Principles, Concepts and Theory
Page 1
ICAN – Advanced Accounting – CAP II- CHAPTER I
CHAPTER 1
Accounting Principles, Concepts & Standards
UNIT 1:
Accounting Principles, Concept and Theory
Page 2
UNIT 1: Accounting Principles, Concepts and Theory
ICAN – Advanced Accounting – CAP II- CHAPTER I
1.1 INTRODUCTION
In order to maintain uniformity and consistency in preparing and maintaining books of
accounts, certain rules or principles have been evolved. These rules/principles are classified
as concepts, principles, theory and conventions. These are foundations of preparing and
maintaining accounting records. In this lesson we shall learn about various accounting
concepts, their meaning and significance.
Let us take an example. In Nepal there is a basic rule to be followed by everyone that one
should walk or drive on his/her left hand side of the road. It helps in the smooth flow of
traffic. Similarly, there are certain rules that an accountant should follow while recording
business transactions and preparing accounts. These may be termed as accounting concept.
Thus, accounting concept refers to the basic assumptions, rules and principles which work
as the basis of recording of business transactions and preparing accounts.
The main objective of such concepts and principles is to maintain uniformity and
consistency in accounting records. These concepts constitute the very basis of accounting.
All the concepts have been developed over the years from experience and thus they are
universally accepted rules. Following are the various accounting concepts that have been
discussed in the following sections:









Business entity concept
Money measurement concept
Going concern concept
Accounting period concept
Accounting cost concept
Duality aspect concept
Realization concept
Accrual concept
Matching concept
1.2 BUSINESS ENTITY CONCEPT
This concept assumes that, for accounting purposes, the business enterprise and its owners
are two separate independent entities. Thus, the personal transactions of its owner are
separated from the transactions of the business. For example, when the owner invests
money in the business, it is recorded as liability of the business to the owner. Similarly,
when the owner takes away from the business cash/goods for his/her personal use, it is not
treated as business expense. Thus, the accounting records are made in the books of
accounts from the point of view of the business unit and not the person owning the
business. This concept is the very basis of accounting.
UNIT 1: Accounting Principles, Concepts and Theory
Page 3
ICAN – Advanced Accounting – CAP II- CHAPTER I
The following points highlight the significance of business entity concept:
 This concept helps in ascertaining the profit of the business as only the business
expenses and revenues are recorded and all the private and personal expenses are
ignored.
 This concept restraints accountants from recording of owner’s private personal
transactions.
 It also facilitates the recording and reporting of business transactions from the business
point of view
 It is the very basis of accounting concepts, conventions and principles.
1.3 MONEY MEASUREMENT CONCEPT
This concept assumes that all business transactions must be measured in terms of money i.e
in the currency of a country. In our country such transactions are expressed and measured
in terms of rupees. Thus, as per the money measurement concept, transactions which can
be expressed in terms of money are recorded in the books of accounts. For example, sale of
goods worth Rs.200,000, purchase of raw materials of Rs.100,000, Rent Paid Rs.10000
etc. are expressed in terms of money, and so they are recorded in the books of accounts.
But the transactions which cannot be expressed in monetary terms are not recorded in the
books of accounts. For example, sincerity, loyalty, honesty of employees are not recorded
in books of accounts because these cannot be measured in terms of money although they do
affect the profits and losses of the business concern.
The following points highlight the significance of money measurement concept :
 This concept guides accountants what to record and what not to record.
 It helps in recording business transactions uniformly.
 If all the business transactions are expressed in monetary terms, it will be easy to
understand the accounts prepared by the business enterprise.
 It facilitates comparison of business performance of two different periods of the same
firm or of the two different firms for the same period.
1.4 GOING CONCERN CONCEPT
This concept states that a business firm will continue to carry on its activities for an
indefinite period of time. Simply stated, it means that every business entity has continuity
of life. Thus, it will not be dissolved in the near future. This is an important assumption of
accounting, as it provides a basis for showing the value of assets in the Statement of
Financial Positions;
The following points highlight the significance of going concern concept:
Page 4
UNIT 1: Accounting Principles, Concepts and Theory
ICAN – Advanced Accounting – CAP II- CHAPTER I
 This concept facilitates preparation of financial statements.
 On the basis of this concept, depreciation is charged on the fixed asset.
 It is of great help to the investors, because, it assures them that they will continue to get
income on their investments.
 In the absence of this concept, the cost of a fixed asset will be treated as an expense in
the year of its purchase.
 A business is judged for its capacity to earn profits in future.
1.5 ACCOUNTING PERIOD CONCEPT
All the transactions are recorded in the books of accounts on the assumption that profits on
these transactions are to be ascertained for a specified period. This is known as accounting
period concept. Thus, this concept requires that a Statement of Financial Position and
Statement of Profit and Loss should be prepared at regular intervals. This is necessary for
different purposes like, calculation of profit, ascertaining financial position, tax
computation etc. Further, this concept assumes that, indefinite life of business is divided
into parts. These parts are known as Accounting Period. It may be of one year, six months,
three months, one month, etc. But usually one year is taken as one accounting period which
may be a calendar year or a financial year. Year that begins from 1st of Shravan and ends
on Ashadh-end of the following year is known as Financial Year in Nepal and the year that
begins from 1st of Baishakh and ends on Chaitra-end is known as calendar year.
The following points highlight the significance of Accounting Period concept:
 It helps in predicting the future prospects of the business.
 It helps in calculating tax on business income calculated for a particular time period.
 It also helps banks, financial institutions, creditors, etc to assess and analyze the
performance of business for a particular period.
 It also helps the business firms to distribute their income at regular intervals as
dividends.
1.6 ACCOUNTING COST CONCEPT
Accounting cost concept states that all assets are recorded in the books of accounts at their
purchase price, which includes cost of acquisition, transportation and installation and not at
its market price. It means that fixed assets like building, plant and machinery, furniture, etc.
are recorded in the books of accounts at a price paid for them. The cost concept is also
known as historical cost concept. The effect of cost concept is that if the business entity
does not pay anything for acquiring an asset this item would not appear in the books of
accounts. Thus, goodwill appears in the accounts only if the entity has purchased this
intangible asset for a price.
UNIT 1: Accounting Principles, Concepts and Theory
Page 5
ICAN – Advanced Accounting – CAP II- CHAPTER I
The following points highlight the significance of Accounting Cost concept :
 This concept requires asset to be shown at the price it has been acquired, which can be
verified from the supporting documents.
 It helps in calculating depreciation on fixed assets.
 The effect of cost concept is that if the business entity does not pay anything for an
asset, this item will not be shown in the books of accounts.
1.7 DUAL ASPECT CONCEPT
Dual aspect is the foundation or basic principle of accounting. It provides the very basis of
recording business transactions in the books of accounts. This concept assumes that every
transaction has a dual effect, i.e. it affects two accounts in their respective opposite sides.
Therefore, the transaction should be recorded at two places. It means, both the aspects of
the transaction must be recorded in the books of accounts. For example, goods purchased
for cash has two aspects which are (i) Giving of cash (ii) Receiving of goods. These two
aspects are to be recorded.
Thus, the duality concept is commonly expressed in terms of fundamental accounting
equation:
Assets = Liabilities + Capital
The above accounting equation states that the assets of a business are always equal to the
claims of owner/owners and the outsiders. The claim of the owners towards the assets is
also termed as capital or owners’ equity and the claim of outsiders is termed as liabilities
or creditors’ equity.
The following points highlight the significance of Dual Aspect concept :
 This concept helps accountant in detecting error.
 It encourages the accountant to post each entry in opposite sides of two affected
accounts.
1.8 REALISATION CONCEPT
This concept states that revenue from any business transaction should be included in the
accounting records only when it is realized. The term realization means creation of legal
right to receive money. Selling goods is realization, receiving order is not. In other words,
it can be said that revenue is said to have been realized when cash has been received or
right to receive cash on the sale of goods or services or both has been created.
Page 6
UNIT 1: Accounting Principles, Concepts and Theory
ICAN – Advanced Accounting – CAP II- CHAPTER I
The concept of realization states that revenue is realized at the time when goods or services
are actually delivered. In short, the realization occurs when the goods and services have
been sold either for cash or on credit. It also refers to inflow of assets in the form of
receivables.
The following points highlight the significance of Realisation concept :
 It helps in making the accounting information more objective.
 It provides that the transactions should be recorded only when goods are delivered to
the buyer.
1.9 ACCRUAL CONCEPT
The accrual concept makes a distinction between the actual receipt of cash and the right to
receive cash as regards revenue and actual payment of cash and obligation to pay cash as
regards expenses. So the revenues are recognized when they become receivable, though the
cash is received or not received and the expenses are recognized when they become
payable though the cash is paid or not paid.
In brief, accrual concept requires that revenue is recognized when realized and expenses
are recognized when they become due and payable without regard to the time of cash
receipt or cash payment.
The following points highlight the significance of Accrual concept :
 It helps in knowing actual expenses and actual income during a particular time period.
 It helps in calculating the net profit of the business.
1.10 MATCHING CONCEPT
The matching concept states that the revenue and the expenses incurred to earn the
revenues must belong to the same accounting period. So once the revenue is realized, the
next step is to allocate it to the relevant accounting period.
The following points highlight the significance of Matching concept:
 It guides how the expenses should be matched with revenue for determining exact profit
or loss for a particular period.
 It is very helpful for the investors/shareholders to know the exact amount of profit or
loss of the business.
PRACTICAL EXERCISE
1.
Fill in the blanks with suitable word/words:
i. Recording of transactions in the books of accounts with a definite period is called ……..
concept
ii. The commonly accepted accounting period in Nepal is.…………….
UNIT 1: Accounting Principles, Concepts and Theory
Page 7
ICAN – Advanced Accounting – CAP II- CHAPTER I
iii. According to accounting period concept , revenue and expenses are related to a .......
period
iv. If accounting begins from 1st of Baishakh, and ends on Chaitra end., it is known as
……..….
v. If accounting year begins from 1stshrawanand ends on ashadh end, then accounting year
is known as ………..
2.
Fill in the blanks with suitable word/ words:
i. Accrual concept related to the determination of …….
ii. Goods of Rs 5000 are sold on 25thAshadh 2069 but payment is received on 10thshrawan
2069, it will be a revenue for the year ending…………..
iii. Accrual concept requires revenue is recognized when ….. and expenses are recognized
when they become……………….
3.
Fill in the blanks with suitable word/words
i.
Expense are matched with ……. generated during a period
ii. Goods sold for cash is an example of ………….
iii. Salary paid is example of ……
iv. Profit is the excess of ……………. over ……..
v. ……………. concept states that the revenue and the expense incurred to earn the
revenue must belong to the same accounting period
vi. ……….. concept states how the expenses should be compared with revenues for
ascertaining exact profit or loss for a particular period.
Answer to Practical Exercise
Exercise 1
(i) accounting period (ii) one year (iii) particular (iv) accounting year (v) financial year
Exercise 2
(i) income and expenses (ii) Ashadh-end, 2069 (iii) realised, due
Exercise 3
(i) revenue (ii) revenue (iii) expense (iv) revenue, expenses (v) matching (vi) matching
Page 8
UNIT 1: Accounting Principles, Concepts and Theory
ICAN – Advanced Accounting – CAP II – CHAPTER I
CHAPTER I
Accounting Principles, Concepts
& Standards
UNIT 2:
Historical and Fair Value Concept of
Preparation of Financial Statements
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
Page 9
ICAN – Advanced Accounting – CAP II – CHAPTER I
2.1 INTRODUCTION
Academicians as well as practitioners have long debated the issue of historical cost
accounting versus current value accounting. It seems like this is a never-ending story. The
historical cost basis requires that most assets and liabilities be measured and reported at
their acquisition price. Current cost accounting, on the other hand, requires that assets and
liabilities be measured and reported at their current or market value.
2.2 HISTORICAL COST ACCOUNTING
Historical cost is defined as the aggregate price paid by the firm to acquire ownership and
use of an asset, including all payments necessary to obtain the asset in the location and
condition required for it to provide services in the production or other operations of the
firm. The conventional accounting model base don historical cost was designed for use in a
situation where prices are stable or where prices change slowly. The conventional style of
accounting does not make any provision for changes in purchasing power. According to
conventional theory, the stewardship function of managers must be the focus of attention of
accountants in reporting to external parties. Owners and creditors are primarily concerned
about what management has done with the funds entrusted to them. Thus the net worth of a
firm is not a relevant measure. Stockholders as equity holders wish to know the results of
their investment in the corporation. Hence, the determination of income is the most
important function for the accountant. This leads to the view that income statement is the
most important financial report since it reveals the results of the operations of the
enterprise.
Historical cost is relevant for making economic decisions. There are three reasons why
historical cost is relevant for decision-making. Historical cost affects the evaluation and
selection of decision rules. To determine which decision rules to use, managers need
information about the quality of their past decisions. Historical cost is directly related to
past decisions. Also, in the decision-making process, a forecast of future prices must be
made, and past prices(historical cost) serve as the basis for such a forecast. Historical cost
provides input to the “satisfying” notion. Some decision makers do not seek to optimize but
to satisfy. The question for them is how much has already been earned rather than how
much more they can earn. Thus, historical cost is an important input for such cases.
Historical cost is used because it is imposed on the decision maker by his environment. The
fact that historical cost is employed in many different contexts, such as taxable income and
cost-plus contracts, cannot be denied.
Advantages of Historical cost
i) Historical cost is less subject to manipulation: Historical cost is based on actual, not
merely possible, transactions. It is the acquisition price of the assets. The managers only
Page 10
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
ICAN – Advanced Accounting – CAP II – CHAPTER I
have to record all the assets and liabilities at their acquisition price. Hence they are
measured and reported objectively. Historical cost is therefore basically verifiable.
Thus, this minimizes the risk of manipulation of figures by the managers.
ii) Historical cost is useful for control purposes: In conventional accounting, the
objective of accounting is seen as involving mainly the stewardship function of
management. Managers are to give accounts to the equity holders. Income is the
essential measure of that function. The income statement provides the evidence for
determining how effective management has met its responsibilities. Records of past
transactions are necessary for accountability.
iii) Historical cost survives test of time: Historical cost has survived the test of time. Most
users of accounting data believe that accounting income is useful and that it constitutes
a determinant of the practices and thought patterns of decision makers. Scholars in
accounting state that ‘accounting is what it is today not so much because of the desire of
accountants but because of the influence of businessmen’.
Criticism of Historical cost
Although it has been used for ages, historical cost still cannot escape criticisms that mainly
come from the proponents of current cost accounting.
i) Historical cost is not relevant for decision making: Historical cost has usefulness,
butt is insufficient for the evaluation of business decisions. The focus of conventional
accounting on the stewardship function of accounting is not the only focus of
accounting.
The history of accounting reveals that the primary role of accounting is to meet the
needs of users of accounting information. Users of accounting information are not only
interested in the stewardship function, but also in increases and decreases in the value of
their investments as represented by the net assets of the company.
ii) Historical cost accounting is misleading: Historical cost accounting has inconsistent
principle. There are examples of major fraud such as that of McKesson and Robbins in
1938, in which conventional accounting figures were used to misguide investors and
creditors to part with their money. The reasons of such frauds is that the transactionoriented accountants are more interested in checking documents for historic cost than
the current physical reality and valuation of the entity. Hence, the implementation of the
historical cost concept can be misleading, meaning that it cannot guarantee the quality
of justice and honesty within the information it carries.
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
Page 11
ICAN – Advanced Accounting – CAP II – CHAPTER I
2.3 FAIR VALUE ACCOUNTING
Fair Value is the amount for which an asset could be exchanged or a liability settled
between knowledgeable willing parties in an arm’s length transaction. air value is
measured using the price in the principal market for the asset or liability (i.e. the market
with the greatest volume and level of activity for the asset or liability) or, in theabsence of a
principal market, the most advantageous market for the asset or liability. Detailed guidance
shall be required for measuring the fair value of liabilities, including a description of the
compensation that market participants would demand to take on an obligation.
Fair value hierarchy
Level 1:Quoted prices in active markets for identical assets and liabilities. Level 1input
must be used without adjustment whenever available.
Level 2:Inputs not included within Level 1 that are observable for the asset or liability,
either directly or indirectly.
Level 3: Unobservable inputs, including the entity's own data, which are adjusted if
necessary, to reflect market participants 'assumptions.
A narrative discussion is required about the sensitivity of a fair value measurement
categorized within Level 3 of the fair value hierarchy to changes in significant
unobservable inputs and any interrelationships between those inputs that might magnify or
mitigate the effect on the measurement. In addition, a quantitative sensitivity analysis is
required for financial instruments measured at fair value.
Information about an entity’s valuation processes is required for fair value measurements
categorized within Level 3 of the fair value hierarchy.
Fair Value reflects the prices that must be paid for an asset or its use at the date of the
Statement Of Financial Position or the date of the use or sale if that asset is not already
owned. For example, Fair Value for inventories is the current acquisition price of the
merchandise or the Fair Value to produce it. There are two components of business income,
namely current operating profit and realizable cost savings. The former is the excess of the
fair value of the output sold over the current cost of the related inputs. Realizable cost
savings are the increase in the current cost of the assets while held by the firm in the
current period. In short, holding gains or losses is emphasized in fair value accounting.
Furthermore, fair value accounting theory recommends that the fair value of assets should
be measured and reported in the Statement Of Financial Position. Like historical cost
accounting, fair value accounting has its own advantages and disadvantages.
Page 12
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
ICAN – Advanced Accounting – CAP II – CHAPTER I
Advantages of Fair Value Accounting
i) Relevant for decision-making purposes: This is the main advantage of fair value
accounting as agreed by its proponents. There are many studies that indicate fair value
accounting is value-relevant. The market value of fair value accounting better presents
the economic reality of transactions and therefore tends to provide more useful and
relevant information than does historical cost financial reporting. As business
environments are changing rapidly and becoming increasingly volatile, the financial
statements of firms should portray the underlying economic reality of the firms rather
than the summary of past transactions. The market value of financial reporting may be
less reliable due to the subjectivity of certain measurements, but it can provide much
more relevant and meaningful information to the users despite the subjectivity involved
in the measurement. Fair value accounting provides more relevant information which
was perceived to be just as reliable as and possibly more reliable than historical cost
statements.
ii) It provides a better measure of efficiency: Fair value accounting gives a better
measure of efficiency of the company. Fair value accounting provides a separation of
profit into that part which arises from holding assets before they are sold. This
separation reflects the results of asset management decisions and the impact of the
environment on the firm not reflected in transactions. Proponents of fair value
accounting believe that a failure to recognize this dichotomy of profit may result in an
inadvertent ‘capital erosion’. In addition, it is suggested that the separate reporting of
holding gains will enable users of financial statements to make a more accurate
assessment of managers’ operating performance. Despite the advantages of using
current cost accounting, it has also received some criticism from academicians as well
as practitioners.
Disadvantage and problems of implementing fair value accounting
i) Fair value accounting is open to subjectivity: Fair value accounting is claimed to be
very subjective. This conclusion is perhaps derived from the fact that in most instances,
the fair value to be used is not based on actual transactions. It is difficult to determine
the exact current value, for example if a second-hand market does not exist and it cannot
be replaced with an identical asset. The determination of fair value then is up to the
discretion of managers. For assets where no market prices are available, appraisals,
calculations of reproduction costs and use of index numbers will be necessary.
However, these methods require a great deal of judgment. Thus, for fair value to be
objective and verifiable, a standardization of the method used as well as the availability
and accessibility of market price are needed.
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
Page 13
ICAN – Advanced Accounting – CAP II – CHAPTER I
ii) Fair value accounting is relevant only for short-term decisions: Investors use fair
value information in their short-term portfolio decisions. Telfair value information does
not seem to be the driving force behind long-term returns. Share return sin the long run
are more closely associated with historical data than with fair value financial data.
Historical cost profits generally provide the best explanation for the change in
dividends. Further, there was no convincing evidence that individual current cost
adjustments play a significant part in the dividend decision.
Example 1
A business began operations with a single item of inventory which cost Rs. 1,000. The
Statement Of Financial Position at the date of commencement is as follows:
Cash
Inventory
Total
1,000
1,000
Capital
1000
Total
1, 000
The inventory was eventually sold for Rs. 1,500 cash, giving a profit of Rs. 500, which was
immediately withdrawn by the owner. Now the Statement Of Financial Position is as follows:
Cash
Inventory
Total
1,0001,000
Capital
1000
Total
1, 000
The owner then attempted to replenish the inventory only to find out that its replacement cost
was Rs. 1,200. The business had insufficient cash to restore itself to its pre-sale condition. The
problem arose because the owner failed to distinguish between the gains made from holding
inventory for some time before selling it and the revenue from trading. If the replacement cost at
the time of sale (Rs. 1,200) had been matched against revenue of Rs. 1,500, profit would have
been Rs. 300.If this profit had been withdrawn, cash of Rs1,200 would have been available for
replacing the inventory. Thus, this simple illustration shows that (1) historical cost accounting
can mislead the user of the accounting information (2) fair value accounting is value relevant.
Example 2
Closing stock: Historical cost:
Rs. 55,000
Current fair value:
Rs. 35,000
Page 14
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
ICAN – Advanced Accounting – CAP II – CHAPTER I
i. As per Historical Cost
Trading Account
Particular
Sales
Less: Costs of Goods Sold
Opening Stock
(+)Purchases
(-) Closing Stock
Gross Profit
Amount
160,000
50,000
80,000
(55,000)
(75,000)
85,000
ii. As per Fair Value Accounting
Trading Account
Particular
Sales
Less: Costs of Goods Sold
Opening Stock
(+)Purchases
(-) Closing Stock
Gross Profit
Stock adjustment
(-) Overstated closing stock
Adjusted Gross Profit
Amount
160,000
50,000
80,000
(55,000)
(75,000)
85,000
(20,000)
65,000
2.4 Conclusion
It is obvious there is no clear-cut answer to the debate. For each method, there are its own
benefits and problems, and each person or entity has its own reasons and interests for
preferring any method over the other. All relevant parties, including practitioners, as well
as academicians, should try to reconcile their ideas in order to find the best method for
valuation and measurement for all purposes at all times. This may enhance the credibility
of financial statements, in particular and the accounting profession, in general. In this
respect IASB has brought IFRS 13 on Fair Value Measurement which will solve most of
the problem seen in fair value accounting.
UNIT 2: Historical and Fair Value Concept of Preparation of Financial Statements
Page 15
ICAN-Advanced Accounting-CAP II-CHAPTER I
CHAPTER I
Accounting Principles, Concepts
& Standards
UNIT 3:
Effect of Price Level Changes and Financial Reporting
Page 16
UNIT 3: Effect of Price Level Changes and Financial Reporting
ICAN-Advanced Accounting-CAP II-CHAPTER I
3.1 INTRODUCTION
For more than 80 years, the accounting profession has been reminded that inflation (one of
the manifestations of changing price levels) affects the contents of financial statements. In
1932, the legendary accounting theorist, W. A. Patton, admonished the accounting
profession regarding its lack of attention to inflation hidden in financial statements
prepared using historical costs. It is evident that this whole problem of accounting for the
effects of changes in price level is an unsettled one.
3.2 EFFECT OF PRICE CHANGE
Inflation, the systematic decrease of purchasing power and destroyer of wealth, is a
fundamental fact of economic activity over time and creates serious financial reporting and
financial management problems. Deflation also creates serious valuation and decisionmaking problems; however, this phenomenon is seen less frequently. In this respect the
accounting establishments have been continuing the lack of commitment to measure and
report appropriate, relevant information for decision-making in a timely manner. The users
believed that traditional financial statements do not meet their information needs. Some
believe that the information value and decision relevance of price adjusted financial
statements should be demonstrated within the context of the reporting of comprehensive
income. In the complexity of intellectual calculus, it is more beneficial for the information
market place to have relevant, albeit somewhat inaccurate information, than to have
accurate, reliable, but irrelevant information.
3.3 CONCEPTUAL ISSUES
i. Accounting for the effect of changing prices
There is a social need to provide people with information about economic wealth and
real income, i.e. increase in wealth, as a result of the performance of entities and their
managers or a period. The argument is based on several fundamental principles and
observations. The problem of reporting the effects of changing prices is not unique nor
is it unique to this period or point in time. The exchange of goods and services of value
between individuals and entities has been a fact of the world's social history for
centuries. The academic discipline within which the exchange process is studied is
economics, one of the disciplines in the social sciences. Financial accounting is the
practical language used to identify and describe economic events, measure the values in
exchange, and report the cumulative effects of the economic exchange activities.
ii. Accounting Measurement and Cost
Financial accounting measurement begins with cost i.e. the price paid or exchange
value in the transaction. A “price” can be understood as a monetary quantification of
the exchange or economic value i.e. fair value. At the instant of financial accounting
measurement the following relationship pertains:
Price = Cost = Fair Value
UNIT 3: Effect of Price Level Changes and Financial Reporting
Page 17
ICAN-Advanced Accounting-CAP II-CHAPTER I
In a market economy, the determination and quantification of value are the culmination of
a complex process which is dynamic. As a result, at a different time, the same
relationship pertains, but the combined and cumulative effects of changes in society
produce changes in prices. Thus:
Pricet-0 = Costt-0 = Fair Valuet-0  Pricet-1 = Costt-1 = Fair Valuet-1
The Mapping Function
The conversion or mapping function from time t-0 to t-1, etc. is very complex. Perhaps,
it is not subject to precise formulation. Efforts to construct such a function belong to
econometricians, not accountants. A general or specific price index can be understood as
a proxy for the function, plus provision for error, because an index is not completely
efficient. There is no question that the index or mapping function is imprecise, but that
does not mean that it is necessarily wrong or significantly in error.
The Problems of the Mapping Function
The value today, expressed in monetary terms, reflects the effects of the social, political,
economic, regulatory, and technological (SPERT) forces producing changes in the
environment. The probability is very high that the effect of the SPERT factors will, in
fact, produce a change in apparent value i.e. the price of goods and services. The
significance of that change in terms of real wealth can only be measured or estimated by
making a comparison between today’s values and a set of values established at some
point in the past i.e. the monetary amount recorded by accountants, adjusted for the
effects captured in the SPERT function. To properly evaluate and understand the causes
and implications of the changes in reported values between periods, the past must be
restated (estimated) in terms of the values found in the SPERT related mapping function.
That is it is necessary to remove from reported income the effects of changes unrelated to
entity or management performance.
The Risks Inherent in the Use of Indices
The use of an index is inherently risky for several reasons. As noted above, the mapping
function is extra-ordinarily complex and, perhaps, it is not definable with the degree of
certainty deemed necessary and appropriate by accountants. Additional errors may be
introduced by the fact that exactly the same goods and services may not be available for
comparison at a later date. Also, goods and services, when combined in an entity by a
specific management, may have a value that is greater than or less than the prices paid for
them individually i.e. implicit goodwill.
Another less technical, but significant problem is: who is going to select the index or
assign the adjustment factor in a specific situation? The answer lies in understanding
Page 18
UNIT 3: Effect of Price Level Changes and Financial Reporting
ICAN-Advanced Accounting-CAP II-CHAPTER I
who is responsible for the outcomes and the consequences in terms of the legitimacy of
the restated values. Accountants see this as part of the reliability versus relevance debate.
iii. Reality Check
Sophisticated financial statement users know that price level changes have not been
reflected in the financial statements. As a result they either estimate the effects or they
by-pass the financial statements and analyze nominal cash flows. Several academicians
believe that'We live in and make decisions about a world of market or fair values, not
the historic past of the accountants.' In either case, the work of financial accountants,
based on unadjusted for the effects of changing prices, appears irrelevant.
Thus, for the accountants the consequence of using a mapping function with a value of
zero results in a perceived information gap that damages or destroys the alleged
usefulness of financial statement. If users make the adjustments, they may lack the
technical knowledge of the adjustment method and, more seriously, the most
appropriate adjustment function and/or factors. In either case the outcome is wrong
information.
Therefore, the accountants within reporting entities, working with management, can and
should develop mapping functions and adjustment factors that relate well to the unique
characteristics of the entity’s economic activities. The information marketplace is
capable of evaluating the decisions of management and rewarding competence in
developing price-level adjusted financial information that is reliable and relevant.
These issues and problems produce significant opportunities for need based accounting
approach.
3.4 ACCOUNTING INCOME
Accounting income is the difference between revenues and expenses (expired costs).
This computation presents accounting income simply as the periodic change in the book
value of an enterprise, excluding any investment by owners and dividends paid to owners.
In other words, income is defined strictly in monetary terms.
In recent years, however, the need for values that reflect current market conditions, not
the market values/conditions at the time of initial recording, has affected reported values.
Generally, but not always, market re-valuations have been downward from the initial
amount, not upward. This is the practical expression of conservatism in accounting
practice. For example, inventories are reported at the “lower-of-cost-or market” with a
loss of value taken directly into the current period income statement.
The valuation adjustments related to several specific transactions and events have been
reflected as “line item” increases or decreases in equity because these “losses and
UNIT 3: Effect of Price Level Changes and Financial Reporting
Page 19
ICAN-Advanced Accounting-CAP II-CHAPTER I
recoveries” have been deemed to be “unrealized”, but not unreal, changes in values of
Statement of Financial Position, which will ultimately be determined at some time in the
future when they are realized. On an overall basis, the current accounting model uses a
mixture of cost and fair value measures that produces a blended picture of entity and
management performance and status.
3.5
ECONOMIC INCOME
The general economic concept of income was defined by Sir John Hicks (1946) as
'…The amount which a person can consume during a period of time and still remain
as well off at the end of the period as he/she was at the beginning…” suggests that
income is the difference between the present value of beginning economic values and the
present value of current economic values. In other words, income is defined in terms of
real wealth. The value today, expressed in monetary terms, reflects the effects of the
social, political, economic, regulatory, and technological (SPERT) forces producing
changes in the environment. The probability is very high that the effect of the SPERT
factors has, in fact, produced a change in apparent value i.e. the price of goods and
services. The significance of that change in terms of real wealth can only be measured or
estimated by making a comparison between today’s values and a set of values established
at some point in the past i.e. the monetary amount recorded by accountants adjusted for
the effects of price level changes. The change in a price, that is a change in value, may be
an expression of change in wealth.
3.6
PURPOSE OF THE COMPARISON
Reporting the effects of changing prices is essential, because the information required for
resource management decision-making and for entity and manager performance appraisal
should be seen, evaluated, and understood without effects unrelated to performance. The
current mixed value model does not provide appropriate information. The failure to
measure and report the effect of changing prices means that the measure of wealth—
existing and changing—is inefficient, ineffective, and misleading. For example, holding
gains are buried in income when realized. The reported performance is not a measure of
management or entity performance, but rather the effect of recognition timing. Knowing
this, it could be asserted that the financial statements, unadjusted for price level changes,
are fraudulent.
3.7
THE CONFLICT—HISTORICAL COST VERSUS FAIR VALUE
The discussion above highlights the fundamental conceptual conflict: Is income best
measured using the accountants’ historic cost approach (in monetary terms) or is the
economists’ fair value approach (in real wealth terms) the best. As indicated earlier, there
is a link between the two. The difference between the two valuation schemes is not
whether the values or amounts reported are a fair or market value. Both are/were fair
Page 20
UNIT 3: Effect of Price Level Changes and Financial Reporting
ICAN-Advanced Accounting-CAP II-CHAPTER I
values. The problem lies with what to do about the mapping function, which is a
consequence of time. The conceptual conflict leads to several questions: Which measure
is more relevant, to whom, for what purpose, and how important is a relevant measure
versus a reliable one? Who is in the best position to estimate the values produced by the
SPERT mapping function? Is a general price index (PI), a specific CPI, or any PI
sufficiently robust, stable, and conceptually defensible to be used generally?
Different answers to these questions, based on legitimate and defensible alternatives,
yield significantly different policy decisions.
3.8
THE ULTIMATE QUESTION
Is the traditional, conservative approach to answering these operational questions and to
the setting of accounting and reporting policy appropriate for the information and
decision making environment of the 21st Century? The answer is “NO” and the
discussion of and reporting of comprehensive income brings the issue to the fore.
3.9
COMPREHENSIVE INCOME
Comprehensive income is ‘the change in equity [net worth] of a business enterprise
during a period from transactions and other events and circumstances from non-owner
sources.
This statement uses the term comprehensive income to describe the total of all
components of comprehensive income, including net income. This statement uses the
term other comprehensive income to refer to revenues, expenses, gains, and losses that
under generally accepted accounting principles are included in comprehensive income but
excluded from net income.
Purpose of Reporting Comprehensive Income
The purpose of reporting comprehensive income is to report a measure of all changes in
equity of an enterprise that result from recognized transactions and other economic events
of the period other than transactions with owners in the capacity as owners.
Although total comprehensive income is a useful measure, information about the
components that make up comprehensive income also is needed. A single focus on total
comprehensive income is likely to result in a limited understanding of an enterprise’s
activities. Information about the components of comprehensive income often may be
more important than the total amount of comprehensive income.
3.10 VALUE CHANGE
The output of the traditional financial accounting process constitutes much of the input
used in economic analysis, fiscal and monetary policy-making, and financial
UNIT 3: Effect of Price Level Changes and Financial Reporting
Page 21
ICAN-Advanced Accounting-CAP II-CHAPTER I
management. It is ironic that a process, which by design is deficient and defective, plays
such a central role in the world economy. As noted in the prior section, the key weakness
lies in the traditional financial accounting measurement of income. The failure to
consider the effect of changing prices contributes significantly to the measurement
problem.
A curious parallel exists between the effects of changing prices on income and wealth
measurement and the effects of changing information needs on the usefulness of
accounting reports. Economic wealth is damaged or destroyed when the effects of
changing prices (values) are not properly identified, measured, and reported. Likewise
the value of accounting, as the “practical language of economics,” is damaged or
destroyed when changing user needs (values) are not appreciated. In both cases, denial of
the importance of value changes leads to disaster.
3.11 THE PROBLEM
The position of the accounting establishment with respect to accounting for the effect of
price changes and user demands for better, more relevant financial information is
understandable. Its lack of a proactive response is rooted in the relative success of the
profession and the historic cost model.
Few models, expressions of relationships, have withstood centuries of use as well as the
double entry model. It is based on a relatively simple, straightforward set of assumptions
and principles, which have provided stability and critical values for its operation. But
therein lays the weakness. The needs, so well served for centuries, have changed, but the
assumptions and principles have remained effectively the same.
Of particular importance to this discussion is “conservatism” which essentially is a
behavioral imperative. A second critical dimension is a value driven choice that places
reliability ahead of relevance in terms of information attributes. The consequence is that
the accounting establishment is biased in favor of the status quo psychologically and,
furthermore, it finds comfort in reporting what can be verified which reflects the audit
experience bias of most professional accountants. The affective problem is that these long
held values result in inadequate responses to current and emerging problems.
3.12 A PARADIGM SHIFT
Today information is consumed at such a high rate that the marketplace cannot wait for it
to be “true and fair” in the parlance and tradition of the accounting profession. The
alternative of “quick and dirty” is also not acceptable. Possibly there is something to be
learned from the discipline of statistical process control. That is, the design of the
accounting process and the rules for its operation need to be examined and revised or
Page 22
UNIT 3: Effect of Price Level Changes and Financial Reporting
ICAN-Advanced Accounting-CAP II-CHAPTER I
redesigned to minimize production errors. The ongoing focus then shifts to the control
for errors.
This type of shift, a paradigm shift, also affects the way users of accounting information
understand the accuracy and, therefore, the arithmetic reliability of accounting reports.
Any number in an accounting report, even with the qualification that it represents a “true
and fair view” or “fairly presents,” implies a degree of accuracy and certainty that is not
possible to achieve and cannot be achieved with the accounting process. The audit report
is naively believed by many users to indicate that the numbers are what they purport to be
in an absolute sense. The accounting establishment’s dogged determination to report
reliable information contributes to the perceptual problem.
There has been a paradigm shift at the user level. Sophisticated users ask for traditional
financial statements because there are no other formal reports available. But their
usefulness is problematic, not because they are unreliable but because they lack
relevance. Even the best reporting reflects old information, at historic cost, that does not
relate well to the needs of the moment and future.
3.13 THE THEORY OF INCOME
The discussion of income measurement and disclosure theory provides an interesting
retrospective on accounting approaches. It does not venture into economic theory as
discussed earlier. The information users, the decision-makers of today, live in and make
decisions about today and tomorrow. Accounting theory and practice that has been
driven by traditional conservative values, including a pre-occupation with reliability at
the expense of relevance, do not serve the social need.
There is little current incentive for the accounting establishment to behave differently.
For example, the current rate of inflation in the developed countries including US and
much of the Western world, a cause for changes in price levels, is very low and has been
for several years. There is no perceived need to report the effect of changing prices.
Therefore, the approach to reporting has been low key and non-directive. However, for
most of countries rapid change in prices is in fact important at the national level and,
because of international trade and investment, it is becoming a world class financial and
economic problem with significant fiscal and monetary policy implications.
The importance of economic and financial decisions requires that the best information be
used, even if is less reliable numerically, but more relevant. There is a value choice or
tension between what can be readily verified i.e. historical cost, and probable current
value that is a function of approximations.
UNIT 3: Effect of Price Level Changes and Financial Reporting
Page 23
ICAN-Advanced Accounting-CAP II-CHAPTER I
3.14 CONCLUSION
It is absolutely necessary to provide users with some idea of the relationship between the
historical cost and the price/value-adjusted basis of assets. Additionally, it is the
management of an entity that has the best information about the most appropriate
mapping function to use. It also has a vested interest in getting the disclosure “right,”
because the information marketplace has the capacity to evaluate the competence of
management administering rewards and punishments as appropriate. Financial statements
that reflect assets reported at market, net realizable value, and possibly current cost and/or
constant Rupees are essential to public policy makers, investors and lenders, economists,
and others who make decisions that shape the future. The current statements are a
“mixed bag” of values with significant recognized assets is-reported and hidden holding
gains that distort entity and management performance when realized. Historical costing
system suffers from the problem that plagues virtually all financial reporting: a
preoccupation with reliability, rather than relevance.
Page 24
UNIT 3: Effect of Price Level Changes and Financial Reporting
ICAN – Advanced Accounting – CAP II- CHAPTER I
CHAPTER I
Accounting Principles, Concepts
&
Standards
UNIT 4:
Financial Reporting Standards
UNIT 4: Financial Reporting Standards
Page 25
ICAN – Advanced Accounting – CAP II- CHAPTER I
4.1
Introduction to Accounting Standards Board (ASB)
The Accounting Standards Board (ASB) is an independent statutory body with the
responsibility to set and issue accounting standards for preparation and presentation of
financial statements in Nepal. The ASB was established in March 2003 with an
amendment to the Institute of Chartered Accountants of Nepal Act 1997 incorporating the
provision for its establishment and operation. The ASB is primarily responsible for
setting accounting and financial reporting standards for business enterprises in line with
the International Financial Reporting Standards (IFRSs). Since 2007, ASB has also been
entrusted by Nepal Government with the responsibility to develop accounting standards
for public sector as well in line with the International Public Sector Accounting Standards
(IPSASs). The ASB consists of 13 members comprising a Chairman appointed by the
Government of Nepal from Fellow Chartered Accountants and other members
representing Ministry of Finance, Office of the Auditor General, Financial Comptroller
General Office, Inland Revenue Department, Company Registrar Office, Security
Exchange Board, the Institute of Chartered Accountants of Nepal and the Registered
Auditors.
4.2
Need of Accounting Standards
Financial statements are prepared and presented for external users by many types of
entities. Although such financial statements may appear similar from entity to entity,
there are differences which have been caused by the absence of a clear conceptual
framework to guide the choices made by preparers and auditors. These differences have
led to the use of a variety of definitions of the elements of financial statements; that is, for
example, assets, liabilities, equity, income and expenses. They have also resulted in the
use of different criteria for the recognition of items in the financial statements and in a
preference for different bases of measurement. The scopes of the financial statements and
the disclosures made in them have also been affected. ASB is committed to narrowing
these differences by seeking to harmonize regulations, accounting standards and
procedures relating to the preparation and presentation of financial statements. It believes
that further harmonization can best be pursued by focusing on financial statements that
are prepared for the purpose of providing information that is useful in making economic
decisions.
Accounting standards aim at improving the quality of financial reporting by promoting
comparability, consistency and transparency, in the interests of users of financial
statements. Good financial reporting not only promotes healthy financial markets, it also
helps to reduce the cost of capital because investors can have faith in financial reports and
consequently perceive lesser risks.
Page 26
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
4.3
Standards Setting Process
The Institute of Chartered Accountants of Nepal (ICAN), being a premier accounting
body in the country, took upon itself the leadership role by constituting the
NepalAccounting Standards Board (ASB). The ICAN has taken significant initiatives in
the setting and issuing procedure of Accounting Standards to ensure that the standardsetting
processisfully consultative and transparent. The ASB considers the
International Accounting Standards (lAS)/ International Financial Reporting Standards
(IFRS) while framing Nepal Accounting Standards (NAS) and try to integrate them, in
the light of the applicable laws/ customs, usages and business environment in the country.
ASB is a body constituted by the Government of Nepal, it (ASB) is independent in the
formulation of accounting standards and Council of the ICAN is not empowered to make
any modifications in the draft accounting standards formulated by ASB without
consulting with the ASB,
The standard-setting procedure of ASB can be briefly outlined as follows:









Identification of broad areas by ASB for formulation of accounting standards,
Constitution of study groups by ASB to consider specific projects and to prepare
preliminary drafts of the proposed accounting standards. The draft normally includes
objective and scope of the standard, definitions of the terms used in the standard,
recognition and measurement principles wherever applicable and presentation and
disclosure requirements,
Consideration of the preliminary draft prepared by the study group of ASB and
revision, if any, of the draft on the basis of deliberations,
Circulation of draft of accounting standard (after revision by ASB) to the Council
Members, Members of ICAN and specified outside bodies such as Registrar of
Companies, Nepal Security Board, Inland Revenue Department, Office of the
Auditor General of Nepal etc. for comments,
Meeting with the representatives of the specified outside bodies to ascertain their
views on the draft of the proposed accounting standard,
Finalization of the exposure draft of the proposed accounting standard and its
issuance inviting public comments,
Consideration of comments received on the exposure draft and finalization of the
draft accounting standard by the ASB for submission to the Council of the ICAN for
its consideration and approval for issuance.
Consideration of the final draft of the proposed standard and by the Council of the
ICAN, and if found necessary, modification of the draft in consultation with the ASB
is done
The accounting standard on the relevant subject is then issued by the ICAN.
UNIT 4: Financial Reporting Standards
Page 27
ICAN – Advanced Accounting – CAP II- CHAPTER I
4.4
Need of Convergence with Global Standards
During the couple of decade the world economic environment has witnessed a sea change
in the global economic scenario. The emergence of trans-national corporations in search
of money, not only for fuelling growth, but to sustain on-going activities has necessitated
raising of capital from all parts of the world, cutting across frontiers.
Traditionally each country has its own set of rules and regulations for accounting and
financial reporting. Therefore, when an enterprise decides to raise capital from the
markets other than the country in which it is located, the rules and regulations of that
other country will apply and this in turn will require that the enterprise is in a position to
understand the differences between the rules governing financial reporting in the foreign
country as compared to its own country of origin. Therefore translation and
reinstatements are of utmost importance in a world that is rapidly globalizing in all ways.
In themselves also, the accounting standards and principle need to be robust so that the
larger society develops degree of confidence in the financial statements, which are put
forward by organizations.
International analysts and investors would like to compare financial statements based on
similar accounting standards, and this has led to the growing support for an
internationally accepted set of accounting standards for cross-border filings. The
harmonization of financial reporting around the world will help to raise confidence of
investors generally in the information they are using to make their decisions and assess
their risks. Also a strong need was felt by legislation to bring about uniformity,
rationalization, comparability, transparency and adaptability in financial statements.
Having a multiplicity of accounting standards around the world is against the public
interest. If accounting for the same events and information produces different reported
numbers, depending on the system of standards that are being used, then it is self-evident
that accounting will be increasingly discredited in the eyes of those using the numbers, it
creates confusion, encourages error and facilitates fraud. The cure for these ills is to have
a single set of global standards, of the highest quality, set in the interest of public. Global
Standards facilitate cross border flow of money, global listing in different bourses and
comparability of financial statements.
The convergence of financial reporting and accounting standards is a valuable process
that contributes to the free flow of global investment and achieves substantial benefits for
all capital market stakeholders. It improves the ability of investors to compare
investments on a global basis and thus lowers their risk of errors of judgment. It
facilitates accounting and reporting for companies with global operations and eliminates
Page 28
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
some costly requirements say reinstatement of financial statements. It has the potential to
create a new standard of accountability and greater transparency, which are values of
great significance to all market participants including regulators; it reduces operational
challenges for accounting firms and focuses their value and expertise around an
increasingly unified set of standards. It creates an unprecedented opportunity for standard
setters and other stakeholders to improve the reporting model. For the companies with
joint listings in both domestic and foreign country, the convergence is very much
significant.
4.5
Standards Issued by ASB
ASB has issued 13 NFRSs and 27 NASs. The students are advised to visit
www.ican.org.np to refer the whole text of the Standards.
S.N
1
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15
16.
17.
18.
19.
20.
21.
Particulars of Standards
Framework for the Preparation and Presentation of Financial
Statements
First Time Adoption of Nepal Financial Reporting Standards
Share-based Payment
Business Combinations
Insurance Contracts
Non-current Assets Held for sale & Discontinued Operation
Exploration for and Evaluation of Mineral Resource
Financial Instruments: Disclosures
Operating Segments
Financial Instruments
Consolidated Financial Statements
Joint Arrangement
Disclosure of Interest in other Entities
Fair Value Measurement
Presentation of Financial Statements
Inventories
Statement of Cash Flow
Accounting Policies, Changes in Accounting Estimates and
Errors
Event after the Reporting Period
Construction Contracts
Income Taxes
UNIT 4: Financial Reporting Standards
NAS
IAS/IFRS
NFRS 1
NFRS 2
NFRS 3
NFRS 4
NFRS 5
NFRS 6
NFRS 7
NFRS 8
NFRS 9
NFRS 10
NFRS 11
NFRS 12
NFRS 13
NAS 1
NAS 2
NAS 7
NAS 8
IFRS 1
IFRS 2
IFRS 3
IFRS 4
IFRS 5
IFRS 6
IFRS 7
IFRS 8
IFRS 9
IFRS 10
IFRS 11
IFRS 12
IFRS 13
IAS 1
NAS 2
IAS 7
IAS 8
NAS 10
NAS 11
NAS 12
IAS 10
IAS 11
IAS 12
Page 29
ICAN – Advanced Accounting – CAP II- CHAPTER I
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
41.
Property, Plant and Equipment
Leases
Revenue
Employee Benefits
Accounting for Government Grants and Disclosure of
Government Assistance
The Effect of Change in Foreign Exchange Rates
Borrowing Cost
Related Party Disclosures
Accounting and Reporting By Retirement Benefit Plans
Consolidated and Separate Financial Statements
Investment in Associates
Financial Instruments: Presentation
Earnings Per Share
Interim Financial Reporting
Impairment of Assets
Provisions, Contingent Liabilities and Contingent Assets
Intangible Assets
Financial Instruments: Recognition and Measurements
Investment Property
Agriculture
NAS 16
NAS 17
NAS 18
NAS 19
NAS 20
IAS 16
IAS 17
IAS 18
IAS 19
IAS 20
NAS 21
NAS 23
NAS 24
NAS 26
NAS 27
NAS 28
NAS 32
NAS 33
NAS 34
NAS 36
NAS 37
NAS 38
NAS 39
NAS 40
NAS 41
IAS 21
IAS 23
IAS 24
IAS 26
IAS 27
IAS 28
IAS 32
IAS 33
IAS 34
IAS 36
IAS 37
IAS 38
IAS 39
IAS 40
IAS 41
NAS 01 PRESENTATION OF FINANCIAL STATEMENT
The objective of this standard is to prescribe the basis for presentation of general purpose
financial statements, to ensure comparability both with the entity’s financial statements of the
previous year and with the financial statements of other entities. This standard sets out overall
considerations for the presentation of financial statements, guidelines for their structure and
minimum requirements for their content.
Scope
This standard shall be applied to all general purpose financial statements prepared and presented
in accordance with Nepal Accounting Standards. General purpose financial statements are those
intended to meet the needs of users who are not in a position to demand reports tailored to meet
their specific information need.
However, it does not preclude the application of this standard to other tailored made financial
statements.
Page 30
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Classification of entities for presentation of Financial Statements
The following set of NFRSs applies to the financial statements prepared by the different
entities:
Types of entities
Applicable NFRS
Having public accountability
NFRS
Government business enterprises and Public entities not preparing NFRS
financial statement under NSPAS
Not having public accountability
NFRS for SMEs
Not having public accountability other than SMEs
NAS for MEs
Government business enterprises and Public entities
NSPAS
Definitions
1. General Purpose Financial Statements
General purpose financial statements are those intended to meet the needs of users who are
not in a position to require an entity to prepare reports tailored to their particular information
needs.
2. Other Comprehensive Income
Other comprehensive income comprises items of income and expenses (including
reclassification adjustments) that are not recognized in profit or loss as required or permitted
by other NFRSs.
The components of other comprehensive income include:
a. changes in revaluation surplus (NAS 16 PPE and NAS 38 Intangible assets);
b. remeasurements of defined benefit plans (NAS 19 Employee benefits)
c. gains and losses arising from investment in equity instruments measured at fair value
through other comprehensive income (NFRS 9 Financial instruments)
d. gains and losses arising from translating the financial statements of a foreign operations
(NAS 21 The effects of changes in foreign exchange rates)
e. the effective portion of gains and losses on hedging instruments in a cash flow hedge
(NAS 39 Financial Instruments)
f. for a particular liabilities designated as at fair value through profit or loss, the amount of
the change in the fair value that is attributable to changes in the liability’s credit risk
(NFRS 9 Financial instruments)
3. Nepal Financial Reporting Standards (NFRSs)
Nepal Financial Reporting Standards (NFRSs) are standards and interpretation issued by the
Accounting Standards Board (ASB). They comprise:
a. Nepal financial reporting standards
b. Nepal accounting standards
c. IFRIC interpretation
UNIT 4: Financial Reporting Standards
Page 31
ICAN – Advanced Accounting – CAP II- CHAPTER I
d. SIC interpretation; and
e. Interpretation developed by the Accounting Standards Board (ASB)
Purpose of financial statements
Financial statements are a structured presentation of financial position of and the transactions
undertaken by an entity. The objective of general purpose financial statements is to provide
information about the financial position, financial performance and cash flows of an entity that
is useful to a wide range of users in making economic decisions. To meet this objective,
financial statements provide information about an entity’s:
a. assets;
b. liabilities;
c. equity;
d. income and expense, including gains and losses;
e. other changes in equity; and
f. cash flows.
Components of financial statements
A complete set of financial statements includes the following components:
a. a statement of financial position at the end of the period;
b. a statement of profit or loss and other comprehensive income for the period;
c. a statement of changes in equity for the period;
d. a cash flow statement for the period; and
e. notes, comprising a summary of significant accounting policies and other explanatory
notes.
Entities are encouraged to present additional statements if management believes they will assist
users in making economic decisions such as environment reports, value added statements.
General features of financial statements
1. Fair presentation and compliance with NFRSs
Financial statements shall present fairly the financial position, financial performance and
cash flows of an entity. Fair presentation requires the faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the Framework.
In virtually all circumstances, an entity achieves a fair presentation by compliance with
applicable NFRSs. A fair presentation also requires an entity:
a. to select and apply accounting policy as per NAS 8. NAS 8 sets guidance for selecting
policy in absence of NFRS;
b. to present information including accounting policies in a manner that provides relevant,
reliable, comparable and understandable information;
c. to provide additional disclosure when compliance with the specific requirements of
NFRS, is insufficient to understand the financial position and performance.
Page 32
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
2. Going Concern
An entity shall prepare financial statements on a going concern basis. If an entity has doubt
upon its ability to continue as a going concern, the entity shall disclose those uncertainties.
When financial statements cannot be prepared on going concern basis, it shall disclose that
fact together with the basis on which it prepared the financial statements and reason why the
entity is not regarded as a going concern.
3. Accrual basis of Accounting
An entity shall prepare its financial statements, except for cash flow information, using the
accrual basis of accounting.
4. Materiality and Aggregation
An entity shall present separately each material class of similar items. An entity shall present
separately items of a dissimilar nature or function unless they are immaterial.
5. Offsetting
An entity shall not offset assets and liabilities or income and expenses, unless required or
permitted by a NFRS.
6. Frequency of Reporting
An entity shall present a complete set of financial statements (including comparative
information) at least annually. When an entity changes the end of its reporting period and
present financial statements for a period longer or shorter than one year, an entity shall
disclose, in addition to the period covered by the financial statements:
a. the reason for using a longer or shorter period; and
b. the fact that amounts presented in the financial statements are not entirely comparable.
7. Comparative Information
Except when NFRSs permit or require otherwise, an entity shall disclose comparative
information.
8. Consistency of presentation
An entity shall retain the presentation and classification of items in the financial statements
from one period to the next period unless:
a. it is apparent that the another presentation or classification would be more appropriate as
per guidance in NAS 8; or
b. a NFRS requires a change in presentation.
Structure and Content of Financial Statements
An entity shall clearly identify the financial statements and distinguish them from other
information in the same published document.
An entity shall clearly identify each financial statement and notes. In addition, an entity shall
display the following information prominently, and repeat it when necessary for the information
presented to be understandable:
UNIT 4: Financial Reporting Standards
Page 33
ICAN – Advanced Accounting – CAP II- CHAPTER I
a. the name of the reporting entity or other means of identification, and any change in that
information from the end of the preceding reporting period;
b. whether the financial statements are of an individual entity or a group of entities;
c. the date of the reporting period or the period covered by the set of financial statements or
notes;
d. the presentation currency; and
e. the level of rounding used in presenting amounts in the financial statements.
Information to be presented in the statements of financial position
As a minimum, the statement of financial position shall include line items that present the
following items:
a. property, plant and equipment;
b. investment property;
c. intangible assets;
d. financial assets (excluding amounts shown under e, h and i)
e. investments accounted for using the equity method;
f. biological assets;
g. inventories;
h. trade and other receivables
i. cash and cash equivalent;
j. the total of assets classified as held for sale and assets included in disposal groups
classified as held for sale (NFRS 5)
k. trade and other payables;
l. provisions;
m. financial liabilities (excluding amounts shown under k and l);
n. liabilities and assets for current tax (NAS 12)
o. deferred tax liabilities and deferred tax assets (NAS 12)
p. liabilities included in disposal groups classified as held for sale (NFRS 5)
q. non-controlling interest, presented within equity; and
r. issued capital and reserves attributable to owners of parent.
Current and non-current classification
An entity shall present current and non-current assets, and current and non-current liabilities, as
separate classification in its statement of financial position except when a presentation based on
liquidity provides information that is reliable and more relevant. Under presentation based on
liquidity, an entity shall present all assets and liabilities in order of liquidity.
For some entities, such as financial institutions, a presentation of assets and liabilities in
increasing or decreasing order of liquidity provides information that is reliable and more
relevant than a current and non-current presentation. Such types of entities do not supply goods
or services within a clearly identifiable operating cycle.
Current assets
An entity shall classify an asset as current when:
Page 34
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
a. it expects to realize the asset or intends to sell or consume it, in its normal operating
cycle;
b. it holds the asset primarily for the purpose of trading;
c. it expects to realize the asset within twelve months after the reporting period; or
d. the asset is cash or a cash equivalent (NAS 7)
An entity shall classify all other assets as non-current.
Current liabilities
An entity shall classify a liability as current when:
a. it expects to settle the liability in its normal operating cycle;
b. it holds the liability primarily for the purpose of trading;
c. the liability is due to be settled within twelve months after the reporting period; or
d. it does not have an unconditional right to defer settlement of the liability for at least
twelve months after the reporting period.
An entity shall classify all other liabilities as non-current.
Operating cycle
The operating cycle of an entity is the time between the acquisition of assets for processing and
their realization in cash or cash equivalents. When the entity’s operating cycle is not clearly
identifiable, it is assumed to be twelve months.
Information to be presented in the profit or loss section or the statement of profit or loss
In addition to items required by other NFRSs, the profit or loss section or the statement of profit
or loss shall include line items that present the following amounts for the period:
a. revenue;
b. gains and losses arising from the derecognition of financial assets measured at
amortized cost;
c. finance costs;
d. share of profit or loss of associates and joint ventures accounted for using the equity
method;
e. gain or loss on reclassification of financial assets as per NFRS 9;
f. Tax expenses;
g. a single amount for the total of the discontinued operations (NFRS 5)
NAS 02 INVENTORIES
This standard prescribes the accounting treatment of inventories. It also prescribes principles for
determining carrying amount of inventories until the related revenue is recognized on sale of
goods or services.
Applicability
This standard applies to all inventories other than the following:
UNIT 4: Financial Reporting Standards
Page 35
ICAN – Advanced Accounting – CAP II- CHAPTER I
i.
work in progress arising under construction contracts including directly related service
contract (covered under NAS 11 construction contracts)
ii. financial instruments; and
iii. biological assets related to agricultural activity and agricultural produce at the point of
harvest.
Meaning of Inventories
Inventories are assets:
i.
held for sale in the ordinary course of business (finished goods);
ii. in the process of production for such sale (raw material and work in progress); and
iii. in the form of materials or supplies to be consumed in the production process or in the
rendering services (stores, spares, consumables).
For service providers, inventories represent cost of service for which the related revenue is not
yet recognized.
Measurement of inventories
Inventories shall be measured at the lower of cost and net realizable value.
The following inventories are excluded from measurement principle of this standard:
Biological assets (like livestock, forest products, cropping) at the point of harvest is valued at
net realizable value less costs to sell.
Producers of agricultural and forest products, agricultural produce after harvest, and minerals
and mineral products are valued at net realizable value. When such inventories are measured at
net realizable value, changes in the value are recognized in profit and loss account in the period
of change.
Inventories of commodity broker traders which are measured at fair value less costs to sell.
Changes in the fair value less costs are recognized in profit and loss account in the period of
change.
Cost of inventories
Cost of inventories comprises of all cost of purchase, cost of conversion and other costs
incurred in bringing the inventories to their present location and conditions.
Page 36
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Cost of purchase
Cost of purchase comprises of purchase price, import duties and other taxes (other than those
subsequently recoverable by the entity from the taxing authorities) and transport, handling and
other costs directly attributable to the acquisition of finished goods, materials and services.
Trade discount, rebates are deducted in determining cost of purchase.
Cost of conversion
Costs of conversion include costs directly related to the units of production, such as direct
labour and production royalty. They also include a systematic allocation of fixed and variable
overheads that are incurred in connection of converting materials into finished goods.
Variable overhead is charged based on actual expenses. Fixed overhead is charged based on
normal capacity, where normal capacity is expected capacity after considering normal
unproductive time due to maintenance etc. Unabsorbed fixed overhead is expensed in the year
the expense is incurred.
A production process may result in more than one product being produced simultaneously.
When the products are of equal importance the joint cost may be allocated on the relative sales
value of each product either at the stage of separation or at the stage of completion. In case of
by-product, the value of by-product is deducted from total cost and the balance cost is allocated
to main product.
Illustration
AB limited produces a product ‘T’, which requires the following expenses:
Direct Materials per unit
Rs.10
Direct Labour per unit
Rs.7
Direct Expenses per unit
Rs.5
During the month of May 2009, 10,000 units were produced. The normal capacity of the
company is 12,000 units per month. The variable overheads and fixed overheads for the month
were Rs.130,000 and Rs.120,000 respectively. It has a closing stock of 2,500 units. You are
required to determine the cost of closing stock.
Solution:
Statement showing cost of closing stock
Direct materials (2,500 units ×Rs.10)
Rs.25,000
Direct labour (2,500 units × Rs.7)
Rs.17,500
Direct expenses (2,500 units × Rs.5)
Rs.12,500
UNIT 4: Financial Reporting Standards
Page 37
ICAN – Advanced Accounting – CAP II- CHAPTER I
Variable overheads (Rs.130,000 × 2,500 / 10,000)
Rs.32,500
Fixed overheads (Rs.120,000 × 2,500 / 12,000)
Rs.25,000
Value of closing stock
Rs.112,500
Illustration
Everest Limited incurred Rs.12,000,000 as fixed production overhead per year. In normally
produces 100,000 units in a year. In 2017-18 however its production has been only 60,000 units.
At the year end 16th July 2018, the closing stock was 15,000 units. The cost of unit is given
below:
Material
Labour
Variable production overheads
Fixed production overheads
Fixed administrative overheads
Calculate the value of closing stock.
Rs.500 per unit
Rs.250 per unit
Rs.100 per unit
Rs.12,000,000 per annum
Rs.10,000,000 per annum
Solution:
The cost per unit of the finished goods should be calculated as follows:
Costs
Rs.
Materials
500
Labour
250
Variable production overheads
100
Fixed production overheads (Rs.12,000,000/100,000 units)
120
Total cost of conversion per unit
970
Thus the value of 10,000 units of finished goods on stock at the year-end will be Rs.14,550,000
(15,000 units × Rs.970).
Illustration
The following costs were incurred by AC Limited for production of a product and a by-product
was also produced:
Direct Materials 1,000 units
Direct Labour
Manufacturing overheads
Total production of Main product
Sales of main product
Amount realized from sale of by-product
Page 38
Rs.30,000
Rs.20,000
100% of direct wages
1,000 units
800 units @ Rs.100 p.u.
Rs.400
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
You are required to find out the cost of closing stock of main product, utilizing the cost data and
other information provided above.
Solution:
Direct Materials
Direct Labour
Manufacturing Overheads
Total Joint Costs
Less: Sale value of by-product
Costs of main product
Value of closing stock (Rs.69,600 × 200/ 1,000)
Rs.30,000
Rs.20,000
Rs.20,000
Rs.70,000
Rs.400
Rs.69,600
= 13,920
Illustration
AD Limited manufactures three different products X, Y and Z. The joint costs incurred was
Rs.18,000. The products did not require any further processing costs after split off point. The
output and selling price per unit of each product are:
Products
Selling price per unit
Output in Units
X
Rs.12
200
Y
Rs.8
600
Z
Rs.4
700
Required: Apportion the joint costs.
Solution:
Product
Output (units)
Sales value (Rs.)
Joint Cost apportioned (Rs.)
(Rs.18,000 in 24: 48 : 28)
X
200
2,400
4,320
Y
600
4,800
8,640
Z
700
2,800
5,040
Illustration
AB limited has the following production data and overhead:
Year
Production (units)
Fixed overheads (Rs.)
2016
1,200,000
11,000,000
2017
1,500,000
13,000,000
2018
1,000,000
14,500,000
Direct labour cost for 2018 = Rs.57,000,000
UNIT 4: Financial Reporting Standards
Variable overheads (Rs.)
5,000,000
6,170,000
4,400,000
Page 39
ICAN – Advanced Accounting – CAP II- CHAPTER I
There was low production in 2018 because of market recession. Can the company include actual
fixed overhead for the determination of cost of conversion? Find out conversion cost in
accordance with NAS 02.
Answer:
The company had achieved production growth in 2017 and there is a production decline in 2018
because of market recession. So normal capacity cannot be linked to 2017 level. The company
can derive normal capacity level covering 2016 and if it feels appropriate it can use 2015 or
2014 data as well. A five yearly average production data could be good approximation.
However, increase in capacity level should be taken into account. If the company has increased
production capacity since 2015, then 2014 data would be irrelevant.
Normal capacity = average capacity = 1,233,333 units
Determination of conversion cost
Direct labour
Rs.57,000,000
Variable overheads
Rs.4,400,000
Fixed overheads
Rs.11,756,759
(14,500,000 × 1,000,000/1,233,333)
Total
Rs.73,156,759
Balance of fixed overheads of Rs.2,743,241 (Rs.14,500,000 – Rs.11,756,759) is to be expensed.
Other costs
Other costs includes costs incurred for bringing the inventories into present condition and
location such as cost of designing product for specific customers is included in cost of
inventories.
The following costs are excluded from cost of inventories:
i. abnormal amount of wastage materials, labour or other production costs;
ii. storage costs, unless those are necessary in the production process; and
iii. administrative overheads that are not incurred from bringing inventories to their present
condition and location
iv. Selling costs.
v. interest expenses.
Borrowing costs may be included in cost of inventories if inventories are qualifying assets.
When inventories are purchased on deferred payment, the interest expense is excluded from cost
of inventory.
Page 40
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
The following invoice was received from a supplier for the product ‘Part A’:
Invoice
Rs.
200 units Part A 32 @ Rs.5
1,000.00
Less: 20% Discount
200.00
800.00
Add: Excise duty @ 15%
120.00
920.00
Add: Packing charges (15 non-returnable boxes) 50.00
970.00
Note:
(a) A 2 percent discount will be given for payment in 30 days.
(b) Documents substantiating payment of excise duty is enclosed for claiming refund.
(c) Closing stock of Part A is 50 units.
Required: Cost of inventory.
Solution:
Note: The discount offered is cash discount and cash discount is not considered for calculation
of cost of material. Cash discount is separately accounted for as an income.
Statement showing cost of stock
Particulars
Purchase Price
Less: Discount
Add: Excise Duty
Add: Packing Charges
Less: Excise Duty refundable
Cost of goods purchased
Cost of Inventory (850 ×50/200)
Amount (Rs.)
1,000
200
800
120
920
50
970
120
850
212.50
Illustration
AD Limited belonging to the process industry incurs the following storage costs:
Expenses for raw material warehouse
Rs.10 million
Expenses for intermediate process stores Rs.12 million
Expenses for finished goods stores
Rs.18 million
Total
Rs.40 million
UNIT 4: Financial Reporting Standards
Page 41
ICAN – Advanced Accounting – CAP II- CHAPTER I
In addition, it has incurred cost for supplying goods from the factory to the sales depots
amounting to Rs.20 million from where goods are dispatched to the dealers, and transport
expenses to the dealers depot Rs.24 million.
It has incurred Rs.4 million interests on working capital loan which has been used for financing
raw material and finished goods inventories. Administrative expenses Rs.30 million and other
selling expenses were Rs.20 million.
Find out which of the above items should be included in the cost of inventories.
Answer:
Items
Expenses for raw material warehouse
Expenses for intermediate process stores
Expenses for finished goods stores
Transportation from the factory to sales depot
Transportation from the sales depot to dealers
Interest on working capital loan
Administrative expenses
Other selling expenses
Total other costs to be included in cost of inventories
Comment
Included
Included
Excluded
Included
Excluded
Excluded
Excluded
Excluded
Rs. in million
10
12
20
42
Cost of inventories is computed based on cost formula.
The cost of inventories of items that are not ordinarily interchangeable and goods or services
produced and aggregated for specific projects shall be assigned by using specific identification
of individual costs.
For inventories items other than covered under specific identification, cost is calculated by
FIFO or weighted average cost method. The assumption of FIFO formula is that units purchased
first are issued/consumed first. Whereas in weighted average cost beginning inventory and new
purchases are added up and weighted average cost is computed. Weighted average cost can be
computed for each new purchase or periodically.
Standard cost method can also be used if the results approximate costs. Standard costs take into
account normal levels of material and supplies, labour efficiency and capacity utilization. They
are regularly reviewed and, if necessary, revised in the light of current conditions.
The retail method is often used in the retail industry for measuring inventories of large numbers
of rapidly changing items that have similar margins. The cost of inventory is determined by
reducing the sales value of inventory by the appropriate percentage margin.
Page 42
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
This standard requires an entity to use the same cost formula for all inventories having a similar
nature and use to the entity. For inventories with a different nature or use, application of
different formula may be justified. Different cost formula may be applied in different operating
segment whereas it disallows adoption of different cost formula in different geographical
segments simply because of tax rules.
Net Realizable Value
Net realizable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
Estimation of net realizable value of finished goods/service
Estimates of net realizable value are based on the most reliable evidence available at the time of
estimation.
Estimates of net realizable value also take into consideration the purpose for which the
inventory is held.
Often an entity holds the inventory to fulfill firm sales contract, in such a case net realizable
value of inventory should be contract price.
Estimation of net realizable value of raw materials and supplies
Estimates of net realizable value of the materials and supplies held for use in production of
finished goods is estimated as under:
a. if finished product in which the raw materials and supplies used is sold at cost or above
cost, then the estimated realizable value of raw materials and supplies is considered
more than its cost.
b. if finished product in which the raw materials and supplies used is sold below cost, then
the estimated realizable value of raw materials and supplies is equal to replacement cost
of raw materials and supplies.
Comparison between cost and net realizable value
a. The comparison between cost and net realizable value should be made item by item.
b. Grouping of certain items may be appropriate if they have same end user and marketed
in the same geographical region or they belong to the same product line.
c. It is inappropriate to group all items belonging to an operating segment.
d. In case of the service provider, each service is treated as a separate item.
UNIT 4: Financial Reporting Standards
Page 43
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
ABC Limited deals in four products A, B, C and D. The historical cost and net realizable value
of closing stock of each product are given below:
Product
Historical Cost
Net Realizable Value
A
Rs.220,000
Rs.280,000
B
Rs.250,000
Rs.245,000
C
Rs.210,000
Rs.180,000
D
Rs.100,000
Rs.120,000
Find out the value of closing stock for the financial statements.
Solution:
Stock should be valued at Rs.745,000 (Rs.220,000 + Rs.245,000 + Rs.180,000 + 100,000).
Recognition as expense
When inventories are sold, the carrying amount of those inventories shall be recognized as an
expense in the period in which the related revenue is recognized. The amount of any write-down
of inventories to net realizable value and all losses of inventories shall be recognized as an
expense in the period the write down or loss occurs. The amount of any reversal of any write
down of inventories, arising from an increase in net realizable value, shall be recognized as a
reduction in the amount of inventories recognized as an expense in the period in which the
reversal occurs.
Disclosure
The financial statement shall disclose:
i. the accounting policies adopted in measuring inventories including the cost formula
used;
ii. the total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
iii. the carrying amount of inventories carried at fair value less costs to date;
iv. the amount of inventories recognized as an expense during the period;
v. the amount of any write down of inventories recognized as an expense in the period;
vi. the amount of any reversal of any write down that is recognized as a reduction in the
amount of inventories recognized as expense in the period;
vii. the circumstances or events that led to the reversal of a write down of inventories;
viii. the carrying amount of inventories pledged as security for liabilities.
Page 44
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
NAS 8 Accounting Policy, Changes in Accounting Estimates and Errors
Accounting Policy
Accounting policies are the specific principles, bases, conventions, rules and practices applied
by an entity in preparing and presenting financial statements.
For example:
NAS 16 Property, Plant and Equipment allow the use of the cost model or the revaluation,
model for measurement after initial recognition.
The selection of method to be applied is refereed as accounting policy.
Selection and application of accounting policy
When a NFRS specifically applies to a transaction, other event or condition, the accounting
policy or policies applied to that item shall be determined by applying the NFRS.
In the absence of NFRS that specifically applies to an item in the financial statements,
management must use its judgment to develop and apply an accounting policy that results in
information that is:
a.
b.

relevant to the decision making needs of the users; and
reliable in that financial statements:
represent faithfully the financial position, financial performance and cash flows of the
entity;

reflect the economic substance of transactions, other events and conditions, and not
merely the legal form;

are neutral i.e. free from bias;

are prudent; and

are complete in all materials respect.
In making the judgment, the management must consider the following sources in descending
order:
a.
b.
the requirement in NFRS dealing with similar and related issue; and
the definitions, recognition criterion and measurement concepts for assets, liabilities,
income and expenses in the Framework.
Change in accounting policy
An entity shall select and apply its accounting policies consistently for similar transactions,
other events and conditions, unless an NFRS specifically required or permits categorization of
UNIT 4: Financial Reporting Standards
Page 45
ICAN – Advanced Accounting – CAP II- CHAPTER I
items for which different policies may be appropriate. If an NFRS requires or permits such
categorization, an appropriate accounting policy shall be selected and applied consistently to
each category.
An entity shall change an accounting policy only if the change:
a. is required by an NFRS or
b. results in better presentation of financial statements.
The following are not changes in accounting policies:
a.
b.
the application of an accounting policy for transactions, other events or conditions that
differ in substance from those previously occurring; or
the application of new accounting policy for transactions, other events or condition that
did not occur previously or were immaterial.
Illustration
Rama Ltd has always valued its inventory applying FIFI method. In 2020 it decides to change
the method to the weighted average method of valuation.
The profit for the year 2019 was derived as below:
Revenue
Cost of sales:
Opening inventory
Purchase
Closing inventory
Rs.
1,000,000
50,000
700,000
(65,000)
685,000
Gross profit
315,000
It was found that as per weighted average method the value of opening inventory of 2020 would
have been 75,000.
Suggest the accounting treatment.
Solution
Change in valuation of inventory is case of change in accounting policy. Rama Ltd is required
to recalculate profit of 2019 as it will result in change in closing inventory of 2019. It will revise
the statement of 2019 as below:
Revenue
Cost of sales:
Opening inventory
Purchase
Page 46
1,000,000
50,000
700,000
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Closing inventory
(75,000)
675,000
Gross profit
325,000
This will result an increase in gross profit of 2019 which will increase the retained earnings by
the same amount.
Treatment in 2020
The opening inventory for 2020 will be Rs.75,000 and the statement of changes in equity for
2020 will show an Rs.10,000 adjustments to opening retained earnings.
Treatment of Changes in Accounting Policy
An entity shall account for a change in accounting policy resulting from the initial application of
a NFRS in accordance with the specific transitional provisions, if any, in that NFRS.
Where the initial application of a NFRS does not prescribe specific transitional provisions,
changes in accounting policy are accounted retrospectively by:
a.
b.
adjusting the opening balance of each affected component of equity for the earliest prior
period presented; and
adjusting comparative amounts for each prior period presented as if the accounting
policy had always been applied.
Disclosures for Accounting Policy
Main disclosures:
a. the nature of the change in accounting policy
b. the reasons for the change
c. the amount of the adjustment for the current and each prior period presented for each
item line affected.
d. the amount of the adjustment to period before those presented.
Accounting Estimates
An accounting estimate is made for an item in the financial statements when the item cannot be
measured with precision, and there is some uncertainly about it.
The estimation involves judgments based on the latest available reliable information. For
example, estimates may be required of:
a.
b.
c.
bad debts,
inventory obsolesces,
the fair value of financial assets or financial liabilities,
UNIT 4: Financial Reporting Standards
Page 47
ICAN – Advanced Accounting – CAP II- CHAPTER I
d.
e.
the useful lives or expected pattern of consumption of future economic benefits
embodied in depreciable assets,
warranty obligation
For example:
Whether to use the straight line method or the reducing balance method for depreciation is a
choice of accounting estimates.
Changes in accounting estimates
Changes in accounting estimates result from changes in the circumstances on which the estimate
was based or as a result of new information or more experience.
Change in accounting estimates that gives rise to changes in assets and liabilities, or related to
an item of equity, it shall be recognized by adjusting carrying amount of the related assets,
liabilities or item in the period of change.
Changes in accounting estimates that gives rise to changes other than assets, liability or equity,
shall be recognized prospectively by including it in profit or loss in:
a.
the period of change, if the change affects that period only; or
b.
the period of change and future periods, if the change affects both.
Disclosure for Accounting Estimates
The nature and amount of changes in accounting estimates that affect current and/or future
periods should be disclosed.
Errors
Prior period errors are omissions from, and misstatements in, the entity’s financial statements
for one or more prior periods arising from failure to use, or misuse or, reliable information that:
a. was available when financial statements for those periods were authorized for issue; and
b. could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.
They may arise from:
a. Mathematical mistakes,
b. Mistakes in applying accounting policies,
c. Oversights,
d. Misinterpretation of facts,
e. Frauds
Page 48
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Accounting treatment of errors
An entity shall correct materials prior period errors retrospectively in the first set of financial
statements authorized for issue after their discovery by:
a.
restating the comparative amounts for the prior period(s) presented in which the error
occurred; or
b. if the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for the earliest prior period presented.
Disclosure for Errors
Main disclosures:
a. the nature of the prior period error,
b. the amount of the correction for each prior period presented for each line item affected,
c. the amount of the correction at the beginning of the earliest prior period presented.,
Illustration
During 2019 Krishna Ltd discovered that the closing inventory of 2018 includes certain items
ting Rs.5,000 which was sold before the year end. The following figures for 2018 and (draft)
figures for 2019 are made available to you:
2018
2019
Revenue
1,000,000
1,200,000
Cost of sales
800,000
900,000
Profit before tax
200,000
300,000
Income tax @ 25%
50,000
75,000
Profit after tax
150,000
225,000
st
Retained earnings as on 1 January 2018 was Rs.500,000. No dividends have been paid.
Required:
Show the statement of profit or loss for the 2019 with comparatives and retained earnings.
Solution
Statement of profit or loss
Revenue
Cost of sales (800,000 +5,000) (900,000 -5,000)
Profit before tax
Income tax @ 25%
Profit after tax
UNIT 4: Financial Reporting Standards
2018
1,000,000
805,000
195,000
48,750
146,250
2019
1,200,000
895,000
305,000
76,250
228,750
Page 49
ICAN – Advanced Accounting – CAP II- CHAPTER I
Retained earnings
Opening balance (as reported)
Correction of errors (5,000 – 1,250)
Retained earnings as restated
Profit for the year
Closing retained earnings
2018
500,000
-500,000
146,250
646,250
2019
650,000
3,750
646,250
228,750
875,000
NAS 10 Events after Reporting Period
This standard prescribes the accounting treatment/disclosure of events that occur between the
balance sheet date and the date when the financial statements are authorized for issue. Events
after the balance sheet date are of two types:
i. Adjusting events; and
ii. Non-adjusting events.
Adjusting Events
An entity shall adjust the amounts recognized in its financial statements for events after the
balance sheet date that provide further evidence of conditions that existed on the balance sheet
date.
The following are the examples of adjusting events:
i. the settlement after the balance sheet date of a court case that confirms that the entity
had a present obligation at the balance sheet date.
ii.
the receipt of information after the balance sheet date indicating that an assets was
impaired at the balance sheet date or that the amount of a previously recognized
impairment loss for that assets needs to be adjusted.
iii. the determination after the balance sheet date of the cost of assets purchased, or the
proceeds from assets sold, before the balance sheet date.
iv. the determination after the balance sheet date of the amount of profit sharing or bonus
payments, if the entity had a present legal or constructive obligation at the balance sheet
date to make such payments as a result of events before that date to make such
payments as a result of events before that date.
v.
Page 50
the discovery of fraud or errors that show that the financial statements are incorrect.
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
AX Limited prepares its financial statement on 31st March each year. A client sued the company
on 15th March 2009, for damages against company’s failure to fulfill the warranty amounting
Rs.500,000. The company made a provision of Rs.300,000 on advice of the lawyer. The
financial statements were authorized on 30th April 2009. On 15th April 2009, the court decided
against the company and a compensation of Rs.450,000 was awarded. You are required to
advise the treatment.
Solution:
The entity shall adjust the provision made and provide an additional provision of Rs.150,000 in
the financial statements of the financial year 31st March 2009. The company can not disclose
only as a contingent liability as the decision of court provides additional evidence of a present
obligation on the balance sheet date.
Illustration
BX Limited valued the closing stock of finished goods (10,000 units) at Rs.100,000 being its
cost as it was lower than net realizable value which was estimated at Rs.120,000 on the basis of
selling price available on 23rd March 2009 as the selling price on 31st March was not available.
The balance sheet date was 31st March 2009. The financial statements were authorized on 15th
April 2009. On 3rd April 2009, the company sold its one lot of finished goods of 100 units for
Rs.800. Advise the company on valuation of its finished goods for the financial statements of
the year 31st March 2009.
Solution:
The sale of finished goods provides additional information about net realizable value of stock.
The company should adjust the value of its stock at Rs.80,000 (10,000 units × Rs.8).
Illustration
The Board of directors of CX Limited approved its financial statements for the year ended on
31st March 2009 on 30th June 2009. A debtor against whom insolvency proceeding were
instituted before 31st March 2009, is declared 10th June 2009. The amount receivable from the
debtor was Rs.100,000. Advice the appropriate treatment for the year ended 31st March 2009,
to CX Limited.
Solution:
The company should make a provision for loss of Rs.100,000 in its financial statements of the
year ended on 31st March 2009.
UNIT 4: Financial Reporting Standards
Page 51
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
The Board of directors of DX Limited approved its financial statements for the financial year
ended on 31st March 2009 on 30th June 2009.DX Limited entered into an agreement to sell its
land included in its balance sheet at Rs.1,000,000 for Rs.2,500,000. The agreement to sell was
concluded on 24th January 2009 but the sale deed was registered on 15th April 2009.
Solution:
Amounts recognized in balance sheet should be adjusted for events occurring after balance sheet
date that provide additional information for determining amount relating to condition existing
on balance sheet date. The sales were existing on balance sheet date, the deed registration gives
and additional evidence. So the transaction should be adjusted in the financial statements for the
year ended 31st March 2009.
Illustration
The Board of directors of AB Limited approved its financial statements for the financial year
ended on 31st March 2009 on 30th June 2009. Employees were entitled to performance bonus as
a percentage of turnover. The evaluation was incomplete on 31st March 2009. An estimated sum
of Rs.100,000 was provided for bonus in the financial statement of the year ended 31st March
2009. The bonus was finalized at Rs.120,000 on 15th April 2009.
Solution:
The finalization of bonus provides additional information about determination of bonus which
was existing on balance sheet date. The provision for performance bonus should be adjusted and
increased to Rs.120,000.
Illustration
The Board of directors of BB Limited approved its financial statements for the financial year
ended on 31st March 2009 on 30th June 2009. The company had given advance amounting to
Rs.1,000,000 to a foreign party for purchase of a machine on 5th March 2009. The machine was
to be delivered on 15th March 2009 but was not delivered. On 15th April 2009, it was discovered
that the advance was given to a fictitious party and the party was not traceable. The company is
in process of collecting the advance.
Solution:
This standard requires adjustment in the financial statement for frauds and errors discovered
after balance sheet date that show that financial statements are incorrect. So the company should
create provision for the amount advanced to the foreign party i.e. for Rs.1,000,000.
Page 52
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Non-adjusting Events
An entity shall not adjust the amounts recognized in its financial statements for events after the
balance sheet date for which no condition was prevailing on or before the balance sheet date.
The following is the example of non-adjusting event:
i. Decline in market value of investments after the balance sheet date.
Illustration
The Board of directors of ABX Limited approved its financial statements for the financial year
ended on 31st March 2009 on 30th April 2009. It has investments held for trading and therefore
valued at market price of 31st March 2009 which is fair value of the investment. The market
price of the investment was decreased on 12th April 2009.
Solution:
Subsequent decline in the market price does not reflect the conditions prevailing as on the
balance sheet date. And such event is non-adjusting event. So it should not be adjusted in the
financial statement for the year ended on 31st March 2009. But it should be disclosed in notes to
accounts.
Disclosure of Non-adjusting Events
Sometimes non-adjusting events are so significant that their non-disclosure would affect the
understanding about the financial statements. Users would not be able to evaluate financial
statements in absence of such disclosure, in that case additional disclosures are necessary for
each significant category of non-adjusting events after the balance sheet date:
i.
the nature of event; and
ii. the estimate of its financial effect
Examples of such non-adjusting events requiring additional disclosure are:
i.
major business combinations after the balance sheet date or disposing of subsidiaries.
ii. announcing a plant to discontinue an operation.
iii. major purchase of assets, classification of assets as held for sale, other disposal of
assets, or expropriation of major assets by government.
iv. the destruction of major production plant by a fire after the balance sheet date.
v. announcing or commencing the implementation of major restructuring.
vi. major ordinary share transactions and potential ordinary share transactions after the
balance sheet date (NAS 24 Related Party Disclosure)
vii. abnormally large changes after the balance sheet date in asset price or foreign
exchange rates.
UNIT 4: Financial Reporting Standards
Page 53
ICAN – Advanced Accounting – CAP II- CHAPTER I
viii. changes in tax rates or tax laws enacted or announced after the balance sheet date that
have a significant effect on current and deferred tax assets and liabilities (NAS 12)
ix. entering into significant commitments or contingent liabilities, for example, by
issuing significant guarantees; and
x. commencing major litigation arising solely out of events that occurred after the
balance sheet date.
Dividends
If dividends are declared or proposed after the balance sheet date but before the financial
statements are authorized for issue, the dividends are not recognized as a liability at the balance
date. Such dividends are disclosed in notes to accounts.
Illustration
The Board of directors of AX Limited approved its financial statements for the year ended on
31st March 2009 on 30th June 2009. The board of directors has recommended a dividend of 10%
on 10th June 2009.
Solution:
The dividend cannot be provided in the financial statements for the year ended on 31st March
2009. It should be disclosed in notes to accounts.
Going Concern
Deterioration in operating results and financial position after the balance sheet date may indicate
a need to consider whether the going concern assumption is still appropriate. If the going
concern assumption is no longer appropriate, there is a need for a fundamental change in the
basis of accounting rather than adjustment. In this case the following specific disclosure is
required:
i. the financial statements are not prepared on a going concern basis; or
ii. management is aware of material uncertainties related to events or conditions that may
cast significant doubt upon the entity’s ability to continue as going concern. The events
or conditions requiring disclosure may arise after the balance sheet date.
Disclosure
An entity should disclose the date when the financial statements were authorized for issue and
who gave the authorization. If the owners of the entity or other have power to amend the
financial statements after issuance, the entity shall disclose the fact.
Page 54
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Updating disclosure
An entity shall update disclosures that relate to the conditions that existed at the balance sheet
date in the light of any new information that it receives after the balance sheet date.
NAS 16 Property, Plant and Equipment
This accounting standard prescribes the accounting treatment of Property, Plant and Equipment.
It lays down the recognition criterion of property, plant and equipment as an assets, the
determination of carrying amount and the depreciation thereof.
Applicability
This standard applies to property, plant and equipment other than then the cases when other
standards are applied such as accounting standard on lease applies to leased assets (NAS 17)
and accounting standard on investment property applies to investment property (NAS 40).
This standard does not apply to:
a. Property, Plant and Equipment classified as held for sale;
b. Biological assets related to agriculture;
c. the recognition and measurement of exploration and evaluation assets;
d. mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative
resources.
However, this standard applies to property, plant and equipment used to develop or maintain the
assets prescribed in (b) – (d).
Definitions:
i. Property, plant and Equipment
Property, plant and equipment are tangible assets that:
a. are held for use in the production or supply of goods or services, for rental to others, or
for administrative purposes; and
b. are expected to be used during more than one period.
Spare parts and servicing equipments are usually carried as inventory and recognized in profit
and loss account as consumed. However, major spare parts and stand-by equipment qualify as
property, plant and equipment when an entity expects to use them during more than one period.
UNIT 4: Financial Reporting Standards
Page 55
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
AB Limited purchased some spare parts as on 1st January 2009 costing Rs.1,000,000. The
management estimates that the spare parts can be used upto 31st December 2011. Give your
opinion whether the spare parts should be classified as an item of inventory or property, plant
and equipment?
Answer:
Spare parts are generally classified as inventory and recognized in profit and loss account as
consumed. But major spare parts major spare parts qualify as property, plant and equipment
when an entity expects to use them during more than one period. Since the spare parts are
estimated to be used for more than one period, it should be classified as property, plant and
equipment.
ii. Carrying Amount
Carrying amount is the amount at which an asset is recognized in the balance sheet after
deducting accumulated depreciation and accumulated impairment losses.
iii. Cost
Cost is the amount of cash or cash equivalents paid
or
the fair value of other consideration given to acquire an asset at the time of its acquisition or
construction.
iv. Depreciable Amount
Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual
value.
v. Entity Specific Value
Entity specific value is the present value of the cash flows an entity expects to arise from the
continuing use of an asset and from its disposal at the end of its useful life or expects to incur
when settling a liability.
Illustration
AC Limited purchased a truck for Rs.4,000,000 on 1st January 2009. The management estimates
that the following rental charges can be collected during the life of five years:
Page 56
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Year ending
31st December 2009
31st December 2010
31st December 2011
31st December 2012
31st December 2013
The truck can be sold on 31st December 2013 for
Rental Charges
Rs.1,500,000
Rs.1,200,000
Rs.1,210,000
Rs.1,000,000
Rs.650,000
Rs.1,200,000.
You are required to calculate entity specific value for AC Limited. (Assume discount rate of
10%)
Solution:
Entity specific value is the present value of the cash flows an entity expects to arise from the
continuing use of an asset and from its disposal at the end of its useful life. In this case, specific
value is Rs.5,096,180.72
{1,500,000/ (1+ 0.10)1 + 1,200,000/ (1+ 0.10)2 + 1,210,000/ (1+ 0.10)3 +1,000,000/ (1+ 0.10)4 +
650,000/ (1+ 0.10)5 + 1,200,000/ (1+ 0.10)5}
vi. Fair Value
Fair value is the amount for which an asset could be exchanged between knowledgeable,
willing parties in an arm’s length transactions.
vii. Impairment Loss
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount.
Initial Recognition as property, plant and equipment as asset
The cost of an item of property, plant and equipment shall be recognized as an asset, if and only
if:
a. it is probable that future economic benefit s associated with the item will flow to the
entity; and
b. the cost of the item can be measured reliably.
Assets acquired for safety or environmental reason is exception of the general recognition
principle. The acquisition of such property, plant and equipment, although not directly
increasing the future economic benefits, but may be necessary for an entity to obtain the future
economic benefits of other assets. Such item of property, plant and equipment are recognized as
assets as they enable the entity to derive future economic benefits from related assets. However,
these assets are reviewed for impairment loss in accordance with NAS 36 Impairment of Assets.
UNIT 4: Financial Reporting Standards
Page 57
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
AD Limited, engaged in manufacturing chemicals, purchased and installed a chemical handling
plant to comply with environmental requirements for production and storage of dangerous
chemicals. The cost of the plant was Rs.12,000,000. Can the company recognize the item as
property, plant and equipment?
Answer:
Yes. Related plant can be recognized as an asset because, without the plant, the entity is unable
to manufacture and sell chemicals. However, the plant will be reviewed for impairment loss in
accordance with NAS 36 Impairment of Assets.
Measurement of Property, Plant and Equipment at Recognition
Initially an item of property, plant and equipment should be measured at cost. The cost includes
the followings:
a. its purchase price, including import duties and non-refundable purchase taxes, after
deducting trade discounts and rebates;
b. any costs directly attributable to bringing the asset to the working condition; and
c. the present value, of the initial estimate of the costs of dismantling and removing the
item and restoring the site.
Examples of directly attributable costs
a. costs of employees benefits arising from the construction or acquisition of the item of
property, plant and equipment;
b. costs of site preparation;
c. initial delivery and handling costs;
d. installation and assembly costs;
e. costs of testing net of sales of any goods produced in the process of testing;
f. professional fees.
Items not included in costs
The following items of costs are not included in cost of property, plant and equipment:
a.
b.
c.
d.
Page 58
costs of opening a new facility;
costs of introducing a new product or service (advertisement and promotional costs)
costs of conducting business in a new location or with a new class of customer’
staff training costs;
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
A shipping company is required to put its ship into dry dock every five years for an overhaul, at
a cost of Rs.3 million. The ship has a useful life of 20 years. A ship was purchased at a cost of
Rs.300 million.
Advise the accounting treatment for the cost of purchase of ship.
Answer:
Rs.3 million of the cost of the ship overhaul should be treated as a separate component and
depreciated over five years.
The remaining cost of Rs.297 million should be depreciated over the useful life of 20 years.
Cost of assets purchased under deferred payment
The cost of an item of property, plant and equipment is the cash price equivalent at the
recognition date. If payment is deferred beyond the normal credit period, the difference between
cash price and the total payment is recognized as interest expense. However, the interest can be
added to cost of the asset to the extent permissible under NAS 23 Borrowing costs.
Cost of self-constructed assets
All the expenditure incurred on startup and commissioning of the project, including, the
expenditure incurred on test runs and experimental production should be capitalized as part of
the cost of the assets. However, the expenditure incurred after the plant has begun commercial
production is not capitalized and is treated as revenue expenditure. The cost of self-constructed
asset is derived by eliminating any internal profit. Also cost of any abnormal loss of material,
labour and other resources incurred are not included in the cost of the asset.
Illustration
A company is in the process of setting up a production line for manufacturing a new product.
Based on trial runs conducted by the company, it was noticed that the production lines output
was not of the desired quality. However, company has taken a decision to manufacture and sell
sub-standard product over the next one year due to the huge investment involved. In the
background of the relevant accounting standard, advise the company on the cut-off date for
capitalization of the project cost.
Answer:
As per NAS 16 “Property, Plant and Equipment”, all the expenditure incurred on startup and
commissioning of the project, including, the expenditure incurred on test runs and experimental
production should be capitalized as part of the cost of the assets. However, the expenditure
UNIT 4: Financial Reporting Standards
Page 59
ICAN – Advanced Accounting – CAP II- CHAPTER I
incurred after the plant has begun commercial production is not capitalized and is treated as
revenue expenditure.
In the present case, the company did not stop production even if the output was not of the
desired quality, and continued the sub-standard production due to huge investment involved in
the project. Capitalization should cease at the end of trail run. And the cut-off date for
capitalization of project cost should be taken the date when the trial run was completed.
Cost of assets held under finance lease
The cost of an item of property, plant and equipment held by a lessee under a finance lease is
determined in accordance with NAS 17 Leases.
Receipts of Government Grant
The carrying amount of an item of property, plant and equipment may be reduced by the amount
of government grants in accordance with NAS 20 Accounting for Government Grants and
Disclosure of Government Assistance.
Land and building acquired together
Land and buildings are separable assets and accounted for separately, even when they are
acquired together.
Operations during construction period
Some operation occur in connection with the construction or development of an item of
property, plant and equipment, but are not necessary to bring the item to the location and
condition necessary for it to be capable of operating in the manner intended by the management.
Such income and incidental expenses of the operation are recognized in profit and loss account.
Illustration
AB Limited purchased land for building construction. The land was given on rent for car
parking until the construction started. Advise the accounting treatment of the income as rent.
Answer:
The operation of lending as car parking is not necessary to bring the item to the location and
condition necessary for building construction. So the rental income form land and incidental
expenses of the operation should be recognized in profit and loss account.
Exchange of Assets
One or more items of Property, Plant and Equipment may be acquired in exchange for a nonmonetary asset or assets. If an entity is able to determine reliably the fair value of either the
Page 60
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
asset given up, then the fair value of the assets given up is used to the measure the cost of the
assets received. The fair value of assets received may be taken if more clearly evident.
If the acquired item is not measured at fair value, its cost is measured at the carrying amount of
the assets given up.
Illustration
X Limited acquired a plant from Y Limited. The plant has a fair value of Rs.1,500,000.
Both parties agreed that the plant would be paid for with a plot of land owned by X Limited.
This plot of land had a carrying value of Rs.1,000,000. The land was recently valued at
Rs.1,400,000.
How should X Limited recognize the transaction?
Answer:
X Limited should recognize the new assets at the fair value of assets given up to pay the
consideration i.e. at Rs.1,400,000. It should recognize a profit on disposal of the land of
Rs.400,000 (1,400,000 – 1,000,000).
Plant Dr.
1,400,000
To Land
1,000,000
To Profit on sale of land
400,000
Subsequent Costs
Subsequent costs are those which are incurred after initial recognition. These are costs incurred
while the asset is already in use.
Subsequent costs are added to the carrying amount only when it is probable that future
economic benefits, in excess of originally assessed, will flow to the entity. All other subsequent
expenses are expensed in the period in which they are incurred.
Examples of subsequent costs that can be added to carrying amount are:
a.
b.
c.
d.
modification of an item to extend its useful life;
modification of an item to extend production capacity;
upgrading machines parts to achieve a substantial improvement in the quality of output.
upgrading machines parts to achieve a substantial reduction in operating costs.
UNIT 4: Financial Reporting Standards
Page 61
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
During the current year 2069/70, M/S Harish Power made the following expenditure relating to
its Plant and Machinery:
Particulars
Rs.
General repairs
400,000
Repairing of Electric Motors
100,000
Particle replacements of parts of machinery
50,000
Substantial improvement to the electrical wiring system which will increase
efficiency of the plant and machinery
1,000,000
Explain with reference to relevant NAS; how the above expenditure should be treated.
Answer:
As per NAS 16 ‘Property, Plant and Equipment’, expenditure that increase the future benefits
from the existing asset beyond its previous assessed standard of performance is included in the
book value. Hence in the given case, repairs amounting to Rs.500,000 and partial replacement
of parts of Rs.50,000 should be charged to profit and loss account. Rs.1,000,000 incurred for
substantial improvement to the electric wiring system which will increase efficiency should be
capitalized.
In summary,
Particulars
Charged to Profit & Loss Account
Added to carrying amount of Plant & Machinery
Rs.
550,000
1,000,000
Regular replacement of parts
Parts of some item of property, plant and equipment may require replacement at regular
intervals. Cost of replacement can be capitalized when the parts has different useful lives or
provide benefit to the entity in different manner. The carrying amount of the parts replaced are
derecognized in accordance with derecognition provisions.
Inspection Costs
Some property, plant and equipment may require regular major inspection for faults. When each
major inspection is performed, its cost is added in the carrying amount of property, plant and
equipment. Any remaining carrying amount of the cost of the previous inspection is
derecognized.
Page 62
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Measurement after Initial Recognition
Property, plant and equipment should be measured either applying cost model or revelation
model.
a. Cost Model
Under the cost model, an item of property, plant and equipment is carried at cost less
accumulated depreciation less any accumulated impairment losses.
b. Revaluation Model
Under revaluation model, an item of property, plant and equipment is carried at revalued
amount less accumulated depreciation less accumulated impairment losses.
Revaluation
Revaluations are carried at fair value of the assets. An asset can be carried at revalued value
whose fair value can be measured reliably. When an item of property, plant and equipment is
revalued, the entire class of the asset is revalued. The following are examples of separate class:
a. land;
b. land and building;
c. machinery;
d. ships;
e. aircraft;
f. motor vehicles;
g. furniture and fixtures; and
h. office equipment.
Frequency of revaluation depends upon volatility in the fair value of the assets. An asset that
experiences highly volatile movement in fair value requires annual revaluation while other
assets may be revalued in an interval of every three to five years.
Treatment of revaluation figure
i. First time downward revaluation
The decrease amount below the carrying amount is debited to profit and loss account.
ii. First time upward revaluation
The increase amount above the carrying amount is credited to revaluation account which is
part of other comprehensive income.
UNIT 4: Financial Reporting Standards
Page 63
ICAN – Advanced Accounting – CAP II- CHAPTER I
iii. First time downward revaluation and subsequent upward revaluation
The increase amount above carrying amount can be credited to profit and loss account to the
extent earlier debited to profit and loss account. And balance amount should be credited to
revaluation account.
iv. First time upward revaluation and subsequent downward revaluation
The decrease amount above carrying amount can be debited to revaluation account to the
extent the amount earlier credited is unutilized. And balance amount should be debited to
profit and loss account.
Illustration
What is the accounting entry to be passed as per NAS 16 Property, plant and equipment for the
following situations?
a. increase in value of fixed assets by Rs.5,000,000 on account of revaluation.
b. decrease in value of fixed assets by Rs.3,000,000 on account of revaluation.
Answer:
a. The increase amount should be credited to revaluation surplus and taken to other
comprehensive income.
Fixed Assets
Dr. 5,000,000
To Revaluation surplus
5,000,000
b. The decrease amount would be charged to the statement of profit or loss.
Statement of Profit or Loss
Dr. 3,000,000
To Fixed Assets
3,000,000
Illustration
AB Ltd had revalued its one of the non-depreciable assets resulting a decrease in value of the
assets by Rs.200,000 in the year 2075.
During the years 2076 it again revalued the above asset, this time resulting an increase by
Rs.300,000.
Give accounting treatment for the year 2076 for the revaluation.
Answer:
Amount of increase equal to amount of previous decrease (which were expensed in previous
year in statement of profit or loss) should be taken as income in the statement of profit and loss
and remaining amount should be taken to the other comprehensive income (i.e. revaluation
surplus).
Page 64
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
AB Ltd should give the following treatment in the year 2076:
Assets
To Statement of Profit/Loss
To Revaluation surplus (OCI)
Dr. 300,000
200,000
100,000
Adjustment of accumulated depreciation of revalued assets
When an item of property, plant and equipment is revalued, any accumulated depreciation at the
date of the revaluation is treated in one of the following ways:
a. When the asset is revalued by means of applying an index to determine its depreciated
replacement cost:
Accumulated depreciation is restated proportionately with the change in gross carrying amount
of the asset so that the carrying amount of the asset after revaluation equals the revalued
amount.
b. When the asset is revalued to its market value:
Accumulated depreciation is eliminated against the gross carrying amount of the asset and the
net carrying amount of the asset is revalued.
Illustration
Gross carrying amount of plant and machinery is Rs.1,000,000 and accumulated depreciation is
Rs.200,000. It is estimated that the current market value of the plant and machinery is
Rs.900,000. Suggest how should the accumulated depreciation be adjusted?
Answer:
The accumulated depreciation can be adjusted in the following manner:
First adjust the accumulated depreciation against the gross carrying amount and hence the
remaining carrying amount becomes Rs.800,000 (1,000,000 – 200,000).Then revalue the assets
from Rs.800,000 to Rs.900,000.
This treatment gives an amount to be credited to revaluation reserve of Rs.100,000.
Fair Value
Fair value of land and building is determined on the basis appraisal of market value, which is
undertaken by qualified valuers.
Fair value of plant and machinery is determined at market value.
UNIT 4: Financial Reporting Standards
Page 65
ICAN – Advanced Accounting – CAP II- CHAPTER I
If there is no market based evidence, fair value is determined using an income or depreciated
replacement cost approach.
Depreciation
Depreciable amount of an asset shall be allocated on a systematic basis over its useful life.
Depreciation charge begins when the assets is available for use i.e. when it is in the location and
condition necessary for it to be capable of operating in the manner intended by management.
Depreciation charges ends from the date when the asset is classified as held for sale or from the
date the asset is derecognized.
Each part of an item of property, plant and equipment with a cost that is significant in relation to
the total cost of the item, shall be depreciated separately. An entity allocates the amount initially
recognized separately to its parts and depreciate each part separately. An entity may choose to
depreciate separately the parts of an asset that do not have a cost that is significant in relation to
the total cost of the item.
The depreciation charge for each period is usually recognized in the profit and loss account.
However, sometimes it is included in the carrying amount of other assets. For example,
depreciation which represents expense for carrying the inventories to their present location and
condition should be included in the cost of inventory.
Illustration
Should land and building be depreciated if they are purchased together?
Answer:
No. Cost of land and should be separated even if they are purchased together. Land is not
depreciated. Only building is depreciated.
Illustration
A machinery costing Rs.10 lakhs has useful life of 5 years. After the end of 5 years, its scrap
value would be Rs.1 lakh. How much depreciation is to be charged in the books of the company
as per NAS 16?
Answer:
As per NAS 16 ‘Property, Plant and Equipment’ the depreciable amount of a depreciable asset
should be allocated on a systematic basis to each accounting period during the useful life of the
asset. In the given case, the depreciation amount can be calculated as follows:
Cost of machine
Less: Scrap value at the end of useful life
Page 66
Rs.
1,000,000
100,000
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Amount to be written off during useful life of machine
Useful life of the machine
Depreciation to be provided each year (900,000/5)
900,000
5 years
180,000
Derecognition
The carrying amount of an item of property, plant and equipment shall be derecognized
(eliminated from balance sheet):
a. on disposal; or
b. when no future economic benefits are expected from its use or disposal.
Gain or loss on derecognition of an asset is recognized in profit and loss account when the item
is derecognized. Such gain or loss should not be classified as revenue but should be classified as
non-operating gain or loss. Gain or loss on derecognition should be calculated with reference to
carrying amount excepts in case of sale and leaseback (NAS17).
Disclosure
The financial statement shall disclose, for each class of property, plant and equipment:
a. the measurement bases used for determining the gross carrying amount;
b. the depreciation method used;
c. the useful lives or the depreciation rates used;
d. the gross carrying amount and the accumulated depreciation (aggregated with
accumulated impairment losses) at the beginning and end of the period; and
e. a reconciliation of the carrying amount at the beginning and end of the period showing:
i. additions;
ii. assets classified as held for sale or included in a disposal group classified as held
for sale and other disposals;
iii. acquisitions through business combinations;
iv. increases or decreases resulting from revaluation and from impairment losses
recognized or reversed directly in equity;
v. impairment losses recognized in profit and loss;
vi. impairment losses reversed in profit and loss;
vii. depreciation;
viii. the net exchange differences arising on the translation of the financial statements
from the functional currency into a different presentation currency, including the
translation of a foreign operation into the presentation currency of the reporting
entity; and
ix. other changes.
UNIT 4: Financial Reporting Standards
Page 67
ICAN – Advanced Accounting – CAP II- CHAPTER I
The financial statement shall also disclose:
a. the existence and amounts of restrictions on title, and property, plant and equipment
pledged as security for liabilities;
b. the amount of expenditures recognized in the carrying amount of an item of property,
plant and equipment in the course of its construction;
c. the amount of contractual commitments for the acquisition of property, plant and
equipment; and
d. if it is not disclosed separately on the face of the income statement, the amount of
compensation from third parties for items of property, plant and equipment that were
impaired, lost or given up that is included in profit or loss.
If items of property, plant and equipment are stated at revalued amounts the following
shall be disclosed:
a. the effective date of the revaluation;
b. whether an independent valuer was involved;
c. the methods and significant assumptions applied in estimating the items’ fair values;
d. the extent to which the items’ fair values were determined directly by the reference to
observable prices in an active market or recent market transactions on arm’s length
terms or where estimated using other valuation techniques;
e. for each revalued class of property, plant and equipment the carrying amount that would
have been recognized had the assets being carried under the cost model; and
f. the revaluation surplus, indicating the change for the period and any restrictions on the
distribution of the balance to shareholders.
NAS 17 Leases
1. Introduction
The objective of this unit is to focus on the appropriate accounting policies and disclosure to
apply in relation to leases.
Lease is an agreement whereby the lessor conveys to the lessee in return for rent the rights to
use an asset for an agreed period of time.
The classification of leases is based on the extent to which risks and rewards incidental to
ownership of a leased asset lie with the lessor or the lessee. A lease is classified as a finance
lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is
classified as an operating lease if it does not transfer substantially all the risks and rewards
incidental to ownership. Accounting and disclosures depend on classification of lease. NAS 17
Leases guide accounting and disclosures about leases.
Page 68
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
An entity holds a property that it owns to earn rentals and for capital appreciation. It enters into
an agreement whereby it conveys to an independent third party in return for payment of Rs
1,000 per year the right to use the building for ten years.
Solution:
The arrangement is a lease—it is an agreement whereby the lessor (the entity) conveys to the
lessee (the independent third party) in return for payment or a series of payments (payment of
Rs. 1,000 per year) the right to use an asset (the building) for an agreed period of time (ten
years).
2. Classification of Lease
Lease transactions are classified into two types: finance lease and operating lease. Lease
classification is based on the extent to which risks and rewards incidental to the ownership of a
leased asset lie with the lessor or with the lessee. Finance lease is defined as lease that transfers
substantially all risks and rewards to the lessee. Title may or may not be transferred. An
operating lease is other than finance lease. Lease classification is carried out at the inception of
the lease.
The following situations individually or in combination would normally lead to a lease
being classified as a finance lease:
a. the lease transfers ownership of the asset to the lessee by the end of the lease term;
b. the lessee has the option to purchase the asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable for it
to be reasonably certain, at the inception of the lease, that the option will be exercised;
c. the lease term is for the major part of the economic life if the asset even if title is not
transferred;
d. at the inception of the lease the present value of the minimum lease payments amounts
to at least substantially all of the fair value of the leased assets; and
e. the leased assets are of such a specialized nature that only the lessee can use them
without major modifications.
The following situations individually or in combination could also lead to a lease being
classified as a finance lease:
a. if the lessee can cancel the lease, the lessor’s losses associated with the cancellation
are borne by the lessee.
b. gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
(for example in the form of a rent rebate equaling most of the sales proceeds at the end
of the lease); and
c. the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
UNIT 4: Financial Reporting Standards
Page 69
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
A Ltd has taken a new lease comprising a factory building and surrounding land. The fair value
of the building is Rs.5,000,000 and the fair value of land is Rs.3,000,000. The lease term period
is 20 years, which is the expected life of the factory, with annual payments in arrears of
Rs.500,000. ALtd’s cost of capital is 8%. The annuity factor for Rs.1 receivable every year for
20 years is 9.818.
Solution
The lease payment should be split into payment for building and land in the ratio of fair value
i.e. in the ratio of 5: 3. Rs.312,500 (500,000 x 5/8) will be treated as payment for building and
Rs.187,500 (500,000 x 3/8) will be treated as payment for land.
The payment for building will be treated as a finance lease because it is for the expected useful
life of the building.
The present value of the minimum lease payment for the land amounts to Rs.1,840,875
(187,500 x 9.818), this is not substantially the fair value of the land, so the lease of the land will
be treated as an operating lease.
3.
The following terms should be known to for the understating of accounting for
leases:
a.
Gross investment in the lease
Gross investment in the lease is the aggregate of:
i. the minimum lease payments receivable by the lessor under a finance lease; and
ii. any unguaranteed residual value accruing to the lessor.
Lease Term
The lease term is non-cancellable period for which the lessee has contracted to lease the
asset together with any further terms for which the lessee has the option to continue to
lease the asset, with or without further payment, when at the inception of the lease it is
reasonably certain that the lessee will exercise the option.
b.
c.
Contingent Rent
Contingent rent is that portion of the lease payment that is not fixed in amount but is
based on the future amount of a factor that changes other than with the passage of time
(e.g. percentage of future sales, amount of future use, future price indices, and future
market rate of interest)
d.
Non-cancellable lease
A non-cancelable lease is a lease that is cancellable only:
i. upon the occurrence of some remote contingency;
Page 70
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
ii. with the permission of the lessor;
iii. if the lessee enters into a new lease for the same or a equivalent asset with the same
lessor; or
iv. upon payment by the lessee of such as additional amount that, at inception of the
lease, continuation of the lease is reasonable certain.
e.
Unguaranteed residual value
Unguaranteed residual value is that portion of the residual value of the leased asset, the
realization of which by the lessor is not assured or is guaranteed solely by a party related
to the lessor.
f.
Minimum Lease Payments
Minimum lease payments are payments over the lease term that the lessee is or required
to make, excluding contingent rent, costs for services and taxes to be paid by and
reimbursement to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee.
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor.
g.
Net investment in the Lease
Net investment in the lease is the gross investment in the lease discounted at the interest
rate implicit in the lease.
4.
Leases in the financial statements of lessees
a.
Operating Leases
Lease payments under an operating lease shall be recognized as an expense on a straightline basis over the lease term unless another systematic basis is more representative of the
time pattern of the user’s benefit.
b.
Finance Leases
At the commencement of the lease term, lessees shall recognize finance leases as assets
and liabilities in their balance sheets at amounts equal to the fair value of the leased
property or, if lower, the present value of the minimum lease payments, each determined
at the inception of the lease.
The discount rate to be used in calculating the present value of the minimum lease
payments is the interest rate implicit in the lease, if this is practicable to determine; if not,
the lessee’s incremental borrowing rate shall be used. Any initial direct costs of the lessee
are added to the amount recognized as an asset. Minimum lease payments shall be
apportioned between the finance charge and the reduction of the outstanding liability. The
finance charge shall be allocated to each period during the lease term so as to produce a
UNIT 4: Financial Reporting Standards
Page 71
ICAN – Advanced Accounting – CAP II- CHAPTER I
constant periodic rate of interest on the remaining balance of the liability. Contingent
rents shall be charged as expenses in the periods in which they are incurred.
A finance lease gives rise to depreciation expense for depreciable assets as well as
finance expense for each accounting period. The depreciation policy for depreciable
leased assets shall be consistent with that for depreciable assets that are owned, and the
depreciation recognized shall be calculated in accordance with NAS 16 Property, Plant
and Equipment and NAS 38 Intangible Assets. If there is no reasonable certainty that the
lessee will obtain ownership by the end of the lease term, the asset shall be fully
depreciated over the shorter of the lease term and its useful life.
Example
On 1 January 2011 an entity entered, as lessee, into a five-year non-cancellable
lease of a machine that has an economic life of ten years, at the end of which it is
expected to have no value.
At the inception of the lease, the fair value (cash cost) of the machine is Rs.
100,000. On 31 December of each of the first four years of the lease term the lessee
is required to pay the lessor Rs.23,000. At the end of the lease term ownership of
the machine transfers to the lessee upon payment of the final lease payment of
Rs. 23,539.
The interest rate implicit in the lease is 5 per cent per year which approximates
the lessee’s incremental borrowing rate.
On 1 January 2011 the lessee recognises the leased machine (as an item of
property, plant and equipment) and a finance lease liability measured at Rs.
100,000 (fair value of the leased machine at the inception of the lease, which is the
same as the present value of the minimum lease payment). The following journal
entry shall be passed to recognize the leased machine and obligation to pay:
Dr Property, plant and equipment (machine)
Rs. 100,000
Cr Finance lease liability
Rs. 100,000
To recognize the leased machine and the obligation to pay the lessor under the finance
lease.
5.
Leases in the financial statements of lessor
a.
Operating Leases
Lessor shall present assets subject to operating leases in their balance sheets according to
the nature of the asset. The depreciation policy for depreciable leased assets shall be
consistent with the lessor’s normal depreciation policy for similar assets, and depreciation
Page 72
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
shall be calculated in accordance with NAS 16 and NAS 38. Lease income from
operating leases shall be recognized in income on a straight-line basis over the lease term,
unless another systematic basis is more representative of the time pattern in which use
benefit derived from the leased asset is diminished.
b.
Finance Leases
Lessor shall recognize assets held under a finance lease in their balance sheets and
present them as a receivable at an amount equal to the net investment in the lease. The
recognition of finance income shall be based on a pattern reflecting a constant periodic
rate of return on the lessor’s net investment in the finance lease.
Manufacturer or dealer lessor shall recognize selling profit or loss in the period, in
accordance with the policy followed by the entity for outright sales. If artificially low
rates of interest are quoted, selling profit shall be restricted to that which would apply if a
market rate of interest were charged. Costs incurred by manufacturer or dealer lessor in
connection with negotiating and arranging a lease shall be recognized as an expense when
the selling profit is recognized.
Illustration
Initial investments of the lessor is Rs.1,000,000 on account of purchase price of the plant and
machinery which was given on finance lease basis. As per the lease agreement, the lessor will
get annual lease payment of Rs.230,000. The lessee also guarantees residual value of
Rs.200,000 at the end of the lease term of 5 years which is also the economic life of the asset.
The lessor estimates unguaranteed residual value of Rs.50,000. The lessor incurred legal fees of
Rs.25,000 for lease documentation. He also apportioned Rs.30,000 on account of general
overheads for initiating and finalization of the lease arrangement.
How should the lessor account for the finance lease transactions?
Answer:
1.
2.
3.
4.
Gross Investment in Lease
Annual lease payment (Rs.230,000 ×5)
Guaranteed residual value
Minimum lease payments
Unguaranteed residual value
Rs.1,150,000
Rs.200,000
Rs.1,350,000
Rs.50,000
Rs.1,400,000
Fair value of leased out asset at the inception of the lease is its purchase price i.e.
Rs.1,000,000.
Direct costs to be included in the initial measurement of finance lease receivable is
Rs.25,000 incurred on account of legal expenses. General overheads are not included.
Calculation of implicit interest rate
(It is Internal Rate of Return of cash flows arising out of fair value of leased assets and
initial direct cost)
UNIT 4: Financial Reporting Standards
Page 73
ICAN – Advanced Accounting – CAP II- CHAPTER I
Year
0
1
2
3
4
5
Lessor’s purchase
price and initial
direct costs
-1,025,000
Annual
Lease
Rental
Guaranteed
residual
value
Unguaranteed
residual value
230,000
230,000
230,000
230,000
230,000
200,000
Implicit Interest Rate
5. Net investment in lease
(Present value of gross investment at 10.07%)
Year
Gross Investment
Discount Factor
0
1
1
230,000
0.9085
2
230,000
0.8254
3
230,000
0.7498
4
230,000
0.6812
5
480,000
0.6189
Net Investment in Lease
Gross Investment in Lease
Unearned Finance Income
Net cash
flow
-1,025,000
230,000
230,000
230,000
230,000
480,000
10.07%
50,000
Discounted Cash Flow
208,955
189,842
172,454
156,676
297,073
1,025,000
1,400,000
375,000
6. Income recognition and Balance Sheet value of Lease Receivables
Annual Lease
Finance
Year
Net Investment in Lease
Payment
Charge
0
1,025,000
1
230,000
898,218
103,218
2
230,000
758,669
90,451
3
230,000
605,067
76,398
4
230,000
435,997
60,930
5
480,000
0
44,003
Recovery of
Investments
126,782
139,549
153,602
169,070
435,997
7. Accounting Entries in the books of Lessor
Year 0
Finance Lease Receivables Dr. 1,025,000
To Bank
1,025,000
(Purchase price of plant and machinery and Initial Direct Cost)
Year 1
Bank Dr.
To Finance Charge
To Finance Lease Receivables
Page 74
230,000
103,218
126,782
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Year 2
Bank Dr.
To Finance Charge
To Finance Lease Receivables
230,000
90,451
139,549
And so on………
6.
Sale and leaseback transactions
A sale and leaseback transaction involves the sale of an asset and the leasing back of the
same asset. The lease payment and the sale price are usually interdependent because they
are negotiated as a package. The accounting treatment of a sale and leaseback transaction
depends upon the type of lease involved.
Finance lease
If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds
over the carrying amount shall be deferred and amortized over the lease term.
Operating lease
If a sale and leaseback transaction results in an operating lease, and it is clear that the
transaction is established at fair value, any profit or loss shall be immediately recognized.
If the sale price is below fair value, any profit or loss shall be immediately recognized
except that, if the loss is compensated for by future lease payments below market price, it
shall be deferred and amortized in proportion to the lease payments over the period for
which the asset is expected to be used.
If the sale price is above fair value, the excess over fair value shall be deferred and
amortized over the period for which the asset is expected to be used.
Example
Sales value Rs.100,000, Fair Value Rs.100,000. Assume carrying amount (a) Rs.80,000, (b)
Rs.100,000 and (c) Rs.120,000. How should we recognize profit/ loss on sale (assuming case of
operating lease)?
Answer:
The sale is at fair value so we should immediately recognize the profit /loss on sale.
Carrying amount
Rs.100,000
Carrying amount Rs.80,000
Carrying amount Rs.120,000
Fair Value = Rs.100,000
Fair Value = Rs.100,000
Fair Value = Rs.100,000
Sale Value = Rs.100,000
Sale Value = Rs.100,000
Sale Value = Rs.100,000
Recognize the profit
Rs.20,000 immediately.
of No profit, no loss so no Recognize the Loss
recognition of profit/loss.
Rs.20,000 immediately.
UNIT 4: Financial Reporting Standards
of
Page 75
ICAN – Advanced Accounting – CAP II- CHAPTER I
Example
Sale Value Rs.80,000, Fair Value Rs.100,000. Carrying amount Rs.70,000. How should we deal
with profit on sale (assuming case of operating lease)?
Answer:
If the sale price is below fair value, any profit or loss shall be immediately recognized.
We should recognize the profit of Rs.10,000 immediately.
Example
Sale Value Rs.100,000, Fair Value Rs.80,000. Assume carrying amount (a) Rs.70,000, (b)
Rs.80,000 , (c) Rs.90,000. How should we deal with the profit/loss on sale (assuming case of
operating lease) ?
Answer:
If the sale price is above fair value, the excess over fair value shall be deferred and amortized
over the period for which the asset is expected to be used.
Carrying amount Rs.70,000
Carrying
Rs.80,000
amount
Sale Value Rs.100,000
Sale Value Rs.100,000
Sale Value Rs.100,000
Fair Value Rs.80,000
Fair Value Rs.80,000
Fair Value Rs.80,000
Carrying amount Rs.90,000
Recognize the profit of Profit of Rs.20,000 should Recognize
the
loss
of
Rs.10,000 immediately (Fair be deferred and amortized Rs.10,000
immediately
value – carrying amount).
(sale value – fair value).
(carrying amount – fair value).
Profit of Rs.20,000 should be
deferred and amortized (sale
value – fair value).
Profit of Rs.20,000 should be
deferred and amortized (sale
value – fair value).
Example
Sale Value Rs.80,000, Fair Value Rs.100,000. Assume carrying amount (a) Rs.90,000, (b)
Rs.100,000 and (c) Rs.110,000. How should we deal with loss on sale (assuming case of
operating lease) ?
Page 76
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Answer:
Carrying amount Rs.90,000
Carrying amount Rs.100,000
Carrying amount Rs.110,000
Sale Value Rs.80,000
Sale Value Rs.80,000
Sale Value Rs.80,000
Fair Value Rs.100,000
Fair Value Rs.100,000
Fair Value Rs.100,000
Loss of Rs.10,000 (carrying Loss of Rs.20,000 (carrying Recognize the loss of
amount – sale value)
amount – sale value)
Rs.10,000
immediately
(carrying amount – fair
a. if compensated by future a. if compensated by future
value).
lease payments at below lease payments at below
market price, the loss should market price, the loss should Loss of Rs.20,000 (Fair
Value – sale value)
be deferred and amortized.
be deferred and amortized.
b. otherwise recognize the b. otherwise recognize the a. if compensated by future
lease payments at below
loss immediately.
loss immediately.
market price, the loss should
be deferred and amortized.
b. otherwise recognize the
loss immediately.
4.
Disclosures
A lessee shall make the following disclosures for finance leases:
(a) for each class of asset, the net carrying amount at the end of the reporting period.
(b) the total of future minimum lease payments at the end of the reporting period, for each
of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years; and
(iii) later than five years.
(c) a general description of the lessee’s significant leasing arrangements including, for
example, information about contingent rent, renewal or purchase options and
escalation clauses, subleases, and restrictions imposed by lease arrangements.
NAS 18 Revenue
This accounting standard prescribes the principles in determining when to recognize
revenue. Revenue is recognized when it is probable that future economic benefits will flow
to the entity and these benefits can be measured reliably. This standard identifies the
circumstances in which these criteria will be met and, therefore, revenue will be
recognized.
UNIT 4: Financial Reporting Standards
Page 77
ICAN – Advanced Accounting – CAP II- CHAPTER I
Applicability:
This standard shall be applied in accounting for revenue arising from the following
transactions:
a.
the sale of goods;
b.
the rendering of services; and
c.
the use by others of entity assets yielding interest, dividend and royalties.
This standard does not apply to contracts for the rendering of services directly related to
construction contracts e.g. service of project manager and architects.
This standard does not deal with revenue arising from:
a. lease agreements ;
b.
dividends arising from investments which are accounted under the equity method;
c.
insurance contracts of insurance companies;
d.
changes in the fair value of financial assets and financial liabilities or their
disposal;
e.
changes in the value of other current assets;
f.
initial recognition and from changes in the fair value of biological assets related to
agricultural activity;
g.
initial recognition of agricultural produce; and
h.
the extraction of mineral ores.
Meaning of Revenue
Revenue is gross inflow of economic benefits during the accounting period arising from the
ordinary operating activities of an entity that result in increase in equity, other than
increases relating to contributions from equity participants. Ordinary activities mean sale of
goods, rendering of services, income by way of royalty, interest and dividend. Collections
on behalf of third party do not increase entity’s equity, so they are not recognized as
revenue.
Measurement of Revenue
Revenue is measured at the fair value of the consideration received or receivable. Fair value
of the transaction is determined by the agreement between the buyer and the seller.
Normally, selling price invoiced is fair value of transaction. Fair value excludes trade
discounts and volume discounts allowed by the entity.
Page 78
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
AB Limited sold goods to its customers for Rs.500,000 inclusive of VAT of Rs.50,000 and
Trade discounts of Rs.25,000. What would the amount of revenue?
Answer:
Revenue does not include amount received on behalf of other parties. The VAT received
represents the money of Government and cannot be included in revenue. Fair value of
revenue is after deducting discounts and rebates so amount of discounts should be
deducted.
Hence the amount of revenue should be Rs.425,000.
Illustration
A company pays dividend to its shareholders. The shareholders receive the dividend net of tax
deducted at source (TDS) on dividends. Is it appropriate for shareholders to recognize its
dividend revenue net of the tax withheld?
Answer:
NAS 18 defines revenue as gross inflow of economic benefits received or receivable by the
entity on its own behalf.
In accordance with the above, revenue is to be recognized for the gross inflows, which are
received and receivable by the entity on its own account. The tax deducted at source by the
company on dividend paid is deposited with the government on behalf of the shareholders.
Exchange of goods and services
Exchange goods are of similar nature
When goods or services are exchanged with goods or services which are of a similar nature
and value, the exchange is not regarded as a transaction which generates revenue. Meaning
thereby, this type of transaction is not included in revenue.
Exchange goods are of dissimilar nature
When goods or services are exchanged with goods or services which are of a dissimilar
nature, the exchange is regarded as a transaction which generates revenue. The revenue is
measured at fair value of the goods or services received, adjusted by the amount of cash or
cash equivalent transferred. When the fair value of goods or services received cannot be
measured reliably, the revenue is measured at the fair value of goods or services given up,
adjusted by the amount of cash or cash equivalent transferred.
UNIT 4: Financial Reporting Standards
Page 79
ICAN – Advanced Accounting – CAP II- CHAPTER I
Sale of Goods
Revenue from sale of goods shall be recognized when all the following five conditions
have been satisfied:
a. the entity has transferred to the buyer the significant risks and rewards of ownership
of the goods;
b. the entity does not retain any continuing managerial involvement which is normally
associated with the ownership of the goods;
c. the amount of revenue can be measured reliably;
d. it is probable that the economic benefits associated with the transaction will flow to
the entity; and
e. the costs incurred or to be incurred in respect of the transaction can be measured
reliably.
Revenue recognition when delivery of goods sold subject to condition
Installation and inspection
Revenue should be recognized when goods are installed at the buyer’s place to his place
and goods are inspected and accepted by the customer.
Sale on approval basis
Revenue should be recognized when the buyer approves the goods.
Warranty sales
Sales should be recognized immediately but the provisions should be made to cover
unexpired warranty.
Consignment Sales
Revenue should be recognized only when the goods are sold to third party.
Illustration
AC Limited sells goods to its consignment agent who resale the goods on commission
basis. However, the consignment agent carries the risk of loss of goods in the Godown and
the risk of collection from the buyer. Can AC Limited treat that significant risks attached to
the ownership have been transferred to the agent and recognize the revenue?
Page 80
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Answer:
No. Title of the goods has not been transferred from the seller to the buyer. And it should
not be recognized in the revenue. It should be recognized in revenue only when goods are
sold by the consignee.
Bill and Hold Sales
Bill and Hold sales, in which delivery is delayed at the buyer’s request but the buyer takes
title and accepts billing.
Revenue is recognized when the buyer takes title, provided:
i.
it is probable that delivery will be made;
ii.
the item is on hand, identified and ready for delivery to the buyer at the time sale is
recognized;
iii. the buyer specifically acknowledge the deferred delivery instructions; and
iv. the usual payment terms apply.
Lay away Sales
Lay away sales under which the goods are delivered only when the buyer makes the final
payment in a series of installments.
Revenue from such sales is recognized when the goods are delivered. However, when
experience indicates that most such sales are consummated, revenue may be recognized
when a significant deposit is received provided the goods are on hand, identified and ready
for delivery to the buyer.
Sale and Repurchase Agreement
Sale and repurchase agreement under which the seller concurrently agrees to repurchase the
same goods at a later date.
When the risks and rewards of ownership is not transferred to the buyer, even though the
legal title has been transferred, the transaction is a financing arrangement and does not give
rise to revenue.
Real Estate Sales
Revenue is normally recognized when legal title passes to the buyer. However, if the seller
is obliged to perform any significant acts after the transfer of the title, revenue is recognized
as the acts are performed. An example is building or other facility on which construction
has not been completed.
UNIT 4: Financial Reporting Standards
Page 81
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
A car manufacturing company books order in 10 days advance and makes the car ready for
delivery accordingly. It normally takes 10% advance. Can the company recognize revenue
at the time of receipt of advance?
Answer:
No. It should recognize the revenue only when the car is delivered to the buyers.
Illustration
A car manufacturing company books order in 10 days advance and makes the car ready for
delivery accordingly. It normally takes 90% advance. Can the company recognize revenue
since the advance is substantial?
Answer:
No. It should recognize the revenue only when the car is delivered to the buyers even when
the amount of advance is substantial.
Rendering of Services
Revenue from rendering of services shall be recognized by reference to the stage of
completion, upon fulfillment of the following four conditions:
a.
the amount of revenue can be measured reliably;
b.
it is probable that the economic benefits associated with the transaction will flow
to the entity;
c.
the stage of completion of the transaction at the balance sheet date can be
measured reliably; and
d.
the costs incurred or to be incurred in respect of the transaction can be measured
reliably.
Installation Fees
Revenue should be recognized when the installation has been completed and accepted by
the client.
Admission Fees
Revenue from artistic performance, banquets and other special events should be recognized
when event takes place.
Tuition Fees
Revenue should be recognized over the period of instruction.
Page 82
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
On 25th Poush 2075, ABC Advertising P Ltd obtained advertising right for ACC Football Cup to
be held in Baisakh and Jestha 2076 for Rs.520 lakhs.
They furnish the follow information:
i. The company obtained the advertizing for 70% available time for Rs.700 lakhs by
25thFalgun 2075.
ii. For the balance time they got booking in 20thChaitra 2075 for Rs.240 lakhs.
iii. All the advertisers paid the full amount at the time of booking the advertisements.
iv. 40% of the advertisements appeared before the public in Baisakh and balance 60%
appeared in the month of Jestha.
Calculate the amount of profit/loss to be recognized for the month Baisakh and Jestha 2075 as
per NAS 18 ‘Revenue’.
Answer:
As per the NAS 18 ‘Revenue’, in a transaction involving the rendering of services, performance
should be measured either under the completed service contract method or under the
proportionate completion method, which ever relates the revenue to the work accomplished.
Further as per NAS, it states that revenue from advertising should be recognized when the
service is completed. The service as regards advertisements is deemed to be completed when the
related advertisement appears before the public.
In the given case 40% advertisement appeared in the month of Baisakh 2076 and balance in the
month of Jestha 2076.
Total profit is computed as follows:
Particulars
Revenue:
- Advertisement for 70% of available time obtained by Falgun 2075
- Advertisement for 30% of available time obtained by Chaitra 2075
Total revenue
Less:
- Cost of advertisement right
Total profit
Rs. In lakhs
700
240
940
520
420
The profit amounting to Rs.420 lakhs should be apportioned in the ratio of 40 : 60 for the month
of Baisakh and Jestha 2076.
UNIT 4: Financial Reporting Standards
Page 83
ICAN – Advanced Accounting – CAP II- CHAPTER I
Hence the company should recognize a profit of Rs.168 lakhs (420 × 40%) in the month of
Baisakh 2076 and Rs.252 lakhs (420 × 60%) in the month of Jestha 2076.
Interest, Royalties and Dividends
Revenue arising from the use by others of entity assets yielding interest, royalties and
dividend shall be recognized when:
a. it is probable that the economic benefits associated with the transaction will flow to
the entity; and
b. the amount of revenue can be measured reliably.
Interest
Interest shall be recognized using the effective interest method. Accrued interest of the preacquisition period is included in the carrying amount of the investment.
Royalties
Royalties shall be recognized on accrual basis in accordance with the substance of the
relevant agreement.
Dividend
Dividends shall be recognized when the shareholder’s right to receive payment is
established. The right is established when the dividend is declared in the shareholders
meeting. When dividends on equity securities are declared from pre-acquisition profits,
those dividends are deducted from the cost of the securities.
Illustration
X Limited has recognized Rs.10 lakhs on accrual basis income from dividend on shares of the
face value of Rs.50 lakhs held by it as at the end of the financial year 32.3.2075. The dividends
on shares were declared at the rate of 10% on 15.6.2075. The dividend was proposed on
10.4.2075 by declaring company. Whether the treatment is as per relevant accounting standard?
Answer with reference to provisions of NAS 18.
Answer:
NAS 18 ‘Revenue’ states that dividend from investments in shares are not recognized in the
statement of profit and loss until a right to receive the payment is established.
In the given case, the dividend is proposed on 10.4.2075, while it is declared on 15.6.2075.
Hence the right to receive the payment is established only on 15.6.2075. As per NAS 18,
income from dividend on shares should be recognized by X Limited in the financial year ended
Page 84
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
31.3.2076. The recognition of Rs.10 lakhs on accrual basis in the financial year 2074-75 is not
as per NAS 18.
Uncertainty in collectability
Revenue is recognized only when it is probable that the economic benefits associated with
the transaction will flow to the entity. When an uncertainty arises about collectability of an
amount already included in revenue, the uncollectible amount or the amount in respect of
which recovery has ceased to be probable, is recognized as an expense. Adjustment of the
amount of revenue originally recognized is not sufficient.
Illustration
SCL Limited sells agriculture products to dealers. One of the condition of sale is that interest is
payable at the rate of 2% p.a. for delayed payments. Percentage of interest recovery is only 10%
on such overdue outstanding due to various reasons. During the year 2075-2076 the company
wants to recognize the entire interest receivable. Do you agree?
Answer:
As per NAS 18 “Revenue’ revenue arising from the use by others of enterprise resources
yielding interest and royalties should be recognized when no significant uncertainty as to
measurability or collectability exists. In such cases, it may be appropriate to recognize revenue
only when it is reasonably certain that the ultimate collection will be made. Where there is no
uncertainty as to ultimate collection, revenue is recognized at the time of sale or rendering of
service even though payments are made by installments.
Thus SCL Limited, should not recognize the interest amount unless the company actually
receives it. 10% rate of recovery on overdue outstanding is also an estimate and is not certain.
Hence, the company is advised to recognize interest receivable only on receipt basis.
Disclosure
An entity shall disclose:
a. Accounting policies adopted for recognition of revenue under stage of completion
methods including methods used to determine the stage of completion.
b. Amount of revenue under each significant category:
i. sale of goods;
ii. rendering of services;
iii. interest;
UNIT 4: Financial Reporting Standards
Page 85
ICAN – Advanced Accounting – CAP II- CHAPTER I
iv. royalties
v. dividends
c. Amount of revenue arising from exchange of goods or services under each of the
categories.
NAS 20 Accounting for Government Grants and Disclosure of Government Assistances
This accounting standard prescribes the accounting treatment and disclosures of government
grants and other forms of government assistance.
Applicability:
This NAS does not apply:
a.
b.
c.
d.
Grants in financial statement reflecting the effects of changing prices or information of
similar nature.
Government assistance in the form of benefits in determining taxable profit/loss or
basis of income tax liability such as tax holidays, tax credits, accelerated depreciation
and reduced tax rates etc.
Government participation in ownership.
Government grants covered by NAS 41 Agriculture
Definitions:
1.
Government
Government refers to government, government agencies and similar bodies whether local,
national or international
2. Forgivable Loans
Forgivable loans are loans which the lender undertakes to waive repayment of under
certain prescribed conditions.
3. Government Assistance
Government assistance is action by government designed to provide an economic benefit
specific to an entity or range of entity’s qualifying under certain criterion. Government
assistance for the purpose of this standard does not include benefits provided only indirectly
through action affecting general trading concern, such as the provision of infrastructure in
development areas or the imposition of trading constraints on competitors.
Page 86
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
4. Government Grants
Government Grants are assistance by government in the form of transfers of resources to an
entity in return for past or future compliances with certain conditions relating to the
operating activities of the entity. They exclude those forms of government assistance which
cannot reasonable have a value placed upon them and transactions with government which
cannot be distinguished from the normal trading transactions of the entity.
Government grants are classified into:
a. grants related to assets; and
b. grants related to income.
Grants related to assets are those grants primary condition of which is to purchase, construct or
otherwise acquire long term asset. Subsidiary conditions of the grant may be type or location of
the asset or period within which it is to be acquired or held. Grant related to income is a grant
which is not classified as grant related to asset.
Recognition of Government Grants
Government grants ‘including non-monetary grants’ shall be recognized only when there is a
reasonable assurance that:
a. the entity will comply with the conditions attaching to them; and
b. the grants will be received.
Receipt of a grant does not of itself provide conclusive evidence that the conditions attaching to
the grant have been or will be fulfilled.
A forgivable loan from government is treated as a government grant when there is reasonable
assurance that the entity will meet the terms for forgiveness of the loan.
The benefit of a government loan at a below market rate of interest is treated as government
grant. The loan shall be recognized and measured in accordance with NFRS 9 Financial
Instruments. The benefit shall be measured as the difference between the carrying amount as per
NFRS 9 and the proceeds received. The benefit is accounted for as per this NAS.
Once a government grant is recognized, any related contingent liability or contingent asset is
treated in accordance with NAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Accounting of Government Grants related to Income
Grant receivable as a compensation for expenses or losses already incurred
The grant shall be recognized as income of the period in which it becomes receivable.
UNIT 4: Financial Reporting Standards
Page 87
ICAN – Advanced Accounting – CAP II- CHAPTER I
Grant receivable for expenses or losses to be incurred
Grant shall be recognized as income over the periods necessary to match them with the related
costs which they are intended to compensate. They shall not be credited directly to
shareholders’ interest.
Illustration
AB Limited received a grant of Rs.1,000,000 for the transportation cost of salt to Humala –
Jumala. The entity expects that the transportation cost will be Rs.300,000 per annum for the
next five years. How should the grant be treated by AB Limited?
Answer:
The entity should recognize the grant as income on the straight line basis over the five years i.e.
Rs.200,000 per annum for the coming five years.
Illustration
AB Limited received a grant of Rs.1,000,000 for the transportation cost of salt to Humala –
Jumala. The transportation cost as expected and actual expenses for the next five years is given
as below:
Year
Estimated Expenses Actual Expenses
1
500,000
300,000
2
400,000
250,000
3
200,000
300,000
4
600,000
650,000
5
150,000
100,000
How should the grant be treated by AB Limited?
Answer:
Grant received for the expenses yet to be incurred, shall be recognized as income over the
periods necessary to match them with the related costs which they are intended to compensate.
The grant should be recognized as income over the five years as below:
Year 1
Rs.181,818
(1,000,000 × 300,000/ (300,000 + 400,000 + 200,000 +600,000 + 150,000)
Year 2
Page 88
Rs.184,849
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
(1,000,000 × (300,000 + 250,000)/(300,000 + 250,000 +200,000 +600,000 +150,000 ) –
181,818
Year 3
Rs.164,583
(1,000,000 × (300,000 + 250,000 +300,000)/ (300,000 + 250,000 + 300,000 +600,000
+150,000) – 181,818 – 184,849
Year 4
Rs.436,492
(1,000,000 × (300,000 + 250,000 +300,000 + 650,000)/ (300,000 + 250,000 + 300,000
+650,000 +150,000) – 181,818 – 184,849 – 164,583
Year 5
Rs.32,257
(1,000,000 × (300,000 + 250,000 +300,000 + 650,000+ 100,000)/ (300,000 + 250,000 +
300,000 +650,000 +100,000) – 181,818 – 184,849 – 164,583 – 436,493
Presentation of Government Grants related to Income
The grants related to income shall be presented in either of the following way:
a. as a credit in the income statement, either separately or under a general heading such as
other income; or
b. are deducted in reporting the related expense.
Accounting of Government Grants related to Asset
Government grants related to assets shall be accounted for in either of the following methods:
a. grants shall be treated as deferred income which is recognized as income on systematic
and rational basis over the useful life of the asset; or
b. grants shall be deducted in arriving the carrying amount of the asset which results in
recognition of income over the life of a depreciable assets by way of a reduced
depreciation charges.
Presentation of Government Grants related to Asset
The grants related to assets shall be presented in either of the following way:
a. as deferred income; or
b. deducted in arriving at carrying amount of the assets.
UNIT 4: Financial Reporting Standards
Page 89
ICAN – Advanced Accounting – CAP II- CHAPTER I
Repayment of Government Grants
A government grant that becomes repayable shall be accounted for as a revision to an
accounting estimate.
Grant related to income
Repayment of a grant related to income shall be adjusted first against any unamortized deferred
credit set up in respect of the grant. The balance amount or where no deferred credit exists, the
repayment amount shall be immediately treated as expenses.
Grants related to assets
Repayment of government grant related to asset shall be recorded by increasing the carrying
amount of the asset or reducing the deferred income balance by the amount repayable.
Illustration
A limited received a grant of Rs.2 crores from the government for purchase of special purpose
machinery during the year 2062- 63. The cost of machinery was Rs.38 crores and had a useful
life of 9 years. During the current year 2065-66 the grant has become refundable due to nonfulfillment of certain conditions attached to it. Assuming that the entire amount of grant was
deducted from the cost of machinery in the year of acquisition, state with reasons, and the
accounting treatment to be followed in the year 2065-66.
Answer:
As per NAS 20 ‘Government Grants’ specifies that the repayment of government grant related
to assets shall be recorded by increasing the carrying amount of the asset. Accordingly, the
cumulative additional depreciation that would have been recognized to date as expenses in the
absence of grant shall be recognized immediately as an expense.
Hence the repayment of grant for the non-compliance in the terms shall be treated remaining
within NAS 20. As such the shortfall in depreciation of the 3 prior years from FY 2062-63 to
2064-65 amounting to Rs.0.66 crore shall be treated as expense during FY 2065-66 together
with the depreciation for the year 2065-66 amounting to Rs.4.22 crores and the carrying amount
will be Rs.21.12 crores.
Calculations
Value of assets without grant
Value after deducting grant
Depreciation per annum (36/9)
Depreciation provided from FY 2062-63 to 2064-65
After refund of grant
Page 90
38 crores
36 crores
4 crores
12 crores
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Value of assets to restated at
New depreciation per annum (38/9)
New depreciation from FY 2062-63 to 2064-65
Short depreciation (12.66-12)
Revised book value for FY 2065-66 (38 – 4.22 × 4 years)
38 crores
4.22 crores
12.66 crores
0.66 crores
21.12
Government Assistance
This accounting standard requires the disclosure of the nature, extent and duration of the
government assistance.
Disclosures:
The following maters shall be disclosed:
a.
the accounting policy adopted for government grants, including the methods of
presentation adopted in the financial statements;
the nature and extent of government grants recognized in the financial statements and
an indication of other forms of government assistance from which the entity has
directly benefited; and
unfulfilled conditions and other contingencies attaching to government assistance that
has been recognized.
b.
c.
NAS 21 The Effects of Changes in Foreign Exchange Rates
This standard prescribes how to include foreign currency transactions and foreign operations in
the financial statements of an entity and how to translate financial statements into a presentation
currency. It also prescribes how to select exchange rates and how to report the effects of
changes in exchange rates in the financial statements.
Applicability:
This standard shall be applied:
a. in accounting for transactions and balances in foreign currencies;
b.
in translating the results and financial position of foreign operations that are included
in the financial statements of the entity by consolidation, proportionate consolidation
or the equity method; and
c.
in translating an entity’s results and financial position into a presentation currency.
UNIT 4: Financial Reporting Standards
Page 91
ICAN – Advanced Accounting – CAP II- CHAPTER I
This standard does not apply to:
a. hedge accounting for foreign currency transaction; and
b.
the presentation of cash flow arising from transactions in a foreign currency in a cash
flow statement or to the translation of cash flows of a foreign operation.
Definitions:
i.
Closing Rate:
Closing rate is the spot exchange rate at the balance sheet date.
ii.
Exchange Rate:
Exchange rate is the ratio of exchange for two currencies.
iii. Exchange Difference:
Exchange difference is the difference resulting from translating a given number of
units of one currency into another currency at different exchange rates.
iv. Functional Currency:
Functional currency is the currency of the primary economic environment in which
the entity operates.
v.
Foreign Currency:
Foreign currency is a currency other than the functional currency of the entity.
vi. Presentation Currency:
Presentation currency is the currency in which the financial statements are presented.
vii. Spot Exchange Rate:
Spot exchange rate is the exchange rate for immediate delivery.
viii. Monetary Items
Monetary items are units of currency held and assets and liabilities to be received or paid in a
fixed or determinable number of units of currency. The essential features of a monetary item is a
right to receive (or an obligation to deliver) a fixed or determinable number of units. Examples
are pensions and other employee benefits to be paid in cash; provisions that are to be settled in
cash; and cash dividend that are recognized as a liability. Amounts prepaid for goods and
services (e.g. prepaid rent); goodwill; intangible assets; inventories; property; plant; equipment
are non-monetary items.
Page 92
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
ix. Foreign Operation
Foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a
reporting entity, the activities of which are based or conducted in a country or currency other
than those of the reporting entity.
x. Net Investment in a Foreign Operation
Net investment in a foreign operation is the amount of the reporting entity’s interest in the net
assets of that operation. An item for which settlement is neither planned nor likely to occur in
foreseeable future, forms part of net investment in foreign operation. Net investment in foreign
operation include long term receivables or loans but excludes trade receivables or trade
payables.
Foreign Currency Transactions
Foreign currency transactions defined
A foreign currency transaction is a transaction that is denominated or requires settlement in a
foreign currency, including transactions arising when an entity:
a. buy or sells goods or services whose price is denominated in foreign currency;
b. borrows or lends funds when the amounts payable or receivable are denominated in
foreign currency; or
c. otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in
foreign currency;
Initial Recognition
All foreign currency transactions are translated into functional currency of the entity by
applying spot exchange rate.
For practical reasons, a rate that approximates the actual rate at the date of transaction is often
used. An average rate for a week or a month might be used for all transactions in each foreign
currency transactions occurring during that period. But in period of highly volatile exchange
rate use of average rate is inappropriate.
Reporting at subsequent balance sheet date
Translation subsequent to initial recognition:
a. monetary itemsare translated applying closing rate;
b. non-monetary items, which are carried at cost, are translated applying exchange rate of
the date of transaction;
UNIT 4: Financial Reporting Standards
Page 93
ICAN – Advanced Accounting – CAP II- CHAPTER I
c. non-monetary items, which are carried at fair value, are translated applying exchange
rate of the date when the fair value was determined.
Carrying amount of a non-monetary item is determined in accordance with other relevant
Standards. For example, property, plant and equipment may be measured in terms of fair value
of historical cost as per NAS 16. First the carrying amount is determined as per NAS 16 and
then the carrying amount is translated as per this Standard.
Treatment of Exchange Differences
For Monetary items, gain or loss on settlement or translation at the end of reporting period is
recognized in the profit and loss of the period.
For non-monetary items, gain or loss on settlement or translation at the end of reporting period
is accounted for in the same manner the gain or loss on non-monetary item is recognized.
Meaning thereby, when gain or loss on non-monetary item is recognized directly in equity,
exchange gain or loss shall be directly recognized in equity. Conversely, when a gain or loss on
non-monetary item is recognized in profit and loss account, exchange gain or loss shall be
recognized in profit and loss account.
Exchange difference arising on the net investments in foreign operation is accounted for in the
profit or loss in the separate or individual financial statements of the investor (in which financial
statements of the foreign operation is not included).
Exchange difference arising on the net investments in foreign operation is accumulated in
separate component of equity (in which financial statement of the foreign operation is included
i.e. consolidated financial statement).
Illustration
31st December 2009 is closing date of AB Limited. It purchased inventory costing US $ 10,000
on 15.4.2009 (when the rate was Rs.75 per US $). The rate of exchange on 31st December 2009
is Rs.76 per US $. And net realizable value of the inventory on 31st December 2009 was US $
10,200. Find out the value of inventories to be included in financial statements as on 31st
December 2009. (Assume functional currency is Rs.)
Answer:
As per NAS 21, carrying amount of non-monetary asset is first determined applying appropriate
standards then the provision of NAS 21 applies.
Inventories are valued at lower of cost and net realizable value i.e. at cost of US $ 10,000. The
inventories are then translated into rupees applying the rate when the cost was determined i.e.
Rs.75. so the value of closing inventories will be Rs.750,000.
Page 94
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Illustration
AC Limited sold goods for US $ 10,000 on 15.4.2009 (when the rate was Rs.75 per US $). The
rate of exchange on 31st December 2009 is Rs.76 per US $. On 31st December 2009 the amount
from customer is receivable. Give the accounting treatment for the accounting year ending 31st
December 2009. (Assume functional currency is Rs.)
Answer:
The transaction will be recorded applying rate of Rs.75 on 15.4.2009 i.e.
Debtors A/c Dr.
Rs.750,000
To Sales A/c
Rs.750,000
The debtors being monetary item will be translated applying closing rate of Rs.76 and it will
result in exchange gain of Rs.10,000. The exchange gain of Rs.10,000 will be recognized in
profit.
Illustration
AD Limited purchased goods costing US $ 10,000 on 12.1.2009 (when the rate was Rs.70 per
US $). The amount was settled on 14.7.2009 (when the rate was Rs.69 per US $).
Give necessary journal entries to record the transaction in the books of AD Limited.
Answer:
The transaction will be recorded on 12.1.2009 applying spot rate of Rs.70:
Purchase A/c Dr.
Rs.700,000
To Creditors A/c
Rs.700,000
The settlement will be made at Rs.69, it will result in a exchange gain of Rs.10,000 which will
be included in profit:
Creditors A/c Dr.
To Bank A/c
To Exchange Fluctuation Gain
Rs.700,000
Rs.690,000
Rs.10,000
Use of presentation currency other than functional currency
If the presentation currency differs from the entity’s functional currency, it translates its results
and position into the presentation currency.
The results and financial position of an entity whose functional currency is not currency of
hyperinflationary economy shall be translated into the presentation currency using the following
rates:
UNIT 4: Financial Reporting Standards
Page 95
ICAN – Advanced Accounting – CAP II- CHAPTER I
a. assets and liabilities for each balance sheets presented (i.e. including comparatives)
shall be translated at the closing rate i.e. rate at the date of balance sheet.
b. income and expenses for each income statements presented (i.e. including
comparatives) shall be translated at the rates at the date of transactions.
c. The resulting exchange difference shall be recognized as a separate component of
equity.
The results and financial position of an entity whose functional currency is the currency of
hyperinflationary economy shall be translated into the presentation currency using the following
rates:
a. all items (i.e. income, expenses, assets, liabilities, equity items) shall be translated at the
closing rate at the date of most recent balance sheet
b. The resulting exchange difference shall be recognized as a separate component of
equity.
Translation of a Foreign Operation when foreign operation is consolidated
1. The result and financial position of an entity whose functional currency is not currency
of a hyperinflationary (hyperinflation is where the country’s rate of inflation is very
high):
a. The assets and liabilities of the foreign operation (including comparatives) shall be
translated at closing rate. This means both monetary and non-monetary items are
translated using closing rate.
b. Income and expenses of the foreign operation (including comparatives) shall be
translated at exchange rate at date of transactions. For practical reasons, average rate of
week or month can be used for transactions during that period. However, if exchange
rate fluctuates significantly, the use of the average rate for a period is inappropriate.
c. all arising exchange differences shall be recognized in other comprehensive income (in
reserve) and not as a gain or loss in profit or loss statement.
2. The result and financial position of an entity whose functional currency is currency of a
hyperinflationary:
a. all items (assets, liability, income, expenses, including comparatives) of foreign
operation shall be translated using closing rate at the date of most recent statement of
financial position, except that:
Page 96
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
b. when amounts are translated into the currency of a non-hyperinflationary economy,
comparative amounts shall be those that were presented as current year amounts in the
relevant prior year financial statements.
Any goodwill arising out of acquisition of a foreign operation and fair value adjustments to the
carrying amounts of assets and liabilities arising on the acquisition of that foreign operation is
treated as an asset and liabilities of the foreign operation. Accordingly, it is expressed in the
functional currency of the foreign operation and then translated into presentation currency
applying closing rate.
When the results and financial position of a foreign operation are translated into a presentation
currency. The incorporation of the results and financial position of a foreign operation with
those of the reporting entity follows normal consolidation procedure. Such as the elimination of
intragroup balances and intragroup transactions. Exchange difference that arises on the
intragroup monetary asset or monetary liability (other than net investment in foreign operation)
is accounted for in profit and loss and then such assets or liability is eliminated in the
consolidation process.
When the financial statements of a foreign operation are as of a date different from that of the
reporting entity, the foreign operation generally prepares additional financial statements as of
the same date as the reporting period. However, the entity may be allowed for use of the
financial statements of a different reporting date provided that the difference is no greater than
three months and adjustments are made for the effects of any significant transactions between
the periods. In such a case, the assets and liabilities of the foreign operation are translated at the
exchange rate at the balance sheet date of the foreign operation. Adjustments are made for
significant changes in exchange rates upto the balance sheet date of the reporting entity.
Illustration
BC Limited has trade receivable from its subsidiary in US amounting to Rs.750,000. The
subsidiary has shown it as trade payable at US $ 10,000. The closing rate was Rs.70 per US $.
Show how the BC Limited carries out the elimination of this intra-group balance for the purpose
of consolidation?
Answer:
The trade payable of subsidiary comes at Rs.700,000 when converted applying closing rate of
Rs.70. Exchange fluctuation loss of Rs.50,000 is accounted for in the profit or loss to bring
down the trade receivables to the level of translated amount of subsidiary’s balance and then
eliminated for the purpose of consolidation.
Change in Functional Currency
UNIT 4: Financial Reporting Standards
Page 97
ICAN – Advanced Accounting – CAP II- CHAPTER I
When there is a change in an entity’s functional currency, the entity shall apply the translation
procedures applicable to the new functional currency prospectively from the date of the change.
All items are translated into new functional currency using the exchange rate at the date of
change. The resulting translated amounts for non-monetary items are treated as their historical
cost.
Exchange differences arising from the translation of a foreign operation previously classified
into equity are not recognized in profit and loss account until the disposal of foreign operation.
Disposal of foreign operation
On the disposal of foreign operation, the cumulative amount of the exchange difference deferred
in the separate component of equity relating to that foreign operation shall be recognized in
profit or loss when the gain or loss on disposal is recognized.
Disclosure
An entity shall disclose:
a. the amount of exchange difference recognized in profit and loss except for those arising
on financial instruments measured at fair value through profit or loss;
b. net exchange difference classified in a separate component of equity; and
c. a reconciliation of the amount of such exchange differences at the beginning and end of
the period.
Disclosure when the presentation currency is different from functional currency:
a. disclose the fact
b. disclose the functional currency; and
c. disclose the reason for using a different presentation currency.
Disclosure when there is a change in functional currency:
a. disclose the fact; and
b. disclose the reason for change in functional currency.
NAS 37 Provisions, Contingent Liabilities and Contingent Assets
Provisions
Provisions are liabilities of uncertain timing or amount. Liability is a present obligation of the
entity arising from past events, the settlement of which is expected to result in an outflow from
the entity of resources embodying economic benefits. An obligating event is an event that
Page 98
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
creates a legal or constructive obligation that results in an entity having no realistic alternative
to settling that obligation.
Recognition of Provisions
Provision should be recognized as a liability in the financial statements when the followings
conditions are satisfied:
a.
b.
An entity has a present obligation (legal or constructive) as a result of past event; and
It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
c. A reliable estimate can be made of the amount of the obligation.
Unless these conditions are met, no provision can be recognized.
Present obligation and obligating events
A past event which leads to a present obligation is called as obligating event. For an event to be
an obligating event, it is necessary that the entity has no realistic alternative to settling that
obligation created by the event.
The event leading to the obligation must be past, and must have occurred before the end of the
reporting period when the provision is first recognized. No provision is made for costs that may
be incurred in the future but where no obligation yet exists.
An obligation can either be legal or constructive.
a. Legal obligation
A legal obligation is one that derives from a contract, legislation or any other operation of law.
b. Constructive obligation
A constructive obligation is an obligation that derives from the actions of the entity where:
i.
ii.
From an established pattern of past practice, published policies or a specific statement,
the entity has indicated to other parties that it will accept certain responsibilities; and
As a result the entity has created a valid expectation in other parties that it will
discharge those responsibilities.
Illustration
X Limited is required to fit a smoke filters to its factories by 30th September 2018. The entity
has not fitted the filters as on 31st December 2017 which is the reporting date of the entity.
Give the treatment for the 31st December 2017. What will be the position as on 31st December
2018 if the entity has not fitted the filers till date?
UNIT 4: Financial Reporting Standards
Page 99
ICAN – Advanced Accounting – CAP II- CHAPTER I
Solution
31.12.2017
No provision is required as obligatory event has not taken place.
31.12.2018
The obligating event has taken place. The possible obligation could be fines and penalties. The
entity should make the provision for fines and penalties based on estimate of the management.
Illustration
In which of the following circumstances might a provision be recognized?
a. On 31st December 2018 the board of the entity decided to close down a division. The
closing date of the entity is 31st December. Before 31st December 2018, the decision
was not communicated to any of those affected and no other steps were taken to
implement the decision.
b. The board agreed a detailed closure plan on 20th December 2018 and details were given
to customers and employees.
c. The entity is obliged to incur cleanup costs for environmental damage (that has already
been caused).
d. The entity intends to carry out future expenditure to operate in a particular way in the
future.
Solution
a.
b.
c.
d.
No provision would be recognized as the decision has not been communicated.
Provision should be made in the year 31st December 2018.
Provision should be made.
No provision required. The cost can be avoided by operating in other manner.
Measurement of provisions at initial recognition
The amount recognized as a provision is the best estimate of the expenditure required to settle
the obligation at the end of the reporting period. The estimate will be determined by the
judgment of the entity’s management supplemented by the experience of similar transactions.
Time value
Where the effect of the time value of money is material, a provision is measured at the present
value of the expenditure expected to be required to settle the obligation. The discount rate
should be a pre-tax rate that reflects current market assessments of the time value of the money.
Page 100
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Uncertainties
Uncertainties about the amount to be recognized as provision should be considered. Where the
provision being measured involves a large population of items, the amount is estimated by
weighting all possible outcomes by their associated probabilities i.e. expected value. Where the
provision involves a single item, provision is made for the most likely outcome.
Future events
Future events which are reasonably expected to occur (e.g. new legislation, changes in
technology) may affect the amount required to settle the entity’s obligation and should be taken
into accounts.
Reimbursements
Some or all of the expenditure needed to settle a provision may be expected to be recovered
from a third party. If so, the reimbursement should be recognized only when it is virtually
certain that reimbursement will be received if the entity settles the obligation.
a.
The reimbursement should be treated as a separate asset, and the amount recognized
should not be greater that the provision itself.
b. The provision and the amount recognized for reimbursement may be netted off in
statement of profit or loss.
Illustration
X Solar Power Ltd, a power company, has a present obligation to dismantle its plant after 35
years of useful life. X Solar Power Ltd cannot cancel this obligation or transfer to third party. X
Solar Power Ltd has estimated the total cost of dismantling at Rs.5,000,000, the present value of
which is Rs.3,000,000. Based on the facts and circumstances, X Solar Power Ltd considers the
risk factor of 5% i.e. the risk that the actual outflows would be more from the expected present
value. How should X Solar Power Ltd account for the obligation?
Answer:
The obligation should be measured at the present value of future expected outflows i.e. at
Rs.3,000,000. Further the obligation should be adjusted for risk @ 5% i.e. 5% of Rs.3,000,000 =
Rs.150,000. Therefore, the total amount of provision to be made will be Rs.3,150,000.
Illustration
A Ltd sells goods with a warranty under which customers are covered for the cost of repairs of
any manufacturing defect that becomes apparent within the first six months of purchase. The
UNIT 4: Financial Reporting Standards
Page 101
ICAN – Advanced Accounting – CAP II- CHAPTER I
company’s past experience and future expectation indicate the following pattern of likely
repairs:
% of goods sold
Defects
Cost of repairs if all items suffered
from these defects (Rs. million)
75
20
5
None
Minor
Major
Nil
1.0
4.0
Required:
What should be the amount of provision?
Solution
Amount of provision should be expected value of cost of repairs at Rs.400,000.
(75% of Nil + 20% of Rs.1,000,0000 + 5% of Rs.4,000,000)
Measurement at subsequent reporting date
Provisions should be reviewed at the end of each reporting period and adjusted to reflect the
current best estimate. If it is no longer probable that a transfer of resources will be required to
settle the obligation, the provision should be reversed.
Illustration
A company was sued by a customer in the year ended 31st December 2014. Legal advice is that
the customer is virtually certain to win the case as several similar cases have been already been
decided in the favor of the injured parties.
At 31st December 2014
The company’s lawyer was of the opinion that the cost of the settlement would be Rs.1,000,000.
At 31st December 2015
The claim has still not been settled. The lawyer now advises that the claim will probably be
settled in customer’s favor at
Rs.1,200,000.
At 31st December 2016
The claim has still not been settled. The lawyer now advises that the claim will probably be
settled in customer’s favor at
Rs.900,000.
Page 102
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
At 31st December 2017
Was settled for
Solution
At 31st December 2014
Provision should be made for
Statement of profit/loss
Dr.
To Provision for Claim
At 31st December 2015
Provision should be increased by Rs.200,000.
Statement of profit/loss
Dr.
To Provision for Claim
At 31st December 2016
Provision should be decreased by Rs.300,000.
Provision for Claim
Dr.
To Statement for Profit/loss
Rs.950,000.
Rs.1,000,000
1,000,000
1,000,000
200,000
200,000
300,000
300,000
At 31st December 2017
Charge in statement of profit/loss would be Rs.50,000
Provision for Claim
Dr.
900,000
Statement of Profit/Loss
Dr.
50,000
To Bank
950,000
Future operating losses
Provisions shall not be recognized for future operating losses as they do not meet the definition
of liability or provisions.
Onerous contract
If an entity has a contract that is onerous, the present obligation under the contract shall be
recognized and measured as provision.
A onerous contract is a contract entered into with another party under which the unavoidable
costs of fulfilling the terms of contract exceeds revenue to be received, directly or indirectly,
and where the entity would have to compensate the other party if it did not fulfill the terms of
the contract.
Restructuring
Restructuring is a program that is planned and is controlled by management and materially
changes one of two things:
UNIT 4: Financial Reporting Standards
Page 103
ICAN – Advanced Accounting – CAP II- CHAPTER I
a.
b.
The scope of business undertaken by the entity.
The manner in which that business is controlled.
The following are examples of restructuring:
a. Sale or termination of a line of business.
b. The closure of business locations in a country or region or the relocation of business
activities from one country or region to another.
c. changes in management structure e.g. the elimination of a layer of management.
d. fundamental reorganizations that have a material effect on the nature and focus of the
entity’s operations.
Obligation to restructure may be legal or constructive. A constructive obligation to restructure
arises only when an entity:
a.
b.
has a detailed plan for restructuring; and
has raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those affected by it.
No obligation arises for the sale of an operation until the entity is committed to the sale i.e. there
is a binding sale agreement.
A restructuring provision shall include only the direct expenditures arising from the
restructuring, which are those that are both:
a. necessarily entailed by the restructuring; and
b. not associated with the ongoing activities of the entity.
A restructuring provision does not include such costs as:
a. retaining or relocating continuing staff,
b. marketing, or
c. investment in new systems and distribution network.
Contingent liabilities
Contingent liability is either:
a.
A possible obligation arising from past events whose existence will be confirmed only
by the occurrence of one or more uncertain future events not wholly within the control
of the entity; or
b.
A present obligation that arises from the past events but is not recognized because:
i.
ii.
Page 104
it is not possible that an outflow of economic benefits will be required to settle the
obligation; or
the amount of obligation cannot be measured with sufficient reliability.
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Recognition
An entity should not recognize a contingent liability. A contingent liability is disclosed unless
the possibility of an outflow of economic benefits is remote.
Disclosure
For each class of contingent liability an entity should disclose at the reporting date, all of the
following:
a. the nature of the contingent liability
b. an estimate of the financial effect
c. an indication of the uncertainties relating to the amount or timing of any outflow.
d. the possibility of any reimbursement.
Illustration
During 2017 A Ltd gives a guarantee of certain borrowings of B Ltd, whose financial condition
at that time was sound. During 2018, the financial condition of B Ltd deteriorates and at 30th
June 2018, Pony Co files for protection from its creditors.
Required:
What accounting treatment is required?
a. at 31st December 2017?
b. at 31st December 2018?
Solution
31st December 2017
There is a present obligation as a result of a past obligating event (giving guarantee). However,
no provision will be required as there is no transfer of resources is probable in settling the
obligation.
The guarantee should be disclosed as contingent liability.
31st December 2018
There is a present obligation as a result of a past obligating event (giving guarantee).
Provision should be made as it is probable that a transfer of resources will be required to settling
the obligation.
UNIT 4: Financial Reporting Standards
Page 105
ICAN – Advanced Accounting – CAP II- CHAPTER I
Contingent Assets
A contingent asset is a possible asset arising from past events whose existence will only be
confirmed by the occurrence of one or more uncertain future events not wholly within the
control of the entity.
Recognition
An entity should not recognize a contingent asset because it could result in the recognition of
profits that may never be realized. However, where the realization of profits is virtually certain,
then the related asset is not a contingent assets and recognition is appropriate.
A contingent asset is disclosed where an inflow of economic benefits is probable.
Disclosure
The following should be disclosed:
a. a brief description of the nature of the contingent asset at the reporting date.
b. where practicable, an estimate of the financial effect.
Illustration
On 1st October 2015, Alpha completed the construction of a non-current asset with an estimated
useful life of 20 years. The costs of construction were recognized in property, plant and
equipment and depreciated appropriately. Alpha has a legal obligation to restore the site on
which non-current asset is located on 30th September 2035. The estimated cost of restoration
work at 30th September 2035 prices, is Rs.25 million. The directors of Alpha have made a
provision of Rs.1.25 million (1/20 × Rs.25 million) in the draft statement of financial position at
30th September 2016. An appropriate annual discount rate to use in any relevant calculations is
6% and at this rate the present value of Rs.1 payable in 20 years is Re.0.312.
Solution
The cost of restoration should not be charged to statement of profit/loss, it should be capitalized
at present value as a part of cost of property, plant and equipment i.e. at Rs.7,800
(25,000×0.312).
PPE
Dr.
7,800
To Provision
7,800
Finance charge of Rs.468 (7,800 × 6%) should be considered on provision amount.
Finance cost (Statement of profit/loss)
Dr.
468
To Provision
468
Page 106
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Statement of profit /loss (30th September 2016)
Finance charge
468
Statement of financial position (30th September 2016)
Non-current liabilities
-Provision (7,800 + 468)
8,268
NFRS 3 Business Combination
Business combinations
A business combination is a transaction or other event in which an acquirer obtains control of
one or more business. A business is integrated set of activities and asserts that is capable of
being conducted and managed for the purpose of providing a return in the form of dividends,
lower costs or other economic benefits directly to investors or other owners, members or
participants.
Guidance /accounting treatment is discussed in two NFRS- (i) NFRS 3 Business Combinations
and (ii) NFRS 10 Consolidated Financial Statements. NFRS 3 is about initial accounting for a
new investment, setting out the rules on the calculation of goodwill on acquisition of
investment. NFRS 10 explains the on-going rules related to procedure of preparation of
consolidated financial statements.
Objectives of NFRS 3
The objective of this NFRS is to improve the relevance, reliability and comparability of the
information that a reporting entity provides in its financial statements about a business
combination and its effects. To accomplish this, this NFRS establishes principles and
requirements for how the acquirer:
a. recognizes and measures in its financial statements the identifiable assets acquired, the
liability assumed and any non-controlling interest in the acquiree.
b. recognizes and measures the goodwill acquired in the business combination or a gain
from a bargain purchase; and
c. determines what information to disclose to enable users of the financial statements to
evaluate the nature and financial effects of the business combination.
Recognition Principle
An acquirer must recognize (separately from goodwill), identifiable assets acquired, liabilities
assumed and any non-controlling interest in the acquiree as of the acquisition date, if they meet
UNIT 4: Financial Reporting Standards
Page 107
ICAN – Advanced Accounting – CAP II- CHAPTER I
the definitions of assets and liabilities in the Framework for the Preparation and Presentation of
Financial Statements at the acquisition date. This might result in recognition of assets and
liabilities not previously recognized by the acquiree.
Intangible Assets
When a company acquires a subsidiary, it may identify intangible assets of the acquiree, which
were not included in the financial statements of the acquiree. If these assets are separately
identifiable and can be measured reliably, they should be included in the consolidated financial
statement as intangible assets.
Re-structuring expenses
An acquirer should not recognize any liability for the cost of restructuring a subsidiary or for
any other costs expected to be incurred as a result of the acquisition.
Reacquired rights
As a part of business combination, an acquirer may reacquire a right that it had previously
granted to the acquiree to use one or more of the acquirer’s recognized or unrecognized assets.
A reacquired right is an identifiable intangible asset that the acquirer recognizes separately from
goodwill.
Contingent liabilities
The requirements in NAS 37 do not apply in determining which contingent liabilities to be
recognized as of the acquisition date. Instead, the acquirer shall recognize as of the acquisition
date a contingent liability assumed in a business combination if it is a present obligation that
arises from past events and its fair value can be reliably measured.
A contingent liability of acquiree which was not recognized in the financial statement of the
acquiree, the acquirer should recognize it at acquisition date even if it is not probable that an
outflow of resources will be required to settle the obligation.
Contingent assets should not be recognized.
Measurement Principle
The acquirer should measure all the identifiable assets and liabilities assumed at their
acquisition date fair value.
Page 108
UNIT 4: Financial Reporting Standards
ICAN – Advanced Accounting – CAP II- CHAPTER I
Income tax
As per NAS 12 Income Tax.
Employee Benefits
As per NAS 19 Employees Benefits
Contingent liabilities
At Fair value
Intangible assets
At fair value
Purchase consideration (Cost of Investment)
Three type of consideration
- Immediate payment
- Deferred payment
- Contingent consideration
Immediate payment – at fair value at acquisition.
Deferred payment – at present value.
Contingent consideration – at fair value at date of acquisition
Contingent consideration after initial recognition
The fair value of contingent consideration should be reviewed at the end of each accounting
period and any increase/ decrease should be adjusted with retained earnings in the consolidated
financial statements.
Acquisition related costs
Acquisition related costs include advisory, legal, accounting fee and other expenses incurred for
the acquisition of shares. All the acquisition related costs should be expensed in the period in
which they are incurred.
The costs to issue debt or equity
The costs to issue debt or equity securities shall be recognized in accordance with NAS 32 and
NFRS 9.
Non- controlling interest
Non-controlling interest (shares held by others than parents) should be recognized at fair value
at date of acquisition. Alternatively, it may be shown at proportionate share by non-controlling
interest in net assets of acquiree at the acquisition date.
Non-controlling interest at subsequent reporting date
UNIT 4: Financial Reporting Standards
Page 109
ICAN – Advanced Accounting – CAP II- CHAPTER I
Non-controlling interest should be reported at fair value (proportionate assets) of noncontrolling interest at acquisition date after adjusting with share of NCI in increase or decrease
in net assets of acquiree after the date of acquisition to reporting date.
Recognizing and measuring goodwill or gain from a bargain purchase
Goodwill
The acquirer shall recognize goodwill as of the acquisition date as the excess of (a) over (b)
below:
(a) the aggregate of:
i. the consideration transferred (sum of all three type)
ii. value of non-controlling interest at acquisition date
iii. in a business combination achieved in stages, the acquisition date fair value of the
acquirer’s previously held equity interest in the acquiree.
(b) the net assets of the acquiree as on the acquisition date.
The excess is goodwill. The amount of goodwill should be separately recognized (separately
from assets and liabilities). This goodwill on acquisition should not be amortized. However the
goodwill is subject to impairment loss as per NAS 27.
Goodwill at subsequent reporting date
Recognized at goodwill at date of acquisition adjusted with impairment loss if any.
Gain from a Bargain Purchase
It results in gain if (b) is excess over (a). The acquirer shall recognize the resulting gain in profit
or loss on the acquisition date.
Page 110
UNIT 4: Financial Reporting Standards
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 1: Accounting For Lease
UNIT 2: Hire Purchase and Installment Transactions
UNIT 3: Goods on Sale Or Return
UNIT 4: Contract Accounts
UNIT 5: Branch Accounts
UNIT 6: Departmental Accounts
UNIT 7: Computation ofthe Insurance Claims for Loss of Stock and Profit
UNIT 8: Investment Accounts
UNIT 1: Accounting for Lease
Page 111
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 1:
Accounting for Lease
Page 112
UNIT 1: Accounting for Lease
ICAN Advanced Accounting CAP II CHAPTER II
1. BACKGROUND
It was found that due to different possible treatments for leased assets, the industry was using it
to its convenience and advantage, particularly in the context of allow ability of depreciation,
using the expenditure of lease rental as a measure of tax avoidance, entering into the lease
arrangements without effecting the transactions in real terms etc. Nepal Accounting Standard 17
has standardized the accounting treatment followed by the lessors and the lessees in transaction
sofleases.NAS-17 has defined different terms used in Lease accounting as below:
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or
series of payments the right to use an asset for an agreed period of time.
The inception of the lease is the earlier of the date of the lease agreement and the date of
commitment by the parties to the principal provisions of the lease. As at this date:
(a) a lease is classified as either an operating or a finance lease; and
(b) in the case of a finance lease, the amounts to be recognized at the commencement of the
lease term are determined.
The commencement of the lease term is the date from which the lessee is entitled to exercise
its right to use the leased asset. It is the date of initial recognition of the lease (i.e. the
recognition of the assets, liabilities, income or expenses resulting from the lease, as
appropriate).
The lease term is the non-cancellable period for which the lessee has contracted to lease the
asset together with any further terms for which the lessee has the option to continue to lease the
asset, with or without further payment, when at the inception of the lease it is reasonably certain
that the lessee will exercise the option.
Minimum lease payments are the payments over the lease term that the lessee is or can be
required to make, excluding contingent rent, costs for services and taxes to be paid by and
reimbursed to the lessor, together with:
(a) for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party unrelated to the lessor that is financially capable of discharging the
obligations under the guarantee.
However, if the lessee has an option to purchase the asset at a price that is expected to be
sufficiently lower than fair value at the date the option becomes exercisable for it to be
reasonably certain, at the inception of the lease, that the option will be exercised, the minimum
lease payments comprise the minimum payments payable over the lease term to the expected
date of exercise of this purchase option and the payment required to exercise it.
A non-cancellable lease is a lease that is cancellable only:
(a) upon the occurrence of some remote contingency;
(b) with the permission of the lessor;
UNIT 1: Accounting for Lease
Page 113
ICAN Advanced Accounting CAP II CHAPTER II
(c)
if the lessee enters into a new lease for the same or a equivalent asset with the same
lessor; or upon payment by the lessee of such an additional amount that, at inception of
the lease, continuation of the lease is reasonably certain.
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on
the future amount of a factor that changes other than with the passage of time (eg. percentage of
future sales, amount of future use, future price indices, and future market rates of interest).
Gross investment in the lease is the aggregate of:
(a) the minimum lease payments receivable by the lessor under a finance lease, and
(b) any unguaranteed residual value accruing to the lessor.
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
Unearned finance income is the difference between:
(a) the gross investment in the lease, and
(b) the net investment in the lease.
Guaranteed residual value is:
(a) for a lessee, that part of the residual value that is guaranteed by the lessee or by a party
related to the lessee (the amount of the guarantee being the maximum amount that
could,in any event, become payable); and
(b) for a lessor, that part of the residual value that is guaranteed by the lessee or by a third
party unrelated to the lessor that is financially capable of discharging the obligation
sunder the guarantee.
Unguaranteed residual value is that portion of the residual value of the leased asset, there
alisation of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
Initial direct costs are incremental costs that are directly attributable to negotiating and
arranging a lease, except for such costs incurred by manufacturer or dealer lessors.
The interest rate implicit in the lease is the discount rate that, at the inception of the lease,
causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed
residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial
direct costs of the lessor.
The lessee’s incremental borrowing rate of interest is the rate of interest the lessee would
have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the
lease, the lessee would incur to borrow over a similar term, and with a similar security, the
funds necessary to purchase the asset.
Economic life is either:
(a) the period over which an asset is expected to be economically usable by one or more users;
or
Page 114
UNIT 1: Accounting for Lease
ICAN Advanced Accounting CAP II CHAPTER II
(b)
the number of production or similar units expected to be obtained from the asset by one
or more users.
Useful life is the estimated remaining period, from the commencement of the lease term,
without limitation by the lease term, over which the economic benefits embodied in the asset are
expected to be consumed by the entity.
The scope of NAS 17does not extend to cover lease agreement to use lands, agreements of items
such as motion picture films, licensing of copyrights, patents etc. and also the agreements to
explore and for use of natural resources.
2. TYPES OF LEASES
The leases have been classified into two types i.e. financial leases and operating leases.
2.1 FINANCE LEASE
Finance lease is a lease that transfers substantially all the risks and rewards incident to
ownership of an asset, whereas an operating lease is a lease other than a financial lease. The
classification of leases adopted is based on the extent to which risks and rewards incident to
ownership of a leased asset lie with the lesser or the lessee. Risks include the possibilities of
losses from idle capacity or technological obsolescence and of variations in return due to
changing economic conditions. Rewards may be represented by the expectation of profitable
operation over the economic life of the asset and of gain from appreciation in value or
realization of residual value.
Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than its form. Examples of situations which would normally lead to lease
being classified as a finance lease are:
(a) The lessor transfers ownership of the asset to the lessee by the end of the lease term;
(b) The lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable such that,
at the inception of the lease, it is reasonably certain that the option will be exercised;
(c) The lease term is for the major part of the economic life of the asset even if title is not
transferred;
(d) At the inception of the lease the present value of the minimum lease payments amount
stoat least substantially all of the fair value of the leased asset; and
(e) The leased asset is of a specialized nature such that only the lessee can use with out major
modifications being made.
Indicators of situations which individually or in combination could also lead to a lease being
classified as a finance lease are:
(a) If the lessee can cancel the lease, the lessor's losses associated with the cancellation are
borne by the lessee;
UNIT 1: Accounting for Lease
Page 115
ICAN Advanced Accounting CAP II CHAPTER II
(b) Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for
example, in the form of a rent rebate equaling most of the sales proceeds at the end of the
lease); and
(c) The lessee can continue the lease for a secondary period at a rent which is substantial lower
than market rent.
1.
Treatment of finance lease in the financial statements of Lessees
(a) The fair value of the asset or the present value of lease payments whichever is less
should be recognized as an asset with a corresponding liability. The discounting rate is
the rate at which the annual lease rental along with the residual value of the asset
discounted comes to the fair value of the asset at the time of inception.
(b) Any amount of directly attributable cost of acquiring the asset under lease shall also be
capitalized along with the above.
(c) The annual lease payment shall be allocated into the financial charge i.e. the interest
portion and also the principal repayment. The financial charge will be charged to the
profit and loss account and the portion of principal amount paid shall be deducted
from the liability.
(d) The lessee shall also charge the depreciation to the profit and loss account as he is the
practical user of the asset and responsible for the risks and rewards associated with the
asset.
(e) The leased asset should be disclosed separately and the reconciliation statement on the
lease payments should be prepared in a way to show the position upto one year, one to
five years and later than five years.
The rationale for capitalizing the finance lease in the books of the lessee are:
•
•
•
•
To account for and present the transaction in accordance with substance and financial
reality and not merely legal form of transaction.
Lessee acquires the economic benefits of the use of the leased asset for the major part
of its economic life, although no legal title is transferred.
Obligation to lessor approximately represents aggregate of fair value and finance
charge.
If not capitalized, the economic resources and the level of obligation of an enterprise
are understated thereby distorting financial ratios.
In practical implementation of the standards, the following implications arise which need to be
addressed with:
(a)
(b)
(c)
(d)
to determine the fair value of the asset
to determine the discount rate
to approximate the useful life of the asset
to equalize the finance charge for the life of the asset
Page 116
UNIT 1: Accounting for Lease
ICAN Advanced Accounting CAP II CHAPTER II
2.
Treatment of finance lease in the financial statements of the Lessor:
(a) Lessors shall recognize assets held under a finance lease in their Statement of
Financial Positions and present them as a receivable at an amount equal to the net
investment in the lease.
(b) Lessor shall determine the finance income in such a manner so as to reflect the
constant periodic rate of return on the net investment outstanding in respect of finance
lease and shall recognize that in the income statement.
(c) For finance leases other than those involving manufacturer or dealer lessors, initial
direct costs are included in the initial measurement of the finance lease receivable and
reduce the amount of income recognized over the lease term.
2.2 OPERATING LEASES
1. Treatment by the Lessee
(a) Operating leases are practically the cases of giving an asset on hire without
transferring the risks and rewards thereon. The Accounting Standards prescribes the
logical accounting treatment in case of operating leases. The lessee shall charge the
leased payments as an expense in the income statement and shall make the disclosure
on future lease payments for the period out 1 year, 1 -5 years, and later than 5 years.
(b) The disclosure of lease payments in the income statement shall be made under a
separate head.
(c) The disclosure on any sub lease payments received or expected to be received shall
also be made separately.
2.
Treatment by the lessor
(a) The lessor shall recognize the lease payments in the income statements and shall
continueto treat the leased asset as a fixed asset.
(b) The lessor shall adopt the normal depreciation policy for the leased asset but in
addition he would make a separate disclosure regarding the depreciation on such
assets and reconciliation statement for the lease payments receivable on periodic basis.
3. SALE AND LEASE BACK TRANSACTIONS
A sale and lease back transaction involves the sale of an asset by the vendor and the leasing of
the same asset back to the vendor. The accounting treatment in such cases would depend on the
type of lease involved in the second transaction between the same parties.
If the second transaction results in finance lease any surplus arising on account of excess of sale
proceeds over the carrying amount of asset or otherwise any deficiencies arising out of that
should be amortized over the lease term in proportion to the depreciation of the leased asset.
Incase of operating lease such surplus/deficiency should be recognized to the profit and loss
account provided the fair value of the transaction could be established.
NAS 17 provides that if a sale and lease back transaction results in finance lease, any excess or
deficiency of sale proceeds over carrying amount should not be immediately recognized as
UNIT 1: Accounting for Lease
Page 117
ICAN Advanced Accounting CAP II CHAPTER II
income in the financial statements of a seller-lessee, instead it should be deferred and amortized
over the lease term.
Illustration 1
A Ltd. leased machinery to B Ltd. on the following terms:
(Rs. in Lakhs)
20
5 years
5
1
2
15%
Fair value of the machinery
Lease term
Lease rental per annum
Guaranteed Residual value
Expected Residual value
Internal Rate of Return
Depreciation is provided on straight-line method @ 10% per annum. Ascertain unearned
financial income considering relevant Accounting Standard and necessary entries may be passed
in the books of the Lessee in the first year.
Solution
a) According to NAS 17 on Leases, unearned finance income is the difference between (a) the
gross investment in the lease, and (b) the net investment in the lease. Net investment in
lease is the gross investment in the lease discounted at the interest rate implicit in the lease.
Where:
i) Gross investment in the lease is the aggregate of (i) minimum lease payments from the
standpoint of the lessor; and (ii) any un-guaranteed residual value accruing to the lessor.
Gross investment = Minimum lease payments + Un-guaranteed residual value
= (Total lease rent + Guaranteed residual value) + Un-guaranteed residual value
= [(Rs. 500,000 × 5 years) + Rs. 100,000] + Rs. 100,000
= Rs. 2,700,000
ii)
Table showing present value of (i) Minimum Lease payments (MLP) and (ii) Unguaranteed residual value (URV).
Year
1
2
3
4
5
Page 118
MLP inclusive of URV Rs.
500,000
500,000
500,000
500,000
500,000
100,000 (Guaranteed residual value)
The present value of minimum cash
payments
100,000(Un-guaranteed residual
value)
Total (b)
Internal rate of return
(Discount factor 15%)
0.8696
0.7561
0.6575
0.5718
0.4972
0.4972
0.4972
Present Value
Rs.
434,800
378,050
328,750
285,900
248,600
49,720
(i) 1,725,820
(ii)
(i) + (ii)
49,720
1,775,540
UNIT 1: Accounting for Lease
ICAN Advanced Accounting CAP II CHAPTER II
Unearned Finance Income
= (a) – (b)
= Rs. 2,700,000 – Rs. 1,775,540
= Rs. 924,460
Particulars
At the inception of lease
Machinery Account Dr.
To A Ltd.
(Being lease of machinery recorded at present value of
MLP)
Dr. (Rs.)
Cr. (Rs.)
1,725,820
1,725,820
At the end of the first year of lease
Finance Charges Account (Refer WN) Dr.
To A Ltd.
(Being the finance charges for first year due)
A Ltd. Dr.
To Bank Account
(Being lease rent paid to the lessor which includes
outstanding liability of Rs. 241,127 and finance charge of
Rs. 258,873)
Depreciation Account Dr.
To Machinery Account
(Being the depreciation provided @ 10% p.a. on straight
line method)
Profit and Loss Account Dr.
To Depreciation Account
To Finance Charges Account
(Being the depreciation and finance charges transferred to
profit and loss account)
258,873
258,873
500,000
500,000
172,582
172,582
431,455
172,582
258,873
Note: As per NAS 17, if the fair value of the leased asset exceeds the present value of minimum
lease payments from the standpoint of lessee, the amount recorded should be the present value
of these minimum lease payments. As the fair value of the leased asset i.e. Rs 20,00,000 is more
than the present value of minimum lease payments amounting Rs. 1,725,820 , the machinery has
been recorded at Rs. 1,725,820 in the books of B Ltd. (the lessee) at the inception of the lease.
Working Note:
Table showing apportionment of lease payments by B Ltd. between the finance charges and
the reduction of outstanding liability
UNIT 1: Accounting for Lease
Page 119
ICAN Advanced Accounting CAP II CHAPTER II
Outstanding
Finance
Reduction in
liability
Lease Rent
Charges Rs.
Year
outstanding
(closing
Rs.
(Opening bal
liability Rs.
balance) Rs.
*15%)
1
500,000
258,873
241,127
1,484,693
2
500,000
222,704
277,296
1,207,397
3
500,000
181,110
318,890
888,507
4
500,000
133,276
366,724
521,783
5
500,000
78,267
521,783
100,050*
874,230
1,725,820
* The difference between this figure and guaranteed residual value (Rs. 100,000) is due to
approximation in computing the interest rate implicit in the lease.
Outstanding
liability
(opening
balance) Rs.
1,725,820
1,484,693
1,207,397
888,507
521,783
Illustration 2
Rama and company has acquired assets on lease whose fair value at the inception of the lease
was Rs. 16 Lakhs. The lease term was agreed as 4 years. The annual lease rental was Rs. 5
Lakhs. Guaranteed Residual Value is Rs. 1 Lakh. Expected residual value is Rs. 3 Lakhs.
Interest rate implicit in the lease i.e. IRR is 14.97%. Depreciation method adopted by lease is on
SLM basis. Ascertain whether the lease is finance lease as per the Nepal Accounting Standard
and advice accounting treatment in the books of lessee. Also, provide disclosure requirement.
Solution
i. Computation of present value of minimum lease payment
Discount Factor
Year
Components
Amount
@ 14.97 %
1
Annual Rental
500,000
0.8698
2
Annual Rental
500,000
0.7565
3
Annual Rental
500,000
0.6580
4
Annual Rental
500,000
0.5724
Guaranteed
4
100,000
0.5724
Residual Value
Total
2,100,000
Present Value
434,896
378,269
329,016
286,175
57,235
1,485,591
Since the present value of minimum lease payment amount to at least substantially all of the fair
value of leased assets i.e. 92.85% (greater than 90%), the lease transaction meets the definition
of finance lease as per NAS 17.
ii.
Presentation and disclosure in the books of lessee
Lower of fair value of leased assets and present value of minimum lease payment i.e. Rs.
1,485,591 shall be measured as carrying amount of the leased assets in the books of lessee.
The same amount shall be measured as carrying amount of liabilities. The journal entries at
the inception of the lease term shall be as follows:
Page 120
UNIT 1: Accounting for Lease
ICAN Advanced Accounting CAP II CHAPTER II
Property plant and equipment account
To Lessor Account
Dr
1,485,591
1,485,591
The determination of interest and principle included in lease payment is as follows:
Year
1
2
3
4
Opening
Balance
1,485,591
1,207,984
88,819
521,875
MLP
500,000
500,000
500,000
600,000
Finance Charges
@14.97%
222,393
180,835
133,056
78,125
Journal Entry for 1st year:
Interest Expense Account
Dr
To Lessor Account
Lessor Account
Dr
To bank Account
Depreciation Account Dr
To Accumulated Depreciation a/c
Principal
Closing Balance
277,607
319,165
366,944
521,875
1,207,984
888,819
521,875
0
222,393
222,393
500,000
500,000
148,559
148,559
Presentation in Statement of Financial Position
Extracts of Statement of Financial Position
Liabilities
Amount
Loans:
Secured Loans:
-Liability for Finance Lease
1,207,984
Assets
Fixed Assets
Property Plant and Equipment:
Leasehold Property1,485,591
Less: Acc. Depn148,559
Disclosure in Notes to Accounts
a.
Future Minimum Lease Payables
Period
MLP
Present Value of MLP
Up to 1 year
500,000
1 to 5 years
1,100,000
> 5 years
Nil
b.
c.
d.
Amount
1,337,032
378,269
672,426
NIL
Contingent Rent – Nil
Sub Lease Income – Nil
Restrictive Covenants in the Lease – Nil
UNIT 1: Accounting for Lease
Page 121
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 2:
Hire Purchase and Installment Transactions
Page 122
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
1.
HIRE PURCHASE TRANSACTION
1.1 INTRODUCTION OF HIRE-PURCHASE SYSTEM
Hire-purchase system is a special system of purchase and sale of goods. Under this system
purchaser pays the price of the goods in installments. The installments may be annual, semiannual, quarterly, monthly, fortnightly, etc. Under this system the goods are delivered to the
purchaser at the time of agreement before the payment of installments but the title on the goods
is transferred after the payment of all installments as per the hire-purchase agreement. The
special feature of a hire-purchase transaction is that the payment of every installment is treated
as the payment of hire charges by the purchaser to the hire vendor till the payment of the last
installment. After the payment of the last installment, the amount of various installments paid is
appropriated towards the payment of the price of the goods sold and the ownership or the goods
is transferred to the purchaser. Thus hire-purchase means a transaction where the goods are sold
by vendor to the purchaser under the following conditions:
 the goods will be delivered to the purchaser at the time of agreement.
 the purchaser has a right to use the goods delivered.
 the price of the goods will be paid in installments.
 everyinstallment will be treated to be the hire charges of the goods which is being used
by the purchaser.
 if all installments are paid as per the terms of agreement , the title of the goods is
transferred by vendor to the purchaser.
If there is a default in the payment of any of the installments, the vendor will take away the
goods from the possession of the purchaser without refunding him any amount received earlier
in the form of various installments.
Usually every hire-purchase agreement contain the following terms:
 the cash price of the goods, cash price means the price at which goods may be
purchased against cash payment.
 the hire-purchase price, hire purchase price means the total amount which is payable by
the hire-purchaser under the agreement.
 the date on which the hire-purchase agreement will commence.
 the description of the goods that will be delivered to the hire-purchaser at the
commencement of the agreement.
 the number of installments to be paid by the hire-purchaser along with the amount of
each installment and the date of payment of each installment.
 the down payment if any, the down payment means the amount which is required to be
paid by hire-purchaser to the hire vendor at the time of commencement of hire-purchase
agreement.
 the rate interest charged by the hire vendor (optional).
UNIT 2: Hire Purchase and Installment Transactions
Page 123
ICAN Advanced Accounting CAP II CHAPTER II
1.2 CALCULATION OF CASH PRICE, IF CASH PRICE IS NOT GIVEN
Some times in a problem of hire-purchase, cash price of goods sold is not given. Only hirepurchase price is given under such situation, first of all, cash price is to be calculated in order to
find out the amount of interest included in each installment. The cash price can be calculated
under following two situations.
1.2.1
By Annuity Method, if the annuity value of Re. 1 is given:
Cash Price = (Annuity, Value of Re.1 x Amt. of one installment) + down payment if, any.
Calculation of Cash Price by Annuity Method
Illustration 1:
On 1stShrawan 2069 a manufacturing company buys on Hire-purchase system, amachinery for
Rs. 60,000, payable by three equal annual installments combining principal and interest, the rate
of interest was 5% per annum. Calculate the amount of cash price and interest. The present
value of an annuity of one rupee for three years at 5% interest is Rs. 2.72325.
Solution:
a. Calculation of Cash Price
The present value of an annuity of Re. 1 paid for 3 year @ 5% = Rs. 2.72325
Then the present value of Rs. 20,000 for 3 years = 2.72325 x 20,000 = Rs. 54,465 Cash Price
=Rs. 54,465
b. Interest on Hire Purchase System
= Full Value- Cash Price of machinery
= Rs 60,000 – Rs 54,465
= Rs 5,535
1.2.2 By Arithmetic Method, if the annuity value of Re. 1 is not given:
First take the last installment and calculate interest included in that installment.
Interest: = (Amount of installment x Rate of Interest) / (100+Rate of Interest)
Thereafter interest included in last but one installment should be calculated.
Interest = [(Amount of last but one installment + principal price included in the last installment)
x Rate of Interest] / 100+ Rate of Interest
 Interest included in all proceeding installment should be calculated in the same manner.
 In the end, interest included in each installment should be added. It should be
remembered that down payment does not include any interest.
 Finally cash price = Hire purchase price – Total interest included in various
installments.
Page 124
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 2:
Mr. Arpanpurchased a machine on Hire-Purchase system on 1st Shrawan 2069. He paid Rs.
5,000 at spot and then three annual installments of Rs. 5,000 each. The rate of interest was 5%
per annum. Find out the amount of interest included in installments and cash price of the
machine.
Solution:
(1) First of all Interest included in the 3rd installment is to be calculated.
Interest=(5000x5)/105=Rs. 238,Principal= 5000-238=4762
(2) Interest included in second installment = [(5000+4762)x5]/105 = 465, Principal=4535
(3) Interest included in 1st installment = [(5000+4762+4535)x5]/105 = 681,Principal=4319
Cash Price = 4,762+4,535+4,319+down payment Rs.5,000 = Rs.18,616
Total Interest=Rs.20,000-18,616=1,384. I Yr. Rs.681, IIYr. Rs.465, III Yr.Rs.238
Note: Now you can make the interest table in the usual manner as explained in worked out
example-1 and check your calculation of amount of interest.
Illustration 3:
MsAakriti acquired on 1st Shrawan 2069 a machine under a Hire-Purchase agreement which
provides for 5 half-yearly installments ofRs. 6,000 each, the first installment being due on 1st
Magh 2069. Assuming that the applicable rate of interest is 10 per cent per annum, calculate the
cash value of the machine. All working should form part of the answer.
Solution
Statement showing cash value of the machine acquired on hire-purchase basis
Installment
Amount
ss
5th Installment
Less: Interest
Add: 4th Installment
Less: Interest
Add: 3rd installment
Less: Interest
Add: 2nd installment
Less: Interest
Add: 1st installment
Less: Interest
Rs.
6,000
– 286
5,714
6,000
11,714
558
11,156
6,000
17,156
817
16,339
Interest @ 5% halfyearly (10%
p.a.) =5/105 = 1/21
(in each installment)
Rs.
286
558
817
1,063
1,299
4,023
UNIT 2: Hire Purchase and Installment Transactions
Principal Amount (in
each installment)
Rs.
5,714
5,442
(11,156–5,714)
5,183
(16,339–11,156)
4,937
(21,276–16,339)
4,701
(25,977–21,276)
25,977
Page 125
ICAN Advanced Accounting CAP II CHAPTER II
6,000
22,339
1,063
21,276
6,000
27,276
1,299
25,977
The cash price of the machinery is Rs. 25,977.
1.3 CALCULATION OF AMOUNT OF INTEREST
The total payment made under hire-purchase system is more than cash price. In fact, this excess
of payment over the cash price is interest. It is very essential to calculate interest because the
amount paid for interest is charged to revenue and the asset is capitalized at cash price. Thus
normally all installments will include a part of cash price and a part of interest on the
outstanding balance. However, the amount paid at the time of agreement (down payment) will
not include any interest. The calculation of interest is made under two conditions:
i.
Calculation of amount of interest, if rate of interest is not given
a. When cash price and the amounts of installments are given and the amount of each
installment is same.
The following worked out example will make the calculation clear.
Illustration 4:
A machine was sold on hire-purchase system on 1stshrawan, 2069,Rs 10,000 was paid at spot
and rest was paid by four equal quarterly installments of 22,000 each. The cash price of machine
was Rs 90,000. Find out the amount of interest included in each installment.
Solution;
Hire purchase price
10,000 +( 22,000*4)
= Rs 98,000
Less: Cash Price
= Rs 90,000
Total Interest
= Rs 8,000
The total interst of Rs 8,000 is to be apportioned among the various installments ie 4th, 3rs, 2nd,
and 1st installment in the ratio of 1:2:3:4 ( ie among 1st, 2nd,3rd and 4th installment in the ratio of
4:3:2:1)
Share of 1st Installment in the interest
= 8000 *4/10
= Rs 3,200
Share of 2nd Installment in the interest = 8000 *3/10
= Rs 2,400
Page 126
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Share of 3rd Installment in the interest = 8000 *2/10
= Rs 1,600
Share of 4th Installment in the interest
= Rs 800
b.
= 8000 *1/10
When Rate of interest is not known and Installments of different amounts
Illustration 5:
Cash price of a machine is Rs 37,400 on 1stshrawan 2069. Its hire purchase price is Rs50,000 .
This hire purchase price is paid in five annual installments in the following manner: Rs 15,000
at the end of the first year, Rs 12,000 at the end of second year, Rs 10,000 at the end of third
year, Rs 8,000 at the end of fourth year, Rs 5,000 at the end of fifth year. Calculate interest and
cash price included in each installment
Solution
Calculation of interest included in each installment
Total interest = Hire purchase price – Cash price
= Rs 50,000- 37,400
= Rs 12,600
Total interest of Rs 12,600 is to be apportioned among the five installments in the following
manner
Installment no
Unpaid Amount (Rs)
First
50,000
Calculation of Interest (Rs)
(12,600 * 50,000)/12,600 = 5,000
Second
50,000- 15,000 = 35,000
(12,600 * 35,000)/12,600 = 3,500
Third
35,000- 12,000 = 23,000
(12,600 * 23,000)/12,600 = 2,300
Fourth
23,000 -10,000 = 13,000
(12,600 * 13,000)/12,600 = 1,300
Fifth
13,000- 8,000
(12,600 * 5,000)/12,600
= 5 ,000
= 500
Calculation of Price included in each installment
Installment No
First
Second
Third
Fourth
Fifth
Total
Installment ( Rs)
Interest ( Rs)
15,000
5000
12,000
3500
10,000
2300
8,000
1300
5,000
500
50,000
12,600
UNIT 2: Hire Purchase and Installment Transactions
Cash Price ( Rs)
10,000
8,500
7,700
6,700
4,500
37,400
Page 127
ICAN Advanced Accounting CAP II CHAPTER II
ii.
Calculation of amount of interest, if rate of interest is given
(a) When interest is included in amount of installment:Where the hire-purchase price
i.e. payment made in the form of down payment and all installments is more than the
cash price, it is regarded that the interest is included in installments. It is explained in
the following example.
Illustration 6:
On 1st Shrawan 2069 Mr. Rampurchased from M/s IME & Co. one 'Motor Truck' under hirepurchase system, Rs. 5,000 being paid on delivery and the balance in five annual installments of
Rs. 7,500 each payable on Ashad endeach year. The cash price of the motor truck is Rs. 37,500
and vendors charge interest at the rate of 5 per cent per annum on yearly balances. Find out the
amounts of principal and interest included in each installment.
Calculation of Interest
\Calculation of Interest
Cash Price
Cash Price
Less : Paid on Delivery
Balance Cash Price
Rs
37,500
(5,000)
32,500
First Installment
Less: Interest on Rs 32,500 @ 5%
Principal repayment
Balance Cash Price
7,500
(1,625)
5,875
26,625
Second Installment
Less: Interest on Rs 26625 @ 5%
Principal repayment
Balance Cash Price
7,500
(1,331)
6,169
20,456
Third Installment
Less: Interest on Rs 20456 @ 5%
Principal repayment
Balance Cash Price
7,500
(1,023)
6,477
13,979
Fourth Installment
7,500
Page 128
Installment
Principal Interest
Rs
Rs
Total
Rs
5,000
5,000
5,875
1,625
7,500
6,169
1,331
7,500
6,477
1,023
7,500
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Less: Interest on Rs 13979 @ 5%
Principal repayment
Balance Cash Price
(699)
6,801
7,178
Fifth Installment
Amount Paid
Interest
7,500
7,178
322
Total
6,801
699
7,500
7,178
322
7,500
37,500
5,000
42,500
(b) When interest is not included in installments: Where the total amount paid in the form
of down payment and all installments is exactly equal to the cash price, it is regarded that
the interest is not included in installments. It means that interest is payable in addition to
the agreed amount of installment. It is explained in the following example.
Illustration 7:
(Calculation of Interest):On1st Shrawan,2069, a Transport Company purchased a Motor Lorry
from SagarmathaMotor Supply Co. Ltd. on hire-purchase basis, the cash price being Rs. 60,000.
Rs. 15,000 on signing of the contract and balance in three annual installments of Rs. 15,000
each on Ashad end every year. In addition to it, interest at 5 % per annum was also payable to
vendors on outstanding balances.
Calculation of Interest
Calculation of Interest
Cash Price
Rs
Cash Price
60,000
Less : Paid on Delivery
(15,000)
Balance Cash Price
45,000
First Installment
15,000
Less: Interest on Rs 45,000 @ 5%
2,250
Total repayment
Installment
Principal
nterest
Total
Rs
Rs
Rs
15,000
15,000
15,000
2,250
17,250
15,000
1,500
16,500
17,250
Balance Cash Price
30,000
Second Installment
15,000
Less: Interest on Rs 30,000 @ 5%
1,500
UNIT 2: Hire Purchase and Installment Transactions
Page 129
ICAN Advanced Accounting CAP II CHAPTER II
Total repayment
16,500
Balance Cash Price
15,000
Third Installment
15,000
Less: Interest on Rs 15,000 @ 5%
750
Total repayment
Balance Cash Price
15,000
750
15,750
60,000
4,500
64,500
15,750
-
Total
1.4 ACCOUNTING IN THE BOOKS OF HIRE PURCHAER
There are two methods of accounting in the books of Hire-purchaser. These are Interest
Suspense Method and Cash Price Method.
1.4.1 CASH PRICE METHOD:
Under this method the full cash price of the assets is debited to the Assets Account and credited
to the Hire Vendor Account. It is done on the assumption that the ownership of the asset is also
transferred to the purchaser with the delivery of goods. The following journal entries are
recorded under this method.
(i)
On taking the delivery of assets at the time of agreement:
Asset A/c Dr.
To Hire vendor A/c.
(ii)
(Amount
of
down
payment)
(Amount of interest)
(Amount of installment)
On charging the depreciations:
Depreciation A/c. Dr.
To Asset A/c.
(vi)
Asset)
On payment of installment:
Hire-Vendor a/c Dr.
To Cash/Bank A/c
(v)
of
On becoming the installment due:
Interest A/c. Dr.
To Hire-Vendor A/c
(iv)
price
On making the down-payment (if any):
Hire-Vendor....... A/c. Dr.
To Cash/Bank A/c
(iii)
(Cash
(Amount of depreciation)
On Transfer of interest and depreciation to P/L A/c:
Page 130
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
P/L A/c. Dr.
To Interest A/c.
(Total)
(Bal. of Intt. A/c.)
To Depreciation A/c.
(Bal. of Dep. A/c.)
Illustration 8:
On 1st January 2017, A Limited acquired furniture on the hire purchase system from B Limited
agreeing to pay four semi-annual installments of Rs.800 each, commencing on 30th June, 2017.
The cash price of the furniture was Rs.3,010 and interest of 5% per annual at half yearly rests
was chargeable.
Required:
Prepare the ledger accounts in the books of the purchaser presuming that the purchaser charges
depreciation @10% p.a. and follows cash price method for accounting.
Solution
Books of A Limited
B Limited A/c
Date
30.6.2017
31.12.2017
31.12.2017
Particulars
To Bank
To Bank
To balance c/d
30.06.2018
31.12.2018
To Bank
To Bank
Rs.
800
800
1,542
3,142
800
800
Date
1.1.2017
30.6.2017
31.12.2017
Particulars
By furniture a/c
By Interest
By Interest
1.1.2018
30.06.2018
31.12.2018
By Balance b/d
By Interest
By Interest
1,600
Rs.
3,010
75
57
3,142
1,542
39
19
1,600
Furniture A/c
Date
1.1.2017
1.1.2018
Particulars
To B Limited
Rs.
3,010
To balance b/d
3,010
2,709
2,709
UNIT 2: Hire Purchase and Installment Transactions
Date
31.12.2017
31.12.2017
Particulars
By Depreciation
By Balance c/d
31.12.2018
31.12.2018
By Depreciation
By Balance c/d
Rs.
301
2,709
3,010
271
2,438
2,709
Page 131
ICAN Advanced Accounting CAP II CHAPTER II
Working note
1.
Calculation of interest
Installment on 30.6.2017
3,010 × 5% × 6/12
= 75
Installment on 31.12.2017
(3,010 + 75 -800)× 5% × 6/12
= 57
Installment on 30.6.2018
1,542 × 5% × 6/12
= 39
Installment on 30.6.2018
(1,542 +39 -800)× 5% × 6/12
= 19
Illustration 10
AB Ltd purchased a truck on 1st January 2017 on hire purchase basis from M. Ltd. The cash
price of the truck was Rs.30,000 under the agreement, a sum of Rs.12,000 was payable initially
on 1st January 2017, and the balance in 12 quarterly installments of Rs.1,920 each. The financial
year of the transport company ended on 30th June. On 30 September 2018, truck was sold for
Rs.20,000 and the amount due to M. Ltd settled for Rs.10,200.
AB Ltd opened Truck Account at total cash price and spread the interest over the period of hire
purchase proportionately. Depreciation was provided at 20% p.a. on cost.
Show the necessary ledger accounts in the books of AB Ltd.
Solution
Books of AB Ltd
Truck A/c
Date
Particulars
Rs.
Date
Particulars
Rs.
1.1.2017
To M Ltd
30,000
30.6.2017
By Depreciation
3,000
30.6.2017
By Balance c/d
27,000
30,000
1.7.2017
To Balance b/d
30,000
27,000
M Ltd A/c
Date
Particulars
Rs.
Date
Particulars
Rs.
1.1.2017
To Bank
12,000
1.1.2017
By Truck
30,000
31.3.2017
To Bank
1,920
31.3.2017
By Interest
775
30.6.2017
To Bank
1,920
30.6.2017
By Interest
711
Page 132
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
30.6.2017
To Balance c/d
31,486
31,486
1.7.2017
By Balance b/d
Working Note:
1.
Calculation of interest included in installments
Cash price
Rs.30,000
HP Price
Down payment + installments
12,000 + (1,920 × 12)
Total interest
= 35,040
HP Price – cash price
35,040 – 30,000 = Rs.5,040
Total interest allocated in the ratio of installments
Date of installments
Amount of interest
31.3.2017
(5,040 × 12/78) = Rs.775
30.6.2017
(5,040 × 11/78) = Rs.711
30.9.2017
(5,040 × 10/78) = Rs.646
31.12.2017
(5,040 × 9/78)
= Rs.582
31.3.2018
(5,040 × 8/78)
= Rs.517
30.6.2018
(5,040 × 7/78)
= Rs.452
30.9.2018
(5,040 × 6/78)
= Rs.388
1.4.2 INTEREST SUSPENSE METHOD:
Under this method, at the time of transfer of possession of assets, the total interestunaccrued is transferred to Interest Suspense Account. At later years as and when interest
becomes due, Interest Account is debited and Interest Suspense Account is credited. The
following journal entries are recorded under this method.
i.
When the asset is acquired on hire purchase
Asset Account
Dr
To Hire Vendor Account
ii. For total interest payment is made
H.P. Interest Suspense Account
Dr
To Hire Vendor Account
iii. When down payment is made
Hire Vendor Account
Dr
To Bank Account
UNIT 2: Hire Purchase and Installment Transactions
Page 133
ICAN Advanced Accounting CAP II CHAPTER II
iv. For Interest of the relevant period
Interest Account
Dr
To H.P. Interest Suspense Account
v. When an installment is paid
Hire Vendor Account
Dr
To Bank Account
vi. When depreciation is charged on the asset
Depreciation Account
Dr
To Asset Account
vii. For closing interest and depreciation account
Profit and Loss Account
Dr
To Interest Account
To Depreciation Account
Illustration 11
On 1st January 2017, A Limited acquired furniture on the hire purchase system from B Limited
agreeing to pay four semi-annual installments of Rs.800 each, commencing on 30th June, 2017.
The cash price of the furniture was Rs.3,010 and interest of 5% per annual at half yearly rests
was chargeable.
Required:
Prepare the ledger accounts in the books of the purchaser presuming that the purchaser charges
depreciation @10% p.a. and follows interest suspense method for accounting.
Solution
Books of A Limited
B Limited A/c
Date
30.6.2017
31.12.2017
31.12.2017
30.06.2018
31.12.2018
Page 134
Particulars
To Bank
To Bank
To balance c/d
To Bank
To Bank
Rs.
800
800
1,600
3200
Date
1.1.2017
1.1.2017
800
800
1,600
1.1.2018
Particulars
By furniture a/c
By Interest Suspense
Rs.
3,010
190
3200
By Balance b/d
1600
1,600
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Interest Suspense A/c
Date
1.1.2017
Particulars
To B Limited
Rs.
190
Date
Particulars
30.06.2017
By Interest
75
31.12.2017
By Interest
57
31.12.2017
By balance c/d
58
190
1.1.2018
To balance b/d
58
Rs.
190
30.06.2018
By Interest
39
31.12.2018
By Interest
19
58
58
Furniture A/c
Date
1.1.2017
Particulars
To B Limited
Rs.
3,010
1.1.2018
To balance b/d
3,010
2,709
Date
31.12.2017
31.12.2017
Particulars
By Depreciation
By Balance c/d
31.12.2018
31.12.2018
By Depreciation
By Balance c/d
2,709
Rs.
301
2,709
3,010
271
2,438
2,709
Working note
1.
Calculation of interest
Installment on 30.6.2017
3,010 × 5% × 6/12
=
Installment on 31.12.2017
(3,010 + 75 -800)× 5% × 6/12
75
=
57
1,542 × 5% × 6/12
=
39
Installment on 30.6.2018
(1,542 +39 -800)× 5% × 6/12
=
19
Installment on 30.6.2018
Total interest
190
1.5 ACCOUNTING IN THE BOOKS OF HIRE-VENDOR
There are different methods of recording the entries in the books of hire-vendor. It is
selected according to the type and value of goods sold, volume of transactions, the length
of the period of purchase etc. The different methods are discussed below:
UNIT 2: Hire Purchase and Installment Transactions
Page 135
ICAN Advanced Accounting CAP II CHAPTER II
1.5.1 CASH PRICE METHOD
A business that sells relatively large items on hire purchase may adopt this method. Under
this method, hire purchase is treated as credit sales. The only exception is that the vendor
agrees to accept the payment in installments and for that he charges interest. Amount due
from the hire purchaser at the end of the fiscal year is shown in the Balance Sheet as
Account Receivable from Hire Purchaser. The entire profit on sale under hire purchase
agreement is credited to Statement of profit or Loss and Other Comprehensive Income of
the year in which the sale has taken place. Interest pertaining to each accounting period is
credited to the Statement of profit or Loss and Other Comprehensive Income of that year.
(i)
On delivery of goods to the hire-purchaser at the time of agreement:
Hire – purchaser A/c Dr.
To Sales A/c.
(ii)
Cash Price
On receipt of cash at the time of agreement (down payment), if any:
Bank A/c. Dr.
(Amt. of down payment)
To Hire-Purchaser
(iii)
When Installment become due:
Hire – Purchaser A/c Dr.
To Interest A/c.
(iv)
Amt. of Interest
On receipt of installment:
Bank A/c.
To Hire – Purchaser
(v)
(Amt. of Installment)
On Transfer of Balance of Hire-Sales A/c. to Trading A/c. (at the end of first year
only):
Hire – Sales A/c Dr.
To Trading A/c.
(vi)
Cash Price
On Transfer of amount of interest to P/L A/c:
Interest A/c. Dr.
To P/L A/c.
(Balance of Int. A/c.)
Illustration 12
On 1st January 2017, A Limited acquired furniture on the hire purchase system from B Limited
agreeing to pay four semi-annual installments of Rs.800 each, commencing on 30th June, 2017.
The cash price of the furniture was Rs.3,010 and interest of 5% per annual at half yearly rests
was chargeable.
Page 136
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Required:
Prepare the ledger accounts in the books of the vendorunder cash price method for accounting.
Solution
Books of B Limited
A Limited A/c
Date
1.1.17
30.6.17
31.12.17
Particulars
To HP Sales
To Interest
To Interest
1.1.18
30.6.18
31.12.18
To Balance b/d
To Interest
To Interest
Rs.
3,010
75
57
3,142
1,542
39
19
1,600
Date
30.6.17
31.12.17
31.12.17
Particulars
By Bank
By Bank
By Balance c/d
30.6.18
31.12.18
By Bank
By Bank
Rs.
800
800
1,542
3,142
800
800
1,600
Working note
1.
Calculation of interest
Installment on 30.6.2017
3,010 × 5% × 6/12
=
75
Installment on 31.12.2017
(3,010 + 75 -800)× 5% × 6/12
=
57
1,542 × 5% × 6/12
=
39
Installment on 30.6.2018
(1,542 +39 -800)× 5% × 6/12
=
19
Installment on 30.6.2018
1.5.2 INTEREST SUSPENSE METHOD
This method is almost similar to the sales method, except the accounting for interest. Under
this method, the hire purchaser is debited with full cash price and interest (total) included in
the hire selling price. Credit is given to the H.P. Sales Account and Interest Suspense
Account. When the installment is received, the Bank Account is debited and the Hire
Purchaser Account is credited. At the same time an appropriate amount of interest (i.e.,
interest for the relevant accounting period) is removed from the Interest Suspense Account
and credited to the Interest Account. At the time of preparation of Final Accounts, interest
is transferred to the credit of the Statement of profit or Loss and Other Comprehensive
Income. The balance of the Interest Suspense Account is shown in the Statement of
Financial Position as a deduction from Hire Purchase Debtors.
UNIT 2: Hire Purchase and Installment Transactions
Page 137
ICAN Advanced Accounting CAP II CHAPTER II
i.
ii.
When goods are sold and delivered under hire purchase
Hire Purchase Account
Dr. [Full cash price + total interest]
To H.P. Sales Account
[Full cash price]
To Interest Suspense Account
[Total Interest]
When down payment/installment is received
Bank Account
Dr.
To Hire Purchaser Account
iii.
For interest of the relevant accounting period
Interest Suspense Account
Dr.
To Interest Account
iv.
For closing interest Account
Interest Account
Dr.
To Profit and Loss Account
v.
For closing Hire Purchase Sales Account
H.P. Sales Account
Dr.
To Trading Account
The disclosure in Statement of Financial Position of the respective parties will be:
Statement of Financial
Statement of Financial
Position of Hire Purchaser
Position of Vendor
Assets
Assets
Fixed assets :
Current assets :
Asset on Hire purchase
Hire purchase debtors
Add : Balance in Interest suspense A/c
Less : Balance in Int suspense A/c
Less : Depreciation
Illustration 13
On 1st January 2017, A Limited acquired furniture on the hire purchase system from B Limited
agreeing to pay four semi-annual installments of Rs.800 each, commencing on 30th June, 2017.
The cash price of the furniture was Rs.3,010 and interest of 5% per annual at half yearly rests
was chargeable.
Required:
Prepare the ledger accounts in the books of the vendor under interest suspense method for
accounting.
Page 138
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Solution
Books of B Limited
A Limited A/c
Date
1.1.17
1.1.17
Particulars
Rs.
To HP Sales
3,010
To Interest Suspense 190
1.1.18
3,200
1,600
To Balance b/d
Date
30.6.17
31.12.17
31.12.17
Particulars
By Bank
By Bank
By Balance c/d
30.6.18
31.12.18
By Bank
By Bank
1,600
Rs.
800
800
1,600
3,200
800
800
1,600
Interest Suspense A/c
Date
30.6.17
31.12.17
312.17
30.6.18
31.12.18
Particulars
To Interest
To Interest
To Balance c/d
To Interest
To Interest
Rs.
75
57
58
190
39
19
58
Date
1.1.17
1.1.18
Particulars
By A Limited
Rs.
190
By Balance b/d
190
58
58
Working note
1.
Calculation of interest
Installment on 30.6.2017
3,010 × 5% × 6/12
= 75
Installment on 31.12.2017
(3,010 + 75 -800)× 5% × 6/12
= 57
Installment on 30.6.2018
1,542 × 5% × 6/12
= 39
Installment on 30.6.2018
(1,542 +39 -800)× 5% × 6/12
= 19
Total Interest
190
UNIT 2: Hire Purchase and Installment Transactions
Page 139
ICAN Advanced Accounting CAP II CHAPTER II
1.5.3 STOCK AND DEBTORS METHOS
In this method credit of profit is taken on the portion of installment due only. Installment
due is taken as hire purchase sales, installment not due is taken as hire purchase stock and
installment due but not received is taken as hire purchase debtors.
When good are sold on hire purchase
H P Stock
Dr.
(Hire purchase price)
To HP Adjustment (Loading)
To Shop Stock
(Cost)
For down payment
Bank
Dr.
To HP Stock
When installments become due
HP Debtors
Dr.
To HP Stock
For receipt of installments
Bank
Dr
To HP Debtors
When goods are repossessed
Goods Repossessed Stock
Dr.
To HP Stock (Installment not due on repossessed goods)
To HP Debtors (Installment due but not received on repossessed goods)
Repairs of repossessed stock
Goods Repossessed Stock
Dr.
To Bank A/c
Sale of Repossessed stock
Bank A/c
Dr.
To Goods Repossessed Stock
Profit on repossessed stock
Goods Repossessed Stock
Dr.
To HP Adjustment A/c
Unrealized profit in HP Stock
HP Adjustment Dr.
To Stock Reserve
Page 140
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 14
AB Limited sold one machine costing Rs.10,000 to Rama on hire purchase system at a price of
Rs.15,000 on 1st March 2013. Rs.3,000 was payable as down payment and monthly installment
of Rs.1000 was payable, first installment being payable in the month of delivery. At the end of
2013, 6 installments were received.
Prepare necessary ledgers in the books of AB Limited under stock and debtors method.
Solution
Books of AB Ltd
HP Stock A/c
Particulars
To Goods sold on HP
Rs.
15,000
Particulars
By Bank (DP)
By HP Debtors (Install. Due)
By Balance c/d
15,000
HP Debtors A/c
Particulars
To HP Stock (Install. Due)
Rs.
10,000
Particulars
By Bank (Install. Received)
By Balance c/d
10,000
Rs.
3,000
10,000
2,000
15,000
Rs.
6,000
4,000
10,000
HP Adjustment A/c
Particulars
To Stock Reserve
5,000/15,000)
To Profit on HP
(2,000
Rs.
× 667
4,333
5,000
Particulars
Rs.
By Goods sold on HP (Loading) 5,000
5,000
Illustration 15
The hire purchase department of SungavaLtd. sells television sets and room coolers. This
department was newly started in 2010. The relevant information is as follows:
UNIT 2: Hire Purchase and Installment Transactions
Page 141
ICAN Advanced Accounting CAP II CHAPTER II
Television Set
Room Coolers
Rs.
Rs.
Cost
5,400
2,000
Cash Price
6,300
2,400
Cash down payment
900
400
Monthly installment
600
200
Number of installments
10
12
During the year, 100 television sets and 120 room coolers were sold on hire purchase basis. Two
television sets on which 3 installments only could be collected and 4 room coolers on which 5
installments had been collected were repossessed. These were valued at Rs. 10,000 and after
reconditioning at a cost of Rs. 1,000 were sold outright for Rs. 14,000. Other installments
collected and those due (customer still paying) were respectively as follows:
Television sets
270 and 20
Room coolers
400 and 30
Prepare Accounts on stocks and debtors system to reveal the profit of the Department
Solution :
Sungava Limited
Hire Purchase Stock Account
Rs.
Rs.
Particulars
Rs.
Particulars
Rs.
To Goods sold on H.P
1,026,000
By H P Debtors A/c,
405,600
By Goods Repossessed A/c 14,000
(Installment not due on
repossessed goods)
By Balance c/d (Installment not 606,400
yet due)
1,026,000
1,026,000
Hire Purchase Debtors A/c
Particulars
To H.P Stock A/c,
Rs.
405,600
405,600
Page 142
Particulars
By Bank A/c
By Balance c/d
Rs.
387,600
18,000
405,600
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Goods Repossessed A/c
Particulars
To H.P Stock A/c
Rs.
14,000
To Balance b/d
To Bank (Expenses)
To H . P. Adjustment (Profit)
14,000
10,000
1,000
3,000
14,000
Particulars
By H. P. Adjustment A/c
(Balancing figure)
By Balance c/d
By Bank (Sales)
Rs.
4,000
10,000
14,000
14,000
14,000
Goods sold on Hire Purchase A/c
Particulars
Rs.
Particulars
Rs.
To H.P. Adjustment A/c
(Loading)
246,000
By H.P Stock A/c
1,026,000
To Shop Stock (Cost)
780,000
1,026,000
1,026,000
Hire Purchase Adjustment A/c
Particulars
To Goods Repossessed
(Loss on valuation)
To Stock Reserve
To Profit on H.P.
Rs.
A/c 4,000
144,971
Particulars
By Goods sold on H.P
(Loading)
By Goods repossessed (Profit
on sale)
100,029
249,000
Rs.
246,000
3,000
249,000
Working Notes :
(i)
Hire Purchase Price is Rs. 6,900 for each television set and Rs. 2,800 for each room
cooler. Total cost and sales on this basis are as follows:
H.P. Price Rs.
Cost Rs.
Television sets (100)
6,90,000
5,40,000
Room Coolers (120)
3,36,000
2,40,000
10,26,000
7,80,000
UNIT 2: Hire Purchase and Installment Transactions
Page 143
ICAN Advanced Accounting CAP II CHAPTER II
Television sets Room Coolers
Rs.
(ii)
Rs.
Cash collected Down payment
(900 × 100)
90,000
48,000
(400 × 120)
Installments collected
(600 × 270)
1,62,000
80,000
(400 × 200)
Amount collected on Repossessed goods
(3 × 2 × 600)
3,600
4,000
5 × 4 × 200)
2,55,600
(iii) Installment not yet due:
1,32,000
Rs.
Television:
Total installments on 98 sets
980
Less: Installments collected & due
290
690
Amount of 690 installments @ Rs. 600 each
4,14,000
Room Coolers:
Total installment on 116 Room Coolers
1,392
Less :Installments collected & due
430
962
Amount of 962 installments @ Rs. 200 each
1,92,400
Total amount
6,06,400
(4,14,000 + 1,92,400)
(iv) Stock Reserve
Television Set
Room Cooler
1500 / 6900 * 414,000
800 / 2800 * 192,400
90,000
54,971
144,971
(v) Installment not due on repossessed goods:
2 Television sets 7 installments on each @ Rs. 600
8,400
4 Room Coolers 7 installments on each @ Rs. 200
5,600
14,000
(vi) Installment due but not collected :
Television sets (20 × Rs. 600)
12,000
Room Cooler (30 × Rs. 200)
6,000
18,000
Page 144
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
1.3.4 DEBTORS METHOD
In this method the Hire purchase Trading account is prepared. The objective of preparing
Hire Purchase Trading Account is to measure the profitability of the Hire Purchase division
separately. Let us see how to prepare Hire Purchase Trading Account.
 Credit all down payments and installments falling due to hire purchase sales account.
Transfer balance in Hire Purchase Sales Account to Hire Purchase Trading Account.
 Transfer cost of all transactions to Hire Purchase Trading Account.
Hire Purchase Trading A/cDr.
To Shop Stock A/c
 Charge any special expenses to Hire Purchase Trading Account.
 Treat installments not yet due as stock lying with customers and transfer to Hire
PurchaseTrading Account.
 Charge appropriate stock reserve.
Dr.
Date
To
To
To
To
To
To
Hire Purchase Trading Account
Rs.
Particulars
Date
Particulars
Balance b/d:
By Cash A/c
Hire Purchase Stock
By Goods Repossessed
(at H.P. price)
By A/c (Installments due
Hire Purchase
By but not paid)
Debtors
By Stock Reserve A/c
Goods Sold on H.P.
(Loading on opening
A/c (H.P. price)
H.P. stock)
Loss on Goods
Goods sold on H.P.
Repossessed A/c
A/c
Expenses A/c
(Loading on goods
Stock Reserve A/c
sold)
(Loading on closing
Balance c/d:
H.P. stock)
H.P. Stock (at H.P.
Profit & Loss A/c
price)
H.P. Debtors
Cr.
Rs.
Illustration 16
AB Limited sold one machine costing Rs.10,000 to Rama on hire purchase system at a price of
Rs.15,000 on 1st March 2013. Rs.3,000 was payable as down payment and monthly installment
of Rs.1000 was payable, first installment being payable in the month of delivery. At the end of
2013, 6 installments were received.
UNIT 2: Hire Purchase and Installment Transactions
Page 145
ICAN Advanced Accounting CAP II CHAPTER II
Prepare necessary ledgers in the books of AB Limited under debtors method.
Solution
Books of AB Ltd
HP Trading A/c
Particulars
To Goods sold on HP
To Stock reserve
(2,000 × 5,000/15,000)
To profit on HP (BF)
Rs.
15,000
667
4,333
Particulars
By Goods sold on HP (Loading)
By Bank
- Down Payment
- Installments
By Balance c/d
- HP Stock (Instal not due)
- HP Debtors (Instl due not received)
20,000
Rs.
5,000
3,000
6,000
2,000
4,000
20,000
Illustration 17
CSC & Co. sell goods on hire purchase, adding 50% to cost. From the following figures prepare
the Hire Purchase Trading Account:
Goods with customers in Shrawan, 2067, installments not yet due
5,400
Goods sold on hire purchase during 2067-68
25,500
Cash received from customers during 2067-68
20,100
Installments due but not yet received at the end of the year,
customers paying
1,800
All figures are on the basis of hire purchase price.
Solution
Hire-purchase Trading Account for the year ending 31st Ashadh, 2068
Dr
Particular
Amount
To Stock with customers on
01.04.2067 hire Purchase price
5,400
To Goods sold on Hire Purchase
25,500
To Stock Reserve Required
3,000
To Profit and Loss a.c
7,300
Page 146
Cr
Particular
By Cash
Amount
20,100
By Installments due
1,800
By Goods sold on Hire 8,500
Purchase A/c- Loading
By Stock Reserve(opening)
1,800
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
By Stock with Customers
41,200
*Stock with Customer on 31-03-2068
41,200
Installment not due on 01-04-2067
Rs. 5400
Goods Sold on Hire Purchase
Rs. 25,500
Less:
Rs. 20,100
Cash Received
Installment due
9,000
Rs.1,800
1.6 REPOSSESSION
In a hire purchase agreement the hire purchaser has to pay up to the last installment to obtain the
ownership of goods. If the hire purchaser fails to pay any of the installments, the hire vendor
takes the asset back in its actual form without any refund of the earlier payments to the hire
purchaser. The amounts received from the hire purchaser through down payment and
installments are treated as the hire charges by the hire vendor. This act of recovery of possession
of the asset is termed as repossession.
Repossessed assets are resold to any other customer after repairing or reconditioning (if
necessary). Accounting figures relating to repossessed assets are segregated from the normal
hire purchase entries. Repossessions are then accounted for in a separate “Goods Repossessed
Account”. So far as the repossession of assets are concerned, the hire vendor can take back the
whole of the asset or a part thereof depending on the agreement between the parties. The former
is called “Complete Repossession” and the latter “Partial Repossession”.
1.6.1 Complete Repossession
The hire vendor closes Hire Purchaser’s Account by transferring balance of Hire Purchaser
Account to Goods Repossessed Account.
The hire purchaser closes the Hire Vendor’s Account by transferring the balance of Hire Vendor
Account to Hire Purchase Asset Account and then finding the profit and loss on repossession in
Asset Account.
UNIT 2: Hire Purchase and Installment Transactions
Page 147
ICAN Advanced Accounting CAP II CHAPTER II
1.6.2 Partial Repossession
In case of a partial repossession, only apart of the asset is taken back by the hire vendor another
part is left with the hire purchaser. The Journal Entries are as usual up to the date of default
(excepting entry for payment) in the books of both the parties. As a portion of the assets still left
with the hire purchaser, neither party closes the account of the other in the irrespective books.
Assets are repossessed at a mutually agreed value (based on agreed rate of depreciation which is
an enhanced rate). The hire vendor debits the Goods Repossessed Account and credit the Hire
Purchaser Account with the value as agreed upon on the repossession. Similarly, the hire
purchaser debits the Hire Vendor Account and credits the Assets Account with the same
amount. If the repossessed value is less than the book value of the asset, the difference is
charged to the Statement of profit or Loss and Other Comprehensive Income of the hire
purchaser as ‘loss on surrender'. For the remaining portion of the asset lying with the hire
purchaser, the (Hire Purchaser)applies the usual rate of depreciation and shows the Asset
Account at its usual written-down value.
Illustration 18
From the following prepare Hire Purchase Trading Account of M/s Sipradi Traders who sells
goods on hire purchase basis at cost plus 25%.
Rs.
Installments not due on 31-12-2009
3,00,000
Installments due and collected during 2010
8,00,000
Installments due but not collected during 2010
Including. 10,000 for which goods were repossessed
50,000
Installments not due on 31-12-2010 including
Rs. 20,000 for which goods were repossessed
3,70,000
Installments collected on repossessed stock
15,000
M/s Sipradi Traders valued repossessed stock at 60% of original cost.
Page 148
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Solution
Working Notes:
(1) Hire Purchase Sales:
Rs.
Particular
Installments due and collected
Add: Installments due but not collected
Amount
8,00,000
50,000
8,50,000
(2) Loss on Repossessed stock:
Particular
Installment Collected
Installment Due
Installment Not Due
Cost
Value on Repossession
Cost of Installment due + Installment not
yet due
Loss
3. Goods taken from Shop Stock at Cost:
Particular
H.P sales at Cost
Add: Stock with Customers on 31.12.2010
at Cost
Less: Stock With Customer On 21.12.2009
at cost
45,000 * 100 / 125
36,000 * 60 / 100
( 10,000 + 20,000) * 100 /125
Amount
15,000
10,000
20,000
45,000
36,000
21,600
24,000
(24,000- 21,600)
(2,400)
850,000 * 100 / 125
Amount
680,000
280,000
(370,000 -20,000) * 100 / 125
300,000 * 100 / 125
(240,000)
720,000
4. Bad Debts
Particular
Installment due but not Collected
Installment not yet due at cost
20,000 * 100 /125
Less: Cost of Installments due and Installments not yet due
UNIT 2: Hire Purchase and Installment Transactions
Amount
10,000
16,000
26,000
24,000
2,000
Page 149
ICAN Advanced Accounting CAP II CHAPTER II
Hire Purchase Trading Account
Particular
To Goods with customer at Cost
( 31.12.2009)
To Goods taken from Shop
Stock at Cost:
To, Bad debt
To, Loss On repossession
To , Profit and Loss A/c Transfer of H.P
Amount
240,000
Particular
By, Hire Purchase Sales
Amount
850,000
720,000
By, Stocks with customer at 280,000
Cost (31.12.2010)
2,000
2,400
165,600
1,130,000
1,130,000
1.7 CALCULATION OF MISSING FIGURES
Sometimes in the examination, some figures required to calculate profit/loss are not given.
These may be: (i) Hire Purchase Stock; (ii) Hire Purchase Debtors; (iii) Purchases; or (iv)Cash
received, etc.. Before preparing the Hire Purchase Trading Account, the missing item(s)should
be calculated first. The following steps are followed:
Step 1: Draw up the following Memorandum Accounts.
(a) Memorandum Stock at Shop Account.
(b) Memorandum H.P. Stock Account/Stock with H.P. Customers Account.
(c) Memorandum H.P. Debtors Account/Installments Due Account
Step 2: Place the available figures in the respective accounts.
Step 3: Balance the account having maximum figures available. It will be helpful in finding out
the missing figure of that account.
Step 4: Place the figures so calculated in Step 3 to the relevant account.
Step 5: Continue the process of transfer until all the figures are available.
The proforma of these accounts are given below:
Memorandum Stock at Shop Account
Particular
To Balance b/d ( at Cost)
To Purchases
Page 150
Rs
Particular
Rs
By, Goods Sold on Hire
Purchase A/c ( at Cost)
By Balance c/d
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Memorandum Hire Purchase Stock Account
Dr.
Particular
Rs
To Balance B/d ( At HP price)
To H.P Stock A/c ( Total Installment
Due)
Dr.
Memorandum Hire Purchases Debtors Account
Particulars
To
To
Particular
By, Cash A/c
By, Goods Repossessed
A/c
By, Balance C/d
Cr.
Rs
Balance b/d (at H.P.
price)
H.P. Stock A/c
(total
installments due)
Rs.
Particulars
By
By
By
Cr.
Rs.
By ,Cash A/c
By, Goods Repossessed A/c
(install, due but not yet
recd.)
By, Balance c/d
2. INSTALLMENT PAYMENT SYSTEM
In installment payment system, the ownership of the goods is passed immediately to the buyer
on the signing the agreement. Because of this basic difference the accounting entries under
installment payment system are slightly different from those passed under the hire-purchase
system. The scheme of entries is as under:
a.
Books of buyer:
Buyer debits asset account with full cash price, credits vendor’s account with full
installment price and debits interest suspense account with the difference between full cash
price and full installment price. Interest is debited to interest suspense account (not interest
account) because it includes interest in respect of a number of years. Every year interest
account is debited and interest suspense account is credited with the interest of current
year.
Interest account, at the end of the year, is closed by transferring to Statement of profit or
Loss and Other Comprehensive Income.
The balance of interest suspense account (this is a debit balance) is shown in the Statement
of Financial Position on the asset side. Vendor is paid the installment due to him and entry
for the depreciation is passed in the usual way.
UNIT 2: Hire Purchase and Installment Transactions
Page 151
ICAN Advanced Accounting CAP II CHAPTER II
b. Books of Seller:
The seller debits the purchaser with the full amount (installment price) payable by him and
credits sales account by the full cash price and credits interest suspense account by the
difference between the total installment price and total cash price. Seller, like the buyer,
also transfers the amount of interest due from the interest suspense account to interest
account every year. Interest account is closed by transferring to Statement of profit or Loss
and Other Comprehensive Income and the balance of interest suspense account is shown in
the Statement of Financial Position on the liability side. On receiving the installment the
vendor debits cash/bank account and credits purchaser's account.
3.
DIFFERENCE BETWEEN HIRE PURCHASE AGREEMENT AND
INSTALLMENT PAYMENT AGREEMENT
A hire purchase agreement is a contract of bailment coupled with an option to the hire purchaser
to acquire the goods delivered to him under such an agreement. By the delivery of goods to the
hire purchaser, the hire vendor merely parts with their possession, but not the ownership. The
property or title to the goods is transferred to the hire-purchaser, on his paying the last
installment of the hire price or complying with some other conditions stipulated in the contract.
At any time before that the hire-purchaser has the option to return the goods and, if he does so,
he has only to pay the installments of price that by then have fallen due. The right or option to
purchase is the essence of hire-purchase agreement. In the event of a default by the buyer (hire
purchaser) in the payment of any of the installments of hire price, the vendor can take back the
goods into his possession. This is legally permissible since the property in the goods is still with
the vendor.
On the other hand, it may have been agreed between the buyer and the seller that the price of the
goods would be payable by installments and the property would immediately pass to the buyer;
in the event of a default of installments, it would not be possible for the vendor to recover back
the goods. He, however, would have the right to bring an action against the purchaser for the
recovery of the part of the price that has not been paid to him.
Analysis of the hire purchase price: The hire purchase price is always greater than the cash
price, since it includes interest payable over and above the price of the goods to compensate the
seller for the sacrifice he has made by agreeing to receive the price by installments and the risk
that he thereby undertakes. It is thus made up of following elements:
(a) cash price;
(b) interest on unpaid installments; and
(c) a charge to cover the risk involved in the buyer defaulting to pay one or more of
installments of price or that of his returning the goods in a damaged condition.
Page 152
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Interest is the charge for the facility to pay the price for the goods by installments after they
have been delivered. The rate of interest is generally higher than that payable in respect of an
advance or a loan since it also includes a charge to cover the risk that the hirer may fail to pay
any of the installments and, in such an event, the goods may have to be taken back into
possession in whatever condition they are at the time. A separate charge on this account is not
made as that would not be in keeping with the fundamental character of the hire-purchase sale.
Self-Assessment Question for Hire Purchase
Question 1
CG Electronics sells colour TVs., on hire purchase basis. Cost per set is Rs. 14,000,Cash sale
price Rs. 15,500 and hire purchase sale price is Rs. 16,800 for 12 monthly installments payable
by 10th of every month. However, the buyer has to make cash down Rs. 1,800 at the time of
purchase. Hire Purchase transactions (No. of sets) in 2069-70- Shrawan. 10, Bhadra. 12,
Ashwin10, Kartik12, Mangshir10, Poush10, Magh10, Falgun15, Chaitra. 11, Baishak.20,
Jestha.20, Ashad. 10.
Let us suppose all installments are duly collected. Show necessary Journal Entries.
Question 2
Kathmandu Television Emporium sells goods both on cash and hire- purchase basis and records
hire-purchase transactions on ‘stock and Debtors’ system and closes its books on Ashad end,
every year.
On 01.07.2069, it sold a colour TV set and DVD set to Rajkumar, other particulars are as
follow:Items
TV Set
DVD
Cost Price
Rs.9, 000
Rs.16,000
Down Payment
Rs.2, 000
Rs.4,000
Number of Installments Payable
10
8
Amount in each installment
Rs.1, 000
Rs.2,000
Mode of Payment
Monthly
Once in two months
First Installment Due on
1-5-2004
1-6-2004
Rajkumar paid all the installments due except for those due on Chaitra 1, 2069. it was decided
that Kathmandu Television Emporium will take back DVD at an agreed price of Rs.11, 000 and
excess amount, if any, will be adjusted against the installment due on TV set.
UNIT 2: Hire Purchase and Installment Transactions
Page 153
ICAN Advanced Accounting CAP II CHAPTER II
DVD repossessed was sold for Rs.12,000 after repair , charges for repairing was Rs.5000.
prepare necessary ledger accounts to record the above transactions and find out the profit, if
any.
Question 3
Home Equipment (Nepal) Ltd. commenced business on 1stShrawan 2069. The Business is to sell
toasters and geysers both for cash and on hire-purchase basis.
Information about terms is given below:Cash Price
Cost
Cash Down for hire-purchase
Monthly installment
Number of installment
Toasters (Rs.)
500
400
100
50
10
Geysers (Rs.)
1500
1200
300
150
12
The company purchased goods costing Rs.5,00,000 in all and made cash sales
Rs.4,30,000 Stock in hand on 31stAshad , 2070was valued at Rs.60,000.
totaling
Hire Purchase transaction were as follows:Installment
Number sold
Installment due
(Customers
paying)
Collected
Toasters
40
260
15
Geysers
20
110
10
3 toasters and 2 geysers on which only four installments per piece had been collected were
repossessed and were valued at a total sum of Rs.1,600. This is not included in the figure of
stock mentioned above. Prepare Accounts showing the profit earned by the company.
(Hint: Profit-Rs. 15,831)
Question 4
Lumbini Agencies started business on 1st Shrawan 2069. During the year ended 31st Ashad
2070,they sold under-mentioned durables under two schemes — Cash Price Scheme (CPS)
adhere-Purchase Scheme (HPS).
Under the CPS they priced the goods at cost plus 25% and collected it on delivery.
Page 154
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
Under the HPS the buyers were required to sign a Hire-purchase Agreement undertaking today
for the value of the goods including finance charges in 30 installments, the value being
calculated at Cash Price plus 50%.
The following are the details available at the end of 31st Ashad 2070 with regard to the
products:
Product
TV sets
Washing
Machines
Nos.
purchased
Nos. sold
under
CPS
90
70
20
20
Nos.
sold
under
HPS
60
40
Cost
per
unit
16,000
12,000
No. of
installments
due during
the year
1,080
840
No.
ofinstallments
receivedduring
theyear
1,000
800
The following were the expenses during the year:
Rs.
Rent
120,000
Salaries
144,000
Commission to Salesmen
12,000
Office Expenses
120,000
From the above information, you are required to prepare:
(a) Hire-purchase Trading Account, and
(b) Trading and Profit & Loss Account.
(Hints: HP Stock Rs. 990,000 Shop Stock Rs. 280,000 HP Stock Reserve Rs. 462,000, Profit
and Loss Rs. 798,000)
Calculation of Interest on Hire Purchase and Installments
1.
Calculation of interest when cash price and rate of interest is given
This is the case where cash price of goods sold on hire purchase is given and interest to be
charged in the hire purchase transaction is also given. In this situation, interest can be calculated
from beginning towards end of the installments.
Cash price
= Rs.400,000
Rate of Interest
= 10% p.a.
Date of sale
= 1.1.2015
Down payment
= Rs.100,000
UNIT 2: Hire Purchase and Installment Transactions
Page 155
ICAN Advanced Accounting CAP II CHAPTER II
Installment payments:
Date of Installments
Amount of Installments
31.12.2015
Rs.130,000
31.12.2016
Rs.120,000
31.12.2017
Rs.110,000
Cash price 1.1.2015
Rs.400,000
Less: Down payment
Rs.100,000
Balance
Rs.300,000
Add: Interest from 1.1.2015 to 31.12.2015
(300,000 × 10%)
Rs.30,000
Balance
Rs.330,000
Less: Installment (31.12.2015)
Rs.130,000
Balance as on 1.1.2016
Rs.200,000
Add: Interest from 1.1.2016 to 31.12.2016
(200,000 × 10%)
Rs.20,000
Balance
Rs.220,000
Less: Installments (31.12.2016)
Rs.120,000
Balance as on 1.1.2017
Rs.100,000
Add: Interest from 1.1.2017 to 31.12.2017
(100,000 × 10%)
Rs.10,000
Balance
Rs.110,000
Less: Installments (31.12.2017)
Rs.110,000
2.
Calculation of interest when rate of interest and amount of installments are given
This is the case where cash price is not given but amount of interest and rate of interest is
given. In such situation interest should be calculated from last installment towards
beginning of the installments.
Rate of Interest
Date of sale
Down payment
Installment payments:
Date of Installments
31.12.2015
31.12.2016
31.12.2017
Page 156
= 10% p.a.
= 1.1.2015
= Rs.100,000
Amount of Installments
Rs.130,000
Rs.120,000
Rs.110,000
UNIT 2: Hire Purchase and Installment Transactions
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 3:
GOODS ON SALE OR RETURN
UNIT 3: Goods on Sale or Return
Page 157
ICAN Advanced Accounting CAP II CHAPTER II
1.
INTRODUCTION
Sometimes goods are sent to the customers with an option to accept or reject the goods by the
customers within a specified time frame. This type of sale is called a “sale on approval basis" or
“sale on sale or return basis". The aim of selling the goods on approval basis is to push up the
sales. This option of “sale or return” is normally given only to approved and reliable customers.
When the goods are sold on approval basis it is a mere transfer of possession of goods (not the
ownership of goods) to the customer; therefore it cannot be called a sale. It becomes a sale only
when the approval of the customers is received or 'specified time frame' is elapsed or when
certain other conditions under Nepal Contract Act 2056 are fulfilled.
2.
METHODS FOR RECORDING GOODS SOLD ON APPROVAL BASIS
Accounting for goods sold on approval basis takes three forms according to the magnitude of
transactions in the accounting year. Transaction may be:
1. Recording of only few transactions;
2. Considerable number of transactions; and
3. Many transactions.
Accounting system for each situation has been explained below.
2.1 Recording of Few Transactions
If the transactions of goods sold on approval basis are few, there is no need to have a separate
entry system. In this case transactions are recorded as usual sales. If goods are accepted by
customer; no further entries are needed. In case the customer rejects the whole or part of the
goods, the sale has to be cancelled and reverse entry is passed accordingly. With respect to
goods which are rejected by the customer or not physically received by the customers, such
goods must be taken into stock at the time of preparing the final accounts. There is also the
possibility that with respect to some goods, neither acceptance nor rejection is received at the
time of preparing the final accounts. For such goods sale has to be cancelled and the goods lying
with customers must be taken into stock. The following are the accounting entries for different
scenarios discussed earlier.
Accounting Events
Debited
Customer
(1)
Goods sent on sale or return basis
No
(2)
On receipt of approval
Sales
(3)
On receipt of rejection by customer
(4)
No intimation from the customer at the Sales
end of accounting year
Account to be
Credited
Sales
Entry Customer
Customer
Note: In case of the items (3) and (4) goods lying with the customers must be taken into
inventory at cost or make price whichever is less. Such inventory is shown separately as 'goods
with customers on sale or return basis’.
Page 158
UNIT 3: Goods on Sale or Return
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 1: A cloth merchant casually sells goods to its approved customers on “sale or
return” basis treating all such transactions as actual sale at the time of dispatch. Just before the
end of the financial year some cloth costing Rs. 2000 was sent to Ram Babu Shah at 20% profit
on sale, and was passed through sale day book. How will you adjust the transaction on Ashad
end, if consent of Ram Babu Shah is pending?
Solution:
Cost of Goods
Add: Profit at 20% on sale or 25% on cost, i.e.
Sale price of goods sent on approval
25*Rs.2,000/100
Rs.
2,000
500
2,500
Entry made at the time of dispatch must have been:
Ram Babu Shah
To Sale Account
Rs.
Dr. 2,500
Rs.
2,500
Now as the consent of Ram Bahu Shah is pending on ashad end, two journal entries will be
passed. The first entry shall be for the cancellation of sale at sales price and second for bringing
stock at the end of the year into account at cost price. Entries are:
Rs.
(i)
Sale account
Dr. 2500
To Ram Babu Shah
2500
(For cancellation of sales)
(ii)
Stock with the customer’s account
Dr. 2000
To Trading account
(For recording stock at the end with the customer at cost price)
2000
2.2
Recording of Considerable Number of Transactions
If the number of transactions is considerable, the recording is not done as per first method
because in that case many entries for the cancellation on disapproval of the goods are needed
which become highly cumbersome. Recording in this case shall be as follows:
1.
A separate book called “sale or returns day book” is maintained as a memorandum record.
It is divided into 4 parts – first column for recording the total goods sent with date and
particulars of the party; second column for recording the actual sale when approval of the
customer is received; third column for recording the goods returned and fourth column for
recording the balance of stock still with the customers.
2.
When goods are sent for “Sales on Approval Basis” it is recorded in the first column only
as an aid to memory. No entry is passed in the main books. Customer is not a debtor nor is
it a sale.
3.
When goods are approved, it is recorded in the second column, and from there personal
accounts are debited and monthly total of the column is credited to sales account in the
main ledger. The usual posting arising out of sale are completed.
UNIT 3: Goods on Sale or Return
Page 159
ICAN Advanced Accounting CAP II CHAPTER II
4.
When goods returned, it is recorded in the third column but no entry for the return is made
because at the time goods were sent no entry was made.
5.
Balance of stock with each customer is taken to the fourth column and cost price of the
goods is calculated and entry for recording stock with the customers is passed at the end of
the year by debiting “stock with the customer account: and crediting “Trading Account” .
The form of the book is as follows:
First Column
Goods sent on approval
Date Particulars
Rs.
No entry is
made from
this column
Second Column
Goods approved
Particulars
Rs.
Entry for
sale is
made from
this column
Third Column
Goods returned
Particulars Rs.
No entry for
returns is made
from this
column
Fourth Column
Balance
Particulars R
s.
Balance is reduced
to cost price and
stock at the end is
recorded by passing
journal entry
2.3 Recording of many Transactions
If it is the usual practice of selling goods on approval basis and the number of transactions in a
given period of time is fairly large, in such a situation an elaborate recording procedure should
be adopted. For this purpose a separate day book is maintained for goods sent on sale or return
basis. This book is called ‘Sale or Return Day Book’. From this book individual accounts of
customers are debited with goods sent and credit is given to ‘Sale Or Return Total Account’
in a separate ledger called ‘Sale Or Return Ledger’.
Sale or Return Day Book
Date
Proforma Invoice
No
Name of
Customer
Description of
Goods
L.F.
Rs.
For the purpose of recording returns and retentions a separate Day Book is kept called ‘Sale or
Return inward Day Book’. The format of the Day Book is given below:
Sale or Return Inward Day Book
Date
Page 160
Proforma
Credit Note No.
Name of
Customer
Description
of Goods
L.F.
Retained
Rs.
Returns
Rs.
UNIT 3: Goods on Sale or Return
ICAN Advanced Accounting CAP II CHAPTER II
Proforma Credit Note refers to the goods returned by customers. For Goods retained, the
customer may intimate by way of retention note which the seller has to send along with goods.
From the day book both the returns and retentions are posted to the debit of ‘sale or return total
account’ in the ‘Sale or Return Ledger’ and credit is given to individual customers accounts in
the same ledger. Thus the balance in the customers account represents the balance of goods with
him for which he has neither accepted nor rejected. Similarly, the net balance in the ‘sale or
return ledger account’ represents the goods with the customer for which there is neither
approval nor rejection. While the balances in the individual accounts are debit balances, the
balances in the ‘sale or return ledger account’ are credit balance. These accounts are only
control accounts. Therefore, with respect to goods retained by the customers, sale should be
recorded in the Sale Day Book and posted to the concerned customers' accounts in the regular
ledger.
Illustration 2: Hundai Automobiles Ltd. sent out motor cars on Sale or Return basis. They
maintained a separate set of books for this type of business. During the month of Shrawan 2070
they sent out motor cars as follows:
2070
Shrawan 2
Shrawan 16
Shrawan 20
Shrawan 28
Customer's name
Y & Co. Ltd.
X & Co. Ltd
Y & Co. Ltd
X& Co. Ltd
Rs.
100,000
150,000
160,000
200,000
2070
Shrawan 7
Shrawan 20
Shrawan 25
Shrawan 28
Remarks
Returned
Retained
Returned
No information received
as to approval and car
not yet returned.
Required:
Show Day Books and Ledger Accounts.
Solution:
Sale or Return Day Book
Date
Particulars
Shrawan 2
Y & Co. Ltd.
Shrawan 16
X & Co. Ltd
Shrawan 20
Y & Co. Ltd
Shrawan 28
X & Co. Ltd
Total
Date
2002 Shrawan 7
Shrawan 20
Shrawan 25
Folio
Amount Rs.
100,000
150,000
160,000
200,000
610,000
Sale or Return Sold and Returned Day Book
Sales
or Sales
Goods
Particulars
Return Folio
Folio
Sold Rs.
Y&Co.Ltd.
X&Co.Ltd
150,000
Y&Co.Ltd
-
UNIT 3: Goods on Sale or Return
Goods
Returned Rs.
100,000
160,000
Page 161
ICAN Advanced Accounting CAP II CHAPTER II
Sales or Return Account
Date
Particulars
Rs.
Date
Particulars
Rs.
Shrawan 30
To
Sales
Sundries
150,000
2070
Shrawan 30
By Sundaries:
Goods sent
on sale or
return basis)
610,000
Shrawan 30
To
Sundaries
Return
To Balance C/d
260,000
Shrawan 30
Date
2070
Shrawan 2
Shrawan
20
Date
2070
Shrawan 16
Shrawan 28
Particulars
To Sales
Return
To Sales
Return
or
or
Particulars
To Sales or
Return
To Sales or
Return
200,000
610,000
610,000
Y & Co. Ltd Account
Rs.
Date
100,000 2070
Shrawan 7
160,000 Shrawan
25
260,000
X & Co. Ltd Account
Rs.
Date
150,000 2070 Shrawan 7
200,000
Shrawan 25
350,000
Particulars
Sales or Return
By
Sales
Return
Rs.
100,000
or
160,000
260,000
Particulars
By Sales or
Return
By Balnce c/d
Rs.
150,000
200,000
350,000
Note: Balance of sale or return account represents goods with customer on Sale or Return at
invoice price, awaiting approval.
Self-Assessment Questions
Question 1: Robin Polymer Nepal Ltd. supply their products in returnable bags. A bag is
invoiced to the customer @ Rs. 40 but if it is returned within two months, a credit of Rs.
35 is given to him. A bag costs Rs.35 to the company and its estimated life is 6 years at the
end of which the scrap value is likely to be Rs.5. The following Particulars are supplied to
you:
Bags with customers ( 01.04.2069)
Bags in hand (01.04.2069)
Bags sent to customers during 2069-70
Bags returned by customers during 2069-70
Bags Purchased during 2069-70
Bags returnable
Bags scrapped during 2069-70, useful life being over
Page 162
Nos.
10,000
14,000
60,000
63,000
1,000
6,000
1,500
UNIT 3: Goods on Sale or Return
ICAN Advanced Accounting CAP II CHAPTER II
Amount realised from sale of scrapped Bags is Rs. 8,000. Depreciation is to be provided on
straight line basis.
Question 2: Sagarmatha Ltd supplied goods on Sale or Return basis, the particulars of
which are as under:
Date of
Dispatch
Ashad 10
Ashad 15
Ashad 20
Ashad 27
Ashad 28
Customer’
s name
A Ltd
B Ltd
C Ltd
B Ltd
C Ltd
Amount
Rs.
2,600
3,400
1,900
2,200
1,700
Other Particulars
Ashad 14- Returned
Ashad 17- Retained
Ashad 25- Goods worth Rs.
800 returned
No information till Ashad31
- do-
(Hint: Goods sold Rs. 4,500; Goods returned- Rs. 3,400, Invoice value of goods not
yet approved: Rs. 3,900)
UNIT 3: Goods on Sale or Return
Page 163
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 4:
CONTRACT ACCOUNTS
Page 164
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
1. INTRODUCTION OF CONSTRUCTION CONTRACT
A construction contract is a contract specifically negotiated for the construction of an asset or a
combination of assets that are closely interrelated or interdependent in terms of their design,
technology and function or their ultimate purpose or use. A construction contract may be
negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road,
hydropower, runway of airport or tunnel. A construction contract may also deal with the
construction of a number of assets which are closely interrelated or interdependent in terms of
their design, technology and function or their ultimate purpose or use; examples of such
contracts include those for the construction of refineries and other complex pieces of plant or
equipment. Construction contracts include:
1.
2.
Contracts for the rendering of services which are directly related to the construction of the
assets, for example, those for the services of project managers and architects; and
Contracts for the destruction or restoration of assets, and the restoration of the environment
following the demolition of assets.
When a contract covers a number of assets, the construction of each asset shall be treated as a
separate construction contract when:
- separate proposals have been submitted for each asset;
- each asset has been subject to separate negotiation and the contractor and customer
have been able to accept or reject that part of the contract relating to each asset; and
- the costs and revenues of each asset can be identified.
A group of contracts, whether with a single customer or with several customers, shall be treated
as a single construction contract when:
- the group of contracts is negotiated as a single package;
- the contracts are so closely interrelated that they are, in effect, part of a single project
with an overall profit margin; and
- the contracts are performed concurrently or in a continuous sequence.
A contract may provide for the construction of an additional asset at the option of the customer
or may be amended to include the construction of an additional asset. The construction of the
additional asset shall be treated as a separate construction contract when:
- the asset differs significantly in design, technology or function from the asset or assets
covered by the original contract; or
- the price of the asset is negotiated without regard to the original contract price.
The main feature of a ‘contract’ is that it is a major job and normally, executed during more
than once accounting period. It is also work done, not at the premises of the contractor, but, at
locations chosen by the contractee - owner or employer. A contractor is a person who
undertakes the construction of a building, a bridge, a cinema hall or such other civil works, for
which he has the necessary experience and expertise. The other party to the contract is called the
contractee - owner or employer, who seeks the helps of the contractor to construct a building
UNIT 4: Contract Accounts
Page 165
ICAN Advanced Accounting CAP II CHAPTER II
etc., and agrees to pay consideration for the same. The contract is the agreement between the
contractor and the contractee - owner or employer, which stipulates the rights and obligations of
both the parties.
Construction contract is generally of two types:
- A Cost Plus Contract is a construction contract in which the contractor is reimbursed
for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.
- A Fixed Price Contractis a construction contract in which the contractor agrees to a
fixed contract price, or a fixed rate per unit of output, which in some cases is subject to
cost escalation clauses.
2.
CONTRACT REVENUE
Contract Revenue shall comprise:
(a) the initial amount of revenue agreed in the contract; and
(b) variations in contract work, claims and incentive payments :
- to the extent that it is probable that they will result in revenue; and
- they are capable of being reliably measured.
Contract revenue is measured at the fair value of the consideration received or receivable. The
measurement of contract revenue is affected by a variety of uncertainties that depend on the
outcome of future events. The estimates often need to be revised as events occur and
uncertainties are resolved. Therefore, the amount of contract revenue may increase or decrease
from one period to the next. For example:
 a contractor and a customer may agree variations or claims that increase or decrease
contract revenue in a period subsequent to that in which the contract was initially
agreed;
 the amount of revenue agreed in a fixed price contract may increase as a result of cost
escalation clauses;
 the amount of contract revenue may decrease as a result of penalties arising from delays
caused by the contractor in the completion of the contract; or
 when a fixed price contract involves a fixed price per unit of output, contract revenue
increases or decreases as the number of units is increased or decreased.
Variation is an instruction by the customer for a change in the scope of the work to be
performed under the contract. A variation may lead to an increase or a decrease in contract
revenue. Examples of variations are changes in the specifications or design of the asset and
changes in the duration of the contract. A variation is included in contract revenue when:
(a) it is probable that the customer will approve the variation and the amount of revenue arising
from the variation; and
(b) the amount of revenue can be reliably measured.
Page 166
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Claim is an amount that the contractor seeks to collect from the customer or another party as
reimbursement for costs not included in the contract price. A claim may arise from, for
example,customer caused delays, errors in specifications or design, and disputed variations in
contract work. The measurement of the amounts of revenue arising from claims is subject to a
high level of uncertainty and often depends on the outcome of negotiations.
Therefore, claims are included in contract revenue only when:
- negotiations have reached an advanced stage such that it is probable that the customer
will accept the claim; and
- the amount that it is probable will be accepted by the customer can be measured
reliably.
Incentive Paymentsare additional amounts paid to the contractor if specified performance
standards are met or exceeded. For example, a contract may allow for an incentive payment to
the contractor for early completion of the contract. Incentive payments are included in contract
revenue when:
(a) the contract is sufficiently advanced that it is probable that the specified performance
standards will be met or exceeded; and
(b) the amount of the incentive payment can be measured reliably.
3. CONTRACT COSTS
Contract costs shall comprise:
(a) costs that relate directly to the specific contract;
- Site labour costs, including site supervision;
- Costs of materials used in construction;
- Depreciation of plant and equipment used on the contract;
- Costs of moving plant, equipment and materials to and from the contract site;
- Costs of hiring plant and equipment;
- Costs of design and technical assistance that is directly related to the contract;
- Estimated costs of rectification and guarantee work, including expected warranty costs;
and
- Claims from third parties.
These costs may be reduced by any incidental income that is not included in contract revenue,
for example income from the sale of surplus materials and the profit on disposal of plant and
equipment at the end of the contract.
(b) Costs that are attributable to contract activity in general and can be allocated to the
contract;
Costs that may be attributable to contract activity in general and can be allocated to specific
contracts include:
UNIT 4: Contract Accounts
Page 167
ICAN Advanced Accounting CAP II CHAPTER II
i.
ii.
iii.
insurance;
costs of design and technical assistance that is not directly related to a specific contract;
and
construction overheads.
Such costs are allocated using methods that are systematic and rational and are applied
consistently to all costs having similar characteristics. The allocation is based on the normal
level of construction activity. Construction overheads include costs such as the preparation and
processing of construction personnel payroll. Costs that may be attributable to contract activity
in general and can be allocated to specific contracts also include borrowing costs as permissible
by NAS 23 Borrowing Costs.
(c) Such other costs as are specifically chargeable to the customer under the terms of the
contract.
Costs that are specifically chargeable to the customer under the terms of the contract may
include some general administration costs and development costs for which reimbursement is
specified in the terms of the contract.
Costs that cannot be attributed to contract activity or cannot be allocated to a contract are
excluded from the costs of a construction contract. Such costs include:
i.
ii.
iii.
iv.
General administration costs for which reimbursement is not specified in the contract;
Selling costs;
Research and development costs for which reimbursement is not specified in the contract;
and
Depreciation of idle plant and equipment that is not used on a particular contract.
Contract costs include the costs attributable to a contract for the period from the date of securing
the contract to the final completion of the contract. However, costs that relate directly to a
contractand are incurred in securing the contract are also included as part of the contract costs if
they can be separately identified and measured reliably and it is probable that the contract will
be obtained. When costs incurred in securing a contract are recognized as an expense in the
period in which they are incurred, they are not included in contract costs when the contract is
obtained in a subsequent period.
4. RECOGNITION OF CONTRACT REVENUE AND EXPENSES
There are two methods for revenue recognition applied differently depending upon the
estimation of the outcome of a construction contract:
a
When the outcome of a construction contract can be estimated reliably
When the outcome of a construction contract can be estimated reliably, contract revenue
and contract costs associated with the construction contract shall be recognised as revenue
and expenses respectively by reference to the stage of completion of the contract activity
at the Statement of Financial Position date. An expected loss on the construction contract
shall be recognised as an expense immediately.
Page 168
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
In the case of a fixed price contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:
- total contract revenue can be measured reliably;
- it is probable that the economic benefits associated with the contract will flow to the
entity;
- both the contract costs to complete the contract and the stage of contract completion at
the Statement of Financial Position date can be measured reliably; and
- the contract costs attributable to the contract can be clearly identified and measured
reliably so that actual contract costs incurred can be compared with prior estimates.
In the case of a cost plus contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:
- it is probable that the economic benefits associated with the contract will flow to the
entity; and
- the contract costs attributable to the contract, whether or not specifically reimbursable,
can be clearly identified and measured reliably.
The outcome of a construction contract can only be estimated reliably when it is probable that
the economic benefits associated with the contract will flow to the entity. However, when an
uncertainty arises about the collectability of an amount already included in contract revenue,
and already recognised in the income statement, the uncollectible amount or the amount in
respect of which recovery has ceased to be probable is recognised as an expense rather than as
an adjustment of the amount of contract revenue.
An entity is generally able to make reliable estimates after it has agreed to a contract which
establishes:
(a) each party’s enforceable rights regarding the asset to be constructed;
(b) the consideration to be exchanged; and
(c) the manner and terms of settlement.
It is also usually necessary for the entity to have an effective internal financial budgeting and
reporting system. The entity reviews and, when necessary, revises the estimates of contract
revenue and contract costs as the contract progresses. The need for such revisions does not
necessarily indicate that the outcome of the contract cannot be estimated reliably.
The recognition of revenue and expenses by reference to the stage of completion of a contract is
often referred to as the Percentage Of Completion Method. Under this method, contract
revenue is matched with the contract costs incurred in reaching the stage of completion,
resulting in the reporting of revenue, expenses and profit which can be attributed to the
proportion of work completed. This method provides useful information on the extent of
contract activity and performance during a period.
Under the percentage of completion method, contract revenue is recognised as revenue in the
income statement in the accounting periods in which the work is performed. Contract costs are
UNIT 4: Contract Accounts
Page 169
ICAN Advanced Accounting CAP II CHAPTER II
usually recognised as an expense in the income statement in the accounting periods in which the
work to which they relate is performed. However, any expected excess of total contract costs
over total contract revenue for the contract is recognised as an expense immediately.
The stage of completion of a contract may be determined in a variety of ways. The entity uses
the method that measures reliably the work performed. Depending on the nature of the contract,
the methods may include:
- the proportion that contract costs incurred for work performed to date bear to the
estimated total contract costs;
- surveys of work performed; or
- completion of a physical proportion of the contract work.
Progress payments and advances received from customers often do not reflect the work
performed.
When the stage of completion is determined by reference to the contract costs incurred to date,
only those contract costs that reflect work performed are included in costs incurred to date.
Examples of contract costs which are excluded are:
- contract costs that relate to future activity on the contract, such as costs of materials that
have been delivered to a contract site or set aside for use in a contract but not yet
installed, used or applied during contract performance, unless the materials have been
made specially for the contract; and
- payments made to subcontractor in advance of work performed under the subcontract.
The percentage of completion method is applied on a cumulative basis in each accounting
period to the current estimates of contract revenue and contract costs. Therefore, the effect of a
change in the estimate of contract revenue or contract costs, or the effect of a change in the
estimate of the outcome of a contract, is accounted for as a change in accounting estimate (see
NAS-08 Accounting Policies, Changes in Accounting Estimates & Errors). The changed
estimates are used in the determination of the amount of revenue and expenses recognised in the
income statement in the period in which the change is made and in subsequent periods.
b. When the outcome of a construction contract cannot be estimated reliably
When the outcome of a construction contract cannot be estimated reliably:
- revenue shall be recognised only to the extent of contract costs incurred that it is
probable to be recoverable; and
- contract costs shall be recognised as an expense in the period in which they are incurred.
An expected loss on the construction contract shall be recognised as an expense
immediately.
During the early stages of a contract it is often the case that the outcome of the contract cannot
be estimated reliably. Nevertheless, it may be probable that the entity will recover the contract
costsincurred. Therefore, contract revenue is recognised only to the extent of costs incurred that
are expected to be recoverable. As the outcome of the contract cannot be estimated reliably, no
profit is recognised. However, even though the outcome of the contract cannot be estimated
Page 170
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
reliably, it may be probable that total contract costs will exceed total contract revenues. In such
cases, any expected excess of total contract costs over total contract revenue for the contract is
recognised as an expense immediately.
Contract costs that are not probable of being recovered are recognised as an expense
immediately. Examples of circumstances in which the recoverability of contract costs incurred
may not be probable and in which contract costs may need to be recognized as an expense
immediately include contracts:
a.
b.
c.
d.
e.
which are not fully enforceable, i.e., their validity is seriously in question;
the completion of which is subject to the outcome of pending litigation or legislation;
relating to properties that are likely to be condemned or expropriated;
where the customer is unable to meet its obligations; or
where the contractor is unable to complete the contract or otherwise meet its obligations
under the contract.
When the uncertainties that prevented the outcome of the contract being estimated reliably no
longer exist, revenue and expenses associated with the construction contract shall be recognized.
5.
CONTRACT WORK IN PROGRESS
A contractor may have incurred contract costs that relate to future activity on the contract. Such
contract costs are recognised as an asset provided it is probable that they will be recovered.
Such costs represent an amount due from the customer and are often classified as contract work
in progress.
6.
RECOGNITION OF EXPECTED LOSSES
When it is probable that total contract costs will exceed total contract revenue, the expected loss
shall be recognised as an expense immediately. The amount of such a loss is determined
irrespective of:
a.
b.
c.
7.
whether work has commenced on the contract;
the stage of completion of contract activity; or
the amount of profits expected to arise on other contracts which are not treated as a single
construction contract
DISCLOSURE REQUIREMENT IN CASE OF CONSTRUCTION CONTRACT
An entity shall disclose:
a. the amount of contract revenue recognised as revenue in the period;
b. the methods used to determine the contract revenue recognised in the period; and
c. the methods used to determine the stage of completion of contracts in progress.
An entity shall disclose each of the following for contracts in progress at the Statement of
Financial Position date:
UNIT 4: Contract Accounts
Page 171
ICAN Advanced Accounting CAP II CHAPTER II
a.
b.
c.
the aggregate amount of costs incurred and recognized profits (less recognised losses) to
date;
the amount of advances received; and
the amount of retentions.
Retentions are amounts of progress billings which are not paid until the satisfaction of
conditions specified in the contract for the payment of such amounts or until defects have been
rectified. Progress billings are amounts billed for work performed on a contract whether or not
they have been paid by the customer. Advances are amounts received by the contractor before
the related work is performed.
An entity shall present:
a. the gross amount due from customers for contract work as an asset; and
b. the gross amount due to customers for contract work as a liability.
The gross amount due from customers for contract work is the net amount of:
a.
b.
costs incurred plus recognised profits; less
the sum of recognised losses and progress billings for all contracts in progress for which
costs incurred plus recognised profits (less recognised losses) exceeds progress billings.
The gross amount due to customers for contract work is the net amount of:
a.
b.
costs incurred plus recognised profits; less
the sum of recognised losses and progress billings for all contracts in progress for which
progress billings exceed costs incurred plus recognised profits (less recognised losses).
An entity discloses any contingent liabilities and contingent assets in accordance with NAS-37
Provisions, Contingent Liabilities and Contingent Assets. Contingent liabilities and contingent
assets may arise from such items as warranty costs, claims, penalties or possible losses.
Illustration 1: A contractor has entered into a contract to construct a building. The costs on the
contract worked out to Rs. 1,050,000. What would be his profit or loss on the contract?
(i) If the contract is for a fixed price of Rs. 1,000,000
(ii) For a price of cost plus 10%
Solution:
(i)
In this case as the revenue is Rs. 1,000,000 and the costs are Rs. 1,050,000, the loss on
contract is Rs.
500,00.
(ii) In this case, the contractor would receive
Rs. 1,155,000
Rs. 1,050,000 plus 10% of Rs. 1,050,000
1,050,000
Less: Cost incurred
Profit on the contract
Rs.
105,000
Page 172
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
8.
TRADITIONAL METHOD FOR ACCOUNTING FOR CONTRACT
In the traditional method there are two steps involved in determining the profit (or loss) to be
taken for the accounting period from the contract partly executed. They are:
 Finding out the notional profit on the contract by matching the costs with revenues and
revenues are recognized on the basis of work certified by the architects.
 Determining the amount of profit to be considered for the accounting period having
regard to the stage of completion.
8.1 Ascertainment of Notional Profit
There are again two methods of ascertaining the notional profit. The first method is to match the
revenues recognized for the accounting period with the costs incurred up to the accounting date.
The second method is followed when the contract is at an advanced stage of completion. In this
case the notional profit is calculated by matching the total costs required to complete the
contract with the total revenue being the contract price. The total contract cost is arrived at by
adding to the costs so far incurred, the estimated costs required to complete the balance of
contract.
Whatever method is followed to ascertain the notional profit, the accounting entries, needed to
complete the contract, are given below:
No.
Account to be
Transaction
5
Debited
Materials Purchased for the Contract Contract
Wages and Salaries
Contract
Plant Issued to Contract
Contract
Depreciated Value of Plant on Plant*
accounting date
Wage and Salaries Out-standing
Contract
6
7
8
9
Value of Work Certified
Cash Received from Contractee
Work Uncertified
Materials at Site
1
2
3
4
*
Contractee**
Bank
Work-in-progress
Work-in-process
Credited
Bank
Bank
Plant
Contract
Wages and salaries
outstanding
Contract
Contractee
Contract
Contract
Alternatively, the amount may be debited to work in progress. In the next accounting
period as part of work in progress, the plant would once again be transferred to the debit of
contract account. When the contract is completed the remaining value of the plant would
have to be transferred to the plant account and not to work in progress account.
UNIT 4: Contract Accounts
Page 173
ICAN Advanced Accounting CAP II CHAPTER II
**
Alternatively work certifiedmay be debited to work in progress account, during the next
accounting period the same will be transferred to the credit side of contract account.
8.2
Calculation of Profit from the Notional profit
If the contract account shows a loss, such loss must be fully provided. However, when the
contract account discloses a profit, all such profit cannot be deemed as profit since, in a
subsequent accounting period there may be escalation of costs and such other contingencies.
Therefore, only a proportion of the national profit is deemed to be profit and balance is credited
to work in progress account. There are certain rules of thumb regarding the portion of profit to
be provided for contingencies. They are given below:Completion stage
Below 25%
25% to less than 50%
50% to less than 95%
95% and above
Profits to be provided for contingencies
Full
Two –Thirds
One- Third
Nil
The profits to be taken, as earned for the accounting period, must further be reduced on what is
called ‘cash basis’. Cash basis is the proportion of cash received to work certified. For example,
if 40% of contract is completed, Rs. 60,000 is the notional profit and 80% of work certified is
received in cash from the contractee, profit earned would be calculated as shown below:
Profit earned = National profit X 1/3 X80%
= Rs. 60,000 X 1/3 X80%
= Rs. 16,000
In the above example, out of the notional profit of Rs. 60,000, a sum of Rs. 16,000 will be
deemed to be the profit for the accounting period and the balance of Rs. 44,000 will be carried
forward towards contingencies.
Illustration 2: The contract ledger of a company showed the following expenditure on account
of a contract on 31stAshad 2070.
Materials
Plant
Wages
Establishment charges
Rs. 1,200,000
Rs. 200,000
Rs. 1,644,000
Rs. 86,000
The contract was commenced on 1stShrawan 2069, and the contract price was Rs. 6,000,000.
Cash received, on the contract to date, was Rs. 2,400,000, representing 80% of the work
certified, the remaining 20%, being retained until completion. The value of material on hand
was Rs. 40,000 and the cost of work finished, but not certified, on 31stAshad 2070 was Rs.
60,000.
Prepare an account in respect of the contract showing the profit to date, assuming depreciation
on plant at 10% per annum and state the proportion of profit the company would be justified in
talking to the credit of Statement of Profit or Loss.
Page 174
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Contract Account
Dr.
Particular
To materials
To Plant
To Wages
To Estt. Charges
To Balance being notional profit
To General profit and loss
account
To Work-in-progress account
reserve for contingencies
(balancing figure)
Cr.
Rs. Particular
1,200,000 By Work-in-progress:
200,000
Work certified
1,644,000
Work uncertified
86,000
Materials on hand
150,000 By Plant less depreciation
3,280,000
Rs.
3,000,000
60,000
40,000
180,000
3,280,000
80,000
70,000 By Balance being notional
profit
150,000
150,000
______
150,000
Notes:
1.
2.
3.
Work certified: Since cash received is 80% of work certified and cash received is Rs.
24,00,000.
Work certified = 24,00,000 x 100/80 = Rs. 30,00,000.
Plant less depreciation = Rs.2,00,000 – Rs.20,000 = Rs.1,80,000.
Profit earned is taken to general Statement of Profit or Loss: Since only half the contract
has been completed. Two-thirds of the profit reduced on cash basis can be taken and the
calculation is shown below:
Rs. 1,50,000 X 2/3 X 80/100 = Rs.80,000.
Illustration 3:Mr Santosh Shrestha commenced a contract on 1stShrawan 2069. The price,
agreed for the contract, was Rs. 5,00,000. At the end of 2069-70, the contract was in advanced
stage of completion and it was decided to arrive at the notional profit on the basis of the total
contract. The contract is expected to be completed by the end of Poush 2070. Actual
expenditure, for the 2069-70 and estimated expenditure for 2070-71, are given below:
Expenses
Materials
Labour
Plant purchased (at original cost)
Misc. Expenses
Plant returned on stores on 31st
Dec. 1998
UNIT 4: Contract Accounts
Actual till 31-032070
Rs.1,40,000
80,000
40,000
25,000
10,000
Estimated for 2069-70
(up to 30-09-2070)
Rs. 40,000
20,000
4,000
-
Page 175
ICAN Advanced Accounting CAP II CHAPTER II
(Original cost)
Plant returned to stores on 30th
June 1999
(Original cost)
Materials at Site
3,60,000
Work certified
Work uncertified
Cash received
-
20,000
5,000
4,50,000
10,000
Nil
5,00,000
Nil
5,00,000
The plant is subject to annual depreciation at 20% on straight line basis. You are required to
prepare the contract account for the year ended 31stAshad 2070. Working should be part of your
answer.
Solution:
Particular
To materials
To Labour
To Plant
To Misc. Expenses
To Profit and Loss A/c (2)
To Work-in-progressBalance of profit c/d
To Work-in-progress b/d
In the books of Santosh Shrestha
Contract Account
For the year ended 31.03.2070
Rs.
Particular
140,000 By Plant returned to stores (3)
80,000 By Work-in-progress:
40,000
Plant at site (4)
25,000
Materials at site
136,800
Work certified
75,200
Work uncertified
_______
497,000
489,000 By work-in-progress b/d (7)
Rs.
8,000
24,000
5,000
450,000
10,000
_______
497,000
75,200
Working notes:
1.
Particular
To materials
To Labour
To Plant
To Misc. Expenses
To Estimated Profit
Page 176
Memorandum Contract Account
For Six months ended 30th Poush 2070
Rs.
Particular
180,000 By Plant returned to stores (3&4)
100,000 By Plant at site(6)
40,000 By Contractee’s A/c
29,000
190,000
539,000
Rs.
32,000
7,000
500,000
_______
539,000
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
2.
Profit on contract to be taken to Statement of Profit or Loss for the year ending
31.03.2070.
Estimated profit
x
Rs.1,90,000
Work certified
Cash received x
Work Certified Total Contract Price
x
3,60,000
x
4,50,000
4,50,000
5,00,000
3.
Plant returned to stores on 31.03.2070
Original cost
Less: Depreciation @ 20% for one year
4.
Plant at site on 31.03.2070
Original cost
Less: Plant returned to Stores
Balance at site at original cost
Less: Depreciation@20% on Rs. 30,000
5.
6.
7.
Plant returned to stores on 30th Poush.2070
Original cost
Less: Depreciation @ 20% for 18 months
Plant returned to stores on 30th Poush, 2070
Original cost
Less: Depreciation @ 20% for 18 months
= Rs.1,36,800
Rs.
10,000
2,000
8,000
40,000
10,000
30,000
6,000
24,000
20,000
6,000
14,000
10,000
3,000
7,000
Alternatively, Rs. 75,200 can be shown as deduction from work-in-progress on the debit
side of contract account.
Illustration 4:Dhurmuse secured a contract to construct a building for a sum of Rs. 3,00,000.
He received, from time to time, cash equal to 80% of the value of work certified. The following
is the abstract of particulars, relating to the contract for the year ending 31stAshad 2067.
Particular
Machinery and tools issued
Stores sent to site
Direct purchase of materials
Wages
Misc. Expenses
Materials on hand
Materials returned to stores
Wages due and remaining unpaid
Progress payment received
UNIT 4: Contract Accounts
Rs.
28,000
68,000
12,000
50,000
12,500
4,200
6,200
8,900
1,70,000
Page 177
ICAN Advanced Accounting CAP II CHAPTER II
A portion of the machinery, costing Rs. 5,000 was found unserviceable and was sold for Rs.
4,000. The value of the machinery and tools on hand on Ashad end was Rs. 16,000.
In order to ascertain his profits to 31stAshad 2067, the contractor decided to take into
consideration the additional expenditure to complete the contract and to take to the Statement of
Profit or Lossfor the year that portion of the net profit to be realized on the contract which the
certified value of the work done bore to the contract price. He estimated the additional
expenditure at Rs. 70,000 and the residual value of machinery at Rs. 3,700 on the completion of
the contract.
Prepare the contract account for the year ended 31stAshad 2067 and show your calculation of
the profit to be credited to the Statement of Profit or Loss for the year.
Solution:
CONTRACT ACCOUNT
for the year ended 31stAshad 2067
Particular
To Machinery and tools
Stores ledger control account
stores sent to site
Bank-direct purchase
Bank-wages paid
Wages outstanding
Miscellaneous expenses
Balance-notional profit
Profit and loss account
Work-in-progress-profit
forward
carried
Rs.
Particular
28,000 By Stores ledger control
accountMaterials returned
68,000 By Bank-sale of machinery
12,000 By Work-in-progress:
50,000
Work certified
8,900
Materials on hand
12,500
Machinery
63,500
2,42,900
36,550 By Balance-notional profit
26,950
63,500
Rs.
6,200
4,000
2,12,500
4,200
16,000
_______
2,42,900
63,500
______
63,500
Working Notes
1. Notional profit on contract:
Expenditure during the account period:
Rs.
Machinery and tools used
Stores sent to site
Direct purchase of materials
Wages paid
Wages due
Miscellaneous expenses
Less: Materials returned
Materials sold
Machinery at close
Page 178
Rs.
28,000
68,000
12,000
50,000
8,900
12,500
1,79,400
6,200
4,000
3,700
13,900
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
1,65,500
70,000
2,35,500
3,00,000
64,500
Add: Estimated additional expenditure
Total expenditure
Contract price
Profit on contract
Profit to be taken to Statement of Profit or Loss reduced on cash basis:
Rs.64,500 X 2,12,500 X 80=36,550
3,00,000 100
Profit to be carried forward for contingencies:
Rs. 63,500 – Rs.36,500 = Rs.26,950
Illustration 5: The following particulars are obtained from the books of Lumbini Construction
Co. Ltd., as on Ashad 31st 2070:
Plant and equipment at cost
Rs. 4,900,000
Vehicles at cost
Rs. 2,000,000
Details of contract which remain uncompleted as on 31.3.2070:
Contract Nos.
V.20
Estimated final sales value
8.00
Estimated final cost
6.40
Wages
2.40
Materials
1.00
Overheads(excluding depreciation)
1.44
Total costs to date
4.84
Value certifies by architects
7.20
Progress payments received
5.00
Rs. in Million
V.24
V.25
5.60
16.00
7.00
12.00
2.00
1.20
1.10
0.44
1.46
0.58
4.56
2.22
4.20
2.40
3.2
2.00
Depreciation of Plant and Equipment and Vehicles should be charged at 20% to the three
contract in proportion to work certified.
You are required to prepare statements showing contract-wise and total.
(i) Profit/Loss to be taken to the P & L A/c for the year ended 31stAshad 2070; and
(ii) Work-in-progress as would appear in the Statement of Financial Position as at 31stAshad
2070.
UNIT 4: Contract Accounts
Page 179
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Lumbini Construction Co. Ltd.
Profit /Loss to be taken to Statement of Profit or Loss
(for the year ended 31stAshad,2070)
Particulars
A. Percentage of completion
Estimated final sales vale
Work certified
Percentage of completion (WN-1)
B. Estimated results on completion
Estimated sales value
Estimated costs
Estimated profit(Loss)
C. Result to date
Work certified
Cost to date (excluding depreciation)
Depreciation(WN-2)
Total cost
Notional profit (loss)
Profit (loss) to be taken to
profit & loss account (WN-3)
Reserve for contingencies (WN-4)

V 20
V 24
V 25
Total
8.00
7.20
90
5.60
4.20
75
16.00
2.40
15
-
8.00
6.40
1.60
5.60
7.00
(1.40)
16.00
12.00
4.00
-
7.20
4.84
0.72
5.56
1.64
1.00
4.20
4.56
0.42
4.98
(0.78)
(1.40)
2.40
2.22
0.24
2.46
(0.06)
(0.06)
13.80
11.62
1.38
13.00
0.80
(0.40)
0.64
0.62*
-
1.26
Charged against P & L A/c
Statement of work-in-progress as would appear in Statement of Financial Position
As on 31stAshad 2070
Work certified
Less: Reserve
for contingencies
Less: Payment received
Work-in-progress
Working Notes:
1. Percentage of completion
V.24
4.20
0.62
V. 25
2.40
-
Total
13.80
1.26
5.00
1.56
3.20
0.38
2.00
0.40
10.20
2.34
=
Percentage of completion for V.20
=
Rs. 7.20
Percentage of completion for V.24
=
Rs. 4.20
Percentage of completion for V.25
=
Page 180
V.20
7.20
0.64
Rs. 2.40
x 100
= 90
x 100
= 75
x 100
= 15
Work certified
x 100
Estimated sales value
Rs. 8.00
Rs. 5.60
Rs.16.00
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
2. Total cost of plant, equipment and vehicle = Rs. 4,900,000 + Rs. 2,000,000 = Rs. 6,900,000
Total depreciation is 20% of total cost of plant, equipment and vehicle, i.e., Rs. 6,900,000
or
20 x Rs. 6,900,000 = Rs. 1,380,000
100
The total depreciation, viz., Rs. 1,380,000 has been apportioned over three contracts in the ratio
of the work certified as shown below:
Rs. 1.38 x 7.2
Depreciation for Contract V.20
=
= Rs. 0.72 .
Rs. 13.80
Rs. 1.38 x 4.2
Depreciation for Contract V.24
=
= Rs. 0.42
Rs. 13.80
Rs. 1.38 x 2.40
Depreciation for Contract V.25
=
= Rs. 0.24
Rs. 13.80
3. Contract V.20 is almost complete; therefore the profit to be taken to Statement of Profit or
Loss has been calculated as follows;
Profit = Total estimated profit x
Cash received
Contract price
5
= Rs. 1
8
Alternatively the profit to be taken to P & L Account could have been calculated as follows:
(a) Estimated profit x Work certified
Contract price
(b) Estimated profit x Cost of work to date ,
Estimated total cost
Cost
of work to date x Cost of work to date
(c) Estimated profit x
Estimated total cost
Work certified
4. The total loss on Contract, V.24 is estimated at Rs. 1.40. The current year’s loss is Rs. 0.78.
This should be charged to P & L Account. Besides this Rs. 0.62 lakh should be charged
further to P & L Account for the likely loss as per the concept of conservatism, the total loss
to be charged to P & L, therefore, amounts to Rs. 1.40.
= Rs. 1.60 x
9. Contract Account with Statement of Financial Position
Illustration 6: The following is the Trial Balance of Butwal Construction Company engaged on
the execution of Contract No. 747 for the year ended 31stAshad, 2070:
Contractee’s Account- amount received
Buildings
Creditors
Bank balance
Capital Account
Materials
Wages
Expenses
Plant
UNIT 4: Contract Accounts
3,00,000
1,60,000
72,000
35,000
5,00,000
2,00,000
1,80,000
47,000
2,50,000
8,72,000
________
8,72,000
Page 181
ICAN Advanced Accounting CAP II CHAPTER II
The work on contract No. 747 commenced on 1stShrawan, 2069. Materials costing Rs. 170,000
were sent to the site of the contract but those of Rs. 6,000 were destroying in an accident.
Wages of Rs. 180,000 were paid during the year. Plant costing Rs. 50,000 was used on the
contract all through the year; plant with a cost of Rs. 200,000 was used from 1stShrawanto
30thChaitra and was then returned to the stores. Materials of the cost of Rs. 4,000 were at site on
31stAshad, 2070.
The contract was for Rs. 600,000 and the contractee pays 75% for the work certified. Work
certified was 80% of the total contract work at the end of 2069-70. Uncertified work was
estimated at Rs. 15,000 on 31stAshad, 2070. Expenses are charged to contract at 25% of wages.
Plant is to be depreciated at 10% for the entire year.
Prepare Contract No. 747 Account for the year 2069-70and make out the Statement of Financial
Positionas on 31stAshad, 2070 in the books of Butwal Construction Company.
Solution:
Contract no. 747 Account
For the year ended 31stAshad, 2070
Dr.
To Materials
Wages
Expenses (25% on wages)
Plant
P & L A/c (Note 1)
W.I. (being reserve)
Cr.
Rs.
1,70,000 By P & L A/c (Ab. Loss)
1,80,000 By Plant retd. to store
(Note 2)(Rs.2,00,000 – 15,000)
45,000 By Plant at site (Rs.50,000 – 5,000)
2,50,000 By Materials at site
45,000 By Work certified
45,000 By Work uncertified
_______
7,35,000
Rs.
6,000
1,85,000
45,000
4,000
4,80,000
15,000
7,35,000
Statement of Financial Position
As on 31stAshad, 2070
Liabilities
Capital
Profit and Loss A/c:
Profit from
Contract 45,000
Less:
Abnormal Loss
6,000
Dep. on Plant
5,000
Unabsorbed
Expenses
2,000
Creditors
Page 182
Rs.
Assets
500,000 Buildings
Plant:
In store
At contract site
Materials:
In store
At contract site
Work-in-progress:
480,000
32,000 Workcertified
15,000
72,000 Work-uncertified
495,000
Rs.
160,000
180,000
45,000
30,000
4,000
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Less:Reserve
45,000
Less: Cash recd. from
Contractee 300,000
Bank balance
604,000
150,000
35,000
604,000
Working Notes:
1. The profit taken to Profit and Loss Account has been arrived at as follows:
90,000 x 2/3 x 75% = Rs. 45,000
The profit to be taken to P & L account may also be calculated on the basis of actual
receives. In such a case the amount will be Rs. 37,500 calculated as follows:
90,000 x2/3x 300,000/480,000 = Rs. 37,500.
2. Depreciation is to be charged @10% on plant for the whole year. However, plant costing
Rs. 2,100,000 has been used only for 9 months on the contract site. Therefore, Rs. 15,000
has been charged from the contract and the balance of Rs. 5,000 has been charged to
Statement of Profit or Loss.
3. Unabsorbed expenses van be carried forward also on the assets side, depending on the
method for treatment of under/over-recovered overheads.
Illustration 7: The following Trial Balance was extracted from the books of Bhatbhateni
Contractors as on 31stAshad 2070:
Dr. Rs.
Cr. Rs.
300,000
Contractee’s Account
100,000
Buildings
62,000
Creditors
35,000
Bank
300,000
Capital Account
100,000
Materials
70,000
Wages
37,000
Expenses
250,000
Plant
100,000
Work-in-progress (Contract No. 837 as on 01.04.2069)
30,000
Contract No. 837 Account (01.04.2069) (Unadjusted Profit)
Total
692,000
692,000
Contract No. 837 which was in progress on 1stAshad 2069 was completed on 31stAshwin, 2069.
Contract No. 838 commenced on 1stAshad 2069.
Rs. 20,000 materials and Rs. 10,000 wages were paid for contract No. 837.
Rs. 60,000 materials were sent to Contract No. 838 site but Rs. 3,000 worth was lost there by
accident.
Rs. 60,000 wages paid for contract No. 838.
Rs. 50,000 Plant was used in Contract No. 838 all through,
UNIT 4: Contract Accounts
Page 183
ICAN Advanced Accounting CAP II CHAPTER II
Plant costing Rs. 2,00,000 was used on Contract No. 838 from 1stKartik, 2069; prior to that
above machinery was used on Contract No. 837.
Rs. 4,000 materials were at site on Contract No. 838, at the end of the year.
Provide 10% depreciation on the plant and 2% on Buildings.
Contract No. 837 was for Rs. 150,000 and certified work up to last year was Rs. 100,000. The
work has been certified up to the full extent, but payment has been received up to 80% of the
certified amount. The balance has not been paid yet nor has any entry been passed on
completion of the contract.
Expenses are charged to contracts on the basis of 50% of direct wages. The new contract is for
Rs. 400,000 and 90% is paid on certification. The uncertified work for contract as on 31stAshad,
2070 is estimated at Rs. 15,000.
You are required to prepare:
(a) Contract N. 837 Account,
(b) Contract No. 838 Account,
(c) Profit & Loss A/c for 2067-68,
(d) Contract No. 837 Contractee A/c,
(e) Contract No. 838 Contractee A/c, and
(f)
Statement of Financial Positionas on 31stAshad, 2070.
Solution:
Contract No. 837 Account
Particular
Rs.
Particular
Rs.
By Contractee’s 1,50,000
To work-in-progress
A/c
01.04.2069
1,00,000
Less: Unadjusted profit
70,000
01.04.2069 30,000
20,000
To Materials
10,000
To Wages
5,000
To Expenses (50% of direct wages)
5,000
To Depreciation on Plant
40,000
To P & L A/c
1,50,000
Page 184
1,50,000
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Particular
To Materials
To Wages
To Expenses (50%
of direct wages)
To Depreciation on Plant
( 5,000 + 15,000)
To P & L A/c
To work-in-progress (Reserve)
Particular
To Contractee A/c
Contract No. 838 Account
Rs. Particular
60,000 By P & L A/c ( Ab. Loss)
60,000 By Materials at site
By work-in-progress:
Work certified
30,000
(1,80,000 x 100/90)
Work uncertified
20,000
31,200
20,800
2,22,000
Contract No. 837 - Contractee Account
Rs.
Particular
1,50,000 By Balance b/d
By Cash
By Balance c/d
Rs.
3,000
4,000
2,00,000
15,000
2,22,000
Rs.
80,000
40,000
30,000
1,50,000
Particular
To balance c/d
1,50,000
Contract No. 838 - Contractee Account
Rs.
Particular
1,80,000 By Bank
Rs.
1,80,000
Particular
UNIT 4: Contract Accounts
1,80,000
Profit & Loss Account
Rs.
Particular
To Expenses not charged to contracts
To Contract No. 838 (Abnormal loss)
To Depreciation on Building
To Balance c/d
1,80,000
Rs.
2,000 By Contract No. 837
3,000 By Contract No. 838
2,000
64,200
40,000
31,200
71,200
71,200
Page 185
ICAN Advanced Accounting CAP II CHAPTER II
Statement of Financial Position
As on 31stAshad 2070
Liabilities
Creditors
P & L A/c
Capitals
Rs.
Assets
62,000 Bank
64,200 Amount due by contractee of
3,00,000
Contract No. 837
Stock of materials:
Instore
20,000
At site
4,000
Work-in-progress:
Contract No. 838
2,15,000
Less:Reserve
20,800
1,94,200
Less: Cash recd. From
Contractee
1,80,000
Plant
2,50,000
Less: Depreciation
25,000
Buildings
1,00,000
Less: Depreciation
2,000
4,26,200
Rs.
35,000
30,000
14,200
2,25,000
98,000
4,26,200
Working Notes:
1.
Cash received on contracts has been computed as follows:
Total cash received from contractee’s
3,00,000
Cash received on Contract No. 837 till 31.03.2070
1,20,000
Cash received on Contract No. 838 till 31.03.2070
1,80,000
2.
Profit taken to P & L Account on Contract No. 838:
Since, half the contract is complete, profit taken to the P & L Account has been
calculated as follows:
52,000 x 2 x 90 =Rs. 31,200.
3
100
10. ESTIMATED CONTRACT ACCOUNT
Illustration 8: A contractor secured a contract to supply and erect machinery for the sum of Rs.
750,000. He was to receive payments on account from time to time equal to 90% of the certified
value of the work done. He commenced work on 1stShrawan 2069 and incurred the following
expenditure during the year:
Plant and tools Rs. 70,000;
Machinery and stores Rs. 200,000;
Wages 150,000;
Page 186
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Sundry Expenses Rs. 30,000; and
Establishment charges Rs. 40,000.
A part of the machinery costing Rs. 20,000 was unsuited to the contract and was immediately
sold at a profit of Rs. 5,000. The Value of plant and tools on 31stAshad, 2070 was Rs. 40,000
and the value of Machinery and Stores then in hand Rs. 30,000. By 1st Shrawan, 2070 he had
received payments on account amounting to Rs. 438,750 being 90% of the certified value of
work done up to 31stAshad 2070.In order to calculate the profit made on the contract up to
31stAshad 2070 the contractor estimated the further expenditure that would be incurred in
completing the contract and took to the credit of Profit and Loss A/c for the year that proportion
of the estimated net profit to be realized on contract which the certified value of the work done
bore to the contract price. He estimated:
(a) That the contract would be completed in a further period of six months.
(b) That plant and tools would have a residual value of Rs. 10,000 upon the completion of the
contract.
(c) That the cost of machinery and stores required in addition to those in stock on 31stAshad
2070 would be Rs. 100,000 and that further sundry expenses of Rs. 20,000 would be
incurred.
(d) That wages on the contract for the six months of 30thPoush, 2070 would amount to Rs.80,
000.
(e) That the establishment would cost the same sum per month as in the previous year.
(f) That 2 ½ % of the total cost of the contract (excluding this percentage) should be provided
for contingencies.
Prepare the Contract Account for the year ended 31stAshad 2070 and show your calculation of
the profit to be credit to profit and loss account for the year.
Solution:
Contract Account
Particular
To Plant and tools
To Machinery
To Wages
To Sundry expenses
To Establishment charges
To Profit and Loss A/c
(profit on sale of machinery )
To Profit c/d
To Profit and loss
To,Work-in-progress (reserved)
UNIT 4: Contract Accounts
Rs.
70,000
2,00,000
1,50,000
30,000
40,000
5,000
Particular
By Sale of machinery
By Plant and tools at site
By Machinery and stores at site
By Work-in-progress:
Certifies
87,500
5,82,500 By Profit b/d
34,450
53,050
87,500
Rs.
25,000
40,000
30,000
4,87,500
_______
5,82,500
87,500
______
87,500
Page 187
ICAN Advanced Accounting CAP II CHAPTER II
Rs. 4,00,000
Statement for Computation of Profit
Add:
Add:
Expenditure incurred on contract to
31stAshad,2070Estimated further expenditure for 6
months:
Plant and books (Rs. 40,000 – Rs. 10,000)
Sundry expenses
Wages
Establishment charges (proportionately)
2 ½ % provision for contingencies
Estimated total cost
Estimated total profit
Contract Price
Profit to be taken credit for
30,000
1,30,000
20,000
80,000
20,000
2,80,000
6,80,000
17,000
6,97,000
53,000
7,50,000
Estimated profit x Work certified
Contract price
= Rs.53,000 x Rs. 4,87,500
Rs. 7,50,000
= Rs.34,450
Illustration 9:Universal Ltd. commenced a contract on 1stShrawan, 2069. The total contract
was for Rs. 1,000,000 (estimated by the contractee) and was accepted by Universal Ltd. at 10%
less. It was decided to estimate the total profit and to take to the credit of P & L A/c that
proportion of estimated profit on cash basis which thework completed bore to the total contract.
Actual expenditure in 2069-70and estimated expenditure for 2070-71 are given below:
Particulars
Materials
Labour: Paid
Accrued
Plant purchased
Expenses
Plant returned to store on cost
Materials at site
Work certifies
Work uncertified
Cash received
2069-70 (Actual) Rs.
1,50,000
1,00,000
10,000
80,000
40,000
20,000
( on 31stAshad.)
10,000
4,00,000
15,000
3,00,000
2070-71 (Estimate) Rs.
2,60,000
1,20,000
71,000
50,000
(on 30.12.70)
Full
Full
The plant is subject to annual depreciation @ 20% of cost. The contract is likely to be
completed on 30thChaitra 2070. Prepare the Contract Account.
Page 188
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Particular
To Materials
To Labor-Paid
1,00,000
Accrued
10,000
To Plant
To Expenses
To Profit and Loss Account
(profit transferred)
To Work-in-progress A/c
(Reserve)
Contract Account
Rs.
Particular
150,000 By Plant returned to Store
(Rs.20,000 – Dep. Rs. 4,000)
110,000 By Plant at site
80,000 (Rs. 60,000 – Dep. Rs. 12,000)
40,000 By Materials at site
By Work-in-progress:
42,500*
Work certified
66,500
Work uncertified
489,000
Rs.
16,000
48,000
10,000
400,000
15,000
489,000
* the figure has been arrived at after preparing an estimated contract account.
Estimated Contract Account
(2069-70) and (2070-71)
Particular
Rs.
Particular
To Materials
(1,50,000 + 2,60,000)
To Labor
(1,10,000 + 1,10,0002)
To Plant
To Expenses
To Profit made to date
4,10,000 By Plant returned to Store
On 31.03.2070
16,000
2,20,000 On 30.12.207032,500
By Contractee’s account
80,000
1,11,000
1,27,500
948,500
Profit to be taken on Statement of Profit or Loss in 2069-70:
Total estimate profit X work certified X3 .
Total Contract price
=Rs. 1,27,500 X
4,00,000
X
3 .
9,00,000
= Rs. 42,500
1.
2.
Rs.
48,500
9,00,000
______
948,500
4
4
It has been presumed that plant costing Rs. 10,000 would be exhausted on the contract
site during the course of the second year and it would be normal loss.
Wages for 2070-71is assumed to be same that of 2069-70, thus to be Rs. 110,000.
Illustration 10: Civil Homes Engineer Company undertakes long-term contracts which involve
the fabrication of pre-stressed concrete blocks and the erection of the same on consumer’s site.
The following information is supplied regarding the contract which is incomplete on 31stAshad,
2070:
UNIT 4: Contract Accounts
Page 189
ICAN Advanced Accounting CAP II CHAPTER II
Rs.
Fabrication costs to date:
Direct materials
Direct labor
Overheads
2,80,000
90,000
75,000
4,45,000
15,000
4,60,000
8,19,000
6,00,000
Erection costs to date
Total
Contract price
Cash received on account
Technical estimated of work completed to date:
Fabrication:
Direct materials 80%
Direct labour and overheads 75%
Erection 25%
You are required to prepare a statement for submission to the management indicating:
(a) The requested profit on the completion of the contract, and
(b) The estimated profit to-date on the contract.
Solution:
Statement showing the Estimated Profit to date and on Completion of Contract
Cost Elements
Fabrication costs:
Direct materials
Direct labor
Overheads
Fabrication cost
Erection cost
Total
Estimated profit
(See Working Note 1)
%
Completion
80
75
75
25
Cost To
Date
2,80,000
90,000
75,000
4,45,000
15,000
4,60,000
1,38,000
_______
5,98,000
%
Completion
20
25
25
75
Further
Cost Rs.
70,000
30,000
25,000
1,25,000
45,000
1,70,000
51,000
_______
2,21,000
Total
Cost Rs.
3,50,000
1,20,000
1,00,000
5,70,000
60,000
6,30,000
1,89,000
_______
8,19,000
Working Notes:
1.
Estimated profit to-date has been calculated as follows:
Profit on the whole contract x Costs incurred so far
Total contract cost
= 189,000 x 460,000
= 138,000
630,000
The amount of profit to-date can also alternatively be calculated on the following basis:
Page 190
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
Estimated profit on the whole contract x
=189,000 x 600,000
819,000
2.
Cash received
Contract price
or Rs.138,000
It has been presumed that further costs will be incurred on the same pattern as they have
been incurred now. There are no chances of increase in costs due to inflation or any other
reason.
11. ESCALATION CLAUSE
Illustration 11: Sungava Limited undertook a contract for Rs. 500,000 on 1stMagh,2069. On
30thPoush 2070 when the accounts were closed, the following details about the contract were
gathered:
Rs.
Materials purchased
1,00,000
Wages paid
45,000
General expenses
10,000
Plant purchased
50,000
Materials on hand 30.09,2070
25,000
Wages accrued 30.09,2070
5,000
Work certified
2,00,000
Cash received
1,50,000
Work uncertified
15,000
Depreciation on plant
5,000
The above contract contained an escalation clause which read as follows:
“In the event of price of materials and rates of wages increase by more than 5% the contract
price will be increased accordingly by 25% of the rise in the cost of materials and wages beyond
5% in each case.”
It was found that since the date of signing the agreement, the price of materials and wage rates
increased by 25%. The value of the work certified does not take into account the effect of the
above clause. Prepare the contract account. Working would from part of the answer.
Solution:
Contract Account
Particular
To Materials
To Wages (45,000 + 5,000)
To General Expenses
To Depreciation on Plant
To P & L A/c (WN 2)
To Balance taken to WIP
UNIT 4: Contract Accounts
Rs. Particular
1,00,000 By Work-in-progress:
50,000
Work certified
10,000
Work uncertified
5,000
Contract escalation
20,000
(Working Note 1)
60,000
2,45,000 By Materials in hand
Rs.
2,00,000
15,000
5,000
25,000
2,45,000
Page 191
ICAN Advanced Accounting CAP II CHAPTER II
Working Notes:
1. Escalation charges:
(a) Materials
Effect of increase in price of Materials
Total increase
Upto 5% Rs.
Beyond
75,000 x 25/12575,000 x 5/125
= 15,000
= 3,000
= 12,000
(b) Wages
Effect of increase in Wage rate
50,000 x 25/12550,000 x 5/125
= 10,000
= 2,000
(c) Total increase (a) + (b)= 25,000
= 5,000
(d) Increase in Contract Price 20,000x25/100
= 8,000
= 20,000
= Rs. 5000
2. Computation of profit transferred to Profit & Loss Account:
Since more than 1/4th but less than ½ of the contract has been completed 1/3 of the profit earned
as reduced on cash basis has been transferred to Profit & Loss Account.
80,000 x 1 x 150,000 = Rs. 20,000.
3
200,000
Self-Assessment Question
Question 1: A firm of contractors obtained a contract for construction of a bridge across river
Rapti. The following details are available is the records kept for the year ended 31stChaitra,2070
Rs. In lakhs
1,000
605
495
400
Total contract price
Costs incurred to date
Estimated further costs for completion
Progress payment being 80% of work certified
The firm seeks your advice and assistance in presentation of accounts keeping in view the
requirements of NAS-11.
Loss to be provided for the year = Rs. 55 Lakh, Loss to be provided in Financial Statement
=100 Lakh
Question 2: Baburamhas undertaken two contracts to construct primary health centres during
the calendar year 2069-70. From the information given below, compute the profit to be
considered or loss to be provided for in accordance with NAS-11.
Particular
Total contract price (fixed)
Costs incurred to date
Estimated costs for completion
Progress payments received and receivable
Page 192
Contract
000)
1,500
160
1,440
100
1(Rs. Contract 2(Rs. 000)
1,000
500
300
600
UNIT 4: Contract Accounts
ICAN Advanced Accounting CAP II CHAPTER II
(Hint: Contract 1: Loss for the accounting period = 10 Thousand, Further loss to be
provided as per NAS-11 = 90 Thousand; Contract 2- Profit to be recognized= 125
Thousand)
Question 3: The following particulars relate to two houses which a firm of builders had in
course of construction under contract:
Particulars
House A
Work-in-progress on 1stShrawan, 2069 (excluding
Rs.800 estimated profit which was taken to profit
& loss account in 2069-69)
Materials purchased
16,600
Wages
14,000
Electrical services and fittings
Road-making charges
Contract price (including road-making)
Cash received to 31stAshad, 2070
Percentage of cash received to work certified
Value of materials in hand on 31stAshad, 2070
Completed work not certified
Value of plant used on sites
6,000
Period of plants remained on sited during the year
6,000
House B
14,000
23,000
-
20,000
1,400
300
8,000
60,000
60,000
100%
400
40,000
24,000
66.67%
540
2,500
12,000
12,000
Total establishment expenses incurred during the year 2069-70amounted to Rs. 12,240. These
are charged to the two contracts in proportion to the Statement of Profit or Loss.
Prepare the two contract accounts (in columnar from) showing the profit or loss on each house
for the year 2069-70and the sums which you consider appropriately transferable to the
Statement of Profit or Loss.
(Hint: Loss on House A= Rs. 15,000 and profit on House B= 2700)
UNIT 4: Contract Accounts
Page 193
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 5:
BRANCH ACCOUNTING
Page 194
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
1. INTRODUCTION
As a business grows, it often establishes branches in order to market its products over a large
territory. The accounting system adopted for the branch depends on the size and nature of
branch and degree of control needed by the head office. Thus, in order to study the accounting
systems employed for the various types of branches it is convenient to divide them into the
following three categories:
o Branches not keeping full system of accounting (i.e. Dependent Branch); and
o Branches keeping full system of accounting (i.e. Independent Branch).
o Foreign Branches.
2. BRANCH NOT KEEPING FULL SYSTEM OF ACCOUNTING
When the business policies and the administration of a branch are wholly controlled by the head
office, its accounts are also maintained by it. Branch accounts, in such a case, are written up at
the head office out of the reports and returns received by it from the branch. Following are the
salient features of such branches:
a.
b.
c.
d.
e.
f.
g.
These branches sell only such goods which are supplied by the head office. They are
normally not allowed to make purchases in the open market;
Goods to such branches are supplied by the head office at cost price (sometimes at invoice
price);
All branch expenses of regular nature, e.g., rent of the shop, salary of the staff,
advertisement, are paid by the head office;
Some petty expenses, e.g., cartage, entertainment, are paid by the branch manager out of
petty cash balance. Petty cash account at the branch may be maintained either on simple
system or imprest system;
Such branches are instructed to deposit daily cash proceeds (both cash sales and cash
collected from debtors) into the bank account opened in the name of head office;
Sales are normally made on cash basis but some branches are authorized to make credit
sales also; and
Branches keep only some memorandum records, e.g., stock register.
Depending upon the size of the branch and the degree of control head office wants to exercise
accounts of such branches may be kept by head office in any of the following ways: (i)
Debtors method: -Under this system head office opens only one account for one branch
called "Branch Account". This system is normally adopted when branch is fairly small in
size.
(ii)
Final account method: -Under this system, head office opens ;
a. Branch trading and Statement of Profit or Loss, and
b. Branch account.
The branch account opened under this method is different from that opened under debtors
method.
UNIT 5: Branch Accounting
Page 195
ICAN Advanced Accounting CAP II CHAPTER II
(iii) Stock and debtors method: -Under this system, head office opens ;
a. Branch stock account
b. Branch debtors account
c. Branch assets account,
d. Branch expenses account, and
e. Branch adjustment account.
(iv) Wholesale Price method: - This method is adopted when head office supplies goods to the
branch at the price at which it supplies to wholesalers. Thus, under this method branch is
treated at par with the wholesale branch.
All these system are explained in the following pages.
2.1 Debtors method
The system of calculating profit by preparing one account for one branch (called
".....Branch Account") is termed as debtors system. Branch account is a nominal account in
nature and is prepared in the head office books. Under this system the head office makes
the following entries:
Transactions
Goods sent to branch
Goods returned by branch
Debited
Branch
Goods sent
to branch
Account
Credited
Goods sent
to branch
Branch
Balance in the goods sent to branch
account
Goods sent
to branch
Trading/ Purchases
Expenses met by head office
Branch
Bank
Remittances sent by the branch
Bank
Branch
Branch liabilities at close
Branch assets
Branch
Branch profit (credits more than debits)
Branch loss (debits more than credits)
Branch
Branch Liabilities
Branch
General profit
and loss
General profit
andloss
Branch
Branch assets at close
Page 196
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Branch assets and liabilities will figure in the head office Statement of Financial Position at the
time of preparing the final accounts. At the commencement of the next accounting period
branch assets and liabilities will be transferred to branch account and the difference represents
the opening balance of the branch account. The entries are reverse entries given for transactions
(6) and (7) listed above. They are: (A)
Debit Branch account
Credit Branch assets
(B)
Debit Branch liabilities
Credit Branch account
When these entries are posted, the branch account will appear as given under:
Books of Head Office
Branch Account
Particulars
Amount
Rs.
(A) To Balance b/d (Assets in
the beginning)
(a) Cash in hand
(b) Stock (at cost)
(c) Debtors
(d) Furniture
(e) Any other assets like
prepaid rent, prepaid
insurance, etc.
(B) To goods sent to Branch a/c
(at cost)
(C) To bank (expenses paid by
the head office)
(D) To balance c/d(liabilities at
the end, if any)
To Profit*
Particulars
Amount
Rs.
(E) By Balance b/d
(Liabilities in the
beginning, if any)
(F) By Remittances by the
branch, i.e., Cash sales +
Cash received from
debtors
(Credit sales are not to be
shown anywhere)
(G) By balance c/d (Assets at
the end):
(a) Cash in hand
(b) Stock (at cost)
(c) Debtors
(d) Furniture
(e) Any other assets like
prepaid rent, prepaid
insurance, etc.
By Loss*
* Balancing figure is either profit or loss.
UNIT 5: Branch Accounting
Page 197
ICAN Advanced Accounting CAP II CHAPTER II
Some Specialized nature of transactions
1. Invoice price method: Sometimes head office may send goods to the branch not at cost but after adding a margin. Such
price is known as the invoice price. In this case certain adjustments become necessary for the
ascertainment of correct profit. They are:
(a)
Debit: Goods sent to branch account
Credit: Branch account
(For the difference between the invoice price and cost price of the goods sent to the
branch)
(b)
Debit: Branch account
Credit: Stock reserve account
(For the difference between the invoice price and cost price of the closing stock)
In the Statement of Financial Position stock reserve will be shown as a deduction from
stock which is valued at invoice price. This enables the head office to show stock at cost
price. At the commencement of the next period, stock reserve account will be transferred
to the branch account, the entry being
(c)
Debit: Stock reserve account
Credit: Branch account
Under this method the relevant items will appear in the branch account as shown under:
Particulars
To Opening stock (at
invoice price)
To Goods sent to branch a/c
(at invoice price)
To Stock reserve account
(for the difference between
the invoice price and cost
price of closing stock)
Books of Head Office
Branch Account
Amount
Particulars
Rs.
By Stock reserve account
(difference between invoice price
and cost price of the opening stock)
By Goods sent to branch account...
(for the difference between invoice price and cost price of
the goods sent to branch)
By Closing stock
(at invoice price)
Amount
Rs.
2. Branch expenses paid by branch from out of petty cash: These need not be shown in the branch account as such payments reduce branch cash at close
and only the reduced balance is shown on the credit side of branch account.
However, if petty cash is maintained on imprest system, the actual expenses paid by branch are
reimbursed by head office. In either word, head office meets such expenses and they must be
Page 198
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
debited to the branch account. The opening and closing balances of petty cash will appear on the
debit and credit side of the branch accounts respectively.
3. Depreciation on fixed asset: Depreciation is not shown in the branch account. However, the asset is shown on the credit
side only after deducting the amount of depreciation.
4. Bad debts, discounts allowed, etc.: Bad debts and discounts allowed do not appear in branch account, but the debtors (at close)
are shown on the credit side after adjusting these items.
5. Purchase of fixed assets by the branch: When an asset is purchased by the branch from its cash collections, the remittance to head
office will be less to that extent. The assets will appear in the branch account on credit side.
If the purchase is made on credit basis, there will be no reduction in the remittance, but the
liability will appear on the debit side.
6. Sale of fixed asset: The effect of this is to reduce the value of branch assets at close and increase the remittance
from the branch in case the sale is for cash. If the sale is on credit it will increase the debtor's
balances. Any loss or gain on the sale of assets does not appearseparately in the branch
account. The effect of such loss or gain, no doubt, influences the branch profit through the
above adjustments.
It is, thus, important for the student to note that under this system of preparing the branch
account, items like sales, bad debts, discounts, depreciation, loss or gain on sale of assets and
such other items do not appear at all. The profit is ascertained by a comparison of the branch
assets and liabilities at the beginning and close of the trading period and having regard to
remittances, goods sent to branches and remittances received from the branch.
Illustration 1: (When branch account is made at (i) Cost price or (ii) invoice price).
United Distributor Pvt Ltd, Kathamdnu has a branch at Nepalgunj. It invoices goods to the
branch at selling price which is cost plus 33 1/3%. From the following particulars prepare
Branch account at (i) Cost Price and (ii) at Invoice price. Show also Branch debtors account and
Goods sent to branch account in the books of United Distributor Pvt Ltd, Kathmandu.
Particular
Stock on 1st shrawan, 2069 (invoice price)
Debtors on 1st Shrawan, 2069
Goods invoiced to branch during the year at invoice
price
Sale at Branch
Cash
Credit
Cash received from debtors
Discount allowed to customers
UNIT 5: Branch Accounting
Amount
Amount
15,000
11,400
67,000
31,000
37,400
68,400
40,000
300
250
Page 199
ICAN Advanced Accounting CAP II CHAPTER II
Bad debts written off
Cheque sent to branch- Salaries
-Sundry expenses
Stock on 31st Ashad 2070 (invoice price)
5,000
1,700
6,700
13,400
Solution:
Case 1: - When goods are shown at cost price
In the books of United Distributor Pvt Ltd, Kathmandu
Nepalgunj Branch Account
Particulars
Amount
Rs
To Opening branch assets
Stock ( Rs 15,000- Rs 3,750)
Debtors
To Goods sent to branch
account (Rs. 67,000-Rs.
16,750)
To Bank—
Particulars
Amount
Rs
By Bank Remittance
received from the
branch
11,250 Cash sales
31,000
11,400
40,000
Cash from debtors
71,000
50,250
Salaries
5,000
Sundry expenses
1,700
To Net profit transferred to
General P/L a/c
By Branch assets
at close
Stock (Rs.
13,400 - 3,350)
6,700
Debtors
10,050
8,250
9,700
89,300
89,300
To balance b/d:
Stock
10,050
Debtors
8,250
18,300
Branch Debtors Account
Particulars
To balance b/d
To, Credit Sales
Page 200
Amount Rs.
11,400
Particulars
Amount Rs.
By Bank - amounts received
37,400 By, Discounts
40,000
300
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
By Bad debts
250
By Balance c/d.
8,250
48,800
To balance b/d
48,000
8,250
Goods sent to Branch account
Particulars
Amount
Particulars
Rs.
50,250
To Purchase a/c transfer
Amount
Rs.
50,250
By Branch account
50,250
50,250
Case II: - When goods are shown at Invoice Price:
In the books of United Distributor Pvt. Ltd. Kathmandu
Nepalgunj Branch Account
Amount
Rs.
Particulars
To Opening branch
assets
Stock
Debtors
To Goods sent to
branch
Account
To Bank—
Salaries
Sundry expenses
To stock Res. (closing)
To Net profit
transferred to General
P/L a/c
To balance b/d:
Stock
Debtors
UNIT 5: Branch Accounting
15,000
11,400
67,000
5,000
1,700
6,700
3,350
By Stock Res.
(opening)
By GSTB a/c- loading
By Bank - Remittance
received
from the branch
Cash sales
Cash from debtors
By Branch assets at
9,700 close
Stock
1,13,150
Debtors
13,400
8,250
Amount
Rs.
3750
16,750
Particulars
31,000
40,000
71,000
13,400
8,250
21,650
1,13,150
21,650
Page 201
ICAN Advanced Accounting CAP II CHAPTER II
Particulars
To Branch a/c -loading
To Purchase a/c- cost of
goods
sent to branch t/f
Goods sent to Branch account
Amount Rs.
Particulars
16,750 By Branch account
Amount Rs.
67,000
50,250
67,000
67,000
Illustration 2: Himal Sales Ltd. has a head office and many retail branches which are supplied
goods from the head office at 20% profit on sales price. Accounts are kept at head office from
where all expenses (except petty expenses) are paid. Such petty expenses are paid by the
branches which are allowed to maintain petty cash balance of Rs. 300 on imprest system. From
the following balances, as shown by the books, prepare branch account.
Rs.
Balances on 1st January, 2012:
Petty cash in hand at branch
Stock in hand at branch at sales price
Sundry debtors at branches
Sundry creditors at branches
Furniture and fixtures at branch
Rent prepaid (up to 31st March, 2012)
Transactions for the year ended 31st
Dec, 2012 were as follows: Goods sent to branch
(Less: Returns)
Cash sales at branch
Credit sales at branch
Allowance to debtors
Cash received from customers
Bad debts to be written off
300
20,000
4,000
1,200
8,000
300
1,04,00
0
80,000
45.000
500
40.000
200
Cash purchases by the branch
(on
permission from head office)
Cash paid to creditors
Creditors at the end
Payment made by the head
office:
Rent for one year (paid on 1st
April, 2012)
Salaries
Insurance paid for the year
ending
31st March, 2013
Payments made by the branch:
Petty expenses
Balance on 31st December,
2012:
Stock at cost
Rs.
10.500
8,000
3,000
1,800
2,000
360
180
30,000
Write off 10% depreciation on furniture.
Page 202
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Particulars
To Opening branch
assets
Petty Cash
Stock(20,0004,000)
Debtors
Furniture
Rent Prepaid
To Goods sent to
branch
Account
Less: Margin
To Bank—
Rent
Salaries
Insurance
300
16,000
4,000
8,000
300
1,04,0
00
20,800
1,800
2,000
360
To Bank (for petty
exp.)
To balance of
creditors
To profit and loss
a/c
Branch Account
Amount Rs.
Particulars
By balance:
Creditors
By Cash Remitted
By balance: 28,600
Stock
Debtors
Petty cash
83,200
Furniture
Rent Prepaid
(Rs.1800- 1350)
Insurance
4,160
Amount Rs.
To Balance b/d
To Sales (credit)
4,000
45,000
Amount Rs.
8,000
3,000
UNIT 5: Branch Accounting
30,000
8,300
300
7,200
450
90
46,340
1,49,040
Debtors a/c
Particulars
Amount Rs.
By Allowances
By Bad debts
By Cash received from debtors
By Balance c/d (bal. fig.)
500
200
40,000
8.300
49,000
11,000
12,00
*1,01,500
**180
3,000
29,900
1,49,040
Particulars
Particulars
To cash
To Balance c/d
Amount Rs.
49,000
Creditors a/c
Particulars
By Balance b/d
By Purchases (bal fig.)
Amount Rs.
1,200
9,800
11,000
Page 203
ICAN Advanced Accounting CAP II CHAPTER II
Particulars
To cash sales
To Debtors
Amount Rs.
80,000 40,000
1,20,000
Particulars
To balance c/d
To Cash
Amount
Rs.
300
180
*Cash a/c
Particulars
By Purchases
By Creditors
By Cash remitted
**Petty Cash a/c
Particulars
By Petty expenses
By Balance c/d
480
Amount Rs.
10,500 8,000
1,01,500
1,20,000
Amount Rs.
180
300
480
Notes:
1. As petty cash account is maintained on imprest system, amount spent by the branch must
have been reimbursed by the head office.
2. Credit purchases and credit sales do not figure in the branch account. But these are
considered in arriving at the creditors and debtors amounts respectively.
3.
Cash purchases and cash sales also do not figure. However, these amounts are considered
in arriving at the cash balance.
Illustration 3: Laxmi Intercontinental has a branch at Birtamode. Goods are invoiced to the
branch at cost plus 25%. Branch is instructed to deposit cash every day in the head office
account in the bank. All expenses are paid by cheque by the head office except petty cash
expenses which are paid by the branch manager. From the following particulars, prepare branch
account in the books of head office: Particular
Stock on 1st Shrawan, 2068
Amount
2,500
Stock on 31st Ashad 2069
Sundry debtors on 1st Shrawan,
2068
Sundry debtors-on 31st , Ashad
2069
Cash sales for the year
3,000
1,400
Particular
Amount
Furniture purchased by the branch
1,200
manager
Goods invoiced from the HO
18,200
Expenses paid by the HO
1,640
1,800
Expenses paid by the branch
10,800
Cash remitted by H.O. to the
Branch for purchase of safe
Credit sales for the year
Cash remitted to the HO
7,000
15,000
Page 204
120
1,300
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Particulars
To Stock
(Rs. 2,500-Rs. 500)
To Sundry debtors
To Goods sent to branch
(Rs. 18,200-Rs. 3,640)
To Bank (expenses)
To Bank (safe)
To Bank—transferred to
general profit and loss
account
Branch Account
Amount Rs. Particulars
By Cash remitted
2,000 By Stock
1,400 (Rs. 3,000 - Rs. 600).
By Debtors
14,560 By Furniture
1,640 By Safe
1,300 By Cash
1.880
22,780
Amount Rs.
15,000
2,400
1,800
1,200
1,300
1,080
22,780
Working Note:
Cash in hand has been arrived at as follows: Debtors Account
Particulars
Amount Rs.
Particulars
To Balance b/d
1,400 7,000 By Cash received
To Sales (credit)
(balancing figure)
By
Balance
c/d
8,400
Amount Rs.
6,600
1,800
8,400
(ii)
Cash sales for the year
Add: Cash received from debtors
Less: Cash remitted to the head office
Balance of cash with the branch
Less: Furniture purchase
Less: Petty expenses paid
Cash in hand with the branch
10,800
6,600
17,400
15,000
2,400
1,200
1,200
120
1,080
2.2 Final Account method
Under this method, students are required to calculate profit or loss made by the branch by
preparing branch trading and Statement of Profit or Loss (not branch account as was prepared
under the debtors system). However, if a student is asked to open branch account, besides
branch trading and profit and loss a/c, then such branch account prepared under the debtors
system explained in the preceding pages. The branch account under debtors system, as already
stated, is a nominal account.
UNIT 5: Branch Accounting
Page 205
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 4:M/s Bright and Company with its H.O. in Biratnagar invoiced goods to its branch
at Pokhara at 20% less than the catalogue price which is cost plus 50% with instruction that cash
sales were to be made at invoice price and credit sales at catalogue price. Discount on credit sale
at 15% on prompt payment will be allowed. From the following particulars available from the
branch, prepare branch trading and Statement of Profit or Loss for the year ended 31st
March2011, in the H.O. books, so as to show the actual profit or loss of the branch for the
year2010-11:
Rs.
12,000
1,32,000
10,000
46,000
1,00,000
85,635
13,365
6,000
1,20,000
11,000
5,635
15,000
Stock on 1.4.2010(invoice price)
Goods received from H.O. (invoice price)
Debtors on 1.4.2010
Sales—Cash
Sales—Credit
Cash realised from debtors
Discount allowed to debtors
Expenses at the branch
Remittances to H.O.
Debtors on 31.3.2011
Cash in hand on 31.3.2011
Stock on 31.3.2011(Invoice price)
It was reported that a part of the stock at the branch was lost by fire during the year whose value
is to be ascertained; and a provision should be made for discount to be allowed to debtors as at
31st March2011, on the basis of the year's trend of prompt payment.
Solution:
H.O Books
Branch Trading And Profit And Loss A/C
For The Year Ended 31-3-2011
Particulars
Amount
Particulars
Rs.
To Opening stock
To Goods from H.O
To Gross Profit c/d
10,000
1,10,000
41,000
46,000
1,00,000
By Sales -Cash
- Credit
By Abnormal loss—
To Branch expenses
To Discount
To Abnormal loss a/c
To Provision for discount
Page 206
1,61,000
6,000
13,365
Amount
Rs.
loss of stock by fire
2,500
12.500
1,61,000
41,000
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
To Net Profit transferred toGeneral
P/L A/c
2,500
1,337
17,798
By Closing stock
By Gross Profit b/d
41,000
41,000
Computation of Invoice Price percentage
Assume Cost price to be
Thus Catalogue price will be
80
Invoice price being 20% less than Catalogue150 ×
100
Valuation of goods at cost price
Items
I.P
Conversion Factor
100
12,000
Opening stock
Closing stock
Goods from H.O.
15,000
1,32,000
Computation of loss of stock by fire
This will be the balancing figure in Branch Stock A/c
—Refer Stock and Debtors System.
Particulars
To balance b/d
To Goods from H.O.
UNIT 5: Branch Accounting
100
150
120
Cost Price
120
10,000
100
120
12,500
100
120
1,10,000
Branch Stock A/C
Amount Rs.
Particulars
12,000
By Cash- Cash sales
1,32,000
By branch debtors
-Credit Sales
By abnormal loss
-bal.fig.
To balance b/d
1,44,000
Amount Rs.
46,000
80,000
3,000
15,000
1,44,000
Page 207
ICAN Advanced Accounting CAP II CHAPTER II
(i)
(ii)
(iii)
Credit sales of Rs. 1,00.000 is at Catalogue price. Since Branch stock is at invoice price,
. Thus Rs.
sales at catalogue price are to be multiplied by conversion factor
1,00,000×
= . 80,000.
Abnormal loss in the branch stock is at invoice price. To reduce it to cost multiply by
. Thus, . 3000 ×
= . 2,500.
conversion factor
Prompt paying debtors are those who have availed discount of Rs. 13,365 being the
discount at 15% on what is due, such debtors will be:
Rs.
. 13,365 ×
100
15
89,100
Total debtors during 2010-2011
Opening Balance
Credit sales
10,000
1,00,000
Proportion of prompt payers to total debtors
∴ Provision for discount on the
closing balance will be
Rs 11,000 ×
1,10,000
89,100
. 1,10,000
89,100
15
× 100
1,10,000
1,337
Illustration 5:From the following information, prepare a Memorandum trading and Statement
of Profit or Loss of branches and also show the branch account as it would appear in the head
office books at the end of the year.
Branches’ Cash A/C
Date
Amount
Amount
Date
Particulars
Particulars
2069-70
Rs. 2069-70
Rs.
Shrawan. 1
To Balance
Ashad 31
To Receipts
from debtors
To Cash sales
7,500 Ashad 31
37,500
25
By Petty cash
By Bank
By Balance
70,000
3,000
62,000
5,000
70,000
Branches’ Debtors A/C
Date
Particulars
2069-70
Particulars
Rs. 2069-70
Shrawan. 1
To Balance
Ashad 31
To Sales
Page 208
Amount Date
3,000 Ashad 31
45,000
Amount
Rs.
By Cash
By Discounts
allowed
37,500
1,000
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
By Bad debts
By Balance
1,500
8,000
48,000
48,000
Branches’ A/C
Date
Particulars
2069-70
Shrawan 1 To Balance:
Amount
Rs.
Cash
7,500
Debtors
Furniture
3,000
7,500
Stock
Ashad 31 To Goods
transferred
To Furniture
To Sundry
expenses
10,000
Date
2069-70
Shrawan. 1
Ashad 31
Particulars
Amount
Rs.
By
Balance
b/d:
Expenses
outstanding
By Bank
By
Balance
1,000
62,000
20,500
28,000
45,000
2,500
8,000
83,500
83,500
Closing stock at branches was Rs. 4,000 and expenses outstanding were Rs. 900. Depreciation
@ 10% of the book value has to be provided on furniture.
Solution:
In the books of Head Office
Memorandum Trading And Statement of Profit or Loss Of The Branches
Particulars
To- Opening stock
To Goods transferred
from head office
To Gross profit c/d
To Expenses:
Petty expenses
Other expenses
Outstanding at end
UNIT 5: Branch Accounting
Amount Rs. Particulars
10,000 By Sales:
Cash
Credit
45,000
19,000
By Closing
74,000 stock
3,000
8,000
900
11,900
By Gross profit
b/d
Amount Rs.
25,000
45,000
70,000
4,000
74,000
19,000
Page 209
ICAN Advanced Accounting CAP II CHAPTER II
Less: Outstanding in
the beginning
1,000
10,900
1,000
1,500
1,000
4,600
19,000
To Discounts
To Bad debts
To Depreciation
To Net profit
transferred
to HO
19,000
Branches A/C
Date
2069-70
Ashad. 31
2070-71
Shrawan.
1
Particulars
To balance b/d
To net profit
To Balance c/d
(O/s exp.)
To balance b/d
Amount
Date
2069-70
20,500 Ashad. 31
4,600
900
26,000 2070-71
Shrawan. 1
26,000
Amount
Rs.
Particulars
By Bal. c/d
Cash
Debtors
Furniture
Stock
5,000
8,000
9,000
4,000
26,000
26,000
Tob balance
b/d(O/s exp.)
900
Hint: (1) No workings are involved as every figure needed for the preparation of Memorandum
trading, profit, and loss a/c is available from Branches cash a/c, Branch debtors'a/c and
Branches’ a/c.
2.3 Stock and Debtors System
There are three different bases for H.O. to send the goods to the branches. They are: (i) At cost price
(ii) At selling price
(iii) At cost price plus a fixed mark-up
In this case the branch may be selling goods at higher or lower than the invoice price.
The accounts maintained under stock and debtors system depend on the base adopted by H.O.
and accordingly the accounting arrangements are discussed below: 2.3.1 When goods are sent at cost price.
Under this system the following accounts are maintained separately for each branch. They are:
Page 210
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
(a) Branch stock account: - Although the name may give the student a different impression,
it is virtually a branch trading account and gives the gross profit of the branch.
(b) Branch debtors account if there are credit sales.
(c) Branch cash account
(d) Goods sent to Branch account
(e) Branch expenses account
(f) Branch Statement of Profit or Loss
Accounting entries: - When the following entries are made for the transactions taking place
between H.O. and branch, the posting of such entries will complete the accounts listed above.
Transactions
1)
2)
3)
4)
5)
6)
7)
8)
9)
10)
11)
12)
13)
14)
Goods sent to branch
Goods returned by branch
Net value of goods sent to branch
Cash sales
Credit sales
Returns by customer
Cash paid by debtors
Bad debts and discounts
Stock of goods at branch
Gross profit made by the branch
(difference in branch stock account)
Branch expenses met by H.O.
Branch expenses met by branch
Remittance from branch
Branch profit
Account
Debited
Branch stock
Goods sent to Branch
Goods sent to Branch
Credited
Goods sent to branch
Branch stock
Purchases/ Trading
Branch cash
Branch debtors
Branch stock
Branch cash
Branch expenses
Branch closing stock*
Branch stock
Branch stock
Branch debtors
Branch debtors
Branch debtors
Branch stock
Branch-stock
Branch P/L a/c
Branch expenses
...do...
Bank/cash
Branch P/L a/c
Bank/cash
Branch cash
Branch cash
General P/L a/c
* Branch closing stock will be valued at cost or market price whichever is less and the amount
will be shown along with H.O. Stock in the Statement of Financial Position. Branch debtors and
Branch cash will also be shown in the Statement of Financial Position with corresponding H.O.
items.
Illustration 6: The Network Trading Company invoiced goods to its Birgunj branch at cost.
Head Office paid all the branch expenses from its bank account except petty cash expenses
which were met by the Branch. All the cash collected by the branch was banked on the same
day to the credit of the Head Office. The following is a summary of the transactions entered into
at the branch during the year ended 31st Ashad, 2070
UNIT 5: Branch Accounting
Page 211
ICAN Advanced Accounting CAP II CHAPTER II
Stock Shrawan1
Debtors, Shrawan 1
Petty Cash, Shrawan1
Goods sent from H.O.
Goods returned to H.O.
Cash Sales
Credit Sales
Allowances to customers
Discount to customers
Rs.
7,000
12,600
200
26,000
1,000
17,500
28,400
200
1,400
Bad Debts
Goods returned by customers
Salaries & Wages
Rent & Rates
Sundry Expenses
Cash received from
Sundry Debtors
Stock, Ashad. 31
Debtors, Ashad. 31,
Petty Cash, Ashad. 31
Rs.
600
500
6,200
1,200
800
28,500
6,500
9,800
100
Prepare: Branch Stock Account, Branch Profit & Loss Account, Branch Debtors and Branch
Expenses Account by adopting the Stock and Debtors Method.
Solution
Branch Stock Account
Date
2069-70
Particulars
Shrawan 1
To Stock
Ashad 31
To Goods Sent to
Branch A/c
To Branch P & L
A/c
(Gross profit c/d
Amount
Rs.
Date
2069-70
7,000 Ashad.31
Particulars
By Sales:
Cash
26,000
Credit
Less: Ret.
19,900
52,900
Amount
Rs.
By Goods sent
to Branch
A/c-Return
By Balance
c/d (Stock)
17,
500
28,
400
500
45,400
1,000
6,500
52,900
2070-71
Shrawan 1
Page 212
To balance c/d
6,500
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Birjung Branch Debtors Account
Date
Amount
Particulars
Date
2069-70
Shrawan 1
To Balance b/d
Rs.
2069-70
12,600 Ashad 31
Ashad 31
To Sales
28,400
Particulars
By Cash
By Returns
By Allowances
By Discounts
By Bad Debts
By Balance c/d
41,000
Shrawan 1
Date
2069-70
Ashad 31
To Balance b/d
Particulars
Amount
Rs.
28,500
500
200
1,400
600
9.8
41,000
9,800
Birjung Branch Expense Account
Amount Date
Particulars
Rs.
2069-70
To Salaries & Wages
6,200 Ashad 31
To Rent & Rates
To Sundry Expenses
To Petty Cash
Expenses
To Allowances to
customers
To Discounts
To Bad Debts
1,200
800
By Branch P & L
A/c
Amount
Rs.
10,500
100
200
1,400
600
10,500
10,500
Birjung Branch Profit & Loss Account
Date
2069-70
Ashad 31
To Branch Exp. A/c
Amount Date
Rs.
2069-70
10,500
Ashad 31
To Net Profit to General
P&L a/c
9,400
Particulars
19,900
UNIT 5: Branch Accounting
Particulars
By Gross Profit
b/d
Amount
Rs.
19,900
19,900
Page 213
ICAN Advanced Accounting CAP II CHAPTER II
2.3.2. When Goods are invoiced at Selling Price
Under this procedure the branch is required to sell the goods at selling price at which the
goods have been invoiced to the branch. There are two ways to work out the branch
accounts in this case. They are (A) Memorandum Column method and (B) Branch
Adjustment Account method.
A.
Memorandum Column Method
Under this method, the branch stock account contains extra column on memorandum
basis. That is, the entries shown under this column help us to find out stock discrepancies,
if any.
Illustration 7: - A company with its head office at Kathmandu has a branch at Pokhara. Goods
are invoiced to the branch at cost plus 33 % which is the selling price. The following
information is given in respect of the branch for the year ended 31st March, 2012.
Rs.
4,80,000
24,000
1,80,000
6,000
53,500
30,000
1,000
1,500
48,000
36,500
2,70,000
5,000
Goods sent to branch (invoice value)
Stock at branch (1-4-2011) at selling price
Cash sales
Returns from customers
Branch expenses paid for cash
Branch debtors’ balance (1.4.2011)
Discounts allowed
Bad debts
Stock at branch (31.3.2012) at selling price
Branch debtors’ balance (31.3.2012)
Collections from debtors
Branch debtors’ cheque returned dishonored
You are required to prepare the Branch Stock a/c by Memorandum Column method to ascertain
the shortage/surplus and also ascertain the Net Profit made by the Branch.
Solution:
Branch Stock A/C
Particulars
To Balance b/d
To Goods sent to
Branches A/c
To Branch Debtors
- Returns
To Branch Profit &
loss A/c
Page 214
Memo
(SP)
24,000
4,80,000
6,000
5,10,000
AmountRs
Particulars
18,000 By Branch Bank
By Branch
3,60,000 debtors
By Stock
6,000 discrepancy
-shortage
1,13,500
By
Balance
c/d
4,97,500
1,80,000
2,80,000
Amount
Rs.
1,80,000
2,80,000
2,000
48,000
1,500
36,000
5,10,000
4,97,500
Memo(SP)
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Branch Debtors’ A/C
Particulars
Amount Rs. Particulars
To Balance b/d
30,000 By Return from Customers
To Bank- cheques
5,000 By Discounts
dishonored
2,80,000 By Bad debts
To Credit Sales
By Cash received
3,15,000 By Balance c/d
Particulars
To Branch debtors A/c
-Discount
-Bad debts
To Branch Bank
-Expenses
To Branch Stock
-Shortage
To Net Profit transferred
to General Profit &
Loss A/c
Branch Profit and Loss A/C
Amount
Particulars
Rs.
By Branch Stock A/C
-Gross Profit
1,000
2,500
1,500
Amount Rs.
6,000
1,000
1,500
2,70,000
36,500
3,15,000
Amount
Rs.
1,13,500
53,500
1,500
56,000
1,13,500
1,13,500
B. Branch Adjustment Method
Under this method three accounts deserve special mention and discussion. They are (1) Branch
stock account, (2) Branch adjustment account, and (3) Goods sent to branch account.
Branch stock account: Under cost price method stock account is a nominal account prepared to
disclose the gross profit made by the branch. Under the selling price method stock account is a
real account and the main purpose of preparing this account is to ascertain stock discrepancies.
Thus it helps to control branch stock. To prepare this account all transactions including losses, if
any, must be entered at selling price only. If any figure relevant to the account is given at cost it
must be converted to selling price.
Branch adjustment account: Because of this account the method is called 'Branch adjustment
method'. This account is analogous to branch trading account and reveals the gross profit made
by the branch. On the credit side (i) stock reserve on the opening stock, (ii) profit element in
goods sent to the branch and (iii) the profit element of stock surplus are shown. On the debit
side (i) Stock reserve of the closing stock and (ii) profit element of stock shortage, if any, are
shown. The difference in the totals of the two sides is gross profit or gross loss. The same is
transferred to branch Statement of Profit or Loss.
UNIT 5: Branch Accounting
Page 215
ICAN Advanced Accounting CAP II CHAPTER II
Goods sent to branch account: This account is credited with goods sent to branches at selling
price. Before transferring the balance to purchase account, it is necessary to reduce the value to
cost basis. For this purpose a reverse entry is passed by debiting this account and crediting
branch adjustment account with the profit element included in the goods sent to the branch. In
case goods are returned by branch to H.O., such goods are debited to this account and the profit
element included in such goods is eliminated by crediting this account and debiting branch
adjustment account.
There is no change in the other accounts. The accounting entries under this method are shown
below:
Transactions
Account
Debited
Branch stock
Credited
1) Goods sent to branch (at selling price)
Goods sent to branch
2) Goods returned by the branch (at
selling price)
Goods sent to branch Branch stock
3) Cash sales (at selling price) remitted to
H.O.
Cash
Branch stock
4) Credit Sales (at selling price)
5) For bad debts and any allowance and Branch debtors
Branch stock
cash discounts allowed to debtors
6) Cash paid by branch debtors and
remitted to head office
7) For the difference between selling
price and cost price of the goods sent
to branch less returns
8) For any shortage in the branch stock
account
a) Loading on such shortage
b) Cost of such shortage
9) For any surplus in the branch stock
account
a) Loading on such surplus
b) Cost of such surplus
10) For the difference between the
selling price and cost price of the
closing stock
11) Gross profit made by the branch
12) For Gross loss
13) Expenses paid by head office
Page 216
Branch expenses
Branch debtors
Cash
Branch debtors
Goods sent to branch
Branch adjustment
Branch adjustment
Branch P/L
Branch stock
Branch stock
Branch stock
Branch stock
Branch adjustment
Branch profit and loss
Branch adjustment
Stock reserve
Branch adjustment
Branch profit & loss
Branch profit & loss
Branch adjustment
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
14) Transfer of branch expenses
Branch expenses
15) For the net profit disclosed by the Branch P/L a/c
branch P/L a/c
16) For the net loss
Branch P/L a/c
General P/L a/c
Cash
Branch expenses
General P/L a/c
Branch adjustment
Notes:
1. Branch stock account discloses shortage or surplus after entering the closing stock at
selling price on the credit side. Closing stock is taken by actual count. If the debit side is
more, shortage occurs and if the credit side is more it is surplus. Shortage is entered on the
credit side while surplus is entered on the debit side.
2. During the next accounting period stock reserve will be transferred to branch adjustment
account by means of the following entry:
Debit Stock reserve account
Credit Branch adjustment account
Thus in every branch adjustment account, opening stock reserve will figure on the credit
side and closing stock reserve on the debit side.
3.
In some cases there may be a 'branch cash account' in which case amounts received from
cash sales and debtors are debited to branch cash account. Likewise for any remittances
made by the branch, debit will be to head office cash account and credit goes to branch
cash account. When a branch cash account is maintained for any expenses paid by the
branch debit will be to 'branch expenses account and credit goes to branch cash account.
Illustration 8:Taking the same data as in Illustration 7 you are required to ascertain the profit
made by the Branch by preparing the necessary accounts under the Branch Adjustment Method.
Solution:
Branch Stock A/C
Particulars
AmountRs.
To Balance b/d
To Goods sent to
Branches A/c
To Branch Debtors
- Returns
UNIT 5: Branch Accounting
Particulars
24,000 By Branch Bank
By Branch debtors
4,80,000 By Branch Adjustment
- Loading on shortage
By Branch Profit & Loss A/c
6,000
- Cost of shortage
By balance c/d
5,10,000
Amount
Rs.
1,80,000
2,80,000
500
1,500
48,000
5,10,000
Page 217
ICAN Advanced Accounting CAP II CHAPTER II
Particulars
Branch Debtors A/C
Amount Rs.
Particulars
30,000 By Branch stock A/c
-returns
5,000 By Branch expenses A/c
-Discount
2,80,000
-Bad debts
By Bank
-paid by debtors
3,15,000 By Balance c/d
To Balance b/d
To Bank
- Dishonoured Cheque
To Branch stock A/c
-Sales
(balancing figure)
Particulars
Goods Sent To Branch A/C
Amount
Particulars
Rs.
1,20,000 By Branch stock A/c
To Branch adjustment A/c
-Loading
To Trading Account
-Cost of goods sent to branches –
transfer
Amount
Rs.
6,000
1,000
1,500
2,70,000
36,500
3,15,000
Amount
Rs.
4,80,000
3,60,000
4,80,000
4,80,000
Branch Adjustment A/C
Particulars
Amount
Amount
Rs.
Rs.
500
To Branch stock A/c
By Stock Reserve
6,000
-Loading on shortage
-opening stock
12,000
To Stock Reserve
By Goods sent to branch 1,20,000
-on closing stock
A/C
1,13,500
To Gross Profit
-Loading
-transferred to Profit and Loss A/c
1,26,000
1,26,000
Particulars
Particulars
To Cash A/c
-Expenses
To Branch debtors
-discount & bad debts
Branch Expenses A/C
Amount Rs. Particulars
Amount Rs.
53,500
By Branch Profit and 56,000
Loss A/c
2,500
-transfer
56,000
Page 218
56,000
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Branch Profit and Loss A/C
Particulars
To Branch expenses A/c
To Branch Stock A/c
-Cost of shortage
To General Profit & Loss A/c
Amount Rs.
56,000
1,500
Particulars
Amount Rs.
By Branch adjustment
A/c
1,13,500
-Gross Profit
56,000
1,13,500
1,13,500
2.3.3. Goods sent to Branch with a Fixed Markup
There can be any amount of variation in branch accounts, depending on the need of individual
firm. Goods may be sent to branch at cost plus a percentage, but with instructions to sell at a
different price. In such a case Stock account can be prepared at mark-up prices except for sales.
Sales will be credited to Branch stock account and the stock account discloses gross Profit. For
the difference between cost and mark-up price with respect to stock, stock reserves can be
maintained and they would also help the H.O. to provide for unrealized profit and later transfer
the reserve to H.O. Statement of Profit or Loss when the stock is sold. The following journal
entries are suggested:
Transactions
1)
2)
3)
4)
5)
6)
7)
8)
Goods invoiced to Branch
Goods sent to branch
Sales effected by Branch in which cash
will be received
Stock at Branch (at close)
G.P. made by branch
Expenses paid by the branch
Branch Net Profit
Reserve for unrealised profit
Account
Debited
Credited
Goods sent to branch
Stock
Goods sent to branch H.O. Trading
Branch stock A/c
Bank
Branch A/c
Branch P&L A/c
Branch stock
Bank
Branch stock
H.O. P/L A/c
Branch P & L A/c
Stock Reserve
Branch P & L A/c
H.O. Profit & loss
A/c
At the commencement of next year Branch stock would be transferred to Branch account and
stock reserve to H.O. Statement of Profit or Loss. The following illustration will make the
procedure clear.
Illustration 9: Gopal Limited operates a number retail outlets to which goods are invoiced at
wholesale price which is cost plus 25%. These outlets sell the goods at the retail price which is
wholesale price plus 20%.
Following is the information regarding one of the outlets for the year ended 31.3.2012:
UNIT 5: Branch Accounting
Page 219
ICAN Advanced Accounting CAP II CHAPTER II
Rs.
30,000
3,24,000
60,000
?
20,000
36,000
Stock at the outlet 1.4.20111
Goods invoiced to the outlet during the year
Gross profit made by the outlet
Goods lost by fire
Expenses of the outlet for the year
Stock at the outlet 31.3.2012
You are required to prepare the following accounts in the books of Gopal Limited for the year
ended 31.3.2012:
(a)
(b)
(c)
Outlet Stock Account
Outlet Profit & Loss Account
Stock Reserve Account.
Solution:
Particulars
To Balance b/d
To Goods sent to outlet
To Gross Profit c/d
Outlet Stock A/C
Amount Rs. Particulars
30,000
By Sales {Tutorial Note 1}
3,24,000
By Goods Lost by fire
60,000
By Balance c/d
4,14,000
Particulars
To Expenses
To Goods lost by fire
(Tutorial Note 2)
To Profit Transferred
Particulars
To HO P & L A/c - Transfer
To Balance c/d
Page 220
Amount Rs.
3,60,000
18,000
36,000
4,14,000
Outlet Profit & Loss A/C
Amount Rs. Particulars
20,000
18,000
By Gross Profit b/d
Amount Rs.
60,000
22,000
60,000
60,000
Stock Reserve A/C
Amount Rs. Particularsss
6,000
By Balance b/d
7,200
By HO P & L A/c (Tutorial
Note 3)
(Stock Res. required)
13,200
Amount Rs.
6,000
7,200
13,200
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Working Notes:
1. Wholesale Price
Retail Price
Gross Profit at the outlet: Retain
Price - Wholesale Price
Retail Sales Value
100 + 25 =
125 + 20%=
(150 – 125)
150
= 60,000 ×
25
=
125
150
25
. 3,60,000
2. Goods Lost by Fire
Op. Stock + Goods Sent + Gross Profit - Sales - Closing Stock
30,000 + 3,24,000 + 60,000 - 3,60,000 - 36,000 = Rs. 18,000
3. Stock Reserve
= . 6,000
Opening Stock = 30,000 ×
Closing Stock = 36,000 ×
=
. 7,200
2.3.4. When the selling Price of the Branch is not given
In this case while the invoice price is given, the selling price of the branch is not known. The
branch may be selling above or below the invoice price. In this case Branch adjustment method
will be followed. Branch stock account when prepared at invoice price will disclose the, surplus
or deficiency over the invoice price which will be transferred to Statement of Profit or Loss. The
following illustration will explain the procedure in this regard.
Illustration 10: Chaudary Industries, Kathmandu, has a branch at Biratnagar. The goods are
invoiced at cost plus 25%. The branch makes sales, - both for cash and on credit. Branch
expenses are paid directly from Head Office and, the Branch has to remit all cash received into
the Head Office Bank Account at Biratnagar.
From the following details, relating to Calendar Year 2069-70, prepare the accounts in the Head
Office ledger and ascertain Branch profits. Branch does not maintain any books of account, but
sends weekly returns to Head Office.
Goods received from Head Office at invoice price
Returns to Head Office at invoice prices
Stock at Biratnagar Branch on 1stShrawan 2069
Sales in the year
— Cash
— Credit
Sundry Debtors at Biratnagar on 1stShrawan 2069
Cash received from Debtors
Discounts allowed to Debtors
UNIT 5: Branch Accounting
60,000
1,200
6,000
20,000
36,000
7,200
32,000
600
Page 221
ICAN Advanced Accounting CAP II CHAPTER II
400
800
1,800
6,000
600
12,000
Bad debts in the year
Sales returns at Biratnagar Branch
Rent, Rates and Taxes at Branch
Salaries, Wages and Bonus at Branch
Office Expenses
Stock at Branch on 31stAshad 2070 at invoice price
Date
2069
Shrawan 1
Dr.
Date
2069-70
Date
Books of Chaudary Industries, Kathmandu
Biratnagar Branch Stock Account
Particulars
Amount Date
Particulars
6,000
To Balance b/d
2069-70 By Bank Account
(Cash Sales)
To Goods sent to
60,000
By Branch Debtors
Branch
800
(Credit Sales)
To Branch Debtors
By Goods sent to
(Sales returns)
Ashad
2,400
Branch A/c
To Branch Profit &
31st,
(Returns)
Loss A/c- Surplus
2070
By Balance c/d
(Closing stock)
69,200
Biratnagar Branch Stock Adjustment Account
Particulars
Amount Date
Particulars
By Balance b/d
240
To Goods sent to
2069
Branch A/c
Shrawan 1
By Goods sent to
(on returns)
Branch A/c
10,560
To Branch Profit &
Loss A/c
(Profit on goods)
at invoice price)
2,400
To Balance c/d
th
(1/5 of 12,000)
13,200
Particulars
2069-70 To Biratnagar
Branch Stock adj.
To Biratnagar
Branch Stock A/c
To Purchase A/c
Goods Sent To Branch Account
Amount Date
Particulars
12,000*
1,200
36,000
1,200
12,000
69,200
Cr.
Amount
1,200
12,000
13,200
Amount
By Biratnagar Branch
Stock
By Biratnagar Branch
stock Adj.
60,000
240*
47,040
60,240
Page 222
2069-70
Amount
20,000
60,240
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
* Net Debit of Rs. 11,760 can also be shown here.
Date
2069-70
Date
2069-70
Particulars
To Branch Stock
(Cash sales)
To Branch
Debtors
(Collection)
Particulars
To Balance b/d
To Branch Stock
A/C
Date
2069-70
Date
2010
Bank Account (Extract)
Date
Particulars
2069-70 By Branch Expenses:
20,000
Rent, Rates & Taxes
Salaries, etc
Office Expense
32,000
Amount
Branch Debtors Account
Amount
Date
Particulars
2069-70 By Bank A/c
7,200
By Branch Profit &
Loss A/c:
36,000
Discount
600
Bad Debts
400
By Branch Stock A/c
(Sales Return)
By Balance c/d
43,200
Particulars
To Bank (Rent, Rates
& Taxes)
To Bank, (Bonus, Salaries
,Wages)
To Bank (Office Expenses)
Branch Expense Account
Amount Date
20691,800 70
1,800
6,000
600
Amount
32,000
1,000
800
9,400
43,200
Particulars
Amount
By
Branch
8,400
P/L A/c
6,000
600
8,400
Branch Profit & Loss Account
Particulars
Amount Date Particulars
To Branch Expenses
8,400 2010 By Branch Stock Adj A/C
To Branch Debtors:
By Branch Stock A/c
Discount
600
-Surplus of Sale
Bad Debts
400
Proceeds
To Net Profit
transferred to Profit
3,560
& Loss A/c
12,960
UNIT 5: Branch Accounting
Amount
8,400
Amount
10,560
2,400
12,960
Page 223
ICAN Advanced Accounting CAP II CHAPTER II
2.3.5. Abnormal Losses—Treatment:
When goods are sent to branches, abnormal losses may arise due to loss of goods in transit or
theft and pilferages at branch. In such cases the Branch stock account must be credited with
such abnormal losses. This is necessary to find out stock discrepancies for other reasons.
The loading on abnormal losses is to be debited to Branch adjustment account and the of goods
to Statement of Profit or Loss. Any losses, given as normal losses, should be ignored. This is
because the gross profit must absorb such losses.
Illustration 11: Butwal Ltd. invoices goods to its branch at cost plus 33 % . From the
following particulars prepare the Branch stock account and the Branch stock adjustment account
as they would appear in the books of the Head office.
Rs.
1,50,000
Stock at commencement at branch at invoice price
1,20,000
Stock at close at branch at invoice price
Goods sent to branch during the year, at invoice price
10,00,000
(include goods invoiced at Rs. 20,000 to branch on 31st Ashad, 2070
but not received by branch before close of the year)
50,000
Return of goods to Head office (invoice price)
9,00,000
Cash sales at branch
50,000
Credit sales at branch
10,000
Invoice value of goods pilfered
Normal loss at Branch due to wastage and
15,000
deterioration of stock (at invoice value)
Butwal Ltd. closes its books on 31st Ashad 2070
Solution:
Date
Shrawa
n1
Page 224
Butwal Ltd.
Branch Stock Account
Particulars
Amount
Date
Particulars
1,50,000
To Balance b/d
Shrawan 1 By Bank
To Goods sent
(cash sales)
to branch
10,00,000
By branch debtors
(credit sales)
By Goods sent to
branch (return)
By Abnormal loss
-goods pilfered
By Balance c/d
-at branch
1,20,000
-in transit
20,000
11,50,000
Amount
9,00,000
50,000
50,000
10,000
1,40,000
11,50,000
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Date
Branch Stock Adjustment A/C
Particulars
Amount Date Particulars
To Abnormal loss
By Balance b/d
2,500
-Loading on goods
By Goods sent to
pilfered
branch
To Profit & Loss a/c
(1/4 of 9,50,000)
2,37,500
To Balance c/d
(1/4 of 1,40,000)
35,000
2,75,000
By balance b/d
Amount
37,500
2,37,500
2,75,000
35,000
2.4 Wholesale Branch
In the branch accounting hitherto followed we have not made a distinction between the
wholesale profit and retail profit. Such a distinction is essential so that Head Office takes credit
of the wholesale profit and the branch reflects only the retail profit made by it. To make the
point clear let us take the example of Electronic Toys Ltd. at Mahendranagar which imports
electronic toys at a cost of Rs. 100 cash from Singapore. The list price is prepared by adding
100% margin working out to Rs. 200. If this is invoiced to its branches at a cost of Rs. 100 only,
the branch would be making a profit of Rs. 100 for every toy sold.
However the Head Office invoices the toy to its branches at a price say 30% less than the list
price. The wholesale price thus works out to 70% of Rs. 200 i.e., Rs. 140. Where this procedure
is followed, H.O. makes a profit of Rs. 40 (the difference between wholesale price and the cost)
and the branch would be making a retail profit of Rs. 60 (the difference between the list price
and the wholesale price). When such a procedure is followed establishing the distinction
between the wholesale profit and the retail profit, the branch is called a wholesale Branch.
Under this procedure the wholesale profit of Rs. 40 for the head office is realized only when the
toy is sold by the branch. Therefore in respect of stock unsold by the branch, H.O. has to make a
provision of unrealized profit. In the given example Rs. 40 has to be provided for every toy
unsold by the branch. Such provision would also reduce the branch stock to the cost price for
Statement of Financial Position purpose. The following illustration reveals the manner of
ascertaining the profit in these cases.
Illustration 12: A head office sends goods to its branch at 20% less than the list price (i.e.,
catalogue price). Goods are sold to consumers at cost plus 100%. From the following particulars
ascertain the profit made at the head and the branch on the wholesale basis.
Head Office (Rs.)
Purchases
2,00,000
Goods sent to branch (invoice price)
80,000
Sales
1,70,000
Assume that head office is selling goods to customers at catalogue price.
UNIT 5: Branch Accounting
Branch (Rs.)
80,000
Page 225
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Branch Stock Account
Amount Particulars
2,00,000 By Goods sent to branch @
1,15,000 160
By Sales @ 200
Particulars
To Purchases @ 100
To Gross profit
To Stock reserve being unrealised
profit on stock sent to branch
and remaining unsold there:
1,600
60 × .
160
To Net profit
3,15,000
6,000
By Stock at the end* @ 100
1,15,000
Branch Trading Account
Particulars
Amount Rs. Particulars
To Goods from head office @ 160
80,000
By Sales @ 200
To Profit - To general profit and
By Stock** 160
loss account
16,000
96,000
1
2
1,70,000
65,000
3,15,000
1,15,000
By Gross profit
1,09,000
1,15,000
*Closing stock at head office is
arrived at as follows:
Goods purchased at cost, i.e., @ 100
Deduct: 1,70,000
Sale price of goods sold to 85,000
customers.
Less: Profit at 50% of sales
80,000
Deduct: 30,000
Invoice price of goods "sent" to
branch
Amount
80,000
Amount Rs.
80,000
16,000
96,000
Rs.
2,00,000
85,000
50,000
1,35,000
65,000
Less: Profit at 37 % on invoice
price
Total cost of goods sold and sent
Closing stock
80,000
**Closing stock at branch has been 16,000
arrived at as follows:
Page 226
80,000
64,000
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Goods received at invoice price i.e., @
160
Deduct: List price of goods sold to
customers
Less: 20% profit on list price
Invoice price of goods sold
Stock at the end (at invoice price)
16,000
Workings:
Let the cost price to H.O. be Rs. 100
List price of the goods sold = Rs. 100 + 100% Margin = Rs. 200
Invoice price to the branch
= List price less 20%
= Rs. 200 - 20% of Rs. 200
= Rs. 160
Profit made by the Branch on Invoice price =
Profit on list price
.
=
.
= 25 %
=
Mark-up on the basis of invoice
3. BRANCH KEEPING FULL SYSTEM OF ACCOUNTING
Independent branches maintain comprehensive account books for recording their transactions;
therefore a separate trial balance of each branch can be prepared. The head office maintains one
ledger account for each such branch, wherein all transactions between the head office and the
branches are recorded. The head office A/c in branch books and Branch A/c in head office
books should tie up whereby completeness of recording of transactions can be ensured.
3.1
Accounting Entries for Various Transaction between Head office & Branch
Transactions
Head Office books
(a) Dispatch of goods to BranchA/c Dr
To Good sent to
branch by H.O.
Branch A/c
Branch Books
Goods recd. from
H.O A/c Dr.
To Head Office A/c
(b) When goods are returned Goods sent to BranchA/c Dr. Head Office A/c Dr.
To Goods reed. from
To Branch A/c
by the Branch to H.O.
H.O. A/c
UNIT 5: Branch Accounting
Page 227
ICAN Advanced Accounting CAP II CHAPTER II
(c) Branch Expenses
paid by the Br.
are No Entry
Expenses A/c
To Cash A/c
Dr.
(d) Branch Expenses paid by Branch A/cDr.
To Bank A/c
H.O.
Expenses A/c Dr.
To Head Office A/c
(e) Outside purchases made No Entry
by the Br.
Purchases A/c Dr.
To Bank (or) Crs. a/c
(f) Sales effected by the No Entry
Branch
Cash or Debtors A/c Dr
To Sales A/c
(g) Collection from Debts. of Cash or Bank A/c Dr.
To Branch A/c
the Br. recd. by H.O.
Head office A/c Dr.
To Sundry Drs. A/c
(h) Payment by H.O. for Branch A/c Dr.
To Bank A/c
purchase made by Br.
Purchase (or) Sundry
Creditors A/c Dr.
To Head Office A/c
(i) Purchase of Asset by No Entry
Branch
Sundry Assets A/cDr.
To Bank (or) Liability
A/c
(j) Asset purchased by the Branch Asset A/cDr.
Br. but Asset A/c To Branch A/c
retained at H.O. books
Head office A/c Dr.
To Bank (or) Liability a/c
(k) Depreciation on (j) above
Branch A/c Dr.
To Branch Asset a/c
(l) Remittance of funds by Branch A/c Dr.
To Bank A/c
H.O. to Branch
Depreciation A/c Dr.
To Head Office A/c
Bank A/c Dr.
To Head Office A/c
(m) Remittance of funds by Reverse entry of (l) above
Branch to H.O
Reverse entry of (l) above
(n) Transfer of goods from (Recipient) Br. A/c Dr.
one Branch to another To Supplying
Branch A/c
branch
Supplying Branch
H.O. A/c
Dr.
To Goods Received
from Head office A/c
Recipient Branch
Goods Received
from Head office A/c Dr.
To Head Office A/c
Page 228
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Students may find a few further practical situations and it is hoped that they can pass entries on
the basis of accounting principles explained above.
The final result of these adjustments will be that so far as the Head Office is concerned, the
branch will be looked upon either as a debtor or creditor, as a debtor if the amount of its assets
is in excess of its liabilities and as a creditor if the position is reverse. A debit balance in the
Branch
Account should always be equal to the net assets at the branch. The important thing to
remember, when independent sets of accounts are maintained, is that the branch and head office
books are connected with each other only through the medium of the Branch and the Head
Office Account of their component which are converse of each other. Therefore, whatever
adjustments have to be made must be passed only through them; also when accounts of the
branch and head office are consolidated both the Branch and Head Office Accounts will be
eliminated.
3.2
Adjustment and reconciliation of Branch and Head Office Accounts
If the branch and the head office accounts, converse of each other, do not tally, these must be
reconciled before the preparation of the final accounts of the concern as a whole.
It is very important to note that the Balance of Head Office A/c in Branch books and Branch A/c
in Head Office books are tallied before financial statements are prepared.
The point at which an action has been effected should be taken as the basis and the other point
should adjust its books on the basis of the transaction effected at the other end. In Accounting
language, if Head Office has sent goods worth Rs. 50,000 but the branch has received till the
closing date goods only Rs. 40,000, then the branch should treat Rs. 10,000 as goods in transit
and should pass the following entry:
Goods in transit A/c
To Head Office A/c
Dr
10,000
10,000
However, there will be no entry in Head office books being the point where the event has been
recorded in full, hence no further entries in Head office books.
Reasons for Disagreement: Following are the possible reasons for the disagreement between
Branch A/c in Head office books and Head office A/c in Branch books on the closing date:  Goods dispatched by the Head office not received by the branch. These goods may be in
transit or lost in transit.
 Goods returned by the branch to Head Office may have been received by the H.O.
Again, these goods may be in transit or lost in transit.
 Sum remitted by Head office to branch or vice versa remaining in transit on the closing
date.
UNIT 5: Branch Accounting
Page 229
ICAN Advanced Accounting CAP II CHAPTER II
 Receipt of income or payment or expenses relating to the Branch transacted by the head
office or vice versa, hence not recorded at the respective ends wherein they are normally
to be recorded.
The technique of reconciliation has been illustrated through the example given below:
Head Office
Dr.
Cr.
1,50,000
1,12,000
-
Goods sent to Branch
Goods recd. from H.O. A/c
Branch A/c
Head office A/c
Branch
Dr.
Cr.
1,40,000
78,500
On analysis of Branch A/c in Head office books and Head office A/c in branch books, you find:
 Rs. 15,000 remitted by the branch has not been received, hence not recorded in the head
office books.
 Direct collection of Rs. 10,500 from a customer of the branch by Head office not
informed to the branch, hence not recorded by the branch.
 A sum of Rs. 14,500 paid by branch to the suppliers of head office not recorded at Head
office.
 Head office expenditure allocation to the branch Rs. 12,000 not recorded in the branch.
 Rs. 7,500 being FD interest of head office received by the branch on oral instructions
from H.O., not recorded in the head office books.
Particulars
i. Goods in
transit (Rs.
10,000)
ii. Cash in
Transit:
iii. Direct
Collection
by H.O. on
behalf of the
Branch
Head Office
Books
No Entry
Page 230
Cr.
-
Cash in Transit 15,000
A/c Dr
To Branch A/c
15,000
Sundry Cr. A/c
Dr
To Branch A/c
Branch
Books
Goods in
Transit A/c
Dr.
To Head
office A/c
(No Entry)
Dr.
10,000
-
14,500
14,500
Cr.
10,000
Head Office
A/c Dr
To Debtors
A/c
No Entry
iv. Direct
payment of
Rs. 14,500
by Branch
on behalf of
Dr.
(No Entry)
10,500
10,500
-
-
12,000
12,000
No Entry
Branch Exp.
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
A/c.
H.O.
v. Expenditure
Allocated to
branch
Branch A/c
Dr
To Sundry
income
Dr
To H.O.
A/c
7,500
(No Entry)
7,500
vi. Fixed
Deposit
interest of
Rs. 7,500
directly
received by
the Branch
In the books of Branch
Particulars
Head Office Account
Amount Rs. Particulars
To Sundry Debtors A/c
To Balance c/d
10,500
90,000
By Balance b/d
By Goods in transit
By Branch expenses
1,00,500
By balance b/d
Amount
Rs.
78,500
10,000
12,000
1,00,500
90 000
In the books of Head-Office
Branch Account
Particulars
Amount Rs.
Particulars
Amount Rs.
To Balance b/d
1,12,000
By Cash in Transit
15,000
To Sundry income
7,500
By Sundry Creditors
14,500
By Balance c/d
90,000
1,19,500
To balance b/d
1,19,500
90,000
Students may note (i) the balance of Head Office A/c in Branch books and Branch A/c in
HeadOffice books have tallied (ii) Adjustment are made only at the point;
UNIT 5: Branch Accounting
Page 231
ICAN Advanced Accounting CAP II CHAPTER II
 Where the recording has been omitted, and
 Other than the point where action has been effected.
Other Points
1) Inter-branch transactions are usually adjusted as if they were entered into only with the
head office. It is a very convenient method of treating such transaction especially where the
numbers of branches are large. Suppose Biratnagar Branch incurred an expenditure on
advertisement of Rs. 1,000 on account of Kathmandu Branch, the entries that would be
made in such a case would be as follows:
2)
In Biratnagar Books: Head Office A/c
To Cash
Dr.
In Kathmandu Books: Advertisement A/c
To H.O. A/c
Dr.
In H.O. Books: Kathmandu Branch A/c
To Biratnagar Branch A/c
Dr.
Dr.Rs.
1,000
Cr.Rs.
1,000
1,000
1,000
1,000
1,000
Often the accounts of fixed assets of a branch are kept in the head office books; in such a
case, at the end of the year, the amount of depreciation on the assets is debited to the
branch concerned by recording the following entry:
Branch Account
Dr.
To Branch Asset Account
The branch will pass the following entry:
Depreciation Account
Dr.
To Head Office A/c
3) Usually the head office has to devote considerable time in attending to the affairs of the
branch; on that account, it may decide to raise a charge against the branch in respect of the
cost of such time. In such a case the amount is debited to the branch as 'Expenses' and is
credited to appropriate revenue head such as Salaries Accounts, General Charges Account,
Entertainment Account etc. The branch credits the H.O. Account and debits Expenses
Account.
3.3 Incorporation of Branch Balance in Head Office Books
The method that will be adopted for incorporating the trading result of the branch with that of
the head office would depend on whether it is desired to prepare separate Profit & Loss Account
and Statement of Financial Position of the branch and the Head Office or consolidated statement
of account of both branch and head office.
In the first-mentioned case, the amount of profit or loss shown by the Profit & Loss Account of
the branch only will be transferred to Head office Account in the branch books and a converse
Page 232
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
entry will be passed in the Head Office books by debit to the Branch Account. This method has
already been illustrated above. In such a case, not only the Profit & Loss Account of the branch
and that of the head office would be prepared separately but also there would be separate
Statement of Financial Position for the branch and the head office. The branch Statement of
Financial Position would show the amount advanced by the head office to it, as capital. In the
head office Statement of Financial Position, the same amount would be shown as an advance to
the branch.
If however, it is desired to prepare a consolidated Profit & Loss Account and Statement of
Financial Position, individual balances of all the revenue accounts would be separately
transferred to the Head Office Account by debit or credit in the branch books and the converse
entries would be passed in the head office books. The effect thereof will be similar to the
amount of net profit or loss of the branch having been transferred since it would be composed of
the balances that have been transferred. In case it is also desired that consolidated Statement of
Financial Position of the branch and the head office should be prepared, it will also be necessary
to transfer the balance of assets and liabilities of the branch to the head office. The adjusting
entries that would be passed in this respect are shown below:
(a)
Head Office Account
To (individual) Asset Account
Dr.
(b)
(Individual) Liability Account
Dr.
To Head Office Account
Converse entries are passed in the head office books.
It is obvious that after afore-mentioned entries have been passed, the Branch Account in the
Head Office books and Head Office Account in the branch books will be closed and it will be
necessary to restart them at the beginning of the next year.
In consequence, at the beginning of the following year, the under-mentioned entry is recorded
by the branch:
Asset Account (In Detail)
Dr
To Liability Accounts
To H.O. Account (The difference between assets and liabilities)
Illustration 13:The following trial balances as at 31st Ashad,2070 have been extracted from
the books of Major Ltd. and its branch at a stage where the only adjustments requiring to be
made prior to the preparation of a Statement of Financial Position for the undertaking as a
whole are of an internal character.
UNIT 5: Branch Accounting
Page 233
ICAN Advanced Accounting CAP II CHAPTER II
Particular
Share capital
Sundry fixed assets
Sundry current assets
Sundry current liabilities
Stock reserve, 1stsharawan 2069 (Note 2)
Revenue account
Branch account
Head Office account
Head Office
Rs.
Rs.
1,50,000
75,125
1,21,809
34,567
693
43,210
31,536
2,28,470
2,28,470
Branch
Rs.
Rs.
18,901
23,715
(Note 3)
9,721
10,250
42,616
22,645
42,616
Notes:
1) Goods transferred from H.O. to the branch are invoiced at cost plus 10% and both
revenue accounts have been prepared on the basis of the prices charged.
2) Relating to H.O. goods held by branch on 1st shrawan, 2069, includes goods received
from H.O. at invoice price Rs. 4,565.
3) Goods invoiced by H.O. to branch of Rs. 3,641 were in transit at 3lst December, 1993, as
was also a remittance of Rs. 3,500 from branch.
4) At 31st Ashad,2070, the following transactions were reflected in the H.O. books but
unrecorded in the branch books;
a) the purchase price of a lorry, Rs. 2500, which reached the branch on December 25;
b) a sum received on 31st Ashad,2070 from one of the branch debtors, Rs. 750.
You are required:
(i) to record the foregoing in the appropriate ledger accounts in both set of books.
(ii) to prepare a Statement of Financial Position on at 31st Ashad 2070 for the undertaking
as a whole.
Solution:
In H.O. Books
Branch Account
Particulars
To Balance b/d
Page 234
Amount
Particulars
Rs.
31,536 By Cash in Transit
By Balance c/d
31,536
Amount
Rs.
3,500
28,036
31,536
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Cash In Transit A/c
Amount
Particulars
Rs.
3,500 By Balance c/d
Particulars
To Balance b/d
Amount
Rs.
3,500
3,500
Stock Reserve A/c
Particulars
To Balance b/d
3,500
Amount Rs.
Particulars
746 By Balance b/d
By Revenue a/c
746
Amount Rs.
693
53
746
Rs.
4,565
3,641
H.O. goods in stock at branch
Goods in transit
8,206
Stock Reserve required as at 3lst Ashad, 2070 , 1/11 of Rs. 8,206 = 746
Dr.
Particulars
To Stock Reserve
To Balance b/d
Particulars
To current assets (debtors)
To balance c/d
Revenue A/c
Amount
Particulars
Rs.
53
By Balance b/d
43,157
43,120
In Branch Books
Head Office A/c
Amount Rs.
Particulars
750
By Balance b/d
28,036
By Goods in Transit
By Motor lorry
28,786
Amount
Rs.
43,210
43,210
Amount Rs.
22,645
3,641
2,500
28,786
Goods In Transit A/c
Particulars
To Head Office
Amount
Rs.
3,641
3,641
UNIT 5: Branch Accounting
Amount
Rs.
Particulars
By Balance c/d
3,641
3,641
Page 235
ICAN Advanced Accounting CAP II CHAPTER II
Motor lorry A/c
Particulars
To Head Office
Particulars
To balance b/d
Amount
Rs.
2,500
2,500
Amount
Rs.
23,715
Amount
Rs.
Particulars
By Balance c/d
2,500
2,500
Sundry Current Assets A/c
Particulars
Amount
Rs.
750
22,965
23,715
By H.O. (Remittance by debtor)
By Balance c/d
23,715
Major Ltd.
Statement of Financial Position
as on 31st Ashad,2070
Liabilities
Amount Rs. Assets
Amount Rs.
Share capital:
Fixed assets:
1,50,000 Gross
96,526
Issued and subscribed
block
less
capital
depreciation
53,047 Investments
Reserves and surplus:
- Current assets, Loans and
Revenue reserve
- advances:
1,51,169*
Secured loans
Unsecured loans
Sundry current assets
44,288
Current
liabilities
and
provisions:
2,47,695
2,47,695
Sundry current liabilities
*Current Assets:
Head office
Cash in transit
Branch (less debt collected)
Stock in transit
Gross
Less: Stock Reserve
1,21,809
3,500
22,965
3,641
1,51,915
746
1,51,169
Working Notes:
In the head office Statement of Financial Position branch current account does not figure due to
incorporation of branch assets and liabilities. As has been stated earlier branch current account
will equal branch assets minus branch liabilities. The profit is shown below:
Page 236
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Branch account—opening balance
Add: Current profit made by branch
Branch assets:
Fixed Assets
Motor vehicle
Sundry current assets
Goods in transit
Gross assets
Less: Current liabilities
Net Assets of branch
28,036
**10,250
38,286
18,901
2,500
22,965
3,641
48,007
9,721
38,286
** For the profit made by the branch the entry is to debit branch account and credit Head Office
Statement of Profit or Loss. That is why H.O. reserve account is shown at Rs. 53,407, i.e., Rs.
43,157+Rs. 10,250.
Illustration 14: Deep Well Ltd. Makwanpur has a Branch at Pokhara where a separate set of
books is used. The following is the trial balance extracted on 31st Ashad 2070.
Head Office Trial Balance
Particular
Share Capital (Authorised: 10,000
Equity Shares of Rs. 100 each):
Issued: 8,000 Equity shares
Profit and Loss A/c – 1.1.2010
Interim Dividend paid- Falgun, 2070
General Reserve
Fixed Assets
Stock
Debtors and Creditors
Profit for 2005
Cash Balance
Branch Current Account
Rs.
Rs.
8,00,000
25,310
30,000
1,00,000
5,30,000
2,22,470
50,500
62,730
1,33,710
10,29,410
21,900
82,200
10,29,410
Branch Trial Balance
Particular
Fixed Assets
Profit for 2070
Stock
Debtors and Creditors
Cash Balance
Head Office Current Account
Rs.
95,000
31,700
50.460
19,100
6,550
1,71,110
UNIT 5: Branch Accounting
Rs.
10,400
1,29,010
1,71,110
Page 237
ICAN Advanced Accounting CAP II CHAPTER II
The difference between the balances of the Current Account in the two sets of books is
accounted for as follows:
a) Cash remitted by the Branch on 31st Ashad, 2070, but received by the Head Office on
1stshrawan 2070 - Rs. 3,000.
b) Stock stolen in transit from Head Office and charged to Branch by the Head Office, but not
credited to Head Office in the Branch books as the Branch Manager declined to admit any
liability (not covered by insurance) - Rs. 1,700.
Give the Branch Current Account in Head Office books after incorporating Branch Trial
Balance through journal. Also prepare the company's Statement of Financial Position as on 31st
Ashad, 2070
Solution:
The Branch Current Account in the Head Office Books and Head Office Current Account in
theBranch Books do not show the same balances. Therefore, in order to reconcile them, the
following journal entries will be passed in the Head Office books:
Journal Voucher
2069-70
Ashad 31
Particular
Cash in Transit A/c
To Branch Current A/c
Dr
Dr. Rs.
3,000
Cr. Rs.
3,000
(Cash sent by the Branch on 31st Ashad, 2069
but received at H.O. on 1st Shrawan, 2070)
Loss by theft A/c
To Branch Current A/c
Dr
1,700
1,700
(Stock lost in transit from H.O. to Branch)
In order to incorporate, in the H.O. books, the given Branch trial balance which has been drawn
up after preparing the Branch Profit & Loss Account, the following journal entries will be
necessary:
Journal Voucher
2069-70
Ashad 31
Particular
Branch Current Account
To P & L A/c
Dr
Dr. Rs.
31,700
Cr. Rs.
31,700
(Branch Profit for 2070)
Branch Fixed Assets
Branch Stock
Branch Debtors
Branch Cash
Page 238
Dr
Dr
Dr
Dr
95,000
50,460
19,100
6,550
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
1,71,110
To Branch Current Account
(Branch assets brought into H.O. Books)
Branch Current A/c
To Branch Creditors
Dr
10,400
10,400
(Branch creditors brought into H.O. Books)
Branch Current Account
Particulars
To Balance b/d
To Profit & Loss A/c
To Branch Creditors
Amount Rs.
1,33,710
31,700
10,400
1,75,810
Particulars
By Cash in transit
By Loss of theft
By Sundry Branch Assets
AmountRs.
3,000
1,700
1,71,110
1,75,810
Statement of Profit or Loss for 2069-70
Liabilities
Amount Rs.
Particulars
Amount Rs.
1,700 By Balance b/d
25,310
To Loss by Theft
30,000 By Year's Profit:
82,200
To Interim Dividend for Aug., 2010
1,07,510 H.O.
31,700
To Balance c/d
Branch
1,39,210
1,39,210
Statement of Financial Position of the Company
as on 31st Ashad 2070
Particulars
Amount Rs.
Fixed Assets:
H.O.
Branch
10,00,000
Authorized capital:
10,000 Equity Shares
of Rs. 100
each
Issued and Subscribed
Capital: 8,000 Equity
Shares of Rs. 100
each Fully paid
General Reserve
Profit & Loss Account
Creditors :
H.O.
Branch
8,00,000
21,900
10,400
1,00,000
1,07,510
32,300
10,39,810
5,30,000
95,000
Stock:
2,22,470
H.O.
50,460
Branch
Debtors:
50,500
H.O.
19,100
Branch
Cash
in 62,730
Hand:
6,550
H.O.
Branch
Cash in
Transit
UNIT 5: Branch Accounting
Amount
Rs.
Assets
6,25,000
2,72,930
69,600
69,280
3,000
10,39,810
Page 239
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 15: NB Ltd. manufactures a range of goods which it sells to wholesale customers
only from its head office. In addition, H.O. transfers goods to a newly opened branch at factory
cost plus 15%. The branch then sells these goods to the general public on only cash basis.
The selling price to wholesale customers is designed to give a factory profit which amounts to
30% of the sales value. The selling price to the general public is designed to give a gross margin
(i.e., selling price less cost of goods from H.O.) of 30% of the sales value.
The company operates from rented premises and leases all other types of fixed assets. The rent
and hire charges for these are included in the overhead costs shown in the trial balances.
From the information given below, you are required to prepare for the year ended 31st Ashad,
2070 in columnar form.
(a)
(b)
A Profit & Loss account for (i) H.O. (ii) the branch (iii) the entire business.
Sheet as on 31st Ashad, 2070 for the entire business.
Particulars
Raw materials purchased
Direct wages
Factory overheads
Stock on 01-04-2069
Raw materials
Finished goods
Debtors
Cash
Administrative Salaries
Salesmen's Salaries
Other administrative & selling overheads
Inter-unit accounts
Capital
Sundry Creditors
Provision for Unrealised profit in stock
Sales
Goods sent to Branch
Goods Received from H.O.
H.O
Rs.
35,000
1,08,500
39,000
Rs.
1,800
13,000
37,000
22,000
13,900
22,500
12,500
5,000
Branch
Rs.
Rs.
9,200
1,000
4,000
6,200
2,300
2,000
50,000
13,000
1,200
2,00,000
46,000
3,10,000
3,10,200
65,200
44,500
67,200
67,200
Notes:
1) On 28th Ashad, 2070 the branch remitted Rs. 1,500 to the H.O. and this has not yet been
recorded in the H.O. books. Also on the same date, the H.O. dispatched goods to the
branch invoiced at Rs. 1,500 and these too have not yet been entered into the branch books.
It is the company's policy to adjust items in transit in the books of the recipient.
2)
The stock of raw materials held at the H.O. on 31st Ashadh ,2070 was valued at Rs. 2,300.
Page 240
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
3)
You are advised that:
(a) there were no stock losses incurred at the H.O. or at the branch.
(b) it is the company's practice to value finished goods stock at the H.O. at factory cost.
(c) there were no opening or closing stock of work-in-progress.
4)
Branch employees are entitled to a bonus of Rs. 156 under a bilateral agreement.
Solution
NB Ltd.
Trading and Profit & Loss Account for the year ended 31st Ashad, 2070
Particulars
ToMaterials
To wages
To Factory
Overheads
Factory cost
To Opening
stock of
finished goods
To Goods from
H.O.
To Gross Profit
To Admn.
Salaries
To Salesmen
Salaries
To Other Admn.
& selling
Overheads
To Stock
Reserve
(increase)
To Bonus to
Staff
To Net Profit
H.O.
Rs.
34,500
1,08,500
39,000
1,82,000
13,000
Branch
Rs.
9,200
Total
Rs.
1,82,000
22,200
46,000
1,95,000
66,000
2,61,000
19,560
74,760
85,560
2,89,760
13,900
22,500
4,000
6,200
17,900
28,700
12,500
2,300
14,800
47
-
47
17,053
66,000
156
6,904
19,560
156
Particulars
By Sales
By Goods
Sent to
Branch
By
Closing
stock
H.O.
Rs.
Branch
Rs.
Total
Rs.
2,00,000
65,200
2,65,200
46,000
15,000
9,560
24,560
74,760
2,89,760
19,560
85,560
19,560
85,560
2,61,000
66,000
UNIT 5: Branch Accounting
By Gross
Profit
66,000
23,957
85,560
Page 241
ICAN Advanced Accounting CAP II CHAPTER II
Statement of Financial Position as on 31stAshad, 2070
Liabilities
Capital
Profit:
H.O.
17,053Branch
6,904
Trade
Creditors
Bonus
Payable
H.O. Account
Stock Reserve
H.O.
Rs.
50,000
Branch
Rs.
23,957
13,000
156
10,404
1,247
88,204
10,560
Total
Assets
Rs.
50,000 Fixed Assets
Current
23,957 Assets
Raw
13,000 material
156
Finished
Goods
(Less Res.)
Debtors
Cash
87,113
(+ transit )
Branch A/c
H.O.
Rs.
-
Branch
Total
Rs.
Rs.
-
2,300
15,000
9,560
2,300
*23,313
37,000
23,500
1,000
37,000
24,500
**10,404
88,204
10,560
87,113
*9,560 x 100/115 i.e., 8,313 + 15,000 = 23,313
** 5,000 + 6,904 -1500 = 10,404.
3.4 Incomplete Information in Branch Books
If it is desired that profitability of the branch should be kept secret from the branch staff, the
head office would hold back some key information from the branch, e.g., amount of opening
stock, cost of goods sent to the branch, etc. The head office, in such a case would maintain a
record of goods sent to the branch by passing the entry:
Goods Supplied to the Branch Account
To Purchases Account
Dr.
The value of the closing stock will also be adjusted only in head office books.
In such a case, for closing its books at the end of the year, the branch will simply transfer
various revenue accounts to the head office without drawing up a Trading and Profit & Loss
Account.
On that basis, supplemented by the record of transactions maintained at the head office, it will
be possible to construct the Trading and Profit & Loss Account of the branch.
Illustration 16: Electricals Ltd. of Pokhara has a branch at Kathmandu to which the goods are
supplied from Pokhara but the cost thereof is not recorded in the Head Office books. On 31st
Ashad 2069the Branch Statement of Financial Position was as follows:
Page 242
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Liabilities
Creditors Balance
Head Office
Amount Rs. Assets
Amount Rs.
40,000 Debtors Balance
2,00,000
1,68,000 Building Extension A/c closed
by transfer to H.O. A/c
Cash at Bank
8,000
2,08,000
2,08,000
During the six months ending on 30-9-2069, the following transactions took place at
Kathmandu.
Sales
Purchases
Wages paid
Salaries (inclusive of advance of
Rs. 2,000)
General Expenses
Fire Insurance (paid for one year)
Remittance to H.O.
2,40,000 Manager's Salary
Collections from Debtors
48,000
Discounts allowed
20,000
Discount earned
Cash paid to Creditors
6,400
Building Account
1,600
(further payment)
3,200
Cash in Hand
Cash at Bank
38,400
4,800
1,60,000
8,000
1,200
60,000
4,000
1,600
28,000
Set out the Head Office Account in Kathmandu books and the Branch Statement of Financial
Position as on 30-9-2069. Also give journal entries in the Kathmandu books.
Solution
Journal Entries
Date Particular
Dr.
2069, Salary Advance A/c
To Salaries A/c
Poush
(The amount paid as advance adjusted by debit to
30
Salary Advance Account)
Dr.
Prepared Insurance A/c
To Fire Insurance A/c
(Six months premium transferred to the Prepaid
Insurance A/c)
Dr.
Head Office Account
To Purchases A/c
To Wages A/c
To Salaries A/c
To General Expenses A/c
To Fire Insurance A/c
UNIT 5: Branch Accounting
Dr. Rs.
2,000
Cr. Rs.
2,000
1,600
1,600
88,400
48,000
20,000
4,400
1,600
1,600
4,800
Page 243
ICAN Advanced Accounting CAP II CHAPTER II
8,000
To Manager's Salary A/c
To Discount Allowed A/c
(Transfer of various revenue accounts (Dr.) to the
H.O. Account for closing the accounts)
Sales Accounts
Discount Earned A/c
To Head Office A/c
[Revenue accounts (cr) transferred to H.O.]
Dr.
Dr.
2,40,000
1,200
2,41,200
Dr.
4,000
4,000
Head Office Account
To Building Account
(Transfer of amounts spent on building extension to
H.O. A/c)
Head Office Account
Date
2069,
Poush 30
Particulars
To Cash-remittance
To Sundries (Revenue A/c)
To Building A/c
To Balanced c/d
Amount
Date
38,400 Ashwin 1
88,400 Poush 30
4,000
2,78,400
4,09,200
Particulars
By Balance b/d
Sundries
(Revenue A/c)
Amount
1,68,000
2,41,200
4,09,200
Statement of Financial Position of Kathmandu Branch as on Paush 20, 2069
Liabilities
Creditors Balances
Head Office Account
Page 244
Total
Assets
Rs.
26,800 Debtors Balances
2,78,400 Salary Advance
Prepaid Insurance
Building Extension A/c
transferred to H.O.
Cash in Hand
Cash at Bank
3,05,200
Total
Rs.
2,72,000
2,000
1,600
1,600
28,000
3,05,200
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Cash and Bank A/c
Date
31st
Ashwin,
2069
Particulars
To Balance b/d
Amount Date
8,000 Kartik1
Paush
30
To Collection from 1,60,000
Debtors
Particulars
By Wages
By Salaries
By Insurance
By General Exp.
By H.O.A/c
By Manager's Salary
By Creditors
By Building A/c
By Balance c/d
Cash in Hand
1,600
Cash at Bank
28,000
1,68,000
Dr.
Date
2069
Ashwin
Paush
Particulars
To balance b/d
Magh 1
To balance b/d
Dr.
Date
Paush 2069
4.
To Sales
Debtors Account
Amount
Date
Particulars
Paush 2069 By Cash Collection
2,00,000
By Discount (allowed)
By Balance c/d
2,40,000
4,40,000
Amount
20,000
6,400
3,200
1,600
38,400
4,800
60,000
4,000
29,600
1,68,000
Cr.
Amount
1,60,000
8,000
2,72,000
4,40,000
2,72,000
Particulars
To Cash
To
Discount
(earned)
To Balance c/d
Creditors Account
Amount Date
Particulars
Ashad
By Balance b/d
60,000
2069Paush,
By Purchases
1,200
2069Magh,
26,800
2069
88,000
By Balance b/d
Cr.
Amount
40,000
48,000
88,000
26,800
FOREIGN BRANCHES
Foreign branches generally maintain independent and complete record of business transacted by
them in currency of the country in which they operate. Thus problems of incorporating balances
of foreign branches relate mainly to translation of foreign currency into Nepalese rupees. This is
because exchange rate of Nepalese rupees is not stable in relation to foreign currencies due to
international demand and supply effects on various currencies.
4.1 Accounting For Foreign Branches
For the purpose of accounting Foreign branch can be classified into two types:
UNIT 5: Branch Accounting
Page 245
ICAN Advanced Accounting CAP II CHAPTER II
(a) Integral Foreign Operation;
(b) Non- Integral Foreign Operation
Let us discuss these two types of foreign branches in detail.
Integral Foreign Operation (IFO): It is a foreign operation, the activities of which are an
integral part of those of the reporting enterprise. The business of IFO is carried on as if it were
an extension of the reporting enterprise's operations. Generally, IFO carries on business in a
single foreign currency, i.e. of the country where it is located. For example, sale of goods
imported from the reporting enterprise and remittance of proceeds to the reporting enterprise.
Non-Integral Foreign Operation (NFO): It is a foreign operation that is not an Integral
Foreign Operation. The business of a NFO is carried on in a substantially independent way by
accumulating cash and other monetary items, incurring expenses, generating income and
arranging borrowing in its local currency. An NFO may also enter into transactions in foreign
currencies, including transactions in the reporting currency. An example of NFO may be
production in a foreign currency out of the resources available in such country independent of
the reporting enterprise.
The following are the indicators of Non-Integral Foreign Operation(a) While the reporting enterprise may control the foreign operation, the activities of foreign
operation are carried independently without much dependence on reporting enterprise.
(b) Transactions with the reporting enterprises are not a high proportion of the foreign
operation's activities.
(c) Activities of foreign operation are mainly financed by its operations or from local
borrowings. In other words it raises finance independently and is in no way dependent on
reporting enterprises.
(d) Foreign operation sales are mainly in currencies other than reporting currency.
(e) All the expenses by foreign operations are primarily paid in local currency, not in the
reporting currency.
(f) Day-to-day cash flow of the reporting enterprises is independent of the foreign enterprises
cash flows.
(g) Sales prices of the foreign enterprises are not affected by the day-to-day changes in
exchange rate of the reporting currency of the foreign operation.
(h) There is an active sales market for the foreign operation product.
The above are only indicators and not decisive/conclusive factors to classify the foreign
operations as non-integral, much will depend on factual information, situations of the particular
case and, therefore, judgment is necessary to determine the appropriate classification.
Controversies may arise in deciding the foreign branches of the enterprises into integral or nonintegral. However, there may not be any controversy that subsidiary associates and joint
ventures are non-integral foreign operation.
Page 246
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
In case of branches classified as independent for the purpose of accounting are generally
classified as non-integral foreign operations.
4.2 Change In Classification
When there is a change in classification from Integral to non-integral
Non-integral to integral.
Accounting treatment is as underIntegral to non-integral
i. Translation procedure applicable to non-integral shall be followed from the date of change.
ii. Exchange difference arising on the translation of non-monetary assets at the date of reclassification is accumulated in foreign currency translation reserve.
From Non-integral to integral
i. Translation procedure as applicable to integral should be applied from the date of change.
ii. Translated amount of non-monetary items at the date of change is treated as historical cost.
iii. Exchange difference lying in foreign currency translation reserve is not to be recognized as
income or expense till the disposal of the operation even if the foreign operation becomes
integral.
4.3 Techniques for Foreign Currency Translation
Integral Foreign Operation IFO
Following are the standard recommendations for foreign currency translation:
1)
All transactions of IFO are translated at the rate prevailing on the date of transaction. This
will require date wise details of the transaction entered by that operation together with the
rates. Weekly or monthly average rate is permitted if there are no significant variations in
the rate.
2) Translation at the Statement of Financial Position datei. Monetary items1 at closing rate;
ii. Non-monetary items2: The cost and depreciation of the tangible fixed assets is translated
using the exchange rate at the date of purchase of the asset if asset is carried at cost. If
tangible fixed asset is carried at fair value, translation should be done using the rate
existed on the date of the valuation.
iii. The cost of inventories is translated at the exchange rates that existed when the cost of
inventory was incurred and realizable value is translated applying exchange rate when
realizable value is determined which is generally closing rate.
iv. Exchange difference arising on the translation of the financial statement of integral
foreign operation should be charged to Statement of Profit or Loss.
1
Monetary item is money held and assets and liabilities to be received or paid in fixed and
determinable amounts of money. Cash, receivables and payables are examples of monetary
items.
UNIT 5: Branch Accounting
Page 247
ICAN Advanced Accounting CAP II CHAPTER II
2
Non- monetary items are assets and liabilities other than monetary items. Fixed assets,
Investments in equity shares, Inventories are examples of non-monetary assets.
Non- Integral Foreign Operation - Accounts of non-integral foreign operation are translated
using the following principles:
i.
ii.
Statement of Financial Position items i.e. Assets and Liabilities both monetary and nonmonetary: – apply closing exchange rate.
Items of income and expenses: - At actual exchange rates on the date of transactions.
iii.
However, accounting standard allows average rate subject to materiality.
iv.
Resulting exchange rate difference should be accumulated in a "foreign currency
translation reserve" until the disposal of "net investment in non-integral foreign
operation".
Illustration 17: S & M Ltd., Kathmandu, have a branch in Sydney, Australia. Sydney branch is
an integral foreign operation of S & M Ltd.
At the end of 31st Ashad, 2070, the following ledger balances have been extracted from the
books of the Kathmandu Office and the Sydney Office:
Kathmandu
(Rs. thousands)
Share Capital
Reserves & Surplus
Land
Buildings (Cost)
Buildings Dep. Reserve
Plant & Machinery (Cost)
Plant & Machinery Dep. Reserve
Debtors/Creditors
Stock (1.4.2069)
Branch Stock Reserve
Cash & Bank Balances
Purchases/Sales
Goods sent to Branch
Managing Director's salary
Wages & Salaries
Rent
Office Expenses
Commission Receipts
Branch/ H.O. Current A/c
Page 248
Debit
500
1,000
2,500
280
100
10
240
30
75
25
120
Credit
2,000
1,000
200
600
200
4
520
100
256
-
Sydney
(Australian dollars
thousands)
Debit
Credit
200
130
30
60
20
10
123
20
5
45
12
18
100
7
-
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
The following information is also available:
Stock as at 31.3.2070:
Kathmandu Rs. 1,50,000
Sydney A $ 3,125
You are required to convert the Sydney Branch Trial Balance into rupees;
(Use the following rates of exchange rates)
Opening rate
Closing rate
Average rate
For Fixed Assets
A$ = Rs. 74
A$ = Rs. 80
A$ = Rs. 77
A$ = Rs. 72
Solution
Sydney Branch Trial Balance (in Rupees)
As on 31stAshadh, 2070Rs. ‘000
Conversion rate per A$
72
Plant & Machinery (cost)
72
Plant & Machinery Dep. Reserve
80
Debtors / Creditors
74
Stock (1.4.2069)
80
Cash & Bank Balances
77
Purchase/Sales
Goods received from H.O.
77
Wages & Salaries
77
Rent
77
Office expenses
77
Commission Receipts
H.O. Current A/c
Exchange loss (balancing figure)
Dr.
14,400
4,800
1,480
800
1,540
100
3,465
924
1,386
28,877
174
29,051
Cr.
9,360
2,400
9,471
7,700
120
29,051
29,051
Illustration 18: - Carlin &Co. has head office at New York (U.S.A.) and branch at
Kathmandu (Nepal). Kathmandu branch is an integral foreign operation of Carlin & Co.
Kathmandu branch furnishes you with its trial balance (inNRs. '000) as on 31st Ashad 2070 and
the additional information given thereafter:
Stock on 1st Shrawan, 2069
Purchases and sales
Sundry Debtors and creditors
Bills of exchange
UNIT 5: Branch Accounting
Dr.
300
800
400
120
Cr.
1,200
300
240
Page 249
ICAN Advanced Accounting CAP II CHAPTER II
Wages and salaries
Rent, rates and taxes
Sundry charges
Computers
Bank balance
New York office a/c
560
360
160
240
420
3,360
1,620
3,360
Additional information: (a) Computers were acquired from a remittance of US $ 6,000 received from New York
head office and paid to the suppliers. Depreciate computers at 60% for the year.
(b) Unsold stock of Kathmandu branch was worth Rs. 4,20,000 on 31st Ashad 2070.
(c) The rates of exchange may be taken as follows:
i.
on 1.4.2069@ Rs. 40 per US $
ii.
on 31.3.2070@ Rs. 42 per US $
iii.
average exchange rate for the year @ Rs. 41 per US $
iv.
Conversion in $ shall be made upto two decimal accuracy.
You are asked to prepare in US dollars the revenue statement for the year ended 31st Ashad,
2070 and the Statement of Financial Position as on that date of Kathmandu branch as would
appear in the books of New York head office of Carlin & Co. You are informed that Kathmandu
branch account showed a debit balance of US $ 39,609.18 on 31.3.2070in New York books and
there were no items pending reconciliation.
Solution
Carlin & Co. Ltd.
Kathmandu Branch Trial Balance in (US $)
as on 31st Ashad, 2070
Conversion
Dr. US $
rate per Us $ (Rs.)
7,500.00
40
Stock on 1.4.2069
19,512.20
41
Purchases and sales
9,523.81
42
Sundry debtors and creditors
2.857.14
42
Bills of exchange
13,658.54
41
Wages and salaries
8,780.49
41
Rent, rates and taxes
3,902.44
41
Sundry charges
6,000.00
Computers10,000.00
42
Bank balance
New York office A/c
81,734.62
Page 250
Cr. US $
29,268.29
7,142.86
5,714.29
39,609.18
81,734.62
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Trading and Statement of Profit or Loss
Dr.
For the year ended 31stAshadh, 2070
Amount
Particulars
Particulars
Rs.
7,500.00 By Sales
To Opening Stock
19,512.20 By Closing stock
To Purchases
13,658.54 By Gross Loss c/d
To Wages and salaries
40,670.74
To Gross Loss b/d
To Rent, rates and taxes
To Sundry charges
To Depreciation on computers
(US $6,000x0.6)
Cr.
Amount
Rs.
29,268.29
10,000.00
1,402.45
40,670.74
1,402.45 By Net Loss
8,780.49
3,902.44
3,600.00
17,685.38
17,685.38
17,685.38
Statement of Financial Position of Kathmandu Branch
as on 31st Ashadh, 2070
Liabilities
Amount Rs. Assets
Amount Rs.
New York Office A/c less
Computers less depreciation
21,923.80 of Rs. 3,600,000
2,400.00
loss of Rs. 17,685.38
7,142.86 Closing stock
10,000.00
Sundry creditors
5,714.29 Sundry debtors
9,523.81
Bills payable
10,000.00
Bank balance
2,857.14
Bills receivable
34,780.95
34,780.95
Self-Assessment Question
Question No. 1
Carlin Co. has head office at New York (USA) and branch at Kathmandu, Nepal. Nepal
branch is an integral foreign operation of Carlin & Co. Nepal branch furnishes you with its
trial balance as on 31st Ashad 2070 and the additional information given there after:
Particulars
Stock on 1st April,2069
Purchases and Sales
Sundry Debtors and Creditors
Bills of exchange
Wages and Salaries
UNIT 5: Branch Accounting
Debit
NRs
300,000.00
800,000.00
400,000.00
120,000.00
560,000.00
Credit
NRs
1,200,000.00
300,000.00
240,000.00
-
Page 251
ICAN Advanced Accounting CAP II CHAPTER II
Rent, rates and taxes
Sundry charges
Computers
Bank balance
New York office a/c
Total
360,000.00
160,000.00
240,000.00
420,000.00
3,360,000.00
1,620,000.00
3,360,000.00
Additional Information:
a) Computers were acquired from a remittance of US $6,000 received from New York head
office and paid to the supplier. Depreciate computers at 60% for the year.
b) Unsold stock of Nepal branch was worth NRs. 420,000 on 31st Ashad, 2070.
© The rates of exchange may be taken as follows:
# on 1.4.2069@ Rs 40 per US$
# on 31.3.2070@ Rs42 per US $
# Average exchange rate for the year @ Rs 41 per US $
#conversion in $ shall be made up to two decimal accuracy
You are asked to prepare in US dollars the revenue statement for the year ended 31st
Ashad, 2070 and the Statement of Financial Position as on that date of Nepal branch as
would appear in the books of New York head office of Carlin & Co
You are informed that Nepal branch account showed a debit balance of US $ 39,609.18 on
31.03,2070 in New York books and there were no items pending reconciliation.
(Hint: Net loss of Nepal Branch= US$17,685.38, Statement of Financial Position Total=
US$ 34,780.95)
Question No. 2
Following are the trial balances as on 31stAshadh, 2070 of PD Ltd.
Capital
Retained Earnings 1.4.2069
Profit for the year
Creditors on Open Account
Creditors for expenses
Goods from Head Office
Cash Received from Branch
Head Office current account 1.4.2069
Total
Premises
Page 252
(Amount in '000)
Head Office
Branch
20,000
2,715
8,415
3,484
5,930
390
7,000
9,987
7,298
47,437
17,782
8,000
4,000
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Furniture & Fittings
Stock in Trade
Trade Debtors
Branch current account 1.4.2069
Goods sent to branch
Cash remitted to Head Office
Cash at Bank
Total
800
9,000
8,000
7,298
7,200
7,139
47,437
400
1,800
650
10,287
645
17,782
From the above prepare the combined Statement of Financial Position of PD Ltd. as on
31stAshadh, 2070 and show the branch current account as it would appear in the head office
books.
(Hint :Branch Current A/c= Rs. 7,495 and Statement of Financial Position Total=
Rs.40,934)
Question 3
SIMRAN (Pvt.) Ltd. is a Kathmandu based trading company having its Branch Office in
Birgunj. As per the policy of the company, goods are sent from the Head Ofice to Branch at cost
plus 10%. Head Office makes a uniform gross profit of 33
1
% on selling price on all its other
3
sales. The Branch sells goods at a uniform gross profit to Branch of 25% on selling price. The
following transactions have taken place during the financial year ended on 16thMagh, 2070
a)
Head Office purchases amounted to Rs. 1,46,40,000, purchase returns were Rs. 6,16,500
and discount allowed by suppliers amounted to Rs. 3,00,900.
b)
Sales by Head Office amounted to Rs. 1,08,00,000, Goods sent to Branch were Rs.
54,45,000 (at invoice price) and discount allowed to customers amounted to Rs. 91,800.
c)
Goods sent to Branch for Rs. 6,60,000 in Magh, 2070 were not received at the Branch until
Magh end.
d)
Branch purchased goods locally for Rs. 18,75,000, discount allowed by suppliers amounted
to Rs. 48,750.
e)
Overhead expenses of Head Office were Rs. 28,02,600 and of Branch Rs. 8,04,750.
f)
Sales by the Branch amounted to Rs. 72,00,000, discount allowed to customers amounted
to Rs. 56,400 and cost of goods lost in-transit was Rs. 80,100.
Branch Stock as on 16thMagh, 2070 included Stock invoiced by Head Office at Rs. 11, 55,
000.
You are required to prepare Trading, Statement of Profit or Loss of the Head Office and Branch
for the year ended 16thMagh, 2070 in columnar form.
g)
(Hint: Net Profit HO = Rs. 1,336,500, Branch= 907,500)
UNIT 5: Branch Accounting
Page 253
ICAN Advanced Accounting CAP II CHAPTER II
Question 4
On Bhadra 1, 2070 goods costing Rs. 33,000 were invoiced by Rameshoor (Nepal) Ltd.
Inaruwato its branch at Biratnager and charged up at a selling price designed to produce a gross
profit of 25 per cent on the selling price. At the end of the month, the return from the Biratnagar
branch showed that sales were Rs.30, 000. Goods invoiced at Rs. 600 to Biratnager branch had
been returned to Inaruwa Head Office. The closing stock at Biratnagar branch was Rs. 12,300 at
selling price.
Record the above transaction in Biratnagar Branch Stock Account, Biratnagar Branch
Adjustment Account and Goods sent to Biratnagar Branch Account in the ledger and balance
the said accounts of 20th Bhadra, 2070.
(Hint: Biratnagar Branch Stock a/c Credit Balance = Rs. 12,300, Biratnagar Branch
Adjustment a/c- Gross Profit= Rs. 7,500; Biratnagar Branch Profit and Loss a/c- Net
profit = Rs. 6,6,75)
Page 254
UNIT 5: Branch Accounting
ICAN Advanced Accounting CAP II CHAPTER II
CHAPTER II
Accounting for Special Transactions
UNIT 6:
DEPARTMENTAL ACCOUNTING
UNIT 6: Departmental Accounting
Page 255
ICAN Advanced Accounting CAP II CHAPTER II
1. INTRODUCTION
When a trader deals in different kinds of merchandise under the same roof, he, normally, divides
his store into departments allocating to each department a particular class of goods, for example
a departmental store may have separate departments for selling different items like machines
,textiles, stationery items, crockery, provisions, etc. At the end of the year, trading and
Statement of Profit or Loss may be prepared for each department separately. The information
furnished by such separate accounts is helpful to the management to judge the relative
performance of the departments and helps in answering the following:
(a) Which departments are to be expanded because of high profitability?
(b) Which departments have high operating expenses? What steps should be taken to improve
the operating efficiency of such departments?
(c) Which departments are to be closed because of poor selling prices and high operating
expenses?
2. DIVISION OF SUBSIDIARY BOOKS
In order to prepare trading and Statement of Profit or Loss separately for each department it is
necessary for the trader to know the department wise date regarding the stock, purchases, sales,
expenses. To obtain such information the merchant uses columnar subsidiary books.
3. ALLOCATION OF EXPENSES
Expenses that can be allocated directly to any department must be charged thereto, other
expenses being apportioned on some equitable basis such as ratioof turnover, wages or floor
area, etc. To have a clear perspective of the problem, a list of some expenses with normal basis
of apportionment has been given below:
 Rent and rates. The value of the floor space occupied by each department , taking into
consideration that office and sales departments normally occupy a more valuable part of
site than other departments.
 Repairs to machines. The actual cost of repairs to the machines in the department. In the
absence of any information, value of machinery can be the basis for apportionment.
 Electric lighting. In proportion to the number of points used in each department taking
into consideration the wattage of the lamps.
 Electric power for machines. Where each department has a separate meter the actual
consumption as shown by meter readings, otherwise the consumption is estimated on
the basis of past experience having regard to the number of machines in each
department and the number of running hours in the period.
 Insurance premiums. In the case of fire insurance premiums, these may be apportioned
on the basis of stocks carried by different departments and the proportion of premises
occupied, if the premium relates to premises. Workmen’s compensation insurance can
be apportioned on the basis of the departmental profits of the preceding period.
Page 256
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
 Works manager’s salary. In proportion to the time spent in or devoted to the work of
each department.
 Depreciation on plant. Based on values of plant possessed by each department.
Illustration 1:-Pokhrel, the proprietor of a departmental store, decided to calculate separate
profits for his first two departments Sadhu & Sudha for the month ending 32ndShrawan, 2069 .
Stock on 32ndShrawancould not be valued for certain unavoidable reasons but his rates of gross
profit (calculated without reference to direct expenses) on sales for the two departments are 40
per cent and 30 per cent.
The following figures are given
Deptt.
Sadhu
Rs.
9,000
42,000
27,000
5,490
Stock on 1stShrawan 2069
Sales
Purchases
Direct expenses
Deptt.
Sudha
Rs.
8,400
3,6000
21,600
8,520
Indirect expenses for the whole business (containing five departments) are Rs. 10,800 which are
to be charged in proportion to departmental sales, except as to one-sixth, which is to be divided
equally. Sales for remaining three departments were Rs. 1,02,000.
Prepare a statement showing profits for the two departments.
Solution:
Trading Account
For the period ending on 32ndShrawan, 2069
Dr.
Particular
To Stock
To Purchases
To Gross profit c/d
Sadhu40 * Rs.42000
100
Sudha 30 * Rs.36000
100
Cr.
Sadhu
Rs
9,000
27,000
UNIT 6: Departmental Accounting
Sudha
Rs
8,400
21,600
Particular
By Sales
By Stock
(balancing figure)
Sadhu
Rs
42,000
10,800
Sudha
Rs
36,000
4,800
_____
52,800
_____
40,800
16,800
_____
52,800
10,800
40,800
Page 257
ICAN Advanced Accounting CAP II CHAPTER II
Statement of Profit or Loss
For the period ending on 32ndShrawan, 2069
Dr.
Cr.
Particular
To Direct expenses(2)
To Indirect expenses
(1) Equally:On sales
basis
To Net profit
SadhuRs
SudhaRs
5,490
8,520
360
2,100
8850
16,800
360
1,800
120
10,800
Particular
By Gross
profit b/d
SadhuRs
SudhaRs
16,800
10,800
_____
16,800
_____
10,800
Tutorial Notes:
(1) Indirect expenses have been divided as follows:
Total indirect expenses
1/6 to be charged equally, i.e., for five departments
For each departments is (1800/5)
Rs.
10,800
1,800
360
Remaining Rs. 9,000 (i.e., Rs.10,800 - Rs.1,800)have been charged in the ratio of sales as
follows:
Department Sales
Rate
Sales expenses
Sadhu
42,000
× 9000 = 2100
Sudha
36,000
× 9000 = 1800
Other three
1,02,000
× 9000 = 5100
Total
1,80,000
Rs.9,000
(2) Direct expenses have not been shown in trading account because the rate of gross profit has
been given on sale without reference to direct expenses.
4 CALCULATION OF DEPARTMENTAL PURCHASES
Illustration 2:BhatbhataniLimited has three departments Aamne, Samne and Magne. From the
particulars given below compute:
(a) the values of stock as on 31stAshad, 2070 and
(b) the departmental trading results.
Page 258
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
(i)
Aamne
Rs.
24,000
1, 46,000
1, 72,500
20%
Stock as on 1stShrawan, 2069
Purchases
Actual sales
G.P on normal selling prices
Samne
Rs.
36,000
1,24,000
1,59,400
25%
Magne
Rs.
12,000
48,000
74,600
331/3 %
(ii) During the year certain items were sold at discount and these discounts were reflected in the
values of sales shown above. The items sold at discount were:
Aamne
10,000
7500
Sales at normal price
Sales at actual prices
Samne
3000
2,400
Magne
1000
600
Solution:
Dr
Particulars
To Opening
Stock
To Purchases
To Gross profit
Departmental Trading Account
For the year ending 31stAshadh,2070
Cr
Aamne
Samne Magne Particular Aamne
Samne Magne
s
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
24,000
36,000 12,000 By Sales
1,72,500 1,59,400 74,600
1,46,000
1,24,000
32,500
39,400
2,02,500 199400
48,000 By Closing
Stock
24,600
84,600
30,000
40,000 10,000
2,02,500
199400 84,600
Working Notes:
a. Calculation of Closing Stock
(1)
Departments
Aamne
Samne
Rs.
Rs.
Magne
Rs.
Ascertainment of cost of sales:
Sales at actual price
Add: Discounts
Sales at normal prices
1,72,500
2,500
1,75,500
1,59,400
600
1,60,000
74,600
400
75,000
Profit on normal prices
Cost of sales as a % of sales
Value of cost of sales
20%
80%
1,40,000
25%
75%
1,20,000
33 1/3%
66 2/3 %
50,000
UNIT 6: Departmental Accounting
Page 259
ICAN Advanced Accounting CAP II CHAPTER II
(2)
Ascertainment of closing stock:
Opening stocks
Purchases
Less: Cost of sales
Closing Stocks
24,000
1,46,000
1,70,000
1,40,000
30,000
36,000
1,24,000
1,60,000
1,20,000
40,000
12,000
48,000
60,000
50,000
10,000
5. CALCULATION OF REMUNERATION OF DEPARTMENTAL MANAGERS
Illustration 3:Yog, Yoga & Nirog are in partnership in a business with two departments Rog
and Rogi. Dept. Dept Rog is managed by Yoga and Dept. Rogi by Nirog.Yoga is entitled to a
salary of Rs. 500 p.a. and to 30% of the net profits of his department after charging his salary
and interest at 10% p.a. on the average net assets (exclusive of cash) of the department, while
Nirog is entitled to a similar salary and percentage of the Rogi Dept. profits.
Interest at 5% p.a. is allowed on partner’s capital accounts but not charged on drawings.
The balance of profits is divisible as to ½ to Yog, 3/10 to Yoga and 1/5 to Nirog.
The following is the summarized list of balances as on 31stMagh, 2069 after closing the
Statement of Profit or Loss of the departments.
Capital and drawing accounts:
Yog
Yoga
Nirog
Assets (other than cash) and liabilities:
Deptt. Rog
Deptt. Rogi
Dr. Rs.
Cr. Rs.
3,000
1,750
1,400
20,000
8,000
6,000
9,380
7,210
1,220
950
Profit for the year to 31stMagh, 2069
Deptt. Rog (before charging salary)
Deptt. Rogi (before charging salary)
3,190
2,760
4,265
Cash
It was reported that net assets at Deptt. Rog have increased during the year by Rs. 520 and
Deptt. Rogiby Rs. 320.
You are required to prepare a statement showing the division of profit between partners.
Page 260
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Department Rog
Profit and Loss Adjustment Account
Particulars
To Salary to Yoga
To Yoga’s Share, 30% of Rs. 1,900 (W.N -1)
To General Statement of Profit or Loss
Amount
500
570
2120
Particulars
By Profit
Amount
3190
3190
3190
Working Note: 1
Profit after charging Yoga salary (Rs. 3,190 – Rs. 500)
Less: Interest at 10% on average net assets, which is as follows:*
Net assets (Rs. 9,380 – Rs. 1,220)
Less: Increase during the year on average basis, i.e., ½ X Rs. 520 **
Net average assets
Interest at 10% on Rs. 7,900
Profit after charging interest and salary
Yoga’s share, 30% of Rs. 1,900
2690
8160
260
7900
790
1900
570
Department Rogi
Profit & Loss adjustment Account
Particulars
Amount
Particulars
To Nirog’s salary
500 By Profit
To Nirog’s share, 30% of Rs. 1,650 (W
495
N – 2)
To general Statement of Profit or Loss
1,765
Amount
2,760
2,760
Working Notes: 2
*Profit after charging Nirog’s salary (Rs. 2,760 – Rs. 500)
Less: Interest at 10% on average net assets which is as follows: *
Net assets (Rs. 7,210 – Rs.950 )
Less: Increase during the year on average basis, i.e. ½ X Rs. 320 **
UNIT 6: Departmental Accounting
2,760
2,260
6,260
160
Page 261
ICAN Advanced Accounting CAP II CHAPTER II
Net average assets
Interest at 10% on Rs. 6,100
Profit after charging interest and salary
Nirog’s share, 30% of Rs. 1,650
6,100
610
1,650
495
** For calculation average net assets deduct ½ of the increase in the net assets from the balance
of net assets at the end. This is based on the following theory:
Let assets in the beginning be Rs. 4,000 and let there be an increase of Rs.50 so that assets at the
end become Rs. 4,050. Now average assets is nothing but sum of assets in the beginning and at
the end divided by 2, i.e., 4,050-1/2 × 50 = Rs. 4,025.
*This is to be taken into account only for the purpose of calculating manager’s share in profits.
General Statement of Profit or Loss
Particular
Total interest on
capital:
Yog
Yoga
Nirogi
To Net Profit
Yog
Yoga
Nirogi
Amount
Amount
Rs.
1000
400
300
1,700
1,092.50
655.5
437.5
2,185
Particular
By Net
profit:
Deptt. Rog
Deptt. Rogi
Amount
3,885
6.
Amount
Rs.
2,120
1,765
3,885
3,885
INTER-DEPARTMENTAL TRANSFERS – AT COST PRICE
The basic idea underlying departmentalization is to make each department a responsibility
centre. In the case of departments they are also profit centre. When one responsibility centre
renders services or supplies goods to another centre, the price at which this is done is known as
‘transfer price’. Thus, transfer price refers to the charge made for goods or services sold
internally. Transfer price may be market price if one is available. Such price may be adjusted for
cash discount and selling costs that do not arise in internal transfers. Such a price would be
equitable both for the buying and selling centres. Where market price is not available the
transfer price may be based on cost plus a margin as profit. Again the cost may be preferably
standard cost so that the selling centre may not pass on its inefficiencies to the buying
department. Recording inter-departmental transaction at transfer price helps the management in
setting up profit centres, fixing responsibility on departmental managers and eventually
evaluates the performance and efficiency of the concerned departments.
Page 262
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
In this section illustrations are given to deal with recording of transfers at cost price. The simple
rule to be applied in these cases is to debit the receiving department for the cost of goods or
services and credit the supplying (or selling) department.
Illustration 4:
A hotel proprietor had two departments, vis., Apartment Department and Meals Department.
Following is the trial balance of his business.
Particular
Income from Apartment Department
Income from Meals Department
Provision from Meals Department
Stock of provision in the beginnings
Cash in hand and at bank
Capital
Customers debit balance
Suppliers’ accounts
Buildings (1/10 is used for meals deptt.)
Provision for depreciation on buildings
Furniture and equipments
General expenses
Interest
Interest accrued
Income tax
Life insurance premium
Wages
Dr. Rs.
Cr. Rs.
46,000
32,000
15,500
1,020
10,000
220,000
800
9,800
210,000
24,000
60,000
27,410
1,130
200
400
1,600
6,000
332,930
332,930
Additional Information:
(i)
(ii)
(iii)
(iv)
The servants in the Apartment Department had occupied a room worth Rs. 120 and took
meals worth Rs. 60. Similarly, servants in the Meals Department had occupied a room
worth Rs. 150 and took meals worth Rs.90.
Wages are charged in the proportion of ½ to the Apartment Department, ¼th to the Meals
Department and remaining to the general Statement of Profit or Loss.
Increase provision for depreciation on building to Rs. 30,000.
A sum of Rs. 800 representing accommodation Rs. 240, and meals Rs. 560 to be charged
to proprietor of the hotel.
UNIT 6: Departmental Accounting
Page 263
ICAN Advanced Accounting CAP II CHAPTER II
*Responsibility centre is a unit of the organization headed by a responsible manager.
Responsibility accounting facilitates the management to evaluate and control the working of
responsibility centres. A ‘responsibility centre’ becomes ‘profit centre’, if it has revenue and
expenses.
You are required to prepare final accounts for the year ending 31stAshad, 2070.
Solution:
Particulars
To Stock
To Provisions
To Depreciation on
buildings
To Wages (as per
T.B.)
To Adjustment as
per (i)
To Net profits
Particulars
To Wages
TO General expenses
To net profit
Page 264
Statement of Profit or Loss
For the year ending 31stAshad, 2070
Meals
Apartment
Particulars
Rs.
Rs
1,020 By Income:
15,500 By, Proprietor
Drawing
600 By interest
5,400
3,000
180
37,930
1,500
240
13,850
46,510
32,710
Apartmen
t Rs.
46,000
240
Meals
Rs.
32,000
560
270
150
46,510
32,710
General Statement of Profit or Loss
Amount
Particulars
Rs.
15,00
By Net profits: Apartment
27,410
Meals
24,000
By interest
Amount
Rs.
37930
13850
1130
52,910
52,910
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Statement of Financial Position
As on 31stAshadh, 2070.
Amount
Assets
Rs.
Liabilities
2,20,000
Capital: Balance
Less: Drawings
Income tax
Premium
Meals
Apartment
400
1,600
560
240
2,41,200
9,800
30,000
Buildings
Furniture and equipment
Customers accounts
Interest accrued
Cash in hand and at bank
2800
2,17,200
24,000
Amou
nt
Rs.
2,10,0
00
60,000
800
200
10,000
Add: Net profit
Suppliers
account
Provisions for
depreciation
281000
281000
Working Notes:
a.
Inter-departmental adjustment is done as follows:
Dept.
Dept.
Apart.
Meals
(i) Expenses on servants in
60
120
apartment department
ii) Expenses on servants in
meals department
150
90
270
150
Total expenses
180
(for apart.
deptt.)
240
(for meals
deptt.)
Illustration 5:Mr. Kulangar carries on trade as scrap-metal merchant also operates a foundry.
The trial balance as on 30thAshad 2070 was as follows:
Particular
Dr.
Cr.
Rs.
Rs.
Capital account 31stAshad 2069
5,500
st
Current account 31 Ashad, 2070
UNIT 6: Departmental Accounting
Page 265
ICAN Advanced Accounting CAP II CHAPTER II
(before crediting profit for the current year)
2,160
Administrative expenses
3,160
Balance in hand and at bank
1,420
Repairs-Foundry
520
Sales-Scrap
24,520
Foundry
20,380
Wages-Scrap
1,200
Foundry
3,520
Purchase-Scrap
18,400
Foundry
8,300
Budget ledger balances
3,140
Sales ledger balances-Scrap
Foundry
2,200
880
Provision for doubtful debts-Scrap
80
Stock-Scrap
4,600
Foundry
1,800
Plant at cost-Scrap
3,600
Foundry
2,400
Provision for depreciation on plant -Scrap
1,400
Foundry
900
st
Motor cycle at cost on 31 Ashad, 2069
Motor cycle purchases and sales account
2,400
800
Provision for depreciation: Motor cycle
1,440
57,360
57,360
Adjustments
(i)
Scrap valued at Rs. 4,600 was transferred from scrap department to foundry.
(ii) Stock on 30thAshad, 2070 were valued at:
Scrap department
Rs.3,400
Foundry department
Rs.1,600
(iii) Provision for depreciation may be calculated as follows:
Plant –Scrap Department 10 per cent on cost
Foundry department
5 per cent on cost
Motor Cycle
10 per cent on cost
Page 266
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
(iv)
(v)
(vi)
The scrap department sales ledger balance includes a debt of 200 which is to be written
off and a provision of 5% is required against the remainder of these debtors. No provision
is considered necessary in the case of the foundry debtors.
Motor cycle is used by the scrap department. The balance of Rs. 800 on the motor
purchases and sales account represent the purchases of a new vehicle during the year for
Rs. 1,600 less for depreciation was Rs. 600.
Administrative expenses are to be apportioned on the basis: scrap department ¼, foundry
department ¾.
You are required to prepare:
(a) Trading and Statement of Profit or Loss for the two departments; and
(b) Statement of Financial Position (Consolidated).
Solution:
Statement of Profit or Loss
For the year ending 30thAshad, 2070
Particulars
To Stock
To Purchases
To Transfer
To Wages
To Gross profit c/d
To Administrative
Expenses
To Repairs
To Bad debts
To Depreciation :
Plant
Motor cycle
To Net profit
transferred
to capital
Scrap
Deptt.
Rs.
Foundry
Deptt.
Rs.
4,600
18,400
1,200
8,200
32,520
1,800
8,300
4,600
3,520
3,760
21,980
790
220
2,370
520
-
360
280
120
-
6,870
750
8520
3760
UNIT 6: Departmental Accounting
Particulars
By Sales
By Transfer
By Stock
By
Gross
profit b/d
By profit on
sales
of motor
cycle
Scrap
Deptt.
Rs.
Foundry
Deptt.
Rs.
24,520
4,600
3,400
20,380
1,600
_____
32,520
8,320
_____
21,980
3,760
200
-
8520
3760
Page 267
ICAN Advanced Accounting CAP II CHAPTER II
Liabilities
Capital
Current
A/C:
Profit:
Scrap Dept.
Foundry
dept.
6,870
750
7,620
2,160
Less:
Current A/C
(Dr.
balance)
Sundry
creditors
Statement of Financial Position
As On 30thAshadh, 2070
Amount
Assets
Rs.
Plant:
5,500
Scrap
Department
Cost
Less: Provision
Foundry
5,460
Department :
Cost
Less: Provision
Motor Cycle:
Cost
Less: provision
3,140
Stock:
Scrap Dept.
Foundry Dept.
Debtors:
Scrap Dept.
Less: provision
Foundry
Balance at bank and
in hand
Amount
Rs.
3,600
1,760
1,840
2,400
1,020
1,380
3,220
2,800
1,120
1,680
3,400
1,600
5,000
2,000
100
1,900
800
14,100
2,780
1,420
14,100
Working Notes:
Following adjustments are necessary in respect of purchase and sale of motor cycle:
Motor Cycle Account
Particulars
To Balance b/d
To Additions
Amount Rs.
2,400
1,600
4000
Page 268
Particulars
By Motor cycle
disposal account
By Balance c/d
Amount Rs.
1,200
2,800
4,000
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Provision For Depreciation On Motorcycle Account
Amount
Particulars
Particulars
Rs.
To provision for dep. on 600
By Balance b/d By
Profit and Loss account
motorcycle sold
1,120
(10% on Rs. 2,800)
To Balance c/d
1,720
AmountRs.
1,440
280
1,720
Motor Cycle Disposal Account
Particulars
To Motor Cycle account
To Profit & Loss account
Amount Rs.
1,200
200
1,400
Particulars
By Provision
By Sale Proceeds
Amount Rs.
600
800
1,400
Illustration 6: Anil was the sole proprietor of a garage. He owned the buildings and charged the
business a rent of Rs. 1,000 p.a. The trial balance on 31stAshadh, 2070 was:
Debits
Rs.
Credit
Rs.
Sales:
Purchases:
Cars-new and second- 1,00,110
1,05,000
Cars-new and second-hand
hand
30,000
34,150
Petrol
Petrol
12,520
Materials including tyres,
Tyres,
accessories,
etc.
11,270
41,070
accessories, etc.
Repairs
1,000
52,660
Stock on petrol-1-4-2069
Capital account
Stock of materials-1-4-2069
(tyres, accessories, etc)
Cost of motor showroom
Furniture
Plant
Wages:
Mechanics
Petrol pump attendants
Office
Rates and insurance
Rent on 29thChaitra, 2069
Office expenses
Balance at bank
Cash in hand
UNIT 6: Departmental Accounting
4,000
13,880
4,000
30,000
21,630
1,940
4,190
2,530
750
9,200
1,100
20
_______
2,40,510
_______
2,40,510
Page 269
ICAN Advanced Accounting CAP II CHAPTER II
You are given the following information:
(1)
Rent Rs. 1,400 p.a. were paid to 31stAshad, 2070.
(2)
Depreciation is to be charged at 15% p.a. on plant and 5% p.a. on furniture.
(3)
Stock on 31stAshadh, 2070 were:
Cars Rs. 15,600; petrol Rs. 850; materials (including tyres and accessories) Rs. 3,200
(4)
Materials and used on repair jobs cost Rs. 2,250.
(5)
Petrol used on demonstration runs cost Rs. 450
(6)
Mechanic’s time on reconditioning second-hand cars cost Rs.1,500.
(7)
The manager is entitled to 10% commission on profits after charging such commission.
You are required to prepare trading and Statement of Profit or Loss for the year ended
31stAshadh, 2070and Statement of Financial Position as on that date.
(For Trading and Statement of Profit or Loss see next page).
Liabilities
Capital:
Add: Profit
Less: Drawings
Rent
outstanding
Manager’s
commission
Statement of Financial Position
As on 31st Ashadh,2070
Amount
Amount
Assets
Amount
52,660
Fixed assets:
Furniture
less
10,335
dep.
63,015
Plant less dep.
13,880
49,135 Floating Assets:
Stock
19,650
250
Cash at bank
1,100
1,035
50,420
Cash in hand
20
Prepayments
350
Amount
3,800
25,500
21,120
50,420
Notes
1.
2.
Manager’s commission has been calculated to the nearest rupee.
Since rent has been charged to the business, the cost of construction of showroom has been
treated as drawing.
Page 270
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
7
INTER – DEPARTMENTAL TRANSFERS AT SALE PRICE
When goods or services are transferred from one department to another department to another at
sale price, then the following procedure is adopted:
(a)
(b)
(c)
(d)
Debit the receiving department and credit the giving department with sales price of goods
or services transferred. No effort should be made for making the entry at cost price.
Prepare trading and Statement of Profit or Loss in a normal way after considering
transfers at sale prices.
Bring down the net profit or loss as disclosed by the departmental Statement of Profit or
Loss to the third section, the first two being trading account and Statement of Profit or
Loss.
Adjust the profit so brought down to the third section keeping in view the following
guidelines:
(i) Adjust the profit of that department which supplies goods or services;
(ii) The profit is adjusted after considering receiving department’s that portion of stock
at the end which is supplied by the other department at sale by the department itself
from the open market;
(iii) The amount of the adjustment is equal to the difference between the sale pride and
the cost price;
(iv) Entry for the adjustment is
Debit Statement of Profit or Loss (of the supplying department)
Credit Stock reserve (on the stock at the end with the receiving department
UNIT 6: Departmental Accounting
Page 271
ICAN Advanced Accounting CAP II CHAPTER II
STATEMENT OF PROFIT OR LOSS
For the year ending 31st Ashadh,2070
Particulars
Cars Rs.
To Stock
To Purchases
To Wages
To materials for repairs deptt.
To mechanic’s time on cars
To petrol for demonstration
To gross profit c/d
To rent
To rates
To office wages
To office expenses
To depreciation:
Plant
Furniture
To manager’s commission
1,05,00
0
1,500
450
10
×
110
8,760
1,15,710
Petrol
Rs.
1,000
30,000
1,940
2,510
35,450
Materials
Rs.
4,000
11,270
2,950
18,220
Repairs
Rs.
21,630
2,500
18,440
42,570
Particulars
By Sales
By
materials
for repairs
deptt.
By petrol
for
demonstr
ation
By
mechanic
’s time on
cars
By stocks
Cars
Rs.
1,00,110
Petrol
Rs.
34,15
0
-
- 450
- 850
15,600
35,450
Material
s Rs.
12,520
Repairs
Rs.
41,070
2,500
3,200
1,500
-
18,220
42,570
1,15,710
. 11,390
To Net Profit
4,500
200
1,000
2,180
4,190
9,200
4,700
1,035
10,335
32,660
Page 272
UNIT 6: Departmental Accounting
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 7: Global IME Ltd. has two departments: Global and IME. From the following
particulars prepare the consolidated Trading Account and Departmental Trading Account for the
ending 31stAshad, 2070:
Global Rs.
IME Rs.
12000
20000
Opening stock (at cost)
68000
92000
Purchases
112000
140000
Sales
8000
12000
Wages
2000
2000
Carriage
Closing stock:
6000
4500
(i) Purchased goods
14000
24000
(ii) Finished goods
Purchased goods transferred
10000
by IME to Global
8000
by Global to IME
Finished goods transferred
35000
by Global to IME
40000
by IME to Global
Return of Finished goods
10000
by Global to IME
7000
by IME to Global
You are informed that purchased goods have been transferred mutually at their respective
departmental purchase cost and finished goods at departmental market price and that 20% of the
finished stock (closing) at each department represented finished goods received from the other
department.
Solution:
Particulars
To Opening stock
To Purchases
To Wages
To Carriage
To Purchased goods
—
transferred
To Finished goods
—
transferred
To Finished goods
returned
- Gross Profit
Departmental Trading Accounts
For the year ended 31stAshadh, 2070
Global
IMERs.
Particulars
Rs.
20,000
12,000 By sales
92,000
68,000 " Purchased goods
12,000
8,000
-transferred
2,000
2,000 " Finished goods
-transferred
10,000
8,000 " Return of finished
goods
40,000
35,000 " Closing stock:
7,000
10,000
Purchased goods
38,500
46,000
Finished goods
2,21,500
1,89,000
UNIT 6: Departmental Accounting
Global
IMERs.
Rs.
1,40,000 1,12,000
8,000
10,000
35,000
40,000
10,000
7,000
4,500
6,000
24,000
14,000
2,21,500 1,89,000
Page 273
ICAN Advanced Accounting CAP II CHAPTER II
Calculation of Stock Reserve against Finished goods received from the other departments:
Sales
Add: Goods transferred at selling
price
Less: Finished goods returned
Percentage of unrealized profit
Stock of finished goods received
from the other department
Stock reserve to be provided for
Dept. Global
Rs.
1,40,000
35,000
1,75,000
7,000
1,68,000
38,500
× 100 = 22.916
168000
Dept. IME
Rs.
1,12,000
40,000
1,52,000
10,000
1,42,000
46000
× 100
142000
= 32.394
20% of 14,000
i.e. 2,800
. 2800 × 22.916%
=Rs. 642
20%of 24,000
i.e. 4,800
Rs. 4,800 × 32.394%
=Rs. 1555
Consolidated Trading Account
For the year ended 31stAshadh, 2070
Particulars
Amount Rs.
32,000
1,60,000
20,000
4,000
2,197
82,303
_____
3,00,500
To Opening stock
To Purchases
To Wages
To Carriage
To Stock Reserve
To Gross Profit
Particulars
Amount Rs.
By Sales
By Closing Stock:
Purchased goods
Finished goods
2,52,000
10,500
38,000
______
3,00,500
(i) The sum of all transfers is nil in the Consolidated Trading A/c.
(ii) Stock Reserve as calculated earlier is provided so as to eliminate the profit arising due to
over-valuation of stocks resulting out of internal transfers.
Illustration 8:The following balances were extracted from the books of SaagPaat. You are
required to prepare departmental trading account and Statement of Profit or Loss for the year
ended 31stAshadh, 2070, after adjusting the unrealized department profits if any.
Opening Stock
Purchases
Sales
Dept. Saag Rs.
50,000
6,50,000
10,00,000
UNIT 6: Departmental Accounting
Dept. Paat Rs.
40,000
9,10,000
15,00,000
Page 274
ICAN Advanced Accounting CAP II CHAPTER II
General expenses incurred for both the departments were Rs. 1,25,000 and you are also supplied
with the following information: (a) Closing stock of Department Saag Rs. 1,00,000 including
goods from Department Paat for Rs. 20,000 at cost of Department Saag. (b) Closing stock of
Department Paat Rs. 2,00,000 including goods from Department Saag for Rs. 30,000 at cost to
Department Paat. (c) Opening stock of Department Saag and Department Paat include goods of
the value of Rs. 10,000 and Rs. 15,000 taken from Department Paat and Department Saag
respectively at cost to transferee departments. (d) The gross profit is uniform from year to year.
Solution:
Departmental Trading And Loss Account Of saagPaat
For the year ended 31stAshadh, 2070
Particulars
Saag Rs.
Paat Rs. Particulars
Saag Rs.
50,000
10,00,000
To Opening stock
40,000 By Sales
6,50,000
1,00,000
To Purchases
9,10,000 By Closing
4,00,000
________
To Gross profit
7,50,000 stock
11,00,000
11,00,000 17,00,000
4,00,000
To General expenses
50,000
75,000 By Gross
(in ratio of sales)
profit
To Profit to general
profit
and
loss
3,50,000
6,75,000
_______
account
4,00,000
4,00,000
7,50,000
Paat Rs
15,00,000
2,00,000
________
17,00,000
7,50,000
_______
7,50,000
General Statement of Profit or Loss
Particulars
To Stock reserve required
(additional: Stock in Dept Saag
*50% of (Rs.20,000-Rs.10,000)
Stock in Dept. Paat
**40% of (Rs.30,000-Rs.15,000)
To Net profit
Amount Rs.
5,000
6,000
10,14,000
10,25,000
Particulars
By Profit from:
Deptt. Saag
Deptt. Paat
Amount Rs.
3,50,000
6,75,000
_______
10,25,000
*Stock of department Saag will be adjusted according to the rate applicable to department Paat.
This is 50%, i.e., 7,50,000 ÷ 15,00,000.
**Stock of department Paat will be adjusted according to the rate applicable to department
Saag. This is 40%.i.e., 4,00,000 ÷ 10,00,000.
Illustration 09: M/s Indreni Foods consists of three departments – Tito, Mithoand Chhito, Each
department is managed by a manager who is paid commission which has been fixed @ 5%,
10% and 10% respectively of the departmental profits. In the absence or adequacy of profits, a
UNIT 6: Departmental Accounting
Page 275
ICAN Advanced Accounting CAP II CHAPTER II
minimum commission of Rs. 3,000 is to be paid to the manager. Inter-departmental transfers of
goods and services are made on the basis of a loaded price given as under:
From Tito to Mitho
5% above cost
From Tito to Chhito
10% above cost
From Chitoto Mitho
10% above cost
For the year ended 31.3.2070, the books had already been closed and positions drawn. On a
scrutiny subsequently made, it was discovered that the closing stock of the departments
included inter-departmental transfers at loaded price. From the following details, you are to
prepare a revised statement, re-computing the profits or losses of each of the department.
Book results
Inter –departmental
transfers-at loaded
price
Tito
Loss Rs. 19,000
Mitho
Profits Rs. 25,200
Chhito
Profits Rs. 36,000
Rs. 10,500 from
Titoand Rs. 22,000
from Chitto
Rs. 2,100 from Tito
--
Solution:
In The Books Of M/S. Indreni Foods
Statement Recomputing Departmental Profits And Loss
For The Year Ended 31.03.2070
Particulars
Tito (Rs.)
Mitho (Rs.)
(-) 19,000
Given Net Profit/Loss
25,200
Add: Back Commission of Dept Tito.
+ 3,000
Manager
_
i) Minimum ( due to loss)
_
ii)1/9th of 25,200= 2,800
3,000
_
_
Minimum 3,000
_____
______
iii) 1/9th of 36,000
(-) 16,000
28,200
Less: Adjustment of unrealized profits
Included in stocks wrongly
Valued in books at loaded prices
(-) 500
a) 5/105 of 10,500
b) 10/110 lf 22,000
(-) 191
___-___
c) 10/110 of 2,100
28,200
Adjusted profit / loss
(-)16,691
Less: Commission of Departmental manager
i) Minimum
(-) 3,000
3,000
ii) Minimum
___-___
iii) 10%
___-____
Recomputed net profit / loss
25,200
(-)19,691
UNIT 6: Departmental Accounting
Chitto (Rs.)
36,000
_
_
4,000
40,000
(-) 2,000
__-___
38,000
3,800
34,200
Page 276
ICAN Advanced Accounting CAP II CHAPTER II
8. INTER-DEPARTMENTAL TRANSFERS AT COST WHEN COST IS UNKNOWN
Illustration 10:Khajuri Biscuits sells two products manufactured in his own factory. The goods
are made in two departments, Messi and Ronaldo for which separate sets of accounts are
maintained. Some of the manufactured goods of department Messiare used as raw materials by
department Ronaldo and vice versa.
From the following particulars, you are required to ascertain the total cost of goods
manufactured in departments Messi and Ronaldo;
Total units manufactured
Total cost of manufacture
(excluding Inter-departmental transfers)
Dept. Messi
10,00,000
Rs.10,000
Dept. Ronaldo
5,00,000
Rs. 5,000
Department Messi transferred 2,50,000 units to Department Ronaldo and the latter transferred
1,00,000 units to the former.
Solution:
Suppose a is the total cost of department Messi and b the total cost of department Ronaldo.
a = Rs.10,000 + 1/5 b
b = Rs. 5,000 + ¼ a
or
a = Rs. 10,000 + 1/5 (5,000 + ¼ a)
= Rs. 10,000 + 1,000 + 1/20 a
= Rs.11,000 + 1/20 a
or
20a = Rs. 2,20,000 + a
or
19a = Rs. 2,20,000
or
a = Rs. 11,579
Now
b = Rs. 5,000 + 1/4a
= Rs. 5,000 + ¼ (11,579)
= Rs. 5,000 + 2,895 or Rs. 7,895.
Total cost of goods manufactured:
Cost as per the question
Add: Cost of goods transferred
Cost as determined above
Less: Transfer to the department
Net cost of goods manufactured
UNIT 6: Departmental Accounting
Deptt. Messi Rs.
10,000
1,579
11,579
2,895
8,684
Deptt.Ronaldo Rs.
5,000
2,895
7,895
15,789
6,316
Page 277
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 11:Deurali Trade Links has a factory with two departments X and Y. Because of
nature of business, part of manufactured goods of X department is required by Y and of Y by X
which are transferred at cost. X transfers 1/5 of its output to Y and Y 1/10 to X. All the goods
manufactured by the two departments are supplied at 1/6 profit on sale price to retail shop. From
the following information prepare statement of cost of the two departments:
X Dept. Rs.
76,516
41,360
42,124
1,60,000
Raw material used (without including transfers)
Indirect expenses
Direct expenses
Total cost (before transfer)
Y Dept. Rs.
42,730
21,184
36,086
1,00,000
Solution:
Computation of transfers of finished goods to be used in other department:
Let x = Total cost (including the cost of goods from Y Deptt. to X Deptt.)
and y = Total cost (including the cost of goods from X Deptt. to Y Deptt.)
Therefore,
. (76,516 + 41,360 + 42,124) +
=
=
Similarly,
. 1,60,000 +
………..(1)
. (42,730 + 21,184 + 36,086) +
=
=
. 1,00,000 +
………..(2)
By substituting the value of y in equation (1) , we get
=
Or
Or
Or
=
. 1,60,000 +
. 1,60,000 +
(
. 1,00,000 +
)
. 10,000 +
50x = Rs.80,00,000 + Rs.5,00,000 + x
49x = Rs.85,00,000
∴
=
,
,
= Rs. 1,73,469 (to the nearest rupee)
Total cost to Deptt. X
1,73,469
Cost before transfer
1,60,000
Cost of transfer from Deptt. Y
UNIT 6: Departmental Accounting
Rs. 13,469
Page 278
ICAN Advanced Accounting CAP II CHAPTER II
Statement Showing Cost To Departments
(After Taking Into Consideration Transfer From Other Department)
Deptt. X Rs.
Deptt. Y Rs.
1,60,000
Cost (as given ) before transfer
1,00,000
Add: Transfer from Deptt. Y ( calculated above )
13,469
also 1/10 of Rs.1,34,694, total cost of Y
Add: Transfer from Deptt. X, i.e., 1/5 × Rs. 1,73,469
34,694
1,73,469
1,34,694
Less: Transfer to other department
34,694
13,469
Net Cost
1,38,775
1,21,225
Add: Profit at 1/6 of sales to retail shop, i.e., 1/5 of cost
27,7551
24,2452
Sales price
1,66,530
1,45,470
Note: Profit in each department is 1/6 of sales price of retail shop, i.e.
1
Deptt. x = 1/6 X Rs. 1,66,530 = Rs. 27,755
2
Deptt. y = 1/6 X Rs. 1,45,470 = Rs. 24,245
Illustration 12:Gandaki Store Ltd. is a retail store operating two departments. The company
maintains a memorandum stock account and memorandum mark-up account for each of the
departments. Supplies issued to the departments are debited to the memorandum stock account
of the department at cost plus the mark-up, and departmental sales are credited to this account.
The mark-up on supplies issues to the departments is credited to the mark up account for the
department. When it is necessary to reduce the selling price below the normal selling price, i.e.,
cost plus mark-up, the reduction (mark-down) is entered in the memorandum stock account and
in the mark up account. Department Y has a mark-up of 33 % on cost and Department Z 50%
on cost.
The following information has been extracted from the records of Gandaki Store Ltd. for the
year ended 31stAshadh, 2070:
st
Stock at 1 Shrawan, 2069 at cost
Purchases
Sales
(1)
Department Y Rs.
24,000
1,62,000
2,10,000
Department Z Rs.
36,000
1,90,000
2,85,000
The stock of Department Y at 1stShrawan, 2069 includes goods on which the selling
price has been marked down by Rs. 510. These goods were sold in Shrawan, 2069 at the
reduced price.
UNIT 6: Departmental Accounting
Page 279
ICAN Advanced Accounting CAP II CHAPTER II
(2)
Certain goods purchased in 2069-70for Rs. 2,700 for department Y, were transferred
during the year to department Z, and sold for Rs. 4,050. Purchase and sale are recorded in
the purchases of department Y and the sales of department Z respectively, but no entries
in respect of the transfer have been made.
(3)
Goods purchased in 2069-70were marked down as follows:
Department Y Rs.
8,000
800
Cost
Mark down
Department Z Rs.
21,000
4,100
At the end of the year there were some items in the stock of department Z, which had been
marked down to Rs. 2,300. With this exception all goods marked down in 2069-70were sold
during the year at the reduced prices.
During stock taking at 31stAshadh, 2070 goods which had cost Rs.240 were found to be
missing in Department Y . It was determined that the loss should be regarded as
irrecoverable.
(5) The closing stock in boththe departments are to be valued at cost for the purpose of the
annual accounts.
You are requested to prepare for each department for the year ended 31stAshadh, 2070:
(a) a Trading Account,
(b) a Memorandum Stock Account, and
(c) a Memorandum Mark-up Account.
(4)
Solution:
Gandaki Store Ltd.
Trading Account
For the year ended 31stAshadh, 2070
Particulars
To Opening Stock
at Cost
To Purchases
To Transfer from
Dept. Y
To Gross profit
Dept. Y
Rs.
24,000
1,62,000
51,518
2,37,518
UNIT 6: Departmental Accounting
Dept. Z
Rs.
36,000
1,90,000
2,700
92,496
3,21,196
Particulars
By sales
By Transfer to
Dept. Z
By Goods Lost
By Closing stock
at Cost
Dept. Y
Rs.
2,10,000
2,700
240
24,578
2,37,518
Cr.
Dept. Z
Rs.
2,85,000
36,196
3,21,196
Page 280
ICAN Advanced Accounting CAP II CHAPTER II
Particulars
To Balance b/d
To Purchases
To Memorandum
Mark-up a/c (on
purchases)
To Transfer
To Memorandum
Mark-up a/c
To Memorandum
Mark-up a/c
(on marked down
goods still in stock)
Memorandum Stock Account
Dept. Y
Dept. Z
Particulars
Rs.
Rs.
54,000 By Balance b/d
32,000
1,90,000 By sales
1,62,000
By Transfer
95,000 By Memorandum
54,000
2,700 Mark-up a/c ( on
1,350 transfer)
Memorandum
Mark-up
a/c(Marked-down)
344
By Loss of Stock
By Memorandum
Mark-up a/c (on
lost stock)
By Balance c/d
2,48,000
3,43,394 (Closing stock)
Dept. Y
Rs.
510
2,10,000
2,700
Dept. Z
Rs.
2,85,000
900
800
240
4,100
80
32,770
2,48,000
54,294
3,43,394
Memorandum Mark-up Account
Particulars
Dept. Y
Rs.
To Balance b/d
To Purchases
To Memorandum
Stock a/c (on
transfer)
To Memorandum
Stock a/c (Markeddown)
To Memorandum
Stock a/c (Markeddown on goods
destroyed)
To Gross profit
(balancing figure)
To Balance c/d
510
900
800
80
51,518
8,192
62,000
UNIT 6: Departmental Accounting
Dept. Z
Rs.
Particulars
By Balance b/d
By Memorandum
Stock a/c
(Marked-down on
purchase)
By Memorandum
4,100
Stock a/c (Markup on transfer)
By Memorandum
Stock a/c
(Marked-down
92,496 goods still in
stock)
18,098
1,14,694
Dept. Y
Rs.
Dept. Z
Rs.
8,000
18,000
54,000
95,000
-
1,350
-
344
62,000
1,14,694
Page 281
ICAN Advanced Accounting CAP II CHAPTER II
Working Notes:
(i)
Closing stock at cost
Closing stock at Invoice price
Closing stock At Cost Price
(ii)
Mark-down in unsold Stock of Dept. Z:
(iii)
Verification of gross profit:
Sales
Add: Reduction( mark down)
Gross profit (1/4)
Less: Mark down
Gross profit as per Memorandum Mark up Account
Deptt.Y
Rs.
Deptt. Z
Rs.
32,770
24,578
3/4th
54,294
36,196
2/3rd
2,10,000
1,310
2,11,310
2,85,000
3,756
2,88,756
(1/3rd)
96,252
3,756*
92,496
52,828
1,310
51,518
Illustration 13:MeriBassai& Co. has two Departments Dhurmushe & Suntali. Department
Dhurmuse sells goods to Department Suntali at normal selling prices. From the following
particulars prepare Departmental Trading and Statement of Profit or Loss of the year ended
31.3.2070 and also ascertain the Net profit to be transferred to Statement of Financial Position:
Particulars
Opening Stock
Purchases
Goods from Department Dhurmushe
Wages
Traveling Expenses
Closing Stock at cost to the Department
Sales
Printing and stationery
Department Dhurmushe
Rs.
1,00,000
23,00,000
1,00,000
10,000
5,00,000
23,00,000
20,000
Department Suntali
Rs.
NIL
2,00,000
7,00,000
1,60,000
1,40,000
1,80,000
15,00,000
16,000
The following expenses incurred for both the departments were not apportioned between the
Departments:
(a)
(b)
(c)
Salaries
Advertisement expenses
General expenses
UNIT 6: Departmental Accounting
Rs.2,70,000
Rs. 90,000
Rs. 8,00,000
Page 282
ICAN Advanced Accounting CAP II CHAPTER II
(d) Depreciation @ 25% on the machinery value of Rs. 48,000. Advertisement expenses are to
be apportioned in the turnover ratio, Salaries in 2:1 ratio and Depreciation in 1:3 ratio
between the departments Dhurmushe and Suntali. General expenses are to be apportioned
in 3:1 ratio.
Solution:
Meri Bassi & Co.
Departmental Trading and Statement of Profit or Loss
For the year ended 31stAshadh, 2070
Dept.
Dept.
Dept.
Particular
Dhurmushe
Suntali
Particular
Dhurmushe
Rs.
Rs.
Rs.
1,00,000
23,00,000
__
By Sales
To Opening
23,00,000
2,00,000
By Transfer
stock
7,00,000
to
To Purchases
5,00,000
7,00,000
Dept.
To Transfer
1,00,000
_
1,60,000
Suntali
from Dept.
10,00,000
6,20,000
By Closing ______
Dhurmushe
35,00,000
Stock
To Wages
35,00,000
16,80,000
To Gross profit
10,00,000
1,80,000
90,000
c/d
10,000
1,40,000
By
Gross
20,000
16,000
Profit b/d
To Salaries(2:1)
To Traveling
54,474
35,526
To Printing and
Stationary
To
6,00,000
2,00,000
Advertisement
(23:15) (WN1)
3,000
9,000
To General
Expenses (3:1)
To Depreciation 1,32,526
________
1,29,474
on Machinery
10,00,000
10,00,000
6,20,000
(1:3)
To General
profit and loss
a/c
(Departmental
Profit
transferred)
UNIT 6: Departmental Accounting
Dept.
Suntali
Rs.
15,00,000
1,80,000
_
_______
16,80,000
6,20,000
________
6,20,000
Page 283
ICAN Advanced Accounting CAP II CHAPTER II
General Statement of Profit or Loss
for the year ended 31stAshadh, 2070
Particulars
Rs.
Particulars
Rs.
To Stock Reserve
By Departmental
46,667 Trading & P/L
for Unrealized
2,15,333 Dept.Dhurmuse1,32,526
Profit
To Net Profit (taken
Dept. Suntali1,29,474
2,62,000
to Statement of
2,62,000
Financial Position)
2,62,000
Working Notes:
1. Apportionment of Advertisement Expenses: Advertisement expenses have been apportioned
on the basis of outside sales made by the two departments. No advertising effort is required
for inter-departmental transfers.
2. Computation of Stock reserves for Closing Stock of Dept. Suntali.
Percentage of gross profit of Dept. Dhurmuse:
Proportion of stock transferred by Dept. Dhurmuse included in the closing stock of Dept.
Suntali:
Hence, Stock Reserve comes to
Illustration 14:Department Desktop sells goods to Department Lapto at a profit of 25% on cost
and to Department Mouse at 10% profit on cost. Department Laptop sells goods to Desktop and
Mouse at a profit of 15% and 20% on sales, respectively. Department mouse charges 20% and
25% profit on cost to department Desktop and Laptop respectively.
Department Managers are entitled to 10% commission on net profit subject to unrealised profit
on department sales being eliminated. Departmental profits after charging Managers’
commission but before adjustment of unrealised profit are as under:
Department Desktop
Department Laptop
Department Mouse
36,000
27,000
18000
Stocks lying at different departments at the end of the year are as under:
From Department Desktop
From Department Laptop
From Department Mouse
Dept Desktop Rs.
14,000
6,000
Dept Laptop Rs.
15,000
5,000
Dept Mouse Rs.
11,000
12,000
-
Find out the correct department profits after charging Managers’ Commission.
UNIT 6: Departmental Accounting
Page 284
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Calculation of correct Profit
Department
Desktop Rs.
36,000
4,000
40,000
Department
Laptop Rs.
27,000
3,000
30,000
Department
Mouse Rs.
18,000
2,000
20,000
4,000
36,000
4,500
25,500
2,000
18,000
3,600
32,400
2,550
22,950
1,800
16,200
Department
Desktop Rs.
Department
Laptop Rs.
Department
Mouse Rs.
Total Rs.
__
1/5x15,000
=3,000
1/11x11,000
=1,000
0.20x12,000
=2,400
Profit
after
charging
managers
commission
Add back: Managers Commission (1/9)
Less: Unrealised Profit on Stock
(Working Note)
Profit before Managers’ Commission
Less : Commission for Department
Manager @ 10%
Working Notes:
Stock lying with
Unrealised Profit of:
Department Desktop
Department Laptop
Department Mouse
.015x14,000
=2,100
1/6x6,000
=1,000
UNIT 6: Departmental Accounting
1/5x5,000
=1,000
4,000
4,5000
2,000
Page 285
ICAN Advanced Accounting CAP II CHAPTER II
Chapter II
Accounting for Special Transactions
UNIT 7:
Computation of Insurance Claims For
Loss of Stock and Profit
Page 286
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
1. MEANING OF FIRE
For purposes of insurance, fire means:
1.
2.
3.
Fire (whether resulting from explosion or otherwise) not occasioned or happening through :
(a) Its own spontaneous fomentation or heating or its undergoing any process involving
the application of heat;
(b) Earthquake, subterraneous fire, riot, civil commotion, war, invasion act foreign
enemy, hostilities (whether war be declared or not), civil war, rebellion, revolution,
insurrection, military or usurped power.
Lightning.
Explosion, not occasioned or happening through any of the perils specified in 1(a) above.
(i)
(ii)
(iii)
of boilers used for domestic purposes only;
of any other boilers or economizers on the premises;
in a building not being any part of any gas works or gas for domestic purposes or
used for lighting or heating the building.
The policy of insurance can be made to cover any of the excepted perils by agreement and
payment of extra premium, if any. Damage may also be covered if caused by storm or tempest,
flood, escape of water, impact and breakdown of machinery, etc., again by agreement with the
insurer.
Usually, fire policies covering stock or other assets do not cover explosion of boilers used for
domestic purposes or other boilers or economizers in the premises but policies in respect of
profit cover such explosions.
2.
CLAIM FOR LOSS OF STOCK
A fire insurance contract provides for indemnification by the insurer, of any financial loss
suffered by the insured, as a result of damage or destruction of the insured property by fire or
other specified perils. The contract is for a specified period, usually for a year and the
consideration for the promise by the insurer is the premium paid by the insured. Stocks of all
kinds are important items of property for any business to insure and more so for a trading
concern. A substantial part of the working capital, in any business, is locked up in stocks and
working capital most of which comes from the borrowings. Therefore, if stocks are destroyed or
damaged by fire, it will very much affect the financial solvency of the business. Insurance of
stocks will help business to cover this risk adequately.
2.1 Average Clause
Some unscrupulous businessmen may resort to under-insurance of stocks in order to save some
amount of premium. Under-insurance means insuring for a lesser value. Under-insurance is
resorted to because, usually the loss will not be total and therefore, in spite of under-insurance,
the businessman can recover his loss. For example, stocks worth Rs. 1,00,000 may be insured
for, say, Rs. 60,000, because the insured knows, from experience, that in the event of fire not all
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 287
ICAN Advanced Accounting CAP II CHAPTER II
his stocks are likely to be lost. (There are, of course, materials like plastics, cotton and other
materials where nothing can be saved in the event of fire. These are exceptions.) So, if there is a
fire and the actual loss is Rs. 50,000, the insured can recover the amount in the absence of an
'average clause'. To prevent such misuse of insurance, the policy incorporates an 'average
clause'.
By inserting average clause, the insured is called upon to bear a portion of loss himself in the
event of under-insurance. The main object of this clause is to discourage under-insurance, to
encourage full-insurance and, above all, to impress upon the property owner the necessity of
having his property valued accurately before insurance. Under this clause the loss is suffered by
both insurer and insured proportionately. This is based on the principle that, in case of underinsurance, the owner of the property himself acts as an insurer to the extent the property has not
been insured with the insurance company. If, for example, a building of Rs. 60,000 is insured
for Rs. 50,000, then, to the extent of Rs. 10,000, the owner himself is acting as insurer and will
bear proportionate losses. If, because of fire there is a complete loss of building of Rs. 60,000,
then insurance company will bear only Rs. 50,000 and the proprietor of the building will bear
Rs. 10,000. If the loss is less than Rs. 60.000, then the share of the insurance company is
reduced proportionately. The formula, therefore, may be laid down as follows:
Loss to be borne by the insurance company
=
=
× ActualLoss
,
,
× 60,000 = Rs. 60,000
(When there is a complete loss)
If the actual loss to the building is estimated at Rs. 30,000 then insurance company will pay:
=
=
×
,
,
× 30,000 =
. 25,000
Alternatively, since the building of Rs. 60,000 has been insured by two parties, i.e., by the
insurance company to the extent of Rs. 50,000 and by the owner himself to the extent of Rs.
10,000, loss also must be suffered by both the parties in the ratio of risk insured, i.e., 5: 1. So,
calculate total loss and divide it in the ratio of risk covered. In the above example, since loss is
estimated at Rs. 30,000, the insurance company will bear 5/6th of Rs. 30,000, i.e. Rs. 25,000 and
property owner will bear 1/6th of Rs. 30,000, i.e., Rs. 5.000.
2.2 Deductible or excess
With respect to each type of policy, the insurance company may deduct a specified amount at
the time of paying the claim. This is known as 'deductible' or 'excess'. For example, in the case
of a fire policy, a sum of Rs. 10,000 is deducted as per the tariff advisory committee
recommendations in force. Similarly, for other claims under other types of policies, specified
amounts are deductible.
Page 288
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
2.3 Survey expenses
When a claim is made on the occurrence of a loss, the insurance company appoints a surveyor to
assess the loss, so that the claim may be admitted and eventually paid. He has to be paid some
fees, which, in some cases, is paid by the insured in the first instance and later reimbursed by
the insurer.
2.4 Journal Entries
The following entries are to be made on the payment of premium, occurrence of a loss,
admission and payment of claim:
Account
Debited
Credited
Bank
Ins. Premium
Payment of premium
Ins. Premium
Transfer of premium to Statement of Profit and Loss A/c
Profit or Loss
Asset
Loss of Stock
On the occurrence of a loss to an asset
like building / stock
Surveyor fees/ Bank Insurance Co.
On the payment of surveyor fees
On the reimbursement of surveyor fees Bank
Insurance Co.
Surveyor fees
Profit and Loss A/c
If surveyor fees is not reimbursable
Loss of Stock
Insurance company
Insurance Co.
Bank
On the admission of claim by insurance
company
On the payment of claim
Loss of Stock
Profit and Loss
There will be a balance in the loss
account if the claim admitted is less than
loss. Such loss would be transferred to
Profit and Loss A/c
Transaction/event
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
(ix)
Illustration 1: Goods of Rs. 80,000 of M/s Champa Devi & Sons are insured for Rs. 70,000.
Loss due to fire is assessed at Rs. 16.000. Calculate the claim of M/s Champa Devi & Sons
against the insurance company. The policy is subject to average clause.
Solution:
First Method:
Claim
= Amount of Policy x Actual loss/ Total value of goods insured
=
,
,
×
. 16,000 =
. 14,000
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 289
ICAN Advanced Accounting CAP II CHAPTER II
Second Method:
Goods of Rs. 80,000 have been insured by two parties, i.e., to the extent of Rs. 70,000 by the
insurance company and to the extent of Rs. 10.000 by M/s Champa Devi& Sons. Hence, total
loss of Rs. 16,000 will be divided between them in the ratio of 7: 1. Hence, M/s Champa Devi&
Sons will suffer: 1/8 × Rs. 16.000 = Rs. 2,000. Thus, out of the total loss of Rs. 16,000, the
insurance company will pay only Rs. 14.000. i.e., Rs. 16,000 - Rs. 2,000.
2.5 Calculation of total stock and claim on the date of fire
Claim for loss of stock depends upon actual loss of stock due to fire. Actual loss of stock is
equal to “Total stock on the date of fire less stock salvaged”. Therefore, in order to lodge the
claim it is essential to calculate –
(i)
Total stock in the shop on the date of fire, and
(ii) Stock salvaged.
In many cases information about total stock is not available. The figure has to be constructed
from the details as explained. Total stock is equal to stock in the beginning plus purchases [from
the beginning of accounting year to the date of fire) less cost of stock sold (from the beginning
of accounting year to the date of fire). Cost of stock sold is calculated by deducting gross profit
from sales. This may be put in the form of trading account as under:
Dr.
Particulars
To Stock in the beginning
To Purchases
To Gross profit
Proforma Trading Account
Amount Particulars
Rs.
By Sales
By Stock on the date of fire
(Balancing fig.)
Cr.
Amount
Rs.
-
(a)
Figures for (i) Stock in the beginning, (ii) Purchases, and (iii) Sales up to the date of fire
can be found out from the subsidiary books or accounts of the business and in case
accounting records are destroyed then from sources such as income-tax returns, copies of
invoices from suppliers, bank statements, records of other parties, etc.
(b)
Gross profit can be calculated with the help of sales and rate of gross profit which are
given in the question. Gross profit can also be taken at the same rate as in the preceding
year for which information is usually given. Rate of profit is given sometimes on sales
and sometimes on cost. In case it is given 'on cost' then it must be converted to 'on sale'.
In case it is not given then it must be calculated by preparing the trading account of the
preceding year or years.
Page 290
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
However, it must be remembered that the effect of abnormal happenings [e.g., (i) variation in
the practice of stock valuation, (ii) selling a part of goods either at a loss or at a rate of profit
which is different from that normally followed, (iii) charging productive or direct expenses as
indirect expenses] must be nullified at the time of preparing the trading account for the
calculation of rate of gross profit. This is necessary because the rate of gross profit has a direct
impact on the calculation of claim for loss of stock. Higher the rate of gross profit more is the
stock at the end (because it is a balancing figure) and more is the claim. Therefore, insurance
company is very particular about the rate of gross profit used for the calculation of claim. The
insurer has to ensure that it is not higher than what it should be.
Illustration 2: On 31st Falgun, 2069 a fire occurred in the premises of a firm which carried on
the business of general merchandise. From the various books, which were saved from fire, it
was ascertained that: Sales from 1st Shrawanto 31st Falgun, 2069
Purchases from 1st Shrawan. to 31st Falgun, 2069
Stock on hand on 31stAshadh, 2069
Rs.
12,80,000
8,40,000
2,36,000
Gross profit for the past five years had averaged at 35% on sales.
The value of the salvaged stock was agreed at Rs. 30,000.
Draft a statement showing amount of the claim. There was no average clause.
Solution:
Calculation Of Claim
Memorandum Trading Account
For The Period Ending 31stFalgun, 2069
Amount
Particulars
Particulars
Rs.
To Stock in the beginning 2,36,000 By Sales
8,40,000 By Stock on the date of fire (balancing
To Purchases
4,48,000 figure)
To Gross profit on sales:
=
35 ×
. 12,80,000
100
15,24,000
Estimated claim:
Stock as on 31st Falgun, 2069
Less: Salvaged stock
Claim (loss of stock)
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Amount
Rs.
12.80,000
2,44,000
15,24,000
Rs.
2,44,000
30.000
2,14,000
Page 291
ICAN Advanced Accounting CAP II CHAPTER II
Illustration 3: Unilever Nepal have taken out a fire policy of Rs. 80,000 covering its stock-in
trade. A fire occurs on 30thChaitra, 2069 and stock was destroyed with the exception of the
value of Rs. 20,680. Following particulars are available from the books of account of the firm:
Rs.
30,000
Stock as on 1 Baishak, 2069
1,30,000
Purchases to the date of fire
90,000
Sale to the date of fire
2%
Commission paid to the Purchase Manager on purchases
800
Carriage paid on purchases
50%
Average gross profit on cost
The policy was subject to average clause. You are required to arrive at the (i) Total loss of
stock, and (ii) amount of claim to be made against the insurance company.
st
Solution:
Uniliver Nepal
Memorandum Trading Account
for the period ending 30thChaitra, 2069
Particulars
Amount Rs.
Particulars
30,000
To Stock
By Sales
By Stock on the date
To Purchases
1,30,000
of fire
Add: Com. @2%
2,600*
(balancing figure)
Add: Carriage
800*
Total cost of
1,33,400
1,33,400
purchase
To Gross profit
30,000
50% on cost 1/2 of
1,93,400
cost = 1/3rd of
sale**
Amount Rs.
90,000
1,03,000
1,93,400
Rs.
1,03,400
20.680
Rs. 82.720
Stock as on the date of fire
less; Salvage
Loss of stock
=
=
×
,
,
,
×
. 82,720 =
. 64,000
Though there is a loss of stock of Rs. 82,720 the claim of Rs. 64,000 only will be entertained.
Page 292
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
*Commission on purchases Rs. 2,600 and carriage on purchases Rs. 800 are direct expenses and
must be added to calculate the total cost of purchases. In case of fire, Pacific Traders will lose
not only the price of goods Rs. 1, 30,000 but also cost of purchasing it. In case it is not added
the balancing figure of stock at the end will be less by Rs. 3,400, i.e., (Rs. 2,600 + Rs. 800) and
accordingly the claim will be less which is not correct.
**Rate of gross profit "on cost" must be converted to "on sale".
Illustration 4: On 1st Kartik, 2069 the stock of Shikhar Traders was destroyed by fire but
sufficient records were saved from which following particulars were ascertained:
Rs.
73,500
79.600
3,98,000
4,87,000
1,62,000
2,31.200
st
Stock at cost-1 Shrawan, 2068
Stock at cost-31stAshadh, 2069
Purchases-year ended 31stAshadh, 2069
Sales-year ended 31stAshadh, 2069
Purchases 1stShrawan, 2069 to 30thAshwin, 2069
Sales1stShrawan, 2069 to 30thAshwin, 2069
In valuing the stock for the Statement of Financial Position at 31stAshadh, 2069Rs. 2,300 had
been written off on certain stock which was a poor selling line having the cost Rs. 6,900. A
portion of these goods were sold in Ashwin, 2069 at loss of Rs. 250 on original cost of Rs.
3450. The remainder of this stock was now estimated to be worth its original cost. Subject to the
above exception, gross profit had remained at a uniform rate throughout the year.
The value of stock salvaged was Rs. 5,800. The policy was for Rs. 50,000 and was subject to
the average clause. Work out the amount of the claim of loss by fire.
Solution
Shikhar Traders
Trading Account for 2068-69
(to determine the rate of gross profit)
Rs. Particulars
Particulars
To Opening Stock
73,500 By Sales A/c
To Purchases
Rs.
4,87,000
3,98,000 By Closing Stock:
To Gross Profit
97,400 As valued
79,600
Add: Amount (written off) to
restore stock to full cost
5.68.900
ℎ (
Rs.
)
=
Memorandum Trading Account up to 30th Ashwin, 2069
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
2,300
81,900
5.68.900
97,400
× 100 = 20%
4,87,000
Page 293
ICAN Advanced Accounting CAP II CHAPTER II
Particulars
To Opening
Stock
To Purchases
Normal
items
Abnormal
Total
Items
75,000
6900*
1,62,000
-
1,62,000 By Loss
45.600
-
45,600 By
Closing
2,82,600
6,900
To Gross
Profit
(20% on
Particul
ars
Normal
items
81,900 By Sales 2,28,000
2,89,500
Rs 2,28,000)
Stock
(balanci
ng
figure)
Abnor
mal
items
3,200
Total
2,31,200
-
250
250
54,600
3,450
58,050
2,82,600
6,900
2,89,500
*at cost, book value is Rs. 4,600
Calculation of Insurance Claim
Rs.
58,050
5.800
52.250
Value of Stock on 30thAshwin, 2069
Less: Salvage
Loss of stock
Claim subject to average clause:
=
=
×
.
,
,
× 52,250 =
. 45,004
Illustration 5:A fire occurred on 15th December, 2012in the premises of Pathivara Ltd. From
the following figures, calculate the amount of claim to be lodged with the insurance company
for loss of stock
During current year,cost of purchases has risen by 10% above last year's levels. Selling prices
Rs.
20.000
Stock at cost on 1st April, 2011
30,000
Stock at cost on 31st March, 2012
40,000
Purchases during the year ended 31st March, 2012
88,000
Purchases from 1st April, 2012to 15th Dec., 2012
60,000
Sales during the year ended 31st March, 2012
1,05,000
Sales from 1st April, 2012to 15th December, 2012
have gone up by 5%. Salvage value of stock after fire was Rs. 2,000.
Page 294
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
Trading Account
for the year ending on 31st March, 2012
Particulars
Amount Rs. Particulars
To Opening stock
20,000
By Sales
To Purchases
40,000
By Closing stock
To Gross profit (50% on sales)
30,000
90,000
Memorandum Trading A/c
from 1 April,2011 to 15th December, 2012
Actual
Last Years’
Particulars
Actual
Rs.
RatesRs.
Rs.
30,000
30,000
By Sales A/c
1,05,000
88,000
80,000
By Closing
53,000
50,000
Stock
66,000
1,71,000 1,60,000
1,71,000
Amount Rs.
60,000
30,000
90,000
st
Particulars
To Opening stock
To Purchases
To Gross profit
Last Years’
RatesRs.
100,000
60,000
1,60,000
Amount of Claim
The amount of claim shall be equal to the value of the closing stock i.e. Rs. 66,000 less salvage
value of stock after fire i.e. Rs. 2,000 i.e. Rs. 64,000.
Tutorial Notes:
(i) Gross profit from 1st April to 15th December, 2012has been first calculated at last year's
rates; i.e. 50% on sales of Rs. 1,00,000.
(ii) Closing stock at last year's rates in the balancing figure, taking gross profit at Rs.
50,000.ie 50% on sale of Rs 100,000
(iii) Closing stock at current rates on FIFO basis shall be 10% higher than the one at previous
year's rates as cost of purchase has been risen by 10% and therefore, it comes to Rs.
66,000.
(iv) Last year's columns have been given only for information purposes.
3. CLAIM FOR LOSS OF STOCK
3.1 Scope and Coverage
Fire insurance provides cover only for material damage occurring to buildings, plant and
machineries and fixtures, etc. But this result in partial or total stoppage of business, leading to
trading losses and the policy does not provide cover for such losses. In order to give complete
protection to the insured, a new type of insurance, known as 'loss of profits insurance' or
'consequential loss insurance' has come into vogue. The points of distinction between ‘fire
insurance’ and 'loss of profits insurance' are:
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 295
ICAN Advanced Accounting CAP II CHAPTER II
1.
The subject matter of fire insurance is tangible and covers material property. In the case of
'loss of profits insurance’, it is intangible and covers the earning capacity of the business.
Fire insurance protects the insured against losses of material property, whereas 'loss of
profits insurance' gives protection against trading losses arising due to partial or complete
cessation of business activity. Therefore, while fire insurance covers capital losses, 'loss of
profits insurance' covers revenue losses.
Loss of profits insurance covers the following risks consequent upon fire:
2.
3.
(a)
(b)
(c)
Loss of net profits due to stoppage of business.
Payment of standing charges such as salaries, rent, rates and taxes, directors' fees,
lighting and heating, repairs and maintenance, depreciation, postage and stationary, etc.,
which the insured is obliged to incur in spite of stoppage of business. The insured has to
specify the standing charges which he would like to insure.
Increased working expenses incurred by the insured during the indemnity period in
order to maintain normal business activity.
It must be noted that items (a) and (b) together constitute gross profit. So, in working out
problems if gross profit is calculated for the purpose of indemnification it covers net profit as
well as standing charges.
3.2 Explanation of Certain Terms
Under 'loss of profit' policy the insurer pays the following amounts:
(a)
(b)
Loss of gross profit due to reduced turnover: and
Increased working expenses subject to certain adjustments.
For understanding the procedure of making the claim one should know the meaning of certain
terms explained below:
Indemnity Period: “The period beginning with the occurrence of the damage and ending not
later than 12 months, thereafter, during which the results of the business shall be affected in
consequence of the damage". It must be remembered that the claim under the policy must
relate only to the indemnity period which is chosen by the insured himself. The period can be
anywhere between three to thirty-six months. It is not necessary; however, for the policy to
cover the entire indemnity period, what is essential is that on the date of fire leading to partial
or complete cessation of activity, the policy must be in force. For example, Lumbini Traders
takes a loss of profits policy on 1st Shrawan, 2069 for a year. (The usual period is one year
only). The indemnity period chosen by the insured is one year. There is an outbreak of fire and
damage to premises on 1st Ashad, 2070. The indemnity period runs from 1st Ashad, 2070to
30thJestha, 2071. In this case the indemnity period runs beyond the expiry date of insurance,
however, if the damage takes place after 31st Ashadh, 2070, there is no question of indemnity
period as the policy itself is not in force.
Page 296
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
Standard Turnover: Reduction in turnover is the difference between the standard turnover
and actual turnover during the indemnity period. Standard turnover is defined as 'the turnover
during that period in the twelve months immediately before the date of the damage which
corresponds with the indemnity period. For example, if a fire occurred on 1st Magh, 2069, and
the indemnity period is six months, then the standard turnover is the sales of the period from
1st Magh, 2068 to 31st Ashad, 2069 corresponding to the sales of indemnity period namely,
sales for the period 1st Magh, 2069 to 31st Ashad, 2070.
Annual Turnover: It is the turnover during the twelve months immediately before the date of
damage. In the example given above, annual turnover will be the sales for the period from
1stMagh, 2068 to 30thPaush 2069.
3.3 Steps in the preparation of claim under loss of profits policy
1.
Loss due to reduction in turnover is calculated by applying the gross profit rate to
reduction in turnover. The gross profit rate is calculated with reference to the last
accounting period as follows:
+
ℎ
In case of net loss the formula will be amended as follows:
ℎ
−
× 100
× 100
In case all the standing charges are not insured, the net loss must be reduced as follows:
2.
(a)
ℎ
×
ℎ
ℎ
The increased cost of working is allowed subject to the following adjustments:
Where all the insurable standing charges are not covered by the policy then only a
proportion of the claim is allowed, the proportion being which the sum of the net profit
and insured charges bears to the sum of the net profit and all the standing charges, thus
+
+
ℎ
ℎ
×
This limitation provided in Memo 2 is a limited form of average to increased cost of
working.
(b) The amount is further restricted to a sum which is equal to the product of gross profit rate
and reduction in turnover avoided due to increased cost of working.
3. From the claim so computed under steps (1) and (2) deduction must be made of any
saving in standing charges.
4. Finally the claim calculated under step (3) will have to be proportionately reduced if the
sum insured under the policy is less than the sum produced by applying the rate of gross
profit to annual turnover. The following formula will be helpful
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 297
ICAN Advanced Accounting CAP II CHAPTER II
×
(
3)
This is similar to average clause in respect of fire claim.
Students should carefully go through the working of the following illustration to understand the
process of the computation of the claim made on a "Loss of Profit" policy.
Illustration 6:- Suppose the following information is given:
(i) Indemnity period 13 months
(ii)
Sum insured Rs. 2,00,000
(iii)
Turnover, last financial year ended 31st Ashadh, 2070 Rs. 12,00,000.
(iv)
Gross Profit, i.e., Net profit plus insured standing charges, Rs. 2,00,000 giving a gross
profit rate of 20%.
(v)
Net profit plus all standing charges, Rs. 2, 50,000 i.e., 50,000 of the standing charges
are not insured.
(vi)
Fire occurs on 31st Ashwin 2070 and affects business for 6 months.
(vii)
Turnover for 12 months ended 31st Ashwin, 2070, Rs. 11,70,000.
I.
Turnover: 1st Kartik, 2069 to30th Chaitra, 2069
5,00,000
3.00.000
II.
1st Kartik, 2070 to 30th Chaitra, 2070
III.
Reduction in turnover
2.00.000
(viii)
Increase in cost of working, Rs. 30,000 otherwise of which turnover during 1st Kartik,
2070to 30th Chaitra, 2070 would reduce hereinafter by Rs. 1,60,000.
(ix)
Saving in insured charges in the indemnity period Rs. 10,000.
Solution
The claim in respect of profit will be calculated as follows:
A. Calculation of Gross Claim
Particular
Gross Profit @ 20% on short Sale (W N – 1)
Add: Claim for increase in cost of working
Less: Saving in insured standing charges
Gross Claim
(W N- 2)
Rs.
30,000
24,361
-10,000
44,361
Working Note
W N – 1 : Short Sales
Reduction in turnover 1stKartik, 2069 to 30thChaitra, 2069
Less: 10% down-trend (W N – 3)
Less: turnover 1stKartik, 2070 to 30thChaitra, 2070
Page 298
500,000
(50,000)
(300,000)
150,000
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
W.N – 2 : Claim for increased cost of working
=
(ii)
. .
×
(i)
. .
10,80,000 ×
. 30,000 ×
10,80,000 ×
= . 24,361
+ 50,000
Gross Profit on sales generated by the increased cost of workings
20
= . 1,60,000 ×
= . 32,000
100
Lower of the two i.e. Rs. 24,361 is allowable
W. N – 3 : Calculation of Down trend
Down-trend:
Quarterly sales in 2069-70
.
Sales of first quarter in 2070-71:
. 11,70,000 −
,
,
×3
12,00,000
.
×9
12
300,000
270,000
30,000
Quarterly Downfall
Down- trend (%):
.
,
,
,
× 100 = 10%
W. N 4 :
Calculation of Adjusted Turnover
Sales for the period 1st Kartik,2069 to 31stAshad, 2070 (11,70,000-2,70,000)
Less: Down-trend 10%
Add: Sales from 01-04-2070 to 31-06-2070
B .Application of average clause
Particular
Gross profit of annual turnover, 20% on Rs. 10, 80,000
Sum insured
Hence, claim limited to
44,361 ×
,
,
,
,
900,000
(90,000)
270,000
1,080,000
Rs.
2,16,000
2,00,000
41,075
Illustration 7: There was a serious fire in the premises of M/s Fortunate on 1st September,
2010. Their business activities were interrupted until 31st December, 2010, when normal
trading conditions were re-established. M/s. Fortunate is insured under the loss of profit policy
for Rs. 42,000, the period of indemnity being six months.
You are able to ascertain the following information:
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 299
ICAN Advanced Accounting CAP II CHAPTER II
i.
ii.
iii.
iv.
v.
The net profit for the year ended 31st December, 2009 was Rs. 20,000.
The annual insurable standing charges amounted to Rs. 30,000 of which Rs.2,000 were
not included in the definition of insured standing charges under the policy.
The additional cost of working in order to mitigate the damage caused by the fire
amounted to Rs. 600, and, but for this expenditure, the business would have had to shut
down.
The saving in insured charges in consequence of the fire amounted to Rs. 1,500.
The turnover for the period of four months ended April 30, August 31, and December
31in each of the years 2009and 2010was as under:
2009
2010
Rs.
65.000
70,000
Rs.
80,000
80,000
Rs.
95,000
15,000
You are required to compute the relevant claim under the terms of the loss of profits policy.
Solution:
Calculation of Gross Claim
Particular
Claim for reduction in turnover ( W. N – 1)
Claim for increased cost (W. N – 2 )
Less: Savings in standing charges
Total claim for loss of profits
Rs.
16,000
576
-1,500
15,076
W. N – 1 : Calculation of Reduction in Turnover
Rs.
95,000
15,000
Standard turnover (for the 4 months ending on 31st December 2009)
Actual sales for the indemnity period (for the 4 months ending on 31st
December 2010)
Reduction in turnover
80,000
Gross profit rate:
Net Pro it + Insured standing charges
× 100
Turnover
=
20,000 + 28,000
× 100 = 20%
24,000
Reduction in turnover in GP Ratio:
= 20%
Page 300
80.000 =
. 16,000
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
W.N – 2: Calculation of Standing Charge allowed for Claim
Additional cost of working in order to mitigate the damage = Rs.600.
Since all the standing charges are not insured the amount of claim allowed will be:
+
ℎ
+
×
ℎ
=
20,000 + 28,000
× 600 =
20,000 + 30,000
. 576
Calculation of average clause:
Annual turnover
G. P. on annual turnover
× claim
= Sales for 12 months ending on August 31, 2010
= Rs. 2,45,000
G.P. on annual turnover
= 20% of Rs. 2, 45,000 = Rs. 49,000.
=
=
. 12,922
42,000
×
49,000
. 15,076
Illustration 8: From the following information, you are required to work out the claim under
the loss of profits insurance policy:
1.
2.
3.
4.
5.
6.
7.
Cover — Gross profit Rs. 1, 00,000.
Indemnity period — 6 months.
Damage — due to a fire accident on 28th Ashadh— accounting year ends on 31stAshadh.
Net profit plus all standing charges in the prior accounting year Rs, 1, 50,000.
Standing charges uninsured — Rs. 25,000.
Turnover of the last accounting year was Rs. 5, 00,000, the rate of gross profit being 25%.
The annual turnover, namely, the turnover for 12 months immediately preceding the fire Rs. 5, 20,000.
8. As a consequence of fire, there was a reduction in certain insured standing charges at the
rate of Rs. 25,000 per annum.
9. The standard turnover was Rs. 2, 60.000.
10. Increased costs of working during the period of indemnity were Rs. 20,000.
11. Turnover during the period of indemnity was Rs. 1, 00,000 and out of this turnover Rs.
80,000 was maintained due to increased cost of working.
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 301
ICAN Advanced Accounting CAP II CHAPTER II
Solution:
A. Calculation of Gross Claim
Claim for reduction in turnover ( W. N – 1)
Claim for increased cost (W. N – 2 )
Less: Savings in standing charges
Total claim for loss of profits
W. N – 1 : Calculation of Reduction in Turnover
40,000
16,667
12,500
44,167
Rs.
2,60,000
1,00,000
1,60,000
Standard turnover
Sales during the period of indemnity
Reduction in turnover
Gross profit rate:
Net Pro it + Insured standing charges
× 100
Turnover
Net Pro it + All Standing Charges − Uninsured char
Turnover
× 100
1,50,000 − 25,000
=
× 100
5.00,000
1,25,000
=
× 100 = 25%
5,00,000
=
Gross profit on reduction in turnover
W.N – 2 : Calculation of Standing Charge allowed for Claim
Additional cost of working
= Rs.20, 000.
Since all the standing charges are not insured the amount of claim
allowed will be:
+
ℎ
+
ℎ
=
Page 302
1,25,000
20,000 =
1,50,000
×
. 16,667
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
This must be restricted to G.P. on turnover saved due to increased cost of working. This
works out to Rs. 20,000 i.e. 25% on Rs. 80.000. Therefore amount of Rs. 16,667 towards
increased cost of working will be allowed.
B. Calculation of average clause:
G. P. on annual turnover
× claim
Annual turnover = Rs 5,20,000
G.P. on annual turnover = 25% of Rs. 5, 20,000 = Rs. 1, 30,000.
Illustration 9: A loss of profit policy was taken for Rs. 80,000. Fire occurred on 15th March,
2011. Indemnity period was for three months. Net profit for 2010 year ending on 31st December
was Rs. 56,000 and standing charges (all insured) amounted to Rs. 49,600. Determine Insurance
claims from the following details available from quarterly sales tax returns:Sales
2008 Rs.
2009 Rs.
From 1st Jan to 31st Mar
1,20,000
1,30,000
From 1st Apr to 30th Jun
80,000
90,000
From 1st Jul to 30th Sept
1,00,000
1,10,000
st
From 1st Oct to 31 Dec
1,36,000
1,50,000
Sales from 16.3.2010to 31.3.2010were Rs. 28,000.
Sales from 16.3.2011to 31.3.2011were Rs. Nil.
Sales from 16.6.2010to 30.6.2010were Rs. 24,000 and,
Sales from 16.6.2011to 30.6.2011were Rs. 6,000.
2010 Rs.
1,42,000
1,00,000
1,20,000
1,66,000
2011 Rs.
1,30,000
40,000
1,00,000
1,60,000
Solution:
(i)
Total sales for 2008
Total sales for 2009
Total sales for 2010
Each year represents an increase of 10% sales
over the previous year. This has to be adjusted.
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Rs.
4,36,000
4.80,000
5,28,000
Page 303
ICAN Advanced Accounting CAP II CHAPTER II
(ii)
Gross profit rate:
Net Pro it + Standing charges
× 100
Turnover
=
(iii)
56,000 + 49,600
× 100 = 20%
5.28,000
Computation of short sales
Indemnity period is from 15.3.2011to 15.6.2011
a. Sales of the corresponding period in the previous year:
Sales for the period 16.3.2010to 31.3.2010
Sales for the period 1.4.2010 to 30.6.2010
Less: Sales for the period 16.6.2010 to 30.6.2010
Add: Increase in percentage of sales @'10%
28,000
1,00,000
1,28,000
24,000
1,04,000
10,400
1,14,000
NIL
40,000
40,000
6,000
34,000
b. Sales effected during the indemnity period:
Sales from 16.3.2011to 31.3.2011
Sales from 1.4.2011to 30.6.2011
Less: Sales from 16.6.2011to 30.6.2011
∴ Short sales (Rs. 1,14,400 - Rs. 34,000) =Rs. 80,400
Loss of Profit on short sales =
(iv)
. 80.400 ×
=
. 16,080
Adjusted Annual Turnover for the 12 months ending on 15.3.2011:
Sales
from
16.3.2010 to 31.3.2010
"
"
1.4.2010 to 30.6.2010
"
"
1.7.2010 to 30.9.2010
"
"
1.10.2010 to 31.12.2010
28,000
1,00,000
1,20,000
1,66,000
1,30,000
5,44,000
54,400
5,98,400
(v)
Page 304
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
"
"
1.1.2011 to 15.3.2011
(Sales was nil during 16.3.2011 to 31.3.2011)
Add 10% increase in trend
Adjusted Annual Sales
Application of average clause:
G.P. on adjusted Annual Sales
. 5,98,400 ×
20
=
100
. 1,19,680
Amount of policy = Rs. 80,000
∴ Average clause is applicable
Claim after subjecting
. 16,080 ×
,
,
,
=
. 10,748.66
to Average clause
Rounded off to Rs. 10,749.
Illustration 10: Arniko Ltd's Trading and Statement of Profit or Loss for the year ended
31stDecember, 1993 were as follows:
Trading And Profit & Loss Account
For The Year Ending On 31stAshadh,2069
Particulars
AmountRs.
Particulars
20,000 By Sales
To Opening Stock
6,50,000 By Closing Stock
To Purchases
1,70,000
To Manufacturing Expenses
2.50.000
To Gross Profit c/d
10.90.000
To Administrative Expenses
80,000 By Gross Profit b/d
To Selling Expenses
20,000
To Finance Charges
1,00,000
To Net Profit c/d
50.000
2.50.000
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
AmountRs.
10,00,000
90,000
10,90,000
2,50,000
2,50,000
Page 305
ICAN Advanced Accounting CAP II CHAPTER II
The company had taken out a fire policy for Rs. 3, 00,000 and a loss of Profits Policy for Rs. 1,
00,000 having an indemnity period of 6 months. A fire occurred on 1stKartik, 2069 at the
premises and the entire stocks were gutted with NIL salvage value. The sales for the quarter
1stKartik, 2069 to 30thPaush, 2069 were severely affected. The following are the other
information:
Rs.
2.50,000
1.1.2069 to 31.3.2069
Sales during the period
3,00,000
1.1.2069 to 31.3.2069
Purchase during the period
70,000
1.1.2069 to 31.3.2069
Manufacturing expenses
87,500
1.4.2069 to 30.6.2069
Sales during the period
50,000
Standing charges insured
60,000
Actual expenses incurred after fire
The general trend of the industry shows an increase of sales by 15% and decrease in G.P. by 5%
due to increased costs.Ascertain the claim for stock and Loss of Profits.
Solution:
Calculation of Loss of Stock
Particulars
TRADING ACCOUNT
for the period of 1.04.2069 to 31.32070
Amount Rs.
Particulars
To Opening Stock
To Purchases
ToManufacturing Expenses
To Gross Profit c/d
(20% of Rs. 2,50,000)
90,000
3,00,000
70,000
50.000
By Sales
By Closing Stock
5.10.000
Amount Rs.
2,50,000
2,60,000
5.10.000
Stock destroyed by fire
Rs. 2, 60,000
Amount of Fire policy
Rs. 3, 00,000
As the value of stock destroyed by fire is less than the policy value, the entire claim will be
admitted.
Computation of short sales:
Average sales for the period 01.07.2068 to 30.09.2068
(Rs. 7,82,610/3) (T.N.I)
Add: Increasing trend of sales (15%)
Page 306
Rs. 2,60,870
39,130
(approx.)
3,00,000
87,500
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
Less; Sales during the period 01.07.2069 to 30.09.2069
Short Sales
2,12,500
Computation of G.P. Ratio:
+
=
=
ℎ
× 100
. 50,000 + . 50,000
× 100
. 10,00,000
= 10%
Gross Profit Ratio
Less: Decreasing trend in G.P.
10%
5%
5%
Loss of profit = 5% of Rs. 2, 12,500
Amount allowable in respect of additional expenses:
Least of the following:i. Actual expenditure
ii. G.P. on sales generated by additional expenses 5% of Rs. 87,500 (Assumed
that entire sales during disturbed period is due to additional expenses)
10,625
.×
i.
=
60,000
4,375
,
,
. 60,000 ×
55,000
=
55,000 + 1,30,000
=
. .,
. 17,838 (
.)
. 4,375
G.P. on Annual Turnover:
Adjusted Annual Turnover:
Average Turnover for the period 01.07.2068 to 31.06.2069 (T.N. 1)
Turnover for the period 01.04.2069 to 30.06.2069
Add: Increase in trend 15% (of Rs. 7,82,610) (T.N. 2)
Gross profit on annual turnover (5% of Rs. 11,50,000)
As the gross profit on annual turnover (Rs. 57,500) is less than policy value
(Rs. 1,00,000), average clause is not applicable
Insurance claim to be submitted:
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
782,610
250,000
117,392
1,150,002
57,500
2,60,000
Page 307
ICAN Advanced Accounting CAP II CHAPTER II
Loss of stock
Loss of Profit
Additional Expenses
10,625
4,375
2,75,000
Note: According to the given information standing charges include administrative expenses (Rs.
80.000) and finance charges (Rs. 1, 00,000). Insured standing charges being Rs. 50,000,
uninsured standing charges would be Rs. 1, 30,000.
Tutorial Notes:
(1)
(2)
Break up of sales for the year 2068-69:
Sales for the last quarter of 2068-69
(Rs. 2,50,000 × 100/115)
2,17,390*
Sales for the remaining three quarters of 2068-69
(approx.)
Rs. (10,00,000-2.17,390)
7,82,610
* Sales for the last quarter of 2068-69is computed
on the basis of sales of the first quarter of 2069-70
The increase in trend of sales has been applied to the sales of 2068-69 only as the sales
figure of the first quarter of 2069-70 was already adjusted for the trend.
Self-Assessment Questions
Question No. 1: Sanima Ltd wants to take up a loss of profit policy. Turnover during the
current year is expected to increase by 20%. The company will avail overdraft facilities from its
bank @ 15% interest to boost up the sales. The average daily overdraft balance will be around
Rs. 3 Lakh. All other fixed expenses will remain same. The following further details are also
available from the previous year’s account.
Rs.
Total variable expenses
24,00,000
Fixed expenses:
Salaries
3,30,000
Rent, Rates, and Taxes
30,000
Travelling expenses
50,000
Postage, Telegram, Telephone
60,000
Page 308
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
ICAN Advanced Accounting CAP II CHAPTER II
Director’s fees
10,000
Audit fees
20,000
Miscellaneous income
70,000
Net Profit
4,20,000
Determine the amount of policy to be taken for the current year.
(Hint: Rs. 1,065,000)
Question No. 2: Janta Trading Ltd. gives the following Trading, Statement of Profit or Loss for
the year ended 31stAshadh, 2070.
Trading, Statement of Profit or Loss for the year ended 31stAshadh, 2070
To opening stock
To Purchase
To wages( Rs.20,000 for skilled labour)
To Manufacturing Expenses
To Gross Profit
To Office Administrative Expenses
To Advertising
To Selling Expenses (Fixed)
To Commission on sales
To Carriage outward
To Net profit
Rs.
50,000 By Sales
300,000 By Closing Stock
160,000
120,000
240,000
870,000
60,000 By Gross Profit
20,000
40,000
48,000
16,000
56,000
240, 000
Rs.
800,000
70,000
870,000
240,000
240,000
The company had taken out policies both against loss of stock and against loss ofprofit for
Rs.80, 000 and Rs.172, 000 respectively. A fire occurred on 1stMangsir, 2070
and as a result of which sales were seriously affected for a period of a 4 months. The following
information is available:
a. Purchase wages and other manufacturing expenses for the first four months of 2070-71 were
Rs.100, 000, Rs.50, 000 and Rs.36, 000 respectively.
b. Sales for the same period were Rs.240, 000
c. Other sales figures were as follows:
Rs.
From 01.04.2069to 30.07.2069
300,000
From 11.08.2069 to 30.11.2069
360,000
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
Page 309
ICAN Advanced Accounting CAP II CHAPTER II
From 01.08.2070 to 30.11.2070
60,000
d. Due to rise in wages, gross profit during 2070 was expected to decline by 2% on sales.
Additional expenses incurred during the period after fire, amounted to Rs. 140,000. the amount
of the policy included Rs.120, 000 for expenses leaving Rs.20, 000 uncovered. Ascertain the
claim for loss of stock and loss of profit.
(Hint: Claim for loss of Stock Rs. 80,000, Gross profit= Rs.128,000)
Page 310
UNIT 7: Computation of Insurance Claim for Loss of Stock and Profit
CHAPTER II
Accounting for Special Transactions
UNIT 8:
Investment Accounts
ICAN Advanced Accounting CAP II Chapter II
1.
BACKGROUND
Investments are the financial assets which does not form any physical substance. They represent
legal claims on other entities in the form of various descriptions such as bonds, shares,
debentures etc. Nepal Accounting Standard Board has not issued any accounting standard to
prescribe accounting treatment for recognition, measurement, presentation and disclosure
requirement of investment. Para 7 of NAS 8 on Accounting Policies, Changes in Accounting
Estimates & Errors states that when a standard specifically applies to a transaction, other event
or condition, the accounting policy or policies applied to that item shall be determined by
applying the Standard and considering any relevant Implementation Guidance issued by the
Nepal Accounting Board for the Standard. Further, Para 10 states that in the absence of a
Standard that specifically applies to a transaction, other event or condition, management shall
use its judgment in developing and applying an accounting policy that results in information
that is relevant and reliable. Para 11 further state that in making the judgement, management
shall refer to, and consider the applicability of, the following sources in descending order:
(a) The requirements and guidance in Standards dealing with similar and related issues; and
(b) The definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Framework.
In making the judgement, management may also consider the most recent pronouncements of
other Standard – setting bodies that use a similar conceptual framework to develop accounting
Standards, other accounting literature and accepted industry practices, to the extent that these do
not conflict with the sources described above.
But in practice, entities are following Indian Generally Accepted Accounting Principles (Indian
GAAP) and classify the investment in two categories i.e. Long term investment and short term
investment. As per Indian GAAP, the long term investments are measured at cost unless there is
a permanent fall in the value of the investment. Further, short term investments are accounted at
fair value and any profit or loss due to increment or fall in fair value than carrying amount shall
be charged to Statement of Profit or Loss. But many countries including India have already
gone on convergence with IFRS and Nepal has also committed to go on convergence with IFRS
from mid July 2013, hence it is advisable to adopt the accounting policies as prescribed by
International Accounting Standard Board (IASB) for Investment.
2.
APPLICATION OF NEPAL ACCOUNTING STANDARD (NAS/NFRS)
IASB has issued two separate set of Accounting Standard which deals with the accounting
treatment for Investment. NAS 39 on Financial Instrument: Recognition and Measurement and
IFRS 7 on Financial Instrument: Disclosures. NAS 39 deals with the recognition and
measurement requirement of financial Instruments whereas NFRS 7 deals with the presentation
and disclosure requirement of Financial Instruments. Here, we discuss only about the
recognition and measurement of the financial instruments which are Investments. We shall not
discuss the presentation and disclosure requirement of financial assets. As NAS 39 deals with
UNIT 7: Investment Accounts
Page 311
ICAN Advanced Accounting CAP II Chapter II
the recognition and measurement of the financial instrument, firstly we need to understand the
meaning of financial instrument and how it also covers investment.
3.
FINANCIAL INSTRUMENT
Financial Instruments is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity. Hence, financial instruments include
financial assets, financial liability and equity instruments. This means that financial assets of
one entity shall be financial liabilities or equity instruments of another entity and financial
liabilities or equity instruments of one entity shall be financial assets of another entity. For
example, bond, debenture or bank loan is financial liabilities of entity issuing such bond or
debenture or raising loan and it is financial assets for holder of debenture or bond holder or
provider of loan. Similarly, share capital is equity instrument for share issuing entity and it is
financial assets of holder of equity.
4.
FINANCIAL ASSET:
As per NAS 39 financial asset is any asset that is



Cash;
An equity instrument of another entity, i.e. investment in equity share of another entity;
A contractual right to receive cash or another financial asset from another entity, or to
exchange financial assets or financial liabilities with another entity under conditions that
are potentially favorable to the entity. This includes investment in bond, debenture, loans
provided to other entity, bills receivables, account receivables, investment in treasury bills,
loans and advances provided etc. or

A contract that may or will be settled in the entity’s own equity instrument and is not
classified as an equity instrument of the entity. This includes a option to buy equity shares
or a warrant.
Hence, the definition of financial asset includes investment and it is accounted for as per the
requirement of the NAS 39. As per the requirement of the NAS 39 and entity shall segregate it’s
investment into following three categories.
4.1 Held for Trading Investment
Trading generally reflects active and frequent buying and selling, and investment held for
trading generally are used with the objective of generating a profit from short term fluctuation in
price or dealer’s margin. Hence, an investment that is made for the purpose of generating a
profit from short term fluctuations in price should be classified under this category. An asset
should be classified as held for trading even if it is a part of a portfolio of similar assets for
which there is a pattern of trading for the purpose of generating a profit from short term
fluctuations in price. Examples for held for trading investments are investment in securities like
treasury bills of Nepal government, bonds of Nepal government, debentures or shares of a entity
held with a motive of short term fluctuation gain and entity has not invention to hold the
securities till their maturity.
UNIT 7: Investment Accounts
Page 312
ICAN Advanced Accounting CAP II Chapter II
4.2 Held to Maturity Investment
The investments made with positive intent and ability of the entity to hold till maturity should
be classified as held to maturity investments. The entity does not have the positive intent to hold
an investment to maturity, if any of the following conditions are met:
1.
2.
Entity has the intent and the ability to hold the asset for only an undefined period; or
Entity stands ready to sell the asset (other than if a situation arises that is non-recurring and
could not have been reasonably anticipated) in response to changes in market interest rates
or risks, liquidity needs, changes in the availability of and the yield on alternative
investments, changes in financing sources and terms, or changes in foreign currency risk.
The held to maturity investments should be valued at amortised cost i.e. the cost price less
any impairments (if applicable). The impairments should be included in the Statement of
Profit or Loss for the period.
Hence, held to maturity investment includes those investments which have fixed maturity period
and entity has positive intention and ability to hold the investment till maturity. Examples of
held to maturity investments are investment in bonds and debentures with fixed maturity period,
bonds issued by Nepal Government, Treasuring bills of Nepal Government held with intention
of holding till maturity and not with a motive of short term fluctuation gains.
4.3 Available for Sale Investment
All other investments that are neither "held for trading" nor "held to maturity" should be
classified under this category. These investments should be marked to market on a regular basis
and the difference to be adjusted through reserves. Examples of available for sale investments
are investment in equity shares of another entity, irredeemable preference shares, perpetual
debts which do not have a maturity period and the entity does not have an intention to hold it for
short term fluctuation gains.
5. MEASUREMENT OF THE INVESTMENT
As per NAS 39, an investment shall be measured as per its classification. Following principles
shall be applicable for measurement of investment:
A.
Upon initial measurement
1.
2.
For held for trading category investment- It shall be measure at fair value
For held for maturity and available for sale category investment – It shall be measured at its
fair value plus any transaction cost that are directly related to the acquisition of the
investment. Transaction cost include fees and commissions paid to agent, advisors, brokers
and dealers, levies by regulatory agencies and securities exchanges and transfer taxes and
duties. The transaction cost does not include debt premiums or discounts, financing costs or
internal administrative or holding costs.
B.
1.
Upon Subsequent measurement
Held for trading and available for sale investments – It shall be measure at Fair value
UNIT 7: Investment Accounts
Page 313
ICAN Advanced Accounting CAP II Chapter II
2.
3.
6.
Held to maturity investments – It shall be measure at amortized cost using effective interest
rate method
Investment in equity instruments that do not have a quoted market price and whose fair
value could not measured reliably – It shall be measured at actual cost
EFFECTIVE INTEREST RATE
Effective interest rate is the discount rate which equates the present value of the cash inflows to
the present value of its out flows. This means that the effective interest rate is the Internal Rate
of Return (IRR). Effective interest rate amortize the fees, points paid or received, transaction
costs and other premiums or discounts over the expected life of the investment on a systematic
basis by adopting the internal rate of return of the investment.
Illustration 1: A debt security has a stated principal amount of Rs. 100,000, which will be
repaid by the issuer at maturity in five years, and a stated coupon interest rate of 6% per year
payable annually at the end of each year until maturity (i.e., Rs. 6,000 per year). Muktinath Ltd
purchases the debt security in the market on 01.04.2069, for Rs. 93,400 (including transaction
costs of Rs. 100), that is, at a discount of Rs. 6,600 to its principal (par) amount of Rs. 100,000.
Solution:
In above case, the debt has maturity period of 5 years and it is assumed that the Muktinath Ltd
has invention and ability to hold the investment till maturity. Hence Muktinath Ltd classifies the
debt security as held to maturity and makes this journal entry:
01.04.2069
Held-to-Maturity Investments A/c Dr
93,400
To Cash
93,400
Now, we find the effective interest rate (i.e. IRR) to amortize the discount of the debt over the
maturity period of the debt. Hence, we calculate IRR.
Fake payback period
=
Investment Amount / Average Cash Inflow
=
93,400/{(6000*5+100,000)/5}
=
93,400/26,000
=
3.5923
This fake payback period lies in 12% at 5 year period. But annual cash flow is significantly less
than average cash flow taken as above hence internal rate of return must be lower than 12%.
Hence, we here calculate the total present value of cash inflows at 8%.
Total Present Value at 8%
UNIT 7: Investment Accounts
=
Annual Cash flow X Annuity factor for 5 years +
Maturity value X PVIF at 5 year
=
=
6,000 X 3.9927 + 100,000 X 0.6806
92,015
Page 314
ICAN Advanced Accounting CAP II Chapter II
Here, total present value of cash inflow is lower than cash outflow at inception i.e. Rs. 93,400,
hence now we calculate the total present value at 7%
Total Present Value at 7%
=
Annual Cash flow X Annuity factor for 5 years + Maturity
value X PVIF at 5 year
= 6,000 X 4.1002 + 100,000 X 0.7130
= 95,900
Here, total present value of cash inflow is higher than cash outflow at inception i.e. Rs. 93,400,
hence IRR lies between 7 % and 8%. Now, we calculate the IRR by interpolation
=
7.64%
Amortization Schedule of Debt
Year
(A) Beginning
of period
amortized cost
(B) Interest
and
principal
cash inflow
(C) Reported
interest
income
[=(A) ×7.64%]
(D) Amortization
of debt Discount
[=(C) – (B)]
(E) End-ofperiod
amortized
cost[=(A)+(D)]
2069
93,400
6,000
7,133
1,133
94,533
2070
94,533
6,000
7,220
1,220
95,753
2071
95,753
6,000
7,313
1,313
97,066
2072
97,066
6,000
7,413
1,413
98,479
2073
98,479
1,06,000
7,521
1,521
0.00
At the end of 2069-70, Muktinath Ltd shall make this journal entry:
Cash A/c Dr
Held-to-Maturity Investment A/c Dr
To Interest income
6,000
1,133
7,133
(Interest income is booked on effective interest rate method and the difference between the
interest income booked and actual interest received is debited to Held to Maturity Investment
Account)
Note: the entity shall make above entry for 2070 to 2072 at the amount stated in amortization
schedule)
At the end of 2073, Muktinath Ltd makes this journal entry:
Cash A/c Dr
To Held-to-maturity investment
To Interest income
UNIT 7: Investment Accounts
1,06,000
98,479
7,521
Page 315
ICAN Advanced Accounting CAP II Chapter II
(Held to maturity investment is derecognized on its maturity. The amount received on its
maturity is segregated between the interest income and capital refund)
7. RECOGNITION OF INCOME
Income encompasses both revenue and gains. As per provisions of NAS 39, revenue on
investment like interest and dividend income shall be recognized as per provisions of
accounting standards on Revenue. NAS 18 on Revenue contains the provisions of such revenue
recognition. Para 30 of NAS 18 states that interest shall be recognized using the effective
interest method and dividend shall be recognized when the shareholder’s right to receive the
payment is established. Generally shareholder’s right to receive the payment is established when
dividend is declared by shareholders at AGM. Further, Para 31 of the NAS 18 states that when
unpaid interest has accrued before the acquisition of an interest-bearing investment, the
subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods;
only the post-acquisition portion is recognized as revenue. When dividends on equity securities
are declared from pre-acquisition net income, those dividends are deducted from the cost of the
securities. Hence pre-acquisition interest income and dividend income shall be deducted from
the cost of investment and post acquisition interest and dividend income shall be recognized as
revenue.
8. RECOGNITION OF GAIN AND LOSSES
As per provisions of NAS 39, any gain and losses arising from changes in fair value of
investment shall be recognized as follows:
a)
b)
c)
A gain or loss on investment classified as held for trading shall be recognized in Statement
of Profit or Loss.
A gain or loss on investment classified as available for sale shall be recognized directly in
equity through statement of changes in equity, until the investment is derecognized. At derecognition, the cumulative gain or loss recognized in equity shall be recognized in profit
and loss. The gain or loss arises from impairment and foreign exchange gain or loss shall
not be recognized in equity, instead it shall be charged to Statement of Profit or Loss.
A gain or loss on investment classified as held to maturity shall be recognized in Statement
of Profit or Loss when such investment is derecognized or impaired and through
amortization process.
9. IMPAIRMENT LOSS
An entity shall assess at each Statement of Financial Position date whether there is any objective
evidence that an investment or group of investment is impaired. Impairment loss is defined as
difference between the investment carrying amount and the present value of estimated future
cash flows. Impairment shall be evidenced from the significant financial difficulty of the issuer
or obligor, a breach of contract, a troubled debt restructuring, probable that borrower will enter
into bankruptcy or other financial reorganization, disappearance of active market of financial
assets. If such evidence exits, an entity shall account for the impairment loss as follows:
UNIT 7: Investment Accounts
Page 316
ICAN Advanced Accounting CAP II Chapter II
 If there an impairment loss on held to maturity investment carried at amortized cost has
been incurred, the impairment loss shall be measured at difference between the carrying
amount and the present value of estimated future cash flows discounted at effective
interest rate. The carrying amount shall be reduced to present value of all cash follows
of investment directly or through the use of an allowance account. The amount of the
loss shall be recognized o Statement of Profit or Loss. If in a subsequent period if there
is decrease in impairment loss which was recognized earlier, the entity shall reverse
such impairment loss booked in earlier period. The previously recognized impairment
loss shall be reversed either directly or by adjusting allowance account. The reversal
shall not result in a carrying amount of the investment that exceeds the carrying amount
of amortized cost that would have been had the impairment loss not been recognized at
the date the impairment is reversed.
 If an impairment loss has been incurred on unquoted investment in equity instruments
that is not carried at fair value because its fair value cannot be reliably measured, the
amount of impairment loss is measured at the differences between the carrying amount
of the investment and the present value of estimated future cash flows discounted at
current rate of return for a similar investment. Such impairment loss shall not be
reversed.
 If an impairment loss has been incurred on available for sale investment, the impairment
loss shall be charged to Statement of Profit or Loss. When the decline in market value
of investment has been charged directly, the cumulative loss that had been recognized
directly in equity shall be removed from equity and shall be charged to Statement of
Profit or Loss. The impairment loss booked on investment in equity instrument
classified as available for sale shall not be reversed. But if debt instrument is classified
as available for sale investment and any impairment loss that has been recognized
previously shall be reversed and shall be credited to Statement of Profit or Loss
Illustration 2: Retirement Benefit Plan of Himalayan Bank Ltd. purchased preference shares of
Siddhartha Bank Ltd. face value of Rs. 1,000,000 at Rs. 1,037,000 on 1st Shrawan 2069. The
coupon rate of the preference shares is 12% and maturity date of the shares is 31st Ashadh,
2070. You are required to prepare the investment account in the books of retirement benefit plan
for the year ended 31st Ashadh, 2070 . The effective interest rate of the shares is 11%
Solution:
The above preference shares have a fixed maturity period and fixed interest rate. It is also
assumed that the benefit plan has positive intension and ability to hold the investment till its
maturity period, the investment is classified as Held to Maturity Investment and accounted for
as follows:
UNIT 7: Investment Accounts
Page 317
ICAN Advanced Accounting CAP II Chapter II
Retirement Benefit Plan of Himalayan Bank Ltd.
Held to Maturity Investment Account
Date
Particulars
1,04.2069 To Bank A/c
Amount
Date
10,37,000 31.03.2070
31.03.2070
Total
1,04.2070 To Balance B/d
10,37,000
1,04.2071 To Balance B/d
10,31,070 31.03.2071
10,31,070
1,04.2072 To Balance B/d
10,24,488 31.03.2072
10,24,488
1,04.2073 To Balance B/d
Total
UNIT 7: Investment Accounts
By Bank A/c
By Balance C/d
By Bank A/c
By Balance C/d
Total
10,17,181 31.03.2073
31.03.2073
Total
By Balance C/d
Total
31.03.2072
Total
By Bank A/c
Total
31.03.2071
Total
Particulars
10,17,181
By Bank A/c
By Balance C/d
Total
Amount
5,930
10,31,070
10,37,000
6,582
10,24,488
10,31,070
7,306
10,17,181
10,24,488
8,110
10,09,071
10,17,181
10,09,071 31.03.2074
By Bank A/c
9,071
31.03.2074
By Bank A/c
10,00,000
10,09,071
Total
10,09,071
Page 318
ICAN Advanced Accounting CAP II Chapter II
Amortization Schedule
Year
(A) Beginning
of period
amortized cost
(B) Dividend
and maturity
cash inflow
(C) Reported
dividend
income
[=(A) ×11%]
(D)
Amortization
of Premium
[=(C) – (B)]
(E) End-ofperiod
amortized
cost[=(A)+(D)]
2069-70
10,37,000
1,20,000
1,14,070
5,930
10,31,070
2070-71
10,31,070
1,20,000
1,13,418
6,582
10,24,488
2071-72
10,24,488
1,20,000
1,12,694
7,306
10,17,181
2072-73
10,17,181
1,20,000
1,11,890
8,110
10,09,071
2073-74
10,09,071
11,20,000
1,10,929
9,071
10,00,000
The entity shall make following entry in its books:
On Purchase of Investment:
Held to Maturity Investment A/c Dr.
10,37,000
To Bank A/c
10,37,000
(Held for sale investment acquired and measured at fair value plus transaction cost)
On year ended 2069-70
Bank A/c Dr
1,20,000
To Interest Income Account
1,14,070
To Held to Maturity Investment A/c
5,930
(Interest income is recognized at effective interest rate and difference between the interest
received and interest income is credited to investment account)
Similarly the above entry shall be made through 2013 to 2016 with amount shown in
amortization schedule which is as follows:
On year ended 2070-71
Bank A/c Dr
1,20,000
To Interest Income Account
To Held to Maturity Investment A/c
1,13,418
6,582
(Interest income is recognized at effective interest rate and difference between the interest
received and interest income is credited to investment account)
On year ended 2071-72
Bank A/c Dr
UNIT 7: Investment Accounts
1,20,000
Page 319
ICAN Advanced Accounting CAP II Chapter II
To Interest Income Account
1,12,694
To Held to Maturity Investment A/c
7,306
(Interest income is recognized at effective interest rate and difference between the interest
received and interest income is credited to investment account)
On year ended 2072-73
Bank A/c Dr
1,20,000
To Interest Income Account
1,11,890
To Held to Maturity Investment A/c
8,110
(Interest income is recognized at effective interest rate and difference between the interest
received and interest income is credited to investment account)
On year ended 2073-74
Bank A/c Dr
To Interest Income Account
To Held to Maturity Investment A/c
1,20,000
1,10,929
9,071
(Interest income is recognized at effective interest rate and difference between the interest
received and interest income is credited to investment account)
On receipt of maturity amount, the following entry shall be made in books on 31.03.2074
Bank A/c Dr
1,00,000
To Held to Maturity Investment A/c
1,00,000
(On maturity of preference shares, the investment is derecognized)
Illustration 3: Nepal Life Insurance Co. Ltd. purchased the following equity shares of different
company. The date of purchase, purchase price and market price of these securities are given as
follows:
Company
Purchase
Date
Face
Value
Cost
Price
Market Value
on purchase
Market Value
on year end
BPC Ltd.
1.1.2011
2,000
2,500
3,000
2,800
Chameliya Co. Ltd.
6.2.2011
3,000
3,000
2,500
2,700
Mero Bank Ltd.
31.6.2011
1,000
1,000
800
900
NTC Nepal Ltd.
17.7.2011
1,000
1,500
2,000
2,100
7,000
8,000
8,300
8,500
Total
UNIT 7: Investment Accounts
Page 320
ICAN Advanced Accounting CAP II Chapter II
Assuming that the financial year the insurance co. end on 31st December, journalize the above
transaction and prepare the investment account.
Solution:
Journal entries in books of Nepal Life Insurance Co. Ltd
On 1.1.2011
Available for Sale Investment A/c Dr
3,000
To Bank A/c
2,500
To Investment Revaluation Reserve
500
(On acquisition of available for sale investment, fair value in excess of cost price credited to
investment revaluation reserve account under equity account)
On 6.2.2011
Available for Sale Investment A/c Dr
2,500
Investment Revaluation Reserve
500
To Bank A/c
3,000
(On acquisition of available for sale investment, cost price in excess of fair value debited to
investment revaluation reserve account under equity account)
On 31.6.2011
Available for Sale Investment A/c Dr
800
Investment Revaluation Reserve
200
To Bank A/c
1,000
(On acquisition of available for sale investment, cost price in excess of fair value debited to
investment revaluation reserve account under equity account)
On 17.7.2011
Available for Sale Investment A/c Dr
2,000
To Bank A/c
1,500
To Investment Revaluation Reserve
500
(On acquisition of available for sale investment, fair value in excess of cost price transferred to
investment revaluation reserve account)
UNIT 7: Investment Accounts
Page 321
ICAN Advanced Accounting CAP II Chapter II
6.2.011
Nepal Life Insurance Co. Ltd.
Available for Sale Investment Account
Particulars
Amount
Date
Particulars
To Bank A/c
2,500
To Investment
500
Revaluation Reserve
To Bank A/c
2,500
31.6.011
To Bank A/c
800
17.7.011
To Bank A/c
1,500
17.7.011
To Investment
Revaluation Reserve
To Investment
Revaluation Reserve (B.f.)
Total
Date
1.1.011
1.1.011
31.3.03
Amount
500
200 31.12.011
8,500
By Balance
C/d
Total
8,500
8,500
As per IAS 39 the available for sale investment shall be measured at fair value plus transaction
cost if any on initial measurement. Upon subsequent measurement it shall be measured at fair
value. In above case the market value is fair value, at the year end the value of investment is Rs.
8,500. The difference between the previous carrying amount and the market value shall be
credited to equity under investment revaluation reserve.
Illustration 4: Assuming that in above illustration, the shares of BPC Ltd were sold on
subsequent year at Rs 3700. Pass the journal entry in the books of insurance co. ltd.
Solution:
Journal entry on the sale of shares:
Bank A/c
Dr
3,700
To Available for Sale Investment A/c
2,800
To Profit and Loss A/c
900
(Profit on sale of available for sale investment credited to Statement of Profit or Loss)
Investment Revaluation Reserve A/c
Dr
300
To Profit and Loss A/c
300
(Revaluation reserve maintained for shares in BPC Ltd. Rs. 300 (i.e. carrying amount Rs. 2,800
less purchase price Rs. 2,500) transferred to Statement of Profit or Loss on its disposal)
Self-Assessment Question
Question No.1: On 1.7.2070 , Citizen Investment Trust had 25000 equity shares of Laxmi Bank
Ltd. at the book value of Rs 150 per share (Face value Rs. 100). On 20.09.2070 he purchased
another 5000 shares of the company at Rs. 160 per share. The directors of Laxmi Bank Ltd.
UNIT 7: Investment Accounts
Page 322
ICAN Advanced Accounting CAP II Chapter II
announced a bonus and rights issue. No dividend was payable these issues. The terms of the
issues are as follows:
Bonus basis
1 : 6 (Date 16.11.2070)
Rights basis
3 : 7 (Date 31.11.2070) price Rs. 150 per share
Due date for payment 30.12.2070
Shareholders can transfer their rights in full or in part. Accordingly, Citizen Investment Trust
sold 33.33% of his entitlement to Shekhar for a consideration of Rs. 20 per share.
Dividends: Dividends for the year ended 31.6.2070 at the rate of 20% were declared by Laxmi
Bank Ltd. and received by the Trust on 31.01.2071 . Dividends for shares acquired by him on
20.9.2070 are to be adjusted against the cost of purchase.
On 15.02.2071, the Trust sold 25000 equity shares at a premium of Rs. 50 per share.
You are required to prepare in the books of Citizen Investment Trust
(i)
(ii)
Investment account
Statement of Profit or Loss
For your exercise, assume that the books are closed on 32.03.2071 and market price per share
on that date was Rs. 140.
(Hint: Security classified as held for trading, balance of Investment a/c 45,000 shares of
Rs. 28,00,000, P/L a/c credited by Rs. 12,00,000)
Question 2: On 1.4.2012 Rukum Bank Limited purchased 1000 equity shares of Rs. 100 each
in Nepal Telecom Ltd. at the rate Rs. 120 each from a broker, who charges 2% brokerage. He
incurred 50 paisa per rupee 100 as cost of shares transfer stamps. On 31.1.2013 bonus was
declared in the ratio of 1 : 2. Before and after the record date of bonus shares the shares were
quoted at Rs. 175 per share and Rs. 90 per share respectively. On 31.3.2013 the Bank sold
bonus shares to a broker, who charges 2% brokerage. Show the investment account in the books
of Rukum Bank Ltd. who held the shares as current assets.
(Hint: Security classified as held for trading, balance of Investment a/c 1,000 shares)
UNIT 7: Investment Accounts
Page 323
ICAN Advanced Accounting CAP II Chapter III
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
UNIT1: Accounting for Share Capital
UNIT 2: Accounting for Redeemable Preference Share
UNIT 3: Accounting for Debenture
UNIT 4: Underwriting of Share and Debenture
UNIT 5: Preparation of Financial Statement of a Company
UNIT 6: Winding Up of Companies
UNIT 7: Accounting for Business Combination
UNIT 8: Cash Flow Statement
UNIT 9: Application of Nepal Accounting Standards in the
Preparation of Financial Statements for General Purpose
Page 324
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
Unit 1:
Accounting of Share Capital
UNIT 1: Accounting for Share Capital
Page 325
ICAN Advanced Accounting CAP II Chapter III
1. MEANING OF COMPANY AND ITS FORMATION
A company is a voluntary and legal association of persons who contribute money or money’s
worth to a common stock and uses it for a common purpose. It is a legal person just as much
as an individual, but with no physical existence. A company has the following essential
characteristics:
Artificial legal person
A company is an artificial person as it is created by law. It has almost all the rights and powers
of a natural person. It can enter into contract. It can sue in its own name and can be sued.
Incorporated body
A company must be registered under Companies Act or any other law regulating companies in
a country. By virtue of this, it is vested with corporate personality. It has an identity of its own.
Although the capital is contributed by its members called shareholders yet the property
purchased out of the capital belongs to the company and not to its shareholders.
Capital divisible into shares
The capital of the company is divided into shares. A share is an indivisible unit of capital. The
face value of a share is generally of a small denomination which may be of Rs 10, Rs 25 or Rs
100.
Transferability of shares
The shares of the company are easily transferable. The shares can be bought and sold in the
stock market.
Perpetual existence
A company has an independent and separate existence distinct from its shareholders. Changes
in its membership due to death, insolvency etc. does not affect its existence and its continuity.
Limited Liability
The liability of the shareholders of a company is limited to the extent of face value of shares
held by them. No shareholder can be called upon to pay more than the face value of the shares
held by them. At the most the shareholders may be asked to pay the unpaid value of shares.
Representative Management
The number of shareholders is so large and scattered that they cannot manage the affairs of the
company collectively. Therefore they elect some persons among themselves to manage and
administer the company. These elected representatives of shareholders are individually called
the ‘directors’ of the company and collectively the Board of Directors.
Common seal
A common seal is the official signature of the company. Any document bearing the common
seal of the company is legally binding on the company.
Section 2 of Company Act, 2063 has defined different types of company as below:
Page 326
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
(a) “Company” means a company incorporated under this Act.
(b) “Private company” means a private company incorporated under this Act. Some of the
major characteristics of private company as per the law are:
The number of shareholders of a private company shall not exceed fifty.
A private company shall add the words “private limited’’ to its name as the last words.
A private company shall not sell its shares and debentures publicly
A private company shall not pledge, or otherwise transfer title to, its securities to any
person other than its shareholder without fulfilling the procedures contained in the
memorandum of consensus agreement,
(c) “Public company” means a company other than a private company. A public company
must have at least seven shareholders and minimum share capital of 10 million rupees.
(d) “Holding company” means a company-having control over a subsidiary company.
(e) “Subsidiary company” means a company controlled by a holding company.
(f) “Foreign company” means a company incorporated outside Nepal.
(g) “Listed company” means public company which has its securities listed in the stock
exchange .
Formation of a Company
Any person desirous of undertaking any enterprise with profit motive may, either singly or
jointly with others, incorporate a company for the attainment of one or more objectives set
forth in the memorandum of association. There shall be a minimum of seven promoters for the
incorporation of a public company. Provided, however, that seven promoters shall not be
required for the incorporation of another public company by any public company.
Any person desirous of incorporating a company shall make an application to the Office of
Registrar, in such format and accompanied by such fees as prescribed, and along with the
following documents, as well:
 The memorandum of association of the proposed company,
 The articles of association of the proposed company,
 In the case of a public company, a copy of the agreement, if any, entered into between
the promoters prior to the incorporation of the company,
 In the case of a private company, a copy of the consensus agreement, if any, entered
into ,
 Where prior approval or license has to be obtained from anybody under the prevailing
law prior to the registration of a company carrying on any particular type of business
or transaction pursuant to the prevailing law, such approval or license,
 Where the promoter is a Nepalese citizen, a certified copy of the citizenship certificate
and where a corporate body is a promoter, a certificate of registration of incorporation,
decision of the Board of directors, regulating the incorporation of the company and
major documents regarding incorporation.
UNIT 1: Accounting for Share Capital
Page 327
ICAN Advanced Accounting CAP II Chapter III
 Where the promoter is a foreign person or company or body, permission obtained
under the prevailing law to make investment or carry on business or transaction in
Nepal,
 Where the promoters is a foreign person, a document proving the country of his/her
citizenship,
 Where the promoter is a foreign company or body, a certified copy of the
incorporation of such company or body and major documents relating to such
incorporation.
Where an application is made for the incorporation of a company the Office shall, after
making necessary inquiries, register such company within 15 days after the date of making of
the application and grant the company registration certificate to the applicant, in the format as
prescribed. After a company has been registered the company shall be deemed incorporated.
The certificate of incorporation is an important document in as much as it evidences the
existence of the company from the date on which the certificate has been issued and also it is
the conclusive evidence of the fact that the company has been duly registered. The effect of
the certificate is to give the company a distinct and separate entity, perpetual existence,
common seal, and make all members a body corporate. The certificate of incorporation is the
conclusive evidence of the registration of the company and cannot be cancelled afterwards
even if some irregularities are subsequently detected. The only remedy for undoing the effect
of registration is to wind up the company in accordance with the provisions of the Company
Act.
After the incorporation of a company , the matters contained in the memorandum of
association and the articles of association shall be binding on the company and its shareholders
as if these where the provisions contained in separate agreements between the company and
every shareholder and amongst its shareholders.
Without registering a company under this Act, no person shall use the name company and
carry on any kind of transaction by the name of any firm or institution.
2. SHARES OF THE COMPANY AND ITS TYPE
Total capital of the company is divided into units of small denomination. One of the units into
which the capital of the company is divided is called a share. For example, in one company the
total capital of Rs. 4, 00,000 is divided into 4,000 units of Rs. 100 each then each unit of
Rs.100 is called a share of Rs.100 each. According to Sec.2 (n) of the CompanyAct, 2063,
share means the divided portion of the share capital of a companyand includes stock except
where a distinction between stock and shares is expressed or implied. Shares must be
numbered so that they may be identified; they are movable property and are transferable in the
manner provided by the Articles of Association.
Classes of shares: Companies usually issue two classes of shares, namely equity shares and
preference shares.
(a)
Equity Share Capital:
Page 328
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
(i)
(ii)
with voting rights; or
with differential rights as to dividend, voting or otherwise in accordance with such
rules and subject to such conditions as may be prescribed.
(b)
Preference Share Capital
Preference shares:
Preference share is that part of the share capital of the company which enjoys preferential right
as to –
(a)
the payment of dividend at a fixed rate during the lifetime of the company; and
(b)
the return of capital on winding up of the company.
Section 65 of Company Act has following provision relating to preference shares:
A company may issue preference shares as provided for in this Act, memorandum of
association or articles of association. Except as provided in the articles of association, no
shares issued shall be converted into ordinary shares. In issuing preference shares the
following maters, inter alia, shall be disclosed:
(a) Whether preference is given to receive dividends against ordinary shares;
(b) Percentage of dividends receivable by preference shareholders;
(c) Whether dividends get cumulated every year (cumulative) or profits are distributed only
in a year wherein profit is made (non-cumulative);
(d) Whether preference is given while paying amount of share in the event of liquidation of
company;
(e) Whether voting right is attached there to; and if voting right is attached, whether such
right is available only in the case of preference share or also in other matters;
(f) Whether voting right is available also in other matters pursuant to Clause (e) , the
proportion to which such right is exercisable;
(g) Whether preference shares can be converted into ordinary shares;
(h) Whether the amount of preference shares can be redeemed (redeemable) or cannot be
redeemed (irredeemable) after a certain period;
(i) Whether, in redeeming preference shares, premium is payable on redemption.
Where any redeemable shares are issued, the shares shall not be redeemed unless they are fully
paid. No amount of preference shares shall be redeemed except out of profits which would
otherwise be available for dividend or out of the proceeds of a fresh issue of shares made by
the company for the purposes of the redemption. Where a premium is payable on the
redemption of any redeemable preference shares, there shall be provided for a separate fund
out of the profits of the company or out of the company’s shares premium account, for the
purposes of redemption of such shares.
Except in cases where any redeemable preference shares are redeemed out of the proceeds of a
fresh issue of shares, while redeeming preference shares, a Capital Redemption Reserve
Account shall be established and a sum equal to the nominal amount of the shares redeemed
shall be transferred to that account, out of profits which would otherwise have been available
for dividend. The Capital Redemption Reserve Account established shall be maintained as if it
were the paid–up capital. After the completion of the redemption of any preference shares
UNIT 1: Accounting for Share Capital
Page 329
ICAN Advanced Accounting CAP II Chapter III
redeemed pursuant to this Section, such shares shall be deemed to have, ipso facto, been
cancelled. A company shall while redeeming any preference shares, follow such terms and
procedures as provided by the Articles Of Association of the company, subject to this Section;
and such redemption of preference shares shall not be taken as reducing the amount of
authorized share capital of the company. Where a company has redeemed or is about to
redeem any preference shares, it shall have power to issue new shares up to the nominal
amount of the shares so redeemed or to be redeemed. Where a company has redeemed any
preference shares, the company shall give information thereof to the Office within one month
of such redemption; and on receipt of such information, the Office shall record such
information in the company register. A company may issue new shares to its shareholders as
fully paid bonus shares, out of the capital redemption reserve funds.
Types of Preference shares
(a) From the point of view of dividend, they may be dividedinto cumulative and noncumulative. In the case of cumulative preference shares dividends accumulate when not paid.
So when the company wants to pay any dividend to equity shareholders, it must first pay
arrears of such dividend to cumulative preference shareholders. If the company goes into
liquidation, arrears of dividend are not payable unless they are either declared or Articles of
Association contain express provision in this regard.
A non-cumulative preference share is that share where the arrears of dividend do not
accumulate. If a dividend is not declared in any year then it lapses.
(b) From the point of view of participation in profits, they may be called participating and
non-participating. A participating preference share is a share which carries the right of sharing
profits left after paying preference and equity dividends at specified rates. The right of
participation may also extend to surplus assets available at the time of liquidation, after,
paying off all equities.
A non-participating preference share is that share which does not carry the right of sharing
in the surplus after paying specified dividend to equity shareholders. Unless otherwise stated
in the articles, Preference shares are deemed to be non-participating.
(c) From the point of view of convertibility they may be classified as convertible and nonconvertible. A convertible preference share is one which can be converted into an equity share.
When it cannot be so converted, it is called a non-convertible preference share. Unless the
articles or terms of issue provide otherwise, preference shares are deemed to be nonconvertible.
(d) From the point of view of redemption they may be classified as irredeemable and
redeemable preference shares. Redeemable preference share are those which is refunded after
specified period of time. Irredeemable preference shares are those which can be redeemed
only in the event of company’s liquidation.
Ordinary (Equity) Shares
The Act defines an ordinary share in a negative way. An ordinary share is one which is not a
preference share. These are normally risk-bearing shares. In lean years ordinary shareholders
Page 330
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
do not receive any dividends, but in years of profit they receive substantial dividends. During
liquidation of a company they are paid out –but are usually entitled to all the surplus assets
after the payment of creditors and preference shareholders. The value of these shares in the
market fluctuates with the fortunes of the company. A wise investor in ordinary shares not
only receives regular dividend but is also assured of capital appreciation.
Sweat equity shares:
These are not different from equity shares. However the peculiarity of these shares is that, the
company issues these to employees or directors at discount. These are not issued for cash but
for consideration such as providing know-how or making available rights in the nature of
intellectual property rights or value addition. The issue of these shares must be authorized by a
special resolution passed by company in general meeting, giving details about number of
shares, current market price and consideration.
3. PRESENTATION OF SHARE CAPITAL IN THE STATEMENT OF
FINANCIAL POSITION
Share capital is shown in the Statement of Financial Position under the following categories:
Authorized capital: - This is the maximum capital that the company is authorized to raise and
this amount is stated in the Memorandum of Association. This is also described as ‘Registered
capital’ or ‘Nominal capital’.
Issued Capital: This is the part of the capital which can be offered to public/private
placement for subscription. The difference between authorized capital and the issued capital
represents the unissued capital. The form requires the statement of different classes of capital
under the head” issued capital”. Further particulars of buyers of preference shares, terms of
redemption or conversion in the case of redeemable preference shares and particulars of any
option on unissued share capital are to be specified.
Subscribed capital: - Subscribed capital refers to that part of the issued capital which has
been subscribed by the public and also allotted to the directors of the company. Under this
heading also the company should give regarding shares allotted for consideration other than
cash and shares allotted as fully paid-up by way of bonus shares. The sources from which
bonus shares are issued must also be stated.
Called-up capital: - It refers to that part of the subscribed capital which has been called up by
the company for payment. For example, if 1,00,000 shares of Rs.100 each have been
subscribed by the public of which Rs.50 per share has been called up, the subscribed capital of
the company works out to Rs.1,00,00,000(Rs.100x1,00,000) of which the called-up capital is
Rs.50,00,000 (Rs.50 x 1,00,000). Paid –up capital is the figure that forms part of the total of
the Statement of Financial Position and for determining that, called up capital is the basis, as
we shall see later.
Paid - up capital: - It refers to that part of the called-up capital which has been actually paid
up by the shareholders. Some of the shareholders might have defaulted in paying the allotment
or call money. Such amount defaulted is known as calls in arrears. From the called-up capital,
UNIT 1: Accounting for Share Capital
Page 331
ICAN Advanced Accounting CAP II Chapter III
calls-in-arrears is deducted to obtain the paid-up capital. Calls-up-arrears due from directors
have to be stated separately.
A specimen showing how capital appears in the Statement of Financial Position is shown
below:
Share capital
Authorized:
5,00,00,000 Equity shares of Rs.10 each
15,00,00,000, 10.5% Redeemable preference Shares of Rs.10 each
Issued and Subscribed:
3,50,00,000 Equity shares of Rs.10 each
10,00,00,000 Redeemable preference shares of Rs.10 each
Rs.’000
5,00,000
15,00,000
20,00,000
3,50,000
10,00,000
13,50,000
Called up capital:
3,50,00,000 Equity shares of Rs.10 each Rs.5 called up
10,00,00,000 Redeemable preference shares fully called up
Paid up capital:
Called up capital
Less: Calls-in-arrears
1,75,000
10,00,000
11,75,000
11,75,000
25,000
11,50,000
(Of the above 15,00,000 Redeemable Preference Shares of Rs.10 each
were allotted as fully paid-up pursuant to a contract without payment
being received in cash)
4. METHOD OF RAISING SHARE CAPITAL
Company is a convenient institution to raise capital by the issue of shares. A company can
raise its share capital in any one of the following three ways:
Circular method: A body corporate shall issue and sale securities by using letter or electronic
means targeting to a maximum of fifty investors through the use of circular method. While
issuing shares through circular method, the body corporate shall be required to have obtained
the resolution of the general meeting and target the sale of the securities to different
associations, institutions, persons or institutional investors designated to be qualified by the
Securities Board.
Public issue: This is by far the most important method. The company invites the public to
subscribe to its share capital through the issue of prospectus. As noted already only public
limited companies can go in for this mode of raising the capital. The focus of this chapter is on
public issues.
Page 332
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Rights issues: In this issue, shares are offered to existing shareholders in proportion to their
equity shareholding. An issue is called a composite issue when share are offered to public as
well as existing shareholders.
The capital of a company can also increase in other ways. They are:
1)
By issue of bonus share: Bonus shares are issued to shareholders by converting reserves
into equity capital. This does not result in flow of cash to the company.
2)
By issue of convertible debentures: Convertible debentures are instruments, which can
be converted partially or fully into shares according to the terms of issue. This may be
done at the option of the holder or without his applying for such conversion. In this case
also there is no flow of cash. It is a process by which an external liability is converted
into capital, an internal liability.
3)
By conversion of loans into shares: A loan is converted into shares in accordance with
a clause in the loan agreement. This is similar to item (2).
4)
By issue of shares for consideration other than cash: Shares may be issued in
exchange for tangible or intangible assets acquired by a company. In this mode a
company can acquire tangible assets such as plant, buildings, etc. or intangible assets
like copyrights or patents. In this mode the company allots shares instead of paying
cash.
5. REGULATION OF PUBLIC ISSUES
Public issues are well regulated by the provisions of the CompaniesAct as well as SEBON
guidelines with a view to protect the investor’s money and their interests in general. We will
first deal with the provisions in the CompaniesAct having a bearing on public issues and later
deal with SEBON guidelines on the same aspect.The following are some of the salient
provisions in the CompanyAct and SEBON Regulation having a bearing on share issue.
A body corporate incorporated as a public limited company or if incorporated in other form
enabled to raise funds through the issuance of securities to the general public, shall be required
to get its securities registered with the Securities Board before issuance of the securities.
The body corporate shall inform the Securities Board with the following particulars of the
securities registered under these regulations within seven days of distribution and allotment:
(a)
(b)
(c)
(d)
Allotment date, type of securities issued and number thereof.
Method of issue
Name and address of the buyer or holders of the allotted shares
Paid up value of each securities
If a Corporate Body intends to sale and distribute its securities to more than fifty persons at a
time, it shall be required to make public issuance of securities. If the Corporate Body is
making public issuance shall unless otherwise prescribed by the regulating body related with
the concerned business, set aside at least thirty percent of its issued capital for public
subscription. However, the corporate body using local natural resource and materials as its raw
materials shall be required to set aside at least fifteen percent of its issued capital to the public
UNIT 1: Accounting for Share Capital
Page 333
ICAN Advanced Accounting CAP II Chapter III
and ten percent of its issued capital for the people residing in the area affected by the industry.
The shares issued to the people residing in the area affected by the industry shall not be
allowed to sell or transfer within the minimum period of three years from the date of
allotment.The shares set aside for the public shall be sold only after selling the shares set aside
for the people residing in the area affected by the industry. The body corporate making public
issuance may reserve and allot up to five percent of the shares, as prescribed in Securities
Issuance Directives, from the shares that is set aside for public issuance for the working staffs.
The shares allotted as such shall not be eligible to be sold or transferred within a minimum
period of three years from the date of allotment.
Unless otherwise it is prescribed by the concerned regulating body, the public issuance shall
be made making at least fifty one percent promoters' shareholding.
If the corporate body making public issuance, is a Bank, Financial Institution or Insurance
Company, it shall be required to have completed one year of business operation under its
objectives and also required to have published its audited financial reports and completed its
Annual General Meeting. If the corporate body making public issuance is other than a Bank,
Financial Institution or Insurance Company, it shall be required to complete the conditions as
follows:(a) The Company is required to complete one year of initiating necessary works required for
operation of business under its objectives,
(b) Have completed Audit and Annual General Meeting as per the regulations,
(c) If the Corporate Body has to obtain approval, license or consent from anybody pursuant
to the prevailing laws, it is required to have obtained such approval, license or consent,
(d) Have purchased or managed through other means, the land required for the Corporate
Body and have initiated construction works of factory building, office building,
warehouse and other necessary amenities.
(e) If it is required to select the manufacturing technology and purchase necessary
mechanical equipment required for the industry, should have initiated the purchasing
procedure,
(f) Should have concluded financial closure for the construction of the project,
(g) If it is a corporate body manufacturing hydropower, it should have concluded Power
Purchase Agreement and have called tender for construction of Powerhouse and other
infrastructure.
(h) Should have agreed to maintain the loan and capital ratio of the Company throughout the
project construction period as it is prescribed by the Securities Issuance Directives.
(i) The share amount as agreed by the promoters should have been paid in full.
(j) The shares set aside for the public issuance should have been underwritten as prescribed
in the Securities Issuance Directives.
In case the application money has been deposited with the Banker to the Issue for interest,
eighty percent of the interest so received shall be required to be given to the applicant in a
Page 334
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
proportional basis for the days from the application date to the day before the allotment date
and the Board shall be informed of such arrangement.
The people residing in the area affected by the industry shall not be eligible for re-applying the
shares issued for the public. If the shares set aside for people residing in the area could not be
sold completely and is remained, such remaining shares may be added to the public shares and
issued.
The body corporate may issue additional shares within the limit of five percent of the issued
capital in case practical difficulties arise while making allotment and require flexibility. The
following conditions shall be required to have fulfilled for the issuance of such additional
shares:
(a) The issuance of the additional shares shall have to be in congruence to the capital
structure and composition of the board of directors of the body corporate mentioned in
the Memorandum and Articles of Association.
(b) The prospectus requires having disclosures regarding the issuance of the additional
shares.
(c) The registration fee for the additional capital shall have to be paid.
(d) Agrees to publish about issuance of additional shares and the rationale
A body corporate, before the issuance of its securities to the public pursuant to these
regulations shall require publishing the prospectus in the format prescribed in the Schedule9of Securities Registration and Issue Regulation, 2065, issued by SEBON. Provided, however,
that the issuance of bonus share shall not require the publication of the prospectus. The
prospectus requires the approval of the Securities Board before its publication.
The prospectus accompanied by share application is an invitation to offer. It gives detailed
information about the company, the details of the issue, issue highlights, risk factor, term of
the present-issue, history of the company, main object and present-business financial
performance in the case of an existing company, details of the projects for which the finance is
raised, prospects, and profitability, market- price if the share and justification for premium,
previous issues, companies under the same management, minimum subscription and such
other details as stated in the CompanyAct and Securities Board guidelines.
6. PROCEDURE FOR ALLOTMENT
Allotment of share means an appropriation of a certain number of shares to an applicant in
response to his application for shares. While the application is an offer to buy shares,
allotments of shares by the company constitute an acceptance of such offer.
Share should be allotted to the applicant on proportionate basis as per the group of investors. If
the number of share to be distributed is in fraction the number can be rounded up. At least
40% share should be allocated to retail investor group (applying for shares amounting to Rs.
50,000 and less). But if the application received from retail investor is more than 40% of total
application all applicants shall be treated as one group and allocation should be made on
proportionate basis.
UNIT 1: Accounting for Share Capital
Page 335
ICAN Advanced Accounting CAP II Chapter III
Minimum subscription:
In cases where at least fifty percent of the total shares issued publicly cannot be sold failing a
guarantee/underwriting agreement on the subscription of at least fifty percent of the publicly
issued shares, no shares shall be allotted.
Under-subscription: Due to poor response, all the shares offered may not be taken by public. This is a case of under
subscription. However, shares cannot be allotted if minimum subscriptions not received.
Under-subscription poses no problem in the matter of allotment. All those who have duly
applied will obtain the allotment. Only applications with drawbacks such as incomplete
information or absence of signature or the application is not accompanied with sufficient
application money, will be rejected. Under subscription also involves automatically allotment
in tradable lots.
Over-subscription: It is the situation when the issuing company receives application for share exceeding total
number of shares offered for sale. A company cannot allot more shares than were offered to
public through the prospectus. Allotment of shares should not be made discriminatorily or
with intent to cause any loss or damage to any investor. In case there is oversubscription, 40%
share should be allocated for retail investor and remaining shares should be distributed to other
investor. The company can set minimum number of shares to be allocated to a shareholder.
While allocating shares on proportionate basis, if all applicant has applied for more than the
minimum allocation number then it should be distributed accordingly otherwise proportionate
allotment should done as per following example:
Suppose 1,000,000 shares has been issued at the rate of Rs. 100. Shares have been
oversubscribed by 8 times out of which 5 times oversubscription is from retail investor group.
Minimum allotment number is set as 10 shares i.e. of Rs. 1,000. Since small investors are the
applicant who have applied for shares amounting to Rs. 20,000, applicants applying up to 200
shares shall be kept in retail group. Shares to be allocated for retail group will be 40% of
10,00,000 i.e. 4,00,000 shares. Suppose among the retail investors, A, B, C and D has applied
for 200, 100, 50 and 20 shares respectively.
Since retail group is oversubscribed by 5 times the number of share to be allocated to the retail
investor will be 5 times smaller than their size of application as below:
Investor
A
B
C
D
Share applied for
200
100
50
20
Shares to be allocated on proportionate
200/5 = 40
100/5= 20
50/5=10
20/5=4
Here applicant D is eligible to receive only 4 shares which is less than the minimum number
of shares to be allocated i.e. 10. In such case the allotment shall be done based on lottery
system. In case, A, B and C type are also very large number in comparison to the available
Page 336
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
number of shares, lottery system shall be followed. For allotment of share the proportionate
allotment as described above should be followed.
Calculation under pro rata allotment
When a shareholder obtains partial allotment, due to number of shares available being less
than the shares applied for, the directors may proceed with pro-rata allotment. For example, if
the shares applied for are 60,000 but available for allotment are only 40,000, the applicants
may get an allotment of 4 shares for every 6 applied for or in the ratio of 2:3. Since a basis is
set for allotment it is called pro rata allotment.
In the case of partial / pro-rata allotment, instead of returning the excess application money,
the same will be adjusted towards money due on allotment and the balance of allotment
money will be payable by the applicants. For example, if a person has applied for 100shares of
Rs. 100 each, Rs.20 being payable on application; Rs.30 on allotment and he gets an
allotment of 60 shares. The company will not refund the excess application money on 40
shares. Instead the applicant will pay the allotment money on 60 shares after adjusting the
excess application money on 40 shares. The amount payable by him is shown below:
Particular
Amount due on Application and Allotment in respect of 60 shares
(60xRs.50)
Less: Money paid on Application on 100 shares
Rs.
3,000
Balance payable on allotment
1,000
2,000
Or Alternatively
Money due on allotment on 60 shares (60xRs.30)
=Rs.1800
Less: Excess application money adjusted (40x Rs.2)
=Rs.800
Balance payable on allotment
1000
However, if the application money is more than what is due on application and allotment, such
money may be refunded or adjusted towards calls as (calls-in-advance). Suppose in the
example above the person has applied for 200shares and is allotted only 60 shares, the balance
in excess of moneys due on application and allotment will be adjusted towards calls-inadvance.
Rs.
Money due on application and allotment
3000
Money paid on application of 200 shares
4000
Excess money adjusted towards calls-in-advance
1000
In future when the call is made, the amount will be adjusted from calls-in-advance to the
extent it is available, and only the balance will be paid by the shareholders.
Allotment and calls
After the shares are allotted the amount due on allotment is transferred to share capital
account. Allotment letters will be sent to each applicant, calling them to pay the amount due.
UNIT 1: Accounting for Share Capital
Page 337
ICAN Advanced Accounting CAP II Chapter III
After the receipt of such letters, the amount will be paid by them. Similarly when calls are
made by the directors for the balance of the amount, at every call the amount due on such call
will be transferred to share capital account and call notices will be sent to the shareholders
who will make the payment. Any amount not paid is called ‘calls-in-arrears’. There may be
one call or more than one call according to terms of issue. If there is only one call, it is called
first and final call. If there are three calls, they are called first call, second call and third and
final call respectively.
7. ACCOUNTING ENTRIES
7.1 ISSUE OF SHARES AT PAR
When shares are issued at a price equal to its face value the issue is known as Shares Issued at
par. There are two types of journal entries connected with share issue. They are called cash
entries and transfer entries. Cash entries involve receipt of cash on application, allotment and
calls. Transfer entries relate to transfer of amounts to share capital from share application,
share allotment and call accounts. In the case of share application, cash entry is made first and
transfer entry follows. But in the case of allotment and calls, transfer entry is made first and
then the cash entry on receiving the cash is made. This is because, immediately after the
allotment or call is made, money becomes due and therefore share capital is credited without
waiting for the receipt of cash.
Earlier we have discussed the procedure from application to making of calls. Now entries are
given for each transaction discussed in that context.
Transaction
Account
Debited
Bank
Receipt of application money
Application Money in respect of shares Share Application
allotted
Share Application
3. Refund in respect of rejected
applications
Share Application
4. Adjustment of excess application
Share Application
money towards allotment
5. Adjustment of excess application
Share Allotment
money towards calls-in-advance
6. When allotment is made and the
Bank
money becomes due
7. Receipt of Allotment money
Share call
8. Where a call is made for the call
money due
9. Adjustment of money in calls-inCalls-in-advance
advance towards the call accounts
Bank
10. Receipt of call money
Illustration: 1
Sagar Construction Ltd. issued 100,000 shares of Rs. 10 each on
amount payable on these shares was as under:
1.
2.
Page 338
Credited
Share Application
Share Capital
Bank
Share Allotment
Calls-in-advance
Share Capital
Share Allotment
Share Capital A/c
Share Call A/c
Share Call A/c
1st Shrawan, 2070. The
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Rs 2 per share on application.
Rs 3 per share on allotment.
Rs 5 per share on call.
Make journal entries and prepare relevant accounts in the books of company.
Sagar Construction Ltd.
Journal entries
Particulars
1 Bank A/c
To Share Application A/c
(Application money received @ Rs 2 per share)
Dr
Dr 200,000
2 Share Application A/c
To Share Capital A/c
(Share application money for 100,000 shares
transferred
to share capital A/c due to allotment of share)
Dr 200,000
3 Share Allotment A/c
To Share Capital A/c
(Allotment money made due on 100,000 shares @
Rs 3/- per share)
Dr 300,000
4 Bank A/c
To Share Allotment A/c.
(Allotment money received on 100,000 shares @Rs
3 per share.)
Dr 300000
5 Share First & Final call A/c.
To Share Capital A/c
(Call money on 100,000 shares @ Rs 5 per share
made due)
Dr 500,000
6 Bank A/c
To Share First & Final call A/c.
(Call money received on 100,000 shares @ Rs 5 per
share)
Dr 500,000
Cr
200,000
200,000
300,000
300,000
500,000
500,000
Calls-in-advance and calls-in-arrears
If a shareholder pays any amount to company before it is demanded, it is called Call-inAdvance. This amount is put in a separate account known as Calls-in-Advance A/c. This
UNIT 1: Accounting for Share Capital
Page 339
ICAN Advanced Accounting CAP II Chapter III
amount is not shown as capital of the company, till such time the company makes a demand
from all the shareholders. Call-in-Advance A/c is shown on the liabilities side of the Statement
of Financial Position.
When the company sends notice to the shareholders to pay allotment and /or call money, it has
to be paid by them within the specified time period. If it is not paid by any one or more of the
shareholders, the unpaid amount becomes arrears due from them. Such arrears are transferred
to an account termed as Calls-in-Arrears A/c.
Illustration: 2
On 1stShrawan, 2070, Global Ltd makes an issue of 10,000 equity shares of Rs.10 each
payable as below:
Rs.
On application
2
On allotment
3
On first and final call
6 (Three months after allotment)
Application were received for 13,000 shares and directors made allotment in full to the
applicants demanding five or more shares and returned money to the applicants for 3000
shares. One shareholder, who was allotted 20 shares, paid first and final call with allotment
money and another shareholder did not pay allotment money on his 30 shares but which he
paid with first and final call. Journalize the transactions.
Solution (Without narration)
Journal Entries in the books of Global Ltd
Particulars
Bank account Dr.
To Equity share application account
Equity shares application account Dr.
To Bank account
To Equity share capital account
Equity share allotment account Dr.
To Equity share capital account
To Security premium account
Bank A/c
To Equity share allotment A/c
To Call-in-advance A/c
Equity first and final call account Dr.
To Equity share capital account
Page 340
Debits Rs.
26,000
Credit Rs.
26,000
26,000
6,000
20,000
30,000
20000
10000
30000
29910
120
60000
60000
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Bank A/c Dr.
Calls-in-advance A/c Dr.
To Equity first and final call A/c
To Equity share allotment A/c
59970
120
60000
90
Illustration: 3
A company made an issue of 10,000 shares of Rs.10 each, payable Rs.3 on application; Rs.4
on allotment and the balance on call. 43,825 shares were applied for, including an application
for 300 shares from a person who paid for the full face value of the shares. Owing to oversubscription, allotments were scaled down as follows: Applicants for 11825 shares (in respect
of applications for 500 or less) received 5750 shares (including the applicant for 300shares
who got 150 shares). Applicants for 32,000 shares (in respect of applications for 500 shares),
received 4250 shares.
The amounts received were first applied towards allotment and call money (after satisfying
amount due on application), and any balance left was returned.
You are required to show the cash book and ledger accounts to record the above transactions.
Solution:
Dr.
Cash book
Particular
Rs.
To Share application A/c.
(application money for
43,825 shares)
” Share allotment A/c.
(Balance allotment
Money due)
” Share call account
(balance call money due)
Cr.
Particular
1,33,575
4,625
Rs.
Rs.
By Share application
A/c
(excess
money 55,000
1,00,000
received
Returned)
” balance c/d
16,800
1,55,000
1,55,000
Dr.
Particular
To Share capital A/c
” Share allotment A/c
” Call-in-advance A/c
” Cash A/c
Share Application A/c
Rs.
30,000
35,375
13,200
55,000
1,33,575
UNIT 1: Accounting for Share Capital
Particular
Cr.
Rs.
1,33,575
By cash
1,33,575
Page 341
ICAN Advanced Accounting CAP II Chapter III
Dr.
Calls-in-advance A/c
Particular
To Share call A/c
Dr
Particular
By Share application A/c
Share Allotment A/c
Particular
To Share capital A/c
Dr.
Rs.
13,200
13,200
Cr.
Rs.
40,000
40,000
Share First and Final Call A/c
Particular
Rs.
30,000
To Share capital A/c
30,000
Dr.
Share Capital
Particular
Cr.
Particular
By Share application A/c
” Cash A/c
Rs.
35,375
4,625
40,000
Cr.
Particular
By Calls-in-advance A/c
By Cash A/c
Rs.
13,200
16,800
30,000
Cr.
Rs.
1,00,000
To Balance c/d
Particular
By Share application A/c
By Share allotment A/c
By Share First & Final Call A/c
1,00,000
Page 342
Rs.
13,200
13,200
Rs.
30,000
40,000
30,000
1,00,000
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Tutorial notes
Table showing calculation
Shares
Category
Number of
shares
applied
1
2
Money
Numb
er of
shares
allotte
d
3
Amount
received
with
application
Amount due
on
application
and
allotment
4
Balance
due on
allotment
(4)-(3)
Surplus to
be
transferre
d to callsin advance
6
5
8=
Amount
due on
first and
final call
Call in advance
adjusted
against call
account
(3)-(4)+(6)
9
10
Amount to
be refunded
7
Amount payable
on first and final
call account
11= (8)-(10)
I
300
150
30,000
1,050
-
450
1,500
450
450
-
II
11,525
5,600
34,575
39,200
4,625
-
-
16,800
-
16,800
III
32,000
4,250
96,000
29,750
-
12,750
53,500
12,750
12,750
-
43,825
10,000
1,33,575
70,000
4,625
13,200
55,000
30,000
13,200
16,800
UNIT 1: Accounting for Share Capital
Page 343
ICAN Advanced Accounting CAP II Chapter III
(1) Out of Rs. 3,000 received Rs. 900 is towards application money and the balance towards
calls-in-advance. Since only 150 shares are allotted to this category of shareholders,
money received in respect of the balance of 150 shares is refunded.
(2) 11,825 – 300 = 11,525
7.2
ISSUE OF SHARES AT PREMIUM
As per Sec. 29 of the Companies Act when securities are issued at a premium, whether
for cash or other consideration, the amount received over and above the nominal value
of securities should be transferred to ‘Securities premium account’. The term
securities include shares. Therefore if shares are issued at premium, such premium
should be transferred to ‘Securities premium account’. Securities premium account can
be utilized for the following purpose only:
(a)
(b)
(c)
To issue bonus shares;
To write off preliminary expenses;
To write off issue expenses, or the commission paid or discount allowed on any issue of
securities or of any debentures of the company;
To provide for the premium payable on the redemption of any redeemable preference
securities or of any debentures of the company.
(d)
The balance in this account is treated as paid-up capital and the provisions on reduction of
capital apply except when the balance is used for the above purposes.
Share premium may be collected along with application or at the time of allotment. If
collected along with the application the following entry will be made:
Debit Share application account
Credit Share Capital account
Credit Securities premium account
If premium is collected at the time of allotment the following entry will be made:
Debit Share allotment account (including the premium)
Credit Share capital account
Credit Securities premium account
Illustration: 4
Name bankLimited issued 2,00,000 equity shares of Rs. 10 each at Rs. 12 per share. Terms of
payment being: Rs.2 on application, Rs.5 on allotment, including premium*, Rs.3 on first call
and Rs.2 on second and final call. Make journal entries up to allotment money received.
Page 344
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Solution:
Journal Entries in the Books of Name Bank Ltd.
Particular
(i)
Bank account
Dr.
To Equity share application account
(Application money received on 2,00,000 share)
(ii)
Equity share application account
Dr.
To Equity share capital account
(Application money transferred to capital)
(iii)* Equity share allotment account
To Equity share capital account
To Securities premium account
(Allotment money consisting of Rs.3 towards
capitaland Rs.2 towards premium became due on
2,00,000 shares)
(iv)* Bank account
Dr.
To Share allotment account
(Allotment money received)
Debti Rs.
Credit Rs
.
4,00,000
4,00,000
4,00,000
4,00,000
10,00,000
10,00,000
6,00,000
4,00,000
10,00,000
*Some companies charge premium with share application money and some companies charge
premium partly with share application money and partly at the time of allotment of shares.
In the above illustration securities premium account is credited even before the receipt of cash.
That being the case if someone fails to pay the allotment money, securities premium account
will have to be debited at the time these shares are forfeited. In order to avoid this, security
premium account can be recorded only at the time of actual receipt of cash. If this method is
followed the entries will appear as under:
At the time of allotment:
Debit share allotment account (with allotment money only)
Credit Share capital account
At the time of receipt of cash:Debit Bank account
Credit Share allotment account (with allotment money)
Credit securities premium account (with premium money)
Illustration: 5
Sunkishi Hydropower Ltd. issued 10,000 equity shares of Rs. 10 each at a premium of Rs. 3
per share payable on first and final call. There was enough number of applications and all the
shares were allotted. One shareholder who applied for 500 shares failed to pay the allotment
money. Show the entries relating to allotment only.
UNIT 1: Accounting for Share Capital
Page 345
ICAN Advanced Accounting CAP II Chapter III
Solution:
The solution to the problem is given under the methods, viz., (1) recording securities premium
at time of allotment itself, and (2) recording securities premium only after its receipt in cash.
Journal Entires in the Books of Sunkoshi Hydropower Ltd
Particular
Case (1):
(i)Equity share allotment account
Dr.
To Equity share capital account
To securities premium account
(Being the allotment money due on 10,000 shares
consisting of Rs. 2 towards capital and Rs. 3 towards
premium on each share)
(ii)Bank account
Dr.
To Equity share allotment A/c
(Being the receipt of allotment money on 9,500 shares)
Case (2):
(i) Equity share allotment account
Dr.
To Share capital account
(Being the allotment money due on 10,000 shares)
(ii) Bank account
Dr.
To Equity share allotment account
To Securities premium account
(Being the allotment money and security premium
money received on 9,500 shares)
Debit Rs
Credit Rs
50,000
20,000
30,000
47,500
47,500
20,000
20,000
47,500
19,000
28,500
The first method suffers from a disadvantage, in case the shares are forfeited. Since the
securities premium is not received in cash, it has to be debited when such shares are forfeited.
Under the second method, there is no need for such debit, since securities premium is credited
only after it is received in cash. In view of the restrictions imposed by Sec. 29 of the
Companies Act, there are some who doubt the propriety of debiting securities premium
account for non-receipt of cash at the time of forfeiture. Therefore, the second method is
preferable.
7.3 ISSUE OF SHARES AT DISCOUNT
When a share is issued at a price which is less than its par value then it is said that it has been
issued at discount. For example, if a share of Rs. 10 is issued for Rs. 9 then it is issued at 10%
discount. A company can issue shares at a discount only when the following conditions are
satisfied (Sec. 64):
(a)
(b)
(c)
The issue is authorized by a special resolution in the general meeting;
In issuing or selling shares pursuant to a capital restructuring scheme of the company,
In issuing or selling shares pursuant to a scheme of converting loans borrowed by the
company into shares with the consent of creditors;
Page 346
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
(d)
(e)
In issuing or selling shares pursuant to an employee share scheme;
In issuing shares on such other conditions as approved by the Office.
When shares are issued at discount, company stands to lose money and thus it is recorded in
the books by Debiting “Discount on Issue of Share Account”. Journal entry for the issue of
shares at discount, which is generally recorded at the time of allotment of shares, is as under:
Debit Share allotment account
Debit Discount on issue of shares account
Credit Share capital account
“Discount on issue of shares account”, being a loss of capital nature, is shown on the assets
side of the Statement of Financial Position and is amortized (written off) over three or four
years. The journal entry for writing off the discount on shares is as under:
Debit Profit and loss account
Credit Discount on issue of share account
Illustration:6
Nepal Power Company Ltd. Issued 2, 00,000 shares of Rs. 10 each. Terms of payment being:
Rs.3 on application, Rs.2 on allotment and Rs. 4 on first and final call. The company received
application for 2, 80,000 shares. Pro rata allotment was made on the applications for 250,000
shares. Give journal entries assuming that an applicant who was allotted 100 shares did not
pay “allotment” and “first and final call” money.
UNIT 1: Accounting for Share Capital
Page 347
ICAN Advanced Accounting CAP II Chapter III
Solution:
Journal Entries in the Books of Nepal Power Company Ltd
Particular
(i) Bank account Dr.
To Share application account
(Application money received on 2,80,000 shares)
(ii) Share application account Dr.
To Bank account
(Application money for 30,000 shares returned)
(iii) Share application account Dr.
To Share allotment account
To Share capital account
(Application money for 2,00,000 shares converted into
share capital account and that for 50,000 shares utilized
for allotment money)
(iv) Share allotment account Dr.
Discount on issue of shares account Dr.
To Share capital account
(Allotment money at Rs. 2 per share and discount onshares at
Re.1 per share brought into account)
(v) Bank account Dr.
To Share allotment account
(Allotment money due on 1,99,900 shares received)
(vi Call-in-arrear account Dr.
To Share allotment account
(Allotment money due on 100 shares not received
transferred to call-in-arrear account)
(vii) Share first and final call account Dr.
To Share capital account
(First and final call money at Rs.4 per share due
on2,00,000 shares brought into account)
(viii) Bank account
Dr.
To Share first and final call account
(First and final call at Rs.4 per share received
on1,99,900 shares)
(ix) Call-in-arrear account
Dr.
To share first and final call account
(Call money due on 100 shares not received transferred to
call-in-arrear account)
Page 348
DebitRs
8,40,000
CreditRs
8,40,000
90,000
90,000
7,50,000
1,50,000
6,00,000
4,00,000
2,00,000
2,49,875
125
8,00,000
7,99,600
400
6,00,000
2,49,875
125
8,00,000
7,99,600
400
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Tutorial Notes
(a) In the absence of any instructions, discount is recorded with the entry made for the
allotment amount due on shares allotted.
(b) Calculation of calls-in-arrear on account of allotment money. A shareholder who was
allotted 100 shares must have applied for 125 shares, being allotment made on pro rata
basis to the applicants for 2, 50,000 shares. Now the calculations can be shown as
under:
Application money received, 125 x Rs.3
Application money transferred to capital account, 100 x Rs.3
Advance on application available for adjustment towards allotment money
Allotment money due on 100 shares, 100 x Rs.2
Allotment money already received with application money (as above)
Allotment money not received
Rs.
375
300
75
200
75
125
7.4 ISSUE OF SHARES FOR CONSIDERATION OTHER THAN CASH
In case a company does not have sufficient funds for the purchase of fixed assets or for
payment to creditors it may offer and allot its shares to vendors/ creditors in lieu of cash. Any
allotment of shares against which cash is not to be received is called ‘issue of shares for
consideration other than cash’. When such shares are issued then it must be clearly stated in
the Statement of Financial Position and must be distinguished from the issue made for cash.
This may be further issued either at par, or at discount, or at premium. In case of purchase of
assets like building, machinery, stock of materials, etc. the following journal entry is made:
Assets A/c
Dr
To Vendors/Creditors A/c
(Assets purchased)
Vendors/Creditors A/c
Dr
To Share Capital A/c
(Issue of shares of Rs…….each fully paid up)
Illustration: -7
Lumbini Ltd. Purchased assets of Rs.3,80,000 from Butwal Traders. It issued equity shares of
Rs.10 each fully paid in satisfaction of their claim. What entries will be made in case such
issue is: (a) at par, (b) at discount of 5%, and (c) at premium of 25%.
Solution:
Particular
When assets are purchased:
Assets account Dr.
To Butwal Traders
(Being purchase of assets)
UNIT 1: Accounting for Share Capital
Journal Entries in the books of Lumbini Ltd
DebitRs
CreditRs
3,80,000
3,80,000
Page 349
ICAN Advanced Accounting CAP II Chapter III
When shares are issued at par:
Butwal Traders Dr.
To Equity share capital account
(Being issue of 38,000 shares of Rs.10 each fully paid up)
When shares are issued at discount:
Butwal Traders Dr.
Discount account Dr.
To Equity share capital account (Being issue of 40,000
shares of Rs.10 each at a discount of 5%)
When shares are issued at premium:
Butwal Traders Dr.
To Equity shares capital account
To Security premium account
(Being issue of 30,400 shares of Rs.10each at a premium
of 25%)
3,80,000
3,80,000
3,80,000
20,000
4,00,000
3,80,000
3,04,000
76,000
Tutorial Notes: In order to find out exact amount of issue after taking into consideration
discount or premium, the following procedure is recommended to students:
(a)
(b)
First of all, find out the discounted price or the price with premium of one share which
is issued to the vendor. Here it is Rs.9.50 in case of discount, and 12.50 in case of
premium.
Then, find out the Number of shares to be issued to vendors with the help of unitary
method as explained below:
For making payment of Rs. 9.50 Company issues 1 share
For making payment of Rs.3, 80,000 Company issues 3,80,000/9.50 = 40,000 shares
(c)
After finding out number of shares issued, find out the amount of share capital by
multiplying number of shares with the paid-up value of shares. Now calculate amount
of discount or premium with the help of rate which is given in the question.
7.5 FORFEITURE OF SHARES
In case a shareholder member fails to pay any call on the day appointed for payment the
directors may after giving notice to the concerned shareholder in a manner as provided in sec
53(3), proceed to forfeit the shares held by such a defaulting shareholder in the event of nonpayment of the call on or before the day so named in the notice. The Articles of the company
should expressly provide for the forfeiture in order to enable the board of directors to
proceed.Where any share is forfeited as provided in section 53(3), the board of directors may
refund the amount already paid up in respect of the share so forfeited and the amount equal to
the dividends, if any attached in respect of such share, or issue the share to the extent covered
by such amount; and where the amount is to be refunded, it has to be refunded within three
months after the forfeiture of share.
Page 350
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
When shares are forfeited the company makes the following journal entries:
Debit Share capital account
(with called-up amount)
Credit forfeited shares account (with amount already paid by members)
Credit Calls account (with the amount which became due but was not paid)
It may be noted that share capital account is debited with the called-up amount and not with
the face value of the share. For example, if a shareholder pays application money of Rs.2 per
share and fails to pay allotment money of Rs.3 and first call money of Rs.2.50 on a share of
the face value of Rs.10 then the following journal entry will be made:
Share capital account
Dr. 7.50
To Share allotment account
3.00
To Share first call account
2.50
To Forfeited share account
2.00
Since a company can issue shares either at par, or at discount, or at premium, it is possible that
shares forfeited by the company may belong to any of the above three categories. Accounting
treatment in the above three cases has been explained by giving illustrations.
Forfeiture of shares which were issued at par
Illustration:8
Hari Khadka was holding 20 shares of Rs.10 each on which he paid Rs.2 on application but
could not pay Rs.3 on allotment and Re.1 on first call. Directors forfeited the shares. Give
journal entry needed for recording the forfeiture of shares.
Solution
Journal Entries
Particular
Share capital account (20×Rs.6)
To Forfeited shares account (20 × Rs.2)
To Share allotment account (20 × Rs.3)
To Share first call account (20 × Re.1)
Dr.
Debit Rs
120
Credit Rs
40
60
20
Forfeiture of shares which were issued at discount
At the time of making a journal entry for the forfeiture of shares which were issued at
discount, student is required to cancel the discount on shares account. Since discount account,
being a loss, is debited at the time of issue of shares, it is credited at the time of its
cancellation.
Illustration: - 9
Anil Gurung was holding 30 shares of Rs.10 each of X Ltd., issued at 10% discount. He paid
Rs.2 application but could not pay the allotment money of Rs.3 and his shares were forfeited.
Make journal entry for the forfeiture of shares.
UNIT 1: Accounting for Share Capital
Page 351
ICAN Advanced Accounting CAP II Chapter III
Solution
Journal Entries
Particular
Share capital account (30 × Rs.6)
Dr.
To Forfeited shares account (30 × Rs.2)
To Share allotment account (30 × Rs.3)
To Discount on shares account (30 × Re.1)
Debit Rs
Credit Rs
180
60
90
30
Forfeiture of shares which were issued at premium
When shares are issued at premium, the premium so collected is strictly guided by the
provisions of Sec. 29. According to that, premium once collected cannot be cancelled even if
that share is forfeited later on. But, if a share, on which premium has become due but has not
been received, is forfeited then any credit given to securities premium account at the time of
issue of shares must be cancelled on the forfeiture of shares by debiting securities premium
account.
Illustration: -10
MalikaLtd. issued shares of Rs.10 each at 10% premium payable as follows:
Rs.
On application
On allotment
On first call
On final call
2
3 (including premium)
2
4
Mahesh who was holding 50 shares did not pay his allotment and first call and his shares were
forfeited. Suresh, who was holding 30 shares, did not pay first call and his shares also were
forfeited. Journalize transactions relating to forfeiture of shares
Solution:
Journal Entries
Particular
Share capital account (50 × 6)
Securities premium account (50 × 1)
To Forfeited shares account (50 × 2)
To Share allotment account (50 × 3)
To Share first call account (50 × 2)
(Being forfeiture of Mahesh’s shares)
Share capital account (30 × 6)
To Forfeited shares account (30 × 4)
To Share first call account (30 × 2)
(Being forfeiture of Suresh’s shares)
Page 352
Dr.
Dr.
Debit Rs
300
50
Credit Rs
100
150
100
Dr.
180
120
60
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Tutorial Notes. In the first case the credit balance of securities premium account has been
cancelled by debiting that account because the premium has not been paid but in the second
case it has not been done so because the premium has been paid. Premium once received
cannot be cancelled in accordance with the provisions of Sec.78.
As per section 53(3) of Companies Act, 2063 the forfeited amount may be refunded to the
shareholder or share should be issued to shareholder to the extent covered by forfeited amount.
If share issued to shareholder is forfeited his number of holding will be come down to the
extent of the forfeited shares. For example if 1000 shares having face value and issue price of
Rs. 100 was forfeited for non-payment of final call of Rs. 40 then number of share that can be
issued to the shareholder will be 600 (1000 x 60/100). Accounting entry for the transaction
will be:
Share Forfeiture a/c
Dr
Rs. 60,000
To Share capital a/c
Rs. 60,000
{Being 600 shares issued to shareholder who defaulted for payment of final call of Rs. 40 on
1000 shares equivalent to the amount already paid (Rs. 100 – unpaid amount of Rs. 40 = Rs.
60x1000 shares)}
Balance 400 shares may be issued at the option of the company.
If the forfeited amount is refunded to the shareholder then the entry in above case will be:
Share Forfeiture a/c
Dr
Rs. 60,000
To Bank A/c
Rs. 60,000
(Being share forfeited amount refunded to the shareholder)
7.6
RE-ISSUE OF FORFEITED SHARES
Shares forfeited on the non-payment of calls can be re-issued by the company as and when the
company finds it suitable. The accounting entries for reissue will be same as the fresh issue.
Illustration: -11
Oriental Hotel Ltd invited application for 10,000 shares of Rs. 100 each at a discount of 6%
payable as follows:
On Application
Rs. 25
On Allotment
Rs. 34
On First and final call Rs. 35
The applications received were for 9,000 shares and all of these were accepted. All moneys
due were received except the first and final call on 100 shares which were forfeited. BOD of
the company decided to refund the forfeited amount. 50 shares were re-issued @ Rs.90 as
fully paid. Pass entries in the Book of the Company.
UNIT 1: Accounting for Share Capital
Page 353
ICAN Advanced Accounting CAP II Chapter III
Journal Entries In the book of Oriental Hotel Ltd.
Solution:
Particulars
L.F
Bank A/c Dr
To Share application account
(Being share application money receive for 9,000
shares @Rs. 25)
Share application account
Dr
To Share capital account
(Being the application moneys transferred to share
capital on allotment of shares)
i) Share allotment account
Dr
Discount on issue of shares account Dr
To Share capital account
(Being the allotment money due on 9,000 shares at Rs.
34 per share and discount allowed at Rs. 6 per shares)
Bank A/c Dr To Share Allotment a/c (Being allotment
money received on 9,000 shares @ Rs. 34)
ii) Share first and final call account Dr To Share
capital account (Being the first and final call due
on 9,000 shares at Rs. 35 per share)
Bank A/c Dr
To Share first and final call a/c (Being first and
final call received on 8,900 shares @ Rs. 35)
Share capital account Dr
To Share first and final call account
To Discount on issue of share a/c
To Forfeited shares account
(Being the forfeited of 100 shares for nonpayment of the final call of Rs. 35 per share)
Share Forfeiture a/c Dr
To Bank a/c (Being forfeited amount refunded as per
BOD decision)
Bank A/c Dr
Discount A/c Dr
To Share Capital a/c
(Being 50 shares issued at Rs. 90 each)
Debit Rs
2,25,000
2,25,000
3,06,000
54,000
306,000
3,15,000
311,500
10,000
5,900
4,500
500
Credit Rs
2,25,000
2,25,000
360,000
306,000
3,15,000
311,500
3,500
600
5,900
5,900
5,000
Illustration: -12
Kaski Shoe Ltd. had allotted 10,000 shares to applicants for 14,000 shares on a pro-rata basis.
The amount payable was Rs.2 on application, Rs. 5 on allotment (including premium of Rs. 2
each), Rs. 3 on first call and Rs. 2 on final call. Bikas failed to pay the first call and final call
on his 300 shares. BOD decided to refund the amount of forfeiture. All the shares were
forfeited and out of them 200 shares were re-issued @ Rs.9 per share. Give the accounting
treatment.
Page 354
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Solution
Journal Entries In the Books of Kaski Shoe Limited
L.F
Debti Rs
Particular
Bank A/c Dr
To Share application account
(Being share application money receive for 14,000
shares @Rs. 2)
Share application account Dr
To Share capital account
To Share Allotment a/c
(Being the application moneys transferred to share
capital on allotment of shares)
Share allotment account Dr
To Securities Premium a/c
To Share capital account
(Being the allotment money due on 10,000 shares at
Rs. 5 per share including Rs. 2 as premium)
Bank A/c Dr
To Share Allotment a/c (Being allotment money
received on 10,000 shares @ Rs. 4.2)
Share first call account Dr
To Share capital account (Being the first call due on
10,000 shares at Rs. 3 per share)
Bank A/c Dr
To Share first and final call a/c (Being first and
final call received on 9,700 shares @ Rs. 3)
Share final call account Dr
To Share capital account (Being the first call due
on 10,000 shares at Rs. 3 per share)
Bank A/c Dr
To Share final call a/c (Being first and final call
received on 9,700 shares @ Rs. 3)
Share capital A/c (300 × Rs. 10) Dr
To share first call A/c (300 × Rs. 3)
To Share final call A/c (300 × Rs. 2)
To Forfeited shares A/c
(Being the forfeiture of 300 shares for non-payment
first and second calls)
Share Forfeiture a/c Dr
UNIT 1: Accounting for Share Capital
28,000
28,000
50,000
42,000
30,000
29,100
20,000
19,400
3,000
Credit Rs
28,000
20,000
8,000
20,000
30,000
42,000
30,000
29,100
20,000
19,400
900
600
1,500
1,500
Page 355
ICAN Advanced Accounting CAP II Chapter III
To Bank a/c (Being forfeited amount refunded as per
BOD decision)
Bank A/c Dr
Discount A/c Dr
To Share Capital a/c
(Being 200 shares issued at Rs. 9 each)
1,500
1,800
200
2,000
7.7 FORFEITURE OF SHARES WHEN THERE IS AN OVER SUBSCRIPTION AND
PRO-RATA ALLOTMENT
If a company is of repute it is quite possible that the shares applied for would be more than
what the company offered to issue. Under such circumstances it is not possible for the
company to satisfy the demands of all the applicants. It rejects some applications altogether,
allots in full on some applications and makes a pro-rata allotment on some other applications.
In solving questions relating to over-subscription, students face the difficulty only at such
places where some of the shares belonging to pro-rata category are forfeited. In such a case the
calculation of amount to be forfeited poses a problem which is to be calculated by finding the
amount the applicant sent on total shares applied for. Therefore, to reach correct solution the
following procedure is recommended:
(a)
Calculate total shares applied for
(b)
Multiply the number of shares with the application money. This gives total money sent
with the application. This amount is forfeited on default.
(c)
Deduct from it the amount due on application with the help of shares allotted. This
gives money sent by the applicant in advance with the application. This money is
available for adjustment towards allotment.
(d)
Calculate amount due on allotment and deduct from that the amount sent in advance
with application as per (c) above. This gives the amount in arrears on allotment. It is
credited to share allotment account at the time of forfeiture.
Illustration 13
A limited company issued a prospectus inviting applications for 2,000 equity shares of Rs. 10
each at a premium of Rs. 2 per share payable as follows:
On application
- Rs. 2
On allotment
- Rs. 5 (including premium)
On first call
- Rs. 3
On second and final call
- Rs. 2
Applications were received for 3,000 shares and pro-rata allotment was made on the
applications for 2,400 shares. Money overpaid on applications was employed on account of
sum due on allotment.
Page 356
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Messi, to whom 40 shares were allotted, failed to pay the allotment money and on his
subsequent failure to pay the first call, his shares were forfeited, Ronaldinho, the holder of 60
shares, failed to pay the two calls, and his shares were forfeited after the second call.
Of the shares forfeited, 80 shares were sold to Pedro credited as fully paid @ Rs. 11 per share,
the whole of Messi’s shares being included.
Pass the necessary journal entries and prepare the cash book of the company.
Solution
Journal Entries In the Books of A Ltd
Particulars
Equity share applications A/c
Equity share allotment A/c
To Equity share capital A/c
To securities premium A/c
(Capitalisation of application money @ Rs. 5 per share and
allotment money due @ Rs. 5 per share, including premium
@ Rs. 2 per share on 2,000 equity shares allotted by the
Board of directors)
Equity share application A/c
To Equity share allotment A/c
(Surplus application money appropriated towards allotment
money)
Equity share first call A/c
To Equity share capital A/c
(The first call due @ Rs. 3 per share on 2,000 equity shares)
Equity share capital A/c
Securities premium A/c
To Equity share allotment A/c
To Equity share first call A/c
To Share forfeited A/c
(Forfeiture of 40 equity shares held by Messifor nonpayment of part of allotment money and the first call)
Equity share second and final call A/c
To Equity share capital A/c
(Second and final call due @ Rs. 2 per share on 1,960
equity shares)
Equity share capital A/c
To Equity share first call A/c
To Equity share second and final call A/c
To Shares forfeited A/c
(Forfeiture of Ronaldinho’s 60 equity shares for nonpayment of the two calls)
UNIT 1: Accounting for Share Capital
Dr.
Dr.
DebitRs.
4,000
10,000
CreditRs.
10,000
4,000
Dr.
800
800
Dr.
6,000
6,000
Dr.
Dr.
320
80
184(i)
120
96(ii)
Dr.
3,920
3,920
Dr.
600
180
120
300
Page 357
ICAN Advanced Accounting CAP II Chapter III
Shares forfeited A/c
Dr.
To Securities premium A/c
(Credit to securities premium A/c on re-issue of shares
earlier held by Messi)
Shares forfeited A/c
To Capital reserve A/c
Dr.
(Profit on re-issue of 80 equity shares transferred to Capital
Reserve A/c)
40
40
256
256(iii)
Cash Book (Bank Columns only)
To Equity share application A/c
(Rs. 2 on 3,000 equity shares applied for)
Rs.
6,000
To Equity share allotment A/c
(Rs. 10,000-800)-Rs. 184
9,016
To Equity share first call A/c
(receipt of first call on 2,000 equity
shares less the shares of Messi
and Ronaldino)
To Equity share second and final call A/c
(receipt of second call on 1,960 equity
shares less Ronaldino’s shares)
5,700
Rs.
By
Equity share 1,200
application
A/c
(refund of Rs. 2 per
share on 600 shares
applied for but not 24,196
allotted)
By Balance c/d
3,800
To Equity share capital A/c
To Securities premium A/c
To Balance b/d
(i)
800
80
25,396
24,196
25,396
Tutorial Notes:
Money due from Mession account of allotment is Rs. 184
calculated as follows:
Total (gross) sum due to allotment on 40 equity shares
Less Pawan’s share out of excess application money of Rs. 800
(nobody received full allotment – everybody must have applied
for more equity shares than were actually allotted)
i.e.,
(ii)
Page 358
200
16
184
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Messi has paid Rs. 96 in all, thus :
Shares allotted 2,000 out of equity shares applied for 2,400
Shares
allotted
40
out
of
equity
shares
(iii) Application money on 48 equity shares @ Rs. 2
applied
for
=
96
=
=
96
40
56
Profit on forfeiture of equity shares held by Messi
Loss on re-issue of these equity shares
Net gain transferred to capital reserve
=
Profit on forfeiture of 40 equity shares held by Ronaldino= Rs. =
=
Loss on re-issue of these equity shares
=
Net gain transferred to capital reserve
Thus, the total amount transferred from forfeited shares account
to
Capital Reserve = Rs. 56 + Rs. 200
200
NIL
200
256
7.8 RIGHT ISSUE
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their
existing holdings. A rights issue is, therefore, a way of raising new cash from shareholders this is an important source of new equity funding for publicly quoted companies. Legally a
rights issue must be made before a new issue to the public. This is because existing
shareholders have the “right of first refusal” (otherwise known as a “preemption right”) on the
new shares. By taking these preemption rights up, existing shareholders can maintain their
existing percentage holding in the company. However, shareholders can, and often do, waive
these rights, by selling them to others. Shareholders can also vote to rescind their preemption
rights.
The body corporate may increase capital through the issuance of shares to the existing
shareholders through rights issue. While making rights issue, the “Provisions and Disclosures
Related to the Issue of Rights Shares” drafted in the format prescribed in the Schedule-5 of
Securities Registration and Issue Regulation, 2065, issued by SEBON, shall require to be
signed by all of the members of board of directors and be submitted to the Board through the
Issue Manager which, after getting registered with and approved by the Board, shall be
published.
A public company shall publish a notice on the issue of right shares, which may be subscribed
by the existing shareholders only, in a daily newspaper of national circulation for at least three
consecutive times prior to fifteen days of the issue of such shares. The existing shareholders
shall have the first right to subscribed the shares in proportion to their respective shareholding.
UNIT 1: Accounting for Share Capital
Page 359
ICAN Advanced Accounting CAP II Chapter III
No shareholder of a company existing for the time being shall have the first right over the
following shares to be issued by the company:
(a) Shares issued by the company for any consideration other than cash,
(b) Shares issued to any person under any right or facility provided in accordance with the
terms of an agreement concluded with the company,
(c) Shares issued under an employee share scheme,
(d) Shares issued in accordance with an agreement concluded between the company and its
creditors,
(e) Shares existed on converting preference shares into ordinary shares or debentures into
shares by the company,
(f) Shares issued in accordance with an agreement between the concerned parties in the
course of management of the company, restructuring of its capital or loan or in the
course of implementation of a restructuring program agreed upon between the relevant
parties in accordance with the prevailing law on insolvency or in the course of
implementation of a program of conversion of a public company into another public
company.
While issuing rights shares, if the rights to be exercised by the existing shareholder are to be
transferred wholly or partially to other nominee, the existing shareholder shall be required to
apply to the issuer body corporate having fulfilled the following conditions:
(a)
The memorandum or articles shall require to contain provision of transferring the rights
of existing shareholder to other person
(b)
The rights obtained by the shareholder shall have to be nominated wholly or partially to
only one person or institution.
(c)
Provision of applying as nominee shall have to correspond to the trading lot fixed by the
stock exchange.
(d)
Provision that a shareholder who has nominated others to exercise his / her rights shall
not be a nominee to exercise the rights of others. However, those who have exercised
their own rights fully may exercise the rights as nominee of others.
(e)
The nomination of the rights shall require being in compliance to the limit of
shareholding prescribed by the memorandum or articles of the company or that
prescribed, if any, by the related regulator and that the nominee shall not apply for the
shares including the existing shareholding that result in exceeding the said limit within
the groups and that there should be clear provision regarding the exercise of voting
rights.
(f)
The person or the institution so nominated shall not be in the black list and shall not be
having any disqualification under the prevailing laws.
(g)
Require having provision that the nominee shall exercise the rights within the period
opened for rights subscription.
Page 360
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Accounting for Right Issue:
Bank a/c Dr
Discount on Issue of Share a/c Dr (if issued at a price less than face value)
To Share Capital a/c
To Securities premium a/c (if issued at a price more than face value)
7.8
BONUS SHARE
7.8.1 Meaning of Bonus Share
As per Companies Act 2063, Bonus share means a share issued as an additional share to
shareholders, by capitalizing the saving earned from the profits or the reserve fund of a
company, and this term includes the increase of the paid up value of a share by capitalizing the
saving or reserve fund. While the issue of Bonus shares increase the total number of shares
issued it does not affect the net worth of the company. Although total number of shares
increases the ratio of shares held by each share holders remain the same. Detail provision for
issue of bonus share is guided by the Bonus Share Issue Guidelines, 2067 of SEBON.
Relevant provisions of the guideline is as below:
7.8.2 Conditions of issuing bonus share
 Bonus share can be issued by capitalizing free reserve or security premium received in
cash;
 Shares already issued must have been fully paid;
 The company must have earned profit in its audited financial statement;
 Fully paid bonus share can be issued utilizing the Capital Redemption Reserve.
7.8.3 Conditions in which bonus shares cannot be issued:
 Conditions required for issue of bonus shares, as mentioned above, is not satisfied;
 Company has negative net worth;
 Interest or principal payable has not been paid by the company even after the expiry of
its due date;
 Dividend payable to preference share has not been distributed;
 Amount payable to government of regulatory body has not been paid;
 Sufficient amount has not been allocated for the liability to employees;
 Bonus share cannot be issued utilizing the reserve and surplus created out of gain on
revaluation or sale of fixed assets;
 Prevailing law has restricted distribution of dividend.
7.8.4 Process of Issuing Bonus Shares
The Articles of Association of the company must contain the provision of issuing bonus share.
Section 83 of Companies Act 2063 requires Special resolutions to be passed in the general
meeting of a company for decision on issue of bonus share. In case of banks and insurance
company the issue must be approved by Nepal Rastra Bank and Insurance Board. “Company
not distributing profit”, shall not distribute dividend, bonus or any other amount, from the
UNIT 1: Accounting for Share Capital
Page 361
ICAN Advanced Accounting CAP II Chapter III
profits earned by it, to its members or employees; and the profits earned by the company shall
be used to increase the capital of the company or for the attainment of its objectives. Where a
company is to issue bonus shares pursuant, the company should give information there of to
the Office before is suing such shares.
Notice of closure of shareholders book should be published in National Daily along with the
notice of general meeting.
If the authorized capital and issued capital is increased beyond the amount mentioned in MOA
and AOA of the company, special resolution at general meeting should be passed. Approval of
Office of Company of Registrar should be obtained in case of increase in Authorized capital.
In case of increase in Issued Capital the increased amount should be recorded with the Office.
7.8.5 Accounting Entries for Bonus Issue
A (1) Upon the sanction of an issue of bonus shares
Debit Profit & Loss Account
Debit General Reserve Account
Debit Capital Reserve Account
Debit Securities Premium Account
Debit Capital Redemption Reserve Account
Credit Bonus Share to Shareholders Account.
(2)
Upon issue of share
Debit Bonus Share to Shareholders Account
Credit Share Capital Account.
(B) (1) upon the sanction of bonus by converting partly paid shares into fully paid shares
Debit Profit & Loss Account
Debit General Reserve Account
Debit Capital Reserve Account
Credit Bonus Share to Shareholders Account
(2) On making the final call due
Debit Share Final Call Account
Credit Share Capital Account.
(3) On adjustment of final call
Bonus to Shareholders Account
Credit Share Final Call Account
Illustration 14
Following is the extract of the Statement of Financial Position of ABC & Co. as at 31st Ashad
2070:
Page 362
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Authorised capital :
10,000
12% Preference shares of Rs. 10 each
1,00,000
Equity shares of Rs. 10 each
1,00,000
10,00,000
11,00,000
Issued and Subscribed capital:
8,000 12% Preference shares of Rs. 10 each fully paid80,000
90,000 Equity shares of Rs. 10 each, Rs. 8 paid up
7,20,000
Reserves and Surplus:
General reserve
1,20,000
Capital reserve
75,000
Securities premium
25,000
Profit and Loss Account
2,00,000
Secured Loan:
12% Partly Convertible Debentures @ Rs. 100 each
5,00,000
On 1st Shrawan, 2070 the Company has made final call @ Rs. 2 each on 90,000 equity shares.
The call money was received by 20th Shrawan, 2070. Thereafter the company decided to
capitalize its reserves by way of bonus at the rate of one share for every four shares held.
Share premium of Rs. 25,000 includes a premium of Rs. 5,000 for shares issued to vendors
pursuant to a scheme of amalgamation. Capital reserves include Rs. 40,000 being profit on
sale of plant and machinery. 20% of 12% debentures are convertible into equity shares of Rs.
10 each fully paid on 1st Kartik, 2070.
Show necessary entries in the books of the company and prepare the extract of the Statement
of Financial Position immediately after bonus issue but before conversion of debentures. Are
the convertible debenture holders entitled to bonus shares?
Solution:
Date
2070
Shrawan 1
Shrawan 20
Journal Entries In the Books of ABC & Co
Particular
Debit
Equity Share Final Call A/c
To Equity Share Capital A/c
(Final call of Rs. 2 per share on 90,000
equity shares due as per Board’s
Resolution dated....)
Bank A/c
To Equity Share Final Call A/c
(Final Call money on 90,000 equity shares
received)
Capital Reserve A/c
UNIT 1: Accounting for Share Capital
Dr.
Credit
1,80,000
1,80,000
Dr.
1,80,000
1,80,000
Dr.
40,000
Page 363
ICAN Advanced Accounting CAP II Chapter III
Shrawan 20
Securities Premium A/c
General Reserve A/c
Profit and Loss A/c
To Bonus to Shareholders A/c
(Bonus issue @ one share for every four
shares held by utilizing various reserves
as per Board’s Resolution dated...)
Bonus to Shareholders A/c
To Equity Share Capital A/c
(Capitalization of profit)
Dr.
Dr.
Dr.
20,000
1,20,000
45,000
2,25,000
Dr.
2,25,000
2,25,000
Statement of Financial Position (Extract) as on 30th Shrawan 2070 (after bonus issue)
Particulars
(Rs.)
Equity and Liabilities
Shareholders' funds
a
Share capital
b
Reserves and Surplus
Non-current liabilities
a
Long-term borrowings
Total
Notes to Accounts
1 Share Capital
Equity share capital
Authorised share capital
1,25,000 Equity shares of Rs. 10 each
Issued, subscribed and fully paid share capital
1,12,500 Equity shares of Rs. 10 each, fully paid
(Out of above, 22,500 equity shares @ Rs. 10 each were
issued by way of bonus)
Preference share capital
Authorised share capital
10,000 12% Preference shares of Rs. 10 each
Issued, subscribed and fully paid share capital
8,000 12% Preference shares of Rs. 10 each
Total (A + B)
2 Reserves and Surplus
Capital Reserves
Securities Premium Reserves
Surplus (Profit & Loss Account)
Total
Page 364
1
2
1,205,000
195,000
3
500,000
1,900,000
12,50,000
11,25,000
1,00,000
80000
12,05,000
35,000
5,000
1,55,000
1,95,000
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
3 Long-term borrowings
Secured
Secured12% Convertible Debentures @ Rs. 100 each
(Out of above, 1,000 Debentures @ Rs. 100 each to be converted
into 10,000 Equity shares @ Rs. 10 each on 1st Kartik, 2070)
Total
5,00,000
500,000
Working Notes:
1.
As per Claus 5 (Cha) of Bonus Share Issue Guidelines, 2067 of SEBON; Bonus share
cannot be issued out of the profit made from sale of fixed assets.
2.
As per Claus 4 (ka) of Bonus Share Issue Guidelines, 2067 of SEBON; As per SEBON
guidelines, securities premium collected in cash can only be utilized for bonus issue.
3.
It is assumed that the company will pass necessary resolution at its general bodymeeting
for increasing the authorized capital. In anticipation, the authorized capital hasbeen
suitably increased as below:
Existing number of equity shares as authorized
Add: Issue of bonus shares to equity shareholders
Add: Number of bonus shares to be issued to debenture holders
after conversion
4.
1,00,000*
22,500
2,500
1,25,000
As per Claus 5 (ga) of Bonus Share Issue Guidelines, 2067 of SEBON; a company
cannot issue bonus share unless the principal and interest of debenture is paid. Pending
the conversion of debenture, necessary number of share should be earmarked for
convertible debenture holders. Therefore convertible debenture holders are also entitled
to the bonus shares in the same ratio as the equity shareholders.
Illustration:15
The Statement of Financial Positionof Krishi Bikash Bank Ltd. as at 31.3.2070 is as follows:
Statement of Financial Position as on 31.3.2070
Liabilities
Authorized Share Capital
1, 50,000 Equity Shares of Rs 10 each
Issued, Subscribed and Paid-up
80,000 Equity shares of Rs,
7.50 each called-up and paid-up
Reserves
Capital Redemption Reserve
Plant Revaluation Reserve
UNIT 1: Accounting for Share Capital
Rs.
Assets
Rs.
17,00,000
15,00,000
Sundry Assets
6,00,000
1,50,000
Page 365
ICAN Advanced Accounting CAP II Chapter III
Share Premium Account
Development Rebate Reserve
Investment Allowance Reserve
General Reserve
20,000
1,50,000
2,30,000
2,50,000
3,00,000
17,00,000
17,00,000
The company wanted to issue bonus shares to its shareholders at the rate of one share for
every two shares held. Necessary resolutions were passed: requisite legal requirements were
complied with:
(a) You are required to give effect to the proposal by passing journal entries in the books
of Krishi Bikash Bank Ltd
(b) Show the amended Statement of Financial Position.
Solution
(a) In the Books of Krishi Bikash Bank Ltd
Journal Entry
Particular
(i)
Debit Rs
Capital Red. Reserve A/c
Dr.
Share Premium A/c
Dr.
General Reserve A/c
Dr.
To Bonus to Shareholders’ A/c
(Being sanction of an issue of bonus of 40,000
shares @ Rs. 10 each)
(ii) Share Final Call A/c
To Share Capital A/c
Dr.
(Being the final call of Rs. 2.50 each on 80,000
equity shares to make them fully paid-up)
(i)
Bank A/c
To Share Final Call A/c
(ii) Bonus to Shareholders’ A/c
To Share Capital A/c
(Being 40,000 bonus shares issued @ Rs. 10 each)
Dr.
Rs.
Rs.
1,50,000
1,50,000
1,00,000
4,00,000
2,00,000
2,00,000
2,00,000
2,00,000
Dr.
4,00,000
Statement of Financial Position
(After bonus issue)
Liabilities
Rs.
Assets
Sundry
Authorized Share Capital
Assets
1,50,000 Equity Shares of Rs 10 each
15,00,000
Page 366
Credit Rs
4,00,000
Rs.
19,00,000
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Issued, Subscribed and Paid-up
1,20,000 Equity shares fully paid-up
Reserves
Plant Revaluation Reserve
Development Rebate Reserve
Investment Allowance Reserve
General Reserve
12,00,000
20,000
2,30,000
2,50,000
2,00,000
19,00,000
19,00,000
Illustration: 16
Provisional Statement of Financial Position of Life Company Ltd. as at 31stAshadh, 2070 was
as under:
Statement of Financial Positionas at 31stAshadh, 2070
Liabilities
Rs.
Share Capital:
50,000 equity sharesof Rs 10 each, Rs.
7per share called-up
3,50,000
Less: Calls-in-arrear on 10,000 shares @
Rs.2 per share
20,000
3,30,000
Add:Calls-in-advance on 40,000shares
@ Rs. 3 per share 1,20,000
4,50,000
20,000 10% Redeemable preference
shares of Rs. 10 each. Fully paid up
2,00,000
Reserves & Surplus:
General Reserve
Profit & Loss Account
Current Liabilities
Assets
Fixed Assets (at
cost less depreciation)
Cash & Bank balances
Other Current assets
3,00,000
2,70,000
2,80,000
15,00,000
Rs.
7,00,000
2,00,000
6,00,000
________
15,00,000
Calls-in-arrear are outstanding for 6 months. Calls-in-advance were also received 6 months
back. Interest @ 10% p.a. on calls in advance and 12% p.a. on calls-in-arrear are
allowed/charged. The Board of Directors have recommended that:
i)
Dividend for the year 2000-01 be allowed @ 20% on equity shares.
ii)
Money-on-calls-in-advance be refunded and partly-paid equity shares be covered
as fully paid up by declaring bonus dividend to shareholders.
iii) The preference shares, which are redeemable at a premium of 10% any time after
31stAshadh, 2070, may be redeemed by issue of 10% Debentures of Rs. 100 in
cash.
UNIT 1: Accounting for Share Capital
Page 367
ICAN Advanced Accounting CAP II Chapter III
Show Journal Entries to give effect to the above proposals including payment and receipt of
cash and redraft the Statement of Profit or Loss and Other Comprehensive Income and
Statement of Financial Position of Life Company Ltd
Solution
Journal Entries in the Books of Life Company Ltd.
Particular
Interest on Calls-in-Arrear A/c Dr.
To Profit & Loss A/c
(Being interest @ 12% p.a. on Rs. 20,000 for 6 months credited to
Profit and Loss Account)
Bank A/c Dr.
To Calls-in-Arrear A/c
To Interest Calls-in-Arrear A/c
(Being interest on calls-in-arrear received)
Profit & Loss A/c Dr.
To Interest on Calls-in-Advance A/c
(Being interest @ 10% on Rs. 1,20,000 for 6 months allowed on
calls in advance)
Profit & Loss A/c Dr.
To Preference Dividend A/c
To Equity Dividend A/c
(Being dividend @ 10% on Preference share capital & 20% on
Equity share capital proposed)
Profit & Loss A/cDr.
To Bonus to Equity Shareholders A/c
(being bonus dividend declared)
Dr. Rs.
1,200
Share Final Call A/c Dr.
To Equity Share Capital A/c
(Being final call made @ Rs. 3 on 5,00,000 shares)
Bonus to Equity Shareholders A/c Dr.
To Share Final Call A/c
(Being adjustment of bonus dividend against final call)
1,50,000
Calls-in-Advance A/c Dr.
Interest Calls-in-Arrear A/c Dr.
To Bank A/c
(Being amount of calls-in-advance along with interest refunded)
Bank A/c Dr.
To 10% Debentures A/c
(Being 2,200 Debentures of Rs. 10 each issued in cash)
Profit & Loss A/cDr.
To Premium on Redemption of Preference Shares A/c
1,20,000
6,000
Page 368
Cr. Rs.
1,200
21,200
20,000
1,200
6,000
6,000
90,000
70,000
20,000
1,50,000
1,50,000
1,50,000
1,50,000
1,50,000
1,26,000
2,20,000
2,20,000
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
(Being premium payable on redemption)
Profit & Loss A/c Dr.
General Reserve A/c Dr.
To Capital Redemption Reserve A/c
(Transfer to capital redemption reserve)
Preference Shares Capital A/c Dr.
Premium on Redemption of Preference Shares A/c
To Preference Shareholders A/c
(Amount due on redemption of preference shares)
Preference Shareholders A/c Dr.
To Bank A/c
(Amount paid to preference shareholders)
Profit & Loss Account of Life Company Ltd.
for the year ended 31stAshadh, 2070
20,000
20,000
5,200
1,94,800
2,00,000
20,000
2,20,000
2,00,000
2,20,000
2,20,000
Particulars
To interest on calls-in-advance
To Balance c/d
Rs.
Particulars
Rs.
6,000 By Balance c/d
2,70,000
2,65,200 By Interest on calls1,200
2,71,200 in-arrear
2,71,200
To Premium on redemption
20,000
2,65,200
To Preference Dividend
20,000 By Balance c/d
To Equity Dividend
70,000
To Bonus Dividend
1,50,000
To Capital Redemption Reserve
5,200
_______
2,65,200
2,65,200
Statement of Financial Position of Life CompanyLtd.
as on 31stAshadh, 2070
Liabilities
Rs.
Assets
Rs.
7,00,000
Fixed Assets
Share Capital:
(cost
less
50,000 equity shares of Rs. 10
5,00,000
depreciation)
Each fully paid-up
Cash & Bank 95,000
(Of the above equity shares
balance (W.N)
Rs.3 per share has not been received in cash
Other Current 6,00,000
but has been capitalised by issuing bonus
Assets
dividend)
2,00,000
Reserves & Surplus:
Capital Redemption Reserve
General Reserve
3,00,000
1,05,200
Less: Utilised for redemption
on preference shares 1,94,800
2,20,000
Profit & Loss Account
2,80,000
10% Debentures
________
90,000
Current Liabilities
13,95,200
Proposed dividend
13,95,200
UNIT 1: Accounting for Share Capital
Page 369
ICAN Advanced Accounting CAP II Chapter III
Working Note:
Cash and Bank Balance
As on 31stAshadh, 2070
Cash and bank balance (given)
Add:
Recovery of calls-in-arrear and interest thereon
Proceeds from issue of 10% Debentures
Less:
Payment of calls-in-advance and interest thereon
Rs.
2,00,000
21,200
2,20,000
4,41,200
1,26,000
2,20,000
95,200
Redemption of preference shares
Note: In the absence of information, it has been assumed that the calls-in-arrear amount has
been received in the given solution. It has been assumed that 20% dividend on equity shares
has been proposed before the equity shares are made fully paid by way of bonus dividend.
7.9
BUY BACK OF SHARES
7.91
Meaning of Buy Back of Shares
Buy-back of shares essentially means repurchase by a company of its own shares. This may be
done at par or premium or discount. The par value of the shares purchased is reduced from the
equity capital. Any excess paid is debited to reserves or surplus. If purchased at discount the
same will be transferred to capital reserve.
Some of the important reasons for buy-back are listed below:
1)
To return surplus cash to the investors. Companies want to have buy-back since it
facilitates them to manage their surplus cash. If it is paid as dividend companies will
have to pay dividend tax on the distribution.On the other hand, if cash is distributed
through buy-back, the tax burden shifts to the shareholder who has to pay capital gains
tax.
2)
To increase underlying share value. Buy-back reduces equity and enables the company
to increase earnings per share, which would result on enhancing the share value. A share
buy-back may also be announced when share prices are depressed in the market. Such a
move will have signaling effect on the market.
3)
To prevent hostile takeover bids. A cash rich company (cash cow) is often the target of
hostile takeover bid. By eliminating surplus cash through buy-back such a bid can be
avoided.
4)
Buy-backs also facilitate a company to maintain a target capital structure. Buy-back aid
a company to achieve an optimal debt-equity ratio.
Page 370
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
5)
To profit from treasury operations. Companies can buy shares when the prices are low
and reissue later at attractive prices thus making profit. In Nepal buy-back for treasury
operations is not possible. This is because shares bought will have to be cancelled.
7.9.2 Conditions of Buy-back
Section 61 of Companies Act 2063 has prescribed following circumstances in which, a
company may buy back its shares out of its free reserves available for being distributed as
dividends, by giving information to the Office of Registrar:
(a) Where the shares issued by the company are fully paid up;
(b) Where the shares issued by a public company have been listed in the Securities
Exchange;
(c) Where the buy-back of shares is authorized by the articles of association of the concerned
company;
(d) Where a special resolution has been adopted at the general meeting of the concerned
company authorizing the buyback;
(e) Where the ratio of the debt owed by the company is not more than twice the capital and
general reserve fund after buy-back of shares;
(f) where the value of shares to be bought back by a company is not more than twenty percent
of the total paid up capital and general reserve fund of that company;
(g) Where the buy-back of shares is not in contravention of the directives issued by the Office
of Registrar in this respect.
7.9.3 Accounting Requirements
There shall be established a separate capital redemption reserve fund, to which a sum equal to
the nominal value of the shares bought back shall be transferred; and the amount of such fund
shall be maintained as if it were the paid-up capital.A sum equal to nominal value of the shares
purchased should be transferred to Capital redemption Reserve Account (CRR). To the extent
of the nominal value of the shares bought back, paid-up share capital will be reduced and
correspondingly there will be an increase in the Capital Redemption Reserve Account.
The nominal value of the shares bought back is debited to share capital account. If such buyback is at premium, such premium should be debited to free reserves ccount. On the other
hand, if the purchase is at discount, the discount will be credited to capital reserve. Any
expenses incurred will be debited as buy-back expenses and they are treated as business
expenses. The following accounting entries will explain the position.
Accounting Entries
Transaction
Nominal value of the shares bought back
Premium paid on buy-back
Discount on buy-back
UNIT 1: Accounting for Share Capital
Account to be
Debited
Credited
Share Capital
Bank
Free Reserve
Bank
Capital
Share Capital
Reserve
Page 371
ICAN Advanced Accounting CAP II Chapter III
Redemption from out of free reserves
Expenses on buy-back
Free Reserves
Buy-back Expenses
CRR Account
Bank
Illustration: 17
Below is given the Statement of Financial Position of Kuber Ltd. as at Ashadh 31, 2070
Particulars
(Rs. In Crores)
100
100
Share Capital- Authorised
Subscribed: Equity shares of Rs. 10 each
Reserves & Surplus
Capital Reserves
Securities premium
Revenue Reserves
15
25
260
Fixed Assets
Less Provision for depreciation
Investments (market value Rs. 400 crores)
Current Assets
Less Current Liabilities
100
100
340
40
300
400
NIL
100
300
400
The company bought back 50 lakh equity shares of Rs. 10 each at Rs. 50 per share, in view of
huge cash balances. You are required to give the necessary journal entries and also show the
Statement of Financial Position after buy-back.
Solution :
In the Journal of Kuber Ltd.
Particulars
Equity Share Capital A/c
Dr.
Revenue Reserves
Dr.
To Bank A/c
(Being the buy- back of 50,00,000 equity shares of Rs.
10 each at Rs 50 per share)
Revenue Reserves
Dr.
To Capital Redemption Reserve A/c
( Being the transfer of nominal value of shares bought
back to capital redemption reserve account)
Page 372
Debit
(Rs. in crores)
5
20
Credit
(Rs. in crores)
25
5
5
UNIT 1: Accounting for Share Capital
ICAN Advanced Accounting CAP II Chapter III
Statement of Financial Position of Kuber Ltd.
(after buy-back)
Particulars
Share Capital- Authorised
Subscribed: Equity shares of Rs. 10 each
Reserves & Surplus
Capital Reserves
Securities premium
Revenue Reserves
Capital Redemption Reserve
Fixed Assets
Less Provision for depreciation
Investments (market value Rs. 400 crores)
Current Assets
Less Current Liabilities
UNIT 1: Accounting for Share Capital
(Rs. In Crores)
100
95
15
25
235
5
100
100
315
40
280
375
NIL
100
275
375
Page 373
ICAN Advanced Accounting CAP II Chapter III
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
Unit 2:
Redeemable Preference Shares
Page 374
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
1. INTRODUCTION
Total capital of the company is divided into units of small denomination. One of the units into
which the capital of the company is divided is called a share. For example, in one company the
total capital of Rs. 4, 00,000 is divided into 4,000 units of Rs. 100 each then each unit of Rs.100
is called a share of Rs.100 each. According to Sec.2 (n) of the Companies Act, 2063, share
means the divided portion of the share capital of a company and includes stock except where a
distinction between stock and shares is expressed or implied. Shares must be numbered so that
they may be identified; they are movable property and are transferable in the manner provided
by the Articles of Association.
Classes of shares: Refer to Unit 1 of this chapter.
2. TYPES OF PREFERENCE SHARES
Refer to Unit 1 of this chapter.
3. CONDITIONS FOR ISSUE AND REDEMPTION OF REDEEMABLE
PREFERENCE SHARES
The conditions are provided in Sec. 65 of the Act and are summarized below:
A company may issue preference shares as provided for in this Act, memorandum of association
or articles of association. Except as provided in the articles of association, no such shares issued
shall be converted into ordinary shares. In issuing preference shares, the following maters, inter
alia, shall be disclosed:
(a)
(b)
(c)
Whether preference is given to receive dividends against ordinary shares;
Percentage of dividends receivable by preference shareholders;
Whether dividends get cumulated every year (cumulative) or profits are distributed only
in a year wherein profit is made (non-cumulative);
(d) Whether preference is given while paying amount of share in the event of liquidation of
company;
(e) Whether voting right is attached there to; and if voting right is attached, whether such
right is available only in the case of preference share or also in other matters;
(f) Whether voting right is available also in other matters pursuant to Clause (e) , the
proportion to which such right is exercisable;
(g) Whether preference shares can be converted into ordinary shares;
(h) Whether the amount of preference shares can be redeemed (redeemable) or cannot be
redeemed (irredeemable) after a certain period;
(i)
Whether, in redeeming preference shares, premium is payable on redemption.
Where any redeemable shares are issued, the shares shall not be redeemed unless they are fully
paid. No amount of preference shares shall be redeemed except out of profits which would
otherwise be available for dividend or out of the proceeds of a fresh issue of shares made by the
UNIT 2: Redeemable Preference Shares
Page 375
ICAN Advanced Accounting CAP II Chapter III
company for the purposes of the redemption. Where a premium is payable on the redemption of
any redeemable preference shares, there shall be provided for a separate fund out of the profits
of the company or out of the company’s shares premium account, for the purposes of
redemption of such shares.
Except in cases where any redeemable preference shares are redeemed out of the proceeds of a
fresh issue of shares, while redeeming preference shares, a capital redemption reserve account
shall be established and a sum equal to the nominal amount of the shares redeemed shall be
transferred to that account, out of profits which would otherwise have been available for
dividend. The capital redemption reserve account established shall be maintained as if it were
the paid–up capital. A company may issue new shares to its shareholders as fully paid bonus
shares, out of the capital redemption reserve funds.
After the completion of the redemption of any preference shares, such shares shall be deemed to
have, ipso facto, been cancelled. Redemption of preference shares shall not be taken as reducing
the amount of authorized share capital of the company. Where a company has redeemed or is
about to redeem any preference shares, it shall have power to issue new shares up to the nominal
amount of the shares so redeemed or to be redeemed.
A company may issue new shares to its shareholders as fully paid bonus shares, out of the
capital redemption reserve funds.
Comments on Legal Provisions
A careful analysis of the manifold conditions attached to the redemption of redeemable
preference shares reveals the policy of protecting the interest of creditors. Sec. 65 of the Act
lays down that redemption of redeemable preference shares can be carried out either from out of
the profits of the company or from out of the proceeds of the fresh issue of shares. If redemption
is carried out in any other manner, say, from out of borrowing or by sale of available assets, it
will lead to erosion of available security to the creditors. It is not the case when redemption is
made from out of profits. In this case creditors are least affected as the increase in profits would
have resulted to that extent in an increase in the available assets of the company. Similarly when
there is a fresh issue of shares, it results in an increase in the available assets. So in either case
the security of the present creditors in the form of assets prior to redemption is intact. In the case
of redemption carried out from borrowings, although it results in an increase in the available
assets, it also results in a corresponding increase in the liabilities and therefore does not protect
and safeguard the interests of the creditors.
However, in the case of redemption from out of profits, the company is expected to transfer an
equal amount to an account head ‘capital redemption reserve account’. This provision is made
with a view to immobilize profits from being used for any other purpose, such as declaration of
dividends, redemption of debentures, etc. This account, however, can be utilized for the issue of
fully paid-up bonus shares.
Page 376
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
As the Act permits the redemption of shares from out of the profits, which are otherwise liable
for dividend, transfer to capital redemption reserve account must be made only from out of such
divisible profits.
Proceeds of fresh issue:
The phrase ‘proceeds of a fresh issue of shares’ needs further discussion as it has led to a lot of
controversy. Albeit this has been interpreted by many authors in the strict dictionary meaning of
the term ‘proceeds’ under all conditions of issue: at par, premium and discount- a closer
examination of the provisions and intentions of the company law will reveal that such
interpretation fails to satisfy the requirements of law. The word ‘proceeds’ used in the present
context implies the amount received excluding the amount of share premium, if shares are
issued either at par or at discount. To put in a nutshell, the word ‘proceeds of shares’ does not
include the amount of premium if shares are issued at premium but stands for the actual amount
received if shares are issued at par or at discount. This argument is based on the theory that
when shares are issued at discount the actual amount received as against the face value of shares
represents tangible assets capable of providing the real protection to the third party. This may be
clearer from the following example:
A company is to redeem its preference shares of (say) Rs. 1, 00,000. If the company decides to
redeem these shares by making an equivalent issue of fresh shares at (say) 10% discount, the
company, on the one hand, gets Rs. 90,000 in cash from the fresh issue and on the other hand
pays Rs. 1,00,000 for redeeming shares. Though the liability side of the Statement of Financial
position apparently discloses that shares have been properly replaced because new shares of Rs.
1, 00,000 will appear at face value, it does not amount to a replacement of assets utilized in the
redemption of redeemable preference shares. This is particularly amplified, talking of an
extreme case, when by chance the company goes into liquidation immediately after the
redemption of preference shares, and when the financial position of the company is as bad as
not to be able to pay back its creditors in full. In such a case it does mean the repayment of
capital in priority over the creditors to the extent of Rs. 10,000 which is the amount of discount.
If ‘proceeds’ were interpreted as the amount actually received, preference shares would have
been redeemed only to the extent of Rs. 90,000 which is properly replaced by a fresh issue.
However, if shares are issued at premium the total amount received including the amount of
premium cannot be taken to purport ‘proceeds’ in the sense in which the Act has used this word.
The amount of premium is to be deducted from the total proceeds for arriving at the ‘proceeds
of a fresh issue’ for the purpose of this section. This is based on the following premises:
i.
The proceeds of premium, although represented by tangible assets, do not provide any
protection to the third party as proceeds of premium may not be kept intact like proceeds
of the share capital until the repayment of all creditors because the premium has been
allowed to be used (not share capital) for the following four purposes under Sec. 29(3) of
the Company Act, 2063.
a.
In paying up unissued shares of the company to be issued to members of the company as
fully paid bonus shares;
UNIT 2: Redeemable Preference Shares
Page 377
ICAN Advanced Accounting CAP II Chapter III
b.
In writing off the preliminary expenses of the company;
c.
In writing off the expenses of, or the commission paid or discount allowed on, any issue
of shares or debentures of the company, or
d.
In providing for the premium payable on the redemption of any redeemable preference
shares or of any debentures of the company.
The utilization of the premium for the above purposes distinguished it from the proceeds
of share capital which is made available only to creditors in the event of liquidation.
ii.
If proceeds of premium be allowed to be included in the total proceeds for the redemption
purpose, the capital redeemed will be replaced partly by share capital and partly by
security premium. If this interpretation of the proceeds is taken to be correct, the security
available to the creditors may be reduced after some time by the amount of premium as
the utilization of premium is open for specified purposes under the provisions of the Act
itself.
The purpose of fully paid-up shares:
Whenever creditors lend money to the company they look for security. It is not the existing
assets only which they count on for the security. The prospective amount of assets which is
certainly to be received also makes for a good security. Thus when shares are partly paid up, the
uncalled amount of share capital can always be called upon by the liquidator of the company
under the conditions of the contract. The creditors thus are sure of this uncalled amount of share
capital and take it into consideration while dealing with the company. If redemption of partly
paid redeemable preference shares is allowed by Sec. 65, it would mean the replacement of
equivalent amount either by fresh issue or by capital redemption reserve account. This in turn
will deceive creditors who base their calculations on the face value of shares at the time of
making loans or extending credit facilities. Thus in order to protect the creditors, it was felt
necessary that is not the paid-up amount but the face value of the share which requires
replacement. In order to achieve this aim it has been made compulsory under Sec. 65(4) that
such partly paid-up shares be always made fully paid-up before redemption takes place so that
the replacement may automatically be of the amount needed to satisfy the wish of creditors.
4. ACCOUNTING ENTRIES NECESSARY FOR REDEMPTIONS
Step 1: - Issue of shares.
If there is a fresh issue of share capital for the purpose of redemption, then make journal entry
for it. This issue can be made either at par or at premium or at discount. Entries for the issue
will be made in the usual way. Taking an example of a share of Rs. 100 and discount and
premium at 5%, following journal entries may be made in all the three cases.
Page 378
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
Bank account
To Share capital account
Dr.
(b) Bank account
Discount account
To Share capital account
Dr.
Dr.
(a)
(c)
Bank account
To Share capital account
To Securities premium a/c
Rs.
100
Rs.
(when share is issued at par)
100
(when share is issued at discount)
95
5
100
Dr.
105
(when share is issued at
100 premium)
5
Step 2: - Redemption of shares.
Make entry for redemption of preference shares. This redemption can be done either at par or at
premium. If redemption takes place at premium, premium is a loss and should be debited.
Journal entries are:
i)
When redemption is at par (without premium):
(a) For transferring the capital to shareholders’ account
Redeemable preference share capital A/c
Dr. (nominal)
To Redeemable preference shareholders’ A/c.
(b) Paying the amount due to shareholders:
Redeemable preference share capital A/c
To Bank account
ii)
Dr.
When redemption is at premium:
(a) For transferring the amount due to shareholders:
Redeemable preference share capital A/c
Dr. (nominal)
Premium on redemption A/c
Dr. (premium)
To Redeemable preference shareholders’ account
(b) Paying the amount due to shareholders:
Redeemable preference shareholders’ A/c
To Bank account
Dr.
Step 3: - Transfer premium on redemption account.
Transfer premium on the redemption of preference shares to either Statement of Profit or Loss
and Other Comprehensive Income or any reserve account or securities premium account.
Although there is no restriction on transferring this account to any particular account, it is
desirable to set it off against securities premium account which can be used only for limited
purposes. Journal entry is:
UNIT 2: Redeemable Preference Shares
Page 379
ICAN Advanced Accounting CAP II Chapter III
Securities premium account
Dr.
Profit and loss account
Dr.
To premium on redemption of preference share capital account
Step 4: - Transfer to capital redemption reserve account.
Compare the amount of preference shares redeemed (without premium) with the proceeds of
fresh issue of shares (without premium but after discount). If the proceeds of fresh issue of
shares are less than the amount of shares redeemed, the amount equal to the difference must be
transferred to capital redemption reserve account.
Journal entry is:
General reserve (or any other revenue profit)
To Capital redemption reserve account
Dr.
The amount required to be transferred to capital redemption reserve account can also be
calculated with the help of the following equation:
Redeemable preference =Fresh issue of +
Shares redeemed
share capital
Capital redemption
reserve account
It will be much appreciated if students realize the significance of the above equation because
this helps in determining the amount of missing information. For example, if fresh issue made
for redemption is given then the amount to be transferred out of profits to capital redemption
reserve account can be calculated with the help of the above equation, namely, by deducting
fresh issue from the nominal value of shares redeemed.
Step 5: - Declaration of bonus shares.
If bonus sharesare issued out of capital redemption reserve account, the following journal
entries are made:
i)
Capital redemption reserve account
Dr.
To bonus to shareholders account
ii)
Bonus to shareholders account
To Share capital account
Dr.
Step 6: - Arranging for cash balance.
If liquid assets are not available then current assets* may be realized. Journal entry is as under:
Bank account
Dr.
To Current assets account
Any loss or gain on such realization must be transferred to Statement of Profit or Loss and
Other Comprehensive Income or general reserve.
Step 7: - Conversion of shares.
If shares are redeemed by converting into some other type of shares, then debit preference share
capital account and credit new share capital account. In such a case no amount is needed to be
transferred to capital redemption reserve account.
Page 380
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
Illustration: -1
Find out in each case what amount shall be transferred to capital redemption reserve account:
Redeemable preference share redeemed
Fresh issue of share capital
i) Rs. 2,00,000 at par
i)
Rs. 80,000 at par
ii) Rs. 2,00,000 at 5% premium
ii)
Rs. 80,000 at par
iii) Rs. 2,00,000 at par
iii)
Rs. 80,000 at 10% premium
iv) Rs. 2,00,000 at par
iv)
Rs. 80,000 at 10% discount
v) Rs. 2,00,000 at 5% premium
v)
Rs. 80,000 at 10% premium
Solution
In case (iv) Rs. 1, 28,000 and in rest of the cases Rs. 1, 20,000 must be transferred to capital
redemption reserve account.
Illustration: - 2
From the following information, find out how much minimum fresh issue is necessary in order
to comply with the provisions of Sec. 65 of the Company Act, 2063:
Redeemable preference share redeemed
i)
ii)
iii)
Rs. 2,00,000 at par
Rs. 2,00,000 at 10% premium
Rs. 2,00,000 at 10% premium
Profit shown in the Statement of Financial
position
Profit Rs. 30,000; security premium Rs. 10,000
Profit Rs. 30,000; security premium Rs. 10,000.
Profit Rs. 30,000; general reserve 20,000:
security premium Rs. 8,000; Dividend
equalization fund Rs. 50,000.
Solution:
Following fresh issue is essential:
i. Rs. 1, 70,000. Because profit available for transfer to capital redemption reserve account is
Rs. 30,000. Securities premium of Rs. 10,000 (as it is not available for dividend) is not
available for transfer to capital redemption reserve account.
ii.
Premium payable on redemption is Rs. 20,000. However as there is only Rs. 10,000 in the
security premium account, the balance must be met from out off profits. Therefore only Rs.
20,000 is available to carry out redemption. As the amount redeemed is Rs. 2, 00,000, the
balance of Rs. 1, 80,000 must be met by issuing fresh capital.
iii.
Here too premium on redemption is Rs. 20,000. As the balance in securities premium
account is Rs. 8,000 only, balance Rs. 12,000 must be met from out off profits, etc.
Therefore profits available for redemption are Rs. 30,000 + Rs. 20,000 + Rs. 50,000 - Rs.
12,000 that is Rs. 88,000. Therefore fresh issue would be Rs. 2, 00,000 – Rs. 88,000 = Rs.
1, 12,000.
UNIT 2: Redeemable Preference Shares
Page 381
ICAN Advanced Accounting CAP II Chapter III
Illustration: 3
A company issued Rs. 1, 80,000 Redeemable preference shares at par on 1st Shrawan, 2066,
redeemable at the option of the company on or after 31st Ashad, 2071 in whole or in part. The
following redemption was made from out of profits:
On 30 -09-2069
On 30 -09-2069
Rs. 60,000
Rs. 40,000
In Ashadh, 2071 the company issued equity shares of the face value of Rs. 60,000 at a premium
of 2% and on 31st Ashadhin the same year, it redeemed the balance of preference shares. Pass
the necessary journal entries to record the above transaction.
Solution
Journal Entries
Date
Particulars
30-09-2069
Redeemable Pref. Share Capital A/c
To Redeemable Pref. Shareholders A/c
Redeemable Pref. Shareholders A/c
To Bank A/c
Profit and Loss A/c
To Capital Redemption Reserve A/c
Redeemable Pref. Share Capital A/c
To Redeemable Pref. Shareholders A/c
Redeemable Pref. Shareholders A/c
To Bank A/c
Profit and Loss A/c
To Capital Redemption Reserve A/c
Bank A/c
To Equity Share Capital A/c
To Security Premium A/c
Redeemable Pref. Share Capital A/c
To Redeemable Pref. Shareholders A/c
Redeemable Pref. Shareholders A/c
To Bank A/c
Profit and Loss A/c
To Capital Redemption Reserve A/c
30-09-2070
30-03-2071
31-03-2071
Dr.
Debits
Rs.
60,000
Dr.
60,000
Dr.
60,000
Dr.
40,000
Dr.
40,000
Dr.
40,000
Dr.
61,200
Credits
Rs.
60,000
60,000
60,000
40,000
40,000
40,000
60,000
1,200
Dr.
80,000
Dr.
80,000
Dr.
20,000
80,000
80,000
20,000
Illustration: 4
Arun Valley Ltd had issued 1,50,000, 10% Preference shares of Rs. 10 each, redeemable at a
premium of 10% on 31st Ashadh, 2070. The Dividend for 2064-65is yet to be paid. The
company has adequate balance in general reserves. To provide funds for redemption, company:
i)
ii)
Sold investments costing Rs. 2, 00,000 for Rs. 3, 00,000.
Issued for cash 2,500, 15% Debentures of Rs. 100 at par
Page 382
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
iii)
Issued 50,000 equity shares of Rs. 10 at a premium of Rs. 4 per share. The payment of
dividend, premium and capital was duly carried out. Show journal entries.
Solution
Journal of Arun Valley. Ltd.
Date
31.03.2070
-do-
-do-
-do-
-do-
-do-
-do-
-do-
Particulars
BankA/c
Dr.
To Investment A/c
To Profit and Loss A/c
(Being the sale of investments at a profit of Rs.
1,00,000)
Bank A/c
Dr.
To 15% Debentures A/c
(Being the issue of 2,500 15% Debentures at
par)
Bank A/c
Dr.
To Equity Share capital A/c
To Security Premium A/c
(Being the issue of 50,000 equity shares at a
premium of Rs. 4 per share)
Preference Dividend A/c Dr.
To Bank A/c
(being the payment of Pref. dividend)
10% Preference Share Capital A/c Dr.
Premium on Redemption A/c Dr.
To Redeemable Pref. Shareholders A/c
(Being the amount due to on redemption)
Redeemable Pref. Shareholders A/c
Dr.
To Bank A/c
(Being the payment to Pref. shareholders)
Revenue Reserve A/c
Dr.
To Preference Dividend A/c
To Capital Redemption reserve A/c
(Being the transfer to capital redemption reserve
and appropriation of Pref. dividend)
Security premium A/c
Dr.
To premium on Redemption A/c
UNIT 2: Redeemable Preference Shares
Debits Rs.
Credits Rs.
3,00,000
2,00,000
1,00,000
2,50,000
2,50,000
7,00,000
5,00,000
2,00,000
1,50,000
1,50,000
15,00,000
1,50,000
16,50,000
16,50,000
16,50,000
11,50,000
1,50,000
10,00,000
1,50,000
1,50,000
Page 383
ICAN Advanced Accounting CAP II Chapter III
5. USE OF EQUATION FOR DETERMINING THE AMOUNT
In some cases student is not given the number of shares to be issued and he is required to make
the minimum possible issue. This problem becomes difficult only when the new issue of shares
is to be either at premium or at discount and the existing redeemable preference shares are
required to be discount and the existing redeemable preference shares are required to be
redeemed at premium. For example, if shares are redeemed at premium then such premium is to
be set off first against the security premium account, including that on the fresh issue of shares
(which is not known), and then against other divisible profits. The balance left in the divisible
profit determines the amount of fresh issue. How can a student know the amount of divisible
profit unless he knows the fresh issue? How can he know the premium on fresh issue unless he
knows the balance available in divisible profit which can be used for capital redemption reserve
account? Thus it completes a cycle where one factor depends on another factor. In such a case
the following equation can be used with advantage:
Redeemable Preference Shares + Premium on Redemption= Security Premium in the Statement
of Financial position + Divisible profit in the Statement of Financial position + Proceeds from
New Issue
Illustration 5: From the following information, determine the number and amount of fresh issue of shares:
Redeemable preference shares redeemed
i)
Rs. 2,00,000 at 10% premium
ii)
Rs. 2,00,000 at 10% premium
Balance as per the Statement of Financial
position
Profit Rs. 30,000; security premium Rs. 4,000
and new issue is to be made at 5% premium.
Profit Rs. 45,000; security premium Rs. 4,000
and new issue is to be made at 5% discount.
Solution:
(i) Rs. 1, 77,143. this has been determined as follows:
Let fresh issue be x.
Premium on fresh issue at 5% is
Rs. 2, 00,000 + Rs. 20,000 = Rs. 30,000 + Rs. 4,000 +
= Rs. 1,77,143 (if share is of Re. 1; or Rs. 1,77,145 if share is of Rs. 5 each; or Rs.
1,77,150 if share is of Rs. 10 each)
Verification
Share issue as ascertained above Rs. 1, 77,143
Page 384
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
Premium on issue at 5% of Rs. 1, 77,143 = Rs. 8,857
Premium on redemption @ 10 on Rs.2,00,000 = Rs.20,000.
Balance in security premium A/c to set off premium on redemption Rs. 4,000 + Rs. 8,857 = Rs.
12,857.
The balance of premium on redemption Rs. 20,000 – Rs. 12,857
i.e.Rs. 7,143must be met out of division profits.
Balance of profits available for transfer to capital redemption reserve account will be Rs. 30,000
– Rs. 7,143, i.e., Rs. 22,857.
Fresh issue to be made will be Rs. 2, 00,000 – Rs. 22,857, i.e., Rs. 1, 77,143.
(ii) The equation to be solved would be:
Or,
Verification
Premium on issue nil
Premium on redemption @ 10% on Rs. 2, 00,000, i.e., Rs. 20,000
Share premium available for set off Rs. 40,000
Balance of Rs. 16,000 must be set off against divisible profits.
Balance of divisible profits available for capital redemption reserve will be Rs. 45,000 – Rs.
16,000, i.e., Rs. 29,000.
Proceeds of fresh issue must equal Rs. 12, 00,000 – Rs. 29,000, i.e., Rs. 11, 71,000.
From the equation the issue is ascertained at Rs. 1, 80,000. Since the issue is at 5% discount the
0.95 = Rs. 1, 71,000.
net proceeds would be Rs. 1, 80,000
When to use the equation?
It will be seen that the amounts of fresh issue of share capital in cases (i) and (ii) were
ascertained with the help of algebraic equation. It is now necessary to a student to know that
such equations are used only when the following conditions are satisfied:
a.
b.
c.
When the amount of fresh issue is not given.
When the fresh issue is to be made at premium or discount.
When the premium on the minimum issue together with the existing premium is not
sufficient to cover fully the premium on redemption of redeemable preference shares. The
UNIT 2: Redeemable Preference Shares
Page 385
ICAN Advanced Accounting CAP II Chapter III
amount of minimum subscription is determined by deducting the amount of divisible
profits from the face value (which is the paid-up value also because shares must be fully
paid) of redeemable preference shares.
Illustration: 6
Redeemable preference shares to be redeemed Rs. 10,000.
Premium on redemption: 10%.
Divisible profit available Rs. 2,000.
Fresh issue of equity shares is to be made at 25% premium.
From the above particulars you are required to ascertain:
a. The minimum issue of shares.
b. The necessity of applying formula.
c. The amount of issue.
Solution:
a. Calculation of minimum issue:
Minimum issue = Redeemable Pref. shares to be redeemed – Divisible profit available
= Rs. 10,000 – Rs. 2,000 = Rs. 8,000
b. Is it necessary to use the equation:
Rs.
Premium on minimum issue at 25%
2,000
Add existing premium
Nil
Total premium
2,000
This premium fully covers the Rs. 1,000 premium on redemption of preference shares and
hence the equation is not to be applied.
c. Minimum issue of Rs. 8,000 is to be made for the redemption of preference shares.
Illustration: -7
Redeemable preference shares to be redeemed Rs. 10,000.
Premium on redemption: 10%.
Profit available for dividend:Rs. 2,000.
Fresh issue is to be made at 10% premium.
From the above particulars you are required to ascertain:
a. Minimum issue,
b. The necessity of using equation, and
c. The amount of issue.
Page 386
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
Solution:
a. Calculation of minimum issue:
Minimum issue Rs. 8,000, i.e., paid-up value of redeemable preference shares to be redeemed
less profit available for dividend.
b.
Use of equation:
Rs.
800
Nil
800
This does not cover the premium to be paid on the redemption of preference shares hence the
amount of fresh issue is to be determined by applying the equation.
Premium on minimum issue at 10 %
Add existing premium
Total premium
c.
Amount of issue:
The fresh issue is to be of Rs. 8,182.
Verification:
Premium on redemption at 10%
Premium on fresh issue at 10%
Premium to be met out of divisible profits
Profits available for dividend
Less: Used for premium on redemption
Profit available for transfer to capital redemption reserve account
Redeemable preference shares redeemed
Less: Replaced by capital redemption reserve account
Amount to be collected by the fresh issue ascertained as above
Rs.
1,000
818
182
2,000
182
1,818
10,000
1,818
8,182
Illustration: 8
The following balances were extracted from the books of PRAGATI Ltd.
UNIT 2: Redeemable Preference Shares
Page 387
ICAN Advanced Accounting CAP II Chapter III
Rs.
1.
8 per cent redeemable cumulative preference shares:
1,000 shares of Rs. 100 each fully called up
Less Calls unpaid at Rs. 25 per shares
Amount paid up
2.
security premium account
3.
General reserve
4.
Cash at bank
5.
Proposed dividend on cumulative preference shares
(since sanctioned)
1,00,000
500
99,500
14,000
34,000
55,000
7,840
The directors redeemed the preference shares at a premium of 10% and for that purpose made a
fresh issue of equity shares for such amount as was necessary for the purpose after utilizing the
available sources to the maximum extent and satisfied the amount of preference dividend.
You are required to show the journal entries including those relating to cash for recording the
above transactions. Ignore taxation.
Solution:
Pragati Ltd.
Journal Entries
Date
(i)
(ii)
(iii)
(iv)
Page 388
Particulars
Debits Rs.
Bank Account
Dr.
To Equity share capital account
(Issue of new equity shares of Rs. 66,000 for
collecting proceeds for redeeming the redeemable
cumulative preference shares)
8% Redeemable cumulative preference shares A/C
Dr.
Premium on redemption account
Dr.
To Redeemable preference shareholders A/C
(Amount due on the redemption of preference
shares credited to shareholders account)
66,000
Dr.
1,07,800
Redeemable preference shareholders account
To Bank Account
(Payment made to shareholders)
Security premium account
To Premium on redemption account
(Premium on redemption met out of the credit
balance in security premium account)
Credits
Rs.
66,000
98,000
9,800
1,07,800
1,07,800
Dr.
9,800
9,800
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
(v)
(vi)
(vii)
Proposed dividend on cumulative preference shares
To Preference dividend payable account
(Declaration of dividend on the redeemable
cumulative preference shares)
Dr.
Dr.
Preference dividend payable account
To Bank Account
(Payment of dividend on preference shares (income
tax ignored))
General reserve account
Dr.
To Capital redemption reserve account
(General reserve transferred to capital redemption
reserve account)
7,840
7,840
7,840
7,840
32,000
32,000
Tutorial Notes:
(i)
Since proceeds of fresh issue together with the existing bank balance are able to meet the
amount payable on account of preference dividend and redemption of preference shares,
no arrangements for the bank overdraft have been made.
(ii) 20 shares having calls-in-arrears have not been redeemed. Alternatively, it was possible
to first collect calls in arrears in such shares and then redeem them.
(iii) For the purpose of calculating the amount of fresh issue, all shares (including those on
which there are calls in arrears) have been considered. Since there is a divisible profit of
Rs. 34,000 a fresh issue of Rs. 66,000 (i.e. Rs. 1,00,000- Rs. 34,000) has been made. It is
not advisable to issue less in number of shares because at the time of redemption of those
20 shares on which there is a call in arrear, company cannot arrange to make another
fresh issue. However, balance has been kept in general reserve which will be transferred
to capital redemption reserve account when these 20 shares are redeemed.
Illustration: -9
A company’s share capital consists of 1, 00,000 ordinary shares of Rs.10 each fully paid, and
50,000, 6% redeemable preference shares of Rs. 10 each fully paid, redeemable at a premium of
Re. 1 per share. The company had a credit balance of Rs. 4, 00,000 on Statement of Profit or
Loss and Rs.5, 00,000 on general reserve. The company resolved:
(i)
(ii)
(iii)
To make a bonus issue of one share for every two held by the existing ordinary
shareholders from the general reserve.
To redeem the preference shares.
To issue 30,000 ordinary shares of Rs. 10 each at Rs. 11.25 per share in order to provide
part of the funds for the redemption of the preference shares.
The resolutions were carried into effect. You are required to show: (a) the ledger accounts
necessary to record the above transactions, and (b) the share capital and reserves of the company
as they would appear in its Statement of Financial position after their completion.
UNIT 2: Redeemable Preference Shares
Page 389
ICAN Advanced Accounting CAP II Chapter III
Solution:
Ledger Account
Particular
To Balance c/d
Rs.10 Ordinary share capital
Rs
Particular
18,00,000
By Balance b/d
By General reserve - issue of bonus
shares
By Application and allotment
account - issue of shares for cash
18,00,000
6 percent R.P.S. Capital
Rs
Particular
Particular
To Redeemable preference
shareholders account
Particular
5,00,000 By Balance b/d
5,00,000
Redeemable Pref. Shareholders Account
Rs
Particular
To Bank
5,50,000 By 6% R.P.S capital
5,50,000 account
By Prem. on redemption
account
Premium on redemption account
Rs
Particular
Particular
.
50,000 By Security premium
50,000 account
By P&L Account
To Redeemable pref.
shareholders A/c
Particular
To Ordinary share
account
To Security premium
Page 390
Application and Allotment Account
Rs
Particular
capital
.
3,00,000 By Bank
37,500
3,37,500
Rs
10,00,000
5,00,000
3,00,000
18,00,000
Rs
5,00,000
5,00,000
Rs
5,00,000
50,000
5,50,000
Rs
.
37,500
12,500
50,000
Rs
3,37,500
3,37,500
UNIT 2: Redeemable Preference Shares
ICAN Advanced Accounting CAP II Chapter III
Security Premium Account
Rs
Particular
Particular
To Premium on
account
redemption
Particular
37,500
Application
37,500 By
allotment account
Rs
General Reserve Account
Rs
Particular
5,00,000
To Ordinary share capital
(Bonus issue)
.
37,500
37,500
and
By balance
5,00,000 b/f
Rs
.
5,00,000
5,00,000
Particular
To capital redemption accountpremium on redemption
To Capital redemption reserve
account
To Balance c/d
Statement of Profit or Loss a
Rs
Particular
By balance b/f
12,500
2,00,000
1,87,500
4,00,000
Rs
4,00,000
4,00,000
Extracts from Statement of Financial position
Capital/ Liabilities
Share capital
1,80,000 Rs. 10 ordinary share,
fully paid
Capital reserve
Capital redemption reserve
account
Revenue reserve
Profit and loss account
UNIT 2: Redeemable Preference Shares
Rs
Assets
Rs
18,00,000
2,00,000
1,87,500
21,87,500
Page 391
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
Unit 3:
Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
1. MEANING AND NATURE OF DEBENTURES
The long-term requirements of capital are raised by any company primarily through issue of
shares and debentures. While the shareholders are essentially the owners of the enterprise, those
who buy debentures are creditors who have lent long-term funds and do not enjoy voting rights.
As per the definition given in Companies Act 2063, “Debenture” means any bond issued by the
company whether putting its assets as collateral or not. [Sec 2(s)]. As the definition states, these
debentures may be secured with a charge on the assets or unsecured without any charge on such
assets. A debenture like a share is also a property transferable in the manner provided in the
Articles of the company. A commercial definition for the debenture is an acknowledgement of a
debt in writing, given under the seal of the company, containing a contract for the repayment of
the principal sum at a specified date and for the payment of interest (usually half yearly) at a
fixed rate per cent until the principal sum is repaid, and it may or may not give a charge on the
assets of the company as a security for the loan. At this stage it is worth noting the differences
and similarities between shares and debentures.
2. DIFFERENCES BETWEEN SHARES AND DEBENTURES
Points of difference
Legal Position
of holder
Shares
Debentures
Shareholder is an owner and a Debenture holder is not a
member of the company
member but a creditor
Voting Rights
Shareholderhas voting rights.
Debenture holdercannot have
voting right.
Nature of Income
A shareholder receives dividend
only when a company makes
profit. The dividend rate can vary
for a shareholder in relation to
profit position
A debenture holder is entitled
to a fixed rate of interest.
She/he has a right to interest
on the amount lent even if the
company does not make profit.
Redemption
In the case of shares, the concept
of redemption does not apply.
However, a company can buy
back shares in accordance with
the provisions in the Act.
Debentures
are
normally
redeemable
although
a
company can issue perpetual
debentures.
Priority of
settlement at
the time of
liquidation
At the time of liquidation of the
company amount owing to
shareholder is paid after all
amount of debenture holder is
settled
Debenture holders get priority
over the shareholder for
settlement of their claim at the
time of liquidation of the
company.
UNIT 3: Debentures: Issue and Redemption
Page 393
ICAN Advanced Accounting CAP II Chapter III
3. PURPOSES OF ISSUING DEBENTURES
As already stated companies raise substantial amount of long-term funds through the issue of
debentures. The objects of the issue can be among other things:
(i)
(ii)
(iii)
(iv)
(v)
Setting up of new projects
Expansion or diversification of existing projects
Normal capital expenditure for modernization
Merger/amalgamation of companies in pursuance of schemes approved by banks,
financial institutions and/ or any legal authority.
To augment long-term resources of the company for working capital requirements.
4. TYPES OF DEBENTURES
Debentures can be classified according to security, permanence, priority, convertibility, and
records point of view.
(a)
Security point of view.
(a) Naked debentures (Secured) are those which are not secured. Companies of very
good standing are able to issue debentures of this type. They are not very common.
(b) Mortgage debentures (Unsecured) are those debentures which are secured either on a
particular asset called fixed charge or on the general assets of the company called
floating charge.
(b)
Permanence point of view.
(a) Redeemable debentures are those debentures which are redeemed or the payment of
which is made after a specified time. Debentures are redeemable-(i) at the expiry of a
specified period at par or at premium; (ii) by purchasing in the open market at any time
at the price prevailing in the market; and (iii) by annual drawings.
(b)Irredeemable debentures: In this case the issuing company does not fix any date by
which they should be redeemed and the holders of such debentures cannot demand
payment from the company so long as it is a going concern. Usually such debentures are
repayable after a long period of time or on winding up of the company.
(c)
Priority point of view.
(a) First debentures are those which are repaid before other debentures are paid out.
(b) Second debentures are those which are paid after the payment to the first debenture
holders is made.
(d)
Convertible debentures
(a) Convertible debentures, the holders of which are given the option to convert the
debentures fully or partly into equity shares after a specified time. Those debentures
which are fully convertible are called “Fully Convertible Debentures’ or simply ‘FCDs’.
Those which are partly convertible are called ‘Partly Convertible Debentures’ or simply
PCDs. Conversion may be at par or premium. (b) Non-convertible debentures, the
Page 394
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
holders of which have no right to convert them into equity shares. These are called
NCDs.
(e)
Records point of view.
(a) Bearer debentures are those which are transferred by mere delivery and the company
does not keep any record of debenture holders’ names and addresses. Payment of interest
is made on production of coupons attached with the debentures.
(b) Registered debentures are those which are transferable only by transfer deed. Names,
addresses, particulars of the debentures possessed by them are entered in the register.
Interest is paid to one whose name appears in the register.
5. STAGES OF DEBENTURES.
There are three stages of accounting for debentures:
(i) when debentures are issued;
(ii) when provision for its redemption is made; and
(iii) when ultimately debentures are redeemed. A detailed study of each stage is made in the
following pages.
6. ISSUE OF DEBENTURES
Important Provisions in the Companies Act on Issue of Debentures:
If a public company deems necessary to issue debentures, it may, specifying the reason
therefore, a work plan to be executed from proceeds and budget necessary for that propose raise
loans or issue debentures with or without pledging or mortgaging its immovable assets.
Provided, however, that no debentures may be issued unless and until an approval to commence
its business is obtained and its issued capital is fully paid up.
Any company may, raise additional loans or issue additional debentures against the security
already furnished by that company with the previous creditors as a security from such creditors,
within the limit of such security, by clearly indicating the previous creditors as well as amount
of loan (amount) already obtained.
The matters relating to the terms, repayment period and interest of a loan borrowed or lent by a
company shall be governed by a deed or contract concluded between the creditor and the
borrower.
A public company shall, in issuing debentures, issue debentures after making provision of a
debenture trustee. Such debenture trustee has to be a debenture trustee licensed by the Securities
Board. The matters relating to the creditor and the borrower, in issuing debentures with a
debenture trustee, shall be as mentioned in an agreement to be concluded between such trustee
and the company.
An agreement has to be concluded between a company issuing debentures anda debenture
trustee acting as a trustee for the protection of the interest of debenture-holders, in respect of the
debentures to be raised by such company setting out the following matters:
UNIT 3: Debentures: Issue and Redemption
Page 395
ICAN Advanced Accounting CAP II Chapter III
(a) that the debenture trustee is entitled to carry out, or cause to be carried out, valuation of the
company’s assets, project analysis or management analysis,
(b) the period of repayment of the principal and interest of debentures subscribed by the
debenture-holder, interest rate, mode of repayment of the principal and interest, mode of
repayment of the principal and interest, and matter of conversion of debentures into shares,
if there is such provision, (c) Matters, relating to a provision made on the lights of other
creditors over the assets of the company and liabilities that may arise there from in the
future.
(c) A provision that, in the case of violation or non-fulfillment of the terms mentioned in the
agreement or for any other reasonable reason, if it is required to take the control of
financial transactions of the company or to take possession of the security as referred to in
the agreement, the debenture trustee may take in his/her possession the assets or properties
of such company to the property that he has taken as the security of guarantee or hold the
security of guarantee with himself/herself or sell the same by auction or in any other
appropriate manner,
(d) Procedures for payment by the company of the service charges and other direct expenses of
the debenture trustee,
(e) That the debenture trustee shall not be liable to any loss or damage caused to the company
or the debenture-holder from any act done by the trustee in that capacity,
(f)
That, in the event of occurrence of any circumstances necessitating the liquidation of the
company, the debenture trustee is entitled to take such legal action as may be taken in
behalf of the debenture- holder and exercise the powers of the debenture holder.
(g) Other necessary matters on the protection of interest of the debenture-holder.
If the memorandum of association or the articles of association provides that debentures can be
converted into shares or such term has been specified prior to the issuance of debentures, a
debentures may be converted into shares, subject to the share capital related provisions of
Companies Act. If any debentures are to be converted into shares, this matter has to be clearly
mentioned in the prospectus.
Securities Issue Guidelines, 2065 of SEBON requires a company to specifically mention
conversion ratio, price, premium, date of conversion and voting rights in case of the convertible
debenture. Further the guidelines requires the company to mention in its prospectus that the debt
to equity ratio will not be more than 70:30 during the period debenture exist, any deviation in
the ratio should be properly justified in the prospectus. The prospectus should also mention
whether the debenture holder will have first charge on the assets of the company or second
charge. If there is second charge, then the company should mention the amount and name of the
right holders in its prospectus. Debt having second charge on the assets of the company should
not be more than 50% of the net worth of the company. Debenture Redemption Reserve fund
should be created for the Redeemable debenture.
Page 396
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Accounting Aspects of issue
Accounting aspects of issue of debentures may be studied from three different angles.
1. From the angle of consideration
a. issued for cash
b. Issued for consideration other than cash
c. Issued as collateral security
2. From the angle of price
a. Issued at par
b. Issued at premium
c. Issued at discount
3. From the angle of redemption.
a. Redeemed at par
b. Redeemed at premium
c. Redeemed at discount
The following combination results if we combine the angle of price and the angle of redemption:
(a) Issued at par and redeemable at par
(b) Issued at discount and redeemable at par
(c) Issued at premium and redeemable at par
(d) Issued at premium and redeemable at premium
(e) Issued at par and redeemable at premium
(f) Issued at discount and redeemable at premium
a. Issue for Cash
The accounting entries for the above six combinations are given in the table below:
Account
Transaction
Debited
Credited
A. Issued at par and Bank
Debentures
redeemable at par
B. Issued at discount and
Bank Discount on
Debentures
redeemable at par
issue of debentures(1)
C. Issued at premium and
Bank
Debentures
redeemable at par
Security premium
D. Issued at premium and
Bank A/c*
Debentures A/c Security Premium
redeemable at premium
Loss on issue of
A/c Premium on redemption of
debenture A/c**
debentures(3)
E. Issued at par and
Bank Loss on issue of Debentures A/C Premium on
redeemable at premium
debentures(2)
redemption of debentures (3)
F. Issued at discount and
Bank
Debentures Premium on
redeemable at premium
Loss on issue of
redemption of debentures
debentures(4)
UNIT 3: Debentures: Issue and Redemption
Page 397
ICAN Advanced Accounting CAP II Chapter III
* Bank account includes the face value of debentures plus premium on issue.
** Loss on issue of debentures Comprises Premium on redemption.
Notes:
1. When debentures are issued at discount the company will be agreeing to pay more than
what it agrees to pay on redemption. This is done with a view to pay slightly lesser rates of
interest than those prevailing in the market. Discount on issue of debentures appears under
the heading ‘Miscellaneous Expenditure and Losses’ on the assets side of the Statement of
Financial Position till it is completely written off.
2.
3.
The premium payable on redemption is debited to ‘loss on issue of debentures’ account.
Since the company agrees to pay more than what it has received, the excess paid represents
capital loss and it can be written off over a period. Until it is written off entirely ‘loss on
issue of debentures’ account will appear under the heading. ‘Miscellaneous Expenditure
and Losses’ on the assets side of Statement of Financial Position. The idea of paying
premium on redemption is to pay slightly lesser rates of interest on the debentures. Thus it
represents a trade-off between capital loss and revenue expenditure.
Premium on redemption of debentures is in the nature of a personal account as it
represents the amount due to debenture holders at the time of redemption. This appears on
the liability side of the Statement of Financial Position until repayment is made. At the
time of redeeming debentures it will be transferred to redemption account.
It is also possible to ignore premium on redemption at the time of issue and bring it into
account at the time of redemption. In that case the entry will be as follows:
Debit Premium on Redemption of Debentures
Credit Debentures Redemption/Debenture holders’ A/c
4.
In this case loss on issue of debentures includes the discount on issue as well as the
premium on redemption. Alternatively discount may be shown as such and only premium
on redemption may be debited to ‘loss on issue’.
Illustration 1: Journalize the following transactions. Narration is not required:
1. Issue at par 14% 1,000 debentures of Rs. 100 each, redeemable at par.
2. Issue at 10% discount 15% 1,500 debentures of Rs. 100 each, redeemable at par.
3. Issue at 10% premium 16% 2,000 debentures of Rs.100 each, redeemable at par.
4. Issue at par 14% 1,000 debentures of Rs.100 each, redeemable at a premium of 5%
Issue at 10% discount 15% 1,000 debentures of Rs. 100 each, and redeemable at premium of
5%.
Page 398
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Particular
Dr.
1. Bank Account
To 14% Debenture Account
Dr.
2. Bank Account
Dr.
Discount in Issue of Debentures Account
To 15% Debenture Account
Dr.
3. Bank Account
To 16% Debenture Account
To Securities Premium Account
Dr.
4. Bank Account
Dr.
Loss on issue of Debenture Account
To 14%Debenture Account
To premium on Redemption of
Dr.
Debentures
Dr.
5. Bank Account
Loss on issue of Debenture Account
To 15% Debenture Account
To Premium on Redemption of
Debentures
Debit Rs.
Credit Rs.
1,00,000
1,00,000
1,35,000
15,000
1,50,000
2,20,000
2,00,000
20,000
1,00,000
5,000
1,00,000
5,000
90,000
15,000(1)
1,00,000
5,000
(1) This amount includes Rs. 10,000 discount on issue of debentures and Rs. 5,000 premium on
redemption. Alternatively Rs. 10,000 may be debited to discount account and Rs. 5,000 to loss
on issue of debentures.
b. Issue for Consideration other than Cash
In this case debentures are issued for consideration other than cash. Examples are allotment of
debentures for assets purchased or technical services received. There is no receipt of cash in
these transactions for the allotment of debentures. The following are the accounting entries:
Transaction
Purchase of assets by the company
Allotment of debentures at par
Allotment of debentures at premium
Allotment of debentures at discount
Account
Debited
Credited
Vendor
Assets
Debentures
Vendor
Debentures
Vendor
Security
Vendor
Discount on issue of premium
Debentures
debentures
Illustration 2 (For consideration other than cash): Three Stars Company Ltd. took over assets of Rs. 3,50,000 and liabilities of Rs. 30,000 of RCT
Company for the purchase consideration of Rs. 3,30,000. The Three Star Company Ltd. paid the
purchase consideration issuing debentures of Rs. 100 each at 10% premium. Give journal
entries in the books of the Three Star Company Ltd.
UNIT 3: Debentures: Issue and Redemption
Page 399
ICAN Advanced Accounting CAP II Chapter III
Solution
Journal of Three Star Company Ltd.
Date
Particulars
Rs.
3,50,000
10,000
Dr.
Sundry Assets
Dr.
Goodwill (1)
To Liabilities
To RCT Company
(Being purchase of assets and liabilities of
the RCT Company)
Dr.
RCT Company
To Debentures (2)
To Security Premium A/c
(Being issue of debentures of 10%
premium)
Rs.
30,000
3,30,000
3,30,000
3,00,000
30,000
Tutorial Notes:
1. Excess value of net assets (Gross assets minus liabilities) over the purchase price is to be
debited to goodwill a/c. If the value of net assets is more than the purchase price, the
difference is to be taken as capital reserve.
2.
The amount of debenture has been calculated as follows:
For making payment of Rs. 110, company has to issue 1 Debenture.
For making payment of Rs. 3, 30,000, company has to issue (1/110 of Rs.330,000)
= 3,000 Debentures of Rs.100 each i.e. Rs.300,000
Illustration 3 (For consideration other than cash): A company purchased assets of Rs. 3, 50,000 and took over liabilities of Rs. 30,000. It agreed to
pay the purchase price Rs. 3, 35,000 by issuing debentures of Rs. 100 each at a premium of
10%. The debentures of the same company are quoted in the market at Rs. 130.
You are required to give journal entries for recording the transactions in the books of the
purchasing company.
Solution:
Journal of the Purchasing Company
Date
Dr.
Sundry assets account
Dr.
Goodwill account
To Vendor account
To Sundry liabilities account
(Being the takeover of the business of the
vendor company)
Vendor account
Dr.
To Debenture account
Page 400
Rs.
Rs.
3,50,000
15,009
3,35,009(1)
30,000
3,35,009
3,04,500
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
To Security Premium A/c
To Cash account
(Being payment of purchase consideration by
issuing debentures at 10% premium)
30,450
59(1)
Tutorial Notes:
(1) The purchase price of Rs. 3, 35,000 is to be discharged by issue of debentures of Rs. 100
each at a premium of 10%. In order to calculate the number of debentures to be issued, we have
to divide the purchase price by Rs. 110, which works out to 3,045.45, debentures. As fractional
debentures cannot be issued, the company can issue only 3,045 debentures. For the fractional
debentures of 0.4545, payment has to be made in cash. All payments in lieu of fractional shares
or debentures have to be made at market price and not to be based on paid-up value. Although
the agreed purchase price is Rs. 3, 35,000, the real purchase price is much more than that, since
the vendor company can sell the debentures at Rs. 130 each. Therefore for calculating the value
of fractional debenture, market price must be the basis. Applying the cash to be paid works out
to Rs. 59,
. So the purchase consideration would be
3,045 debentures at Rs. 110 each
Cash payment in lieu of fractional debenture
Total
3, 34,950
59
3, 35,009
Illustration 4 (For consideration other than cash): A company purchased assets of Rs. 4, 20,000 and took over liabilities of Rs. 40,000 at an agreed
value of Rs. 3, 60,000. The company issued debentures at 10% discount in full satisfaction of
the purchase price. Give journal entries in the books of the purchasing company.
Solution:
Journal of the Purchasing Company
Particulars
Sundry assets account
To Sundry liabilities account
To Capital reserve account
To Vendor company
(Being the takeover of assets and liabilities)
Vendor company
Discount on issue of debentures account
To Debentures account
(Being issue of debentures at 10% discount)
Dr.
Rs.
Rs.
4,20,000
40,000
20,000
3,60,000
Dr.
Dr.
3,60,000
40,000
4,00,000
Tutorial Notes: The number of debentures has been calculated as follows:
Debentures of Rs. 100 each at 10% discount, i.e. Debentures are
of Rs. 4, 00,000 and discount is 10% of Rs. 4, 00,000, i.e. Rs. 40,000 ,net Rs. 3, 60,000.
UNIT 3: Debentures: Issue and Redemption
Page 401
ICAN Advanced Accounting CAP II Chapter III
c. Debentures issued as Collateral Security
This is the third type of consideration for which company issues debentures. Issue of debentures
as a collateral security means issue of debentures as a subsidiary or secondary security, that is, a
security in addition to the principal security. Secondary security is to be realized only when the
principal security fails to pay the amount of loan. Debentures issued as a collateral security can
be dealt with in two ways in the books:
(i) First Method: - No entry is made in the books.
On the liability side of the Statement of Financial Position below the item of loan, a note to the
fact that it has been secured by the issue of debentures is appended. This is shown in the
Statement of Financial Position as follows:
Statement of Financial Position
Debentures:
5,000 debentures of Rs. 100 each at par
Loan from bankers (collaterally secured
by the issue of Rs. 10,000 debentures)
Rs.
5, 00,000
8,000
(ii) Second Method: -Journal Entries is made in the Books
Sometimes issue of debentures as collateral security is recorded by making a journal entry as
follows:
Debenture suspense account
Dr.
To Debenture account
(This appears on the assets side)
(This appears on the liabilities side)
When the loan is paid the above entry is cancelled by means of a reverse entry. In the second
case the Statement of Financial Position is framed as follows:
Statement of Financial Position (Extract)
Capital and Liabilities
Debentures:
5,100 debentures of Rs. 100 each at
par
Loan from bankers:
Rs.
5,10,000
8,000
Property and Assets
Debentures suspense account
(Debentures issued at
collateral security for loan as
per contra)
Rs.
10,000
Illustration 5: You are required to set out the journal entries relating to the issue of following debentures in the
books of SansarSewaLtd.
1.
2.
3.
8%, 120 Rs. 1,000 debentures are issued at a discount of 5% and are repayable at par.
Another 7% 150 Rs. 1,000 debentures are issued at 5% discount and repayable at 10%
premium.
Further 80, 9% Rs. 1,000 debentures are issued at 5% premium.
Page 402
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
4.
In addition another 400, 8% Rs. 100 debentures are issued as a collateral security
against a loan of Rs. 40,000.
Solution:
Journal Entires in the Books of
SansarSewa Ltd
Particulars
1.
2.
3.
4.
Debits (Rs.)
Bank Account
Discount on issue of debentures
To 8% Debentures Account
Bank Account
Loss on issue of debentures a/c
To 7% Debentures Account
To Premium on Redemption
Bank Account
To 9% Debentures Account
To Security Premium Account
Debenture Suspense Account(1)
To 8% Debentures
Dr.
Dr.
1,14,000
6,000
Dr.
Dr.
1,42,500
22,500
Credits
(Rs.)
1,20,000
1,50,000
15,000
Dr.
84,000
80,000
4,000
Dr.
40,000
40,000
(1) Alternatively there is no need for this entry. It is sufficient to give a note in the Statement of
Financial Position under the loan account about the issue of collateral as shown below.
Statement of Financial Position (Extract)
Capital and liabilities
Rs
Assets
Rs
Loan
40,000
(Collaterally secured by the issue of 400,
8% debentures of Rs. 100 each)
d. Debenture Issued at Discount
When debentures are issued at discount, it is prudent to write off the loss during the life of
debentures. When the directors of the company decide to write it off, it can be done in two
ways:
(i) First method: Under this method the total discount is spread over the life of debenture equally. Thus, if
debentures are issued for 15 years, the total discount is divided by 15 and the amount so arrived
at is taken to the Statement of Profit or Loss and Other Comprehensive Income every year for
15 years. This method is suitable only in one respect, that is, it spreads the burden of discount
equally over the years. Thus it is good only when debentures are redeemed at the expiry of the
period.
UNIT 3: Debentures: Issue and Redemption
Page 403
ICAN Advanced Accounting CAP II Chapter III
(ii) Second method: If the debentures are redeemed every year by serving a notice or by drawing a lot, the first
method fails in as much as the burden of discount is not in the proportion of benefit received out
of money collected by issuing debentures. Under these circumstances the second method is
adopted. Under this method the discount is written off in the proportion of debenture debt
outstanding during the year.
Illustration 6: PraposaLtd. issues Rs. 1, 00,000 debentures on 1stShrawan, 2069 at a discount of 10% repayable
in annual drawing of Rs. 20,000 commencing of 1stAshadh, 2070. The company’s financial year
ends on 31stAshadh.Show the account to be charged to Statement of Profit or Loss and Other
Comprehensive Income for five years.
Solution
First method: - If the amount is to be written off equally every year then Rs. 2,000 (Rs. 10,000
÷ 5 years) will be transferred to Statement of Profit or Loss and Other Comprehensive Income
every year.
Second method: - If the amount is to be written off proportionately, it will be decided as
follows:
Years
1
2
3
4
5
Amount used
1,00,000
80,000
60,000
40,000
20,000
Ratio
5
4
3
2
1
15
Amount
5/15 × 10,000 = 3,333
4/15 × 10,000 = 2,667
3/15 × 10,000 = 2,000
2/15 × 10,000 = 1,333
1/15 × 10,000 = 667
Rs.10, 000
Illustration 7: (When amount is written off proportionately): A company issued debentures of Rs. 60,000 on 1st Shrawan 2069. These debentures are
repayable in three equal installments of Rs 20,000 each on 31st Ashadhevery year. Calculate the
amount of discount to be written off each year when the total discount on issue is Rs. 3,000. The
financial year of the company ends on 31st Chaitraevery year.
Solution:
Year
1
1st
2nd
3rd
4th
Page 404
Amount
used
2
60,000
60,000
40,000
40,000
20,000
20,000
Month for which amount used
3
9 (from Shrawan to 30th Chaitra)
3 (from Baishakh to Ashadh)
9 (from Shrawan to 30thChaitra)
3 (from Baishak to Ashadh)
9 (from Shrawan to 30thChaitra)
3 (from Baishakh to Ashadh)
Total amount
(Product of 2x3)
4
5,40,000
1,80,000
3,60,000
1,20,000
1,80,000
60,000
Ratio
5
54 or 9 = 9/24
54 or 9 = 9/24
30 or 5 = 5/24
6 or 1 = 1/24
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Discount to be written off is determined as follows:
Year 1
2
3
4
9/24 x Rs. 3,000
9/24 x Rs. 3,000
5/24 x Rs. 3,000
1/24 x Rs. 3,000
=1,125
=1,125
= 625
= 125
Rs. 3,000
e. Interest on Debentures
Interest on debentures is a charge against profit of the company and is normally payable half
yearly. The company is bound to deduct income tax on the interest* before making the final
payment of the amount. Book-keeping entries for recording the transactions are as under:
*This is done only if interest exceeds a specified sum:
(i) Entry of interest due:
Debit Debenture interest account (with the gross amount of interest due)
Credit Income tax account (with the amount of income tax deducted)
Credit Debenture-holders account (with the amount to be paid after the deduction of income
tax)
(ii) Entry for the payment of amount:
Debit Debenture-holders account
Credit Bank account
The gross amount debited to debenture interest account is transferred to the Statement of Profit
or Loss and Other Comprehensive Income at the end of the year and the income tax account is
shown in the Statement of Financial Position as a liability. When income-tax is paid by the
company to the Government this account is debited and cash account is credited.
Illustration 8: SambidhaLimited recently made a public issue in respect of which the following information is
available:
(a)
(b)
(c)
(d)
(e)
(f)
No. of partly convertible debentures issued 2, 00,000; face value and issue price Rs. 100
per debentures.
Convertible portion per debenture 60%, date of convertible on expiry of 6 months from
the date of closing of issue.
Date of closure of subscription lists 1-05-2069, date of allotment 01-06-2069, rate of
interest on debenture 15% payable from the date of allotment, value of equity share for
the purpose of conversation Rs. 60 (Face value Rs. 10).
Underwriting Commission 2%.
No. of debentures applied for 1, 50,000.
Interest payable in debentures half-yearly on 30th Poushand 31st Ashadh.
UNIT 3: Debentures: Issue and Redemption
Page 405
ICAN Advanced Accounting CAP II Chapter III
Write relevant journal entries for all transactions arising out of the above during the year ended
31st Ashadh, 2070(including cash and bank entries).
Solution
In the books of SambidhaLtd.
Journal Entries
Date
1.5.2069
1.6.2069
30.9.2069
31.10.2069
31.3.2070
Page 406
Particulars
Bank A/c
To Debenture Application A/c
(Application money received on
1,50,000 debentures @ Rs. 100 each)
Dr.
Debenture Application A/c
Underwriter A/c
To 15% Debenture A/c
(Allotment of 1,50,000 debentures to
applications and 50,000 debentures to
underwriters)
Dr.
Dr.
Underwriting Commission A/c
To Underwriters A/c
(Commission payable to underwriters
@ 2% on Rs. 2,00,00,000)
Dr.
Bank A/c
To Underwriters A/c
(Amount received from underwriters
in settlement of account)
Debenture Interest A/c
To Bank A/c
(Interest paid on debentures for 4
months @ 15% on Rs. 2,00,00,000)
15% Debentures A/c
To Equity Share Capital A/c
To Security Premium A/c
(Conversion of 60% of debentures into
shares of Rs. 60 each with a face value
of Rs 10)
Dr.
Debentures Interest A/c
To Bank
(Interest paid on debentures for the
half year)
Dr.
Amount
1,50,00,000
Cr.
Amount
1,50,00,000
1,50,00,000
50,00,000
2,00,00,000
4,00,000
4,00,000
46,00,000
46,00,000
Dr.
10,00,000
10,00,000
Dr.
1,20,00,000
20,00,000
1,00,00,000
Dr.
7,50,000
7,50,000
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Working Note:
Calculation of Debenture Interest for the half year ended 31st Ashadh 2070:
On Rs. 80, 00,000 for 6 month @ 15% =
On Rs. 1, 20, 00,000 for 1 month @ 15%
=
Rs. 6, 00,000
Rs. 1, 50,000
Rs. 7, 50,000
Debenture interest in trial balance
The treatment of debenture interest in the final accounts should also be very carefully
understood. Sometimes the trial balance shows debenture interest paid less tax at a specified
rate. For example, if trial balance shows “half year’s debenture interest less tax at 42% Rs.1,450
then in the above circumstances, the Statement of Profit or Loss and Other Comprehensive
Income will be debited with the gross figure of Rs.2,500 (i.e. 100/58 x Rs.1,450) and Rs. 1,050
(i.e. 42/100 x Rs.2,500) will be shown in the Statement of Financial Position as liability under
the heading income-tax payable account.
7. PROVISION FOR REDEMPTION OF DEBENTURES
When a company issues debentures it must also plan the resources required for such
redemption. This can be done by setting aside profits every year and investing them wisely in
investments outside, so that there will be no liquidity problem at the time of redemption.
Alternatively, the company can take an insurance policy by paying regular premium, so that the
policy matures coinciding with the time of redemption. With the amount received on the
maturity of policy the company faces no problem in carrying out the redemption. These are the
two ways in which a company can make provisioning for redemption of debentures.
It is always prudent for a company to save money for redeeming debentures on the due date. In
the absence of such a provision it becomes difficult for the company to find lump sum amount
to repay the debt. This can be done by adopting any of the two methods explained below:
a. Sinking fund method
Under this method the amount is invested in first class securities which when allowed
accumulating with compound interest produce the amount required to redeem the debentures on
the due date. This method of providing for funds is also called debenture redemption fund
method. The sinking fund method for redeeming a loan is different from sinking fund method
for replacing an asset in the following ways:
1.
Sinking fund created for replacing an asset is in the nature of accumulated depreciation,
while sinking fund created for repaying loan is in the nature of accumulated profits. It is
for this reason that sinking fund’s balance (after the redemption of loan) is transferred to
general reserve, while that for an asset is transferred to asset account.
2.
Annual installment set aside for the replacement of an asset is a charge and is debited to
Statement of Profit or Loss and Other Comprehensive Income, while that for the
redemption of a loan is an appropriation and is debited to profit and loss appropriation
account.
Accounting entries for making the provision for the redemption of debentures are as follows:
UNIT 3: Debentures: Issue and Redemption
Page 407
ICAN Advanced Accounting CAP II Chapter III
At the end of the first year:
1. Debit Profit and loss appropriation account
Credit Sinking fund account
(For setting aside the amount which is calculated after consulting the sinking fundtable)
2.
Debit Sinking fund investment account
Credit Bank account
(For investing the amount set aside).
Second and subsequent years
3.
Debit Bank Account
Credit Interest on sinking fund investments account
(For receiving interest on the investment made in the past year/years)
4.
Debit Interest on sinking fund investments account
Credit Sinking fund account
(For transferring interest to sinking fund account)
Alternatively:
Debit Bank account
Credit Sinking fund account
(For the amount of interest on sinking fund investment received and transferred
sinking fund account.)
to
This entry has been made by combining the two journal entries
5.
Debit Profit and loss appropriation account
Credit Sinking fund account
(For setting aside the amount calculated by consulting the sinking fund table.)
6.
Debit Sinking fund investments account
Credit Bank account
(For investing the amount set aside and the amount of interest received.)
Last year:
1. Debit Bank account
Credit Sinking fund interest account
(For the receipt of interest on sinking fund investment)
2.
Debit Profit and loss appropriation account
Credit Sinking fund account
(For setting aside the amount)
3.
Debit Sinking fund interest Account
Page 408
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Credit Sinking fund account
(For transferring interest to sinking fund account)
It may be noted that in the final year the amount appropriated from the profits of the company
and the amount received as interest on sinking fund investment are not invested as the amount
would be needed on the following day for the redemption of debenture. It will be helpful for
students to note that in the first year of provision only two journal entries, in the second and all
subsequent year’s four journal entries and in the final year only three journal entries are made.
Illustration 9:
A company issued 6% debentures of Rs. 6, 00,000 with a condition that they should be
redeemed after 3 years at 10% premium. The amount set aside for the redemption of debenture
is invested in 5% Government securities. The sinking fund table shows that 0.31720856 at 5%
compound interest in three years will become Re. 1. You are required to give journal entries and
open ledger accounts for recording the transactions for three years.
Solution:
Date
FirstYear
Shrawan 1
First year
Ashadh 31
Ashadh 31
Second Yr
Ashadh 31
Ashadh 31
Ashadh 31
Books of the Company
Journal Entries
Particulars
Bank account
Loss on issue account
To 6% debenture account
To Premium on redemption account
(Being entry for the issue of debenture)
Profit and loss appropriation a/c
ToDebenture sinking fund a/c
(Being transfer of profit to debenture
sinking fund for the redemption of
debenture)
Debenture sinking fund investment a/c
To Bank account
(Being investment of the amount set aside)
Bank account
To Debenture sinking fund a/c
(Being interest on debenture sinking fund
investment received and transferred to
debenture sinking fund A/ c)
Profit and loss appropriation account
To Debenture sinking fund a/c
(Being amount appropriated for debenture
sinking fund)
Debenture sinking fund investment
To Bank Account
(Being investment of amount appropriated
UNIT 3: Debentures: Issue and Redemption
Dr.
6,00,000
60,000
Cr.
6,00,000
60,000
2,09,357.65
2,09,357.65
2,09,357.65
2,09,357.65
10,467.88
10,467.88
2,09,357.65
2,09,357.65
2,19,825.53
2,19,825.53
Page 409
ICAN Advanced Accounting CAP II Chapter III
Third Yr.
Ashadh 31
Ashadh 31
Date
1 Year
Ashadh
31
st
nd
2 Year
Ashadh
31
3rd Year
Ashadh
31
and interest received on the investment)
Bank account
21,459.16
To Debenture sinking fund a/c
21,459.16
(Being interest at 5% on total investment of
Rs. 4,29,183.18 received and credited to
debenture sinking fund account)
2,09,357.66*
Profit and loss appropriation account
2,09,357.66*
To debenture sinking fund a/c
(Being amount appropriated out of profits)
(No investment will be made as this is the
last year of provision.)
Ledger Accounts
Debenture Sinking Fund Account
Particular
Rs.
Date
Particular
st
1 Year
To Balance c/d
Ashadh 31 By P & L Appropriation
209,358
a/c
209,358
2nd Year
To Balance c/d
Shrawan 1 By Balance b/d
429,183
Ashadh 31 By Bank (interest)
Ashadh 31 By P&L appropriation a/c
429,183
3rd Year
To Balance c/d
Shrawan 1 By Balance b/d
660,000
Ashadh 31 By Bank (interest)
Ashadh 31 By P & L appropriation
a/c
660,000
Rs.
209,358
209,358
209,358
10,468
209,358
429,183
429,183
21,459
209,358
660,000
*In the last year the amount has been increased by one paisa in order to make up the difference
from adjustment of figures on interest to the nearest paisa.
Date
st
1 Year
Ashad. 31
Page 410
Debenture Sinking Fund Investment Account
Particular
Rs.
Date
Particular
1st Year
To Bank
209,358
09,358
Ashad. 31
By Balance b/d
Rs.
209,358
09,358
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
2nd Year
Shrawan 1
Ashad. 31
2nd Year
To Balance c/d
To Bank
209,358
219,826
29,183
Ashad. 31
By Balance c/d
429,183
29,183
rd
3 Year
Shrawan 1
To balance b/d
429,183
Tutorial Notes:
(1) Although the sinking fund balance stands at Rs. 6, 60,000, the balance in the investment
account is far less than the value of debentures to be redeemed. This is because the interest and
appropriation for the last year are not inverted in view of the impending redemption. However,
the amount available at the end of the 3rd year will be as follows:
Amount available from investments
Interest received for the 3rd year
Annual appropriation set aside for the 3rd year
The amount required for redemption
Rs.
4,29,183.18
21,459.16
2,09,357.66
6,60,000.00
(2) Annual appropriation is arrived at as follows:
For obtaining Re. 1 at the end of 3 years, the amount to be invested at 5% compound interest =
Rs. 0.31720856
For obtaining Rs. 6, 60,000
= 6, 60,000 × 0.31720856
= 2, 09,357.65
(3) In the above example the exact amount set aside has been invested while, in practice, it
may happen that the amount may be invested in the securities which may be available in the
multiple of Rs. 5 or Rs. 10 or Rs. 100. In case, the question states that the amount is invested in
the securities of Rs. 100 each, then any amount which is not making multiple of Rs. 100 either
will not be invested or will be invested by adding a little more to that amount in order to make it
a multiple of Rs. 100, in such circumstances, it will be seen that the balance of sinking fund
investment account and sinking fund account will not exactly be the same.
b. Non-cumulative sinking fund
A non-cumulative sinking fund differs from the cumulative type of sinking fund only in one
respect: in non-cumulative sinking fund, interest received on sinking fund investment is not reinvested nor is it transferred to sinking fund. Interest on sinking fund investment is treated as a
simple profit and is kept in the business without earmarking its use and the amount is
transferred to Statement of Profit or Loss. Nevertheless, a careful study of the two types of
funds will reveal that there is no difference between the two methods. In a non-cumulative type
UNIT 3: Debentures: Issue and Redemption
Page 411
ICAN Advanced Accounting CAP II Chapter III
of fund, the appropriation from the profits is more but the excess burden on the profits is
corrected by the transfer of interest on the investment to Statement of Profit or Loss. While in
the case of a cumulative type of sinking fund method, the appropriation from the profit is less,
but that amount is made up by crediting to sinking fund the amount of interest earned on
investment. Journal entries in the case of non-cumulative sinking fund method are as follows:
First Year
2nd and
subsequent
years
Specimen Journal Entries
Profit and loss appropriation account
To Sinking fund account
(For appropriating the amount)
Sinking fund investment account
To Bank account
(For the investment of the amount set aside)
Bank account
To Interest on sinking fund investment account
(For interest on investment received)
Interest on sinking fund investment A/c
To Profit and loss account
(For transferring the interest)
Note. In cumulative sinking fund this interest is transferred to
sinking fund account instead of Statement of Profit or Loss
account.
Profit and loss appropriation account
To Sinking fund account
(For setting aside the amount)
Sinking fund investment account
To Bank account
(For investing the amount set aside)
Note. In the cumulative sinking fund method these investments
include the amount of interest received on investment.
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
c. Insurance policy method
Taking an insurance policy for the required amount is another method for making a provision
for the redemption of debentures at the end of a fixed period. Under this system, the premium is
paid regularly in instalments and the insurance company, in its turn, returns the total
accumulated money at the expiry of the period. Money so received is used for redeeming
debentures. This method differs from the sinking fund method in respect of interest on
investment. Unlike sinking fund method, the insurance company does not give any interest on
the instalments received but the amount of premium is proportionately reduced (taking into
consideration the expected rate of interest). It follows from the above that the total premium
paid is less than the total amount of policy. The difference between the amount paid in and
Page 412
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
amount received on realisation of policy represents the total amount of interest earned on
premiums. Many accountants, in order to avoid the lump profit at the time of realisation, make
entries for the interest every year taking into consideration the expected rate of interest. Entries
in respect of insurance policy are as follows:
Debit Profit and loss appropriation account
Credit Debenture redemption fund account
(For the appropriation of amount of premium to be paid on the policy)
Debit Debenture redemption policy account
Credit Cash account
(For the payment of premium on the policy)
These entries are repeated every year, including the last year. Premium on the policy is always
paid in advance and, therefore, it must be paid even in the last year. This is not done in simple
sinking fund method.
Journal entries on the realisation of policy are as follows:
Debit Bank account (amount of policy taken)
Credit Debenture redemption policy account
(with the amount at which policy account stands)
Credit Debenture redemption fund account
(with the difference in the two amounts which represents accumulated interest)
Many accountants, as said earlier, like to take into consideration the amount of interest every
year. If the accounting is done from this point of view then each year journal entry for the
interest is made and policy account does not show any profit at the time of realisation of policy
on the completion of period. The journal entry for the interest is as follows:
Debit Debenture redemption policy account
Credit Debenture redemption fund account
In the illustration given below the interest on premiums has been considered every year.
Illustration 10
BaburamLtd. has made an issue of Rs. 1, 00,000 5% debentures on 1st Shrawan 2069, the terms
of which include that the company must provide a sinking fund for the redemption, on 31st
Ashadheach year, from 2071-72 for 3 years. The directors decide to take out an insurance policy
to provide the necessary cash, the annual premium being Rs. 31,410.80 on which the return is at
3 per cent per annum at compound interest.Show the necessary ledger accounts.
UNIT 3: Debentures: Issue and Redemption
Page 413
ICAN Advanced Accounting CAP II Chapter III
Solution
5% Debentures Account
Date
Particular
Rs.
Date
Particular
3rd Year
To Bank
1,00,000
1st Year
By Bank
Debenture Redemption Fund Account
Date
Particular
Rs.
Date
Particular
st
st
1 Year
1 Year
By Profit & Loss
31stAshadh appropriation a/c
31stAshadh To
By Debenture redemption
Balance
32,353
policy a/c - 3% interest on
c/d
Rs. 31,410.80 for one year
32,353
2nd Year
2nd Year
31stAshadh To
balance
c/d
1st
65,677 Shrawan
By balance b/d
Rs.
1,00,000
Rs.
31,411
942
32,353
32,353
31stAshadh By Profit & Loss
appropriation a/c
By Debenture redemption
policy a/c - 3% interest on
Rs. 63,763.92
65,677
31,411
1,912
65,677
nd
2 Year
31stAshadh To
General
Reserve
3rd Year
By balance b/d
65,677
100,000
1st
By Profit & Loss
Shrawan
appropriation a/c
st
31 Ashadh By Debenture redemption
policy a/c - 3% interest on
Rs. 97,087.64
100,000
31,411
2912.36*
100,000
Debenture Redemption Policy Account
Date
Particular
st
1 Year
1st
Shrawan
31st
Page 414
Rs.
Date
Particular
Rs.
1st Year
To Cash- Premium
31st
31,411 Ashadh
By balance c/d
32,353
To debenture Redemption
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Ashadh
Fund A/c
942
32,353
2nd Year
1st
Shrawan
1st
Shrawan
31st
Ashadh
2nd Year
To balance b/d
31st
32,353 Ashadh
By balance c/d
65,677
To Cash- Premium
31,411
To debenture Redemption
Fund A/c
1,913
65,677
rd
3 Year
1st
Shrawan
1st
Shrawan
31st
Ashadh
32,353
65,677
3rd Year
To balance b/d
31st
65,677 Ashadh
By Bank
100,000
To Cash- Premium
31,411
To debenture Redemption
Fund A/c
2912.36*
100,000
100,000
* Actual interest as per calculation is Rs. 2,912.63; but it has been adjusted to get the exact
amount of policy. This difference is caused due to approximation made in calculations.
8. REDEMPTION OF DEBENTURES—DIFFERENT METHODS
Meaning: - Redemption of debentures is the process of extinguishing or discharging the
liability on account of debentures in accordance with the terms of redemption stated in the
debenture trust deed. Discharge of debenture liability is usually by paying cash to the debenture
holders. But this can take other forms such as conversion or rollover. In the case of conversion,
debentures are converted into preference shares or equity shares. Rollover refers to the issue of
new debentures in exchange for the old ones.
Sources of redemption: - Redemption may be carried out with the help of any of the following
sources:
a.
b.
c.
d.
Out of capital,
Out of profits,
Conversion or rollover (already discussed), and
Out of provision in the nature of sinking fund. We shall now consider each case.
a. Redemption from out of capital
If profits are not available at the time of redemption of debentures, they may be redeemed from
out of capital. When redemption is carried from out of capital only entries are made for
redemption and no entry will be made to transfer profits to 'Debenture Redemption Reserve'.
UNIT 3: Debentures: Issue and Redemption
Page 415
ICAN Advanced Accounting CAP II Chapter III
Accounting entries to be made for redemption when redemption is carried from out of capital
are given below. The student may note that these entries are basic to other redemptions that
follow.
Account
Transaction
Debited
Credited
A. Board resolves to redeem the Debentures
Debenture Redemption/
debentures
Debenture holders
B. Any premium payable on
Premium on
Debenture Redemption/
redemption
redemption
Debenture holders
C. Payment to debenture holders Debenture
Bank
in cash
Redemption/
Debenture holders
Illustration 11
A company issued 1,000 10% debentures of Rs. 100 each at par redeemable at a premium of
10%. After 10 years the company served notice of redemption and redeemed all debentures as
per the terms of issue. You are required to make entries at the time of issue and at the time of
redemption.
Solution
Journal Entries
Date
First Year
beginning
10th Year
end
10th Year
end
Particular
Bank account
Loss on issue of debentures account
To 10% Debentures account
To Premium on redemption account
10% Debentures account
Premium on redemption account
To Debenture Redemption account
Debenture redemption account
To Bank account
Dr.
Dr.
DebitRs
1,00,000
10000
Credit Rs.
1,00,000
10000
Dr.
Dr.
1,00,000
10000
1,10,000
Dr.
1,10,000
1,10,000
b. Redemption from out of Profits
When profits are available at the time of redemption, the company can redeem its debentures by
setting up a ‘Debenture Redemption Reserve’.
Transaction
Account
Debited
A.
transfer of profit to P/L Appropriation A/c
Debenture Redemption Reserve
Page 416
Credited
Debenture Redemption
Reserve A/c
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Illustration 12:
Prachanda Ltd. issued 1,000 debentures of Rs. 100 each redeemable at the end of 8 years but
reserves the right to redeem earlier from the end of 5th year. The company decides at the end of
5th year to redeem 200 debentures from out of profits it has made. Pass necessary journal entries
relating to redemption only.
Solution
Journal Entires
Date
5th year end
Particular
Debit Rs Credit Rs.
Debentures account
Dr.
20,000
To Debenture redemption A/c
20,000
5th year end
Debenture redemption A/c
Dr.
20,000
To Bank account
20,000
5th year end
Profit and loss appropriation account
Dr.
20,000
To Debenture redemption reserve
20,000
c. Conversion or rollover
In the case of conversion, debentures are converted into equity or preference shares. In the case
of rollover, old debentures are replaced by the issue of new debentures.
The additional accounting entries for conversion or rollover are given below:
Transaction
Debited
A. Conversion into shares at par Debenture
Redemption/
Debenture holders
B. Conversion into shares at Debenture
premium
Redemption/
Debenture holders
C. Rollover at par
Debenture
Redemption/
Debenture holders
D. Rollover at premium
Debenture
Redemption/
Debenture holders
Account
Credited
Equity/Preference
capital
share
Share capital
Security premium
New debentures
New debentures
Security premium
Illustration 13: On Shrawan1, 2069 Neha Ltd. issued 2,500 10% fully convertible debentures of Rs. 100 each
at par. The debenture holders were given the call option to convert the debentures into Rs. 10
equity shares at a premium of Rs. 40 per share on or after Magh 1, 2070. On Ashadh 31
debenture holders holding 2,000 debentures exercised their option. Pass the necessary journal
entries.
UNIT 3: Debentures: Issue and Redemption
Page 417
ICAN Advanced Accounting CAP II Chapter III
Solution:
Journal Entries
Date
01-04-2069
32-03-2071
Particular
Bank A/c Dr.
To 10% Convertible debentures
(Issue of 2,500 convertible debentures of
Rs. 100 each)
Dr.
Debit Rs
2,50,000
Credit Rs.
2,50,000
10% Convertible Debenture redemption A/c
To Equity Share Capital
To Security Premium A/c
(Conversion of 2,000 debentures each into
two equity shares at a premium of Rs. 40
each)
Dr.
2,00,000
40,000
1,60,000
Illustration 14: DhaniyaLtd. had issued 5,000 debentures of Rs. 100 each redeemable on 31stAshadh, 2070 at a
premium of 5%. The company offered three options to debenture holders as under:
i) 14% Preference shares of Rs. 10 each at Rs. 12
ii) 15% debentures of Rs. 100 at par.
iii) Redemption in cash.
The options were accepted as under.
Option (i) by holders of 1,500 debentures.
Option (ii) by holders of 1,500 debentures.
Option (iii) by holders of 2,000 debentures.
The company carried out the redemption. Pass the necessary journal entries.
Solution:
Date Particular
1 12% Debentures A/c
Premium on redemption of debentures A/c
To Debenture Redemption A/c
Debenture holders account
To 14% Preference share capital account
To Security premium account
2 12% Debentures Account
Page 418
Dr.
Dr.
Dr.
Debit Rs
Credit Rs.
1,00,000
5,000
1,05,000
1,05,000
87,500
17,500
Dr.
1,50,000
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Premium on redemption A/c
To Debenture holders A/c
Dr.
Debenture holders account
To 15% Debenture account
Dr.
7,500
1,57,500
1,57,500
1,57,500
3 12% Debentures account
Premium on redemption A/c
To Debenture holders A/c
Dr.
Dr.
Debenture holders account
To Bank Account
Dr.
2,00,000
10,000
2,10,000
2,10,000
2,10,000
d. Redemption with the help of Sinking Fund
As discussed earlier, company usually set up a sinking fund for redemption of debentures. A
sinking fund usually signifies investment in other then liquid securities. When the time for
redemption comes such investments are sold. Such sale will never realize exact book values,
thus resulting in profit or loss on sale of such investments. The sale of investments provides
liquid cash to the company to carryout redemption. Once the redemption is carried out sinking
fund does not serve any purpose. Since the fund represents undistributed profits, the same is
transferred to general reserve. Sinking fund might have been used for investing in 'own
debentures'. These are usually acquired when they are sold in the market at below par price. In
the case of such debentures, there is no redemption. Such debentures are cancelled. There can be
profit or loss on the cancellation of such debentures depending on the cost of acquisition and the
par value of such debentures. Entries relating to the setting up of sinking fund have been already
given in the previous section. The additional entries required for sale of investments and
redemption are given below.
Transaction
A. Board decides on redemption
Account
Debited
Debentures
Credited
Debenture Redemption
B. Premium on redemption
Premium
Redemption
C. Transfer of Premium
Sinking Fund
Premium on Redemption
D.Realisationof outside investments
Bank
Sinking Fund Investments
E. Profit on sale of outside
investments
Sinking
Fund Sinking Fund
Investments
F. Loss on realisation
Sinking Fund
UNIT 3: Debentures: Issue and Redemption
on Debenture Redemption
Sinking Fund Investments
Page 419
ICAN Advanced Accounting CAP II Chapter III
G. Cancellation of investment in
own debentures
Debenture
Redemption
Own Debentures
H. Profit on such cancellation
Debenture
Redemption
Sinking Fund
I. Loss on such cancellation
Sinking Fund
Debenture Redemption
J. Redemption of debentures held by
outsiders
Debenture
Redemption
Bank
K. Transfer of sinking fund
Sinking Fund
General Reserve
Notes:
1)
Entry (G) deals with profit on cancellation. There can also be loss on cancellation if own
debentures have been purchased at a price above par. A reverse entry will be passed in
such a case.
2)
Entry (J) requires transfer of sinking fund balance to General reserve. Sinking fund being
a specific fund appears in the Statement of Financial Position only up to the time the
purpose for which such fund is maintained, is not fulfilled. Once the purpose is over, the
fund being undistributed profits is transferred to General Reserve.
However, the entire balance in the sinking fund does not represent undistributed profit. As we
have seen earlier sinking fund is also credited with capital profits such as profit on cancellation
of debentures and profit on sale of investments. The total of such items credited to sinking fund
must be transferred to Capital reserve and the Balance only to General Reserve.
Illustration 15: -The following balances stood in the books of PropoosaLtd. as on 31-03-2070
6% Debentures
Debenture Redemption Fund
The above Fund was invested in the following Securities and Shares:
Rs. 80,000 3.5% Government Loan
Rs. 90,000 4% Government Loan
Rs. 30,000 6% Debentures
835 Preference Shares of Rs. 100 each
Rs.
2,50,000
2,82,500
85,000
86,000
28,000
83,500
The above Investments were sold on the day as under: 3.5% Government Loan at par, 4%
Government Loan at Rs. 96, 6% Debenture at Rs. 90 and the Preference Shares at Rs. 105.
On 04-01-2070, the Company redeemed the Debentures at a premium of 10%. You are required
to show 6% Debentures Account, Debenture Redemption Fund Investment Account and the
Debenture holders' Account.
Page 420
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Solution:
In the Books of Propoosa Ltd
Date
31.03.207
0
Particular
To Debenture
Redemption A/c
(transferred)
6% Debentures Account
Rs.
Date
2,50,000
31.03.2070
Particular
By Balance
b/d
2,50,000
Date
31.0
3.
2070
31.0
3.
2070
31.0
3.
2070
Rs.
2,50,000
2,50,000
Debenture Redemption Fund Account
Particular
Rs.
Date
Particular
31.03.2070 By Balance b/d
To Debenture
Redemption Fund
Investment A/c
(loss on sale)
3.5 % Govt. Loan
31.03.2070 By Debenture
5,000
Redemption Fund
Investment a/c (Profit on
sale)
6% Debentures
6,000
- 4% Gov. Loan
400
1,000
- Pref. Shares
4,175
To Debenture
25,000
holders A/c
(premium)
To General
2,56,075
Reserve A/c
(transferred)
2,87,075
Date
31.3.2070
Debenture Redemption Fund Investment Account
Particular
Rs.
Date
Particular
To Balance b/d
31.3.2070
By Bank A/c
(Sale
Rs. 8,000 3.5 %
3.5% Govt, Loan
Loan
85,000
at par 80,000
Rs. 90,000 4%
4% Govt. Loan
Govt. Loan
(at 96) 86,400
86,000
UNIT 3: Debentures: Issue and Redemption
Rs.
2,82,500
4,575
2,87,075
Rs.
Page 421
ICAN Advanced Accounting CAP II Chapter III
31.3.2070
Rs. 30,000 6%
Debentures
28,000
835 Pref. Shares of
Rs. 100 each
83,500
To Debenture
Redemption Fund
A/c (Profit on Sale)
6% Debentures
(at 90) 27,000
2,82,500
Pref. Shares (835
× 105)
87,675
31.3.2070
- 4% Govt. Loan
400
- Pref. Shares
4,175
4,575
By Debenture
Redemption Fund
A/c (Loss on
Sale)
3.5 % Govt. Loan
5,000
6 % Debentures
1,000
2,87,075
Date
Particular
01.04.207
0
To Bank
A/c—Payment
2,81,075
6,000
2,87,075
6% Debentures Account
Rs.
Date
Particular
Rs.
2,75,000 31.3.2070
By 6% Debentures A/c
2,50,000
31.3.2070
By Debenture
Redemption
Fund A/c Premium
25,000
2,75,000
2,75,000
e. Purchase of Debentures from the Open Market
The company may sometimes purchase its own debenture from the open market, where there is
a sinking fund out of the fund and if there is none, as a general investment, with a view to
cancel them. When debentures are to be redeemed at maturity, the company must redeem them
in accordance with the terms of issue, usually at par, in some cases at premium and rarely at
discount. Therefore it would be advantageous for a company to purchase them from open
market and cancel them, so that the company would secure some profit on cancellation of such
debentures. However, the terms of issue must empower the company to make such a purchase.
Accounting Entries
Transaction
Debited
A. Purchase of own debentures
Own Debentures
B.
Cancellation
of
own Debentures
debentures
C. Profit on cancellation
Debentures
Page 422
Account
Credited
Bank
Own Debentures
Profit on Cancellation of
Debentures/Sinking Fund
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
D. Loss on cancellation
Sinking Fund/
Loss on Cancellation
E. Reissue (or sale) of own Bank
debentures
F. Profit on re-issue
Own Debentures
G. Loss on re-issue
Profit and Loss A/c
H. Interest on own debentures
Debentures interest
Own Debentures
Own Debentures
Profit and Loss A/c
Own Debentures
Profit and Loss A/c
Sinking Fund
Illustration 16: - On 1st Shrawan, 2068,Anisha Ltd. made an issue of 10,000 12% debentures
of Rs. 100 each at Rs. 98 per debenture. According to the terms of issue, commencing from
2069-70, the company should redeem 500 debentures either by purchasing them from the open
market or by drawing lots at par at the company's option. Profit, if any, on redemption is to be
transferred to capital reserve. The company's accounting year ends on 31st Ashadh. Interest is
payable on 30th Poush and 31st Ashadh.
During 2068-69, the company wrote off Rs. 5,000 from debenture discount account.
During 2069-70, the company purchased and cancelled the debentures as given below:
(i)
(ii)
Rs. 20,000 at Rs. 97 per debenture on 30th Poush, and
Rs. 30,000 at Rs. 96 per debenture on 31st Ashadh.
Give the journal entries in the books of Anisha Ltd. for both the years and show how these items
will appear in the financial statements for 2069-70, giving the corresponding figures for the
previous year.
Journal of AnishaLtd
Date
Particular
01.04.2068 Bank A/c
Discount on issue of debentures A/c
To 12% Debentures A/c
30.09.2068 Debentures interest A/c
To Bank
31.03.2069 Debentures interest A/c
To Bank
31.03.2069 Profit and loss A/c
To Debenture interest A/c
To Discount on issue of Debentures A/c
30.09.2069 Debentures interest A/c
To Bank
30.09.2069 Own debentures A/c
To Bank A/c
30.09.2069 12% Debentures A/c
To Own debentures A/c
UNIT 3: Debentures: Issue and Redemption
Dr.
Dr.
Debit Rs
9,80,000
20,000
Credit Rs.
10,00,000
Dr.
60,000
Dr.
60,000
Dr.
1,25,000
60,000
60,000
1,20,000
5,000
Dr.
60,000
Dr.
19,400
Dr.
20,000
60,000
19,400
19,400
Page 423
ICAN Advanced Accounting CAP II Chapter III
31.03.2070
31.03.2070
31.03.2070
31.03.2070
To Capital reserve A/c
Debentures interest A/c
To Bank
Own debentures A/c
To Bank A/c
12% Debentures A/c
To Own debentures A/c
To Capital reserve A/c
Profit and loss A/c
To Debenture interest A/c
600
Dr.
58,800
Dr.
28,800
Dr.
30,000
58,800
28,800
28,800
1,200
Dr.
1,18,800
1,18,800
Statement of Financial Position of Anisha Ltd.
As on 31-03-2070 (Extracts)
2068-69 Liabilities
2069-70 2068-69 Assets
Reserves & Surplus
Capital Reserve
1,800
15,000 Misc. Expenses and
Secured Loans
Losses not written off
10,00,000
12% Debentures
2069-70
15000
9,50,000
Anisha Ltd
Profit & Loss A/c
For the year ending 31-03-2070
2068-69
Particulars
To Interest on
debentures
2069-70
2068-69
1,18,800
Particulars
2069-70
9. EX-INTEREST AND CUM-INTEREST QUOTATIONS
Sometimes debentures are purchased in the open market on a date other than the date of
declaration of interest. In such a case distinction must be made between the capital and revenue
portion of the price paid for the debentures. Amount paid towards the cost of debentures
constitutes the capital portion. Amount paid towards interest from the last date of interest
payment to the date of purchase constitutes the revenue portion. Again the price paid for the
debentures depends on the quotation. If the quotation is cum-interest, the price quoted includes
the interest for the expired period. On the other hand, in the case of ex-interest quotation, the
latter does not include the interest and therefore the buyer has to pay, in addition, the interest for
the expired period.
At the time of recording the purchase of 'own debentures' only the price paid for them (capital
portion) must be debited to the account. Amount paid by way of interest (revenue portion) must
be debited to interest account.
Page 424
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Therefore for the same quotation, if it is ex-interest, the buyer has to pay higher amount than
under cum-interest. At the time own debentures are cancelled, it naturally follows that profit on
cancellation will be more in the case of cum-interest rather than ex-interest quotation.
Interest on Own Debentures
When the investment is held as 'own debentures', interest becomes receivable on such
investment. The company has also to pay interest on the whole of debentures including those
held as investment. The company will, however, pay interest only to outsiders, interest on own
debentures being a book adjustment.
It may be noted that interest has also to be recorded when own debentures are purchased when
the purchase is made between interest dates. Therefore, when own debentures account is
recorded interest columns should be opened on both the sides. On the debit side interest paid at
the time of purchase is recorded. Credit side is recorded with the interest receivable on own
debentures. The difference being net interest receivable is transferred to Statement of Profit or
Loss in case there is no sinking fund and to sinking fund where there is one.
Illustration 17: Pratistha Ltd. buys its own 6% debentures of the nominal value Rs. 20,000 at Rs. 96 on 31st
Ashad, 2069. Record the transaction in the books of PratisthaLtd. if the quotation is (1) cuminterest, and (2) ex-interest. PratisthaLtd. pays debenture interest half-yearly on 30th Ashwinand
31st Chaitra.
Solution:
2069
Ashadh31
Ashadh 31
Cum-interest
Own debentures account
Interest account
To Bank account
(Being the purchase of company's own
debentures
at 96 cum- interest)
Ex-interest
Own debentures account
Interest account
To Bank account
(Being the purchase of company's own
debentures
at Rs. 96 ex-interest)
UNIT 3: Debentures: Issue and Redemption
Dr.
Dr.
18,900
300
19,200
Dr.
Dr.
19,200
300
19,500
Page 425
ICAN Advanced Accounting CAP II Chapter III
Tutorial Notes:
i)
ii)
Cum-interest:
Total price paid at Rs. 96 for Rs. 20,000
Less: Interest on Rs. 20,000 at 6% for three months
i.e. from 1st Baishak 2069 to 31st Ashadh, 2069
Price paid for debenture alone
Ex-interest:
Price paid for debentures alone at Rs. 96 for Rs. 20,000
Add: Interest for the expired period namely
from 1st Baishak 2069 to 31st Ashadh, 2069
Total price paid
Rs.
19,200
300 (Revenue)
(Capital)
18,900
19,200
300
19,500
(Capital)
(Revenue)
Own debentures may be cancelled immediately or carried as an investment for some time and
cancelled on a subsequent date. Occasionally they may be re-issued (without cancellation)
which means they are resold. When debentures are cancelled, interest ceases to be payable on
such debentures from the date of cancellation. So when the own debentures are not cancelled
immediately after the purchase, interest become payable on such debentures and also receivable
because they are held as an investment. At the time of cancellation whether immediately or on a
subsequent date debenture account is debited with the actual paid-up value of debentures
redeemed and own debentures are credited with the amount standing in the books (i.e., fair
value). The difference between the two amounts is a profit or a loss and is transferred to Capital
Reserve if no debenture sinking fund is maintained, to debenture sinking fund account if
debenture sinking fund is maintained.
Illustration 18: Sure Ltd. made an issue of 1,000 6% debentures of Rs. 1,000 each on 1-1-2010 at the issue
price of Rs. 960. The terms of issue provided that beginning with 2012, Rs. 40,000 debentures
should be redeemed either by purchase in the market or by lot at par. The expenses of the issue
amounted to Rs. 8,000 which was written off in 2010. In 2011 and 2012, the discount on issue
of debentures was written off, equally.
In 2012, the company purchased Rs. 12,000 debentures at Rs. 940 cum-interest on 30th
September and Rs. 20,000 debentures at Rs. 950 ex-interest on 30th November, the expenses
being Rs. 800. On 31st December the debentures necessarily to be redeemed were paid off at
par by drawings by lot. Assuming the interest is payable on 30th June and 31st December, make
journal entries to record the above transaction.
Page 426
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Solution:
Journal
Date
Jan 1, 2010
Particulars
Bank Account
Discount on debentures account
To 6% Debentures account
(Being the issue of 1,000 6% debentures of
Rs. 1,000 each at Rs. 960)
Jan 1, 2010 Debenture issue expenses account
To Bank account
(Being the expenses incurred on the issue
of debentures)
June
30, Debenture interest account
2010
To Bank account
(Being the payment of half yearly interest
at 6% p.a. on Rs. 10,00,000)
Dec
31, Debenture interest account
2010
To Bank account
(Being the payment of half yearly interest)
Profit & loss account
Dec 31,
To Debenture interest account
2010
To Debenture issue expenses account
(Being the transfer of debenture interest
and writing off of issue expenses)
Debenture interest account
June 30,
To Bank account
2011
(Being the payment of half yearly interest)
Debenture interest account
Dec 31,
To Bank account
2011
(Being the payment of half yearly interest)
Profit & loss account
Dec 31,
To Debenture interest account
2011
To Debenture issue expenses account
(Being the transfer of debenture interest
and
writing off of half of discount account)
Debenture interest account
June 30,
To Bank account
2012
(Being the payment of half yearly interest)
UNIT 3: Debentures: Issue and Redemption
Dr.
Dr.
9,60,000
40,000
10,00,000
Dr.
8,000
8,000
Dr.
30,000
30,000
Dr.
30,000
30,000
Dr.
68,000
60,000
8,000
Dr.
30,000
30,000
Dr.
30,000
30,000
Dr.
80,000
60,000
20,000
Dr.
30,000
30,000
Page 427
ICAN Advanced Accounting CAP II Chapter III
Sept 30,
2012
Nov 30,
2012
Dec 31,
2012
Dec 31,
2012
Dec 31,
2012
Dec 31,
2012
Page 428
Own debentures account
Debenture Interest account
To Bank account
(Being the purchase of company's own
debentures at Rs. 940 cum-interest)
Own debentures account
Debenture Interest account
To Bank account
(Being the purchase of 20 debentures at Rs.
950
ex-interest and expense of Rs. 500
thereon)
6% Debentures account
To Own debentures account
To Profit on cancellation
To Bank account
(Being the redemption of debentures of the
nominal value Rs. 40,000 of which Rs.
8,000
were redeemed by annual drawings)
Debenture interest account
To bank account
To Interest on own debenture
account
(Being the half-yearly interest on
debentures
of which Rs. 280 is receivable on own
debentures)
Profit and loss account
Profit on cancellation account
To Debenture interest account
To Discount on debenture account
(Being the transfer of debenture interest
and writing
off of remaining discount)
Interest on own debenture account
To Profit and loss account
(Being the transfer of interest on own
debentures)
Dr.
Dr.
11,100
180
11,280
Dr.
Dr.
19,800
500
20,300
Dr.
40,000
30,900
1,100
8,000
Dr.
29,320
29,040
280
Dr.
Dr.
78,900
1,100
60,000
20,000
Dr.
280
280
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Tutorial Notes:
1.
The amount debited to own debentures on 30th September, 2012 is calculated as
follows:
Rs.
Price paid for 12% debenture at Rs. 940 each
11,280
Less Interest on Rs. 12,000 for 3 months at 6%
180
Amount paid towards cost of debentures
11,100
2.
Amount credited to bank on 30th November, 2012 is calculated as follows:
Rs.
19,000
800
19,800
500
20,300
Cost of 20 debentures at Rs. 950 ex-interest
Expenses of purchase
Total cost
Interest on Rs. 20,000 for 5 months at 6%
Total amount paid
In the absence of details, expenses of purchase are presumed to be in respect of debentures
purchased on 30th November. Otherwise a portion of the expenses must be debited to own
debenture account on 30th September.
3.
Debenture interest on 31st December, 2012 is calculated as follows:
Interest for the half yearly ending 31st December
Less: Interest already debited at the time of purchasing own
debenture
30th September
30th November
Balance of interest debited on 31st December
4.
Rs.
30,000
180
500
Interest on own debentures is calculated as follows:
On Rs. 12,000 for 3 months, i.e., from 1st October to 31st December
On Rs. 20,000 for 1 month, i.e., from 1st December to 31st December
Total Rs.
5.
680
29,320
Rs.
180
100
280
Profit on cancellation is utilized to write off discount on debenture account.
Illustration 18: -Sencom Limited issued Rs. 1, 50,000 5% Debentures on which interest is
payable half yearly on 31st March and 30th September. The company has power to purchase
debentures in the open market for cancellation thereof. The following purchases were made
UNIT 3: Debentures: Issue and Redemption
Page 429
ICAN Advanced Accounting CAP II Chapter III
during the year ended 31st December, 2010 and the cancellation was made on the following
31st March:
1st March Rs. 25,000 nominal value purchased for Rs. 24,725 ex-interest.
1st September Rs. 20,000 nominal value purchased for Rs. 20,125 cum-interest.
You are required to draw up the following accounts up to the date of cancellation:
(i)
Debentures Account;
(ii)
Own Debenture Investment Account; and
(iii)
Debenture Interest Account.
Ignore taxation and make calculations to the nearest rupee.
Solution:
Sencom Limited
2010
Dec. 31
2011
Mar. 31
To Balance c/d
To Own Debenture
A/c
To Balance c/d
Debentures Account
2010
1,50,000 Jan. 1
2011
45,000 Jan. 1
1,05,000
1,50,000 Apr. 1
By Balance b/d
1,50,000
By Balance b/d
By Balance b/d
1,50,000
1,50,000
1,05,000
Page 430
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Own Debenture Investment Account
Nominal
Rs.
Interest
Rs.
Cost
Rs.
2010
Nominal
Rs.
2010
Mar. 1
To Bank
25,000
521
24,725 Mar. 31
Sep. 1
To Bank
20,000
417
19,708
Dec. 31
ToP&LA/c
1,375
Interest
Rs.
Cost
Rs.
By Debenture
Interest A/c
Sep. 30
To balance b/d
2,313
45,000
625
–
–
1,125
–
By Debenture
Interest A/c
Dec. 31
–
By Debenture
44,433
Interest A/c
–
563
–
44,433
By balance c/d
45,000
–
44,433
45,000
2,313
44,433
To Capital Res
(Profit on
2011
Jan. 1
Mar. 31
45,000
563
cancellation)
To P & L A/c
–
–
–
567
–
562
–
2011
45,000
1,125
45,000
Mar. 31
By Debenture
45,000
Interest A/c
–
1,125
45,000
–
By 5% Deb.
A/c
UNIT 3: ssswDebentures: Issue and Redemption
45,000
1,125
45,000
Page 431
ICAN Advanced Accounting CAP II Chapter III
Debenture Interest Account
2010
Mar. 31
Sep. 30
Dec. 31
2011
Mar. 31
Particulars
Rs.
To Bank (on Rs. 1,25,000 for
6
months)
To Interest on own Debentures
To Bank (on Rs. 1,05,000
@ 5% for 3 months)
To Interest on own Debentures
To Interest accrued (on
Rs. 1,05,000 for 3 months)
To Interest on own debentures
(on Rs. 45,000 for 3
months)
3,125
625
To Bank (on Rs. 1,05,000 for
6 months)
To Interest on own debentures
(on Rs. 45,000 for 3 months)
Particulars
2010
Jan.
Dec. 31
2,625
1,125
By Accrued Interest
(on
Rs. 1,50,000 @ 5%
for 3 months
By P&LA/c
Rs.
1,875
7,500
1,312
563
9,375
2,625
563
By Interest Accrued
By P&L A/c
2011
Jan. 1
Mar. 31
3,188
9,375
1,312
1,876
3,188
Illustration 19: - The Summary Statement of Financial Position of Chanjit Ltd. at March 31,
2006 was:
Rs.
Rs.
Issued and Fully Paid Share Capital:
Sundry Assets
21,55,000
50,000 6% Redeemable 'A' Pref.
Own Debentures
Shares of Rs. 10 each
5,00,000 (Nominal Rs.
1,05,000
40,000 7% Redeemable 'B' Pref.
1,20,000)
Shares of Rs. 10 each (less calls in
Cash at Bank
5,80,000
arrear on 5,000 shares)
3,95,000
50,000 Equity shares of Rs. 10 each
5,00,000
Share Premium Account
1,00,000
Capital Reserve Account
1,00,000
Profit and Loss Account
4,00,000
General Reserve Account
2,00,000
5% Debentures, 2007
4,00,000
Creditors
2,45,000
28,40,000
28,40,000
On September 30, 2006 following were due for redemption:
(1) Rs. 4, 00,000 5% Debentures at a premium of 10 per cent.
(2) Rs. 5, 00,000 6% 'A' Preference Shares at a premium of Re. 1 per share.
(3) Rs. 4, 00,000 7% 'B' Preference Shares at a premium of 5 per cent,
Page 432
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
It was decided:
(a) Out of the trading profits of Rs. 2,00,000 earned in the seven months to Oct. 31, 2006, to
pay the debenture interest and preference dividends for the half year to September 30,
2006;
(b) To offer to the debenture holders new 6% debentures 2006 or repayment in cash. The
offer of new debentures in exchange for the original holding was accepted by 50 per cent
of the debenture holders including those held by Chanjit Ltd. The whole transaction was
completed on September 30, 2006, and a transfer was made to General Reserve of a sum
equivalent to the cash applied on redemption:
(c) To make an issue of 60,000 Equity Shares of Rs. 10 each at a premium of Rs. 2.50 per
share. This was done on August 31, 2006 and all moneys were received on that date;
(d) To repay in cash both 'A' and 'B' Preference shares and this was carried through on
September 30, 2006.
You are required to (1) show the ledger accounts recording the above transaction in the
company books and (2) give the company's Statement of Financial Position at Oct. 31, 2006.
Ignore expenses and taxation.
Solution:
Dr.
2006
Sep. 30
5% Debentures Account
Particulars
Rs.
To 6% Debentures A/c
2,00,000 2006
To 5% Debenture
2,00,000 Apr. 1
holders A/c
4,00,000
Dr.
2006
Apr. 1
Particulars
To Balance b/d
Dr.
Own Debentures Account
Rs.
1,05,000 2006
Sep. 30
To (Old) Own Deb. A/c
To Balance b/d
Dr.
Particulars
2006
Oct. 31
Rs.
To Balance b/d
1,05,000
1,05,000
4,00,000
Particulars
By New Own
Deb. A/c
6% Debentures Account
Rs.
2006
20,000 Sep. 30
Nov. 1
UNIT 3: ssswDebentures: Issue and Redemption
Cr.
Rs.
1,05,000
Cr.
Particulars
2006
Sep. 30
Cr.
Rs.
4,00,000
By Balance b/d
(New) Own Debentures Account
Particulars
2006
Sep. 30
Particulars
By Balance b/d
Particulars
By 5%
Debentures A/c
By Balance b/d
Rs.
1,05,000
Cr.
Rs.
2,00,000
2,00,000
Page 433
ICAN Advanced Accounting CAP II Chapter III
Dr.
Particulars
2006
Sep. 30
To Bank A/c
Dr.
Particulars
2006
Oct, 31
Dr.
To Balance c/d
5% Debenture holders Account
Rs.
Particulars
2006
By 5%
2,20,000 Sep. 30
Debentures A/c
By Premium on
Redemp.
2,20,000
of Debentures
A/c
General Reserve Account
Rs.
Particulars
2006
4,00,000 Apr. 1
By Balance b/d
Sep. 30
Profit & Loss A/c
4,00,000
Nov. 1
By Balance b/d
Profit and Loss Account
Rs.
2006
To General Reserve A/c
2,00,000 Apr. 1
Apr. 1
To Capital Redemption
Reserve A/c
3,00,000 To
To Dividends A/c
29,000 Oct. 30
To Interest on 5% Deb. A/c
10,000
To Balance c/d
61,000
6,00,000 Nov. 1
Particulars
2006
Sep. 30
Particulars
Cr.
Rs.
2,00,000
20,000
2,20,000
Cr.
Rs.
2,00,000
2,00,000
4,00,000
4,00,000
Cr.
Rs.
By Balance b/d
4,00,000
By Bank A/c
2,00,000
By balance b/d
6,00,000
61,000
Note: It has been assumed that cash balance has increased by the sum of profit earned.
Dr.
Equity Share Capital Account
Particulars
Rs.
2006
Oct. 31
Particulars
Rs.
2006
To Balance c/d
11,00,000
Apr. 1
By Balance b/d
5,00,000
Aug. 31
By Bank A/c
6,00,000
Nov. 1
By balance b/d
11,00,000
11,00,000
Page 434
Cr.
11,00,000
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Dr.
Share Premium Account
Rs.
2006
Apr. 1
To Premium on Redemp. of
Preference Shares A/c
70,000 Aug. 30
To Premium on Redemp. of
Debentures A/c
20,000
To Balance c/d
1,60,000
2,50,000 Nov. 1
Particulars
2006
Sept.
30
Dr.
Oct. 31
Rs.
To Balance b/d
To Equity Share
Capital A/c
To Share
premium A/c
To Profit & Loss
A/c
Nov. 1
To Balance b/d
Dr.
Particulars
2006
Sept.
30
Dr.
To Bank
A/c
5,80,000
6,00,000
1,50,000
2,00,000
Oct. 31
15,30,00
0
3,53,500
By balance b/d
2,50,000
11,00,000
By 6% 'A' Preference
Shareholders A/c
By 7% 'B' Preference
Shareholders A/c
By 5% Debenture holders
Account
By Pref. Dividend A/c
By Interest on 5% Deb.
A/c
By Balance c/d
6% 'B' Preference Shareholders Account
Rs.
Particulars
2006
By 7% 'A' Preference
3,67,500 Sep. 30
Shares Capital A/c
(35,000 shares)
By Premium on Redemp.
of Pref. Shares A/c
3,67,500
6% 'A' Preference Shareholders Account
Rs.
Particulars
By 6% 'A' Preference
2006
Shares Capital A/c
To Bank A/c
5,50,000 Sep. 30
By Premium on Redempof
Pref.
S. hares A/c
5,50,000
Particulars
2006
Sept.
30
1,00,000
1,50,000
Particulars
2006
Sep. 30
UNIT 3: ssswDebentures: Issue and Redemption
Cr.
Rs.
By Balance b/d
By Bank A/c
Cash at Bank
Particulars
2006
Apr. 1
Aug.
31
Particulars
Cr.
Rs.
5,50,000
3,67,500
2,20,000
29,000
10,000
3,53,500
15,30,000
Cr.
Rs.
3,50,000
17,500
3,67,500
Cr.
Rs.
5,00,000
50,000
5,50,000
Page 435
ICAN Advanced Accounting CAP II Chapter III
Dr.
Premium on Redemption of Preference Shares Account
Particulars
2006
Sept.
30
Dr.
2006
Sept.
30
Dr.
To 6% 'A' Pref. Shareholders
Account
To 7% 'B' Pref. Shareholders
Account
To Balance c/d
Rs.
50,000
2006
Sep. 30
17,500
2,500
70,000
Oct. 1
Particulars
By Share
Premium A/c
Rs.
70,000
By Balance b/d
Premium on Redemption of Debentures Account
Particulars
Rs.
Particulars
2006
Sep. 30
To 5% Debenture
By Share Premium A/c,
holders
Transfer
20,000
Account
20,000
Capital Redemption Reserve Account
Rs.
Particulars
2006
To Balance c/d
3,00,000 Sep. 30
By Profit & Loss A/c
3,00,000
Nov. 1
By Balance b/d
Particulars
2006
Oct.
31
Cr.
70,000
2,500
Cr.
Rs.
20,000
20,000
Cr.
Rs.
3,00,000
3,00,000
3,00,000
Statement of Financial Position of Chanjit Ltd. as on 31st Oct., 2006
Liabilities
Issued and Fully Paid Share Capital:
1,10,000 Equity shares of Rs. 10
eachfully paid up
7% 'B' Pref. Share Capital
(pending redemption)
50,000
Less: calls in arrears
5,000
Reserves & Surplus:
Capital Reserve
Capital Redemption Reserve
Share Premium
General Reserve
Profit and Loss Account
Page 436
Rs.
11,00,000
45,000
1,00,000
3,00,000
1,60,000
4,00,000
61,000
Assets
Sundry Assets
Investments:
Own Debentures
(Nominal value
Rs. 1,20,000)
Current Assets:
Cash at Bank
Rs.
21,55,000
1,05,000
3,53,500
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Secured Loans:
6% Debentures
2,00,000
2,45,000
Current Liabilities & Provisions:
Creditors
Premium payable on redemption of
5,000 B Preference shares
2,500
26,13,500
26,13,500
Illustration 20: - Progressive Ltd. issued Rs. 10, 00,000 6% debenture stocks at par on 2-1-84.
Interest was payable on 30th June and 31st December each year. Under the terms of the
debenture trust deed the stock is redeemable at par. The trust deed obliges the company to pay
to the trustees on 31st December 1995 and annually thereafter, the sum of Rs. 1, 00,000 to be
utilized for the redemption and cancellation of an equivalent amount of stock, which is to be
selected by drawing lots.
Alternatively, the company is empowered as from 1st January 1995 to purchase its own
debentures in the open market. These debentures must be surrendered to the trustees for
cancellation and any adjustments for accrued interest recorded in the books of account. If in any
year the nominal amount of the stock surrendered under this alternative does not amount to Rs.
1, 00,000, then the shortfall is to be paid by the company to the trustees in cash on the 31st
December.
The following purchases of stock were made by the company:
1.
2.
3.
30th September, 1995
31st May, 1996
31st July, 1997
Nominal value of stock
Purchased Rs.
1,20,000
75,000
1,15,000
Purchase price per Rs. 100
of stock Rs.
98
95 (Ex- Int.)
92
The company fulfilled all its obligations under the trust deed.
Prepare the following ledger accounts: (a) Debenture stock A/c; (b) Debenture redemption A/c
(c) Debenture interest A/c. Ignore costs and taxation.
UNIT 3: ssswDebentures: Issue and Redemption
Page 437
ICAN Advanced Accounting CAP II Chapter III
Solution:
Ledger of M/s Prosperous Ltd.
Dr.
1995
Sept. 30
Dec. 31
1996
May. 31
Dec. 31
Dec. 31
1997
July. 31
Dec. 31
Dr.
6% Debenture Stock Account
Particulars
Rs.
1995
1,20,000 Jan. 1
To Debenture
8,80,000
redemption a/ c
To Balance c/d
10,00,000
1996
75,000
Jan. 1
To Debenture
25,000
redemption A/c
7,80,000
To Debenture
8,80,000
redemption account
(shortage met)
1997
1,15,000
To Balance c/d
Jan. 1
6,65,000
7,80,000
To Debenture
redemption A/c
To Balance c/d
1996
May 31
1997
July 31
Page 438
By Balance b/d
10,00,000
10,00,000
By Balance b/d
8,80,000
8,80,000
By Balance b/d
6% Debenture Redemption Account
Rs.
Particulars
1995
1,15,800 Sept. 30
To Bank Account (1)
By 6% Deben.
4,200
To Capital reserve A/c
stock A/c
1,20,000
71,250 1996
To Bank account
May 31
(ex-interest price)
By 6% Deben.
3,750
To Capital reserve A/c
stock A/c
Dec. 31
(Profit on
25,000
cancellation)
By 6% Deben.
1,00,000
To Bank a/c (shortage
Stock A/c
met)
(shortage met)
1997
July 31
1,05,000
To Bank A/c (2)
9,775
To Capital reserve A/c
By 6% Deben.
1,15,000
(Profit on
stock A/c
cancellation)
Particulars
1995
Sept. 30
Particulars
Cr.
Rs.
7,80,000
7,80,000
Cr.
Rs.
1,20,000
1,20,000
75,000
25,000
1,00,000
1,15,000
1,15,000
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Tutorial Notes:
(1) Interest paid on debentures @ 6% per annum:
Interest
Amount of Debentures
Period
Date
Rs.
Rs.
1995
30,000
6 months
10,00,000
June 30
1,800
3 months
1,20,000
Sept. 30
26,400
6 months
8,80,000
Dec. 31
1996
1,875
5 months
75,000
May 31
24,150
6 months
8,05,000
June 30
24,150
6 months
8,05,000
Dec. 31
1997
23,400
6 months
7,80,000
June 30
575
1 month
1,15,000
July 31
19,950
6 months
6,65,000
Dec. 31
(2) It has been assumed that debentures are purchased for immediate cancellation.
(3) It The purchases of 30th September, 1995 and 31st July, 1997 have been taken on cuminterest basis.
Dr.
Particulars
1995
June. 30
Sept. 30
Dec. 31
1996
May. 31
June. 31
Dec. 31
1997
June. 31
July. 31
Dec. 31
6% Debenture Stock Account
Rs.
To Bank (on Rs. 10,00,000)
To Bank (interest on cum-interest
purchase
To Bank (on Rs. 8,80,000)
To Bank (interest paid on purchase
of debentures)
To Bank (interest on Rs. 8,05,000)
To Bank (interest on Rs. 8,05,000)
To Bank (on Rs. 7,80,000)
To Bank (interest on cum-interest
purchase
To Bank (on Rs. 6,65,000)
UNIT 3: ssswDebentures: Issue and Redemption
1995
30,000 Dec. 31
1,800
26,400
58,200
1,875 1996
Dec. 31
24,150
24,150
50,175
1997
23,400
Dec. 31
575
19,950
43,925
Particulars
By profit &
loss a/c
Cr.
Rs.
53,200
58,200
By profit &
loss a/c
50,175
50,175
43,925
43,925
By profit &
loss a/c
Page 439
ICAN Advanced Accounting CAP II Chapter III
Illustration 21: - A company issued 10% debentures of Rs. 1, 00,000 at par but redeemable
after 3 years at 10% premium. The amount set aside for redemption of debentures was invested
in 5% Government securities. The amount was invested in multiple of Re. 1. The sinking fund
table shows that 0.31720855 at 5% compound interest in three years will become Re. 1. On due
date the investments were sold at a loss of Rs. 5,000. You are required to show the necessary
Ledger accounts for the three years. You are not required to show the ledger accounts for
payment of debenture interest.
Solution:
Dr.
1st year
Dec. 31
2nd year
Dec. 31
3rd year
Dec. 31
Debenture Sinking Fund Account
Particulars
Rs.
Particulars
1st year
34,982.95 Dec. 31
To Balance c/d
By Profit and
Loss
Appropriation
34,982.95
A/c
2nd year
To Balance c/d
Jan.
1
71,530.55
Dec. 31
By Balance b/d
"
By Bank-interest
By Profit and
71,530.55
Loss
3rd year
To Balance c/d
Appropriation
Jan. 1
A/c
Dec. 31
Dec. 31
1,10,000
1,10,000
-do-
Page 440
To S.F.
Investment
A/c
—Loss on sale
To General
Reserve—
transfer
5,000
1,05,000
1,10,000
Dec. 31
By Balance b/d
By Bank interest
By P & L Appr.
A/c
Cr.
Rs.
34,892.95
34,892.95
34,892.95
1,744.65
34,892.95
71,530.55
71,530.55
3,576.50
34,892.55
1,10,000
1,10,000
1,10,000
By Balance b/d
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
Dr.
1st year
Dec. 31
2nd year
Jan. 1
Dec. 31
3rd year
Jan. 1
Debenture Sinking Fund Investment Account
Particulars
Rs.
Particulars
1st year
To Bank
34,893 Dec. 31 By Balance c/d
34,893
To Balance b/d
To Bank
To Balance b/d
2nd year
34,893 Dec. 31
36,637
71,530
71,530
71,530
Dr.
Particulars
3rd year
Dec. 31
To Debenture
holders A/c
Dr.
Particulars
3rd year
Dec. 31
Dr.
3rd year
Dec. 31
To Bank
3rd year
Dec. 31
Dec. 31
By Balance c/d.
34,893
34,893
71,530
71,530
By Bank
By Debenture S.F.
Loss on sale of
investments
10% Debentures Account
Rs.
Particulars
3rd year Jan. 1
1,00,000
By Balance b/d
1,00,000
Debenture holders Account
Rs.
Particulars
3rd year
1,10,000 Jan. 1
By Debentures A/c
By Premium on
redemption of
debentures
1,10,000
Premium on Redemption of Debentures Account
Particulars
Rs.
Particulars
3rd year
To Debenture
Jan. 1
By balance c/d
10,000
holders A/c —
transfer
10,000
UNIT 3: ssswDebentures: Issue and Redemption
Cr.
Rs.
66,530
5,000
71,530
Cr.
Rs.
1,00,000
1,00,000
Cr.
Rs.
1,00,000
10,000
1,10,000
Cr.
Rs.
10,000
1,10,000
Page 441
ICAN Advanced Accounting CAP II Chapter III
1.
Tutorial Notes:Assumption is made that premium on redemption of debentures is brought
into account at the time of issue of debentures. It can also be brought into account at the
time of redemption.
2.
The interest received at the end of the third year and the appropriation made for the third
year will not be invested, as redemption has to be made at about the same time. If these
amounts are taken into account, sinking fund Investment will also equal the balance in the
sinking fund account as shown below:
Balance in the Sinking Fund Investment A/c
Add: Interest on investments for the 3rd year
Add: Appropriation for the third year
Balance as per sinking fund
Page 442
71,530
3,577
34,892
1,10,000
UNIT 3: Debentures: Issue and Redemption
ICAN Advanced Accounting CAP II Chapter III
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
UNIT 4:
Underwriting of Shares and Debenture
UNIT 4: Underwriting of Shares and Debenture
Page 443
ICAN Advanced Accounting CAP II Chapter III
1. MEANING OF UNDERWRITING
Underwriting is an agreement entered into by the company with one or more persons or
institutions, called underwriters, who undertake to take-up the whole or certain portion of such
shares or debentures which are not subscribed for by the public in consideration of a certain
remuneration called underwriting commission. The underwriting agreement, among others,
must provide for the period during which the agreement is in force, the amount of underwriting
obligations, the period within which the underwriter has to subscribe to the issue after being
intimated by the issuer, the amount of commission and details of arrangements, if any, made by
the underwriter for fulfilling the underwriting obligations. As per section 28 of Companies Act
provides that in cases where at least fifty percent of the total shares issued publicly cannot be
sold failing a guarantee/underwriting agreement on the subscription of at least fifty percent of
the publicly issued shares, no shares shall be allotted. Clause 4 of Securities Issue Guidelines
2065, provides that the organized institution which intends to go for public issue of its share
must enter into underwriting agreement with licensed underwriter for at least 50% of its public
issue. As per Schedule 10 Clause 2 of Securities Business Person (Merchant Banker)
Regulation, 2064, the underwriting commission (Service charge of Underwriter) may not
exceed four percent on the amount underwritten for the underwriting of securities for the public
issue or issue through circular method. Underwriters get their commission irrespective of
whether they have to buy a single security or not.
2. IMPORTANCE OF UNDERWRITING
Underwriting has become very important in recent years with the growth of the corporate
sector. It provides several benefits to a company:-
It relieves the company of the risk and uncertainty of marketing the securities.
-
Underwriters have an intimate and specialized knowledge of the capital market. They
offer valuable advice to the issuing company in the preparation of the prospectus, time of
floatation and the price of securities, etc. They also provide publicity service to the
companies which have entered into underwriting agreements with them.
-
It helps in financing of new enterprises and in the expansion of the existing projects.
-
It builds up investors' confidence in the issue of securities. The association of well-known
underwriters lends prestige to the company and the investors feel that the issue is sound
enough for profitable investment. Also, the securities underwritten by reputed
underwriters receive better response from the public.
-
The issuing company is assured of the availability of funds. Important projects are not
delayed for want of funds.
It facilitates the geographical dispersal of securities because generally, the underwriters
maintain contacts with investors throughout the country.
Page 444
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
3. TYPES OF UNDERWRITING AGREEMENT
Underwriting agreement may take any of the following two forms:
Pure underwriting: - Under this type of contract, underwriters undertake to subscribe for shares
to a certain limit only when the offer made to the public is not fully subscribed for by them.
Thus if underwriters underwrite 10,000 shares issued by a company, they will have to purchase
2,000 shares if the public applies for 8,000 and 3,000 shares if the public applies for 7,000 and
nothing if the public applies for 10,000 or more shares. The underwriting contract may be
signed by one underwriter if the financial position of the underwriter is as good as to take the
risk of subscribing the whole issue in the worst circumstances of no response by the public. But
generally, the underwriting contract is signed between the company and two or more
underwriters each agreeing to insure against the risk only to a limited extent.
Firm underwriting: - Under ‘firm underwriting’ contract, the underwriters’, instead of standing
behind the offer, agree to make an outright purchase of shares. Thus under ‘firm underwriting’,
the underwriters stipulate that they be allotted a given number of shares whether or not the issue
is oversubscribed. The underwriters under such agreement get priority over the general public in
relation to allotment of shares in the event of over-subscription. If, for example, underwriters
have ‘firm underwritten’ 10,000 shares of the total issue of 40,000 shares, only 30,000 shares
shall be available to the public even if there are applications for 50,000 shares.
Underwriter and Broker distinguished. An underwriter, as stated above, is a person who
agrees to take a specified number of shares or debentures, or a specified amount of debenture
stock in the event of the public not subscribing for them in consideration for a commission
which is called ‘underwriting commission’. A broker, on the other hand, is a person who gives
his services in bringing a settlement between a vendor and a purchaser for a reward which is
generally called ‘brokerage’. Brokerage is to be distinguished from underwriting commission.
While brokerage is paid for the service of placing the shares, underwriting commission is paid
for guaranteeing the subscription.
4. MARKED AND UNMARKED APPLICATIONS
It has already been stated that shares or debentures issued by a company are usually
underwritten by two or more underwriters in an agreed ratio. If the issue is underwritten by
several underwriters, each of them makes an effort for selling shares or debentures through him
so that the subscription so collected may be counted to reduce the risk undertaken by him
(particular underwriter). In order to prevent counting of his subscription to the advantage of
some other underwriters, it is a common practice to put a seal on the application form. This seal
helps the company in recognizing as to which underwriter should get the credit for that
application. Such applications are called marked applications. When the members of the public
do not get the application form through some underwriters, but get them directly from the
company, such forms do not bear any seal and are called unmarked applications. The credit of
such applications is given to all the underwriters. In fact, such subscription is deducted from the
total issue in order to calculate the gross liability of all the underwriters. Where the issue is
underwritten by only one underwriter, he will get credit for all the applications whether sent
UNIT 4: Underwriting of Shares and Debenture
Page 445
ICAN Advanced Accounting CAP II Chapter III
through him or directly and, therefore, the division of applications into marked and unmarked is
of no significance.
5. ACCOUNTING TREATMENT UNDER PURE UNDERWRITING
Journal entries in the books of the insured Company are given below:
Transaction
Account to be
Debited
Credited
Underwriters/brokers
Underwriting
Commission/brokerage
Bank
Underwriters/brokers
Commission or brokerage due to
underwriters/brokers
Payment made for
commission/brokerage
Share Capital/debentures
Underwriters
Liability for shortfall in public
Underwriters
subscription
Bank
Receipt of money for
shares/debentures taken up by
underwriters.
Instead of transactions (2) and (4) being separately effected, it is quite common to settle the
payment by receiving the net amount and thus making only one entry.
Determination of the liability of underwriters
The determination of the liability of the underwriters depends on the nature of underwriting
agreement. Therefore, the liability under different types of agreement is discussed below.
I. When the entire issue is underwritten
Again, the entire issue may be underwritten by one underwriter or more than one underwriter.
Where the issue is underwritten by one person, he will get credit for all the applications whether
marked or not. So his liability will be equal to the number of shares underwritten minus the
number of shares applied for. So if the issue is fully subscribed or oversubscribed, there will be
no liability for the underwriters to take up any shares. The underwriter will, however, be entitled
to get his commission only on the issue price of shares underwritten by him.
Where the issue is underwritten by two or more underwriters in an agreed ratio, the procedure is
as follows:
Step 1: Calculate the gross liability of each underwriter in the agreed ratio. In many problems
it will be given as such and does not involve any calculation.
Step 2: Deduct the marked applications from the gross liability
Step 3: Give credit to unmarked applications in the ratio of gross liability. This is done by way
of deduction from the balance after step 2.
Step 4: In case some figure is in minus then transfer that figure to other underwriters’ accounts
in the ratio of gross liability inter se. This gives the liability of underwriters on account
of shortfall in the public subscription.
Page 446
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
Sometimes credit to unmarked applications is given in the ratio of gross liability as reduced by
the marked applications. The individual liability calculated in this way will differ from the
liability calculated as per the earlier procedure. The difference that these two methods cause in
the calculation of net liability is illustrated below.
Illustration1
Everest Finance Ltd. incorporated on 1stShrawan, 2069 issued a prospectus inviting applications
for 500,000 equity shares of Rs.10 each at a premium of 10 per cent.
The whole issue was fully underwritten by Suraj, Sishir, Sudan and Smriti as follows:
Suraj
Sishir
Sudan
Smriti
2, 00,000 shares
1, 50,000 shares
1, 00,000 shares
50,000 shares
Applications were received for 4, 50,000 shares of which marked applications were as follows:
Suraj
Sishir
Sudan
Smriti
2, 20,000 shares
90,000 shares
1, 10,000 shares
10,000 shares
It is agreed that underwriters be paid commission at 5 % on the issue price. You are required
(a) to find out the liabilities of individual underwriters, and
(b) to give necessary journal entries including for cash transactions.
Solution
The net liability of the individual underwriters is ascertained by giving credit to unmarked
applications (1) in the ratio of gross liability (Statement A) and (2) in the ratio of gross liability
as reduced by marked applications (Statement B)
UNIT 4: Underwriting of Shares and Debenture
Page 447
ICAN Advanced Accounting CAP II Chapter III
Statement A
Particulars
a. Gross liability as per
the agreement
b. Less Marked
applications
c. Resultant liability
d. Credit for unmarked
application in the
ratio of gross liability
(4:3:2:1)
e. Resultant liability
f. Surplus of Suraj and
Sudan distributed to
Sishir and Smriti in
the ratio of 3:1
g. Net liability
Net Liability of Underwriters
Suraj
Sishir
Sudan
2,00,000
1,50,000
1,00,000
Smriti
50,000
Total
5,00,000
2,20,000
-20,000
90,000
60,000
1,10,000
-10,000
10,000
40,000
4,30,000
70,000
8,000
-28,000
6,000
54,000
4,000
-14,000
2,000
38,000
20,000
50,000
28,000
Nil
-31,500
22,500
14,000
Nil
- 10,500
27,500
50,000
Sishir
1,50,000
90,000
60,000
Sudan
1,00,000
1,10,000
- 10,000
Smriti
50,000
10,000
40,000
Total
5,00,000
4,30,000
70,000
(-) 22,500
37,500
10,000
- 7,500
32,500
70,000
Statement B
Net Liability of Underwriters
Suraj
2,00,000
a. Gross liability
2,20,000
b. Less marked
applications
(-)20,000
c. Resultant liability
d. Surplus distributed
20,000
in the ratio of gross
liability
Nil
e. Gross liability as
reduced by marked
applications
f. Credit for unmarked
applications in the
Nil
ratio of 37,000 :
32,500
g. Net liability
Nil
12,000
25,500
8,000
24,500
Nil
20,000
50,000
From the above statement it is clear that the liability of the underwriter varies according to the
method adopted.
Page 448
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
So it is essential to specify the method in the underwriting agreement. As for the student he/she
can adopt any one of the above two methods but indicating by way of footnote the alternative
method of calculating the net liability.
Journal Entries
Particular
Bank account
To equity share application account
Equity share application account
To Equity share capital account
To Securities premium account
Sishir’s account
Smriti’s account
To Equity share capital account
To Securities premium account
Commission on shares account
To Suraj’s account
To Sishir’s account
To sudan’s account
To Smriti’s account
Bank account
To Sishir’s account
To smriti’s account
Suraj’s account
Sudan’s account
To Bank account
Dr.
Debit
Rs.
49,50,000
Credit
Rs.
49,50,000
Dr.
49,50,000
45,00,000
4,50,000
Dr.
Dr.
2,47,500
3,02,500
5,00,000
50,000
Dr.
2,75,000
1,10,000
82,500
55,000
27,500
Dr.
4,40,000
1,65,000
2,75,000
Dr.
Dr.
1,10,000
55,000
1,65,000
The entries in the journal have been made on the basis of net liability as per Statement A.
II. When the issue is partially underwritten
By partial underwriting, it is meant that only a portion of the issue is underwritten. In such a
case for the balance not underwritten, the company itself becomes the underwriter. Again as in
the case of complete underwriting, partial underwriting may be done by one underwriter, or
more than one underwriter. The calculation of liability in each is discussed below:
(A) When the partial underwriting is done by one person only.
In this case the net liability of the underwriter will be equal to his gross liability minus the
marked applications received to his credit. All the unmarked applications are treated as marked
in favor of the company and, therefore, the underwriter does not get any credit for them.
Illustration: - 2
Suntali Ltd. issued 1, 00,000 equity shares of which only 75% was underwritten by Dhurmuse.
Applications for 60,000 shares were received out of which applications for 48,000 shares were
marked in favour of Dhurmuse. Determine the net liability of Dhurmuse.
UNIT 4: Underwriting of Shares and Debenture
Page 449
ICAN Advanced Accounting CAP II Chapter III
Solution
No. of shares
Gross liability of Dhurmuse-75% of 1, 00,000
75,000
Less marked applications
48,000
Net liability of Dhurmuse
27,000
Note: The underwriters will have no liability if the company receives applications for 1, 00,000
shares or more although the marked applications were for 48,000 shares. Similarly, if the
applications for shares exceed the gross liability of the underwriter, his net liability will be
restricted to total issue minus the number of shares subscribed. In the above example if the
company received applications for 85,000 shares, the net liability of Dhurmuse will be
restricted to 15,000 shares, i.e., 1, 00,000 shares minus 85,000 shares.
If no information is given about marked and unmarked applications, the total applications
received must be multiplied by the percentage of issue underwritten to find out the number of
marked applications. In the above example, if details are not given, marked applications would
be 75% of 60,000 = 45,000 shares.
(B) When the partial underwriting is done by more than one person.
As under (A), the company is deemed to be the underwriter for the balance not underwritten and
get the credit for unmarked applications. An illustration will make it clear that the method is
similar to one discussed under II (A).
Illustration: - 3
SitaLtd. issued 20,000, 10% debentures of Rs. 100 each for public subscription. The issue was
underwritten as follows:
Ram 25%; Laxman 30% and Bharat 25%. The company received a total number of 14,000
applications of which marked applications were as follows:
Ram
4,000
Laxman
3,000
Bharat
4,000
Determine the liability of each of the underwriters.
Solution
Gross liability
Less marked applications
Net liability
Page 450
Ram 25%
5,000
4,000
1,000
Laxman 30%
6,000
3,000
3,000
Bharat 25%
5,000
4,000
1,000
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
6. FIRM UNDERWRITING
When the underwriters agree to firm underwriting, it becomes an additional liability and must
be added to the net liability arising under the agreement. In the calculation of net liability, the
shares underwritten by firm may be treated as marked or unmarked application. The liabilities
of the underwriters differ under the two methods. Steps involved under both the methods are
given below followed by an illustration worked out under both methods.
Firm underwriting treated as Marked Applications
1.
2.
3.
4.
5.
6.
Calculate the gross liability of each underwriter in the agreed ratio.
Deduct the marked applications from the gross liability.
Give credit to unmarked applications in the ratio of gross liability.
Give credit to firm underwriting according to the commitment of each underwriter.
If, as a result of the above steps, the figure is minus (surplus) for any underwriter, then
transfer that figure to the other underwriters in the ratio of gross liability inter se. This
gives the net liability.
Add firm commitment to the net liability calculated under step (5). This gives the total
liability of each underwriter.
Firm underwriting treated as Unmarked Applications
1. Calculate the unmarked applications by deducting the marked applications from the total
subscription including firm underwriting. Under this procedure unmarked applications
include firm underwriting.
2.
3.
4.
5.
6.
Calculate the gross liability in the agreed ratio.
Deduct unmarked applications (calculated under step 1 ) in the ratio of gross liability.
Deduct marked applications from the figure arrived under step (3).
Repeat step (5) as under the first method. This gives net liability.
Repeat step (6) as under the first method to arrive at total liability.
Illustration: -4
NagarikLimited invited applications from public for 1, 00,000 equity shares of Rs. 10 each at a
premium of Rs. 5 per share. The entire issues are underwritten by the underwriters A, B, C and
D to the extent of 30%, 30%, 20% and 20% respectively with the provision of firm underwriting
of 3,000, 2,000, 1,000 and 1,000 shares respectively. The underwriters were entitled to 2.5%
commission.
The company received applications for 70,000 shares from public out of which applications for
19,000, 10,000, 21,000 and 8,000 shares were marked in favour of A, B, C and D respectively.
Calculate the liability of each one of the underwriters. Also ascertain the underwriting
commission payable to the different underwriters.
UNIT 4: Underwriting of Shares and Debenture
Page 451
ICAN Advanced Accounting CAP II Chapter III
Solution:
(A) Treating “Firm Underwriting’ as Marked Application
Liability of Underwriters (No. of Shares)
Total
A
B
1,00,000
30,000
30,000
Gross Liability
12,000
3,600
3,600
Less: Unmarked
Applications
88,000
26,400
26,400
Balance
58,000
19,000
10,000
Less: Marked
30,000
7,400
16,400
Applications
7,000
3,000
2,000
Balance
23,000
4,400
14,400
Less :Firm Underwriting
–
-1,650
-1,650
Balance
23,000
2,750
12,750
Adjustment
Net Liability
30,000
5,750
14,750
Total Liability including
firm underwriting
C
20,000
2,400
17,600
21,000
-3,400
1,000
- 4,400
+ 4,400
–
D
20,000
2,400
17,600
8,000
9,600
1,000
8,600
- 1,100
7,500
1,000
8,500
(B) Treating ‘Firm Underwriting’ as Unmarked Applications
Shares Applications received including firm underwriting
77,000 (70,000 + 7,000)
Less: Marked Applications
58,000
Unmarked Applications
19,000
Gross Liability
Less: Unmarked
Applications
Balance
Less: Marked
Applications
Balance
Adjustment
Net Liability
Add Firm Underwriting
Total Liability
Liabilities of Underwriters (No. of Shares)
Total
A
B
C
1,00,000
30,000
30,000
20,000
19,000
5,750
5,750
3,800
D
20,000
3,800
81,000
58,000
24,300
19,000
24,300
10,000
16,200
21,000
16,200
8,000
23,000
–
5,300
-1,800
14,300
-1,800
- 4,800
+ 4,800
8,200
1,200
23,000
7,000
3,500
3,000
12,500
2,000
–1,000
7,000
1,000
30,000
6,500
14,500
1,000
8,000
Underwriting Commission
Commission payable to
Page 452
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
Illustration: - 5A
A company made a public issue of 1, 25,000 equity shares of Rs. 100 each. Rs. 50 is payable on
application. The entire issue was underwritten by four parties- A, B, C and D, in the proportion
of 30%, 25%, 25% and 20% respectively. Under the terms agreed upon, a commission of 2%
was payable on the amounts underwritten.
A, B, C and D had also agreed on “firm” underwriting of 4,000, 6,000, Nil and 15,000 shares
respectively.
The total subscriptions excluding firm underwriting, including marked applications were 90,000
shares. Marked applications received were as under:
A
24,000
B
20,000
C
12,000
D
24,000
Ascertain the liability of the individual underwriters and also show the journal entries that you
would make in the books of the company. All workings should form part of your answer.
Solution
(i) Computation of Unmarked Applications
Particular
Shares subscribed excluding firm underwriting but including marked
applications
Less Marked applications (24,000 + 20,000 + 12,000 + 24,000)
Unmarked Applications
No. of shares
90,000
80,000
10,000
(ii) Statement showing liability of underwriters
Particulars
Gross Liability (30: 25: 25: 20)
Less: Marked Applications
Less: Unmarked Applications
(in gross liability ratio)
A
37,500
24,000
13,500
3,000
Less: Firm Underwriting
10,500
4,000
Surplus of D allocated to A, B and
6,500
C
in the ratio of 30: 25: 25
6,000
Surplus of B allocated to A and C
500
500
–
UNIT 4: Underwriting of Shares and Debenture
B
31,250
20,000
11,250
C
31,250
12,000
19,250
D
25,000
24,000
1,000
Total
1,25,000
80,000
45,000
2,500
8,750
6,000
2,750
2,500
16,750
–
16,750
2,000
(1,000)
15,000
16,000
10,000
35,000
25,000
–
5,000
+2,250
-2,250
–
5,000
11,750
1,750
10,000
(16,000)
–
–
–
–
10,000
–
10,000
Page 453
ICAN Advanced Accounting CAP II Chapter III
(iii) Statement of underwriters liability
Particulars
A
Firm (No. of Shares)
4,000
Others (No. of Shares)
–
Total
4,000
B
6,000
–
6,000
(iv) Statement showing liability of underwriters
Particulars
A
B
Shares to be subscribed as
4,000
6,000
per
(iii) above
2,00,000 3,00,000
Amount due @ Rs. 50 per
share
Less: Commission due @ 2%
on nominal value of shares
75,000
62,500
underwritten (Rs.)
1,25,000 2,37,500
D
15,000
–
15,000
Total
25,000
10,000
35,000
C
D
Total
10,000
5,00,000
15,000
7,50,000
35,000
17,50,000
62,500
4,37,500
50,000
7,00,000
2,50,000
15,00,000
Journal Entries
Particulars
Bank Account
To Share Application Account
(Being application money received on 90,000 shares
at Rs. 50 per share from public)
Share Application A/c
To Share Capital A/c
(Being money received on share applications on
90,000 shares transferred to Share Capital A/c)
A
B
C
D
To Share Capital A/c
(Being application money due from underwriters
including firm underwriting)
Underwriting Commission A/c
To A
To B
To C
To D
(Being
underwriting
Commission
due
to
underwriters)
Bank A/c
To A
Page 454
C
–
10,000
10,000
Dr.
Dr. Rs.
45,00,000
Cr. Rs.
45,00,000
Dr.
45,00,000
45,00,000
Dr.
Dr.
Dr.
Dr.
2,00,000
3,00,000
5,00,000
7,50,000
17,50,000
Dr.
2,50,000
75,000
62,500
62,500
50,000
Dr.
15,00,000
1,25,000
2,37,500
4,37,500
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
7,00,000
To B
To C
To D
(Being amount received from underwriters on
account of share application less underwriting
commission due to them)
Illustration: 6
KantipurLtd. came up with an issue of 20, 00,000 equity shares of Rs. 10 each at par. 5, 00,000
shares were issued to the promoters and the balance offered to the public was underwritten by
three underwriters Messi, Ronaldo and Falcaoequally with firm underwriting of 50,000 shares
each. Subscriptions totaled 12, 97,000 shares including the marked forms which were:
Messi
4, 25,000 shares
Ronaldo
4, 50,000 shares
Falcao
3, 50,000 shares
The underwriters had applied for the number of shares covered by firm underwriting. The
amounts payable on application and allotment were Rs. 2.50 and Rs. 2.00 respectively. The
agreed commission was 5%.
Pass summary journal entries for: (a) the allotment of shares to the underwriters;
(b) the commission due to each of them; and
(c) the net cash paid and or received.
Note: Unmarked applications are to be credited to underwriters equally.
Solution:
KantipurLtd.
JournalEntires
Particulars
Bank A/c
To Share Application A/c
(Application money received on firm applications for
50,000 each @ Rs. 2.50 per share from Messi, Ronaldo
&Falcao)
Messi
Ronaldo
Falsao
Share Application A/c
To Share Capital A/c
(Allotment of shares to underwriters: 50,000 to Messi;
50,000 to Ronaldo and 1,03,000 to Falcao; application and
alllotment money credited to share capital A/c)
Underwriting Commission A/c
UNIT 4: Underwriting of Shares and Debenture
Dr.
Rs.
3,75,000
Rs.
3,75,000
Dr.
Dr.
Dr.
Dr.
1,00,000
1,00,000
3,38,500
3,75,000
9,13,500
Page 455
ICAN Advanced Accounting CAP II Chapter III
To Messi
To Ronaldo
To Falcao
(Amount of underwriting commission payable to Messi,
Ronaldo and Falco @ 5% on the amount of shares
underwritten.)
Bank A/c
To Falcao
(Amount received from Falcao on shares allotted less
underwriting commission)
Messi
Ronaldo
To Bank A/c
(Amount paid to Messi&Ronaldo in final settlement of
underwriting commission due less amount payable on
shares allotted payable to him.)
Dr.
7,50,000
7,50,000
Dr.
88,500
88,500
Dr.
Dr.
1,50,000
1,50,000
Working Notes:
1) CALCULATION OF THE LIABILITY OF UNDERWRITERS
Messi
Ronaldo
5,00,000
Gross Liability (No. of shares)
5,00,000
Less: Firm Underwriting
50,000
50,000
4,50,000
4,50,000
Less: Marked Applications
4,25,000
4,50,000
25,000
–
Less: Unmarked Applications (equally)
36,000
–
11,000
–
Less: Adjustment of Messi'ssurplus
(11,000)
–
–
–
Net liability, excluding firm underwriting
50,000
50.000
Firm underwriting
50,000
50.000
Gross liability
2) CALULATION OF AMOUNTS PAYABLE BY UNDERWRITERS
50,000
50,000
Liability (No. of shares)
Rs.
Rs.
2,25,000
2,25,000
Amount payable @ Rs. 4.50 per share
Less: Amount paid on Firm Applications of 50,000
each @ Rs. 2.50
1,25,000
1,25,000
Balance payable
1,00,000
1,00,000
Underwriting Commission Receivable
2,50,000
2,50,000
Amount Paid
1,50,000
1,50,000
Amount received by the Co.
–
–
Page 456
3,00,000
Falcao
5,00,000
50,000
4,50,000
3,50,000
1,00,000
36,000
64,000
11,000
53,000
50,000
1,03,000
1,03,000
RS.
4,63,000
1,25,000
3,38,500
2,50,000
–
88,500
UNIT 4: Underwriting of Shares and Debenture
ICAN Advanced Accounting CAP II Chapter III
Benefit of unmarked applications has not been given to Vijay as has surplus would have
ultimately been credited for Messi&Falcao.
Illustration: - 7
A joint stock company resolved to issue 10 lakhs equity shares of Rs. 10 each at a premium of
Re. 1 per share. One lakh of these shares were taken up by the directors of the company, their
relatives, associates and friends, the entire amount being received forthwith. The remaining
shares were offered to the public, the entire amount being asked for with applications.
The issue was underwritten by Clean, Clear and Click for a commission @ 2% of the issue
price, 65% of issue was underwritten by Clean, while Clear’s and Click’s shares were 25% and
10% respectively.
Their firm underwriting was as follows:
Clean 30,000 shares, Clear20,000 shares and Click10,000 shares. The underwriters were to
submit unmarked applications for shares underwritten firm with full application money along
with members of the general public.
Marked Applications were as follows:
Clean 1, 19,500 shares, Clear 57,500 shares and Click 10,500 shares.
Unmarked applications totaled 7, 00,000 shares.
Accounts with the underwriters were promptly settled.
You are required to:
(i) Prepare a statement calculating underwriters’ liability for shares other than shares
underwritten firm.
(ii) Pass journal entries for all the transactions.
Solution:
(i) Statement showing underwriters’ liability for shares
Other than shares underwritten firm
Particular
Gross Liability (9,00,000 shares
in the ratio of 65: 25: 10)
Less: Marked applications
Less: Allocation of unmarked applications
(including firm underwriting i.e. 7,00,000)
in the ratio of 65: 25: 10
Clean
Rs.
5,85,000
1,19,500
4,65,000
Clear
Rs.
2,25,000
57,500
1,67,500
Click
Rs.
90,000
10,500
79,500
Total
Rs.
9,00,000
1,87,500
7,12,500
4,55,000
10,500
1,75,000
(7,500)
70,000
9,500
7,00,000
12,500
7,500
(1,000)
–
Surplus of Clear allocated to Clean and
Click
(6,500)
in the ratio of 65:10
UNIT 4: Underwriting of Shares and Debenture
Page 457
ICAN Advanced Accounting CAP II Chapter III
Liability amount @ Rs. 11
Underwriting commission payable
(Gross liability x Rs. 11 x 2%)
Net Amount payable
Net Amount receivable
–
4,000
8,500
44,000
1,28,700
84,700
12,500
93,500
49,500
49,500
19,800
73,700
(ii) Journal Entries
Particulars
Bank A/c
To Equity Share Application A/c
(Being application money received on 1 lakh
equity shares @ Rs. 11 per share)
Bank A/c
To Equity Share Application A/c
(Application money received on 8,87,500 equity
shares @ Rs. 11 per share from general public and
underwriters for shares underwritten firm)
Equity Share Application A/c
Clean’s A/c
Click’s A/c
To Equity Share Capital A/c
To Securities (share) Premium A/c
(Allotment of 10 lakh equity shares of Rs. 10 each
at a premium of Re. 1 per share)
Underwriting Commission A/c
To Clean’s A/c
To Clear’s A/c
To Click’s A/c
(Amount of underwriting commission payable to
Clean, Clear and Click @ 2% on the amount of
shares underwritten)
Bank A/c
To Click’s A/c
(Amount received from Click in final settlement)
Clean’s A/c
Clear’s A/c
To Bank A/c
(Amount paid to Clean and Clear in final
settlement)
Page 458
Dr.
Dr.
Rs.
11,00,000
Cr.
Rs.
11,00,000
Dr.
97,62,500
97,62,500
Dr.
Dr.
Dr.
1,08,62,500
44,000
93,500
1,00,00,000
10,00,000
Dr.
1,98,000
1,28,700
49,500
19,800
Dr.
73,700
73,700
Dr.
Dr.
84,700
49,500
1,34,200
UNIT 4: Underwriting of Shares and Debenture
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
Unit 5:
Preparation of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
1. INTRODUCTION
Financial statements are a structured representation of the financial position and the
transactions undertaken by an entity. The objective of general purpose financial statements is to
provide information about the financial position, financial performance and cash flows of an
entity that is useful to a wide range of users in making economic decisions. Financial statements
also show the results of management’s stewardship of the resources entrusted to it. To meet this
objective, financial statements provide information about an entity’s assets, liabilities, equity,
income and expenses, including gains and losses, other changes in equity and cash flows.
This information, along with other information in the notes to financial statements, assists users
in predicting the entity’s future cash flows and in particular the timing and certainty of the
generation of cash and cash equivalents.
The board of director and / or other governing body of an entity is responsible for the
preparation and presentation of its financial statements.
2. LEGAL PROVISION RELATING TO BOOKS OF ACCOUNT & FINANCIAL
STATEMENTS
Companies Act 2063 in its chapter 7 has made following provisions relating to Books of
Accounts and Financial Statement of a company:
Every company shall duly maintain its books of accounts in the Nepali or the English language.
The accounts to be maintained shall be maintained according to the double entry system of
accounting and in consonance with the accounting standards enforced by the competent body
under the prevailing law and with such other terms and provisions required to be observed
pursuant to Companies Act in such a manner as to clearly reflect the actual affairs of the
Company.
The books of account of a company shall not be kept at any place other than its registered
office, except with the approval of the Office.
The cash balance of a company, other than the amount specified by the board of directors, shall
be deposited in a bank and transaction shall be done through the bank.
The directors or other officers shall have the final responsibility to maintain books of account
and records of the company. Where there is a default in complying with the provisions made in
the Act in respect of the preparation of books of account and annual financial statements of a
company, the director or officer him/herself, during whose tenure the annual financial
statements and other reports have been prepared, shall be responsible under the Act.
The following annual financial statements shall be prepared by the board of directors of a public
company every year at least thirty days prior to the holding of its annual general meeting, and in
the case of a private company, within six months of the expiry of its financial year:
(a) Statement of Change in Position as at the last date of the financial year.
(b) Statement of Profit or Loss of the financial year.
Page 460
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
(c) Statement of cash flow of the financial year.
(d) Statement in the change in equity
(e) Basic accounting policies followed and notes to Accounts
The annual financial statement should give true and fair view of the state of affairs of the
company as at the last day of the financial year concerned and also state the account of profit
and loss and description of cash flow made in that financial year. Such financial statements shall
be prepared in the format prescribed by the prevailing law. The annual financial statements shall
have to be approved by the board of directors and audited.
The board of directors of every public company or every private company with the paid –up
capital of ten million rupees or more or with an annual turnover of ten million rupees or more
shall also prepare a separate report of board of directors during that period stating the following
matters, in addition to the annual financial statements:
(a) Review of the transactions of the previous year;
(b) Impacts, if any, caused on the transactions of the company from national and international
situation;
(c) Achievements in the current year as at the date of report and opinions of the board of
directors on matters to be done in the future;
(d) Industrial or professional relations of the company;
(e) Alterations in the board of directors and the reasons therefore;
(f) Major things affecting the transactions;
(g) If there are any remarks in the audit report, the comments of the board of directors on
such remarks;
(h) Amount recommended for payment by way of dividend;
(i) In the event of forfeiture of shares, details regarding the number of forfeited shares, face
value of such shares, total amount received by the company for such shares prior to the
forfeiture thereof, proceeds of sale of such shares after the forfeiture thereof, and refund
of amount ,if any, made for such forfeited shares;
(j) Progress of transactions of the company and of its subsidiary company in the previous
financial year and review of the situation existing at the end of that financial year;
(k) Major transactions completed by the company and its subsidiary company in the financial
year and any material changes taken place in the transactions of the company during that
period;
(l) Disclosures made by the substantial shareholders of the company to the company in the
previous financial year;
(m) Details of shareholding taken by the directors and officers of the company in the previous
financial year and , in the event of their involvement in share transaction of the company,
details of information received by the company from them in that respect;
UNIT 5: Prepartion of Financial Statements
Page 461
ICAN Advanced Accounting CAP II Chapter III
(n) Details of disclosures made about the personal interest of any director and his/her close
relative in any agreements related with the company during the previous financial year;
(o) In the event that the company has bought its own shares (buy-back), the reasons for such
buy-back ,number and face value of such shares, and amount paid by the company for
such buy-back;
(p) Whether there is an internal control system in place or not; and details of such system, if it
is in place;
(q) Details of total management expenses during the previous financial year;
(r) Name-list of the members of audit committee, remuneration, allowances and facilities
received by them, details of the functions performed by that committee, and details of
suggestions, if any, made by that committee;
(s) Amount, if any, outstanding and payable to the company by any director, managing
director ,chief executive, substantial shareholder or his/her close relative or by any firm
company, corporate body in which he/she is involved;
(t) Amount of remuneration, allowances and faculties paid to the director, managing director,
chief executive and officer;
(u) Amount of dividends remaining unclaimed by the shareholders ;
(v) Details of sale and purchase of properties pursuant to Section 141;
(w) Details of transactions carried on between the associated companies pursuant to Section
175 of the Companies Act;
(x) Any other matters required to be set out in the report of board of directors under this Act
and the prevailing law;
(y) Other necessary matters.
The annual financial statements shall also contain, in the case of the year of incorporation of the
company, the accounts from the date of its incorporation to the last day of that financial year,
and thereafter, the accounts of the previous financial year.
The annual financial statements shall be kept open for inspection by any shareholder, if he/she
so desires. The annual financial statements and the report of board of directors prepared
pursuant to this Section shall be approved by the board of directors and signed by the
Chairperson of the board of directors and at least one director. The accounts and annual
financial statements prepared by a company shall be kept safely for at least five years after the
date of expiry of the financial year concerned.
The officers who prepare any false annual financial statements, reports of board of directors and
other returns and reports required to be prepared under Companies Act and the directors who
approve the same shall be liable to punishment.
Page 462
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
3. COMPONENTS OF FINANCIAL STATEMENTS
Financial statements shall present fairly the financial position, financial performance and cash
flows of the entity. The appropriate application of Nepal Financial Reporting Standards, with
additional disclosure when necessary, results, in virtually all circumstances, in financial
statements that achieve a fair presentation. A Complete set of financial statements includes the
following components:
a. A Statement of Financial Position (A balance sheet);
b. A Statement of Profit or Loss and Other Comprehensive Income (An income
statement);
c. A statement of changes in equity showing either:
i.
All changes in equity, or
ii. Changes in equity other than those arising from transactions with equity holders
acting in their capacity as equity holders;
d. A cash flow statement; and
e. Notes, comprising a summary of significant accounting policies and other explanatory
notes.
An entity shall prepare its financial statements, except for cash flow information, using the
accrual basis of accounting.
Assets and liabilities, and income and expenses, shall not be offset except when offsetting is
required or permitted by another Nepal Accounting Standard.
Except when a Nepal Financial Reporting Standard permits or requires otherwise, comparative
information shall be disclosed in respect of the previous period for all amounts reported in the
financial statements. Comparative information shall be included for narrative and descriptive
information when it is relevant to an understanding of the current period’s financial statements.
Financial statements shall be presented at least annually. When, in exceptional circumstances,
an entity’s Statement of Financial Position date changes and the annual financial statements are
presented for a period longer or shorter than one year, an entity shall disclose, in addition to the
period covered by the financial statements:
a.
b.
the reason for a period other than one year being used; and
the fact that comparative amounts for the income statement, changes in equity, cash flow
and related notes are not comparable
3.1 Statement of Financial Position (A Balance Sheet)
A Statement of Financial Position or Balance Sheet is the statement prepared to show the
financial position of an entity on a specific date generally as at the last date of fiscal year.
UNIT 5: Prepartion of Financial Statements
Page 463
ICAN Advanced Accounting CAP II Chapter III
Capital, liabilities and assets are presented in the Statement of Financial Position. As a
minimum, the face of the Statement of Financial Position shall include line items which present
the following amounts:
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.
Property, Plant and Equipment
Investment Property
Intangible Assets
Financial assets (excluding e, h and i)
Investments accounted for using the equity method.
Biological Assets
Inventories
Trade and other receivables
Cash and cash equivalents
Total of assets classified as held for sale and assets included in disposal groups
classified as held for sale.
Trade and other payables.
Provisions.
Financial Liabilities
Liabilities and assets for current tax.
Deferred tax liabilities and deferred tax assets.
Liabilities included in disposal groups classified as held for sale in accordance with
IFRS 5.
Non- controlling interests, presented within equity.
Issued capital and reserves attributable to owners of the parent.
The general outline of Balance is as below:
Statement of Financial Position
As at…………
Particular
Schedule
Equity and Liabilities
Equity Share Capital
Preference Share Capital
Reserve and surplus
Long Term Liabilities
Trade and Other Payables
Provisions
Tax Liabilities
Page 464
Amount
xxx
xxx
xxx
xxx
xxx
xxx
xxx
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Total of Equity & Liabilities
Assets
Property Plant and Equipment
Intangible Assets
Financial Assets
Investment
Inventories
Trade and Other Receivables
Cash and Cash Equivalents
Total of Assets
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
An entity shall disclose, either on the face of the Statement of Financial Position or in the notes
to the Statement of Financial Position, further sub-classifications of the line items presented,
classified in a manner appropriate to the entity’s operations. Each item shall be sub – classified,
when appropriate, by its nature and, amounts payable to and receivable from the parent entity,
fellow subsidiaries and associates and other related parties shall be disclosed separately.
An entity shall disclose the following, either on the face of the Statement of Financial Position
or in the notes:
A. For each class of share capital:
i.
ii.
iii.
iv.
The number of shares authorized;
The number of shares issued and fully paid, and issued but not fully paid;
Par value per share;
A reconciliation of the number of shares outstanding at the beginning and at the end of the
year;
v. The rights, preferences and restrictions attaching to that class including restrictions on the
distribution of dividends and the repayment of capital;
vi. Shares in the entity held by the entity itself or by subsidiaries or associates of the entity;
and
vii. Shares reserved for issuance under options and sales contracts, including the terms and
amounts;
B. A description of the nature and purpose of each reserve within owners’ equity.
An entity without share capital, such as a partnership or public corporation, shall disclose
information equivalent to that required above, showing movements during the period in each
category of equity interest, and the rights, preferences and restrictions attaching to each category
of equity interest.
UNIT 5: Prepartion of Financial Statements
Page 465
ICAN Advanced Accounting CAP II Chapter III
Order of Presentation in Statement of Financial Position:
There are 3 approaches which may include:
Approach 1
Classify current and noncurrent Assets.
Classify current and noncurrent Liabilities
Approach 2
Present all assets and liabilities in the order of liquidity if such presentation provides more
reliable and relevant information especially in entities like financial institutions.
Approach 3
Mixed basis of presentation; some of its assets/ liability using current / non- current
classification and others in order of liquidity.
3.2 Statement of Profit or Loss Account and Other Comprehensive Income ( An Income
Statement)
Income Statement is the statement prepared to show the financial performance of an
entity during a specific accounting period generally of one year. Revenue, Expense, Gain and
Loss are presented in Income Statement. As a minimum, the face of the income statement shall
include line items which present the following amounts:
a.
b.
c.
d.
e.
f.
g.
h.
Revenue
The result of operating activities;
Finance costs;
Share of the profit or loss of associates and joint ventures accounted for using the equity
method;
Tax expense;
Profit or loss from or ordinary activities;
Where consolidated financial statements are prepared, minority interest; and
Net profit or loss for the period.
An entity shall not present any items of income and expense as extraordinary items, either on
the face of the income statement or in the notes.
Circumstances that would give rise to the separate disclosure of items of income and expense
include;
i.
ii.
iii.
Write–downs of inventories to net realizable value or of property, plant and equipment
to recoverable amount, as well as reversals of such write–downs’
Restructurings of the activities of an entity and reversals of any provisions for the cost
of restructuring;
Disposals of items of property, plant and equipments;
Page 466
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
iv.
v.
vi.
vii.
Disposals of investments;
Discontinued operations;
Litigation settlement; and
Other reversals of provisions.
An entity shall present, either on the face of the income statement or in the notes to the income
statement, an analysis of expenses using a classification based on either the nature of expenses
or their function within the entity. It is better to present this classification on the face of the
income statement.
An example of a classification using the nature of expense method is as follows:
Statement of Profit or Loss
As at…………
Particular
Revenue
Other income
Changes in inventories of finished goods
and work in progress
Raw materials and consumables used
Staff costs
Depreciation and amortization expense
Other expenses
Total expenses
Profit
Schedule
Amount
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
The second analysis is referred to as the function of expense or ‘cost of sales’ method and
classifies expenses according to their function as part of cost of sales or, distribution or
administrative activities. This presentation often provides more relevant information to users
than the classification of expenses by nature, but the allocation of costs to functions can be
arbitrary and involves considerable judgment. An example of a classification using the function
of expense method is as follows:
Particular
Revenue
Cost of Sales
Gross Profit
Other Income
Distribution Costs
Statement of Profit or Loss Account
As at…………
Schedule
UNIT 5: Prepartion of Financial Statements
Amount
xxx
xxx
xxx
xxx
xxx
Page 467
ICAN Advanced Accounting CAP II Chapter III
Administrative Expenses
Other Expenses
Profit
xxx
xxx
xxx
Entities classifying expenses by function shall disclose additional information on the nature of
expenses, including depreciation and amortization expense and staff costs.
The choice of analysis between the function of expense method and the nature of expense
method depends on both historical and industry factors and the nature of the organization. Both
methods provide an indication of those costs which might be expected to vary, directly or
indirectly, with the level of sales or production of the entity. Because each method of
presentation has merit for different types of entity, this Standard requires a choice between
classifications which most fairly presents the elements of the entity’s performance. However,
because information on the nature of expenses is useful in predicting future cash flows,
additional disclosure is required when the cost of sales classification is used.
An entity shall disclose, either on the face of the income statement or in the notes, the amount of
dividends per share, declared or proposed, for the period covered by the financial statements.
Other comprehensive income
Other comprehensive income comprises items of income and expenses (including
reclassification adjustments) that are not recognized in profit or loss as required or permitted by
other NFRSs.
The components of other comprehensive income include:
a. changes in revaluation surplus (NAS 16 PPE and NAS 38 Intangible assets);
b. re-measurements of defined benefit plans (NAS 19 Employee benefits)
c. gains and losses arising from investment in equity instruments measured at fair value
through other comprehensive income (NFRS 9 Financial instruments)
d. gains and losses arising from translating the financial statements of a foreign operations
(NAS 21 The effects of changes in foreign exchange rates)
e. the effective portion of gains and losses on hedging instruments in a cash flow hedge (NAS
39 Financial Instruments)
f. for a particular liabilities designated as at fair value through profit or loss, the amount of the
change in the fair value that is attributable to changes in the liability’s credit risk (NFRS 9
Financial instruments)
3.3 Interpretation of items of financial statement
Financial Statement of an entity covers different types of Assets, Liability, Equity, Income
and expenses. The nature and composition of individual items of assets, liability, equity, income
and expense can be different in entity to entity based on its nature of operation. Details of
individual item is presented in the respecting topics of accounting standard. In general the
assets, liability, equity, income and expense can be interpreted as follows:
Page 468
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Assets
An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
The future economic benefit embodied in an asset is the potential to contribute, directly or
indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a
productive one that is part of the operating activities of the entity. It may also take the form of
convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as
when an alternative manufacturing process lowers the costs of production.
An entity usually employs its assets to produce goods or services capable of satisfying the wants
or needs of customers; because as these goods or services can satisfy the wants or needs,
customers are prepared to pay for them and hence contribute to the cash flow of the entity. Cash
itself renders a service to the entity because of its command over other resources.
The future economic benefits embodied in an asset may flow to the entity in a number of ways.
For example, an asset may be:
(a)
(b)
(c)
(d)
used singly or in combination with other assets in the production of goods or services to
be sold by the entity;
exchanged for other assets;
used to settle a liability; or
distributed to the owners of the entity.
Many assets, for example, Property, Plant and Equipment, have a physical form. However,
physical form is not essential to the existence of an asset; hence patents and copyrights, for
example, are assets if future economic benefits are expected to flow from them to the entity and
if they are controlled by the entity.
Many assets, for example, Receivables and Property, are associated with legal rights, including
the right of ownership. In determining the existence of an asset, the right of ownership is not
essential; thus, for example, property held on a lease is an asset if the entity controls the benefits
which are expected to flow from the property. Although the capacity of an entity to control
benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an
asset even when there is no legal control. For example, know-how obtained from a development
activity may meet the definition of an asset when, by keeping that know-how secret, an entity
controls the benefits that are expected to flow from it.
The assets of an entity result from past transactions or other past events. Entities normally
obtain assets by purchasing or producing them, but other transactions or events may generate
assets; examples include property received by an entity from government as part of a program to
encourage economic growth in an area and the discovery of mineral deposits.
UNIT 5: Prepartion of Financial Statements
Page 469
ICAN Advanced Accounting CAP II Chapter III
Transactions or events expected to occur in the future do not in themselves give rise to assets;
hence, for example, an intention to purchase inventory does not, of itself, meet the definition of
an asset.
There is a close association between incurring expenditure and generating assets but the two do
not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence
that future economic benefits were sought but is not conclusive proof that an item satisfying the
definition of an asset has been obtained. Similarly the absence of a related expenditure does not
preclude an item from satisfying the definition of an asset and thus becoming a candidate for
recognition in the Statement of Financial Position; for example, items that have been donated to
the entity may satisfy the definition of an asset.
Goodwill
Goodwill acquired in a business combination represents a payment made by the acquirer in
anticipation of future economic benefits from assets that are not capable of being individually
identified and separately recognized. The future economic benefits may result from synergy
between the identifiable assets acquired or from assets that, individually, do not qualify for
recognition in the financial statements but for which the acquirer is prepared to make a payment
in the business combination.
Property Plant and Equipments
Property, plant and equipment are tangible items that:
(a) are held for use in the production or supply of goods or services, for rental to others, or
for administrative purposes; and
(b) are expected to be used during more than one period.
Spare parts and servicing equipments are usually carried as inventory and recognized in profit or
loss as consumed. However, major spare parts and stand-by equipment qualify as Property,
Plant and Equipment when an entity expects to use them during more than one period.
Similarly, if the spare parts and servicing equipment can be used only in connection with an
item of property, plant and equipment, they are accounted for as Property, Plant and Equipment.
Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical substance. Entities
frequently expend resources, or incur liabilities, on the acquisition, development, maintenance
or enhancement of intangible resources such as scientific or technical knowledge, design and
implementation of new processes or systems, licences, intellectual property, market knowledge
and trademarks (including brand names and publishing titles). Common examples of items
encompassed by these broad headings are computer software, patents, copyrights, motion
picture films, customer lists, mortgage servicing rights, fishing licences, import quotas,
franchises, customer or supplier relationships, customer loyalty, market share and marketing
rights. Not all the items meet the definition of an intangible asset, i.e. identifiability, control
over a resource and existence of future economic benefits.
Page 470
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Expenditure on internally generated brands, mastheads, publishing titles, customer lists and
items similar in substance cannot be distinguished from the cost of developing the business as a
whole. Therefore, such items are not recognized as intangible assets.
Non Current Assets Held for Sale
An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying
amount will be recovered principally through a sale transaction rather than through continuing
use.
For this to be the case, the asset (or disposal group) must be available for immediate sale in its
present condition subject only to the terms that are usual and customary for sales of such assets
(or disposal groups) and its sale must be highly probable.
For the sale to be highly probable, the appropriate level of management must be committed to a
plan to sell the asset (or disposal group), and an active programme to locate a buyer and
complete the plan must have been initiated. Further, the asset (or disposal group) must be
actively marketed for sale at a price that is reasonable in relation to its current fair value. In
addition, the sale shall be expected to qualify for recognition as a completed sale within one
year from the date of classification, , and actions required to complete the plan shall indicate
that it is unlikely that significant changes to the plan will be made or that the plan will be
withdrawn.
Investment Property
Investment property is property (land or a building-or part of a building-or both) held (by the
owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both,
rather than for:
(a) use in the production or supply of goods or services or for administrative purposes; or
(b) sale in the ordinary course of business.
Investment property is held to earn rentals or for capital appreciation or both. Therefore, an
investment property generates cash flows largely independently of the other assets held by an
entity. This distinguishes investment property from owner-occupied property. The following are
examples of investment property:
(a)
(b)
(c)
(d)
Land held for long-term capital appreciation rather than for short-term sale in the
ordinary course of business.
Land held for a currently undetermined future use. (if an entity has not determined that it
will use the land as owner-occupied property or for short-term sale in the ordinary course
of business, the land is regarded as held for capital appreciation.)
A building owned by the entity (or held by the entity under a finance lease) and leased
out under one or more operating leases.
A building that is vacant but is held to be leased out under one or more operating leases.
UNIT 5: Prepartion of Financial Statements
Page 471
ICAN Advanced Accounting CAP II Chapter III
Investment
Investments are the financial assets which does not form any physical substance. They represent
legal claims on other entities in the form of various descriptions such as bonds, shares,
debentures etc. Investments are not directly identified with primary activities of business.
Deferred Tax Assets
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
(a)
(b)
(c)
deductible temporary differences;
the carry forward of unused tax losses; and
the carry forward of unused tax credits.
Loans and Receivables
Loans and Receivables are non-derivative financial assets with fixed or determinable payments
that are not quoted in an active market, other than held for trading or designated on initial
recognition as assets at fair value through profit or loss or as available-for-sale.
Inventories
Inventories are assets:
a. held for sale in the ordinary course of business;
b. in the process of production for such sale; or
c. in the form of materials or supplies to be consumed in the production process or in the
rendering of services.
Inventories encompass goods purchased and held for resale including, for example, merchandise
purchased by a retailer and held for resale, or land and other property held for resale. Inventories
also encompass finished goods produced, or work in progress being produced, by the entity and
include materials and supplies awaiting use in the production process. In the case of a service
provider, inventories include the costs of the service, for which the entity has not yet recognized
the related revenue.
Trade and other Receivables
Trade and other Receivable are the current assets in respect of goods sold or service rendered or
in respect of other contractual obligations but not include the amount which is in nature of loans
and advances.
Cash and Cash Equivalents
Cash comprises cash on hand and demand deposits. Cash equivalents are short-term, highly
liquid investments that are readily convertible to known amounts of cash and which are subject
to an insignificant risk of changes in value.
Cash equivalents are held for the purpose of meeting short-term cash commitments rather than
for investment or other purposes. For an investment to qualify as a cash equivalent it must be
readily convertible to a known amount of cash and be subject to an insignificant risk of changes
Page 472
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a
short maturity of, say, three months or less from the date of acquisition. Equity investments are
excluded from cash equivalents unless they are, in substance, cash equivalents, for example in
the case of preferred shares acquired within a short period of their maturity and with a specified
redemption date.
Liabilities
A liability is a present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.
An essential characteristic of a liability is that the entity has a present obligation. An obligation
is a duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. This is normally
the case, for example, with amounts payable for goods and services received.
Obligations also arise, however, from normal business practice, custom and a desire to maintain
good business relations or act in an equitable manner. If, for example, an entity decides as a
matter of policy to rectify faults in its products even when these become apparent after the
warranty period has expired, the amounts that are expected to be expended in respect of goods
already sold are liabilities.
A distinction needs to be drawn between a present obligation and a future commitment. A
decision by the management of an entity to acquire assets in the future does not, of itself, give
rise to a present obligation. An obligation normally arises only when the asset is delivered or the
entity enters into an irrevocable agreement to acquire the assets. In the latter case, the
irrevocable nature of the agreement means that the economic consequences of failing to honour
the obligation, for example, because of the existence of a substantial penalty, leave the entity
with little, if any, discretion to avoid the outflow of resources to another party.
The settlement of a present obligation usually involves the entity giving up resources
embodying economic benefits in order to satisfy the claim of the other party. Settlement of a
present obligation may occur in a number of ways, for example, by:
(a)
(b)
(c)
(d)
(e)
payment of cash;
transfer of other assets;
provision of services;
replacement of that obligation with another obligation; or,
conversion of the obligation to equity.
An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting
its rights.
Liabilities may result from past transactions or other past events. Thus, for example, the
acquisition of goods and the use of services give rise to trade payables (unless paid for in
advance or on delivery) and the receipt of a bank loan results in an obligation to repay the loan.
UNIT 5: Prepartion of Financial Statements
Page 473
ICAN Advanced Accounting CAP II Chapter III
An entity may also recognise future rebates based on annual purchases by customers as
liabilities; in this case, the sale of the goods in the past is the transaction that gives rise to the
liability.
Some liabilities can be measured only by using a substantial degree of estimation. Some entities
describe these liabilities as provisions. TThus, when a provision involves a present obligation
and satisfies the rest of the definition, it is a liability even if the amount has to be estimated.
Examples include provisions for payments to be made under existing warranties and provisions
to cover pension obligations.
Non – current interest – bearing liabilities and other long term liabilities;
All other liabilities other than current liabilities are non-current liabilities. Financial liabilities
that provide the financing on a long – term basis (i.e. are not part of the working capital used in
the entity’s normal operating cycle) and are not due for settlement within twelve month of the
Statement of Financial Position date, are non – current liabilities.
Current Liability
A liability shall be classified as a current liability when it satisfies any of the following criteria:
a.
b.
c.
d.
it is expected to be settled in the normal course of entity’s operating cycle; or
it is held primarily for the purpose of being trade;
is due to be settled within twelve months of the Statement of Financial Position date; or
the entity does not have an unconditional right to defer settlement of the liability for at least
twelve months after the Statement of Financial Position date.
Some current liabilities, such as trade payables and accruals for employee and other operating
costs, form part of the working capital used in the normal operating cycle of the business. Such
operating items are classified as current liabilities even if they are due to be settled after more
than twelve months from the Statement of Financial Position date.
Other current liabilities are not settled as part of the normal operating cycle, but are due for
settlement within twelve months of the Statement of Financial Position date or held primarily
for the purpose of being traded. Examples are current portion of interest – bearing liabilities,
bank overdrafts, dividends payable, income taxes and other non – trade payables.
Tax liabilities;
Tax Liability consists of Current Tax Liabilities and Deferred Tax Liabilities. Current Tax
Liability is the amount of income taxes payable in respect of the taxable profit for a period less
the amount of Income Tax paid during the period. Deferred Tax Liabilities are the amounts of
income taxes payable in future periods in respect of taxable temporary differences.
Provisions
A provision is a liability of uncertain timing or amount. Provisions can be distinguished from
other liabilities such as trade payables and accruals because there is uncertainty about the timing
Page 474
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
or amount of the future expenditure required in settlement. Provisions are recognized as
liabilities because they are present obligations and it is probable that an outflow of resources
embodying economic benefits will be required to settle the obligations
Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Although equity is defined as a residual, it may be sub classified in the Statement of Financial
Position. For example, in a corporate entity, funds contributed by shareholders, retained
earnings, reserves representing appropriations of retained earnings and reserves representing
capital maintenance adjustments may be shown separately. Such classifications can be relevant
to the decision-making needs of the users of financial statements when they indicate legal or
other restrictions on the ability of the entity to distribute or otherwise apply its equity.
They may also reflect the fact that parties with ownership interests in an entity having different
rights in relation to the receipt of dividends or the repayment of capital.
The creation of reserves is sometimes required by statute or other law in order to give the entity
and its creditors an added measure of protection from the effects of losses. Other reserves may
be established if existing tax law grants exemptions from, or reductions in, taxation liabilities
when transfers to such reserves are made. The existence and size of these legal, statutory and tax
reserves is information that can be relevant to the decision-making needs of users. Transfers to
such reserves are appropriations of retained earnings rather than expenses.
The amount at which equity is shown in the Statement of Financial Position is dependent on the
measurement of assets and liabilities. Normally, the aggregate amount of equity, only by
coincidence, corresponds with the aggregate market value of the shares of the entity or the sum
that could be raised by disposing of either the net assets on a piecemeal basis or the entity as a
whole on a going concern basis.
Commercial, industrial and business activities are often undertaken by means of entities such as
sole proprietorships, partnerships and trusts and various types of government business
undertakings. The legal and regulatory framework for such entities is often different from that
applying to corporate entities. For example, there may be few, if any, restrictions on the
distribution to owners or other beneficiaries of amounts included in equity.
Income
Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
The definition of income encompasses both revenue and gains. Revenue arises in the course of
the ordinary activities of an entity and is referred to by a variety of different names including
sales, fees, interest, dividends, royalties and rent.
UNIT 5: Prepartion of Financial Statements
Page 475
ICAN Advanced Accounting CAP II Chapter III
Gains represent other items that meet the definition of income and may, or may not, arise in the
course of the ordinary activities of an entity. Gains represent increases in economic benefits and
as such are no different in nature from revenue. Gains include, for example, those arising on the
disposal of non-current assets. The definition of income also includes unrealized gains; for
example, those arising on the revaluation of marketable securities and those resulting from
increases in the carrying amount of long term assets. When gains are recognized in the income
statement, they are usually displayed separately because knowledge of them is useful for the
purpose of making economic decisions. Gains are often reported net of related expenses.
Various kinds of assets may be received or enhanced by income; examples include cash,
receivables and goods and services received in exchange for goods and services supplied.
Income may also result from the settlement of liabilities. For example, an entity may provide
goods and services to a lender in settlement of an obligation to repay an outstanding loan.
Expenses
Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.
The definition of expenses encompasses losses as well as those expenses that arise in the course
of the ordinary activities of the entity. Expenses that arise in the course of the ordinary activities
of the entity include, for example, cost of sales, wages and depreciation. They usually take the
form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property,
plant and equipment. Losses represent other items that meet the definition of expenses and may,
or may not, arise in the course of the ordinary activities of the entity. Losses represent decreases
in economic benefits and as such they are no different in nature from other expenses. Losses
include, for example, those resulting from disasters such as fire and flood, as well as those
arising on the disposal of non-current assets. The definition of expenses also includes unrealized
losses, for example, those arising from the effects of increases in the rate of exchange for a
foreign currency in respect of the borrowings of an entity in that currency. When losses are
recognized in the income statement, they are usually displayed separately because knowledge of
them is useful for the purpose of making economic decisions. Losses are often reported net of
related income.
Cost of Goods Sold
The cost of Goods Sold is the amount of cost of inventories which has been sold by the
organization. It shall comprise all costs of purchase, costs of conversion and other costs incurred
in bringing the inventories to their present location and condition. The costs of purchase of
inventories comprise the purchase price, import duties and other taxes (other than those
subsequently recoverable by the entity from the taxing authorities), and transport, handling and
other costs directly attributable to the acquisition of finished goods, materials and services.
Trade discounts, rebates and other similar items are deducted in determining the costs of
Page 476
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
purchase. The costs of conversion of inventories include costs directly related to the units of
production, such as direct labour. They also include a systematic allocation of fixed and variable
production overheads that are incurred in converting materials into finished goods. Fixed
production overheads are those indirect costs of production that remain relatively constant
regardless of the volume of production, such as depreciation and maintenance of factory
buildings and equipment, and the cost of factory management and administration. Variable
production overheads are those indirect costs of production that vary directly, or nearly directly,
with the volume of production, such as indirect materials and indirect labour
Depreciation
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful
life. The future economic benefits embodied in an asset are consumed by an entity principally
through its use. However, other factors, such as technical or commercial obsolescence and wear
and tear while an asset remains idle, often result in the diminution of the economic benefits that
might have been obtained from the asset.
Depreciation of an asset begins when it is available for use, i.e. when it is in the location and
condition necessary for it to be capable of operating in the manner intended by management.
Depreciation of an asset ceases at the earlier of the date that the asset is classified as held for
sale (or included in a disposal group that is classified as held for sale) and the date the asset is
derecognized. Therefore, depreciation does not cease when the asset becomes idle or is retired
from active use unless the asset is fully depreciated. However, under usage methods of
depreciation the depreciation charge can be zero while there is no production. Depreciation is
recognized even if the fair value of the asset exceeds its carrying amount, as long as the asset’s
residual value does not exceed its carrying amount. Repair and maintenance of an asset do not
negate the need to depreciate it.
Amortization
Amortization is the systematic allocation of the depreciable amount of an intangible asset over
its useful life. While the fixed assets with physical substance is depreciated, the intangible assets
is amortized over the useful life of the assets.
Impairment Loss
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount. The recoverable amount of an asset is the higher of its fair value less costs
to sell and its value in use.
Borrowing Cost
Borrowing costs are interest and other costs incurred by an entity in connection with the
borrowing of funds. Borrowing costs may include:
(a) interest on bank overdrafts and short-term and long-term borrowings;
(b) amortisation of discounts or premiums relating to borrowings;
(c) amortisation of ancillary costs incurred in connection with the arrangement of
borrowings;
UNIT 5: Prepartion of Financial Statements
Page 477
ICAN Advanced Accounting CAP II Chapter III
(d) finance charges in respect of assets acquired under finance leases or under other similar
arrangements; and
(e) exchange differences arising from foreign currency borrowings to the extent that they are
regarded as an adjustment to interest costs.
Illustration 1
You are required to prepare financial statements from the following trial balance of Haria
Chemicals Ltd. for the year ended 31st March, 2012.
Stock
Discount
Loan to Directors
Advertisement
Bad debts
Commission
Purchases
Plant and Machinery
Rentals
Furniture
Current account
Cash
Interest on bank loans
Preliminary expenses
Fixtures
Wages
Consumables
Freehold land
Tools & Equipments
Goodwill
Debtors
Bills receivable
Dealer aids
Transit insurance
Trade expenses
Distribution freight
Debenture interest
Page 478
Butwal Chemicals Ltd.
Trial Balance as at 31st Ashadh, 2070
Equity Shares Capital
6,80,000
(Rs. 10 each)
40,000 11% Debentures
80,000 Bank loans
20,000 Bills payable
35,000 Creditors
1,20,000 Sales
23,19,000 Rent received
8,60,000 Transfer fees
25,000
P/L account
2,00,000 Depreciation/Machinery
45,000
8,000
1,16,000
10,000
3,00,000
9,00,000
84,000
15,46,000
2,45,000
2,65,000
2,87,000
1,53,000
21,000
30,000
72,000
54,000
20,000
85,35,000
25,00,000
5,00,000
6,45,000
1,25,000
1,56,000
42,68,000
46,000
10,000
1,39,000
1,46,000
85,35,000
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Additional information: Closing stock on 31-3-2070: Rs. 8,23,000.
Solution
Butwal chemicals Ltd.
Statement of Financial Position as at 31st Ashadh, 2070
SN
1
2
3
1
2
Equity and Liabilities
Shareholders’ funds:
(a) Capital
(b) Reserves and Surplus
Non-Current Liabilities
(a) Secured loans
Current Liabilities
(a) Current Liabilities
Total
Assets
Non-Current Assets
Fixed Assets:
(a) Tangible Assets
Current Assets:
(a) Inventories
(b) Trade receivables
(c) Cash and cash equivalents
(d) Short term loans and advances
(e) Other current assets
Schedule
1
21
Amounts
25,00,000
7,50,000
11,45,000
3
281,000
4
46,76,000
5
32,70,000
8,23,000
2,87,000
53,000
2,33,000
10,000
6
7
Total
46,76,000
Note: Other assets represent preliminary expenses not written off Rs. 10,000.
Butwal Chemicals Ltd.
Income Statement for the year ended 31st Ashadh, 2070
Particulars
Schedule
Revenue from operations
Other income
Amounts
42,68,000
8
Total Income (A)
56,000
43,24,000
Cost of materials consumed
9
2,176,000
Manufacturing & other expenses
10
1,401,000
Interest & other financial charges
11
136,000
UNIT 5: Prepartion of Financial Statements
Page 479
ICAN Advanced Accounting CAP II Chapter III
Total Operating Expenses (B)
3,713,000
Profit Before Tax (A-B)
611,000
Provision for Tax
Profit After Tax
611,000
P/L Account of the previous years
139,000
P/L Account Carried forward to Statement of Financial
750,000
Position
Schedules
Schedule Particulars
1
Share capital
Authorized:
Equity share capital of Rs. 10 each
Issued and Subscribed:
Equity share capital of Rs. 10 each
2
3
4
Amounts
25,00,000
25,00,000
750,000
Reserves and Surplus:
Balance as per last Statement of Financial
Position
Balance of profit of the year
Long term Borrowings
11% Debentures
Bank loans
Trade Payables
Creditors
Bills Payables
139,000
611,000
1,145,000
500,000
645,000
281,000
156,000
125,000
Schedule 5. Tangible Assets
Assets
Goodwill
Freehold land
Furniture
Fixtures
Plant & Machinery
Tools & Equipment
Total
Page 480
Gross Block
Depreciation
15,46,000
8,60,000
2,45,000
34,16,000
1,46,000
1,46,000
Net Block
2,65,000
15,46,000
2,00,000
3,00,000
7,14,000
2,45,000
32,70,000
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Schedule
6
7
8
9
10
11
Particulars
Cash and cash equivalents
Current account balance
Cash
Short-term loans and Advances
Loan to directors
Bills Receivables
Other Income
Rent received
Transfer Fee
Cost of materials consumed
Opening stock
Add: purchases
Less: Closing stock
Manufacturing and Other Expenses:
Consumables
Wages
Bad debts
Discount
Rentals
Commission
Advertisement
Dealers’
aids
Transit insurance
Trade expenses
Distribution freight
Interest and Other Financial Charges
Interest on bank loans
Debenture interest
Amounts
53,000
45,000
8000
233,000
80,000
153,000
56,000
46,000
10,000
2,176,000
6,80,000
23,19,000
8,23,000
1,401,000
84,000
9,00,000
35,000
40,000
25,000
1,20,000
20,000
21,000
30,000
72,000
54,000
116,000
20,000
136,000
Illustration 2: From the following particulars furnished by Sunsari Traders Ltd., prepare the
Statement of Financial Position as at 31st Ashadh, 2070 Give notes at the foot of the Statement
of Financial Position as may be found necessary:
Particulars
Equity Capital (Face value of Rs. 100)
Calls in Arrears
Land
Building
Plant and Machinery
UNIT 5: Prepartion of Financial Statements
Debit Rs.
Credit. Rs.
1,000,000
1,000
200,000
350,000
525,000
Page 481
ICAN Advanced Accounting CAP II Chapter III
Furniture
General Reserve
Loan from State Financial Corporation
Stock :
Finished Goods
Raw Materials
Provision for Taxation
Sundry Debtors
Advances
Proposed Dividend
Profit and Loss Account
Cash Balance
Cash at Bank
Preliminary Expenses
Loans (Unsecured)
Sundry Creditors (For Goods and Expenses)
50,000
210,000
150,000
200,000
50,000
68,000
200,000
42,700
60,000
100,000
30,000
247,000
13,300
19,09,000
121,000
200,000
19,09,000
The following additional information is also provided:
(1)
Miscellaneous expenses included Rs. 5,000 audit fees and Rs. 700 for out of pocket
expenses paid to the auditors.
(2)
2,000 equity shares were issued for consideration other than cash.
(3)
Debtors of Rs. 52,000 are due for more than six months.
(4)
The cost of assets:
Building
Rs. 4,00,000
Plant and Machinery
Rs.7,00,000
Furniture
Rs. 62,500
(5)
The balance of Rs. 1,50,000 in the loan account with State Finance Corporation is
inclusive of Rs. 7,500 for interest accrued but not due. The loan is secured by
hypothecation of the Plant and Machinery.
(6)
Balance at Bank includes Rs. 2,000 with Perfect Bank Ltd., which is not a Scheduled
Bank.
Bills receivable for Rs. 2,75,000 maturing on 30th June, 2012 have been discounted.
The company had contract for the erection of machinery at Rs. 1,50,000 which is still
incomplete.
(7)
(8)
Page 482
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Solution:
Sunsari Traders Ltd.
Statement of Financial Position as on 31st Ashadh, 2070
SN
1
2
3
1
2
Schedule
Equity and Liabilities
Shareholders’ funds:
(c) Capital
(d) Reserves and Surplus
1
2
999,000
310,000
3
263,500
4
200,000
7,500
128,000
19,08,000
5
1,125,000
6
7
8
9
250,000
2,00,000
277,000
56,000
Non Current Liabilities
(a) Secured loans
Current Liabilities
a. Trade payables
b. Other Current Liabilities
c. Short terms provisions
Total
Assets
Non-Current Assets
Fixed Assets:
(b) Tangible Assets
Current Assets:
(a) Inventories
(b) Trade receivables
Cash and cash equivalents
(e) Other current assets
Amounts
(c)
Total
Schedules
Schedule
1
2
3
4
1,908,000
Particulars
Share capital:
Equity share capital
Less Calls in arrears
Reserves and Surplus:
Balance as per last Statement of
Financial Position
Balance of profit of the year
Long term Borrowings
Secured
Unsecured
Trade Payables
Interest Accrued but not due
Provision for Taxation
Proposed Dividend
UNIT 5: Prepartion of Financial Statements
Amounts
999,000
1,000,000
1,000
310,000
210,000
100,000
363,500
142,500
121,000
135,500
7,500
68,000
60,000
Page 483
ICAN Advanced Accounting CAP II Chapter III
Schedule 5
Tangible Assets: Fixed Assets
Assets
Gross Block
Depreciation
Net Block
Land
200,000
Building
400,000
50,000
350,000
Plant & Machinery
700,000
175,000
525,000
62,500
12,500
50,000
1,362,500
1,37,500
1,125,000
Furniture
Total
Schedule
6
7
8
9
Particulars
Inventories:
Raw Materials
Finished Goods
Trade Receivables
Debtors o/s > 6 months
Other Debtors
Cash & Cash Equivalent
Cash at Bank
Cash in Hand
Other Current Assets
Preliminary Expenses
Advances
2,00,000
Amounts
250,000
50,000
200,000
200,000
52,000
148,000
277,000
247,000
30,000
56,000
13,300
42,700
Notes:
a. Estimated amount of contract remaining to be executed on capital account and not provided
for Rs. 1,50,000.*
b. Bills receivable discounted maturing on 31st Ashwain, 2070 amount to Rs. 2,75,000.
* It has been assumed that the company had given this contract for purchase of machinery.
3.4 Statement of Changes in equity
Changes in an entity’s equity between two Statement of Financial Position dates reflect the
increase or decrease in its net assets or wealth during the period, under the particular
measurement principles adopted and disclosed in the financial statements. Except for changes
resulting from transactions with shareholders, such as capital contributions and dividends, the
overall change in equity represents the total gains and losses generated by the entities activities
during the period. An entity shall present a statement of changes in equity showing on the face
of the statement:
a. Profit or loss for the period;
Page 484
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
b. Each item of income and expense for the period, which, as required by other Standards, is
recognized directly in equity, and the total of these items; and
c. Total income and expense for the period (calculated as the sum of (a) and (b):, showing
separately the total amounts attributable to equity holders of the parent and to minority
interest; and
d. The cumulative effect of changes in accounting policy and the correction of fundamental
errors dealt with under the benchmark treatments in NAS 08: Accounting Policies,
Changes in Accounting Estimates & Errors. In addition, an entity shall present, either
within this statement or in the notes: Capital transactions with owners and distributions to
owners;
e. The balance of accumulated profit or loss at the beginning of the period and at the
Statement of Financial Position date, and the movements for the period; and
f. A reconciliation between the carrying amount of each class of equity capital, share
premium and each reserve at the beginning and the end of the period, separately
disclosing each movement.
One approach follows a columnar format which reconciles between the opening and closing
balances of each element within shareholders’ equity, including items (a) to (f). An alternative is
to present a separate component of the financial statements which presents only items (a) to (c).
Under this approach, the items described in (d) to (f) are shown in the notes to the financial
statements. Whichever approach is adopted, a sub – total of the items in (b) to enable users to
derive the total gains and losses arising from the entity’s activities during the period.
General Outline of Statement of Changes in Equity is as below:
Particulars
Balance at 31
Ashadh, 2069
Changes in
accounting policy
Restated balance
Surplus on
revaluation of
properties
Deficit on
revaluation of
investments
Currency translation
differences
Net gains and losses
not recognized in the
income statement
Share
Capital
Share
Revaluation
Premium
reserve
Translation
reserve
Accumulated profit
Total
xxx
Xxx
(xxx)
xxx
Xxx
(xxx)
(xxx)
xxx
Xxx
xxx
Xxx
UNIT 5: Prepartion of Financial Statements
xxx
xxx
xxx
xxx
Xxx
(xxx)
(xxx)
(xxx)
(xxx)
Page 485
ICAN Advanced Accounting CAP II Chapter III
Net profit for the
period
Divided
Issue of share capital
Balance at 31
Ashadh, 2069
Deficit on
revaluation of
properties
Surplus on
revaluation of
investments
Currency translation
difference
Net gains and losses
not recognised in the
income statements
Net profits for the
period
Dividends
Issue of share capital
Balance at 31
Ashadh, 2070
xxx
Xxx
xxx
Xxx
xxx
(xxx)
xxx
Xxx
xxx
Xxx
3.5 Cash flow statement
Cash Flow Statement is dealt in a separate Unit of this Chapter in detail.
3.6 Notes to the financial statements
Notes to the financial statements include narrative descriptions or more detailed analyses of
amounts shown on the face of the Statement of Financial Position, income statement, cash flow
statement and statement of changes in equity, as well as additional information such as
contingent liabilities and commitments. They include information required and encouraged to
be disclosed by Nepal Financial Reporting Standards, and other disclosures necessary to achieve
a fair presentation. The notes to the financial statements of an entity shall:
a. Present information about the basis of preparation of the financial statements and the
specific accounting policies selected and applied for significant transactions and events;
b. Disclose the information required by Nepal Financial Reporting Standards that is not
presented elsewhere in the financial statements; and
c. Provide additional information which is not presented on the face of the financial
statements but that is necessary for a fair presentation.
Notes to the financial statements shall, as far as practicable, be presented in a systematic
manner. Each item on the face of the Statements of Financial Position, Statement of Statement
of Profit or Loss statement of changes in equity and cash flow statement shall be cross –
Page 486
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
referenced to any related information in the notes are normally presented in the following order,
which assists users in understanding the financial statements and comparing them with financial
statements of other entities:
a. statement of compliance with Nepal Financial Reporting Standards (see paragraph 13);
b. statement of the measurement basis (bases) and accounting policies applied;
c. Supporting information for items presented on the face of each financial statement in
order in which each line item and each financial statement is presented; and
d. other disclosures, including:
i. contingencies, commitments and other financial disclosures; and
ii. non-financial disclosures.
In a nut cell the order of the notes to account is as below:




Statement of compliance with IFRS/NAS
Summary of significant accounting policies applied.
Supporting information for items presented in the statements of financial position and of
comprehensive income, statement of changes in equity, cash flows.
Other disclosures like contingent liabilities and unrecognized contractual commitments,
non financial disclosures like financial risk management objectives and policies.
Disclosure of Accounting Policies
An entity shall disclose in the summary of significant accounting policies:
a. the measurement basis (or bases) used in preparing the financial statements; and
b. the other accounting policy used that are relevant to an understanding of the financial
statements.
In deciding whether a particular accounting policy shall be disclosed, management considers
whether disclosure would assist users in understanding the way in which transactions and events
are reflected in the reported financial performance and financial position. The accounting
policies that an entity might consider to present include, but are not restricted to, the following:
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
revenue recognition;
consolidation principles, including subsidiaries and associates;
business combination;
joint ventures;
recognition and depreciation / amortization of tangible and intangible assets;
capitalization of borrowing costs and other expenditure;
construction contract;
investment properties;
financial instruments and investments;
leases;
research and development costs;
UNIT 5: Prepartion of Financial Statements
Page 487
ICAN Advanced Accounting CAP II Chapter III
l.
m.
n.
o.
p.
q.
inventries;
taxes;
provisions;
employee benefit costs;
foreign currency translation and hedging;
definition of business and geographical segments and the basis for allocation of costs
between segments;
r. definition of cash and cash equivalent; and
s. government grant.
Self Assessment Question
Question No. 1
The following balances have been extracted from the books of Paschimanchal Books Limited as
on 31st Ashadh, 2070
Cash in hand
Cash at Bank
Bills Receivable
Investment
Security Deposit
Advances
Debtors
Land and Buildings
Furniture
Motor Car
Closing Stock
Establishment expenses
Repairs and renewals
Motor Car Expenses
Travelling and Conveyance
Printing and Stationery
Telephone
Debenture Interest
Commission on sales
Advertisement
Managing Director’s remuneration
Directors fees
3,800
12,600
4,000
1,000
400
8,500
75,000
1,05,000
4,500
25,000
95,000
35,200
2,600
4,200
1,600
900
1,200
2,025
3,200
3,500
3,600
2,000
394,825
Page 488
Share Capital
9% Debentures
Sundry Creditors
Profit and Loss A/c
Secured Loan from bank
Gross Profit
Share Suspense
Liabilities for expenses
Sale of Furniture
Bills Payable
Miscellaneous Receipts
90,000
30,000
29,000
2,000
50,000
1,75,000
3,000
12,000
300
3,000
425
394,825
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
The following further particulars are available:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
(14)
(15)
(16)
Amount of share capital has been arrived at as follows:9,200 equity shares of Rs. 10 each, fully called up
92,000
Less: Calls-in-arrear @ Rs. 2 on 1,000 shares
2,000
90,000
The Statement of Profit or Loss balance has been arrived at after charging Rs. 5,000 on
account of short provision of taxation for the earlier year.
A Bank advice, for debit of Rs. 710 on account of interest on loan up to 31st Ashadh,
2070, was received on 5th Shrawan, 2070 the loan having been taken on 1stAshadh,
2070.
The Bank statement shows a wrong credit of Rs. 3,000 on 16th Ashadh, 2070, the same
being detected and adjusted by the Bank on 30th Shrawan, 2070
The 1,000 shares, on which calls were forfeited by the Board, and Share Suspense
represents the amount received on their reissue, as fully paid, by Board’s resolution.
Sale of furniture represents disposals, during the year, of a few old items of furniture
having a written-down value of Rs. 400 on 30th Poush, 2070, against their original cost
of Rs. 800.
Cost of land Rs. 30,000 is included in the amount of land and buildings.
Sundry debtors, which are all unsecured and considered goods, include Rs. 10,000 due
for more than six months.
Advertisement charges include materials of Rs. 1,500.
Advances include Rs. 3,000 paid for a new telephone installed during the year under the
OYT Scheme, of which an amount of Rs. 150 has been set off against the current year’s
bills.
Amounts of Rs. 2,000 and Rs. 1,200 debited to purchases and wages respectively, were
for making new furniture during the year.
Investment represents purchase of 200 equity shares of Rs. 10 each, Rs. 5 per share
called and paid up.
Charge depreciation on the closing written down amount of –
Buildings @ 2.5%
Furniture @ 10%
Motor Car @ 20%
Original costs of fixed assets were Buildings 1,00,000
Furniture 9,000
Motor Car 35,000
The Managing Director is entitled to 5% of the annual net profits as his remuneration,
subject to a minimum of Rs. 300 per month. The net profits, for this purpose, are to be
taken without charging income-tax and his remuneration itself.
Bills discounted not matured Rs. 1,500.
UNIT 5: Prepartion of Financial Statements
Page 489
ICAN Advanced Accounting CAP II Chapter III
(17) Provision for income-tax is to be made, for the year, of Rs. 65,000.
(18) The following appropriations have been proposed by the Board of Directors out of the
profit for the year (a) Transfer of Rs. 20,000 to General Reserve.
(b) Dividend of 12% on the paid-up capital.
(19) Debentures were issued two years back, and are not secured.
You are required to prepare the Statement of Profit or Loss for the year ended 31st Ashadh,
2070 and the Balance as on that date. Ignore previous year’s figures.
Question No.2
From the following information of AB Limited, you are required to prepare statement of
changes in equity for the year ended 31st Ashadh 2067:
Balance as on 1st Shrawan 2066:L
-
Share premium
Share Capital
Retained Earnings
General reserve
Rs.500,000
Rs.1,000,000
Rs.700,000
Rs.200,000
Profit earned during the year Rs.450,000
Cash dividend paid during the year Rs.200,000
10,000 shares of Rs.100 each were issued at Rs.120 per share.
Plant and machinery was revalued from Rs.100,000 to Rs.150,000.
Question No.3
Trial Balance (after preparation statement of profit or loss) of AD Limited as on 31st March
2019 was as follows:
Particulars
Dr. Rs.
Property, plant and Equipment
80,000
Inventory
3,000
Receivables
16,000
Cash
2,000
Cr. Rs.
Equity share capital of Rs.10 each
45,000
Revaluation reserve
12,000
Retained earnings
26,000
Trade payables
18,000
128,000
Page 490
101,000
UNIT 5: Prepartion of Financial Statements
ICAN Advanced Accounting CAP II Chapter III
Prepare statement of financial position at the end of the year. (based on current and non-current
classification).
Question No.4
The following information relates to BD Limited for the year ending 31st March 2019:
Rs.’000
Sales Revenue
1,350
Cost of Sales
780
Administrative expenses
180
Income tax provision
70
Gain on property revaluation
20
Required:
Statement of profit or loss and other comprehensive income for the year.
UNIT 5: Prepartion of Financial Statements
Page 491
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
UNIT 6:
Winding up of Companies
ICAN Advanced Accounting CAP II Chapter III
1. MEANING OF WINDING UP
Winding up of company is a legal procedure to dissolve the company and put an end to its life.
The company ceases to be a 'going concern'. The term winding up is defined as, 'the process by
which the life of a company is ended and its property is administered for the benefit of its
members and creditors.' During the process of winding up, the assets of the company are sold
and all the debts of the company are paid off. An administrator, called the liquidator, is
appointed to take control of the winding up process of the company. If any surplus is left, the
liquidator would distribute it among the owners of the company in accordance to their rights. In
case the assets are insufficient, the owners may have to compensate if the agreement so
specifies. Following are the steps of company dissolution:
Winding Up
When a company makes the decision to go out of business, it generally cannot simply close its
doors immediately after it makes that decision. Most businesses have long-term obligations to
employees, suppliers and customers as well as landlords and various other parties. A company
will have to take time to end these relationships and handle any obligations it has to various
stakeholders before it can close its doors.
Liquidation
Once a company has wound up its affairs, it can then sell its remaining assets. Some of these
assets, such as remaining inventory, may be liquidated as part of the winding up phase. Others,
such as land, buildings and equipment will typically be sold only after the company has
completely gone out of business.
Distribution of Assets
After a company's assets have been liquidated and converted into cash, the company must then
distribute that cash to the appropriate stakeholders. If the company has any outstanding debt, the
creditors have the right to be repaid first, according to the order in which their debt is
subordinated. Those creditors with the most subordinated debt will be repaid last. Only after all
creditors are repaid will the owners of the company be repaid, typically in proportion to their
level of ownership.
Dissolution
Once the company has wound up its affairs, liquidated its assets and distributed the proceeds of
that liquidation, it will dissolve the company formally. Companies have legal identities that
require a legal creation. Similarly, when a company ceases to be a going concern, it must legally
end its existence. This is known as dissolution. Typically, this only requires informing the
secretary of the state in which the company was founded that the company has gone out of
business
Modes of winding up may be Voluntary winding up, Winding up by Company Registrar Office
and Winding up by Court's order.
UNIT 6: Winding up of Companies
Page 493
ICAN Advanced Accounting CAP II Chapter III
2. VOLUNTARY LIQUIDATION OF COMPANY
Chapter 10 of Companies Act 2063 has made following provisions relating to voluntary
liquidation of a company:
Except in case where a company has become insolvent in accordance with the prevailing law on
insolvency, the shareholders of the company may liquidate the company either by adopting a
special resolution in the general meeting or according to the provision stated in memorandum of
association, articles of association or consensus agreement. A company may be voluntarily
liquidated under the following circumstance:
(a) If the company is able to pay its debts or other liabilities in full;
(b) If there exists no situation where an application for the review of insolvency of the
company is pending under the prevailing law on insolvency or where the company would
be in any manner subject to an insolvency proceeding under the prevailing law on
insolvency;
(c) If the directors of the company, have, after due inquiry, made a declaration in writing that
the company is able to pay its debts and other liabilities in full and that the debts and
liabilities to be paid on behalf of such company can be paid up or can be fully settled in any
other process within one year from the date of the adoption of the resolution to liquidate the
company;
(d) If the written declaration made by the directors pursuant to Clause (c) was presented in the
general meeting called to discuss the matter of liquidation of the company or such
declaration was made at the time of discussions on that matter in the general meeting.
A copy of the special resolution adopted with respect to the liquidation of a company and a
written declaration of directors shall be submitted to the Office of Registrar in no later than
seven days after the date of adoption of the resolution.
While adopting a resolution to liquidate a company, the company shall appoint a liquidator, a
practitioner licensed under the prevailing law on insolvency. The meeting should fix
remuneration to be paid to such liquidator. The company shall give information of the
appointment of a liquidator pursuant to the Office of Registrar no later than seven days after the
date of such appointment. After a liquidator is appointed the directors and officers of the
company shall relieved of their office and the liquidator shall exercise all such powers with
respect to the operation and management of company as may be exercisable by the directors and
officers of the company. The service of employees of a company shall, ipso facto, be terminated
after the liquidator commences the operation and management of the company. Provided,
however, that the liquidator may retain or appoint necessary employees for his/her support and
assistance. The liquidator appointed shall complete the liquidation proceedings of the company
within the period of time specified at the time of his/her appointment. Provided, however, that
in the case where the liquidation proceedings cannot be complete for any reason within the
specified period of time, a reasonable time limit may be extended by following the same
procedure as followed in his/her appointment. While appointing a liquidator, an auditor shall
also be appointed.
Page 494
UNIT 6: Winding up of Companies
ICAN Advanced Accounting CAP II Chapter III
If, after the liquidator has commenced proceedings of liquidation of accompany r, he/she is
satisfied that the company is insolvent and is not able to pay debts required to be paid or
discharge liabilities required to be discharged in full he/she shall make an application to have a
review of insolvency of the company in accordance with the prevailing law on insolvency.
After a liquidator has commenced his/her act, the liquidator shall take into his/her custody and
under his/her control all property, accounts and all records and documents of the company. The
liquidator appointed shall, mutatis mutandis, exercise and perform all the powers and duties
which may be exercised and performed by a liquidator under the prevailing law on insolvency.
It shall be the duty of the liquidator to do the following acts:
(a) To prepare and submit to the office, the statements and accounts of incomes and
expenditures in the course of liquidation in every six months after the appointment of the
liquidator;
(b) To inform the shareholders of the company about the progress on the liquidation
proceedings in every six months after the appointment of the liquidator;
(c) To obtain and recover all properties or amounts required to be obtained and recovered on
behalf of the company and repay and discharge the debts and other liabilities of all the
creditors of the company;
(d) Following the completion of the act as referred to in Clause (c) , to call the general meeting
of shareholders and present therein a proposed report and return on the distribution of the
remaining properties of the company to the shareholders;
(e) If the shareholders holding at least seventy five per cent of the paid up share capital consent
to the return as referred to in Clause (d), to make payment of amounts to the shareholders
accordingly;
(f) At the completion of liquidation proceedings, to prepare a report on the properties
recovered, payments made to the creditors and distributions made to the shareholders, on
behalf of the company, and submit such report, certifying that the company has been
liquated, accompanied by the auditor’s report, to the Office.
3. INSOLVENCY PROCEEDINGS
Insolvency Act, 2006 of Nepal defines the term “being insolvent” as a state of being unable, or
appearing to be unable, to pay any or all of the debts due and payable to or payable in the future
to creditors or a situation where the amount of liabilities of a company exceeds the value of the
assets. A company shall be deemed to have become insolvent on the following condition:
(a) The general meeting of shareholders adopts a resolution that the company has become
insolvent or a meeting of the board of directors of the company makes such decision; or
(b) The Court issues an order requiring the company to pay the debt and the debt is not paid up
within thirty five days from the date of receipt by the company of such order; or
UNIT 6: Winding up of Companies
Page 495
ICAN Advanced Accounting CAP II Chapter III
(c) The company fails to pay the debt within thirty five days after the service by the creditor on
the company a notice for the payment of the debt or fails to make an application to the
Court within the said period to void such notice.
No person can commence insolvency proceedings against any company without order of Court.
Where it is required to institute insolvency proceedings against any company, any of the
following persons may make an application to the Court in the prescribed form for the
institution of such proceedings:
(a) A company itself which has become insolvent;
(b) Out of the total creditors of a company which has become insolvent, at least ten percent
creditor or creditors who has or have lent money;
(c) Shareholder or shareholders that has or have subscribed at least five percent of shares, out
of the total shareholders of a company;
(d) Debenture-holder or debenture-holders that has or have subscribed at least five percent of
debentures, out of the total debenture-holders of a company;
(e) A liquidator who has been appointed to liquidate a company; or
(f) In the case of a company that carries on any specific type of business, a body authorized to
administer and regulate such business such as for BFIs, Nepal Rastra Bank.
Where the Court makes an order to restructure any company, the restructuring manager shall
prepare a restructuring scheme of the company in writing. The scheme prepared shall contain
the following programs:
(a) To capitalize the debt of the company and alter the capital structure ;
(b) To pay the claims of creditors by selling any portion of the assets of the company;
(c) To change the nature of claims of creditors of the company and issue securities for the
same;
(d) To get the creditors of the company to participate in capital investment by issuing shares in
consideration for their claims;
(e) To amalgamate the company with any other company;
(f) To change the management of the company; or
(g) To do any such other act which the Court considers appropriate to restructure the company.
Where the Court makes an order to liquidate a company, the Court shall make an order to
appoint one person as the liquidator, from amongst the persons who are entitled to carry on
insolvency business at the time of making of such order. Following the making of order, the
liquidation proceedings of the company shall be deemed to have commenced.
On the commencement of the liquidation proceedings of any company, the following provisions
shall govern the following matters in relation to such company:
(a) Where the director and officer of the company are relieved of office, the liquidator shall
exercise all such powers as may be exercisable by the director and officer of the company
in relation to the management of that company;
Page 496
UNIT 6: Winding up of Companies
ICAN Advanced Accounting CAP II Chapter III
(b) The liquidator shall take in his or her custody and control all assets, accounts and books of
account of the company, except the properties in possession of secured creditors;
(c) Except as ordered otherwise by the liquidator, the service of all employees appointed by
the company shall terminate.
The functions, duties and powers of the liquidator shall be as follows:
(a) To institute or defend any case or legal action on behalf of the company;
(b) To appoint employees to assist in the discharge of his or her functions;
(c) Where any installment on any share of the company is due, to make a call on the
shareholder for payment of such installment;
(d) To do and execute, or cause to be done and executed, all such acts and deeds or documents
as required to be done and executed on behalf of the company and in the name of the
company and use the seal of the company for that purpose;
(e) To borrow loans against security of the assets of the company;
(f) Where the liquidator considers that the sale and disposal of any property or termination of
any contract or liability will render benefits to the company, to sell and dispose of such
property or terminate such contract or liability;
(g) To enter into compromise with any creditor of the company or any person who claims to be
a creditor of the company in relation to the claim made by such creditor or person;
(h) To enter into compromise with any person against whom the company may make a claim
in relation to any loan, liability or any other claim;
(i) To sell the assets of the company and distribute the proceeds of such sale pursuant to this
Act; and
(j) To perform, or cause to be performed, all such other acts as may be necessary to liquidate
the company.
It shall be the duty of the liquidator to perform the following functions:
(a) To collect, protect and sell the assets of the company;
(b) To examine the business and financial situation of the company;
(c) To accept debt claim of any creditor;
(d) To distribute the proceeds of sale of the assets of the company subject to the order of
priority determined for the payment of liability;
(e) To call and conduct the meeting of creditors;
(f) To prepare a report on his or her acts and actions and present it to the Court and the Office;
(g) To facilitate the cancellation of registration of the company; and
(h) To examine or inquire into whether any director or employee or shareholder of the
company or any person has committed any fraud, cheating or deception against the
company or its creditors and institute necessary legal action against such person.
UNIT 6: Winding up of Companies
Page 497
ICAN Advanced Accounting CAP II Chapter III
In addition to the functions, duties and powers set forth above, the liquidator may also perform
other functions such as to get back any property of the company if such property is used by any
person or to institute legal action to get back such property or amount involved in a void
transaction, provided that the liquidator shall not be entitled to make such expenses as may not
be payable from the assets of the company.
Even though the company does not have adequate amount to pay necessary expenses or
remuneration to the liquidator for the exercise of the powers or performance of the duties , the
liquidator shall exercise such powers and perform such duties. Where the liquidator faces any
difficulty with the exercise of any power or the performance of any duty, the liquidator may
make an application to the Court for the removal of such difficulty; and where an application is
so made, the Court may, if it holds the application to be reasonable, remove difficulty.
Where any act to be done by any company which has become insolvent may render or yield
benefit or advantage to the creditors, any creditor of such company may advance money to the
liquidator to do such act. Any amount borrowed shall be paid from the amount received from
such act.
The liquidator shall prepare a progress report on the proceedings carried out in relation to the
company and submit it to the Court and the Office no later than three months after the date of
his or her appointment. The report shall state the following matters, in addition to other matters:
(a) The amount of issued capital of the company, capital that the shareholders have undertaken
to subscribe and paid-up capital;
(b) Estimated value of the assets and liabilities of the company;
(c) Opinion of the liquidator in relation to the reason for financial failure of the company;
(d) Opinion of the liquidator on the need to further examine or inquire into the promotion,
incorporation of the company or the affairs of the company and its directors and
shareholders;
(e) Such other necessary matters as the liquidator considers
A creditor of the company which has become insolvent shall submit a claim for the loan due and
outstanding or payable by such company to him or her also submit the proof and evidence
substantiating such claim, Where any company which has become insolvent has borrowed a
loan on the condition of paying interest on it according to the agreement entered into at the time
of borrowing such loan, such interest may also be included in the claim. Claim on any liability
of an undetermined value which has resulted from any loss caused by the company, or from any
compensation to be paid by the company to anyone as a result of its failure to comply with any
contract or for having violated any contract, or from any other action which creates a civil
obligation, or any claim on any contingent obligation of the company whose value is yet to be
determined but which has resulted from the failure of a debtor to fulfill any obligation for which
the company has provided guarantee under any guarantee agreement may be presented.
Page 498
UNIT 6: Winding up of Companies
ICAN Advanced Accounting CAP II Chapter III
Where there has been any other transaction between a company which has become insolvent
and any creditor who makes a debt claim against the company, the debt or such debt claim or
transaction shall be adjusted as follows:
(a) To determine the amount due to be paid by one party to the other party;
(b) To deduct the amount payable by one party to the other party from the amount determined
pursuant to Clause (a);
(c) To fix only the amount that remains after making deduction pursuant to Clause (b) as the
claim of debt payable by the company.
Any person who has supplied to or obtained a debt from the company when that person has
knowledge or had a reasonable reason to have knowledge that the company has become
insolvent shall not be entitled to make a claim to have the amount due to be paid to that person
by the company deducted from the amount payable by that person to the company.
Where any creditor who is also a shareholder of a company which has become insolvent makes
a claim against the company, and where that creditor has not paid any amount due on his or her
share and where the time has already matured to pay such amount or there may arise a situation
requiring him or her to pay the same, his or her claim up to the extent of the amount likely to be
so paid shall not be accepted.
4. ADDITIONAL DISCLOSURE AND COMMENTS ON 'GOING CONCERN' IN
RELATION TO WINDING UP
The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future. Hence, it is assumed that the
entity has neither the intention nor the need to liquidate or curtail materially the scale of its
operations; if such an intention or need exists, the financial statements may have to be prepared
on a different basis and, if so, the basis used is disclosed.
When preparing financial statements, management shall make an assessment of an entity’s
ability to continue as a going concern. Financial statements shall be prepared on a going concern
basis unless management either intends to liquidate the entity or to cease trading, or has no
realistic alternative but to do so. When management is aware, in making its assessment, of
material uncertainties related to events or conditions which may cast significant doubt upon the
entity’s ability to continue as a going concern, those uncertainties shall be disclosed.
An entity shall not prepare its financial statements on a going concern basis if management
determines that it intends to liquidate the entity or to cease trading or that it has no realistic
alternative but to do so. When financial statements are not prepared on a going concern basis,
that fact shall be disclosed, together with the basis on which the financial statements are
prepared and the reason why the entity is not considered as a going concern.
In case of winding up of the entity, the management of the entity decides to liquidate the entity.
Hence, the financial statement of the entity shall not be prepared on going concern basis and
measurement basis used in preparation of the financial statement may not be appropriate.
UNIT 6: Winding up of Companies
Page 499
ICAN Advanced Accounting CAP II Chapter III
Deterioration in operating results and financial position may indicate a need to consider whether
the going concern assumption is still appropriate. If the going concern assumption is no longer
appropriate, the effect is so pervasive that a fundamental change in the basis of accounting is
required, rather than an adjustment to the amounts recognized within the original basis of
accounting.
5.
ORDER OF SETTLEMENT OF LIABILITIES:
While settling the liabilities of a company which is being liquidated as per Insolvency Act, the
liquidator shall make payment of liabilities from the available funds according to the following
order of priority:
(a) All expenses associated with the functions discharged by the interim administrator
appointed and remuneration;
(b) Other amounts to be settled;
(c) All expenses associated with the functions discharged by the inquiry officer appointed and
remuneration;
(d) All expenses associated with the functions discharged by the restructuring manager and
remuneration;
(e) All debts of the company borrowed during the period of investigation of the insolvency
proceedings;
(f) All debts of the company borrowed during the period of the restructuring program of the
company;
(g) All expenses associated with the functions discharged by the liquidator appointed:
(h) and remuneration;
Wages and remuneration due and payable to the workers or employees of the company at
the time of the issue of the order under this Act to liquidate or restructure the company;
Provided that no director of the company shall be entitled to such amount.
(i) Amounts payable to the workers or employees of the company in consideration of home
leave, sick leave, gratuity and employee provident fund, if any, at the time of the issue of
the order under Insolvency Act, 2006 to liquidate or restructure the company; Provided that
no director of the company shall be entitled to such amount.
(j) All other amounts in consideration of debt claims accepted by the liquidator.
Every liability falling in the order of priority shall be treated equally; and all liabilities falling in
such order shall be settled fully, provided that if such liabilities cannot be settled fully, they
shall be settled proportionately. Where any liability of the company is insured, the amount
receivable under such insurance contract shall be paid to that person who is entitled to it. Where
the liabilities mentioned above are settled fully, the surplus shall be used by the liquidator to pay
interest payable on debts from the date of the order issued to liquidate or restructure the
Page 500
UNIT 6: Winding up of Companies
ICAN Advanced Accounting CAP II Chapter III
company to the date of acceptance of the debt claim. The amount remaining after such payment
shall be distributed among the preference shareholders, and the remaining amount shall be
distributed among the other shareholders proportionately.
Any claims made in relation to any debt or other liability in a foreign currency under this Act
shall be settled by calculating the value in the Nepali currency according to the exchange rate
fixed by the Nepal Rastra Bank for the day on which an application is made to the Court for the
liquidation, insolvency of the company or its restructuring.
Illustration
AB Ltd. was placed in voluntary liquidation on 31st December 2018 when its balance sheet was
as follows:
Liabilities
50,000 Equity Shares Rs.100 each Rs.10
per share paid up
Less calls in arrears amounting to
Rs.25,000
6,000 5% cumulative preference shares of
Rs.100 each fully paid
Securities premium account
5% Debentures account
Interest on debentures
Bank overdrafts
Creditors
Rs.
475,000
600,000
50,000
100,000
2,500
58,000
115,000
1,400,500
Assets
Freehold property
Plant & machinery
Motor Vehicles
Stock
Debtors
Profit & Loss A/c
Rs.
580,000
289,000
57,500
186,000
74,000
214,000
1,400,500
The preference dividends are in arrears from 2015 onwards.
The company’s articles provide that on liquidation, out of the surplus assets remaining after
payment of liquidation costs and outside liabilities there shall be paid firstly all arrears of
preference dividend, secondly the amount paid up on the preference shares together with a
premium thereon of Rs.10 each per share, and thirdly the balance then remaining shall be paid
to the equity shareholders.
The bank overdraft was guaranteed by the directors who were called upon by the bank to
discharge their liability under the guarantee. The directors paid the amount to the bank.
The liquidator realized the assets as under:
Freehold property Rs.700,000, Plant & machinery Rs.240,000, Motor vehicles Rs.59,000, stock
Rs.150,000 debtors Rs.60,000, calls in arrears Rs.25,000.
Creditors were paid less discount of 5 percent. The debentures and accrued interest were repaid
on 31st March 2019.
Liquidation costs were Rs.3,820 and the liquidator’s remuneration was 2% on the amounts
realized.
UNIT 6: Winding up of Companies
Page 501
ICAN Advanced Accounting CAP II Chapter III
Prepare liquidator’s final statement of accounts.
Solution
Liquidator’s Final Statement of Account
Receipts
To Assets realized:
- Calls in arrears
- Debtors
- Stock
- Motor Vehicle
- Plant & Machinery
- Freehold Property
Rs.
25,000
60,000
150,000
59,000
240,000
700,000
Payments
By Payment made:
- Liquidation costs
- Liquidator’s remuneration
(2% of 1,234,000)
- Debenture holders
(100,000 + 2,500 + 1,250)
- Bank Overdraft
- Creditors
- Preference Dividend
- Preference share (6,000 x 110)
- Equity shareholders (BF)
1,234,000
Rs.
3,820
24,680
103,750
58,000
109,250
120,000
660,000
154,500
1,234,000
Illustration
The available cash with the liquidator of a company after realizing all assets and paying all
liabilities is Rs.330,000.
The issued capital of the company is made up of:
30,000
10% preference shares of Rs.10 each fully paid.
30,000
Equity shares of Rs.10 each fully paid.
30,000
Equity shares of Rs.10 each Rs.8 paid per share.
30,000
Equity shares of Rs.5 each Rs.3 paid per share.
Preference dividend has been paid to date.
Prepare liquidator’s statement of account assuming that the required calls were made and the
amounts due were received in full.
Solution
Liquidator’s Final Statement of Account
Receipts
Rs.
To Assets realized:
- Cash Balance
330,000
- Call on Shares (30,000 x 30,000
Rs.1)
360,000
Page 502
Payments
Rs.
By Payment made:
- Preference share
300,000
- Refund to equity shares 60,000
(30,000 x Rs.2)
360,000
UNIT 6: Winding up of Companies
ICAN Advanced Accounting CAP II Chapter III
Working Note:
Paid up equity capital
30,000 x 10
30,000 x 8
30,000 x 3
300,000
240,000
90,000
630,000
30,000
Amount for equity after payment of preference
(330,000 – 300,000)
Deficit to equity share holders
No of equivalent equity shares of Rs.10 each
(30,000 + 30,000 + 30,000 x 5/10)
Deficit to each equity of Rs.10 (600,000/75,000)
Deficit to each equity of Rs.5 (8 x 5/10)
Refund to equity of Rs.10 fully paid
Call on equity of Rs.5, Rs.3 paid
600,000
75,000
Rs.8
Rs.4
(10 -8)
(4-3)
Rs.2
Rs.1
Illustration
AB Ltd. went into voluntary liquidation on 31-3-2018. The balances in its books on that date
were:
Liabilities
Authorized and subscribed:
5,000 6% preference shares of Rs.100
each fully paid
2,500 equity shares of Rs.100 each Rs.75
paid up
7,500 Equity shares of Rs.100 each of
Rs.60 paid up
5% debentures (secured by a floating
charges on all assets)
Interest due on debentures
Bank Overdraft
Unsecured Creditors
Taxes due to Govt.
Salaries & Wages
Rs.
500,000
187,500
450,000
250,000
12,500
100,000
200,000
12,000
60,000
1,772,000
Assets
Land
Building
Plant & Machine
Stock
Sundry Debtors
Cash at Bank
Profit & Loss A/c
Rs.
50,000
200,000
625,000
137,000
275,000
75,000
410,000
1,772,000
The liquidator is entitled to a remuneration of 5% on assets realized except cash and 1 % on the
amount distributed to unsecured creditors other than preferential creditors. Bank overdraft is
secured by deposit of the title deed of land and building which realized Rs.300,000. Other assets
realized the following sums:
UNIT 6: Winding up of Companies
Page 503
ICAN Advanced Accounting CAP II Chapter III
Plant & machinery
Stock
Sundry debtors
Expenses of liquidator’s amounted to Rs.
Rs.
500,000
150,000
200,000
27,750.
Prepare Liquidator statement of account. Liquidator realized all assets on and discharged his
obligation on the same date. Dividend on preference shares were in arrears for two years.
Solution
Receipts
To Assets realized:
- Cash in Hand
- Debtors
- Stock
- Plant & Machinery
- Land & Building
(Net of Liability)
Liquidator’s Final Statement of Account
Rs.
Payments
Rs.
By Payment made:
75,000
- Liquidation Expenses
27,750
200,000
- Liquidator’s Remuneration
54,500
150,000
- Debenture holders
112,500
500,000
- Taxes due to Govt.
12,000
200,000
- Salaries and Wages
60,000
- Unsecured Creditors
200,000
- Preference Dividend
60,000
- Preference Share
500,000
- Refund to equity of Rs.75 paid 52,687.5
(2,500 x 21.075)
- Refund to equity of Rs.60 paid 45,562.5
(7,500 x 6.075)
1,125,000
1,125,000
Working Note:
1.
Liquidator’s Remuneration
5% of (200,000 + 150,000 + 500,000 +200,000)
1% of (200,000)
Total
2.
Distribution to Equity Shareholders
Cash available for equity shareholders
Paid up equity capital (187,500 + 450,000)
Deficit to equity shareholders
No. of equity shares
Deficit to each equity (539,250/10,000)
Refund to equity of Rs.75 paid (75-53.925)
Refund to equity of Rs.60 paid (60- 53.925)
Page 504
= 52,500
= 2,000
54,500
Rs.98,250
Rs.637,500
Rs.539,250
10,000
Rs.53.925
Rs.21.075
Rs.6.075
UNIT 6: Winding up of Companies
CHAPTER III
Preparation and Presentation of
Financial Statements for Company
UNIT 7:
Accounting for Business Combination
ICAN Advanced Accounting CAP II Chapter III
1. MEANING OF BUSINESS COMBINATION
A business combination is the bringing together of separate entities or businesses into one
reporting entity. The result of nearly all business combinations is that one entity, the acquirer,
obtains control of one or more other businesses, the acquiree. If an entity obtains control of one
or more other entities that are not businesses, the bringing together of those entities is not a
business combination. A business combination may be structured in a variety of ways for legal,
taxation or other reasons. It may involve the purchase by an entity of the equity of another
entity, the purchase of all the net assets of another entity, the assumption of the liabilities of
another entity, or the purchase of some of the net assets of another entity that together form one
or more businesses. It may be effected by the issue of equity instruments, the transfer of cash,
cash equivalents or other assets, or a combination thereof. The transaction may be between the
shareholders of the combining entities or between one entity and the shareholders of another
entity. It may involve the establishment of a new entity to control the combining entities or net
assets transferred, or the restructuring of one or more of the combining entities.
A business combination may result in a parent-subsidiary relationship in which the acquirer is
the parent and the acquiree is thesubsidiary of the acquirer. A business combination may
involve the purchase of the net assets, including any goodwill, of another entity rather than the
purchase of the equity of the other entity. Such a combination does not result in a parentsubsidiary relationship.
A business combination involving entities or businesses under common control is a business
combination in which all of the combining entities or businesses are ultimately controlled by
thesame party or parties both before and after the business combination, and that control is not
transitory.
The entity that issues equity is usually the acquirer in a business combination that primarily
involves the exchange of equity. However, it is sometimes not clear which party is the acquirer
if a business combination is effected through the exchange of equity interests. In these
situations, the acquirer for accounting purposes may not be the legal acquirer (i.e., the entity that
issues its equity interest to effect the business combination). Business combinations in which
the legal acquirer is not the accounting acquirer are commonly referred to as “reverse
acquisitions”.
“Roll-up” or “put-together” transactions typically result when several unrelated companies in
the same market or in similar markets combine to form a larger company.
Merger: In this case two more companies are dissolved and assets and liabilities of the
dissolved companies are transferred to a newly created company.
Acquisition: In this case only one of the combining companies survives and the other losses its
separate identity. The assets and liabilities of the acquired company are transferred to the
acquiring company.
Page 506
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Reconstruction: The term reconstruction mainly refers to the reorganization of a company
which has suffered heavy losses in the past or is overcapitalized. Such reorganization may take
the form of external or internal reconstruction. In the case of external reconstruction, a new
company is floated to take over the business of the company to be reorganized which is then
liquidated. In case of internal reconstruction, reorganization is done without resorting to the
liquidation of the company. The object of the internal reconstruction is usually to reorganize
capital or to compound with creditors or to effect economies. No new company is formed in this
case and no sale of business takes place.
There are generally three common ways in which companies can amalgamate together to gain
advantage in their market. They are as under:
Horizontal merger occurs between companies in the same industry. It is a business
consolidation that occurs between firms which operate in the same space, often as competitors
offering the same good or service. Horizontal mergers are common in industries with fewer
firms, as competition tends to be higher and the synergies and potential gains in market share
are much greater for merging firms in such an industry.
Vertical merger takes place when firms from different parts of the supply chain consolidate in
order to make the production process more efficient or cost effective.By directly merging with
suppliers, a company can decrease reliance and increase profitability. An example of a vertical
merger is a car manufacturer purchasing a tire company.
Conglomerate merger is a merger between firms that are involved in totally unrelated business
activities. There are two types of conglomerate mergers: pure and mixed. Pure conglomerate
mergers involve firms with nothing in common, while mixed conglomerate mergers involve
firms that are looking for product extensions or market extensions. There are many reasons for
firms to want to merge, which include increasing market share, synergy and cross selling. Firms
also merge to diversify and reduce their risk exposure. However, if a conglomerate becomes too
large as a result of acquisitions, the performance of the entire firm can suffer.
2. Legal procedure for Business Combination
Section 177 of Companies Act 2063 has made following provisions relating to merger:
(1)
(2)
(3)
A public company may, by adopting a special resolutions in its general meeting to that
effect, be merged with another company subject to Sub-section (3).
Provided, however, that, in the case of a private company it shall be as provided in its
memorandum of association, articles of association or consensus agreement.
A public company, upon merging into a private company or a private company, upon
merging into a public company shall stand as a public company.
If a resolution for merger is adopted pursuant to Sub-section(1),such company shall,
within thirty days , make an application, setting out the following matters to the Office for
approval:
(a) In the case of a public company, a copy of the decision of the general meeting as
referred to in sub- section (1) ,and in the case of private company , copies of the
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 507
ICAN Advanced Accounting CAP II Chapter III
(4)
(5)
(6)
(7)
related provisions contained in the memorandum of the associations, articles of the
associations, or consensus agreement authorizing the merger;
(b) Last Statement of Financial Position and auditor's report of the merging company;
(c) A copy of the letter of consent in writing, of the creditors of the merging company
and of the merged company;
(d) Valuation of the movable and immovable properties of ,and actual details of the
assets and liabilities of, the merging company;
(e) If the merging company and merged company have made a decision as to the
creditors and employees and workers of the merging company, a copy of such
decision;
(f)
The scheme of arrangement concluded between the companies for merger with
each other.
Where the information as referred to in Sub-section (3) is given to the Office, it shall
study the matter given information and give its decision within three months.
On receipt of an approval from the Officer for merger pursuant to Sub-section (4), all the
assets and liabilities of the merging company shall be deemed to have been transferred to
the merged company.
The office shall maintain separate records of the merging company in the company
registration book.
Except as otherwise provided in the memorandum of association, articles of association
or consensus agreement of the company, a shareholder who does not express his/her
consent in writing to the unification or merger or alteration in, or transfer of, shares of the
company or the sale of entire assets of the company shall be entitled to get the company’s
assets valuated prior to such unification, merger or alteration in or transfer of shares or
sale of assets and get return of the amount in proportion to the shares held by him/her
from the merging company.
Notwithstanding anything contained elsewhere in this Section, the Office shall not give
approval for the merger of a company if such merger appears to create a monopoly or unfair
trade restriction or to be contrary to public interest.
3. PURCHASE CONSIDERATION
Purchase consideration refers to the cash and non-cash payments made to the shareholders (both
equity and preference) of the transferor company as consideration for the business acquired
from the transferor company (i.e. vendor Company).
Methods of Computing Purchase Consideration
Purchase consideration is sometimes given as a certain amount directly. In this case there is no
need to compute the purchase consideration. When such amount is not given, there is need to
compute and there are three methods of computing purchase consideration. They are:
 Net payment method,
 Net assets method, and
 Ratio of exchange method.
Page 508
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
3.1 Net Payments Method
Under this method all payments made in the form of shares, debentures, other securities and
cash to the shareholders of the transferor company are aggregated to obtain purchase
consideration.
Statement showing calculation of
Purchase Consideration
Particular
Rs.
×××
Payment in cash
×××
Payment in equity shares
×××
Payment in Pref. shares
×××
Payment in Assets
Purchase Consideration
×××
Illustration: -1
Annapurna Ltd. agrees to take over the business of Sampurna Ltd. on the following terms:
(a)
The shareholders of Sampurna Ltd. are to be paid Rs. 25 in cash and the offer of four
shares of Rs. 10 each in Annapurna Ltd. for every share of SampurnaLtd. Sampurna Ltd.
has 50,000 equity shares outstanding.
(b)
The debenture holders holding 5,000 debentures of Rs. 100 each are to be redeemed at a
premium of 10%.
(c)
Costs of liquidation amounting to Rs. 25,000 are to be borne by Annapurna Ltd.
Compute the amount of purchase consideration
Solution:
Calculation of Purchase Consideration for Sampurna Ltd
Particular
Cash payment (50,000 × Rs. 25)
Shares issued (50,000 × 4 × Rs. 10)
Cash paid for liquidation expenses
Total purchase consideration
Rs .
12,50,000
20,00,000
25,000
32,75,000
3.2 Net Assets Method
Under this method, student is given the values at which various assets and liabilities are taken
over by the transferee company and there is no mention of payments to the shareholders. Here
purchase consideration is to be ascertained by adding the agreed values of assets taken over and
deducting there from the agreed values of liabilities taken over. In the absence of agreed values,
book values can be taken. It may be noted that this method is used only in circumstances where
the first method cannot be adopted.
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 509
ICAN Advanced Accounting CAP II Chapter III
Statement showing calculation of
Purchase Consideration
Particular
Assets taken over (fair value)
Liabilities taken over (fair value)
Net Assets taken over/ Purchase Consideration
Rs
×××
×××
×××
Under Net Assets method, there will be no goodwill or capital reserve because there will be no
difference in between Net Assets and Purchase Consideration.
Illustration:2
You are given the Statement of Financial Position of Hamro. Ltd. as on 31st Ashadh, 2070:
Liabilities
10,000 Equity shares of Rs. 10 each fully paid
General Reserve
Profit and Loss account
Trade Creditors
Provision for Taxation
Proposed Dividends
Rs.
1,00,000
3,00,000
1,00,000
1,50,000
1,20,000
80,000
8,50,000
Assets
Fixed Assets
Investments
Current Assets
Preliminary Expenses
Share Issue Expenses
4,00,000
1,00,000
2,50,000
60,000
40,000
8,50,000
On the date of Statement of Financial Position the company was taken over by TimroLtd. on the
following terms:
1.
2.
3.
4.
5.
Fixed assets are revalued at Rs. 5, 60,000.
Investments have only a market value of Rs. 80,000.
Current assets are agreed at Rs. 3, 00,000 for the purpose of absorption.
The tax liability which is estimated at Rs. 1, 30,000.
Dividends are to be paid before absorption by Hamro. Ltd.
You are required to compute the purchase consideration.
Page 510
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Solution:
Calculation of Purchase Consideration
Particular
Rs
Assets taken over by TimroLtd.
Fixed assets
Investments
Current assets
Less: Cash for payment of dividend
3,00,000
80,000
Less: Liabilities taken over- Trade creditors
Tax liability
1,50,000
1,30,000
Purchase consideration payable to the shareholders of Hamro. Ltd.
Rs.
5,60,000
80,000
2,20,000
8,60,000
2,80,000
5,80,000
This amount TimroLtd. may pay in the form of securities (debentures and shares) and/or Cash.
3.3 Share Exchange method
In many cases the transferee company issues its own shares to the shareholders of the
transferor company on the basis of certain ratio. The ratio of exchange may be decided on the
basis of the intrinsic or market value of the shares concerned. The purchase consideration is
arrived at by multiplying the number of shares issued to the shareholders of the transferor
company with the market value or intrinsic value of the shares of the transferee company as the
case may be.
Illustration: - 3
Strong Ltd. takes over Weak Ltd. in pursuance of a scheme of amalgamation and it was agreed
that shareholders of Weak Ltd. must be issued shares in Strong Ltd. and the exchange is to be
determined on the basis of the intrinsic values of the shares of the two companies concerned.
The capital of Weak Ltd. comprises 1, 00,000 equity shares of Rs. 10 each. The intrinsic values
were, Strong Ltd. Rs. 40 and Weak Ltd. Rs. 25. In allotment fractional shares are aggregate to
500. The market value of the share of Strong Ltd. was Rs. 60. You are required to compute the
purchase consideration payable to Weak Ltd.
Solution:
5 shares of Strong Ltd. would have intrinsic value of 5 x Rs. 40 = Rs. 200
8 shares of Weak Ltd. would have intrinsic value of 8 x Rs. 25 = Rs. 200
 The ratio of exchange would be 5 shares of Strong Ltd. for every 8 shares of Weak Ltd.
 Number of shares to be issued by Strong Ltd = 1,00,000 x 5/8 = 62,500.
Actual number of shares to be issued to shareholders of Weak Ltd. would be 62,500 less 500
fractional shares, i.e., 62,000.
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 511
ICAN Advanced Accounting CAP II Chapter III
The purchase consideration=
62,000 shares × Rs. 40
Fractional shares 500 × Rs. 40
=
=
Total
Rs. 24,80,000
20,000
25,00,000
However the 500 shares representing fractional shares will be sold in the market at Rs. 60 per
share and the total amount of Rs. 30,000 will be remitted to the individual shareholders
according to the fraction of share shareholdersare entitled to. If Mr A is getting a fractional
share, he will receive 0.3 x 60 = Rs. 18,similarly,Mr B is entitled to 0.5 fractional share, he will
receive 0.5 x 60 = Rs. 30 and others similarly. The total amount so remitted equals Rs. 30,000.
Cost of Business Combination (Purchase Consideration) as per
NFRS 3: Business Combination
The acquirer shall measure the cost of a business combination as the aggregate of:
(a) the fair values, at the date of exchange, of assets given, liabilities incurred or
assumed, and equity instruments issued by the acquirer, in exchange for control of the
acquiree; plus
(b) any costs directly attributable to the business combination.
When settlement of all or any part of the cost of a business combination is deferred, the fair
value of that deferred component shall be determined by discounting the amounts payable to
their present value at the date of exchange, taking into account any premium or discount
likely to be incurred in settlement.
Future losses or other costs expected to be incurred as a result of a combination are not
liabilities incurred or assumed by the acquirer in exchange for control of the acquiree, and are
not, therefore, included as part of the cost of the combination.
The cost of a business combination includes any costs directly attributable to the
combination, such as professional fees paid to accountants, legal advisers, valuers and other
consultants to effect the combination. General administrative costs, including the costs of
maintaining an acquisitions department, and other costs that cannot be directly attributed to
the particular combination being accounted for are not included in the cost of the
combination; they are recognized as an expense when incurred.
4. METHOD OF ACCOUNTING FOR AMALGAMATIONS
Method of Accounting for Business Combination as per NFRS 3
All business combinations shall be accounted for by applying the purchase method. The
purchase method views a business combination from the perspective of the combining entity
that is identified as the acquirer. The acquirer purchases net assets and recognizes the assets
acquired and liabilities and contingent liabilities assumed, including those not previously
recognized by the acquiree. The measurement of the acquirer’s assets and liabilities is not
affected by the transaction, nor are any additional assets or liabilities of the acquirer recognized
as a result of the transaction, because they are not the subjects of the transaction.
Page 512
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Applying the purchase method involves the following steps:
(a)
identifying an acquirer;
(b)
measuring the cost of the business combination; and
(c)
allocating, at the acquisition date, the cost of the business combination to the assets
acquired and liabilities and contingent liabilities assumed.
The acquirer shall, at the acquisition date:
(a)
recognize goodwill acquired in a business combination as an asset; and
(b)
initially measure that goodwill at its cost, being the excess of the cost of the business
combination over the acquirer’s interest in the net fair value of the identifiable assets,
liabilities and contingent liabilities recognized
Goodwill acquired in a business combination shall not be amortized. Instead, the acquirer shall
test it for impairment annually or more frequently if events or changes in circumstances indicate
that it might be impaired, in accordance with NAS 36Impairment of Assets.
If the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent
liabilities recognised exceeds the cost of the business combination (said as Capital Reserve in
Indian context), the acquirer shall:
(a)
(b)
reassess the identification and measurement of the acquiree’s identifiable assets,
liabilities and contingent liabilities and the measurement of the cost of the combination;
and
recognize immediately in profit or loss any excess remaining after that reassessment.
Illustration 4
Following are the Statement of Financial Positionof Kantipur Ltd. and Nagarik ltd.
Statement of Financial Position
Liabilities
Equity Share
Capital
(Rs. 10 each)
14% Preference
ShareCapital (Rs.
100 each)
General Reserve
Export Profit
Reserve
Investment
AllowanceReserve
Profit & Loss A/c
13%
Kantipur
Ltd.
Rs.'000
50,00
22,00
5,00
3,00
7,50
5,00
Nagarik
Ltd.
Rs.'000
Assets
Land &
30,00 Building
Plant &
Machinery
17,00 Furniture &
2,50 Fittings
2,00 Investments
Stock
1,00 Debtors
5,00 Cash & Bank
Kantipur
Ltd.
Rs.'000
25,00
32,50
5,75
7,00
12,50
9,00
7,25
Nagarik
Ltd.
Rs.'000
15,50
17,00
3,50
5,00
9,50
10,30
5,20
3,50
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 513
ICAN Advanced Accounting CAP II Chapter III
4,50
2,00
99,00
Debenture(Rs. 100
each)
Trade Creditors
Other Current
Liabilities
3,50
1,50
66,00
99,00
66,00
Kantipur Ltd. takes over Nagarik Ltd. on 1st Shrawan, 2070. Kantipur Ltd. discharges the
purchase consideration as below:
a.
Issued 3, 50,000 equity shares of Rs. 10 each at par to the equity shareholders of Nagarik
Ltd.
b.
Issued 15% preference shares of Rs. 100 each to discharge the preference shareholders of
Nagarik Ltd. at 10% premium.
c.
The debentures of Nagarik Ltd. will be converted into equivalent number of debentures of
Kantipur Ltd. The statutory reserves of Nagarik Ltd. are to be maintained for 2 more
years.
Show the Statement of Financial Position of Kantipur Ltd. after amalgamation.
Solution:
Statement of Financial Position of Kantipur Ltd.
Liabilities
Equity Share Capital
(Rs. 10 each)
15% Preference Share
Capital (Rs. 100
each)
14% Preference Share
Capital (Rs. 100
each)
General Reserve
Capital Reserve
Profit & Loss A/c
Export Profit Reserve
Investment Allowance
Reserve
13% Debentures
(Rs. 100 each)
Trade Creditors
Other Current Liabilities
Kantipur Ltd.
Rs.'000
Assets
Land & Building
85,00 Plant & Machinery
Furniture & Fittings
Investments
18,70 Stock
Debtors
Cash & Bank
22,00 Amalgamation
5,00 Adjustment A/c
3,80
7,50
5,00
1,00
8,50
8,00
3,50
168,00
Page 514
Kantipur Ltd.
Rs.'000
40,50
49,50
9,25
12,00
22,00
19,30
12,45
3,00
168,00
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Workings Notes: Capital Reserve arising on Amalgamation:
Rs. ('000)
(A)
(B)
Net Assets taken over:
Sundry Assets
Less: 13% Debentures
Trade Creditors
Other current liabilities
Purchase consideration:
To Equity Shareholders of Nagarik Ltd.
To Preference Shareholders of Nagarik
Ltd.
Rs.('000)
66,00
3,50
3,50
1,50
(C)
Capital Reserve (A - B)
8,50
57,50
35,00
18,70
53,70
3,80
5. ACCOUNTING IN THE BOOKS OF TRANSFEROR COMPANY
The scheme of accounting in the books of the transferor company is to close the books by
eliminating all assets and external liabilities, find out the profit or loss on realization, transfer
the same along with other amounts due to shareholders, to a newly opened ‘shareholders
account’ and close the same by payment to shareholders, the purchase consideration received
from the transferee company.
The profit or loss on realization (sale of business) is ascertained by opening a realization
account to which all assets and liabilities are transferred. The account is credited with purchase
consideration and debited with Realization expenses, if any, paid by the transferor company.
The realization account discloses the profit or loss which is transferred to shareholders’ account.
All amounts due to shareholders such as share capital, reserves and Statement of Profit or Loss
balances are also transferred to shareholders’ account. Likewise fictitious assets and
accumulated losses are also transferred to shareholders’ account. As stated in the previous
paragraph, the shareholders’ account is closed by debiting the same with the shares and cash
received from the transferee company and distributed among the shareholders in settlement of
their claims.
Accounting entries for various steps involved in closing the books of the transferor company are
given below:
Transactions
Account to be
1.
Closing of assets accounts
Debited
Realization
2.
Closing of liabilities
Loans A/c
UNIT 7: Amalgamation, Absorption and Reconstruction
Credited
Fixed assets A/c
Investment A/c
Current Assets
A/c(except cash &
Bank)
Page 515
ICAN Advanced Accounting CAP II Chapter III
Current Liabilities A/c
Realization
Transferee Company
Realization
Bank
Realization
Realization
Bank
Realization
Bank
Realization
8.
Purchase consideration payable by
the transferee company
Realization of assets not taken over
by transferee company
Payment of liabilities not taken over
by transferee company
Realization expenses borne by
transferor company
Premium
on
redemption
of
Preference shares
Profit on realization
9.
Loss on realization
Equity Shareholders
A/c
Pref. Shareholders
A/c
Equity Shareholders
A/c
Realization
3.
4.
5.
6.
7.
Realization
10. Transfer of Equity Share Capital,
Reserves, etc. to Equity shareholders Equity Share Capital
General Reserve
A/c
Profit & Loss(Cr.)
11. Transfer of Preference Share Capital
Preference Share
to Preference Shareholders A/c
capital A/C
12. Transfer of accumulated losses and
fictitious
assets
to
Equity Equity Shareholder A/c
Shareholders A/c
Shares/Debentures
/Bank
13. Receipt of purchase consideration
14. Payment to Preference Shareholders
15. Payment to Equity Shareholders
Equity Shareholders
A/c
Pref. Shareholders
A/c
Profit & Loss (Dr.)
Fictitious Asset
Transferee company
A/c
Preference
Shareholders
Shares/Debentures
/Bank
Equity Shareholders
Shares/Debentures
/Bank
Notes:
1.
The cash may not be taken over by the transferee company. In thiscase, the cash and bank
balance should not be transferred to realization account and such cash may be utilized to
meet realization expenses and payment of creditors and shareholders.
2.
In case fair value is not specified for any asset then book value can be used in practical
questions. However, the specified principle should not be applied on Intangible Assets.
Transferee Company can incorporate intangible assets of the transferor company in its
books only if fair value can be measured. Otherwise, NIL value is to be taken.
Page 516
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
3.
4.
5.
If taken over items are specified in the question, then transferee company should
incorporate in its books the specified items only. But in the absence of any specific
information, Transferee Company should take over all assets and liabilities (including
cash and bank balances).
When cash and bank balances of transferor company is taken over by transferee
company, then such cash and bank balance should be transferred to Realization A/c.
Realization A/c…………………..Dr
To cash and bank A/c
If liquidation expenses of Transferor Company are paid by the transferee company the
goodwill a/c should be debited by Transferee Company.
Goodwill A/c…………………….Dr
To Bank A/c
Illustration 5:
Prachanda Ltd. acquires the business of Baburam Ltd. whoseStatement of Financial Position
on 31st Ashadh, 2070 is as under:
Liabilities
Share capital divided into shares
of Rs. 100 each
6% Preference share capital
Equity share capital
Capital Reserve
Profit & Loss A/c
6% Debentures
Interest outstanding on above
Workmen's Compensation
Reserve
(Expected liability Rs. 5,000)
Trade Creditors
Rs. Assets
Goodwill
Land & Buildings
4,00,000 Plant and Machinery
8,00,000 Patents
1,00,000 Stock
50,000 Books Debts
2,00,000 Cash at Bank
12,000 Underwriting Commission
8,000
1,20,000
16,90,000
Rs.
2,00,000
4,00,000
6,00,000
50,000
1,50,000
1,80,000
70,000
40,000
16,90,000
Prachanda Ltd. was to take over all assets (except cash) and liabilities (except for interest due on
debentures) and to pay following amounts:
i.
Rs. 2,00,000 7% Debentures (Rs. 100 each) in Prachanda Ltd. for the existing
debentures in Baburam Ltd.; for the purpose, each debenture of Prachanda Ltd. is to be
treated as worth Rs. 105.
ii.
For each preference share in Baburam Ltd. Rs. 10 in cash and one 9% preference share
of Rs. 100 each in Prachanda Ltd.
iii.
For each equity share in Baburam Ltd. Rs. 20 in cash and one equity share in Prachanda
Ltd. of Rs. 100 each having the market value of Rs. 140.
iv.
Expenses of liquidation of Baburam Ltd. are to be reimbursed by Prachanda Ltd. to the
extent of Rs. 10,000. Actual expenses amounted to Rs. 12,500.
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 517
ICAN Advanced Accounting CAP II Chapter III
Prachanda Ltd. valued Land and building at Rs. 5, 50,000 Plant and Machinery at Rs. 6, 50,000
and patents at Rs. 20,000.
Solution:
Purchase Consideration:
(i)
Preference Shares : Rs. 10 per share
Preference shares
(ii)
Equity shares : Rs. 20 per share
8,000 equity shares in Y
Ltd.
@ Rs. 140
Rs.
40,000
4,00,000
Rs.
From
Cash
4,40,000 Preference Shares
Cash
1,60,000
12,80,000
Equity Shares
11,20,000
17,20,000
JOURNAL ENTRIES
Date
Page 518
Particular
Realization A/c
To Sundries —
Goodwill
Land & Building
Plant & Machinery
Patents
Stock
Book debts
(Transfer of assets to Realization Account on sale
of business to Prachanda Ltd..)
Dr.
6% Debentures in Prachanda Ltd..
Workmen's Compensation Reserve
Trade Creditors
To Realization A/c
(Transfer of liabilities taken over by Prachanda
Ltd.. to Realization A/c)
Dr.
Prachanda Ltd..To Realization A/c
(Amount receivable from Prachanda Ltd.. for sale
of business)
Dr.
Cash A/c
9% Preference shares in Prachanda Ltd.
Equity shares in Prachanda Ltd.
Dr.
Debit Rs.
15,80,000
Credit Rs.
2,00,000
4,00,000
6,00,000
50,000
1,50,000
1,80,000
2,00,000
5,000
1,20,000
3,25,000
17,20,000
17,20,000
2,00,000
4,00,000
11,20,000
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
To Prachanda Ltd..
(Receipt of purchase consideration from the
purchase company)
17,20,000
Prachanda Ltd..
Realization A/c
To Cash A/c
(Liquidation expenses out of which Rs. 10.000 is
payable by Prachanda Ltd..)
Dr.
Cash A/c
To Prachanda Ltd..
(Account reimbursed by Prachanda Ltd.. for
expense)
Dr.
Interest Outstanding
To Debenture holders A/c
(Amount due to debenture holders for debentures
interest)
Dr.
Debenture holders A/c
To Cash A/c
(Debenture holders paid cash Rs. 12,000 for
outstanding interest)
Dr.
6% Pref. Share Capital A/c
Realization A/c
To Preference Shareholders A/c
(The amount due to preference shareholders for
capital and the extra amount payable under the
scheme of absorption)
Dr.
Dr.
Preference shareholders A/c
To Cash A/c
To 9% Preference shares in Prachanda Ltd..
(Cash and preference shares in Prachanda Ltd..
given to preference shareholders)
Dr.
Equity Share Capital A/c
Capital Reserve A/c
Profit and Loss A/c
Workmen's Compensation Reserve A/c
Dr.
Dr.
Dr.
Dr.
UNIT 7: Amalgamation, Absorption and Reconstruction
10,000
2,500
12,500
10,000
10,000
12,000
12,000
12,000
12,000
4,00,000
40,000
4,40,000
4,40,000
40,000
4,00,000
8,00,000
1,00,000
50,000
3,000
Page 519
ICAN Advanced Accounting CAP II Chapter III
Realization A/c
To Sundry Equity Shareholders A/c
(Various accounts representing capital and profit
transferred to Equity Shareholders Account)
Dr.
Equity Shareholders A/c
To Underwriting Commission A/c
(Underwriting Commission A/c closed by transfer
to
Equity Shareholders A/c)
Dr.
Equity Shareholders A/c
To Equity Shares in Prachanda Ltd.
To Cash A/c*
Dr.
4,22,500
13,75,500
40,000
40,000
13,35,000
11,20,000
2,15,500
* The student shall prepare Cash Account to ascertain the cash balance.
Realization Account
Particulars
To Sundry Assets
To Cash (excess expenses of
liquidation)
To Preference Shareholders A/c
To Equity Shareholders A/c
Profit transferred
Amount
Particulars
Rs.
15,80,000 By Sundries Liabilities
2,500 By Prachanda Ltd..
Amount
Rs.
3,25,000
17,20,000
40,000
4,22,500
20,45,000
20,45,000
6. ACCOUNTING IN THE BOOKS OF TRANSFEREE COMPANY
For the transferee company it is essentially a business purchase. It has to record the assets and
liabilities taken over and also show the payment of purchase consideration in its books. Payment
is made by issue of its own securities such as shares/debentures and/or payment of cash.
Accounting Entries
Transaction
1. On amalgamation of the
business, the entry would be
for the amount of purchase
consideration
Page 520
Account
Debited
Business purchase
Credited
Liquidator
of
transferor
company
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
2. On the acquisition of assets Fixed Assets A/c
Investment A/c
and liabilities
Current assets A/c
Goodwill A/c (bal. fig)
3. On the payment of purchase
consideration in the form of Liquidator of vendor
company
shares, debentures and cash
4. Transfer of Statutory reserves,
Amalgamation
if any
adjustment A/c
5. On cancellation of InterCreditors A/c
company balances
Bills Payable A/c
Loans A/c
Current Liabilities A/c
Business Purchase A/c (PC)
Capital Reserve A/c (bal. fig)
Assets A/c
Share Capital/ Debentures
Bank
Statutory reserves
Debtors A/c
Bills Receivable A/c
In the above case the entry to be passed shall be:
Journal Entries
Date
Particular
Debit Rs.
Business Purchase A/c
To Liquidator of Baburam Ltd...
(Amount payable to Baburam Ltd.. as per the
agreement dated….)
Dr.
Land and Building A/c
Plant and Machinery A/c
Patents A/c
Stock A/c
Sundry Debtors
Goodwill
To Sundries:
Provision for Workmen’s Compensation A/c
Trade Creditors
Debentures in Baburam Ltd.
Business Purchase A/c
(Various assets and liabilities taken over from
Baburam Ltd.. Goodwill ascertained as a
balancing figure)
Dr.
Liquidator of Baburam Ltd.. A/c
To Cash
To 9% Preference Share Capital A/c
Dr.
UNIT 7: Amalgamation, Absorption and Reconstruction
Credit Rs.
17,20,000
17,20,000
5,50,000
6,50,000
20,000
1,50,000
1,80,000
5,05,000
5,000
1,20,000
2,10,000
17,20,000
17,20,000
2,00,000
4,00,000
Page 521
ICAN Advanced Accounting CAP II Chapter III
To Equity Share Capital A/c
To Securities Premium A/c
(Payment of cash and issue of shares in
satisfaction of purchase consideration)
8,00,000
3,20,000
Debentures in Baburam Ltd. A/c
To 7% Debentures A/c
To premium on Debentures A/c
(Payment to debenture holders of Baburam
Ltd.. by issue of own
7% debentures)
Dr.
Goodwill A/c
To Cash A/c
(Amount paid towards liquidation expenses of
Baburam Ltd..)
Dr.
2,10,000
2,00,000
10,000
10,000
10,000
Illustration 6:
Naramro Ltd. and Chamro Ltd. were amalgamated on and from 1st Shrawan, 2070. A new
company Ramro Ltd. was formed to take over the business of the existing companies. The
Statement of Financial Positions of Naramro Ltd. and chamro Ltd. as on 31stAshadh, 2070 are
given below:
Liabilities
Share capital
Equity Shares of Rs. 100
each
12% Preference of Rs.
100 each
Reserves and Surplus
Revaluation Reserve
General Reserve
Investment Allowance
Reserve
P & L Account
Secured Loans
10% Debentures (Rs. 100
each)
Current Liabilities and
Provisions
Sundry creditors
Bills Payable
Page 522
Naramro Chamro
Ltd.
Ltd.
800
300
150
170
50
50
Assets
Fixed Assets
750 Land & Building
Plant
&
200 Machinery
Investments
Current
Assets,
100 Loans
and
150 advances
Stock
50 Sundry Debtors
Bills Receivable
30 Cash and Bank
60
30
270
150
2,000
120
70
1,500
Naramro Chamro
Ltd.
Ltd.
550
350
150
400
250
50
350
250
50
300
250
300
50
200
2,000
1,500
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Additional Information:
i.
10% Debenture holders of Naramro Ltd. and Chamro Ltd. are discharged by Ramro
Ltd. issuing such number of its 15% Debentures of Rs. 100 each so as to maintain the
same amount of interest.
ii.
Preference shareholders of the two companies are issued equivalent number of 15%
preference shares of Ramro Ltd. at a price of Rs. 150 per share (face value Rs. 100).
iii.
RamroLtd. will issue 5 equity shares for each equity share of Naramro Ltd. and 4
equity shares for each equity share of Chamro Ltd. The shares are to be issued @ Rs. 30
each, having a face value of Rs. 10 per share.
iv.
Investment allowance reserve is to be maintained for 4 more years.
Prepare the Statement of Financial Position of Ramro Ltd. as on 1st Shrawan, 2070 after the
amalgamation has been carried out on the basis of amalgamation in the nature of purchase.
Solution:
Statement of Financial Position of RamroLtd
as on 1stShrawan, 2070
(Rs. in lakhs)
Liabilities
Amount Assets
Share Capital:
Fixed assets:
70,00,000 Equity shares of Rs. 10
700 Goodwill
each
500 Land and building
5,00,000 Preference shares of Rs.
100 each (all the above shares are
allotted as fully paid-up for
consideration other than cash)
Reserves and Surplus:
Plant and Machinery
Share Premium Account
1,650 Investment
Investment Allowance Reserve
100 Current Assets, Loans and
Contra
Advances
A. Current Assets
Stock
Secured Loans
15% Debentures
60 Sundry debtors
Cash and Bank
Unsecured Loans
Current Liabilities and Provisions
B. Loans and Advances
A. Current Liabilities
Bills Receivable
Acceptances
220 Amalgamation Adjustment
Account contra
Sundry Creditors
390
3,620
UNIT 7: Amalgamation, Absorption and Reconstruction
Amount
20
950
600
200
600
550
500
100
100
3,620
Page 523
ICAN Advanced Accounting CAP II Chapter III
Tutorial Notes:
1.Computation of Purchase Consideration
(a) Preference Shareholders:
300,00,000 , i.e., 3,00,000 shares × Rs. 150 each
100
Naramro Ltd.
450
200,00,000 , i.e., 2,00,000 shares × Rs. 150 each
100
(b) Equity Shareholders:
8,00,00,000 × 5 , i.e., 40,00,000 shares × Rs. 30 each
100
7,50,00,000 × 4 , i.e., 30,00,000 shares × Rs. 30 each
100
Amount of Purchase Consideration (in Rs. Lakh)
2. Net Assets taken over
Assets taken over:
Land and building
Plant and machinery
Investments
Stock
Sundry debtors
Bills receivable
Cash and bank
Total (A)
Liabilities taken over:
Debentures
Sundry creditors
Bills payable
Total (B)
Net assets taken over (A - B)
Purchase consideration
Goodwill
Capital reserve
Chamro Ltd.
300
1,200
____
1,650
900
____
1,200
550
350
150
350
250
50
300
2,000
400
250
50
250
300
50
200
1,500
40
270
150
460
1,540
1,650
110
20
120
70
210
1,290
1,200
90
Note: - Since Investment Allowance Reserve is to be maintained for 4 more years, it is carried
forward by a corresponding debit to Amalgamation Adjustment Account .
Page 524
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Illustration 7:
You are given below the Statement of Financial Position of Ram Ltd. and Laxman Ltd. as on
Ashad 31, 2070:
Liabilities
Equity Share Capital (Rs. 10 each)
12% Preference Share Capital (Rs.
General Reserve
Export Profit Reserve
Investment Allowance Reserve
Profit and Loss A/c
15% Debentures (Rs.100 each)
Trade Creditors
Outstanding Expenses
100 each)
Assets
Land and Buildings
Plant and Machinery
Furniture and Fittings
Investments
Stock
Debtors
Cash and Bank balances
Ram Ltd.
(Rs.'000)
10,000
4,500
1,200
800
500
2,000
1,500
1,000
5,00
22,000
Laxman Ltd.
(Rs. '000)
5,000
3,000
1,000
500
400
1,600
1,000
800
200
13,500
6,000
6,500
1,200
1,500
3,000
2,000
1,800
22,000
4,000
3,500
1,000
1,000
2,000
1,000
1,000
13,500
Ram Ltd. takes over Laxman Ltd. as on Shrawan 1, 2070 . You are also given the following
additional information:
1.
Ram Ltd. discharges the purchase consideration as stated below:
Issued 12% preference shares of Rs. 100 each to discharge the preference shareholders of
Laxman Ltd. at 10% premium.
Issued 5, 00,000 equity shares of Rs. 10 each at par.
Paid cash at Rs. 2.50 per equity share.
2.
3.
Laxman Ltd. followed weighted average method for valuing inventories whereas Ram
Ltd. followed FIFO basis. Had Laxman Ltd. followed FIFO basis, its value of stock as
on Ashadh 31. 2070 would have been more by Rs. 2, 00,000.
The amalgamation is considered as amalgamation in the nature of merger.
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 525
ICAN Advanced Accounting CAP II Chapter III
You are required to prepare the Statement of Financial Position of Ram Ltd. after
amalgamation.
Solution:
Statement of Financial Position of Ram Ltd. (After Amalgamation)
Liabilities
Equity Share capital (Rs. 10 each)
12% Preference Share Capital
General Reserve
Export Profit Reserve
Investment Allowance Reserve
Profit and Loss A/c
Secured Loan—15% Debentures
Trade Creditors
Outstanding Expenses
Rs. '000
15,000
7,800
650
1,300
900
3,800
2,500
1,800
700
34,450
Assets
Plant and Machinery
Land and Buildings
Furniture and Fittings
Investment
Stocks
Trade Debtors
Cash and Bank Balances
Rs. '000
10,000
10,000
2,200
2,500
5,200
3,000
1,550
34,450
Tutorial Notes:
1.
General Reserve
Ram Ltd.
Laxman Ltd.
Less: Difference between the purchase consideration and the
share capital of Laxman Ltd.
Premium paid on redemption of preference shares
Balance shown in the Statement of Financial Position (after
amalgamation)
Profit and Loss Account
Ram Ltd.
Laxman Ltd.
2.
Add: Under valuation of inventories of Laxman Ltd.
3.
Purchase consideration:
5,00,000 equity shares of Rs. 10 each
Cash at Rs. 2.50 on 5,00,000 equity shares
Share capital of Laxman Ltd.
Excess paid adjusted against reserve
Page 526
1,250
300
1,200
1,000
2,200
1,550
650
2,000
1,600
3,600
200
3,800
50,00,000
12,50,000
62,50,000
50,00,000
12,50,000
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Illustration 8: K Ltd. and L Ltd. amalgamate to form a new company LK Ltd. The financial
position of these two companies on the date of amalgamation was as under:
Liabilities
K Ltd.
Share Capital
Equity Shares of Rs.
100 each
7% Preference Share
of Rs. 100 each
5% Debentures
General Reserve
Profit and Loss
Account
Sundry Creditors
Secured Loan
L Ltd.
Assets
Goodwill
8,00,000
3,00,000 Land & Building
4,00,000
3,00,000
—
Plant &
Machinery
Furniture and
—
Fittings
1,00,000 Sundry Debtors
4,31,375
97,175 Stores & Stock
2,00,000
1,00,000
—
2,10,000 Cash at Bank
2,00,000 Cash in hand
Preliminary
Expenses
19,31,375 12,07,175
K Ltd.
L Ltd.
80,000
—
4,50,000
3,00,000
6,20,000
5,00,000
60,000
20,000
2,75,000
1,75,000
2,25,000
1,40,000
1,20,000
41,375
55,000
17,175
60,000
—
19,31,375 12,07,175
The terms of amalgamation are as under:
(A)
1)
2)
3)
4)
The assumption of liabilities of both the Companies.
Issue of 5 Preference shares of Rs. 20 each in LK Ltd. @ Rs. 18 paid up at
premium of Rs. 4 per share for each preference share held in both the Companies.
Issue of 6 Equity shares of Rs. 20 each in LK Ltd. @ Rs. 18 paid up at a premium
of Rs. 4 per share for each equity share held in both the Companies. In addition,
necessary cash should be paid to the Equity Shareholders of both the Companies as
is required to adjust the rights of shareholders of both the Companies in accordance
with the intrinsic value of the shares of both the Companies.
Issue of such amount of fully paid 6% debentures in LK Ltd. as is sufficient to
discharge the 5% debentures in K Ltd. at a discount of 5% after takeover.
(B)
1)
2)
The assets and liabilities are to be taken at book values stock and debtors for which
provisions at 2% and 2.5 % respectively to be raised.
The sundry debtors of K Ltd. include Rs. 20,000 due from L Ltd.
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 527
ICAN Advanced Accounting CAP II Chapter III
(C)
The LK Ltd. is to issue 15,000 new equity shares of Rs. 20 each, Rs. 18 paid up at
premium of Rs. 4 per share so as to have sufficient working capital. Prepare ledger
accounts in the books of K Ltd. and L Ltd. to close their books.
Solution:
BOOKS OF K LTD.
Realization Account
Particular
To Goodwill
Rs. Particular
80,000 By 5% Debentures
Rs.
2,00,000
To Land & Building
4,50,000 By Sundry creditors
1,00,000
To Plant & Machinery
15,60,000
To Furniture & Fitting
6,20,000 By LK Ltd (Purchase
consideration)
60,000
To Sundry debtors
To Stores & Stock
2,75,000 By Equity shareholders A/c (loss)
2,25,000
To Cash at Bank
1,20,000
To Cash in hand
41,375
To Preference shareholders
(excess payment)
40,000
19,11,375
Particular
To Preliminary Expenses
To Realization A/c (loss)
51,375
19,11,375
Equity Shareholders A/c
Rs.
Particular
By Share capital
60,000
By Profit & Loss A/c
51,375
Rs.
800,000
431,375
To Equity Shares in LK Ltd.
To Cash
1,056,000
64,000
1,231,375
Page 528
1,231,375
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
LK Ltd. A/c
Particular
To Realization A/c
Rs. Particular
15,60,000 By Equity Shares in LK
Equity
10,56,000
Pref
By Cash
4,40,000
15,60,000
Rs.
14,96,000
64,000
15,60,000
BOOKS OF L LTD
Particular
To Land & Building
To Plant & Machinery
To Furniture & Fittings
To Sundry debtors
To Stock of stores
To Cash at bank
To Cash in hand
To Pref. shareholders
Realization Account
Rs. Particular
80,000 By Sundry creditors
4,50,000 By Secured loan
6,20,000 By LK Ltd.
60,000 (Purchase consideration)
2,75,000 By Equity shareholders A/c
2,25,000
(loss)
1,20,000
41,375
40,000
12,37,175
Particular
To Equity shares in LK Ltd.
To Realization
To Cash
Equity Shareholders A/c
Rs. Particular
3,96,000 By Share capital
37,175 By Profit & Loss A/c
64,000 By Reserves
4,97,175
Particular
To Realization A/c
LK Ltd. A/c
Rs. Particular
7,90,000 By Equity Shares in LK
For Equity
3,96,000
Pref.
3,30,000
By Cash
7,90,000
UNIT 7: Amalgamation, Absorption and Reconstruction
Rs.
2,10,000
2,00,000
7,90,000
37,175
12,37,175
Rs.
3,00,000
97,175
1,00,000
4,97,175
Rs.
7,26,000
64,000
7,90,000
Page 529
ICAN Advanced Accounting CAP II Chapter III
Working Notes:
(i)
Purchase consideration
Payable to preference shareholders:
Preference shares at Rs. 22 per share
Equity Shares at Rs. 22 per share
Cash [See W.N. (ii)]
(ii)
Value of Net Assets
Goodwill
Land & Building
Plant & Machinery
Furniture & Fittings
Debtors less 2.5 %
Stock less 2%
Cash at Bank
Cash in hand
Less: Debentures
2,00,000
Creditors
1,00,000
Secured Loans
K ltd.
Rs.
L Ltd.
Rs.
4,40,000
10,56,000
64,000
15,60,000
3,30,000
3,96,000
64,000
7,90,000
80,000
4,50,000
6,20,000
60,000
3,00,000
5,00,000
20,000
2,68,125
2,20,500
1,20,000
41,375
18,60,000
1,70,625
1,37,200
55,000
17,175
12,00,000
3,00,000
15,60,000
14,96,000
64,000
Purchase Consideration
Payable in shares
Payable in cash
–
2,10,000
2,00,000
4,10,000
7,90,000
7,26,000
64,000
7. TREATMENT OF FRACTIONAL SHARES
In this method one also has to reckon with the problem of fractional shares to be allotted to the
shareholders of the transferor company. For example, if Sriram holds 70 shares inBBLIL, there
he is entitled to 70/20 × 9 = 31.5 shares. Since shares will have to be issued in whole number,
only 31 shares can be issued to Sriram. He will be compensated in cash for the 0.5 share which
could not be allotted to him. Such compensation is always at the market price. The transferee
company will aggregate all such fractional shares, and after selling those at market price
compensate the individual shareholders. Fractional shares, although settled at market price,
should be valued on the same basis as the rest of the shares issued. Where the basis is market
price, there is no difficulty. Where it is intrinsic value, the issue of fractional share is also at
intrinsic value. However, the transferee company sells such shares at market price on behalf of
the transferor company and remits the proceeds to shareholders of the transferor company.
Page 530
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
8. DIFFERENCE BETWEEN THE PURCHASE AND POOLING OF INTEREST
METHOD
At this stage after having explained and illustrated the two methods of accounting it may be
worthwhile to summarize the basic differences between the two methods. They are:
1.
2.
3.
4.
The purchase consideration under the purchase method is to be valued at market price of
the shares issued and under pooling of interests method at par value. This is so because
purchase method is concerned about fair values while the pooling of interests method is
concerned with book values.
The assets and liabilities of the transferor company are brought into the book of the
transferee company at fair value under the purchase method. These are recorded at book
value under the pooling of interests method. Only occasion to revise the book value is to
ensure uniform accounting policies.
The pooling of interests method brings the reserves of the transferor company into the
books of the transferee company. They are adjusted only when there is difference
between the share capital of the company and the purchase price paid by the transferee
company. Under the purchase method only the statutory reserves of the transferor
company are brought into the books of the transferee company by passing an entry
debiting ‘amalgamation adjustment account’ and crediting the statutory reserve.
The purchase method records goodwill or capital reserve as the case may be if there is
difference between the purchase consideration and the fair value of the net assets
acquired. This does not arise under pooling of interests method.
9. DISSSENTING SHAREHOLDERS
Dissenting shareholders are persons who have not given their assent to the scheme of
amalgamation/merger entered into by the prescribed majority of shareholders. According to
Section 177 (7) of Companies Act 2063 such shareholders may refuse to transfer their shares to
the absorbing/merged company in accordance with the scheme of amalgamation or absorption
or merger. The shares of such dissenting shareholders may be acquired by the amalgamated
company:
(a)
(b)
(c)
(d)
on the same terms on which the willing shareholders passed on their shares; or
based on the fair value of share; or
on other terms agreed upon between the amalgamated company and dissenting
shareholders; or
on terms ordered by the court on an application made either by the amalgamated
company or thedissenting shareholders.
So in some problems, one may come across a different type of settlement with dissenting
shareholders. In such cases the paid-up capital held by the dissenting shareholders must be
transferred to a separate shareholders’ account named ‘Dissenting Shareholders’ Account’. Any
premium they receive or discount they suffer as per the agreement or the order of the court must
be adjusted through realization account as in the case of preference Shareholders and Debenture
holders. The remaining profit or loss on realization will be transferred to willing shareholders’
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 531
ICAN Advanced Accounting CAP II Chapter III
account. All Statement of Financial Position items pertaining shareholders will be transferred to
majority (willing) shareholders account only.
Illustration 9:
Machhapuchre Company Limited agrees to acquire, as a going concern, the business of the
Standard Company Limited on the basis of the vendor’s Statement of Financial Position at 31st
Ashadh, 2070, which is as follows:
Liabilities
Authorized Capital – 25,000 shares of
Rs. 50 each
Issued Capital – 20,000 shares of Rs.
50 each
Called –up capital – 20,000 shares
called-up Rs. 30 each
Reserve fund
Creditors
Profit and loss account
Rs.
12,50,000
10,00,000
6,00,000
1,25,000
75,000
60,000
8,60,000
Assets
Freehold property
Plant and machinery
Stock
6% Government paper
Debtors
2,30,000
Less: Reserve
10,000
Bank
Rs.
2,50,000
50,000
3,00,000
10,000
2,20,000
30,000
_______
8,60,000
The Machhapuchre Company Limited took over all the assets and liabilities of the vendor
company, subject to the retention out of such assets of Rs. 15,000, to provide for cost of
liquidation, income-tax, etc., and to satisfy any dissentient shareholders.
The consideration for the sale is the allotment to the shareholders in the vendor company of one
share of Rs. 100 (Rs. 50 paid-up) in the Machhapuchre Company for every two shares in the
Standard Company Limited.
The market value of the Machhapuchre Company’s shares, which are Rs. 50 paid-up, at date of
sale is Rs. 70 each. The liquidator of the vendor company has paid out of Rs. 15,000 retained,
costs of liquidation amounting to Rs. 2,500; income-tax Rs. 7,500 and dissentient shareholders
of 100 shares at Rs. 32.50 per share, i.e., Rs. 3,250.
The sale and purchase were carried through in terms of the agreement. Pass the necessary
entries in the books of the respective companies.
Solution: Calculation of purchase consideration = 19,900x Rs. 50/2 = Rs. 4,97,500
Journal Entries of Standard Company Limited
Particular
Rs.
Rs.
Dr.
8,55,000
Realization A/c
2,50,000
To Freehold Property
50,000
To Plant and machinery
3,00,000
To Stock
10,000
To 6% Government paper
2,30,000
To Debtors
15,000
To Bank
7500
Creditors A/c
Dr.
Page 532
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Provision for bad debts A/c
To Realization A/c
Realization A/c
To Bank
(Expenses Rs. 2,500, Income-tax Rs. 7,500)
Machhapuchra Company limited A/c
To Realization A/c
Realization A/c
To Dissentient Shareholders A/c
Shareholders A/c
To Realization A/c
Share Capital A/c
To Dissentient Shareholders A/c
To Shareholders A/c
Reserve fund A/c
Profit and Loss A/c
To Shareholders A/c
Dissentient Shareholders’ A/c
To Bank A/c
Shares in Misisipi Co. Ltd.
To Machhapuchra Company Limited
Shareholders’ A/c
To Shares in Machhapuchra Co. Ltd.
Shareholders’ A/c
To Bank A/c
Dr.
10,000
Dr.
10,000
85,000
10,000
Dr.
4,97,500
Dr.
250
Dr.
2,82,750
Dr.
6,00,000
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
4,97,500
250
2,82,750
1,25,000
60,000
3,000
5,97,000
3,250
1,85,000
4,97,500
3,250
4,97,500
4,97,500
1,750
4,97,500
1,750
Journal Entries of
Machhapuchre Company Limited
Particulars
Business Purchase A/c
Dr.
To Liquidator of Standard Company Limited
Freehold property A/c
Plant and machinery A/c
Stock A/c
6% Government paper A/c
Debtors A/c
Bank A/c
To Creditors A/c
To Provision for bad debts A/c
To Capital reserve A/c
To Business purchase A/c
Liquidator of Standard Company Ltd. A/c
To Share capital A/c
UNIT 7: Amalgamation, Absorption and Reconstruction
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
Rs.
Rs.
4,97,500
4,97,500
2,50,000
50,000
3,00,000
10,000
2,30,000
15,000
75,000
10,000
2,72,500
4,97,500
4,97,500
4,97,500
Page 533
ICAN Advanced Accounting CAP II Chapter III
Note: Although the market value of the share of All Machhapuchre Company Limited is Rs. 70,
since they are issued only as Rs. 50 paid-up, purchase price is calculated on this basis.
10. INTER COMPANY OWINGS
At the time of absorption many time it is seen that the purchasing company already stands as a
debtor or creditor in the absorbed company’s books. This position may be the result of
purchase/sale transactions taking place between these companies or may be due to loans or bills
given by one company to another company. These transactions call for different accounting
treatments which can be summarized as follows:
10.1 Cancellation of Common Debts
Books of Vendor Company: So far as the books of Vendor Company are concerned there is no
effect of these types of transactions on the accounting entries suggested in the earlier part of this
chapter. The accounts are closed by transferring them to realization accounts in the usual way.
Any owing to or from the purchasing company is transferred to realization account under the
presumption that the purchasing company has taken over the accounts.
Books of purchasing company: In the books of purchasing company also, the entries for the
purchase of business and that for payment of purchase consideration are made in the usual way.
But in addition to these varies entries, extra adjustment entries are needed which are as follows:
(i)
Entry for canceling the debtors account in the books of Vendor Company and
corresponding creditors account in the books of purchasing company
Debit Purchasing company’s creditors
Credit Vendor company’s debtors
The above entry will have the effect of canceling the debtor in the vendor company and
the creditor in the purchasing company.
(ii)
Entry for canceling the debtors of the purchasing company and creditors of the vendor
company:
Debit Vendor company’s creditors
Credit Purchasing company’s debtors
10.2 Cancellation of Unrealized Profits
The purchase and sale transactions also result in profits charged by one company to another
company. The situation is worth considering only when the unsold stock (sold by purchasing
company) stands as stock at the end in the books of vendor company. When the company is
absorbed by the purchasing company, the stock of the vendor company (sold by the purchasing
company) becomes the stock of the purchasing company itself and thus it results in a sale by the
purchasing company to itself. It means that it will result in inflating the profits of the purchasing
company by increasing its own stock to sales price. This should be corrected by making the
following entry:
Debit Profit and loss account
Page 534
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Credit Stock reserve account
Alternatively, the stock may be taken at cost price while debiting all assets purchased from
Vendor Company. This automatically increases the amount of goodwill which can be written
off by debiting the Statement of Profit or Loss. It may be noted that no entry is required for
adjusting the stock, when goods are sold by the absorbed company to the purchasing company
and remain unsold with the purchasing company. This is owing to the fact that the absorption of
the company does not cancel the transactions which resulted in the past and also the
shareholders of the vendor company will not surrender their profits only because of the
absorption of their company by the company to whom they sold goods and charged profits. This
is treated as a simple purchase made by the purchasing company from any other company in the
market.
Illustration10:
Following are the Statement of Financial Positions of Desktop Ltd. and Laptop Ltd. s on 31st
Ashadh, 2070:
Particulars
Share capital
(Rs. 10each)
Reserve fund
Workmen
compensation fund
Creditors (including
Laptop Ltd. Rs. 5,000)
Creditors
Loan from Desktop
Ltd.
Desktop
Ltd. Rs.
Laptop
Ltd. Rs.
Particulars
Fixed Assets
1,00,000 2,00,000 Loan to Laptop Ltd.
60,000 Debtors (including
40,000
Desktop Ltd. Rs.
5,000)
10,000
Debtors
Stock
30,000
40,000 Cash at bank
10,000
_______- 3,10,000
1,80,000
Desktop Laptop
Ltd. Rs. Ltd. Rs.
1,20,000 2,50,000
10,000
30,000
20,000
-
20,000
30,000
10,000
_______ _______
1,80,000 3,10,000
Laptop Ltd. agreed to absorb Desktop Ltd. on the following terms: Laptop Ltd. shall give 1
share of Rs. 35 each for every 3 shares in Desktop Ltd. You are informed that stock of Desktop
Ltd. includes stock worth Rs. 15,000 purchased by them from Laptop Ltd. which was sold to
them at a profit of 20% on cost. The shares of Laptop Ltd. are quoted in the market at Rs. 45 per
share. Open ledger accounts of Desktop Ltd. and give journal entries in Laptop Ltd. draft the
Statement of Financial Position of Laptop Ltd. after the purchase of business.
Solution:
Calculation of purchase consideration:
Number of shares
Value of shares (leaving fraction), 3,333 x Rs. 35
Fraction is to be satisfied in cash which is based
UNIT 7: Amalgamation, Absorption and Reconstruction
1
/ 3x 10,000 = 3,333 1 / 3shares
Rs. 1,16,655
Page 535
ICAN Advanced Accounting CAP II Chapter III
on the market value of the share. Thus the amount
aid in cash 1/3 x Rs. 45
Total purchase consideration
To Fixed assets
To Loan to Laptop Ltd.
To Debtors
To Stock
To Realization account-Loss
To Share in Laptop Ltd.
To Bank
15
Rs.1,16,670
Books of Desktop Ltd.
Realization Account
Rs.
1,20,000 By Creditors
10,000 By Laptop Ltd.
30,000 By Shareholders-Loss
20,000
1,80,000
Rs.
30,000
1,16,670
33,330
_______
1,80,000
Shareholders’ Account
Rs.
33,330 By Share capital
1,16,655 By Reserve fund
_____15 By Workmen compensation
1,50,000
Rs.
1,00,000
40,000
10,000
1,50,000
Laptop Ltd.
To Realization account
Rs.
1,16,670
_______
1,16,670
By Share in Laptop Ltd.
By Bank
Rs.
1,16,655
15
1,16,670
Books of Laptop Ltd.
Journal
Fixed assets of Desktop Ltd.
Loan of Laptop Ltd.
Debtors
Stock
To Creditors
To Liquidator of Desktop Ltd.
To capital reserve
(Being purchase of assets and liabilities of Desktop Ltd.)
Liquidation of Desktop Ltd.
To Share capital
To Bank
Page 536
Dr.
Dr.
Dr.
Dr.
Rs.
1,20,000
10,000
30,000
20,000
Rs.
30,000
1,16,670
33,330
Dr.
1,16,670
1,16,655
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
(Being payment of purchase consideration)
Loan from Desktop Ltd. (Books of Laptop Ltd.)
Dr.
To Loan to Laptop Ltd. (Books of Desktop Ltd.)
(Entry for cancellation of common debt)
Creditors (Books of Desktop Ltd.)
Dr.
To Debtors (Books of P Ltd.)
(Entry for cancellation of common debt)
Profit and loss of Laptop Ltd. (1)
Dr.
(or Goodwill account or capital reserve)
To Stock (Reserve)
(Entry for cancellation of unrealized profit on stock left
unsold with Desktop Ltd.)
Share capital
Shares of Rs. 35
each
Shares of Rs. 10
each
Reserve fund
Creditors :Laptop
Ltd.
Desktop Ltd.
Capital reserve
Less Unrealised
profit
15
10,000
10,000
5,000
5,000
2,500
2,500
Statement of Financial Position of Laptop Ltd.
Rs.
Rs.
Rs.
Rs.
Fixed assets
1,16,655 Laptop Ltd.
2,50,000
2,00,000 Desktop Ltd.
3,70,000
1,20,000
60,000 Debtors:
40,000
Laptop Ltd.
15,000
25,000
65,000 Desktop Ltd.
45,000
30,000
Stock:
33,330
30,830 Laptop Ltd.
2,500
30,000
Desktop Ltd.
47,500
20,000
17,500
9,985
Less Pro 2,500
4,72,485 Cash at bank
4,72,485
11. INTERCOMPANY HOLDING OF SHARES
11.1 When Purchasing Company Holds Shares in Vendor Company
In this case the purchasing company being shareholder of the vendor company has a right to
proportionate net assets of the absorbed company. Therefore, the absorbing company
(purchasing company) buys only the net assets belonging to outside shareholders. Usually the
absorbing company issues its own shares and debentures in payment of the purchase
consideration. This it does only in respect of amount due to outsiders. For the amount due to
itself it cannot receive its own shares. How the accounting is done in the books of the absorbed
company (vendorcompany) and the absorbing company is explained and also illustrated.
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 537
ICAN Advanced Accounting CAP II Chapter III
Books of the Vendor Company:
Purchase consideration is calculated for the entire undertaking either by the net assets or net
payment method as the case may be. The purchasing company is debited with the full price, but
credited with only what is received in respect of outsiders. This leaves a debit balance
representing the amount still receivable from the purchasing company towards purchase price.
Likewise in the shareholders’ account, since only outside shareholders are paid, there will be a
credit balance vendor company. The amount in question is neither paid by the absorbing
company as the buyer of the business nor received by it as a shareholder. These two accounts
will be closed by means of the following set-off entry:
Debit Shareholders’ account
Credit Purchasing Company’s account
Books of the Purchasing Company:
As usual, business purchase account is debited with full purchase price crediting the liquidator
of the vendor company. Business purchase account is then closed by incorporating the assets
and liabilities and making the necessary adjustment of Goodwill or Capital reserve as the case
may be. However, when the question of settling the amount due to the liquidator arises,
payment is shown only in respect of what is due to outsiders and for the balance the shares in
the vendor company are surrendered by crediting the investment account. The entry will appear
as under:
Debit Liquidator of vendor company
(with full purchase price)
Credit Share capital/debenture/Bank
(amount payable to outsiders)
Credit Shares in the vendor company
(amount due to purchasing company)
Any difference in the ‘shares in the vendor company account’ will be transferred to ‘Goodwill
or capital reserve’, as the case may be.
Illustration 11:
The Statement of Financial Position of Laamo Ltd. and Chhoto Ltd. as on 30th Ashadh, 2070
were as follows:
(Rs. In crores)
Liabilities
Equity Share Capital
Reserves and Surplus
10% 25 lakhs Debentures of Rs. 100 each
25
Other Liabilities
Assets
Fixed Assets at cost
Less: Depreciation
Investments in Chhoto Ltd
Page 538
Chhoto Ltd.
25
75
Laamo
Ltd.
80
400
_____
125
120
600
200
100
75
50
25
100
32
24
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
2 crore Equity Shares of Rs. 10 each at cost
10% 25 lakh Debentures of Rs. 100 each at
cost
Current Asset
Less: Current Liabilities
800
356
56
300
200
444
600
100
125
In a scheme of absorption duly approved by the court, the assets of Chhoto Ltd. were taken over
at an agreed value of Rs. 130 crores. The liabilities were taken over at par. Outside shareholders
of Chhoto Ltd. were allotted equity shares in Laamo Ltd. at a premium of Rs. 90 per share in
satisfaction of their claims in Chhoto Ltd. for purposes of recording in the books of Laamo Ltd.
fixed assets taken over from Chhoto Ltd. were revalued at Rs. 40 crores.
The scheme was put through on 1st Shrawan, 2070.
(a) Give journal entries in the books of Laamo Ltd. to record the transactions.
(b) Show the Statement of Financial Position of Laamo Ltd. after absorption of Chhoto Ltd.
Solution:
(a) Journal of Laamo Ltd.
Particulars
1 Business Purchase Account
To Liquidator of Chhoto Ltd
(Being the purchase consideration payable to
Liquidator of Chhoto Ltd. for business purchased)
2 Fixed Assets
Current Assets
To Current Liabilities
To Debenture Liabilities
To Business Purchase Account
(Being the assets and liabilities taken over from
Chhoto Ltd.)
3 Liabilities for Debentures
To Investment in Debentures
To Capital Reserve
(Being the cancellation of debentures of Chhoto
Ltd. against debentures held as investments)
4 Liquidator of Chhoto Ltd
To Equity Share Capital
To Share Premium
(Being the allotment of 21 lakh equity shares of
Rs. 10 each to outside shareholders of Chhoto
UNIT 7: Amalgamation, Absorption and Reconstruction
L.F.
Dr.
Debit
(Rs. In
crores)
105
Credit (Rs.
In crores)
105
40
290
Dr.
Dr.
200
25
105
25
Dr.
21
24
1
Dr.
2.10
18.90
84
Dr.
Page 539
ICAN Advanced Accounting CAP II Chapter III
32
52
Ltd. at a premium of Rs. 90 per share)
5 Liquidator of Chhoto Ltd
To Investments in Equity Shares of
Chhoto Ltd
To Capital Reserve
(Being the investments in equity shares of
Chhoto Ltd. cancelled and the resultant profit
transferred to Capital Reserve)
(b) Statement of Financial Position of Laamo Ltd
As at 1at Shrawan, 2070
Liabilities
Share Capital:
821 lakh equity shares of Rs.10
each
(of the above shares, 21 lakh
equity shares are allotted as fully
paid-up for consideration other
than cash)
Reserves and surplus
As per last Balance Sheet
400.00
Capital Reserve
53.00
Share Premium Account
18.90
Rs. in
crores
Rs. in
crores
Assets
Fixed Assets:
82.10 Fixed Assets
Less: Depreciation
Add: Taken over
200.00
100.00
100.00
40.00
Investments current assets,
Loan and advances
Current Assets
800.00
471.90 Add Taken over
290.00
140.00
1,090.00
120.00
556.00
1,230.00
1,230.00
Other liabilities
Current liabilities and
Provisions
Current liabilities
356.00
Add: Taken over
200.00
Page 540
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Tutorial Note:
Calculation of Shares Allotted
(Rs. In crores)
Net Assets taken over:
Assets*
Less: Debentures
Net assets taken over
Less: Belonging to Laamo Ltd. 2 x 105
2.5
Payable to other equity shareholders
Number of equity shares of Rs. 10 each to
be issued at premium of Rs. 90
130.00
25.00
105.00
84.00
21.00
= Rs. 21,00,00,000/100
=21,00,000 shares of Rs. 10 each
* Fixed Assets + Current Assets – Current Liabilities
Since net Assets are taken at Rs. 130 crores, fixed assets are valued at Rs. 40 crores, and there is
no change in the values of current liabilities Rs. 290 crores represents the fair value of current
assets.
Alternative Method
Under this method purchase consideration is not calculated for the entire under taking. Under
the net payments method purchase consideration is calculated on the basis of what is due to
outside shareholders and creditors. In the case of net assets method, purchase consideration is
calculated for the whole under taking and then reduced proportionately on the basis of the
purchasing company’s interest in the vendor company. For example,
Liabilities
Share Capital
Profit
Creditors
Statement of Financial Position of Laamo Ltd
Rs.
Assets
Rs.
4,00,000 Fixed assets
2,00,000 Current assets
2,50,000
8,50,000
6,00,000
2,50,000
______
8,50,000
If Rs. 1,00,000 shares of Laamo Ltd. are held by Chhoto Ltd and later on Chhoto Ltd.
purchases the assets at R. 10,50,000 and takes over creditors at Rs. 2,40,000 then purchase
consideration will be as follows:
Rs.
Total assets taken over at revised values
10,50,000
Less: Liabilities taken over at revised values
2,40,000
Total purchase consideration on net asset method
Rs. 8,10,000
Since the company is liquidated, this consideration is to be distributed as follows:
Received by Laamo Ltd
8,10,000
Less: already belonging to Chhoto Ltd., 1/3
2,02,500
6,07,500
For outside shareholders – purchase consideration
UNIT 7: Amalgamation, Absorption and Reconstruction
Page 541
ICAN Advanced Accounting CAP II Chapter III
Cancellation of shares held by the purchasing company:Since no purchase consideration is
to be paid by the purchasing company to the vendor company for that part of shares which are
already held by the purchasing company, the vendor company also does not pay out such share
capital. The share capital to the extent already held by the purchasing company is closed by
transferring to realization account. Entry is:
Debit Share capital account
Credit Realization account
(cancellation of share already held by the purchasing
company)
Cancellation of purchasing company’s investments: The purchasing company’s investment
in the shares and debentures of the vendor company also becomes useless after the liquidation
of the vendor company. The investment account (for these investments) is closed by crediting
the account and debiting goodwill account or capital reserve account as the case may be.
Illustration 12: The Statement of Financial Position of AgloLtd. and Hocho Ltd. as on
31.032070 were as follows:
Statement of Financial Position as on 31.03.2070
Hocho
Assets
Ltd
(Rs.)
(Rs.)
Equity Share Capital
Building
8,00,000 3,00,000 Machinery
(Rs. 10)
10% Preference Share
Furniture
Capital (Rs. 100)
2,00,000 Investment:
3,00,000 1,00,000 6,000 Shares of
General Reserve
2,00,000 1,00,000 Hocho Ltd
Profit & Loss A/c
2,00,000 3,00,000 Stock
creditors
Debtors
Cash and Bank
________ ________ Preliminary
15,00,000 10,00,000 Expenses
Liabilities
Aglo Ltd
Aglo Ltd
(Rs.)
2,00,000
5,00,000
1,00,000
Hocho
Ltd
(Rs.)
1,00,000
3,00,000
60,000
60,000
1,50,000 1,90,000
3,50,000 2,50,000
90,000
70,000
50,000
30,000
15,00,000 10,00,000
Aglo Ltd has taken over the entire undertaken of Hocho Ltd on 30.09.2070 on which date the
position of current assets except Cash and Bank balance and Current Liabilities were as under:
Particulars
Stock
Debtors
Creditors
Aglo Ltd Rs
1,20,000
3,80,000
1,80,000
Hocho Ltd Rs
1,50,000
1,50,000
2,10,000
Profit earned for the half year ended on 30.09.2070 after charging depreciation at 5% on
building, 15% machinery and 10% on furniture, are:
Aglo Ltd
Hocho Ltd
Page 542
Rs. 1,02,500
Rs.54,000
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
On 30.08.2070 both companies have declared 15% dividend for 2069-70.
Goodwill of Hocho Ltd has been valued at Rs. 50,000 and other Fixed assets at 10% above
their book value on 31.03.2070. Preference shareholders of Hocho Ltd are to be allotted 10%
Preference Shares of Aglo. Ltd. and equity shareholders of Hocho Ltd are to receive requisite
number of equity shares of Aglo Ltd valued at Rs. 15 per share in satisfaction of their claims.
Show the Statement of Financial Position of Aglo Ltd as on 30.09.2070assuming absorption is
through by that date.
Aglo Ltd
Statement of Financial Position
as on 30th Paush, 2070
Solution:
Liabilities
Share capital:
1,09,600 Equity shares of
Rs. 10 each
10% Preference shares
(of the above Shares,
29,600 equity shares and all
preference
shares
are
allotted as fully paid –up
for consideration other than
cash)
Reserve and Surplus:
Capital Reserve
Share Premium account
General Reserve
Profit and Loss Account
Secured Loans
Unsecured Loans
Current liabilities
And Provision
Sundry creditors
Amount
Rs.
Assets
Fixed Assets:
10,96,000 Building
2,00,000 2,00,000
Less: Depreciation
5,000
1,000
1,48,000
3,00,000
1,91,500
-
1,95,000
Add: Taken over
1,07,500
Machinery
5,00,000
Less: Depreciation
37,500
4,62,500
Add: Taken over
3,90,000 3,07,500
Furniture
1,00,000
Less: Depreciation
5,000
95,000
Add: Taken over
63,000
Investments
Current Assets, Loans and
Advances
Current Assets:
UNIT 7: Amalgamation, Absorption and Reconstruction
Amount
Rs.
3,02,500
7,70,000
1,58,000
2,70,000
6,30,000
1,46,000
50,000
23,26,500
Page 543
ICAN Advanced Accounting CAP II Chapter III
Stock
Sundry Debtors
Cash and Bank
Miscellaneous Expenditure
(to the extent not written off
________ or adjusted)
23,26,500 Preliminary Expenses
Working Notes:
1. Ascertainment of Cash and Bank Balances as on 30th Paush, 2070
Statement of Financial Position as on 30th Paush , 2070
Hocho Ltd
Assets
Rs.
Equity Share
3,00,000 Building**
Capital
Machinery**
10% preference
2,00,000 Furniture**
3,00,000
Share Capital
1,00,000 Investment
1,91,500
General Reserve
89,000 Stock
1,80,000
Profit and Loss
2,10,000 Debtors
A/c*
Cash and
Creditors
Bank
_______
_______ (Balancing
14,71,500
8,99,000 figure)
Preliminary
Expenses
* Balance of Statement of Profit or Loss on 30th Paush, 2070
Liabilities
Aglo Ltd
Rs.
8,00,000
Liabilities
Net Profit (for the first half)
Balance brought forward
Less: Dividend on Equity Share Capital Paid
Less: Dividend on Preference Share Capital Paid
Aglo Ltd
Rs.
1,95,000
4,62,500
95,000
60,000
1,20,000
3,80,000
1,09,000
Hocho Ltd
Rs.
97,500
2,77,500
57,000
1,50,000
2,50,000
37,000
50,000
14,71,500
30,000
8,99,000
Aglo Ltd Rs. Hocho Ltd Rs.
1,02,500
54,000
2,00,000
1,00,000
3,02,500
1,54,000
1,20,000
45,000
1,82,500
1,09,000
_______
20,000
1,82,500
89,000
Add: Dividend received 1 x 45,000
5
9000
_______
1,91,500
______
89,000
**Fixed Assets on 30th Ashad 2070 (Before absorption)
Page 544
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Aglo Ltd
Rs.
2,00,000
5,000
1,95,000
Hocho Ltd
Rs.
1,00,000
2,500
97,500
(2) Machinery as on 1.4.2002
Less: Depreciation (15% p.a.)
5,00,000
37,500
4,62,500
3,00,000
22,500
2,77,500
(3) Furniture as on 1.4.2002
Less: Depreciation (10% p.a.)
1,00,000
5,000
95,000
60,000
3,000
57,000
Assets
(1) Building as on 1.4.2002
Less: Depreciation (5% p.a.)
2.
Calculation of Shares Allotted
Particular
Assets taken over:
Goodwill
Building
Add: 10%
Less: Depreciation
Machinery
Add: 10%
Less: Depreciation
Furniture
Add: 10%
Less: Depreciation
Stock
Debtors
Cash and Bank
Total Asset Taken Over
Less: Liabilities taken over:
Creditors
Net assets taken over
UNIT 7: Amalgamation, Absorption and Reconstruction
Rs.
Rs.
50,000
1,00,000
10,000
1,10,000
2,500
1,07,500
3,00,000
30,000*
3,30,000
22,500
3,07,500
60,000
6,000
66,000
3,000
63,000
1,50,000
2,50,000
37,000
9,65,000
2,10,000
7,55,000
Page 545
ICAN Advanced Accounting CAP II Chapter III
Less; Allotment of 10% preference shares to
preference shareholders of Hocho Ltd
Less; Belonging to Aglo Ltd*** 1/5 x 5,55,000
2,00,000
Payable to other Equity Shareholders
= 4,44,000/15
Number of equity shares of Rs. 10 each to be issued
=29,600
(valued at Rs. 15 each)
Ascertainment of Goodwill/ Capital Reserve
Particular
(A) Net Assets taken over
(B) Preference shares allotted
Payable to other equity shareholders
Cost of Investments
(C) Capital Reserve [(A) – (B)]
(D) Goodwill taken over
(E) Final figure of Capital Reserve [(C) – (D)]
Rs
2,00,000
4,44,000
60,000
1,11,000
______
4,44,000
Rs.
7,55,000
7,04,000
51,000
50,000
1,000
*** 6,000 shares out of 30,000 share of Hocho Ltd are already with Aglo Ltd
11.2 When Vendor Company Holds Shares in Purchasing Company
(a) Net Payment method. If net payment method of purchase consideration is adopted, deduct
the number of shares already held by the vendor company from the shares agreed to be issued.
Thus the shares held by the vendor company before its absorption continue to be with them and
are treated as part payment of purchase consideration. The investment of the vendor company in
shares of the purchasing company is not taken over by the purchasing company. Therefore, the
investment in the purchasing company should not be transferred to realization account.
Sometimes the issue price of the shares now received and the price at which the previous
investment has been acquired may differ. In such a case the investment in the purchasing
company already made must be revalued by adopting the latest price and any profit or loss on
such revaluation must be transferred to shareholders’ account.
Illustration 12:
Aakash Ltd. absorbs Baadal Ltd. by payment of 5 shares of Rs. 10 each at a premium of 10%,
for every 4 shares in BaadalLtd. the Statement of Financial Position of Baadal Ltd. as on the
date of absorption is given below:
Liabilities
Share Capital (Rs. 10 each)
General Reserve
Creditors
Page 546
Rs.
1,00,000
10,000
30,000
1,40,000
Assets
Fixed Assets
2,000 Shares in Aakash Ltd.
Current Assets
Rs.
90,000
20,000
30,000
1,40,000
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
Show the important ledger accounts in the books of BaadalLtd. and the acquisition entries in the
books of Aakash Ltd.
Solution:
Purchase Consideration:
Shares to be issued by AakashLtd. 10,000 x 5/4
Less: Shares already with BaadalLtd.
Net shares to be issued by AakashLtd.
No. of shares
12,500
2,000
10,500
: . Purchase price = 10,500 x Rs. 11
Particular
To Fixed Assets
To Current Assets
To Shareholder’s Account-Profit
= Rs. 1,15,500
Ledger of Baadal Ltd.
Realization Account
Rs
Particular
Rs
90,000 By Sundry Creditors
30,000 By Aakash Ltd.-Purchase price
__25,500
.
30,000
1,15,500
_______
1,45,500
1,45,500
Note: Shares in Aakash Ltd. are not transferred to Realization Account. They will be used to
settle the amount due to shareholders.
Shareholders’Account
Particular
Rs
Particular
To Shares in A Ltd.
1,37,500 By Share Capital
By General reserve
By Realization a/c
_______ By Shares in A Ltd
1,37,500
Rs
1,00,000
10,000
25,500
2,000
1,37,500
Tutorial Notes:
(1) Value of 2,000 shares already held
Revalued at the latest price of Rs. 11 each
Profit on revaluation transferred to shareholders’ account
UNIT 7: Amalgamation, Absorption and Reconstruction
Rs. 20,000
Rs. 22,000
Rs. 2,000
Page 547
ICAN Advanced Accounting CAP II Chapter III
Share in Aakash Ltd.
Amount
Rs.
2,000
20,000 By Shareholders
2,000 Account
10,500
1,15,500
12,500
1,37,500
Number
To Balance b/d
To Shareholders
A/c
To Aakash Ltd.
Number
Amount Rs.
12,500
1,37,500
_____
12,500
_______
1,37,500
Journal Entries of Aakash Ltd.
Date
Particulars
Business Purchase A/c
To The Liquidator of Baadal Ltd.
Goodwill account
Fixed Assets
Current Assets
To Sundry Creditors
To Business Purchase A/c
Liquidator of Baadal Ltd.
To Share Capital Account
To Share Premium Account
L.F. Debit
Credit
Rs.
Rs.
Dr.
1,15,500
1,15,500
25,500
Dr.
90,000
Dr.
30,000
Dr.
30,000
1,15,500
1,15,500
Dr.
1,05,500
10,500
Instead of acquiring the shares in Aakash Ltd. already held by BaadalLtd., they can be used by
payment of purchase consideration.
(b)
Net Assets Method. If net assets method is adopted, the assets in the form of
‘Investment in shares of the purchasing company’ are not taken into consideration for
calculating the purchase consideration.
11.3 When Shares are held by both the Companies in each other
This is case of cross-holdings. This calculation of purchase consideration again depends on
the method given in the problem. The procedure is explained and illustrated under both the
methods:
(a)
Net Payment method. Under this method, purchase price is calculated as follows:
1)
Calculate the number of shares to be issued to outside shareholders in the absorbed
company.
2)
Calculate the number of shares due to purchasing company as shareholder in the
vendor company. These however will not be issued. The value of these shares
would be set-off against shareholders’ account.
Page 548
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
3)
4)
5)
Add the shares calculated under (1) and (2) to get the total number of shares.
From the total under (3) deduct the number of shares already held by the absorbed
company.
Multiply the number of shares arrived at under (4) with the issue price and the
resultant figure is purchase consideration.
Illustration 11:
PeleLtd. is to absorb MarodonaLtd., by issuing 5 shares of Rs. 10 each at a premium of 10% for
every 4 shares held in Marodona Ltd. On the date of absorption the Statement of Financial
Position were as under:
Liabilities
Share capital
(shares of Rs.
10 each)
General
reserve
Creditors
Pele Ltd.
Rs.
5,00,000
50,000
1,00,000
_______
6,50,000
Marodona
Ltd.
Rs.
3,00,000
40,000
60,000
_______
4,00,000
Assets
Fixed assets:
Investments
6,000 shares
in Marodona
Ltd.
5,000 shares
in Pele Ltd.
Current assets
Pele
Ltd.
Rs.
4,00,000
Marodona
Ltd.
Rs.
2,00,000
80,000
1,70,000
6,50,000
60,000
1,40,000
4,00,000
You are required to show (a) the important ledger accounts in the books of Marodona Ltd. and
(b) the acquisition entries in the books of Pele Ltd.
Solution:
Purchase Consideration
1.
Shares to be issued to outside shareholders of
Marodona Ltd.
2.
Shares due to Pele Ltd. (which however will not be
issued)
3.
4.
5.
6.
Total of (1) and (2)
Deduct shares already held by Marodona Ltd.
Net number of shares constituting P. C.
P.C. will therefore be 32,500 x Rs. 11
UNIT 7: Amalgamation, Absorption and Reconstruction
No. of Shares
24,000 x 5 = 30,000
4
6,000 x 5 = 7,500
4
________
37,500
5,000
32,500
= Rs. 3,57,500
Page 549
ICAN Advanced Accounting CAP II Chapter III
Particular
To Fixed Assets
To Current Assets
To Shareholders’ A/c-Profit
Ledger in the books of
Marodona Ltd.
Realization Account
Rs Particular
2,00,000
1,40,000 By Sundry Creditors
77,500 By Pele Ltd.-Purchase price
60,000
3,57,500
4,17,500
4,17,500
Rs
Pele Ltd. Account
Particular
To Balance b/d
Particular
To Balance b/d
To Pele Ltd. – Shares
Received now
Rs Particular
3,57,500 By Shares in Pele Ltd.
By Shareholders’ account
_______ -set –off
3,57,000
Shares in Pele Ltd. Account
Rs Particular
By Shareholders’ account
60,000
-loss on revaluation
By Shareholders’ A/c
2,75,000 distribution
3,35,000
Particular
To Pele Ltd.-Set-off
To Shares in Pele Ltd.
-loss on revaluation
To Shares in Pele Ltd.-distribution
Shareholders’ Account
Rs Particular
82,500 By Share Capital
By General Reserve
5,000 By Realization A/c
3,30,000
-Profit
4,17,500
Rs
2,75,000
82,500
3,57,000
Rs
5,000
3,30,000
3,35,000
Rs
3,00,000
40,000
77,500
4,17,500
Journal of PeleLtd.
Particulars
(i)
Business Purchase A/c
To the liquidator of Marodona Ltd.
(ii)
Goodwill A/c (balancing figure)
Fixed Assets
Current Assets
To Sundry Creditors
To Business purchase account
Page 550
Dr.
Dr.
Dr.
Dr.
Debit
Credit
3,57,500
3,57,500
77,500
2,00,000
1,40,000
60,000
3,75,500
UNIT 7: Amalgamation, Absorption and Reconstruction
ICAN Advanced Accounting CAP II Chapter III
(iii)
(1)
(iv)
Liquidator of B Ltd.
Dr.
To Share Capital Account
To Share Premium Account
To Shares in Marodona Ltd. Account
3,57,500
2,50,000
25,000
82,500
2,500
Shares in B Ltd.
To Goodwill Account (2)
Dr.
2,500
(1)
Pele Ltd. will issue net 25,000 shares only. Of the 32,500 shares, 7,500 shares are due to
Pele Ltd. itself and therefore these will not be issued.
(2)
Shares in Marodona Ltd., stand in the books of Pele Ltd., at Rs. 80,000. But these are
surrendered to the liquidator at Rs. 82,500 that being the amount due to Pele Ltd. The
resulting profit of Rs. 2,500 is utilized to reduce goodwill arising out of absorption.
(b)
Net Asset method. Under this method, the net assets of a company can be ascertained
only by solving simultaneous equations.This is so because the value of the share of one
company affects the value of the shares of the other company. Following steps are
necessary:
(1)
Calculate the total value of assets of each company by algebraic equation.
(2)
From the total assets of the vendor company (calculated as per 1 above) deduct the
proportionate value of assets because of the claim of the purchasing company in the
vendor company.
(3)
From the balance thus remaining make one more deduction for the shares of the
purchasing company held by the vendor company.
12. DISCOUNTED CASH FLOW MODEL
In the Chapter on Valuation of Shares, we have given the different models for valuing shares
such as zero growth rate and constant growth rate. Therefore the valuation of the shares of the
target company can be done on the basis of