MCA-14-Financial Accounting:
I. Financial Statements
Financial Statements- meaning-Usefulness-Trading Account – Manufacturing AccountProfit and Loss A/c- Balance Sheet- Distinction between Fixed Assets and Current
Assets-Tangible Assets and Intangible Assets- Distinction between Trading and Profit
and Loss Account and a Balance Sheet-Distinction between a Trial Balance and a
Balance Sheeet
Introduction:
Financial statements give detailed information about the firm. Financial
statements are organized summaries of detailed information and are thus a form of
analysis. The type of statement, the accountants prepares, the way they arrange items on
these statements, and their standard of disclosure are all influenced by a desire to provide
information in a convenient form.
A financial statement is an organized collection of data according to logical and
consistent accounting procedures. Its purpose is to convey financial information to
concerned party. It may show the financial position of the business as on a particular day
as in the case of balance sheet or disclose a series of activities during a given period, as in
case of income statement or profit and loss account. The focus of financial analysis is on
key figures contained in the financial statement. Financial statements are indicators of
two significant factors, namely:
a) Profitability
b) Financial soundness
Meaning of Final accounts of company :
Section 209 of the Companies Act requires every company to maintain proper
Books of accounts and section 210 has made it mandatory on the company to lay
before its shareholders, at every annual general meeting, a balance sheet and profit and
Loss account. Therefore every company is under legal obligation to present its
accounts in the prescribed manner.
The final accounts of a joint stock company refer to profit and loss account
(Income Statement) and Balance Sheet (Position statement) prepared at the end of
every year. Though the Act mentions only profit and loss account and Balance sheet, in
practice Profit and Loss account is divided into Trading account, Profit and Loss
account and profit and Loss Appropriation account. Trading account shows the result
of trading by disclosing Gross Profit/Loss and Profit and Loss account shows the Net
Profit/loss of the business.
Trading and Profit and Loss Account
The Trading and Profit and Loss Account shows operating expenses and other
expenses incurred by the company during the accounting period.It contains items as
detailed below.
Format of Trading and Profit and Loss account:
Trading and Profit and Loss Account for the year ended....
Dr
TRADING ACCOUNT
Cr
--------------------------------------------------------------------------------------------------------PARTICULARS
Rs
PARTICULARS
Rs
To Opening stock
xxxx
By Sales
xxxx
xxxx
xxxx
less: sales returns
xxx
xxxx
By Closing Stock
Wages
xxxx
By Gross loss c/d
Fuel and power
xxxx
Coal,gas and water
xxxx
Freight
xxxx
Import duty
xxxx
Excise duty
xxxx
Octroi
xxxx
Royalty paid
xxxx
Other direct expenses
xxxx
To Gross profit c/d
xxxx
To Purchases
Less purchase returns
xxx
xxxx
xxx
To Direct/Mfg.expenses
xxxx
.......
PROFIT AND LOSS ACCOUNT
PARTICULARS
Rs
PARTICULARS
To gross loss b/d
xxxx
By gross profit b/d
xxxx
By interest received
xxxx
To Office/Admn. expenses
Rs
Salaries
xxxx
By discount received
xxxx
Rent,rates and taxes
xxxx
By commission received
xxxx
Printing &Stationery
xxxx
By rent received
xxxx
Postage & telegrams
xxxx
By dividend received
xxxx
Insurance
xxxx
By transfer fees
xxxx
Legal charges
xxxx
By Miscellaneous incomes
xxxx
Telephone charges
xxxx
By Net loss transferred to
Audit fees
xxxx
P&L Appn.account
Bank Charges
xxxx
General expenses
xxxx
Director’s fees
xxxx
Miscellaneous exps. xxxx
To Selling &Distribution Expenses
Advertising
xxxx
Travelling expenses
xxxx
Commission paid
xxxx
Discount allowed
xxxx
Carriage/freight outwards
xxxx
Bad debts etc.
To financial expenses:
Interest on loan
xxxx
Interest on debentures
xxxx
To provision for:
Bad & doubtful debts
xxxx
Depreciation
xxxx
Repairs & maintenance
xxxx
Managerial remuneration
xxxx
To any other expenses
xxxx
To Net profit transferred
To P&L Appropriation a/c
xxxx
--------------------------------------------------------------------------------------------------------xxxx
xxxx
Profit and Loss Appropriation Account
xxxx
The Profit and Loss Appropriation account is prepared in order to show how the
profits of the company are appropriated or allocated for various purposes such as
payment of dividend, transfer to vaious reserves etc.
Format of Profit and Loss Appropriation account
Name of the company.......
Dr
Profit and Loss appropriation account for the year ended....
Cr
--------------------------------------------------------------------------------------------------------Particulars
To Balance b/d
Rs
xxxx
Particulars
Rs
By balance b/d
(losses b/d from previous year)
(profit b/d from previous year)
To Net loss transferred
By net profit transferred
xxxx
from P&L a/c of current year
xxxx
from P&L a/c of current year
xxxx
To transfer to funds
xxxx
By transfer from any fund
xxxx
(Reserve fund, Sinking fund
By balance carried to
Dividend Equalization Fund etc.)
to assets side of the Balance sheet
To Dividend paid
xxxx
To Interim dividend
xxxx
To Proposed dividend
xxxx
To Balance carried to liabilities
side of the balance sheet
xxxx
--------------------------------------------------------------------------------------------------------xxxx
xxxx
Differences between Profit and Loss account and Profit and Loss Appropriation
account
1. Profit and loss account is prepared for recording expenses, losses, and gains of
the current uear, whereas profit and loss appropriation acount is prepared for recording
the appropriation of profit i.e how the profits are utilized for various purposes such as
payment of dividend, etc.
2. Profit and Loss account is always prepared whereas the profit and loss
appropriation account is prepared only when there is appropriation of profits.
3. The balance of profit and loss accounti.e net profit or loss is transfered to
profit and loss appropriation account. On the other hand the balance of Profit and Loss
Appropriation account is carried forward from year to year.
4. Profit and loss accunt discloses the net profit or net loss before appropriation
whereas the closing balance of profit and loss appropriation account represents net
xxxx
profit
appropriation.
or
net
loss
after
Balance sheet
Section 211 provides that the balance Sheet shall give a true and fair value of the
state of affairs of the company as at the end of the financial year and shall be in the
prescribed form set out in part I of schedule VI. The balance Sheet is prepared in order
to indicate the financial position of the company as on the last date of the trading
period.
The Balance sheet of a company can be drawn either in horizontal form or in
vertical form. In the horizontal form of presentation assets are shown on the right hand
side and liabilities are shown on the left hand side. In the vertical form, the liabilities
are shown under the “Sources of funds” and assets are shown under the heading
“Application of funds” given below are the two forms of Balance Sheet:
Horizontal form:
Name of the company
Balance Sheet as at....
--------------------------------------------------------------------------------------------------------Liabilities
Rs
Assets
Rs
-------------------------------------------------------------------------------------------------------1. Share capital
1. Fixed Assets
Authorized: Shares of Rs... each
a) Goodwill
.....
Issued: Shares of Rs...each
b) Land
.....
Subscribed: Shares of Rs...each
c) Building
.....
Called up: Shares of Rs...each
d) Leaseholds
.....
Rs....called up
.....
e) Railway Sidings
.....
Less calls unpaid
.....
f) Plant and Machinery
.....
.....
g) Furniture and fittings
.....
.....
h) Development of property
.....
i) Patents, Trade marks & designs
.....
j) Live stock
.....
k) Vehicles
.....
Add: Forfeited Shares
Paid up capital
.....
2. Reserves and Surplus
1) Capital Reserve
.....
2) Capital Redemption Reserve
.....
3) Securities premium a/c
.....
4) Other Reserves
Less Debit balance in
......
2. Investments:
1) In Government Securities
2) In Shares, Debentures,
P& L Account, if any
.....
5) P & L Appropriation a/c
3) In immovable Properties
.....
3) Current Assets, Loans
6) Proposed Addition to reserve
& Advances
7) Sinking Funds
A) Current Assets
3. Secured Loans:
1) Interst accured on investments
.....
2) Stores and Spare parts
.....
3) Loose Tools
.....
4) Stock in Trade.....
.....
5) work in progress
.....
1) Debentures
.....
2) Loans and advances
from Banks
.....
3) Loans and Advances
from subsidiaries
.....
6) Sundry Debtors
.....
4) Other Loans and Advances
.....
7) Cash Balance on hand
.....
8) Bank Balance
.....
4. Unsecured loans
1) Fixed Deposits
.....
B) Loans and Advances
2) Loans and Advances
9) Loans and Advances
3) Short-term loans & Advances:
to subsidiaries
a) From Bank
.....
10) Bills of exchange ie.,Bills
b) From Others....
Receivable
.....
11) Prepaid expenses
5. Current Liabilites
4. Miscellaneous Expenditure
and Provisions
1) Preliminary expenses
(A) Current Liabilites
2) Expenses including commission
1) Acceptances (B/P)
.....
or brokerage on underwriting of
2) Sundry Creditors
.....
Shares or Debentures
3) Outstanding expenses
.....
4) Income recieved in advance
.....
3) Discount allowed on
5) Unclaimed Dividends
.....
issue of shares
6) Other Liabilities
.....
or debentures
(B) Provisions
4) Development expenditure
7) Provision for Taxation
.....
not adjusted
8) Proposed dividends
.....
5) Other sums
9) Provision for Contingencies
.....
5. Profit & Loss Account
10) Provision for Insurance,
Debit balance of profit
Pension and Similar Staff
and loss accounts
.....
....
Benefit Scheme
.....
which could not be deducted
11) Other Provision
.....
from free reserves, if any
Total
.....
Total.....
---------------------------------------------------------------------------------------------------------
Vertical form of Balance Sheet:
Balance sheet as on..........
--------------------------------------------------------------------------------------------------------Schedule No.
Figures as ath the
Figures as at the
End of the current
end of the previous
Financial Year
Financial year
--------------------------------------------------------------------------------------------------------Rs.
Rs.
I Sources of Funds
1. Shareholders Funds
a) Capital
b) Reserves and Surplus
2. Loans Funds:
a) Secured Loans
b) Unsecured Loans
Total
II Application of Funds:
1. Fixed Asets:
a) Gross Block
b) Less Depreciation
c) Capital Work-in-progress
2. Investments
3. Current Assets,
Loans and Advances:
a) Inventories
b) Sundry Debtors
c) Cash and Bank balances
e) Loans and Advances
Less: Current Liabilities and Provisions
a) Liabilities
.....
b) Provisions
Net Current Assets
4. a) Miscellaneous expenditure
(to the extent not written off or adjusted)
b) Profit and Loss account
(Debit Balance)
-------------------------------------------------------------------------------------------------Total
------------------------------------------------------------------------------------------------Details under each of the above items are to be given by way of a separate
schedule. The schedule incorporates all the information required.
TRIAL BALANCE:
Trial Balance is a statement showing Debit and Credit Balances of Accounts
obtained after balancing them. It contains two separate sides called debit side and credit
side. The totals of both debit side and credit side of the trial balance should be equal
keeping in conformity with the basic rule of double entry book keeping that every debit
should have a corresponding credit. There are mainly two methods of preparing the trial
balancenamely; The Balances method and the totals method. Under the Balances
method only balances obtained by balancing various accounts will be listed. Under the
totals method, the totals of accounts are listed. A third method of showing both totals
and balances is also used rarely.
Differences between Trial Balance and Balance sheet:
.1. A trial Balance shows balances of all the accounts maintained where as a
balance sheet shows the balances of Assets and Liabilities only.
2. A trial balance may be prepared in any format as long as debit and credit
balances are shown. It is not a statutory document. Balance sheet has to be prepared
keeping in mind the provisions of companies act.
3. A trial Balance has debit and credit columns where as a Balance sheet has
Liabilities and Assets columns.
4. A trial Balance shows only balances of various accounts, whereas a Balance
sheet shows financial position of a company as at the end of an accounting period.
Important points to be considered while preparing the final accounts of
companies
Treatment of some items while preparing final accounts:
1.Outstanding or Accrued Expenses: Expenses which have been incurred
during the year, the benefit out of which has been derived during the year, but the
payment in respect of which the payment has not been made is called accrued expense.
It is shown on the debit side of the profit and loss account. It will also be shown in the
Balance sheet on the liability side.
2.Accrued or outstanding income: These are incomes or benefits which have
been earned but not yet received in cash during the year. It will be shown on the credit
side of the Profit and Loss account and it also appears on the Asset side of the Balance
sheet.
3.Prepaid or unexpired expenses: In some cases the benefits of payment made
during the previous year will be available in the next year also. It is shown in the
balance sheet as an asset. It is shown as a deduction from the account concerned on
the debit side of the profit and loss account.
4.Capital and Revenue expenditure: Of the total expenditure incurred by a
company during a year, two types are there, viz.Capital Expenditure and Revenue
Expenditure. Revenue expenditure are shown in the Profit and loss account. The
benefit derived from revenue expense are having benefits during a short period. The
capital expenses are shown in the balance sheet and the benefits derived from capital
expenditure are long range. Viewed from this angle, the profit and loss account is
called Revenue Account.
5.. Calls in arrears:
Calls-in-arrears represent the amount not paid by the shareholders on the calls
made by the company. This items usually appears on the debit side of the trial balance
and in the balance sheet it should be shown by the way of deduction from called-upcapital.
6. Calls in advance:
Calls in advance represent the amount received from the shareholders before
calls are made by the company. It is shown separately as an item under the heading
‘share capital’. It should not be added to called up or paid up capital.
7. Forfeited shares:
It represents shares forfeited by the company for the non payment of allotment
money or/and call money.It is shown on the liabilities side of the balance sheet by way
of addition to the paid up capital.
8. Preliminary expenses:
They represents expenses incurred in the formation of a company. They are
entered on the assets side of the balance sheet under the heading ‘Miscellaneous
expenditure’
However,
preliminary expenses written off should be debited to profit and loss account.
9. Dividend:
Dividend refers to that portion of profits of a company distributed among the
shareholders. If it appears in the trial balance (debit balance) it should be shown on the
debit side of the profit and loss appropriation account. On the other hand, if it appears
in the adjustment, first it should be shown on the debit side of the profit and loss
appropriation account and secondly it should be shown as a liability under the heading
‘provisions’ in the balance sheet.
10. Interim dividend:
It is the dividend declared by the directors of company in the middle of the year
in anticipation for the profits of the current year. It should be shown on the debit side
of
the
profit
and
loss
appropriation account.
11. Final dividend:
It is the dividend recommended by the directors and approved in the annual
general meeting by the shareholders. When the final dividend is declared, the interim
dividend already declared and paid should not be adjusted against the final dividend,
unless otherwise instructed. Final dividend appearing in the adjustments should be first
entered
on
the
debit
side
of
the
profit
and
loss
appropriations account and secondly it should be recorded as a liability in the balance
sheet under the head “Provisions”.
13. Proposed dividend:
it is dividend proposed by the directors and it is usually given in the adjustment.
Therefore it should be recorded on the debit side of profit and loss appropriation
account and also shown as a liability in the balance sheet under the heading
“provisions”.
Further
when
dividend
is
to
be
calculated as a percentage on share capital, it should be calculated only on paid up
capital (i.e, called up capital less calls in arrears)
14. Unclaimed dividend:
It represents dividend not collected by the shareholders from the company.
Therefore
it
is
a
liability and shown under the heading “current liabilities” in the balance sheet.
15. Dividend received:
It represents income of the company on investments made by it in the shares of
other
companies. It appears as a credit balance in the trial balance and hence recorded on the
credit side of the profit and loss account.
Illustration -1
From the following information of Ajantha limited, prepare Trading and profit
and loss account for the year ended 31-12-2005
Opening stock
16,000
Purchases
28,600
Sales
50,900
Purchases returns
600
Sales returns
900
Wages
2,400
Salaries
2,800
Directors Fees
2,000
Gas and water
1,100
Carriage inwards
1,600
Trade expenses
2,000
Rent, rates and insurance
1,100
Discount allowed
400
Discount received
200
Bad debts
1,200
Audit fees
1,400
Interim dividend
2,800
Preliminary expenses written off
400
Profit and Loss appropriation a/c (cr)
3,000
Adjustments:
Closing stock
16,000
Transfer to general reserve
2,200
Depreciation on machinery
1,300
Solution Trading and profit and loss Account for the year ended 31-12-2005
Dr.
Cr.
--------------------------------------------------------------------------------------------------------Particulars
Rs
To opening stock
To Purchases
16,000
28,600
Particulars
By Sales
Less sales returns
To Carriage inwards
1,600
To Wages
2,400
To Gas and water
1,100
To Gross profit c/d
16,900
Rs
50,900
900
---------------------------------------------------------------------------------------------------------
50,000
66,000
66,000
--------------------------------------------------------------------------------------------------------To Salaries
2,800
By Gross profit b/d
To Trade expenses (Gen expenses)
2,000
By Discount received
To Rent, rates and insurance
1,100
To Directors Fees
2,000
To Audit Fees
1,400
To Prel.expenses written off
400
To Discount allowed
400
To Bad debts
1,200
To Depreciation on machinery
1,300
16,900
200
To Net profit transferred
to profit and loss
appropriation a/c
4,500
--------------------------------------------------------------------------------------------------------17,100
17,100
--------------------------------------------------------------------------------------------------------Dr.
Profit and Loss Appropriation account for the year 31-12-2005
Particulars
Rs
Particulars
Cr.
Rs
To Interim dividend
2,800
By bal c/d (last year’s bal)
3,000
To Transfer to Gen. reserve
2,200
By current year’s profit b/d
4,500
To Balance carried to
Balance sheet
2,500
--------------------------------------------------------------------------------------------------------7,500
7,500
--------------------------------------------------------------------------------------------------------Illustration - 3
From the following balances of the Bahubali Trading company Ltd., for the year ended
31-12-2005, prepare profit and Loss appropriation Account and Balance sheet after
transferring Rs. 20,000 to reserve fund, Rs. 10,000 to Dividend Equalization Fund and
Rs. 6,000 to Insurance Fund from the current year’s profit.
Rs.
Share Capital
20,000
Reserve Fund
34,000
Dividend Equalization Fund
16,000
Insurance Fund
8,000
Land & Buildings
1,00,000
Profit & Loss Appropriation A/c (Cr)
14,000
Profit & Loss Account (Current year Net profit)
42,000
Machinery
12,000
Interim dividend paid
12,000
Stock
48,000
Debtors
50,000
Creditors
20,000
Cash
30,000
Security premium A/c
2,000
Forfeited Shares A/c
4,000
Calls in Arrears
20,000
Solution - 3
Bahubali Trading Co., Ltd.,
Profit and Loss Appropriation A/c for the year ended 31-12-2005
Dr.
Cr.
--------------------------------------------------------------------------------------------------------Particulars
Rs
Particulars
Rs
To Interim Dividend
12,000
by Balance B/d
14,000
To Transfer to reserve fund
20,000
By Current years Net profit
42,000
To Transfer to Dividend
Equalization fund
To Transfer to Insurance fund
10,000
6,000
To Balance carried to
Balance sheet
8,000
--------------------------------------------------------------------------------------------------------56,000
56,000
Bahubali Trading Co., Ltd.,
Balance sheet as on 31-12-2005
Liabilities
Rs
Assets
Rs
--------------------------------------------------------------------------------------------------------1. Share Capital
1. Fixed Assets
Authorised capital
2,00,000
Land & Buildings
Issued & Subscribed
2,00,000
Machinery
Called up
Less calls in arrears
2,00,000
1,00,000
80,000
2. Investments------------------------
20,000
3. Current assets and--------------------
1,80,000
Loans and Advances--------------------
Add forfeited Shares
4,000
Paid up capital
A. Current Assets
1,84,000
2.Reserve & Surplus:
Reserve Fund
34,000
Add Addition
-
20,000
54,000
Dividend
Stock
48,000
Debtors
50,000
Cash
30,000
B. Loans & Advances
4. Miscellaneous Expenditure---------
Equalisation Fund
16,000
Add Additions
10,000
Insurance Fund
8,000
Add. Additions
6,000
26,000
14,000
Security premium
2,000
Profit & Loss Appropriation A/c
8,000
3. Secured Loans
-
4. Unsecured Loans
-
5. Current Liabilities & Provisions:
A. Current Liabilities Creditors
20,000
B. Provisions
--------------------------------------------------------------------------------------------------------3,08,000
----------------------------------------------------------------------------------------------------------
3,08,000
Illustration
Following is the trial balance of Cheman Company Ltd”. As on 31st December, 2004
Prepare trading account, Profit and loss account, profit and loss appropriation account
and balance sheet.
-----------------------------------------------------------------------------------------------------Particulars
Dr.
Cr.
Rs.
Rs.
-------------------------------------------------------------------------------------------------------Capital
-
2,00,000
1,30,000
-
Investments
60,000
-
Machinery
15,000
-
Furniture
4,000
-
Bills receivable
6,400
-
Carriage inwards
2,500
-
Wages
21,000
-
Salary
8,500
-
-
5,000
60,000
1,10,000
Returns
2,000
1,000
Rent and rates
1,800
-
Preliminary expenses
6,000
-
Debtors and Creditors
42,000
15,000
2,500
10,000
-
14,000
30,000
-
Insurance
1,300
-
Discount
2,000
-
-
40,000
(2500 shares of Rs. 100 each
on which Rs. 80 called up
Land and Buildings
Bills payable
Purchases and Sales
Advertising & Reserve Fund
Profit and Loss a/c
Stock (1-1-94)
5% debentures
--------------------------------------------------------------------------------------------------
3,95,000
3,95,000
--------------------------------------------------------------------------------------------------Adjustments:
a) Write off Rs. 2,000 from preliminary expenses
b) Transfer Rs. 10,000 to reserve fund
c) Stock on 31-12-2004 Rs. 65,000
d) Provide for dividend on share capital at 10%
e) Debentures interest is outstanding for one year
Solution -4
Cheman Company Ltd.,
Dr.
Trading and Profit and Loss Account for the year ended 31-12-2004
Cr.
--------------------------------------------------------------------------------------------------------Particulars
Rs
Particulars
To Opening stock
30,000
By Sales
To Purchases
60,000
Less Purchase returns
1,000
To Carriage inwards
Less sales returns
59,000
Rs
1,10,000
2,000
By Closing stock
1,08,000
65,000
2,500
To Wages
21,000
To Gross profit c/d
60,500
--------------------------------------------------------------------------------------------------------1,73,000
To Salaries
8,500
To Rent & rates
1,800
To Advertising
2,500
To Insurance
1,300
To Discount
2,000
To Preliminary exp.written off
2,000
To Interest due on Debentures
2,000
[4,000x5/100]
To Net profit transferred to profit
and loss appropriation a/c
40,400
1,73,000
By Gross profit b/d
60,500
--------------------------------------------------------------------------------------------------------60,500
60,500
--------------------------------------------------------------------------------------------------------Dr.
Profit and Loss appropriation A/c for the year 31-12-2004
Cr.
--------------------------------------------------------------------------------------------------------Particulars
Rs
Particulars
Rs
--------------------------------------------------------------------------------------------------------To Transfer to Reserve fund
10,000
By BalanceB/d
14,000
(Last year’s profit)
To Proposed dividend
20,000
By Current year’s Net profit
40,400
[2,00,000x10/100]
To Balance carried to
Balance sheet
24,400
------------------------------------------------------------------------------------------------54,400
54,400
Balance Sheet as on 31-12-2004
-----------------------------------------------------------------------------------------------Liabilities
Rs
Assets
Rs
-----------------------------------------------------------------------------------------------1. Share Capital
Authorised capital
1. Fixed Assets
2,50,000
Land & Buildings
2,500 share of Rs. 100 each
Machinery
Issued & Subscribed 2,500
Furniture
shares of Rs. 100 each
2. Investments
Called up and paid up
2,50,000
15,000
4,000
60,000
3. Current Assets &
2500 shares of Rs.100
Loans and Advances
each, 80 called up and paid up
A. Current Assets
2,00,000
1,30,000
Stock
65,000
Debtors
42,000
B. Loans and Advances
Bills Receivable
6,400
2. Reserves & Surplus:
Reserve Fund
10,000
Add. Additions
10,000
4. Miscellaneous Expenditure
20,000
Profit and Loss
Appropriation A/c
Preliminary Exps.
6,000
Less written off
2,000
4,000
24,400
3. Secured Loans
5% Debentures
40,000
Add interest due
2,000
42,000
4. Unsecured Loans
5. Current Liabilities and
Provisions
A. Current Liabilities
Creditors
Bills payable
B. Provision: Proposed Dividend
15,000
5,000
20,000
------------------------------------------------------------------------------------------------------3,26,400
---------------------------------------------------------------------------------------------------------****************
3,26,400
2. Consignment Accounts
CONSIGNMENT
Consignment: Sometimes businessmen appoint their agents at distant place to sell
their products or goods with a view to increase the sales and earn larger profits. Goods
are sent to these agents who sell them on commission on account and risk of the
principal. The Word “consignment” is derived from these types of principal agent
relationships and implies sending of goods to another person without transferring the
ownership to that other person. In such a case, if the goods do not fetch the required
price or are destroyed, the loss will be borne by the person who sends them.
In consignment business, generally there are two parties-the consignor and the
consignee. The person who sends the goods to the agent for sale is called the consignor.
The person to whom the goods are sent for sale is called the consignee. The consignee
sells the goods and remits the proceeds to the consignor after deducting his expenses.
Consignment Terminology
1. Consignment A/c. : A consignment account is separately prepared which is
debited with the cost of goods supplied and expenses incurred both by the consignor and
the consignee. It is credited by the sales proceeds and the stock of unsold gods.
Consignment account reveals profit or less on consignment which is transferred to profit
and loss A/c. Goods sent to an agent for the purpose of sale cannot be treated as sales.
The transfer of such goods is credited to Goods sent on Consignment A/c and debited to
Consignment A/c.
2. Account Sales. This is a statement of account prepared and sent by the agent to
the principal. After a certain period of time, the agency (consignee) prepares the account
sales which show the quantity and description of goods sold, sales proceeds realized, the
expenses incurred by consignee, his commission and the balance amount payable by him
to the principal. The account sales is rent to the consignor, who makes entries in
Consignment A/c and consignee’s A/c and ascertains the amount of profit or loss on
consignment. (A specimen of Account sales is given below.)
Account Sales of 200 Transistor received from and sold on behalf
And at the risk of M/s Shri Sounds, Bangalore.
------------------------------------------------------------------------------------------------------Date
Particulars
Amount
--------------------------------------------------------------------------------------------------------
Total
1976
Sept.30
150 Transistors Sold @ Rs.150 each
50 Transistors Sold @ Rs.180 each
Less: Expenses Incurred:
Cartage and Freight
Insurance
Godown rent
Commission @ 10% of sales
22,500
9,000
31,500
250
150
100
3,150
Less Bill accepted by us
Bank Draft enclosed
3,650
27,850
10,000
17,850
--------------------------------------------------------------------------------------------------------E.& O.E.
For Shri Sounds
Ramesh, Partner
3. Consignee’s Commission. Commission is the remuneration paid to the
consignee by the cosignor is consideration of the services provided by him in selling the
goods consigned. This is given over and above the amount of expenses incurred by
consignee on sale of goods. Commission is paid at an agreed percentage over the sales
proceeds. It thus depends on the amount of sales done by the consignee.
4. Del Credere Commission. Sometimes the consignor expects that the consignee
should himself recover all the debts and bear the loss, on account of bad debts, if any. In
order to compensate him from this type of loss, some extra commission is paid to him.
This extra commission is called Del Credere commission and is calculated on the total
amount of sales unless there is a special agreement that it is to be paid only on the amount
of credit sales. Payment of this commission imposes extra liability on the consignor and
induces him to deal in a prudent and cautions manner became otherwise loss on account
of bad debts will be borne by him.
5. Proforma Invoice. As already stated, goods sent on consignment cannot be
treated as sale therefore invoice can’t be prepared in respect of such goods. Therefore,
the consignor sends a proforma invoice (invoice for form’s sake to the consignee so as to
inform him about the cost of goods supplied, expenses incurred and a minimum sale price
to be charged by him on sales. A proforma invoice also includes information about the
quantity and description of goods, the number and weight, mark, packing of the
containers of goods and so on.
A proforma invoice may reflect (i) actual cost and expenses incurred by the
consignee or it may be prepared at (ii) inflated price of goods so that consignee may not
know the actual cost of the goods. The main object for which inflated proforma invoice
is prepared is to ensure a minimum margin of profit over the cost of goods supplied to the
consignee.
6. The Consignee. The consignee does not become the owner of goods on
receiving the consignment. H remains as an agent of the consignor. The law of agency
applies between consignor-consignee relationships. The consignee is to sell the goods
consigned to him. If he has incurred some expenses, such as advertisement, insurance,
godown rent, salesmen’s salaries etc., he can recover them from the amount of sales
proceeds received by him. We can also charge his commission, including del Credere
commission out of the sales proceeds. He is not liable to make payment to the consignor
until the goods are sold. When goods are sold out or after a certain period of time, he
sends an account sales to the consignor giving details of the goods sold, his expenses and
commission and the balance payable by him to the consignor.
Difference between a Consignment and a Sale:
1. In a sale, the relationship between the parties is that of a buyer and seller
whereas in a consignment, the relationship is that of an agent and principal.
2. Where a sale is complete, the buyer becomes the debtor of the seller but in a
consignment, the consignee does not become debtor of the consignor on receipt of the
consignment.
3. In case of a sale, the legal ownership and title of goods sold of transferred to the
buyer whereas in a consignment, the legal ownership and title over goods remains with
the consignor.
4. Goods can’t be returned after the sale is complete. But in the case of
consignment, the consignee can return the unsold goods to the consignor.
5. In case of a sale, expenses incurred by the buyer on goods after sale are to be
borne by the buyer himself. But in a consignment, consignee can recover the amount of
expenses incurred by them on the goods consigned.
6. If goods are destroyed after sale, buyer only will suffer the Loss, because he
becomes the owner of goods, after sale. But in case of consignment, risk attached to the
goods is borne by the consignor and not the consignee.
ACCOUNTING TREATMENT
Accounting Treatment. Journal entries in the books of the consignor and the
consignee relating to the transactions of consignment will be made in the manner
discussed below:
1. When goods are sent to the consignee. As consignment of goods can’t be
treated as sales of goods, sales account will not be credited in the books of the consignor.
In its place, an account entitled goods sent on consignment account will be credited.
The following entry will be recorded:
Consignor’s Books
Consignee’s Books
Consignment Account
Dr.
No Entry
To Goods sent on Consignment Account
The entry in consignor’s books will be made with the cost of the goods consigned.
If consignments have been sent to more than one consignees, the consignment accounts
may be distinguished by adding the names of the place or the consignees along with the
Consignment A/s, (for example Consignment to Bombay A/c, Consignment to Ramesh
A/c etc.) It may be noted that no entry will be passed by the consignee.
2. Consignor’s Expenses. All expenses incurred by the consignor on consignment
of goods to the consignee are debited to the consignment account and are thus added to
cost of goods consigned. The following entry will be recorded in this connection.
Consignor’s Books
Consignment Account
To Cash Account
Dr.
Consignee’s Books
No Entry
It may be noted that no entry will be recorded in the books of the consignee in this
respect.
3. Advance Remittance by Consignee. Usually the consignee remits a certain sum
of money either by way of cash, bank draft or accepting a bill of exchange as a security
against the goods received by him on consignment. The amount of advance can’t be
treated as sales proceeds and therefore should not be credited to the consignment account.
The following journal entries will be recorded in this connection:
or
or
Consignor’s Books
Cash Account
Bank Account
Bills Receivable Account
To Consignee
Dr.
Dr.
Dr.
Consignee’s Books
Consignor
To Cash Account or
To Bank Account or
To Bills Payable
Dr.
4. On discounting the bill, If consignor gets the bill receivable discounted from his
bankers, the following entry will be recorded in his books:
Consignor’s Books
Bank Account
Dr.
Discount Account
Dr.
To Bills Receivable Account
Consignee’s Books
No Entry
The amount of discounts is not debited to Consignment Account.
5. Consignee’s Expenses. Sometimes the consignee also has to incur some
expenses either on the upkeep and maintenance of the goods in safe condition or on their
sale. These expenses may be freight, cartage, godown rent, advertisement, insurance
charges etc. All such expenses are to be borne by the consignor. The following entries
will be recorded in the books in this connection:
Consignor’s Books
Consignment Account
To Consignee’s A/c
Consignee’s Books
Consignor
Dr.
To Cash Account
Dr.
6. Goods sold by Consignee: When the goods are sold out or after a certain period
of time, the consignee will send an account sales to the consignor, intimating him the
total sales and the amount of his expenses and commission, with the amount of total
Gross sales, the following entries will be recorded in books of the consignor and the
consignee:
Consignor’s Books
Consignee’s A/c
To Consignment Account
Consignee’s Books
Dr.
(i) For Cash Sales:
Cash or Bank Account Dr.
To Consignor’s A/c
(ii) For Credit Sale:
Consignment Debtors
Account
Dr.
To Consignor’s A/c
(iii) When Cash received from
Debtors:
Cash or Bank Account Dr.
To Consignment Debtors
Account
7. Consignee’s Commission: The consignee is entitled to commission at an agreed
rate on the gross sales proceeds. The Commission is paid in consideration of the services
provided by him in selling the goods. Commission paid to consignee is debited to
consignment account in consignor’s books. To the consignee, the amount of commission
is an item of income therefore commission account is credited for it. The following
entries are recorded:
Consignor’s Books
Consignment Account
Dr.
To Consignee’s A/c (commission)
Consignee’s Books
Consignor A/c
Dr.
To Commission Account
8. Goods returned by Consignee: Sometimes defective or obsolete goods are
returned by the consignee to the consignor. When such goods are received book the
consignor records this transaction by making the following journal entry:
Consignor’s Books
Goods sent on Consignment Account
Consignee’s Books
Dr.
To Consignment A/c
No Entry
It may be noted that no entry will be recorded in the books of the consignee for
this transaction as he is not required to maintain accounts for goods received on
consignment.
9. Bad Debts: When Del Credere commission is paid. Del Credere commission
is paid to the consignee, if he undertakes to bear the bad debits himself. In case, some
debits are not recorded from consignment debtors, the following entries will be recorded
in the books:
Consignor’s Books
No Entry
Consignee’s Books
Bad Debts Account
To Consignment
Debtors Account
Dr.
10. Remittance by Consignee in settlement of account. Out of the sales proceeds
collected by the consignee, the following items are deducted: expenses incurred by
consignee, his commission (ordinary and del Credere) and the advance remittance made
by him. The balance made by him. The balance amount will have to be remitted by the
consignee to the consignor in settlement of the account. The following entries, in this
connection, will be recorded:
Consignor’s Books
Cash or Bank Account
To Consignee’s A/c
Dr.
Consignee’s Books
Consignor A/c
Dr.
To Cash or Bank Account
11. Unsold stock with the Consignee. It at the end of the accounting period, some
goods remain unsold with the Consignee, the value of such goods be ascertained. The
value is ascertained should be shown in the asset side of the consignor’s balance sheet.
Valuation of stock. The unsold stock with the consignee is to be valued like
ordinary stock. The method of valuation of unsold stock is cost or market price
whichever is lower. Cost price of the unsold stock must included proportionate expenses
incurred by the consignor as well as the consignee relation to the goods sent on
consignment. But consignee’s commission selling expenses, salesmen’s salaries,
advertisement etc. Should be included in such expenses. It may be expressed in simple
terms like this: “All expenses which of incurred up to the point of time; the goods are
received into the godown after consignee should be included in valuation of stock. But
expenses incurred after the goods have been put into consignee’s godown should not be
included in the cost of unsold stock because such expenses usually do not increase the
value of the goods.”
The following expenses, which are of non-recurring nature, should be
proportionately added to the value of the unsold stock:
Carriage,
Freight,
Custom Duty,
Loading and unloading charges,
Insurance,
Dock Charges,
Import duty,
Normal loss etc,
The Following expenses, which are of recurring nature, should not be included in
the value of the unsold stock:
Advertisement,
Godown Rent,
Godown Insurance,
Selling expenses,
Travelling expenses of Salesmen,
Free Samples,
Abnormal loss etc.
The following entry is passed to record the value of unsold stocks:
Consignor’s Books
Consignee’s Books
Consignment Stock Account Dr.
To Consignment Account
No Entry.
12. Normal loss of goods.: In consignment business, Normal loss of goods is that
part of loss which is unavoidable. Normal loss occurs because of some inherent, natural
or unavoidable reasons. Examples of normal loss are: loss of coal in loading and
unloading, loss of spirit or petrol due to evaporation, loss of timber in cutting it into
pieces and so on. Suppose 100 tons of atta at the rate of Rs. 80 per ton was consigned to
the consignee who received 95 tons of coal and the remaining 5 tons of atta was wasted
in loading and unloading. It can legitimately be said that the cost of 95 tons of atta is Rs.
7600 (95 Tons X Rs.80 per ton). Loss of normal type should be apportioned on the
amount of unsold stock in the proportion of the above example,if 10 tons of atta was left
unsold with the consignee, it will be valued like this:
7600 X 10= Rs.800.
95
In the case of normal loss of goods, no entry is to be passed in the books of the
consignor as well as the consignee.
13. Abnormal loss of goods. Abnormal loss is that loss which could have been
avoided. It occurs because of negligence, carelessness, theft, mischief fraud of
employees or inefficiency. Examples of abnormal loss are destruction of goods by fire
theft, breakage, leakage, loss of goods because of mishandling etc. Loss of this nature is
to be treated separately. It is not to be apportioned on the amount of unsold stock. The
cost of goods lost because of abnormal or avoidable reasons is ascertained din the same
manner as cost of unsold stocks is ascertained. This value is debited to abnormal loss
account and credited to consignment Account. The following entry is passed to record
abnormal loss of goods:
Consignor’s Books
Abnormal Loss Account Dr.
To Consignment Account
Consignee’s Books
No Entry
It is to be noted here that abnormal loss account is finally closed by debiting the
balance of this account to the profit and loss account after giving credit for any amount
received from the insurance company.
14. Profit or Loss on Consignment. The balance of the consignment account in
the books of the consignor will now show the amount of profit or loss on consignment.
The following journal entries are recorded in the connection:
Consignor’s Books
Consignee’s Books
(i)
In case there is profit
Consignment Account Dr.
No Entry
To Profit & Loss Account
(ii)
In case there is loss:
Profit and Loss Account Dr.
No Entry
To Consignment A/c
After making this entry, the consignment account will be closed.
17. Closing Entry for Goods sent on Consignment Account. When the goods
have been sold out by the consignee, they can be treated as sales and may be credited
either to Purchases account or trading account at the end of the period. The entry to close
goods sent on consignment account is given below:
Consignor’s Books
Goods Sent on Consignment account Dr.
To Trading Account
Consignee’s Books
No Entry
Consignment Account
A Consignment account is prepared by the consignor of goods to the consignee, All
transactions such as cost of goods supplied, expense incurred by consignor or consignee,
consignee’s commission, sales, unsold stock, profit or loss on consignment are to be
recorded through this account. This account presents a summary of the transactions that
have taken place between the consignor and the consignee. The consignment account
reveals profit or loss on consignment and is thus a mini trading and profit and losses
account Consignment account is a nominal account. Therefore the following items are
debited to this account:
1) Cost of goods sent on Consignment
2) Expenses incurred by the consignor
3) Expenses incurred by the consignee
4) Consignee’s commission.
5) Bad debts when Del Credere commission is not paid.
6) Profit on consignment.
The following items are credited to the consignment account:
1. Sales proceeds.
2. Returns of goods by consignee.
3. Abnormal loss of goods.
4. Unsold Stock with the consignee.
5. Loss on consignment (if any).
Performa of a consignment account is given below:
Consignment Account
Consignment to ………………….Account
----------------------------------------------------------------------------------------------------------Date
Particular
Amount Date
Particulars
Amount
Rs.
To Goods sent on Consignment A/c”
!! Cash (Expenses Incurred by consignor)”
!! Consignee (consignee’s
Expenses)”
Rs.
By Consignee(Sales Proceeds)”
!! Goods sent on Consignment
(Returns of goods by consignee)”
!! Consignee (Commission)”
!! Abnormal Loss A/c”
!! Consignee (Bad Debts)” Profit &
!! Consignment Stock A/c
Loss A/c ( Profit on consignment
stock) (By Profit & Loss A/c)
(unsold
transferred to Profit & Loss A/c)
(Loss on consignment, if any,
transferred to Profit & Loss
A/c)
----------------------------------------------------------------------------------------------------------------------
METHODS OF ACCOUNTING
There are three different method of preparing accounts relating the consignment of
goods.
These are:
1.
Cost Price Method
2.
Invoice Price Method
3.
Memorandum Columns Method
1. Cost Price Method: Under this Method entries relating to consignment in the
books of consignor or passed with the actual cost of goods and amount spent or expenses
incurred by him. The journal entries already mentioned in a previous question will be
passed in the books of consigner under this method.
2. Invoice Price Method (When consigned goods are invoiced at higher than
actual cost price). Sometimes the consigner sends a Performa invoice to the consignee.
In a Performa invoice goods are generally priced at higher than actual cost say cost plus
20 percent. This may be done with any of the following objective.
1. Not to disclose actual cost of goods to the consignee
2. Suggesting the consignee a minimum cost price which already includes some
profit margin.
3. To ensure minimum amount of profit and consignment.
4. To Provide for all the expenses and consignee’s commission in the invoice price.
5. To discourage consignee from starting competing business.
If the goods are invoiced at cost plus 10per cent and the cost of goods is Rs. 20,000,
these will be invoiced at Rs.22,000 in the Performa invoice. A difference of Rs. 2,000
will then arise in the books of accounts. In order to nullify the effect of such difference,
some entries are passed by the consignor in his books of accounts.
1. Recording Performa Invoice Price. Referring to above example when goods
are invoiced at higher then cost price, the following entry will be recorded by the
consignor on consignment of goods:
Consignment A/c
Dr. Rs.22, 000
To Goods sent on Consignment
22,000
2. Recording the difference of invoice & cost price. In order to nullify the
difference of Rs.2,000 between invoice and cost price, the following entry is recorded by
the consignor in his books of accounts:
Goods sent on Consignment A/c
To Consignment A/c
Dr.Rs.2, 000
2,000
The effect of this entry is to show the actual cost of goods consigned in the
consignment account so that profit or loss on consignment can be properly calculatedly.
This entry is in one sense an adjusting entry which adjusts both the consignment account
and the goods sent on consignment account. Goods sent on consignment account are to
be transferred to the trading account at the end of the year. Therefore unless this account
is adjusted, trading account will not show correct figures of profit or loss.
3. Unsold Stock. The unsold amount of stock in the hands of the consignee is to be
valued at invoice price plus the proportionate share of expenses includable in the value of
goods. For example, if in the above example, 25% goods are buying unsold and
proportionate expenses on these 25% goods are Rs. 300, the amount of unsold stock will
be calculated as under:
Invoice price of goods
Rs.22, 000
Value of 25% goods
Rs. 5,500
Add Proportionate expenses
Rs.
Value of unsold stock
Rs. 5,200
300
The following entry will be passed to record this value of unsold stock:
Consignment stock A/c
Dr.
.5,200
To Consignment A/c
. 5200
4. Recording the difference of invoice and cost price of unsold stock. The value
of closing stock must be ascertained by the consignor at cost or Market value whichever
is lower, But the value of closing stock, recorded above does not conform to this
principle. In the above example, the cost of 25% unsold stock is Rs. 5,000 (25% of
Rs.20,000) but the invoice price of 25% unsold stock is Rs. 5,500 (25% of Rs.22,000),
the difference of Rs.500 in the valuation of closing stock has got to be adjusted by
passing the following entry:
Consignment stock A/c
To Consignment Stock Suspense A/c
Dr.
Rs.500
Rs.500
This entry will be adjusting the excess of invoice price over cost price of unsold
stock. Consignment stock suspense is deducted from consignment stock account to
ascertain the cost of unsold stock with the consignee.
It is important to note here that there is no difference in the entries to be passed in
the books of the consignee.
5. Memorandum Columns Method: It is a combined method recording
transactions at both the invoice and the cost price. For this purpose, separate columns are
provided for Invoice prices and cost price in the following accounts:
1. Consignment A/c
2. Goods sent on consignment A/c
3. Consignment stock A/c
Columns relating to invoice price are called memorandum columns. They are not
to taken into consideration while preparing the final accounts but are useful to compare
profit on consignment on the basis of Invoice and cost price. A proforma of consignment
account with memorandum columns is given below:
Consignment Account
-----------------------------------------------------------------------------------------------------------Date
Particulars
Invoice Actual Date
Particulars
Invoice Actual
Price Price
Price
Price
--------------------------------------------------------------------------------------------------------
Illustration:
(i) The firm of Delta & Co., Of Delhi consigned to Premier & Co. of Rangoon 50
cases of Piece goods valued at Rs. 350 each.
(ii) The consignors paid freight and insurance thereon Rs. 1800,
(iii) They received as an advance from Premier & Co Rs. 8000.
(iv) Received an Account Sales from Premier & Co. giving particulars as under:
Gross proceeds Rs. 28000, expenses of Warehousing, Carriage, Dock Dues, etc,
Incurred by them amounted to Rs. 900. and their commission to Rs. 1000.
(v) Received a Bank Demand Draft of the balance due by them on the consignment.
From the above particular, prepare the necessary Ledger Accounts in the books of
the Consignors and those of the Consignees.
Solution
In the Books of Delta&Co.,
Consignment Account
-------------------------------------------------------------------------------------------------------Rs.
To Goods sent on consignment a/c
To Cash A/c (Freight and Insurance)
To Premier & Co. (Exp.)
17,500
By Premier & Co.
Rs.
28,000
1,800
900
To Premier & Co. (Com.)
1,000
To Profit and loss A/c
6,800
-------------------------------------------------------------------------------------------------------28,000
28,000
Premier & Co’s Account
Rs.
Rs.
To Consignment A/c
28,000
By Cash (Advance)
8,000
By Consignment a/c (Exp)
900
By Consignment a/c (Com.)
1,000
By Bank A/c.
28,000
18,000
28,000
In the Books of Premier & Co,
Delta & Co’s Account
-------------------------------------------------------------------------------------------------------Rs.
To Cash (Advance)
8,000
To Cash (Expenses)
900
To Commission
To Bank
Rs.
By Cash (Sales) A/c
28,000
1,000
18,100
28,000
3. Accounting for Partnership Accounts
Fundamentals
Partnership. Partnership is the relation which subsists between persons carrying on
business in common with a view of profit. The Indian Partnership Act 1932 vide its
section 4 defines the term Partnership as under. “Partnership is the relation between
persons who have agreed to share the profits of a business carried on by all or any of
them acting for all”.
According to this definition the essential features of partnership form of business
organisation are :
1. Two or more persons. None can be a partner with himself. There must be at
least two or more persons to form a partnership. The term person does not include firms
and joint stock companies and as such only partners on firms or members of joint stock
companies can enter into a Partnership agreement provided the number of partners
remains within statutory limit. The maximum number is ten in case of banking firms and
twenty in all other business.
2. Agreement. Partnership arises out of an agreement only. It does not arise out of
status or by operation of law. There must be an agreement among the partners of the firm.
28,000
3. Business. Partners must carry some lawful business and not for any other
purpose. Business includes any trade, occupation and profession.
4. Profit Motive and Sharing of Profits. Partners must enter into partnership
agreement with a motive to earn and distribute among themselves profits of a business in
an agreed ratio. Clubs, building societies or any other associations, religious or charitable
are not partnerships as there is no motive to earn profit. Agreement to share profit inplies
agreement to share losses also.
5. Application of law of Agency. According to the definition, partnership business
may be carried on by all or any of them acting for all. This implies that partnership is
based on law of agency. Each partner acts as an agent as well as principal of other
partners. Thus every partner can bind other partners and the firm by his own acts and be
bound by the acts of the other partners. This means that a partner has implied authority to
bind other partners for the acts done by him in the course of the business.
Legal points affecting Partnership:
1. Members. The maximum number of partners in a partnership is limited to 10 in
the case of banking business and 20 in the case of other business. A minor can’t become
full fledged member of a partnership but a female can be. A minor however can be
admitted to the benefits of partnership with the consent of other partners.
2. Liability. In partnership, liability of partners is unlimited.
3. Admission. No new partner can be introduced in the partnership save with the
unanimous consent of all partners.
4. Death of a partner. Death of a partner will bring about the dissoulution of the
partnership unless the partnership agreement provides otherwise.
5. Dissolution. In case of partnership at will, Partnership may be dissolved at the
desire of any partner ant at any time by giving a notice in writing to other partners.
6. Registration. Registration of the partnership is not compulsory but the law has
indirectly made registration compulsory because an unregistered firm suffers from many
disabilities
like :(a) A partner of an unregistered firm cannot file a suit against the firm or any
partner thereof for the purpose of enforcing a right arising from contact or right conferred
by the Partnership Act.
(b) No suit can be filed on behalf of an unregistered firm against any third party for
the purpose of enforcing a right arising from a contract.
(c) An unregistered firm cannot claim a set off in a suit against the firm by a third
party to enforce a right arising from a contract (where the claim of set off is above Rs.
100).
7. The rights and liabilities of the partners are governed by the Indian Partners Act,
1932.
8. Firm and firm name. Persons who have entered into partnership with one
another are called individually partners and collectively a firm and the name under which
the business is carried on is called the firm name.
Legal point affecting Partnership Accounts.
1. Partners are entitled to share profits equally, and must likewise bear losses
equally irrespective of the amount of their respective capital accounts unless agreed
otherwise.
2. Partners are not entitled to Interest on capital, salaries or remuneration, unless
otherwise agreed.
3. Partners who advance loan to the partnership firm over and above the amount of
capital contributed by them are entitled to charge interest thereon, at the rate of 6 percent
per year, unless otherwise agreed.
4. No interest is charged to the partners in respect of their drawings, unless
otherwise agreed.
5. Generally, an outgoing partner is entitled to have his proper share of the net
assets (i.e.,) asset less liabilities), including goodwill, as they exist at the date of his
retirement, quite apart from their book values.
6. A partner is entitled to be indemnified for expenses properly incurred by him on
behalf of the partnership firm.
Partnership Deed
According to the definition of partnership under the Indian Partnership Act, there
must be an agreement between the partners of a partnership firm. The agreement may be
express or implied. It may be a written or oral agreement. In most of the cases, these
agreements are drawn up in writing. These written agreements are called by various
names such as partnership deed, partnership agreement, constitution of partnership or
Articles of partnership etc. The exact terms of the partnership deed (or agreement) will
depend upon circumstances but, generally partnership deeds contain the following points
:
1.
2.
3.
4.
The name of the firm and business to be carried on under that name.
Address (s) of business place (s)
Nature and scope of the Business.
Commencement and duration of partnership.
5.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
The capital and the contribution made by each partner.6. Provision for further
capital and loans by partners to the firm.
Partner’s Drawings.
Interest on capital, loans, drawings and current account.
Salaries, commission and remuneration to partners.
Profit )or loss) sharing ratio of partners.
The keeping of proper books of accounts, inspection and audit, Bank
Accounts and its operation
The accounting period and the date on which final accounts are to be
prepared.
Rights, power and duties of partners.
Whether, and in what circumstances, notice of retirement or dissolution can
be given by a partner.
Provision that death or retirement of a partner will not bring about dissolution
of partnership.
Valuation of goodwill on retirement, death dissolution etc.
The method of valuation of assets (and liabilities) on retirement or death of
any partner.
Provision for expulsion of a partner.
Provision regarding the allocation of business activities to be performed by
individual partners.
The arbitration clause for the settlement of disputes.
It may be noted that the exact terms of the partnership deed will a depend upon the
circumstances of each case.
The Rights of partners in a partnership firm are as follows :
1. Every partner is entitled to take active part in the management of the business.
2. Every partner has an inherent right to be consulted in all matters affecting the
partnership.
3. Every partner has a right to have access to the accounts of the firm and he can
have a copy of the books of the firm.
4. Every partner is entitled to share profits equally with other partners unless
otherwise agreed.
5. If a partner contributes in excess of the amount he is supposed to subscribe, he is
entitled to receive an interest on that amount @ 6% per annum out of profits of the firm.
6. Every partner has a right to use for the dissolution of the firm.
7. Every partner has a right to be indemnified by the firm in respect of payments
made and liabilities incurred by him (a) in the conduct of the business and (b) in doing
such act in an emergency for the purpose of protecting the firm from loss, as would be
done by a person of ordinary prudence in his own case, under similar circumstances.
8. Every partner has a right to retire :
(a) with the consent of all the partners, of
(b) in accordance with an express agreement by the partners, or
(c) where the partnership is at will, by giving a notice in writing to all partners of
his intention to retire.
9. Every partner has a right not to be expelled from the partnership.
Obligations :
The following are the main obligations of the partners :
1. Every partner is bound to act honestly, faithfully and diligently for the greatest
common advantage of the firm’s business.
2. Every partner is bound to render true, proper and correct accounts of partnership
and allow other partners to inspect and copy them.
3. If due to negligence or fraud of a partner, the firm suffers losses, the partner
responsible for such acts shall make good the loss.
4. Every partner is bound to use the property of the business for the purpose of the
business only.
5. Every partner must share losses equally, unless agreed otherwise.
6. Every partner is under an obligation to account for private profits made by him
from any use of partnership property, name of business connection.
7. Every partner is bound not to carry on competing business to the firm, during his
stay in the partnership firm.
8. Every partner must act within the scope of his authority and where he exceeds,
he must compensate other partners for any loss unless such act is ratified.
9. Every partner is liable severally and jointly with all other partners, for all acts of
the firm done while he is a partner.
Kinds of Partners :
Partners can be divided into the following categories :
1. General Partners. All partners, if there is no specific agreement otherwise, are
basically general partners and their liability is unlimited.
2. Active Partners. Those partners who take active part in the management of the
business are known as active partners.
3. Sleeping Partners. Partners who though subscribe their share of capital but do
not take active part in the management of the business are called as sleeping partners.
4. Secret Partners. Certain persons, though become partners, want to remain
behind the screen. Such partners are called Secret Partners. The liability of such partners
is unlimited.
5. Nominal Partners. Sometimes persons of credit or importance lend their name
to the firm but neither they invest nor share the profits. But such partners can’t escape
liability towards third person.
6. Partners by Estoppel. Some persons, though not partners, mislead other persons
by saying that they are partners in a certain firm. Such persons are known as partners by
estoppel. They are liable to third parties for their acts done in inducement of the
statements given by such person.
7.Sub-Partner. Where a partner agrees to share his profits derived from a firm with
a third person that third person is known as a sub-partner. He is not connected with the
firm is any way and has no right or obligations towards the firm.
Goodwill
The Goodwill of a business is the advantage which a person gets by continuing to
carry on, and being entitled to represent to the outside world that he is carrying on a
business, which has been carried on for some time in the past.
Goodwill is a thing very easy to describe, very difficult to define. (It is the benefit
and advantage of the good name. reputation and connection of a business). It is the
attractive force which brings in customers to the business. It is the one thing which
distinguishes an old established business from a new business at the first start. Goodwill
is composed of a variety of elements. It differs in its composition in different trades and
in different business in the same trade.
We may describe Goodwill as an intangible asset arising out of super profit earning
capacity of a concern. The existence of Goodwill of a firm distinguishes the same from
others. If a firm being situated in a comparable position with others and doing the same
nature of trade earns extra profit, then there is some factor favorable in the firm for
bringing more and more customers to that particular firm. In economic sense, marginal
firms have no goodwill but super marginal (above marginal) firms enjoy goodwill upto
the value they are away from marginal firm.
But Goodwill, in the sense of attracting customers, has little significance unless it is
valuable in the sense of having a saleable value.
The Goodwill possessed by a firm may be due to the following elements of the
business :
1. Favorable Location of the Business premises.
2. Quality of firm’s products or services.
3. Personal reputation of the partners.
4. The possession of efficient and contented employees.
5. The possession of well known Trade Marks, patents etc.
6. The possession of favorable contracts or monopoly
7. The continuity of advertisement.
8. Flexibility and development of business with charging conditions.
9. Freedom from legislative restrictions.
Although a firm may possess goodwill, it is not always necessary to raise a
goodwill account in the books of accounts except to the extent that cash or other assets of
the firm have been used to pay for it. Because if payment is made for goodwill but is not
recorded in the books, the capital accounts of the partners of the firm are understated to
the extent of the value of goodwill account is opened, it is not always adjusted to give
effect to every fluctuation in its value.
Valuation of Goodwill
There are various methods of valuation of goodwill much as
1. Average Profit Basis. In this case the profits of the past few years are averaged
and adjusted (multiplied) for any charge that is expected to occur in the near future. The
average is multiplied (adjusted) by a certain number. This is expressed, for example as 3
years of five years profits, suppose the profits for last 5 years are 10,000, 15,000, 20,000,
25,000,30,000 Goodwill will amount to
10,000 + 15,000 + 20,000 + 25,000 + 30,000
----------------------------------------------------5
If there was a loss in the 2nd year of Rs. 15,000 then Goodwill would have been
Rs. 42,000
2. Super Profit Basis. The super profits of a business are the profits which can be
expected in the future over and above those necessary to pay a fair return upon the
capital invested in the business, having regard to the risk involved in that particular
business and a fair remuneration for the services of the partners who work thereon.
Super Profits-Net Profits-(Normal rate of Int. on Cap.
+ Reasonable Salary to Partners)
Super profits multiplied by the number of years purchase agreed upon gives
goodwill.
thus
Goodwill = Super Profits x No. of years purchase.
Illustration
Suppose Annual profits expected is
Average Capital employed
Expected Interest rate on Cap. 10%
Rs. 10,000
Rs. 50,000
Remuneration to Purchase Rs. 2,500
Profits
Interest
-Remuneration
Super Profits
Goodwill = 2,500 X ‘x’ No. of years purchase.
3. Capitalisation Method.
According to this method, the value of the business as a running concern is
ascertained, and from the figure arrived at the value of the tangible assets is deducted, the
difference being taken to represent Goodwill.
The value of the business may be found out by the formula.
Profit
----------------------------------Reasonable Return on Cap.
and goodwill may be calculated by deducting the capital employed from the figure
of the value of the business. In the above example.
Estimated annual Profit
Rs. 10,000
Less Partner’s remuneration
Rs. 2,500
__________
Available for Interest on Capital employed Rs. 7,500
Value of Business =
7,500
------- X100=75,000
10%
Goodwill
75,000-50,000 (Cap. employed)=Rs. 25,000
=
Adjustment in Goodwill Account :
Whenever there is a change in the constitution of the firm or the business, value of
the business fluctuates and Goodwill account needs some adjustment. In each of the
following cases, a change in the profit sharing ratio takes place, and therefore, unless a
Goodwill account already stands in the books at its correct value, some adjustment must
be made.
1. Upon the Admission of a partner.
2. On the death or retirement of a partner.
10,000
5,000
2,500
______
2,500
3. Upon an agreement between partners to change the profit sharing ratio between
themselves.
Distinction between Partnership & Co.,
The following are the main points of distinction between a partnership firm and a
joint stock company :
1. Registration. A company comes into existence only after registration under the
companies Act. In case of partnership registration is not compulsory.
2. Legal Status. A company is a legal person and regarded by law as a single
person. A partnership is a collection of individuals.
3. Minimum number of members. The minimum number required to form a
company is two in case of private limited companies and seven in case of public limited
companies. The minimum number of persons required to form partnership is two.
4. Liability of members. The liability of the members of a company is limited
where as the liability of the partners for the debts of a firm is unlimited. Partners are also
personally liable for the debts of a firm.
5. Transferbility. A shareholder can transfer his share without the consent of other
share-holders. In case of partnership, a partner cannot transfer his share without the
consent of other partners.
6. Maximum number of members. A public company may have any number of
members. In case of a private company the maximum number cannot be more than 50. In
a trading partnership the maximum number of members is twenty, in a banking
partnership ten.
7. Contractual capacity. The shareholders of the company can enter into contract
with the company and can be an employee of the company. Partners can contract with
other partners but not with the firm.
8. Duration of existence. The death or retirement or a partner dissolves the
partnership. But a company having legal existence can continue, inspite of death or
retirement of a member. It has thus perpetual succession.
9. Statutory obligations. A company is required to comply with various statutory
obligations regarding management, e.g. filing of balance sheet, maintaining of prescribed
registers etc. In case of partnership there are no such statutory obligations.
10. Authority of members, (a) In case of companies, management vest in the
hands on a few directors, elected from amongst the share holders. A share holder as such
cannot participate in the management. All the partners are entitled to share in the
management of the firm.
11.
Each partner is prima face the agent of the other partners and can bind
hem for the acts done in the course of the partnership business. Shareholders in the
company are not the agents of one another.
Capital Accounts
Capital Accounts. The amount of contribution by each partner in the partnership
firm is called his capital and is credited to his Capital Account Capital accounts of the
partners may be either fixed or fluctuating.
Fixed Capital Accounts. If the capital accounts of partners are to remain intact
(expect under exceptional circumstances mentioned in the partnership agreement during
the continuance of the partnership, the capital accounts will be called as fixed capital
accounts, In the case of fixed capital accounts, no adjustments are made in the capital
account and the balance on each such account will remain at the same figure year after
year, representing the amount of capital briginally contributed. Where fixed capital
accounts are maintained, capital and share of profits etc., are to be recorded in an account
called as current account is shown quite separately in the Balance Sheet. If the current
account shows a credit balance, it represents the surplus of profits and salaries etc., over
drawings and on the other hand, if it shows a debit balance it represents account being
overdrawn and the debit balance will be shown on the asset side of the Balance Sheet.
This if capitals of partners are to be kept fixed, the following two accounts will be opened
for each partner.
1. Capital Account.
2. Current Account.
Fluctuating Capital Accounts. When the partners agree upon the employment of
capital account only, for each partner, it will contain all transactions relating to the
amount of capital contributed, drawings, interest on capital and drawings, salary,
commission or remuneration and the share of profit or loss etc. It is, therefore, that the
balance of this account will fluctuate from year to year the account is called as fluctuating
capital account. In the case of fluctuating capital accounts, current accounts are not
maintained.
:
Interest on Capital
(i) Interest on Capital. According to the provisions of the Act, no partner is
entitled to Interest on capital unless otherwise agreed. If Interest is agreed to be payable,
it is payable only out of profits of the business, when allowed, Interest account is debited
and partner’s capital accounts are credited Subsequently the amount of interest is debited
to the profit and loss account of the firm.
Generally interest on capital is provided in the following cases :
(i) When capitals are unequal but profit sharing ratios are equal.
(ii) When capitals are unequal and profit sharing ratios are also unequal.
Interest on capital in the above instances reduces the inequalities in the distribution
of profits amount the partners. The following journal entries are recorded for interest on
capital.
1.
2.
When interest is allowed.
Interest Account
To Capital Account
Dr.
When interest account is closed at the end of the year.
Profit and loss Account
To Interest Account.
Dr.
(ii) Interest on Drawngs. Just like interest is allowed on capitals, partners may
decide to charge interest on drawings also. Interest charged on drawings in an item of
income and is credited to the profit and loss account. The amount of interest thus adds to
the profits of the business which is further distributed among the partners. The following
entries are passed for interest on drawings.
(i)
(ii)
When interest is charged on drawings
Capital Account
To Interest Account
Dr.
Closing entry for Interest account.
Interest Account.
To Profit and loss Account
Dr.
Calculation of Interest on Drawings
It may be noted that the interest on drawings is charged for the time period which
lapses between the date of withdrawal and the end of accounting year. Problem arises
when many withdrawals have been made on different dates during the year. The interest
on drawing in such caes may be calculated after calculating an average date for all the
withdrawals. The following illustration will calrify the point :
Illustration :
A, a partner has withdrawn the following sums of money :
Rs.
On 1st March 1976
On 1st April 1976
On 1st uly 1976
On 1st November 1976
Calculate interest @ 6 per cent per annum if the accounts are closed on 31st
December every year.
500
400
600
300
Solution
Interest
Rs.
On 500
On 400
On 600
On 300
Rs.
25
18
18
1.50
_______
for 10 months
for 9 months
for 6 months
for 2 months
Total Interest
62.50
_______
Alternatively. Interest can be calculated in the following manner :
Amount
Months
Rs.
500
400
600
300
Product
Rs.
5,000
3,600
3,600
600
_______
12,800
_______
10
9
6
2
1,800
Interst on Rs. 12,800 for one month @ 6% p.a. is Rs. 62.50
(iii) Salary to Partner. Sometimes, a partner who devotes more time and efforts
towards the business of the firms than the other partners is allowed a certain amount of
salary or commission for services rendered by him. This amount is adjusted to the profit
and loss account and is credited to the capital account of the Active partner (to whom
salary or commission is payable). The following entry is passed in the books of accounts.
Profit and loss Account
To Capital Account (Concerned)
Dr.
Profit or loss arrived at after making the adjustments relating to interest on capitals
or drawings, salaries or commission etc, is distributed among the partners in their profit
sharing ratio. The following entry is recorded for the distribution of profits :
Profit and loss Account
To all Partners Capital Accounts
(in their profit sharing ratio)
A reverse entry will be passed in case of loss in business.
Dr.
(iv) Adjustments of closed Partnership Accounts. After the preparation of final
accounts for a certain period, if it is discovered that some errors or omissions were
committed in the accounts, the closed partnership accounts will have to be readjusted.
The errors or omissions may relate to the following.
1.
2.
3.
4.
Charging a very high (or low) rate of interest on capitals or drawings.
Distributing profits or loss in a ratio different than that agreed upon.
Wrong payment of salary to any partner.
Not debiting the capital account in respect of drawings and so on.
Adjustment entries required to correct any such error or omission will have to be
made in the usual manner.
4. Accounting for Partnership Accounts
ADMISSION OF A PARTNER
Goodwill on Admission of a new Partner :
Goodwill is the attractive force that brings in customers. It is the benefit of a good
name, reputation and connection of a business. It is one thing that distinguishes an old
established business with a new bussiness at its first start. It is the benefit that attaches to
the ownership of a successful business. It is therefore but natural to think that the owners
of a successful business will nto like it to be shared by any one else. It is therefore that
whenever a new person is admitted to the partnership, he is charged some amount of
premium over and above his share of capital for the participation in the profits and the
reputation established by the hard work, character, industry, enterprise and business
capacity of the old partners. This amount of premium is called the price of Goodwill.
Goodwill is dealt with on the admission of a new partner as follows :
(A) Premium Method :
This method is used when the new partner brings in the amount of Goodwill as
cash. Under this method, the receipt of Goodwill is dealt with in the following ways :
1. As a Private Transaction. When the amount of Goodwill is received by old
partners privately and outside the business in cash. In such a case, no entry will be made
in the books of the firm.
2. As a firm’s Transaction ; The cash being Immediately withdrawn In such a
case the receipt of Goodwill money is recorded in the books of the firm and transferred
to the capital accounts of the old partners in their Profit Sacrifions also. The amount thus
transferred is immediately withdrawn by the old partners.
The following entries are recorded in firm’s books in the above case.
(i) For the amount of Goodwill received in cash.
Cash Account
To New Partner’s Capital Account
Dr.
Note. The above entry is made with the amount of Capital plus Goodwill brought in
by the new partner. For example if X brings in Rs. 10,000 as capital and Rs. 2,500 as
Goodwill, the above entry will be made with Rs. 12,500).
(ii) For the distribution of goodwill among old partners.
New Partners’ Capital, Account
To Old Partner’s Capital Account
Dr.
Note. The above entry is made with the amount of Goodwill only brought in by
new partner. The amount of Goodwill is to be shared by old partners in their profit
sacrificing ratio).
(iii) For the amount of Goodwill withdrawn by old partners :
Old Partner’s Capital Accounts
Dr.
To Cash Account
It is emphasised here again that the amount of Goodwill is to be distributed among
the old partners in their Profit sacrificing ratio and not in their Profit sharing ratio. For
example, if A and B are partners sharing profits in the ratio of 2:1. They admit O who
brings in Rs. 10,000 as capital and Rs. 4,000 as Goodwill and they now become equal
partners, the profit sacrificing ratio will be calculated as under :
Old Profit Sharing Ratio
New Profit Sharing Ratio
Profit Sacrificing Ratio
=
A
2/3
1/3
B
1/3
1/3
2/3-1/3
1/3
1/3-1/3
= Nil
C
1/3
In the above example, the entire amount of Goodwill (Rs. 4,000) will be taken by A
and B will get nothing as he is not sacrificing anything out of his share of firm’s profits.
3. As a firm’s Transaction-the cash being retained in the business. The entries
in this case will be similar to the entries passed in 2nd method above except that the entry
no (iii) for cash withdrawal will not be passed in the firm’s books. In this case, the cash is
retained within the business and becomes a part of the working capital.
(B) Memorandum Revaluation Methos. Sometimes new partner may not be in a
position to bring in Goodwill as cash or it may be agreed among the partners that the
goodwill account may be created or adjusted in the books of accounts. The created or
adjusted Goodwill is credited to the old partners in their old profit sharing ratio and then
again the same amount is debited to all the partners (including the new partner) in their
new profit sharing ratio.
The following entries are recorded under the above method.
(i) When Goodwill account is raised with full value
Goodwill Account
Dr.
To Old Partner’s Capital Accounts
(ii) When Goodwill account is written off.
All Partners’ Capital Accounts
Dr.
To Goodwill Account
[Note : If Goodwill is not written off, it will remain in the books and will be shown
on the Asset side of the Balance Sheet].
(C) Revaluation Method. Sometimes, it so happens that Goodwill account exists
in the books of the firm at the time of admission of the new partner. In such a case the
Goodwill of the firm is revalued according to any of the following methods :
(i) Goodwill based on average profits basis.
(ii) Goodwill based on share of Incoming Partner or
(iii) Goodwill on super profit basis.
The amount of Goodwill so valued is compared with the amount shown in the
Goodwill account. The excess of the revaluation over the existing amount of Goodwill is
credited to the old partners capital accounts.
The following Journal entry is passed under this method :
Goodwill account
To Old Partners’ Capital Accounts.
[Note. This entry is made with the difference of Revalued amount and existing
Goodwill].
If the amount of Goodwill already appearing int he account books is in excess of
the revalued amount, the following entry is passed to bring down the value of Goodwill at
its new value.
Old partners’ Capital Accounts
To Goodwill Account
Dr.
[Note. This entry is passed with difference of the amount of Goodwill existing in
accounts and the revalued amount].
It may be noted that in the above entry old partner’s capital accounts will be
credited or debited (as the case may be) in their Old profit sharing ratio.
Illustration :
A and B are equal partners. They admit C into partnership firm, C paying Rs.
10,000 as his Capital and Rs. 2,000 for Goodwill. The new profit sharing ratio is 2 : 2 : 1.
Pass Journal entries in the firm’s books :
(i) When Goodwill is received as a private transaction.
(ii) When Goodwill is received as a Firm’s t5ransaction, the amount being retained
in the business.
(iii) When Goodwill is received as a Firm’s t5ransaction, the amount being
immediately withdrawn by the old partners.
Solution
(i) When Goodwill is received as a Private Transaction ;
Rs.
10,000
Cash Account
Dr.
To C’s Capital Account
[Note. No entry will be passed for the amount of Goodwill].
(ii) When Goodwill is received as a firm’s Transaction, the amount being retained
in the business :
Rs.
(a) Cash Account
Dr.
12,000
To C’s Capital Account
(For the amount of Goodwill and Capital
Credited to C’s Capital Account)
Rs.
(b) C’s Capital Account
Dr.
2,000
To A’s Capital Account
To B’s Capital Account
(For the amount of Goodwill distributed
between Old Partners)
(iii) When Goodwill is received as a firms transaction, the amount being
immediately withdrawn by old partners :
Rs.
(a) and (b) as above
(c) A’s Capital Account
Dr.
1,000
B’s Capital Account
Dr.
1,000
To cash Account
(For the amount withdrawn by Old Partners)
Rs.
10,000
Rs.
12,000
Rs.
1,000
1,000
Rs.
2,000
Distribution of Goodwill
A
B
Old Profit Sharing Ratio
1/2
1/2
New Profit Sharing Ratio
2/5
2/5 :
C
1/5
Profit Sacrificing Ratio
=
(1/2-2/5)
(1/2-2/5)
1/10
1/10
As the profit sacrificing ratio is equal, the amount of Goodwill is to be shared
equally viz. Rs. 1,000 each.
Question. How the following adjustments are recorded in the books of the firms
(a) Adjustments in the Book values of Assets and Habilities.
(b) Adjustments in the values of Accumulated profits, reserves or losses.
(c) Adjustments regarding Capitals.
Answer
Revaluation of Assets and Liabilities on an Admission :
The most important adjustment necessitated by the admission of a partner are those
of revaluation of the assets and liabilities at their actual values in place of book values. It
is to be carefully seen that the new partner does not get any benefit form any appreciation
in the values of assets nor does he suffer any loss from the increase in the value of
liabilities. It is therefore that the all assets and liabilities are revalued on the admission of
a new partner and the resalt of such revaluation is to be enjoyed or suffered by the old
Partners in their old profit sharing ratio. The adjustments in the values of assets and
liabilities are recorded in the following ways :
(Values to be altered in the Books) :
1st METHOD
If the assets and liabilities are to be recorded in the books at their adjusted values,
upon the admission of a new partner, the following entries will be recorded in the books
of accounts.
1.
Revaluation Account
Dr.
To Assets Account
(For the book values of assets debited to Revaluation Account)
2.
Assets Account
To Revaluation Account
(For the revised values of assets recorded in the assets Accounts)
3.
Liabilities Account
To Revaluation Account
(For the book values of liabilities Credited to Revaluation Account)
4.
Revaluation Account
Dr.
To Liabilities Account
(For the revised values of Liabilities recorded in the liabilities Account)
5.
The Balance of Revaluation Account is treated as Profit or Loss :
In case of Profit :
Revaluation Account
Dr.
To Old Partners’ Capital Accounts
(In their Old Profit Sharing Ratio)
In case of Loss :
Old Partners’ Capital Accounts
Dr.
To Revaluation Account
[Note. A Profit and Loss Adjustment may also be opened in place of Revaluation
Account].
2ND METHOD :
Alternatively, the entries may be made as under :
1.
Revaluation Account
Dr.
To Liabilities
To Assets
(For Increased Liabilities and Decreased Assets Transferred to Revaluation
Account)
2.
Liabilities
Dr.
Assets
Dr.
To Revaluation Account
(For Decreased Liabilities and Increased Assets Transferred to Revaluation
Account)
3.
The Balance of Revaluation is Treated as Profit or Loss In case of Profit :
Revaluation Account
Dr.
To their Old partners Capital Accounts
(In their Old Profit Sharing Ratio)
In Case of Loss :
Old Partners Capital Accounts
Dr.
To Revaluation Account
When Values are not to be altered in the books
3RD METHOD :
When the new firm desires to keep the book values of assets and liabilities
unchanged in the books, the following steps will be taken to record the adjustments in
their values.
1.
A Memorandum Revaluation Account is opened. This account is debited
with all decreases in the value of assets or increases in the values of liabilities. The
account is also credited with all increases in the values of assets or decreases in the values
of liabilities.
2.
The difference in the totals of debits and credits is then transferred to the old
partners caital accounts in the old profit sharing ratio.
3.
The items (adjustments in the book values of assets and liabilities) are again
recorded in the memorandum revaluation account but on the opposite sides.
4.
The difference now is transferred to all partners capital accounts in new
profit sharing ratio.
The system mentioned above is illustrated with the help of imaginary figures as
given on next page.
Memorandum Revaluation Account
Rs.
1975
Dec. 31
To Decrease in the
values of Assets :
Debtors
Land and Buildings
To increase in the values
of liabilities
1975
Dec. 31
1,500
3,000
1,000
Rs.
By balance in value of
Assests
Investments
By Capital Accounts
A (½)
B (½)
4,000
750
750
5,500
1976
Jan. 1
To Increase in Values of
Assets Investments
To Capital Accounts
A(½)
B(½
C(½)
4,000
5,500
1976
Jan.1
500
500
500
7,500
By Decrease in values of
Assets Debtors
Land and Buildings
1,500
3,000
By Decrese in values of
liabilities
1,000
7,500
Capital Accounts
A
B
C
A
B
C
Rs.
Rs.
Rs.
Rs.
--
Rs.
--
Rs.
--
500
500
500
500
500
500
Loss on
Revaluation
750
750
--
To Balance
--
--
--
750
750
Accumulated Reserves, Profits or Losses :
By Balance
By loss on
Revaluation
(written back)
If the accounts relating to accumulated reserves, profits or losses appear in the
partnership business at the time of admission of a new partner, these should always be
distributed among the old partners in their old profit sharing ratio. The followingm entries
are recorded in this respect.
(i)
(ii)
For reserve Account or reserve fund
Reserves
To old partner’s Capital Accounts
Dr.
For P. and L. Account (Credit balance).
Profit and Loss Account
To old Partner’s Capital Accounts
Dr.
(iii)
For P. and L Account (Debit balance)
Old Partner’s Capital Account
Dr.
To Profit and Loss Account
[Note. In the examination, if any of these items appear in the question, it is to be
distributed among old partners, even though the question is silent over this issue].
Adjustments regarding capitals :
In connection with the problems regarding adjustments of capital accounts, the
following cases may arise.
1.
Capitals, may be adjusted on the basis of new partners contribution or
2.
New partner may be asked to contribute the amount of capital in proportion
to his share in the firm.
In the first case, the total capital of the firm is calculated on the basis of capital
contributed by new partner and share of profit allowed to him. For example if C is
admitted to a partnership firm of A and B, and brings in Rs. 10,000 as his capital and is
given 1/3rd share in the firm, the total capital of the firm (A, B and C) would be Rs.
30,000. The old partners capitals will be adjusted accordingly. Thus if in this example A
and B were equal partners having capital balances of Rs. 11,000 and Rs. 8,000
respectively and are again equal partners with C, their capital accounts will be adjusted to
show balances Rs. 10,000 in each account, thereby making payment of Rs. 18,000 to A
and receiving a sum of Rs, 2,000 from B.
In the second case, the amount of capital contribution may be calculated by taking
the profit proportion and deducting fro the denominator the figure of the numerator e.g.
one fourth becoming one third, one sixth becoming one fifth, two sevenths becoming two
fifths and so on. This fraction will be multiplied to the total capitals of the old partners
(aftef making all adjustments regarding revaluation of assets and liabilities, profits,
reserves, losses etd.) so as to give the amount of capital, the new partner may be asked to
bring in.
In the above example, if the adjusted capitals of A and B shows balancel of Rs.
14,000 and Rs. 11,000 respectively and C is given one third share, capitals contribution
by C will be calculated as under.
C’s share in Profits
=
rd
C’s Contribution
=
of A+B’s adjusted capitals
=
X (14,000+11,000)
C’s Capital = Rs. 12,500
5.
Accounting for Partnership Accounts
RETIREMENT & DEATH OF A PARTNER
RETIREMENT OF A PARTNER:
A partner may retire from the partnership firm with the unanimous consent of all
the partners. In the case of partnership at will, he may retire at any time on giving a
written notice to the other partners of his intention to retire from the firm. Retirement of a
partner involves following accounting problems
1.
Treatment of Goodwill
2.
Revaluation of assets and liabilities.
3.
Distribution of accumulated reserves, Profits or losses.
4.
Adjustments in capitals and profit sharing ratio of the remaining partners.
5.
Payment of the dues to the outgoing partner.
To a large extent, these problems are similar to those arising at the admission of a
new partner. A detailed discussion of each one of these is given belwo.
1. Goodwill. Just as an incoming partner is supposed to bring in some amount of
Goodwill, an outgoing partner, in the similar way, becomes entitled to his share of
goodwill at the time of his retirement. The calculation of the value of goodwill is done in
the same way as is done in the case of admission of a partner. The share of goodwill of
the outgoing partner is calculated by multiplying the value of goodwill to his profit
sharing ratio. For example, if the profit sharing of goodwill of the firm is arrived at Rs.
30,000 and C, the retiring partner has a one-third share in the profits of the firm, his share
of goodwill will be Rs. 10,000 (Rs. 30,000X1/3rd share), C is entitled to the payment of
Rs. 10,000 as his share of Goodwill.
Adjustments regarding Goodwill may be made in either of the following ways.
1.
When Goodwill is raised with the share of retiring partner and is allowed to
appear in the books.
In such a case the following entry will be made in the books of accounts.
Goodwill Account
To Retiring Partner’s Capital Account
Dr.
2.
When Goodwill is raised with the share of retiring partner and is
immediately
written off :
The following entries will be made in such a case,
(a) Goodwill Account
Dr.
To Retiring Partner’s Capital Account
(b) Remaining Partner’s Capital Account
Dr.
To Goodwill Account
It may be noted that Goodwill is written off in the gaining ratio of the remaining
partners.
3. When Goodwill is raised at full value and is allowed to appear in the books.
Goodwill Account
Dr.
To All Partnor’s Capital Accounts.
The above case, capital accounts of all partners (including the retiring partner) will
be credited in the profit sharing ratio.
4. When Goodwill is raised at full value and is immediately written off :
The following entries will be passed :
(a) Goodwill Account
Dr.
To All Partner’s Capital Accounts
(b) Remaining Partner’s Capital Accounts
Dr.
To Goodwill Account
[Note : In the first entry, Goodwill is credited to the capital accounts of all partners
(including the retiring partner) in their profit sharing ratio before retirement. In the
second entry, capital accounts of only the remaining partners are to be debited in their
new profit sharing ratio).
Revaluation of Assets and Liabilities. If partnership deed provides for revaluation
of assets and liabilities on retirement of any partner, the revaluation should be done
exactly in a similar manner as was done in case of admission of a partner. A revaluation
account is opened. It is credited with the amount of increased liabilities or decreased
assets and is credited with the amount of decreased liabilities or increased assets. The
balance of revaluation (or Profit and loss adjustment) account is treated as profit or loss
and is transferred to the capital accounts of all the Partners in their profit sharing ratio
before retirement. The assets and liabilities will then appear at adjusted values in the
Balance Sheet.
But if the book values of the assets and liabilities are not to be altered, a
memorandum revaluation account will be opened. The profit or loss of the first part of
this account is transferred to the capital accounts of all the partners including the retiring
partner) but the profit or loss of the second part is transferred to the capital accounts of
only the remaining partners in their new profit sharing ratio.
3. Accumulated Reserves, Profits or Losses. The retiting partner is also entitled to
his share in the accumulated reserves representing undistributed profits and is also liabile
to
share accumulated losses. Adjustment in this respect may be made in either of the
following two ways :
1. The entire amount of undistributed profits or reserves is transferred to the capital
accounts of all the partners in their profit sharing ratio before retirement. The following
entry will be made.
Reserve Account
Dr.
Or
Profit and loss account
To All partner’s Capital Accounts
Dr.
If previous losses appear in the balance sheet, the above entry will be reversed.
2. Only the share of retiring partner in the undistributed profits and/or reserves is
calculated and the amount is credited to his capital account, thereby reducing the balance
of undistributed reserves, profits or losses. The following entry will be made.
Reserve Account
Dr.
Or
Profit and loss account
To Retiring partner’s Capital Account
Dr.
If previous losses appear in the books, the above entry will be reversed.
4. Adjustments in Capitals or Profit sharing ratios of the remaining partner. When a
partner retires from a firm, the profit sharing ratio of the remaining partner changes. For
example, if A, B and C are equal partners in a firm, where from C retires and A and B
agree to share future profits equally. The effect of C’s retirement will be that A and B
(both) will be getting one. half of profits (each) instead of previous one third ratio of
profit.
Unless there is an agreement to the contrary, or if the examination question is silent
over it, the remaining partners will continue to share between themselves profits or losses
in the ratio which existed before the retirement.
For example if A, B and C were sharing profits in the ratio 2:1:1 and C retires. A
and B will now be sharing profits in the ratio of 2:1.
But if new ratios for the remaining partners are given, the gaining ratio can be
calculated by deducting the old ratio from the new ratio. Calculation of gaining ratio is
important as the amount of Goodwill payable to retiring partner will be shared by the
remaining partners in their ratios.
Further, the capital accounts of the remaining partners may be adjusted according to
their new profit sharing ratio and any excess of capital may be paid or shortage demanded
from the partners.
5. Payment of the dues to the Retiring Partner. The total amount payable to the
retiring partner is calculated and paid to him in any of the following manners :
1. In lump sum or
2. In annual Instalments or
3. In the form of Annuities.
The following entries are made to recored the transaction of payments in the firm’s
books.
1. When a lump sum payment is made. In such a case, retiring partner’s capital
account is closed by making the following entry :
Retiring Partner’s capital Account
Dr.
To Cash Account
2.
When payment is made in annual instalments. In such a case, the balance of
capital account of the retiting partner is first transferred to his loan Account. Interest at
agreed rate is paid on the balance of the loan account eac year till the last instalment is
paid and the loan account is closed. The following entries aremade in this respect :
(a) Transferring the balance of capital Account to loan Account
Retiring Partner’s Capital Account
Dr.
To Retiting Partner’s Loan Account
(b) For Interest on loan.
Interest Account
To Retiring Partner’s loan Account
Dr.
(c) For payment of Instalment.
Retiring Partner’s Capital Account
To Cash Account
Dr.
It may be noted that the balance of the Retiring Partner’s loan Account is shown on
the liabilities side of the Balance Sheet till the last instalment is paid to him.
3. When payment is made in the form of Annuities. Under this method an annual
payment is made to the retiring partner in lieu of his capital in the firm. The balance due
to the retiring partner is transferred to Annuity Suspense Account and the entries for
interest and payment are made out of this account. Balance of this account is shown on
the liabilities side till exhausted. An important point to note here is that annuities are paid
to the retired partner every year irrespective of the fact that the balance in the account has
exhausted or not. If the retiring partner dies and any balance is left in Annuity Suspense
Account, it is treated as a profit and transferred to partner’s capital accounts in their profit
sharing ratio. However, if the retiring partner lives even after the exhaustion of the
balance of Annuity Suspense Account the payment will be treated as loss and will be
debited to the profit and loss account every year.
The following entries are recorded :
(a) Transferring the amount due to Annuity suspense Account.
Retiring Partner’s Capital Account
Dr.
To Annuity Suspense Account
(b) For the amount of Interest.
Interest Account
To Annuity Suspense Account
(c) For payment
Annuity Suspense Account
To Cash Account
Dr.
Dr.
(d) If retired partner dies and any balance is left in Annuity Suspense Account
Annuity Suspense Account
Dr.
To Partner’s Capital Accounts
(e) If Annuity Suspense Account has been exhausted and payment is made.
(i) Profit and oss Account
Dr.
To Annuity Suspense Account
(ii) Annuity Suspense Account
Dr.
To Cash Account
DEATH OF A PARTNER
Accounting problems arising on the death of a partner in the partnership firm are
similar to those arising in the case of retirement. These problems are to be dealt with in a
manner exactly similar to that followed in the case of retirement of a partner. However,
the following points may be noted :
1. Death of a partner may occur at any time during the accounting period. If a
partner dies after the last date of an accounting year, it becomes necessary to calculate his
share for that period in respect of the following :
(a) Profit or loss
(b) Interest on capital
(c) Salary, commission, remuneration etc., (if any)
(2) The total amount due to the deceased partner is to be transferred to his
Executor’s Account (Account of his legal representatives). The amount to transferred will
include the following:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
Deceased Partner’s capital in the firm.
His share of goodwill.
Profit or loss on revaluation of Assets and liabilities.
His share of undistributed profits, reserves or losses.
His share of Profit (upto the date of his death)
Interest on capital
Salary, remuneration etc., upto the date of his death.
Any other amount payable.
Computation of Deceased Partner’s share of profit ;
If a partner dies during the course of an accounting year, he will be entitled in the
ordinary way to his share of Profit to the dae of death. This may be ascertained in any of
the following manners, subject of course to the terms of the partnership agreement :
1.
Computation of Profits on the basis of current years working.
(a) By drawing up accounts to the actual date of death or
(b) By drawing up account for the full normal accounting year and splitting
them
into the (i) pre-and
(ii) Post death period.
2.
Computation of Profits on the basis of last years working :
(a) on Time Basis (b) on Turnover Basis
Out of the above methods, method (1) (a) is most satisfactory but circumstances
may prevent this being carried out. Method (1) (b) may be put to use on any of the two
basis viz. (i) The time basis or (ii) The turnover basis.
Time Basis. Under the method, the amount of the share of profits of the deceased
partner is calculated on the basis of time elapsed from the last Balance Sheet. Thus, if it is
to base on last year’s profits the following formula may be used :
Deceased Partner’s share of Profit =
X Number of
Days upto the date of death.
X Profit sharing ratio of the deceased Partner.
For example, if last year’s profits were Rs. 15,000 and C, the deceased partner
enjoys one-third share out of profits and he dies 73 days after the date of last balance
sheet, his (c’s) share of profit for the period (73 days) will be computed as under :
C’s Share of Profit =
x 73 days 1/3rd share
= 3000 x 1/3 = Rs. 1,000
C’s capital account is to be credited by Rs. 1,000 as his share of profit upto the date
of his death.
Turnover Basis. Under thismethod, Profit is calculated on the basis of sales upto
the date of his death and the figure of last year’s sales. The following formula may be
used.
Deceased Partner’s share of Profit =
Last year’s Profits X Total Sales uptot the date of death
Last year’s Total Sales X Profit shareing
Ratio of deceased partner.
For example if last year’s sales figure was Rs. 3 lacs, Profits Rs. 30,000 and sales
upto the date of death of C, a one - third partner in the firm amounts to Rs. 60,000 then
c’s share of profit will be calculated as under :
C’s share of Profit =
X 60,000
X 1/3
C’s Shae of Profit = Rs. 2,000
If deceased partner’s share of Profit upto the date of his dealth is calculated on the
basis of last year’s figures, the following entry will be recorded :
Profit and loss suspense Account
Dr.
To Deceased Partner’s Capital Accounts
At the end of the accounting period the profit and loss Suspense Account will be
closed by transferring the balance to the debit of profit and Loss Account.
JOINT LIFE POLICY
A joint life policy involves the insurance of two or more lives smiultaneously. The
policy money is payable upon the death of any one of the lives assured and the assured
sum will be payable to the surivor or survivors. In partnership firms, mostly joint life
polices are taken to provide funds for :
(i) Payment to the legal representatives of the deceased person.
(ii) Payment to the retiring partner, if the policy is an endowment policy.
The object behind taking of a joint life policy is generally to avoid under pressure
on the working capital of the business, in the case of death of a partner, when payment is
to be made to his legal representatives. It is also possible that separate policies are taken
on the lives of cash of the partners but the accounting treatment is similar in both the
cases.
Transactions relating to joint life policy are dealt with in three ways. mentioned
below:
1. When payment of premium is considered as a business expenditure. under this
method, the amount of premium is charged off to Profit and Loss account each year and
the amount received from the insurance company on the death of any partner is treated as
income and is credited to all partner’s capital accounts in their profit sharing ratio. The
following entries are recorded.
(a) On Payment of Premium
Insurance Premium Account
To Cash Account
Dr.
(b) Closing entry for Insurance Premium Account
Profit and Loss Account
To Insurance Premium Account
Dr.
(c) On the death of a partner, when Policy money is received :
Cash/Bank Account
To Joint Life Policy Account
Dr.
(d) Amount received in (3) above transferred to Partner’s capital Accounts
Joint Life Policy Account
Dr.
To All Partner’s capital Accounts
2.
When Payments of Premium are treated as an Investment up to the amount of
surrender value. The following entries are made under this method :
(a) On Payment of Premium
Joint Life Policy Account
To Cash Account
Dr.
(b) When Excess of Premium over surrender value is written off
Profit and Loss Account
Dr.
To Joint life Policy Account
(c) When policy money is received on the dealth of a Partner
Cash/Bank Account
To Joint life Policy Account
Dr.
(d) When the balance of Joint life Policy Account (which is treated as an income) is
transferred to capital accounts
Joint Life Policy Account
Dr.
To All Partner’s Capital Accounts
3. When Payments of Premium are treated as Investment and a Reserve Account is
opened :
(a) On Payment of Premium
Joint Life Policy Account
To Cash/Bank Account
(b) On creation of Reserve
Profit and Loss Account
To Joint life policy Reserve Account
Dr.
Dr.
Dr.
(c) When Joint Life Policy Account is written down to its surrender value
Joint Life Policy Reserve Account
Dr.
To Joint Life Policy Account
(d) On receiving the policy money on death of a partner
Bank Account
To Joint Life policy Account
Dr.
(e) On transferring the balance of Joint Life Policy Reserve Account to the Joint
Life Policy Account
Joint Life Policy Reserve Account
Dr.
To Joint Life Policy Account
(f) On transferring the balance among partner’s capital Accounts
Joint Life Policy Account
To all Partner’s Capital Accounts.
Dr.
6. SHARES AND DEBENTURES
Definition of Company :
A company is a voluntary Association of persons formed for some common
purpose, with capital divisible into parts, known as shares and with a limited liability. It is
a creation of law and is sometimes known as an artificial person with a perpetual
succession and a common seal.
Features of a company
(a) It is a Voluntary Association of persons
(b) It is an artificial person
(c) It enjoys separate legal entity
(d) Liability of its members is limited
(e) It has perpetual succession and common seal
(f) Shares of the company are transferable
(g) Large capital can be mobilised by company
(h) Large Profits are earned
Types of companies
(1) On the basis of incorporation: companies are classified as(a) Chartered company : These are the companies which are incorporated under a
special charter granted by the King or Queen. eg. The East India Company.
(b) Statutory Companies : These are the companies which are created by a special
Act of the legislature. eg. Reserve Bank of India, LIC etc.
(c) Registered Companies: These are the companies which are formed and
registered under the companies Act of 1956.
(2) On the Basis of Liability : Companies are classified as(a) Companies with limited liability
(b) Companies with unlimited liability
Companies limited liability may be(a) Companies limited by shares: Where the liability of the members of a
company is limited to the amount unpaid on the shares.
(b) Companies limited by Gurantee : Where the liability of the members of a
Company is limited to a fixed amount which the members undertake to contribute to the
assets of the company in case of its winding up.
(c) Unlimited Companies : A Company without limited Liability is known as an
unlimited company. It may or may not have a share capital and there is no limit on the
liability of its members.
(3) On the Basis of number of members: Companies are classified as (a) a Private
Company (b) a Public Company.
(a) A Private Company : Means a Company which by its articles,
(i) Restricts the rights to transfer its shares if any
(ii) Limits the number of its members to 50 and
(iii) Prevents the public to subscribe for any shares in or debentures of the
company.
(b) A Public Company : Means of a company which is not a Private Company. In
other words, a public company is a company which by its articles does not
(i) Restricts the right to transfer its shares.
(ii) Limit the number of its members and
(iii) Prohibit any invitation to the public to subscribe for any shares in or debentures
of the company.
(4) On the Basis of Control: Companies may be classified into (a) Holdig
companies (b) Subsidiary Companies.
(a) Holding Company : a Company is deemed to be the holding Co. of another if,
but only that other is its subsidiary.
(b) A company is known as a subsidiary of another company when control is
exercised by the latter over the former, called subsidiary company.
(5) On the basis of ownership: Company may be a Government Company or a
Non Government company.
(a) Government company means any company in which at least 51% of the paid-up
share capital is held by the central government or by any State Government or partly by
the Central Government and partly by one or more State Governments.
(b) Foreign Company is any company incorporated outside India but which has a
place of business in India.
FORMATION OF A COMPANY
Formation of any public Company involves different stages like:
(a) Promotion Stage
(b) Incorporation Stage
(c) Capital Subscription Stage
(d) Commencement of business stage
Promotion stage: It invloves doing the necessary preliminary work incidental to
the formation of the company. The persons who undertake the work incidental to the
formation of a company are called as promoters.
Incorporation Stage: This is the stage of registration of the company. The
Promoters have to take certain steps for getting the certificate of incorporation from the
Registrar of companies(a) Memorandum of Association
(b) Articles of Association
(c) The address of the registered office of the company.
(d) A list of directors with their names, addresses and occupations
(e) Consent in writing of the directors to act as directors
(f) The statutory declaration
Memorandum of Association:
The Memorandum of Association is the most important document of the company.
It sets out the constitution of a company and as such it is a charter. It defines the co’s
relation with the outside world & the scope of its activities. Its purpose isto enable the
shareholders, creditors as well as those who deal with the compay to know the company’s
activities. It contains important clause & Association & Subscription clause.
The Memorandum has to be divided into paragraphs, consecutively numbered and
printed. It must be signed by the subscribrs...
Articles of Association
Articles of Association contains rules and regulations for inner managment. It
provides rules for the conduct of the day-to day administration of the company. It
regulates the relationship between the company & its members and employees. Articles
must be printed, divided into paragraphs, numbered consecutively & signed by each
subscriber of the memorandum and filed with the registrar.They lay down the powers of
the directors, shareholders & officers. It contains rules and regulations regarding share
capital, lien on shares, calls on shares, transfer, transmission, forfeiture and surrender of
shares, issue of share warrant, voting powers, borrowing powers, proceedings at the
board and generalbody meetings, dividend & reserves, appointment, powers, duties,
qualification
and
remuneration
of
directors, managing directors, secretary and auditors, maintenance of books of a/c s
winding
up
procedures
etc.
Prospectus
A Public Company invites the public to subscribe for its shares or debentures
through issue of a document known as prospectus. The companies Act of 1956 defines
Prospectus as Prospectus, notice, circular, advertisement or other document inviting
offers from the public for the subscription of any shares or debentures of a body
corporate. The main objects of the prospectus are (a) to inform the public about the
forming of a new company (b) to include the investors to invest in its shares &
debentures & (c) to make the directors responsible for the statement in the prospectus.
Statement in lieu of prospectus:
If the promoters intend to secure capital from their relatives andfriends without
public subscription, they need not issue prospectus but instead can prepare a statement
containing similarinformationfor filing with the Registrar which is known as Statement in
lieu of the prospectus.
Listing of Shares
Entering the shares of a company in the official list of stock exchanges for the
purpose of trading is known as listing of shares. Some of the advantage of listing are (a)
It provides a continuous market for securities (b) It enhances the prestige of the company
and (c) It provides an indirect check against manipulation by the management.
Underwriting Agreement:
The act of ensuring the sale of shares or debentures of a company, even before
offering to the public, is called underwriting and those engaged in such ativities are called
underwriters. The terms and conditions under which the underwriters agree to underwrite
the shares are embodied in a document known as underwriting agreement.
Minimum Subscription
The minimum subscription is the minimum amount of capital which is in the
opinion of the directors, is required to commence business. In case of a public company
the registrar will issue the certificate to commence business only when the amount raised
by alloting shares,is not less than the amount equivalent to the minimum subscription
mentioned in the prospectus.
Share Capital
It is the capital raised by a company by the issue of shares. It can be raised by the
company at the time of its formation and later on for the purpose of meeting the
requriements of its expansion.
Classses of Capital
(a) Authorised or Nominal or Registered Capital : This is the maximum amount
which thecompany is authorised to raise by issuing shares. This is the sum stated in the
memorandum of association as the nominal capital of the company. This capital is also
known as registered capital becuase it is the amount of capital with which the company
registered or incorporated. This amount is usually fixed by the company taking into
account the present as well as its future needs for finance. Ex. Nominal capital may be
Rs.10,00,000 dividend into 1,00,000 equity shares of Rs. 10 each.
(b) Issued Capital : It is that part of the authorised or nominal capital which the
company needs for the time being and has been issued to public for subscription. Ex: Out
of Rs. 10,00,000 nominal capital,the company may decide to issue for public subscription
Rs. 8,00,000 divided into 80,000 equity shares at Rs. 10 each.
(c) Subscribed Capital : That part of the issued capital which is subscribed by
thepublic is known as subscribed capital. In other words the amount of the issued capital
which has been taken up by the public is known as subscribed capital. Ex: out of 80,000
equity shares issued for subscription only 70,000 shares may be taken up by the public.
Thus the subscribed capital will be Rs. 7,00,000
(d) Called up Capital : The company often does not need the full amount of its
subscribed capital. In which case it calls up only, part of the amount of the face value of
shares immediately and later makes further calls as necessary. Ex: if the company
decided to call Rs.5 per share out of its nominal value of Rs.10, it is called up capital.
(e) Uncalled capital: The difference between the subscribedcapital and called up
capital is known as uncalled capital.
(f) Paid up Capital: The amount actually paid by the shareholders is known as
paid-up capital.
(g) Reserve Capital: It is that part of the uncalled capital of a company which shall
not be called up except at the time of winding up of the company. The purpose of
creating reserve capital is to protect the interest of creditors and to create public cofidence
in the company.
(h) Fixed Capital: It is that part of the capital which is invested in fixed assets. Eg.
Land and Building, Plant and Machinery.
(i) Working Capital : It is the capital which is used for the purpose of day to day
business of the co. In other words this capital is used again and again Eg. buying raw
materials goods etc.
Shares
Share is a share is the share capital of a company. It is nothing but a company’s
owned capital which is divided into a large number of equal parts.
Kinds of Shares
Preferences Shares
Ordinary/Equity Shares Deferred/ Founders
(a) Cumulative & non Cumulative
(b) Participating & non participating
(c) Redeemable & irredeemable
Preference Shares
Preference shares are those shares which carry preferential rights in respect of
dividend and the return of capital. The rate of divident on the shares is fixed & the
dividend must be paid to them before paying any dividend on other shares. They provide
long term and medium term finance.
(a) Cumulative Preference Share: Cumulative preference shares enjoys rights
over arrears of dividend on shares to be paid out of future profits, in case profits are
inadequate in any year.
(b) Non-cumulative Preference Share: Non Cumulative preference shares do not
receive any dividend incase profits are nil in any year. In other words, in case the profits
are inadequate i.e. the arrears of dividends do not accumulate and hence any unpaid
dividend in any year will not be paid out of future profits.
(c) Participating Preference Share: These shares have the right to participate in
dividends if there is any balance after paying dividendon equity shares at a certain rate.
(d) Non Participating Share: These shares do not have the right to participate in
dividends if there is any balance after paying dividend on equity shares.
(e) Redeemable Preference Share: Redeemable Preference Shares are those
shares where the company undertakes to return the amount paid on them subject to
certain conditions like shares must be fully paid, shares must be redeemed only out of the
dividable profits, & articles of the company must authorise for the issue of shares.
Equity Shares:
Equity Shares or Ordinary Shares are not preference shares. They receive dividend
only after preference dividends are paid. They enjoy voting rights. Equity shares have the
chance of receiving high dividend. They participate in the management. They are not
subject to redemption during the life time of the company. It is also called as risk capital
of the company. They provide only long term finance.
Deferred Shares/Founder’s Share
Only private companies are allowed to issue deffered shares. These shares are held
by the promoters. They enjoy differential voting rights and enable the promoters to have
control over the company.
Distincition between preference shares and equity shares.
Preference shares
Equity Shares
(1) They are entitled for first
(1) They
preference
rank
next
to
preference in receiving dividend
shares in receiving dividend
(2) For receiving back their capital,
capital
(2) They receive back their
they enjoy first preference.
are paid.
only after preference shares
(3) Rate of dividend is fixed by the articles.
fixed.
(3) Rate of dividend is not
It fluctuates according to the
earning
power of the company.
(4) They enjoy voting rights only
(4) They enjoy normal voting
rights.
under exceptional circumstances.
(5) Their rights are limited
in the control of management
(5) They enjoy full control of
management.
(6) Face Value is relatively much higher
(6) Face value is neither too
high nor too low
(7) They can be redeemed
reemption
(7) They are not subject to
during the lifetime of the company
company.
during the lifetime of the
(8) They provide long term
(8) They provide only long
and medium term capital
term finance
(9) This is called rentier capital
(9) This is called risk capital
Subscription of Shares: There may be (a) Over subscription , (b) Equal
subscription, (c) Under subscription. When the company receives application for more
number of shares than issued, it is known as over subscription. When the company
receives application for the same number of shares as issued, it is known as equal
subscription and when the company receives application for less than the number of
shares issued it is known as under subscription.
Issue of Shares: The company may issue shares (a) at par, (b) at premium or (c) at
discount. If the shares are issued at the face value, it is known as issue at par.
Ex. Face value is Rs.100 per share issued at Rs. 100. If the shares are issued at
more than the face value, it is known as issue at premium, Ex: face value is 100 per share
issued at 110, Rs.10 is premium. If the shares are issued at less than face value, it is
known as issue at discount. Ex. Face value being Rs. 100, issued at Rs. 90, Rs. 10 is
discount.
Allotment of shares
Allocation of shares to applicants is known as allotment of shares.
Methods of allotment
(a) First cum first served basis
(b) Giving preference for application for smaller number of shares.
(c) Pro-rate allotment/ Proportionate allotment.
(d) Lottery method.
Procedure for recovering the amount of shares.
The company may receive the amount on shares allotted ininstalments. It may be
received at different stages like Application, Allotment etc., The instalment amount
payable on application is called application money. The instalment amount payable on
allotment of share is called allotment money and the instalment amount payable on
demand in future is called calls on shares.
Calls in arrears : The amount of call money not paid by the shareholder by due
date is called call-in-arrears. Such calls are subject to a charge of interest at 6% p.a.
Calls in Advance : Payment of money on the shares by the share holders before the
call is made is known as call in advance. Such amount is entitled to get 6% p.a. interest.
Forfeiture of shares :
Cancellation of shares for no-payment of call money due is known as forfeiture of
shares. The amount paid by the shareholder on the forfeited shares will not be returned.
The forfeiture of shares take place only for no-payment of call money and not for any
other reason.
Surrender of shares : Returning of shares by the shareholder to the company on
account of inability to pay call money is known as surrender of shares. Here shareholder
himself pleads his inability to pay the call money.
Surrender V/s forfeiture
(1) Surrender is a voluntary action taken by a shareholder where as forfeiture is a
compulsory action taken by the company.
(2) In case of surrender, the company may exempt the holder from paying the
outstanding call amount and interest & return a part of te amount already paid on the
shares. But no such concession is allowed in case of forfeiture of shares.
Lien on shares :
Lien is the right of a person to retain some property of another person until the
claims of the person is possession of the property are satisfied. The company may
exercise a right of lien on shares of a shareholder who has failed to pay his debts to the
company.
Lien V/s Forfeiture
(a) Lien is a right to retain the possession of shares till due amount is paid where as
forteiture is a right to cancell the shares for no-payment of call amount.
(b) Lien does not be lead to reduction in capital but forfeiture may lead to reduction
in capital.
Re-issue of shares : Issuing again the forfeited shares is known as re-issue of
shares.
Capital Reserve : The balance remaining in the forfeited shares account after reissue is transferred to an account known as capital reserve. The balance in this account
canot be used for any other purpose, other than for issue of Bouns shares.
Journal Entries for share transaction
(1) For receipt of application money
Bank A/c............................. Dr.
To Share application a/c
(2) For transfer of application money on allotment
Share application a/c.............Dr.
To Share capital a/c
(3) For return of application money on rejected applications
Share application a/c ............... Dr.
To Bank a/c
(4) For allotment money due
Share allotment a/c ........... Dr.
To Share capital a/c
(5) For receipt of allotment money
Bank a/c ............. Dr.
To Share allotment a/c
(6) For first call money due
Share first call a/c ......... Dr.
To Share Capital a/c
(7) For first call money received
Bank a/c ............. Dr.
To share first call a/c
(8) For second & final call money due
Share second & final call a/c .......... Dr.
To Share capital a/c
(9) For second and final call money received
Bank a/c .................... Dr.
To share second and final call a/c.
Sometimes shares are issued at premium and the premium amount is received along
with application money. In such a case, the following jurnial entry is passed as receipt of
application money.
Bank A/c ..................Dr.
To Share appliation a/c
The following journal entry is passed to transfer the application money on
allotment of shares.
Share application a/c ................. Dr.
To Share capital a/c
To Share Premium a/c
Sometimes shares are issued at premium and the premium amount is received at
allotment stage. In such a case, the following jurnial entry is passed.
Share allotment a/c .............Dr.
To Share capital a/c
To Share premium a/c
Sometimes shares are issued at discount and the discount amount is adjusted in
allotment stage. In such a case, the following jurnial entry is passed.
Share allotment a/c ............. Dr.
Discount on issue of shares a/c ......... Dr.
To share capital a/c
(10) For forfeiture of shares
Share capital a/c (called up amount) ........Dr.
To share allotment a/c (amount not received)
To Share calls a/c (amount not recevied)
To Share forfeiture a/c (Balancing figure)
(11) For re-issue of forfeited shares
Bank a/c.............. Dr.
Share forfeiture a/c ...........Dr.
To Share capital a/c
(12) For transfer of balance in share forfeiture a/c
Share forfeiture a/c.........Dr.
To Capital reserve a/c
Illustration-1
Red Star Ltd. invited Application for 10,000 shares of Rs. 10 each payble Rs. 2/- on
application, Rs. 3/- on allotment, Rs. 2/- on 1st call & Rs. 3/- on second & final call.
12,000 Applications are received. The directors rejected 2000 applications and accepted
the remaining applications. All the calls were made & all the shares were fully paid up.
Give journal entries & prepare ledger a/cs.
Solution - 1
Journal Entries
-----------------------------------------------------------------------------------------------------------Particulars
(1) Bank a/c..............Dr,
L/F
Debit
Rs.
Credit
Rs.
24,000
To Share Application a/c
24,000
(Being application amount received on
12,000 shares at Rs. 2/(2) Share Application a/c....... Dr.
4,000
To Bank a/c
4,000
(Being refund of application money on 2000
rejected application)
(3) Share Application a/c ..........Dr.
20,000
To Share capital a/c
20,000
(Being application amount transferred to share capial a/c)
(4) Share Allotment a/c..............Dr,
30,000
To Share Capital a/c
30,000
(Being allotment amount due at Rs. 3/- on 10,000 Shares)
(5) Bankd a/c ...................Dr
30,000
To Share allotment a/c
30,000
(Being allotment amount received at Rs.3/- on 10,000 shares)
(6) Share 1st Cal a/c............Dr
20,000
To Share Capital a/c
20,000
(Being 1st call amount due on 10,000 shares at Rs.2/- shares)
(7) Bank a/c......................Dr
20,000
To Share 1st call amount received on 10,000 shares
20,000
at Rs.2/- shares)
(8) Share 2nd & final call a/c.............Dr
30,000
To share capital a/c
30,000
(Being 2nd & final call amount due on 10,000 shares
at Rs.3/- shares)
(9) Bank a/c...................Dr
30,000
To share 2nd & final call a/c
30,000
(Being final call amount received on 10,000 shares
at 3/- share)
--------------------------------------------------------------------------------------------------------Dr
Share Application a/c
Cr
--------------------------------------------------------------------------------------------------------Particulars
Amount
Particulars
Amount
--------------------------------------------------------------------------------------------------------To share Capital20,000
To Bank a/c
By Banka/c
24,000
4,000
--------------------------------------------------------------------------------------------------------24,000
24,000
--------------------------------------------------------------------------------------------------------Dr
To Share capital a/c
Dr.
To Share capital a/c
Dr.
To Share capital
Dr.
Particulars
Share Allotment a/c
30,000
By Bank a/c
Share first call a/c
20,000
Cr
30,000
Cr.
By Bank a/c
Share 2nd & Final call a/c
30,000
By Bank a/c
Bank Account
Amount
20,000
Cr.
30,000
Cr.
Particulars
To Share Application
24,000
By Share Application
To Share Allotment
30,000
By Balance c/d
To Share 1st Call
20,000
To Share 2nd & Final Call
30,000
Amount
4,000
1,00,000
--------------------------------------------------------------------------------------------------------1,04,000
1,04,000
Dr.
Share capital A/c
Cr.
--------------------------------------------------------------------------------------------------------Particulars
Amount
Particulars
Amount
--------------------------------------------------------------------------------------------------------To Balance c/d
1,00,000
By Share application
20,000
By Share Allotment
30,000
By Share 1st Call
20,000
By Share 2nd & Final Call
30,000
--------------------------------------------------------------------------------------------------------1,00,000
1,00,000
Illustration-2
The Gold Ltd. having nominal capital of 2000 preference shares of Rs.100 each, issued
1000 preference shares of Rs. 110 each, payable Rs.10 on application, Rs.20 on
allotment Rs.35 on 1st call and Rs.35 on final call. 2000 application were received &
400 applications were rejected. All the calls were made & money was duly received
except 1st call money on 50 shares & final call money on 100 shares
Pass journal entries, prepare ledger a/cs, and show the Balance Sheet.
Solution - 2
Journal Entries
Particulars
(1) Bank A/c..............Dr.
L/F
Debit
Rs.
Credit
Rs.
20,000
To Preference share application a/c
20,000
(Being application amount received on 2000 shares at Rs.10/-)
(2) Preference Shares Application a/c....... Dr.
10,000
To Preference share capital a/c
10,000
(Being application amount transfered to Share capital a/c
on1,000 shares at Rs. 10/- share)
(3) Preference Share Application a/c ..........Dr.
4,000
To Bank a/c
4000
(Being refund of application money on 400 shares rejected )
(4) Preference Share Allotment a/c..............Dr,
20,000
To Preference Share Capital a/c
20,000
(Being allotment amount due on 1,000 shares at Rs.20 each)
(5) Preference Share Application a/c ...................Dr
6,000
Bank a/c ...............Dr
14,000
To Preference Share allotment a/c
20,000
(Being allotment received on allotment and adjustment
of application money)
(6) Preference Share 1st Cal a/c............Dr
35,000
To Preference Share Capital a/c
35,000
(Being 1st call amount due on 1,000 shares at Rs.35/- shares)
(7) Bank a/c......................Dr
33,250
To Preference Share 1st call a/c
(Being 1st call amount received on 950 shares at Rs.35/- )
33,250
(8) Preference shares final call a/c.............Dr
35,000
To Preference share capital a/c
35,000
(Being final call amount due on 10,000 shares at Rs.35/-)
(9) Bank a/c...................Dr
31,500
To Preference Share final call a/c
31,500
(Being final call amount received on 900 shares at 35/-)
Dr
Share Application a/c
Particulars
Amount
To Pref. share Capital a/c
10,000
To Bank a/c
4,000
To Pref. Share Allotment a/c
6,000
Cr
Particulars
Amount
By Bank a/c
20,000
20,000
Dr
To Pref. share capital a/c
20,000
Preference Share Allotment a/c
20,000
Cr
By Bank a/c
14,000
By Pref. Share Application a/c
6,000
20,000
Dr
To Pref. share capital a/c
20,000
Preference Share 1st call a/c
35,000
Cr
By Bank a/c
33,250
By Balance c/d
1,750
35,000
Dr
To P/S capital a/c
35,000
Preference Share final call a/c
35,000
By Bank a/c
Cr
31,500
By Balance c/d
3,500
35,000
Dr
35,000
Preference Share capital a/c
To Balance c/d
1,00,000
Cr
By Pref. Share Application
10,000
By Pref. Share Allotment
20,000
By Pref. Share 1st call a/c
35,000
By Pref. share Final call a/c
35,000
1,00,000
Dr
1,00,000
Bank a/c
Cr
To Pref. Share application
20,000
By Pref. Share
4,000
To Pref. Share Allotment
14,000
By Balance c/d
94,750
To Pref. Share 1st call
33,250
To Pref. share Final call
31,500
98,750
98,750
Balance sheet of Gold Ltd. as on ................
Liabilities
Rs.
Nominal Capital 2000 Preference
Shares of Rs. 100/- issued &
Assets
Cash at Bank
Rs.
94,750
2,00,000
Subscribed Capital 1,000 pref.
shares of 100 each
1,00,000
Called up capital 1,000
pref Shares of 100 each 1,00,000
Less “Calls in arrears
Paid up capital
5,250
94,750
94,250
94,250
Illustration - 3
The Bharat Co. Ltd. issued 1,00,000 equity shares of Rs. 10 each payable Rs. 2 on
application, Rs. 3/- on allotment Rs. 3 on 1st call & Rs. 2 on final call. Application were
received for 80,000 shares which were fully alloted & allotment money received on
75,000 shares. When the 1st call was made, the amount was received in full along with
balance of allotment money.
Pass Journal entries for the books of the company
Solution -3
Journal Entries
Particulars
L/F
1. Bank a/c...............Dr
Debit
Rs.
Credit
Rs.
1,60,000
To Equity share application a/c (Being application amount
1,60,000
received on 80,000 shares at Rs.2 each)
2. Equity share application a/c.........Dr
1,60,000
To equity share capital a/c
1,60,000
(Being application money transferredto share capital a/c)
3. Equity share allotment a/c............Dr
2,40,000
To equity share capital a/c (Being allotment amound due
2,40,000
on 80,000 shares at Rs. 3 each)
4. Bank a/c.................Dr
2,25,000
To Equity Share allotment a/c (Being allotment money on
2,25,000
75,000 shares at Rs. 3 each)
5. Equity share 1st call a/c..........Dr
2,40,000
To Equity share capital a/c (Being 1st call & final call money
2,40,000
due on 80,000 shares at Rs. 2 each)
6. Bank a/c.............Dr
4,15,000
To Equity Share 1st call a/c
2,40,000
To Calls in Advance a/c
1,60,000
To Equity share allotment a/c
(Being 1st call money & final call money received on
80,000 shares at 2 each and allotment money received
on Balance of 5,000 shares at Rs. 3 each)
15,000
ACCOUNTING FOR DEBENTURES:
Issue of Debenture
Meaning : A debenture is a mere acknowledgement of a debt. It may be defined as
an instrument in writing issued by a company under its common seal acknowledging a
debt and setting forth the terms under which it is issued and to be repaid.
Generally debentures are issued in fixed denominatins. They carry a fixed
percentage of interest. The Debentures holders are not entitiled toparticipate in the profits
of the company. They get only interest at a fixed rate. They are only creditors of the
company.
Classes of Debentures
The debentures issued by a company may be calssified as under:
(1) On the basis of title & transfarability- Debentures can be Register Debenture
& Bearer Debentures.
(a) Registered Debentures and (b) Bearer Debentures.
In case of Registered debentures, the names of the debentures holders are entered in
the books of the company & for transfring them regular transfer deed has to be prepared.
In case of Bearer Debentures the names of the holders of bearer debentures are not
registered in the books of the company and therefore, for transfering them , there is no
need for preparing transfer deed. They can be transferred by mere delivery.
(2) On the basis of Security: Debentures can be simple or naked or unsecured
debentures and secured or mortgage debentures.
Simple/ naked/ unsecured debenturesare issued with merely a promise to pay the
holder interrest and alos to repay the principal without any charge on any assets of the
company.
Secured / morgage debentures are issued with charge on the company’s assets as
security.
(3) On the basis of Redeemability: debentures may be redeemable debentures,
irredeemable or perpetual debentures and convertable debentures.
In case of Redeemable debentures, the company reserves the right of off the
principal on or after a specified date.
In case of irredeemable debentures the company reserves the right not of on the
principal as long as the company is a going concern & does not make default in the
payment of interest.
convertable debentures are convertable into shares at the option of the holders after
a special period.
Issue of debentures
Debentures can be issued at Par, at a Premium, or even at a Discount. Similarly,
debentures can be redeembed at Par, or at premium but redumption of debentures at a
discount is not allowed.
A public Company can issue debentures only after getting the certificate of
commencement of business but a private company can issue debentures immediately
after incorporation.The articles usually empower the board of directors to issue
debentures.
Distinctions between debentures and shares
Debentures
Shares
1. Debentures from
capital
creditorship securities
1. Shares form ownership
2. It receive interest
2. It receives Dividend
3. Debentures holders are
creditors of the company
3. Share holders are owners
of the company
4. Debentures are issued later
4. Shares are issued intially
5. Debentures can be
converted into shares
5. Shares can not be
converted into debentures
6. Debentures are secured by a charge
on the asset of the company
6. Shares cannot be secured
by a charge on the assets
of the company
7. Debentures are issued
for cash only
7. Shares may be issued for
for cash of kind
8. Debentures are
always paid up fully
8. Shares may be fully or
partly paid up
Illustration - 1
ABC Co. issued 10,000 debentures of Rs. 100/- each at a discount of 10% payable
Rs. 20 on application, Rs.20/- on allotment and Balance on first and final call. Pass the
necessary journal entries.
Journal entries
Particulars
1. Bank a/c...............Dr
L/F
Debit
Rs.
2,00,000
Credit
Rs.
To Debenture Application a/c (Being application amount
2,00,000
received on 10,000 shares at Rs.20/- each)
2. Debentures application a/c.........Dr
2,00,000
To Debentures a/c
2,00,000
(Being application money transferredto Debentures a/c)
3. Debenture allotment a/c............Dr
2,00,000
Discount on debentures a/c..........Dr.
1,00,000
To Debenture a/c (Being allotment amound due
3,00,000
on 10,000 debentureincluding discount)
4. Bank a/c.................Dr
2,00,000
To Debenture allotment a/c
2,00,000
(Being Debenture allotment money received)
5. Debenture 1st & final call a/c........
5,00,000
To Debenture a/c (Being 1st & final call money
5,00,000
due on 10,000 debentures at Rs. 50 each)
6. Bank a/c .................Dr
5,00,000
To Debenture 1st & final call a/c
5,00,000
(Being final call money received)
Balance sheet as on.............
Liabilities
10,000 debenture at 100 each
Rs.
10,00,000
Assets
Rs.
Cash at Bank
9,00,000
Discount on Debentures
1,00,000
10,00,000
10,00,000
Illustration - 2
Star Ltd. issued 5,000 8% Debenture of Rs. 100/- each at a premium of Rs. 10/repayable at the end of 20yrs at Par. The amount was payable as follows: Rs. 10 on
Application, Rs.30 on Allotment (including Premium) Rs.30 on 1st Call & Rs.40 on final
call. Pass the necessary Journal Entries
Journal entries
Particulars
1. Bank a/c...............Dr
To Debenture Application a/c (Being application amount
L/F
Debit
Rs.
Credit
Rs.
50,000
50,000
received on 5,000 shares at Rs.10/-per share)
2. Debentures application a/c.........Dr
50,000
ToDebentures a/c (Being application money transferred)
50,000
3. Debenture allotment a/c............Dr
1,50,000
To Debenture a/c
1,00,000
To Debenture premium a/c (Being allotment amound due
50,000
on 5,000 debenture at Rs.30/- per debenture)
4. Bank a/c.................Dr
1,50,000
To Debenture allotment a/c
1,50,000
(Being Debenture allotment money received)
5. Debenture 1st call a/c..........Dr
1,50,000
To Debenture a/c
1,50,000
(Being 1st call money due on 5,000 debentures at Rs. 30 each)
6. Bank a/c...................Dr
1,50,000
To Debenture 1st call a/c (Being 1st call money received
1,50,000
on 5,000 debenture at Rs.40 each)
7. Debenture Final call a/c............Dr
2,00,000
To Debenture a/c
2,00,000
(Being final call money due on 5,000 including premium)
8. Bank a/c................Dr
2,00,000
To Debenture final call a/c
2,00,000
(Being final call amount received)
Distinction between shareholder and debenture holder
Share holders
Debenture Holders
1. Share holder is
1. Debenture holder is a
owner of the company
creditor of the company
2. Share holder cannot receives any
entitled to
2.
dividend unless the company
of
receive interest irrespective
makes a profit
company
the profit or loss of the
3. Capital except in the case
3. A Debenture loan can be
Debenture
holder
is
of redeemable preference shares,
liquidated.
cannot be repaid unless legal formalities
for capital redemption are observed.
4. In the event of winding up of the
4. Debentures holder are paid
company, share holders are paid
first in the event of
only after debentures are paid
winding up of the company.
5. Shares can be issued at discount,
5. Debentures can be issued
or at a premium only subject
at par or at a premium easily
tocertain conditions laid down
by the Companies Act
6. Share holder has a right to vote
holder has no
6.
Generally
at the meeting of the company.
voting right.
Debenture
Illustration - 3
AB Ltd. issued 5,000 5%debentures of Rs. 100 each payable Rs. 30 on application,
Rs.30 on allotment & Rs. 40 on final call. 6,000 applications were received & 4,000
applications accepted is full & 500 applications were rejected & remaining debentures
were issued to remaining applicants.
Give the Journal Entries & show Bank a/c & Debentures account
Journal entries
Particulars
1. Bank a/c...............Dr
L/F
Debit
Rs.
Credit
Rs.
1,80,000
To Debenture Application a/c (Being application amount
1,80,000
received on 6,000 shares at Rs.30/-per share)
2. Debentures application a/c.........Dr
1,50,000
To Debentures a/c (Being application money transferred
1,50,000
to5,000 debentures at Rs.30 each)
3. Debenture Application a/c............Dr
15,000
To Bank a/c (Being refund of application money
15,000
on 500 debentures at Rs. 30 each)
4. Debenture Allotment a/c................Dr
To debenture a/c (Being allotment amount due
1,50,000
1,50,000
on 5,000 debentures at Rs.30 each)
5. Bank a/c............Dr
1,35,000
Debentures application a/c .......Dr
15,000
To Debentures allotment (Being cash on allotment &
1,50,000
adjustment of debenture application received)
6. Debenture final call a/c.............Dr
2,00,000
To Debenturea/c (Being final call amount due on 5,000
2,00,000
debentures at Rs. 40 each)
7. Bank a/c.................Dr
2,00,000
To Debenture final call a/c (Being final call amount received)
Dr.
2,00,000
Bank Account
Cr.
To Debenture application
1,80,000
By Debenture application
To Debenture allotment
1,35,000
By Balance c/d
To Debenture final call
2,00,000
5,00,000
5,15,000
Dr.
To Balance c/d
15,000
5,15,000
Debenture Account
5,00,000
Cr.
By Debenture Application
1,50,000
By Debenture Allotment
1,50,000
By Debenture final call
2,00,000
5,00,000
5,00,000
Illustration -4
The Hindustan Co. Ltd. issued 10,000 debenture of Rs. 100 each at a premium of
Rs.20 each, payable as follows- Rs. 30 on application, Rs. 50 on allotment including
premium, Rs. 40 on first & final call.
All the debenture were fully subscribed & the money duly received by the Co. Give
Journal Entries to record the above transactions.
Solution - 4
Journal entries
Particulars
1. Bank a/c...............Dr
To Debenture Application a/c (Being application amount
L/F
Debit
Rs.
Credit
Rs.
3,00,000
3,00,000
received on 10,000 shares at Rs.30/-per share)
2. Debentures application a/c.........Dr
3,00,000
To Debentures a/c
3,00,000
(Being application money transferred to Debentures a/c)
3. Debenture allotment a/c............Dr
5,00,000
To Debenture a/c
3,00,000
To Debenture premium a/c
2,00,000
(Being allotment amound due along with premium)
4. Bank a/c.................Dr
5,00,000
To Debenture allotment a/c (Being Debenture allotment
5,00,000
money received along with premium)
5. Debenture final call a/c................Dr
4,00,000
To Debenture a/c
4,00,000
(Being final call amount due on 10,000 debentures)
6. Bank a/c...................Dr
4,00,000
To Debenture final call a/c
4,00,000
(Being final call amount received)
Illustration - 5
The ‘X’ Co Ltd. issued 1,000 12% Debentures of Rs. 1,000 each at a premium of
Rs. 200 per debenture payable as under; on application Rs. 200, on allotment Rs. 500
(including premium) on final call Rs. 500
All the debentures were fully subscribed called up and paid up. Pass necessary
Journal Entries.
Solution- 5
Journal entries
Particulars
1. Bank a/c...............Dr
L/F
Debit
Rs.
2,00,000
To Debenture Application a/c (Being application amount
2,00,000
received on 1,000 shares at Rs.200/-)
2. Debentures application a/c.........Dr
Credit
Rs.
2,00,000
To Debentures a/c (Being application amount due)
2,00,000
3. Debenture allotment a/c............Dr
5,00,000
To Debenture a/c
3,00,000
To Debenture premium a/c (Being allotment amound due
2,00,000
on 1,000 debentures along with premium)
4. Bank a/c.................Dr
5,00,000
To Debenture allotment a/c
5,00,000
(Being Debenture allotment money received)
5. Debenture call a/c................Dr
5,00,000
To Debenture a/c (Being final call amount due )
5,00,000
6. Bank a/c...................Dr
5,00,000
To Debenture final call a/c (Being final call amount received)
5,00,000
Illustration -6
Sriram Co. Ltd. issued 20,000 12% debentures of Rs.100 each at discount of 10%
payable in full on application . Application received for 23,000 debentures. It was alloted
only to the extent of issued & the excess was refunded.
Pass Journal entries, show ledger a/c & B/s
Solution - 6
Journal entries
Particulars
L/F
1. Bank a/c...............Dr
Debit
Rs.
Credit
Rs.
20,70,000
To Debenture Application a/c (Being application amount
20,70,000
received on 23,000 debenture at Rs.90/-per share)
2. Debentures application a/c.........Dr
1,80,000
Discount on Debenture a/c..............Dr
20,000
To Debentures a/c (Being Allotment of 20,000 debentur at
20,00,000
Rs.100 each at a discount of Rs. 10 each)
3. Debenture Application a/c.............Dr
To Bank a/c
2,70,000
2,70,000
(Being the excess money on 3,000 Debenture refunded)
Dr.
Debenture Application A/c
Cr.
To Debentures a/c
18,00,000
To Bank a/c
By Bank a/c
20,70,000
2,70,000
20,70,000
20,70,000
Dr.
Debenture Account
To Balance c/d
20,00,000
By Debenture Application
18,00,000
By Discoun on Debenture
2,00,000
20,00,000
Dr.
20,00,000
Discount on Debenture a/c
To Debenture a/c
2,00,000
By Balance c/d
2,00,000
Dr.
20,70,000
Cr.
2,00,000
2,00,000
Bank Account
To Debenture Application a/c
Cr.
Cr.
By Application
2,70,000
By balance c/d
18,00,000
20,70,000
20,70,000
Balance Sheet as on.............
Liabilities
Rs.
Share capital secured
loans 12% debentures
Assets
Bank
20,00,000
20,00,000
Discount on debenture
Rs.
18,00,000
2,00,000
20,00,000
8. RATIO ANALYSIS
Meaning of Ratio :Ratios are nothing but one set of figures compared with another set. It explains the
relationship between the two. It is a method to understand the financial position of a
business unit. According to Accountant's Handbook by Wixon, Kell and Bedford, a ratio
"is an expression of the quantitative relationship between two numbers". In simple
language .ratio is one number expressed in terms of another and can be worked out by
dividing one number to the other.
For example, the ratio of two figures 100 and 50 may be expressed in any of the
following ways:
(a) 2:1
(b) 2
(c) 2/1 (d) 2 to 1
(e) 200%
In all these cases the inference is that the first figure is double, 200%, or 2 times than
that of the second.
Nature of Ratio Analysis :
Quantitative ratio analysis does not provide solution for all the problems faced by
financial analyst, unless several ratios, each of which related to the other are compiled
and analysed in a proper perspective. There are a number of ratios, which can be
computed from a single set of financial statements. But only a few can be used in a
particular situation. The ratio to be computed depends upon the purpose for which such
ratios are required.
Ratio analysis is a technique of analysis and interpretation of financial statements. It
is the process of establishing and interpreting various ratios for helping in making certain
decisions. It involves four steps:
i)
ii)
iii)
iv)
Selection of relevant data from the financial statements depending upon the
Objective of the analysis.
Calculation of appropriate ratios from the above data.
Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the ratios of
some other firms or the comparison with the ratios of the industry to which the
firm belongs.
Interpretation of the ratios.
The interpretation of ratios should be done by taking into analysis a group of related
ratios in sufficient number. Some times an individual ratio may also give some
information. But a comprehensive analysis can be made only when a set of inter related
ratios are analysed.
Ratios provide clues to the financial position of a concern. These are the points or
indicators of financial strength, soundness, position or weakness of an enterprise. One
can draw conclusions about the exact financial position of a concern with the help of
ratios.
Advantages of Ratio Analysis
Following are some of the advantages of Ratio analysis:
1. Simplifies financial statement: Ratio analysis simplifies the comparison of financial
statements.
2. Inter-firm comparison: It facilitates inter-firm and intra-firm comparison.
3. It provides the management the area of weakness and strength. So, that it can
concentrate on improving the weak point.
4. Helps in planning: Ratio can help the management in its basic function of planning
and forecasting. Over a period of time, the firm/industry can develop certain norms,
which may indicate future success or failure.
Limitations of Ratio analysis.
Following are the limitations of Ratio analysis.
1. Comparative study required: Ratios are useful in judging the efficiency of the
business only when they are compared with the past results of the business or with the
results of the similar business. However, such a comparison only provides a glimpse of
the past performance. But forecast for future may not be correct, because there are
several other factors like market condition, management policy etc., may affect future
operations.
2, Limitations of Financial Statement: Ratios are based only on the information which
has been recorded in the financial statements. A change in the management may have a
change in the operations of the firm.
3. Only quantitative aspects: Ratios gives only the quantitative aspect of the firm. For
example, a current ratio of 4:1 indicates the company’s liquidity position is very good.
But for an outsider, not only the capacity of the firm but its attitude is also important.
Courtesy, Promptness, punctuality and decency in dealing with the customers depends
upon attitude of the persons occupying the helm of affairs. Those aspects are not
disclosed by the ratio analysis.
4. Window dressing: The term window dressing means manipulation of accounts in
such a way so as to conceal vital facts. Financial statements may be presented in a way
to show a different position, than what it is. In such a situation the ratios developed from
such figures may not disclose the actual facts.
5. Problems of price level changes: Financial analysis based on accounting ratios may
be misleading if the effect of change in the price level is not taken into account.
6. No fixed standard: No fixed standard has been laid down for ideal changes. For
example, if the current assets are twice the current liability, the liquidity position is
satisfactory. But when a company has established a good rapport with their bankers, to
provide additional finance, then even if the current ratio is lesser, still the liquidity
position may be good.
Therefore, it may be concluded that ratio analysis , if done mechanically is not only
misleading but also dangerous. It is indeed a double edged sword which requires a great
deal of understanding. Ratio analysis is an aid to management in taking correct decision.
Ratios if discriminately calculated and widely interpreted can be a useful tool of financial
analysis.
CLASSIFICATION OF RATIOS
Various accounting ratios can be classified as follows:
1) Classification according to statement from which they are derived. In this
case, classification is made depending upon the statement from which the data
is collected. This is the convenient mode of classification. In this type ratios
are developed on the following three lines:
a) Revenue statement ratios: These ratios are also known as operating
ratios. These establish relationship between two items of a group of
items which are taken from the revenue statements.
b) Balance Sheet ratios or Financial ratios: These are the ratios which
deal with the relationship between any two items or a group of items
given in the balance sheet.
c) Combined ratios: These ratios portray the relationship between items,
one of which is taken from revenue statement and the other from the
balance sheet.
Traditional Classification or Statement Ratios
Balance Sheet Ratio
OR
Position Statement
Ratios
1. Current Ratio.
2. Liquid Ratio (Acid test
or Quick Ratio).
3. Absolute Liquidity
Ratio.
4. Debt Equity Ratio.
5. Proprietary Ratio.
6. Capital Gearing Ratio.
Profit and Loss Account Ratios
OR
Revenue / Income Statement
Ratios
1. Gross Profit Ratio.
2. Operating Ratio.
3. Operating Profit
ratio.
4. Net Profit ratio
5. Expense Ratio
6. Interest coverage
Ratio
Composite / Mixed Ratio
OR
Inter – Statement Ratios
1. Stock Turnover ratio.
2. Debtors Turnover
ratio.
3. Payables Turnover
ratio.
4. Fixed Assets Turnover
Ratio.
5. Return on Equity
Capital.
Some important types of ratios are as follows:
1. Liquidity Ratios,
2. Solvency Ratios,
3. Profitability Ratios.
4. Activity Ratios
1.LIQUIDITY RATIOS
These ratios indicates about the financial position of the company. A company is deemed
to be financially sound if it is in a position to carry on its business smoothly and meet all its
obligations – both long term and short term without strains. Thus, the financial position has
to be judged from two angles – long term as well as short term. It is a sound principle of
finance that long term requirements of funds should be met out of long term funds. Short
term requirements shall be met out of sort term funds. For example, if fixed assets are
purchased out of funds provided by bank overdraft, the company will face the problem, when
it has to repay bank overdraft. It cannot sell fixed asset for repaying bank overdraft. The
following are some of the important financial ratios.
1. SHORT TERM LIQUIDITY.
The smooth day to day working of the company
depends upon its capacity to pay all its short term obligations. To judge the company’s
capacity to pay all its obligations on time, the following ratios have to be examined.
1) CURRENT RATIO: It is the most important ratio for measuring short term
liquidity. Since it is related to working capital analysis, it is also called working capital ratio.
Current ratio express the relationship between current assets and current liabilities. Current
ratio is the ratio of total current assets to total current liability. It is calculated by dividing
current assets by current liability.
Current ratio = Current assets
Current liability
Current assets are those that can be converted into cash within a very short period. They
include cash in hand, cash at bank, sundry debtors, bills receivable, stock, prepaid expenses,
outstanding income etc.,
Current liabilities are those that are to be paid within a short period of time. They include
sundry creditors, bills payable, bank overdraft, outstanding expenses and any other short term
liabilities.
Importance of Current Ratio
The current ratio of a firm measures the short term solvency i.e. its ability to meet its
short term obligations. The excess of current assets over current liability, becomes working
capital. Therefore, higher the current ratio, the higher will be the amount of working capital
available to the firm for conducting day to day operation and safer will be the position of the
creditors. In a financially sound business, a current ratio of 2:1 is considered to be ideal i.e.
current assets shall be twice the amount of current liability. In the rarest situation, if all the
current liabilities are paid, there should be sufficient working capital left over in the business.
However, all current assets do not have same amount of liquidity. For example, for cash
sales, lower margin may be sufficient but for credit sale higher margin is required because all
debtors may not pay in time.
Current ratio is an index of firm’s financial stability i.e. an index of technical solvency
and strength of working capital. In brief, the current ratio has the following significance.
a) Current ratio indicates the firm’s ability to pay its current liability.
b) It shows short term financial strength.
c) It indicates strength and solvency of the firm.
d) A higher current ratio shows effective financial and operational efficiency of the firm.
Precautions: In determining the current ratio, it is important that all current assets and
current liabilities should be properly valued, over valuation of inventory, un-saleable
inventory included in stock, sufficient provision not being made for bad and doubtful debts
etc., may mislead the current ratio. Short term investment in marketable securities, shall be
included in current assets but fictitious assets shall be excluded. Similarly, every long term
liabilities, if it is due for payment within a year shall be included in current liabilities.
Regarding bank overdraft, unless it is mentioned as permanent arrangements, shall be
included in current liability.
Problems of window dressing: The financial analyst shall be very careful, while examining
the current assets (on account of window dressing i.e. practice of manipulating the current
assets and current liability). Many firms, may show excess value of current assets, by
inflating inventory value, not making provision for doubtful debts, advance received for next
year as cash receipt etc., similarly short term liability may be treated as long term liability.
Illustration 1
The following information are taken from the Balance sheet of a firm.
Rs.
Creditors
80,000 Cash
Bills Payable
20,000 Debtors
Bank Overdraft
50,000 Bills Receivable
Outstanding expenses
25,000 Marketable Securities
Inventories
Prepaid Expenses
Total Current Liability
1,75,000 Total Current Assets
Rs.
1,00,000
80,000
20,000
80,000
60,000
10,000
3,50,000
Current Ratio = Current Assets
Current Liability
= 350000
175000
= 2:1
It means for every Re. 1 current liability, there are Rs. 2 Current assets. Assume that full
amount of outstanding expenses and Rs. 25000 creditor are paid then there is a reduction in
cash by Rs. 50,000 i.e. current asset is reduced to Rs. 3,00,000. Similarly current liability is
reduced by Rs. 50,000 i.e. current liability is Rs. 1,25,000. Then, the current ratio is
300000 = 2.4:1
125000
Therefore, when current liabilities are paid, out of cash the current ratio has increased
from 2:1 to 2.4:1.
LIQUID RATIO
This ratio is also called as “Acid Test Ratio” or “Quick ratio”. This ratio indicates the
relationship between the liquid assets (assets which are immediately convertible into cash) to
liquid liability. All current assets except stock and prepaid expenses are considered as liquid
assets. All current liability except bank overdraft is known as liquid liability. Normally, the
banker will not demand back he amount of overdraft so long as payment of interest is made
promptly.
Liquid Ratio = Liquid Assets
Liquid Liabilities
On the basis of illustration no. 4.10 the liquid asset will be Rs. 3,50,000-60000 (Stock) –
290000. The liquid liability will be Rs. 175000-50000(bank overdraft) = Rs. 1,25,000.
Therefore, the liquid ratio is
290000 = 2.32:1
125000
The main defect of current ratio is that it fails to distinguish between inventory and
receivables. A firm may have a huge amount of inventory compared to receivables and other
current assets. Then even with a very high current ratio, it may not be in a position to pay its
liabilities in time.
In so far as eliminating inventory is concerned while calculating acid test ratio, it is a
rigorous test of liquidity. It gives a better picture of firm’s ability to meet its short term
obligations. When a business has 1:1 liquid ratio, then the liquidity position of the firm is
supposed to be satisfactory.
A comparison of the current ratio to quick ratio indicates the inventory hold-ups, for
example, if two units have the same current ratio but different liquid ratio, it indicates over
stocking by the firm, which has low liquid ratio.
Absolute liquidity ratio: The superiority of liquid ratio, over the current ratio is on account
of inventory. It may take a longer period to convert inventory into stock. Similarly,
conversion of account receivable into cash may also take longer period and the total amount
may not be received full due to bad and doubtful debts. Therefore, absolute liquidity ratio
relates to the sum of cash and marketable securities to the total quick liabilities. It gives
more meaningful measure of liquidity when used in comparison with current and acid test
ratios. However, this ratio is not much in use.
Long term liquidity: These ratios indicate the long term solvency of the company. Every
trading company has implied power to borrow. This borrowing power is generally limited to
the amount of paid up capital and free reserves. It means, if a company has Rs. 100 paid-up
capital, Rs. 50 reserves i.e. total Rs. 150, then it can borrow up to Rs. 150, 50% may be
short term borrowing and another 50% long term borrowings. This is supposed to be an ideal
borrowing.
2.SOLVENCY RATIOS:
The following are the important ratios that determines the long term solvency of the firm.
1. Debit Equity Ratios. The financing of the total assets of a business is done by owners
equity (also known as internal equity) as well as outside debt (also known as external equity).
How much fund has been provided by the owners and how much by outsiders in the purchase
of total asses is very significance factor in deciding the long term solvency of the firm. In
other words, the relationship between, the sorrowed fund and owners funds is a popular
measure of long term financial solvency of a firm. This relationship is shown by the debtequity ratio. This is also known as external-internal equity ratio. This calculated by the
following formula.
Debt equity Ratio = External Equities
Internal Equities
The term external equity includes debentures and other long term loans. Internal equities,
include equity share capital, preference share capital and undistributed profits and reserves.
The following additional formula is used.
i)
Debt equity ratio = Total Long term debt
Total long term funds
ii)
Debt equity ratio = Share holders funds
Total long term debt
iii)
Debt equity ratio = Total long term debt
Share holders funds
Method iii is very popular.
Whatever the way, the debt equity ratio is calculated, it shows the extent to which
debt financing has been used in the business. A high ratio shows that the claim of the
creditors are greater than those of owners. It is unfavourable from the company’s point of
view because creditors will interfere in the company’s administration. A low debt-equity is
favourable as owners have greater say in the administration and creditors are more secured.
Illustration 2
From the following information calculate the debt equity ratio.
Rs.
Preference share capital
2,00,000
Equity share capital
4,00,000
Capital Reserve
1,00,000
Profit and Loss account
1,00,000
12% Mortgage Debentures
2,00,000
Unsecured loan
1,00,000
Sundry Creditors
80,000
Bills payable
40,000
Provision for taxes
20,000
Provision for dividends
40,000
The debt equity ratio is calculated in any one of the following methods, depending
upon the purpose for which the information is required.
i)
ii)
iii)
Debt Equity Ratio = External Equities
Internal Equities
= 480000
800000
= 0.6:1
Debt Equity Ratio = Total Long Term Debt
Total Long Term Funds
= 3,00,000 (Debentures + Unsecured Loan)
11,00,000 (Share holders funds + Long term loans)
= 0.27:1
Debt Equity Ratio = Share Holders Funds
Total Long Term Funds
= 8,00,000
11,00,000
= 0.73:1
iv)
Debt Equity Ratio = Long Term Debt
Share Holders Funds
= 3,00,000
8,00,000
= 0.375:1
The fourth method is very commonly used. A ratio of 0.5:1 is said to be satisfactory.
It indicates the proportion of owner’s stake in the business. Excessive liabilities tend to
cause overstrain on the business. This ratio shows to what extent, the firm depends on
outsider for its survival. Too much dependency is dangerous.
3.PROFITABILITY RATIOS:
It is an indication of the efficiency with which the operations of the business are carried
on. A lower profitability may be the result of under sales or over expenditure. Bankers,
financial institutions and other creditors look at the profitability ratios as an indicator of
the capacity of the firm to pay interest. Owners are interested to know the profitability as
it indicates the return on their investments. Profit is the engine that drives the business
enterprise. It is an index of economic progress. Profits are the test of efficiency and a
measure of control to the management. It is a source of fringe benefits to the employees.
Profit is a measure of tax paying capacity to the government. It is a hint for a price cut to
the customers. Finally the profitability ratios judge the overall efficiency of the business.
Most of the profitability ratios are expressed a percentage on sales. Profitability ratio
may be broadly be classified into two types. A) Those ratios that indicates the
operational efficiency of the business. B) Those ratios that indicate the return on
investment.
The following are the important profitability ratios for judging operational efficiency.
A)
Gross Profit Ratios: It is also known as Gross Margin Ratios.
The difference between the cost of goods sold and net sales is known as gross profit. It is
very useful as a test of profitability. It is generally believed that the margin of gross
profit should be sufficient enough to cover all operating expenses and to leave adequate
amount as net sales.
Opening Stock + Purchases + All direct expenses = Cost of goods sold
This amount is deducted from sales + Closing Stock to get the Gross Profit.
Gross Profit Ratio
= Gross Profit
X 100
Net Sales
Generally the gross profit ratio should remain same from year to year, because
cost of sales will normally vary in direct proportion to the sales. Higher the ratio, greater
will be the profitability. The Finance Manager must be able to detect the causes of a
decrease in Gross margin and initiate action to improve the situation. There is no fixed
standard percentage of gross profit to sales. It depends upon the nature of productions
and type of goods. However a ratio of 25% to 35% may be considered reasonable.
A higher gross profit ratio may indicate:
a) Increase in selling price.
b) Reduction in cost of goods sold or both.
c) Under valuation of opening stock or over valuation of closing stock.
B) Operating Ratio: This ratio establishes the relationship between total operating
expenses and sales. Total operating expenses includes cost of goods sold, administration
expenses, financial expenses and selling expenses. Cost of goods sold is also known as
direct operating expenses and the rest are known as other operating expenses. This ratio
is also expressed as a percentage on sales.
Operating Ratio = (Cost of Goods sold + Operating Expenses) X 100
Net Sales
i) Cost of Goods sold = Opening Stock + Purchases – Closing Stock
ii). Operating expenses = Administration Expenses + Financial Expenses + Selling
Expenses.
This ratio shows the operating efficiency of the firm. Lower operating ratio indicates
higher operating profit and vice-versa.
C) Expenses ratio: This is a supporting ratio to operating ratio. It becomes imperative
that each aspect of cost of goods sold and/or operating expenses should be analysed in
detail. Just to find out as how for the firm is able to save or is making over expenditure
in respect of different items of expenses. In order to know which item of expenditure is
more, it is very essential to find out the ratio of each item of expenditure to net sales. The
following are the four important expenses ratio:
a) Factory Expenses Ratio = Factory Expenses X 100
Net Sales
b) Administrative Expenses Ratio
= Administrative Expenses
Net Sales
c) Selling Expenses Ratio = Selling Expenses X 100
Net Sales
d) Any other particular expenses Ratio = Particular Expenses
Net Sales
X 100
X 100
D)
Operating Profit Ratio: This ratio indicates the operating profit to net
sales. It shows the overall operational efficiency of the firm. Although there is no fixed
standard, 12% to 15% of net sales is supposed to be a reasonable operating profit.
Operating Profit Ratio = Operating Profit
Net Sales
X 100
E)
Net Profit Ratio: The Profit margin is an indictor of management ability
to operate the business with sufficient success, not only to recover from revenues of the
cost but also to leave a reasonable margin.
Net Profit Ratio = Net Profit
Net Sales
X 100
The following are the profitability ratio which indicates the return on investments.
The profitability of the firm is also measured in relation to investments. The term
investment may refer to total assets, capital employed or owner’s equity. The efficiency
of an enterprise has to be judged not only on the profit earned in relation to sales, but also
the profit earned in relation to the total investments made in the business. Investments
are represented by those assets, which are acquired for conducting the business
operations. The size of the investments certainly affects the volume of profits. The
following are the important ratios in this type.
a) Return on Total Assets: Profitability can be measured in terms of relationship
between the Net profit and total assets. The overall profitability can be measured
by using the following formula.
Return on Asset = Net Profit X 100
Total Assets
b) Return on Capital employed: This is a ratio which establishes the relationship
between the operating profit and capital employed. The Prime objective of
making investment in any business is to get satisfactory return on capital invested.
The following formula is used.
X 100
Return on Investment = Operating Profit
Capital Employed
The term Capital employed refers to the long term funds supplied by the creditor
and owners of the firm. Capital employed is to be found out by long term liabilities plus
owners’ equity. Alternatively, it is also equivalent to net working capital plus fixed
assets. Thus, the capital employed basis provides a test of profitability related to the long
term funds. A comparison of this ratio with similar firms and with the industrial average
would provide information regarding the efficiency of long term funds. Higher the ratio,
more is the efficient use of long term funds.
c) Return on Share holder’s equity: This ratio establishes the relationship
between the net profit and the shareholders funds. In this context, Net profit
means net income, after interest and tax, including non-operating income. It is the
final income available for distribution as dividends to shareholders. Share holders
funds include both equity share capital and preference share capital and all
reserves and surplus belonging to shareholders.
Return on Share holders equity =
Net Profit X 100
Share holder’s funds.
d) Return on Equity share holders Funds: Profitability from the equity share
holders point of view will be judged after taking into account the amount of
dividends payable to preference share holders.
X 100
Return on Equity =
Net Profit
Equity Share holders funds.
e) Earning per share (E.P.S.) In order to avoid confusion on account of different
meaning of the capital employed, the overall profitability can also be judged by
calculating earning per share by using the following formula.
EPS = Net Profit (after preference dividends)
No. of Equity Share
The EPS helps in determining the market price of equity shares of the company.
A comparison of EPS of the company with similar other company will also help in
deciding whether the equity share capital is being effectively used or not. It also
helps in estimating the company’s capacity to pay dividend to it’s equity share
holders.
f). Price Earning Ratio: This ratio indicates the number of times the earning per
share is covered by it’s market price. This is calculated by using the following
formula.
Price Earning Ratio = Market price per equity share
Earning per share
For example, the market price is Rs. 100.
The EPS is Rs. 20, then price earning ratio = 100/20, = 5 It means the market
value of every Re. 1 earning is 5 times.
2.. Proprietary Ratio: It is a variant of debt equity ratio. It establishes relationship
between proprietors funds (Shareholders funds) and total tangible assets. The ratio
provides a margin of safety to creditors. It tells the owner the extent to which they can
gain the benefit or maintain the control with a limited investment. It is found out by
using the following formula.
Proprietary Ratio = Share holders funds
Total Tangible assets
Illustration No. 3
From the following particulars, calculate the proprietary ratio.
Liabilities
Rs.
Assets
Rs.
Preference Share Capital
4,00,000 Fixed Assets
8,00,000
Equity Share Capital
8,00,000 Current Assets
4,00,000
Reserves and Surplus
2,00,000 Good Will
1,80,000
Debentures
4,00,000 Investments
6,00,000
Creditors
2,00,000 Preliminary Expenses
20,000
20,00,000
20,00,000
Solution:
Proprietary Ratio
= Share holders funds
Total Tangible assets
= 14,00,000
18,00,000
= 0.77:1
4.ACTIVITY RATIOS:
These ratios are intended to measure the effectiveness of the employment of resources.
They not only analyse the use of the total resources of the firm but also the use of the
component of the total assets. Activity analysis together with the degree of leverage
employed by the firm is a key factor in determining the profitability.
(Shareholders funds includes preference share capital + Equity Share Capital +Reserves
and Surplus Tangible Assets, All assets excluding goodwill and preliminary expenses)
This ratio focuses the attention on the general financial strength of the business
enterprise. This ratio has particular importance to creditor as it helps them to find out the
proportion of the shareholders funds in the total assets of the company. Higher ratio
indicates the secured position of the creditor. It shows the long term solvency of the firm.
Capital Gearing Ratio:
This is also known as Capitalisation ratio or leverage ratio. This ratio is mainly used to
analyse the capital structure of the firm. The term capital gearing normally refers to the
proportion between fixed interest or dividend bearing funds to equity shareholders funds.
Capital Gearing Ratio = Fixed Interest Bearing Funds
Equity Share Holders Funds
The Capital gearing shows the relationship between the fixed interest bearing
funds to non-fixed interest (dividend) bearing funds. This proportion is leverage.
Strictly, leverage means the effect of pressure applied in one end on the other. In the
context of capital structure of the company, the effect o fixed interest bearing funds to
non-fixed interest bearing funds. The extent to which the capital is geared shows the
speed with which the firm is accelerating towards the corporate goal. Further, high
gearing means trading in this equity and low gearing means trading in thick equity.
Highly geared capital structure may be indicative of under capitalisation which
means that the amount of capital is far less than the needs measured by the volume of
activity. A low capital gearing ratio indicates over-capitalisation. It must be very
carefully planned to avoid both over and under capitalisation. There should be a
balanced capital structure.
1) Equity Capital = Loan Capital = Even Gear
2) Equity Capital > Loan Capital = Low Gear = Over Capitalisation
3) Equity Capital < Loan Capital = High Gear = Under Capitalisation
Therefore, an analysis of capital gearing ratio helps for balanced capital structure of the
company.
Illustration No. 4
Find out the capital gearing from the following details
Equity Share capital
10% Preference Share Capital
12% Debentures
15% Long Term Loans
Current Liabilities
General Reserve
Rs.
1,00,000
50,000
80,000
14,000
30,000
80,000
Solution:
Capital Gearing Ratio = Fixed Interest and Dividends bearing funds
Equity Share holders funds
= 1,44,000 (Preference shares + Debentures + Long term loans)
1,80,000 (Equity Share capital + Reserves
= 0.8:1
Since, it is less than one, it is low geared.
Illustration No.5
From the following balance sheet of a company, you are required to calculate current
ratio and solvency ratio
Share Capital
5,00,000 Fixed Assets
6,00,000
Fixed Liabilities
2,50,000 Current Assets
4,00,000
Current Liabilities
2,50,000
10,00,000
10,00,000
Solution:
1) Current Ratio = Current Assets
Current Liability
= 4,00,000
2,50,000
= 1.6:1
2) Solvency Ratio = Outsiders Liability X 100
Total Assets
= 5,00,000 X 100
10,00,000
= 50%
Although, the current ratio is slightly less than standard, the solvency ratio is very good.
The Total assets are 200% of outsiders liability. It means, the company is fully capable
of paying all outsiders liability, out of its assets.
Illustration No. 6
The following is the summarised Profit and Loss Account of Progress Ltd., for the
year ended 31.03.2003.
To Opening Stock
To Purchases
To Direct Expenses
To Gross Profit
To Administration Expenses
To Selling Expenses
To Finance Expenses
To Loss on Sale of Assets
To Net Profit
1,99,000
10,90,500
28,500
6,80,000
19,98,000
3,00,000
60,000
30,000
8,000
3,00,000
6,98,000
By Sales
By Closing Stock
17,00,000
2,98,000
By Gross Profit b/f
By Interest on investment
By Profit on sale of shares
19,98,000
6,80,000
6,000
12,000
Balance Sheet as on 31.03.2003
Liabilities
Rs.
Assets
Share Capital 4,000 Shares of
Land and Building
Rs. 100 each
4,00,000 Machinery
Reserves
1,80,000 Stock in Trade
Profit and Loss account
2,80,000 Sundry Debtors
Debentures
2,00,000 Cash and Bank balances
40,000
Bank Overdraft
Other current Liability
60,000
11,60,000
6,98,000
Rs.
5,00,000
1,60,000
2,98,000
1,42,000
60,000
11,60,000
Re-arrange the above statement in a suitable form for proper analysis and calculate
the following ratios.
a) Gross Profit Ratio, b) Operating Ratio, c) Operating Expenses Ratio, d) Operating
Profit Ratio, e) Net Profit Ratio, f) Return on Total resources Ratio, g) Return on
Capital employed Ratio, h) Earning per share ratio, i) Current Ratio, j) Liquid
Ratio, k) Debt equity Ratio, l) Proprietary Ratio, m) Solvency Ratio, n) Stock turn
over ratio, and o) Fixed Asset turnover ratio.
Solution:
Progress Ltd.,
Income Statement for the year ended 31.03.2003
Sales
17,00,00
0
Less:
Cost of goods sold
Opening Stock
Purchases
Direct Expenses
1,99,000
10,90,50
0
28,500
13,18,00
0
2,98,000
Closing Stock
Gross Profit
Less: Operating Expenses
10,20,00
0
6,80,000
A. Administration Expenses
B. Selling Expenses
C. Finance Expenses
Operating Profit
ADD: Non Operating Income
Interest on Investment
Profit on sale of shares
b) Operating Ratio
c) Operating Expenses Ratio
3,90,000
2,90,000
6,000
12,000
18,000
Less Non Operating Expenses
Loss on sale of assets
Net Profit
a) Gross Profit Ratio
3,00,000
60,000
30,000
8,000
10,000
3,00,000
= Gross Profit X 100
Net Sales
= 6,80,000 X 100
17,00,000
= 40%
= (Cost of Goods + Operating Expenses) X 100
Net Sales
= (10,20,000+3,90,000)X100
17,00,000
= 82.90%
= Operating Expenses X 100
Net Sales
= 3.90,000 X 100
17,00,000
= 22.9%
d) Operating Profit Ratio
= Operating Profit X 100
Net Sales
= 2,90,000 X 100
17,00,000
= 17.05%
e) Net Profit Ratio
= Net Profit X 100
Net Sales
= 3,00,000 X 100
17,00,000
= 17.64%
f) Return on Total Resources Ratio = Net Profit X 100
Total Assets
= 3,00,000X 100
11,60,000
= 25.86%
e) Return on Capital Employed Ratio = Net Profit X 100
Capital Employed
= 3,00,000 X 100
8,60,000 (Equity Capital + Reserve +
Profit and Loss Account)
= 34.88%
h) Earning per Share ratio
= Net Profit
No. of Equity Shares
= 3,00,000
4,000
= Rs. 75 per Share
i) Current Ratio
= Current Assets
Current Liability
= 5,00,000
1,00,000
= 5:1 Ratio
j) Liquidity Ratio
= Liquid Assets
Liquid Liability
= 2,02,000
60,000
= 3.36:1
k) Debt Equity Ratio
= Long Term Debt
Equity Shareholders funds
= 2,00,000
8,60,000
= 0.23:1
l) Proprietary Ratio
= Share Holders funds
Total Assets
m) Solvency Ratio
n) Stock Turnover Ratio
= 8,60,000
11,60,000
= 0.74:1
= Outsiders liability X 100
Total Assets
= 3,00,000 X 100
11,60,000
= 25.86%
= Cost of Goods Sold
Average Stock]
= 10,20,000
2,48,500(Opening Stock + Closing Stock)
2
o) Fixed Assets Turn Over Ratio
=
=
4.1 Times
Sales
Fixed Assets
= 17,00,000
6,60,000
= 2.5 Times
9. FUND FLOW STATEMENT
Introduction:
Trading Account, Profit and Loss Account and Balance Sheet are the basic
financial statements. They give sufficient information about profitability and financial
position of a company. But these statements do not disclose some vital information
regarding the changes in current assets and current liabilities that have taken place during
the year. As such, the usefulness of these statements to the financial analyst is limited.
For financial analysis and planning, the financial managers shall know how the financial
position of the firm has changed during the financial year. It was felt that an additional
statement was required to indicate the changes in financial position. As a result of this,
an additional statement was prepared which was called “Where got, where gone”
statement. Later it was called “Statement showing the changes in financial position”.
But these names were not well accepted by the business community. Now, it is
commonly known as “Fund Flow Statement”.
Meaning of Fund
The term “fund” has a variety of meaning. There are people who believe that
fund is equal to cash; others say that cash and marketable securities constitute the Fund.
In this context, either cash or those that can be converted into cash become fund. Though
there were ambiguities in them beginning, now the “working capital” concept is
commonly accepted for fund. There are further two concepts –‘ Gross working capital’
and ‘Net working capital’. The totals of current assets is called ‘Gross Working Capital’,
where as the total of current assets minus current liability is called’ Net working capital’.
Current Assets:
The term “current assets” includes assets, which are acquired with the intention of
converting them into cash during the normal business operation of the company, with in a
calendar year. The following items are included in current assets in this connection:
a. Cash and Bank balance including fixed deposits with banks.
b. Accounts Receivable i.e. Debtors and bills receivables.
c. Inventory i.e. raw material, work-in-progress, finished goods, stores and
spares.
d. Advances given to various persons including government agencies.
e. Prepaid expenses.
f. Short-term investments and marketable securities.
g. Income earned but not received.
Current Liabilities:
The term ‘current liabilities’ is used for those liabilities, which require to be paid
within a short period, say about a year. In other words, current liabilities refer to those
obligations that are to be paid during the operating cycle of the business with in a
calendar year. The mere fact that the amount is due within a year does not make it current
liability unless it is payable out of existing current assets or creation of additional current
liabilities. For example, debentures due for redemption within a year will not be taken as
current liabilities, if they are to be paid out of the proceeds of fresh issue of
shares/debentures or out of the proceeds of the sale of debenture redemption fund
investments. The following items are included in current liabilities.
a. Account payable i.e. Bills payable and trade creditors.
b. Outstanding expenses i.e. expense for which services has been received by
the business but for which payment has not been made.
c. Bank overdraft.
d. Short term loans i.e. loans which are payable within a year.
e. Advances received by the business for the services to be rendered or goods
to be supplying during the next accounting cycle.
f. Provisions against current assets i.e. provision for doubtful debts, discount
on debtor etc., are treated as current liability since, they reduced the
amount of current assets.
Non-Current Assets
All assets other than current assets specified as above are termed as ‘non current
assets’. Such assets include Fixed Assets like Good will, Land, Building, Machinery,
Furniture, Patents, Trade Mark, Debit balance of Profit and Loss account, Discount on
issue of shares and Debentures, Preliminary expenses etc.,
Non-Current Liability
All liabilities, other than current liabilities are called as non-current liabilities.
They include Long Term Liabilities like Share capital, Long term loans, Debentures,
Share Premium, Revenue reserves, Capital reserves, Credit balance of Profit and Loss
account, any other undistributed profit in any form (like debenture redemption fund,
dividend equalization fund etc.,)
Treatment of provision for taxation and proposed dividends
a) Provision for taxation: There is a debate regarding the treatment of this item. Some
accountants are treating it as current liability and others non-current liability. It may
either be treated as a current liability or as a non-current liability. If it is treated as a
current liability, then it is taken to the schedule of charges in working capital. Then
payment of tax is not regarded as “application of fund”. Tax provision is not debited to
adjusted profit and loss account. When provision for tax is treated as a current liability,
for creating tax provision, profit and loss account is debited and provision for tax account
is credited (which is a current liability). In this case, when tax is paid, there is no change
in working capital as there is a reduction in one current liability with a corresponding
reduction in one current asset. However, there is a clear difference between provision
and liability. The amount set aside for a likely payment, which may or may not be paid
during the accounting cycle is a provision, where as the amount to be paid within the next
accounting cycle is a current liability. In this context, taxation provision is to be treated
as ‘non current liability’. Then the provision for taxation is debited to adjusted profit and
loss account and the amount of tax paid is treated as “application of fund”. This is a
stronger view, which is more commonly accepted.
b) Proposed Dividend
Whatever, has been said about “taxation provision” is applicable for “proposed
dividends” also. It can also be dealt in two ways.
a) Proposed dividend may be taken as a current liability, since acceptance of
dividends by shareholders, declared by the directors is only a formality, once it is
accepted by general meeting; it has to be paid with in the stipulated time as per law.
(42days). In this case, the proposed dividend will be shown in the schedule of changes in
working capital. When it is paid, it will not be shown as application of fund.
b) The difference in figures of proposed dividends cannot be treated as additional
dividends proposed, because as already said, when the director proposes the dividends
and it is shown in the appropriation account, the payment is bound to be made, as the
acceptance by share holders is only a formality. In such a case, proposed dividend for the
current year shall be added back to the current year profit in adjusted profit and loss
account, to determine the fund received from business operations.
amount of dividend paid is shown as application of fund.
Then the actual
Meaning of Fund Flow statement.
Flow of fund means, the change in the amount of fund. When there is a business
transaction, there is a flow of fund i.e. either there may be inflow of fund or outflow of
fund. When there is inflow of fund, it is considered as a source of fund. When there is
outflow of fund, it is shown as application of fund. Therefore, a fund flow statement is a
statement of sources and uses of fund. In other words it is a statement, which shows how
the net working capital is obtained and how it is used.
Uses of Fund flow statement:
Fund flow statement is very useful tool for the financial managers. The following
are the uses of fund flow statement for different parties.
1.Fund flow statement determines the financial consequences of business
operations. Finance managers can know how the firm has obtained the fund and
how it is has been used.
2.The management can formulate its financial policies on the basis of the
information provided by Fund flow statements.
3.It serves a control mechanism, when compared with the budgeted figures. It
helps for taking corrective actions.
4.It enables the creditors, bankers and other financial institutions in assessing the
degree of credit involved in granting credit to the business.
5.The management can formulate more effective financial policy, with the help of
fund flow statement.
6.It tells whether the sources of fund are increasing, decreasing or constant.
7.The statement compared with the budgeted figures will show to what extent the
resources were used according to plans.
Limitations of Fund flow statements:
A fund flow statement suffers from the following limitations.
1.The fund flow statement ignores the non-fund item which has a greater impact on the
working of the firm. As a result, it becomes a crude device.
2.The information used for preparing the fund flow statement is basically historical in
nature. As a result, it fails to give proper guidance for future planning.
3.Fund flow statement discloses the changes in the working capital in the summarized
form. Individual changes are not disclosed.
4.The statement lacks originality, because all information is taken from the other
financial statements.
5.When both aspects of transactions are current or when both aspects are non-current,
they are excluded from fund flow statement.
Preparation of Fund flow statement.
The following four steps are involved in preparation of fund flow statement.
1. Schedule of changes in working capital.
For preparing the fund flow statement two years Balance sheet of the firm are
given, from these balance sheets, the changes in the current assets and current liabilities
have to be recorded. Increase or decrease of each item of current assets and current
liabilities are recorded. The object of preparing this statement is to ascertain the increase
or decrease in net working capital. The following pro-forma may be used.
Particulars
Schedule of changes in working capital
Effect on Working capital
Previous
Current
Year
Year
Increase
Decrease
Rs.
Rs.
Rs.
Rs.
Current Assets
Cash in hand
Cash at Bank
Bills Receivable
Sundry Debtors
Marketable Securities
Inventories
Prepaid Expenses
Outstanding Income
Total Current Assets (C.A.)
Current Liabilities
Trade Creditors
Bills Payable
Outstanding Expenses
Bank Overdraft
Advance Received
Total Current Liabilities (C.L.)
Working Capital (C.A. – C.L.)
Increase/Decrease in working
capital
Total
Hints:
1) The above schedule is prepared with the help of current assets and current
liabilities given with in the two years balance sheet.
2) Additional information given outside the balance sheet has no effect on the above
statement.
3) Increase in current asset or decrease in current liability increases the working
capital.
4) Decrease in current asset and increase in current liability reduces the working
capital.
5) Increase in working capital becomes the uses of fund and decrease in working
capital becomes the sources of fund.
2) The second step in preparation of fund flow statement is to find out the funds
received from business operations (Funds from operation)
The amount received from business operation is the single largest source of fund.
The cash received from debtors or from sales cannot be taken as fund received because it
has to be spent for purchases and for other payments. The net profit, as disclosed from
profit and loss account cannot also be taken as fund received during the year, as profit
and loss account includes a number of non-fund item. Non-fund item means those items
in which neither the fund is received, nor the fund is given. These items are only book
adjustments. Therefore, in order to find out the fund received from business operations
these items have to be excluded. For example, depreciation on fixed asset. For the
amount of depreciation profit and loss account is debited and the amount is deducted
from the asset. In this case neither fund is received nor the fund goes out. Therefore, in
order to adjust a number of non-fund items, an adjusted profit and loss account is
prepared.
Particulars
To Opening debit balance of
profit and loss account
To Depreciation
To Good will written off
To Preliminary Expenses
written off
To Underwriting commission
written off
To Discount on issue of shares
and debentures written off
To Premium paid on
redemption of preference
shares or debentures
To Loss on sale of assets
To Profit transferred to
reserve
To Bonus shares issued
To Dividends proposed
To Taxation provision
To Balance c/f (Profit and loss
account credit balance at the
end of the year)
To Fund lost in business
operations (when credit side is
more)(Balancing figure)
Adjusted profit and loss account
Rs.
Particulars
By Opening balance of Profit
and loss appropriation account
By Profit on sale of assets or
appreciation of assets.
By Non trading income
By Balance c/f (Profit and loss
account debit balance at the
end of year)
By Fund received from
business operations (when
debit side is more)Balancing
figure
Rs.
3) Ascertainment of hidden transactions:
Sometimes, certain items required for fund flow statement may not be given
directly. They have to be found out by preparing various assets account. The third step
involved in preparation of various fixed assets accounts to find out either depreciation on
fixed assets, profit or loss on sale of fixed assets or purchase of fixed assets.
Fixed Assets Account
Particulars
Rs.
Particulars
Rs.
To Opening balance b/f
By Depreciation on fixed
c)
To Bank: - purchase of fixed
a)
assets
assets
By Bank: – sale of fixed assets
d)
To Profit and loss account
b)
By Profit and loss account
e)
(Profit on sale of fixed assets)
(loss on sale of fixed assets)
By Closing balance c/f
Hint: The opening and closing balance of fixed assets are always given. The remaining
items i.e. a to e may or may not be given. They are the missing items to be found out.
Similarly, provision for taxation account is to be prepared. The opening and
closing balances are always given. Either tax paid or provision for tax paid or provision
for tax created during the year is given. The balance will be either tax paid or provision
made during the year.
Depreciation Fund account:
There are two methods of charging depreciation on fixed assets. Normally, the
amount of depreciation is debited to profit and loss account and deducted from the
respective assets. Alternatively, the amount of depreciation may be charged to Profit and
loss account and credited to depreciation fund account. Then asset will be shown at its
full value in the balance sheet. But, when the asst is sold, for the amount of depreciation
on the asset sold, depreciation fund account is debited and asset account credited.
4) After following all the above three steps, the final step is the preparation of fund flow
statement. It is similar to cash account, where in the left side is used for showing the
sources of fund and the right side is used for showing the application of fund.
Fund Flow statement
Sources
Rs.
Applications
Rs.
1. Redemption of preference shares
1. Issue of shares
2. Redemption of debentures
2. Issue of Debentures
3. Repaying loans to
3. Borrowing loans from
institutions
institutions
4. Purchase of fixed assets
4. Sale of Fixed assets
5. Purchase of investments
5. Sale of investments
6. Fund lost in business
6. Fund received from business
operations
operations
7.
Increase in working capital
7. Decrease in working capital
8. Non trading payment
8. Non trading receipt
Is depreciation a source of fund?
There is a debate going on, whether depreciation is a source of fund. While
preparing the adjusted profit and loss account, the amount of depreciation is added back
to the profit, which increases, the fund received from business operations. Higher the
amount of depreciation charged, higher will be the fund received from business
operations. Therefore, depreciation may be considered as a source of fund.
Besides, depreciation is charged on fixed assets. Fixed assets are used to generate
the revenue. If there is no fixed assts, then the particular assets have to be hired for
which hire charges are to be paid. Depreciation, which is charged on the fixed asset,
prevents fund from going out of business. Fund saved become fund earned. Therefore,
depreciation may be treated as a source of fund.
Depreciation is debited to profit and loss account, which reduces the amount of
profit. Since profit is reduced on account of depreciation, to that extent tax liability is
also reduced. Therefore, the amount of depreciation reduces the fund from going out as
tax. Hence, it is taken as a source of fund.
The question is, whether the depreciation can really be considered as a source of fund? If
it were to be so, all firms would have charged higher amount of depreciation and increase
their sources of fund. But it is not so, because depreciation is only a book adjustment.
PRACTICAL PROBLEMS
Illustration No. 2.1
From the following Balance sheets, make out
1. Statement of changes in working capital
2 funds flow statement.
BALANCE SHEET
Liabilities
Assets
1989
Rs.
1990
Rs.
1989
Rs.
1990
Rs.
Share Capital
300000
400000 Goodwill
100000
80000
8% Redeemable
Preference shares
150000
100000 Building
200000
170000
20000 Plant
80000
200000
20000
30000
140000
170000
Capital reserve
-
Gen Reserve
40000
50000 Investment
P & L A/c
30000
48000 Debtors
Proposed Divd.
42000
50000 Stock
77000
109000
Sundry Creditors
25000
47000 B/R
20000
30000
B/P
20000
16000 Cash
15000
10000
O/S. Exp.
30000
36000 Bank
10000
8000
Provn. For Tax.
40000
50000 Preliminary Exp.
15000
10000
677000
817000
677000
817000
Other information:
i. A portion of the building was sold in 1990 and the profit has been transferred to
Capital Reserve.
ii. Written down value of a machine was Rs. 12000. it was sold for Rs. 10000.
Depreciation of Rs. 1000 is charged in 1990.
iii. Dividend on investment received in 1990 Rs. 3000.
iv. An interim dividend paid in 1990 was Rs. 20000.
Solution:
Statement showing change in working capital :
Liabilities
1990
1989
Current Assets
Stock
Debtors
B/R
Cash in hand
Cash in bank
Less current Liabilities
Creditors
B/P
Liability for Exp
Increase
Decrease
Rs.
Rs.
Rs.
77,000
1,40,000
20,000
15,000
10,000
1,09,000
1,70,000
30,000
10,000
8,000
32,000
30,000
10,000
2,62,000
3,27,000
72,000
25,000
20,000
30,000
47,000
16,000
36,000
Rs.
5,000
2,000
7,000
22,000
4,000
6,0000
76,000
35,000
41,000
76,000
76,000
Increase in Working
capital
Plant A/c:
Rs.
To Op. Balance
To Plant Purchased
(Bal. Figure)
80,000
1,33,000
Rs.
By Depreciation
By Cash sales
By Loss on Sales
By Closing Balance
2,13,000
Goodwill A/c:
By P & L A/c
1,00,000 By closing Bal.
To Opening
balance
1,00,000
Building A/c :
By Sales
To Opening Bal
2,00,000 By Closing Bal
To Capital Reserve
20,000
2,20,000
1,000
10,000
2,000
2,00,000
2,13,000
20,000
80,000
1,00,000
50,000
1,70,000
2,20,000
Investment A/c:
To Opening Bal.
To Purchases
20,000
10,000 By Closing Bal.
30,000
30,000
30,000
Proposed Dividend:
Closing Bal
Add. L.Y’s Paid this
year
50,000
42,000
92,000
Less Opening Bal.
42,000
Current Provis ion
50,000
Gen. Reserve:
Closing Bal.
Less Opening Bal.
50,000
40,000
Provision during the
year
10,000
Tax Provision :
Closing Bal.
Less Opening Bal.
Provision during the
year
50,000
40,000
10,000
Preliminary expenses :
Opening Bal.
Less Opening Bal.
Written during the year
15,000
10,000
5,000
i) Adjusted Profit and Loss A/c:
To General Reserve
Propose dividend
Int. Dividend
Tax. Reserve
Goodwill
Depreciation on
plant
Loss on plant
Preliminary
By Opening Balance
10,000
Dividend
50,000
Funds from
operation
20,000
10,000
20,000
1,000
2,000
30,000
3,000
1,33,000
expenses
Closing Balance
5,000
48,000
1,66,000
1,66,000
Funds Flow Statement:
Sources
Equity Capital
Sale of land
Sale of plant
Div on investment
Fund from Operation
Applications
Rs.
1,00,000
50,000
10,000
3,000
1,33,000
2,96,000
Increase in Working
Capital
Pref. shares
Int. Div. Paid
Plant Purchased
Investment
Dividend Paid
Rs.
41,000
50,000
20,000
1,33,000
10,000
42,000
2,96,000
Illustration No. 2.2
From the following balance sheets of Y Ltd., as on 31st December 2001 and 2002.
You are required to prepare
a) A Schedule of changes in working capital
b) A fund Flow Statement.
Liabilities
2001
2002
Rs.
Rs.
1,00,000
1,00,000
Share Capital
General Reserve
14,000
18,000
Profit and Loss Account
16,000
13,000
Sundry Creditors
8,000
5,400
Bills payable
1,200
800
Provision for taxation
16,000
18,000
Provision for doubtful debts
400
600
1,55,600
1,55,800
Assets
2001
2002
Goodwill
12,000
10,000
Building
40,000
36,000
Plant
37,000
36,000
Investments
10,000
11,000
Stock
30,000
23,400
Debtors
18,000
19,000
Bills receivables
2,000
5,200
Cash at Bank
6,600
15,200
1,55,600
1,55,800
The following additional information has been given:
1) Depreciation charged on plant was Rs. 4,000 and on building was Rs. 4,000
2) Provision for taxation of 19,000 was made during the year 2002.
3) Interim (1/2 year) dividend of Rs. 8,000 was paid during the year 2002.
Solution:
Schedule of charges in working capital
Effect on working capital
Particulars
Current Assets
Stock
Debtors
Bills receivables
Cash at Bank
Total of Current Assets (CA)
Current Liability
Sundry Creditors
Bills payable
Provision for Doubtful debts
Total of Current Liability (CL)
Working Capital (CA-CL)
Increase in Working Capital
Sources
Fund
Received
Business Operation
from
2001
2002
30,000
18,000
2,000
6,600
56,600
Increase
Rs.
23,400
19,000
5,200
15,200
62,800
6,600
1,000
3,200
8,600
8,000
5,400
2,600
1,200
800
400
400
600
9,600
6,800
47,000
56,000
9,000
56,000
56,000
15,800
Fund Flow Statement
Rs. Application
38,000 Purchase of:a) Plant
b) Investment
Tax paid
Interim Dividends paid
Increase in working capital
38,000
Decrease
Rs.
200
9,000
15,800
Rs.
3,000
1,000
17,000
8,000
9,000
38,000
Working Note:
To Balance b/f
Building Account
40,000 By Depreciation
4,000
By Balance c/f
To Balance b/f
To Bank: Purchase of Plant
(Balancing figure)
To Balance b/f
To Bank Purchase
(Balancing figure)
40,000
Plant Account
37,000 By Depreciation
3,000 By Balance c/f
40,000
Investment Account
10,000 By Balance c/f
1,000
11,000
Provision for Taxation Account
To Bank Tax paid
17,000 By Balance c/f
(Balancing figure)
18,000 By Profit and Loss A/c
To Balance b/f
(Provision made during
the year)
35,000
Adjusted Profit and loss Account
To Depreciation
By Balance b/f
a) Plant
4,000 By Fund Received from
b) Building
4,000 business operation
To Good will written off
2,000 (Balancing figure)
To Taxation provision
19,000
To General Reserve
4,000
To Interim Dividend
8,000
To Balance c/f
13,000
54,000
Note: Tax provision is treated as non-current liability.
Illustration No. 2.3
From the following Balance sheets of Bharath Ltd., make out:
a) Statement of changes in working capital
b) Fund Flow Statement.
Liabilities
1999
2000
Rs.
Rs.
Equity share capital
30,000
40,000
8% Redeemable preference
15,000
10,000
shares
Capital reserve
2,000
General reserve
4,000
5,000
Profit and Loss account
3,000
4,800
Proposed dividend
4,200
5,000
Creditors
2,500
4,700
Bills payable
2,000
1,600
Liabilities for Exps.
3,000
3,600
Provision for tax
4,000
5,000
36,000
40,000
4,000
36,000
40,000
11,000
11,000
16,000
19,000
35,000
16,000
38,000
54,000
67,700
1999
10,000
20,000
8,000
2,000
14,000
7,700
2,000
1,500
1,000
1,500
67,700
Assets
Goodwill
Land and Buildings
Machinery
Investments
Sundry debtors
Stock
Bills receivable
Cash balance
Bank balance
Preliminary expenses
81,700
2000
8,000
17,000
20,000
3,000
17,000
10,900
3,000
1,000
800
1,000
81,700
You are informed that:
a) A piece of land has been sold out in 2000 and profit on sale has been credited to
capital reserve.
b) A machine has been sold for Rs. 1000. Written Down Value (W.D.V.) of the machine
was Rs. 1200. The Depreciation of Rs. 1000 was charged on machinery in 2000.
c) Dividends received on investments Rs. 200.
d) An Interim dividend of Rs. 2000 was paid in the year 2000.
Solution:
Schedule of changes in working capital
Effect on working capital
Particulars
Current Assets
Sundry Debtors
Stock
Bills receivable
Cash balance
Bank balance
Total of Current Assets (CA)
Current Liability
Sundry Creditors
Bills payable
Liability for Exp,
Provision for Tax
1999
2000
14,000
7,700
2,000
1,500
1,000
26,200
17,000
10,900
3,000
1,000
800
32,700
2,500
2,000
3,000
4,000
4,700
1,600
3,600
5,000
Increase
Rs.
Decrease
Rs.
3,000
3,200
1,000
500
200
2,200
400
600
1,000
Total of Current Liability (CL)
Working Capital (CA-CL)
Increase in Working Capital
Sources
Issue of Equity shares
Fund
received
from
business operations
Dividends received
Sale of Land
Sale of Machinery
11,500
14,700
3,100
17,800
14,900
17,800
17,800
7,600
Fund Flow Statement
Rs. Application
10,000 Purchase of:13,300 a) Machinery
b) Investments
200 Preference shares
5,000 redeemed
1,000 Dividends paid (1999)
Interim dividends paid
Increase in working
capital
29,500
3,100
7,600
Rs.
14,200
1,000
5,000
4,200
2,000
3,100
29,500
Working Note:
To Balance b/f
To Capital Reserve
To Balance b/f
To Bank -Purchase
To Balance b/f
To Bank Purchase
To Balance c/f
To Bank – preference
shares redeemed
To Balance c/f
Land and Building Account
20,000 By
Bank
–
2,000 (3000+2000)
By Balance c/f
22,000
Machinery Account
8,000 By Bank – Sales
14,200 By Loss on sale
By Depreciation
By Balance c/f
22,200
Sale
Investment Account
2,000 By Balance c/f
1,000
3,000
Equity share capital Account
40,000 By Balance b/f
By Bank – issue of share
(Balancing figure)
40,000
8% Preference share capital Account
5,000 By Balance b/f
10,000
15,000
5,000
17,000
22,000
1,000
200
1,000
20,000
22,200
3,000
3,000
30,000
10,000
40,000
15,000
15,000
To Depreciation on
Machinery
To Loss on sale of
Machinery
To Interim Dividend paid
To General Reserve
To Dividends proposed
(2000)
To Goodwill written off
To Preliminary expenses
written off
To Balance c/f
Adjusted Profit and loss Account
1,000 By Balance b/f
By Dividends received
200 on investment
By Fund received from
2,000 business operations
1,000 (Balancing figure)
5,000
3,000
200
13,300
2,000
500
4,800
16,500
16,500
Tutorial Note:
1) Tax provision has been taken as current liability
2) Dividends proposed in 1999 is paid in 2000
3) Profit on sale of land is not taken to adjusted profit and loss account because it has not
been added to profit.
4) Dividends received on investment is a non-trading income.
Illustration No. 2.4
The Balance Sheets of Sri Mookambika Company Ltd. as at the end of 2001 and 2002 are
given below:
Liabilities
2001
2002
Rs.
Rs.
Equity share capital
1,00,000
1,50,000
Share premium
5,000
General reserve
50,000
60,000
Profit and Loss Account
10,000
17,000
6% Debentures
70,000
50,000
Provision for depreciation of
plant and machinery
50,000
56,000
Provision for depreciation of
furniture
5,000
6,000
Provision for taxation
20,000
30,000
Creditors
86,000
95,000
3,91,000
4,69,000
Assets
2001
2002
Plant and Machinery at cost
1,04,000
1,00,000
Furniture at cost
7,000
9,000
Investments at cost
1,60,000
1,80,000
Debtors
30,000
70,000
Stock
60,000
65,000
Cash
30,000
45,000
3,91,000
4,69,000
A Plant which had been purchased for Rs. 4,000 (Accumulated depreciation Rs.
2,000) was sold for cash Rs. 800 on 30.09.2002. On 30.06.2002 an item of furniture was
purchased for Rs. 2,000. These were the only transactions concerning Fixed Assets
during 2002. Depreciation on Plant was provided at 8% p.a. on original cost (the sold out
item is not taken into consideration) and on Furniture at 12 ½ % p.a. on average cost. A
dividend of 22 ½ % on original shares was paid.
Prepare a statement showing sources and destination (uses) of Fund during 2002.
Solution:
Schedule of charges in working capital
Effect on working capital
Particulars
Current Assets
Debtors
Stock
Cash
Total of Current Assets (CA)
Current Liability
Creditors
Provision for taxation
Total of Current Liability (CL)
Working Capital (CA-CL)
Increase in Working Capital
Sources
Issue of shares
Premium collected
Fund
received
business operations
Sale of Machinery
from
1999
2000
30,000
60,000
30,000
1,20,000
70,000
65,000
45,000
1,80,000
86.000
20,000
1,06,000
14,000
41,000
55,000
95,000
30,000
1,25,000
55,000
55,000
Fund Flow Statement
Rs. Application
50,000 Purchase of:5,000 a) Furniture
b) Investments
49,700 Debentures repaid
800 Dividends paid
Increase in working
capital
1,05,500
Increase
Rs.
Decrease
Rs.
40,000
5,000
15,000
9,000
10,000
60,000
41,000
60,000
Rs.
2,000
20,000
20,000
22,500
41,000
1,05,500
Working Note:
Depreciation Fund on Plant and Machinery Account
To Machinery A/c
2,000 By Balance b/f
To Balance c/f
56,000 By Depreciation
(Balancing figure)
58,000
Plant and Machinery Account
To Balance b/f
1,04,000 By Depreciation
By Cash – Sale
By Loss on Sale
By Balance c/f
1,04,000
Investment Account
To Balance b/f
1,60,000 By Balance c/f
To Bank: - Purchase
20,000
To Balance c/f
To Balance b/f
To Cash: - Purchase
To Depreciation
a) Machinery
b) Furniture
To Loss on sale of
Machinery
To General Reserve
To Dividends (22.5% on
1,00,000)
To Balance c/f
1,80,000
Depreciation on Furniture Account
6,000 By Balance b/f
By Depreciation
(Balancing figure)
6,000
Furniture Account
7,000 By Balance c/f
2,000
9,000
Adjusted Profit and loss Account
By Balance b/f
8,000 By Fund received from
1,000 business operations
50,000
8,000
58,000
2,000
800
1,200
1,00,000
1,04,000
1,80,000
1,80,000
5,000
1,000
6,000
9,000
9,000
10,000
49,700
1,200
10,000
22,500
17,000
59,700
59,700
Tutorial Notes:
1. Tax provision is taken as current liability.
2. Difference in share capital is to be taken as issue of additional shares.
3. Reduction in debentures to be treated as debentures re-paid.
4. Under the depreciation fund system, when the asset is sold, for the amount of
depreciation on the asset sold, fund is account to be debited and asset account credited.