Books of Account to be kept by a Company

Every company must maintain proper books of accounts of its affairs. The following
transactions must be entered in the books of accounts of the company which must be
kept at its registered office :-

a. all sums of money received and expended by the company and the matters in
respect of which the respect of which the receipt and expenditure took place;
b. all sales and purchases of goods by the company; and
c. the assets and liabilities of the company.
d. in the case of a company engaged in production, processing, manufacturing
or mining activities, such particulars relating to utilisation of material or other
items of cost as may be prescribed relating to certain class of companies as
the Central Government may require.

The books of accounts must comply with the following conditions :-

1. The books must give a true and fair view of the state of affairs of the company
or the branch office, if any, and explain its transaction.
2. The books must be kept on accrual basis and according to double entry
system of accounting.

Every company must keep its books of account at its registered office. However,
some of the books of account may be kept at such other place in India as the Board
of Directors may decide, provided a notice in writing giving full address of that other
place alongwith requisite filing fee is filed with the Registrar of Companies within
seven of such decision.

If the company has a branch office, the books of account relating to transactions at
the branch office may be kept at that branch office, but proper summarised reports
and statements must be sent to the registered office or such other place where the
books are kept, at intervals of not more than three months. The books of account of
the branch must give a true and fair view of the affairs of the branch and clearly
explain its transactions.

They must not conceal any transaction and also not disclose any transaction which is
fictitious. The books of accounts and other documents and records are open to
inspection by any director during business hours. Similarly, they are open to
inspection by the Registrar of Companies or an officer authorised by the Central
Government.

These books and papers together with the vouchers pertaining to entries made must
be maintained for at least 8 years. It has been clarified by the Department of
Company Affairs in their Circular No. 2/83 dated 2/3/1983 that the books of account
should be prepared and maintained in indelible ink (and not in pencil).

The following persons are responsible for maintaining the books of accounts of a
company :-

1. The managing director or manager;

2. If the company has neither a managing director nor manager, then every
director of the company;
 3. Every officer and other employee who has been authorised and to whom
responsibility to maintain the books has been alloted by the Board of
Directors.

If any of the persons referred to above fails to take all reasonable steps to maintain
proper books of accounts or has by his own willful act been the cause of any default
by the company in this respect, he is punishable with imprisonment up to six months
or with fine which may extend to Rs. 1,000 or with both. However, no person can be
sentenced to imprisonment unless it is proved that the contravention was committed
by him wilfully.

Preparation of Balance Sheet and Profit and Loss Account

The company has to prepare its balance sheet and profit & loss account from the
books of account maintained by it. Every Balance Sheet of a company must give a
true and fair view of the state of affairs of the company as at the end of the financial
year and must be in the prescribed format.

If the responsible for maintaining proper books of account fails to take all reasonable
steps to secure compliance by the company with the requirement of law relating to
the form and contents of the balance sheet, he is liable for each offence to
imprisonment for a term extending up to six months or to fine up to Rs.1,000/- or to
both.

Form of Balance Sheet,

Part 1 to Schedule VI of the Companies Act, 1956 gives the format in which the
balance sheet is to be prepared. The schedule specifies 2 types of formats, the
horizontal format and the vertical format. A company can prepare its balance sheet
in either of the 2 formats. In the horizontal format, the liabilities including the share
capital are placed on the left side and assets of all types on the right. The main heads
in this form are arranged as under:

(a) Share Capital (a) Fixed assets

(b) Reserves and surplus (b) Investments
(c) Loans (c) Current assets, loans and advances
Current liabilities and (d) Miscellaneous
(d) expenditure to the provisions extent not written
off or adjusted
(e) Profit & Loss Account
----------- -----------
Total
----------- -----------

In the vertical format, the various heads of liabilities and assets are arranged
vertically and current liabilities are shown as deduction, from current assets.
Whatever information which is required to be given in the horizontal format must also
be given in the vertical format. Summarised prescribed vertical form of balance sheet
is given below:

I. Sources of Funds
(1) Shareholders' funds
(2) Loan funds
----------------------
Total
----------------------

II Application of Funds

(1) Fixed assets

(2) Investments
(3) Current assets, loans and advances
Less: Current liabilities & provisions
(a) Miscellaneous expenditure to the extent not
(4)
written off or adjusted
(b) Profit & Loss Account
----------------------
Total
----------------------

The Central Government may, on the application or with the consent of the Board of
Directors of the company, by order, modify in relation to that company, any of the
requirements as to matters to be stated in the company's balance sheet or profit and
loss account for adapting them to the circumstances of the company.

Contents of Profit and Loss Account

Though no format has been prescribed for the profit and loss account, Part II to
Schedule VI of the Companies Act, 1956 gives a list of items which must be disclosed
in every profit & loss account. Every profit and loss account of a company must give
a true and fair view of the company's profit or loss for the financial year for which it is
drawn up.

Adoption of Balance Sheet and Profit & Loss Account

The Board of directors must present to the shareholders of the company, the balance
sheet and a profit and loss account for the financial year at every annual general
meeting. In the case of companies which are not commercial organisations such as
Section 25 companies, instead if the profit & loss account, an income & expenditure
account may be prepared. The profit and loss account to be placed in the FIRST
annual general meeting should relate to a period beginning with the incorporation of
the company and ending with a day, the interval between which and the date of the
meeting does not exceed nine months. In case of subsequent annual general
meetings, the profit and loss account should relate to a period beginning with a day
immediately after the period for which the preceding profit & loss account was made
and ending with a day, the interval between which and the date of the meeting
should not exceed six months. The financial year may be more or less than a
calendar year, but it must not exceed 15 months or with the special permission of the
Registrar, 18 months.
If any director fails to take all reasonable steps to comply with the aforesaid
requirements he is, in respect of each offence liable to be punished with
imprisonment up to six months or with fine up to Rs.1,000/- or with both.

Authentication of Balance Sheet and Profit & Loss Account

The balance sheet and profit & loss account of a company must be signed on behalf
of the Board of directors by two directors out of whom one must be the managing
director, where there is one and the manager, or secretary, if any. The balance sheet
and profit and loss account must be approved by the Board of directors before they
are submitted to the auditors for the purpose of audit. The report of the auditors
must be attached to the balance sheet and profit & loss account.

The company and every officer of the company who is in default with the above
provisions shall be punishable with the fine which may extend to Rs.500/-, if:

a. any copy of balance sheet and profit and loss account is issued, circulated or
published, without being signed as required ; or
b. any copy of balance sheet is issued, circulated or published, without there
being annexed or attached thereto, a copy each of the following :-

1. the profit and loss account;

2. any accounts, reports or statements pertaining to subsidiary companies which
are required to be attached to the balance sheet,
3. the auditors' report; and
4. the Report of the Board of Directors

Circulation of Balance Sheet and Auditors' Report

A copy of every balance sheet, profit and loss account, auditors' report and every
other document required to be annexed or attached to the balance sheet must be
sent not less than twenty-one days before the general meeting to every member, to
every trustee for debenture holders, and to all other persons who are entitled to have
a notice of general meetings. In the case of a company not having a share capital,
the above documents need not be sent to a member, or debenture holder who is not
entitled to have notice of general meetings.

In case of listed companies, the company may keep the aforesaid documents
available for inspection at its registered office during working hours for a period of
twenty-one days before the meeting and send to every member and trustee for
debentureholders only a summarised statement containing the salient features of
these documents in the prescribed format.

Filing of Annual Accounts with the Registrar

Every company must file with the Registrar within 30 days from the day on which the
annual accounts, auditor’s report and the director’s report were presented at the
annual general meeting, three certified copies of these documents signed by the
managing director, manager or secretary of the company or if there be none of these
by a director of the company.

These accounts may be inspected and copies thereof may be obtained by any
member of the public at the Registrar of Companies on payment of the requisite fee.
However, no person other than a member of the company is entitled to inspect, or
obtain copies, of the profit and loss account in the case of the following types of
companies :-

1. a private company which is not a subsidiary of public company;

2. a private company whose entire paid-up capital is held only by one or more
bodies corporate incorporated outside India; or
3. a private company which is deemed to be a public company by virtue of
Section 43A, if the Central Government directs that it is not in the public
interest that any person other than a member of the company should be
entitled to inspect or obtain copies of the profit and loss account of the
company.

In case the annual general meeting of a company for any year has not been held, , 3
copies of the balance sheet and profit and loss account, duly signed, within thiry days
from the latest day on or before which that meeting should have been held in
accordance with the provisions of the Act must be filed with the Registrar of
Companies. If for any reason, the annual general meeting before which a balance
sheet is laid does not adopt it, or is adjourned without adopting the balance sheet or
if the annual general meeting of a company for any year has not been held, a
statement of the fact and reasons thereof must also be annexed to the balance sheet
and to the copies thereof to be filed with the Registrar.

If default is made in complying with the above provisions, then the company and
every officer of the company who is in default shall be punishable with fine which
may extend to Rs.50 for every day during the period the default continues.

Directors' Report

The report of the Board of Directors must be attached to every balance sheet
prsented at the annual general meeting. The report must contain information
regarding the following matters :-

1. The state of affairs of the company

2. The amount, if any, which it proposes to carry to any reserves in such balance
sheet
3. The amount of dividend recommended
4. Details of any material changes and commitments, if any, affecting the
financial position of the company which have occurred between the end of the
financial year of the company to which the balance sheet relates and the date
of the report
5. Conservation of energy, technology absorption, foreign exchange earnings
and outgo.
6. Names, designations and other particulars of all employees drawing more
than Rs. 50000/- p.m. in the company
7. Details necessary for a proper understanding of the state of the company's
affairs and which are not, in the Board's opinion, harmful to the business of
the company or of any of its subsidiaries, in respect of changes which have
occured during the financial year :-

i. in the nature of company's business;

 ii. in the company's subsidiaries or in the nature of the business carried on by
them; and
iii. generally in the classes of business in which the company has an interest

Auditors of Company

Auditors of Government Companies

The auditor of a Government company is appointed or re-appointed by the Central
Government on the advice of the Comptroller and Auditor-General of India provided
that the audit would be within the number of acceptable audits available to each
auditor.

The Comptroller & Auditor General of India has the power :-

a. to direct the manner in which the company's accounts are to be be audited by

the auditor so appointed and to give such auditor instructions in regard to any
matter relating to the performance of his functions as such
b. to conduct supplementary or test audit of the company's accounts by such
person or persons or persons as he may authorise in this behalf; and for the
purpose of such audit, to require additional information to be furnished to any
person or persons so authorised, on such matters, by such person or persons,
and in such form, as the Comptroller and Auditor-General may, by general or
special order, direct.

The auditor must submit a copy of his audit report to the Comptroller and Auditor-
General of India who shall have the right to comment upon or supplement, the audit
report in such manner as he may think fit.

Any such comments upon, or supplement to, the audit report must be placed before
the annual general meeting of the company at the same time and in the same
manner as the auditors' report.

Auditors of Other Companies

It is the duty of the auditor conduct the audit of the books of accounts of the
company and to make his report to the members of the company on the accounts
examined by him, and on every balance sheet, every profit and loss account and on
every other document declared by the Act to be part of or annexed to the balance-
sheet or profit and loss account and laid before the company in general meeting
during his tenure of office. The auditor’s report, besides other things necessary in any
particular case, must expressly state-

1. whether, in his opinion and to the best of his information and according to
explanation given to him, the accounts give the information required by the
Act and in the manner as required;
2. whether the balance-sheet gives a true and fair view of the company's affairs
as at the end of the financial year and the profit and loss account gives a true
and fair view of the profit or loss for the financial year;
3. whether he has obtained all the information and explanations required by him
for the purposes of his audit;
4. whether in his opinion, the profit & loss account and balance sheet refered to
in his report comply with the accounting standards recommended by the
Institute of Chartered Accountants of India;
 5. whether, in his opinion, proper books of account as required by law have been
kept by the company, and proper returns for the purposes of his audit have
been received from the branches not visited by him;
6. whether the company's balance sheet and profit and loss account dealt with
by the report are in agreement with the books of account and returns.

In case any of the above matters is answered in the negative or with a qualification,
the auditor's report must state the reason for the same. Where the auditor is unable
to express any opinion in answer to a particular question, his report shall indicate
such fact together with the reasons why it is not possible for him to give an answer to
such question.

The Central Government is empowered to issue orders requiring the auditor to

include in his report a statement on such matters as may be specified. In exercise of
this power the Central Government has issued an order called "The Manufacturing
and other Companies (Auditor's Report) Order, 1975. It is the duty of the auditor to
comply with this order when making his report to the shareholders.

Only the person appointed as auditor of the company or where a firm of auditors is so
appointed, only a partner of that the firm practising in India, can sign the auditor's
report or sign or authenticate any other document of the company required by law to
be signed or authenticated by the auditor.

===================================================
=======================

Inter Corporate Loans and Investments

A company cannot :-

i. make any loan to any other body corporate

ii. give guarantee or security in connection with any loan made by any person to
another body corporate
iii. acquire, by subscription, purchase or in any other manner, securities in any
other body corporate

exceeding 60 % of its paid up share capital and free reserves or 100 % of its free
reserves, whichever is more, unless approved by a special resolution passed at a
general meeting of members.

The Board of the company may give a guarantee without being previously authorised
by a special resolution of members if all the following conditions are satisfied :-

i. a Board resolution is passed to this effect

ii. there exist exceptional circumstances which prevent the company from
obtaining previous authorisation by special resolution
iii. the Board resolution is confirmed within 12 months in a general meeting or its
next Annual general meeting, whichever is earlier.
Notice of such resolution must clearly indicate the specific limits, the particulars of
the body corporate in which the investment / loan / guarantee / security is proposed,
the purpose of the investment / loan / guarantee / security, sources of funding, etc.

No investment / loan / guarantee / security may be made or given unless the Board
resolution sanctioning it is with the consent of all directors present at the meeting
and prior approval of the public financial institution ( if any term loan is outstanding )
is obtained.

Approval of the public financial institution is not required if the investment / loan /
guarantee / security is with the 60 % limit as mentioned above and there has been
no default in repaying the term loan and / or interest thereon.

No loan can be made at a rate of interest lower than the bank rate prescribed by the
Reserve Bank of India.

A company which has defaulted in repaying public fixed deposits cannot make or
give any investment / loan / guarantee / security unless the fixed deposit is fully
repaid along with interest due as per the terms and conditions of the fixed deposit.

A register of such inter-corporate loans and investments must be maintained giving

the relevant details.

The above provisions do not apply to :-

i. Any loan / guarantee / security made or given by :-

a. a banking company or an insurance company or a housing finance

company in the ordinary course of its business or a company
established with the object of financing industrial enterprises or
providing infrastructural facilities
b. a company whose principal business is the acquisition of shares,
stocks, debentures or other securities
c. a private company unless it is a subsidiary of a public company

ii. Investment made under Rights issue of securities

iii. Loan made by holding company to its wholly subsidiary company
iv. Guarantee or security given by a holding company for loan to its wholly owned
subsidiary
v. Acquisition of securities by a holding company in its wholly owned subsidiary

Print This Article

All the Inventory transactions will look for the valuation class and the
corresponding GL Accounts and post the values in the G.L accounts.

1) For Example: during Goods Receipt

Stock Account - Dr
G/R I/R Account - Cr
Freight Clearing account - Cr
Other expenses payable - Cr

2) During Invoice Verification

G/R I/R Account - Dr
Vendor - Cr
3) When the Goods are issued to the Production Order the following transactions
takes place:
Consumption of Raw Materials - Dr
Stock A/c - Cr
4) When the Goods are received from the Production Order the following
transactions takes place:
Inventory A/c - Dr
Cost of Goods Produced - Cr
Price difference - Dr/Cr
(depending on the difference between standard cost and actual cost)
5) When the Goods are dispatched to customer through delivery the following
transactions takes place:
Cost of Goods Sold - Dr
Inventory A/c - Cr
6) When the Goods are issued to a Cost Center or charged off against expenses the
following transactions takes place:
Repairs and Maintenance/Expenses - Dr
Inventory A/c - Cr
7) When the Goods are stock transferred from one plant to another, the following
transactions takes place:
Stock A/c - Dr (Receiving location)
Stock A/c - Cr (Sending location)
Price difference - Dr/Cr
(due to any difference between the standard costs between the two
locations)
8) When the stocks are revalued, the following transactions take place:
Stock A/c - Dr/Cr
Inventory Revaluation A/c - Cr / Dr
9) When the Work in Progress is calculated the following transaction takes place:
 Work in Progress A/c - Dr
Change WIP A/c - Cr

1. Investment Basics
What is Investment?
The money you earn is partly spent and the rest saved for meeting future
expenses. Instead of keeping the savings idle you may like to use savings in
order to get return on it in the future. This is called Investment.
Why should one invest?
One needs to invest to:
earn return on your idle resources
generate a specified sum of money for a specific goal in life
make a provision for an uncertain future
One of the important reasons why one needs to invest wisely is to meet the
cost of Inflation. Inflation is the rate at which the cost of living increases.
The cost of living is simply what it costs to buy the goods and services you
need to live. Inflation causes money to lose value because it will not buy the
same amount of a good or a service in the future as it does now or did in the
past. For example, if there was a 6% inflation rate for the next 20 years, a
Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why it is
important to consider inflation as a factor in any long-term investment
strategy. Remember to look at an investment's 'real' rate of return, which is
the return after inflation. The aim of investments should be to provide a
return above the inflation rate to ensure that the investment does not
decrease in value. For example, if the annual inflation rate is 6%, then the
investment will need to earn more than 6% to ensure it increases in value.
If the after-tax return on your investment is less than the inflation rate, then
your assets have actually decreased in value; that is, they won't buy as
much today as they did last year.
When to start Investing?
The sooner one starts investing the better. By investing early you allow your
investments more time to grow, whereby the concept of compounding (as
we shall see later) increases your income, by accumulating the principal and
7
the interest or dividend earned on it, year after year. The three golden rules
for all investors are:
Invest early
Invest regularly
Invest for long term and not short term
What care should one take while investing?
Before making any investment, one must ensure to:
1. obtain written documents explaining the investment
2. read and understand such documents
3. verify the legitimacy of the investment
4. find out the costs and benefits associated with the investment
5. assess the risk-return profile of the investment
6. know the liquidity and safety aspects of the investment
7. ascertain if it is appropriate for your specific goals
8. compare these details with other investment opportunities available
9. examine if it fits in with other investments you are considering or you
have already made
10. deal only through an authorised intermediary
11. seek all clarifications about the intermediary and the investment
12. explore the options available to you if something were to go wrong,
and then, if satisfied, make the investment.
These are called the Twelve Important Steps to Investing.
What is meant by Interest?
When we borrow money, we are expected to pay for using it – this is known
as Interest. Interest is an amount charged to the borrower for the privilege
of using the lender’s money. Interest is usually calculated as a percentage of
the principal balance (the amount of money borrowed). The percentage rate
may be fixed for the life of the loan, or it may be variable, depending on the
terms of the loan.
What factors determine interest rates?
When we talk of interest rates, there are different types of interest rates -
rates that banks offer to their depositors, rates that they lend to their
borrowers, the rate at which the Government borrows in the
8
Bond/Government Securities market, rates offered to investors in small
savings schemes like NSC, PPF, rates at which companies issue fixed
deposits etc.
The factors which govern these interest rates are mostly economy related
and are commonly referred to as macroeconomic factors. Some of these
factors are:
Demand for money
Level of Government borrowings
Supply of money
Inflation rate
The Reserve Bank of India and the Government policies which
determine some of the variables mentioned above
What are various options available for investment?
One may invest in:
Physical assets like real estate, gold/jewellery, commodities etc.
and/or
Financial assets such as fixed deposits with banks, small saving
instruments with post offices, insurance/provident/pension fund etc.
or securities market related instruments like shares, bonds,
debentures etc.
What are various Short-term financial options available for
investment?
Broadly speaking, savings bank account, money market/liquid funds and
fixed deposits with banks may be considered as short-term financial
investment options:
Savings Bank Account is often the first banking product people
use, which offers low interest (4%-5% p.a.), making them only
marginally better than fixed deposits.
Money Market or Liquid Funds are a specialized form of mutual
funds that invest in extremely short-term fixed income instruments
and thereby provide easy liquidity. Unlike most mutual funds, money
market funds are primarily oriented towards protecting your capital
and then, aim to maximise returns. Money market funds usually yield
9
better returns than savings accounts, but lower than bank fixed
deposits.
Fixed Deposits with Banks are also referred to as term deposits
and minimum investment period for bank FDs is 30 days. Fixed
Deposits with banks are for investors with low risk appetite, and may
be considered for 6-12 months investment period as normally
interest on less than 6 months bank FDs is likely to be lower than
money market fund returns.
What are various Long-term financial options available for
investment?
Post Office Savings Schemes, Public Provident Fund, Company Fixed
Deposits, Bonds and Debentures, Mutual Funds etc.
Post Office Savings: Post Office Monthly Income Scheme is a low
risk saving instrument, which can be availed through any post office.
It provides an interest rate of 8% per annum, which is paid monthly.
Minimum amount, which can be invested, is Rs. 1,000/- and
additional investment in multiples of 1,000/-. Maximum
amount is Rs. 3,00,000/- (if Single) or Rs. 6,00,000/- (if held
Jointly) during a year. It has a maturity period of 6 years. A bonus of
10% is paid at the time of maturity. Premature withdrawal is
permitted if deposit is more than one year old. A deduction of 5% is
levied from the principal amount if withdrawn prematurely; the 10%
bonus is also denied.
Public Provident Fund: A long term savings instrument with a
maturity of 15 years and interest payable at 8% per annum
compounded annually. A PPF account can be opened through a
nationalized bank at anytime during the year and is open all through
the year for depositing money. Tax benefits can be availed for the
amount invested and interest accrued is tax-free. A withdrawal is
permissible every year from the seventh financial year of the date of
opening of the account and the amount of withdrawal will be limited
to 50% of the balance at credit at the end of the 4th year
immediately preceding the year in which the amount is withdrawn or
at the end of the preceding year whichever is lower the amount of
loan if any.
Company Fixed Deposits: These are short-term (six months) to
medium-term (three to five years) borrowings by companies at a
fixed rate of interest which is payable monthly, quarterly, semi10
annually or annually. They can also be cumulative fixed deposits
where the entire principal alongwith the interest is paid at the end of
the loan period. The rate of interest varies between 6-9% per annum
for company FDs. The interest received is after deduction of taxes.
Bonds: It is a fixed income (debt) instrument issued for a period of
more than one year with the purpose of raising capital. The central or
state government, corporations and similar institutions sell bonds. A
bond is generally a promise to repay the principal along with a fixed
rate of interest on a specified date, called the Maturity Date.
Mutual Funds: These are funds operated by an investment company
which raises money from the public and invests in a group of assets
(shares, debentures etc.), in accordance with a stated set of
objectives. It is a substitute for those who are unable to invest
directly in equities or debt because of resource, time or knowledge
constraints. Benefits include professional money management,
buying in small amounts and diversification. Mutual fund units are
issued and redeemed by the Fund Management Company based on
the fund's net asset value (NAV), which is determined at the end of
each trading session. NAV is calculated as the value of all the shares
held by the fund, minus expenses, divided by the number of units
issued. Mutual Funds are usually long term investment vehicle
though there some categories of mutual funds, such as money
market mutual funds which are short term instruments.
What is meant by a Stock Exchange?
The Securities Contract (Regulation) Act, 1956 [SCRA] defines ‘Stock
Exchange’ as any body of individuals, whether incorporated or not,
constituted for the purpose of assisting, regulating or controlling the
business of buying, selling or dealing in securities. Stock exchange could be
a regional stock exchange whose area of operation/jurisdiction is specified at
the time of its recognition or national exchanges, which are permitted to
have nationwide trading since inception. NSE was incorporated as a national
stock exchange.
What is an ‘Equity’/Share?
Total equity capital of a company is divided into equal units of small
denominations, each called a share. For example, in a company the total
equity capital of Rs 2,00,00,000 is divided into 20,00,000 units of Rs 10
each. Each such unit of Rs 10 is called a Share. Thus, the company then is
11
said to have 20,00,000 equity shares of Rs 10 each. The holders of such
shares are members of the company and have voting rights.
What is a ‘Debt Instrument’?
Debt instrument represents a contract whereby one party lends money to
another on pre-determined terms with regards to rate and periodicity of
interest, repayment of principal amount by the borrower to the lender.
In the Indian securities markets, the term ‘bond’ is used for debt
instruments issued by the Central and State governments and public sector
organizations and the term ‘debenture’ is used for instruments issued by
private corporate sector.

What Is Capital?
Let's imagine that you decide to start up your own ice cream shop business. You will need to
invest in equipment, food supplies and property. All the money that you invest to start your
business is called capital. Essentially, the capital of a business consists of all of its assets (or
items to assist in the creation of wealth).
What if it dawns on you that you don't have enough cash to buy all the needed assets? Let's see
how new businesses and companies deal with this problem.
Top
Equity vs. Debt
To start a new business (or fund a new project) a company can raise money in two ways - by
selling shares of equity or by incurring debt. If the owner of our ice cream parlor invested all their
own savings to buy the materials necessary to start the business, they made an equity
investment in the company. Equity is simply ownership of a corporation. Typically, ownership
units in a corporation are referred to as stock.
However, if our owner did not have necessary funds to start their own business they could
finance their operation in one of two ways:
1. Issue stock (or certificates of partial ownership in his company) to people who may be
interested in helping their venture out in return for a proportional share of the profits that
the company might generate.
2. Borrow money that will need to be paid back with interest.
So, what are the advantages of selling stock?
Top
Why Do Corporations Issue Stock?
Businesses issue stock to raise capital.
Advantages of issuing stock:
1. A Company can raise more capital than it could borrow.
2. A Company does not have to make periodic interest payments to creditors.
3. A Company does not have to make principal payments.
Disadvantages of Issuing Stock:
1. The principal owners have to share their ownership with other shareholders.
2. Shareholders have a voice in policies that affect the company operations.
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Advantages for Stockholders
As part owner of a corporation, you may be entitled to share in the profits of the company. There
is also a chance that the company will grow and the price of the stock may rise.
If the company achieves economic success, the stock value will go up and stockholders will
benefit. For example, if you invested $1,000 to buy 100 shares of a company at $10 each and the
shares rose to $13 each you would gain $300. This is equivalent to a 30% return. In cases like
this, both the stockholders and the business would be pleased.
Initial Public Offerings (IPOs)
The very first sale of stocks to the public is called an initial public offering (IPO), and occurs on
the primary market. This tutorial will cover the following factors involved in initial public offerings:
__ The Process of Issuing Securities
__ The Basics of Underwriting
__ Types of Underwriting Arrangements
__ The Prospectus
__ Ways a Stock May Be Advertised Before it is Sold
__ Newly Issued Stocks: Getting the Names Straight
The Process of Issuing Securities
Corporations sell stock to the public as one way to raise capital. Before it can issue new stock, a
corporation must first file registration statements with the Securities and Exchange Commission
(SEC) www.sec.gov. A twenty-day wait is required before it can sell the stocks.
The issuing company may make their registration statement public with a preliminary prospectus
called a red herring that summarizes the registration statement. Basic information about the new
offering is also provided, including how many shares are being offered and which brokerage
companies will distribute the stock to the public. At the time of issue, a final prospectus is
presented. This includes the price of the stock (its offering price).
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The Basics of Underwriting
A Corporation going public hires an investment banker to help it sell its stock. This process is
called underwriting. The investment banker functions as an intermediary between the issuing
corporation and the public. In most cases, the underwriter (investment banker) purchases the
stocks from the company for resale to the public. To reduce its own risk, the investment banker
may form an underwriting syndicate of other investment bankers to co-purchase the shares. The
underwriting syndicate forms a selling group to sell specified allotments of the issue. The
investment banker (underwriting syndicate) then marks up the price of the offering. This markup
represents the fee for the syndicate's service. The difference between the price the underwriter
pays and the price the public pays is called the underwriting spread.
The syndicate manager may bid on the stock in the offering to "stabilize" the price. This bid must
be less than or equal to the offering price. By law, the prospectus must make this attempt to
stabilize the stock price known to the public.
The SEC also requires the underwriter to investigate the issuing company-particularly any audits,
how it uses proceeds, its financial statements and the management team. This process is called
due diligence.
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Types of Underwriting Arrangements
A stock issue can be underwritten by several methods.
The underwriter can act as an agent, in which it tries to sell as much of the issue as it can at
market prices. This is a best effort arrangement.
The issuing company can also agree to issue new stock on the condition that all of it is sold. If all
of the stock is not sold, then it will withdraw the issue. This is an all-or-none arrangement.
A negotiated underwriting is when the issuer and the corporation negotiate the terms of the issue,
the price, the size and other details.
The issue may be subject to competitive bids from investment bankers. The top bidder
underwrites the issue and resells it to the public.
When a public company issues more of its stock, it must first offer that stock to existing
shareholders; that is their preemptive right. A standby is the public sale of whatever stock the
existing shareholders have not yet purchased.
A firm commitment arrangement is when an investment banker buys all of the stock from the
corporation and then resells it to the public at a higher price.
A private placement is an offering in which the company sells to private investors and not to the
public. Private placements do not have registration fees.
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The Prospectus
Prospectuses are legal documents that explain the financial facts important to an offering. They
must precede or accompany the sale of a primary offering. The law requires companies selling
primary offerings to send prospectuses to anyone who wants to buy a primary offering.
Prospectuses may also be used to solicit orders. Customers should read a prospectus carefully
before purchasing any primary offering.
Prospectuses include but are not limited to the following:
__ Offering price
__ Legal opinions about the issue
__ Underwriting method
__ The history of the company
__ Other costs related to investing in the stock
__ The management team
__ The handling of proceeds
The prospectus must be provided to customers before they complete any transactions. It must
also include the SEC's disclaimers that it does not approve or disapprove of the stock being
offered, and that it does not judge the prospectus' statements for accuracy.
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Ways an Issue May Be Advertised Before it is Sold
A new issue of stock is allowed to be advertised before it is actually sold, although it may not be
sold during the actual registration period.
Registered representatives are allowed to accept oral solicitations from clients. They are not
allowed to sell any shares of the new stock. Neither are they allowed to affirm any offers of sale.
Registered representatives may send red herrings, or preliminary prospectuses, to clients.
Information in these documents will discuss why the stock is being sold and the offering
timetable. Red herrings are only issued for information purposes.
Tombstone advertisements are ads that announce the new stock. Their sole purpose is to
function as communication. They are not prospectuses. They are called tombstones because
they provide prospective buyers with the "bare bones" information: the name of the stock, the
issuer and how to obtain a red herring.
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Newly Issued Stocks: Getting the Names Straight
Two aspects of IPOs deserve special attention: hot issues and the so-called "when, as, and
ifissued"
stocks.
A hot issue is a security sold by broker-dealers on the secondary market just after it is first issued.
New stock may not be sold until after the registration period has expired. If the stock has not been
issued by that time, it may be sold conditionally as a "When, as, and if-issued" stock. Should it fail
to be issued, all buys, sells, earnings and losses will be canceled.
This concludes the introductory tutorial on initial public offerings. For more information on
investing in IPOs check out the tutorial titled Investing in Initial Public Offerings.
Stock Market Players
As an investor, you need to be familiar with the different players in the investment arena and how
they buy and sell securities. Broker-dealers, registered representatives and the others have
specific roles in clearing the way for commerce in securities.
This tutorial will cover the following topics:
__ Broker-Dealers
__ What Broker-Dealers Are Not Allowed to Do
__ Other Broker Services
__ Registered Representatives, Market Makers and Specialists
Broker-Dealers
A broker is a person or firm that facilitates trades between customers. A broker acts as a
gobetween
and, in doing so, does not assume any risk for the trade. The broker does, however,
charge a commission. A dealer is a person or firm that buys and sells for his or her own inventory
of securities and for others. A dealer therefore assumes risk for the transactions. Dealers may
mark securities up or down to make a profit on their transactions.
Many publications or websites use the term broker-dealer. A broker-dealer is allowed to operate
in either role, but never as both at the same time.
To be involved in the buying, selling or trading of securities, a person or firm must be registered
with the National Association of Securities Dealers (NASD). The NASD is a self-regulatory
organization created by the Securities and Exchange Commission (SEC). Brokers and dealers
must follow all rules of the NASD and SEC, including the NASD's Conduct Rules and its rules for
arbitration, complaints and dealings with the public.
Broker-dealer status can be revoked for freely breaking securities rules; for having been expelled
or suspended from any self-regulatory organization; for making misleading statements to the SEC
or the NASD; or for having committed felonies or misdemeanors in the securities industry.
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What Broker-Dealers Are Not Allowed to Do
The following are practices that broker-dealers are forbidden to do:
__ Churning: Excessive trading of a client's discretionary account to increase the broker's
commissions.
__ Use deception or manipulation to trade securities, or failing to state material facts
__ Recommending low-priced, speculative securities without determining whether they are
suitable for the customer
__ Make unauthorized transactions
__ Guarantee that loss will not occur
__ Try to talk clients into buying mutual funds inappropriate for their means and goals
__ Use fictitious accounts to disguise trades
__ State that the SEC has approved or judged positively either the security or the broker
__ Not promptly transmitting the client's money or securities
Broker-dealers convicted of any of these actions may be expelled or suspended by the NASD.
Because brokers have so much control over other people's money, their activities are highly
regulated.
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Other Broker Services
Brokers, when authorized by the client, may set up discretionary accounts. These accounts allow
brokers to buy and sell securities for a client's account without contacting the client for each
transaction. The authorized broker may determine the security traded, how much of it may be
traded, the price and the time of transaction.
Brokers may lend funds to customers who have margin accounts. With margin accounts,
customers can buy additional securities with money borrowed from a broker.
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Registered Representatives, Market Makers and Specialists
Registered Representatives
A registered representative is an individual who has passed the NASD's registration process and
is therefore licensed to work in the securities industry. The process includes an examination that
tests the candidate's knowledge of securities and markets. Further, the registration agreement
requires that the candidate agree to follow the rules of the NASD.
Registered representatives sell to the public; they do not work on exchange floors.
Market Makers
Market makers are firms that maintain a firm bid and offer price in a given security by standing
ready to buy or sell at publicly-quoted prices. The Nasdaq is a decentralized network of
competitive market makers. Market makers process orders for their own customers, and for other
NASD broker/dealers; all NASD securities are traded through market maker firms. Market makers
also will buy securities from issuers for resale to customers or other broker/dealers. About 10
percent of NASD firms are Market Makers; a broker/dealer may become a Market Maker if the
firm meets capitalization standards set down by the NASD.
Specialists
Specialists keep markets for securities orderly and continuous. This means they must buy when
there are others selling without buyers, and they must sell when others are buying without sellers.
They must maintain their own inventories of securities that are large enough for sizable trades.
Specialists both buy and sell out of these inventories and mediate between other customers.
Specialists work on the exchanges where they hold seats. Among their duties is buying and
selling odd-lots (trades of less than 100 shares) for exchange members. To trade a security, a
specialist must be able to keep a position on it with at least 5,000 shares. Specialists, like others,
who buy and sell for the public, are subject to rules and regulations. Specialists often choose to
keep inventories in multiple securities, often in more than one market sector.
This conclude
s our tutorial on brokers, specialists and market makers

Q.1. What is meant by Comparison of Financial Statements?

Answer: "Comparison of Financial Statements is primarily an analytical study of the

different items shown in the Income Statement and Position Statement (Balance Sheet)
over a period of time. It may refer to:

1. Financial statements of an enterprise for two or more accounting years.

2. Financial statements of different enterprises for the same accounting year.

Q.2. What is meant by Comparative Income Statement? Why is it prepared?

Answer: The Profit & Loss Account reveals the trading results of a concern i.e. its profit
or loss during the year. But the Comparative Income Statement presents a review of two
or more years. It shows the absolute change from one period to another.

Comparative Income Statement is prepared:

1. To study increase or decrease in ‘Sales’.

2. To study the increasing or decreasing tendency of ‘Cost of Goods Sold’.
3. To study the increase or decrease in Gross Profit, Net Profit and Operating
Profits.

4. To analyse the various items of incomes.

Q.3. What are the purposes of Comparative Financial Statement? Explain.

Answer: The basic objectives of Comparative Financial Statements are as under:

a. Comparison of financial statements helps to identify the size and direction of

changes in financial position of an enterprise.
b. These statements help to ascertain the weakness and soundness about liquidity,
profitability and solvency of an enterprise.
c. These statements help the management in making forecasts for the future.

Q.4. What are the various methods of presenting Comparative Financial

Statements?

Answer: The various methods of presenting Comparative Financial Statements are:

1. Ratio Analysis
2. Funds Flow Statement
3. Cash Flow Statement
4. Comparative Income Statement
5. Comparative Position Statement
6. Common Size Statement
7. Trend Percentage

Q.5. What is the meaning and objective of "Trend Analysis"?

Answer: Trend analysis is an important tool of horizontal financial analysis. This is

helpful in making a comparative study of the financial statements for several years.
Under this method trend percentages are calculated for each item of the financial
statements taking the figure of base year as 100. The starting year is taken as the base
year.

The trend percentages show the relationship of each item with its preceding year’s
percentages. These percentages can also be presented in the form of Index Numbers
showing relative change in the financial date of certain period. This will exhibit the
direction to which the concern is proceeding. The trend ratio may be compared with the
industry, in order to know the strong or weak points of a concern. These are calculated
only for major items instead of calculating for all items in the financial statements.

Q.1. What do you mean by the term ‘Debenture’? What are the kinds of Debentures?

Answer: When a company desires to borrow a considerable sum of money for its expansion, it invites
the general public to subscribe to its debentures. A debenture is a certificate issued by the company
acknowledging the debt due by it to its holders and is issued by means of a prospectus in the same
manner as shares.

Kinds of Debentures:

The following are the various types of debentures issued by a company:

1. Security Point of View

i. Secured Debentures

a. Fixed Charge: A fixed charge is created on certain specified assets generally immovable such
as land and building, plant and machinery, long term investments and the like. So it is
equivalent to mortgage. When the charge is fixed, the company can only deal with the property
subject to the charge, that is, a fixed charge allows the company to retain possession of the
assets but prevents the company from selling, leasing etc., of the assets without the consent of
the charge holders. The property identified remains so identified during the period for which
the charge is created.

b. Floating Charge: A floating charge is generally in respect of movables, that is, properties
which are constantly changing. It does not amount to mortgage of property. A charge on the
stock-in-trade from time to time of a business is a floating charge. When an item is sold out of
the stock, the charge ceases to attach to it and the buyer cannot be asked to pay the debt. When
a new item is added to it the charge automatically attaches to it without further new agreement.
So the property is certainly identified at the time of creation of charge; its very identification
goes on changing and the final identification is at the point of time when the charge crystallizes
or becomes fixed after which the company can mortgage or sell that property subject the
 charge. The charge will continue to attach only so long as the item remains unsold.

i. Unsecured Debentures: When debentures are issued without any charge or security, they are
termed as unsecured or naked debentures. Holders of unsecured debentures are ordinary
unsecured creditors and do not enjoy any special rights.

1. Tenure Point of View

i. Redeemable Debentures: Such debentures are redeemable at par or premium after the expiry
of a particular period or under a system of periodical drawings.
ii. Perpetual Debentures: Debentures may be made irredeemable or in other words perpetual.
Such debentures are redeemable either on the happening of a contingency or when the company
is wound up or when the company decides to redeem.

1. Mode of Redemption Point of View

i. Convertible Debentures: Debentures may be convertible into equity or preference shares of

the company on certain dates or during certain periods on the basis of an agreement between
company and debenture holders.

a. Fully Convertible Debentures: When the full amount of debentures is converted into shares
of the company at agreed terms and conditions. The conversion is to be made at or after 18
months from the date of allotment but before 36 months.
b. Partly Convertible Debentures: When only a part of the amount of debentures is convertible
into shares at a specified time and remaining part of debenture is redeemable on agreed terms.

i. Non-Convertible Debentures: Such debentures are not convertible into equity or preference
shares.

1. Coupon Rate Point of View: Usually the debentures are issued with a specified rate of
interest, which is called as coupon rate. The specified rate may either be fixed or floating. The
floating interest rate is usually tagged with the bank rate and yield on Treasury bond plus a
reward for risk. Since the bank rate and yield on treasury securities keep on fluctuating over a
period of time any change is compensated in the risk premium. The rate of interest in such a
case is quoted as "PLR + 50 basis points". In this case if it is assume a PLR of 9% the rate of
interest would 9.5%. The "+ basis points" is determined in relation to risk involved.

A zero coupon bond is one which does not carry a specified rate of interest. In order to
compensate the investors such bonds are then issued at a substantial discount. The difference
between the face value and issue price is the total amount of interest related to the duration of
the bond. In order to calculate the periodic charge of interest, the amount is calculated by using
the following formula:
 BO = MV/(1+ i)n

Where

BO = Value of zero coupon bond.

MV = Maturity value of zero coupon bond.

n = Life of zero coupon bond.

i = Required rate of return.

In the above formula the value of (1 +i)n is easily computed by dividing issue price in the
maturity value of the bond. To find out the interest rate applicable to such bonds, we need to
look for present value interest factor tables across the period equal to 'n' and find out the value
near the above computed value. The interest rate in that column will be the interest on bonds.
Thus, if we know the interest rate, years to maturity and the issue price, then the maturity value
can be computed. In the same manner, if interest rate, years to maturity and maturity value are
known, then the issue price can be computed. Present value interest factor for i rate of interest
and 'n' years is written as PVIF,i.n and are given in present value of Re. 1 table shown in the
appendix.

BO = MV x PVIF,i,n

MV= BO/PVIF, i. n

PVIFi.n = BO/ MV

Q.2. Briefly explain the following concepts:

1. Debentures
2. Bond
3. Charge
4. Debenture Stock

Answer:

1. Debentures: The word ‘Debenture’ is used to signify the acknowledgement of a debt, given under
the seal of the company and containing a contract for the repayment of the principal sum at a specified
date and for the payment of interest (usually half yearly) at a fixed rate until the principal sum is repaid
and it may or may not give a charge on the assets of the company as security for the loan.

Section 2 (12) of the Companies Act states that "a debenture includes debenture stock, bonds and any
other securities of a company, whether constituting a charge on the assets of the company or not".
2. Bond: Bond is similar to that of debenture both in terms of contents and texture. Traditionally
government issued the bonds, but now these are also issued by semi-government and non-government
organizations. The significant difference between bonds and debentures is with respect to the issue
condition i.e., bonds can be issued without predetermined rte of interest.

3. Charge: A charge is created on certain specified assets generally immovable such as land and
building, plant and machinery, long term investments and the like. So it is equivalent to mortgage.
When the charge is fixed, the company can only deal with the property subject to the charge, that is, a
fixed charge allows the company to retain possession of the assets but prevents the company from
selling, leasing etc., of the assets without the consent of the charge holders. The property identified
remains so identified during the period for which the charge is created.

4. Debenture Stock: Debenture stock is a document representing the loan capital of the company
consolidated into one single composite debt which may be divided into the transferable in convenient
units of fixed amount. This sum may be of any amount and may include fraction of a rupee.
Certificates are issued to each debenture stockholder indicating the amount of his contribution or
holding. The debenture stock must be fully paid. Debenture is always for a fixed sum and is
transferable only in its entirety by a debenture stock may be the consideration of the several debenture
amounts and a single certificate issued covering many debenture. Similarly debenture stock may be
transferable in parts if articles so permit.

Q.3. Distinguish between Shares and Debentures.

Answer:

Basis of Shares Debentures

Difference
1. Capital A share is a part of equity or A debenture is a part of loan capital of the
preference share capital of a company. The holder of a debenture is the
company. The holders of the shares creditor of the company.
may be described as part owner of the
company.
2. Return Return on share is known as dividend. Return on a debenture is known as interest
A company declares dividend only and the company compulsorily pays it at a
when there are profits and its rate fixed rate whether there are profits or
may vary from year to year. losses.
3. Appropriation Dividend is an appropriation of profit Interest on debenture is a charge against
and is therefore debited in Profit & profits and is therefore debited in Profit &
Loss Appropriation Account. Loss Account.
4. Charge on Shares do not create any charge on Debentures create a charge on the asset of
Property the assets of the company. the company.
5. Redemption Normally the share capital is not The amount of debentures has to be
returned during the lifetime of the returned after a stipulated period of time
company. as per the conditions of issue.
6. Discount on Shares can be issued at discount only There are no restrictions on issue of
Issue when the conditions lay down in debentures at a discount.
Section 79 of the Companies Act
1956 are fulfilled.
7. Premium on The premium received on issue of Premium received on issue of debentures
Issue shares can be utilised by the company can be utilised by company in any manner
subject to the conditions given in it likes.
Section 78 of the Companies Act
1956.
8. Purchase A company cannot purchase its own A company can purchase own debentures
shares from the open market.
9. Convertibility Shares cannot be converted into Debentures can be converted into shares
debentures. according to the conditions of issue of
debentures.
10. Control A shareholder has the right to control A debenture holder does not have any
the affairs of the company by right to control the affairs of the company.
exercising his right to attend the
general meeting of the company and
by exercising his voting right.
11. Winding up At the time of winding up the Debenture holders have a priority as to
shareholders are paid their capital at return of amount received from them in
the end. the event of winding up of the company.

Q.4. Explain the meaning of debentures issued as collateral security by a company. Show its
treatment in the Balance Sheet.

Answer: When debentures are issued as security in addition to any other security against a loan or
bank overdraft such an issue of debentures is known as issue of debentures as collateral security. The
idea of such an issue is that if the company does not repay the loan and the interest and the main
security is not sufficient, the bank will be entitled to sell the debentures in the market or the bank may
keep the debentures with it. If the company repays the loan, the bank will return the debentures issued
as collateral security to the company.

No entry needs to be passed in the books of the company because debentures are issued only as a
collateral security. Debentures become alive only when loan is not repaid. The fact of such an issue of
debentures must be clearly stated in the Balance Sheet by way of a note under the loan and debentures
as shown below:

Balance Sheet of --- Co. Ltd.

As on---

Liabilities Rs. Assets Rs.

Secured Loans 5,00,000

Bank Loan

(secured by issuing 6,000 12%

Debentures of Rs. 100 each)

Alternatively, the following entry may be passed in books of the company:

Date Particulars L.F. Debit Credit

Rs. Rs.
Bank A/c Dr. 5,00,000
To Bank Loan A/c 5,00,000
(For loan borrowed from bank)
Debentures Suspense A/c Dr. 6,00,000
To 12% Debentures A/c 6,00,000
(For 6,000 Debentures of Rs. 100 each issued as collateral
security)

Balance Sheet of --- Co. Ltd.

as on---

Liabilities Rs. Assets Rs.

Secured Loans Miscellaneous Expenditures
Bank Loan 5,00,000 Debentures Suspense A/c 6,00,000
12% Debentures 6,00,000

(6,000 12% Debentures of Rs. 100

each issued as collateral security)

Q.5. Briefly explain the meaning of Trust Deed. Who can be a Trustee? What the duties of a
Trustee?

Answer: When a series of debentures are issued to numerous debenture holders, it is not a practical
proposition to create a number of separate charges on the properties of the company in favour of
individual debenture holders. And it is practically impossible for the debenture holders also to keep a
watch on the assets of the company in order to safeguard their own interests. It is thus becomes
necessary to execute trust deed by which properties of the company are charged by way of mortgage to
the trustees. A trust deed is therefore a contract between the company and the trustees for the debenture
holders. Generally trust deed has to be executed before the debentures are offered for public
subscriptions so that the prospective investors may satisfy themselves as to the contents of the trust
deed and credibility of the trustees selected by the company to look after their interest. A trust deed is
also a mortgage deed between the company and the trustees for debenture holders. The debenture
holders are merely beneficiaries under the trust deed. Section 118 of the Companies Act gives the right
to obtain the copies and inspect trust deed by any member of the company. The advantages of creating
a trust deed are:

i. The trustees can act expeditiously and effectively in safeguard interests of the debenture
holders and enforcing the security on their behalf.
ii. They will act as watchdogs in seeing and insisting that company’s obligations under the trust
deed are carried out properly.
iii. They are generally empowered to settle and adjust matters of dispute with the company.
iv. In cases of doubt or difficulty they can convene meetings and enable the debenture holders to
meet and discuss and authorize the trustees to pursue any course of action to be beneficial to
the debenture holders as a whole.

Who can be Trustees?

Only the following are eligible to be debenture trustee:

a. A scheduled bank carrying on commercial activity.

b. A public financial institution within the meaning of sections 4A (1) of the Companies Act
1956.
c. Insurance Company.
d. Body Corporate.

Who can not be a Trustee?

No person can be appointed as a trustee if he:

a. Beneficially holds share in the company.

b. Beneficially entitle to receive money, which are to be paid to/the by the company to the
debenture trustee.
c. Has entered into any guarantee in respect of principal debts, secured by debenture or interest
thereon.
Duties of Trustees

a. Call for periodic reports from the body corporate

b. Take possession of trust property in accordance with the provisions of the trust deed
c. Enforce security in the interest of debenture holders
d. The charge created against the assets under debenture trust deed should be completed within 30
days of the issue of allotment letter and dispatch of debenture certificate.

A debenture trustee who fails to comply with any conditions, contravenes any of the provisions of the
Act, rules or regulations, the Companies Act or rules made thereunder, may disqualify him to act as
trustee.

Q.1. What do you mean by Cash Flow Statement?

Answer: A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow
statement all the current assets and current liabilities are taken into consideration. But in a cash flow
statement only those sources of funds are taken which provide cash and only the uses of cash are taken
into consideration, even liquid asset like Debtors and Bills Receivables are ignored.

A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the
activities of a business enterprise and the uses for which such resources have been used during a
particular period of time. Any transaction, which increases the amount of cash, is a source of cash and
any transaction, which decreases the amount of cash, is an application of cash.

Q.2. What are the objectives of Cash Flow Statement?

Answer: A Cash Flow Statement provides very useful help to financial management of a business
enterprise. It summarises the sources from where the cash may be obtained and the specific uses to which
the cash may be applied during a particular period of time.

A Cash Flow Statement has the following uses:

Helpful in short-term financial planning: Cash Flow Statement provides useful information to a business
enterprise to make decision for its short-term financial planning.

Helpful in preparing Cash Budget: A Cash Budget is an estimate of cash receipts and disbursement for a
future period of time. Cash Flow Statement provides help to the management to prepare Cash Budget. A
comparison of cash budget and cash flow statement reveals the extent to which the sources of the
business were generated and used as per the plans of the business.
Helps to understand liquidity: Liquidity means ability of a business enterprise to pay off its liabilities
when due. Cash Flow Statement helps to know about the sources where from the cash will be available to
pay off the liabilities.

Prediction of sickness: With the help of preparing cash from operation a business enterprise may come to
know about cash losses in operation. It helps to predict this type of sickness.

Dividend decisions: Dividend is paid within 42 days, when company declares it. Cash Flow Statement
helps the management to know about the sources of cash to pay off dividend.

Q.3. What are the sources and uses of Cash?

Answer: The major sources of cash are as under:

Cash from Operation

Issue of Equity Share Capital for cash

Issue of Preference Share Capital for cash

Raising long term loans for cash

Sale of Investments

Sale of Fixed Assets

Premium on Issue of Shares / Debentures etc.

The major uses of cash are as under:

Redemption of Preference Share Capital for cash

Redemption of Debentures/ Repayment of Long-term Loans

Purchase of Investment

Purchase of Fixed Assets

Premium on Redemption of Preference Share/Debentures

Dividend Paid
Taxes Paid etc.

Q.4. Differentiate between a cash flow statement and a funds flow statement. (CBSE)

Answer:

Difference between Funds Flow Statement and Cash Flow Statement

Basis of Difference Funds Flow Statement Cash Flow Statement

1. Basis of Analysis Funds flow statement is based on Cash flow statement is based on narrow
broader concept i.e. working concept i.e. cash, which is only one of
capital. the elements of working capital.
2. Source Funds flow statement tells about Cash flow statement stars with the
the various sources from where the opening balance of cash and reaches to
funds generated with various uses the closing balance of cash by
to which they are put. proceeding through sources and uses.
3. Usefulness Funds flow statement is more Cash flow statement is useful in
useful in assessing the long-range understanding the short-term
financial strategy. phenomena affecting the liquidity of
the business.
4. Schedule of Changes In funds flow statement changes in In cash flow statement changes in
in Working Capital current assets and current current assets and current liabilities are
liabilities are shown through the shown in the cash flow statement itself.
schedule of changes in working
capital.
5. Causes Funds flow statement shows the Cash flow statement shows the causes
causes of changes in net working the changes in cash.
capital.
6. Principal of Funds flow statement is consonant In cash flow statement data obtained on
Accounting with the accrual basis of accrual basis are converted into cash
accounting. basis.

.
Q.1. Give major headings of the assets and liabilities-side of a company’s balances sheet as per
Schedule VI, Part I.

Answer: Major headings of Assets side

i. Fixed Assets
ii. Investments
iii. Current Assets, Loans and Advances: Current Assets, Loans and Advances
iv. Miscellaneous Expenditures
v. Profit & Loss Account (Loss in Business)

Major headings of Liabilities side

i. Share Capital
ii. Reserves and Surplus
iii. Secured Loans
iv. Unsecured Loans
v. Current Liabilities and Provisions

a. Current Liabilities
b. Provisions

Q.2. What is contingent liability? Mention four examples of contingent liabilities. Where is it
shown in the balance sheet?

(CBSE Delhi 1999)

Answer: A possible future liability, which depends on the happenings of certain uncertain event, is
called contingent liability. These liabilities are not shown in the total of liability side, but are shown as a
footnote to the balance sheet.

The following are some examples of contingent liabilities: -

i. Uncalled liabilities on partly paid shares

ii. Liabilities under Guarantee
iii. Arrears of dividends on cumulative preference shares
iv. Claim against the company now acknowledged as debts
v. Liabilities on Bills Receivable discounted but not matured.

Q.3. Under what headings will you show the following items in the balance sheet of a company:

i. Goodwill
ii. Unclaimed Dividends
iii. Provision for Tax
iv. Share Premium Account
 v. Loose Tools

(CBSE 1996)

Answer:

Items Headings Sub-headings

Goodwill Fixed Assets ---
Unclaimed Current Liabilities and Provisions Current Liabilities
Dividend
Provision for Tax Current Liabilities and Provisions Provisions
Share Premium A/c Reserves and Surplus ---
Loose Tools Current Assets, Loans and Advances Current Assets

Q.4. Give the headings under which the following items will be shown in a company’s balance sheet as
per Schedule VI, Part I:

i. Sundry Creditors
ii. Debentures Sinking Fund
iii. Bills Receivable
iv. Discount on Issue of Debentures
v. Motor Car

Answer:

Items Headings Sub-headings

Sundry Creditors Current Liabilities and Provisions Current Liabilities
Debentures Sinking Fund Reserves and Surplus ---
Bills Receivable Current Asset, Loans and Advances Loans and Advances
Discount on Issue of Miscellaneous Expenditures ---
Debentures
Motor Car Fixed Assets ---

Q.5. Give the headings under which any four of the following items will be shown in Company’s
Balance Sheet.

i. Debentures
ii. Interest accrued on investment
iii. Goodwill
iv. Preliminary Expenses
v. Bills of Exchange

(CBSE 1991 (Foreign))

Answer:

Items Headings Sub-headings

Debentures Secured Loans ---
Interest accrued on Investment Current Assets, Loans and Advances Current Assets
Goodwill Fixed Assets ---
Preliminary Expenses Miscellaneous Expenditures ---
Bills of Exchange Current Assets, Loans and Advances Loans and Advances
Q.6. Give the Performa of balance sheet in horizontal form according to the requirements of
Schedule VI of the Companies Act 1956.

Solution:

Balance Sheet of---Co. Limited

As at----

Figures Figures Figures Figures

for the for the for the for the
previous current previous current
year year year year
Liabilities Assets
Rs. Rs. Rs. Rs.
Rs. Rs.
(1) Share Capital (1) FIXED ASSETS:
Authorised Capital: 1. Goodwill
XXX … Shares of Rs. … each XXX 2. Land
Issued Capital: 3. Building
XXX … Equity Shares of Rs. … XXX 4. Leaseholds
each
XXX … Preference Share of Rs. … XXX 5. Railway Sidings
each
Subscribed Capital: 6. Plant and Machinery
… Equity Shares of Rs. … 7. Furniture and Fittings
each Rs. … Called up XXX
… Preference Share of Rs. … 8. Development of Property
each Rs. … Called up XXX
Less Calls Unpaid XXX 9. Patents, Trade Marks and
Designs
(i) By directors XXX 10. Live Stocks
(ii) By Others XXX 11. Vehicles etc.
XXX Add Forfeited shares XXX XXX (2) INVESTMENTS:
(2) RESERVES AND (3) CURRENT ASSETS,
SURPLUS: LOANS AND ADVANCES:
XXX 1. Capital Reserve, not XXX (A) Current Assets:
available for Dividend
XXX 2. Capital Redemption XXX 1. Interest accrued on
Reserve investments
XXX 3. Share Premium Account XXX 2. Stores and Spare parts
XXX 4. Other Reserves specifying XXX 3. Loose Tools
the nature of reserve and the
amount in respect thereof.

Less: Debit balance in Profit

& Loss account (if any)
XXX 5. Surplus, that is balance in XXX 4. Stock in trade
Profit and Loss account after
providing for proposed
allocation namely:

Dividend, Bonus or Reserves

XXX 6. Proposed addition to XXX 5. Work in progress
reserves
XXX 7. Sinking Funds XXX 6. Sundry Debtors:

a. Debts outstanding for a

period exceeding 6
months
b. Other Debts

Less: Provision
(3) SECURED LOANS: 7. (a) Cash balance in hand

(b) Bank balance:

i. With scheduled Banks

ii. With others

XXX 1. Debentures XXX (B) Loans and Advances:
XXX 2. Loans and Advances from XXX 8. (a) Advances and loans to
Banks. subsidiaries

(b) advances and loans to

partnership firms in which the
Company or any of its
subsidiaries is a partner
XXX 3. Loans and Advances from XXX 9. Bills of Exchange
 subsidiaries
XXX 4. Other Loans and Advances
XXX 5. Interest accrued and due
on secured loans
(4) UNSECURED LOANS:
XXX 1. Fixed Deposits
XXX 2. Loans and Advances from
subsidiaries
XXX 3. Short Term Loans and
Advances
a. From Banks
b. From Others
XXX 4. Other Loans and Advances
a. From Banks
b. From Others
(5) CURRENT
LIABILITIES AND
PROVISIONS:
(A) Current Liabilities:
XXX 1. Acceptances
XXX 2. Sundry Creditors
XXX 3. Subsidiary Companies
XXX 4. Unclaimed Dividends
XXX 10. Advances recoverable in
cash or in kind (e.g. Rates,
Taxes, Insurance, etc. prepaid)
XXX 11. Balances with customs,
Port Trusts, and excise
authorities etc.
(4) MISCELLANEOUS
EXPENDITURE:
XXX 1. Preliminary Expenses
XXX 2. Expenses, including
commission or Brokerage on
under writing of Shares or
Debentures
XXX 3. Discount allowed on the
issue of Shares or Debentures
XXX 4. Interest paid out of capital
during construction period
5. Development expenditure
not adjusted
6. Other sums (specifying
nature)
XXX 5. PROFIT & LOSS
ACCOUNT: (This is shown
only when its debit balance
count not be written off out of
others reserves)
XXX
XXX
XXX
XXX 5. Interest accrued but not XXX
due on loans
XXX 6. Advance payments and XXX
unexpired discounts for the
portion for which value has
still to be given, e.g. in the
case of the following classes
of companies: Newspaper,
Fire Insurance, Theatres,
Clubs, Banking, Steamship
Companies etc.
XXX 7. Other Liabilities (if any) XXX
(B) Provisions:
XXX 8. Proposed Dividends XXX
XXX 9. Provision for Taxation XXX
XXX 10. Provision for XXX
Contingencies
XXX 11. Provision for Provident XXX
Fund schemes
XXX 12. Provision for insurance, XXX
pension and similar staff
benefit schemes.
XXX 13. Other Provisions XXX
(6) CONTINGENT
LIABILITIES (by way of
foot- note only):
1.Uncalled liabilities on
partly paid shares
2.Liabilities under Guarantee
3.Arrears of dividends on
cumulative preference shares
4.Claim against the company
now acknowledged as debts
5.Liabilities on Bills
Receivable discounted but
not matured.
XXX XXX XXX XXX
Q.1. Define Company. Mention its main characteristics. Also explain the different kinds of
shares, which a public company can issue.

Answer: " A Company is an association of many persons who contribute money or money’s worth
to a common stock and employ it for a common purpose. The common stock so contributed is
denoted in money and is capital of the company. The persons who contribute it or to whom it
belongs are members. The proportion of capital to which each member is entitled is his share."

The company is an artificial legal person created by law. A Company has a right to sue and can be
sued, can own property and has banking account in its own name, own money and be a creditor. A
Company has a separate legal entity, which is distinct from its shareholder.

According to Section 3 (1) of Indian Companies Act 1956 " Company means a company formed
and registered under this Act."

According to Professor Haney " A Company is an artificial person, created by law having a
separate entity with a perpetual succession and a common seal."

Characteristics of a Company:

1. Artificial Person: A company is an artificial person, which exists only in the eyes of law.
The company carries business on its own behalf. It has a right to sue and can be sued, can
have its own property and its own bank account. It can also own money and be a creditor.
2. Created by law: A company can be formed only with registration. It has to fulfill a lot of
formalities to be registered. It has also to fulfill a lot of legal formalities in order to be
dissolved.
3. Perpetual succession: A company has a continuous existence. Its existence does not
affected by admission, retirement, death or insolvency of its members. The members may
come or go but the company may go forever. Only law can terminate its existence
4. Limited Liability: The liability of every member is limited to the face value of shares, held
by him.
5. Voluntary Association: A company is a voluntary association. It can not compel any one
to become its member or shareholder.
6. Capital Structure: A company has to mention its maximum capital requirements in future
in its memorandum of association. Its capital is divided into shares, which are easily
transferable from person to person.
7. Common Seal: As a company is an artificial person, so it can sign any type of contracts.
 For this purpose its requires a common seal which acts as the official signatories of the
company. All the contracts prepared by its directors must bear seal of the company.
8. Democratic Ownership: The directors of a company are elected by its shareholders in a
democratic way.

Q.2. Distinguish between Partnership Firm and Joint Stock Company.

Answer:

Partnership Joint Stock Company

1. Partnership Firm is formed under Indian 1. A Joint Stock Company is formed under
Partnership Act 1932. Indian Companies Act 1956.
2. Minimum number of partners are 2 and 2. Minimum number of members are 7 in case of
maximum 10 in case of banking business and 20 a public company and maximum no limit. In a
in other kind of business. private limited company minimum number of
members are 2 and 50 are maximum.
3. Liability of a Partnership firm is unlimited. 3. Liability of members is limited to extent of
shares held by him.
4. Every partner can take active part in the 4. Boards of Directors manage a company.
management of the firm.
5. Auditing of books is not compulsory. 5. Auditing of books is compulsory.
6. A Partnership firm can do the business as 6. A company can do only that business which is
agreed upon by the partners. stated in Memorandum of Association.
7. A partnership firm do not have a separate 7. A company has a separate legal entity.
legal entity
8. Insolvency of a Partnership firm means 8. Winding up of a company does not mean
insolvency of all partners. insolvency of its members.

Q.3. Distinguish between Equity Shares and Preference Shares. (CBSE 1991, 1993)

Answer:

Equity Share: According to Indian Companies Act 1956 " an equity share is share which is not
preference share". An equity share does not carry any preferential right. Equity shares are entitled
to dividend and repayment of capital after the claims of preference shares are satisfied. Equity
shareholders control the affairs of the company and have right to all the profits after the preference
dividend has been paid.

Preference Share: A share that carries the following two preferential rights is called ‘Preference
Share’:
 i. Preference shares have a right to receive dividend at a fixed rate before any dividend given
to equity shares.
ii. Preference shares have a right to get their capital returned, before the capital of equity
shareholders is returned. in case the company is going to wind up.

Difference between Preference Share and Equity Share

Basis of Difference Preference Share Equity Share

Right of Dividend Preference shares are paid dividend Equity shares are paid dividend out of
before the Equity shares.
Rate of Dividend Preference shares are given
dividend at a fixed rate.
Management Preference shareholders do not
carry the right to participate in the
management of the company.
Voting Right Preference shareholders do not
carry the voting right. They can
vote only in special circumstances.
Redemption of Share In case the preference shares are
Capital redeemable, the amount of capital
will be refunded to shareholders
after a certain period.
Refund of Capital At the time of dissolution of the
company, preference share capital
is paid before the payment of
Equity share capital.
the balance of profit after the dividend
paid to preference shareholders.
Dividend on Equity shares depend on
the balance of profit left after the
payment of dividend to preference
shares.
Equity shareholders carry the right to
interfere in management of the
company due to investigating risk of
capital in the company.
Equity shareholders carry the right to
vote in all circumstances.
Equity shares capital is refundable
only at the time of winding up of the
company.
Equity shareholders are paid their
capital if there is some balance left
after the payment of preference
shareholders.

Q.4. What is meant by ‘Share Capital’? Explain the different categories of share capital.

Answer: The capital of a joint stock company is divided into shares and called ‘Share Capital’.
The share capital may be classified as below:

1. Nominal/Authorised/Registered Capital: This is the amount of the capital which is stated

in Memorandum of Association and with which the company is registered. Nominal capital
is the maximum amount which the company is authorised to raise from the public.
 2. Issued Capital: This is the nominal amount of shares actually issued to the public. In other
words, issued capital is that part of the nominal capital, which is offered to the public for
subscription. The balance of the nominal capital, which is not offered to the public for
subscription, is called unissued capital.
3. Subscribed Capital: This is the nominal amount of the shares taken up by the public. In
other words, subscribed capital is that part of the issued capital, which is applied for by the
public. The balance of the issued capital, which is not subscribed for by the public is called,
unsubscribe capital.
4. Called up Capital: This is the amount of the capital that the shareholders have been called
to pay on the shares subscribed for by them. The nominal amount of the shares is usually
collected from the shareholders in installments and it is possible that the entire amount of
the subscribed capital may not have been called. The amount of the subscribed capital,
which is not called, is known as uncalled capital.
5. Paid up Capital: This represents that part of the called up capital, which is actually
received by the company. The amount of the called-up capital, which not paid by the
shareho0lders, is called as unpaid capital or calls in arrears.
6. Reserve Capital: A company may by special resolution determine that any portion of its
share capital which has not been already called up, shall not be capable of being called-up,
except in the event of winding up of the company. Such type of share capital is known as
reserve-capital.

Q.5. Give the meaning of ‘Issuing the shares at Premium’. For what purpose, the amount of
Securities Premium can be utilized?

(CBSE 1996, 1997)

Or

State the provision of Section 78 of the Company Act 1956, regarding the utilisation of
Securities Premium.

Or

State any three purposes for which the balance of Securities Premium account can be
utilized.

(CBSE 1998, 2001(Outside Delhi)

Answer: If Shares are issued at a price, which is more than the face value of shares, it is said that
the shares have been issued at a premium.

The Company Act 1956 does not place any restriction on issue of shares at a premium but the
amount received, as premium has to be placed in a separate account called Security Premium
Account.

Under Section 78 of the Company Act 1956, the amount of security premium may be used only for
the following purposes:

1. To write off the preliminary expenses of the company.

2. To write off the expenses, commission or discount allowed on issued of shares or
debentures of the company.
3. To provide for the premium payable on redemption of redeemable preference shares or
debentures of the company.
4. To issue fully paid bonus shares to the shareholders of the company.

Q.6. Can a company issue shares at discount.

Or

What condition must a Company satisfy for issuing shares at a discount? (CBSE 1996)

Or

Explain Section 79 of the Company Act 1956.

Answer: As a general rule, a company cannot ordinarily issue shares at a discount. It can do so
only in cases such as ‘reissue of forfeited shares’ and in accordance with the provisions of
Companies Act.

But according to Section 79 of company act 1956, a company is permitted to issue shares at
discount provided the following conditions are satisfied: -

a. The issue of shares at a discount is authorised by an ordinary resolution passed by the

company at its general meeting and sanctioned by the Company Law Board.
b. The resolution must specify the maximum rate of discount at which the shares are to be
issued but the rate of discount must not exceed 10 per cent of the nominal value of shares.
The rate of discount can be more than 10 per cent if the Government is convinced that a
higher rate is called for under special circumstances of a case.
c. At least one year must have elapsed since the company was entitled to commence the
business.
d. The shares are of a class, which has already been issued.

e. The shares are issued within two months from the date of sanction received from the
Government.
Q.1. Explain briefly the various methods of redemption of debentures.

Answer: Repayment or discharge of liability on account of debentures is called redemption of

debentures. The method of debenture redemption adopted determines to a very large extent, the
actual accounting for redemption as well as the marshalling of resources for the same.

There are broadly four methods for the redemption of debentures which are as follows:

1. Lump-sum payment method: In this method, redemption of debentures is done by

repayment in one lump sum after the expiry of a stipulated period. The total amount
payable to debenture holders is decided at the time of issue of debentures (i.e. debentures
will be redeemed at par or at premium). Usually a company creates sinking fund or an
insurance policy fund for the redemption of debentures.
2. Drawings of Lots method: In order to reduce the liability of debentures, company may
repay the debentures in some instalments. A certain amount of debentures is redeemed at
regular interval of time during the lifetime of the debentures by drawings of lots.
3. Purchase in the Open Market: The company from the open market can purchase its
own Debentures. Debentures so purchased may be cancelled immediately or may be kept
as an investment, which will be cancelled later. It may beneficial for the company if it
purchases its own debentures at a discount from the open market.
4. Conversion Method: Usually debentures are redeemed in cash but sometimes debenture
holder are given an option to get their debentures converted either in shares or for new
debentures of the company. The redemption of debentures by means of shares or new
debentures is known as redemption by conversion. Debentures, which carry such right,
are called ‘Convertible Debentures’.

Q.2. Distinguish between redemption of debentures out of capital and out of profit.

Answer:

Redemption out of Capital:

When debentures are redeemed out of capital, no transfer is made to general reserve or debenture
redemption reserve account. In this method it is assumed that the company has sufficient funds to
redeem the debentures. So the profits are not utilised to replace the debentures. It affects
adversely to the Working Capital of the company. The following entries are passed when
debentures are redeemed out of capital: -

1. For amount of debentures due to Debenture holders:

(a) when debentures are redeemable at par:
% Debentures A/c Dr.
To Debenture holders A/c
(b) when debentures are redeemable at premium:
 % Debentures A/c Dr.
Premium on Redemption of Debentures A/c Dr.
To Debenture holders A/c
2. For payment to Debenture holders:
Debenture holders A/c Dr.
To Bank A/c

Redemption out of Profit:

When it is intended to redeem the debentures out of profits, a part of profits available for
distribution of dividends is withheld by the company every year to be used for redemption
purposes as and when the need arises for the same. There are two alternatives available to the
company in this regard namely: (a) the amount of divisible profits withheld by the company may
be retained in the business itself as a source of internal financing. (b) The amount of divisible
profits withheld from distribution as dividend may be invested either (i) in readily marketable
securities or (ii) in taking out insurance policy to provide funds when required. The following
entries are passed when debentures are redeemed out of profit:

1. For amount of debentures due to Debenture holders:

(a) when debentures are redeemable at par:
% Debentures A/c Dr.
To Debenture holders A/c
(b) when debentures are redeemable at premium:
% Debentures A/c Dr.
Premium on Redemption of Debentures A/c Dr.
To Debenture holders A/c
2. For payment to Debenture holders:
Debenture holders A/c Dr.
To Bank A/c
3. For profit transferred to General Reserve
Profit & Loss Appropriation A/c Dr.
To General Reserve A/c
Q.3. Explain with the help of journal entries, how Sinking Fund Method for redemption of
Debentures is used?

(A.I.S.S.C.E. 1987)

Answer: A sinking fund may be defined as a fund created by a charge against or appropriation of
profits and represented by specific investments. The accounting entries for creating a Sinking
Fund would be as under:

I. First Year:
On the date of issue of Debentures:
1. For issue of Debentures
Bank A/c Dr.
To % Debentures A/c
At the end of first year:
2. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c
Profit & Loss Appropriation A/c Dr.
To Sinking Fund A/c
3. For Investments made for the amount of sinking fund
Sinking Fund Investment A/c Dr. (with the amount of sinking fund)
To Bank A/c
II. At the end of second and subsequent years during the life of the debentures
excepting last year:
1. For receipt of interest on investment
Bank A/c Dr.
To Interest on Sinking Fund Investment A/c
2. For interest on investment t/f to sinking fund
Interest on Sinking Fund Investment A/c Dr.
To Sinking Fund A/c
3. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c
Profit & Loss Appropriation A/c Dr.
To Sinking Fund A/c
4. For Investments made for the amount of sinking fund
 Sinking Fund Investment A/c Dr. (with the total amount of annual sinking fund +
interest)
To Bank A/c
III. Last year:
1. For receipt of interest on investment
Bank A/c Dr.
To Interest on Sinking Fund Investment A/c
2. For interest on investment t/f to sinking fund
Interest on Sinking Fund Investment A/c Dr.
To Sinking Fund A/c
3. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c
Profit & Loss Appropriation A/c Dr.
To Sinking Fund A/c
4. For sale of investment
Bank A/c Dr.
To Sinking Fund Investment A/c
5. For gain on sale of investment
Sinking Fund Investment A/c Dr.
To Sinking Fund A/c
Or
For loss on sale of investment
Sinking Fund A/c Dr.
To Sinking Fund Investment A/c
6. For amount of debentures due to Debenture holders:
(a) when debentures are redeemable at par:
% Debentures A/c Dr.
To Debenture holders A/c
(b) when debentures are redeemable at premium:
% Debentures A/c Dr.
Premium on Redemption of Debentures A/c Dr.
 To Debenture holders A/c
7. For payment to Debenture holders:
Debenture holders A/c Dr.
To Bank A/c
8. For transfer of Sinking Fund to General reserve
Sinking Fund A/c Dr.
To General Reserve A/c

Q.4. Explain the concept of compulsory creation of Debenture Redemption Reserve.

Answer: The amount required for the redemption of debentures is usually very large. It creates a
great difficulty for the company to arrange this large amount to pay off its debentures. In case
this large amount is paid out of company’s working capital, it may affect the routine working of
the company and that will affect the profitability of the company also. So in order to avoid this
difficulty a company needs funds to repay its debentures.

According to a notification of Government of India issued by Controller of Capital Issue as

on 1-1-1987, it is compulsory for all companies to create a Debenture Redemption Reserve
up to at least 50% of the amount of debentures issued before the commencement of
redemption of debentures. The effect of such a notification is that a Company cannot
redeem its debentures purely out of capital or purely out of current profits.

Q.1. Define Partnership. Enumerate the essential elements of partnership. (Delhi

1987, 92, 93, 97)

Answer: In India, Partnership firm is governed by the Indian Partnership Act 1932.
Section 4 of this act defines partnership as:

" The relationship between persons, who have agreed to share the profits of a
business carried on by all or any one of them acting for all."

According to Prof. Haney, partnership is "the relation between persons

competent to make contract who agree to carry on a lawful business in
common with a view to private gain."

Partnership in this way is an agreement, between two or more persons to carry on legal
business with profit motive, carried on by all or any one of them acting for all. In this
way, partnership has the following characteristics:

(i) Contract: Partnership is the result of contract between the partners and their relation
of partnership arises from contract and not from status. The relationship between the
members of a Joint Hindu Family (governed by the Mitakshara School of Hindu Law) is
determined by birth and not by agreement. Therefore, a Joint Hindu Family firm is not a
partnership under the act.

(ii) Number of Persons: In a partnership firm there must be at least two person to form
the business. Partnership Act 1932, does not specifies the maximum numbers of persons,
but the Indian Company Act 1956, restricts the number of Partners to 10 for a partnership
carrying on banking business and 20 in case of other kinds of business.

(iii) Business: Business must be carried on by all or any one of them acting for all. This
is the cardinal principle of the working of the partnership firms. An act of one partner in
the course of the business of the firm is in fact an act of all the partners. Each partner
carrying on the business is the principle as well as the agent for all the other partners.

(iv) Motive: For a partnership firm there must be motive to earn profit. A partnership
firm cannot be formed with service motive.

(v) Legality of the Business: The business to be carried on by the partners must be legal.
There should be lawful consideration and the business should not be illegal in the eyes of
law.

Q.2. What is a partnership deed? State the main contents of the partnership deed.

Ans. A partnership is formed by an agreement. This agreement may be oral or in writing.

Though the law does not expressly require that the partnership agreement should be in
writing, it is desirable to have it in writing. A document, which contains the terms of
partnership, as agreed to by the partners is called ‘Partnership Deed.’

Contents of the Deed:

1. Name of the firm and its permanent address.

2. Names and addresses of the partners.
3. Nature of Business.
4. Methods of evaluating of assets and liabilities.
5. Date of commencement of partnership.
6. Amount of capital to be contributed by each partner.
7. Interest of Capital: According to section 13 of Partnership Act 1932, a partner is
not entitled to interest on capital as a matter of right, but if there is an agreement
that partner would receive interest on capital, it is paid at the agreed rate but such
interest is payable only out of profits.
8. Drawings by the partners.
9. Interest on Drawings: The partnership deed must specifically mention whether
interest on drawings will be charged, or not. If the interest is to be charged, rate of
 interest should also be specified.
10. Accounting Period of the Firm: -The period after which the final accounts of the
firm are to be prepared. Whether yearly or half-yearly and the date on which
accounts are to be closed every year.
11. Profit and loss sharing ratio: Partners must agree as to the ratio in which they will
be distributing profit or loss. In the absence of any agreed ratio profit or loss will
be shared equally
12. Partner’s salary: If any partner is allowed salary, it should be mentioned in the
partnership deed and the amount of salary should also be specified.
13. Duration of partnership: The period for which the partnership has established and
the mode of dissolution of partnership.
14. Valuation of goodwill: Method of valuation of goodwill in case of admission or
retirement of a partner should also be mentioned.
15. Auditing: Whether the firm’s books will be audited or not? If so, the mode of
auditor’s appointment.
16. Operation of Bank Account: -The deed should mention the name of partner or
partners, authorised to operate Bank Account, i.e., who is authorised to sign on
cheque.
17. Application of the Decision of Garner vs. Murray: -The partnership deed should
specify whether accounts will be closed as per the decision of Garner Vs. Murray
in case of dissolution of the firm caused by the insolvency of the partners.

18. Settlement of Disputes:-In case of dispute among the partners, how the dispute
will be solved.

Q.3. What are the Duties and Rights of a Partner?

Answer. Duties (Obligations ) of a Partner:

a. Devotion of time and attention: It becomes duty to each partner to devote his full
attention and time to the firm.
b. To carry on the business with the greatest common advantage and diligently. No
partner is allowed any salary unless the deed provides.
c. To act within the authority and to be just and faithful to other partners.
d. Not to engage in competition against the firm. If he does so, he must account for
the profits made in the competing business.
e. To hold and use of property of the firm only for the firm. In case the partner
makes use of the property of the firm for his personal use and earns, he will have
to hand over the profit so earned to the firm. If the partner suffers loss, the firm
will not be liable for it.
f. To make good the loss that may have been caused by his willful neglect or breach
of trust.
Rights of a Partner:

a. Every partner has a right to part in the conduct and management of the business.
b. Every partner has a right to be consulted in the matters of the partnership.
c. Every partner has a right to share profits (or losses) with others in the agreed ratio.
d. Partners have a right of free access to all records, books of accounts and also to
examine and copy them.
e. A partner who has advances loan to the firm is entitled to receive interest. In case
the rate of interest is not agreed, he will be given it @ 6% p.a.
f. Every partner has the right to prevent the introduction and admission of a new
partner.
g. After giving a proper notice every partner has the right to retire from the business.

Q.4. State the main provisions of the Partnership Act relating to partnership
accounts if there is no partnership agreement. (All India, 1993, 94,Delhi 94, 94 C, 99
C)

Answer: According to Indian Partnership Act 1932 (sec. 4), the following provision
are applicable in the absence of partnership deed:

1. Profit Sharing Ratio: In the absence of partnership deed all partners will share
Profit or losses in equal ratio.
2. Interest on Capital: No interest will be given to any partner on his capital. In
case, there is a partnership deed, which allows interest on capital, it will be
allowed in case of profit but not in case of loss in the business.
3. Interest on Drawings: No interest will be charged on drawing in the absence of
partnership deed.
4. Partner’s Salary: No salary or commission will be given to any partner in the
absence of partnership deed.
5. Interest on Partner’s Loan: Interest on partner’s loan will be given @ 6% p.a.
In case of partnership deed interest will be allowed at the agreed rate.

Q.5. What is a Joint Life Policy? What is the purpose of taking joint life policy by a
partnership firm?

Answer: A Joint Life Policy is an assurance policy taken on the joint lives of the
partners. On the death of a partner, the firm becomes liable to pay the executors of
deceased partner his capital, interest on capital, his share of profit from the closing of the
previous year to the date of death and his share of reserves, goodwill etc. The total
amount thus becoming due to the executors is usually significant and immediate payment
of such heavy amount out of firm’s resources is likely to affect firm’s finances very
adversely.
The above problem can be tackled if the firm takes policy on the lives of all the partners
jointly from the Life Insurance Corporation of India. According to the firms of the policy,
the premium is paid, periodically by the firm to the L. I. C. of India who undertakes to
pay the sum assured to the firm either on the death of any partner or on the maturity of
the policy whichever is earlier. The amount received is credited to all the partners
including the deceased in their profit sharing ratio, while the amount received enables the
firm to make the payment to the executors without affecting adversely the financial
position of the firm.

Q.1. What is meant by admission of a Partner? What is the purpose of admission of a

Partner?

Answer: Sometimes, it becomes difficult to run the partnership business due to lack of
sufficient capital or managerial help or both. In this case a firm may decide to admit a new
partner into the firm. But according to Indian Partnership Act 1932, no partner can be
admitted into the firm without the consent of all the existing partners. A person who is
admitted, as a partner into the firm does not thereby becomes liable for any act of the firm,
done before his admission. A partner is admitted for any one or more of the following
reasons:

i. In order to acquire more capital for the business.

ii. In order to have more managerial skill, a competent and experienced person is
needed.
iii. In order to expand and boost up the business.
iv. In order to increase the goodwill by admitting a well-reputed person into the business.
v. In order to reduce the competition.

Q.2. State the two main rights acquired by a New Partner.

Answer: Rights of a New Partner:

i. Sharing in the assets of the firm: - In order to acquire the right of becoming the
owner of a part of assets of the firm, new partner has to contribute towards the
amount of capital into the business.
ii. Sharing in the future profits or losses of the firm: - In order to have right to share
in profit in future new partner has to pay for the amount of goodwill into the business.

Q.3. Mention various matters that need adjustment at the time of admission of a
partner. (D.H.S.E.)

Answer: Required adjustments at the time of admission of a Partner:

i. Calculation of New Profit Sharing Ratio.

ii. Revaluation of Assets and Liabilities of the firm.
 iii. Treatment of Goodwill.
iv. Adjustment of Accumulated Reserves and Profits /Losses.
v. Adjustment of Capital (if agreed).

Q.4. Explain the accounting treatment of Goodwill at the time of admission of a

Partner.

Answer: Accounting treatment of goodwill at the time of admission of a partner is classified

in four parts:

(1) When new partner pays amount of goodwill privately: In this case no entry will be
passed in the books of the firm.

(2) When new partner brings his share of goodwill in Cash or kind. In this case the
following entries are passed:

i. For amount of Capital + Goodwill brought in by new partner

Cash / Bank/ Assets A/c Dr.

To New Partner’s Capital A/c (for amount of capital)

To Premium A/c (for amount of goodwill)

ii. For amount of goodwill brought in by new partner credited to Old Partner’s Capital
A/cs in their Sacrificing Ratio.

Premium A/c Dr.

To Old Partner’s Capital A/cs

iii. When old partners withdraw the amount of goodwill.

Old Partner’s Capital A/c Dr.

To Cash/Bank A/c

Condition: When new partner brings his share of goodwill in cash, in this case no goodwill
should already appear in the books. In case goodwill already appears in the books it should
be written off in old ratio. Entry will be:

Old Partner’s Capital A/cs Dr.

To Goodwill A/c

Example: A and B are partners sharing profit and losses in the ratio of 5:3. C is admitted as a
new partner for 1/5th share. C brings Rs. 15,000 as his Capital and necessary amount of his
share of goodwill in cash. Total goodwill of the firm is Rs. 60,000. Goodwill already appears
in the Balance Sheet of A and B is Rs. 20,000. Pass necessary journal entries.

Solution:

Journal

S. No. Particulars L.F. Dr. Cr.

Rs. Rs.
(i) Cash A/c Dr. 27,000
To C’s Capital A/c 15,000
To Premium A/c 12,000
(For amount of Capital and Goodwill brought in by C)
(ii) Premium A/c Dr. 12,000
To A’s Capital A/c 7,500
To B’s Capital A/c 4,500
(For amount of goodwill brought in by C credited to A and B
in their Sacrificing Ratio, which is 5:3)
(iii) A’s Capital A/c Dr. 12,500
B’s Capital A/c Dr. 7,500
To Goodwill A/c 20,000
(For existing goodwill written off in Old Ratio)

Workings: C’s Share of Goodwill = 1/5 x Rs. 60,000 = Rs. 12,000

(3) When new partner does not bring his share of goodwill in cash.

In this case new partner’s share of goodwill is charged to his capital account and t/f to old
partner’s capital accounts in their sacrificing ratio. Entries for this will be:

(i) For amount of capital brought in by new partner

Cash / Bank/ Assets A/c Dr.

To New Partner’s Capital A/c

(ii) For new partner’s share of goodwill credited to old partner’s capital accounts in their
sacrificing ratio
New Partner’s Capital A/c Dr.

To Old Partner’s Capital A/cs

(iii) When old partners withdraw the amount of goodwill.

Old Partner’s Capital A/c Dr.

To Cash/Bank A/c

Condition: No goodwill should already appear in the books. In case goodwill already
appears in the books it should be written off in old ratio. Entry will be:

Old Partner’s Capital A/cs Dr.

To Goodwill A/c

Example: A and B are partners sharing profits and losses in the ratio of 5:3. C is admitted as
a new partner for 1/5th share. C brings Rs. 50,000 as his capital but he is not able to bring his
share of Goodwill in cash. Total Goodwill of the firm is Rs. 60,000. Pass necessary journal
entries when in the books of A and B:

a. No Goodwill already appears.

b. Goodwill already appears at Rs. 24,000.

Solution:

Journal

Date Particulars L.F. Debit Credit

Rs. Rs.
(a) Bank A/c Dr. 50,000
To C’s Capital A/c 50,000
(For amount of capital brought in by C)
C’s Capital A/c Dr. 12,000
To A’s Capital A/c 7,500
To B’s Capital A/c 4,500
(For C’s share of goodwill credited to A’s and B’s
Capital A/cs in their sacrificing ratio.)

(b) Bank A/c Dr. 50,000

To C’s Capital A/c 50,000
 (For amount of capital brought in by C)
C’s Capital A/c Dr. 12,000
To A’s Capital A/c 7,500
To B’s Capital A/c 4,500
(For C’s share of goodwill credited to A’s and B’s
Capital A/cs in their sacrificing ratio.)
A’s Capital A/c Dr. 15,000
B’s Capital A/c Dr. 9,000
To Goodwill A/c 24,000
(For existing goodwill in the books written off in old
ratio)

(4) When new partner brings only a part of his share of goodwill in cash or kind.

In this case amount brought in by new partner as his share of goodwill t/f to old partner’s
capital accounts in their sacrificing ratio and the amount that is not brought in by him is
charged to his capital account and is also t/f to old partner’s capital accounts in their
sacrificing ratio. Entries will be in following manner:

1. For amount of Capital + Goodwill brought in by new partner

Cash / Bank/ Assets A/c Dr.

To New Partner’s Capital A/c (Amount of Capital)

To Premium A/c (Amount of Goodwill brought in by new partner)

2. For amount of goodwill brought in by new partner credited to old partner’s capital
accounts in their sacrificing ratio.

Premium A/c Dr.

To Old Partner’s Capital A/cs

3. For amount of goodwill not brought in by new partner charged to his capital account
and credited to old partner’s capital accounts in their sacrificing ratio.

New Partner’s Capital A/c Dr.

To Old Partner’s Capital A/cs

Condition: No goodwill should already appear in the books. In case goodwill already
appears in the books it should be written off in old ratio. Entry will be:
Old Partner’s Capital A/cs Dr.

To Goodwill A/c

Example: A and B are partners sharing profits and losses in the ratio of 5:3. C is admitted as
a new partner for 1/5th share. C brings Rs. 50,000 as his capital and brings only 60% of his
share of Goodwill in cash. Total Goodwill of the firm is Rs. 60,000. Pass necessary journal
entries when A and B withdraw 50% of the amount brought in by C as his share of goodwill
in cash. Goodwill already appears in the books at Rs. 16,000.

Solution:

Journal

Date Particulars L.F. Debit Credit

Rs. Rs.
Bank A/c Dr 57,200
To C’s Capital A/c 50,000
To Premium A/c 7,200
(For amount of capital and goodwill brought in by C)
Premium A/c Dr. 7,200
To A’s Capital A/c 4,500
To B’s Capital A/c 2,700
(For amount of goodwill brought in by credited to old
partner’s capital account in their sacrificing ratio)
C’s Capital A/c Dr. 4,800
To A’s Capital A/c 3,000
To B’s Capital A/c 1,800
(For amount of goodwill not brought in by C charged to
his capital A/c and credited to old partner in their
sacrificing ratio)
A’s Capital A/c Dr. 2,250
B’s Capital A/c Dr. 1,350
To Bank A/c 3,600
(For amount of goodwill withdrawn by old partners)
A’s Capital A/c Dr. 10,000
B’s Capital A/c Dr. 6,000
To Goodwill A/c 16,000
(For existing goodwill in the books written off in old ratio)
Workings:

C’s Share of Goodwill = 1/5 x Rs. 60,000 = Rs. 12,000.

But C brings only 60% of his share of goodwill in cash i.e. Rs. 12,000 x 60/100 = Rs.
7,200.

C does not bring 40% of his share of goodwill in cash i.e. Rs. 12,000 x 40/100 = Rs.
4,800.

Recommendation of Accounting Standard 10 (AS-10) – Issued by The Institute of

Chartered Accountants of India

According to AS – 10 goodwill should be recorded in the books only when some

consideration in money or money’s worth has been paid for it. Thus, in case of
admission or retirement/death of a partner or in case of change in profit sharing ratio
among partners, goodwill, following the accounting standard should not be raised in the
books of the firm because no consideration in or money worth is paid for it. If any
partner brings any premium over and above his capital should be distributed to other
existing partners.

If goodwill is evaluated at the time of change in the constitution of the firm (by way of
admission/retirement/death/change in profit sharing ratio), goodwill should not be
brought in books since it is inherent goodwill. If it is raised then it should be
immediately written off.

Q.1. Distinguish between dissolution of a partnership and dissolution of a firm.

(CBSE 1991(Delhi) (C))

Answer: The dissolution of the partnership is not the dissolution of a partnership firm. Any
type of change in the partnership agreement is called dissolution of partnership. A partnership
may also be dissolved at the time of admission of a new partner into the firm or at the time of
retirement or death of a partner. In this case a new partnership agreement is formed, this is
why the old partnership comes to an end and a new partnership begins.

However, dissolution of a firm means discontinuation of the firm’s business and the
relationship between the partners. According to Sec. 39 of Indian Partnership Act 1932, "
Dissolution of firm means a dissolution of partnership between all the partners in the
firm." Therefore when a firm is dissolved, assets of the firm are disposed off, liabilities are
paid off and the accounts of all the partners are also settled.

Q.2. Distinguish between Revaluation Account and Realisation Account.

(DSSE 1987, AISSE 1988,1989 CBSE 1992)

Answer:

Revaluation Account Realisation Account

(1) Revaluation account is prepared at the
time of admission, retirement of death of a
partner.
(2) Revaluation account is prepared in order
to work out the profit or loss on revaluation
of assets and liabilities at the time of
admission, retirement or death of a partner.
(3) Revaluation profit or loss is distributed
only among the old partners of the firm in
their profit sharing ratio.
(4) After preparing the revaluation account
the firm’s business gets going with the same
set of books.
This account is prepared at the time of
dissolution of a partnership firm.
This account is prepared to work out the profit
or loss on realisation of assets and payment to
liabilities at the time of dissolution of the firm.
Realisation profit or loss is distributed among
all the partners in their profit sharing ratio.
After preparation of this account the firms
business comes to an end.

Q.3. Explain the provisions of Sec. 48 of the Indian Partnership Act 1932 dealing with
settlement of accounts the time of the dissolution of firm. (DSSE 1991,1992)

Answer: Sec. 48 of Indian Partnership Act 1932 lays down the following rules regarding the
settlement of accounts:

(i) Losses including deficiencies of capital shall be paid:

a. first out of profits;

b. then out of capitals; and
c. lastly, if necessary by the partners individually in their profit sharing ratio.

(ii) The amount realised from the assets of the firm including any sums of money contributed
by the partners to make up deficiencies of capital shall be applied in the following order:

a. First of all in paying the debts of the third party.

b. Secondly to pay off partner’s loan.
c. Then to refund partner’s capital balances.
d. The surplus, if any distributed among the partners in their profit sharing ratio.

In case a partner has provided loan to the firm has debit balance of capital, first the debit
balance of capital will be completed by his loan, thereafter, if there is a balance in loan
account, it will be paid before the payment of other partner’s capital.

Q.4. Enumerate the circumstances under which a firm is dissolved.

Answer: According to Sec. 40 to Sec. 44 of the Indian Partnership Act 1932, the firm is
dissolved in the following ways:

1. Dissolution by Agreement: When all the partners give their intention to dissolve the
partnership firm.
2. Compulsory Dissolution:

i. When all the partners or all except one partner is declared insolvent.
ii. When the partnership business becomes illegal.
iii. When all the partners except one decide to retire from the firm.
iv. When one of the partner is the citizen of an enemy country.
v. When specific purpose or the venture of the partnership firm is completed.

1. Dissolution by Notice: When the partnership is at will, any partner may dissolve the
firm by giving notice in writing to the other partners.
2. Dissolution by Court:

i. When one of the partner becomes unsound mind.

ii. When the business of the firm cannot be carried on save at loss.
iii. When a partner becomes permanently incapable of performing his duties as a partner.
iv. When a partner is guilty of misconduct, which is likely to affect the firms business.
v. When a partner intentionally commits breach of agreement.
vi. When a partner transfers whole of his interest in the firm to a third party.
vii. When the court is satisfied on any just and equitable ground.

Q.5. Distinguish between firm’s debts and private debts.

Answer:

Firm’s Debts:

When a firm owes to an outsider, this debt is called firm’s debt. The firm is basically
responsible to pay these debts. At the time of dissolution of the firm these debts are paid first
out of the money realised.

Private Debts:

When a partner owes some amount from an outsider this debt is called his private debt. The
firm is basically not responsible for these types of debts. Such debts are paid off from the
money realised by selling the private property of the partner. If private property of partner
exceeds the amount of his private debt, surplus is used to settle the firm’s debts.

Q.6. All the partners want to dissolve the firm. C, a partner, wants that his loan of Rs. 30,000
must be paid off before the payment of capitals to the partners. But A and B, other partners
want that capital must be paid before the payment of C’s loan. State who is correct?

Answer: C is correct because according to Sec. 48 of Indian Partnership Act 1932,

partner’s loan is repaid before the payment of capitals of partners.

Q.1. What is meant by accounting ratios? How are they useful?

Answer: A relationship between various accounting figures, which are connected with
each other, expressed in mathematical terms, is called accounting ratios.

According to Kennedy and Macmillan, "The relationship of one item to another

expressed in simple mathematical form is known as ratio."

Robert Anthony defines a ratio as – "simply one number expressed in terms of another."

Accounting ratios are very useful as they briefly summarise the result of detailed and
complicated computations. Absolute figures are useful but they do not convey much
meaning. In terms of accounting ratios, comparison of these related figures makes them
meaningful. For example, profit shown by two-business concern is Rs. 50,000 and Rs.
1,00,000. It is difficult to say which business concern is more efficient unless figures of
capital investment or sales are also available.

Analysis and interpretation of various accounting ratio gives a better understanding of the
financial condition and performance of a business concern.

Q.2. What do you mean by ratio analysis? What are the advantages of such
analysis? Also point out the limitations of ratio analysis.

Answer: Ratio analysis is one of the techniques of financial analysis to evaluate the
financial condition and performance of a business concern. Simply, ratio means the
comparison of one figure to other relevant figure or figures.

According to Myers, " Ratio analysis of financial statements is a study of relationship

among various financial factors in a business as disclosed by a single set of statements
and a study of trend of these factors as shown in a series of statements."

Advantages and Uses of Ratio Analysis

There are various groups of people who are interested in analysis of financial position of
a company. They use the ratio analysis to workout a particular financial characteristic of
the company in which they are interested. Ratio analysis helps the various groups in the
following manner: -

1. To workout the profitability: Accounting ratio help to measure the profitability

of the business by calculating the various profitability ratios. It helps the
management to know about the earning capacity of the business concern. In this
way profitability ratios show the actual performance of the business.
2. To workout the solvency: With the help of solvency ratios, solvency of the
company can be measured. These ratios show the relationship between the
liabilities and assets. In case external liabilities are more than that of the assets of
the company, it shows the unsound position of the business. In this case the
business has to make it possible to repay its loans.
3. Helpful in analysis of financial statement: Ratio analysis help the outsiders just
like creditors, shareholders, debenture-holders, bankers to know about the
profitability and ability of the company to pay them interest and dividend etc.
4. Helpful in comparative analysis of the performance: With the help of ratio
analysis a company may have comparative study of its performance to the
previous years. In this way company comes to know about its weak point and be
able to improve them.
5. To simplify the accounting information: Accounting ratios are very useful as
they briefly summarise the result of detailed and complicated computations.
6. To workout the operating efficiency: Ratio analysis helps to workout the
operating efficiency of the company with the help of various turnover ratios. All
turnover ratios are worked out to evaluate the performance of the business in
utilising the resources.
7. To workout short-term financial position: Ratio analysis helps to workout the
short-term financial position of the company with the help of liquidity ratios. In
case short-term financial position is not healthy efforts are made to improve it.
8. Helpful for forecasting purposes: Accounting ratios indicate the trend of the
business. The trend is useful for estimating future. With the help of previous
years’ ratios, estimates for future can be made. In this way these ratios provide the
basis for preparing budgets and also determine future line of action.

Limitations of Ratio Analysis

In spite of many advantages, there are certain limitations of the ratio analysis
techniques and they should be kept in mind while using them in interpreting
financial statements. The following are the main limitations of accounting ratios:
 1. Limited Comparability: Different firms apply different accounting policies.
Therefore the ratio of one firm can not always be compared with the ratio of other
firm. Some firms may value the closing stock on LIFO basis while some other
firms may value on FIFO basis. Similarly there may be difference in providing
depreciation of fixed assets or certain of provision for doubtful debts etc.
2. False Results: Accounting ratios are based on data drawn from accounting
records. In case that data is correct, then only the ratios will be correct. For
example, valuation of stock is based on very high price, the profits of the concern
will be inflated and it will indicate a wrong financial position. The data therefore
must be absolutely correct.
3. Effect of Price Level Changes: Price level changes often make the comparison
of figures difficult over a period of time. Changes in price affects the cost of
production, sales and also the value of assets. Therefore, it is necessary to make
proper adjustment for price-level changes before any comparison.
4. Qualitative factors are ignored: Ratio analysis is a technique of quantitative
analysis and thus, ignores qualitative factors, which may be important in decision
making. For example, average collection period may be equal to standard credit
period, but some debtors may be in the list of doubtful debts, which is not
disclosed by ratio analysis.
5. Effect of window-dressing: In order to cover up their bad financial position some
companies resort to window dressing. They may record the accounting data
according to the convenience to show the financial position of the company in a
better way.
6. Costly Technique: Ratio analysis is a costly technique and can be used by big
business houses. Small business units are not able to afford it.
7. Misleading Results: In the absence of absolute data, the result may be
misleading. For example, the gross profit of two firms is 25%. Whereas the profit
earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the
other one is Rs. 10,00,000 and sales are Rs. 40,00,000. Even the profitability of
the two firms is same but the magnitude of their business is quite different.

8. Absence of standard university accepted terminology: There are no standard

ratios, which are universally accepted for comparison purposes. As such, the
significance of ratio analysis technique is reduced.

Q.3. Classify the various profitability ratios. Also explain the meaning, method of
calculation and objective of these ratios.

Answer:

Classification of various profitability ratios: -

a. Gross Profit Ratio (CBSE Outside Delhi 2001, Delhi 2002)

 b. Net Profit Ratio
c. Operating Net Profit Ratio
d. Operating Ratio (CBSE Outside Delhi 2001)
e. Return on Investment or Return on Capital Employed (CBSE 1998, 2000,
Outside Delhi 2001)
f. Return on Equity (CBSE 1999)
g. Earning Per Share (CBSE Outside Delhi 2001)

Meaning, Objective and Method of Calculation: -

a. Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross
Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the
following manner: -

Gross Profit Ratio = Gross Profit/Net Sales x 100

Where Gross Profit = Net Sales – Cost of Goods Sold

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses –

Closing Stock

And Net Sales = Total Sales – Sales Return

Objective and Significance: Gross Profit Ratio provides guidelines to the

concern whether it is earning sufficient profit to cover administration and
marketing expenses and is able to cover its fixed expenses. The gross profit ratio
of current year is compared to previous years’ ratios or it is compared with the
ratios of the other concerns. The minor change in the ratio from year to year may
be ignored but in case there is big change, it must be investigated. This
investigation will be helpful to know about any departure from the standard mark-
up and would indicate losses on account of theft, damage, bad stock system, bad
sales policies and other such reasons.

However it is desirable that this ratio must be high and steady because any fall in
it would put the management in difficulty in the realisation of fixed expenses of
the business.

b. Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of
the concern and Its Net Sales. Net Profit Ratio can be calculated in the following
manner: -

Net Profit Ratio = Net Profit/Net Sales x 100

Where Net Profit = Gross Profit – Selling and Distribution Expenses – Office and
Administration Expenses – Financial Expenses – Non Operating Expenses + Non
 Operating Incomes.

And Net Sales = Total Sales – Sales Return

Objective and Significance: In order to work out overall efficiency of the

concern Net Profit ratio is calculated. This ratio is helpful to determine the
operational ability of the concern. While comparing the ratio to previous years’
ratios, the increment shows the efficiency of the concern.

c. Operating Profit Ratio: Operating Profit means profit earned by the concern
from its business operation and not from the other sources. While calculating the
net profit of the concern all incomes either they are not part of the business
operation like Rent from tenants, Interest on Investment etc. are added and all
non-operating expenses are deducted. So, while calculating operating profit these
all are ignored and the concern comes to know about its business income from its
business operations.

Operating Profit Ratio shows the relationship between Operating Profit and Net
Sales. Operating Profit Ratio can be calculated in the following manner: -

Operating Profit Ratio = Operating Profit/Net Sales x 100

Where Operating Profit = Gross Profit – Operating Expenses

Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating

Incomes

And Net Sales = Total Sales – Sales Return

Objective and Significance: Operating Profit Ratio indicates the earning

capacity of the concern on the basis of its business operations and not from
earning from the other sources. It shows whether the business is able to stand in
the market or not.

d. Operating Ratio: Operating Ratio matches the operating cost to the net sales of
the business. Operating Cost means Cost of goods sold plus Operating Expenses.

Operating Ratio = Operating Cost/Net Sales x 100

Where Operating Cost = Cost of goods sold + Operating Expenses

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses –

Closing Stock

Operating Expenses = Selling and Distribution Expenses, Office and

 Administration Expenses, Repair and Maintenance.

Objective and Significance: Operating Ratio is calculated in order to calculate

the operating efficiency of the concern. As this ratio indicates about the
percentage of operating cost to the net sales, so it is better for a concern to have
this ratio in less percentage. The less percentage of cost means higher margin to
earn profit.

e. Return on Investment or Return on Capital Employed: This ratio shows the

relationship between the profit earned before interest and tax and the capital
employed to earn such profit.

Return on Capital Employed

= Net Profit before Interest, Tax and Dividend/Capital Employed x 100

Where Capital Employed = Share Capital (Equity + Preference) + Reserves and

Surplus + Long-term Loans – Fictitious Assets

Or

Capital Employed = Fixed Assets + Current Assets – Current Liabilities

Objective and Significance: Return on capital employed measures the profit,

which a firm earns on investing a unit of capital. The profit being the net result of
all operations, the return on capital expresses all efficiencies and inefficiencies of
a business. This ratio has a great importance to the shareholders and investors and
also to management. To shareholders it indicates how much their capital is
earning and to the management as to how efficiently it has been working. This
ratio influences the market price of the shares. The higher the ratio, the better it is.

f. Return on Equity: Return on equity is also known as return on shareholders’

investment. The ratio establishes relationship between profit available to equity
shareholders with equity shareholders’ funds.

Return on Equity

= Net Profit after Interest, Tax and Preference Dividend/Equity

Shareholders’ Funds x 100

Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and

Surplus – Fictitious Assets

Objective and Significance: Return on Equity judges the profitability from the
point of view of equity shareholders. This ratio has great interest to equity
 shareholders. The return on equity measures the profitability of equity funds
invested in the firm. The investors favour the company with higher ROE.

g. Earning Per Share: Earning per share is calculated by dividing the net profit
(after interest, tax and preference dividend) by the number of equity shares.

Earning Per Share

= Net Profit after Interest, Tax and Preference Dividend/No. Of Equity

Shares

Objective and Significance: Earning per share helps in determining the market
price of the equity share of the company. It also helps to know whether the
company is able to use its equity share capital effectively with compare to other
companies. It also tells about the capacity of the company to pay dividends to its
equity shareholders.

Q.1. What do you mean by Goodwill? What are the different methods of calculating
goodwill? Discuss every method with suitable examples. (CBSE 1982,85,87,88,89,98; All
India 1986,1990)

Answer: Goodwill is a thing which is not so easy to describe but in general words good-
name, reputation and wide business connection which helps the business to earn more profits
than the profit could be earned by a newly started business. The monetary value of the
advantage of earning more profits is known as goodwill. Goodwill is an attractive force,
which brings in customers to old place of business. Goodwill is an intangible but valuable
asset. In a profitable concern it is not a fictitious asset.

Prof. Dicksee has defined goodwill as " When a man pays for goodwill, he pays for
something which places him in the position of being able to earn more than he would be
able to do by his own unaided efforts."

According to J. O. Magee " The capacity of a business to earn profits in future is basically
what is meant by the term goodwill."

According to Lord Lindley " The term goodwill is generally used to denote benefit arising
from connections and reputation."

Lord Eldon has defined goodwill as " Goodwill is nothing more than the probability, that
the old customers will resort to the old place."

In the words of Lord Macnaghten, " Goodwill is a thing very easy to describe, very
difficult to define. It is the benefit and advantage of the good name, reputation and
connections of a business. It is the attractive force, which brings in customers. It is one
thing which distinguishes an old established business from a new business at its first
start."

In the words of Dr. Canning, "Goodwill is the present value of a firm’s anticipated excess
earnings."

Methods of Valuation of Goodwill

The following are the methods of valuation of goodwill of a firm: -

i. Average Profit Method

ii. Weighted Average Profit Method
iii. Super Profit Method
iv. Capitalization of Average Profit Method
v. Capitalization of Super Profit Method
vi. Present Value of Super Profits Method

1. Average Profit Method: Under this method goodwill is calculated on the basis of the
average profit of previous years. The average profit is multiplied by the number of year’s
purchase.

Goodwill = Average Profit x Number of Years Purchase

Example: Calculate goodwill at twice the average profits of last four years’ profits. The
profits of the last four years were:

2001. Rs. 27,000

2002. Rs. 39,000
2003. Rs. 16,000 (Loss)
2004. Rs. 40,000

Solution: Total Profit for last four years = Rs. 27,000+ Rs. 39,000-Rs. 16,000+Rs. 40,000 =
Rs. 80,000

Average Profit = Rs. 80,000/4 = Rs. 20,000.

Goodwill = Rs. 20,000 x 2 = Rs. 40,000.

2. Weighted Average Profit Method: This method is a modified version of the average
profit method. Under this method the respective number of weights i.e. 1,2,3,4 multiplies
profit of every year, in order to find out value product and the total of products is then
divided by the total of weights in order to ascertain the weighted average profits.
Goodwill = Weighted Average Profits x No. of years Purchase

Weighted Average Profit = Total of Products of Profits/ Total of Weights

Example: Calculate goodwill at twice the weighted average profits of last four years’ profits.
The profits of the last four years were:

2001. Rs. 37,000

2002. Rs. 29,000
2003. Rs. 26,000
2004. Rs. 40,000

Solution:

Years Profits Weight Product

Rs. Rs.
2001 37,000 1 37,000
2002 29,000 2 58,000
2003 26,000 3 78,000
2004 40,000 4 1,60,000
Total 10 3,33,000

Weighted Average Profit = Rs. 3,33,000/10 = Rs. 33,300

Goodwill = Rs. 33,300 x 2 = Rs. 66,600

3. Super Profit Method: When the actual profit is more than the expected profit or normal
profit of a firm, it is called ‘Super Profit.’ Under this method goodwill is to be calculate of on
the following manner:

Goodwill = Super Profit x Number of Years Purchase

Example: The books of a business showed that the capital employed on January 1, 2001 was
Rs. 4,50,000 and the profits for the last five years were as follows: 2001-Rs. 40,000; 2002
-Rs. 50,000; 2003 - Rs. 60,000; 2004 -Rs. 70,000 and 2005 -Rs. 80,000.

You are required to find out the value of goodwill, based on three years’ purchase of the
super profit of the business given that the normal rate of return is 10%.

Solution: Total Profit of last five years = Rs. 40,000 + Rs. 50,000 + Rs. 60,000 + Rs. 70,000
+ Rs. 80,000 = Rs. 3,00,000

Average Profit = Rs. 3,00,000/5 =Rs. 60,000

Normal Profit = Rs. 4,50,000 x 10/100 = Rs. 45,000

Super Profit = Actual/Average Profit – Normal Profit

Super Profit = Rs. 60,000 – Rs. 45,000 = Rs. 15,000

Goodwill = Rs. 15,000 x 3 = Rs. 45,000.

4. Capitalization of Average Profit Method: Under this method goodwill is difference

between the total Capitalized value of the firm and the net assets of the firm.

Goodwill = Capitalized Value the firm – Net Assets

Capitalized Value of the firm = Average Profit x 100/ Normal Rate of Return

Net Assets = Total Assets – External Liabilities

Example: A firm earns Rs. 65,000 as its average profits. The usual rate of earning is 10%.
The total assets of the firm amounted to Rs. 6,80,000 and liabilities are Rs. 1,80,000.
Calculate the value of goodwill.

Solution : Total Capitalized value of the firm = Rs. 65,000 x 100/10 = Rs. 6,50,000

Net Assets = Rs. 6,80,000 – Rs. 1,80,000 = Rs. 5,00,000

Goodwill = Total Capitalized value of the firm – Net Assets

Goodwill = Rs. 6,50,000 – Rs. 5,00,000 = Rs. 1,50,000.

5. Capitalization of Super Profit Method:

a. Calculate Capitalized value of the firm

b. Calculate required profit on capital employed by using the following formula:

Normal Profit = Capital Employed x Required Rate of Return/100

c. Calculate average profit

d. Calculate super profit

Goodwill = Super Profit x 100/Normal Rate of Return

Example: Verma Brothers earn a profit of Rs. 90,000 with a capital of Rs. 4,00,000. The
normal rate of return in the business is 15%. Use Capitalization of super profit method to
value the goodwill.

Solution:

Normal Profit = Rs. 4,00,000 x 15/100 = Rs. 60,000

Super Profit = Rs. 90,000 – Rs. 60,000 = Rs. 30,000

Goodwill = Super Profit x 100/Normal Rate of Return

= Rs. 30,000 x 100/15 = Rs. 2,00,000

6. Present Value of Super Profit: Under this method, goodwill is estimated as the
present value of the future super profits. The following steps are taken:

a. Calculate the future super profits for next years

b. Choose the required rate of return
c. Calculate present value factors
d. Multiply present value factors with future super profits
e. The sum of product of present value factors and super profits is the value of goodwill.

Example: A firm has the forecasted profits for the coming 4 years as follows:

Years Profits

Rs.
1 80,000
2 1,00,000
3 90,000
4 1,20,000

The total assets of the firm are Rs. 9,00,000 and outside liabilities are Rs. 3,00,000. The
present value factors at 10% are as follows:

Years Present Value Factor

1 .9279
2 .8029
3 .7056
4 .6978

Calculate the Value of goodwill.

Solution:

Net Assets = Total Assets – Liabilities

= Rs. 9,00,000 – Rs. 3,00,000

= Rs. 6,00,000

Normal Profit = 10/100 x Rs. 6,00,000 = Rs. 60,000

Years 1 2 3 4
Profits (Rs.) 80,000 1,00,000 90,000 1,20,000
Normal Profit 60,000 60,000 60,000 60,000
Super Profit 20,000 40,000 30,000 60,000
Present Value Factor .9279 .8029 .7056 .6978
Present Value of 18,558 32,116 21,168 41,868
Super Profit

Goodwill = Rs. 18,558 + Rs. 32,116 + Rs. 21,168 + Rs. 41,868 = Rs. 1,13,710.