MF 0010 Security Analysis and Portfolio Management

Set- 1
Q.1 Frame the investment process for a person of your age group.

Ans. As investors, we would all like to beat the market handily, and we would all like to pick "great" investments on instinct. However, while intuition is undoubtedly a part of the process of investing, it is just part of the process. As investors, it is not surprising that we focus so much of our energy and efforts on investment philosophies and strategies, and so little on the investment process. It is far more interesting to read about how Peter Lynch picks stocks and what makes Warren Buffett a valuable investor, than it is to talk about the steps involved in creating a portfolio or in executing trades. Though it does not get sufficient attention, understanding the investment process is critical for every investor for several reasons: 1. The investment process outlines the steps in creating a portfolio, and emphasizes the sequence of actions involved from understanding the investors risk preferences to asset allocation and selection to performance evaluation. By emphasizing the sequence, it provides for an orderly way in which an investor can create his or her own portfolio or a portfolio for someone else. 1. The investment process provides a structure that allows investors to see the source of different investment strategies and philosophies. By so doing, it allows investors to take the hundreds of strategies that they see described in the common press and in investment newsletters and to trace them to their common roots. 1. The investment process emphasizes the different components that are needed for an investment strategy to by successful, and by so doing explain why so many strategies that look good on paper never work for those who use them. The best way of describing this book is by noting what it does not do. It does not emphasize individual investors or push an investment philosophy. It does not focus heavily on coming up with strategies that beat the market, though there is reference to some of them in the course of the book. Instead, it talks about the process of investing and how this process is the same no matter what investment philosophy one might have. The book is built around the investment process. The process always starts with the investor and understanding his or her needs and preferences. For a portfolio manager, the investor is a client, and the first and often most significant part of the investment process is understanding the clients needs, the clients tax status and most importantly, his or her risk preferences. For an individual investor constructing his or her own portfolio, this may seem simpler, but understanding ones own needs and preferences is just as important a first step as it is for the

portfolio manager. The next part of the process is the actual construction of the portfolio, which we divide into three sub-parts. The first of these is the decision on how to allocate the portfolio across different asset classes defined broadly as equities, fixed income securities and real assets (such as real estate, commodities and other assets). This asset allocation decision can also be framed in terms of investments in domestic assets versus foreign assets, and the factors driving this decision. The second component is the asset selection decision, where individual assets are picked within each asset class to make up the portfolio. In practical terms, this is the step where the stocks that make up the equity component, the bonds that make up the fixed income component and the real assets that make up the real asset component are picked. The final component is execution, where the portfolio is actually put together, where investors have to trade off transactions cost against transactions speed. While the importance of execution will vary across investment strategies, there are many investors who have failed at this stage in the process. The final part of the process, and often the most painful one for professional money managers, is the performance evaluation. Investing is after all focused on one objective and one objective alone, which is to make the most money you can, given the risk constraints you operate under. Investors are not forgiving of failure and unwilling to accept even the best of excuses, and loyalty to money managers is not a commonly found trait. By the same token, performance evaluation is just as important to the individual investor who constructs his or her own portfolio, since the feedback from it should largely determine how that investor approaches investing in the future. These parts of the process are summarized in Figure 1, and we will return to this figure to emphasize the steps in the process as we move through the book. The book is built around the same structure. It begins with a chapter that provides an overview of investment management as a business. The first major section is on understanding client needs and preferences, where we look at not only how to think about risk in investing but also at how to measure an investors willingness to take risk. The second section looks at the asset allocation decision, while the third section examines different approaches to selecting assets. The fourth section takes a brief look at the execution decision, and the fifth section develops different approaches to evaluating performance.

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated. Ans. Introduction SENSEX, first compiled in 1986, was calculated on a "Market Capitalization-

Weighted" methodology of 30 component stocks representing large, wellestablished and financially sound companies across key sectors. The base year of SENSEX was taken as 1978-79. SENSEX today is widely reported in both domestic and international markets through print as well as electronic media. It is scientifically designed and is based on globally accepted construction and review methodology. Since September 1, 2003, SENSEX is being calculated on a freefloat market capitalization methodology. The "free-float market capitalizationweighted" methodology is a widely followed index construction methodology on which majority of global equity indices are based; all major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the free-float methodology. The growth of the equity market in India has been phenomenal in the present decade. Right from early nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the 'TMT' sectors. More recently, real estate caught the fancy of the investors. SENSEX has captured all these happenings in the most judicious manner. One can identify the booms and busts of the Indian equity market through SENSEX. As the oldest index in the country, it provides the time series data over a fairly long period of time (from 1979 onwards). Small wonder, the SENSEX has become one of the most prominent brands in the country. Index Specification: Base Year 1978-79 01-01-1986 of Launched on full market capitalization method and effective September 01, 2003, calculation method shifted to free-float market capitalization.

Base Index Value 100 Date of Launch Method calculation

Number of scrips 30 Index Constituents Click here for list of constituents

Index calculation Real Time frequency Index calculation Click here for Index calculation and maintenance and Maintenance Index Reach Click here for scrip-wise, sector wise market capitalization, weightage etc.

Market Click here for market capitalization and turnover coverage Capitalization and Turnover

Coverage Historical Values Index, Price Earnings, Price to Book Value ratio and Dividend Yield % of Index Historical Notices Click to search Historical Notices on Index Replacements Historical Replacements Click here for historical replacements

SENSEX Calculation Methodology SENSEX is calculated using the "Free-float Market Capitalization" methodology, wherein, the level of index at any point of time reflects the free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX on a continuous basis. Dollex-30 BSE also calculates a dollar-linked version of SENSEX and historical values of Dollex series of BSE indices') this index are available since its inception. SENSEX - Scrip Selection Criteria 1. Equities of companies listed on Bombay Stock Exchange Ltd. (excluding companies classified in Z group, listed mutual funds, scrips suspended on the last day of the month prior to review date, scrips objected by the Surveillance department of the Exchange and those that are traded under permitted category) shall be considered eligible Listing History: The scrip should have a listing history of at least three months at BSE. An exception may be granted to one month, if the average free-float market capitalization of a newly listed company ranks in the top 10 of all companies listed at BSE. In the event that a company is listed on account of a merger / demerger / amalgamation, a minimum listing history is not required.

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The scrip should have been traded on each and every trading day in the last three months at BSE. Exceptions can be made for extreme reasons like scrip suspension etc. Companies that have reported revenue in the latest four quarters from its core activity are considered eligible. From the list of constituents selected through Steps 1-4, the top 75 companies based on free-float market capitalisation (avg. 3 months) are selected as well as any additional companies that are in the top 75 based on full market capitalization (avg. 3 months). The filtered list of constituents selected through Step 5 (which can be greater than 75 companies) is then ranked on absolute turnover (avg. 3 months). Any company in the filtered, sorted list created in Step 6 that has Cumulative Turnover of >98%, are excluded, so long as the remaining list has more than 30 scrips. The filtered list calculated in Step 7 is then sorted by free float market capitalization. Any company having a weight within this filtered constituent list of <0.50% shall be excluded All remaining companies will be sorted on sector and sub-sorted in the descending order of rank on free-float market capitalization.

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10. Industry/Sector Representation: Scrip selection will generally attempt to maintain index sectoral weights that are broadly in-line with the overall market. 11. Track Record: In the opinion of the BSE Index Committee, all companies included within the SENSEX should have an acceptable track record. Understanding Free-float Methodology Concept Free-float methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in the index. Freefloat market capitalization takes into consideration only those shares issued by the company that are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other

locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a free-float index is reduced to the extent of its readily available shares in the market. Subsequently all BSE indices with the exception of BSE-PSU index have adopted the free-float methodology. Major advantages of Free-float Methodology

A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market. Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. A Free-float index aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis- -vis an investible index. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. This improves market coverage and sector coverage of the index. For example, under a Full-market capitalization methodology, companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. However, under the Free-float Methodology, since only the free-float market capitalization of each company is considered for index calculation, it becomes possible to include such closely-held companies in the index while at the same time preventing their undue influence on the index movement. Globally, the Free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same. MSCI, a leading global index provider, shifted all its indices to the Free-float Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) - QQQ is based on the Free-float

Methodology. Definition of Free-float Shareholding of investors that would not, in the normal course come into the open market for trading are treated as 'Controlling/ Strategic Holdings' and hence not included in free-float. Specifically, the following categories of holding are generally excluded from the definition of Free-float:

Shares held by founders/directors/ acquirers which has control element Shares held by persons/ bodies with "Controlling Interest" Shares held by Government as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings) Equity held by Employee Welfare Trusts Locked-in shares and shares which would not be sold in the open market in normal course.

The remaining shareholders fall under the Free-float category. Determining Free-float Factors of Companies BSE has designed a Free-float format, which is filled and submitted by all index companies on a quarterly basis. (Format available on www.bseindia.com). BSE determines the Free-float factor for each company based on the detailed information submitted by the companies in the prescribed format. Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. Once the Free-float of a company is determined, it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. A Free-float factor of say 0.55 means that only 55% of the market capitalization of the company will be considered for index calculation. Free-float Bands:

% Free-Float >0 - 5% >5 - 10% >10 - 15% >15 - 20% >20 - 25% >25 - 30% >30 - 35% >35 - 40% >40 - 45% >45 - 50%

Free-Float Factor 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50

% Free-Float >50 - 55% >55 - 60% >60 - 65% >65 - 70% >70 - 75% >75 - 80% >80 - 85% >85 - 90% >90 - 95% >95 - 100%

Free-Float Factor 0.55 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00

Index Closure Algorithm The closing SENSEX on any trading day is computed taking the weighted average of all the trades on SENSEX constituents in the last 30 minutes of trading session. If a SENSEX constituent has not traded in the last 30 minutes, the last traded price is taken for computation of the Index closure. If a SENSEX constituent has not traded at all in a day, then its last day's closing price is taken for computation of Index closure. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value. Maintenance of SENSEX One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like 'rights issue' etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The BSE Index Cell does the day-to-day maintenance of the index within the broad index policy framework set by the BSE Index Committee. The BSE Index Cell ensures that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. The BSE Index Committee comprises of capital market expert, fund managers, market participants and members of the BSE Governing Board. On-Line Computation of the Index

During trading hours, value of the Index is calculated and disseminated on real time basis. This is done automatically on the basis of prices at which trades in Index constituents are executed. Adjustment for Bonus, Rights and Newly Issued Capital SENSEX calculation needs to be adjusted for issue of Bonus or Rights shares If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the BSE Index Cell , the base value is adjusted, which is used to alter market capitalization of the component stocks to arrive at the SENSEX value. The BSE Index Cell keeps a close watch on the events that might affect the index on a regular basis and carries out daily maintenance of all BSE Indices.

Adjustments for Rights Issues When a company, included in the compilation of the index, issues right shares, the free-float market capitalization of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market capitalization (see 'Base Market capitalization Adjustment' below). Adjustments for Bonus Issue When a company, included in the compilation of the index, issues bonus shares, the market capitalization of that company does not undergo any change. Therefore, there is no change in the Base Market capitalization, only the 'number of shares' in the formula is updated. Other Issues Base Market capitalization adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-back of shares, corporate restructuring etc. Base Market capitalization Adjustment

The formula for adjusting the Base Market capitalization is as follows: New Base Market capitalization = Old Base Market capitalization x New Market capitalization / Old Market capitalization To illustrate, suppose a company issues right shares which increases the market capitalization of the shares of that company by say, Rs.100 crores. The existing Base Market capitalization (Old Base Market capitalization), say, is Rs.2450 crores and the aggregate market capitalization of all the shares included in the

index before the right issue is made is, say Rs.4781 crore. The "New Base Market capitalization " will then be: 2450 x (4781+100) -------------------------- = Rs.2501.24 crores 4781 This figure of Rs. 2501.24 crore will be used as the Base Market capitalization for calculating the index number from then onwards till the next base change becomes necessary. Index Review Frequency The BSE Index Committee meets every quarter to discuss index related issues. In case of a revision in the Index constituents, the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision of the Index. Q.3 Perform an economy analysis on Indian economy in the current situation. Ans. India economic analysis provides various inputs on economic condition of this south-east Asian country. It can be done both at a microeconomic as well as a macroeconomic level. India economic analysis could also be described as being an explanation of various economic phenomena going on in this country. Recent macroeconomic developments in India In April 2008, industrial sector in India had recorded a growth of 7 percent. However, this figure is lesser than 11 percent development, which had been achieved in April 2007. Much of this critical condition could be attributed to an increase in prices of oil. Measures that have been taken by Reserve Bank of India, like upward revision of repo rate and CRR, have also contributed to decrease in industrial production. Manufacturing and electric sector have suffered as well in recent times. Their growth rates have come down too. For manufacturing sector it was 7.5 percent and for electricity sector, rate of development stood at 1.4 percent in April 2008. This rate is significantly low when compared to statistics of April 2007, when rates of development for manufacturing and electricity were 12.4 percent and 8.7 percent respectively. In case of manufacturing sector much of this slump could be attributed to increase in input costs like expenses of oil, raw materials, rates of interest and prices of goods and services. Mining sector has been comparatively better off as it has managed to grow at a rate of 8 percent in April 2008 compared to 2.6 percent that was achieved in April 2007. In core infrastructural industries, there has been deceleration as well, but it is still better off compared to non infrastructural industries in India. Growth in April 2008

has been around 3.6 percent, which is less than 5.9 percent achieved in April 2007. Industries like crude oil production, electricity and petroleum refinery have been performing below expectations but coal, finished steel and cement have performed better than April 2007. Inflation in India In financial year 2007-08, average inflation in India was around 4.66 percent. This rate was lower than average inflation of financial year 2006-07. In 2007-08, fiscal high prices of food items were primary cause behind high rates of inflation. That high rate of inflation had to be controlled by banning a number of necessary commodities as well as various financial steps. High prices of oil were responsible for proportionately high rate of inflation in 2008-09. Q.4 Identify some technical indicators and explain how they can be used to decide purchase of a companys stock. Ans. A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, high, low or closing price over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulae. The price data is entered into the formula and a data point is produced. For example, say the closing prices of a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43. A number of technical indicators are in use. Some of the technical indicators are discussed below for the purpose of illustration of the concept : Moving average : The moving average is a lagging indicator which is easy to construct and is one of the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. The new total is then divided by the total number of days (10) and the resultant average computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action. Moving average convergence divergence (MACD) : MACD is a momentum indicator and it is made up of two exponential moving averages. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line. When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go above it, its a bullish signal. This indicator measures short-term momentum as compared to longer term momentum and

signals the current direction of momentum. Traders use the MACD for indicating trend reversals. Relating Strength Index : The relative strength index (RSI) is another of the well-known momentum indicators. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI is plotted in a range of 0-100. a reading above 70 suggests that a security is overbought, while a reading below 30 suggests that is oversold. This indicator helps traders to identify whether a securitys price has been unreasonably pushed to its current levels and whether a reversal may be on the way. Stochastic Oscillator : The stochastic oscillator is one of the most recognized momentum indicators. This indicator provides information about the location of a current closing price in relation to the periods high and low prices. The closer the closing price is to the periods high, the higher is the buying pressure, and the closer the closing price is to the periods low, the more is the selling pressure. The idea behind this indicator is that in an uptrend. The price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. Q.5 Compare Arbitrage pricing theory with the Capital asset pricing model. Ans: In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost. In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage. People who engage in arbitrage are called arbitrageurs (IPA: /rbtrr/) such as a bank or brokerage firm. The term is mainly applied to trading in

financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Conditions for arbitrage Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.[note 1] In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other. See rational pricing, particularly arbitrage mechanics, for further discussion. Mathematically it is defined as follows: and where Vt means a portfolio at time t. Examples Suppose that the exchange rates (after taking out the fees for making the exchange) in London are 5 = $10 = 1000 and the exchange rates in Tokyo are 1000 = $12 = 6. Converting 1000 to $12 in Tokyo and converting that $12 into 1200 in London, for a profit of 200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it almost

never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are much more common. One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually. Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some which require command of English are going to India and the Philippines. In popular terms, this is referred to as offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.) Sports arbitrage numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour

and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market. Exchange-traded fund arbitrage Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a lowrisk profit, while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value. Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities, assets and derivatives with similar characteristics, and hedge any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk.

Comparison between APT & CAPM 8 APT applies to well diversified portfolios and not necessarily to individual stocks. 9 With APT it is possible for some individual stocks to be mispriced - not lie on the SML. 10 APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. 11 APT can be extended to multifactor models. 12 Both the CAPM and APT are risk-based models. There are alternatives. 13 Empirical methods are based less on theory and more on looking for some regularities in the historical record. 14 Be aware that correlation does not imply causality. 15 Related to empirical methods is the practice of classifying portfolios by

style e.g. o Value portfolio o Growth portfolio 16 The APT assumes that stock returns are generated according to factor models such as:

17 As securities are added to the portfolio, the unsystematic risks of the individual securities offset each other. A fully diversified portfolio has no unsystematic risk. 18 The CAPM can be viewed as a special case of the APT. 19 Empirical models try to capture the relations between returns and stock attributes that can be measured directly from the data without appeal to theory. 20 Difference in Methodology v CAPM is an equilibrium model and derived from individual portfolio optimization. v APT is a statistical model which tries to capture sources of systematic risk. Relation between sources determined by no Arbitrage condition. 21 Difference in Application v APT difficult to identify appropriate factors. v CAPM difficult to find good proxy for market returns. v APT shows sensitivity to different sources. Important for hedging in portfolio formation. v CAPM is simpler to communicate, since everybody agrees upon. Q.6 Discuss the different forms of market efficiency.

Ans. A financial market displays informational efficiency when market prices reflect all available information about value. This definition of efficient market required answers to two questions : what is all available information? & what does it mean to reflect all available information ?. different answers to these questions give rise to different versions of market efficiency. What information are we talking about? Information can be information about past prices, information that is public information and information that is private information. Information about past prices refers to the weak form version of market efficiency, information that consists of past prices and all public information refers to the semi-strong version of market efficiency and all information (past prices, all public information and all private information) refers to the strong form version of market efficiency.

Prices reflect all available information means that all financial transactions which are carried out at market prices, using the available information, are zero NPV activities. The weak form the EMH states that all past prices, volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It would mean that if the weak form of EMH is correct, then technical analysis is fruitless in generating excess returns. the semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. OLD information then is already discounted and cannot be used to predict stock price fluctuations. In sum, the semi-strong form suggests that fundamental analysis is also fruitless; knowing what a company generated in terms of earnings and revenues in the past will not help you determine what the stock price will do in the future. This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions. Lastly, the strong form the EMH suggests that stock prices reflect all information, whether it be public (say in SEBI filings) or private (in the minds of the CERO and other insiders). So even with material non-public information, EMH asserts that stock prices cannot be predicted with any accuracy.

MF 0011 Mergers and Acquisitions

Set- 1
Q.1 What are the basic steps in strategic planning for a merger? Ans. Basic steps in Strategic planning in Merger : Any merger and acquisition involve the following critical activities in strategic planning processes. Some of the essential elements in strategic planning processes of mergers and acquisitions are as listed here below : 1. Assessment of changes in the organization environment 2. Evaluation of company capacities and limitations 3. Assessment of expectations of stakeholders 4. Analysis of company, competitors, industry, domestic economy and international economies 5. Formulation of the missions, goals and polices 6. Development of sensitivity to critical external environmental changes 7. Formulation of internal organizational performance measurements 8. Formulation of long range strategy programs 9. Formulation of mid-range programmes and short-run plans 10. Organization, funding and other methods to implement all of the proceeding elements 11. Information flow and feedback system for continued repetition of all essential elements and for adjustment and changes at each stage 12. Review and evaluation of all the processes In each of these activities, staff and line personnel have important Responsibilities in the strategic decision making processes. The scope of mergers and acquisition set the tone for the nature of mergers and acquisition activities and in turn affects the factors which have significant influence over these activities. This can be seen by observing the factors considered during the different stages of mergers and acquisition activities. Proper identification of different phases and related activities smoothen the process of involved in merger

Q.2

What are the sources of operating synergy?

Ans. Sources of Operating Synergy Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. We would categorize operating synergies into four types: 1. Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. Economics of scales can be seen in mergers of firms in the same business For example : two banks combining together to create a larger bank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of cost reducing operating synergy. Both the banks after combination can expect to cut costs considerably on account of sharing of their resources and thus avoiding duplication of facilities available. 2. Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income. This synergy is also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in the business. When there are more firms in the industry ability of firms to exercise relatively higher price reduces and in such a situation the synergy does not seem to work as desired. An example of limiting competition to increase pricing power is the acquisition of universal luggage by Blow Plast. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. After the acquisition blow past acquired a strong hold on the market and operated under near monopoly situation. Another example is the acquisition of Tomco by Hindustan Lever. 3. Combination of different functional strengths, combination of different functional strengths may enhance the revenues of each merger partner thereby enabling each company to expand its revenues. The phenomenon can be understood in cases where one company with an established brand name lends its reputation to a company with upcoming product line or a company. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so. In other words the two companies should get the advantage of the combination of their complimentary functional strengths.

4. Higher growth in new or existing markets, arising from the combination of the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products. Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition. Synergy results from complementary activities. This can be understood with the following example Example : Consider a situation where there are two firms A and B. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). If A and B combine with each other both can utilize each other strengths, for example here A can invest its resource in the opportunities available to B. note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one. Q.3 Explain the process of a leveraged buyout.

Ans. In the realm of increased globalized economy, mergers and acquisitions have assumed significant importance both with the country as well as across the boarders. Such acquisitions need huge amount of finance to be provided. In search of an ideal mechanism to finance and acquisition, the concept of Leverage Buyout (LBO) has emerged. LBO is a financing technique of purchasing a private company with the help of borrowed or debt capital. The leveraged buyout are cash transactions in nature where cash is borrowed by the acquiring firm and the debt financing represents 50% or more of the purchase price. Generally the tangible assets of the target company are used as the collateral security for the loans borrowed by acquiring firm in order to finance the acquisition. Some times, a proportionate amount of the long term financing is secured with the fixed assets of the firm and in order to raise the balance amount of the total purchase price, unrated or low rated debt known as junk bond financing is utilized. Modes of purchase There are a number of types of financing which can be used in an LBO. These include : Senior debt : this is the debt which ranks ahead of all other debt and equity capital in the business. Bank loans are typically structured in up to three trenches : A, B and C. The debt is usually secured on specific assets of the company, which means the lender can automatically acquire these assets if the company breaches its

obligations under the relevant loan agreement; therefore it has the lowest cost of debt. These obligations are usually quite stringent. The bank loans are usually held by a syndicate of banks and specialized funds. Typically, the terms of senior debt in an LBO will require repayment of the debt in equal annual installments over a period of approximately 7 years. Subordinated debt : This debt ranks behind senior debt in order of priority on any liquidation. The terms of the subordinated debt are usually less stringent than senior debt. Repayment is usually required in one bullet payment at the end of the term. Since subordinated debt gives the lender less security than senior debt, lending costs are typically higher. An increasingly important form of subordinated debt is the high yield bond, often listed on Indian markets. High yield bonds can either be senior or subordinated securities that are publicly placed with institutional investors. They are fixed rate, publicly traded, long term securities with a looser covenant package than senior debt though they are subject to stringent reporting requirements. Mezzanine finance : This is usually high risk subordinated debt and is regarded as a type of intermediate financing between debt and equity and an alternative of high yield bonds. An enhanced return is made available to lenders by the grant of an equity kicker which crystallizes upon an exit. A form of this is called a PIK, which reflects interest paid in kind, or rolled up into the principal, and generally includes an attached equity warrant. Loan stock : This can be a form of equity financing if it is convertible into equity capital. The question of whether loan stock is tax deductible should be investigated thoroughly with the companys advisers. Preference share : This forms part of a companys share capital and usually gives preference shareholders a fixed dividend and fixed share of the companys equity. Ordinary shares : This is the riskiest part of a LBOs capital structure. However, ordinary shareholders will enjoy majority of the upside if the company is successful. Q.4 What are the cultural aspects involved in a merger. Give sufficient examples. Ans. The value chains of the acquirer and the acquired, need to be integrated in order to achieve the value creation objectives of the acquirer. This integration process has three dimensions: the technical, political and cultural. The technical integration is similar to the capability transfer discussed above. The integration of social interaction and political relationships represents the informal processes and systems which influence peoples ability and motivation to perform. At the time of integration, the acquirer should have regard to these political

relationships, if acquired employees are not to feel unfairly treated. An important aspect of integration is the cultural integration of the acquiring and acquired firms. The culture of an organization is embodied in its collective value systems, beliefs, norms, ideologies myths and rituals. They can motivate people and can become valuable sources of efficiency and effectiveness. The following are the illustrative organizational diverse cultures which may have to be integrated during post-merger period: Strong top leadership versus Team approach Management by formal paper work versus management by wandering around Individual decision versus group consensus decision Rapid evaluation based on performance versus Long term relationship based on loyalty Rapid feedback for changes versus formal bureaucratic rules and procedures Narrow career path versus movement through many areas Risk taking encouraged versus one mistake you are out Risky activities versus low risk activities Narrow responsibility arrangement versus Everyone in this company is salesman (or cost controller, or product quality improver etc.) Learn from customer versus We know what is best for the customer The above illustrative culture may provide basis for the classification of organizational culture. There are four different types of organizational culture as mentioned below: Power - The main characteristics are: essentially autocratic and suppressive of challenge; emphasis on individual rather than group decision making Role - The important features are: bureaucratic and hierarchical; emphasis on formal rules and procedures; values fast, efficient and standardized culture service Task/achievement - The main characteristics are: emphasis on team commitment; task determines organization of work; flexibility and worker autonomy; needs creative environment Person/support

- The important features are: emphasis on equality; seeks to nurture personal development of individual members Poor cultural fit or incompatibility is likely to result in considerable fragmentation, uncertainty and cultural ambiguity, which may be experienced as stressful by organizational members. Such stressful experience may lead to their loss of morale, loss of commitment, confusion and hopelessness and may have a dysfunctional impact on organizational performance. Mergers between certain types can be disastrous. Differences in culture may lead to polarization, negative evaluation of counterparts, anxiety and ethnocentrism between top management teams of the acquired and acquiring firms. In assessing the advisability of an acquisition, the acquirer must consider cultural risk in addition to strategic issues. The differences between the national and the organizational culture influence the cross-border acquisition integration. Thus, merging firms must consciously and proactively seek to transform the cultures of their organizations. Q.5 Study a recent merger that you have read about and discuss the synergies that resulted from the merger. Ans. Synergy is the additional value that is generated by the combination of two or more than two firms creating opportunities that would not be available to the firms independently. There are two main types of synergy : 22 Operating synergy 23 Financial synergy Operating Synergy Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. We would categorize operating synergies into four types: 1. Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable. Economics of scales can be seen in mergers of firms in the same business For example : two banks combining together to create a larger bank. Merger of HDFC bank with Centurian bank of Punjab can be taken as an example of cost reducing operating synergy. Both the banks after combination can expect to cut costs considerably on account of sharing of their resources and thus avoiding duplication of facilities available. 2. Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income. This synergy is also more likely to show up in mergers of firms which are in the same line of business and should be more likely to yield benefits when there are relatively few firms in the business. When there are more firms in the industry ability of firms to exercise relatively higher price reduces and in such a situation the synergy does

not seem to work as desired. An example of limiting competition to increase pricing power is the acquisition of universal luggage by Blow Plast. The two companies were in the same line of business and were in direct competition with each other leading to a severe price war and increased marketing costs. After the acquisition blow past acquired a strong hold on the market and operated under near monopoly situation. Another example is the acquisition of Tomco by Hindustan Lever. 3. Combination of different functional strengths, combination of different functional strengths may enhance the revenues of each merger partner thereby enabling each company to expand its revenues. The phenomenon can be understood in cases where one company with an established brand name lends its reputation to a company with upcoming product line or a company. A company with strong distribution network merges with a firm that has products of great potential but is unable to reach the market before its competitors can do so. In other words the two companies should get the advantage of the combination of their complimentary functional strengths. 4. Higher growth in new or existing markets, arising from the combination of the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products. Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition. Synergy results from complementary activities. This can be understood with the following example Example : Consider a situation where there are two firms A and B. Firm A is having substantial amount of financial resources (having enough surplus cash that can be invested somewhere) while firm B is having profitable investment opportunities ( but is lacking surplus cash). If A and B combine with each other both can utilize each other strengths, for example here A can invest its resource in the opportunities available to B. note that this can happen only when the two firms are combined with each other or in other words they must act in a way as if they are one. Financial Synergy With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate). Included are the following: 24 A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that were taken with the

excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses. 25 Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This, in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm. This tax benefit can either be shown as higher cash flows, or take the form of a lower cost of capital for the combined firm. 26 Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its depreciation charges after an acquisition will save in taxes, and increase its value. Clearly, there is potential for synergy in many mergers. The more important issues are whether that synergy can be valued and, if so, how to value it. This result has to be interpreted with caution, however, since the increase in the value of the combined firm after a merger is also consistent with a number of other hypotheses explaining acquisitions, including under valuation and a change in corporate control. It is thus a weak test of the synergy hypothesis. The existence of synergy generally implies that the combined firm will become more profitable or grow at a faster rate after the merger than will the firms operating separately. A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth) relative to their competitors, after takeovers. On this test, as we show later in this chapter, many mergers fail. Q.6 What are the motives for a joint venture, explain with an example of a joint venture. Ans:- As there are good business and accounting reasons to create a joint venture with a company that has complementary capabilities and resources, such as distribution channels, technology, or finance, joint ventures are becoming an increasingly common way for companies to form strategic alliances. In a joint venture, two or more parent companies agree to share capital, technology, human resources, risks and rewards in a formation of a new entity under shared control. Broadly, the important reasons for forming a joint venture can be presented below: Internal Reasons to Form a JV 27 Spreading Costs: You and a JV partner can share costs associated with marketing, product development, and other expenses, reducing your financial burden.

28 Opening Access to Financial Resources: Together you and a JV partner might have better credit or more assets to access bigger resources for loans and grants than you could obtain on your own. 29 Connection to Technological Resources: You might want access to technological resources you couldn't afford on your own, or vice versa. Sharing innovative and proprietary technology can improve products, as well as your own understanding of technological processes. 30 Improving Access to New Markets: You and a JV partner can combine customer contacts and together even form a joint product that accesses new markets. 31 Help Economies of Scale: Together you and a JV partner can develop products or services that reduce total overall production expenses. Bring your product to market cheaper where the customer can enjoy the cost savings. External Reasons to Form a JV 32 Develop Stronger Innovative Product: Together you and a JV partner may be able to share ideas to develop a product that is more competitive in your industry. 33 Improve Speed to Market: With shared access to financial, technological, and distribution resources, you and a JV partner can get your joint product to market faster and more efficiently. Strategic Move Against Competition: A JV may be able to better compete against another industry leader through the combination of markets, technology, and innovation. Strategic Reasons 34 Synergistic Reasons: You may find a JV partner with whom you can create synergy, which produces a greater result together than doing it on your own. 35 Share and Improve Technology and Skills: Two innovative companies can share technology to improve upon each other's ideas and skills. Diversification - There could be many diversification reasons: access to diverse markets, development of diverse products, diversify the innovative working force, etc. Don't let a JV opportunity pass you by because you don't think it will fit in

with your own small business. Small and big companies alike can benefit from the reasons listed above. Analyze how your company can benefit internally, externally, and strategically, and then find a joint venture partner that will fit with your needs.

MF 0012 Taxation Management

Set- 1

Q.1 Tax evasion is a menace to the people, economy and the country. In the wake of recent Swiss bank account scandal give your views on the following: a. How does it affect the Indian economy and the growth prospects? Ans. In view of the facts set out so far, it becomes necessary to look at the extent of compliance of tax laws in India. Though many estimates of black money have been coming forth, an attempt was made to determine the extent of tax evasion in the Mumbai Income Tax charge, which collected about 35% of the Income Tax collections of the country and 43% of the corporate tax collections. The study was made on the basis of results of the survey and search cases for all the years covered by such cases. It came to light that none of the taxpayers concerned declared for taxation purposes anything more than 25% of their true incomes after 1999. The figure arrived at was given to the press specifying the basis on which it was so calculated. Not a single protest was received from any of the taxpayer, including companies. The said figure was thereafter cited for some more time, and even thereafter no protest was received. There was, therefore, every reason to believe this estimate. However, there appears 10 to be higher tax evasion in the case of companies. Some of the companies have shown their entire capital as having come from the countries regarded as Tax Havens. Considering the extent of Indian monies stacked in Swiss Bank Accounts, and bank accounts of the developed countries, and comparing the same with the annual income tax collections of the Central Government, it appears that the real income admitted for taxation purposes is less than 25% . The extent of evasion appears to be very much higher in the case of companies as the companies have resorted to evolution of tax evasion devices in the accounts and such methods have not yet been properly investigated by the Income Tax Department. There are companies which have camouflaged their capital investments and shown it in the books as if it is explained capital for income tax purposes. The Indian Scenario - Peculiar problems of tax evasion : It will be appropriate at this stage to highlight some of the key problems from the view point of computerisation in India : (a) Investments in Real Estate : The one field where black monies have been invested on the largest scale is that of real estate properties. Lands were sold for only 20% of their real values and the balance 80% given in cash out of the tax evaded monies, ever since 1947. But later on when the tax rates were lowered to

30% for individuals and 35% for companies, the black portion got reduced to 40% . It may be a difficult task to trace such black transactions through the computer system, suggested for adoption on the U.S. pattern for India. But it is common knowledge that the black monies invested in land have been reinvested in bank accounts, shares and in other properties, apart from real estate property. It is now confirmed knowledge that in regard to buildings constructed, only 40% of the cost is shown to income tax. It is possible to detect such investment by analysis of the data obtained from the trade and industry governing commodities used for construction of buildings. Further, as all the transactions relating to sale of real estate properties are now recorded in computers maintained by the Registration Offices all over the country, and if the same data is brought on the computers of the Income Tax Department, it should be possible to know many owners of property who have not filed their tax returns at all so far. In India, there are only 3 crores of tax assessees at present, and thus a large number of people with taxable income have evidently chosen not to file income tax returns. (b) Gold and Jewellery Holdings : India is having the largest private holdings of gold and diamond jewellery among all the countries of the world. In the searches conducted by the Income Tax Department, huge unaccounted cash balances and gold and diamond jewellery have been found in the bank lockers maintained by tax payers in bogus names and in their own names. At current market rates, purchases of gold, silver and diamonds may now reach about Rs. 80,000 crores a year. Gold and diamond traders are mostly keeping their transactions outside bank accounts. They are also giving vouchers to the effect that raw gold has been given by the customers, though, in fact, it would have come from the traders themselves. Therefore, it is necessary to introduce a law requiring them to transact only through bank cheques and issue computerized bills, to facilitate proper flow of information to the computer system of the tax department. (c) Shares, Mutual Funds, etc : There are vast investments in shares and debentures, travelers cheques, mutual funds and the primary bonds issued by the Reserve Bank of India. The data regarding company shares and other investments mentioned can be easily transferred to the computer system of the Income Tax Department. The Mumbai Stock Exchange is having a separate computer system with complete data on daily transactions and the Income Tax Department has so far not made use of such data. There is also the data generated in the computers of the organizations in charge of demat of shares. Like-wise, the data on post office savings and other accounts is easy to be brought on the computers of the tax department for verification with the individual returns, which are available with the Government itself. d) Undisclosed Stock in-trade held by companies and traders : Many firms and individuals have also a tendency to keep undisclosed business assets like cars and private assets, unaccounted cash holdings etc., They have ability to give extensive bribes to protect business and other interests. All such practices would varnish once fear is caused among the tax payers about the use of

computerized data for taxation purposes. (e) Benami Investments : Benami investments are typical of the Indian economy. Even big companies have indulged in such practices to impart total secrecy to their undisclosed accounts. It may be difficult to determine whether the investment found in the computers of the income tax department is benami or not, and benami shares will have to be traced sometimes by extensive studies to be conducted by teams of revenue officers. This problem requires comprehensive study because it is peculiar to the Indian Taxation System. (f) Swiss Bank and other undisclosed bank accounts held abroad: Swiss Bank Accounts are shrouded in secrecy and hence no information will be available to the computer system of the Income Tax Department. The amounts in Swiss Bank Accounts, which are held in foreign currency, have been utilised by big companies and other taxpayers in India to import huge machineries at vastly underinvoiced prices. Such practices enable payment of secret trade commissions in foreign currency and unaccounted funds in Indian currency to those contesting general elections. Several major companies have converted Swiss Account holdings into benami shares and debentures. The large amounts of Swiss Bank deposits have, thus, been utilized and every year, there are additions to the Swiss Bank Account holdings. b. Does black money cause Inflation? Ans. Illegally earned money is called black money. It is the result of hoarding, smuggling, tax evasion and dealing in immovable property for which the consideration is paid in black. It has been beyond the control of the Government. The black money has already created a serious problem in our country. The Indian economy stands badly shattered because of the huge amount of this tainted wealth lying in the coffers of the rich. It has given rise to parallel economy operating in the country. As a result, the prices continue to rise in spite of all government efforts to control them. The poor go on becoming poorer while the rich go on becoming richer. The gap between the haves and the have nots is widening every day. Black money is used by the rich in various evil activities. They use this money for corrupting and demoralizing social and political life. They display it in ostentatious living and wasteful luxuries. They bribe Government officers and lead them to corruption and dishonesty. They purchase political bosses and control the strings of the Government. Thus the entire social structure comes to be badly polluted. It is difficult to form an exact idea of the amount of black money in circulation in the country. Searches and raids by Income Tax authorities are conducted from time to time. Such raids yield crores of rupees. But the people are, at times, cleverer than the Government. They seek the aid of the best legal brains and get the law twisted in their favour. Most of the offenders use all their money and

influence and go scot free whenever they are caught. The Government has, at various times, announced some voluntary disclosure schemes for unearthing the black money. These schemes have proved successful to a very limited extent. What has come to the surface is believed only to be the tip of the huge iceberg lying hidden underneath. The 1997 Voluntary Disclosure Scheme announced by the Government of India unearthed a big amount of black money as the tax rate in this scheme had been reduced to thirty per cent. The black money, according to some reliable estimates has gone up to Rs. 10,000 crores in our country. It is to a great extent responsible for a great rise in prices because the purchasing power of the people has increased. People having black money are leading a life of luxury whereas the poor people are leadinng a miserable life. Some leading economists of the country have suggested stringent measures to the government to unearth black money but successive governments have been rejecting those measures. The vested interests always stand in the way of effective measures and get them diluted. The government of the day appears to be doing its best to unearth black money. A number of steps have been taken. Taxation structure and system have been made easier. At different times, the government has brought forward several schemes and asked the people to declare their wealth. There has been some success. A lot soil remains to be done. It must be clear to all that the nation cannot shut her eyes to this state of affairs. Smugglers and black-marketeers can no longer be tolerated. They are striking at the very roots of our democratic structure. All steps to weed the black money out of circulation must be taken as early as possible.The government must come down with a heavy hand on smugglers, tax evaders, black-marketeers and hoarders. Black money is a curse. It must be rooted out from public life. Q.2 Detail death cum retirement gratuity under Sec 17(1)iii of IT Act. Is commutation of pension a viable option in terms of tax planning? Ans. Death-cum-retirement gratuity or any other gratuity which is exempt to the extent specified from inclusion in computing the total income under clause (10) of Section 10. Any death-cum-retirement gratuity received under the revised Pension Rules of the Central Government or, as the case may be, the Central Civil Services (Pension) Rules, 1972, or under any similar scheme applicable to the members of the civil services of the Union or holders of posts connected with defence or of civil posts under the Union (such members or holders being persons not governed by the said Rules) or to the members of the all-India services or to the members of the civil services of a State or holders of civil posts under a State or to the employees of a local authority or any payment of retiring gratuity received under the Pension Code or Regulations applicable to the

members of the defence service. Gratuity received in cases other than above on retirement, termination etc is exempt up to the limit as prescribed by the Board. Under the provisions of Section 10(10) of the IT Act, any death-cum-retirement gratuity of a government servant is completely exempt from income tax. However, in respect of private sector employees gratuity received on retirement or on becoming incapacitated or on termination or any gratuity received by his widow, children or dependants on his death is exempt subject to certain conditions. The maximum amount of exemption is Rs. 3,50,000;. Of course, this is further subject to certain other limits like the one half-month's salary for each year of completed service, calculated on the basis of average salary for the 10 months immediately preceding the year in which the gratuity is paid or 20 months' salary as calculated. Thus, the least of these items is exempt from income tax under Section 10(10). Any payment in commutation of pension received under the Civil Pension(Commutation) Rules of the Central Government or under any similar scheme applicable to the members of the civil services of the Union, or holders of civil posts/posts connected with defence, under the Union,or civil posts under a State, or to the members of the All India Services/Defence Services, or, to the employees of a local authority or a corporation established by a Central,State or Provincial Act, is exempt under sub-clause (i) of clause (10A) of Section 10. As regards payments in commutation of pension received under any scheme of any other employer, exemption will be governed by the provisions of sub-clause (ii) of clause (10A) of section 10. Also, any payment in commutation of pension received from a Regimental Fund or Non-Public Fund established by the Armed Forces of the Union referred to in Section 10(23AAB) is exempt under sub-clause (iii) of clause (10A) of Section 10. The entire amount of any payment in commutation of pension by a government servant or any payment in commutation of pension from LIC [Get Quote] pension fund is exempt from income tax under Section 10(10A) of IT Act. However, in respect of private sector employees, only the following amount of commuted pension is exempt, namely: (a) Where the employee received any gratuity, the commuted value of one-third of the pension which he is normally entitled to receive; and (b) In any other case, the commuted value of half of such pension. It may be noted here that the monthly pension receivable by a pensioner is liable to full income tax like any other item of salary or income and no standard deduction is now available in respect of pension received by a tax payer.

Q.3 Explain the essential conditions to be satisfied by a firm to be assessed as firm under Section 184. Ans. Position of Firm under the Income Tax Act Legally, a partnership firm does not have a separate entity from that of the partners constituting the firm as the partners are the owners of the firm. However, a firm is treated as a separate tax entity under the Income Tax Act. Salient features of the assessment of a firm are as under: 1. A firm is treated as a separate tax entity. 2. While computing the income of the firm under the head Profits and gains of business or profession, besides the deductions which are allowed u/ss 30 to 37, special deduction is allowed to the firm on account of remuneration to working partners and interest paid to the partners. However, it is subject to certain limits laid down u/s 40 (b). 3. Share of profit which a partner receives from the firm (after deduction of remuneration and interest allowable) shall be fully exempt in the hands of the partner. However, only that part of the interest and remuneration which was allowed as a deduction to the firm shall be taxable in the hands of the partners in their individual assessment under the head profits and gains of business or profession. 4. The firm will be taxed at a flat rate of 30% plus education cess @ 3% plus for the financial year 2010-11. 5. The firm will be assessed as a firm provided conditions mentioned under Section 184 are satisfied. In case these conditions are not satisfied in a particular assessment year, the firm will be assessed as affirm, but no deduction by way of payment of interest, salary, bonus, commission or remuneration, by whatever name called, made to the partner, shall be allowed in computing the income chargeable under the head profits and gains of business or profession and such interest, salary, bonus, commission or remuneration shall not be chargeable to income tax in the hands of the partner. Assessment of firm From point (5) stated above, it can be concluded that for taxation purposes, a firm can be of two types: 1. Firm assessed as firm (provided conditions mentioned u/s 184 are satisfied).and the firm shall be eligible for deduction on account of interest, salary etc while computing its income under the head business and profession). However, it will be subject to the maximum of the limit specified under Section 40(b) 2. If the prescribed conditions are not satisfied, no deduction shall be allowed to

the firm on account of such interest, salary, bonus etc. Essential conditions to be satisfied by a firm to be assessed as firm (Section 184) 1. In the first assessment year: The firm will be assessed as a firm, also known as Firm Assessed as Such (FAAS) if the following conditions are satisfied: (a) Partnership is evidenced by an instrument i.e. there is a written document giving the terms of partnership. (b) The individual share of the partners is specified in that instrument. (c) Certified copy of partnership deed must be filed: A certified copy of the said instrument of partnership shall accompany the return of income in respect of the assessment year for which the assessment as a firm is first sought. Where certified copy is not filed with the return there is no provision for condonation of delay. However where the return itself is filed late then there is no problem if the certified copy is filed along with such return as the condition that it shall accompany the return of income is satisfied. Further Delhi ITAT in the case of Ishar Dass Sahini & Sons v CIT held that where uncertified Photostat copy of the instrument of partnership is submitted along with the return of income and the certified copy is produced at the time of assessment, it will satisfy this condition. 2. In the subsequent assessment years: If the above three conditions are satisfied the firm will be assessed as such (FAAS) in the first assessment year. Once the firm is assessed as firm for any assessment year, it shall be assessed in the same capacity for every subsequent year if there is no change in the constitution of the firm or the share of the partners. Where any such change had taken place in the previous year, the firm shall furnish a certified copy of the revised instrument of partnership along with the return of income for the assessment year relevant to such previous year. Read the box for some important points to be considered in this regard.

Circumstance where the firm will be assessed as a firm but shall not be eligible for deduction on account of interest, salary, bonus, etc. [Section 184(5)] The firm will be assessed as a firm but shall not be eligible for any deduction on account of interest, salary and bonus etc if there is failure on the part of the firm as is mentioned in Section 144 (relating to Best Judgment Assessment) and where the firm does not comply with the three conditions mentioned under Section 184.

Q.4 Ans.

List out the steps to compute total income.

Step 1 Determination of residential status The residential status of a person has to be determined to ascertain which income is to be included in computing the total income. The residential statuses as per the Income-tax Act are shown below In the case of an individual, the duration for which he is present in India determines his residential status. Based on the time spent by him, he may be (a) resident and ordinarily resident, (b) resident but not ordinarily resident, or (c) nonresident. The residential status of a person determines the taxability of the income. For e.g., income earned outside India will not be taxable in the hands of a non-resident but will be taxable in case of a resident and ordinarily resident. Step 2 Classification of income under different heads The Act prescribes five heads of income. These are shown below HEADS OF INCOME SALARIES INCOME FROM PROFITS AND GAINS CAPITAL INCOME HOUSE PROPERTY OF BUSINESS OR GAINS FROM OTHER PROFESSION SOURCES These heads of income exhaust all possible types of income that can accrue to or be received by the tax payer. Salary, pension earned is taxable under the head Salaries. Rental income is taxable under the head Income from house property. Income derived from carrying on any business or profession is taxable under the head Profits and gains from business or profession. Profit from sale of a capital asset (like land) is taxable under the head Capital Gains. The fifth head of income is the residuary head under which income taxable under the Act, but not falling under the first four heads, will be taxed. The tax payer has to classify the income earned under the relevant head of income. Step 3 - Exclusion of income not chargeable to tax There are certain income which are wholly exempt from income-tax e.g. Agricultural income. These income have to be excluded and will not form part of Gross Total Income. Also, some incomes are partially exempt from income-tax e.g. House Rent Allowance, Education Allowance. These incomes are excluded only to the extent of the limits specified in the Act. The balance income over and above the prescribed exemption limits would enter computation of total income and have to be classified under the relevant head of income. Step 4 - Computation of income under each head

Income is to be computed in accordance with the provisions governing a particular head of income. Under each head of income, there is a charging section which defines the scope of income chargeable under that head. There are deductions and allowances prescribed under each head of income. For example, while calculating income from house property, municipal taxes and interest on loan are allowed as deduction. Similarly, deductions and allowances are prescribed under other heads of income. These deductions etc. have to be considered before arriving at the net income chargeable under each head Step 5 Clubbing of income of spouse, minor child etc. In case of individuals, income-tax is levied on a slab system on the total income. The tax system is progressive i.e. as the income increases, the applicable rate of tax increases. Some taxpayers in the higher income bracket have a tendency to divert some portion of their income to their spouse, minor child etc. to minimize their tax burden. In order to prevent such tax avoidance, clubbing provisions have been incorporated in the Act, under which income arising to certain persons (like spouse, minor child etc.) have to be included in the income of the person who has diverted his income for the purpose of computing tax liability. Step 6 Set-off or carry forward and set-off of losses An assessee may have different sources of income under the same head of income. He might have profit from one source and loss from the other. For instance, an assessee may have profit from his textile business and loss from his printing business. This loss can be set-off against the profits of textile business to arrive at the net income chargeable under the head Profits and gains of business or profession. Similarly, an assessee can have loss under one head of income, say, Income from house property and profits under another head of income, say, Profits and gains of business or profession. There are provisions in the Income-tax Act for allowing inter-head adjustment in certain cases. Further, losses which cannot be set-off in the current year due to inadequacy of eligible profits can be carried forward for set-off in the subsequent years as per the provisions contained in the Act. Step 7 Computation of Gross Total Income. The final figures of income or loss under each head of income, after allowing the deductions, allowances and other adjustments, are then aggregated, after giving effect to the provisions for clubbing of income and set-off and carry forward of losses, to arrive at the gross total income. Step 8 Deductions from Gross Total Income There are deductions prescribed from Gross Total Income. These deductions are of three types. Step 9 Total income The income arrived at, after claiming the above deductions from the Gross Total Income is known as the Total Income. It is also called the Taxable Income. It should be rounded off to the nearest Rs. 10.

The process of computation of total income is shown hereunder Step 10 Application of the rates of tax on the total income The rates of tax for the different classes of assesses are prescribed by the Annual Finance Act. Taxation For individuals, HUFs etc., there is a slab rate and basic exemption limit. At present, the basic exemption limit is Rs. 1,00,000 for individuals. This means that no tax is payable by individuals with total income of up to Rs. 1,00,000. Those individuals whose total income is more than Rs. 1,00,000 but less than Rs. 1,50,000 have to pay tax on their total income in excess of Rs. 1,00,000 @ 10% and so on. The highest rate is 30%, which is attracted in respect of income in excess of Rs. 2,50,000. For firms and companies, a flat rate of tax is prescribed. At present, the rate is 30% on the whole of their total income. The tax rates have to be applied on the total income to arrive at the income-tax liability. Step 11 Surcharge Surcharge is an additional tax payable over and above the income-tax. Surcharge is levied as a percentage of income-tax. At present, the rate of surcharge for firms and domestic companies is 10% and for foreign companies is 2.5%. For individuals, surcharge would be levied @10% only if their total income exceeds Rs. 10 lakhs. Step 12 Education cess The income-tax, as increased by the surcharge, is to be further increased by an additional surcharge called education cess@2%. The Education cess on incometax is for the purpose of providing universalised quality basic education. This is payable by all assesses who are liable to pay income-tax irrespective of their level of total income. Step 13 - Advance tax and tax deducted at source Although the tax liability of an assessee is determined only at the end of the year, tax is required to be paid in advance in certain installments on the basis of estimated income. In certain cases, tax is required to be deducted at source from the income by the payer at the rates prescribed in the Act. Such deduction should be made either at the time of accrual or at the time of payment, as prescribed by the Act. For example, in the case of salary income, the obligation of the employer to deduct tax at source arises only at the time of payment of salary to the employees. Such tax deducted at source has to be remitted to the credit of the Central Government through any branch of the RBI, SBI or any authorized bank. If any tax is still due on the basis of return of income, after adjusting advance tax and tax deducted at source, the assessee has to pay such tax (called self-assessment tax) at the time of filing of the return Taxation

Q.5

Detail the important provisions under Wealth tax Act.

Ans. Wealth tax is not a very important or high revenue tax in view of various exemptions. Wealth tax is a socialistic tax. It is not on income but payable only because a person is wealthy. Wealth tax is payable on net wealth on valuation date. As per Section 2(q), valuation date is 31st March every year. It is payable by every individual, HUF and company. Tax rate is 1% on amount by which net wealth exceeds Rs 30 lakhs from AY 2010-11. (Till 31-3-2009, the limit was Rs 15 lakhs). No surcharge or education cess is payable. No wealth-tax is chargeable in respect of net wealth of any company registered under section 25 of the Companies Act, 1956; any co-operative society; any social club; any political party; and a Mutual fund specified under section 10(23D) of the Income-tax Act [section 45] Net wealth = Value of assets [as defined in section 2(ea] plus deemed assets (as defined in section 4) less exempted assets (as defined in section 5), less debt owed [as defined in section 2(m)]. Debt should have been incurred in relation to the assets which are included in net wealth of assessee. Only debt owed on date of valuation is deductible. In case of residents of India, assets outside India (less corresponding debts) are also liable to wealth tax. In case of non-residents and foreign national, only assets located in India including deemed assets less corresponding debts are liable to wealth tax [section 6]. Net wealth in excess of Rs. 30,00,000 is chargeable to wealth-tax @ 1 per cent (on surcharge and education cess). Assessment year - Assessment year means a period of 12 months commencing from the first day of April every year falling immediately after the valuation date [Section 2(d)] All.). 1-1 Assets Assets are defined in Section 2(ea) as follows. Guest house, residential house or commercial building - The following are treated as assets - (a) Any building or land appurtenant thereto whether used for commercial or residential purposes or for the purpose of guest house (b) A farm house situated within 25 kilometers from the local limits of any municipality (whether known as a municipality, municipal corporation, or by any other name) or a cantonment board [Section 2(ea)(i)] A residential house is not asset, if it is meant exclusively for residential purposes

of employee who is in whole-time employment and the gross annual salary of such employee, officer or director is less than Rs. 5,00,000. Any house (may be residential house or used for commercial purposes) which forms part of stock-in-trade of the assessee is not treated as asset. Any house which the assessee may occupy for the purposes of any business or profession carried on by him is not treated as asset. A residential property which is let out for a minimum period of 300 days in the previous year is not treated as an asset. Any property in the nature of commercial establishments or complex is not treated as an asset. Motor cars - Motor car is an asset, but not the following - (a) motor cars used by the assessee in the business of running them on hire (b) motor cars treated as stock-in-trade [Section 2(ea)(ii)]. In the case of a leasing company, motor car is an asset. Jewellery, bullion, utensils of gold, silver, etc. [Section 2(ea)(iii)] - Jewellery, bullion, furniture, utensils and any other article made wholly or partly of gold, silver, platinum or any other precious metal or any alloy containing one or more of such precious metals are treated as assets [Section 2(ea)(ii)] For this purpose, jewellery includes ornaments made of gold, silver, platinum or any other precious metal or any alloy containing one or more of such precious metals, and also precious or semi-precious stones, whether or not set in any furniture, utensils or other article or worked or sewn into any wearing apparel. Where any of the above assets (i.e., jewellery, bullion, utensils of gold, etc.) is used by an assessee as stock-in-trade, then such asset is not treated as assets under section 2(ea)(iii). Yachts, boats and aircrafts - Yachts, boats and aircrafts (other than those used by the assessee for commercial purposes) are treated as assets [Section 2(ea)(iv)] Urban land - Urban land is an asset [Section 2(ea)(v)] Urban land means land situated in the area which is comprised within the jurisdiction of a municipality and which has a population of not less than 10,000 according to the last preceding census. Land occupied by any building which has been constructed with the approval of the appropriate authority is not asset. Any unused land held by the assessee for industrial purposes for a period of 2 years from the date of its acquisition by him is not an asset. Any land held by the assessee as stock-in-trade for a period of 10 years from the date of its acquisition by him is also not an asset. Cash in hand - In case of individual and HUF, cash in hand on the last moment of the valuation date in excess of Rs. 50,000 is an asset. In case of companies, any amount not recorded in books of account is asset [Section 2(ea)(vi)]

1-2 Deemed assets Often, a person transfers his assets in name of others to reduce his liability of wealth tax. To stop such tax avoidance, provision of deemed asset has been made. In computing the net wealth of an assessee, the following assets will be included as deemed assets u/s 4. Assets transferred by one spouse to another - The asset is transferred by an individual after March 31, 1956 to his or her spouse, directly or indirectly, without adequate consideration or not in connection with an agreement to live apart will be deemed asset [Section 4(1)(a)(i)] If an asset is transferred by an individual to his/her spouse, under an agreement to live apart, the provisions of section 4(1)(a)(i) are not applicable. The expression to live apart is of wider connotation and even the voluntary agreements to live apart will fall within the exceptions of this sub-clause. Assets held by minor child - In computing the net wealth of an individual, there shall be included the value of assets which on the valuation date are held by a minor child (including step child/adopted child but not being a married daughter) of such individual [Section 4(1)(a)(ii)] The net wealth of minor child will be included in the net wealth of that parent whose net wealth [excluding the assets of minor child so includible under section 4(1)] is greater. Assets transferred to a person or an association of persons - An asset transferred by an individual after March 31, 1956 to a person or an association of person, directly or indirectly, for the benefit of the transferor, his or her spouse, otherwise than for adequate consideration, is deemed asset of transferor [Section 4(1)(a)(iii)] Assets transferred under revocable transfers - The asset is transferred by an individual to a person or an association of person after March 31, 1956, under a revocable transfer is deemed asset of transferor [Section 4(1)(a)(iv)] Assets transferred to sons wife [Section 4(1)(a)(v)] - The asset transferred by an individual after May 31, 1973, to sons wife, directly or indirectly, without adequate consideration will be deemed asset of transferor [Section 4(1)(a)(iv)] Assets transferred for the benefit of sons wife - If the asset is transferred by an individual after May 31, 1973, to a person or an association of the immediate or deferred benefit of sons wife, whether directly or indirectly, without adequate consideration, it will be treated as deemed asset of the transferor [Section 4(1) (a)(vi)]. Interest of partner- Where the assessee (may or may not be an individual) is a partner in a firm or a member of an association of persons, the value of his interest in the assets of the firm or an association shall be included in the net wealth of the partner/member. For this purpose, interest of partner/member in the firm or association of persons should be determined in the manner laid down in

Schedule III to the Wealth-tax Act [Section 4(1)(b)]. Admission of minor to benefits of the partnership firm - If a minor is admitted to the benefits of partnership in a firm, the value of his interest in the firm shall be included in the net wealth of parent of minor in accordance with the provisions of section 4(1)(a)(ii) [see para 546.2]. It will be determined in the manner specified in Schedule III. Conversion by an individual of his self-acquired property into joint family property - If an individual is a member of a Hindu undivided family and he converts his separate property into property belonging to his Hindu undivided family, or if he transfers his separate property to his Hindu undivided family, directly or indirectly, without adequate consideration, the converted or transferred property shall be deemed to be the property of the individual and the value of such property is includible in his net wealth [Section 4(1A)] If there was such transfer and if the converted or transferred property becomes the subject-matter of a total or a partial partition among the members of the family, the converted or transferred property or any part thereof, which is received by the spouse of the transferor, is deemed to be the asset of the transferor and is includible in his net wealth. Gifts by book entries - Where a gift of money from one person to another is made by means of entries in the books of account maintained by the person making the gift, or by an individual, or a Hindu undivided family, or a firm or an association of persons, or a body of individuals with whom he has business connection, the value of such gift will be included in the net wealth of the person making the gifts, unless he proves to the satisfaction of the Wealth-tax Officer that the money had actually been delivered to the other person at the time the entries were made [Section 4(5A)] Impartible estate - For the purpose of the Wealth-tax Act, the holder of an impartible estate shall be deemed to be the owner of all the properties comprised in the estate [Section 4(6)] Property held by a member of a housing society - Where the assessee is a member of a co-operative housing society and a building or part thereof is allotted or leased to him, the assessee is deemed to be the owner of such building and the value of such building is includible in computing his net wealth. In determining the value of such building, any outstanding instalments, payable by the assessee to the society towards the costs of such house, are deductible as debt owed by the assessee. The above rules are also applicable if the assessee is a member of a company or an association of persons [Section 4(7)] Property held by a person in part performance of a contract [Section 4(8)] A person who is allowed to take or retain possession of any building or part thereof in part performance of a contract of the nature referred to in section 53A of the Transfer of Property Act, 1882. Similarly, a person can acquire any rights, excluding any rights by way of a lease from month to month or for a period not exceeding one year, in or with respect to any building or part thereof, by virtue of transaction as is referred to in section 269UA(f) of the

Income-tax Act. In above cases, the assets are taxable in the hands of beneficial owners, in the same manner in which they are taxed under the Income-tax Act :

1-3 Assets which are exempt from tax The following assets are exempt from wealth-tax, as per section 5. Property held under a trust - Any property held by an assessee under a trust or other legal obligation for any public purpose of charitable or religious nature in India is totally exempt from tax. [Section 5(i)]. Business assets held in trust, which are exempt - The following business assets held by as assessee under a trust for any public charitable/religious trust are exempt from tax - (a) where the business is carried on by a trust wholly for public religious purposes and the business consists of printing and publication of books or publication of books or the business is of a kind notified by the Central Government in this behalf in the Official Gazette (b) the business is carried on by an institution wholly for charitable purposes and the work in connection with the business is mainly carried on by the beneficiaries of the institution (c) the business is carried on by an institution, fund or trust specified in sections 10(23B) or 20(23C) of the Income-tax Act. Any other business assets of a public charitable/religious trust is not exempt. Coparcenary interest in a Hindu undivided family - If the assessee is a member of a Hindu undivided family, his interest in the family property is totally exempt from tax [Section 5(ii)]. Residential building of a former ruler - The value of any one building used for the residence by a former ruler of a princely State is totally exempt from tax [Section 5(iii)] Former rulers jewellery - Jewellery in possession of a former ruler of a princely State, not being his personal property which has been recognised as a heirloom is totally exempt from tax [Section 5(iv)] The jewellery shall be permanently kept in India and shall not be removed outside India except for a purpose and period approved by the Board. Reasonable steps shall be taken for keeping that jewellery substantially in its original shape. Reasonable facilities shall be allowed to any officer of the Government, or authorised by the Board, to examine the jewellery as and when necessary.

Assets belonging to the Indian repatriates - Assets (as given below) belonging to assessee who is a person of Indian origin or a citizen of India, who was ordinarily residing in a foreign country and who has returned to India with intention to permanently reside in India, is exempt. A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grand-parents, was born in undivided India. After his return to India, following shall not be chargeable to tax for seven successive assessment years - (a) moneys brought by him into India (b) value of asset brought by him into India (c) moneys standing to the credit of such person in a Non-resident (External) Account in any bank in India on the date of his return to India and (d) value of assets acquired by him out of money referred to in (a) and (c) above within one year prior to the date of his return and at any time thereafter [Section 5(v)] One house or part of a house - In the case of an individual or a Hindu undivided family, a house or a part of house, or a plot of land not exceeding 500 sq. meters in area is exempt. A house is qualified for exemption, regardless of the fact whether the house is self-occupied or let out. In case a house is owned by more than one person, exemption is available to each co-owner of the house [Section 5(vi)]

Q.6 What is meant by Full value of consideration? How short term capital gains and long term capital gains are computed using full value of consideration? Ans. Full value of consideration means & includes the whole/complete sale price or exchange value or compensation including enhanced compensation received in respect of capital asset in transfer. The following points are important to note in relation to full value of consideration. 36 The consideration may be in cash or kind. 37 The consideration received in kind is valued at its fair market 38 value. 39 It may be received or receivable. 40 The consideration must be actual irrespective of its adequacy. COST OF ACQUISITION Cost of Acquisition (COA) means any capital expense at the time of acquiring capital asset under transfer, i.e., to include the purchase price, expenses incurred up to acquiring date in the form of registration, storage etc. expenses incurred on completing transfer. In other words, cost of acquisition of an asset is the value for which it was acquired by the assessee. Expenses of capital nature for completing or acquiring the title are included in the cost of acquisition.

Indexed Cost of Acquisition = COA X CII of Year of transfer CII of Year of acquisition The indices for the various previous years are given below: S.No. Fin. Year Cost S.No. Fin. Year Inflation Index 1 1981-82 100 15 1995-96 2 1982-83 109 16 1996-97 3 1983-84 116 17 1997-98 4 1984-85 125 18 1998-99 5 1985-86 133 19 1999-2000 6 1986-87 140 20 2000-01 7 1987-88 150 21 2001-02 8 1988-89 161 22 2002-03 9 1989-90 172 23 2003-04 10 1990-91 182 24 2004-05 11 1991-92 199 25 2005-06 12 1992-93 223 26 2006-07 13 1993-94 244 27 2007-08 14 1994-95 259 Cost Inflation Index 281 305 331 351 389 406 426 447 463 480 497 519 551

If capital assets were acquired before 1.4.81, the assesses has the option to have either actual cost of acquisition or fair market value as on 1.4.81 as the cost of acquisition. If assesses chooses the value as on 1.4.81 then the indexation will also be done as per the CII of 1981 and not as per the year of acquisition. COST OF IMPROVMENT Cost of improvement is the capital expenditure incurred by an assessee for making any addition or improvement in the capital asset. It also includes any expenditure incurred in protecting or curing the title. In other words, cost of improvement includes all those expenditures, which are incurred to increase the value of the capital asset. Indexed Cost of improvement = COA X CII of Year of transfer CII of Year of improvement Any cost of improvement incurred before 1st April 1981 is not considered or it is ignored. The reason behind it is that for carrying any improvement in asset before 1st April 1981, asset should have been purchased before 1st April 1981. If asset is purchased before 1st April we consider the fair market value. The fair market value of asset on 1st April 1981 will certainly include the improvement made in the asset. Provisions for computation of Capital Gain

Provisions under section 48 The income under the head Capital Gains shall be computed by deducting the following from the full value of the consideration received or accrued as a result of the transfer of the capital asset : 41 Expenditure incurred wholly and exclusively in connection with such transfer. 42 The cost of acquisition of the asset and the cost of any improvement thereto. Computation of Short Term Capital Gains From full value of consideration, deduct 43 Expenditure incurred wholly and in exclusively 44 Cost of acquisition 45 Cost of any improvement of asset Computation of Long Term Capital Gains From full value of consideration, deduct 46 Expenditure incurred wholly and in exclusively connection with the transfer 47 Indexed cost of acquisition of asset 48 Indexed cost of any improvement of asset

MF 0013 Internal Audit and Control Set- 2

Q.1 Why Internal check in necessary? Choose an organization of your choice and find out how internal checks are put in place. Ans. In accounting and auditing, internal control is defined as a process effected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives.[1] It is a means by which an organization's resources are directed, monitored, and measured. It plays an important role in preventing and detecting fraud and protecting the organization's resources, both physical (e.g., machinery and property) and intangible (e.g., reputation or intellectual property such as trademarks). At the organizational level, internal control objectives relate to the reliability of financial reporting, timely feedback on the achievement of operational or strategic goals, and compliance with laws and regulations. At the specific transaction level, internal control refers to the actions taken to achieve a specific objective (e.g., how to ensure the organization's payments to third parties are for valid services rendered.) Internal control procedures reduce process variation, leading to more predictable outcomes. Internal control is a key element of the Foreign Corrupt Practices Act (FCPA) of 1977 and the SarbanesOxley Act of 2002, which required improvements in internal control in United States public corporations. Internal controls within business entities are also referred to as operational controls. Internal controls have existed from ancient times. In Hellenistic Egypt there was a dual administration, with one set of bureaucrats charged with collecting taxes and another with supervising them.[2] In the Republic of China, the Control one of the

five branches of government, is an investigatory agency that monitors the other branches of government. Definitions There are many definitions of internal control, as it affects the various constituencies (stakeholders) of an organization in various ways and at different levels of aggregation. Under the COSO Internal Control-Integrated Framework, a widely-used framework in the United States, internal control is broadly defined as a process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: a) Effectiveness and efficiency of operations; b) Reliability of financial reporting; and c) Compliance with laws and regulations. COSO defines internal control as having five components: 1. Control Environment-sets the tone for the organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control. 2. Risk Assessment-the identification and analysis of relevant risks to the achievement of objectives, forming a basis for how the risks should be managed 3. Information and Communication-systems or processes that support the identification, capture, and exchange of information in a form and time frame that enable people to carry out their responsibilities 4. Control Activities-the policies and procedures management directives are carried out. that help ensure

5. Monitoring-processes used to assess the quality of internal control performance over time. The COSO definition relates to the aggregate control system of the organization, which is composed of many individual control procedures. Discrete control procedures, or controls are defined by the SEC as: "...a specific set of policies, procedures, and activities designed to meet an objective. A control may exist within a designated function or activity in a process. A controls impact...may be entity-wide or specific to an account balance, class of transactions or application. Controls have unique characteristics for example, they can be: automated or manual; reconciliations; segregation of duties; review and approval authorizations; safeguarding and accountability of assets; preventing or detecting error or fraud. Controls within a process may consist of financial reporting controls and operational controls (that is, those designed to

achieve operational objectives)."[3] Context More generally, setting objectives, budgets, plans and other expectations establish criteria for control. Control itself exists to keep performance or a state of affairs within what is expected, allowed or accepted. Control built within a process is internal in nature. It takes place with a combination of interrelated components - such as social environment effecting behavior of employees, information necessary in control, and policies and procedures. Internal control structure is a plan determining how internal control consists of these elements.[4] The concepts of corporate governance also heavily rely on the necessity of internal controls. Internal controls help ensure that processes operate as designed and that risk responses (risk treatments) in risk management are carried out. In addition, there needs to be in place circumstances ensuring that the aforementioned procedures will be performed as intended: right attitudes, integrity and competence, and monitoring by managers.

Roles and responsibilities in internal control According to the COSO Framework, everyone in an organization has responsibility for internal control to some extent. Virtually all employees produce information used in the internal control system or take other actions needed to affect control. Also, all personnel should be responsible for communicating upward problems in operations, noncompliance with the code of conduct, or other policy violations or illegal actions. Each major entity in corporate governance has a particular role to play: Management: The Chief Executive Officer (the top manager) of the organization has overall responsibility for designing and implementing effective internal control. More than any other individual, the chief executive sets the "tone at the top" that affects integrity and ethics and other factors of a positive control environment. In a large company, the chief executive fulfills this duty by providing leadership and direction to senior managers and reviewing the way they're controlling the business. Senior managers, in turn, assign responsibility for establishment of more specific internal control policies and procedures to personnel responsible for the unit's functions. In a smaller entity, the influence of the chief executive, often an owner-manager, is usually more direct. In any event, in a cascading responsibility, a manager is effectively a chief executive of his or her sphere of responsibility. Of particular significance are financial officers and their staffs, whose control activities cut across, as well as up and down, the operating and other units of an enterprise. Board of Directors: Management is accountable to the board of directors, which

provides governance, guidance and oversight. Effective board members are objective, capable and inquisitive. They also have a knowledge of the entity's activities and environment, and commit the time necessary to fulfill their board responsibilities. Management may be in a position to override controls and ignore or stifle communications from subordinates, enabling a dishonest management which intentionally misrepresents results to cover its tracks. A strong, active board, particularly when coupled with effective upward communications channels and capable financial, legal and internal audit functions, is often best able to identify and correct such a problem. Auditors: The internal auditors and external auditors of the organization also measure the effectiveness of internal control through their efforts. They assess whether the controls are properly designed, implemented and working effectively, and make recommendations on how to improve internal control. They may also review Information technology controls, which relate to the IT systems of the organization. There are laws and regulations on internal control related to financial reporting in a number of jurisdictions. In the U.S. these regulations are specifically established by Sections 404 and 302 of the Sarbanes-Oxley Act. Guidance on auditing these controls is specified in PCAOB Auditing Standard No. 5 and SEC guidance, further discussed in SOX 404 top-down risk assessment. To provide reasonable assurance that internal controls involved in the financial reporting process are effective, they are tested by the external auditor (the organization's public accountants), who are required to opine on the internal controls of the company and the reliability of its financial reporting. Limitations Internal control can provide reasonable, not absolute, assurance that the objectives of an organization will be met. The concept of reasonable assurance implies a high degree of assurance, constrained by the costs and benefits of establishing incremental control procedures. Effective internal control implies the organization generates reliable financial reporting and substantially complies with the laws and regulations that apply to it. However, whether an organization achieves operational and strategic objectives may depend on factors outside the enterprise, such as competition or technological innovation. These factors are outside the scope of internal control; therefore, effective internal control provides only timely information or feedback on progress towards the achievement of operational and strategic objectives, but cannot guarantee their achievement. Describing Internal Controls Internal controls may be described in terms of: a) the objective they pertain to; and b) the nature of the control activity itself. Objective categorization Internal control activities are designed to provide reasonable assurance that

particular objectives are achieved, or related progress understood. The specific target used to determine whether a control is operating effectively is called the control objective. Control objectives fall under several detailed categories; in financial auditing, they relate to particular financial statement assertions,[5] but broader frameworks are helpful to also capture operational and compliance aspects: 1. Existence (Validity): Only valid or authorized transactions are processed (i.e., no invalid transactions) 2. Occurrence (Cutoff): Transactions occurred during the correct period or were processed timely. 3. Completeness: All transactions are processed that should be (i.e., no omissions) 4. Valuation: Transactions are calculated using an appropriate methodology or are computationally accurate. 5. Rights & Obligations: Assets represent the rights of the company, and liabilities its obligations, as of a given date. 6. Presentation & Disclosure (Classification): Components of financial statements (or other reporting) are properly classified (by type or account) and described. 7. Reasonableness-transactions or results appears reasonable relative to other data or trends. For example, a control objective for the accounts payable function may be stated as: "Payments are made only for authorized products and services received." This is a validity objective. A typical control procedure designed to achieve this objective is: "The accounts payable system compares the purchase order, receiving record, and vendor invoice prior to authorizing payment." Multiple controls may be applicable to achieve a given control objective with a reasonable level of assurance. Management is responsible for implementing appropriate controls that apply to transactions in their areas of responsibility. Internal auditors perform their audits to evaluate whether the controls are designed and implemented effectively to address the relevant objectives. Activity categorization Control activities may also be explained by the type or nature of activity. These include (but are not limited to):

Segregation of duties - separating authorization, custody, and record keeping roles of fraud or error by one person.

Authorization of transactions - review of particular transactions by an appropriate person. Retention of records - maintaining documentation to substantiate transactions. Supervision or monitoring of operations - observation or review of ongoing operational activity. Physical safeguards - usage of cameras, locks, physical barriers, etc. to protect property, such as merchandise inventory. Top-level reviews-analysis of actual results versus organizational goals or plans, periodic and regular operational reviews, metrics, and other key performance indicators (KPIs). IT Security - usage of passwords, access logs, etc. to ensure access restricted to authorized personnel. Top level reviews-Management review of reports comparing actual performance versus plans, goals, and established objectives. Controls over information processing-A variety of control activities are used in information processing. Examples include edit checks of data entered, accounting for transactions in numerical sequences, comparing file totals with control accounts, and controlling access to data, files and programs.

Control precision Control precision describes the alignment or correlation between a particular control procedure and a given control objective or risk. A control with direct impact on the achievement of an objective (or mitigation of a risk) is said to be more precise than one with indirect impact on the objective or risk. Precision is distinct from sufficiency; that is, multiple controls with varying degrees of precision may be involved in achieving a control objective or mitigating a risk. Precision is an important factor in performing a SOX 404 top-down risk assessment. After identifying specific financial reporting material misstatement risks, management and the external auditors are required to identify and test controls that mitigate the risks. This involves making judgments regarding both precision and sufficiency of controls required to mitigate the risks. Risks and controls may be entity-level or assertion-level under the PCAOB guidance. Entity-level controls are identified to address entity-level risks. However, a combination of entity-level and assertion-level controls are typically identified to address assertion-level risks. The PCAOB set forth a three-level hierarchy for considering the precision of entity-level controls.[6] Later guidance by the PCAOB regarding small public firms provided several factors to consider

in assessing precision.[7] Fraud and internal control Internal control plays an important role in the prevention and detection of fraud.[8] Under the Sarbanes-Oxley Act, companies are required to perform a fraud risk assessment and assess related controls.[9] This typically involves identifying scenarios in which theft or loss could occur and determining if existing control procedures effectively manage the risk to an acceptable level.[10] The risk that senior management might override important financial controls to manipulate financial reporting is also a key area of focus in fraud risk assessment.[11] The AICPA, IIA, and ACFE also sponsored a guide published during 2008 that includes a framework for helping organizations manage their fraud risk.[12] Internal Controls and Improvement If the internal control system is implemented only to prevent fraud and comply with laws and regulations, then an important opportunity is missed. The same internal controls can also be used to systematically improve businesses, particularly in regard to effectiveness and efficiency.[13] Continuous Controls Monitoring Advances in technology and data analysis have led to the development of numerous tools which can automatically evaluate the effectiveness of internal controls. Used in conjunction with continuous auditing, continuous controls monitoring provides assurance on financial information flowing through the business processes. Q.2 Detail the specific problems of electronic data process relating to Internal control. Ans. In an EDP system, the following implementation of internal control : problems arise in the

49 Separation of duties : In a manual system, separate individuals are responsible for initiating transactions, recording transactions, and custody of assets. As a basic control, separation of duties prevents of detects errors and irregularities. In a computer system, however, the traditional notion of separation of duties does not always apply. For example, as program may reconcile a vendor invoice against a receiving document and print a cheque for the amount owed to a creditor. Thus, this program is performing functions that in a manual systems would be considered incompatible. In a minicomputer and microcomputer environments, separation

of incompatible functions may be even more difficult to achieve. Some minicomputers and microcomputers allow users to change programs and data easily; furthermore, they provide no record of these changes. If the minicomputer or microcomputer does not have an inbuilt capability to provide a secure record of changes. It may be difficult to determine whether incompatible functions have been performed by system users. 50 Delegation of authority and responsibility : A clear line of authority and responsibility is an essential control in both manual and computer systems. In a computer system, however, delegating authority and responsibility in an unambiguous way may be difficult because some resources are shared among multiple users. For example, one of the objectives of using a database management system is to provide multiple users with access to the same data, thereby reducing the control problems that arise with maintaining redundant data. When multiples users have access to the same data and integrity of the data is somehow violated, it is not always easy to trace who is responsible for corrupting the data and who is responsible for identifying and correcting the error. Some organizations have attempted to overcome these problems by designating a single user as the owner of data. This user assumes ultimate responsibility for the integrity of the data. 51 Competent and trustworthy personnel : The technology of data processing is now exceedingly complex much more complex than in the days of manual systems. Highly skilled personnel are needed to develop, modify. maintain and operate todays computer systems. Thus, the existence of competent and trustworthy personnel becomes even more important when computer systems are used to process an organizations data, since a relatively small number of individuals assume major responsibility for the integrity of the data. Unfortunately, assuring that an organization has competent and trustworthy data processing personnel has been a difficult task. Historically, well trained and experienced data processing personnel have been in short supply. Therefore, organizations sometimes have been forced to compromise in their choice of staff. Moreover, it Is not always easy for an organization to assess the competence and integrity of its EDP staff. High turnover in the data processing industry has been the norm, and the rapid evolution of technology inhibits managements ability to evaluate an employees skills.

52 System of authorizations : Management issues two types of authorizations to execute transactions. General authorizations establish policies for the organization to follow. For example, a fixed price list is issued for personnel to use when products are sold. Specific authorizations apply to individual transactions : for example, acquisitions of major capital assets may have to be approved by the board of directors. In a manual system, auditors evaluate the adequacy of procedures for authorization by examining the work of employees. In a computer system, authorization procedures often are embedded within a computer program. For example, the order entry module in a sales system may determine the price to be charged to a customer. Thus, when evaluating the adequacy of authorization procedures, auditors have to examine not only the work of employees but also the veracity of program processing. 53 Adequate documents and records : In a manual system, adequate documents and records are necessary to provide an audit trail of activities within the system. In computer systems, documents may not be used to support the initiation, execution and recording of some transactions. For example, in an online order entry system customers orders received by telephone may be entered directly into the system. Similarly, some transactions may be activated automatically by a computer system : for example, an inventory replenishment program may initiate purchase orders when stock levels fall below a set amount. Thus, no visible audit or management trail may be available to trace the transaction. The absence of a visible audit trail is not a problem for the auditor provided that systems have been designed to maintain a record of all events and there is a means of accessing these records. In a well designed computer systems. Audit trails are often more extensive than those maintained in manual systems. Unfortunately, not all computer systems are well designed. Some minicomputer and microcomputer software packages for example, provide inadequate access controls and logging facilities to ensure preservation of an accurate and complete audit trail. When this situation is coupled with a decreased ability to separate incompatible functions, serious control problems can arise. 54 Physical control over assets and records : Physical control over access to assets and records is critical in both manual

systems and computer systems. Computer systems differ from manual systems, however, in the way they concentrate the data processing assets and records of an organization. For example, in a manual system, a person wishing to perpetrate a fraud may be maintained at a single site the data processing installation. Thus, the perpetrator does not have to go to physically distance locations to execute the fraud. This concentration of data processing assets and records also increases the loss that can arise from computer abuse or a disaster. For example, a fire that destroys a computer room may result in the loss of all major master files in an organization. If the organization does not have suitable backup, it may be unable to continue operations. 55 Adequate management supervision : In a manual system, management supervision of employee activities is relatively straight forward because managers and employees are often at the same physical location. In computer systems, however, data communications may be used to enable employees to be closer to the customers they service. Thus, supervision of employees may have to be carried out remotely. Supervisory controls must be built into the computer system to compensate for the controls that usually can be exercised through observation and inquiry. 56 Comparing recorded accountability with assets : Periodically, data and the assets that the data purports to represent should be compared to determine whether incompleteness or inaccuracies in the data exist or shortages in the assets have occurred. In a manual system, independent staff prepares the basic data used for comparison purposes. In a computer system, however, programs are used to prepare this data. For example, programs may sort an inventory file by warehouse location and prepare counts by inventory item at different warehouses. If unauthorized modifications occur to the programs or data files that the programs use, an irregularity may not be discovered. Q.3 Explain the principal considerations in internal control on: a. Purchases and creditors b. Fixed assets

Ans. a. Purchases and creditors Basic considerations for having an effective internal control system for Purchase and creditors are as follows :

57 The procedure for issuing purchase requisitions should be specified. 58 Where tenders are invited, the procedure for opening and acceptance thereof should be laid down. 59 The preparation and authorization of purchase orders should be under a senior manager. 60 Predetermine guidelines should exist for inspection of goods received, especially with regard to quantity and quality. 61 Documents showing the receipt and acceptance of goods should also be send to the accounts department. 62 The goods receipt documents should be cross checked with final purchase order. 63 An authorize official from the accounts department should be made responsible for checking suppliers invoices, documents regarding purchase returns, purchase records, payments to suppliers, maintenance of ledger accounts and reconciliation of statements sent by suppliers. 64 Before payments are made to suppliers, payment documents duly authorized by a senior official, showing that the goods have been received as specified in the purchase order should be verified by the accounts department. 65 Adequate procedures should be established with regard to purchase returns, discounts on account of inferior quality of goods, and other similar adjustments. 66 Lawful policies and procedures should be implemented with regard to purchases from the companies under the same group and from the employees. 67 The accounts of various suppliers should be confirmed periodically from statements received from them. b. Fixed assets Basic considerations for having an effective internal control system for Fixed Assets are as follows : 68 Payments for fixed assets should be made only after authorization of the top management. 69 Capital expenditure budget should be prepared regularly. 70 Fixed assets registers should be maintained showing brief particulars of all items. 71 Fixed assets should be physically verified periodically. Serial numbers should be allotted to each item for easy identification. 72 Proper accounting records should be maintained for expenditure during the construction period distinguishing carefully between capital and revenue expenditure.

73 Sale, scrapping, or write off of fixed assets should be allowed only under proper authorization of the top management. The receipts from such disposals should be properly accounted for. 74 Depreciation rates should be properly authorized. Q.4 Explain the steps of evaluating internal control system using flow chart Ans. The different steps undertaken by the auditor for evaluating the system of internal control has been illustrated through Figure: 11.1 (adapted from Contemporary Audit by Kamal Gupta) below:

Study and Evaluation of Internal Controls an Illustration Now, let us discuss the steps of evaluating internal control system which are as follows: i) Understanding the system: At first the auditor should understand the internal control system with the purpose to have an idea of the flow of transactions and the various controls procedures. This will help him to pinpoint those internal controls on which he might base in doing his audit. To understand the internal control system, it may be useful to choose a few transactions through the system. The auditor should also ascertain whether the internal controls were effective and efficient throughout the period under audit. Organization charts, procedure manuals, job description, and flow charts etc. are some of the tools to have an idea about internal controls system. The auditor can also discuss with different officials of organization. Sometimes, he may have to rely on direct observations and inquiry only. The auditor should, especially in the case of first audit, maintain a detailed written record of his observations on the internal controls system. ii) Test through compliance procedures: Having reviewed the system, the auditor may select the specific controls on which he intends to rely and which, therefore, need to be tested through compliance procedures. He may decide not to rely on certain internal controls which are defective in design, or reliance on which may not be cost effective. It is important to test the application of internal controls in practice. For example, an auditor may take up a few sales bills at random and examine all the related documents right from the order of the customer to the payment received from the customer. At each stage, the auditor would see whether the transaction has taken place as stipulated in the flow chart or in the procedure manual. Thus, if the flow chart prescribes that the detail terms and condition of each order of customer has to be verified by a particular manager, the auditor should examine whether or not this has been done in practice.

The objective of compliance tests is to provide a fair confidence to the auditor that the internal controls procedures are being effective as prescribed. The auditor should carry out such tests in case of all procedures on which audit reliance is intended to be placed. Tests of compliance are concerned primarily with the following questions: - Were the necessary procedures complied with? - How were they complied with? - By whom they were complied with? iii) Evaluating the system: Based on his observation during the tests made by him, the auditor has to make an estimate of how far he can depend on various internal controls. Normally, he should have a reasonable confidence that the system is such that the errors and fraud can be discovered automatically. He has to ascertain whether the control procedures as designed to implement are in practice and competent in preventing or detecting material errors and fraud in the accounting system. This is essentially a question of individual judgment in a particular situation. If he finds certain errors or weaknesses in the system, he should try to evaluate the impact of the same on various transactions. Let us suppose he finds weaknesses in the system of maintaining debtors ledger. Since this is a material item, he should ask for independent confirmations from the debtors. Thus, the auditors evaluation of internal control system will determine the nature, timing and extent of his substantive procedures.

Q.5 Lehman Brothers Holding filed for Chapter 11 bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock and devaluation of its assets. In context with this case, examine internal control and risk assessment system. Ans. The nature and extent of the procedures performed by the auditor to obtain an understanding of the accounting and internal control systems generally depend on : 75 76 77 78 79 Nature of policies or kind of procedures, Changes in operating environment, Size and complexity of the business, Way of documentation of business operations, Auditors assessment of inherent risk.

The auditor should make a study of internal control relevant for his

audit. Although most controls related to audit are relevant for financial reporting but all controls relevant for financial reporting may not be relevant for audit. It is the judgment of auditor to decide whether a control individually or in combination with other is relevant for audit or not. Auditor normally classified audit risk for assessment into control risk and inherent risk. Control risk signifies that a material misstatement could occur but would not be prevented or detected by internal control system. Inherent risk signifies the chances that recording of transactions have been done either erroneously or under the influence of management fraudulent activity. Assessment of control risk Assessing control risk is the process of evaluating the effectiveness of an entitys accounting an internal control systems in preventing or detecting material mis-statements in the financial statements. After having a basic idea of the accounting and internal control system, the auditor should make an initial assessment of control risk for the appropriate assertions in the financial statements. When planning the audit approach, the auditor should consider the initial assessment of control risk to determine the appropriate detection risk to accept for the financial statement assertions. Some of the procedures performed to obtain understanding of the accounting and internal control systems may not have been specifically planned as tests of control but they may provide evidence about the effectiveness of both the design and operation of policies and procedures relevant to certain assertions and, consequently, serve as tests of control e.g. in obtaining understanding of the system pertaining to cash, the auditor may have obtained evidence about the effectiveness of bank reconciliation process through inquiry and observation. Relationship between the assessments of inherent and control risks : In many cases, inherent risk and control risk are highly interrelated. Also management often reacts to inherent risk situations by designing accounting and internal control systems to prevent and detect misstatements in such situations, if the auditor attempts separately to

assess inherent and control risk when they are highly interrelated, there is a possibility of inappropriate risk assessment. As a result, audit risk may be more appropriately determined in such situation by making a combined assessment. The auditor, in forming his opinion on financial information, needs reasonable assurance that transactions are properly recorded in the accounting records and that transactions have not been omitted. Internal controls, even if fairly simple and unsophisticated, may contribute to the reasonable assurance the auditor seeks. The auditors control risk assessment, together with the inherent risk assessment, influences the nature, timing and extent to substantive procedures to be performed to reduce detection risk to an acceptable level. The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any substantive procedure for significant account balance and transaction classes. Consequently, regardless of the assessed levels of inherent and control risks the auditor should perform some substantive procedures. The higher the assessment of inherent and control risk, the more assurance the auditor must obtain from the performance of substantive procedures. When both inherent and control risks are assessed at a high level, the auditor should also consider whether substantive procedures will provided sufficient assurance to reduce detection risk to an acceptable level. When the auditor determines that detection risk cannot be reduced to an acceptable level, he should either qualify or disclaim the opinion or, if this if not practicable, withdraw from the engagement. Q.6 Explain the importance of working papers.

Ans. The importance of working papers is due to following reasons : 80 Planning, organization, control and review of audit work : Working papers provide a means of planning, organizing, controlling, administering and review of the work. They are the supporting evidence that the audit was conducted as per the generally accepted, auditing standards and practices. 81 Basis of auditors opinion : Working papers are the basic documents for the report of the auditor. They also provide a proof that generally accepted auditing standards and practices have been duly followed in the conduct of work. If the validity of the auditors opinion, assertion or

recommendation as to the financial statements is later questioned, working papers can be produced as an evidence to establish the said opinion or assertion. The auditor should therefore ensure that the working papers are conclusive and complete in every respect, leaving no question raised therein unanswered. 82 Division of labor : Working papers help in appropriate division of work among the audit stag, in the sense that different working papers may be made the responsibility of different audit clerks under the supervision of a senior clerk or the auditor himself. The progress of the work can thus be effectively monitored even where the audit work extends to different offices or branches of monitored. Even where the audit work extends to different offices or branches of the client, the audit programmes may be divided into so many parts, or separate audit programmes may be prepared for each place, and then working papers prepared at each place may be complied at the central office to have an overall view of the work. 83 Use as permanent record : Working papers constitute a permanent record of auditing procedure employed, and the financial records examined. The client can make use of these, in case his own records are lost. 84 Bridge between original transactions and financial statements : Working papers provide an important link between original transactions and the financial statements. This is because an auditors work mostly consists in tracing the business transactions, though on a sample basis, from the original records to the financial statements, and vice versa. Working papers also constitute the basis for making rectification and adjustment entries. 85 Basis for review and revision of internal controls : Internal control questionnaires form part of the working papers. Comments as to the working of the internal control system will also be found in working papers relating to audit tests in respect of each aspect of the enterprise. Thus, working papers facilitate an in-depth review of the internal control system, which forms the basis of recommending suitable changes therein. 86 Basis for evaluation and training of audit staff : Working papers provide a means to test whether the auditor and his staff have done their jobs as per the required standards. They serve as an index to the auditors ability to plan and organize the audit, because at teach stage of audit, he has to take decision as to the nature of evidence to be obtained and the

tests to which evidence should be subjected. Review of the past years working papers and reports submitted by senior audit clerks can also be used as a basis to provide the required training to the staff. 87 Basis for further work : In the course of his examination, the auditor may come across certain situations or conditions in the pattern of management of the clients business which, though not directly connected with his work and, therefore, being outside the purview of his report, may nevertheless be useful in future planning. Thus, the notes and analysis prepared by the auditor as part of his working papers may also prove useful to the client in several other areas.