ADVANCED ACCOUNTING

B.Com
Third Year
302

SAVITRIBAI PHULE PUNE UNIVERSITY

School of Open Learning
(Distance Education Program)
Authors:
Dr. S.N. Maheshwari, Professor Emeritus and Academic Advisor, Delhi Institute of Advanced Studies, Delhi
Dr. Suneel K. Maheshwari, Professor of Accounting, Eberly College of Business and Information Technology, Indiana University of
Pennsylvania, USA
CA Sharad K. Maheshwari, Maheshwari Sharad & Co. Chartered Accountants, Gurugram, Haryana
Units (1-8)

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SYLLABI-BOOK MAPPING TABLE
Advanced Accounting
Syllabi Mapping in Book

Unit 1: Accounting Standards & Financial Reporting Unit 1: Accounting Standards &
– Brief Review of lndian Accounting Standards Financial Reporting
(Pages 1-25)
– Introduction to AS-3. AS-12 and AS-19 with simple numerical.
– Introduction to IFRS - Fair Value Accounting.

Unit 2: Accounting for Capital Restructuring (Internal Unit 2: Accounting for Capital
Reconstruction) Restructuring (Internal
– Meaning and Concept of Capital Restructuring. Types of Reconstruction)
Capital Restructuring, Meaning & of Internal Reconstruction (Pages 27-48)
– Accounting Entries: Alteration of Share Capital, Reduction of
Share Capital, Reduction in Liabilities. Cancellation of
Expenses, Losses etc.
– Preparation of Balance Sheet after lnternal Reconstruction

Unit 3: Final Accounts of Banking Companies Unit 3: Final Accounts of Banking

– Introduction of Banking Company, Legal Provisions regarding Companies
Non-Performing Assets (NPA) - Reserve Fund - Acceptance, (Pages 49-111)
Endorsements & Other Obligations - Bills for Collection -
Rebate on Bills Discounted - Provision for Bad and Doubtful
Debts
– Vertical form of Final Accounts as per Banking Regulation Act
1949.
– Simple Numerical on preparation of Profit & Loss A/C and
Balance Sheet in Vertical Form

Unit 4: lnvestmcnt Accounting Unit 4: Investment Accounting

– Meaning & lntroduction, Classification of Investments, (Pages 113-122)
– Meaning & Calculation of the Concept of Acquisition Cost &
Carrying Cost of Investment,
– Calculation of Profit/loss on disposal of investments.

Unit 5: Final Accounts of Co-operative Societies Unit 5: Final Accounts of

– Meaning and Introduction, Co-operative Societies
– Allocation of Profit as per Maharashtra State Co-operative (Pages 123-130)
Societies Act.
– Preparation of Final Accounts of Credit Co-op. Societies &
Consumer Co-op. Societies
Unit 6: Branch Accounting Unit 6: Branch Accounting
– Concept of Branches & their Classification from (Pages 131-170)
accounting point of view.
– Accounting treatment of dependent branches &
independent branches.
– Methods of charging goods to branches.

Unit 7: Recent Trends in Accounting Unit 7: Recent Trends in Accounting

(Pages 171-189
– Forensic Accounting
– Accounting for Corporate Social Responsibility
– Accounting for Derivative Contracts
– Artificial Intelligence in Accow1ting

Unit 8: Analysis of Financial Statements Unit 8: Analysis of Financial

– Ratio Analysis: Meaning - Objectives - Nature of Ratio Statements
analysis, Types of Ratios - Profitability, Liquidity, (Pages 191-229
Leverage etc.
– Simple Problems on following Ratios: - Gross Profit, -
Net Profit, - Operating, - Stock Turnover, - Debtors
Turnover, - Creditors Turnover, - Current Ratio, Liquid
Ratio, - Debt- Equity Ratio, - Working Capital to Net
worth, Assets Turnover Ratio.
CONTENTS

UNIT 1 ACCOUNTING STANDARDS & FINANCIAL REPORTING 1–25

1.0 Introduction
1.1 Objectives
1.2 Brief Review of Indian Accounting Standards
1.2.1 Introduction to AS-3, AS-12 and AS-19
1.2.2 Simple Numericals on AS-3, AS-12 and AS-19
1.3 Introduction to IFRS
1.3.1 Fair Value Accounting
1.4 Answers to Check Your Progress Questions
1.5 Summary
1.6 Key Words
1.7 Self Assessment Questions and Exercises
1.8 Further Readings

UNIT 2 ACCOUNTING FOR CAPITAL RESTRUCTURING 27–48

(INTERNAL RECONSTRUCTION)
2.0 Introduction
2.1 Objectives
2.2 Meaning , Concept and Types of Capital Restructuring
2.3 Meaning of Internal Reconstruction and Accounting Entries
2.3.1 Alteration of Share Capital
2.3.2 Reduction of Share Capital, Reduction in Liabilties and Cancellation of Expenses, Losses etc.
2.4 Preparation of Balance Sheet after Internal Reconstruction
2.5 Answers to Check Your Progress Questions
2.6 Summary
2.7 Key Words
2.8 Self Assessment Questions and Exercises
2.9 Further Readings

UNIT 3 FINAL ACCOUNTS OF BANKING COMPANIES 49–111

3.0 Introduction
3.1 Objectives
3.2 Introduction of Banking Company
3.3 Legal Provisions
3.3.1 Capital
3.3.2 Reserve Fund
3.3.3 Deposits
3.3.4 Borrowings
3.3.5 Other Liabilities and Provisions
3.3.6 Cash and Balance
3.3.7 Investment
3.3.8 Advances
3.3.9 Fixed and Other Assets
3.3.10 Acceptances, Bills for Collection, Endorsements and Other Obligations
3.4 Accounting Treatment: Rebate on Bills Discounted, Provision for Bad and Doubtful Debts, NPA,
Rebate on Bills Discounted
3.5 Vertical Form of Final Accounts as per Banking Regulation Act 1949
3.5.1 Simple Numerical on Preparation of Profit and Loss A/C and Balance Sheet in Vertical Form
3.6 Answers to Check Your Progress Questions
3.7 Summary
3.8 Key Words
3.9 Self Assessment Questions and Exercises
3.10 Further Readings

UNIT 4 INVESTMENT ACCOUNTING 113–122

4.0 Introduction
4.1 Objectives
4.2 Investment Accounting: Meaning and Introduction
4.2.1 Classification of Investments
4.2.2 Meaning and Calculation of the Concept of Acquisition Cost and Carrying Cost of Investment
4.2.3 Calculation of Profit/Loss on Disposal of Investments
4.3 Answers to Check Your Progress Questions
4.4 Summary
4.5 Key Words
4.6 Self Assessment Questions and Exercises
4.7 Further Readingss

UNIT 5 FINAL ACCOUNTS OF CO-OPERATIVE SOCIETIES 123–130

5.0 Introduction
5.1 Objectives
5.2 Meaning and Introduction
5.3 Allocation of Profit as per Maharashtra State Co-operative Societies Act: Preparation of Final Accounts
of Credit Co-operative Societies and Consumer Co-operative Societies
5.4 Answers to Check Your Progress Questions
5.5 Summary
5.6 Key Words
5.7 Self Assessment Questions and Exercises
5.8 Further Readings

UNIT 6 BRANCH ACCOUNTING 131–170

6.0 Introduction
6.1 Objectives
6.2 Concept of Branches and Their Classification from Accounting Point of View
6.3 Accounting Treatment of Dependent Branches and Independent Branches and Methods of Charging
Goods to Branches
6.4 Answers to Check Your Progress Questions
6.5 Summary
6.6 Key Words
6.7 Self Assessment Questions and Exercises
6.8 Further Readings
UNIT 7 RECENT TRENDS IN ACCOUNTING 171–189
7.0 Introduction
7.1 Objectives
7.2 Forensic Accounting
7.2.1 Objectives and Key Principles
7.2.2 Ethical Principles and Responsibilities
7.3 Accounting for Corporate Social Responsibility
7.4 Accounting for Derivative Contracts
7.5 Artificial Intelligence in Accounting
7.6 Answers to Check Your Progress Questions
7.7 Summary
7.8 Key Words
7.9 Self Assessment Questions and Exercises
7.10 Further Readings

UNIT 8 ANALYSIS OF FINANCIAL STATEMENTS 191–229

8.0 Introduction
8.1 Objectives
8.2 Ratio Analysis: Meaning
8.2.1 Objectives and Nature
8.3 Types of Ratios
8.3.1 Profitability
8.3.2 Turnovers
8.3.3 Liquidity and Leverages
8.4 Simple Problems on Gross Profit, Net Profit, Operating Ratio, Stock Turnover, Debtors Turnover,
Creditors Turnover, Current Ratio, Liquid Ratio, Debt-Equity Ratio, Working Capital to Net Worth
and Assets Turnover Ratio
8.5 Answers to Check Your Progress Questions
8.6 Summary
8.7 Key Words
8.8 Self Assessment Questions and Exercises
8.9 Further Readings
INTRODUCTION

Accounting has assumed much importance in today's competitive world of business in which corporate
organizations have to show the true and fair view of their financial position. Thus, the application of accounting
in the business sector has become an indispensable factor. Consequently, accounting information is becoming
increasingly critical to the continuing success of an organization. With the growing importance of information
as a resource, organizations have felt the need for a system that is capable of managing this resource
efficiently. This is, perhaps, the basic reason for business students to study the anatomy and operation of
the accounting system, which provides information to managers for decision making. To explore and utilize
the financial information generated by the accounting system of an organization for competitive advantage,
managers must have a fair knowledge of the tools and techniques that they can use for analyzing and
interpreting the available information.
This book, Advanced Accounting, has been designed keeping in mind the self-instruction mode
(SIM) format and follows a simple pattern, wherein each unit of the book begins with the Introduction
followed by the Objectives for the topic. The content is then presented in a simple and easy-to-understand
manner and is interspersed with Check Your Progress questions to reinforce the student's understanding of
the topic. A list of Self-Assessment Questions and Exercises is also provided at the end of each unit. The
Summary and Key Words further act as useful tools for students and are meant for effective recapitulation
of the text.
Accounting Standards &
Financial Reporting
UNIT 1 ACCOUNTING STANDARDS
& FINANCIAL REPORTING
NOTES
Structure
1.0 Introduction
1.1 Objectives
1.2 Brief Review of Indian Accounting Standards
1.2.1 Introduction to AS-3, AS-12 and AS-19
1.2.2 Simple Numericals on AS-3, AS-12 and AS-19
1.3 Introduction to IFRS
1.3.1 Fair Value Accounting
1.4 Answers to Check Your Progress Questions
1.5 Summary
1.6 Key Words
1.7 Self Assessment Questions and Exercises
1.8 Further Readings

1.0 INTRODUCTION
Accounting Standards were introduced by the Accounting Standards Boards
in India to bring about uniformity in accounting results. There was a need to
harmonize policies and practices in India and keeping in mind the International
Accounting Standards, the Indian Accounting Standards were introduced in 1977.
This unit will discuss in detail AS-3, AS-12 and AS-19, along with the concept
of fair value accounting. The importance of the IFRS will also be highlighted.

1.1 OBJECTIVES
After going through this unit, you will be able to:
Discuss in detail Indian Accounting Standard
Examine AS-3, AS-12 AND AS-19
Describe the objective and scope of the IFRS
Understand Fair Value Accounting

1.2 BRIEF REVIEW OF INDIAN ACCOUNTING

STANDARDS
In order to bring uniformity in terminology, approach and presentation of
accounting results, the Institute of Chartered Accountants of India established
on 22 April, 1977, an Accounting Standards Board (ASB). The main function
of the ASB is to formulate accounting standards so that such standards will be
established by the Council of the Institute of Chartered Accountants. While
formulating the accounting standards, the ASB will give due consideration to Self-Instructional
Material 1
Accounting Standards & the International Accounting Standards and try to integrate them to the extent
Financial Reporting
possible. It will also take into consideration the applicable laws, customs, usages
and the business environments prevailing in India.

NOTES Preface to The Statements of Accounting Standards

The following are the specific features of the Preface to the Statements of
Accounting Standards issued by the Council of the Institute of Chartered
Accountants of India.
1. Formation of the Accounting Standards Board
(1) The Institute of Chartered Accountant of India (ICAI), recognising the need to harmonise
the diverse accounting policies and practices in use in India, constituted the Accounting
Standards Board (ASB) on 21st April, 1977.
(2) The composition of the ASB is fairly broad-based and ensures participation of all
interest-groups in the standard-setting process. Apart from the elected members of the
Council of the ICAI nominated on the ASB, the following are represented on the ASB:
(i) Nominee of the Central Government representing the Department of Company
Affairs on the Council of the ICAI.
(ii) Nominee of the Central Government representing the Office of the Comptroller
and Auditor General of India on the Council of the ICAI.
(iii) Nominee of the Central Government representing the Central Board of Direct Taxes
on the Council of the ICAI.
(iv) Representative of the Institute of Cost Accountants of India.
(v) Representative of the Institute of Company Secretaries of India.
(vi) Representatives of Industry Associations (one from Associated Chambers of
Commerce and Industry (ASSOCHAM), one from Confederation of Indian Industry
(CII) and one from Federation of Indian Chambers of Commerce and Industry
(FICCI).
(vii) Representative of Reserve Bank of India.
(viii) Representative of Securities and Exchange Board of India.
(ix) Representative of Controller General of Accounts.
(x) Representative of Central Board of Excise and Customs.
(xi) Representatives of Academic Institutions (one from Universities and
one from Indian Institutes of Management)
(xii) Representive of Financial Institutions.
(xiii) Eminent professionals co-opted by the ICAI (they may be in practice
or in industry, government, education, etc.)
(xiv) Chairman of the Research Committee and the Chairman of the Expert
Advisory Committee of the ICAI, if they are not otherwise members
of the Accounting Standards Board.
(xv) Representative(s) of any other body, as considered appropriate by
the ICAI.

Self-Instructional
2 Material
2. Objectives and Functions of the Accounting Standards Board Accounting Standards &
Financial Reporting
The following are the objectives of the Accounting Standards Board:
(i) To conceive of and suggest areas in which Accounting Standards need
to be developed. NOTES
(ii) To formulate Accounting Standards with a view to assisting the Council
of the ICAI in evolving and establishing Accounting Standards in India.
(iii) To examine how far the relevant International Accounting Standard/
International Financial Reporting Standard can be adapted while
formulating the Accounting Standard and to adapt the same.
(iv) To review, at regular intervals, the Accounting Standards from the point
of view of acceptance or changed conditions, and, if necessary, revise
the same.
(v) To provide, from time to time, interpretations and guidance on Accounting
Standards.
(vi) To carry out such other functions relating to Accounting Standards.
The Accounting Standards are issued under the authority of the Council of
the ICAI. The ASB has also been entrusted with the responsibility of propagating
the Accounting Standards and of persuading the concerned parties to adopt them
in the preparation and presentation of financial statements. The ASB will provide
interpretations and guidance on issues arising from Accounting Standards. The
ASB will also review the Accounting Standards at periodical intervals and, if
necessary, revise the same.
3. General Purpose Financial Statements
(1) For discharging its functions, the ASB will keep in view the purpose
and limitations of financial statements and the attest function of the
auditors. The ASB will enumerate and describe the basic concept to
which accounting principles should be oriented and state the accounting
principles to which the practices and procedures should conform.
(2) The ASB will clarify the terms commonly used in financial statements
and suggest improvements in the terminology wherever necessary. The
ASB will examine the various current alternative practices in vogue
and endeavour to eliminate or reduce alternatives within the bounds of
rationality.
(3) Accounting Standards are designed to apply to the general purpose
financial statements and other financial reporting, which are subject to the
attest function of the members of the ICAI. Accounting Standards apply
in respect of any enterprise (whether organised in corporate, cooperative
or other forms) engaged in commercial, industrial or business activities,
irrespective of whether it is profit-oriented or it is established for charitable
or religious purposes. Accounting Standards will not, however, apply to Self-Instructional
enterprises only carrying on the activities which are not of commercial, Material 3
Accounting Standards & industrial or business nature, (e.g., an activity of collecting donations and
Financial Reporting
giving them to flood affected people). Exclusion of an enterprise from
the applicability of the Accounting Standards would be permissible only
if no part of the activity of such enterprise is commercial, industrial or
NOTES business in nature. Even if a very small proportion of the activities of an
enterprise is considered to be commercial, industrial or business in nature,
the Accounting Standards would apply to all its activities including those
which are not commercial, industrial or business in nature.
(4) The term ‘General Purpose Financial Statements’ includes balance sheet,
statement of profit and loss, a cash flow statement (wherever applicable)
and statements and explanatory notes which form part thereof, issued
for the use of various stakeholders, governments and their agencies and
the public. References to financial statements in the Preface and in the
standards issued from time to time will be construed to refer to General
Purpose Financial Statements.
(5) Responsibility for the preparation of financial statements and for
adequate disclosure is that of the management of the enterprise. The
auditor’s responsibility is to form his opinion and report on such financial
statements.
4. Scope of Accounting Standards
(1) Efforts will be made to issue Accounting Standards which are in
conformity with the provisions of the applicable laws, customs, usages
and business environment in India. However, if a particular Accounting
Standard is found to be not in conformity with law, the provisions of the
said law will prevail and the financial statements should be prepared in
conformity with such law.
(2) The Accounting Standards by their very nature cannot and do not override
the local regulations which govern the preparation and presentation of
financial statements in the country. However, the ICAI will determine the
extent of disclosure to be made in financial statements and the auditor’s
report thereon. Such disclosure may be by way of appropriate notes
explaining the treatment of particular items. Such explanatory notes will
be only in the nature of clarification and therefore need not be treated as
adverse comments on the related financial statements.
(3) The Accounting Standards are intended to apply only to items which are
material. Any limitations with regard to the applicability of a specific
Accounting Standard will be made clear by the ICAI from time to time.
The date from which a particular Standard will come into effect, as well
as the class of enterprises to which it will apply, will also be specified by
the ICAI. However, no standard will have retroactive application unless
otherwise stated.
Self-Instructional
4 Material
5. Procedure for Issuing an Accounting Standard Accounting Standards &
Financial Reporting
Broadly, the following procedure is adopted for formulating Accounting
Standards:
(1) The ASB determines the broad areas in which Accounting Standards NOTES
need to be formulated and the priority in regard to the selection thereof.
(2) In the preparation of Accounting Standards, the ASB will be assisted by
Study Groups constituted to consider specific subjects. In the formation
of Study Groups, provision will be made for wide participation by the
members of the Institute and others.
(3) The draft of the proposed standard will normally include the following:
(a) Objective of the Standard
(b) Scope of the Standard
(c) Definitions of the terms used in the Standard
(d) Recognition and measurements principles, wherever applicable
(e) Presentation and disclosure requirements.
(4) The ASB will consider the preliminary draft prepared by the Study Group
and if any revision of the draft is required on the basis of deliberations,
the ASB will make the same or refer the same to the Study Group.
(5) The ASB will circulate the draft of the Accounting Standard to the
Council members of the ICAI and the following specified bodies for
their comments:
(i) Department of Company Affairs (DCA)
(ii) Comptroller and Auditor General of India (C&AG)
(iii) Central Board of Direct Taxes (CBDT)
(iv) The Institute of Cost Accountants of India (ICAI)
(v) The Institute of Company Secretaries of India (ICSI)
(vi) Associated Chambers of Commerce and Industry (ASSOCHAM),
Confederation of Indian Industry (CII) and Federation of Indian
Chambers of Commerce and Industry (FICCI)
(vii) Reserve Bank of India (RBI)
(viii) Securities and Exchange Board of India (SEBI)
(ix) Standing Conference of Public Enterprises (SCOPE)
(x) Indian Banks’ Association (IBA)
(xi) Any other body considered relevant by the ASB keeping in view the
nature of the Accounting Standard.
(6) The ASB will hold a meeting with the representatives of specified
bodies to ascertain their views on the draft of the proposed Accounting
Standard. On the basis of comments received and discussion with the
representatives of specified bodies, the ASB will finalise the Exposure Self-Instructional
Material 5
Draft of the proposed Accounting Standard.
Accounting Standards & (7) The Exposure Draft of the proposed Standard will be issued for comments
Financial Reporting
by the members of the Institute and the public. The Exposure Draft will
specifically be sent to specified bodies (as listed above), stock exchanges,
and other interest groups, as appropriate.
NOTES
(8) After taking into consideration the comments received, the draft of the
proposed Standard will be finalised by the ASB and submitted to the
Council of the ICAI.
(9) The Council of the ICAI will consider the final draft of the proposed
Standard, and if found necessary, modify the same in consultation with
the ASB. The Accounting Standard on the relevant subject will then be
issued by the ICAI.
(10) For a substantive revision of an Accounting Standard, the procedure
followed for formulation of a new Accounting Standard, as detailed
above, will be followed.
(11) Subsequent to issuance of an Accounting Standard, some aspect(s) may
require revision which are not substantive in nature. For this purpose,
the ICAI may make limited revision to an Accounting Standard. The
procedure followed for the limited revision will substantially be the
same as that to be followed for formulation of an Accounting Standard,
ensuring that sufficient opportunity is given to various interest groups
and general public to react to the proposal for limited revision.
6. Compliance with the Accounting Standards
(1) The Accounting Standards will be mandatory from the respective date(s)
mentioned in the Accounting Standard(s). The mandatory status of an
Accounting Standard implies that while discharging their attest functions,
it will be the duty of the members of the Institute to examine whether
the Accounting Standard is complied within the presentation of financial
statements covered by their audit. In the event of any deviation from the
Accounting Standard, it will be their duty to make adequate disclosures
in their audit reports so that the users of financial statements may be
aware of such deviation.
(2) Ensuring compliance with the Accounting Standards while preparing
the financial statements is the responsibility of the management of the
enterprise. Statutes governing certain enterprises require of the enterprises
that the financial statements should be prepared in compliance with the
Accounting Standards, e.g., the Companies Act, 2013 (section 129),
and the Insurance Regulatory and Development Authority (Preparation
of Financial Statements and Auditor’s Report of Insurance Companies)
Regulations, 2000.

Self-Instructional
6 Material
(3) Financial Statements cannot be described as complying with the Accounting Standards &
Financial Reporting
Accounting Standards unless they comply with all the requirements of
each applicable standard.
Issue of Accounting Standards: In all 32 accounting standards have been
NOTES
issued out of which 1 has been withdrawn while 3 are only recommendatory. The
applicable of these standards is dependent on the size—Level I/II/III company.
The following table lists out the Accounting Standards and their applicability.
Accounting Standards
No. Title Mandatory from Applicability
accounting period level of
beginning on or enterprise
after
AS 1 Disclosure of Accounting Policies 1-4-1991 I, II, III
AS 2 (Revised) Valuation of lnventories 1-4-1999 I, II, III
AS 3 (Revised) Cash Flow Statements 1-4-2001 I
AS 4 (Revised) Contingencies and Events occurring 1-4-1995 I, II, III
after Balance Sheet Date
AS 5 (Revised) Net Profit or Loss Prior Period and 1-4-1996 I, II, III
Extraordinary Items and Changes in
Accounting Policies
AS 6 (Revised) Depreciation Accounting withdrawn 1-4-1995 I, II, III
w.e.f. 1st April 2017
AS 7 (Revised) Accounting for Construction Contracts 1-4-2003 I, II, III
AS 8 Accounting for Research and 1-4-1991 Withdrawn
Developments (withdrawn w.e.f. 1-4- 1-4-1991 I, II, III
2003)
AS 9 Revenue Recognition 1-4-1991 I, II, III
AS 10 Property, Plant & Equipment (changed 1-4-1991 I, II, III
from Accounting for Fixed Assets)
AS 11 (Revised Accounting for the Effect of Changes 1-4-2004 I, II, III
2003) in Foreign Exchange Rates
AS 12 Accounting for Government Grants 1-4-1995 I, II, III
AS 13 Accounting for Investments* 1-4-1995 I, II, III
AS 14 Accounting for Amalgamations* 1-4-1994 I, II, III
AS 15 Employee Benefits 7-12-2006 I, II, III
(Revised 2005)
AS 16 Borrowing Costs 1-4-2000 I. II, III
AS 17 Segment Reporting 1-4-2001 II, II, III (with
modifications)
AS 18 Related Party Disclosures 1-4-2001
AS 19 Leases 1-4-2001
AS 20 Earnings Per Share 1-4-2001
AS 21 Consolidated Financial Statements* 1-4-2001
AS 22 Accounting for Taxes on Income 1-4-2001 I, II, III
AS 23 Accounting for Investments in 1-4-2002 I
Associates
AS 24 Discounting Operations 1-4-2004 I
AS 25 Interim Financial Reporting 1-4-2004 I
AS 26 Intangible Assets 1-4-2003 I, II, III
AS 27 Financial Reporting of Interests in Joint
Ventures 1-4-2002 I. II, III (with
clarifications) Self-Instructional
Material 7
Accounting Standards & No. Title Mandatory from Applicability
Financial Reporting
accounting period level of
beginning on or enterprise
after
AS 28 Impairment of Assets 1 -4-2004 I, II. III (with
NOTES modifications)
AS 29 Provisions, Contingent Liabilities and 1-4-2004 I
Contingent Assets*
AS 30 Financial Instruments: Recognition and
Measurement (recommendatory
w.e.f. 1-4-2009)
AS 31 Financial Instruments: Presentation
(recommendatory w.e.f. 1-4 2009)
AS 32 Financial Instruments: Disclosures
(recommendatory w.e.f. 1-4-2009)
Level I Company: Enterprises, which fall in any one or more of the following
categories, at any time during the accounting period, are classified as Level I
enterprises.
(i) Enterprises whose equity or debt securities are listed whether in India or
outside India.
(ii) Enterprises, which are in the process of listing their equity or debt
securities as evidenced by the board of directors’ resolution in this regard.
(iii) Banks including co-operative banks.
(iv) Financial Institutions
(v) Enterprises carrying on insurance business
(vi) All commercial, industrial and business reporting enterprises, whose
turnover (excluding other income) exceeds 50 crore in the immediately
preceding accounting year.
(vii) All commercial, industrial and business reporting enterprises having
borrowings, (including public deposits), in excess of 10 crore at any
time during the immediately preceding accounting year.
(viii) Holding and subsidiary enterprises of any one of the above at any time
during the accounting period.
Level II Company: Enterprises, which are, not Level I enterprises but fall in
any one or more of the following categories are classified as Level II enterprises:
(i) All commercial, industrial and business reporting enterprises, whose
turnover (excluding other income) for the immediately preceding
accounting year exceeds 40 lakh, but does not exceed fifty crore.
Turnover does not include ‘other income’.
(ii) All commercial, industrial and business reporting enterprises having
borrowing, (including public deposits), in excess of one crore but not
in excess of 10 crore at any time during the immediately preceding
accounting year.
Self-Instructional
8 Material
(iii) Holding and subsidiary enterprises of any one of the above.
Level III Company: Enterprises, which are not covered under Level I and Level Accounting Standards &
Financial Reporting
II are considered as Level III enterprises.
Applicability
Level II and Level III enterprises are considered as SMEs. NOTES
Level I enterprises are required to comply fully with all the accounting
standards.
No relaxation is given to Level II and Level III enterprises in respect of
recognition and measurement principles. Relaxations are provided with regard to
disclosure requirements. Accordingly, Level II and Level III enterprises are fully
exempted from certain accounting standards, which mainly lay down disclosure
requirements. In respect of certain other accounting standards, which lay down
recognition, measurement and disclosure requirements, relaxations from certain
disclosure requirements have been given.
In the following pages we are giving brief details of some of the important
Accounting Standards issued by ICAI.
1.2.1 Introduction to AS-3, AS-12 and AS-19
Accounting standard was originally issued in June 1981 as AS 3 “Changes in
Financial Positions”. It was in 1997 revised as Cash Flow Statement.
In the initial years this accounting standard was recommendatory. It has
become mandatory in respect of accounts for the periods commencing on or
after 1st Apri1 2001.
The Standard is concerned with the provision of information about the
historical changes in cash and cash equivalents of an enterprise by means of a
cash flow statement.
The objective and the scope of the standard are as under:
Objective: Information about the cash flows of an enterprise is useful in providing
users of financial statements with a basis to assess the ability of the enterprise
to generate cash and cash equivalents and the needs of the enterprise to utilise
those cash flows. The economic decisions that are taken by users require an
evaluation of the ability of an enterprise to generate cash and cash equivalents
and the timing and certainty of their generation.
The Standard deals with provision of information about the historical
changes in cash and cash equivalents of an enterprise by means of a cash flow
statement, which classifies cash flows during the period from operating, investing
and financial activities.
Scope: An enterprise should prepare a cash flow statement and should present
it for each period for which financial statements are presented.
Users of an enterprise’s financial statements are interested in how the
enterprise generates and uses cash and cash equivalents. This is the case regardless
of the nature of the enterprise’s activities and irrespective of whether cash can Self-Instructional
be viewed as the product of the enterprise, as may be the case with a financial Material 9
Accounting Standards & enterprise. Enterprises need cash for essentially the same reasons, however,
Financial Reporting
different their principal revenue-producing activities might be. They need cash
to conduct their operations, to pay their obligations, and to provide returns to
their investors.
NOTES
AS 12: Accounting for Government Grants
This Standard was originally issued in 1991. This standard has come into effect
in respect of accounting periods commencing on or after 1 April 1992. It was
recommendatory in nature for initial period of two years. The standard has
become mandatory in respect of accounts for periods commencing on or after
the 1st April, 1994.
The Standard deals with accounting for government grants. Government
grants are sometimes called by other names such as subsidies, cash incentives,
duty drawbacks, etc.
This Standard does not deal with:
(i) the special problems arising in accounting for government grants in financial
statements reflecting the effects of changing prices or in supplementary
information of a similar nature;
(ii) government assistance other than in the form of government grants;
(iii) government participation in the ownership of the enterprise.
AS 19: Leases
AS 19 prescribes the accounting and disclosure requirements for both finance
leases and operating leases in the books of the lessor and lessee.
This standard comes into effect in respect of all assets leased during
accounting periods commencing on or after 1st April 2001 and is mandatory in
nature from that date.
The objective and the scope of the standard are as under:
Objective: The objective of this Standard is to prescribe, for lessees and
lessors, the appropriate accounting policies and disclosures in relation to finance
leases and operating leases.
A finance lease is a lease that transfers substantially all the risks and rewards
incident to ownership of an asset.
An operating lease is a lease other than a finance lease.
Scope: 1. This Standard should be applied in accounting for all leases
other than:
(a) lease agreement to explore for or use natural resources, such as oil, gas,
timber, metals and other mineral rights; and
(b) licensing agreements for items such as motion picture films, video
recordings, plays, manuscripts, patents and copyrights.
Self-Instructional
10 Material (c) Lease agreements to use lands.
1.2.2 Simple Numericals on AS-3, AS-12 and AS-19 Accounting Standards &
Financial Reporting
I 1.1. A company has the following capital structure:
10,000 Equity shares of 10 each 1,00,000
2,000 10% Pref. shares of 100 each 2,00,000
NOTES
2,000 10% Debentures of 100 each 2,00,000
Calculate the EPS for each of the following levels of EBIT: (i) 1,00,000; (ii) 60,000; (iii)
1,40,000. The company is in 50% tax bracket.
Calculate also the Financial Leverage taking EBIT level under (i) as base.
S :
Computation of Earning per Share
(i) (ii) (iii)
EBIT 1,00,000 60,000 1,40,000
Less: Interest on Debentures 20,000 20,000 20,000
PBT 80,000 40,000 1,20,000
Less: Income Tax 40,000 2,40,000 6,40,000
PAT 40,000 20,000 60,000
Less: Preference Dividend 20,000 20,000 20,000
Earnings available for Equity Shareholders (EAES) 20,000 — 40,000
Earning per share (EPS) 2 Nil 4
The above table shows that
(a) In Case (ii) the EBIT has decreased by 40% (i.e., from 1,00,000 to 60,000
while the earning per share has decreased by 100% (from 2 per share to
nil).
(b) In case (iii) the EBIT has increased by 40% (from 1,00,000 to 1,40,000)
as compared to case (i) while the earning per share has increased by 100%
(from 2 to 4).
The degree of financial leverage can therefore be computed as follows:

Financial Leverage in between (i) and (ii) = = 2.5

The same result can be obtained by using the equation OP/PBT as shown
below.
Computation of Financial Leverage

(i) (ii) (iii)

OP 1,00,000 60,000 1,40,000
Less: Interest 20,000
Pref. Dividend (grossed up) 40,000 60,000 60,000
60,000
40,000 – 80,000

Financial Leverage

=
Self-Instructional
Material 11
Accounting Standards & This means that with every 1% change in Operating Profit (OP), the Profit before Tax (PBT)
Financial Reporting will change (in the same direction) by 2.5%. For example, in situation (i) OP has decreased by
40%. This has resulted in decrease of PBT by 100% (i.e., 40 × 2.5). In situation (iii) OP has
increased by 40%. This has resulted in increase of PBT by 100% (i.e., 40 × 2.5).
NOTES Utility
Financial leverage helps the financial manager considerably while devising the
capital structure of the company. A high financial leverage means high fixed
financial costs and high financial risk. A financial manager must plan the capital
structure in a way that the firm is in a position to meet its fixed financial costs.
Increase in fixed financial costs requires necessary increase in EBIT level. In the
event of failure to do so the company may be technically forced into liquidation.
Composite Leverage
As explained in the preceding pages, operating leverage measures the percentage
change in operating profit due to percentage change in sales. It explains the degree
of operating risk. Financial leverage measures percentage change in taxable profit
(or EPS) on account of percentage change in operating profit (i.e., EBIT). Thus, it
explains the degree of financial risk. Both these leverages are closely concerned
with the firm’s capacity to meet its fixed costs (both operating and financial). In
case both the leverages are combined, the result obtained will disclose the effect
of change in sales over change in taxable profit (or EPS).
Composite leverage thus expresses the relationship between revenue on
account of sales (i.e., contribution or sales less variable cost) and the taxable
income. It helps in finding out the resulting percentage change in taxable income
on account of percentage change in sales. This can be computed as follows:
Composite leverage = Operative leverage × Financial leverage

where:
C = Contribution (i.e., Sales – Variable cost)
OP = Operating Profit or Earning before Interest and Tax
PBT = Profit before Tax but after Interest.
The computation of the composite leverage can be explained with the help
of the following illustration.
Illustration 1.2. A company has sales of 1 lakh. The variable costs are 40%
of the sales while the fixed operating costs amount to 30,000. The amount of
interest on long-term debt is 10,000.
You are required to calculate the composite leverage and illustrate its
impact if sales increase by 5%.

Self-Instructional
12 Material
S : Accounting Standards &
Statement Showing Computation of Composite Leverage Financial Reporting

Sales 1,00,000
Less: Variable Cost (40% of Sales) 40,000
Contribution (C) 60,000 NOTES
Less: Fixed Operating Costs 30,000
Earning before Interest and Tax (EBIT) or Operating Profit (OP) 30,000
Less: Interest 10,000
Taxable Income (PBT) 20,000

Composite Leverage

The composite leverage of ‘3’ indicates that with every increase of 1 in

sales, the taxable income will increase by 3 (i.e., 1 × 3).
This can be verified by the following computations when the sales increase
by 5%.
Sales 1,05,000
Less: Variable Costs 42,000
Contribution (C) 63,000
Less: Fixed Operating Costs 30,000
Earning before Interest and Tax (EBIT) or Operating Profit (OP) 33,000
Less: Interest 10,000
Taxable Income (PBT) 23,000

It is clear from the above computation that on account of increase in sales by 5%, the profit before tax
has increased by 15%. This can be verified as follows:

Example 1: ABC Ltd. (the lessee) acquires a machinery on lease from a

leasing company (the lessor) on January 1, 2015. The lease term covers the
entire economic life of the machinery, i.e., 3 years. As per the terms of the lease
agreement, the machinery would revert to the lessor at the end of the lease term.
The fair value of the machinery on January 1, 2015 is 2,35,500. The lease
agreement requires the lessee to pay an amount of 1,00,000 per year beginning
December 31, 2015. The lessee has guaranteed a residual value of 17,000
on December 31, 2017 to the lessor. The lessor, however, estimates that the
machinery would have a salvage value of only 3,500 on December 31, 2017.
The interest rate implicit in the lease is 16 per cent (approx.). This is
calculated using the following formula:
Fair Value

where ALR = Annual lease rental (for 1st, 2nd...n years),

RV = Residual value (both guaranteed and unguaranteed),
n = Lease term, Self-Instructional
Material 13
r = Interest rate implicit in the lease.
Accounting Standards & The present value of minimum lease payments from the standpoint of the
Financial Reporting
lessee is 2,35,500.
On putting the value in the above formula:
NOTES 2,35,500 = or r = 16%
Later on, Trial and Error Method may be used in cases where the cash inflows
are not uniform.
In the present case, the factor can be located as under:
F = I/C
F = Factor to be located
where I = Fair Value of the machinery, C = Average Cash Inflow per annum
On putting the values in the above formula, we get
F= = = 2.22
The factor 2.22 will be located in the Annuity Table given in Appendix 2 on
the line representing number of years corresponding to estimated useful life of the
asset. This would give the estimated rate of return to be applied for discounting
the cash inflows for the implicit interest rate. It comes to 16%. At this rate, the
fair value of the asset would be almost equal to the present value of cash inflows
over the useful life of the asset.
The workings are shown below:
Year end Rentals ( ) PV factor at 16% Present
(See Appendix 1) Value ( )
1 1,00,000 0.862 86,200
2 1,00,000 0.743 74,300
3 1,17,000* 0.641 74,997

2,35,497

* Includes 17,000 Residual Value.

Note: In the present case, the total Present Value of 2,35,497, calculated at interest rate of 16% is almost
equal to the fair value of the asset. This is because the rentals or cash inflows are almost uniform. However,
if the cash inflows had not been uniform, the trial and error method would have to be adopted. For instance,
if the fair value of the asset had been 2,60,000 and the cash flows had been the same, we would have ap-
plied trial and error method to find out the exact implicit interest rate.

At 16%, the present values of the cash flows is less than the fair value of the
asset. Hence, a lower interest rate, say 10%, may be applied. If this done, the workings
would have been as under:
Year end Rentals ( ) PV factor at 10% Present
(See Appendix 1) Value ( )
1 1,00,000 0.909 90,900
2 1,00,000 0.826 82,600
3 1,17,000 0.751 87,867
2,61,367

Self-Instructional At 10%, the present value is (+) 1,367 At 16%, the present value is (–)
14 Material 24,503
The interpolation of the interest rate can now be done as follows: Accounting Standards &
Financial Reporting
= 10% + 6 = 10 + 0.31 = 10.31%

The lessee would record the machinery as an asset at 2,35,500 with a

corresponding liability representing the present value of lease payments over NOTES
the lease term (including the guaranteed residual value).
BALANCE SHEET OF LESSEE

as on January 1, 2016
Liabilities Assets

Obligations under Finance Lease 2,35,500 Leased Machinery 2,35,500

Check Your Progress

1. What is the main function of the ASB?
2. What does AS 12 deal with?

1.3 INTRODUCTION TO IFRS

International Accounting Standards Committee (IASC) came into existence on
29 June, 1973 when 16 accounting bodies from nine nations (called founder-
members) signed the agreement and constitution for its formation. The Committee
has its headquarters at London. Its interpretative arm was known as Standard
Interpretation Committee (SIC).
The objective of the committee was “to formulate and publish in the
public interest standards to be observed in the presentation of audited financial
statements and to promote their world-wide acceptance and observance.” The
formulation of such standards will bring uniformity in terminology, approach
and presentation of results. This will not only help in a correct understanding
and exchange of economic and financial information but also in facilitating a
smooth flow of international investment.
Between 1973 and 2000, the IASC issued several Accounting Standards,
known as International Accounting Standards (IASs). Since 2001, the IASC was
renamed as the International Accounting Standard Board (IASB). The IASB has
now taken over the work of IASC. Its members (currently 15 full time members)
are responsible for the development and publication of IFRSs and approving
interpretations as developed by IFRIC as discussed later.
The IASB has issued a new series of pronouncements known as International
Financial Reporting Standards (IFRSs) on topics on which there was no previous
IAS. Besides this, the IASB has replaced some lASs with new IFRSs. Thus, now
the lASs issued by the IASC and IFRSs issued by the IASB all come within the
purview of IASB. An International Financial Reporting Interpretation Committee
(IFRIC) has also been formed to provide interpretations of the standards similar
to previous SIC. Self-Instructional
Material 15
Accounting Standards & The IASB works closely with stakeholders around the world, including
Financial Reporting
investors, analysts, regulators, business leaders, accounting standard-setters and
the accountancy profession.
Objectives of IASB: The broad objectives of IASB as per the IFRS Foundation,
NOTES
(not for profit private sector organisation) can be summarised as under.
(a) To develop, in the public interest, a single set of high quality,
understandable, enforceable and globally accepted financial reporting
standards based upon clearly articulated principles. These standards
should require high quality, transparent and comparable information
in financial statements and other financial reporting to help investors,
other participants in the world’s capital markets and other users of
financial information to make economic decisions;
(b) To promote the use and rigorous application of those standards;
(c) To pay attention to the needs of medium and small scale enterprises
and emerging economies in tunc with (a) and (b) objectives stated
above; and
(d) To promote and facilitate adoption of IFRSs, being the standards
and interpretations issued by the IASB, through the convergence of
national accounting standards and IFRSs.
Meaning of IFRS: It is a set of international accounting standards developed
by the International Accounting Standards Board (IASB) providing the mode of
reporting particular type of transactions and events in the financial statements.
They include standards and interpretations issued by the International Accounting
Standards Board (IASB) and its predecessor body, viz., International Accounting
Standards Committee (IASC). They comprise:
(a) International Financial Reporting Standards;
(b) International Accounting Standards, and
(c) Interpretations developed by the International Financial Reporting
Interpretations Committee (IFRIC) or the former Standing
Interpretations Committee (SIC).
Objective of IFRS: The basic objective of IFRSs is to make international
comparison of financial statements of business enterprises as easy as possible.
At present it is difficult since each country has its own set of rules. IFRSs have
been designed as a common global language for business affairs to synchronize
accounting standards across the globe. They are progressively replacing the many
different national accounting standards. They require the accountants to maintain
books of account in a manner that the financial statements based on them are
comparable, understandable, reliable and relevant as per the requirements of
users—both internal and external.
Scope of IFRS: The scope of IFRS is as under.
(i) IFRS apply to the general purpose financial statements and other
Self-Instructional
16 Material financial reporting by profit-oriented entities— those engaged in
commercial, industrial, financial, and similar activities, regardless of Accounting Standards &
Financial Reporting
their legal form.
Explanations:
(a) General purpose financial statements are intended to meet the NOTES
common needs of shareholders, creditors, employees, and the
public at large for information about an entity’s financial position,
performance, and cash flows.
(b) Other financial reporting includes information provided outside
financial statements that assists in the interpretation of a complete
set of financial statements or improves users’ ability to make efficient
economic decisions.
(ii) Entities other than profit-oriented business entities may also find IFRSs
appropriate.
(iii) IFRSs apply to individual company and consolidated financial
statements.
IFRS Assumptions: There are four underlying assumptions in IFRS as detailed
below.
1. Accrual basis: The assumption that the financial effect of transactions
and events are recognised as they occur, not when cash is received or
paid.
2. Going concern: The assumption that a business entity will be in
operation for the foreseeable future.
3. Measuring unit: Measuring unit for valuation of capital is the current
purchasing power. In other words assets should be reflected in the
financial statements at their fair value.
4. Unit of constant purchasing power: The value of capital should
be adjusted at end of the financial year to inflation prevailing in the
economy.
IFRS Around the World
IFRS is a globally accepted financial reporting framework. It is used over 110
countries but in both the US and the UK, the Generally Accepted Accounting
Principles (GAAP) is the more widely used set of guidelines for accountants.
Currently the Financial Accounting Standards Board (FASB) of USA and
the IASB are working on numerous joint projects designed to improve the GAAP
and the IFRS with the goal to ultimately make the standards fully compatible.
In India also we are following GAAP i.e., accounting standards as
prescribed by Institute of Chartered Accountants of India. Of course steps are
being taken for converging the Indian Accounting Standards with IFRS.
Self-Instructional
Material 17
Accounting Standards & IFRS Main Financial Statements
Financial Reporting
Types : The IFRS financial statements include the following.
• A Statement of Financial Position. It comprises Assets, Liabilities and
NOTES Equity
• A Statement of Comprehensive Income. It includes two separate
statements (i) an Income Statement and (ii) a Statement of
Comprehensive Income. The Statement of Comprehensive Income
reconciles the Profit or Loss as per Income Statement to total
comprehensive income
• A Statement of Changes in Equity
• A Cash Flow Statement or Statement of Cash Flows
• Notes, comprising a summary of the significant accounting policies
Objective: A financial statement should present true and fair picture of the
business affairs of an organisation. Since these statements are used by different
constituents of the regulators/society, they are required to present the true view
of financial position of the organisation.
Qualitative characteristics: As per IFRS, the main characteristics required in its
main financial statement include:
• Understandability
• Relevance
• Reliability
• Comparability
Current Status of IAS/IFRS and Interpretations: The current status of
International Accounting Standards (IAS), International Financial Reporting
Standards (IFRS), and Interpretations issued by Standing Interpretation
Committee (SIC), International Financial Reporting Interpretation Committee
(IFRIC) is as under.
International Accounting Standards (IASs): All 41 IASs have been issued
out of which 12 have been withdrawn. Thus, at present 28 IAS are in operation.
They are as under.
IAS 1. Presentation of Financial Statements.
IAS 2. Inventories.
IAS 7. Cash Flow Statements.
IAS 8. Accounting Policies, Changes in Accounting Estimates and Errors.
IAS 10. Events after the Balance Sheet Date.
IAS 11. Construction Contracts.
IAS 12. Income Taxes.
IAS 16. Property, Plant and Equipment.
Self-Instructional IAS 17. Leases..
18 Material
IAS 19. Employee Benefits.
IAS 20. Accounting for Government Grants and Disclosure of Government Accounting Standards &
Financial Reporting
Assistance.
IAS 21. The Effects of Changes in Foreign Exchange Rates.
IAS 23. Borrowing Costs NOTES
IAS 24. Related Party Disclosures.
IAS 26. Accounting and Reporting by Retirement Benefit Plans.
IAS 27. Consolidated and Separate Financial Statements.
IAS 28. Investments in Associates.
IAS 29. Financial Reporting in Hyperinflationary Economies.
IAS 31. Interests in Joint Ventures.
IAS 32. Financial Instruments: Presentation
IAS 33. Earnings per share.
IAS 34. Interim Financial Reporting.
IAS 36. Impairment of Assets.
IAS 37. Provisions, Contingent Liabilities and Contingent Assets.
IAS 38. Intangible Assets.
IAS 39. Financial Instruments: Recognition and Measurement. (Superseded
by IFRS 9 where IFRS 9 is applied)
IAS 40. Investment Property.
IAS 41. Agriculture.
International Financial Reporting Standards (IFRSs): In all the following
IFRSs have been issued out of which one is under reconsideration. The list is
as under.
No. Title Originally issued Effective
IFRS I First-time Adoption of International Finacial 2003 Jan. 1, 2004
Reporting Standard
IFRS 2 Share-based Payment 2004 Jan. 1, 2005
IFRS 3 Business Combinations 2004 Apr. l, 2004
IFRS 4 Insurance Contracts 2004 Jan. 1, 2005
IFRS 5 Non-current Assets held for Sale and 2004 Jan. 1,2005
Discontinued Operations
IFRS 6 Exploration for and Evaluation of Mineral 2004 Jan. 1, 2006
Resources
IFRS 7 Financial instrument: Disclosures 2005 Jan. 1, 2007
IFRS 8 Operating Segments 2006 Jan. 1, 2009
IFRS 9 Financial instruments 2009 Jan. 1, 2018
(updated 2014)
IFRS 10 Consolidated Financial Statements 2011 Jan. 1, 2013
IFRS 11 Joint Arrangements 2011 Jan. 1, 2013
IFRS 12 Disclosure of Interests in Other Entities 2011 Jan. 1, 2013
IFRS 13 For Value Measurement 2011 Jan. 1, 2013
IFRS 14 Regulatory Deferral Accounts 2014 Jan. 1, 2016
IFRS 15 Revenue from Contracts with Customers 2014 Jan. 1, 2017
IFRS 16 Leases 2016 Jan. 1, 2019 Self-Instructional
IFRS 17 Insurance contracts financial 2017 Jan. 1, 2023 Material 19
Accounting Standards & Interpretations Issued by SIC/IFRIC: The following interpretations have been
Financial Reporting
issued as given under.
SIC 7 Introduction of the Euro
NOTES SIC 10 Government Assistance - No Specific Relation to Operating
Activities
SIC 12 Consolidation - Special-Purpose Entities
SIC 13 Jointly Controlled Entities - Non-monetary Contributions by
Ventures
SIC 15 Operating Leases - Incentives
SIC 21 Income Taxes - Recovery of Revalued Non-Depreciable Assets
SIC 25 Income Taxes - Changes in the Tax Status of an Enterprise or
its Shareholders.
SIC 27 Evaluating the Substance of Transactions Involving the Legal
Form of a Lease
SIC 29 Service Concession Arrangements: Disclosures
SIC 31 Revenue - Barter Transactions lnvolving Advertising Services
SIC 32 Intangible Assets - Web Site Costs
IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar
Liabilities
IFR1C 2 Members’ Shares in Co-operative Entities and Similar Liabilities
IFRIC 4 Determining Whether an Arrangement contains a Lease
IFRIC 5 Rights to Interests arising from Decommissioning, Restoration
and Environmental Rehabilitation Funds.
IFRIC 6 Liabililies arising from Participating in a Specific Market - Waste
Electrical and Electronic Equipment
IFRIC 7 Applying the Restatement Approach under IAS 29, Financial
Reporting in Hyperinflationary Economies
IFRIC 8 Scopc of IFRS 2
IFRIC 9 Reassessment of Embedded Derivatives
IFRIC 10 Interim Financial Reporting and Impairment
IFRIC 11 IFRS 2: Group and Treasury Share Transactions
IFRIC 12 Service Concession Arrangements
IFRIC 13 Customer Loyalty Programmes
IFRIC 14 IAS 19 - The Limit on a Defined Benefit Asset, Minimum
Funding Requirements, and their Interaction
IFRIC 15 Agreements for the Construction of Real Estate
IFRIC 16 Hedges of a Net Investment in a Foreign Operation
Self-Instructional
20 Material
IFRIC 17 Distributions of Non-cash Assets to Owners Accounting Standards &
Financial Reporting
IFRIC 18 Transfers of Assets from Customers
IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments
IFRIC 20 Stripping Costs in the Production Phase of a Surface Mine NOTES
IFRIC 21 Levies
IFRIC 22 Foreign Currency Transactions and Advance Consideration
IFRIC 23 Uncertainty over Income Tax Treatments

Advantages and Disadvantages of IFRS

The following are the advantages of IFRS:
• It simplifies the process of accounting for different accounting users and
entities.
• It streamlines and makes the understanding of the accounting statements
consistent.
• It makes companies following the standard practices more competitive
and attractive in the global market.
• It will make the comparison of different entities across the world more
easier.
• It acts like a global gold standard in terms of accounting practices.
The following are the disadvantages of IFRS:
• Differences in items of the financial statements will still not have similar
reasons due to different national laws and conditions affecting them. So
understanding the reasoning behind differences will still not be easier.
• IFRS is highly influenced by cultural and environment factors including
language and legal issues making a dent in its comparison capabilities.
• Different historical practices in the countries will have a bearing on how
the interpretive IFRS are applied.
• It may be a costly affair for companies since it requires certain level of
global understanding of business practices and therefore specialized skills.
• IFRS may also drive up costs of the companies when they will have to
bring changes to the internal operations and training to be in tune with the
global accounting standards and their applicability.
1.3.1 Fair Value Accounting
Current market values are used as the foundation for recognising certain assets
and liabilities in fair value accounting. Under present market conditions, fair
value is the projected price at which an asset or liability can be sold or settled
in an orderly transaction to a third party. The concepts listed below are included
in this definition.
Self-Instructional
Material 21
Accounting Standards & Current Market Condition
Financial Reporting
Fair value should be determined based on market conditions on the measurement
date, rather than a transaction that occurred at a previous date.
NOTES The Intention of the Holder
The intention of the holder of asset or liability to keep the item or liability is not
relevant in determining fair value. In the absence of such intent, the calculated
fair value could be skewed. If the objective is to sell an asset right away, for
example, this could be interpreted to mean a hasty sale, which could result in a
lower sale price.
Organized transaction
Fair value must be determined based on an orderly transaction, which means
one in which there is no excessive pressure to sell, as in a corporate liquidation.
Third-Party Purchase
Fair value is determined based on the assumption of a sale to an entity that is
neither a corporate insider or affiliated to the seller in any manner. A related-party
transaction, on the other hand, could skew the price paid.
Active Market
The best way to determine fair value is to look at pricing in a live market. An
active market is one with a high enough volume of transactions to offer real-
time pricing information. Also, the market from which a fair value is calculated
should be the asset or liability’s primary market, as the higher transaction volume
associated with this market should theoretically result in the highest prices for
the seller. The major market is understood to be the market where a company
generally sells the asset type in question or settles liabilities.
Methods of Calculating Fair Value
There are various main ways to determining fair values that are allowed under
fair value accounting, as listed below.
Market Value
To calculate a fair value, the market approach examines the prices associated
with actual market transactions for similar or identical assets and liabilities. The
prices of securities held, for example, can be received from a national exchange
where these securities are purchased and sold on a regular basis.
Income Approach
The income approach uses estimated future cash flows or earnings, adjusted
by a discount rate that indicates the time value of money and the risk of cash
Self-Instructional
flows not being achieved, to derive a discounted present value. Another way to
22 Material incorporate risk in this approach is to develop a probability-weighted-average
set of possible future cash flows.
Cost Approach Accounting Standards &
Financial Reporting
The cost approach uses the estimated cost to replace an asset, adjusted for the
obsolescence of the existing asset.
NOTES
Check Your Progress
3. What is the basic objective of the IFRS?
4. State two advantages of IFRS.

1.4 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS
1. The main function of the ASB is to formulate accounting standards so
that such standards will be established by the Council of the Institute of
Chartered Accountants.
2. AS 12 deals with accounting for government grants. Government grants
are sometimes called by other names such as subsidies, cash incentives,
duty drawbacks, etc.
3. The basic objective of IFRS is to make international comparison of financial
statements of business enterprises as easy as possible.
4. The advantages of IFRS are given below:
• It simplifies the process of accounting for different accounting users
and entities.
• It streamlines and makes the understanding of the accounting statements
consistent.

1.5 SUMMARY
• In order to bring uniformity in terminology, approach and presentation
of accounting results, the Institute of Chartered Accountants of India
established on 22 April 1977, an Accounting Standards Board (ASB).
• The main function of the ASB is to formulate accounting standards so
that such standards will be established by the Council of the Institute of
Chartered Accountants.
• In all 32 accounting standards have been issued out of which 1 has been
withdrawn while 3 are only recommendatory.
• Accounting Standard 3 was originally issued in June 1981 as AS 3 “Changes
in Financial Positions”. It was in 1997 revised as Cash Flow Statement.
The Standard is concerned with the provision of information about the
historical changes in cash and cash equivalents of an enterprise by means
of a cash flow statement.
Self-Instructional
Material 23
Accounting Standards & • Accounting Standard 12 was originally issued in 1991. This standard
Financial Reporting
has come into effect in respect of accounting periods commencing on or
after the 1st April 1992. It deals with accounting for government grants.
Government grants are sometimes called by other names such as subsidies,
NOTES cash incentives, duty drawbacks, etc.
• Financial leverage helps the financial manager considerably while devising
the capital structure of the company. A high financial leverage means high
fixed financial costs and high financial risk.
• Composite leverage expresses the relationship between revenue on account
of sales (i.e., contribution or sales less variable cost) and the taxable income.
It helps in finding out the resulting percentage change in taxable income
on account of percentage change in sales.
• International Accounting Standards Committee (IASC) came into existence
on 29th June, 1973 when 16 accounting bodies from nine nations (called
founder members) signed the agreement and constitution for its formation.
The Committee has its headquarters at London. Its interpretative arm was
known as Standard Interpretation Committee (SIC).
• Since 2001, the IASC was renamed as the International Accounting
Standard Board (IASB). The IASB has now taken over the work of IASC.
Its members (currently 15 full time members) are responsible for the
development and publication of IFRSs and approving interpretations as
developed by IFRIC
• IFRS is a set of international accounting standards developed by the
International Accounting Standards Board (IASB) providing the mode
of reporting particular type of transactions and events in the financial
statements.
• The basic objective of IFRSs is to make international comparison of
financial statements of business enterprises as easy as possible.
• IFRS is a globally accepted financial reporting framework. It is used over
110 countries but in both the US and the UK, the Generally Accepted
Accounting Principles (GAAP) is the more widely used set of guidelines
for accountants.
• Current market values are used as the foundation for recognising certain
assets and liabilities in fair value accounting. Under present market
conditions, fair value is the projected price at which an asset or liability
can be sold or settled in an orderly transaction to a third party.
• There are various main ways to determining fair values that are allowed
under fair value accounting. These are Market Approach, Income Approach
and Cost Approach.

Self-Instructional
24 Material
Accounting Standards &
1.6 KEY WORDS Financial Reporting

• Accounting Standard: It is a set of practices and policies used to

systematize bookkeeping and other accounting functions across firms and NOTES
over time.
• Cash flow statement: It is a financial statement that provides aggregate data
regarding all cash inflows a company receives from its ongoing operations
and external investment sources.
• Balance Sheet: It is a financial statement that reports a company’s assets,
liabilities, and shareholder equity.

1.7 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. What are the objectives of the Accounting Standards Board?
2. What do you mean by composite leverage?
3. Briefly mention the objectives of IASB.
4. Write a short note on the scope of the IFRS.
5. State the disadvantages of IFRS.
Long Answer Questions
1. Discuss in detail the procedure for issuing an accounting standard.
2. Examine the meaning, objective and assumption of the IFRS.
3. Analyse the main ways in which fair value can be determined.

1.8 FURTHER READINGS

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing
House.
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
An Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Hill Education.

Self-Instructional
Material 25
Accounting for Capital
Restructuring (Internal
UNIT 2 ACCOUNTING FOR Reconstruction)

CAPITAL RESTRUCTURING
NOTES
(INTERNAL
RECONSTRUCTION)
Structure
2.0 Introduction
2.1 Objectives
2.2 Meaning , Concept and Types of Capital Restructuring
2.3 Meaning of Internal Reconstruction and Accounting Entries
2.3.1 Alteration of Share Capital
2.3.2 Reduction of Share Capital, Reduction in Liabilties and Cancellation of
Expenses, Losses etc.
2.4 Preparation of Balance Sheet after Internal Reconstruction
2.5 Answers to Check Your Progress Questions
2.6 Summary
2.7 Key Words
2.8 Self Assessment Questions and Exercises
2.9 Further Readings

2.0 INTRODUCTION
Companies should restructure and concentrate on capital restructuring in order
to survive in the present competitive environment. Restructuring is a conscious
decision taken by companies to ensure that they maintain their position in the
market. The term reconstruction is concerned with reorganizing the capital
structure of the company. This unit will discuss the meaning and types of capital
restructuring. The unit will also discuss the concept of internal reconstruction
and the preparation of balance sheet after internal reconstruction.

2.1 OBJECTIVES
After going through this unit, you will be able to:
• Understand the meaning and types of capital restructuring
• Explain the concept of internal reconstruction and alteration of share capital
• Discuss the concept of reduction of share capital
• Discuss in detail the preparation of Balance Sheet after Internal
Reconstruction

Self-Instructional
Material 27
Accounting for Capital
Restructuring (Internal 2.2 MEANING, CONCEPT AND TYPES OF CAPITAL
Reconstruction)
RESTRUCTURING
NOTES In order to expand or survive in a competitive climate, a company must restructure
and concentrate on its competitive edge. Economies of scale can be achieved
by a larger company. A larger company has a better corporate position. As a
result of its status, it is able to raise funds at a lesser cost. Because the cost of
capital is lower, profits are more. Corporate restructuring aims to reduce costs
while also increasing efficiency and profitability. Corporate restructuring is the
process of reorganising a company’s operations in order to improve its efficiency
and profitability. Restructuring is no longer an option; it is a conscious decision
made by businesses.
Types of corporate restructuring
The following types of restructuring can be done to achieve strategic and financial
synergies:
• Merging two or more than two companies.
• Buying assets of another company
• Acquiring equity shares of another firm, which results in change of
ownership
• Financial re-engineering
• Buying-back of shares
• Issuing various types of debts to meet the demand of fixed and working
capital
• Infusing foreign debts and equity
Furthermore, companies can follow certain strategies to achieve internal
reorganizing. These strategies are:
• Decreasing the manpower
• Closing uneconomical/non-value-adding units
• Cost reduction programs
• Disposing off obsolete assets
• Reorganizing the business processes
Various modes of Corporate Restructuring are given below:
(1) Merger
(2) Demerger
(3) Reverse Merger
(4) Disinvestment
(5) Takeovers
Self-Instructional
28 Material (6) Joint Venture
(7) Strategic alliance Accounting for Capital
Restructuring (Internal
(8) Franchising Reconstruction)

(9) Slump Sale

NOTES
Check Your Progress
1. What is corporate restructuring aimed at?
2. Define corporate restructuring.

2.3 MEANING OF INTERNAL RECONSTRUCTION

AND ACCOUNTING ENTRIES
The term reconstruction means reorganising the capital structure of a company
including the reduction of claims of both the shareholders and the creditors against
the company. Such a reconstruction generally becomes necessary on account of
bad financial position of the company. It may be “external” as well as “internal.”
External Reconstruction
In case of such a reconstruction, a new company is formed to take over the
business of an existing company which is in a bad financial position. The vendor
company goes into liquidation after selling its business to the new company.
Internal Reconstruction
In case of such reconstruction, the capital of a company is reorganised to infuse
new life in the company. It includes both alteration and reduction of share capital.
Final Accounts for Capital Restructuring
The accounting entries for internal reconstruction are as follows:
Journal Entries
Sr. No. Particulars Dr Cr
1. For reduction of Equity Share Capital
(Old) Equity Share Capital Account Dr.
To (new) Equity Share Capital Account
To Capital Reduction Account
2. For reduction of Preference Share Capital
(Old) Preference Share Capital Account Dr.
To (new) Preference Share Capital Account
To Capital Reduction Account
3. For reduction of the amount due to debenture holders
Debenture holders Account Dr.
To Capital Reduction Account
Self-Instructional
Material 29
Accounting for Capital 4. For reduction of the amount due to Creditors
Restructuring (Internal
Reconstruction) Creditors Account Dr.
To Capital Reduction Account
5. For appreciation in the value of Assets
NOTES
Assets Account Dr.
To Capital Reduction Account
6. For the payment of Reconstruction expenses
Reconstruction Expenses Account Dr.
To Bank Account
7. For utilization of capital reduction account in writing off accumulated losses and various
fictitious assets
Capital Reduction Account Dr.
To Profit and Loss account (loss)
To Preliminary Expenses
To Discount of issue of shares or debentures account
To underwriting commission account
To Advertising Suspense’s account
To Reconstruction Expenses account
To Good will account
To Patents or Trade Marks account
To Fixed assets account (over valued assets)
To Other assets account
To Capital Reserves account (if some balance is still)

2.3.1 Alteration of Share Capital

The Companies Act has used the words, ‘‘Alteration Proper’’ for alteration of
share capital. Such alteration can be done under provisions of Sections 61 and 62
of the Companies Act, 2013. The term alteration proper includes the following:
(i) Increase of share capital by issue of new shares.
(ii) Consolidation or subdivision of the existing shares into shares of larger or
smaller denominations.
(iii) Conversion of fully paid shares into stocks and vice versa.
(iv) Cancellation of the unissued shares.
A company can make these alterations by passing an ordinary resolution,
if it is authorised by its Articles of Association to do so. Such alteration must be
notified and a copy of the resolution should be filed with the Registrar within 30
days of the date of the passing of such resolution.
Accounting entries
The accounting entries in respect of alteration of share capital are as follows:
Self-Instructional (i) Increase of share capital: This is similar to making a fresh issue of
30 Material
share capital.
(ii) Consolidation of shares: In case of consolidation of shares, shares Accounting for Capital
Restructuring (Internal
of smaller denominations are converted into shares of larger denominations. In Reconstruction)
such a case the paid up share capital remains the same but the number of shares
get reduced.
NOTES
Example. A company having equity share capital of 1 lakh divided into shares
of 10 each decides to convert the share capital into equity shares of 100 each.
The following journal entry will be passed for such conversion:
Equity Share Capital ( 10) A/c Dr. 1,00,000
To Equity Share Capital ( 100) A/c 1,00,000
(Being conversion of 10,000 equity shares of
10 each into 1,000 shares of 100 each)

(iii) Subdivision of shares: In this case, shares of larger denominations

are converted into shares of smaller denominations. The journal entry in respect
of such conversion would be on the same pattern as explained in case of
consolidation of shares, except the number of shares would increase.
Example. A company having equity share capital of 1 lakh divided into shares
of 100 each decides to convert it into shares of 10 each.
In such a case the journal entry will be as follows:
Equity Share Capital ( 100) A/c Dr. 1,00,000
To Equity Share Capital ( 10) A/c 1,00,000
(Being conversion of 1,000 shares of 100
each into 10,000 equity shares of 10 each)

(iv) Conversion of shares into stock: A company can convert its fully paid
up shares into stock or vice-versa. In case shares are converted into stock, the
following journal entry will be passed:
Share Capital A/c Dr.
To Capital Stock A/c

(v) Cancellation of unissued shares. In case a company cancels its unissued

shares, it does not require any accounting entry to be passed. The authorised share
capital of the company will stand reduced by the amount of unissued shares now
cancelled.
Example: Pass journal entries for the following transactions:
(i) Conversion of 2 lakh fully paid equity shares of 10 each into stock of
1,00,000 and balance has 12% fully convertible Debenture.
(ii) Consolidation of 40 lakh fully paid equity shares of 2.50 each into 10
lakh fully paid equity share of 10 each.
(iii) Sub-division of 10 lakh fully paid 11% preference shares of 50 each into
50 lakh fully paid 11% preference shares of 10 each.
(iv) Conversion of 12% preference shares of 5,00,000 into 14% preference
shares 3,00,000 and remaining balance as 12% Non-cumulative preference
shares. (CA, IPCC, 2013)

Self-Instructional
Material 31
Accounting for Capital Solution
Restructuring (Internal
Journal Entries
Reconstruction)
Particulars
(i) Equity share Capital A/c Dr 20,00,000
NOTES To Equity stock A/c 1,00,000
To 12% Fully convertible debentures A/c 19,00,000
(Being conversion of 2 lakh equity shares of 10 each
into stock of 1,00,000 and balance as fully convertible
debentures as per resolution)
(ii) Equity Share Capital A/c ( 2.50) Dr 100,00,000
To Equity share capital A/c ( 10) 100,00,000
(Being consolidation of 40 lakh shares of 2.50 each into
10 lakh shares of 10 each as per resolution)
(iii) 11% Preference Shares Capital A/c ( 50) Dr 500,00,000
To 11% Preference share capital A/c ( 10) 500,00,000
(Being subdivision of 10 lakh preference shares of 50
each into 50 lakh shares of 10 each as per resolution)
(iv) 12% Preference Share Capital A/c Dr 5,00,000
To 14% Preference share capital A/c 3,00,000
To 12% Non-cumulative preference share capital A/c 2,00,000
(Being conversion of preference shares as per resolution)

2.3.2 Reduction of Share Capital, Reduction in Liabilties and

Cancellation of Expenses, Losses etc.
A company can reduce its share capital as per the provisions of Sections 66 of the
Companies Act, 2013. The term reduction of share capital includes the following:
(i) Writing off lost capital.
(ii) Refunding surplus paid-up capital.
(iii) Reducing liability of the members for uncalled capital.
A company can reduce its share capital only when each of the following
conditions is satisfied:
(i) The Articles of Association of the company permits such reduction.
(ii) The company passes a special resolution for reducing its share capital.
(iii) The company obtains the confirmation of the National Company Law
Tribunal (NCLT) in respect of such reduction.
In order to get the confirmation of the National Tribunal, the company has to
file a scheme of reconstruction with the National Tribunal. The National Tribunal,
before sanctioning such a scheme of reduction would look to the protection of
the interests of the creditors and minority groups of the shareholders. In case
these parties object to the scheme, the National Tribunal will see that their claims
against the company are satisfied to the satisfaction of the National Tribunal.
Reduction of capital will not be effective until a copy of the resolution and
sanction of the National Tribunal is filed and registered with the Registrar of joint
Self-Instructional stock companies. NCLT may, at its discretion, order the words ‘‘and reduced’’
32 Material
to be added to the name of the company for the period it prescribes. NCLT may Accounting for Capital
Restructuring (Internal
also require the company to publish the reasons for reduction of capital for the Reconstruction)
information of the public.
Accounting entries NOTES
Accounting entries to be passed in respect of reduction of share capital are as
follows:
(i) Writing off lost capital: This means writing off or cancelling that part
of the paid up capital which is not represented by tangible assets.
Example. Following is the Balance Sheet of A Ltd. as on 31 March, 2021:
A Ltd.
Balance Sheet as at 31 March, 2021

Particulars
A Equity and Liabilities
1 Shareholders’ Fund
(a) Share Capital
Authorised:
.... Shares of 10 each .................
Issued, Subscribed & Paid-up:
10,000 Equity Shares of 10 each fully paid 1,00,000
(b) Reserves and Surplus:
Profit and Loss Account (50,000)
–
50,000
2 Current Liabilities:
Trade Payables 50,000
50,000
TOTAL (1) + (2) 1,00,000
B Assets
1 Non-current Assets
(a) Fixed Assets
(i) Tangible Assets 50,000
(ii) Intangible Assets: Goodwill 20,000
70,000
2 Current Assets 30,000
30,000
TOTAL (1) + (2) 1,00,000
–

The above balance sheet shows that company has lost 70,000 (i.e. P & L
account 50,000 plus Goodwill 20,000) of its paid up share capital. This may
be written off by means of the following journal entry:
Share Capital A/c Dr. 70,000
To Capital Reduction A/c 70,000

The share capital now stands reduced to 30,000. However, this reduction
of share capital can be effected in two ways. One alternative could be only to
reduce the paid-up value of the existing shares from 10 to 3 each without
reducing the nominal value of the shares. This means, the shareholders can be
asked in future to pay 7 more if the company requires additional funds. The
journal entry in such a case will be the same as explained above.
Self-Instructional
Material 33
Accounting for Capital The shareholders will not generally be willing for the above alternative
Restructuring (Internal
Reconstruction) since it puts additional burden on them. Other alternative can, therefore, be to
reduce both the nominal as well as the paid up value of share to 3 each. In such
a case the following journal entry will be passed:
NOTES Share Capital ( 10) A/c Dr. 1,00,000
To Share Capital ( 3) A/c 30,000
To Capital Reduction A/c 70,000

(ii) Refunding surplus paid-up capital: In case a company finds that it

has more capital than that it can profitably use, it may decide to refund surplus
capital to its shareholders.
Example. A company has share capital of 1 lakh divided into shares of 10
each. The company decides to repay to its members 2 per share and make shares
as of 8 each fully paid-up.
The following journal entries will be passed in such a case:
(i) Share Capital ( 10) A/c Dr. 1,00,000
To Share Capital ( 8) A/c 80,000
To Sundry Members A/c 20,000
(For conversion of share capital and money
due to members)
(ii) Sundry Members A/c Dr. 20,000
To Bank A/c 20,000
(For payment of money to members)

(iii) Reducing liability of members for uncalled capital: In case the liability
of members in respect of the uncalled share capital is reduced, the paid-up value
of the share capital will remain unchanged. However, the members will stand
to gain since they will not have to pay money to the company to the extent of
uncalled capital cancelled.
Example. A company has share capital of 1 lakh divided into shares of 10
each, called and paid-up 6 each. The company decides to cancel the liability
of members to the extent of the 2 per share, thus making the shares of 8 each,
6 paid-up.
The following journal entry will be passed in such a case:
Share Capital ( 10) A/c Dr. 60,000
To Share Capital ( 8) A/c 60,000
(Being conversion of shares of 10 each
into shares of 8 each)

(iv) Reduction in claims of creditors, debenture-holders, etc: Sometimes,

the creditors and the debenture-holders of the company are required to reduce
their claims against the company on account of heavy losses suffered by the
company which cannot be met in full by the company’s shareholders.
Example. Following are the extracts from a company’s balance sheet as on 31
December, 2021:
Liabilities Assets
13% Debentures of 100 each 1,00,000
Creditors 50,000
Self-Instructional
34 Material
Under the scheme of internal reconstruction, the debenture-holders agree Accounting for Capital
Restructuring (Internal
to accept new 15 per cent debentures of 80,000 in full satisfaction of the claims Reconstruction)
while the creditors agree to reduce their claims by 10,000.
The following journal entry will be passed for the sacrifice made by the
NOTES
debenture-holders and the creditors:
13% Debentures A/c Dr. 1,00,000
Unsecured Creditors A/c Dr. 10,000
To 15% Debentures A/c 80,000
To Capital Reduction A/c 30,000

Tutorial Note
Some accountants are of the opinion that in case the creditors and debenture-
holders are required to make sacrifice under a reconstruction scheme, the company
should open in its books ‘‘Reorganisation’’ or ‘‘Reconstruction Account”, in
place of ‘‘Capital Reduction Account’’. In support of their argument, they say
that the word capital stands only for the claims of the shareholders. However,
this is not wholly true. The term capital, in a wider sense includes not only the
funds provided by the shareholders but also funds provided by others including
debenture-holders and creditors. The students, may, therefore, use any of the terms
viz. Capital Reduction Account or Reorganisation Account or Reconstruction
Account.
(v) Disposal of capital reduction account: As explained in the preceding
pages, the capital reduction account represents the sacrifice made by the different
parties i.e. shareholders, debenture-holders, creditors, etc. This sacrifice is used
for writing off accumulated losses, intangible assets, over valuation of asset,
etc. Similarly, any appreciation in the value of the assets, capital profits, etc.
are also credited to this account. The balance of this account is transferred to
capital reserve.
The following journal entry will be passed for disposal of capital reduction
account:
Capital Reduction A/c Dr.
To Profit and Loss A/c (Debit balance)
To Goodwill A/c
To Preliminary Expenses A/c
To Assets
To Capital Reserve
(Each asset should be credited individually with the amount of over-valuation)

(vi) Treatment of arrears of preference dividends: The preference

shareholders are entitled to get dividend at a fixed rate in priority to other
shareholders. However, the company is not bound to pay them dividends.
Moreover, the liability to pay dividends arises only when the dividends have
been declared by the company. Of course, no dividend can be paid to the equity
shareholders unless all arrears of dividends in respect of cumulative preference
shares have been cleared. Preference shares are always taken as cumulative
unless otherwise stated. Self-Instructional
Material 35
Accounting for Capital In case dividends in respect of preference shares have been declared but
Restructuring (Internal
Reconstruction) have not yet been paid, the unpaid dividends will appear as a liability in the
company’s balance-sheet. The claimants of the unpaid dividends are just like any
other creditors of the company. In case they agree to sacrifice under a scheme
NOTES of reconstruction of the company, their sacrifice will be credited to the capital
reduction account.
However, if the preference dividends have not yet been declared by the
company, the arrears of preference dividends will appear either in the inner column
of the company’s balance-sheet or by way of footnote outside the company’s
balance-sheet. In case claimants of such arrears of preference dividends, agree,
under a reconstruction scheme, to sacrifice either in whole or in part, their arrears
of dividends, no accounting entry is necessary since the company had not so far
admitted any liability in respect of them. However, if the company is required to
pay in full or in part the arrears of preference dividends under the reconstruction
scheme, this will be an additional loss to the company. The following journal
entries will be passed in such a case:
(i) Capital Reduction A/c Dr.
To Preference Dividends A/c
(With the amount payable as dividends)
(ii) Preference Dividends A/c Dr.
To Bank A/c
(With the amount paid)

2.4 PREPARATION OF BALANCE SHEET AFTER

INTERNAL RECONSTRUCTION
The accounting entries in respect of internal reconstruction can be well understood
with the help of comprehensive illustrations given in the following pages.
Illustration 2.1: The paid-up capital of Toy Ltd. amounted to 2,50,000 consisting
of 25,000 equity shares of 10 each.
Due to losses incurred by the company continuously, the directors of the company prepared a
scheme for reconstruction which was duly approved by the court. The terms of reconstruction were as under:
(i) In lieu of their present holdings, the shareholders are to receive:
(a) Fully paid equity shares equal to 2/5th of their holding.
(b) 5% preference shares fully paid-up to the extent of 20% of the above new equity
shares.
(c) 3,000 6% second debentures of 10 each.
(ii) An issue of 2,500 5% first debentures of 10 each was made and fully subscribed in
cash.
(iii) The assets were reduced as follows:
(a) Goodwill from 1,50,000 to 75,000.
(b) Machinery from 50,000 to 37,500.
(c) Leasehold premises from 75,000 to 62,500.
Show the journal entries to give effect to the above scheme of reconstruction.

Self-Instructional
36 Material
Solution: Accounting for Capital
Books of Toy Ltd. Restructuring (Internal
Reconstruction)
Journal Entries
Particulars Dr. Cr.
Share Capital A/c (old) Dr. 2,50,000
To Equity Shares Capital A/c ( 2,50,000 × 2/5) 1,00,000
NOTES
To 5% Pref. Shares Capital A/c ( 1,00,000 × 20/100) 20,000
To 6% Second Debentures A/c 30,000
To Capital Reduction A/c 1,00,000
(Being conversion of 25,000 equity shares and balance
being transferred to Capital Reduction A/c in accordance
with the Scheme of Internal Reconstruction)
Bank A/c Dr. 25,000
To 5% First Debentures A/c 25,000
(Being issue of 25,000 5% First debentures for
cash as per Internal Reconstruction scheme)
Capital Reduction A/c Dr. 1,00,000
To Goodwill A/c 75,000
To Plant & Machinery A/c 12,500
To Leasehold Premises A/c 12,500
(Being sundry assets written down as per internal
reconstruction scheme)

Illustration 2.2: The following is the Balance Sheet of Downhill Ltd. as at 31st
March, 2021:
Downhill Ltd.
Balance Sheet as at 31 March, 2021
Particulars
A Equity and Liabilities
1 Shareholders’ Fund
(a) Share Capital
Authorised:
Equity shares of 100 each ................
Issued, Subscribed & Paid-up:
20,000 Equity shares of 100 each fully paid 20,00,000
(b) Reserves and Surplus
Profit and Loss Account (19,80,000)
Preliminary Expenses (20,000)
–

2 Non-current Liabilities
(b) Long-term Borrowings
12% Debentures 5,00,000
5,00,000
3 Current Liabilities
(a) Trade Payables 3,00,000
(b) Other Current Liabilities:
Outstanding Debenture Interest 1,20,000
4,20,000
TOTAL (1) + (2) + (3) 9,20,000
B Assets
1 Non-current Assets
Fixed Assets
(i) Tangible Assets
Land and Building 1,50,000
Plant and Machinery 3,00,000
Furniture 80,000
Self-Instructional
(ii) Intangible Assets: Goodwill 25,000 Material 37
5,55,000
Accounting for Capital 2 Current Assets
Restructuring (Internal (a) Inventories 2,70,000
Reconstruction) (b) Trade Receivables 60,000
(c) Cash and Cash Equivalents 35,000
3,85,000
NOTES TOTAL (1) + (2) 9,20,000
–
The following scheme of reconstruction is executed:
(i) Equity shares are reduced by 95 per share. They are, then, con-
solidated into 10,000 equity shares of 10 each.
(ii) Debenture-holders agree to forego outstanding debenture interest.
As a compensation 12% Debentures are converted into 14% De-
bentures, the amount remaining 5,00,000.
(iii) Creditors are given the option to either accept 50% of their
claims in cash in full settlement or to convert their claim into
equity shares of 10 each. Creditors for 2,00,000 opt for shares
in satisfaction of their claims.
(iv) To make payment to creditors opting for cash payment and to
augment working capital, the company issues 50,000 equity shares
of 10 each at par, the entire amount being payable along with
applications. The issue was fully subscribed.
(v) Land and Buildings are revalued at 2,00,000 whereas Plant and
Machinery is to be written down to 2,10,000. A provision amount-
ing to 5,000 is to be made for doubtful debts.
Pass journal entries and draft the company’s balance sheet immediately
after the reconstruction.
Solution:
Journal Entries
Particulars Dr. Cr.
Equity Share Capital ( 100) A/c Dr. 19,00,000
To Capital Reduction A/c 19,00,000
(Being reduction in the value of equity shares
by 95 each)
Equity Share Capital ( 100) A/c Dr. 1,00,000
To Equity Share Capital ( 10) A/c 1,00,000
[Being conversion of 20,000 equity shares of
100 each ( 5 paid-up) into 10,000 equity shares of
10 each (fully paid-up)]
Outstanding Debentures Interest A/c Dr. 1,20,000
To Capital Reduction A/c 1,20,000
(Being outstanding debentures interest foregone by
debenture-holders)
12% Debentures A/c Dr. 5,00,000
To 14% Debentures A/c 5,00,000
(Being conversion of 12% debentures into
14% debentures)

Self-Instructional
38 Material
Bank A/c Dr. 5,00,000 Accounting for Capital
To Equity Share Capital A/c 5,00,000 Restructuring (Internal
Reconstruction)
(Being 50,000 Equity Shares of 10 each issued
for cash and subscribed in full)
Creditors A/c Dr. 3,00,000 NOTES
To Equity Share Capital ( 10) A/c 2,00,000
To Bank A/c 50,000
To Capital Reduction A/c 50,000
(Being creditors of 1,00,000 paid in cash equivalent
to 50% of their claims and the rest issued equity
shares of 10 each in full settlement)
Land & Buildings A/c Dr. 50,000
To Capital Reduction A/c 50,000
(Being Land & Buildings revalued at 2,00,000)
Capital Reduction A/c Dr. 21,20,000
To Plant & Machinery A/c 90,000
To Provision for Doubtful Debts A/c 5,000
To Goodwill A/c 25,000
To Preliminary Expenses A/c 20,000
To P & L A/c 19,80,000
(Being balance of Capital reduction account utilised
for writing off the fictitious assets and accumulated
losses)

Note: Capital Reduction Account balance has been completely utilised.

Downhill Ltd. (And reduced)
Balance Sheet as at 31 March, 2021
Particulars
A Equity and Liabilities
1 Shareholders’ Fund
Share Capital
Authorised:
Equity Shares of 10 each ..............
Issued, Subscribed & Paid-up:
80,000 Equity Shares of 10 each fully paid 8,00,000
8,00,000
2 Non-current Liabilities
Long-term Borrowings 12% Debentures 5,00,000
5,00,000
TOTAL (1) + (2) 13,00,000
B Assets
1 Non-current Assets
(a) Fixed Assets
Tangible Assets:
Land and Building 2,00,000
Plant and Machinery 2,10,000
Furniture 80,000
4,90,000
2 Current Assets
(a) Inventories 2,70,000
(b) Trade Receivables 60,000
Less: Provision for Doubtful Debts (5,000) 55,000
(c) Cash and Cash Equivalents 4,85,000
8,10,000 Self-Instructional
TOTAL (1) + (2) 13,00,000 Material 39
–
Accounting for Capital Illustration 2.3: The following was the Balance Sheet of Continental Construction
Restructuring (Internal
Reconstruction) Ltd., as on 31 March, 2021:
Continental Construction Ltd. Balance Sheet as at 31 March, 2021
Particulars
NOTES
A Equity and Liabilities
1 Shareholders’ Funds:
(a) Share Capital
Authorised:
20,000 Equity Shares of 10 each 2,00,000
Issued, Subscribed & Paid-up: 12,000 Equity Shares of 10 each 1,20,000
Less: Calls in Arrear 9,000
1,11,000
(b) Reserves and Surplus
Profit and Loss Account as per Last Balance Sheet (22,900)
Less: Profit for the year 2,100 (20,800)

(c) Preliminary Expenses (1,500)

88,700
2 Current Liabilities –
(a) Trade Payables 15,425
(b) Short-term Provisions:
Provision for Taxation 4,000
19,425
TOTAL (1) + (2) 1,08,125
B Assets
1 Non-current Assets
(a) Fixed Assets
(i)Tangible Assets
Land and Building 20,500
Plant and Machinery 50,850 71,350

(ii) Intangible Assets: Goodwill 10,000

81,350

2 Current Assets
(a) Inventories 10,275
(b) Trade Receivables 15,000
(c) Cash and Cash Equivalents 1,500
26,775
TOTAL (1) + (2) 1,08,125

The directors have had a valuation made of the machinery and find
it over-valued by 10,000. It is proposed to write down this asset to its
true value and to extinguish the deficiency in the Profit and Loss Account
and to write off Goodwill and Preliminary Expenses, by the adoption of
the following use:
1. Forfeit the shares on which the call is outstanding.
2. Reduce the paid-up capital by 3 per share.
3. Reissue the forfeited shares at 5 per share.
4. Utilise the provision for taxation, if necessary.

Self-Instructional
40 Material
The shares on which the calls were in arrear were duly forfeited and Accounting for Capital
Restructuring (Internal
reissued on payment of 5 per share. You are required to draft the journal Reconstruction)
entries necessary and the Balance Sheet of the company after carrying out
terms of the scheme as set above.
NOTES
Solution:
Journal Entries
Particulars Dr. Cr.
Equity Share Capital A/c Dr. 30,000
To Calls in Arrear 9,000
To Forfeited Shares A/c 21,000
(Being forfeiture of 3,000 equity shares as per Board’s
Resolution dated...)
Equity Share Capital A/c Dr. 27,000
To Capital Reduction A/c 27,000
(Being reduction of the paid amount on existing shares
as per Reconstruction Scheme dated.....)
Bank A/c Dr. 15,000
Forfeited Shares A/c Dr. 6,000
To Equity Share Capital A/c 21,000
(Being reissue of 3,000 shares of 10 each
7 paid-up, at 5 per share)
Forfeited Shares A/c Dr. 15,000
Provision for Taxation A/c Dr. 300
To Capital Reduction A/c 15,300
(Being transfer of balance in forfeited shares account and
part of provision for taxation account to Capital Reduction
Account)
Capital Reduction A/c Dr. 42,300
To Machinery 10,000
To Profit and Loss A/c 20,800
To Goodwill 10,000
To Preliminary Expenses 1,500
(Being writing off losses, preliminary expenses and
goodwill and reduction in the value of machinery by
10,000 as per the reconstruction scheme)

Continental Construction Ltd. (And Reduced)

Balance Sheet as at 31 March, 2021

Particulars
A Equity and Liabilities
1 Shareholders’ Funds:
Share Capital:
Authorised:
20,000 Equity Shares of 10 each 2,00,000
Issued, Subscribed & Paid-up: 12,000 Equity Shares of
10 each, 7 Paid-up 84,000
84,000
2 Current Liabilities
(a) Trade Payables 15,425
(b) Short-term Provisions:
Provision for Taxation 3,700
19,125
Self-Instructional
TOTAL (1) + (2) 1,03,125 Material 41
Accounting for Capital B Assets
Restructuring (Internal 1 Non-current Assets
Reconstruction)
(a) Fixed Assets
(i) Tangible Assets:
Land and Building 20,500
NOTES Plant and Machinery 50,850
Less: Amount written off under
reconstruction scheme (10,000) 40,850 61,350
2 Current Assets –
(a) Inventories 10,275
(b) Trade Receivables 15,000
(c) Cash and Cash Equivalents 16,500
41,775
TOTAL (1) + (2) 1,03,125
–
Illustration 2.4: The Balance Sheet of XY Limited is as follows:
XY Ltd.
Balance Sheet as at 31 March, 2021
Particulars
A Equity and Liabilities
1 Shareholders’ Funds:
(a) Share Capital
Authorised:
4,00,000 Equity Shares of 5 each 20,00,000
10,000, 8% Preference Shares of 100 each 10,00,000
30,00,000
Issued, Subscribed & Paid-up:
2,00,000 Equity Shares of 5 each 10,00,000
6,000, 8% Preference Shares of 100 each 6,00,000
(b) Reserves and Surplus
Profit and Loss Account (4,08,000)
11,92,000
2 Non-current Liabilities –
Long-term Borrowings:
9% Debentures 6,00,000
6,00,000
3 Current Liabilities
(a) Short-term Borrowings
Bank of India–Overdraft 1,50,000
(b) Trade Payables 69,000
(c) Other Current Liabilities
Interest Accrued on Debentures 1,08,000
Interest Accrued on Bank Overdraft 15,000 1,23,000
3,42,000
TOTAL (1) + (2) + (3) 21,34,000
B Assets
1 Non-current Assets
(a) Fixed Assets
(i) Tangible Assets 11,40,000
(ii) Intangible Assets: Patents and Copyrights 80,000
(b) Non-current Investments 65,000
(Market value 55,000)
12,85,000

Self-Instructional
42 Material
2 Current Assets Accounting for Capital
(a) Inventories 4,00,000 Restructuring (Internal
(b) Trade Receivables Reconstruction)
4,39,000
(c) Cash and Cash Equivalents 10,000
8,49,000 NOTES
TOTAL (1) + (2) 21,34,000

Preference dividend is in arrear for one year.

(i) Preference shareholders to give up their claims, inclusive of divi-
dends, to the extent of 30% and desire to be paid off.
(ii) Debenture-holders agree to give up their claims to interest in
consideration of their interest rate being enhanced to 12%.
(iii) Bank agrees to give up 50% of its interest outstanding in consid-
eration of its being paid off at once.
(iv) Creditors would like to grant a discount of 5% if they paid im-
mediately.
(v) Balance of Profit & Loss Account, Patents and Copyrights and
Debtors of 30,000 to be written off.
(vi) Fixed Assets to be written down by 34,000.
(vii) Investments are to reflect their market value.
(viii) To the extent not specifically stated, equity shareholders suffer on
reduction of their rights. Cost of reconstruction is 3,350.
Draft journal entries in the books of the company assuming that the
scheme has been put though fully with the equity shareholders bringing
in necessary cash to pay off the parties and to take working capital of
30,000 and prepare the Balance Sheet after reconstruction.
Solution:
In the Books of XY Ltd. Journal Entries
Date Particulars Dr. Cr.
8% Preference Share Capital A/c Dr. 6,00,000
To Preference Shareholders A/c 4,20,000
To Capital Reduction A/c 1,80,000
(Being 30% of claim given up by preference shareholders
as per reconstruction scheme dated...)
Capital Reduction A/c Dr. 33,600
To Preference Shareholders A/c 33,600
(Being 70% of arrear preference dividend payable to
preference shareholders as per reconstruction scheme)
9% Debentures A/c Dr. 6,00,000
Interest accrued on Debentures A/c Dr. 1,08,000
To 12% Debentures A/c 6,00,000
To Capital Reduction A/c 1,08,000
(Being 9% debentures converted into equivalent number
of 12% debentures and accrued debentures interest
sacrificed as per Reconstruction scheme)

Self-Instructional
Material 43
Accounting for Capital Equity Share Capital A/c Dr. 3,00,000
Restructuring (Internal To Capital Reduction A/c 3,00,000
Reconstruction) [Being equity shareholders rights reduced
to a share of 3.50 each, the amount
of sacrifice credited to capital
NOTES reduction A/c (WN 1)]
Bank A/c Dr. 7,00,000
To Equity Share Capital A/c 7,00,000
[Being amount received on 2,00,000 equity shares
@ 3.50 per share as per reconstruction scheme
(WN 2)]
Bank of India A/c Dr. l,50,000
Interest accrued on Bank Overdraft A/c Dr. 15,000
To Bank A/c 1,57,500
To Capital Reduction A/c 7,500
(Being bank overdraft paid off including 50% of accrued
interest as per reconstruction scheme, the interest
sacrificed credited Capital to Reduction A/c)
Creditors A/c Dr. 69,000
To Bank A/c 65,550
To Capital Reduction A/c 3,450
(Being creditors claim discharge to the extent of 95%
as per reconstruction scheme, the balance of the claim
sacrificed)
Capital Reduction A/c Dr. 3,350
To Bank A/c 3,350
(Being reconstruction expenses paid)
Preference Shareholders A/c Dr. 4,53,600
To Bank A/c 4,53,600
(Being amount due to preference shareholders discharged)
Capital Reduction A/c Dr. 5,62,000
To Profit and Loss A/c 4,08,000
To Patents & Copyright A/c 80,000
To Debtors A/c 30,000
To Investment A/c 10,000
To Fixed Assets A/c 34,000
(Being writing off debit balance of profit and loss
account, patents, copyrights and writing down the value
of debtors, investments and fixed assets as per
reconstruction scheme)

XY Ltd. (And Reduced)

Balance Sheet as at 31 March, 2021
Particulars
A Equity and Liabilities
1 Shareholders’ Funds:
(a) Share Capital
Authorised:
4,00,000 Equity Shares of 7 each 28,00,000
Issued, Subscribed & Paid-up:
2,00,000 Equity Shares of 7 each 14,00,000
(b) Reserves and Surplus –
14,00,000
2 Non-current Liabilities
Long-term Borrowings:
12% Debentures 6,00,000
6,00,000
Self-Instructional
44 Material
TOTAL (1) + (2) 20,00,000
B Assets Accounting for Capital
1 Non-current Assets Restructuring (Internal
(a) Fixed Assets Reconstruction)
Tangible Assets 11,06,000
(b) Non-current Investments 55,000
(Market value 55,000) 11,61,000 NOTES
2 Current Assets
(a) Inventories 4,00,000
(b) Trade Receivables 4,09,000
(c) Cash and Cash Equivalents 30,000
8,39,000
TOTAL (1) + (2) 20,00,000
–
Working Notes:
1. Computation of sacrifices received and their application:

Sl. Sacrifices received Sl. Amounts to be

No. No. written off or provided for
(i) Preference shareholders: (i) Reconstruction Expenses 3,350
(30% of 6,00,000) 1,80,000 (ii) Profit and Loss A/c
(ii) Debenture-holders: (Dr. balance) 4,08,000
Interest on Debentures 1,08,000 (iii) Patents & Copyrights 80,000
(iii) Bank of India: (iv) Arrear Pref. Dividend
Int. on Bank Overdraft (50%) 7,500 (70% of 48,000) 33,600
(iv) Creditors: (v) Reduction in value of:
5% of 69,000 3,450 Fixed Assets 34,000
(v) Equity Shareholders: Debtors 30,000
Sacrifice @ 1.50 per share Investment 10,000
(Balancing Figure) 3,00,000
5,98,950 5,98,950

2. Cash to be brought in by Equity Shareholders:

Payments to:
Preference Shareholders (including arrear of preference dividend) (70% of 6,48,000) 4,53,600
Bank of India (including interest on bank overdraft) ( 1,50,000 + 7,500) 1,57,500
Creditors 95% of 69,000 65,550
Others:
Reconstruction Expenses 3,350
Additional Cash for Working Capital 20,000
7,00,000
Hence, contribution per equity share comes to = 7,00,000 2,00,000 = 3.50.
3. The total number of issued equity shares remain at 2,00,000 of 7 ( 3.50 + 3.50) each fully Paid-up.

When balance of the Profit and Loss Account is not given

Sometimes in an examination problem the balance of the profit and loss account
is not given. In such a case a memorandum balance sheet of the business should
be prepared with the available information taking assets and liabilities at book
values. The difference of the two sides as disclosed by the memorandum balance
sheet should be taken as the balance of the profit and loss account.
Example. The following balances have been extracted from the Trial Balance
of Notsowell Limited as on 31st March, 2021:
Equity Share Capital A/c ( 10 shares) 1,00,000
Preference Share Capital A/c ( 100 each) 1,00,000
15% Debentures 1,00,000
Sundry Creditors 50,000
Fixed Assets (Market value 1,00,000) 1,50,000
Current Assets 1,50,000 Self-Instructional
Material 45
Accounting for Capital The Balance of the Profit and Loss Account can be ascertained by preparing
Restructuring (Internal
Reconstruction) a Memorandum Balance Sheet as on 31st March, 2021.
Memorandum Balance Sheet
Liabilities Assets
NOTES
Share Capital: Fixed Assets 1,50,000
Equity ( 10 shares) 1,00,000 Current Assets 1,50,000
Preference ( 100 shares) 1,00,000 P & L A/c
15% Debentures 1,00,000 (accumulated loss-bal. fig.) 50,000
Sundry Creditors 50,000
3,50,000 3,50,000

Check Your Progress

3. Define the term ‘reconstruction’.
4. What do you mean by reduction of share capital?

2.5 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS
1. Corporate restructuring aims to reduce costs while also increasing efficiency
and profitability.
2. Corporate restructuring is the process of reorganising a company’s
operations in order to improve its efficiency and profitability.
3. The term reconstruction means reorganising the capital structure of a
company including the reduction of claims of both the shareholders and
the creditors against the company.
4. The term reduction of share capital includes the following:
• Writing off lost capital.
• Refunding surplus paid-up capital.
• Reducing liability of the members for uncalled capital.

2.6 SUMMARY
• Corporate restructuring aims to reduce costs while also increasing efficiency
and profitability. Corporate restructuring is the process of reorganising a
company’s operations in order to improve its efficiency and profitability.
Restructuring is no longer an option; it is a conscious decision made by
businesses.
• The term reconstruction means reorganising the capital structure of a
company including the reduction of claims of both the shareholders and
the creditors against the company.
• In case of external reconstruction, a new company is formed to take over
the business of an existing company which is in a bad financial position.
Self-Instructional
46 Material
The vendor company goes into liquidation after selling its business to the
new company
• In case of internal reconstruction, the capital of a company is reorganised Accounting for Capital
Restructuring (Internal
to infuse new life in the company. It includes both alteration and reduction Reconstruction)
of share capital.
• The Companies Act has used the words, ‘‘Alteration Proper’’ for alteration
NOTES
of share capital. Such alteration can be done under provisions of Sections
61 and 62 of the Companies Act, 2013.
• A company can reduce its share capital as per the provisions of Sections
66 of the Companies Act, 2013.
• The term reduction of share capital includes the following:
(i) Writing off lost capital.
(ii) Refunding surplus paid-up capital.
(iii) Reducing liability of the members for uncalled capital.
• Reduction of capital will not be effective until a copy of the resolution and
sanction of the National Tribunal is filed and registered with the Registrar
of joint stock companies.

2.7 KEY WORDS

• Share capital: It is the money a company raises by issuing common or
preferred stock.
• Liability: It is something a person or company owes, usually a sum of
money.
• Equity shares: These are long-term financing sources for any company.
These shares are issued to the general public and are non-redeemable in
nature.

2.8 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. What are the strategies followed by companies to achieve internal
reorganizing?
2. What does the term ‘alteration proper’ include?
3. Under what conditions can a company reduce its share capital?
Long Answer Questions
1. Discuss the accounting entries which are passed in alteration of share
capital.
2. Examine the accounting entries to be passed in case of reduction of share
capital.
Self-Instructional
Material 47
Accounting for Capital
Restructuring (Internal 2.9 FURTHER READINGS
Reconstruction)

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.

NOTES Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing
House.
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018. An
Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Hill Education.

Self-Instructional
48 Material
Final Accounts of
UNIT 3 FINAL ACCOUNTS OF Banking Companies

BANKING COMPANIES
NOTES
Structure
3.0 Introduction
3.1 Objectives
3.2 Introduction of Banking Company
3.3 Legal Provisions
3.3.1 Capital
3.3.2 Reserve Fund
3.3.3 Deposits
3.3.4 Borrowings
3.3.5 Other Liabilities and Provisions
3.3.6 Cash and Balance
3.3.7 Investment
3.3.8 Advances
3.3.9 Fixed and Other Assets
3.3.10 Acceptances, Bills for Collection, Endorsements and Other Obligations
3.4 Accounting Treatment: Rebate on Bills Discounted, Provision for Bad and
Doubtful Debts, NPA, Rebate on Bills Discounted
3.5 Vertical Form of Final Accounts as per Banking Regulation Act 1949
3.5.1 Simple Numerical on Preparation of Profit and Loss A/C and Balance Sheet
in Vertical Form
3.6 Answers to Check Your Progress Questions
3.7 Summary
3.8 Key Words
3.9 Self Assessment Questions and Exercises
3.10 Further Readings

3.0 INTRODUCTION
The Banking Regulation Act was introduced in 1949 with effectuated the
provisions relating to the final accounts of banking companies. This Act has
been amended from time to time. This unit will discuss the legal provisions with
regards to capital, reserved fund, deposit, etc. The numerical for the preparation
of Profit and Loss Account and Balance Sheet in vertical form will also be
mentioned in the unit.

3.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss in detail the provisions of Banking Regulation Act
• Explain the legal provisions regarding capital, reserve fund, deposits,
borrowings, investment and advances
• Examine the provision for bad and doubtful debts and rebate on bills Self-Instructional
discounted Material 49
Final Accounts of • Explain with numerical the preparation of Profit and Loss Account and
Banking Companies
Balance Sheet in vertical form

3.2 INTRODUCTION OF BANKING COMPANY

NOTES
Banking business in India is largely governed by the Banking Regulation Act,
1949. According to Section 5(b) of this Act, banking means “the acceptance
for the purpose of lending or investment of deposits of money from the public
repayable on demand, order or otherwise and withdrawable by cheque, draft,
order or otherwise.” Thus, according to this definition accepting of deposits from
the public for lending or investment is the main function of a banking company.
However, under Section 6 of the Banking Regulation Act, a banking company can
also carry on some other businesses, such as acting as agents for any government
or local authority or any other person, carrying on every kind of guarantee and
indemnity business, undertaking and executing of trust etc.
The Act has been amended from time to time. The major amendments
have been in 1994, 2007, 2012 and most in recently in 2017 by The Banking
Regulation (Amendment) Act, 2017. The basic provisions of the Amendment
Act, 2017 are as under:
1. Power of Central Government to authorize Bank for issuing
directions to banking companies to initiate insolvency resolution
process (Sec. 35AA): The Central government may by order authorize
the Reserve Bank to issue directions to any banking company or banking
companies to initiate insolvency resolution process in respect of a
Default, under the insolvency and Bankruptcy Code, 2016.
According to the Insolvency and Bankruptcy Code 2016, the term
Default means “non-payment of debt when whole or any part of
instalment of the amount of debt has become due and is not repaid by
the debtor or the corporate debtor, as the case may be”.
2. Power of Reserve Bank to issue directions in respect of stressed
assets (Sec. 35AB): Without prejudice to the provisions of section
35A, the Reserve Bank may, from time to time, issue directions to the
banking companies for resolution of stressed assets.
The Reserved bank may specify one or more authorities or committees
with such members as the Reserve Bank may appoint or approve for
appointment to advise banking companies on resolution of stressed
assets.
Stressed Assets: Stressed assets are a powerful indicator of the health of
Self-Instructional the banking system. Stressed assets comprise :
50 Material
NPAs + Restructured Assets + Written off Assets. Final Accounts of
Banking Companies
Nonperforming Assets (NPAs) include advances whose interest or principal
remain overdue for a period of 90 days. While Restructured Assets include those
advances where the defaulting borrowers have been given another opportunity NOTES
to repay the advances. This opportunity may in the form of charging interest at
a reduced rate, extended time period for repayment written off assets are those
advances which the bank does not count its assets though the borrower owes it.
It does not mean that the borrower is pardoned or got exempted from payment.
The sections given in this unit are of The Banking Regulation Act, 1949
unless stated otherwise.
In this unit, we are concerned mainly with the technique of preparing the
final accounts of banking companies.
The important provisions relating to final accounts of a banking company
are as follows:*
Prescribed form: The final accounts of a banking company include the
Profit & Loss Account and the Balance Sheet. It may be noted that no Profit
& Loss Appropriation Account is prepared in case of a banking company.
All appropriations are done in the Profit & Loss Account itself. The Third
Schedule to the Banking Regulation Act, gives the formats of the Profit &
Loss Account and the Balance Sheet.
Accounting year: On account of the amended provisions of the Income Tax
Act 1961 requiring every company to close its accounts on 31st March each
year, w.e.f. financial year ending 31st March 1989, now a banking company
also closes its accounts on 31st March each year.
Prohibition of trading: A banking company can neither itself nor on behalf of
the others deal in buying or selling or bartering of goods except in connection
with the realisation of security given to or held by it (Section 8).
Non-banking assets: A banking company may have to take possession of
certain assets charged in its favour on account of the failure of a debtor to
repay the loan in time. Such an asset is termed a non-banking asset. It must
be disposed off by the banking company within 7 years of its acquisition
(Section 9). Income from either profit or loss on the sale of such an asset has
to be shown separately in the profit and loss account of the banking company.
Share capital: In order to ensure that no banking company commences or
carries on business with a weak and vulnerable capital structure, section 11
lays down the following minimum limits of paid-up capital and reserves to
be complied with by a banking company which wishes to commence or carry
on business in India. Self-Instructional
Material 51
Final Accounts of Aggregate value
Banking Companies Types of Banking Company of paid-up capital
and reserves
1. Banking companies incorporated outside India
(i) If it has a place of business in Bombay or
NOTES Calcutta or both 20,00,000
(ii) If it has places of business elsewhere 15,00,000
2. Banking companies incorporated in India
(i) If it has places of business in more than one
state and none of them is situated in the city of
Bombay or Calcutta 5,00,000
(ii) If it has places of business in more than one
State and any such place or places of business
are in Bombay or Calcutta or both 10,00,000
(iii) If it has all its places of business in one
state none of which is situated in the city of
Bombay or Calcutta–for the principal place of
business 10,00,000
plus
(a) in respect of each of its other places of
business situated in the same district 10,000
plus
(b) in respect of each place of business situated
elsewhere in the state otherwise than in the
same district 25,000
Subject to an overall limit of 5,00,000
(iv) If it has one place of business and that also not in
Bombay or Calcutta 50,000
(v) If it has all its places of business in one state, one or
more of which is or are situated in the city of
Bombay or Calcutta 5,00,000
plus
in respect of each places of business situated
outside the city of Bombay or 25,000
Calcutta, as the case may be Subject to an overall limit of 10,00,000

According to an amendment in 1962, a banking company commencing

business, after the coming into force of the Banking Companies (Amendment)
Act, 1962, shall have a paid-up capital of not less than 5 lakhs irrespective
of the number of places of its business.
According to Section 12 of the Act a banking company shall not be
entitled to commence its business in India unless it satisfies the following
conditions:
(i) Its subscribed capital is not less than one half of the authorised
capital and paid-up capital is not less than one half of the subscribed
capital. When the capital is increased, it should comply with the
conditions prescribed above within a period not exceeding 2 years
as the Reserve Bank may allow.
(ii) The capital of the banking consists of equity shares only or equity
shares and such preference shares as may have been issued prior
to 1st July, 1945 in accordance with the guidelines framed by the
Self-Instructional Reserve Bank of India. Moreover, such preference shares shall not
52 Material
be entitled to exercise voting rights with equity shareholder even Final Accounts of
Banking Companies
in cases dividend remain unpaid on such shares.
The above provisions do not apply to any banking company incorporated
before 15 Jan., 1937 (Section 12). NOTES
The limits as to share capital given above were fixed a long time back. These
limits have been found to be quite inadequate. In order to strengthen the capital
base of the banks, the Reserve Bank, on the recommendations of the Narasimhan
Committee, introduced in April, 1992 the risk weighted asset ratio system, in
line with capital measurement system introduced by Basel Committee in 1988.
According to the system (popularly known as Basel Norms), paid-up capital
and reserves of a bank (after writing off bad debts) should form an adequate
percentage of the assets of the bank, their investments, loans and advances. All
these items have been assigned weights according to the prescribed risk. Ratio
so computed is known as Capital Adequacy Ratio (CAR).
The Basel Committee Norms were revised by a new accord popularly
known as Basel II Norms, released on June 26, 2004 which were expected to be
implemented by the end of 2006. Under Basel II Norms banks have to maintain
a capital adequacy ratio (CAR) of 9% which includes Tier I Capital i.e. core
capital like Equity and Reserves and Tier II Capital. Now Basel III norms accord
has come into being. As per Basel III banks have to maintain a CAR of 8% with
a minimum of 7% of Tier I Capital. However at present RBI has asked banks to
maintain a CAR of a 9%.
The Reserve Bank of India (RBI) has been allowing since 1989 private
banks to be set up. It comes after almost two decades of nationalization of 14
larger banks in 1969. Such a private bank has to be registered as a company
under the Companies act. As per the recent guidelines issued on August 1, 2016
by Reserve Bank of India regarding licensing of new banks in the private sector,
the initial minimum paid up voting equity capital for such a bank shall be 500
corers. The Promoters shall hold initially 40% of the paid up voting equity capital
of the bank. It will maintain a minimum capital adequacy ratio of 13% on its
risk weighted assets for a minimum period of three years after commencement
of its operations. Subject to any higher percentage as may be prescribed by RBI.
Payment of commission, brokerage etc: A banking company cannot pay by
way of commission, brokerage, discount or remuneration in respect of shares
issued by it an amount exceeding in the aggregate 2.5% of the price at which
the said shares are issued such price shall include the premium charged on
as amended by The Banking Regulation (Amendment Act, 2012).
Charge on uncalled capital: A banking company cannot create any charge
upon its uncalled capital and any such charge shall be void (Section 14).
Payment of dividend: A banking company cannot pay dividend on its shares
until all its capitalised expenses (including preliminary expenses, organisation Self-Instructional
Material 53
Final Accounts of expenses, share selling commission, brokerage, amount of losses incurred and
Banking Companies
any other item of expenditure not represented by tangible assets) have been
completely written off.

NOTES However, a banking company is permitted to pay dividend without writing

off the following items:
(i) Depreciation in the value of its investments in approved securities
where such depreciation has not actually been capitalised or otherwise
accounted for as a loss.
(ii) Depreciation in the value of its investments in shares, debentures or
bonds (other than approved securities) in any case where adequate
provision for such depreciation has been made to the satisfaction of
the auditors of the banking company.
(iii) Bad debts, if any, where adequate provision has been made to the
satisfaction of the auditors of the banking company (Section 15).
RBI Guidelines Regarding Dividends*
Reserve Bank of India has issued the following guidelines to banks regarding
payment of dividend:
1. Eligibility criteria for declaration of dividend: Only those banks, which
comply with the following minimum prudential requirements, would be
eligible to declare dividends:
(i) The bank should have:
• Capital to Risk Weighted Asset Ratio (CRAR) of at least 9%
for preceding two completed years and the accounting year for
which it proposes to declare dividend.
• Net Not Performing Assets (NPA) less than 7%.
In case any bank does not meet the above CRAR norm, but is having
a CRAR of at least 9% for the accounting year for which it proposes
to declare dividend, it would be eligible to declare dividend provided
its Net NPA ratio is less than 5%.
(ii) The bank should comply with the provisions of Section 15 and
Section 17 (discussed below) of the Banking Regulation Act, 1949
as discussed above.
(iii) The bank should comply with the prevailing regulations/guidelines
issued by RBI, including creating adequate provisions for impairment
of assets and staff retirement benefits, transfer of profits to Statutory
Reserves etc.
(iv) The proposed dividend should be payable out of the current year’s
profit.
(v) The reserve Bank should not have placed any explicit restrictions on
Self-Instructional the bank for declaration of dividends.
54 Material
In case any bank does not meet the above eligibility criteria no special Final Accounts of
Banking Companies
dispensation shall be available from the Reserve Bank.
2. Quantum of dividend payable: Banks, which fulfill the eligibility criteria
set out at paragraph1 above, may declare and pay dividends, subject to the
NOTES
following:
(i) The dividend payout ratio shall not exceed 40%.
(ii) In case the profit for the relevant period includes any extra-ordinary
profits/income, the payout ratio shall be computed after excluding such
extra-ordinary items for reckoning compliance with the prudential
payout ratio.
(iii) The financial statements pertaining to the financial year for which
the bank is declaring a dividend should be free of any qualifications
by the statutory auditors, which have an adverse bearing on the
profit during that year. In case of any qualification to that effect, the
net profit should be suitably adjusted while computing the dividend
payout ratio.
Capital Adequacy Ratio
The banking companies must maintain adequate capital to ensure their financial
stability and soundness. This was realized as early as 1974 when Central Bank
Governors of Group of Ten (G-10) Countries established Basel Committee on
Banking Supervision (BCBS). The Committee’s Secretariat is located at Bank
for International Settlement (BIS) in Basel, Switzerland. It provides a forum
for regular co-operation on banking supervisory matters to improve the quality
of banking services worldwide. The Committee also frames and revises capital
adequacy norms popularly known as Basel Committee Norms on Capital
Adequacy. Till date of these norms have been issued in three stages: Basel I
Norms in 1988, Basel II Norms in 2004 and, Basel III Norms in 2010. Basel
III Norms are now desired to be implemented by the banks. The norms call for
minimum ratio of capital to risk weighted assets.
In India, the Reserve Bank of India has also be instructing the banks to
follow these capital adequacy norms in a phased manner. It has also introduced
the “Risk Adjusted (Weighted) Asset Ratio System” which seeks to measure
capital adequacy as the ratio of capital funds to risk weighted assets. The ratio
is calculated as under:
Capital Adequacy Ratio
Capital Funds
= Risk adjusted (weighted) assets and off Balance Sheet Items 100
Or
Risk Weighted Assets Ratio
Each of the above terms are being explained in the following pages.
Self-Instructional
Material 55
Final Accounts of Capital Funds: According to Basel Committee: capital funds have two components:
Banking Companies
(a) Tier I Capital and (b) Tier II Capital.
(a) Tier I Capital: It is also known as the core capital since it is the most
permanent and readily available support to a bank against unexpected
NOTES
losses is capital of Tier I.
Elements of Tier I Capital for Indian Banks: They include the following:
(i) Aggregate of Paid up Capital
(ii) Statutory Reserve
(iii) Other disclosed Free Reserves including Securities Premium and
Capital Reserve arising out of surplus on sale of fixed assets.
The aggregate amount of the above items is to be reduced by: (i) equity
investment in subsidiaries; (ii) intangible assets; and (iii) current and
brought forward losses.
(b) Tier II Capital: It is the capital which is less permanent and less readily
available to a bank compared to Tier I Capital in case of unexpected losses.
Elements of Tier II Capital for Indian Banks: They include the following:
(i) Undisclosed Reserves if they represent accumulations of post-tax
profits
(ii) Revaluation Reserves at a discount of 55%
(iii) General Provisions and Loss Reserves if not attributable to the actual
diminution in value identifiable potential loss in any specific asset and
thus available for meeting unexpected losses. Moreover they can be
taken up only to the extent of 1.25% of total risk weighted assets.
(iv) Hybrid debt instruments as stated below:
(a) Debt capital instruments
(b) Perpetual Cumulative Preference Shares.
(c) Redeemable Cumulative/Non-cumulative Preference Shares.
(v) Sub-ordinated Debt if fully paid, free of restrictive clauses and not
redeemable at the initiative of the holders.
Elements of Tier I Capital for foreign Banks: They include the following
(i) Interest free funds from Head Office kept in a separate account in
Indian books specially for the purpose of meeting the capital adequacy
norms.
(ii) Statutory reserves kept in Indian books.
(iii) Remittable surplus retained in Indian books which is not repatriable
so long as the bank functions in India.
(iv) Capital reserve representing surplus arising out of sale of assets
in India held in a separate account and which is not eligible for
repatriation so long as the bank functions in India.
Self-Instructional
56 Material
(v) Interest free funds remitted from abroad for the purpose of acquisition Final Accounts of
Banking Companies
of property and held in a separate account in Indian books.
(vi) The net credit balance, if any, in the inter-office account with Head
Office/overseas branches will not be reckoned as capital funds.
NOTES
However, any debit balance in Held Office Account will have to be
set off against the capital.
Elements of Tier II Capital for foreign Banks: The elements of Tier II
capital of foreign banks are similar to those of Indian banks.
Ratio of Tier II capital to Tier I capital: The quantum of Tier II capital is
limited to a maximum of 100% of Tier I Capital. The objective is to ensure that
the capital funds of a bank predominantly comprise of core capital rather than
items of a less permanent nature. It may further be noted that the Tier II capital
of a bank may exceed its Tier I capital. If it happens the excess will be ignored
for the purpose of computing the capital adequacy ratio.
Risk Adjusted Assets: They refer to weighted aggregate of funded assets and not
funded or off balance sheet items as detailed later. It may be noted that various
assets of a bank are exposed to different degrees of risks. For example cash
balance has no risk while advances are subject to credit risk. Similarly different
off Balance Sheet Items i.e. items which are not shown in the balance sheet, are
also subject to varying degrees of risks. For example risk involved in counter
guarantee against guarantee given by other bank is much less as compared to
the direct guarantee.
The Reserve Bank of India, realizing the above facts, has given different
weights to different assets as given below. The value of each asset or item is
multiplied by the relevant weight or credit conversion factor to ascertain adjusted
value of assets or off balance sheet items. The aggregate is taken into consideration
for computing the Risk Weighted Asset Ratio. Thus the Risk Weighted Ratio can
be computed as follows
Capital Funds
100
Risk Adjusted assets/off Balance Sheet Items

This ratio can also be termed as the Actual Capital Adequacy Ratio. It should
be compared with the desired Capital Adequacy Ratio to ascertain whether it is
adequate or inadequate.
The risk factor weights for computation of capital change for credit risks are
specified by the Reserve Bank of India through a circular regarding “Prudential
Norms for Capital Adequacy” issued from time to time.
Reserve Bank of India & Basel Committee Norms
As stated earlier, the Basel Committee has already issued minimum capital
adequacy norms for bank as a percentage of Risk Weighted Assets in phases
Basel I in 1988, Basel II in 2004 and Basel III in 2010. The requirements of
Tier I Capital have been constantly increased to strengthen and increase the
Self-Instructional
loss absorbing capacity of the banks Basel III norms have provided Capital Material 57
Final Accounts of Conservation Buffer (CCB) which functions as an additional layer of common
Banking Companies
equity (equity capital) to ensure there that bank makes up at least for the minimum
common equity requirement even in difficult times.
The Reserve Bank of India has been issuing instructions from time to time
NOTES
to scheduled commercial banks to ensure that they also maintain capital adequacy
norms as per the International Standards said down by Basel Committee. In
term of Basel III Capital Regulation the Reserve Bank vide is Maser Circular
dated March 27, 2014 has provided as follows for Minimum Capital Ratios as a
percentage of Risk Weighted Assets (RWAs).

*Note: The difference between the minimum total capital requirement of 9% and the Tier I
requirement can be met with Tier II or higher forms of capital. It will be noticed from the above
that RBI requiring Banks to consistently strengthens and increase their capital adequacy ratio.
Statutory reserve: According to Section 17 of the Banking Regulation Act,
1949 it is obligatory for every banking company incorporated in India to
create a reserve fund and transfer to it at least 20% of its annual profits as
disclosed by its Profit and Loss Account before any dividend is declared.
Subsidiary companies: In order to prevent the banking company from carrying
on trading activities indirectly by acquiring controlling interest, it has been
provided that a banking company can form a subsidiary company only for
one or more of the following purposes:
(i) The undertaking and executing of trust.
(ii) The undertaking of the administration of estates as executor, trustee or
otherwise.
(iii) The carrying on business of banking exclusively outside India, with the
prior permission of the Reserve Bank.
(iv) Such other purposes as are incidental to banking business (Section 19).
Limits as to investments in shares and debentures: Except in the circumstances
given above no banking company shall hold shares in any other company,
whether as pledgee, mortgagee or absolute owner of an amount exceeding 30%
of the paid up share capital of that company or 30% of its own paid up share
capital and reserves. The RBI has removed the above limit on investments
made by the banks in the equity and debentures issues of certain financial
institutions. These include IDBI, IFCI, ICICI, Export Import Bank of India,
IRBI, NABARD, NHB, UTI, LIC, GIC, RCTFC, TDICI, Tourism Finance
Self-Instructional Corporation of India, etc.
58 Material
However, a banks exposure to capital market in all forms has been Final Accounts of
Banking Companies
restricted to 5 per cent of total outstanding advances (including commercial
paper) as on March 31 of the previous year by Reserve Bank of India. The
ceiling of 5 per cent would cover (i) direct investments in equity shares and
convertible bonds and debentures; (ii) advances against shares to individuals NOTES
for investment in equity shares (including IPOs), bonds and debentures, units
of equity-oriented mutual funds; and (iii) secured and unsecured advances to
stock brokers and guarantees issued on behalf of stock brokers. A uniform
margin of 40 per cent was prescribed on all advances/financing of IPOs/
guarantees. A minimum cash margin of 20 per cent (within the margin of 40
per cent) was prescribed in respect of guarantees issued by banks.
Cash reserve: According to Section 42 of the Reserve Bank of India, every
scheduled bank has to maintain with the Reserve Bank, such percentage of
its demand and time liabilities in India as the Reserve Bank may, from time
to time, having regard to the needs of securing the monetary stability in the
country, notify in the Gazette of India. This Cash Reserve Ratio (CRR) is
being constantly reduced to make greater funds available with the banks to
lend money to trade and industry. It now stands at 4% w.e.f. for 16, 2016.
Section 18 of the Banking Regulation Act, also makes such provision for
non-scheduled banks. However, such cash reserved can be maintained with
the bank itself or Reserve Bank or both.
Statutory liquidity ratio: Over and above the Cash reserve, every scheduled
bank is required to maintain in India, assets the value of which shall not be
less than such percentage not exceeding 40% of the total of its demand and
time liabilities in India, in such form and manner which the Reserve Bank by
notification in the official gazette may specify from time to time. At present
it stands at 19.5% w.e.f. October 4, 2017.
Such assets shall be maintained in such form and manner as mmay
be specified in that notification. This is known as Statutory Liquidity Ratio.
Loans and advances: A banking company cannot grant any loans or advances on
the security of its own shares. Moreover, it cannot enter into any commitment
for granting any loan or advance to or on behalf of the following persons:
(i) Any of its directors.
(ii) Any firm in which any of its director is interested as partner, manager,
employer or guarantor.
(iii) Any company (not being a subsidiary of a banking company or a
company registered under Section 8 of the Companies Act, 2013 i.e.,
a charitable or a government company) of which any of the directors
of the banking company is a director, manager, employee or guarantor
or in which he holds substantial interest.
(iv) Any individual in respect of whom any of its directors is a partner or
guarantor (Section 20).
Self-Instructional
Material 59
Final Accounts of The above restrictions on granting of loans and advances were introduced by
Banking Companies
an amendment in 1968 in the Banking Regulation Act.

3.3 LEGAL PROVISIONS

NOTES
The Reserve Bank of India (RBI) has issued guidelines for improving
transparency in the financial statements of banks by which from the accounting
year ending March 2000, banks have been, advised to disclose the following
additional information as a ‘Note to Accounts’:
(a) Maturity pattern of
(i) loans and advances (ii) investment in securities
(iii) deposits and (iv) borrowings
(b) Foreign Currency Assets and Liabilities
(c) Movement in NPAs, and
(d) Lending to sensitive sectors like real estate capital market and other
factors as defined by RBI from time to time.
3.3.1 Capital (Schedule 1)
Nationalised banks: (a) Capital (fully owned by Central Government): The
capital owned by Central Government as on the date of the balance sheet
including contribution from Government, if any, for participating in World
Bank Projects should be shown.
(b) Banking Companies incorporated outside India:
(i) The amount brought in by banks by way of start-up capital as
prescribed by RBI should be shown under this head.
(ii) The amount of deposit kept with RBI, under sub-section 2 of
Section 11 of the Banking Regulation Act, 1949 should also be
shown.
Other banks (Indian): Authorised, Issued, Subscribed, Called-up Capital should
be given separately. Calls-in-arrears will be deducted from called-up capital
while the paid-up value of forfeited shares should be added thus arriving at
the paid-up capital. Where necessary, items which can be combined should
be shown under one head; for instance, ‘Issued and Subscribed Capital’.
Note: The changes in the above items, if any, during the year, say, fresh contribution made by
Government, fresh issue of capital, capitalisation of reserves, etc. may be explained in the notes.

3.3.2 Reserve Fund

(i) Statutory reserves: Reserves created in terms of Section 17 or any other
section of Banking Regulation Act must be separately disclosed.
(ii) Capital reserves: The expression ‘Capital Reserves’ shall not include
any amount regarded as free for distribution through the Profit & Loss
Account. Surplus on revaluation should be treated as Capital Reserve.
Self-Instructional
Surplus on translation of the financial statements of foreign branches
60 Material (which includes fixed assets also) is not a revaluation reserve.
(iii) Share premium: Premium on issue of share capital may be shown Final Accounts of
Banking Companies
separately under this head.
(iv) Revenue and other reserves: The expression ‘Revenue Reserve’ shall
mean any reserve other than capital reserve. This item will include all
NOTES
reserves, other than those separately classified. The expression ‘reserve’
shall not include any amount written off or retained by way of providing
for depreciation, renewals or diminution in value of assets or retained
by way of providing for any known liability.
(v) Balance of profit: Includes Balance of Profit after appropriations.
In case of loss the balance may be shown as a deduction.
Note: Movement in various categories of reserves should be shown as indicated in the schedule.

3.3.3 Deposits (Schedule 3)

Demand deposits
(i) From Banks and
(ii) From Others: Includes all bank deposits repayable on demand. Includes
all demand deposits of the non-bank sectors. Credit balance in overdrafts,
cash credit account, deposits, payable at call, overdue deposits, inoperative
current accounts, matured time deposits and cash certificates, certificates
of deposits, etc. are to be included under this category.

Savings bank deposits

Includes all savings bank deposits (including inoperative savings bank accounts).
Term deposits
(i) From Banks: Includes all types of bank deposits repayable after a
specified term.
(ii) From Others: Includes all types of deposits of the non-bank sector
repayable after a specified term. Fixed deposits, cumulative and recurring
deposits, cash certificates, certificates of deposits, annuity deposits,
deposits mobilised under various schemes, ordinary staff deposits, foreign
currency non-resident deposits accounts, etc. are to be included under
this category.
(I) Deposits of branches in India, and (II) Deposits of Branches outside
India. The total of the two items will agree with the total deposits.
Notes:
(a) Interest payable on deposits which is accrued but not due should not be included but
shown under other liabilities.
(b) Matured time deposits and cash certificates, etc. should be treated as demand deposits.
(c) Deposits under special schemes should be included under term deposits if they are not
payable on demand. When such deposits have matured for payment they should be shown
under demand deposits.
(d) Deposits from banks will include deposits from the banking system in India, co-operative
banks, foreign banks which may or may not have a presence in India. Self-Instructional
Material 61
Final Accounts of 3.3.4 Borrowings
Banking Companies
Borrowings in India
(i) Reserve Bank of India: Includes borrowings/refinance obtained from the
NOTES Reserve Bank of India.
(ii) Other Banks: Includes borrowings/refinance obtained from commercial
banks (including co-operative banks).
(iii) Other Institutions and Agencies: Includes borrowing/refinance obtained
from Industrial Development Bank of India, Export-Import Bank of
India, National Bank for Agriculture and Rural Development and other
institutions, agencies (including liability against participation certificates,
if any).
Borrowings outside India: Includes borrowings of Indian branches abroad as
well as borrowing of foreign branches.
Secured borrowing included above: This item will be shown separately.
Includes secured borrowings/refinance in India and outside India.
Notes:
(i) The total of the above mentioned will agree with the total borrowings shown in the Bal-
ance Sheet.
(ii) Inter-office transactions should not be shown as borrowings.
(iii) Funds raised by foreign branches by way of certificates of deposits, notes, bonds, etc.
should be classified depending upon documentation, as ‘deposits’ ‘borrowings’, etc.
(iv) Refinance obtained by banks from the Reserve Bank of India and various Institutions are
being brought under the head ‘borrowings’. Hence, advances will be shown at the gross
amount on the assets side.

3.3.5 Other Liabilities and Provisions (Schedule 5)

Bills payable: The bank provides the facility of remitting funds from one place
to another by means of bank drafts, telegraphic transfer, circular notes, pay
orders etc. The person intending to remit the money has to deposit the money
with the bank and get a pay order or bank draft in exchange for the money
deposited. Alternatively, he may request the bank for making a telegraphic
transfer from his account to the account of the person to whom he wants
to remit the money. The paying bank is reimbursed by the bank who issues
such draft or instructions. The banks also issues travellers and gift cheques
for carrying or remitting money. If any such drafts, cheques etc. remain
uncashed on the day of preparation of final accounts, they are shown under
the hearing “Bills Payable” in the balance sheet.
Inter-office (or branch) adjustments (net): This item represents the difference
on account of incomplete recording of transactions between one branch and
another branch or between one branch and the head office.
It may have a debit or a credit balance. In case of a credit balance, it
should be shown under this head. It may be noted that only the net portion
Self-Instructional is to be shown as inter-office accounts, inland as well as foreign.
62 Material
Interest accrued: Includes interest accrued but not due on deposits and Final Accounts of
Banking Companies
borrowings.
Others (including provisions): Includes net provision for income tax and other
taxes like interest tax (less advance payment, tax deducted at source, etc.), NOTES
surplus in aggregate in provisions for bad debts provision account, surplus
in aggregate in provisions for depreciation in securities, contingency funds
which are not disclosed as reserves but are actually in the nature of reserves,
proposed dividend/transfer to Government, other liabilities which are not
disclosed under any of the major heads such unclaimed dividend provisions
and funds kept for specific purposes, unexpired discount, outstanding charges
like rent, conveyance, etc. Certain types of deposits like staff security deposits,
margin deposits, etc. where the repayment is not free, should also be included
under this head.
Notes:
(i) For arriving at the net balance of inter-office adjustments all connected inter-office ac-
counts should be aggregated and the net balance only will be shown, representing mostly
items in transit and unadjusted items.
(ii) The interest accruing on all deposits, whether the payment is due or not, should be treated
as a liability.
(iii) It is proposed to show only pure deposits under this head ‘deposits’ and hence all surplus
provisions for bad and doubtful debts contingency funds, secret reserves, etc. which
are not netted off against the relative assets, should be brought under the head ‘Others
(including provisions).’

3.3.6 Cash and Balance

Cash and Balance with the Reserve Bank of India (Schedule 6)
(i) Cash in hand including foreign currency notes);
(ii) Balance with RBI (a) in current account; (b) in other accounts.
Includes cash in hand including foreign currency notes and also of
foreign branches in the case of banks having such branches.

Balances with Banks and Money at Call and Short Notice (Schedule 7)

In India
(i) Balance with banks: (a) in Current Accounts; (b) in other Deposit
Accounts: Including all balances with banks in India (including co-
operative banks). Balances in current accounts and deposit accounts
should be shown separately.
(ii) Money at call and short notice: (a) with Banks; (b) with Other
Institutions. This items mainly represents the loans given by one bank
to another for a short period. Call loans are repayable at any time the
banker recalls them while short notice advances are repayable within a
short notice of (say) 24 hours. The maximum notice period is usually
of two weeks.
Self-Instructional
Material 63
Final Accounts of This includes deposits repayable within 15 days or less than 15 days
Banking Companies
notice lent in the inter-bank call money market.

Outside India
NOTES (i) Current Accounts
(ii) Deposits Accounts: Includes balances held by foreign branches and
Indian branches of the banks outside India. Balance held with foreign
branch by other branches of the bank should not be shown under this
head but should be included in inter-branch accounts. The amounts held
in ‘current accounts’ and ‘deposit accounts’ should be shown separately.
(iii) Money at Call and Short Notice: Includes deposits usually classified in
foreign countries as money at call and short notice.
3.3.7 Investment (Schedule 8)
Investments in India
(i) Government Securities: Includes Central and State Government securities
and government treasury bills. These securities should be shown at the
book value. However, the difference between the book value and market
value should be given in the notes to the balance sheet.
(ii) Other Approved Securities: Securities other than Government Securities
which according to the Banking Regulation Act, 1949 are treated as
approved securities, should be included here.
(iii) Shares: Investments in shares of companies and corporations not included
in item (ii) above should be included here.
(iv) Debentures and Bonds: Investments in debentures and bonds of companies
and corporations not included in items (ii) should be included here.
(v) Investment in Subsidiaries/Joint Ventures: Investments in Subsidiaries/
Joint ventures (including RRBs) should be included here.
(vi) Others: Includes residual investment, if any, like gold, commercial paper
and other instruments in the nature of shares/debentures/bonds.

Investments outside India

(i) Government Securities (including local authorities): All foreign
Government securities including securities issued by local authorities
may be classified under this head.
(ii) Subsidiaries and/or joint ventures abroad: All investments made in the
share capital of subsidiaries floated outside India and/or joint ventures
abroad should be classified under this head.
(iii) Others: All other investments outside India may be shown under this
head.

Classification of Investments
Self-Instructional
64 Material (i) According to the revised guidelines issued by the Reserve Bank of India
w.e.f. 30 September 2000, the banks are required to classify their entire Final Accounts of
Banking Companies
investment portfolio under three categories:
(a) Held to Maturity;
(b) Available for Sale; and NOTES
(c) Held for Trading
(ii) Banks should decide the category of investment at the time of acquisition and
the decision should be recorded on the investment proposals.

Held to Maturity
(i) The securities acquired by the banks with the intention to hold them
up to maturity will be classified under Held to Maturity.
(ii) The investments included under ‘Held to Maturity’ should not exceed
25 per cent of the bank’s total investments.
(iii) The following investments will be classified under ‘Held to Maturity’:
(a) Re-capitalisation bonds received from the Government of India
towards their re-capitalisation requirement and held in their
investment portfolio.
(b) Investment in subsidiaries and joint ventures.
(c) The investments in debentures/bonds, which are deemed to be in
the nature of an advance.
(iv) Profit on sale of investments in this category should be first taken to
the Profit & Loss Account and thereafter be appropriated to the ‘Capital
Reserve Account’. Loss on sale will be recognized in the Profit and
Loss Account.

Available for Sale and Held for Trading

(i) The securities acquired by the banks with the intention to trade by
taking advantage of the short-term price/interest rate movements will
be classified under Held for Trading.
(ii) The securities which do not fall within the above two categories will
be classified under Available for Sale.
(iii) The banks will have the freedom to decide on the extent of holdings
under Available for Sale and “Held for Trading” categories. This will
be decided by them after considering various aspects such as basis of
intent, trading strategies, risk management capabilities, tax planning,
manpower skills, capital position.
(iv) The investments classified under “Held for Trading” category would be
those from which the bank expects to make a gain by the movement
in the interest rates/market rates. These securities are to be sold within
90 days.
(v) Profit or loss on sale of investments in both the categories will be taken Self-Instructional
Material 65
to the Profit & Loss Account.
Final Accounts of Valuation
Banking Companies
(a) Held to Maturity
(i) Investments classified under “Held to Maturity” category need not be
NOTES marked to market and will be carried at acquisition cost unless it is more
than the face value, in which case the premium should be amortised
over the period remaining to maturity.
(ii) Banks should recognize any diminution, other than temporary, in the
value of their investments in subsidiaries/joint ventures which are included
under “Held to Maturity” category and provide therefor. Such diminution
should be determined and provided for each investment individually.

(b) Available for Sale

(i) The individual scrips in the “Available for Sale” category will be
marked to market at the quarterly or at more frequent intervals. While
the net depreciation under each classification should be ignored. The
book value of the individual securities would not undergo any change
after the revaluation.
(ii) The provisions required to be created on account of depreciation in the
“Available for Sale” category in any year should be debited to the Profit
and Loss Account and an equivalent amount (net of tax benefit, if any,
and net of consequent reduction in the transfer to Statutory Reserve or
the balance available in the Investment Fluctuation Reserve Account,
whichever is less), shall be credited the Investment Fluctuation Reserve
Account. It will be shown as a separate item under the head “Revenue
and Other Reserves”.

(c) Held for Trading

The individual scrips in the Held for Trading category will be marked to
market at monthly or at more frequent intervals as in the case of those in
the Available for Sale category. The book value of the individual securities
in this category would not undergo any change after making to market.
Of course, in the Balance Sheet, the investments will continue to be disclosed as per
the existing six classifications discussed above.

Investment Fluctuation Reserve

(i) With a view to building up of adequate reserves to guard against any
possible reversal of interest rate environment in future due to unexpected
developments, banks are advised to build up Investment Fluctuation
Reserve (IFR) of a minimum 5 per cent of the investment portfolio
within a period of 5 years. IFR should be computed with reference to
investments in two categories, viz., “Held for Trading” and “Available
for Sale”. It will not be necessary to include investment under “Held
Self-Instructional
to Maturity” category for the purpose of computation of IFR. However,
66 Material banks are free to build up a higher percentage of IFR up to 10 per cent
of the portfolio depending on the size and composition of their portfolio Final Accounts of
Banking Companies
with the approval of their Board of Directors.
(ii) Banks should transfer maximum amount of the gains realised on sale
of investments in securities to the IFR.
NOTES
(iii) Transfer to IFR shall be as an appropriation of net profit “below the
line” after appropriation to statutory reserve.
3.3.8 Advances (Schedule 9)
(A)
(i) Bills discounted and purchased: The banks also give advances to their
customers by discounting their bills. Net amount after deducting the
amount of discount is credited to the account of customer. The bank
may discount the bills with or without any security from the debtor in
addition to one or more persons already liable on the bill.
(ii) Cash-Credits: Overdrafts and Loans repayable on demand:
Cash credits. A cash credit is an arrangement by which a banker
allows his customer to borrow money upon a certain limit. Cash credit
arrangements are usually made against the security of commodities
hypothecated or pledged with the bank.
In case of a cash credit facility the borrower need not borrow at once
the whole of the amount he is likely to require, but draw such amounts
as and when required. He can put back any surplus amount which he
may find with him for the time being. Interest on cash credit account
has to be paid on the amount actually drawn at any time and not on
the full amount of the credit allowed.
Overdrafts: The customer may be allowed to overdraw his current account
with or without security if he requires temporary accommodation. This
arrangement like cash credit is advantageous from the customer’s point
of view as he is required to pay interest on the actual amount used by
him.
Loans: A loan is a kind of advance made with or without security. In
case of loan the bank makes a lump sum payment to the borrower
or credits his deposit account with the money advanced. Repayments
may be made in instalments or at the expiry of a certain period. The
customer has to pay interest on the total advance whether he withdraws
the money from his account (credited with the loan) or not. A loan once
repaid in full or in part cannot be drawn again by the borrower unless
the banker sanctions a fresh loan.
(iii) Term Loans: A loan may be in the form of a demand loan. Demand loan
is payable on demand. It is usually for a short period not exceeding
a year, while the term loan is given for a fixed term usually exceeding
a year. Self-Instructional
Material 67
Final Accounts of In classification under Section ‘A’, all outstanding-in India as well
Banking Companies
as outside-less provisions made, will be classified under three heads
indicated above and both secured and unsecured advances will be
included under these heads. Term loans should be mentioned including
NOTES overdue instalments.
(B)
(i) Secured by Tangible Assets: All advances or part of advances which are
secured by tangible assets may be shown here. The item will include
advances in India and outside India.
(ii) Covered by Bank/Government Guarantee: Advances in India and outside
India to the extent that they are covered by guarantees of India and
foreign governments and Indian and foreign banks and DICGC and
ECGC are to be included.
(iii) Unsecured: All advances not classified under (i) and (ii) will be included
here.
Total of ‘A’ should tally with total of ‘B’.
(C)
(i) Advances in India (Priority Sectors; Public Sectors; Banks and Others):
Advances should be broadly classified into ‘Advances in India’ and
‘Advances outside India’. Advances in India will be further classified on
the sectorial basis as indicated. Advances to sectors which for the time
being are classified as priority sectors according to the instructions of
the Reserve Bank are to be classified under the head ‘Priority Sectors’.
Such advances should be excluded from item
(ii) i.e. Advances to Public Sector: Advances to Central and State
Governments and other Government undertakings including Government
Companies and corporation which are, according to the statutes, to be
treated as public sector companies are to be included in the category
‘Public Sectors’. All advances to the banking sector including cooperative
banks will come under the head ‘Banks’. All the remaining advances
will be included under the head ‘Others’ and typically this category
will include non-priority advances to the private, joint and cooperative
sectors.
Notes:
(i) The gross amount of advances including refinance and rediscounts but excluding
provision made to the satisfaction of auditors should be shown as advances.
(ii) Term loans will be loans not repayable on demand.
(iii) Consortium advances would be shown net of share from other participating banks/
institutions.

Self-Instructional
68 Material
3.3.9 Fixed and Other Assets Final Accounts of
Banking Companies
Fixed Assets (Schedule 10)
Premises
(i) At cost as on 31st March of the preceding year; NOTES
(ii) Additions during the year;
(iii) Deductions during the year;
(iv) Depreciation to date.
Premises wholly or partly owned by the banking company for the purpose of
business including residential premises should be shown against ‘Premises’.
In the case of premises and other fixed assets, the previous balance, additions
thereto and deductions therefrom during the year as also the total depreciation
written off should be shown. Where sums have been written off on reduction
of capital or revaluation of assets, every balance sheet after the first balance
sheet subsequent to the reduction or revaluation should show the revised
figures for a period of five years with the date and amount of revision made.

Other fixed assets (including furniture and fixtures)

(i) At cost on 31st March of the preceding year;
(ii) Additions during the year;
(iii) Deductions during the year;
(iv) Depreciation to date.
Motor vehicles and all other fixed assets other than premises but including
furniture and fixtures should be shown under this head.

Other Assets (Schedule 11)

They include the following:
Inter/office adjustments (net): The inter-office adjustments balance, if in
debit, should be shown under this head. Only net position of inter-office
accounts, inland as well as foreign, should be shown here. For arriving at the
net balance of inter-office accounts should be aggregated and the net balance,
if in debit, only should be shown representing mostly items in transit and
unadjusted items.
Interest accrued: Interest accrued but not due on investment and advances and
interest due but not collected on investments will be the main components of
this item. As banks normally debit the borrowers’ account with interest due
on the balance sheet date, usually there may not be any amount of interest
due on advance. Only such interest as can be realised in the ordinary course
should be shown under this head.
Tax paid in advance/deducted at source: The amount of tax deducted at
source on securities, advance tax paid etc. to the extent that these items are
not set off against relative tax provisions should be shown against this item. Self-Instructional
Material 69
Final Accounts of Stationery and stamps: Only exceptional items of expenditure on stationery,
Banking Companies
like bulk purchase of security paper, loose leaf or other ledgers, etc., which
are shown as quasi-asset to be written off over a period of time should be
shown here. The value should be on a realistic basis and cost escalation should
NOTES not be taken into account as these items are for internal use.
Non-banking assets acquired in satisfaction of claims: Immovable properties/
tangible assets acquired in satisfaction of claims are to be shown under this
head.
Others: This will include items like claims which have not been met, for
instance, clearing items, debit items representing addition to assets or reduction
in liabilities which have not been adjusted for technical reasons, want of
particulars, etc. advances given to staff by a bank as employer and not as
a banker, etc. Items which are in the nature of expenses which are pending
adjustments should be provided for and the provision netted against this item
so that only realisable value is shown under this head. Accrued income other
than interest may also be included here.
3.3.10 Acceptances, Bills for Collection, Endorsements and Other
Obligations
Contingents Liabilities (Schedule 12)
(i) Claims against the bank not acknowledged debts.
(ii) Liability for partly paid investments: Liabilities on partly paid shares,
debentures, etc. will be included in this head.
(iii) Liability on account of outstanding forward exchange contracts.
(iv) Guarantees given on behalf of constituents (i) In India; (ii) Outside
India.
(v) Acceptances, endorsements and other obligations: This item will include
letters of credit and bills accepted by the bank on behalf of customers.
In such cases the bank takes upon itself the responsibility for payment.
In order to keep a proper record of such liability the bank maintains
a customer acceptances, endorsements and guarantee register. All
obligations undertaken by the bank as a result of guarantees, endorsements,
acceptances etc. are recorded here. At the end of the accounting year,
if some of these obligations remain undisbursed, they are to be shown
as contingent liabilities under this head.
(vi) Other items for which the bank is contingently liable: Arrears of
cumulative dividends, bills rediscounted under underwriting contracts,
estimated amounts of contracts remaining to be executed on capital
account and not provided for, etc. are to be included here.

Bills for Collection

Self-Instructional A banking company receives a large number of bills of exchange for collection
70 Material
purposes. In order to keep a systematic record of such bills it maintains a
book called “Bills for Collection Register” On receipt of a bill for collection Final Accounts of
Banking Companies
the entry is made in this register. On collection of the bill of exchange, besides
making a note of this fact in the bills for collection register, the following
accounting entry is also passed by the banker:
Cash A/c Dr. ..... NOTES
(with the amount of bill collected)
To Customer’s A/c .....
(with the amount of Bill collected less commission charges)
To Commission A/c .....

At the end of the accounting period, the amount of bills yet to be

collected is ascertained from the bills for collection register. The total amount
of such bills is shown here.
Acceptances Endorsement and other Obligations
In order to help its sound and good clients a bank may accept or endorse a bill of
exchange and give guarantee for the payment of a debt. As per Schedule III this
is an “Off Balance Sheet Item” and has to be shown outside the balance sheet.
The details of “Acceptances Endorsements and Other Obligations”
undertaken by the bank may be recorded in a separate register. In case the bank
has to meet an obligation on account of default of a customer, the following
journal entry may be passed;
Customer A/c Dr.
(with the total amount paid
To Bank A/c
(with the amount paid)
To Interest/Commission Account
(with the interest/commission paid, if any)

Compulsory Deposits
About a decade back, certain persons were required to make compulsory
deposits with a bank as per income tax, excise rules etc. These deposits were
received by the concerned bank on behalf of the concerned authority. They
are therefore included in the category of Demand Deposits and shown in the
Balance Sheet accordingly.
Notes and Instruction for Compilation
General Instructions:
1. The formats of balance sheet and profit and loss account cover all items
likely to appear in these statements. In case a bank does not have any
particular item to report, it may be omitted from the formats.
2. Corresponding comparative figures for the previous year are to be
disclosed as indicated in the formats. The words ‘current year’ and
‘previous year’ used in the formats are only to indicate the order of
Self-Instructional
presentation and may not appear in the accounts. Material 71
Final Accounts of 3. Figures should be rounded off to the nearest thousand rupees. Thus, a
Banking Companies
sum of 19,75,921.20 will appear in the balance sheet as 19.76.
4. Unless otherwise indicated, the term ‘banks’ in these statements will
include banking companies, nationalised banks, State Bank of India
NOTES
Associate Banks and all the institutions including co-operatives carrying
on the business of banking whether or not incorporated or operating
in India. The Hindi version of the Balance Sheet will be a part of the
annual report.
Check Your Progress
1. What does the term ‘default’ mean?
2. What does stressed asset comprise?
3. What, according to Basel Committee, are the two components of capital
funds?
4. What is cash credit?

3.4 ACCOUNTING TREATMENT: REBATE ON

BILLS DISCOUNTED, PROVISION FOR BAD
AND DOUBTFUL DEBTS, NPA AND REBATE ON
BILLS DISCOUNTED
Accounting treatment of some specific items in the Profit and Loss Account and
Balance Sheet is explained in the following pages.
Income Recognition
Assets of the banks are classified as performing assets and non-performing assets
for the purpose of income recognition. Assets which are not non-performing are
performing assets. An asset become non-performing when it ceases to generate
income for banks. A non-performing asset would be an advance where:
(i) Interest and/or instalment of principal remain overdue for a period of more
than 90 days in respect of a term loan,
(ii) The account remains ‘our of order’ for a period of more than 90 days, in
respect of an Overdraft/Cash Credit (OD/CC),
(iii) The bill remains overdue for a period of more than 90 days in the case of
bills purchased and discounted,
(iv) Interest and/or instalment of principal remains overdue for two harvest
seasons but for a period not exceeding two half years in the case of an
advance granted for agricultural purposes, and
(v) Any amount to be received remains overdue for a period of more than 90
days in respect of other accounts.
The terms ‘Out of Order’ and ‘Overdue’ have been defined as under:
Self-Instructional
72 Material
Out of Order: An account should be treated as ‘out of order’ if the outstanding Final Accounts of
Banking Companies
balance remains continuously in excess of the sanctioned limit/drawing power.
Overdue: Any amount due to the bank under any credit facility is ‘overdue’ if
it is not paid on the due date fixed by the bank.
NOTES
Banks have been advised by the Reserve Bank of India that they should
identify the non-performing assets and ensure that interest on such non-performing
assets is not recognised as income and taken to the profit and loss account. Banks
are to recognise their income on Accrual Basis in respect of income on performing
assets and on Cash Basis in respect of income on non-performing assets. Any
interest accrued and credited to income account must be cancelled by a reserve
entry once the credit facility comes under the category of non-performing assets.
A non-performing asset may become performing asset
An asset becomes non-performing when the interest and/or instalment of principal
is delayed and not received before a stipulated time. In other words, an asset
becomes non-performing when it ceased to generate income for banks. A term
loan is treated as non-performing asset when interest and/or instalment of principal
remains over due for a period of more than 90 days.
The identification of non-performing assets is to be done on the basis of the
position as on the balance sheet data. If an account has been regularised before
the balance sheet date by payment of overdue amount through genuine sources
(not by sanction of additional facilities or transfer of funds between accounts) the
account need not be treated as non-performing assets. The bank should however
ensure that the account remains in order subsequently.
Hence, non-performing assets, need not be permanently non-performing
assets, it shall resume into performing assets, subject to the satisfaction of their
norms at the discretion of banks.
Illustration 3.1: Given below are details of interest on advances of a Commercial
Bank as on 31-3-2021.
Interest Earned Interest Received
in lakhs in lakhs
Performing assets:
Term loan 240 160
Cash credit and overdraft 1,500 1,240
Bills purchased and discounted 300 300
Non-performing assets:
Term loan 150 10
Cash credit and overdraft 300 24
Bills purchased and discounted 200 40

Find out the income to be recognised for the year end 31-3-2021.
Solution:
Interest on performing assets should be recognised on accrual basis but
interest on non-performing assets should be recognised on Cash basis as per
directions given in various circulars issued by R.B.I. Self-Instructional
Material 73
Final Accounts of in lakhs
Banking Companies Interest on Term loan (240 + 10) 250
Interest on cash credit and overdraft (1500 + 24) 1524
Income from bills purchased and discounted (300 + 40) 340
Income to be recognised: 2114
NOTES
Bad Debts and Provisions for Doubtful Debts
The business of a banking company depends on public confidence. In order
to ensure that this confidence is not impaired, the banks some years back
were given a special privilege permitting them not to show in their published
accounts bad debts and provisions for doubtful debts. They could show income
after making deductions for such losses. In the Profit and Loss account the
income from ‘interest and discount’ was usually shown after meeting such
losses. In the Balance Sheet, the amount of advances was shown after deducting
bad and doubtful debts.
However, with effect from April 1, 1991 this practice has undergone
a change. The amount of bad debts and provision for bad debts has to be
charged under the heading “Provisions and Contingencies” in the Profit and
Loss Account. In the Balance Sheet, the advances are shown after deducting
the both, bad debts and provision for bad debts. It may be noted that the
banks collect from their branches information regarding bad and doubtful
debts also. The Schedule of Advances to be filled in by the branches contains
a separate column regarding doubtful debts in respect of bills purchased and
discounted, cash-credits and overdrafts, and unsecured loans. However, while
consolidating the Schedule of Advances at the Head Office level for Balance
Sheet purposes the advances are shown net of any bad or doubtful debts.
Any surplus provision for doubtful debts has not to the deducted from
advances but to be shown under the heading other liabilities and provisions
in the Balance Sheet.
Assets Classification and Provisions for Doubtful Debts
As per the present guidelines of the Reserve Bank the assets classification
and the requisite provision for doubtful debts is as under.

Assets Classification
Banks are required to classify the loan assets (advances) into four categories
viz.: (i) Standard Assets; (ii) Sub-standard Assets; (iii) Doubtful Assets; and
(iv) Loss Assets.
(i) Standard Assets: Standard asset is one which does not disclose any
problem and which does not carry more than normal risk attached to
the business. Such asset is considered as performing asset.
(ii) Sub-standard Assets: With effect from 31st March, 2005 sub-standard
Self-Instructional
74 Material asset is one which has been classified as a non-performing asset (NPA)
for a period not exceeding 12 months. In such cases, the current net Final Accounts of
Banking Companies
worth of the borrowers/ guarantors or the current market value of
the security charged is not enough to ensure recovery of the dues to
the banks in full. In other words, such assets will have well-defined
NOTES
credit weaknesses that jeopardise the liquidation of the debt and are
characterised by the distinct possibility that the banks will sustain some
loss, if deficiencies are not corrected.
An asset where the terms of the loan agreement regarding interest and
principal have been re-negotiated or rescheduled after commencement
of production, should be classified as sub-standard and should remain in
such category for at least 12 months of satisfactory performance under
the re-negotiated or rescheduled terms. In other words, the classification
of an asset should not be upgraded merely as a result of rescheduling,
unless there is satisfactory compliance of this condition.
(iii) Doubtful Assets: A doubtful asset is one which has remained in sub-
standard category for a peiod exceeding 12 months.
(iv) Loss Assets: A loss asset is one where loss has been identified by the
bank or internal or external auditors or the co-operative Department
or the RBI inspection but the amount has not been written off, wholly
or partly. Such an asset is not realisable, although there may be some
salvage or recovery value.
Provisions: The purpose of classifications of bank assets is to make adequate
provisions on the basis of quality of assets, the realisation of the security and
the erosion in the value of security. It has been directed that the banks should
make provision against the various assets on the following basis:
(i) Standard Assets: The provision has to be made on the outstanding
amount as under:
% Rate of provision
(a) On direct advances to agricultural and SME 0.25
(b) On advances to commercial Real Estate (CRE) sector 1.00
(c) On all other loans and advances not covered by
(a) and (b) above 0.40
(ii) Sub-standard Assets: Provision has to be made as under:
% Rate of provision
(a) On secured exposures without making any allowance
for ECGC Guarantee cover and securities available 15
(b) On unsecured exposures 25
(c) On unsecured exposures in respect of infrastructure
loan accounts where certain safeguards such as
escrow accounts are available 20
Self-Instructional
Material 75
Final Accounts of (iii) Doubtful Assets:
Banking Companies
(a) To the extent the debt is not covered by realisable value of the
security, 100% provision is to be made.
NOTES (b) In addition to the above (a), for the secured portion of the doubtful
assets, provision is required to be made between 25% and 100%
depending upon the period for which the asset has remained doubtful
as given below:
Period for which the advances Percentage of provision
have been considered doubtful
Upto one year 25
More than one year but upto three years 40
Above three years 100

(iv) Loss Assets: The entire assets should be written off or if the assets are
to be retained in the books for any reason 100% provision is required
to be made.
Notes: (i) The provision standard assets should not be reckoned for arriving at net NPAS.
(ii) Provision towards standard assets should not be deducted from advanced but shown sepa-
rately as contingent provisions against standard assets under “Other Liabilities and Provisions”
— ‘Others’ in Schedule V of the Balance Sheet.
Illustration 3.2: Compute the amount of provision for doubtful debts from
the following details of advances of National Bank Ltd.
( in lakhs)
1. Total loans and advances 50
2. Fully secured advances without any default by the borrowers 30
3. Advances overdue for 15 months 10
4. Advances overdue for more than 30 months but less than 36 months
(secured by mortgage of plant worth 3 lakhs) 5
5. Non-recoverable unsecured advances 3
6. Small advances not exceeding 25,000 to each borrower (unsecured) 2

Solution:
COMPUTATION OF PROVISION FOR DOUBTFUL DEBTS
Provision for doubtful debts
S. No. Category of advances lakhs %
1. Standard assets 30 .40 12,000
2. Sub-standard assets 10 15 1,50,000
3. Doubtful assets 5 Unsecured portion + 40%
of secured portion 3,20,000
4. Loss assets 3 100 3,00,000
5. Small advances (sub-standard) 2 20 40,000
50 8,22,000

Illustration 3.3: From the following details, compute the amount of provision required
to be made in the profit and loss account of Evergreen Bank Ltd. for the year 2015-16:
Assets in Lakhs
Standard 16,000
Sub-standard 12,000
Doubtful:
— One year (secured) 4,800
Self-Instructional — For two to three years (secured) 3,600
76 Material
— For more than 3 years (secured by mortgage of Final Accounts of
machinery worth 1,000 lakhs) 1,800 Banking Companies
Non-recoverable assets 3,000

Solution: NOTES
COMPUTATION OF PROVISION AGAINST ADVANCES
Classification of Assets Amount %age of Provision
( in lakhs) Provision ( in lakhs)
Standard 16,000 0.40% 64
Sub-standard 12,000 25% 3,000
Doubtful for 1 year 4,800 25% 1,200
Doubtful 2 to 3 years 3,600 40% 1,440
Doubtful more than 3 years 1,800 100% of unsecured 1,800
Non-recoverable Assets 3,000 100% 3,000
41,200 10,504

Provision for Taxation

Its treatment till a few years back was on the pattern of bad and doubtful
debts. The amount of Provision for Taxation was quietly deducted from
Interest and Discount Income. In the Balance Sheet, the amount was merged
with “Current and Contingencies Accounts”, on the Liabilities side. However,
with effect from 1.4.1991, the above practice has undergone a change. In the
revised formates, effective from 1.4.1991, the item has to be shown as follows:
The amount of Provision for Taxation has to be charged to the Profit and
Loss Account under the hearing “Provision and Contingencies”; in the Balance
Sheet, it will be shown under the heading “Other Liabilities and Provisions”,
on the Liabilities side.
It will be useful here to know the provisions of the Income Tax Act regarding
treatment of Provision of Doubtful Debts while creating provision for Taxation.
Section 36 (1) (VII) (a) of the Income Tax Act, 1961, permits banking
companies to make adequate provisions from their current profits to provide
for risk in relation to advances made by them. The amount of deduction for
bad and doubtful debts is as under:-
1. In case of a bank incorporated outside India or a public financial
institution—an amount not exceeding 5% of the total income of the banking
company or financial institution before making such deduction.
2. In case of a bank incorporated in India:-
(i) an amount not exceeding 5% of the total income of the banking
company before making such deduction, and
(ii) an amount not exceeding 10% of the aggregate advances made by
rural branches of such bank.
Tutorial Note: In the absence of any specific details, the students may create Provisions for
Taxation on Net Profits left after charging Provision for Doubtful Debts.

Self-Instructional
Material 77
Final Accounts of Rebate on Bills Discounted
Banking Companies
This refers to unexpired discount. A banking company charges discount in
advance for the full period of the bill of exchange or promisory note discounted
NOTES with it. The accounting entry made is as follows:
Bill discounted and purchased A/c Dr.
To Customer’s A/c
To Discount A/c

Customer’s account is credited with the net amount remaining after

deducting the amount of discount. The amount credited to the discount account
represents the earning of the bank. However, it may be possible that the bills
discounted may mature after the close of the financial year. It will not be
appropriate to take to the credit of the profit and loss account that part of the
discount charged which relates to the next year. An accounting entry is, therefore,
passed for unearned discount in the following manner:
Discount A/c Dr.
To Rebate on bills discounted
(with the amount of unearned discount relating to the next period)
Rebate on bills discounted, if already appears in the trial balance is taken
to the balance sheet on the “liabilities side”. However, if adjustment has to be
done after preparation of the trial balance in respect of rebate on bills discounted,
the amount of such rebate (i.e. the unearned discount) will be deducted from the
total discount in the profit and loss account and will also appear as a liability in
the balance sheet.
Illustration 3.4: The following information is available in the books of X
Bank Limited as on 31st March, 2021.
Bills discounted 1,37,05,000
Rebate on Bills discounted (as on 1.4.2020) 2,21,600
Discount received 10,56,650
Details of bills discounted are as follows:
Value of bill Due date Rate of discount
( )
18,25,000 5.6.2021 12%
50,00,000 12.6.2021 12%
28,20,000 25.6.2021 14%
40,60,000 6.7.2021 16%

Calculate the rebate on bills discounted as on 31.3.2017 and give necessary

journal entries.
Solution:
STATEMENT SHOWING REBATE ON BILLS DISCOUNTED
Value Due date Days after 31.3.2017 Rate of discount Discount amount
18,25,000 5.6.2020 (30 + 31 + 5) = 66 12% 39,600
50,00,000 12.6.2021 (30 + 31 + 12) = 73 12% 1,20,000
28,20,000 25.6.2021 (30 + 31 + 25) = 86 14% 93,021
40,60,000 6.7.2021 (30 + 31 + 30 + 6) = 97 16% 1,72,633
Self-Instructional
1,37,05,000 Rebate on bills discounted on 31.3.2017 4,25,254
78 Material
Books of X Bank Ltd. Final Accounts of
JOURNAL ENTRIES Banking Companies
Date Particulars Dr. Cr.
Rebate on bills discounted Account Dr. 2,21,600
To Discount on bills Account 2,21,600
NOTES
(Being opening balance of rebate on bills discounted
account transferred to discount on bills account)

Discount on bills Account Dr. 4,25,254

To Rebate on bills discounted Account 4,25,254
(Being provision made on 31st March, 2021)

Discount on bills Account Dr. 8,52,996*

To Profit and Loss Account 8,52,996
(Being transfer of discount on bills, of the year,
to profit and loss account)
*
Credit to Profit and Loss A/c = 10,56,650 + 2,21,600 – 4,25,254 = 8,52,996.

Interest on Doubtful Debts

Interest earned by a banking company on doubtful debts can be treated in any
of the following ways in the accounts of a banking company:
(a) Interest Suspense Method: The interest earned may be credited to Interest
Suspense Account opened for this purpose.
(b) Cash Method: No entry is passed for such interest till it is actually received.
(c) Accrual Method: Interest Account may be credited with the full amount of
interest due on doubtful debts and simultaneously an adequate provision
for bad and doubtful debts may becreated.
It may be noted, as discussed earlier, that the doubtful debts come within the
category of non-performing assets and therefore interest income on such doubtful
advances should not be recognised and taken to the profit and loss account. The
method (b) is therefore best under the present circumstance. However, in the
following illustrations we are explaining each of the above methods:
Illustration 3.5: When closing the books of a banks on 31 March, 2020 (for the
year 2019–20), you find in the ‘Loan Ledger’ an unsecured balance of 2,00,000
in the account of a merchant whose financial condition is reported to you as bad
and doubtful. Interest on the same account amounting to 20,000 (for 2020–21)
remains to be recorded.
During the year 2020–21 the bank accepts 75 paise in a rupee on account
of the total payment of debt from the merchant as on 31 March, 2020.
Pass the necessary journal entries and prepare the necessary ledger accounts
in respect of the above under each of the alternative methods.

Self-Instructional
Material 79
Final Accounts of Solution:
Banking Companies
(I) Interest Suspense Method
JOURNAL ENTRIES
Date Particulars Dr. Cr.
NOTES
2020 Merchant’s A/c Dr. 20,000
31 Mar. To Interest suspense A/c 20,000
(For interest due on doubtful debt of 2,00,000
credited to interest suspense A/c)
P & L A/c Dr. 2,00,000
To Provision for bad debts 2,00,000
(For creation of provision for bad debts)
2021 Cash A/c 1,65,000
31 Mar. To Merchant’s A/c 1,65,000
(For dividend of 75 paise in a rupee received from
the merchant)
Interest suspense A/c Dr. 5,000
Bad debts A/c Dr. 50,000
To Merchant’s A/c 55,000
(Amount of interest not received reversed and balance
of the account transferred to bad debts account)
Interest suspense A/c Dr. 15,000
To Profit and loss A/c 15,000
(Amount of interest received against interest
suspense A/c credited to the Profit and loss A/c)
Provision for bad debts A/c Dr. 50,000
To Bad debts A/c 50,000
(Bad debts written off against provision)
Ledger Accounts
MERCHANT’S ACCOUNT
Date Particulars Date Particulars
2019 2020
1st Apr. To Balance b/d 2,00,000 31 Mar. By Balance c/d 2,20,000
2020
31 Mar. To Interest suspense A/c 20,000
2,20,000 2,20,000
2020 2021 By Cash 1,65,000
1 April To Balance b/d 2,20,000 31 Mar. By Interest suspense A/c 5,000
By Bad debts 50,000
2,20,000 2,20,000
INTEREST SUSPENSE ACCOUNT
Date Particulars Date Particulars
2020 2020
31 Mar. To Balance c/d 20,000 31 Mar. By Merchant’s A/c 20,000
20,000 20,000
2021 2020
31 Mar. To Merchant’s A/c 5,000 1 Apr. By Balance b/d 20,000
To P and L A/c 15,000
Self-Instructional 20,000 20,000
80 Material
(II) Cash Method Final Accounts of
Banking Companies
JOURNAL ENTRIES
Date Particulars Dr. Cr.
2020 P & L A/c Dr. 2,00,000
NOTES
31 Mar. To Provision for bad debts A/c 2,00,000
(For creating of provision for bad debts)
2021 Cash A/c Dr. 1,65,000
31 Mar. To Interest A/c 15,000
To Merchant’s A/c
1,50,000
(For amount received from the merchant 75
per cent of the interest due and of the amount
of the advance)
Bad Debts A/c Dr. 50,000
To Merchant’s A/c 50,000
(For writing off as irrecoverable the balance of
the amount due from the merchant)
Provision for bad debts A/c Dr. 50,000
To Bad debts A/c 50,000
(For writing off bad debts against provision)

Ledger
MERCHANT’S ACCOUNT
Date Particulars Date Particulars
2019 2020
1 Apr. To Balance b/d 2,00,000 31 Mar. By Balance c/d 2,00,000
2020 2021
1 Apr. To Balance b/d 2,00,000 31 Mar. By Cash 1,50,000
By Bad debts A/c 50,000
2,00,000 2,00,000

INTEREST ACCOUNT
Date Particulars Date Particulars
2021 2021
31 Mar. To P & L A/c 15,000 31 Mar. By Cash 15,000
15,000 15,000
BAD DEBTS ACCOUNT
Date Particulars Date Particulars
2021 2021
31 Mar. To Merchant’s A/c 50,000 31 Mar. By Provision for 50,000
50,000 bad debts 50,000

(III) Accrual Method

JOURNAL ENTRIES
Date Particulars Dr. Cr.
2020
31 Mar. Merchant’s A/c Dr. 20,000
To Interest for bad debts A/c 20,000
(For interest due from the merchant on the loan) Self-Instructional
P & L A/c Dr. 2,20,000 Material 81
Final Accounts of To Provision for bad debts A/c 2,20,000
Banking Companies (For creation of provision for bad debts)
2021
31 Mar. Cash Dr. 1,65,000
NOTES Bad Debts A/c Dr. 55,000
To Merchant 2,20,000
(For amount received from the merchant and the
amount written off as irrecoverable)
Provision for bad debts A/c Dr. 55,000
To Bad debts A/c 55,000
(For writing off bad debts against the provision)

Ledger Accounts
MERCHANT’S ACCOUNT
Date Particulars Date Particulars
2019 2020
1 Apr. To Balance b/d 2,00,000 31 Mar. By Balance c/d 2,20,000
2020
31 Mar. To Interest A/c 20,000
2,20,000 2,20,000
2020 2021
1 Apr. To Balance b/d 2,20,000 31 Mar. By Cash 1,65,000
By Bad debts A/c 55,000
2,20,000 2,20,000

INTEREST ACCOUNT
Date Particulars Date Particulars
2020 2021
31 Mar. To P & L A/c 20,000 31 Mar. By Merchant’s A/c 20,000
20,000 20,000

PROVISION FOR BAD DEBTS ACCOUNT

Date Particulars Date Particulars
2020 2021
31 Mar. To Balance c/d 2,20,000 31 Mar. By P & L A/c 2,20,000
2,20,000 2,20,000
2021 2020
31 Mar. To Bad debts A/c 55,000 01 April By Balance b/d 2,20,000
To Balance c/d 1,65,000
2,20,000 2,20,000
BAD DEBTS ACCOUNT
Date Particulars Date Particulars
2021 2021
31 Mar. To Merchant’s A/c 55,000 31 Mar. By Provision for
55,000 bad debts A/c 55,000
Note: While creating a provision for bad debts at the end of March, 2014, the balance in the
Provision for Bad Debts Account remaining unutilised in respect of the merchant, will be taken
into account.

Self-Instructional The illustrations given in the following pages will help the readers in
82 Material understanding and preparing the final accounts of a Banking Company.
Capital Adequacy Final Accounts of
Banking Companies
Capital Adequacy Ratio (CAR) is a specialized ratio used by banks to determine
the adequacy of their capital keeping in view their risk exposures. Banking
regulators require a minimum capital adequacy ratio so as to provide the banks NOTES
with a cushion to absorb losses before they become insolvent. This improves
stability in financial markets and protects deposit-holders. Basel Committee on
Banking Supervision of the Bank of International Settlements develops rules
related to capital adequacy which member countries are expected to follow.
A bank has to comply with the capital adequacy ratio requirements at two
levels: (a) the consolidated level capital adequacy ratio requirements, which
measure the capital adequacy of a bank based on its capital strength and risk
profile after consolidating the assets and liabilities of its subsidiaries / joint
ventures / associates etc. except those engaged in insurance and any non-financial
activities; and (b) the standalone level capital adequacy ratio requirements, which
measure the capital adequacy of a bank based on its standalone capital strength
and risk profile. Accordingly, overseas operations of a bank through its branches
are covered in both the above scenarios.

3.5 VERTICAL FORM OF FINAL ACCOUNTS AS

PER BANKING REGULATION ACT 1949
The Profit and Loss Account of a banking company has to be prepared in Form
B of Schedule III, attached to the Banking Regulation Act. As stated earlier the
form has been revised w.e.f. 1st April 1991 and the Profit and Loss Account of
a banking company for the year ending March 31, 1992, and onwards has to be
prepared in the prescribed new form as given follows:
Form ‘B’
THIRD SCHEDULE
FORM OF PROFIT AND LOSS ACCOUNT
Profit and Loss Account for the year ended 31st March, 19...
Schedule Year ended
Number ( )
I INCOME:
Interest earned 13 ......
Other income 14 ......
Total ......
II EXPENDITURE:
Interest expended 15 ......
Operating expenses 16 ......
Provisions and contingencies ......
TOTAL ......
III PROFIT/LOSS: ......
Net Profit/(Loss) for the year
TOTAL ......
IV APPROPRIATIONS:
Transfer to statutory reserves ......
Transfer to other reserves ......
Transfer to Govt./proposed dividend ......
Balance carried over to balance sheet ...... Self-Instructional
TOTAL ...... Material 83
Final Accounts of Schedules to be annexed with Profit and Loss Account
Banking Companies SCHEDULE 13: INTEREST EARNED

I Interest/Discount on advances/Bills ......

II Income on investments ......
NOTES III Interest on balances with RBI and other inter-bank funds ......
IV Other ......
TOTAL ......

SCHEDULE 14: OTHER INCOME

I Commission, exchange and brokerage ......

II Profit on sale of investments ......
Less: Loss on sale of investments
III Profit on revaluation of investments ......
Less: Loss on revaluation of investments
IV Profit on sale of land/building and other assets ......
Less: Loss on sale of land, Bldg. and other assets
V Profit on exchange transactions ......
Less: Loss on exchange transactions
VI Income earned by way of dividends etc. from subsidiaries/
companies and/or joint ventures abroad/in India ......
VII Misc. Income
TOTAL ......

Note:
Under Items II to V loss figures may be shown in brackets.
SHEDULE 15: INTEREST EXPENDED

I Interest on deposits .....

II Interest on RBI/Inter-Bank borrowings .....
III Others .....
TOTAL .....

SCHEDULE 16: OPERATING EXPENSES

I Payments to and provisions for employees .....

II Rent, taxes and lighting .....
III Printing and stationery .....
IV Advertisement and publicity .....
V Depreciation on Bank’s property .....
VI Directors’ fees, allowances and expenses .....
VII Auditors’ fees and expenses (including branch auditors) .....
VIII Law charges .....
IX Postages, telegrams, telephones etc. .....
X Insurance .....
XI Other expenditure .....
TOTAL .....
Note:
Corresponding figures for the immediately preceding financial year should be shown in separate
columns.

Self-Instructional
84 Material
Final Accounts of Banking Final Accounts of
Banking Companies
Example:
The following are the figures extracted from the books of New Generation Bank
Limited as on 31.3. 2013. NOTES

Interest and discount received 37,05,738

Interest paid on deposits 20,37,452
Issued and subscribed capital 10,00,000
Salaries and allowances 2,00,000
Directors fee and allowances 30,000
Rent and taxes paid 90,000
Postage and telegrams 60,286
Statutory reserve fund 8,00,000
Commission, exchange and brokerage 1,90,000
Rent received 65,000
Profit on sale of investments 2,00,000
Depreciation on bank’s properties 30,000
Statutory expenses 40,000
Preliminary expenses 25,000
Auditor’s fee 5,000
The following further information is given:
(i) A customer to whom a sum of 10 lakhs has been advanced has become
insolvent and it is expected only 50% can be recovered from his estate.
(ii) There were also other debts for which a provision of 1,50,000 was found
necessary by the auditors.
(iii) Rebate on bills discounted on 31.3. 2012 was 12,000 and on 31.3. 2013
was 16,000.
(iv) Provide 6,50,000 for Income-tax.
(v) The directors desire to declare 10% dividend.
Prepare the Profit and Loss account of New Generation Bank Limited for the year
ended 31.3. 2013 and also show, how the Profit and Loss account will appear
in the Balance Sheet, if the Profit and Loss account opening balance was Nil as
on 31.3. 2012.

Self-Instructional
Material 85
Final Accounts of Solution
Banking Companies
New Generation Bank Limited
Profit and Loss Account for the year ended 31st March, 2013

NOTES

The Profit & Loss Account balance of `154.25 thousand will appear in the Balance
Sheet under the head ‘Reserves and Surplus’ in Schedule 2.

Self-Instructional
86 Material
Final Accounts of
Banking Companies

NOTES

*It is assumed that preliminary expenses have been fully written off during the
year.
Working Note:

Comments on Profits and Loss Account Items

Final Accounts of Banks
As per Section 29, a banking company incorporated in India, is required to
prepare, at the end of each accounting year, a Balance sheet and profit and
Loss Account as on the last working day of the year.
Profit and Loss Account
A banking company is required to prepare its Profit and Loss Account according
to Form B in the Third Schedule to the Banking Regulation Act, 1949. Form B
is given as follows:

Self-Instructional
Material 87
Final Accounts of Form B
Banking Companies Form of Profit & Loss Account for The Year Ended 31st March

(000s omitted)
NOTES Schedule Year Year ended
No ended 31.3.(Previous
31.3.. Year)
(Current
Year )
I. Income
Interest earned 13
Other income 14
Total
II. Expenditure Interest
expended Operating
15
expenses
16
Provisions and contingencies
Total

III. Profit/ Loss

Net profit / loss for the
year(I‐II) Profit/loss brought forward
Total
IV. Appropriations
Transfer to statutory reserves
Transfer to other reserves Transfer
to government/ Proposed Divi-
dend
Balance carried over to B/S

Total

SCHEDULE 13 – INTEREST EARNED

(000s omied)
Year end- Year ended
ed 31.3.. 31.3.(Previous
(Current Year)
Year )
I. Interest/ discount on advances/bills
II. Income on investments
III. Interest on balances with Reserve Bank of
India and other inter-bank funds
IV. Others
Self-Instructional Total
88 Material
SCHEDULE 15 – INTEREST EXPENDED Final Accounts of
Banking Companies
(000s omied)
Year ended Year ended
31.3..(Current 31.3.(Previ-
ous NOTES
Year )
Year)
I. Interest on deposits
II. Interest on Reserve Bank of India/ inter-
bank borrowings
III. Others
Total

SCHEDULE – 16 OPERATING EXPENSES

(000s omitted)
Year ended Year ended
(Current (Previous
year)
Year)
i. Payments to and provisions for employees
ii. Rent, taxes and lighting
iii. Printing and stationary
iv. Advertisement and publicity
v. Depreciation on bank’s property
vi. Directors’ fees, allowances and expenses
vii. Auditor’s fees, allowances and expenses (in-
cluding branch auditors)
viii. Law charges
ix. Postages, telegrams, telephones, etc
x. Repairs and maintenance
xi. Insurance
xii. Other expenditure

Self-Instructional
Material 89
Final Accounts of Balance Sheet
Banking Companies
The Balance Sheet of Banking Company is prepared according to Form A in
Third Schedule. Form A is reproduced as follows:
NOTES FORM OF BALANCE SHEET
BALANCE SHEET OF ……
(here enter name of the banking company)
as on 31st March (Year)
(000s omitted)
Schedule As on As on (Pre-
No (Current vious Year)
Year )
Capital & Liabilities
Capital 1
Reserves & Surplus 2
Deposits 3
Borrowings 4
Other Liabilities and Provisions 5

Total

Assets
Cash and balances with RBI 6

Balances with banks & money at call 7

and
short notice
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
Total
Contingent liabilities 12
Bills for collection

Interest Earned (Schedule 13)

(1)Interest/Discount on Advances/Bills: Includes interest and discount on all
types of loans and advances like cash credit, demand, loans, overdrafts,
export loans, term loans, domestic and foreign bills purchased and
discounted (including those rediscounted), overdue interest and also
interest subsidy, if any, relating to such advances/bills.
(2) Income on Investments: Includes all income derived from the investment
portfolio by way of interest and dividend.
(3) Interest on Balances with Reserve Bank of India and other Inter-bank
Funds: Includes interest on balance with Reserve Bank and other banks,
Self-Instructional
90 Material
call loans, money market placements, etc.
(4) Others: Includes any other interest/discount income not included in the Final Accounts of
Banking Companies
above heads.

Other Income (Schedule 14)

(1) Commission, Exchange and Brokerage: Includes all remuneration on NOTES
services such as commission on collections, commission/exchange
on remittances and transfers, commission on letters of credit, letting
out of lockers and guarantees, commission on government business,
commission on other permitted agency business including consultancy
and other services, brokerage, etc. on securities. It does not include
foreign exchange income.
(2) Profit on Sale of Investments; Less: —Loss on Sale of Investments;
(3) Profit on Revaluation of Investments; Less: —Loss on Revaluation of
Investments;
(4) Profit on Sale of Land, Buildings and Other Assets; Less: —Loss on
sale of land, buildings and other assets.
Includes profit/loss on sale of securities, furniture, land and buildings,
motor vehicle, gold, silver, etc. Only the net position should be shown.
If the net position is a loss, the amount should be shown as a deduction.
The Net Profit/Loss on revaluation of assets may also be shown under
this item.
(5) Profit on Exchange transactions; Less: —Loss on Exchange Transactions:
Includes profit/loss on dealing in foreign exchange, all income earned by
way of foreign exchange, commission and charges on foreign exchange
transactions excluding interest which will be shown under interest. Only
the net position should be shown. If the net position is a loss, it is to
be shown as a deduction.
(6) Income earned by way of dividends etc. from subsidiaries, companies,
joint ventures abroad/in India.
(7) Miscellaneous Income: Includes recoveries from constituents for godown
rents, income from bank’s properties, security charges, insurance etc.
and any other miscellaneous income. In case any item under this head
exceeds one percentage of the total income, particulars may be given
in the notes.

Interest Expended (Schedule 15)

(1) Interest on Deposits: Includes interest paid on all types of deposits
including deposits from banks and other institutions.
(2) Interest on RBI/Inter-Bank Borrowings: Includes discount/interest on all
borrowings and refinance from Reserve Bank of India and other banks.
(3) Others: Includes discount/interest on all borrowings/refinance from
financial institutions. All other payments like interest on participation
Self-Instructional
certificates, penal interest paid, etc. may also be included here. Material 91
Final Accounts of Operating Expenses (Schedule 16)
Banking Companies
(1) Payments to and Provisions for Employees: Includes staff salaries/wages,
allowances, bonus, other staff benefits like provident fund, pension,
gratuity, liveries to staff, leave fare concessions, staff welfare, medical
NOTES
allowance to staff, etc.
(2) Rent, Taxes and Lighting: Including rent paid by the bank on building
and other municipal and other taxes paid (excluding income tax and
interest tax) electricity and other similar charges and levies. House rent
allowance and other similar payments to staff should appear under the
head “Payments to and Provisions for Employees.”
(3) Printing and Stationery: Includes books and forms and stationery used
by the bank and other printing charges which are not incurred by way
of publicity expenditure.
(4) Advertisement and Publicity: Includes expenditure incurred by the bank
for advertisement and publicity purposes including printing charges of
publicity matter.
(5) Depreciation on Bank’s Property: Includes depreciation on bank’s own
property, motor cars and other vehicles, furniture, electric fittings, vaults,
lifts, leasehold properties, non-banking assets, etc.
(6) Directors’ Fees, Allowances and Expenses: Includes sitting fees and all
other items of expenditure incurred on behalf of directors. The daily
allowance, hotel charges, conveyance charges, etc. which though in the
nature of reimbursement of expenses incurred may be included under
this head. Similar expenses of Local Committee members may also be
included under this head.
(7) Auditors’ Fees and Expenses (including branch auditors’ fee and
expenses): Includes the fees paid to the statutory auditors and branch
auditors for professional services rendered and all expenses for performing
their duties, even though they may be in the nature of reimbursement of
expenses. If external auditors have been appointed by banks themselves
for internal inspection and audits and other services, the expenses
incurred in that context including fees may not be included under this
head but shown under ‘other expenditure’.
(8) Law Charges: All legal expenses and reimbursement of expenses incurred
in connection with legal services are to be included here.
(9) Postage, Telegrams, Telephones, etc.: Includes all postal charges like
stamps, telegram, telephones, teleprinter, etc.
(10) Repairs and Maintenance: Includes insurance charges on bank’s property,
maintenance charges, etc.
(11) Insurance: Includes insurance charges on bank’s property, insurance
premia paid to DICGC etc. to the extent they are not recovered from
the concerned parties.
Self-Instructional
92 Material
(12) VRS Expenditure: In case a banking company has not expensed Voluntary Final Accounts of
Banking Companies
Retirement Expenditure in full in the same year, the entire ex-gratia
amount shall be treated as an extra-ordinary item and a deferred revenue
expenditure. The period of deferment would be restricted to maximum
of 5 years including the year of acceptance of VRS. While allocating NOTES
the deferred revenue expenditure, it should be recognised that the tax
benefits for the whole expenditure will arise in the first year itself.
Hence the basis of allocation should be:
(i) for the first year the charge should be equal to the firm of tax
benefit obtained + 1/5 of the balance, and
(ii) in each of the others 4 years, the charge should be equal to 1/5 of
the net amount i.e. the gross amount less the tax benefit obtained
for the first year.
(13) Other Expenditure: All expenses other than those included in any of
the other heads, like licence fees, donations, subscriptions to papers,
periodicals, entertainment expenses, travel expenses, etc. may be included
under this head. In case any particular item under this head exceeds one
percentage of the total income particulars may be given in the notes.
Provisions and Contingencies: Includes provisions made for bad and doubtful
debts, provisions for taxation, provisions for dimunition in the value of
investments, transfers to contingencies and other similar items.
Preparation of Balance Sheet
The Balance Sheet of a banking company has to be prepared in Form A of
Schedule III, attached to the Banking Regulation Act. The form of balance
sheet, as stated earlier, has been revised w.e.f. April 1, 1991. The Balance
Sheet of a banking company has to be prepared in the prescribed new form
for the year ending 31st March 1992, and onwards as given below:
The Third Schedule: Form ‘A’
FORM OF BALANCE SHEET
Balance Sheet as on 31st March...
Schedule
CAPITAL AND LIABILITIES:
Capital 1 .....
Reserves and surplus 2 .....
Deposits 3 .....
Borrowings 4 .....
Other liabilities and provisions 5 .....
Total: .....
ASSETS:
Cash and balance with RBI 6 .....
Balance with banks and money at call and short notice 7 .....
Investments 8 .....
Advances 9 .....
Fixed assets 10 .....
Other assets 11 .....
Total: .....
Contingent liabilities: Self-Instructional
Bills for collection 12 ..... Material 93
Final Accounts of The following schedules are required to be furnished with the Balance Sheet:
Banking Companies
SCHEDULE 1: CAPITAL

I FOR NATIONALISED BANKS:

Capital (Fully owned by Central Government) .....
NOTES II FOR BANKS INCORPORATED OUTSIDE INDIA
(i) Capital (the amount brought in by banks by way of start-up capital as
prescribed by RBI should be shown under this head) .....
(ii) Amount of deposit kept with RBI under Section 11(2) of the Banking
Regulation Act, 1949 .....
Total .....
III FOR OTHER BANKS:
Authorised capital (...shares of ...each) .....
Issued capital (...shares of ...each) .....
Subscribed capital (...shares of ...each) .....
Called up capital (...shares of ...each) .....
Less: calls unpaid .....
Add: Forfeited shares .....
SCHEDULE 2: RESERVES AND SURPLUS

I Statutory reserves:
Opening balance .....
Additions during the year .....
Deductions during the year ..... .....
II Capital reserves:
Opening balance .....
Additions during the year .....
Deductions during the year ..... ......
III Share premium:
Opening balance .....
Additions during the year .....
Deductions during the year ..... .....
IV Revenue and other reserves:
Opening balance .....
Additions during the year .....
Deductions during the year ..... ......
V Balance in profit and loss A/c: .....
Total (I, II, III, IV and V)
SCHEDULE 3: DEPOSITS

A I Demand deposits:
(i) From banks .....
(ii ) From others ..... .....
II Savings bank deposits
III Term deposits:
(i) From banks .....
(ii) From others ..... .....
Total (I, II and III )
B (i) Deposits of branches in India ..... .....
(ii) Deposits of branches outside India ..... .....
Total .....

Self-Instructional
94 Material
SCHEDULE 4: BORROWINGS Final Accounts of
Banking Companies
I Borrowings in India:
(i ) Reserve Bank of India .....
(ii) Other banks .....
(iii) Other institutions and agencies ..... NOTES
.....
II Borrowings outside India .....
Total (I and II) .....
Secured borrowing in I and II above .....
SCHEDULE 5: OTHER LIABILITIES and PROVISIONS

I Bills payable .....

II Inter-office adjustments (net) .....
III Interest accrued .....
IV Others (including provisions) .....
Total .....
SCHEDULE 6: CASH AND BALANCES WITH RBI

I Cash in hand (including foreign currency notes) .....

II Balances with RBI in:
(i) Current A/c .....
(ii) Other A/c .....
Total (I & II) .....
SCHEDULE 7: BALANCE WITH BANKS & MONEY AT CALL AND SHORT NOTICE

I In India
(i) Balance with banks:
(a) in Current A/c .....
(b) in Other deposit A/c ..... .....
(ii) Money at call and short notice
(a) With banks .....
(b) With other institutions ..... .....
Total (i) and (ii) .....
II Outside India
(i) In Current A/c .....
(ii) In Other deposit A/c
(iii) Money at call and short notice .....
Total (i), (ii) and (iii) .....
GRAND TOTAL (I and II) .....
SCHEDULE 8: INVESTMENTS

I Investments in India in
(i) Govt. securities .....
(ii) Other approved securities .....
(iii) Shares .....
(iv) Debentures and bonds .....
(v) Subsidiaries and/or joint ventures .....
(vi) Others (to be specified) .....
Total: .....
II Investments outside India in
(i) Govt. securities (incl. local authorities) .....
(ii) Subsidiaries and/or joint ventures abroad .....
(iii) Other investment (to be specified) .....
Total .....
Grand Total (I and II) .....
Self-Instructional
Material 95
Final Accounts of SCHEDULE 9: ADVANCES
Banking Companies

A (i) Bills discounted and purchased .....

(ii) Cash credits, overdrafts and loans payable on demand .....
NOTES (iii) Term loans .....
Total .....
B (i) Secured by tangible assets .....
(ii) Covered by Bank/Govt. guarantees .....
(iii) Unsecured .....
Total .....
C I Advances in India:
(i) Priority sectors .....
(ii) Public sectors .....
(iii) Banks .....
(iv) Others .....
Total .....
II Advances outside India: .....
(i) Due from banks .....
(ii) Due from others:
(a) Bills purchased and discounted .....
(b) Syndicated loans .....
(c) Others ..... .....
Total: .....
Grand Total (CI and CII) .....

SCHEDULE 10: FIXED ASSETS

I Premises:
At cost as on 31st March of the preceding year .....
Additions during the year .....
Deductions during the year .....
Depreciation to date ..... .....
II Other fixed assets (Incl. furniture and fixture):
At cost as on 31st March of the preceding year .....
Additions during the year .....
Deductions during the year .....
Depreciation to date ..... .....
Total (I and II)
SCHEDULE 11: OTHER ASSETS

Inter-office adjustments (net) .....

Interest accrued .....
Tax paid in advance/tax deducted at source .....
Stationery and stamps .....
Non-banking assets acquired in satisfactions of claims .....
Others* .....
Total .....
*In case there is any unadjusted balance of loss (i.e. when the loss exceeds the aggregate of capital,
reserves and surplus), the same may be shown under this item under appropriate footnote.

Self-Instructional
96 Material
SCHEDULE 12: CONTINGENT LIABILITIES Final Accounts of
Banking Companies

IClaims against the bank not acknowledged as debts .....

IILiability for party paid investments .....
IIILiability on account of outstanding forward exchange contracts .....
IV Guarantees given on behalf of constituents:
NOTES
(i) In India .....
(ii) Outside India ..... .....
V Acceptances, endorsements and other obligations .....
VI Other items for which the bank is contingently liable .....
Total .....

3.5.1 Simple Numerical on Preparation of Profit and Loss A/C and

Balance Sheet in Vertical Form
Illustration 3.6 A banking company has outstanding advances of ` 10,00,000
on 31st March, 2021. Out of these advances ` 10,000 has proved to be bad and
` 15,000 is doubtful.
Show how the items will be shown in the Profit and Loss Account and
the Balance Sheet of the banking company.
Solution
Extracts from Profit and Loss Account
as on 31-3-2021
Schedule
I Income: ... ...
II Expenditure:
Provisions and contingencies ( 10,000 + 15,000) 25,000
25,000
III Profit: Net profit for the year ...
Extract from the Balance Sheet
as on 31st March, 2021
Liabilities Schedule Assets Schedule
Advances 9 9,75,000

Illustration 3.7 The following are the details of advances of a commercial bank
Bills purchased and discounted 1,50,000
Cash credits, and loans repayable on demand 2,00,000
Term loans 50,000
The following are the other details of the above advances:
Secured by tangible assets 3,00,000
Covered by Bank, Govt. and ECGC guarantees 60,000
Unsecured 20,000
Doubtful debts 20,000
In case of doubtful debts the bank did not hold any security and they were all sanctioned to
priority sectors in the form of demand loans.
The total advances were outstanding from different sectors as follows:
Priority sectors 1,60,000
Public sectors 30,000
Balance from others 2,10,000
Show the treatment of the above items of advances in the Bank’s Final Accounts.Show the
Self-Instructional
treatment of the above items of advances in the Bank’s Final Accounts. Material 97
Final Accounts of Solution
Banking Companies
Extracts from Profit and Loss Account
........as on
Schedule
NOTES I Income
Expenditure: Provisions and contingencies ... 20,000

Extracts from Balance Sheet

........as on
Liabilities Schedule Assets Schedule
Advances 9 3,80,000
Schedule 9: Advances

A. (1) Bills purchased and discounted 1,50,000

(2) Cash credits, overdraft and loans repayable on demand ( 2,00,000 – 1,80,000
20,000)
(3) Term loans 50,000
Total (1) + (2) + (3) 3,80,000
B. (1) Secured by tangible assets 3,00,000
(2) Covered by Bank/Govt. guarantees/ECGC 60,000
(3) Unsecured 20,000
Total (1) + (2) + (3) 3,80,000
C. (1) Advances in India:
(a) Priority sectors 1,40,000
(b) Public sectors 30,000
(c) Others 2,10,000
Total 3,80,000
(2) Outside India –
Grand Total [C (1) and C (2)] 3,80,000
Illustration 3.8 The following are the ledger balances extracted from books
of a banking company as on 31st March, 2021:
Advances 15,00,000
Bad debts 10,000
The profit before charging bad-debts was 40,000.
Create a Provision for Bad-debts for 15,000 and Provision for Taxation
at 60% of net profits.
Show how the above items will appear in the banking company’s Profit
and Loss Account and the Balance sheet.
Solution
Extracts from Profit and Loss Account
as on 31-3-2021
Schedule
I Income 40,000
II Expenditure
Provisions and contingencies (WN-I) 34,000
Total 34,000
Self-Instructional III Profit (Net Profit for the year) 6,000
98 Material
Extracts From Balance Sheet Final Accounts of
as on 31-3-2021 Banking Companies
Schedule
Capital and liabilities:
Other liabilities and provisions 5 9,000 NOTES
Assets
Advances 9 14,85,000

Working Notes:
1.Provisions and contingencies
Bad debts 10,000
Provision for bad debts* 15,000
Provision for taxation (40,000 – 25,000) 60% 9,000
34,000
*Presuming to be allowable for tax purposes
2. The amount of bad debts of 10,000 must have already been deducted from the amount of
advances of 15,00,000 and hence only Provision for Bad Debts of 15,000 has been deducted
from the amount of advances given in the Balance Sheet.
3. The amount of Provision for Taxation only has been shown under the heading “Other Liabilities
and Provisions” in the Balance Sheet. The amount of Provision for Doubtful Debts (WN-2)
has already been deducted from the amount of advances.

Illustration 3.9 From the following information of Wealth Bank Limited,

Prepare Profit and Loss Account for the year ended 31st March, 2016:
Particulars lakh Particulars in lakh
Interest on Cash Credit 364 Interest paid on Recurring 17
Deposits
Interest on Overdraft 150 Interest paid on Savings Bank 12
Deposits
Interest on Term Loans 308 Auditor’s Fees and Allowances 24
Income on Investments 168 Directors’ Fees and Allowance 50
Interest on Balance with RBI 30 Advertisement 36
Commission on remittances 15 Salaries, Allowances and 248
and transfer Bonus to Employees
Commission on Letters of Credit 24 Payment to Provident Fund 56
Commission on Government 16 Printing & Stationery 28
Business
Profit on Sale of Land & Building 5 Repairs & Maintenance 10
Loss on exchange transactions 10 Postage, Courier & Telephones 16
Interest paid on Fixed Deposits 25

Other Information:
lakh
Earned Collected
(i) Interest on NPA is as follows:
Cash Credit 164 80
Term Loans 90 20
Overdraft 150 50
(ii) Classification of Non-performing Advances:
Standard 60
Sub-standard-fully secured 22
Doubtful assets-fully unsecured 40
Doubtful assets covered fully by security: Self-Instructional
Less than 1 year 6 Material 99
Final Accounts of
lakh
Banking Companies
Earned Collected
More than 1 year upto 3 years 3
More than 3 years 2
NOTES Loss Assets 38
(iii) Investments
Bank should not keep more than 25% of its investment as ‘held-for-
maturity’ investment; the market value of its rest 75% investment is
3,95,00,000 as on 31.03.2016.
(iv) Provide 35% of the profits towards provision for taxation.
(v) Transfer 20% of the profit to Statutory Reserves.
(IPC, Intermediate, May 2016)
Solution
Wealth Bank Limited
Profit and Loss Account
For the year ended 31st March, 2016

in lakh
Particulars Schedule Year ended
31-3-2016
I Income
Interest earned 13 766
Other income 14 50
816
II Expenditure
Interest expended 15 54
Operating expenses 16 468
Provisions and Contingencies (Refer W.N.) 158.96
680.96
III Profit/Loss
Net Profit/(Loss) for the year 135.04
Net Profit/(Loss) brought forward Nil
135.04
IV Appropriations:
(Transfer to Statutory reserve (20% of the profits 27.01
Balance carried to the balance sheet 108.03
Total 135.04

Schedule 13: Interest Earned

Year ended 31-3-

(2016 ( in lakh
I Interest/discount on advances/bills
Interest on cash credit (364 – 84) 280
Interest on overdraft (150 – 100) 50
Interest on term loans (308 – 70) 238 568
II Income on investments 168
III Interest on balance with RBI 30
Self-Instructional 766
100 Material
Interest on NPA is recognized on cash basis, hence difference of accrued Final Accounts of
Banking Companies
interest not received have been reduced from the total accrued interest.
Schedule 14: Other Income

Year ended 31-3-2016 NOTES

(in lakh )
I Commission, Exchange and Brokerage:
Commission on remittances and transfer 15
Commission on letter of credit 24
Commission on Government business 16 55
II Profit on sale of Land and Building 5
III Loss on Exchange Transactions (10)
50

Schedule 15: Interest Expended

Year ended 31-3-2016

(in lakh )
I Interest on Deposits
Fixed deposits 25
Recurring deposits 17
Saving bank deposits 12 54

Schedule 16: Operating Expenses

Year Ended 31-3-2016

(in lakh )
I Payment to and provision for employees
Salaries, allowances and bonus 248
Provident Fund Contribution 56 304
II Printing and Stationery 28
III Advertisement and publicity 36
IV Directors’ fees, allowances and expenses 50
V Auditors’ fees and expenses 24
VI Postage, telegrams, telephones etc. 16
VII Repairs and maintenance 10
468

Working Note:
Provisions and contingencies (in lakh )
Provision for Advances:
Standard 0.40% × 60 0.24
Sub-standard 15% × 22 3.3
Doubtful not covered by security 100% × 40 40
Doubtful covered by security:
Less than 1 year 25% × 6 1.5 4.7
More than 1 year but less 40% × 3 1.2
than 3 years 100% × 2 2.0
More than 3 years
Loss Assets (100% × 38) 38
86.24
Provision for tax 35% of (Total Income -
Total Expenditure)
Self-Instructional
Material 101
Final Accounts of
Provisions and contingencies (in lakh )
Banking Companies
35% of [816 – (54 + 468 +
86.24)]
35% of [816 – 608.24]
NOTES 35% of 207.76 72.72
158.96

Note:
1. Cost of investment has not been given in the question. Hence it is assumed that cost of 75%
of the investments, other than the investments held for maturity, is same as its market value.
No diminution in the value has therefore provided.
Illustration 3.10 From the following information relating to Chandu Banking
Co. Ltd., prepare the Profit and Loss account for and the Balance Sheet as at
the end of 31st March, 2017 in the forms prescribed by the Banking Regulation
Act, 1949:

Share capital:
Shares of 100 each fully paid 2,00,000
(Statutory reserve fund (fully invested in 5% Government securities at par 1,20,000
Bad debts 12,875
Establishment expenses 1,27,725
Current deposits 13,65,227
Interest paid 7,48,440
Saving A/c 17,20,000
Acceptances for customers 47,500
Discount 4,95,000
Profit and loss A/c (2015–16) credit 8,20,400
Fixed deposits 8,75,000
Commission and exchange 2,92,900
Premises 4,80,000
Cash in hand 22,650
Interest received 12,86,400
(Investment in shares (market value 2,00,00 92,500
Cash with Banks in India 2,84,500
Term loans in India 10,00,000
Cash credit-hypothecation in India 12,56,000
Cash credit-pledge in India 9,44,000
Bills purchased 16,00,000
Loans to employees for purchase of bicycles 40,770
Salaries, allowances, bonus, provident fund 4,45,467
Dividend paid for 2015–16 20,000
Dividend received on investments 8,000
Additional Information:
1. The Chief Executive of the bank draws a remuneration of 40,000 p.a. Directors’
fees and allowances are 8,000. All these are included in salaries, allowances etc.
2. Unexpired discount as at 31st March, 2017 was 8,000.
3. Establishment expenses include:
Advertisement 10,000
Stationery 63,000
Rent 18,000
Self-Instructional Lighting 3,000
102 Material
Audit fees 8,000 Final Accounts of
Postage and telegram 4,600 Banking Companies
Revenue stamps 400
Stamp papers 1,500
4. An advance of 8,000 included in cash credit hypothecation above is NOTES
considered doubtful and needs to be fully provided for.
5. Provide for taxation at 55% plus surcharge at 5% thereon.
6. Make necessary appropriation for statutory reserve.
Solution
Chandu Banking Co. Ltd.
Profit & Loss Account
for the year ending 31st March, 2017
Particulars Schedule
I INCOME
Interest earned 13 17,33,400
Other income 14 3,00,900
Total 20,34,300
II EXPENDITURE
Interest expended 15 7,48,440
Operating expenses 16 5,73,192
Provisions and contingencies (WN-1) 4,20,386
Total 17,24,018
III PROFIT: Net Profit for the year 2,92,282
IV APPROPRIATIONS: Transferred to statutory reserve 58,456
Taken to balance sheet 2,33,826

Schedule 13: Interest Earned

I Interest/discount on advances 17,33,400

II Other income –
Total 17,33,400

Schedule 14: Other Income

I Commission, exchange and brokerage 2,92,900

II Income earned by way of dividend 8,000
Total 3,00,900

Schedule 15: Interest Expended

I Interest on deposits 7,48,440

Total 7,48,440

Schedule 16: Operating Expenses

I Payment to and provisions for employees 4,37,467

II Rent, taxes and lighting 21,000
III Printing and stationery 63,000
IV Advertisement and publicity 10,000
V Directors’ fees, allowance and expenses 8,000
VI Auditors’ fees and expenses 8,000 Self-Instructional
Material 103
Final Accounts of VII Law charges 1,500
Banking Companies
VIII .Postage, telegrams, telephones, etxc 5,000
IX Other expenditure 19,225
Total 5,73,192
NOTES
Working Notes:
1. Provisions and Contingencies

Bad Debts 12,875

Bad Debts Provisions 8,000
Provision for Income Tax 3,99,511
Total 4,20,386
2. Computation of Income Tax:
Interest Earned 17,33,400
Other Income 3,00,900
Total 20,34,300
Less: Interest Expended 7,48,440
Operating Expenses 5,73,192
Provisions for Bad Debts 20,875 13,42,507
Profit before Tax 6,91,793
Tax @ 55% 3,80,487
Surcharge @ 5% on above 19,024 3,99,511
Net Profit after Tax 2,92,282
3. It has been presumed that complete Provision for Doubtful Debts is admissible as deduction
for tax purposes.
Chandu Banking Co. Ltd.
Balance Sheet
as on 31st March, 2017
Particulars Schedule
Capital: 1 2,00,000
Reserve and surplus 2 12,12,682
Deposits 3 39,60,227
Borrowings 4 –
Other liabilities and provisions 5 4,59,511
58,32,420
Assets:
Cash and balances with RBI 6 22,650
Balance with banks and money at call and short notice 7 2,84,500
Investments 8 2,12,500
Advances 9 47,92,000
Fixed assets 10 4,80,000
Other assets 11 40,770
58,32,420
Contingent liabilities 12 47,500

Schedule 1: Capital
As on 31-3-2017
Authorised capital .... shares of 100 each ...
Issued capital 2,000 shares of 100 each 2,00,000
Subscribed capital 2,000 shares of 100 each 2,00,000
Called up capital 2,000 shares of 100 each 2,00,000
Self-Instructional
104 Material
Schedule 2: Reserves And Surplus Final Accounts of
As on 31-3-2017 Banking Companies
I Statutory reserves
(i) Opening balance 1,20,000
(ii) Add: Addition during the year 58,456 1,78,456
NOTES
II Capital reserve –
III Share premium –
IV Revenue and other reserves –
Balance of profit (8,20,400 + 2,33,826 – Dividend paid 10,34,226
20,000)
12,12,682

Schedule 3: Deposits
As on 31-3-2017
I Demand deposits
(i) From banks .....
(ii) From others ..... 13,65,227
II Savings bank deposits 17,20,000
III Term deposits
(i) From banks .....
(ii) From others ..... 8,75,000
Total 39,60,227
IV Deposits of branches in India 39,60,227
V Deposits of branches outside India –
39,60,227

Schedule 4: Borrowings
I Borrowing in India –
II Borrowing from outside India –
Schedule 5: Other Liabilities & Provisions
I Bills payable –
II Inter-office adjustments –
III Interest accrued –
IV Other (including 12,000 difference in trial balance) 4,59,511
4,59,511

Schedule 6: Cash and Balances with Reserve Bank of India

I Cash in Hand –
II Balance with Reserve Bank 22,650

Schedule 7: Balance with Banks and Money at Call & Short Notice
I In India 2,84,500
II Outside India –
2,84,500

Schedule 8: Investments
I Investments in India in:
(i) Govt. securities 1,20,000
(ii) Other approved securities –
(iii) Shares 92,500
(iv) Debentures and bonds –
Self-Instructional
Material 105
Final Accounts of (v) Subsidiaries and/or joint ventures –
Banking Companies
(vi) Others (to be specified) 2,12,500
II Investments outside India –
Grand Total 2,12,500
NOTES Schedule 9: Advances
I Bills purchased and discounted 16,00,000
II Cash credits, overdrafts and loans repayable on demand 21,92,000
III Term loans 10,00,000
47,92,000

Schedule 10: Fixed Assets

I Premises 4,80,000
II Other fixed articles –
Total 4,80,000

Schedule 11: Other Assets

I Inter-office adjustments (net) –
II Interest accrued –
III Tax paid in advance/tax deducted at source –
IV Stationery and stamps –
V Non-banking assets acquired in satisfaction of claims –
VI Others (loans to employees) 40,770
Total: 40,770

Schedule 12: Contingent Liabilities

I .Acceptance, endorsement and other obligations 47,500

Illustration 3.11 The following are the figures extracted from the books of
New Generation Bank Limited as on 31.3.2018:

Interest and discount received 37,05,738

Interest paid on deposits 20,37,452
Issued and subscribed capital 10,00,000
Salaries and allowances 2,00,000
Directors’ fee and allowances 30,000
Rent and taxes paid 90,000
Postage and telegrams 60,286
Statutory reserve fund 8,00,000
Commission, exchange and brokerage 1,90,000
Rent received 65,000
Profit on sale of investments 2,00,000
Depreciation on bank’s properties 30,000
Statutory expenses 40,000
Preliminary expenses 25,000
Auditor’s fee 5,000
The following further information is given:
(i) A customer to whom a sum of 10 lakh has been advanced has become
insolvent and it is expected only 50% can be recovered from his estate.
(ii) There were also other debts for which a provision of 1,50,000 was found
necessary by the auditors.
Self-Instructional (iii) Rebate on bills discounted on 31.3.2017 was 12,000 and on 31.3.2018
106 Material
was 16,000.
(iv) Provide 6,50,000 for Income-tax. Final Accounts of
Banking Companies
(v) The directors desire to declare 10% dividend.
Prepare the Profit and Loss account of New Generation Bank Limited for
the year ended 31.3.2018 and also show, how the Profit and Loss account will
appear in the Balance Sheet, if the Profit and Loss account opening balance was NOTES
Nil as on 31.3.2017.
(PEE II, ICAI, May 2008, adapted)
Solution
New Generation Bank Limited
Profit and Loss Account
for the year ending on 31st March, 2018
Schedule Year ended
31.03.2018
( in ’000s)
I Income:
Interest earned 13 3,701.74
Other income 14 455.00
Total 4,156.74
II Expenditure:
Interest expended 15 2,037.45
Operating expenses 16 480.29
Provisions and contingencies (500 + 150 + 650) 1,300.00
Total 3,817.74
III Profits/Losses:
Net profit for the year 339.00
Profit brought forward Nil
339.00
IV Appropriations:
Transfer to statutory reserve (25%) 84.75
Proposed dividend 100.00
Balance carried over to balance sheet 154.25
339.00
The Profit and Loss Account balance of 154.25 thousand will appear in the Balance Sheet
.under the head ‘Reserves and Surplus’ in Schedule 2
Schedule 13: Interest Earned
Year ended
31.3.2018
( in ’000s)
I Interest/discount on advances/bills (Refer W.N.). 3,701.74
3,701.74

Schedule 14: Other Income

Year ended
31.3.2018
( in ’000s)
I Commission, exchange and brokerage 190.00
II Profit on sale of investments 200.00
III Rent received 65.00
455.00 Self-Instructional
Material 107
Final Accounts of Schedule 15: Interest Expended
Banking Companies
Year ended
31.3.2018
( in ’000s)
I Interests paid on deposits 2,037.45
NOTES 2,037.45

Schedule 16: Operating Expenses

Year ended
31.3.2018
( in ’000s)
I Payment to and provisions for employees 200.00
II Rent, taxes and lighting 90.00
III Depreciation on bank’s properties 30.00
IV Director’s fee, allowances and expenses 30.00
V Auditors’ fee 5.00
VI Law (statutory) charges 40.00
VII Postage and telegrams 60.29
VIII Preliminary expenses *25.00
480.29
*It is assumed that preliminary expenses have been fully written off during the year.

Working Note:

Interest/discount (net of rebate on bills discounted) 3,705.74

Add: Rebate on bills discounted on 31.3.2017 12.00
Less: Rebate on bills discounted on 31.3.2018 16.00
3,701.74

Check Your Progress

5. When should an account be treated as out of order?
6. What are the four categories in which loan assets are classified?

3.6 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS
1. According to the Insolvency and Bankruptcy Code 2016, the term Default
means “non-payment of debt when whole or any part of instalment of
the amount of debt has become due and is not repaid by the debtor or the
corporate debtor, as the case may be”.
2. Stressed assets comprise: NPAs + Restructured Assets + Written off Assets.
3. According to Basel Committee capital funds have two components: (a)
Tier I Capital and (b) Tier II Capital.
4. A cash credit is an arrangement by which a banker allows his customer to
borrow money upon a certain limit.
5. An account should be treated as ‘out of order’ if the outstanding balance
Self-Instructional
108 Material
remains continuously in excess of the sanctioned limit/drawing power.
6. Banks are required to classify the loan assets (advances) into four categories Final Accounts of
Banking Companies
viz.: (i) Standard Assets; (ii) Sub-standard Assets; (iii) Doubtful Assets;
and (iv) Loss Assets.

3.7 SUMMARY NOTES

• Banking business in India is largely governed by the Banking Regulation

Act, 1949. According to Section 5(b) of this Act, banking means “the
acceptance for the purpose of lending or investment of deposits of money
from the public repayable on demand, order or otherwise and withdrawable
by cheque, draft, order or otherwise.”
• According to the Insolvency and Bankruptcy Code 2016, the term Default
means “non-payment of debt when whole or any part of instalment of
the amount of debt has become due and is not repaid by the debtor or the
corporate debtor, as the case may be”.
• Stressed assets are a powerful indicator of the health of the banking system.
Stressed assets comprise: NPAs + Restructured Assets + Written off Assets.
• In order to strengthen the capital base of the banks, the Reserve Bank, on
the recommendations of the Narasimhan Committee, introduced in April,
1992 the risk weighted asset ratio system, in line with capital measurement
system introduced by Basel Committee in 1988.
• The Basel Committee Norms were revised by a new accord popularly
known as Basel II Norms, released on June 26, 2004 which were expected
to be implemented by the end of 2006.
• According to Basel Committee capital funds have two components: (a)
Tier I Capital and (b) Tier II Capital.
• The Reserve Bank of India has been issuing instructions from time to time
to scheduled commercial banks to ensure that they also maintain capital
adequacy norms as per the International Standards said down by Basel
Committee.
• The bank provides the facility of remitting funds from one place to another
by means of bank drafts, telegraphic transfer, circular notes, pay orders
etc. The person intending to remit the money has to deposit the money
with the bank and get a pay order or bank draft in exchange for the money
deposited.
• The banks give advances to their customers by discounting their bills. Net
amount after deducting the amount of discount is credited to the account
of customer. The bank may discount the bills with or without any security
from the debtor in addition to one or more persons already liable on the
bill.
• A cash credit is an arrangement by which a banker allows his customer to
borrow money upon a certain limit.
Self-Instructional
Material 109
Final Accounts of • A banking company receives a large number of bills of exchange for
Banking Companies
collection purposes. In order to keep a systematic record of such bills it
maintains a book called “Bills for Collection Register” On receipt of a bill
for collection the entry is made in this register.
NOTES
• An asset becomes non-performing when the interest and/or instalment
of principal is delayed and not received before a stipulated time. In other
words, an asset becomes non-performing when it ceased to generate income
for banks.
• Banks are required to classify the loan assets (advances) into four categories
viz.: (i) Standard Assets; (ii) Sub-standard Assets; (iii) Doubtful Assets;
and (iv) Loss Assets

3.8 KEY WORDS

• Nonperforming Assets: It refers to a classification for loans or advances
that are in default or in arrears.
• Dividend: It is a distribution of profits by a corporation to its shareholders.
• Depreciation: It refers to an accounting method used to allocate the cost
of a tangible or physical asset over its useful life.

3.9 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. Write a short note on capital adequacy ratio.
2. What are the elements of Tier I Capital for Indian banks?
3. What are readjusted assets?
4. Write a short note on contingent liabilities.
5. How can interest earned by a banking company on doubtful debts be
treated?
Long Answer Questions
1. Explain the important provisions regarding the final accounts of a banking
company.
2. Discuss the guidelines of the Reserve Bank of India to banks regarding
payment of dividend.

3.10 FURTHER READINGS

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing
Self-Instructional House.
110 Material
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018. An Final Accounts of
Banking Companies
Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw- NOTES
Hill Education.

Self-Instructional
Material 111
Investment Accounting
UNIT 4 INVESTMENT ACCOUNTING
Structure
4.0 Introduction NOTES
4.1 Objectives
4.2 Investment Accounting: Meaning and Introduction
4.2.1 Classification of Investments
4.2.2 Meaning and Calculation of the Concept of Acquisition Cost and Carrying
Cost of Investment
4.2.3 Calculation of Profit/Loss on Disposal of Investments
4.3 Answers to Check Your Progress Questions
4.4 Summary
4.5 Key Words
4.6 Self Assessment Questions and Exercises
4.7 Further Readingss

4.0 INTRODUCTION
Investment accounting is a subset of the larger area of accounting. Investment
accountants work in brokerage and asset management organisations, where they
account for investments. They also handle investments and keep an eye on third-
party activities. Investment accountants often keep track of third-party activity,
monitor client investments, and handle debt investments. This unit will discuss
in detail the meaning of investment accounting, along with the classification of
investments. The concept of acquisition cost and carrying cost of investment
will also be examined.

4.1 OBJECTIVES
After going through this unit, you will be able to:
• Understand the meaning of investment accounting
• Examine the classification of investments
• Discuss the meaning of acquisition cost and carrying cost of investment
• Explain how profit/loss is calculated on disposal of investments

4.2 INVESTMENT ACCOUNTING: MEANING AND

INTRODUCTION
A firm may hold a large number of investments in the form of different types
of securities. In such a case it is desirable to keep a separate account for each
security so that profit or loss transactions relating to a particular security can be
ascertained and all interests and dividends are properly accounted for. For this
purpose, the firm may keep an investment ledger in which a separate account
may be opened for each type of security. The account may provide for columns
regarding date, face value, interest, and principal amount of securities. While Self-Instructional
Material 113
Investment Accounting recording transactions in the investment ledger, particular care has to be taken
of interest or dividend received or paid by the company.
Cum-interest and Ex-interest, Cum-dividend and Ex-dividend
NOTES Interest on securities or dividend on shares for a particular period is payable only
to those persons whose names appear in the company’s records. Since shares,
debentures, etc. are generally freely transferable, the company closes the register
of members of debenture holders for a certain period by giving a sufficient public
notice to that effect. The closure of the Register means that the company will
not entertain any application for transfer during this period. In other words, the
relevant dividend or interest will be paid to persons whose names appear in the
company’s Register of Shareholders or Debentureholders, as the case may be,
during such period.
A purchaser of debentures or shares can receive the interest due on debentures
or dividend declared on shares from the company only when he gets the delivery
of the debentures or shares from the seller sufficiently before (generally before
10 clear days) the closure of the Register of Members. In case he gets delivery in
time, he can get his name entered in the company’s records and receive the interest
due or dividend declared for the full period. Since in this case the seller loses the
interest/dividend for the period which he held the securities, he charges, besides the
price of securities, any consideration for the interest or dividend lost. For example,
if A sells on 1st May 6% debentures of 10,000 on which interest is payable on
30th June and 31st December, he will charge from the buyer not only the price for
the debentures but also for the 4 months interest lost by him. Similarly, in case of
shares, if the dividend has been declared, the seller will lose the dividend if he
sells the shares and the buyer gets his name registered with the company before
closure of the register of members. The price quoted by the seller may, therefore,
be inclusive or exclusive of interest/dividend. In the former case, it is termed as a
cum-interest or a cum-dividend price; in the latter case, it is termed as an ex-interest
or ex-dividend price.
In actual practice, the terms cum-interest and ex-interest are not used in
case of price quoted in the stock exchange regarding debentures, government
bonds, etc. As a matter of fact, the price quoted in respect of these securities is
always presumed to be exclusive of interest. This means that the buyer will have
to pay to the vendor, besides price for debentures, interest for the period the
debentures were held by the vendor. He will get full period interest on the due
date. However, if, on account of insufficient time, the buyer is not in a position
to get his name recorded in the company’s register of debentureholders, the
delivery of the debenture and payment of the price is postponed to a day which
falls after the period during which the register of debenture holders will remain
closed. Thus, the buyer has not to pay for any interest to the seller which the
buyer could receive from the company otherwise.
In case of shares, cum-dividend price means price inclusive of dividend
Self-Instructional declared by the company in respect of the relevant shares. The price is quoted as
114 Material
ex-dividend when there is not sufficient time between the delivery of the shares Investment Accounting
and closure of register of members or if such register has already been closed. In
case of such a price, the buyer has not to pay anything for the dividend declared
by the company on shares bought by him, since the seller will get the full dividend
declared. The date for delivery of shares and payment of price is also fixed to a NOTES
date after expiry of members’ register closure period.
Accounting Treatment
The following points should be kept in mind while making accounting entries
in respect of investments:
I. Interest: In respect of debentures and government securities, the price
quoted is always to be taken as exclusive of interest. This means the buyer
has to pay, besides the price for the securities, interest for the period for
which the seller held the securities. In case the price has been given as
cum-interest, the buyer shall not have to pay any amount by way of interest,
since the price is inclusive of interest. In such a case the amount of cost of
investment shall be the excess of money paid to the seller over any interest
for the period for which the seller held such securities. The amount paid
as interest should be shown in the interest column on the debit side of
the investment account. On receipt of any interest, the amount should be
credited to the investment account in the interest column.
At the end of the accounting year, a proper entry should be passed for the
amount of interest accrued. This can be done by debiting the accrued interest
account and crediting the investment account (in the interest column) with
that amount of interest accrued. Next year, the entry should be reversed.
II. Dividends: In case the dividend has already been declared by the company
and the shares have been purchased cum-dividend, the amount paid for
dividends should be debited to the investment account in the dividend
column. On receipt of dividend, the investment account should be credited
in the dividend column. However, if the dividend has not yet been declared,
the investment account should be debited with the full amount paid in the
‘Principal’ column. On receipt of dividend, the investment account should
be credited in the ‘Principal’ column.
In case the shares have been purchased ex-dividend, the entire amount paid
should be debited to the investment account in the ‘Principal’ column. In
such a case, no dividend will be received by the buyer and, therefore, no
entry for dividend will be required in the buyer’s books on payment to the
company.
III. Brokerage: Any amount paid by way of brokerage for purchasing securities
should be taken as a part of the cost of securities and should be debited to
the investment account in the ‘Principal’ column. Any brokerage paid on
sale of securities should be deducted from the sale price of the securities
and the investment account should be credited only with the net proceeds Self-Instructional
in the ‘Principal’ column. Material 115
Investment Accounting IV. Bonus shares: Prosperous companies issue bonus shares from time to time
to their equity shareholders. Since, the investor has not to pay any amount
for such shares, entry should be made only in the ‘Nominal value’ column
in the investment account on the debit side. Nothing is to be entered in the
NOTES ‘Principal’ column.
V. Right shares: In case right shares are subscribed, their nominal value
will be entered in the ‘Nominal value’ column and the amount paid in the
‘Principal’ column. Any amount received on account of renunciation of
right in favour of a third party should be credited to the investment account
in the ‘Principal’ column.
VI. Profit or loss on sale of securities: In case any securities are sold during
the year, any profit or loss on sale of such securities is usually transferred
to the profit and loss account. However, when securities are held as long-
term investments, any profit on sale of such securities should preferably
be transferred to the capital reserve in place of the profit and loss account.
VII. Valuation of securities: At the end of the accounting year, the securities
are usually valued on the basis of “cost or market price whichever is less”.
Any loss on account of such valuation should be transferred to the profit
and loss account. The balance in the interest column will also be transferred
to the profit and loss account at the end of the accounting year.
Illustration 4.1 On 1st April, 2015, XY & Co. held 9% debentures in
Banbury Ltd. of face value 10,000 at cost of 8,000. Market value on that date
was 9,000. Interest is payable on 31st December every year. On 1st December,
2015 debentures of nominal value 6,000 were purchased for 5,000 ex-interest
and on 31st December, 2015 debentures of nominal value 2,000 were sold
cum-interest for 1,900. On 1st January, 2016 debentures of nominal value
6,000 were bought at 5,800. The market value of the debentures on 31st
March, 2016 was 90.
Make out Investment Account in the books of XY & Co. showing profit or
loss on sale of investment. Stocks on 31st March each year are valued at lower
of cost and market price. (C.A., Inter N.S., adapted)
Solution
9% Debentures in Banbury Ltd. (Interest payable on 31st Dec.)
Date Particulars Nominal Interest Principal Date Particulars Nominal Interest Principal

2015 2015
April 1 To Balance b/d 10,000 *225 8,000 Dec. 31 By Bank A/c
Dec. 1 To Bank A/c 6,000 495 5,000 (FIFO basis) 2,000 180 1,720
Dec. 31 To Profit & Dec. 31 By Bank A/c
(Int.
Loss A/c on 14,000 for
(Profit on one year) 1,260
sale
on FIFO 120 Mar. 31 By Accrued
Self-Instructional Basis)
116 Material
Investment Accounting
Date Particulars Nominal Interest Principal Date Particulars Nominal Interest Principal

Int. A/c
2016 (Int. on 20,000
Jan. 1 To Bank A/c 6,000 5,800 for 3 months) 450
NOTES
Mar. 31 To Profit & By Balance c/d
Loss A/c 1,170 (Market Value
18,000) 20,000 17,200
22,000 1,890 18,920 22,000 1,890 18,920

Working Notes:
1. Interest is payable on 31st Dec. each year.Interest must have been credit in
the previous year on 10,000 for three months @ 9%. It comes to 225.
2. Purchases on 1st Dec. is ex-interest. XY & Co. shall pay 11 months interest
on 6,000 debentures purchased. It comes to 495.
3. Sales on 31st Dec. is cum-interest. Of the total purchase price received,
180 is interest on 2,000 (nominal value) debentures.
Accrued Interest on 31st March has been calculated on 20,000 .4
.debentures for three months. It comes to 450
Illustration 4.2 On 1st April 2014, Hasan has 20,000 equity shares of Vayu
Ltd., at a book value of 20 per share (face value of 10 each). He provides the
following information:
(i) On 10th June 2014, he purchased another 5,000 shares in Vayu Ltd., @
15 per share.
(ii) On 1st August 2014 Vayu Ltd., issued one bonus share for every five shares
held by the shareholders.
(iii) On 31st August 2014, the directors of Vayu Ltd. announced a rights issue
which entitle the shareholders to subscribe two shares for every six shares
held @ of 15 per share. The shareholders can transfer their rights in full
or in part.
Hasan sold 1/4th of his right shares holding to Harsh for a consideration
of 3 per share and subscribed the rest on 31st of October 2014.
Prepare Investment A/c in the books of Hasan as on 31st October. 2014.
(IPC, Intermediate, November 2014)
Solution
Investment Account in the books of Hasan (Equity shares in Vayu Ltd
Date Particulars No. of Amount Date Particulars No. of Amount
Shares ( ) shares ( )
01.04.14 To Balance b/d 20,000 4,00,000 31.08.14 By Bank A/c (Sale
10.06.14 To Bank A/c 5,000 75,000 (of rights) (WN 3 0 7,500
01.08.14 To Bonus issue 5,000 0 31.10.14 By Balance c/d 37,500 5,80,000
(WN 1) (Bal. fig.)
31.10.14 To Bank A/c
(Right
Self-Instructional
Material 117
Investment Accounting
Date Particulars No. of Amount Date Particulars No. of Amount
Shares ( ) shares ( )
shares) (WN 4) 7,500 1,12,500
37,500 5,87,500 37,500 5,87,500
NOTES Working Notes:
(1) Bonus shares = 25,000/ 5 = 5,000 shares
(2) Right shares = 2 = 10,000 shares
(3) Sale of rights = 10,000 shares ¼ 3 = 7,500
(4) Rights subscribed =

4.2.1 Classification of Investments

Let us understand the classification of investment.
As per AS 13:
Investments are assets held by an enterprise for earning income by way of
dividends, interest, and rentals, for capital appreciation, or for other benefits
to the investing enterprise. Assets held as stock-in-trade are not ‘investments.’
A current investment is an investment that is by its nature readily realisable
and is intended to be held for not more than one year from the date on which
such investment is made.
Current investments are in the nature of current assets, although the
common practice may be to include them in investments.
A long-term investment is an investment other than a current investment.
An investment property is an investment in land or buildings that are
not intended to be occupied substantially for use by or in the operations of the
investing enterprise.
Fair value is the amount for which an asset could be exchanged between
a knowledgeable, willing buyer and a knowledgeable willing seller in an arm’s
length transaction. Under appropriate circumstances, market value or net
realisable value provides an evidence of fair value.
Market value is the amount obtainable from the sale of an investment in
an open market, net of expenses necessarily to be incurred on or before disposal.
Accounting Standard/Classification of Investments
1. An enterprise should disclose current investments and long-term
investments distinctly in its financial statements.
2. Further classification of current and long-term investments should be as
specified in the statute governing the enterprise. In the absence of a statutory
requirement, such further classification should disclose, where applicable,
investments in:
(a) Government or Trust securities;
Self-Instructional (b) Shares, Debentures or Bonds;
118 Material
(c) Investment Properties; Investment Accounting

(d) Others—specifying nature.

4.2.2 Meaning and Calculation of the Concept of Acquisition Cost
and Carrying Cost of Investment NOTES
As per As13;
Cost of Investments
The cost of an investment should include acquisition charges such as
brokerage, fees and duties.
If an investment is acquired, or partly acquired, by the issue of shares
or other securities, the acquisition cost should be the fair value of the
securities issued (which in appropriate cases may be indicated by the
issue price as determined by statutory authorities). The fair value may not
necessarily be equal to the nominal or par value of the securities issued. If
an investment is acquired in exchange for another asset, the acquisition cost
of the investment should be determined by reference to the fair value of the
asset given up. Alternatively, the acquisition cost of the investment may
be determined with reference to the fair value of the investment acquired
if it is more clearly evident.
Investment Properties
An enterprise holding investment properties should account for them in
accordance with cost model as prescribed in AS 10: Property, Plant and
Equipment.
Carrying Amount of Investments
Investments classified as current investments should be carried in the
financial statements at the lower of cost and fair value determined either
on an individual investment basis or by category of investment, but not
on an overall (or global) basis.
Investments classified as long-term investments should be carried in the
financial statements at cost. However, provision for diminution shall
be made to recognise a decline, other than temporary, in the value of
the investments, such reduction being determined and made for each
investment individually.
Illustration 4.3 A manufacturing company purchased shares of another
company from stock exchange on 1st May, 2017 at a cost of 5,00,000. It also
purchased Gold of 2,00,000 and Silver of 1,50,000 on 1st April, 2015. How
will you treat these investments as per the applicable AS in the books of the
company for the year ended on 31st March, 2018, if the value of these investments
are as follows:

Shares 2,00,000
Gold 4,00,000 Self-Instructional
Silver 2,50,000 (PEE II, ICAI, May 2008, adapted) Material 119
Investment Accounting Solution
According to AS 13 on ‘Accounting for Investments’, any investment of long-term
period is shown at cost. Hence, the investment in Gold and Silver (purchased on
NOTES 1st April 2015) shall continue to be shown at cost i.e., 2,00,000 and 1,50,000
respectively as their value have increased.
According to AS 13, for investment in shares— if the investment is for
short-term period then the loss of 3,00,000 is to be charged to profit and loss
account for the year ended 31st March, 2018. If investment is of long-term period
then it will continue to be shown at cost in the Balance Sheet of the company.
However, provision for diminution shall be made to recognise a decline, other
than temporary, in the value of the investments, such reduction being determined
and made for each investment individually.
Changes in Carrying Amounts of Investments
Any reduction in the carrying amount and any reversals of such reductions
should be charged or credited to the profit and loss statement.
4.2.3 Calculation of Profit/Loss on Disposal of Investments
As per the AS 13, the following is to be kept in mind with regards to the Disposal
of Investments:
On disposal of an investment, the difference between the carrying amount
and the disposal proceeds, net of expenses, is recognised in the profit and
loss statement.
When disposing of a part of the holding of an individual investment, the
carrying amount to be allocated to that part is to be determined on the basis
of the average carrying amount of the total holding of the investment.
Check Your Progress
1. What are investments?
2. What is an investment property?
3. What should the cost of an investment include?

4.3 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS
1. Investments are assets held by an enterprise for earning income by way
of dividends, interest, and rentals, for capital appreciation, or for other
benefits to the investing enterprise. Assets held as stock-in-trade are not
‘investments.’
2. An investment property is an investment in land or buildings that are not
intended to be occupied substantially for use by or in the operations of the
investing enterprise.
3. The cost of an investment should include acquisition charges such as
Self-Instructional
120 Material brokerage, fees and duties.
4.4 SUMMARY Investment Accounting

• A firm may hold a large number of investments in the form of different

types of securities. In such a case it is desirable to keep a separate account
for each security so that profit or loss transactions relating to a particular NOTES
security can be ascertained and all interests and dividends are properly
accounted for.
• Interest on securities or dividend on shares for a particular period is payable
only to those persons whose names appear in the company’s records.
• In actual practice, the terms cum-interest and ex-interest are not used in case
of price quoted in the stock exchange regarding debentures, government
bonds, etc. As a matter of fact, the price quoted in respect of these securities
is always presumed to be exclusive of interest.
• In case of shares, cum-dividend price means price inclusive of dividend
declared by the company in respect of the relevant shares. The price is
quoted as ex-dividend when there is not sufficient time between the delivery
of the shares and closure of register of members or if such register has
already been closed.
• Investments are assets held by an enterprise for earning income by way
of dividends, interest, and rentals, for capital appreciation, or for other
benefits to the investing enterprise. Assets held as stock-in-trade are not
‘investments.’
• A current investment is an investment that is by its nature readily realisable
and is intended to be held for not more than one year from the date on
which such investment is made.
• A long-term investment is an investment other than a current investment.
• An investment property is an investment in land or buildings that are not
intended to be occupied substantially for use by or in the operations of the
investing enterprise.
• Fair value is the amount for which an asset could be exchanged between
a knowledgeable, willing buyer and a knowledgeable willing seller in an
arm’s length transaction.
• The cost of an investment should include acquisition charges such as
brokerage, fees and duties.
• An enterprise holding investment properties should account for them in
accordance with cost model as prescribed in AS 10: Property, Plant and
Equipment.
• Investments classified as current investments should be carried in the
financial statements at the lower of cost and fair value determined either
on an individual investment basis or by category of investment, but not
on an overall (or global) basis.
Self-Instructional
Material 121
Investment Accounting • Investments classified as long-term investments should be carried in the
financial statements at cost. However, provision for diminution shall
be made to recognise a decline, other than temporary, in the value of
the investments, such reduction being determined and made for each
NOTES investment individually.
• On disposal of an investment, the difference between the carrying amount
and the disposal proceeds, net of expenses, is recognised in the profit and
loss statement.
• When disposing of a part of the holding of an individual investment, the
carrying amount to be allocated to that part is to be determined on the basis
of the average carrying amount of the total holding of the investment.

4.5 KEY WORDS

• Debentures: It is a long-term security yielding a fixed rate of interest,
issued by a company and secured against assets.
• Bonds: It is a fixed-income instrument that represents a loan made by an
investor to a borrower
• Enterprise: It refers to a company or business, often a small one.

4.6 SELF ASSESSMENT QUESTIONS AND

EXERCISES
Short Answer Questions
1. How is valuation of securities done?
2. What do you mean by market value?
3. Write a short note on carrying amount of investments.
Long Answer Questions
1. Explain the terms cum-interest and ex-interest.
2. Discuss the points that should be kept in mind while making accounting
entries in respect of investments.

4.7 FURTHER READINGS

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing
House.
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018. An
Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Self-Instructional Hill Education.
122 Material
Final Accounts of Co-
operative Societies
UNIT 5 FINAL ACCOUNTS OF CO-
OPERATIVE SOCIETIES
NOTES
Structure
5.0 Introduction
5.1 Objectives
5.2 Meaning and Introduction
5.3 Allocation of Profit as per Maharashtra State Co-operative Societies Act:
Preparation of Final Accounts of Credit Co-operative Societies and Consumer
Co-operative Societies
5.4 Answers to Check Your Progress Questions
5.5 Summary
5.6 Key Words
5.7 Self Assessment Questions and Exercises
5.8 Further Readings

5.0 INTRODUCTION

A Co-operative society consists of people who have limited means and have joined
the organization voluntarily. The cooperative society works on the principle of mutual
help and welfare. It is not driven by profit making. These are different types of Co-
operative societies, all of which serve a distinct role in ensuring public welfare. This
unit will discuss the preparation of final accounts of co-operative societies. The process
of allocation of profit will also explained.

5.1 OBJECTIVES

After going through this unit, you will be able to:

Understand the process of accounting for co-operative societies
Discuss the provisions for allocation of profit as per Maharashtra State
Co-operative Societies Act

5.2 MEANING AND INTRODUCTION OF

ACCOUNTING FOR CO-OPERATIVE SOCIETIES

A co-operative society is an association of people, usually of limited resources, who

have voluntarily joined the organisation, contributing an equitable part of the required
capital and accepting a share of the organization's risks and rewards. A cooperative
society is often a non-profit organisation that is not interested in making a profit. In the
Indian economic landscape, the cooperative society is the most important type of
organisation. Cooperative societies are governed by a variety of state laws that vary Self-Instructional
Material 123
Final Accounts of Co- from one state to the next. The State Cooperative Societies Act and Rule 1961 govern
operative Societies
Maharashtra.
Types of Co-Operative Societies:
NOTES The types of co-operative societies are given below:
1. Credit Co-operative Society: In India, this is the oldest type of co-operative.
With the passage of the Co-operative Societies Act of 1904, it came into being
about 1904. The major goal of these societies is to give low-interest loans to
their members.
2. Consumer cooperative society: Consumers are the ones who create it. The
consumer co-operative organisation buys in bulk and in huge numbers and then
sells it to its members / consumers at competitive costs and of high quality. As a
result, in a consumer cooperative society, intermediaries between buyers and
sellers / manufacturers are eliminated. The following are the many types of
consumer cooperative societies: a. Primary Consumers Society: Such
organisations cater to the demands of direct customers. The controller acquires
items from associated and other central stores in bulk purchases on the open
market and sells them to members at a reasonable price, as well as non-members
in some situations. b. Central Whole Stores: These types of businesses deal in
whole-sale items and cater to the demands of the general public. c. Supermarkets/
Departmental Stores: Supermarkets/Departmental Stores are built up in cities
to stock all of a consumer's needs under one roof. These societies require a
significant amount of capital.
3. Industrial Co-operative Society: It is a type of co-operative society that is formed
by small producers to carry out specific production operations, such as sugar
mills, milk co-operative societies, and cotton cloth co-operative societies.
4. Agricultural Marketing Society: It is a society that is marketing agricultural
produce and has at least ¾ of its member as agriculturist.
5. Co-operative Bank: In order to conduct banking business in accordance with
section 5 of Bank Companies Act/ For doing Banking business, permission of
R.B.I. required.
6. Co-operative Housing Societies: These societies are established with the aim of
providing dwelling houses or flats with amenities and services to its members
dwelling houses or flats. In Maharashtra, the construction of houses is overlooked
and regulated by Maharashtra Ownership Flat Act, 1963.
7. Apex society
8. Central Bank
9. Farming society
10. Crop protection society
11. Federal society
Self-Instructional
12. Lift Irrigation society.
124 Material
Final Accounts of Co-
5.3 ALLOCATION OF PROFIT AS PER operative Societies

MAHARASHTRA STATE CO-OPERATIVE

SOCIETIES ACT: PREPARATION OF FINAL
ACCOUNTS OF CREDIT CO-OPERATIVE NOTES
SOCIETIES AND CONSUMER CO-OPERATIVE
SOCIETIES

As per Section 65 Ascertainment and appropriation of profits of the Maharashtra

Cooperative Societies Act:
(1) A society shall construct its relevant annual financial statements and arrive at its
consequent net profit or loss in the manner prescribed.
(2) A society may appropriate [its net profits] to the reserve fund or any other fund
to payment of dividends to members on their shares [* * * *] to the payment of
bonus on the basis of support received from members and persons who are not
members to its business, to payment of honoraria and towards any other purpose
which may be specified in the rules or bye-laws:
Provided that no part of the profits shall be appropriated except with the approval
of the annual general meeting and in conformity with the Act, rules and bye-laws.
The Calculation of Net Profit
49A. Calculation of net profits.-
(1) A society shall calculate the net profits by deducting the following from the
gross profits for the year-
(i) All interest accrued and accruing on amounts of overdue loans (excepting
overdue amounts of loans against fixed deposit, gold, etc.);
(ii) Interest payable on loans and deposit;
(iii) establishment charges;
(iv) audit fees or supervision fees;
(v) working expenses including repairs, rent and taxes: (vi) depreciation;
(vii) bonus payable to employee under the Payment of Bonus Act, 1965;
(viii) provision for payment of Income Tax;
(ix) amount to be paid for contribution to the Education Fund at the State
Federal Society which may be notified by the State Government, in this
behalf;
(x) amount to be paid for contribution to the Co-operative Cadre Employment
Fund;
(xi) provision for bad and doubtful debts;
(xii) provision for share capital Redemption Fund;
(xiii) provision for Investment Fluctuations Fund;
(xiv) provision for retirement benefits to the employees;
(xv) provisions for any other claims admissible under any other law;
Self-Instructional
(xvi) Provision for bad debts and revenue losses not adjusted against any fund Material 125
created out of profits.
Final Accounts of Co- (2) In addition to the sums referred to in sub-rule (1) of this rule, the following sums
operative Societies
shall be deducted by a society from its profits:-
(i) contribution, if any, to be made, to any sinking fund or guarantee fund,
constituted under the provisions of the Act, these rules or bye-laws of the
NOTES
society for ensuring due fulfillment of guarantee given by Government in
respect of loans raised by the society.
(ii) Provision considered necessary for depreciation in the value of any Security
Bonds or Shares held by the society as part of its investments.
(3) The net profit thus arrived at together with the amount of profits brought forward
from the previous year, shall be available for appropriation.
50. Appropriations of profits.-
(1) The other purposes for which a society may, appropriate its profits shall be
education and enlightenment of the members of the society as also any co-
operative or charitable purpose including relief to the poor, education, medical
relief and advancement of any other general public utility, provided that the
expenditure on such items does not exceed 10 percent of the net profits.
(2) The net profits calculated in accordance with the provisions of rule 49A, shall
be appropriated for the creation of- (a) Development Fund, (b) Divided
Equalization Fund, or (c) any other fund created under bye-laws.
51. Amounts to be deducted by a society from its profits before arriving
at its net profits.-
In addition to the sums referred to in sub-section (1) of section 65, the following sums
shall be deducted by a society from its profits before arriving at its profits for the
purposes of subsection (2) of section 65:-
(i) Contributions, if any, to be made to any sinking fund or guarantee fund, constituted
under the provisions of the Act, the rules or bye-laws of the society for ensuing
due fulfillment of guarantee given by Government in respect of loans raised by
the society.
(ii) Provision considered necessary for depreciation in the value of any security
bonds or shares held by the society as part of its investment.
(iii) Any provision required to be made for the redemption and share capital
contributed by Government or by a federal society.
Different State Cooperative Societies Acts have provisions concerning preparation
and submission of financial statements. The financial statements include Balance Sheet,
Profit and Loss Account and Trading Account of Public Accounts Committees (PACS).
However, it is to be noted that the format for financial statements of PACS has not
been outlined in many States. The present formats have changed over time. There is
lack of uniformity and transparency in the adopted formats.

Self-Instructional
126 Material
Example: Final Accounts of Co-
operative Societies
Cash at bank 61,590 Sales 9,36,200
Cash in hand 11,800 12% bank loan 80,000
Drawings 20,000 Capital 1,60,000
Bill Receivable 39,600 Bills Payable 5,200 NOTES
Salary 44,000 Discount Received 2,400
Sundry Creditors 1,26,200
Income from Investment 1,980
Investment (Market value 28,000) 24,000 Purchase Return 7,400
Stock on 1-1-2011 1,27,360
Land and Building 80,000
Travelling Expenses 13,800
Motor Van 32,000
Furniture 16,000
Sundry Debtors 1,28,000
Discount Allowed 3,600
Sundry Expense 37,240
Stationary 3,200
Bank Loand Interest 6,000
Establishment 9,190
Advertisement 2,000
Sales Return 5,000
Purchase 6,53,400
13,19,380 13,19,380

Additional information
1. Closing stock is valued at 2,40,000
2. Maintain a reserve of 10% of debtors as reserve for debtors
3. Provide a reserve of 5% on sundry debtors as reserve for discount and 5% on
sundry creditors
4. Stock worth 20,000 destroyed by free on 25-11-2011 in respect of which
the insurance company admitted the claim only 15,000
5. The manager of the business is entitled to get a commission of 10% of net profit
after calculating such commission
6. Charge depreciation 2.5% on land building, 10% on furniture, 20% on motor
van
7. Salary paid in advance 3000.

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Material 127
Final Accounts of Co- Solution:
operative Societies
Trading and Profit and Loss Account on Dec 31, 2017

Particulars Amount Particulars Amount

NOTES Opening stock 1,27,360 Sales 9,36,200
Purchase 6,53,400 Less return 5,000 9,31,200
Less return 7,400 6,46,000 Loss of stock on fire 20,000
Gross profit 4,17,480 Closing stock 2,40,000
11,91,200 11,91,200
Salary 44,000 Gross profit b/d 4,17,840
Less prepaid 3,000 Income from investment 1,980
Establishment expenses 41,000 Discount received 2,400
Stationary 9,190
Telegram 3,200
Travelling expenses 1,600
Sundry expenses 13,800
Loss by fire 37,240
Interest on bank loan 6,000 5,000
Add outstanding 3,600
Advertisement 9,600
Discount 2,000
Provision for doubtful debts 3,600
Provision for discount 12,800
Depreciation 5,760
Land and Buildiing 2,000
Furniture 1,600 10,000
Motor Van 6,400 24,885
Managers Commission 2,48,855
Net Profit 4,28,530 4,28,530

Working note:
Net profit after charging commission = 2,73,740
Comission 2,73,740 × 10/110 = 24,885
Balance Sheet as on Dec 31, 2017

Liabilities Assets
Sundry creditors 1,26,200 Cash in hand 11,800
Less provision 6,310 Cash at bank 61,590
1,19,890 Bill receivable 39,600
Bills payable 5,200 Sundry debtors 1,28,000
Interest on bank loan 3,600 Less provision 12,800
Commission payable 24,885
Bank loan 80,000 1,15,200
Capital 1,60,000 Less provision
Add net profit 2,48,855 For discount 5,760
4,08,855 1,09,440
Closing stock 2,40,000
Less drawings 20,000 Salary prepaid 3,000
3,88,855 Insurance claim 15,000
Investment 24,000
Furniture 16,000
Less depreciation 1,600
14,400
Motor van 32,000
Less depreciation 6,400
25,600
Land and building 80,000
Self-Instructional Less depreciation 2,000
128 Material 78,000
6,22,430 6,22,430
Final Accounts of Co-
5.4 ANSWERS TO CHECK YOUR PROGRESS operative Societies

QUESTIONS

1. A co-operative society is an association of people, usually of limited resources, NOTES

who have voluntarily joined the organisation, contributing an equitable part of
the required capital and accepting a share of the organization's risks and rewards.
2. Credit Co-operative Society is the oldest type of co-operative in India.
3. Agricultural marketing society is a society that is marketing agricultural produce
and has at least ¾ of its member as agriculturist.

5.5 SUMMARY

A co-operative society is an association of people, usually of limited resources,

who have voluntarily joined the organisation, contributing an equitable part of
the required capital and accepting a share of the organization's risks and rewards.
The different types of co-operative societies are Credit Co-Operative Society,
Consumer Co-Operative Society, Industrial Co-Operative Society, Agricultural
Marketing Society, Co-operative Banks, Co-operative Housing Societies, etc.
Credit Co-operative Society is the oldest type of co-operative in India. With
the passage of the Co-operative Societies Act of 1904, it came into being about
1904.
As per Section 65 Ascertainment and appropriation of profits of the Maharashtra
Cooperative Societies Act, A society may appropriate [its net profits] to the
reserve fund or any other fund to payment of dividends to members on their
shares to the payment of bonus on the basis of support received from members
and persons who are not members to its business, to payment of honoraria and
towards any other purpose which may be specified in the rules or bye-laws:
Provided that no part of the profits shall be appropriated except with the approval
of the annual general meeting and in conformity with the Act, rules and bye-
laws.
The net profits calculated in accordance with the provisions of rule 49A, shall
be appropriated for the creation of- (a) Development Fund, (b) Divided
Equalization Fund, or (c) any other fund created under bye-laws.

5.6 KEY WORDS

Supermarkets: It is a self-service shop offering a wide variety of food, beverages

and household products, organized into sections.
Financial Statements: These are written records that convey the business
activities and the financial performance of a company.
Self-Instructional
Depreciation: It is the decrease in monetary value of an asset due to wear and Material 129
tear and obsolescence.
Final Accounts of Co-
operative Societies 5.7 SELF ASSESSMENT QUESTIONS AND
EXERCISES

NOTES Short Answer Questions

1. What are the types of consumer co-operative societies?
2. What are Co-operative Housing Societies?
Long Answer Questions
1. Discuss in detail the different types of co-operative societies.
2. Explain the provision for allocation of profits as per Maharashtra State Co-
operative Societies Act

5.8 FURTHER READINGS

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.

Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing House.
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
An Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Hill Education.

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130 Material
Branch Accounting

UNIT 6 BRANCH ACCOUNTING

Structure
6.0 Introduction NOTES
6.1 Objectives
6.2 Concept of Branches and Their Classification from Accounting Point of
View
6.3 Accounting Treatment of Dependent Branches and Independent Branches and
Methods of Charging Goods to Branches
6.4 Answers to Check Your Progress Questions
6.5 Summary
6.6 Key Words
6.7 Self Assessment Questions and Exercises
6.8 Further Readings

6.0 INTRODUCTION
Any business while marketing its products divides its activities across various
department or branches. Accounting systems should be maintained accordingly.
For the purpose of recording transactions, branches can be categorized as
dependent branches and independent branches. This unit will discuss these
classifications from accounting point of view. The accounting treatment of
dependent branches and independent branches will also be explained.

6.1 OBJECTIVES
After going through this unit, you will be able to:
• Understand the concept of branches and their classification from accounting
point of view
• Discuss in detail the accounting treatment of dependent branches and
independent branches

6.2 CONCEPT OF BRANCHES AND THEIR

CLASSIFICATION FROM ACCOUNTING POINT
OF VIEW
In order to market a product over large territories and to have an effective and
efficient retailing, a business is generally split into branches or departments. In
case the various divisions of the business are located under the same roof, they
are known as Departments. If the various divisions of the business are located
in different places, either in the same town or in different towns, they are known
as Branches.
A proper accounting system is to be adopted for recording business
transactions in case of a business having different branches or departments.
The accounting system, in case a business which has several branches, is being Self-Instructional
explained in this section. Material 131
Branch Accounting Types of Branches
Branches can be broadly classified into two categories for the purpose of recording
transactions in the books of accounts:
NOTES (i) Dependent Branches;
(ii) Independent Branches: (a) Home Branches;
(b) Foreign Branches.
Dependent Branches
The term Dependent Branch means a branch which does not maintain
its own set of books. All records have to be maintained by the Head Office. The
following are the salient features of such a branch:
(i) The branch, as mentioned above, does not maintain its own set of books.
The Head Office maintains a record of all transactions. However, the branch
maintains a Debtors’ Ledger and a Stock Ledger. The Debtors’ Ledger
is maintained in order to find out the money due from debtors when the
Branch is authorised to sell goods on credit. The Stock Ledger is kept to
provide information regarding the movement of the goods received from
Head Office and the balance of stock in hand.
(ii) Generally, all goods are supplied to the Branch by the Head Office.
However, sometimes the branch may be allowed to make purchases from
the local parties for which the payments are made directly by the Head
Office.
(iii) Cash received by the Branch from its debtors or on account of cash sales is
daily remitted to the Head Office. Usually, an account of the Head Office
is opened in a local bank where all cash collections are deposited by the
branch.
(iv) All expenses of the Branch are directly paid by the Head Office through
cheques. The Branch submits a summary to the Head Office for payments
to be made by it during a particular period in respect of branch expenses.
(v) In order to meet the petty expenses of the branch, the branch may be
provided with the petty cash from the Head Office. The branch keeps
a record of the petty expenses in the Petty Cash Book, which is usually
maintained on imprest system.
Independent Branches
Independent Branch means a branch which maintains its own set of books. Such
a branch can either be a Home Branch or a Foreign Branch. The method of
accounting is the same in both the cases except that in case of a foreign branch,
Self-Instructional
132 Material
the trial balance sent by the foreign branch is to be converted into the currency Branch Accounting

of the country of the Head Office.

Home Branch
NOTES
The characteristics of the accounting system of an independent Home Branch
can be summarised as follows:
1. Such a Branch keeps a complete set of its books. Besides receiving goods
from the Head Office, it may also purchase goods from outside parties. It
means it maintains its own bank account. It may remit money from time
to time to the Head Office as per the Head Office instructions.
2. It prepares its own Trial Balance and Final Accounts and sends their copies
to the Head Office for their incorporation in the Head Office Books.
3. It maintains a Head Office Account in its books. This is of the nature of a
personal account. All transactions relating to the Head Office are recorded in
this account. The Head Office also maintains a Branch Account in its books.
It is also of the nature of a personal account. It records all transactions
relating to the Branch in this account.
4. For inter-branch transactions, there are two alternatives available:
(a) Each branch may open a separate account for each of the other branches.
Such accounts are of the nature of personal accounts.
(b) A branch may record transactions with the other branch on the same
pattern as if the transactions are with the Head Office. In other words,
all transactions relating to the other branches regarding receipts and
sending of goods or cash are to be treated at par with the receipts of
goods or cash from or to the Head Office. At the end of a period, the
Branch sends a summary of the different transactions entered with
different branches. The Head Office maintains account of each of the
branches in which necessary adjustment entries may be passed and
accounts of different branches reconciled.
The latter method is generally followed by an independent Branch since it
reduces a lot of clerical work at the Branch level. (See Illustration 6.26).
5. On receipt of Trial Balance and Final Accounts from each of the Branches,
the Head Office reconciles the Balance as shown in the Head Office
Account in the Books of the Branch with the balance as shown by the
Branch Account in the books of the Head Office. Necessary adjustment
entries for reconciliation of difference are passed generally in the books
of the Head Office. These entries have been explained later.
6. Having reconciled the Branch balance, the Head Office passes the
incorporation entries for incorporating various branch balances in its books. Self-Instructional
Material 133
Branch Accounting
6.3 ACCOUNTING TREATMENT OF DEPENDENT
BRANCHES AND INDEPENDENT BRANCHES
AND METHODS OF CHARGING GOODS TO
NOTES BRANCHES
Let us learn about the systems of accounting
Systems of Accounting
In case of a dependent branch, the Head Office may keep accounts of the Branch
according to any of the following systems:
(1) Debtors System
(2) Stock and Debtors System
(3) Final Accounts System
(4) Wholesale Branch System
Each of the above accounting systems have been explained in detail in the
following pages:
1. Debtors System
This system is followed in case of branches of small size. The Head Office
maintains a Branch Account, in its books. The Branch Account is of the nature
of a nominal account. It is maintained on the following simple system:
(a) It is debited with whatever the Branch has in the beginning of the accounting
year, e.g., the amount of stock, debtors, petty cash etc., less amount of any
liability.
(b) It is debited with whatever has been sent by the Head Office to the Branch
during the accounting year, e.g., the Head Office may send cash to the
Branch for meeting its expenses or cash for certain purchases made by the
Branch from outside parties.
(c) It is credited with whatever the Head Office receives from the Branch,
e.g., cash remitted by branch on account of cash sales, collections from
debtors, goods returned by the Branch etc.
(d) It is credited with whatever the Branch has at the end of the accounting
period, e.g., the amount of stock, debtors, petty cash, any other asset etc.
The following accounting entries are passed in the books of the Head Office
for recording different branch transactions.
(i) For Goods Supplied by the Head Office to the Branch:
Branch A/c Dr.
To Goods sent to the Branch A/c

Self-Instructional
134 Material
(ii) For Goods Returned by the Branch to the Head Office: Branch Accounting

Goods sent to the Branch A/c Dr.

To Branch A/c
(iii) For Goods sent by Branch to another Branch at instructions from NOTES
Head Office:
Goods sent to the Branch A/c Dr.
To Branch A/c
(treated at par with Goods Returned by Branch to Head Office)
(iv) For Remittances Received from the Branch:
Bank A/c Dr.
To Branch A/c
(v) For Expenses at the Branch met by the Head Office:
Branch A/c Dr.
To Bank A/c
(vi) For Goods Returned by Branch Debtors to Head Office directly:
Goods sent to the Branch A/c Dr.
To Branch A/c
(since this is as good as the Branch returning goods to the Head Office)
(vii) For Transfer of Balance in Goods Sent to Branch Account:
Goods Sent to the Branch A/c Dr.
To Purchases/Trading A/c
(viii) For Assets at the Branch at the end of the Accounting Period:
Branch Assets A/c Dr.
To Branch A/c
(debit each asset individually)
(ix) For Liabilities at the end of the Accounting Period:
Branch A/c Dr.
To Branch Liabilities A/c
(credit each liability individually)
(x) For Profit or Loss:
If Profit: Branch A/c Dr.
To General Profit and Loss A/c
If Loss: General Profit and Loss A/c Dr.
To Branch A/c

Self-Instructional
Material 135
Branch Accounting (xi) The assets and liabilities of the Branch at the end of the accounting year
will appear in the Head Office Balance Sheet. In the beginning of the next
year, they will be transferred to the Branch Account. The entry for such
transfer will be as follows:
NOTES For transfer of Branch Assets:
Branch A/c Dr.
To Branch Assets A/c
(credit each asset individually)
For Branch Liabilities:
Branch Liabilities A/c Dr.
To Branch A/c
(debit each liability individually)
The Branch Account will appear as follows:
Branch Account

Particulars Particulars
To Opening Balances* By Opening Balances*
Stock ... Creditors ...
Debtors ... Outstanding Expenses ... ...
Petty Cash ... By Bank
Furniture ... Cash Sales ...
Pre-paid Expenses ... ... Collections from Debtors ... ...
To Goods sent to the (for remittances)
Branch A/c ... By Goods sent to Branch A/c ...
To Bank (for expenses or any (goods returned by the Branch
payment made by the H.O. on Branch Debtors directly to
behalf of the Branch) the Head Office or sent to other
To Closing Balances* branches)
Outstanding Expenses ... By Closing Balances*
Creditors ... ... Petty Cash ... ...
To Profit Stock ...
(Transferred to General Debtors
Profit and Loss Account**) ... Furniture (at depreciated value) ...
Pre-paid Expenses ... ...
By Loss
(Transferred to General ...
Profit and Loss Account)**
... ...
* Alternatively the net amount may be shown.
** In case the credit side is more than the debit side, the Branch Account will show profit. If the debit side is more
than the credit side, the Branch Account will show loss.

Points Worth Noting

The following points should be kept in mind while recording transactions in the
Branch Account:

Self-Instructional
136 Material
I. Credit sales, shortage/surplus of stock, bad debts, discount, etc. No entry Branch Accounting
is made by the Head Office in the Branch Account in respect of the following:
(a) Credit sales made by the Branch.
(b) Shortage or surplus of stock at the Branch. NOTES
(c) Return of goods by the Branch Debtors to the Branch. Of course, if the
Branch Debtors return the goods directly to the Head Office, they will
be recorded by the Head Office on the same pattern as if the Branch has
returned the goods to the Head Office.
(d) Discount, Bad Debts, etc.
II. Depreciation of fixed assets: Depreciation of Branch fixed assets is not shown
in the Branch Account. However, the Branch Account is debited with the value of
the fixed assets in the beginning of the accounting year and credited with the value
of fixed assets at the end of the accounting year. The difference is the depreciation
which is thus charged automatically. For example, if the branch has fixed assets
worth 10,000 in the beginning of the accounting year and depreciation is to
be charged at 10% p.a., the Branch Account will be debited with 10,000 in
the beginning of the accounting year and credited by 9,000 at the end of the
accounting year. Thus, depreciation of 1,000 has been charged automatically.
III. Petty expenses: No entry is made in respect of petty expenses incurred
by the Branch out of its petty cash. The Branch Account is debited with opening
balance of petty cash and amount sent by Head Office to the Branch for petty
expenses. At the end of the accounting year, the Branch Account is credited with
the closing balance of the petty cash. Thus, petty cash expenses are automatically
charged to the Branch Account. This will be clear from the following example.
Petty cash balance in the Branch at the beginning of the accounting year
100
Cash sent by the Head Office to the Branch for meeting petty expenses 150
Petty expenses incurred by the Branch 200
In the above case the Branch Account will be debited with 250 (i.e., for
opening petty cash balance and cash sent by the H.O.). It will be credited with
50 as petty cash balance at the end of the accounting year. Thus, it has been
charged with 200 as petty cash expenses.
IV. Sale of fixed assets: The Branch may sell its fixed assets. Any amount
realised on account of sale of fixed assets is remitted to the Head Office. In case,
the fixed assets have been sold on credit, the amount due is shown as debtors
at the Branch at the close of the accounting period. The assets at the end of the
accounting period are shown at the net amount derived as follows:
Opening balance + Purchase of fixed assets – Amount realised on a ccount
of sale of fixed assets.

Self-Instructional
Material 137
Branch Accounting No separate entry is made for the profit or loss made on the sale of fixed
assets since it is automatically taken care of when both the opening and the
closing balances and the amount realised on account of sale of fixed assets are
recorded in the Branch Account.
NOTES
V. Amount received from Insurance Company: In case insurance company
admits a claim in respect of stock or any other property damaged at the branch,
the amount received by the branch from the insurance company will be remitted
to the Head Office. Thus, the amount of remittances from the Branch will
increase. In case the claim admitted is outstanding till the date of the closing of
the accounting period, the amount will be shown as an asset at the Branch on
the credit side of the Branch Account.
Illustration 6.1 Gupta Brothers have their Head Office at Delhi and Branch at
Kolkata. The following are the transactions of the Head Office with Branch for
the year ended 31st August, 2016.

Stock at Branch as on 1.9.2015 30,800

Debtors at the Branch as on 1.9.2015 16,500
Petty Cash as on 1.9.2015 500
Goods supplied to the Branch 1,51,200
Remittances from Branch:
Cash Sales 10,500
Realisation of Debtors 1,57,740 1,68,240
Amount sent to Branch:
Salary 7,440
Rent 2,400
Petty Cash 3,000 12,840
Stock at Branch as on 31.8.2016 23,150
Sundry Debtors at the Branch as on 31.8.2016 50,460
Petty Cash as on 31.8.2016 750
Show the Branch Account in the books of the Head Office. (C.A. Entrance,
adapted)
Solution

Gupta Brothers Kolkata Branch Account

Date Particulars Date Particulars

2015 2015
Sep. 1 To Balance b/d: Sep. 1 By Bank / Cash:
Stock at Branch 30,800 Cash Sales 10,500
Branch Debtors 16,500 Debtors 1,57,740 1,68,240
Self-Instructional Cash 500
138 Material To Goods Sent to 2016 By Balance c/d:
Branch A/c 1,51,200 Aug. 31 Stock at Branch 23,150 Branch Accounting
To Bank: (Remittances) Branch Debtors 50,460
Salary 7,400 Cash at Branch 750
Rent 2,400
Petty Cash 3,000 12,840
NOTES
To Profit transferred
to Profit and Loss A/c 30,760
2,42,600 2,42,600

Illustration 6.2. X & Co. of Delhi have a branch at Chennai. Goods are sent
by the Head Office at invoice price which is at the profit of 25% on cost price.
All expenses of the branch are paid by the Head Office. From the following
particulars, prepare Branch Account in Head Office books: (a) when goods are
shown at cost price and (b) when goods are shown at invoice price.
Opening Balance:
Stock at invoice price 11,000
Debtors 1,700
Petty Cash 100
Goods sent to Branch at invoice price 20,000
Expenses made by Head Office:
Rent 600
Wages 200
Salary 900
Remittances made to Head Office:
Cash Sales 2,650
Cash collected from Debtors 21,000
Goods returned by Branch at invoice price 400
Balances at the end:
Stock at invoice price 13,000
Debtors at the end 2,000
Petty Cash 25
(B.Com. (Pass) Delhi, adapted)
Solution

(a) When goods are shown at cost price

Chennai Branch Account

Particulars Particulars
To Opening Balances: By Cash:
Stock ( 11,000 – 2,200) 8,800 Cash Sales 2,650
Debtors 1,700 Cash Collected from Debtors 23,650
21,000 Self-Instructional
Material 139
Branch Accounting
Particulars Particulars
Petty Cash 100 By Goods Sent to Branch A/c
To Goods Sent to Branch A/c 16,000 (Returned) 320
(at cost) By Closing Balances:
NOTES To Bank (Expenses): Stock (at cost) 10,400
Rent 600 Debtors 2,000
Wages 200 Petty Cash 25
Salaries 900 1,700
To Net Profit-transferred to
General Profit and Loss A/c 8,905
36,395 36,395

(b) When goods are shown at invoice price

Chennai Branch Account

Particulars Particulars
To Opening Balances: By Cash:
Stock 11,000 Cash Sales 2,650
Debtors 1,700 Cash collected from Debtors 21,000
Petty Cash 100 By Goods sent to Branch A/c
To Goods sent to Branch A/c 20,000 (returned) 400
To Bank: By Goods sent to Branch A/c
Rent 600 (loading on net goods sent) 3,920
Wages 200 By Stock Reserve
Salary 900 1,700 (loading in op. stock) 2,200
To Stock Reserve By Closing Balances:
(loading in closing stock) 2,600 Stock 13,000
To Net Profit—transferred to Debtors 2,000
General Profit and Loss A/c 8,095 Petty Cash 25 15,025
45,195 45,195

Ascertainment of Branch Stock and Branch Debtors

In case in an examination question, the balance (opening or closing) of the Branch
Stock or Branch Debtors Account is not given, the students should prepare a
Memorandum Branch Stock Account or a Memorandum Branch Debtors Account.
The accounts will be prepared as follows:
Memorandum Branch Stock Account

Particulars Particulars
To Balance b/d ... By Sales:
To Goods Received from H.O. ... Cash Sales ...
To Goods Returned by Branch Debtors ... Credit Sales ... ...
To Surplus of Stock ... By Goods Returned to
Head Office ...
By Shortage of Stock ...
By Balance c/d ...
... ...

Self-Instructional It should be noted that the Branch Stock Account should be prepared either
140 Material at cost or at invoice price. In case some of the items have been given at invoice
price and the others at cost price, they should be suitably decreased or increased Branch Accounting
to bring all items to a uniform price. In case goods have been sent to the branch
at invoice price, it will be better to prepare the Branch Stock Account at invoice
price.
NOTES
Memorandum Branch Debtors Account

Particulars Particulars
To Balance b/d ... By Cash Received ...
To Credit Sales ... By Bills Receivable received ...
To Bills Receivable dishonoured ... By Bad Debts ...
By Discount ...
By Sales Returns ...
By Balance c/d ...
... ...

The Memorandum Branch Debtors Account as shown above, is prepared

on the same pattern on which a Total Debtors Account is prepared under Single
Entry System.
Illustration 6.3. Vanni Music System invoices goods to its Faridabad branch
at cost plus 20%. During the accounting year 2014–15, Vaani Music System
invoiced goods amounting 15,000 were damaged in transit and insurance
company admitted the claim 15,000. Show the treatment of loss in the books
of Head Office under:
(i) Debtors System
(ii) Stock and Debtors System.
(B.Com (Hons.), 2015)
Solution
Books of Head Office
Journal of Faridabad Branch

(i) Debtors System

.S. No Particulars .L.F ( ) .Dr ( ) .Cr
1 Abnormal Loss A/c Dr. 15,000
To Branch A/c 15,000
(Being goods damaged in transit)
2 Insurance claim A/c Dr. 15,000
To Abnormal Loss A/c 15,000
(Being claim received from Insurance company)

(ii) Stock & Debtors System

.S. No Particulars .L.F ( ) .Dr ( ) .Cr
1 Abnormal Loss A/c Dr. 15,000
To Branch Stock A/c 15,000
(Being goods damaged in transit)
2 Branch Adjustment A/c ( 15,000 × 1/6) Dr. 2,500
Branch Profit & Loss A/c (Cost) Dr. 12,500 Self-Instructional
Material 141
Branch Accounting
.S. No Particulars .L.F ( ) .Dr ( ) .Cr
To Abnormal Loss A/c 15,000
(Being Abnormal Loss Adjusted)
3 Insurance Claim A/c Dr. 15,000
NOTES To Branch Profit & Loss A/c 15,000
(Being claim received from Insurance company)

Working Note:
Selling price (Invoice Price) = Cost + 20% Let the Cost of good be 100

Then Selling Price, 100 + 20 = 120 20% Profit on Invoice Price = =

Illustration 6.4. Delhi Head Office supplies goods to its branch at Kanpur at
invoice price which is cost plus 50%. All Cash received by the branch is remitted
to Delhi and all branch expenses are paid by the Head Office. From the following
particulars relating to Kanpur branch for the year 2015, prepare
(i) Branch Account, and
(ii) Branch Stock Account, Branch Debtors Account, Branch Expenses Account
and Branch Adjustment Account in the books of the Head Office so as to
find out the gross profit and net profit made by the branch.

Stock with Branch on 1.1.2015 (at Invoice Price) 60,000

Branch Debtors on 1.1.2015 12,000
Petty Cash Balance on l.1.2015 100
Goods Received from Head Office (at Invoice Price) 1,86,000
Goods Returned to Head Office 3,000
Credit Sales less Returns 84,000
Allowance to Customer off Selling Price (already adjusted while invoicing)
2,000
Cash received from Debtors 90,000
Discount allowed to Debtors 2,400
Expenses (Cash paid by Head Office):
Rent 2,400
Salaries 24,000
Petty Cash 1,000 27,400
Cash Sales 1,04,000
Stock with Branch on 31.12.2015 (at Invoice Price) 54,000
Petty Cash Balance on 31.12.2015 100
(B. Com. Hons, Delhi, adapted)

Self-Instructional
142 Material
Solution Branch Accounting

(i) Branch Account

Particulars Particulars
To Balance b/d : By Stock Reserve A/c 20,000 NOTES
Stock 60,000 By Goods sent to Branch A/c 62,000
Debtors 12,000 By Goods sent to Branch A/c 3,000
Petty Cash 100 72,100 By Bank (90,000 + 1,04,000) 1,94,000
To Goods sent to Branch A/c 1,86,000 By Balance c/d
To Goods sent to Branch A/c 1,000 Stock 54,000
To Bank: Debtors 3,600
Rent 2,400 Petty Cash 100 57,700
Salaries 24,000
Petty Cash 1,000 27,400
To Stock Reserve A/c 18,000
To General Profit and Loss A/c 32,200
3,36,700 3,36,700

(ii) Branch Stock Account

Particulars Particulars
To Balance b/d 60,000 By Goods sent to Branch A/c 3,000
To Goods sent to Branch A/c 1,86,000 By Branch Debtors 84,000
To Branch Adjustment A/c 1,000 By Branch Adjustment A/c 2,000
By Bank A/c 1,04,000
By Balance c/d 54,000
2,47,000 2,47,000

Branch Adjustment Account

Particulars Particulars
To Goods sent to Branch Account 1,000 By Stock Reserve 20,000
To Branch Stock A/c 2,000 By Goods sent to Branch A/c 62,000
To Stock Reserve A/c 18,000 By Branch Stock A/c 1,000
To Branch Profit and Loss Account 62,000
83,000 83,000

Branch Debtors Account

Particulars Particulars
To Balance b/d 12,000 By Bank A/c 90,000
To Branch Stock A/c 84,000 By Branch Profit and Loss A/c 2,400
By Balance c/d 3,600
96,000 96,000

Branch Expenses Account

Particulars Particulars
To Bank A/c: By Branch Profit and Loss A/c 27,400
Rent 2,400
Salaries 24,000
Petty Cash 1,000 27,400
27,400 27,400 Self-Instructional
Material 143
Branch Accounting Branch Profit and Loss Account

Particulars Particulars
To Branch Debtors A/c 2,400 By Branch Adjustment A/c 62,000
To Branch Adjustment A/c 27,400
NOTES To General Profit and Loss A/c 32,200
62,000 62,000

Illustration 6.5. Nitin Bros. has a branch at Allahabad. Goods are invoiced at
cost plus 25%. From the following particulars, prepare Branch Adjustment and
Profit and Loss Account and Branch Account for the year ended 31st March 2015:
Balances as on April 1, 2014:
Branch Stock (Invoice Price) 12,500
Branch Debtors 8,500
Branch Cash 2,000
Balances as on March 31, 2015:
Branch Stock (Invoice Price) 29,925
Branch Debtors 11,960
Branch Cash 4,500
Transactions during 2014-15:
Goods invoiced to Branch 1,62,500
Goods returned by Branch to Head Office 6,250
Cash remitted to Head Office ?
Credit Sales at Branch 87,500
Cash sales at Branch 51,250
Cash received from Debtors of branch 78,650
Bills Receivable received from debtors at branch 5,000
Amount received by branch on discounting of the above
mentioned bills 4,900
Cash sent to branch for expenses 18,000
Actual cash expenses at branch 17,950
Shortage of stock at branch (Invoice Price) 75
Cash discount allowed to branch customers 390
Make a provision for bad and doubtful debts @5% of the debtors.
[B.Com (Hons.), 2015]
Solution
Books of Head Office
Dr. Allahabad Branch Adjustment Account Cr.
Particulars Particulars
To Stock Reserve A/c (Loading on By Stock Reserve A/c (Loading
Self-Instructional
on
144 Material
Branch Accounting
Particulars Particulars
(Closing stock) ( 29,925 × 1/5 5,985 Opening stock) ( 12,500 × 2,500
1/5)
To Goods sent to Branch A/c By Goods sent to Branch A/c
Loading on Returned goods) (6,250 ×) 1,250 (Loading) ( 1 ,62,500 × 1/5) 32,500 NOTES
(1/5
(To Shortage (Loading) ( 75 × 1/5 15
To Gross Profit transf. to P & L A/c 27,750
35,000 35,000

Dr. Allahabad Branch Profit & Loss Account Cr.

Particulars Particulars
To Discount (Bills Receivable) 100 By Gross Profit b/d 27,750
To Expenses (Actual) 17,950
To Shortage (Cost) 60
To Discount Allowed 390
To Provision for Bad Debts
( 11,960 × 5/100) 598
To Net Profit 8,652
27,750 27,750

Dr. Allahabad Branch Account Cr.

Particulars Particulars
To Balance b/d: By Stock Reserve A/c (Loading)
Stock 12,500 ( 12,500 × 1/5) 2,500
Debtors 8,500 By Goods sent to Branch (Loading)
Cash 2,000 23,000 ( 1,62,500 × 1/5) 32,500
To Goods sent to Branch 1,62,500 By Cash A/c (Remittance) 1,32,350
To Goods sent to Branch By Goods sent to Branch (Returns) 6,250
(Return load) (6,250 × 1/5) 1,250 By Balance c/d:
To Cash (sent by Branch for 18,000 Stock 29,925
expenses)
To Stock Reserve A/c (Loading on Debtors 11,960
closing stock) (29,925 × 1/5) 5,985 Provision for Bad Debts (598)
To Profit & Loss A/c (Profit) 8,652 Cash 4,500 45,787
2,19,387 2,19,387

Dr. Allahabad Branch Cash Account Cr.

Particulars Particulars
To Balance b/d 2,000 By Expenses (Actual) 17,950
To Sales 51,250 By HO (Remittance) 1,32,350
(Balancing figure)
To Debtors 78,650 By Balance c/d 4,500
To Bills Receivable 4,900
To Branch (for expenses) 18,000
1,54,800 1,54,800

Self-Instructional
Material 145
Branch Accounting Working Notes:
Loading Selling Price (Invoice Price) = Cost + 25%. Let the cost of good be =
100. Therefore, the Selling price 100 + 25 = 125. 25% Profit on Invoice Price
will be 25/125 = 1/5.
NOTES
Illustration 6.6 Dara Stores Ltd., with its head office at Delhi, invoiced goods
to its branch at Ghaziabad at 20% less than the list price which is cost plus 100%
with instructions that cash sales were to be made at invoice price and credit sales
at catalogue price (i.e., list price).
From the following particulars available from the branch, prepare branch
stock account, branch adjustment account, branch profit and loss account and
branch debtors account for the year ending December 31, 2020. You are also
required to verify the, gross profit so calculated by preparing branch trading
account.

Stock on 1st January, 2020 (invoice price) 6,000

Debtors on January 1, 2020 5,000
Goods received from head office (invoice price) 66,000
Sales: Cash 23,000
Credit 50,000 73,000
Cash received from debtors 42,817
Expenses at branch 8,683
Remittances to head office 60,000
Debtors on December 31, 2020 12,183
Stock at invoice price on December 31, 2020 8,800
Solution
If Cost Price is 100, List Price is Cost plus 100%, i.e., 200. Invoice
Price is 20% less than list price, i.e., 200 – 40 = 160.
Branch Stock Account

Particulars Particulars
(To Balance b/d (Invoice price 6,000 By Cash Sales 23,000
To Goods sent to Branch A/c By Branch Debtors (Credit Sales) 50,000
(at invoice price) 66,000 By Shortage (invoice price
balancing fig.)
To Branch Adjustment A/c Charged to:
excess of list price over invoice) Branch Adj. A/c 75
(price in credit sales 10,000 Branch P&L A/c 125 200
By Balance c/d 8,800
82,000 82,000

Self-Instructional
146 Material
Branch Adjustment Account Branch Accounting

Particulars Particulars
To Branch Stock A/c: Shortage By Branch Stock A/c 10,000
( 200 × 60/160) 75 By Stock Reserve: Opening Stock
To Stock Reserve: Closing Stock ( 6,000 × 60/160) 2,250 NOTES
( 8,800 × 60/160) 3,300 By Goods sent to Branch A/c
To Gross Profit transferred to ( 66,000 × 60/160) 24,750
Branch Profit and Loss A/c 33,625
37,000 37,000

Branch Profit and Loss Account

Particulars Particulars
To Branch Expenses A/c 8,683 By Gross Profit 33,625
To Branch Stock A/c (shortage at
cost, i.e., 200 – 75) 125
To Net Profit taken to General P & L A/c 24,817
33,625 33,625

Branch Debtors Account

Particulars Particulars
To Balance b/d 5,000 By Cash 42,817
To Sales (credit) 50,000 By Balance c/d 12,183
55,000 55,000

Goods Sent to Branch Account

Particulars Particulars
To Branch Adjustment A/c 24,750 By Branch Stock A/c 66,000
To Purchases A/c 41,250
66,000 66,000

Illustration 6.7. Goods costing 50,000 were sent at a profit of 20% on cost to the
Branch. Sales at the Branch were 42,000 (at invoice price). There were no credit sales.
State the journal entries and show the profit made by the Branch if goods of the invoice
value of 6,000 are still in transit, if the accounts by the Head Office are maintained
.according to (i) Debtors System, and (ii) Stock and Debtors System
Solution

Journal (Debtors System)

S. No. Particulars .Dr .Cr

1. Branch Account Dr. 60,000
To Goods Sent to Branch Account 60,000
(For goods sent to the Branch)
2. Goods Sent to Branch Account Dr. 6,000
To Branch Account 6,000
(For goods in transit)
3. Goods Sent to Branch Account Dr. 9,000
To Branch Account 9,000
(For loading included in net goods sent, i.e., 54,000 × 20/120)
Self-Instructional
4. Cash Account Dr. 42,000 Material 147
Branch Accounting
S. No. Particulars .Dr .Cr
To Branch Account 42,000
(Being Sales at Branch)
5. Stock at Branch Account Dr. 12,000
NOTES To Branch Account 12,000
(Being Stock at Branch)
6. Branch Account Dr. 2,000
To Stock Reserve 2,000
(For Loading in Closing Stock)

Branch Account
Particulars Particulars
To Goods Sent to Branch Account 60,000 By Cash Account 42,000
To Stock Reserve 2,000 By Goods Sent to Branch Account 6,000
To General Profit and Loss Account 7,000 By Goods Sent to Branch Account 9,000
By Stock at Branch 12,000
69,000 69,000

In case the Head Office had debited the goods-in-transit of 6,000 to

Goods-in-transit Account instead of Goods Sent to Branch Account, the Branch
Account will appear as follows:
Branch Account

Particulars Particulars
To Goods Sent to Branch Account 60,000 By Cash Account 42,000
To Stock Reserve Account 2,000 By Goods-in-transit Account 6,000
To Goods-in-transit (for loading 1,000 By Goods Sent to Branch Account 10,000
included in goods-in-transit) (Loading)
To Profit taken to General By Branch Stock A/c 12,000
Profit and Loss Account 7,000
70,000 70,000

(Journal (Stock and Debtors System

S. No. Particulars
1. Branch Stock Account Dr. 60,000
To Goods Sent to the Branch Account 60,000
(For goods sent to Branch)
2. Goods Sent to the Branch Account Dr. 6,000
To Branch Stock Account 6,000
(For goods-in-transit)
3. Cash Account Dr. 42,000
To Branch Stock Account 42,000
(For cash sales)
4. Goods Sent to Branch Dr. 9,000
To Branch Adjustment Account 9,000
(For loading included in goods sent to the Branch)
5. Branch Adjustment Account Dr. 2,000
To Stock Reserve 2,000
(For loading included in stock with the Branch)

Self-Instructional
148 Material
Branch Stock Account Branch Accounting
Particulars Particulars
To Goods Sent to Branch Account 60,000 By Goods Sent to Branch Account 6,000
By Cash 42,000
By Balance c/d 12,000 NOTES
60,000 60,000

Branch Adjustment Account

Particulars Particulars
To Stock Reserve (Closing Stock) 2,000 By Goods Sent to Branch Account
To Profit taken to (1/6 of 54,000, i.e., the
Profit and Loss Account 7,000 net goods sent) 9,000
9,000 9,000

Alternatively, the goods in transit could have been debited to Goods-

in-Transit Account and credited to Branch Stock Account. In such a case
the Branch Adjustment Account will be credited with loading of full
10,000 in respect of goods sent and then debited with 1,000 for loading
included in goods-in-transit. The net amount credited to Branch Adjustment
Account of goods sent to branch comes to 9,000, as in the solution given above.
3. Final Accounts System
The profit of a dependent branch can also be found out by the Head Office by
preparing a Memorandum Branch Trading and Profit and Loss Account. The
account is usually prepared at cost of goods sent to the Branch. In such cases,
the Head Office may also maintain a Branch Account. The Branch Account so
maintained is of the nature of a personal account as different from the Branch
Account maintained by the Head Office in case of Debtors System which is of
the nature of a nominal account. The balance in the Branch Account at the end of
a particular period represents the net assets at the Branch (i.e., Assets–Liabilities
at the Branch).
Illustration 6.8. Head Office passes adjustment entry at the end of each month
to adjust the position arising out of inter-branch transactions during the month.
From the following inter-branch transactions in January, 2015, make the entry
in the books of Head Office:
(a) Mumbai Branch
(1) Received Goods: 6,000 from Kolkata Branch; 4,000 from Patna Branch.
(2) Sent Goods: 10,000 to Patna; 8,000 to Kolkata.
(3) Received B/R: 6,000 from Patna.
(4) Sent Acceptance: 4,000 to Kolkata; 2,000 to Patna.
(b) Chennai Branch (apart from the above)
(5) Received Goods: 10,000 from Kolkata; 4,000 from Mumbai.
(6) Cash sent: 2,000 to Kolkata; 6,000 to Mumbai.
Self-Instructional
(c) Kolkata Branch (apart from the above). Material 149
Branch Accounting (7) Sent Goods to Patna: 6,000.
(8) Paid B/P: 4,000 to Patna; 4,000 cash to Patna. (C.A. Inter, adapted)
Solution
NOTES BOOKS OF HEAD OFFICE
Journal

Date Particulars .Dr .Cr

2015
Jan. 31 Chennai Branch A/c 6,000
Patna Branch A/c 16,000
To Mumbai Branch A/c 6,000
To Kolkata Branch A/c 16,000
(Being adjustment entry passed by Head Office
for inter-branch transactions during the month)

Working Note:
Inter-branch transactions
Mumbai Chennai Kolkata Patna

(a) Mumbai Branch

(1) Receivable Goods 10,000(Dr.) 6,000(Cr.) 4,000(Cr.)
(2) Sent Goods 18,000(Cr.) 8,000(Dr.) 10,000(Dr.)
(3) Received B/R 6,000(Dr.) 6,000(Cr.)
(4) Sent Acceptance 6,000(Cr.) 4,000(Dr.) 2,000(Dr.)
(b) Chennai Branch
(5) Received Goods 4,000(Cr.) 14,000(Dr.) 10,000(Cr.)
(6) Cash Sent 6,000(Dr.) 8,000(Cr.) 2,000(Dr.)
(c) Kolkata Branch
(7) Sent Goods 6,000(Cr.) 6,000(Dr.)
(8) Paid B/P and Cash 8,000(Cr.) 8,000(Dr.)
6,000(Cr.) 6,000(Dr.) 16,000(Cr.) 16,000(Dr.)

Reconciliation Entries
It has already been stated that the balance shown by the Branch Account in the
Head Office books may not tally with the balance as shown by the Head Office
Account in the Branch books. The reasons for the difference and accounting
entries required are given below:
I. Goods-in-transit: The Head Office or the Branch may have sent goods to each
other. These goods may not have been received by the end of the accounting year
by the Head Office or the Branch as the case may be. The balance in the Head
Office Account, therefore, will not tally with the balance in the Branch Account.
The entry for reconciling the difference for this reason may either be passed in
the Head Office books or the Branch Books but not in both of them.
In the Head Office Books:
Goods-in-transit Account Dr.
To Branch Account
Self-Instructional
150 Material
In the branch Books: Branch Accounting

Goods-in-transit Account Dr.

To Head Office Account
II. Cash-in-transit: The Head Office or the Branch may have sent cash to each NOTES
other. The amount may not have been received by the Branch or the Head Office as
the case may be, by the end of the accounting period. The entry for reconciliation
of the difference on this account may either be passed by the Head Office or the
Branch, but not in both of them, as follows:
In the Books of the Head Office:
Cash-in-transit Account Dr.
To Branch Account
In the Books of the Branch:
Cash-in-transit Account Dr.
To Head Office Account
Illustration 6.9. A Ltd., with its Head Office at Gurgaon, has an independent
branch at Noida. The Head Office at Noida close their books of account on 31st
March. Pass Journal entries in the books of Head Office and Noida branch for
the following transactions:
(i) Noida branch purchased computers for 80,000. The fixed assets accounts
are maintained at H.O.
(ii) Depreciation @ 15% is to be provided on computers.
(iii) Noida branch collected 1,00,000 from a customer of H.O.
(iv) H.O. paid 10,000 as freight for goods sent to the Noida branch.
(v) Goods worth 90,000 sent by H.O. on 28th March, 2013 to Noida branch
were received by the branch at 4th April, 2013.
(vi) Noida branch sent goods worth 40,000 to Meerut branch on instructions
from H.O.
(vii) Noida branch collected rent amounting to 20,000 on behalf of H.O.
(viii) Noida branch remitted 45,000 on 29th March, 2013 which was received
by H.O. on 3rd April, 2013.
(ix) The salary of Mr. Ashok, an employee of H.O. was 60,000 per month.
Ashok worked for 10 days out of 30 days for Noida branch.
(x) Noida branch profit for the year ended 31st March, 2013 amounted to
35,000.
(B.Com (Hons.), 2013)

Self-Instructional
Material 151
Branch Accounting Solution

Head Office Journal

Date Particulars L.F. Dr. ( ) Cr. ( )

NOTES (i) Branch Assets A/c Dr. 80,000
To Noida Branch A/c 80,000
(Being Computers purchased by Noida branch)
(ii) Noida Branch A/c Dr. 12,000
To Branch Assets (Computers) A/c 12,000
(Being depreciation charged on Computers)
(iii) Noida Branch A/c Dr. 1,00,000
To Sundry Debtors A/c 1,00,000
(Being cash collected from a customer by Noida Branch)
(iv) Noida Branch A/c Dr. 10,000
To Cash A/c 10,000
(Being frieght paid)
(v) Goods-in-transit A/c Dr. 90,000
To Noida Branch A/c 90,000
(Being Goods sent by us (H.O.) still in transit)
(vi) Meerut Branch A/c Dr. 40,000
To Noida Branch A/c 40,000
(Being goods transferred from Noida branch to Meerut
branch under Our (HO.) instructions)
(vii) Noida Branch A/c Dr. 20,000
To Rent A/c 20,000
(Rent collected by Noida branch for H.O.)
(viii) Noida Branch A/c Dr. 20,000
To Salary/Profit & Loss A/c 20,000
(Being salary of Mr. Ashok charged to branch)
(ix) Noida Branch A/c Dr. 35,000
To General Profit & Loss A/c 35,000
(Being Noida branch profit incorporated)

Journal of Noida Branch

Date Particulars L.F. Dr. ( ) Cr. ( )

(i) Head Office A/c Dr. 80,000
To Cash A/c 80,000
(Being Computers purchased)
(ii) Depreciation A/c Dr. 12,000
To Head Office A/c 12,000
(Being depreciation charged)
(iii) Cash A/c Dr. 1,00,000
To Head Office A/c 1,00,000
(Being cash collected from a customer on behalf of
Head Office)
(iv) Freight A/c Dr. 10,000
To Head Office A/c 10,000
(Being frieght paid by Head Office)
(v) Head Office A/c Dr. 40,000
Self-Instructional
152 Material
Branch Accounting
Date Particulars L.F. Dr. ( ) Cr. ( )
To Goods sent to Head Office A/c 40,000
(Being goods sent to Meerut branch as per Head
Office instructions)
(vi) Cash A/c Dr. 20,000 NOTES
To Head Office A/c 20,000
(Being rent collected on behalf of Head Office)
(vii) Head Office A/c Dr. 45,000
To Cash-in-transit A/c 45,000
(Being the entry for cash-in-transit)
(viii) Head Office Expenses A/c Dr. 20,000
To Head Office A/c 20,000
(Being salary of Mr. Ashok Charged by HO.)

Incorporation of Branch Trial Balance in the Head Office Book

Since the consolidated Final Accounts of the Head Office and its Branches have
to be prepared, it will be necessary for the Head Office to incorporate the Branch
Balances in its books by means of suitable Journal entries. The incorporation of
Branch Balances in the Head Office Books can be done by any of the following
two methods:
(i) Detailed Incorporation;
(ii) Abridged Incorporation.
I. Detailed incorporation: In case of this method, all items relating to Trading
and Profit and Loss Account are incorporated in the Head Office Books besides
incorporation of Branch Assets and Liabilities. The Trading and Profit and Loss
Account is prepared in the usual way in the books of the Head Office. The
following entries are passed:
1. For incorporating the items which are shown on the Debit side of the
Trading Account:
Branch Trading Account Dr.
To Branch Account
(This entry is passed with the total amount of various
items which are debited to the Trading Account such as
Opening Stock, Purchases, Wages, Manufacturing Expenses etc.)
2. For incorporating the items which are shown on the Credit side of the
Trading Account:
Branch Account Dr.
To Branch Trading Account
(This entry is passed with the total of the different items
which come on the credit side of the Trading Account,
e.g., Sales, Closing Stock etc.)
3. For transferring of Gross Profit to Branch P & L A/c:
Self-Instructional
Branch Trading Account Dr. Material 153
Branch Accounting To Branch P & L Account
(In case of Gross Loss, the entry will be reversed)
4. For incorporating the items appearing on the Debit side of the Branch P
& L A/c:
NOTES
Branch P & L A/c Dr.
To Branch Account
(This entry is passed with the total amount of the items
which come on the Debit side of the P & L Account such as
Salary, Rent, Commission, Depreciation, Discount, Bad Debts etc.)
5. For incorporating the items which appear on the Credit side of the P & L
Account:
Branch Account Dr.
To Branch P & L Account
(This entry is passed with the total amount of the items
which come on the credit side of the P & L Account e.g.,
Interest received, Discount received, Commission earned.)
6. For transferring the Net Profit as shown by the Branch P & L A/c:
Branch P & L A/c Dr.
To General or H.O. P & L Account
(In case of Loss, the entry will be reversed)
7. For incorporating of Branch Assets (after adjustments, if any):
Branch Assets Account Dr.
(Each asset to be debited individually)
To Branch Account
8. For incorporating of Branch Liabilities (after adjustments, if any):
Branch Account Dr.
To Branch Liabilities Account
(Each liability to be credited individually)
As a result of these incorporation entries, the Branch Account in the Head
Office Books will be completely closed.
In the beginning of the next year, the various assets and liabilities will be
transferred back to the Branch by means of the following entries:
1. For Transfer of Assets:
Branch Account Dr.
To Branch Assets Account
(Credit each asset individually)
2. For Transfer of Liabilities:
Branch Liabilities Account Dr.
(Debit each liability individually)
To Branch Account
II. Abridged incorporation: In case of this method, the Branch Trading and
Self-Instructional Profit and Loss Account is prepared by the Head Office as a Memorandum
154 Material Account only. The entries are passed only for incorporation of the Branch Net
Profit or Net Loss and the Branch Assets and Liabilities. The following entries Branch Accounting
will be passed in the books of the Head Office in case this method is followed:
1. For incorporating Branch Net Profit:
Branch Account Dr. NOTES
To General Profit and Loss Account
(In case of loss, the entry will be reversed)
It may be seen that this entry replaces first six entries which are passed in
case of Detailed Incorporation Method.
2. For incorporating Branch Assets:
Branch Assets Account Dr.
(Debit each asset individually)
To Branch Account
3. For incorporating Branch Liabilities:
Branch Account Dr.
To Branch Liabilities Account
(Credit each liability individually)
It should be noted that in case entries are passed only for transfer of items
relating to Trading and Profit and Loss Account or for incorporating only the
Balance as shown by the Branch Profit and Loss A/c (and not for incorporation
of Branch Assets and Liabilities), the Balance in the Branch Account at any time
will show Net Assets at the Branch.
Entries in the Books of the Branch
The Branch Books have also to be closed at the end of the accounting period.
The entry for closing the books of the Branch may also be passed according to
any of the two methods discussed in the preceding pages:
1. Detailed Incorporation Method: According to this method, each item of
Trading and Profit and Loss Account will be transferred to the Head Office
Account besides each item of assets and liabilities. The following entries will
be passed:
(i) For transfer of items appearing on the Debit Side of the Trading and P &
L Account:
Head Office Account Dr.
To Opening Stock
To Purchases
To Goods Received from the Head Office
To Manufacturing Expenses
To Rent Self-Instructional
Material 155
Branch Accounting To General Expenses etc.
(ii) For transfer of items appearing on the Credit Side of the Trading and Profit
and Loss Account:
NOTES Sales Account Dr.
Closing Stock Dr.
Discount Received Account Dr.
Interest Received Account Dr.
To Head Office Account
(iii) For transfer of Branch Assets:
Head Office Account Dr.
To Branch Assets Account
(Each asset to be credited individually)
(iv) For transfer of Branch Liabilities:
Branch Liabilities Account Dr.
(Each liability to be debited individually)
To Head Office Account
As a result of these entries, the Head Office Account in the books of the
Branch will be completely closed.
2. Abridged Incorporation Method: In case of this method, the Branch
Trading and Profit and Loss Account will be prepared and the Net Profit (or
Net Loss) as shown by the Branch Trading and Profit and Loss Account will be
transferred to the Head Office. The following journal entries will be passed in
the books of the Branch:
In case of Profit:
P & L Account Dr.
To Head Office Account
.In case of Loss, the entry will be reversed
The entries for transferring the Branch Assets and Branch Liabilities in the
books of the branch will be the same as explained in the Detailed Incorporation
Method.
Illustration 6.10. Blue Ltd. has an issued share capital of 8,00,000 in shares
of 10 each, fully paid. It has its head office in Mumbai and operates retail stores
in Delhi and Chennai both of which commenced business on July 1, 2020.
All goods are purchased by the head office and invoiced to the branches at
cost plus 20 per cent. The freehold buildings of the branches are recorded in the
books of the head office, Delhi being debited with an annual rent of 5,000 and
Chennai of 6,000. Subject to this, each branch keeps its own complete set of
books. Goods are transferred from one branch to the other at head office invoice
Self-Instructional
156 Material
price. The following items, relating to the Profit and Loss Accounts, appear in
the Trial Balance as on June 30, 2021.
Branch Accounting
Particulars Mumbai Delhi Chennai

Debits
Purchase at Cost 9,56,300 — —
Purchases at invoice price — 6,21,900 5,37,900 NOTES
Stock on July 1, 2020 at cost 1,06,400 — —
Goods from other branches — 14,300 25,700
Rent 5,000 6,000
Rates 3,600 4,900 5,300
General Expenses 17,800 29,000 29,600
Salaries & Wages 26,800 35,300 40,200
Bad Debts — 6,700 4,200
Depreciation of Premises 13,000 — —
Depreciation of Fittings 1,000 2,800 3,200
Interest 12,000 — —
Credits
Sales — 6,76,300 6,14,600
Goods to other branches — 26,600 14,900
Rent charged to branches 11,000 — —
Goods invoiced to branches 11,64,000 — —
P & L Account 1st July, 2020 34,950 — —

Stock on hand on June 30, 2021 were, H.O., 92,700; Delhi, 40,800 (at
invoice price) and Chennai, 31,500 (at invoice price).
Current accounts between the branches and the head office and between the
branches agreed with one another with the exception of the following transactions
which were not included in the stock of receiving branch or recorded in its books
until July 2, 2021:
Goods invoiced from Mumbai to Delhi, 2,400 and to Chennai, 1,800.
Goods transferred from Delhi to Chennai 900 and from Chennai to Delhi,
600.
Provision is to be made in the head office for Directors’ fees 20,000,
auditors’ remuneration, 5,250 and taxation on profits of 67,000. The Directors
needed to set aside 25,000 to General Reserve, to recommend a dividend of 5
per cent and carry forward the balance of profit and loss account.
Ascertain the profit of the concern:
(i) When Gross Profit is to be ascertained by taking goods sent to the branch
at cost.
(ii) When Gross Profit is to be ascertained by taking goods sent to the branch
at invoice price but adjustment for loading is to be done in the Profit and
Loss Account.
(iii) When Profit is to be ascertained by taking goods sent to the branch at
invoice price.

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Material 157
Branch Accounting Solution
Basic Calculations

Goods Sent to Branches

NOTES Particulars Invoice price Cost price
Delhi Chennai Delhi Chennai
Goods received by Branches 6,21,900 5,37,900 5,18,250 4,48,250
Goods-in-transit 2,400 1,800 2,000 1,500
6,24,300 5,39,700 5,20,250 4,49,750

Goods Received by Branches

Particulars Invoice price Cost price

Delhi Chennai Delhi Chennai
Goods from Head Office 6,21,900 5,37,900 5,18,250 4,48,250
Less: Goods to other Branches 26,600 14,900 22,167 12,417
Add: Goods from other Branches 14,300 25,700 11,917 21,417
Total 6,09,600 5,48,700 5,08,000 4,57,250

Closing Stock

Particulars Delhi Chennai

Invoice Cost Invoice Cost
price price
as on 30th June, 2021 40,800 34,000 31,500 26,250

(i) When Gross Profit is ascertained at cost

Profit and Loss Appropriation Account

(Year ended 30th June 2021)

Particulars Particulars
To Provision for Taxation 67,000 By Balance b/d 34,950
To General Reserve (Transfer) 25,000 By Profit for the current year:
To Proposed Dividend 40,000 Delhi Branch 1,18,600
To Balance c/d 28,200 Chennai Branch 95,100
2,13,700
Less: Loss at Head office 88,450 1,25,250
1,60,200 1,60,200

Note: It is not necessary to take in to account the items in transit for preparing Profit & Loss A/c.

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158 Material
Trading & Profit and Loss Account
for the year ending 30th June, 2021

Particulars Mumbai Delhi Chennai Particulars Mumbai Delhi Chennai

To Opening Stock 1,06,400 – – By Sales – 6,76,300 6,14,600

To Purchases 9,56,300 – – By Goods sent to Branches:
To Goods from Head Office – 5,18,250 4,48,250 Delhi 5,20,250 – –
To Goods from other Branches – 11,917 21,417 Chennai 4,49,750 – –
To Gross Profit c/d – 2,02,300 1,83,600 By Goods to other Branch- – 22,167 12,417
es
By Closing Stock 92,700 34,000 26,250
10,62,700 7,32,467 6,53,267 10,62,700 7,32,467 6,53,267
To Rent – 5,000 6,000 By Gross Profit b/d – 2,02,300 1,83,600
To Rates 3,600 4,900 5,300 By Rent 11,000 – –
To General Expenses 17,800 29,000 29,600 By Net Loss 88,450
To Salaries & Wages 26,800 35,300 40,200
To Bad Debts – 6,700 4,200
To Depreciation of Premises 13,000 – –
To Depreciation of Fittings 1,000 2,800 3,200
To Interest 12,000 – –
To Directorsʼ Fee Outstanding 20,000 – –
To Auditorsʼ Remuneration
outstanding 5,250 – –
To Net Profit 1,18,600 95,100
99,450 2,02,300 1,83,600 99,450 2,02,300 1,83,600

When Gross Profit is ascertained at invoice price but adjustment for loading in Profit & Loss Account (ii)

Material
Self-Instructional
NOTES
Branch Accounting

159
160
Material
Branch Accounting

NOTES

Self-Instructional
Trading & Profit and Loss Account for the year ending 30th June, 2021

Particulars Mumbai Delhi Chennai Particulars Mumbai Delhi Chennai

To Stock 1,06,400 – – By Sales – 6,76,300 6,14,600

To Purchases 9,56,300 – – By Goods sent to Branches: 11,64,000 – –
To Goods from Head Office – 6,21,900 5,37,900 By Goods sent to other Branches – 26,600 14,900
To Goods from other Branches – 14,300 25,700 By Stock 92,700 40,800 31,500
To Gross Profit c/d 1,94,000 1,07,500 97,400
12,56,700 7,43,700 6,61,000 12,56,700 7,43,700 6,61,000
To Rent – 5,000 6,000 By Gross Profit bid 1,94,000 1,07,500 97,400
To Rates 3,600 4,900 5,300 By Rent 11,000 – –
To General Expenses 17,800 29,000 29,600 By Goods from Head Office
To Salaries and Wages 26,800 35,300 40,200 (including goods from and to
To Bad Debts – 6,700 4,200 other Branches—Loading) – 1,01,600 91,450
To Depreciation of Premises 13,000 – – By Loss transferred to Profit &
To Depreciation of Fittings 1,000 2,800 3,200 Loss Appropriation A/c 88,450 – –
To Interest 12,000 – –
To Stock Reserve (on Closing Stock) – 6,800 5,250
To Goods sent to Branches – Loading 1,94,000 – –
To Directors Fees Outstanding 20,000 – –
To Auditorsʼ Remuneration
Outstanding 5,250 – –
To Profit transferred to Profit & Loss
Appropriation A/c – 1,18,600 95,100
2,93,450 2,09,100 1,88,850 2,93,450 2,09,100 1,88,850

The Profit & Loss Appropriation Account will be prepared as in case (i).
same.
Profit and Loss Account

Particulars Mumbai Delhi Chennai Particulars Mumbai Delhi Chennai

To Rent – 5,000 6,000 By Gross Profit as per
To Rates 3,600 4,900 5,300 Trading A/c 1,94,000 1,07,500 97,400
To General Expenses 17,800 29,000 29,600 By Rent 11,000 – –
To Salaries and Wages 26,800 35,300 40,200
To Bad Debts – 6,700 4,200
To Depreciation of Premises 13,000 – –
To Depreciation of Fittings 1,000 2,800 3,200
To Interest 12,000 – –
(iii) If profit is ascertained at invoice price

To Directorsʼ Fees Outstanding 20,000 – –

To Auditorsʼ Remuneration
Outstanding 5,250 –
To Net Profit 1,05,550 23,800 8,900
2,05,000 1,07,500 97,400 2,05,000 1,07,500 97,400
will be different but total Net Profit of the Business for the year will remain the
However, the amount of Net Profit of the Branches and that of the Head Office
In such a case, the Gross Profit will be the same as shown under Method II.

Material
Self-Instructional
NOTES
Branch Accounting

161
Branch Accounting General Profit and Loss Account

Particulars Particulars
To Stock Reserve (Closing Stock): By Net Profit bid:
Delhi 6,800 Delhi Branch 23,800
NOTES Chennai 5,250 Chennai Branch 8,900
In transit Head Office 1,05,550
[(1/6 of (2,400 + 1,800 + 900 + 600)] 950
To Net Profit c/d 1,25,250
1,38,250 1,38,250

Profit & Loss Appropriation Account

Particulars Particulars
To Provision for Taxation 67,000 By Balance b/d 34,950
To General Reserve (Tr) 25,000 By General P & L Account
To Proposed Dividend 40,000 (Net Profit b/d) 1,25,250
To Balance c/d (To b/s) 28,200
1,60,200 1,60,200

Illustration 6.11. A trader commenced business on 1st January, 2015

establishing a Head Office and one branch. Purchases were made exclusively
by the Head Office, where the goods were processed before sales. There was no
loss or wastage in processing. Only processed goods received from Head Office
were handled by the branch. These were charged to the branch at processed cost
plus 10%.
All sales, whether by H.O, or the branch, were at uniform gross profit of
25 per cent on the cost after processing. From the following information, prepare
Profit and Loss Account for the year and Balance Sheet as on 31st December,
2015.

Capital 2,20,000
Drawings 25,000
Purchases 19,93,350
Cost of processing 34,650
Sales – H.O. 14,20,000
Sales – Branch 6,40,000
Goods sent to Branch 6,51,200
Selling and General Expenses 2,41,000
Debtors 3,22,000
Creditors 5,85,750
Branch Current a/c 2,05,550
Balance at Bank 1,96,000
The following informations are relevant:
(i) Stock taking a Branch disclosed a shortage of 5,000 (at selling price).

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162 Material
(ii) Goods charged by head office to branch during the year include 11,000 not Branch Accounting
received by branch during the year. A remittance of 43,750 from branch
to head office was not received by before January 2016. The necessary
adjustments, in respect of these items, are to be made in head office books.
NOTES
(iii) Cost of unprocessed goods at head office on 31st December, 2015 was
1,80,000.
(C.A. Inter New Scheme, C.A. Final O.S., adapted)
Solution

Profit and Loss Account for the year ending 31st Dec. 2015

Particulars Particulars
To Purchases 19,93,350 By Sales H.O. 14,20,000
To Cost of Processing 34,650 Branch 6,40,000 20,60,000
To Selling & General Expenses 2,41,000 By Closing Stock:
To Net Profit transferred to Capital A/c 1,67,000 Unprocessed goods 1,80,000
Processed Stock 1,96,000 3,76,000
24,36,000 24,36,000

Working Notes:

(i) Selling Price 100

Gross profit 25% on cost of 20% on selling price 20
Cost of processed goods 80
Invoice price of processed goods (cost plus 10%) 88
Profit at Branch on invoice price 12
(ii) Closing Stock at H.O. and Branch:
Purchases 19,93,350
Less: Cost of unprocessed goods 1,80,000
18,13,350
Add: Cost of processing 34,650
Cost of processed goods 18,48,000
Less: Cost of H.O. Sales: 14,20,000 × 80/100 11,36,000
7,12,000
Less: Cost of Branch Sales: 6,40,000 × 80/100 5,12,000
2,00,000
Less: Cost of shortage at Branch: 5,000 × 80/100 4,000
Total Stock at cost including Stock of 10,000 in transit 1,96,000
(iii) Memorandum H.O./Cash Bank Account

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Material 163
Branch Accounting
Particulars Particulars
To Capital 2,20,000 By Payments to Creditors
To Collections from Debtors Purchases 19,93,350
Sales 14,20,000 Less: Due 5,85,750 14,07,600
NOTES Less: Due 3,22,000 10,98,000 By Drawings 25,000
By Cost of processing 34,650
To Branch A/c By Selling & General Expenses 2,41,000
(Cash received – Balancing figure) 5,86,250 By Balance c/d 1,96,000
19,04,250 19,04,250

(iv) Branch Cash Account

Particulars Particulars
To Branch Debtors (Balancing By H.O. (Cash remitted) 5,86,250
figure: 6,40,000 less 10,000) 6,30,000 By Cash in transit 43,750
6,30,000 6,30,000

Alternative Solution
Alternatively, the Profit and Loss Account may be set out as follows:
Profit and Loss Account

Particulars Branch .H.O Particulars Branch .H.O

To Purchases 19,93,350 By Goods sent to 6,51,200

Branch
Less: Stock on hand 1,80,000 By Sales 6,40,000 14,20,000
18,13,350 By Profit & Loss
To Cost of Processing 34,650 A/c (shortage) 4,400
To Goods received from 6,40,200 By Closing Stock 72,600 1,20,000
H.O.
To Gross Profit c/d 76,800 3,43,200
7,17,000 21,91,200 7,17,000 21,91,200

General Profit and Loss Account

Particulars Particulars
To Selling Expenses 2,41,000 By Gross Profit b/d
To Trading Account (shortage) 4,400 Head Office 3,43,200
To Stock Reserve @ 1/11 Branch 76,800
Goods in transit 1,000
Stock at Branch 6,600
To Net Profit 1,67,000
4,20,000 4,20,000

Workings:
Computation of Value of Stock at H.O. and Branch:
Head Office
Cost of processed goods 18,48,000
Less: Cost of goods sold: 14,20,000 × 80/100 11,36,000
Cost of goods sent to Branch: 6,51,200 × 100/110 5,92,000 17,28,000
1,20,000
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164 Material
Branch Branch Accounting
Invoice value of goods sent from H.O. 6,51,200
Less : Goods-in-transit 11,000
Goods received from Head Office 6,40,200
Invoice value of sales: 6,40,000 × 88/100 5,63,200 NOTES
Invoice value of shortage: 5,000 × 88/100 4,400 5,67,600
72,600
Total Stock: At H.O. Processed 1,20,000
Goods-in-transit (at cost) 10,000
At Branch at cost 66,000
1,96,000

Balance Sheet at 31st December, 2015

Liabilities Assets
Capital Account: Stock-in-trade:
Opening Capital 2,20,000 Unprocessed 1,80,000
Add: Net Profits 1,67,000 Processed
3,87,000 (including 10,000 in transit) 3,76,000
1,96,000
Less: Drawings 25,000 3,62,000 Sundry Debtors:
Head Office 3,22,000
Sundry Creditors 5,85,750 Branch 10,000 3,32,000
Cash at Bank 1,96,000
Cash-in-transit 43,750
9,47,750 9,47,750

Illustration 6.12. XY & Co. commenced business on 1.1.2014 with Head Office
at Calicut and a Branch at Trichur.
All goods were purchased by Head Office and normally packed immediately.
But on 31.12.2014, goods costing 5,000 remained unpacked.
Only packed goods were sent to the Branch which was charged at selling
price less 10%.
Following information is furnished to you as on 31st Dec., 2014 from the
Head Office and Branch Office books:
Head Office Branch

Capital Account 40,000 —

Drawings by proprietor 10,000 —
Purchases 4,00,000 —
Packing materials bought 6,000 —
Sales 3,20,000 1,00,000
Despatch of goods to Branch 1,13,400 —
Selling expenses 16,000 800
Clerk’s salary, wages, etc. 20,000 3,000
Sundry Debtors 28,000 4,200
Self-Instructional
Sundry Creditors 26,000 5,000 Material 165
Branch Accounting Current Accounts:
Head Office (Credit balance) 12,000
Branch Office (Debit balance) 19,000
Bank Balances 1,000
NOTES
Goods received from Head Office — 1,08,000
You are further informed that:
(a) Sales by Head Office were at a uniform gross profit, after charging packing
material of 20% on the fixed selling price.
(b) Sales at Branch were at fixed selling price.
(c) Goods invoiced and despatched by Head Office to Branch in December,
2014 for 5,400 were received in the Branch only on 10th January, 2015
(d) Stock of packing materials on hand as on 31st December, 2014 was valued
at 1,000
(e) Remittance of 1,600 from the Branch to the Head Office was in transit
on 31.12.2014.
(f) 2,000 worth of stock at selling price was damaged at the Branch. For
valuing Stock this was reduced by 1,090 below the invoice cost to the
Branch. It was decided that the Head Office and the Branch would share
equally the loss occasioned by this and also the deficit in stock ascertained
on actual stock taking at the Branch of goods at selling price of 500.
Prepare the Profit and Loss Accounts of the Trichur and Calicut Offices
and also a Balance Sheet as at 31.12.2014. of the business.
(C.A. Inter, New Scheme, adapted)
Solution
XY & Co.
Trading and Profit & Loss Account

Dr. for the year ended 31st Dec., 2014 Cr.

Particulars .H.O Branch Particulars .H.O Branch

To Purchases By Sales 3,20,000 1,00,000

(less unpacked goods) 3,95,000 By Goods sent to
Branch A/c
To Packing material 5,000 (in transit 1,13,400
consumed 5,400)
To Goods from H.O. 1,08,000 By Stock destroyed
To Gross profit c/d and written off 1,540
(working notes 1 and 2) 76,000 10,000 By Closing Stock
(balancing figure) 43,200 16,460
4,76,600 1,18,000 4,76,000 1,18,000
To Salaries and Wages 20,000 3,000 By Gross Profit b/d 76,600 10,000
To Selling Expenses 16,000 800
To Stock Destroyed 770 770
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166 Material
Branch Accounting
Particulars .H.O Branch Particulars .H.O Branch

To Stock Reserve
(unrealised profit) 2,350
To Net Profit to Capital A/c 37,480 5,430 NOTES
76,600 10,000 76,600 10,000

XY & Co Balance Sheet as on 31st Dec., 2014

Liabilities Assets
Capital 40,000 Stock-in-trade:
Add: Net Profit 42,910 H.O. packed 43,200
82,910 Unpacked 5,000
Less: Drawings 10,000 72,910 Packing material 1,000
Sundry Creditors 31,600 At Branch 16,460
In transit 5,400
71,060
Less: Unrealised profit 2,350 68,710
Sundry Debtors 32,200
Cash at Bank 2,000
Cash in transit 1,600
1,04,510 1,04,510

Working Notes:

(1) Gross Profit made by Head Office

20% of Sales of 3,20,000 64,000
10/90 of Goods sent to Branch (since invoice price is 90% of
normal selling price) 12,600
76,600
(2) The gross profit made by branch is 10% of sales or 1,00,000
(3) The amount to be written off at invoice value at branch
Amount written off on damaged goods 1,090
Invoice price of deficit in stock 500 × 90/100 450 1,540
(4) Goods of selling price of 2,000 have been damaged. The invoice value
of the damaged goods comes to 1,800. Since 1,090 have been written
off in respect of these goods, only goods of 710 would be included in
closing stock of 16,460. On this, however, there will be no stock reserve
required. Stock Reserve required has been calculated as follows:
Stock (as per Trading Account) 16,460
Less: Damaged goods 710
15,750
Add : Goods in Transit 5,400
21,150
Stock Reserve @ 10/90 2,350 Self-Instructional
Material 167
Branch Accounting
Check Your Progress
1. What are the two categories into which branches can be classified?
2. What do you mean by dependent branch?
NOTES
3. How can incorporation of Branch Balances in Head Office Books be
done?

6.4 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS
1. Branches can be broadly classified into two categories for the purpose of
recording transactions in the books of accounts:
(i) Dependent Branches;
(ii) Independent Branches
2. The term Dependent Branch means a branch which does not maintain its
own set of books. All records have to be maintained by the Head Office.
3. The incorporation of Branch Balances in the Head Office Books can be
done by any of the following two methods:
(i) Detailed Incorporation;
(ii) Abridged Incorporation.

6.5 SUMMARY
• In order to market its product over large territories and to have an effective
and efficient retailing, a business is generally split into branches or
departments. In case the various divisions of the business are located under
the same roof, they are known as Departments. If the various divisions of
the business are located in different places, either in the same town or in
different towns, they are known as Branches.
• Branches can be broadly classified into two categories for the purpose of
recording transactions in the books of accounts:
(i) Dependent Branches;
(ii) Independent Branches
• The term Dependent Branch means a branch which does not maintain its
own set of books. All records have to be maintained by the Head Office.
• Independent Branch means a branch which maintains its own set of books.
Such a branch can either be a Home Branch or a Foreign Branch. The
method of accounting is the same in both the cases except that in case
of a foreign branch, the trial balance sent by the foreign branch is to be
converted into the currency of the country of the Head Office.
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168 Material
• In case of a dependent branch, the Head Office may keep accounts of the Branch Accounting
Branch according to any of the following systems:
a. Debtors System
b. Stock and Debtors System NOTES
c. Final Accounts System
d. Wholesale Branch system
• Debtors system is followed in case of branches of small size. The Head
Office maintains a Branch Account, in its books. The Branch Account is
of the nature of a nominal account.
• In case in an examination question, the balance (opening or closing) of the
Branch Stock or Branch Debtors Account is not given, the students should
prepare a Memorandum Branch Stock Account or a Memorandum Branch
Debtors Account.
• The incorporation of Branch Balances in the Head Office Books can be
done by any of the following two methods:
(i) Detailed Incorporation;
(ii) Abridged Incorporation.
• In case of Detailed Incorporation, all items relating to Trading and Profit
and Loss Account are incorporated in the Head Office Books besides
incorporation of Branch Assets and Liabilities. The Trading and Profit and
Loss Account is prepared in the usual way in the books of the Head Office.
• In case of Abridged Incorporation, the Branch Trading and Profit and Loss
Account is prepared by the Head Office as a Memorandum Account only.
The entries are passed only for incorporation of the Branch Net Profit or
Net Loss and the Branch Assets and Liabilities.

6.6 KEY WORDS

• Trial Balance: It is a bookkeeping worksheet in which the balance of all
ledgers are compiled into debit and credit account column totals that are
equal.
• Discount: It is a reduction made from the gross amount or value of
something.
• Gross Profit: It refers to a company’s profits earned after subtracting the
costs of producing and distributing its products.

6.7 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

Self-Instructional
1. State any two features of a dependent branch. Material 169
Branch Accounting 2. Write a short note on debtors system.
3. What is detailed incorporation method?
Long Answer Questions
NOTES
1. Discuss in detail the characteristics of an independent branch.
2. Examine the points that should be kept in mind while recording transactions
in the Branch Account.

6.8 FURTHER READINGS

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing
House.
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018. An
Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Hill Education.

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170 Material
Recent Trends in
UNIT 7 RECENT TRENDS IN Accounting

ACCOUNTING
NOTES
Structure
7.0 Introduction
7.1 Objectives
7.2 Forensic Accounting
7.2.1 Objectives and Key Principles
7.2.2 Ethical Principles and Responsibilities
7.3 Accounting for Corporate Social Responsibility
7.4 Accounting for Derivative Contracts
7.5 Artificial Intelligence in Accounting
7.6 Answers to Check Your Progress Questions
7.7 Summary
7.8 Key Words
7.9 Self Assessment Questions and Exercises
7.10 Further Readings

7.0 INTRODUCTION
Ever-evolving technology and a trend toward automation of repetitive accounting
tasks are some of the most exciting developments in the accounting industry.
Cloud technology is becoming popular in the accounting industry as it makes
remote work easier. Cloud-based accounting systems allow firms to access data
anywhere and anytime. They can create workflows, track inventory, manage
projects and communicate with clients remotely.
Accountants are turning to artificial intelligence to match up with the
speed and efficiency demanded of them as Artificial Intelligence (AI) optimizes
administrative duties, increases work speed and productivity with minimal errors.
In this unit you will study about, recent trends in accountings like
forensic accounting, accounting for derivative contracts, artificial intelligence
in accounting, etc.

7.1 OBJECTIVES

After going through this unit, you will be able to:

• Understand the recent trends in accounting
• Conceptualize forensic accounting
• Explain the accounting for derivative contracts
• Describe the role of artificial intelligence in accounting

Self-Instructional
Material 171
Recent Trends in
Accounting 7.2 FORENSIC ACCOUNTING
Forensic accounting is a fast emerging field in the world of accounting and
NOTES gaining constant increased prominence due to rapid increase in financial frauds
and white collar crimes resulting in collapse of many corporate giants, viz.,
Maxwell Communication Group in UK, Enron & Lehman Brothers in USA and
Satyam in India. The corporate auditors largely at present are only expected to
check the compliance of companies’ books of account to the generally accepted
accounting principles, auditing, standards and companies policies. However,
many white collar crimes and financial frauds could not be detected by the auditors
because they were not trained to look the business reality of the situation. This
created the need for development of an accounting system integrating accounting,
auditing and investigative skills. This resulted in the emergence of a new concept
of accounting popularly known as Forensic Accounting.
Meaning of Forensic Accounting
The meaning of forensic accounting is changing in response to the growing needs
of business and industry. In simple words, forensic accounting is accounting
that is suitable for legal review offering the highest level of assurance about the
accuracy of the financial statements based on scientific and objective verification.
Some of the definitions of forensic accounting are as under:
(i) “Forensic Accounting is the science of gathering and presenting financial
information in a form that will be accepted by a court of jurisprudence
against perpetrators of economic crimes.” – George A. Mannie
(ii) “Forensic Accounting is the application of financial skills and an
investigative mentality to unresolved issues conducted within the context
of rules of evidence. As an emerging discipline it encompasses financial
expertise, fraud, knowledge and understanding of business reality and
the working of the legal system.” – Bologana & Lind Quist
(iii) “Forensic Accounting is the application of accounting principles,
theories and discipline to facts or hypotheses at issues in a legal dispute
and encompasses every branch of accounting knowledge.” – American
Institute of Certified Public Accountants (AICPA)
(iv) “Forensic Accounting is the science that deals with the relation and
application of finance, accounting, tax and auditing knowledge to analyze,
investigate, enquire, test and examine matters in civil law, criminal law
and jurisprudence in an attempt to obtain the truth from which to render
and expert opinion.” – Horty
Types
From the above definitions it can be concluded that forensic accounting includes
the use of accounting, auditing and investigating skills to assist in legal matters.
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Thus, forensic accounting is the bridge which connects accounting system to
172 Material legal system. It consists of two major components:
(i) Litigation services that recognize the role of an accountant as an expert Recent Trends in
Accounting
consultant; and
(ii) Investigative services for looking deep into the financial books, records
and data to uncover for hidden assets, siphoned funds, etc.
NOTES
It may be noted that a forensic accountant does not win or lose a case but seeks
only the truth by conducting evaluations, examinations and enquiries. The services
of a forensic accountant are in great demand in the following areas:
(i) Assessment and settlement of insurance claims: The claims may relate
to loss of property, loss of profits or loss due to any other risk insured.
(ii) Detection of fraud committed by employees: Such frauds may relate
to loss of property or embezzlement of funds by dishonest employees.
(iii) Assistance in criminal investigation proceedings: A criminal offence
may also have financial implications. The services of a forensic accountant
are quiet useful in preparing and presenting the desired evidence.
(iv) Arbitration services: The parties to a dispute may like to get the financial
liability settled through arbitration. In some cases, settlement of dispute
through arbitration may be mandatory as per the terms of the agreement.
The services of a forensic accountant may be used in such cases.
(v) Miscellaneous disputes: These disputes may relate to the following
matters:
(a) Settlement of dues of an outgoing partner.
(b) Liability for professional negligence.
(c) Matrimonial matters.
(d) Infringement of patents and trade marks etc.
7.2.1 Objectives and Key Principles
The fundamental objective of forensic accounting is identifying and reporting
a proof of financial crime which can be used in the court of law. Another major
objective for forensic accountants is to ensure the prevention of a financial crime.
This means making sure that the books of the person or company who has hired
the accountant is compliant with the applicable law of the land. The foreign
accountants are expected to keep a broad perspective, in the sense that their task
is not limited to uncovering abnormalities in the numbers and figures but to keep
in consideration the entirety of the nature of the company’s business operations
and actions in order to understand the possible existence of criminal activity.
The objectives of forensic accounting can be summarized as:
• To identify and prove the existence of financial crimes
• To prevent financial crimes from possibly occurring
• To predict and prepare for future crimes
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Material 173
Recent Trends in Principles of Forensic Accounting
Accounting
In India, ICAI for the first time ever released the Forensic Accounting and
Investigation Standards in February 2021. It has provided general or basic
NOTES governing principles.
The principles can be summarised as follows:
i. Independence & Neutrality
ii. Integrity and Objectivity
iii. Due Professional Care
iv. Confidentiality & Secrecy
v. Skills and Competence
vi. Contextualisation of Situation
vii. Primacy of Truth
viii. Respecting Rights and Obligations
ix. Segregating facts from opinions
x. Quality and Continuous Improvement
7.2.2 Ethical Principles and Responsibilities
An accountant engaged in the forensic accounting is known as forensic accountant.
He utilizes his understanding of business information, financial reporting systems,
accounting and auditing standards, investigative techniques and legal knowledge
in performance of his job which may include the following:
(i) Investigating and analyzing financial evidence.
(ii) Developing appropriate computerized applications which could help in
the analysis and presentation of financial evidence.
(iii) Communicating his findings in the form of documents, reports, exhibits,
etc.
(iv) Assisting in legal proceedings including testifying in a law court as a
key and expert witness.
Requisites for a Successful Forensic Accountant
The discussion in the preceding pages explains that the job of a forensic
accountant is quite demanding and therefore, requires high degree of both personal
and professional skills.
He should be a specialist in accounting and financial systems. He should
have in depth knowledge of preparing and presenting financial statements and
the ability to examine and analyze them critically.

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174 Material
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Check Your Progress
1. What do you understand by forensic accounting?
2. State the fundamental objective of forensic accounting. NOTES
3. What do you understand by forensic accountant?

7.3 ACCOUNTING FOR CORPORATE SOCIAL

RESPONSIBILITY
Corporate Social Accounting: With a view to have greater responsibility towards
society by the corporates, section 135 of the Companies 2013 Act, provides for
(CSR) as under:
(i) Provisions applicable to every company having:
(a) net worth of 500 crore or more; or
(b) turnover of 1,000 crore or more; or
(c) net profit of 5 crore or more during any financial year
(ii) Board of Directors of such companies are required to spend, in every
financial year, minimum 2% of the average net profits of the company
made during the three immediately preceding financial years, in pursuance
of the CSR Policy.
(iii) Such companies are required to constitute CSR committee of
its Board of Directors which is responsible for formulating and
recommending to the BOD the CSR Policy of the company.
The activities covered by CSR have been given in Schedule VII* to the
Act as under:
(a) Eradicating hunger, poverty and malnutrition, promoting preventive
health care and sanitation including contribution to Swatch Bharat
Kosh set up by the Central Government for promotion and sanitation
and making available safe drinking water.
(b) Promoting education, including special education and employment
enhancing vocation skills especially among children, women, elderly,
and the differently abled and livelihood enhancement projects.
(c) Promoting gender quality, empowering women, setting up homes and
hostels for women and orphans, setting up old age homes, day care
centres and such other facilities for senior citizens and measures for
reducing inequalities faced by socially and economically backward
groups.
(d) Ensuring environmental sustainability, ecological balance, protection
of flora and fauna, animal welfare, agroforestry, conservation of natural
resources and maintaining quality of soil, air and water including
contribution to clean Ganga Fund set up by the Central Government Self-Instructional
for rejuvenation of river Ganga. Material 175
Recent Trends in (e) Protection of national heritage, art and culture including restoration of
Accounting
buildings and sites of historical importance and works of art; setting
up public libraries; promotion and development of traditional arts and
handicrafts.
NOTES
(f) Measures for the benefit of armed forces veterans, war widows and
their dependents;
(g) Training to promote rural sports, nationally recognised sports,
paralympic sports and Olympic sports.
(h) Contribution to the Prime Minister’s National Relief Fund or any other
fund set up by the Central Government for socio-economic development
and relief and welfare of the Scheduled Castes, the Scheduled Tribes,
other backward classes, minorities and women.
(i) Contributions or funds provided to technology incubators located within
academic institutions which are approved by the Central Government.
(j) Rural development projects.
(k) Slum area development.
(iv) Board of Directors is required to approve the CSR policy and disclose its
content in the directors’s report and also place the same on the company’s
website.
(v) The company is required to give preference to local area and areas where
it operates for spending the amount earmarked to CSR.
(vi) If the company fails to spend such amount, Board of Directors is required
to specify the reasons for not spending the amount in the directors’ report.
Corporate Social Responsibility Committee (CSR) (Sec. 135): Each business
entity is expected to have a CSR Policy to guide its strategic planning and provide
a road map for its CSR initiatives. The policy has to care for all stakeholders and
the governance system should be ethical, transparent and accountable.
The Companies Act provides as under:
(i) Every company having net worth of rupees five hundred crore or more,
or turnover of rupees one thousand crore or more or a net profit of rupees
five crore or more during any financial year shall constitute a Corporate
Social Responsibility Committee of the Board consisting of three or more
directors, out of which at least one director shall be an independent director.
(ii) The Board’s report shall disclose the composition of the Corporate Social
Responsibility Committee
(iii) The Corporate Social Responsibility Committee shall:
(a) Formulate and recommend to the board, a Corporate Social
Responsibility Policy which shall indicate the activities to be undertaken
by the company as specified in Schedule VII;
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176 Material referred to in clause (a), and
(c) Monitor the Corporate Social Responsibility Policy of the company Recent Trends in
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from time to time.
(iv) The board of every company referred above shall -
(a) After taking into account the recommendations made by the Corporate NOTES
Social Responsibility Committee, approve the Corporate Social
Responsibility Policy for the company and disclose contents of such
policy in its report and also place it on the company’s website, if any,
in such manner as may be prescribed; and
(b) Ensure that the activities as are included in Corporate Social
Responsibility Policy of the company are undertaken by the company.
(v) The Board of every company referred to in sub-section (1), shall ensure
that the company spends, in every financial year, at least two per cent of
the average net profits of the company made during the three immediately
preceding financial years, in pursuance of its Corporate Social Responsibility
Policy.
Provided that the company shall give preference to the local area and areas
around it where it operates, for spending the amount earmarked for Corporate
Social Responsibility activities.
Provided further that if the company fails to spend such amount, the Board
shall, in its report specify.
For the benefit of the readers we are giving below extracts regarding CSR
activities from annual report of Infosys Ltd. for 2016-17.
Infosys Ltd.—Annual Report
(Pursuant to Section 135 of the Companies Act, 2013)
Corporate Social Responsibility (CSR) is a large part of our overall sustainability
policy, encompassing social, economic and environmental actions. Along with
philanthropy, we help build institutions, and use technology to safeguard natural
resources against climate change risks.
Infosys Foundation (‘the Foundation’), our CSR trust, was established
in 1996 with a vision to boosting our CSR initiatives. This was long before
the Companies Act, 2013 mandated that a company should function through
a registered trust or society for any CSR activities to be undertaken by it. The
foundation publishes a report of its yearly activities, which along with other
details of the foundation’s activities, is available on https://www.infosys.com/
infosys-foundaion.
CSR Committee
The CSR committee of the board is responsible for overseeing the execution
of the Company’s CSR policy. The CSR committee of the Infosys Foundation
comprises two independent directors and the CEO and MD. The members of
the CSR committee are:
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• R. Seshasayee, Chairperson • Kiran Mazumdar-Shaw • Dr. Vishal Sikka Material 177
Recent Trends in Our Objectives
Accounting
Our broad objectives, as stated in our CSR policy, include:
• Making a positive impact on society through economic development and
NOTES reduction of our resource footprint.
• Taking responsibility for the actions of the company while also encouraging
a positive impact through supporting causes concerning the environment,
communities and our stakeholders.
For more details on our CSR policy, visit https://www.infosys.com/
investors/corporate-governance/Documents/corporate-social-responsibility-
policy.pdf.
Focus Areas
The foundation’s focus areas are:
• Healthcare
• Destitute care
• Eradication of hunger and promotion of education
• Rural development, rehabilitation and disaster relief
• Art and culture
• Environmental sustainability
Financial Details
Section 135 of the Companies Act, 2013 and rules made under it prescribe that
every company having a net worth of 500 crore or more, or turnover of 1,000
crore or more, or a net profit of 5 crore or more during any financial year shall
ensure that it spends, in every financial year, at least 2% of the average net profits
made during the three immediately preceding financial years, in pursuance of its
CSR Policy. The provisions pertaining to CSR as prescribed under the Companies
Act, 2013 are applicable to Infosys Limited.
The financial details as sought by the Companies Act, 2013 for fiscal year
2017 are as follows:
( in crore)
Particulars Amount
Average net profit of the Company for last three financial years 14,371
Prescribed CSR expenditure (2% of the average net profit as computed above)
Total amount to be spent for the financial year 287.42
Amount spent 289.44
Amount unspent –

The Infosys Foundation primarily works with non-governmental

organizations as the nodal agency for implementing projects. The major projects
and heads under which the outlay amount was spent in fiscal 2017 are as follows:
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(in crore ) Recent Trends in
Accounting
Theme-based CSR project/activity/ Location of the proj- Amount Amount Cumula-
beneficiary ect / program outlay spent on tive ex-
(budget) the proj- penditure
ects or up to the NOTES
programs reporting
in fiscal period
2017
(i) Expenditure on projects/programs
through the Foundation
Eradicating hunger, poverty and
sanitation programs
Akshaya Patra Foundation Bengaluru 4.00 4.00 4.00
Measures for die benefit of armed
forces and their dependents
Relief to martyrs’ families Andhra Pradesh,
Haryana, Karnataka,
Kerala, Maharashtra,
Odisha, Punjab,
Rajasthan, Tamil
Nadu, Telangana 19.46 19.46 19.46
Zila Sainik Welfare Office Chandigarh 5.00 5.00 5.00
Rehabilitation and Welfare
Section, Integrated Headquarters
of Ministry of Defence Delhi 5.00 5.00 5.00
Promoting education, enhancing
vocational skills
International Institute of
Information Technology (IIIT),
Bengaluru Bengaluru 12.51 12.51 12.51
Bhagavatula Charitable Trust Visakhapatnam 6.66 6.66 6.66
National Centre for Biological Bengaluru 5.00 5.00 5.00
Sciences (NCBS)
The Indian Institutes of Science
Education and Research (IISER)
Pashan 5.00 5.00 5.00
Harish-Chandra Research Institute Allahabad 5.00 5.00 5.00
IIIT, Dharwad Dharwad 3.17 3.17 3.17
Tata Institute of Fundamental Bengaluru 3.00 3.00 3.00
Research (TIFR)
Ramakrishna Mission Narottam Nagar 2.50 2.50 2.50
Indraprastha Institute of Information Delhi 2.50 2.50 2.50
Technology Delhi
Central Institute of Plastic
Engineering &
Technology, Bhubaneshwar Bhubaneshwar 2.38 2.38 2.38
The International Centre for Bengaluru 2.30 2.30 2.30
Theoretical Sciences — TIFR
Student Tracking System Udupi, Vijayapura 2.00 2.00 2.00
Banaras Hindu University Varanasi 2.00 2.00 2.00
AMBA Bengaluru 1.30 1.30 1.30
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Theme-based CSR project/activity/ Location of the proj- Amount Amount Cumula-
Accounting
beneficiary ect / program outlay spent on tive ex-
(budget) the proj- penditure
ects or up to the
programs reporting
NOTES in fiscal period
2017
Ramakrishna Mission, Delhi Delhi 1.25 1.25 25 1
The Kailash Satyartht Children's Delhi 1.10 1.10 1.10
Foundation
Promoting healthcare including
preventive healthcare
Karnataka Chinmaya Seva Trust Bengaluru 6.50 6.50 6.50
Sri Ramakrishna Sevashrama Pavagada 6.02 6.02 6.02
Regional Cancer Centre Thiruvananthapuram 5.25 5.25 5.25
Trivandrum Medical College Thiruvananthapuram 5.21 5.21 5.21
corridor
Indian Red Cross Society Chandigarh 5.02 5.02 5.02
Kidwai Memorial Institute of Bengaluru 3.13 3.13 3.13
Oncology
Vittala International Institute of
Ophthalmology Bengaluru 2.51 2.51 2.51
Centre for Infectious Disease Bengaluru 1.61 1.61 1.61
Research (CIDR)
Sankara Eye Hospital Bengaluru 1.54 1.54 1.54
Hyderabad Eye Institute Bhubaneshwar 1.00 1.00 1.00
Rashtrotthana Blood Bank Bengaluru 1.00 1.00 1.00
Protection of national heritage,
promotion of
art & culture, Sahapedia Delhi 2.00 2.00 2.00
Raja Dinkar Kelkar Museum Pune 1.00 1.00 1.00
Rehabilitation of homeless and
orphans
Chittaprakasha Charitable Trust Bengaluru 5.00 5.00 5.00
Rural development
Swachh Bharat projects Hubballi,
Hyderabad,
Bhubaneshwar,
Mysuru 9.46 9.46 9.46
Swami Vivekananda Integrated
Rural Health Centre Pavagada 5.00 5.00 5.00
Ramakrishna Sarada Mission Dirang 4.55 4.55 4.55
Diagnostic laboratories Kolar 4.37 4.37 4.37
Road construction Mudipu 12.38 4.11 4.11
Shivganga Samagra GramVikas Jhabua 3.99 3.99 3.99
Parishad
Drought relief work Dharwad, Gadag 3.57 3.57 3.57
Bannerghatta Biological Park Bengaluru 1.05 1.05 1.05
Kalyan Ashram Guwahati 1.00 1.00 1.00
Others Various locations 19.29 19.29 19.29

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Recent Trends in
Theme-based CSR project/activity/ Location of the proj- Amount Amount Cumula-
Accounting
beneficiary ect / program outlay spent on tive ex-
(budget) the proj- penditure
ects or up to the
programs reporting
NOTES
in fiscal period
2017
(ii) Expenditure on projects/
programs by Infosys
Environmental sustainability and
ecological balance
Energy projects(1) Pune, Hyderabad,
Tumakuru 151.11 74.25 74.25
Biomass Cook Stove Project Maharashtra,
Odisha, Rajasthan 22.15 9.66 12.12
Promoting education, enhancing
vocational skills
Infosys Science Foundation Bengaluru 10.00 10.00 10.00
(iii) Overhead
Admin expenses Bengaluru 1.22 1.22 1.22
Total 387.06 289.44 291.90
Notes: A few of the projects undertaken in the table above are multi-year projects.
Spent towards construction/acquisition of assets.

Our CSR Responsibilities

We hereby affirm that the CSR Policy, as approved by the board, has been
implemented and the CSR committee monitors the implementation of the projects
and activities in compliance with our CSR objectives.
Check Your Progress
3. When was the Infosys Foundation CSR Trust established?
4. What the CSR committee responsible for?

7.4 ACCOUNTING FOR DERIVATIVE CONTRACTS

Financial instruments can be categorised by form depending on whether they
are cash instruments or derivative instruments:
1. Cash Instruments: These are the financial instruments whose value is
determined directly by markets. They can be further sub-divided into
securities, which are readily transferable, and other cash instruments, such
as, loans, securities and deposits, etc., where both the borrower and the
lender mutually agree on a transfer.
2. Derivative Instruments: These are financial instruments which derive
their value from the value and characteristics of one or more underlying
assets. They can be further sub-divided into exchange-traded derivatives
and over the counter derivatives.
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depending on the fact that if they are equity based (reflecting ownership of the
issuing entity) or debt based (reflecting a loan the investor has made to the issuing
entity). If it is debt based then it can be further sub-categorised into short-term
NOTES (less than one year) or long-term.
Derivative: An asset, as discussed above, which has no independent value.
Its value is determined from value of some underlying asset. The underlying asset
may be equity commodity or security. A derivative, consists of the following:
• A security derived from a debt instrument, share, loan if secured or
unsecured, risk instrument or contract for differences or any other form
of security; and
• A contract which derives its value from the prices, or index of prices, of
underlying securities.
The essential accounting for a legal document is made public within the
following sections:
Initial Recognition: When it is first acquired, recognize a derivative instrument
in the balance sheet as an asset or liability at its fair value.
Subsequent Recognition (Hedging Relationship): Recognize all subsequent
changes in the fair value of the derivative (known as marked to market). If the
instrument has been paired with a hedged item, then recognize these fair value
changes in other comprehensive income.
Subsequent Recognition (Ineffective Portion): Recognize all subsequent
changes in the fair value of the derivative. If the instrument has been paired
with a hedged item but the hedge is not effective, then recognize these fair value
changes in earnings.
Subsequent Recognition (Speculation): Recognize in earnings all subsequent
changes in the fair value of the derivative. Speculative activities imply that a
derivative has not been paired with a hedged item.
7.4.1 Additional Accounting Rules
The following additional rules apply to the accounting for derivative instruments
when specific types of investments are being hedged:
Held-to-Maturity Investments: This is a debt instrument for which there
is a commitment to hold the investment until its maturity date. When such an
investment is being hedged, there may be a change in the fair value of the paired
forward contract or purchased option. If so, only recognize a loss in earnings
when there is other-than-temporary decline in the hedging instrument’s fair value.
Trading Securities: This can be either a debt or equity security, for which
there is an intent to sell in the short term for a profit. When this investment is
being hedged, recognize any changes in the fair value of the paired forward
contract or purchased option in earnings.
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182 Material Available-For-Sale Securities: This can be either a debt or equity security
that does not fall into the held-to-maturity or trading classifications. When such
an investment is being hedged, there may be a change in the fair value of the Recent Trends in
Accounting
paired forward contract or purchased option. If so, only recognize a loss in
earnings when there is other-than-temporary decline in the hedging instrument’s
fair value. If the change is temporary, record it in other comprehensive income.
NOTES
Check Your Progress
5. What do you understand by cash instruments?
6. What do you understand by derivative instruments?

7.5 ARTIFICIAL INTELLIGENCE IN ACCOUNTING

Artificial intelligence permits machines (bots) to decipher data, learn from
experience, make changes and apply what they “know” to perform human-like
activities. Machines first “get” data and afterward they really “think” of the
consequences of that information and examine it with machine thinking.
Meaning and Features of Artificial Intelligence
The simulation of human like intelligence by computer systems or machines
is known as artificial intelligence. The foundation of artificial intelligence is
to combine the power of intelligent algorithms, iterative processing, and large
amounts of data to allow the software to learn from patterns. The software
then learns automatically and mimics human actions and patterns. Since this
‘intelligence’ is shown by the machine, it is called artificial intelligence.
There are many popular applications which AI powered including natural
language processing, machine vision, expert systems, and speech recognition.
Artificial intelligence programming is based on three important programming
skills including learning, reasoning as well as self-correction. While learning
is concerned about taking data inputs and creating actionable information by
creating new algorithm. The reasoning aspect as the name suggests involves
the selection of the right algorithm for the desired results. The self-correction
component of artificial intelligence is concerned with updating and correcting
algorithms to get the desired results.
Artificial intelligence technologies can be of four main types including
reactive machines which are task-specific and does not concern with memory
building. The second category is of limited memory technologies where the
systems have a limited memory to take future actions. Another category is of
theory of mind where the system develops social intelligence. The last type
of artificial intelligence involves self-awareness where the system develops
consciousness. This type of system has not been fully developed yet.
The features of artificial intelligence can be summarized as:
It is created to imitate human intelligence and the pattern of human
cognition.
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Material 183
Recent Trends in It has the capability of storing and saving large volume of data from varied
Accounting
sources and use the data as per need.
It can undertake repetitive tasks.
NOTES It is an innovative system in that it reacts to situations based on the possible
actions that can be taken based on historical pattern of actions.
It can be used for technologies like chat bots, facial recognition, deep
learning, quantum computing and artificial neural networks, etc.
It has the capability to interact with the knowledge input in the system.
How AI Can Be Applied To Accounting?
The main function of finance in business should be to act as a strategic partner
accomplice and add to the value of the business – yet in general, it spends a
dominant part of its work on transaction processing. One of the primary benefits
of artificial intelligence to the field of accounting is that it can take over the dreary
errands and free human accounting experts to do more significant and worthwhile
analysis of financial information and provide counsel to their customers. However,
companies wonder whether or not to utilize AI in their employees because of
vulnerabilities around the business case or ROI.
One of the primary difficulties for the bookkeepers generally is the enormous
measure of transactions that the clients may need to manage particularly in the
B2B space where you have hundreds and thousands of clients and a great many
invoices and obligations and you need to record and classify all transactions. So
that is the place where a ton of time is being spent by having groups physically
manage enormous transactions. So, when you need to follow such countless
transactions, tracking each exchange, there comes the use of innovation. This is
why the finance department of many companies are on the lookout for business
bookkeeping software and devices to limit the human resource spend on menial
transactional exercises, permitting them to divert their emphasis on analysis of
information and giving noteworthy inputs to the business.
Artificial intelligence vows to help both profitability and nature of output
while allowing more transparency and auditability. Not just AI will give an
expansive scope of conceivable outcomes and limit the regular duties of the
finance departments, however, it will likewise save time and help bookkeeping
experts with a chance to lead fundamental exploration on different viewpoints.
Other than that, AI will help in providing precise budget summaries. The central
idea is that with AI, bookkeeping experts would foresee future information
dependent on past information/records.
Advantages
Machines Imitate The Human Brain: Mechanization, AI chatbots, and
other AI related technologies are assume a crucial space in the financial
sector. Accounting as well as financial organizations are making them a
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184 Material
AI applications and ML applications are bringing a change in the role of Recent Trends in
Accounting
accountants and financial experts. Utilizing AI and ML, financial specialists
can improve profitability and manage new clients. AI can supplant people
from the repetitive tasks of identifying, recording and classifying and
organizing data. The consultants and accountants working with AI can NOTES
instead perform various assignments. In the first place, they encourage the
AI what information to search for and how to put it together. At that point
they examine peculiarities. Along these lines, AI can take on the long and
tedious tasks like entry of data and reconciliation and eliminate errors as
well as reduce liability.
Battling Misrepresentation: With the assistance of AI calculations, fake
activities can be identified more easily by payment companies. A unique
identifiable information is included in every single consumer transaction.
Machine learning as well as artificial learning assist with the processing
of large volume of data beyond the common vectors of time, speed, and
amount. Artificial intelligence helps in paying special attention to risky
transactions and connections, and report them in a visual apparatus that,
thus, will permit the compliance team to deal with such kinds of dubious
cases all the more viably.
Accounting Tasks Made Easier: Artificial intelligence can help in
automating tasks related to accounting in a very broad manner. It guarantees
operational effectiveness while lessening costs. As mechanization is getting
to each areas of the organizations, the financial organizations will gain
invariably from the computerized change due to innovation advancements.
Use of AI in Accounting and Finance
The benefits of artificial intelligence in accounting is increasing with newer
innovations:
Pay/Receive Processing: Generally, one of the most tedious, time
consuming and costly activity done manually in an organization is the
processing of invoice. This activity, however, large or small is very crucial
and cannot be evaded. In fact, it requires great accuracy and for proper
identification and record, the accountants need to look through each email,
download the invoices, then extract and verify information and process
the payments.
In this computerized world, such automation is the need of the hour to
maintain good relationship with the vendors, increase the volume of trade,
get zero-mistake efficiency, and improve accounting overall. Advanced
change in bookkeeping and account has gone to another level, because
of AI-based management of invoices, receipt preparation and processing
has become greatly efficient. Because of technological upgradations in the
financial sector, AI machine learning are learning the bookkeeping codes
and guidelines that are best suited for and easily applicable for every type
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of invoice. Material 185
Recent Trends in Supplier Onboarding: Utilizing AI into the onboarding process of an
Accounting
organization can help the company greatly by reaching a more wide pool
of new customers, differentiate the company from the competitors as
well as increase income. The AI-controlled systems would now be able
NOTES to conduct supplier survey by analysing intelligently their credit scores
and tax compliance history. AI tools are especially beneficial for aligning
suppliers in the organization’s systems without the association of a human.
Likewise, to get the necessary information, the AI tools can also set up
query portals.
Procurement: There is a ton of paperwork included with regards to
recording of the company’s methods of purchasing and procurement
activities. Additionally, there comes the need to keep an enormous measure
of records on the systems separately since they are not related to one
another. As AI-machines measure unstructured information utilizing APIs,
the cycle of procurement will be computerized.
Audits: Auditors regard data analytics are a very significant element since
it assists them with effectively drawing up the extent of the audit and
do an accurate assessment of risk. The tracking and analysis of routine
transactions become easier with robotics process automation. AI assists
with more intricate and non-routine transactions of the organization that
require the appropriate use of estimates and decision-making. Many manual
tasks like ingesting of data can now be automated through the use of AI. It
breaks down 100% of the dataset without requiring a human to make the
tests, compose scripts, or recall every one of the guiding principles. AI is
contribution to the future of auditing by lending expertise in identifying
the entirety of the risks involved and the anomalies that might arise thereby
expanding the scope of reasonable assurances.
The security has also improved due to the digitization of the process of
audit. A digital tracker can be used by the auditors to access each document
that is accessed. It makes feasible for auditors to work better and more
intelligent by testing into the advanced records as opposed to investing an
excess of energy looking through all the paper archives. It empowers them
to utilize their human judgment to break down a more extensive and more
profound arrangement of information and records. Thus, the digitization
interaction in reviewing gives improves the audit accuracy.
Monthly/Quarterly Cash Flow: Artificial intelligence helps financial
organizations to access historical data of the company and reconcile the
activities to rapidly and effectively display historical and future trends.
Check Your Progress
7. Define Artificial Intelligence (AI).
8. What is the main motive of developing the artificial intelligence for
Self-Instructional accounting?
186 Material
Recent Trends in
7.6 ANSWERS TO CHECK YOUR PROGRESS Accounting

QUESTIONS
1. Forensic accounting is accounting that is suitable for legal review offering NOTES
the highest level of assurance about the accuracy of the financial statements
based on scientific and objective verification.
2. The fundamental objective of forensic accounting is identifying and
reporting a proof of financial crime which can be used in the court of law.
3. Infosys Foundation (‘the Foundation’), the CSR trust of Infosys, was
established in 1996.
4. The CSR committee of the Board is responsible for overseeing the execution
of the Company’s CSR policy.
5. Cash instruments are the financial instruments whose value is determined
directly by markets.
6. Derivative instruments are financial instruments which derive their value
from the value and characteristics of one or more underlying assets.
7. The simulation of human like intelligence by computer systems or machines
is known as artificial intelligence.
8. The foundation of artificial intelligence is to combine the power of
intelligent algorithms, iterative processing, and large amounts of data to
allow the software to learn from patterns.

7.7 SUMMARY
• Ever-evolving technology and a trend toward automation of repetitive
accounting tasks are some of the most exciting developments in the
accounting industry.
• Cloud-based accounting systems allow firms to access data anywhere and
anytime.
• Artificial Intelligence (AI) optimizes administrative duties, increases work
speed and productivity with minimal errors.
• Forensic accounting is a fast emerging field in the world of accounting and
gaining constant increased prominence due to rapid increase in financial
frauds.
• Forensic accounting is accounting that is suitable for legal review offering
the highest level of assurance about the accuracy of the financial statements
based on scientific and objective verification.
• The fundamental objective of forensic accounting is identifying and
reporting a proof of financial crime which can be used in the court of law.
• In India, ICAI for the first time ever released the Forensic Accounting and
Investigation Standards in February 2021. Self-Instructional
Material 187
Recent Trends in • An accountant engaged in the forensic accounting is known as forensic
Accounting
accountant.
• Each business entity is expected to have a CSR Policy to guide its strategic
planning and provide a road map for its CSR initiatives.
NOTES
• Corporate Social Responsibility (CSR) is a large part of our overall
sustainability policy, encompassing social, economic and environmental
actions.
• The CSR committee of the Board is responsible for overseeing the execution
of the Company’s CSR policy.
• The Infosys Foundation primarily works with non-governmental
organizations as the nodal agency for implementing projects.
• Financial instruments can be categorised by form depending on whether
they are cash instruments or derivative instruments.
• The simulation of human like intelligence by computer systems or machines
is known as artificial intelligence.
• Artificial intelligence permits machines (bots) to decipher data, learn from
experience, make changes and apply what they “know” to perform human-
like activities.
• The software then learns automatically and mimics human actions and
patterns. Since this ‘intelligence’ is shown by the machine, it is called
artificial intelligence.
• Artificial intelligence programming is based on three important
programming skills including learning, reasoning as well as self-correction.
• The self-correction component of artificial intelligence is concerned with
updating and correcting algorithms to get the desired results.
• Artificial intelligence vows to help both profitability and nature of output
while allowing more transparency and auditability.
• The central idea is that with AI, bookkeeping experts would foresee future
information dependent on past information/records.
• Artificial intelligence helps financial organizations to access historical
data of the company and reconcile the activities to rapidly and effectively
display historical and future trends.

7.8 KEY WORDS

• Forensic Accounting: Forensic accounting is accounting that is suitable
for legal review offering the highest level of assurance about the accuracy
of the financial statements based on scientific and objective verification.

Self-Instructional
188 Material
Recent Trends in
• Corporate Social Responsibility: Corporate Social Responsibility (CSR) Accounting
is a large part of our overall sustainability policy, encompassing social,
economic and environmental actions.
• CSR Committee: The CSR committee of the Board is responsible for NOTES
overseeing the execution of the Company’s CSR policy.
• Artificial Intelligence: The simulation of human like intelligence by
computer systems or machines is known as artificial intelligence.

7.9 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Type Questions

1. State the key principles of forensic accounting.
2. What is the key requisite for a successful forensic accountant?
3. State the major components of forensic accounting.
4. What are the CSR responsibilities of Infosys ltd.?
5. What do you understand by derivative?
Long Answer Type Questions
1. Discuss the objectives and key principles of forensic accounting.
2. Discuss the main service area of a forensic accountant.
3. Discuss in detail section 135 of the Companies 2013 Act with respect to
CSR.
4. Explain the way artificial intelligence can be applied to accounting.
5. Analyse the uses of artificial intelligence in accounting and finance.

7.10 FURTHER READINGS

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing
House.
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018. An
Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Hill Education.

Self-Instructional
Material 189
Analysis of Financial
Statements
UNIT 8 ANALYSIS OF FINANCIAL
STATEMENTS
NOTES
Structure
8.0 Introduction
8.1 Objectives
8.2 Ratio Analysis: Meaning
8.2.1 Objectives and Nature
8.3 Types of Ratios
8.3.1 Profitability
8.3.2 Turnovers
8.3.3 Liquidity and Leverages
8.4 Simple Problems on Gross Profit, Net Profit, Operating Ratio, Stock Turnover,
Debtors Turnover, Creditors Turnover, Current Ratio, Liquid Ratio, Debt-Equity
Ratio, Working Capital to Net Worth and Assets Turnover Ratio
8.5 Answers to Check Your Progress Questions
8.6 Summary
8.7 Key Words
8.8 Self Assessment Questions and Exercises
8.9 Further Readings

8.0 INTRODUCTION

Financial statement analysis is the process of analyzing a company’s financial statements

for decision-making purposes. These statements include the income statement, balance
sheet, statement of cash flows, notes to accounts and a statement of changes in equity,
etc. Financial statement analysis is used by internal and external stakeholders to evaluate
business performance and value.
Financial statement analysis evaluates a company’s performance or value through
a company’s balance sheet, income statement, or statement of cash flows. All three
statements are interconnected and create different views of a company’s activities and
performance.
In this unit you will study about various aspects of analysis of financial statements
like ratio analysis, profitability, turnovers, liquidity and leverages, working capital, net
worth, etc.

8.1 OBJECTIVES

After going through this unit, you will be able to:

Understand the concept of ratio analysis
Define profitability Self-Instructional
Material 191
Analysis of Financial Compare the debtors and creditors turnover
Statements
Analyse the assets turnover ratio
Discuss debt equity ratio
NOTES
8.2 RATIO ANALYSIS: MEANING
An accounting ratio determines the relationship between two interrelated accounting
figures. Accounting ratios are relationships expressed in mathematical terms between
figures which are connected with each other in some manner. Obviously, no purpose
will be served by comparing two sets of figures which are not at all connected with
each other. Moreover, absolute figures are also unfit for comparison.
8.2.1 Objectives and Nature
Financial statement analysis converts the mass of data into useful information which is
always in scarce supply. It pinpoints the strengths and weaknesses of a business
undertaking by use of various techniques, such as ratio analysis, comparative statements,
etc. Such analysed information is used by management, bankers, creditors, investors
and others to form judgement about the operating performance and financial position
of the business. Thus financial statement analysis helps in evaluating a business
performance according to some specific objectives.
Parties Interested in Financial Statement Analysis
Information contained in financial statements is useful to different categories of users of
financial data. These are managers, shareholders, creditors, Government, auditors
and other interested groups. Uses of financial data for each of these are briefly described
below:
1. Management: Management of a company is interested in its financial condition,
profitability and progress. It uses a number of methods, tools and techniques
available to it to analyse the financial data. Such analysis is used by the
management to exercise control over the business and to make decisions to run
it more efficiently.
2. Shareholders: Shareholders are the suppliers of basic capital to run the business.
Such capital is exposed to all the risks of ownership. Shareholders are interested
in the profitability, dividends declared and market value of their holdings. The
current earnings of the company determine both dividends and market value of
the shares. In other words, shareholders mainly analyse the profitability and
long-term solvency of the company.
3. Creditors: Creditors include short-term creditors like bankers, trade creditors
and also long-term credit grantors like debenture-holders and financial institutions,
etc. All creditors are mainly interested in the short-term and long-term solvency
of the company. They are also interested in the profitability because profit is
viewed as the primary source for payment of interest on loans and debentures.
Self-Instructional
192 Material
4. Purchaser of Business: Any person interested in the purchase of a going Analysis of Financial
Statements
concern analyses the financial statements to determine its real value. It makes
an assessment of the financial and operating strengths and weaknesses of the
business.
NOTES
5. Government: Financial statements are used by various government
departments, like income tax, Sales Tax, excise duty, etc., to determine the tax
liability of the company. On the basis of such financial statements of companies
in different industries, the government determines tax policy, import-export policy
and industry policy.
6. Other Interested Groups: Financial statement analysis also serves the needs
of many other user groups. For example, workers’ trade unions analyse the
financial statements to prepare ground for collective bargaining, to claim bonus,
etc.
Lawyers also use financial statement analysis in furtherance of their investigative
and legal work.
Researchers also get useful data from the analysis of financial statement to make
comparative study of profitability of many companies.
Significance and Purposes of Financial Statement Analysis
Financial statement analysis performs the essential function of converting mass data
into useful information. Such analysed financial information serves many and varied
purposes, as described below:
1. Judging Profitability: Profitability is a measure of the efficiency and success
of a business enterprise. A company which earns profits at a higher rate is
definitely considered a good company by the potential investors. The potential
investors analyse the financial statements to judge the profitability and earning
capacity of a company so as to decide whether to invest in a company or not.
2. Judging Liquidity: Liquidity of a business refers to its ability to pay off its
short-term liabilities, when they become due. Short-term creditors, like trade
creditors and bankers, make an assessment of liquidity before granting credit to
the company.
3. Judging Solvency: Solvency refers to the ability of a company to meet its
long-term debts. Long-term creditors, like debenture-holders and financial
institutions, judge the solvency of a company before any lending decisions. They
analyse company’s profitability over a number of years and its ability to generate
sufficient cash to be able to repay their claims.
4. Judging the Efficiency of Management: Performance and efficiency of
management of a company can be easily judged by analysing its financial
statements. Profitability of a company is not the only measure of company’s
managerial efficiency. There are a number of other ways to judge the operational
efficiency of management. Financial analysis tells whether the resources of the
business are being used in the most effective and efficient way. Self-Instructional
Material 193
Analysis of Financial 5. Inter-Firm Comparison: A comparative study of financial and operating
Statements
efficiency of different firms is possible only after proper analysis of their financial
statements. For this purpose, it is also necessary that the financial statements
are maintained on a uniform basis so that financial data of various firms are
NOTES comparable.
6. Forecasting and Budgeting: Financial analysis is the starting point for making
plans by forecasting and preparing budgets. Analysis of the financial statements
of the past years helps a great deal in forecasting for the future.

Check Your Progress

1. What do you understand by accounting ratio?
2. What is the management of a company interested in?
3. Define inter-firm comparison.

8.3 TYPES OF RATIOS

Ratios can be classified into different categories depending upon the basis of
classification.
(i) Traditional Classification: This classification has been on the basis of the financial
statements to which the determinants of a ratio belong. On this basis, the ratios could
be classified as:
1. Profit and loss account ratios, i.e., ratios calculated on the basis of the items of
the profit and loss account only, e.g., gross profit ratio and stock turnover ratio.
2. Balance sheet ratios, i.e., ratios calculated on the basis of the figures of balance
sheet only, e.g., current ratio and debt-equity ratio.
3. Composite ratios or inter-statement ratios, i.e., ratios based on figures of profit
and loss account as well as the balance sheet, e.g., fixed assets turnover ratio
and overall profitability ratio.
(ii) Functional Classification: The traditional classification has been found to be too
crude and unsuitable because the analysis of balance sheet and income statement
cannot be done in isolation. They have to be studied together in order to determine the
profitability and solvency of the business. In order that ratios serve as a tool for financial
analysis, they are classified according to their functions as follows:
1. Profitability Ratios; 2. Turnover Efficiency Ratios; 3. Financial Solvency Ratios.
8.3.1 Profitability
Profitability is an indication of the efficiency with which the operations of the business are
carried on. Poor operational performance may indicate poor sales and hence poor profits.
A lower profitability may arise due to the lack of control over the expenses. Bankers,
financial institutions and other creditors look at the profitability ratios as an indicator
whether or not the firm earns substantially more than it pays interest for the use of borrowed
Self-Instructional
194 Material
funds and whether the ultimate repayment of their debt appears reasonably certain. Owners Analysis of Financial
Statements
are interested to know the profitability as it indicates the return which they can get on
their investments. The following are the important profitability ratios
Overall Profitability Ratio NOTES
It is also called as ‘Return On Investment’ (ROI). It indicates the percentage of return
on the total capital employed in the business. It is calculated on the basis of the following
formula:
Operating Profit
× 100
Capital Employed
The term capital employed has been given different meanings by different accountants.
Some of the popular meanings are as follows:
(i) Sum-total of all assets whether fixed or current
(ii) Sum-total of fixed assets
(iii) Sum-total of long-term funds employed in the business, i.e.:
Share Reserves Long-term Non - business Fictitious
Capital + and Surplus + Loans –
Assets Assets

In management accounting, the term capital employed is generally used in the

meanings given in the third point above.
The term ‘operating profit’ means ‘profit before interest and tax’. The term
‘interest’ means ‘interest on long-term borrowings’. Interest on short-term borrowings
will be deducted for computing operating profit. Non-trading incomes, such as, interest
on government securities or non-trading losses or expenses, such as, loss on account
of fire, etc., will also be excluded.
The computation of ROI can be understood with the help of the following
illustration:
Illustration 8.1: From the following figures extracted from the income statement and
the balance sheet of Anu Pvt. Ltd, calculate the return on total capital employed (ROI):
Particulars Particulars

Fixed Assets 4,50,000 Reserves 1,00,000

Current Assets 1,50,000 Debentures 1,00,000
Investment in Government Securities 1,00,000 Income from Investments 10,000
Sales 5,00,000 Interest on Debentures at 10 per cent
Cost of Goods sold 3,00,000 Provision for Tax at 50 per cent
Share Capital: of Net Profits
10 per cent Preference 1,00,000
Equity 2,00,000

Solution:
It will be appropriate to prepare the profit and loss account and the balance sheet of
the company before computation of the return on capital employed.
Self-Instructional
Material 195
Analysis of Financial Anu Sales Pvt. Limited
Statements Profit and Loss Account

Particulars Particulars

To Cost of goods sold 3,00,000 By Sales 5,00,000

NOTES To Interest on Debentures 10,000 By Income from Investments 10,000
To Provision for Taxation 1,00,000
To Net Profit after Tax 1,00,000
5,10,000 5,10,000

Balance Sheet
as on.....

Liabilities Assets

Share Capital: Fixed Assets 4,50,000

10% Preference 1,00,000 Current Assets 1,50,000
Equity 2,00,000 Investment in Government Securities 1,00,000
Reserves 1,00,000
10% Debentures 1,00,000
Profit and Loss A/c 1,00,000
Provision for Taxation 1,00,000
7,00,000 7,00,000

Net Operating Profit before Interest and Tax

Return on total capital employed = 100
Total Capital employed

20,00,000
= 100 = 40 per cent
5,00,000
Net Operating Profit = Net Profit + Provision for Tax – Income from Investments
+ Interest on Debentures
= 1,00,000 + 1,00,000 – 10,000 + 10,000 = 2,00,000
Capital employed = Fixed Assets + Current Assets – Provision for Tax
= 4,50,000 + 1,50,000 – 1,00,000 = 5,00,000
Share Capital + Reserves + Debentures + Profit and
Loss A/c Balance – Investments in Government Securities
= 3,00,000 + 1,00,000 + 1,00,000 + 1,00,000 – 1,00,000 = 5,00,000

Return on Investment (ROI) can be computed for calculating the return for different
purposes. Some of the ratios that are calculated are as follows:
(i) Return of Shareholders’ Funds: In case it is desired to work out the
profitability of the company from the shareholders’ point of view, it should be
computed as follows:
Net Profit after Interest and Tax
× 100
Shareholders' Funds

The term net profit here means ‘net income after interest and tax’. It is different
from the ‘net operating profit’, which is used for computing the ‘return on total
capital employed’ in the business. This is because the shareholders are interested
in total income after tax including net-non-operating income (i.e., non-
Self-Instructional operating income – non-operating expenses).
196 Material
The Return on Shareholders' Funds will be computed as follows: Analysis of Financial
Statements
1,00, 000
100 20 per cent
5,00,000

(ii) Return on Equity Shareholders’ Funds: The profitability from the point of NOTES
view of the equity shareholders will be judged after taking into account the
amount of dividend payable to the preference shareholders. The return on equity
shareholders’ funds will, therefore, be computed on the following basis:
Net Profit after Interest, Tax and Preference Dividend
× 100
Equity Shareholders Funds

The return on equity shareholders’ funds will be computed as follows:

90,000
100 23 p er cen t
3,90,000

(iii) Return on Total Assets: This ratio is computed to know the ‘productivity of
the total assets.’ There are three methods for computing it:
Net Profit after Tax
(a) Total Assets
× 100

The ratio will be:

1,00,000
100
7,00,000

Net Profit after Tax + Interest

(b) × 100 = 14.29 per cent
Total Assets

The ratio will be:

1,00,000 10,000
100 15.71 p er cent
7,00,000

The inclusion of interest is conceptually sound because total assets have been
financed from the ‘pool’ of funds supplied by the creditors and the owners. The
objective of computing the ‘return on total assets’ is to find out how effectively
the funds pooled together have been used. Hence, it will be proper to include
the interest in computing the return on total assets.
A further modification of this formula has been suggested by many accountants.
It excludes ‘intangible assets’ from the ‘total assets‘. However, it will be proper
to exclude only fictitious assets and not all intangible assets. The term ‘fictitious
assets' includes assets such as preliminary expenses, debit balance in the profit
and loss account, etc. The return on assets, according to this method, may,
therefore, be calculated as follows:
Net Profit after Tax + Interest
(c) × 100
Total Assets excluding Fictitious Assets

(iv) Return on Gross Capital Employed: The term gross capital employed means
Self-Instructional
the total of fixed assets and the current assets employed in the business. The Material 197
Analysis of Financial formula for its computation can be put as follows:
Statements
Net Profit before Interest (on long as well as
short - term borrowings) and Tax
× 100
Gross Capital employed (i.e., Net Fixed Assets
NOTES + Current Assets employed in the business)

The Return on Gross Capital employed can be computed as follows:

2,00,000
100 = 33.3%
6,00,000

Tutorial Note: The students are advised to give their assumptions regarding
computation of ‘net profits’ as well as ‘capital employed’ while calculating the return
on investment (ROI).
Average Capital Employed: Some people prefer to use ‘average capital
employed’ (or average total assets, as the case may be) in place of only ‘capital
employed’ (or total assets). Average capital employed is the average of the capital
employed at the beginning and at the end of the accounting period. For example, the
capital employed at the beginning of the accounting period was 4,50,000 the ROI
will be calculated as follows:
Net Profit before Interest and Tax
ROI = × 100
Average Capital employed

2,00,000
100
1 2(5,00,000 4,50,000)
2,00,000
100 42.11%
4,75,000

It should be noted that while computing ‘return on investment” according to any of the
above methods ‘abnormal gains or losses’ should always be excluded form net profit.
Significance of ROI: The return on capital invested is a concept that measures the
profit which a firm earns on investing a unit of capital. ‘Yield on capital’ is another term
employed to express the idea. It is desirable to ascertain this periodically. The profit
being the net result of all operations, the return on capital expresses all efficiencies or
inefficiencies of a business collectively and, thus, is a dependable measure for judging
its overall efficiency or inefficiency. On this basis, there can be comparison of the
efficiency of one department with that of another, of one plant with that of another, one
company with that of another and one industry with that of another. For this purpose,
the amount of profits considered is that before making deductions on account of interest,
income tax and dividends and capital is the aggregate of all the capital at the disposal
of the company, viz., equity capital, preference capital, reserves, debentures, etc.
The return on capital, when calculated in this manner, would also show whether
the company’s borrowing policy was wise economically and whether the capital had
been employed fruitfully. Suppose funds have been borrowed at 8 per cent and the
return on capital is 7½ per cent, it would have been better not to borrow (unless
Self-Instructional borrowing was vital for survival). It would also show that the firm had not been employing
198 Material
the funds efficiently.
Return on capital, as explained, may also be calculated on equity shareholders’ Analysis of Financial
Statements
capital. In that case, the profit after deductions for interest, income tax and preference
dividend will have to be compared with equity shareholders’ funds. It would not indicate
operational efficiency or inefficiency but merely the maximum rate of dividend that
might be declared. NOTES
The business can survive only when the return on capital employed is more than
the cost of capital employed in the business.
Earning Per Share (EPS)
In order to avoid confusion on account of the varied meanings of the term ‘capital
employed’, the overall profitability can also be judged by calculating earning per share
with the help of the following formula:
Net Profit after Tax and Preference Dividend
Earning per Equity Share =
Number of Equity Shares

Illustration 8.2. Calculate the earning per share from the following data:
Net Profit before Tax 1,00,000
Taxation at 50% of Net Profit
10% Preference Share Capital ( 10 each) 1,00,000
Equity Share Capital ( 10 shares) 1,00,000

Solution:
Net Profit after Tax and Preference Dividend
Earning per Share =
Number of Equity Shares

40,000
= = 4 per share
10,000

Significance The earning per share helps in determining the market price of the equity
share of the company. A comparison of earning per share of the company with another
will also help in deciding whether the equity share capital is being effectively used or
not. It also helps in estimating the company’s capacity to pay dividend to its equity
shareholders.
Earnings Per Share (EPS – AS 20)
The Institute of Chartered Accountants of India (ICAI) has issued AS 20 – Earnings
per Share, which has become mandatory w.e.f. 1.4.2001, in respect of enterprises
whose equity shares or potential equity shares are listed on a recognized stock exchange
in India.
The standard makes a distinction between basic and diluted earning per share.
The enterprise has to give both types of earnings as per the standard.
(i) Basic Earnings Per Share (BEPS): The basic earnings per share is
computed as follows:
Net Profit (or Loss) for the Period Attributable to Equity Shareholders
Weighted Average Number of Equity Shares Outstanding during the year Self-Instructional
Material 199
Analysis of Financial The net profit for the above purpose means profit after deducting preference
Statements
dividend and tax, excluding dividend tax on equity shares. The weighted average number
of equity shares are the equity shares outstanding at the beginning of the period adjusted
by the number of equity shares bought back or issued in the period, multiplied by the
NOTES time weighting factor.
Illustration 8.3. From the following details, compute the basic earnings per share:
Net profit for the year ending 31-12-2021 after tax and preference dividend 21,000
Equity as on 1-1-2021 1,800
Issued Equity Shares for Cash on 31-5-2021 600
Bought back Equity Shares on 1-11-2021 300

Solution:
Weighted Average Number of
Equity Shares Outstanding = (1,800 × 12/12 + 600 × 7/12 – 300 × 2/12) = 2,100 shares
Basic Earnings Per Share =
Net Profit for the Period Attributable to Equity Shareholders
Weighted Average No. of Equity Shares Outstanding during the Year

21,000
= = 10 per share
2,100

(ii) Diluted Earnings Per Share (DEPS): Diluted earnings per share are
calculated when there are potential equity shares in the capital structures of the
enterprise. A potential equity share is a financial instrument or other contract
(e.g., convertible debentures, convertible preference shares, option warrants,
etc.) that entitles or may entitle its holder to equity shares. The diluted earnings
per share are calculated as follows:
Adjusted Net Profit (or Loss) for the Period Attributable to Equity Shareholders
Adjusted Weighted Average Number of Shares

Illustration 8.4. From the following details, calculate:

(a) Basic Earnings per Share
(b) Diluted Earnings per Share.
Net Profit for the year ending 31-12-2021 after Preference Dividend and Tax 1,00,000
No. of Equity Shares as on 1-1-2021 50,000
No. of 12% Convertible Debentures of 100/- each 1,00,000
Each debenture is convertible into 10 equity shares. The tax rate applicable to the company is 30%.

Solution:
Net Profit Available for Equity Shareholders
(a) Basic Earning per Share =
No. of Equity Shares Outstanding
1,00,000
= = 20 per share
5,000
(b) Diluted Earnings per Share = Adjusted Net Profit for the Current Year
Net Profit after Interest Tax and Preference Dividend = 1,00,000
Add: Interest Expense after Tax effect
( 1,20,000 – 36,000) = 84,000

1,84,000
Self-Instructional
200 Material
No. of Equity shares Resulting from Analysis of Financial
Statements
conversion of Debentures = 10,000
Total number of Equity Shares
after conversion of Debentures into Shares = 60,000
Adjusted Net Profit for the Period for Equity Shareholders NOTES
Diluted Earning per Share =
Adjusted weighted Average no. of Shares
1,84,000
= 3.06 per share
60,000

Price Earning (P/E) Ratio (PER)

This ratio indicates the number of times the earning per share is covered by its market
price. This is calculated according to the following formula:
Market Price Per Equity Share
Earning Per Share

For example, if the market price of a share is 30 and earning per share is 5, the
price earning ratio would be 6 (i.e., 30 ÷ 5). It means the market value of every one
rupee of earning is six times or 6. The ratio is useful in financial forecasting. It also
helps in knowing whether the shares of a company are under or overvalued. For
example, if the earning per share of AB Limited is 20, its market price 140 and
earning ratio of similar companies is 8, it means that the market value of a share of AB
Limited should be 160 (i.e., 8 × 20). The share of AB Limited is, therefore, undervalued
in the market by 20. In case the price earning ratio of similar companies is only 6, the
value of share of AB Limited should have been 120 (6 × 20), thus the share is
overvalued by 20.
Significance Price–earning ratio helps the investor in deciding whether to buy or not
to buy the shares of a company at a particular market price.
Gross Profit Ratio
This ratio expresses relationship between gross profit and net-sales. Its formula is:
Gross Profit
× 100
Net Sales

Illustration 8.5. Calculate the gross profit ratio from the following figures:

Sales 1,00,000 Purchases 60,000

Sales Returns 10,000 Purchases Returns 15,000
Opening Stock 20,000 Closing Stock 5,000

Solution:
Gross Profit
Gross Profit Ratio = 100
Net Sales
Net Sales Cost of goods sold
= 100
Net Sales
Self-Instructional
Material 201
Analysis of Financial 90,000 60,000
Statements = 100
90,000
30,000
= 100
90,000
NOTES 1
= 33 %
3

Significance: This ratio indicates the degree to which the selling price of goods per
unit may decline without resulting in losses from operations to the firm. It also helps in
ascertaining whether the average percentage of mark up on the goods is maintained.
There is no norm for judging the gross profit ratio, therefore, the evaluation of
the business on its basis is a matter of judgement. However, the gross profits should be
adequate to cover operating expenses and to provide for fixed charges, dividends and
building up of reserves.
Net Profit Ratio
This ratio indicates net margin earned on a sale of 100. It is calculated as follows:
Net Operating Profit
× 100
Net Sales

Net operating profit is arrived at by deducting operating expenses from gross profit.
Illustration 8.6. Calculate net profit ratio from the following data:

Sales less Returns 1,00,000 Selling Expenses 10,000

Gross Profit 40,000 Income from Investments 5,000
Administration Expenses 10,000 Loss on account of fire 3,000

Solution:
Net Operating Profit
Net Profit Ratio = 100
Net Sales
20,000
= 100 = 20%
1,00,000

Significance Net profit ratio helps in determining the efficiency with which affairs of
the business are being managed. An increase in the ratio over the previous period
indicates improvement in the operational efficiency of the business, provided the gross
profit ratio is constant. The ratio is thus, an effective measure to check the profitability
of a business.
An investor has to judge the adequacy or otherwise of this ratio by taking into
account the cost of capital, the return in the industry as a whole and market conditions
such as boom or depression period. No norms can be laid down. However, constant
increase in the above ratio year after year is a definite indication of improving conditions
of the business.

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202 Material
Operating Expense Ratio Analysis of Financial
Statements
This ratio is complementary to net profit ratio. In case the net profit ratio is 20%, it
means that the operating ratio is 80%. It is calculated as follows:
Operating Costs NOTES
× 100
Net Sales

Operating costs include the cost of direct materials, direct labour and other
overheads, viz., factory, office or selling. Financial charges such as interest, provision
for taxation, etc., are generally excluded from operating costs.
For example, in the Illustration 8.6 given for the net profit ratio above, when
the net profit ratio is 20%, the operating ratio will be 80%. The ratio can be calculated
regarding each element of operating cost to sales, viz.
Direct Material Cost
(i) Direct Material Cost to Sales = × 100
Net Sales
Direct Labour Cost
(ii) Direct Labour Cost to Sales = × 100
Net Sales
Factory Overheads
(iii) Factory Overheads to Sales = × 100
Net Sales

Similarly, the percentage of other operating costs such a administration and

selling costs to sales can be computed.
Significance: This ratio is the test of the operational efficiency with which the
business is being carried. The operating ratio should be low enough to leave a portion
of sales to give a fair return to the investors.
A comparison of the operating ratio will indicate whether the cost component is
high or low in the figure of sales. In case the comparison shows that there is increase in
this ratio, the reason for such increase should be found out and management be advised
to check the increase.
Fixed Charges Cover
The ratio is very important from the lender’s point of view. It indicates whether the
business would earn sufficient profits to pay periodically the interest charges. The
higher the number, the more secure the lender is in respect of his periodical interest
income. It is calculated as follows:
Income before Interest and Tax
Interest Charges

This ratio is also called as ‘debt service ratio.’

The standard for this ratio for an industrial company is that interest charges
should be covered six to seven times.
Illustration 8.7. The operating profit of A Ltd after charging interest on debentures
and tax is a sum of 10,000. The amount of interest charged is 2,000 and the provision
for tax has been made of 4,000.
Calculate the interest charges cover ratio.
Self-Instructional
Material 203
Analysis of Financial Solution:
Statements
Net Profit before Interest and Tax
Interest Charges Cover =
Interest Charges
16,000
NOTES = = 8 times
2000
In case it is desired to compute the ‘fixed dividend cover’ it can be computed on the
following basis:
Net Profit after Interest and Tax
Fixed Dividend Cover =
Preference Dividend
In the above illustration if the amount of preference dividend payable is a sum of
1000, the fixed dividend cover will be computed as follows:
10,000
= = 10 times
1000

Debt Service Coverage Ratio

The interest coverage ratio, as explained above, does not tell us anything about the
ability of a company to make payment of principal amount also on time. For this
purpose debt service coverage ratio is calculated as follows:
Net Profit before Interest and Tax
Principal Payment Instalment
Principal Payment Instalment
Interest +
I - tax Rate

The principle payment instalment is adjusted for tax effects since such payment
is not deductible from net profit for tax purposes.
Illustration 8.8. Net profit before interest and tax 50,000. 10 per cent Debentures
(payable in 10 year in equal instalments) 1,00,000.
Tax Rate 50%
Calculate the Debt Service Coverage Ratio.
SOLUTION:
Net Profit before Interest and Tax
Debt Service Coverage Ratio = Principal Payment Instalment
Interest +
I-tax Rate
The ratio comes to 1.67. It means net profit before interest and tax covers
adequately both interest and principal repayment instalment. Some accountants prefer to
compute the debt service coverage ratio as under:
Cash Profit available for Debts Service
Interest + Principal Payment Instalment
Cash Profit available for debt service is computed by adding to net profit items like
depreciation, interest on debt and amortization of items like goodwill, preliminary
expenses, etc.

Self-Instructional
204 Material
However, the former seems to be a better method since by giving the tax effect, it Analysis of Financial
Statements
puts the two items interest and principal payment instalment on the same footing.
The higher the ratio, better it is.
Payout Ratio NOTES
This ratio indicates what proportion of earning per share has been used for paying
dividend. The ratio can be calculated as follows:
Dividend per Equity Share
Earning per Equity Share

A complementary of this ratio is retained earning ratio. It is calculated as follows:

Retained Earning per Equity Share
=
Earning per Equity Share
or
Retained Earnings
= × 100
Total Earning

Illustration 8.9. Compute the payout ratio and the retained earning ratio from the
following data:

Net Profit 10,000 No. of Equity Shares 3,000

Provision for Tax 5,000 Dividend per Equity Share 0.40
Preference Dividend 2,000

Solution:
Dividend per Equity Share
Payout Ratio = 100
Earning per Equity Share
0.40
= 100 = 40%
1
Retained Earnings
Retained Earning Ratio = 100
Total Earning
1,800
= 100 = 60%
3,000
Retained Earning per share
= 100
Total Earning per share
0.60
= 100 = 60%
1
Significance: The payout ratio and the retained earnings ratio are indicators of the
amount of earnings that have been ploughed back in the business. The lower the payout
ratio, the higher will be the amount of earnings ploughed back in the business and vice
versa. Similarly, the lower the retained earnings ratio, the lower will be the amount of
earnings ploughed back into the business and vice versa. A lower payout ratio or a
higher retained earnings ratio means a stronger financial position of the company.

Self-Instructional
Material 205
Analysis of Financial Dividend Policy Ratio
Statements
This ratio is particularly useful for those investors who are interested only in dividend
income. The ratio is calculated by comparing the rate of dividend per share with market
NOTES value. Its formula can be put as follows:
Dividend per share
Market Price per share

For example, if a company declares dividend at 20 per cent on its shares, each
having a paid-up value of 8 and market price of 25, the dividend yield ratio will be
calculated as follows:
20
Dividend per Share = × 8 = 1.60
100

Divid en d p er Share 1.6

Dividend Yield Ratio = × 100 = × 100 = 6.4%
Market Price p er Sh are 25

Significance: Dividend policy ratio helps an intending investor in knowing the effective
return he is going to get on the proposed investment. For example, in the above case
though the company is paying a dividend of 20% on its shares, a person who purchases
the shares of the company from the market will get only an effective return of 6.4%.
He, therefore, can decide whether he should opt for this investment or not.
8.3.2 Turnovers
The turnover ratios or activity ratios indicate the efficiency with which the capital
employed is rotated in the business. The overall profitability of the business depends
on two factors: (i) the rate of return of capital employed; and (ii) the turnover, i.e., the
speed at which the capital employed in the business rotates. Higher the rate of rotation,
the greater will be the profitability. Thus, overall profitability ratio can be classified into:
1. Net Profit Ratio
2. Turnover Ratio
As already explained the Net Profit Ratio is calculated as follows:
Net Op erating Profit
100
Sales
Turnover ratio is calculated as follows:
Sales
Capital employed
Turnover ratio indicates the number of times the capital has been rotated in the
process of doing business.
When these two ratios are put together, we get the overall profitability ratio.
Overall profitability ratio = Net Profit Ratio × Turnover Ratio
Net Profit Sales
= 100 ×
Sales Capital em p loyed
Self-Instructional
Net Profit
206 Material = × 100
Cap ital em p loyed
Illustration 8.10. Determine which company is more profitable. Analysis of Financial
Statements
A Ltd B Ltd

Net Profit Ratio 5% 8%

Turnover Ratio 6 times 3 times
NOTES
Solution:
In the above case, if only net profit ratio is seen, Company B seems to be more
profitable. But actually Company A is more profitable, because it has a higher turnover
ratio which gives it a higher return on capital employed, i.e., 30% in com parison to
24% in case of Company B.
In order to find out which part of capital is efficiently employed and which part
not, different turnover ratios are calculated. These ratios are as follows:
Fixed Assets Turnover Ratio
This ratio indicates the extent to which the investments in fixed assets contributed
towards sales. If compared with a previous period, it indicates whether the investment
in fixed assets has been judicious or not. The ratio is calculated as follows:
Net Sales
Fixed Assets (Net)

Illustration 8.11. The following details have been given to you for Messrs Reckless
Ltd for two years. You are required to find out the fixed assets turnover ratio and
comment on it.
2020 2021

Fixed Assets at written-down value 1,50,000 3,00,000

Sales less Returns 6,00,000 8,00,000

Solution:
Sales
Fixed Assets Turnover Ratio =
Fixed Assets
2020 2021
= 6,00,000 ÷ 1,50,000 = 4 times 8,00,000 ÷ 3,00,000 = 2.67 times

There has been a decline in the fixed assets turnover ratio though, absolute
figures of sales have gone up. It means, increase in the investment in fixed assets has
not brought about commensurate gain. However, the results for next two or three
years must also be seen before commenting on judiciousness or otherwise of increase
in investments in the fixed assets.
The fixed assets turnover ratio can further be divided into turnover of each
item of fixed assets to find out the extent each fixed asset has been properly used. For
example:
N et Sales Self-Instructional
Plant and Machinery to Turnover = Plant and M achinery (N et) Material 207
Analysis of Financial
Net Sales
Statements Land and Buildings to Turnover
Land and Buildings (Net)

Working Capital Turnover Ratio

NOTES
This ratio indicates whether or not working capital has been effectively utilized in making
sales. The ratio is calculated as follows:
Net Sales
Working Capital

Working capital turnover ratio may take different forms for different purposes. Some
of them are being explained below:
(i) Debtors’ Turnover Ratio (Debtors’ Velocity): Debtors constitute an
important constituent of current assets and therefore the quality of debtors to a
great extent determines a firm’s liquidity. Two ratios are used by financial analysts
to judge the liquidity of a firm. They are (i) debtors turnover ratio, and (ii) debt
collection period ratio.
The debtors turnover ratio is calculated as under:
Credit Sales
A verage Accounts R eceivable

The term accounts receivable include ‘trade debtors’ and ‘bills receivable.’
Illustration 8.12. Calculate the Debtors Turnover Ratio from the following figures:

Total Sales for the year 2021 1,00,000

Cash Sales for the year 2021 20,000
Debtors as on 1 January 2021 10,000
Debtors as on 31 December 2021 15,000
Bills Receivable as on 1 January 2021 7,500
Bills Receivable as on 31 December 2021 12,500

Solution:
Credit Sales
Debtors’ Turnover Ratio =
Average Accounts Receivable
80,000
= = 3.56 times
22,500*
*
1/2 of ( 17,500 + 27,500)

In case the details regarding opening and closing receivables and credit sales are not
available the ratio may be calculated as follows:
Total Sales
Accounts Receivable

Significance: The sales to accounts receivable comparison indicates the efficiency

of the staff entrusted with collection of book debts. The higher the debtors’ turnover
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208 Material
ratio, the better it is, since it would indicate that debts are being collected more promptly.
For measuring the efficiency, it is necessary to set up a standard figure; a ratio lower Analysis of Financial
Statements
that the standard will indicate inefficiency.
The ratio helps in cash budgeting since the flow of cash from customers can be
worked out on the basis of sales. NOTES
(ii) Debt Collection Period Ratio: The ratio indicates the extent to which the
debts have been collected in time. It gives the average debt collection period.
The ratio is very helpful to the lenders because it explains to them whether their
borrowers are collecting money within a reasonable time. An increase in the
period will result in greater blockage of funds in debtors. The ratio may be
calculated by the following methods:
Months (or days) in a year
(a)
Debtor’s Turnover

Average Accounts Receivable × Months (or days) in a year

(b)
Credit Sales for the year

Accounts Receivable
(c)
Average Monthly or Daily Credit Sales

Illustration 8.13

Credit Sales for the year 12,000 Bills Receivable 1,000

Debtors 1,000

Calculate the debtors’ turnover ratio and debt collection period.

Solution:
Credit Sales 12,000
Debtors’ Turnover Ratio = = 6 times
Accounts Receivable 2,000
Debt Collection Period (or Average Age of Receivables)
Months in a year 12
= = 2 months
Debtors’ Turnover 6
Or
Accounts Receivable × Months in a year 2,000 × 12
= = 2 months
Credit Sales in the year 12,000
Or
Accounts Receivable 2,000
= = 2 months
Monthly Credit Sales 1,000

The two ratios are interrelated. Debtor’s turnover can be obtained by dividing
the months (or days) in a year by the average collection period (e.g., 12/2 = 6).
Similarly, where the number of months (or days) in a year are divided by the debtors
turnover, average debt collection period is obtained (i.e., 12/6 = 2 months).
Significance Debtors’ collection period measures the quality of debtors since it
measures the rapidity or slowness with which money is collected from them. A shorter
collection period implies prompt payment by debtors. It reduces the chances of bad Self-Instructional
Material 209
Analysis of Financial debts. A longer collection period implies a too liberal and inefficient credit collection
Statements
performance. However, in order to measure a firm’s credit and collection efficiency,
its average collection period should be compared with the average of the industry. It
should be neither too liberal nor too restrictive. A restrictive policy will result in lower
NOTES sales which will reduce profits.
It is difficult to provide a standard collection period of debtors. It depends
upon the nature of the industry, seasonal character of the business and credit policies
of the firm. In general, the amount of receivables should not exceed 3–4 months’
credit sales.
(iii) Creditors’ Turnover Ratio (Creditors’ Velocity): It is similar to
debtors’ turnover ratio. It indicates the speed with which the payments for
credit purchases are made to the creditors. The ratio can be computed as
follows:
Credit Purchases
Average Accounts Payable

The term accounts payable includes ‘trade creditors’ and ‘bills payable.’
In case the details regarding credit purchases, opening and closing accounts
payable have not been given, the ratio may be calculated as follows:
Total Purchases
Accounts Payable

(iv) Debt Payment Period Enjoyed Ratio (Average Age of

Payables): The ratio gives the average credit period enjoyed from the
creditors. It can be computed by any one of the following methods:
Months (or days) in a year
(a)
Creditors’ Turnover

Average Accounts Payable × Months (or days) in a year

(b)
Creditors’ Turnover

Average Accounts Payable

(c)
Average Monthly (or daily) Credit Purchases

Illustration 8.14. From the following figures, calculate the creditors’ turnover ratio
and the average age of accounts payable:

Credit Purchases during 2008 1,00,000 Bills Payable on 1 Jan. 2008 4,000
Creditors on 1 Jan. 2008 20,000 Bills Payable on 31 Dec. 2008 6,000
Creditors on 31 Dec. 2008 10,000

Solution:
Credit Purchase 1,00,000
Creditors’ Turnover Ratio = = 5 times
Average Accounts Payable 20,000
Months in a year 12
Average Age of Accounts Payable = = = 2.4 months
(or credit period enjoyed) Creditor's Turnover 5
Self-Instructional
210 Material
Or Analysis of Financial
Statements
Average Accounts Payable × Months in a year 20,000 × 12
= = 2.4 months
Credit Purchases in the year 1,00,000
Or
Average Accounts Payable 20,000 NOTES
= = 2.4 months
Average Monthly Credit Purchases 8,333.33

Significance: Both the creditors turnover ratio and the debt payment period enjoyed
ratio indicate about the promptness or otherwise in making payment of credit purchases.
A higher ‘creditors turnover ratio’ or a ‘lower credit period enjoyed ratio’ signifies that
the creditors are being paid promptly, thus enhancing the creditworthiness of the
company. However, a very favourable ratio to this effect also shows that business is
not taking full advantage of credit facilities which can be allowed by the creditors.
(v) Stock Turnover Ratio: This ratio indicates whether investment in inventory is
efficiently used or not. It, therefore, explains whether investment in inventories
is within proper limits or not. The ratio is calculated as follows:
Cost of Goods Sold during the year
Average Inventory

Average inventory is calculated by taking stock levels of raw materials, work-

in-process, finished goods at the end of each month, adding them up and dividing
by twelve.
Inventory ratio can be calculated regarding each constituent of inventory. It may
thus be calculated regarding raw materials, work-in-progress and finished goods:
Cost of Goods Sold
(a)
Average Stock of Finished Goods

Material Consumed
(b)
Average Stock of Raw Materials

Cost of Completed Work

(c)
Average Work-in-process

The method discussed above is, as a matter of fact, the best basis for computing
the stock turnover ratio. However, in the absence of complete information, the
inventory turnover ratio may also be computed on the following basis:
Net Sales
Average Inventory at Selling Price

The average inventory may also be calculated on the basis of the average of
inventory at the beginning and at the end of the accounting period.
Inventory at the beginning of the accounting period +
Inventory at the end of the accounting period
Average Inventory =
2

Illustration 8.15. Following is the trading account of Skylarks Ltd. Calculate the
stock turnover ratio: Self-Instructional
Material 211
Analysis of Financial Trading Account
Statements Dr. Cr.

Particulars Particulars

To Opening Stock 40,000 By Sales 2,00,000

NOTES To Purchases 1,00,000 By Closing Stock 20,000
To Carriage 10,000
To Gross Profit 70,000
2,20,000 2,20,000

SOLUTION:
Cost of Sales 1,30,000
Stock Turnover Ratio = = 4.33 times
Average Stock 30,000

Significance of the Ratio: As already stated, the inventory turnover ratio signifies
the liquidity of the inventory. A high inventory turnover ratio indicates brisk sales. The
ratio is, therefore, a measure to discover the possible trouble in the form of overstocking
or overvaluation. The stock position is known as the graveyard of the balance sheet.
If the sales are quick such a position would not arise unless the stocks consist of
unsaleable items. A low inventory turnover ratio results in blocking of funds in inventory
which may ultimately result in heavy losses due to the inventory becoming obsolete or
deteriorating in quality.
8.3.3 Liquidity and Leverages
Financial ratios indicate the financial position of the company. A company is deemed
to be financially sound if it is in a position to carry on its business smoothly and meet all
its obligations—both long-term as well as short-term without strain. Thus, its financial
position has to be judged from two angles—long-term as well as short-term. It is a
sound principle of finance that long-term requirements of funds should be met out of
long-term funds and short-term requirements should be met out of short-term funds.
For example, if fixed assets are purchased out of funds provided by bank overdraft,
the company will come to grief because such assets cannot be sold away when payment
will be demanded by the bank. We are giving below some of the important ratios
which are calculated in order to judge the financial position of the company.
Fixed Assets Ratio
This ratio is expressed as follows:
Fixed Assets
Long-term Funds
The ratio should not be more than 1. If it is less than 1, it shows that a part of the
working capital has been financed through long-term funds. This is desirable to some
extent because a part of working capital termed as ‘core working capital’ is more or
less of a fixed nature. The ideal ratio is 0.67.
Fixed assets include ‘net fixed assets’ (i.e., original cost – depreciation to date)
and trade investments including shares in subsidiaries. Long-term funds included share
Self-Instructional capital, reserves and long-term loans.
212 Material
Illustration 8.16. From the following information compute the fixed assets ratio: Analysis of Financial
Statements
Particulars Particulars

Share Capital 1,00,000 Furniture 25,000

Reserves 50,000 Trade Debtors 50,000
12 per cent Debentures 1,00,000 Cash Balance 30,000
NOTES
Trade Creditors 50,000 Bills Payable 10,000
Plant and Machinery 1,00,000 Stock 40,000
Land and Buildings 1,00,000

Solution:
Fixed Assets 2,25,000
Fixed Assets Ratio = = 0.9
Long-term Funds 2,50,000

Current Ratio
This ratio is an indicator of the firm’s commitment to meet its short-term liabilities. It is
expressed as follows:
Current Assets
Current Liabilities
Current assets include cash and other assets convertible or meant to be converted
into cash during the operating cycle of the business (which is of not more than a year).
Current liabilities mean liabilities payable within a year’s time either out of existing
current assets or by creation of new current liabilities. A list of items included in current
assets and current liabilities has already been given in the pro forma analysis balance
sheet in the preceding pages.
Book debts outstanding for more than six months and loose tools should not be
included in current assets. Prepaid expenses should be taken into current assets.
Illustration 8.17. From the following, compute the ‘Current Ratio’:
Particulars Particulars

Sundry Debtors 40,000 Sundry Creditors 20,000

Prepaid expenses 20,000 Debentures 1,00,000
Short-term investments 10,000 Inventories 20,000
Loose Tools 5,000 Outstanding Expenses 20,000
Bills Payable 10,000

Solution:
Current Assets 90,000
Current Ratio = 1.8
Current Liabilities 50,000
An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of
solvency due to the fact that if the current assets are reduced to half, i.e., 1 instead of
2, then also the creditors will be able to get their payments in full. However, a business
having seasonal trading activity may show a lower current ratio at certain period in the
year. A very high current ratio is also not desirable since it means less efficient use of
funds. This is because a high current ratio means excessive dependence on long-term
sources of raising funds. Long-term liabilities are costlier than current liabilities and
therefore, this will result in considerably lowering down the profitability of the concern.
Self-Instructional
It is to be noted that the mere fact that current ratio is quite high does not means Material 213
Analysis of Financial that the company will be in a position to meet adequately its short-term liabilities. In
Statements
fact the current ratio should be seen in relation to the components of the current assets
and their liquidity. If a large portion of the current assets comprises obsolete stocks or
debtors outstanding for a long time, company may fail if the current ratio is higher than 2.
NOTES The current ratio can also be manipulated very easily. This may be done either
by postponing certain pressing payments or postponing purchase of inventories or
making payment of certain current liabilities. Consider the following examples:
Example 1:

Current Assets: Sundry Debtors 40,000

Inventories 60,000
Cash in Hand 1,00,000
Current Liabilities: Sundry Creditors 80,000
Bills Payable 20,000
2,00,000
Current Ratio = = 3.
1,00,000
In case the creditors are paid to the extent of 50,000 out of cash in hand, the current ratio will
be as follows:
1,50,000
Current Ratio = = 3.
50,000
Example 2:
A business has current assets of 30,000 including stock of goods of 5,000. Its current liabilities are
of 15,000. The current ratio is 2. However, if the business should have maintained a stock of
15,000, the current ratio would have been as follows:
30,000 10,000 40,000
1.6
15, 000 10,000 * 25,000
*Presuming that the goods are purchased on credit.

Significance: The current ratio is an index of the concern’s financial stability since it
shows the extent of the working capital which is the amount by which the current
assets exceed the current liabilities. As stated earlier, a higher current ratio would
indicate inadequate employment of funds while a poor current ratio is a danger signal
to the management. It shows that the business is trading beyond its resources.
Liquidity Ratio
This ratio is also termed as ‘acid test ratio’ or ‘quick ratio.’ This ratio is ascertained by
comparing the liquid assets (i.e., assets which are immediately convertible into cash
without much loss) to current liabilities prepaid expenses and stock are not taken as
liquid assets. The ratio may be expressed as under:
Liquid Assets
Current Liabilities
On the basis of the figures given in the Illustration 8.15 the liquidity ratio will be computed
as under:
Liqu id Assets 90,000 40,000 50,000
= = = = 1
Cu rren t Liabilities 50,000 50,000
Self-Instructional
214 Material Some accountants prefer the term ‘liquid liabilities’ for ‘current liabilities’ for the purpose
of ascertaining this ratio. Liquid liabilities mean liabilities which are payable within a Analysis of Financial
Statements
short period. The bank overdraft (if it becomes a permanent mode of financing) and
cash credit facilities will be excluded from current liabilities in such a case:
Liqu id Assets NOTES
The ideal ratio for is 1.
Liqu id Liabilities

The ratio is also an indicator of short-term solvency of the company.

A comparison of the current ratio to quick ratio shall indicate the inventory
hold-ups. For example, if two units have the same current ratio but different liquidity
ratios, it indicates over-stocking by the concern having low liquidity ratio as compared
to the concern which has a higher liquidity ratio.
Debt–equity Ratio
The debt–equity ratio is determined to ascertain the soundness of the long-term financial
policies of the company. It is also known as ‘external-internal’ equity ratio. It may be
calculated as follows:
External Equities
Debt–Equity Ratio =
Internal Equities

The term ‘external equities’ refers to total outside liabilities and the term ‘internal equities’
refers to shareholders’ funds or the tangible net worth (as used in the pro forma balance
sheet given in the preceding pages). In case the ratio is 1 (i.e., outsider's funds are
equal to shareholders’ funds), it is considered to be quite satisfactory.
Total Long-term Debt
(i) Debt–equity Ratio =
Total Long-term Funds

Shareholders' Funds
(ii) Debt–equity Ratio = Total Long-term Funds

Total Long-term Debt

(iii) Debt–equity Ratio =
Shareholders' Funds
Note: Method (iii) is most popular.
Ratios (i) and (ii) give the proportion of long-term debt/shareholders’ funds in
total long-term funds (including borrowed as well as owned funds), while ratio
(iii) indicates the proportion between shareholders’ funds (i.e., tangible net worth),
and the total long-term borrowed funds.
Ratios (i) and (ii) may be taken as ideal if they are 0.5 each, while the ratio
(iii) may be taken as ideal if it is 1. In other words, the investor may take debt–equity
ratio as quite satisfactory if shareholders’ funds are equal to borrowed funds. However,
a lower ratio, say 2/3rd, borrowed funds and 1/3rd owned funds may also not be
considered as unsatisfactory if the business needs heavy investment in fixed assets and
has an assured return on its investment, e.g., in case of public utility concerns.
It is to be noted that preference shares redeemable within a period of 12 years
from the date of their issue should be taken as a part of debt.
Self-Instructional
Material 215
Analysis of Financial Illustration 8.18. From the following figures calculate the debt–equity ratio:
Statements
Particulars Particulars

Preference Share capital 1,00,000 Unsecured Loans 50,000

NOTES Equity Share Capital 2,00,000 Creditors 40,000
Capital Reserves 50,000 Bills Payable 20,000
Profit and Loss A/c 50,000 Provision for Taxes 10,000
12 per cent Mortgage Debenture 1,00,000 Provision for Dividends 20,000

Solution:
The debt–equity ratio may be calculated according to any of the following methods
depending on the purpose for which the information is required.
External Equities 2,40,000
(i) Debt–Equity Ratio = Internal Equities = = 0.6
4,00,000

Total Long-term Debt* 1,50,000

(ii) Debt–Equity Ratio = = = 0.27
Total Long-term Liabilities 5,50,000
Shareholders ' Funds 4,00,000
(iii) Debt–Equity Ratio = = = 0.73
Total Long-term Funds 5,50,000
Total Long-term Debt 1,50,000
(iv) Debt–Equity Ratio = = = 0.73
Shareholders Fund 4,40,000
* Unsecured loan has been taken as a long-term loan.

Significance: The ratio indicates the proportion of owners’ stake in the business.
Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which
the firm depends upon outsiders for its existence. The ratio provides a margin of safety
to the creditors. It tells the owners the extent to which they can gain the benefits of
maintaining control with a limited investment.
Proprietary Ratio
It is a variant of debt–equity ratio. It establishes relationship between the proprietors’
or shareholders’ funds and the total tangible assets. It may be expressed as under:
Shareholders’ Funds
Total Tangible Assets

Illustration 8.19. From the following, calculate the proprietary ratio:

Particulars Assets

Preference Share Capital 1,00,000 Fixed assets 2,00,000

Equity Share Capital 2,00,000 Current assets 1,00,000
Reserves and Surplus 50,000 Goodwill 50,000
Debentures 1,00,000 Investments 1,50,000
Creditors 50,000
5,00,000 5,00,000

Solution:
Shareholders’ Funds 3,00,000
Proprietary Ratio = 0.67 or 67%
Total Tangible Assets 4,50,000
Significance: This ratio focuses the attention on the general financial strength of the
Self-Instructional
216 Material business enterprise. The ratio is of particular importance to the creditors who can find
out the proportion of shareholders’ funds in the total assets employed in the business. Analysis of Financial
Statements
A high proprietary ratio will indicate a relatively lesser danger to the creditors, etc., in the
event of forced reorganization or winding up of the company. A low proprietary ratio
indicates greater risk to the creditors since in the event of losses a part of their money
may be lost besides loss to the proprietors of the business. The higher the ratio, the NOTES
better it is. A ratio below 50 per cent may be alarming for the creditors since they may
have to lose heavily in the event of company’s liquidation on account of heavy losses.
Table 8.1 Summary of Basic Ratios and their Purpose
Ratio Computation Formula Purpose
(1) (2) (3) (4)
(i) Gross Profit Ratio Gross Profit Indicates the efficiency of
×100 the production/trading
Net Sales
operations.
(ii) Net Profit Ratio Net Profit Indicates net margin on
×100 sales
Net Sales
(iii) Operating or Expenses Operating Costs A measure of
Ratio ×100 management’s ability to
Net Sales
keep operating expenses
properly controlled for
level of sales achieved.
(iv) Net Profit to Total Assets Gross Profit after Tax + Interest A measure of productivity
×100 of total assets.
Total Assets
(v) Return on Shareholder’s Profit available for Equity Shareholders Measures earning power
×100 of equity capital.
Average Equity Shareholders' Funds

(vi) Earning per Equity Share Profit available for Equity Shareholders Shows the amount of
×100 earnings attributable to
No. of Equity Shares
each equity share.
(vii) Dividend Yield Dividend per Share Shows the rate of return to
×100 shareholders in the form of
Market Price per Share
dividends based on the
market price of the share.
(viii) Price Earning Ratio Market price of a share A measure for determining
×100 the value of a share. May
Earning per share
also be used to measure
the rate of return expected
by investors.
(ix) Fixed Interest Cover Operating Income Shows the margin of
Annual Interest Expense coverage of interest
requirements.
(x) Fixed Dividend Cover Net Income Shows the extent to which
Annual Preference Dividends current earnings are
available to pay dividends
on preference shares.
(xi) Inventory Turnover Cost of goods sold Evaluation of the liquidity
Average Inventory of inventory and adequacy
of inventory controls.
(xii) Accounts Receivable Net Sales on Credit Measures liquidity of
Turnover Average Receivable accounts, receivable and
the effectiveness of credit
policy.
(xiii) Current Ratio Current Assets Measures short-term debt
Current Liabilities paying ability.

(xiv) Quick (Acid Test) Ratio Quick Assets A refined measure of the
(i) short-term debt paying
Current Liabilities
ability by measuring short-
Quick Assets term liquidity.
(i)
Quick Liabilities
(xv) Proprietary Ratio Total Shareholders's Funds Measures conservatism of
Total Tangible Assets capital structure and shows
the extent of shareholder’s
funds in the total assets
employed in the business.
(xvi) Debt-Equity Ratio External Equities Indicates the percentage of
(i) funds being financed
Internal Equities Self-Instructional
through borrowings; a
(i)
Total Long-term Debt measure of the extent of Material 217
Total Long-term Funds trading on equity.
Analysis of Financial
Statements 8.4 SIMPLE PROBLEMS ON GROSS PROFIT, NET
PROFIT, OPERATING RATIO, STOCK
TURNOVER, DEBTORS TURNOVER,
NOTES CREDITORS TURNOVER, CURRENT RATIO,
LIQUID RATIO, DEBT-EQUITY RATIO,
WORKING CAPITAL TO NET WORTH AND
ASSETS TURNOVER RATIO
Illustration 8.20. Following is the profit and loss account and balance sheet of Jai Hind
Ltd. Redraft them for the purpose of analysis and calculate the following ratios:
(i) Gross profit ratio; (ii) Overall profitability ratio; (iii) Current ratio; (iv) Debt–
equity ratio; (v) Stock turnover ratio; (vi) Liquidity ratio.
Profit and Loss Account

Particulars Particulars

Opening Stock of Finished Goods 1,00,000 Sales 10,00,000

Opening Stock of Raw Materials 50,000 Closing Stock of Raw Materials 1,50,000
Purchase of Raw Materials 3,00,000 Closing Stock of Finished Goods 1,00,000
Direct Wages 2,00,000 Profit on Sale of Shares 50,000
Manufacturing Expenses 1,00,000
Administration Expenses 50,000
Selling and Distribution Expenses 50,000
Loss on Sale of Plant 55,000
Interest on Debentures 10,000
Net Profit 3,85,000
13,00,000 13,00,000

Balance Sheet

Liabilities Assets

Share Capital: Fixed Assets 2,50,000

Equity Share Capital 1,00,000 Stock of Raw Materials 1,50,000
Preference Share Capital 1,00,000 Stock of Finished Goods 1,00,000
Reserves 1,00,000 Sundry Debtors 1,00,000
Debentures 2,00,000 Bank balance 50,000
Sundry Creditors 1,00,000
Bills Payable 50,000
6,50,000 6,50,000

Solution.
Income Statement

Sales 10,00,000
Less: Cost of Sales:
Raw Materials consumed
Self-Instructional (Opening Stock + Purchases – Closing Stock) 2,00,000
218 Material
Direct wages 2,00,000
Manufacturing Expenses 1,00,000 Analysis of Financial
Statements
Cost of Production 5,00,000
Add: Opening Stock of Finished Goods 1,00,000
6,00,000
Less: Closing Stock of Finished Goods 1,00,000 NOTES
Cost of goods sold 5,00,000
Gross Profit 5,00,000
Less: Operating Expenses:
Administration Expenses 50,000
Selling and Distribution Expenses 50,000 1,00,000
Net Operating Profit: 4,00,000
Add: Non-trading Income:
Profit on Sale of Shares 50,000
4,50,000
Less: Non-trading Expenses or Losses:
Loss on sale of Plant 55,000
Income before Interest and Tax 3,95,000
Less: Interest on Debentures 10,000
Net Profit before Tax 3,85,000
Balance Sheet (or Position Statement)

Bank Balance 50,000

Sundry Debtors 1,00,000
Liquid Assets: 1,50,000
Inventories:
Stock of raw materials 1,50,000
Stock of finished goods 1,00,000
Current Assets: 4,00,000
Sundry Creditors 1,00,000
Bills Payable 50,000
Current Liabilities 1,50,000
Working Capital ( 4,00,000 – 1,50,000) 2,50,000
Add: Fixed Assets 2,50,000
Capital Employed 5,00,000
Less: Debentures 2,00,000
Shareholders’ Net Worth 3,00,000
Less: Preference Share Capital 1,00,000
Equity Shareholders’ Net Worth 2,00,000
Equity Shareholders’ Net Worth is represented by: Equity Share Capital 1,00,000
Reserves 1,00,000
2,00,000
Ratios:
Gross profit 5,00,000
(i) Gross Profit Ratio: 100 = × 100 = 50%
Sales 10,00,000
Operating profit 4,00,000
(ii) Overall Profitability Ratio: Capital employed 100 = 100 = 80%
5,00,000
Current Assets 4,00,000
(iii) Current Ratio: Current Liabilities = = 2.67 Self-Instructional
5,00,000
Material 219
Analysis of Financial External Equities 3,50,000
Statements (iv) Debt–Equity Ratio: = = 1.17
Internal Equities 3,00,000
Or
Total Long-term Debt 2,00,000
= = = 0.40
NOTES Total Long-term Funds 5,00,000
Or
Total Long-term Debt 2,00,000
= = = 0.67
Total Long-term Funds 3,00,000
(v) Stock Turnover Ratio:
(a) As regards average total inventory
Cost of goods sold 5,00,000
= = 2.5
Average inventory* 2,00,000
(* of raw material as well as finished goods)
(b) As regards average inventory of raw materials:
Cost of goods sold 5,00,000
= =5
Average inventory of raw materials 1,00,000
(c) As regards average inventory of finished goods:
Cost of goods sold 5,00,000
= =5
Average inventory of finished goods 1,00,000
(vi) Liquidity Ratio:
Liquid Assets 1,50,000

Current Liabilities 1,50,000

Illustration 8.21. The balance sheet of Y Ltd stood as follows as on:

( in lakhs)

Liabilities 31.3.05 31.3.04 Assets 31.3.05 31.3.04

Capital 250 250 Fixed Assets 400 300

Reserves 116 100 Less: Depreciation 140 100
Loans 100 120 260 200
Creditors and Other Investments 40 30
Current Liabilities 129 25 Stock 120 100
Debtors 70 50
Cash/Bank 20 20
Other Current Assets 25 25
Misc. Expenditure 60 70
595 495 595 495

You are given the following information for the year 2004–05:
( in lakhs)
Sales 600
PBIT 150
Interest 24
Provision for tax 60
Proposed dividend 50

Self-Instructional
220 Material
From the above particulars calculate for the year 2004–05: Analysis of Financial
Statements
(a) Return on Capital Employed Ratio
(b) Stock Turnover Ratio
(c) Return on Net Worth Ratio
(d) Current Ratio NOTES
(e) Proprietary Ratio

Solution:
(i) Return on Capital Employed
PBIT 150
100 i.e., 100 = 37.22%
Average Capital Employed 403
(ii) Stock Turnover Ratio
Sales 600
i.e., = 5.45 times
Average Stock 110
(iii) Return on Net Worth
PAT 235
× 100 i.e., = 22.53%
Average Net Worth 129
(iv) Current Ratio
Current Assets 235
i.e., = 1.82 times
Current Liabilities 129
Proprietary Funds 306
(v) = = 0.57
Total Assets Misc. Expenditure 595 60

Working Notes:
(i) Average capital employed ( in lakhs)
31-3-2005 31-3-2004
Total Assets (excluding Misc. ex) 535 425
Less: Creditors and Other Current Liabilities 129 25
406 400

Average: 466 + 470 ÷ 2 = 468 lakh

(ii) Average Net Worth
Capital 250 250
Reserves 116 100
366 350
Less: Misc. Expenses 60 70
306 280
Average: 306 + 280 ÷ 2 = 293 lakh
Proprietary Funds as on 31.3.2005 mean Net worth as on that date, i.e., 306 lakh
(iii) Average Stock ( in lakhs)
(120 + 100)/2 = 110
(iv) Profit after Tax (PAT) ( lakh)
PBIT 150
Less: Interest 24
126
Less: Tax 60
66

Self-Instructional
Material 221
Analysis of Financial (v) Current Assets as on 31.3.2005
Statements

( in lakhs)
Stock 120
NOTES Debtors 70
Cash/Bank 20
Other Current Assets 25
235

Computation of Items of Financial Statements

Illustration 8.22. With the help of the following ratios regarding Indu Films, draw the
balance sheet of the company for the year 2005:
Current Ratio 2.5
Liquidity Ratio 1.5
Net Working Capital 3,00,000
Stock Turnover Ratio (cost of sales/closing stock) 6 times
Gross Profit Ratio 20 per cent
Fixed Assets Turnover Ratio (on cost of sales) 2 times
Debt Collection Period 2 months
Fixed assets to Shareholders Net Worth 0.80
Reserve and Surplus to Capital 0.50

Solution:
Balance Sheet
as on......
Liabilities Assets

Share Capital 5,00,000 Fixed Assets 6,00,000

Reserve and Surplus 2,50,000 Debtors 2,50,000
Long-term Borrowings Stock 2,00,000
(balancing figure) 1,50,000 Bank 50,000
Current Liabilities 2,00,000
11,00,000 11,00,000

Working Notes:
If Current Liabilities =1
Current Assets = 2.5
It means the difference or Working Capital = 1.5
Working Capital is 1.5 = 3,00,000
Therefore, Current Assets = 5,00,000
Current Liabilities = 2,00,000
As Liquidity Ratio = 1.5
And Current Liabilities = 2,00,000
Therefore, the Liquid Assets
(bank and debtors) (2,00,000 × 1.5) = 3,00,000
Stock (5,00,000 – 3,00,000, i.e.,
current assets–liquid assets) = 2,00,000
Cost of Sales (as stock turnover ratio is 6) = 12,00,000
Sales (as G.P. ratio is 20 per cent,
20
Self-Instructional 12,00,000 12,00,000 = 15,00,000
222 Material
80
Fixed Assets are 12,00,000/2 since fixed assets Analysis of Financial
turnover ratio is 2 = 6,00,000 Statements
Debtors are 15,00,000/6 since debt collection
period is 2 months = 2,50,000
6,00,00 1
Shareholders’ Net Worth = 7,50,000 NOTES
0.80
Out of Shareholders' Net Worth Reserves and Surplus = 2,50,000
Therefore, share capital = 5,00,000

Illustration 8.23. The following extracts of financial information relate to Curious Ltd:
Balance Sheet
as on 31 December
( in lakhs)

Particulars 2005 2004

Share Capital 10 10
Reserve and Surplus 30 10
Loan Fund 60 70
100 90
Fixed Assets (Net) 30 30
Current Assets:
Stocks 30 20
Debtors 30 30
Cash and Bank balances 10 20
Other Current Assets 30 10
100 80
Less: Current Liabilities 30 20
Net Working Capital 70 60
Total Assets 100 90
Sales ( lakh) 270 300

(a) Calculate, for the two years debt–equity ratio, quick ratio and working capital turnover ratio
(b) Find the sales volume that should have been generated in 2005 if the company were to have
maintained its working capital turnover ratio.

Solution:
(a) (i) Debt–Equity Ratio 2005 2004
Debt Loan Funds 60 70
= = =
Equity Share Capital + Reserves 40 20
(ii) Quick Ratio
Quick Assets 30 10
= =
Current Liabilities 30
30 20
20
= 1.33 : 1 2.5 : 1
(iii) Working Capital Turnover Ratio
Sales 270 300
= =
Working Capital 70 60
= 3.86 times 5 times
Self-Instructional
Material 223
Analysis of Financial (b) Sales volume to be maintained
Statements
Required Sales
5=
70
Sales required for 2005 = 350 lakh
NOTES Illustration 8.24. With the following ratios and further information given below,
prepare a trading account, profit and loss account and a balance sheet of Shri Narain:
(i) Gross Profit Ratio 25% (vi) Fixed Assets/Capital 5/4
(ii) Net Profit/Sales 20% (vii) Fixed Assets/Total
(iii) Stock-turnover Ratio 10 Current Assets 5/7
(iv) Net Profit/Capital 1/5 (viii) Fixed Assets 10,00,000
(v) Capital to Total (ix) Closing Stock 1,00,000
Liabilities 1/2

Solution:
Trading and Profit & Loss Account
for the year ended...

Particulars Particulars

To Opening Stock 20,000 By Sales 8,00,000

To Purchases (balancing figure) 6,80,000 By Closing Stock 1,00,000
To Gross Profit c/d 2,00,000
9,00,000 9,00,000
To Expenses 40,000 By Gross Profit b/d 2,00,000
To Net Profit 1,60,000
2,00,000 2,00,000

Balance Sheet
as on....

Liabilities Assets

Capital: Fixed Assets 10,00,000

Openings balance 6,40,000 Closing Stock 1,00,000
Add: Net Profit 1,60,000 8,00,000 Other Current Assets 13,00,000
(balancing figure)
Liabilities 16,00,000
24,00,000 24,00,000

Working Notes:
1. Fixed Assets are 10,00,000
Fixed Assets Capital = 5 4
Capital = 10,00,000 4 5 = 8,00,000
2. Capital is 1/2 of Total Liabilities
Liabilities = 8,00,000 2 = 16,00,000
3. Net Profit is 1/5 of Capital
Net Profit = 8,00,000 1/5 = 1,60,000
4. Net Profit is 20% of Sales
Sales = 1,60,000 100 20 = 8,00,000
5. Gross Profit Ratio is 25% of Sales
Self-Instructional
224 Material
Gross Profit = 2,00,000
6. Stock Turnover Ratio (i.e., Cost of Sales/Average Inventory) is 10 Analysis of Financial
Cost of Sales = Sales – Gross Profit Statements
= 8,00,000 – 2,00,000 = 6,00,000
Average Inventory is 6,00,000
7. Closing Stock is 1,00,000
NOTES
Average Inventory is 60,000
Opening Stock is 20,000
8. Fixed Assets are 10,00,000
Fixed Assets/Total Current Assets = 5 7
Total Current assets are 10,00,000 7/5 14,00,000
Stock is 1,00,000
Other Current Assets are 13,00,000
Illustration 8.25. From the following particulars prepare the balance sheet of Shri
Mohan Ram & Co. Ltd:
Current Ratio 2
Working Capital 4,00,000
Capital Block to Current Assets 3:2
Fixed Assets to Turnover 1:3
Sales Cash/Credit 1:2
Stock Velocity 2 Months
Creditors Velocity 2 Months
Debtors Velocity 3 Months
Capital Block:
Net profit 10% of Turnover
Reserve 2.5% of Turnover 1:2
Debentures/Share Capital
Gross Profit Ratio 25% (to Sales)

Solution:
Since current ratio is 2, current assets must be twice the current liabilities. In case current
liabilities are ‘x’, current assets will be 2x.
2x – x = 4,00,000
x = 4,00,000

Current Liabilities 4,00,000

Current Assets 8,00,000
Capital Block 12,00,000

Since the total liabilities are 16,00,000 (i.e., 12,00,000 + 4,00,000), the total assets will also be
16,00,000.

Fixed Assets (16,00,000 – 8,00,000) 8,00,000

Turnover (8,00,000 3) 24,00,000
Credit Sales 16,00,000
Cash Sales 8,00,000
Debtors’ velocity 3 months

Self-Instructional
Material 225
Analysis of Financial
Statements

Debtors are therefore (16,00,000 3/12) 4,00,000

Gross Profits (24,00,000 25/100) 6,00,000
Cost of Sales 18,00,000
NOTES Stock Turnover 2 Months
Stock is therefore (18,00,000 2/12) 3,00,000
Creditors’ Velocity 2 Months
Creditors are therefore (18,00,000 2/12) 3,00,000
Cash balance (8,00,000 – 7,00,000) 1,00,000
Reserves (24,00,000 2.5/100) 60,000
Profit (24,00,000 10/100) 2,40,000
Block or Fixed Capital 12,00,000
Reserves and Profit 3,00,000
Debentures and Share Capital 9,00,000
Share Capital 6,00,000
Debentures 3,00,000

Check Your Progress

4. What do you understand by profit-loss ratio?
5. Classify the accounting ratio on the basis of functional classification.
6. Define profitability.
7. State the significance of dividend policy ratio?
8.5 ANSWERS TO CHECK YOUR PROGRESS
QUESTIONS

1. An accounting ratio determines the relationship between two interrelated

accounting figures.
2. Management of a company is mainly interested in its financial condition,
profitability and progress.
3. An inter-firm comparison is a comparative study of financial and operating
efficiency of different firms is possible only after proper analysis of their financial
statements.
4. Ratios calculated on the basis of the items of the profit and loss account only are
called the profit-loss ratio.
5. On the basis of functional classification, accounting ratios are of three types,
i.e., profitability ratio, turnover efficiency ratio, financial solvency ratio.
6. Profitability is an indication of the efficiency with which the operations of the
business are carried on.
7. Dividend policy ratio helps an intending investor in knowing the effective return
that he/she is going to get on the proposed investment.

Self-Instructional
226 Material
Analysis of Financial
8.6 SUMMARY Statements

Financial statement analysis is the process of analyzing a company's financial

statements for decision-making purposes. NOTES
Financial statement analysis evaluates a company's performance or value through
a company's balance sheet, income statement, or statement of cash flows.
An accounting ratio determines the relationship between two interrelated
accounting figures.
Accounting ratios are relationships expressed in mathematical terms between
figures which are connected with each other in some manner.
Financial statement analysis converts the mass of data into useful information
which is always in scarce supply.
Financial statement analysis helps in evaluating a business performance according
to some specific objectives.
Lawyers also use financial statement analysis in furtherance of their investigative
and legal work.
Financial statement analysis performs the essential function of converting mass
data into useful information.
Profitability is an indication of the efficiency with which the operations of the
business are carried on.
Bankers, financial institutions and other creditors look at the profitability ratios
as an indicator whether or not the firm earns substantially more than it pays
interest for the use of borrowed funds and whether the ultimate repayment of
their debt appears reasonably certain.
The profitability from the point of view of the equity shareholders will be judged
after taking into account the amount of dividend payable to the preference
shareholders.
The return on capital invested is a concept that measures the profit which a firm
earns on investing a unit of capital.
The business can survive only when the return on capital employed is more than
the cost of capital employed in the business.
Cash Profit available for debt service is computed by adding to net profit items
like depreciation, interest on debt and amortization of items like goodwill,
preliminary expenses, etc.
The pay-out ratio and the retained earnings ratio are indicators of the amount of
earnings that have been ploughed back in the business.
Dividend policy ratio helps an intending investor in knowing the effective return
he is going to get on the proposed investment.
The turnover ratios or activity ratios indicate the efficiency with which the capital Self-Instructional
employed is rotated in the business. Material 227
Analysis of Financial Debtors' collection period measures the quality of debtors since it measures the
Statements
rapidity or slowness with which money is collected from them.
The current ratio is an index of the concern's financial stability since it shows the
extent of the working capital which is the amount by which the current assets
NOTES
exceed the current liabilities.
The debt-equity ratio is determined to ascertain the soundness of the long-term
financial policies of the company.

8.7 KEY WORDS

Shareholders: They are the suppliers of basic capital to run the business. Such
capital is exposed to all the risks of ownership.
Liquidity: It refers to the business ability to pay off its short-term liabilities,
when they become due.
Solvency: Solvency refers to the ability of a company to meet its long-term
debts.
Profitability: It is an indication of the efficiency with which the operations of
the business are carried on.
Gross Profit Ratio: This ratio expresses relationship between gross profit and
net-sales. Its formula is:

8.8 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Type Questions

1. Mention the key motive of the management of a company.
2. What do you understand by forecasting and budgeting?
3. State the significance of ROI.
4. Define turnovers.
5. What do you understand by liquidity and leverages?
Long Answer Type Questions
1. Discuss in detail financial statement analysis and parties interested in financial
statement analysis.
2. Explain the significance and purposes of financial statement analysis.
3. Examine the concept accounting ratio.
Self-Instructional
228 Material 4. Discuss in detail various types of turnover ratios.
Analysis of Financial
8.9 FURTHER READINGS Statements

Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.

Advanced Accountancy Volume-II, 11/e. New Delhi: Vikas Publishing House. NOTES
Maheshwari, SN, Sharad K Maheshwari and Suneel K Maheshwari. 2018.
An Introduction to Accountancy, 12/e. New Delhi: Vikas Publishing House.
Goyal, V. K. and R Goyal. 2012. Corporate Accounting. India: PHI Learning.
Radhika, P and Anita Raman. 2018. Corporate Accounting. New Delhi: McGraw-
Hill Education.

Self-Instructional
Material 229