Académique Documents
Professionnel Documents
Culture Documents
I. Financial Statements
Financial Statements- meaning-Usefulness-Trading Account – Manufacturing Account-
Profit and Loss A/c- Balance Sheet- Distinction between Fixed Assets and Current
Assets-Tangible Assets and Intangible Assets- Distinction between Trading and Profit
and Loss Account and a Balance Sheet-Distinction between a Trial Balance and a
Balance Sheeet
Introduction:
Financial statements give detailed information about the firm. Financial
statements are organized summaries of detailed information and are thus a form of
analysis. The type of statement, the accountants prepares, the way they arrange items on
these statements, and their standard of disclosure are all influenced by a desire to provide
information in a convenient form.
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xxxx xxxx
Differences between Profit and Loss account and Profit and Loss Appropriation
account
1. Profit and loss account is prepared for recording expenses, losses, and gains of
the current uear, whereas profit and loss appropriation acount is prepared for recording
the appropriation of profit i.e how the profits are utilized for various purposes such as
payment of dividend, etc.
2. Profit and Loss account is always prepared whereas the profit and loss
appropriation account is prepared only when there is appropriation of profits.
3. The balance of profit and loss accounti.e net profit or loss is transfered to
profit and loss appropriation account. On the other hand the balance of Profit and Loss
Appropriation account is carried forward from year to year.
4. Profit and loss accunt discloses the net profit or net loss before appropriation
whereas the closing balance of profit and loss appropriation account represents net
profit or net loss after
appropriation.
Balance sheet
Section 211 provides that the balance Sheet shall give a true and fair value of the
state of affairs of the company as at the end of the financial year and shall be in the
prescribed form set out in part I of schedule VI. The balance Sheet is prepared in order
to indicate the financial position of the company as on the last date of the trading
period.
The Balance sheet of a company can be drawn either in horizontal form or in
vertical form. In the horizontal form of presentation assets are shown on the right hand
side and liabilities are shown on the left hand side. In the vertical form, the liabilities
are shown under the “Sources of funds” and assets are shown under the heading
“Application of funds” given below are the two forms of Balance Sheet:
Horizontal form:
Name of the company
Balance Sheet as at....
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Liabilities Rs Assets Rs
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1. Share capital 1. Fixed Assets
Authorized: Shares of Rs... each a) Goodwill .....
Issued: Shares of Rs...each b) Land .....
Subscribed: Shares of Rs...each c) Building .....
Called up: Shares of Rs...each d) Leaseholds .....
Rs....called up ..... e) Railway Sidings .....
Less calls unpaid ..... f) Plant and Machinery .....
..... g) Furniture and fittings .....
Add: Forfeited Shares ..... h) Development of property .....
Paid up capital ..... i) Patents, Trade marks & designs .....
2. Reserves and Surplus j) Live stock .....
1) Capital Reserve ..... k) Vehicles .....
2) Capital Redemption Reserve .....
3) Securities premium a/c ..... 2. Investments:
4) Other Reserves ...... 1) In Government Securities
Less Debit balance in 2) In Shares, Debentures,
P& L Account, if any ..... 3) In immovable Properties
5) P & L Appropriation a/c ..... 3) Current Assets, Loans
6) Proposed Addition to reserve & Advances
7) Sinking Funds A) Current Assets
3. Secured Loans: 1) Interst accured on investments .....
1) Debentures ..... 2) Stores and Spare parts .....
2) Loans and advances 3) Loose Tools .....
from Banks ..... 4) Stock in Trade..... .....
3) Loans and Advances 5) work in progress .....
from subsidiaries ..... 6) Sundry Debtors .....
4) Other Loans and Advances ..... 7) Cash Balance on hand .....
4. Unsecured loans 8) Bank Balance .....
1) Fixed Deposits ..... B) Loans and Advances
2) Loans and Advances 9) Loans and Advances
3) Short-term loans & Advances: to subsidiaries
a) From Bank ..... 10) Bills of exchange ie.,Bills
b) From Others.... Receivable
..... 11) Prepaid expenses .....
5. Current Liabilites 4. Miscellaneous Expenditure
and Provisions 1) Preliminary expenses ....
(A) Current Liabilites 2) Expenses including commission
1) Acceptances (B/P) ..... or brokerage on underwriting of
2) Sundry Creditors ..... Shares or Debentures
3) Outstanding expenses .....
4) Income recieved in advance ..... 3) Discount allowed on
5) Unclaimed Dividends ..... issue of shares
6) Other Liabilities ..... or debentures
(B) Provisions 4) Development expenditure
7) Provision for Taxation ..... not adjusted
8) Proposed dividends ..... 5) Other sums
9) Provision for Contingencies ..... 5. Profit & Loss Account
10) Provision for Insurance, Debit balance of profit
Pension and Similar Staff and loss accounts
Benefit Scheme ..... which could not be deducted
11) Other Provision ..... from free reserves, if any .....
Total ..... Total.....
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TRIAL BALANCE:
Trial Balance is a statement showing Debit and Credit Balances of Accounts
obtained after balancing them. It contains two separate sides called debit side and credit
side. The totals of both debit side and credit side of the trial balance should be equal
keeping in conformity with the basic rule of double entry book keeping that every debit
should have a corresponding credit. There are mainly two methods of preparing the trial
balancenamely; The Balances method and the totals method. Under the Balances
method only balances obtained by balancing various accounts will be listed. Under the
totals method, the totals of accounts are listed. A third method of showing both totals
and balances is also used rarely.
Differences between Trial Balance and Balance sheet:
.1. A trial Balance shows balances of all the accounts maintained where as a
balance sheet shows the balances of Assets and Liabilities only.
2. A trial balance may be prepared in any format as long as debit and credit
balances are shown. It is not a statutory document. Balance sheet has to be prepared
keeping in mind the provisions of companies act.
3. A trial Balance has debit and credit columns where as a Balance sheet has
Liabilities and Assets columns.
4. A trial Balance shows only balances of various accounts, whereas a Balance
sheet shows financial position of a company as at the end of an accounting period.
Solution - 3
Bahubali Trading Co., Ltd.,
Profit and Loss Appropriation A/c for the year ended 31-12-2005
Dr. Cr.
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Particulars Rs Particulars Rs
To Interim Dividend 12,000 by Balance B/d 14,000
To Transfer to reserve fund 20,000 By Current years Net profit 42,000
To Transfer to Dividend
Equalization fund 10,000
To Transfer to Insurance fund 6,000
To Balance carried to
Balance sheet 8,000
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56,000 56,000
Bahubali Trading Co., Ltd.,
Balance sheet as on 31-12-2005
Liabilities Rs Assets Rs
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1. Share Capital 1. Fixed Assets
Authorised capital 2,00,000 Land & Buildings 1,00,000
Issued & Subscribed 2,00,000 Machinery 80,000
Called up 2,00,000 2. Investments------------------------
Less calls in arrears 20,000 3. Current assets and--------------------
1,80,000 Loans and Advances--------------------
-
Add forfeited Shares 4,000 A. Current Assets
Paid up capital 1,84,000 Stock 48,000
2.Reserve & Surplus: Debtors 50,000
Reserve Fund 34,000 Cash 30,000
Add Addition 20,000 54,000 B. Loans & Advances
-
Dividend 4. Miscellaneous Expenditure---------
Equalisation Fund 16,000
Add Additions 10,000 26,000
Insurance Fund 8,000
Add. Additions 6,000 14,000
Security premium 2,000
Profit & Loss Appropriation A/c 8,000
3. Secured Loans -
4. Unsecured Loans -
5. Current Liabilities & Provisions:
A. Current Liabilities Creditors 20,000
B. Provisions
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3,08,000 3,08,000
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Illustration
Following is the trial balance of Cheman Company Ltd”. As on 31st December, 2004
Prepare trading account, Profit and loss account, profit and loss appropriation account
and balance sheet.
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Particulars Dr. Cr.
Rs. Rs.
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Capital - 2,00,000
(2500 shares of Rs. 100 each
on which Rs. 80 called up
Land and Buildings 1,30,000 -
Investments 60,000 -
Machinery 15,000 -
Furniture 4,000 -
Bills receivable 6,400 -
Carriage inwards 2,500 -
Wages 21,000 -
Salary 8,500 -
Bills payable - 5,000
Purchases and Sales 60,000 1,10,000
Returns 2,000 1,000
Rent and rates 1,800 -
Preliminary expenses 6,000 -
Debtors and Creditors 42,000 15,000
Advertising & Reserve Fund 2,500 10,000
Profit and Loss a/c - 14,000
Stock (1-1-94) 30,000 -
Insurance 1,300 -
Discount 2,000 -
5% debentures - 40,000
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3,95,000 3,95,000
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Adjustments:
a) Write off Rs. 2,000 from preliminary expenses
b) Transfer Rs. 10,000 to reserve fund
c) Stock on 31-12-2004 Rs. 65,000
d) Provide for dividend on share capital at 10%
e) Debentures interest is outstanding for one year
Solution -4
Cheman Company Ltd.,
Dr. Trading and Profit and Loss Account for the year ended 31-12-2004 Cr.
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Particulars Rs Particulars Rs
To Opening stock 30,000 By Sales 1,10,000
To Purchases 60,000 Less sales returns 2,000 1,08,000
Less Purchase returns 1,000 59,000 By Closing stock 65,000
To Carriage inwards 2,500
To Wages 21,000
To Gross profit c/d 60,500
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1,73,000 1,73,000
To Salaries 8,500 By Gross profit b/d 60,500
To Rent & rates 1,800
To Advertising 2,500
To Insurance 1,300
To Discount 2,000
To Preliminary exp.written off 2,000
To Interest due on Debentures 2,000
[4,000x5/100]
To Net profit transferred to profit
and loss appropriation a/c 40,400
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60,500 60,500
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Dr. Profit and Loss appropriation A/c for the year 31-12-2004 Cr.
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Particulars Rs Particulars Rs
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To Transfer to Reserve fund 10,000 By BalanceB/d 14,000
(Last year’s profit)
To Proposed dividend 20,000 By Current year’s Net profit 40,400
[2,00,000x10/100]
To Balance carried to
Balance sheet 24,400
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54,400 54,400
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2. Consignment Accounts
CONSIGNMENT
Consignment Terminology
1. Consignment A/c. : A consignment account is separately prepared which is
debited with the cost of goods supplied and expenses incurred both by the consignor and
the consignee. It is credited by the sales proceeds and the stock of unsold gods.
Consignment account reveals profit or less on consignment which is transferred to profit
and loss A/c. Goods sent to an agent for the purpose of sale cannot be treated as sales.
The transfer of such goods is credited to Goods sent on Consignment A/c and debited to
Consignment A/c.
2. Account Sales. This is a statement of account prepared and sent by the agent to
the principal. After a certain period of time, the agency (consignee) prepares the account
sales which show the quantity and description of goods sold, sales proceeds realized, the
expenses incurred by consignee, his commission and the balance amount payable by him
to the principal. The account sales is rent to the consignor, who makes entries in
Consignment A/c and consignee’s A/c and ascertains the amount of profit or loss on
consignment. (A specimen of Account sales is given below.)
4. Del Credere Commission. Sometimes the consignor expects that the consignee
should himself recover all the debts and bear the loss, on account of bad debts, if any. In
order to compensate him from this type of loss, some extra commission is paid to him.
This extra commission is called Del Credere commission and is calculated on the total
amount of sales unless there is a special agreement that it is to be paid only on the amount
of credit sales. Payment of this commission imposes extra liability on the consignor and
induces him to deal in a prudent and cautions manner became otherwise loss on account
of bad debts will be borne by him.
6. The Consignee. The consignee does not become the owner of goods on
receiving the consignment. H remains as an agent of the consignor. The law of agency
applies between consignor-consignee relationships. The consignee is to sell the goods
consigned to him. If he has incurred some expenses, such as advertisement, insurance,
godown rent, salesmen’s salaries etc., he can recover them from the amount of sales
proceeds received by him. We can also charge his commission, including del Credere
commission out of the sales proceeds. He is not liable to make payment to the consignor
until the goods are sold. When goods are sold out or after a certain period of time, he
sends an account sales to the consignor giving details of the goods sold, his expenses and
commission and the balance payable by him to the consignor.
1. In a sale, the relationship between the parties is that of a buyer and seller
whereas in a consignment, the relationship is that of an agent and principal.
2. Where a sale is complete, the buyer becomes the debtor of the seller but in a
consignment, the consignee does not become debtor of the consignor on receipt of the
consignment.
3. In case of a sale, the legal ownership and title of goods sold of transferred to the
buyer whereas in a consignment, the legal ownership and title over goods remains with
the consignor.
4. Goods can’t be returned after the sale is complete. But in the case of
consignment, the consignee can return the unsold goods to the consignor.
5. In case of a sale, expenses incurred by the buyer on goods after sale are to be
borne by the buyer himself. But in a consignment, consignee can recover the amount of
expenses incurred by them on the goods consigned.
6. If goods are destroyed after sale, buyer only will suffer the Loss, because he
becomes the owner of goods, after sale. But in case of consignment, risk attached to the
goods is borne by the consignor and not the consignee.
ACCOUNTING TREATMENT
Accounting Treatment. Journal entries in the books of the consignor and the
consignee relating to the transactions of consignment will be made in the manner
discussed below:
1. When goods are sent to the consignee. As consignment of goods can’t be
treated as sales of goods, sales account will not be credited in the books of the consignor.
In its place, an account entitled goods sent on consignment account will be credited.
The following entry will be recorded:
The entry in consignor’s books will be made with the cost of the goods consigned.
If consignments have been sent to more than one consignees, the consignment accounts
may be distinguished by adding the names of the place or the consignees along with the
Consignment A/s, (for example Consignment to Bombay A/c, Consignment to Ramesh
A/c etc.) It may be noted that no entry will be passed by the consignee.
4. On discounting the bill, If consignor gets the bill receivable discounted from his
bankers, the following entry will be recorded in his books:
Consignor’s Books Consignee’s Books
Bank Account Dr. No Entry
Discount Account Dr.
To Bills Receivable Account
The amount of discounts is not debited to Consignment Account.
5. Consignee’s Expenses. Sometimes the consignee also has to incur some
expenses either on the upkeep and maintenance of the goods in safe condition or on their
sale. These expenses may be freight, cartage, godown rent, advertisement, insurance
charges etc. All such expenses are to be borne by the consignor. The following entries
will be recorded in the books in this connection:
6. Goods sold by Consignee: When the goods are sold out or after a certain period
of time, the consignee will send an account sales to the consignor, intimating him the
total sales and the amount of his expenses and commission, with the amount of total
Gross sales, the following entries will be recorded in books of the consignor and the
consignee:
It may be noted that no entry will be recorded in the books of the consignee for
this transaction as he is not required to maintain accounts for goods received on
consignment.
9. Bad Debts: When Del Credere commission is paid. Del Credere commission
is paid to the consignee, if he undertakes to bear the bad debits himself. In case, some
debits are not recorded from consignment debtors, the following entries will be recorded
in the books:
Consignor’s Books Consignee’s Books
No Entry Bad Debts Account Dr.
To Consignment
Debtors Account
11. Unsold stock with the Consignee. It at the end of the accounting period, some
goods remain unsold with the Consignee, the value of such goods be ascertained. The
value is ascertained should be shown in the asset side of the consignor’s balance sheet.
Valuation of stock. The unsold stock with the consignee is to be valued like
ordinary stock. The method of valuation of unsold stock is cost or market price
whichever is lower. Cost price of the unsold stock must included proportionate expenses
incurred by the consignor as well as the consignee relation to the goods sent on
consignment. But consignee’s commission selling expenses, salesmen’s salaries,
advertisement etc. Should be included in such expenses. It may be expressed in simple
terms like this: “All expenses which of incurred up to the point of time; the goods are
received into the godown after consignee should be included in valuation of stock. But
expenses incurred after the goods have been put into consignee’s godown should not be
included in the cost of unsold stock because such expenses usually do not increase the
value of the goods.”
The following expenses, which are of non-recurring nature, should be
proportionately added to the value of the unsold stock:
Carriage,
Freight,
Custom Duty,
Loading and unloading charges,
Insurance,
Dock Charges,
Import duty,
Normal loss etc,
The Following expenses, which are of recurring nature, should not be included in
the value of the unsold stock:
Advertisement,
Godown Rent,
Godown Insurance,
Selling expenses,
Travelling expenses of Salesmen,
Free Samples,
Abnormal loss etc.
The following entry is passed to record the value of unsold stocks:
Consignor’s Books Consignee’s Books
Consignment Stock Account Dr.
To Consignment Account No Entry.
12. Normal loss of goods.: In consignment business, Normal loss of goods is that
part of loss which is unavoidable. Normal loss occurs because of some inherent, natural
or unavoidable reasons. Examples of normal loss are: loss of coal in loading and
unloading, loss of spirit or petrol due to evaporation, loss of timber in cutting it into
pieces and so on. Suppose 100 tons of atta at the rate of Rs. 80 per ton was consigned to
the consignee who received 95 tons of coal and the remaining 5 tons of atta was wasted
in loading and unloading. It can legitimately be said that the cost of 95 tons of atta is Rs.
7600 (95 Tons X Rs.80 per ton). Loss of normal type should be apportioned on the
amount of unsold stock in the proportion of the above example,if 10 tons of atta was left
unsold with the consignee, it will be valued like this:
13. Abnormal loss of goods. Abnormal loss is that loss which could have been
avoided. It occurs because of negligence, carelessness, theft, mischief fraud of
employees or inefficiency. Examples of abnormal loss are destruction of goods by fire
theft, breakage, leakage, loss of goods because of mishandling etc. Loss of this nature is
to be treated separately. It is not to be apportioned on the amount of unsold stock. The
cost of goods lost because of abnormal or avoidable reasons is ascertained din the same
manner as cost of unsold stocks is ascertained. This value is debited to abnormal loss
account and credited to consignment Account. The following entry is passed to record
abnormal loss of goods:
Consignor’s Books Consignee’s Books
Abnormal Loss Account Dr. No Entry
To Consignment Account
It is to be noted here that abnormal loss account is finally closed by debiting the
balance of this account to the profit and loss account after giving credit for any amount
received from the insurance company.
17. Closing Entry for Goods sent on Consignment Account. When the goods
have been sold out by the consignee, they can be treated as sales and may be credited
either to Purchases account or trading account at the end of the period. The entry to close
goods sent on consignment account is given below:
Consignment Account
A Consignment account is prepared by the consignor of goods to the consignee, All
transactions such as cost of goods supplied, expense incurred by consignor or consignee,
consignee’s commission, sales, unsold stock, profit or loss on consignment are to be
recorded through this account. This account presents a summary of the transactions that
have taken place between the consignor and the consignee. The consignment account
reveals profit or loss on consignment and is thus a mini trading and profit and losses
account Consignment account is a nominal account. Therefore the following items are
debited to this account:
1. Sales proceeds.
Consignment Account
Consignment to ………………….Account
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Date Particular Amount Date Particulars Amount
Rs. Rs.
To Goods sent on Consignment A/c” By Consignee(Sales Proceeds)”
!! Cash (Expenses Incurred by consignor)” !! Goods sent on Consignment
!! Consignee (consignee’s Expenses)” (Returns of goods by consignee)”
!! Consignee (Commission)” !! Abnormal Loss A/c”
!! Consignee (Bad Debts)” Profit & !! Consignment Stock A/c
(unsold
Loss A/c ( Profit on consignment stock) (By Profit & Loss A/c)
transferred to Profit & Loss A/c) (Loss on consignment, if any,
transferred to Profit & Loss
A/c)
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METHODS OF ACCOUNTING
There are three different method of preparing accounts relating the consignment of
goods.
These are:
1. Cost Price Method
2. Invoice Price Method
3. Memorandum Columns Method
1. Cost Price Method: Under this Method entries relating to consignment in the
books of consignor or passed with the actual cost of goods and amount spent or expenses
incurred by him. The journal entries already mentioned in a previous question will be
passed in the books of consigner under this method.
2. Invoice Price Method (When consigned goods are invoiced at higher than
actual cost price). Sometimes the consigner sends a Performa invoice to the consignee.
In a Performa invoice goods are generally priced at higher than actual cost say cost plus
20 percent. This may be done with any of the following objective.
If the goods are invoiced at cost plus 10per cent and the cost of goods is Rs. 20,000,
these will be invoiced at Rs.22,000 in the Performa invoice. A difference of Rs. 2,000
will then arise in the books of accounts. In order to nullify the effect of such difference,
some entries are passed by the consignor in his books of accounts.
2. Recording the difference of invoice & cost price. In order to nullify the
difference of Rs.2,000 between invoice and cost price, the following entry is recorded by
the consignor in his books of accounts:
The effect of this entry is to show the actual cost of goods consigned in the
consignment account so that profit or loss on consignment can be properly calculatedly.
This entry is in one sense an adjusting entry which adjusts both the consignment account
and the goods sent on consignment account. Goods sent on consignment account are to
be transferred to the trading account at the end of the year. Therefore unless this account
is adjusted, trading account will not show correct figures of profit or loss.
3. Unsold Stock. The unsold amount of stock in the hands of the consignee is to be
valued at invoice price plus the proportionate share of expenses includable in the value of
goods. For example, if in the above example, 25% goods are buying unsold and
proportionate expenses on these 25% goods are Rs. 300, the amount of unsold stock will
be calculated as under:
The following entry will be passed to record this value of unsold stock:
4. Recording the difference of invoice and cost price of unsold stock. The value
of closing stock must be ascertained by the consignor at cost or Market value whichever
is lower, But the value of closing stock, recorded above does not conform to this
principle. In the above example, the cost of 25% unsold stock is Rs. 5,000 (25% of
Rs.20,000) but the invoice price of 25% unsold stock is Rs. 5,500 (25% of Rs.22,000),
the difference of Rs.500 in the valuation of closing stock has got to be adjusted by
passing the following entry:
This entry will be adjusting the excess of invoice price over cost price of unsold
stock. Consignment stock suspense is deducted from consignment stock account to
ascertain the cost of unsold stock with the consignee.
Illustration:
(i) The firm of Delta & Co., Of Delhi consigned to Premier & Co. of Rangoon 50
cases of Piece goods valued at Rs. 350 each.
(ii) The consignors paid freight and insurance thereon Rs. 1800,
(iii) They received as an advance from Premier & Co Rs. 8000.
(iv) Received an Account Sales from Premier & Co. giving particulars as under:
Gross proceeds Rs. 28000, expenses of Warehousing, Carriage, Dock Dues, etc,
Incurred by them amounted to Rs. 900. and their commission to Rs. 1000.
(v) Received a Bank Demand Draft of the balance due by them on the consignment.
From the above particular, prepare the necessary Ledger Accounts in the books of
the Consignors and those of the Consignees.
Solution
In the Books of Delta&Co.,
Consignment Account
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Rs. Rs.
To Goods sent on consignment a/c 17,500 By Premier & Co. 28,000
To Cash A/c (Freight and Insurance) 1,800
To Premier & Co. (Exp.) 900
To Premier & Co. (Com.) 1,000
To Profit and loss A/c 6,800
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28,000 28,000
Rs. Rs.
To Cash (Advance) 8,000 By Cash (Sales) A/c 28,000
To Cash (Expenses) 900
To Commission 1,000
To Bank 18,100
28,000 28,000
1. Two or more persons. None can be a partner with himself. There must be at
least two or more persons to form a partnership. The term person does not include firms
and joint stock companies and as such only partners on firms or members of joint stock
companies can enter into a Partnership agreement provided the number of partners
remains within statutory limit. The maximum number is ten in case of banking firms and
twenty in all other business.
2. Agreement. Partnership arises out of an agreement only. It does not arise out of
status or by operation of law. There must be an agreement among the partners of the firm.
3. Business. Partners must carry some lawful business and not for any other
purpose. Business includes any trade, occupation and profession.
4. Profit Motive and Sharing of Profits. Partners must enter into partnership
agreement with a motive to earn and distribute among themselves profits of a business in
an agreed ratio. Clubs, building societies or any other associations, religious or charitable
are not partnerships as there is no motive to earn profit. Agreement to share profit inplies
agreement to share losses also.
3. Admission. No new partner can be introduced in the partnership save with the
unanimous consent of all partners.
4. Death of a partner. Death of a partner will bring about the dissoulution of the
partnership unless the partnership agreement provides otherwise.
6. Registration. Registration of the partnership is not compulsory but the law has
indirectly made registration compulsory because an unregistered firm suffers from many
disabilities
like :-
(a) A partner of an unregistered firm cannot file a suit against the firm or any
partner thereof for the purpose of enforcing a right arising from contact or right conferred
by the Partnership Act.
(b) No suit can be filed on behalf of an unregistered firm against any third party for
the purpose of enforcing a right arising from a contract.
(c) An unregistered firm cannot claim a set off in a suit against the firm by a third
party to enforce a right arising from a contract (where the claim of set off is above Rs.
100).
7. The rights and liabilities of the partners are governed by the Indian Partners Act,
1932.
8. Firm and firm name. Persons who have entered into partnership with one
another are called individually partners and collectively a firm and the name under which
the business is carried on is called the firm name.
1. Partners are entitled to share profits equally, and must likewise bear losses
equally irrespective of the amount of their respective capital accounts unless agreed
otherwise.
3. Partners who advance loan to the partnership firm over and above the amount of
capital contributed by them are entitled to charge interest thereon, at the rate of 6 percent
per year, unless otherwise agreed.
5. Generally, an outgoing partner is entitled to have his proper share of the net
assets (i.e.,) asset less liabilities), including goodwill, as they exist at the date of his
retirement, quite apart from their book values.
Partnership Deed
According to the definition of partnership under the Indian Partnership Act, there
must be an agreement between the partners of a partnership firm. The agreement may be
express or implied. It may be a written or oral agreement. In most of the cases, these
agreements are drawn up in writing. These written agreements are called by various
names such as partnership deed, partnership agreement, constitution of partnership or
Articles of partnership etc. The exact terms of the partnership deed (or agreement) will
depend upon circumstances but, generally partnership deeds contain the following points
:
1. The name of the firm and business to be carried on under that name.
2. Address (s) of business place (s)
3. Nature and scope of the Business.
4. Commencement and duration of partnership.
5. The capital and the contribution made by each partner.6. Provision for further
capital and loans by partners to the firm.
7. Partner’s Drawings.
8. Interest on capital, loans, drawings and current account.
9. Salaries, commission and remuneration to partners.
10. Profit )or loss) sharing ratio of partners.
11. The keeping of proper books of accounts, inspection and audit, Bank
Accounts and its operation
12. The accounting period and the date on which final accounts are to be
prepared.
13. Rights, power and duties of partners.
14. Whether, and in what circumstances, notice of retirement or dissolution can
be given by a partner.
15. Provision that death or retirement of a partner will not bring about dissolution
of partnership.
16. Valuation of goodwill on retirement, death dissolution etc.
17. The method of valuation of assets (and liabilities) on retirement or death of
any partner.
18. Provision for expulsion of a partner.
19. Provision regarding the allocation of business activities to be performed by
individual partners.
20. The arbitration clause for the settlement of disputes.
It may be noted that the exact terms of the partnership deed will a depend upon the
circumstances of each case.
1. Every partner is entitled to take active part in the management of the business.
2. Every partner has an inherent right to be consulted in all matters affecting the
partnership.
3. Every partner has a right to have access to the accounts of the firm and he can
have a copy of the books of the firm.
4. Every partner is entitled to share profits equally with other partners unless
otherwise agreed.
6. Every partner has a right to use for the dissolution of the firm.
7. Every partner has a right to be indemnified by the firm in respect of payments
made and liabilities incurred by him (a) in the conduct of the business and (b) in doing
such act in an emergency for the purpose of protecting the firm from loss, as would be
done by a person of ordinary prudence in his own case, under similar circumstances.
(c) where the partnership is at will, by giving a notice in writing to all partners of
his intention to retire.
Obligations :
1. Every partner is bound to act honestly, faithfully and diligently for the greatest
common advantage of the firm’s business.
2. Every partner is bound to render true, proper and correct accounts of partnership
and allow other partners to inspect and copy them.
3. If due to negligence or fraud of a partner, the firm suffers losses, the partner
responsible for such acts shall make good the loss.
4. Every partner is bound to use the property of the business for the purpose of the
business only.
6. Every partner is under an obligation to account for private profits made by him
from any use of partnership property, name of business connection.
7. Every partner is bound not to carry on competing business to the firm, during his
stay in the partnership firm.
8. Every partner must act within the scope of his authority and where he exceeds,
he must compensate other partners for any loss unless such act is ratified.
9. Every partner is liable severally and jointly with all other partners, for all acts of
the firm done while he is a partner.
Kinds of Partners :
2. Active Partners. Those partners who take active part in the management of the
business are known as active partners.
3. Sleeping Partners. Partners who though subscribe their share of capital but do
not take active part in the management of the business are called as sleeping partners.
6. Partners by Estoppel. Some persons, though not partners, mislead other persons
by saying that they are partners in a certain firm. Such persons are known as partners by
estoppel. They are liable to third parties for their acts done in inducement of the
statements given by such person.
7.Sub-Partner. Where a partner agrees to share his profits derived from a firm with
a third person that third person is known as a sub-partner. He is not connected with the
firm is any way and has no right or obligations towards the firm.
Goodwill
The Goodwill of a business is the advantage which a person gets by continuing to
carry on, and being entitled to represent to the outside world that he is carrying on a
business, which has been carried on for some time in the past.
Goodwill is a thing very easy to describe, very difficult to define. (It is the benefit
and advantage of the good name. reputation and connection of a business). It is the
attractive force which brings in customers to the business. It is the one thing which
distinguishes an old established business from a new business at the first start. Goodwill
is composed of a variety of elements. It differs in its composition in different trades and
in different business in the same trade.
We may describe Goodwill as an intangible asset arising out of super profit earning
capacity of a concern. The existence of Goodwill of a firm distinguishes the same from
others. If a firm being situated in a comparable position with others and doing the same
nature of trade earns extra profit, then there is some factor favorable in the firm for
bringing more and more customers to that particular firm. In economic sense, marginal
firms have no goodwill but super marginal (above marginal) firms enjoy goodwill upto
the value they are away from marginal firm.
But Goodwill, in the sense of attracting customers, has little significance unless it is
valuable in the sense of having a saleable value.
The Goodwill possessed by a firm may be due to the following elements of the
business :
If there was a loss in the 2nd year of Rs. 15,000 then Goodwill would have been
Rs. 42,000
2. Super Profit Basis. The super profits of a business are the profits which can be
expected in the future over and above those necessary to pay a fair return upon the
capital invested in the business, having regard to the risk involved in that particular
business and a fair remuneration for the services of the partners who work thereon.
Super Profits-Net Profits-(Normal rate of Int. on Cap.
+ Reasonable Salary to Partners)
Super profits multiplied by the number of years purchase agreed upon gives
goodwill.
thus
Goodwill = Super Profits x No. of years purchase.
Illustration
Suppose Annual profits expected is Rs. 10,000 Profits 10,000
Average Capital employed Rs. 50,000 Interest 5,000
Expected Interest rate on Cap. 10% -Remuneration 2,500
______
Remuneration to Purchase Rs. 2,500 Super Profits 2,500
(i) When capitals are unequal but profit sharing ratios are equal.
(ii) When capitals are unequal and profit sharing ratios are also unequal.
Interest on capital in the above instances reduces the inequalities in the distribution
of profits amount the partners. The following journal entries are recorded for interest on
capital.
1. When interest is allowed.
Interest Account Dr.
To Capital Account
2. When interest account is closed at the end of the year.
Profit and loss Account Dr.
To Interest Account.
(ii) Interest on Drawngs. Just like interest is allowed on capitals, partners may
decide to charge interest on drawings also. Interest charged on drawings in an item of
income and is credited to the profit and loss account. The amount of interest thus adds to
the profits of the business which is further distributed among the partners. The following
entries are passed for interest on drawings.
In the above example, the entire amount of Goodwill (Rs. 4,000) will be taken by A
and B will get nothing as he is not sacrificing anything out of his share of firm’s profits.
Distribution of Goodwill
A B C
Old Profit Sharing Ratio 1/2 1/2
New Profit Sharing Ratio 2/5 2/5 : 1/5
Profit Sacrificing Ratio (1/2-2/5) (1/2-2/5)
= 1/10 1/10
2ND METHOD :
Alternatively, the entries may be made as under :
1. Revaluation Account Dr.
To Liabilities
To Assets
(For Increased Liabilities and Decreased Assets Transferred to Revaluation
Account)
2. Liabilities Dr.
Assets Dr.
To Revaluation Account
(For Decreased Liabilities and Increased Assets Transferred to Revaluation
Account)
3RD METHOD :
When the new firm desires to keep the book values of assets and liabilities
unchanged in the books, the following steps will be taken to record the adjustments in
their values.
2. The difference in the totals of debits and credits is then transferred to the old
partners caital accounts in the old profit sharing ratio.
3. The items (adjustments in the book values of assets and liabilities) are again
recorded in the memorandum revaluation account but on the opposite sides.
The system mentioned above is illustrated with the help of imaginary figures as
given on next page.
A B C A B C
In the first case, the total capital of the firm is calculated on the basis of capital
contributed by new partner and share of profit allowed to him. For example if C is
admitted to a partnership firm of A and B, and brings in Rs. 10,000 as his capital and is
given 1/3rd share in the firm, the total capital of the firm (A, B and C) would be Rs.
30,000. The old partners capitals will be adjusted accordingly. Thus if in this example A
and B were equal partners having capital balances of Rs. 11,000 and Rs. 8,000
respectively and are again equal partners with C, their capital accounts will be adjusted to
show balances Rs. 10,000 in each account, thereby making payment of Rs. 18,000 to A
and receiving a sum of Rs, 2,000 from B.
In the second case, the amount of capital contribution may be calculated by taking
the profit proportion and deducting fro the denominator the figure of the numerator e.g.
one fourth becoming one third, one sixth becoming one fifth, two sevenths becoming two
fifths and so on. This fraction will be multiplied to the total capitals of the old partners
(aftef making all adjustments regarding revaluation of assets and liabilities, profits,
reserves, losses etd.) so as to give the amount of capital, the new partner may be asked to
bring in.
In the above example, if the adjusted capitals of A and B shows balancel of Rs.
14,000 and Rs. 11,000 respectively and C is given one third share, capitals contribution
by C will be calculated as under.
= X (14,000+11,000)
1. Treatment of Goodwill
2. Revaluation of assets and liabilities.
3. Distribution of accumulated reserves, Profits or losses.
4. Adjustments in capitals and profit sharing ratio of the remaining partners.
5. Payment of the dues to the outgoing partner.
To a large extent, these problems are similar to those arising at the admission of a
new partner. A detailed discussion of each one of these is given belwo.
1. When Goodwill is raised with the share of retiring partner and is allowed to
appear in the books.
In such a case the following entry will be made in the books of accounts.
It may be noted that Goodwill is written off in the gaining ratio of the remaining
partners.
3. When Goodwill is raised at full value and is allowed to appear in the books.
Goodwill Account Dr.
To All Partnor’s Capital Accounts.
The above case, capital accounts of all partners (including the retiring partner) will
be credited in the profit sharing ratio.
[Note : In the first entry, Goodwill is credited to the capital accounts of all partners
(including the retiring partner) in their profit sharing ratio before retirement. In the
second entry, capital accounts of only the remaining partners are to be debited in their
new profit sharing ratio).
But if the book values of the assets and liabilities are not to be altered, a
memorandum revaluation account will be opened. The profit or loss of the first part of
this account is transferred to the capital accounts of all the partners including the retiring
partner) but the profit or loss of the second part is transferred to the capital accounts of
only the remaining partners in their new profit sharing ratio.
If previous losses appear in the balance sheet, the above entry will be reversed.
2. Only the share of retiring partner in the undistributed profits and/or reserves is
calculated and the amount is credited to his capital account, thereby reducing the balance
of undistributed reserves, profits or losses. The following entry will be made.
If previous losses appear in the books, the above entry will be reversed.
For example if A, B and C were sharing profits in the ratio 2:1:1 and C retires. A
and B will now be sharing profits in the ratio of 2:1.
But if new ratios for the remaining partners are given, the gaining ratio can be
calculated by deducting the old ratio from the new ratio. Calculation of gaining ratio is
important as the amount of Goodwill payable to retiring partner will be shared by the
remaining partners in their ratios.
Further, the capital accounts of the remaining partners may be adjusted according to
their new profit sharing ratio and any excess of capital may be paid or shortage demanded
from the partners.
5. Payment of the dues to the Retiring Partner. The total amount payable to the
retiring partner is calculated and paid to him in any of the following manners :
1. In lump sum or
2. In annual Instalments or
3. In the form of Annuities.
The following entries are made to recored the transaction of payments in the firm’s
books.
1. When a lump sum payment is made. In such a case, retiring partner’s capital
account is closed by making the following entry :
Retiring Partner’s capital Account Dr.
To Cash Account
It may be noted that the balance of the Retiring Partner’s loan Account is shown on
the liabilities side of the Balance Sheet till the last instalment is paid to him.
3. When payment is made in the form of Annuities. Under this method an annual
payment is made to the retiring partner in lieu of his capital in the firm. The balance due
to the retiring partner is transferred to Annuity Suspense Account and the entries for
interest and payment are made out of this account. Balance of this account is shown on
the liabilities side till exhausted. An important point to note here is that annuities are paid
to the retired partner every year irrespective of the fact that the balance in the account has
exhausted or not. If the retiring partner dies and any balance is left in Annuity Suspense
Account, it is treated as a profit and transferred to partner’s capital accounts in their profit
sharing ratio. However, if the retiring partner lives even after the exhaustion of the
balance of Annuity Suspense Account the payment will be treated as loss and will be
debited to the profit and loss account every year.
(d) If retired partner dies and any balance is left in Annuity Suspense Account
Annuity Suspense Account Dr.
To Partner’s Capital Accounts
(e) If Annuity Suspense Account has been exhausted and payment is made.
(i) Profit and oss Account Dr.
To Annuity Suspense Account
DEATH OF A PARTNER
Accounting problems arising on the death of a partner in the partnership firm are
similar to those arising in the case of retirement. These problems are to be dealt with in a
manner exactly similar to that followed in the case of retirement of a partner. However,
the following points may be noted :
1. Death of a partner may occur at any time during the accounting period. If a
partner dies after the last date of an accounting year, it becomes necessary to calculate his
share for that period in respect of the following :
(2) The total amount due to the deceased partner is to be transferred to his
Executor’s Account (Account of his legal representatives). The amount to transferred will
include the following:
If a partner dies during the course of an accounting year, he will be entitled in the
ordinary way to his share of Profit to the dae of death. This may be ascertained in any of
the following manners, subject of course to the terms of the partnership agreement :
Time Basis. Under the method, the amount of the share of profits of the deceased
partner is calculated on the basis of time elapsed from the last Balance Sheet. Thus, if it is
to base on last year’s profits the following formula may be used :
For example, if last year’s profits were Rs. 15,000 and C, the deceased partner
enjoys one-third share out of profits and he dies 73 days after the date of last balance
sheet, his (c’s) share of profit for the period (73 days) will be computed as under :
C’s capital account is to be credited by Rs. 1,000 as his share of profit upto the date
of his death.
Turnover Basis. Under thismethod, Profit is calculated on the basis of sales upto
the date of his death and the figure of last year’s sales. The following formula may be
used.
For example if last year’s sales figure was Rs. 3 lacs, Profits Rs. 30,000 and sales
upto the date of death of C, a one - third partner in the firm amounts to Rs. 60,000 then
c’s share of profit will be calculated as under :
If deceased partner’s share of Profit upto the date of his dealth is calculated on the
basis of last year’s figures, the following entry will be recorded :
Profit and loss suspense Account Dr.
To Deceased Partner’s Capital Accounts
At the end of the accounting period the profit and loss Suspense Account will be
closed by transferring the balance to the debit of profit and Loss Account.
The object behind taking of a joint life policy is generally to avoid under pressure
on the working capital of the business, in the case of death of a partner, when payment is
to be made to his legal representatives. It is also possible that separate policies are taken
on the lives of cash of the partners but the accounting treatment is similar in both the
cases.
Transactions relating to joint life policy are dealt with in three ways. mentioned
below:
(d) When the balance of Joint life Policy Account (which is treated as an income) is
transferred to capital accounts
Joint Life Policy Account Dr.
To All Partner’s Capital Accounts
(c) When Joint Life Policy Account is written down to its surrender value
Joint Life Policy Reserve Account Dr.
To Joint Life Policy Account
(e) On transferring the balance of Joint Life Policy Reserve Account to the Joint
Life Policy Account
Joint Life Policy Reserve Account Dr.
To Joint Life Policy Account
Features of a company
(a) It is a Voluntary Association of persons
(b) It is an artificial person
(c) It enjoys separate legal entity
(d) Liability of its members is limited
(e) It has perpetual succession and common seal
(f) Shares of the company are transferable
(g) Large capital can be mobilised by company
(h) Large Profits are earned
Types of companies
(a) Chartered company : These are the companies which are incorporated under a
special charter granted by the King or Queen. eg. The East India Company.
(b) Statutory Companies : These are the companies which are created by a special
Act of the legislature. eg. Reserve Bank of India, LIC etc.
(c) Registered Companies: These are the companies which are formed and
registered under the companies Act of 1956.
(2) On the Basis of Liability : Companies are classified as-
(3) On the Basis of number of members: Companies are classified as (a) a Private
Company (b) a Public Company.
(4) On the Basis of Control: Companies may be classified into (a) Holdig
companies (b) Subsidiary Companies.
(a) Holding Company : a Company is deemed to be the holding Co. of another if,
but only that other is its subsidiary.
(b) Foreign Company is any company incorporated outside India but which has a
place of business in India.
FORMATION OF A COMPANY
Memorandum of Association:
Articles of Association
Prospectus
A Public Company invites the public to subscribe for its shares or debentures
through issue of a document known as prospectus. The companies Act of 1956 defines
Prospectus as Prospectus, notice, circular, advertisement or other document inviting
offers from the public for the subscription of any shares or debentures of a body
corporate. The main objects of the prospectus are (a) to inform the public about the
forming of a new company (b) to include the investors to invest in its shares &
debentures & (c) to make the directors responsible for the statement in the prospectus.
If the promoters intend to secure capital from their relatives andfriends without
public subscription, they need not issue prospectus but instead can prepare a statement
containing similarinformationfor filing with the Registrar which is known as Statement in
lieu of the prospectus.
Listing of Shares
Entering the shares of a company in the official list of stock exchanges for the
purpose of trading is known as listing of shares. Some of the advantage of listing are (a)
It provides a continuous market for securities (b) It enhances the prestige of the company
and (c) It provides an indirect check against manipulation by the management.
Underwriting Agreement:
The act of ensuring the sale of shares or debentures of a company, even before
offering to the public, is called underwriting and those engaged in such ativities are called
underwriters. The terms and conditions under which the underwriters agree to underwrite
the shares are embodied in a document known as underwriting agreement.
Minimum Subscription
The minimum subscription is the minimum amount of capital which is in the
opinion of the directors, is required to commence business. In case of a public company
the registrar will issue the certificate to commence business only when the amount raised
by alloting shares,is not less than the amount equivalent to the minimum subscription
mentioned in the prospectus.
Share Capital
It is the capital raised by a company by the issue of shares. It can be raised by the
company at the time of its formation and later on for the purpose of meeting the
requriements of its expansion.
Classses of Capital
(b) Issued Capital : It is that part of the authorised or nominal capital which the
company needs for the time being and has been issued to public for subscription. Ex: Out
of Rs. 10,00,000 nominal capital,the company may decide to issue for public subscription
Rs. 8,00,000 divided into 80,000 equity shares at Rs. 10 each.
(c) Subscribed Capital : That part of the issued capital which is subscribed by
thepublic is known as subscribed capital. In other words the amount of the issued capital
which has been taken up by the public is known as subscribed capital. Ex: out of 80,000
equity shares issued for subscription only 70,000 shares may be taken up by the public.
Thus the subscribed capital will be Rs. 7,00,000
(d) Called up Capital : The company often does not need the full amount of its
subscribed capital. In which case it calls up only, part of the amount of the face value of
shares immediately and later makes further calls as necessary. Ex: if the company
decided to call Rs.5 per share out of its nominal value of Rs.10, it is called up capital.
(e) Uncalled capital: The difference between the subscribedcapital and called up
capital is known as uncalled capital.
(f) Paid up Capital: The amount actually paid by the shareholders is known as
paid-up capital.
(g) Reserve Capital: It is that part of the uncalled capital of a company which shall
not be called up except at the time of winding up of the company. The purpose of
creating reserve capital is to protect the interest of creditors and to create public cofidence
in the company.
(h) Fixed Capital: It is that part of the capital which is invested in fixed assets. Eg.
Land and Building, Plant and Machinery.
(i) Working Capital : It is the capital which is used for the purpose of day to day
business of the co. In other words this capital is used again and again Eg. buying raw
materials goods etc.
Shares
Kinds of Shares
Preferences Shares Ordinary/Equity Shares Deferred/ Founders
(a) Cumulative & non Cumulative
(b) Participating & non participating
(c) Redeemable & irredeemable
Preference Shares
Preference shares are those shares which carry preferential rights in respect of
dividend and the return of capital. The rate of divident on the shares is fixed & the
dividend must be paid to them before paying any dividend on other shares. They provide
long term and medium term finance.
(c) Participating Preference Share: These shares have the right to participate in
dividends if there is any balance after paying dividendon equity shares at a certain rate.
(d) Non Participating Share: These shares do not have the right to participate in
dividends if there is any balance after paying dividend on equity shares.
Equity Shares:
Equity Shares or Ordinary Shares are not preference shares. They receive dividend
only after preference dividends are paid. They enjoy voting rights. Equity shares have the
chance of receiving high dividend. They participate in the management. They are not
subject to redemption during the life time of the company. It is also called as risk capital
of the company. They provide only long term finance.
Only private companies are allowed to issue deffered shares. These shares are held
by the promoters. They enjoy differential voting rights and enable the promoters to have
control over the company.
Issue of Shares: The company may issue shares (a) at par, (b) at premium or (c) at
discount. If the shares are issued at the face value, it is known as issue at par.
Ex. Face value is Rs.100 per share issued at Rs. 100. If the shares are issued at
more than the face value, it is known as issue at premium, Ex: face value is 100 per share
issued at 110, Rs.10 is premium. If the shares are issued at less than face value, it is
known as issue at discount. Ex. Face value being Rs. 100, issued at Rs. 90, Rs. 10 is
discount.
Allotment of shares
Methods of allotment
The company may receive the amount on shares allotted ininstalments. It may be
received at different stages like Application, Allotment etc., The instalment amount
payable on application is called application money. The instalment amount payable on
allotment of share is called allotment money and the instalment amount payable on
demand in future is called calls on shares.
Calls in arrears : The amount of call money not paid by the shareholder by due
date is called call-in-arrears. Such calls are subject to a charge of interest at 6% p.a.
Calls in Advance : Payment of money on the shares by the share holders before the
call is made is known as call in advance. Such amount is entitled to get 6% p.a. interest.
Forfeiture of shares :
(2) In case of surrender, the company may exempt the holder from paying the
outstanding call amount and interest & return a part of te amount already paid on the
shares. But no such concession is allowed in case of forfeiture of shares.
Lien on shares :
Lien is the right of a person to retain some property of another person until the
claims of the person is possession of the property are satisfied. The company may
exercise a right of lien on shares of a shareholder who has failed to pay his debts to the
company.
(a) Lien is a right to retain the possession of shares till due amount is paid where as
forteiture is a right to cancell the shares for no-payment of call amount.
(b) Lien does not be lead to reduction in capital but forfeiture may lead to reduction
in capital.
Capital Reserve : The balance remaining in the forfeited shares account after re-
issue is transferred to an account known as capital reserve. The balance in this account
canot be used for any other purpose, other than for issue of Bouns shares.
Sometimes shares are issued at premium and the premium amount is received at
allotment stage. In such a case, the following jurnial entry is passed.
Sometimes shares are issued at discount and the discount amount is adjusted in
allotment stage. In such a case, the following jurnial entry is passed.
Illustration-1
Red Star Ltd. invited Application for 10,000 shares of Rs. 10 each payble Rs. 2/- on
application, Rs. 3/- on allotment, Rs. 2/- on 1st call & Rs. 3/- on second & final call.
12,000 Applications are received. The directors rejected 2000 applications and accepted
the remaining applications. All the calls were made & all the shares were fully paid up.
Give journal entries & prepare ledger a/cs.
Solution - 1
Journal Entries
------------------------------------------------------------------------------------------------------------
Particulars L/F Debit Credit
Rs. Rs.
(1) Bank a/c..............Dr, 24,000
To Share Application a/c 24,000
(Being application amount received on
12,000 shares at Rs. 2/-
---------------------------------------------------------------------------------------------------------
24,000 24,000
---------------------------------------------------------------------------------------------------------
Dr Bank a/c Cr
To Pref. Share application 20,000 By Pref. Share 4,000
To Pref. Share Allotment 14,000 By Balance c/d 94,750
To Pref. Share 1st call 33,250
To Pref. share Final call 31,500
98,750 98,750
Illustration - 3
The Bharat Co. Ltd. issued 1,00,000 equity shares of Rs. 10 each payable Rs. 2 on
application, Rs. 3/- on allotment Rs. 3 on 1st call & Rs. 2 on final call. Application were
received for 80,000 shares which were fully alloted & allotment money received on
75,000 shares. When the 1st call was made, the amount was received in full along with
balance of allotment money.
Solution -3
Journal Entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 1,60,000
To Equity share application a/c (Being application amount 1,60,000
received on 80,000 shares at Rs.2 each)
2. Equity share application a/c.........Dr 1,60,000
To equity share capital a/c 1,60,000
(Being application money transferredto share capital a/c)
3. Equity share allotment a/c............Dr 2,40,000
To equity share capital a/c (Being allotment amound due 2,40,000
on 80,000 shares at Rs. 3 each)
4. Bank a/c.................Dr 2,25,000
To Equity Share allotment a/c (Being allotment money on 2,25,000
75,000 shares at Rs. 3 each)
5. Equity share 1st call a/c..........Dr 2,40,000
To Equity share capital a/c (Being 1st call & final call money 2,40,000
due on 80,000 shares at Rs. 2 each)
6. Bank a/c.............Dr 4,15,000
To Equity Share 1st call a/c 2,40,000
To Calls in Advance a/c 1,60,000
To Equity share allotment a/c 15,000
(Being 1st call money & final call money received on
80,000 shares at 2 each and allotment money received
on Balance of 5,000 shares at Rs. 3 each)
ACCOUNTING FOR DEBENTURES:
Issue of Debenture
Classes of Debentures
(1) On the basis of title & transfarability- Debentures can be Register Debenture
& Bearer Debentures.
In case of Registered debentures, the names of the debentures holders are entered in
the books of the company & for transfring them regular transfer deed has to be prepared.
In case of Bearer Debentures the names of the holders of bearer debentures are not
registered in the books of the company and therefore, for transfering them , there is no
need for preparing transfer deed. They can be transferred by mere delivery.
Simple/ naked/ unsecured debenturesare issued with merely a promise to pay the
holder interrest and alos to repay the principal without any charge on any assets of the
company.
Secured / morgage debentures are issued with charge on the company’s assets as
security.
In case of Redeemable debentures, the company reserves the right of off the
principal on or after a specified date.
In case of irredeemable debentures the company reserves the right not of on the
principal as long as the company is a going concern & does not make default in the
payment of interest.
convertable debentures are convertable into shares at the option of the holders after
a special period.
Issue of debentures
A public Company can issue debentures only after getting the certificate of
commencement of business but a private company can issue debentures immediately
after incorporation.The articles usually empower the board of directors to issue
debentures.
Illustration - 1
ABC Co. issued 10,000 debentures of Rs. 100/- each at a discount of 10% payable
Rs. 20 on application, Rs.20/- on allotment and Balance on first and final call. Pass the
necessary journal entries.
Journal entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 2,00,000
To Debenture Application a/c (Being application amount 2,00,000
received on 10,000 shares at Rs.20/- each)
2. Debentures application a/c.........Dr 2,00,000
To Debentures a/c 2,00,000
(Being application money transferredto Debentures a/c)
3. Debenture allotment a/c............Dr 2,00,000
Discount on debentures a/c..........Dr. 1,00,000
To Debenture a/c (Being allotment amound due 3,00,000
on 10,000 debentureincluding discount)
4. Bank a/c.................Dr 2,00,000
To Debenture allotment a/c 2,00,000
(Being Debenture allotment money received)
5. Debenture 1st & final call a/c........ 5,00,000
To Debenture a/c (Being 1st & final call money 5,00,000
due on 10,000 debentures at Rs. 50 each)
6. Bank a/c .................Dr 5,00,000
To Debenture 1st & final call a/c 5,00,000
(Being final call money received)
Illustration - 2
Star Ltd. issued 5,000 8% Debenture of Rs. 100/- each at a premium of Rs. 10/-
repayable at the end of 20yrs at Par. The amount was payable as follows: Rs. 10 on
Application, Rs.30 on Allotment (including Premium) Rs.30 on 1st Call & Rs.40 on final
call. Pass the necessary Journal Entries
Journal entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 50,000
To Debenture Application a/c (Being application amount 50,000
received on 5,000 shares at Rs.10/-per share)
2. Debentures application a/c.........Dr 50,000
ToDebentures a/c (Being application money transferred) 50,000
3. Debenture allotment a/c............Dr 1,50,000
To Debenture a/c 1,00,000
To Debenture premium a/c (Being allotment amound due 50,000
on 5,000 debenture at Rs.30/- per debenture)
4. Bank a/c.................Dr 1,50,000
To Debenture allotment a/c 1,50,000
(Being Debenture allotment money received)
5. Debenture 1st call a/c..........Dr 1,50,000
To Debenture a/c 1,50,000
(Being 1st call money due on 5,000 debentures at Rs. 30 each)
6. Bank a/c...................Dr 1,50,000
To Debenture 1st call a/c (Being 1st call money received 1,50,000
on 5,000 debenture at Rs.40 each)
7. Debenture Final call a/c............Dr 2,00,000
To Debenture a/c 2,00,000
(Being final call money due on 5,000 including premium)
8. Bank a/c................Dr 2,00,000
To Debenture final call a/c 2,00,000
(Being final call amount received)
Illustration - 3
AB Ltd. issued 5,000 5%debentures of Rs. 100 each payable Rs. 30 on application,
Rs.30 on allotment & Rs. 40 on final call. 6,000 applications were received & 4,000
applications accepted is full & 500 applications were rejected & remaining debentures
were issued to remaining applicants.
Give the Journal Entries & show Bank a/c & Debentures account
Journal entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 1,80,000
To Debenture Application a/c (Being application amount 1,80,000
received on 6,000 shares at Rs.30/-per share)
2. Debentures application a/c.........Dr 1,50,000
To Debentures a/c (Being application money transferred 1,50,000
to5,000 debentures at Rs.30 each)
3. Debenture Application a/c............Dr 15,000
To Bank a/c (Being refund of application money 15,000
on 500 debentures at Rs. 30 each)
4. Debenture Allotment a/c................Dr 1,50,000
To debenture a/c (Being allotment amount due 1,50,000
on 5,000 debentures at Rs.30 each)
5. Bank a/c............Dr 1,35,000
Debentures application a/c .......Dr 15,000
To Debentures allotment (Being cash on allotment & 1,50,000
adjustment of debenture application received)
6. Debenture final call a/c.............Dr 2,00,000
To Debenturea/c (Being final call amount due on 5,000 2,00,000
debentures at Rs. 40 each)
7. Bank a/c.................Dr 2,00,000
To Debenture final call a/c (Being final call amount received) 2,00,000
Illustration -4
The Hindustan Co. Ltd. issued 10,000 debenture of Rs. 100 each at a premium of
Rs.20 each, payable as follows- Rs. 30 on application, Rs. 50 on allotment including
premium, Rs. 40 on first & final call.
All the debenture were fully subscribed & the money duly received by the Co. Give
Journal Entries to record the above transactions.
Solution - 4
Journal entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 3,00,000
To Debenture Application a/c (Being application amount 3,00,000
received on 10,000 shares at Rs.30/-per share)
2. Debentures application a/c.........Dr 3,00,000
To Debentures a/c 3,00,000
(Being application money transferred to Debentures a/c)
3. Debenture allotment a/c............Dr 5,00,000
To Debenture a/c 3,00,000
To Debenture premium a/c 2,00,000
(Being allotment amound due along with premium)
4. Bank a/c.................Dr 5,00,000
To Debenture allotment a/c (Being Debenture allotment 5,00,000
money received along with premium)
5. Debenture final call a/c................Dr 4,00,000
To Debenture a/c 4,00,000
(Being final call amount due on 10,000 debentures)
6. Bank a/c...................Dr 4,00,000
To Debenture final call a/c 4,00,000
(Being final call amount received)
Illustration - 5
The ‘X’ Co Ltd. issued 1,000 12% Debentures of Rs. 1,000 each at a premium of
Rs. 200 per debenture payable as under; on application Rs. 200, on allotment Rs. 500
(including premium) on final call Rs. 500
All the debentures were fully subscribed called up and paid up. Pass necessary
Journal Entries.
Solution- 5
Journal entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 2,00,000
To Debenture Application a/c (Being application amount 2,00,000
received on 1,000 shares at Rs.200/-)
2. Debentures application a/c.........Dr 2,00,000
To Debentures a/c (Being application amount due) 2,00,000
3. Debenture allotment a/c............Dr 5,00,000
To Debenture a/c 3,00,000
To Debenture premium a/c (Being allotment amound due 2,00,000
on 1,000 debentures along with premium)
4. Bank a/c.................Dr 5,00,000
To Debenture allotment a/c 5,00,000
(Being Debenture allotment money received)
5. Debenture call a/c................Dr 5,00,000
To Debenture a/c (Being final call amount due ) 5,00,000
6. Bank a/c...................Dr 5,00,000
To Debenture final call a/c (Being final call amount received) 5,00,000
Illustration -6
Sriram Co. Ltd. issued 20,000 12% debentures of Rs.100 each at discount of 10%
payable in full on application . Application received for 23,000 debentures. It was alloted
only to the extent of issued & the excess was refunded.
Solution - 6
Journal entries
Particulars L/F Debit Credit
Rs. Rs.
1. Bank a/c...............Dr 20,70,000
To Debenture Application a/c (Being application amount 20,70,000
received on 23,000 debenture at Rs.90/-per share)
2. Debentures application a/c.........Dr 1,80,000
Discount on Debenture a/c..............Dr 20,000
To Debentures a/c (Being Allotment of 20,000 debentur at 20,00,000
Rs.100 each at a discount of Rs. 10 each)
3. Debenture Application a/c.............Dr 2,70,000
To Bank a/c 2,70,000
(Being the excess money on 3,000 Debenture refunded)
Meaning of Ratio :-
Ratios are nothing but one set of figures compared with another set. It explains the
relationship between the two. It is a method to understand the financial position of a
business unit. According to Accountant's Handbook by Wixon, Kell and Bedford, a ratio
"is an expression of the quantitative relationship between two numbers". In simple
language .ratio is one number expressed in terms of another and can be worked out by
dividing one number to the other.
For example, the ratio of two figures 100 and 50 may be expressed in any of the
following ways:
(a) 2:1 (b) 2 (c) 2/1 (d) 2 to 1 (e) 200%
In all these cases the inference is that the first figure is double, 200%, or 2 times than
that of the second.
iii) Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the ratios of
some other firms or the comparison with the ratios of the industry to which the
firm belongs.
Ratios provide clues to the financial position of a concern. These are the points or
indicators of financial strength, soundness, position or weakness of an enterprise. One
can draw conclusions about the exact financial position of a concern with the help of
ratios.
CLASSIFICATION OF RATIOS
Various accounting ratios can be classified as follows:
Balance Sheet Ratio Profit and Loss Account Ratios Composite / Mixed Ratio
OR OR OR
Position Statement Revenue / Income Statement Inter – Statement Ratios
Ratios Ratios
2. Solvency Ratios,
3. Profitability Ratios.
4. Activity Ratios
1.LIQUIDITY RATIOS
These ratios indicates about the financial position of the company. A company is deemed
to be financially sound if it is in a position to carry on its business smoothly and meet all its
obligations – both long term and short term without strains. Thus, the financial position has
to be judged from two angles – long term as well as short term. It is a sound principle of
finance that long term requirements of funds should be met out of long term funds. Short
term requirements shall be met out of sort term funds. For example, if fixed assets are
purchased out of funds provided by bank overdraft, the company will face the problem, when
it has to repay bank overdraft. It cannot sell fixed asset for repaying bank overdraft. The
following are some of the important financial ratios.
1. SHORT TERM LIQUIDITY. The smooth day to day working of the company
depends upon its capacity to pay all its short term obligations. To judge the company’s
capacity to pay all its obligations on time, the following ratios have to be examined.
1) CURRENT RATIO: It is the most important ratio for measuring short term
liquidity. Since it is related to working capital analysis, it is also called working capital ratio.
Current ratio express the relationship between current assets and current liabilities. Current
ratio is the ratio of total current assets to total current liability. It is calculated by dividing
current assets by current liability.
Current ratio = Current assets
Current liability
Current assets are those that can be converted into cash within a very short period. They
include cash in hand, cash at bank, sundry debtors, bills receivable, stock, prepaid expenses,
outstanding income etc.,
Current liabilities are those that are to be paid within a short period of time. They include
sundry creditors, bills payable, bank overdraft, outstanding expenses and any other short term
liabilities.
Illustration 1
The following information are taken from the Balance sheet of a firm.
Rs. Rs.
Creditors 80,000 Cash 1,00,000
Bills Payable 20,000 Debtors 80,000
Bank Overdraft 50,000 Bills Receivable 20,000
Outstanding expenses 25,000 Marketable Securities 80,000
Inventories 60,000
Prepaid Expenses 10,000
Total Current Liability 1,75,000 Total Current Assets 3,50,000
LIQUID RATIO
This ratio is also called as “Acid Test Ratio” or “Quick ratio”. This ratio indicates the
relationship between the liquid assets (assets which are immediately convertible into cash) to
liquid liability. All current assets except stock and prepaid expenses are considered as liquid
assets. All current liability except bank overdraft is known as liquid liability. Normally, the
banker will not demand back he amount of overdraft so long as payment of interest is made
promptly.
Liquid Ratio = Liquid Assets
Liquid Liabilities
On the basis of illustration no. 4.10 the liquid asset will be Rs. 3,50,000-60000 (Stock) –
290000. The liquid liability will be Rs. 175000-50000(bank overdraft) = Rs. 1,25,000.
Therefore, the liquid ratio is
290000 = 2.32:1
125000
The main defect of current ratio is that it fails to distinguish between inventory and
receivables. A firm may have a huge amount of inventory compared to receivables and other
current assets. Then even with a very high current ratio, it may not be in a position to pay its
liabilities in time.
In so far as eliminating inventory is concerned while calculating acid test ratio, it is a
rigorous test of liquidity. It gives a better picture of firm’s ability to meet its short term
obligations. When a business has 1:1 liquid ratio, then the liquidity position of the firm is
supposed to be satisfactory.
A comparison of the current ratio to quick ratio indicates the inventory hold-ups, for
example, if two units have the same current ratio but different liquid ratio, it indicates over
stocking by the firm, which has low liquid ratio.
Absolute liquidity ratio: The superiority of liquid ratio, over the current ratio is on account
of inventory. It may take a longer period to convert inventory into stock. Similarly,
conversion of account receivable into cash may also take longer period and the total amount
may not be received full due to bad and doubtful debts. Therefore, absolute liquidity ratio
relates to the sum of cash and marketable securities to the total quick liabilities. It gives
more meaningful measure of liquidity when used in comparison with current and acid test
ratios. However, this ratio is not much in use.
Long term liquidity: These ratios indicate the long term solvency of the company. Every
trading company has implied power to borrow. This borrowing power is generally limited to
the amount of paid up capital and free reserves. It means, if a company has Rs. 100 paid-up
capital, Rs. 50 reserves i.e. total Rs. 150, then it can borrow up to Rs. 150, 50% may be
short term borrowing and another 50% long term borrowings. This is supposed to be an ideal
borrowing.
2.SOLVENCY RATIOS:
The following are the important ratios that determines the long term solvency of the firm.
1. Debit Equity Ratios. The financing of the total assets of a business is done by owners
equity (also known as internal equity) as well as outside debt (also known as external equity).
How much fund has been provided by the owners and how much by outsiders in the purchase
of total asses is very significance factor in deciding the long term solvency of the firm. In
other words, the relationship between, the sorrowed fund and owners funds is a popular
measure of long term financial solvency of a firm. This relationship is shown by the debt-
equity ratio. This is also known as external-internal equity ratio. This calculated by the
following formula.
Debt equity Ratio = External Equities
Internal Equities
The term external equity includes debentures and other long term loans. Internal equities,
include equity share capital, preference share capital and undistributed profits and reserves.
The following additional formula is used.
i) Debt equity ratio = Total Long term debt
Total long term funds
ii) Debt equity ratio = Share holders funds
Total long term debt
iii) Debt equity ratio = Total long term debt
Share holders funds
= 8,00,000
11,00,000
= 0.73:1
iv) Debt Equity Ratio = Long Term Debt
Share Holders Funds
= 3,00,000
8,00,000
= 0.375:1
The fourth method is very commonly used. A ratio of 0.5:1 is said to be satisfactory.
It indicates the proportion of owner’s stake in the business. Excessive liabilities tend to
cause overstrain on the business. This ratio shows to what extent, the firm depends on
outsider for its survival. Too much dependency is dangerous.
3.PROFITABILITY RATIOS:
It is an indication of the efficiency with which the operations of the business are carried
on. A lower profitability may be the result of under sales or over expenditure. Bankers,
financial institutions and other creditors look at the profitability ratios as an indicator of
the capacity of the firm to pay interest. Owners are interested to know the profitability as
it indicates the return on their investments. Profit is the engine that drives the business
enterprise. It is an index of economic progress. Profits are the test of efficiency and a
measure of control to the management. It is a source of fringe benefits to the employees.
Profit is a measure of tax paying capacity to the government. It is a hint for a price cut to
the customers. Finally the profitability ratios judge the overall efficiency of the business.
Most of the profitability ratios are expressed a percentage on sales. Profitability ratio
may be broadly be classified into two types. A) Those ratios that indicates the
operational efficiency of the business. B) Those ratios that indicate the return on
investment.
The following are the important profitability ratios for judging operational efficiency.
A) Gross Profit Ratios: It is also known as Gross Margin Ratios.
The difference between the cost of goods sold and net sales is known as gross profit. It is
very useful as a test of profitability. It is generally believed that the margin of gross
profit should be sufficient enough to cover all operating expenses and to leave adequate
amount as net sales.
Opening Stock + Purchases + All direct expenses = Cost of goods sold
This amount is deducted from sales + Closing Stock to get the Gross Profit.
D) Operating Profit Ratio: This ratio indicates the operating profit to net
sales. It shows the overall operational efficiency of the firm. Although there is no fixed
standard, 12% to 15% of net sales is supposed to be a reasonable operating profit.
The following are the profitability ratio which indicates the return on investments.
The profitability of the firm is also measured in relation to investments. The term
investment may refer to total assets, capital employed or owner’s equity. The efficiency
of an enterprise has to be judged not only on the profit earned in relation to sales, but also
the profit earned in relation to the total investments made in the business. Investments
are represented by those assets, which are acquired for conducting the business
operations. The size of the investments certainly affects the volume of profits. The
following are the important ratios in this type.
d) Return on Equity share holders Funds: Profitability from the equity share
holders point of view will be judged after taking into account the amount of
dividends payable to preference share holders.
Return on Equity = Net Profit X 100
Equity Share holders funds.
f). Price Earning Ratio: This ratio indicates the number of times the earning per
share is covered by it’s market price. This is calculated by using the following
formula.
Solution:
Proprietary Ratio = Share holders funds
Total Tangible assets
= 14,00,000
18,00,000
= 0.77:1
4.ACTIVITY RATIOS:
These ratios are intended to measure the effectiveness of the employment of resources.
They not only analyse the use of the total resources of the firm but also the use of the
component of the total assets. Activity analysis together with the degree of leverage
employed by the firm is a key factor in determining the profitability.
(Shareholders funds includes preference share capital + Equity Share Capital +Reserves
and Surplus Tangible Assets, All assets excluding goodwill and preliminary expenses)
This ratio focuses the attention on the general financial strength of the business
enterprise. This ratio has particular importance to creditor as it helps them to find out the
proportion of the shareholders funds in the total assets of the company. Higher ratio
indicates the secured position of the creditor. It shows the long term solvency of the firm.
Illustration No. 4
Find out the capital gearing from the following details
Rs.
Equity Share capital 1,00,000
10% Preference Share Capital 50,000
12% Debentures 80,000
15% Long Term Loans 14,000
Current Liabilities 30,000
General Reserve 80,000
Solution:
Capital Gearing Ratio = Fixed Interest and Dividends bearing funds
Equity Share holders funds
= 1,44,000 (Preference shares + Debentures + Long term loans)
1,80,000 (Equity Share capital + Reserves
= 0.8:1
Since, it is less than one, it is low geared.
Illustration No.5
From the following balance sheet of a company, you are required to calculate current
ratio and solvency ratio
Share Capital 5,00,000 Fixed Assets 6,00,000
Fixed Liabilities 2,50,000 Current Assets 4,00,000
Current Liabilities 2,50,000
10,00,000 10,00,000
Solution:
1) Current Ratio = Current Assets
Current Liability
= 4,00,000
2,50,000
= 1.6:1
2) Solvency Ratio = Outsiders Liability X 100
Total Assets
= 5,00,000 X 100
10,00,000
= 50%
Although, the current ratio is slightly less than standard, the solvency ratio is very good.
The Total assets are 200% of outsiders liability. It means, the company is fully capable
of paying all outsiders liability, out of its assets.
Illustration No. 6
The following is the summarised Profit and Loss Account of Progress Ltd., for the
year ended 31.03.2003.
Re-arrange the above statement in a suitable form for proper analysis and calculate
the following ratios.
Meaning of Fund
The term “fund” has a variety of meaning. There are people who believe that
fund is equal to cash; others say that cash and marketable securities constitute the Fund.
In this context, either cash or those that can be converted into cash become fund. Though
there were ambiguities in them beginning, now the “working capital” concept is
commonly accepted for fund. There are further two concepts –‘ Gross working capital’
and ‘Net working capital’. The totals of current assets is called ‘Gross Working Capital’,
where as the total of current assets minus current liability is called’ Net working capital’.
Current Assets:
The term “current assets” includes assets, which are acquired with the intention of
converting them into cash during the normal business operation of the company, with in a
calendar year. The following items are included in current assets in this connection:
a. Cash and Bank balance including fixed deposits with banks.
b. Accounts Receivable i.e. Debtors and bills receivables.
c. Inventory i.e. raw material, work-in-progress, finished goods, stores and
spares.
d. Advances given to various persons including government agencies.
e. Prepaid expenses.
f. Short-term investments and marketable securities.
g. Income earned but not received.
Current Liabilities:
The term ‘current liabilities’ is used for those liabilities, which require to be paid
within a short period, say about a year. In other words, current liabilities refer to those
obligations that are to be paid during the operating cycle of the business with in a
calendar year. The mere fact that the amount is due within a year does not make it current
liability unless it is payable out of existing current assets or creation of additional current
liabilities. For example, debentures due for redemption within a year will not be taken as
current liabilities, if they are to be paid out of the proceeds of fresh issue of
shares/debentures or out of the proceeds of the sale of debenture redemption fund
investments. The following items are included in current liabilities.
Non-Current Assets
All assets other than current assets specified as above are termed as ‘non current
assets’. Such assets include Fixed Assets like Good will, Land, Building, Machinery,
Furniture, Patents, Trade Mark, Debit balance of Profit and Loss account, Discount on
issue of shares and Debentures, Preliminary expenses etc.,
Non-Current Liability
All liabilities, other than current liabilities are called as non-current liabilities.
They include Long Term Liabilities like Share capital, Long term loans, Debentures,
Share Premium, Revenue reserves, Capital reserves, Credit balance of Profit and Loss
account, any other undistributed profit in any form (like debenture redemption fund,
dividend equalization fund etc.,)
a) Provision for taxation: There is a debate regarding the treatment of this item. Some
accountants are treating it as current liability and others non-current liability. It may
either be treated as a current liability or as a non-current liability. If it is treated as a
current liability, then it is taken to the schedule of charges in working capital. Then
payment of tax is not regarded as “application of fund”. Tax provision is not debited to
adjusted profit and loss account. When provision for tax is treated as a current liability,
for creating tax provision, profit and loss account is debited and provision for tax account
is credited (which is a current liability). In this case, when tax is paid, there is no change
in working capital as there is a reduction in one current liability with a corresponding
reduction in one current asset. However, there is a clear difference between provision
and liability. The amount set aside for a likely payment, which may or may not be paid
during the accounting cycle is a provision, where as the amount to be paid within the next
accounting cycle is a current liability. In this context, taxation provision is to be treated
as ‘non current liability’. Then the provision for taxation is debited to adjusted profit and
loss account and the amount of tax paid is treated as “application of fund”. This is a
stronger view, which is more commonly accepted.
b) Proposed Dividend
Whatever, has been said about “taxation provision” is applicable for “proposed
dividends” also. It can also be dealt in two ways.
Flow of fund means, the change in the amount of fund. When there is a business
transaction, there is a flow of fund i.e. either there may be inflow of fund or outflow of
fund. When there is inflow of fund, it is considered as a source of fund. When there is
outflow of fund, it is shown as application of fund. Therefore, a fund flow statement is a
statement of sources and uses of fund. In other words it is a statement, which shows how
the net working capital is obtained and how it is used.
Fund flow statement is very useful tool for the financial managers. The following
are the uses of fund flow statement for different parties.
Hints:
1) The above schedule is prepared with the help of current assets and current
liabilities given with in the two years balance sheet.
2) Additional information given outside the balance sheet has no effect on the above
statement.
3) Increase in current asset or decrease in current liability increases the working
capital.
4) Decrease in current asset and increase in current liability reduces the working
capital.
5) Increase in working capital becomes the uses of fund and decrease in working
capital becomes the sources of fund.
2) The second step in preparation of fund flow statement is to find out the funds
received from business operations (Funds from operation)
The amount received from business operation is the single largest source of fund.
The cash received from debtors or from sales cannot be taken as fund received because it
has to be spent for purchases and for other payments. The net profit, as disclosed from
profit and loss account cannot also be taken as fund received during the year, as profit
and loss account includes a number of non-fund item. Non-fund item means those items
in which neither the fund is received, nor the fund is given. These items are only book
adjustments. Therefore, in order to find out the fund received from business operations
these items have to be excluded. For example, depreciation on fixed asset. For the
amount of depreciation profit and loss account is debited and the amount is deducted
from the asset. In this case neither fund is received nor the fund goes out. Therefore, in
order to adjust a number of non-fund items, an adjusted profit and loss account is
prepared.
4) After following all the above three steps, the final step is the preparation of fund flow
statement. It is similar to cash account, where in the left side is used for showing the
sources of fund and the right side is used for showing the application of fund.
Fund Flow statement
Sources Rs. Applications Rs.
1. Issue of shares 1. Redemption of preference shares
2. Issue of Debentures 2. Redemption of debentures
3. Borrowing loans from 3. Repaying loans to
institutions institutions
4. Sale of Fixed assets 4. Purchase of fixed assets
5. Sale of investments 5. Purchase of investments
6. Fund received from business 6. Fund lost in business
operations operations
7. Decrease in working capital 7. Increase in working capital
8. Non trading receipt 8. Non trading payment
Is depreciation a source of fund?
There is a debate going on, whether depreciation is a source of fund. While
preparing the adjusted profit and loss account, the amount of depreciation is added back
to the profit, which increases, the fund received from business operations. Higher the
amount of depreciation charged, higher will be the fund received from business
operations. Therefore, depreciation may be considered as a source of fund.
Besides, depreciation is charged on fixed assets. Fixed assets are used to generate
the revenue. If there is no fixed assts, then the particular assets have to be hired for
which hire charges are to be paid. Depreciation, which is charged on the fixed asset,
prevents fund from going out of business. Fund saved become fund earned. Therefore,
depreciation may be treated as a source of fund.
Depreciation is debited to profit and loss account, which reduces the amount of
profit. Since profit is reduced on account of depreciation, to that extent tax liability is
also reduced. Therefore, the amount of depreciation reduces the fund from going out as
tax. Hence, it is taken as a source of fund.
The question is, whether the depreciation can really be considered as a source of fund? If
it were to be so, all firms would have charged higher amount of depreciation and increase
their sources of fund. But it is not so, because depreciation is only a book adjustment.
PRACTICAL PROBLEMS
BALANCE SHEET
Liabilities Assets
1989 1990 1989 1990
Rs. Rs. Rs. Rs.
Share Capital 300000 400000 Goodwill 100000 80000
8% Redeemable 150000 100000 Building 200000 170000
Preference shares
Capital reserve - 20000 Plant 80000 200000
Gen Reserve 40000 50000 Investment 20000 30000
P & L A/c 30000 48000 Debtors 140000 170000
Proposed Divd. 42000 50000 Stock 77000 109000
Sundry Creditors 25000 47000 B/R 20000 30000
B/P 20000 16000 Cash 15000 10000
O/S. Exp. 30000 36000 Bank 10000 8000
Provn. For Tax. 40000 50000 Preliminary Exp. 15000 10000
677000 817000 677000 817000
Other information:
i. A portion of the building was sold in 1990 and the profit has been transferred to
Capital Reserve.
ii. Written down value of a machine was Rs. 12000. it was sold for Rs. 10000.
Depreciation of Rs. 1000 is charged in 1990.
Solution:
Plant A/c:
Rs. Rs.
To Op. Balance 80,000 By Depreciation 1,000
To Plant Purchased 1,33,000 By Cash sales 10,000
(Bal. Figure) By Loss on Sales 2,000
By Closing Balance 2,00,000
2,13,000 2,13,000
Goodwill A/c:
By P & L A/c 20,000
To Opening 1,00,000 By closing Bal. 80,000
balance
1,00,000 1,00,000
Building A/c :
By Sales 50,000
To Opening Bal 2,00,000 By Closing Bal 1,70,000
To Capital Reserve 20,000
2,20,000 2,20,000
Investment A/c:
Proposed Dividend:
Gen. Reserve:
Tax Provision :
Preliminary expenses :
1,66,000 1,66,000
Solution:
Schedule of changes in working capital
Effect on working capital
Particulars 1999 2000 Increase Decrease
Rs. Rs.
Current Assets
Sundry Debtors 14,000 17,000 3,000
Stock 7,700 10,900 3,200
Bills receivable 2,000 3,000 1,000
Cash balance 1,500 1,000 500
Bank balance 1,000 800 200
Total of Current Assets (CA) 26,200 32,700
Current Liability
Sundry Creditors 2,500 4,700 2,200
Bills payable 2,000 1,600 400
Liability for Exp, 3,000 3,600 600
Provision for Tax 4,000 5,000 1,000
Total of Current Liability (CL) 11,500 14,900
Working Capital (CA-CL) 14,700 17,800
Increase in Working Capital 3,100 3,100
17,800 17,800 7,600 7,600
Investment Account
To Balance b/f 2,000 By Balance c/f 3,000
To Bank Purchase 1,000
3,000 3,000
Equity share capital Account
To Balance c/f 40,000 By Balance b/f 30,000
By Bank – issue of share 10,000
(Balancing figure)
40,000 40,000
8% Preference share capital Account
To Bank – preference 5,000 By Balance b/f 15,000
shares redeemed 10,000
To Balance c/f
15,000 15,000
Adjusted Profit and loss Account
To Depreciation on 1,000 By Balance b/f 3,000
Machinery By Dividends received 200
To Loss on sale of 200 on investment
Machinery By Fund received from 13,300
To Interim Dividend paid 2,000 business operations
To General Reserve 1,000 (Balancing figure)
To Dividends proposed 5,000
(2000)
To Goodwill written off 2,000
To Preliminary expenses 500
written off
To Balance c/f 4,800
16,500 16,500
Tutorial Note:
1) Tax provision has been taken as current liability
2) Dividends proposed in 1999 is paid in 2000
3) Profit on sale of land is not taken to adjusted profit and loss account because it has not
been added to profit.
4) Dividends received on investment is a non-trading income.
Solution:
Schedule of charges in working capital
Effect on working capital
Particulars 1999 2000 Increase Decrease
Rs. Rs.
Current Assets
Debtors 30,000 70,000 40,000
Stock 60,000 65,000 5,000
Cash 30,000 45,000 15,000
Total of Current Assets (CA) 1,20,000 1,80,000
Current Liability
Creditors 86.000 95,000 9,000
Provision for taxation 20,000 30,000 10,000
Total of Current Liability (CL) 1,06,000 1,25,000
Working Capital (CA-CL) 14,000 55,000
Increase in Working Capital 41,000 41,000
55,000 55,000 60,000 60,000
1,80,000 1,80,000
Depreciation on Furniture Account
To Balance c/f 6,000 By Balance b/f 5,000
By Depreciation 1,000
(Balancing figure)
6,000 6,000
Furniture Account
To Balance b/f 7,000 By Balance c/f 9,000
To Cash: - Purchase 2,000
9,000 9,000