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Accounting often is called the language of business. The basic function of any language
is to serve as a means of communication. In this, context, the purpose of
accounting is to communicate or report the results of business operations and the
financial health of the organization.
Features of Accounting
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• Financial Accounting
• Cost Accounting
• Management Accounting
• Social Responsibility Accounting
• Human Resource Accounting
• Inflation Accounting
• In the preparation of the accounting standards, the ASB will be assisted by study
groups constituted to consider specific subjects. It will also hold a dialogue with
the representatives of the government, public and private sector industries and
other organisations, for ascertaining their views.
• Based in the above, an exposure draft of the proposed standard will be prepared
and issued to its members for comments and the public at large.
• After taking into consideration the comments received, the exposure draft will be
finalised by the ASB for submission to the council of ICAI.
A mandatory accounting standard, if not followed, requires the auditors, who are
members of ICAI, to qualify their audit reports, failing which they will be guilty of
professional misconduct. Both the SEBI and Companies Act 2013 require auditors of
qualify the audit reports that do not conform to mandatory accounting standards.
Section 134(5) of the Companies Act 2013 also casts a responsibility on the board of
directors to comply with mandatory accounting standards.
Under the Section 129(5) of the Companies Act 2013, where the financial statements
do not comply with the accounting standards, such companies shall disclose the
following:
• The deviation from the accounting standards
• The reasons for such a deviation
• The Financial effects, of any arising out of such a deviation.
Accountancy Standards
The Institute of Chartered Accountants of India (ICAI) has so far issued twenty-nine
standards:
• (AS 1) Disclosure of Accounting Policies
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U.S. law requires businesses that release financial statements to the public and
companies that are publicly traded on stock exchanges and indices to follow GAAP
guidelines, which incorporate 10 key concepts:
GAAP compliance makes the financial reporting process transparent and standardizes
assumptions, terminology, definitions, and methods. External parties can easily
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Because GAAP standards deliver transparency and continuity, they enable investors and
stakeholders to make sound, evidence-based decisions. The consistency of GAAP
compliance also allows companies to more easily evaluate strategic business options.
What is IASB?
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Transfer Pricing
Transfer pricing is the method used to sell a product from one subsidiary to another
within a company. This approach is used when the subsidiaries of a parent company
are measured as separate profit centers. Transfer pricing impacts the purchasing
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behavior of the subsidiaries, and may have income tax implications for the company
as a whole. Here are the key issues:
• Revenue basis
• Preferred customers
• Preferred suppliers
Traditional Methods
• Market rate transfer price. The simplest and most elegant transfer price is
to use the market price. By doing so, the upstream subsidiary can sell either
internally or externally and earn the same profit with either option. It can
also earn the highest possible profit, rather than being subject to the odd
profit vagaries that can occur under mandated pricing schemes.
• Adjusted market rate transfer price. If it is not possible to use the market
pricing technique just noted, then consider using the general concept, but
incorporating some adjustments to the price. For example, you can reduce
the market price to account for the presumed absence of bad debts, since
corporate management will likely intervene and force a payment if there is a
risk of non-payment.
• Resale Price Methods: The Resale Price (RP) while similar to the Cost plus
method, is found by working backwards from the transactions taking place at
the next stage in the supply chain and is determined by subtracting an
appropriate gross mark-up from the sale price, to an unrelated third party,
with the appropriate gross margin being determined by examining the
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conditions, under which, the goods or services are sold and comparing the
said transaction to other third party Transactions.
As with language, accounting has many dialects. There are differences in terminology. In
dealing with the framework of accounting theory, one is confronted with a serious
problem arising from the differences in terminology. A number of words and terms
have been used by different writers to express and explain the same idea or notion.
The various terms used for describing the basic ideas of accounting are: concepts,
postulates, propositions, basic assumptions, underlying principles, fundamentals,
conventions, doctrines, rules, etc.
Concepts of Accountancy
Accounting of often called the language of business through which a business house
normally communicates with the outside world. In order to make this language
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• The rules of revenue recognition determines that the earning process should be
either complete or near completion.
Historical records Concept: In accounts, The historical cost principle states that
businesses must record and account for most assets and liabilities at their purchase or
acquisition price. In other words, businesses have to record an asset on their balance
sheet for the amount paid for the asset.
Going concern concept: This concept indicates that the business is a going concern and
the transactions are recorded accordingly. If an expense is incurred and its utility is
consumed during the year, then it is treated as an expense, otherwise it is recorded as
an asset.
Applications
• The fixed assets are valued at cost and not at market value.
• Current assets are valued at cost or the market value whichever is less.
• Depreciation is provided based on the total number of years of life of asset.
Balances of one year are carried forward to the next year.
Accounting of full disclosure: Entries are made in such a way, that they provide
honestly all information relating to the activities of the business. The records should not
conceal anything from outsider. Secret reserves should not be maintained as per this
convention.
Convention of materially: All material information, must be recorded. What is material
depends upon the value of the item involved and circumstances of individual case of
business. Exp: Paisa is not recorded.
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The going concern concept of accounting implies that the business entity will
continue its operations in the future and will not liquidate or be forced to
discontinue operations due to any reason. A company is a going concern if no
evidence is available to believe that it will or will have to cease its operations in
foreseeable future.
An example of the application of going concern concept of accounting is the
computation of depreciation on the basis of expected economic life of fixed assets rather
than their current market value. Companies assume that their business will continue for
an indefinite period of time and the assets will be used in the business until fully
depreciated. Another example of the going concern assumption is the prepayment and
accrual of expenses. Companies prepay and accrue expenses because they believe that
they will continue operations in future.
• The single entry system appears to be time saving and economical but it is
unscientific as under this system some transactions are not recorded at all,
whereas some other transactions are recorded only partially. Under the double
entry system of bookkeeping, both aspects of each and every transaction are
recorded. This is known as the dual aspect analysis. Under the single entry
system, only one aspect of the transaction, i.e. personal is recorded and the other
aspect is ignored.
• For example, in case goods are sold on credit to a customer, only the customer’s
account is opened and debited but the goods account is not opened. Under this
system, only the accounts which are absolutely necessary are maintained. Other
accounts, i.e. nominal and real accounts are not opened except cash. The
accounts maintained under this system are incomplete and unsystematic and,
therefore, the system is not reliable. The system is followed by small business
firms.
Double Entry System
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• The double entry system is based on scientific principles and is, therefore, used
by most of the business houses. The system recognises the fact, that every
transaction has two aspects and records both the aspects of each and every
transaction.
• Under this system, in every transaction, an account is debited and some other
account is credited. The crux of accountancy lies in finding out which of the two
accounts are affected by a particular transaction and out of these two accounts,
which account is to be debited and which account is to be credited.
Principles of Double Entry System The following are the main principles of double
entry system:
• For every transaction, two parties must be interested.
• Every business transaction has two aspects, one of receiving the benefit and the
other of giving it. In simple words, ‘double entry’ system means ‘every debit has a
corresponding credit’.
• Both the aspects, are recorded in the books of account.
• The two-fold effect of a business transaction is recorded by debiting one account
and crediting the other account at the same time.
Merits of Double Entry System
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Single entry system: A single entry system records each accounting transaction with a
single entry to the accounting records, rather than the vastly more widespread double
entry system. The single entry system is centered on the results of a business that are
reported in the income statement.
Double entry system: The double-entry system of accounting or bookkeeping means
that for every business transaction, amounts must be recorded in a minimum of two
accounts. The double-entry system also requires that for all transactions, the amounts
entered as debits must be equal to the amounts entered as credits.
Principles of Double Entry system
Principle of Conservatism
Accrual Concept
The accrual concept makes a distinction the receipt of cash and right to receive, it and
the payment of cash and the legal obligation to pay it. In actual business operations, the
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obligation to pay and the actual movement of cash may not coincide. The accrual
recognises this distinction. In connection with the sale of goods, revenue may be
received.
Journal
The form of a journal contains a column Ledger folio. Journal records each transaction.
However, if anyone wants to find out transactions affecting a personal account or an
expense account, he will have to turn over pages of journal, add all debits and credits
and then find out the balance of a particular account.
Cash Book
The Book that keeps records of all cash transactions, i.e. cash receipts and cash
payments is called a cash book. Its ruling is like a ledge account and is divided into two
sides, viz, debit and credit. All receipts are recorded on the debit side whereas all
payment are recorded on the credit side. Since it serves the function of cash account,
there is no need for opening cash account in the ledger.
Accounting cycle includes the following:
Recording: In the first instance, all transactions should be recorded in the journal or
the subsidiary books as and when they take place.
Classifying: All entries in the journal or subsidiary books are posted to the appropriate
ledger account to find out at a glance the total effect of all such transactions in a
particular account.
Summarising: The last stage is to prepare the trial balance and final accounts with view
to ascertain the profit or loss made during a particular period and the financial position
of the business on a particular date.
Ledger
The Ledger is the principal book of accounts where similar transactions relating
to a particular person or property or revenue or expense are recorded. In other
words, it is a set of accounts. It contains all accounts of the business enterprise whether
real, nominal or personal. The main function of a ledger is to classify or sort out all the
items appearing in the journal or the other subsidiary books under their appropriate
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accounts, so that at the end of the accounting period each account will contain the entire
information of all the transactions relating to it in a summarized or condensed form.
Relationship Between ‘Journal’ and ‘Ledger’
Meaning The book in which all the The book which enables to
transactions are recorded, as and transfer all the transactions into
when they arise is known as separate accounts is known as
Journal. Ledger.
ledger accounts.
2016 Rs.
May 2 Paid interest to Loan 4,000
Ramesh who owed Rs.3,000 has become insolvent. He pays 50
May 3 paise in rupee in full settlement.
A cheque received from Ranjan deposited into bank was
May 4 returned dishonored. 6,300
May 5 Wood used for making office furniture. 5,000
May 21 Due from Rama are bad debts. 600
May 25 Purchased building and issued cheque. 4,300
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Journal Entry
Dr. Cr.
Date Particulars L.F. Rs. Rs.
2016
May 2 Interest to Loan A/c Dr. 4,000
To Cash A/c 4,000
(Being interest payment made on
loan)
May 3 Cash A/c Dr. 1,500
Bad Debts A/c Dr. 1,500
To Ramesh A/c 3,000
(Being 50 paise in rupee received
from Ramesh out of the debt
of Rs.3,000 in full settlement)
May 4 Ranjan A/c Dr. 6,300
To Bank A/c 6,300
(Being the cheque deposited into
bank dishonoured)
May 5 Furniture A/c Dr. 5,000
To Purchases A/c 5,000
(Being the wood used in making
office furniture)
Bad Debts A/c Dr. 600
To Rama A/c 600
May 21 (Being the bad debts written off )
May 25 Building A/c Dr. 4,300
To Bank A/c 4,300
(Being the goods purchased and
payment made through cheque)
Account Categories
• Real Accounts
• Nominal Accounts
Personal Accounts
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These accounts show the transactions with customers, suppliers, moneylenders, banks
and the owner.
Personal accounts can take the following forms:
• Natural Personal accounts: The term natural person means persons who are
the creation of God. For example, proprietor’s account, supplier’s account,
receiver’s account (Abhinav a/c, Alpa A/c).
• Artificial personal accounts: These accounts include the accounts of corporate
bodies or institutions that are recongnised as persons in business dealings.
Example: firm’s a/c , club a/c.
• Representative personal account: These are accounts that represent a certain
person or group of person. Example: Salary outstanding, Rent prepaid etc.
There following list indicates, some more of the usual accounts coming under each
category: (Personal accounts)
Impersonal Accounts
Real Accounts
Real accounts may be of the following types:
Tangible real accounts: These are accounts of such things that are tangible, i.e, which
can be seen, touched, physically. Example: Land, building, cash etc.
Intangible real accounts: These account represent such things that cannot be touched.
Example: Trademarks, Patent right etc.
There following list indicates, some more of the usual accounts coming under each
category: (Real accounts)
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• Bill receivable
• Trademarks
• Cash
Nominal Accounts
Nominal accounts are opened in the books to explain the nature of the transactions.
Example: Salary is paid to the employees, rent is paid to the property owner etc.
There following list indicates, some more of the usual accounts coming under each
category: (Nominal accounts)
• Interest
• Salaries
• Rent
• Carriage
• Commission received
• Insurance
• Discount received
• Wages
• Credit and Debit Concepp
Cash book may be defined as the record of transactions concerning cash receipts and
cash payments. In other words, in cash book, all transactions (i.e receipts and payment
of cash) are recorded as soon as they take place. Cash book is in the form of an account
and actually it serves the purpose of a ‘Cash Account’.
Cash book thus serves the purpose of a book of original entry as well as that of a
ledger account. A cash book has the following features:
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Simple (Single column) cash book: This cash book will only record cash transactions.
The cash coming in (receipts) will be on the left and the cash payments will be on the
right. And since we will record all cash transactions here there is no need for a cash
ledger account.
Date Particulars L.F Receipt Amount Date Particulars L.F. Vr. Amount
No. No.
Date: The date on which cash is received or paid is entered in this column.
Particulars: The name of the account in respect of which the amount is received or paid
is shown.
LF (Ledger folio): The column shows page number of the ledger where the entry has
been posted.
Two Column Cash Books
Here instead of one column, we have an additional column for discounts. So along with
the cash transactions, we will also record the discounts in the same cash book. So both
discounts received and the discount that is given is recorded here. If any organization is
in a general practice of giving or receiving discounts this is the preferable option.
Discount is a nominal account – so the discount is given (loss) is on the debit side and
discount received (profit) is on the credit side. At the end of the period, we balance both
columns and transfer the closing balances.
Prepare a two column cash book from the following entries
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Journalising
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Date: In the first column the date of the transaction is entered, the year is most
probably written on the top of the column than to repeat it every day.
Particulars: Here the accounting entry is written in a summarised form of debit and
credit. The names of the accounts involved in the transaction are written in the journal
entry.
On the first line, the account is debited, the word “Dr.” is written at the right end of the
same line of account debited.
On the second line, the account credited is written with a prefix “To” after leaving a little
space towards the start.
Immediately below the entry, a small explanation of the transaction called ‘narration’ is
written. The narration begins with the word “Being”.
Ledger Folio No. (L.F.): In this column, the page number of the Ledger in which the
journal entry is posted, is recorded. This also helps is easy cross verification and
reference in the future.
Debit Amount: The amounts to be debited to the accounts concerned or involved are
written.
Credit Amount: The amounts to be credited to the accounts concerned or involved are
written.
Rules for Journalising Transactions: (Golden rules of Accountancy)
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Rule: Debit all the expenses or losses and Credit all the incomes, gains or profits.
E.g. Paid Rs. 2000/- as commission to the agent. Here, commission a/c is debited
because it is a business expense.
Question: Journalise the following transactions in the Journal of Mr. Abhinav for the
year 2018
2018
Rent A/c ………………. Dr. 4000
01/01
To Cash A/c 4000
Record the following transactions in a bank column cash book for December
2019:
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Cash book
Dr. Cr.
Date Receipts L.F. Cash Bank Date Payments L.F. Cash Bank
₹ ₹ ₹ ₹
2019 2019
01 Capital 80,000 04 Bank C 50,000
Dec Dec
04 Cash C 50,000 15 Purchases 8,000
Dec Dec
10 Abhinav 1,000 22 Purchases 10,000
Dec Dec
30 Bank C 2,000 25 Alpa 20,000
Dec Dec
30 Cash C 2,000
Dec
31 Rent 1,000
Dec
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Meaning A book that keeps a record of A book issued by the bank to the
cash transactions is known account holder that records the
as cash book. deposits and withdrawals is known
as passbook.
Side affected Receipts will be shown in the Deposits will be shown in credit
debit side while payments side while withdrawals are shown
are entered in credit side. in debit side.
What do the Debit balance shows cash at Debit balance shows overdraft
balances reflect? bank while the credit while the credit balance shows
balance shows overdraft. cash at bank.
Understanding Reconciliation
The Bank statement is received periodically, say every month. We check it for clerical
and if any errors are found, we obtain a revised statement containing no errors. The
balance is this statement gives us a firm starting point to proceed for:
• Finding out entries which do not requires change in cashbook (these entries are
present in the cashbook but not in the bank statement). These entries give us the
‘Adjusted bank balance’.
• Finding out clerical mistake in our cashbook and rectifying them.
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• Finding out entries which require change in our cashbook (these entries are present in
the statement but not in the cashbook).
• Accuracy
• Check on the Entries
• Rectifying Incorrect Entries
• Updated Cash Book
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• Detection of Delays
• Check on the Dishonest Behavior of Employees
Example:
The cash book of Mr Abhinav shows Rs 8364 as the balance at the bank as on 31
December 2018, but you find this does not agree with the balance as per the bank pass
book, which shows a balance of Rs 15534.
On scrutiny, you find the following discrepancies:
• On 1st December, the payment side of the cash book was undercast by Rs100
• A cheque of Rs 131 issued on 25th December, was not taken in the bank
column.
• One deposit of Rs 150 was recorded in the cash book as if there is no bank
column therein.
• On 18th December, the debit balance of Rs 1526 as on the previous day, was
brought forward as credit balance.
• Of the total cheque, amounting to Rs 11,514 drawn in the last week of
December, cheques aggregating to Rs 7815 were encashed in December.
• Dividend of Rs 250, collected by bank and, subscription of Rs 100, paid by it,
were not recorded in the cash book
• One out-going cheque of Rs 350 was recorded twice in the cash book.
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___________________________
Adjusted balance in the bank Rs 11835 A
statement
When the cash book and pass book abstracts are given, the following points should
be noted.
• Find out the period for which both the abstracts are given
• Compare the cash book debit side with the pass book credit side and the cash
book credit side with the pass book debit side.
• When the period for which both the abstracts are given is common, i.e. the cash
book abstract relates to January and the pass book abstract is also given for
January, take into account only uncommon entries.
• When the period for which both the abstracts are given is uncommon, i.e, the
cash book relates to January but the pass book relates to February, take into
account only common entries.
• Where the period is same, uncommon entries will appear in the reconciliation
statement.
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• When the period is different, common entries will appear in the reconciliation
statement.
We have learnt that certain entries appear in the pass book first and then by comparing
the pass book with the cashbook, these missing entries are incorporated in the cash
book. The trader must know the correct bank balance at any time so that he can issue
cheques only to the extent of the available bank balance. Therefore, preparing a bank
reconciliation statement, the accountant makes the necessary corrections in the cash
book and adjusts the cash book balance.
The items, which can usually be adjusted in the cash book are:
• It helps the management to check the accuracy of the entries made in the cash
book.
• It helps to detect errors and to take timely action for the correction of balances.
• It is a very important control technique for the management.
• It shows the correct bank balance at any particular time
• It reveals frauds committed by the staff handling cash and cheques and thus,
helps the management to have effective control.
Multiple entries in various accounts will make a Ledger. Taking all the ledger
balances and presenting them in a single worksheet as on a particular date is Trial
Balance.
To understand a trial balance, we must first understand the following:
• Double entry system – Recording two entries for a single transaction that is
equal and opposite in nature
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Example:
On 31st March 2014, the totals of debit and credit sides of various ledger accounts and
receipts and payments sides of cash and bank columns of cash book of Mr. Abhinav are
as under:
Total of debit side (Rs.) Name of the account Total of credit
side (Rs.)
10, 000 Abhinav Capital 1,35,000
25,000 Drawings -
15,000 Stock on 31st March, 1996 -
1,90,000 Purchases 4,000
- Purchases Returns 18,000
6,000 Sales 2,45,000
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Solution
Gross Trial Balance as on 31st March 2014
Name of the Account L.F Debit (Rs.) Credit (Rs.)
Abhinav Capital 10000 1,35,000
Drawings 25000 --
Stock on 31st March, 15000 --
2013
Purchases 190000 4000
Purchases Returns -- 18000
Sales 6000 2,45,000
Sales Returns 13000 --
Expenses 12000 --
Customers 3,05,000 2,50,000
Suppliers 2,00,000 2,35,000
Car 1,00,000 --
Dena Bank 2,81,000 2,75,000
Cash 43,000 38,000
Total 12,00,000 12,00,000
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Classification of Errors
• Clerical Errors
• Principle Errors
Clerical Errors
• Errors of Omission,
• Errors of Commission, and
• Compensating errors.
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Errors of Omission
The Errors of Omission will occur when a transaction is not recorded in the books of
accounts or omitted by mistake. The Errors of Omission two types.
• Partial
• Complete
The partial errors may happen in relation to any subsidiary books. This is the result of
when a transaction is entered in the subsidiary book but not posted to the ledger. For
example, cash paid to the suppliers has been entered in the payment side of the cash
book but it will not be entered in the debit side of the suppliers account.
The complete omission may happen the transaction is completely omitted from the
books of accounts. For example, an accountant fails to enter a specific invoice from the
sales day book.
Errors of Commission
When a transaction is entered in the books of accounts in wrongly, this may be entered
as partially or incorrectly. This kind of errors are known as Errors of Commission. The
Errors of Commission may happens because of ignorance or negligence of the
accountant. This may be of different types, the main reasons are Errors relating to
subsidiary books and Errors relating to ledger. Following are some of the examples:
Compensating Errors
Compensating Errors are those errors which compensates themselves in the net results
of the business. This means, if there are over debit in one account which will be
compensated by the over credit in some account in the same extent of the business. Like
that, if there is a wrong debit in one account which will be neutralized by some wrong
credit in the same extent of the business.
Errors of Principles
This kind of errors are occurs when the entries are made against the principle of
accounting. These Errors are made because of the following reasons:-
• Errors happens due to the inability to make a distinction between the revenue
and capital items.
• Errors happens due to the inability to make a difference between the business
expenses and personal expenses.
• Errors happens because of the inability to make a distinction between the
productive expense and nonproductive expenses.
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Rectification of Errors
• These errors affect only one account. Thus, these are one-sided errors. We can
rectify these errors by giving an explanatory note in the account or by passing a
journal entry with the help of Suspense A/c. When we detect an error before
posting to the ledger, we can correct it by simply crossing the wrong amount,
writing the correct amount above it and initializing it. Similarly, we can also
correct an error in the ledger account.
• Errors of casting, errors of carrying forward the balances, errors of balancing the
accounts, errors of posting the wrong amount in the correct account, error of
posting in the correct account on the wrong side, omitting to show an account in
the trial balance, posting in wrong side with wrong amount are the examples of
errors affecting the Trial Balance.
Two-sided Errors
• These errors affect two or more accounts simultaneously. Thus, these are two-
sided errors. We can rectify these by passing a journal entry giving the correct
debit and credit to the accounts. In order to rectify an error, we need to cancel
the effect of wrong debit or credit by reversing it and restore the effect of correct
debit or credit.
• When there is short debit or excess credit in an account we need to debit the
concerned account. Whereas, when there is short credit or excess debit in an
account we need to credit the concerned account.
• Complete omission to record an entry in the journal or the subsidiary books,
incorrect recording of transactions in the books, complete omission of posting
and errors of principle are the examples of these errors.
Suspense Account
When the trial balance does not tally due to the one-sided errors in the books, an
accountant puts the difference between the debit and credit side of the trial balance on
the shorter side as the Suspense A/c. As and when we locate and rectify the errors, the
balance in the Suspense A/c reduces and consequently becomes zero. Thus, we cannot
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categorize the Suspense A/c. It is a temporary account and can have debit or credit
balance depending upon the situation.
While using the Suspense A/c to rectify the one-sided errors, the accountant needs
to follow the following steps:
Example
Q: Trial Balance of M/s Srivastav Enterprises did not agree. It puts the difference to the
Suspense A/c. Rectify the following errors and prepare the Suspense A/c to ascertain
the original difference in the trial balance.
Amount paid for the installation of the machinery ₹10000 was posted to the Repairs
and maintenance A/c.
Total of Purchases book ₹50000 was not posted to the ledger.
Goods returned to John ₹3000 were recorded in Sales Book.
Salary paid to Ram ₹6000 was debited to his personal account.
Depreciation written-off on furniture ₹500 was not posted to the furniture account.
Ans: In the books of M/s Srivastav Enterprises
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Suspense A/c
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50000 50000
Adjusting Entries
• Final Account are the accounts which are prepared at the end of the trading year.
These accounts show the final results of the business carried out. Final accounts are
prepared to find out profit earned or loss sustained by a concern.
• At the end of the accounting year, all ledger accounts are balanced and then trial
balance is prepared. Form the trial balance, final accounts, i.e. trading, profit and
loss account and balance sheet are drawn. While preparing trading and profit and
loss account, all expenses and incomes for the full period are to be taken into
consideration. If expenses have been incurred but not paid or income is due but not
received, necessary entries are required to be passed to show the correct picture of
the business. These entries are called “Adjusting Entries’.
Closing Entries
At the end of cash year, all accounts of expenses and incomes must be closed. The balance
of these accounts are transferred to trading account and profit and loss account. The
entries passed to transfer these balances are called “Closing entries”.
Depreciation is a charge to profit and loss account for the fall in value of an asset
during each year of its use.
• Depreciation is a part of the opening cost.
• It is a reduction in the value of the asset.
• The decrease in the value of an asset is due to its use, caused by wear and tear, or
by other reasons.
• The decrease in the value of an asset is gradual and continuous.
Causes of Depreciation
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• Obsolescence
• Accidents
• Fall in market price
• Efflux of time
Factors of Depreciation
For calculating depreciation, the basic factors are:
• The cost of the asset;
• The estimated resident or scrap value at the end of its life;
• The estimated number of year of its commercial life.
Methods of Depreciation
• Straight line method, the cost of the asset is written off equally during its useful
life.
• Therefore, an equal amount of depreciation is charged every year throughout the
useful life of an asset.
• After the useful life of the asset, its value becomes nil or equal to its residual
value.
• Thus, this method is also called Fixed Instalment Method or Fixed percentage on
original cost method.
If an asset is used only for 3 months in a year then depreciation will be charged only for
3 months. However, for the Income Tax purposes, if an asset is used for more than 180
days full years’ depreciation will be charged.
Advantages
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• The depreciation is equal for all the year, however, the expenditure on repairs
and renewal goes on increasing as the asset gets older, resulting in higher
amount charged to profit and loss account on account of deprecation and repairs
in the subsequent years.
Formula:
• Amount of Depreciation = (Cost of Asset – Net Residual Value) / Useful Life
• The rate of Depreciation = (Annual Depreciation x 100) / Cost of Asset
Journal Entries for Straight Line Method of Depreciation
Example
Q. Abhinav purchased a machine on 1 Apr 2015 for ₹400000. The useful life of the
machine is 3 years and its estimated residual value is ₹40000. At the end of its useful
life, the machine is sold for 40000. Prepare the necessary ledger accounts in the books
of Abhinav for the year ending 31st December every year. Use SLM.
Ans: In the books of Abhinav
Working Notes:
Calculation of amount of depreciation
Depreciation = (Cost of Asset – Net Residual Value)/Useful life
= (400000 – 40000)/3 = 120000 p.a.
Machinery A/c
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Depreciation A/c
Advantage
• This method is recognised under the Income-Tax Act and the Companies Act.
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• The total expenditure on repairs and renewal and depreciation on asset are
equal in all year, as in the initial years the depreciation will be more and less and
in later years the expenditure on repairs will be high and depreciation less,
through both may not exactly compensate the decrease/increase in the other.
Disadvantage
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Working Notes:
Calculation of amount of depreciation
Amount of depreciation=Book Value × Rate of Depreciation/100
• 2015: Depreciation = 500000 x 10/100 x 9/12 = 37500
• 2016: Depreciation = 462500 x 10/100 = 46250
• 2017: Depreciation = 416250 x 10/100 = 41625
• 2018: Depreciation = 374625 x 10/100 x 3/12 = 9366
Calculation of loss on sale of machinery
Loss = Book Value on 1 Jan 2018 – depreciation for 3 months – cash received
= 374625 – 9366- 250000 = 115259
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According to SOYD method, to calculate the depreciated value we have to take the
expected life of an asset (in years0 count back to one and add the figures together. This
is a method of calculating deprecation of an asset that assumes a higher depreciation
charge and a greater tax benefit in the early years of an asset’s life.
Example
A new machine was purchased for Rs. 3 lac with 5 years economic life. What is
WDV at the end of 3rd year as per SOYD method?
Sum of Years Digit total = 5+4+3+2+1=15
Depreciation for 3 years = 12/15*300000=240000
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• Since depreciation expense is a non-cash expense (i.e. cash is usually paid out in
the year the asset is acquired, but the expense is distributed over several years),
• it is important to plan for the replacement of fixed assets as they wear out or
become obsolete.
• For example, some organisations set aside an amount of cash equal to the
amount of their yearly depreciation expense so that money will be available to
purchase a new asset once the current one is fully depreciated.
• Under this method, a ‘Depreciation Fund’ or ‘Sinking Fund’ is created and the
amount is invested in readily saleable securities.
• At the end of the life of the asset, the securities are sold and the sale proceeds of
the old assets are used for replacement of the asset.
• Many of the intangible assets (e.g. patents, licences, trademarks, etc.) also have a
limited useful life.
• Therefore, it is logical to reduce their value in every accounting year before
carrying them to the new accounting year. This is called amortisation.
• Our discussion about depreciation, in this chapter, is equally applicable to
amortization.
• Indian Accounting Standard (Ind AS) 38, which deals with intangible assets,
describes amortisation as under; “Amortisation is the systematic allocation of the
depreciable amount of an intangible asset over its useful life.”
• This Standard defines an intangible asset as, “an identifiable non-monetary asset
without physical substance”.
• Some other examples of intangible assets are; Scientific or technical knowledge,
design and implementation of new process or systems, intellectual property,
copyrights, computer software, motion picture films, marketing rights, fishing
licences etc.
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These are expenditures for high-value items that holds longer duration
requirements. Capital expenditures are long-term expenditures. In other words,
when the expenses are made for a particular asset but they do not get completely
consumed in the specific time. Due to this the earning capacity increases, and in the
meanwhile, the price of the assets decreases. Example: Cash money spent on business
purposes, Purchasing of Plants and machinery items Etc.
Costs which are classified as Capital Expenditure
• Initial costs: These include purchase price including duties and non-refundable
taxes, costs directly attributable to bringing the asset to the location and
condition necessary for it to be operational. This is also applicable to acquisition
of intangible assets.
• Subsequent costs: These include costs of parts of some items of the assets
requiring replacement at regular intervals. These also include the costs of major
inspections for potential faults in the assets.
Some of the examples of the above costs are:
• Costs of employee benefits arising directly from the construction or acquisition
of the asset
• Costs of site preparation
• Initial delivery and handling costs
• Installation and assembly costs
• Costs of testing
• Professional fees
• Research of development expenditure
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In contrast to the capital expenditure, revenue expenditures are not the high-
value items, instead, they are the routine expenditures that takes place in the normal
business. In other words, this kind of expenditure maintains fixed assets.
Unlike capital expenditure, earnings do not increase but stay maintained in revenue
expenditure. The assets get consumed in an accounting year and no future benefits
are available.
Capital VS Expenditure
Receipts
Capital Receipts
Capital Receipts are from issue of Equity/ Preference share/ Capital Instruments or
from sale of Disposal of fixed Assets/Long Term investment or from Grants received
from Government for Building of Capital Assets. Capital receipts are not routed through
Profit & Loss account. However profit/loss, if any, arising from such transactions is
recorded in the P & L account.
Revenue Receipts
Revenue Receipts are from day to day operation of the company or receipts where is no
further obligation on the entry to perform certain actions. Revenue Receipts are routed
through Profit and loss account.
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Bills of Exchange
Promissory Notes
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notes, on the other hand, is written by the debtor (buyer) promising the creditor (seller)
to pay a specified sum after a specified period. Thus, it can be defined as:
Features of Promissory Notes
• An instrument in writing
• Containing an unconditional undertaking
• Signed by the maker to pay a certain sum of money
• To or to the order of a certain person or the bearer of the instrument (section
4 of the Negotiable instrument Act)
• Maker: A person who makes the note and promises to make the payment.
• Payee: A person who is to receive money.
Or
• The holder: A holder is basically the person who holds the notes. He may be
either the payee or some other person.
• Written notes
• Express undertaking
• Unconditional promise
• Specific amount
• Legal tender
Example:
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Cheque
• A cheque must have to fulfill all the essential elements of a bill of exchange.
• It must be payable to bearer or to order but in either case, it must be payable
on demand.
• The banker named pays it when it is presented for payment.
• The signature must tally with the specimen sign of the drawer kept in the
bank
• A cheque must be dated.
• A cheque drawn with a future is valid but the same is payable on or after such
specified period.
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A bill of exchange can be drawn upon any A cheque can be drawn only upon a bank.
person including a bank.
A bill of exchange requires acceptance. A cheque does not requires any acceptance
The acceptor of a bill of exchange is allowed A cheque is always payable on demand
three days of grace after the date maturity of
the bill.
Notice of dishonor is necessary Notice does not requires any stamp.
A bill of exchange must be stamped A cheque does not require any stamp.
Accommodation Bill
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Bill Books
Bills receivable book is a book where all the bills, which are received, are recorded and
posted directly to the credit of respective customer’s account from there. The total
amount of bills so received during the period, either at the end of the week or month, is
to be posted to, in one lump sum, to the debit of the bills receivable account. The usual
form of bills receivable book, with imaginary figures is shown below.
N Date Fro Accep Date Term Date Wher Amo L. How Rema
o. of m tor of due e unt F Dispo rks
Recei who bill paya sed off
pt m ble
1 1/1/ A A 1/1/ 1mo 1/1/ Delhi 4000 - - -
20 20 nht 20
This is a book where all particular relating to the bills accepted are recorded and ,
posted from there, directly to the debit of the respective creditor’s account. The total
amount of the bills so accepted during the period, either at end of the week or month, is
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to be posted in one lump sum to the credit of bills payable account. The usual form of
‘Bill payable book’ with imaginary figures,
N Date Draw Paye Dat Ter Dat Wher Amou L. How Remar
o. of n by e e of m e e nt F Dispos ks
Recei bill due payab ed off
pt le
Important Terms
• Honouring of Bill: When the drawee pays the amount of the bill on due date, the
bill is said to be ‘Honoured Bills’.
• Dishonour of Bill: When the drawee pays the amount of the bill on due date, the
bill is said to be ‘Honoured Bills’.
• Discounting of Bills: The drawer may discount the bill with the bank before the
due date. The bank charges discounting charges from the drawer at a certain
rate.
Thus, at the time of discounting the bank deposits the net amount after charging such
amount of discount in the account of the holder of the bill.
Discount = Amount of bill
× Rateofinterestordiscount/100 × Remainingperiodtomaturity/12
• Endorsement of bills: Transfer of bill to same other person by the holder.
• Retirement of bills: When a drawee pays the bill before its due date. It is called
retirement of bill.
• Renewal of bill: Renewal of bill of exchange is an act of cancellation of old bill
before its maturity in return of a new bill, including interest, for an extended
period. It is done by drawer on request of drawee.
• Accommodation of bill: An accommodation bill is a bill of exchange signed for
by a person (the accommodation party) acting as a guarantor. The
accommodation party is liable for the bill should the acceptor fail to pay at
maturity. Accommodation bills are sometimes also referred to as windbills or
windmills.
• Notary Public: A notary public of the common law is a public officer constituted
by law to serve the public in non-contentious matters usually concerned with
estates, deeds, powers-of-attorney, and foreign and international business.
• Rebate: When a bill is paid by drawee before due date, same allowance is given
to him. This allowance is called ‘Rebate’.
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• 1st entered in the ledger accounts concerned and then in the journal.
• In manual operations, the entries are entered in the physical ledgers by the staff
concerned.
• After that, all the entries in a particular ledger head are entered in the journal
(day book) and
• finally, the total is entered in the control account concerned of the General
Ledger which is used in preparing the balance sheet and the P&L account.
Any accounting entry in manual operations can only be made based on a physical
voucher which is authenticated by the authorised officer of the branch.
In case of computerised operations, the accounting entry in the system is made by the
staff concerned and authenticated by the official concerned. The system takes care of
the remaining operations affecting the day books and the GL.
The branch staff has only to enter the accounting entry, originated at the branch, to the
accounts concerned and all other operations till the preparation of financial statements
are automatically performed by the system.
But, it is still important to understand the manual system of accounting so that the staff
concerned is clear about the process involved and is able to reply to the queries of the
customers and auditors instead of claiming ignorance of the systems and procedures.
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• In the case of banks, the need for the ledger accounts, especially those of
customers, being accurate and up-to-date is much stronger than in most other
types of enterprises.
• A bank cannot afford to ignore its ledgers particularly those containing the
accounts of its customers and has to enter every transaction into the ledgers as
soon as it takes place.
• In the case of banks, relatively lesser emphasis is placed on books of prime entry
such as cash books or journals.
• This is unlike most other types of enterprises where books of prime entry are
generally kept up-to-date while ledgers, including the general ledger and
subsidiary ledgers for debtors, creditors, etc. are written afterwards.
• Banks follow the accounting procedure of ‘voucher posting’ under which the
vouchers are straightaway posted to the individual accounts in the subsidiary
ledgers.
• At the end of each day, the debit and credit vouchers relating to a particular type
of transaction (e.g. savings bank accounts, current accounts, demand loans, cash
credit accounts, etc.) are entered on separate voucher summary sheets and the
total thereof is posted to the respective control account in the general ledger.
• The general ledger trial balance is prepared every day.
Types of Transactions
• Transactions in a bank are of two types, cash and non-cash. In the latter case,
also called ‘transfer transactions’, one or both of the accounts concerned may be
of the customers or the internal accounts of the bank.
• For example, if ‘A’ deposits a cheque drawn in his favour by ‘B’, who is also a
customer of the branch, the accounts of the two customers will be affected. On
the other hand, if ‘A’ deposits a draft drawn on the branch, the ‘Draft, account, an
internal account of the bank, will be debited. Likewise, on payment of interest on
deposit accounts, the ‘Interest Account’ at the branch will be debited and many
personal accounts credited.
Vouchers
Both debit and credit operations on all accounts, either by customers or by the bank
itself, are made by means of vouchers. There are two kinds of vouchers, one, which
evidences only debit or credit to an account, and the other, which contains both debit
and credit to different accounts. For the sake of convenience, the latter kind of vouchers
may be called ‘composite vouchers’.
The debit vouchers are, broadly the following:
• Cheques issued by the customers.
• Cheques/pay orders issued by the bank.
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▪ It is difficult to identify a single accounting system that describes all the features
of systems in operation in different banks as the accounting systems of different
banks vary in terms of hardware configuration, software capabilities, levels of
hardware and software security, and nature of transactions processed.
▪ The accounting system in a bank is designed keeping in view the nature and
volume of operations and information needs of the stakeholders.
▪ Every big bank has customized banking software as per its own requirement and
as such, the accounting systems differ amongst different banks.
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Illustration
PB branch of bank ABC Ltd. has a number of deposit accounts.
Mr. A also has his SB account in that branch.
On February 28, 2022, Mr. A had the following transactions concerning his account:
• Deposited Rs. 2,000 by cash
• Deposited cheque of Rs. 5,000 issued on the same branch by another customer,
Mr. B
• Cheque of Rs. 3,000 deposited earlier is paid through clearing
• Cheque of Rs. 4,000 issued to Mr. C is received at the branch in clearing
• Purchased draft for Rs. 6,000 on an outstation branch of the bank (Draft issued at
par by the branch)
(a) What will be the different entries in the account of Mr. A (assume opening balance of
Rs. 9,000) ?
(b) Which other accounts will be affected by each of the other entries?
(c) How the control account pertaining to Savings Bank, in the General Ledger, will be
affected by the transactions in the account of Mr. A?
( a) The entries in the account of Mr. A, due to the above transactions, are given in
the following table:
(b) The accounts affected by the transactions in the account of Mr. A will be as
under:
• Deposit of Rs. 2,000 by cash will be credited to Mr. A’s account and result in a
debit entry of Rs. 2,000 in the cash account. This entry is part of the cash scroll of
the cashier concerned. The total of the cash scroll is taken in the cash book.
• Deposit of the cheque of Rs. 5,000 issued on the same branch by another
customer, Mr. B, will result in a transfer credit entry of Rs.5000 in the account of
Mr. A. The corresponding debit entry will be a transfer entry of Rs. 5,000 in the
account of Mr. B.
• Payment received through clearing for a Cheque of Rs. 3,000 deposited earlier
will result in a credit entry (clearing-in) in the account of Mr. A and a debit entry
of Rs. 3,000 in the account of the bank conducting the clearing house.
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• Cheque of Rs 4,000 issued to Mr. B is received at the branch in clearing will result
in debit to his account (clearing –out) and a credit entry of Rs 4,000 in the
account of the bank conducting the clearing house.
• Purchase of a draft for Rs. 6,000 on an outstation branch of the bank at par, will
result in debit entry of Rs. 6,000 in the account of Mr. A and credit entry of Rs.
6,000 in Inter- Office account/ Draft account
(c)At the end of the day, all the vouchers pertaining to the transactions in all the
Savings Bank accounts at the branch, including those pertaining to the
transactions in the account of Mr. A, will be entered in the SB Day Book.
The credit and debit summations of the Day Book will be entered in the respective
columns of the SB control account in the GL and the balance derived.
Separate vouchers are not prepared for ATM/Internet Banking/Mobile banking/system
triggered standing instructions/interest application, transactions. Such transactions are
processed and recorded by the system.)
▪ Back offices carry out various functions to support the front office activities.
▪ In specialised functions like Treasury operations and Forex, the back offices
perform the mainstream role of directly supporting the trading room or front
office by controlling confirmations and settlement transactions.
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The back office functions relating to the normal banking activities can be grouped
as under:
Book keeping and accounting:
• Transaction processing,
• Maintenance of General Ledger and other books of account,
• Balancing of branch accounts,
• Reconciliation of entries and sub-systems,
• Rreparation of financial statements.
Deposits:
• Calculation and posting of interest,
• Service charges,
• Reminders for renewals of term deposits,
• nature of operation of account - single/jointly, etc.
Loans:
• Processing end-to-end loan originations or any aspect of loan servicing,
• Loan modification,
• Default management and collections,
• Calculation of EMIs,
• Calculation and posting of interest,
• Penal interest,
• Processing fee,
• Commission and prepayment charges,
• Processes implementation for credit products,
• Operational Limits,
• Risk management, etc.
Regulatory Compliance:
• Identifying KYC gaps,
• Customer grievance redressal system, etc.
E- banking:
• Handling transactions through internet,
• Mobile banking or ATMs,
• Card based payments, etc.
Other functions:
• Clearing, collection, remittances, etc.
The basic reconciliation functions in a bank can be divided into groups, as under:
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• What happens if branch A has not issued the draft and the draft paid by the
branch B is a forged one.
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• In this case, there will not be any entry pertaining to this draft in the daily
statement of Branch A, while the daily statement of branch B will contain a
responding entry of Rs.5,000.
• The CRD will not be able to match the responding entry and it will appear as an
unreconciled entry in the statement prepared by the department.
• Follow up by the staff of CRD will reveal the fact of payment of forged draft.
In core banking systems, office accounts are bifurcated between accounts which
have a requirement of entering a mandatory reference number while passing the
entry (pointing) and accounts which do not have such a mandate (non-pointing).
• In case of pointing accounts, the reconciliation process is easier as the entries
can be knocked off based on the reference number and each outstanding entry
outstanding on the reporting date can be identified.
• In case of non-pointing accounts, reconciliation requires manual intervention
and tracking due to non-availability of a unique reference number. Thus in most
of the above mentioned types of transactions, which need to be reconciled, the
reconciliation is automatically executed by the system.
▪ As such, monitoring is required only in those cases, where manual intervention is
required.
The typical and most common types of errors observed in office accounts are as
under:
▪ Considering the fraud prone nature and the fact that there are large number of
transactions in inter-office account and the non-reconciliation is widely extended
across the banks, RBI has taken a number of measures to achieve an expeditious
reconciliation of these transactions by the banks concerned.
▪ Non- reconciliation results in a ‘fraud risk factor’.
Certain objectionable practices observed by RBI in respect of office accounts are as
follows:
• Disguising the cash transactions of customers to avoid and bypassing reporting
of Cash/Suspicious Transactions.
• Misuse of funds and indulgence in window dressing by disbursal or repayment of
loan through Office Account General Ledger.
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▪ With the increase in the size of the companies and the volume of transactions,
the main objective of audit shifted to ascertaining whether the accounts were
true and fair, rather than true and correct.
▪ Hence the emphasis was not on arithmetical accuracy but on a fair
representation of the financial efforts.
▪ The later developments in auditing pertain to the use of computers in accounting
and auditing.
▪ With the advent of technology and rapid changes taking place in technology and
emergence of various risks, the importance of data analysis has increased to a
great extent.
Computer Aided Audit Techniques (CAATs) have become a part of the audit to
process data of audit significance and to improve the effectiveness and efficiency of the
audit process.
▪ Thus, while the overall objective and scope of audit do not change simply
because the
▪ data is maintained on computers,
▪ the procedures followed by the auditor in his study and evaluation of the
accounting system and related Internal Controls
▪ the nature, timing and extent of his other audit procedures are affected in a
Computerised Information System environment.
▪ Audit procedures are now transformed from ‘Auditing around the computer’ to
‘Auditing through the computer’.
▪ The incidental objectives of auditing are detection and prevention of errors and
frauds.
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Limitations:
▪ The auditor’s work involves exercise of judgment and he can only express an
opinion. He has to depend on explanations by others.
▪ Certain non-monetary facts can’t exhibit the true position.
▪ Auditor can’t check each and every transaction.
▪ Audit involves a systematic and scientific examination of the books of account
and records of a business entity to confirm that the profit and loss account and
the Balance Sheet are properly drawn up to exhibit a true and fair picture of the
financial state of affairs of the business and results of the financial period.
▪ It is also meant to cross check that the applicable regulatory provisions have
been adhered to.
▪ Audit provides comfort to the users of the financial statements of a business that
the information available in the statements can be relied upon.
▪ Banking sector deals with large amounts of public monies exposed to various
risks in its operations. It is important that the banking sector stays healthy, safe
and stable.
▪ Quality bank audit plays a crucial role to ensure this.
▪ Banking operations are mainly conducted at the branches, while other offices act
as controlling authorities or administrative offices.
▪ These offices lay down policies, systems and Internal Control procedures so that
the conduct of business is in compliance with the statutory/regulatory
provisions and in compliance of accepted accounting principles and practices
that cover all transactions and economic events.
▪ The transactions in banks are voluminous and it should be ensured that in the
system of recording, transmission and storage of information/data, is free of
risks of errors, omissions, irregularities and frauds.
▪ Bank managements continuously endeavour to make the internal control
systems robust, safe and secure.
▪ Bank audit is the procedure of reviewing the financial statements, services and
procedures adopted by Banks as required under various legislations and the
guidelines of Reserve Bank of India.
▪ It is the routine procedure that all banks must undergo in order to ensure that
they are in compliance with industry standards and regulatory norms.
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• Testing of accuracy
• Reliability of accounting records and financial reports,
• Integrity, reliability and timeliness of control reports,
• Adherence to legal and regulatory requirements.
However, in the changing scenario, the scope of internal audit has widened to evaluate
the adequacy and effectiveness of risk management procedures and internal control
systems adopted by the banks.
Thus, RBI vide circular dated December 27, 2002, had introduced Risk-Based Internal
Audit (RBIA) system in Scheduled Commercial Banks.
(SCBs) as part of their internal control framework.
This was further supplemented vide circular dated January 07, 2021.
This framework relies broadly on
• Well-defined policy for internal audit,
• Functional independence with sufficient standing,
• Effective channels of communication
• Adequate audit resources with sufficient professional competence.
The internal audit function of banks is expected to proactively identify the new risks to
ensure that appropriate controls are in place to mitigate them.
The Guidance Note of Reserve Bank of India on RBIA/RBS states that the audit function
should provide high quality counsel to management on effectiveness of risk
management and internal controls including regulatory compliance by the Bank.
▪ The Risk-Based Internal Audit would not only offer suggestions for mitigating
current risks but also anticipate areas of potential risks and plays an important
role in protecting the bank from various risks.
▪ The implementation of Risk-Based Internal Audit would mean that greater
emphasis is placed on the internal auditor’s role in mitigating risks.
▪ Risk-Based Internal Auditing is a methodology that links internal auditing to an
organisation’s overall risk management framework.
▪ RBIA allows internal audit to provides an assurance to the Board of Directors
and the Senior Management on the quality and effectiveness of bank’s internal
controls, risk management and governance related systems and processes.
▪ RBIA is not about auditing risks but about auditing the management of risk.
▪ It focuses on the process applied by the management team to respond to risks.
▪ Focus is shifted from the historical internal audit system of fullscale transaction
testing to risk identification, prioritization of audit areas and allocation of audit
resources in accordance with the risk assessment.
▪ Not only covers assessment of risks at the branch level but also covers,
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As banks accept deposit from the public and also lend funds, authenticity and reliability
of accounts is a must for public confidence. Keeping this view in mind, banks are
subjected to multiple types of audit. Bank Audit can be classified into three broad
categories: -
• Concurrent Audit
• Internal Audit/Information System Audit
• Statutory Audit
Concurrent Audit
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• Coverage
• Appointment of Auditors
• Accountability
• Tenure
• Remuneration
• Review of effectiveness of Concurrent Audit
• Reporting System
Internal Audit/Information Systems Audit
Internal Audit
Internal Audit is generally undertaken by bank’s own staff and to some extent by the
firms of Chartered Accountants.
• Aimed: At ensuring the accuracy and correctness of the books of account of
banks.
• One of the broad objectives: Detection of frauds, along with detection of errors,
omissions, irregularities etc.,
• Internal auditor’s job in banks: Invariably include detection of perpetrated
frauds.
• It cannot be denied that frauds have virtually engulfed the entire banking sector
be it public, private or foreign banks.
• Considering the adoption of liberalised policy in the Indian Economy and the
sweeping changes in the banking scenario, an auditor’s priorities should centre
around detection of frauds inter alia other important objectives of the
audit of banks.
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• Many banks are conducting Internal Audits instead of Concurrent Audits or even
in addition to the Concurrent Audits.
Important aspects to be considered about Internal Audit are:
• Internal Audit’s important role in overall governance mechanism of the Banks,
• Role of Risk-Based Internal Audit in evaluating & improving the effectiveness of
Risk Management and governance processes
• Risk-Based Internal Audit Procedures
• Role of Internal Audit in Risk Management
• Evaluation of Financial Information through analysis of non-financial data
• Auditing and Assurance Standards.
Information Systems Audit (IS)
• In the past decade, with the increased technology adoption by Banks, the
complexities within the IT environment have given rise to considerable
technology related risks requiring effective management.
• This led the Banks to implement an Internal Control Framework, based on
various standards and their own control requirements and the current RBI
guidelines.
• As a result, Bank managements and RBI, need an assurance on the effectiveness
of internal controls implemented and expect the IS Audit to provide an
independent and objective view of the extent to which the risks are managed.
IS Audit is a process of collecting and evaluating evidence/information to determine
whether a computer system could:
• Safeguard its assets (hardware, software and data) through adoption of adequate
security control measures;
• Maintain data integrity;
• Achieve goals of the organisation effectively; and
• Result in the efficient use of the available information System resources.
Reserve Bank of India Guidelines on Information Systems Audit
Reserve Bank of India has been taking many initiatives in sensitising Banks to the risks
and concerns that emerge from adoption of information Technology. Various Committee
reports, instructions and circulars have been issued from time to time towards assisting
banks in adopting sound Information System Audit policy framework and practices on
Information Security, Electronic Banking, Technology Risk Management and Cyber
Frauds.
Final guidelines in these areas were issued by RBI vide its circular dated 29th April,
2011. These Guidelines cover the following areas:
• Information Technology (IT) Governance
• Information Security
• Information Systems Audit
• Information Technology (IT) Operations
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Introduction As per the Banking Regulation Act, 1949, annual Financial Statements in
the form of Profit and Loss Account and Balance Sheet are required to be audited in
accordance with the requirements of applicable statutes.
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Salient Features
• It is conducted by a ‘Statutory Auditor’ - the word ‘Statute’ means - mandated or
compulsorily required by any law or Act.
• In case of Banks, sub-section (1) of Section 30 of the Banking Regulation Act,
1949 requires that the Balance Sheet and Profit and Loss account of a banking
company should be audited.
• Independent audit of financial statements of Banks is important for a healthy,
safe and sound banking system.
• Statutory audit does not look at the intricacies of the banking transactions
(which are looked into by concurrent and Internal audits); instead they rely on
the concurrent audit & internal Audit Reports and test checking to form their
opinion.
• Statutory audit mainly looks at the loans and advances, Compliance with Priority
Sector Lending (PSL) requirements, CRR, SLR, CRAR
Stages in Statutory Audit
There is a sea change in banking as use of technology and its continuous evolution has
enabled banks to provide its customers comfort of anytime, anywhere banking. The
auditor should not assume that the system generated information is correct and can be
relied upon without evidence.
The stages in Bank/Statutory audit are:
• Initial consideration by the statutory auditor
• Identifying and assessing the Risks of Material Misstatements
• Understanding the Risk Management Process
• Engagement - Team Discussions
• Establishing the overall Audit strategy
• Developing the Audit Plan
• Preparation of Audit Planning Memorandum
• Determining Audit Materiality
• Assessment of ability to continue as Going Concern
• Assessing the Risks of Fraud including Money Laundering
• Assessing Specific Risks
• Assessing Risks Associated with Outsourcing of Activities
• Response to the Associated Risks
• Conformity to Basel III framework
• Reliance on/review of other reports
• Classification of NPAs (It should be based on the record of recovery)
• Asset classification (It should be Borrower-wise and not facility-wise) In
carrying out his Substantive procedures, the auditor should examine all large
advances while other advances may be examined on a sampling basis.
Types of Audit Reports to be issued by Statutory Auditors
• Statutory Audit Report (As per SA 700/705/706 Issued by ICAI)
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• Long Form Audit Report (As per the requirements of RBI guidelines)
• Tax Audit Report (As per Income-tax Act, 1961) RBI has revised the format of
Long Form Audit Report vide its circular dated September 05, 2020
Appointment of Statutory Auditors in Banks
Sub-section (1) of section 30 of the Banking Regulation Act, 1949 requires that the
Balance Sheet and Profit and Loss of a banking company should be audited by a person
duly qualified under any law for the time being in force to be auditor of companies. RBI
prepares a panel of Chartered Accountants eligible for conducting statutory audit of
banks based upon the data obtained from the Institute of Chartered Accountants of
India. Inputs of Comptroller & Auditor General of India are also obtained before
finalising the list. As per the provisions of relevant enactments:
• The auditors of Private Banks are appointed at the Annual General Meeting of the
shareholders.
• The auditors of Public Sector Banks are appointed by their Board of Directors.
(As per RBI guidelines)
Some of the Important Auditing, Review and Other Standards applicable to the audit of
Financial Statements as prescribed by the Institute of Chartered Accountants of India
are given below:
• 300 (Revised) Planning and Audit of Financial Statements
• 220 (Revised) Quality Control for an Audit of Financial Statements
• 210 (Revised) Agreeing to terms of Audit Engagement
• 510 (Revised) Initial Audit Engagements - Opening balances
• 315 Identifying and Assessing the Risks of Material Misstatements through
Understanding the entity and its environment
• 299 Responsibility of Joint Auditors
• 600 Using the work of Another Auditor
• 250 Consideration of Laws and Regulations in an Audit of Financial Statements
• 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial
Statements
• 330 The Auditors Responses to Assessed Risks
Other than Concurrent Audit, Internal Audit & Statutory Audit, banks undertake the
following types of audits:
• Revenue Audit (known as Income & Expenditure audit) Revenue Audit is
usually conducted at Exceptionally Large/Very Large/Large and Medium
branches and is aimed at identifying cases related to leakage of interest and
other charges.
• Stock and Receivables Audit In terms of extant RBI guidelines, stock audits
may be assigned to qualified professionals (Chartered Accountants/Cost
Accountants/consultants) periodically, say annually to check on the stock and
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book debts statements submitted by the borrowers to the bank. Only large
borrower accounts are normally are subjected to this audit.
• Forensic Audit Forensic Audit is an examination and evaluation of a firm’s or
individual’s financial information for use of evidence in court. Concept of
Forensic Audit may be defined as “A concentrated audit of all the transactions of
the entity to find the correctness of such transactions and to report whether or
not any financial benefit has been attained by way of presenting an unreal
picture.
• Management Audit Management Audit is an assessment of methods and
policies of an organisation’s management in the administration and the use of
resources, tactical and strategic planning and employee and organisational
improvement. The main objective of management audit is to see how far the
objectives of management are fulfilled. It aims to ascertain whether sound
management prevails throughout the organisation and evaluates its efficiency in
the system of its operation.
• Tax Audit including Goods and Services Tax (GST) Audit This is an analysis of
the tax returns submitted by an individual or business entity, to see if the tax
Information and resulting income tax payment is valid. Statutory auditors of
Banks usually deal with provision for Taxation & GST.
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The first step in the preparation of final accounts is the preparation of trial
balance. So it is absolutely essential that we prepare the trial balance perfectly, so our
final accounts do not contain any errors. Let us learn more about the methods and
procedures of preparation of trial balance.
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Trial Balance
A trial balance is a bookkeeping worksheet-like account that reflects all the credit and
debit balances of all the ledger accounts. Once we prepare this statement, we can
prepare the final accounts of the company on the basis of this trial balance.
One other important use of the trial balance is that it can determine the arithmetic
accuracy of the accounts. So if both columns of the trial balance tally, we can be
reasonably assured of the accuracy of the accounts. It does not ensure that the accounts
are free of all errors but it can at least establish mathematical accuracy.
Trial Balance (ABC Trading as at 30 June 2018)
Adjustment Entries
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Usually, adjustment entries are made after preparation of trial balance. In a case when
he makes the adjustment entries after preparation of trial balance, he needs to treat
each of the adjustment twice while preparing trading and profit and loss account and
balance sheet.
In case adjustment entries made before preparation of trial balance, such adjustment
appears in the trial balance. Also, such adjustments appear only once in the preparation
of final accounts.
Adjustment Entries Relating to Income and Expendure
Some of the expenses may have been incurred but not paid: For example- Salary for
the month of March has been incurred during the month but will be paid in April. For
this, adjusting entries, will be passed in the ledger by debit to charges (salary) account
and credit to “Salary payable” account.
Some of the expenses may have been paid in advance but not incurred: If a
payment has been made in advance i.e. it does not pertain to the accounting period in
question, it is not treated as an expense, and the person who received the amount is
treated as a debtor.
Some income may have accrued but not received: For example, interest accrued on a
fixed deposit with the bank which will be paid by the bank on maturity along with the
principal. For accounting the interest income, credit ‘Interest income’ ‘account and
debit’ ‘interest receivable’ account.
Some incomes may have been received but not accrued: If an income has been
received but not accrued, it should not be accounted for. For example, advance payment
of rent by a tenant. This should not be taken into account. Therefore, rent account
should be debited and ‘Advance rent Received’ account should be debited.
If we have recorded all the transactions, their arithmetical accuracy has been checked
by the trial balance and the required adjusting entries have been made, we should be
able to find out the results of the operations during the accounting period (day year)
and also know the financial position of the business at the close the year.
This is done through preparing the Profit and loss account and the Balance sheet
(Both these are called the financial statements).
Entries Relating to Depreciation of Fixed Assets
Before we can start preparing the financial statements, it is important to pass entries for
depreciation to include it in the records as an expense.
Entries Relating to closing stocks
Every sales transaction results in reduction in available stocks and every purchase
transaction increases the stocks available in the godown. However, the entries passed in
the ledger, do not affect the stocks account:
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Example-
Purchase of goods worth Rs 2000 results in the following postings in the ledger-
Dr. Purchase A/C Rs. 2000
Cr. Cash A/c Rs. 2000
Similarly, sales of goods for Rs. 500 result in the following posting in the ledger-
Dr. Cash A/c Rs. 5000
Cr. Sales A/c Rs 5000
As no entry is passed in the stocks account during the year, the balance in it remains the
same as in the beginning of the year, i.e. the opening balance of the stock (this is a debit
balance and is shown in the balance sheet of the last year as closing stock)
As we will see in our discussion in the P/L account, the Profit= sales- (purchases+
opening stock-closing stock+ expenses)
In the above formula, all items, except the closing stock, are available from the ledger. As
the amount of the closing stock in not available from the ledger, we will have to actually
verify the available stock at the close of the year and value it. This is called ‘Inventory
Valuation’ and has its impact on the Profit of loss of the firm during that year.
Entries Relating to other items
Other adjustments pertain to provision for bad and doubtful debts, writing off part
fictitious assets like preliminary expanses etc. provisioning for contingent events etc.
Closing Entries
At the end of each accounting period, al; the income and expenses accounts should be
closed by transferring the balance to the P & L account. The entries passed for this
purpose are called Closing Entries.
Example: If the salary account is showing the debit balance of Rs 300000 a credit entry
‘By transfer to P&L account will be posted in this account and debit entry will be posted
to P & L account. Thus balance in the salary account will become Nill.
Trading Account
This is not a necessary step for preparation of the P & L account but many accountants
prefer to prepare it. It forms part of the P & L account. A trading account takes into
account only the direct costs associated with the materials in which the firm is dealing.
The operating costs are not included. This means that we calculate the ‘Cost of Goods
Sold’ and subtract it from the Revenue to arrive at what is called ‘Gross Profit’. It is
important to note here that under ‘Cost of Goods Sold’, we calculate the cost of only
those goods which are sold and not the cost of entire goods purchased. If we have only
purchased the goods during a year and not sold anything, there will be no cost
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associated with selling of goods as the purchase resulted in only increasing the
inventory (Closing stock).
Cost of Goods Sold= (purchases + opening stock)- closing stock + expenses
Preparation of Profit and Loss account
There are prescribed formats for preparing Profit and loss accounts for all the
companies in India. Such form is either provided in the Companies Act 2013 or the
Banking Regulation Act or some other Act for specific types of companies. However, for
other business entities, there is no prescribed format, Traditionally, all the formats used
put sales and other incomes on the credit side and all the expenses on the debit side and
arrive at the profit figure. This is achieved by passing the closing entries in respect of all
the earnings and expenses accounts in the General Ledger so that the balances in all the
remaining accounts in the GL, form the balance sheet, discussed in the next paragraphs.
A typical format of a P & L account may be as under if the practice of preparation a
Trading account is followed:
Profit and Account of ……..
For the year ending …..2019…..
To salary ………. By Gross profit carried over
From Trading a/c ………………
To electricity charges ………… Gross Loss ………………
To conveyance charges ……………..
To depreciation
To office charges ……………
To other charges …………..
To Taxes
Net Profit …………..
If the practice of preparing the Trading account is not followed, the format may look as
under.
Profit and loss Account of …………
For the year ending …….2019……
To opening stock ………….. By sales ………...
To purchases ………. Less returns ………….
…………
Less returns ………. By closing stock ………..
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Net profit, as arrived at in the P&L A/c, is utilized by the company, for providing
dividend, dividend distribution tax, adjustments to income tax and transfer to
reserves etc. This is done through the profit and loss Appropriation account.
Profit and loss Appropriation account is different from profit and loss account and is
normally put before the net profit figure in the same statement. The net profit is
transferred to the credit side of profit and loss appropriation account. Profit and loss
account shows only the net profit or net loss from operations of business while the
profit and loss appropriation accounts shows all non- operational adjustment.
A typical format of this account is given below. The items included may vary from
company to company.
Particulars Amount Particulars Amount
To transfer to …………… By last year’s balance ……………
reserves brought down
To debenture …………… By net profit of the ……………
redemption reserve year brought down
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• Cash
• Accounts receivable
• Inventory
• Fixed assets
• Other assets
• Accounts payable
• Accrued liabilities
• Debt
• Other liabilities
• Common stock
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• Retained earnings
Validate the balance sheet- The total for all assets recorded in the balance sheet
should be similar to the liabilities and stockholders’ equity accounts.
Present in the required balance sheet format
Liabilities Amount Asset Amount
Capital ……………… Fixed Asset-land, Bldg ………….
Loan Taken ……………. Current Assets …………
Current Liabilities …………….. Cash/Bank B/s ………….
Outstanding Expenses ……………… Accounts Receivable ………….
(Debtors)
Bank Overdraft ………….. Bills Receivable ………..
Account Payable …………… Inventories (stock) ………..
(Creditors)
XYZ XYZ
• Incorporated association
• Artificial person
• Perpetual succession
• Common seal
• Limited liability
• Separation of management from ownership
• Transferability of shares
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Types of companies
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• Government company: Any company in which not less than 51 per cent of the
paid-up share capital is held by the Central Government or by any State
Government or partly by Central Government and partly by one or more State
Governments, is a Government Company.
• Holding company: Section 2 (46) (Chapter I) of the Companies Act 2013: a
Holding company, in relation to one or more subsidiary companies, means a
company of which such companies are subsidiary companies.
• Associate Company: In relation to another company, Associate Company means
a company in which that other company has a significant influence, but which is
not a subsidiary company of the company having such influence and includes a
joint venture company.
• One Person Company: One Person Company means a company which has only
one person as a member.
• Subsidiary company: Section 2(87) (Chapter I) of the Companies Act, 2013
defines a subsidiary company as a company in which the Holding Company (i)
controls the composition of the Board of Directors: or. (ii) exercises or controls
more than one-half of the total share capital either at its own or together with
one or more of its subsidiary companies.
• Company limited by shares: It is a company in which liability of its members is
limited by memorandum to the amount, if any, unpaid on the shares respectively
held by them. Most of the companies in India are companies with limited liability.
• Company limited by guarantee: It is a company in which liability of a member
is fixed to a certain amount and he is liable to pay that much amount in the event
of winding up of the company. This amount is called the ‘Guarantee’. Such
companies are generally floated for the promotion of sports, education, religion,
fine art, etc., and are essentially non-profit making organisations.
• Company with unlimited liability: It is a company in which the liability of a
member is unlimited. Such a company can be incorporated with or without
share capital.
Partnership Vs Limited Liability Partnership (LLP)
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Contractual It cannot enter into contract in its It can sue and be sued in its name.
capacity name.
Legal Status Partners are collectively known as It has a separate legal status.
firm, so there is no separate legal
entity.
Property Cannot be held in the name of firm. Can be held in the name of the LLP.
Perpetual No Yes
Succession
Relationship Partners are agents of firm and Partners are agents of LLP only.
other partners as well.
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Issue of Shares
Over subscription
• share application Debited ………..
• share capital ………. Credited
………… Credited
• bank (refund) ………… Credited
• share allotment
……………. Credited
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Forfeiture of shares
• Share capital A/c Debited ………
• Call in arrears A/c ……….. Credited
• Forfeited shares A/c ……… Credited
Re-issue of shares
• Bank A/c Debited ……….
• Forfeited shares A/c Debited ……….
• Share capital A/c ……….. Credited
• Capital reserve A/c ……….. Credited
Section 43 of the Companies Act 2013, Provided that share capital of the company
shall consist of the following:
• Equity shares with voting rights
• Equity shares with differential rights as to dividend, voting or otherwise in
accordance with such rules as may be prescribed; and
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▪ Name of the Company……………………. Profit and loss statement for the year
ended ………………………(Rupees in…)
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i)Apply to the income and expenditure a/c referred to in subclause (ii) of clause (40) of
section 2 in like manner as they apply to a statement of profit and loss.
ii)In respect of a company other than a finance company revenue from operations
shall disclose separately in the notes revenue from:
• Sale of products;
• Sale of services;
• Other operating revenues;
Less:
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• Excise duty.
In respect of a finance company, revenue from operations shall include revenue from:
• Interest; and
• Other financial services.
Revenue under each of the above heads shall be disclosed separately by way of notes to
accounts to the extent applicable.
iii)Finance Costs
Finance costs shall be classified
• Interest expense;
• Other borrowing costs;
• Applicable net gain/loss on foreign currency transactions and translation.
iv)Other income
• Interest Income (in case of a company other than a finance company);
• Dividend Income;
• Net gain/loss on sale of investments;
• Other non-operating income (net of expenses directly attributable to such
income).
v)Additional Information
A Company shall disclose by way of notes additional information regarding
aggregate expenditure and income on the following items:
(a) Employee Benefits Expense [showing separately
• Salaries and wages,
• Contribution to provident and other funds,
• Expense on Employee Stock Option Scheme (ESOP) and Employee Stock
Purchase Plan (ESPP),
• Staff welfare expenses].
(b) Depreciation and amortization expense;
(c) Any item of income or expenditure which exceeds one per cent. of the revenue from
operations or Rs. 1,00,000, whichever is higher;
(d) Interest Income;
(e) Interest expense;
(f) Dividend income;
(g) Net gain/loss on sale of investments;
(h) Adjustments to the carrying amount
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(vi) Expenditure incurred on each of the following items, separately for each item:
• Consumption of stores and spare parts;
• Power and fuel;
• Rent;
• Repairs to buildings;
• Repairs to machinery;
• Insurance;
• Rates and taxes, excluding, taxes on income;
• Miscellaneous expenses
(vii)
• Dividends from subsidiary companies.
• Provisions for
• losses of subsidiary companies.
(viii) The profit and loss account shall also contain by way of a note the following
information, namely:
(a)Value of imports calculated on C.I.F basis by the company during the financial year in
respect of
• Raw materials;
• Components and spare parts;
• Capital goods.
(b)Expenditure in foreign currency during the financial year on account of royalty,
know- how, professional and consultation fees, interest, and other matters;
(c)Total value if all imported raw materials, spare parts and components consumed
during the financial year and the total value of all indigenous raw materials, spare parts
and components similarly consumed and the percentage of each to the total
consumption;
(d)The amount remitted during the year in foreign currencies on account of dividends
with a specific mention of the total number of non-resident shareholders, the total
number of shares held by them on which the dividends were due and the year to which
the dividends related;
(e)Earnings in foreign exchange classified under the following heads, namely:
• Export of goods calculated on F.O.B. basis;
• Royalty, know-how, professional and consultation fees;
• Interest and dividend;
• Other income, indicating the nature thereof.
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Ind AS-1 prescribes that the balance sheet shall include line items that present the
following amounts:
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• The total of assets classified as held for sale and assets included in disposal
groups classified as held for sale in accordance with Ind AS 105, Non-current
Assets Held for Sale and Discontinued Operations;
• Trade and other payables;
• Provisions;
• Financial liabilities (excluding amounts shown under (k) and (l));
• Liabilities and assets for current tax, as defined in Ind AS 12, Income Taxes;
• Deferred tax liabilities and deferred tax assets, as defined in Ind AS 12;
• Liabilities included in disposal groups classified as held for sale in accordance
with Ind AS 105;
• Non-controlling interests, presented within equity; and
• Issued capital and reserves attributable to owners of the parent.
It also provides the following guidelines regarding the balance sheet:
i)When an entity presents current and non-current assets, and current and non-current
liabilities, as separate classifications in its balance sheet, it shall not classify deferred tax
assets (liabilities) as current assets (liabilities).
ii)Current assets: An entity shall classify an asset as current when:
• it expects to realise the asset, or intends to sell or consume it, in its normal
operating cycle;
• it holds the asset primarily for the purpose of trading;
• it expects to realise the asset within twelve months after the reporting period; or
• the asset is cash or a cash equivalent (as defined in Ind AS 7) unless the asset is
restricted from being exchanged or used to settle a liability for at least 12
months after the reporting period.
iii)Current liabilities: An entity shall classify a liability as current when:
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• An entity should present a single statement of profit and loss, with profit or loss
and other comprehensive ‘income presented in two sections.
• The sections shall be presented together, with the profit or loss section
presented first followed directly by the other comprehensive income section.
• Ind AS-1 prescribes certain line items amount of which should appear in this
statement, at the minimum.
It also provides the following guidelines regarding this Statement:
• An entity shall present additional line items, headings and subtotals in the
statement of profit and loss when such presentation is relevant to an
understanding of the entity’s financial performance.
• An entity shall not present any items of income or expense as extraordinary
items, in the statement of profit and loss or in the
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▪ Paragraph 10 of Ind AS-1: Notes are part of the set of financial statements as
prescribed
▪ This Standard mentions the following guidelines regarding Notes:
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a)Contingent liabilities (see Ind AS 37) and unrecognised contractual commitments; and
b)Non-financial disclosures, e.g. the entity’s financial risk management objectives and
policies (Ind AS 107).
Disclosure of accounting policies
Paragraphs 38, 38A and 38B of Ind AS-1, prescribe the minimum comparative information
in respect of preceding period, as under:
▪ Para 38 of Ind AS-1: Except when Ind ASs permit or require otherwise, an entity
shall present comparative information in respect of the preceding period for all
amounts reported in the current period’s financial statements.
Para 38A: An entity shall present, as a minimum,
• 2 balance sheets,
• 2 statements of profit and loss,
• 2 separate statements of profit and loss,
• 2 statements of cash flows and
• 2 statements of changes in equity, and related notes.
▪ Para 38B: In some cases, narrative information provided in the financial
statements for the preceding period(s) continues to be relevant in the current
period.
▪ For example, an entity discloses in the current period details of a legal dispute,
the outcome of which was uncertain at the end of the preceding period and is yet
to be resolved.
▪ Users may benefit from the disclosure of information that the.
Uncertainty existed at the end of the preceding period and from the disclosure of
information about the steps that have been taken during the period to resolve the
uncertainty.
Change in Accounting Policy, Retrospective Restatement or Reclassification
Para 40A of Ind AS-1 : An entity shall present a third balance sheet as at the beginning
of the preceding period in addition to the minimum comparative financial statements
required in paragraph 38A if:
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▪ Ind AS-110 requires an entity (the parent) that controls one or more other
entities (subsidiaries) to present consolidated financial statements.
▪ It defines the principle of control, and establishes control as the basis for
consolidation;
▪ It further sets out the accounting requirements for the preparation of
consolidated financial statements; and defines an investment entity and sets out
an exception to consolidating particular subsidiaries of an investment entity.
▪ This Ind AS does not deal with the accounting requirements for business
combinations and their effect on consolidation including goodwill arising on a
business combination.
▪ A cash flow statement, prepared for a period, tells us the position of cash at the
beginning and end of that period.
▪ Cash also includes Cash equivalents.
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▪ Cash equivalents are short-term, highly liquid investments that are readily
convertible to known amounts of cash and which are subject to an insignificant
risk of changes in value.
▪ Information about the cash flow of an enterprise is useful in providing users of
financial statements a basis to assess the ability of the enterprise to generate
cash and cash equivalents.
Components Of Cash Flow
• Let us take the example of a simple trading enterprise which starts its
business on 1/04/2022 with its assets and liabilities as under:
• On 2/04/2022, the firm buys wheat for Rs. 90,000 for cash and sells it for Rs.
95,000 on cash basis. Its balance sheet changes as under:
It is easy to see that there is a cash inflow of ` 5,000 during the day, due the trading
activity, which we call “Operating activity” in Accounting parlance. On 3/04/2022, the
firm buys wheat for ` 80,000 for cash and sells it for ` 85,000 on cash basis. It also
purchases a weighing machine for ` 15,000 to facilitate its operations. Its balance sheet
changes as under:
We can see that there is a cash outflow of Rs. 10,000 during the day, despite trading
activity earning a profit of Rs. 5,000 and cash inflow of Rs. 5,000. This is because there
was a cash outflow of Rs. 15,000 for purchasing fixed assets. So, the net result was an
outflow of Rs. 10,000. This falls among the items which we group under “Investing
activity” in Accounting parlance.
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On 4/04/2022, the firm buys wheat for ` 75,000 for cash and sells it for ` 80,000 on cash
basis. On the same day the proprietor withdraws capital of ` 10,000. Its balance sheet
changes as under:
• We can see that there is a cash outflow of Rs. 5,000 during the day, despite
trading activity earning a profit of Rs. 5,000 and cash inflow of Rs. 5,000.
• This is because there was a cash outflow of Rs. 10,000 by way of reduction in
capital. So, the net result was an outflow of Rs. 5,000
• This falls among the items which we group under “Financing activity” in
Accounting parlance.
• Such an activity will also affect the net cash flow of the firm
The activities of a business entity are grouped under 3 categories
• If an enterprise keeps on having positive cash flows from its operating activities
for a very long time, its cash balance will become very high. We have to
remember that while cash is a very desirable asset for liquidity, it is also the
most unproductive asset and no enterprise would like to have huge cash
balances.
• Investment of cash in fixed assets or financial assets is a way to deploy this cash.
Cash outflows due to investing activities represent the extent to which
expenditures have been made for resources intended to generate future income
and cash flows. Cash inflows from investing activities means that there is a net
decrease in such assets.
Examples of cash flows arising from investing activities are:
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• Cash payments to acquire property, plant and equipment, intangibles and other
long-term assets. These payments include those relating to capitalised
development costs and self-constructed property, plant and equipment;
• Cash receipts from sales of property, plant and equipment, intangibles and other
long-term assets;
• Cash payments to acquire equity or debt instruments of other entities and
interests in joint ventures (other than payments for those instruments
considered to be cash equivalents or those held for dealing or trading purposes);
• Cash receipts from sales of equity or debt instruments of other entities and
interests in joint ventures (other than receipts for those instruments considered
to be cash equivalents and those held for dealing or trading purposes);
• Cash advances and loans made to other parties (other than advances and loans
made by a financial institution);
• Cash receipts from the repayment of advances and loans made to other parties
(other than advances and loans of a financial institution);
• Cash payments for futures contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities; and
• Cash receipts from futures contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities.
Financing activities can be useful in utilising the cash generated through operating of
investing activities. These can also be utilises for increasing cash inflows in times of
need. Examples of cash flows arising from financing activities are:
• Cash proceeds from issuing shares or other equity instruments;
• Cash payments to owners to acquire or redeem the entity’s shares;
• Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other
short-term or long-term borrowings;
• Cash repayments of amounts borrowed; and
• Cash payments by a lessee for the reduction of the outstanding liability relating
to a finance lease.
Those business entities which are required to follow the Accounting Standards, have to
prepare the cash flow statement also as it forms part of the set of financial statements.
AS-3 and Ind AS-7 provide detailed guidelines for preparing this statement. Cash flows
are shown separately for each of the three categories of activities. As per the Ind AS- 7,
which sets out requirements for the presentation and disclosure of cash flow
information, an entity shall report cash flows from operating activities using either:
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• The direct method, whereby major classes of gross cash receipts and gross cash
payments are disclosed; or
• The indirect method, whereby profit or loss is adjusted for the effects of
transactions of a non- cash nature, any deferrals or accruals of past or future
operating cash receipts or payments, and items of income or expense associated
with investing or financing cash flows.
Other Important Points Mentioned in Ind AS-7
Some of the other important points mentioned in Ind AS-7 are as under:
• Cash flows exclude movements between items that constitute cash or cash
equivalents because these components are part of the cash management of
an entity rather than part of its operating, investing and financing activities.
Cash management includes the investment of excess cash in cash equivalents.
• A single transaction may include cash flows that are classified differently. For
example, when the cash repayment of a loan includes both interest and
capital, the interest element may be classified as an operating activity and the
loan element is classified as a financing activity.
• The amount of cash flows arising from operating activities is a key indicator
of the extent to which the operations of the entity have generated sufficient
cash flows to repay loans, maintain the operating capability of the entity, pay
dividends and make new investments without recourse to external sources
of financing. Information about the specific components of historical
operating cash flows is useful, in conjunction with other information, in
forecasting future operating cash flows.
• The separate disclosure of cash flows arising from investing activities is
important because the cash flows represent the extent to which expenditures
have been made for resources intended to generate future income and cash
flows. Only expenditures that result in a recognised asset in the statement of
financial position are eligible for classification as investing activities
• The separate disclosure of cash flows arising from financing activities is
important because it is useful in predicting claims on future cash flows by
providers of capital to the entity.
• Cash flows arising from transactions in a foreign currency shall be recorded
in an entity’s functional currency by applying to the foreign currency amount
the exchange rate between the functional currency and the foreign currency
at the date of the cash flow. The cash flows of a foreign subsidiary shall be
translated at the exchange rates between the functional currency and the
foreign currency at the dates of the cash flows. Cash flows denominated in a
foreign currency are reported in a manner consistent with Ind AS 21.
• Cash flows from interest and dividends received and paid shall each be
disclosed separately. These cash flows shall be classified in a consistent
manner from period to period as either operating, investing or financing
activities. The total amount of interest paid during a period is disclosed in the
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• For preparing this statement, items available in the Balance Sheet and the Profit
and Loss Account can be used.
• There is no prescribed format for preparation of cash flow statement. It may be
different for different entities depending upon the peculiar nature of the
activities.
An indicative format of the Statement of cash flows is as under:
1.Cash flows from Operating Activities
(a) Operating income (EBIT)
(b) Add: Depreciation
(c) Subtract/add: profit/loss on sale of long term assets
(d) Add decrease in accounts receivables
(e) Subtract Decrease in accounts payable
(f) Add/subtract decrease/increase in other items of current assets
(g) Add/subtract increase/decrease in other items of current liabilities
Net cash flow from operating activities (A)
2. Cash flows from Investing Activities
(h) Sale of Long term assets
(i) Subtract Purchase of Long term assets
Net cash flow from operating activities (B)
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• Each item in the balance sheet represents either source of funds or use of funds.
• Source of funds: All items on the liabilities side
• Use of funds: all items on the assets side (except cash)
• Cash in the balance sheet represents the unutilized portion of funds, available to
the enterprise.
• If cash is also perceived as a use of funds, then all the uses of funds are equal to
all the sources of funds.
• This perception of available cash, as a use of funds, is what causes the
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For the purpose of preparing the funds flow statement, the information contained in the
two subsequent balance sheets is organized into two principal groups;
While preparing the funds flow statement, we have to take special care of the
following two aspects:
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• Changes in fixed assets: While comparing the figures of two successive balance
sheets, we have to take into account the depreciation charge during the year. We
should also know if any assets have been sold during the year. For example:
Assume that the figures of fixed assets shown in the balance sheets of 31/3/21
and 31/3/22 are same at ` 5,00,000. This may give the impression that there has
been no long term source and use of funds on this account, during the year. But
this is not correct. If the depreciation charged during the year is ` 60,000, it
means that additional fixed assets of the same amount have been purchased
during the year. So, in both sources and uses of funds, an amount of ` 60,000 is to
be shown. Similarly, the amount received from sale of fixed assets is to be shown
as a source.
• Change in Net worth: While comparing the figures of two successive balance
sheets, we have to take into account the outgo on account of dividend or
withdrawal of capital. For example: If the company has reduced its equity capital
through buy back of shares, it may not be reflected correctly as the profit has
been added to the reserves. Also, withdrawal of profits through dividend is to be
shown as a use of funds while the entire net profit should be shown as a source
of funds.
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▪ A Company registered under the Companies Act, 2013 is required to present its
financial statements, i.e. balance sheet and profit and loss account in the formats
laid down in the Schedule III annexed to the Companies Act. Similarly, banking
company, (since it is a company) is also required to prepare and submit its
accounts in a specified format.
Signatures
▪ Section 29 of the Act requires that the financial statements of banking companies
incorporated in India should be signed by the manager or principal officer of the
banking company and by at least three directors (or all the directors in case the
number is less than three).
▪ The financial statements of a foreign banking company are to be signed by the
manager or agent of the principal office in India. The provisions of section 29 are
also applicable to nationalised banks, State Bank of India, regional rural banks,
private sector banks, small finance banks and payments banks.
Audit (Section 30)
▪ Accounts must be audited by a person, duly qualified under any law, for the time
being in force, to be an auditor of companies. However, every banking company
is, before appointing, reappointing or removing any auditor, required to obtain
the prior approval of the Reserve Bank of India.
Submission of Accounts (Secs 31 and 32)
▪ Three copies of the balance sheet and profit and loss account prepared
under Section 29 together with auditors’ report under Section 30 must be
submitted to the Reserve Bank of India within three months from the end of the
period to which they refer. However, it can be extended up to a further period of
three months by RBI (Section 31).
▪ Section 32 of the Act requires a banking company (but not other types of banks)
to furnish three copies of its annual accounts and auditor’s report thereon to the
Registrar of Companies at the same time when it furnishes these documents to
the RBI.
Publication of Accounts
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• All cash receipts and payments are recorded in the receiving cashier’s cash book
and paying cashier’s cash book respectively.
• After this, on the basis of pay-in slips received by the receiving cashier and
cheques and withdrawals slips by the paying cashier, these transactions are
entered first in the accounts of customers and after that Day Books are written.
This is called the ‘Slip System’ of posting.
Ledger Book
General Ledger contains the total accounts of each ledger. Besides the GL, the
following ledger books are maintained:
• Current Accounts Ledger
• FD Accounts Ledger
• RD Accounts Ledger
• Loan Ledger
• Investment Ledger
• Bills discounted and purchased Ledger
Other Books
• Clearing Register
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• Securities Register
• Draft Register
• Bills for collection Register
• Safe deposit vault Register
• Dishonoured cheques Register
• Letter of credit Register
The principal books of account, subsidiary books and statistical records generally
maintained by banks are described in the following paragraphs.
General Ledger
• Contains the control accounts of all personal ledgers, the profit and loss account
and different assets and liabilities accounts.
• There are certain additional accounts also (known as contra accounts) which are
kept with a view to keeping control over transactions which have no direct effect
on the assets and liabilities of the bank and represent the agency business
handled by the bank on which it earns service charges, e.g. letters of credit
opened, bills received or sent for collection, guarantees given, etc.
Profit and Loss Ledger
• Some banks maintain a profit and loss account in the general ledger and
maintain separate books for each revenue or expense head/sub-head.
• Some banks maintain columnar books having separate columns for each revenue
and expense head/sub-head, while others maintain separate books for revenue
and expense heads/sub-heads.
• These books are prepared from vouchers.
• The totals of debits and credits each day are posted to the profit and loss account
in the general ledger from voucher summary sheets.
• In some banks, the revenue accounts too are maintained in the general ledger
itself,
• while in others, broad revenue heads are kept in the general ledger and their
details are kept in subsidiary ledgers
• For example, there are separate accounts for basic salary, dearness allowance
and various other allowances, which are grouped together in the published
accounts.
• Similarly, various accounts comprising general charges, interest paid, interest
received, etc. are maintained separately in the profit and loss ledgers.
Subsidiary Books
Personal Ledgers
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Each control account in the general ledger is supported by a subsidiary ledger (or more
than one subsidiary ledger if the number of accounts is large).
Thus, in respect of control accounts relating to accounts of customers, subsidiary
ledgers are maintained for:
• Various types of deposit accounts (savings bank, current account, recurring
deposits, etc.) which contain accounts of individual customers. Each account
holder is allotted a separate folio in the ledger;
• Various types of loan and related accounts (cash credit, term loans, demand
loans, bills purchased and discounted, letters of credit, bank guarantees issued
etc.) wherein the liability of each customer is reflected. Generally, there is no
separate ledger for overdraft accounts which are granted in a current account.
• Banks generally do not allot separate folios to each customer. The register is
divided into various sections, each section for a particular period of deposit
and/or the rate of interest payable on deposits.
• The voucher summary sheets are prepared in the department which originates
the transactions, by persons other than those who write the ledgers.
• They are subsequently checked with the vouchers by persons generally
unconnected with the writing of ledgers/registers or the voucher summary
sheets.
Bills Registers
▪ Details of different types of bills are kept in separate registers which have
suitable columns.
▪ For example, bills purchased, inward bills for collection, outward bills for
collection etc. are entered serially on a daily basis in separate registers.
▪ In the case of bills purchased or discounted, party-wise details are also kept in a
normal ledger form. This is done to ensure that the sanctioned limits of parties
are not exceeded.
▪ Entries in these registers are made by reference to the original documents.
▪ A voucher for the total amount of the transactions of each day is prepared in
respect of each register. This voucher is entered in the day book.
▪ When a bill is realised or returned, its original entry in the register is marked off.
▪ A daily summary of such realisations or returns is prepared in separate registers
whose totals are taken to vouchers which are posted in the day book.
▪ In respect of bills for collection, contra vouchers reflecting both sides of the
transaction are prepared at the time of the original entry, and this entry is
reversed on realisation.
▪ Outstanding entries are summarised at stipulated intervals and their totals
agreed with the balances of the respective control accounts in the general ledger.
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Other Registers/Records
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Schedule 1: Capital
i)For Nationalised banks: Capital
ii)For banks Incorporated outside India:
▪ Capital (the amount brought in by banks by way of start-up capital as prescribed
by RBI should be shown under this head)
▪ Amount of deposit kept with RBI under Section 11(2) of the Banking Regulation
Act, 1949
Total
III. For other banks:
Authorised capital (.... shares of Rs.... each)....
Issued capital (.... shares of Rs.... each)....
Subscribed capital (.... shares of Rs.... each)....
Called-up capital (.... shares of Rs.... each)....
Less: Calls unpaid ....
Add: Forfeited shares ....
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▪ Others ....
Total:---------------
(II) Advances outside India:
Due from banks ....
Due from others: ....
▪ Bills purchased and discounted ....
▪ Syndicated loans ....
▪ Others .... ....
Total....
Grand Total (C.I and C.II)....
Schedule 10: Fixed Assets Rs.
(i)Premises
At cost as on 31st March of the preceding year
Additions during the year .....
Deductions during the year .....
Depreciation to date ..... .....
(IA) Premises under construction
(II) Other fixed assets (incl. furniture and fixture)
At cost on 31st March of the preceding year ....
Additions during the year ....
Deductions during the year ....
Depreciation to Date ..... ...
(IIA) Leased Assets
At cost as on 31st March of the preceding year ....
Additions during the year including adjustments ....
Deductions during the year including provisions ....
Depreciation to date .... ....
Total (I and II) ....
(IIIA) Capital-Work-in progress (Leased Assets)
net of Provisions ....
Total (I, IA, II, IIA & III) ....
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Accounting treatment of some specific items in the profit and loss account and
balance sheet are being explained
▪ Charged under the heading ‘Provision and Contingencies’ in the Profit and Loss
account.
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▪ In the Balance Sheet, the advances are shown after deducting both bad debts and
provision for bad debts.
▪ The Schedule of Advances to be filled in by the branches contains a separate
column regarding doubtful debts in respect of ‘bills purchased and discounted’,
cash-credits and overdrafts, and unsecured loans.
▪ However, while consolidating the Schedule of Advances at the head office level,
for balance sheet purposes, the advances are shown net of any bad or doubtful
debts.
Provision for Taxation
▪ Charged to the Profit and Loss Account under the heading ‘Provisions and
Contingencies’, in the Balance Sheet, it will be shown under the heading ‘Other
Liabilities and Provisions’, on the Liabilities side.
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▪ In order to encourage market discipline, Reserve Bank has over the years
developed a set of disclosure requirements which allow the market participants
to assess key pieces of information on capital adequacy, risk exposures, risk
assessment processes and key business parameters which provide a consistent
and understandable disclosure framework that enhances comparability.
▪ Banks are also required to comply with the Accounting Standard 1 (AS 1) on
Disclosure of Accounting Policies issued by the Institute of Chartered
Accountants of India (ICAI).
▪ In addition to the 16 detailed prescribed schedules to the balance sheet, banks
are required to furnish the information in the “Notes to Accounts”, a gist of which
is given below.
Summary of Significant Accounting Policies’
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Illustration 3
The following are details of advances of Punjab Bank Ltd.,
▪ Bills Purchased and Discounted 15,00,000
▪ Cash Credits, Overdrafts and Loans Repayable on Demand 20,00,000
▪ Term Loans 5,00,000
▪ The following are the other details of the above advances:
▪ Secured by Tangible Assets 30,00,000
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• Speed
• Accuracy
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• Data
• Record
• Data file or file
• System
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Core Banking is delivered as a set of integrated core banking components that are then
tailored to fit the institution’s individual business requirements. These components can
be easily re-configured as business requirement change, protecting the orginisation’s
strategic investment and maintaining a unified business approach.
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Information Security
Information systems security provides essential information for managing the security
of an organization where information technology is an important factor. It is mainly for
all the staff, who are the first-line support, responsible for the daily, efficient operation
of security policies, procedures, standards and practices. It cover
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• Application/data migration
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▪ When the business is started, the owners bring funds in the form of capital.
▪ It has to raise further funds in the form of further issue of capital and
borrowings.
▪ The funds are needed for creating the fixed assets as well as for the working
capital.
▪ How these funds are used most efficiently is also important.
▪ The financial activities of a business organisation mainly relate to its assets,
liabilities and revenues.
▪ Planning, organizing, conducting and controlling all these financial activities of
the organisation is the function of Financial Management.
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Sole Proprietary
Partnership is the relation between persons who have agreed to share the profits of a
business carried on by all or any of them acting for all.
▪ Governed by the Indian Partnership Act, 1932.
▪ As per Section 4 of the Indian Partnership Act
From this definition, the following points are clear:
✓ An association of two or more persons
✓ An agreement/contract between the persons
✓ The agreement is to carry on a business with the object of sharing profits
✓ The business is to be carried on by all or any of them acting for all.
▪ The persons involved in the agreement are called partners and the entity created
for the business is called partnership firm.
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▪ Exists only in India and is governed by the provisions of the Hindu Law.
▪ It is different from a partnership firm as it comes into existence not out of any
contract but birth in a Hindu family.
▪ The firm is owned by the members of undivided Hindu family, called co-
parceners.
▪ Typically managed by the senior-most male member, also known as Karta or
Manager.
▪ For the sake of income tax, the HUF is considered as a separate entity and is
taxed separately
Association of Persons or Body of Individuals
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▪ Both AOP and BOI are treated as separate entity for the purpose of assessment
under the Income Tax Act.
Company
Financial decisions in a firm mainly relate to the acquisition and utilization of capital
funds in meeting the financial needs and overall objectives of the firm.
Therefore, the primary function of finance department is to acquire capital funds and
put them to proper use, as per firm’s objectives. Financial decisions in an organisation,
normally, relate to the following:
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The objectives of the financial management are to efficiently carry out all the functions
mentioned above under scope of financial management. These objectives can be
summarised as under:
• To ensure adequate and timely supply of long and short term funds to the
organisation, at reasonable cost.
• To ensure optimum utilization of funds
• To take sound capital investment decisions
• To decide on optimum capital structure
• To ensure statutory and regulatory compliance
• To ensure balance between shareholder benefits and organisational objectives
• To ensure appropriate financial risk-management system
While discussing the principles of finance, let us keep in mind that finance is not the
same as money lending. Lending is just one constituent of finance. So, the principles of
finance should not be confused with principles of lending.
The main principles of finance are as under:
• Time Value of Money
• Opportunity Cost of Money
• Risk and Return
• Liquidity and Return
• Diversification
• Reducing asset-liability mismatch/Hedging
• Cash flow
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▪ The risk-return tradeoff means that the potential return rises when a higher risk
is taken, and vice versa.
▪ Financial decisions of a firm are often guided by the risk-return trade off.
▪ Risk is inherent in every investment, though its scale varies.
▪ In order to increase the possibility of higher return, the firm needs to increase
the risk taken and vice-versa
▪ Depending upon the risk-taking ability, investment objectives, and the time
horizon available to achieve it, a firm has to find the optimal combination of risk
and return in a financial decision.
▪ A proper balance between return and risk should be maintained to get optimum
return from the investment.
▪ Such balance is called Risk-Return Trade off and every financial decision involves
this trade off.
Required Rate of Return
▪ The firm has to decide on the rate of return it wants on its investment, below
which it would not like to invest its money.
▪ The relationship between required rate of return and risk can be expressed
as under:
Required Rate of Return = Risk-free Return + Risk Premium
▪ Various tools are used in financial management for measuring the risk. One of
these is the Standard Deviation.
▪ Higher the risk, the higher the risk premium is, which pushes up the required
rate of return.
▪ While the investment in Government bonds is considered to be risk free as the
interest rate is known and the risk of default is almost nil, investment in junk
bonds involves high risk because of high probability of default, though the yield
is high due to low market rate
▪ In general, ethics are concerned with classifying what is right and what is wrong.
▪ Business ethics: Focus on what is right for the shareholders and stakeholders.
▪ Drives the code of conduct of a company.
▪ Normally, each company has a well-documented code of conduct applicable to
both the business and to its employees.
▪ Companies voluntarily adopt this code of conduct containing the principles of
corporate ethics.
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The code of conduct, adopted by an organisation, is affected by both the nature of the
company’s business and its location. The broad principles of code of conduct or ethics,
in business, can be mentioned as under:
• Personal responsibility
• Corporate responsibility
• Corporate Transparency
• Honesty
• Integrity
• Promise-Keeping
• Trustworthiness
• Loyalty
• Fairness
• Concern for Others
• Respect for Others
• Customer Prioritisation
• Law Abiding
• Community and Environmental Responsibility
• Data Protection
• Whistle-blower Protection
• Workplace Diversity and employee compensation
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A finance manager of a firm deals with how the money is raised from investors, how
that money is invested and how the investors are rewarded with suitable return on
their investments.
The key areas in which changes are taking place, are as under:
• Selection of project
• Raising Equity
• Raising debt
• Interest rate on debts
• Foreign exchange management:
• Treasury operations
• Coping with technological changes/data availability
• Dealing with Rating Agencies
• Investor communication
Accounting ratio is the comparison of two or more financial data which are used
for analyzing the financial statements of companies. It is an effective tool used by the
shareholders, creditors and all kinds of stakeholders to understand the
profitability, strength and financial status of companies.
Classification of Ratios
The traditional classification has been on the basis of the financial statements, to which
the determinants of a ratio belong. On this basis, the ratios could be classified as:
• Profit and loss account ratios, i.e, ratios calculated on the basis of the profit and
loss account only.
• Balance sheet ratios, i.e, ratios calculated on the basis of the figures of balance
sheet only.
• Composite ratios or inter-statement ratios, i.e, ratios based on figures of profit
and loss account as well as the balance sheet.
Functional classification
Traditional basis of classification, as given above, has been found to be too crude and
unsuitable because, analysis of balance sheet and income statement cannot be done in
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isolation. They have to be studied together in order to determine the profitability and
solvency of the business. According to the order that ratios serve as a tool for financial
analysis, they are now classified as:
• Profitability ratios,
• Turnover or activity ratios, and
• Financial or solvency ratios
Financial ratios two categories:
• Short term Solvency Ratios are the ratios that disclose the financial position or
solvency of the firm in the short period. Some accountants prefer to call them
simply as ‘Liquidity Ratios’.
• Long term Solvency Ratios are the ratios that disclose the financial position or
solvency of the firm in the long period. Some accountants prefer to call them
simply as ‘Solvency Ratios’.
• The firm can make some year-end changes to their financial statements, to
improve their ratios. Then the ratios end up being nothing but window dressing.
• Ratios ignore the price level changes due to inflation. Many ratios are calculated
using historical costs, and they overlook the changes in price level between the
periods. This does not reflect the correct financial situation.
• Accounting ratios completely ignore the qualitative aspects of the firm. They only
take into consideration the monetary aspects (quantitative)
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• There are no standard definitions of the ratios. So firms may be using different
formulas for the ratios. One such example is Current Ratio, where some firms
take into consideration all current liabilities but others ignore bank overdrafts
from current liabilities while calculating current ratio
• And finally, accounting ratios do not resolve any financial problems of the
company. They are a means to the end, not the actual solution.
Profitability Ratios
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This ratio indicates net margin earned on a sale of Rs. 100. It is calculated as follows:
Net Operating Profit
× 100
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
Solvency Ratios
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Turnover Ratios
Stock turnover Ratio: This ratio indicates whether the investment in inventories is
efficiently used or not. It, therefore, explains whether investment in inventories is
within proper limits or not.
Cost of goods sold during the year/ Average inventory
Debtors ‘Turnover Ratio (Debtors Velocity): Debtors are an important constituent of
current assets and therefore, the quality of debtors, to a great extent, determines a
firm’s liquidity. Two ratios are used by financial analysis to judge this. They are:
(i)Debtors, turnover ratio, and
(ii) Debt collection period ratio.
Debtor’s turnover ratio is calculated as under:
Credit sales/ Average accounts receivable
Debt collection period Ratio: The ratio indicates the extent to which the debts have
been collected in the time. It gives the average debt collection period. The ratio is very
helpful to the lenders because it explains to them whether their borrowers are
collecting money within a reasonable time. An increase in the period will result in
greater blockage of funds in debtors. The ratio may be calculated by any of the following
methods:
(i)Months (or days) in a year/ Debtors turnover
(ii)
Months (or days) in a year
× Average accounts receivable
Credit sales for the year
• Fixed charges cover= Income before interest and tax/ Interest charges
• Debt service coverage ratio= Cash profit available for debt service/ Interest +
Principal payment instalment
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• Earnings per share= Profit available for equity shareholders/ No. of equity
shares
• Dividend yield ratio= Dividend per share/ Market price per share
• Interest can be defined as the price paid by a borrower for the use of a lender’s
money.
• It is compensation paid to the depositor.
• In another words, it is excess of money paid or received on deposits or
borrowings.
• Interest is the price paid by a borrower for the use of a lender’s money. If you
borrow (or lend) some money from (or to) a person for a particular period you
would pay (or receive) more money than your initial borrowing (or lending).
Types of Interest
SI is interest earned on only the original amount, called Principal, lent over a period of
time at a certain rate.
Illustration:
Q.A student purchases a computer by obtaining a loan on simple interest.
The computer costs ₹ 60,000 and the interest rate on the loan is 12% per annum
(simple). If, the loan is to be paid back after two years, calculate:
• The amount of total interest to be paid,
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Compound Interest:
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CI= P(1+i)^n- P
A= P(1+i)^n
P = Principal (Initial amount you borrowed or deposited)
r = Annual rate of interest (expressed as fraction, e.g. 6 per cent per annum = 6/100 =
0.06)
n = Number of years for which the amount is deposited
A = Amount of money accumulated after n years including interest.
Frequently compounding of Interest
What if the interest is paid more frequently?
The accumulated amount (A), at the end of one year will be:
❑ Annually = P (1 + r) = Annual compounding
❑ Quarterly = P (1 + r/4)4 = Quarterly compounding
❑ Monthly = P (1 + r/12)12 = Monthly compounding
▪ Interest is computed on an account balance (i.e. a saving account).
▪ However, when interest is added to the principal amount lying in the account
versus returning it immediately to the customer, the interest itself will earn
interest till the next date for computing the interest. This is known as the
compounding of the interest or more simply stated as compound interest.
▪ Compounding Interest: The time interval between which the interest is added
to the account
The interest rate together with compounding period and balance in the account
determines how much interest is added in each compounding period.
▪ The basic formula is A = P (1 + r/n) nt
▪ P = the principal
▪ A = the amount accumulated (Principal + Interest)
▪ r = the rate (expressed as fraction, e.g. 6 per cent = 0.06)
▪ n = number of times per year the interest is compounded
▪ t = number of years for which the principal amount is invested
▪ Note: The above explanation is more easily understandable by thinking in terms
of a simplified compound interest. When the interest is only compounded once
per year (n = 1)
illustration simplifies.
▪ A = P (1 + r)t A = 10,000 (1 + 0.06)1 = 10,600
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▪ The following table shows the final accumulated amount (A) after t = 1 year of an
account initially with P = 10,000 at 6 per cent interest rate with given
compounding (n)
▪ If the applicable interest rate and the length of the deposit all remain the
same, more interest is earned by increasing the number of compounding
periods per year.
▪ Special Note: When interest is compounded continually (in other words, when n
approaches infinity) the compound interest equation takes the form A = Pert
where e is approximately 2.71828 (the exponential number).
▪ The Rule of 72: Allows you to determine the approximate number of years
before your money doubles with yearly compounding. Here is how to do it;
Divide the number 72 by the percentage rate you are paying on your debt (or
earning on your investment).
Illustration:
You borrowed Rs.1,000 at 6% interest. Then, 72 divided by 6 is 12. That makes 12 the
approximate number of years it would take for your debt to double to Rs. 2,000, if you
did not make any payment.
Similarly, a saving account with Rs. 500 deposited in it, earning 4% interest and
compounded yearly, will take 18 years for Rs. 500 to double to Rs. 1,000 if you do not
make any further deposit, as 72 divided by 4 is 18.
Illustration
The simple interest in 3 years and the compound interest in 2 years on a certain
sum at the same rate are Rs. 1,200 and Rs. 832 respectively. Find
• The rate of interest,
• The principal,
• The difference between the C.I. and S.I. for 3 years
(i)CI(2 year)– SI(2 year) = SI (2 year) * r /200 = PR^2/ 100^2
SI for 3 years = 1200
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Floating Rate:
• In the floating rate or variable rate, the rate of interest changes, depending upon
the market conditions. Under floating rate, the interest rate is usually linked to a
benchmark rate which could be the MCLR/base rate of the bank or any other
benchmark rate of the banking industry.
• It may increase or decrease depending upon the change in the benchmark rate.
• For example, if a home loan is taken at an interest rate of 12 per cent, repayable
in 10 years, in April 2021, and if the benchmark rate increases to 12.5 per cent in
April, 2022, the interest rate of this loan will also be increased to 12.5 per cent. If
the loan is under an EMI system, depending upon the change in interest rate, the
repayment period varies, but equated monthly instalment remains the same.
However, the borrower may choose to have the repayment period same and pay
a higher EMI.
If the interest is deducted from the principal amount and only the net amount is
disbursed, it is called front-end interest.
For example, when the bank discounts a bill, the interest applicable for the tenure of the
bill is calculated and is deducted from the bill amount along with other charges and the
net amount is paid to the customer.
However, the normal practice in banking industry is to charge back-end interest rate
which means that the full amount of the loan is disbursed and the interest is charged
subsequently on monthly/quarterly/agreed basis.
For example, in a term loan, the interest is calculated on the actual daily balances in the
account during a period and applied at the end of the period. Obviously, the frontend
interest application results in effective interest rate being more as the borrower gets
less amount for use whereas, the interest is applied on the full amount.
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▪ Such products are calculated for the entire period for which the interest is to be
applied.
▪ The sum of such products is multiplied by the applicable interest rate and
divided by 365(No. of days in a year).
The following illustration will clarify this. Illustration The following table
shows date-wise closing debit balances in the cash credit account of customer
for the month of June 2022, and the calculation of products.
Annuities
At some point in your life, you may have had to make a series of fixed
payments over a period of time –such as rent or car payments-or have received a
series of payments over a period of time, such as bond coupons. These are called
annuities. (Regular periodic payment)
• Ordinary Annuity: Payment are required at the end of each period. For an
illustration, straight bonds usually make coupon payments at the end of
every six months until the bond’s maturity date.
• Annuity Due: Payments are required at the beginning of each period. Rent is
an illustration of annuity due. You are usually required to pay rent when you
first move in at the beginning of the month, and then on the first of each
month thereafter.
Calculating The Future Value Of An Ordinary Annuity
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▪ If you know how much you can invest per period for a certain time period, the
future value of an ordinary annuity formula is useful for finding out how much
you would have in the future by investing at your given interest rate.
▪ If you are making payments on a loan, the future value is useful for determining
the total cost of the loan.
Let us now run through the illustration 1.
Consider the following annuity cash flow schedule:
In order to calculate the future value of the annuity, we have to calculate the future
value of each cash flow.
Let us assume that you are receiving Rs. 1,000 every year for the next five years, and
you invest each payment at 5%.
The following diagram shows how much you would have at the end of the five-year
period:
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Q.If Rs. 10000 is deposited at the end every year, how much amount will be
received after 5 years at 10% p.a. interest.
= 10000 [1.10^5 -1]/ .10
= Rs.61051
▪ If you would like to determine today’s value of a series of future payments, you
need to use the formula that calculates the present value of an ordinary annuity.
▪ You would use this formula as part of a bond pricing calculation.
▪ The PV of ordinary annuity calculates the present value of the coupon payments
that you will receive in the future.
For the illustration
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▪ When you are receiving or paying cash flows for an annuity due, your cash flow
schedule would appear as follows: Since, each payment in the series is made one
period sooner; we need to discount the formula one period later.
▪ A slight modification to the FV-of-an-ordinary-annuity formula accounts for
payments occurring at the beginning of each period.
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▪ For the present value of an annuity due, we need to discount the formula one
period forward, as the payments are held for a lesser amount of time.
▪ When calculating the present value, we assume that the first payment made was
today.
▪ We could use this formula for calculating the present value of your future rent
payments as specified in a lease you sign with your landlord. Let us say for the
illustration that you make your first rent payment at the beginning of the month
and are evaluating the present value of your five-month lease on that same day.
Your present value calculation would work as follows:
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Repayment Of A Debt
A debt is required to be repaid as per the terms of the contract with lender.
In the banking industry in India, the following three methods of repayment are
common.
✓ Equal monthly/quarterly installment of principal plus the interest applied during
the period.
✓ Equated monthly/quarterly installment covering both the principal and the
interest.
✓ Bullet/balloon repayment under which the entire loan amount is repaid at the
end of the period with accumulated interest. Alternatively, the interest is paid
periodically, as and when applied, and the principal amount of the loan is paid at
the end of the contract period.
These are discussed below in detail.
Equal monthly/quarterly installment of principal plus the interest applied during
the period.
Illustration
Your friend has borrowed Rs.1,000 from you and wants to repay you on a monthly basis
rather than the whole amount all at once at the end of the year. The important point
here is that he will owe you less in principal each month.
The applicable rate of interest 8% p.a. means 0.667% per month.
Calculation:
The principal payment each month will be Rs. 83.33 (1,000/12)
First month: Interest = 1,000 × 0.667% × 1 = 6.67 + 83.33 =Rs. 90.
The principal owed at the end of the month is Rs. 916.67.
Second month: Interest = 916.67 × 0.667% × 1 = 6.11 + 83.33 = 89.44.
Third month: Interest = 833.34 × 0.667% × 1 = 5.56 + 83.33 = 88.89.
And so on for the twelve months.
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Debt means a sum of money due by one party to another. Most business need a mix
of debt and equity to run their operations. This is called the capital structure of that
firm/company.
Debts can arise through bank borrowings, fixed deposits, bonds or other instruments.
Where the amount is fixed and specific, and does not depend upon any future valuation
to settle it.
Bonds
Bonds are issued by organizations generally for a period of more than one year to
raise money by borrowing.
Organizations in order to raise capital issue bond to investors which is nothing but a
financial contract, where the organization promises to pay the principal amount and
interest (in the form of coupons) to the holder of the bond after a certain date. (Also
called maturity date). Some Bonds do not pay interest to the investors, however it is
mandatory for the issuers to pay the principal amount to the investors.
Every individual needs to put some part of his income into something which
would benefit him in the long run. Investment is essential as unavoidable
circumstances can arise anytime and anywhere. One needs to invest money into
something which would guarantee maximum returns with minimum risks in future.
Money saved now will help you overcome tough times in the best possible way.
Characteristics of a Bond
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• Face value: Also known as, the par value and stated on the face of the bond. It
represents the amount borrowed by the firm, which it promises to repay after a
specified period.
• Coupon rate: A bond carries a specific rate of interest, which is also called as the
coupon rate.
• Market value: A bond may be traded on a stock exchange. Market value is the
price at which the bond is usually bought or sold in the market. Market value
may be different from the par value or the redemption value.
• Redemption Value: The value, which the bondholders gets on maturity. Is called
the redemption value, A bond is generally issued at a discount (less than par
value) and redeemed at par.
• Maturity date: Maturity date refers to the final date for the payment of any
financial product when the principal along with the interest needs to be paid to
the investor by the issuer.
Types of Bonds
• Fixed Rate Bonds: In Fixed Rate Bonds, the interest remains fixed through out
the tenure of the bond. Owing to a constant interest rate, fixed rate bonds are
resistant to changes and fluctuations in the market.
• Floating Rate Bonds: Floating rate bonds have a fluctuating interest rate
(coupons) as per the current market reference rate.
• Zero Interest Rate Bonds: Zero Interest Rate Bonds do not pay any regular
interest to the investors. In such types of bonds, issuers only pay the principal
amount to the bond holders.
• Inflation Linked Bonds: Bonds linked to inflation are called inflation linked
bonds. The interest rate of Inflation linked bonds is generally lower than fixed
rate bonds.
• Perpetual Bonds: Bonds with no maturity dates are called perpetual bonds.
Holders of perpetual bonds enjoy interest throughout.
• Subordinated Bonds: Bonds which are given less priority as compared to other
bonds of the company in cases of a close down are called subordinated bonds. In
cases of liquidation, subordinated bonds are given less importance as compared
to senior bonds which are paid first.
• Bearer Bonds: Bearer Bonds do not carry the name of the bond holder and
anyone who possesses the bond certificate can claim the amount. If the bond
certificate gets stolen or misplaced by the bond holder, anyone else with the
paper can claim the bond amount.
• Covered bond: Covered bond are backed by cash flows from mortgages or
public sector assets. Contrary to asset-backed securities the assets for such
bonds remain on the issuers balance sheet.
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Occasionally a bond may contain an embedded option; that is, it grants option-like
features to the holder or the issuer:
• Callability: Some bonds give the issuer the right to repay the bond before the
maturity date on the call dates. This is call option. These bonds are referred to
as callable bonds. Most callable bonds allow the issuer to repay the bond at
par. With some bonds, the issuer has to pay a premium, the so-called call
premium.
• Putability- Some Bonds give the holder the right to force the issuer to repay
the bond before the maturity date on the put dates. This is put option. These
are referred to as retractable or putable bonds.
Valuation of Bonds
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to be received after 6 periods at the interest rate of 10% period. PVIFA (10%,6) means
present value of an ordinary annuity one Rupee per period for 6 period at the interest
rate of 10% per period.
Example:
A bond, whose par value is Rs 1000, bears a coupon rate of 12% and has a maturity
period of 3 years. The required rate of return on the bond is 10%. What is the value of
this bond?
Solution-
Annual interest payable= 1000* 12%=120
Principle repayment at the end of 3 years= Rs 1000
The value of the bond
120(PVIFA 10%, 3yrs) + 1000 (PVIF 10%, 3 yrs)
=120(2.487)+1000(0.751)
=298.44+ 751
=1049.44
If the Bond carries a semi-annual, as the amount of the half-yearly interest can be
reinvested, the value of such bonds would be more the value of bonds with an annual
interest payment. Hence, by multiplying the numbers of years to maturity by two and
dividing the (i) annual interest payment, (ii) discount rate by two we can modify bond
valuation formula as follows:
Example:
A bond, whose par value is Rs 1000 bears a coupon rate of 12% payable semiannually
and has a maturity period of 3 years. The required rate of return on bonds is 10%. What
is the value of this bond?
Solution-
Semi-annual interest payable= 1000*12%/2=60
Principal repayment at the end or 3 years=1000
The value of the bond
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Current yield represents the prevailing interest rate that a bond or fixed income
security is delivering to its owners.
The formula for current yield is defined as follows:
CY = Annual interest payment / Current Bond Price
For example, let's assume a particular bond is trading at par, or 100 cents on the dollar,
and that it pays a coupon rate of 3%. In this case, the bond's current yield will also be
3% (as shown below).
CY = 3 / 100 = 3.00%
However, let's now assume that the same bond is trading at a discount to its par value.
For the sake of example, let's say investors can now purchase the bond for just 95 cents
on the dollar. In this case, even though the bond will still be paying a 3% coupon, its
current yield will actually be slightly higher (as shown below):
CY = 3 / 95 = 3.16%
As another example, let's say the bond is trading at a premium to its face value -- 110
cents on the dollar. In this case, even though the bond will still be paying a 3% coupon,
its current yield will actually be quite a bit lower (as shown below):
CY = 3 / 110 = 2.73%
Use our Yield to Call (YTC) Calculator to measure your annual return if you hold a
particular bond until its first call date.
Use our Yield to Maturity (YTM) Calculator to measure your annual return if you plan to
hold a particular bond until maturity.
It is the rate of return earned by an investor, who purchases a bond and holds it until
the maturity. The YTM is the discount rate, which equals the present value of promised
cash flows to the current market price/ Purchase price.
Example:
Consider a Rs 1000 par value bond, whose current market price is Rs 850/-, The bond
carries a coupon rate of 8% and has the maturity period of 9 yrs. What would be the
rate of return that an investor earns if he purchase the bond and holds until maturity?
Solution:
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Duration of Bond
The duration of a bond expresses the sensitivity of the bond price to changes in the
interest rate. In other words, the bond duration measures the movement in the price of
the bond for every 1% change in the interest rate.
The unit of bond duration is expressed in years. Also, the price of the bond and the
interest rates are inversely related. Therefore, if a bond has a duration of 5 years, it
signifies that for every 1% increase in the interest rate, the price of the bond will fall by
5% and vice-a-versa. The greater is the bond duration, the greater will be the
amplification in the movement of bond price for every single unit of change of the
interest rates.
There is a simple way of computing the desired duration period:
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• Multiply each of the present values by respective numbers of years left before
the present value is received.
• Sum these products up and divide by the present value to get the duration of the
bond.
Properties of Duration
The sensitivity of the bond price to changes in the interest rates is called “Bond
Volatility”. Bond prices and YTM are inversely related. Therefore, instantaneous
changes in market yields cause prices to changes in the opposite direction. The extent of
change in the bond princes for a change in YTM measures the interest rate risk of a
bond. The interest rate risk is a function of the interest rate elasticity. Interest rate
elasticity (IE) can be defined as:
IE= Percentage change in price for bond In period t/Percentage change in yield to
maturity for bond
Interest rate elasticity is always a negative number, due to the inverse relationship
between YTM and bond prices.
Bond price elasticity can also be computed with the help of following mathematical
formula:
IE= D* YTM/1+YTM
The above equation suggests that the duration and interest rate elasticity of a bond are
directly related. Anything that causes the duration of a bond to increase will also
increase the bond’s interest rate elasticity.
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▪ The exchange rate movements in the Indian forex market do not necessarily
follow the international trend, particularly in the short run.
▪ The main reason for this is the restriction on the free flow of capital into or out of
the country.
▪ Prior to the modified ‘Liberalised Exchange Rate Management System’
(LERMS), the Reserve Bank fixed the buying and selling rates and the market
would remain within the ceiling and the floor, thus fixed by the Reserve Bank.
▪ However, at present, the forces of demand and supply in the local interbank
market drive the exchange rate.
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Cross Rate
• If a person wants to remit Euros from India, and as a banker, and for argument
sake, rupees/Euros are not normally quoted and therefore, what we have to do is
first buy dollars against the rupees and the same dollars will be disposed of
overseas to acquire the Euros.
Chain Rule
The value date is a date on which the exchange of currencies actually takes place. Based
on this concept, we have the following types of exchange rates.
• Cash/ready: It is the rate when an exchange of currencies takes place on the
date of the deal.
• TOM: When the exchange of currencies takes place on the next working day, i.e.
tomorrow it is called the TOM rate.
• SPOT: When the exchange of currencies takes place on the second working day
after the date of the deal, it is called the spot rate.
• Forward rate: If the exchange of currencies takes place after a period of spot
date, it is called the forward rate. Forward rates generally are expressed by
indicating a premium/discount for the forward period.
• Premium: When a currency is costlier in forward or say, for a future value date,
it is said to be at a premium. In the case of the direct method of quotations, the
premium is added to both the selling and buying rate.
• Discount: If currency is cheaper in the forward or for a future value date, it is
said to be at a discount. In the case of a direct quotation, the discount is
(deducted) subtracted from both the rates, i.e. buying and selling rates.
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▪ The date on which the values are exchanged can be any date starting from the
date of transaction onwards.
▪ Generally, the exchange rates are quoted on a spot basis, i.e. the settlement takes
place on the 2nd working day after the date of transaction.
▪ The exchange rate for settlement on a date beyond the spot is naturally different
and the same is called the forward rate.
Forward rate has two components:
✓ Spot rate
✓ Forward points reflecting the interest rate differentials adjustment for different
settlement dates.
Forward Points
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Suppose someone borrows Euro 100 for one year @ 3% per annum converting it
into US$ and places the same as a deposit for one year @ 6%, his cash flows will
be as under:
Thus, a person can make Euro 3 in one year by borrowing Euro and converting
the same into US$ and after one year converting US$ again into Euro.
However, it is being presumed that US$/Euro rate continues to be same for spot and
one year forward.
The US$/Euro rate will be: Euro 103 = US$159 i.e. Euro 1 = 159/103
= US$ 1.5436
Thus, 0.0436 represents the forward differential between spot and one year forward.
Arbitrage
▪ Arbitrage is an operation by which one can make risk free profits by undertaking
offsetting transactions.
▪ Arbitrage can be in interest rates, i.e. borrow at one centre and lend at another at
a higher rate.
▪ Arbitrage can occur in exchange rates also. However, with the present day
efficient communication system, arbitrage opportunities are very rare.
▪ In the above example forward rate, i.e.
Euro 1 = US$ 1.5436, would perfectly offset the interest rate differential and can
be calculated as follows:
Principal + interest of US$ investment = US$ 159
Principal + interest of Euro loan = Euro 103
Therefore, Euro 103 = US$ 159 Or
Euro 1 = US$ 159/103 = US$ 1.5436
We can calculate the approximate forward points for a given forward period with
the help of the following information:
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Forward differential, is also known as the ‘Swap Rate’. Three months forward rate for a
US$/Euro can be calculated by adjusting spot rate with the forward differential.
Interest differential from forward points:
The formula for calculating the interest rate differential from the forward points is
as under:
▪ forward exchange rates are quoted when the value date in the foreign exchange
transaction is beyond the spot date.
▪ Spot exchange rate and forward rates are different.
▪ The difference between spot rate and forward rate is known as the forward
differential and the same can be at a premium or a discount. Let us illustrate this
with the help of spot and forward exchange rates:
Spot inter-bank rate US$ 1 = Rs. 74.8450
3 months forward US$ 1 = Rs. 74.8725
Thus, if one has to buy 3 months forward US$ against rupees he has to pay more for the
same US$ by 0.0275. To understand this, it can be said that the three months forward
US$ is costlier by Rs. 0.0275 as compared to spot. Therefore, US$ is at a premium in
forwards vis-à-vis rupee.
▪ In case of direct quotations, a premium is always added, i.e. added to both buying
and selling side.
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▪ 2nd: Partly financing the current assets required to be held by the firm, also
called the working capital.
▪ The long term sources of capital, used by the firm to part finance the total
working capital requirements is the margin money or better known as the Net
Working Capital (NWC).
Meaning of Capital Structure
▪ This long term money required by the firm is known as the capital.
Now, this long term money can be from two sources:
• EQUITY or owner’s money
• DEBT
DIFFERENCE: Equity is the risk capital put in the business by the owners who get
return on their investment by way of profits earned by the firm while the debt
providers are not owners of the firm and they lend the money to the firm on agreed
terms of repayment and interest payment.
The purpose of these lenders is to earn interest on their surplus funds and at the same
time not to take any business risk as they do not share profit or loss of the firm.
Capital Structure is referred to as the proportion of debt and equity in the total long
term funds raised by the firm.
Illustration:
A firm starts its business by raising total long term funds of Rs. 500 lakh, to meet its
requirements, as under:
• Equity capital Rs.200 lakh
• Debt capital Rs. 300 lakh
This gives a capital structure of 60% debt capital (300/500) and 40% equity capital
(200/500)
Leverage/Gearing
▪ If the ratio of debt capital is very high, it is called Highly Leveraged or highly
geared firm.
▪ If the ratio of debt capital is low; it is called a Low Leveraged or low geared firm.
Examples of debt capital are:
▪ Term loans.
▪ Debentures,
▪ Corporate deposits,
▪ Fixed deposits from public, etc.
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The decision on proportion of debt and equity, as also the instruments through which
these two are to be sourced, is influenced by various factors, the main of which are
as under:
Norms prevailing in the financial system:
• The banks and financial which are the prominent source of debt financing, have
their lending policies and norms .
• They will not permit a borrowing firm to violate the prescribed debt equity
norms.
• For example, if a company applies for a term loan to set up cement factory with
90% debt and 10% equity, the Indian lender will not approve it and ask the
company to improve the structure of the project (to say 60% debt and 40%
equity).
• In capital market also, the investors will not subscribe to the debt or equity
instruments of a company if the debt equity proportion is beyond a reasonable
point.
• Rating agencies also take note of the proportion of debt and equity, in their
analysis, while assigning a rating to any financial instrument of the company
Degree of control:
• If the promoters of a company, do not want to dilute their voting rights beyond a
point, they will not issue further equity capital to outsiders.
• In such a case, they will prefer additional funds by issuing debt instruments like
debentures.
Trading on Equity
• This concept is based on the premise that the firm will earn more profit by
deploying funds than the cost of those funds.
• For example, if the cost of borrowing Rs. 1 crore is Rs. 12 lakh in a year, the firm
will earn Rs. 15 lakh by investing 1 crore during the year. The surplus of Rs. 3
lakh will be additional profit for the owner over and above the profit earned by
investing the capital which they have brought in the firm.
• Thus, more the debt taken by a firm, more will be the profit on each rupee of the
equity capital. Trading on equity means taking advantage of equity capital to
borrow funds on reasonable basis.
Cost of Debt
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▪ The capital structure of a firm also depends on the size of the firm, its business
model and market practices also.
▪ A firm with little intention of future expansion, may not keep a high equity
capital base and may prefer higher proportion of debt because the debt is easier
to be repaid.
▪ Reduction in equity capital is more difficult as share buy-back is subject to strict
regulatory compliance and is a slow process.
There are many theories/approaches which establish the relationship between financial
leverage, weighted average cost of capital and the total value of the firm.
▪ Net Operating Income Approach, developed by David Durand, assumes that the
WACC or the value of a firm remains unaffected by the change of debt proportion
in the capital structure.
▪ According to this approach, the benefit that a firm derives by debt is negated by
the simultaneous increase in the required rate of return by the equity
shareholders as the increased debt increases the risk perception of the firm,
mainly bankruptcy risk.
▪ According to this approach, the market value is dependent on the operating
income and the business risks of the firm.
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▪ The traditional position takes into account a different but more realistic
approach towards cost of debt capital and cost of equity capital. According to this
approach, when the proportion of debt capital increases in the capital structure
of a firm, the cost of debt will start increasing beyond a point.
▪ This is because the creditors will be wary of higher risk due to enhanced leverage
of the firm.
▪ This theory also assumes that the cost of equity capital also increases with
increasing leverage.
▪ It remains constant up to a certain level of leverage, gradually increases
thereafter and beyond a point, shows sharp increase.
▪ Due to this type of relationship between leverage and costs of debt and equity
capitals, as the leverage of a firm increases, WACC may show decline up to a
point, remain constant up to another point and increase thereafter
Assumptions in the Approaches on Capital Structuring
• Both Net Income and Net Operating Income approaches assume that the increase
in debt will not affect the risk perception of the creditors and the rate of interest
(cost) of debt will not change with leverage. However, the traditional approach
assumed otherwise
• All firms distribute the entire profit to the equity holders.
• For the sake of simplicity, total capital is assumed to be comprising of only debt
capital and equity capital.
• There is no income tax, individual as well as on the firm.
• The business conditions will remain same so that the operating profit is not
changed.
• There is no transaction cost and the frim can change its capital structure
whenever it wants so.
• There are no redeemable sources in the capital composition of the firm and will
continue for long time.
• Capital market is perfect and all investors are rational.
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▪ If a firm has EBIT of Rs. 100 lakh with 100% debt and 0% equity, it will have the
same EBIT of Rs. 1 lakh with capital structure of 0% debt and 100% equity.
▪ What will change is the net profit of the firm i.e. the profit after paying interest
and tax.
Illustration:
Firm ABC, having total capital of Rs. 2 lakh, has EBIT of Rs. 1 lakh for the year.
Income tax for the firm (Corporate tax) is at 25%. Rate of interest on debt is 12% p.a.
Let us consider the following 3 scenario:
• Scenario A: Debt 100%, Equity capital 0%
• Scenario B: Debt 50%, Equity capital 50%
• Scenario C: Debt 0%, Equity capital 100%
It can be observed from the above table that the combined income on debt and equity
capital increases as the leverage of the firm increases.
This is because of 100% tax exemption provided under the IT Rules on interest paid on
debt. So, should the firms go for more debt capital in comparison to the equity capital?
The answer is not so simple. We have discussed earlier the perils of disproportionately
high debt for the firm, including the risk of bankruptcy. Also, as the leverage increases,
the investors will have a higher risk perception of the firm and the cost of debt and
equity capital may not remain same, as assumed in above.
▪ The capital of a firm represents its long term sources of funds, shown in the
balance sheet as liabilities. It consists of both debt capital and the equity capital.
▪ The common perception is that the equity capital of a firm does not involve any
cost as it is under no legal obligation to pay to the equity holders. Also, it can be
argued that the equity capital includes retained profits, which are earned by the
firm and so no cost is involved in using such funds.
▪ But, let us think from the point of view of equity holders. They have taken more
risk by investing in the firm compared to any other investor. The debt capital
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investors are assured of a fixed return irrespective of whether the firm earns
profits or not. They have legal rights to recover their money from the assets of
the firm The preference share-holders also get an assured return on their
investment as also preference over the equity share-holders in case of
liquidation of the firm.
▪ When providers of equity capital are taking maximum amount of risk and also
foregoing the opportunity cost of their capital, they expect that the firm will earn
for them more than what other investors are getting. If the firm fails to do so, the
equity capital investors may like to put their money in other investment avenues.
▪ That is why it is said that the cost of equity capital is more than the prevailing
market cost of preference and debt capital.
▪ Whereas, calculating the cost of preference and debt capital is comparatively
simpler, arriving at the cost of equity capital is often a difficult exercise as the
risk premium expected by equity capital investors depends on the perception of
the investors, to a considerable extent.
▪ Why it is important to know the correct cost of capital of the firm?
▪ It is important because it provides a benchmark above which the firm should
earn from its business.
▪ For example, if the firm is appraising an investment proposal on the premise that
the cost equity capital is zero, it may approve a project which gives a low rate of
return.
▪ The cost of capital should correctly represent the opportunity cost of the various
components of capital structure of the firm to arrive at the correct benchmark
for the firm to evaluate investment proposals.
▪ If the firm raises a term loan from a bank or a financial institution, the rate of
interest is transparently known.
▪ Term loans are not traded in the secondary market and the bank has already
fulfilled its expectations of returns on its funds by quoting the interest rate on
the term loan.
▪ Therefore, no calculation is involved in arriving at the cost of this and the rate of
interest charged by the bank is taken as the cost.
▪ PROBLEM: In case of bonds and debentures.
▪ But what we are talking here is the rate expected by the investors from these
debentures in the secondary market.
▪ That rate will depend on the coupon rate as also investors’ perception of firm’s
risk profile and prevailing market conditions.
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▪ An operating firm can get additional equity capital through internal accruals
and/or through issue of fresh equity.
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▪ Issue of additional equity capital involves a floatation cost which may be low in
case of a rights issue and high in case of a public issue of equity shares.
▪ For the sake of simplicity, here we will assume the floatation cost to be 0 which
means that the cost of equity capital is same in both the cases of retained
earnings and additional issue of equity shares.
▪ As a company has no commitment to pay any assured dividend every year, the
estimation of cost of equity capital becomes difficult.
There are many approaches used for this estimation. Some of the widely used
methods are:
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▪ Under this approach, an equity risk premium is added to the yield on long term
bonds of the firm.
▪ While the yield on long term bonds of the firm are known in the market, decision
on equity risk premium is a matter of individual investor perception.
Illustration
If the yield on long term bonds of the firm is 12% p.a. and the equity risk premium is
4%, what will be the required rate of return on firm’s equity capital?
The required rate = 12 + 4 =16
Dividend Growth Model approach
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▪ Once we have estimated the cost of each component of capital of a firm, the
WACC is arrived at by multiplying the proportion of each component with its
cost and adding them.
Illustration
The capital structure of a firm is as under: Equity capital 40% Preference capital 10%
Debt capital 50%
The cost of each is estimated as under: Equity capital 20% Preference capital 15% Debt
capital 10%
WACC = (20 × 0.4 + 15 × 0.1 + 10 × 0.5) = 8 + 1.5 + 5 = 14.5%
The factors affecting the Weighted Average Cost of Capital of a firm can be
classified under 2 categories,
Internal factors and the external factors.
❑ Internal factors:
The internal factors affecting the Weighted Average Cost of Capital are:
✓ Capital structure policy
✓ Capital investment policy
✓ Dividend policy
❑ External factors:
The external factors affecting the Weighted Average Cost of Capital are:
✓ Prevailing interest rates in the market
✓ Risk perception and market risk premium
✓ Rates of corporate and personal taxes
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This chapter sets out two main discounting techniques of investment appraisal namely
the net present value (NPV) method and the internal rate of return (IRR) methods. Two
main assumptions that are made in discussing the two techniques, are as follows:
• That the sums of moneys, resulting from an investment, that accrue in future, are
know with certainty.
• That there is no inflation.
Net present value
NPV method involves comparing the present value of the future cash flows of an
investment opportunity with the cash outlay that is required to finance the opportunity.
In this ways, we determine whether the investment opportunity provides a surplus,
when the cash flows are measured in present value terms.
The stages involved in using the NPV method are as follows:
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• Estimate all future net cash flows (revenue minus cost) associated with an
investment opportunity.
• Convert these net cash flow figures to their present value equivalents by
discounting at the appropriate discount rate;
• Add all the present value figures of future cash flows;
• Subtract from this value, the initial cost of investment
• Positive NPV: In this situation, the present value of cash inflows is greater than
the present value of cash outflows. This is an ideal situation for investment
• Negative NPV: In this situation, the present value of cash inflows is less than the
present value of cash outflows. This is not an ideal situation and any project with
this NPV should not be accepted.
• Zero NPV: In this situation, the present value of cash inflows equals the present
value of cash outflows. You may or may not accept the project.
Question: An Investor invested Rs. 8 lac in a project that gives profit of Rs.2 lakh
in the 1st year , Rs. 2.60 lac in 2nd year & Rs. 4 lac in the 3rd year. At 10% discount
rate, what is NPV?
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Total = 8
lakh
Total 696960
Question: ABC Co Ltd. Is considering a new piece of machinery costing Rs. 8000
and it will produce a cash flow of Rs.1200 each year for next 12 years. What is NPV
if discount rate is 10%
PV = A/r [1 – 1/ (1+r)^n]
= 1200/.1 [ 1- 1/ (1.1)^12
= 8176
NPV = 8176- 8000
= 176
Internal Rate of Return (IRR)
• The internal rate of return (IRR) is a discounting cash flow technique which gives
a rate of return earned by a project.
• The internal rate of return is the discounting rate where the total of initial cash
outlay and discounted cash inflows are equal to zero. In other words, it is the
discounting rate at which the net present value (NPV) is equal to zero.
How is the Internal Rate of Return computed?
For the computation of the internal rate of return, we use the same formula as NPV. To
derive the IRR, an analyst has to rely on trial and error method and cannot use
analytical methods. With automation, various software (like Microsoft Excel) is also
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available to calculate IRR. In Excel, there is a financial function that uses cash flows at
regular intervals for calculation.
The rate at which the cost of investment and the present value of future cash flows
match will be considered as the ideal rate of return. A project that can achieve this is a
profitable project. In other words, at this rate the cash outflows and the present value of
inflows are equal, making the project attractive.
▪ For independent investment opportunities,
▪ if the IRR > cost of capital, then the project should be undertaken, since a rate of
return is being earned by the project that is greater than the amount that has to
be paid out to the providers of capital. Thus, the project is earning a surplus over
and above the cost of funds and thus shareholders’ wealth will be increased.
▪ If the IRR < cost of capital, then the project, should not be undertaken, as going
ahead with the project will have the result of reducing the shareholders’ wealth.
▪ For mutually exclusive investment opportunities, the IRR decision rule involves
undertaking that investment that has the highest IRR, provided that the IRR is
greater than the cost of capital.
▪ According to number of studies, IRR is more widely used than NPV. The main
reason for this appears to be that people in business are more used to thinking in
terms of rates of return than in terms of NPVs or surpluses.
▪ IRR = R1 + NPV / (NPV1 – NPV2 ) * (R2- R1)
▪ R1 = Lower discount rate chosen
▪ R2 = Higher discount rate chosen
Question: The NPV of a project is Rs. 2 lac at 10% discount rate & (-) .5 lac at 11%
discount rate. Calculate IRR of the project
= 10 + 2 / [2 – (-) .5 ] * (11-10)
= 10 + .8 * 1
= 10.8 = 11%
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▪ All investment appraisal techniques are seeking to identify whether the cash
flows, resulting from an investment, are sufficient to make the investment
worthwhile.
▪ The payback method adopts the most straightforward approach to this problem.
▪ It simply seeks to measure the length of time that will be taken before the
receipts from the investment are sufficient to payback the cost of the investment.
▪ The receipts from the investment are measured as the net cash flows resulting
from the project being undertaken (i.e., the difference between the total amount
of cash receipts and total amount of cash outlays in each period).
▪ Examination of the net cash flows of the two projects tells us that the initial
outlays of 50,000 is recouped in four years for the project A and in five years for
the project B,
▪ Thus, the project A has a payback period of 4 years and the project B has a
payback period of five years.
▪ To use payback method, it is necessary first to establish a payback period within
which all acceptable projects must recoup the outlay of the investment.
For example, a business, with a considerable potential cash flow problems and
severe capital rationing, may opt for a short payback period, say 3 years. In this case,
neither the project A nor B, would be acceptable.
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▪ In contrast, if a 4 year payback period were chosen, then the project A would be
acceptable, but project B would not be, while a 5 year payback
▪ Would make both the projects acceptable to the company.
Payback method has several shortcomings that make its use highly undesirable
✓ It takes no account of the time value of money
✓ The choice of the payback period is arbitrary
✓ With the payback, the only cash flows to be considered are those that fall in the
payback period
✓ Using payback may well lead to an increase in risk, since by demanding rapid
payback, companies are building in a bias towards the acceptance of risky
projects.
Question: A firm requires an initially cash outflow of Rs.20000 & cash inflow for 5 years
are Rs.5000, 7000, 6000, 6000, 8000. Calculate Payback period?
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Accounting Rate of Return (ARR): The accounting rate of return (also known as
Average Rate of Return or Simple Rate of Return) measures the profitability of an
investment by using the accounting profit given in the financial statements.
It is computed as under:
ARR = Average profit after tax / Average value of investment
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Advantages:
❑ Like Payback period method, this method is simple to understand and involves
simple calculations.
❑ It considers the entire stream of income over the life of the project for evaluating
the profitability of the project.
Question: A company is planning to start a business which requires Rs. 100000 to
purchase of machinery having a life of 5 years.
Next 5 years expected profit before dep & tax = 100000, 50000, 40000, 30000,
25000. Income tax @30%. Calculate ARR?
• Banks provide term loans normally for acquiring the fixed assets like land,
building, plant and machinery, infrastructure etc., (personal loans, consumption
loans, educational loans, etc., being exceptions) while the working capital loans
are provided for sustaining the working capital, i.e. current assets level.
• In exceptional cases, banks provide term loans for current assets also. This is
called Working Capital Term Loan (WCTL). As we are aware, the business
enterprise is supposed to bring a part of its funds required to maintain the
desired level of current assets from its long term sources (capital or term
liabilities), called NWC, so that the stipulated current ratio can be maintained. If
the enterprise is not able to bring in the required amount of NWC, it will feel
liquidity crunch and business operations will be affected. In such cases, banks
may provide WCTL.
• Working capital loans are normally sanctioned for one year but are payable on
demand. Term loans are payable as per the agreed repayment schedule, which is
stipulated in the terms of the sanction. Therefore, for the purpose of matching
assets and liabilities of the bank, term loans are considered long term assets
while working capital loans are considered as short term assets.
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• As a term loan is expected to be repaid out of the future cash flows of the
borrower, the DSCR assumes great importance while considering term loans,
while for working capital loans, the liquidity ratios assume greater importance
• There is no uniform repayment schedule for all term loans. Each term loan has
its own peculiar repayment schedule depending upon the cash surplus of the
borrower. Thus, in case of a salaried person, where income level is constant, the
repayment can be through EMI system and in case of a farmer, the repayment of
principal and interest may coincide with the cropping pattern.
• In case of industrial enterprises, normally, banks stipulate monthly/quarterly
repayment of principal along with all the accumulated interest.
Project Appraisal
The appraisal of managerial aspects involves seeking the answer to the following
questions:
✓ What are the credentials of the promoters?
✓ What is the financial stake of promoters in the project? Can they bring additional
funds in case of contingencies arising out of delay in project implementation and
changes in market conditions?
✓ What is the form of business organisation? Who are the key persons to be
appointed to run the business?
Technical Appraisal:
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✓ Return on Investment: The usual methods used are the NPV, IRR, payback
period, cost benefit ratio, accounting rate of return, etc
✓ Break-even Analysis: A project with a high break-even point is considered
riskier compared to the one with lower break-even point.
✓ Sensitivity Analysis: As market conditions are uncertain, a small change in the
prices of raw materials or finished goods may have a drastic impact on the
viability of a project. Sensitivity analysis examines such impact.
Infrastructure Projects
The sectors included in the definition of “Infrastructure” are as per the Gazette
Notifications issued by the Ministry of Finance, Government of India, from time to
time.
Presently, the following infrastructure sectors qualify under ‘infrastructure
lending’:
▪ Transport: This includes Roads and bridges, Ports, Inland Waterways, Airport,
Railway Track, tunnels, viaducts, bridges and Urban Public Transport (except
rolling stock in case of urban road transport).
▪ Energy: This includes Electricity Generation, Electricity Transmission, Electricity
Distribution, Oil pipelines, Oil/Gas/Liquefied Natural Gas (LNG) storage facility
and Gas pipelines.
▪ Water & Sanitation: This includes Solid Waste Management, Water supply
pipelines, Water treatment plants, Sewage collection, treatment and disposal
system, Irrigation (dams, channels, embankments etc.), Storm Water Drainage
System and Slurry Pipelines.
▪ Communication: This includes Telecommunication (Fixed network),
Telecommunication towers, Telecommunication & Telecom Services.
▪ Social and Commercial Infrastructure: This includes Education Institutions
(capital stock), Hospitals (capital stock), Common infrastructure for industrial
parks, SEZ, tourism facilities and agriculture markets, Fertilizer (Capital
investment), Post-harvest storage infrastructure for agriculture and horticultural
produce including cold storage, Terminal markets, Soil-testing laboratories, Cold
Chain, Hotels and Convention Centers with certain restrictions regarding project
cost.
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▪ In exceptional cases, like personal loans or consumption loans, the amount may
be credited to the account of the customer with the bank.
▪ In cases where the execution of the project is spread over a period of time, the
disbursement is normally related to the progress of the project.
RBI guidelines in respect of disbursement of project loans are as under:
At the time of financing projects banks generally adopt one of the following
methodologies as far as determining the level of promoters’ equity is concerned.
✓ Promoters bring their entire contribution upfront before the bank starts
disbursing its commitment.
✓ Promoters bring certain percentage of their equity (40% – 50%) upfront and
balance is brought in stages.
✓ Promoters agree, ab initio, that they will bring in equity funds proportionately as
the banks finance the debt portion. RBI has advised the banks to have a clear
policy regarding the Debt Equity Ratio (DER) and to ensure that the infusion of
equity/fund by promoters should be such that the stipulated level of DER is
maintained at all times.
Syndication Of Loans
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• A lease is a contract under which one party agrees to allow use of its property to
another party, for a specific period of time, on agreed payment terms. The party
which owns the property is called Lessor and the party which gets right to use
the asset, is called Lessee.
• The agreed payment for the right to use the property is called the lease rental.
The property to be leased may be land, building, animal, industrial equipment or
any other fixed or movable asset
Features Of A Lease
• Legal: It is a legal, binding contract containing the terms on which one party
agrees to allow use of its property by another party.
• Guarantees: It guarantees the lessee use of the property and guarantees the
lessor regular payments for a specified period, in exchange for allowing use of its
property.
• A lease can be residential lease, which is normally same for all tenants, or
commercial lease, which is often of various types.
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Types Of Leases
As pet Accounting Standard Ind AS 116, “A lessor shall classify each of its leases as
either an operating lease or a finance lease”.
Leveraged lease
TO PURCHASE AN ASSET
May Borrow all or majority of money
Owner
• 3 parties: the lessor, lessee, and the lender.
• Out of each lease payment from the lessee, one portion is passed on to the lender
for debt servicing and the other portion is received by the lessor. The leased
asset is charged to the lender as also the lease rentals payable by the lessee.
❑ Domestic lease,
▪ All parties involved in lease transaction, are domiciled in India.
▪ If any party is not domiciled in India, it is called an international lease or cross-
border lease.
❑ An international lease may have implications like country risk and currency risk.
❑ A cancellable lease is one that can be cancelled as per the terms contained in the
lease agreement.
❑ A non-cancellable lease is one that is cancellable only upon the occurrence of
some remote contingency or, with the permission of the lessor or, if the lessee
enters into a new lease for the same or an equivalent asset with the same lessor.
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❑ A Wet lease is one in which the lessor operates the equipment and is responsible
for its insurance, maintenance etc
❑ In a Dry lease, all these functions are responsibilities of the lessee.
❑ Under a Sale and Lease-back transaction, the asset owned by one party is sold to
the other party and simultaneously taken back on lease. So, practically, the
possession does not change, only the ownership is transferred. This method is
used to unlock value of assets of a firm. Sale and leaseback transactions came
under a lot of criticism during 1990s, when transactions in junk assets were
made at very high values and labeled as sale and leaseback transactions.
Finance Lease
The accounting standard, Ind AS 116, defines a finance lease as: “A lease is
classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership of an underlying asset”.
Illustration The situations under which a lease is normally classified as a finance
lease are:
• The ownership of the asset is transferred to the lessee by the end of the lease
term.
• The lessee has the option to purchase the asset at a price which is substantially
lower than the fair value, and it is reasonably certain that the option will be
exercised.
• The lease term is for the major part of the economic life of the asset.
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• The present value of the minimum lease payments at the inception of the lease,
amounts to substantial fair value of the leased asset, or more.
• The leased asset is of a such a specialised nature that it can be used only the
lessee.
• The lessee has right to cancel the lease and the lessor’s losses due to the
cancellation, are borne by the lessee.
• The lessee has the right to continue the lease for a secondary period at a rent
which is substantially lower than market rent.
Operating Lease
▪ The accounting standard, Ind AS 116, defines an operating lease as: “Alease
is classified as an operating lease if it does not transfer substantially all the risks
and rewards incidental to ownership of an underlying asset”.
▪ Lease classification is made at the inception date and is reassessed only if there
is a lease modification.
▪ An operating lease is classified as wet lease if the lessor provides the know-how
and related services for operating the asset and takes care of its insurance,
maintenance etc.
▪ Otherwise, it is classified as dry lease
Illustration
• The lease term is substantially less than the economic life of the asset.
• The lessee has right to cancel the lease without paying any substantial penalties.
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• Therefore, a firm experiencing shortage of funds can acquire assets more quickly
under leasing arrangement than in buying.
Convenience:
• Lease financing is also used by many firms as a tax planning device to reduce tax
liability.
• Normally, the lessee firm is benefitted if it can charge off the cost of an asset
more rapidly through lease rentals than through depreciation charges.
• As the firm can choose from a variety of leasing products available, it can address
its needs and requirements regarding cash flows, transaction structure, cyclical
fluctuations, expansion plans, profitability etc., by selecting the most suitable
products.
• Leasing allows a firm to match its cash outflow on rental payments for leased
equipment, with its revenue receipts, in a better way.
Less restrictive covenants:
▪ The lease agreement is a written agreement between the lessor and the lessee
stating the terms and structure of the lease.
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▪ All the future actions of lessor and lessee, relating to the leased asset are guided
by this agreement.
▪ Therefore, it is very carefully drafted envisaging all the future situations.
Contents of a lease agreement are different for different assets and different
types of leases. A lease agreement typically contains the details relating to the
following aspects:
Particulars of the Parties
In case of leveraged lease, tripartite agreement etc., third party information should also
be included.
Description of the Asset:
This also includes details regarding scope and validity of manufacturer’s warranty.
The agreement should clearly mention about the delivery and installation of equipment
at the beginning, as also the end of the lease.
This also includes interest payable on security deposit, mode and frequency of payment,
rent escalation clause and penalty in case of delay in payment of lease rental.
Transferability of ownership:
The agreement should mention regarding transfer of ownership at the end of the lease
period.
The party which will bear the cost of repair and alteration, should be specified.
Insurance/ Government Dues:
The agreement should mention about who will pay the cost of insuring the asset, as also.
the municipal dues, property taxes, etc.
Sub-Lease/Restricted Activities:
The activities, including sub-lease of the asset, which are not permitted by the lessee,
should be specified.
Surrender/Termination of Lease Agreement:
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If the asset can be surrendered during the period of the lease, the penalties payable
should be specified. Also, the circumstances, under which any party can terminate the
agreement, details about the notice period and compensation should be specified.
Default and arbitration:
▪ Definition: Transfer of Property Act and Indian Registration Act, covers only the
property and not equipment.
▪ In absence of a separate law for equipment leasing: bailment in the Indian
Contract Act may be construed to be applicable to equipment leasing contracts.
▪ As per this Act, the obligations of the lessor and the lessee are similar to those of
the bailor and the bailee, unless specified in the lease contract.
As per Sec 7 of the CGST Act, 2017, the expression supply includes all forms of supply
of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease
or disposal made or agreed to be made for a consideration by a person in the course or
furtherance of business.
From this, it is clear that the lease is covered within the meaning & scope of “supply”
and it is taxable.
GST does not differentiate between a Finance lease and an Operating Lease. GST
rates on lease transactions are as under:
✓ Nil rate on lease of industrial plots, provided by the State Government Industrial
Development Corporations or Undertakings to industrial units and Leasing of
Agro Machinery/ Vacant land.
✓ GST on Lease transactions which will be covered under the category of “Supply
of Goods” and “Supply of Services” is chargeable at same rate as on supply of
similar goods and services.
Income Tax rules do not differentiate between a Finance lease and an Operating
Lease. Income Tax implications of a lease transaction are as under:
In a lease transaction, the lessor is eligible for depreciation on the asset, as he owns the
assets. The lessee, therefore, will not be eligible to claim any depreciation.
In sale and leaseback transactions, income Tax rules permit depreciation on the
sold asset’s depreciated value rather than the actual value of the sales
transaction.
✓ The entire lease rentals are taxed as income of the lessor.
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✓ Lessors present assets, given under operating leases, in their balance sheet
according to the nature of the asset.
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The distinction between a finance and an operating lease, as far as accounting treatment
in the books of lessee is concerned, has been removed by Ind AS 116.
Ind AS 116 prescribes the following in respect of Accounting of Lease Transactions
in Books of lessee:
• At the commencement date, a lessee shall recognise a right-of-use asset and a
lease liability.
• At the commencement date, a lessee shall measure the right-of-use asset at cost.
• The cost of the right-of-use asset shall comprise:
✓ The amount of the initial measurement of the lease liability,
✓ Any lease payments made at or before the commencement date, less any lease
incentives received,
✓ Any initial direct costs incurred by the lessee; and,
✓ An estimate of costs to be incurred by the lessee in dismantling and removing the
underlying asset, restoring the site on which it is located or restoring the
underlying asset to the condition required by the terms and conditions of the
lease, unless those costs are incurred to produce inventories. The lessee incurs
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▪ The role of a financial manager does not stop with arranging long term sources
of finance for creation of fixed assets to enable the firm to carry out its intended
business operations.
▪ The money is also required for purchasing raw materials, converting them into
finished goods and selling on credit to customers.
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The normal operations of a business enterprise consist of some or all of the actions like,
purchase of raw materials, processing/conversion of raw materials into finished goods,
selling these goods on cash/ credit basis, receive cash on sale or end of credit period
and again purchase raw materials. This is called working capital cycle. The length of
this cycle depends on:
• The stocks of raw materials required to be held.
• The work in process, which in turn depends on the process involved in
manufacturing/processing to convert the raw materials into finished goods.
• The credit required to be provided to the purchasers.
The longer the working capital cycle, the more is working capital requirement, i.e.,
the need for maintaining the current assets.
Current assets depends on various factors. The main factors that influence the
need of working capital in a business are as under:
Nature of Business:
• Public utility undertakings such as electricity, water supply and railways require
very little working capital finance because they sell their services on cash terms.
They supply services not products, and very little funds are tied up in inventories
and receivables.
• On the other hand, trading and financial firms require less investment in fixed
assets but need large sums as working capital and fixed investments.
Size of the business:
• Greater the size of the business, greater is the requirement of working capital.
Production Policy:
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Seasonal variations:
• Generally, during the busy season, a unit will require larger working capital than
in slack season.
Operating/Working capital cycle:
The following are the main sources of finance for acquiring current assets;
• Firm’s own working capital funds
• Accruals
• Trade Credit
• Working Capital Advance by Commercial Banks/ Financial Institutions
• Public Deposits
• Inter-Corporate Deposits
• Rights Debentures for Working Capital
• Commercial Paper
• Factoring
• Forfaiting
Working Capital Assessment By Banks
▪ First step in any method of assessment of working capital limits: Deciding on the
Level of Turnover of the firm
▪ In case of existing enterprises, the past performance is used as a guide to make
an assessment and In case of new enterprises, this is based on the production
capacity, proposed market share, availability of raw materials, industry norm,
etc.
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▪ Despite analysis of all the data, accurate estimate of future turnover is often an
area of disagreement between the bank and the borrower.
▪ Based on the projected turnover, banks adopt various methods for assessing the
working capital needs of a firm
▪ For regulatory purposes, derivatives have been defined in the Reserve Bank of
India Act, as follows: “Derivative means an instrument, to be settled at a future
date, whose value is derived from change in interest rate, foreign exchange rate,
credit rating or credit index, price of securities (also called “underlying”), or a
combination of more than one of them and includes interest rate swaps,
forward rate agreements, foreign currency swaps, foreign currency-rupee
swaps, foreign currency options, foreign currency-rupee options or such
other instruments as may be specified by the Bank from time to time”.
Characteristics of Derivatives
• Transfer of Risk: Derivatives shift the risk from the buyer of the derivative
product to the seller and as such are very effective risk management tools
• Price Discovery: Derivatives improve the liquidity of the underlying instrument.
Derivatives perform an important economic function viz. price discovery.
• They provide better avenues for raising money.
• They contribute substantially to increasing the depth of the markets.
Users of Derivatives
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Derivatives Markets
There are two distinct groups of derivative contracts based on their market:
Over-the-counter (OTC) derivatives:
• Contracts that are traded directly between two eligible parties, with or without
the use of an intermediary and without going through an exchange.
• The parameters of the contract, like the size, maturity etc., are not standardised
and are mutually agreed to between the parties to a contract.
Exchange-traded derivatives:
Regulators Of Derivatives
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Types Of Derivatives
Forwards
Futures
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These are:
• The spot price of the underlying asset
• The cost of financing, storing, insuring and transporting the asset
• The income if any, earned from the asset
• Taking all these three factors into account futures price(FP) will be
• Spot price (SP) + financing and other costs – income if any. F.P = S.P + Costs –
Income
Swaps
Options
▪ An option is a contract, which gives the buyer (holder) the right, but not the
obligation, to buy or sell specified quantity of the underlying assets, at a specific
(strike) price on or before a specified time (expiration date).
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If on the date of settlement, which is the date three months from today when the
borrowing commitment has to be met, the benchmark rate agreed to by the
counterparties settles, say, at 7.00%, the corporate’s view on the interest rate has come
true and it is paid by the seller of FRA the difference of 0.50% (7 - 6.5) on the notional
principal for a period of 6 months discounted at 7%. On the other hand, if the
benchmark interest rate settles at, say,6.25% on the settlement date, the corporate pays
the seller of FRA the difference of 0.25% (6.5-6.25) on the notional principal of Rs. 1
crore discounted at 6.25%. Thus in both the cases (whether interest rate rises or falls)
the corporate’s effective borrowing rate remains unchanged at 6.5%.
Salient Points of FRA
• As FRAs are OTC contracts, it is easy to customise the size and periods to suit the
needs of the customer. Further, as the commitment is only to settle the interest
differential, the credit risk with the counter party is minimal
• FRAs are used to hedge short term interest rate risk. FRAs do not enjoy very
liquid markets. At times, it may become difficult to dispose of an FRA in the
market at competitive prices.
• A FRA is a contract between two parties by which they agree to settle between
them the interest differential on a notional principal on a future settlement date
for a specified future period
• A person who has a commitment to borrow money at a future point of time buys
a FRA to protect himself against interest rate risk and a person who has a
commitment to lend money at a future point of time sells a Forward Rate
Agreement to hedge his interest rate exposure.
• FRAs can be used effectively to lock in interest rates and thus manage the gaps
between rate sensitive assets and liabilities of the balance sheet. Thus they are
very useful in Asset Liability Management.
▪ A Plain Vanilla Swap is the simplest form of Interest rate swaps where a
fixed rate is exchanged for a floating rate or vice versa on a given notional
principal at pre-agreed intervals, during the life of the contract.
Important RBI guidelines regarding interest rate swaps are as under:
▪ Banks can undertake IRS as a product for their own balance sheet management
or for market making.
▪ Banks may also offer these products to corporates for hedging their own balance
sheet exposures.
▪ Banks should ensure adequate infrastructure and risk management systems
before venturing into market making activities.
▪ The Bench Mark rate should necessarily evolve on its own in the market and
require market acceptance.
▪ The parties are free to use any domestic money or debt market rate as
benchmark rate provided the methodology of computing the rate is objective,
transparent and mutually acceptable.
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▪ Interest Rate options are fundamentally of two types, the Cap and the Floor.
▪ A Cap is an interest rate option in which the buyer of the option, with the
intention of locking himself to a ceiling in interest costs for his borrowing,
reserves the right to receive the difference in interest rate on a notional principal
in case the interest rate on the underlying borrowing goes higher than the ceiling
he has chosen at pre-agreed periodic intervals for a given time maturity.
Illustration
▪ To illustrate, let us say we have issued a bond for Rs. 100 crore and raised
money in the market at a floating rate of 6 Mibor + 50 basis points.
▪ And let us assume that we have invested the money at fixed rate of 8%. We
have also agreed to pay the investors in our bond interest at 6 monthly
intervals and the maturity of the bond is say 5 years.
▪ This means that we have an interest rate risk for the next 5 years in case the
6m Mibor goes higher and higher.
▪ If the 6m Mibor is currently 5%, our return is 8 - 5.5 =2.5%.
▪ However, if 6m Mibor were to go higher at future points of time, our return
would go down below 2.5% till the interest rate reaches 7.5%, when we
would just break even.
▪ Beyond 7.5% level in Mibor, we will make a negative spread.
▪ In order to eliminate this risk we may buy a CAP at, say, 7.0%. This means
that we are sure of getting a spread of at least 0.5% in the above structure
and any movement in 6m Mibor beyond 7% will result in our being
compensated by the seller of the CAP.
▪ The 6m Mibor rate is prevailing on each of the 6 monthly coupon payment
dates and if it is higher than 7%, the difference on the notional principal will
be paid by the seller of the CAP.
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▪ However, if the 6m Mibor is less than 7%, we choose not to exercise the
option and hence we need not pay the seller the difference as is obtaining in
an FRA or an IRS.
Salient Points of Interest Rate Options
▪ This is a bilateral contract in which the risk seller (lending bank) pays a premium
to the buyer for protection against credit default or any other specified credit
event resulting in loss in the value of an underlying debt instrument.
▪ The protection buyer makes periodic payments (premium) to the protection
seller until the maturity of the contract or the credit event, whichever is earlier.
▪ Normally, CDS is a standardized instrument of ISDA (International Swaps and
Derivatives Association).
▪ The credit events defined by ISDA are, bankruptcy, failure to pay, restructuring,
obligation acceleration, obligation repudiation/moratorium etc.
▪ As per RBI guidelines, only plain vanilla CDSs are allowed.
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▪ Every person who earns or gets an income in India is subject to income tax.
▪ NRI are also subject to Income tax on their income earned in India.
▪ The levy of income tax in India is governed by the Income Tax Act, 1961 and
Income Tax Rules, 1962.
▪ The finance budget, presented every year in the month of February, brings
various amendments in Income-tax Act, 1961.
▪ Such amendments, if approved, become part of the income tax Act.
This Act contains detailed provisions on important topics like
✓ Computation of income,
✓ Exemptions and deductions available,
✓ Tax slabs,
✓ Calculation of tax liability,
✓ Formats of return forms applicable to different assessee, etc.
▪ As per the Income Tax Act, any company or person making a payment, is
required to deduct tax at source, at the rates prescribed by the income tax
department, if the payment exceeds certain threshold limits.
▪ The provisions of TDS apply to several payments like salary, interest,
commission, brokerage, dividend payments, professional fees, royalty, etc.
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It is the deductor’s responsibility to deduct TDS before making the payment and deposit
the same with the government
▪ Each deductor (except when tax is deducted under Section 194-IA) is required to
obtain a Tax Deduction Account Number (TAN).
▪ TDS is required to be deducted irrespective of the mode of payment-cash, cheque
or credit-and is linked to the TAN of the deductor and PAN of the deductee.
▪ There are separate rules for individuals for deducting TDS when they make rent
payments or pay fees to professionals like lawyers and doctors.
▪ TDS is a kind of advance tax paid by the deductee.
▪ For the deductees, the deducted TDS is claimed as a tax paid and a refund can be
claimed if the tax liability is less than the TDS.
▪ Tax collected at source (TCS) represents the tax collected by a seller from the
buyer at the time of sale.
▪ Section 206C of the Income-tax act specifies the categories of goods and the
%age of TCS to be collected by the seller from the buyers.
For example
TCS on Liquor of alcoholic nature, made for consumption by humans, is 1% and on
Tendu leaves it is 5%.
Exempts certain buyers from the scope of TCS.
✓ Public sector companies,
✓ Central or State Governments, Embassies etc.
• Int of 1% in case of delay: If the tax collector, who is responsible for collecting
the tax, does not collect the tax or after collecting doesn’t pay it to the
government before or on the due dates, he is liable to pay interest of 1% per
month.
▪ Submit quarterly TCS return (Form 27EQ) in respect of the tax collected by him
in a particular quarter.
▪ The interest on delay in payment of TCS to the government should be paid before
filing of the return.
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▪ Form 27 D: The tax collector has to provide a TCS certificate to the purchaser of
the goods.
▪ Section 206 (1H): Introduced in October 2020 for collecting TCS from the
buyers of goods who makes a payment of more than Rs 50 lakhs towards sale
consideration in the financial year.
▪ 206CCA: Inserted in 2021 for collecting a higher rate of TCS for non-filers of the
income tax return in the last two years.
Important provisions in this regard, effective from 1st Oct 2018, are as under:
• Any dealer or traders selling goods online would get the payment from the
online platform after deducting an amount tax @ 1% under IGST Act. (0.5% in
CGST & 0.5% in SGST)
• The tax would have to be deposited to the government by 10th of the next
month.
• All the dealers/traders are required to get registered under GST compulsorily.
For the purpose of income tax, the term, ‘Person’, as mentioned in Section 2 of IT Act,
includes the following:
• An individual: An individual means a natural human being and also includes a
person of unsound mind.
• A Hindu undivided family: Under Hindu Law, an HUF is a family which consists
of all persons lineally descended from a common ancestor and includes their
wives and unmarried daughters. Jain and Sikh families are treated as HUF under
the Act, even though they are not governed by the Hindu Law.
• A Company: Both domestic and foreign companies are included under this
classification. An individual and a company are not taxed at the same rate.
Individuals are taxed on the basis of tax slabs at different rates The income-tax
paid by domestic and foreign companies, on their income in India, is corporate
income tax (CIT)
• A Firm or LLP: Under the partnership law, a Firm is not a legal entity. However,
for income tax as well as GST, it is a separate legal entity. Thus, a firm is regarded
as a unit of assessment.
A limited liability partnership (LLP) is a body corporate formed and
incorporated under the Limited Liability Partnership Act, 2008. It is a legally
separated entity from that of its partner. All firms and LLPs are, presently,
taxed at a flat rate of 30%.
• An association of persons (AOP) or body of individuals (BOI), whether
incorporated or not: Here it is important to note that an AOP or BOI is deemed
to be a person, whether or not, it was formed or established or incorporated
with the object of deriving income, profits or gains.
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Trust created wholly for charitable or religious purposes are allowed various
benefits under the Income Tax Act, inter-alia, and exemption u/s 11.
• A local authority: A local authority means the Municipalities and Panchayats
etc.
• Artificial Juridical Person (AJP): If an Assessee does not fall under any of the
other categories that are included in the definition of Person then it is regarded
as an Artificial Juridical Person.
These entities are not natural persons but separate entities as per law. The tax
liability of a person depends upon his legal status and above mentioned
categories. Different rates of tax are prescribed for different categories.
For the purpose of Income Tax, the income is categorised in to five heads, as
under:
• Income from salary and pension is covered under this head. The amount is
arrived at after allowing standard deduction of Rs. 50,000, a deduction in
respect of any allowance in the nature of an entertainment allowance (subject to
certain conditions), and deduction of any sum paid on account of a tax on
employment.
• This consists mostly of rental income. The taxes levied by any local authority in
respect of the property, are allowed to be deducted.
• The amount of any interest payable on borrowed capital is also allowed to be
deducted.
Profits and gains of Business or Profession:
• This is when you are self - employed, work as a freelancer or contractor, or you
run a business.
• Life insurance agents, doctors, chartered accountants, and lawyers who have
their own practice, tuition teachers, architects etc., Corporates, Banks, Insurance
Companies and Financial Institutions are taxed under this head.
Income from Capital Gains:
• Income from sale of a capital asset such as mutual funds, shares, house property,
and agricultural land is included under this head.
• Where a shareholder receives any money or other assets from the company on
its liquidation, he shall be chargeable to income-tax under this head.
Income from Other Sources:
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• Consists of income from savings bank account, fixed deposits, winnings from
competitions etc. Gross total income is the total income earned by the assessee
during any financial year.
• It is the sum total of all incomes earned by the Assessee under each of the above
mentioned heads of income.
Incomes Not Included In Total Income
▪ In computing the total income of any person, any income falling within any of
the clauses of Section 10 of the IT Act are not included.
▪ Some of these incomes: Agricultural income, share of a partner in the total
income of the firm, the value of any travel concession or assistance received by
an individual, gratuity received, sum received on voluntary retirement or
termination of service, payment from an approved superannuation fund,
scholarships granted to meet the cost of education
Chapter VIA specifies the exemptions available for deductions from the Gross Income
for the arriving at the taxable income of the Assessee to calculate the income tax
liability.
These deductions are specified in sections 80C to 80U. Some of these deductions are
mentioned below:
▪ Through the Finance Act 2020, a new section 115BAC has been inserted in
the IT Act, wherein an individual gets an option to choose between the existing
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tax rates and the new concessional tax rates by foregoing prescribed exemptions
or deductions.
▪ In 2019 - Section 115BAA, has been inserted in the IT Act: benefit of a
reduced corporate tax rate to domestic companies. It states that domestic
companies have the option to pay tax at a rate of 22% (plus applicable surcharge
and cess), from the FY 2019-20 onwards if they adhere to certain conditions
specified.
▪ The domestic companies who do not wish to avail of this concessional rate
immediately can opt for the same after the expiry of their
exemptions/incentives.
▪ However, once a company opts for the concessional tax rate under this section, it
cannot subsequently withdraw from it.
Filing IT Return
▪ It is mandatory to file the income tax returns for residents and NRIs whose gross
total income (before allowing any deductions under section 80C to 80U)
exceeds threshold exempt income for that assessment year.
▪ It is also mandatory if an income tax refund is to be claimed or a loss under a
head of income is to be carried forward.
▪ It is also mandatory in case of a Resident individual having an asset or financial
interest in an entity located outside of India.
▪ It is mandatory for a company or a firm irrespective of whether it has income or
loss during the financial year.
▪ If after furnishing the return, a person finds any mistake, omission or any wrong
statement, the return can be revised within prescribed time limit.
▪ e-Filing of return is mandatory.
▪ However, paper returns can be filed by those who are above 80 years of age
and do not have any income from regular business or profession.
▪ Particulars of income earned during a financial year and taxes paid on such
income are provided to the IT Department.
▪ If the tax already paid > that payable, a refund is claimed.
▪ Certain losses can also be carry -forward to the next assessment year.
▪ Different forms of returns of income are prescribed for filing of returns
depending on the status of the person and the nature of income.
▪ For the assessment year 2021-22 (i.e., financial year 2020-21) ITR – 1 to ITR -7
have been prescribed.
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Deferred Tax
▪ The taxable income and accounting income may not be the same as the taxable
income is calculated in accordance with tax laws while the accounting income is
calculated by applying the accounting policies.
▪ The differences can be classified into permanent differences and timing
differences.
Permanent differences
▪ Taxation is the process adopted by a government to levy and collect taxes from
individuals, business entities and other organisations in the country.
▪ Due to Federal structure, both the Central and State governments are involved in
determining the various aspects of taxation, in India.
▪ Over the last few years, various policy reforms have been undertaken by the
Central and State governments to streamline the process of taxation
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Direct tax
Which can be shifted to another person/entity. It is not the tax levied on the income or
profit but on the goods and services rendered. Can be shifted from one individual/entity
to another.
For example, a sales tax paid by the buyer in a retail setting is not paid directly by
the buyer.
❑ It is collected by the seller from the buyer and paid to the government.
❑ implementation of goods and services tax (GST) regime from 01 July 2017 has
resulted in replacing all forms of indirect taxes, imposed on goods and services
by the state and central governments.
❑ Other levies which were applicable on inter-State transportation of goods have
also been done away in the GST regime.
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Payment course This tax is directly paid to the This tax is indirectly paid to the
government. government through an
intermediary.
Paying Entity These taxes are paid by These taxes are paid by end-
individuals and businesses. consumers.
Rate of Payment The rate of tax is decided by the Tax rates are the same for
government based on profit and everyone.
income.
Transferability This type of tax is non- This type of tax is transferable.
of tax transferrable.
Nature of Tax This is a progressive type of tax. This is a regressive type of tax,
This tax rate increases with an which means the tax rate is not
individual’s profit and income. affected by the individual’s income.
Types of tax Income tax, wealth tax, corporate Sales tax, service tax, value added
tax, etc. tax, etc.
Tax Collection Collecting this type of tax is Tax collection is relatively easier.
difficult.
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▪ Transactions made within a single state are levied with Central GST (CGST)
by the Central Government and State GST (SGST) by the State governments.
▪ For inter-State transactions and imported goods or services, an Integrated GST
(IGST) is levied by the Central Government and they give the share of State or
Union Territory.
▪ UGST is applicable for Union Territories like Chandigarh, Andaman and Nicobar
Islands etc.
▪ GST is a destination based tax on consumption of goods and services. Therefore,
taxes are paid to the state where the goods or services are consumed and not to
the state in which they were produced.
▪ The tax would accrue to the taxing authority which has jurisdiction over the
place of consumption, which is also termed as place of supply.
GST Council
▪ The concept of GST is based on permitting set-off for the tax paid on the inputs
and this is given effect through the input tax credit against the amount of a
dealer’s output tax. The related tax liability of the dealer can be arrived at by
deducting input tax credit from tax collected on supplies during the payment
period.
Who is liable to pay GST?
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Every person registered under GST will have to file returns in some form or other.
▪ A registered person will have to file returns either
✓ monthly (normal supplier)
✓ quarterly basis (Supplier opting for composition scheme).
▪ An Input Service Distributor will have to file monthly returns showing details of
credit distributed during the particular month.
▪ A person required to deduct tax (TDS) and persons required to collect tax (TCS)
will also have to file monthly returns showing the amount deducted/collected
and other specified details.
▪ A non-resident taxable person will also have to file returns for the period of
activity undertaken.
▪ There are separate returns required to be filed by special cases such as
composition dealers.
▪ Since Banks are service providers, Composite Scheme is not applicable to them.
The returns to be filed are as under:
✓ Details Return Forms Periodicity Return for registered persons with aggregate
turnover of more than ₹ 1.50 crores GSTR-1 and GSTR-3B Monthly Return for
registered persons with aggregate turnover up to ₹ 1.50 crores GSTR-1 Quarterly
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Return for registered persons with aggregate turnover up to ₹ 1.50 crores GSTR-
3B Monthly
✓ The system requires that one must manually enter details in the return - GSTR-1.
Late Fees :
✓ If GST Returns are not filed within time, interest on delayed payment of tax is
payable @ 18% per annum.
✓ It has to be calculated on the amount of tax liability from the next day of due date
of return till the date of payment
Advantages Of GST
Service sectors are impacted more by the GST than the manufacturing or trading
sectors.
Owing to the nature and volume of operations provided by banks, GST compliance is
quite difficult to implement.
Some of the issues and impacts pertaining to the provisions of GST Law are as
below.
Due to widespread number of branches, the registration is a hassle. However, under
GST, such Banks are required to obtain a separate registration for each state where they
operate.
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compliance burden about filing of returns has also increased substantially in terms of
payments of taxes, the periodicity of returns, number of return formats and level of details
required in these returns.
Concept of cost
▪ For an organisation producing only one product, the costing exercise may be
simple as the cost per unit can be arrived at by dividing total cost by the number
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The main objective of cost accounting is to ascertain the cost of each product
manufactured or service provided by an organisation.
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Inventory management
Elements of cost
There are various methods of classifying the cost elements of a product or service.
The classification of the elements of cost based on the nature of these elements is as
under:
Material
In is of two types: direct material cost and indirect material cost.
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• Direct expenses: incurred on a specific cost unit and are identifiable with the
cost unit.
• For examples: The cost incurred in designing a special car model can be
attributed to the number of cars of that model produced.
• Indirect expenses are those expenses which cannot be directly or conveniently
allocated to a specific cost unit.
• For examples: Expenses incurred on rent, taxes, insurance, lighting etc. in a car
factory can be treated as indirect expenses as these cannot be attributed to a
particular model of cars being manufactured in the factory.
The classification of the elements of cost based on their association with the
volume of production is fixed, variable and semi-variable cost.
• Fixed costs: These are the costs which, during a period, do not depend on the
volume of production or the level of activity. For example: The insurance
premium paid for the factory building and other fixed assets remains the same
irrespective of the number of cars produced during the year.
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• Variable costs: These are the costs which, depend directly on the volume of
production or the level of activity. For example: The cost of engines will be
directly proportional to the number of cars produced during the year.
• Semi-variable costs: Such costs qualities of both fixed and variable costs.
Because of their partly variable nature, they increase with the volume but they
do not increase in direct proportion to increase in output, due to their partly
fixed nature. For example: If the production of cars doubles in the factory, the
administrative department will also have to employ more staff but the increase
will not be 100%.
Cost Centre
• Cost centre is the smallest organisational sub-unit for which separate cost
allocation can be made.
• Chartered Institute of Management Accountants(CIMA), London, describes a cost
centre as: “A production or service location, function, activity or item of
equipment whose costs may be attributed to cost units”.
• In other words, a cost centre is one of the many convenient units into which the
whole production facility has been divided for the purpose of costing the goods
produced.
• Each such unit consists of a specific production centre, or a department or a sub-
department or, specific type of machinery or a group of persons.
• For example can be a bank branch where cash department can be considered as
one cost centre while the loan department can be another cost centre.
• Classified as Productive, Unproductive or Mixed Cost Centres.
• Productive cost centre is actually engaged in making the products.
• Unproductive cost centre does not directly contribute in making the product
but provides essential support to the productive centres.
• Mixed cost centre is sometimes involved directly in contributing to the
manufacture of the product and sometimes in providing service to the
productive departments.
Cost Unit
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▪ An example of time being the cost unit is finding the hourly cost of a machining
centre. Similarly, if a factory is producing chemicals, its cost unit can be a litre or
a gallon. In case of crude oil, the commonly used cost unit is barrel.
Methods of Costing
Depending on the type and nature of the product, the costing method adopted by
organisations are different.
Technique of Costing
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Management Accounting
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The scope of providing information and reports under management accounting is much
wider than under the financial accounting and cost accounting systems. Statistical and
mathematical techniques, including budgetary control, are also used in management
accounting in addition to the accounting techniques. Some of the important tasks,
which fall under the scope of management accounting, are as under:
• Management accountancy involves developing financial accounting, cost
accounting, tax accounting and information systems to meet the changing needs
of management functions.
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▪ As the operations became more complex, the companies felt increasing need for
management-oriented reports and improved tools and techniques in
management accounting have been devised based on the new requirements.
▪ This is a continuing process and improved tools and techniques continue to
evolve with increase in complexity and needs of the businesses.
Presently, the main tools and techniques used in management accounting are as
under:
• Financial Planning
• Selecting appropriate tool for decision making
• Financial Statement Analysis
• Statistical and Graphical Techniques
• Selecting appropriate method of reporting
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▪ Some methods make part use of job costing and part use of processing costing.
▪ Under these broad categories, Unit or output Costing, Job Costing, Batch costing,
Contract costing, Process costing and Service costing are amongst the widely
used methods of costing, in the industry.
• The cost sheet, maintained under the single-output/ unit cost, is a periodic
statement.
• It is a document which records the detailed cost of a cost centre or cost unit.
• It contains information on expenditure incurred on material, labour and direct
expenses.
• The administration expenses actually incurred are also included in the total cost.
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• Indirect expenses, payable at periodical intervals, are included in the cost sheet
on the basis of estimates.
• Selling and distribution expenses may or may not be included in cost sheets,
depending upon the management decision.
• Not recorded: Taxes/interest/dividends paid, provisions and write offs, cash
discounts, profit or loss on sale of assets, etc.
Job Costing
▪ Job costing system is required by the industries where each unit or batch of
output of a product is different form the other units or batches.
▪ This is in contrast to process costing system, which is used in industries where
production units are similar and the production takes place on a continuous
basis.
▪ When the production is not on a continuous basis and each job is different from
the other
▪ Also known as Job Order Costing
Applications of Job Costing
Execution of a job order involves meticulous planning of resources to control the costs.
Execution of a specific job, as per the specifications of the customer, is more difficult
compared to production under continuous process, where the systems and procedures
are stable and standardised. The job execution may not be just arranging for materials
and labour but may also involve design and innovation.
The main features of job costing system can be summarised as under:
• It is costing of a specific order for production or rendering of services as per the
requirements of the customer.
• It involves recording all the costs incurred for completing a job so that it may be
appropriately priced.
• Estimation of costs is difficult as very little data may be available due to
uniqueness of the job.
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• At the end of the job, the materials left may be difficult to value due to
uncertainties about their use in other jobs.
Job Cost Cards/Sheets
▪ A job cost card is used for each job, which is the object of costing, to record the
costs of materials, labour and overheads pertaining to that particular job.
▪ Job card basically provides a record to the management for their decision making
and controlling the cost.
▪ The job cost card also records the time spent by operators on each job.
▪ Any breaks or idle time taken by the operators is also recorded in the job cost
card.
The main advantages of a job cost card are as under:
✓ It gives clear and relevant information to the management to enable them to take
appropriate decisions
✓ It is an effective tool for cost control
✓ It helps in reducing the idle time of labour involved in the job
✓ Job card information can be used to check the accuracy of job account
✓ It acts as a link between the production control and costing departments
Following is a specimen of a simple costing card/sheet, only for the purpose of
illustrating its concept:
Job cost card/sheet (specimen)
Customer ______________
Name of Job ______________
Job No ______________
Date of start ______________
Date of completion ______________
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The job costing collects the following direct costs pertaining to a job:
✓ Direct material costs
✓ Direct labour costs
✓ Direct overhead costs or production overheads
Direct material costs
➢ On receipt of a production order, the production department submits a
requisition note to the stores to issue the requisite materials. Surplus, excess or
incorrect materials are returned by the production department to the stores with
materials return note.
➢ The job cost sheet records all these issues and returns of materials.
Direct labour costs
➢ Each day, the time spent by various types of labour on a particular job, is
recorded.
➢ Labour summaries or wages analysis sheets are prepared for each week or any
other suitable accounting period.
➢ This analysis also includes the amounts on account of overtime, idle time, shift-
differential etc.
➢ Direct labour costs are posted on the respective job cost-sheets.
• Direct overhead costs or production overheads
➢ Direct overhead costs for a job are recorded for all the cost centres through
which the job passes in the course of its completion.
➢ The amount of direct overhead costs for each job order is summarised in an
analysis sheet and is posted in the relevant cost cards/sheet of that job
Allocation of Fixed/Non-Manufacturing Overheads
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• For each job, a Job account is maintained so that the cost of that job is known
readily.
• The Job Account is different from the job cost sheet.
• Job account contains only the monetary information, while the job cost sheet
records other information also.
• As in the case of job sheet, depending upon the nature of the job and the
requirements of the organisation, the format of the Job account is devised and
used.
An illustrative format of a job account may be as under:
Contract Costing
• Contract costing is a form of job costing applied to relatively large jobs which
take a considerable time to complete (normally, more than one year).
• Like in job costing, in contract costing also, each contract is treated as a cost unit
and its costs are separately ascertained.
• Examples where contract costing is suitable include shipbuilding, engineering
projects, construction contracts, infrastructure projects etc.
• In some industries and government contracting, contract costing is the primary
task of the accounting department.
• Proper contract costing is crucial to earn adequate profits, and so is usually
staffed with experienced accountants.
• The work is usually carried out at a site different from contractor’s workplace, in
a contract. In execution of a job, the job is usually carried out at the contractor’s
workplace.
• A contract and a job are differentiated on the basis of size and time taken also.
Contracts are usually larger and take longer time compared to jobs.
• In a contract, most of the costs are of direct nature, unlike in a job.
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• In costing a contract, each contract is treated as a cost unit while in job costing,
there can be more than one cost units.
Types of Contracts
• Fixed price: Under this type of contracts, the price is not dependent on any
factor like materials, labour, time etc. but is a fixed total amount.
• Cost plus: Under this type of contracts, the contract price is based on the costs
actually incurred, plus a percentage profit or fixed profit. This is used in those
contracts whose exact cost cannot be correctly estimated at the time of starting a
work. In this type of contracts, the customer may use the services of an auditor to
examine the contractor’s contract costs, and may not sallow some of them.
• Time and material: This is similar to the cost plus arrangement, except that the
contractor includes a profit into its billings, rather than being given a specific
profit. In this arrangement also, the customer may verify all the costs in detail.
Progress Payments and Retention Money
▪ When a contractor undertakes to execute a large contract for a customer, the two
parties agree on the terms of reimbursement to the contractor. As a contract
involves considerable period of time, large amount of contractor’s working
capital may get stuck up if there is no periodic payment by the customer. Thus, it
is always suggested to have a system of progress payments. Normally, this
progressive payment is based, at least in part, on the costs incurred by the contractor
in execution of the contract. Therefore, the contractor must keep a track of the costs
associated with the execution of that contract to justify its billings to the customer.
▪ As a contract is spread over a long period of time, the contractor runs the risk of
price escalation of input costs. Therefore, an escalation clause is normally
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included in the contracts to safeguard the contractor against any likely changes
in the prices of material and labour.
▪ This clause provides that in case prices of materials, labour etc. specified in the
contract, change beyond a specified limit over the prices prevailing at the time of
signing the contract, during the execution of the contract, the contract price will
be suitably adjusted.
▪ This clause may be useful in safeguarding the interest of the customer also in
case of decline in the prices of material, labour etc. which is highly unlikely in
present inflationary environment.
▪ As a contract is spread over a long period, the contract work may not be
complete during an accounting period.
▪ Financial accounting normally recognises profit when the goods are sold. But, it
may not be fair to adopt this principle in case of contracts, because it will result
in low or no profit during the accounting periods in which the contract is
continuing and abnormal profit in the accounting period in which the contract is
finished.
▪ It is therefore, necessary to determine the profit relating to a contract for each
accounting period during which the contract is under execution.
▪ AS 7 and Ind AS 115 also recognise this principle and provide guidelines in this
respect.
▪ While precise calculation of profit on an incomplete contract is difficult due the
uncertainties involved during the time remaining for completion of the contract,
the broad principle applied can be as under:
Profit to date = (Cost of work completed/ Total estimated contract cost) *
Estimated contract profit.
For arriving at the cost of work completed, a contract account is maintained.
Illustration
In a factory, refining the groundnut oil, total production of refined oil during the month
was 1000 ton. The unrefined oil used in the production was 1020 ton. This loss of 20
ton was considered to be a normal process loss. If the total cost during the month,
including the cost of unrefined oil used was ₹ 10 crore, what is the cost of one ton of
refined oil, assuming that no scrap is generated?
Solution:
The total cost during the month = ₹ 10 crore
Quantity of unrefined oil consumed = 1020 ton
Quantity of refined oil produced = 1000 ton
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Value of scrap = 0
Cost of one ton of refined oil = 10, 00,00,000/ (1020 – 20) = ₹ 1,00,000 per ton
Abnormal Loss:
▪ The normal losses are estimated assuming that the production will take place
under normal circumstances. However, in practice, the actual losses may be
more due to abnormal conditions such as power failures, machine or plant
breakdowns, inferior quality of materials, carelessness of workers, accidents etc.
▪ Such losses are in excess of the estimated normal losses. The difference between
the actual losses and the expected normal losses is called Abnormal Loss.
Abnormal Gain
• If the actual process loss is less than the estimated normal loss, it is called
Abnormal Gain.
▪ Due to the increased efficiency of workers, favourable process conditions or
expected loss not materializing.
▪ Abnormal gain does not mean that the output is more than the input. It only
means that the extent of reduction in output quantity, compared to input
quantity, which was estimated by us before starting production, was higher
than that actually achieved. Therefore, the abnormal gain is equal to
normal loss minus the actual loss.
▪ Calculation: Gain is not used to reduce the cost of units of production, but is
taken into the Profit and Loss A/c.
Work-In-Progress and Equivalent Units
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▪ If 10 units are at the stage of 80% completion, we treat them equivalent to 8 fully
finished units, and so on.
Inter-Process Profit
▪ If we examine the working of a petroleum refinery, we will see that while the
input is crude oil, the finished goods produced include petrol, diesel, LPG,
kerosene and aviation fuel, apart from some minor products called by products)
like coal tar, lubricating oils etc.
▪ There are many such process industries where more than one products of
significant proportion and value are simultaneously produced.
▪ Such products are called joint products.
▪ As per the definition of CIMA, London, joint products are “two or more products
separated in processing, each having a sufficiently high saleable value to merit
recognition as a main product.”
By-Products
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▪ To the value of joint products which are petrol, diesel and LPG.
▪ By-products usually do not influence the decision regarding manufacture of main
products.
▪ A by-product is different from scrap/waste which is a material of insignificant
value.
▪ Split point : In the production process, joint products are identifiable only after
a stage of common raw material processing is achieved.
▪ After the split point a joint product may or may not require further processing.
▪ After the split point, the processing cost of each product is separate and is
allocated to that product only
Batch Costing
▪ The cost accumulation system may not, always, be classified into job costing and
process costing.
▪ If the products have some common characteristics and also some individual
characteristics, we may have to use a combination of both the systems.
▪ For example; a company manufacturing tables manufactures same type of tables
except that some tables are given extra polishing.
▪ In such a case, the costs of common processes through which all the tables pass
are calculated by applying the job costing system, while the cost of extra work
done on some items is calculated by applying the process costing system in
which a product goes to another process centre after completion of previous
process.
▪ Important features of batch costing system that costing is done not for an
individual unit but for a batch of identical units.
The cost of one unit = Batch cost / number of units in the batch.
Illustration
A furniture manufacturer has received order for supplying 100 identical wooden chairs.
The company estimates the requirements of materials at ₹ 1,00,000, labour at ₹ 50,000,
and manufacturing overheads at ₹ 20,000. As per company’s policy, the fixed/non-
manufacturing overheads are allocated at 20% of material cost. What will be cost of one
table, applying the batch costing system?
Answer
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The total variable cost of the batch of 100 tables is 1,00,000 + 50,000 + 20,000 = ₹
1,70,000.
The fixed cost allocated to the batch is 20% of ₹ 1,00,000 = ₹ 20,000. Total cost for the
batch is ₹ 1,90,000.
So, cost of one table is 1,90,000/100 = ₹ 1,900.
Batch costing is useful in industries like pharmaceuticals, readymade garments, toys,
tyres and tubes etc.
Service Costing
▪ Service costing provides the basis for pricing the services rendered. It helps
service sector organisations like hospitals, hotels, transport companies, utility
companies etc. Service costing helps an organisation in not only pricing its
services but also in tracking and controlling the costs by benchmarking them
against standard costs of the industry.
▪ Unit Costing is used to where the production consists of units which are identical
and are normally mass produced.
▪ Examples are mining, brick making, cement production etc
▪ Multiple Costing refers to the costing method used in cases where a large variety
of articles are produced.
▪ The difference may be in regard to material required and/or the process
involved in manufacturing.
▪ In such cases, one costing method may not be sufficient.
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▪ Therefore, more than one method of costing may be used to compute the cost of
each unit separately.
▪ As the technique of standard costing involves comparison of actual costs with the
estimated costs by calculating the variance, it enables the management to locate
and eliminate the sources of inefficiencies and wastages.
Delegation is simple:
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▪ As the standards are already known, the operating staff tends to be more
competitive to achieve the standards and show greater efficiency.
More realistic:
▪ Prices based on standard costs are more realistic. If the selling prices are fixed on
the basis of actual costs, the market may not accept these. as it is not concerned
with the inefficiencies of any particular producer. The market prefers the product
which is available at the competitive price.
Suppose, a transport company wants to find out how many kilometres a truck driver
can drive in a day. It wants to set an appropriate standard for the purpose of preparing
its budgets and to compare the performance of the truck drivers employed by it. The
company may fix standards on the basis of performance of a few drivers who have
maximum efficiency, have very little idle time, and can work
Basic Standards
▪ These are the standard which are established for use over a long period of time.
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▪ These standards take into account the perfect performance. These standards
represent the costs which are achievable under the ideal operating conditions.
Hence, these are more idealistic and less realistic.
▪ As these standards may have an adverse impact on motivation and moral of the
workers, their us is also limited in practice.
Currently Attainable Standards
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Starts with ascertaining the standard costs of the elements of cost i.e. materials, labour
and overheads.
As the efficacy depends largely upon the correct estimate of the standard costs, we have
to exercise extreme care in deciding these.
Some of the important points in setting the cost standards, are as under:
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❑ Standard Labour Time : The labour time required per unit of production. In
ascertaining this time, we have to consider the performance of a particular grade
of labour required for the particular operation involved in the production
process.
▪ Setting the standard time of labour: Standards published by the International
Labour Organisation (ILO) or the industry bodies or the time and motion studies
conducted by the organisation.
▪ Past performance with adjustments for change of conditions can also form a
basis for setting this standard.
❑ Labour Rate Standard: To the wage rates estimated to be paid to different
grades of labour used for performing particular types of operations in the
production process.
▪ The factors to be considered while setting the standard wage rates, include past
and future trends of the labour market, agreement with the labour unions,
statutory minimum wages etc.
Standard Overhead Costs
▪ Overhead costs may be variable costs which depend on the volume of production
or, the fixed costs which do not depend on the volume of production but have to
be incurred over a period of time irrespective of the production volume.
▪ We should be able to correlate the work to be done by the service departments
to the level of activity of production departments.
▪ The standard overhead rates for each of the service departments should be
ascertained and then applied to various producing departments.
▪ Make use of past data, suitably adjusted for prevailing conditions and the
anticipated future trends, for the purpose of ascertaining the costs of the service
departments.
▪ The standard overhead rates for the producing departments may be expressed
as a % of the direct labour costs or, machine hour rate etc.
Setting Standards for Other Costs
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We have to decide on the sales price, based on cost of production, prices of products of
the competitors, consumer preference etc.
Sales = sales volume * sales price per unit of the product
▪ The budget provides the estimates for the entire period for which the budget has
been prepared.
▪ The estimates of sales, costs and profit provide a suitable base to the
management to periodically review the actual performance and compare it with
the budgeted one.
Variance Analysis
▪ Variance in standard costing refers to the deviation of actual cost from the
standard cost and provides the basis for cost control by initiating the appropriate
corrective actions.
▪ The variances indicate the extent to which the standards set have been achieved.
▪ Variance analysis is the process of ascertaining the amount of variance and
identifying the cause of variance between actual cost and standard cost.
The cost variances can be divided into the following three broad categories,
depending upon which cost element is involved:
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Illustration
In a furniture manufacturing factory, while estimating the cost of wood and steel which
go into producing one table, the cost of material as ₹ 2,000
▪ After one week, when the review exercise was conducted, it was found that the
actual cost of material in each table was ₹ 2,100 against the standard cost of ₹
2,000.
▪ It was found out that the quantities of wood and steel, actually consumed were
the same as estimated in the standard costing.
▪ Further analysis revealed that while the price of wood was the same as the
standard cost, the price of stainless steel has increased
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▪ These estimates may not materialise during the actual manufacturing process.
Illustration
▪ We will take the same example of the furniture manufacturing factory, taken
above.
▪ When the review exercise was conducted after one week, it was found that the
actual cost of material in each table was ₹ 2,100 against the standard cost of ₹
2,000.
▪ The analysis revealed that while the prices of both wood and steel were the same
as contained in the standard cost.
▪ The consumption of steel was as per the estimates in the standard costing. This
caused a variance of ₹ 100 in the total cost of material consumed for each table.
▪ (It is important to note that the variance should be calculated for each material
separately. As in above example, an increase in quantity of wood consumed could
be nullified in money terms by a decrease in the quantity of steel consumed. The
increased consumption of wood would not have been noticed if separate analysis
of both materials had not been conducted).
Possible causes of Material usage variance:
✓ Inferior quality of material purchased
✓ Theft, pilferage
✓ Increased wastage due to careless handling during manufacturing
✓ Not following the standard production procedures
✓ Changes in quality of the finished goods compared to that envisaged in standard
costing
Labour Cost Variance
▪ Total cost of labour depends on the rate of wages for the labour and the quantity
of labour used in manufacturing each unit.
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So, the variance of the actual cost of labour from the standard cost, in producing one
unit, can also be arrived at by these two factors, as under:
Labour rate variance:
▪ The variance under this head is caused due to actual wages paid per hour being
different from the standard wages per hour estimated in the standard costing.
Illustration
▪ While preparing the estimates of standard costs, it was estimated that the labour
hours required for manufacturing one table
▪ After one week, when the review exercise was conducted, it was found that the
actual cost of labour for each table was ₹ 960 against the standard cost of ₹ 900.
▪ It was found out that while the actual labour hours for manufacturing each table
were 6 hours, same as the estimates in standard costing,
The total variance in labour cost, due to this reason will be equal to the variance for one
unit multiplied by the total number of units manufactured during the period
Possible causes of Labour rate variance:
▪ Labour rate variance is, in all likelihood, not a controllable item as it is governed
by the factors beyond the control of the management of the individual
companies. Sometimes, arise due to new wage agreement with the workers’
union while, in the standard costing, the rates applicable earlier may have been
taken.
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▪ Another possible reason of the variance could be the wrong estimate of mix of
skilled and unskilled labour hours involved in manufacturing, as the rates for
both are different.
Labour time or labour efficiency variance:
▪ The variance under this head is caused due to actual time taken for
manufacturing one unit being different from the standard hours estimated in the
standard costing.
Illustration
Taking the same example as above, where the labour hours consumed in manufacturing
one unit is estimated at 6 hours @ ₹ 150 per hour. When the review exercise was
conducted, it was found that the actual cost of labour for each table was ₹ 1,050 against
the standard cost of ₹ 900.
The total variance in labour cost, due to this reason will be equal to the variance for one
unit multiplied by the total number of units manufactured during the period.
Overheads Cost Variance
The total overhead cost variance is the difference between the actual overhead cost
incurred and the standard overhead cost allowed for the actual output achieved.
Overhead cost variance consists of two parts:
▪ Variable overhead variance
▪ Fixed overhead variance
Variable Overhead Variance
This also consists of two broad categories, viz.:
✓ Variable Overhead expenditure variance
✓ Variable Overhead volume or efficiency variance.
Variable Overhead expenditure variance:
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This variance is due to actual variable overhead expenditure per hour being more than
the budgeted (standard) variable overhead expenditure per hour, while the actual
variable overhead hours, consumed in producing one table, are the same as the
budgeted (standard) hours.
Illustration
❑ In a factory, the cost of each variable overhead hour, for producing one table
❑ When the actual performance is reviewed,
▪ There is no uniform system of maintaining the cost records and making entries
under a system of standard costing.
Normally, the cost variances at the end of the accounting period, may be dealt
with in any of the following ways:
i)Transfer to costing profit and loss account
ii)Allocation of variances to finished stock, work-in-progress and cost of sales account
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✓ While analysing and reporting the uncontrollable variances, same care should be
exercised as while reporting the controllable variances.
✓ The forms of reports for variances are to be selected keeping in view the
preferences and needs of the management and the company.
▪ Marginal cost is the cost of producing one additional unit of product or service.
▪ According to CIMA, marginal costing is the ascertainment of marginal costs and
of the effect on profit of changes in volume or type of output by differentiating
between fixed costs and variable costs.
▪ In this technique of costing, only variable costs are charged to operations,
processes or products, leaving all indirect costs to be written off against profits,
in the period in which they arise.
Thus, marginal costing is the accounting system in which only
▪ Wariable costs are charged to cost units
▪ Fixed costs are charged to the contribution or profit.
Features Of Marginal Costing
Marginal costing is distinct from other costing techniques. Its unique features can
be summarised as under:
• Marginal costing involves both cost recording and cost reporting.
• Under marginal costing, TC= VC + FC. Some costs which have features of both
fixed and variable costs, are segregated as semi-variable costs.
• Only the average variable cost of a unit is considered as its value.
• Fixed costs are not taken into account for calculating the product cost and are
charged to revenue of the period in which they are incurred.
• Marginal contribution of a product or department is taken into account for
calculating its profitability.
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• Marginal costs and contribution figures make easier the relative appraisal of
products, territories and various segments of the business.
• Marginal costing offers more effective plans for cost control compared to other
techniques of costing.
• The marginal costing effectively emphases the impact of fixed costs on profits.
• Marginal costing provides a very effective tool to the management to formulate
marketing strategies specially under difficult market conditions.
❑ For example: Suppose a company producing steel is not able to increase
its capacity utilisation beyond 70% as the domestic market is saturated
with supply from local producers. The company can export to a
neighbouring country but the prevailing price of steel there is less than
that in India. The management has to decide whether to export or not at
lower prices.
❑ Marginal costing tells what the variable cost of production is, and if the
export price is more than the variable cost of production, it may be a good
decision to export.
This will have two benefits.
• First, the company will gain at least some “Contribution” as the export price is
morethan the variable cost.
• Second, the country will gain through increased deployment of labour and
narrowing of trade deficit.
Limitations/Disadvantages Of Marginal Costing
• Segregation of costs into fixed and variable costs is not easy as some expenses
have characteristics of both and cannot be done with precision. The personal
judgement of the accountant comes into play and it may not always be correct.
• The assumption that the fixed costs do not vary at all and the variable costs are
100% proportional to the volume of production, is not realistic.
• In practice, the fixed costs may show an increase if the volume of production
increases beyond a certain level, specially if additional plant and machinery is
required to be used.
• Similarly, the relationship between the variable costs and the volume may not be
linear, specially over a longer period of time.
• Under marginal costing technique, the inventory valuation may become
unrealistic as fixed costs are not included in the value of work-in-process and
finished goods.
• In case of seasonally sensitive products, this may result in inflated profit during
the periods of higher sales and deflated profit during the periods of lower sales.
• The assumption under marginal costing, that the sales price per unit will remain
same irrespective of production and sales is not realistic. In practice, too much
production and availability of a product may affect its sales value.
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Break-Even Analysis
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The break-even analysis, which is a part of Cost–volume– profit (CVP) analysis, also
involves finding correlation between the fixed costs, variable costs, sales revenue and
profit. Whenever one unit of the product is sold, its sales value minus its variable
cost provides a surplus which goes towards meeting the fixed expenses.
This sales value of one unit minus its variable cost is called “Contribution” as this is
what one unit of the product contributes towards recovering the fixed expenses.
Break-even level is that activity level at which all relevant fixed costs are recovered and
there is no profit or no loss. For activity level below the breakeven level, the company
will make losses, while above this level it will make profit.
Illustration:
A company manufacturing LED bulbs has the following financial information:
a)Total fixed costs ₹ 2,00,000
b)Sales price per bulb ₹ 60
c)Cost of all direct inputs like material, labour, utilities etc. ₹ 40
d)We have to calculate the Break-even level.
• As the sales price of one bulb is ₹ 60 and its variable cost is ₹ 40, the contribution
is ₹ 20(60-40).
• So, sale of each bulb contributes ₹ 20 towards meeting the fixed cost. We have
total fixed cost ₹ 2,00,000. For meeting this cost, we have to sell 2,00,000/20 =
10,000 bulbs.
• As this activity level of selling 10,000 bulbs, the fixed costs are fully met and
there is no profit or loss.
• The next bulb we sell, results in profit of ₹ 20 as the fixed costs have
already been met.
The break-even point can be expressed in any of the following ways:
• In number of units: Example: In the above illustration, the B-E point is 10,000
units.
• In sales volume in money terms: Example: In the above illustration, the B-E
point is sales volume of ₹6,00,000.
• In percentage capacity utilisation: Example: In the above illustration, if the
total capacity of the plant is to manufacture 20,000 bulbs per year, the B-E point
is 50%. (10,000/ 20,000 = 0.5 or, 50% of the plant capacity).
▪ In appraising the term loan proposals, the financier expects that the operations
will be substantially above the break-even level so that, term loan is repaid
within a reasonable period, from the surplus generated.
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▪ If the break-even point of the project is calculated to be very high, say 75%, the
margin of safety available to the project to withstand unexpected disruptions,
and operate substantially above the break-even level, becomes narrow. The
financers, therefore, prefer projects which have a lower break-even level.
▪ Some of the other applications/uses of break-even/CVP analysis are as
under:
✓ The management gets a clear idea of the minimum level of activity below
which it cannot afford to operate.
✓ It helps in devising an incentive scheme as the management has clear idea
about impact of increased production on the profit vis-à-vis the cost of
incentives.
✓ It helps in comparing the relative profitability of different products.
✓ It helps the management in deciding if the production of a particular
component or product is to be outsourced.
✓ It provides a very effective tool to the management to formulate marketing
strategies specially under difficult market conditions.
Margin Of Safety
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▪ Some disruption is part of the normal risk faced by the businesses in general.
▪ But if the business declines below a level where there is a loss, such a situation
cannot be sustained for a long period, As we have seen above, this level is
indicated by the break-even level.
▪ The gap between the estimated/budgeted level of operations and the break-even
level indicates the cushion available to the business for sustaining its operations
in times of adversity.
▪ This is referred to as “Margin of Safety”.
It is expressed in percentage terms. In equation form, it can be expressed as
under:
Margin of Safety = [(Estimated sales – Break-even sales)/ Estimated sales] × 100
Illustration:
If the estimated sales of a company during the year are ₹ 110 lakh and its break-
even sales level is ₹ 70 lakh, the margin of safety is:
[(110 – 70) /110] ×100
= (40/110) ×100 = 36.36%
Absorption Costing
Under marginal costing, only the variable cost is allocated to a product. So, the cost of a
finished unit in inventory will include only the direct materials, direct labour, and
variable overhead costs. It will not used.
Therefore, the absorption costing is also called full costing or the full absorption
costing.
Absorption costing is needed for external financial reporting and for income tax
reporting purposes while the marginal costing is mainly useful to the
management for decision making and the outsiders may not be much interested
in it.
Illustration:
A company manufacturing LED bulbs has the following financial information:
Fixed overhead costs: ₹ 1,50,000
Cost of all direct inputs like material, labour, utilities etc. per bulb: ₹ 40
Variable overhead costs: ₹ 60,000
Total bulbs produced in the year: 15,000
Under marginal costing, the costs allocated to each bulb are only the
variable costs i.e. 40 + (60,000/15,000) = ₹ 44.
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The fixed overhead costs are not included in the product cost.
Under absorption costing, in addition to the variable costs of ₹ 44 per bulb, the fixed
overhead cost of ₹ 1,50,000 is also allocated on pro-rata basis i.e. 1,50,000/15,000 = ₹
10 per bulb.
So, the total cost of each bulb under the absorption costing is ₹ 54 per bulb.
▪ Costs allocated to each unit of the product, under the absorption costing will be
more than that under the marginal costing.
▪ Higher valuation of finished goods
▪ If there is no change in the inventory of the finished goods, during the year, it will
make no difference in the valuation of stocks whether we use marginal costing or
the absorption costing.
Effect on profit
▪ If inventories increase during a period, higher profit will be shown under the
absorption costing than marginal costing.
▪ When inventories decrease, less profits are shown
▪ The difference in the profit is due to difference in accounting for fixed overhead
costs for valuation of finished goods.
▪ When the entire stock, produced during the year is sold, there is no change in the
inventory of finished goods, and so, the profit revealed by both the methods will
be same.
▪ But when sales and production are not same, difference in profit will be shown in
the profit and loss account.
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Types Of Budgets
Budgets may be classified into various categories depending upon the base adopted to
prepare it. Budgets may be classified on the basis of:
• The scope of their coverage or the functions covered by them. Examples: Sales
budget, Production budget, Overheads budget, cash budget, Production Cost
budget, Capital expenditure budget, etc. These are called Functional Budgets.
• the capacity or efficiency to which they are related. Based on this, a budget may
be Fixed or Flexible budget.
• The conditions on which they are based. Based on this, a budget may be Basic or
Current budget.
• The periods which they cover. Based on this, a budget may be a Long period or a
Short period budget.
The highlights about the characteristics and preparation and monitoring of various
types of budgets are given below:
Functional budgets
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Budgets are prepared for each of the various interrelated activities in the organisation.
These budgets are then consolidated to show the combined budget for all the activities.
This consolidated budget is called the “Master Budget”. Approved budgets for individual
functions are called “functional budgets”. The main functional budgets are:
Sales Budget:
• Forms the basis for preparing other functional budgets.
• estimate of total sales, expressed in money terms as also in terms of quantity.
• The sales during the budget period (normally one year), are estimated taking
into account various internal and external factors.
• Internal Factors: Present production capacity of the company, expansion plans,
development of new products, pricing policy etc.
• The external Factors: Competition in the market, growth of economy,
Consumer preference, Government policies, etc.
Production Budget:
• It contains the estimated production quantities of various products during the
budget period.
• This is an offshoot of the sales budget and depends on the decision taken by the
management regarding the sales estimates of various products.
Production Cost Budget:
▪ As per the components of cost of products, this budget may be a combination of
three budgets, viz., Materials, Labour and Overhead costs budgets.
Cash Budget:
▪ This budget contains the detailed estimates of cash inflows (receipts) and cash
outflows (payments) periodically.
▪ For this, the budget period is further sub-divided on quarterly, monthly or even
weekly basis.
Capital Expenditure Budget:
▪ The Capital expenditure budget details the plan of the proposed expenditure on
fixed assets to enhance the capacity and efficiency of production process of the
organisation.
▪ Capital expenditure is a continuous process in any organisation and is planned
through a long-term budget.
▪ Capital forecasts should be made for a number of years. As the capital budget
affects the cash budget also, normally, a short-term forecast to cover the general
budget period is also prepared along with the long term capital expenditure plan.
Master budget:
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• It does not change with the level of activity actually attained. In practice,
however, a fixed budget is revised if the business conditions undergo a basic
change or if, due to any reasons, actual operations are widely different from the
planned ones.
• It is designed for a specific planned output level.
• It is not adjusted to the actual level of activity at periodic reviews which compare
the budgeted and actual costs.
• Normally, fixed budgets are established for a shorter period of time during which
the actual output and the budgeted output are not anticipated to differ much
from each other
The characteristics of a flexible budget are;
• It recognises different cost behaviour patterns.
• It is designed to change as volume of output changes.
• It is prepared in such a manner that it gives the budgeted cost for any level of
activity.
• It recognises the difference between fixed, semi-fixed and variable costs and
changes with the actual activity level attained.
Basic and Current budgets
Basic budgets:
▪ Basic budget is prepared for use over a long period of time without any change.
▪ This is attainable only under standard conditions as current conditions are not
take into consideration for preparing this budget.
Current budgets:
▪ Current budget is prepared for use over a relatively shorter period of time and
takes into account the current conditions. without any change.
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▪ As the target laid down in the current budget take into account the current
conditions, it is considered to be more useful than the basic budget.
Long-term or Short-term budget
Long-term budget:
▪ A budget which is prepared for a period longer than a year is, normally
considered to be a long-term budget.
▪ As the period is long, the precise details of various items are not included in this
budget. It is more helpful in business forecasting and forward planning.
▪ For example, a Capital expenditure budget contains planning for a period beyond
one year. Similarly, a research and developments budget involve strategic
planning over a longer period.
Short-term Budget:
▪ A budget which is prepared for a period of up to one year is, normally considered
to be a short-term budget. It emphasises on the micro aspects of the business
rather than the long term strategic planning of the organisation.
▪ A short-term budget is not in contradiction to the long-term budget but is fits
into it.
The CIMA, London, defines Budgetary control as “the establishment of budgets, relating
the responsibilities of executive to the requirements of a policy and the continuous
comparison of actual with budgeted results either to secure by individual action the
objectives of that policy or to provide a firm basis for its revision”.
This definition implies that a budgetary control system involves:
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• The comparison of actual achievement with the budgeted figure may, sometimes,
lead to conflicts specially when the budgeted figure is estimated on unrealistic
presumptions and is far from reality.
• The budgeted figures are for a future period (normally one year). The business
conditions may change too fast to keep these figures relevant. For example, the
Covid pandemic has caused an unprecedented business turmoil over a short
period of time and this has upset the budget estimates of many organisations.
• The personal/human aspect is often neglected in formation of budgets and their
monitoring. The monitory and quantitative aspects of the business often prevail
at the cost of personal/human considerations.
• Like any other control, the budgetary controls are also not liked by many
persons. They consider these as blocks in the way of their creativity and
innovative skills.
This chart shows the functional responsibilities of each functional executive, the
delegation of authority to him and his relative position with other functional heads.
Budget Centre
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• Setting out instructions and guidelines relating to the preparation and use of
budgets, is known as the budget manual.
• Pertain to forms and records, responsibilities of persons, the procedures to be
followed and the time schedules to be followed etc.
• The intention behind the budget manual is to lay down in unambiguous terms
the procedures to be followed by the executive so that, there is no confusion or
resentment regarding these, in future.
Budget Committee:
• These budget centres or functionaries are inter-related and budget for each
cannot be set in isolation. They have to consult each other before finalising the
budget.
• For example; The sales promotion department may plan a budget for promoting
new products but it may turn out that the production department will not be
ready to produce these in near future.
• Unless there is co-ordination between the two departments, a realistic budget for
the organisation will not be finalised.
• The budget committee consists of the representatives of various departments of
the organisation. This committee co-ordinates in preparing and finalising the
budget.
Budget Controller:
• The function of the budget controller is to bring together and co-ordinate the
various functions involve in preparation of the budget.
• He mainly carries out the function of compiling various types of information for
the purposes of preparation of realistic budgets and proper reporting.
Budget Reports:
• The budget reports contain the comparison of actual performance with the
budgeted one.
• These reports are submitted periodically and regularly to the management.
• The budget reports are submitted irrespective of whether the variance is
positive or negative.
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▪ Zero base budgeting is budgeting from the beginning without any reference to
any base.
▪ For example: A company, which has achieved a sales level of ₹ 50 Crore, may
budget for a 10% increase in sales for the next year. In this process a base of ₹ 50
Crore has been used to form the budget.
▪ In Zero base budgeting, the process starts from the scratch and the potential of
the company is judged without any constraint of the past data.
▪ It is based on the premise that every rupee of expenditure requires justification.
▪ This is a deviation from the traditional budgeting approach where an
expenditure of previous year is automatically incorporated in new budget
proposals and only the quantum of increment is subjected to discussion.
Programme Budgeting
Performance Budgeting
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