1

MEANING OF COMPANY

In India, the history of company as a distinct form of organisation began with the
enactment of the Joint Stock Companies Act, 1913. In India, some companies came into
existence by a special act of parliament, for example, Reserve Bank of India, State Bank of
India. Such type of companies are called statutory companies and not governed by
Companies Act. Presently, from formation to winding up of majority of companies, all
aspects are governed by the Companies Act, 2013. Here we will deal with those companies
only which are registered under Companies Ltd. According to Section 3(1) (i) of the
Companies Act, a company means “ A Company formed and registered under this Act or an
existing Company”. An existing Company means, “A company formed and registered under
any of the previous Companies Laws”.

The definition given in the Companies Act is not exhaustive. A more comprehensive
definition of a company would be : a company may be viewed as an association of persons
who contribute money or money’s worth to a common stock and use it for a common
purpose. It Is a creation of law. It is also called an artificial person. A company has a capital
divisible into transferable shares, having a corporate legal entity and a common seal.
Though a company is a creation of the members of such a company, it is distinct and
separate from its members.

Special Features of a Company

If we analyse the definition of the term ‘company’ and look into the statutory provisions
under the Companies Act, we notice the following special features:

a) Voluntary association: Persons who would like to form a company come together
voluntarily for carrying out a business.
b) Separate legal entity: A company has a separate legal entity. It means that the
existence of the company is independent and separate from its members.
Accordingly, a company can hold, purchase, and sell properties, it can open a bank
account in its own name, and it can enter into a contract with others including its
own shareholders.
c) Limited liability: In fact, this is the main feature of a company. A company may be
limited by shares or limited by guarantee. In a company limited by shares, the liability
of a member is limited to the unpaid amount of the shares held by him. In other
words no member is bound to contribute anything more than the nominal value of
the shares held by him. For example, if the face value of a share in a company is Rs.
100 and a member has paid Rs. 60 per share. He is liable to contribute only Rs. 40 on
the share (the difference between par value and amount actually paid). In a company
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limited by guarantee the liability of members is limited to such an amount as the

members may undertake to contribute to the assets of the company in the case of
winding up of the company.
d) Perpetual succession: A company is an artificial person created by law. It never dies.
A company continues to exist irrespective of changes a membership of the company.
The death or insolvency of individual members does not in any case affect the
corporate existence of the company.
e) Common seal: As you know that a company is an artificial person it cannot sign its
name and enter into a contract by itself. So it works with the help of a seal. A
common seal is used as a substitute for its signature. Any document not having the
common seal of a company is not authentive and is not binding on the company.
f) Transferability of shares: The shares of a company are freely transferable. A member
can sell and buy shares in the open market. This facility provides liquidity for the
investment of member of a company. This right to transfer share is an absolute right
and cannot be taken away by a provision the articles of the company. But the articles
of a company can prescribe the manner in which the transfer of shares will be made.
g) Separate property: A company being a legal person distinct from its members. It is
the owner of its assets and bound by its liabilities. It is therefore, capable of owing,
enjoying and disposing of its property in its own name. Although the capital and
assets of a company are contributed by its shareholders hut they are not the joint
owners of its assets. So we can say that the property of the company is not the
property of the shareholders, but it is the property of the company.
h) Capacity to sue and be sued: Since a company enjoys the status of an artificial
person. It can sue and be sued in its own name

Kinds of Companies

On the basis of liability of shareholders or members companies can be divided into three
categories:

a) Companies limited by shares: In this case, the liability of members is limited to the
amount, if any, unpaid on the shares. The liability can be enforced during the
existence on the company as well as during the winding up. If the shares are fully
paid, the liability of the members holding such shares is nil.
b) Companies limited by guarantee: In this case, the liability of members is limited to
the amount which they undertake to contribute in the event of winding up of the
company. Thus, the liability shall arise only in the event of winding up.
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c) Unlimited companies: In this case, the liability of its members is not limited at all.
They have to contribute the necessary amount in order to pay off company’s debts
and liabilities. Such companies (are not found in practice.

On the basis of number of members, a company can be divided into two categories: (a) a
private company, and (b) a public company.

a)Private Company: The Companies Act defines a private company as a company which by
its articles:

i) restrict the right to transfer its shares, if any;

ii) limits the number of its members to fifty (excluding its employees), and

iii) prohibits any invitation to the public to subscribe for any shares in, or debentures
of, the company

A private limited company must use the words “Private Limited” as the last words to its
name.

b) Public Company: A public company means a company which is not a private company.
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DISTINCTION BETWEEN A COMPANY AND A PARTNERSHIP

S.No. Basis of Company Partnership

Comparison
1 Formation Comes into existence after Created by agreement
registration under Companies between partners.
Act, 2013 Registration is not
compulsory under
Partnership Act
2 Regulating Act Regulated by Companies Act Regulated by Companies Act
2013 1932
3 Legal Status Independent legal status No independent legal status
4 Membership Minimum 2 and Maximum 50 Minimum is 2, maximum in
in case of Private Limited banking business 10 and 20
Company and Minimum 7 and in others
no maximum limit in Public
Limited Company
5 Owner’s liability Limited Unlimited
6 Basis of profit Shared by owners in the Shared by partners as per
sharing proportion of shares held agreement
7 Business stability Perpetual succession, death, Depends upon the life,
insolvency of members do not insolvency, retirement of
affect the life partners
8 Transferability of Shares are feely transferable Not transferable without
interest the consent of other
partners
9 Audit of accounts Compulsory Not required
10 Authority of Shareholder is not an agent of Partner is an agent of the
members the company and has no power firm and binds the firm and
to bind the company by his acts other partners by his acts
done in the course of
business
11 Restriction of Restriction in the Articles of Restriction on the powers of
powers Association are effective as a particular partner
against the public as they are contained in the partnership
public document agreement are of no avail
against the outsiders
12 Winding up Under the Act At will
13 Insolvency Winding up of an insolvent Insolvency of partnership
company does not make its firm means insolvency of all
members insolvent the partners
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FORMATION OF A COMPANY

In simple terms, the person who gets an idea to form a company is known as promoter. In
many cases, there could be more than one promoter. The promoters initiate the following
steps for forming a company

Filing of Basic Documents

The application for registration of a company should be submitted to the Registrar of the
state in which the business office of the company is situated. The application shall be
accompanied by the following documents.

1. Memorandum of Association.

2 Articles of Association.

3 Agreement, if any, for appointment of a managing director or manager.

4 A statement of the nominal capital where it exceeds one crore of rupees alongwith
certificate from the Controller of Capital Issues permitting the issue of capital.

5 A notice of address of the registered office of the company.

6 A list of directors and their consent to act as such duly signed by each.

7 An undertaking in writing signed by each director to take and pay for his qualification
shares.

8 A statutory declaration that all the requirements of the Act have been complied with.
Such declaration should be signed by an Advocate of Supreme Court or of a High Court, or
by a practicing Chartered Accountant or by a person named as Secretary, director or
manager of the company.

The Memorandum of Association and Articles of Association must bear the prescribed
stamp duty. The promoters have also to arrange payment of registration fees and filing fees
at the time of submitting the application.

Certificate of Incorporation

The Registrar of Companies issues a certificate of Incorporation on payment of the

prescribed fees by the company concerned provided he is satisfied that all the conditions
laid down under the Companies Act have been fulfilled. Companies are classified into two
categories viz., Private Limited and Public Limited. In case of Private Limited Companies, the
following restrictions apply:
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a) Minimum and maximum memberships are 2 and 50 respectively

b) Public participation by issuing a prospectus is prohibited.

c) Shares are not freely transferable.

As it is evident from the above para, private limited companies are not entitled to issue a
prospectus. Hence, private limited company can commence business immediately after
receiving a Certificate of Incorporation, whereas a public limited company has to wait till
the Registrar grant o its certificate to commence business.

Public Ltd Companies have to issue either a prospectus or a statement in lien of a

prospectus for the purpose of inviting the public to subscribe to the shares or debentures of
the company. Prospectus may be considered as the basis for contract between the
company and the person who buys the shares on the strength of the prospectus

ALLOTMENT OF SHARES

Allotment of the shares is the acceptance by the company of the offer to purchase shares.
Allotment of shares may be considered as an appropriation by the directors of shares to a
particular person. It is an appropriation out of the previously un-appropriated capital of a
company. A valid allotment creates a binding contract between the company and the
shareholder.

Requisites a Valid Allotment

In brief, the following are considered as essential requisites of a valid allotment:

a) The directors of a company are required to specify the minimum subscription amount in
the prospectus. Law has very clearly laid down the principle that shares cannot be allotted
unless the minimum subscription has been subscribed.

b) The entire application money, not being less than 5qc of nominal capital must have been
received in cash.

c) In case minimum subscription has not been received within 120 days of the date of issue
of the prospectus, the money received from the public must be repaid without any interest.
However, interest @ 6% per annum becomes payable by the directors of the company if
the money is not paid back to the applicants within 130 days of the issue. Interest is not
payable if it could be proved that default was not due to any negligence or misconduct on
their part.
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d) In cases where prospectus is not issued by a company, a statement lieu of prospectus has
to be filed with the Registrar at least three days before any allotment is made, otherwise
allotment of shares shall be irregular.

e) Allotment of shares cannot be initiated until the beginning of the 5th day from the date
of issue of prospectus. If the directors desire to extend the period, they can do so provided
that they have clearly stated this in the prospectus.

f) With effect from 15th June, 1988, every company intending to offer shares or debentures
to the public for subscription by way of prospectus, should get their shares listed on one or
more recognised stock exchanges. When the fact of application made to stock exchanges is
disclosed in the prospectus, if permission is n granted by any stock exchange within ten
weeks from the closure of subscription list, the allotment becomes void.

g) Allotment of shares must be made by a resolution of the board of directors.

h) Allotment of shares must be communicated within a reasonable time to the concerned

applicant.

i) Allotment must be absolute. It should have been made in accordance with the terms
conditions stated in the application.

STATUTORY BOOKS

The provisions of Section 209 of the Companies Act, 2013 specifically require a few books
to be kept or its registered office of maintaining a record of different aspects of the
company’s activities. These are known as Statutory Books. Some of the important ones are
the following:

i) Register of investments of the company not held in its own name.

ii) Register of mortgages and charges

iii) Register of members and index

iv) Register of debenture holders and index

v) Register of foreign members and debenture holders and their duplicates

vi) Minute Books

vii) Register of contracts, companies and firms in which directors are interested

viii) Register of directors

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ix). Register of director’s shareholding

x) Register of loans, guarantees etc. to or investment in shares and debentures of

companies in the same group

BOOKS OF ACCOUNT

Section 209 (1) of the Companies Act requires a company to maintain at its registered office
proper books account in respect of the following items:

a) all sums of money received and spent by the company and the matters in respect of
which the receipts and expenditure take place;

b) all sales and purchase of goods by the company;

c) all assets and liabilities of the company; and

d) utilization of material or labour or other items of cost as may be prescribed by the

Central Government in case the company belongs to a class of companies engaged in
manufacturing, processing and mining.

Sub-section (2) of Section 209 provides that a company which has a branch office, whether
in or outside India, is deemed to have complied with the conditions stated above in respect
of branch offices as well if the following conditions are satisfied.

i) proper books of account relating to the transactions effected at the branch offices are
kept at these offices.

ii) proper summarized returns for period of not more than 3 months each are sent by
branch offices to the company at its registered office or any other place that may be
approved by the Board of Directors of the company

Sub-section (3) of Section 209 provides a very important yardstick that should be kept in
view by all those connected with accounting for a company. It has been amended by the
Companies (Amendment) Act, l988 with effect from 15th June, 1988. Consequent upon the
above amendment it stipulates that proper books of account are deemed to have been
kept up by a company only if the following conditions are satisfied.

i) the Profit and Loss Account and the Balance Sheet of the company should give a true and
fair view of financial position of the company or the branch office.

ii) books of accounts maintained both at the head office and branch offices, as the c se may
be, must explain their transactions, and
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iii) such books of account must have been kept on accrual basis and have been prepared
according to the double entry system of accounting.

The books of account and other books and papers shall be opened to inspection by any
General Introduction director during business hours.

SHARE CAPITAL

A company should have capital in order to finance its activities. Share capital means the
capital raised by a company by the issue of shares. In case of a company the term capital’
and share capital’ means the same thing. A company limited by shares should state its
amount of share capital in its memorandum of association. An unlimited company and a
company limited by guarantee may not have any share capital.

Categories of Share Capital

From accounting point of view, there are different types of share capital. These are as
follows:

1 Authorized or Registered or Nominal Capital: The Authorized or Nominal or Registered

capital is the amount of share capital which a company is authorised to issue by its
memorandum of association. This is the maximum amount which a company is authorised
to raise by the issue of shares. The amount of authorised capital of a company depends
upon its business requirements, it can be increased or decreased by adopting the
prescribed legal procedure.

2 Issued Capital: It is that part of nominal capital which is actually offered to the public for
subscription. Normally a company does not issue its entire nominal capital at a time. In this
case the issued capital-is less than the nominal capital. The difference between issued
capital and nominal capital is called “unissued capital”. Issued capital can never be more
than the nominal capital. It can at the most be equal to the nominal capital.

3 Subscribed Capital: It is that portion of the issued capital which has been actually
subscribed by the public. Where the shares issued for subscription are wholly subscribed,
issued capital would be the same as the subscribed capital.

4 Called up Capital: It is that part of nominal value of issued capital which has been called
up on the shares. For example, a share may be of Rs. 10 each. But at the time of issue the
company is collecting Rs. 5 per share only. The remaining Rs 5 may be collected later on as
and when needed. So called up will be Rs. 5 per share.
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5 Paid-up Capital: It refers to that amount of the called-up capital which has actually been
received from shareholders. It is quite possible that some shareholders may not pay the full
amount called up. The amount not paid in respect of the allotment and calls made are
known as calls in arrears. Thus the paid-up capital is equal to the called up capital minus
calls in arrears. In care there are no calls in arrears, the paid-up capital will be same as
called up capital.

6 Uncalled Capital: This is the remaining part of the issued capital which has not yet been
called. The company may call this amount, any times, when it needs further capital,
according to the provisions of the Articles.

7 Reserve Capital: A Company may, by a special resolution, resolve that part of the uncalled
capital shall be called only in the event of winding up of the company. This amount is called
‘reserve capital’ of the company. It cannot be turned into ordinary capital without the leave
of the Court and cannot be charged by the company. It is available only for the creditors on
winding up of the company.

Classes of Shares

Total capital of the company is divided into units of small denomination. One of the units
into which the capital of the company is divided is called a share. A company can raise the
required capital through one class of shares or different classes of shares. As per Section 85
of the Companies Act, a public limited company can issue the following two kinds of shares:
(a) Preference Shares, and (b) Equity Shares.

Preference Shares

Preference shares are shares which satisfy the following two conditions:

i) With reference to dividends, they carry a preferential right over equity shares. The
preferential rights of dividend as ascertained at a fixed amount per share or an amount
calculated at a fixed rate.

ii) With reference to capital, on the occasion of winding up of a company or repayment of

capital, they carry a preferential right to be paid back. In other words, the amount paid
upon preference shares must be paid back before anything is paid to the equity
shareholders. This preference, unless there is an agreement to the contrary, exists only up
to the amount paid up, or deemed to have been paid up, on the shares

The preference shares can be of various types. These are discussed below.
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i) Cumulative and Non-Cumulative Preference Shares: Preference shares are issued with
two distinctive features in respect of right to dividend based on which they are classified as
cumulative and non-cumulative preference shares. In case of cumulative preference shares,
if there are no sufficient profits in a year for payment of dividends at the stipulated rate,
the arrears of dividend are to be carried forward and paid out of the profits of subsequent
years. In case of noncumulative preference shares, right of recovery of arrears of dividend
does not exist.

ii) Redeemable and Irredeemable Preference Shares: Preference shares are also classified
based on redemption, into redeemable preference shares and irredeemable preference
shares. In case of redeemable preference shares, at the end of specified period, the
company pays back the amount of capital to the holders thereof. Sometime redemption
may be made at premium. For example, a preference share of Rs. 100 of PQR Co. Ltd. is
redeemable at a premium of Rs. 5 after ten years. After the lapse of 10 years, on
redemption the holder will get Rs: 105 on each preference shares. In case of irredeemable
preference shares, the amount of capital is not paid back before the winding up. According
to the new Section 80-A of the Companies (Amendment) Act. 1988 all the existing
irredeemable preference shares shall be compulsorily redeemed the company within five
years from the commencement of this Amendment Act.

iii) Participating and Non-participating Preference Shares: Generally, preference shares are
non-participatory i.e., they are not entitled to have any share in surplus. But, some
companies issue participating preference shares. A participating preference share is a share
which carries the right of sharing profits left after paying preference and equity dividends at
a fixed rate. Non-participating preference shares are those which are not entitled to share
in the ‘surplus profit’. They are entitled to a fixed rate of dividend

iv) Convertible and Non-convertible Preference Shares: A convertible preference share is

one which can be converted into equity shares. When a share cannot be converted into
equity shares, then it is said to be a non-convertible preference share. From the above
discussion, it is clear that there are different classes of preference shares based on different
factors.

Equity Shares

They are entitled to dividend after payment of dividend on preference shares. The rate of
dividend is decided by the Board of Directors and approved by the shareholders at the
Annual General Body Meeting. Shares normally enjoy right over surplus profits which are
counted by a company in the form of reserves and surplus
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On the basis of Issues of shares, company has two types of capital: (i) preference share
capital and (ii) equity share capital.

Preference Share Capital: Preference share capital means, in case of a company limited by
share, that part of share capital which carries a preferential right as to the payment of the
dividend at a fixed rate and also a preferential right to the repayment of the paid-up capital.

Equity Share Capital: Equity share capital means all share capital which is not preference
share capital.

PROCEDURE AND ACCOUNTING ENTRIES FOR ISSUE OF SHARES

You know that a company mostly issues two types of shares: (i) equity shares, and (ii)
preference shares. In each case, the company can either collect full amount of the issue
price of the share along with application itself or collect it in easy instalments over a period
of time. In practice, the companies usually collect the amount in instalments as it ensures
better response from the investors

The first instalment is collected along with application and is thus known as application
money’. The remaining instalments are termed as first call, second call and so on. The word
‘final’ is suffixed to the last instalment. For example, A company issues equity shares of Rs.
10 each collecting Rs. 2 on application. Rs. 3 on allotment. Rs. 3 on first call and Rs. 2 on
second call. The second call will be termed as ‘second and final call’. If the company were to
collect Rs. 5 on first call itself, the first call will be termed as ‘first and final call’

Procedure for Issue of Shares

The procedure followed for the issue of the shares is as follows

I Issue of Prospectus: First of all, the company issues a prospectus which provides complete
information about the company to the prospective investors. It also mentions the manner
in which the amount on shares is to be collected. 2 Receipt of Applications: The Company
makes its application 1irrns available to the public through its brokers and banks.
Applications are received through a Scheduled bank for at least four days from the date of
opening the subscription to the issue.

3 Allotment of Shares: After the closure of the subscription list, the shares have to be
allotted within 120 days of the issue of prospectus provided ‘minimum subscription’ has
been received. Minimum subscription is the amount which in the opinion of directors, must
be raised to meet the basic needs of the business operations of the company. If the same is
not received, the company cannot proceed with the allotment of shares and the application
money must be refunded to the applicants within 130 days of the issue of the prospectus.
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If the minimum subscription has been received, the directors after completion of certain
legal formalities send the allotment letters to the successful subscribers. The letters of
regret and the refund orders are sent to those to whom no allotment has been made.

Basic Accounting Entries for Issue of Shares

The procedure for accounting for the issue of both equity and preference shares is the
same. However, the words ‘equity share’ or ‘preference share’ is prefixed to the
instalments in order to differentiate between the two. The amount of money paid with
various instalments represents the contributions to share capital and should ultimately be
credited to Share Capital Account. However, for the sake of convenience, individual
accounts are opened for each instalment. All money received along with applications are
deposited with a scheduled bank for which a separate account has to be opened. In fact, all
applications are received through banks which collect the money and credit it to the
company’s public issue account opened for the purpose. The company, in its books, passes
the following entry for the application money received.

Bank A/c dr

To Share Application A/c

(Application money for ……………. Shares @ Rs ……………..per share received)

The money received with applications represents contributions towards share capital. This

will have to be transferred to the Share Capital Account. The next entry, therefore, will be
as follows:

Share Application A/c dr

To Share Capital A/c

(Application money on Shares at Rs……………………….. allotted as per directors’ resolution

no……………………… date………transferred to share capital)

After this, the sequence of entries will change. Allotment money on first and/or second call
money will fall due for payment as soon as allotment is done or calls are made. Hence, the
entry for the amount due will have to be made first and the entry for the actual cash
receive will be made later.
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ISSUE OF SHARES FOR CONSIDERATION OTHER THAN CASH

A company can issue its shares for cash or for consideration other than cash such as against
purchase of land and buildings, plant and machinery, etc. The purchase of an asset against
the issue of shares comprises two distinct transactions: (1) the purchase of an asset (on
credit), and (2) the issue of shares.

Hence two separate entries can be made as follows:

1 Asset A/c Dr.

To Vendors

(Asset purchased from the Vendors)

2 Vendors Dr.

To Share Capital A/c

(Allotment of shares of Rs ……………each fully paid to Vendors)

Sometimes, a company rewards its promoters for their services by issuing shares to them
without any payment. Such an issue of shares also comes under the issue of shares for
consideration other than cash. The full amount of the shares issued to the promoters for
their services is regarded as the cost of goodwill and the entry shall be just the same as the
purchase of any other asset. Some conservative accountants prefer to consider the issue of
such shares as ‘incorporation costs’ and so debit this amount to Incorporation Costs
Account. The entry thus will be:

Goodwill/Incorporation Costs A/c Dr.

To Share Capital A/c

(Issue of …………..Shares of Rs ………………. each as fully paid to the Promoters as per

Directors’ Resolution no………………… dated ……………)

ISSUE OF SHARES FOR CASH

The issue of shares for cash can be at par or at a premium or at a discount. Let us now
discuss these three situations in detail.
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Issue of Shares for Cash at Par

When the shares are issued for cash at par, the applicants will be required to pay the face
value of the share in one lump sum or in instalments as explained earlier in this unit under
Section 2.2. The basic entries have also been discussed there.

Issue of Shares for Cash at a Premium

When a company offers to issue shares for more than the face value of shares, the excess
amount is known it as premium. A company can issue shares at premium subject to the
sanction by the Controller of Capital Issues. The amount of premium is decided by the
Controller of Capital Issues after taking into consideration the market value of the shares,
the accumulated profits, and the net worth of the company etc. The premium can be any
amount approved by the Controller. The amount of premium received is credited to a
separate account known as Share Premium Account’. It is shown on the liability side of the
Balance Sheer as a separate item.

According to the Section 78 of the Companies Act, 2013 the amount of share premium
received can be unused for the following purposes.

i) issuing fully paid bonus shares to the members;

ii) writing off the preliminary expenses of the company;

iii) writing off the expenses of, or the commission paid or discount allowed on, any issue of
shares or debentures of the company; or

iv) providing for the premium payable on the redemption of any redeemable preference
shares or any debentures of the company.

If the company wants to utilise the premium for any other purpose, it will have to obtain
the consent of the Court. Thus it should be clear that there are no restrictions on the issue
of shares at premium or the quantum of premium subject to the approval of the Controller
of capital Issues but there are restrictions on the utilization of share premium.

The amount of premium may be demanded with application, allotment or any one of the
calls or may be spread over any two or more of the above instalments. Thus the amount
emanded and received will include share premium in addition to contributions towards
share capital and the two should be bifurcated and credited to their respective accounts.
The bifurcation should always be done at the time of making transfer entry and not at the
time of making entry for cash receipt
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Issue of Shares for Cash at a Discount

When a company issues shares at a price less than the face value of the share, it is known
as ‘issue of shares at a discount’. Shares are ordinarily not issued at a discount by
companies because the discount allowed is a loss to the company which no company would
like to incur in normal circumstances. A company can issue shares at a discount subject to
the conditions laid down in Section 79 of the Companies Act

The conditions laid down in Section 79 of the Companies Act are as follows:

i) The issue of shares at a discount is authorised by a resolution passed by the company in

general meeting and the sanction by the Company Law Board.

ii) The resolution specifies the maximum rate of discount at which the shares are to be
issued. (The rate of discount must not exceed 10% unless the Company Law Board is of the
opinion that a higher percentage of discount may be allowed in the special circumstances
of the case.)

iii) Not less than one year has, at the date of issue. elapsed since the date on which the
company was entitled to commence business.

iv) The shares are of a class which has already been issued.

v) The shares are issued within two months of the date on which the issue is sanctioned by
the Company Law Board or within such extended time as the Board may allow.

Thus, it is clear that a newly formed company cannot issue shares at a discount nor a new
class of shares can be issued at a discount. The loss on such issue is to be debited to
‘Discount on Issue of Shares Account’ which will be written off out of the profits in
subsequent years or may be set off against share premium or other capital profits. The
amount of discount will be shown on the assets side of Balance Sheet till it is completely
written off

OVERSUBSCRIPTION OF SHARES

When the number of shares applied for is more than the number of shares the company
has offered to the public, it is known as ‘Oversubscription’. Even in the case of
oversubscription the company cannot issue anti allot more than the number of shares it
had offered to the public for subscription. But, in the recent years there has been a trend
amongst the companies entering the capital market to clearly mention their intention to
retain a certain percentage (not more than 15 per cent) of the number of shares offered
out of over subscription in which case the number of shares to be issued by the company
17

will be the number offered plus the retention percentage. In case of oversubscription there
may be three possibilities: (1) some applicants may he allotted the full number of ‘shares
they have applied for which is known as ‘full allotment’, (2) some applicants may not be
allotted any shares in which case their applications are treated as ‘rejected’, and (3) some
applicants may be allotted less number of shares than they have applied for. In the first
case, there is no excess money received. In the second case of rejection, the whole amount
will have to be refunded to the applicants. In the third case of partial allotment, the excess
amount received on application may be utilised towards the money due on allotment by
transferring the excess amount from the Share Application Account to the Share Allotment
Account

Full Allotment

As already mentioned, whenever there is oversubscription one of the alternatives available

to the director is to allot full shares to a few applicants and reject the remaining
applications. In this case, the application money for the rejected applications will be
returned. Hence, there will be no application money left for adjustment against the
allotment money due. Illustration 4 will help you to understand it better.

Pro-rata Allotment

When a company allot shares rate ably to all the applicants it is known as pro-rata
allotment. Alternatively, it can reject certain applications and refund the application
money; allot full shares to some applicants and make pro-rata allotment to others. All these
will be done by draw of lots and not arbitrarily. Now the main problem is what to do with
the excess amount received on application in case of pro-rata allotment. It would be quite
foolish to refund the excess money first and then ask the allottees to pay the allotment
money. Hence, usually the excess amount received on application is transferred and
adjusted towards money due on allotment.

Now in case pro-rata allotment, the amount of money received on application from an
applicant is bifurcated into two parts: (1) amount adjusted on the shares allotted in respect
of application money and, (2) excess amount transferred and adjusted towards the shore
allotment money due being the application money received on shares not allotted.

CALLS IN ARRERS

When any allottee fails to pay the amount due on allotment or any of the calls in respect of
shares allotted o him. Such amount is known as ‘Calls in Arrears’. When full amount is not
received, the Share Allotment and Calls accounts will show some balance representing the
unpaid amounts on allotment and calls.
18

The unpaid amounts on allotment and calls may be kept in their respective accounts as
balance not received or may be transferred to a new account opened for the purpose
known as Calls in Arrears Account’. The Calls in Arrears Account shows a debit balance
which is shown as a deduction from the paid up share capital on liabilities side of the
Balance Sheet. The company can charge interest on calls in arrears for the period for which
such amount remains unpaid at the rate given in the Articles of Association of the company.
In case the company does not the Articles of Association of its own, Table ‘A’ of the
Companies Act will apply. In that case, the rate of interest shall not exceed 5 per cent per
annum. On receipt of the call together with interest, the interest portion shall be credited
to Interest Account while call money shall be credited to the respective call account or to
call in Arrears Account as the case may be.

CALLS IN ADVANCE

When a company accepts money paid by some allottee in respect of calls not yet due, such
amount is known as ‘Calls in Advance’. It may also happen in case of partial allotment of
shares when the full amount of application money paid by an applicant is not adjusted to
allotment and if the company decides to retain such excess amount, it is called ‘Calls in
Advance’. It is a liability of the company and should be transferred to ‘Calls in Advance’
Account. It will be adjusted when the respective call is made

But till then it will be shown as liability in the Balance Sheet. The company must pay
interest on the amount of calls in advance at a rate stipulated in its Articles of Association.
In the absence of any Articles of Association of its own, the company will have to follow the
provision of Table A’ of the Companies Act according to which the rate of interest to be
allowed on calls in advance should not exceed 6 per cent per annum.

FORFEITURE OF SHARES

In case a shareholder does not pay the calls made on him, the directors can forfeit the
shares held by him, remove his name from the Register of Members and treat the amount
already paid by him forfeited to the company, if authorised by its Articles of Association.
Table authorises the directors to forfeit shares for non-payment of calls made. But they
have to strictly follow the procedure laid down in this regard. The directors must give clear
14 days’ notice to the defaulting shareholder asking him to pay the amount due from him in
respect of the calls not paid by him, together with interest at the applicable rate on or
before a certain date expressly mentioned in the notice. The notice must also state that if
the shareholder fails to pay the amount by the appointed date, the shares will be forfeited.
If payment is not received by the company up to the appointed date, the directors can pass
19

a resolution in their meeting forfeiting the shares held by the defaulting shareholder and
remove his name from the Register of Members.

When shares are forfeited. we shall debit the share Capital Account with the amount called
(including application money) upto the date of forfeiture in respect of shares forfeited and
credit (i) Share Forfeiture Account with the amount already received, and (ii) the respective
unpaid calls’ accounts (or Calls in Arrears Account if unpaid-calls have already been
transferred to Calls in Arrears Account) in respect of such shares. It should be noted that
the Share Capital Account should be debited only with the amount called in respect of such
shares and not with their total nominal value unless full amount per share has been called.
Thus, the journal entry for forfeiture of shares will be

Share Capital A/c Dr.

To Share Forfeiture A/c

To Calls in Arrears A/c

When shares were issued at a premium: Where the forfeited share had originally been
issued at a premium, the question arises as to whether, while passing the journal entry for
forfeiture of shares, the Premium on Shares Account should also be debited. This depends
upon whether the amount of premium on forfeited shares has already been received or
not. If the premium on such share has already been received, the premium on Shares
Account will not be debited because law does not permit the premium on shares once
collected to be refunded or cancelled. (As per Section 75 it can be utilised only for the
specified purposes.) But, if the premium on shares has not been received because it formed
part of the instalment which remained unpaid, then premium on Share Account will also be
debited. Thus, the journal entry for forfeiture of such shares will be

Share Capital A/c. Dr.

Share Premium A/c Dr.

To Calls in Arrears A/c

It should be noted that the premium is usually collected along with allotment money.
Hence, where premium on shares is involved, the premium Shares Account will be debited
whet’ there is default in respect of the allotment money. Let us take an example to clarify
this point: Atul Ltd. issued equity shares of Rs. 10 each at a premium of Rs. 3 per share
payable Rs. 3 on application, Rs. 5 on allotment (including premium) and the balance in two
calls of equal Amount. A, who was allotted 400 shares, did not pay die allotment money
20

and the first call. His shares were forfeited after the first call. B who was allotted 200
shares, did not pay the two calls. His shares were forfeited after the 2nd & final call.

When the shares were issued at a discount: Where the forfeited shares had been originally
issued at a discount, the Discount on Issue of Shares Account should also be credited while
passing the journal entry for forfeiture of shares. In that case, Share Forfeiture Account will
simply show the actual cash received from the defaulting shareholders in respect of the
shares forfeited. Thus, the entry for forfeiture in case the shares had been issued at
discount will be as follows.

Share Capital A/c Dr.

To Share Forfeiture A/c

To Calls in Arrears A/c

To Discount on Issue of Shares A/c

REISSUE OF FORFEITED SHARES

The directors can either cancel or reissue the forfeit shares. In most cases, however, they
decide to reissue these shares which may he at par, at a premium or at a discount.

The forfeited shares are usually reissued as fully paid and that too at a discount. In this
connection it should he noted that the amount of discount allowed on reissue should not
exceed the amount which has already been received (the amount forfeited) in respect of
these shares on their original issue and the same should be debited to the Share Forfeited
Account.

CONCEPT AND PROCESS OF BOOK BUILDING

Book building is a process by which the issuer company before filing of the prospectus,
builds-up and ascertains the demand for the securities being issued and assesses the price
at which such securities may be issued and ultimately determines the quantum of securities
to be issued. The issue price is not priced in advance. It is determined by offer of potential
investors about price which they may be willing to pay for the issue. To tieup the issue
amount, the company organizes road shows and various advertisement campaigns. Book
building refers to the collection of bids from investors, which is based on an indicative price
range, the offer price being fixed after the bid closing date. When a company has planned
to list its shares on the stock exchanges for the first time via IPO, the company
management has to decide various things to get its share listed on the stock exchange such
21

as issue size, share price, etc. and to get through all this process, company management has
to appoint underwriter to help in the listing process.

The issuing company hires an investment bank to act as an underwriter who is tasked with
determining the price range the security can be sold for and drafting a prospectus to send
out to the institutional investing community.

1. The investment bank invites investors, normally large scale buyers and fund managers, to
submit bids on the number of shares that they are interested in buying and the prices that
they would be willing to pay.

2. The book is 'built' by listing and evaluating the aggregated demand for the issue from the
submitted bids. The underwriter analyzes the information and uses a weighted average to
arrive at the final price for the security, which is termed the cut-off -price.

3. The underwriter has to, for the sake of transparency, publicize the details of all the bids
that were submitted.

4. Shares are allocated to the accepted bidders.

Book building is one of the most efficient mechanisms by which companies, with the help of
the investment banker, price their share in IPOs, and also it is recommended by all the
major stock exchanges and regulators. It also helps investors to value the price of the
shares by submitting the bids to the underwriter, which is not possible if the company
chooses a fixed-price mechanism to price its share.

ISSUE OF RIGHT SHARES

When an existing company makes subsequent issue of shares to the existing shareholders,
it is called right issue. According to Section 81 of the Companies Act, 2013 when at any
time, after the formation of two years of the company or the completion of one year of the
first allotment of shares in the company, whichever happens earlier, it is decided by the
board of directors to increase the subscribed capital of the company through the allotment
of the subsequent shares; then:

Such subsequent shares should be offered to persons who are at that time, the holders of
the shares of the company, and proportionately in the ratio of the shares held by them.

The offer of such shares should be given through notice which should specify the number
of shares offered, limiting the time to a minimum of 15 days from the date of offer within
which, if the offer is not accepted, it will be deemed to be rejected.
22

After the expiry of the time of notice or information received from the shareholders, and
before the date of rejecting the offer of the company, the Board of Directors can proceed
to dispose of the shares in the manner which they feel beneficial for the company.

Section 81 will not apply to a Private Company

The increase in the subscribed capital of the public company caused by the exercise of an
option attached to debentures issued or loans raised by the company:

 To subscribe for shares of the company

 To convert such debentures or loans into shares of the company

Advantages of Right Issue

(1) Ownership is Retained: With the issue of right shares, the company can retain the
control in the hands of the existing shareholders. The right issue makes possible
equitable distribution and it does not disturb the established equilibrium as the
allotment under right issue is made proportionately among the shareholders
(2) No Dilution in Value: The existing shareholders do not suffer dilution in the value of
their shares due to the fresh issue made by the company because of the right issue.
(3) Avoid Expenses: The expenses which are required to be incurred for the fresh issue of
shares can be avoided through right issue.
(4) Enhancement in the Image: Image of the company becomes better when right issues
are made from time-to-time. This is because existing shareholders remain satisfied.
(5) More Certainty of Funds: There is more certainty of capital or the funds when the
fresh issue of shares is offered to the existing shareholders than to the general
public.
(6) No Misuse of Opportunity: Directors cannot misuse the opportunity of issuing the
new shares at lower rates to their friends and relatives, and in maintaining more
control hands with the issue of right shares.

Accounting for Right Issue

The accounting for right issue is done in the same manner as in the case of public issue.
Directors can call the amount of right shares in different installments as in the case of
public issue.

CONDITIONS FOR BUY BACK OF SHARES

1. The Articles of Association of the company authorize buy back of shares.

2. The special resolution is to be passed in the General Meeting of the company.

23

3. The buy back of shares should not exceed 25% of the paid-up capital and free reserves of
the company.

4. After such buy back, the debt equity ratio should not exceed 2:1.

5. From the 12 months of the date of passing the resolution, the buy back should be
completed.

6. All the buy back shares should be fully paid-up.

7. A declaration of the company should be filed with the Registrar of the Companies and
Securities Exchange Board of India in the form of an affidavit.

8. The securities should be listed at the Stock Exchange of India.

9. Within seven days of the last date of completion of buy back, the company shall
extinguish or physically destroy such shares.

10. Company shall not make further issue of shares within a period of 24 months, except
the issue of bonus shares after completing the buy back of shares.

11. The buy back cannot be done through a subsidiary or investment company

MOTIVES OF BUY BACK OF SHARES

There may be various objectives of buy back of shares. Some of them are as follow:

 Return the surplus cash to shareholders.

 Enhance the Earning Per Share (EPS).
 Convey the view of the management to investors
 Stabilize the market price of the share of the company.
 Raise the promoters’ voting power without spending any amount
 Word off a hostile takeover threat.
 Move towards a desirable Capital Structure

SEBI GUIDELINES

SEBI has made certain regulations in 1998, in relation to the buy back of shares, which are
as follows:

1. Buy back of shares cannot be done through negotiated deals. Therefore, the
company is required to make public announcements through one national English
daily newspaper, one national Hindi daily, and one national language daily where the
registered office of the company is situated.
24

2. Buy back should be permissible:

 From the existing shareholders on a proportionate basis.
 From the open market.
 From the old lot of holders
 By purchasing the shares issued to employees of the company pursuant to the
scheme of stock option or sweat equity.
 Buy back offer should remain open for a minimum of 15 days and a maximum
of 30 days.
 The maximum price of buy back should be determined by the shareholders
through the special resolution of the shareholders or through a special
resolution of the board of directors.
 If the tendered shares are more than the number of shares to be bought back,
the buy back should be done on a proportionate basis.

METHODS OF BUY BACK OF SHARES

There are two methods of buy back. Let us discuss both the methods in detail.

Tender Method

In this method, company preparing the buy back fixes the price at which it is prepared to
buy back. If number of shares offered for buy back by the shareholders at this price exceeds
the total number of shares determined by the company to be bought back, then shares
shall be bought from each shareholder proportionately. In this method, promoters may also
offer their shares for buy back provided proper disclosures are made. Under this method,
price offered by company will be at a premium over the prevalent market price in order to
act as an incentive to the shareholders to offer their shares for buy back.

Open Market Purchases

(A) Through Stock Exchange: In this method, company buys back through the stock
exchanges for cancellation till it reaches the maximum number of shares it had originally
started out to buy back and cancel. While adopting this method of buy back, company has
to comply with the given regulations.

 Company has to specify maximum price of buy back in the special resolution
through which the buy back decision has been made.
 Promoters and persons in control of the company are not permitted to offer
their shares for buy back under this method.
 The buy back of shares shall be made only on the stock exchanges with
electronic trading facility.
25

 The buy back of shares shall be through the ‘all or none' order matching
mechanism on these stock exchanges.

(B) Through Book Building: This method fixes the buy back price based on the shareholders
assessment of the fair price for the shares to be offered by them for buy back. This method
is also known as 'Dutch Auction'. Under this method, shareholders are invited to quote a
range of prices and the number of shares at each price level that they would be interested
in offering for buy back. Based on this information provided by all the quoting shareholders,
a common price and the respective number of shares against quoted by all the
shareholders, aggregate of which will be equal the total number of shares that the
company would like to buy back, will decide the price and number of shares to be bought
back from the participating shareholders. In this respect, SEBI requires following
compliances:

 The special resolution through which buy back decision has been taken should
specify the maximum price at which buy back will be made.
 The number of bidding centres shall not be less than thirty and there shall be at least
one electronically linked computer terminal at all the bidding centres.
 The final buy back price, which shall be the highest price accepted shall be paid to all
the holders whose shares have been accepted for buy back.

ADVANTAGES OF BUY BACK OF SHARES

There are various advantages of buy back of shares. Some of them are as follow:

1. Under the buy back process, the companies having large amount of free reserves are
free to use funds to acquire the shares and other specified securities.
2. Buy back of shares helps the promoters to formulate an effective defense strategy
against hostile takeovers.
3. Through buy back of shares, the company avails the advantage of servicing reduced
capital base with high dividend yield.

ESCROW ACCOUNT

Escrow is a contract or bond deposited with the third person by whom it is delivered to the
guarantee on the fulfillment of some conditions. For the purpose of buy back, the company
has to open the Escrow Account consisting of:

1. Cash deposited with the commercial bank.

2. Bank guarantee in favour of the merchant banker.

26

3. Deposit of acceptable securities with the appropriate margin.

4. Combination of 1, 2, 3 with the merchant banker with an amount equal to 25% of the
consideration payable, if consideration is not more than 100 crores plus 10% of the
consideration exceeding 100 crores

CONDITIONS FOR REDEMPTION OF PREFERENCE SHARES

Under Section 80 of the Companies Act, 2013, certain conditions are laid down, which are
to the followed by the company for making the redemption of preference shares valid. Let
us discuss these valid conditions:

Authorized by Article of the Company

If authorized by the Article, the company limited by shares can issue preference shares,
which are at the option of the company, can be redeemed after the expiry of the stipulated
period.

Fully Paid-up Shares

The preference shares cannot be redeemed unless these are fully paid-up. Therefore, the
partly paid-up shares cannot be redeemed and for redemption, these partly paid-up shares
are to be converted into fully paid-up for the purpose of redemption.

Out of Profits or Issue of New shares

Preference shares can be redeemed either out of profits, which would be available for
dividend or out of the proceeds of the fresh issue of shares (equity shares or new
preference shares) made for the purpose of the redemption. Preference Shares cannot be
redeemed out of the proceeds of the issue of debentures or the proceeds from the sale of
the property.

Creation of Capital Redemption Reserve

When the redemption of preference shares is made out of the profits, it is necessary to
transfer the equivalent amount from reserves to the Capital Redemption Reserve.

Use of Capital Redemption Reserve A/c

Capital Redemption Reserve A/c can be used for issuing fully paid bonus shares to the
shareholders. This account cannot be reduced except in accordance with the sanction of
the court relating to the reduction of share capital.
27

Time Period of Redemption

If the redemption of shares is done through issue of new shares then it should be done
within one month of the issue of new shares.

Premium on Redemption

Any premium on redemption of preference shares should be provided either from

securities premium or from the revenue profits or capital profits actually realized.

ISSUE OF BONUS SHARES

If the Company has more than required accumulated profits or reserves, then it can
distribute these profits in the form of Stock dividend to the shareholders of the company.
Thus the profits distributed to the shareholders in the form of shares without charging any
cost from them are called bonus shares. Only the existing shareholders are entitled for the
bonus shares. Sometimes the company does not have the cash and it wants to share its
accumulated profits with the shareholders, then without disturbing the working capital, the
company issues the bonus shares to the shareholders of the company.

Bonus shares can be given in the following ways:

(1) By making partly paid up shares fully paid up

(2) Issue of new fully paid bonus shares

Through bonus shares the profit becomes the part of the capital and due to this reason the
issuing of bonus shares is also called the capitalization of profits.

SEBI Guidelines for Issue of Bonus Shares

A listed company proposing to issue bonus shares shall comply with the following
guidelines issued by SEBI vide press release dated 13.4.1991:

(1) No company shall, pending conversion of FCDs/PCDs, issue any shares by way of bonus
unless similar benefit extended to the holders of such FCDs/PCDs, through reservation of
shares in proportion to convertible part of FCDs or PCDs.

(2) The bonus issue shall be made out of free reserves built out of the genuine profits or
securities premium collected in cash only. Reserves created by revaluation of fixed assets
are not capitalized.

(3) The declaration of bonus issue in lieu of dividend is not made.

(4) The bonus issue is not made unless the partly paid shares are made fully paid up.
28

(5) The Company has not defaulted in payment of interest or principal in respect of the
fixed deposits and interest on the existing debentures or principal on redemption thereof:

(6) A Company which announces its bonus issue after the approval of the Board of Directors
must implement the proposal within six months from the date of such approval and shall
not have the option of changing the decision.

(7) The Article of Association of the Company shall contain the provision for capitalization
of reserves, etc. If there is no such provision then company should pass the special
resolution for the issue of bonus shares in general body meeting of the shareholders.

(8) If on the issue of the bonus shares the subscribed and the paid up capital exceed the
authorized capital then special resolution should be passed in the general body meeting for
increasing the authorized capital.

(9) A Certificate duly signed by the issuer company and counter signed by statutory auditor
or by the Company Secretary in practice to the effect that the provisions have been
complied with shall be forwarded to the Board.

Circumstances for Issue of Bonus Shares

Following are the circumstances that warrant the issue of bonus shares:

(1) When a company has accumulated large reserves (whether capital or revenue) and it
wants to capitalize these reserves by issuing bonus shares.

(2) When the company is not in a position to give cash bonus because it adversely affects its
working capital.

(3) When the value of fixed assets far exceeds the amount of the capital.

(4) When the higher rate of dividend is not advisable for the distribution of the
accumulated reserves because shareholders will demand the same rate of dividend in
future which the directors may not be able to give. To obviate this difficulty, bonus shares
are issued to facilitate the payment of the regular dividend year to year.

(5) When there is a big difference between the market value and paid up value of shares of
the company i.e., market value of shares far exceeds the paid up value of shares.

A company issuing bonus shares is better placed in the market. There is a sharp rise in the
price of equity shares following the declaration of bonus issues.
29

Sources for the Issue of Bonus Shares

There are various sources for the issue of bonus shares. Bonus shares can be issued out of
the following:

1. Capital Redemption Reserve created at the time of redemption of preference shares.

2. Securities Premium A/c

3. (Both the CRR and Securities premium can only be used for fully paid new bonus shares.
These cannot be used for making partly paid up shares fully paid up.)

4. Capital Reserve

5. General Reserve

6. Balance of Profit and Loss A/c

7. Any other Reserves

Advantages of Issue of Bonus Shares

Issue of bonus shares has following advantages:

(a) Advantages from the Viewpoint of the company

1. Liquidity or working capital of the company is not affected as the bonus issue does not
involve any cash payment.

2. The share capital remains the same and the profits and the reserves goes on increasing
this disparity between the assets and the reserves of the company is reduced through the
issue of bonus shares.

3. By not declaring the cash dividend, company can meet its long term claims and on the
other hand through issue of bonus shares, shareholders also remain happy.

4. As the profits are permanently ploughed back in the company, the credit worthiness of
the company is also improved.

(b) Advantages from the viewpoint of shareholders

1. For fulfilling their cash requirements, the shareholders can dispose of their bonus shares.

2. The shareholders will receive increased dividends in the future because of the increase in
their shareholdings.
30

3. Bonus issue enables the shareholders to increase their holdings in successful companies,
the price of whose share is very high and it is very difficult to purchase their shares from the
open market.

4. The shareholders in the high tax brackets are particularly benefited because there is only
Capital Gain Tax on the sale of such shares which is much lesser than the tax on the other
incomes.

Disadvantages of Issue of Bonus Shares

Issue of bonus share suffers from many disadvantages. Some are:

1. The issue of bonus shares sometimes led to the drastic fall in the market price of the
shares and the advantages gained by the shareholders is neutralized due to the fall in the
price of the shares.

2. The bonus issue encourages the speculative dealings in the shares of the company in the
market.

3. As only the capital of the company increases and not the profits of the company with the
bonus shares, as a result the rate of dividend reduces.

WHAT IS A DEBENTURE?

Issue of debentures is a method of raising loan from the public. Thus, a debenture may be
defined as an instrument acknowledging a debt by a company to some person or persons
which may or may not be secured by a charge on its assets. According to Mr. Topham “A
debenture is a document given by a company as evidence of a debt to the holder usually
arising out of a loan and most commonly secured by a charge”. Section 2(12) of the
Companies Act, 2013 “Debenture includes debenture stocks, bonds and any other securities
of the company whether constituting a charge on the company’s assets or not”.

According to the above definitions the main features of debentures are as follows.

1. A debenture in the form of a certificate like a share certificate.

2 It is issued under the common seal of the company.

3 This certificate is an acknowledgement of debt by the company to its holder.

4 A debenture usually provides for the repayment of a specified principal sum on a

specified date. However, there is no restriction on issue of irredeemable debentures.
31

5 It usually provides for the payment of interest at regular intervals at fixed dates until the
principal sum is completely paid back.

6 It is normally secured by a floating charge on the assets of the company

DIFFERENCE BETWEEN SHARES AND DEBENTURES

1 A share represents a portion of the capital of a company whereas a debenture represents

a portion of debt of a company.

2 A shareholder is a member of the company whereas a debenture holder is a creditor of

the company.

3 A shareholder enjoys the rights of proprietorship of a company whereas a debenture-

holder can enjoy the rights of a lender only.

4 A shareholder has a right of control over the working of the company by attending and
voting in the general meeting which is the supreme authority of the company whereas a
debenture holder has no such right.

5 A shareholder can get dividend only when there are profits whereas a debenture holder is
entitled to interest which the company must pay whether or not there are profits to the
company.

6 A debenture holder gets a fixed rate of interest per annum payable on fixed dates
whereas a shareholder gets a dividend far higher if the company earns good profits.

7 A shareholder has a claim on the accumulated profits of the company and is normally
rewarded with bonus shares whereas a debenture holder has no claims whatsoever after
he has been paid the interest amount.

8 Debentures are normally issued for a specified period after which they are repaid but no
such repayment is possible in case of shares.

9 A company cannot purchase its own shares from the market whereas it can purchase its
own debentures and cancel them or re-issue them.

10 In liquidation, debenture holders being secured creditors normally, get priority in

payment whereas shareholders are the last to get payment after all other claims have been
satisfied.
32

TYPES OF DEBENTURES

A company can issue various types of debentures which can be classified on the basis of
security, permanence, convertibility and records.

1 Redeemable and Irredeemable Debentures: Redeemable Debentures are issued for a

specified period after which the company must repay the amount of debentures on a
specified date or after notice or by periodical drawings. Irredeemable Debentures, on the
other hand are those debentures for which no fixed date is specified for repayment and the
holders of which cannot demand payment as long as the company is functioning and does
not make default in interest payment. Normally companies issue redeemable debentures.

2 Registered and Bearer Debentures: Registered debentures are those which are registered
in the name of the holder by the company in the Register of Debentureholders. Such
debentures are made out in the name of holder which appears in the debenture certificate.
Such debentures are transferable in the same manner as shares by transfer deeds. Interest
on such debentures is payable to the person whose name is registered with the company in
the register of Debenture holders. Bearer debentures are those which are transferable by
mere delivery. Interest on such debenture is payable on the basis of coupons attached with
the debenture certificate.

3 Secured and Unsecured Debentures: Secured debentures are those debentures which
are secured either by the mortgage of a particular asset of the company known as Fixed
Charge or by the mortgage of general assets of the company known as Floating Charge.
Secured debentures are also known as Mortgaged Debentures. Unsecured debentures, on
the other hand are those debentures which are not secured by any charge or mortgage on
any property of the company. Unsecured debentures are also known as ‘Naked
Debentures’. Only good companies of strong financial standing can issue such naked
debentures.

4 Convertible and Non-convertible Debentures: Convertible debentures are those

debentures wherein the debenture holder is given an option to exchange a part or whole of
the debenture amount for equity shares in the company on the expiry of a specified period.
Some companies issue convertible debentures wherein a part or whole of the debenture
amount, after the specified period, is compulsorily converted into equity shares of the
company. Where only a part of the debenture amount is convertible into equity shares such
debentures are known as ‘Partly Convertible Debentures’ but when the full amount of the
debenture is convertible into equity shares such debentures are known as ‘Fully Convertible
Debentures’. Non-convertible debentures, on the other hand, are those debentures for
which the debenture holder does not have any right for conversion into equity shares.
33

ISSUE OF DEBENTURES

The procedure and accounting entries for the issue of debenture are, more or less, the
same as those for the issue of shares. Like shares, the money on debentures may be
collected in instalments and they can be issued at par, at a premium or at a discount. They
can also be issued for consideration other than cash. Let us now study the accounting
entries passed in different situations.

When Debentures are issued for Consideration other than Cash

When debentures are issued for consideration other than cash say, for payment to vendors
for purchase of some fixed assets, they will be fully paid up and the journal entry passed is
as follows.

Vendors Dr.

To Debentures A/c

(debentures of Rs per deb. issued to vendors)

When Debentures are issued for Cash

When debentures are issued for cash, they may be issued at par, at a premium or at a
discount, and the money may be collected in instalments. In practice, however, the
debentures are usually issued at par and money is collected in two instalments i.e., on
application and on allotment. Hence, the journal entries made are as follows.

1 Bank A/c Dr.

To Debenture Application A/c

(Application money received on debentures at Rs per debenture)

2 Debenture Application A/c Dr.

To Debentures A/c

(Debentures allotted as per Board’s Resolution no dated and application money adjusted)

3 Debenture Allotment A/c Dr.

To Debentures A/c

(Allotment money due on allotment of debentures @ Rs per debenture)

34

.4 Bank A/c Dr.

To Debenture Allotment A/c

(Allotment money received on debentures @ Rs per debenture)

Issue of Debentures as a Collateral Security

Issue of debentures as a collateral security means the issue of debentures as secondary

security against some loan taken by the company.. If the loan is paid back, those
debentures are returned to the company. If the lender’s claim is not fully satisfied by the
sale proceeds of the principal security, the lender will claim the remaining balance of his
claim against these debentures issued as collateral security. There are two methods of
recording the issue of debentures as a collateral security. Under the first method, no entry
is made for such issue but only a note is given in the Balance Sheet regarding debentures
issued as collateral security. Under the second method, an accounting entry is made for the
issue by debiting the Debentures Suspense Account and crediting the Debentures Account.

Debentures Issued at Different Terms

A company may issue debentures at different terms. These terms may not only relate to the
issue of debentures but also to their redemption. For example, just as the issue can be
made at par, at a premium or at a discount, the redemption can also be stipulated at par, at
a premium or at a discount. In practice, however, the redemption is never made at a
discount. Thus, combining such terms of issue and redemption of debentures, the following
five possibilities are commonly found in practice.

a) Debentures issued at par and redeemable at par

b) Debentures issued at a premium and redeemable at par

c) Debentures issued at a discount and redeemable at par

d) Debentures issued at par and redeemable at a premium

e) Debentures issued at a discount and redeemable at a premium

35

a) Issued at par, redeemable at par

Bank A/c Dr.

To Debentures A/c

b) Issued at a premium, redeemable at par

Bank A/c Dr.

To Debentures A/c

To Premium on Issue of Debenture A/c

c) Issued at a discount, redeemable at par

Bank A/c Dr.

Discount on Issue of Deb. A/c Dr.

To Debentures A/c

d) Issued at par, redeemable at a premium

Bank A/c Dr.

Loss on Issue of debentures A/c Dr.

To Debentures A/c

To Premium on Redemption of Deb. A/c

e) Issued at a discount, redeemable. at premium

Bank A/c Dr.

Loss on Issue of Debentures A/c Dr.

To Debenture A/c

To Premium on Redemption of Deb. A/c

Writing off Loss on Issue of Debentures

The loss on issue of debentures (both discount on issue and premium on redemption) is a
fictitious asset shown on the asset side on the Balance Sheet. This must be written off as
soon as possible, against the capital profits or by debiting the Profit & Loss Account. The
Journal entry for writing off the loss is as follows.
36

Capital Reserve/Profit and Loss A/c Dr

To Loss on Issue of Debentures A/c

The amount to be written off depends on how the debentures are redeemed. The
debentures can be redeemed either after a fixed period or in instalments. Let us now see
how their amount is calculated in both the situations.

i) When the debentures are redeemed after a fixed period: In this case the total
amount of loss is calculated and written off evenly over the years. If, for example, the
loss on issue of debentures is Rs. 5,000 and the debentures are to be redeemed after
5000
ten years then the amount to be written off every year will be Rs. 500 ( 10
)
ii) When the debentures are redeemed in instalments: In this case the amount to
be written off each year should be in proportion to the amount of debentures
outstanding in the beginning of the year. Suppose a company issues 2,000
debentures of Rs. 100 each at a discount of 5% and the debentures are to be
repaid by equal instalments of Rs. 40,000 at the end of year.
5
In this case the amount of discount Rs.12, 000 ( X200000) will be written off as
100
follows:

REDEMPTION OF DEBENTURES

The money raised through the issue of debentures is a loan to the company and must be
repaid on the specified date and in the specified manner. Normally the Lime and mode of
repayment is indicated in the prospectus at the time of issue of debentures by the
company.

The repayment of the amount of debentures is called redemption of debentures. There are
a number of ways by which the debentures can be redeemed. These are as follows:

1. Redemption on maturity

2 Redemption in instalments

3 Redemption by purchase in the open market

4 Redemption by conversion

Redemption on Maturity:-The debentures are issued for a specified period of time. After
the expiry of that period, the amount of debenture is to be paid back. The debentures may
be redeemed at par or at a premium. The entries are as follows:
37

a) When redeemed at par

Debentures A/c Dr.

To Bank A/c

b) When redeemed at a premium

Debentures A/c Dr.

Premium on Redemption of Deb. A/c Dr.

To Bank A/c

Sinking Fund Method

Sinking fund method is another method by which the debenture can be redeemed on
maturity. Under this method a fixed amount worked out with the help of sinking fund table
is taken from Profit & Loss Appropriation Account and a sinking fund is created. This
amount is then investe4 in certain government securities. The amount so set aside earns a
certain amount of interest, which is reinvested together with fixed amount in the
subsequent years. In the last year, the interest and the appropriated amount are not
invested. On the other hand, all investments are sold and the amount so obtained is used
for redeeming the debentures. The balance in Sinking Fund Investment Account represents
the profit or loss which will be transferred to Sinking Fund Account. Then after, the Sinking
Fund Account is transferred to General Reserve. Journal entries will be as follows:

At the end of 1st year

i) When the amount is set aside

Profit & Loss Appropriation A/c Dr.

To Sinking Fund A/c

ii) When the amount is invested

Sinking Fund Investment A/c Dr.

To Bank A/c
38

At the end of 2nd and subsequent years

i) When the interest is received

Bank A/c Dr.

To Interest on Sinking Fund Inv. A/c

ii) When the interest is transferred

Interest on Sinking Fund Investment A/c Dr.

To Sinking Fund A/c

Instead of passing entry (i) and (ii), only one entry can be passed

Bank A/c Dr.

To Sinking Fund A/c

iii) When the amount is set aside

Profit & Loss Appropriation A/c Dr.

To Sinking Fund A/c

iv) When the amount appropriated plus interest is invested

Sinking Fund Investment A/c Dr.

To Bank A/c

At the end of last year

i) When the interest is received

Bank A/c Dr.

To Interest on Sinking Fund Investment A/c

ii) When the interest is transferred

Interest on Sinking Fund Investment A/c Dr.

To Sinking Fund A/c

iii) When the amount is set aside

Profit & Loss Appropriation A/c Dr.

39

To Sinking Fund A/c.

iv) There will be no investment in the last year and the investments in hand will be sold.

When the instalments are sold

Bank A/c Dr.

To Sinking Fund Investment A/c

After this entry Sinking Fund Investment A/c is prepared to know profit or loss on sale of
investments.

v) When Profit or Loss is transferred to Sinking Fund Account

In case of profit

Sinking Fund Investment A/c Dr.

To Sinking Fund A/c

In case of loss

Sinking Fund A/c Dr.

To Sinking Fund Investment A/c

vi) When the debentures are redeemed

Debentures A/c Dr.

To Bank A/c

vii) When Sinking Fund Account is closed

Sinking Fund A/c Dr.

To General Reserve A/c

Insurance Policy

Some companies create a sinking fund for the redemption of debentures but investment is
not made in securities earning fixed rate of interest but instead an insurance policy is taken
for the amount required for redemption of debentures paying premium to the Insurance
Company. It is on the same lines as Sinking Fund with the only exception that no interest is
received under Insurance Policy Method.
40

Redemption in Instalments

about the accounting treatment of redemption of debentures on maturity. Sometimes the

terms of issue provide that beginning from a particular year, a fixed amount of debentures
will be redeemed annually. For example: A company issues 1,000 debentures of Rs. 100
each. The prospectus provides that beginning with the 4th year, 200 debentures will be
redeemed every year. This means that Rs. 20,000 debentures will be redeemed at the end
of 4th, 5th, 6th, 7th and the 8th year. As far the debenture holders whose money is to be
returned, they can be selected either (i) by drawing lots, or (ii) by serial number of the
debentures.

The debentures, in such asituation caneither be redeemed out of profit or out of capital.
The entries are as follow

i) If redeemed out of profit

a) When amount is taken out of profits

Profit & Loss Appropriation A/c Dr.

To Debenture Redemption Reserve A/c

b) When the debentures are redeemed

Debentures A/c Dr.

To Bank A/c

ii) If redeemed out of capital

Debentures A/c Dr.

To Bank A/c

Redemption by Purchase from the Market

The Company can also redeem its debentures by purchase in the open market. It can be
done only if the Article of Association of the company so permits, by purchasing its
debentures in the open market, the company is able to redeem its debenture as well as use
its surplus funds. The Company usually purchases its own debentures from the market price
of the debenture, (ii) premium promised at the time of redemption, if any, and (iii) the
annual interest from the date of purse to the date of actual redemption.

When the company purchases its own debentures in the open market, it may have to pay a
higher or a lower price than the face value of its debentures. The difference between the
41

face value of debentures and the price at which they are purchased, will be the profit or
loss on their cancellation. Hence, when own debentures are purchased for cancellation, the
entry should also account for such profit or loss.

Payment of Interest on Debentures:

When the company purchases its own debentures in. the open market and cancels them, it
reduces the debenture interest payable. It is because the interest in that case is payable
only on the outstanding debentures. Hence, while making the entries for payment of
interest, we should ensure that Debenture Interest Account is debited only in respect of the
outstanding debentures and not the total debentures.

Redemption by Conversion

Debentures can also be redeemed by converting them into new debentures or shares.

If it is decided to redeem the existing debentures by conversion into new debentures, the
company has to follow the prescribed procedure for the purpose and give the necessary
option to the debenture holders who will take their own decision. It cannot be made
compulsory unless the terms of the issue had provided for such conversion. In case of
debentures for which the option for such conversion has been exercised, the entry will be
as follows.

Debentures (old) A/c Dr.

To Debentures (new) A/c

As for redemption by conversion into shares, it can be done only in case of convertible
debentures. Non-convertible debentures cannot be converted into shares as per the latest
rules prescribed by the Controller of Capital Issues. The conversion into shares may be
optional or compulsory depending upon the terms at which convertible debentures had
been issued. It may also involve premium on shares which was indicated at the time of
issue or as approved by the Controller. of Capital Issues at the time of conversion. The
entries for conversion of debentures into equity shares are as follows:

When shares are issued at par

Debentures A/c Dr.

To Equity Share Capital A/c

When Shares are issued at a Premium

Debentures A/c. Dr.

42

To Equity Share Capital A/c

To Share Premium A/c

COMPANY FINAL ACCOUNTS

The Final Accounts of a company refer to the annual financial statements which all business
enterprises have to prepare. Section 209 of the Companies Act makes it obligatory for a
company to maintain certain books of account. Section 210 of the Companies Act lays down
that at every annual general meeting of shareholders, the Board of Directors of the
company must present (1) Balance Sheet as at the end of ‘the period, and (2) Profit and
Loss Account for the period. The period is interpreted as a ‘Financial year’ which may be
less or more than a calendar year but is not to exceed fifteen months.

LEGAL REQUIREMENTS AS TO PROFIT AND LOSS ACCOUNT (SCHEDULE VI PART II)

In the Companies Act, 2013 there is no Proforma prescribed for the preparation of the
Profit and Loss Account of a company. However, the particulars and information to be given
in the Profit and Loss Account are laid down in Schedule VI part II of the Act.

The Profit and Loss Account must set out various items relating to the income and
expenditure of the company arranged under the most convenient heads.

Income

Items of income which are required to be included in the Profit and Loss Account of a
Company are:

1 Turnover: It refers to total sale value of goods or income derived from services rendered.
If the company deals in more than one type of goods, income from different classes of
goods are to be shown separately. The amount of income from sale is arrived at after
deducting sales returns and trade discount allowed from the total sales.

2 Income from investment: Income may be earned from two types of investments: (a)
Interest on trade investments such as Loans and advances, and (b) dividend and interest on
investments in shares and debentures of other companies. The two types of investment
income are to be shown separately.

3 Profit (or loss) on sale of investment in shares or debentures has to be shown as a

separate item.

4 Dividend received from subsidiary companies (if any).

43

5 Miscellaneous income: Such income may include income from other sources, like rent on
land and buildings, recovery of insurance claims.

6 Extraordinary profits: Profits earned during the year from non-recurring transactions, for
example, due to changes in the method of valuation of stock, are to be shown under this
head.

Expenses and Provisions

Items of expenditure arc required to be shown under different heads as follows:

1 Cost of goods sold: The cost of goods sold is generally arrived at by adding opening stock
and purchases and deducting closing stock from the total:

Alternatively, the difference between the value of stock (of finished and semi-finished
goods) at the beginning of the year and at the end of year is calculated. This may indicate
increase in stock or decrease of stock at the end of year. If there is increase in stock, it is
shown as a deduction from the cost of Goods sold. On the other hand, if there is decrease
in stock, it is added to the cost of goods sold. Purchases of finished goods, if any, are shown
separately. Raw materials consumed are shown under another head as an item of
manufacturing expenses.

2 Manufacturing and Selling Expenses. Expenditure incurred on manufacturing and selling

operations include:

i) Raw materials consumed (opening stock plus purchases less closing stock)

ii) Stores consumed

iii) Power and Fuel

iv) Rent

v) Repairs to buildings

vi) Repairs to machinery

vii) Insurance

viii) Rates and taxes

ix) Miscellaneous expenses

x) (a) Salaries, wages and bonus (b) Contribution to provident fund, pension fund (c)
Employee welfare expenses
44

xi) Commission to selling agents, discounts and allowances

xii) Depreciation on fixed assets. (The methods and rates of depreciation to be charged on
different categories of assets are laid down in the Companies Act)

xiii) Interest on debentures and Long-term loans paid or payable

xiv) Remuneration payable to Directors (including managing director) or manager, if any xv)
Amount reserved, for (a) repayment of preference share capital (b) repayment of loans and
debentures

xvi) Provision for Taxation, Provision for bad and doubtful debts

xvii) Audit Fees

Appropriation of Profits

After ascertaining profits, the amount of profit for the current year and that of the previous
year are distributed or ‘appropriated’ for different purposes. Thus, the balance of profit
brought forward from the previous year is added to the profit for the current year. The
items of appropriation generally are: transfer to reserves and provision for dividend
proposed to be paid to shareholders. Other items included in this part of the Profit and Loss
Account are: Debenture Redemption Reserve and Arrears of depreciation of previous year,
if any.

The final balance of profit after the appropriation is carried forward and taken to the next
year’s account. This part of the Profit and Loss Account may be regarded as Profit& Loss
Appropriation Account; but there is no separate heading used for it. 4The second part of
the account showing appropriation of profits is sometimes called ‘Below the Line’ Account.

Special Features of Company Profit and Loss Account

The special features of the Profit and Loss Account of a company are summarized below.

1 It is not necessary to prepare a Trading Account showing gross profit. The Profit and Loss
Account includes all items of income and expenditure and shows the net profit.

2 After net profit is ascertained, the distribution or appropriation of profit is show in the
second part of the Profit and Loss Account known as ‘Below the line’. In this part, the
balance of profit brought forward from, the previous year is added to the current year’s
profit. Dividend proposed to be paid to shareholders and transfer to general reserve is two
main items of appropriation. The final balance of profit is shown in the Balance Sheet.
45

3 The Companies Act requires that figures of the previous year must be shown r a separate
column alongside the respective figures of the current period.

4 Since various details relating to income and expenditure must be shown as required by
the Act, a summarised Profit and Loss Account is prepared and details of items are shown
separately in the form of annexures.

5 The form of presentation may be ‘vertical’ or ‘horizontal,(Left-Right)’. It is not necessary

to write ‘To’ and ‘By’ on the two sides even when the account is prepared in ‘horizontal’
form.

LEGAL REQUIREMENTS AS TO COMPANY BALANCE SHEE (SCHEDULE VI PART I)

The Balance Sheet of a company like that of any other type of business organisation is a
statement of assets and liabilities. However, in the case of a company, the nature of details
to be shown and the order of arrangement of the items must conform to the requirements
prescribed in Schedule VI, Part I of the Companies Act.

Proforma of Balance Sheet

There are two alternative Proforma given in Schedule VI: (i) horizontal, and (ii) vertical. Any
one of these forms may be adopted for the Balance Sheet of a company

In the horizontal form, liabilities are presented on the left hand side and assets on that right
hand side. In the vertical form, the liabilities are shown under the heading ‘Sources of
Funds’. This is followed by the assets shown under the heading ‘Application of Funds’.

Both the prescribed forms of Balance Sheet require that figures of the previous year should
be shown in separate column along with the figures of the current year with respect to
each of the items of liabilities and assets.

TREATMENT OF SPECIAL ITEMS RELEVANT TO COMPANY FINAL ACCOUNTS

There are certain items appearing in the final accounts which are peculiar to the company
form of organisation. They are as follows.

Preliminary Expenses

All expenses relating to the formation of company are grouped under one heading known
as Preliminary Expenses. This includes expenses like cost of printing the Memorandum and
Articles of Association, fees paid to lawyers for drafting various documents, stamp duty,
and registration and filing fees payable at the time of registration of the company. The total
amount debited to Preliminary Expenses Account is treated as a capital expenditure. It is
46

generally written off within a period of 3 to 5 years. The annual amount decided to be
written off is debited to the Profit and Loss Account. The balance of the Preliminary
Expenses Account is shown on the asset side of the Balance Sheet as a separate item under
the heading ‘Miscellaneous Expenditure and Losses’. Suppose a company incurred
preliminary expenses amounting to Rs. 9,000 and decided to write off the amount in equal
proportions over three years. At the end of first year, Rs. 3,000 will be charged to the Profit
& Loss Account and Rs. 6,000 will be shown on the asset side of the Balance Sheet. The
debit balance of Rs. 6,000 in the Preliminary Expenses Account will be carried forward to
the next year. At the close of second year, another Rs. 3,000 will be charged to Profit and
Loss Account and the remaining balance of Rs. 3,000 will be shown on the asset side of
Balance Sheet. In the third year again Rs. 3,000 will be charged to Profit & Loss Account.
The Preliminary Expenses A/c will thus be closed, and it will no longer appear in the Balance
Sheet.

Expenses on Issue of Shares and Debentures

When shares and debentures are issued to the public, company incurs expenses by way of
underwriting commission, brokerage and fees. Underwriting commission is agreed to be
paid to an individual, a firm or an institution which undertakes to subscribe to that part of
the shares or debentures which may not be subscribed by the public. The commission is
generally fixed as a percentage of the issue price of shares or debentures underwritten.
Brokerage is paid by the company to brokers who procure subscription for the shares or
debentures. Sometimes, one or more institutions may be appointed managers to the issue
for which fees are payable and fixed as a percentage of the issue price of shares or
debentures. The maximum rates at which underwriting commission, brokerage and fees
can be paid by any company are laid down in the Companies Act and prescribed by
Government order.

All expenses on issue of shares and debentures arc capitalised and normally charged to the
Profit & Loss Account over a period not exceeding 5 years. The unwritten off amount is
shown every year on the asset side of the Balance Sheet as a separate item under the
heading ‘Miscellaneous Expenditure and Losses’.

Let us illustrate the treatment of the above mentioned item in the Company final accounts
with the help of an example. A company was registered in January 2021 with an authorised
capital of 1, 00,000 equity shares of Rs. 10 each. Preliminary expenses amounted to Rs.
9,000. The company issued 50,000 shares to the public. The issue was underwritten by a
firm for which the company agreed to pay commission at 2.5% of the issue price.
Applications were received for 45,000 shares from the public which were duly allotted and
47

fully paid. The company decided to carry forward the preliminary expenses and expenses
on issue of shares to the next year. How will the transactions be reflected in the Balance
Sheet for 2021? Before preparing the Balance Sheet of the company, we should note the
following points:

i) The public subscription being less than the number of shares issued the balance of shares
were to be taken up by the underwriters.

ii) The amount payable to the underwriters on account of underwriting commission was Rs.
12,500 (2.5% on Rs. 5, 00,000 issued capital). On the other hand, the Underwriters were to
pay Rs.50, 000 (Rs. 10 per share on 5,000 shares) to the company. The net amount due to
the company from the underwriters was Rs.37, 500. 1-lowever, underwriting commission
payable should be treated separately as a deferred revenue expenditure or loss.

iii) Preliminary expenses and expenses on issue of shares including (underwriting

commission) were decided to be carried forward to the next year. This was so possibly
because operations were not started in 2021.

Discount on Issue of Shares and Debentures

Discount allowed on the issue of shares or debentures implied capital loss for the company,
the amount realised on issue being less than the face value of the securities. The amount of
discount may be written off by charging it against capital profits, if any. Otherwise, it is
charged to Profit and Loss Account over a period of 3 to 5 years. The amount, not so
written off, is carried forward to the next year and shown in current year’s Balance Sheet as
a separate item under the heading ‘Miscellaneous Expenditure and Losses’. In other words,
discount on issue of shares and debentures is also treated as deferred revenue expenditure
and treated in the company final accounts in the same way as preliminary expenses.

Premium on Issue of Shares

Premium on shares issued refers to the value realised over the above the issue price.
Where shares are issued at a premium, the amount of premium is required to be credited
to separate account called ‘Share Premium Account’. It represents capital profit for the
company, and may be applied to write off capital expenditure and capital losses like
preliminary expenses, underwriting commission and brokerage, discount allowed on the
issue of shares and debentures, premium payable on the redemption of preference shares
or debentures, etc. The credit balance of Share Premium Account which remains after
meeting any of the above expenses or losses is to be shown on the liabilities side of the
Balance Sheet as a separate item under the heading ‘Reserves and Surpluses’.
48

Calls in Arrears and Calls in Advance

A company issuing shares to the public requires payment to be made by subscribers - partly
along with applications, partly on allotment of shares and the balance in one or two
instalments, known as call money. If the amount due on call remains unpaid in respect of
some shares, it is debited to Calls in Arrears Account. This amount is shown as a deduction
from the amount of subscribed and called up capital on the liabilities side of the Balance
Sheet.

A different situation may arise where a company receives applications for a larger number
of shares than offered by it to the public for subscription. This is known as over-
subscription. In that event generally the applicants are allotted a smaller numbs of shares
than applied for. The excess amount of application money is adjusted towards the amount
due on allotment. If there is still an excess of application money it should be refunded. But
the amount may be retained by the company to be adjusted against call money, as and
when calls are made. For the time being, this amount is regarded as calls in advance, that is,
the money received in anticipations for future calls. Calls in Advance Account is credited
with this sum. It is shown as a separate item under the head ‘Share Capital’ on the liabilities
side of the Balance Sheet, but not added to the subscribed and called up capital.

Forfeited Shares

In case calls on certain shares remain unpaid on the expiry of the time allowed for it
payment as per notice of demand, the company may forfeit those shares and the amount
received thereon, which may include application and allotment money. Forfeiture of shares
leads to reduction of share capital and requires that the Calls in Arrears Account
(representing calls unpaid) should be adjusted accordingly. The amount received on the
forfeited shares is credited to a new account termed as ‘Forfeited Shares Account’ and
added to the paid up share capital till such shares ar reissued.

Shares which have been forfeited may be reissued at a later stage at the convenience of the
company. If it is decided to reissue those shares at a discount, the maximum amount of
discount which may be allowed to new allottees cannot exceed the amount received on the
shares from the previous allottees. The discount allowed on reissue is charged to the
Forfeited Shares Account. If the discount allowed on reissue of forfeited shares is less than
the amount originally received on these shares, the difference should be treated as a
capital profit and transferred to Capital Reserve Account to be shown under the heading
‘Reserves and Surpluses’.
49

Suppose, for example, a company has forfeited 100 shares of Rs. 10 each on which Rs.5 per
share had been paid as application, and the allotment money and call money of Rs. 5 per
share was not paid. In this case, Rs. 500 will be credited to Forfeited Shares Account on the
forfeiture of shares. Assume that 60 shares were reissued at a discount of Rs. 3 per share,
that is, discount allowed on reissue amounted to Rs. 180 against Rs. 300 (Rs. 5 per share)
originally received on these 60 shares. The amount credited to the Forfeited Shares
Account will be reduced by Rs. 300, of which Rs. 180 will be transferred to Share Capital
Account and Rs. 120 (capital profit) transferred to Capital Reserve. The remaining balance
of Rs. 200 in the Forfeited Shares Account (representing the amount received on 40 shares
which are not yet reissued) will be carried forward and shown on the liabilities side of
Balance Sheet as an addition to the amount of subscribed and called up capital.

Depreciation on Fixed

Assets In the case of companies, the annual provision for depreciation on fixed assets, like
land and buildings, plant and machinery, etc., is charged (debited) to the Profit and Loss
Account. The amount of depreciation is accumulated from year to year in the Depreciation
Account for each category of fixed assets. Thus, in the Trial Balance prepared at the end of
any year total depreciation provided till the end of previous year appears as a credit
balance. To this amount, the amount of depreciation provided for the current year is
added. The total amount of depreciation provided Li the end of current year is shown as a
deduction from the original cost of fixed assets in the Balance Sheet, the item is shown as
Net Block (original cost less depreciation) under the heading ‘Fixed Assets’. The detailed
particulars are required to be shown separately for each category of fixed assets i.e.,
original cost of the asset as at the beginning of the year, additions made during the year,
sale, if any, depreciation provided till the end of previous year and during the current year,
total amount of depreciation provided till date, and the net value of the assets.

Provision for Taxation

Every company makes provision for taxation in respect of profit made during a particular
year. Provision for taxation should, strictly speaking, be regarded as an appropriation of
profits and thus shown ‘below the line’, that is, after net profits have been arrived at.
However, many companies actually show it ‘above the line’ that is, in the first part of the
Profit and Loss Account. The credit balance in the ‘Provision for Taxation Account’ is shown
on the Liabilities side of the Balance Sheet as a separate item under the sub-heading
‘Provisions’ which comes under the heading ‘Current Liabilities and Provisions’. The balance
of the account is carried forward till assessment of tax in respect of the relevant year has
been finalized.
50

Dividends

Every profit-earning company generally distributes a part of the profits among its
shareholders. The amount so distributed is known as dividend. When directors declare
dividend during the course of an accounting year in anticipation of profits of the same year
it is known as interim dividend. However, the general practice is that directors declare the
dividend to be paid at the annual general meeting of the company. This is known as the
final dividend. Interim dividend if any, declared is shown as an appropriation of profit and
debited ‘below the line’ in the Profit & Loss Account. The final dividend proposed to be
declared is also an appropriation of profits and debited to the Profit & Loss Account ‘below
the line’.

The proposed dividend for the current year appears on the liabilities side of the Balance
Sheet under the sub-heading ‘Provisions’ below the heading ‘Current Liabilities and
Provisions’. This is because the proposed dividend is payable after it is approved at the
annual general meeting which is to be held after the final accounts have been prepared at
the close of the year. If dividends remain unclaimed, the amount is shown under the
heading ‘current liabilities’ in the Balance Sheet.

Interest on Debentures

You know that the rate of interest on debentures is always mentioned with the debentures.
The interest is generally payable half-yearly on 30th June and 31st December (or 31st
March and 30th September). You will always find a figure of interest on debentures in the
Trial Balance where the company has issued the debentures. But it will usually be far the
half year. This implies that we have to provide for the remaining half year interest whether
specified in adjustments or not in other words, unless debentures have been issued during
the course of the –accounting year, we must provide for full year’s interest.

Transfer to Reserves

It is a common practice in companies to transfer a part of profits to reserves. The amount

transferred to general reserve or any specific reserve is treated as an appropriation of
profits and is thus shown below the line’ in the Profit and Loss Account of a company. This
amount is also added to the concerned reserve while preparing the Balance Sheet.

Balance of Profit and Loss Account

The balance of Profit and Loss Account of current year before appropriations, and the
balance of Profit & Loss Account brought forward from the previous year are shown in the
second part (below the line) of the current year’s Profit & Loss. Account, if there are profits,
51

appropriations are made out of the same which may consist of transfer to general reserve,
dividends declared, and provision for taxation. The final balance of profit is carried forward
to the next year. The amount is also shown as a surplus on the liabilities side of Balance
Sheet under the heading ‘Reserves and Surplus’.

However, if the final balance of Profit & Loss Account indicates Net Loss (that is, a debit
balance) it is shown as a deduction from General Reserve on the liabilities side. If, however,
the net loss is more than the amount of General Reserves, it will be shown on the asset side
of Balance Sheet (to the extent not adjusted) under the beading ‘Miscellaneous
Expenditure and Losses’.
52

Proforma of Profit & Loss Account

………………………Co. Ltd. Profit & Loss Account for the year ending

Dr Cr

Particulars Amount Particulars Amount

Part I Rs. Rs.
Opening Stock xx Sales xx
Purchases xx Less Sales Returns xx xx
Less Purchase Returns xx xx Cloning Stock xx
Carriage inward xx
Wages xx
Manufacturing Expenses xx
Gross Profit c/d xx
xx xx
Part II Gross Profit b/d xx
General & Administrative Non Operating incomes xx
like rent, interest,
dividend, etc
Expenses
Salaries, Rent. Stationery, xx
Electricity. Insurance, etc
Selling and Distribution
Expenses
Advertising, Salesmen salary, xx
Commission, Discount, Bad
debts, etc.
Repairs & Maintenance
Repairs, renewals, xx
depreciation etc.
Financial Expenses
Interest, taxes, etc. xx
NET PROFIT xx
Part III
Reserves xx Balance b/d xx
Dividends xx Net Profit xx
Balance c/f xx

xx xx
53

NEED FOR CASH FLOW STATEMENT

The primary objective of the statement of cash flows is to provide information about an
entity’s cash receipts and cash payments during a period. The net effect of cash flow is
provided under different heads namely cash flow from operating, investing and financing
activities. It helps users to find answers to the following important questions:

a) Where did the cash come from during the period?

b) What was the cash used for during the period?

c) What was the change in the cash balance during the period?

The AS-3 identifies two important uses of cash flow statement as follows:

a) A cash flow statement, when used in conjunction with the other financial statements,
provides information that enables users to evaluate the changes in net assets of an
enterprise, its financial structure (including its liquidity and solvency) and its ability to affect
the amounts and timing of cash flows in order to adapt to changing circumstances and
opportunities. Cash flow information is useful in assessing the ability of the enterprise to
generate cash and cash equivalents and enables users to develop models to assess and
compare the present value of the future cash flows of different enterprises. it also
enhances the comparability of the reporting of operating performance by different
enterprises because it eliminates the effects of using different accounting treatments for
the same transactions and events.

b) Historical cash flow information is often used as an indicator of the amount, timing and
certainty of future cash flows. It is also useful in checking the accuracy of past assessments
of future cash flows and in examining the relationship between profitability and net cash
flow and the impact of changing prices.

A Statement issued by Securities and Exchange Board of India in 1995 when it made the
cash flow statement mandatory also lists the above are primary objective of requiring the
listed companies to provide cash flow statement to the investors.

The importance of cash flow as a measure of corporate performance and as a critical

variable to appraise loan decisions has been supported by several influential persons or
organisations. The importance of cash flow statements is clear from the following excerpts:

1) Harold Williams (the then chairman of the SEC) made the following comments in a
speech to the Financial Executives Research Foundation:
54

Corporate earnings reports communicate, at best, only part of the story. And, their most
critical omission - in recognition that insufficient cash resources are a major cause of
corporate problems particularly in inflationary times - is their failure to speak to a
corporation’s cash position. Indeed, in my view, cash flow from operations is a better
measure of performance than earnings-per-share. What should be considered is more
revealing analytical concepts of cash flow or cash- flow-per-share, which reflect the total
cash earnings available to management - that is earnings before expenses such as
depreciation and amortization are deducted? An even more sophisticated - and, in my
opinion, more informative - analytical tool is free cash flow, which considers cash flow after
deducting such spiraling corporate costs as capital expenditures. This technique allows
(evaluation of) the costs of maintaining the corporation’s present capital and market
position - cost which are, in essence, expenses and cash flow obligations that should be
considered in determining the corporation ‘s financial position. Arthur Young Views
(January 1981)

2) Robert Morris Associates, a national association of bank loan and credit officers,
advocates the use of cash flow analysis as a tool necessary to evaluate, understand, and
accurately determine a borrower’s ability to repay loans:

Banks lend cash to their clients, collect interest in cash, and require debt repayment in cash.
Nothing less, just cash. Financial statements, however usually are prepared on an accrual
basis, not on a cash basis. Yet, cash repays loans. Therefore, we are compelled to shift our
focus f we truly wish to assess our client’s ability to pay interest and repay debt. We must
turn our attention to cash, working through the roadblocks thrown up by accrual
accounting, to properly evaluate the creditworthiness of our client. (RMA Uniform Credit
Analysis, Philadelphia, Robert Morris Associates, 1982).

CASH FLOW STATEMENT VS. OTHER FINANCIAL STATEMENTS

The cash flow statement is different from other principal financial statements in many
different ways. Financial statements like P&L account and Balance Sheet are prepared using
accrual accounting principle. For instance, when a firm sells its products, it is assumed that
profit is realised. It is assumed as a going concern, the firm will eventually realise its profits.
Similarly, the expenses incurred against the sale are assumed to have incurred or paid
irrespective of the fact whether cash is paid or not. Interest expenses are charged against
profit though it is an outcome of financing decision. Several non-cash expenses like
depreciation are also charged against profit. On the other hand, cash flow statement is
prepared on the principle for cash accounting concept. It is simply a summary of cash book
classified under three headings namely cash flow from operating, investing and financing
55

activities. In a broad context, the cash flow from operating activities culls out all Profit and
Loss Account entries of cash book (like sales, material, wages, etc.,) and summarize the
same. The cash flow from investing activities summarises all the assets side entries like
purchase of fixed assets, sale of fixed assets, etc., of cash book. Finally, the cash flow from
financing activities summarises all the liability side entries like borrowing, repayment, fresh
equity, etc. of cash book. The following table shows the Cash Flow Statement of a company,
which simply summaries the cash book entries under different headings which are easily
readable.

Profit and Loss account is also equally readable but the problem is it may be confusing too.
For example, many companies as a part of expenditure put an additional entry titled
“changes in stocks” or “increase/decrease in stocks” and sometime add and sometime
deduct the value from sales. For example, see the next table, where we have reproduced
Birla 3M Ltd. Profit and Loss Account for the year ended 31st December, 2020. As an
accounting student, you will know that this is nothing but changes in opening and closing
stock but a non-accounting reader will get confused. Many readers are not aware of the
meaning of depreciation and also “Balance in Profit and Loss Account Brought Forward”.
Starting from the year 2020-21, the P&L account has one more confusion for ordinary
readers namely “Deferred Tax”. To add further confusion, in the Balance Sheet, it has both
Deferred Tax Asset and Deferred Tax Liability. The mismatch between the depreciation
value and deferred tax value shown in P&L account and Balance Sheet is further confusion
to ordinary readers. As an accounting, you are familiar with all these jargons but it is really a
maze for ordinary readers. They will give up after reading couple of pages.

The Balance Sheet is also equally puzzle to investors. Many students and even executives
ask us if the company has huge reserves and surplus, does it mean the company has such
amount of cash. Many of you after having some much accounting background would still
have the doubt. In fact, when we answer such questions that Reserves will not be in the
form of cash, then the next question is where is it or where it has gone or when it is not in
the form of cash, why is it called ‘Reserves”? These are really genuine doubts to ordinary
readers of financial statements. To a great extent, cash flow statement is free of this kind of
confusion

CASH FLOW STATEMENTS

In the previous unit you have learnt that flow of funds means change in working capital. An
Inflow of funds increases the working capital. Under cash flow analysis, all movements of
cash, rather than the inflow and outflow of working capital would be considered. In other
words, cash flow analysis focuses attention on cash instead of working capital. When the
56

movements of cash (i.e., cash inflow and cash outflow) are depicted in a statement, it is
called Cash Flow Statement. Thus, a cash flow statement summarises the causes of changes
in cash position of a business between two balance sheet dates. The flow of cash may be
inflow or outflow. When cash inflows are more than the cash outflows, there would be an
increase in cash balance. On the other hand, if cash outflows are more than the cash
inflows, there would be decrease in cash balance. The term cash includes both cash and
bank balances.+

Availability cash, generally, determines the ability to meet the maturing obligations. If cash
is not available and current obligations cannot be met, it may result in technical insolvency.
Therefore, it is very essential for a business to maintain adequate cash balance. A proper
planning of the cash resources will enable the management to have cash available
whenever needed and employees’ surplus cash, if any, to the most profitable or productive
use. For this purpose, we prepare cash flow statement which shows the sources and
application during a year and the resultant effect on cash balance.

Sources and Uses of CasH

The change in the cash position is computed by considering ‘Sources’ and ‘Applications’ of
cash which are as follows:

Sources of cash

1) Cash from Operations 2) Issue of Shares 3) Issue of Debentures 4) Long term Loans
Raised 5) Sale of Fixed Assets

Application (uses) of cash

1) Redemption of Preference Shares 2) Redemption of Debentures 3) Repayment of Loans

4) Purchase of Fixed Assets 5) Payment of Dividends 6) Payment of Taxes

Ascertaining Cash from Operations

the main purpose of preparing a cash flow statement is to explain the increase/decrease in
the cash balance between the two balance sheet dates and that it is prepared on the same
pattern as the fund flow statement. Just as the net profit is adjusted to ascertain the
amount of funds from operations, the funds from operations are now adjusted to ascertain
the cash from operations. For this purpose, you have to look at the changes in current
assets and current liabilities that have taken place during the year.

Conversion of ‘Funds from Operations’ to ‘Cash from Operations’ is necessary because,

under the working capital concept, funds from operations are based on accrual concept of
57

accounting, and total sales (whether credit or cash) and total purchases (whether credit or
cash) are recognised as sources and uses of working capital respectively. But under a cash
concept of funds only cash sales and receipts from debtors are treated as sources of cash,
while cash purchases and payment to creditors are regarded as uses of cash. The same
holds good for the other incomes and expenses. Therefore, funds from operations (based
on the accrual concept) require conversion into cash from operations (based on cash
accounting). For example, assume that a business was started on 1-1-2019 and the sales
during the year were Rs. 3, 00,000. Also assume that there were no closing debtors. As
there are no opening and closing debtors, it must be assumed that the entire amount of Rs.
3, 00,000 was realised by way of cash. Now assume that the closing debtors on 31-12-2019
were Rs. 40,000. This would mean that the entire amount of sales was not collected during
the year. Since Rs. 40,000 (closing debtors) was still to be realised, the cash from sales
would be Rs. 2, 60,000 (Rs. 3, 00,000 —Rs. 40,000).

REGULATIONS RELATING TO CASH FLOW STATEMENT

Accounting standards in India are formulated by the Accounting Standards Board (ASB) of
the Institute of Chartered Accountants of India (ICAI). Though International Accounting
Standard Committee has revised the International Accounting Standard (IAS-7) in 1992 and
switched over to cash flow statement, Accounting Standard-3 (AS-3) of ASB, which is
equivalent to earlier IAS-7, was not revised till 1997. In 1997, ASB of ICAI revised the AS-3 in
line with revised IAS-7 and issued an accounting standard on reporting cash flow
information. However, this standard was not been made mandatory immediately in 1997.
However, AS-3 was made mandatory for the accounting period starting on or after 1St April
2001 for the following enterprises:

i) Enterprises whose equity or debt securities are listed on a recognised stock exchange in
India, and enterprises that are in the process of issuing equity or debt securities that will be
listed on a recognised stock exchange in India as evidenced by the board of directors’
resolution in this regard.

ii) All other commercial, industrial and business reporting enterprises, whose turnover for
the accounting period exceeds Rs. 50 crore.

Since ASB of ICAI took a long time for the introduction of cash flow statement, the SEBI had
formed a group consisting of representatives of SEBI, the Stock Exchanges, ICAI to frame
the norms for incorporating Cash Flow Statement in the Annual Reports of listed
companies. The group has recommended cash flow statement to be supplied by listed
companies. SEBI, following the recommendation of the group, has instructed the Governing
58

Board of all the Stock Exchanges to amend the Clause 32 of the Listing Agreement as
follows:

“The company will supply a copy of the complete andfull Balance Sheet, Profit and Loss
Account and the Directors Report to each shareholder and uponapplication to any member
of theexchange. The companywill also give a Cash Flow Statement along with Balance Sheet
and Profit and Loss Account. The Cash Flow Statement will be preparedin accordance with
the Annexure attached hereto”.

Cash Flow Statement, as a requirement in the Listing Agreement, has been made effective
for the accounts prepared by the companies and listed entities from the financial year
1994-95. Cash Flow Statement, as a requirement of the Listing Agreement, has been made
effective for the accounts prepared by the companies listed in stock exchanges from the
financial year 1994-95.

CASH FLOW FROM INVESTING AND FINANCING ACTIVITIES

\Measuring cash flow from investing and financing activities is simple and straight forward.
Any amount spent in purchase of fixed assets forms part of investing activities. For instance
if a firm spends Rs. 20 lakhs to buy new assets and also sold Rs. 3 lakhs worth of asset for
Rs. 8 lakhs, the net cash flow on investing activities is Rs. 12 lakhs (Cash outflow of Rs.20
lakhs less Cash inflow Rs. 8 lakhs). Similarly, it is easier to compute cash flow from financing
activities. Here we will try to find out the fresh equity and loan that the company has raised
during the period

and from that we deduct loan amount repaid. In addition to this, we also deduct dividend
since dividend is outcome of financing activities. However, you may wonder why interest is
not deducted here since it is also related to financing activity. There is no straight answer to
this but accounting standards require interest to be shown as a cash outflow item in
operating activities.

The cash flow from investing and financing activities of Infosys is given below. Infosys is
spending a lot on fixed asset acquisition during the last three years. At the same time, it is
not raising any fresh capital and hence its cash flow financing activities is also negative due
to high dividend payment.

USES OF CASH FLOW STATEMENT

Cash flow statement is very useful to the financial management. It is used as a tool for
financial analysis for short term planning
59

The preparation of cash flow statement has several uses. The more important uses are as
follows:

1) Changes in cash balance between two points of time and the contributing factors for
such changes are clearly revealed
2) The cash flow statement explains the reasons for
a. The presence of very low cash balance inspite of huge operating profits: or
b. The presence of a higher cash balance inspite of a very low level of profit
3) Projected cash flow statements help the management in short-term planning and
several other ways like:
i) Determination of additional cash requirements during a given period and making
timely arrangements
ii) Identification of the size of surplus and the time for which such surplus funds are
likely to be available
iii) Judging the ability of the firm to repay/redeem debentures/preferences
iv) Examining the possibility of maintaining/increasing dividends
v) Assessing the capability of finance, replacement of fixed assets
vi) Assessing the capacity of the firm to finance expansion.
vii) More efficient and effective management of cash flows.

DISTINCTION BETWEEN CASH FLOW ANALYSIS AND FUND FLOW ANALYSIS

Following are the major points of difference between cash flow analysis and fund flow
analysis:

1) Fund flow analysis deals with the change in working capital position between two
balance sheet dates, whereas the cash flow analysis is concerned with the change in
cash position.
2) Cash flow analysis is more useful as a tool in short-term financial planning, whereas
fund flow analysis is more useful in long-term financial planning.
3) An increase in current liability or decrease in current asset (other than cash) results in
an increase in cash whereas such changes result in decrease in the net working
capital. Similarly, a decrease in any current liability or an increase in current asset
(other than cash) results in a decrease in cash, whereas such changes increase the
net working capital.
4) Cash flow statement recognizes ‘cash basis of accounting’ where as funds flow
statement is based on accrual basis of accounting.
5) Cash flow analysis explains only the causes of cash variations, whereas funds flow
analysis discloses the causes of overall working capital variations.
60

Holding Company

As per 2(46) of the Companies Act, 2013 defines holding company as: A company which has
one or more subsidiary company having full control over them. It is formed for the purpose
of purchases and owning share in other company. Holding company offers several benefits
such as gaining more control, retaining the management of the subsidiary firm and
incurring lower tax liabilities.

Subsidiary Company

Section 2(87) of the Companies act, 2013 defines “Subsidiary Company” as an enterprise
that is controlled by another enterprise (known as holding company). Subsidiary companies
are of two types:

i) Wholly owned: This is the company in which 100% of the shares and the voting rights are
owned by holding company

i) Wholly owned: This is the company in which 100% of the shares and the voting rights are
owned by holding company

OBJECTIVESS OF HOLDING COMPANIES

There are many objectives of holding companies. Let us discuss some of them which are as
follow:

1. To eliminate of competition 2. To enjoy the economies of large scale of production 3.

To achieve an assured market for the product of the company 4. To ensure a smooth
supply of raw materials

TYPES OF HOLDING COMPANY

1 Pure: This refers to those companies which do not participate in another business other
than controlling one or more firms. It is formed for the purpose of owning stocks in other
companies.

2 Mixed Holding Companies: Refers to those companies which do not only control other
companies but also engages in its own operations.

3 Immediate: refers to that company which retains voting power or control of another
company, inspite of the fact that the company itself is already controlled by another entity.
It is a company that is already a subsidiary of another.
61

4. Intermediate: It is a firm that is both a holding company of another entity and a

subsidiary of a large corporation. This type of firm might be exempted from publishing
financial records as a holding company of the smaller group.

ADVANTAGES OF HOLDING COMPANIES

(1) Better quality Decisions: The holding companies allow the better quality decisions at all
levels of the company. The holding company concentrates on the corporate policies and
strategies and the operating levels in the implementation.

(2) Better Utilization of Resources: Holding companies facilitate the better utilization of the
financial and the other resources of the companies. The holding company pools the
resources of group of enterprises.

(3) Easy method of Acquiring Control: Through this method organizations have to spend
less in acquiring the control of the other company.

(4) Reduces Competition: Competition among the two companies is totally eliminated as
both of the companies are managed by the same group.

(5) Easy Rid from Subsidiary: If the company wants to get rid of the subsidiary; it can easily
do so by selling the shares of the subsidiary in the open market.

(6) Income tax benefits: Separate identities are maintained by both the companies so that
they can avail the tax benefits by carrying forward their losses of the previous years.

(7) Efficient Management: It becomes easier to manage both the companies as both the
companies maintain their separate identities. This increases the efficiency of the
management.

(8) Enhances Corporate Planning: The holding company is able to concentrate to corporate
planning, acquisition, and update technology and building of corporate culture on sound
business principles.

(9) Managerial and Commercial Culture: The management of the holding company
promotes the commercial and managerial culture instead of bureaucratic culture.

LIMITATIONS OF HOLDING COMPANY

(1) Secret Reserves: To the detriment of the minority interest, the unscrupulous directors
can easily create secret reserves.
62

(2) Difficulty in Ascertaining Financial Position: The creditors in the subsidiary company and
the shareholders in the holding company may not be aware of the true financial position of
the company.

(3) Mismanagement: When in the holding company number of constituents is more and
there is not equivalent management efficiency, it results in the mismanagement of the
operations of the company.

(4) Fraud in Inter-Company Transactions: There are more chances of fraud due to the inter-
company transactions. This is due to the reason that inter-company transactions are settled
at very high or very low price according to the requirement of the holding company.

(5) Forced Appointment of the Directors: The subsidiary company is sometimes forced by
the holding company to appoint some directors or the officers in the company.

(6) Difficulty in Valuation of Stock: It becomes difficult to value the stock as the stock of the
company consists of huge quantity of inter-company goods.

(7) Oppression of Minority Shareholders: There is always the fear of oppression of minority
shareholders as the financial and other resources are totally managed in a way that suits
the interest of the holding company

Calculation of Goodwill/Capital Reserve

Goodwill/Capital Reserve is the difference between amount paid i.e. investment and the
amount due, i.e. the sum total of Equity share capital, Reserves, Profit and Loss A/c. It is
calculated as follows:

Amount Paid i.e., Investment in subsidiary by Holding Co.

Less: Amount due (Equity Share Capital of Subsidiary Co. + Reserves of subsidiary Co. +
Profit and Loss A/c – Preliminary expenses of subsidiary Co.)

= Goodwill (Excess of Amount Paid over amount due)/Capital Reserve (Excess of Amount
due over amount paid)

(i) If amount paid is more than the amount due, then the difference is Goodwill

(ii) If amount due is more than the amount paid, then the difference is Capital Reserve

Minority Interest

When the holding company does not own 100% shares of the subsidiary company, then the
subsidiary is known as partly owned subsidiary. For example, H Ltd. owns, only 60% of the
63

shares of S Ltd., the remaining 25% shares will be owned by the outsiders or other people.
The interest of the outsiders or the other persons is called the minority Interest. The
amount of this minority interest is shown on the liabilities side of Balance Sheet between
the Share Capital and Reserves and Surplus

Calculation of Minority Interest

Minority Interest = (Equity Share Capital of Subsidiaries Co. + Reserves of Subsidiaries Co. +
P&L A/c (Cr.) of Subsidiaries Co. – Fictitious Asset of Subsidiaries Co.) × Remaining
Percentage.

Calculation of Goodwill/Capital Reserve

Amount paid i.e., Investment in Subsidiary

Less: Amount due

= Goodwill (Excess of Amount Paid over amount due)/Capital Reserve (Excess of Amount
due over Amount paid)

Amount due = (Equity Share Capital + Reserves + Profit & Loss A/c –Preliminary Expenses) ×
Acquisition percentage

(i) If amount paid is more than the amount due then the difference is Goodwill.

(ii) If amount due is more than the amount paid then the difference is Capital Reserve.

DIFFERENCE BETWEEN WHOLLY OWNED AND PARTLY OWNED SUBSIDRIES

S.No Wholly Owned Subsidiary Companies Partly owned Subsidiary Companies

1. A Company whose all the shares are When the majority of shares of the
owned by the holding company is known subsidries are owned by the holding
as wholly owned subsidiary company. company. It is known as partly owned
subsidiary companies.

2. Under this situation, 100% of voting Under this situation, more than 50% and
rights are vested by the Holding less than 100% of voting rights are
Company. vested by the holding company
64

3. Under this situation, there is no case of Here, arises a case of minority interest,
minority interest, just because of the fact which i.e., always less than 50% of
that the whole of the share is owned by shares.
the holding company

EXEMPTION FROM PREPARATION OF CONSOLIDATED FINANCIAL STATEMENTS

There are certain conditions under which the companies are not required to maintain or
the preparation of consolidated financial statements. As per companies (accounts)
amendments Rule 2016, they are as follows:

1 it is a wholly-owned subsidiary, or is a partially-owned subsidiary i.e B Ltd. is a partly

owned subsidiary of A of another company and all its other members, including those not
otherwise entitled to vote, having been intimated in writing and for which the proof of
delivery of such intimation is available with the company i.e with B Ltd. do not object to the
company not presenting consolidated financial statements;

2 securities of subsidiary companies i.e (B Ltd.) are not listed or are not in the process of
listing on any stock exchange, whether in India or outside India and

3 its ultimate i.e (A Ltd.) or any intermediate holding company files Consolidated Financial
Statements with the Registrar.

CONSOLIDATED FINANCIAL STATEMENTS

Consolidated financial statements are the statements which are prepared by the holding
company for the group of enterprises controlled and owned by it. These financial
statements present the financial information about the holding company and its
subsidiaries as the separate entities. These statements highlight the following:

(i) Economic resources owned by the group of enterprises.

(ii) The obligations of the group.

(iii) The results achieved by the group with its resources.

The enterprise that presents the consolidated financial statement should present these
statement strictly according to the Accounting Standard 21 ‘Consolidated Financial
Statements’, issued by the Council of the Institute of the Chartered Accountants of India,
which came into effect in respect of the accounting period commencing on or after
1.4.2001. According to this standard, the holding company which presents consolidated
65

financial statements should present these statements in addition to the separate financial
statements

Benefits of Consolidated Financial Statement

(1) Unified Source of Document: The consolidated financial statement acts as an uniform
source of document and presents the ultimate picture to the users of the financial
statements. Despite the fact that both the companies maintain the separate entities but it
is desirable that a single balance sheet and the single profit and loss account is presented
for the group as a whole through consolidation of the accounts.

(2) Ascertainment of return on Investment in Subsidiary: Return on investment is measured

on the basis of the total share of the holding company in the revenue profits of the
subsidiaries and this information is provided by the consolidated balance sheet.

(3) Measurement of Liquidity: The consolidated financial statement helps in the

measurement of the liquidity of the holding company as well as the enterprises under its
control.

(4) Measurement of Efficiency: The consolidated financial statements help in the

measurement of the efficiency of the holding company as a whole. The statements help the
investors to evaluate the efficiency of the company and take their decisions accordingly.

(5) Ascertainment of the intrinsic value of the shares: The consolidated financial statements
of the holding company are necessary to ascertain the intrinsic value of the shares of the
company

Disadvantages of Consolidated Financial Statements

(1) Misleading Information: If the activities of the subsidiary company do not match with
the other companies of the group, it misleads the investors in taking the decisions.

(2) Concealment of Important Information: When the financial statements of the

companies in the group are aggregated, sometimes the important information is concealed
from the investors.
66

PROCEDURE OF PREPARING CONSOLDIATED FINANCIAL STATEMENTS WITH ADJUSTMENT

As the main objective of Consolidated Financial Statements is to show the information of

holding company and subsidiary company under a consolidated form as a single entity.
Following steps are involved in the formation of consolidated financial statements. Let us
discuss these steps in detail

(a) The cost to the parent of its investment in each subsidiary and the parent’s portion of
equity of each subsidiary, at the date on which investment in each subsidiary is made,
should be eliminated;

(b) Any excess of the cost to the parent of its investment in a subsidiary over the parent’s
portion of equity of the subsidiary, at the date on which investment in the subsidiary is
made, should be described as goodwill to be recognized as an asset in the consolidated
financial statements;

(c) When the cost to the parent of its investment in a subsidiary is less than the parent’s
portion of equity of the subsidiary, at the date on which investment in the subsidiary is
made, the difference should be treated as a capital reserve in the consolidated financial
statements;

(d) Minority interests in the net income of consolidated subsidiaries for the reporting
period should be identified and adjusted against the income of the group in order to arrive
at the net income attributable to the owners of the parent; and

(e) Minority interest in the net assets of consolidated subsidiaries should be identified and
presented in the consolidated balance sheet separately from liabilities and the equity of the
parent’s shareholders. Minority interests in the net assets consist of:

(i) The amount of equity attributable to minorities at the date on which investment in
a subsidiary is made; and

(ii) The minorities’ share of movements in equity since the date the parentsubsidiary
relationship came in existence.

Dividend from Subsidiary Company out of Pre-Acquisition Profit

During the first time, when the holding company receive any kind of dividend out of
preacquisition from its subsidiary company. The following journal entries are recorded.

1) Bank A/c Dr.

To Shares in Subsidiary Company

67

(Being dividend received from Subsidiary Company out of pre-acquisition required)

2) Dividend Received from Subsidiary Company A/c Dr.

To Profit & Loss A/c

(Transfer of dividend from subsidiary company to profit & Loss Account)

Pre-acquisition & Post-acquisition Profits

The various Illustrations earlier were assuming that the shares of the subsidiary company
were acquired on the date of balance sheet. So, all the profits of the subsidiary given in the
Balance Sheet were treated as pre-profits or the capital profits. However, in the actual
practice, the date of acquisition of shares and the date of Balance Sheet are different. In
such cases, the subsidiary company’s reserves and profits must be divided into pre-profits
(Capital profits) and post-profits (Revenue profits) on the basis of the date of acquisition of
the shares.

Holding company’s share in pre-acquisition profits is treated as the capital profit and is used
for the purpose of calculation of Goodwill/Capital Reserve.

Calculation of Pre-acquisition Profits of subsidiary/Capital profits:

Pre-acquisition profits = Opening Balance of Profit and Loss A/c + Opening balance of
General Reserve – Preliminary Expenses.

Calculation of Post-acquisition profits/Revenue Profits:

Post acquisition Profits = (Closing Profit and Loss A/c + Closing General Reserve –
Preliminary Expenses) – (Pre-acquisition profits)

Calculation of Goodwill/Capital Reserve in case of pre-acquisition and post-acquisition

profits

Goodwill/Capital Reserve = Amount Paid (amount of investment) – Amount Due Amount

Due = (Equity Share Capital + Pre-acquisition Profits) × Acquisition %age

Calculation of Minority Interest

Minority Interest = (Equity Share Capital + Pre-acquisition Profits + Post-acquisition Profits)

× Remaining Percentage
68

MEANING OF GOODWILL

Goodwill is the value of reputation of a firm in respect of the profits expected in the future
over and above the normal profits earned by the similar firms in the industry. Goodwill
represents the firm’s brand name, loyal customer base, reputation for high quality of
products due to which firm earns more profits above the normal profits. This excess of
profits over the normal profits is known as super profits. So, the goodwill exists when the
firm earns super profits and any firm which is earning only normal profits or incurring losses
has no goodwill. Goodwill consists of the advantages a business has in connection with its
customers, employees and outside parties with whom it has to contact. Goodwill has been
defined by various prominent authors and some of the definitions are:

Acceding to Lord Lindley, “The term goodwill is generally used to denote benefit arising
from the connections and the reputation.”

According to Kohler, “Goodwill is the current value of expected future income in excess of
the normal return on investment in net tangible assets.”

CHARACTERISTICS OF GOODWILL

Goodwill is an intangible asset. It is associated with the purchase of one company by

another. Specifically, goodwill is the portion of the purchase price that is higher than the
sum of the net fair value of all of the assets purchased in the acquisition and the liabilities
assumed in the process. Goodwill has many characteristics. Let us discuss some of the
characteristics which are as follow:

(1) It is an intangible asset: Goodwill basically is a type of intangible asset like patents
trademarks, etc. The question of depreciation does not arise on it as it does not duffer wear
and tear like the other assets.

(2) Its value tends to fluctuate: Goodwill cannot have an exact cost. Its value tends to
fluctuate from time to time. This is due to the internal and the external factors which
ultimately affect the fortune of the company.

(3) Valuable at the time of sale of business: Goodwill is valued and sold with the sale of
entire business and it cannot be sold in part. The exception to this feature is the admission
and retirement of the partner. At the time of retirement the retiring partner gives up his
shares to the remaining partners so, the remaining partners contribute the retiring partner
in the gaining ratio and on the other hand at the time of admission, the new partners
acquire the right of profits from the existing partners so, the new partner contributes them
in their sacrificing ratio.
69

(4) Difficulty in placing value of goodwill: It is difficult to place the value of goodwill because
its value fluctuates from time-to-time due to the changing circumstances.

(5) No objective valuation: There is no objective valuation of goodwill as the valuation of

goodwill is done in the subjective manner and differs from estimator to estimator.
Therefore, the value of goodwill is based on the subjective judgment of the valuer.

(6) Arising of goodwill: Goodwill either arises when on business is purchased by the other
business where purchase consideration is higher the actual value of net assets acquired or
the goodwill is generated by the business over a period of time due to some favorable
factors like efficient management, favorable location, etc.

NATURE OF GOODWILL

Goodwill is nothing but the reputation of a partnership firm. It is computed on the basis of
expected profits in excess of normal profits. It denotes the firm’s capacity to earn a greater
profit in the future based on its track record.

1. Goodwill is an intangible fixed asset. It is intangible because it has no physical existence.

It cannot be seen or touched.

2. It has a definite value depending on the profitability of the business enterprise.

3. It cannot be separated from the business.

4. It helps in earning more profit and attracts more customers.

5. It can be purchased or sold only when the business is purchased or sold in full or in part.

FACTORS AFFECTING THE VALUE OF GOODWILL

The value of goodwill depends upon various factors. Let us identify those factors that
influence the value of goodwill.

(1) Location of Business: If the firm is located in the centralized place where there is more
traffic, has high sales, so earns more goodwill. Therefore, if the business is located at the
prominent place, it will attract more customers and will generate more goodwill.

(2) Management: If the business has good and efficient management, it helps the business
to earn more profit and goodwill. So, the business with efficient and experienced
management will generate more goodwill
70

(3) Business longevity: The business with higher longevity or the older business is known by
more customers and therefore will have more goodwill as with time business can earn
more reputation and with the number of customers also goes on increasing.

(4) Nature of Product: The business which deals in the daily use products will have stable
profits and demand so will have more goodwill in comparison to those business which deals
in the fancy products

(5) Risk: if the risk involved in the business is more than it will have less goodwill and on the
other hand if the risk involved is less, firm will have more goodwill.

(6) Competition: If in the near future there are chances of increase in the competition of
the firm, it will reduce the goodwill of the business.

(7) Profit trend: If the profits of the firms are reducing from the past years, i.e. the profits
are showing the declining trend then, the goodwill of the firm will also reduce and vice
versa.

(8) License: If the firm has the import license, definitely its goodwill will increase because it
can take the advantage of their license which the other firms without license cannot avail.

(9) Requirement of Capital: The capital requirement of the business also affects its goodwill.
If the two firms earn same rate of return then, the business with lesser capital will enjoy
more goodwill.

NEED FOR THE VALUATION OF GOODWILL

Goodwill arises when a company acquires another business. The amount of goodwill is the
cost to purchase the business minus the fair market value of the tangible assets, the
intangible assets and the liabilities obtained in the purchase. There are various situations in
which the need for the valuation of goodwill arises. Let us enumerate those situations

 The difference in the profit-sharing ratio (PSR) amongst the existing partners
Admission of a new partner
 Retirement of a partner
 Death of a partner
 Dissolution of an enterprise involving the sale of the business as a trading concerN
 Consolidation of partnership firms

METHODS OF VALUATION OF GOODWILL

It is very difficult to assess the value of goodwill, as it is an intangible asset. In case of sale of
a business, its value depends on the mutual agreement between the seller and the
71

purchaser of the business. There are many methods of valuing goodwill but some of the
important methods are as follow:

A. Average Profit Method

B. Weighted Average Profit Method
C. Super Profit Method
D. Capitalization Method
E. Annuity Method
F. Purchase Method

Average Profit Method

It is the most simple and widely used method for the calculation of goodwill. Under this
method, the past profits of number of years are taken into consideration. The average of
the past profits is multiplied by the number of years of purchase for the purpose of the
valuation of goodwill. Following steps are followed for the valuation of goodwill under this
method:

Goodwill = Average Profits × Number of Years’ of Purchase

Weighted Average Profit Method

This method is the modified version of the simple average profit method. Under this
method each year’s adjusted profits calculated in the step 2 above are multiplied with the
respective number of weights in order to calculate the total product. The total of products
is then divided by the total of weights to calculate the weighted average profits. Thereafter
the weighted average profits are multiplied by the number of years’ of purchase. This
method is generally used when the profits show the continuous increasing trend over the
years.

Weighted Average Profits = Total of Products of Profits/Total of weights Goodwill =

Weighted average profits × No of years’ of purchase

Super Profit Method

Super profit method: In super profit method, the average/actual profits of the business are
compared with the normal profit which would have earned with the same capital in the
same type of business. If the average profit of the company exceeds the normal profit the
difference is known as super profit. Under this method value of goodwill is calculated on
the basis of super profit and the following steps are followed for this:

Step 1: Calculate Capital Employed by the following Formula

72

Capital employed = Fixed Assets + Working Capital

Or

Capital Employed = Capital + Reserve/Accumulated Profits – Fictitious Assets

Step 2: Calculation of Current Year profits after tax

Current years’ Profit after Tax = [Current year’s Profits – Abnormal Gain + Abnormal Loss –
Normal Loss + Normal Gain] – Tax

Step 3: Calculation of Average Capital Employed

Average Capital Employed = Capital Employed – ½ of Current Year’s Profit after tax

Step 4: Calculate Normal Profits by the following formula

Normal Rate
Normal Profits = Average Capital Employed x
100

Step 5: Calculate the Average Profit after tax as per the Average Profit Method

Step 6: Super Profit = Average Profit after Tax – Normal Profit

Step 7: Goodwill = Super Profit × Number of years of Purchase

Calculation of Capital Employed

The capital employed helps in calculating the normal profits of the business. The following
points are considered while calculating the capital employed

(i) Both current and fixed assets should be included in the capital employed. These assets
should be valued at the current market prices. Following assets should not be included:

Fictitious assets like discount on issue of share/debentures, preliminary expenses, etc.

Outside investments should not be included in the assets.

Goodwill appearing in the balance sheet should also not be included.

(ii) From the total assets the outside liabilities should be deducted. The outside liabilities
will include: debentures, creditors, provision for tax, outstanding expenses, bills payable,
loans, etc.

So, Net Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
73

Capitalization Method

Capitalization Method: Under this method, Goodwill is calculated in two ways:

1. Capitalization of Super Profit Method 2. Capitalization of Average Profit Method

Capitalization of Super Profit Method

Step 1: Calculate super profit according to the super profit method

100
Step 2: Goodwill = Super Profit Method ×
Normal ofRate Re turn

Capitalization of Average Profit Method

Step 1: Calculate average profit after tax as per average profit method

Step 2: Calculate capitalized value of average profits as under

100
Capitalized value of average profit = Average Profit after Tax ×
NormalRate

Step 3: Calculate Average Capital Employed as calculated in Super Profit Method

Step 4: Goodwill = Capitalized Value of Average Profit – Average Capital Employed

Annuity Method

The reason for using the super profit method is that the amount paid for the goodwill in
lump sum will be recovered in the coming years. For example, Rs. 60,000 goodwill is paid
today but this amount purchaser will get in the shape of super profits as Rs. 20,000 in the
first year, another Rs. 20,000 in the second year, and Rs. 20,000 in the third year. The
purchaser will lose the amount of interest over Rs. 60,000. In the annuity method the loss
of interest is compensated.

Purchase Method

The purchase consideration is the price received for the sale of the assets. Goodwill is the
excess of purchase consideration over the net assets of the business.

Goodwill = Purchase consideration – Net Assets of the firm

Net Assets = Assets – Outside Liabilities

74

MEANING OF VALUATION OF SHARES

The problem of valuation of shares does not arise if the shares are quoted on the stock
exchange as it provides the ready means for ascertaining the value placed on such shares
by the buyers and sellers. Even sometimes the quotations of the stock exchange does not
present the true value of the shares, so the valuation of shares has to be done by the expert
valuer by adopting sound and the reasonable basis. The provisions are made by the various
tax laws for the valuation of shares and the exact procedure to be followed has also been
laid out. Valuation of shares is the process of knowing the value of a company’s shares.
Share valuation is done based on quantitative techniques. Value of share will vary
depending on the market demand and supply. The share price of the listed companies
which are traded publicly can be known easily. But shares of private companies are not
publically traded, therefore the valuation of shares of private companies is really important
and challenging.

FACTORS AFFECTING THE VALUATION OF SHARES

The factors that affect the value of shares of a company are similar to those that affect the
value of goodwill of the company. In fact, valuation of goodwill and valuation of shares are
inter-related. The value of a share is greatly affected by the economic, political and social
factors. Let us discuss these factors:

1. Dividend declared by the company in the last years. 2. Demand and supply of the shares
of the company. 3. Nature of the business. 4. Future prospectus of the company. 5. Rate of
return in the same type of business. 6. Future prospectus of the company. 7. Limitation of
competition. 8. Limitation of government control over the company. 9. Financial Ratios. 10.
Political conditions such as fear of nationalization. 11. Position of peace and security in the
country. 12. Accumulated reserves of the company. 13. Prospectus of bonus or right issue.
14. Capital structure of the company. 15. Number of shareholders. 16. Management of the
company. 17. Net tangible assets of the company.

NEED FOR THE VALUATION OF SHARES

In most cases, shares are quoted on the stock exchange. For ordinary transactions in shares
or debentures or Government securities, the price prevailing on the stock exchange may be
taken as the proper value. The stock exchange price does not hold good for very large lots.
All the shares are not quoted on the stock exchange. Shares of private companies in any
case will not be quoted. Shares of such a company have to change hands and therefore, the
value of such shares will have to be ascertained.

The necessity for valuation of a share arises in the following circumstances:

75

(1) For amalgamation and reconstructions: Where companies amalgamate or are

similarly reconstructed, it may be necessary to arrive at the value of the shares held
by the members of the company being absorbed or taken over
(2) At the time of dissolution: Where the shares are held jointly by the partners and the
dissolution of the firm takes place, it becomes necessary to value the shares for
proper distribution of the partnership property among the partners
(3) Transfer of shares: Where a portion of the shares is to be given by a member of the
proprietary company to another member as the member cannot sell it in the open
market, it becomes necessary to certify the fair prices of the shares by the auditor or
an accountant.
(4) At the time of taking loan: When the loan is taken on the security of the shares it
becomes necessary to value the share on the basis of which loan is to be taken.
(5) At the time of conversion: When the preference shares or debentures are to be
converted into equity shares it becomes necessary to value the equity shares for the
purpose of calculation of the number of equity shares to be issued in place of
preference shares or debentures.
(6) Shares of private companies: Shares of private companies are not quoted on the
stock exchange. If shares of such companies are to be sold, the value of such shares
has to be ascertained
(7) At the time of appraisal of shares: When the shares of the company are not quoted
on the stock exchange and shareholders require the appraisal of their shares, at such
times the valuation of shares is required.
(8) For declaring the Net Assets Value: The valuation of shares is made by such
companies to find the correct value of his assets for declaring the net asset value.
(9) For determination of gift and wealth tax: When the shares are received as a gift, it is
necessary to determine the value of shares for the purpose of assessing the gift duty
and also for determination of the wealth tax by the taxation authorities.

METHODS OF VALUATION OF SHARES

The different methods of valuation of shares are classified as under:

A. Net Assets (Intrinsic Value or Breakup Value) Method. B. Dividend Yield Method. C.
Earning Capacity Method. D. Fair Value Method

Net Assets Method

This method is concerned with the assets backing per share and may be either on the view
that the company is going concern or on the fact that the company is being liquidated. This
method is also called net intrinsic value method or breakup value method or asset backing
76

method or asset valuation method. In order to value the share under this method it is
necessary to estimate the net tangible assets. Non-trading assets are also included in the
assets and the assets are taken at the market value.

Dividend Yield Method

As stated earlier that one of the main limitation of the net assets method is that it can be
used at the time of liquidation only. But the shareholders are always interested in knowing
the value of the shares in terms of the return on the investments. He compares his returns
with the price paid by him for the share. Therefore, under this method the value of the
share is calculated by comparing the expected rate of dividend with the normal rate of
dividend which is prevailing in the industry. Following formula is used for valuing the share
under this method:
Expected Rate of Dividend
Value of Share= × Paid–Up Value per Share
Normal Rate of Dividend

Earning Capacity Method

This method of valuation of shares is particularly suitable in the case of big investor because
they are more interested in the company’s earnings rather than what the company
distributes in the form of dividend. This method covers up some of the limitations of the
yield method. This method assumes that the company will continue to operate its business
in the near future. Hence in this method the rate of earnings are compared with the normal
rate of return prevailing in the industry. The formula for this method is as follow:
Rate of Earning
Value of share = × Paid-up value per share
Normal Rate of return

Fair Value Method

There is much difference in the value of the same share in case it is calculated under
different methods, so none of the methods give the true or fair view of the value of the
share. So it is considered appropriate by the experts to calculate the value under any two
methods and then averaging the both. So, calculated average value can be taken as the fair
value of the share. The formula for the calculation of the fair value of the share is:

Fair value per share = Value as per Net Assets Method + Value as per Earning Capacity Method

Fair value per share = Value as per Net Assets Method + Value as per Dividend Yield Method

2
77

OBJECTIVES OF AMALGAMATION

Amalgamation means the merging of two or more than two companies for eliminating
competition among them or for growing in size to achieve the economies of scale.
Amalgamation is a broad term which includes mergers (uniting of two existing companies)
and acquisition (one company buying out another company).There are many objectives of
amalgamation. Some of the objectives are as follow: Let us discuss them in detail

(i) To have a better control over the market and also to increase the market share and area
• of operations.

(ii) To eliminate the cut-throat competition and rivalry among competing the amalgamating
companies.

(iii) To enjoy the economies of large scale production.

(iv) To utilize the services of professional experts

(v) To increase the availability of funds for the future investment plans.

(vi) To achieve all other advantages of combination.

RECONSTRUCTION

Reconstruction is entirely of different nature. The objective is not to bring about a

combination of companies but merely to reorganize a company which has suffered huge
losses which are to be written off. Reconstruction may be of two types:

External Reconstruction

It is not exactly similar to amalgamation. In external reconstruction, existing company is

wound up by selling its business to newly formed company which is generally similar named
or owned by the same shareholders.

Internal Reconstruction

It is altogether a different form of business combination. In internal reconstruction, the

company continues with its legal entity and is only internally reorganized. In this,
rearrangement and reduction of share capital is done. Under internal reconstruction, the
share capital is reduced to its real worth and the same amount is used to eliminate the
accumulated losses, fictitious assets and to write down the overvalued assets of the
company.
78

DIFFERENCE BETWEEN AMALGAMATON, ABSORPTION AND RECONSTRUCTION

Basis Amalgamation. Absorption Reconstruction

Formation A new company is No new company is Company is
formed. formed. reconstructed.
Liquidation All the companies The company whose The company which
which go for business is is reconstructed goes
amalgamation are purchased by into liquidation.
liquidated. another company
goes into liquidation
Financial Position of Financial position of Financial position of Financial position of
the Company all the involved the absorbing the old company is
companies is same company is bad and is usually
comparatively sound considered as the
than the absorbed sick unit.
company.
Objective To eliminate the To expand the To write off the
competition among business and to accumulated losses
the amalgamated achieve the and offering the real
companies. economies of large worth of the
scale production business to the
shareholders.
Position of Shareholders of the Shareholders of the Most of the
shareholders in new amalgamated selling company may shareholders of the
company companies become become the old company
the shareholders of shareholders of the continue to be the
the new company purchasing company shareholders of the
new company with
the proportionate
share

IMPORTANT TERMS IN AMALGAMATION

(1) Transferor Company: This means the company which is amalgamated into another
company.

(2) Transferee Company: It is a company in which transferor company amalgamate

(3) Amalgamation: Amalgamation is basically of two types:

(i) Amalgamation in the nature of merger: Amalgamation in the nature of merger is an

amalgamation which satisfies all the following conditions: .
79

a) All the assets and liabilities of the transferor company become, after amalgamation, the
assets and liabilities of the transferee company.

b) Shareholders holding not less than 90% of the face value of the equity shares of the
transferor company (other than the equity shares already held therein, immediately before
the amalgamation by the transferee company or its subsidiaries or their nominees) become
equity shareholders of the transferee company by virtue of the amalgamation.

c) The consideration for the amalgamation receivable by those equity shareholders of the
transferor company who agree to become equity shareholders of the transferee company is
discharged by the transferee company wholly by the issue of equity shares in the transferee
company, with the exception that cash may be paid only in respect of fractional shares.

d) The business of the transferor company is intended to be carried on, after the
amalgamation, by the transferee company.

e) No adjustment is intended to be made to the book value of the assets and liabilities of
the transferor company when they are incorporated in the financial statements of the
transferee company except to ensure uniformity of the accounting policies.

(ii) Amalgamation in the nature of purchase: Amalgamation in the nature of purchase is an

amalgamation which does not satisfy any one or more of the five conditions stated above.

(4) Assets purchased and Business purchased: If it is mentioned in the question that the
transferee company has purchased the assets of the Transferor company, it means that
Transferee Company has acquired all the assets including cash and not the liabilities of the
business of the transferor company. If it is mentioned that the Transferee company has
purchased the business of the transferor company, it means that Transferee Company has
acquired all the assets and liabilities of the transferor company.

(5) Liabilities and Trade liabilities: The term liabilities includes trade creditors, Bills payable,
debentures, bank overdraft, outstanding expenses, pension fund, provident fund, workmen
profit sharing fund etc. The term trade liabilities include creditors and bills payable which
are associated with sale/purchase of goods and services.

METHODS OF ACCOUNTING FOR AMALGAMATION

There are two main methods of accounting for amalgamation: (a) The pooling of interest
method; and (b) The purchase method.

The use of the pooling of interest method is confined to circumstances which meet the
criteria referred to in paragraph 3(e) for an amalgamation in the nature of merger. The
80

object of the purchase method is to account for the amalgamation by applying the same
principles as are applied in the normal purchase of assets. This method is used in
accounting for amalgamations in the nature of purchase.

The Pooling of Interests Method

Under the pooling of interests method, the assets, liabilities and reserves of the transferor
company are recorded by the transferee company at their existing carrying amounts (after
making the adjustments required).

If, at the time of the amalgamation, the transferor and the transferee companies have
conflicting accounting policies, a uniform set of accounting policies is adopted following the
amalgamation. The effects on the financial statements of any changes in accounting policies
are reported in accordance with Accounting Standard (AS) 5, Net Profit or Loss for the
Period, Prior Period Items and Changes in Accounting Policies.

The Purchase Method

Under the purchase method, the transferee company accounts for the amalgamation either
by incorporating the assets and liabilities at their existing carrying amounts or by allocating
the consideration to individual identifiable assets and liabilities of the transferor company
on the basis of their fair values at the date of amalgamation. The identifiable assets and
liabilities may include assets and liabilities not recorded in the financial statements of the
transferor company.

values may be influenced by the intentions of the transferee company. For example, the
transferee company may have a specialized use for an asset, which is not available to other
potential buyers. The transferee company may intend to effect changes in the activities of
the transferor company which necessitate the creation of specific provisions for the
expected costs, e.g. planned employee termination and plant relocation costs.

TREATMENT OF RESERVES ON AMALGAMATION

If the amalgamation is an ‘amalgamation in the nature of merger', the identity of the

reserves is preserved and they appear in the financial statements of the transferee
company in the same form in which they appeared in the financial statements of the
transferor company. Thus, for example, the General Reserve of the transferor company
becomes the General Reserve of the transferee company; the Capital Reserve of the
transferor company becomes the Capital Reserve of the transferee company and the
Revaluation Reserve of the transferor company becomes the Revaluation Reserve of the
transferee company. As a result of preserving the identity, reserves which are available for
81

distribution as dividend before the amalgamation would also be available for distribution as
dividend after the amalgamation. The difference between the amount recorded as share
capital issued (plus any additional consideration in the form of cash or other - assets) and
the amount of share capital of the transferor company is adjusted.

If the amalgamation is an ‘amalgamation in the nature of purchase', the identity of the

reserves, other than the statutory reserves dealt above, is not preserved. The amount of
the consideration is deducted from the value of the net assets of the transferor company
acquired by the transferee company. If the result of the computation is negative, the
difference is debited to goodwill arising on amalgamation and dealt with in the manner
stated in above. If the result of the computation is positive, the difference is credited to
Capital Reserve.

TREATMENT OF GOODWILL ARISING ON AMALGAMATION

Goodwill arising on amalgamation represents a payment made in anticipation of future

income and it is appropriate to treat it as an asset to be amortized to income on a
systematic basis over its useful life. Due to the nature of goodwill, it is frequently difficult to
estimate its useful life with reasonable certainty. Such estimation is, therefore, made on a
prudent basis. Accordingly, it is considered appropriate to amortize goodwill over a period
not exceeding five years unless a somewhat longer period can be justified.

Balance of Profit and Loss Account

In the case of an 'amalgamation in the nature of merger', the balance of the Profit and Loss
Account appearing in the financial statements of the transferor company is aggregated with
the corresponding balance appearing in the financial statements of the transferee
company. Alternatively, it is transferred to the General Reserve, if any.

In the case of an ‘amalgamation in the nature of purchase', the balance of the Profit and
Loss Account appearing in the financial statements of the transferor company, whether
debit or credit, looses its identity.

PURCHASE CONSIDERATION

Purchase Consideration is the amount which is paid by the transferee company for the
purchase of the business of the transferor company. In other words, consideration for
amalgamation means the aggregate of the shares and other securities issued and payment
in cash or other assets by the transferee company to the shareholders of the transferor
company. It should not include the amount of liabilities taken over by the transferee
company, which will be paid directly by this company. Payments made to debenture
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holders should not be considered as part of purchase consideration. The calculation of

purchase consideration is very important and may be calculated in the following ways:

(1) Lump sum Payment Method: When the transferee company agrees to pay a fixed
sum to the transferor company, it is called a lump sum payment of purchase
consideration. For example, if A Ltd. purchases the business of B Ltd. and agrees to
pay Rs. 25,00,000 in all, it is an example of lump sum payment.
(2) Net Assets Method: According to this method, the purchase consideration is
calculated by calculating the net worth of the assets taken over by the Transferee
Company. The net worth is calculated by adding the agreed value of assets taken
over by the transferee company. Following points should be taken care of:
 Value of only those assets is included which are acquired by the transferee
company
 Value of only those liabilities will be deducted which have been taken over by
the Transferee Company.
 Cash Balance is normally included in assets but if it is not taken over it will not
be included. Goodwill is an intangible but valuable asset and as such is
included in assets.
 Fictitious assets not written off should not be added
 This method is used only when the Net Payment cannot be adopted.
(3) Net Payment Method: Under this method, purchase consideration is calculated by
adding the various payments in the form of shares, securities, cash, etc. made by the
transferee company. No amount of liabilities is deducted even if these are assumed
by the purchasing company. Thus, purchase consideration is the total of all the
payments whether in shares, securities, or cash. For example, X Ltd. agrees to give for
every 10 shares of Y Ltd. 15 shares of Rs. 10 each, Rs. 8 paid up. X Ltd. agrees to pay
Rs.15, 000 cash to discharge the creditors. The purchase consideration is calculated
as follows:
(4) (4) Intrinsic worth/value Method: This method is just an extension of net assets
methods. Under method, purchase consideration is required to be calculated on the
basis of intrinsic value of shares. The intrinsic value of a share is calculated by dividing
the net assets available for equity shareholders by the number of equity shares. This
value determines the ratio of exchange of shares between the transferor and
transferee company. Suppose A Ltd. and B Ltd. are two companies carrying on the
business in the same line of activity. Their capital is Rs. 6, 00,000 and Rs. 2, 00,000
(value of each share Rs. 10). The two companies decided to amalgamate in C Ltd. If
each share of A Ltd. and B Ltd. is valued at Rs. 15 and Rs. 25 per share for the purpose
of amalgamation. The purchase consideration will be as under:
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A Ltd. 60,000 shares @ Rs. 15 each Rs. 9, 00,000

B Ltd. 20,000 shares @ Rs. 25 each Rs. 5, 00,000

ACCOUNTING ENTRIES IN THE BOOKS OF TRANSFEREE COMPANY

Accounting Treatment in the books of Transferee Company will be different in both the
types of amalgamation. There are two methods for this:

(1) The Pooling of Interest Method: This method is applicable in case of amalgamation in
the Nature of Merger. In this case, the amalgamation is accounted for as if separate
businesses of amalgamated companies were intended to be carried on by the transferee
company. That is when only minimum changes are made in aggregating the individual
financial statements of the transferor companies. The following factors are considered in
this method:

 The assets, liabilities and reserves of the transferor company are recorded by the
transferee company at their existing carrying amount and in the same form as at the
date of amalgamation.
 The balance of profit and loss account of the transferor company is aggregated with
the balance of the transferee company or transferred to general reserve
 The identity of the reserves is preserved and they are shown in the balance sheet of
the transferee company in the same form in which they appeared in the Balance
Sheet of the transferor company.
 The difference between the amounts recorded as share capital issued plus any
additional consideration in the form of cash on the one hand and the amount of
share capital of the transferor company on the other hand is adjusted in Reserves or
Profit and Loss as the case may be.

ACCOUNTING ENTRIES IN THE BOOKS OF TRANSFEROR COMPANY

Accounting treatment in the books of the transferor company is similar in both the cases
whether the nature is of Merger or Purchase:

All assets which are taken over by the Transferee Company are transferred to
Realization A/c at their book values

Realization A/c Dr

To Sundry Assets (Individually)

(Transfer of various assets taken over by the Transferee Co.)

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STEPS INVOLVED IN INTERNAL RECONSTRUCTION

The usual steps involved in internal reconstruction are discussed as follow: In brief the
modus operandi of capital reduction involved sacrifices on the part of the shareholders,
debenture holders and creditors and utilizing the amount foregone by them to write off
losses and also scale down assets to their real values. An account names as ‘capital
reduction account’ also called ‘internal reconstruction account’ is opened for this
purpose. Amounts sacrificed by various interests are credited to this account and then
the balance in this account is utilized to write off the losses. The items that are written
off as part of capital reduction are as follow:

1. Goodwill: In the case of a company which lost capital the appearance of goodwill in
the balance sheet does not make any sense so this item is usually written off.

2. Other items like discount on Issue of shares and debentures, capital issue expenses,
preliminary expenses are only deferred expenses and it is not healthy to keep such items
in the balance sheet. Such items are also written off on reorganization.

3. Any debit balance in profit and loss account represents accumulated losses and such
losses will be written off as part of capital reorganization.

4. Assets with inflated book values. Some of the assets may be appearing at
unreasonable book values either due to insufficient depreciation or due to technological
changes. Such assets must be brought down to realistic values.

MODES OR METHODS OF INTERNAL RCONSTRUCTION

There are two methods of internal reconstruction. A) Alteration in share capital and B)
Reduction in share capital. Let us discuss these two methods in detail

A. Alteration in Share Capital

The alteration of share capital involves those cases which do not require any
approval from the court. Following are the alterations which a company can carry
out, if the Articles of the company empower
(i) Increase in Share Capital: The share capital of the company can be increased
only by issue of new shares.
(ii) Consolidation of shares: It is done by consolidation the existing shares of
smaller denomination into shares of higher denomination. For example, A Ltd.
having a share capital Rs. 30, 00,000 divided into 3, 00,000 shares of Rs. 10
each, resolve to consolidate the shares into 30,000 shares of Rs. 10 each. The
following journal entry will be passed
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(iii) Sub-division of shares: In this method the existing shares of higher

denomination are sub-divided into shares of smaller denomination. In this
method if the shares are partly paid-up then care must be taken that the ratio
between the face value and the paid up value should remain the same. For
example, A Ltd. having a share capital Rs. 30,00,000, divided into 30,000 shares
of Rs. 100 each, resolve to sub-divide the shares into 3,00,000 shares of Rs. 10
each. The following journal entry will be passed:
(iv) (iv) Cancellation of Unissued Shares: In this method the shares which have not
been subscribed are cancelled, which leads to the decrease in the unissued
capital. However, the company without the sanction of the court cannot cancel
the unpaid amount on the already issued shares.
(v) (v) Conversion of Shares into Stock: In this method the fully paid shares are
converted into stock or stock is re-converted into fully paid shares. For
example, A Ltd. converts its 3, 00,000 shares of Rs. 10 each, into equity stock of
Rs. 30, 00,000. The following journal entry will be passed:

(B) Reduction of Share Capital

Reduction of capital can be carried out by a company according to the provisions laid down
in Section 100 to 105 of the Companies Act. The reduction of capital can only be made if it
is mentioned in the Articles of the company and a special resolution is passed to that effect.
Further, the scheme of reconstruction should be approved by the court and sanction of the
court should be maintained. The scheme is passed by the court only if it thinks fit and the
consent of the creditors is obtained, or their claims are settled. Capital reduction can take
place in any of the three forms:

(i) Reducing the liability in respect of uncalled amount of shares

(ii) Paying off the unpaid capital which is in excess of the needs of the company.

(iii) Cancelling the paid-up capital which is already lost or not represented by the available
assets.

Creditors consent is required in case (i) and (ii) because their interests are affected by the
reductions

Procedure for Reducing Share Capital

The following procedure is to be followed for reducing share capital:

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(a) The company cannot reduce its share capital unless it is authorised by its articles of
association. However, if the articles do not permit capital reduction, they may be
altered by special resolution to enable the company to reduce its share capital.
(b) (b) The company must pass a special resolution for reduction of capital
(c) The company must apply to the court for an order confirming the capital reduction.
The court must look after the interest of creditors and shareholders before giving an
order confirming the capital reduction. The court may make an order confirming the
capital reduction on such terms and conditions as it thinks proper, if it is satisfied that
every creditor of the company entitles to object capital reduction has consented to
the reduction or his debt has been discharged or secured by the company. The court
may also order the company to add the words “and reduced” to the name of the
company for such period as it deems fit. The court may also order the company to
publish reasons for reduction and all other information in regard thereto for public
information.
(d) The order of the court confirming the reduction must be produced before the
registrar and the certified copy of the order and of the minutes of reduction should
be filed with the registrar for registration

In the following cases, the procedure of reduction of capital is not called for:

(a) Where the redeemable preference shares are reduced in accordance with the provisions
of Section 80.

(b) Where any shares are forfeited for nonpayment of calls.

(c) Where there is surrender of shares or a gift is made to a company of its own shares.

(d) Where the nominal share capital of a company is reduced by cancelling any shares
which have not taken or agreed to be taken by any person

BANKING COMPANIES

To understand the meaning of banking company, we are required to understand the

meaning of two words- banking and company. The definitions of both the words are given
in section 5 of the act:

 Banking means the accepting, for the purpose of lending or investment, of deposits
of money from the public repayable on demand or otherwise and withdrawable by
cheque, draft, order form or otherwise.
 Banking company means any company which transacts the business of banking in
India
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Licensing of Banking Companies

 In India, no company can carry on banking business unless it holds a license issued
from RBI and such license may be issued subject to certain conditions as the RBI may
think fit to impose in the case. Before granting a license to the company, the RBI may
require to be satisfied by an inspection of the books of the company. Further, the
following conditions are to be fulfilled strictly.
(a) The company is or will be in a position to pay its present or future depositors in
full as their claims accrue.
(b) The affairs of the company are not being conducted in a manner detrimental to
the interests of its present or future depositors
(c) The general character of the proposed management of the company will not be
prejudicial to the public interest or the interest of its depositors.
(d) The company has adequate capital structure and earning prospects.
(e) The public interest will be served by the grant of a license to the company to carry
on banking business in India
(f) The grant of license would be suitable for the monetary stability and economic
growth of the area of operation of the company. The potential scope for
expansion of banks already in existence in the area and other relevant factors
would be examined before issuance of the license.
(g) Any other additional condition whichever is considered fit to be imposed by the
RBI for carrying on banking business.

Forms of Business of Banking Companies

In addition to the business of banking, a banking company may engage in any one or more
of the following forms of business:

(a) the borrowing, raising, or taking up of money; the lending or advancing of money

(b) the drawing, making, accepting, discounting, buying, selling, collecting and dealing in
bills of exchange, hundies, promissory notes, coupons, drafts, bills of lading, railway
receipts, warrants, debentures, certificates, scrips and other instruments and securities

(c) the granting and issuing of letters of credit, traveller's cheques and circular notes

(d) the buying, selling and dealing in bullion and specie

(e) the buying and selling of foreign exchange including foreign bank notes
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(f) the acquiring, holding, issuing on commission, underwriting and dealing in stock, funds,
shares, debentures, debenture stock, bonds, obligations, securities and investments of all
kinds

(g) the purchasing and selling of bonds, scrips or other forms of securities on behalf of
constituents or others, the negotiating of loans and advances;

(h) the receiving of all kinds of bonds, scrips or valuables on deposit or for safe custody or
otherwise; the providing of safe deposit vaults

(i) the collecting and transmitting of money and securities

(j) acting as agents for any Government or local authority or any other person or persons;
the carrying on of agency business of any description including the clearing and forwarding
of goods, giving of receipts and discharges and otherwise

(k) acting as an attorney on behalf of customers

(l) contracting for public and private loans and negotiating and issuing the same

(m) the effecting, insuring, guaranteeing, underwriting, participating in managing and

carrying out of any issue, public or private, of State, municipal or other loans or of shares,
stock, debentures, or debenture stock of any company, corporation or association and the
lending of money for the purpose of any such issue

(n) carrying on and transacting every kind of guarantee and indemnity business

(o) Managing, selling and realizing any property which may come into the possession of the
company in satisfaction or part satisfaction of any of its claims

(p) Acquiring and holding and generally dealing with any property or any right, title or
interest in any such property which may form the security or part of the security for any
loans or advances or which may be connected with any such security

(q) Undertaking and executing trusts

(r) Undertaking the administration of estates as executor, trustee or otherwise

(s) establishing and supporting or aiding in the establishment and support of associations,
institutions, funds, trusts and conveniences calculated to benefit employees or
exemployees of the company or the dependents or connections of such persons; granting
pensions and allowances and making payments towards insurance; subscribing to or
guaranteeing moneys for charitable or benevolent objects or for any exhibition or for any
public, general or useful object
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(t) the acquisition, construction, maintenance and alteration of any building or works
necessary or convenient for the purposes of the company

(u) selling, improving, managing, developing, exchanging, leasing, mortgaging, disposing of

or turning into account or otherwise dealing with all or any part of the property and rights
of the company

(v) acquiring and undertaking the whole or any part of the business of any person or
company, when such business is of a nature enumerated in this list

(w) doing all such other things as are incidental or conducive to the promotion or
advancement of the business of the company

(x) any other form of business notified by the Govt. in the official gazette

Disposal of non-banking assets

No banking company can directly or indirectly deal in buying or selling or bartering of

goods, except in connection with realization of security given or held by it. A bank cannot
acquire certain asset but can lend against such assets. This means that sometimes, in case
of failure on part of borrower to repay the loans, the bank may have to take possession of
such assets. In that case, the assets will be shown in the balance sheet as ‘non-banking
assets’. These assets must be disposed off in maximum seven years. The banking company
may, within the period of seven years deal or trade in such property for the purpose of
facilitating the disposal thereof. The duration of seven years may be further extended by
the RBI up to the maximum five years where the RBI is satisfied that such extension would
be in the interest of the depositors of the banking company.

Slip system of ledger posting

In this system, posting is made from slips prepared inside the organization itself or slips
filled by the customers. The slip system is a method of rapid posting in books maintained
under double entry principle. In this system, posting is done from slips and not from
journals or cash books. The subsidiary books are not maintained in the system. Slips are
loose leaves and they are given by the customers or by the bank staff. In a banking
company the main slips are – pay in slip, withdrawal slip and cheques and all these slips are
filled by clients of the bank. In fact, the slips are the vouchers dealt in a bank. It becomes
necessary for a bank to know the position of its individual customer’s account at any time
to see that the transaction is recorded as soon as they take place. It is not actually possible
if transactions are recorded in bound books. So, original cheques and pay in slips are used
as vouchers. The transactions which are not covered by original slips are posted by mean of
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‘dockets’ which are made out by the bank staff. These are used for posting purposes. In
banking system, there is a need that accounts stand updated very quickly. In fact, after
every transaction they should be updated simultaneously. After introduction of CBS
accounting, the optimum speed in ledger posting is warranted and it is easily done through
the softwares.

Advantages of slip system

1. It reduces the possibility of errors 2. It mitigates the chances of frauds. 3. It saves a lot of
time since slips are s prepared by the customers themselves. 4. It provides an efficient
system of internal check and later in audit work.

Disadvantages of slip system

1. There is risk of loss of a slip since they are loose. 2. There is chance of misappropriation
and destruction because they can be easily changed or removed

Bank Teller System

A teller system is the integrated hardware and software used for retail or wholesale
banking transactions. The most of systems communicate with a core banking system or
mainframe over a secured network. It is used in order to improve service and productivity.
The bank teller system with advanced architecture design concept is trouble free and user
friendly interface. It can be developed in a short time frame. The system has high degree of
integration, compatibility and expansibility to meet the requirement of the counter system
functions and performance of the banking business development. It provides strong system
support for banking development and business integration. This leads to significant cost
savings for banks.

The hardware commonly used in bank teller system are computer or terminal, cash
drawers, receipt and pass book validators, printers, magnetic strip readers, pin key pads,
bill counters and bill coin dispensers. The software is usually based on client/server where
several clients (teller stations) are networked to a server which communicates to the
mainframe via a dedicated line or satellite.

Objectives of a bank teller system

a) Integrate front and operation to improve service efficiency

b) Business process reengineering and business product innovation

c) Improve user experience and promote product sale

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d) Control business risk and promote bank’s process

e) System portal services

f) Uniform management

g) Customer service oriented business process reengineering

NON-BANKING FINANCIAL COMPANY

A non-banking financial company is a company registered under the Companies Act, 1956
or 2013 and is engaged in the business of:

i) Loan and advances

ii) Acquisition of shares/stock/bonds/debentures/securities issued by Govt. or local

authority

iii) Other marketable securities

iv) Leasing

v) Hire purchase

vi) Insurance

vii)Chit business

But it does not include any institution whose principal business is of agriculture activity or
industrial activity.

Further, it is mandatory that every NBFC should be registered with RBI to commence or
carry on any business of non-banking financial institutions. But certain categories of NBFCs
which are regulated by other regulator are exempted from the requirement of registration
with RBI. An insurance company will obtain a certificate from IRDA. A merchant banking
company or a venture capital fund or stock broking company will be registered with SEBI.
The housing finance companies are regulated by the National Housing Bank.

 Asset Finance Company [AFC]

 Investment Company [IC]
 Loan Company [IC]

AFC is defined as any company which is financial institution carrying on as its principal
business the financing of physical assets supporting productive/ economic activity, such as
automobiles, tractors, lathe machines, generator sets, earth moving and material handling
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equipments, general purpose industrial machines. Principal business for this purpose is
defined as aggregate of financing real/physical assets supporting economic activity and
income arising therefrom is not less than 60% of its total assets and total income
respectively. AFCs are further classified into those accepting deposits and those not
accepting deposits.

RESIDUARY NON-BANKING COMPANY

Besides the above classification of NBFC, the Residuary Non-Banking Companies are also
registered as NBFC with the RBI. Residuary Non-Banking Company is a class of NBFC which
is a company and has as its principal business the receiving of deposits under any scheme of
arrangement or in any other and not being investment, asset financing, loan Company.
These companies are required to maintain investments as per directions of RBI in addition
to liquid assets. The functioning of these companies is different from those of NBFCs in
terms of method of mobilization of deposits and requirement of deployment of depositors’
funds. However, Prudential Norms Directions are applicable to these companies. To ensure
the interest of depositors, such companies are required to invest in a portfolio comprising
of highly liquid and secured instruments. The secured instruments include central or state
Govt. securities, fixed deposits of scheduled commercial banks, certificate of deposits of
SCB/FIs, units of mutual funds etc. An RNBC can accept deposits for a minimum period of 12
months and maximum period of 84 months from the date of receipt of such deposit. They
cannot accept deposits repayable on demand.

DIFFERENCE BETWEEN NBFCs AND BANKS

NBFCs are doing the functions similar to banks but there are certain differences between
NBFCs and banks.

i. A NBFC cannot accept demand deposits. The demand deposit means – savings accounts
or current accounts.

ii. It is not a part of the payment and settlement system which includes clearing house
services and facilities like NEFT, RTGS, IMPS.

iii. It cannot issue cheque books to its customers.

iv. The deposit insurance facility of DICGC is not available for NBFC depositors as it is
available to all bank depositors

DEPOSITORS CONCERN & NBFC REGULATIONS

Some of the important regulations related to the depositors’ point of view are as under:
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 NBFCs are allowed to accept public deposit for a minimum of 12 months and
maximum period of 60 months. They cannot accept deposits repayable in demand.
 NBFCs cannot offer interest rate higher than the ceiling rate prescribed by RBI from
time to time. The present ceiling is 12.5 per cent per annum. The interest may be
compounded at rests not shorter than monthly rests.
 NBFCs cannot offer gifts /incentives or any other additional benefit to the depositors
 NBFCs (except certain AFCs) should have minimum investment grade credit rating.
An unrated NBFC cannot accept public deposits. The rating agencies are CRISIL,
CARE, ICRA and FITCH. If rating of a NBFC is downgraded to below minimum grade
rating, it has to stop accepting public deposit and the report to be sent to the RBI
within 15 days.
 The Deposits with NBFCs are not insured.
 The repayment of deposits by NBFCs is not guaranteed by the RBI.
 There are certain mandatory disclosures about the company in the application form
issued by the company soliciting deposits.
 If a company defaults in repayment of deposit, the depositor can approach Company
Law Board or Consumer Forum or file a civil suit to recover the deposits.
 In case of a complaint against the NBFC, the depositor can mail an application in
prescribed form to the appropriate bench of the Company Law Board according to its
territorial jurisdiction with the prescribed fee.

PERIODICAL RETURNS TO BE SUBMITTED TO RBI

There are prudential norms for NBFCs set by the RBI. The prescribed guidelines are to be
followed by the NBFCs. They are on income recognition, asset classification, provisioning
requirements, exposure norms, constitution of audit committee, disclosure in the balance
sheet, requirement of capital adequacy, restrictions on investment in land and building and
unquoted shares. The control mechanism of the regulator works through periodical returns.

The NBFCs accepting public deposits are required to furnish to RBI:

(i) Audited final accounts of the year as passed in the general meeting together with a copy
of the report of the board of directors and a copy of audit report

(ii) Statutory Annual Report on deposits on the prescribed format

(iii) Certificate from the auditors that the company is in a position to repay the deposits as
and when the claims arise

(iv) Quarterly Return on liquid assets

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(v) Half-yearly Return on prudential norms

(vi) Half-yearly ALM returns by companies having public deposits of ₹ 20 crore and above or
with assets of ₹ 10 crore above irrespective of the size of deposits

(vii) Monthly Return on exposure to capital market by companies having public deposits of
₹ 50 crore and above

(viii) A copy of the credit rating obtained once a year

STOCKINVEST SCHEME

There was a large number of complaints regarding non-receipt or delayed refund of share
application money. The SEBI advanced a suggestion in this regard and a new instrument
was introduced by the SBI. The instrument is ‘Stockinvest’ and it is approved by the RBI. An
investor who has an account for a deposit with the bank issuing Stock Invest will apply for
Stock Invest. The issuing bank will give the stock invest duly signed and also marking the
date to the investor. Simultaneously, the bank will mark a lien on the investor’s account to
the extent of the stockinvests. The investor while applying for public issues will enclose the
stockinvest forms duly filled in along with the application forms and send them to the
collecting bank as he normally does in the case of cash, cheques and drafts. The stockinvest
is not an alternative but an additional facility available to the investor in case he so opts.
Under the scheme the company while deciding the basis of allotment would consider along
with other applications, the applications received from the investor who has opted for
payment by new instrument. Once the basis of allotment to all the applicants is decided the
company would incash the stockinvest instrument in respect of those applicants who are
successful allottees and partially of those who are partially successful. The unsuccessful
applicants’ stockinvest instruments would be returned to the investor without encashing
them. The successful applicants’ instruments would, after encashing be deposited in the
separate bank account where the cash and other money received from other investors are
deposited.

Features of the Stockinvest Instrument

 The stockinvest is a special payment system for investors in the primary capital
market.
 The stockinvest instrument is approved by the RBI for public issue of shares or
debentures.
 The Stock invest is a letter of authority cum cheque which the payee can encash for
the authorized sum based on actual allotment made to the investor
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 All individuals can seek issue of stockinvest against deposit held by them in their bank
account. The lien will be marked against the deposit for the amount of stockinvest
issued. The remainder will be free from lien.
 The stockinvest is valid for a period of four months. Earlier, the validity was for a
period of six months.
 The stockinvest is payable at par at all the branches of the bank and can be presented
in Banks Clearing House. It bears the appropriate MICR cheque features.
 Once the basis of allotment is decided, the stockinvest of successful allottees is
encashed
 The stockinvests instrument of unsuccessful applicants is returned without encashing
it.
 The money received on encashment would be kept in separate account where the
company would also deposit the cash and other money by way of cheque, bank
drafts etc.
 The money received as proceeds of stockinvest is not to be utilized for any other
purpose except for adjustment against allotment of shares or debentures.
 No allotment is made to any investor (including an investor opting for stockinvest)
unless the minimum subscription is received.
 The above procedure would be required to be completed within the stipulated time
as per company law.

The stockinvest is issued after a lien is marked for appropriate amount on the deposit
account of the investor but the deposit will continue to accrue interest at the agreed rate
till the instrument is actually to be debited. The banker’s lien on the investor’s deposit
account would be automatically lifted when a valid instrument is presented after allotment.
The cancelled stockinvest is surrendered by the investor. An indemnity bond is to be
executed in favour of the bank after the expiry period of four months in cases where the
investor has not received the advice of allotment. Cancelled instruments are directly sent
back by the registrar of the issue to the investors. Earlier, the stockinvest were issued for
certain denominations but now be printed without specifying the denominations. The
amount would be filled up by the issuing branch at the time of issuing the instrument. This
is to ensure that as far as possible, only one stockinvest is submitted with each application
for shares.

Revision of the Stockinvest Scheme

The scrutiny of the stockinvest operations scheme conducted by the RBI revealed certain
shortcoming of the scheme. On the basis of review, the RBI issued instructions to all
scheduled commercial banks in order to make the stockinvest scheme more investor
96

friendly and safe as well. It was observed that the banks were allowing bulk purchases of
stockinvest by corporate bodies, financial institutions and share brokers. In this regard, the
RBI issued instructions that the stockinvest is available to individual investors and mutual
funds only. Stock brokers, corporate bodies, banks and financial bodies would not be
allowed this facility.

It was observed that the stockinvest are also being issued without adequate deposit cover.
There were instances that the stockinvest were issued against third party deposits. It was
found that the stockinvests were being used by third parties (i.e. other than the purchaser).
Later, it was clarified by the RBI that the stockinvest would be issued against the term
deposit and credit balances available in savings bank or current accounts.

In the starting of the scheme, the stockinvest were issued in blank and the particulars of the
public issue were to be filled in by the investor thereon. The RBI issued revised instructions
modifying the scheme. The banks will not issue the stockinvest in blank but the details of
the public issue will be given compulsorily on it. The banks should, henceforth, fill in the
name of the capital issuing company before the stockinvests are delivered to the
applicants. In consultation with SEBI, the RBI prescribed a ceiling of ₹ 10 lakh per individual
per capital issue for stock invests issued by banks. The ceiling is not applicable to mutual
funds. The banks are asked to follow the instructions very strictly

The photocopy of the stockinvest or cheque accompanied with the share application will
not be treated as valid. Only original stockinvest or cheque will be accepted because it was
observed that in some instances promoters of capital issuing companies submitted their
application along with photocopies of stockinvest in order to fulfil the requirement of the
minimum subscription of 90 per cent of the issue. The stockinvest were then cancelled
within one week of their issue though the cancelled instruments had been included for
reckoning the minimum subscription. Banks would henceforth be allowed to issue
stockinvest only if they make payment arrangements at all the ‘mandatory collection
centres’. The centres are notified by the SEBI time to time. Mainly, they include big cities
and stock exchange headquarters. The issuing bank shall

ave a branch or make arrangement with another bank to facilitate payment against the
stockinvest at par at all collection centres.

Stockinvest for NRIs/OCBs

Initially when the scheme was started, the stockinvest facility was not open for NRIs and
OCBs (Overseas Corporate Bodies) but soon it was made available for NRIs and OCBs. The
authorized dealers may issue stockinvest to NRIs/OCBs. The stockinvest to be issued to NRIs
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should be of light green colour. It should be superscribed with the notation that the
stockinvest has been issued against lien on NRE/FCNR accounts of the investor and the
same will be paid when presented out of repatriable funds held in the accounts. All other
rules and procedure of the scheme is same as in case of resident individuals.

Terms of Issue & Payment of Stockinvest

1. It is issued to the applicant, to be used for applying new issues of shares/

debentures/bonds only.

2. The applicant will authorize payment of the maximum sum payable towards application
money for the share/debenture/bonds applied on the left hand side of stockinvest. The
payee will fill in the actual amount receivable on the right hand side indicating the number
of shares/debentures/bonds for which payment is appropriated. The amount shown on the
right will be equal to or less than the amount indicated in the left hand side.

3. Stockinvest is paid to the payee filling in the required particulars on the right side under
due authorization and discharge by their authorized signatory and presenting it for
payment.

4. Stockinvest is neither transferable nor negotiable. The issuing bank undertakes to pay the
lower of the two sums indicated on the face of the instrument. It would be the application
money payable on entitlement of shares/ debentures/ bonds. The payment will be made
only by credit to the payee’s account with their banker.

5. The stockinvest is current for four months from the date of its issue indicated on its face.
No amount can be claimed on the stockinvest by the issuing bank branch unless it is
presented to it within four months.

6. Stockinvest is payable at all branches of the issuing bank and where the correspondent
arrangement is done by the bank.

7. The account holder’s instructions in respect of stockinvest to the bank are irrevocable.

8. The investor shall provide details, such as payee’s name, amount, number of shares
applied for, application form number etc., in the left hand portion of the stock invest and
his name and address on the reverse of the stockinvest before depositing it with banker to
the issue.

9. The investor should not hand over stockinvest taken against their own account to any
third party. The stockinvest is intended to be utilized only by the account holder applicants.
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10. The registrar to the issue will return stockinvest duly cancelled to the unsuccessful
applicants. Accordingly, on production of the cancelled stockinvest by the applicant the
issuing bank shall lift the lien immediately

FUNCTIONS OF COMMERCIAL BANK

According to Banking Regulation Act of 1949, “Banking means the accepting for the purpose
of lending or investment of deposits of money from the public, repayable on demand or
otherwise, and withdrawal by cheque, draft, order or otherwise”. From the above
definitions we can conclude that the primary functions of banks are accepts deposits and
lending of these deposits. The business of commercial banks is primarily to keep deposits
and make loan and advances for short-period up to one or two years made to industry and
trade either by the system of overdrafts of an agreed amount or by discounting bills of
exchange to make profit to the shareholders. On the basis of the above discussion,
functions of commercial banks are classified into two main categories—(A) Primary
functions and (B) Secondary functions.

Primary Functions:

1. Accepts Deposits: The first primary function of a commercial bank is to accept deposits in
the form of current, savings and fixed deposits. It collects the surplus balances of the
individuals, firms and finances the temporary needs of commercial transactions. Therefore,
the first task of the bank is the collection of the savings of the public. The bank does this by
accepting deposits from its customers. Deposits are the lifeline of banks. Deposits are of
three types i.e. (i) Current Account Deposits: Such deposits are payable on demand and are,
therefore, called demand deposits. (ii) Fixed Deposits (Time deposits): Fixed deposits have a
fixed period of maturity and are referred to as time deposits. They can be withdrawn only
after the maturity of the specified fixed period and (iii) Savings Account Deposits: These are
deposits whose main objective is to save and savings account is most suitable for individual
households. They combine the features of both current account and fixed deposits.

2. Gives Loans and Advances: The second major function of a commercial bank is to give
loans and advances particularly to businessmen and entrepreneurs and earn interest from
them. This is, in fact, the main source of income of the bank. A bank keeps a certain portion
of the deposits with itself as reserve and gives (lends) the balance to the borrowers as loans
and advances in the form of cash credit, demand loans, short-run loans, overdraft. The
details of these are as explained under
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(i) Cash Credit: In this function of commercial bank, an eligible borrower is first sanctioned a
credit limit and within that limit he is allowed to withdraw a certain amount on a given
security. The withdrawing power of the eligible borrower depends upon the borrower’s
current assets, the stock statement of which is submitted by him to the bank as the basis of
security. For this interest is charged by the bank on the drawn or utilised portion of credit
(loan).

(ii) Demand Loans: In this function of commercial bank the entire loan amount is paid in
lump sum by crediting it to the loan account of the borrower. A loan which can be recalled
on demand is called demand loan and there is no stated maturity in such type of loan.
Those like security brokers whose credit needs fluctuate generally, take such loans on
personal security and financial assets.

(iii) Short-term Loans: In this function of commercial bank, short-term loans are given
against some security as personal loans to finance working capital or as priority sector
advances. The entire amount is repaid either in one instalment or in a number of
instalments over the period of loan.

Secondary Functions:

Accepts deposits and give loans and advances are the primary functions of the commercial
banks. Apart from the above-mentioned two primary (major) functions, commercial banks
perform the secondary functions also. These secondary functions are:

3. Discounting Bills of Exchange: The commercial banks provide the facility of discounting of
bills to its depositors. A bill of exchange represents a promise to pay a fixed amount of
money at a specific point of time in future. It can also be encashed earlier through
discounting process of a commercial bank. Alternatively, a bill of exchange is a document
acknowledging an amount of money owed in consideration of goods received. It is a paper
asset signed by the debtor and the creditor for a fixed amount payable on a fixed date.

4. Credit Creation. Credit creation is one of the most important functions of the commercial
banks. Like other financial institutions, they aim at earning profits. In this function of
commercial banks they accept deposits and advance loans by keeping small cash in reserve
for day-to-day transactions. When a bank advances a loan, it opens an account in the name
of the customer and does not pay him in cash but allows him to draw the money by cheque
according to his needs. By granting a loan, the bank creates credit or deposit.

5. Financing Foreign Trade. The commercial banks provide the facility of financing foreign
trade to its customers by accepting foreign bills of exchange and collecting them from
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foreign banks. These banks also transact other foreign exchange business and buy and sell
foreign currency.

6. Overdraft Facility: An overdraft is an advance given by allowing a customer keeping

current account to overdraw his current account up to an agreed limit. In this function of
commercial bank, bank provides the facility to a depositor for overdrawing the amount
than the balance amount in his account. In other words, depositors of current account
make arrangement with the banks that in case a cheque has been drawn by them which are
not covered by the deposit, then the bank should grant overdraft and honour the cheque.

Difference between overdraft facility and loan is that in the case of overdraft it is made
without security in current account the borrower is given the facility of borrowing only as
much as he requires and but on the other hand loans are given against security and the
borrower has to pay interest on full amount sanctioned.

7. Agency Functions of the Bank: Agency functions are also important functions of
commercial bank. The bank acts as an agent of its customers and gets commission for
performing agency functions as under:

(i) Collection and Transfer of Funds: It provides facility for cheap and easy remittance of
funds from place-to-place through demand drafts, mail transfers, telegraphic transfers, etc.
to its customers. A bank also collects funds through cheques, bills, bundles and demand
drafts on behalf of its customers.

(ii) Payments of Various Items: In this agency function, a bank makes payment of taxes,
insurance premium, bills, etc. as per the directions of its customers.

(iii) Purchase and Sale of Shares and Securities: It buys and sells and keeps in safe custody
securities and shares on behalf of its customers.

(iv) Collection of Dividends and Interest: A bank collects dividends and interest on shares on
behalf of its customers and acts as trustee and executor of property of its customers on
advice of its customers.

(v) Letters of References: Apart from the above mentioned agency functions of the bank; it
gives information about economic position of its customers to traders and provides similar
information about other traders to its customers.

8. General Utility Services: The banks also provide many general utility services to its
customers. These are as under:

(i) The banks issue traveler’s cheques and gift cheques to its customers.
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(ii) The customers can keep their ornaments and important documents in lockers for safe
custody.

(iii) It provides the facility of underwriting securities issued by government, public or private
bodies.

STRUCTURE OF INDIAN COMMERCIAL BANKS

1. Scheduled Banks: Scheduled Banks refer to those banks which have been included in
the Second Schedule of Reserve Bank of India Act, 1934. In India, scheduled
commercial banks are of three types. These are public sector banks, private sector
banks and foreign sector banks.

(h) Public Sector Banks: These banks are owned and controlled by the government. In
other words, majority of the control is hold by the government. The main
objective of these banks is to provide service to the society, not to make profits.
State Bank of India, Bank of India, Punjab National Bank, Canada Bank and
Corporation Bank are some examples of public sector banks. SBI and its
subsidiaries and other nationalized banks are two types Public sector banks.
(i) Private Sector Banks: These banks are owned and controlled by private
businessmen. In other words, majority of the control is hold by the private
owners. The main objective of these banks is to earn profits. ICICI Bank, HDFC
Bank, and IDBI Bank are some examples of private sector banks
(j) Foreign Banks: These banks are owned and controlled by foreign promoters.
When the process of economic liberalization had started in India, their number
has grown rapidly. Bank of America, American Express Bank, Standard Chartered
Bank are examples of foreign banks.
2. Non-Scheduled Banks: Non-Scheduled banks refer to those banks which are not
included in the Second Schedule of Reserve Bank of India Act, 1934.

SOURCES OF FUNDs

A commercial bank is a financial institution that offers business loans and trade financing in
addition to the more traditional deposit, withdrawal and transfer services. A commercial
bank’s main sources of funds come from the customers’ deposits, the issue of certificates of
deposit, the share capital contributed by the bank’s shareholders and the reserves from the
retained profits.

The major source of funds of commercial banks is its deposits. Deposits are the life and
blood of commercial banks as they are the mainstay of bank funds and account for about
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90 percent of bank liabilities. Credit creation and deployment depend upon deposits, which
is very essential for the economic development of a country. The banks act as
intermediaries between the savers and users of funds. By pooling the savings together,
banks can make available funds to specialized institutions that finance different sectors of
the economy, which need capital for various purposes like agriculture, industries, housing
etc. Indian banks accept two main types of deposits-demand deposits and term deposits.
The growth of deposits of the banks depends upon various factors like increase in national
income, expansion of banking facilities in new areas and for new classes of people, increase
in bank credit, inflow of deposits from NRIs and increase in banking habit etc.

Borrowing from other banks is the other source of funds of commercial banks. Since the
cost of these funds will be more, they go for this source as an alternative for temporary
adjustment. With such a diverse business profile, the sources of funds in commercial banks
are varied. Some of them are given below:

INVESTMENT NORMS

The Reserve Bank of India issues guidelines for the investment portfolio of the banks,
keeping in view the developments in the financial markets and taking into consideration the
evolving international practices. It is directed by the RBI that banks should frame internal
investment policy guidelines and obtain the board’s approval. The investment policy may
be suitably framed/ amended to include Primary Dealer (PD) activities also. It is also
suggested by the central bank that the investment policy guidelines should be implemented
to ensure that operations in securities are conducted in accordance with sound and
acceptable business practices. RBI also directed that banks may sell a government security
already contracted for purchase, provided the purchase contract is confirmed prior to the
sale and the purchase contract is guaranteed by Clearing Corporation of India Ltd. (CCIL) or
the security is contracted for purchase from the Reserve Bank.

Banks successful in the auction of primary issue of government securities may enter into
contracts for sale of the allotted securities in accordance with the terms and conditions
mentioned in the respective annexure. Banks may exercise due caution, while taking any
investment decision to subscribe to bonds, debentures, shares etc., and refer to the ‘list of
defaulters/wilful defaulters disseminated by the Reserve Bank /obtained from the Credit
Information Companies to ensure that investments are not made in companies/entities
who are defaulters/wilful defaulters to banks/FIs. Banks should not invest in non-SLR
securities of original maturity of less than one-year, other than commercial paper and
certificates of deposits and NCDs with original or initial maturity up to one year issued by
corporates (including NBFCs), which are covered under RBI guidelines.
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The entire investment portfolio of the banks (including SLR securities and non-SLR
securities) should be classified under three categories viz. ‘Held to Maturity’, ‘Available for
Sale’ and ‘Held for Trading’. However, in the balance sheet, the investments will be
disclosed as per the existing six classifications: viz. a) Government securities, b) Other
approved securities, c) Shares, d) Debentures & Bonds, e) Subsidiaries/ joint ventures and f)
Others (CP, Mutual Fund Units, etc.). With a view to building up of adequate reserves to
guard against any possible reversal of interest rate environment in future due to
unexpected developments, banks were advised to build up Investment Fluctuation Reserve
(IFR) of a minimum 5 per cent of the investment portfolio within a period of 5 years. It is
also suggested that to ensure smooth transition to Basel II norms, banks were advised in
June 24, 2004 to maintain capital charge for market risk in a phased manner over a two
year period. In view of high credit risk involved in long-term Zero Coupon Bonds (ZCBs)
issued by corporate (including those issued by NBFCs) banks should not invest in such ZCBs
unless the issuer builds up sinking fund for all accrued interest and keeps it invested in
liquid investments/ securities (Government bonds). On studying the balance sheet of the
bank, it has been found that the investments constitute one of the important assets of the
bank next to loans and advances. In the year 2010-11, loans and advances and investments
were ₹ 42,974.88 Billion and ₹ 19236.33 Billion respectively. But in the year 2015-16, loans
and advances and investments were ₹ 78,964.67 Billion and ₹ 31749.27 Billion respectively.
It shows that there is remarkable increase in the loans and advances and investments of the
banks. A bank makes investments for the purpose of earning profits. First it keeps primary
and secondary reserves to meet its liquidity requirements. As per the directions of the RBI,
banks invest in securities either for fulfillment of SLR/CRR requirements or for earning profit
on the idle funds. Banks invest in “approved securities” (predominantly Government
securities) and “others” (shares, debentures and bonds). The values/rates of these
securities are subject to change depending on the market conditions. Some securities are
transacted frequently and some are held till maturity. The Ghosh Committee recommended
that “a bank’s investment portfolio should be bifurcated into two parts, namely,
‘permanent investment’ and ‘current investment’.

RBI has also advised the banks to classify the existing investment in approved securities into
two categories. Initially from the accounting year 1992-93, banks should not keep more
than 70% of their investment in permanent category, and 30% of the portfolio as current
investments to facilitate valuing all the investments on fully ‘marked to market’ basis.
Guidelines were laid down for transfer of approved securities from ‘current’ to ‘permanent’
and ‘vice versa’ in 1992. These guidelines ensure that latent losses are provided for at the
time of such transfer. In 1993 the entire investment portfolio of banks other than
investments classified as ‘permanent’ has to be classified into six categories for the purpose
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of valuation. The valuation will be done for each category of investments. While net
depreciation has to be provided by debit to the profit and loss account, net gains have to be
ignored. Permanent investments can be carried at book value. Premium will have to be
amortized over the life of the investment but discount cannot be recognized as income.

ASSET STRUCTURE OF COMMERCIAL BANKS

Balance sheet of a bank is of great importance to know the sources and uses of its funds. As
it is well known that a balance sheet of an institution indicates its liabilities and assets. The
liabilities of a bank show the sources of its funds and assets show its uses by it. Commercial
banks use their funds primarily to purchase income earning assets, mainly loans and
investments. These assets are shown in the balance sheet of the bank in decreasing order
of the liquidity

Assets structure will reflect the deployment of sources of funds of commercial banks.
The main source of funds of commercial banks is deposits. The other sources of funds are
borrowings from other banks, capital, reserves and surplus. The deposits of commercial
banks are from savings deposits, current account deposits and term deposits. These
deposits constitute 77.9 per cent of the total sources of funds during the year 2015. Out of
the total deposits, term deposits constitute 50 per cent. Borrowings are around 5 per cent
of the total liabilities of the commercial banks. These sources are deployed by the
commercial banks mainly on its financial assets i.e, loans and advances which constitute
60.9 per cent of the total assets of the banks. The investment is another important
component of the assets of commercial banks which is around 24.5 per cent of the total
assets of the banks during the year 2015. This is because of pre-emptions like SLR and CRR
requirements in the banking sector. The investments in commercial banks have increased
also because of surplus liquidity in Indian banks during this period due to reduction of SLR
and CRR to 25 and 4.5 respectively during that period and less demand for loans and
advances from credit-worthy customers. This scenario is changing in India due to increasing
demand in credit from industrial, agriculture sector and also the growth of FMCG market.
The assets structure of the banks is governed by certain principles, like liquidity, and
profitability. The other factors which influence the assets structure of commercial banks are
nature of money market, economic growth of the country, policies and vision of the
governments.

The asset side of the balance sheet of a bank shows for what purposes it has used the funds
obtained from the depositors. In order to meet the demands for withdrawals by the public
and thus to retain faith and credibility, bank has to keep some ready cash with it, that is, it
has to ensure some liquidity. Profitability and liquidity are the two major considerations
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that weigh with the commercial banks in deciding about the composition of its assets.
Bank's assets comprise cash, money at short notice, bills and securities discounted, bank's
investments, loans sanctioned by the bank, etc. Bank's cash in hand, cash with other banks
and cash with central bank (RBI) are its assets. When a bank makes money available at
short notice to other banks and financial institutions for a very short period of 1-14 days it
is also treated as bank's asset. Apart from these items bank always make money available
to people on the form of loans and advances. They are also become bank's assets. Now let
us examine each of the important assets of the commercial bank.
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MEANING OF COMPANY 1

Special Features of a Company 1-2

Kinds of Companies 2-3

DISTINCTION BETWEEN A COMPANY AND A PARTNERSHIP 4

FORMATION OF A COMPANY 5

Filing of Basic Documents 5

Certificate of Incorporation 5-6

ALLOTMENT OF SHARES 6

Requisites a Valid Allotment 6-7

STATUTORY BOOKS 7-8

BOOKS OF ACCOUNT 8-9

SHARE CAPITAL 9

Categories of Share Capital 9-10

Classes of Shares (Preference Shares, Equity Shares, Preference Share Capital, Equity Share
Capital)10-11-12

PROCEDURE AND ACCOUNTING ENTRIES FOR ISSUE OF SHARES 12

Procedure for Issue of Shares 12-13

Basic Accounting Entries for Issue of Shares 13

ISSUE OF SHARES FOR CONSIDERATION OTHER THAN CASH 14

ISSUE OF SHARES FOR CASH 14-15

Issue of Shares for Cash at a Discount 16

OVERSUBSCRIPTION OF SHARES 16-17

Full Allotment 17

Pro-rata Allotment 17

CALLS IN ARRERS 17-18

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CALLS IN ADVANCE 18

FORFEITURE OF SHARES 18-19

When shares were issued at a premium 19-20

When the shares were issued at a discount 20

REISSUE OF FORFEITED SHARES 20

CONCEPT AND PROCESS OF BOOK BUILDING 20-21

ISSUE OF RIGHT SHARES 21-22

Advantages of Right Issue 22

Accounting for Right Issue 23

CONDITIONS FOR BUY BACK OF SHARES 23-24

MOTIVES OF BUY BACK OF SHARES 23

SEBI GUIDELINES 23-24

METHODS OF BUY BACK OF SHARES (Tender Method, Open Market Purchases) 24-25

ADVANTAGES OF BUY BACK OF SHARES 25

ESCROW ACCOUNT 25-26

CONDITIONS FOR REDEMPTION OF PREFERENCE SHARES 26

Authorized by Article of the Company 26

Fully Paid-up Shares 26

Out of Profits or Issue of New shares 26

Creation of Capital Redemption Reserve 26

Use of Capital Redemption Reserve A/c 26

Time Period of Redemption 27

Premium on Redemption 27

ISSUE OF BONUS SHARES 27

SEBI Guidelines for Issue of Bonus Shares 27-28

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Circumstances for Issue of Bonus Shares 28

Sources for the Issue of Bonus Shares 29

Advantages of Issue of Bonus Shares 29

Advantages from the Viewpoint of the company 29

Advantages from the viewpoint of shareholders 29-30

Advantages from the viewpoint of shareholders 30

WHAT IS A DEBENTURE 30-31

DIFFERENCE BETWEEN SHARES AND DEBENTURES 31

TYPES OF DEBENTURES 32

Redeemable and Irredeemable Debentures 32

Registered and Bearer Debentures 32

Secured and Unsecured Debentures 32

Convertible and Non-convertible Debentures 32

ISSUE OF DEBENTURES 33

When Debentures are issued for Consideration other than Cash 33

When Debentures are issued for Cash 33-34

Issue of Debentures as a Collateral Security 34

Debentures Issued at Different Terms 35

Writing off Loss on Issue of Debentures 35-36

REDEMPTION OF DEBENTURES 36

Redemption on Maturity 36-37

Sinking Fund Method 37-38-39

Sinking Fund Method 39

Redemption in Instalments 40

Redemption by Purchase from the Market 40-41

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Payment of Interest on Debentures: 41

Redemption by Conversion 41-42

COMPANY FINAL ACCOUNTS 42

LEGAL REQUIREMENTS AS TO PROFIT AND LOSS ACCOUNT (SCHEDULE VI PART II) 42

Income 42-43

Expenses and Provisions 43-44

Appropriation of Profits 44

Special Features of Company Profit and Loss Account 44-45

LEGAL REQUIREMENTS AS TO COMPANY BALANCE SHEE (SCHEDULE VI PART I) 45

Proforma of Balance Sheet 45

TREATMENT OF SPECIAL ITEMS RELEVANT TO COMPANY FINAL ACCOUNTS 45-46

Expenses on Issue of Shares and Debentures 46-47

Discount on Issue of Shares and Debentures 47

Premium on Issue of Shares 47

Calls in Arrears and Calls in Advance 48

Forfeited Shares 48-49

Depreciation on Fixed 49

Provision for Taxation 49

Dividends 50

Interest on Debentures 50

Transfer to Reserves 50

Balance of Profit and Loss Account 50-51

Proforma of Profit & Loss Account 52

NEED FOR CASH FLOW STATEMENT 53-54

CASH FLOW STATEMENT VS. OTHER FINANCIAL STATEMENTS 54-55

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CASH FLOW STATEMENTS 55-56

Sources and Uses of CasH 56

Ascertaining Cash from Operations 56-57

REGULATIONS RELATING TO CASH FLOW STATEMENT 57-58

CASH FLOW FROM INVESTING AND FINANCING ACTIVITIES 58

USES OF CASH FLOW STATEMENT 58-59

DISTINCTION BETWEEN CASH FLOW ANALYSIS AND FUND FLOW ANALYSIS 59

Holding Company 60

Subsidiary Company 60

OBJECTIVESS OF HOLDING COMPANIES 60

TYPES OF HOLDING COMPANY 60-61

ADVANTAGES OF HOLDING COMPANIES 61

LIMITATIONS OF HOLDING COMPANY 61-62

Calculation of Goodwill/Capital Reserve 62

Minority Interest 62-63

Calculation of Minority Interest 63

Calculation of Goodwill/Capital Reserve 63

DIFFERENCE BETWEEN WHOLLY OWNED AND PARTLY OWNED SUBSIDRIES 63-64

EXEMPTION FROM PREPARATION OF CONSOLIDATED FINANCIAL STATEMENTS 64

CONSOLIDATED FINANCIAL STATEMENTS 64-65

Benefits of Consolidated Financial Statement 65

Disadvantages of Consolidated Financial Statements 65

PROCEDURE OF PREPARING CONSOLDIATED FINANCIAL STATEMENTS WITH ADJUSTMENT

66

Dividend from Subsidiary Company out of Pre-Acquisition Profit 66-67

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Pre-acquisition & Post-acquisition Profits 67

Calculation of Minority Interest 67

MEANING OF GOODWILL 68

CHARACTERISTICS OF GOODWILL 68-69

NATURE OF GOODWILL 69

FACTORS AFFECTING THE VALUE OF GOODWILL 69-70

NEED FOR THE VALUATION OF GOODWILL 70

METHODS OF VALUATION OF GOODWILL 70-71

Average Profit Method 71

Weighted Average Profit Method 71

Super Profit Method 71-72

Calculation of Capital Employed 72

Capitalization Method 73

Annuity Method 73

Purchase Method 73

MEANING OF VALUATION OF SHARES 74

FACTORS AFFECTING THE VALUATION OF SHARES 74

NEED FOR THE VALUATION OF SHARES 74-75

METHODS OF VALUATION OF SHARES 75

Net Assets Method 75-76+

Dividend Yield Method 75

Earning Capacity Method 75

Fair Value Method 75

OBJECTIVES OF AMALGAMATION 77

RECONSTRUCTION 77
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External Reconstruction 77

Internal Reconstruction 77

DIFFERENCE BETWEEN AMALGAMATON, ABSORPTION AND RECONSTRUCTION 78

IMPORTANT TERMS IN AMALGAMATION 78-79

METHODS OF ACCOUNTING FOR AMALGAMATION 79

The Pooling of Interests Method 80

The Purchase Method 80

TREATMENT OF RESERVES ON AMALGAMATION 80-81

TREATMENT OF GOODWILL ARISING ON AMALGAMATION 81

Balance of Profit and Loss Account 81

PURCHASE CONSIDERATION 81-82-83

ACCOUNTING ENTRIES IN THE BOOKS OF TRANSFEREE COMPANY 83

The Pooling of Interest Method 83

ACCOUNTING ENTRIES IN THE BOOKS OF TRANSFEROR COMPANY 83

STEPS INVOLVED IN INTERNAL RECONSTRUCTION 84

MODES OR METHODS OF INTERNAL RCONSTRUCTION 84

Alteration in Share Capital 84-85

Reduction of Share Capital 85-86

BANKING COMPANIES 86

BANKING COMPANIES 87

Forms of Business of Banking Companies 87-88-89

Disposal of non-banking assets 89

Slip system of ledger posting 89-90

Advantages of slip system 90

Disadvantages of slip system 90

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Bank Teller System 90

Objectives of a bank teller system 90-91

NON-BANKING FINANCIAL COMPANY 91-921

RESIDUARY NON-BANKING COMPANY 92

DIFFERENCE BETWEEN NBFCs AND BANKS 92

DEPOSITORS CONCERN & NBFC REGULATIONS 92-93

PERIODICAL RETURNS TO BE SUBMITTED TO RBI 93-94

STOCKINVEST SCHEME 94

Features of the Stockinvest Instrument 94-95

Revision of the Stockinvest Scheme 95-96

Stockinvest for NRIs/OCBs 96-97

Terms of Issue & Payment of Stockinvest 97-98

FUNCTIONS OF COMMERCIAL BANK 98-99-100-101

STRUCTURE OF INDIAN COMMERCIAL BANKS 101

SOURCES OF FUNDs 101-102

INVESTMENT NORMS 102-103-104

ASSET STRUCTURE OF COMMERCIAL BANKS 104-105