Banking and Insurance Companies:

Meaning of Banking Companies:

A bank is a commercial institution, permitted to accept, collect, transfer, lend and exchange
money and claims to money both the domestically and internationally and thereby conduct
smooth banking activities.

Definition:
Banking companies are governed by the Banking Regulation Act of 1949 and also subject to
the companies’ act. 1956.

According to Banking Regulation act, 1949 Banking means – “The accepting, for the purpose
of lending or investment, of deposit of money from the public repayable on demand or
otherwise and withdraw able by cheque, draft, order or otherwise.’

Business of Banking Companies:

As per section 6 of the Act, banking companies may engage in the following business in
addition to their usual banking business.
1. The borrowing, raising or taking up on money, the lending or advancing of money either
upon or without security, the drawing, making, accepting, discounting, buying, selling,
collecting and dealing in bills of exchange, ‘hundies’, promissory notes, drafts, bills of lading,
railways receipt, warrants, debentures, certificates, scrip’s and other instruments and securities
whether transferable or negotiable or not; granting and issuing of letters of credit, traveller’s
cheques and circular notes; the buying, selling and dealing in bullion and specie; the buying
and selling of foreign exchange including foreign bank notes; the acquiring, holding, issuing
on commission, underwriting and dealing in stock, funds, shares, debentures, debenture stock
bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds,
scrips or other forms of securities on behalf of constituents or other, the negotiating of loans
and advances; the receiving of all kinds of bonds, scrips or valuables on deposit or for safe
custody or otherwise; the providing of safe deposit vaults; the collecting and transmitting of
money and securities.
2. 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 acting as on attorney on behalf of
customers but excluding the business of (managing agent or secretary and treasurer) of a
company.
3. Contracting for public and private loans and negotiating and issuing the same.
4. 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 of the lending
of money for the purpose of any such issue.
5. Carrying on and transacting every kind of guarantee and indemnity business.
6. 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.
7. 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 which may be connected with any such security.
8. Undertaking and executing trusts.
9. Undertaking the administration of estates as executor, trustee or otherwise.
10. Establishing and supporting or aiding in the establishment and support of associations,
institutions, funds, trusts and conveniences calculated to benefit employees or ex-employees
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.
11.The acquisition, construction maintenance and alteration of any building or works necessary
or convenient for the purpose of the company.
12. 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.
13. Acquiring and undertaking the whole or any part of the business of any person or company,
when such business is of a nature enumerated or described in section 6.
14. Doing all such other things as are incidental or conclusion to the promotion or advancement
of the business of the company.
15. Any other form of business which the central Government may by notification in the official
Gazette, specify as a form of business in which it is lawful for a banking company to engage.

No Banking Company shall engage in any form of business other than those referred to in
section 6.

Restrictions on Business:

The Banking Companies are restricted from conducting certain activities.

A bank cannot directly or indirectly deal in the buying or selling or bartering of goods, except
in connection with the realization of security given to or held by it, or engage in any trade or
buy or sell of barter goods for others otherwise than in connection with bills of exchange,
immovable property, except that required for its own use, however acquired, must be disposed
of within seven years from the date of acquisition.
Non-Banking Assets:
The case in which the customer to whom a bank sanctioned loan against some security and if
he fails to repay the same, the bank decides to acquire such property kept as security to satisfy
its claim. Such property or assets termed as ‘Non-Banking Assets’. These Assets are exhibited
in schedule 11 – “Other Assets”.
Important accounting provisions of banking regulation act 1949.

1. Minimum Capital and reserves – Section 11.

According to the provision of section 11 (2) of the Banking Regulation Act 1949 the following
are the limits imposed on value of paid up Capital and Reserves of a banking Company.

1) In the case of Banking Company incorporated outside India. If it has a place or places
of business in the city of Bombay or Calcutta or both Rs. 20 lakhs. If the places of
business are other than Bombay or Calcutta Rs. 15 lakhs. In addition, 20% of the profits
earned in India must be added to the sums mentioned above.
2) In the case of a banking company incorporated in India.
a) If it has places of business in more than one state and it has a place or places of
business in Bombay or Calcutta or both Rs. 10 lakhs.
b) It is having places of business in more than one state but not in Bombay or Calcutta
Rs. 5 lakhs.
c) If it has places of business in one state but not in Bombay or Calcutta. Rs. 1 lakh in respect
of its principal place plus Rs. 10,000 for each of its other places of business in the same district
and Rs. 25,000 in respect of each place of business outside the district. The total need not
exceed Rs. 5 lakhs. In case there is only one place of business Rs. 50,000.
(In case of companies, which have commenced business after the commencement of the
Banking Companies (Amendment) Act of 1962, a minimum of Rs. 5 lakhs is required)
d) If it has all its places of business in one state / Rs. 5 lakhs and if the places of business are
also in / plus Rs. 25,000 Bombay or Calcutta. / In respect of each place of business
situated outside the city of Bombay or Calcutta. The total need not exceed Rs. 10 lakhs.

2. Restriction on commission Brokerage, Discount, etc.

On sale of shares-section B:
A Banking company is not allowed to pay directly or indirectly commission, Brokerage,
Discount or remuneration in any form in respect of any shares issued by it, any amount
exceeding two and one-half person of the paid up value of the said shares.

3. Restriction on payment of dividend – section 15:

A Banking company shall not pay dividend unless all of its capitalized expenses (including
preliminary expenses, organization expenses, share selling commission, Brokerage, amount of
losses incurred and any other item. Of expenditure not represented by tangible assets) have
been completely written-off. However, a banking company may pay dividend on its shares
without writing off.
 4. Statutory Reserve – Section 17:
Section 17 of the act lays down that every banking company should create a reserve fund by
transferring to it at least 20 percent of its annual profit as disclosed by its profit and loss account
before any declaration of dividend, such reserve is known as statutory reserve. The transfer of
profit to reserve fund should be continued even after the accumulated amount of reserve fund
and share premium account together exceed its paid-up capital. Unless the central government
grant on exemption in this regard on the recommendation of Reserve Bank of India.

5. Cash Reserves – Section 18:

Every Banking Company requires to maintain a balance equal to 3 percent of its time and
demand liabilities with RBI (a non-scheduled bank has to keep similar balances either in cash
or deposit with RBI)

6. Restrictions on loans and Advances –section 20

A Bank can not

i) grant loans and advances on the security of its own shares and
ii) grant or agree to grant loan or advance to or on behalf of
a) Any of its directors;
b) Any firm in which any of its directors is interested as partner, manager or gurantor;
c) Any company of which any of its directors is a director manager, employee or guarantor
or in which he holds substantial interest; or
d) Any individual in respect of whom any of its directors is a partner or guarantor.

Books of accounts
In order to have immediate entry of voluminous transaction and enables continuous internal
check on the record of these transactions, Banks are required to maintain subsidiary books
along with its principal books of accounts.
A) Subsidiary books
i. Receiving cashier’s counter cash book;
ii. Paying cashier’s counter cash book;
iii. Current accounts ledger.
iv. Savings bank accounts ledger
v. Fixed deposit accounts ledger
vi. Investments Ledger
vii. Loans Ledger
viii. Bills discounted and purchased ledger
ix. Customer’s acceptances endorsements and guarantee ledger

B) Principal Books
i. Cash book: It records all cash transactions
ii. General Leger: It contains control Accounts of all subsidiary ledgers and different
assets and liabilities account

Provisioning of non-performing assets

Meaning:
The ‘Non-Performing Assets’ refers to those assets which fails to generate expected returns to
the bank due to borrowers’ default in making repayment.
In accordance with the international practice and the directives of RBI, the bank should
recognize income on Non-Performing Assets (NPA) when it is actually received and not on
accrual basis.
Similarly, the RBI has accepted the definition of a NPA given by Narasimham committee from
March 1995 onwards –
‘as an advance where, as on the bank’s balance sheet date,
(a) interest on a term loan account is past due or
(b) a cash credit /overdraft account remains out of order or
(c) a bill purchased /discounted is unpaid or overdue or
(d) any amount to be received in respect of any other account remains past due, for a period
more than 180 days.
(e) in respect of agricultural finance / advance (eg crop loans) interest and / or installment of
principal remains overdue for two harvest seasons but for a period not exceeding two
half years. The period of 180 days has been reduced to 90 days effective from March 31, 2004.
A ‘past due’ account has been defined as an amount which remains outstanding 30 days beyond
the due date. Assets classification and provisioning In order to make adequate provisions, assets
have been classified as follows:

Standard assets – These are the assets which does not disclose any problems and does not
carry more than normal risk attached to the business therefore no provision is to be made
against them.
Substandard assets – These assets exhibit problems and would include assets classified as
non-performing for a period not exceeding two years. Hence the provision is to be made at the
rate of 10 percent of the total outstanding amount of substandard assets.
Doubtful assets – these are the assets which remain non performing for a period exceeding
two years and would also include loans in respect of which instalments are overdue for a period
exceeding two years.
The provision for doubtful assets as follows:
Period for which the advance Provision requirements (%) Has been considered
As doubtful
Upto one year 20
One to three years 30
More than three years 50
Loss assets – Loss assets are those assets where the loss has been identified but the amounts
have not been return off.

FINAL ACCOUNTS
The Banking Regulation act, 1949 prescribes formats of preparing final accounts of the
Banking companies. The third schedule of section 29 gives forms ‘A’ for the balance sheet and
Form ‘B’ for Profit and loss account. The balance sheet consists of total 12 schedules. Schedule
1 to schedule 5 depicts capital and liabilities and schedule 6 to schedule 11 shows Assets of the
bank and schedule 12 shows contingent liabilities and there is no specific schedule prescribes
for bills for collection.
SCHEDULE 1 --- CAPITAL

As on 31.3…. (Current Year) As on 31.3…. (previous Year)

I. For Nationalized Banks
Capital (Fully owned by Central Government)

II. For Banks Incorporated Outside India

Capital
(The amount brought in by banks by way of start-up capital as prescribed by RBI should be
shown under this head) Amount of deposit with the RBI under

Section 11(2) of Banking Regulation Act, 1949

Total
III. For Other Banks Authorized Capital
……. shares of Rs……… each Issued Capital
……. shares of Rs……… each Subscribed Capital
……. shares of Rs……… each Called-up Capital
……. shares of Rs……… each Less: Calls unpaid
Add: Forfeited shares

SCHEDULE 2 – RESERVES & SURPLUS

As on 31.3…. (Current Year) As on 31.3…. (Previous Year)

I. Statutory Reserves Opening Balance Additions during the year Deductions during the
year
II. Capital Reserves Opening Balance Additions during the year Deductions during the
year
III. Shares Premium
Opening Balance Additions during the year Deductions during the year
IV. Revenue and other Reserves Opening Balance
Additions during the year Deductions during the year
V. Balance in Profit and Loss Account

Total (I + II + III + IV + V)

SCHEDULE 3 – DEPOSITS

As on 31.3…. (Current Year) As on 31.3…. (previous Year)

A. I. Demand Deposits
i) From Banks
ii) From Banks
II. Savings Bank Deposits
III. Term Deposits
i) From banks
ii) From others
Total (I + II + III)
B. i) Deposits of branches in India
ii) Deposits of branches outside India

Total
SCHEDULE 4 – BORROWINGS
As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Borrowings in India
i) Reserve Bank of India
ii) Other banks
iii) Other institutions and agencies
II. Borrowings outside India
Total (I + II) Secured borrowings included in I & II above – Rs.

SCHEDULE 5 – OTHER LIABILITIES AND PROVISIONS

As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Bills payable
II. Inter-office adjustments (net)
III. Interest accrued
IV. Others (including provisions)

Total

SCHEDULE 6 – CASH AND BALANCES WITH RESERVE BANK

OF India
As on 31.3…. As on 31.3….

(current Year) (Previous Year)

I. Cash in hand (including foreign currency notes)
II. Balances with RBI
(i) in Current Account
(ii) in Other Accounts
Total (I + II)

SCHEDULE 7 – BALANCES WITH BANKS & MONEY AT CALL & SHORT NOTICE

As on 31.3…. (Current Year) As on 31.3…. (previous Year)

I. In India
(i) Balances with banks
(a) in Current Accounts
b) in Other Deposit Accounts
(ii) Money at call and short notice
a) With banks
b) With other institutions Total
II. Outside India
(i) in Current Accounts
(ii) in Other Deposit Accounts
(iii) Money at call and short notice Total

Grand Total (I + II)

SCHEDULE 8 – INVESTMENTS

As on 31.3…. (Current Year) As on 31.3…. (previous Year)

I. Investments in India in
i) Government securities
ii) Other approved securities
iii) shares
iv) Debentures and Bonds
v) Subsidiaries and / or joint ventures
vi) Others (to be specified Total
II. Investments outside India in
i) Government securities (including local authorities)
ii) Subsidiaries and / or joint ventures abroad
iii) Other investments (to be specified)
Total

Grand Total (I + II)

SCHEDULE 9 – ADVANCES

As on 31.3…. (Current Year) As on 31.3…. (previous Year)

A. i) Bills purchased and discounted
ii) Cash credits, overdrafts and loans repayable on demand
iii) Term loans
Total
B. i) Secured by tangible assets
ii) Covered by Bank / Government guarantees
iii) Unsecured
Total
C. I. Advances in India
i) Priority Sectors
ii) Public Sector
iii) Banks
iv) Others
Total
II. Advances outside India
i) Due from banks
ii) Due from others
a) Bills purchased and discounted
b) Syndicated loans
c) Others Total
Grand Total (C. I. + C. II.)

SCHEDULE 10 – FIXED ASSETS

As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Premises
At cost as on 31 st
March of the preceding year
Additions during the year Deductions during the year Depreciation to date
II. Other Fixed Assets (including furniture and fixtures)
At cost as on 31 st
March of the preceding year
Additions during the year Deductions during the year Depreciation to date
Total (I + II)
SCHEDULE 11 – OTHER ASSETS
As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Inter-office adjustments (net)
II. Interest accrued
III. Tax paid in advance / tax deducted at source
IV. Stationery and stamps
V. Non-banking assets acquired in satisfaction of claims
VI. Others @
Total
@ In case there is any unadjusted balance of loss, the same may be shown under this item with
appropriate foot-note.

SCHEDULE 12 – CONTINGENT LIABILITIES

As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Claims against the bank not acknowledged as debts
II. Liability for partly paid investment
III. Liability on account of outstanding forward exchange contracts
IV. Guarantee given on behalf of constituents’
a) In India
b) Outside India
V. Acceptances, endorsements and, other obligations
VI. Other items for which the bank is contingently liable

Total
SCHEDULE 13 – INTEREST EARNED
As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Interest / discount on advances / bills
II. Income on investments
III. Interest on balances with Reserve Bank of India and other inter-bank funds
IV. Others
Total
SCHEDULE 14 – OTHER INCOME
As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Commission, exchange and brokerage
II. Profit on sale of investments Less: Loss on sale of investments
III. Profit on revaluation of investments
Less: Loss on revaluation of investments
IV. Profit on sale of land, buildings and other assets
Less: Loss on sale of land, buildings and other assets.
V. Profit on exchange transactions Less: Loss on exchange
transactions
VI. Income earned by way of dividends etc. from subsidiaries / companies and / or joint
ventures abroad / in India
VII. Miscellaneous Income

Total
Note : Under items II to V loss figures may be shown in brackets

SCHEDULE 15 – INTEREST EXPENDED

As on 31.3….
(current Year) As on 31.3….
(Previous Year)
I. Interest on deposits
II. Interest on Reserve Bank of India / inter-bank borrowings
III. Others
Total
SCHEDULE 16 – OPERATING EXPENSES
As on 31.3….(current Year)
As on 31.3….(Previous Year)
I. Payments to and provisions for employees
II. Rent, taxes and lighting
III. Printing and stationery
IV. Advertisement and publicity
V. Depreciation on bank’s property
VI. Directors’ fees, allowances and expenses
VII. Auditor’ fees and expenses (including branch auditors’ fees and expenses)
VII. Law charges
IX. Postages, telegrams, telephone, etc.
X. Repairs and maintenance
XI. Insurance
XII. Other expenditure
Total
GUIDELINES OF RBI FOR COMPILATION OF FINANCIAL STATEMENTS BALANCE
SHEET
Item Schedule Coverage Notes and instructions for compilation
(1) (2) (3) (4)
Capital 1 Nationalized The capital owned by Banks Central Government as
Capital (fully on the date of the
Owned by Central Balance sheet including
Government) contribution from Government, if any, for participating in World Bank,
Projects, should be shown

Banking (i) The amount brought in

Companies by banks by way of start-up
Incorporated capital as prescribed
By outside India RBI, should be shown Under this Head
(i) The amount or deposits kept with RBI under sub-section 2 of
Section 11 of the Banking Regulation Act, 1949 should also be shown.
Authorized, Issued, Subscribed, Called-up Capital should be given separately. Calls-inarrears
will be deducted from Called-up Capital
While the paid-up value of forfeited shares should be added, thus arriving at the paid-up capital.
The necessary Items which canbe combined should be shown under one head,for
instance,“Issued
and Subscribed Capital”. Notes: General
The changes in the above items, if any, during the years, say, fresh contribution made by the
Government, fresh issue of capital, capitalization of reserves, etc., may be explained in the
notes.
Reserves
and Surplus 2 (I) Statutory
Reserves Reserves created in terms of Section 17 or another section of Banking
Regulation Act,
must be separately
disclosed.

(II) Capital The expression ‘capital Reserve reserve’ shall not include
any amount regarded as free for distribution through the Profit and Loss Account. Surplus on

revaluation should be treated as Capital Reserves. Surplus on translation of the financial

statements of foreign branches (which includes fixed assets also) is not a revaluation reserve.
(III) Share Premium on issue of Premium share capital may be
shown separately under this head.
(IV) Revenue The expression ‘Revenue and other Reserve’ shall mean any Reserve
reserve other than those
separately classified. This expression ‘reserve’ shall not include any amount, written-off or
retained by way of providing for depreciation, renewals or diminution in value of assets or
retained by way of providing for any known liability.
(V) Balance of Includes balance of profit Profit after appropriation. In
case of loss the balance may be shown as a deduction.

Disclosure of Accounting Policies

In order that the financial position of banks represent a true and fair view, the Reserve Bank of
India has directed the banks to disclose the accounting policies regarding the key areas of
operations along with the notes of account in their financial statements for the accounting year
ending 31.3.1991 and onwards,on a regular basis. The accounting policies disclosed may
contain the following aspects subject to modification by individual banks:
1) General
The accompanying financial statements have been prepared on the historical cost and conform
to the statutory provisions and practices prevailing in the country.

2) Transactions involving Foreign Exchange

a) Monetary assets and liabilities have been translated at the exchange rates, prevailing at
the close of the year. Non-monetary assets have been carried in the books at the historical cost.
b) Income and expenditure items in respect of Indian branches have been translated at the
exchange rates, ruling on the date of the transaction and in respect of overseas branches at the
exchange rates prevailing at the close of the year.
c) Profit or losses on pending forward contracts have been accounted for.

3) Investments
a) Investments in Governments and other approved securities in India are valued at the
lower of cost or market value.
b) Investments in subsidiary companies and associate companies (i.e., companies in which
the bank holds at least 25 percent of the share capital) have been accounted for on the historical
cost basis.
c) All other investments are valued at the lower of cost or market value.
4) Advances
a) Provisions for doubtful advances have been made to the satisfaction of the auditors:
i) In respect of identified advances, based on a periodic review of advances and after
taking into account the portion of advance guaranteed by the Deposit Insurance and Credit

Guarantee Corporation, the Export Credit and Guarantee Corporation and similar statutory
bodies;
ii) In respect of general advances, as a percentage of total advances taking into account the
guidelines issued by the Government of India and the Reserve Bank of India.

b) Provisions in respect of doubtful advances have been deducted from the advances to
the extent necessary and the excess have been included under “Other Liabilities and
Provisions”.

c) Provisions have been made on a gross basis. Tax relief, which will be available when
the advance is written-off, will be accounted for in the year of write-off.

5) Fixed Assets
a) Premises and other fixed assets have been accounted for at their historical cost.
Premises which have been revealed are accounted for the value determined on the basis of such
revaluation made by the professional values; profit arising on revaluation has been credited to
Capital Reserve.

b) Depreciation has been provided for on the straight line/diminishing balance method.

c) In respect of revalue assets, depreciation is provided for on the revalue figures and an
amount equal to the additional depreciation consequent of revaluation is transferred annually
from the Capital Reserve to the General Reserve / Profit and Loss Account.

6) Staff Benefits
Provisions for gratuity / pension benefits to staff have been made on an accrual / casual basis.
Separate funds for gratuity / pension have been created.

7) Net Profit
a) The net profit disclosed in the Profit and Loss Account is after:

i) provisions for taxes on income, in accordance with the statutory requirements.

ii) provisions for doubtful advances.
iii) adjustments to the value of “current investments” in Government and other approved
securities in India, valued at lower of cost or market value.
iv) transfers to contingency funds.
v) other usual or necessary provisions.

b) Contingency funds have been grouped in the Balance Sheet under the head
“Other Liabilities and Provisions”.

Some important transactions

Rebate on Bills Discounted:

Rebate on Bills Discounted is the Discount income not earned by the bank of discounting off
the Bill of the Bill as it get mature after the closing date of its accounting year.

Journal entries :
i) On discounting of Bill

Bills Discounted and purchased A/c Dr (with its full value) To Customer’s Account (with the
proceeds value)
To Discount A/c (with the amount of Discount earned during the year) To Rebate on Bills
Discounted (with the amount of unearned Discount)

‘Rebate on Bills Discounted’ appears on Liabilities side of

Balance sheet under – “other liabilities and provisions” (schedule-5) as it is the income received
in advance.

ii) At the beginning of Accounting year entry will be Rebate on

Bills Discounted A/c Dr.
To Discount A/c (with the amount of unearned Discount)

Acceptance Endorsement and other obligations

The Bank accepts or encloses a bill on behalf of its customers who has raised loan or made
purchases on credit basis and a customer deposit equal amount of security into the bank. On
maturity bank pays amount to the party on behalf of its customer and at the same time claims
same amount from its customer. It is shown under the heading ‘contingent Liabilities’
(Schedule -12)

Bills for collection

Many bank customers usually handover bills receivables to the bank for the purpose of its
collection on maturity when the bills get mature, bank credit the amount to the respective
client’s account. The ‘Bills for collection’ is shown at the foot of the Balance sheet.

Provisions and contingencies

There is no separate schedule given by the Banking Regulation Act, 1949 regarding provisions
and contingencies but it is shown in the profit and loss account under the heading ‘Provisions
and contingencies’. It includes provisions for bad and doubtful debts, Provision for income tax
provisions for Rebate on bills discounted and such other required provisions and contingencies.
It is included in schedule – 5 ‘other liabilities and provisions’ with sub- heading – IV – others”.

ACCOUNTS OF INSURANCE COMPANIES

Introduction

The business of Insurance in India is governed by The Insurance Act, 1938 along with the
regulations framed by Insurance Regulations and Development Authorities Act, 1999 (IRDA)

Insurance is an agreement or contract of indemnity between ‘insurer’ and ‘insured’. Insurer is

one party agrees to provide protection against loss or damage in the form of promise to pay for
such loss to other party known as ‘insured’ in consideration for a
fixed sum of money known as ‘premium’. The terms and conditions of such insurance contract
in the written is called ‘Insurance Policy’.
Insurance are of the types –
I) Life Insurance
II) General Insurance
a) Fire insurance
b) Marine insurance
c) Miscellaneous insurance

Life insurance business

In case of Life Insurance, the insurer guarantees to pay a certain sum of money to the assured
on completing a stipulated period or in the event of the death to his legal representative. It
covers risks and gives protection for the investment. Section 2(II) of the Insurance Act, 1938
has defined ‘Life Insurance Business” as the business of effecting. Contracts of
insurance upon human life, including any contract whereby the payment of money is assured
on death or the happening of any contingency dependent on human life, and any contract which
is subject to payment of premiums for a term dependent on human life and shall be deemed to
include

a) The granting of disability and double or triple indemnity accident benefits, if so

provided in the contract of insurance;
b) The granting of annuities upon human life; and
c) The granting of superannuation allowances and annuities

payable out of any fund applicable solely to the relief and maintenance of person engaged or
who have been engaged in any particular profession, trade or employment or of the dependents
of such persons.

Statutory books and subsidiory books

A] Statutory Books –
The Insurance Act, 1938, requires the following books to be maintained by all insurance
company –
I. Register of Policies – It contains all the details in respect of each policy such as name
and address of the policy holder, the date when the policy was effected and a record of any
assignment of the policy.
II. Register of claims – All the particulars of claims are recorded – date of claim, name
and address of claimant, the date on which the claim was discharged, the case of a claim which
is rejected and reasons for rejection.
III. Register of agents – It contains all the information of licensed insurance agents such as
name and address of the agent, date of appointment, etc.
B] Subsidiary books –
Apart from statutory books, the insurance companies also maintain the following books

I. Ledgers – Life insurance Fund ledger; revenue ledger and miscellaneous ledger
II. Cash books – Receipts cash books and expenditure cash books.
III. Journal – Journal for recording transactional relating to outstanding premium and
claims and inter-departmental transfer.
IV. First year premium book
V. Renewal premium book
VI. Surrender policy book

Some important terms

I. Whole life policy –

Policy under which, amount of policy is received only when the insured expired.
II. Endowment policy –
Amount of policy received by the insured either he/she reaches certain age or expired
whichever is earlier.

III. With profit policies -

Policy holder is entitled to share in profit of insurer along with the guaranteed amount payable
on maturity
Without profit policies –

On maturity policy holder received only fixed sum of money stated in the policy
. Bonus –
The share of profit enjoyed by insured is called bonus –
a) ‘Reversionary bonus’ is one which is paid only on maturity of the policy along with
guaranteed amount.
b) ‘Bonus in cash’ is paid immediately
c) ‘Bonus in reduction of premium’ is normally adjusted by policy holder against the
future premium due from him.
d) ‘Interim bonus’ is paid on maturity of policy before deciding the exact profit amount

Premium –
First year’s premium is the premium paid for the first year of the life insurance policy and
premium paid for the subsequent year is termed as renewal premium. Single
premium is the total of all the premiums amount, paid by the policy holder once at the
initiation of policy period

Surrender value –
It is the amount which is life insurance company agrees to pay when policy holder
discontinue to pay further premium and surrender the policy.

Claims –
It is the amount payable by an insurer against the policy either on maturity (known as claim by
maturity or survivance) or on the death of the policy holder (known as claim by death).

Re-insurance –
Re-insurance is the transfer of part of risk by the insurance company on another insurance
company. When the insurance company find it difficult to carry risk involves huge amount, it
makes an arrangement for reinsurance by giving away a part of its business to another company
(known as accepting company or re-insurance) and receives commission from accepting
company

Annuities –
The insurance company agrees to pay a fixed sum of money at regular intervals of time to the
policy holder during a specified period in return for a lump sum paid in advance known as
annuities

Preparation of financial statements

The financial statement of the life insurance companies consist of Revenue account, Profit &
loss account and Balance sheet. These statements to be prepared in accordance with the
provisions of IRDA (Preparation of Financial Statements and Auditors’ Report of Insurance
Companies) Regulations, 2002 and comply with the requirements of schedule ‘A’. The Insurer
needs to prepare Revenue A/C in form A-RA; profit & loss A/C inform A-PL and Balance
sheet in form A-BS.

The Revenue account contains total 4 schedules- schedule1– Premium; schedule 2-

Commission expenses; Schedule 3-Operating expenses and schedule 4 – Benefits paid. It also
shows the items having no specific schedule such as Income from Investments, Interim bonus
paid; Provision for doubtful debts; tax and such other provisions. The bottom section of
Revenue account exhibits appropriators of surplus such as transfer to shareholders accounts,
transfer to other reserves, etc. The remaining balance of revenue account is transferred to life
Insurance Fund account.
The profit and loss account shown all expenses and income not directly related to Insurance
business

The Balance Sheet of like insurance companies are prepared in ‘vertical form’ having too
sections – sources of fund and application of fund. The schedule 5,6 and 7 deals with sources
of fund and schedule 8 to schedule 15 shows the application of Fund. The contingent liabilities
is disclosed as part of financial statement by way of notes to Balance Sheet.

FROM A-RA
Name of the Insurer:
Registration No. and Date of Registration with the India:

Revenue Account for the year ended 31 st March,201 Policyholder’s Account (Technical
account)

Particulars sche dule Current Year (RS’000) Previous Year (Rs’000)

Premiums earned – net
(a) Premium 1
(b) Re-insurance ceded
(c) Re-insurance accepted
Income from investments
(a) Interest, Dividends and Rent –Gross
(b) Profit on sale / redemption of Investments
(c) (Loss on sale / redemption of Investments)
(d) Transfer / Gain on
revaluation /change in fair value*

Other Income (to be specified)

Total (A)
Commission 2
Operating Expenses related to Insurance Business 3
Provision for doubtful debts
Bad debts written off
Provision for taxation
Provision (other than taxation)
(a) For diminution in the value of investment (Net)
(b) Other (to be specified)
Total (B)
Benefits Paid (Net) 4
Interim Bonuses Paid
Change in valuation of liability in respect of life policies
(a) Gross**
(b) Amount ceded in Reinsurance
(c) Amount accepted in Reinsurance
Total (c)
Surplus / (Deficit( (D) = (A) - (B) - (C)
Appropriations
Transfer to Shareholders’ Accounts
Transfer to other Reserves (to be specified)
Balance being Funds for Future appropriations
Total (D)

Notes:
* Represents the deemed realized gain as per norms specified by the authority.
** Represents Mathematical Reserves after allocation of bonus. The total surplus shall be
disclosed separately with the following details:
a) Interim bonuses Paid;
b) Allocation of Bonus to Policyholders;
c) Surplus shown in the Revenue Account;
d) Total Surplus [(a) + (b) + (c)].
See Notes appended at the end of Form A-PL.

FROM A-PL

Name of the Insurer:

Registration No. and Date of Registration with the IRDA: Profit and Loss Account for the year
ended 31stMarch, 20.. Shareholders’ Account (Non-technical Account)

Particulars Scheduled Current Year (RS’000) Previous Year (Rs’000)

Amounts transferred from /to

the Policyholders’ Account (Technical account)

Income from investments
(a) Interest, dividends and Rent – Gross
(b) Profit on sale /redemption of Investments
(c) (Loss on sale/ redemption on Investments)
Other income (to be specified)
Total (A)
Expenses other than those directly related to the insurece business
Bad debts written off
Provisions (other than taxation)
(a) For diminution in the value of investments (Net)
(b) Provisions for doubtful debts
(c) Others (to be specified)
Total (B)
Profit / (Loss) before tax

Provision for Taxation

Profit / (Loss) after tax
Appropriations
(a) Balance at the beginning
of the year
(b) Interim dividends paid
during the year
(c) Proposed final dividend
(d) Dividend distribution on tax
(e) Transfer to reserves/ other accounts (to be specified)
Profit carried… to the Balance Sheet

Notes to Form A-RA and A-PL:

(a) Premium income received from business concluded in and outside India shall be
separately disclosed.
(b) Reinsurance premiums whether on business ceded or accepted are to be brought into
account gross (i.e. before deducting commissions) under the head reinsurance
premiums.
(c) Claims incurred shall comprise claims paid, specific claims settlement costs wherever
applicable and change in the outstanding provision for claims at the year end.
(d) Items of expenses and income in excess of one per cent of the total premiums (less re-
insurance) or Rs. 5,00,000 whichever is higher, shall be shown as a separate line item.
(e) Fees and expenses connected with claims shall be included in claims.
(f) Under the sub-head “Others” shall be included items like foreign exchange gains or
losses and other items.
(g) Interest, dividends and rentals receivable in connection with an investment should be
stated as gross amount, the amount of income-tax deducted at source being included under
“advance taxes paid and taxes deducted at source”.
(h) Income from rent shall include only the realized rent. It shall not include any notional
rent.

FORM A-BS

Name of the Insurer:

Registration No. and Date of Registration with the IRDA:

Balance Sheet as at 31 st March, 20 …

Particulars schedule Current Year (RS’000) Previous Year (Rs’000)

SOURCES OF FUNDS
Shareholders’ Funds:
Share Capital 5
Reserves and Surplus 6
Credit/ [Debit] Fair Value Change Account
Sub total
Borrowings 7
Policyholders’ Funds:
Credit/ [Debit] Fair Value Change Account
Policy Liabilities
Insurance Reserves
Provision for Linked Liabilities
Sub Total
Funds for Future Appropriations
Total
APPLICATION OF FUNDS
Investments
Shareholders’ 8

Policyholders’ 8a
Assets Held to Cover Linked Liabilities 8b
Loans 9
Fixed Assets 10
Current Assets
Cash and Bank Balances 11
Advances and other Assets 12
Sub total (A)
Current Liabilities 13
Provisions 14
Sub total (B)
Net Current Assets (C) = (A)-(B)
Miscellaneous Expenditure (to the extent not written off
or adjusted) 15
Debit balance in profit and loss account
(Shareholders ‘Account)
Total

CONTINGENT LIABILITIES

Particulars Current Year (RS’000) Previous Year (Rs’000)

1. Partly paid-up investments

2. Claims, other than against policies, not acknowledge as debts by the company
3. Underwriting commitments outstanding (in
respect of shares and securities)
4. Guarantees given by or on behalf of the company
5. Statutory demands/liabilities in dispute, not
provided for
6. Reinsurance obligations to the extent not
provided for in accounts
7. Others (to be specified)
TOTAL

General insurance business

General Insurance Business is the business other than Life Insurance. It is carried by General
Insurance Corporation of India through its subsidiary companies and many private companies
also involve in General Insurance business.
Section 2(60) of the Insurance Act 1938 has defined ‘General Insurance Business’ as fire,
marine or miscellaneous insurance business, whether carried on singly or in combination with
one or more of them. Fire insurance business means the business of effecting, otherwise than
incidentally to some other class of insurance business, contracts of insurance against loss by or
incidental to fire or other occurrence customarily included among the risks insured against the
fire insurance policies. Marine Insurance Business means the business of effecting contracts of
insurance upon vessels of any descriptions, including cargoes, freights and other interests
which may be legally insured in or in relation to such vessels, cargoes and freights, goods
wares, merchandise and property of whatever description insured for any transit by land or
water, or both and whether or not including warehouse risks or similar risks in addition or
incidental to such transit, and includes any other risks customarily included among the risks
insured against in marine insurance policies.

Some important terms

Reserved for unexpired risk:

General Insurance Policies are taken for one year period and so risk is covered for 12 months
from the date of insurance.The policies are issued throughout the year and remain in force even
after the close for the current financial year and the entire premium for his period is collected
in advance. For e.g. this period is collected in advance. For e.g. a policy is issued on 15 January
200 and it will be in force up to 14 January 2007 so the premium received on such policy covers
partly current year 2005-06 and partly next year 2006-07. the risk may happen on any day
during the lifetime of policy. The premium received on individual policy is
not separated on time basis. Therefore a provision against unexpired risk is made to meet future
claims arises under such policies
Reserves for unexpired risks are laid down as follows.
Fire and miscellaneous business 50% of the premium, net of re-insurance, during the preceding
12 months.
Marine cargo business 50% of the premium, net of re-issue during sthe preceding 12 months.
Marine hull business 100% of the premium, net of re-issue during the preceding 12 months.
However, an insurance company may keep additional reserve if it feels so.

Accounting Treatment
The opening balance of reserve for unexpired risk is credited to revenue account and closing
balance is debited to revenue account.

PREPARATION OF FINANCIAL STATEMENT.

The General insurance company in India prepares its financial statements in accordance with
provision of IRDA regulations, 2002. The financial statements consist of revenue account,
profit and loss account and vertical balance sheet in form B-RA, form B-PL and Form B-BS
respectively’. Revenue accounts for fire, marine and miscellaneous insurance business to be

prepared separately. Revenue account contains schedule-1,schedule-2, schedule-3, and

schedule -4 and given operating profit or loss from insurance business which is transferred to
profit and loss account.

Items not directly related to the insurance business are exhibited in profit and loss account for
e.g. transfer fees, diminution in the value of investment bad debts written-off.
Balance sheet contains source of funds and application of fund. Sources of funds consists of
schedule-5, schedule-6 and schedule-7 and application of funds consist of schedule-8 to
schedule 15. Contingent liabilities are disclosed at the bottom of Balance Sheet.

Form B-BA
Name of the lnsurer:
Registration No. and Date of Registration with the IRDA: Revenue Account for the year ended
31
Particulars schedule Current Year (RS’000) Previous Year (Rs’000)
1. Premiums eamed – net 1
2. Profit /Loss on Sale/Redemption of
Investments
3. Other (to be Specified)
4. Interest, Dividends and Rent - Gross
Total (A)
1. Claims Incurred (Net) 2
2. Commission 3
3. Operating Expenses related to Insurance
Business 4
Total (B)
Operating profit/ (Loss) from Fire / Marine
/Miscellaneous Business C = (A-B)

Appropriations
Transfer to Shareholder Account
Transfer to Catastrophe Reserve
Transfer to other Reserves (to be specified)
Total (c)
Note: See Notes appended at the end of Form B-PL

FORM B-PL
Name of the Insurer
Registration No. and Date of Registration with the IRDA: Profit and Loss Account for the year
ended 31
Particulars schedule Current Year (RS’000) Previous Year (Rs’000)
1. Operating Profit / (Loss)
a) Fire insurance
b) Marine insurance
c) Miscellaneous insurance
2. Income form Investment
Interest, Dividend and Rent – Gross Profit on sale of investments
Less: Loss on sale of investments
3.Other income (to be specified)
Total (A)
4. Provisions (other than taxation)
a) For diminution in the value of investments
b) For doubtful debts

c) Others (to be specified)

a) Expenses other than those related to
insurance business
b) Bad debts written off
c) Others (to be specified)
Total (B)
Profit Before Tax
Provision for Taxation
Appropriations
a) Interim dividend paid during the year
b) Proposed final dividend
c) Dividend distribution tax
d) Transfer to any reserves/ other accounts (to be specified)
Balance of profit/ loss brought forward from last
year
Balance carried forward to Balance Sheet
Notes to Form B-RA and B-PL:
a) Premium income received from business concluded in and outside India shall be
separately disclosed.
b) Reinsurance premiums whether on business ceded or accepted are to be brought into
account gross (i.e. before deducting commissions) under the head reinsurance premiums.
c) Claims incurred shall comprise claims paid, specific claims settlement costs wherever
applicable and change in the outstanding provision for claims at the year end.
d) Items of claims at the year end.
e) Fees and expenses connected with claims shall be included in claims.
f) Under the sub-head “others” shall be included items like foreign gains or losses and
other items.
g) Interest, dividends and rentals receivable in connection with an investment should be
stated as gross amount, the amount of income-tax deducted at source beings included under
‘advance taxes paid and taxes deducted at source”.

h) Income from rent shall include only the realized rent. It shall not include any national
rent.

FROM B-BS
Name of insurer:
Registration No. and Date of Registration with the IRDA: Balance Sheet as at 31st March,
20…

Particulars schedule Current Year (RS’000) Previous Year (Rs’000)

Sources of Funds
Share capital 5
Reserves and surplus 6
Fair value change account
Borrowings 7
Sub Total
Application of Funds
Investments 8
Loans 9
Fixed assets 10
Current assets
Cash and bank balance 11
Advances and other assets 12
Sub Total (A)
Current Liabilities 13
Provisions 14
Sub Total (B)
CONTINGENT LIABILITIES

Particulars Current Year (RS’000) Previous Year (Rs’000)

Partly paid-up investments
Claims, other than against policies, not
acknowledged as debts by the company
Underwriting commitments outstanding (in respect
of shares and securities)
Guarantees given by or on behalf of the company
Statutory demands / liabilities in dispute, not
provided for
Reinsurance obligations to the extent not provided
for in accounts
Others (to be specified)
Total

ELECTRICITY COMPANY

1. DOUBLE ACCOUNTING SYSTEM:

Electricity Company accounts are prepared by following the double accounting system.
Accounts are made on Double Accounting System because a Public Utility company cannot
invest in fixed Assets until & unless it arranges for some long-term liabilities. In other words
such companies cannot use its short-term fund for financing fixed assets. Thus in this system
of accounting the: -
Balance sheet is prepared in two parts i.e.
• Capital account: -
✓ It is a receipt & expenditure on capital account.
✓ Shown in three columns i.e. Opening, During the year, Closing.
✓ Preliminary expenses on formation are treated as capital expenditure.
✓ Premium received on issue of shares or debentures is deducted from the proceeds of the
issue and the proceeds are shown net.
• General Balance-sheet
Profit and loss account in two parts i.e.

• Revenue Account: - Similar to P&L a/c. But it should be noted that depreciation is
debited to this account and credited to Depreciation Reserve and not to asset account.
• Net Revenue Account: - Similar to P&L Appropriation a/c. But it should be noted that
interest on loans & debentures are treated as an appropriation and therefore debited to this
account. This is done because debentures and loans are considered as part of the capital of the
concern.

2. REPLACEMENT ACCOUNTING:

a) Replacement of New Asset

New Asset Account DR (Cash capitalization or Balancing Figure)

Replacement Account DR (Present Value of Old Asset)

To Bank Account (Cash Cost of New Asset or Net Payment)

b) Cost of Auxiliary Assets
Auxiliary Assets account DR

To Bank Account
c) Use of Old Material in Auxiliary Assets Auxiliary Assets account DR
To Replacement account
d) Combined entry for Use of Old material in new asset; Sale of old material; Any balance in
Replacement account transferred to Revenue account
New Asset Account DR (Amount of old Material used in New Asset)

Bank Account DR (Sale of old material)

Revenue Account DR (Balancing figure of Replacement account) To Replacement
Account
Note : - Auxiliary Assets are any abnormal expenditure for repairing any existing Assets. For
Example on a total track of 80 KM, 50 KM is totally replaced but 30 KM is repaired. Thus the
track of 30 KM is called Auxiliary Asset and the track of 50 KM is called New Asset.
3. DISPOSAL OF SURPLUS

Step 1 Computation of Reasonable Return (R.R.)

(RBI rate + 2%) of Capital Base xxxx
Income from investment (Excluding income from investment against contingency Reserve)
xxxx
.05% Of: -
• Debentures xxxx
• Development reserve balance xxxx
• Approved institution borrowings xxxx
• Electricity Board loans xxxx
Reasonable Return xxxx
Less: Clear Profit (i.e. Actual profit after interest & tax) xxxx

Gross Surplus xxxx

Less: Return to customer by rebate in rate xxxx
(Gross surplus – 20% of R.R.)
Gross Adjusted Surplus xxxx

Step 2 Disposal of gross Adjusted Surplus (G.A.S.)

• At company disposal xxxx
(1/3 of GAS or 5% of RR whichever is less)
• Transfer to Tariff & Dividend Control Reserve xxxx
(1/2 of the Balance)
• Transfer to Consumer Benefit Reserve xxxx
(1/2 of the Balance)

xxxx
Notes: -

1. Calculation of Capital Base

• Original cost of fixed assets available for use xxxx
• Cost of intangible assets xxxx
• Original cost of WIP xxxx
• Compulsory investments (contingency reserve) xxxx
• Working capital equal to 1/12th of: -
✓ Book cost of stores, material & supplies at end of each month xxxx
✓ Cash, bank balance, call & short deposits at end of each month xxxx
(Not exceeding in aggregate 1/4th of the expenditure)
LESS
• Depreciation w/o xxxx
• Intangible assets w/o xxxx
• Loans advanced by Board xxxx
• Loans borrowed institutions approved by SG. xxxx
• Debentures issued by the licensee xxxx
• Security deposits held in cash xxxx
• Tariffs & Dividends Control Reserve xxxx
• Development reserve xxxx
• Amount c/f for distribution to consumers xxxx

xxxx

General conclusion above calculation of Capital Base is that in calculation of Capital Base we
take every item except share capital and Investment (other than contingency Reserve
investment)
2. Compulsory transfer to Contingency Reserve
Minimum .25% and maximum .50% of original cost of fixed assets must be transferred to
contingency reserve until it equals 5% of the original cost of fixed assets.
3. 4% of the opening balance of depreciation fund is charged from revenue account and
added to depreciation fund in the balance sheet.
4. If nothing is given about Bank Rate than it is taken as 10%
Clear Profit in Profit and Loss Account of Electricity Company

Clear profit means the difference between the total income and total expenditure plus specific
appropriations. The above two laws define the income, expenditure and appropriations of
electricity company. The provisions are set out below for ready understanding in the form of
an account :

Expenditures Incomes
1. Gross receipts from

1. Cost of generation
and
purchase of energy

2. Cost of distribution and sale of energy

3. Rent, rates and taxes (

Excluding taxes on income or profits)

sale of energy less discounts applicable to sale

2. Rental of meters and other apparatus hired to consumers

3. Sale and repair of lamps and apparatus

4. Intereston loans advanced by the board

5. Interest on security deposits

6. Bad Debts
7. Auditor's fees

8. Management expenses
including remuneration to managing agents
9. Depreciation
10. Other expenses
11. Contribution to provident fund, staff pension, gratuity, apprentice and other
training
schemes
12. Bonus paid to the employees of the undertaking in

4. Rents less outgoings not otherwise provided for

5. Transfer fees

6. Interest from investments, fixed and call deposits and bank balances
7. Other receipts liable for Indian income tax and arising from ancillary or incidental to
the
business of electricity supply.
accordance with the decision of labor tribunal of state govt.
13. Balance Profit C/d

Appropriations

1. All taxes on income

2. Balance being Clear Profit

1. Balance Profit b/d

PRUDENTIAL NORMS ON INCOME RECOGNITION, ASSET CLASSIFICATION AND

PROVISIONING PERTAINING TO ADVANCES-
Basis of Accounting-
• Cash basis
– Actual cash receipts and payments are recorded.
– Credit transactions are not recorded.
• Accrual basis
– The income whether received or not but has been earned or accrued during the period
forms part of the total income of the period.
– The firm has taken benefit of a particular service, but has not paid within that period,
the expenses will relates to the period in which the service has been utilized and not to the
period in which payment for it is made.

3. Income recognition
3.1 Income Recognition Policy
3.1.1 The policy of income recognition has to be objective and based on the record of
recovery. Internationally income from non-performing assets (NPA) is not recognised on

accrual basis but is booked as income only when it is actually received. Therefore, the banks
should not charge and take to income account interest on any NPA. This will apply to
Government guaranteed accounts also.
3.1.2 However, interest on advances against Term Deposits, National Savings Certificates
(NSCs), Indira Vikas Patras (IVPs), Kisan Vikas Patras (KVPs) and Life policies may be taken
to income account on the due date, provided adequate margin is available in the accounts.
3.1.3 Fees and commissions earned by the banks as a result of renegotiations or rescheduling
of outstanding debts should be recognised on an accrual basis over the period of time covered
by the renegotiated or rescheduled extension of credit.
3.2 Reversal of income
3.2.1 If any advance, including bills purchased and discounted, becomes NPA, the entire
interest accrued and credited to income account in the past periods, should be reversed if the
same is not realised. This will apply to Government guaranteed accounts also.
3.2.2 In respect of NPAs, fees, commission and similar income that have accrued should
cease to accrue in the current period and should be reversed with respect to past periods, if
uncollected.
3.2.3 Leased Assets
The finance charge component of finance income [as defined in ‘AS 19 Leases’ issued by the
Council of the Institute of Chartered Accountants of India (ICAI)] on the leased asset which
has accrued and was credited to income account before the asset became non- performing, and
remaining unrealised, should be reversed or provided for in the current accounting period.
3.3 Appropriation of recovery in NPAs
3.3.1 Interest realised on NPAs may be taken to income account provided the credits in the
accounts towards interest are not out of fresh/ additional credit facilities sanctioned to the
borrower concerned.
3.3.2 In the absence of a clear agreement between the bank and the borrower for the purpose
of appropriation of recoveries in NPAs (i.e. towards principal or interest due), banks should
adopt an accounting principle and exercise the right of appropriation of recoveries in a uniform
and consistent manner.
3.4 Interest Application
On an account turning NPA, banks should reverse the interest already charged and not collected
by debiting Profit and Loss account, and stop further application of interest. However, banks
may continue to record such accrued interest in a Memorandum account in their books. For the
purpose of computing Gross Advances, interest recorded in the Memorandum account should
not be taken into account.
3.5 Computation of NPA levels
Banks are advised to compute their Gross Advances, Net Advances, Gross NPAs and Net
NPAs, as per the format in Annex -1.
4. ASSET CLASSIFICATION
4.1 Categories of NPAs
Banks are required to classify nonperforming assets further into the following three categories
based on the period for which the asset has remained nonperforming and the realisability of the
dues:
Substandard Assets Doubtful Assets Loss Assets
4.1.1 Substandard Assets
With effect from March 31, 2005, a substandard asset would be one, which has remained NPA
for a period less than or equal to 12 months. Such an asset will have well defined credit
weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct
possibility that the banks will sustain some loss, if deficiencies are not corrected.
4.1.2 Doubtful Assets

With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in
the substandard category for a period of 12 months. A loan classified as doubtful has all the
weaknesses inherent in assets that were classified as substandard, with the added characteristic
that the weaknesses make collection or liquidation in full, – on the basis of currently known
facts, conditions and values – highly questionable and improbable.

4.1.3 Loss Assets

A loss asset is one where loss has been identified by the bank or internal or external auditors
or the RBI inspection but the amount has not been written off wholly. In other words, such an
asset is considered uncollectible and of such little value that its continuance as a bankable asset
is not warranted although there may be some salvage or recovery value.
4.2 Guidelines for classification of assets

4.2.1 Broadly speaking, classification of assets into above categories should be done taking
into account the degree of well-defined credit weaknesses and the extent of dependence on
collateral security for realisation of dues.
4.2.2 Banks should establish appropriate internal systems (including technology enabled
processes) for proper and timely identification of NPAs, especially in respect of high value
accounts. The banks may fix a minimum cut off point to decide what would constitute a high
value account depending upon their respective business levels. The cut off point should be
valid for the entire accounting year. Responsibility and validation levels for ensuring proper
asset classification may be fixed by the banks. The system should ensure that doubts in asset
classification due to any reason are settled through specified internal channels within one
month from the date on which the account would have been classified as NPA as per extant
guidelines.
4.2.3 Availability of security / net worth of borrower/ guarantor
The availability of security or net worth of borrower/ guarantor should not be taken into account
for the purpose of treating an advance as NPA or otherwise, except to the extent provided in
Para 4.2.9.
4.2.4 Accounts with temporary deficiencies
The classification of an asset as NPA should be based on the record of recovery. Bank should
not classify an advance account as NPA merely due to the existence of some deficiencies which
are temporary in nature such as non-availability of adequate drawing power based on the latest
available stock statement, balance outstanding exceeding the limit temporarily, non-
submission of stock statements and non-renewal of the limits on

the due date, etc. In the matter of classification of accounts with such deficiencies banks may
follow the following guidelines:
i) Banks should ensure that drawings in the working capital accounts are covered by the
adequacy of current assets, since current assets are first appropriated in times of distress.
Drawing power is required to be arrived at based on the stock statement which is current.
However, considering the difficulties of large borrowers, stock statements relied upon by the
banks for determining drawing power should not be older than three months. The outstanding
in the account based on drawing power calculated from stock statements older than three
months, would be deemed as irregular.
A working capital borrowal account will become NPA if such irregular drawings are permitted
in the account for a continuous period of 90 days even though the unit may be working or the
borrower's financial position is satisfactory.
ii) Regular and ad hoc credit limits need to be reviewed/ regularised not later than three
months from the due date/date of ad hoc sanction. In case of constraints such as non--
availability of financial statements and other data from the borrowers, the branch should furnish
evidence to show that renewal/ review of credit limits is already on and would be completed
soon. In any case, delay beyond six months is not considered desirable as a general discipline.
Hence, an account where the regular/ ad hoc credit limits have not been reviewed/ renewed
within 180 days from the due date/ date of ad hoc sanction will be treated as NPA.

4.2.5 Upgradation of loan accounts classified as NPAs

If arrears of interest and principal are paid by the borrower in the case of loan accounts
classified as NPAs, the account should no longer be treated as nonperforming and may be
classified as ‘standard’ accounts. With regard to upgradation of a restructured/ rescheduled
account which is classified as NPA contents of paragraphs 12.2 and 15.2 in the Part B of this
circular will be applicable.

4.2.6 Accounts regularised near about the balance sheet date

The asset classification of borrowal accounts where a solitary or a few credits are recorded
before the balance sheet date should be handled with care and without scope for

subjectivity. Where the account indicates inherent weakness on the basis of the data available,
the account should be deemed as a NPA. In other genuine cases, the banks must furnish
satisfactory evidence to the Statutory Auditors/Inspecting Officers about the manner of
regularisation of the account to eliminate doubts on their performing status.
4.2.7 Asset Classification to be borrower-wise and not facility-wise
i) It is difficult to envisage a situation when only one facility to a borrower/one investment
in any of the securities issued by the borrower becomes a problem credit/investment and not
others. Therefore, all the facilities granted by a bank to a borrower and investment in all the
securities issued by the borrower will have to be treated as NPA/NPI and not the particular
facility/investment or part thereof which has become irregular.
ii) If the debits arising out of devolvement of letters of credit or invoked guarantees are
parked in a separate account, the balance outstanding in that account also should be treated as
a part of the borrower’s principal operating account for the purpose of application of prudential
norms on income recognition, asset classification and provisioning.
iii) The bills discounted under LC favouring a borrower may not be classified as a Non-
performing advance (NPA), when any other facility granted to the borrower is classified as
NPA. However, in case documents under LC are not accepted on presentation or the payment
under the LC is not made on the due date by the LC issuing bank for any reason and the
borrower does not immediately make good the amount disbursed as a result of discounting of
concerned bills, the outstanding bills discounted will immediately be classified as NPA with
effect from the date when the other facilities had been classified as NPA.
iv) Derivative Contracts
a) The overdue receivables representing positive mark-to-market value of a derivative
contract will be treated as a non-performing asset, if these remain unpaid for 90 days or more.
In case the overdues arising from forward contracts and plain vanilla swaps and options become
NPAs, all other funded facilities granted to the client shall also be classified as non-performing
asset following the principle of borrower-wise classification as per the existing asset
classification norms. However, any amount, representing positive mark-to-market value of the
foreign exchange derivative contracts (other than forward
contract and plain vanilla swaps and options) that were entered into during the period April
2007 to June 2008, which has already crystallised or might crystallise in future and is / becomes
receivable from the client, should be parked in a separate account maintained in the name of
the client / counterparty. This amount, even if overdue for a period of 90 days or more, will not
make other funded facilities provided to the client, NPA on account of the principle of
borrower-wise asset classification, though such receivable overdue for 90 days or more shall
itself be classified as NPA, as per the extant Income Recognition and Asset Classification
(IRAC) norms. The classification of all other assets of such clients will, however, continue to
be governed by the extant IRAC norms.
b) If the client concerned is also a borrower of the bank enjoying a Cash Credit or
Overdraft facility from the bank, the receivables mentioned at item (iv) (a) above may be
debited to that account on due date and the impact of its non-payment would be reflected in the
cash credit / overdraft facility account. The principle of borrower-wise asset classification
would be applicable here also, as per extant norms.
c) In cases where the contract provides for settlement of the current mark-to-market value
of a derivative contract before its maturity, only the current credit exposure (not the potential
future exposure) will be classified as a non-performing asset after an overdue period of 90 days.
d) As the overdue receivables mentioned above would represent unrealised income
already booked by the bank on accrual basis, after 90 days of overdue period, the amount
already taken to 'Profit and Loss a/c' should be reversed, and held in a ‘Suspense Account-
Crystalised Receivables’ in the same manner as done in the case of overdue advances.
e) Further, in cases where the derivative contracts provides for more settlements in future,
the MTM value will comprise of (a) crystallised receivables and (b) positive or negative MTM
in respect of future receivables. If the derivative contract is not terminated on the overdue
receivable remaining unpaid for 90 days, in addition to reversing the crystallised receivable
from Profit and Loss Account as stipulated in para (d) above, the positive MTM pertaining to
future receivables may also be reversed from Profit and Loss Account to another account styled
as ‘Suspense Account – Positive MTM’. The subsequent positive changes in the MTM value
may be credited to the ‘Suspense Account – Positive MTM’, not to P&L Account. The
subsequent decline in MTM value may be adjusted

against the balance in ‘Suspense Account – Positive MTM’. If the balance in this account is
not sufficient, the remaining amount may be debited to the P&L Account. On payment of the
overdues in cash, the balance in the ‘Suspense Account-Crystalised Receivables’ may be
transferred to the ‘Profit and Loss Account’, to the extent payment is received.
f) If the bank has other derivative exposures on the borrower, it follows that the MTMs
of other derivative exposures should also be dealt with / accounted for in the manner as
described in para (e) above, subsequent to the crystalised/settlement amount in respect of a
particular derivative transaction being treated as NPA.
g) Since the legal position regarding bilateral netting is not unambiguously clear,
receivables and payables from/to the same counterparty including that relating to a single
derivative contract should not be netted.
h) Similarly, in case a fund-based credit facility extended to a borrower is classified as
NPA, the MTMs of all the derivative exposures should be treated in the manner discussed
above.
4.2.8 Advances under consortium arrangements
Asset classification of accounts under consortium should be based on the record of recovery of
the individual member banks and other aspects having a bearing on the recoverability of the
advances. Where the remittances by the borrower under consortium lending arrangements are
pooled with one bank and/or where the bank receiving remittances is not parting with the share
of other member banks, the account will be treated as not serviced in the books of the other
member banks and therefore, be treated as NPA. The banks participating in the consortium
should, therefore, arrange to get their share of recovery transferred from the lead bank or get
an express consent from the lead bank for the transfer of their share of recovery, to ensure
proper asset classification in their respective books.
4.2.9 Accounts where there is erosion in the value of security/frauds committed by borrowers
In respect of accounts where there are potential threats for recovery on account of erosion in
the value of security or non-availability of security and existence of other factors such as frauds
committed by borrowers it will not be prudent that such accounts should go through various
stages of asset classification. In cases of such serious credit impairment the asset should be
straightaway classified as doubtful or loss asset as appropriate:

Erosion in the value of security can be reckoned as significant when the realisable value of the
security is less than 50 per cent of the value assessed by the bank or accepted by RBI at the
time of last inspection, as the case may be. Such NPAs may be straightaway classified under
doubtful category and provisioning should be made as applicable to doubtful assets.
If the realisable value of the security, as assessed by the bank/ approved valuers/ RBI is less
than 10 per cent of the outstanding in the borrowal accounts, the existence of security should
be ignored and the asset should be straightaway classified as loss asset. It may be either written
off or fully provided for by the bank.
4.2.10 Advances to Primary Agricultural Credit Societies (PACS)/Farmers’ Service Societies
(FSS) ceded to Commercial Banks
In respect of agricultural advances as well as advances for other purposes granted by banks to
PACS/ FSS under the on-lending system, only that particular credit facility granted to PACS/
FSS which is in default for a period of two crop seasons in case of short duration crops and one
crop season in case of long duration crops, as the case may be, after it has become due will be
classified as NPA and not all the credit facilities sanctioned to a PACS/ FSS. The other direct
loans & advances, if any, granted by the bank to the member borrower of a PACS/ FSS outside
the on-lending arrangement will become NPA even if one of the credit facilities granted to the
same borrower becomes NPA.
4.2.11 Advances against Term Deposits, NSCs, KVPs/IVPs, etc.
Advances against term deposits, NSCs eligible for surrender, IVPs, KVPs and life policies need
not be treated as NPAs, provided adequate margin is available in the accounts. Advances
against gold ornaments, government securities and all other securities are not covered by this
exemption.
4.2.12 Loans with moratorium for payment of interest
In the case of bank finance given for industrial projects or for agricultural plantations etc. where
moratorium is available for payment of interest, payment of interest becomes 'due' only after
the moratorium or gestation period is over. Therefore, such amounts of interest do not become
overdue and hence do not become NPA, with reference to the date of debit of interest. They
become overdue after due date for payment of interest, if uncollected.

In the case of housing loan or similar advances granted to staff members where interest is
payable after recovery of principal, interest need not be considered as overdue from the first
quarter onwards. Such loans/advances should be classified as NPA only when there is a default
in repayment of instalment of principal or payment of interest on the respective due dates.

4.2.13 Agricultural advances

A loan granted for short duration crops will be treated as NPA, if the instalment of principal or
interest thereon remains overdue for two crop seasons. A loan granted for long duration crops
will be treated as NPA, if the instalment of principal or interest thereon remains overdue for
one crop season. For the purpose of these guidelines, “long duration” crops would be crops
with crop season longer than one year and crops, which are not “long duration” crops, would
be treated as “short duration” crops. The crop season for each crop, which means the period up
to harvesting of the crops raised, would be as determined by the State Level Bankers’
Committee in each State. Depending upon the duration of crops raised by an agriculturist, the
above NPA norms would also be made applicable to agricultural term loans availed of by him.
The above norms should be made applicable to all direct agricultural advances as listed at
paragraph III (1.1) of the Circular on Priority Sector Lending – Targets and Classification
RPCD.CO.Plan.BC.9/04.09.01/2013-14 dated July 1, 2013. An extract of the list of these items
is furnished in the Annex - 2. In respect of agricultural loans, other than those specified in the
Annex - 2 and term loans given to non-agriculturists, identification of NPAs would be done on
the same basis as non-agricultural advances, which, at present, is the 90 days delinquency
norm.
Where natural calamities impair the repaying capacity of agricultural borrowers, banks may
decide on their own as a relief measure conversion of the short-term production loan into a
term loan or re-schedulement of the repayment period; and the sanctioning of fresh short-term
loan, subject to guidelines contained in RBI circular RPCD. No.PLFS.BC.6/05.04.02/2013-14
dated July 1, 2013.
In such cases of conversion or re-schedulement, the term loan as well as fresh short-term loan
may be treated as current dues and need not be classified as NPA. The asset classification of
these loans would thereafter be governed by the revised terms &

conditions and would be treated as NPA if interest and/or instalment of principal remains
overdue for two crop seasons for short duration crops and for one crop season for long duration
crops. For the purpose of these guidelines, "long duration" crops would be crops with crop
season longer than one year and crops, which are not 'long duration" would be treated as "short
duration" crops.
While fixing the repayment schedule in case of rural housing advances granted to agriculturists
under Indira Awas Yojana and Golden Jubilee Rural Housing Finance Scheme, banks should
ensure that the interest/instalment payable on such advances are linked to crop cycles.
4.2.14 Government guaranteed advances
The credit facilities backed by guarantee of the Central Government though overdue may be
treated as NPA only when the Government repudiates its guarantee when invoked. This
exemption from classification of Government guaranteed advances as NPA is not for the
purpose of recognition of income. The requirement of invocation of guarantee has been
delinked for deciding the asset classification and provisioning requirements in respect of State
Government guaranteed exposures. With effect from the year ending March 31, 2006 State
Government guaranteed advances and investments in State Government guaranteed securities
would attract asset classification and provisioning norms if interest and/or principal or any
other amount due to the bank remains overdue for more than 90 days.
4.2.15 Projects under implementation
4.2.15.1 For all projects financed by the FIs/ banks after May 28, 2002, the ‘Date of
Completion’ and the ‘Date of Commencement of Commercial Operations’ (DCCO), of the
project should be clearly spelt out at the time of financial closure of the project and the same
should be formally documented. These should also be documented in the appraisal note by the
bank during sanction of the loan.
4.2.15.2 Project Loans
There are occasions when the completion of projects is delayed for legal and other extraneous
reasons like delays in Government approvals etc. All these factors, which are beyond the
control of the promoters, may lead to delay in project implementation and involve restructuring
/ reschedulement of loans by banks. Accordingly, the following

asset classification norms would apply to the project loans before commencement of
commercial operations.
For this purpose, all project loans have been divided into the following two categories:
(a) Project Loans for infrastructure sector
(b) Project Loans for non-infrastructure sector
For the purpose of these guidelines, 'Project Loan' would mean any term loan which has been
extended for the purpose of setting up of an economic venture. Further, Infrastructure Sector
is a sector as defined in extant RBI circular on 'Definition of Infrastructure Lending'.
4.2.15.3 Project Loans for Infrastructure Sector
(i) A loan for an infrastructure project will be classified as NPA during any time before
commencement of commercial operations as per record of recovery (90 days overdue), unless
it is restructured and becomes eligible for classification as 'standard asset' in terms of paras (iii)
to (v) below.
(ii) A loan for an infrastructure project will be classified as NPA if it fails to commence
commercial operations within two years from the original DCCO, even if it is regular as per
record of recovery, unless it is restructured and becomes eligible for classification as 'standard
asset' in terms of paras (iii) to (v) below.
(iii) If a project loan classified as 'standard asset' is restructured any time during the period
up to two years from the original date of commencement of commercial operations (DCCO),
in accordance with the provisions of Part B of this Master Circular, it can be retained as a
standard asset if the fresh DCCO is fixed within the following limits, and further provided the
account continues to be serviced as per the restructured terms.
(a) Infrastructure Projects involving court cases Up to another 2 years
(beyond the existing extended period of 2 years, as prescribed in para 4.2.15.3 (ii), i.e., total
extension of 4 years), in case the reason for extension of date of commencement of production
is arbitration proceedings or a court case.
(b) Infrastructure Projects delayed for other reasons beyond the control of promoters Up to
another 1 year (beyond the existing extended period of 2 years, as prescribed in para 4.2.15.3
(ii), i.e., total extension of 3 years), in other than court cases.
(iv) It is re-iterated that the dispensation in para 4.2.15.3 (iii) is subject to adherence to the
provisions regarding restructuring of accounts as contained in the Master Circular

which would inter alia require that the application for restructuring should be received before
the expiry of period of two years from the original DCCO and when the account is still standard
as per record of recovery. The other conditions applicable would be:
a. In cases where there is moratorium for payment of interest, banks should not book
income on accrual basis beyond two years from the original DCCO, considering the high risk
involved in such restructured accounts.
b. Banks should maintain following provisions on such accounts as long as these are
classified as standard assets in addition to provision for diminution in fair value due to
extension of DCCO:
Particulars Provisioning Requirement
If the revised DCCO is within two years from the original DCCO prescribed at the time
of financial closure
0.40 per cent

If the DCCO is extended beyond two years and upto four years or three years from the
original DCCO, as the case may be, depending upon the reasons for
such delay Project loans restructured with effect from June 1, 2013:
5.00 per cent – From the date of such restructuring till the revised DCCO or 2 years from the
date of restructuring, whichever is later
Stock of project loans classified as restructured as on June 1, 2013:
* 3.50 per cent - with effect from March 31, 2014 (spread over the four quarters
of 2013-14)
* 4.25 per cent - with effect from March 31, 2015 (spread over the four quarters
of 2014-15)
* 5.00 per cent - - with effect from March 31, 2016 (spread over the four quarters
of 2015-16) The above provisions will be applicable from the date of restructuring till the
revised DCCO or 2 years
from the date of restructuring, whichever is later.
(v) For the purpose of these guidelines, mere extension of DCCO would not be considered
as restructuring, if the revised DCCO falls within the period of two years from

the original DCCO. In such cases the consequential shift in repayment period by equal or
shorter duration (including the start date and end date of revised repayment schedule) than the
extension of DCCO would also not be considered as restructuring provided all other terms and
conditions of the loan remain unchanged. As such project loans will be treated as standard
assets in all respects, they will attract standard asset provision of 0.40 per cent.
(vi) In case of infrastructure projects under implementation, where Appointed Date (as
defined in the concession agreement) is shifted due to the inability of the Concession Authority
to comply with the requisite conditions, change in date of commencement of commercial
operations (DCCO) need not be treated as ‘restructuring’, subject to following conditions:
a) The project is an infrastructure project under public private partnership model awarded
by a public authority;
b) The loan disbursement is yet to begin;
c) The revised date of commencement of commercial operations is documented by way
of a supplementary agreement between the borrower and lender and;
d) Project viability has been reassessed and sanction from appropriate authority has been
obtained at the time of supplementary agreement.
4.2.15.4 Project Loans for Non-Infrastructure Sector (Other than Commercial Real
Estate Exposures)
(i) A loan for a non-infrastructure project will be classified as NPA during any time before
commencement of commercial operations as per record of recovery (90 days overdue), unless
it is restructured and becomes eligible for classification as 'standard asset' in terms of paras (iii)
to (iv) below.
(ii) A loan for a non-infrastructure project will be classified as NPA if it fails to commence
commercial operations within one year from the original DCCO, even if is regular as per record
of recovery, unless it is restructured and becomes eligible for classification as 'standard asset'
in terms of paras (iii) to (iv) below.
(iii) In case of non-infrastructure projects, if the delay in commencement of commercial
operations extends beyond the period of one year from the date of completion as determined at
the time of financial closure, banks can prescribe a fresh DCCO, and retain the "standard"
classification by undertaking restructuring of accounts in accordance with

the provisions contained in this Master Circular, provided the fresh DCCO does not extend
beyond a period of two years from the original DCCO. This would among others also imply
that the restructuring application is received before the expiry of one year from the original
DCCO, and when the account is still "standard" as per the record of recovery. The other
conditions applicable would be:
a. In cases where there is moratorium for payment of interest, banks should not book
income on accrual basis beyond one year from the original DCCO, considering the high risk
involved in such restructured accounts.
b. Banks should maintain following provisions on such accounts as long as these are
classified as standard assets apart from provision for diminution in fair value due to extension
of DCCO:
Particulars Provisioning Requirement
If the revised DCCO is within one year from the original DCCO prescribed at the time of
financial closure
0.40 per cent
If the DCCO is extended beyond one year and upto two years from the original DCCO
prescribed at the time of financial closure Project loans restructured with effect from June
1, 2013:
5.00 per cent – From the date of restructuring for 2 years
Stock of Project loans classified as restructured before June 01, 2013:
* 3.50 per cent - with effect from March 31, 2014 (spread over the four quarters of
2013-14)
* 4.25 per cent - with effect from March 31, 2015 (spread over the four quarters of
2014-15)
* 5.00 per cent - with effect from March 31, 2016 (spread over the four quarters of
2015-16) The above provisions will be applicable from the date of restructuring for 2 years.
(iv) For the purpose of these guidelines, mere extension of DCCO would not be considered
as restructuring, if the revised DCCO falls within the period of one year from

the original DCCO. In such cases the consequential shift in repayment period by equal or
shorter duration (including the start date and end date of revised repayment schedule) than the
extension of DCCO would also not be considered as restructuring provided all other terms and
conditions of the loan remain unchanged. As such project loans will be treated as standard
assets in all respects; they will attract standard asset provision of 0.40 per cent.
4.2.15.5 Other Issues
(i) All other aspects of restructuring of project loans before commencement of commercial
operations would be governed by the provisions of Part B of this Master Circular on Prudential
norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances.
Restructuring of project loans after commencement of commercial operations will also be
governed by these instructions.
(ii) Any change in the repayment schedule of a project loan caused due to an increase in
the project outlay on account of increase in scope and size of the project, would not be treated
as restructuring if:
(a) The increase in scope and size of the project takes place before commencement of
commercial operations of the existing project.
(b) The rise in cost excluding any cost-overrun in respect of the original project is 25% or
more of the original outlay.
(c) The bank re-assesses the viability of the project before approving the enhancement of
scope and fixing a fresh DCCO.
(d) On re-rating, (if already rated) the new rating is not below the previous rating by more
than one notch.
(iii) Project Loans for Commercial Real Estate
It has been represented that commercial real estate (CRE) projects also face problems of delays
in achieving the DCCO for extraneous reasons. Therefore, it has been decided that for CRE
projects mere extension of DCCO would not be considered as restructuring, if the revised
DCCO falls within the period of one year from the original DCCO and there is no change in
other terms and conditions except possible shift of the repayment schedule and servicing of the
loan by equal or shorter duration compared to the period by which DCCO has been extended.
Such CRE project loans will be treated as standard assets in all respects for this purpose without
attracting the higher provisioning applicable for

restructured standard assets. However, as stated in paragraph 15.1 of this circular, the asset
classification benefit would not be available to CRE projects if they are restructured.
(iv) Multiple revisions of the DCCO and consequential shift in repayment schedule for
equal or shorter duration (including the start date and end date of revised repayment schedule)
will be treated as a single event of restructuring provided that the revised DCCO is fixed within
the respective time limits stipulated at paragraphs 4.2.15.3 (iii) and
4.2.15.4 (iii) above, and all other terms and conditions of the loan remained unchanged.
(v) Banks, if deemed fit, may extend DCCO beyond the respective time limits stipulated at
paragraphs 4.2.15.3 (iii) and 4.2.15.4 (iii) above; however, in that case, banks will not be able
to retain the ‘standard’ asset classification status of such loan accounts.
(vi) In all the above cases of restructuring where regulatory forbearance has been extended,
the Boards of banks should satisfy themselves about the viability of the project and the
restructuring plan.
4.2.15.6 Income recognition
(i) Banks may recognise income on accrual basis in respect of the projects under
implementation, which are classified as ‘standard’.
(ii) Banks should not recognise income on accrual basis in respect of the projects under
implementation which are classified as a ‘substandard’ asset. Banks may recognise income in
such accounts only on realisation on cash basis.
Consequently, banks which have wrongly recognised income in the past should reverse the
interest if it was recognised as income during the current year or make a provision for an
equivalent amount if it was recognised as income in the previous year(s). As regards the
regulatory treatment of ‘funded interest’ recognised as income and ‘conversion into equity,
debentures or any other instrument’ banks should adopt the following:
a) Funded Interest: Income recognition in respect of the NPAs, regardless of whether these
are or are not subjected to restructuring/ rescheduling/ renegotiation of terms of the loan
agreement, should be done strictly on cash basis, only on realisation and not if the amount of
interest overdue has been funded. If, however, the amount of funded interest is recognised as
income, a provision for an equal amount should also be made simultaneously. In other words,
any funding of interest in respect of NPAs, if recognised as income, should be fully provided
for.

b) Conversion into equity, debentures or any other instrument: The amount outstanding
converted into other instruments would normally comprise principal and the interest
components. If the amount of interest dues is converted into equity or any other instrument,
and income is recognised in consequence, full provision should be made for the amount of
income so recognised to offset the effect of such income recognition. Such provision would be
in addition to the amount of provision that may be necessary for the depreciation in the value
of the equity or other instruments, as per the investment valuation norms. However, if the
conversion of interest is into equity which is quoted, interest income can be recognised at
market value of equity, as on the date of conversion, not exceeding the amount of interest
converted to equity. Such equity must thereafter be classified in the “available for sale”
category and valued at lower of cost or market value. In case of conversion of principal and /or
interest in respect of NPAs into debentures, such debentures should be treated as NPA, ab
initio, in the same asset classification as was applicable to loan just before conversion and
provision made as per norms. This norm would also apply to zero coupon bonds or other
instruments which seek to defer the liability of the issuer. On such debentures, income should
be recognised only on realisation basis. The income in respect of unrealised interest which is
converted into debentures or any other fixed maturity instrument should be recognised only on
redemption of such instrument. Subject to the above, the equity shares or other instruments
arising from conversion of the principal amount of loan would also be subject to the usual
prudential valuation norms as applicable to such instruments.
4.2.16 Takeout Finance
Takeout finance is the product emerging in the context of the funding of long-term
infrastructure projects. Under this arrangement, the institution/the bank financing infrastructure
projects will have an arrangement with any financial institution for transferring to the latter the
outstanding in respect of such financing in their books on a predetermined basis. In view of the
time-lag involved in taking-over, the possibility of a default in the meantime cannot be ruled
out. The norms of asset classification will have to be followed by the concerned bank/financial
institution in whose books the account stands as balance sheet item as on the relevant date. If
the lending institution observes that the asset has turned NPA on the basis of the record of
recovery, it should be classified accordingly. The lending institution should not recognise
income on accrual basis and

account for the same only when it is paid by the borrower/ taking over institution (if the
arrangement so provides). However, the taking over institution, on taking over such assets,
should make provisions treating the account as NPA from the actual date of it becoming NPA
even though the account was not in its books as on that date.
4.2.17 Post-shipment Supplier's Credit
In respect of post-shipment credit extended by the banks covering export of goods to countries
for which the Export Credit Guarantee Corporation’s (ECGC) cover is available, EXIM Bank
has introduced a guarantee-cum-refinance programme whereby, in the event of default, EXIM
Bank will pay the guaranteed amount to the bank within a period of 30 days from the day the
bank invokes the guarantee after the exporter has filed claim with ECGC.
Accordingly, to the extent payment has been received from the EXIM Bank, the advance may
not be treated as a nonperforming asset for asset classification and provisioning purposes.
4.2.18 Export Project Finance
In respect of export project finance, there could be instances where the actual importer has paid
the dues to the bank abroad but the bank in turn is unable to remit the amount due to political
developments such as war, strife, UN embargo, etc.
In such cases, where the lending bank is able to establish through documentary evidence that
the importer has cleared the dues in full by depositing the amount in the bank abroad before it
turned into NPA in the books of the bank, but the importer's country is not allowing the funds
to be remitted due to political or other reasons, the asset classification may be made after a
period of one year from the date the amount was deposited by the importer in the bank abroad.
4.2.19 Advances under rehabilitation approved by Board for Industrial and Financial
Reconstruction (BIFR)/Term Lending Institutions (TLIs)
Banks are not permitted to upgrade the classification of any advance in respect of which the
terms have been renegotiated unless the package of renegotiated terms has worked
satisfactorily for a period of one year. While the existing credit facilities sanctioned to a unit
under rehabilitation packages approved by BIFR/TLIs will continue to be classified as
substandard or doubtful as the case may be, in respect of additional facilities sanctioned under
the rehabilitation packages, the Income Recognition, Asset

Classification norms will become applicable after a period of one year from the date of
disbursement.
4.2.20 Transactions Involving Transfer of Assets through Direct Assignment of Cash Flows
and the Underlying Securities
i) Originating Bank: The asset classification and provisioning rules in respect of the
exposure representing the Minimum Retention Requirement (MRR) of the Originator of the
asset would be as under:
a) The originating bank may maintain a consolidated account of the amount representing
MRR if the loans transferred are retail loans. In such a case, the consolidated amount receivable
in amortisation of the MRR and its periodicity should be clearly established and the overdue
status of the MRR should be determined with reference to repayment of such amount.
Alternatively, the originating bank may continue to maintain borrower-wise accounts for the
proportionate amounts retained in respect of those accounts. In such a case, the overdue status
of the individual loan accounts should be determined with reference to repayment received in
each account.
b) In the case of transfer of a pool of loans other than retail loans, the originator should
maintain borrower-wise accounts for the proportionate amounts retained in respect of each
loan. In such a case, the overdue status of the individual loan accounts should be determined
with reference to repayment received in each account.
c) If the originating bank acts as a servicing agent of the assignee bank for the loans
transferred, it would know the overdue status of loans transferred which should form the basis
of classification of the entire MRR/individual loans representing MRR as NPA in the books of
the originating bank, depending upon the method of accounting followed as explained in para
(a) and (b) above.
ii) Purchasing Bank: In purchase of pools of retail and non-retail loans, income
recognition, asset classification and provisioning norms for the purchasing bank will be
applicable based on individual obligors and not based on portfolio. Banks should not apply the
asset classification, income recognition and provisioning norms at portfolio level, as such
treatment is likely to weaken the credit supervision due to its inability to detect and address
weaknesses in individual accounts in a timely manner. If the purchasing bank is not maintaining
the individual obligor-wise accounts for the portfolio of loans purchased, it should have an
alternative mechanism to ensure application of

prudential norms on individual obligor basis, especially the classification of the amounts
corresponding to the obligors which need to be treated as NPAs as per existing prudential
norms. One such mechanism could be to seek monthly statements containing account- wise
details from the servicing agent to facilitate classification of the portfolio into different asset
classification categories. Such details should be certified by the authorized officials of the
servicing agent. Bank’s concurrent auditors, internal auditors and statutory auditors should also
conduct checks of these portfolios with reference to the basic records maintained by the
servicing agent. The servicing agreement should provide for such verifications by the auditors
of the purchasing bank. All relevant information and audit reports should be available for
verification by the Inspecting Officials of RBI during the Annual Financial Inspections of the
purchasing banks.
iii) The guidelines prescribed above at 4.2.20 (i) & (ii) do not apply to
(a) Transfer of loan accounts of borrowers by a bank to other bank/FIs/NBFCs and vice
versa, at the request/instance of borrower;
(b) Inter-bank participations;
(c) Trading in bonds;
(d) Sale of entire portfolio of assets consequent upon a decision to exit the line of business
completely. Such a decision should have the approval of Board of Directors of the bank;
(e) Consortium and syndication arrangements and arrangement under Corporate Debt
Restructuring mechanism;
(f) Any other arrangement/transactions, specifically exempted by the Reserve Bank of
India.
4.2.21 Credit Card Accounts
(i) In credit card accounts, the amount spent is billed to the card users through a monthly
statement with a definite due date for repayment. Banks give an option to the card users to pay
either the full amount or a fraction of it, i.e., minimum amount due, on the due date and roll-
over the balance amount to the subsequent months’ billing cycle.
(ii) A credit card account will be treated as non-performing asset if the minimum amount
due, as mentioned in the statement, is not paid fully within 90 days from the next statement
date. The gap between two statements should not be more than a month.
(iii) Banks should follow this uniform method of determining over-due status for credit card
accounts while reporting to credit information companies and for the purpose of levying of
penal charges, viz. late payment charges, etc., if any.
 Valuation of Goodwill
Meaning of Goodwill
Goodwill is an intangible but real asset. It is not a fictitious asset. Sometimes, it is more valuable
than a tangible asset. It is the value of good name and reputation of a business house which brings
in the customers, as a result of which the business is expected to earn in future higher return on
its capital employed as compared to normal level of return in the same class of business.
In technical language it may be defined as the present value of firm's anticipated excess earnings.
The words "excess earnings" imply the rate of return on tangible assets and intangible assets other
than goodwill over and above the normal rate of return earned by respective firms in the same
industry. In his "A Dictionary for Accountants". Kohler defines goodwill as "the current value of
expected future income in excess of a normal return on the investment in net tangible assets."

Features of Goodwill
Following are the special features of goodwill:

(i) It is an intangible asset.

(ii) It is a real and not a fictitious asset.

(iii) It cannot be sold in isolation. Except on admission and retirement of a partner, goodwill is
valuable only when the entire business is sold.

(iv) It is valuable only if it is capable of being transferred from one person to another.

(v) It is difficult to place an exact cost of goodwill

(Vi) Valuation of goodwill is based on the subjective judgement of the valuer.

Reasons for arising Goodwill

As stated earlier, the main reason for arising goodwill is firm's expectation of higher earnings in
future and this expectation is influenced by a number of causes which are as follows:

1 Personality of owner, his integrity, ability and behavior.

2. Managerial superiority, i.e., active, intelligent, dynamic and forward-looking management.

3. Managerial attitude towards fulfilment of commitments (e.g., timely delivery of goods, timely
payment to creditors, delivery of goods at committed prices etc.).

4. Efficiency, integrity and faithfulness of employees.

5. Long-term arrangement of availability of technical knowhow of high degree.

6. Reputation of goods sold or services rendered and their reasonable price.

7. Good labor relations.

8. Favorable location of business premises and effective advertisement.

9. Possession of special advantages, such as patents, trademarks, copyrights, agencies and

monopoly.

10. Special business gains, e.g., regular supply of raw materials and components, low rate and
assured supply of electricity, favorable long-term sale contracts, import license etc.

11. Adequate financial resources and good credit worthiness

12. After sales services.

Need for Valuation of Goodwill

Need for valuation of goodwill may be in the following circumstances:

(A) In the case of a company:

(i) When two or more companies are amalgamated.

(ii) When a company absorbs the other.

(iii) When a company is desirous of acquiring controlling interest in another company.

(IV) When the business of the company is sold or taken over by the Government.

(v) When stock exchange quotations are not available and shares have to be valued for
estate

(vi) When shares of one class are being converted into shares of other class.

(Vii) when the company has previously written off goodwill and now it wants to write it
back in order to wipe off or reduce the debit balance in the profit and loss account.

(B) In the case of a partnership firm:

(i) On admission of a partner.

(ii) On retirement of a partner.

(iii) On death of a partner.

(iv) On change in the profit-sharing ratio among the partners.

(v) On sale of business by a firm.

(vi) On amalgamation of two or more firms.

(vii) On conversion of partnership into a company.

(C) In the case of a sole trader:

(i) On death of the owner for wealth tax purpose.

(ii) On sale of business.

(iii) On admitting somebody as a partner in the business.

(iv) On amalgamation of two sole trade businesses for making a partnership firm.

Main factors affecting the value of Goodwill

The main determinants of the value of goodwill of a business are as follows:

(1) Profitability of business.

(2) Income expectations of investors.

(3) Capital employed in the business.

(4) Other factors

(4) Profitability of Business: Future profitability of the business is the chief factor in the
valuation of goodwill Future profitability implies assessment of the quantity of future
maintainable profits of the concern. Greater the amount of such profits, higher will be the
goodwill of the business. Future maintainable profits of a business concern are assessed on
the basis of its past profits, they’re markedly rising or falling tendency and expected
developments.

(A) Profits of past years: Profits of past years of the business concern is the most
important basis for estimating the profits expected to be earned by the concern. While
calculating the past profits, the following points should be duly considered:

(i) All usual working expenses including interest to debenture holders and depreciation of
assets should be provided for

(ii) All necessary provisions including provision for taxation should be made. But no
appropriation of profit should be made, such as transfer to general reserve, dividend
equalization fund or sinking fund for redemption of liabilities etc.

If non-trading assets have been excluded from capital employed then the income derived
from such assets should also be excluded.

(iv) Average of the profits of four or five years is more reliable than a single year's profit. If
results of any year in the past have been affected by certain exceptional events such as
 earthquake, flood etc. then results of such exceptional year should be excluded in the
calculation of average profit.

(v) In determining the profit of each year, extra-ordinary and non-recurring incomes or
expenses should be excluded.

(vi) In case assets have been revalued or shown at their replacement cost then
depreciation should be calculated on their revised values.

(B) Markedly rising or falling profits: If the profits over the past years have been continuously
falling or rising in a marked manner then average profit should be calculated by weighted
average basis instead of simple average, attaching more importance to the profits of the
last year and least importance to the profits of the first year. For example, if profits of
1998, 1999, 2000 and 2001 are given and they are showing continuous rise then they can
respectively be attached weights of 1, 2, 3 and 4 for calculating average profits. If,
however, there is continuous and marked decline in profits then profits for the future
should be estimated on the basis of the trend - they will be lower than the profits for the
latest year.

(C) Expected developments: If development expenditures in the undertaking are

significant then the average profit of past years should be adjusted for the likely fruits in
future of such expenditure in order to arrive at the future maintainable profit.

(2) Yield Expected by Investors: In the valuation of goodwill, the second main factor is the
income expectation of investors on their investments. In fact, expectations of investors
determine the normal level of profits or normal rate of return. This rate is determined on
the basis of prevalent price-earnings ratio of shares of other companies of similar nature in
the same industry. On increase in income-expectation rate of investors, goodwill decreases
and goodwill increases on decrease in this rate. This expectation is affected by the
following factors

(i) The degree of business and financial risk in the investment - Higher the risk, higher will
be the income expectation rate of investors.

(ii) The period of investment - Longer the period, higher the income expectation rate.

(iii) The bank rate-An increase in the bank rate will lead to an increase in income-
expectation rate and on decrease, the rate decreases.

(iv) Business cycle - During boom period, investors' income expectation rate increases and
during depression, this rate decreases.

(v) The general economic and political situation - Stable economic and political situation in
the country leads to decrease in investors' income-expectation rate. In case investors'
confidence is shaken in the economic and political stability, there will be a sharp rise in this
rate.

(3) Capital Employed: This is the third important factor in the valuation of goodwill, since
the size of profits is significant only in relation to the capital used to earn it. Capital
employed generally implies net fixed assets plus net current assets and non-trading assets
(e.g., investment of spare funds in government securities) are excluded. This may also be
expressed as aggregate of share capital, reserves and surplus and long-term loans

The aforesaid idea of capital employed is not suitable for the valuation of goodwill of a
company since the advantage of goodwill accrues to shareholders only. Hence, the amount
of debentures and other loans should not be included in capital employed. Here, it is
important to note that profit considered for valuation of goodwill should also be after
interest on debentures and loans. Again, as profits are expressed at current values, it is
proper that fixed assets are shown at their current prices.

In brief, capital employed may be calculated by either of the following two approaches:

1 Assets side approach:

Rs. Assets (other than goodwill, fictitious

assets, such as preliminary

expenses, discount etc. and trading losses) at market value

Less Liabilities to outside parties (such as creditors, bills payable,

debentures, taxation, outstanding bills, loans etc.) at revised values, if any

Capital Employed

2. Liabilities side approach:

Share Capital

Add Reserves, profits and gains on revaluation of assets and liabilities

Less Fictitious assets, goodwill, trading losses and losses on revaluation of assets and
liabilities Capital Employed

Note: Some authors are of the view that capital employed should be calculated on the
basis COSE or assets. If this view is followed then it will be essential to adjust depreciation
on the basis replacement cost of the assets.

Average Capital Employed

A refinement to the above approach of capital employed is that the figure of capital
employed should be the average for the year concerned since this figure changes during
the year at least because of the profit. The average capital employed is calculated as
follows:

(1) Average capital employed may be calculated by taking the mean of the capital
employed at the end of the year and that employed in the beginning of the year, i.e.,
opening capital employed plus closing capital employed divided by two.
(2) As, except for fresh capital, capital employed increases over a year mainly due to profits
earned, hence average capital employed can be found out by deducting half the profit of
the year from the capital employed at the end of the year or by adding half of the profits of
the year to the capital employed in the beginning of the year. This approach is based on
the assumption that profits have been earned evenly over the year (hence by the middle of
the year half the profits were earned and so used in the business) and that the profits have
not yet been distributed.

If proposed dividend appears in the balance sheet of the company, this amount should be
treated as part of profits for this purpose. If the business concern pays advance income-tax
then the amount of income-tax will also be deducted from the profit of the year and
adjustment will be made for half of the profit after tax.

(4) Other Factors: Besides the above mentioned three main factors, the following factors
also affect the value of goodwill:

(A) Personal Skill in Management: If higher profits in the business are due to personal skill
and reputation of its management and owners, goodwill cannot be valued at a high figure
if the services of old management and owners are not to be available.

(B) Nature of Business: If there are effective barriers for the new firms to enter into that
business, the goodwill of existing firms will be high by the mere fact of their existence.
Similarly, if the firm deals in articles or services of continuous demand, its goodwill will be
higher as compared to a firm which deals in articles of fashion or public fancy (e.g., jeans).

(C) Favorable Location: A favorable location plays a significant role in assessing the value of
goodwill.

(D) Easy availability of raw materials and trained labor: If the firm enjoys favorable position
regarding regular supply of materials and trained labor its goodwill will be high (E) Useful
life of patents and trade mark: A firm possessing valuable patent rights for long-term use
will have valuable goodwill. Similarly, if the firm has built up good reputation for its
products by means of a trademark or if the firm has copyrights of publishing the works of
renounced authors, its goodwill is likely to go up.

(F) Political and Government Protection: The value of goodwill of those firms will be high
which enjoy political and/or government protection.

(G) Capital Requirements: If the capital required is large considering the profits likely to be
available, the value of goodwill will be small. Conversely, if the capital required is relatively
small and the business is highly profitable, the value of goodwill will be higher.

(H) Specific Contracts: Exceptionally favorable contracts for supply of goods or services to
the customers will raise the value of goodwill. But if it is unlikely that such contracts will be
obtained in future, the value of goodwill will not be influenced by such existing contracts.

Methods of Valuation of Goodwill

Following are the methods of valuation of goodwill!

1 Average Profit Method.

2. Super Profit Method.

3. Capitalization of Profit Method.

Average Profit Method Under this method, goodwill is valued at an agreed number of
years' purchase (normally two or three years and this is purely arbitrary) of the average
annual profits of three to five past years. Average annual profit is calculated by aggregating
the amounts of profit or loss of specified years and then dividing this aggregate by the
number of years.

In arriving at the annual profits, all income and expenditure of extra-ordinary and non-
recurring nature should be excluded. Similarly, expenses and losses expected to be borne
in future are deducted and all profits likely to come in future are added to such profits.
Where the profits of the concern are progressively rising or falling, it is better to calculate
the average annual profits by means of a weighted average instead of a simple average.
Alternatively, simple average of past profits may be adjusted considering the trend of the
business.

Merits of Average Profit Method

1 This is a simple method and free from mathematical complexities.

2. Since under this method average profit is calculated on the basis of results of past
several years, it is possible to know the true earning capacity of the business.

Demerits of Average Profit Method

1 This method ignores the amount of capital employed for earning the profit. In fact, the
amount of profit of a business concern is relevant only in reference to capital used to earn
it.

2. There can be no any concrete basis of ascertaining the number of past years on the basis
of which average profit is to be calculated.

3. There is no scientific basis of ascertaining the number of years' purchase of profits.

4. It is wrong to make total profits of business as the base for valuation of goodwill. If fact
goodwill is attached to profits over and above the normal profits. Hence, every rupee of
profit earned does not accrue goodwill. Due to this very defect this method is not popular
in business world. However, this method is usually adopted for valuing the goodwill of the
professional persons or firms such as chartered accountants or doctors.
Super Profit Method
Under this method, super profits (or excess earnings) of the business concern are taken as
a basis of computing the value of goodwill. The super profits of a business are the excess of
actual average profit of the business over its normal profit, i.e...

Super Profit- Actual Average Profit-Normal Profit

Actual average profit implies estimated future annual profit or future maintainable profit
of the business concern. For this purpose, the amount of average normal profits of past
few years is adjusted with reference to future expectations. Normal profit is calculated by
multiplying the firm's average capital employed (or net capital employed) with normal rate
of return for representative firms in the industry. The normal rate of return is that rate of
earning which investors in general expect on their investments having regard to the
prevailing rates of interest and the business and financial risks associated with the
investment. This rate is usually given in the problem but if it is not given, the students
should solve the problem assuming a normal rate of return basing his judgment on the
merit of each case,

For example, estimated future annual profit of a firm are Rs. 1.50,000 and capital
employed in it is Rs. 8.00.000. If normal rate of return in that business is 10% then the
super profit will be 1.50.000 10% of 800.000 = Rs. 70.000 and this figure will be taken as
the basis of computation of goodwill.

Here, it is important to remember that if the amount of super profit is zero or a negative
figure, the value of goodwill will be considered zero.
 Valuation of shares and goodwill
Meaning of Goodwill:

Goodwill may be described as the aggregate of those

intangible attributes of a business which contributes to

its superior earning capacity over a normal return on

investment. It may arise from such attributes as

favorable locations, the ability and skill of its

employees and management, quality of its products and

services, customer satisfaction etc.

Some definitions of goodwill are:

1. According to SSAP-22, UK Accounting Standard on

Accounting for Goodwill, “Goodwill is the difference

between the value of a business as a whole and the

aggregate of the fair values of its separable net

assets.”
2. If time value of money is taken into account, goodwill

may be defined as the present value of the firm’s

anticipated excess earnings.

3. “Goodwill is nothing more than the profitability that

the old customers will resort to the old place.” —Lord

Eldon

4. According to Lord Macraughton “Goodwill is a thing

very easy to describe, very difficult to define. It is

the benefit and advantage of good name, reputation

and connection of a business. It is the attractive force

which brings in customers. It is one thing which

distinguishes an old established business from a new

business at its start.”

Features of Goodwill:
The following are the features of goodwill:

1. Goodwill is an intangible asset. It is non-visible but it

is not a fictitious asset.

2. It cannot be separated from the business and

therefore cannot be sold like other identifiable and

separable assets, without disposing off the business as

a whole.

3. The value of goodwill has no relation to the amount

invested or cost incurred in order to build it.

4. Valuation of goodwill is subjective and is highly

dependent on the judgment of the valuer.

5. Goodwill is subject to fluctuations. The value of

goodwill may fluctuate widely according to internal and

external factors of business.

Types of Goodwill:
Goodwill is generally of two types:

(a) Purchased goodwill; and

(b) Non-Purchased or Inherent goodwill.

(а) Purchased Goodwill: Purchased goodwill arises

when a business concern is purchased and the purchase

consideration paid exceeds the fair value of the

separable net assets acquired. The purchased goodwill

is shown on the assets side of the Balance sheet. Para

36 of AS-10 ‘Accounting for fixed assets’ states that

only purchased goodwill should be recognized in the

books of accounts.

(b) Non-Purchased Goodwill/Inherent Goodwill:

Inherent goodwill is the value of business in excess of

the fair value of its separable net assets. It is

referred to as internally generated goodwill and it

arises over a period of time due to good reputation of a

business. The value of goodwill may be positive or

negative. Positive goodwill arises when the value of

business as a whole is more than the fair value of its

net assets. It is negative when the value of the

business is less than the value of its net assets.

Factors Affecting Goodwill:
The important factors that give rise to goodwill are as

follows:

1. Outstanding quality of products/services.

2. Locational factors—if a business is located at a

favorable place; it enhances the value of goodwill.

3. The period for which the business has been in

business.

4. Special advantages—A company that enjoys special

advantages such as favorable contracts, assured supply

of raw material at low rates, possession of trademarks,

patents, copyrights, technical knowhow and research

and development, well known collaborators etc.

contribute to higher value of goodwill.

5. Nature of Business—a business having stable

continuous demand for its products such as consumer

goods is able to earn more profits and hence has more

goodwill. If the business is risky, profits will be

uncertain. The monopoly condition or limited

competition enables the enterprise to earn higher

profits which leads to higher value of goodwill.

6. Good relations with customers, suppliers, labour and

government.

7. Efficiency of Management— a firm having efficient

management enjoys advantages of high productivity and

cost of efficiency. This leads to higher profits which in

turn increases the value of goodwill.

8. Capital required— if two businesses have same rate

of profit, the business which requires lesser amount of

capital tends to enjoy more goodwill.

Accounting for Goodwill:
The various ways in which goodwill can be accounted

for are as follows:

(a) Carry it as an asset and write it off over a period of

years through the profit and loss account.

(b) Write it off against profits or accumulated

reserves immediately.

(c) Retain it as an asset with no write-off unless a

permanent diminution in value becomes evident.

(d) Show it as a deduction from shareholders’ funds

which may be authorized carried forward indefinitely.

In this connection, it is important to state that

goodwill should be recognized and recorded in business

only when some consideration in money or money’s

worth has been paid for it.

Need for Valuation of Goodwill:
Valuation of goodwill may be made due to any one of

the following reasons:

(a) In the Case of a Sole-Proprietorship Firm:

If the firm is sold to another person;

If it takes any person as a partner and

If it is converted into a company.

(b) In the Case of a Partnership Firm:

If any new partner is taken;

If any old partner retires from the firm;

If there is any change in profit-sharing ratio

among the partners;

If any partner dies;

If different partnership firms are amalgamated;

If any firm is sold;

If any firm is converted into a company.

(c) In the Case of a Company:

If the goodwill has already been written-off in the

past but value of the same is to be recorded

further in the books of accounts.

If an existing company is being taken with or

amalgamated with another existing company;

If the Stock Exchange Quotation of the value of

shares of the company is not available in order to

compute gift tax, wealth tax etc.; and

If the shares are valued on the basis of intrinsic

values, market value or fair value methods.

Methods of Valuing Goodwill:

Years’ Purchase of Average Profit Method:

Under this method, average profit of the last few

years is multiplied by one or more number of years

in order to ascertain the value of goodwill of the

firm. How many years’ profit should be taken for

calculating average and the said average should be

multiplied by how many number of years — both

depend on the opinions of the parties concerned.

The average profit which is multiplied by the

number of years for ascertaining the value of

goodwill is known as Years’ Purchase. It is also

called Purchase of Past Profit Method or

Average Profit Basis Method:

Average Profit = Total Profits for all the

years/Number of years

Value of Goodwill = Average Profit × Years’ Purchase.

Illustration 1: Sumana, Suparna and Aparna are

partners in a firm. They share profits and losses in the

ratio of 3: 2: 1. The partnership deed provides that, on

the retirement of a partner, Goodwill shall be

calculated on the basis of 5 years’ purchase of the

average net profits of the preceding 8 years. Aparna

retires from the business on 31.12.1993.

The net profits for the last 8 years are as follows:

1996 Rs. 6,000; 1997 Rs. 12,000; 1998 Rs. 20,000;

1999 Rs. 16,000; 2000 Rs. 25,000; 2001 Rs. 30,000;

2002 Rs. 36,000; 2003 Rs. 31,000.

Compute the Goodwill of the firm which is payable to

Aparna.

Solution:
Average profit of the last 8 years:

= Rs. 22,000
Total value of Goodwill = Rs. 22,000 × 5 = Rs. 1, 10,000

Aparna’s share of Goodwill Rs. 1, 10,000 × 1/6 = Rs.

18,333 Say, Rs. 18,300

Years’ Purchase of Weighted Average

Method:

This method is the modified version of Years’

Purchase of Average Profit Method. Under this

method, each and every year’s profit should be

multiplied by the respective number of weights,

e.g. 1, 2, 3 etc., in order to find out the value of

product which is again to be divided by the total

number of weights for ascertaining the weighted

average profit. Therefore, the weighted average

profit is multiplied by the years’ purchase in order

to ascertain the value of goodwill. This method is

particularly applicable where the trend of profit is

rising.
Weighted Average Profit = Total Profits for all the

years/Number of years

Value of Goodwill = Weighted Average Profit x Years’

Purchase.

Illustration 2: X Y, Z Co. Ltd intends to purchase the

business of ABC & Co. Ltd. Goodwill in the purpose is

agreed to be valued at 13 years’ purchase of the

weighted average profits of the past 4 years.

The appropriate weights to be:

2003 — 1

2004 — 2

2005 — 3

2006 — 4

The profits in these years were 2003 Rs. 30,900; 2004

Rs. 45,400; 2005 Rs. 35,700; and 2006 Rs. 48,000.

The following information was available:

(i) On 1.9.2004 a major repair was made in respect of a

Plant at a cost of Rs. 8,000 and this was charged to

revenue. The said sum is agreed to be capitalized for

Goodwill calculation subject to adjustment of

Depreciation of 10% p.a. on Diminishing Balance

Method.

(ii) The Closing Stock for the year 2005 was

overvalued by Rs. 3,000.

(iii) To cover the Management cost an annual charge of

Rs. 10,000 should be made for the purpose of Goodwill

valuation.

You are asked to compute the value of Goodwill of the

company.
 Capitalisation Method: Under this method, the

value of the entire business is determined on the

basis of normal profit. Goodwill is taken as the

difference between the Values of the Business

minus Net Tangible Assets. Under this method,

the following steps should be taken into

consideration for ascertaining the amount of

goodwill:

(i) Expected Average Net Profit should be ascertained;

(ii) Capitalised value of profit is to be calculated on the

basis of normal rate of return;

(iii) Net Tangible Assets (i.e. Total Tangible Assets –

Current Liabilities) should also be calculated;

(iv)To be deducted : (iii) from (ii) in order to ascertain

the value of Goodwill.

Capitalised Value of Profit = Profit (Adjusted)/Normal

Rate of Return × 100

Value of Goodwill = Capitalised Value of Profit – Net

Tangible Assets.

Illustration 3:
The following is the Balance Sheet of P. Ltd as at

31.12.1999:

The profits of the past four years (before providing

for taxation) were:

1996 Rs. 20,000; 1997 Rs. 30,000; 1998 Rs. 36,000 and

1999 Rs. 40,000.

Compute the value of Goodwill of the company assuming

that the normal rate of return for this type of

company is 10%. Income Tax is payable @ 50% on the

above profits.

Super-Profit Method: Super-profit represents

the difference between the average profit earned

 by the business and the normal profit (on this

basis of normal rate of return for representative

firms in the industry) i.e., the firm’s anticipated

excess earnings. As such, if there is no

anticipated excess earning over normal earnings,

there will be no goodwill.

This method for calculating goodwill depends on:

(i) Normal rate of return of the representative firms:

(ii) Value of Capital Employed /Average Capital

Employed; and

(iii) Estimated future profit, i.e. the average profit of

the last few years.

Super-Profit = Average Profit (Adjusted) – Normal

Profit

Value of Goodwill = Super -Profit X Years’ Purchase

The students should remember that the number of

years’ purchase of goodwill differs from firm to firm

and industry to industry. Also that one or two years’

purchase should be taken into consideration if the

retiring partner of a business was the main source of

success. It should also be remembered that three to

five years’ purchase is usually taken. Of course, a large

number of years’ purchase may be considered if the

super-profit itself is found to be large. If there is a

declining trend in super-profit, one or two years’

purchase may be considered.

Illustration 5:
State with reasons whether the following statement is

correct or not: X and Y’s financial position is as under:

Illustration 6: The following is the Balance sheet of

Mithu Ltd as on 31.12.2005:

Illustration 7: The Balance sheet of ABC Co. Ltd

disclosed the following financial position as at

31.12.2005:
Illustration 8:
From the following information, compute the Goodwill

of the firm XYZ Co. Ltd on the basis of four years’

purchase of the average Super-Profits on a 10% yield

basis:
As per the Articles of Association of this private

company, its Directors have declared and paid

dividends to its members in the month of December

each year out of the profit of the related year.

The cost of the Goodwill to the company was Rs. 5,

00,000. Capital employed at the beginning of the year

2003 was Rs. 19, 30,000 including the cost of Goodwill

and balance in Profit and Loss Account at the same

time was Rs. 60,000.

 Valuation of shares
Meaning:

The share capital is the most important requirement of

a business. It is divided into a ‘number of indivisible

units of a fixed amount. These units are known as

‘shares’.

According to Section 2 (46) of the Companies Act,

1956, a share is a share in the share capital of a

company, and includes stock except where a distinction

stock and shares is expressed or implied. The person

who is the owner of the shares is called ‘Shareholder’

and the return he gets on his investment is called

‘Dividend’.

Example: Total capital of a company is? 5, 00,000

divided in to 50,000 shares of Rs. 10 each, each unit of

Rs. 10 is called share. In this case there are 50,000

units i.e. shares of Rs. 10 each and the capital is Rs. 5,

00,000.

Nature of Shares:
 The shares of company are movable property and

are transferable in the manner provided in the

Articles of Association.

 A share is undoubtedly a movable property in the

same way in which a bale of cloth or a bag of

wheat is a movable property. Such commodities are

not brought in to existence by legislation but a

share in a company belongs to a totally different

category of property.

 It is incorporeal in nature and it consists merely

of a bundle of rights and obligations.

Factors Affecting the Value of Shares:
The value of a share is greatly affected by the

economic, political and social factors such as:

The nature of the company’s business

The economic conditions of the country

Other political and economic factors (e.g.,

possibility of nationalization, excise duty on goods

produced etc.)

The demand and supply of shares

Proportion of liabilities and capital

Rate of proposed dividend and past profit of the

company

Yield of other related shares of the Stock

Exchange etc.
Need for Share Valuation:
The necessity for valuation of a share arises in the

following circumstances:

a) For Estate Duty and Wealth Tax purposes

b) For Amalgamation and Absorption schemes

c) For Gift Tax purposes

d) For discharge of debts and liabilities, in

exceptional nature

e) Purchasing shares for control

f) For selling shares of a shareholder to a purchaser

(which are not quoted in the Stock Exchange)

g) For the conversion of one class of share to another

class

h) For the compensation made to a company when the

said company is being nationalized

 i) For granting loans on the basis of security of

shares (i.e. when the shares are held as security,

etc.).

Methods of Share Valuation:

The valuation of Shares may broadly be classified

as:

Asset-Backing Method:

Since the valuation is made on the basis of the assets

of the company, it is known as Asset-Basis or Asset-

Backing Method} At the same time, the shares are

valued on the basis of real internal value of the assets

of the company and that is why the method is also

termed as Intrinsic Value Method or Real Value Basis

Method.

This method may be made either:

(i) On a going/continuing concern basis; and

(ii) break-up value basis.

In the case of the former, the utility of the assets is

to be considering for the purpose of arriving at the

value of the assets, but, in the case of the latter, the

relisable value of the assets is to be taken.

Under this method, value of the net assets of the

company is to be determined first. Thereafter, the net

assets are to be divided by the number of shares in

order to find out the value of each share. At the same

time, value of goodwill (at its market value), investment

(non-trading assets) are to be added with net assets.

Similarly, if there are any preference shares, those

are also to be deducted with their arrear dividends

from the net assets.

Alternatively —

Net Assets = Share Capital + Reserves and Surplus –

Miscellaneous Expenditure + Profit on Revaluation –

Loss on Revaluation.

Applicability of the Method:

(i) The permanent investors determine the value of

shares under this method at the time of purchasing the

shares;
(ii) The method is particularly applicable when the

shares are valued at the time of Amalgamation,

Absorption and Liquidation of companies; and

(iii) This method is also applicable when shares are

acquired for control motives.

Illustration 1:

From the following Balance Sheet of Sweetex Ltd

you are asked to ascertain the value of each Equity

share of the company:

I. Yield-Basis Method:

Yield is the effective rate of return on investments

which is invested by the investors. It is always

expressed in terms of percentage. Since the valuation

of shares is made on the basis of Yield, it is called

Yield-Basis Method. For example, an investor purchases

one share of Rs. 100 each (face value and paid-up value)

at Rs. 150 from a Stock Exchange on which he receives

a return (dividend) @ 20%.

In that case, yield of the said investor will be:

Note:

Practically, yield may also be termed as:

Expected Yield, Normal Rate of Return/Earning, Rate

of Fair Return, Rate of General Expectations,

Estimated Rate for Capitalisation etc.

Under Yield-Basis method, valuation of shares is made

on (i) Profit Basis; (ii) Dividend Basis.

(i) Profit Basis:

Under this method, at first, profit should be

ascertained on the basis of past average profit.

Thereafter, capitalized value of profit is to be

determined on the basis of normal rate of return, and,

the same (capitalized value of profit) is divided by the

number of shares in order to find out the value of each

share.

The following procedure may be adopted:

Here, profit means and includes Future Maintainable

Profit, i.e., the rate of profit which is expected to be

earned in future. “It is to be remembered that the

analysis of profit that is made in order to determine

future annual maintainable profit must seek a profit

that is capable of distribution as dividend.”— Yorston,

Smyth and Brown, Advance Accounting.

Illustration 2:

Two companies, A Ltd and B. Ltd, are found to be

exactly similar as to their assets, reserves and

liabilities except that their share capital structures

are different.

The share capital of A. Ltd is Rs. 11,00,000, divided

into 1,000, 6% Preference Shares of Rs. 100 each and

1,00,000 Equity Shares of Rs. 10 each.

The share capital of B. Ltd is also Rs. 11,00,000,

divided into 1,000, 6% Preference Shares of Rs. 100

each and 1,00,000 Equity Shares of Rs. 10 each.

The fair yield in respect of the Equity Shares of this

type of companies is ascertained at 8%.

The profits of the two companies for 1993 and 1994

are found to be Rs. 1,10,000 and Rs. 1,50,000,

respectively.

Calculate the value of the Equity Shares of each of

these two companies on 31.12.1993 on the basis of this

information only. Ignore taxation.

(ii) Dividend Basis:

Valuation of shares may be made either (a) on the basis

of total amount of dividend, or (b) on the basis of

percentage or rate of dividend.

(a) On the basis of total amount of Dividend:

(b) On the basis of percentage or Rate of Dividend:

Whether Profit Basis or Dividend Basis method is

followed for ascertaining the value of shares depends

on the shares that are held by the respective

shareholders. In other words, the shareholder holding

minimum number of shares (i.e., minority holding) may

determine the value of his shares on dividend basis

since he has to satisfy himself having the rate of

dividend which is recommended by the Board of

Directors, i.e., he has no such power to control the

affairs of the company. On the contrary, the

shareholders holding maximum number of shares (i.e.,

majority holding) has got more controlling rights over

the affairs of the company including the

recommendation for the rate of dividend among others.

Under the circumstances, valuation of shares should be

made on profit basis.

In short, Profit Basis should be followed in the case of

Majority Holding and Dividend Basis should be followed

in the case of Minority Holding.

The same principle may be represented in the

following form:
Illustration 3:

On December 31, 2003 the Balance Sheet of

MAKALI Ltd disclosed the following position:

On which 20% was placed to Reserve, this proportion

being considered reasonable in the industry in which

the company is engaged and where a fair investment

return may be taken at 10%.

Compute the value of the company’s share under yield-

basis method.
II. Fair Value Method:
There are some accountants who do not prefer to use

Intrinsic Value or Yield Value for ascertaining the

correct value of shares. They, however, prescribe the

Fair Value Method which is the mean of Intrinsic Value

and Yield Value method and the same provides a better

indication about the value of shares than the earlier

two methods.

Illustration 4:

The following is the Balance Sheet of Sweet Mithu

Ltd as on 31.12.2000:

The Plant is worth Rs. 60,000 and Land and Building

have been valued at Rs. 1,20,000. Debtors include Rs.

4,000 as bad. The profits of the company have been

1998 Rs. 40,000; 1999 Rs. 45,000, and 2000 Rs.

53,000. It is the company’s practice to transfer 25%

of profit to Reserve.
Similar companies give a yield of 10% on the market

value of shares. Value of Goodwill is Rs. 80,000. Ignore

Income-tax. Find out the Fair Value of the Equity

Share.