1 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Chapter 1
Accounting for Partnership Firms: Basic Concepts

Section 4 of the Indian Partnership Act 1932 defines partnership as the ‘relation between persons who have agreed
to share the profits of a business carried on by all or any of them acting for all’. Persons who have entered into
partnership with one another are individually called ‘partners’ and collectively called ‘firm’. The name under which the
business is carried is called the ‘firm’s name’.
Features/Characteristics of Partnership
1. Two or More Persons: The minimum number of partners in a firm can be two. There is, however, a limit
to their maximum number. By virtue of Section 464 of the Companies Act 2013, the Central Government
is empowered to prescribe maximum number of partners in a firm but the number of partners can not be
more than 100. The Central government has prescribed the maximum number of partners in a firm to be 50
under Rule 10 of the Companies (Miscellaneous) Rules, 2014. Thus, a partnership firm cannot have more
than 50 partners.
2. Agreement: Agreement becomes the basis of relationship between the partners to run the partnership business.
Partnership agreement can be either oral or written. An oral agreement is equally valid. But in order to avoid
disputes, it is preferred that the partners have a written agreement.
The document which contains terms of the agreement is called ‘Partnership Deed’. It generally contains
the details about all the aspects affecting the relationship between the partners including the objective of
business, contribution of capital by each partner, ratio in which the profits and the losses will be shared by
the partners and entitlement of partners to interest on capital, interest on loan, etc.
• The partnership deed should be properly drafted and prepared as per the provisions of the ‘Stamp Act’
and preferably registered with the Registrar of Firms.
• The clauses of partnership deed can be altered with the consent of all the partners.
• According to Partnership Act 1932, “It may be agreed between the partners that one or more of them
shall not be liable for losses.”
3. Business: The agreement should be to carry on some business. Mere co-ownership of a property does
not amount to partnership. For example, if Piyush and Yash jointly purchase a plot of land, they become
the joint owners of the property and not the partners. But if they are in the business of purchase and sale of
land for the purpose of making a profit, they will be called partners.
4. Sharing of Profit: The agreement between partners must be to share profits and losses of a business. If
some persons join hands with the purpose of some charitable activity, it will not be termed as partnership.
5. Mutual Agency: The business of a partnership concern may be carried on by all the partners or any of
them acting for all. This statement has two important implications:
• First, every partner is entitled to participate in the conduct of the affairs of its business.
• Second, that there exists a relationship of mutual agency between all the partners. Each partner carrying on the
business is the principal as well as the agent for all the other partners. He can bind other partners by his acts and
also is bound by the acts of other partners with regard to business of the firm.
6. Liability of Partnership: Each partner is liable jointly with all the other partners and also severally to the
third party for all the acts of the firm done while he is a partner. Not only that, the liability of a partner for
acts of the firm is also unlimited. This implies that his private assets can also be used for paying off the
firm’s debts.
PROVISIONS OF THE INDIAN PARTNERSHIP ACT, 1932
If there is no express agreement on certain matters, the provisions of the Indian Partnership Act, 1932 shall apply.
1. Profit Sharing Ratio: If the partnership deed is silent about the profit sharing ratio, the profits and losses
of the firm are to be shared equally by partners, irrespective of their capital contribution in the firm.
 2 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

2. Interest on Capital: No interest on capital is payable if the partnership deed is silent on the issue.
3. Interest on Drawings: No interest is to be charged on the drawings made by the partners, if there is no mention
in the Deed.
4. Interest on Partner’s Loan: If any partner has advanced loan to the firm, he shall be entitled to get an
interest on the amount at the rate of 6% per annum.
5. Remuneration for Firm’s Work: No partner is entitled to get salary or commission for taking part in the
conduct of the business of the firm unless there is a provision for the same in the Partnership Deed.

• If a partner derives any profit for himself/herself from any transaction of the firm or from the use
of the property or business connection of the firm or the firm’s name, he/she shall account for the
profit and pay it to the firm.
• If a partner carries on any business of the same nature as and competing with that of the firm,
he/she shall account for and pay to the firm, all profits made by him/her in that business.
• Interest on capital is generally provided for in two situations:
(i) when the partners contribute unequal amounts of capitals but share profits equally, and
(ii) where the capital contribution is same but profit sharing is unequal.
 When there is no partnership deed or the partnership deed is silent on the issue: No interest is allowed on
partners’ capitals.
 When the firm incurs a loss during the year: The interest on capital is allowed only when the firm has earned
profit during the accounting year. Hence, no interest will be allowed if the firm has incurred net loss during the year.
• If in a year the net profit is less than the amount due to the partners as interest on capital, the
payment of interest on capital will be restricted to the amount of profits. In that case, the profit will be
effectively distributed in the ratio of interest on capital of each partner.
• When opening capitals of partners are not given, in such a situation before calculation of interest on
capital, the opening capitals will have to be calculated using the following equation:
Opening Capital + Addition to Capital – Withdrawal of Capital + Interest on Capital – Drawings – Interest
on drawings ± Share of profit (or loss) = Closing Capital
Charging interest on drawings discourages excessive amounts of drawings by the partners.
 When varying amounts are withdrawn at different intervals: Interest is calculated using the product
method and interest for 1 month at the specified rate is worked out, on the total of the products.
 When fixed amount is withdrawn every month throughout the year:
(i) If the amount is withdrawn on the first day of every month, interest on total amount of drawings will be calculated for
6½ months.
(ii) If at the end of every month, 5½ months.
(iii) If at the middle of the month, 6 months.

Top Tip
Average period for calculation of interest on drawings: No. of months after first drawing + No. of months after lasst drawing
2

 When fixed amount is withdrawn quarterly throughout the year:

(i) If the amount is withdrawn at the beginning of each quarter, the interest is calculated on total drawings, for a period
of 7½ months.
(ii) If at the end of each quarter, it will be calculated for a period of 4½ months.
 When fixed amount is withdrawn half yearly:
(i) If the amount is withdrawn at the beginning of each half year, interest is calculated on total drawings, for a period of
9 months.
(ii) If at the end of each half year, 3 months.
 When dates of withdrawal are not specified:
Average Period would be taken as 6 months.
 When a fixed amount is withdrawn for the first six months of a year:
(a) At the beginning of every month (i.e., on the first day of every month)
Average period = (12 + 7)/2 = 9.5 months
(b) At the end of every moth (i.e., on the last day of every month)
Average period = (11 + 6)/2 = 8.5 months
 3 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

(c) In the middle of every month: Average period = (11.5 + 6.5)/2 = 9 months
 When a fixed amount is withdrawn for the last six months of a year:
(a) At the beginning of every month (i.e., on the first day of every month):
Average period = (6 + 1)/2 = 3.5 months
(b) At the end of every month (i.e., the last day of every month):
Average period = (5 + 0)/2 = 2.5 months
(c) In the middle of every month: Average period = (5.5 + 0.5)/2 = 3 months
Maintenance of Capital Accounts of Partners
There are two methods by which the capital accounts of partners can be maintained — (i) fixed capital method, and
(ii) fluctuating capital method.
Basis Fixed Capital Fluctuating Capital
1. N
 umber of Two accounts are maintained for each partner – ‘capital Each partner has one account, i.e.
accounts account’ and ‘current account’. capital account.
2. Adjust-ments Adjustments of share of profit and loss, interest on All adjustments are made in current
capital, drawings, interest on drawings, salary or accounts. So, balance in capital
commission etc. are made in current accounts. account fluctuates from time to time.
3. Fixed balance Capital account balance remains fixed unless there is Balance of capital account fluctuates
addition to capital or withdrawal of capital. from year to year.
4. Credit balance Capital accounts always show a credit balance. Partners’ Capital account may also show a debit
current account however, may show a debit also. balance.

Distribution of Profit among Partners

In case of partnership, adjustments such as interest on drawings, interest on capital, salary to partners, and
commission to partners are required to be made. For this purpose, Profit and Loss Appropriation Account is prepared.
Profit and Loss Appropriation Account is merely an extension of the Profit and Loss Account of the firm. It shows
how the profits are appropriated or distributed among the partners.

Top Tips
1. If there is Net Loss as per Profit and Loss Account, no interest on capital, salary, remuneration is to be allowed to
partners.
2. The following are treated as expenses for the business, i.e. charge against profits. These are debited to Profit and
Loss Account, not Profit and Loss Appropriation Account:
• Interest on Partner's Loan
• Manager's Commission
• Payment of Rent to a Partner capital, salary, remuneration is to be allowed to partners.

Chapter 2
Accounting for Partnership Firms: Reconstitution

2.1 Reconstitution of a Partnership Firm

A Modes of Reconstitution of a Partnership Firm

Any change in the existing agreement amounts to reconstitution of the partnership firm. This results in an end of the existing
agreement and a new agreement comes into being with a changed relationship among the partners. However, the firm continues.
1. Admission of a new partner – When firm requires additional capital or managerial help or both for the
expansion of its business, a new partner may be admitted to supplement its existing resources.
 4 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

According to the Partnership Act 1932, a new partner can be admitted into the firm only with the consent of
all the existing partners unless otherwise agreed upon.
A newly admitted partner acquires two main rights in the firm:
• Right to share the assets of the partnership firm; and
• Right to share the profits of the partnership firm.
For the right to acquire share in the assets and profits of the partnership firm, the partner brings Capital
(either in cash or in kind) and Premium for goodwill to compensate the existing partners for loss of their
share in super profits of the firm. Premium for goodwill is shared by the old partners in the ratio in which
they sacrifice their shares in favour of the new partner, which is called sacrificing ratio.
Sacrifice by a Partner = Old Share of Profit – New Share of Profit
2. Change in the profit sharing ratio among the existing partners – Sometimes the partners of a firm may
decide to change their existing profit sharing ratio. This may happen on account of a change in the existing
partner’s role in the firm.
3. Retirement of an existing partner – It means withdrawal by a partner from the business of the firm due to
his bad health, old age or change in business interests. In fact, a partner can retire any time if the partnership
is at will.
4 Death of a partner
5. Insolvency of a partner

B Goodwill: Meaning, Nature, Factors and Valuation

Goodwill is an intangible asset. It is the value of the reputation of a firm in respect of the profits expected in
future over and above the normal profits.
Goodwill can be defined as:
• The present value of a firm’s anticipated excess earnings.
• The capitalised value attached to the differential profit capacity of a business.

Top Tip
Goodwill exists only when the firm earns super profits. Any firm that earns normal profits or is incurring losses has
no goodwill.
FACTORS AFFECTING THE VALUE OF GOODWILL
1. Nature of business: A firm that produces high value added products or having a stable demand is able to
earn more profits and therefore has more goodwill.
2. Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends
to be high.
3. Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity
and cost efficiency. This leads to higher profits and so the value of goodwill will also be high.
4. Market situation: The monopoly condition or limited competition enables the concern to earn high profits
which leads to higher value of goodwill.
5. Special advantages: The firm that enjoys special advantages like import licences, low rate and assured
supply of electricity, long-term contracts for supply of materials, well-known collaborators, patents,
trademarks, etc. enjoy higher value of goodwill.
CIRCUMSTANCES WHEN THERE IS NEED FOR VALUATION OF GOODWILL
1. Change in the profit sharing ratio amongst the existing partners
2. Admission of new partner
3. Retirement of a partner
4. Death of a partner
5. Dissolution of a firm involving sale of business as a going concern
6. Amalgamation of partnership firms
 5 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

VALUATION OF SELF-GENERATED GOODWILL

Since goodwill is an intangible asset it is very difficult to accurately calculate its value.
1. Average Profits Method: Under this method, the goodwill is valued at agreed number of years’ purchase of the average
profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during
the first few years of its operations. Hence, the person who purchases a running business must pay in the form of
goodwill a sum which is equal to the profits he is likely to receive for the first few years.
Goodwill = Average Profits × Number of years purchase*
*Number of years during which the anticipated profits are expected to accrue in future.
Top Tip
For the purpose of valuation of goodwill, Average Profits means ‘Average Maintainable Profits’.
Maintainable Profit of each year = Given profit – Unprovided depreciation – Annual management cost + Abnormal
loss (e.g. loss by fire, theft, etc.) – Abnormal gain (e.g. insurance claim received etc.) ± Rectification (e.g. + over
valuation of opening stock – over valuation of closing stock)

Weighted Average Profits Method: If there exists an increasing or decreasing trend, it is considered better to give a
higher weightage to the profits of the recent years than those of the earlier years because the recent profit is likely to be
maintained in the future by the firm. Hence, it is a advisable to work out weighted average based on specified weights
like 1, 2, 3, 4 and so on for respective year’s profit.
2. Super Profits Method
The buyer’s real benefit does not lie in total profits but the super profits, which are in excess of the normal return on capital
employed in similar business. So, it is desirable to value goodwill on the basis of the excess profits and not the actual profits.
The excess of actual profits over the normal profits is termed as ‘super profits’. (Super Profit = Actual Profit –
Normal Profit)
Goodwill = Super Profit × Number of years purchase
Normal Rate of Return (NRR)
Normal Profit = Actual Firm ' s Capital ×
100
Actual Firm’s Capital (= Net Assets) = Total Assets excluding purchased goodwill and fictitious assets (e.g. debit balance of
Profit and Loss Account, Deferred Revenue Expenditure) – External Liabilities (both short-term and long-term liabilities e.g.
creditors, bills payable, bank loan, etc.)
Alternately, Actual Firm’s Capital = Partners’ capital account credit balances + Partners’ current account credit balances –
Partner’s capital/current account debit balance, if any + Reserves and Surplus (i.e. general reserve or reserve fund, credit
balance of profit and loss account) – Fictitious Assets (e.g. debit balance of Profit and Loss Account, Deferred Revenue
Expenditure, etc.) – Purchased goodwill (i.e. goodwill appearing in the balance sheet)
3. Capitalisation Methods
(a) Capitalisation of Average Profits Method:
Goodwill = Capitalised value of the firm – Net Assets
100
• Capitalised value of the firm = Average profits ×
NRR
• Net Assets = Actual Firm’s Capital
100
is called the ‘Required Rate of Return Multiplier’.
NRR

(b) Capitalisation of Super Profit Method:

100
Goodwill = Super Profit ×
NRR
 6 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

C Revaluation of Assets and Reassessment of Liabilities

At the time of admission of a new partner or in case of change in the profit sharing ratio amongst the existing
partners:
It is always desirable to ascertain whether the assets of the firm are shown in books at their current values. In case the
assets are overvalued or undervalued, these are revalued. Similarly, a reassessment of the liabilities is also done so that
these are brought in the books at their correct values. There may also be some unrecorded assets and liabilities of the
firm. These must be brought into the books of the firm. For this purpose the firm has to prepare the Revaluation Account.
 Revaluation account is credited with increase in the value of each asset and decrease in its liabilities
because it is a gain.
 Revaluation account is debited with decrease in the value of assets and increase in its liabilities because it
is a loss.
 Similarly unrecorded assets are credited and unrecorded liabilities are debited to the revaluation account.
 If the revaluation account finally shows a credit balance, then it indicates a net gain.
 If the revaluation account finally shows a debit balance, then it indicates a net loss.
 Net gain or net loss on revaluation will be transferred to the capital accounts of the old partners in their old
profit sharing ratio.
At the time of retirement or death of a partner:
There may be some assets which may not have been shown at their current values. Similarly, there may be certain
liabilities which have been shown at a value different from the obligation to be met by the firm. Also, there may be
some unrecorded assets and liabilities which need to be brought into books. Revaluation Account is prepared in order to
ascertain net gain (loss) on revaluation of assets and/or liabilities and bringing unrecorded items into firm’s books. Net
gain (loss) on revaluation of assets and liabilities is transferred to the capital accounts of all partners (including retiring/
deceased partner) in their old profit sharing ratio.

F Adjustment for Accumulated Profits and Losses

In case of Admission of a Partner
Accumulated profits (undistributed profits):
• They are usually in the form of General Reserve, Reserve Fund, Credit Balance of Profit and Loss
Account. They appear on the liabilities side of the balance sheet.
• Accumulated profits belong to the old partners only as these had been earned with their efforts before the
admission of a new partner. The new partner is not entitled to have any share in such accumulated profits.
• Accumulated profits are distributed among the old partners by transferring it to their capital accounts in old profit
sharing ratio.
Accumulated losses:
• Accumulated losses appear on the assets side of the balance sheet in the form of Debit Balance of Profit
and Loss Account or Deferred revenue expenditure (e.g. advertisement suspense account).
• Accumulated losses should be debited from the old partners’ capital accounts in old profit sharing ratio.
In case of Retirement/Death of a Partner
The retiring partner is entitled to his/her share in the accumulated profits (credit balance of Profit and Loss Account and
General Reserve/Reserve Fund) and is also liable to share the accumulated losses (debit balance of Profit and Loss
Account and Deferred Revenue Expenditure).
Accumulated profits or losses belong to all the partners and should be transferred to the capital accounts of all partners
(including retiring/deceased partner) in their old profit sharing ratio.
2.2 Change in Profit Sharing Ratio Among the Existing Partners
Sometimes, the partners of a firm decide to change their existing profit sharing ratio without any admission or retirement
of a partner. This results in a gain of additional share in future profits of the firm for some partners while a sacrifice of a
part thereof for other partners.
 7 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

 Sacrificing share of a partner = Old share of profit – New share of profit

 Gaining share of a partner = New share of profit – Old share of profit

2.3 Admission of a Partner

A newly admitted partner acquires two main rights in the firm:
1. Right to share the assets of the partnership firm; and
2. Right to share the profits of the partnership firm.
For the right to acquire share in the assets and profits of the partnership firm, the partner brings in an agreed amount of
capital either in cash or in kind.
In the case of an established firm which may be earning more profits than the normal rate of return on its capital the new
partner is also required to contribute some additional amount known as premium for goodwill. This is done primarily to
compensate the existing partners for loss of their share in profits of the firm.
Hidden Goodwill
Value of Firm’s Goodwill = Total Capital of the new firm (based on new partner’s capital and his share) – Actual firm’s
capital of the new firm

• Total Capital of the new firm (based on new partner’s capital and his share) = New partner’s capital ×
Reciprocal of new partner’s share
• Actual firm’s capital of the new firm = Old partners’ Firm’s capital + New partner’s capital
Where, Old partners’ Firm’s capital (= Net assets) = Total Assets (excluding goodwill and fictitious assets) – External
Liabilities
OR Sum of old Partners’ capital and current accounts credit balances – Old Partners’ capital and current accounts debit
balance, if any + Reserves and Surplus (general reserve or reserve fund, Profit and Loss A/c Cr.) – Fictitious Assets
(Profit and Loss A/c Dr., Deferred Revenue Expenditure) – Existing goodwill ± Profit/Loss on
2.4 Retirement of a Partner
Retirement or death of a partner leads to reconstitution of a partnership firm because, the existing partnership deed
comes to an end, and in its place, a new partnership deed needs to be framed whereby, the remaining partners continue
to do their business on changed terms and conditions.
The retirement of a partner may take place:
• With the consent of all other partners, in accordance with terms of the deed (i.e. there may be express
agreement to that effect) or,
• In case of retirement at will, by giving notice in writing by a partner desiring to do so.

B Treatment of Goodwill
Retiring/deceased partner is entitled to his share of goodwill at the time of retirement/death because the goodwill has been
earned by the firm with the joint efforts of all the existing partners. Hence, at the time of retirement/death of a partner,
goodwill is valued as per agreement among the partners; and the retiring/deceased partner is compensated for his share of
goodwill by the continuing partners (who have gained due to acquisition of share of profit from the retiring partner) in their
gaining ratio.

Preparation of Revaluation Account, Partners’ Capital Accounts and

C Balance Sheet and Disposal of Amount Due to Retiring Partner
Disposal of Amount Due to Retiring Partner
The retiring partner’s account is settled as per the terms of partnership deed i.e., in lump sum immediately or in various
installments with or without interest as agreed or partly in cash immediately and partly in instalment at the agreed intervals.
In the absence of any agreement, Section 37 of the Indian Partnership Act, 1932 is applicable, which states that the
outgoing partner has an option to receive either interest @ 6% p.a. till the date of payment or such share of profits which
has been earned with his/her money (i.e., based on capital ratio).
 8 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

2.5 Death of a Partner

Disposal of Amount Due to Deceased Partner’s Executors
The accounting treatment for disposal of amount due to retiring partner and deceased partner is similar with a difference
that in case of death of a partner, the amount credited to him/her is transferred to his Executors’ Account and the payment
has to be made to him/her.
In the absence of any agreement, Section 37 of the Indian Partnership Act, 1932 is applicable, which states that the
deceased partner’s executor has an option to receive either interest @6% p.a. till the date of payment or such share of
profits which has been earned with his/her money (i.e., based on capital ratio).

Chapter 3
Dissolution of a Partnership Firm

Dissolution of Firm and Dissolution of Partnership

DISSOLUTION OF PARTNERSHIP FIRM

It implies breaking or discontinuance of partnership business and termination of economic relations between the
partners.
According to Section 39 of the Partnership Act 1932, the dissolution of partnership between all the partners of a firm is
called the dissolution of the firm.
This brings an end to the existence of firm, and no business is transacted after dissolution of firm except the activities
related to closing of the firm as the affairs of the firm are to be wound up by selling firm’s assets and paying its liabilities
and discharging the claims of the partners.
Dissolution of Partnership
Dissolution of partnership changes the existing relationship between partners but the firm may continue its business as
before. In other words, it results in the dissolution of partnership but not dissolution of firm.
The dissolution of partnership may take place in any of the following ways:
• Change in the profit sharing ratio amongst the existing partners;
• Admission of a new partner;
• Retirement of a partner;
• Death of a partner;
• Insolvency of a partner;
• Completion of the venture, if partnership is formed for that; and
• Expiry of the period of partnership, if partnership is for a specific period of time.

Top Tip
Dissolution of firm necessarily brings in dissolution of partnership but dissolution of partnership does not necessarily
mean dissolution of firm. A partnership gets terminated/dissolved in case of admission, retirement death, etc. of a
partner. This does not necessarily involve dissolution of the firm.

Basis Dissolution of Partnership Dissolution of Firm

1. Termination of Business The business is not terminated. The business of the firm is closed.
2. Settlement of assets and Assets and liabilities are revalued and new Assets are sold and liabilities are
liabilities balance sheet is drawn. paid-off.
3. Court’s intervention Court does not intervene because partnership A firm can be dissolved by the
is dissolved by mutual agreement. court’s order.
 9 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

4. Economic relationship Economic relationship between the partners Economic relationship between the
continues in a changed form. partners comes to an end.
5. Closure of books Does not require because the business is The books of account are closed.
not terminated.

Types/Modes of Dissolution of a Firm

1. Dissolution by Agreement: A firm is dissolved:

(a) with the consent of all the partners or
(b) in accordance with a contract between the partners.
2. Compulsory Dissolution:
(a) When all the partners or when all except one partner, become insolvent, rendering them incompetent to sign a
contract.
(b) When the business of the firm becomes illegal.
(c) When some event has taken place which makes it unlawful for the partners to carry on the business of the firm
in partnership, e.g., when a partner who is a citizen of a country which becomes an alien enemy because of the
declaration of war on his country by India.
3. On the happening of certain contingencies: Subject to contract between the partners, a firm is dissolved:
(a) if constituted for a fixed term, by the expiry of that term;
(b) if constituted to carry out one or more ventures, by the completion thereof;
(c) by the death of a partner;
(d) by the adjudication of a partner as an insolvent.
4. Dissolution by Notice: In case of partnership at will, the firm may be dissolved if any one of the partners
gives a notice in writing to the other partners, signifying his intention of seeking dissolution of the firm.
5. Dissolution by Court: At the suit of a partner, the court may order a partnership firm to be dissolved on
any of the following grounds:
(a) when a partner becomes insane;
(b) when a partner becomes permanently incapable of performing his duties as a partner;
(c) when a partner is guilty of misconduct which is likely to adversely affect the business of the firm;
(d) when a partner persistently commits breach of partnership agreement;
(e) when a partner has transferred the whole of his interest in the firm to a third party;
(f) when the business of the firm cannot be carried on except at a loss; or
(g) when, on any ground, the court regards dissolution to be just and equitable.

Settlement of accounts on dissolution of a firm

Rules of Section 48 of the Partnership Act 1932:

1. Treatment of Losses: Losses, including deficiencies of capital, shall be paid:
(i) first out of profits,
(ii) next out of capital of partners, and
(iii) lastly, if necessary, by the partners individually in their profit sharing ratio.
2. Application of Assets: The assets of the firm, including any sum contributed by the partners to make up
deficiencies of capital, shall be applied in the following manner and order:
(i) Payment of outside/external liabilities of the firm such as creditors, loans, bank overdraft, bills payable,
partner’s relative’s loan etc.). Secured loans, e.g. bank loan obtained by mortgage of plant and machinery, are
repaid before the unsecured loans such as creditors, bills payable, etc.
(ii) Partner’s loan — If balance amount is not adequate enough to pay off full amount of all partners’ loans, they are
to be paid proportionately.
(iii) Partners’ capitals — In paying to each partner proportionately what is due to him on account of capital; and the
balance, if any, shall be divided among the partners in their profit sharing ratio.
 10 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Rules of Section 49 of the Partnership Act 1932 — Private Debts and Firm’s Debts
Where both firm’s debts and private debts of partner(s) co-exist, the following rules shall apply.
1. The property of the firm shall be applied first in the payment of debts of the firm and then the surplus, if any,
shall be divided among the partners as per their claims, which can be utilised for payment of their private
liabilities.
2. The private property of any partner shall be applied first in payment of his private debts and the surplus, if
any, may be utilised for payment of the firm’s debts, in case the firm’s liabilities exceed the firm’s assets.
Thus, if the assets of the firm are not adequate enough to pay off firm’s liabilities, the partners have to contribute out of their
net private assets (private assets minus private liabilities).

The private property of the partner does not include the personal properties of his wife and children.

Accounting Treatment — Preparation of Realisation Account

When the firm is dissolved, its books of account are to be closed and the profit or loss arising on realisation of its assets
and discharge of liabilities is to be computed. For this purpose, a Realisation Account is prepared to ascertain the net
effect (profit or loss) of realisation of assets and payment of liabilities which may be is transferred to partner’s capital
accounts in their profit sharing ratio. Hence, all assets (other than cash in hand bank balance and fictitious assets, if any),
and all external liabilities are transferred to this account. It also records the sale of assets, and payment of liabilities and
realisation expenses. The balance in this account is termed as profit or loss on realisation which is transferred to partners’
capital accounts in the profit sharing ratio.

Chapter 4
Accounting for Share Capital

Features of a Company
A company is an association of persons who contribute money or money’s worth to a common inventory and use it for a
common purpose. It is an artificial person having corporate legal entity distinct from its members (shareholders) and has a
common seal used for its signature.
1. Body Corporate: A company is formed according to the provisions of Law enforced from time to time.
Generally, in India, the companies are formed and registered under Companies Law except in the case of
Banking and Insurance companies for which a separate Law is provided for.
2. Separate Legal Entity: A company has a separate legal entity which is distinct and separate from its
members. It can hold and deal with any type of property. It can enter into contracts and even open a bank
account in its own name.
3. Limited Liability: The liability of the members of the company is limited to the extent of unpaid amount of
the shares held by them.
4. Perpetual Succession: The company being an artificial person created by law continues to exist irrespective
of the changes in its membership. A company can be terminated only through law. The death or insanity or
insolvency of any member of the company in no way affects the existence of the company. Members may come
and go but the company continues.
5. Common Seal: The company being an artificial person, cannot sign its name by itself. Therefore, every
company is required to have its own seal which acts as official signatures of the company. Any document
which does not carry the common seal of the company is not binding on the company.
 11 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

6. Transferability of Shares: The shares of a public limited company are freely transferable. The permission
of the company or the consent of any member of the company is not necessary for the transfer of shares.
But the Articles of the company can prescribe the manner in which the transfer of shares will be made.
7. May Sue or be Sued: A company being a legal person can enter into contracts and can enforce the
contractual rights against others. It can sue and be sued in its name if there is a breach of contract by the
company.

Types of Companies

Classification on the basis of the number of members:

1. Public Company: A public company means a company which:
(a) is not a private company;
(b) is a company which is not a subsidiary of a private company.
2. Private Company: A private company is one which by its articles of association:
(a) restricts the right to transfer its shares;
(b) must have at least 2 persons (except in case of one person company);
(c) limits the number of its members to 200 (excluding its employees).
3. One Person Company (OPC): Section 2(62) of the companies Act, 2013, defines OPC as a “company which has only
one person as a member”.
Rule 3 of the Companies (Incorporation) Rules, 2014 provides that:
• Only a natural person, being an Indian citizen and resident in India, can form one person company.
• It cannot carry out non-banking financial investment activities.
• Its paid-up share capital is not more than `50 Lakhs
• Its average annual turnover of 3 years does not exceed `2 Crores.
Classification on the basis of liability of its members:
1. Companies Limited by Shares: In this case, the liability of its members is limited to the extent of the
nominal value of shares held by them. If a member has paid the full amount of the shares, there is no
liability on his part whatsoever may be for the debts of the company. He need not pay a single paise from
his private property.
2. Companies Limited by Guarantee: In this case, the liability of its members is limited to the amount they
undertake to contribute in the event of the company being wound up. Thus, the liability of the members will
arise only in the event of its winding up.
3. Unlimited Companies: When there is no limit to the liability of its members, the company is called an
unlimited company. When the company’s property is not sufficient to pay off its debts, the private property
of its members can be used for the purpose.
Top Tip
Unlimited Companies are not found in India even though permitted by the Companies Act.

Nature and Classes of Shares

‘Shares’ refer to the units into which the total share capital of a company is divided. Thus, a share is a fractional
part of the share capital and forms the basis of ownership interest in a company. The persons who contribute money
through shares are called ‘shareholders’.
As per the Companies Act, 2013 a company can issue two types of shares:
Preference Shares: According to Section 43 of The Companies Act, 2013, a preference share is one, which fulfills the
following conditions:
(i) That it carries a preferential right to dividend before any dividend is paid to the equity shareholders. The dividend payable
to preference shareholders may be either a fixed amount or calculated by a fixed rate of the nominal value of each share.
(ii) That it carries a preferential right to the repayment of capital on the winding up of the company before anything is paid
to equity shareholders.
 12 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

• A preference shareholder may have a right to participate, whether fully or to a limited extent, in the surpluses
of the company as specified in the Memorandum or Articles of the company.
• The preference shares can be participating and nonparticipating, cumulative or non-cumulative, and
redeemable or irredeemable.
Equity Shares (or ordinary shares)
According to Section 43 of The Companies Act, 2013, an equity share is a share which is not a preference share. In
other words, shares which do not enjoy any preferential right in the payment of dividend or repayment of capital, are
termed as equity(or ordinary shares).
• The equity shareholders are entitled to share the distributable profits of the company after satisfying the dividend rights
of the preference shareholders.
• The dividend on equity shares is not fixed and it may vary from year to year depending upon the amount of profits
available for distribution.
• The equity share capital may be:
(i) with voting rights; or
(ii) with differential rights as to voting, dividend or otherwise in accordance with such rules and conditions as may be
prescribed in the Articles of Association of the company.

Different Types/Categories of Share Capital

1. Authorised Capital (or Nominal or Registered Capital): Authorised capital is the amount of share capital which a
company is authorised to issue by its Memorandum of Association.
• The company cannot raise more than the amount of capital as specified in the Memorandum of Association.
• The company need not issue the entire authorised capital for public subscription at a time. Depending upon its
requirement, it may issue share capital but in any case, it should not be more than the amount of authorised capital.
• The authorised capital can be increased or decreased as per the procedure laid down in the Companies Act 2013.

Top Tip
• Amount of authorised capital, together with the no. of shares in which it is divided, is stated in the Memorandum of Association.
• But the classes of shares in which the company’s share capital is to be divided, along with their respective rights
and obligations, are prescribed by the Articles of Association.
2. Issued Capital: Issued capital is that part of the authorised capital which is offered to the public for subscription and
includes the shares allotted to vendors and the signatories to the company’s memorandum.

Top Tip
The authorised capital which is not offered for public subscription is known as ‘unissued capital’, which may be
offered for public subscription at a later date.
3. Subscribed Capital: Subscribed capital is that part of the issued capital which has been actually subscribed by the
public.
• When the shares offered for public subscription are subscribed fully by the public, the issued capital and subscribed
capital would be the same.
• If the number of shares subscribed is less than what is offered (i.e., Under Subscription), the company may allot only
the number of shares for which subscription has been received. In this case, the subscribed capital is less than issued
capital.
• In case, the number of shares subscribed is more than what is offered (i.e., Over Subscription), the allotment must be
equal to the offer. A company cannot allot more number of shares than what is offered for subscription. Thus, the fact
of over subscription is not reflected in the books.
4. Called up Capital: Called-up capital is that part of the subscribed capital which has been called up on the shares.
The company may decide to call the entire amount or part of the face value of the shares. For example, if the face value
(also called nominal value) of a share allotted is `10 and the company has called up only `7 per share, in that case, the
called-up capital is `7 per share. The remaining `3 may be collected from its shareholders as and when needed.
 13 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Top Tip
‘Uncalled Capital’ is that portion of the subscribed capital which has not yet been called up. The company may
collect this amount any time when it needs further funds.
5. Paid up Capital: Paid up capital is that portion of the called up capital which has been actually received from the
shareholders.
• When the shareholders have paid all the call amount, the called up capital is the same to the paid up capital.
• If any of the shareholders has not paid amount on calls, such an amount may be called as ‘calls-in-arrears’.
Paid up capital = Called up capital – Calls-in-Arrears
In such situation: Paid up capital < Called up capital
6. Reserve Capital: A company may reserve a portion of its uncalled capital to be called only in the event of winding up of
the company, which is called ‘Reserve Capital’. It is available only for the creditors on winding up of the company
‘Capital Reserve’ is the reserve that is created out of capital profits/gains.

Over Subscription
Over Subscription is a situation when applications for more shares of a company are received than the number offered to the
public for subscription.
This usually happens in respect of shares issue of well-managed and financially strong companies.
First Alternative: When the directors decide to fully accept some applications and totally reject the others, the application money
received on rejected applications is fully refunded.
Second Alternative: When the directors opt to make a proportionate allotment to all applicants (called ‘pro-rata’ allotment), the excess
application money received is normally adjusted towards the amount due on allotment. In case, the excess application money received
is more than the amount due on allotment of shares, such excess amount may either be refunded or credited to calls in advance.
Third Alternative: When the application for some shares are rejected outrightly; and pro-rata allotment is made to the remaining applicants,
the money on rejected applications is refunded and the excess application money received from applicants to whom pro-rata allotment has
been made is adjusted towards the amount due on the allotment of shares allotted.

Under Subscription
Under subscription is a situation where number of shares applied for is less than the number for which
applications have been invited for subscription. For example, a company offered 2,00,000 shares for subscription to
the public but the applications were received for 1,90,000 shares only. In such a situation, the allotment will be confirmed
to 1,90,000 shares. However, it must be ensured that the company has received the Minimum Subscription within 120
days from the date of the issue of the prospectus. Otherwise, the company cannot proceed for the allotment of shares and
application money should be returned within 130 days of the date of issue of prospectus. If a delay occurs beyond 8 days
from the date of closure of subscription list, the company shall be liable to pay the amount with interest @15% [Section
73(2)].
‘Minimum subscription’ of capital cannot be less than 90% of the issued amount according to SEBI (Disclosure and
Investor Protection) Guidelines, 2000.
Minimum subscription is the minimum amount which, in the opinion of directors, must be raised must be raised to meet the
needs of business operations of the company relating to:
• the price of any property purchased/to be purchased, which has to be met wholly/partly out of the proceeds of issue;
• preliminary expenses and any commission payable in connection with the issue of shares;
• the repayment of any money borrowed by the company for the above two matters;
• working capital; etc.

Concepts of Private Placement, Sweat Equity and Employees

Stock Option Plan
Private Placement of Shares: The Companies Act, 2013 (Section 42) describes Private Placement as an offer of
securities or invitation to subscribe securities to a select group of persons through issue of private placement offer letter.
Sweat Equity: ‘Sweat equity’ means such equity shares as are issued by a company to its directors, promotors or
employees at a discount.
 14 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Employees Stock Option Plan (ESOP): Under Section 62(1)(b) of the Companies Act, 2013, a Company may offer
shares to its employees under a scheme of ‘Employees Stock Option Plan’ which means the option (right) given to the
whole-time directors, officers or permanent employees of a company to purchase or subscribe the securities offered by
the company at a future date, at a pre-determined price, which is lower than the market price.

Top Tip
1. ESOP being an option granted by the company, an employee may or may not exercise the right to subscribe.
2. Employees Stock Option Plan (ESOP) falls in the category of Sweat Equity; Sweat Equity being a wider.
A company issuing the Stock Options has to fulfill following prescribed conditions:
1. Shares must be of the class already issued.
2. Authorised by a special resolution passed by the company. The resolution specifies the number of shares, the
current market price, consideration, if any, and the class or classes of directors or employees to whom such
equity shares are to be issued.
3. Not less than one year has elapsed since the date of commencement of business.
4. Shares are issued as per SEBI regulations, if the shares are listed.

Issue of Shares at a Premium

Issue of shares at a premium means issue of shares at an amount more than the nominal or par value of shares.
For example, when a share of the nominal value of `100 is issued at `105, it is said to have been issued at a premium of
5%.
• Financially strong and well-managed companies generally issue shares at a premium.
• The premium amount is credited to a separate account called ‘Securities Premium Account/Securities Premium
Reserve Account’, which can be used only for the following 5 purposes:
1. To issue fully paid bonus shares to the members to the extent not exceeding unissued share capital of the company.
2. To write-off preliminary expenses of the company.
3. To write-off the expenses of, or commission paid, or discount allowed on any securities of the company.
4. To pay premium on the redemption of debentures or preference shares of the company.
5. To purchase its own shares (i.e., Buy back of shares).
Extra Shots
When a company purchases its own shares, it is called ‘Buy-back of Shares’.
Sources of buy back of shares:
Section 68 of The Companies Act, 2013 provides that the company can buy their own shares from either of the following
sources:
• Existing equity shareholders on a proportionate basis
• Open Market
• Odd-lot shareholders
• Employees of the company
The company can buy back its own shares either from the free reserves, securities premium or from the proceeds of any
shares or other specified securities. In case shares are bought back out of free reserves, the company must transfer a
sum equal to the nominal value of shares bought back to ‘Capital Redemption Reserve A/c’.
Procedure for buy back of shares:
• The Articles of Association must authorise for buy back of shares.
• A special resolution must be passed in the company’s Annual General Body meeting.
• The buy-back of the shares should be completed within 12 months from the date of passing the special resolution.
• The amount of buy back of shares in any financial year should not exceed 25% of the paid-up capital and free reserves.

• Debt-equity ratio cannot be more than 2:1 after buy back of shares.
• All the shares of buy back should be fully paid-up.
• The company should file a solvency declaration with the Registrar and SEBI which must be signed by at least 2 directors
of the company.
 15 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Calls in Arrears
When any shareholder fails to pay the amount due on allotment or on any of the calls, such amount is known as ‘Calls in
Arrears’/‘Unpaid Calls’.
• Calls in Arrears represent the debit balance of all the calls account. Such amount shall appear as ‘Note to
Accounts’.
• However, where a company maintains ‘Calls in Arrears’ Account, it needs to pass the following additional
journal entry:
Calls in Arrears A/c Dr.
To Share First Call Account A/c
To Share Second and Final Call Account A/c
The Articles of Association of a company may empower the directors to charge interest at a stipulated
rate on calls in arrears.
If the Articles are silent in this regard, the rule contained in Table F shall be applicable which states that the
interest on calls-in-arrears in charged at a rate not exceeding 10% p.a.
When the shareholder makes the payment of calls in arrears together with interest, the entry will be as
follows:
Bank A/c Dr.
To Calls in Arrears A/c
Note: Accounting Treatment of Interest on calls-in-arrears is not in the CBSE Syllabus.

Calls in Advance
Sometimes shareholders pay a part or the whole of the amount of the calls not yet made. The amount so received from
the shareholders is known as “Calls in Advance”.
The amount received will be adjusted towards the payment of calls as and when they becomes due.
The following journal entry is recorded for the amount of calls received in advance:
Bank A/c Dr.
To Calls in Advance A/c
On the due date of the calls, the amount of ‘Calls in Advance’ is adjusted by the following entry :
Calls in Advance A/c Dr.
To Particular Call A/c
‘Calls in Advance’ is a liability of the company, therefore it is under obligation to pay interest on Calls in Advance at a rate
specified in the Articles of Association.
However, if Articles are silent on this account, Table F is applicable which provides for interest on calls in advance at a
rate not exceeding 12% p.a.

Top Tip
According to Section 50 of the Companies Act 2013, the amount of Calls in Advance can be accepted by the
Company only when it is authorised by the Articles of Association.

Issue of Shares at a Discount

Issue of shares at a discount means issue of shares at an amount less than the nominal or par value of shares.
For example, when a share of the nominal value of `100 is issued at `98, it is said to have been issued at a discount
of 2%.
• The difference between the nominal value and issue price represents discount on the issue of shares.
• As a general rule, a company cannot ordinarily issue shares at a discount. It can do so only in cases such
as:
(i) Reissue of forfeited shares; and
(ii) Issue of sweat equity shares.
 16 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Accounting Treatment — Public Issue of Shares

The important steps in the procedure of issue of shares are:
1. Issue of Prospectus
Prospectus is an invitation to the public that a new company has come into existence and it needs funds for doing business. It
contains complete information about the company and the manner in which the money is to be collected from the prospective investors.
2. Receipt of Applications
When prospectus is issued to the public, prospective investors intending to subscribe the share capital of the company would make an
application along with the application money and deposit the same with a scheduled bank as specified in the prospectus.

Top Tip
The application money should be at least 5% of the face value of the share.
3. Allotment of Shares
‘Allotment of shares’ implies a valid contract between the company and the applicants who now become the allottees and
assume the status of shareholders or members of the company.
If minimum subscription has been received, the company may proceed for the allotment of shares after fulfilling certain other legal
formalities. Letters of allotment are sent to those whom the shares have been alloted, and letters of regret to those to whom no allotment
has been made.
4. Calls
• Timing of payment of calls by the shareholders is determined at the time of share issue itself and given in
the prospectus.
• The amount on any call should not exceed 25% of the face value of shares.
• There must be an interval of at least one month between the making of two calls unless otherwise provided
by the articles of association of the company.
• A minimum of 14 days’ notice is given to the shareholders to pay the amount of any call.

Forfeiture of Shares
Some shareholders may fail to pay one or more instalments, viz. allotment money and/or call money. In such circumstances,
the company can forfeit their shares, i.e. cancel their allotment and treat the amount already received thereon as forfeited
to the company within the framework of the provisions in its Articles of Association. These provisions are usually based
on Table F which authorise the directors to forfeit the shares for non-payment of calls made.
Forfeiture of Shares issued at Par
When the shares are forfeited, all entries relating to the forfeited shares must be reversed except the entry relating to
securities premium, if any. Accordingly, the share capital account is debited at the rate of called-up capital and credited to
(i) respective unpaid calls account or Calls in Arrears Account and (ii) Share Forfeiture Account with the amount already
received on shares.
Forfeiture of Shares issued at a Premium
If shares were initially issued at a premium and the premium amount has been fully realised, but some of the shares are
forfeited due to non-payment of call money (which does not include premium), the accounting treatment for forfeiture shall
be on the same pattern as in the case of shares issued at par.

Top Tip
In the entry of forfeiture of shares issued at a premium, Share Capital Account is debited with the called up amount
(excluding premium) and Share Forfeiture Account is credited with the amount already received on forfeited shares
excluding premium amount, i.e. share forfeiture account does not include premium received on forfeited shares.
In case, the premium amount has not been received, either wholly or partially, in respect of the shares forfeited, the
Securities Premium Account will also be debited with the amount of premium not received along with the Share Capital
Account. This will usually be the case when even the amount due on allotment has not been received.
The journal entry to record the forfeiture of shares issued at a premium on which premium has not been fully received:
 17 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Re-issue of Forfeited Shares

The directors can either cancel or re-issue the forfeited shares. In most cases, they reissue such shares.
Forfeited shares may be reissued at par, premium or discount.
• Discount allowed on reissue of forfeited shares should be debited to the ‘Share Forfeiture Account’.
• Amount of discount allowed cannot exceed the amount that had been received on forfeited shares at the time of initial
issue.

Top Tips
• Maximum discount on re-issue of forfeited shares
= Amount forfeited (i.e. amount already received at the time of forfeiture)
• Minimum re-issue price of a forfeited share
= Paid-up value of a share – Forfeited amount per share = Amount not received on forfeited share
The balance, if any, left in the Share Forfeiture Account relating to reissued shares, should be treated as capital profit and
transferred to Capital Reserve Account.

Issue of Shares for Consideration other than Cash

Sometimes a company purchases assets from vendors and instead of making payment in cash issues fully paid shares
of the company for consideration thereof. Such issue of shares is called shares issued for consideration other than cash
because no such cash is received for issue of shares.
These shares can also be issued either at par, or at premium. The number of shares to be issued will depend upon the
price at which the shares are issued and the amount payable to the vendor.
The number of shares to be issued to the vendor will be calculated as follows:
Amount Payable
Number of shares to be issued =
Issue Price
Sometimes a company may purchase the assets as well as take over the liabilities of another concern. It happens usually
in case of purchase of the whole business of the other concern. In such a situation, the purchase consideration will be
equal to the value of net assets (Assets – Liabilities) taken over, and if the whole amount of the consideration is paid by
issue of shares, the journal entry will be:
In case of the whole business being taken over if the purchase consideration is more than the amount of the net assets
taken over, the difference (excess) will be treated as value of goodwill and it will be debited to Goodwill Account while
passing the journal entry for the purchase of vendor’s business. But if it is the other way round, i.e. the purchase
consideration is less than the value of the net assets taken over the difference will be credited to Capital Reserve
Account.

Chapter 5
Accounting for Debentures

Meaning of Debentures
A company raises its capital by means of issue of shares. But the funds raised by the issue of shares are seldom adequate
to meet the long term financial needs of a company. Hence, most companies turn to raising long-term funds also through
debentures, known as long-term debt.
Methods of Issue of Debentures:
1. Issue of debentures to the public
2. Private place of debentures
3. Issue of debentures for consideration other than cash
 18 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

4. Issue of debentures as collateral security

Debenture is a written instrument acknowledging a debt under the common seal of the company. It contains a
contract for repayment of principal after a specified period or at intervals or at the option of the company and for payment
of interest at a fixed rate payable usually either half-yearly or yearly on fixed dates.
According to Section 2(30) of The Companies Act, 2013, ‘Debenture’ includes Debenture Inventory, Bonds and any other
securities of a company whether constituting a charge on the assets of the company or not.

Top Tip
‘Bond’ is also an instrument of acknowledgment of debt. Traditionally, the Government issued bonds, but
these days, bonds are also being issued by semi-government and non-governmental organisations. The
terms ‘Debentures’ and ‘Bonds’ are now being used inter-changeably.
Distinction between Shares and Debentures
Basis Shares Debentures
Ownership • A ‘share’ represents ownership of the • A ‘debenture’ is an acknowledgment of debt.
company. • A debenture is a part of the borrowed capital.
• A share is a part of the owned capital. • Debentureholders are the creditors of a company.
• Shareholders are the owners of a company.
Return • The return on shares is known as ‘dividend’. • The return on debentures is called ‘interest’.
• The rate of dividend may vary from year to year • The rate of interest on debentures is prefixed.
depending upon the profits of the company. • The payment of interest is a charge on profits and
• The payment of dividend is an appropriation is to be paid even if there is no profit.
of profits.
Repayment Normally, the amount of shares is not returned Generally, the debentures are issued for a specified
during the life of the company. period and repayable on the expiry of that period.
Voting Rights Shareholders enjoy voting rights. Debentureholders do not normally enjoy any voting
right.
Security Shares are not secured by any charge. Debentures are generally secured and carry a fixed
or floating charge over the assets of the company.
Convertibility Shares cannot be converted into debentures. Debentures can be converted into shares if the terms of
issue so provide, and in that case these are known as
convertible debentures.
Issue at discount As a general rule, a company cannot ordinarily The Companies Act, 2013 does not impose any
issue shares at a discount. restrictions upon the issue of debentures at a discount.

Fixed charge: A fixed charge is created on a specific asset. It is created against those assets which are
held by a company for use in operations, not meant for sale.
Floating charge: A floating charge is on the general assets of the company. It involves all assets excluding those assigned to
the secured creditors.
TYPES OF DEBENTURES
From the Point of view of Security
1. Secured Debentures: Secured debentures refer to those debentures where a charge is created on the assets of the
company for the purpose of payment in case of default. The charge may be fixed or floating.
2. Unsecured Debentures: Unsecured debentures do not have a specific charge on the assets of the company. However,
a floating charge may be created on these debentures by default. Normally, these kinds of debentures are not issued.
From the Point of view of Tenure
1. Redeemable Debentures: Redeemable debentures are those which are payable on the expiry of the specific period
either in lump sum or in instalments during the life time of the company. Debentures can be redeemed either at par or at
premium.
2. Irredeemable Debentures: Irredeemable debentures are also known as Perpetual Debentures because the company
does not give any undertaking for the repayment of money borrowed by issuing such debentures. These debentures are
repayable on the winding-up of a company or on the expiry of a long period.
From the Point of view of Convertibility
 19 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

1. Convertible Debentures: Debentures which are convertible into equity shares or in any other security either at the
option of the company or the debentureholders are called convertible debentures. These debentures are either fully
convertible or partly convertible.
2. Non-Convertible Debentures: The debentures which cannot be converted into shares or in any other securities are
called non-convertible debentures. Most debentures issued by companies fall in this category.
From Coupon Rate Point of view
1. Specific Coupon Rate Debentures: These debentures are issued with a specified rate of interest, which is called the
coupon rate. The specified rate may either be fixed or floating. The floating interest rate is usually tagged with the bank rate.
2. Zero Coupon Rate Debentures: These debentures do not carry a specific rate of interest. In order to compensate the
investors, such debentures are issued at substantial discount and the difference between the nominal value and the
issue price is treated as the amount of interest related to the duration of the debentures.
From the view Point of Registration
1. Registered Debentures: Registered debentures are those debentures in respect of which all details including names,
addresses and particulars of holding of the debentureholders are entered in a register kept by the company. Such
debentures can be transferred only by executing a regular transfer deed.
2. Bearer Debentures: Bearer debentures are the debentures which can be transferred by way of delivery and the company
does not keep any record of the debentureholders. Interest on debentures is paid to a person who produces the interest
coupon attached to such debentures.

A Issue of Debentures to the Public with Terms of Redemption

The procedure for the issue of debentures is the same as that for the issue of shares. The intending investors apply for
debentures on the basis of the prospectus issued by the company.
Normally the whole amount of debenture is collected on application or in two installments, i.e., on application and allotment.
Debentures can be issued at par, at a premium or at a discount.

Top Tip
When the whole amount of debenture is collected in two installments, i.e., on application and allotment
and Debentures are issued at a discount, if nothing is specified, discount is adjusted with allotment money.
When a company issues debentures, it usually mentions the terms on which they will be redeemed on their maturity.
Redemption of debentures refers to discharge of liability on account of debentures by repayment made to the
debentureholders.

Top Tip
Debentures can be redeemed either at par or at a premium. Debentures are never redeemed at a
discount.

B Writing-off Discount or Loss on Issue of Debentures (AS 16)

• Discount or Loss on issue of debentures is a capital loss and is written-off in the same year when debentures
are issued.
• Discount or loss on issue of debentures can be written-off from Securities Premium (if it exists). In case,
Securities Premium does not exist or is inadequate, the amount or the balance should be written-off against
revenue profits of the year, i.e. by debiting Statement of Profit and Loss.

C Interest on Debentures
• When a company issues debentures, there is an obligation to pay interest at fixed percentage periodically
(half-yearly or annually).
• Interest on debentures is calculated at the nominal value of debentures.
• Interest on debenture is a charge against the profit of the company and must be paid whether the company
has earned any profit or not.
 20 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

D Issue of Debentures for Consideration other than Cash

Sometimes a company purchases assets from vendors and instead of making payment in cash issues debentures for
consideration thereof. Such issue of debentures is called debentures issued for consideration other than cash. Such
debentures may be issued at par, at a premium or at a discount.
Sometimes a company may purchase the assets as well as takeover the liabilities of another business enterprise. It happens
usually in case of purchase of the whole business of the other enterprise.
Purchase consideration = Net Assets
    = Assets purchased – Liabilities taken over
If Purchase consideration agreed > Net assets taken over: the difference (excess) will be debited to ‘Goodwill’ A/c.
If Purchase consideration agreed < Net assets taken over: the difference will be credited to ‘Capital Reserve’ A/c.

E Issue of Debentures as a Collateral Security

A collateral security may be defined as a subsidiary or secondary or additional security besides the primary security when a
company obtains a loan or overdraft from a bank or any other financial institution. It may pledge or mortgage some assets as a
secured loan against the said loan. But the lending institutions may insist on additional assets as collateral security so that the
amount of loan can be realised in full with the help of collateral security in case the amount from the sale of principal security
falls short of the loan money. In such a situation, the company may issue its own debentures to the lenders in addition to some
other assets already pledged. Such an issue of debentures is known as ‘Debentures issued as Collateral Security’.

Top Tip
Interest is NOT paid on Debentures issued as Collateral Security.

If the company fails to repay the loan along with interest, the lender is free to receive his money from the sale
of primary security and if the realisable value of the primary security falls short to cover the entire amount,
the lender has the right to invoke the benefit of collateral security whereby debentures may either be presented for
redemption or sold in the open market.

Chapter 6
Analysis of Financial Statements

6.1 Financial Statements of a company and Financial Analysis

Meaning, Nature and Uses and importance of Financial

Statements
Meaning of Financial Statements
Financial statements are the basic and formal annual reports through which the corporate management communicates
financial information to its owners and various other external parties which include investors, tax authorities,government,
employees, etc. These refer to:
1. Balance Sheet (position statement)
2. Statement of profit and loss (income statement)
3. Cash flow statement
 21 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Nature of Financial Statements

1. Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books.
The original cost or historical cost is the basis of recording transactions. The assets purchased at different times and at
different prices are put together and shown at costs. As these are not based on market prices, the financial statements
do not show current financial condition of the concern.
2. Accounting Conventions: Use of accounting conventions makes financial statements comparable, simple and realistic.
• The convention of valuing inventory at cost or market price, whichever is lower, is followed.
• The valuing of fixed assets at cost less depreciation principle for balance sheet purposes is followed.
• The convention of materiality is followed in dealing with small items like pencils, pens, postage stamps, etc. These
items are treated as expenditure in the year in which they are purchased even though they are assets in nature.
• The stationery is valued at cost and not on the principle of cost or market price, whichever is less.
3. Postulates: Financial statements are prepared on certain basic assumptions (pre-requisites) known as postulates such
as going concern postulate, money measurement postulate, realisation postulate, etc.
4. Personal Judgements: Facts and figures presented through financial statements are based on personal opinion,
estimates and judgements. E.g. Provisions for doubtful debts are made on estimates and personal judgements. Similarly,
while deciding either cost of inventory or market value of inventory, many personal judgements are to be made.
Uses and Importance of Financial Statements
1. Report on stewardship function: The gaps between the management performance and ownership expectations can
be understood with the help of financial statements.
2. Basis for fiscal policies: The fiscal policies, particularly taxation policies of the government, are related with the financial
performance of corporate undertakings.
3. Basis for granting of credit: Credit granting institutions take decisions for granting of credit on the basis of the financial
performance of the undertakings.
4. Basis for prospective investors: Financial statements help the investors to assess long-term and short-term solvency
as well as the profitability of the concern.

Current and Non-current Classification

An item is classified as current:
• If it is involved in entity’s operating cycle or,

Top Tip
Operating cycle is the time between the acquisition of assets for processing and their realization into cash or cash
equivalents.
• Operating cycle may vary from few days to few years.
• Where the operating cycle cannot be identified, it is assumed to have a duration of 12 months.
• If it is expected to be realised/settled within 12 months or,
• If it is held primarily for trading or,
• If it is cash and cash equivalent or,
• If the entity does not have unconditional rights to defer settlement of liability for at least 12 months after the
reporting period.
Other assets and liabilities are non-current.
Reserves and Surplus
(i) Capital Reserve (e.g. gain on reissue of forfeited shares)
(ii) Capital Redemption Reserve
(iii) Securities Premium Reserve
(iv) Debenture Redemption Reserve
(v) Revaluation Reserve
(vi) Stock Options Outstanding Account
(vii) Other Reserves (e.g. General Reserve, Subsidy Reserve)
(viii) Surplus, i.e. Balance in Statement of Profit and Loss (disclosing appropriation such as dividend, bonus
shares, transfer to/from reserve, etc.)
 22 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Top Tip
1. A reserve specifically represented by earmarked investments shall be termed as “Fund”.
2. ‘Debit’ balance of statement of profit and loss shall be shown as a negative figure under ‘Surplus’ head.
3. The balance of “Reserve and Surplus” after adjusting negative balance of Surplus, if any, shall be shown under
“Reserve and Surplus” head even if the resulting figure is ‘negative’.
4. Preliminary expenses and discount/loss on issue of debentures will be shown under Reserves and Surplus as a
negative item. This is because they are to be written-off completely in the same year from securities premium reserve
(if any) and the balance from statement of profit & loss.
5. Share options outstanding account has been recognised as a separate item under ‘Reserve and Surplus’.

ICAI’s Guidance Note on Accounting for Employee share based payments requires a credit balance
in the ‘Stock option outstanding Account’ to be disclosed in balance sheet under separate heading’
between share capital and reserves and surplus as a part of shareholders fund.
Money received against share warrants
It is the amount received by the company which are converted into shares at a specified date on a specified rate. The
instrument issued against the amount so received as share warrants.
Money received against share warrants’ to be disclosed as a separate line item under ‘shareholder’s fund’.
Share application money pending allotment
Share application money not exceeding the issued capital and to the extent non-refundable shall be classified as non-
current.

Top Tip
Share application money to the extent refundable or where minimum subscription is not met, such amount shall be
shown separately under ‘Other Current liabilities’.
Borrowings
Total borrowings are categorised into long-term borrowings, short-term borrowings and current maturities to long-term debt.
(i) Loans which are repayable in more than 12 months/operating cycle are classified as long-term borrowings
under non-current liabilities on the face of balance sheet. Examples:
• Debentures/Bonds/Long-term loans (e.g. term-loan from bank, Mortgage Loan) repayable after one year
• Long-term deposits
• Public deposits
(ii) Loans repayable on demand or whose original tenure is not more than 12 months/operating cycle are
classified as short-term borrowings under current liabilities on the face of balance sheet. Examples:
• Bank Overdraft
• Loans repayable on demand from banks and other parties
• Short-term deposits payable on demand
(iii) Current maturities to long-term loan include amount repayable within 12 months/operating cycle under
other current liabilities with Note to Account.
Examples of Other Current Liabilities :
• Unpaid/Unclaimed dividends
• Interest accrued and due or not due on long-term borrowings (e.g. debentures)
• Income received in advance/Unearned income (e.g. advance from customers)
• Calls in advance and Accrued Interest on calls in advance
• Outstanding expenses
• Provident Fund payable/ESI payable/GST payable
• Application money received for allotment of securities and due for refund and interest due thereon
• Unpaid matured debentures or deposits and interest thereon
Other Long-term Liabilities
• Trade payables to be settled beyond 12 months from the date of balance sheet/operating cycle.
• Premium on redemption of debenture.
 23 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Provisions
• The amount of provision settled within 12 months from balance sheet date/operating cycle is classified as short-
term provisions and shown under current liabilities on the face of balance sheet. Examples:
— Provision for tax
— Provision for bad and doubtful debts
• All provisions for which the related claims are expected to be settled beyond 12 months after the reporting date are
classified as long-term provisions. Examples
• Provision for employee benefits/Retirement benefits payable to employees e.g. Provident Fund
— Provision for Warranties
Trade payables
A trade payable refers to the amount due on account of goods purchased or services rendered in the normal
course of business, e.g. Creditors, Bills Payable or Acceptance.
• Trade payables to be settled beyond 12 months from the date of balance sheet/operating cycle are classified under
“other long-term liabilities” with Note to Account.
• The balance of trade payables are classified as current liabilities on the face of balance sheet.
Property, Plant and Equipment
Examples:
• Land • Buildings
• Plant and Machinery • Furniture, Fixture and Fittings
• Vehicles • Office Equipment
• Livestock • Computer and Related Equipment

Top Tip
Provision for Depreciation/Accumulated Depreciation will be deducted from Property, Plant and Equipment under
notes to account and the net value will be shown on the face of the balance sheet under this head.
Intangible Assets
• Goodwill • Patents and other intellectual property rights
• Brand • Trademarks • Copyrights
• Licenses and franchise • Computer Software • Masthead and Publishing titles
• Mining rights • Recipes • Formulae
• Models, Designs and Prototypes
Non-Current Investments
Non-current investments are investments which are held not with the purpose to resell but to retain them.
Non-current Investments are further classified into ‘Trade Investments’ and ‘Other Investments’.
• Trade Investments are investments made by a company in shares or debentures of another company, not being its
subsidiary, to promote its own trade and business.
• Other Investments are those investments which are not trade investments, e.g. Investment in Land for investment purpose.

Top Tip
Investments are classified into current and non-current categories.
• Investments expected to realise within 12 months are considered as current investments under current assets.
• Others are classified as non-current investments under non-current assets.
Both are, however, shown on the face of the balance sheet.
Long-term Loans and Advances
• Capital Advances
• Security Deposits, e.g. for telephones, electricity, etc.
Current Investments
Current investments are those investments which are held to be converted into cash within a short period i.e., within
12 months. Examples:
• Marketable securities • Treasury bills
• Debenture Redemption Investment
• Long-term Investments in Equity Instrument, Preference shares, Government Securities, Debentures, or Mutual Funds
with maturity period of less than 12 months
 24 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Inventories
All inventories are always treated as current.
• Stock of raw materials • Work-in-progress • Stock of finished goods
• Stores and Spares • Loose tools • Goods in transit
• Stock in trade (i.e. Goods required for trading)
Trade Receivables
Trade receivables refer to the amount due on account of goods sold or services rendered in the normal course of business.
It includes both Debtors and Bills receivables.
• Trade receivables to be realised beyond 12 months from reporting date/operating cycle are classified as “Other non-
current assets” under the head Non-Current Assets.
• Others are classified as current assets.
Cash and cash equivalents
• Balance with banks; Cheques, drafts on hand and Cash on hand
• Earmarked balances with banks (e.g., for unpaid dividend)
• Balances with banks held as margin money or security against the borrowings
• Bank deposits with more than 12 months maturity
Other Current Assets
• Prepaid expenses, e.g. unexpired insurance, prepaid rent, advance to suppliers
• Accrued incomes, e.g. interest accrued on investments
• Advance tax
• Goodwill, Patents, etc. to be written off within 12 months
• Interest due on calls-in-arrears
Proposed Dividend is a Contingent Liability.
Dividend is proposed by the Board of Directors and declared (approved) by the shareholders in their Annual General Meeting.
Board of Directors propose the dividend after the annual accounts for the year have been prepared. Annual General
Meeting of the shareholders is held thereafter, i.e. held in the next financial year.

Top Tip
Shareholders may reduce the amount of proposed dividend but cannot increase it.
• Since declaration of proposed (final) dividend is contingent upon shareholders approval, Proposed dividend is a
contingent liability.
• AS-4, Contingencies and Events Occurring after the Balance Sheet Date prescribes that proposed dividend will be
shown in the Notes to Accounts.
• After the Proposed dividend is declared by the shareholders, Dividend payable becomes a liability for the company and
is shown under ‘other current liabilities’ in the balance sheet.
Proposed dividend of previous year will be declared (approved) by the shareholders in the current year and this declared
(approved) dividend will be accounted during the current year, whereas, proposed dividend for the current year will be
relevant for the next financial year.

Statement of Profit and Loss

Revenue from operations

This includes: (i) Sale of products (ii) Sale of services (iii) Other operating revenues
Note: In respect to a finance company, revenue from operations shall include revenue from interest, dividend and income
from other financial services.
Other income
(i) Interest and Dividend incomes (in case of a non-finance company)
(ii) Net gain on sale of investments
(iii) Other non-operating incomes (net of expenses directly attributable to such income).
 25 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Expenses
• Cost of Materials consumed: It applies to manufacturing companies. It consists of raw materials and
other materials consumed in manufacturing of goods.
• Purchase of Stock-in-trade: It means purchases of goods for the purpose of trading.
• Changes in inventories of finished goods, work-in-progress (WIP) and stock-in-trade:
Opening inventory – Closing inventory
• Employees benefit expenses: Expenses incurred on employees towards salary, wages, leave
encashment, staff welfare, etc.
• Finance costs
– Interest paid on long-term borrowings such as debentures, long-term loans, etc.
– Interest on bank overdraft
– Interest paid on public deposits
– Loss on issue on debentures

Top Tip
Other financial expenses such as Bank Charges are shown under ‘Other Expenses’.
• Depreciation and Amortisation Expenses:
– Depreciation is the decrease in the value of fixed assets (e.g. depreciation on plant and machinery).
– Amortisation is writing off the amount relating to intangible assets (e.g. goodwill or patents written off).
• Other expenses: All other expenses which do not fall in the above categories are shown under ‘Other
Expenses’.
Note: Other expenses may further be categorised into direct expenses, indirect expenses and non-operating
expenses.

Analysis of Financial Statements

Meaning of ‘Financial Statement Analysis’
‘Financial Analysis’ is the process of identifying the financial strengths and weaknesses of the firm by properly
establishing relationships between the various items of the balance sheet and the statement of profit and loss.
It essentially involves regrouping and analysis of information provided by financial statements to establish relationships and
throw light on the points of strengths and weaknesses of a business enterprise, which can be useful in decision-making
involving comparison with other firms (cross-sectional analysis/inter-firm comparison) and with firm’s own performance over
a time period (time series analysis/intra-firm comparison).

Top Tip
The term ‘financial analysis’ includes both ‘analysis’ and ‘interpretation’.
• ‘Analysis’ means simplification of financial data by methodical classification given in the financial statements.
• ‘Interpretation’ means explaining the meaning and significance of the data.
These two are complimentary to each other. Analysis is useless without interpretation, and interpretation without
analysis is difficult or even impossible.
Objectives of Analysis of Financial Statements
1. To assess the current profitability and operational efficiency of the firm as a whole as well as its different departments so
as to judge the financial health of the firm.
2. To ascertain the relative importance of different components of the financial position of the firm.
3. To identify the reasons for change in the profitability/financial position of the firm.
4. To judge the ability of the firm to repay its debt and assessing the short-term as well as the long-term liquidity position of
the firm.
Significance of Analysis of Financial Statements
Financial analysis is useful and significant to different users in the following ways:
1. Finance manager
• Financial analysis focuses on the facts and relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
• It helps in constant review of financial operations and to analyse causes of major deviations which further help in
taking corrective actions.
 26 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

2. Top management
• Top management is interested to see that the resources are used most efficiently and the firm’s financial condition is sound.
• It helps the management in measuring the success of company’s operations, appraising the individual’s performance
and evaluating the system of internal control.
3. Trade payables
• Trade payables, through an analysis of financial statements, evaluate not only the ability of the company to meet its
short-term obligations, but also judge the probability of its continued ability to meet all its financial obligations in future.
• Trade payables are particularly interested in the firm’s ability to meet their claims over a very short period of time, i.e.
firm’s liquidity position.
4. Lenders
• Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They analyse the firm’s
profitability over a period of time, its ability to generate cash, to be able to pay interest and repay the principal.
• Long-term lenders analyse the historical financial statements to assess its future solvency and profitability.
5. Investors
• Investors, who have invested their money in the company’s shares, are interested about its earnings. As such, they
concentrate on the analysis of the firm’s present and future profitability.
• They are also interested in the firm’s capital structure to ascertain its influences on firm’s earning and risk.
• They also evaluate the efficiency of the management and determine whether a change is needed or not.
6. Labour unions: Labour unions analyse the financial statements to assess whether the enterprise can
presently afford a wage increase through increased productivity or by raising the prices.
7. Others
• Economists, researchers, etc. analyse the financial statements to study the present business and economic
conditions.
• Government agencies need it for price regulations, taxation and other similar purposes.
• Tax authorities are interested to analyse the financial statements to know about the performance of the company
and to collect various types of taxes.
Limitations of Financial Analysis
1. Financial analysis suffers from the limitations of financial statements as it is based on the information available in
financial statements. Hence, the analyst must be conscious of the impact of window dressing of financial statements,
personal judgement, etc.
2. Financial analysis does not consider price level changes.
3. Financial analysis may be misleading without the knowledge of the changes in accounting policies and procedure
followed by a firm, accounting concepts and conventions, etc.
4. Financial analysis is just a study of reports of the company.
5. Monetary information alone is considered in financial analysis while non-monetary aspects are ignored.
6. Since financial statements are prepared on the basis of accounting concept, as such, financial analysis does not reflect
the current position.
Tools (or techniques) of Financial Analysis
1. Comparative statements: Comparative statements refer to the statements showing the profitability and financial
position of a firm for different periods of time in a comparative form to give an idea about the position of two or more
periods. Comparative statements are:
(i) Comparative statement of profit and loss, and (ii) Comparative balance sheet.
Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also
known as ‘horizontal analysis’.
2. Common-size statements: Common size statements are the statements which indicate the relationship of different
items of a financial statement with a common item by expressing each item as a percentage of that common item, for
example, as a percentage of net revenue from operations for statement of profit & loss and total assets/total liabilities for
balance sheet.
Common size statements allow an analyst to compare the operating and financing characteristics of two companies of
different sizes in the same industry. This analysis is also known as ‘Vertical analysis’.
3. Ratio Analysis: Ratio Analysis describes the significant relationship which exists between various items of a balance
sheet and a statement of profit and loss of a firm. It is possible to assess the profitability, solvency and efficiency of a firm
through the technique of ratio analysis.
4. Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an organisation.
 27 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

6.2 Comparative and Common Size Statements

COMPARATIVE STATEMENTS
MEANING
Comparative statements refer to the statements showing the profitability and financial position of a firm for different periods of time
in a comparative form to give an idea about the position of two or more periods.
It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss
prepared in a comparative form. Thus, comparative statements are:
(i) Comparative statement of profit and loss, and
(ii) Comparative balance sheet
These are prepared by providing columns for the figures for both the current year as well as for the previous year and for
the changes during the year, both in absolute and percentage terms.

Must know!
Uses of Comparative Statements:
• It is possible to find out not only the balances of accounts as on different dates and summaries of different operational
activities of different periods, but also the extent of their increase or decrease between these dates.
• The figures in the comparative statements can be used for identifying the direction of changes and also the trends in
different indicators of performance of an organisation.

COMMON SIZE STATEMENTS

MEANING
Common size statements are the statements which indicate the relationship of different items of a financial statement with a
common item by expressing each item as a percentage of that common item, for example, as a percentage of net revenue from
operations for statement of profit & loss and total assets/total liabilities for balance sheet.
The percentage calculated can be easily compared with the results of corresponding percentages of the
previous year or of some other firms, as the numbers are brought to common base.
Common size statements also allow an analyst to compare the operating and financing
characteristics of two companies of different sizes in the same industry. This analysis is also known
as ‘Vertical analysis’.
Particulars Firm 1 Firm 2 Firm 1 Percentage Firm 2 Percentage
Interesting Fact I II III IV V

Must know!
Uses of common size statements
Common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm
comparisons for the same year or for several years.
• If a common size statement is prepared for a single firm for successive periods, it shows the changes of the respective
percentages over a period of time.
• Inter-firm comparison or comparison of the company’s position with the related industry as a whole is possible with
the help of common size statements.

6.3 Ratio Analysis

Ratio Analysis — Meaning, Objectives and Classification

Meaning of Ratio Analysis/Accounting Ratios
Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its
interpretation is a complex matter.
 28 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Objectives of Ratio Analysis

1. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.
2. To provide information for making cross-sectional analysis by comparing the performance with the best industry
standards.
3. To know the areas of the business which need more attention.
4. To know about the potential areas which can be improved with the effort in the desired direction.
5. To provide information derived from financial statements useful for making projections and estimates for future.
Advantages of Ratio Analysis
1. Helps to understand efficacy of decisions: It helps to understand whether the business firm has taken
the right kind of operating, investing and financing decisions.
2. Simplifies complex accounting figures and establishes their relationships: Accounting ratios
help summarise the financial information effectively and assess the managerial efficiency, firm’s credit
worthiness, earning capacity, etc.
3. Helpful in comparative analysis: Accounting ratios are calculated for many years; they help in exploring
the trends visible in the business. The knowledge of trend helps in making projections about the business.
4. Helps in identification of problem areas as well as the bright areas of the business. Problem areas
would need more attention and bright areas will need polishing to have still better results.
5. Enables SWOT analysis: Accounting ratios help in explaining the changes occurring in the business,
which enables the management in understanding the current threats and opportunities and allows business
to do its own SWOT (Strength-Weakness-Opportunity-Threat) analysis.
6. Helps comparisons with certain benchmarks: With the help of ratio analysis the profitability, liquidity,
solvency and efficiency of a business, may be compared: (i) over a number of accounting periods with
itself (Intra-firm Comparison/Time Series Analysis) and (ii) with other business enterprises (Inter-firm
Comparison/Cross-sectional Analysis).
Limitations of Ratio Analysis
The limitations of ratio analysis which arise primarily from the nature of financial statements:
1. Limitations of Accounting Data: Accounting data give an unwarranted impression of precision and finality.
In fact, accounting data reflect a combination of recorded facts, accounting conventions and personal
judgements which affect them materially. For example, profit of the business is not a precise and final
figure. It is merely an opinion of the accountant based on application of accounting policies, accounting
conventions, etc.
2. Ignores Price-level Changes: A change in the price-level makes ratio analysis meaningless because
accounting records ignore changes in value of money.
3. Ignores Qualitative or Non-monetary Aspects: Accounting provides information about quantitative (or
monetary) aspects of business. Hence, the ratios also reflect only the monetary aspects, ignoring completely
the non-monetary (qualitative) factors.
4. Variations in Accounting Practices: As there are variations in accounting practices followed by different
business enterprises (e.g. different accounting policies for valuation of inventory, calculation of depreciation,
etc.) a valid comparison of their financial statements is not possible.
5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible. Proper forecasting
requires consideration of non-financial factors as well.
The other limitations of ratio analysis are:
6. Means and not the End: Accounting ratios are means to an end rather than the end by itself.
7. Lack of ability to resolve problems: Their role is essentially indicative and that of a whistle blower, and
not providing a solution to the problem.
8. Lack of standardised definitions: There is a lack of standardised definitions of various concepts used in
ratio analysis. For example, there is no standard definition of liquid liabilities. Normally, it includes all current
liabilities, but sometimes it refers to current liabilities less bank overdraft.
9. Lack of universally accepted standard levels: There is no universal yardstick which specifies the level of
ideal ratios. There is no standard list of the levels universally acceptable.
10. Ratios based on unrelated figures: A ratio calculated for unrelated figures would essentially be a
meaningless exercise. For example, creditors of ` 1,00,000 and furniture of `1,00,000 represent a ratio of
1 : 1. But it has no relevance to assess efficiency or solvency.
 29 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Classification/Types of Accounting Ratios

Traditional Classification of Ratios:
1. Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as
statement of profit and loss ratio. E.g. Gross Profit Ratio
2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios. E.g.
Current Ratio
3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable
from the balance sheet, it is called composite ratio. E.g. Trade receivables turnover ratio
Functional Classification of Ratios
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. Liquidity of business refers to the firm’s ability
to meet its current obligations/short term liabilities, and the ratios calculated to measure it are known as ‘Liquidity Ratios’.
These are essentially short-term in nature. These are calculated to measure the short-term solvency of the business, i.e.
the firm’s ability to meet its current obligations.
Liquidity Ratios:
(i) Current ratio (ii) Liquid ratio/Quick ratio/Acid-test ratio
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations towards
stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position are
known as ‘Solvency Ratios’, which are essentially long-term in nature.
Solvency ratios are calculated to determine the ability of the business to service its debt in the long run.
Solvency ratios:
(i) Debt-Equity Ratio (ii) Debt to Capital Employed Ratio (iii) Proprietary Ratio (iv) Total Assets to Debt Ratio
(v) Interest Coverage Ratio.
3. Activity (or Turnover or Efficiency) Ratios: These ratios are calculated for measuring the efficiency
of operations of business based on effective utilisation of resources. These ratios indicate the speed at
which, activities of the business are being performed.
The activity ratios express the number of times assets employed or any constituent of assets, is turned into
sales during an accounting period. Higher turnover ratio means better utilisation of assets and signifies
improved efficiency and profitability, and as such are known as efficiency ratios.
Activity (or Turnover or Efficiency) Ratios:
(i) Inventory Turnover Ratio (ii) Trade Receivables Turnover Ratio
(iii) Trade payables Turnover Ratio
(iv) Investment (or Net assets or Capital employed) Turnover Ratio
(v) Fixed assets Turnover Ratio (vi) Working Capital Turnover Ratio
4. Profitability Ratios: Profitability refers to the analysis of profits in relation to revenue from operations or
funds (or assets) employed in the business and the ratios calculated to meet this objective are known as
‘Profitability Ratios’.
Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of
utilisation of resources employed in the business.
Profitability Ratios:
(i) Gross profit ratio (ii) Operating ratio
(iii) Operating profit ratio (iv) Net profit ratio
(v) Return on Investment or Return on Capital Employed

Liquidity Ratios — Computation and Significance

1. Current Ratio: Current ratio is the ratio of current assets to current liabilities.
Current Assets
Current Ratio =
Current Liabilities

Top Tips
• (Net) Working capital = Current Assets – Current Liabilities
• In ratio analysis, Inventories do not include 'Loose Tools' and 'Stores and Spares'.
 30 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Significance: It provides a measure of degree to which current assets cover current liabilities. The excess of current
assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current
assets and flow of funds.
Current ratio should neither be very high nor very low.
• A very high current ratio implies heavy investment in current assets and reflects under/improper utilisation
of resources.
• A low current ratio increases risk of facing a situation where the company will not be able to pay its short-
term debt on time. It may affect firm’s credit worthiness adversely.

Normally, it is safe to have current ratio within the range of 2 : 1.

2. Quick Ratio (or Liquid Ratio or Acid-Test Ratio)
It is the ratio of quick assets (or liquid assets) to current liabilities.
Quick Assets
Quick ratio =
Current Liabilities
Quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we
exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current
assets because they are not quickly convertible into cash, and hence considered as non-liquid current assets.

Top Tip
Quick assets = Current assets – Closing inventory – Other current assets (prepaid expenses, advance tax, etc.)
Significance: The quick ratio provides a measure of the capacity of the business to meet its short-term obligations
without any flaw.
• Because of exclusion of non-liquid current assets, quick ratio (or liquid ratio) is considered better
than current ratio as a measure of liquidity position of the business.
• Quick ratio is also known as ‘Acid-Test Ratio’ because it is calculated to serve as a supplementary check on
liquidity position of the business.
• It is advocated to be safe to have a quick ratio of 1 : 1 as low ratio will be very risky and a high ratio suggests
unnecessarily deployment of resources in less profitable short-term investments.

Solvency Ratios — Computation and Significance

1. Debt-Equity Ratio
Debt-Equity Ratio measures the relationship between long-term debt and shareholders’ funds.
Long-term Debts
Debt-Equity Ratio =
Shareholders' Funds
• Long-term Debts (‘Debt’) = Non-Current Liabilities = Long term borrowings + Other long-term liabilities + Long-
term provisions
• Shareholders’ Funds (‘Equity’) = Share capital + Reserves and Surplus + Money received against share
warrants + Share application money pending allotment
Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender
regarding extent of security of the debt.
• A low debt-equity ratio reflects more security of the debt. Thus, capital structure with less debt and more equity is considered
favourable as it reduces the chances of bankruptcy.
• A high debt equity ratio is considered risky as company may find difficulty in meeting its obligations to outsiders.
However, greater use of debt may help in ensuring higher returns for equity shareholders (owners) if Return on Investment
(ROI) > Rate of interest on long-term debt. This is called ‘Trading on equity’.

Normally, it is considered to be safe if debt equity ratio is 2 : 1.

 31 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

2. Debt to Capital Employed Ratio

It refers to the ratio of long-term debt to the total of external and internal funds (i.e. capital employed or net assets).

Long-term Debt
Debt to Capital Employed Ratio =
Capital Employed {or Net Assets}
• Capital employed = Long-term debt + Shareholders’ funds
• Alternatively, Capital employed = Net assets = Total assets (non-current assets + current assets) – Current
liabilities
Significance: It shows proportion of long-term debts in capital employed. Low ratio provides security to lenders and high
ratio helps management in trading on equity.

Top Tip
Debt to Capital Employed Ratio can also be computed in relation to total assets. In that case, it usually refers to
the ratio of total debts (long-term debts + current liabilities) to total assets, i.e., total of non-current and current
assets (or shareholders’ funds + long-term debts + current liabilities).
Total Debts
Debt to Capital Employed Ratio =
Total Assets
3. Proprietary Ratio
Proprietary ratio expresses relationship of shareholders’ funds (proprietors’ funds) to total assets.
Shareholders' Funds
Proprietary Ratio =
Total Assets
Significance: Higher proportion of shareholders’ funds in financing the assets is a positive feature as it provides security
to creditors.

t Top Tip
Proprietary ratio can also be calculated as:
Shareholders'Funds
Proprietary Ratio =
Net Assets(= Capital employed)
Then, Debt to capital employed ratio + Proprietary ratio = 1

4. Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets.
Total assets
Total assets to Debt Ratio =
Long-term debts
Significance: This ratio indicates the rate of external funds in financing assets and the extent of coverage of long-term
debts by assets. The higher ratio indicates that assets have been mainly financed by owners’ funds and the long-term
loan is adequately covered by assets.

Top Tip
It is better to take the net assets (capital employed) instead of total assets for computing Total Assets to Debt
Ratio also.
Net assets (capital employed)
Total assets to Debt Ratio =
Long - term debts
Then, Total Assets to Debt Ratio = 1/Debt to Capital Employed Ratio
5. Interest Coverage Ratio (ICR)
ICR deals with the servicing of interest on long-term debts.
Significance: It reveals the number of times interest on long-term debts is covered by the profits available for payment
of interest. It is a measure of security of interest payable on long-term debts. A higher interest coverage ratio ensures
safety of interest on debts.
 32 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Activity (or Turnover or Efficiency) Ratios

1. Inventory Turnover Ratio
It expresses the relationship between the cost of revenue from operations and average inventory.
Opening Inventory + Closing Inventory
• Average Inventory =
2
• Cost of Revenue from Operations = Revenue from Operations – Gross Profit (or + Gross Loss)
Alternately, Cost of Revenue from Operations = Opening Inventory
+ Net Purchases (cash purchases + credit purchases – returns outward) + Direct Expenses (wages, carriage inward, etc.) – Closing Inventory

Top Tip
Cost of Revenue from Operations = Net Purchases + Direct Expenses + Decrease in Inventories (Opening Inventory – Closing Inventory)
Significance: It studies the frequency of conversion of inventory of finished goods into revenue from operations during
an accounting period. It determines how many times inventory is purchased or replaced during a year.
• Low inventory turnover ratio may be due to bad buying, obsolete inventory, etc., and is a danger signal.
• High inventory turnover ratio is good but it may be due to buying in small lots or selling quickly at low margin to realise
cash. Thus, it throws light on utilisation of inventory of goods.
2. Trade Receivables Turnover Ratio
It expresses the relationship between net credit revenue from operations and average trade receivables.
Net Credit Revenue from Operations
Trade Receivables Turnover ratio = Average Trade Receivabless
Note: Trade receivables = Debtors + Bills Receivable
Opening Trade Receivables + Closing Trade Receivables
Average Trade Receivables =
2
Top Tip
Debtors should be taken before making any provision for doubtful debts.
Significance: This ratio indicates the speed (number of times) with which trade receivables are realised, i.e. converted
into cash in an accounting year.
This ratio helps in working out the average collection period.
Months in a year/ Days in a year
Average collection period =
Trade Receivables Turnover Ratio
A high ratio means speedy collection from trade receivables.
3. Trade Payables Turnover Ratio
Trade payables turnover ratio indicates the pattern of payment of trade payables. As trade payables arise on account of
credit purchases, it expresses relationship between net credit purchases and average trade payables.
Net Credit Purchases
Trade Payables Turnover ratio =
Average Trade Payables
Note: Trade payables = Creditors + Bills payable
Opening Trade Payables + Closing Trade Payables
Average Trade Payables = .
2
Significance: It reveals average payment period.
Number of days / months in a year
Average Payment Period =
Trade Payables Turnover Ratio
Lower Trade Payables Turnover ratio means:
(i) Credit allowed by the supplier is for a long period, or
(ii) Delayed payment to suppliers, which is not a good policy as it may affect the reputation of the business.
4. Net Assets Turnover Ratio (or Capital Employed Turnover Ratio or Investment Turnover Ratio)
It reflects relationship between revenue from operations and net assets (capital employed) in the business.
Net Revenue from Operations
Net Assets Turnover ratio =
Capital employed {or Net assets}
Significance: It reflects the efficiency in utilisation of capital employed/net assets. A high ratio reflects efficient utilisation of
capital employed resulting in higher liquidity and profitability.
 33 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Capital employed turnover ratio is analysed by two turnover ratios — Fixed Assets Turnover Ratio
and Working Capital Turnover Ratio.
5. Fixed Assets Turnover Ratio
It reflects relationship between revenue from operations and net fixed assets.
Net Revenue from Operations
Fixed asset turnover Ratio =
Net Fixed Assets
Note: Net fixed assets = Fixed assets – Accumulated depreciation
Significance: It reflects the efficiency in utilisation of fixed assets. A high ratio is a good sign and reflects efficient utilisation
of fixed assets resulting in higher liquidity and profitability in the business.
6. Working Capital Turnover Ratio
It reflects relationship between revenue from operations and working capital.
Net Revenue from Operations
Working Capital Turnover Ratio = Working Capital
Note: Working Capital = Current Assets – Current Liabilities
Significance: It reflects relationship between revenue from operations and working capital. A high ratio is a good sign and
reflects efficient utilisation of working capital, resulting in higher liquidity and profitability in the business.

Profitability Ratios — Computation and Significance

1. Gross Profit Ratio
Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin.
Gross Profit
Gross Profit Ratio = Net Revenue of Operations × 100
Significance: It indicates gross margin on products sold. It also indicates the margin available to cover operating
expenses, non-operating expenses, etc.
• Higher gross profit ratio is always a good sign as it indicates higher gross margin on products sold.
• A low gross profit ratio may indicate unfavourable purchase and sales policy.
Top Tip
Change in gross profit ratio may be due to change in selling price or cost of revenue from operations or a combination of both.

Cost of Revenue from Operations + Operating Expenses

2. Operating Ratio = ×100
Net Revvenue from Operations
Note: Operating expenses = Office expenses + Administrative expenses+ Selling expenses + Distribution expenses +
Depreciation + Employee benefit expenses
Significance: It is computed to analyse cost of operations excluding financial charges in relation to revenue from
operations. Lower operating ratio is a very healthy sign.

Top Tip
Cost of operations is determined by excluding non-operating incomes and non-operating expenses.
• Non-operating expenses = Loss by fire/Accidental loss, Loss on sale of non-current assets, Interest on long-term debts paid,
Bank charges, etc.
• Non-operating incomes = Interest received, Rent received, Dividend received, Profit on sale of non-current assets, Speculation
gain, etc.
3. Operating Profit Ratio:
It may be computed directly as under:
Operating Profit
Operating Profit Ratio = × 100
Revenue from Operations
Alternately, it may be computed as a residual of operating ratio.
Operating Profit Ratio = 100 – Operating Ratio
 34 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Significance: Operating Profit Ratio is calculated to reveal operating margin. It helps to analyse the performance of
business and throws light on the operational efficiency of the business. It is very useful for inter-firm as well as intra-firm
comparisons.

4. Net Profit Ratio

Net profit ratio is based on all inclusive concept of profit. It relates revenue from operations to net profit after operating
as well as non-operating expenses and incomes.
Net profit
Net Profit Ratio = × 100
Net Revenue from Operations

Top Tip
Generally, Net Profit refers net profit after tax. However, as per CBSE guideline, Net Profit Ratio is to be calculated on the basis
of net profit before and after tax.

Significance: It is a measure of net profit margin in relation to revenue from operations. It reflects the overall efficiency
of the business, assumes great significance from the point of view of investors.
5. Return on Investment (ROI) or Return on Capital Employed (ROCE)
It explains the overall utilisation of funds by a business enterprise.
Net Profit before Interest and Tax
Return on Investment = Capital Employed × 100

Capital employed (i.e. the long-term funds employed in the business) = Shareholders’ Funds + Long-term Debts (or
Non-current liabilities)
Alternately, Capital employed = Non-current assets + Working capital
Significance: ROI measures return on capital employed in the business. It reveals the efficiency of the business in
utilisation of funds entrusted to it by shareholders, debenture-holders and long-term loans.
• For inter-firm comparison, ROI is considered a good measure of profitability.
• It also helps in assessing whether the firm is earning a higher ROI as compared to the interest rate paid on long-term
debts. This is so because if ROI > Rate of Interest on Debt, it is advantageous for a company to use more debt to
increase Earnings per share (Trading on equity).

Net profit after tax and preference dividend

Note: Earnings per share (EPS) =
Number of equity shares

Chapter 7
Cash Flow Statement

Meaning of Cash Flow Statement

Cash Flow Statement is a financial statement which shows inflows and outflows of cash and cash equivalents from various
activities (operating activities, investing activities and financing activities) of an enterprise during an accounting year.
Objectives of Cash Flow Statement
1. The primary objective of cash flow statement is to provide useful information about cash flows (inflows and outflows) of
an enterprise during a particular period under various heads, i.e., operating activities, investing activities and financing
activities.
 35 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

2. This information is useful in providing users of financial statements with a basis to assess the ability of the enterprise to
generate cash and cash equivalents and the needs of the enterprise to utilise those cash flows.
Benefits/Advantages of Cash Flow Statement
1. A cash flow statement when used along with other financial statements provides information that enables users to
evaluate changes in net assets of an enterprise, its financial structure and its ability to affect the amounts and timings of
cash flows.
2. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and
enables users to develop models to assess and compare the present value of the future cash flows of different enterprises.
3. It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates
the effects of using different accounting treatments for the same transactions and events.
4. It also helps in balancing its cash inflow and cash outflow, keeping in response to changing condition.
Cash and Cash Equivalents
Cash: As per AS-3, ‘Cash’ comprises cash in hand and cash at bank (demand deposits with banks).
Cash equivalents: ‘Cash equivalents’ means short-term highly liquid investments which are easily convertible into cash
having insignificant risk of changes in value. Examples:
(i) Preference shares of a company acquired shortly before their specific redemption date with insignificant risk of
failure of the company to repay the amount at maturity.
(ii) Short-term marketable securities which can be readily converted into cash are treated as cash equivalents and is
liquidable immediately without considerable change in value.

Top Tips
• Current Investments are to be taken as Marketable securities, i.e. cash and cash equivalents, unless otherwise
specified.
• An investment will be treated as cash equivalents only when it has a short maturity of 3 months/90 days or less.
• Investments in shares are excluded from cash equivalents unless they have maturity of 3 months or less from the date
of acquisition.
Cash Flows
‘Cash Flows’ (cash inflows and cash outflows) means movement of cash and cash equivalents (in and out) due to non-
cash items. (Non-cash items are the items other than cash and cash equivalents, e.g. machinery, share capital, etc.)
• Proceeds from sale of machinery, cash received from trade receivables, dividend received, etc. are cash inflows.
• Purchase of machinery for cash, payment to trade payables, interest payments, etc. are cash outflows.
Cash management includes the investment of excess cash in cash equivalents. Hence, purchase
of marketable securities or short-term investment is not considered while preparing cash flow
statement as it constitutes cash equivalents only. It is only the movement between the items of
cash and cash equivalents. There is no flow of cash and cash equivalents.

Classification of Activities for Preparation of Cash Flow

Statement as per AS-3 (Revised)
1. Cash flows from Operating Activities
Operating activities are the principal revenue generating activities (or the primary or main activities) of the enterprise and
these activities are not investing or financing activities.
For example, for a company manufacturing garments, operating activities are procurement of raw material, manufacturing
expenses incurred, sale of garments, etc.
Cash flows from operating activities generally result from the transactions and other events that enter into the determination
of net profit or loss.

Top Tip
The amount of cash from operations indicates the internal solvency level of the company, and is regarded as the key
indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the
operating capability of the enterprise, paying dividends, making of new investments and repaying of loans without recourse
to external source of financing.
 36 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Examples of Cash Inflows from Operating Activities Examples of Cash Outflows from Operating Activities
• Cash receipts from sale of goods and the rendering of • Cash payments to suppliers for goods and services
services to customers (i.e. Cash revenue from operations) purchased (Cash purchases)
and Cash collection from trade receivables • Cash payments to and on behalf of the employees (i.e.
• Cash receipts from royalties, fees, commissions (e.g. payment of employees benefits expenses)
Trading commission) and other revenues • Cash payments of operating expenses — office and
• Refund of income-tax received administrative expenses, selling and distribution expenses,
etc. E.g. Manufacturing overheads paid, Rent paid.
• Cash payments to an insurance enterprise for premiums
and claims, annuities, and other policy benefits
• Cash payments of income tax

• An enterprise may hold securities and loans for dealing or for trading purposes. In both cases they represent ‘Inventory’
specifically held for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are
classified as operating activities.
• Cash advances and loans made by financial enterprises (whose main business is lending and borrowings) are usually
classified as operating activities since they relate to main activity of that enterprise. Thus, Interest or dividend received by
a Bank or a Mutual Fund Company will be classified as cash inflow from operating activities. Similarly, Short-term loans
and advances made to third parties by a financial enterprise will be classified as cash outflow from operating activities.
2. Cash Flows from Investing Activities
Investing activities are the acquisition and disposal of long-term assets and long-term investments. In other words,
investing activities relate to purchase and sale of fixed assets such as machinery, furniture, etc. and long-term investments.

Top Tip
Separate disclosure of cash flows from investing activities is important because they represent the extent to which
expenditures have been made for resources intended to generate future income and cash flows.
Examples of Cash Inflows from Investing Activities Examples of Cash Outflows from Investing Activities
• Cash receipts from sale of fixed assets (both tangible and • Cash payments to acquire fixed assets (both tangible
intangible fixed assets) and non-current investments e.g. and intangible fixed assets) and capitalised research
Proceeds from sale of patents, property, plant or equipment and development, e.g. Purchase of property, plant or
• Cash receipt from the repayment of advances or loans equipment for cash, Purchase of goodwill for cash
made to third parties (except in case of financial enterprise) • Cash payments to acquire shares, warrants or debt
• Cash receipts from sale of shares, warrants or debt instruments of other enterprises (other than the
instruments of other enterprises (except those held for trading instruments those held for trading purposes), i.e.
purposes) Purchase of non-current investment
• Interest received in cash by a non-financial enterprise • Brokerage paid on purchase of non-current investment
from loans and advances made to third parties or Interest • Cash advances and loans made to third party by non-
received by a non-financial enterprise on debentures held financial enterprises (since advances and loans made by
as investments a financial enterprise is classified as operating activities)
• Dividend received on shares held as investment by a
non-financial enterprise
• Rent received on property held as investment

3. Cash Flows from Financing Activities

As per AS‑3, financing activities are activities that result in changes in the size and composition of the owners’ capital
(including preference share capital in case of a company) and borrowings of the enterprise. In simple words, financing
activities relate to long-term funds or capital of an enterprise, e.g., cash proceeds from issue of equity shares, debentures,
raising long-term bank loans, repayment of bank loan, etc.
 37 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Top Tip
Separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on
future cash flows by providers of funds (both capital and borrowings) to the enterprise.

Examples of Cash Inflows from Financing Activities Examples of Cash Outflows from Financing Activities
• Cash proceeds from issuing shares (equity or/and • Cash repayments of amounts borrowed, e.g. redemption
preference) of debentures or preference shares, buy back of equity
• Cash proceeds from issuing debentures, bonds and shares, repayment of long-term debts, etc.
short-term borrowings (e.g. Bank overdraft and Cash • Interest paid on long-term borrowings (on debentures and
credit) and other long-term borrowings (e.g. procurement long-term debts) by a non-financial enterprise
of term-loans) • Equity and preference dividends paid (both final dividend
• Securities Premium Reserve on issue of shares or and interim dividend) by a finance company or a non-
debentures financial company
• Underwriting commission paid
• Dividend distribution tax paid

Accounting Treatment of Some Peculiar Items

1. Extraordinary items
Extraordinary items are not the regular phenomenon, i.e. non-recurring in nature. Examples:
(i) Loss of stock of goods due to theft/earthquake/flood
(ii) Insurance proceeds from the famine settlement/ earthquake disaster settlement

Top Tip
Cash flows associated with extraordinary items should be classified and disclosed separately as arising from operating,
investing or financing activities. This is done to enable users to understand their nature and effect on the present and
future cash flows of an enterprise.
For example, Loss of stock of goods due to fire/theft/earthquake/flood is classified under operating activities,
whereas, loss of machinery due to fire/theft/earthquake/flood is classified under investing activities.
2. Interest and Dividend
In case of a non-financial enterprise:
(i) Payment of interest and dividends are classified as cash outflows from financing activities.
(ii) Receipt of interest and dividends are classified cash inflows from investing activities.
In case of a financial enterprise (whose main business is lending and borrowing):
(i) Interest paid, interest received and dividend received are classified as operating activities.
(ii) Dividend paid is a cash outflow from financing activities.

• Examples of activities which are an investing activity for every type of enterprise: (i) Purchase of Goodwill (ii)
Purchase of Fixed assets (iii) Sale of fixed assets
• Examples of activities which are a financing investing activity for every type of enterprise: (i) Dividends paid
(ii)Issue of Shares (iii) Redemption of Preference shares (iv) Buy Back of equity shares (v) Issue of Debentures
(vi) Redemption of Debentures (vii) Obtaining Long Term Loans (viii) Repayment of long term loans
• A transaction may include cash flows that are classified differently. For example, when the instalment paid in
respect of a fixed asset acquired on deferred payment basis includes both interest and loan, the interest element is
classified under financing activities and the loan element is classified under investing activities.
• Same activity may be classified differently for different enterprises. For example, purchase of shares is an operating
activity for a share brokerage firm (an investment company) while it is investing activity in case of other enterprises.
 38 SUBHASH DEY (Shree Radhey Publications) Accountancy Class 12

Types of Taxes Classification of Activities

Income tax (i.e. tax on normal profit/operating profit) Cash outflow from operating activities
Capital gains tax (i.e. tax on capital profits, e.g. tax paid Cash outflow from investing activities
on sale of land and building)
Dividend tax (i.e. tax on amount distributed as dividend) Cash outflow from financing activities
4. Non-Cash Transactions
As per AS-3, investing and financing transactions that do not require the use of cash or cash equivalents are
termed as non-cash transactions.
Non-cash transactions should be excluded from a cash flow statement since there is no inflow or outflow of cash and cash
equivalents.
Examples of non-cash transactions:
(i) Issue of shares or debentures to the vendors for the purchase of fixed assets
(ii) Redemption of debentures by converting them into equity shares
(iii) Issue of fully paid bonus shares by utilising the balance of securities premium account.

Top Tip
Non-cash transactions should be excluded from a cash flow statement. They should be disclosed elsewhere in the
financial statements in a way that provide all the relevant information about these investing and financing activities.
5. Proposed Dividend
As per AS-4, Contingencies and Events Occurring after the Balance Sheet Date, Proposed dividend is shown in the
Notes to Accounts. It will be shown as contingent liability since it becomes a liability after it is declared (approved)
by the shareholders. It will be accounted in the books of account after it is declared (approved) by the shareholders
in the Annual General Meeting. Since, previous year’s Proposed Dividend will be declared (approved) in the current
year; previous year’s Proposed Dividend will be accounted as dividend payable.
Proposed dividend of previous year after declaration (approved) by the shareholders will be debited to surplus
i.e., Balance in Statement of Profit and Loss. While preparing cash flow statement, previous year’s proposed
dividend will be added to Net Profit under operating activities and will be shown under financial activity.
Current years’ Proposed Dividend will be ignored as it will be accounted for in the next year after it is declared by
the shareholders.