CBSE SAMPLE PAPERS 2008
SAMPLE PAPER 1
Chapter 1
Partnership Accounts - Fundamentals
Introduction
A partnership firm is a business jointly owned by two or more persons. Partnership is defined by Indian Partnership Act of 1932 as “the relation between persons who have agreed to share profits of a business carried on by all or any one of them acting for all”. This definition highlights the following features of a partnership business.
i) A partnership involves two or more persons.
ii) It is formed on the basis of an agreement.
iii) It is formed for conducting a business.
iv) Profit or loss arising from the business will be shared by the partners.
v) It may be run by all the partners or any one of the partners representing all of them.
Accounting for partnership involves several special adjustments due to the presence of more than one owner. It should safeguard the rights of partners and it should establish liabilities of partners in an impartial manner. Any error in accounting decision will result in undue advantage to some partners at the expense of others. This problem does not arise in a sole trading business since there is only one owner, whose decisions, whether they are right or wrong would affect only his own interest.
Nature / Characteristics of Partnership
1. Two or More Owners
The basic feature of a partnership is the presence of more than one owner of the business. Partnership is formed by two or more persons joining together to conduct a business within the legal framework of Indian Partnership Act of 1932. The maximum number of partners in a firm is legally restricted to 10 for banking business and 20 for non banking business.
2. Agreement
As stated in the definition a partnership business is based on the agreement between partners. This agreement should be in conformity with the provisions of Indian Partnership Act, 1932, which is the governing law for the partnership firms in India. From the legal point of view, it is not compulsory that the partnership agreement is made in writing. But it is a matter of common sense that the agreement is made in writing to avoid unnecessary dispute between partners in future. The written agreement between partners is known as Partnership Deed.
3. Business
The object of partnership is to conduct a lawful business. In the absence of such a business, an agreement between individuals will not become a partnership in the legal sense.
4. Sharing of profit
A business activity will result in profit or loss. This profit or loss has to be shared by the partners. Usually the profit sharing ratio will be mentioned in the partnership agreement. But if it is not mentioned in the agreement, the Partnership Act specifies that, the partners shall share profit or loss equally.
5. Mutual Agency
Mutual principal agency relationship is a special feature of a partnership business. Due to this relationship any act by a partner on behalf of the firm shall be automatically be binding on other partners also. Similarly any default of a partner shall be considered a default of all the partners.
Partnership Deed – Meaning, Impact
Partnership deed is the written agreement between partners. This agreement contains all the terms and conditions agreed between partners. Rights, duties and liabilities of all partners are stated in the partnership deed.
The effect or impact of partnership deed is that it guides partners’ decisions at all stages of the business. In the absence of a Partnership Deed or when the Deed is silent on an issue, the partners are expected to follow the relevant provisions of the Indian Partnership Act, 1932. The Act gives guidelines on the general principles of partnership business. If the partners agree on any specific condition such as interest on capital, salary etc. such agreements are to be clearly stated in the partnership deed.
Contents of the Partnership Deed
A Partnership Deed contains elaborate provisions on almost all aspects of a partnership business. If the partnership deed does not contain any specific condition on any issue, it will be decided according to the provisions of the Partnership Act. Following is the list of major items mentioned in a partnership deed.
i) Name address of the partnership business
ii) Names and addresses of partners
iii) Nature of partnership business
iv) Profit or loss sharing arrangement
v) Duties and responsibilities of each partner in conducting the business
vi) Method of accounting, auditing etc.
vii) Conditions regarding maintenance of bank account.
viii) Conditions regarding drawings
ix) Conditions regarding interest on capital, interest on drawings etc.
x) Whether, or not salary is allowed to partners, conditions regarding salary.
xi) Conditions regarding loans from partners, loans to partners
xii) Valuation and presentation of goodwill
xiii) Procedures for settlement of accounts in the event of retirement or death of a partner.
xiv) Arbitration clause, to settle disagreement if any.
Rules Applied in the Absence of Specific Conditions in the Partnership Deed.
In the absence of specific conditions in the partnership deed regarding the following issues, they will be settled according to the provisions of the Partnership Act as follows:
a. A partner is not entitled to any salary for his service rendered to the firm.
b. Partner is not entitled to interest on capital
c. No interest is charged on partner’s drawings.
d. A Partner is entitled to interest at the rate of 6% p.a. on any loan given to the firm.
f. The profit or loss from the business has to be shared equally.
Special Aspects of Final Accounts of Partnership
1. Fixed and Fluctuating Capital Accounts
The partners of a firm have the option to decide whether their capital accounts may remain fixed or fluctuating. This aspect is not much relevant in a sole trading business, where the capital account is usually fluctuating. Stability in capital balances is important in a firm, because the capital investment is usually one of the major aspects of partner’s business relationship. When the capital accounts are said to be ‘fixed’ it implies that the capital accounts will remain steady for a reasonably long time. In other words the daily items of credit and debit to partners will not be recorded in the capital accounts. They will open current accounts in each partner’s name. These current accounts are regarded as subsidiary capital accounts. Daily transactions related to a partner are recorded in his current account, instead of capital account. Thus the current account keeps on changing as the transactions are posted into it, while the capital balance stays the same. However, if there is any additional capital investment by a partner or capital withdrawal, other than minor routine drawings, it will be recorded in the capital account, not in the current account. In the event of rescheduling of capitals transfers can be made from current accounts to capital or vice versa to adjust the capital balances.
When the capital accounts are fluctuating there will not be a current account in the name of partner. All transactions related to a partner, such as salary to a partner, interest on capital, additional capital investment and similar items are directly credited to the capital accounts of partner. Drawings, interest on drawings capital withdrawal etc. are debited to the capital accounts. Thus the balance in the capital account keeps on changing with every transaction posted into it.
Fixed Capital Fluctuating Capital
1. Opening and Closing balances in the capital account will remain the same.
2. Current Accounts will be opened in the name of partners when capitals are fixed.
3. Regular transactions related to partners are not entered in the capital accounts.
4. Fixed capital accounts always have credit balance Opening and closing balances rarely remain the same.
Current accounts are not required.
All regular transactions related to partners are recorded in their capital accounts.
Fluctuating capital accounts can sometimes have debit balance
2. Division of Profit among Partners
Profit making and profit sharing are the main objectives of partnership business. When the partners do not have any special conditions regarding the profit distribution the task of profit sharing is a simple, one-step operation of dividing the profit in the given ratio. But in actual practice the partners are compelled to include many conditions such as interest on capital, interest on drawings, salaries, commission on profit etc. The purpose of these special conditions is to fairly compensate extra capital, extra effort or similar additional factors contributing to the profitability of the firm. Thus the profit distribution becomes little more complex. A profit and loss appropriation account is prepared with full details of profit distribution. This is prepared as a supplementary account to the profit and loss account, prior to preparing the balance sheet.
3. Past Adjustments
3.1. Omission of Interest on Capital / Interest on Drawings
This step is almost like rectification of errors that you studied last year. Let us first consider omission of interest on capital. Interest on capital is taken out of the available net profit and distributed to partners. Thereafter the balance of net profit is distributed in the profit sharing ratio. So, when the interest on capital is omitted in the first place it means that the entire net profit is distributed.
Now how do we correct it?
Simple, take out the total amount required for paying interest on capital from the capital accounts of partners in the profit sharing ratio, and give it back to them as interest.
What is the use of taking out from partners and give them back the same?
We usually do not give back exactly what we take out. The profit sharing ratio plays a very important role here. See the next illustration. We take out the total interest divided equally from the three partners, and redistribute them as interest according to capital balance. The point to notice here is, that there is no definite relationship between profit sharing ratio and capital balance. In the illustration the partners are sharing profits and losses equally even though their capitals are not equal.
3.3 Omission of Outstanding Expenses and Incomes
Outstanding expenses and outstanding incomes have direct effect on the net profit. Outstanding expense is an expense in the first place and a liability as well. When it is omitted it means a higher profit is distributed to partners and a liability is not provided in the books. Outstanding income has the opposite effect. Rectification of these errors is a simple procedure.
i) If the number of items is less, correct it by passing simple rectification entry, by debiting outstanding income, crediting outstanding expense and passing the difference into capital account. This way you are creating asset account in the books for the outstanding income, creating liability account for the outstanding expense, and transferring the net loss or gain into capital accounts.
ii) When the number of items involved is more or when it is specifically asked in the question, you should open a profit and loss adjustment account.
iii) P&L adjustment account can be safely assumed as a combined capital account of partners. When you want debit partner’s capital account you can debit P&L adjustment account instead.
iv) When there is an outstanding expense, we usually debit capital accounts and credit outstanding expense account. Now you debit P&L adjustment account for any outstanding expense and credit it for the outstanding income.
v) The net balance of profit and loss adjustment account is transferred to the capital accounts of partners in the profit sharing ratio.
4. Guarantee of Profits
Sometimes partners agree to guarantee minimum profit to a partner as a special privilege. There can be many reasons for granting such a privilege. Attracting a reputed individual, who is unwilling to bear the risk of income fluctuations to become a partner, is one of such reasons. If the share of profit for such a partner falls short of the minimum amount guaranteed, the other partners will adjust that shortage form their share of profit according to the agreed conditions. If the share of profit of the partner holding guarantee privilege comes equal or more than the guaranteed sum, that actual share will be given without any adjustments.
5. Accounting for Joint Life Policy
A partner ceases to be a partner either by retirement or death. At the time of retirement or death of a partner the firm represented by the continuing partners, has to settle the amount due to the outgoing partner. Since retirement is a pre-planned event proper arrangement for the payment of amount due to retiring partner can be made. Death comes unexpectedly. The firm suffers the loss of an experienced partner and it has the added burden of settling a huge amount of capital and other dues to the deceased partner. Unlike retirement, death of a partner results in a financial emergency, as the amount due cannot be delayed for long time. Unless adequate precautions are made, this emergency can turn into deep financial crisis.
(Please refer Chapter 4 – Retirement of Partners for details on Joint Life Policy)
Miscellaneous Adjustments
Interest on Capital
Interest is allowed on partner’s capitals only if there is a specific agreement in the partnership deed. When interest is allowed on partner’s capital it should be calculated on the basis of period of capital investment. Suppose a partner makes additional investment after three months from the starting of a year, interest on this additional capital is allowed for nine months only, not for the full year.
Commission to Partners
Commission is allowed to a partner for his service if all partners agree to such a payment. Again, in the absence of a specific condition in the partnership deed, a partner is not entitled to any salary or commission for his service rendered to the firm.
When commission is allowed it may be stated as ‘payable on the profit before charging commission’ or ‘payable on the profit after charging commission’. If commission is payable on the profit before charging commission, it simply means that the commission is to be calculated at the given percent on the given amount of profit. But if it is a certain percentage after charging such commission, the amount of commission should be exactly the percentage specified on the balance of profit after deducting such commission, not the total amount.
Calculation of Capital Ratio
Capital ratio should be understood as investment ratio. Money is considered an important working factor in the business. When the capital contribution of a partner is higher, it also means that his money worked more in making the profit. In calculating the capital ratio the amount and the period of investment are to be considered. Suppose A contributes 10,000 in January and B contributes the same amount on 1st July, A's capital has worked double that of B due to earlier investment, even though both the amounts are the same at the end of the year. Therefore, capital ratio should be based on the amount of capital multiplied by the number of months the investment remained with the firm.
Theory Questions
1. What is meant by partnership?
2. Mention any three features of partnership.
3. Distinguish between fixed and fluctuating capital accounts.
4. State provisions of the Partnership Act, 1932, in the absence of a partnership agreement regarding the following:
(i) Division of profit (ii) Interest on capital and (iii) Interest on partner’s drawings
5. State any three items that should be included in the partnership agreement form accounting point of view.
6. Why is profit and loss appropriation account prepared?
7. Name any six items, which are shown in the profit and loss appropriation account.
8. How will you calculate interest on the drawings of equal amounts on the first day of every month of a calendar year?
9. How will you calculate interest on the drawings of equal amounts on the last day of every month of a calendar year?
10. How will you calculate interest on the drawings of equal amounts on 15th day of every month of a calendar year?
11. List any two items appearing on the debit side of the partner’s current account.
12. In the absence of partnership deed, how are the interest on capital and interest on partner’s loan treated?
13. Give items that may appear on the credit side of partner’s current account.
14. State at least five important points from accounting point of view which must be incorporated in the partnership deed.
15. In the absence of partnership deed, state four important points that you should note for proper accounting treatment amongst the partners. (hint: rules regarding salary to partners, interest on capital etc.)
End of Chapter 1
Chapter 2
Partnership Accounts - Reconstitution by Changing Ratios
A partnership business may undergo several structural changes during its lifetime. When the existing partners of a firm decide to reconstitute their business by changing their profit sharing ratio, it becomes essential to make appropriate accounting steps. Reconstitution of partnership can take place as a result of decision by the partners to change their profit sharing ratio, or by way of admission of a new partner, retirement of a partner or by death of a partner. The following are the essential aspects to be considered on reconstitution of the partnership among existing partners.
1. Change in profit sharing ratio among existing partners; sacrificing ratio and gaining ratio
2. Distribution of reserves and accumulated profits
3. Revaluation of assets and liabilities
4. Treatment of goodwill
5. Readjustment of capital accounts
1. Change in Profit Sharing Ratio among existing partners - Sacrificing Ratio and Gaining Ratio
Existing partners may decide to change their profit sharing ratio for various reasons. When the profit sharing ratio is revised among existing partners, there ought to be a partial sacrifice of profit share by some partners in favour of others. The sacrifice of one or a group of partners becomes the gain of the remaining partners. When the profit sharing ratio is revised it is important to calculate the sacrificing ratio and gaining ratio. These ratios are required to adjust the value of goodwill of a firm without raising goodwill account in the books. Sacrifice / gain ratios can be applied to adjust the profit or loss on revaluation of assets and liabilities in the capital accounts of partners without actually changing the values of those assets and liabilities.
Remember the most important rule in adjusting sacrifice/gain in all situations:
Gaining Partner Dr.
To Sacrificing Partner
Method of calculating sacrificing ratio and gaining ratio
Sacrificing ratio in partnership accounting is the ratio in which existing partners sacrifice their share of profit. This happens due to a revision in profit sharing ratio or admission of a new partner. This is calculated by deducting the new ratio from the old. When there is sacrifice new ratio is always lower than the old.
Gaining ratio is the opposite of sacrificing ratio. This is the ratio gain to the existing partners of a firm when they revise the profit sharing ratio, or when the profit share of the deceased or retired partner is shared by the other partners. This ratio is calculated by deducting the old ratio from the new ratio. The new share will be higher than the old when there is a gain.
Shortcut to calculate sacrificing ratio and gaining ratio
When there is a revision of profit sharing ratio by existing partners, there will be sacrifice as well as gain within the same partnership. Therefore it is easier to stick to one formula. Take the result of new ratio minus old ratio. If the result is negative it is sacrifice; and positive it is gain.
Notice the steps once again:
a. Write the new ratio in the first line
b. Write the old ratio in the second line (remember to adjust the ratios to add up to the a convenient total)
c. Deduct the old from new
d. Negatives result indicates sacrifice; positive result indicates gain
2. Revaluation of Assets and Liabilities
Assets and liabilities are often shown in the accounts at their historical value rather than realisable value. Due to conservatism the partners usually do not revise the values of assets even when their actual market values are much higher than book values. Similarly inadequate depreciation, change in technology etc. make the book values of certain assets more than their realisable value. It is not practical for the partners to keep on changing the book values of their assets according to their market values. The difference between book value and market value is not a problem as long as the partnership business goes on normally. But when they change the structure of the partnership in the form of revision in profit sharing ratio, admission of a new partner, retirement or death of a partner, amalgamation of two partnership firms, absorption of a firm by another etc., the values of assets and liabilities are to be reassessed and difference if any, should be accounted.
What is the purpose of revaluation?
When the realisable value of asset or liability is different from the book value there is a profit or loss is hidden in the difference in value. The partners are entitled to all the profits and loss in the existing profit sharing ratio. If the ratio remains unchanged there is practically no use in estimating the hidden profit or loss. However, if the partners want to change the profit sharing ratio, this hidden profit or loss should be distributed first before changing the ratio. If this profit or loss is not distributed prior to changing profit sharing ratio some partners are likely to lose and others gain due to the change in ratio.
For example: A&B, who were equal partners purchased land for Rs.10,000 in Jan 1975. They decided to share profits and losses in the ratio 2:1 from 1st January 2001. The market value of land on 1st January stood at Rs.70,000; whereas the book value remains at the purchase price of Rs.10,000. There is a hidden profit of Rs.60,000 in the value of land which A & B entitled to share Rs.30,000 each. Suppose they ignored this factor and changed the profit sharing ratio to 2:1 and sold the land for Rs.70,000 afterwards, the profit on sale of land Rs.60,000 will go to A and B in the new ratio 2:1, which means A will get 40,000 and B will get only 20,000. In other words Rs.10,000 belonging to B will wrongfully go to A. Vice versa can happen in case of a hidden loss. To prevent such problems the partners revalue the assets and liabilities and transfer the net result into their capital accounts in the existing ratio before making a change.
Revaluation Account
When the value of one asset is to be increased in the books it can be easily done by debiting the asset and crediting it to partners’ capital accounts in the profit sharing ratio. But when there is a major shake up, values of almost every asset and liabilities are to be revised. For the purpose of convenience, revised values of assets and liabilities are brought into books by opening a temporary account called ‘revaluation account’. The revaluation account summarises the effect of revaluation of assets and liabilities.
Revaluation account is a special profit & loss account representing the combined capital accounts of partners. Any gain on revaluation of asset or liabilities, which are to be credited to partners, will be credited in the revaluation account. Similarly any loss on revaluation will be debited in revaluation account instead of debiting the capital accounts. The final balance in revaluation account indicates the profit or loss on the entire revaluation process. The revaluation account is closed by transferring this profit or loss to partner’s capital accounts in the ratio before revision (old profit sharing ratio). All assets and liabilities will appear at their revised values in the books and in all future balance sheets.
When the partners want to adjust the profit or loss on revaluation process without actually changing the values of assets and liabilities in the books they can do so by opening a memorandum revaluation account. This revaluation account has two parts. The first part is a normal revaluation account and the profit or loss on this part is transferred in the old profit sharing ratio. The second part of memorandum revaluation account is almost a mirror image of the first part. Whatever debited in the first section is credited in the second and whatever credited is debited. Naturally if there was profit in the first section, there will be loss in the second and vice versa. The profit or loss in the first part is transferred to capital accounts in the old ratio, and that at the second part will be transferred to capital accounts new profit sharing ratio. As a result of this exercise the effect of profit or loss on revaluation will be fairly embedded in the capital accounts of partners.
3. Distribution of Reserves and Accumulated Profits
Distribution of reserves and accumulated profits is the first step in any reorganisation process. They include general reserves, credit balance in P & L accounts or any other fund that are retained in the business. These are profits earned in the past, but not taken out by the partners, or profits kept aside. Therefore, when the partners decide to change their future profit sharing ratio, the past profits retained in the above accounts should be distributed to partners in the old ratio as a first step.
4. Accounting for Goodwill
Meaning of Goodwill
Goodwill is the monetary value assigned to the advantages of a reputed business in comparison with a new one. It indicates the extra earning capacity of the business. Goodwill is an intangible asset. But it is not a fictitious asset. Goodwill has a realisable value. It is acquired in a gradual consistent process of good business. Ideal location, experience of staff, reputation of owners, faithful customers etc. contribute to the creation of goodwill.
Usually goodwill is not shown in books due to conservatism. However, it is essential to assess the value of goodwill and pass appropriate entries in the books prior to any change in profit sharing or ownership structure. If this step is ignored while making any rearrangement in profit sharing or ownership structure, some partners will lose and some others will make undue gain, since goodwill is a valuable hidden asset of the business.
Nature of Goodwill
1. Goodwill is an intangible asset
2. Goodwill is a valuable asset.
3. Goodwill generates extra income for the business
4. It is acquired in a gradual process
Following are the major situations in which the goodwill of the firm is to be estimated.
a. Change in profit sharing ratio
b. Admission of a new partner
c. Retirement or death of a partner
d. Amalgamation of two partnership firms
e. Absorption of a firm by another one
Factors Influencing Goodwill
There are several factors that influence the formation of goodwill. The following are some of the important factors helping the formation of goodwill in a business.
1. Honest business dealings
A firm builds up its reputation over a long period by consistent good dealing with the customers. Once the customers start identifying a business for clean and honest dealings they would prefer to stay with the firm, which in turn help the firm to earn higher profits.
2. Good quality of products
A manufacturing concern maintaining a very good quality in their production will gradually build up reputation, which will help them while launching new products. Similarly trading concerns dealing only in good quality products will gradually build up their reputation.
3. Ideal Location
Good location of the business is another favourable factor enhancing the profitability and thereby goodwill of the business. A business which is centrally located will naturally attract more business and more profit.
4. Special skill or Technical Know-how
The business builds up skill in dealing with their product line, dealing with the clients’ specific requirements, problems associated with the geographical location of their business etc. through experience. The problems are wide and varied, and solutions are also equally diverse. Thus the actual experience help develop skill in dealing with similar situations in future, which is naturally promote efficiency and goodwill of the business.
5. Monopoly of Business
Some established business concerns manage to build up their monopoly simply by being the first one in the market. This enables them to establish its position in and to some extent, restrict future competition. Even though, monopolies are undesirable from the customer’s point of view, they are unavoidable and harmless at a limited scale.
Methods of Valuation of Goodwill
Following are the most common methods adopted for valuation of Goodwill.
a. Average Profit Method
Average profit method, as the name suggests, is based on the average profit of the business. Under this method, average profits for the past three or four years as agreed by the partners will be taken. Goodwill is estimated as twice or thrice of this average profit.
b. Super Profit Method
The existence of Goodwill is recognised in a firm only when its profitability is beyond the level of a new firm. Such excess profit earned by the firm is termed as super profit.
c. Capitalisation Method (Goodwill based on Capital Saved)
Capitalization method considers goodwill as the value of capital saved due to higher profitability. Under this method the amount of effective capital is estimated on the basis of market condition. This effective capital is always higher than the actual capital due to better profitability. The excess of effective capital over the actual capital is regarded as capital saved which is considered the goodwill of the firm. Capitalization of super profit and capitalization of actual profit and estimation of capital saved as goodwill are practically the same.
Accounting Treatment of Goodwill
Once the value of goodwill is estimated it should be properly accounted prior to readjustment of profit sharing ratio. There are basically three methods of treatment of goodwill which are:
Margin Adjustment Method
Margin Adjustment Method
This method is used when the partners do not want the goodwill account to appear in the books and to adjust the goodwill only through the capital accounts. When profit sharing ratio is changed what actually happens is something is added or deducted from their old profit share. In other words they retain a major part of their old profit share for which no adjustment is required. Goodwill under this method is adjusted on the basis of marginal increase or decrease of goodwill. The basic rule is that the gaining partner shall compensate the sacrificing partner.
Following are the steps involved in goodwill adjustment.
i) Find out the partner’s sacrifice / gain
ii) Debit gaining partner and credit the sacrificing partner with the proportionate value of goodwill.
If you find the ratios bit difficult, you can arrive at the margin values by following memorandum revaluation in a different format in the workings. This is basically crediting full value of goodwill to partners’ capital accounts in the old ratio and debiting it in the new ratio. The net result is premium being adjusted in the account. You are not allowed to show these entries in the capital account. But the examiner has no problem if you do it in the workings. I followed this method in all illustrations in "Concise Accountancy"
5. Adjustment of Capital Accounts
When the partners change their profit sharing ratio, they may also change their capitals. Contribution of capital is not essentially the basis of profit sharing. But in most cases capital contribution is considered the most important factor in determining profit sharing ratio. Capital balances are usually adjusted by bringing in or taking out cash. However as a temporary measure capital balances can be adjusted by transferring the differences through current accounts.
Theory Questions
1. What is goodwill?
2. State any four factors which influence the valuation of goodwill
3. On what occasions does the need for valuation of goodwill arise?
4. What are the different methods of valuation of goodwill?
5. Distinguish between ‘average profit’ and ‘super profit’ methods of goodwill.
6. Explain the revaluation method of treatment of goodwill.
7. What is sacrificing ratio?
8. Give two circumstances in which sacrificing ratio must be applied.
9. Why is there a need for revaluation of assets and liabilities of a firm, if there is a change in profit sharing ratio?
10. Distinguish between Revaluation Account and Memorandum Revaluation Account.
11. Explain various accounting steps involved in the in the reconstitution among existing partners.
End of Chapter 2
Chapter 3
Partnership Accounts - Admission of a New Partner
Effect of Admission of a Partner
Admission of a new partner is a major event in a partnership business. A new admission can take place only with the unanimous consent of all the existing partners. New partners are admitted for several reasons. Additional capital contribution, fresh ideas more contacts etc. are some of the advantages in admitting a new partner.
Following are the most important accounting aspects to be considered at the time of admission of a new partner.
1. Change in profit sharing ratio
2. Accounting treatment of Goodwill
3. Revaluation of assets and liabilities
4 Treatment of reserves and accumulated profits / losses
5. Adjustment of Capital Accounts
1. Change in Profit Sharing Ratio
When a new partner comes into the business, old partner have to adjust his profit share from their portion. Thus change in profit sharing ratio is the first accounting aspect to be considered on admission of a new partner. In academic accounting, change in profit sharing ratio can be presented in various ways:
a. The new partner’s share is mentioned without specifying the old partner’s profit sharing arrangement.
In this case it is to be assumed that the profit available after paying the new partner’s share is to be divided by the old partners in their old profit sharing ratio. In other words the even though the overall profit sharing ratio changes, the old ratio is still maintained between the old partners, within the new ratio.
3. Revaluation of Assets and Liabilities
Revaluation of assets and liabilities is another major step prior to admission or retirement. Revaluation is important, as there are hidden profits or losses in the difference between book value and actual market value of assets or liabilities. Revaluation is necessary whenever there is a change in profit sharing ratio, even without admission or retirement. The hidden profits or losses should be distributed in the ratio prior to change (Old ratio).
Revised values of assets and liabilities are brought into books by opening a temporary account called ‘revaluation account’. The purpose of revaluation account is to summarise effect of revaluation of assets and liabilities.
Revaluation account represents the combined capital account of partners. Any gain on revaluation of asset or liabilities, which are to be credited to partners, will be credited in revaluation account. Similarly any loss on revaluation will be debited in revaluation account instead of capital accounts. The revaluation account is closed by transferring its net balance to partner’s capital accounts in the profit sharing ratio.
4. Treatment of Reserves and Accumulated Profits
Accumulated profits such as general reserve, credit balance in profit &loss account etc. will be transferred to the capital accounts of old partners in the old profit sharing ratio. Similarly accumulated losses shall be transferred to the debit side of old partner’s capital accounts. Therefore these items will not appear in the new balance sheet.
5. Adjustment of Capital Accounts
When the partners change their profit sharing ratio at admission, retirement or any other reason, they also rearrange their capital accounts. Capital contribution is not essentially the basis of profit sharing. However the in most partnerships capital contribution is considered as the major factor in determining profit sharing ratio.
At the time of admission, capital contribution will be raised as an important condition. When a new partner is admitted for a certain share of profit for a certain amount of capital contribution he would naturally expect the other also maintain a capital balance matching with their profit share. Admission of a partner is not the only situation when a capital rearrangement is considered. Retirement, death or any other change in profit sharing ratio would prompt rescheduling the capital balances. The basic purpose of following ‘fixed capital method’ is to maintain a steady capital ratio. When capital is readjusted on the basis of new partner’s capital contribution, the first step is to determine the revised capital balances of each partner. Readjustment in capital account is usually done by bringing in or taking out cash. Sometimes, in place of cash transactions, old partners may adjust their capital balances by transferring the excess or deficit in the capital accounts to their current accounts as a temporary measure. Once the capital balances are adjusted current accounts can be settled in due course.
Theory Questions
1. Explain the premium method of treatment of goodwill on admission a new partner.
2. What is sacrificing ratio on admission of a partner?
3. Give two circumstances in which sacrificing ratio must be applied.
4. Why is there a need for revaluation of assets and liabilities of a firm, if there is an admission of a new partner?
5. Explain the treatment of goodwill on admission of a partner.
6. Explain various accounting steps involved in the admission of a new partner.
7. What is meant by super profit in the valuation of goodwill?
8. Explain with reason the treatment of reserves and surplus existing in the books of the firm on admission of a partner.
End of Chapter 3
Chapter 4
Partnership Accounts - Retirement / Death of Partners
A person becomes a partner at his own will, as a result of a voluntary agreement. It does not happen due to inheritance or any other external factor on which one has no control. Similarly a partner can retire from the firm at his will subject to reasonable restrictions.
From the accounting pint of view retirement or death of a partner have almost similar effect. Retirement is a planned exit of a partner, while death is an unplanned exit.
Retirement or death dissolves the partnership. This dissolution does not mean the winding up of the business. It happens only in the legal aspect, not in its physical aspect. The remaining partners will continue to run the firm in a reorganised form with a new agreement. As retirement is a planned event, it is mostly done at the end of a financial year. The partners prepare themselves to deal with the problems associated with retirement. Death comes unexpectedly. It can happen any time during a financial year. Exit of a partner can create a vacuum in management and a financial emergency. Accounting treatment for retirement and death are almost the same. Capital and current account balances, along with the share of accumulated profits funds etc. are to be settled. Settlement of claim from Life insurance policies also has to be done. In the event of death, calculation of the deceased partner’s share of profit for the period of his service during the year of death is an additional factor to be accounted.
The following are the common accounting aspects to be considered at the time of retirement or death of partners.
1. Change in profit sharing ratio
2. Treatment of goodwill
3. Revaluation of assets and liabilities
4. Accumulated profits; reserves; losses etc.
5. Adjustment of Joint Life Policy
6. Adjustment of capital
1. Change in profit sharing ratio
Retirement or death reduces the number of partners to share future profits or losses. Naturally the share of profit for the continuing partners will increase by the retirement or death of a partner. Recalculation of ratios is the first step in for further accounting procedures. Revision in ratio may be indicated in any of the following ways in a question:
a. Old ratio is given and nothing is mentioned about the new arrangement after retirement.
This is practically the easiest way of presenting new profit sharing arrangement. The new ratio under this method is found out simply by canceling the outgoing partner’s share of profit assuming that the ratio between the continuing partners does not change. When this method is followed the outgoing partner’s share merges into the continuing partners share in their profit sharing ratio.
Example: A, B and C have been sharing profits and losses in the ratio 3:2:1. B has retired from the business. Find out new ratio between A & C.
Here B is retired and nothing is mentioned about the arrangement between A & C. The new ratio is found out by simply canceling the B’s share of profit.
New ratio = 3:1
Here B’s share of 2/3 of profit is merged in the shares of A and C in the ratio 3:1.
b. The outgoing partner’s share is taken over by the continuing partners in a certain ratio.
A & B have been sharing profits and losses in the ratio 3:2:1. B retired from the firm. His share of profit is divided equally between A & C. Find out new ratio.
Here B’s share of 2/6 is shared between A & C equally. The new share of A is his old share of 3/6 + 1/6 from B. Thus his new share is 4/6. C’s new share is his old share of 1/6 + 1/6 from B. Thus his new share is 2/6. New profit sharing ratio is 4:2 that is 2:1.
c. The new ratio is directly given.
When the new ratio is directly given, the need for calculating it is taken away. But it is important to remember that new ratio is only a first step for further adjustments in accounts on retirement or death.
2. Accounting Treatment of goodwill
Accounting treatment of goodwill on retirement and death is very close to that in admission Following are the different methods followed:
1. The outgoing partner’s share adjusted in the books
(Margin Adjustment)
This method is similar to the premium method adopted in admission of partners. Under this method the outgoing partner’s share of goodwill is credited to his capital account and the continuing partner’s capital accounts are debited for the same in the “gaining ratio.”
Gaining ratio
Gaining ratio is the ratio of gain. This happens due to the retirement or death of a partner. When a partner leaves the firm the ratio is revised and the continuing partners will share the outgoing partner’s share in addition to their old ratio. It is calculated by deducting the old ratio from the new.
Calculation of gaining ratio is important when the partners decide to adjust the outgoing partner’s share of goodwill without raising the goodwill account in the firm.
[Notice that we use sacrificing ratio when the new partner brings in cash for the share of goodwill on admission. Compare the two situations carefully learn thoroughly the difference in accounting treatment.]
2. Goodwill raised in the books (Revaluation Method, for information only).
This is the revaluation method of treatment of goodwill. Goodwill is raised in the books of the firm by debiting goodwill account and crediting “all partners’ capital accounts” in the old ratio.
With this journal entry goodwill account is actually opened in the books and will appear in the future balance sheets at its full value. The outgoing partner gets his share of goodwill along with the continuing partners.
If the continuing partners decide to reduce the value of goodwill or to write it off completely they can do so by debiting their capital accounts in the new ratio and crediting the goodwill account with the amount to be reduced. The outgoing partners share or his position is in no way affected due to this step.
3. Revaluation of assets and liabilities
Revaluation of assets and liabilities are done exactly the same way it is done on admission of a partner. The reason behind revaluation in admission or retirement is to make the balance sheet reflect a true and fair view of the assets and liabilities of the firm, prior to making any other major changes in the ownership structure of the business. Any loss or gain in this rearrangement should go to those persons, only to those persons, who are responsible. In other words the incoming new partner in admission or the outgoing partner in retirement or death shall not lose or gain due to wrong valuation of assets and liabilities.
Revaluation is done in the books through a revaluation account. Profit or loss on revaluation is transferred to the capital accounts of all partners (including the outgoing partner) in the old profit sharing ratio.
Remember the rule we follow in admission; “old partners in old ratio”. Here also we apply the same rule. We don’t call them old partners just because we don’t have any “new partner in retirement”. Also notice that the expression “outgoing partner” is used in this book as a convenient term to refer the “retiring partner” as well as the “deceased partner”. Again deceased partner means dead partner. The term deceased sounds less deadly.
4. Reserves and Accumulated profits losses etc.
Accumulated profits, reserves, losses etc. are treated on retirement or death exactly the way they were done in admission. The profits or reserves are transferred to the credit of capital accounts of all partners in the old profit sharing ratio. As a result these items will disappear from the books and from future balance sheets as well. Accumulated losses that are appearing on the asset side of the balance sheet are transferred to the debit side of all partners in the old profit sharing ratio.
5. Adjustment of Joint Life Policy
Joint life policy is a precautionary measure to protect the firm from financial crisis, on account of death of a partner. This is a life insurance policy by which more than one life is insured. In case of a partnership firm all partners are covered usually by a single life insurance policy. The firm, not the partner, pays the premium on this policy. In the event of death of any one of the partners, the insurance company will pay the full amount assured sum to the firm. This amount will be regarded as a special income to the firm and credited to capital accounts of all partners in the profit sharing ratio.
Does this sound little unfair on the part of the continuing partners to share the insurance amount in the profit sharing ratio? How can someone share the life insurance money on the death of another man? This doubt is quite natural. A person is allowed to take any number of policies on his own life and pay from his private income. Nobody except the legal heirs shall get the insurance amount. But the joint life policy discussed here is different. The main aim of this policy is not supporting the family of the partner, but to save the firm from landing into financial crisis due to death of a partner. However this indirectly helps the family of the deceased by quick settlement of dues. Here all the partners (including the deceased one) decided together to insure their lives jointly and pay the premium from the firm’s funds. There is another aspect also to this problem. Suppose the entire insurance claim is credited only to the deceased partner. This will defeat the very purpose for which the policy is taken, since the capital account or the amount payable to the executors will directly increase to the extent of the insurance claim. Now firm has to find out other sources of finance to settle original capital investment and related amounts. Therefore it is perfectly logical and legally valid to consider the insurance amount as a business income and share the amount in the normal profit sharing ratio.
Sometimes the partners insure their lives separately and pay the premium from the firm. This will help the continuing partners to keep their life insurance policy valid even after the death of a partner. When there are separate life insurance policies, the full amount due on the policy of deceased partner and the surrender values of the policies of the continuing partners will be credited to all partners in their profit sharing ratio. The surrender values will appear in the subsequent balance sheets.
The following are the three methods of accounting treatment of joint life policies:
i) The insurance premium treated as normal business expense
When insurance premium is treated as normal business expense, the premium paid will be initially debited to the premium account and later on transferred to the profit and loss account just like any other business expense.
Journal entries
a) For payment of premium:
Joint life insurance premium account Dr.
To Cash
b) For Transfer of expense to P & L account
P & L account Dr.
To Joint Life Premium Account
c) At the time of maturity (claim due to death)
Insurance Claim Account Dr. (full amount of insurance policy)
To All Partner’s Capital Accounts (in the profit sharing ratio)
d) For cash received
Cash / Bank account Dr.
To Insurance Claim
6. Adjustment of Capital Accounts
Capital accounts of the continuing partners may be readjusted on the basis of new profit sharing ratio. Generally partners bring in or take out cash to adjust the capital balances. They can even do this adjustment by opening current accounts and passing the surplus or deficiency there, without bringing in or taking out cash.
Theory Questions
1. What are the accounting problems arising from the retirement of a partner?
2. Discuss the accounting treatment of goodwill on retirement without raising goodwill at all.
3. Explain the accounting treatment of reserves and surplus at the time of retirement of a partner.
4. What is the purpose of Joint Life Policy on Partners?
5. What is Joint Life Policy Reserve?
6. What are the major differences in accounting steps between retirement and death of a partner?
7. What is gaining ratio on retirement of a partner?
8. List the items which the retiring partner is entitled to claim from the firm.
Chapter 5
Partnership Accounts - Dissolution of Partnership Firms
Meaning of Dissolution
Dissolution of a partnership firm is the process by which the existence of a partnership firm comes to an end. This involves the sale or disposal of assets, settlement of liabilities and closing of books of accounts. Once the outside liabilities of the firm are settled, the partners take away their capital investment. If there is any surplus or deficit in this process it will be shared by the partners in their profit sharing ratio.
Dissolution of a partnership firm can take place on account of any of the following reasons:
a. Dissolution by Agreement: When the partners themselves reach an agreement to discontinue their business for whatever reason, it is known as dissolution by agreement.
b. Compulsory Dissolution: Compulsory dissolution takes place when the business of the firm is declared illegal, or the partners become insolvent or the citizen of an enemy country happens to be partner of the firm.
c. Dissolution by notice: A partner can demand dissolution of a partnership at will, by serving a notice to the firm.
d. Dissolution by Court: Court may initiate dissolution of a firm under the following circumstances:
i) When one of the partners has become of unsound mind
ii) When a partner is guilty of misconduct which may affect the business
iii) When a partner commits wilful breach of contract
iv) Any other reason which the court may find adequate
e. Dissolution by the expiry of a pre determined period or completion of event: This dissolution takes place in case of particular partnerships which are formed for a specific period or the completion of a specific project. Such partnerships will be dissolved at the completion of the specific period of or the project as the case may be.
Dissolution of Partnership and Dissolution of Partnership Firm
The term dissolution, referred in relation to a partnership business generally denotes the winding up of the business. However, there is a difference between ‘dissolution of partnership’ and ‘dissolution of the partnership firm’. The former indicates ending of agreement only to replace it with a new one, but the latter indicates the ending of partnership business altogether. The following points may be noted in comparison between the two:
Dissolution of Partnership
Only the agreement is dissolved, no physical disposal takes place.
The partners will continue to run the business with a new agreement.
Limited effect on employees or debtors and creditors of the business
Many dissolutions of agreement can take place during the life of a partnership business.
Admission, retirement and or death of a partner can result in compulsory dissolution of existing agreement. Dissolution of Partnership Firm
The Firm is dissolved, by selling off assets and settling liabilities.
The partners will discontinue the business
Since the business is closed down it affects the workers, debtors and creditors of the firm
Dissolution of firm can take place only once in the lifetime of a partnership business.
None of these events can lead to a compulsory dissolution of the firm.
Settlement of Accounts on Dissolution
The first step in dissolution is the realisation of assets followed by the settlement of outside liabilities. All individual accounts for assets and liabilities, except cash, are closed by transferring their balances to a Realisation Account. Realisation account is the temporary account for accumulating all assets and liabilities for convenient accounting treatment. All ledger accounts except partner’s capital accounts and cash account are closed prior to realisation procedure. Accumulated profits or losses are directly transferred into the capital accounts in the profit sharing ratio. The following is the order of priority in settlement of liabilities and capital upon dissolution:
i) Expense incurred on realisation of assets such as commission, cartage, brokerage etc.
ii) All outside creditors
iii) Partner’s Loan accounts
iv) Balances in Capital Accounts of partners
Special Items in Accounting for Dissolution
1. Realisation Account: This is the most important account prepared to facilitate dissolution of firms. This is equal in importance to Revaluation Account in Reconstitution. There is no scope of revaluation of assets and liabilities of a firm under liquidation. Realisation account is used to accumulate all assets and liabilities in one place for convenient accounting steps for disposal and settlement of liabilities.
2. Treatment of Goodwill: Goodwill is the most prominent item in Reconstitution of partnership. But goodwill does not have any special treatment in dissolution. If it appears in the books it has to be transferred into Realisation Account. This will automatically gets transferred into the Capital Accounts of Partners, by way of realisation profit or loss. If goodwill does not appear in the books it is just ignored. There is no meaning in raising it or treating it in any way when the firm is being dissolved.
3. Realisation Expenses: Expenses of realisation such as commission paid to brokers for the disposal of assets, expenses on transportation of items, registration documentation charges for the assets sold etc. are debited to Realisation Account and credited to Cash Account. However if any partner agrees to bear the expense for a certain fees, the fees charged by the partner becomes the common expense which is debited in Realisation Account; whereas the actual realisation expense, if mentioned, should be treated as personal drawing of the partner concerned.
4. Wife’s Loan: Loans from a partners’ wife is to be treated as normal creditor. The basic aim of providing a loan in the name of partner’s wife is to by-pass the legal restrictions on the Loan from a Partner to the firm.
5. Provident Fund: Provident fund should be understood as a liability payable to the employees. It should be paid off even when the question is silent about its treatment. Same rule applies to all other outside liabilities, such as creditors, bills payable etc.
6. Specific Funds: Specific funds such as Investment Fluctuation Funds are preferably credited to Realisation account along with the transfer of related asset, which will get transferred to capital accounts by way of profit of loss on Realisation. Provision for doubtful debts, accumulated depreciation etc. must be credited to Realisation Account along with the transfer of assets.
7. Profits Kept Aside: General Reserve; credit balance in P& L Account etc should be directly transferred into the Capital Accounts of Partners, in the profit sharing ratio.
8. Unrecorded Assets: Unrecorded assets or assets which are completely written off may fetch some cash at the time of dissolution. There is no need of bringing them into books and selling them afterwards. It can be directly treated by crediting realisation account and debiting cash account.
9. Creditors Purchasing Some Assets in Part Settlement of Claim: When creditors purchase some of the assets in part settlement, this is not specifically recorded by way of a journal entry, since the asset and liability are appearing in the same Realisation Account. The balance amount due to the creditors is aid in full satisfaction of the claim. If the value of asset taken over is more than the amount due, the creditors will pay the excess amount to the firm.
Please note: The treatment of creditors taking over part of the assets mentioned above is a questionable accounting treatment. What I mentioned above is only on ‘examination point of view’. The correct account treatment is to debit the Creditors account in the Ledger by passing a journal entry and transferring the balance of creditors into Realisation Account
Profit or loss on realization will be transferred to the Capital Accounts of partners in the profit sharing ratio. At the final stage of the realization process, only Cash Account and Capital Accounts will be left. The final balances of each other will match exactly, and the cash will be paid off to capital accounts to close both the accounts. This is the last transaction in the books of the firm.
The entire accounting steps in realization can be summarized as follows:
Step 1: Reduce the Number of Accounts into THREE: As you are aware each item in a detailed Balance Sheet represents an account in the Ledger. You have to reduce them into just three accounts, namely
i) Realisation Account
ii) Capital Accounts of Partners (considered one account)
iii) Cash Account
Step 2: Reduce the Number of Accounts into TWO: Major activities of realisation process take place at this stage. Sell assets one by one and add it to (debit) Cash and reduce it from (credit) Realisation Account. Take out cash and pay to liabilities placed in the Realisation Account. Now the Realisation Account is reduced to a residue, without any active accounts inside. This balance is transferred into capital accounts as realisation profit or loss. Now you have only two accounts, the Cash Account and the Capital Account.
Step 3: Reduce the Number of Accounts to NIL: This is the most interesting step. Here the cash balance has to be exactly equal to the credit balance in capital account. Take out cash (cr); Pay off Capital (Dr.), and there ends the Partnership Business.
Journal Entries in Dissolution
Accounting for dissolution begins with the closing of assets and liabilities accounts by transferring them to Realisation Account.
i) For transfer of assets
Realisation Account Dr.
To Asset Account
ii) For Transfer of liabilities
Liability Account Dr.
To Realisation Account
Accumulated profits such as General Reserves, Profit and Loss Account Credit Balance etc. are transferred to capital Accounts in the profit sharing ratio.
iii) For transfer of accumulated profits
Accumulated Profit Account (General Reserve; P&L etc.) Dr.
To Realisation Account
Note: Provision for doubtful debts; Investment fluctuation fund etc. are credited to realization account and ignored thereafter. These are internal provisions having no claim against the firm and therefore these amounts will merge into realization profit or loss and finally get transferred to Capital Accounts of partners.
iv) For assets realized
Cash/Bank account Dr
To Realisation Account
Note: We do not have separate asset account anymore. Realisation account is the common account representing all assets and liabilities transferred into it. Please check the next entry also.
v) For Liabilities paid off
Realisation Account Dr.
To Cash Account
vi) For asset taken over by a partner
Partner’s Capital Account Dr.
To Realisation Account
vii) For Liability taken up by the partner
Realisation Account Dr.
To Partner’s Capital Account
viii) For unrecorded asset taken over by a partner
Partner’s Capital Account Dr.
To Realisation Account
ix) Unrecorded Liability settled by the firm
Realisation Account Dr.
To Cash account
x) Realisation expense
Realisation Account Dr.
To Cash
xi) Asset taken over by creditors
No entry; Only settlement of balance amount is shown in the books.
Author’s Comment
This is the easiest chapter in Partnership accounts. You have 10 marks for this chapter under revised syllabus. Here you need not remember different methods of treatment of goodwill, no ratio calculations etc. Everything is plain and simple. Pay serious attention to this chapter to secure full 10 marks. Look at some of the important adjustments in the previous chapters becoming very simple here.
1. Goodwill
You must have spent maximum time in understanding various ways of treatment of goodwill in the earlier chapters. Here it is very simple; if there is goodwill given in the Balance Sheet, just debit it in the realisation account and forget it, yes, forget it. If it does not appear in the Balance Sheet, just ignore it; who cares about the goodwill of a firm under liquidation anyway? Simple, simple indeed!
2. Old Ratio, New Ratio, Sacrificing Ratio, Gaining Ratio, any other ratio? See the long list of ratios you need NOT apply here. You have just one profit sharing ratio, to transfer the profit or loss on realisation.
3. Revaluation: You need not struggle with the revaluation of assets and liabilities. There are no provisions to be kept. Here you just have a Realisation Account to move your ledger account items for the time being to help you transfer them to cash as and when realised.
4. Balance Sheet In dissolution you have to prepare NO Balance Sheet at all. Instead you have to destroy one Balance Sheet given in the question. Too good to be true, but it is very true. What you have to do here is to break up old Balance Sheet, extract cash out of it, pay to creditors and finally to owners. Remember how funny it looked when you played video cassettes in reverse mode, cars running backwards at full speed, food taken out of mouth and put back into plate and all those funny stuff. Dissolution is the action replay of partnership formation in the ‘reverse mode’. The process of forming cash and other assets and liabilities in a business forming a Balance Sheet in the beginning of a business is now reversed to show how a Balance Sheet melts into cash, finally goes from the cash box to the owners’ pockets as return of capital.
Simple Steps, Easy Chapter, Study all the illustrations carefully and I need every one of you get full marks in this chapter.
Theory Questions
1. What is meant by dissolution of Partnership Firms?
2. What are the circumstances under which a Partnership firm is dissolved?
3. Distinguish between Dissolution of Partnership and Dissolution of Firm.
4. State order in which the claims against a firm under dissolution are settled.
5. State how the goodwill appearing in the books is treated at the time of dissolution.
6. How is the general reserve treated on dissolution of a firm?
7. State accounting treatment of joint life policy of a firm not appearing in the book surrendered for a certain amount.
8. How do you treat when an unrecorded asset is given to creditors in part settlement/
9. What is the accounting treatment for unrecorded liability is taken up by a partner?
10. State how the entries would be made if a partner agrees to pay off his wife’s loan? What if he does not agree to take up the loan?
11. A Partner and his wife gave loans to the firm. What difference is there between these two loans on dissolution of the firm?
End of Chapter 5
Chapter 6
Accounting for Share Capital
Introduction
Joint Stock Company is the most practical form of organization for large scale business. In India the Indian Companies Act of 1956 governs joint stock companies. Owners of a company are known as shareholders, because they hold the shares of capital of the company.
Share and Share Capital: Meaning, Nature and Types
The most striking feature of a joint stock company is its ownership structure. The capital in a joint stock company is divided into small shares of fixed value. This facilitates easy investment. Shareholders do not directly mange the company. They elect directors who carry out management of a joint stock company. The shareholders have only limited liability in the event of extreme loss or liquidation with excessive outside liability. The face value of the shares held by a person is the maximum amount that he can lose in a joint stock company. If the shares are fully paid up he need not pay anything further even if the company is liquidated with heavy unpaid claims. If the shares held are partly paid up, the unpaid portion of the shares may be called up if the assets available in the company are not enough to pay off liabilities.
Shares can be sold and purchased in the stock exchange. By purchasing shares a person gets part ownership of the business. By becoming a share holder a person cannot immediately start managing the company. Directors are the people who manage the business. Directors are elected representatives of shareholders who carry out the management of a joint stock company. Thus a shareholder can vote to elect directors. He can also contest in the election to become director. A joint stock company is regarded as an artificial person. It is considered to have an identity apart from the shareholders. A company can enter into contract, buy or sell properties in its own name, file lawsuits or can be sued.
Types of share capital
Share capital is basically classified into equity and preference share capital. Equity capital is that part of the share capital whose fortunes are directly linked to the performance of the business. Preference shares on the other hand are the ones having priority in the payment of dividend and repayment of capital in the event of liquidation of a company. Divided for the preference shares are paid at a prescribed rate. Preference shareholders have fixed income irrespective of the performance of the business. Equity dividend is declared each year, which will vary according to the profit earned by the business. The equity shareholders are the ones who actually bear the risk in business. When the performance of the business is good, they get a high percentage of income. The value of shares will also increase in the market. Capital appreciation is the prime attraction of equity shares in a company having consistently good performance.
Apart from the basic classification of equity and preference share capital may be referred by different qualifying terms highlighting certain specific aspects of share capital. Following terms used to qualify share capital.
1. Authorized Capital or Registered Capital
This is the maximum amount of capital a company is authorised to raise from the public. This is specified in the Memorandum of Association of the company.
2. Issued Capital
Issued capital indicates that part of the authorised capital offered to public subscription.
3. Subscribed Capital
This is the part of the issued capital actually purchased or subscribed by the public.
4. Called up Capital
Called up capital indicates the portion of the subscribed capital called up by the company for payment.
5. Paid up Capital
This the amount of called up capital actually paid up by the public. Paid up capital becomes the liability of the company towards its shareholders.
6. Reserve Capital
Reserve capital is the part of the uncalled capital set aside as reserve, by the company to call up only in the event of liquidation of the company.
Accounting for Share Capital
Capital of joint stock companies is referred as share capital because it is divided into shares. Share capital is usually not collected in lump sum, but in instalments at various stages, such as application, allotment, 1st call etc. For the purpose of convenient accounting, a temporary account representing each of these stages will be opened in the ledger which will be closed once the amounts expected on that stage is fully collected or the shares are cancelled for unpaid amounts.
Following are the journal entries for issue of share capital:
Share Application Stage
The first stage in issue of share is the application stage. At this point the company will give extensive publicity to the share issue and invite the public to apply for the shares. A prospectus which is official invitation to the public, containing details of the company, proposed number of shares, its type, value etc. will be issued to the pubic and registered with the registrar of companies.
In response to the invitation by the company, public will apply for the shares. A part of the value of shares will be specified as application money which is to be paid along with the application. This amount will be deposited in the bank account of the company. Application money cannot be less than 25% of the issue price. Following journal entries are passed at the collection and capitalisation of application money.
i.. When share application money is received
Bank Account Dr.
To Share Application Account
ii. Application money credited to Capital Account
Share Application Account Dr.
To Share Capital
The second entry will close the Share Application Account, and in the ledger there will be Cash at Bank on one side and Share Capital on the other, provided the number of applications invited and the number of applications received are the same.
Over-Subscription and Under-Subscription
Over-subscription: It is unlikely that the public apply for the exact number of shares invited by the company. When applications received exceed the number invited, the share is said to be over-subscribed. It also means that the company received more application money than what was originally invited. Now the company cannot conveniently increase the number of shares and keep the money as capital. Instead, it must refund the excess amount received or make a part allotment on applications from each individual, and adjust the money on the subsequent payments due from the same applicant.
Under-subscription: Under-subscription is a situation just the opposite of over-subscription. Here the company received less number of applications than what was invited. In case of under subscription the company will proceed to allotment and subsequent stages with the actual number of shares applied by the public.
When there is over subscription share capital account will not be closed by the transfer to capital alone (second entry above). This is because the company has received more money. This excess amount should either be paid off or adjusted to subsequent payments due by passing one of the following entries depending on what is decided by the directors.
i. If the excess amount is refunded to applicants
Share Application Account Dr.
To Bank
ii. If the excess amount is adjusted to Allotment
Share Application Account Dr.
Share Allotment
Share Allotment Stage
After the closure of share issue the directors proceed to the allotment of shares. An additional amount towards the capital on the allotted shares is collected at this stage. This amount is called allotment money.
Following journal entries are passed at allotment stage:
i.. Allotment money credited to capital
Share Allotment Account Dr.
To Share Capital
ii. Collection of allotment money
Bank Account Dr.
To share Allotment Account
Share 1st Call
After the share allotment, the company will collect the remaining capital in one or two additional instalments which are known as calls on shares. Same accounting entries are passed for all calls.
Following are the typical entries:
i. Call money credited to capital
Share 1st Call Dr.
To Share Capital
ii. Collection of call money
Bank Account Dr.
To Share 1st Call
Issue and Allotment of Preference Shares
Preference shares as also part of capital. But these shares as the name suggest are having some special privileges or preferences. Following are the important features of preference shares.
a. Preference shares are issued with a prescribed rate of dividend. Thus such shareholders have an assured income from their shares. When the company does not make huge profits there is an advantage to the Preference shareholder. But when the profit is high, a preference shareholder must satisfy with his prescribed rate of dividend.
b. In the event of liquidation of the company the preference shareholders get a priority over the equity shareholder in the repayment of capital.
c. Preference shareholders have less say in the management of the company. Equity shareholders who are the real risk bearing investors mainly control management.
Form the accounting point of view there is no much difference between the issue of equity shares or preference shares. The only difference is that the preference capital account will be clearly stated as “preference share capital” in the journal entry. But there is no need to specify “equity capital” when it is issued. The term capital is understood as equity capital.
Private Placement and Public Subscription of Share Capital
Issue of shares under private placement implies the issue of shares to a selected group of persons. Private placement is an issue that is not a public issue. In order to make private placement, a company should pass a special resolution to that effect. If the number of votes cast in favour of private placement is not sufficient to pass a special resolution, but more than the number of votes cast against, the directors can approach Central Government for approval, stating that the proposed private placement is most beneficial to the company.
1. What is authorized capital? What is its significance? How does it differ from issued capital?
Authorized capital is also known as registered capital. This is the capital registered by stating it in the in the Memorandum of Association of a Joint Stock Company. It is the maximum amount of capital that a company is normally allowed to raise by way of share capital. If a company needs to raise more amount it must first alter the Memorandum of Association. Authorized capital is different from issued capital. Out of the authorized capital the portion that is issued to public is known as issued capital. Therefore issued capital can be equal or less than the authorized capital, but can never be more than the authorized capital.
2. State the provisions of the Companies Act, 1956 for the issue of shares at discount.
Conditions regarding the issue of debentures at discount are stated in Section 79 of the Indian Companies Act, 1956. Following are the important conditions:
1. A new company cannot issue shares a discount. A company is allowed to issue shares at a discount only one year after commencement of business.
2. An ordinary resolution authorizing the issue of shares at a discount must be passed in the general meeting of shareholders.
3. A new class of share cannot be issued at a discount.
4. Rate of discount cannot exceed 10% of the face value, unless special permission from the Company Law Board is obtained.
5. The shares must be issued within two months of obtaining permission from the Company Law Board
3. Distinguish between over-subscription and under-subscription. How is over subscription dealt with?
When a company issues shares to the public it is very unlikely that the public apply for the exact number of shares issued. Application can either beyond or below the actual number of shares issued, depending on the reputation of the company of attraction of the offer. When the application received exceed the issue it is said to be “over subscribed”. The company has the following options in dealing with the over-subscription.
1. The company can reject the excess application with refund of application money.
2. It can make a pro-rata allotment, which is proportionate allotment on the basis of number of applications and the number of shares issued.
3. It can work out a combination of the above two options.
5. State any three purposes for which ‘securities premium’ can be used.
According to Section 78 of the companies Act 1956, amounts raised by way of securities premium can be utilized for the following purposes:
1. Issue of fully paid bonus shares
2. Writing off preliminary expenses
3. Writing off discount on issue of shares or debentures
4. Providing for the premium on redemption of debentures
5. Writing off the expenses incurred on the issue of shares or debentures.
6. Write notes on ‘capital reserve’ and ‘reserve capital’.
Capital reserves are generated out of capital profits. A company is not allowed to utilize these reserves for paying dividends. Following are the common source of capital reserve in a company:
i) Profits prior to incorporation
ii) Profit on the reissue of forfeited shares
iii) Profit on sale or revaluation of fixed assets; and
iv) Profit on purchase of business.
Reserve Capital is not a generated reserve. This only a part of uncalled portion of issued capital, which a company has decided not to call unless it goes into liquidation. This arrangement indirectly assure the creditors that the shareholders shall be liable to pay additional amount in the event that the company does not have enough assets to settle the creditors claim in the event of liquidation of the company. However, this method is hardly practiced in real life, because the company can offer more meaningful assurance to creditors without keeping the shares partly paid up.
7. Distinguish between Capital Reserve and Reserve Capital
Basis Capital Reserve Reserve Capital
1. Meaning
2. Disclosure
3. Availability
4. Application of reserve
5. Special Resolution Capital reserve is generated out of capital profits
Capital reserve is disclosed in the balance sheet of the company
Capital reserve is readily available for writing off capital losses.
Capital reserve is retained in the existing assets of the company
Capital reserve is created without any resolution Reserve capital is not a reserve generated. It is only capital not to be called up unless the company goes into liquidation.
Reserve Capital is not mentioned in the balance sheet.
Reserve capital is available only during liquidation process
Reserve capital is not retained in the existing assets of the company.
A special resolution should be passed to set aside reserve capital.
8. Write a note on the issue of shares for consideration other than cash.
a. Normally shares are issued for cash. But a company can issue shares for consideration other than cash. For example a company purchases fixed assets and issues shares to the vendor instead of paying cash or issues shares in settlement of loans or other creditors. In these transactions the company does not receive cash directly but it receives benefits equivalent to cash by way of assets or settlement of liabilities.
Issue of shares in this case also can be made at par, premium or discount. The value of assets purchased or liabilities settled will be considered equivalent to cash received in normal transactions and the amount of discount premium or discount will be worked on that basis.
8. What is meant by private placement of shares?
Issue of shares under private placement implies the issue of shares to a selected group of persons. Private placement is an issue that is not a public issue. In order to make private placement, a company should pass a special resolution to that effect. If the number of votes cast in favour of private placement is not sufficient to pass a special resolution, but more than the number of votes cast against, the directors can approach Central Government for approval, stating that the proposed private placement is most beneficial to the company.
9. Distinguish between equity and preference shares.
Equity Shares Preference Shares
1. Equity shares do not carry any assurance as to dividend payment
2. Equity share holders have voting rights to elect directors
3. In the event of liquidation of the company, equity shareholders get what money left after settling all other claims
4. Equity shares are not redeemed or taken back by the company. Once they are issued, they remain permanently with the company Preference shares are issued with a conditional assurance regarding and a prescribed rate of dividend
Preference shareholders have no voting rights
Preference shareholders get a priority over equity shareholders in repayment of capital in the event of liquidation of the company
There are redeemable preference shares, which the company can pay off
10. Can forfeited shares be reissued at discount? If yes, to what extent?
A forfeited share can be reissued at discount. The amount of capital paid by the previous shareholder is retained in the share forfeiture account. A forfeited share can be reissued at discount to the extent of amount so retained on that share reissued. In case the share was originally issued at discount, the old discount can be allowed in addition to the amount available in the forfeiture account.
11. Explain pro-rata allotment of shares
Pro-rata allotment means proportionate allotment. When there is over subscription of applications, the company has the option to either reject the excess applications or to issue lesser number of shares on the applications adjusting the excess application money in to the amounts due at subsequent stages. The second option is known as pro-rata allotment.
12. What is meant by forfeiture of shares?
Normally a company is not allowed to cancel or take back its shares. But when a person fails to pay the allotment money or call money due on a share, the company is allowed to withdraw those shares and reissue them to another party. Forfeiture is withdrawal of shares due to non-payment of dues by the shareholder.
i. Capital representing the forfeited shares removed from share capital account
ii. Unsettled balances in temporary accounts such as Share Allotment, Share Call etc. (or calls in arrears account) are wiped out from the books.
iii. The paid up portion the forfeited shares is transferred from the capital account to a separate account called ‘Share Forfeiture Account”.
13. Explain the accounting treatment of forfeiture of shares, when they have been issued at a discount.
Accounting treatment on forfeiture of shares will vary according to the conditions under which they have been issued. Shares issued at par, premium and discount are treated differently at the time of forfeiture.
When the shares have been issued at discount the capital representing the shares to be forfeited includes discount as well. When we reverse the capital the calls in arrears as well as the discount accounts have to be credited to clear those balances from the account. When the company reissues the shares issued at discount it is allowed to reinstate the discount that was originally allowed.
14. Explain the accounting treatment of forfeiture of shares when they have been issued at premium.
Accounting treatment on forfeiture of shares will vary according to the conditions under which they have been issued. Shares issued at par, premium and discount are treated differently at the time of forfeiture.
When shares are issued at premium and the premium has been collected by the company before forfeiture, no special treatment is required for the premium portion. The shares can be treated as shares issued at par, on which the capital is debited and the portion of capital received is credited to share forfeiture account and capital not received credited to calls in arrears account.
However if the premium is not received, the premium account should be reversed along with the capital account at the time of forfeiture. This is because the premium not collected inflates the calls in arrears account and a mere reversal of capital account will not be enough to wipe out the calls in arrears account.
15. Where will you show the ‘discount on issue of shares’ in the balance sheet?
Discount on issue of shares is treated as expenditure to be written off. This is placed on the assets side of the balance sheet under the heading Miscellaneous Expenditure, along with other fictitious assets such as preliminary expenses, commission and brokerage.
16. What is meant by private placement of shares?
Issue of shares under private placement implies the issue of shares to a selected group of persons. Private placement is an issue that is not a public issue. In order to make private placement, a company should pass a special resolution to that effect. If the number of votes cast in favour of private placement is not sufficient to pass a special resolution, but more than the number of votes cast against, the directors can approach Central Government for approval, stating that the proposed private placement is most beneficial to the company.
Don’t waste your time reading the stuff below – Out of Syllabus Items from your Text Book
What is Escrow Account?
The word escrow means a contract or bond deposited with a third person, who is to deliver it to the party involved in a contract on fulfilment of certain conditions. In order to ensure that the company fulfils the obligation under buy back it is required to open an escrow account with a merchant banker with an amount equivalent 25% of the total obligation under buy-back scheme, where the total is not more than Rs.100 crores: and 10% of the obligations exceeding Rs.100 crores. This account can consist of (a) cash deposit with commercial bank (b) bank guarantee (c) deposit of acceptable securities with adequate margin against prince variance. This amount is kept as a guarantee, and after payment of all the amounts due on buy-back scheme, it will be released to the company. In case of non-fulfilment of obligation under buy-back, SEBI can forfeit the escrow account.
What is Preferential Allotment?
Preferential allotment is the bulk allotment to an individual, venture capitalist or a company. Preferential allotment is made to a pre-identified buyer at a predetermined price. SEBI prescribed that the price shall be the average of highs and lows of the last 26 weeks preceding the date on which the directors have resolved to make such preferential allotment. Preferential allotment is made to individuals or institutions wish to make a strategic investment in the company. They may or may not be existing shareholders. Preferential allotment can take place only if three-fourth of the existing shareholders approve such an allotment. Shares issued on preferential allotment are not to be sold in the open market for a period of three years. This period is known as lock in period.
What is Sweat Equity?
Sweat equity are shares issued to employees or directors of a company at reduced rate. They are issued for consideration other than cash for such as technical know how or intellectual property. Following are the conditions to be fulfilled for the issue of sweat equity:
1. The company must have been in business for not less than 1 year.
2. Sweat equity shares should belong to a class of shares already issued.
3. Issue of sweat should be authorized by special resolution passed by shareholders.
4. SEBI regulations should be followed where the shares are listed in a stock exchange.
What is ‘Rights Issue’?
When a company makes fresh issue of shares, the existing shareholders have the right to subscribe them in the proportion in which they are holding shares. This condition is a safeguard that enables existing shareholders to retain their control over the company. They have the option to accept the offer, reject the offer or to sell their rights.
End of Chapter 6
Chapter 7
Company Accounts - Debentures
Meaning of debentures
Debentures are debt instruments issued by a joint stock company. Amounts collected by way of debentures form part of the loan capital of a company. They are repayable after a fixed period. Debentures are issued in units of small value for convenient buying and selling in the market. Debenture holders get interest on their debenture. They are creditors of the company. They do not get dividend. Only shareholders get dividend.
According to S.2 (12) of the companies Act, 1956, debentures include “debenture stock, bonds and any other securities of a company”. The basic difference between debentures and bonds is that the debentures are usually secured. Unlike debentures bonds can be floated with a fixed interest or floating interest rate. They can also be issued without interest as discount bonds. Discount bonds are issued at a discount on the face value. The investor gets full amount on redemption of debenture. From the point of view of investor, bonds are instruments carrying higher risks and higher rates of returns compared to debentures.
The characteristics of debentures can be summarised as follows:
1. Debentures are debt instruments.
2. They generally carry fixed rate of interest.
3. They are normally repayable at the end of a fixed period. Repayment of debenture or cancellation of debenture liability in the books of the company is known as redemption of debentures.
4. They can be issued at par, premium or at discount depending on the reputation of the company.
5. They can either be placed privately or offered for public subscription.
6. They may or may not be listed in the stock exchange.
7. If offered for public subscription, they should be rated by a credit rating agency approved by SEBI, prior to listing.
8. Interest is payable on debentures at a fixed rate irrespective of the profit earned by the business.
9. Debentures may be issued with or without the security of assets of the company.
10. In the event of winding up of the company the debenture holders are treated as creditors and given priority in repayment of their money.
11. Debenture holders normally do not have representation in the Board of the company.
Distinction between Shares and Debentures
Shares Debentures
1.
2.
3.
4.
5.
6.
7.
8.
Shares represent the ownership of the company
Share holders are paid dividend if the company makes profit
Dividend is usually paid once a year
There is no fixed rate of dividend on shares.
Directors are elected by shareholders and thus the shareholders participate in the management through representatives
Shares are permanent (except redeemable preference shares)
Shares are not issued on the security of any asset of the company
In the event of winding up of the company, share holders get their payment at the end, only after all other claims are settled. Debentures represent the loan of the company
Debenture holders are paid interest at the fixed period irrespective of profit
Interest on debenture is usually paid in six months
Interest on debenture is paid at the fixed rate
Debenture holders are allowed to have their representatives in the Board only under special circumstances
Debentures are repayable at a fixed period and failure to repay the debentures on due date can cause disqualification of directors.
Debentures can be issued on the security of any specific asset or with a general charge on all the assets of the company.
Secured debentures get priority over all the normal creditors. Unsecured debentures are listed with creditors and settled prior to any payment to shareholders.
Types of Debentures
Debentures are classified as follows:
1. On the Basis of Repayment:
a. Redeemable Debentures
These debentures are paid off or redeemed after the prescribed period.
b. Irredeemable or Perpetual Debentures
These debentures are permanent debentures of a company. They are paid back only in the event of winding up of a company.
2. On the Basis of Transferability:
a. Registered Debentures
These are debentures for which the company maintains record of debenture holders. Therefore when such debentures are sold or transferred it should be intimated to the company for making change in the register of debenture holders.
b. Bearer Debentures
These debentures are transferable by mere delivery. There is no need or registration of transfer with the company.
3. On the Basis of Security:
a. Simple or Naked Debentures
These are debentures not secured by any asset of the company. If the company goes into liquidation these debentures are treated as unsecured creditors.
b. Mortgage Debentures
Mortgage debentures are issued on the security of certain assets of the company. They can be secured by fixed assets or floating assets of the company. If the debentures are secured by a fixed charge on assets, the company cannot sell or exchange the assets without paying off the debentures. However in case of floating charge, the company can buy or sell the assets involved until the winding up procedures are initiated or the debenture holders exercise their right to ‘crystallise’ the claim.
4. On the basis of Conversion:
a. Convertible Debentures
These debentures are issued with an option to debenture holders to convert them into shares after a fixed period. Convertible debentures are either partially convertible debentures or fully convertible debentures. In case of partially convertible debentures part of the instrument is redeemed and part of it is converted into shares.
In case of fully convertible debentures the full value of the debenture is converted into equity. Convertible debentures are generally issued to prevent sudden outflow of the capital at the time of maturity of the instrument, which may cause liquidity problems. The conversion ratio, which is the number of equity shares exchanged per unit of the convertible debenture is clearly stated when the instrument is issued.
b. Non Convertible Debentures
These are debentures issued without conversion option. The total amount of the debenture will be redeemed by the issuing company at the end of the specific period.
5. On the Basis of Pre-Mature Redemption Rights:
a. Debenture with “Call” option
A callable debenture is one in which the issuing company has the option of redeeming the security before the specified redemption date at a pre-determined price.
b. Debenture with “Put” option
This is a debenture in which the holder has the option of getting it redeemed before maturity.
6. On the Basis of Coupon Rate (interest rate):
a. Fixed Rate Debentures
Most of the time debentures are issued with a prefixed rate interest. These debentures are called fixed interest debentures
b. Floating rate Debentures
Floating rate as the names suggests keeps changing. It is usually linked with PLR (prime lending rate). It may add a risk premium to PLR on debenture. Thus PLR + 50 “basis points” and if the PLR is 11 percent, debenture interest rate will be 11.5 percent.
c. Zero Coupon Bonds
These are debentures issued with no interest specified. They are issued at a substantial discount to compensate the investors. These bonds are known as deep discount bonds. The difference between the face value and the issue price is the total amount of interest for the duration of the bond. From the account point of view this discount is recorded as “Deferred Interest Expense Account” at the time of issue bonds and proportionate amounts are written off each year over the life of the bond.
Issue of Debentures
Like shares debentures can also be issued at par, premium or discount. Collection of money also can be made in installments. Debentures can be issued for cash or consideration other than cash.
Journal Entries for the issue of debentures are similar to that of shares. In comparison with issue of shares, all temporary accounts for issue of debentures bear the prefix ‘debenture’ instead of share, such as debenture application, debenture allotment, debenture 1st call etc. Share capital account on the credit side of the journal entry is replaced by Debenture Account bearing a prefix indicating the rate of interest.
Journal Entries for the issue of Debentures
Journal entries for the issue of debentures will vary according to the conditions of issue and the conditions of redemption. Debentures can be issued at par, premium or discount. Similarly the debentures can be redeemed at par, premium or discount. Thus there can be nine different combinations for the issue of debentures.
1. Debentures issued at par, to be redeemed at par
2. Debentures issued at par, to be redeemed at premium
3. Debentures issued at par, to be redeemed at discount
4. Debentures issued at premium, to be redeemed at par
5. Debentures issued at premium, to be redeemed at premium
6. Debentures issued at premium, to be redeemed at discount
7. Debentures issued at discount, to be redeemed at par
8. Debentures issued at discount, to be redeemed at premium
9. Debentures issued at discount, to be redeemed at discount
Thursday, September 13, 2007
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