M.

Com/BS (Accounting & Finance)

ADVANCED FINANCIAL
ACCOUNTING
COURSE CODE: 8553 UNIT: 1-9

Department of Commerce
Faculty of Social Sciences & Humanities
ALLAMA IQBAL OPEN UNIVERSITY
 ADVANCED FINANCIAL
ACCOUNTING

COURSE CODE: 8553 UNITS: 1-9

Level: M. Com./BS (Accounting & Finance)

ALLAMA IQBAL OPEN UNIVERSITY, ISLAMABAD

i
 (All rights reserved with the publishers)

Year of Printing .......................... 2022

Quantity ...................................... 1000
Price ............................................
Incharge Printing ........................ Dr. Sarmad Iqbal
Printer ........................................ AIOU Printing Press, Islamabad
Publisher ......................................... Allama Iqbal Open University, Islamabad

ii
 COURSE TEAM
Chairman: Prof. Dr. Syed Muhammad Amir Shah
Chairman Department of Commerce

Course Development Dr. Muhammad Munir Ahmad

Coordinator:

Writers: Dr. Muhammad Munir Ahmad

Muhammad Ashraf Bhutta-FCMA
Shuja Ali Khan- ACMA
Mazhar Arshad-ACA

Reviewer: Prof. Dr. Syed Muhammad Amir Shah

Dr. Muhammad Munir Ahmad

Layout by: Muhammad Javed

Editor: Humera Ejaz

iii
 FOREWORD
Revision of courses and programs is a continuous process for enhancing student
learning through latest and updated learning materials. In the process of revising
the accounting course, students and teachers’ feedback, as well as new and
emerging trends and updates in accounting standards are included. It is a matter of
immense pleasure that the Department of Commerce, Allama Iqbal Open
University, is offering a revised and improved version of “Advanced Financial
Accounting (8553) for BS and M. Com students.

The course contents have been upgraded to make them more comprehensible and
specific while targeting the needs of the students. We hope that the revised edition
of this course will prove to be beneficial for both students and teachers of the cause
alike.

We shall be welcoming suggestion for improvement.

Prof. Dr. Zia-Ul-Qayyum

Vice Chancellor

iv
 INTRODUCTION
Accounting and Finance is one of the professions, for which there is always a great
demand all the time within the country and abroad. There is no such organization
which does not require services of Accountant. Realizing its importance, the
Department of Commerce felt dine need to develop a book on accounting for the
students of BS and M. Com, which reflect the Accounting Standards and Financial
Reporting Standards.

After completing the M. Com degree, most of the students prefer to join any
organization according to their interests. Specialized accounts are introduced in the
book, i.e., insurance accounts, bank accounts, lease accounts etc. So that, the
students have knowledge about the preparation of accounts of various industries
and can perform better on their job. The course consists of 9 units, which comprises
on few International Accounting Standards i.e., IAS 1, 17, 27 etc. Each unit consists
of introduction of that unit and related exercises and problems at the end of each of
the unit.

It is earnestly hoped that the book will amply fulfil the objectives for which it has
been designed. At the end respected teachers and readers of this book who gave us
valuable comments and suggestions for the development of this book.

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 OBJECTIVES

Advanced Financial Accounting course is aimed to achieve the following objectives:

a) To understand different fundamentals, jargons, systems of Financial Accounting
and Reporting.
b) To understand about the conceptual framework for financial reporting.
c) To be able to read and prepare financial statements such as Profit and Loss
Accounts, Balance Sheet, Cash Flow Statements
d) To understand the challenges of financial reporting
e) To evaluate the financial health of the firm using financial information and
comparing financial performance
f) To understand about preparation of consolidated financial statements.
g) To gain awareness of emerging accounting trends in the Insurance and Banking
industry.
h) To know about the lease accounting.

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 ACKNOWLEDGEMENT
Many individuals have contributed their shares for the development of this course
and the department, and we are highly thankful for their valuable contribution,
support and suggestions.

I am grateful to Professor Dr. Syed Hassan Raza, Dean Faculty of Social Sciences
and Humanities and Professor Dr. Syed Muhammad Amir Shah, Chairman
Department of Commerce, whose supervision, support and guidance made possible
the revision of this book. We owe a great deal and oblige to the efforts of Mr. Shuja
Ali Khan – ACMA, Principal SKANS School of Accountancy, CA Campus
Islamabad, who spared his precious time to write the Unit 05, Consolidated
Accounts, that is great contribution in the development of this book and benefited
for Commerce and Accountancy students as well as for the teachers of Commerce.
Finally, we are very thankful to Mr. Mazhar Arshad – ACA, who wrote a very
unique unit 07, “Accounts of Banking Companies” with a full devotion and hard
work. The completion of this unit was not possible without the expertise of
Chartered Accountant like Mr. Mazhar Arshad.

Dr. Muhammad Munir Ahmad

Course Coordinator

vii
 CONTENTS
Sr. No. Titles Page No.

UNIT 1 Introduction to Regulatory & Conceptual Framework of Accounting and

Accounting Policies ..................................................................................1
UNIT 2 Accounting Information System .............................................................25
UNIT 3 Accounting for Merchandising Activities...............................................61
UNIT 4 Financial Assets ......................................................................................75
UNIT 5 Consolidated Accounts .........................................................................117
UNIT 6 Stockholders’ Equity Paid-In Capital, Income and Changes in Retained
Earnings ................................................................................................161
UNIT 7 Accounting for Banking Companies .....................................................219
UNIT 8 Accounting for Insurance Companies ...................................................259
UNIT 9 Accounting for Leases ..........................................................................309

viii
Unit – 1

Introduction to Regulatory &

Conceptual Framework of Accounting
and Accounting Policies

Written by: Dr Muhammad Munir Ahmad

Reviewed by: Prof. Dr. Syed Muhammad Amir Shah
Unit-1 Regulatory & Conceptual Framework of Accounting

CONTENTS

Introduction .............................................................................................................3
Objectives .............................................................................................................3
1.1 INTRODUCTION TO IFRS ...........................................................................4
1.1.1 Significance of IFRS adoption ..................................................................... 5
1.1.2 Objectives of IFRS ..............................................................................6
1.1.3 Scope of IFRS .....................................................................................6
1.1.4 IFRS versus GAAP ...................................................................................... 7
1.1.5 Principles-Based and Rules-Based Framework ..................................7

1.2 IMPORTANT BODIES BEHIND THE IFRS ...............................................8

1.2.1 IFRS Foundation .................................................................................8
1.2.2 The IASB ............................................................................................9
1.2.3 The IFRS Interpretations Committee .................................................9

1.3 THE REGULATORY FRAMEWORK OF ACCOUNTING .........................9

1.3.1 The Regulatory System .....................................................................10
1.3.2 Financial Reporting Council .............................................................10
1.3.3 Accounting Standards Board ............................................................11
1.3.4 Financial Reporting Review Panel....................................................11
1.3.5 Urgent Issues Task Force ..................................................................12
1.3.6 Why a regulatory framework is necessary ........................................12

1.4 THE CONCEPTUAL FRAMEWORK OF ACCOUNTING .......................13

1.4.1 Chapter 1- Objectives of Financial Reporting ..................................13
1.4.2 Chapter 2- Qualitative characteristics of useful financial information .14
1.4.3 Chapter 3 - Financial statements and the reporting entity ................16
1.4.4 Chapter 4- The elements of financial statements ..............................16
1.4.5 Chapter 5- Recognition and derecognition .......................................17
1.4.6 Chapter 6- Measurement ...................................................................18
1.4.7 Chapter 7- Presentation and disclosure .............................................18
1.4.8 Chapter 8- Concepts of capital and capital maintenance ..................18
Assessment questions.............................................................................................19
Appendix 1.1 ..........................................................................................................20
Appendix 1.2 ..........................................................................................................24

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Unit-1 Regulatory & Conceptual Framework of Accounting

INTRODUCTION

This unit prescribes the detail of regulatory and conceptual framework of financial
reporting. It consists upon two parts, first part describes the need of development
of Globally Accepted Accounting Principles (GAAP), difference between rule
based and principle-based accounting and in the last it narrates about the important
bodies which plays important role in development of accounting standards i.e.,
International Accounting Standards (IAS) and International Financial Reporting
Standards (IFRS). The second part is about the conceptual framework, describing
the detail of its eight chapters. At the end of the unit Question are given to prepare
the students for their examination.

OBJECTIVES

After studying this unit, you will be able:

a) To understand the regulatory framework and its importance
b) To know the structure and objectives of the International Accounting Bodies
c) To get the idea of updated conceptual framework and its importance
d) To describe the elements of financial statements
e) To differentiate between a principles-based and a rules-based framework
f) To comprehend the recognition criteria in financial statements
g) To distinguish between an accounting policy and an accounting estimate
h) To deal with the different measurement criteria in financial statements

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Unit-1 Regulatory & Conceptual Framework of Accounting

1.1 INTRODUCTION TO IFRS

Almost every country has its own accounting language. The language describes
how particular types of transactions and other events should be reflected in financial
statements. Like US GAAP, German GAAP etc. or IACs. However, the differences
between two country’s GAAP may be relatively minor that is like comparing
languages like Dutch with Afrikaans or Scottish with Irish. These differences,
however small, will still result in miscommunication.

The acronym "IAS" stands for International Accounting Standards. This is a set of
accounting standards set by the International Accounting Standards Committee
(IASC), located in London, England. The IASC has a number of different bodies,
the main one being the International Accounting Standards Board (IASB), which is
the standard-setting body of the IASC.

The IASC does not set GAAP, nor does it have any legal authority over GAAP.
However, a lot of people actually do listen to what the IASC and IASB have to say
on matters of accounting.

When the IASB sets a new accounting standard, a number of countries tend to adopt
the standard, or at least interpret it, and fit it into their individual country's accounting
standards. These standards, as set by each particular country's accounting standards
board, will in turn influence what becomes GAAP for each particular country. For
example, in the United States, the Financial Accounting Standards Board (FASB)
makes up the rules and regulations which become GAAP. The best way to think of
GAAP is as a set of rules that accountants follow. Each country has its own GAAP,
but on the whole, there aren't many differences between countries.

To avoid the miscommunication, accounts all over the world are joining together to
develop a single global accounting language, that is understandable and of a high
quality. The rules of this language are explained in a set of global standards, i.e.
IFRS. All the countries that adopt the global accounting language, must comply
with these rules (IFRSs).

To fulfill the Need for one globally accepted accounting standards that could
provide quality, reliability and transparency in financial reporting, in the year 2001
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Unit-1 Regulatory & Conceptual Framework of Accounting

IASC was restructured and IASB (International Accounting Standards Board) was
born. IASB adopted all the Pronouncements issued by its predecessor body and all
subsequent pronouncements where Termed as IFRS. In short, the rules of our global
accounting consist of:
♦ The Framework
♦ The global accounting standards (IFRS), including both the (i) standards
(IASs and IFRS) and their (ii) Interpretations (SICs and IFRICs), short detail
is as under:
♦ IAS – Standards issued before 2001 (total 41 IAS issued)
♦ IFRS –Standards issued after 2001 (total 13 IFRS issued)
♦ SIC-Interpretations of accounting standards, giving specific guidance on
unclear issues (34 SIC)
♦ IFRIC- Newer interpretations, issued after 2001 (15 IFRIC) All International
Accounting Standards (IASs) and Interpretations issued by the former IASC
(International Accounting Standard Committee) and SIC (Standard
Interpretation Committee) continue to be applicable unless and until they are
amended or withdrawn.

1.1.1 Importance of the International Financial Reporting Standards (IFRS)

With the advent of globalization in the last decade, the need for and importance of
IFRS has grown, particularly since their adoption by the European Union in 2005
and the Securities and Exchange Commission of the United States allowing foreign
listed companies to file financial statements using IFRS (without reconciliation
with US GAAPS). More than 100 countries already allow or mandate the use of
IFRS, with many more expecting convergence or adoption by 2011. This
widespread acceptance of IFRS is due to the following advantages:
♦ Comparability: Local entities' financial statements may be easily and reliably
compared to their global rivals; these characteristic aids potential investors and
stakeholders in properly analyzing the performance of businesses.
♦ Cross – Border Investments: Because of the goodwill that IFRS enjoys
across global investor communities, adoption/convergence with IFRS is
expected to boost investments.
♦ Multiple-Reporting: Different companies within the group may be obliged
to compile two sets of financial statements for external financial reporting:
one for local statutory financial reporting in the home nation and the other for
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Unit-1 Regulatory & Conceptual Framework of Accounting

reporting to the parent company. This increases the finance function's efforts,
adds complexity to financial reporting, and raises the finance function's
expenses. If IFRS is approved or needed in all countries where the company
operates, it will eliminate the need for duplicate reporting.
♦ Cost of Capital: Because IFRS is recognized as a worldwide financial
reporting standard, it removes obstacles to cross-border listings and allows
firms to seek admission to nearly all the world's bourses. Even when local
GAAP is authorized for listing on abroad markets, international investors
usually assign an extra risk premium if the underlying financial data is not
produced in line with international standards.

1.1.2 What is the purpose of the International Financial Reporting Standards

(IFRS)?

The goal of the International Financial Reporting Standards (IFRS) is to develop, in

the public interest, a single set of high-quality, understandable, and enforceable global
accounting standards that require high-quality, transparent, and comparable
information in financial statements and other financial reporting to assist participants
in the world's capital markets and other users in making economic decisions, as well as
to promote the use and rigorous application of accounting standards.

1.1.3 IFRS Applicability

The International Financial Reporting Standards (IFRS) define the standards for
transaction and event recognition, measurement, presentation, and disclosure in
general purpose financial statements. Shareholders, creditors, workers, and the
general public all require information about an entity's financial status, performance,
and cash flows, and general purpose financial statements are designed to satisfy
those demands. Information supplied outside financial statements that aids in the
comprehension of a complete set of financial statements or improves users' capacity
to make effective economic decisions is referred to as other financial reporting.
IFRS applies to profit-oriented businesses' general-purpose financial statements
and other financial reporting, regardless of their legal structure. IFRSs may be
applicable for entities other than profit-oriented businesses. The International
Financial Reporting Standards (IFRS) apply to both individual and consolidated
financial accounts. Some International Financial Reporting Standards (IFRS)
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Unit-1 Regulatory & Conceptual Framework of Accounting

provide for both a 'benchmark' and a 'approved alternative approach.'

1.1.4 IFRS versus GAAP

GA Statements of Generally Accepted Accounting Practice is the abbreviation for

Statements of Generally Accepted Accounting Practice. The established approved
techniques used by firms to "recognize, measure, and disclose" commercial
transactions are among them. The finest of these statements from throughout the
world are being combined into the International Financial Reporting Standards, or
IFRSs. The most significant distinction is that IFRS has fewer specific regulations
than US GAAP.

The International Financial Reporting Standards (IFRS) also provide certain

industry-specific guidelines. The scope of the distinctions between IFRS and
GAAP has been reducing because of long-running convergence initiatives between
the IASB and the FASB. Significant variances certainly exist and depending on a
company's industry and unique facts and circumstances, any one of them might
result in considerably different reported results.

Consider the following scenario: Last In, First Out is not permitted under the
International Financial Reporting Standards (IFRS) (LIFO). For impairment write-
downs, IFRS utilizes a single-step procedure rather than the two-step technique
employed by US GAAP, making write-downs more likely. Once certain qualifying
requirements are fulfilled, IFRS mandates capitalization of development expenses.
Except for expenditures connected to the creation of computer software, which
must be capitalized if certain conditions are satisfied, U.S. GAAP requires
development costs to be expensed as incurred.

1.1.5 PRINCIPLES-BASED AND RULES-BASED FRAMEWORK

There are two main approaches to accounting:

• Principles based approach such as that used by the IASB.
• Rules based approach such as that used in the USA.

(A) Principles-based framework

• Based upon a conceptual framework such as the Statement of Principles.
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Unit-1 Regulatory & Conceptual Framework of Accounting

• Accounting standards set based on the conceptual framework.

No of accounting standards are designed based on principles based conceptual
framework of accounting, named as international accounting standards and
International financial reporting standards. (See Appendix 1 and Appendix 2).

(B) Rules-based framework:

• A ‘recipe book' approach
• Accounting standards are a collection of regulations that businesses must
adhere to
According to rules-based accounting, a set of rules known as GAAPs are
developed and applied in nations that do not follow International Accounting
Standards or International Financial Reporting Standards. For example, the
United States follows GAAPs known as US GAAP.

1.2 IMPORTANT BODIES BEHIND THE IFRS

1.2.1 IFRS Foundation.

The IFRS Foundation (International Financial Reporting Standards) is a non-profit private

sector organization that works in the public interest. Its main goals are as follows:
• Through its standard-setting organization, the IASB, to establish a single set
of high-quality, comprehensible, enforceable, and universally accepted
international financial reporting standards (IFRSs);
• To encourage the usage and strict adherence to such standards;
• To consider the financial reporting requirements of emerging economies and
small and medium-sized businesses (SMEs); and through the convergence of
national accounting standards and IFRSs,
• To promote and ease adoption of International Financial Reporting Standards
(IFRSs), which are the standards and interpretations produced by the IASB.

The Trustees of the IFRS Foundation and its standard-setting body are in charge of
governance and oversight of the organization's operations, as well as protecting the
IASB's independence and guaranteeing its financial stability. A Monitoring Board
of public authority holds the Trustees responsible in front of the public.

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Unit-1 Regulatory & Conceptual Framework of Accounting

1.2.2 The International Accounting Standards Board

The IASB is the IFRS Foundation's independent standard-setting organisation,

which was created in April 2001 to replace the International Accounting
Standards Committee, which was founded in London in June 1973. Its members
(now 15 full-time members) are in charge of developing and publishing IFRSs,
including the International Financial Reporting Standards for SMEs, as well as
approving IFRS Interpretations prepared by the IFRS Interpretations Committee
(formerly called the IFRIC). The IASB's meetings are open to the public and
broadcast. The IASB maintains a comprehensive, open, and transparent due
process in performing its standard-setting responsibilities, which includes the
release of consultation materials for public comment, such as discussion papers
and exposure draughts. Investors, analysts, regulators, business leaders,
accounting standard-setters, and the accountancy profession are among the
stakeholders with which the IASB works closely.

1.2.3 The IFRS Interpretations Committee

The IASB's interpretive body is the IFRS Interpretations Committee. The Trustees
nominate 14 voting members from a range of nations and professional backgrounds to
the Interpretations Committee. The Interpretations Committee's mission is to examine
and offer authoritative advice (IFRICs) on widespread accounting issues that have
developed in the context of existing IFRSs on a timely manner. Meetings of the
Interpretation Committee are accessible to the public and broadcast. The
Interpretations Committee collaborates closely with comparable national committees
in formulating interpretations and follows a transparent, rigorous, and open due process.

1.3 THE REGULATORY FRAMEWORK OF ACCOUNTING

The regulatory framework of accounting consists of the followings:

♦ The Regulatory System
♦ Regulatory Bodies
♦ Standard- Setting Process

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Unit-1 Regulatory & Conceptual Framework of Accounting

1.3.1 The Regulatory System

The current standard-setting regime was introduced in 1990 and is as follows:

Financial Reporting Council

The FRC Promotes Good
Financial Reporting

Financial Reporting Review Panel

Accounting Standards Board
The FRRP inquiries into apparent
The ASB develops, issues and
Departures from accounting standards and the provisions
withdraws accounting standards. of the companies Acts in the annual accounts of large
companies.

Urgent Issue Task Force

The UITF assists the ASB in areas
Where an accounting standard or
Companies Act provision exists, but
Where unsatisfactory or conflicting
interpretations have developed or
Seem likely to develop.

1.3.2 Financial Reporting Council

The Financial Reporting Council (FRC) is responsible for guiding the standard-
setting process and ensuring that its work is adequately financed. It also serves as
the ‘Political' face of the bodies participating in the standard-setting process,
producing an annual report that summarizes previous events and the organizations’
probable actions. The FRC is made up of about 25 individuals who are account
users, preparers, and auditors.

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Unit-1 Regulatory & Conceptual Framework of Accounting

1.3.3 Accounting Standards Board

The ASB's mission is to create and enhance financial accounting and reporting
standards for the benefit of financial information consumers, preparers, and
auditors. The ASB plans to achieve its objectives by:
• Creating principles to guide it in setting standards and providing a framework
within which others might use judgment in addressing accounting difficulties.
• In response to changing company practices, new economic developments, and
flaws in present practice, new accounting standards are being issued or old
ones are being amended.
• Taking care of important matters as soon as possible
• Working with the International Accounting Standards Board (IASB), national
standard setters, and appropriate European Union (EU) authorities to promote
the IASB's standards' high quality and acceptance throughout the EU.

The ASB consists of:

• A group of up to ten people
• A chairperson who works full-time
• A technical director who works full-time
• Part-time members who are all knowledgeable in accounting and finance

1.3.4 Financial Reporting Review Panel

The FRRP, which has around 30 members, is focused with the investigation and
questioning of big corporations' deviations from accounting norms. It will choose
industrial sectors that are expected to give rise to severe accounting difficulties in
conjunction with the Financial Services Authority (FSA), which is the regulator of
publicly traded firms. It will then pick several accounts for evaluation from each of
them, as well as investigate any issues that are brought to its notice.

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Unit-1 Regulatory & Conceptual Framework of Accounting

The following are the FRRP's abilities:

• It can now force firms to redraft violating accounts if there are severe
violations.
• It is more likely to seek firms for assurances that the regulations will be
followed in the future for small flaws.

1.3.5 Urgent Issues Task Force

The UITF is a committee of the Accounting Standards Board (ASB) comprised of

a number of prominent figures in the financial reporting industry.

The role of the UITF is to:

Only large differences in present practice or major changes expected to cause
considerable divergences in the future are of interest to the UITF. Assist the ASB
in circumstances where an accounting standard or a provision of the Companies
Act exists, but multiple interpretations have emerged, some of which are
unacceptable or contradictory. Determine an agreement on the proper accounting
treatment (UITF Abstract). By focusing on concepts rather than precise regulations,
you may reach this agreement. Only large differences in present practice or major
changes expected to cause considerable divergences in the future are of interest to
the UITF.

1.3.6 Why a regulatory framework is necessary

For the following reasons, a regulatory framework to produce financial statements

is required:
• Financial statements are utilized by a diverse group of people, including
investors, lenders, and consumers.
• They must be beneficial to these users.
• They should be comparable.
• They must offer some essential details.
• They improve users' knowledge of financial figures and their trust in them.
• They govern how businesses interact with their investors.
• Accounting standards alone would not be sufficient to provide a
comprehensive regulatory framework. Legal and market laws are also
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Unit-1 Regulatory & Conceptual Framework of Accounting

necessary to adequately control the creation of financial statements and the

duties of firms and directors.

1.4 THE CONCEPTUAL FRAMEWORK OF ACCOUNTING

A conceptual framework is:
• a coherent system of interrelated objectives and fundamental principles
• a framework which prescribes the nature, function and limits of
financial accounting and financial statements.

The IASB issued the revised comprehensive set of concepts for financial reporting
in March 2018 that is known as the conceptual framework of financial reporting. It
consists upon the eight chapters:
Chapter 1-The objective of financial reporting
Chapter 2 - Qualitative characteristics of useful
financial information
Chapter 3 - Financial statements and the reporting
entity

Chapter 4 - The elements of financial statements

Chapter 5 - Recognition and derecognition

Chapter 6 - Measurement

Chapter 7 - Presentation and disclosure

Chapter 8 - Concepts of Capital and Capital
Maintenance

1.4.1 Chapter 1- Objectives of Financial Reporting

This chapter discusses the goals of general-purpose financial reporting, the

information required to meet those goals, and the key users (users) of financial
reports. The purpose of financial statements is to provide users with financial
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Unit-1 Regulatory & Conceptual Framework of Accounting

information that will help them make decisions about giving resources to the
organization.

Such choices entail:

• Purchasing, selling, and holding equities and debt securities.
• making or repaying loans or other types of credit; or
• influencing management's decisions by voting or other means.

Users consider a variety of factors while making their selections.

• The entity's economic resources, claims against those resources, and
anticipated net cash inflows to the entity, as well as
• The entity's economic resources are stewarded by management.

1.4.2 Chapter 2- Qualitative characteristics of useful financial information

This chapter discusses the (A) Fundamental features and (B) Enhancing attributes
that make financial statements valuable financial information.

(A) Fundamental characteristics

The following are two basic features described in the conceptual framework for
financial reporting:
i. Relevance
Information is relevant if it has the potential to impact users' economic
decisions and is delivered in a timely manner. If financial information has
predictive or confirmatory value, it can make a difference in decisions.
ii. Faithful Representation
Accounting data should accurately reflect what it purports to represent, and
the chosen technique of measurement should be free of mistake and prejudice.
Validity is another name for this feature. The economic substance of
transactions, not simply their form and appearance, must be reported in data.
A faithful depiction is comprehensive, impartial, and error-free to the greatest
extent feasible.

(B) Enhancing qualities

These qualities are helpful in differentiating more useful and less useful information.
These qualities increase the more usefulness of information but cannot make non-
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Unit-1 Regulatory & Conceptual Framework of Accounting

useful information as valuable. These are:

i. Comparability
These characteristics aid in distinguishing between information that is more
valuable and information that is less beneficial. These traits make information
more helpful, but they can't make non-useful knowledge as valuable. These
are the following:
Compatibility
Users can utilise comparability to find similarities and differences between
two or more sets of economic conditions.

Users must be able to:

• Identify patterns by comparing an entity's financial statements across time.
• Evaluate the relative financial condition and performance of different
companies by comparing their financial statements.

Accounting policies must be consistent and transparent in order for this to be

achievable.

Users are informed about the accounting policies used in the production of the
financial statements, as well as any changes in those rules and their implications.
Comparability is aided by adherence to accounting standards, which includes the
disclosure of the entity's accounting procedures. Because users want to compare an
entity's financial status, performance, and changes in financial position over time,
it's critical that the financial statements include information from previous periods.

ii. Verifiability
The term "verifiability" refers to the keeping of audit trails for information
source documents that may be double-checked for accuracy. Verifiability also
refers to the availability of other data sources as a backup. Verification means
agreement and that independent measurements using the same measuring
procedures would get to a same conclusion.

iii. Timeliness
If accounting data is to be used to influence choices, it must be current. Stale
financial information, like international news, has less influence than new
information. The lack of timeliness decreases the significance of information.
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Unit-1 Regulatory & Conceptual Framework of Accounting

iv. Understandability
Understandability is determined by:
• The presentation of information in financial statements.
• The capabilities of the financial statement users.

Users are expected to:

• Have a basic understanding of economic and commercial operations.
• Are willing to conduct a thorough examination of the material given.
Users must be able to recognise the relevance of information in order
for it to be comprehensible; it must be included in financial statements
if it is important and dependable, even if it is difficult to understand for
some users.

1.4.3 Chapter 3 - Financial statements and the reporting entity

This is a new chapter in the 2018 updated conceptual framework that explains the
scope and goals of financial statements. A description of the reporting entity is also
included. Financial statements are a type of financial report that contains
information on a reporting entity's revenue, spending, assets, liabilities, and equity.
A reporting entity is an entity that is needed to prepare financial statements but is
not required to be a legal entity. It might be a portion of an entity, a single entity, or
a collection of entities. As a result, financial statements can be divided into three
categories: consolidated, unconsolidated, and combined.

The parent business and its subsidiaries are presented as a single entity in
consolidated financial statements, but the parent company solely discloses its own
financial condition in unconsolidated financial statements. Assets, liabilities, equity,
income, and costs of unrelated companies, such as parent and subsidiary, are
reported in combined financial statements.

1.4.4 Chapter 4- The elements of financial statements

By changing the definitions of assets and liabilities, this chapter has been revised
under the new conceptual framework of 2018. The terms anticipated inflow and
outflow have mostly been removed from asset and liability classifications,
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Unit-1 Regulatory & Conceptual Framework of Accounting

respectively. The following are the new definitions:

i. Assets
A present economic resource controlled by the entity as a result of past events,
whereas an economic resource is a right that has the potential to produce
economic benefits.
ii. Liabilities
A present obligation of the entity to transfer an economic resource as a result
of past events, whereas an obligation is a duty or responsibility that the entity
has no practical ability to avoid.
iii. Equity
Equity is assets minus liabilities.
iv. Income
Income is defined as the increases in assets, or decreases in liabilities, that
result in increases in equity, other than those relating to contributions from
holders of equity claims.
v Expenses
The term expenses are defined as the decreases in assets, or increases in
liabilities, that result in decreases in equity, other than those relating to
distributions to holders of equity claims.

1.4.5 Chapter 5- Recognition and derecognition

This chapter explains how to identify and derecognize financial elements in and out
of financial statements. Recognize simply means to include, whereas derecognize
simply means to eliminate financial components.
i. Recognition is appropriate if it results in both relevant information about
assets, liabilities, equity, income and expenses and a faithful representation of
those items, with the goal of providing valuable information to investors,
lenders, and other creditors.
Only when assets and liabilities are relevant and provide true representation,
as outlined in chapter 2, can they be recognized.

ii. Derecognition is the process of removing all or part of a recognized asset or

liability from an entity's financial statements. When an entity loses possession
of a recognized asset, derecognition takes place. Consider the selling of an
asset. Derecognition occurs in the event of responsibility when the entity no
17
Unit-1 Regulatory & Conceptual Framework of Accounting

longer has a payment obligation.

1.4.6 Chapter 6- Measurement

The notion of measuring refers to the process of recognizing the quantity of assets,
liabilities, equity, income, and costs in financial statements. In this regard, the
conceptual framework distinguishes between two measuring bases: historical cost
and present value.
i. Historical cost basis
This calculation is based on the transaction price now an element of the
financial statement is recognized. However, the cost of an asset may be
reduced in the event of impairment, whereas the cost of a liability may rise if
it becomes burdensome.

ii. Current value basis

Each element in a current value measurement is updated to reflect the
conditions at the time of measurement. It also covers the following three approaches:
➢ Fair Value
➢ Value in use
➢ Current Cost

1.4.7 Chapter 7- Presentation and disclosure

This chapter's major goal is to provide a useful communication tool in the financial
statements. It explains how to include revenue and costs in the profit and loss
statement and other comprehensive income. It also covers the terms "presentation"
and "disclose."

1.4.8 Chapter 8- Concepts of capital and capital maintenance

This chapter is same as was in previous version of framework. It describes two

concepts of capital, i.e., financial capital and physical capital.
i. Financial capital
It is another name of net assets or equity. According to the financial maintenance
concept the profit will be recorded in the financial statements when the net assets
at the end of the period is greater than the beginning period net assets after
excluding the contributions and distributions to equity holders. It may be
18
Unit-1 Regulatory & Conceptual Framework of Accounting

measured at nominal monetary units or units of constant purchasing power.

ii. Physical capital
It means the productive capacity of an entity based on number of
manufactured units per day. Here the profit is earned, if the productive
capacity increases during the period after excluding the movements in equity
holders.

ASSESSMENT QUESTIONS
i. Describe what is meant by a conceptual framework of accounting? Also
discuss whether a conceptual framework is necessary and what an alternative
system might be.
ii. Discuss what is meant by faithful representation and relevance and describe
the qualities that enhance these characteristics?
iii. Distinguish between changes in accounting policies and changes in accounting
estimates and describe how accounting standards apply the principle of
comparability where an entity changes its accounting policies.
iv. Define what is meant by ‘recognition’in financial statements and discuss the
recognition criteria. Also apply the recognition criteria to:
a. assets and liabilities
b. income and expenses.
v. Explain the following measurement basis:
a. Historical cost
b. Current value
vi. Apply the principle of substance of over form to the recognition and de-
recognition of assets and liabilities.
vii. Recognize the substance of transactions in general, and specifically account
for the following types of transaction:
a. goods sold on sale or return/consignment stock
b. sale and repurchase/leaseback agreements
c. factoring of debtors.
viii. Describe the advantages and disadvantages of the use of historical cost accounting.
ix. Discuss whether the use of current value accounting overcomes the problems
of historical cost accounting.
x. Distinguish between a principles-based and a rules-based framework and
discuss whether they can be complementary.

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Unit-1 Regulatory & Conceptual Framework of Accounting

APPENDIX 1.1
International Accounting Standards

No Name Issued

IAS 1 Presentation of Financial Statements 2007

IAS 2 Inventories 2005

Consolidated Financial Statements

IAS 3 1976
Superseded in 1989 by IAS 27 and IAS 28

Depreciation Accounting
IAS 4
Withdrawn in 1999

Information to Be Disclosed in Financial Statements

IAS 5 1976
Superseded by IAS 1 effective 1 July 1998

Accounting Responses to Changing Prices

IAS 6 Superseded by IAS 15, which was withdrawn December
2003

IAS 7 Statement of Cash Flows 1992

Accounting Policies, Changes in Accounting Estimates and

IAS 8 2003
Errors

Accounting for Research and Development Activities

IAS 9
Superseded by IAS 39 effective 1 July 1999

IAS 10 Events After the Reporting Period 2003

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Unit-1 Regulatory & Conceptual Framework of Accounting

Construction Contracts
IAS 11 1993
Superseded by IFRS 15 as of 1 January 2018

IAS 12 Income Taxes 1996

Presentation of Current Assets and Current Liabilities

IAS 13
Superseded by IAS 39 effective 1 July 1998

Segment Reporting
IAS 14 1997
Superseded by IFRS 8 effective 1 January 2009

Information Reflecting the Effects of Changing Prices

IAS 15 2003
Withdrawn December 2003

IAS 16 Property, Plant and Equipment 2003

Leases
IAS 17 2003
Superseded by IFRS 16 as of 1 January 2019

Revenue
IAS 18 1993
Superseded by IFRS 15 as of 1 January 2018

Employee Benefits
IAS 19 1998
Superseded by IAS 19 (2011) effective 1 January 2013

IAS 19 Employee Benefits (2011) 2011

Accounting for Government Grants and Disclosure of

IAS 20 1983
Government Assistance

IAS 21 The Effects of Changes in Foreign Exchange Rates 2003

21
Unit-1 Regulatory & Conceptual Framework of Accounting

Business Combinations
IAS 22 1998
Superseded by IFRS 3 effective 31 March 2004

IAS 23 Borrowing Costs 2007

IAS 24 Related Party Disclosures 2009

Accounting for Investments

IAS 25
Superseded by IAS 39 and IAS 40 effective 2001

IAS 26 Accounting and Reporting by Retirement Benefit Plans 1987

IAS 27 Separate Financial Statements (2011) 2011

Consolidated and Separate Financial Statements

IAS 27 Superseded by IFRS 10, IFRS 12 and IAS 27 (2011) 2003
effective 1 January 2013

IAS 28 Investments in Associates and Joint Ventures (2011) 2011

Investments in Associates
IAS 28 Superseded by IAS 28 (2011) and IFRS 12 effective 1 2003
January 2013

IAS 29 Financial Reporting in Hyperinflationary Economies 1989

Disclosures in the Financial Statements of Banks and

IAS 30 Similar Financial Institutions 1990
Superseded by IFRS 7 effective 1 January 2007

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Unit-1 Regulatory & Conceptual Framework of Accounting

Interests in Joint Ventures

IAS 31 Superseded by IFRS 11 and IFRS 12 effective 1 January 2003
2013

IAS 32 Financial Instruments: Presentation 2003

IAS 33 Earnings Per Share 2003

IAS 34 Interim Financial Reporting 1998

Discontinuing Operations
IAS 35 1998
Superseded by IFRS 5 effective 1 January 2005

IAS 36 Impairment of Assets 2004

IAS 37 Provisions, Contingent Liabilities and Contingent Assets 1998

IAS 38 Intangible Assets 2004

Financial Instruments: Recognition and Measurement

IAS 39 2003
Superseded by IFRS 9 effective 1 January 2015

IAS 40 Investment Property 2003

IAS 41 Agriculture 2001

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Unit-1 Regulatory & Conceptual Framework of Accounting

APPENDIX 1.2
International Financial Reporting Standards

No Name Issued

IFRS 1 First-time Adoption of International Financial Standards 2008

IFRS 2 Share-based Payment 2004

IFRS 3 Business Combinations 2008

IFRS 4 Insurance Contracts 2004

Non-current Assets Held for Sale and Discontinued

IFRS 5 2004
Operations

IFRS 6 Exploration for and Evaluation of Mineral Assets 2004

IFRS 7 Financial Instruments: Disclosures 2005

IFRS 8 Operating Segments 2006

IFRS 9 Financial Instruments 2010

IFRS 10 Consolidated Financial Statements 2011

IFRS 11 Joint Arrangements 2011

IFRS 12 Disclosure of Interests in Other Entities 2011

IFRS 13 Fair Value Measurement 2011

IFRS 14 Regulatory Deferral Accounts 2014

IFRS 15 Revenue from Contracts with Customers 2014

IFRS 16 Leases 2016

IFRS 17 Insurance Contracts 2017

24
Unit – 2

Accounting Information System

Written by: Muhammad Ashraf Bhutta

Dr. Muhammad Munir Ahmad
Reviewed by: Prof. Dr. S M Amir Shah

25
Unit-2 Accounting Information System

CONTENTS

Introduction ...........................................................................................................27
Objectives .............................................................................................................27
2.1 Information Systems .....................................................................................28
2.2 Transactions processing cycles .....................................................................30
2.3 Fundamental System Principles ....................................................................30
2.4 Components of Accounting Systems ............................................................33
2.4.1 Source documents ................................................................................34
2.4.2 Input devices ........................................................................................34
2.4.3 Information Processors and Storage ....................................................34
2.4.4 Output Devices.....................................................................................35
2.5 Special Journals in Accounting .....................................................................35
2.5.1 Sales Journal ........................................................................................36
2.5.2 Cash Receipt Journal............................................................................38
2.5.3 Purchase Journal ..................................................................................41
2.5.4 Cash Payment Journal ..........................................................................45
2.5.5 Cash Book ............................................................................................48
2.6 Technology-Based Accounting Systems ......................................................50
2.7 Summary .......................................................................................................51
2.8 Theoretical questions ....................................................................................52
2.9 Practical Problems ........................................................................................53
2.10 Glossary ........................................................................................................58

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Unit-2 Accounting Information System

INTRODUCTION
This unit is related to application of some accounting information systems in a
business organization for regular inflow of reports for taking timely business
decisions. These accounting information systems are based upon computer
technology for recording and generating reports quickly and be reliable to support
management for review of activities. The special journals for recording repetitive
transactions instead of using single general journal have also been introduced to
facilitate accounting work.

OBJECTIVES
The accounting, apart from a business language, is also viewed as ears and eyes of
the management. These requirements are accomplished to some extent, by
learning this unit by you which explains the following aspects: -
a) The establishment of an accounting information system in an organization
which should be premised upon Six factors of control relevance,
compatibility, informative promptness flexibility and cost- benefit
principles.
b) The computerized accounting system need the hardware and software and
data taken from source documents is entered through input devices to the
processors for storage and reports generation by the output devices.
c) The maintenance of special journals, comprising Sales Journal for recording
all credit Sales transactions, cash receipt journal for recording all cash
collection from sales, accounts receivables and other sources, Purchase
Journals for recording all credit procurement of merchandise, cash payment
journal for recording all payments of accounts payables and other expenses
and also other natively a cash book for recording consolidated receipts and
payments for all categories of business transactions. This indicates as to how
transactions are posting into control leader accounts and subsidiary ledger
accounts and their reconciliation at some period end to ensure accuracy.

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Unit-2 Accounting Information System

2.1 INFORMATION SYSTEMS

In order to stay competitive, businesses rely on information systems. Information,

like plant and equipment, is a valuable resource. Better information systems may
boost productivity, which is critical for staying competitive. Accounting, as an
information system, identifies, collects, processes, and disseminates economic
data about a company to a wide range of individuals. Information is valuable data
that has been structured in such a way that it can be used to make right judgments.
A system is a collection of resources linked together to achieve certain goals. An
accounting information system (AIS) is a combination of people and equipment
that is used to convert financial and other data into information. This data is
disseminated to a wide range of decision-makers. Accounting information
systems, whether they are mostly manual or fully computerized, execute this
transition.
The phrase "information system" refers to an organization's use of computer
technology to offer information to users. A "computer-based" information system
is a set of computer hardware and software that works together to convert input
into usable information: Several forms of computer-based information systems
may be distinguished, as shown in Figure 2.1.
Figure 2.1: Information Systems

INFORMATION SYSTEM

Electronic Date Processing System (EDP)

Data Processing System (DP)
Management Information System (MIS)
Decision Support System (DSS)
Expert System (ES)
Executive Information System (EIS)
Accounting Information System (AIS)

2.1.1 Data Processing

The use of computer technology to accomplish transaction-oriented data processing is
known as electronic data processing (EDP). In any organization, EDP is a critical
accounting information system application. As computer technology has grown more
prevalent, the terms data processing (DP) and enterprise data processing (EDP) have
become interchangeable.

2.1.2 Management Information Systems

The use of computer technology to offer managers with decision-oriented information is
referred to as management information systems (MIS). Beyond the data connected with

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Unit-2 Accounting Information System

DP in companies, a MIS delivers a wide range of information. Managers in an

organization utilize and demand information in order to make decisions, and computer-
based information systems may help provide such information to them.

2.1.3 Decision Support Systems

Data is processed into a decision-making format for the end user in a decision support
system (DSS). A DSS varies from a DP system in that it involves the usage of decision
models and specialized databases. A DSS is designed to respond to management's ad hoc,
non-routine information demands. Routine, recurrent, generic information demands are
met by DP systems. A decision support system (DSS) is intended for certain sorts of
choices made by specified users. The use of spreadsheet software to do what-if analysis
of operational or budget data, such as sales forecasts by marketing staff, is a well-known
example.

2.1.4 Expert Systems

An expert system (ES) is a knowledge-based information system that acts as an expert
adviser to end users by using its expertise in each application area. An ES-, like a DSS,
relies on decision models and specialized databases. / An ES, unlike a DSS, also
necessitates the creation of a knowledge base—the specialized information that an expert
in the decision domain possesses—as well as an inference engine—the method by which
the expert makes a judgment. In the identical choice circumstance, an ES seeks to mimic
the decisions made by an expert, human decision maker. The difference between an ES
and a DSS is that a DSS aids a user in making a choice, whereas an ES makes the
decision.

2.1.5 Executive Information Systems

An executive information system (EIS) is customized to top-level management's strategic
information needs. Top-level management gets a lot of information from places other
than the company's information systems. Meetings, memos, television, magazines, and
social events are all examples. However, the organization's information systems must
handle certain data. An EIS allows top-level management to quickly access data that has
been processed by the organization's information systems. The main success criteria
defined by top-level management as important to the organization's performance are the
subject of this chosen information. For a top-level CEO, real vs planned market share for
product groups and budget versus actual profit and loss statistics for divisions might be
critical success determinants

2.1.6 Accounting Information Systems

An accounting information system (AIS) is a computer-based system that transforms
accounting data into information, like the previous definitions. However, we use the
phrase accounting information system to refer to transaction processing cycles,
information technology utilization, and information system development.

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Unit-2 Accounting Information System

2.2 TRANSACTION PROCESSING CYCLES

The phrase accounting, information system refers to a wide range of operations related to
a company's transaction processing cycles. Despite the fact that no two businesses are
alike, the majority of them face comparable economic challenges. These occurrences
result in transactions that may be classified into four business activity cycles:

2.2.1 Revenue cycle:

Events involving the delivery of products and services to third parties, as well as the
collecting of corresponding payments.

2.2.2 Expenditure cycle:

Acquisition of products and services from third parties, as well as the settlement of
corresponding obligations.

2.2.3 Production cycle:

Events involving the transformation of raw materials into finished goods and services.

2.2.4 Finance cycle:

Events involving the purchase and administration of capital funds, such as cash is.

2.2.5 The transaction cycle:

The financial reporting cycle is a fifth cycle in an organization's transaction cycle model.
The financial reporting cycle is not the same as the operational reporting period. It
collects accounting and operating data from the other cycles and processes it so that
financial reports may be generated. Many valuations and adjusting entries that do not
immediately result from exchanges are required to produce financial reports in
conformity with generally accepted accounting standards. Two common examples are
depreciation and currency translation. These types of operations are part of a company's
financial reporting cycle. The notion of transaction processing cycles is a framework for
evaluating the operations of an organization. Even though various businesses may not use
the same application systems inside a transaction processing cycle, the cycle idea
provides a framework for classifying the flow of economic events that are like all.
Because each of the many cycles has a similar goal, transaction cycles provide a
comprehensive framework for the study and design of accounting information systems.
This goal is to be a key component of an organization's internal control system.

2.3 FUNDAMENTAL SYSTEM PRINCIPLES

The accounting information system envisages the specific requirements of the

management of an organization. This system is evolved by keeping record and
developing periodic reports like financial statements and any other detailed selected
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Unit-2 Accounting Information System

informative in a systematic manner as needed by the management and the regulatory

authorities. The legal requirements must be met by a system that is designed in a cost-
conscious manner. The accounting informative system collects the data of
transactions, records then and then draw reports to communicate than to the decision
makers. A successful rather useful accounting system should be designed in such a
manner to give the blend of simplicity and be efficient and economical. However, an
integrated information system should provide only that particular information which
is needed by each responsible manager. The accumulation of accounting data requires
several forms, methods, and systems due to varying types and sizes of business
activities and the growing need for informative, developing some appropriate
accounting informative system has assumed greater significance during the current
century. The decision makers use the information to take more reliable decisions and
balance the risks and returns amongst different strategies. The well designed
accounting information system comprises Six basic principles as shown in the Pye
Graphic Chart at exhibit 2-1 below:-

EXBIT 2-1
Accounting Information System Principles

Control
Principle Relevance
Principle
Cash benefit
Principle
System
Principle
Compatibility
Principle
Flexibility
Principle
Promptness
Principle

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Unit-2 Accounting Information System

The above principles of an efficient accounting information system are now

deliberated as under:-

2.3.1 Control Principle

Control is a systematic effort of the management to achieve objectives by the
conduct of business activities at predetermined plans. This is possible through
devising internal controls which ensure adherence to the rules, procedures and
methods. The regular monitoring of activities through creation of reports under
accounting information system leads to remove beetle necks to improve
efficiency.

2.3.2 Relevance Principle

The management, which taking business decisions, requires reports from the
accounting information system which must disclose relevant and reliable details/
information to premise better decisions. Therefore, the accounting information
system should be designed to capture data, be understandable, and indicate
pertinent information relevant to the need of management to take effective
decisions.

2.3.3 Compatibility Principle

The accounting information system should be tailored and structured consistently
with the operative functions of the company. The compatible principle
emphasizes uniformity in designing the accounting information system in line
with the nature of workings of the enterprise like professional services, trading or
the manufacturing. Every type of enterprise would require the accounting
information in harmony with its functions. Thus compatible principle of
accounting information system would lead to generate useful reports for the
management.

2.3.4 Promptness Principle

Sometimes the management needs to take instant decisions in order to face some
situations effectively. Thus whether the accounting information system is
developed manually or through electronic devices it must flow the information
reports instantly, timely and in consonance with the deal lives specifically by the
management. Usually the prompt flow of informative is termed as essence of the
accounting information system as delay hampers quick decisions which may be at
least beneficial to the enterprise.

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Unit-2 Accounting Information System

2.3.5 Flexibility Principle

The following principles of the accounting information system prescribe that it
should be able to softly absorb changes in the quantum of activities and nature of
transactions. It must conform to the changes in information needs of the
management. Besides the flexibility principle also envisages that it must be
capable to absorb constantly the technical advancements, consumer’s tastes, legal
regulations and competitors’ pressure conveniently.

2.3.6 Cost – Benefit Principle

Every activity in the business is analyzed in the perspective of cost versus its
benefits. If the benefits exceed from the cost that particular activity is undertaken.
While introducing any type of accounting information system its operation and
maintenance must conform to the foregoing cost – benefit principle. The
preceding all principles at A to E should also be gauged on the cost – benefit
principle because and principle whose cost is greater than its benefit, do not
support the decision of management for its implementation.

2.4 COMPONENTS OF ACCOUNTING SYSTEMS

The components of accounting information system comprise working staff,

records, procedures and methods, software and hardware of computer equipment.
The qualified and competent staff of accounting is recruited and trained according
to the require events of accounting information system of the organization. Proper
record of accounting is maintained. Procedures and methods are developed in
complained to the discipline determined by the management under uniform
reporting system. The tailored software and modern hardware computer
equipment at competitive cost is purchased and installed. This system is used to
capture relevant information of business activities and generate output reports as
are needed by the management including but met limited to the financial
accounting, managerial and tax reports. The computerized accounting system
exceeds from manual accounting system in several perspectives like reliability,
accuracy, speed, flexibility and convenience for operations which is used by all
large organizations. The basic components of accounting system are therefore,
classified as the source documents ( record ), information storage and the output
devices. These components are described in the succeeding paras.

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Unit-2 Accounting Information System

2.4.1 Source Documents

The source documents are the fundamental evidence of an accounting event. The
source documents vary from the nature of business organizations. However, the
most common source documents may be identified purchase and sale
bills/invoices, payments and collection vouchers, cash book, bank book, counter
folios of cheques, bank statements, receipts, general journal, sales and purchase
journals, fixed assets cards, payroll sheets, employees files, utility bills, store
ledger cards and many more. Certain source documents can be verified from the
electronic device files as gradually the web is playing significant role in the
transaction from paper – based documentation to the paperless system in the
current scenario of computerization of records. Identification of relevant source
documents specifically in the electronic environment of accounting information
system is crucial. The input of faulty or incomplete information seriously impairs
the reliability and relevance of the accounting information system. Further the
setting up of comprised accounting information system necessitates application of
control procedures to avoid possibility of entering faulty data in the system which
may lead to non reliable information flow.

2.4.2 Input Devices

The input devices refer to the electronic instruments like Key Board scanners,
modems and mouse of a computer equipment through which the information is
captured from source documents and entered into the system processor
electronically. These input devices also help to convert data of source documents
from written or electronic from to a form useable for the system. Journal entries
both manual and electronic are a type of input device. Further, bar code readers
capture code numbers and enter them into the computer for processing also fall
into the input devices. These input devices are the basic tools of an electronic
accounting information system. Therefore, use of these tools by an unauthorized
official would defeat the trust of satisfactory information.

2.4.3 Information Processers and Storage

Upon entering relevant information from the source documents through input
devices into electronic based accounting system, the said data is processed
through software installed in the processer of hardware. Then the processer
transforms and summarizes the information for use in the analysis and reporting.
The information processers also comprise the journals, ledger accounts, posting
procedures and the working papers. Each of these elements help to transform the
raw data into desired useful information pattern as preferred by the executives.
Currently the computer technology consisting of software and hardware, handled

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Unit-2 Accounting Information System

by the information technology professionals, are entering the data in the

processers and are retrieving reports for analysis and interpretation for better
performance of their jobs.

The information storage is of pivotal importance in any data based electronic

system. The software installed and the modern hardware help to store the data for
current and future use of comparison and analysis as is needed. The stored data
must be accessible only to the authorized users of computers for periodic financial
reports generation. In the past, almost all data was stored manually which
handicapped longer storage. The modern system of information storage is
premised upon electronic storage more detailed data. The greater stored detailed
data enables the managers to plan and control business activities with higher
efficiency. Such state of affairs has enabled the managers competent enough to
deal with the business transactions even under on live communications.

2.4.4 Output Devices

The data retrieved by the users from the electronic processor is the end result of
entire electronic based accounting system. This is possible through use of output
devices. The output devices include several categories like printers, monitors,
projectors, mobile phone screens, and web communications. The output devices
easily provide variety of information like simple reports, analytical reports,
segmental reports, graphics, bill to customers, cheques to suppliers, employee pay
cheques, financial statements and other interval reports. Upon entering the desired
request for certain information in the computer containing pre installed software,
the processor starts functioning and after a short time the requisite information
appears on the output device. The transfer of funds from one bank account to
another through online which is visible on output device is another instance of the
system.

2.5 SPECIAL JOURNALS IN ACCOUNTING

As you have learnt that the general journal is used to record business transactions
and then posting into general ledger accounts as a process of classification
procedure. This general journal may be used by small or medium organizations
where quantum of the transactions is low. However, in large organizations a
single general journal does not suffice as a single employee may not be able to
record all daily transactions. Further, some repetitive types of transactions, where
sale, purchase and cash is involved, may be in coordinately time consuming and
uneconomical in terms of expenses when repetitively accounts receivable, sales

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Unit-2 Accounting Information System

account, purchase account, account payable and cash account are used for sales
and purchases or merchandise. Thus logically in order to facilitate working
environment in an organization, it would be appropriate to employ some special
journals for recording repetitive type of transactions. The broad classification for
introduction of special journals may be as under depending upon the nature of
activities of an organization:-

Types of Transaction Special Journal

1 Sale of merchandise on credit Sales Journal
2 Receipt of cash from any source Cash receipt Journal
3 Purchase of merchandise on credit Purchase Journal
4 Payment of Cash for any purpose Cash Payment Journal

The above special Journal are now illustrated one by one as under:-

2.5.1 Sales Journal

The Sales journal maintained by the trading organizations is exclusively used for
recording all sales of merchandise on credit basis. The sales on cash basis are
recorded in the cash receipt journal. Besides the sale/disposal of assets are not
recorded in the Sales journal rather these are recorded in the general journal in
case these are sold on credit basis while in case of cash basis these are recorded in
the cash receipt journal depending upon the terms of sale. The sales journal is
illustrated in the demonstration problem 2-1 through some sales transactions of
Asad Trading Company which are as follows: -

Demonstration Problem 2-1 (Sales Transactions)

01-02-2021 Sold merchandise to Asif Company on 30 days credit amounting to Rs. 20,000.
03-02-2021 Sold merchandise to Fareed Sons on 15 days credit amounting to Rs. 15,000
05-02-2021 Sold goods at the price of Rs.12,000 to Azam Sons on 30 days credit.
10-02-2021 Sold goods amounting to Rs. 10,000 to Fareed Sons on 40 days credit.
15-02-2021 Sold merchandise at the price of Rs. 18,000 on credit basis to Azam Sons.
20-02-2021 Sold goods amounting to Rs. 6,800 to Arif & Company on 20 days credit.
27-02-2021 Sold merchandise amounting to Rs. 15,000 on 20 days credit basis to Azam Sons.
28-02-2021 Sold goods at the price of Rs.8,000 on cash to Zia Sons

The above Sales transactions are now recorded in the Sales Journal as under:-

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Unit-2 Accounting Information System

Solution to
Asad Trading Company
SALES JOURNAL

Date Invoice No. Account Debited Posting Accounts Receivable Sales Account
2021 Reference Dr 2005 Cr 5100
01 Feb 320 Asif & Company √√ Rs. 20,000
03 Feb 321 Fareed Sons √√ 15,000
05 Feb 322 Azam Sons √√ 12,000
10 Feb 323 Fareed Sons √√ 10,000
15 Feb 324 Azam Sons √√ 18,000
20 Feb 325 Asif & Company √√ 6,000
27 Feb 326 Azam Sons √√ 15,000
Total √√ Rs. 96,800
Accounts Posted (2005) Dr (5100) Cr

All the credit sales transactions have been recorded in the sales Journal of Asad
Trading Company except one transaction dated 28 February 2021 which was the
cash sales transaction. Since Sales Journal is maintained only for credit sales,
therefore, the cash sales will not be recorded in this Sales Journal while this cash
sales transaction will be recorded in the cash receipt Journal.

After recording the transaction in sales Journal, this will not be posted into the
respective subsidiary ledger accounts of Receivable from customers on daily basis
and a tick mark (√) will be inserted against each credit customer in the posting
reference column of the Sales Journal. At the end of each month or on weekly
basis, as in considered expedient, the posting of credit sales will also be posted in
the Accounts Receivable control account to match the balances of all subsidiary
ledger accounts with the control ledger Account.

The subsidiary ledger accounts and the control ledger account for the foregoing
sales Journal transactions are presented as here under:-

Subsidiary ledger Accounts of Credit Customers

Asif & Company
01-02-21 Sales Account Rs. 20,000 28-02-21 Balance c/f Rs. 26,800
20-02-21 Sales Account 6,800
Total Rs. 26,800 Rs. 26,800

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Unit-2 Accounting Information System

Fareed & Sons

03-02-21 Sales Account Rs. 15,000 28-02-21 Balance c/f Rs. 25,000
10-02-21 Sales Account 10,000
Total Rs. 25,000 Rs. 25,000

Azam & Sons

05-02-21 Sales Account Rs. 12,000 28-02-21 Balance c/f Rs. 45,000
15-02-21 Sales Account 18,000
27-02-21 Sales Account 15,000
Total Rs. 45,000 Rs. 45,000

Control ledger Accounts

2005-Accounts Receivable
28-02-21 Sales Account Rs. 96,800 28-02-21 Balance c/f Rs. 96,800

5100- SALES Account

28-02-21 Balance c/f Rs. 96,800 28-02-21 Accounts Receivable Rs. 96,800

Comparing the total of all the credit customers of the subsidiary ledger accounts as 03
in number) i.e Rs. 26,800 of Asif & Company, Rs. 25,000 of Fareed & Sons and Rs.
45,000 of Azam & Sons as presented above with the total balance of control ledger of
Accounts receivable, Rs. 96,800 it is confirmed that these are matching with each
other. Hence accuracy is confirmed. Any amount collected from these customers will
be recorded on the same day in the subsidiary ledger accounts and the control ledger
account to maintain equality after every transaction.

Instead of using the T format traditional ledger accounts, the running balance four
column format ledger account is preferably used by all larger organizations where
electronic accounting information system is employed.

2.5.2 Cash Receipt Journal

The cash receipt Journal is maintained for recording all transactions where from
the cash is collected by the enterprise. This cash can be received from cash sales,
collection from credit customers (Accounts Receivables), rent, interest, dividend
disposal of certain assets and issuance of capital stock. The Cash Receipt Journal
will be divided into two parts, one debit column for recording cash collection and
any discount allowed to customers on earlier payment while the credit column
will be used for the source from which the cash was collected. The credit column
will indicate few major those account sources from which the frequent items will
be recorded in Sundry Accounts column. The cash sales, transactions can usually
be frequent in a deny, therefore, these can first be recorded into a cash sales

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Unit-2 Accounting Information System

register and then can be entered into the cash receipt Journal on daily basis
through a consolidated one entry.

The Cash Receipt Journal can be illustrated in the demonstration problem 2-2
through some cash transactions of Asad Trading Company which are as follows:-

Demonstration Problem 2-2

Cash collection transactions
02-03-20 Collected cash of Rs. 20,000 from Asif & Company for credit sales during February 2020.
04-03-20 Cash sales for the day as per cash register amounting to Rs. 8,650.
06-03-20 Collected rent of Rs. 12,000 from cafeteria contractor for march 2020.
07-03-20 Collected Rs. 12,000 from Azam Sons for credit sales on 5 February 2020
10-03-20 Disposed off an old motor cycle at the cash price of Rs. 13,200 at its cost.
15-03-20 Received dividend income of Rs. 10,000
18-03-20 Collected Rs. 15,000 from Azam Sons for credit Sales during February 2020
25-03-20 Cash sales for the week as per cash register amounting to Rs. 28,500
28-03-20 Collected Rs. 10,000 from Fareed Sons against credit sales during February 2020
31-03-20 Cash sales for the week as per cash register amounting to Rs. 25,110

All the above cash transactions are now recorded into the cash receipt journal as
under:-
Demonstration Problem 2-2
Solution of Asad Trading Company

Cash Receipt Journal

Date Particulars of PR Cash Sales A/R Sundry Accounts

Accounts Debit Credit Credit Credit
credited
March 2020 Rs. Rs. Rs. Rs. Account No.
02 Asif & Company √ 20,000 20,000
04 Sales Account √ 8,650 8,650
06 Rent Income √ 12,000 12,000 5,200
07 Azam Sons √ 12,000 12,1,000
10 Motor cycle √ 13,200 13,200 2,300
15 Dividend A/C √ 10,000 10,000 6,100
18 Azam Sons √ 15,000 15,000
25 Sales Account √ 28,500 28,500
28 Fareed Sons √ 10,000 10,000
31 Sales Account √ 25,110 25,110
Total 154,460 62,260 57,000 35,200
Accounts Posted √ 1,000 5,100 2005 -

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Unit-2 Accounting Information System

The account codes as used in the Sales Journal and the cash Receipt Journal are
those which are usually used by the organizations and are developed by a chart of
accounts with numerical codes for recording convenience in the accounting
records.

The transactions as recorded in the cash Receipt Journal will now be posted in the
control ledger accounts and the subsidiary ledger accounts. The subsidiary ledger
accounts and the control ledger Account for the Accounts Receivable as used in the
sales Journal will be adopted for posting of certain transactions conducted during
March, 2020 in the cash Receipt Journal apart from the opening of certain additional
ledger accounts as involved in the cash Receipt Journal as presented below:-

Subsidiary Ledger Accounts of Credit Customers

Asif & Company

01-02-20 Sales Account Rs. 20,000 02-03-20 Cash Account Rs. 20,000
20-02-20 Sales Account 6,800 31-03-20 Balance C/F 6,800
Total Rs. 26,800 Rs. 26,800

Fareed & Sons

03-02-20 Sales Account Rs. 15,000 28-03-20 Cash Account Rs. 10,000
20-02-20 Sales Account 10,000 31-03-20 Balance c/f 15,000
Total Rs. 25,000 Total Rs. 25,000

Azam Sons

05-02-20 Sales Account Rs. 12,000 07-03-20 Cash Account Rs. 12,000
15-02-20 Sales Account 18,000 18-03-20 Cash Account 15,000
28-02-20 Sales Account 15,000 31-03-20 Balance c/f 18,000
Total Rs. 45,000 Total Rs. 45,000

Control ledger Accounts

2005- Accounts Receivable

29-02-20 Sales Account Rs. 96,800 02-03-10 Cash Account Rs. 20,000
07-03-20 Cash Account 12,000
18-03-20 Cash Account 15,000
28-03-20 Cash Account 10,000
31-03-20 Balance c/f 39,800
Total Rs. 96,800 Total Rs. 96,800

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Unit-2 Accounting Information System

5100- Sales Account

31-03-20 Balance c/f Rs. 159,060 29-02-10 Account Receivable Rs. 96,800
04-03-20 Cash Account 8,650
25-03-20 Cash Account 28,500
31-03-20 Cash Account 52,110
Total Rs. 159,060 Total Rs. 159,060

5200-Rent Income Account

31-03-20 Balance c/f Rs. 12,000 06-03-20 Cash Account Rs. 12,000

2300-Motor Cycle Account

01-03-20 Balance b/d Rs. 13,200 10-03-20 Cash Account Rs. 13,200

6100-Dividend Account

31-03-20 Balance c/f Rs. 10,000 15-03-20 Cash Account Rs. 10,000

The Accounts Receivable control account is now showing a debit balance of Rs.
39,800 based upon the credit sales during February 2020 and collections during
March 2020. For simplicity the credit transactions of sales during March, 2020
have not been considered. The balance of accounts Receivable of Rs. 39,800 is
now matching with the total balance of subsidiary ledger Accounts of three credit
customers namely Asif & Company (Rs.6, 800), Fareed & Sons (Rs.15,000) and
Azam Sons (Rs.18,000) which confirms accuracy. Alternately a schedule of credit
customers with outstanding balance against them can be prepared at period end to
confirm matching with the total amount of Accounts Receivable as tabulated
below:-

Schedule of Accounts Receivable as on 31-03-2020

1 Asif & Company Rs. 6,800

2 Fareed & Sons 15,000
3 Azam Sons 18,000
Total Rs. 39,800

2.5.3 Purchase Journal

Likewise the Sales Journal, the Purchase Journal maintained by the trading
organization is also used for recording all the purchase of merchandise on credit
basis. This is applicable where periodic accounting system is practiced. In case
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Unit-2 Accounting Information System

the enterprises are using the perpetual inventor system the nomenclature of
purchase will be replaced by Inventory Procurement Journal. The purchase on
cash basis will be recorded in the cash disbursement journal. Besides the purchase
of some assets on credit basis can also be recorded in the Purchase Journal with
some additional columns added in it. Since such asset’s items are usually
infrequent, therefore, these can be recorded in the Purchase Journal. The Purchase
Journal is illustrated in the demonstration problem 2-3 through some purchase of
merchandise transactions and some other items of Asad Trading Company which
are enumerated below:-

Demonstrated Problem 2-3

Purchase transactions
02-02-20 Purchase merchandise from Asghar Sons on 30 days credit amounting to Rs. 12,000.
05-02-20 Purchased merchandise from Baqir Company on 30 days credit amounting to Rs. 14,000.
07-02-20 Procured merchandise from Alimad Trading Company at the price of Rs. 20,000 on 30 days credit.
12-02-20 Acquired Store supplies at Rs. 4,000 on credit basis for office use firm decent supplies.
16-02-20 Purchase Computer equipment for office use at the cost of Rs. 12,500 from Ahsan Technology on credit basis.
22-02-20 Procured merchandise from Asghar Sons on 20 days credit amounting to Rs. 15,000.
27-02-20 Purchased merchandise from Ahmad Trading Company at the price of Rs. 12,000 on 2/10, n/30 credit terms.

The above purchase of merchandise and other assets items will now be recorded
in the Purchase Journal as presented below: -

Asad Trading Company

PURCHASE JOURNAL
Date Account Credited PF Account Merchandise Sundry Account
Payable Purchase
February Credit Debit Amount Amount
2020
02 Asghar Sons 12,000 12,000
05 Baqir Company 14,000 14,000
07 Ahmad Trading Company 20,000 20,000
12 Decent Supplies 4,000 - Office Supplies 4,000
16 Ahsan Technologies 12,500 - Office equipment 12,500
22 Asghar Sons 15,000 15,000
27 Ahmad Trading Company 12,000 12,000
Total 89,500 73,000 16,500
Accounts posted (3005) (2010) (2100)
(2200)

The posting of the above transactions as recorded in the Purchase Journal will
now be carried out in the general ledger Accounts and the subsidiary ledger
Accounts as presented below: -

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Unit-2 Accounting Information System

Control ledger Accounts

3005- Accounts Payable
28-02-20 Balance c/d Rs. 89,500 02-03-10 Purchase merchandise Rs. 20,000
12-02-20 Office Supplies 4,000
16-02-20 Office equipment 12,500
Total Rs. 89,500 Total Rs. 89,500

2010 Purchase Account

02-02-20 Asghar Sons Rs. 12,000 28-02-20 Balance c/f Rs. 73,000
Baqir Company 14,000
Ahmad Trading Company 20,000
Asghar Sons 15,000
Ahmad Trading Company 12,000
Total Rs. 73,000 Total Rs. 73,000

2100-Office Supplies Account

12-02-20 Decent Supplies Rs. 4,000 28-02-20 Balance c/d Rs. 4,000
Total Rs. 4,000 Total Rs. 4,000

Subsidiary ledger Accounts of credit Supplies

Asghar Sons
28-02-20 Balance c/d Rs. 27,000 02-02-20 Purchase Account Rs. 12,000
22-02-20 Purchase Account Rs. 15,000
Total Rs. 27,000 Total Rs. 27,000

Baqir Company
28-02-20 Balance c/d Rs. 14,000 05-02-20 Purchase Account Rs. 14,000
Total Rs. 14,000 Total Rs. 14,000

Ahmad Trading Company

29-02-20 Balance c/d Rs. 32,000 07-02-20 Purchase Account Rs. 20,000
28-02-20 Purchase Account Rs. 12,000
Total Rs. 32,000 Total Rs. 32,000

Decent Supplies
28-02-20 Balance c/d Rs. 4,000 12-02-20 Office supplies Rs. 4,000
Total Rs. 4,000 Total Rs. 4,000

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Unit-2 Accounting Information System

Ahsan Technologies
28-02-20 Balance c/d Rs. 12,500 16-02-20 Office equipment Rs. 12,500
Total Rs. 12,500 Total Rs. 12,500

The balance of subsidiary ledger accounts of credit supplies will be matched at

the end of each month to confirm accuracy with the balance of control ledger
account of Accounts Payable which has a balance of Rs. 89,500. This is
confirmed through preparation of schedule of credit supplies as below:-

Schedule of Accounts Payable as on 29-02-2020

1 Asghar Sons Rs. 27,000
2 Baqir Company 14,000
3 Ahmad Trading Company 32,000
4 Decent Supplies 4,000
5 Ahsan Technologies 12,500
Total Rs. 89,500
The Total figure of Rs. 89,500 is matching with the total balance of Rs. 89,500 of the
Accounts Payable Account as on 29 February, 2020 hence the accuracy is satisfied.

Credit Terms and Cash Discounts

In case of cash purchase or cash sales the payment is to be released immediately
upon delivery of goods or merchandise. However, in case of credit purchases or
sales certain credit terms are agreed upon in future. These may be 2/10, n/30 or
1/15, n/60 etc. This means that 2% discount will be applicable if the payment is
released within 10 days or full amount will be payable within 30 days if discount
period for payment is not availed by the purchaser. Similarly, the other term is
that 1% discount will be applicable if payment is made within 15 days of
purchase/sale and if this discount is not availed, full payment will be due within
60 days. The inspiration of cash discount is practiced by supplier for early
collection of funds from the purchases to meet financial requirements apart from
avoiding the chance of bad debts in future. Thus, the cash discount an early
payment will be treated as expense in the accounts of seller, while it will be
treated as income in the accounts of purchaser. However, the trade discount is
usually treated separately which is unsightly deducted from the purchase price.
The 2% discount on payment for the merchandise amounting to Rs. 20,000
purchased from Ahmad Trading Company which words out to Rs. 400 will be
treated by Asad Trading Company as cash discount income if payment is released
up till 16 February, 2020 to Ahmad Trading Company. This cash discount

44
Unit-2 Accounting Information System

expense by Ahmad Trading Company as it collected the funds earlier than the full
credit period. The above credit terms may also be indicated in the Purchase
Journal through a separate column so as to keep vigilance on payments becoming
due within discount period to avail it and get benefits of cash discount.
2.5.4 Cash Payment Journal
Another special journal is classified the cash Payment Journal which is used for
recording all payment transactions for cash purchases payment for credit
purchases (Accounts Payables), Salaries, assets purchase, utilities bills and all
other payments by the enterprise. The cash payment journal contains columns
dependent upon the frequency of transactions are entered in the column named as
Sundry Accounts. Usually all major payments are released through cheques,
therefore a column for a cheque number with its date is also added in the cash
Payment Journal. The relevant accounts against which the payment is released,
will be marked as debit, while the cash column will be credited for payments and
discount availed for early payment will also be marked as credit column.
The cash payment Journal can be illustrated in the demonstrations of Asad
Trading Company which as follows:
Demonstration Problem 2-5
Cash Payment Transactions
03-03-20 Paid Asghar Sons Rs. 12,000 on account of merchandise purchase on 02 February 2020
07-03-20 Paid the amount of Rs. 20,000 due to Ahmad Trading Company for the merchandise purchased on credit
during February, 2020.
08-03-20 Paid amount due to Ahmad Trading Company for purchase of merchandise of Rs. 12,000 on 28-02-2020
azurite discount of 2/10 period.
10-03-20 Paid electricity bill of Rs. 8,600 for the month of February, 2020.
13-03-20 Paid Ahmad Technology for the computer equipment amounting to Rs. 12,500 purchase on credit basis
during February 2020.
15-03-20 Telephone bill amounting to Rs. 1,650 paid.
20-03-20 Paid Rs. 6,800 for repair and maintenance of office building.
22-03-20 Paid Rs. 10,000 for cash purchase of merchandise from Rehmat Ali.
26-03-20 Delivery Van got repaired at the payment of Rs. 5,500.
28-03-20 Paid office rent amounting to Rs. 25,000.
31-03-20 Paid staff salary of Rs. 15,000 for march 2020.

All the above Transactions are now recorded in the cash Payment Journal as here
under:-

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Unit-2 Accounting Information System

Asad Trading Company

Cash Payment Journal
Date Cheque Account Debited Sundry A/P Purchase Discount Cash
No. Accounts merchandise

March Dr Dr Dr Cr Cr
2020
03 16532 Asghar Sons A/C Amount 12,000 12,000
07 16533 Ahmad Trading Co. 20,000 20,000
08 16534 Ahmad Trading Co. 12,000 240 11,760
10 16535 Utilities expenses 4,010 8,600 8,600
13 16536 Ahsan Trading Co. 12,500
15 16537 Utilities expense 4,010 1,650
20 16538 Repair and 4,100 6,800
Maintenance expense
22 16539 Rehmat Ali 10,000 10,000
26 16540 Repair and 4,100 5,500 5,500
maintenance expense
28 16541 Rent expense 4,200 25,000 25,000
31 16542 Salary expense 4,300 15,000 15,000
Total 62,550 56,500 10,000 240 128,810
Accounts posted (3005) (2010) 5200 (1,000)
The transactions as recorded in the cash Payment Journal will now be posted in
the Control ledger accounts and the subsidiary ledger accounts. The control ledger
accounts and the subsidiary ledger accounts as used in the Purchase Journal and
certain additional accounts as involved during payments will be used for posting
of all cash disbursement transactions. These are now prepared as under:-
Control ledger Accounts
3005 – Accounts Payables
03-03-20 Cash Rs. 12,000 28-02-20 Purchase of merchandise Rs. 73,000
07-03-20 Cash 20,000 12-02-20 Office Supplies 4,000
08-03-20 Cash 12,000 16-02-20 Office equipment 12,500
13-03-20 Cash 12,500
31-03-20 Cash 33,000
Total Rs. 89,500 Rs. 89,500

2010- Purchase Account

02-02-20 Asghar Sons Rs. 12,000 31-03-20 Balance c/d Rs. 73,000
05-02-20 Baqir Company 14,000 4,000
07-02-20 Ahmad Trading Co. 20,000 12,500
22-02-20 Asghar Sons 15,000
28-02-20 Ahmad Trading Co. 12,000
22-02-20 Cash Account Rs. 10,000 Rs. 89,500
Total Rs. 83,000 Total Rs. 83,000

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Unit-2 Accounting Information System

5200 – Discount Account

31-03-20 Balance c/d Rs. 240 08-03-20 Ahmad Trading Co. Rs. 240

Utilities Expenses Account

10-03-20 Cash Rs. 8,600 31-03-20 Balance c/d Rs. 10,250
15-03-20 Cash 1,650
Total Rs. 10,250 Total Rs. 10,250

4100 – Repair and Maintained Expenses Account

20-03-20 Cash Account Rs. 6,800 31-03-20 Balance c/d Rs. 12,300
26-03-20 Cash Account 5,500
Total Rs. 12,300 Total Rs. 12,300

4200 – Rent Expenses Account

28-03-20 Cash Account Rs. 25,000 31-03-20 Balance c/d Rs. 25,000

4300 – Salary Expenses Account

31-03-20 Cash Account Rs. 15,000 31-03-20 Balance c/d Rs. 15,000

Subsidiary ledger Accounts

Asghar Sons
03-03-20 Cash Account Rs. 12,000 02-02-20 Purchase Account Rs. 12,000
15-03-20 Cash 15,000 Purchase Account 15,000
Total Rs. 27,000 Total Rs. 27,000

Baqir Company
31-03-20 Balance c/d Rs. 14,000 05-02-20 Purchase Account Rs. 14,000

Ahmad Trading Company

07-03-20 Cash Account Rs. 20,000 0-02-20 Purchase Account Rs. 20,000
08-03-20 Cash Account 11,760 28-02-20 Purchase Account 12,000
08-03-20 Discount Account Rs. 240
Total Rs. 32,000 Total Rs. 32,000

Decent Supplies
31-03-20 Balance c/d Rs. 4,000 12-02-20 Office Supplies Rs. 4,000

Ahsan Technologies
13-03-20 Cash Account Rs. 12,500 16-02-20 Office equipment Rs. 14,000

The balance of subsidiary ledger accounts of the credit supplies after making
certain payments during the month of March, 2020 will scow be matched at the
end of the month to confirm accuracy with the balance of control ledger account
of Accounts payable which has a balance of Rs. 33,000 as on 31 March 2020.

47
Unit-2 Accounting Information System

This is confirmed through preparation of a schedule of credit supplies as given

below:-
Schedule of Accounts Payable as on 31 March, 2020
1. Asghar Sons Rs. 15,000
2. Baqir Company Rs. 14,000
3. Decent Supplies Rs. 4,000
Total Rs. 33,000

The total figure of Rs. 33,000 is matching with the total balance of Rs. 33,000 of the
Accounts Payable Account as on 31 March, 2020 hence the accuracy is satisfied.

2.5.5 Cash Book

The business organizations where the frequency of cash transactions in a day or the
week are significantly greater, it would be appropriate to maintain two Cash Journals
i.e cash receipt Journal and the cash payment Journal as discussed and presented in
the preceding paragraphs. These repeats books can conveniently be entrusted upon
two officials for handling independently. However, in some organizations the
functions of cash receipts and disbursements are assigned to a single official for the
purposes of greater control ones cash inflow and cash outflows. Some times of cash
when certain amount is available for some period, and in the near future no
obligations are maturing, the available cash can be invested with financial institutions
or somewhere else to put the cash in productive use and reap certain interest benefits.
The cash officer or Treasurer will keep watch over the regularity with which cash
from normal business or other operations is being collected. Similarly, he will also
keep I view the magnitude of and the regularity with which normal as well as
occasional liabilities are to be met with. It will be his responsibility to watch that
enough cash, including money in the bank is available to discharge liabilities on due
dates. Thus the cash receipt and disbursements functions are handled by a single cash
officer to control cash transactions more effectively. In this respect, instead of
maintaining two separate cash receipts and cash payment journals, a single cash book
will be used for recording receipts and payment transactions to record conveniently.

In Order to illustrate the presentations of cash book, we may use the same
transactions as dealt with in the cash receipts and cash disbarments journals
during the month of March 2020 as tabulated in the demonstration problems 2-3
and 2-5. The consolidated transactions of cash receipts and disbursements, in a
chronological order of dates, will be recorded in the cash book as per
demonstration problem 2-6 that follows. In this Cash Book it is assumed that all
cash collected from customers was deposited into Bank Account wherefrom all
payments will be made through cheques.

48
Unit-2 Accounting Information System

Demonstration Problem 2-6

Asad Trading Company
CASH BOOK
Date Cheque Particulars P/F Sales A/R Merchandise Accounts Discount Sundry Account Cash Balance
March No. Accounts Credit Credit Purchase Payable Dr/Cr Dr
Particular Amount Dr Cr
2020 Debit Debit
Account
01 - Opening √ 30,500 - 30,500
balance
02 - Asif & √ 20,000 20,000 - 50,000
Company
03 16532 Asghar Sons √ 12,000 - 12,000 38,500
04 - Sales a/c √ 8,650 8,650 - 47,150
06 - Rent income √ Rent Cr. 12,000 12,000 - 59,150
5200
07 - Azam Sons √ 12,000 12,000 - 71,150
07 16533 Ahmad √ 20,000 - 20,000 51,150
Trading Co.
08 16534 Ahmad √ 12,000 Cr. 240 - 11,760 39,390
Trading Co.
10 16535 Utilities √ Utilities 8,600 - 8,600 30,790
Expense exp Dr.
4010
10 - Motor cycle √ Motor 13,200 13,200 - 43,990
cycle Cr.
2300
13 16536 Ahsan Trading √ 12,500 - 12,500 31,490
Co.
15 - Dividend A/C √ Dividend 10,000 10,000 - 41,490
income
Cr. 6100
15 16537 utilities √ Utilities 1,650 - 1,650 39,840
Expense exp.
Dr. 4010
18 - Azam Sons √ 15,000 15,000 - 54,840
20 16538 Repairs √ R and M 6,800 - 6,800 48,040
Maintence Exp exp
Dr. 4100
22 16539 Rehmat Ali √ 10,000 - 10,000 38,040
25 - Sales Account √ 28,500 28,500 - 66,540
26 16540 Repair √ R and M 5,500 - 5,500 61,040
Maintence Exp exp.
Dr 4100
28 16541 Rent Expense √ Rent Exp 25,000 - 25,000 36,040
a/c Dr. 4200
28 - Fareed Sons √ 10,000 10,000 - 46,040
31 16542 Salary √ Salary 15,000 - 15,000 31,040
Expenses Exp
Dr. 4300
31 - Sales A/c √ 25.110 25,110 - 56,150
Total Rs. 57,000 10,000 56,500 240 Net Dr 27,350 184,96 128,81 56,150
62,260 0 0
Accounts (5100) (2005) (2010) (3005) (5200) (1000) (1000) (1000)
posted

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Unit-2 Accounting Information System

The Columns of Cash Book as presented in the demonstration problem 2-6 can be
developed according to the particular requirements. These columns can be
curtailed or expanded in consonance with the activities and accounting
information system. The posting in the control ledger accounts and the subsidiary
ledger accounts from the Cash Book as presented on the pre-page will be identical
to the postings carried out from the cash receipt journal and the cash payment
journal leading to absolutely no change in the account balances.

2.6 TECHNOLOGY – BASED ACCOUNT SYSTEMS

The accounting information systems based upon computer technology have been
explained in the preliminary portion of this unit. However, in order deliberate
further on technology-based accounting system we have to look back as early as
half century ego. During a decode of 1971 – 1980 phase these was an introduction
of simple calculators and afterwards slowly and steadily the computers were
introduced and then penetrated in some segmental affairs of the business offices.
Gradually the people were inclined to learn professional skills of computer
technology and during another next decode phase several professionals were
inducted in the digital technology field for working in the business offices most
preferably in the accounting profession, apart from application of this technology
in the production activities as well.

In the past, most of the accounting record was saint aimed manually. However,
later with the introduction of computer technology, most of the organizations
trained their staff on computer systems and gradually converted accounting
system during subsequent decode. The manual-based accounting information
system was time consuming, costly and cumbersome to the extent that physical
record in the accounting books and files was kept mandatory. This switched over
to the most reliable, fast and non-physical-record-based accounting information
system. The ever increasing and modern digital technology-based sate of the art
computers and software in different categories have facilitated the maintenance of
accounting information system and generation of reports and analysis with
interpretation most rapidly for trustworthy decision making.

The digital networking has facilitated the accounting professional on recording

business transactions, processing and developing daily weekly or monthly
reports through a simple click on Keyboard. Besides, presentation of customer’s
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Unit-2 Accounting Information System

bills communication and transaction on live payments and collection of funds

electronically has created ease to the business community at large. This has been
possible through modern based computer hardware’s and programming
software’s tailored according to the specific requirement demands during the
phase last two decades.

The management of inventory of multiple products being dealt with by

organizations has become possible through technology – based accounting
system. The manger can monitor accounting system the availability of excessive
inventory of any products at any warehouse of locality, city or branch and can
arrange its movement from one branch to the other procurement and its disposal
on-live and thus can perform its functions most effectively with lower investment
of funds.

The computer technology can dramatically reduce the time and efforts of
professionals devoted to the record keeping thus they can concentrate more on
analysis and managerial decisions making of business activities.

Several organizations have developed their own software programmers for

continuously updating the software’s according to the new features of
requirements. Apart from the piliation of inventory as explained earlier, another
problem usually confronted by many of the organizations is related to monitoring
of its accounts receivables. The credit customers usually do not pay their dues
until they are reminded frequently. The technology-based system of accounts
receivable can extend aid to the management for chasing the customers for timely
recovery of dues, through sustained efforts, thus providing adequate financial
resources for meeting its own financial obligations.

2.7 SUMMARY

The accounting information system developed in the organization should meet the
requirements of the management. The system should be based upon the control,
relevance, compatibility, information promptness, flexibility and the cost benefit
principles so as to contribute to the function of management. The accounting
information system is currently premised upon the technology-based accounting
system in most of the organizations. The data is extracted from the source
documents and is entered through input devices in the system processers for
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Unit-2 Accounting Information System

storage. The data is then retrieved in different shapes through output devices as in
needed by the executives and top management for external and internal reporting
purposes. This is possible through computer hardware and software installed in
the enterprise.
The package of accounting information system also comprise the introduction of
Special Journals instead of a single general journal with the objectives distribute
the work lead over several staff mew leers instead of confining over one person.
These special journals include Sales Journal used exclusively for recording credit
sales transactions of merchandise, cash receipt journal for recording collection of
cash from cash and credit sales, and from any other sources, maintaining purchase
Journal for recording procurement of merchandise on credit and the cash payment
journal for recording all cash payments for cash and credit purchases and payment
for all other expenses of the enterprise. The columns of these special journals can
be organized according to the information need of the accounting system. In
several organizations a cash book for recording all cash receipts and payments for
sales, purchases and other expenses including capital receipts and expenditures is
maintained to consolidate all cash transactions. The cash book is maintained in
live of cash receipt and cash payment journals. Thus, greater effective control
over funds management is exercised in the enterprise.

2.8 THEORETICAL QUESTIONS

1) Discuss the conceptual framework of accounting information system in an

enterprise.
2) Describe in detail the six fundamental principles of accounting system.
3) The promptness principle and cost-benefit-principle of an accounting system
are considered as core elements. Explain it.
4) Describe the composition of an electronic accounting information system
designed for generating periodic reports.
5) What is meant by Special Journals in accounting?
6) What objectives can be achieved through introduction of special journals in
a trading enterprise?
7) Elucidate the contents of a Sales Journal and what types of transactions are
recorded in it.
8) Describe the elements of cash Receipt Journal and what types of transactions
are entered in it.

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Unit-2 Accounting Information System

9) Discuss the nature of transactions entered in a purchase journal and indicate

usual columns maintained in it.
10) Describe the columnar information maintained in a cash payment journal
and categories of transactions entered in it.
11) Explain the purpose of maintaining a cash book and explain the different
transactions recorded in it.
12) How the cash book facilitates the executives for better funds management
instead of maintaining two separate cash Journals of receipts and payments?
13) What do you understand by the technology-based accounting system?
Explain in detail.
14) What is the historic development of the technology based accounting system?
15) How the technology-based accounting system helps the executives to achieve
objectives in management of billings, accounts receivables and inventories.
16) Describe credit term 1/10, n/30 and how the cash discount on sales will be
accounted for in books.

2.9 PRACTICAL PROBLEMS

Problem 2-1
3-1. The following sales transactions were conducted by Ashar Trading Enter
price during the month of April 2020:-
03 Merchandise amounting to Rs. 5,800 were sold on credit to Reliance Traders.
06 Sold goods at invoice price of Rs. 16,700 to Shah Sons on credit of 30 days
10 Sold goods at invoice price of Rs. 13,600 to Zaib Traders on 30 days credit.
15 Merchandise amounting to Rs. 8,500 were sold to Shah Sons on 2/10, n/30
credit terms.
26 Supplied merchandise amounting to Rs. 18,000 Reliance Traders on 1/15, n/30
credit terms.
28 Sold goods at invoice price of Rs. 15,000 to Good Luck Trading Enterprise at
30 days credit.

Required
a) Record the above transactions in the Sales Journal and allot suitable account
numbers of control accounts.
b) Post these transactions in the control ledger accounts
c) Post these transactions in the subsidiary ledger accounts.

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Unit-2 Accounting Information System

d) Prepare a schedule of Accounts receivable indicating the amount due from

each credit customer to reconcile at with the balance control account at
month end.

Problem 2-2
Following transactions were carried out by Ashar Trading Enter price during the
month of May 2020.
05. Collected the amount of Rs. 16,700 from Shah Sons for merchandise sold to
them during April, 2020.
09. Received the amount due from Reliance Traders on account of goods
supplied amounting to Rs. 18,000 on 26 April 2020 on credit terms of 1/15,
n/30.
10. Received dues from Reliance Traders of Rs. 5,800 for goods sold to them
during April, 2020.
14. Collected Rs. 8,400 for cash sales during the week.
16. The canteen contractor deposited an amount of Rs. 12,000 for the rent of
May 2020.
20. Received Rs. 560 on disposal of scrap material.
28. Received amount due from Good Luck Trading Enterprise for merchandise
sold to it at the invoice price of Rs. 15,000 on 30 days credit terms.

Required
a) Record the above transactions in the cash Receipt Journal and allot suitable
account numbers of control accounts.
b) Post these transactions in the control ledger of Accounts Receivable which
had the opening balance of Rs. 77,600.
c) Post these transactions also in the subsidiary ledger accounts which had the
following opening balances

i. Reliance Traders Rs. 23,800

ii. Shah Sons 25,200
iii. Zaib Traders 13,600
iv. Good Luck Trading Enterprise 15,000

d) Prepare a schedule of accounts receivable indicating the amount due from

each credit customer to reconcile it with the balance of control account at
month end.

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Unit-2 Accounting Information System

Problem 2-3
The purchase transactions as listed below were conducted by Ashan Trading
Enterprise during April 2020.hase
02 Purchased merchandise at the cost of Rs. 8,500 on credit from Decent
Supplies.
06 Procured Store supplies valuing Rs. 5,000 on credit from Ahmad Supplies
Company.
10 Acquired merchandise amounting to Rs. 22,000 from Decent supplies on 30
days credit.
14 Procured merchandise on credit valuing Rs. 18,500 from Laeeq Sons for sale
20 Purchased Computer equipment from Reliable Technology valuing Rs. 5,500
0n 2/15, n/30 credit terms
25 Purchased merchandise from Laeeq Sons on 20 days credit basis at price of Rs.
10,000
30 Procured Saleable goods worth Rs. 15,000 from Ahmad Supplies Company on
2/10, n/30 credit terms

Required
a) Record the above transactions in the Purchase Journal and allot some
suitable account numbers of control accounts
b) Post these transaction in the control ledger accounts
c) Also post these transactions in the subsidiary ledger accounts
d) Draw a schedule of Accounts Payable indicating the amount due to each
credit supplies at the end of the month and reconcile it with the control
account.

Problem 2-4
The following cash disbursement transactions were arranged by Ahsan Trading
Enterprise during May 2020.
03. Released payment of invoice of Rs. 5,500 of Reliable Technology for
purchase of computer items within discount period of 2/15, n/30 terms
06. Purchased merchandise amounting to Rs. 8,600 on cash basis
08. The invoice amounting to Rs. 15,000 of Ahmad Supplies Company for
purchase of goods on 30 April, 2020 at 2/10, n/30 credit terms was paid
within discount period 0 days credit terms.
15. Paid electricity bill amounting to Rs. 4,800 for the month of May 2020.
18. Paid office rent amounting to Rs. 20,000 for May 2020.

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Unit-2 Accounting Information System

22. Procured merchandise amounting to Rs. 13,500 on cash basis.

26. Paid telephone bill of Rs. 3,200 for the month of April 2020.
31. Paid salary of an employee amounting to Rs. 15,000 for May 2020.

Required
a) Record the above transaction in the cash Payment Journal and allocate
suitable account numbers of control accounts.
b) Post these transactions in the control ledger accounts payable which had the
balance of Rs. 84,500.
c) Post these transactions in the subsidiary ledger accounts which had the
following balances at opening of May 2020:-

Decent Supplies Rs. 30,500

Ahmad Supplies Company Rs. 20,000
Laeeq Sons Rs. 28,500
Reliable Technology Rs. 5,500

d) Prepare schedule of credit supplies to reconcile the outstanding balance with

the control account of Accounts Payable at the end of May, 2020.

Problem 2-5
Under note cash collection and cash disbursement transacting were conducted by
Asher Trading Enterprise during the month of May 2020:-
01. Opening cash balance was amounting to Rs. 35,800.
03. Released payment of invoice of Rs. 5,500 of Reliable Technology for
purchase of computer items within discount period of 2/15, n/30 terms.
05. Collected the amount of Rs. 16,700 from Shah Sons for merchandise sold to
them during April 2020.
06. Purchase merchandise amounting to Rs. 8,600 on cash basis.
08. The invoice amounting to Rs. 15,000 of Ahmad Supplies Company for
purchase of goods on 30 April 2020 at 2/10, n/30 credit terms was paid
within discount period.
09. Received the amount due from Reliable Traders on account of goods
supplied amounting to Rs. 18,000 on 26 April 2020 on credit terms of 1/15,
n/30.
10. The invoice of Rs. 22,000 from Decent Supplies was paid for merchandise
purchased on 30 days credit terms.
14. Collected Rs. 8,400 from Cash Sales during the week.
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Unit-2 Accounting Information System

15. Paid electricity bill amounting to Rs. 4,800 for the month of May 2020.
16. The canteen contractor deposited an amount of Rs. 12,000 for the rent of
May 2020.
18. Paid office rent of Rs. 20,000 for May 2020.
20. Received Rs. 560 on disposal of scrap material.
22. Procured merchandise amounting to Rs. 13,500 on cash basis.
26. Paid telephone bill of Rs. 3,200 for the month of April 2020.
28. Received amount due from Good Luck Trading Enterprise for merchandise
sold to it at the invoice price of Rs. 15,000 on 30 days credit terms.
31. Paid Salary of an employee amounting to Rs. 15,000 for May 2020.

Required
Prepare a Cash Book to record all the above cash collection and disbursement
transactions and allot suitable account numbers for control accounts.

Problem 2-6
Sherazi Enterprise carried out the following transactions during April 2020:-
01. Purchase goods at the cost of Rs. 25,000 on 1/10, n/30 credit terms from
Sohail Sons.
03. Purchased merchandise at the cost of Rs. 18,500 from Shah Enterprises on
60 days credit
05. Sold merchandise at the price of Rs. 8,600 on credit basis to Alam Company.
08. Sold goods at the price of Rs. 16,500 to Hamid Company on 30 days credit.
10. Purchased goods at the cost of Rs. 12,000 on 30 days credit from Nazir Sons.
12. Sold goods to Alam Company at price of Rs. 6,700 on 30 days credit.
15. Purchased merchandise from Alamgir Sons at cash price of Rs. 5,000.
18. Purchased merchandise on credit basis from Zaheer Sons at the cost of Rs.
12,500.
22. Merchandise sold to Hamid Company on credit basis amounting to Rs. 8,300.
27. Merchandise sold to Alam Company on 30 days credit at the price of Rs. 5,500.

Required
a) Record the above transaction in the sales and purchase journals of Sherazi
Enterprise and allocate some suitable account numbers of control accounts.
b) Post these transactions in control ledger accounts.
c) Post these transactions in the subsidiary ledger accounts.

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Unit-2 Accounting Information System

d) Prepare schedules of accounts receivable and accounts payable and

reconcile it with the balances of control accounts.
e) If any of the transactions was not recorded in any of the Two Journals,
explain the reasons for it.

2.10 GLOSSARY

Control principle
The methods and procedures adopted by managers to control and monitor
business activities to promote discipline in the enterprise.

Relevance principle
The accounting information system applied in an organization where by the
reports produced should be relevant, useful understandable and pertinent to the
requirements of management for making decisions.

Compatibility principle
This principle prescribes that the accounting information system should conform
with company’s basic activities, personnel and structure.

Promptness Principle
The flow of accounting information which must be timely and quickly to facilitate
instant decisions by management.

Flexibility principle
The accounting information system which should be capable to adjust changes
and alterations or needed by decision makers.

Cost-benefit-principle
It prescribes that the benefit of an activity in the accounting information system
should be greater than its cost.

Source documents
The relevant documents which provide basic information about happening of an
event of business or a source of an accounting information system

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Input Devices
Electronic instruments like key board, scanners, modems and mouse of a
computer system through which information is captured from source documents
and entered into the system processor electronically.

Information Processors and Storage

The data entered into the system processors for its further processing, storage and
generating analysis reports as needed by the users.

Output Devices
The basic electronically operated devices through which the data is generated like
printers, monitors, projectors, mobile phone screens, and web communications.

Sales Journal
A specifically designed journal only to record repetitive nature of credit sales
transactions of merchandise.

Purchase Journal
A specifically designed journal only to record repetitive nature of credit purchase
of merchandise transactions.

Cash Receipt Journal

A specifically designed journal to record all cash payment transaction of the
enterprise.

Credit Terms
The time duration allowed to credit customer on all Sales and purchase of
merchandise transaction for arranging payment like 30 days and 60 days.

Cash Discount
An inspiration offered to credit customer to arrange quick payment say within 5
or 10 days of sale and enjoy certain discount instead of waiting for full credit
period of 30 or 60 days for payment.

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Unit-2 Accounting Information System

Cash Book
Another specifically designed journal to record combined transactions of all cash
collections and disbursements of any nature to control and exercise intensive
managerial shill on funds management.

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Unit – 3

Accounting For Merchandising

Activities

Written by: Dr Muhammad Munir Ahmad

Reviewed by: Prof. Dr. Syed Muhammad Amir Shah
Unit-3 Accounting for Merchandising Activities

CONTENTS

Introduction ................................................................................................63
Objectives ..................................................................................................63
3.1 Merchandising Companies.........................................................................64
3.1.1 Income Statements for a merchandising concern ..........................65
3.1.2 Inventory System ..........................................................................65
3.2 Accounting for Merchandising Concerns ..................................................67
3.2.1 Comparison of entries under perpetual and periodic inventory
system ............................................................................................68
3.2.2 Measuring merchandise inventory .................................................68
3.2.3 Taking the physical inventory ........................................................69
3.3 Theoretical Questions ................................................................................70
3.4 Practical Questions.....................................................................................71
Glossary .....................................................................................................74

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Unit-3 Accounting for Merchandising Activities

INTRODUCTION
A merchandising enterprise is a business that purchase finished goods on low prices
and sell them at higher prices to earn profit. This unit is concerned with the
accounting for a merchandising enterprise, which does not make or process the
products itself.

As you are well aware that many shops and companies attempt to earn profit by
buying and selling merchandise. Merchandising firms or Companies are either
wholesale or retail, do use the same basic accounting methods as service
companies, but the process of buying and selling merchandise requires some
additional accounts and concepts. Their activities also result in a more complicated
income statement than for a service business.

Accounting systems for merchandising companies normally provide for

accumulating various kinds of data relative to buying and selling transactions.

OBJECTIVES
After studying this unit, you shall be able to:

a) Identify the components of income statement for a merchandising concern.

b) Journalize transactions involving sales and purchases of goods for
merchandising concern.
c) Calculate the cost of goods sold and differentiate between perpetual and
periodic inventory systems.
d) Prepare a work sheet for a merchandising concern.
e) Prepare adjusting and closing entries for a merchandising concern.
f) Prepare an income statement for merchandising concern.

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Unit-3 Accounting for Merchandising Activities

3.1 MERCHANDISING COMPANIES

The majority of merchandising firms' revenue comes from the sale of items.
Inventory refers to goods acquired for the aim of reselling to customers. The
capacity of most merchandising firms to buy, distribute, and sell merchandise
rapidly is critical to their profitability. In many situations, inventory is a "liquid"
asset, meaning it may be sold in a matter of days or weeks. As a result, inventory
is found towards the top of the balance sheet, just below accounts receivable. The
operational cycle refers to the series of transactions that a company uses to earn
revenue and cash from consumers. A merchandising company's operational cycle
consists of three fundamental transactions: (1) merchandise purchases; (2)
merchandise sales, frequently on account; and (3) collection of accounts receivable
from consumers. This chain of events, as the word cycle implies, repeats itself
indefinitely.

Cash Purchase of
merchandise

Collection of
account Sale of
receivables merchandise

Comparing Merchandising Activities with Manufacturing Activities

Many merchandising companies buy their inventory in ready-to-sell condition from
other businesses. Manufacturers, not merchandisers, are companies that make their
own products, such as Nestle, Gourmet Foods, and Unilever. Because the initial
transaction—purchasing products—is replaced by the various operations required
in making the merchandise, the operational cycle of a manufacturing firm is
lengthier and more complicated than that of a retailing company.

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Unit-3 Accounting for Merchandising Activities

3.1.1 Income statement for a merchandising concern

Following is a summarized income statement of Mahmood trading Company for
the year ended December 31, 2021.

Mahmood Trading Company

Income statement
For the year ended 31" December 2021
In Million Rs.
Revenue) from sales 500,000
Less cost of goods sold 180,000
Gross profit from sales 320,000

Less operating expenses 150,000

Net profit (income) 170,000

The above income statement highlights three major parts: (1) revenue or income
from sales, (2) cost of goods sold, and (3) operating expenses. Such an income
statement differs from the income statement for a service firm where net income is
measured as the difference between revenues and expenses whereas in case of
merchandising business you have to calculate gross profit from sale before
operating expenses are deducted to arrive at net income or net profit. Revenue from
sales arise from sales of goods by the merchandising company and the cost of goods
sold tells how much the merchant paid for the goods that were sold.

3.1.2 Inventory system

The perpetual and periodic inventory systems are two ways to accounting for
merchandising transactions and when management need information on inventory
levels and gross profit throughout the year, perpetual systems are employed. When
the primary aims are to produce yearly data and reduce recordkeeping needs,
periodic methods are utilized. Different inventory systems may be used by a single
business to account for different categories of products.

3.1.2.1 Who Uses Perpetual Systems?

There is no replacement for a perpetual inventory system when management or staff
wants up-to-date information on inventory levels. Perpetual systems are used by
almost all industrial companies. These firms require up-to-date information in order
to synchronize their raw material inventories with their production plans. Perpetual
systems are used by most big merchandising firms, as well as many small ones.

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Unit-3 Accounting for Merchandising Activities

Businesses that offered a variety of low-cost items had little choice but to employ
periodic inventory systems in the days when all accounting records were kept by
hand. For example, a Wal-Mart store may sell thousands of goods every hour.
Consider how difficult it would be to keep a perpetual inventory system up to date
if the records were kept by hand. Many high-volume businesses now employ
perpetual inventory systems, thanks to today's point-of-sale terminals and bar-
coded goods. In reality, Wal-Mart has been a pioneer in the development of
merchants' permanent inventory systems. Businesses using point-of-sale terminals
aren't the only ones who use perpetual inventory systems. Perpetual inventory
systems are used by many small firms that employ manual accounting systems.
These firms, on the other hand, may update their inventory data on a weekly or
monthly basis rather than at the moment of each sale. Most firms utilise perpetual
inventory systems in accounting for items with a high per-unit cost, regardless of
whether accounting records are kept manually or by computer. Automobiles, heavy
machinery, electrical equipment, home appliances, and jewelers are all examples.
When the item is pricey, management is more concerned with inventory control.
Also, even if accounting records are kept by hand, sales volume is generally low
enough that a perpetual system may be employed.

3.1.2.2 Who Uses Periodic Systems?

When the requirement for current inventory and sales information outweighs the
cost of running a perpetual system, periodic systems are utilised. For example, in a
small retail business, the proprietor may be so familiar with the goods that official
permanent inventory records aren't required. Most firms, big and small, utilise
periodic methods for inventory that isn't worth a lot of money or when management
isn't interested in the numbers on hand. As previously indicated, firms who sell a
large number of low-cost goods and utilise manual accounting systems may be
forced to use the periodic approach.

3.1.3 Selecting an Inventory System

Accountants—and business managers—often must select an inventory system appropriate
for a particular situation. Some of the factors usually considered in these decisions are
listed on the following page.

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 Unit-3 Accounting for Merchandising Activities

Factors Suggesting a Perpetual Factors Suggesting a Periodic

Inventory System Inventory System
Large company with professional management. Small company, run by owner.

Management and employees wanting information Accounting records of inventories and

about items in inventory and the quantities of specific product sales not needed in daily
specific products that are selling. operations; such information developed
primarily for use in annual income tax
returns.

Items in inventory with a high per-unit cost. Inventory with many different kinds of low-
cost items.

Low volume of sales transactions or a High volume of sales transactions and a

computerized accounting system (for example, manual accounting system.
point-of-sale terminals). Lack of full-time accounting personnel.

Merchandise stored in multiple locations or in All merchandise stored at the sales site (for
warehouses separate from the sales sites. example, in the store).

3.1.4 The Trend in Today's Business World

As technology advances, perpetual inventory systems are being used by more
organisations and for more types of inventory. This pattern is likely to persist.
Unless otherwise stated, you can assume that a perpetual inventory system is in
operation throughout this textbook.

3.2 ACCOUNTING FOR MERCHANDISING CONCERNS

There are two approaches to record the merchandising business transactions (i)
Perpetual Inventory System (ii) Periodic Inventory System
Under the perpetual inventory system detailed record of each inventory transaction
is kept and inventory balance is updated after each transaction. Whereas under the
periodic inventory system inventory balances are updated at the end of the
accounting period.

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Unit-3 Accounting for Merchandising Activities

Both systems are most widely used however perpetual inventory system is most
popular and used by large business setups. Entries are recorded in the following
manners under the perpetual and periodic inventory system.

3.2.1 Comparison of entries under perpetual and periodic inventory system.

Transaction Perpetual Inventory System Periodic Inventory System

July 5 Purchase of merchandise Merchandise Inventory 40,000 Purchases 40,000
on credit Accounts Payable 40,000 Accounts Payable 40,000
July 6 Purchase returns and Accounts Payable 2,000 Accounts Payable 2,000
allowances Merchandise Inventory 2,000 Purchase Returns and Allowance 2,000
July 8 Freight costs on Merchandise Inventory 200 Freight-in 200
purchases Accounts payable 200 Accounts Payable 200
July 14 Payment on account with Accounts Payable 38,000 Accounts Payable 28,000
a discount Cash 37,240 Cash 37,240
Merchandise Inventory 760 Purchase Discounts 760
July 16 Sale of merchandise on Accounts Receivable 24,000 Accounts Receivable 24,000
credit Sales Revenue 24,000 Sales Revenue 24,000
Cost of Goods sold 12,000
Merchandise Inventory 12,000 No entry
July 18 Return on merchandise Sales Returns and Sales Returns and
Allowances 1,000 Allowances 1,000
Accounts Receivable 1,000 Accounts Receivable 1,000
Merchandise Inventory 500
Cost of Goods Sold 500 No entry
July 25 Cash received on Cash 22,770 Cash 22,770
account with a discount Sales Discounts 230 Sales Discounts 230
Accounts Receivable 23,000 Accounts Receivable 23,000

3.2.2 Measuring merchandise inventory

The cost of goods sold is determined in part by the value of the inventories. Because
merchandise inventory comprises products that are available for sale but have yet
to be sold, a technique for calculating the amount and cost of these commodities on
hand is required. The perpetual inventory technique and the periodic inventory
method are the two most common ways to account for the quantity of goods in a
merchandise inventory.

a. Perpetual inventories
A company that sells high-value products like appliances or vehicles is
typically able to account for the cost of each item when it is purchased and sold.
The perpetual inventory technique is the name given to this approach. The cost of
each item in inventory is recorded using the perpetual technique. Each item's cost
is taken from the Inventory account and credited to the Cost of Goods Sold account
when it is sold. The total cost of goods sold is calculated by adding the costs of all
sold products, and the merchandise inventory is calculated by adding the costs of

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Unit-3 Accounting for Merchandising Activities

all goods still on hand. Companies that offer low-value, high-volume products, on
the other hand, would find it difficult and costly to keep track of the cost of each
and every item sold. Instead, they use the approach of periodic inventory.

Using this approach, the firm counts the physical inventory that is still on hand at
the conclusion of the accounting period. The cost of products sold for the full time
is calculated using this actual count of physical inventory, as well as different
accounting data. The periodic inventory approach is used at a grocery shop, which
may sell thousands of goods every hour. It is impractical to keep track of the cost
of each item when it is sold. This group includes most pharmacy stores, auto parts
stores, department stores, bargain stores, and bookstores. These businesses count
inventories "on a regular basis," generally at the conclusion of the accounting
month.

b. The periodic inventory method

To calculate ending inventory and, indirectly, the cost of goods sold, most
firms rely on an actual count of items on hand at the conclusion of each accounting
period. The periodic inventory technique, which is used to determine merchandise
inventory, may be summarized as follows:
1. At the end of the accounting period, do a physical count of the items on hand.
2. Divide the quantity of each type of item by the unit price.
3. To get a total, add the costs of each category of product together. This is the
sum of the merchandise inventory at the end of the day.

To calculate the cost of goods sold, subtract the cost of terminating product
inventory from the cost of items offered for sale. The commencing inventory of the
following period is the period's pending inventory. At the conclusion of the period,
entries are made as part of the closure procedure to delete the beginning inventory
(the previous periods ending inventory) and enter the current period's ending
inventory. During the period, only one of these entries is made to the inventory
account. As a result, the Inventory account only represents the actual quantity on
hand on the balance sheet date and after the closing entries. The inventory figure
becomes a historical amount as soon as purchases or sales are made, and it stays
that way until new inventory is entered at the end of the next accounting period.

3.2.3 Taking the physical inventory

Taking a physical inventory refers to a physical count of all items on hand at the
end of an accounting quarter. It's a challenging process since it's simple to forget
things or count them twice. All salable products held by the company are included
in the merchandise inventory, regardless of where they are situated. All goods on
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Unit-3 Accounting for Merchandising Activities

shelves, in storerooms, in warehouses, and in trucks travelling between warehouses

and stores are included.

It covers items in transit from suppliers if title to the commodities has passed to the
merchant. Ending inventory excludes product that has been sold to customers but
has yet to be delivered, as well as things that cannot be sold due to damage or
obsolescence. If damaged or obsolete goods can be sold at a lower cost, they may
be included in ending inventory at the lower cost. The actual count is generally
obtained after the closure of business on the last day of the fiscal year. To ease the
taking of physical inventory, many businesses finish their fiscal year during a
sluggish season.

Retail department stores, for example, frequently conclude their fiscal year in
January or February. Employees count and record all objects on numbered
inventory tickets or sheets after working hours, at night or on weekends. They stick
to a set of processes to ensure that no things are overlooked. The inventory tickets
or sheets are submitted to the accounting office after they are completed.

3.3 THEORETICAL QUESTIONS

1. Describe the operating cycle of a merchandising company.
2. Compare and contrast the merchandising activities of a wholesaler and a
retailer.
3. The income statement of a merchandising company includes a major type of
cost that does not appear in the income statement of a service-type business.
Identify this cost and explain what it represents.
4. During the current year, Green Bay Company earned a gross profit of
$350,000, whereas New England Company earned a gross profit of only
$280,000. Does this mean that Green Bay is more profitable than New
England? Explain.
5. Thornhill Company's income statement shows gross profit of $432,000, cost
of goods sold of $638,000, and other expenses totaling $390,000. Compute
the amounts of (a) revenue from sales (net sales) and (b) net income.

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Unit-3 Accounting for Merchandising Activities

3.4 PRACTICAL QUESTIONS

Q.1 Shown below are selected transactions of Kiger's, a retail store that uses a
perpetual inventory system.
a. Purchased merchandise on account.
b. Recognized the revenue from a sale of merchandise on account. (Ignore
the related cost of goods sold.)
c. Recognized the cost of goods sold relating to the sale in transaction b.
d. Collected in cash the account receivable from the customer in
transaction b.
e. Following the taking of a physical inventory at year-end, made an
adjusting entry to record a normal amount of inventory shrinkage.

Indicate the effects of each of these transactions on the elements of the company's
financial statements shown below. Organize your answer in tabular form, using the
column headings shown below. (Notice that the cost of goods sold is shown
separately from all other expenses.) Use the code letters / for increase, D for
decrease, and NE for no effect.

Income Statement Balance Sheet

Transaction Net Sales – Cost of Goods Sold – All other expenses = net Income
Assets=Liabilities+Owners’ Equity
a _____ __________ __________ ______ _____ _______
_______

Q. 2 Listed below are eight typical merchandising transactions of everyday Auto

Parts, a retail auto supply store.
a. Purchased merchandise from Acme Wholcsair on account.
b. Paid an account payable to a supplier.
c. Sold merchandise for cash.
d. Sold merchandise on account.
e. Collected an account receivable from Acme Hole sale on account.
f. Returned merchandise to a supplier, receiving credit against the amount
owed.
g. Gave a cash refund to a customer who returned merchandise

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Unit-3 Accounting for Merchandising Activities

h. Reduced the account receivable from a credit customer who returned

merchandise.

Among the accounting records of Everyday Auto parts are subsidiary ledgers for
inventory, accounts receivable, and accounts payable. For each of the eight
transactions, you are to indicate any subsidiary ledger (or ledgers) to which the
transaction would be posted. Use the following codes:
Inv = Inventory subsidiary ledger
AR = Accounts receivable subsidiary ledger
AP = Accounts payable subsidiary ledger
Also indicate whether each posting causes the balance in the subsidiary ledger
account to increase or decrease. Organize your answer in tabular form as illustrated
below. The answer for transaction a is provided as an example.

Transaction Subsidiary Ledger Effect on Subsidiary

Account Balance
a Inv Increase
AP Increase

Q. 3 Concord Products uses a perpetual inventory system. On January 1 the Inventory

account had a balance of $84,500. During the first few days of January the following
transactions occurred:
Jan. 2 Purchased merchandise on credit from Smith Company for $9,200.
Jan. 3 Sold merchandise for cash, $22,000. The cost of this merchandise was
$14,300.
a. Prepare entries in general journal form to record the above
transactions.
b. What was the balance of the Inventory account at the close of
business January 3?
Q 4 This exercise stresses the relationships between the information recorded in a
periodic inventory system and the basic elements of an income statement. Each of
the five lines represents a separate set of information. You are to copy the table and
fill in the missing amounts. A net loss in the right-hand column is to be indicated by
placing brackets around the amount, as for example, in line e (25,000).

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Unit-3 Accounting for Merchandising Activities

Net Sales Beginning Net Ending Cost of Gross Profit Expenses Net
Inventory Purchases Inventory Goods Income or
(Loss)
a. 300,000 95,000 130,000 44,000 ? 119,000 90,000 ?
b. 600,000 90,000 340,000 330,000 ? ? 25,000
c. 700,000 230,000 ? 185,000 490,000 210,000 165,000 ?
d. 900,000 ? 500,000 150,000 ? 260,000 300,000 ?
e. ? 260,000 ? 255,000 660,000 225,000 ? (25,000)

Q. 5 Facts-by-FAX sells facsimile machines, copiers, and other types of office equipment.
On May 10, the company purchased for the first time a new plain-paper fax machine
manufactured by Mitsui Corporation. Transactions relating to this product during
May and June were as follows:
May 10 Purchased five P-500 facsimile machines on account from Mitsui Corporation,
at a cost of $560 each. Payment due in 30 days.
May 23 Sold four P-500 facsimile machines on account to Foster & Cole, stockbrokers;
sales price, $900 per machine. Payment due in 30 days.
May 24 Purchased an additional seven P-500 facsimile machines on account from
Mitsui. Cost, $560 per machine; payment due in 30 days.
June 9 Paid $2,800 cash to Mitsui Corporation for the facsimile machines purchased
on May 10.
June 19 Sold two P-500 facsimile machines to Tri-State Realty for cash. Sales price,
$950 per machine.
June 22 Collected $3,600 from Foster & Cole in full settlement of the credit sale on
May 23.

Instructions
a. Prepare journal entries to record these transactions in the accounting records of
Facts-by-FAX. (The company uses a perpetual inventory system.)
b. Post the appropriate information from these journal entries to an inventory subsidiary
ledger account.
c. How many Mitsui P-500 facsimile machines were in inventory on May 31? From
what accounting record did you obtain the answer to this question?
d. Describe the types of information contained in any inventory subsidiary ledger
account and explain how this information may be useful to various company
personnel in conducting daily business operations.

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Unit-3 Accounting for Merchandising Activities

GLOSSARY

Controlling account: A general ledger account that summarizes the content of a specific
subsidiary ledger.

Cost of goods sold: The cost to a merchandising company of the goods it has sold to its
customers during the period.

Gross profit: Net sales revenue minus the cost of goods sold.

Gross profit margin: Gross profit expressed as a percentage of net sales. Also called gross
profit rate.

Inventory: Merchandise intended for resale to customers.

Inventory shrinkage: The loss of merchandise through, such causes as shoplifting,

breakage, and spoilage.

Net sales: Gross sales revenue less sales returns and allowances and minus sales discounts.
The most widely used measure of dollar sales volume; usually the first figure shown in an
income statement.

Operating cycle: The repeating sequence of transactions by which a business generates its
revenue and cash receipts from customers.

Periodic inventory system: An alternative to the perpetual inventory system. It eliminates

the need for recording the cost of goods sold as sales occur. However, the amounts of
inventory and the cost of goods sold are not known until a complete physical inventory is
taken at year-end.

Perpetual inventory system: A system of accounting for merchandising transactions in

which the Inventory and Cost of Goods Sold accounts are kept perpetually up-to-date.

Taking a physical inventory: The procedure of counting all merchandise on hand and
determining its cost.

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Unit – 4

Financial Assets

Written by: Muhammad Ashraf Bhutta

Dr. Muhammad Munir Ahmad
Reviewed by: Prof. Dr. S M Amir Shah
Unit-4 Financial Assets

CONTENTS
Introduction ........................................................................................................ 77
Objectives ........................................................................................................ 77
4.1 Cash ........................................................................................................ 78
4.2 Bank Statements......................................................................................... 82
4.2.1 Reconciling the bank statement ..................................................... 83
4.2.2 Normal difference between bank records and accounting records .... 84
4.2.3 Steps in preparing the bank reconciliation ..................................... 85
4.3 Petty Cash .................................................................................................. 85
4.3.1 The Cash Budget as a Control Device ........................................... 86
4.4 Accounts Receivables ................................................................................ 86
4.4.1 Recognizing accounts receivable ................................................... 86
4.5 Notes Receivables ...................................................................................... 87
4.5.1 Interest on Notes Receivables ........................................................ 88
4.5.2 Dishonor of Notes Receivable ....................................................... 89
4.6 Disposal of Receivables ............................................................................. 89
4.7 Valuation of Accounts Receivables ........................................................... 91
4.8 Basics of Investments ................................................................................ 97
4.9 Reporting of Non-Influential Investments Are Those Marketable
Equity Securities ...................................................................................... 101
4.10 Trading Securities .................................................................................... 102
4.11 Held-To-Maturity Securities .................................................................... 103
4.12 Available-For-Sale Securities .................................................................. 103
4.13 Demonstration Problems .......................................................................... 104
4.14 Summary .................................................................................................. 107
4.15 Theoretical Questions .............................................................................. 108
4.16 Practical Problems ................................................................................... 109
4.17 Glossary ................................................................................................... 115

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Unit-4 Financial Assets

INTRODUCTION
The term financial assets describe not just cash, but also those assets easily and
directly convertible into known amounts of cash. These assets include cash, short-
term investments (also called marketable securities), and receivables. We address
these three types of financial assets in a single chapter because they are so closely
related. All of these assets represent forms of money; financial resources flow
quickly among these asset categories.

In short, businesses "store" money in three basic forms: cash, short-term

investments, and receivables. These three topics are covered in this unit in three
different sections for the better understanding of the students.

OBJECTIVES
After studying this unit, you would be able to:
a) Find out the Cash and Cash equivalents in Financial Statements
b) Prepare the Bank Reconciliation statements for business concern
c) Perform the accounting treatment of Accounts Receivables and Notes
Receivables when goods are sold on credit basis
d) Record the collection of funds with interest if any from Accounts and Notes
receivables and accounting treatment
e) Perform the factoring and pledging of accounts receivable to different
agencies and financial institution.
f) Deal with the investment of funds in short and long term equity and debt
securities and accounting for unrealized gain or loss and realized gain or
loss these equity securities and presentation in periodic financial statements
of the organization.

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4.1 CASH

Cash is defined by accountants as money on deposit in banks as well as any other

goods that banks will accept for deposit. Not just coins and paper money, but also
checks, money orders, and travelers’ checks fall under this category. Customers
that use bank credit cards, such as Visa and MasterCard, can also sign draughts.
As a result, purchases to consumers who pay with bank cards are cash sales rather
than credit sales to the business that makes the transaction. Most businesses have
several bank accounts and keep a small quantity of cash on hand. As a result, the
general ledger's Cash account is frequently used as a controlling account. Each
bank account and supply of cash on hand inside the organization is represented by
distinct accounts in a cash subsidiary ledger.

4.1.1 Reporting Cash in the Balance Sheet

Because cash is the most liquid of all current assets, it is reported first on the
balance sheet. The balance in the Cash controlling account is merged with the
balance in the controlling account for cash equivalents for balance sheet
presentation.

4.1.2 Cash Equivalents:

Cash equivalents are short-term assets that are extremely liquid. Money market
funds, US Treasury bills, and high-grade commercial paper are examples (very
short-term notes payable that are issued by large, creditworthy corporations).
These assets are so comparable to cash that they are included in the balance sheet
alongside the cash amount. As a result, Cash and Cash Equivalents are frequently
included as the first asset on a balance sheet. An investment must be extremely
secure, have a highly steady market value, and mature within 90 days after
purchase to qualify as a cash equivalent. Even the highest-quality stocks and
bonds of major businesses are not considered to fulfill these requirements.
Marketable Securities are short-term investments that do not qualify as cash
equivalents and show second among current assets on the balance sheet.

4.1.3 Restricted Cash:

Some bank accounts have restrictions on how they may be used, so they can't be
used to satisfy the company's usual operational demands. A bank account, for
example, may have money set aside especially for the purchase of plant assets.
Some foreign nations' bank accounts are restricted by regulations that make it
illegal to transfer funds to another country. Cash that can't be used to meet current
liabilities isn't considered a current asset. As a result, restricted cash should be
shown in the "Investments and Funds" area of the balance sheet, directly below
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Unit-4 Financial Assets

the current asset section. Banks sometimes demand borrowers to keep a

compensatory amount (minimum average balance) on deposit in a non-interest-
bearing checking account as a condition of issuing a loan. This arrangement does
not restrict the borrower from spending the money, but it does require the firm to
replenish the bank account as soon as possible. Although compensating balances
are included in the amount of cash on the balance sheet, they should be mentioned
in the notes to the financial statements.

4.1.4 Credit Lines

Many firms set up credit lines with their banks. A line of credit means the bank
has agreed to give the firm any amount of money up to a certain limit in advance.
This money may be borrowed at any moment by simply writing checks on a
specific bank account. When any money is borrowed—that is, when a portion of
the credit line is used—a obligation to the bank emerges. A line of credit's unused
part is neither an asset nor a liability; it just reflects the capacity to borrow money
quickly and conveniently. Although an unused line of credit does not reflect on
the balance sheet as an asset or a liability, it improves the company's stability. As
a result, unused lines of credit are generally mentioned in the notes to the
financial statements.

4.1.5 The Statement of Cash Flows

The cash held at the conclusion of the accounting period is shown on a balance
sheet. The statement of cash flows summarizes the cash transactions of the
accounting period. The term "cash" is used in both the balance sheet and the
statement of cash flows to refer to cash equivalents. Because transfers of money
between bank accounts and cash equivalents do not affect the amount of cash
possessed, they do not appear on a statement of cash flows. Any interest received
from owning cash equivalents, on the other hand, is shown as cash receipts from
operational operations in the statement of cash flows.

4.1.6 Cash Management

Cash management refers to the process of planning, regulating, and accounting
for cash transactions and balances. Because cash is so easily transferred between
bank accounts and other financial assets, cash management encompasses all
financial resources. Every corporate organization's success—or even survival—
depends on the efficient use of these resources. The following are the primary
goals of cash management:

Anticipate the need for borrowing and ensure that sufficient cash is available to
execute business operations. Every company must have enough cash on hand to
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pay its financial commitments when they become due. Otherwise, the company's
creditors may be forced to declare bankruptcy.

Prevent excessively huge sums of money from languishing in bank accounts

generating little income. Well-managed businesses check their bank balances on a
regular basis to shift any surplus cash to cash equivalents or other revenue-
generating investments.

Provide accurate cash receipts, cash disbursements, and cash balances accounting.
The receiving or disbursement of cash accounts for a large portion of a company's
overall transactions. Cash transactions also have an impact on all financial
statement classifications, including assets, liabilities, owners' equity, income, and
costs. Cash transactions must be accurately recorded if financial statements are to
be trusted.

Prevent or reduce theft and fraud losses. Cash is more vulnerable to theft than any
other asset, necessitating physical safeguards.

4.1.7 Using Excess Cash Balances Efficiently

Cash equivalents are secure and liquid investments, but they only provide a
moderate return. These investments are beneficial for investing short-term cash
surpluses that will be needed for other purposes shortly. However, if a company
has a big quantity of cash that can be invested for a long time, it should anticipate
receiving a greater rate of return than cash equivalents. Cash available for long-
term investment can be utilized to fund corporate development and expansion or
to pay off debt. If the money isn't needed for business, it might be given to the
company's investors.

4.1.8 Internal Control over Cash

Internal cash control is sometimes viewed as just a way of preventing fraud and
theft. A solid internal control system, on the other hand, can help you achieve the
other goals of efficient cash management, such as accurate cash transaction
accounting, predicting the need for borrowing, and maintaining appropriate but
not excessive cash levels.

The following are the key phases in gaining internal control over cash transactions
and cash balances:
• Distinguish the role of managing currency from the function of maintaining
accounting records. Cash-handling employees should not have access to
accounting records, and accounting staff should not have access to cash.
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• Prepare a cash budget (or projection) for each department within the
organization, detailing projected cash collections, cash payments, and cash
balances for the future year, month by month.
• Keep track of cash receipts by creating a control list at the time and location
where the money is received. This listing for cash sales might be a cash
register tape, which is made by ringing up each transaction on a cash
register. A control listing of incoming checks should be prepared by the
person designated to open the mail for checks received through the mail.
• Require that all cash receipts be deposited in the bank on a daily basis.
• Make all of your payments using a check. Small payments made in cash
from a petty cash fund should be the lone exception. (More on petty cash
funds later in this chapter.)
• Require that every expenditure legitimacy and quantity be confirmed before
a check is given as payment. Separate the approval of spending and the
signing of checks functions.
• Reconcile bank statements with accounting records as soon as possible.

A fidelity bond from an insurance firm can be used to enhance a company's

internal control system. An insurance company promises to reimburse an
employer for provable losses caused by bonded workers' fraud or embezzlement
under the terms of a fidelity bond.

4.1.9 Cash Over and Short

A few mistakes in making change will certainly occur while managing over-the-
counter cash receipts. When the cash is tallied and compared to the reading on the
cash register at the end of the day, these mistakes may result in a cash deficit or
overage.

Assume that the total cash sales recorded on the point-of-sale terminals for the
day total $4,500.00. The cash receipts in the register drawers, on the other hand,
totaled just $4,487.30. To update the accounting records for the $12.70 shortfall in
cash receipts, make the following entry:
Cash Over and Short ………………………… 12.70
Cash ………………………………………………… 12.70
To record a $12.70 shortage in cash receipts for the day ($4,500.00 - $4,487.30)
The account entitled Cash Over and Short is debited with shortages and credited
with overages. If the account has a debit balance, it appears in the income
statement as miscellaneous expense; if it has a credit balance; it is shown as
miscellaneous revenue.

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4.1.10 Cash Disbursements

All payments, with the exception of petty cash, should be done by check to provide
appropriate internal control over cash disbursements. The usage of checks creates a
written record of each transaction. Additionally, proper internal control necessitates
that every transaction requiring a cash payment be reviewed, approved, and recorded
prior to the issuance of a check. The duty for authorizing cash disbursements and the
obligation for signing checks should be clearly separated.

4.1.11 The Voucher System

A voucher system is a frequently utilized way of creating internal control over
monetary payments. The accounting department is in charge of approving cash
payments and documenting transactions in a standard voucher system. The
accounting department will review supporting papers such as the supplier's
invoice, the purchase outer, and the receiving report before authorizing an
expense. The accounting department signs a voucher approving payment and
enters the transaction in the accounting records after payment has been approved.
(Invoice approval form and check authorization are two other names for a
"voucher.")

The treasurer or another official in the financial department receives the voucher
and supporting papers. Before writing a check, this official examines the voucher
and accompanying documentation. When the check is signed, the voucher and
accompanying documents are perforated or marked "PAID" to prevent them from
being used to support another check in the future. It's worth noting that neither the
accounting nor the finance departments have the authority to make cash payments
that have not been approved. Accountants are not allowed to sign checks since
they approve and record disbursements. Personnel in the finance department who
issue and sign checks are not permitted to do so unless they first get a permission
voucher from the accounting department.

4.2 BANK STATEMENTS

Every month, the bank sends the depositor a statement of his or her account, along
with the checks paid and charged to the account during that month. A bank
statement displays the balance on deposit at the start of the month, deposits,
checks paid, any additional additions and subtractions during the month, and the
new balance at the end of the month, as shown below. (We've showed a restricted
number of deposits rather than one for each business day in the month to keep the
demonstration brief.)

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Unit-4 Financial Assets

WESTERN NATIONAL BANK CUSTOMER ACCOUNT NO. 50139

100 OLYMPIC BOULEVARD PARKVIEW COMPANY
LOS ANGELES, CALIFORNIA 109 PARKVIEW ROAD
LOS ANGELES, CALIFORNIA
Bank Statement
For the Month Ended July 31, 2021
Date Deposits and Credits Checks and Debits Balance
June 30 5,029.30
July 1 300.00 5,329.30
July 2 1,250.00 1,100.00 5,479.30
July 3 415.20 5,054.10
July 8 993.60 10.00 6,047.70
July 10 96.00 5,551.70
July 12 1,023.77 400.00 5,198.90
July 15 1,376.57 4,773.90
July 18 1,300.00 425.00 3,978.15
July 22 500.00 CM 2,095.75 4,388.15,
July 24 1,083.25 85.00 5.00 DM 4,326.13
July 30 711.55 1,145.27 4,987.43
July 31 24.74 INT 50.25 NSF 5,000.17
12.00 SC
EXPLANATION OF SYMBOLS
CM Credit Memoranda INT Interest on average balance
DM Debit Memoranda NSF Not Sufficient Funds
E Error correction SC Service Charge
Summary of activity:
Previous statement balance, June 30, 2021 ............................................ $5,029.30
Deposits and credit memoranda (9 items).............................................. 7,186.91
Checks and debit memoranda (13 items) .............................................. (7,216.04)
Current statement balance, July 31, 2021 ............................................. $5,000.17

4.2.1 Reconciling the Bank Statement

Bank reconciliation is a schedule that explains any discrepancies between the
bank statement balance and the depositor's accounting records balance. Keep in
mind that the bank and the depositor both keep separate records of the deposits,
checks, and the current amount of the bank account. The depositor should prepare
bank reconciliation once a month to ensure that these two sets of records are in
sync. Internal control problems, such as illegal cash disbursements or failures to
deposit cash revenues, may be revealed by this reconciliation, as well as
inaccuracies in the bank statement or the depositor's accounting records.
Furthermore, the reconciliation highlights transactions that must be documented

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in the depositor's accounting records and assists in determining the actual amount
of cash on deposit. The individual who reconciles the bank statement should not
have any other cash-related tasks for good internal control.

4.2.2 Normal Differences Between Bank Records and Accounting Records

A monthly bank statement's amount rarely corresponds to the balance in the
depositor's accounting records. Some of the depositor's transactions may not have
been recorded by the bank. The following are some of the most popular examples:
• Outstanding checks. Checks that have been issued by the firm and
documented, but have not yet been presented to the bank for payment.
• Deposits in transit. Cash revenues that were documented by the depositor
but arrived at the bank too late to be included in the current month's bank
statement..

In addition, the depositor may not have documented all of the transactions on the
bank statement. Consider the following scenario:
• Service charges. Small accounts are frequently charged a fee by banks. The
amount of this fee is generally determined by the account's average balance
as well as the number of checks written throughout the month..
• Charges for depositing NSF checks. "Not Sufficient Funds" stands for "Not
Sufficient Funds." When checks are placed in an account, the bank usually
offers "immediate credit" to the depositor. On rare occasions, one of these
checks will be uncollectible since the check writer does not have adequate
cash in his or her account. In such instances, the bank will deduct the
amount of the uncollectible item from the depositor's account and return the
check to the depositor stamped "NSF." An NSF check should be seen as an
account receivable from the check's maker, not as cash.
• Credits for interest earned. This interest is credited to the depositor's
account and reflected in the bank statement at the end of the month. (As
previously stated, interest on corporate checking accounts is prohibited
under existing law.)
• Miscellaneous bank charges and credits. Banks charge for services
including printing checks, managing notes receivable collections, and
processing NSF checks. The bank deducts these costs from the depositor's
account and sends a debit memorandum with the depositor's monthly bank
statement. When a bank collects a note receivable on behalf of a depositor,
the depositor's account is credited and a credit memorandum is issued.

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The balances reported on the bank statement and the accounting records are both
corrected for any unrecorded transactions in bank reconciliation. Any mistakes
detected in the bank statement or accounting records may need additional
adjustments. Each depositor's account is viewed as a liability by banks. For
transactions that lower this debt, such as bank service charges, debit memos are
provided. Credit memorandums are provided to acknowledge a rise in this
liability, such as interest earned by the depositor.

4.2.3 Steps in Preparing a Bank Reconciliation The specific steps in preparing

a bank reconciliation are as follows:
1. Match the deposits on the bank statement to the deposits in the accounting
records. Deposits in transit are those that have not yet been registered by
the bank and should be added to the sum shown on the bank statement.
2. Organize paid checks by serial numbers and verify each check to the
accounting records' corresponding entry. Any checks that have been
issued but have not yet been paid by the bank should be recorded as
outstanding checks and subtracted from the bank statement balance.
3. Add any credit memos sued by the bank that have not been recorded by
the depositor to the sum per the depositor's accounting records.
4. Deduct any debit memos issued by the bank that have not been recorded
by the depositor from the balance according to the depositor's records.
5. Make any necessary modifications to the bank statement or the depositor's
accounting records to remedy any mistakes.
6. Confirm that the bank statement's adjusted balance matches the adjusted
balance in the depositor's records.
7. Create journal entries to record any items mentioned as adjustments to the
amount per depositor's records in the bank reconciliation.

4.3 PETTY CASH FUNDS

All large financial disbursements should be made via check, as we have stressed.
Every firm, on the other hand, finds it useful to maintain a modest amount of cash
on hand to cover unexpected expenses. Small purchases of office supplies, taxi
tickets, and doughnuts for an office meeting are examples of these expenses. To
start a petty cash fund, write a check out to "Petty Cash" for a round sum, like
$200, that would cover these little expenses for two or three weeks. This check is
cashed, and the funds are stored in a petty cash box on hand. The fund's custodian
is listed as one employee.

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Unit-4 Financial Assets

All payments from this fund are made by the custodian, who gets a receipt or
produces a "petty cash voucher" that explains the type and amount of each
transaction. A check is written payable to Petty Cash at the conclusion of the
quarter (or when the fund runs low), reimbursing the fund for the expenses
incurred during the period. By debiting the relevant expenditure accounts and
crediting Cash, the issue of this check is documented. The whole negative section
of this item is frequently charged to the Miscellaneous Expense account in
practice.

4.3.1 The Cash Budget as a Control Device

Many firms create thorough cash budgets that contain monthly cash receipts and
spending projections for each department inside the company. Any cash flows
that deviate considerably from the projected amounts will be investigated by
management (or internal auditors). As a result, each department manager is
responsible for his or her department's monthly cash transactions.

4.4 ACCOUNTS RECEIVABLES

Accounts receivable denotes that the other party owes you money. Accounts receivables
are often produced as a result of credit business operations. Currently, the majority of
commercial operations, notably those of wholesalers, pay the seller within a specified
fixed period following the transaction date. Extending credit to customers for the
purchase of goods or services is an important component of marketing strategy, as over
80% of commercial operations are conducted on a credit basis. As a result, no one can
avoid this crucial component of marketing strategy. The vendor may undertake credit
business with the customer on an open account based on his previous proem of credit
worthiness without obtaining a written commitment as evidence. The seller's accounts
receivable accounting records include control accounts receivable and separate accounts
receivable for each credit customer. Each customer's credit accounts are continuously
checked in an effort to recover dues as soon as possible once the credit term granted to
consumers expires.

4.4.1 Recognizing Accounts Receivable

The accounts receivables emerge from the credit sales to customers. The practice
of sales on credit basis has assumed greater momentum during the recent past as a
factor of competition in the market to attract customers. When merchandise is
sold on credit basis the following accounting entry is incorporated in the books:-

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Unit-4 Financial Assets

Date Particulars Dr Cr
05 April 2020 Accounts Receivable (Abaci.) Rs. 35,000
Sales Account Rs. 35,000

After expiring of the credit period, when the dues are collected, the following
accounting entry is passed:-
Date Particulars Dr Cr
04 May 2020 Bank Account Rs. 35,000
Accounts Receivable (AB.Co) Rs. 35,000

The company will maintain two types of ledgers in the accounting record. One
will be the Accounts Receivable as a Control account in the general ledger while
the second will be with the name of individual customers like AB.Co. In the
subsidiary ledger accounts, meant for all credit customers separate from each
other. Periodically, say weekly or monthly, the total sum of all credit customers
will be matched with the balance of Accounts Receivable appearing in the general
ledger account to ensure accuracy of due amounts.

Maintaining the individual customer’s accounts in the subsidiary ledger of

accounts receivable will facilitate the enterprise to monitor and watch on the trend
of business volume with all credit customers, their behavior of payment of dues
and the balance outstanding against each customer to compare it with the credit
ceilings allowed to them. In case the credit business is exceeding the ceilings then
emphasis should be on instant recover of dues instead of curtailing business with
such customers.

4.5 NOTES RECEIVABLES

Contrary to the credit Sales on an open account as described at Para 4.1, the
alternate method of credit sales to some customers is based upon some formal
instrument of credit which is called as a promissory note which is secured by
Negotiable/instruments Act, 1881. The negotiable instrument i.e. the promissory
note represents evidence about the money or money’s worth with a promise to
pay the dues within a specified period. From the point of view of a seller, a claim
evidenced by the promissory note has some advantages over a claim in the form
of an open account. In the case of availability of a promissory note with the seller,
the credit customer acknowledges the debt in writing and agrees to pay it in
accordance with the terms specified in it. They are, therefore, stronger legal
claims in the event of court action. They also are more liquid than an open
account credit sales because the holder of promissory note can transfer it to one of
his creditors in settlement of debt or to a bank in exchange for cash through
discounting it.
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Unit-4 Financial Assets

The credit sales against receipt of the promissory note enable the enterprise to keep
such transactions separate from the open account sales. Therefore, Notes Receivable
Account will be debited instead of Accounts Receivable and accordingly collection
will be from Notes Receivable as per following accounting entries:-
Date Particulars Dr Cr
05 April 2020 Notes Receivables Rs. 35,000
Sales Account Rs. 35,000
05 April 2020 Bank Account Rs. 35,000
Notes Receivables Rs. 35,000

The Accounts Receivables and Notes Receivables are usually generated through
normal trading business activities. These are presented in the balance sheet at
period end under current assets classification but the prissily presentation is for
Notes Receivables and thereafter the Accounts Receivables after presentation of
cash and cash equivalents.

4.5.1 Interest on Notes Receivables

The notes receivables originated from the credit Sales may be non interest bearing
and interest bearing. In case the notes receivable are non-interest bearing, it means
that the amount indicated on the face of promissory note will only be receivable at
its maturity and upon receipt of cash the accounting entry as indicated in Para 4.3
will be passed. However, if the notes receivable is an interest-bearing, then the
interest will also be receivable along with the principal account at its maturity. The
accounting entry for the accrued interest income will be recognized at close of the
accounting period if the maturity date of the notes receivable is beyond the closing
date of the accounting period. This is illustrated through the following data.

A note receivable for Rs. 50,000 for sale of merchandise was received from Ahmad
Sons a credit customer as on 1 May, 2020 having validity of 03 months with
interest bearing of 12% per annum. The following accounting entry will be passed:-
Date Particulars Dr Cr
01-05-2020 Notes Receivables (Ahmad Sons) Rs. 50,000
Sales Account Rs. 50,000

At financial year ending on 30 June, 2020 the interest accounting to Rs. 1,000
(Rs. 50,000x12%2/12) for two months period of May and June 2020 was accrued
on this note receivable. Therefore, the following adjusting accounting entry will
be incorporated:-
Date Particulars Dr Cr
30-06-2020 Interest Receivable on N/R Rs. 1,000
Interest income Rs. 1,000

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Unit-4 Financial Assets

Upon maturity of the foregoing notes receivable as on 01 August 2020, the

following accounting entry for receipt of cash along with interest of 03 months
will be recorded:-
Date Particulars Dr Cr
01-08-2020 Bank Account Rs. 51,500
Notes Receivable(Ahmad Sons) Rs. 50,000
Interest Receivable on N/R Rs. 1,000
Interest income Rs. 500
Through this entry the accrued interest of Rs. 1,000 for two months of last
financial year and the interest of Rs. 500 for the one month (July 2020) of the
succeeding financial year have been adjusted and recorded to the relevant
accounts along with the principal amount of the notes receivable received on 01
August, 2020 at its maturity.

4.5.2 Dishonor of Notes Receivable

Occasionally, when the note receivable is presented for payment at its maturity
the credit customer might not be capable to arrange its payments, probably due to
non arrangement of adequate funds timely. This is termed as dishonor of the notes
receivable. Taking the same data of the preceding illustration of the interest
bearing note receivable at Para 4.3-1, on its due data of 01 August 2020 the
payment could not be arranged by Ahmad Sons. The following accounting entry
for recording dishonor of the notes receivable instead of its collection will be
entered in the accounting record.

Date Particulars Dr Cr
01-08-2020 Accounts Receivable(Ahmad Sons) Rs. 51,500
Notes Receivable(Ahmad Sons) Rs. 50,000
Interest Receivable on N/R Rs. 1,000
Interest income Rs. 500

Thereafter, apart from strenuous efforts for recovery of the amount of accounts
receivable from the credit customer identified as Ahmad Sons as stated above, the
enterprise would review any further credit business with this firm when its
credibility was found doubtful to refrain from any losses of non-recovery in
future.

4.6 DISPOSAL OF RECEIVABLES

Most of the trading and manufacturing organizations who sell their products to
whole sales on credit basis are usually confronted with the compilation of
accounts receivables. This is in fact because of selling the products to all those

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Unit-4 Financial Assets

customers whose credibility was not proven satisfied or the collection policy of
the enterprise was not intensive. Thus the credit customers retain the money even
after maturity of the credit period. The enterprises are therefore fallen prey of
financial crunches and are tightened to discharge their maturing liabilities. Such
sort of situation is often faced by several organizations. Therefore it originates the
ways and means to generate sufficient funds to meet its financial requirements.
This is possible through the following course of action:-
A. Offering cash discounts for early payment.
B. Factoring accounts receivables, through agencies.
C. Pledging accounts receivables with financial institutions.
These courses are now deliberated in the succeeding paras.
a) Offering cash discounts
As explained in unit No.3 different types of cash discount are offered to the credit
customers for on inspiration of early payment instead of waiting for payment by
the customer after a long period of 30 to 90 days or above. The credit terms like
2/10, n/30 or 1/15, n/60 means that 2% discount or 1% discount will be available
to customers if the payment is made within 10 days or 15 days of sale
respectively. This offer provides a temptation to the customers. Thus the cash is
generated from customers promptly and the accounts receivables are squared off.
b) Factoring accounts receivables
Certain dealers or finance companies purchase accounts receivables out right from
business concerns on a without recourse basis. This is called as accounts
receivable factoring. The buyer of accounts receivable is known as the Factor.
Customers are notified that their dues are now payable to the Factor and the
Factor assumes the burden of collecting accounts from such credit customers. In
many instances factoring may involve more than simply the purchase of accounts
receivables and its collection from customers. Factoring frequently involves a
continuing agreement whereby a financial institution assumes the credit functions
as well as collection functions. Under such an agreement, the Factor grants or
denies credit, handles the accounts receivable book keeping, billing the customers
and ensures collection timely. The business organization is thus totally relieved of
all of these activities. The credit sale of goods and factoring provides immediate
cash for business use. Since the Factor absorbs losses from irrecoverable accounts
and also assumes credit and collection responsibilities, the change that he makes
usually exceeds the interest charge currently involved in borrowing funds. This
charge is classified as factoring expenses, the following accounting entries will
usually be entered in the books of Accounts:-

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Unit-4 Financial Assets

i. Sales of goods on credit basis

Date Particulars Dr Cr
15-04-20 Accounts Receivables Rs. 100,000
Sales Account Rs. 100,000

ii. Factoring of accounts receivables with 8% charge.

Date Particulars Dr Cr
20-04-20 Bank Account Rs. 92,000
Factoring expenses Rs. 8,000
Accounts Receivable Rs. 100,000
After factoring the accounts receivables the Balance Sheet would not indicate any
amount for accounts receivables as these have been disposed off to the Factors
and cash has been received against it.

c) Pledging accounts receivables

Another way of disposal of accounts receivables is taking loan from banks or
other financial institutions on the basis of pledging accounts receivables as
collateral security. Usually certain portion or a classified customers accounts
receivables are pledged with the bank account and of the enterprise. The loan may
be granted up to 70% or 80% of the total amount of pledged accounts receivable
with usual interest charge on the loan amount. The amount collected from the
credit customers is immediately deposited with the bank for adjustment against
the loan. Alternatively the banks are authorized to collect the funds from pledged
accounts receivables and off-set against the loan account. Prompt collection of
accounts receivables would reduce the interest expense on the loan. The pledging
of accounts receivables is in fact not a disposal as was treated in factoring of
accounts receivables. The accounts receivables are presented in the balance sheet
of the enterprise with notation of pledging against long or short term loan taken
from the bank or financial institution. Similarly the loan shown in the liability side
of the balance sheet will be linked with the pledged accounts receivables. This is
usually presented on the face of balance sheet as a disclosure requirement.

4.7 VALUATION OF ACCOUNTS RECEIVABLES

The accounts receivables, which are originated from the credit sales, are usually
classified financial assets in the balance sheet. This is because of the fact that
funds flow to the organization from this source during a succeeding period and in
accordance with the credit period allowed to the credit customers which may
usually spread over from 30 to 90 days and in certain cases longer than it.
Therefore, at the end of an accounting period, the value of accounts receivables
must be recognized in the balance sheet at its net realizable value so as to reflect

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Unit-4 Financial Assets

the contents of balance sheet at fair value as possible. Some portion of accounts
receivables is written off during currency of the accounting period on the basis of
some definite efforts which lead that some particular amount of receivables would
not be collectible. On the other hand, the past experience of collection of accounts
receivable may also guide the management that in spite of intensive efforts of
recoveries some of the customers fail to pay their dues although the credit sales
were allowed to such customers after ascertaining their potential credibility and
reputation in the market. As such certain allowance of doubtful for accounts
receivables is recognized in the accounting record which is treated as control of
accounts receivables for presentation in the balance sheet at net realizable value.
Different methods for accounting treatment of valuation of accounts receivables
with regard to the uncollectible accounts are deliberated here under:-

a) Direct write off method

In spite of tremendous efforts for collection of certain accounts receivables, when
it is concluded that there is no chance of collection, such accounts receivables are
excluded from the accounting record by charging the amount to the expense
account through incorporation of the following accounting journal entry.
Date Particulars Dr Cr
20-04-20 Bad Debts expense Account Rs. 3,500
Accounts Receivable (AB co.) Rs. 3,500

This accounting entry reduces the amount of accounts receivables (from AB

Company) and simultaneously increases the periodic expense. This system of
treatment is known as direct write-off because the accounts receivable has directly
been written-off and the amount is charged to the expense account.

Further, later on in case the circumstances are favoring to the organization,

whereby the credit customer somehow pays his dues, then his account, which was
previously written off and abstracted from the accounting record, will first have to
be reinstated and then will be collected. In this respect the reinstatement of
accounts receivable will be carried out through the following journal entry:-
Date Particulars Dr Cr
05-05-20 Accounts Receivables (AB Co.) Rs. 3,500
Bad Debts expense Account Rs. 3,500
Afterwards, the recovery of Accounts Receivable will be recorded through the
following accounting entry:-
Date Particulars Dr Cr
05-05-20 Cash Account Rs. 3,500
Accounts Receivable (AB Co. Rs. 3,500

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Unit-4 Financial Assets

When the direct write-off method is used in the organization, the amount of
accounts receivable will be presented in the balance sheet at gross amount as no
valuation allowance will be used. Therefore, the receivables are not presented at
the net realizable value.

The direct write-off method is normally used by those organizations whose major
sales are on cash basis and small sales are on credit. The bad debts directly
written-off will, therefore be small and will have no material effect on the
reported net income. Besides the direct write – 0ff method works satisfactorily in
a company that sells most of its output to a few large companies which are
financially strong for which no need arises for valuation of accounts receivables
and creation of allowance for bad debts in advance.

Under direct write-off method the bad debts expense it usually recorded when the
receivables finally cannot be collected. Thus such bad debts expenses are
recorded quite later than the credit sales period. Usually the expenses should be
recorded under matching principle when revenues are being recorded under
realization principle. The direct write-off method is therefore a departure from the
matching principle. However, the materiality principle states that an amount can
be ignored if its impact on the financial statements is negligible and unimportant.
The materiality constraint permits the use of direct write-off method when bad
debt expenses are small in relation to the volume of sales and other expenses.

b) The allowance for doubtful Accounts Method

The alternate to the direct write-off method is the allowance method for
computation of doubtful amount of accounts receivables to charge it as periodic
expense. The allowance for doubtful accounts created at the end of accounting
period is shown as deduction from the gross amount of accounts receivables to
present the accounts receivables at net realizable value in the balance sheet. The
allowance for doubtful accounts is created and charged as bad debt expense
during the same period when sales were conducted and revenues were recognized.
Thus the allowance method adequately is in consonance with the concept of
matching and realization principles as the expenses are recorded during the same
period when sales revenues were recognized.

The amount of allowance for doubtful Accounts is computed on some logical

basis which may be premised upon the past experience or of the current scenario
of collections or irrecoverable behavior. There are traditionally two approaches
for computation of the amount of allowance for doubtful accounts against
accounts receivables. These are deliberated as here under:-

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Unit-4 Financial Assets

1) Income Statement Approach

The income statement approach refers to the determination of allowance for
doubtful accounts on the basis of certain percentage of the periodic credit sales.
Premised upon the past experience the management has decided that 2% of the
credit sales amounting to Rs. 1,550,000 might be uncollectible during the tenure
of collection in future. Therefore, the enterprise would create an allowance for
doubtful accounts amounting to Rs. 31,000 (Rs.1,550,000x2%) and the following
adjusting accounting entry would be incorporated:-

Date Particulars Dr Cr
30-06-20 Bad Debts Expense Account Rs. 31,000
Allowance for doubtful Accounts Rs. 31,000

The accounts receivable will be presented in the Balance sheet at its net realizable
value as under:-

Balance Sheet as at 30-06-2020 current Assets

Cash Xxx

Marketable Securities Xxx

Accounts Receivable 1,550,000
Less: Allowance for doubtful accounts 31,000 1,519,000

The Bad debts expense Accounts of Rs. 31,000 will be closed in the income
statement along with other expenses for the period.
The lump sum allowance for doubtful accounts of Rs. 31,000 was created against
the total accounts receivables of Rs. 1,550,000 originated against the credit sales.
The amount of estimated loss of bad debts was computed because when sales
occurred, the management did not know which credit customer will not pay his
dues. This means that at end of each period the allowance method requires an
estimate of the total bad debts expected to result from that period’s sales.
Subsequently when certain accounts receivables are not recoverable in spite of all
efforts of recovery the amount is written off against the allowance for doubtful
accounts created in the past. Assume that Ahmad Company to whom credit sales
were allowed during April, 2020, did not pay his dues amounting to Rs. 8,500.
The write-off entry for these irrecoverable accounts receivables would be
recorded as under:-
Date Particulars Dr Cr
20-07-20 Allowance for doubtful Accounts Rs. 8,500
Accounts Receivable ( Ahmad Company) Rs. 8,500

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Unit-4 Financial Assets

In the balance sheet to be prepared at the end of subsequent period, the amount of
Rs. 8,500 will be reduced both from the allowance from doubtful accounts and the
Accounts Receivables. Thus there would be no impact on the net realizable
amount of Accounts Receivables.
Subsequently in case the recovery of accounts receivables from Ahmad Company
becomes possible due to efforts of the management, first the written-off Accounts
receivable would be reinstated through the accounting entry and then accounting
entry would be recorded for collection of cash as below:-

Date Particulars Dr Cr
15-07-20 Accounts Receivable ( Ahmad Company) Rs. 8,500
Allowance for doubtful Accounts Rs. 8,500
15-08-20 Cash Account Rs. 8,500
Accounts Receivable (Ahmad Company) Rs. 8,500

2) Balance Sheet Approach

The balance sheet approach of creation of the allowance for doubtful accounts is
widely used for computation of the amount probably uncollectible through aging
the accounts receivables or through application of a predetermined percentage rate
of the total amount of accounts receivable. The former system of aging the
accounts receivable is more preferable for computation of the amount of
uncollectible accounts as it is worked out on some logic that older the accounts
receivable have greater chance of non-recovery while the fresh accounts
receivables have lower chance of non-recovery. Therefore higher rate of bad debt
expense is applied on the longer old accounts receivables while lower rate of bad
debt is applied on the longer old accounts receivables while lower rate of bad debt
is applied on fresh accounts receivables to determine the total amount of
allowance for doubtful accounts. Usually different rates of probable bad debts are
applied on the different age groups of accounts receivables for computing the total
amount of doubtful accounts. Therefore the estimates of uncollectible amounts are
made assuming that the longer past due are likely to be uncollectible while
current past due are likely to be lower chance of non-recovery. These different
percentages are applied to the amounts of each class of age group and then totaled
to computer the estimated balance of allowance for doubtful account. The
computation of the allowance for doubtful accounts based on the aging of
accounts receivables is carried out as per Exhibit 4-1 below:-

95
Unit-4 Financial Assets

Exhibit 4-1
Schedule of accounts receivables by age and Estimated Uncollectible
Total Net yet due 1-30 days 31-60 days 61-90 days Over 90 days
past due past due past due past due
Zahid Company Rs. 150,000 Rs. 35,000 100,000 Rs. 15,000 - -
Suleman Sons Rs. 820,000 - 350,000 Rs. 420,000 Rs. 50,000 -
Decent Company Rs. 315,000 Rs. 15,000 200,000 Rs. 100,000 - -
Zeenat Bros Rs. 205,000 - 100,000 Rs. 100,000 - Rs. 5,000
Ahmad Company Rs. 60,000 - - - Rs. 51,500 Rs. 8,500
Total Rs. 1,550,000 Rs. 50,000 Rs. 750,000 Rs. 635,000 Rs. 101,500 Rs. 13,500
Percent uncollectible - 1% 2% 3% 6% 10%
Estimated Rs. 41,090 Rs. 500 Rs. 15,000 Rs. 19,050 Rs. 6,090 Rs. 1,350
uncollectible

The total amount of estimated uncollectible works out of Rs. 41,090 against the
total accounts receivables of Rs. 1,550,000 at end of the accounting period based
on aging schedule as per exhibit 4-1 above. The accounting entry for
incorporation of probable bad debt expense will be passed by considering any
debit or credit balance already available in the allowance for doubtful accounts.
Suppose that a credit balance of Rs. 10,000 is already available in the allowance
for doubtful accounts which was brought forward from the previous accounting
period, this amount will be adjusted from the amount of Rs. 41,090 as computed
in the aging schedule at exhibit 4-1 and the accounting entry for the balance
amount of Rs. 31,090 will be passed as under:-

Date Particulars Dr Cr
30-06-20 Bad debts expense account Rs. 31,090
Allowance for doubtful account Rs. 31,090

Allowance of Rs. 31,090 will be closed to the income statement for the current
accounting period while the allowance for doubtful account will show the
following total credit balance at year end.

Allowance for Doubtful Account

30-06-20 Balance c/f Rs. 41,090 01-06-20 Opening balance Rs. 10,000
30-06-20 Bad debts expense Rs. 31,090
Total Rs. 41,090 Total Rs. 41,090

In the balance sheet at the end of accounting period the accounts receivables will be
presented at net realizable value after deduction of the total amount of allowance for
doubtful accounts from the gross amount of accounts receivable as under:-

96
Unit-4 Financial Assets

Balance Sheet as at 30-06-2020

Current Assets
Cash Xxx
Marketable Securities Xxx
Accounts Receivables Rs. 1,550,000
Less allowance for doubtful accounts Rs. 41,090 Rs. 1,508,910

Later on during the succeeding year when in spite of intensive efforts for recovery of
Rs. 8,500 from Ahmad Company proved to be futile this amount will be struck off
from the accounts receivables through passing of the following accounting entry:-

Date Particulars Dr Cr
20-07-20 Allowance for doubtful account Rs. 8,500
Accounts Receivable (Ahmad Company) Rs. 8,500

It may be noted that the irrecoverable accounts receivables of Rs. 8,500 from
Ahmad Company will be adjusted against the total allowance for doubtful
accounts of Rs. 41,090 available in the accounts instead of confining to the
specific allowance of Rs. 850 which was created on 30 June, 2020 at 10% of Rs.
8,500 receivable from chances of recovery of written-off accounts receivables are
materialized, the similar accounting entry for first reinstatement of written-off
accounts receivables and then collection of cash entries will be passed as
described at the end of the procedure of Income Statement approach was
explained at para graph B-1.

4.8 BASICS OF INVESTMENTS

The investment means and includes the deposit of certain funds outside the
business to earn some gain instead of keeping funds idle in the organization or in
the current accounts with Bank. Apart from it, the companies have motives to
invest its short term liquid funds in the profitable securities long term funds of
gratuity and pension in mutual funds and other long term securities for earning
profit and yet another objective is to acquire controlling interest in other
organizations for achieving specific business relationships on strategic grounds.
The basic intent of investment leads the accounting treatment. The intent of short
term and for temporary purposes, the investment will be presented under current
assets while for the long term intent it will be presented in the non current
investment headings after current assets heading of the balance sheet. The
purchase, retention, and disposal of these short and long term securities are now
deliberated as here under:-

97
Unit-4 Financial Assets

a) Short term investments

The purchase of short term securities are normally recorded at cost which
also includes any brokerage commission etc. These short term securities are
classified as marketable securities and are considered as cash equivalent as
these can be encased any time of wish. Similarly certain securities have
some tenure ranging from 3 to 12 months. Such securities like bonds and
debentures which have now leftover maturity leaser than one year are also
categorized as short term investments or temporary investments.

b) Long Term Securities

Those securities which cannot instantly be encased or are not intended to be
converted into cash in short term period are categorized as non-current or
long term securities. Normally such securities comprise the Debentures and
Bonds which have longer maturity of one to ten years. Similarly the shares
of other companies which have been purchased for holding than for a longer
period on ensuing dividends and for strategic purposes are also classified as
long term securities. These securities will be presented in the balance sheet
under the headings of Long Term Investments at the cost price including
any incidental charges like brokerage fee etc paid at the time of acquisition.

c) Classification and Reporting

The accounting for investment in securities of other companies depends on
three factors namely (1) type of securities whether debts (Bonds and
Debentures) or equity (Preferred and Common Shares), (2) the intent of the
company for holding then either for short period or for longer period and (3)
the percentage of ownership in the other company’s equity securities for
holding control etc in its affairs. The reporting of each type of such
securities will be carried out in the following manner:-
i) Securities held for trading:
These include equity securities (Shares) held for trading purposes will be
reported at fair market value and any increase or decrease from the cost will
be reported as unrealized gain or unrealized loss on income statement of the
accounting period of acquisition.
ii) Securities held to maturity
These include debt securities like Bonds and Debenture having define
period of maturity and will be reported at amortized cost.
iii) Available for sale Securities
Such Securities are like equity and debt securities and debt securities and are
treated in the accounts at fair value as discussed at serial number (i) and (ii) above

98
Unit-4 Financial Assets

iv) Securities for significant influence

Such securities of equity shares which have been acquired at 10 to 20% or
more but lesser than 50% of the total securities of the investee company are
help for significant influence in the other company for business relations are
reported at equity method in the accounts.
v) Controlling influence
These equity securities of other company are procured by the company
which may be greater than 50% of the other company for exercising all the
time controlling influence and are reported in accounts through
consolidation including non controlling interest (NCI) as well.

The accounting treatment of equity securities (Shares of Companies) and the Debt
Securities (Bonds and Debentures) are now explained here under:-

4.8.1 Accounting treatment of equity securities.

The equity securities which comprise shares of other companies are purchased for
investment of funds either for short period of time or for longer period.

When equity securities are purchased these are recorded at cost. Assume Adil
company has purchased 1,000 shares of Decent Company on at 10 June, 2020 the
price of Rs. 150 per share along with agency fee of Rs. 1,000 the following
accounting entry will be recorded.

Date Particulars Dr Cr
10-06-2020 Investment Marketable Securities(Decent Company Rs. 151,000
Cash Account Rs. 151,000

Later on 30 June 2020 the Decent Company declared a dividend of Rs. 15pee
share. The receipt of dividend will be recorded as under:-
Date Particulars Dr Cr
30-06-2020 Cash Account Rs. 15,000
Dividends revenues Rs. 15,000

The Dividend revenues will be closed in the Income Statement for the year ended
30 June, 2020. Later, when these marketable securities are sold assume on 15
July, 2020 at Rs. 165 each share, the following entry will be passed:-
Date Particulars Dr Cr
15-07-2020 Cash Account Rs. 15,000
Investment in Marketable Securities(Decent Company) Rs. 15,000
Gain on Sale of Marketable Securities Rs. 14,000

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Unit-4 Financial Assets

The gain of Rs. 14,000 on sale of marketable securities will be closed in the
Income Statement for the year commencing from 01 July, 2020 onward.

4.8.2 Accounting treatment of Debit Securities

The debit securities include the short or long term bonds and debentures purchased
with the intents of short period or long period holding. In any case, the purchase of
these securities will be recorded at cost. Assume that Adil Company has purchased
two years 12% debentures of Rs. 100,000 from Decent Company on 31 January
2020. The interest is receivable after every 6 months. The purchase of these
debentures on 31 January recognition of accrued interest for 05 month on 30 June,
2020 will be recorded as under:-
Date Particulars Dr Cr
31-01-2020 Investment in Debentures (Decent Co.) Rs. 100,000
Cash Account Rs. 100,000
30-06-20 Accrued Interest on Debentures Rs. 5,000
Interest Income on Debentures Rs. 5000

The interest income of Rs. 5,000 will be closed in the Income Statement for the
year ended on 30 June, 2020. While the 2 years investment will be reported as
long term investment in the Balance Sheet as at 30 June, 2020.
Subsequently when the interest for 06 months is received on 31 July 2020 the
following accounting entry will be passed:-
Date Particulars Dr Cr
31-07-2020 Cash Account Rs. 6,000
Accrued interest on Debentures Rs. 5,000
Interest income on Debentures Rs. 1,000

The receipt of interest for another of months on 31 January 2020| will be recorded
as pee following.
Date Particulars Dr Cr
31-01-2020 Cash Account Rs. 6,000
Interest income on Debentures Rs. 6,000

Similarly the collection of interest income in the subsequent period will be

recorded in the accounting record. However, after maturity of 02 years, the
collection of principal amount of Debentures with its accrued interest on 31-01-
2022 will be recorded as per following:-
Date Particulars Dr Cr
31-01-2020 Cash Account Rs. 106,000
Investment Debentures (Decent Company) Rs. 100,000
Interest income on Debentures Rs. 6,000

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Unit-4 Financial Assets

4.9 REPORTING OF NON-INFLUENTIAL INVESTMENTS ARE

THOSE MARKETABLE EQUITY SECURITIES

The non-influential investments are those marketable equity securities which have
purely been purchased just for earning certain gain and are quite meager in
volume and in monetary terms in reference to holding influential impact of
administrative control of the other subsidiary company. Such equity securities
may be even lesser than 10% of the total equity securities of the investee
company.

The marketable equity securities will be valued at market price on the sporting
date of the balance sheet as at 30 June, 2020. Considering the same data of the
marketable equity securities of Decent Company as purchased and recorded at
sale para 1 of main para 4.6 in the preceding portion of this unit, we may assume
that the market value of such equity shares was amounting to Rs. 170 each as on
30 June, 2020. The increase in the market price by Rs. 19 per share is in fact still
unrealized gain because securities are not yet sold. Therefore, any unrealized gain
or loss (loss in case of decline in the market price of such securities) on
marketable securities will not be accounted for in the periodic income statement.
However, the unrealized gain or loss will be reported separately in the equity
section of Balance Sheet. While the value of securities well be reported in the
current assets at market price with notation of cost-price as well. This treatment is
called as mark to marked concept of valuation of securities which is a departure
from the cost concept of Generally Accepted Accounting Principles.

The following accounting entry will be passed for enhancement in the market
value of securities as on 30 June, 2020 along with simultaneous recognition of
unrealized gain on the marketable securities.

Date Particulars Dr Cr
30-06-2020 Investment in Marketable Securities(Decent Company) Rs. 19,000
Unrealized gain on Marketable Securities Rs. 19,000

Through this accounting entry the value of marketable securities is enhanced and
the increase is required as unrealized gain for Balance Sheet reporting purposes.
The marketable securities in the Balance Sheet are presented as under:-

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Unit-4 Financial Assets

Adil Company
Balance Sheet as at 30 June, 2020
Current Liabilities Current Assets
Accounts Payable xxx Cash xxx
Equity Marketable securities (1,000 shares of decent Rs. 170,000
company purchased at cost of Rs. 151,000)
Capital xxx Fixed Asset
Retained Earnings Building xxx
Unrealized gain on marketable Rs. 19,000
securities of Decent Company

Further later during July, 2020 when these securities are sold at Rs. 165 each
certain portion of the unrealized gain is now realized which will be accounted for,
upon sale, through the following accounting entry: -

Date Particulars Dr Cr
15-07-2020 Cash Account Rs. 165,000
Unrealized gain on marketable Securities Rs. 19,000
Realized gain on marketable securities Rs. 14,000
Investment in Marketable Securities Rs. 170,000

The realized gain of Rs. 14,000 on marketable equity securities will now be
treated as other income in the Income Statement for the year 2020-21. Further the
non influential securities are usually valued of management and nature of
portfolio (Composition of variety of securities of different companies) which may
be classified in three categories as (1) Trading, (2) Held to maturity and (3)
available for sale. These classifications are none deliberated in the ensuing
paragraphs.

4.10 TRADING SECURITIES

The trading securities include these investments in the shape of equity securities
(shares) and debt securities (Bonds and Debentures) as explained at para 4.6 vide
such paras 1 and 2 which have been purchased on temporary basis for the
purchases of frequent trading to earn some financial benefits upon through
increase in the market price of such securities. The securities held on balance
sheet date are always reported as current assets at the market value as explained at
paras 4.6 and 4.7 of preceding pages. Besides, the unrealized gain/loss and
realized gain/loss is also accounted for on purchase and sale of these trading
securities in the same pattern as explained at paras 4.6 and 4.7 of preceding pages.

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Unit-4 Financial Assets

4.11 HELD-TO-MATURITY SECURITIES

The held-to-maturity securities are usually debt securities which comprise bonds,
debentures and redeemable preference shares which have explicit time of maturity
and thereafter are to be redeemed without default. The accounting treatments of
such held-to-maturity securities are two-fold. In case, any of such debt securities
are falling due for payment within next one year, then these will be classified as
current asset in the balance sheet of the investor along with any interest which has
occurred till the balance sheet date as explained at para 4.6 (1) in preceding pages.
However, if the maturity date of such debt securities is longer than one year from
the balance sheet date of current year, then such debt securities will be classified
as long term investment in the balance sheet of the investor while the amount of
interest accrued on it for the expired period will be reported as current asset in the
balance sheet and other income in the income statement.

4.12 AVAILABLE-FOR-SALE SECURITIES

The equity securities (Shares) and debt securities (Bonds, Debentures and
redeemable Preferred Shares) which have been purchased with the instant to sell
then at any time when than cost, then such securities are categorized as available-
for-sale securities. Such types of securities usually do not fall in the category of
treading or held-to-maturity securities. The objectives of available-for-sale
securities are manifold. The first purpose is to earn interest or dividend during the
period of its holding and second purpose is to capture the benefit of price
escalation of such securities. The available-for-sale securities are not actively
managed like trading securities. However, time to time review and evaluation of
their market values are inevitable to secure benefits of enhancement of market
value upon disposal. The reporting of available-for-sale securities is similar to the
other types of securities. In case the intent is to dispose of within one operating
cycle or next year then these will be classified as current assets and in case these
are to be retained for more than one operating cycle then these will be classified
as long term investment. The unrealized gain or loss at the end of accounting
period will be reported in the balance sheet as described in the trading securities
and held-to-maturity equity securities as paragraphs. Similarly the realized gain or
loss will be recognized in the income statement as identical to the treatment of
trading securities and held to maturity equity securities.

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Unit-4 Financial Assets

4.13 DEMONSTRATION PROBLEMS

PROBLEM NO. 1
Shahid Trading Company is applying the balance sheet approach for valuation of
its accounts receivables at year end. Besides during the year it has written of Rs.
4,500 accounts receivable from an insolvent customer by debiting it to the
allowance for doubtful accounts. At the end of year on 30 June, 2020 the ageing
of accounts receivables was computed as under:-

Age group Accounts of Accounts Receivables

1. Not yet-due Rs. 350,000
2. 1-30 days past due Rs.580,000
3. 31-60 days past due Rs. 432,000
4. 61-90 days past due Rs. 218,000
5. 91-180 days past due Rs. 125,000
6. 181-365 days past due Rs. 60,000
Total Rs. 1,765,500

Based upon the past experience, the company has estimated the percentages of
probable uncollectible for the above age groups to be as follow: Group 1 at 0.5%,
Group2 at 2%, Group3 at 4%, Group4 at 5%, and Group5 at 8% and Group6 at
10%.

Required:
a) Based upon the above information, compute the amount of uncollectible
accounts.
b) Prepare necessary adjusting entry at the yearend of bring the allowance for
doubtful accounts of proper account.
c) Suppose that on 25 July, 2020 a customer namely Usman Brothers owing
Rs. 8,400 whose receivable were past due by 150 days died and nothing was
collectible from his property. Prepare necessary journal entry required on 25
July, 2020 to adjust this account.

SOLUTION
Based upon the data of accounts receivables by age groups and the estimate of
percentage of probable uncollectible the amount of estimated uncollectible is
worked out as under:-

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a) Schedule of uncollectible accounts

Age group Percentage uncollectible Uncollectible amount
1. Rs. 350,000 0,50% Rs. 1,750
2. Rs. 580,500 2% Rs. 11,610
3. Rs. 432.000 4% Rs. 17,280
4. 218,000 5% Rs. 10,900
5. 125,000 8% Rs. 10,000
6. Rs. 60,000 10% Rs. 6,000
Total Rs. 1,765,500 Rs. 57,540
b)
Amount of adjusting entry:
Uncollectible amount as per (A) Rs. 57,540
Add existing debit balance of Allowance for doubtful Account Rs. 4,500
Total Amount of adjusting entry Rs. 62,040
Date Particulars Dr Cr
30-06-20 Bad debt expenses Rs. 62,040
Allowance for doubtful accounts Rs. 62,040

c) Writing off Journal entry.

Date Particulars Dr Cr
25-07-20 Allowance for doubtful accounts Rs. 8,400
Accounts Receivables (Usman Brothers) Rs. 8,400

PROBLEM NO. 02
Akbar Enterprises was owning the following short term equity investments in the
shares of joint stock companies listed on Islamabad Stock Exchange:-
1) 4,000 shares of Rs. 1000 each par volume purchased at Rs. 130 each of
Kohat Cement Company which have market value of Rs. 150 each as on 30
June, 2020.
2) 2,500 shares of Rs. 50 each par value purchased at Rs. 60 each of Shahid
Steel Company which have market value of Rs. 65 each as on 30 June,
2020.

During September, 2020 all Akbar Enterprises conducted the following

transactions:-
1) On 18 September, 2020 all shares of Kohat Cement Company were sold at
Rs. 160 each.
2) On 30 September, 2020 all shares of Shahid Steel were sold at Rs. 55 each.

Required In complains with mark to marked concept:

a) Pass necessary accounting entries to purchase and update the values of short
terms investment the end of 30 June, 2020.

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Unit-4 Financial Assets

b) Present the short terms investments in the financial statements in the

following statements as at 30 June, 2020
c) Incorporate the sale of short term equity securities in the accounting record.
d) Present the income from sale of equity securities and the remaining
investment in the following statements as at 30 September 2020.

SOLUTION
a) Accounting entry during June, 2020
Date Particulars Dr Cr
30-06-20 Investment in Marketable Securities (Kohat Cement Co.) Rs. 520,000
Bank Account Rs. 520,000

Date Particulars Dr Cr
30-06-20 Investment in Marketable Securities (Kohat Cement Co.) Rs. 80,000
Unrealized Gain on marketable securities (Kohan Cement Co.) Rs. 80,000

Date Particulars Dr Cr
30-06-20 Investment in Marketable Securities (Shahid Steel Co.) Rs. 150,000
Bank Account Rs. 150,000

Date Particulars Dr Cr
30-06-20 Investment in Marketable Securities (Shahid Steel Co.) Rs. 12,500
Unrealized Gain on Marketable Securities (Shahid Steel Co.) Rs. 12,500

b) Akbar Enterprises

Balance Sheet as at 30 June, 2020

Current Liabilities Current Assets
xxx Cash at Bank Xxx
Investment Marketable equity securities of Kohat
Cement Co.
Equity
Authorized and Issued capital Xxx 4,000 Shares purchased at Rs. 130 each and market Rs. 600,000
value of Rs. 150 each
Unrealized gain on marketable Marketable equity securities of Shahid Steel Co. Rs. 162,500
equity securities of: 2,500 shares purchased Rs. 60 each and market
value of Rs. 65 each.
Kohat Cement Co. Rs. 80,000
Shahid Steel Co. Rs. 12,500

c) Accounting entries during September, 2020.

Date Particulars Dr Cr
18-09-20 Bank Account Rs. 640,000
Unrealized Gain on Marketable Securities (Kohat Cement Co.) Rs. 80,000
Investment in Marketable Securities (Kohat Cement Co). Rs. 600,000
Realized gain on Marketable Securities (Kohat Cement Co.) Rs.120,000

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Unit-4 Financial Assets

Date Particulars Dr Cr
30-09-20 Bank Account Rs137,500
Unrealized Gain on Marketable Securities (Shahid Steel Co.) Rs. 12,500
Realized loss on Marketable Securities (Shahid Steel Co). Rs. 12,500
Investment in Marketable Securities (Shahid Cement Co.) Rs. 162,500

d) Akbar Enterprises
Income Statement for the quarter year ended on 30-09-2020
Operating income xxx
Other income
Realized gain on Marketable Securities (Kohat Cement Co.) Rs. 45,000
Less Realized loss on Marketable Securities (Shahid Steel Co.) Rs. 12,500 Rs. 32,500

Akbar Enterprises
Balance Sheet as at 30-09-2020.
Current Liabilities Current Assets
Cash at Bank xxx
Equity Investment in Marketable Equity Securities of
Kohat Cement Co.
Authorized and Issued Capital Xxx
Unrealized gain on marketable equity Rs. 50,000 2,500 Shares purchased at Rs. 130 each Rs. 375,000
securities of Kohat Cement Co. and market value of Rs. 150 each

4.14 SUMMARY

As a marketing strategy most of the business activities, for sale of merchandise

and securities, are conducted on credit basis by manufactures and wholesalers.
These can be on an open account or through promissory notes. The accounting
entries debiting Accounts Receivables and Notes Receivables and crediting sale
of merchandise are recorded. Upon collection the Bank Account is debited and
Accounts Receivables or Notes Receivables are credited. Sometimes Interest on
notes receivables is also involved which is also collected and treated as other
income.
1. When the organization feel certain liquidity problems, some incentives of
cash discounts are offered to credit customers for early payment of their
obligations instead of waiting for maturity of credit period. Besides if
considerable funds are required instantly then the accounts receivables are
entrusted upon for the collection by certain agencies at due times which is
called as Factoring of accounts receivables. This involves certain factoring
expenses. Apart from it, the funds can be borrowed from banks by pledging
accounts receivables.

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2. The valuation and presentation of the accounts receivables in the Balance

Sheet at year end requires certain adequate procedures consistently to be
followed in the organizations. The credit sales are usually confronted with
the risk of non-recovery some times. There are two methods generally
applied for accounting for such risks. First is the direct write off method
which entails that the irrecoverable accounts may be created periodically by
charging periodic expense and presentation of accounts receivables or net
realizable value in the balance sheet. The amount of allowance for doubtful
accounts may be computed as a percentage of annual credit Sale or on the
basics of aging of accounts receivables. These are called as Income
Statement approach and Balance Sheet approach and Balance Sheet
approach respectively.
3. Occasionally the business organizations possess certain liquid funds beyond
their routine requirements of working capital. These funds are used in
productive manner so as to reap certain financial benefits instead of keeping
idle. Such funds are therefore, usually used for short term equity and debt
securities which are instantly encashable and are presented in the Balance
Sheet as current assets. When some funds are available long term securities
of equity and debt are also purchased usually from the pension, gratuity and
depreciation funds which are presented as long term investment in the
balance sheet. These equity securities are valued at year end at market prices
and any increase or decrease from. Cost are adjusted and reciprocal
unrealized gain or loss on such marketable equity securities are recognized
in balance sheet through mark to marked concept of Generally Accepted
Accounting Principles. The gain or loss is reported in the income statement
only when it is actually realized upon disposal of such marketable securities.

4.15 THEORETICAL QUESTIONS

1) Describe how accounts receivables and notes receivables are originated in a

trading business organization
2) Distinguish between the accounts receivables and notes receivables.
3) What are the sources available for collection of funds quickly from the
accounts receivables?
4) What do you understand by factoring of accounts receivables by an organization?
5) What is meant by pledging of accounts receivables when the enterprise is in
need of funds instantly?
6) Explain the objectives of valuation of accounts receivables.
7) What are the methods available for accounts receivables?

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8) Describe the income statement approach and balance sheet approach for
valuation of accounts receivables.
9) Elucidate the procedure for computation of allowance for doubtful accounts
through ageing of accounts receivables.
10) What do you understand by short term and long term equity and debt
investments?
11) Describe the procedure adopted for valuation and presentation of short term
equity securities in the financial statements at year end under mark to
marked concept.
12) Describe as to how the unrealized gain/loss and realized gain/loss is reported
in the financial statements for short term equity securities by an enterprise.

4.16 PRACTICAL PROBLEMS

P.4-1
Shan Trading Company conducted the following transactions during May, 2020:-
a) Sold merchandise to Rehmat Brothers at Rs. 50,000 on 05 May 2020 terms
30 days credit.
b) On 06 June 2020 Rehmat Brothers could not pay his dues and signed a two
months Promissory Note with 12% per annum interest.
c) On 30 June the accrued interest was accounted for.
d) On 06 August 2020 the payment of promissory note with interest was
collected.

Required
1) Record the above transactions in the books of accounts of Shan Trading
Company.
2) Indicate the interest income on the promissory note at year end of 30 June
2020.
3) Compute the total interest income on the promissory note at maturity

P.4-2
Reliance Traders are involved in the supply of office Furniture on credit basis to
different private and public sector organizations. Due to lose control over
collection procedure of its dues, the company facing financial crises as the
collection is not matching with disbursement schedules of funds. Presently the
accounts receivables from different organizations have accumulated at Rs. 15,500
million. With a view to facilitate meeting its maturing obligations in time, the
enterprise has two options available with it which are as under:-

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Unit-4 Financial Assets

a) Factoring its accounts receivable to the extent of 80% at factoring fee of 6%

to an ageing.
b) Pledging its accounts receivables to the extent of 80% at the flat interest of
7% with a Bank for taking loan.

Required
1) Pass necessary accounting entries separately for both the options.
2) Which of the two options is more appropriate for implementation?

P.4-3
Liaqat Trading Company is a wholesaler of domestic appliances to retailers in the
territory. The company’s accounts receivables from different retailing customers
have accounted to Rs. 875,000 as on 30 April 2020. The company is using direct
write-off method for charging bad debt expenses and valuation of its accounts
receivables. During May, 2020 it was learnt that a customer namely Sadiq
Electronics has died and the accounts receivables accounting to Rs. 50,000 from
this customer are no more receivable. However, late during June, 2020 upon
disposal of his property, 45% of the due were recovered.

Required
1) Record necessary accounting entry for writing off the accounts receivable
from the expired customer.
2) Record collection of the dues from the disposal proceeds of the property of
expired customer.
3) Present the amount of accounts receivables in the balance sheet as at 30
June, 2020.

P.4-4
Citizen Appliances Company is using income statement approach for creating
allowance for doubtful accounts during the period of sales. During 2019-20 the
status of Accounts Receivables was as under:-

Accounts Receivables Rs. 1,850,000

Less allowance for doubtful Accounts Rs. 20,000
Net Accounts Receivables Rs. 1,830,000

During July, 2020 the accounts receivables accounting to Rs. 8,500 from Azad
Company were written off. However, during September 2020, this customer paid
Rs. 5,000. During the year 2020-21 credit Sales accounted to Rs. 1,580,000. The
company has a policy to create 1% for allowance for doubtful accounts on the

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Unit-4 Financial Assets

basis of credit sales for the year. Up till 30 June 2021 the accounts receivables
amounting to Rs. 1,530,000 were also collected from different credit customers.

Required
1) Record adjusting accounting entry for writing off the accounts receivables
from Azad Company.
2) Record Collection of amount from Azad Company who later paid some
dues.
3) Record the creation of additional allowance for doubtful accounts during
2020-21.
4) Present the accounts receivables in the balance sheet as at 30 June, 2021.

P.4-5
So-Soft Garments Industries has stated business of fabrication of men, women
and Kids dresses. These dresses are directly sold to retailers to avoid profit of
wholesaler and reduce prices. The merchandise is usually sold on 30 to 60 days
credit terms. During its first half year of operations, the credit sales amounted to
Rs. 1,360,000. During efforts of collection it was found that the credit sales
amounting to Rs. 6,500 were not collectible as the customer has shifted to some
other city and was not written off. The company is using allowance method for
charging bad debt expenses. During record half of the year the credit sales
amounting to Rs. 1,240,000 were achieved. Total collections during the year
amounted to Rs. 2,000,000. The management is wishing to create an allowance
for doubtful accounts equal to 2% of the balance accounts receivables at year end.
Required
1) Pass necessary accounting entries for writing off the accounts receivables.
2) Create necessary allowance for the doubtful accounts at the end of
accounting period.
3) Present the accounts receivables in the balance sheet at end of the year.

P.4-6
Safe Pharmaceutical Company is engaged in manufacturing of life saving
medicines. In order to avoid multiple panels of wholesale dealers for distribution
of its medicines, the company has registered few wholesale dealers for sale of its
products. The Company is using balance sheet approach for valuation of its
accounts receivables and creating allowance for doubtful accounts based upon
ageing of its year end accounts receivable. Normal credit terms of sale are 30 to
60 days period but some of the dealers do not pay their dues within the prescribed
credit period. The aging of accounts receivables as on 30 June, 2020 was
Conducted as under:-
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Unit-4 Financial Assets

Ageing of Accounts Receivables

180 days past Over one year
Not yet Due 30days past due 90days past due
due past due
Rs. Rs. Rs. Rs. Rs.
A Agency 50,000 — 100,000 — —
B Agency 70,000 80,000 250,000 — 70,000
C Agency 30,000 120,000 520,000 60,000 50,000
D Agency 50,000 70,000 100,000 80,000 30,000
E Agency — 100,000 50,000 100,000 20,000

The Recovery Staff has suggested the following percentages of likelihood for non
recovery of the accounts receivables to which management is inclined.

Net yet due 1%

30 days past due 2%
60 days past due 3%
90 days past due 5%
Over one year past due 10%

The existing balance of allowance for doubtful accounts brought formed from the
previous year is amounting to Rs. 22,500.

Required
1) Compute the amount of estimated bad debts required to be accounted for.
2) Pass necessary adjusting accounting entry for the allowance for doubtful
accounts.
3) Present the net amount of accounts receivables in the balance sheet at year
end.
4) During July, 2020 the amount of Rs. 20,000 receivable from E Agency
which was over one year past due was considered to be bad debts. Pass
necessary accounting for writing off this amount of accounts receivables.

P.4-7
Season Master Trading Company is dealing is consumable merchandise. The
goods are sold on 60 days credit terms. The debit balance in the allowance for
doubtful accounts was amounting to Rs. 8,300 for the accounts receivables
written off during the first half of the year. The sales during the year and the
estimated percentage of doubtful accounts on the basis of ageing of the accounts
receivables are as under:-

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Unit-4 Financial Assets

Classified Expected Amount of Percent of Accounts

Ageing of Receivables
Receivables Uncollectible
1. Not yet due Rs. 85,000 0.5%
2. 60 days past due Rs. 530,000 1%
3. 180 days past due Rs. 650,000 2%
4. One year past due Rs. 320,000 5%
5. Two years past due Rs. 110,000 20%

The accounts receivables amounting to Rs. 25,000 which were over two years
past due were found to be irrecoverable during July 2020.
3) Record necessary accounting entry for adjustment of the allowance for
doubtful accounts receivables.
1. Compute the amount of expected bad debts on the basis of ageing of
accounts receivables
2. Present the amounts receivable in the balance sheet as at 30 June, 2020.
3. Pass necessary accounting entering for writing off the accounts
receivables during. July, 2020 which were found to be irrecoverable?

P.4-8
Subhan Trading Corporation through its intensive efforts for collection of its
accounts receivables during the recent past period has some surplus funds in its
working capital. The management wishes to generate some financial benefits
from these available funds through investment in equity shares. According the
corporation availed some opportunities and invested funds in the marketable
securities as under:-
1) Purchased 1,500 shares of Kohinoor Mills LTD of Rs. 100 each par value, at
Rs. 250 each as on 28 September 2020, Rs. 300 each as on 30 June 2021.
2) Acquired 2,000 shares of Saif Group of Industries Ltd of Rs. 50 each par
value at Rs. 85 each on 15 March, 2021 which have the market value of RS.
100 each as at 30 June, 2021.

Required
1) Record the purchase of marketable securities of both the companies in the
accounting books.
2) Record the increase in the market price of investment in the accounts.
3) Present the marketable securities in the financial statements in compliance
to mark to marked concept of securities.

P.4-9
Three Stars Chemical Company has accumulated funds in its Depreciation Fund
Account. These funds would be required for replacement of machinery after few

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Unit-4 Financial Assets

years. Therefore, the company has decided to invest these funds in 12% Bonds
have maturity of 5 years and were purchased at Rs. 1,000,000 as on 1 April 2020.
The interest is payable semi annually.

Required
1) Record the purchase of Bonds in the books of accounts as on 1 April, 2020.
2) Record accrued interest on Bonds in the books of accounts as on 30 June,
2020.
3) Record the collection of interest on bonds as on 30 September, 2020 and as
on 31 March 2021.

P.4-10
Shadman Enterprises Ltd is a trading company of industrial goods. The company
has sufficient surplus funds available to invest outside the enterprise. Accordingly
the treasurer managed to purchase the following short and long term equity and
debt securities as per approval of the chief Executive officers:-
A) 5000 ordinary shares of Rs. 100 par value at Rs. 180 each as on 12 March,
2020 of Reliance Manufacturing Company Ltd. Agents commission was Rs.
5 each share.
B) 6,500 ordinary shares of Rs. 50 par value at Rs. 75 each as on 08 April 2020
of Beauty Cosmetics Industries Ltd. Agent’s Commission was Rs. 5 each
share.
C) 15% Bonds 1,000 of Rs. 1,000 each of united commercial Bank on 01 May
2020, interest payable semi annually, having maturity of 5 years.

1. The market value of equity securities as on 30 June, 2020 was as under:-

1. Reliance Manufacturing Co. Ltd Rs. 200 each.
2. Beauty Cosmetics Industries
2. The Company was in need of funds to supplement its working capital,
therefore it sold Rs. 2,000 ordinary shares of Reliance Manufacturing
Company Ltd at Rs. 190 each on 20 July 2020. Further the 2,000 ordinary
shares of Beauty Cosmetics Industries were also sold on 31 July 2020 at Rs.
60 each.

Required
1) Record purchase of equity shares of each Company.
2) Record purchase of Bonds.
3) Record the interest due on 30 June, 2020 on Bonds
4) Record the increase or decrease in the market value of equity shares of each
company in terms of mark to market Valuation Concept of securities.
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Unit-4 Financial Assets

5) Present the marketable securities and the 15% Bonds in the balance sheet of
the Enterprise as at 30 June, 2020.
6) Record the receipt of interest on Bonds after 06 month period.
7) Record the sale of equity securities during July 2020.

4.17 GLOSSARY

The debt due from customers on account of goods or securities supplied to them
on credit basis.

Notes Receivables
The note receivable means written evidence supported by the Negotiable
Instrument Act, 1881 regarding due amount for goods services or the funds
provided in the past to customer who is receivable within specific period with or
without interest.

Dishonors of Notes Receivable

Refusal of the credit customer to pay the amount at due date of the notes
receivable because of certain reasons

Factoring Accounts Receivables

Selling of rights of accounts receivable to a third party for collection and in lieu
thereof receipt of funds on lump sum basis after certain reduction

Pledging of Accounts Receivable

Use of accounts receivable rights as collateral security for borrowing money from
bank or financial institutions

Bad debt
The amount of irrecoverable portion of account receivable from credit customers
this is treated as periodic business expense/loss.

Allowance for Doubtful Accounts

The provision created, usually at the end of accounting period, for expected loss
from non-recovery of accounts receivables in future.

Aging of Accounts Receivables

A method for estimation o doubtful accounts receivables based on greater chance
for non recovery of older accounts receivable and lower chance for non recovery
of current accounts receivables. Thus all accounts receivables are phased into
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Unit-4 Financial Assets

different age groups to create allowance for doubtful accounts at different rates at
year end.

Short Term Investment

Investment of funds outside the business with the intent to keep it for
comparatively longer period than one year with the objectives to earn potential
benefits of dividend, interest and hold control in the other company.

Unrealized gain/loss
The increase or decrease in the market value of equity securities of other
companies, at the yearend reporting period, than the purchase cost. This increase
or decrease in market value in capitalized in Balance Sheet instead of in the
Income Statement of reporting period.

Realized gain/loss
The gain or loss actually realized on disposal of equity securities of other
companies. This gain or loss is presented in the income statement of the disposal
period.

Trading Securities
The equity or debt securities which have exclusively been purchased on
temporary basis and which are to be sold immediately to earn some gain

Held to Maturity Securities

The equity or debt securities like shares, bonds and debentures which can be sold
out at any time when market prices are favorable.

Mark to Market
A concept of valuation of marketable securities at market value ate the of
accounting period and recognition of any gain or loss for increase or decrease in
the market value as compared with cost, as unrealized gain or loss in the balance
sheet. This is a departure from the cost concept of GAAP.

116
Unit – 5

Consolidated Accounts

Written by: Qasim Shuja Khan

Dr. Muhammad Munir Ahmad
Reviewed by: Prof. Dr. S.M Amir Shah
Unit-5 Consolidated Accounts

CONTENTS

Introduction ...................................................................................................... 119

Objectives ...................................................................................................... 119
5.1 Introduction to Consolidation .................................................................. 120
5.1.1 Types of investment ...................................................................... 120
5.1.2 Meaning of group .......................................................................... 120
5.1.3 Causes of operating as a group ..................................................... 120
5.1.4 Key Definitions IAS 27 ................................................................ 121
5.1.5 Explanation of Control.................................................................. 121
5.2 Group Accounts ........................................................................................ 122
5.2.1 Objectives of Consolidated Accounts ........................................... 123
5.2.2 Exception of Preparation of Consolidated Accounts .................... 123
5.3 Principles of the Consolidated Statement of Financial Position ... 123
5.4 Fully Acquired Subsidiary ........................................................................ 128
5.5 Partially Acquired Subsidiary ................................................................... 131
5.6 Goods Sold by Subsidiary to Parent ......................................................... 133
5.7 Goods Sold by Parent to Subsidiary ........................................................ 136
5.8 Plant Sold by Subsidiary to Parent and Parent Sold Goods to Subsidiary 138
5.9 Consolidated Income Statement ............................................................... 141
5.10 Problems ................................................................................................... 152

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Unit-5 Consolidated Accounts

INTRODUCTION

This unit is based on the International Accounting Standard 27 (IAS 27), and
International Financial Reporting Standard (IFRS 3), which describes guidelines
regarding the preparation and presentation of consolidated financial statements for
a group of entities under the control of a parent. This unit only covers the
preparation and presentation of statement of financial position and income
statement. Throughout the unit topic wise exercises with solution and related
problems are given for the understanding of the different concepts of the
consolidation. At the end of the unit various problems are given for the practice of
the students.

OBJECTIVES

After reading this unit, you will be able to:

a) Prepare a simple consolidated statement of financial position for single group
(parent and one subsidiary)
b) Calculate pre-post acquisition profits
c) Find out the value of goodwill using the FV method and proportionate method
d) Determine the non-controlling interest (NCI)
e) Treat the intra group trading selling of inventory from subsidiary to parent
and vice versa (PURP)
f) Perform the accounting treatment of unrecognized assets at acquisition
g) Deal with reconciliation of intra group current account balances
h) Prepare a consolidated income statement for a simple group and non –
controlling interest
i) Account for the effects of intra –group trading in the income statement
j) Prepare a consolidated income statement for a single group with an
acquisition in the period and non-controlling interest
k) Perform the accounting treatment for the impairment of goodwill
l) Prepare a consolidated statement of comprehensive income

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Unit-5 Consolidated Accounts

5.1 INTRODUCTION TO CONSOLIDATION

Growth is a major objective of many business organizations. To achieve this

objective, company may expand in several ways. Some firms concentrate on
internal expansion by engaging in product research and development. For other
firms’ external expansion is the goal; that is, they try to expand by acquiring one or
more other firms. This form of expansion, aimed at producing relatively rapid
growth, has exploded in frequency and magnitude in recent years.

Many large companies consist of several companies controlled by one central or

administrative company. Together these companies are called ‘a group’. The
controlling company, called the parent or holding company, will own some or all
the shares in the other companies, called subsidiary and associated companies.

5.1.1 Types of investment:

For the external expansion any company have to invest by purchasing the shares of
other companies. The following table describes the extent of investment and its
impact on other companies with its appropriate accounting treatment.

Size of Investment Degree of Influence Accounting treatment

>50% Control Subsidiary-Consolidate
20% < 50% Significance influence Associate-equity method
0% to < 20% No influence Trade investment

5.1.2 Meaning of Group

Group means a number of persons or things considered as a collective unit. From
the business perspective, this refers to an association of companies under a single
ownership and control, consisting of a parent company or a holding company and
subsidiary companies or associated companies.

5.1.3 Causes of operating as a group

The main causes of such type of business combinations or to operate as a group are:
➢ To avail the tax benefits
➢ To gain the advantages of goodwill associated with other companies

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Unit-5 Consolidated Accounts

5.1.4 Key definitions IAS 27

a. Parent: An entity that has one or more subsidiaries
b. Subsidiary: An entity, including an unincorporated entity such as a
partnership, that is controlled by another entity (known as the parent)
c. Significance influence: This is the power to participate in the financial and
policy decisions of an entity but is not control one those policies.
d. Consolidated Financial Statements: The financial statements of a group
presented as those of a single economic entity.
e. Control: The power to govern the financial and operating policies of an entity
so as to obtain benefits from its activities.

5.1.5 Explanation of control

IAS 27 stated that, Control is presumed when the parent acquires more than half of
the voting rights of the entity. Even when more than one half of the voting rights is
not acquired, control may be evidenced by power:
▪ over more than one half of the voting rights by virtue of an agreement with
other investors, or
▪ to govern the financial and operating policies of the entity under a statute or
an agreement; or
▪ to appoint or remove the majority of the members of the board of directors; or
▪ to cast the majority of votes at a meeting of the board of directors.
Example 5-1
Rockland Co owns the following investments in other companies:

Equity shares held Non-equity shares held

Aqua Co 80% Nil
Ceil Co 25% 80%
Blond Co 45% 25%
Rockland Co also has appointed five of the seven directors of Blond Co.
Which of the following investments are accounted for as subsidiaries in the
consolidated accounts of Rockland Co Group?
a) Aqua only
b) Ceil only
c) Aqua and Blond
d) All of them

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Solution 5-1
Let’s consider each of the investments in turn to determine if control exists and,
therefore, if they should be accounted for as a subsidiary.
➢ Aqua Co –by looking at the equity shares, Rockland Co has more than 50% of the
voting shares, i.e. an 80% equity holding. This gives them control and, therefore,
Aqua Co is a subsidiary.
➢ Ceil Co –you must remember to look at the equity shares, as despite having
the majority of the non-equity shares, these do not give voting power. As
Rockland Co only has 25% of the equity shares, they do not have control and,
therefore, Ceil Co is not a subsidiary.
➢ Blond Co –by looking at the percentage of equity shares, you may incorrectly
conclude that Blond Co is not a subsidiary, as Rockland Co has less than half
of the voting rights. However, by looking at the fact that Rockland Co has
appointed five of the seven directors, effectively they have control over the
decision making in the company. This control should make you conclude that
Blond Co is a subsidiary.

Therefore, the correct answer is C.

5.2 GROUP ACCOUNTS

The terms “Group Accounts” and “Consolidated Accounts” are used interchangeably,
which mean financial statements of all the entities in the group combined. The purpose
of group accounts is to show the combined accounts of the holding or parent company
and its subsidiary or subsidiaries. Group has no legal existence but for the accounting
purposes, on the basis of economic substance of the relationship between the companies
of a group, all the companies in a group are considered as a single entity.

IAS 27 states that, any holding company should prepare the consolidated financial
statements for the group as a whole to:
➢ Combine their profits in a consolidated statement of comprehensive income
➢ Combine their assets and liabilities in a consolidated statement of financial
position.

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5.2.1 Objectives of Consolidated Accounts

The objectives of the consolidated financial statements are to:
➢ Present the performance of the group as a whole
➢ Disclose the financial information of a group as a single unit
➢ Show the liabilities of the group
➢ Show all the economic resources controlled by the group

5.2.2 Exception of preparation of Consolidated Accounts:

A parent is required to present consolidated financial statements in which it
consolidates its investments in subsidiaries with the following exception:

A parent is not required to (but may) present consolidated financial statements if and
only if all of the following four conditions are met:
a. the parent is itself a wholly-owned subsidiary, or is a partially-owned
subsidiary of another entity and its other owners, including those not otherwise
entitled to vote, have been informed about, and do not object to, the parent not
presenting consolidated financial statements;
b. the parent's debt or equity instruments are not traded in a public market.
c. the parent did not file, nor is it in the process of filing, its financial statements
with a securities commission or other regulatory organization for the purpose
of issuing any class of instruments in a public market; and
d. the ultimate or any intermediate parent of the parent produces consolidated
financial statements available for public use that comply with International
Financial Reporting Standards.

5.3 PRINCIPLES OF THE CONSOLIDATED STATEMENT OF

FINANCIAL POSITION

5.3.1 Basic principle

The basic principle of a consolidated statement of financial position is that it
shows all assets and liabilities of the-parent and subsidiary.

Intra-group items are excluded, e. g. receivables and payables shown in the

consolidated statement of financial position only include amounts owed from/to third
parties.

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5.3.2 Method of preparing a consolidated statement of financial position

i) The investment in the subsidiary (S) shown in the parent's (P's) statement of
financial position is replaced by the net assets of S.
ii) The cost of the investment in S is effectively cancelled with the ordinary share
capital and reserves of the subsidiary

This leaves a consolidated statement of financial position showing:

i) the net assets of the whole group (P + S)
ii) the share capital of the group which always equals the share capital of P only
and
iii) the retained profits, comprising profits made by the group (i.e. all of P's historical
profits + profits made by S post-acquisition)

You have to follow the below five steps:

Step 1: Group structure
% of investment & date of acquisition

Step 2: Cost of investment

Cash (if paid) xxx journal entry will be as follow
Share capital xxx cost of investment DR
Deferred liability xxx share capital CR
-------------- deferred liability CR
Cost of invest. xxx cash transaction will not be consider under entry

Step 2: Net asset of subsidiary

At acquisition At end / reporting
Share capital xxx xxx
Share premium xxx xxx
Retain earning xxx xxx
Fair value adjustment: xxx xxx
(Assets & liabilities both)
Depreciation on fair value - (xxx)
Unrecognized brand FV XXX XXX
Amortization adjustment (xxx)
Provision for unrealized profit (S – P) (xxx)
------------ -----------
Total net assets xxxx xxxx
Difference between total net assets is ‘post acquisition profit’

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Step 3: Good will (two methods to calculate goodwill)

Proportion method Fair value method

Cost of investment xxx Cost of investment xxx
Less: % of P in net asset at Acq (xxx) Fair value of NCI xxx
---------- ----------
Good will xxx Xxx
Impairment loss (xxx) less: net assets at Acq. (xxx)
---------- ----------
Net good will xxxx Good will Xxx
Impairment loss (xxx)
----------
Net good will xxx

Step 4: Non – controlling Interest (two methods to calculate NCI)

Proportion method Fair value method

% of NCI in net asset at acq. xxx Fair value of NCI xxx
Add: % of NCI at post acq. Profit xxx % of NCI at post acq. Profit xxx
Less: % of NCI in impairment loss (xxx) % of NCI in impairment loss (xxx)
--------- ---------
Net NCI xxxx Net NCI xxxx

Step 5: Group Reserve/ Retain Earning

Closing balance of retain earning of P xxx

% of P in post acquisition profit xxx
% of P in impairment loss (xxx)
Provision of unrealized profit (P – S) (xxx)
(PURP)
--------------------
Net group reserve xxxx

Sometime a subsidiary has reserves other than retained earnings. The same basic
rules apply. If a reserve existed at the acquisition date, it is included in the goodwill
calculation and treated in the same way as pre-acquisition profits. If a reserve arose
after the acquisition date, it is treated in the same way as post-acquisition profits.

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Example 5-2
Alfa Co acquired 80% of Cadillac’s Co ordinary share capital on 1 January 2021.
As at 31 December 2021, extracts from their individual statements of financial
position showed:
Alfa Co Cadillac Co
Rs. Rs.
Current Assets:
Receivables 50,000 30,000
Current Liabilities:
Payables 70,000 42,000
As a result of trading during the year, Alfa Co’s receivables balance included an
amount due from Cadillac of Rs. 4,600.

What should be shown as the consolidated figure for receivables and payables?
Receivables Payables
Rs. Rs.
A) 80,000 112,000
B) 75,400 112,000
C) 74,000 103,600
D) 75,400 107,400
Solution 5-2
From the question, we can see that Alfa Co has control over Cadillac Co. This should
mean that you immediately consider adding together 100% of Alfa Co’s balances
and Cadillac Co’s balances to reflect control. However, the intra-group balances at
the yearend need to be eliminated, as the consolidated accounts need to show the
group as a single economic entity – in other words, the group position with the
outside world.
As Alfa Co shows a receivable of Rs. 4,600, then in Cadillac Co’s individual
accounts there must be a corresponding payable of Rs. 4,600. When these balances
are eliminated, the consolidated figures become:
Receivables: (Rs.50,000 + Rs.30,000 – Rs.4,600) = Rs.75,400
Payables: (Rs.70,000 + Rs.42,000 – Rs.4,600) = Rs.107,400

Therefore, the correct answer is D, not A which completely omits the elimination
of the intra-group balances, nor answer B which omits to cancel the corresponding
payable within liabilities.
You would not select answer C, which incorrectly adds 100% of Alfa Co (the parent)
and only 80% of Cadillac Co (the subsidiary).

Example 5-3
Dap Co acquired 80% of Lake Co’s 40,000 Rs. 1 ordinary share capital on 1 January
2021 for a consideration of Rs. 3.50 cash per share.

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The fair value of the non-controlling interest was Rs. 50,000 and the fair value of
the net assets acquired was Rs. 145,000.

What should be recorded as goodwill on acquisition of Lake Co in the consolidated

financial statements?
A. Rs. 17,000
B. Rs. 45,000
C. Rs. 46,000
D. Rs. 112,000

Solution 5-3
The first thing to identify is how much the parent company has paid to acquire control
over the subsidiary. In this question, Dap Co acquires control by paying Rs. 3.50 cash
per share. Remember: Dap Co has only acquired 80% of Lake Co’s shares, so
consideration transferred is 80% x 40,000 = 32,000 x Rs. 3.50 = Rs. 112,000.

Secondly, once we have identified the amount of consideration transferred to acquire

control over the subsidiary, the fair value of the non-controlling interest needs to be
identified. In this question the fair value of the non-controlling interest is given, so in
our calculation we just need to add it to the consideration transferred.
In the final part of the calculation, following on from the point just made, it is necessary
to look at all (100%) of the fair value of net assets at acquisition. Again this figure is
given in this question and just requires slotting into our goodwill working.

Goodwill can then be calculated as:

Cost of investment Rs. 112,000
Plus: Non controlling interest 50,000
162,000
Less: fair value of net assets at acquisition (145,000)
17,000
The correct answer is A.
Note: Answer B ignores that Dap Co only acquired 80% of the shares and calculates
the cost of investment incorrectly as 40,000 x Rs. 3.50 = Rs. 140,000 – therefore,
goodwill of Rs. 140,000 + Rs. 50,000 – Rs. 145,000 = Rs. 45,000.

Answer C is incorrect as, despite calculating the cost of investment correctly as Rs.
112,000 + non controlling interest of Rs.50,000 = Rs. 162,000, it incorrectly deducts
(80% x Rs. 145,000) as the share of net assets at acquisition giving goodwill of Rs.
46,000.

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Example 5-4
Ellan purchased 60% of Falcon’s 3,000 shares on 1 January, 2021. Ellan paid Rs.
5,500 cash for their investment. At 1 January 2021, the fair value of Falcon’s net
assets was Rs. 5,000. Falcon’s share price at this date was Rs. 2.25.

Required: Calculate the goodwill arising on the acquisition of Falcon’s, valuing the
NCI’s holding:
a. Using the fair value method
b. Using the Proportion of net assets method.

Solution 5-4
Goodwill is calculated as follows:
Proportion of
Fair Value net
Method Assets method
Rs. Rs.
Fair value of Allen’s holding 5,500 5,500
Add: NCI’s holding (W1/W2) 2,700 2,000
Less: Fair Value of Falcon’s net assets 5,000 5,000

Goodwill at acquisition 3,200 2,500

Working 01
The subsidiary' share price is used to value the NCI’s 40% holding in Falcon.
The NCI owns: 40% x 3,000 shares = 1,200 shares
The fair value of this shareholding is: 1,200 x Rs. 2.25 = Rs. 2,700

Working 02:
The NCI’s 40% holding is simply valued by taking this proportion of the
subsidiary’s net assets at acquisition of Rs. 5,000.
40% x Rs. 5,000 = Rs. 2,000

5.4 FULLY ACQUIRED SUBSIDIARY

Example 5-5
On 1st July, 2017 P Co. acquired 100% shares of S Co. Followings are the financial
position statements of both the Companies. You are required to Prepare the
consolidate Financial Position as on 30th June, 2018. Retained earnings at
acquisition was Rs. 1000.
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Statements of Financial Position of P and S

As at 30th June 2018

P S P S
Rs Rs Rs Rs
Property ,plant and
equipment 15,000 9,500 share capital 6,000 4,000
share premium 4,000 0

Investment 5,000 R/E 12,500 8,200

22,500 12,200

Current Assets 7,500 5,000 Non-current liabilities 1,000 500

current Liabilities 4,000 1,800
Total Equity and
Total Assets 27,500 14,500 Liabilities 27,500 14,500

Solution 5-5
Statement of Financial Position of P and S
As at 30th June 2018 Consolidated Financial Position
P S As at 30th June 2018
Rs Rs Rs
Property, plant and equipment 15,000 9,500 24,500
Investment 5,000 -
Current Assets 7,500 5,000 12,500
Total Assets 27,500 14,500 37,000
share capital 6,000 5,000 6,000
share premium 4,000 4,000
Retained Earning 12,500 7,200 19,700
22,500 12,200 29,700
Non-current liabilities 1,000 500 1,500
current Liabilities 4,000 1,800 5,800
Total Equity and Liabilities 27,500 14,500 37,000

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WORKINGS
W-1 Group Structure:
P

1st July 2017

100%

S
W-2 Net Assets:
At acquisition At reporting
Share capital 4,000 4,000
Retained earnings 1,000 8,200
PURP( S-P) - 0
5,000 12,200
W-3 Goodwill:
P holding (investment ) at FV 5,000
FV of NCI 0
5,000
net assets at acquisition (5,000)
Goodwill 0
impairment loss 0
Goodwill for Financial Position 0
W-4 NCI:
FV of NCI 0
% of Post Acq profit

impairment loss 0
0
W-5 Group retained earnings:
P's R/E 12,500
% of P in post acq profit 7,200
Impairment loss -
19,700

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5.5 PARTIALLY ACQUIRED SUBSIDIARY

Example 5-6
On 1st January, 2018 P Co. acquired 75% shares of S Co. Followings are the
financial position statements of both the Companies. You are required to Prepare
the consolidated Financial Position as on 31st December, 2018. Retained earnings
of S Co. at the date of acquisition was Rs. 1000
Statements of Financial Position of P and S
As at 31st December, 2018
P S P S
Rs Rs Rs Rs
Property ,plant and equipment 15,000 9,500 share capital 6,000 5,000
share premium 4,000 0
Investment 7,000 R/E 12,500 7,200
22,500 12,200
Current Assets 8,000 5,000 Non-current liabilities 1,000 500
current Liabilities 6,500 1,800
Total Assets 30,000 14,500 Total Equity and Liabilities 30,000 14,500

Solution 5-6
Statement of Financial Position of P and S
As at 31st December 2018
Consolidated Financial Position
P S As at 31st December 2018
Rs Rs Rs
Property, plant and equipment 15,000 9,500 24,500
Investment 7,000 -
Goodwill (W-3) 2,500
Current Assets 8,000 5,000 13,000
Total Assets 30,000 14,500 40,000

share capital 6,000 5,000 6,000

share premium 4,000 4,000
Retained Earnings (W-5) 12,500 7,200 17,150
27,150
NCI (W-4) 3,050
22,500 12,200 30,200
Non-current liabilities 1,000 500 1,500
current Liabilities 6,500 1,800 8,300
Total Equity and Liabilities 30,000 14,500 40,000

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WORKINGS
W-1 Group Structure
P

1st Jan 2018

75%
S
W-2 Net Assets:
At acquisition At reporting
Share capital 5,000 5,000
Retained earnings 1,000 7,200
PURP(S-P) - 0
6,000 12,200
W-3 Goodwill:
P holding (investment) at FV 7,000
FV of NCI 0
7,000
Net assets at acquisition (6,000*75%) (4,500)
Goodwill 0
impairment loss 0
Goodwill for Financial Position 2,500
W-4 Non-Controlling Interest:
FV of NCI (6000*25%) 1,500
% of Post Acq. profit (12,200-6000) *25% 1,550
impairment loss 0
3,050
W-5 Group retained earnings:
P's R/E 12,500
% of P in post Acq. profit (12,200-6000)*75% 4,650
Impairment loss -
17,150

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5.6 GOODS SOLD BY SUBSIDIARY TO PARENT

Example 5-7
On 1 January 2021 P bought 60% of S pays Rs. 76000 Cash. The summarized
Statements of Financial Position for the two companies as at 31st December 2021
are as follows
P S P S
Rs Rs Rs Rs
Property ,plant & equipment 128,000 110000 Share Capital 50000 40000
Investment 76000 0 Retained earnings 189000 69000
109,00
204,000 110,000 239,000 0
Stock 15000 17000
Debtors 20000 15,000 8% Loan notes 20000
Cash 3000 Current Liabilities 3,000 13000
38000 32000 3000 33000
142,00
242,000 142,000 242,000 0

The following information is relevant:

1) The inventory of P includes Rs 8000 of goods Purchased from S at cost Plus
25%
2) The P Group values the non-controlling interest using the fair value method.
At the date of acquisition the fair value of the 40% non -controlling interest
was Rs.50,000
3) An Impairment loss of Rs 1,000 is to be charged against goodwill at the year
end.
4) S earned a profit of Rs 9,000 in the year ended 31st December 2021

Required: Prepare the consolidated Statement of Financial Position as at 31st

December 2021

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Solution 5-7
Consolidated Statement of Financial Position
As at 31st December 2021
Rs Rs
Non-current assets:
Property ,plant & equipment 238,000 Share Capital 50,000
Goodwill (W-3) 25,000 Group retained earnings (w-5) 192,840
Investment - 242,840
263,000 NCI (w-4) 52,560
Current assets: 295,400
Stock 30,400 Non-current Liabilities
Debtors 35,000 8% Loan notes 20,000
Cash 3,000 Current Liabilities 16,000
68,400 36,000

331,400 331,400

WORKING
W-1 Group Structure:

P
1st Jan 2021
60%

S
W-2 Net Assets:
At acquisition At reporting
Share capital 40,000 40,000
Retained earnings 60,000 69,000
PURP( S-P) = 8000*25/125 - 1600
100,000 107,400

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W-3 Goodwill:
P holding (investment ) at FV 76,000
FV of NCI 50,000
126,000
Net assets at acquisition (100,000)
Goodwill 26,000
impairment loss (1,000)
25,000

W-4 Non Controlling Interest:

FV of NCI (6000*25%) 50,000
% of Post Acq profit (107,400-100,000)*40% 2,960
impairment loss (400)
52,560
W-5 Group retained earnings:
P's R/E 189,000
% of P in post Acq profit 4,440
Impairment loss (600)
192,840

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5.7 GOODS SOLD BY PARENT TO SUBSIDIARY

Exercise 5-8
On 1st January 2022 P bought 80% of S and pays Rs. 70,000 Cash. Followings
are the summarized Statements of Financial Position of P and S as at 31st
December 2022. You are required to Prepare the consolidated Statement of
Financial Position as at 31st December 2022
P S P S
Rs Rs Rs Rs
Property ,plant &
equipment 110,000 105,000 Share Capital 50,000 40,000
Retained
Investment 70,000 - earnings 189,000 69,000

180,000 105,000 239,000 109,000

Stock 35,000 18,000

Debtors 40,000 16,000 8% Loan notes 20,000

Current
Cash 5,000 Liabilities 21,000 10,000

80,000 34,000 21,000 30,000

260,000 139,000 260,000 139,000

Other information:

1. The inventory of S includes Rs 10,000 of goods Purchased from P at cost

Plus 25%
2. The P Group values the non-controlling interest using the fair value method.
At the date of acquisition the fair value of the 20% non -controlling interest
was Rs.46,000
3. An Impairment loss of Rs 2,000 is to be charged against goodwill at the year
end.
4. S earned a profit of Rs 15,000 in the year ended 31st December 2022

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Solution 5-8
Consolidated Statement of Financial Position
As at 31st December 2022
Rs Rs
Non-current assets:
Property ,plant & equipment 215,000 Share Capital 50,000
Goodwill (W-3) 20,000 Group retained earnings (w-5) 197,400
Investment - 247,400
235,000 NCI (w-4) 48,600
Current assets: 296,000
Stock 51,000 Non-current Liabilities
Debtors 56,000 8% Loan notes 20,000
Cash 5,000 Current Liabilities 31,000
112,000 51,000

347,000 347,000
WORKING
W-1 Group Structure:

P
1st Jan 2022
80%
S
W-2 Net Assets:
At acquisition At reporting
Share capital 40,000 40,000
Retained earnings 54,000 69,000
PURP( S-P) - 0
94,000 109,000
W-3 Goodwill:
P holding (investment ) at FV 70,000
FV of NCI 46,000
116,000
Less: Net assets at acquisition 94,000
Goodwill 22,000
Less: impairment loss 2,000
Goodwill for Financial Position 20,000

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W-4 Non Controlling Interest:

FV of NCI 46,000
% of Post Acq profit (109,000-94,000)*20% 3,000
Less: impairment loss 400
48,600
W-5 Group retained earnings:
P's R/E 189,000
% of P in post Acq profit (109,000-94,000)*80% 12,000
Less: Impairment loss 1,600
Less: PURP (P-S) 2,000
197,400

5.8 PLANT SOLD BY SUBSIDIARYTO PARENT AND PARENT

SOLD GOODS TO SUBSIDIARY

Exercise 5-9 (F.V adjustment plant, F.V of Brand, Intra Loan and Cash in transit
adjustment)
On 1st January 2022 P bought 60% shares of S and pays Rs. 100,000 Cash.
Followings are the summarized Statements of Financial Position of P and S as at
31st December 2022. You are required to Prepare the consolidated Statement of
Financial Position as at 31st December 2022
P S P S
Rs Rs Rs Rs
Property ,plant & equipment 125,000 112,000 Share Capital 80,000 60,000
Investment 100,000 - Retained earnings 170,000 40,000
225,000 112,000 250,000 100,000
Stock 50,000 30,000
Debtors 50,000 45,000 8% Loan notes 30,000
8% Loan note 30,000
Cash 15,000 12,000 Current Liabilities 120,000 69,000
145,000 87,000 120,000 99,000

370,000 199,000 370,000 199,000

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Other information:
1) The inventory of S includes Rs 20,000 of goods Purchased from P at cost Plus 25%
2) The P Group values the non-controlling interest using the fair value method.
At the date of acquisition the fair value of the 30% non -controlling interest
was Rs.44,000
3) An Impairment loss of Rs 2,500 is to be charged against goodwill at the year end.
4) S earned a profit of Rs 15,000 in the year ended 31st December 2022
5) On 1 January 2022 S transferred an item of Plant to P for Rs 20,000; its
carrying amount at that date was Rs. 15,000. The asset had a remaining
useful economic life of 5 Years.
6) At acquisition the FV of S's plant exceeded its book value by Rs 30,000. The
plant had a remaining useful life 5 years at this date.
7) Unrecognized Brand in the books of S at the date of acquisition worth Rs
10,000. The brand had a remaining useful life 5 years at this date.
8) The Loan note in S 's Books represents monies borrowed from P during the
year. All of the loan note interest has been accounted for.
9) Included in P's Debtors is Rs 4,000 relating to inventory sold to S during the
year. S raised a cheque for Rs. 2,500 and sent it to P on 29th November 2022.
P did not receive this cheque until 4 December 2022.

Solution 5-9
Consolidated Statement of Financial Position
As at 31st December 2022
Rs Rs
Non-current assets:
Property ,plant & equipment 257,000 Share Capital 80,000
Goodwill (W-3) 16,500 Group retained earnings (w-5) 166,300
Brand 8,000 246,300
Investment 0 NCI (w-4) 44,200
281,500 290,500
Current assets: Non-current Liabilities
Stock 76,000
Debtors 91,000 8% Loan notes 0
8% Loan note 0
Cash 31,000 Current Liabilities 189,000
198,000 189,000

479,500 479,500

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WORKING
W-1 Group Structure:
P

1st Jan 2022

60%
S
W-2 Net Assets:
At acquisition At reporting
Share capital 60,000 60,000
Retained earnings 25,000 40,000
PURP( S-P), Plant - (4,000)
FV of Plant 30,000 30,000
Dep Adjustment Plant (6,000)
FV of Brand 10,000 10,000
Amortization Adjustment (2,000)

125,000 128,000
W-3 Goodwill:
P holding (investment ) at FV 100,000
FV of NCI 44,000
144,000
Less: Net assets at acquisition 125,000
Goodwill 19,000
Less: impairment loss 2,500
Goodwill for Financial Position 16,500
W-4 Non Controlling Interest:
FV of NCI 44,000
% of Post Acq profit (128,000-125,000)*40% 1,200
Less: impairment loss 1,000
44,200
W-5 Group retained earnings:
P's R/E 170,000
% of P in post Acq profit (128,000-125,000)*60% 1,800
Less: Impairment loss 1,500
Less: PURP (P-S) 4,000
166,300

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W-6 PURP Plant

NBV in the Books (20,000-4,000) 16,000
NBV should be (15,000-3,000) 12,000
PURP (S-P) 4,000
W-7 PURP Stock
Sales 20,000
Cost 16,000
PURP 4,000

Cash in Transit 4,000

To Debtors 4,000

5.9 CONSOLIDATED INCOME STATEMENT

A consolidated statement of comprehensive income brings together the sales

revenue, income and expenses of the parent and the sales revenue, income and
expenses of its subsidiaries.

5.9.1 Pre- and post-acquisition profits

When a parent acquires a subsidiary during a financial year, the profits of the
subsidiary have to be divided into pre-acquisition and post-acquisition profits.

For the purpose of the consolidated statement of comprehensive income, we need to

calculate the pre-and post-acquisition profit in the current year.
a) The pre-acquisition profit is used to calculate the goodwill
b) The post-acquisition profit (or loss) is included in the consolidated profit or
loss for the year, in the consolidated statement of comprehensive income.

Unless you are given information that suggests a alternative, assume that in the year
of acquisition, the profits of the subsidiary occur at an even rate throughout the
course of the year. The division of the annual profit of the subsidiary into pre-
acquisition and post-acquisition elements can be done on a time basis.

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Unit-5 Consolidated Accounts

5.9.2 Non – controlling interest in the consolidated statement of comprehensive

income
When there is a non-controlling interest in a subsidiary, the consolidated statement
of comprehensive income should show:
a) The post-acquisition profit or loss for the year for the group as a whole,
including all the post-acquisition profit of the subsidiary;
b) The amount of this total profit that is attributable to the parent’s equity
shareholders and the amount that is attributable to the non-controlling interest
in the subsidiary

For the purpose of preparing the consolidated statement of comprehensive income,

all the pre-acquisition profits of the subsidiary are excluded. The final lines of a
consolidated statement of comprehensive income should therefore be as follows:
Attributable to:
Owner of the parent xxx
Non-controlling interest xxx
---------------------
Profit for the period xxxx

5.9.3 Other adjustments to the consolidated statement of comprehensive income:

impairment of good will
One such adjustment is impairment of goodwill. When purchased goodwill is
impaired, the impairment does not affect the individual financial statement of the
parent company or the subsidiary. The effect of the impairment applies exclusively
to the consolidated statement of financial position and the consolidated statement of
comprehensive income.

5.9.4 If good will is impaired:

a) It is written down in value in the consolidated SFP
b) The amount of the write-down is charged as an expense in the consolidated
statement of comprehensive income, usually as an administration expense.
A write-down in goodwill affects the parent entity only not the non-controlling
interest. It should therefore be deducted from the profit attributable to the owners in
the parent.

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Unit-5 Consolidated Accounts

5.9.5 Intra – group transactions and their adjustments

In many groups, business and financial transactions take place between entities
within the group. These intra – group transactions might be:
a) The sale of goods or services between the parent and a subsidiary, or between
two subsidiaries in the group
b) Loans by one entity in the group to another and the payment of interest on intra
– group loans

Intra-group transactions should be eliminated on consolidation. The purpose of

consolidated accounts is to show the financial position and the financial performance
of the group as a whole, as if it is a single operating unit. If intra-group transactions
are included in the consolidated financial statement, the statements will show too
many assets, liabilities, income and expenses for the group as a single operating unit.

5.9.6 Intra – group sales

The consolidated statement of comprehensive income shows the total sales and the
total cost of sales for the group as a whole during a financial period. If entities within
the same group sell goods or services to each other, these intra – group transactions
will be included:
a) In the revenue of the entity making the sale
b) As a cost of sale of the entity making the purchase

Looking at the group as a single operating unit, however, there has been no sale and
no purchase. The intra-group sale, for the group as a unit, is simply a transfer of
goods or services within the group.

The revenue from intra-group sales and the cost of intra-group purchases must
therefore be eliminated from the consolidated statement of comprehensive income.

5.9.7 No inventories of intra – group sales items

Provided that the items sold and bought internally have been used to make a sale
outside the group, so that there are no inventories of intra-group sales items, the
adjustment is made in the consolidated statement of comprehensive income by:
a) Deducting the revenue from intra-group sales from the total revenue for the
group
b) Deducting the same amount from the cost of sales

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Unit-5 Consolidated Accounts

5.9.8 When there are inventories of intra-group sales items

A slightly different situation arises when, at the end of the financial year, some intra-
group sales items are still held as inventory by the group entity that bought them.
This is because the inventory includes some ‘unrealized profit’.

5.9.9 Intra – group balances

When entities within a group sell goods to other entities in the same group, the terms
of trading are normally similar to those for sales to external customers. The selling
group company will expect payment in cash for the goods sold, but will give credit
terms to the buying group company.

When this happens, group entities will include other group entities within their trade
receivable (sale) and trade payables (purchase)

The trade receivables of the selling group entity should equal the trade payables of
the buying group entity. These intra-group balances must be eliminated on
consolidation and excluded from the consolidated balance sheet.

5.9.10 Items in transit (cash or goods)

At the year end, there might be a difference in the intra-group balances, due to goods
in transit or cash in transit. When cash or goods are in transit, they are in the process
of being transferred from one group entity to another. The entity sending the cash or
goods will have recorded the transaction in its ledger accounts. However, the entity
receiving the cash or goods has not yet received anything, and so has not yet
recorded the transaction in its accounts.

If the goods are in transit, the entity making the purchase will not yet have recorded
the purchase, the inventory received or the trade payable in its ledger accounts.
If the cash in transit, the entity might not yet have received the payment and so will
not have recorded the cash received or the reduction in its total trade receivables.

Difference in the intra-group balances caused by items in transit must be removed

for the purpose of consolidation.

If cash in transit from the parent to a subsidiary, the following adjustment should be
made to the statement of financial position of the parent:

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Unit-5 Consolidated Accounts

Cash DR
Amount payable to the subsidiary CR
The parent therefore reverses the transaction for the cash in transit, as though
the payment has not yet been made.
If cash is in transit from a subsidiary to the parent, in the statement of financial
position of the parent:

Cash DR
Amount receivable from the subsidiary CR

The parent therefore records the receipt of the cash payment from the subsidiary,
even though the cash has not yet been received.

5.9.11 Unrealized profit in inventory

When intra-group sales are still held as inventory:
a) The entity that made the sale has recorded a profit on the sale, but
b) This profit is included within the inventory valuation of the entity that made
the purchase, because inventory is valued at the purchase cost to the buying
entity.

The inventory is still held within the group, so the group as a unit has not made an
external sale. The profit made by the selling entity is included in the cost of the
closing inventory of the buying entity. The profit on the sale of this inventory must
be eliminated on consolidation. It is unrealized profit.

Unrealized profit is eliminated from the consolidated statement of financial position by:
a) Reducing the consolidated accumulated profit by the amount of the unrealized
profit
b) Reducing the valuation of the inventory by the amount of the unrealized profit

In the consolidated statement of comprehensive income:

a) Reduce consolidated revenue by the amount of the intra-group sales (R)
b) Reduce the consolidated cost of goods sold by the intra-group sales (R) minus
the amount of unrealized profit in the closing inventory (P)

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Unit-5 Consolidated Accounts

Revenue from intra-group sales R

Unrealized profit in closing inventory of intra-group sales P
--------------------
Reduction in consolidated cost of goods sold (R – P)

This has the effect of reducing the consolidated profit or loss for the year by the
unrealized profit in the closing inventory.

When unrealized profit is stated as percentage mark – up on cost, it is calculated as:

Unrealized profit = sales value X mark – up% / mark-up% + 100%

5.9.12 Intra – group loans and interest

It is quite common for group entities to lend money to other group entities, and to
charge interest on the loan.

If one group entity makes a loan to another group entity, the asset of the lender is
matched by the liability of the borrowers, and the asset and liability should both be
eliminated on consolidation.

Any non-controlling interest in the subsidiary will be calculated taking the loan into
account in calculating the net assets of the subsidiary.

When one group entity makes a loan to another group entity, there may be accrued
interest payable in the statement of financial position of the borrower at the year end.
This should be matched by interest receivable by the lender. The current liability
(interest payable) and the current asset (interest receivable) should therefore be self-
cancelling on consolidation, and both the asset and the liability should be excluded
from the consolidated balance sheet.

Note: If one of the entities has failed to record the accrued interest in its accounts,
you should correct this omission and record the transaction in the accounts of the
entity where it is missing. Having recorded the missing transaction, you can then
cancel the matching asset and liability.

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Unit-5 Consolidated Accounts

5.9.13 Non – controlling interest and loans

The non-controlling interest in the equity of a subsidiary and the subsidiary’s profit
or loss for the year is calculated on the assumption that the non-controlling interest
is the relevant proportions of:
a) The subsidiary’s net assets including the intra-group loan as an asset or liability
b) The subsidiary’s profit or loss for the year including the interest as an expense
or as income, depending on whether the subsidiary is the borrower or the
lender.

Example 5-10
The income statements for P and S for the year ended 31st December 2022 are shown
below. P acquired 75% of the ordinary share capital of S several years ago. You are
required to prepare the consolidated comprehensive income for the year 2022.
P S
Rs '000' Rs '000'
Sales 2,400 800
cost of sales and expenses (2,160) (720)
Gross profit 240 80
Investment income:
Dividend received from S 2
profit before tax 242 80
Tax (115) (38)
Profit after tax 127 42

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Unit-5 Consolidated Accounts

Solution 5-10
Consolidated statement of Comprehensive income For the year ended 31
December, 2022
Sales 3,200
cost of sales and expenses (2,880)
Gross profit 320
Expenses Nil
profit before tax 320
Tax (153)
Profit after tax 167
Attributable to:
Group Balancing fig (total -NCI) 156.5
NCI PAT(S)*NCI SHARE 10.5
TOTAL CONSOLIDATED PAT 167
Note: Dividend received from S will be eliminated in consolidated comprehensive
income statement.

Example 5-11
The income statements for Black Co. and White Co. for the year ended 31st
December 2021 are shown below. Black Co. acquired 75% of the ordinary share
capital of White Co several years ago .
P S
Rs '000' Rs '000'
Sales 3,000 1,300
cost of sales and expenses (2,400) (900)
Gross profit 600 400
Investment income:
Dividend received from S 2
profit before tax 602 400
Tax (120) (40)
Profit after tax 482 360
Required: Prepare Consolidated Income Statement for the year 2021.

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Unit-5 Consolidated Accounts

Solution 5-11
Consolidated statement of Comprehensive income
For the year ended 31 December, 2021
Sales 4,300
cost of sales and expenses (3,300)
Gross profit 1,000

profit before tax 1,000

Tax (160)
Profit after tax 840
Attributable to:
Group Balancing fig (total -NCI) 750
NCI PAT(White)*NCI SHARE 90
TOTAL CONSOLIDATED PAT 840
Note: Dividend received from White Co. will be eliminated in consolidated
comprehensive income statement.

Example 5-12
The income statements for P Co. and S Co. for the year ended 31st December 2022
are shown below. P Co. acquired 75% of the ordinary share capital of S Co several
years ago.
P S
Rs '000' Rs '000'
Sales 2,400 800
cost of sales and expenses (2,160) (720)
Gross profit 240 80
Distribution Cost (50) (30)
Admin cost (20) (10)
Investment income:
Dividend received from S 4
profit before tax 174 40
Tax (115) (15)
Profit after tax 59 25
Goods were sold by P to S Rs 10,000 at a margin of 50% (all goods were unsold by
S at the year end)
Required: Prepare Consolidated Income Statement for the year 2022.

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Unit-5 Consolidated Accounts

Solution 5-12
Consolidated statement of Comprehensive income
For the year ended 31 December, 2022
Rs ‘000’
Sales (W1) 3,190
cost of sales and expenses(W2) (2,875)
Gross profit 315
Distribution Cost (80)
Admin Cost (30)
profit before tax 205
Tax (130)
Profit after tax 75
Attributable to:
Group Balancing fig (total -NCI) 68.75
NCI PAT(S)*NCI SHARE 6.25
TOTAL CONSOLIDATED PAT 75

W 1 : Sales (2,400 + 800 - 10) = 3,190

W 2 : C S ( 2,160 + 720 – 5*) = 2,875
*PURP Adjustment from P to S 10*50%

Example 5-13
The income statements for P Co. and S Co. for the year ended 31st December 2022 are
shown below. P Co. acquired 75% of the ordinary share capital of S Co several years ago.
P S
Rs '000' Rs '000'
Sales 3,000 1,500
cost of sales and expenses (2,400) (800)
Gross profit 600 700
Distribution Cost (40) (10)
Admin cost (15) (5)
Investment income:
Dividend received from S 5
profit before tax 550 685
Tax (115) (15)
Profit after tax 435 670
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Unit-5 Consolidated Accounts

Additional information:
i. Goods were sold by S to P Rs 10,000 at a margin of 50% (all goods were
unsold by S at the year end)
ii. Goodwill impairment at the year end Rs 15,000 . The current impairment is to
be recognised as operating cost
iii. Additional depreciation due to FV adjustment Rs 25,000 is to be recognised
at the year end.

Requirement: Prepare the Consolidated Comprehensive Statement of Income for

the year 2022

Solution 5-13
Consolidated statement of Comprehensive income
For the year ended 31 December, 2022

Rs '000'
Sales (W1) 4,490
cost of sales and expenses(W2) (3,195)
Gross profit 1,295
Distribution Cost (50)
Admin Cost (35)
profit before tax 1,210
Tax (130)
Profit after tax 1,080

Attributable to:
Group Balancing fig (total -NCI) 923.75
NCI PAT(S)*NCI SHARE (W 3) 156.25
TOTAL CONSOLIDATED PAT 1,080

W 1: Sales (3,000 + 1,500 - 10) = 4,490

W 2 : C S ( 2,400 + 800 - 5*) = 3,195
*PURP Adjustment from P to S 10*50%

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Unit-5 Consolidated Accounts

5.10 PROBLEMS

Problem 5-1
Bradford Co owns the following investments in other companies:

Non-equity shares
Equity shares held
held
Ely Co 65% 35%
Oxford Co 35% 90%
Wells Co 50% 25%

Which of the following investments are accounted for as subsidiaries in the

consolidated accounts of Bradford Co Group?
a) Ely only
b) Oxford only
c) Ely and Wells
d) All of them

Problem 5-2
Abloy Co acquired 80% of Daco’s Co ordinary share capital on 1 January 2021. As
at 31 December 2021, extracts from their individual statements of financial position
showed:
Abloy Co Daco Co
Rs. Rs.
Current Assets:
Receivables 30,000 18,000
Current Liabilities:
Payables 42,000 25,200

As a result of trading during the year, Abloy Co’s receivables balance included an
amount due from Daco of Rs. 8,500.

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Unit-5 Consolidated Accounts

What should be shown as the consolidated figure for receivables and payables?
Receivables Payables
Rs. Rs.
a) 48,000 67,200
b) 39,500 58,700
c) 56,500 75,700
d) 48,000 58,700
Problem 5-3
Magnum Co acquired 70% of Nav Co’s 25,000 Rs. 1 ordinary share capital on 1
January 2021 for a consideration of Rs. 5.50 cash per share.

The fair value of the non-controlling interest was Rs. 75,000 and the fair value of
the net assets acquired was Rs. 125,000.

You are required to calculate the amount of goodwill to be recorded on acquisition

of Nav Co in the consolidated financial statements.

Problem 5-4
Racal incorporation purchased 75% of the equity share capital of Saft Incorporation
for Rs. 7,20,000 on 1 Jan 2021. Saft’s share capital is made up of 120,000 Rs. 1
shares and it had retained earnings of Rs. 480,000 at the date of acquisition. The
book value of Saft’s net assets was deemed to be equal to their fair value. The fair
value of the NCI’s holding as at 1 January 2021 was Rs. 150,000.

Required: Calculate the goodwill arising on the acquisition of Saft, valuing the
NCI’s holding:
a. Using the fair value method
b. Using the proportion of net assets method.

Problem 5-5
On 1st July, 2020 Lilly Co. acquired 100% shares of Silly Co. Followings are the
financial position statements of both the Companies. You are required to Prepare the
consolidate Financial Position as on 30th June, 2021. Retained earnings at
acquisition was Rs. 1200

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Unit-5 Consolidated Accounts

Statements of Financial Position of Lilly and Silly

As at 30th June 2021
Lilly Silly Lilly Silly
Rs Rs Rs Rs
Property ,plant and
equipment 15,000 9,500 share capital 6,000 5,000
share premium 4,000 0
Investment 7,000 R/E 12,500 7,200
22,500 12,200
Current Assets 7,500 5,000 Non-current liabilities 1,000 500
current Liabilities 6,000 1,800
Total Assets 29,500 14,500 Total Equity and Liabilities 29,500 14,500

Problem 5-6
On 1st January, 2021 Petron Co. acquired 70% shares of Seleron Co. Followings
are the financial position statements of both the Companies. You are required to
Prepare the consolidated Financial Position as on 31st December, 2021. Retained
earnings at acquisition was Rs. 8,000

Statements of Financial Position of Petron and Seleron

As at 31st December, 2021
Petron Seleron Petron Seleron
Rs Rs Rs Rs
Property ,plant and equipment 60,000 38,000 share capital 24,000 20,000
share premium 16,000
Investment 28,000 0 Retained Earning 50,000 28,800
90,000 48,800
Current Assets 32,000 20,000 Non-current liabilities 4,000 2000
current Liabilities 26,000 7,200
Total Assets 120,000 58,000 Total Equity and Liabilities 120,000 58,000

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Unit-5 Consolidated Accounts

Problem 5-7
On 1 January 2022 Pega corporation bought 60% of Sylve corporation by paying
Rs. 76000 Cash. The summarized Statements of Financial Position for the two
companies as at 31st December 2022 are as follows
Pega Sylve Pega Sylve
Rs Rs Rs Rs
Property ,plant & equipment 120,000 100000 Share Capital 60,000 40,000
Investment 70000 0 Retained earnings 150,000 70,000
190,000 100,000 210,000 110,000
Stock 16000 14000
Debtors 30000 20,000 8% Loan notes 20,000
Cash 15000 Current Liabilities 41,000 4,000
61000 34000 41,000 24,000

251,000 134,000 251,000 134,000

The following information is relevant:

1. The inventory of Pega includes Rs 7,000 of goods Purchased from Sylve at
cost Plus 25%
2. The Pega Group values the non-controlling interest using the fair value
method.
At the date of acquisition the fair value of the 30% non -controlling interest
was Rs.45,000

3. An Impairment loss of Rs 1,500 is to be charged against goodwill at the

year end.
4. Sylve earned a profit of Rs 10,000 in the year ended 31st December 2022

Required: Prepare the consolidated Statement of Financial Position as at 31st

December 2022

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Unit-5 Consolidated Accounts

Problem 5-8
On 1st January 2022 Brussels bought 70% shares of Madrid and pays Rs. 80,000
Cash. Followings are the summarized Statements of Financial Position of Brussels
and Madrid as at 31st December 2022. You are required to Prepare the
consolidated Statement of Financial Position as at 31st December 2022
Brussels Madrid Brussels Madrid
Rs Rs Rs Rs
Property ,plant & equipment 125,000 96,000 Share Capital 70,000 50,000
Investment 80,000 - Retained earnings 190,000 79,000
205,000 96,000 260,000 129,000
Stock 50,000 20,000
Debtors 60,000 40,000 8% Loan notes 20,000
Cash 10,000 5,000 Current Liabilities 65,000 12,000
120,000 65,000 65,000 32,000

325,000 161,000 325,000 161,000

Other information:
1. The inventory of Madrid includes Rs 15,000 of goods Purchased from Brussels
at cost Plus 25%
2. The Brussels Group values the non-controlling interest using the fair value
method.
At the date of acquisition the fair value of the 30% non -controlling interest
was Rs.40,000
3. An Impairment loss of Rs 3,000 is to be charged against goodwill at the year end.
4. Madrid earned a profit of Rs 20,000 in the year ended 31st December 2022
Problem 5-9
On 1st January 2022 Plear bought 80% shares of Someo and pays Rs. 120,000
Cash. Followings are the summarized Statements of Financial Position of P and S
as at 31st December 2022. You are required to Prepare the consolidated Statement
of Financial Position as at 31st December 2022

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Unit-5 Consolidated Accounts

Plear Someo Plear Someo

Rs Rs Rs Rs
Property ,plant & equipment 200,000 115,000 Share Capital 70,000 50,000
Investment 120,000 - Retained earnings 150,000 60,000
320,000 115,000 220,000 110,000
Stock 60,000 30,000
Debtors 50,000 45,000 8% Loan notes 20,000
8% Loan note 20,000
Cash 25,000 15,000 Current Liabilities 255,000 75,000
155,000 90,000 255,000 95,000

475,000 205,000 475,000 205,000

Other information
1. The inventory of Someo includes Rs 25,000 of goods Purchased from P at cost
Plus 20%
2. The Plear Group values the non-controlling interest using the fair value
method. At the date of acqusition the fair value of the 30% non -controlling
interest was Rs.45,000
3. An Impairment loss of Rs 3,000 is to be charged against goodwill at the year
end.
4. Someo earned a profit of Rs 10,000 in the year ended 31st December 2022
5. On 1 January 2022 S transferred an item of Plant to Plear for Rs 25,000, its
carrying amount at that date was Rs. 10,000. The asset had a remaining useful
economic life of 5 Years.
6. At acquisition the FV of S's plant exceeded its book value by Rs 40,000. The
plant had a remaining useful life 6 years at this date.
7. Unrecognized Brand in the books of Someo at the date of acquisition worth Rs
15,000. The brand had a remaining useful life 4 years at this date.
8. The Loan note in Someo 's Books represents monies borrowed from P during
the year. All of the loan note interest has been accounted for .
9. Included in Plear's Debtors is Rs 5,000 relating to inventory sold to Someo
during the year. Someo raised a cheque for Rs. 2,500 and sent it to Plear on
29th November 2022. P did not receive this cheque until 4 December 2022.

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Unit-5 Consolidated Accounts

Problem 5-10
The income statements for Pambary Co. and Saab Co. for the year ended 31st
December 2021 are shown below. Pambary Co. acquired 60% of the ordinary share
capital of Saab Co several years ago .
P S
Rs '000' Rs '000'
Sales 4,000 1,500
cost of sales and expenses (2,800) (1,000)
Gross profit 1,200 500
Investment income:
Dividend received from S 3
profit before tax 1,203 500
Tax (125) (45)
Profit after tax 1,078 455

Required: Prepare Consolidated Income Statement for the year 2021.

Problem 5-11
The income statements for Pinder Co. and Sadlar Co. for the year ended 31st
December 2022 are shown below. Pinder Co. acquired 60% of the ordinary share
capital of Sadlar Co several years ago .
P S
Rs '000' Rs '000'
Sales 3,000 1,500
cost of sales and expenses (1,800) (900)
Gross profit 1,200 600
Distribution Cost (60) (35)
Admin cost (25) (20)
Investment income:
Dividend received from S 5
profit before tax 1,120 545
Tax (115) (15)
Profit after tax 1,005 530
Goods were sold by P to S Rs 10,000 at a margin of 30% (all goods were unsold by
S at the year end)
Required: Prepare Consolidated Income Statement for the year 2022.
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Unit-5 Consolidated Accounts

Problem 5-12
The income statements for Xcel Co. and Yarl Co. for the year ended 31st December
2022 are shown below. Xcel Co. acquired 60% of the ordinary share capital of Yarl
Co several years ago .

Xcel Co Yarl Co
Rs '000' Rs '000'
Sales 4,000 2,000
cost of sales and expenses (2,600) (1,000)
Gross profit 1,400 1,000
Distribution Cost (60) (20)
Admin cost (20) (10)

Finance income / (Cost) 5 (5)

profit before tax 1,325 965
Tax (115) (15)
Profit after tax 1,210 950

Additional information:
i. Goods were sold by Yarl Co to Xcel Co Rs 20,000 at a margin of 50% (all
goods were unsold by S at the year end.)
ii. Goodwill impairment at the year end Rs 10000 . The current impairment is to
be recognized as operating cost
iii. Additional depreciation due to FV adjustment Rs 15,000 is to be recognised at
the year end .

Requirement:
Prepare the Consolidated Comprehensive Statement of Income for the year 2022

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Unit-5 Consolidated Accounts

160
Unit – 6

Stockholders’ Equity Paid-in Capital,

Income and Changes in Retained
Earnings

Written by: Muhammad Ashraf Bhutta

Dr. Muhammad Munir Ahmad
Reviewed by: Prof. Dr. S M Amir Shah
Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

CONTENTS
Introduction ..........................................................................................................163
Objectives ............................................................................................................164
6.1 Corporate form of Organization..................................................................165
6.2 Basics of Capital Stock ...............................................................................167
6.3 Common Stock............................................................................................168
6.4 Dividend and its classification ....................................................................173
6.5 Stock splits ..................................................................................................176
6.6 Preferred Stock and its classification ..........................................................176
6.6.1 Cumulative and non-cumulative Preferred Stocks. ........................177
6.6.2 Participating and non-participating Preferred Stocks. ....................178
6.6.3 Convertible Preferred Stocks. .........................................................180
6.6.4 Redeemable Preferred Stocks. ........................................................180
6.7 Issuance of Preferred Stocks .......................................................................180
6.8 Demonstration Problems .............................................................................182
6.9 Treasury Stock ............................................................................................186
6.9.1 Purchases of Treasury Stock ...........................................................187
6.9.2 Reissue of treasury stock ................................................................190
6.10 Retiring Stock. ............................................................................................193
6.11 Reporting of Equity.....................................................................................194
6.12 Demonstration Problems .............................................................................198
6.13 Summary .....................................................................................................201
6.14 Theoretical questions ...................................................................................202
6.15 Practical Problems .......................................................................................204
6.16 Glossary. ......................................................................................................215

162
Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

INTRODUCTION

This unit deals with variety of source for collection of funds to be used as capital
for conduct of a business as a joint stock Company. The corporate form of
business has certain advantages and disadvantages. The Capital Stock is usually
guaranteed from Common and Preferred Stocks. The Stock is issued at par at
premium and at discount. The preferred Stocks has specified rate of dividend
payable on it. The preferred stock may be cumulative; none cumulate
participating, none participating, redeemable and convertible. The capital stock
may be distributed the profit as cash dividend, interim dividend and stock
dividend as decided by Board of directors. The stock split may also be decided
when the market prices of shares are substantially growing.

It further describes the accounting treatment of treasury Stock i.e. the shares of
the company once issued, may be purchased for specific purposes. When these
purposes are accomplished, these treasury stocks are sold at par, at lower than
cost and at higher than cost and are accordingly accounted for. Sometimes the
treasury stocks are retried to reduce the capital. The composition of stock holder’s
equity has also been described in this unit. The objectives of issuance of stock
options have also been enlightened in it.

163
Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

OBJECTIVES
After study of this unit, the students would become conversant to understand the
following contents:-
a) Formation of a joint Stock Company, classification of capital stock into
common and preferred and its accounting treatment upon issuance.
b) Accounting treatment of issuance of capital stock at par at premium and at
discount and its presentation in the equity section of the balance sheet of the
company.
c) Accounting treatment of payment of cash dividend interim dividend and
stock dividend and stock splits.
d) Accounting treatment and distribution of profit in the shape of dividends to
cumulative, non cumulative, participating, none participating preferred
stockholders and common stockholders.
e) Presentation of redeemable Preferred Stocks in long term liabilities instead
of equity section of balance sheet.
f) The presentation of stock splits into accounting record only as memorandum
information instead of accounting entries.
g) The nature and presentation of treasury stock in the equity section of the
balance sheet.
h) The accounting treatment of disposal of treasury stocks when sold at par
value of purchase cost, at above the purchase cost and at below the purchase
cost.
i) Occasionally when the funds are no more needed, the treasury Stock is
retired the subscribed and paid up capital. This has also been explained.
j) The Composition of the statement of Retained and Earnings and stock
holders Equity Statement would enable the students as to how these are
prepared.
k) The accounting treatment of Stock options which are granted to some staff
having care position in the organization is explained for its appropriate
understanding and presentation.

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6.1 CORPORATE FORM OF ORGANIZATION

The gradual growth of trade, commerce and industry during twentieth century, the
size of business activities had grown up, and the sole proprietorship and the
partnership forms of organizations did not supply all the capital needed.
Therefore, a new form of business organization came into existence where in the
public was invited to contribute capital. Such an organization is known as a Joint
Stock Company or simply a company or alternatively named as a corporation.
Such joint stock companies are established in Pakistan under companies Act,
2017.

A Joint Stock Company or Corporation is a fictitious or artificial legal person

existing in the eyes of law. This legal person (Company) once created is distinct
from its owners, stockholders, shareholders or members. The Company can own
property, sue and be sued and generally carry on activities by its own name and
title through its offices and agents. Being a creature of statute, the scope of its
activities is dependent upon its memorandum of association and any activity
beyond its scope would be judged as invalid and ultra virus. The Companies are
thus governed by its relevant law under which it was constituted and registered.

There are two major classifications of joint stock companies. One is a private
company whose members are limited and cannot offer its shares to public for sale.
The second type is a public company whose members are unlimited and can offer
its shares to public for sale. Such shares/stocks once issued are usually traded on
the stock exchanges of the country.

Characteristics of a Company
A Joint Stock Company represents an important type of business organization as
it has unique characteristics, having pivotal role in the building of economy in the
country. It may offer certain advantages and disadvantages as enumerated below:-

A) Advantages
1) Adequate capital: The joint stock company can collect and accurate
sufficient funds in the shape of issuance of shares/stocks to public and also
issuance of debentures and bonds apart from taking loans from financial
institutions. The corporate structure attracts the public for purchase of shares
owing to limited liability, trading facility of such shares and perpetual nature
of the company.
2) Separate legal entity of the company facilitates it to conduct business at its
own responsibility without involving its owners.
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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

3) The stockholders have limited legal liability to the debts of the company.
4) Perpetual life of the company enables it to continue its operations without
interruption upon death of any shareholders.
5) The shares of the company can easily be traded and transferred to others.
6) The shareholders have no rights of mutual agency like in partnership.
7) The business of the company is conducted by a professional group of
persons including board of directors.

B) Disadvantages
1) The corporate organizations are mandatory required to follow the
regulations and controls imposed by the companies Act 2017 and other
instructions issued by the agencies from time to time.
2) The taxation structure comprising general sales tax and income tax is strictly
implemented on the joint stock companies, thus draining out its profit over
by 30% to the government in the shape of income tax and around 15 to 17%
on the sales prices of merchandise. Further the tax on dividend ranging from
10 to 20% leads to double taxation on the income of the company.
3) Sometimes the employees of the company take least care in the conduct of
transactions of the organization due to their non-involvement in the
profitability.

In spite of certain disadvantages of the joint stock form of business organization

the over whelming advantages are greater. Thus the corporate structure is
progressing day by day as no other form of business organization can execute
mega projects and gigantic/complex manufacturing and trading activities.

General administration Structure of the Company

The management of the joint stock company rests with the board of directors who
is responsible for framing policies, taking decisions and arranging resources for
conduct of business activities. The board of directors is elected by the
shareholders of the company. The Managing Director, as authorized by the Board
of Director, is the chief Executive Officer of the company who is responsible to
conduct all business transactions of the organization. The corporate affairs are
looked after by the Company Secretary for holding meetings of the Board of
Directors, maintaining minutes of the board meetings, issuance of share
certificates to shareholders, arranging approval of the board for transfer of shares
from one person to the other and meeting regulatory requirements of the
Securities and Exchange Commission of Pakistan in terms of Companies Act,
2017.

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The administrative and functional set up of the corporation is entrusted upon the
General Managers or Controllers of different Divisions of the organization who
all report to the Managing Director for performance in their departments like
Administration, Human Resource, Accounting & Finance, Production,
Procurement and Marketing etc. There departmental heads are supported by their
Functional staff.

6.2 BASICS OF CAPITAL STOCK

The Capital stock denotes the contribution of funds made by shareholders/
stockholders in the company through purchase of shares/socks of the joint stock
company. This is the main source of the company through which funds are
collected for conduct of business. The capital stock of company is classified into
accounting record with different nomenclatures as deliberated below:

a) Authorized Capital
This is the total amount of capital divided into different classifications, duly
approved by the controller of capital issue of Security and Exchange
Commission of Pakistan, on the request of the Company after depositing
necessary fee. This also matches with the amount of capital authorized and
indicated in the memorandum of association of the company. The company
has the power to issue shares up to this authorized amount of capital. The
authorized capital is divided into shares of fixed amount like Rs. 50 or Rs.
100 each share or. The amount of authorized capital with classifications is
indicated in the equity section of the balance sheet as memorandum
information. No accounting entry is passed for the authorized capital.
b) Issued Capital
This represents the number of shares which have been offered to public
through issuance of prospectus or otherwise in the shape of cash or some
other considerations of assets or services rendered. The issuance of shares
can also be arranged through broker age houses i.e. underwriter also acquire
all or major position of shares and then sell such shares taking all gains or
losses from its resale.
c) Subscribed Capital
It is that part of issued capital which was subscribed by the potential
purchases through their requests expressing intention of purchase to which
the company agreed. The subscription may over or under. In case of over
subscription some modality is developed to maintain some rationale for

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selection of issuance of shares. In case of under subscription usually the

shares are issued as requested by purchasers in all.
d) Collect up Capital
The amount of money which was collects up from the subscribers of shares
for making payment to the company.
e) Paid up Capital
The paid of capital is the amount of called up capital that has actually been
paid up by the subscribers/stockholders to the company.
f) Par Value of Stock
The par value of Stock denotes the amount as indicate and has been issued
at that particular amount to the stockholders. For instance the share of Rs.
100 issued at Rs. 100 each is its par value.
g) Market Value of Stock
The market value of the stock is the price at which the shares can be
purchased and sold each time. This value fluctuates from time to time in the
market at stock exchanges. The amount of dividends growth and other
economic factors in the country which have influence over the corporate
affairs.
h) No – par Value Stock
No par value stock is not assigned any par value by the company and its
memorandum of association. Such shares can be issued at any price without
the possibility of a minimum legal capital deficiency (discount factor).
i) Stated Value Stock
The stated value stock is no-par Stock to which the directors assign a
“stated” value per share. The stated value per share becomes the minimum
legal capital per share.

The shares of the company may be classified into ordinary (common) and
Preferred stocks to which companies Act 2017 permits. These classifications are
further dealt with in the succeeding portion.

6.3 COMMON STOCK

The Common Stock of a joint stock company in reference to its rights and
privilege shall be governed by its memorandum and articles of association.
However, the common stock have the right to profit (dividend) distribution,
voting and other benefits like share in residual assets at the time of liquidation of
the company after all obligations including preference stocks have been satisfied.
The issuance of common stock shall affect the asset amounts and capital accounts.

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The common shares may be issued by a joint stock company at different prices
which are deliberated below along with accounting treatment.

6.3.1 Issuing Par Value Stock at Par

When the common stock of Rs. 100 each denomination is issued at Rs. 100 each
it represents issuance of stock at par. When the applications for stock are
reviewed by the company and shares are issued after approval of the Board of
Directors following two accounting entries are recorded:

Date Particulars Dr Cr
15-03-20 Bank Account Rs. 500,000
Common Stock Application Account Rs. 500,000
31-03-20 Common Stock Application Account Rs. 500,000
Common Stock Capital Account Rs. 500,000

The above accounting entries indicate that the applications for 5000 shares of Rs.
100 each were received which were accepted and after approval the shares were
issued. In case of over subscription, the amount will be refunded to the applicants.
The common stock capital account is a controlling account. It is necessary to
maintain member's record of the name and address of each stockholder and the
number of shares holds in order to issue dividend cheques, proxy forms and
annual reports. This will be applicable in any type or classifications as
enumerated in the succeeding sections. The stockholders equity section in the
balance sheet of the company, at the end of its first year of operation, when net
income of Rs. 100,000 was earned and no dividend declared, would present as
under:-

Stockholders’ equity
Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares at par Rs. 100 each. Rs. 500,000
Retained Earnings Rs. 100,000
Total stockholders’ equity Rs. 600,000

6.3.2 Issuing Par Value Stock at Premium

Sometimes when the shares are issued by a joint stock company at the value
greater than its par value, it is termed as at premium. If the common stock of Rs.
100 each par value is issued at Rs. 120 each the excessive amount of Rs. 20 (Rs.
120-Rs. 100) would be termed as premium. The shares of a company are issued at
premium when the company is earning higher profits and has potentials of
distributing greater amount of dividends than the rate of interest or the dividend
rates of other competing companies. Taking the similar data as at para 6.3.1 for

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issuance of shares, but at premium, the accounting entries will be incorporated as

under:-

Date Particulars Dr Cr
15-03-20 Bank Account Rs. 600,000
Common Stock Application Account Rs. 600,000
31-03-20 Common Stock Application Account Rs. 600,000
Common Stock Capital Account Rs. 500,000
Premium on Common Stock Capital Account Rs.100,000

The Premium on Common Stock is not periodic revenue rather it is capitalized in

owner’s equity. The presentation of owner’s equity in the balance sheet at year
end would be as under:-

Stockholders’ equity
Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares of Rs. 100 at Rs. Rs. 500,000
110 each.
Premium on Common Stock Capital Rs. 100,000
Retained Earnings Rs. 100,000
Total stockholders’ equity Rs. 700,000

6.3.3 Issuing Par Value Stock at Discount

When the stock of a Joint Stock Company is sold to public at the price which is
lessor than its par (face) value, it is called as issuance of stock at discount. A
newly established company is not allowed to issue its stock at discount. However,
it can later issue the stock at discount with the prior approval of its board of
directors and the Exchange Commission of Pakistan with cogent reasons. Suppose
the 5000 shares of Rs. 100 par value are issued at Rs. 90 each during second year
of its operations, the accounting entries would be recorded as under:-

Date Particulars Dr Cr
10-04-21 Bank Account Rs. 450,000
Common Stock Application Account Rs. 450,000
31-04-21 Common Stock Application Account Rs. 450,000
Discount on Common Stock Capital Account Rs. 50,000
Common Stock Capital A/C Rs. 500,000

The discount on Common Stock is not treated as periodic expense rather it is

capitalized in the balance sheet and can be adjustable against the Premium on
similar Common Stock Capital. The presentation of owner’s equity in the balance
sheet at year end when the capital stock is sold at discount would appear as under:-

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Owner’s equity
Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares of Rs. 100 each Rs. 500,000
at Rs. 90 each.
Discount on Common Stock (Rs. 50,000)
Retained Earnings Rs. 100,000
Total stockholders’ equity Rs. 550,000
In case, earlier when some Common Stocks were issued at premium as at para
5.3.2 and later some Common Stocks were sold at discount as per para 6.3.3 the
amount of discount of Rs. 50,000 would be adjusted from the premium of Rs.
100,000 on common stock in the interval column and net balance of premium of
Rs. 50,000 on Common Stock would be reported in the stockholders’ equity apart
from the other contents.

6.3.4 Issuing No-Par Value Stock

When the shares are issued, without its denomination of par or face value, the
entire proceeds collected on sale are credited to the common stock capital without
recognition of any discount or premium. The Companies Act, 2017 does not
contain any provision for issuance of no par value stock in Pakistan. However,
on-par shares were first authorized by the New York State during 1912 and at
present are authorized in nearby all of the States as well as in Canada. The
objectives of no-par shares was to combat abuses of the investing public at the
hands of exploiting and unethical practices by some promoters and to eliminate
complicated accounting for discount on issue of shares. To illustrate, a company
records the issuance of 1,000 Common Stock of no-par for Rs. 80 each at cash,
the following accounting entry will be recorded:-
Date Particulars Dr Cr
10-03-20 Bank Account Rs. 80,000
Common Stock(No-Par Value) Rs. 80,000

6.3.5 Issuing Stated Value Stock

In case no-par stock is issued and assigned a stated value, its stated value becomes
legal capital which is credited to the stated value Stock Account. Assume that the
stated value stock is issued at an amount in excess of stated value; the excess is
credited to the Paid-in Capital in Excess of Stated Value Common Stock, which is
reported in the Stockholders’ equity section. To illustrate, a company that issued
2,000 shares of no-par Common Stock having a stated value of Rs. 100 each at
Rs. 110 cash per share, the accounting entry would be recorded as per following.

Date Particulars Dr Cr
12-03-20 Bank Account Rs. 220,000
Common Stock(Rs. 100 Stated Value) Rs. 200,000
Paid-in Capital in Excess of Stated Value Common Stock Rs. 20,000

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6.3.6 Issuing Stock for Non each Assets

When Common Stocks are issued by a joint stock company in exchange for assets
other than cash, such as land, building and equipment etc, the assets so received
would be recorded at their fair market value. As an illustration, assume that on 15
May 2020, a company acquired land, Building and Equipment with a fair market
value of Rs. 8,000,000, Rs. 12,000,000 and Rs. 5,000,000 respectively in
exchange of 200,000 Common Stock with a par value of Rs. 100 each, the
transaction would be recorded as under:-

Date Particulars Dr Cr
15-05-20 Land Rs. 8,000,000
Building Rs. 12,000,000
Equipment Rs. 5,000,000
Common Stock Capital Rs. 20,000,000
Premium Common Stock Rs. 5,000,000

It may be stated that determination of the fair market value of the assets so
acquired is the responsibility of the Board of Directors of the Company. It is not
always possible to make an objective determination, but if shares are also being
issued for cash at about the same time, the cash price of the shares may provide an
indication of the proper valuation of the assets so acquired. The shares so issued
would be stated in the balance sheet as having been issued for consideration other
than cash as a fall disclosure requirement.

A Company can sometimes also issue its Common Stock to promoters in

exchange for their services and expenses incurred in the establishment of the
Company. Such costs are capitalized in the accounting record as organization
expenses and amortized over a period of three to five years gradually. Assume the
promoters claim that they have incurred an amount of Rs. 280,000 on the
registration of the company and its related documentation, the Common Stock of
2,800 of Rs. 100 each issued to the Promoters would be recorded as under:-

Date Particulars Dr Cr
20-05-20 Organization Expense Rs. 280,000
Common Stock Capital Rs. 280,000

The issuance of above Common Stock would require prior approval of the Board
of Directors of the Company. Such Organization Expenses are termed as
Preliminary Expenses and are also called as Deferred Costs of the Company.

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6.4 DIVIDENDS AND ITS CLASSIFICATIONS

The profitable earnings which are distributed to the Stockholders are called as
dividends. The Companies Act, 2017 provides that the dividends shall be paid
only from profits. This means that is case of loss there would be no payment of
dividend. The authority to distribute earnings to the stockholders rests with the
Board of Directors usually in its meeting, the Board of Directors, based upon the
periodic earnings; recommend payment of a specific amount or percentage of
dividend on Share Capital. This is finally approved by the shareholders in its
annual general meeting (ASM). The stockholders have the right to reduce the
amount of dividend but cannot increase the dividend as recommended by the
Board of Directors. A Company can make no guarantee that its business activities
would definitely be profitable. Hence it cannot guarantee dividends to its common
stockholders. Further, the directors have wide range of discretionary powers in
determining the extent to which earnings should be retained by the company to
provide for expansion, to offset possible future losses or to provide for other
contingencies.

There are different types of dividends which a Company can distribute to its
stockholders which are deliberated as under:-

6.4.1 Cash Dividend

Based upon the recommendations of the Board of Directors of a Company, the
cash dividend may be paid to the stockholders on the list of members on a specific
date. The Cash Dividend shall depend upon the availability of liquid resources
with the company. These cash dividend provide a return to investors and almost
affect the market value of shares. The declaration date of Cash Dividend is when
it was approved by the Board of Directors for identifying those stockholders listed
in the record of the company who would be entitled for the cash dividend. The
Payment date is within forty five days of the declaration in case of a listed
company and within thirty days in case of any other company. The accounting
entries for the cash Dividend would be recorded as under:-

Date of Declaration Dr Cr
Retained Earnings Account XXX
Dividend Payable Account XXX
Date of Payment
Dividend Payable Account XXX
Bank Account XXX

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6.4.2 Interim Dividend

Depending upon the anticipated performance and projected profit of a company,
the Board of Directors can announce more than one interim dividend on the
equity shares. The directors can revoke the decision to pay interim dividend
before it is paid. The interim dividend is paid within forty five days of the
declaration approval. This interim dividend shall be adjustable from the final
dividend when approved by the stockholders in its annual general meeting. The
accounting entries for the interim dividend shall be identical to what have been
stated at Para 5.5-1.

6.4.3 Stock Dividend

The Cash dividend is purely dependent upon the availability of profits and liquid
fund resources. In case the Board of Directors finds it suitable that payment of
cash dividend would tantamount to financial crises in future for the company,
then it may be considered appropriate to issue additional own common stocks to
the existing stockholders without receipt of payment in return at a certain
proportion in lieu of the cash dividend. Such distribution of additional Common
stock is called as stock dividend. Thus overall ownership proportion of the
stockholders in a company is maintained. The stock dividends and cash dividends
are different from each other. The cash dividend reduces the assets and equity
while the stock dividend transfers some portion from retained earnings to the
Capital Stock within Owners’ equity section of the balance sheet. This is termed
as Capitalization of retained earnings. Apart from the anticipated cash crunches in
future from the cash dividends and in lieu, there of issuance of stock dividends,
there are some other administrative and economic reasons as well. One
Consideration may be to keep the market price of the shares at affordable level.
For example, if a company continues to earn profit but does not distribute cash
dividend, the market price of its Common Stock is likely to grow. Thus the
market price of such a stock may become so high that it would discourage some
potential investors to buy the stocks of such companies. Contrary to it when the
stock dividend is distributed by a company, the number of outstanding stocks is
increased which reduces the par share market price and book value. Another
aspect of issuance of stock dividend is to provide evidence by the management
that the performance of the company is going well and is expected to continue
similar better results in future as well.

The issuance of stock dividends requires accounting treatment within its owners’
equity section. In the context of explaining the treatment of stock dividend,
assume the following status of the owners’ equity section of a company at year
end on 30 June 2020. Which hand some earnings as well:-
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30 June 2020
Stockholders’ Equity
Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares of Rs. 100 each. Rs. 500,000
Premium on Common Stock Capital Rs. 100,000
Retained Earnings Rs. 100,000
Total stockholders’ equity Rs. 700,000

The Board of Directors decided on 15 August 2020 to issue stock dividend at 12%
of the outstanding Capital Stock. The market price of the shares of this Company
was at Rs. 140 each. The issuance of 600 stock dividends (5000x12%) would be
accounted for the accounting record through the following entry:-
Date Particulars Dr Cr
15-08-20 Retained Earnings Rs. 84,000
Common Stock Capital Rs. 60,000
Paid in Capital in excess of par value Rs. 24,000

The position of stockholders equity after 15-08-2020 would now appear as

under:-

Stockholders’ Equity
Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,600 shares of Rs. 100 each. Rs. 560,000
Premium on Common Stock Capital Rs. 100,000
Additional paid in Capital in excess of par value Rs. 24,000
Retained Earnings Rs. 16,000
Total stockholders’ equity Rs. 700,000

A Comparison of the stockholders’ equity before distribution of stock dividends

and after distribution of stock dividends indicates that total amount of
stockholders’ equity remained constant while its elements have changed. After
issuance of stock dividends the quantity of common stock is increased from 5,000
issued shares to 5,600 issued shares. The additional paid in capital in excess of par
value at Rs. 24,000 has been added up. This amount can also be merged with the
amount of premium on Common Stock Capital and in the accounting entry passed
on 15 August, 2020 the nomenclature of the Paid in Capital in excess of par value
will have to be changed and used as Premium on Common Stock Capital as both
these nomenclatures represent similar purposes. The balance of Retained Earnings
Account has also been decreased from Rs. 100,000 to Rs. 16,000 as an amount of
Rs. 84,000 (600 shares x Rs. 140) has been converted and capitalized in the
Common Stock and additional paid in capital from the Retained Earnings. After
issuance of the stock dividends the market value and book value of the shares of
this company would reduce from Rs. 140 each (Rs. 700,000/5,000 shares) to Rs.

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125 each (Rs. 700,000/5600 shares). This would facilitate the potential investors
to purchase share of the company at lower investment amount.

6.5 STOCK SPLITS

Another way of reducing the market value of shares on the Stock Exchanges and
enhancing potential trading of a Company’s Stock split refers to a device whereby
the face/par value of the shares is reduced by certain proportion. For instance a
company may decide through its Board of Directors a 2 for 1 stock split. When
this stock split is occurred, the Company calls for the outstanding shares from
members and in lieu thereof new shares in double quantity (in case of 2 for 1
split) are issued to them afresh. The stock split can be arranged in any proportion
like 4 for 1 or 5 for 1 etc, but the par face/stated value of shares should be
divisible without any fraction. The Stock splits thus reduces the par or stated
value per share but does not change the overall ownership of the stockholders in
the Company. We may conclude that the objectives of stock split are grossly
identical to the stock dividends.

When a Company decides stock accounting entries for calling back the earlier
stocks and issuance of fresh stocks and issuance of fresh stocks are needed
because there is no change in the owners’ equity. Only the face/stated value of
shares is changed which is usually carried through memorandum entry in the
ledgers, members register and in the balance sheet. The stock splits would need
only change in the quantity of shares and their denomination of par/stated value in
the relevant records. A stock split merely increases the number of shares. It does
not usually change retained earnings or paid in capital.

6.6 PREERRED STOCK AND ITS CLASSIFICATION

Apart from the Common Stock issuance by a corporate organization as explained
at para 6.3, the other type of stock issuance is the Preferred Stock. The Preferred
Stock issued has some attachments with regard to priority of dividend and also
payment of principal amount of Preferred stock upon liquidation of the company
after other obligations of liabilities are satisfied but before payment to the
Common Stockholders. The preferred stock has different descriptions like 15%
Preferred Stock or Rs. 14 Preferred Stock. The 15% Preferred Stock ensures that
if the preferred stock has par value of Rs. 100 each, then Rs. 15 (Rs.100 x 15%)
would be the amount of annual dividend payable to the preferred stockholders on
each share.

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In case of Rs. 14 Preferred Stock the dividend of Rs. 14 on each preferred stock
would be payable each year irrespective of the par or stated value of each such
preferred stock. Similarly some other characteristics and conditions may
frequently be added to the preferred stock in the extension of certain advantages
or in the limitations of certain rights. These privilege and restrictions are
deliberated in the classifications of preferred stock which follow.

6.6.1 Cumulative and Non-cumulative Preferred Stocks

The cumulative preferred stock carries privilege of dividend accumulation from
one year to the other. Since the dividend can only be paid out of profits, so in case
of no profit or sustain loss, the dividend on cumulative preferred stock would go
in arrears to the next year when in case of sufficient profit the priority shall be
given for payment of arrears of dividend on the cumulative preference Stock and
then current year’s dividend would be paid on preferred stock if resources of
profit can so accommodate. This facility would not be applicable on the non-
cumulative preferred stock as the specified amount or rate of dividend would be
payable to the non-cumulative preferred stock only when current year’s profit is
insufficient only the available amount at lower rates would be paid and any
deficiency would not be carried forward to the next accounting period. Further if
the company has sustained loss during current year, then neither any payment of
dividend to the non-cumulative preferred stock would be made no such dues
would be carried forward to the next accounting period for payment of dividend
of the last year. If is relevant to add here that the dividend on common stock
would become due, out of any leftover profit, if it is so decided by the board of
directors.

Following data is considered for dividend on cumulative, non-cumulative

Preferred Stock and Common Stock of a Company:-

-10% Preferred Stock cumulative 10,000 shares of Rs. 100 each.

-12% Preferred Stock non-cumulative 8,000 shares of Rs. 100 each.
-Common Stock 5,000 shares of Rs. 100 each.
Profit of year 01 Rs. 90,000
Profit of year 02 Rs. 150,000

Distribution of Profit
Year-1:- 10% Preferred Stock cumulative 10,000 x Rs. 100 = Rs. 1,000,000
Due Dividend = Rs. 1,000,000 x 10% = Rs. 100,000

The available profit of Rs. 90,000 would be paid to the 10% Preferred Stock
Cumulative and balance of Rs. 10,000 (Rs. 100,000 – Rs. 90,000) would be
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shown as arrear dividend on the cumulative preferred stock in the balance sheet of
year 1. Further no dividend on the non-cumulative 12% preferred stock would be
payable as no balance profit was available after payment of dividends on 10%
Cumulative Preferred Stock.
No Dividend would be paid to Common Stockholders as no profit was available
after payment of dividend to the 10% cumulative stockholders.

Year-2:- Profit-of Rs. 150,000

a) Dividend on 10% Cumulative Preferred Stock:
Arrear of dividend of year 1 Rs. 10,000
Dividend of year 2 Rs. 1,000,000 x 10% Rs. 100,000
Total dividend to be paid Rs. 110,000

b) Dividend on 12% non-cumulative Preferred Stock

Dividend of year 1 arrear Nil
Dividend of year 2 8,000 x Rs. 100 = Rs. 800,000 x 12% = Rs. 96,000

The dividend of year 2 works out to Rs. 96,000 but the balance profit is
amounting to Rs. 40,000 (Rs. 150,000 – Rs. 110,000). Therefore, the amount of
Rs. 40,000 only would be paid as dividend to the 12% non-cumulative Preferred
Stock while the difference of Rs. 56,000 (Rs. 96,000 – Rs. 40,000) would not be
considered as arrear liability on it.
- No dividend shall be payable on the common stock during year 2 as no
profit was available after payment of dividend to the cumulative and non-
cumulative Preferred Stocks.
- It would be observed from above tabulations that although the rate of
dividends on the cumulative and non-cumulative Preferred Stock was
specified yet dividend payment was not guaranteed as the dividend payment
was dependent upon availability of the profits.

6.6.2 Participating and non-participating 10% Preferred Stocks

The participating characteristics of the Preferred Stocks mean that in case of
excessive profits, the preferred stockholders will also share in the balance profits
after payment of dividend equal to the stated amount or percentage on the
preferred stocks and also the common stocks. This sharing of balance profit
would be based on the amount of capital contribution of the preferred and
common stockholders. The non-participating Preferred Stockholders would not be
entitled for sharing in any excessive profit and entire balance profit would go to
the common stockholders. This is further explained through the following data.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

- Participating 10% Preferred Stocks 10,000 shares of Rs. 100 each

-Common Stocks 8,000 shares of Rs.100 each
-Profit for the year Rs. 270,000

Distribution of Profit as dividend 10% Preferred Stocks 10,000xRs. 100 = Rs. 1,000,000 x 10% = Rs. 100,000
Common Stock 8000 x Rs. 100 = Rs. 800,000 x 10% = Rs. 80,000
Total dividend Rs. 180,000
Balance profit available Rs. 90,000 (Rs. 270,000 – Rs. 180,000). The balance
profit of Rs. 90,000 to be distributed amongst Preferred Stocks and Common
Stock on the basis of their Capital Contribution as under:-

-Preferred Stock Capital Rs. 1,000,000

-Common Stock Capital Rs. 800,000
Total Capital Rs. 1,800,000

Ratio Computation of balance profit

Balance Profit Rs. 90,000 X 100 = 5%
Total Capital Rs. 1,800,000
Distribution of balance profit as additional Dividend

-Preferred Stock: Rs. 1,000,000 x 5% = Rs. 50,000

-Common Stock: Rs. 800,000 x 5% = Rs. 40,000

Total Dividend payable to each category of stockholders.

10% Preferred Stock Participating

Basic dividend Rs. 100,000

Additional dividend Rs. 50,000
Total dividend Rs. 150,000

Common Stock
Basic dividend Rs. 80,000
Additional dividend Rs. 40,000
Total dividend Rs. 120,000

In case the 10% Preferred Stocks have the feature of non-participating, then these
stockholders would not be entitled to any additional dividend except that 10%
specified rate. The entire balance profit would go to the Common Stockholders.
Taking the same data, the profit is distributed as under:-

Dividend to 10% Preferred Stockholders 10,000 x Rs. 100 x 10% = Rs. 100,000
Dividend to Common Stockholders(Entire balance profit) = Rs. 170,000
Total dividend/ profit = Rs. 270,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

It would be noticed from above workings that the Common Stockholders are
virtually benefitted for sharing entire balance profit after dividend distribution at
specified rate to the non-participating Preferred Stockholders was made by the
Company. Sometimes such greater amount of dividends provide an edge to the
Common Stockholder for their sharing the risk of no dividend or at lower rate
dividend after the dividend to the Preferred Stockholders was disbursed at
specified rate.

6.6.3 Convertible Preferred Stocks

The Preferred Stocks have priority of dividend payment over others like common
stock. In case the preferred stocks are non-participating then only a specified
amount of dividend is payable on it. The preferred stocks generally do not have
the voting rights like common stocks. When the company is prospering and
significant profit is being earned then the dividends to the common stock would
definitely be higher than the specified amount or under such circumstances, the
preferred stockholders would like to exercise the option of converting their
preferred stocks into common stocks, if such option is available, so that they
could share greater amount of dividends and also exercise voting powers and play
their roles in the affairs of the company. Once the preferred stocks are converted
into common stock, they would not be allowed to revert back into preferred
stocks.

6.6.4 Redeemable Preferred Stocks

Sometimes when the Company requires funds for a specific period say for five
years or so, for execution of some specific projects, the Company may issue
redeemable preferred stock. Such stocks may be called back and retired by paying
the principal amount as stated on the face of such stocks, thus assuming no
liability for ever. The call price apart from the face value may also include some
dividends in arrears and any premium as specified at the time of issuing such
redeemable preferred stocks. The redeemable preferred stocks would be presented
in the balance sheet of the Company as long term liability instead of making part
of the equity capital.

6.7 ISSUANCE OF PREFERRED STOCK

The preferred stock may be issued by a corporate organization simultaneous to the

issuance of Common Stocks. These preferred stocks attract the investors to the

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extent that such stocks carry privilege of the dividends at specified rate or amount
and also priority on payment of principal amount on liquidation of the company
over the common stockholders. These preferred stocks contain par or face value.
The preferred stocks may be issued at par at premium or at discount likewise
common stocks. However, the capital stock structure in the balance sheet would
indicate the preferred stock with its specified privileges separately from the
common stock. In order to illustrate the accounting entries for issuance of
Preferred Stock, assume the following data.

a) Issued 4,000 15% Preferred Stocks of Rs. 100 each at par value.
b) Issued 4,000 15% Preferred Stocks of Rs. 100 each at 5% Premium
c) Issued 4,000 15% Preferred Stocks of Rs. 100 each at 8% Discount.

The accounting entries for issuance of Preferred Stocks for each alternative would
be as under:-
Sr. No. Particulars
A) Bank Account Rs. 400,000
15% Preferred Stock Capital Rs. 400,000
B) Bank Account Rs. 420,000
15% Preferred Stock Capital Rs. 400,000
Premium on Preferred Stock Capital Rs. 20,000
C) Bank Account Rs. 368,000
Discount on 15% Preferred Stock Rs. 32,000
15% Preferred Stock Capital Rs. 400,000

The equity section of the yearend balance sheet of the company indicating the
issuance of Common and Preferred stocks at par value would be as under:-

Stockholders’ Equity
-Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares at par Rs. Rs. 500,000
100 each.
-15% Preferred Stock 100,000 shares of Rs. 100 each authorized and issued 4,000 shares at Rs. 400,000
par Rs. 100 each.
-Retained Earnings Rs. 100,000
Total Equity of Stockholders Rs. 1,000,000

The equity section of the yearend balance sheet of the company indicating the
issuance of Common and Preferred Stocks at Premium would be as under:-

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Stockholders’ Equity
-Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares of Rs. Rs. 500,000
100 at par Rs. 110 each.
-15% Preferred Stock 50,000 shares of Rs. 100 each authorized and issued 4,000 shares of Rs. Rs. 400,000
100 at Rs. 105 each. Rs. 400,000
-Premium on Common Stock Rs. 100,000
-Premium on 15% Preferred Stock Rs. 20,000
-Retained Earnings Rs. 100,000
Total Equity of Stockholders Rs. 1,120,000

The equity section of the yearend balance sheet of the company indicating the
issuance of Common and Preferred Stock at discount would be as under:-

-Common Stock 100,000 shares of Rs. 100 each authorized and issued 5,000 shares of Rs. 100 Rs. 500,000
each at Rs. 90 each.
-15% Preferred Stock 50,000 shares of Rs. 100 each authorized and issued 4,000 shares of Rs. 100 Rs. 400,000
at Rs. 92 each.
-Discount on Common Stock Rs. 50,000
-Discount on 15% Preferred Stock Rs. 32,000 (Rs. 82,800)
-Retained Earnings Rs. 100,000
Total Equity of Stockholders Rs. 918,000

6.8 DEMONSTRATION PROBLEMS

DP-6.1
Modern Technology Company was established during August, 2018 with the
following authorized capital:-

-Common Stock of Rs. 10 each 500,000 shares

10% Preferred Stock of Rs. 50 each 200,000 shares

The Company issued shares as under:-

10-09-2018 50,000 Common Stock at Rs. 10 each
20-12-2018 40,000 Common Stock at Rs. 12 each
15-09-2019 20,000 Common Stock at Rs. 9 each
10-10-2019 40,000 10% Preferred Stock at Rs. 60 each
12-10-2019 100,000 10% Preferred Stock for Plant and Equipment valuing Rs. 6,000,000
30-06-2020 Earned a profit of Rs. 900,000 during the year 2019-2020 The closing balance of Accounts Receivable
amounted to Rs. 600,000 and Inventories amounted to Rs. 400,000
30-06-2020 Declared 10% dividend on Preferred and 8% dividend on Common Stock. The Accounts Payable at year
end amounted to Rs. 100,000
25-07-2020 Paid dividend to 10% Preferred and Common Stockholders

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Required:
a) Pass necessary journal entries until 30 June 2020.
b) Prepare balance sheet as at 30 June 2020
c) Pass necessary accounting entries for payment of Dividends on 10%
Preferred and Common Stocks on 25 July 2020.

Solution DP-6.1
a) Journal Entries
Date Particulars Dr Cr
10-09-2018 Bank Account Rs. 500,000
Common Stock Capital Rs. 500,000
20-12-2018 Bank Account Rs. 480,000
Common Stock Capital Rs. 400,000
Premium on Common Stock Capital Rs. 80,000
15-09-2019 Bank Account 180,000
Discount on Common Stock Capital 20,000
Common Stock Capital Rs. 200,000
10-10-2019 Bank Account Rs. 2,400,000
10% Preferred Stock Capital Rs. 2,000,000
Premium on 10% Preferred Stock Rs. 400,000
12-10-2019 Plant & Equipment Account Rs. 6,000,000
10% Preferred Stock Capital Rs. 5,000,000
Premium on 10% Preferred Stock Rs. 1,000,000
30-06-2020 Profit & Loss Account Rs. 900,000
Retained Earnings Account Rs. 900,000
30-06-2020 Retained Earnings Account Rs.788,000
Dividend Payable on Preferred Stock Rs. 700,000
Dividend Payable on Common Stock Rs. 88,000

Workings
Dividend on Preferred Stock: 40,000 + 100,000 = 140,000 x Rs. 50 = Rs. 7,000,000
Rs. 7,000,000 x 10% = Rs. 700,000
Dividend on Common Stock: 50,000 + 40,000 + 20,000 = Rs. 110,000
Rs. 110,000 x Rs. 10 = Rs. 1,100,000 x 8% = Rs. 88,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

b) Modern Technology Company

Balance Sheet as at 30-06-2020
Current Liabilities Current Assets
Accounts Payable Rs. 100,000 Cash Rs. 3,560,000
Dividend payable on 10% Preferred and Rs. 788,000 Accounts Receivables Rs. 600,000
Common Stocks
Stockholders’ Equity Fixed Assets
-Common Stock 500,000 Shares of Rs. 10 Rs. 1,100,000 Inventories Rs. 400,000
each authorized and issued 50,000 shares
of Rs. 10 each at par 40,000 shares of Rs.
10 each at Rs. 12 each and 20,000 shares
of Rs. 10 each at Rs. 9 each
-10% Preferred Stock 200,000 shares of Rs. 7,000,000 Plant & Equipment Rs. 6,000,000
Rs. 50 each authorized and issued 40,000
shares of Rs. 50 each at Rs. 60 each and
100,000 shares of Rs. 50 each at Rs. 60
each in consideration of Plant &
Equipment.
Premium on Common Stock Rs. 80,000 Rs. 60,000
Less: Discount on Common Stock (Rs.
20,000)
Premium on 10% Preferred Stock Rs. 1,400,000
Retained Earnings Rs. 112,000
Total Rs. 10,560,000 Total Rs. 10,560,000

c) Accounting Entries for Payment of Dividends

Date Particulars Dr Cr
25-07-20 Dividend Payable on Preferred Stock Rs. 700,000
Dividend Payable on Common Stock Rs. 88,000
Bank Account Rs. 788,000

DP-6.2
Shaman Trading Company had 10,000 shares of 10% Preferred Stock of Rs. 100
each and 80,000 shares of Rs. 10 par value outstanding for last several years.
During 2019 and 2020 the profits earned totaled Rs. 60,000 and Rs. 216,000 for
each year respectively.

Required
Compute the amount of dividends that must have been paid to the Preferred and
Common Stockholders each year based upon the following independent
assumptions:-
A) Preferred Stock is cumulative and non- participating.
B) Preferred Stock is non-cumulative and participating.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

SOLUTION DP-6.2
a) Dividend distribution Preferred Stock cumulative and non-participating
1) Year 2019 Profit = Rs. 60,000
10% Preferred Stock 10,000 x Rs. 100 = Rs. 1,000,000 x 10% = 100,000
Profit available Rs. 60,000 distributed to Preferred Arrear dividend Rs.
40,000 Stockholders.

2) Year 2020 Profit Rs. 216,000

10% Preferred Stock Arrear of 2019 Rs. 40,000
Current year 2020 Rs. 100,000
Total dividend Rs. 140,000
Common Stock = entire balance profit as dividend Rs. 76,000

b) Dividend distribution Preferred Stock non-cumulative and participating

1) Year 2019: Profit Rs. 60,000

-10% Preferred Stock 10,000 x Rs. 100 = No dividend as arrear because Preferred Stock is non-cumulative
Rs. 1,000,000 x 10% = Rs. 100,000
Available profit of Rs. 60,000 to be paid
as dividend to Preferred Stockholders
-Common Stockholders No dividend because on profit is available

2) Year 2020: Profit Rs. 216,000

-10% Preferred Stock (no arrear of year 2019) Rs. 100,000
Participating share of dividend Rs. 1,000,000 x 2% = Rs. 20,000
Total dividend to Preferred Stock Rs. 120,000

-Common Stock at 10% equal to Preferred Stock Rs. 800,000 x 20% Rs. 80,000
Participating share of dividend Rs. 800,000 x 2% = Rs. 16,000
Total dividend to Common Stock Rs. 96,000

Balance profit available Rs. 216,000 – Rs. 100,000 – Rs. 80,000 =Rs. 36,000 Rs.
36,000 to be distributed amongst Preferred and Common Stockholders on the
basics of their Capital ratio. Ratio
Preferred Rs. 1000,000 Rs. 36,000 x 100 = 2%
Common Rs. 800,000 Rs. 1,800,000
Total Rs. 1,800,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

6.9 TREASURY STOCK

Treasury Stock may be defined as the shares of the company which were issued in
the past but later have been purchased by the company itself to reduce assets as
well as equity of the company. A company’s reacquired own shares are called as
treasury Stock. The treasury stock is neither considered as an asset investment nor
as a UN issued stock. The treasury Stock may be held for short term or for the
longer period as decided by the boards of the directors. A company may acquire
its own stock by purchase, by acceptance in satisfaction of a claim or by donation
from stock holders. Such shares may subsequently be re sold or formally retired.
The objections for acquisition of company’s own stocks may be manifold. The
first objective can be to stop the payment of dividend on such treasury Stocks
when a company has ensued substantial profit which would be drained out with
cash resources in the shape of dividends to the stockholders. Another objective
may be to avoid a hostile takeover of the company by the beneficial stock holders.
The third purpose of treasury Stock may be to reissue such share of certain
employees as compensation. The last but not the least objective may to support
the market price of company’s own shares specifically when they are of declining
on the analogy of some economics rule of fixation of price on the basis of two
contributing factors of demand and supply. After reacquisition of Company’s own
stocks, the supply in the market is reduced whereby it supports the revival of
strong prices of the company’s shares in the market.

The shares of Capital Stock held in the treasury are not entitled for dividend and
also lose the title of voting powers or to share in the assets of the company upon
its liquidation. Further the treasury stock would also not be counted in the total
outstanding Stocks for computation of earnings per share and book value per
share.

A listed company has the powers to purchase its own shares (Treasuring Stocks)
as permitted in the companies Act 2017. However, before acquisition of Treasury
Stocks certain procedure it to be followed by it. It may commence with the
presentation of a resolution for purchase of treasury Stock before the directors in
the meeting. After its approval by the Board of directors, another approval from
the shareholders for purchase of its own shares (Treasury Stock) is arranged
through a special resolution in a general meeting of members. Such approval
would be dependent upon availability of adequate funds, against the distributable
profit from retained earnings disclosure for purchase of such shares at discount or
at premium and at competitive rates through tending. Therefore, the purchase of

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

treasury stocks requires the management of the company to exercise ethical

sensitivity because funds are being paid to specific stockholders instead of all
stockholders. Management of the company must be sure that purchase of treasury
stock transaction is in the best interest of all stock holders. The foregoing
concerns cause the company to fully disclose. Treasury Stock transaction in its
reports.

6.9.1 Purchase of Treasury Stock

When the treasury Stock is purchased it reduces the equity balance and cash
balance of the company simultaneously. The purchase of Treasury Stock can be
recorded in the accounting on cost method and par value method. In order to
demonstrate the accounting treatment of purchase of the treasury stock under both
the following data of the balance sheet of a company.

Balance Sheet as at 30 June, 2020

Liabilities Assets
Accounts payables Rs. 70,000 Cash at Bank Rs. 250,000
Dividends payable Rs. 160,000 Accounts Receivables Rs. 320,000
Equity Plant and machinery Rs. 830,000
Common stock 40,000 shares of Rs. 10 Rs. 400,000
each par authorized issued and subscribed
Revenues Reserves Rs. 200,000
Premium on common Stock Rs. 200,000
Retained Earnings Rs. 370,000
Total Rs. 1.400,000 Total Rs. 1,400,000

The Company has purchased its own 10,000 Common Stocks from the stock
exchange at the cost of Rs. 14 each. This cost naturally includes the par value of
Rs. 10 and premium of Rs. 4 each share. The accounting entry for purchase of
Treasury Stock and presentation in the balance sheet after its acquisition would be
as under:-

(a) Cost method under Cost method the total cost paid for acquisition would be
charged to the Treasury Stock.

Date Particulars Dr Cr
20-09-20 Treasury Stock Account 140,000
Bank Account 140,000
(10,000 shares X Rs. 14 each)

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Balance Sheet as at 21-09-2020

Liabilities Assets
Accounts payables Rs. 70,000 Cash at Bank Rs. 110,000
Dividends payable Rs. 160,000 Accounts Receivables Rs. 320,000
Equity Plant and machinery Rs. 830,000
Common stock 40,000 shares of Rs. 10 Rs. 400,000
each par authorized issued and subscribed
Revenues Reserves Rs. 200,000
Premium on common Stock Rs. 200,000
Retained Earnings Rs. 370,000
Less Cost of Treasury Stock 10,000 shares (Rs. 140,000)
Total Rs. 1,260,000 Total Rs. 1,260,000

The purchase of Treasury Stock under cost method has reduced the overall equity
by Rs. 140,000 which was the cost of treasury stock and the cash balance has also
simultaneously been reduced by this amount.

(B) PAR VALUE METHOD

When the par value method is applied for accounting the acquisition of Treasury
Stock, then the par value and any premium paid would separately be treated and
incorporated in the record. Taking the same data of balance sheet and purchase of
Treasury Stock as at the preceding illustration at cost method, the accounting
treatment under par value method would be as hereunder:-

Date Particulars Dr Cr
20-09-20 Treasury Stock 140,000
Bank Account 140,000

10,000 shares X Rs. 10 par Value Rs. 100,000

Premium on 10,000 shares Rs. 40,000
Total Rs. 140,000

The above indication of composition of the purchase of treasury stock would

facilitate appropriate treatment and presentation in the Balance Sheet as under:-

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Balance Sheet as at 21-09-2020

Liabilities Assets
Accounts Payables Rs. 70,000 Cash at Bank Rs. 110,000
Dividends Payable Rs. 160,000 Accounts Receivables Rs. 320,000
Equity Plant & Machinery Rs. 830,000
Common Stock 40,000 shares of Rs. 10 Rs. 400,000
each par authorized, issued and Subscribed

Less Treasury Stock 10,000 shares of Rs. Rs. (100,000)

10 par
Revenue Reserve Rs. 200,000
Premium on Common Stock Rs. 200,000
Less Premium paid on Treasury Stock Rs. (40,000)
Retained Earnings Rs. 370,000
Total Rs. 1,260,000 Total Rs. 1,260,000

The purchase of treasury stock and accounting treatment under par value method
has reduced the par value of common stock and the premium of common stock
separately as was paid on its acquisition to reflect impact of each content in the
equity. Further the cash balance has also been reduced by the total purchase
consideration of treasury stock.

It may be noted that in both the methods of acquisition of treasury stock, the
accounting entry for purchase is similar, while there is only a different treatment
of presentation of the treasury stock in the balance sheet under both the methods.
However, there is no change in the assets and equity of the company on not shell
basis under the cost method and under the par value method of presentation of
treasury stock.

The presentation of treasury stock on the balance sheet under both the methods
exhibits that two disclosures are evident. First the common stock description
indicates that 10,000 shares are held in treasury learning a balance of 30,000
shares outstanding description of retained easing balance stands partly restricted
to the extent of total amount paid on the acquisition of treasury stock which works
out to Rs. 140,000 against the total available balance of Rs. 370,000. This means
that in case the dividend is to be paid to stockholders, the retained earnings
balance to the extent of Rs. 140,000 is not to be used for the purposes of dividend
distribution.

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6.9.2 Reissue of Treasury Stock

As annotated at para 6.1 regarding objectives behind the acquisition of treasury
stocks by the company, it is evident that ultimately the treasury stock is not
permanently retained by the company. As soon as the specific purposes are
achieved, usually the treasury stock is disposed off. The major course of its
disposal is sale in the market. The usual accounting entry would be to debit Bank
Account when cash is collected and the treasury stock Account would be credited
and any gain or loss on its reissue would be credited or debited to Retained
Earnings Account respectively as the case may be. These fluctuations of selling
treasury stock at cost, above cost or below cost are deliberated in the ensuing sub-
paragraphs.

(a) Selling Treasury Stock at Cost

When the treasury stock is reissued/sold at cost, the original entry when it was
purchased is reversed. In this respect the accounting entry for purchase of treasury
stock was recorded as at such para 6.2-1 whereby 1,000 common stock were
purchased at Rs. 140,000. When now on 15 October 2020 these 1,000 Common
Stock are sold at the same price of Rs. 140,000, the following accounting entry
will be recorded:-

Date Particulars Dr Cr
15-10-20 Bank Account Rs. 140,000
Treasury Stock Account Rs. 140,000

After this accounting entry the cash at Bank Account would be enhanced by Rs.
140,000 and the negative balance of treasury stock shown in the equity section of
balance sheet would be eliminated and the balance sheet figures would be
revived.

The foregoing situation may be termed as ideal phenomena when no change in the
market price of common stock was registered. Usually the prices of common
stock fluctuate time and again an even in a day these may change several times.
Therefore, accounting treatment of reissue of treasury stock at above or below
cost is explained in the forthcoming sub-paragraphs.

(b) Selling Treasury Stock at above Cost

Apart from other objectives for acquisition of treasury stock, the basic purpose is
to support the market price of company’s own stock being traded at stock
exchanges. When the market price of stock is declining some shares are
purchased by the company which is later sold when the prices have become

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stable. In this way the company can earn some gain on disposal of treasury stock
provided adequate funds in working capital are available. This situation is
categorized as sale of treasury stock at above cost. The gain due to difference in
cost and sale price is considered to the retained earnings account through profit
and loss account. Taking the same data of purchase of 1,000 common stock at Rs.
140,000, if later these are sold at Rs. 160,000 on 15 October 2020 the accounting
entry and presentation in the balance sheet would be reflected in the following
manner:-

Date Particulars Dr Cr
15-10-2020 Bank Account Rs. 160,000
Treasury Stock Account Rs. 140,000
Gain on sale of Treasury Stock Account Rs. 20,000

The above entry would enhance the balance of cash at Bank Account, eliminate
the negative balance of treasury stock in the equity section of balance sheet and
would increase the balance of retained earnings account by Rs. 20,000 as
ultimately the gain on sale of treasury stock would be closed in this account
through profit and loss account. Afterwards the contents of original balance sheet
dated 21-09-2020 would describe the changes in balance of effected accounts and
would show the following reused position as at 16 October 2020:-
Balance Sheet as at 16 October, 2020.
Liabilities Assets
Accounts Payable Rs. 70,000 Cash at Bank Rs. 270,000
Dividends Payable Rs. 160,000 Accounts Receivable Rs. 320,000
Equity Plant & Machinery Rs. 830,000
Common Stock 40,000 shares of Rs. Rs. 400,000
10 each par authorized, issued and
subscribed
Premium on Common Stock Rs. 200,000
Revenues Reserves Rs. 200,000
Retained Earnings Rs. 390,000
Total Rs. 1,420,000 Total Rs. 1,420,000

(c) Selling Treasury Stock at below cost

Occasionally, rather in certain situations frequently, when the economic
conditions in the country are deteriorating and general business phenomena is
declining, because of international economic slumps , exercise rains, war threats
across the borders, decline in purchasing power of public, sustained losses by the
business enterprises, decline in production and consumption of consumable
products, climate droughts and multiple other identical factors, the prices of
stocks on the stock exchange are also adversely affected whereby the investments
by several investors are treasury stock and its declining prices are not expected to
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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

grow, it is considered expedient , in order to avoid bear greater loss the treasury
stocks are disposal off at below the cost. In case the 1,000 common stocks which
were purchased at Rs. 140,000 are later on 15-10-2020 sold at Rs.115,000 i.e.
below the cost, the accounting entry would be passed as under:-

Date Particulars Dr Cr
15-10-20 Bank Account Rs. 115,000
Loss on disposal of Treasury Stock Rs. 25,000
Treasury Stock Account Rs. 140,000

As against the cost of Rs. 140,000 for purchase of the treasury Stock, these have
been sold at Rs. 115,000 sustaining the loss of Rs. 25,000 on this transaction. This
loss would be charged to the periodic profit and loss account against the retained
earnings by decreasing its total balance. After this transaction of sale of treasury
stock below the cost, the balance sheet contents as at Para 6.2-1 would be
modified and would reflect the following position as at 16 October, 2020:-

Balance Sheet as at 16 October, 2020.

Liabilities Assets
Accounts Payables Rs. 70,000 Cash at Bank Rs. 225,000
Dividends Payables Rs. 160,000 Accounts Receivables Rs. 320,000
Equity Plant & Machinery Rs. 830,000
Common Stock 40,000 shares of Rs. Rs. 400,000
10 each par authorized issued and
subscribed
Premium on Common Stock Rs. 200,000
Revenue Reserves Rs. 200,000
Retained Earnings Rs. 345,000
Total Rs. 1,375,000 Total Rs. 1,375,000

It would be observed from the modified balance sheet dated 16 October, 2020 as
presented above as compared with the balance sheet dated 21 September 2020 the
cash balance is increased by Rs. 115,000 being the sale proceeds of treasury
stock, the retained earnings balance is reduced by Rs. 25,000 being the loss on
sale of treasury stock at lesser than its cost, which the reduction of treasury stock
balance of Rs. 140,000 would altogether be eliminated from equity section of the
revised balance sheet dated 16 October, 2020 after its disposal.

It is relevant to add here, that some school of thoughts do not support to reflect the
gain or loss on sale of treasury stock directly in the profit and loss account and then
into retained earnings account. They usually support to use directly the retained
earnings account or the premium on common stock Account in case of adjustment

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of gain or loss on disposal of the treasury stocks. However, it depends upon the
policy of the company to adopt any course of treatment of such gain or loss.

6.10 RETIRING STOCK

The companies Act, 2017 allows that the capital stock can be reduced or retired
without prejudice to the claims of creditors on the company and if the articles of
association permit by doing so and a special resolution to this effect is passed.
The stock can be retired to the extent of unpaid share capital, lost or
unrepresented assets (in case of assets lost by fire etc) and any excessive capital
which cannot beneficially be used by the company for profitable business
activities. The retirement of capital stock against any excessive capital, already
issued can be performed through its purchase as treasury stock and then its formal
retirement and elimination from the issued capital stock. Thus the retired stock
reduces the number of issued shares. When Treasury Stock is purchased with the
objectives of its retirement, all its related accounts is removed. In case the
purchase price of stock is greater than its issued price, the difference is debited to
the retained earnings and vice versa. Further, if the net amount removed from
capital accounts exceeds the purchase price of Stock, this excessive amount is
credited to the premium on common stock account of equity section. The cash
balance of company would be reduced parallel to the reduction in equity balance
for the retiring stock of the company.

In order to illustrate the accounting assume the same data as was taken previously
when the treasury stock was purchased and accounted for in the books at cost
method. Later the company has decided to retire the capital stock to the extent of
treasury stock. The accounting treatment for the retirement of stock and the status
of balance sheet would represent as under:-

Date Particulars Dr Cr
25-09-2020 Capital Stock Accounts Rs. 100,000
Premium on Common Stock Account Rs. 40,000
Treasury Stock Rs. 140,000

The Company had originally issued the common stock of Rs. 10 par value at Rs.
15 which included Rs. 5 as premium on each common stock. This is evident from
the total Premium on Common Stock of Rs. 200,000 for 40,000 common issued,
for which the premium per share words out to Rs. 5 (Rs. 200,000/40,000 shares).
The capital stock account is being debited by the same amount of Rs. 10 per share
of 10,000 common stock totaling to Rs. 100,000 at which price the capital stock

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

account was originally credited at par value. The premium of Rs. 40,000 paid for
acquisition of 10,000 common stock (Rs. 4per share) is being debited to the
premium on common stock account to remove its corresponding balance of
premium while the difference amount of Rs. 10,000 (Rs. 50,000-Rs. 40,000) will
remain in the premium on common stock. This is in fact a gain from issuance and
retirement of capital stock which would be treated as capital gain instead of
treating it as revenue income for crediting it to the retained earnings account.
However, in case of some loss on acquisition of treasury stock and then its
retirement the same can be debited to the retained earnings account as a
conservative approach. The balance sheet of the company after retirement of 10,000
common stocks as annotated in the foregoing portion would appear as under:-

Balance Sheet as at 26-09-2020

Liabilities Assets
Accounts Payables Rs. 70,000 Cash at Bank Rs. 110,000
Dividends Payable Rs. 160,000 Accounts Receivables Rs. 320,000
Equity Plant & Machinery Rs. 830,000
Common Stock 40,000 shares of Rs. 10 Rs. 300,000
each par authorized, issued and
subscribed 30,000 shares of Rs. 10
each par (10,000 shares retired)
Premium on Common Stock Rs. 160,000
Revenue Reserves Rs. 200,000
Retained Earnings Rs. 370,000
Total Rs. 1,260,000 Total Rs. 1,260,000

This balance sheet is different from the balance sheet as presented as para 6.2-1
on the following three aspects:
a) The issued and subscribed common stock is reduced from Rs. 400,000 to
Rs. 300,000 after retirement of 10,000 common stock of Rs. 10 each par
value.
b) The premium on common stock reduced from Rs. 200,000 to Rs. 160,000
for the amount of Rs. 40,000 on account of premium paid on acquisition of
10,000 common stock and subsequently retired.
c) The cost of treasury stock of Rs. 140,000 shown as negative balance is
eliminated after retirement of 10,000 common stock. However, the total
balance of assets and liabilities with equity are corresponding to each other.

6.11 REPORTING OF EQUITY

The owners’ equity in a company is commonly called as stock holders’ equity,
shareholders’ equity, shareholders’ investment or capital of owners. Generally the

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

stockholders’ equity comprises the contributions in a corporate business

enterprise by owners in shape of cash resources and fixed assets. The company in
turn issues common stock alternatively called as ordinary shares and also
Preferred Stocks. The redeemable preferred stocks are usually not included in the
equity rather these are reported as long term liabilities. The equity also includes
some reserves created out of past profit, premium on issuance of capital stock and
also the balance of retained earnings after deduction of prepared dividends. All
the assets held in an enterprise are usually acquired out of the current and long
term liabilities and also through owners’ equity.

6.11.1 Statement of Retained Earnings

The retained earnings are an integral part of the owners’ equity of a corporate
enterprise. After determination of periodic net income or loss through preparation
of the Profit and Loss Account as Income Statement the resultant balance of net
income is transferred to the statement of retained earnings. This amount is added
up in the opening balance of retained earnings brought forward from the last
year’s closing balance of retained earnings. Out of the total balance available
from the retained earnings any prior years’ adjustments directly affecting the
besides any amount of profits decided by the management for appropriation
towards revenue and capital reserves, to be used in future for meeting any revenue
requirements or for expansion of business activities and acquisition of fixed
assets, is deducted from it. Further the amount of dividends in the shape of
interim, cash and stock dividend approved by the board of Directors is deducted
from the balance of retained earnings and its net closing balance is reported in the
equity section of the balance sheet of the company. A usual format of the retained
earnings statement of a company can be presented in the following manner:-

Statement of retained earnings as at 30-06-2020

Opening balance Rs. 212,000
Less: Prior year’s loss on valuation of inventories damaged Rs. (10,000)
Net balance as on 01-07-2019 Rs. 202,000
Add: current year’s net income as per income statement Rs. 528,000
Total earnings available Rs. 730,000
Less: Amount set aside for revenue reserves 200,000 proposed dividends on common stocks Rs. (360,000)
Closing balance as on 30-06-2020 Rs. 370,000

The amount of proposed dividend would be reported as current liability in the

balance sheet as at 30 June, 2020 while the closing balance of Rs. 370,000 of the
statement of retained earnings would be included in the equity section of the stock
holders in the balance sheet as at 30 June, 2020 of the company.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

6.11.2 Statement of Stockholders’ Equity

During conduct of business activities, several transactions relating to the owners’
equity section of the balance sheet of a company affect the total equity of the
enterprise. Instead of portraying such changes and adjustments in the body of the
owners’ equity section of the balance sheet, to avoid its complicated presentation,
a separate statement of stockholders equity is prepared by most of the
organizations to indicate the workings of each figure of the stockholders equity.
Based upon the data in the foregoing deliberations of the company the statement
of stockholders’ equity may be drawn as per following:-

Statement of Stockholders’ Equity for 2019-20

Particulars No. of Amount of Premium Revenue Retained Total Balance
Common Common Common Reserves Earnings
Stocks stock at par Stock
Opening Balance on 01-07-20 Rs. 40,000 Rs. 400,000 Rs. 200,000 - Rs. 212,000 Rs. 812,000
Less: Acquisition of treasury (Rs.10,000) (Rs.100,000) (Rs.40,000) - - (Rs. 140,000)
stock and retirement
Less adjustments of Retained - - - - (Rs. 10,000) (Rs. 10,000)
Earnings of last year
Add Net income for year - - - - Rs. 528,000 Rs. 528,000
Amount Allocated to revenue - - - Rs. 200,000 (Rs.200,000) -
reserves
Prepared dividends - - - - (Rs.160,000) (Rs. 160,000)
Closing balance as on 30-06-20 Rs. 40,000 Rs. 300,000 Rs. 160,000 Rs. 200,000 Rs. 370,000 Rs. 1,030,000

The above Comprehensive Statement indicates the moments in Stockholders’

equity during the year 2019-20. It has been started with the opening balances of
various contents and the changes occurred during the year for each item has been
presented in it. The closing balance of each content would be presented in the
stockholders equity section of the balance sheet prepared as at 30 June, 2020 of
the enterprise. It would be noted that all the above details could not be presented
in the body of balance sheet; hence preparation of separate statement was
necessitated.

6.11.3 Reporting Stock Options

The Stock Option means some entitlement granted to certain group of employees
of the organization to purchase some stock of the company during subsequent
period of time say 5 years to 10 years at a predetermined price. The objectives to
issue stock options is to motivate managers and employees to focus on better
performance of the company, continue to serve the company for longer period and
participate in the profitability of the enterprise. This stock option provided to the
employees is like an opportunity of investment with no risk of loss, available with

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

employees which can be exercised. In order to illustrate the exercise of stock

options, assume that a company has, at the time of their recruitment, provided
stock options to employees to purchase 10,000 shares of the company of the par
value of Rs. 10 at Rs. 50 each during succeeding 5 years. The employees would
definitely exercise the available option of purchase of stocks during any time over
5 years when the market price of such stocks is exceeding Rs. 50 and get benefit
of price escalation of stocks apart from dividends on it. If the market price of such
stock during 5 years period is lesser than Rs. 50 each share, they will never
exercise such options available with them and would let them expire.

From the accounting point of view when stock options are allowed to the staff at
their recruitment, only memorandum indication is made in the stockholders ledger
about such granted options. However, over the period of time of exercising the
stock options when the pricing trend of stocks is escalating in the market then any
difference in the stock option price and the market price is charged as staff
salaries expense account over some years proportionally and credited to the
obligations for stock options account. When such stock options are exercised the
obligation of stock option account is squared off and the par value of stocks with
premium on it is included in the subscribed and issued capital and the Premium on
Common Stock Account respectively. This is further illustrated through an
example. A company had issued options for purchase of common stock of Rs. 10
each par value at Rs. 50 each during next 5 years by the staff. This position would
be indicated in the capital stock ledger as memorandum information. The staff
would not exercise the option of stock purchase till the market price is up to Rs.
50 per common stock. However, when the market price exceeds Rs. 50 per
common stock, then the chances for exercise of stock option purchase by the staff
becomes definite due to financial benefits to the staff. In case the market price of
common stock during third year has reached at Rs. 70 each, now the option for
purchase of common stock by employees from the company would be definite.
Therefore, the company would incorporate the following entry into accounting
record to recognize this obligation:-
Date Particulars Dr Cr
15-08-2024 Staff Salaries Expense Account Rs. 200,000
Stock Option Obligation Account Rs. 200,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

When the stock purchase option is exercised the following accounting entry
would be passed:-

Particulars Dr Cr
20-09-2024 Bank Account Rs. 500,000
Stock Option Obligation Account Rs. 200,000
Capital Stock Account Rs. 100,000
Premium on Capital Stock Account Rs. 600,000

The Staff salaries expense account will be closed into periodic profit and loss
account while the stock option obligation account would be adjusted when the
common shares are issued to the staff.

6.12 DEMONSTRATION PROBLEMS

DP-6.3
The stockholders’ equity section information of the balance sheet of ABC
Company as on 30 June, 2020 was as under:-

Stockholders’ Equity
50,000 common stock of Rs. 10 each par authorized and 40,000 common stock of Rs. 10 each par Rs. 400,000
subscribed and issued at Rs. 20 each.
Premium on Common Stock Rs. 400,000
Retained Earnings Rs. 500,000
Total equity Rs. 1,300,000

The following transactions took place during July-August 2020:-

a) On 15 July, 2020 the management decided to purchase 15,000 common
stocks from the market at the prevailing price of Rs. 25 each.
b) On 25 July, 2020 the Board of Directors decided which was approved in the
annual general meeting to declare and pay cash dividend of Rs. 3 per
common stock on the record date of 20 July, 2020.
c) On 30 July, 2020 the management decided to sell remaining 4,000 common
stock at Rs. 30 each.

Required
1) Record the above transactions in the books of accounts of the comparing.
2) Present the Stockholders’ Equity section of the balance sheet of the
company as at 31 August, 2020.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Solution DP.6-3
i) General Journal Entries
Date Particulars Dr Cr
15-07-20 Treasury Stock Account Rs. 375,000
Bank Account Rs. 375,000
25-07-20 Retained Earnings Rs. 75,000
Dividends Payable Rs. 75,000
25-07-20 Dividends Payable Rs. 75,000
Bank Account Rs. 75,000
30-07-20 Bank Account Rs. 125,000
Treasury Stock Account Rs. 125,000
10-08-20 Bank Account Rs. 132,000
Loss on disposal treasury stock Rs. 18,000
Treasury Stock Account Rs. 150,000
10-08-20 Retained Earnings Account Rs. 18,000
Loss on disposal of treasury stock Rs. 18,000
20-08-20 Bank Account Rs. 120,000
Treasury Stock Account Rs. 100,000
Gain on disposal of Treasury Stock Rs. 20,000
20-08-20 Gain on disposal of treasury stock Rs. 20,000
Retained Earnings Account Rs. 20,000

ii. Past Balance Sheet as at 31 August 2020

Stockholders’ Equity
50,000 common stock of Rs. 10 each par authorized and 40,000 common stock of Rs. 10 each par Rs. 400,000
subscribed and issued at Rs. 20 each.
Premium on Common Stock Rs. 400,000
Retained Earnings Rs. 427,000
Total Stockholders’ equity Rs. 1,227,000

The balance of Retained Earnings is computed as under:-

Opening balance as per balance sheet as at 30 June, 2020. Rs. 500,000
Less: Dividend declared Rs. (75,000)
Less on disposal of treasury stock Rs. (18,000)
Add: Gain on disposal of treasury Stock Rs. 20,000 (Rs. 73,000)
Closing balance as at 31 August 2020 Rs. 427,000

DP- 6.4
Following was the stockholders’ equity information of the balance sheet of
Subhan Enterprise, Labor as at 30 June, 2019:-

Stockholders’ Equity
Common stock 200,000 of Rs. 50 each par value authorized and 120,000 common stock of Rs. 50 Rs. 6,000,000
each par subscribed and issued at Rs. 60 each.
Premium on Common Stock Rs. 1,200,000
Retained Earnings Rs. 2,250,000
Total Stockholders’ equity Rs. 9,450,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

During July, 2019 following transactions food place by the company:-

15 July 2019 The Company declared a cash dividend of Rs. 8 per common stock.
20 July 2019 a revenue reserve of Rs. 600,000 was created from the retained
earnings.
10 August 2019 the Company acquired its own common stock of 20,000 from the
market at Rs. 55 each.
05 September 2019 The Company decided to retire the Treasury Stock of 20,000
common shares acquired from the market as sufficient liquid surplus funds were
available.

Required
A) Pass necessary accounting entries for the above transactions.
B) Prepare Retained Earnings Account as at 30 September, 2019.
C) Draw the stockholders’ equity section of the balance of the Company as at
30 September, 2019.

Solution
A) General Journal
Date Particulars Dr Cr
15-07-19 Retained Earnings Account Rs.960,000
Bank Account Rs. 960,000
20-07-19 Retained Earnings Account Rs. 600,000
Revenue Reserve Account Rs. 600,000
10-08-19 Treasury Stock Account Rs. 1,100,000
Bank Account Rs. 1,100,000
05-09-19 Capital Stock Rs. 1,000,000
Premium on Common Stock Rs. 100,000
Treasury Stock Rs. 1,100,000

B) Retained Earnings Account as at 30 September, 2019

15-07-19 Dividend Payable Rs. 960,000 01-07-19 Opening Balance Rs. 2,250,000
20-07-19 Revenue Reserve Rs. 600,000
30-09-19 Closing Balance Rs. 690,000
Total Rs. 2,250,000 Total Rs. 2,250,000

C) Stockholders’ Equity (30-09-2019)

Common stock 200,000 of Rs. 50 each par value authorized and 100,000 common stock of Rs. 50 Rs. 5,000,000
each par subscribed and issued at Rs. 60 each, 20,000 Common Stock acquired as treasury stock
at Rs. 55 each and retired.
Premium on Common Stock Rs. 1,100,000
Revenue Reserve Rs. 600,000
Retained Earnings Rs. 690,000
Total Stockholders’ Equity Rs.7,390,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

6.13 SUMMARY
Larger growth in business activities specifically undertaking mega projects
originated development of corporate form of business organizations through
which capital was contributed by public at large. Such corporate organizations are
governed under Companies Act, 2017. Their affairs are regulated to safeguard
interest of investors and owners of such companies by the Securities and
Exchange Commission of every country.

According to the memorandum of association the authorized Capital with

different classification of shares of the Company is issued from time to time upon
receipt of payment. Usual Classification of Stock Comprise Common Shares and
Preference shares. Some specific privileges and priorities of dividend and
payment of principal amount, upon liquidation of Company, are attached to the
Preferred Stock. The shares can be issued at Par, at Discount and at Premium.
These shares can also be issued against initial services and expenses of promoters
for establishment of the company and also in lieu of certain assets acquired by the
company for use in the business against which no cash payment was made.

The dividends are paid by the Company out of the project earned by Company for
which first priority is given to the Preferred Stockholders and then to the
Common Stockholders. The dividend can be paid in cash or in additional stocks
as decided by the Board of Directors of the company. Sometimes when the prices
of shares are considered to be greater and it is curtailing the potential investors to
trade the stocks splits are allowed by the Board of Directors. The stock split
means reducing the par value of shares in certain proportion for example stock
split may be 2 : 1 which indicates the as against one share of Rs. 100, the
Company will issue two shares of Rs. 50 each, against surrender of the one share
of Rs. 100. No accounting entries are needed upon stock split rather memorandum
record is amended to give effect of stock split and quantity of issued shares is
enhanced in record.

The Joint Stock Companies, where stocks are traded at stock exchanges,
sometimes, in order to avoid release of dividends when colossal amount of profit
has been earned, support market prices when its prices are declining, acquire
some shares for distribution to its employees and impede the hostile objectives of
some group of investors. The acquisition of Company’s own shares is classified
as treasury stock. It is neither an investment nor reduction in shares capital of the

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

company. After attaining the specified objectives these treasury stocks are sold in
the market. When the treasury stocks are acquired, the price paid is shown as
negative balance in the equity section of balance sheet of the company. Later
when these treasury stocks are sold out, which may be equal to its purchase price,
above the purchase price or below the purchase price the resultant gain or loss is
adjusted against the retained earnings.

Further, after acquisition of treasury stock when the company has sufficient liquid
resources and do not require so much capital, such treasury stock may be retired
and the subscribed and issued capital may be reduced.

The equity section of balance sheet of the company comprises the capital stock
issued at par value, premium on issue of shares at above the par value and
discount on issue of shares at below the par value. The discount will be a negative
balance. Apart from it, any capital and revenue reserve created out of profits in
the past or current period would also be a part of the equity. Besides the balance
of retained earnings, after distribution of dividend to shareholders, would also be
a part of the equity.

Sometimes while recruiting certain staff the company may grant then entitlement
to purchase the shares of the company at some specified price over some period of
time. The objectives of stock option is to inspire such staff to stay with the
company for longer period of time, motivate than to focus on better performance
of the company for participation in the profit of the company and their feelings for
their ownership in the company. Such stock options are definitely exercised by
the staff when market prices are greater than the specified price at which the stock
option was given by the company. In case the market price of shares is lesser than
the specified price of stock option then it would never be exercised by the staff.
Any difference in stock option price and the market price would be charged by the
company to staff salaries expense account.

6.14 THEORETICAL QUESTIONS

1. Describe the nature of a corporate form of Organization, its functions and
advantages and disadvantages.
2. Explain the authorized capital, subscribed and issued Capital of a Company.
3. What do you understand by par value, no par value, market value and stated
value of Common Stocks?

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

4. What is the basic distinction between the Common Stock and Preferred
Stock?
5. Describe the issuance of Stock at par, at premium and at discount with
accounting entries on presumptive values in each case.
6. Can the shares be issued by a Company other than cash? If so, describe the
situations and considerations suited in each case.
7. Explain the various alternatives available with the management of a
company to distribute profit in the share of dividends and accounting entries
involved in each case.
8. Describe the objectives and procedure adopted for Stock Splits and
accounting entries needed in it.
9. Describe the various classifications of Preferred Stocks in the context of
dividends and payment of principal amount on liquidation of a Company.
10. Explain comprehensively about the redeemable and irredeemable Preferred
Stocks and how each category is presented in the balance sheet of the
organization.
1. What do you understand by treasury stock, what are its objectives for
acquisition?
2. State as to how the treasury stock is treated in the books of accounts of the
company.
3. Describe the accounting treatment of disposal of treasury stock at cost,
above the cost and below the cost.
4. Explain to what extent the treasury stock can be acquired by a company.
5. Describe as to why the treasury stock is not treated as an investment in the
accounting record likewise on the purchase of stocks of other companies.
6. Can the treasury stock be used for retiring of capital stock of the company?
7. What are the contents of the Retained Earnings statement of a company?
8. Describe comprehensively the composition of stockholders’ equity of a joint
stock company.
9. What do you understand by the term stock options and its objectives?
10. What accounting disclosure and treatment is mandatory for stock options
offered by the company and when these options are exercised.
11. Explain the circumstances when the stock options would be exercised.
12. Is it possible that stock options would definitely be exercised beneficiaries?

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

6.15 PRACTICAL PROBLEMS

P.6-1
Shehzad Energy Ltd was established some time back with an authorized capital of
100,000 Common Stocks of Rs. 100 each. The company invested applications for
issuance of 50,000 shares through is prospectus. The applications accompanied
50% advance payment. The Company received subscriptions for 60,000 shares on
15 March 2020. The Board of Directors decided to accept the applications on 31
March 2020. On 15 April, 2020 the balance 50% payment was received from the
successful applicants.
The shares were allotted on 30 April, 2020.

Required
a) Prepare accounting entries to record the above events.
b) Present Balance Sheet of the Company as it would appear on 30 April, 2020.

P.6-2
Fresh Poultry Ltd was organized on 05 July, 2019 with the following authorized
capital:-
a) Common Stock 50,000 of Rs. 100 each.
b) 12% Cumulative Preferred Stock 50,000 of Rs. 50 each.

The Company issued 50% of each category of shares upon receipt of Cash on 15
August, 2019 at par value. The 20% shares of each category were issued upon
receipt of cash with premium of 15% on each share on 20 December, 2019. The
Company also issued 10,000 Common Stock against the acquisition of some
machinery valuing Rs. 1,200,000.

Required
a) Pass necessary accounting entries
b) Prepare a Balance Sheet as at 30 June, 2020.

P.6-3
Sunshine Company was established some year back with an authorized capital of
500,000 Common Stocks of Rs. 50 each.

Required
1. Prepare journal entries in each of the following assumptions:-
a) 300,000 Common Stocks are issued at par value.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

b) 300,000 Common Stocks are issued at 10% premium.

c) 300,000 Common Stocks are issued at 5% discount.
2. Present equity section of the stockholders in Balance Sheet under each of
the above assumptions.

P.6-4
The stockholders equity section of the Balance Sheet of Mahnoor Products
Company appeared as under at the close of its third year of trading activities as on
30 June, 2020:-
Common Stock 50,000 shares of Rs. 100 each authorized and issued 30,000 shares of Rs. 100 at Rs. Rs. 3,000,000
120 each.
10% Preferred Stock 20,000 shares of Rs. 100 each authorized and issued 10,000 shares at Rs. 100 Rs. 1,000,000
each
Premium on Common Stock Rs. 600,000
Retained Earnings Rs. 600,000
Total equity Rs. 5,100,000

The following transactions were completed during 2020 -21:

1) Declared 10% Stock dividend on 15 July 2020 to the Common Stockholders
and issued accordingly on 12 August 2020.
2) Declared cash dividend on 15 July, 2020 to the Preferred Stockholders and
paid it on 15 August 2020.
3) Issued 5,000 additional Common Shares on 18 August 2020 at discount of
5% on payment.

Required
a) Pass necessary accounting entries for the above transactions.
b) Stock split 2 : 1 of Common Stocks was approved and completed on 30
August 2020.

P. 6-5
Shahzeb Manufacturing Company had issued 50,000 12% Preferred Stocks of Rs.
50 each and 20,000 Common Stocks of Rs. 50 each. The Company earned a profit
of Rs. 595,000 and Rs. 250,000 during first year and second year of operation
respectively.

Required
Based upon the above data, compute the amount of dividends to be paid to the
12% Preferred Stockholders and the Common Stockholders under each of the
following independent assumptions:-
a) The 12% Preferred Stock is cumulative and participating

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

b) The 12% Preferred Stock is non-cumulative and non participating

c) The 12% Preferred Stock is cumulative and participating up to 15%

P.6-6
The draft equity sections of the Balance Sheet of Decent Trading Company at the
years ended on 30 June 2019 and 2020 were as under:-

a) Stockholders’ equity 30-06-2019

-Common Stock Rs. 10 par value, 50,000 shares authorized and 20,000 shares issued. Rs. 200,000
-Premium on Common Stock Rs. 100,000
-Retained Earnings Rs. 150,000
Total Rs. 450,000

b) Stockholders’ equity 30-06-2020

-Common Stock Rs. 10 par value, 50,000 shares authorized and 30,000 shares issued. Rs. 300,000
-Premium on Common Stock Rs. 120,000
-Retained Earnings Rs. 200,000
Total Rs. 620,000

Following Transactions were conducted

1. On 20 July, 2019 the company declared a dividend of Rs. 2 to each of the
common stockholders.
2. On 10 August 2019, the dividend declared on 20 July 2019 was paid to
Common Stockholders.
3. During January 2020 the Company issued some more Common Stocks to
the public.
4. On 10 July, 2020 the Company declared a dividend of Rs. 3 per Common
Stock.
5. On 05 August 2020 the dividend declared was paid to the Common
Stockholders.

Required
a) Compute the total amount of dividend declared for the common
stockholders as on 20 July 2019.
b) Determine the total amount of dividend paid on 10 August 2019 to the
Common Stockholders.
c) Compute the amount of premium per share of the Common Stocks issued
during January 2020.
d) Calculate the amount of profit earned by the Company during 2019-20.
e) Compute the total amount of dividend declared for the Common
Stockholders on 10 July, 2020.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

f) Determine the total amount of dividend paid on 05 August, 2020 to the

Common Stockholders.
g) Present the stockholders’ equity section of the balance sheet as on 31
August 2020 of the Company.

P.6-7
Smart Trading Company was established during July 2019. The following equity
transactions were occurred during its first year of operations apart from other
business activities:-

5 July, 2019 Common Stock of 100,000 shares of Rs. 10 par value and 50,000 shares of 15% Preferred
Stocks at Rs. 50 each were authorized.
20 August 2019 Issued 40,000 Common Stocks at Rs. 15 each and 30,000 shares of 15% Preferred Stocks at
Rs. 60 each.
15 September 2019 Issued 30,000 Common Stock to the vender for supply of Motor vehicle having the market
value of Rs. 420,000.
10 December 2019 Declared and paid an interim dividend of Rs. 02 each to the Common Stockholders on record
of 31 November.
31 December 2019 The Stock split of 2 : 1 of Common Stock was approved and new shares were issued.
30 June 2020 The accounting profit for the year ended amounted to Rs. 800,000.
30 June 2020 The board of directors approved stock dividend of one Common Stock for every two Common
Stocks held by the shareholders’ which were issued accordingly.
30 June 2020 The Board of Directors also approved the cash dividend to the Preferred Stockholders.
20 July 2020 The Cash dividend to the Preferred Stockholders was paid.

Required
a) Record the above transactions in the accounting record of the Company.
b) Present equity section of the balance sheet of the Company as at 31 July
2020.

P.6-8
Shaheen International Hospital was established with the following authorized
capital during 2016:-
- Common Stock 1,000,000 shares of Rs. 100 each
- 12% Preferred Stock 2,000,000 Shares of Rs. 50 each.

During 2016 the Hospital management had issued the stocks as under:-
- Common Stock 500,000 shares at Rs. 120 each
- Preferred Stock 1,000,000 shares at Rs. 70 each.

The Preferred Stock was non-cumulative. The Hospital Operated success fully
and declared and paid the following amounts of dividend during four years to its
stockholders.
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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

2017 Rs. 4,000,000

2018 Rs. 5,500,000
2019 Rs. 10,000,000
2020 Rs. 12,000,000

Required
a) Compute the amount of dividend paid to each class of stockholders during
each year of operation.
b) Determine the total amount of dividend paid to the Preferred Stockholders
for all the four years.

P.6-9
The equity sections of balance sheets of Decent Manufacturing Company for the
years ended on 30 June 2019 and 30 June 2020 were as under:-

Stockholders’ equity 30-06-2019

Common Stock Rs. 10 par value 100,000 shares authorized, 40,000 shares issued. Rs. 400,000
Premium on Common Stock Rs. 80,000
Retained Earnings Rs. 420,000
Total Equity Rs. 900,000

Stockholders’ Equity 30-06-2020

Common Stock Rs. 10 par value 100,000 shares authorized, 60,000 shares issued. Rs. 600,000
Premium on Common Stock Rs. 148,000
Retained Earnings Rs. 650,000
Total Equity Rs. 1,398,000

The undernoted transactions and events affected equity sections during 2019-
2020:-
15-07-2019 Declared Rs. 2.00 per share cash dividend to Stockholders of record date 30-06-2019.
10-08-2019 Paid Cash dividend was declared on 15-07-2019
20-08-2019 Declared Stock for every fine Common Stocks of record date 30-06-2019. The market value of Common
Stock on this date was Rs. 14 per share.
10-05-2020 Declared interim cash dividend of Rs. 1.00 per share of record date of 30-04-2020.
10-06-2020 Paid interim cash dividend declared on 10-05-2020.
15-06-2020 Issued additional 12,000 shares of Rs. 10 each at some premium.

Required
1. How many Common Stocks were outstanding on each dividend declaration
dates.
2. Compute the cash amount paid as dividends to the common stockholders.
3. Calculate the amount of capitalization of retained earnings for the stock
dividends.
4. Compute the net income earned during 2019-20.
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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

5. Compute the premium per stock on additional shares issued on 15 -06-2020.

6. Pass necessary accounting entries for the above transactions.

P.6-10
The Common Stock of Rs. 60 per value of Boss Furniture Manufacturing
Company was being traded on Stock Exchange at Rs. 90 per share during
December 2018.
After one year, the stock was being traded at Rs. 120 per share. Considering the
market price like per share the board of Directors decided stock split of the
Common Stock in either of the following proportions:-
a) If the Stock split is decided in the proportion of 2 for 1, at what price would
you expect the sock to trade immediately after Stock Split is arranged as per
forging ratio.
b) If the stock split is decided in the proportion of 3 for 1, at what price would
you expect the stock to trade immediately after this stock is carried out.
c) What were the objectives under consideration of the board of directors of
the company for stock splits and which alternative would be most suitable
for the Company and the investors as well.
d) Describe the accounting treatment for stock split.

P.6-11
Kashif Industries Ltd was established with an authorized capital of 50,000
common shares of Rs. 100 each. The company issued 30,000 shares at Rs. 140
each. Later the company purchased its 5,000 shares at Rs. 150 each from the
market. The revenue reserves and retained earnings balance were amounting to
Rs. 800,000 and Rs. 1,000,000 respectively at that time.

Required
A) Pass necessary accounting entries for acquisition of treasury stock by the
company.
B) Present equity section of balance sheet of the company.

P.6-12
Wajid Trading Company Ltd was organized during 2015 with an authorized
capital of 100,000 Common Stock of Rs. 50 each. The company had issued
70,000 Common Stock at a premium of Rs. 20 each. The operation of company
was quite successful over several years. It transferred an amount of Rs. 600,000 in
revenue reserves during past. Currently it had a balance in the retained earnings of
Rs. 700,000. The Boards of Directors decided to acquire 4,000 Common Stock
from the market which had the prevailing market price of Rs. 100 each. The
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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

balance of Rs. 568,000 was available in the retained earnings after payment of
dividends by the company. Later the company sold out the treasury stocks.
Following independent situations are to be considered for the company.

Required
a) Pass accounting entries for purchase of treasury stock by the company and
present the equity section of balance sheet of the company.
b) Later, these stocks were sold at Rs. 100 each. Pass accounting entries and
draw equity section of balance sheet of the company.
c) In case the treasury stock are sold at Rs. 120 each, pass necessary
accounting entries and present equity section of balance sheet of the
company.
d) The treasury stocks are sold at Rs. 85 each. Pass necessary accounting
entries and draw equity section of balance sheet of the company.

P.6-13
Subhan Industries, Jhelum was established about 10 years ago with an authorized
capital of 500,000 Common Stock of Rs. 100 each. The Company had issued
300,000 Common Stocks revenue reserves and retained earnings as appearing in
the equity section of the balance sheet was amounting to Rs. 800,000 and Rs.
650,000 respectively apart from the Premium on Common Stock Account. The
Company last year purchased its common stock of 50,000 at Rs. 125 each and
retained it. During current year them Board of Directors decided to retire the
common stock equivalent to the purchase quantum as the volume of business was
facing market slump.

Required
a) Prepare necessary accounting entry for purchase of own common stock by
the company from the market as of last year.
b) During current year prepare necessary accounting entries for retirement of
the common stock purchased during last year.
c) Prepare equity section of the balance sheet of the company separately as of
the last year after purchase of common stock and of the current year after
retirement of certain portion of the common stock of the company.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

P.6-14
Reliance Medical Complex Ltd was established some years back under
Companies Ordinance with 1,000,000 Common Stock of Rs. 100 each. The
Company issued 600,000 Common Stock at Rs. 120 each and 200,000 Common
Stock at Rs. 140 each during past period with different intervals. The medical
services business was quite profit able and until June, 2019 it had developed
reserves of Rs. 3,000,000 and balance of retained earnings of Rs. 2,000,000 after
distributing dividends to the shareholders every year as decided by the board of
directors and the shareholders. After creeping the Covid-19 paramedic the number
of patients visiting the medical complex drastically reduced which affected the
medical services business. The company then had sufficient liquid resources and
purchased own common stock of 100,000 at Rs. 90 each from the market during
end of June, 2020. Noticing the gradual declining trend of business activities the
board decided during September, 2020 to retire the common stock to the extent of
shares purchased by it from the market.

Required
a) Record the purchase of Common Stock in the books of accounts of the
company.
b) Present the equity section of the balance sheet as at 30 June, 2020.
c) Record the partly retirement of the common stock purchased from the
market.
d) Present the equity section of the balance sheet as at 30 September, 2020.

P.6-15
Asif Trading Ltd was established during 2017 with an authorized capital of
200,000 common stock of Rs. 50 each. The Company issued 150,000 Common
Stock to the public at Rs. 60 each during August, 2017 and continued business.
During past two years the performance of the company registered sufficient
profitability and after payment of dividends to the shareholders had the balance of
Rs. 750,000 in the Retained Earnings Account as on 30 June, 2020 apart from the
Premium account. The company purchased it own 20,000 common stocks during
August 2020 from the market at Rs. 52 each. These shares were sold at Rs. 48
each and Rs. 55 each in the proportion of 50% at each occasion during January,
2021.

Required
a) Record the purchase of own Common Stock by the company during August
2020 and present the equity section of the balance sheet as at 31 August,
2020.
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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

b) Record the sale of Common Stocks during January, 2021 which were
purchased during August 2020 and also present the equity section of the
balance sheet as at 31 January, 2021.

P.6-16
Ahmad Furniture Manufacturing Company Ltd was established during 2010 with
an authorized capital of 200,000 Common Stock of Rs. 100 each. The company
issued 100,000 Common Stocks to the public at the premium of Rs. 50 each
during February, 2011. Simultaneously during March-June, 2011 Stocks Options
for purchase of 10,000 Common Stocks at Rs. 200 each, over a period of 05 years
were granted to the core staff in order to motivate them. The market price of
Common Stock of the Company gradually escalated over several years and by the
end of 2015 the market price of stocks of the company mounted to Rs. 250 each
common stock. Considering this potential trend of market price of the shares the
staff of the company exercised during fourth year the purchase option at 80%
while the balance 20% staff was still under hesitation. The company recorded the
stock option obligations enabling to issue shares upon demand as promised. The
stocks against 80% options were according issued up till June, 2016.

Required
a) Record all the above events in the accounting and memorandum record of
the Company during the period from 2010 to 2016.
b) Present equity section of the balance sheet of the company as at 30 June,
2016.

P.6-17
The Life Saving Drugs Manufacturing Company Ltd was established during 2016
with an authorized capital of 500,000 Common Stocks of Rs. 100 each. The
Company issued 400,000 Common Stocks during July, 2017 at a premium of Rs.
30 each. During July 2018 some technical and marketing staff was recruited to
whom apart from salary package, the purchase of Stock Options of 20,000 shares
at Rs. 150 each over a period of three years was also granted to them. The market
price of shares of the company fluctuated from time to time and by the end of
May 2021 the prevailing price touched the ceiling of Rs. 165 each. All the
employees exercised the Stock options as committed by the company.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Required
a) Record all the above transactions in the accounting and memorandum record
of the company.
b) Present the equity section of the balance sheet of the company as at 30 June,
2021.

P.6-18
Alamgir Company Ltd has presented the following components of the
stockholders’ equity of the balance sheet as at 30 June 2018:-

Stockholders’ Equity
Common stock Rs. 50 par value 100,000 shares authorized 60,000 shares issued and outstanding. Rs. 3,000,000
Premium on Common Stock Rs. 1,800,000
Retained Earnings Rs. 940,000
Total Equity Rs.5,740,000

During 2018-19 the following transactions were conducted which were related to
the stockholders’ equity.
20 July 2018 Purchased 5,000 shares of its own Stock from the market at Rs. 60 per share.
25 July 2018 Describes declared Rs. 5 per share on record date of 24 July 2018 as cash dividend payable within
60 days.
20 September Paid the dividend was declared during July 2018.
15 November Sold the treasury Stock at Rs. 70 per share
31 December Directors declared an interim cash dividend of Rs. 2 per share to be paid within 60 days.
28 February Paid the interim dividend in cash.
24 May The directors approved re appropriation of Rs. 500,000 towards revenue reserve
30 June The income Statement showed a pretax profit of Rs. 800,000 for the year 2018-19. The tax rate is 30%

Required
a) Record the above transactions in the books of accounts of the company.
b) Prepare a statement of retained earnings for the year ended 30 June, 2019.
c) Draw the stockholders equity section of the balance sheet as at 30 June,
2019 of the company.

P.6-19
The equity sections of balance sheets of Good Luck Trading Company Ltd as at
the close of two years follows:-

Stockholders’ equity as at 30 June, 2019

Common stock Rs. 50 par value 60,000 shares authorized and 45,000 shares issued and Rs. 1,750,000
outstanding.
Premium on Common Stock Rs. 700,000
Retained Earnings Rs. 350,000
Total Equity Rs.2,800,000

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Stockholders’ Equity as at 30 June, 2020

Common stock Rs. 50 par value 60,000 shares authorized and 45,000 shares issued and Rs. 2,250,000
outstanding 2,000 common stocks on treasury.
Premium on Common Stock Rs. 990,000
Retained Earnings Rs. 670,000
Rs. 3,910,000
Less: Cost of treasury stock (Rs. 130,000)
Total Equity Rs.3,780,000

During the year 2019-20 the following events took place:-

20 August 2019 A Cash dividend of Rs. 5 per common share was declared on the record date of 1 August 2029.
15 September 2019 The declared cash dividend was paid
30 September 2019 Purchase treasury stock at Rs. 130,000 cost.
15 March 2020 Declared a stock dividend of 10% of outstanding shares. The market value of Stock was
amounting to Rs. 70 per share.
05 April 2020 Issued stock dividend as approved by the board of directors.
20 June 2020 Declared and paid interim cash dividend of Rs. 3 per share outstanding.

Required
a) How many common stocks were outstanding on each cash and stock
dividend payment/issuance date?
b) What is the rupees amount for each cash dividends?
c) Compute the amount of capitalization of retained earnings for stock
dividend during March, 2020.
d) Workout the per share cost of Treasury stock purchased.
e) How much net income was earned by the company during 2019-20?

P.6-20
Bismillah Trading Company Ltd reported the undernoted components of the
stockholders’ equity section of its balance sheet as at 30 June, 2020:-
Common stock Rs. 20 par value, 500,000 shares authorized 300,000 shares issued and outstanding. Rs. 6,000,000
Premium on Common Stock Rs. 4,500,000
Retained Earnings Rs. 1,850,000
Total Equity Rs.12,350,000

The Company Conducted the following transactions relating to stockholders’

equity during 2020-21:-
15 July 2020 Purchased 50,000 Common Stock of its own company at Rs. 40 each.
10 August 2020 The Board of Directors recommended and shareholders in its Annual General Meeting approved
the cash dividends of Rs. 4 per share on the record date of 31 July 2020.
15 September 2020 Paid Cash dividend as approved.
12 October 2020 Sold Treasury Stock of 30,000 shares at Rs. 50 each.
05 September 2020 Sold balance treasury stock of 20,000 shares at Rs. 35 each.
05 January 2021 The Directors declared an interim cash dividend of Rs. 1.50 each share on record date of 31
December 2020.
20 January 2021 The interim cash dividend was paid.
30 June 2021 Closed the net income of Rs. 830,000 for the year 2020-21 to the retained Earnings Account.

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Required
a) Prepare general journal entries for the above transactions.
b) Draw a schedule of Retained Earnings for the year ended on 30 June 2021.
c) Prepare the stockholders equity section of the company’s balance sheet as at
30 June, 2021.

6.16 GLOSSARY
Joint Stock Company
A form of business organization whose capital is contributed by the public at
large and is governed by Companies Act, 2017.

Capital Stock
An evidence in the shape of Shares certificates for contribution of resources in a
joint Stock Company by the public for conduct of business activities.

Authorized Capital
The total amount of capital ceiling approved by a forum at government level and
divided into different classifications which a Company can issue to public from
time to time.

Issued Capital
The amount of shares issued by a company to the public against the cash or other
considerations

Subscribed Capital
The total amount of Capital Stock for which the potential investors have
expressed willingness for purchase of shares.

Called up Capital
The amount of called up capital which has actually been paid by subscribers to the
company.

Par Value
The matching amount at which a share certificated has been issued by a company
as indicated on its face.

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Market Value
The price at which a share is being traded by sellers and purchases at an arm’s
length.

No par Value
A share certificate which does not indicate on its face any denomination amount.

Stated Value
The stated value stock is no par Stock to which the directors of a company assign
any stated value per share which becomes its minimum legal value.

Common Stock
A general type of share certificate which entitles the holder to the ownership of
projects of the Company and the left and assets after satisfying the claims of first
priority of other types of shareholders.

Share at Premium
The higher amount at which a share has been issued than its face value.

Share at discount
Any lower amount at which a share has been issued than its face value.

Owner’s equity
The total amount of ownership in a company against the assets after deducting all
liabilities.

Dividend
The amount of profit distributed by a company to its stockholders in the shape of
cash, shares or any other form.

Interim dividend
The amount of profit distributed by a company to its shareholders during currency
of the year against considerable profit anticipated by the company.

Stock dividend
The distribution of profit to the stockholders of a company in the shape of
additional shares, without receipt of payment, when the company expects that
cash dividend would likely involve the company in cash crunches.

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Stock splits
A device adopted by the management of the Company to reduce face value of its
stocks in some equally divisible proportion to facilitate its trading for potential
investors.

Preferred Stock
A type of share certificate issued by a Company contains some several privileges
over the common stocks on profit distribution and payment of principal amount
upon liquidation of the company.

Cumulative and non-cumulative Preferred Stocks

The cumulative preferred stock carries the privilege of specified dividend
payment during succeeding year as arrears payment if current year’s profit is
insufficient. The non-cumulative preferred stocks do not carry such privilege as
the payment of specified dividend amount would be paid only out of current
year’s profit and if these are insufficient, the balance amount of dividend would
not be carried forward as arrear to the next accounting period.

Participating and non-participating Preferred Stocks

The participating preferred stocks would be entitled to share in the balance profit
of the year on the basis of capital contribution by the Preferred and Common
Stockholders after allocating the amount of dividend to the Common Stockholders
equal to the preferred stockholders. The non-participating preferred stockholders
would not be entitled for any additional dividend as the entire balance profit
would go to the Common Stockholders.

Convertible Preferred Stocks

The option available with the preferred Stockholders to exercise it for conversion
from preferred stocks into common stocks to share greater amount of dividend of
the Company.

Redeemable Preferred Stocks

The option available with the company to call for the redeemable preferred
Stocks, after a specified period or at any late time, when it is considered expedient
for cancellation of such shares and return the money to such stockholders.

Retained Earnings
The amount of profit retained by the company, for use in future, after payment of
cash or stock dividends out of it.

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Unit-6 Stockholders’ Equity Pain-in Capital, Income and Changes in retained Earnings

Treasury Stock
The Company’s own shares which were issued to public but later purchased and
retained for some period for some specific purposes

Retiring Stock
The shares once issued to the public and subsequently acquired and retired to
curtail the issued capital when the funds are no more needed by the organization
for effective usage.

Equity
The total amount of claims of owners on assets. The equity is composed of the
amount of capital contributed by owners, Premium on shares, Capital and revenue
reserves, retained earnings and any surplus on valuation of assets or liabilities of
the enterprise. The equity is also computed by deducting all liabilities from the
assets.

Retained Earnings
The amount of net income retained in the organization after distribution of
dividends to the stockholders and any other re appropriations carried out from the
profit.

Stock Options
The privilege or entitlement granted to the specific staff of the company to
purchase shares of the company at predetermined rates within a specified period
to motivate than and stay in the organization for longer period of time.

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Unit – 7

Accounting For Banking Companies

Written by: Mazhar Arshad

Reviewed by: Dr. Muhammad Munir Ahmad
Unit-7 Accounting for Banking Companies

CONTENTS

Introduction .......................................................................................................221
Objectives .......................................................................................................221
7.1 Introduction to Banking ..............................................................................222
7.1.1 What are the Financial Statements? .............................................222
7.1.2 Purpose of Financial Statements ..................................................223
7.2 Users of Financial Statements .....................................................................223
7.3 Applicable Laws and Rules for Financial Statements of Banking companies...225
7.4 Basis of Preparation of financial Statements ..............................................225
7.5 Basic Accounting Principles ..........................................................226
7.6 Risk Associated with Banks ...........................................................227
7.7 Preparation of Financial Statements ...........................................................228
7.7.1 Income Statement ................................................................................ 229
7.7.2 Balance Sheet ...................................................................................... 237

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Unit-7 Accounting for Banking Companies

INTRODUCTION
This unit is based upon the accounting of banking companies. It explains the
Accounting Policies and IAS requirements in respect of banking accounts. It deals
with preparation of Income statement, balance sheet, cash flow statement and
various disclosures as required by the IASs and IFRSs etc. In this unit topic wise
exercises with solution and problems are given for the understanding and practice
of the students.

OBJECTIVES
After reading this unit, you will be able to:
a) Understand the concept of Accounts of Banking Companies
b) Know the purpose of banking companies accounts
c) Learn the Applicable laws and rules for Financial Statements of Banking
Companies
d) Work out the Reporting requirements of Banking Business
e) Prepare the Income Statement, Balance Sheet and Cash Flow Statement
f) Find out various risks associated with banking business

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7.1 INTRODUCTION TO BANKING

In this world, we heavily depend upon financial institutions for most of our
financial requirements. In simple, every person in the current situation has some
interaction with the banks. Either the person gets the loans or deposits the money.

Bankers play very important role in the economic life of the nation. The health of
the economy is closely related to the soundness of its banking system. Although
banks create no new wealth but their borrowing, lending and related activities
facilitate the process of production, distribution, exchange and consumption of
wealth. In this way they become very effective partners in the process of economic
development. Today modern banks are very useful for the utilization of the
resources of the country. The banks are mobilizing the savings of the people for the
investment purposes. If there would be no banks then a great portion of a capital of
the country would remain idle.

A bank as a matter of fact is just like a heart in the economic structure and the Capital
provided by it is like blood in it. As long as blood is in circulation the organs will
remain sound and healthy. If the blood is not supplied to any organ then that part would
become useless, so if the finance is not provided to Agricultural sector or industrial
sector, it will be destroyed. Loan facility provided by banks works as an incentive to
the producer to increase the production. Many difficulties in the international payments
have been overcome and volume of transactions has been increased. Cheques, drafts
bills of exchange and letters of credit are very important instruments of the banks. The
banks collect these instruments drawn on banks in other cities or countries and
proceeds according to the accounts of the customer's concerns. It is apparent that they
are interacting with every sector of economy. In order to have knowledge of
performance of banks during a period we need financial statements.

7.1.1 What are the financial statements?

Financial statements are a structured representation of the financial position
(Balance Sheet) and financial performance (Income Statement) of an entity. The
objective of financial statements is to provide information about the financial
position, financial performance and cash flows of an entity that is useful to a wide
range of users in making economic decisions. Financial statements also show the
results of management’s stewardship of the resources entrusted to it.
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7.1.2 Purpose of Financial Statements

The objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an enterprise that is
useful to a wide range of users in making economic decisions.

To meet their basic objective financial statements must be useful; and the
information relevant and reliable. Information will have relevance if it influences
the decisions of the users. Irrelevant information has no use. Relevance and
reliability are primary characteristics relating to content together with the threshold
quality, materiality. The primary characteristics relating to presentation include
comparability, clarity and understandability.

7.2 USERS OF FINANCIAL STATEMENTS

7.2.1 Investor Group

This group would comprise both existing and potential shareholders. They would
consider whether to invest or disinvest in the business. Equity investors consider
two elements to their investment, income and gain. Income in the form of dividends
and gain in the share price. If the investor takes a short-term view then current
dividends are of interest. Whereas a longer-term view would concern future
earnings. A guide to the future can to some extent be seen in company reports with
the chairman’s statement, although based on current performance, company
forward strategy is often included. The investor group would also be interested in
profitability and its trend over a period of time.

7.2.2 Employees
It is encouraging to note that some companies produce a separate employees report.
Employees and their representatives require information on business performance
for two principal reasons:
• wage and salary negotiation
• assessment of current and forward opportunity in terms of employment

They would be interested in both the current financial stability and the longer-term
financial viability of the business. They need information in a clear, simple and
understandable form. I have seen some employee reports which include a value
added approach rather than a profit and loss account view of performance.
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Unit-7 Accounting for Banking Companies

7.2.3 Lenders/ Other Banks

This is often referred to as the loan creditor group. It would include the long,
medium and short term lenders of money. The concern of the existing and/or
potential loan creditor is "will they get their money back?" A short-term loan
creditor will immediately consider cash flow and the Cash Flow Statement based
on FRS1, will be of particular interest here. The Banks make up much of this
grouping and would also have an interest in the (NRV) net realisable value of the
assets.

Medium and long-term creditor groups will review the future cash flow potential
of the business. A further consideration would be on the priority of claims on the
business’s resources. They would have interest in current and future profitability
and growth prospects of the entity.

7.2.4 Customers
This group will be interested in the business’s short and longer term financial
stability and its potential to supply high quality goods and services, with where
appropriate, sound after sales service. They may also have interest in the
environmental policy of the business.

7.2.5 Government
State Bank of Pakistan being a regulator of banks in Pakistan, requires financial
statements for regulation of banking sectors and developing new policies for growth
of sector.

The other government departments require published financial information for the
purposes of taxation etc.

The government is decision makers and their forward economic plans are influenced
by the performance of all businesses within various sectors in the economy.

7.2.6 Prospective Investors

They need Financial Statements to assess the viability of investing in a company.
Investors may predict future dividends based on the profits disclosed in the
Financial Statements. Furthermore, risks associated with the investment may be
gauged from the Financial Statements. For instance, fluctuating profits indicate
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higher risk. Therefore, Financial Statements provide a basis for the investment
decisions of potential investors.

7.2.7 Public
The public are often referred to as "shareholders" and businesses do not exist solely
in isolation. Businesses are part of society at large and as such generate much public
interest. At local and national level factors as employment and the environment are
often key interests. Some of these issues are included in their financial information
and longer term strategy.

7.3 APPLICABLE LAWS AND RULES FOR FINANCIAL

STATEMENTS OF BANKING COMPANIES

1. International Financial Reporting Framework (IFRS) as applicable in

Pakistan
2. Companies Ordinance 1984.
3. Stock Exchange Listing Regulations (Particularly Code of Corporate
Governance)
4. Banking Ordinance 1962
5. Prudential Regulations (Corporate, SMEs’ and Consumers)

Securities and Exchange Commission of Pakistan and State bank of Pakistan are
regulatory authorities for banks in Pakistan.

7.4 BASIS OF PREPARATION OF FINANCIAL STATEMENTS

7.4.1 Fair Presentation and Compliance with IFRS

Financial statements shall present fairly the financial position, financial

performance and cash flows of an entity. Fair presentation requires the faithful
representation of the effects of transactions, other events and conditions in
accordance with the definitions and recognition criteria for assets, liabilities,
income and expenses set out in the Framework.

The application of IFRSs, with additional disclosure when necessary, is presumed

to result in financial statements that achieve a fair presentation.
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7.4.2 Going Concern

When preparing financial statements, management shall make an assessment of an
entity’s ability to continue as a going concern. Financial statements shall be
prepared on a going concern basis unless management either intends to liquidate
the entity or to cease trading, or has no realistic alternative but to do so. When
management is aware, in making its assessment, of material uncertainties related to
events or conditions that may cast significant doubt upon the entity’s ability to
continue as a going concern, those uncertainties shall be disclosed. When financial
statements are not prepared on a going concern basis, that fact shall be disclosed,
together with the basis on which the financial statements are prepared and the
reason why the entity is not regarded as a going concern.

7.5 BASIC ACCOUNTING PRINCIPLES

7.5.1 Accrual Basis of Accounting

An entity shall prepare its financial statements, except for cash flow information,
using the accrual basis of accounting.

7.5.2 Consistency of Presentation

The presentation and classification of items in the financial statements shall be
retained from one period to the next unless:

It is apparent, following a significant change in the nature of the entity’s operations

or a review of its financial statements, that another presentation or classification
would be more appropriate having regard to the criteria for the selection and
application of accounting policies in IAS 8; or a Standard or an Interpretation
requires a change in presentation.

7.5.3 Materiality and Aggregation

Each material class of similar items shall be presented separately in the financial
statements. Items of a dissimilar nature or function shall be presented separately
unless they are immaterial.

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7.5.4 Off setting

Assets and liabilities, and income and expenses, shall not be offset unless required
or permitted by a Standard or an Interpretation.
As the offsetting may prevent users from assessing the performance of the separate
activities of a bank and the return that it obtains on particular classes of assets, the
income and expense items are not allowed to be off-set except for those relating to
hedges and to assets and liabilities where a legal right of set-off exists and the
offsetting represents the expectation as to the realization or settlement of the asset
or liability.

7.5.5 Comparative Information

Except when a Standard or an Interpretation permits or requires otherwise,
comparative information shall be disclosed in respect of the previous period for all
amounts reported in the financial statements. Comparative information shall be
included for narrative and descriptive information when it is relevant to an
understanding of the current period’s financial statements.

7.5.6 Liquidity
Liquidity refers to the availability of sufficient funds to meet deposit withdrawals
and other financial commitments as they fall due.

7.5.7 Solvency
Solvency refers to the excess of assets over liabilities and hence, to the adequacy
of the bank's capital.

7.6 RISKS ASSOCIATED WITH BANKS

7.6.1 Credit risk

The risk that one party to a financial instrument will cause a financial loss for the
other party by failing to discharge an obligation.

7.6.2 Currency risk

The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in foreign exchange rates.

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7.6.3 Interest rate risk

The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market interest rates.

7.6.4 liquidity risk

The risk that an entity will encounter difficulty in meeting obligations associated
with financial liabilities that are settled by delivering cash or another financial asset.

7.6.5 loans payable

Loans payable are financial liabilities, other than short-term trade payables on
normal credit terms.

7.6.6 Market risk

The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises three types of
risk: currency risk, interest rate risk and other price risk.

7.6.7 Other price risk

The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices (other than those arising from interest
rate risk or currency risk), whether those changes are caused by factors specific to
the individual financial instrument or its issuer or by factors affecting all similar
financial instruments traded in the market.

7.7 PREPARATION OF FINANCIAL STATEMENTS

To meet unpredictable needs of financing, apart from commercial banks, a number

of other non-banking financial institutions (NBFIs) have also come into being,
especially in the field of long term financing. These are sometimes referred to as
Development Financial Institutions (DFIs). In addition, to introduce Islamic mode
of financing, institution such as Modarbas and Modarba companies have also been
brought into existence.

Banks represent a significant and influential sector of business worldwide. Most

individuals and organisations make use of banks either as depositor or as borrower.
Banks also play a major role in maintaining confidence in the monetary system
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through their close relationship with regulatory authorities and governments.

Notwithstanding the fact that banks provide the regulatory authorities with all
essential information, the users of the financial statements of a bank need relevant,
reliable and comparable information which must be sufficiently comprehensive
(keeping in view the constraint of what is reasonable to require of the management
of banks) to assist them in evaluating the financial position and performance of the
banks and which is useful to them in making economic decisions. The users of
financial statements are interested in bank's liquidity and solvency and the risks
related to the assets and liabilities recognised on its balance sheet and to it’s off
balance sheet items.

Accounting Policies
In order to enable the users to understand the basis on which the financial statement
of a bank are prepared, accounting policies dealing with the following items may
need to be disclosed:
(a) the recognition of the principal types of income;
(b) the valuation of investment and dealing securities;
(c) the distinction between those transactions and other events that result un the
recognition of assets and liabilities on the balance sheet and those transactions
and, other events that only give rise to contingencies and commitments;
(d) the basis for the determination of losses on loans and advances and for writing
off uncollectable loans and advances; and
(e) the basis for the determination of charges for general banking risks and the
accounting treatment of such charges.

7.7.1 Income Statement

Income of a bank
The principal types of income which arise from the operation of a bank include

Interest based Income

i. Interest,
The main function of a commercial bank is to borrow money for the purpose
of lending at a higher rate of interest Bank grants various types of loans to the
industrialists, traders and general public. The yields from loans constitute the
major portion of the income of a bank The banks grant loans generally for
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short periods, but now the banks also advance call loans which can be called
at a very short notice Such loans are granted to share brokers and other banks
These assets are highly liquid because they can be called at any times.

Non-Interest Incomes
a. Fees for services
Banks usually provide the following services and charges fee against these
services.

i. Collection of Cheques
The bank collects the money of the cheques through clearing section of its
customers. The bank also collects money of the bills of exchange.

ii. Periodic Payments

On standing instructions of the client, the bank makes periodic payments in
respect of electricity bills, rent, etc.

iii. Portfolio Management

The banks also undertakes to purchase and sell the shares and debentures on
behalf of the clients and accordingly debits or credits the account. This facility
is called portfolio management.

iv. Periodic Collections

The bank collects salary, pension, dividend and such other periodic
collections on behalf of the client.

v. Other Agency Functions

They act as trustees, executors, advisers and administrators on behalf of its
clients. They act as representatives of clients to deal with other banks and
institutions.

vi. General Utility Functions

The bank also performs general utility functions, such as :-
• Issue of Drafts, Letter of Credits, etc.
• Locker Facility
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• Underwriting of Shares
• Dealing in Foreign Exchange
• Project Reports
• Social Welfare Programmes
• Other Utility Functions

vii. Transfer of Funds

• The bank transfer funds from one branch to another or from one place to
another.

b. Interest on Investments
Banks also invest an important portion of their resources in government and
other first class industrial securities , the interest and dividend received from
time to time on these investments is a source of income for the banks Bank
also earn some income when the market prices of these securities rise

c. Commission, Brokerage, etc.

Banks perform numerous services to their customers and charge commission
etc. for such services. Banks collect cheques, rents, dividends etc. accepts bills
of exchange. Issue drafts and letters of credit and collect pensions and salaries
on behalf of their customers.
They pay insurance premiums. Rents, taxes etc. on behalf of their customers
for all these services banks charge their commissions. They also earn locker
rents for providing safety vaults to their customers. Recently the banks have
also started underwriting the shares and debentures issued by the joint stock
companies for which they receive underwriting commission.
Commercial banks also deal in foreign exchange. They sell demand drafts,
issue letters of credit and help remittance of funds in foreign countries. They
also act as brokers in foreign exchange. Banks earn income out of these
operations.

d. Discounts
Commercial banks invest a part of their funds in bills of exchange by
discounting them Banks discount both foreign and inland bills of exchange.
or in other words, they purchase the bills at discount and receive the full
amount at the date of maturity .
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For instance, if a bill of Rs. 1000 is discounted for Rs 975. The bank earns a
discount of Rs 25 because bank pays Rs 975 today, but will get Rs. 1000 on the due
date. Discount as a matter of fact, is the interest on the amount paid for the
remaining period of the

The rate of discount on bills of exchange is slightly lower than the interest rate
charged on loans and advances because bills are considered to be highly liquid
assets.

Each type of income is separately disclosed in order that users can assess the
performance of a bank. The principal types of expenses arising from the operations
of a. bank include interest, commission, losses on loans and advances, charges
relating to the reduction in the carry amount of investments and general
administrative expenses. Each type of expense is separately disclosed in order that
users can assess the performance of a bank.

A bank should present an income statement, which groups income and expenses by
nature and discloses the amounts of income and expenses.
In addition to the requirements of other International Accounting Standards, the
disclosure in the notes to the financial statements should include, but are not limited
to the following items of income and expenses:

(a) Interest and similar income

(b) Interest expenses and similar charges.

Interest income and interest expenses are disclosed separately in order to give
a better understanding of the composition, and reason for changes in net
interest. Net interest is a product of both interest rates and the amounts of
borrowing and lending. It is desirable for management to provide a
commentary about average interest rates, average interest earning assets and
average interest bearing liabilities for the period.

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Expenses of Bank

i. Interest Expense
Banks borrows money from following sources:

ii. State Bank of Pakistan. (SBP)

Being banker to the banks, SBP is responsible for availability of money in the
market. SBP regulates the money market by lending money to banks at rate
that is known as bench rate. Banks are always required to pay interest to the
SBP for the money they have borrowed.

SBP regulates its interest rate through monetary policy that issued every
quarter. When SBP want to tighten the money supply in order to reduce the
inflation rate, it increases its interest rate and when money supply is required
to enhance it decreases its interest rate.

iii. Borrowings from other banks

In order to maintain sufficient level funds with it, banks also borrow from
other banks at the interest rate that is known in Pakistan as “Karachi Inter
Bank Offer Rate” (KIBOR).

It’s the rate of interest at which banks offer to lend money to one another in
wholesale money markets in the City of Karachi. Money can be borrowed overnight
or for a period of in excess of five years. The most often quoted rate is for six month
KIBOR. ‘6 month KIBOR’ tends to be used as a yardstick for lenders involved in
high value transactions.

iv. Borrowings from general public

Bank also borrows money from general public in the shape of a deposit
account held at a bank that provides principal security and a modest interest
rate. Depending on the specific type of savings account, the account holder
may not be able to write checks from the account (without incurring extra fees
or expenses) and the account is likely to have a limited number of free
transfers/transactions. Savings account funds are considered one of the most
liquid investments outside of demand accounts and cash. In contrast to
savings accounts, checking accounts allow you to write checks and use
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electronic debit to access your funds inside the account. Savings accounts are
generally for money that you don't intend to use for daily expenses. To open
a savings account, simply go down to your local bank with proper
identification and ask to open an account.

v. Provision against non-performing loans

Non- Performing Loans

A. Non-performing loan is a loan that is in default or close to being in default.

Many loans become non-performing after being in default for 90 days, but
this can depend on the contract terms.

“A loan is nonperforming when payments of interest and principal are

past due by 90 days or more, or at least 90 days of interest payments
have been capitalized, refinanced or delayed by agreement, or payments
are less than 90 days overdue, but there are other good reasons to doubt
that payments will be made in full” (International Monetary Fund).

By bank regulatory definition non-performing loans consist of:

• other real estate owned which is taken by foreclosure or a deed in lieu of
foreclosure,
• loans that are 90 days or more past due and still accruing interest, and
• loans which have been placed on nonaccrual (i.e., loans for which interest is
no longer accrued and posted to the income statement).

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● Rules for provision against non-performing loans

Guidelines In the Matter of Classification and Provisioning For Assets
As per prudential regulation by State Bank of Pakistan

Classification Determinant Treat of income Provision to be made

Substandard Where Un realized 25% of the balance
markup/interest or markup/interest to outstanding of Principle
principle is over be kept in amount less any amount
due by 90 days or Memorandum that can be received
more from the due Account and not to from security without
date. be credited to case from court. It
Income Account means the securities that
except when can be realized freely.
received in cash. Like Shares, bonds etc.
Doubtful Where Same above 50% of the balance
markup/interest or outstanding of Principle
principle is over amount less any amount
due by 180 days that can be received
or more from the from security without
due date. case from court. It
means the securities that
can be realised freely.
Like Shares, bonds etc.
Loss Where Same above 100% of the balance
markup/interest or outstanding of Principle
principle is amount less any amount
overdue by one that can be received
year or more from from security without
the due date. case from court. It
means the securities that
can be realised freely.
Like Shares, bonds etc

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EXAMPLE
You are a credit manager of bank, you have been provided with aging analysis of
your bank as follows:

Classification Principal Outstanding

Rupees
On time payment Portfolio 38,483,326
Late by 1-30 days 325,958
Late by 31-90 days 79,084
Late by 91-180 days 118,499
Late by 181-365 days 426,461
Above 365 days 487952
Total Porfolio at Risk 39,433,328

Required
Calculate the amount of provision to be calculated.

SOLUTION

Classification Principal Rate of Provision

Outstanding Provision Calculated
Rupees (%age) Rupees
On time payment 0% -
38,483,326
Portfolio
Late by 1-30 days 325,958 0% -
Late by 31-90 days 79,084 0% -
Late by 91-180 days 118,499 25% 29,624
Late by 181-365 days 426,461 50% 213,230
Above 365 days 487952 100% 487952
Total Porfolio at Risk 39,433,328 730,806

PROBLEM
Following are the details of the non-performing loans of a bank
Clients name Loan Type Outstanding Interest due Overdue
principle since
Rupees in Million
A-Ltd Short term loan 20 2 300 days
B-Ltd Long term loan 25 1 One year
C-Ltd Long term loan 12 0.5 2.5 years
D-Ltd Long term loan 10 0.5 365 days

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Required
Calculate the provision required for the period.

7.7.2 Balance Sheet

A bank should present a balance sheet that groups assets and liabilities by nature
and lists them in an order that reflects their relative liquidity. Current and non-
current items are not presented separately because most of the assets and liabilities
of a bank can be realised or settled in the near future.

The distinction between balances with other banks and those with other parts of the
money market and from other depositors is relevant information because it gives
an understanding of a bank's relation with, and dependence, on other banks and the
money market.

Hence, the disclosures in the balance sheet or in the notes to the financial statements
should include, but are not limited to, the following assets and liabilities.

a. Assets
i. Cash & balance with the Central Bank (State bank of Pakistan)
State Bank of Pakistan is responsible to regulate the banking sector of Pakistan. In
order to regulate it requires that every banks bank must deposit a certain amount
with it. It is used to adjust the fines and penalties on banks and as a security in
case of default of bank.

ii. Treasury bill and other bills eligible for rediscounting with the Central
Bank. Government and other securities held for dealing (reselling)
purposes.
In order to maintain sufficient supply of money, SBP issues treasury bills and other
bills through Money market operation (also known as MMO) that is an activity by
a central bank to buy or sell government bonds on the open market. A central bank
uses them as the primary means of implementing monetary policy. The usual aim
of open market operations is to manipulate the short term interest rate and the
supply of base money in an economy, and thus indirectly control the total money
supply, in effect expanding money or contracting the money supply. This involves
meeting the demand of base money at the target interest rate by buying and selling

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government securities, or other financial instruments. Monetary targets, such as

inflation, interest rates, or exchange rates, are used to guide this implementation.

iii. Placements with, and loans and advances to other banks.

In order to maintain sufficient supply of money banks borrow and lend funds
to other banks. Any funds lent by a bank

iv. Other money market placement.

v. Loans and advances to customers. Investment securities.
It is important to distinguish dealing securities from investment securities and
from other investments. Dealing securities are marketable securities that are
acquired and held with the intention of reselling them in the short term.
Investment securities are acquired and held for yield or capital growth
purposes and are usually held till maturity.

It is not appropriate in the financial statements of a bank to account for loans,

advances and similar transactions as investments.

b. Liabilities
(i). Deposits from other banks.
(ii) Other money market deposits.
(iii)Amount owed to other depositors.
(iv) Certificate of deposits.
A bank generally does not know the holder of its certificates of deposits
because they are usually traded in an open market, hence, a bank discloses
separately deposits that have been obtained through the issue of its own
certificates of deposit or other negotiable papers.
(v) Promissory notes and other liabilities evidenced by such papers.
(vi) Other borrowed funds.
As the offsetting may reduce the usefulness of balance sheet disclosure, the
amount at which any asset or liability is stated in the balance sheet should not
be off-set by the deduction of another liability or asset unless a legal right of
set-off exists and the off-setting represents the expectation as to the realisation
or settlement of the asset or liability.

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c. Contingencies and commitments

Contingencies and Events Occurring after Balance Sheet Date" is of particular
relevance to banks because banks often become engaged in many types of
contingencies and commitments, some revocable and others irrevocable, which are
frequently significant in amount and substantially larger than those of other
commercial enterprises. The users of the financial statements need to know about
the contingencies and irrevocable commitments of a bank because they may have
bearing on its liquidity and solvency and increase inherent possibility of potential
losses.

A bank should disclose the following contingencies and commitments:

(a) The nature and amount of commitments to extend credit that are irrevocable
because they cannot be, withdrawn at the discretion of the bank without the
risk of incurring significant penalty or expense, and
(b) Many banks also enter in to transactions that are presently not recognised as
assets or liabilities in the balance sheet but which give rise to contingencies
and commitments. Such off balance sheet items of tax represent an important
part of the business of a bank and may have significant bearing on the level
of risk to which the bank is exposed. These items may add to, or reduce, other
risks, e.g. by hedging assets or liabilities on the balance sheet. Off balance
sheet items may arise from transactions carried out on behalf of customers or
from the bank's own trading position. Users also require adequate
information about the nature and amount of off balance sheet transactions
undertaken by a 'bank. The financial statements of a bank should, therefore,
disclose the nature and amount of contingencies and commitments arising
from off balance sheet items including those relating to:
1. Direct credit substitutes including general guarantees of indebtedness, bank
acceptance guarantees and stand-by letter of credit serving as financial
guarantee for loans and securities;
2. Certain transaction-related contingencies including performance bonds, bid
bonds, warranties and stand-by letters of credit related to particular
transactions;
3. Short term self-liquidating trade related contingencies arising from the
movement of goods, such as documentary credits where the underlying
shipment is used as security;
4. Those sale and repurchase agreements not recognised in the balance sheet;
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5. Interest and foreign exchange rate related items including swaps, options and
futures; and
6. Other commitments, note issuance facilities and revolving under-writing
facilities.

d. Maturities of Assets and Liabilities

The matching and controlled mismatching of the maturities and interest rates of
assets and liabilities is fundamental to the management of a bank. It is unusual for
banks ever to be completely matched since business transacted is often of uncertain
terms and of different types. An unmatched position potentially enhances
profitability but can also increase the risks of losses. In order to provide information
relevant for the assessment of its liquidity, its exposure to changes in interest rates
and exchange rates, a bank discloses, as a minimum analysis of assets and liabilities
into various relevant maturity groupings.

A bank should disclose an analysis of assets and liabilities into relevant maturity
groupings based on the remaining period at the balance sheet date to the
contractual maturity date.
Examples of periods used include the following:
1. Upto I month.
2. From 1 month to 3 months.
3. From 3 months to 1 year.
4. From 1 year to 5 years.
5. From 5 years and over.

Some assets of a bank do not have a contractual maturity date. The period in which
these assets are assumed to mature is usually taken as the expected date on which
the assets will be realised.

e. Concentration of assets & liabilities

A bank should disclose any significant concentrations of its assets, liabilities and
off balance sheet items because it is a useful indication of the potential risks
inherent in 'the realisation of the assets and the funds available to the banks. Such
disclosure should be made in terms of geographical areas, customer or industry
groups or other appropriate concentrations of risk. Geographical areas may
comprise individual countries, groups of countries or regions within a country;
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customer disclosures may deal with sectors such as governments, public authorities,
and commercial and business enterprises. A bank should also ' disclose the amount
of significant net foreign currency exposures because it provides a useful indication
of risk of losses arising from changes in exchange rates.

f. Losses on loan and advances:

It is inevitable that in the ordinary course of business, banks suffer losses on loans,
advances and other credit facilities as a result of their becoming partly or wholly
uncollectable. Users of the financial statements of a bank need to know the impact
that losses on loans and advances have had on the financial position and
performance of the banks; this helps them to judge the effectiveness with which the
bank has employed. its resources. Therefore, a bank should disclose:
(a) the accounting policy which describes the basis- on which uncollectable loans
and advances are recognised as an expense and written off;
(b) details of the movements in the provision for losses on loans and advances
during the period. It should disclose separately the amount charged to income
in the period for losses on uncollectable loans and advances, the amount
charge in the period for loans and advances previously written off that have
been recovered;
(c) the aggregate amount of the provision for losses on loans and advances at the
balance sheet date; and
(d) the aggregate amount included in the balance sheet for loans and advances on
which interest is not being accrued and the basis used to determine the
carrying amount of such loans and advances.

Any amount set aside in respect of losses on loans and advances in addition to those
losses that have been specifically identified or potential losses which experience
indicates are present in the portfolio of loans and advances should be accounted for
as appropriations of retained earnings. Any credits resulting from the reduction of
such amounts result in an increase in the retained earnings and are not included in
the determination of net income.

g. General banking risks

In certain countries, circumstances or legislation may require or allow a bank to
make charge against income for general banking risks including future losses or
other unforeseeable risks, in addition to the charges for losses on loans and
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Unit-7 Accounting for Banking Companies

advances. The income statement cannot present relevant and reliable information
about the performance of a bank if net income includes the effects of undisclosed
charges for general banking risks or additional contingencies, or undisclosed credits
resulting from the reversal of such charges. Similarly, the balance sheet cannot
provide relevant and reliable information about the financial position or a bank if
the balance sheet includes overstated liabilities, understated assets or undisclosed
accruals and provisions. Hence, any amount set aside in respect of general banking
risks, including future losses and other unforeseeable risks or contingencies in
addition to those for which accrual must be made in accordance with IAS-10,
Contingencies and Events Occurring After_ the Balance Sheet Date, should be
separately disclosed as appropriations of retained earnings. Any credits resulting
from the reduction of such amounts result in an increase in retained earnings and
are not included in the determination of net income.

h. Assets pledged as securities

Banks are required, either by law or international custom, to pledge assets as
security to support certain deposits and other liabilities. The amounts involved are
often substantial and so may have a significant impact on the assessment of the
financial position of the bank. In these circumstances, a bank should disclose the
aggregate amount of secured liabilities and the nature and carrying amount of the'
assets pledged as security.

Sample Auditor’s Report

Auditors’ Report to the Members

We have audited the annexed unconsolidated statement of financial position of
ABC Bank Limited as at December 31, 2012 and the related unconsolidated profit
and loss account, unconsolidated statement of comprehensive income,
unconsolidated cash flow statement and unconsolidated statement of changes in
equity together with the notes forming part thereof (herein- after referred to as the
‘financial statements’) for the year then ended, in which are incorporated the
unaudited certified returns from the branches except for fifty branches which have
been audited by us and eight branches audited by auditors abroad and we state that
we have obtained all the information and explanations which, to the best of our
knowledge and belief, were necessary for the purposes of our audit.

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Unit-7 Accounting for Banking Companies

It is the responsibility of the Bank’s management to establish and maintain a system

of internal control, and prepare and present the financial statements in conformity
with approved accounting standards and the requirements of the Banking
Companies Ordinance, 1962 (LVII of 1962), and the Companies Ordinance, 1984
(XLVII of 1984). Our responsibility is to express an opinion on these financial
statements based on our audit.

We conducted our audit in accordance with the international standards of auditing

as applicable in Pakistan. These standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free
of any material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting policies and significant estimates made by
management, as well as, evaluating the overall presentation of the financial
statements. We believe that our audit provides a reasonable basis for our opinion
and, after due verification, which in the case of loans and advances covered more
than sixty percent of the total loans and advances of the bank, we report that:
a. in our opinion, proper books of account have been kept by the Bank as
required by the Companies Ordinance, 1984 (XLVII of 1984), and the returns
referred to above received from the branches have been found adequate for
the purpose of our audit;
b. in our opinion:
1. the unconsolidated statement of financial position and unconsolidated
profit and loss account together with the notes thereon have been drawn
up in conformity with the Banking Companies Ordinance, 1962 (LVII of
1962), and the Companies Ordinance, 1984 (XLVII of 1984), and are in
agreement with the books of account and are further in accordance with
accounting policies consistently applied;
2. the expenditure incurred during the year was for the purpose of the
Bank’s business; and
3. the business conducted, investments made and the expenditure incurred
during the year were in accordance with the objects of the Bank and the
transactions of the Bank which have come to our notice have been within
the powers of the Bank;
c. in our opinion and to the best of our information and according to the
explanations given to us, the unconsolidated statement of financial position,
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unconsolidated profit and loss account, unconsolidated statement of

comprehensive income, unconsolidated cash flow statement and
unconsolidated statement of changes in equity together with the notes forming
part thereof conform with approved accounting standards as applicable in
Pakistan, and give the information required by the Banking Companies
Ordinance, 1962 (LVII of 1962), and the Companies Ordinance, 1984
(XLVII of 1984), in the manner so required and give a true and fair view of
the state of the Bank’s affairs as at December 31, 2012 and its true balance
of profit, its comprehensive income, its cash flows and changes in equity for
the year then ended; and
d. in our opinion Zakat deductible at source under the Zakat and Ushr
Ordinance, 1980 (XVIII of 1980), was deducted by the Bank and deposited
in the Central Zakat Fund established under Section 7 of that Ordinance.

A. B C & Co.
Chartered Accountants
Engagement Partner Mr. XYZ
Place:
Dated: February 22, 2013

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FORMATS OF FINANCIAL STATEMENTS OF A BANK

THE SECOND SCHEDULE TO THE BANKING COMPANIES ORDINANCE, 1962 & 34
BALANCE SHEET AS AT
20x2 20x1
Assets Note Rupees in ‘000…
Cash and balances with treasury banks 4 xxxxxxx xxxxxxx
Balances with other banks 5 xxxxxxx xxxxxxx
Lending to financial institutions xxxxxxx
Investments 6 xxxxxxx xxxxxxx
Advances - net of provision 7 xxxxxxx xxxxxxx
Operating fixed assets 8 xxxxxxx xxxxxxx
Capital work in progress xxxxxxx xxxxxxx
(indicating significant item wise details, by way of a note)
Net investment in finance leases 9 xxxxxxx xxxxxxx
Other assets 10 xxxxxxx xxxxxxx
Xxxxxxx. xxxxxxx
Liabilities
Deposits & other accounts 11 xxxxxxx xxxxxxx
Borrowings from other banks, agents etc. 12 xxxxxxx xxxxxxx
Bills payable xxxxxxx xxxxxxx
Other liabilities 13
Liability against assets subject to finance lease 14 xxxxxxx xxxxxxx
Deferred liabilities 15 xxxxxxx xxxxxxx
xxxxxxx xxxxxxx
Net Assets xxxxxxx xxxxxxx
Represented by:
Share capital 16 xxxxxxx xxxxxxx
Reserve fund & other reserves 17 xxxxxxx xxxxxxx
Unappropriated/unremitted profit xxxxxxx xxxxxxx
Shareholders equity xxxxxxx xxxxxxx
Surplus on revaluation of fixed assets xxxxxxx xxxxxxx
(Details to be given by way of note)
Sub-ordinated debt xxxxxxx xxxxxxx
The annexed notes form an integral part of these accounts
PRESIDENT AND
CHIEF EXECUTIVE DIRECTOR DIRECTOR
DIRECTOR

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Profit and Loss Account

For the year ended December 31,
20x 220x1
Rupees(000)
Mark-up/return/interest earned xxx xxx
Mark-up/return/interest expensed xxx xxx
Net Mark-up/return/interest Income xxx xxx

Provision for diminution in the value of investments-net xxx xxx

Provision against loans and advances – net xxx xxx
Bad debts written off directly xxx xxx

Net Mark-up/return/interest Income after provisions xxx xxx

Non Mark-up/Interest income

Fee, Commission and brokerage income xxx xxx
Dividends xxx xxx
Income from dealing in foreign currencies xxx xxx
Gain on sale of securities-net xxx xxx
Other Income xxx xxx

Total Non-Mark-up/Interest income xxx xxx

Non-Mark-up/Interest Expenses
Administrative expenses xxx xxx
Other provisions– net xxx xxx
Other charges xxx xxx

Total Non-Mark-up/Interest Expenses xxx xxx

Profit before taxation xxx xxx
Taxation xxx xxx
Profit after taxation xxx xxx

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Unit-7 Accounting for Banking Companies

CASH FLOW STATEMENT FOR THE YEAR ENDED __________

20x2 0x1
---Rupees in ‘000---
Cash flow from operating activities xxxxx xxxxxx
Profit before taxation xxxxxx xxxxxx
Less Profit/loss from investment securities xxxxxx xxxxxx
Dividend income xxxxxx xxxxxx
Adjustment for non-cash charges xxxxxx xxxxxx
Depreciation xxxxxx xxxxxx
Provision for diminution in the value of investments xxxxxx xxxxxx
Provision against non-performing advances xxxxxx xxxxxx
Other (to be specified) xxxxxx xxxxxx
xxxxxx xxxxxx
xxxxxx xxxxxx
(Increase)/decrease in operating assets
Government securities xxxxxx xxxxxx

Advances xxxxxx xxxxxx

Other assets (excluding advance tax) xxxxxx xxxxxx
xxxxxx xxxxxx
xxxxxx
Increase/(decrease) in operating liabilities xxxxxx
Deposits & other accounts xxxxxx xxxxxx
Bills Payable xxxxxx xxxxxx
Other liabilities (excluding provision for taxation) xxxxxx xxxxxx
xxxxxx xxxxxx
Cash flow before tax xxxxxx xxxxxx
Income tax paid xxxxxx xxxxxx
Net cash flow from operating activities xxxxxx xxxxxx
CASH FLOW FROM INVESTING ACTIVITIES xxxxxx xxxxxx
Net sale proceeds of investment securities xxxxxx xxxxxx
Dividend income xxxxxx xxxxxx
Fixed capital expenditure xxxxxx xxxxxx
Sale proceeds of fixed assets xxxxxx xxxxxx
xxxxxx xxxxxx
Net cash used in investing activities xxxxxx xxxxxx
xxxxxx xxxxxx
CASH FLOW FROM FINANCING ACTIVITIES xxxxxx xxxxxx
Borrowings from other banks agents etc. xxxxxx xxxxxx
Payment of lease obligations xxxxxx xxxxxx
Dividend paid xxxxxx xxxxxx
xxxxxx xxxxxx
Net cash flow from financing activities xxxxxx xxxxxx
xxxxxx xxxxxx
Increase in cash and cash equivalents for the year xxxxxx
xxxxxx
Cash and cash equivalents at the beginning of the year xxxxxx
xxxxxx xxxxxx xxxxxx
Cash and cash equivalents at the end of Dec. 31/June 30, 20Xx xxxxxx
Cash and cash equivalents xxxxxx
Cash
Balances with other banks
Money at call and short notice
247
Unit-7 Accounting for Banking Companies

ABC Bank Limited

Sample Notes to the accounts
(Note- these accounts are for sample only and only major notes are presented her.

For the year ended

1. Status and nature of business
2. Basis of presentation
3. Summary of significant accounting policies, such as;
3.1. Historical cost convention
3.2. Staff retirement benefits
3.3. Taxation
3.4. Advances (including policy which describes the basis on which
uncollectable advances are recognised as an expense and written off) i
3.5. Investments(including policy for valuation)
3.6. Operating fixed assets and depreciation (showing separately for owned
and leased assets)
3.7. Revenue recognition (for principal types)
3.8. Foreign currencies
3.9. Others (specify)

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Unit-7 Accounting for Banking Companies

Note-4 Cash and balances with treasury banks

20x2 20x1
(Rupees in “000”)
Cash in Hand xxxxxx xxxxxx
- Local Currency xxxxxx xxxxxx
- Foreign Currency xxxxxx xxxxxx

xxxxxx xxxxxx
With State Bank of Pakistan xxxxxx xxxxxx
- Local Currency Current Account xxxxxx xxxxxx
- Foreign Currency account xxxxxx xxxxxx
- Foreign Currency deposit account
xxxxxx xxxxxx

With National Bank of Pakistan

- Local Currency current account

xxxxxx xxxxxx
Note-5 Balances with other banks xxxxxx xxxxxx
xxxxxx xxxxxx
In Pakistan
- on current account xxxxxx xxxxxx
- on deposit account xxxxxx xxxxxx
xxxxxx xxxxxx

Outside Pakistan
- on current account xxxxxx xxxxxx
xxxxxx xxxxxx
- on deposit account xxxxxx xxxxxx

Lending to Financial Institutions

- In local currency
In Foreign Currency

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Unit-7 Accounting for Banking Companies

Note- Investments
2012 2011
Held by Given as Held by Given as
Total Total
Investments by Types Bank Collateral Bank Collateral

Amount in Pak Rupees (00000)

Available for Sale (An available-for-sale security is a debt or equity security that is not classified as a
held-for-trading or held-to-maturity security. This type of security is reported at fair value; changes in value
between accounting periods are included in comprehensive income until the securities are sold.)
-Market Treasury Bills xxxx xxxx xxxx xxxx xxxx xxxx
-Pakistan Investment xxxx xxxx xxxx xxxx xxxx xxxx
Bonds
-shares in Listed xxxx xxxx xxxx xxxx xxxx xxxx
Companies
-NIT Units xxxx xxxx xxxx xxxx xxxx xxxx
-Sukkuk Bonds xxxx xxxx xxxx xxxx xxxx xxxx
-Term Finance Certificates xxxx xxxx xxxx xxxx xxxx xxxx
Held to Maturity (A held to maturity security is a debt or equity security that is purchased with the intention
of holding the investment to maturity. This type of security is reported at amortized cost on a company's
financial statements and is usually in the form of a debt security with a specific maturity date.)
-Market Treasury Bills xxxx xxxx xxxx xxxx xxxx xxxx
-Pakistan Investment xxxx xxxx xxxx xxxx xxxx xxxx
Bonds
-Sukkuk Bonds xxxx xxxx xxxx xxxx xxxx xxxx
xxxx xxxx xxxx xxxx xxxx Xxxx
Investment in subsidiaries
-Investment in subsidiary xxxx xxxx xxxx xxxx xxxx xxxx
A
-Investment in xxxx xxxx xxxx xxxx xxxx xxxx
Subsidiary B
xxxx xxxx xxxx xxxx xxxx Xxxx
Investment in subsidiaries
-Investment in Associate xxxx xxxx xxxx xxxx xxxx xxxx
A
-Investment in Associate xxxx xxxx xxxx xxxx xxxx xxxx
B
xxxx xxxx xxxx xxxx xxxx xxxx
Total Investment xxxxx

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Unit-7 Accounting for Banking Companies

Investments by Segment
Amount in Rupees (000)
Particulars 20x2 20x1
Federal Government Securities xxxx xxxx
--Market Treasury Bills xxxx xxxx
--Pakistan Investment Bonds xxxx xxxx
--Euro Bonds xxxx xxxx
--Sukuk Bonds xxxx xxxx

Overseas Investments
--Euro Bonds xxxx xxxx
Investments in Subsidiaries and Associates
Investments xxxx xxxx

Other Investments xxxx xxxx

Other Investments xxxx xxxx
Total Investments xxxx xxxx

Note - Borrowings 20x2 20x1

Amount in Pak Rupees (000)
In Pakistan xxx xxx
Outside Pakistan xxx xxx
xxx xxx
Particulars of Borrowings with respect to currencies
In local currencies xxx xxx
In foreign currencies xxx xxx
xxx xxx
Note-Deposits
Customers
Fixed deposits xxx xxx
Saving deposits xxx xxx
Current Accounts xxx xxx
xxx xxx
Financial Institutions
Remunerative deposits xxx xxx
Non-remunerative deposits xxx xxx
xxx xxx
Particulars of deposits
In local currency xxx xxx
In foreign currency xxx xxx
xxx xxx
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Unit-7 Accounting for Banking Companies

Note-Income
Mark-up/Return/Interest earned 20x2 20x1
PKR (000)
■ Customers xxx xxx

On Investments in:
■ Held for trading securities xxx xxx
■ Available for sale xxx xxx
■ Held to maturity securities xxx xxx
xxx xxx

On deposits with financial institutions xxx xxx

On Securities purchased under resale agreement xxx xxx
Other xxx xxx
xxx xxx

Mark-up/Return/Interest Expensed
■ Deposits xxx xxx
■ Securities sold under repurchase agreement xxx xxx
■ Other Short term borrowings xxx xxx
■ Discounts Commissions and brokerage xxx xxx
■ Others xxx xxx
xxx xxx

PROBLEM 02
Anabi Bank Limited (A Middle East bank having branch in Pakistan) has
outstanding loans of Rs. 8.511. million out of which, Rs. 1.258 million are on non-
performing status.

Loans and advances include Bill discounted and purchased of Rs. 2.233 million out
which 1.752 million are payable outside Pakistan. The remaining advances
represent Loans, Cash Credits etc.

Overall analysis of the loan book shows that advances of Rs. 951 thousand are in
foreign currency and loans of Rs. 5.934 million are of short-term nature i.e. payable
within one year.

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Unit-7 Accounting for Banking Companies

The detail of non-performing loans is as follows:

Outstanding Provision held
(Rs. 000' )
Other Asset Especially Mentioned (OAEM) 377 –
Substandard 151 54
Doubtful 453 230
Loss 1.258 332

Charge for the year of provision for doubtful advances is Rs„ 65 thousand is against
specific Loans and the rest is for general advances. Similarly the reversal
in the provision is Rs. 54 thousand from Specific provision and 71 thousand
against general provision.

The opening balance is Rs. 95 thousand and 182 thousand for specific and general
provisions respectively.

Required
Give the necessary disclosure based on the above information in the
financial statements of Anabi Bank Limited.

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Unit-7 Accounting for Banking Companies

SOLUTION
ANABI BANK LIMITED
ADVANCES NET
Loans, cash credits, running finances, etc. (Rupees `000)

In Pakistan XXXX
Outside Pakistan XXXX
627,8

Bills discounted and purchased (excluding treasury

bills) Payable in Pakistan 1,752
Payable outside Pakistan 481
2,233

Provision for no-performing advances 8,511

(332)
Particulars of Advances 8,179
In local currency 7228
In foreign currencies 951
8,179
Short Term
Long Term 5,934
2,245
8,179

Advances include Rs. 1.:

detailed below:
Category of classification Domestic Overseas Total Provision Provision
Required held
----------- (Rupees 000) -----------
Other As these specially Mentioned xxxx xxxx 377
Substandard xxxx xxxx 277 48 48
Doubtful xxxx xa:xx 151 54 54
Loss xxxx xxxx 453 230 230
1,258 332 332

Particulars of provision against non-performing advances

Specific General Total

----------- (Rupees 000) -----------
Opening balance 95 182 277
Charge for the year 65 115 180*
Reversals 54 (71) 125
Closing balance 106 22 6332

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Unit-7 Accounting for Banking Companies

Exampl‫ش‬
From the Give Trial Balance of Ahsan Bank Ltd for the year ended on 31st December, 2012. You are
required to prepare the Statement of Financial Position and Profit and Loss Account
Debit Balance Rs. '000' Credit Balance Rs. '000'
Cash and balances with treasury banks 31,265,608 Bills payable 4,118,791
Balances with other banks 579,555 Borrowings 20,774,450
Lendings to financial institutions 11,488,944 Deposits and other accounts 371,284,268
Investments 121,173,409 Sub-ordinate loans 5,494,800
Advances 252,345,421 Other liabilities 12,284,360
Operating fixed assets 15,359,742 Share capital 7,821,009
Deferred tax assets 484,387 Reserves 7,516,910
Surplus on revaluation of
Other assets 17,234,460 assets - net of tax 4,808,405
Mark-up / return / interest
Dividend Paid 4,631,270 earned 44,992,696
Provision against non-performing loans reversal against lendings to
and advances 3,074,576 financial institutions 280,595
Provision for diminution in the value of Fee, commission and
investments - net 1,289,404 brokerage income 2,491,200
Mark-up / return / interest expensed 22,427,652 Dividend income 1,118,270
Unrealized loss on revaluation of Income from dealing in
investments classified as held for trading 23,884 foreign currencies 418,524
Gain / (Loss) on sale of
Administrative expenses 11,241,587 securities 1,416,532
Provision against other assets - net 331,077 Other income 251,144
Reversal against off-balance
Workers welfare fund 254,666 sheet obligations-net 88,239
Other charges 71,248 Deferred tax 417,346
Unappropriated profit
Current year tax 4,161,179 brought forward (Last year) 12,198,425
Transfer from surplus on
revaluation of fixed assets
Prior years prior year tax 373,941 (Last year) 36,046
Total 497,812,010 Total 497,812,010

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 Unit-7 Accounting for Banking Companies

Solution
Ahsan Bank Ltd
Profit and Loss Account
For the year ended December 31, 2012
Rs. '000'
Mark-up / return / interest earned 44,992,696
Mark-up / return / interest expensed 22,427,652
Net Mark-up / Interest income 22,565,044
Provision against non-performing loans and advances 3,074,576
Provision for diminution in the value of investments - net 1,289,404
Provision / (reversal) against lendings to financial institutions (280,595)
Bad debts written off directly -
4,083,385
Net Mark-up / Interest income after provisions 18,481,659
Non Mark-Up / Interest Income
Fee, commission and brokerage income 2,491,200
Dividend income 1,118,270
Income from dealing in foreign currencies 418,524
Gain / (Loss) on sale of securities 1,416,532
Unrealized loss on revaluation of investments classified as
held for trading – net (23,884)
Other income 251,144
Total non-markup / interest income 5,671,786
24,153,445
Non Mark-Up / Interest Expenses
Administrative expenses 11,241,587
Provision against other assets – net 331,077
Provision / (reversal) against off-balance sheet obligations-net (88,239)
Workers welfare fund 254,666
Other charges 71,248
Total non-markup / interest expenses 11,810,339
Extra-ordinary / unusual items -
Profit Before Taxation 12,343,106

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Unit-7 Accounting for Banking Companies

Taxation
Current 4,161,179
Prior years 373,941
Deferred (417,346)
4,117,774
Profit After Taxation 8,225,332
Unappropriated profit brought forward 12,198,425
Transfer from surplus on revaluation of fixed assets - net of tax 36,046
12,234,471
Profit Available For Appropriation 20,459,803
Earnings per share - Basic and Diluted (in Rupees) 9.56

Ahsan Bank Ltd

Statement of Financial Position
As at December 31, 2012
Rs. '000'
Assets
Cash and balances with treasury banks 31,265,608
Balances with other banks 579,555
Lendings to financial institutions 11,488,944
Investments 121,173,409
Advances 252,345,421
Operating fixed assets 15,359,742
Deferred tax assets 484,387
Other assets 17,234,460
449,931,526
Liabilities
Bills payable 4,118,791
Borrowings 20,774,450
Deposits and other accounts 371,284,268
Sub-ordinated loans 5,494,800
Liabilities against assets subject to finance lease -
Deferred tax liabilities -
Other liabilities 12,284,360
413,956,669
Net Assets 35,974,857
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Unit-7 Accounting for Banking Companies

Represented By:
Share capital 7,821,009
Reserves 7,516,910
Unappropriated profit 15,828,533
31,166,452
Surplus on revaluation of assets - net of tax 4,808,405
35,974,857

Problem
Following is the Trial Balance of Modern Bank for the year ended on 31st
December, 2011. You are required to prepare the Statement of Financial Position
and Profit and Loss Account.
Debit Balance Rs. '000' Credit Balance Rs. '000'
Final Dividend 11,578 Dividend income 2,796
Balances with other banks 1,449 Borrowings 51,936
Lendings to financial institutions 28,722 Deposits and other accounts 928,211
Provision against non-performing loans
and advances 7,686 Sub-ordinated loans 13,737
Provision for diminution in the value of
investments – net 3,224 Other liabilities 30,711
Operating fixed assets 38,399 Bills payable 10,297
Fee, commission and brokerage
Deferred tax assets 1,211 income 6,228
Surplus on revaluation of assets - net
Other current assets 43,086 of tax 12,021
Administrative expenses 28,104 Mark-up / return / interest earned 112,482
Reversal against lendings to financial
Provision against other assets - net 828 institutions 701
Cash and balances with treasury banks 78,164 Other income 628
Reversal against off-balance sheet
Mark-up / return / interest expensed 56,069 obligations-net 221
Unrealized loss on revaluation of
investments classified as held for Income from dealing in foreign
trading 60 currencies 1,046
Investments 302,934 Gain / (Loss) on sale of securities 3,541
Unappropriated profit brought forward
Advances 630,864 (Last year) 30,496
Workers welfare fund 637 Share capital 19,553
Other charges 178 Reserves 18,792
Current year tax 10,403 Deferred tax 1,043
Transfer from surplus on revaluation
Prior years prior year tax 935 of fixed assets (Last year) 90
Total 1,244,530 Total 1,244,530

258
Unit – 8

Accounting for Insurance Companies

Written by: Dr. Muhammad Munir Ahmad

Reviewed by: Prof. Dr. S.M. Amir Shah
Unit-8 Accounting for Insurance Companies

CONTENTS
Introduction .........................................................................................................261
Objectives .........................................................................................................261
8.1 Introduction .................................................................................................262
8.1.1 Definitions.......................................................................................262
8.1.2 Insurance in Pakistan ......................................................................262
8.2 Kinds of Insurance ......................................................................................263
8.3 Classes of Life and Non-Life Insurance .....................................................264
8.4 Accounts and Audit of Insurance Business ................................................266
8.5 Accounting and Reporting ..........................................................................267
8.6 Accounting of Life Insurance Companies ..................................................268
8.6.1 Statement of Investment Income ....................................................268
8.6.2 Statement of Expenses ....................................................................272
8.6.3 Statement of Claims ........................................................................278
8.6.4 Statement of Premium.....................................................................281
8.6.5 Profit and Loss Account..................................................................284
8.7 Accounting of Non- Life Insurance Companies .........................................294
8.7.1 Statement of Investment Income ....................................................294
8.7.2 Statement of Expenses ....................................................................296
8.7.3 Statement of Claims ........................................................................297
8.7.4 Statement of Premium.....................................................................299
8.7.5 Profit and Loss Account..................................................................300
8.7.6 Balance Sheet .................................................................................304

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Unit-8 Accounting for Insurance Companies

INTRODUCTION
This unit is based upon the accounting of insurance companies. It explains the
various concepts of insurance, its kinds and the accounting and the audit
requirement of insurance companies working in Pakistan. It deals with the
preparation and presentation of Various Accounting Statements of Life and Non-
Life Insurance Businesses, which are required by the Accounting Standards and
SECP. Throughout the unit topic wise exercises with solution and problems are
given for the understanding and practice of the students.

OBJECTIVES
After reading this unit, you will be able to:
a) Work out the concept of Insurance and the various kinds of Insurance
Companies
b) Find out the Accounts and Audit requirements of Insurance Business
c) Complete the Reporting requirements of Insurance Business
d) Prepare the Various Statements of Life Insurance Companies
e) Prepare the Various Statements of Non- Life Insurance Companies

261
Unit-8 Accounting for Insurance Companies

8.1 INTRODUCTION TO INSURANCE COMPANIES

In this modern era, every person faces various types of risks. These risks may be to
his life, property and business. To avoid these types of risks, insurance is used as a
shield. Insurance is a promise between two parties for the compensation of
particular potential losses, against some periodic payment. Insurance is designed
to guard the financial well-being of an individual, company or other entity in the
case of uncertain loss. Some forms of insurance are required by law, while others
are optional. If both the parties (insurer and insured) agreed on the terms and
conditions of an insurance policy, it will create a contract called the insurance. The
company selling the insurance is known as insurer, the person or entity buying the
insurance policy is called the policy holder. The amount which is paid by the policy
holder to the company against the compensation of loss is termed as premium.

8.1.1 Definitions

“Insurance is an arrangement by which a company or the state

undertakes to provide a guarantee of compensation for specified loss,
damage, illness, or death in return of periodic payment”.
(Oxford Dictionary)

8.1.2 Insurance in Pakistan

At the time of independence, there were five domestic and 77 foreign insurance
companies were operating in Pakistan under act of 1938. Later on, two more Habib
Insurance of Bombay and Eastern Federal Union Insurance of Calcutta shifted
their operations into Pakistan making seven domestic companies (Chishti, 1987).
Furthermore, to promote the insurance industry in Pakistan, Pakistan Insurance
Corporation was set up under Pakistan insurance act 1952. As a result, until 1971,
number of domestic companies rose to 47 while number of foreign insurance
companies reduced to 25 due to separation of East Pakistan.

In 1972, then Prime Minister Zulfqar Ali Bhutto nationalizes the life insurance
companies, the total assets were almost 10.4 billion. The Act of 1938 was replaced
with the new Insurance ordinance 2000 by the SECP that increased the minimum
paid-up capital of non-life insurance companies from Rs 40 million to Rs. 80
million and for life insurance companies from Rs 100 million to Rs. 150 million.
Currently, there are 48 insurance companies, out of which 35 provide non-life
insurance, seven provide life insurance, and five are the takaful and one reinsurance
company. Insurance penetration in any country follows the S-curve. Insurance

262
Unit-8 Accounting for Insurance Companies

penetration will be low at initial level of economic development, speed up as the

economy expands and again becomes low when country become as developed. As
the Pakistan is at initial stage of development so the insurance, penetration in the
country is quite low.

In Pakistan, ministry of commerce is responsible for monitoring the imports and

exports under imports and exports (control) Act of 1950. Since 1992, all the imports
are required under law to be insured through insurance companies operating in
Pakistan while exports can be insured anywhere in the world (Either with Pakistani
insurance companies or with other countries insurance providers)

8.2 KINDS OF INSURANCE

From accounting perspective insurance can be classified into broad categories, first
one is life insurance and second one is general insurance. All types of insurance
other than life insurance are categorized under the head of general insurance. The
details of the two categories of insurance are as follows:

a) Life Insurance
This is the very important and well-known kind of insurance. In this type, insurance
companies promise to pay a particular amount to the insured on the death or expiry
of the period of policy, whichever is earlier, to the nominees. Life insurance
business was nationalized in Pakistan in 1972. Some of the types of life insurance
are:
i. Whole life policy
ii. Limited payment policy
iii. Endowment life policy
iv. Group life insurance
v. Term assurance

b) General Insurance
The followings are some type of insurance other than life insurance, which fall
under the head of general insurance:

i. Marine Insurance
It is contract of indemnity. Insurance company undertakes to indemnify the loss
incurred to insured commodity by any marine danger. For getting the compensation
of marine loss, insured promises to pay a certain sum of money as premium.

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Unit-8 Accounting for Insurance Companies

ii. Fire insurance

It is a contract between the policyholder and insurance company wherein the insurer
promises, to indemnify the loss or damage caused by fire or lightning of insured
property in exchange for a premium. This contract is for specific time period and
insurer will pay the actual amount of loss up to the amount of policy amount.

iii. Accidental insurance

It is an agreement in which the insurance company compensate the loss of goods
or life of insured person or company due to accident, in exchange of some amount
of premium.

8.3 CLASSES OF LIFE AND NON-LIFE BUSINESS

(1) According to Insurance Ordinance 2000, the following shall be the classes of
business into which life insurance business is divided:
(a) Class 1 being ordinary life business;
(b) Class 2 being capital redemption business;
(c) Class 3 being pension fund business; and
(d) Class 4 being accident and health business.
(2) For the purposes of sub-section (1)
(a) “Ordinary life business” means effecting and carrying out contracts of life
insurance other than contracts included in Class 2, Class 3 or Class 4;
(b) “Capital redemption business” means effecting and carrying out capital
redemption contracts;
(c) “Pension fund business” means effecting and carrying out contracts of life
insurance that are maintained for the purposes of a pension or retirement
scheme and are owned by trustees under the scheme; and
(d) “Accident and health business” means effecting and carrying out contracts
of insurance providing fixed pecuniary benefits or benefits in the nature
of indemnity or a combination of both, against risks of the policy holder
or a person for whose benefit the contract was made –
(i) sustaining injury as a result of an accident;
(ii) becoming incapacitated in consequence of an accident or disease; or
(iii) suffering loss, including medical expenses, attributable to accident,
sickness or infirmity
(3) For the purposes of this Ordinance, the following shall be the classes of
business into which non-life insurance business is divided:
(a) for direct and facultative reinsurance business;
(i) Class 1 being fire and property damage business;
(ii) Class 2 being marine, aviation and transport business;
(iii) Class 3 being motor third party compulsory business;
(iv) Class 4 being liability business;

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Unit-8 Accounting for Insurance Companies

(v) Class 5 being workers’ compensation business;

(vi) Class 6 being credit and suretyship business;
(vii) Class 7 being accident and health business; and
(viii) Class 8 being agriculture insurance including crop insurance;
(ix) Class 9 being miscellaneous business;
(b) for treaty reinsurance business:
(i) Class 9 being proportional treaty business; and
(ii) Class 10 being non-proportional treaty business.
(4) For the purposes of sub-section (3).-
(a) “fire and property damage business” means effecting and carrying out
contracts of insurance against loss to the policy holder arising from loss of
or damage to property, other than as contained in class2;
(b) “marine, aviation and transport business” means effecting and carrying
out contracts of insurance against loss to the policy holder arising from:
(i) loss of or damage to, or arising out of or in connection with the use of:
(a) means of transport, including motor vehicles and railway rolling stock
used on land, vessels used on the sea or on inland waters, and aircraft; or
(b) the machinery, tackle, furniture or equipment of those means of transport;
including third party risks and carrier’s liability but excluding risks
contained in class 3 or class 5: or
(ii) loss of or damage to merchandise, baggage and all other goods in
transit, irrespective of the form of transport;
(c) “motor third party compulsory business” means effecting and carrying out
contracts of insurance against loss to the policy holder arising from
liabilities incurred to third parties arising out of or in connection with the
use of motor vehicles on land, as specified in the Motor Vehicles Act,
1939 (IV of 1939);
(d) “liability business” means effecting and carrying out contracts of insurance
against loss to the policy holder arising from liabilities incurred to third
parties, other than in respect of risks specified in class 2, class 3 or class 5;
(e) “workers’ compensation business” means effecting and carrying out
contracts of insurance against loss to the policy holder arising from
liabilities incurred to workers arising out of or in connection with the
employment of the workers by the insured persons;
(f) “credit and suretyship business” means effecting and carrying out:
(i) contracts of insurance against loss to the policy holder arising from
failure, whether through insolvency or otherwise, of debtors to pay
debts when they fall due; or
(ii) contracts of insurance against loss to the policy holder arising from
his having to perform contracts of guarantee entered into by him; or
(iii) contracts for fidelity bonds, performance bonds, administration
bonds, bail bonds, custom bonds or similar contracts of guarantee;
(g) “accident and health business” means effecting and carrying out contracts
of insurance, the duration of which under the contract is not more than one
265
Unit-8 Accounting for Insurance Companies

year, providing fixed pecuniary benefits or benefits in the nature of

indemnity or a combination of both, against risks of the policy holder or a
person for whose benefit the contract was made;
(i) sustaining injury as a result of an accident;
(ii) dying as a result of an accident;
(iii) becoming incapacitated in consequence of a disease; or
(iv) suffering loss, including medical expenses, attributable to sickness
or infirmity; but excluding contracts of a type included in class 5;
(h) “agriculture insurance” means effecting and carrying out contracts of
insurance against loss to the policyholder arising from loss of or damage to
agriculture related property including crops;
(i) “miscellaneous business” means effecting and carrying out contracts of
insurance of types not included in any other class;
(j) “proportional treaty business” means effecting and carrying out of
contracts of treaty reinsurance, whether obligatory or otherwise, of such
a nature that a proportion of premium or of a separately identified part of
premium on insurance contracts which are the subject matter of the treaty
is payable to the reinsurer by the cedant and an identical proportion of
claims or of a separately identified part of claims on those contracts is
payable to the cedant by the reinsurer, and including without limitation
treaties of quota-share and surplus classifications; and
(k) “non-proportional treaty business” means effecting and carrying out of
contracts of treaty reinsurance, not being contracts of a type included in
Class 9.

8.4 ACCOUNTS AND AUDIT OF THE INSURANCE BUSINESS

According to the insurance ordinance 2000, followings are the requirements related to
the maintenance of accounts and auditing:
(1) Every insurer, in respect of all insurance business transacted by him, and in the
case of an insurer incorporated in a jurisdiction outside Pakistan in respect of the
insurance business transacted by the insurer in Pakistan, shall maintain proper
books and records.
(2) Books, accounts and records in respect of insurance business transacted in
Pakistan shall be maintained in Pakistan and in either the English or the Urdu
language.
(3) For the purposes of this Ordinance, proper books and records shall include
without limitation:
(a) a register or record of policies, in which shall be entered, in respect of every
policy issued by the insurer, the name and address of the policy holder, the
date when the policy was effected and a record of any transfer, assignment
or nomination of which the insurer has notice;

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(b) a register or record of claims, in which shall be entered every claim made
together with the date of the claim, the name and address of the claimant
and the date on which the claim was discharged, or, in the case of a claim
which is rejected, the date of rejection and the grounds therefore; and
(c) Such other books and records as may from time to time be prescribed.
(4) For the purposes of this Ordinance, the expression “books” includes - 46
(a) a register;
(b) accounts or accounting records, however compiled, recorded or stored;
(c) a document; and
(d) any other record of information.
(5) A book that is required by this Ordinance or the Companies Ordinance, 1984 to
be kept or prepared by an insurer may be kept or prepared
(a) by making entries in a bound or loose leaf book;
(b) by recording or storing the matters concerned by means of a mechanical,
electronic or other device; or
(c) in any other manner approved by the Commission. Provided that the
matters recorded or stored are capable, at any time, of being reproduced in
a written form or a reproduction of those matters is kept in a written form
approved by the Commission.
(6) An insurer shall take all reasonable precautions, including such precautions, if
any, as may be prescribed, for guarding against damage to, destruction of or
falsification of or in, and for discovery of falsification of or in, any book or part
of a book required to be kept or prepared by an insurer.

8.5 ACCOUNTING AND REPORTING

(1) Every insurer shall at the expiration of each year prepare and deliver to the
Commission with reference to that year annual statutory accounts comprising the
following statements duly audited by an approved auditor:

(a) In the Case of a Life Insurance Company

(i) a statement of assets and liabilities for each statutory fund operated by the
life insurer and the shareholders’ fund;
(ii) a statement of profits and losses for the shareholders’ fund;
(iii) a statement of cash flows for each statutory fund operated by the life insurer
and the shareholders’ fund;
(iv) a revenue account for each statutory fund operated by the life insurer;
(v) a statement of premiums for each statutory fund operated by the life
insurer;
(vi) a statement of claims for each statutory fund operated by the life insurer;
(vii) a statement of expenses for each statutory fund operated by the life insurer;
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(viii) a statement of investment income for each statutory fund operated by the
life insurer
(ix) such other statements as may be prescribed by the Federal Government;
each in such form as may be prescribed by the Commission and prepared
in accordance with such regulations as are issued by the Commission from
time to time in this behalf;

(b) In the case of a Non-Life Insurer

(i) a statement of assets and liabilities;
(ii) a statement of profits and losses;
(iii) a statement of cash flows;
(iv) a statement of premiums;
(v) a statement of claims;
(vi) a statement of expenses;
(vii) a statement of investment income;
(viii) a statement of claims analysis;
(ix) a statement of exposures; and
(x) such other statements as may be prescribed by the Federal Government;
each in such form as may be prescribed by the Commission and prepared
in accordance with such regulations as are issued by the Commission from
time to time in this behalf.

8.6 ACCOUNTING FOR LIFE INSURANCE COMPANY

As mentioned earlier that various types of forms and statements are required by the
Insurance Ordinance 2000, to be submitted by each insurance companies. The
followings are the some forms are statements are illustrated:

8.6.1 Statement of Investment Income

The format issued by the Security and Exchange Commission of Pakistan is given as
below. Each and every company is bound to follow the mentioned formats, while
presenting the financial statements in annual reports.

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Company Name Form LH

Financial year ended 31 December ----------------
Statement of Investment Income
Figure in Rs. 000
Statutory Fund
Aggregate Aggregate
Ordinary Life Capital Pension Accident & current year prior year
Ordinary life
(Investment linked) reproduction fund health
Income from Trading Investments
Gain/loss on trading (i.e. buying and selling difference) 0 0
Dividend Income (earned while holding the securities)
Others, if any (please specify) 0 0

Income from Non-Trading Investments

Held to maturity or Available for sale (classify as appropriate)

Return on Government Securities and Deposits 0 0

Return on Other Fixed Income Securities and Deposits 0 0
Dividend Income 0 0
Amortisation of discount/premium relative to par 0 0
Others, if any (please specify) 0 0

Gain/Loss on Sale of Non-Trading Investments

(classify as appropriate)

Gain/Loss on Revaluation of Investments

- Trading Investments 0 0
- Available for sale, if applicable 0 0

Other investment income (Please specify)

Provision for Impairment in Value of Investments

Provision for Portfolio Held to maturity
Provision for Portfolio Available for Sale
Others (Please specify)

Less: Investment Related Expenses

Net Investment Income

The annexed notes form an integral part of these accounts.

Chairman Director Director

Explanation
Classification
Investments which are intended to be held for an undefined period of time but may
be sold in response to the need for liquidity or changes in interest rate are classified
as available for sale. Investments acquired principally for the purpose of generating

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a profit from short-term fluctuation in price are classified as held for trading.
Investments with fixed or determinable payments and fixed maturity where the
company has positive intent and ability to hold to maturity are classified as held-
to-maturity.

Initial Recognition
All investments are initially recognized at fair value including the transaction costs
except held for trading investments which are recognized at fair value. All
purchases and sales of investments which require delivery within time frame
established by the regulations or market convention are accounted for at the
settlement date. Settlement date is the date that an asset is delivered to or by the
company.

Subsequent Measurement
Investments classified as held-to-maturity are subsequently measured at amortized
cost, taking into account any discount or premium on acquisition using the effective
interest method.
Available for sale investments are measured at lower of cost or market value
(market value being taken as lower if the fall is other than temporary) in accordance
with Securities and Exchange Commission (Insurance) Rules, 2002 and is
recognized as provision due to impairment in the value of investment. Any change
in the provision for impairment in the value of investment held for sale is
recognized in profit and loss/revenue account in which it arises.
Investments held for trading are subsequently measured at their fair values and the
difference is taken to respective profit and loss/ revenue accounts in which it arises.

Fair / Market Value Measurement

For investments in government securities fair/market value may be determined by
reference to quotation obtained from Reutors Page (PKRV). For investments in
quoted marketable securities, fair/market value is determined by reference to stock
exchange quoted market price at the close of business on balance sheet date. The
fair /market value of the term finance certificates may be determined by the average
rates quoted by brokers.

Impairment of 'Available for Sale' Equity Investments

The company may determine that 'available-for-sale' equity investments are
impaired when there has been a significant or prolonged decline in the fair value
below its cost. The determination of what is significant or prolonged required
judgment. In making this judgment, the company evaluates among other factors,
the normal volatility in share price. In addition, the impairment may be appropriate
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when there is an evidence of deterioration in the financial health of the invested

industry and sector performance, changes in technology and operational/financial
cash flow.
Investments in Associates
Investment in associates is valued using equity method.

EXAMPLE 01
Prepare the statement of investment income of the Hassan life insurance company
for the year ended on December 31st, 2021 from the following data:
Accident & Universal Ordinary
Health Life Life
Investment Income: Rs. Rs. Rs.

On Fixed Income Securities and Deposits 4,943 62,486 5,312

On Policy Loan 1,685
On Government Securities 22,858 197,674 66,890

Amortization of Premium 956

Amortization of Discount 2,458 27,674 11,797
Gain on Sale of Investments 73,740 435,208 181,260

SOLUTION
Hassan Life Insurance Company
Statement of Investment Income
For The Year Ended December 31, 2021
Amount in Rupees
Statutory Funds
Ordinary Universal Accident & Aggregate
Life Life Health December 31, 2021
Investment Income
On Government Securities 66,890 197,674 22,858 287,422
On Other Fixed Income Securities
and Deposits 5,312 62,486 4,943 72,741
Amortization of Premium (956) (956)
Amortization of Discount 11,797 27,674 2,458 41,928
On Policy Loan 1,685 1,685
83,999 288,562 30,259 402,820
Gain on Sale of Investments 181,260 435,208 73,740 690,208
Net Investment Income 265,259 723,770 103,999 1,093,028

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PROBLEM 01
The following data is extracted from the books of XYZ life insurance company for the year
ended on 31st December, 2021, you are required to prepare the statement of investment
income of the company. (All amounts are in Rs. 000)

Overseas Pension Pakistan

Life Fund Fund Life Fund
Investment income
-On loans to policyholders 8,014 565,414
-On Government securities 43,812 3,996 4,089,654
-On loans to employees 12 169
-Dividend income 1,176 823,067
-On other fixed income securities and deposits 15,768 55 523,393
-Others 50,462 28,202

Investment related expenses 597 4,968

Gain/(loss) on sale of investments (1,799) 11,473

Provision for impairment in shares and fixed income securities are Rs. 289 and 10,000
respectively. Rs. 275 reported as reversal of provision in receivables ans shares

8.6.2 Statement of Expenses

Company Name
Form LH
Financial year ended 31 December ----------------
Statement of Investment Income
Figure in Rs. 000
Statutory Fund
Ordinary Aggregate
Aggregate
Life Ordinary Capital Pension Accident current prior year
(Investment life reproduction fund & health year
linked)
Acquisition Costs
Remuneration to insurance intermediaries on 0 0
individual policies:
- Commission on first year premiums
- Commission on second year premiums 0 0
- Commission on subsequent renewal
premiums
- Commission on single premiums
- Other benefits to insurance
intermediaries

Remuneration to insurance intermediaries on

group policies:
- Commission

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- Other benefits to insurance

intermediaries

Branch overheads

Other acquision costs (provide details)

Administration Expenses
Salaries and other benefits 0 0
Traveling expenses 0 0
Directors’ fees 0 0
Auditors’ fees 0 0
Actuary’s fees 0 0
Medical fees
Legal Expenses
Advertisements
Computer Expenses
Printing and stationery
Depreciation
Rental
Bad and doubtful debts
Others (Please specify)

Other management expenses

Gross management expenses

Commission from reinsurers

Management expenses recovered from other funds

Fees charged to policyholders

The annexed notes form an integral part of these accounts.

Chairman Director Director

EXAMPLE 02
Soban Life Insurance Company has the following expenses for the year ended on December
31, 2021.

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EXAMPLE 02
You are required to prepare the statement of expenses for the year accordingly. Amounts
are denominated in Rupees.

Ordinary Universal Accident &

Life Life Health
Entertainment Expense 200,980 132,496 83,270
Repair and Maintenance 80,638 58,646 3,730
Insurance 55,381 177,000
Stamps 5,906
Consultancy Charges 137,130 85,536 42,768
Bank Charges 166,414 106,341 34,115
Miscellaneous Expense 631,112 207,168 108,021
Advertisements 831,179 271,268 361,691
Printing and Stationary 512,772 375,626 137,200
Operating Lease Rental 118,690 73,121 112,160
Staff Welfare 878,192 622,599 91,273
Postage, Telegram and Telephone 153,349 81,157 314,446
Electricity and Gas 226,796 62,468 182,378
Newspaper and Periodicals 2,887 1,680 1,400
Commission From Reinsurers 2,403,433 128,877
Salaries and Other Benefits 3,484,287 3,515,204 271,580
Travelling Expenses 157,296 163,299 54,321
Auditor’s Remuneration 66,590 26,636 39,954
Actuary's Fees 160,000 160,000 160,000
Medical Fees 351,043 234,029
Policy Stamps 6,100 71,834 8,780
Individual Policies:
Commission on First Year Premiums 6,897,986 198,108
Commission on Second Year Premiums 309,442
Commission on Subsequent Renewal Premiums 310,548
Other Benefits to Insurance Intermediaries 51,327
Branch Overhead:
Salaries, Allowances and Other Benefits 7,558,735 1,574,478
Other Operational Costs 8,677,103 456,155
Group Policies:
Commission 949,888 2,079,813

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SOLUTION
Soban Life Insurance Company
Statement of Expenses
For The Year Ended December 31, 2021
Figures in Rupees
Statutory Funds Aggregate

Acquisition Costs Ordinary Universal Accident & December 31,

Life Life Health 2021

Remuneration to Insurance Intermediaries

on Individual Policies:
Commission on First Year Premiums _ 6,897,986 198,108 7,096,094
Commission on Second Year
Premiums _ 309,442 _ 309,442
Commission on Subsequent Renewal
Premiums _ 310,548 _ 310,548
Other Benefits to Insurance
Intermediaries _ 51,327 _ 51,327
Group Policies
Commission 949,888 2,079,813 3,029,702
949,888 7,569,302 2,277,921 10,797,112
Branch Overhead:
Salaries, Allowances and Other
Benefits _ 7,558,735 1,574,478 9,133,213
Other Operational Costs _ 8,677,103 456,155 9,133,258
16,235,838 2,030,633 18,266,471
Other Acquisition Cost
Policy Stamps 6,100 71,834 8,780 86,714
Total Acquisition Cost 955,988 23,876,975 4,317,334 29,150,297
Administration Expenses:
Salaries and Other Benefits 3,484,287 3,515,204 271,580 7,271,071
Travelling Expenses 157,296 163,299 54,321 374,916
Auditor’s Remuneration 66,590 26,636 39,954 133,181
Actuary's Fees 160,000 160,000 160,000 480,000
Medical Fees 351,043 234,029 _ 585,072
Advertisements 831,179 271,268 361,691 1,464,138

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Printing and Stationary 512,772 375,626 137,200 1,025,597

Operating Lease Rental 118,690 73,121 112,160 303,972
Staff Welfare 878,192 622,599 91,273 1,592,064
Postage, Telegram and Telephone 153,349 81,157 314,446 548,952
Electricity and Gas 226,796 62,468 182,378 471,642
Newspaper and Periodicals 2,887 1,680 1,400 5,967
Entertainment Expense 200,980 132,496 83,270 416,746
Repair and Maintenance 80,638 58,646 3,730 143,014
Insurance 55,381 _ 177,000 232,381
Stamps 5,906 _ _ 5,906
Consultancy Charges 137,130 85,536 42,768 265,434
Bank Charges 166,414 106,341 34,115 306,870
Miscellaneous Expense 631,112 207,168 108,021 946,301
8,220,641 6,177,275 2,175,308 16,573,224
Gross Management Expenses 9,176,629 30,054,250 6,492,642 45,723,521
Commission From Reinsurers (2,403,433) (128,877) _ (2,532,310)
Net Management Expenses 6,773,196 29,925,373 6,492,642 43,191,210

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PROBLEM 02
The following details of expenses are extracted from the books of Zerox Life insurance
company, you are required to prepare the statement of expenses for the year ended on
December 31, 2021

Pakistan Overseas Pension

Life Fund Life Fund Fund
Supervision fee 217,516 0 0
Advertisements 256,564 2700 0
Printing and stationery 390,728 4,276 0
commission on group policies 15,156 0 420
other benefits to insurance intermediaries on group policies 3724 0 0
Salaries and other benefits 9,661,868 406,700 1400
Traveling expenses 647,504 31,192 0
Auditors' remuneration 11,200 4,688 0
Legal expenses 80,904 6,940 0
Postage and telephone 359,152 31,788 0
Other management expenses 373,944 87,928 0
Commission from reinsurers 297,936 21,608 0
Management expenses recovered from/allocated to other funds (35,436) 23,268 476
Policy stamps and medical fee 2,396,660 12,296 0
Branch overhead 5,819,092 215,324 0
Utilities 955,140 4,496 140
Training 76,084 3184 0
Computer expenses 38,252 920 0
Rental 568,844 35,576 0
Gratuity and pension expenses 2,163,076 14,072 0
Bank charges 76,464 45,776 44
Depreciation 277,164 10,188 0
Remuneration to insurance intermediaries on individual policies: 0 0 0
commission on first year premiums 31,985,256 936,340 0
commission on second year premiums 5,597,436 98,304 0
commission on subsequent renewal premiums 3,449,040 159,736 0
other benefits to insurance intermediaries 3,561,004 30,760 0

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8.6.3 Statement of claims

Format of the statement of claims is as under:
Company Name Form LF
Financial year ended 31 December ----------------
Statement of Claim
Figure in Rs. 000
Statutory Fund
Ordinary Aggregate
Aggregate
Life Ordinary Capital Pension Accident current prior year
(Investment life reproduction fund & health year
linked)

Gross Claims
Claims under individual policies (including provision for
claims intimated or incurred but not reported)
By death
By insured event other than death 0 0
By maturity
By surrender
Bonus in cash

Total gross individual policy claims

Claims under group policies (including provision for

Claims intimated or incurred but not reported)
By death
By insured event other than death 0 0
By maturity
By surrender
Bonus in cash
Experience refund

Total gross group claims

Total gross claims

Less: Reinsurance Recoveries

On individual claims 0 0
On group claims 0 0
On ordinary annuities 0 0

Net Claims

The annexed notes form an integral part of these accounts.

Chairman Director Director

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EXAMPLE 03
Malik Brothers engaged in life insurance business, you are required to draw the statement
of claims from the following balance for the period ended on December 31, 2021:

Accident &
Ordinary Life Overseas Life
Health
Claims Under Individual Policies
By Death 0 1,195,618 0
By Insured Event Other Than Death 0 12,500 294,030
By Maturity 0 13,002,698 0
By Surrender 0 12,271,633 0
Bonus in Cash 0 0 0
Reinsurance Recoveries On Group Life Claims 137,937,830 1,717,500 0
Claims Under Group Policies 0 0 0
By Death 185,975,638 0 0
By Insured Event Other Than Death 2,979,415 0 235,235,435

SOLUTION
Malik Brothers Insurance Companies
Statement of Claims
For The Year Ended December 31, 2021
Figures in Rupees
Statutory Funds Aggregate
Ordinary Overseas Accident & December 31,
Gross Claims Life Life Health 2021
Claims Under Individual Policies
By Death 1,195,618 1,195,618
By Insured Event Other Than Death 12,500 294,030 306,530
By Maturity 13,002,698 13,002,698
By Surrender 12,271,633 12,271,633
Bonus in Cash
Total Gross Individual Policy Claims 26,482,448 294,030 26,776,478

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Claims Under Group Policies

By Death 185,975,638 185,975,638
By Insured Event Other Than Death 2,979,415 235,235,435 238,214,850
Total Gross Group Policy Claims 188,955,053 235,235,435 424,190,488
Total Gross Claims 188,955,053 26,482,448 235,529,465 450,966,965
Less: Reinsurance Recoveries
On Group Life Claims (137,937,830) (1,717,500) (139,655,330)
Net Claims 51,017,223 24,764,948 235,529,465 311,311,635

PROBLEM 03
The following balances are extracted from the books of Jameel Life Insurance Company
for the year ended on December 31, 2021, you are required to prepare the statement of
claims as per the Standard. All amounts are shown in Rs '000')
Ordinary Pension Health &
Life Fund Fund Accident
Claims under individual policies
-by deaths 101,532 1,534
-by insured event other than deaths 6,890 450
-by maturity 394,682 13,498
-by surrender 230,481 10,999
-annuity payment 578
Reinsurance recoveries: 0 0
-On individual life first year business claims 229
-On individual life second year business claims 66
-On individual life renewal business claims 478
-On group life claims 2,866
Claims under group policies 0 0
-by deaths 202,610 1,488
-by insured event other than deaths 2,348
-by maturity 12
-by surrender 1
-annuity payment 63
-experience refund 7,474

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8.6.4 Statement of Premiums

Format of the statement of claims is as under:
Company Name Form LE
Financial year ended 31 December ----------------
Statement of Premium
Figure in Rs. 000
Statutory Fund
Ordinary Aggregate
Aggregate
Life Ordinary Capital Pension Accident current prior year
(Investment life reproduction fund & health year
linked)
Gross Premiums
Regular Premium Individual Policies*
First year 0 0
Second year 0 0
Subsequent year renewal 0 0

Single Premium Individual Policies 0 0

Group Policies with Cash Values 0 0

Group Policies without Cash Values 0 0

Annuities 0 0

Total gross Premium 0

Less: Reinsurance Premiums Ceded

On individual policies 0 0
On group policies 0 0
On annuities 0 0

Net Premiums 0 0 0 0 0 0 0

* Individual policies are those underwritten on an individual basis, and includes joint life policies under written as such.

The annexed notes form an integral part of these accounts.

Chairman Director Director

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EXAMPLE 04
S.M life Assurance Company Ltd closes its accounts at the end of each calendar year.
Following are the balances relating to Premium, you are required to prepare the statement
of premium accordingly for the period ended on December 31, 2021. (All amounts are
shown in 'Rs')
Universal Life Accident & Health
Regular Premium Individual Policies:
First Year 5,817,389 416,955
Second Year Renewal 6,400,796
Subsequent Year Renewal 8,908,642
Single Premium Individual Policies 1,076,100
Group Policies 39,808,402
Reinsurance Premiums Ceded:
On Individual Life First Year Business 41,870
On Individual Life Second Year Business 247,891
On Individual Life Renewal Business 393,709
On Group Policies — —
Under the head of Ordinary Life; Reinsurance Premiums Ceded on Group Policies
Amounting Rs. 26,551,140 and Regular Premium on Group Policies Amounting Rs.
36,281,102 are reported in the books of Assurance Company relating to the current period.

SOLUTION
S.M. Life Assurance Company Ltd.
Statement of Premiums
For The Year Ended December 31, 2021
Figures in Rupees
Statutory Funds Aggregate
Ordinary Universal Accident & December 31,
Life Life Health 2021
Gross Premiums
Regular Premium Individual Policies:
First Year 5,817,389 416,955 6,234,344
Second Year Renewal 6,400,796 6,400,796
Subsequent Year Renewal 8,908,642 8,908,642
Single Premium Individual Policies 1,076,100 1,076,100
Group Policies 36,281,102 39,808,402 76,089,504
Total Gross Premiums 36,281,102 22,202,928 40,225,357 98,709,386

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Less: Reinsurance Premiums Ceded:

On Individual Life First Year Business (41,870) (41,870)
On Individual Life Second Year Business (247,891) (247,891)
On Individual Life Renewal Business (393,709) (393,709)
On Group Policies (26,551,140) (26,551,140)
Total Reinsurance Premium Ceded (26,551,140) (683,470) (27,234,610)
Net Premiums 9,729,962 21,519,457 40,225,357 71,474,776

PROBLEM 04
Zab life insurance company has the following data relating to the Premiums under the
following three heads, you are required to prepare the statement of premium for the period
ended on December 31, 2021. (Amounts are shown in Rs.)

Accident & Individual Conventional

Health Life Unit Linked Business
Reinsurance Premiums Ceded:
On Individual Life First Year Business 23 111,335 205
On Individual Life Second Year Business 65,238 428
On Individual Life Subsequent Renewal Business 70 169,465 683
On single premium individual policies 35 5
On Group Policies 998 798,113
Regular Premium Individual Policies: 0 0 0
First Year 238 6,797,043 1,390
Second Year Renewal 143 3,738,185 1,170
Subsequent Year Renewal 270 5,676,350 4,143
Single Premium Individual Policies 610 403,735 20
Group Policies without cash values 1,013,610 2,901,250

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8.6.5 Profit and Loss Account

Company Name Form LS
Financial year ended 31 December ----------------
Profit and Loss account
Figure in Rs. 000
Current year Prior year
Investment income not attributable Investments
Income from Trading Investments
- Gain/loss on trading
- Dividend Income
- others, if any (please specify)
Income form Non-Trading Investments
Held to Maturity or Available for sale (classify as appropriate)
- Return on government securities
- Return on Other Fixed Income Securities and Deposits
- Dividend Income
- Others (please specify)

Gain/Loss on Sale of Investments Available for Sale

Gain/Loss on Revaluation of Investments
- Trading Investments
- Available for sale
Provision for Impairment in Value of Investments

- Provision for Portfolio Held to Maturity

- Provision for Portfolio for Sale
Less: Investment Related Expense3s
Net Investment Income
Rental Income from Investment Property
Other revenue (provide detail)
Expenses not attributable to statutory funds (provide details)
Surplus transferred from statutory funds
Profit/(Loss) before Tax (and extraordinary items, if any)
Extraordinary items (provide details)
Profit/(Loss) before Tax and after extraordinary items
Tax expense
Profit/(Loss) after tax
Profit and Loss Appropriation Account
Balance at commencement of year
Profit for the year
Prior year Adjustments (provide details)
Dividends paid
Transfers to/(from) reserves (provide details
Other appropriations (provide details)
Balance at end of year
The annexed notes form an integral part of these accounts.
Chairman Director Director

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EXAPMLE 05
Zab life insurance company has the following data relating to the Premiums under the
following three heads, you are required to prepare the statement of premium for the period
ended on December 31, 2021. (Amounts are shown in Rs.)

Current Year Balances

Tax Expense 772,645
weighted Average Number of Ordinary Shares 25,864,164
Expenses Not Attributable to Statutory Funds 14,608,348
Share of (Loss) / Profit in Associate (1,376,063)
Provision for Impairment in the Value of Available for Sale Investments 49,513,794
Gain / (Loss) on Sale of Fixed Asset 8,895
Dividend Income 1,020,465
(Loss) / Gain on Sale of Investments (78,487,771)
Return on Government Securities 3,012,985
Return on Other Fixed Income Securities and Deposits 204,877
Amortization of Discount/Premium Relative to Par 616,064

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SOLUTION
Profit and Loss Account
For The Year Ended December 31, 2021
Figures in Rupees
December 31, 2021

Investment Income Not Attributable to Statutory Funds

Return on Government Securities 3,012,985
Return on Other Fixed Income Securities and Deposits 204,877
Amortization of Discount/Premium Relative to Par 616,064
Dividend Income 1,020,465
4,854,391
(Loss) / Gain on Sale of Investments (78,487,771)
Provision for Impairment in the Value of
Available for Sale Investments (49,513,794)
Net Investment Income (123,147,174)
Other Revenue:
Gain / (Loss) on Sale of Fixed Asset 8,895
Total Investment (Loss) / Income and Other Revenue (123,138,279)
Expenses Not Attributable to Statutory Funds (14,608,348)
Share of (Loss) / Profit in Associate (1,376,063)
(Loss) / Profit Before Tax (139,122,689)
Tax Expense (772,645)
(Loss) / Profit After Tax (139,895,334)
(Loss) / Earnings Per Share - Basic and Diluted (5.41)

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PROBLEM 05
From the following balances extracted from the books of T.A Life Insurance company,
you are required to prepare the profit and loss account for the year ended on December
31, 2021, and also calculate the EPS of the year, all figures are reported in Rupees '000',
except the number of shares

Current Year Balances

(Loss) / Gain on Sale of Investments 18,750

Provision for Impairment in the Value of investment on Government Securities 28,125

Expenses Not Attributable to Statutory Funds 778,900

Surplus appropriated to shareholders fund 13,250,000

Tax Expense 5,194,075

weighted Average Number of Ordinary Shares 1,567,800

Gain on Sale of Fixed Asset 128,875

Others Revenue 90,475

Return on Government Securities 1,601,350

Return on Other Fixed Income Securities and Deposits 217,575

Amortization of Discount/Premium Relative to Par 125

Dividend Income 383,325

Provision for Impairment in the Value of investment on Listed Equities 378,225

Investment related expenses 2,575

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Balance Sheet
Company Name Form LA
Financial year ended 31 December ----------------
Balance Sheet
Figure in Rs. 000
Share- Statutory Fund
Holders Ordinary Aggregate
Aggregate
Fund Life Ordinary Capital Pension Accident current
prior year
(Investment life reproduction fund & health year
linked)
Share Capital and Reserves

Authorized Share Capital

Issued, subscribed and paid up Share

Capital
Accumulated Surplus/(Deficit)
Other Reserves (describe)

Less: Capital Contributed by

Shareholders fund
Net Shareholders’ Equity

Balance of statutory fund (including

policyholder liabilities Rs. Prior year:
Rs. )

Deferred Liabilities
Deferred Taxation
Staff Retirement Benefits
Others

Creditors and Accruals

Outstanding claims (including IBNR)
Premiums Received in Advance
Amounts due to other
insurers/reinsurers
Accrued Expenses
Taxation – Provision less payments
Other Creditors and Accruals(Please
specify)

Borrowings
Short term running finance
Loans received from banks
Other loans
Other debt security issued

Other liabilities
Other liabilities (Please specify)
Total Liabilities

Contingencies and Commitments

(if applicable)
The annexed notes form an integral part of these accounts.
Chairman Director Director

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Unit-8 Accounting for Insurance Companies

EXAMPLE 06
M.I.N. Life Assurance Company Ltd has the Authorized Share Capital Amounting Rs. 0.9
Million of Rs. 10 Each ordinary share. From the given Balances, extracted from the trial balance,
you are required to prepare the Balance sheet for the period ended on December 31, 2021.
Amount are in Rupees
Shareholders' Ordinary Universal Accident &
Fund Life Life Health
Sundry Receivables 0 38,215 51,681 30,830
Investment Income Accrued 19,710 90 1,539 0
Stationery 7,462 0 0 0
Premiums Received in Advance 0 0 159,664 6,468
Software 4,119 0 0 0
Cash in Hand 0 25 277 0
Current and Other Accounts 148,088 343,810 1,010,003 70,729
Deposits Maturing Within 12 Months 0 150,000 600,000 0
Loans Secured Against Life Insurance
Policies 0 67,625 51,092 0
Other Creditors and Accruals 2,089 6,604 1,682 1,984
Amount Due to Other Insurers/Reinsurers
– Net 0 229,418 29,105 0
Premiums Due But Unpaid 0 135,945 6,878 158,719
Prepayments 10,125 0 1,013 0
Unclaimed Dividend Payable 1,695 0 0 0
Accumulated Deficit 5,644,959 0 0 0
Balance of Statutory Fund 0 476,324 2,748,111 351,291
Outstanding Gratuity 136 1,222 0 0
Outstanding Claims 0 106,873 26,433 25,099
Listed Equities and Mutual Fund 73,614 0 0 0
Unsecured Advances to Employees 1,372 10,931 0 1,360
Government Securities 1,104,042 145,310 1,285,344 150,438
Other Fixed Income Securities 0 0 40,077 0
Accrued Taxation - Net 33,165 0 0 0
Accrued Expenses 23,657 68,685 65,056 6,902
Agent's Balances (Payable) 0 2,824 17,854 20,333
Furniture, Fixtures, Office 0 0 0 0
Equipment and Vehicles 554,091 0 0 0
Other Information: i. Co has issued Capital Amounting Rs. 7,506,840
ii. Balance of Statutory Fund includes Policy Holders
Liabilities
Rs. 3.429 Million
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Unit-8 Accounting for Insurance Companies

SOLUTION
M.I.N. Life Assurance Company Ltd
Balance Sheet
As At December 31, 2021
Figures in Rupees
Statutory Funds Aggregate
Share-
Ordinary Universal Accident & Dec. 31,
holders'
Life Life Health 2021
Fund
Share Capital and Reserves
Authorized Share Capital
0.9 Million Ordinary Shares of Rs.10 Each 9,000,000 9,000,000
Issued, Subscribed and Paid Up Capital Share 7,506,840 7,506,840
Accumulated Deficit (5,644,959) (5,644,959)
Net Shareholders' Equity 1,861,881 1,861,881
Balance of Statutory Fund (Including
Policyholders’ Liabilities
Rs.3.429 Million) 476,324 2,748,111 351,291 3,575,726
Deferred Liabilities
Outstanding Gratuity 136 1,222 1,358
Creditors and Accruals
Outstanding Claims 106,873 26,433 25,099 158,405
Premiums Received in Advance 159,664 6,468 166,132
Amount Due to Other Insurers/Reinsurers –
Net 229,418 29,105 258,523
Accrued Expenses 23,657 68,685 65,056 6,902 164,300
Agent's Balances 2,824 17,854 20,333 41,011
Taxation – Net 33,165 33,165
Other Creditors and Accruals 2,089 6,604 1,682 1,984 12,358
58,911 414,404 299,793 60,786 833,894
Other Liabilities
Unclaimed Dividend Payable 1,695 1,695
TOTAL LIABILITIES 60,741 891,951 3,047,903 412,077 4,412,673
Contingencies and Commitments
Total Equity And Liabilities 1,922,622 891,951 3,047,903 412,077 6,274,553

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Figures in Rupees
Statutory Funds Aggregate

Share- Accident
Ordinary Universal Dec. 31,
holders' &
Life Life 2021
Fund Health

Cash and Bank Deposits

Cash in Hand 25 277 302
Current and Other Accounts 148,088 343,810 1,010,003 70,729 1,572,630
Deposits Maturing Within 12 Months 150,000 600,000 750,000
148,088 493,835 1,610,280 70,729 2,322,932
Loans Secured Against Life Insurance
Policies 67,625 51,092 118,717
Unsecured Advances to Employees 1,372 10,931 1,360 13,664
Investments
Government Securities 1,104,042 145,310 1,285,344 150,438 2,685,133
Other Fixed Income Securities 40,077 40,077
Listed Equities and Mutual Fund 73,614 73,614
1,177,656 145,310 1,325,420 150,438 2,798,823
Current Assets-Other
Premiums Due But Unpaid 135,945 6,878 158,719 301,542
Prepayments 10,125 1,013 11,138
Sundry Receivables 38,215 51,681 30,830 120,727
Investment Income Accrued 19,710 90 1,539 21,339
Stationery 7,462 7,462
37,297 174,250 61,111 189,550 462,208
Fixed Assets
Tangible
Furniture, Fixtures, Office
Equipment and Vehicles 554,091 554,091
Intangible
Software 4,119 4,119
558,210 558,210
TOTAL ASSETS 1,922,622 891,951 3,047,903 412,077 6,274,553

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PROBLEM 06
Prepare the Balance Sheet as on December 31, 2021 from the following balances which are
extracted from the books of Zerox Life Insurance Corporation. Amounts are in Rupees '000'

Shareholders’ Pakistan Overseas Pension

Fund Life Fund Life Fund Fund

Inter - fund balances (Payable) 11,258 3,882 772

Others current liabilities 2,930 122,983 974 37
Provision for impairment in value of
investment Properties 36
Accumulated depreciation on Investment
Properties 90,760
Provision for diminution in value of
investment 16,765

Accumulated depreciation on Fixed Assets 38,765 770

Government grant for health insurance fund
(Deferred Liab.) 21,723
Outstanding claims 613,102 7,994
Premium received in advance 242,242 4,929
Amounts due to other insurers/reinsurers 11,153 2,675
Amount due to agents 169,822 4,440
Accrued expenses 99,665 1,871 8
Accumulated surplus 31,213
Balance of Statutory fund 15,747,239 355,977 11,560
Staff retirement benefits (Deferred Liab) 86,934 1,047
Loans To employees (secured) 14,313 586
Loans To agents (secured) 800 335
Loans Others (secured) 57
Unsecured Loans To employees 6,939
Unsecured Loans To agents 2,263 50

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Investment Properties Cost 265,842

Premiums due but unpaid 400,907 9,531 1,485

Amounts due from other insurers/reinsurers 9,373

Agents balances (Receivables) 12
Investment income due but outstanding 16,224 3,306
Investment income accrued 231,165 2,822 343
Cash and others 12,185
Current and other accounts 243,957 27,302 224
Deposits maturing within 12 months 4,476 1,455,342 17,514
Fixed deposits maturing after 12 months 108 64,433

Loans secured against life insurance policies 1,324,203 31,552

Taxation - payments less provision (Debit
Bal) 89,627 0.06
Prepayments 20,558 582
Inter - fund balances 15,912 0
Sundry receivables 12,769 137
Others current assets 1,818 13
Furniture, fixtures, office equipment,
computers and vehicles 53,264 1,283
Government securities 77,163 11,403,842 175,752 10,325
Other fixed income securities 184,248 50,332
Listed equities and mutual fund 1,444,266
Unlisted equities and mutual fund 71,489
Holding in subsidiary companies 8,497

Other Information:
i. Balance of Statutory funds includes policyholders' liabilities Amounting Rs. 15,910 Million
ii. Corporation has Issued and subscribed Capital Amounting Rs. 66,000,000
iii. Co has authorized Capital Amounting Rs. 90,000,000 of Rs. 100 each ordinary shares

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8.7 ACCOUNTING FOR NON-LIFE INSURANCE COMPANY

As mentioned earlier that various types of forms and statements are required by the Insurance
Ordinance 2000, to be submitted by each insurance companies. The followings are the some
forms or statements are illustrated:

8.7.1 Statement of Investment Income

The format investment income for the non-life insurance company is the same as described
above for the life insurance company, except the number of columns. In life insurance
Company, the investment income is classified into different columns under the head of
statutory fund whereas in Non-life insurance Company all the incomes are shown into one
column. For the understanding the following example 7 is illustrated:

EXAMPLE 07

Following Balance related to investment income are extracted from the books of Faizan
General Insurance Company Ltd for the year ended on December 31, 2021. You are
required to prepare the statement of investment income according to the standard.
Amounts are in Rupees
Unrealized (loss)/profit on re-measurement of investments at fair value
through profit and loss (2,625,284)
Investment related expenses 1,517
Return on other fixed income securities 5,040,646
Gain/(loss) on trading investments 278,353
Dividend income on trading investments 395,312
Return on government securities 1,089,232
Dividend income on available for sale investments 141,332
Gain/(loss) on sale of investments 16,519,614

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Unit-8 Accounting for Insurance Companies

SOLUTION

Faizan General Insurance Company Ltd.

Statement of Investment Income
For The Year Ended December 31, 2021
Amount Rupees
Income from trading investments:
Gain/(loss) on trading 278,353
Dividend income 395,312
673,666
Income from non-trading investments 0
Return on government securities 1,089,232
Return on other fixed income securities 5,040,646
6,129,879
Available for sale investments 0
Dividend income 141,332
Gain/(loss) on sale of investments 16,519,614
16,660,945
Unrealized (loss)/profit on re-measurement of investments at fair value through profit and
loss (2,625,284)
0
Reversal of impairment in available for sale investments _
Provision for impairment in held to maturity investments _
Investment related expenses (1,517)
Net investment income 20,837,688

PROBLEM 07
Rupees in '000'
Return on Government Securities 95,610
Return on other fixed income securities and Term finance certificates 32,238
Amortization of premium on Held to maturity securities (9,306)
Dividend income on available for sale investment 27,381
Others Income on available for sale investment 249,561
Gain on sale of non-trading investments 845,916
Investment related expenses 18,606
Prepare the statement of investment for the S.R.A general insurance company for the year ended on
December 31, 2021 from the above given data

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8.7.2 Statement of Expenses

For the non-life insurance company, (General insurance company) the statement of
expenses is prepared in two parts for those companies, who are engaged in business inside
and outside of the Pakistan. Statement of Expenses is prepared in two parts:
a. Business underwritten inside Pakistan
b. Business underwritten outside Pakistan

Following example 08 is illustrated for the understanding of statement of expenses,

assuming that company is engaged in business within Pakistan.

EXAMPLE 08

Prepare the statement of Expenses, from the Following data extracted from the books of TA Insurance
Company for the period ended on December 31, 2021. Amounts in Rs. '000'.
Commission Other Deferred commission Commission
From management paid or
Reinsurers expenses Opening Closing payable
Fire and property damage 8,947 31,252 11,657 12,181 26,282
Marine, aviation and transport 266 22,083 1,554 1,800 14,700
Motor 4 32,216 5,315 4,916 11,221
Liability 3,082 1,715 822 860 1,951
Accident and health 22,494 1,342 1,140 2,737
Miscellaneous 15,361 16,833 7,353 6,334 10,905
Non-proportional _ _ _ _ (0.2)

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Unit-8 Accounting for Insurance Companies

SOLUTION
T. A. Insurance Company Ltd.
Statement of Expenses
For The Year Ended December 31, 2021
(Rupees in ‘000
Commiss Deferred Other Under Commiss Net
Net
ion commission managem - ion under-
CLASS commission
paid or ent writing from writing
expenses
payable Opening Closing expenses expenses reinsurers expense
d = a+b-
a b c e f = d+e g h = f-g
Direct and facultative c
Fire and property
damage 26,282 11,657 12,181 25,757 31,252 57,009 8,947 48,062
Marine, aviation and
transport 14,700 1,554 1,800 14,454 22,083 36,537 266 36,271
Motor 11,221 5,315 4,916 11,621 32,216 43,836 4 43,832
Liability 1,951 822 860 1,913 1,715 3,628 3,082 546
Accident and health 2,737 1,342 1,140 2,938 22,494 25,432 25,432
Miscellaneous 10,905 7,353 6,334 11,924 16,833 28,757 15,361 13,397
Total 67,796 28,043 27,232 68,607 126,592 195,199 27,659 167,540
Treaty 0 0 0 0 0 0 0 0
Non-proportional (0.2) (0.2) (0.2) 0 (0.2)

Grand total 67,796 28,043 27,232 68,607 126,592 195,199 27,659 167,540

PROBLEM 08
Prepare the statement of expenses for the Nizami general insurance company for the year
ended on December 31, 2021 from the given data. Amounts in Rupees
Commission Deferred commission Commission Other
From paid or management
Reinsurer Opening Closing payable expenses
Fire and property damage 8,260,828 3,189,117 2,757,323 5,632,347 2,316,316
Marine, aviation and transport 5,128,150 500,133 420,395 3,822,770 2,031,325
Motor 192,108 3,507,501 2,937,592 6,207,930 33,897,650
Accident and health 9,353,767 1,512,059 1,038,751 2,268,623 4,955,827
Miscellaneous 4,713,092 2,156,098 948,149 2,123,197 2,398,423

8.7.3 Statement of Claims

For the non-life insurance company, (General insurance company) the statement of claim
is prepared in two parts for those companies, who are engaged in business inside and
outside of the Pakistan. Statement of claim is prepared in two parts:
c. Business underwritten inside Pakistan
d. Business underwritten outside Pakistan

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Unit-8 Accounting for Insurance Companies

On the next page example 09 is illustrated for the understanding of statement of claim:

EXAMPLE 09
Prepare the statement of Claims for the C.F General insurance company for the year ended
on December 31, 2021 from the given data.
Amounts in Rupees '000'
Reinsurance Reinsurance and other
Total Outstanding claims and other recoveries in respect of
Class
claims recoveries outstanding claims
Paid Opening Closing received Opening Closing
Proportional (Treaty) 35,541 68,886 60,996 _ _ _
Fire and property damage 5,342,952 3,506,313 14,681,871 2,550,993 2,129,109 13,004,220
Marine, aviation and
transport 1,396,461 1,079,478 1,278,195 10,689 551,619 498,216
Motor 8,312,199 4,415,496 4,622,214 849,702 2,116,821 2,985,459
Miscellaneous 3,495,885 1,657,536 3,297,951 710,055 1,086,396 2,570,619

Solution
C.F General Insurance Company Ltd.
Statement of Claims for the Year Ended December 31, 2021
Rupees in '000'
Reinsurance and other and Reinsuran
Net
Total Outstanding Claims other recoveries in respect ce
Class claims
claims claims expenses of recoveries outstanding and other
expense
paid claims recoveries
Openi
Opening Closing Received ng Closing Revenue
Direct and d=a-
facultative a b c b+c e f g h=e-f+g i=h-d
Fire and property
damage 5,342,952 3,506,313 14,681,871 16,518,510 2,550,993 2,129,109 13,004,220 13,426,104 3,092,406
Marine, aviation
and transport 1,396,461 1,079,478 1,278,195 1,595,178 10,689 551,619 498,216 (42,714) 1,637,892

Motor 8,312,199 4,415,496 4,622,214 8,518,917 849,702 2,116,821 2,985,459 1,718,340 6,800,577

Miscellaneous 3,495,885 1,657,536 3,297,951 5,136,300 710,055 1,086,396 2,570,619 2,194,278 2,942,022

Total 18,547,497 10,658,823 23,880,231 31,768,905 4,121,439 5,883,945 19,058,514 17,296,008 14,472,897

Treaty
Proportional 35,541 68,886 60,996 27,651 - - - - 27,651

Total 35,541 68,886 60,996 27,651 - - - - 27,651

Grand Total 18,583,038 10,727,709 23,941,227 31,796,556 4,121,439 5,883,945 19,058,514 17,296,008 14,500,548

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Unit-8 Accounting for Insurance Companies

PROBLEM 09
Reinsurance and other Claims Reinsurance
Outstanding claims recoveries in respect of paid and other
outstanding claims recoveries
CLASS Opening Closing Opening Closing received
Fire and property damage 38,855,348 43,031,866 28,235,311 35,655,268 33,099,921 21,571,659
Marine, aviation and
transport 29,843,506 25,612,014 20,197,428 16,286,223 25,067,414 16,438,760
Motor 57,471,628 58,800,287 1,653,345 6,168,990 154,543,139 10,116,757
Accident and health 40,658,923 37,500,425 31,445,909 23,838,511 96,015,775 68,094,284
Miscellaneous 7,198,897 16,710,884 5,457,155 12,083,804 12,126,565 8,500,789

Prepare the statement of Claims for the M.C.M Non-Life insurance company for the year
ended on December 31, 2021 from the above given data. All Amounts are in Rupees.

8.7.4 Statement of Premiums

If the general insurance business underwritten outside Pakistan is more than 10% of the net
premium income, then a separate statement on a similar format should be prepared in
respect of that business. Statement of premiums is prepared in two parts under the
following captioned:
a. Business underwritten inside Pakistan
b. Business underwritten outside Pakistan

Example 10 is illustrated for the understanding of statement of Premiums:

EXAMPLE 10
Class Unearned premium Reinsurance Premiums Prepaid reinsurance
Reserve ceded written premium ceded
Opening Closing Opening Closing
Motor 475,005 440,249 102,690 911,449 49,352 43,833
Marine, aviation and transport 10,525 14,497 45,608 283,555 1,289 3,050
Proportional (Treaty) 1,724
Miscellaneous 194,432 305,218 164,896 626,642 35,504 53,947
Fire and property damage 421,492 494,395 777,319 1,067,673 284,262 342,803
Prepare the statement of Premiums for the M.F insurance company for the year ended on
December 31, 2021 from the above given data. All Amounts are in thousands rupees.

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Unit-8 Accounting for Insurance Companies

SOLUTION
M.F Insurance Company Ltd.
Statement of Premiums
For The Year Ended December 31, 2021
Rupees in '000'
Premiu Unearned Premiu Re- Prepaid Re- Net
Class ms premium ms insurance reinsurance insurance premium
written reserve earned ceded premium ceded expense revenue
Opening Closing Opening Closing
Direct an facultative a b c d=a+b-c e f g h=e+f-g i=d-h
Fire and property
damage 1,067,673 421,492 494,395 994,770 777,319 284,262 342,803 718,779 275,992
Marine, aviation and
transport 283,555 10,525 14,497 279,583 45,608 1,289 3,050 43,847 235,736
Motor 911,449 475,005 440,249 946,205 102,690 49,352 43,833 108,210 837,996
Miscellaneous 626,642 194,432 305,218 515,856 164,896 35,504 53,947 146,453 369,403
Total 2,889,319 1,101,454 1,254,359 2,736,414 1,090,513 370,407 443,631 1,017,289 1,719,126
Treaty
Proportional 1,724 _ _ 1,724 _ _ _ _ 1,724
Total 1,724 _ _ 1,724 _ _ _ _ 1,724

Grand Total 2,891,042 1,101,454 1,254,359 2,738,138 1,090,513 370,407 443,631 1,017,289 1,720,849

PROBLEM 10
The following data is obtained from the books of S.M.W Insurance Company related to
Premiums. All amounts are given in rupees.
Class Reinsurance Premiums Prepaid reinsurance Unearned premium
ceded written premium ceded reserve
Opening Closing Opening Closing
Fire and property damage 38,407,579 49,132,652 23,831,702 18,474,924 28,918,784 23,091,158
Marine, aviation and transport 22,684,549 32,881,187 2,663,085 3,502,943 3,171,563 4,389,644
Motor 3,184,309 144,749,425 1,131,356 1,514,851 54,060,186 62,584,901
Accident and health 43,208,903 71,879,782 22,679,234 21,238,115 31,388,267 34,664,017
Miscellaneous 18,921,380 33,318,657 27,577,551 9,652,523 29,993,506 14,872,970
You are required to prepare the statement of Premium for the year ended on December 31,
2021.

8.7.5 Profit and Loss Account

Profit and loss account is the Component of Financial Statements, which is prepared to
ascertain the operating results of the entity of any type of organization. Following is the

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Unit-8 Accounting for Insurance Companies

format of Profit and Loss Account which is prepared for the business of General Insurance
Companies:
Company Name Form GB
Financial year ended 31 December ----------------
Profit and Loss Account Figure in ‘000

Note Fire & Marine, Motor Act Other Treaty Current Prior year
Property Aviation & Liabilities year Aggregate
Transport Aggregate
Revenue Account
Net Premium Revenue

Net Claims

Premium deficiency expenses

Expenses

Net Commission

Expenses

Underwriting Result

Investment Income
Rental Income
Other income (provide details)
General & Administration expenses

Profit/loss before tax

Provision for taxation

Profit/loss after tax

Profit and loss appropriation Account

Balance at commencement of
year

Profit/loss after tax for the year

Prior year adjustment (provide
details)
Proposed dividend/remittance to
head office
Transfer to/for reserves (provide
details)
Other appropriation (provide
details)

Balance inappropriate profit/

loss at the end of year
The annexed notes from an integral part of these accounts.

Commission (if any) Director Director Principal Officer

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Unit-8 Accounting for Insurance Companies

EXAMPLE 11

B.L.L General Insurance Company reported the following figures for the year ended
on 2021. All Amounts are in thousand rupees.
Issue bonus shares for the year @ 10 % 84,344
Other income 128,429
General and administration expenses 476,192
Investment income 584,317
Rental income 786
Exchange loss 1,047
Finance charge on lease liabilities 14,225
Provision for taxation 43,262
Balance of inappropriate profit at the
commencement of the year 6,390,032
Final dividend for the year 126,516
Weighted average number of shares 92,778,408
Interim dividend @ 10% (Rupee 1/- per share)

OTHER DATA
Fire and Property Marine, Aviation and Motor Misc. Treaty
Damage Transport
Net commission (90,491) (135,660) (182,327) 24,988 (2,432)
Net premium revenue 827,975 707,207 2,513,987 1,108,209 5,171
Net claims 773,102 409,473 1,700,144 735,506 6,913
Expenses 162,728 137,381 421,134 218,840 1,025

Required: Prepare the Profit and Loss Account for the year ended on 31 December,
2021

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SOLUTION
B.L.L. General Insurance Company Ltd.
Profit and Loss Account
For The Year Ended December 31, 2021
Rupees in '000'
Fire and Marine,
Property Aviation & Motor Misc. Treaty Aggregate
Damage Transport
Revenue account
Net premium revenue 827,975 707,207 2,513,987 1,108,209 5,171 5,162,548
Net claims (773,102) (409,473) (1,700,144) (735,506) (6,913) (3,625,137)
Expenses (162,728) (137,381) (421,134) (218,840) (1,025) (941,108)
Net commission (90,491) (135,660) (182,327) 24,988 (2,432) (385,923)
Underwriting result (198,346) 24,693 210,381 178,851 (5,200) 210,380

Investment income 584,317

Rental income 786
Other income 128,429

923,912
General and administration expenses (476,192)
Exchange (loss) / gain (1,047)
Finance charge on lease liabilities (14,225)
Profit before tax 432,449
Provision for taxation (43,262)
Profit after tax 389,187
Profit and loss appropriation account
Balance at the commencement of the year 6,390,032
Profit after tax for the year 389,187
Final dividend for the year ended on December 31, 2009 Rupees 1.5/-
per share (126,516)

Issue bonus shares for the year ended on 31 December, 2009 @ 10 % (84,344)
Interim dividend @ 10% (Rupee 1/- per share) (92,779)

Balance inappropriate profit at the end of the year 6,475,580

Earnings per share - basic and diluted Rs. 4.19

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Unit-8 Accounting for Insurance Companies

PROBLEM 11

The following data is obtained from the books of M.T.P General Insurance Company. All
amounts are denoted in rupees.

Balance of inappropriate profit at Weighted average number

12,465,622 10,023,612
beginning of the year of shares
Issuance of bonus shares: Re. 1
17,830,303 Investment income 17,364,740
(10%) per share
Rental income 233,520 Other income 1,756,170
General and administration expenses 43,350,457 Profit on bank deposits 1,229,000
Share of profit in associated company 1,624,157 Provision for taxation 4,495,719

OTHER DATA
Fire and
Marine, Accident and
property damage Motor Miscellaneous
aviation health
and transport

Net premium revenue 12,439,912 10,909,351 148,248,772 26,615,567 12,880,873

Net claims 4,602,679 4,615,760 78,466,331 17,983,550 3,617,286
Expenses 3,088,421 2,708,433 45,196,867 6,607,770 3,197,897
Net commission 2,928,914 1,634,189 (8,780,976) 8,815,781 1,842,596

You are required to prepare the Profit and Loss Account for the year ended on
December 31, 2021.

8.7.6 Balance Sheet

It is also called the statement of financial position, because it shows the financial position
of an entity. For the general insurance company the format is given below of the Balance
sheet.

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Form for non-life insurance Form GA

Company Name
Financial year ended December 31___________
Balance Sheet
Figures in Rs. 000
Note Current Prior Note Current Prior
year year year year
Rs. Rs. Rs. Rs.
Domestic companies Cash and Bank deposits
Domestic Companies Cash and other equivalent
Authorized Share capital Current and other accounts
Paid-up share capital Deposits maturing within 12 months
Retained earnings Deposits maturing after 12 months
Reasons
Other equity (please specify) Loans (Secured or un-secured – classify as appropriate)

To employees or agents
Foreign companies Others
Head office account
Other domestic equity (please specify)
Investment
Underwriting provisions
Provision for outstanding claims (including INBR) Investment property
Provision for unearned premium
Additional provision for unexpired risks Deferred Taxation
Commission income unearned
Preliminary and deferred expenses
Total underwriting provisions
Current Assets – others
Deferred liabilities Premium due but unpaid
Deferred taxation Amount due from other insures/reinsurers
Self retirement benefits Reinsurance recoveries due but unpaid
Other (please specify) Salvage recoveries accrued
Premium and claim reserves retained by decants
Accrued investment income
Creditors and Accruals Reinsurance recoveries against outstanding claims
Premiums Received in Advance Taxation – payments less provision
Amounts due to other insurers/reinsurers Deferred commission expense
Accrued Expenses Other deferred acquisition costs
Taxation – Provision less payment Prepayments
Other Creditors and Accruals (describe) Sunday receivables ( provide details)

Borrowings Fixed Assets

Short term running finance Tangible & Intangible
Loans received from banks Land and Buildings
Other loans Furniture, Fixtures and Office Equipment
Other debt security issued Motor vehicle
Capital work in progress
Other liabilities Intangibles (please specify)
Other liabilities (please specify)
TOTAL LIABLITIES
TOTAL EQUAITY AND LIABLITIES TOTAL ASSETS
CONTINGENCIES AND COMMITMNTS
(if applicable)

The annexed notes from an integral part of these accounts.

Commission (if any) Director Director Principal Officer

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Unit-8 Accounting for Insurance Companies

EXAMPLE 12
B.T.E. Insurance company has authorized ordinary share capital Rs. 150,000,000 divided
into Rs. 10 each. Company closes it accounts at the end of each calendar year. The
following balances are extracted from the trial balance for the period ended on December
31, 2021. You are required to prepare the Balance Sheet as on 31 December 2021. All
amounts are denoted in Rupees.
Staff compensated absences 2,753,291 Furniture and fixtures 2,356,023
Premium received in advance 3,233,397 Computer and office equipment 3,720,442
Amounts due to other insurers/reinsurers 40,338,606 Motor vehicles 1,500,931
Accrued expenses 770,151 Accrued investment income 957,588
Taxation-provision less payments 1,048,496 Reinsurance recoveries against
Sundry creditors 38,803,288 outstanding claims-unsecured,
Provision for outstanding claims (including 90,827,738 considered good 47,016,398
IBNR) Deferred commission expense 9,722,651
Prepayments 58,870,069

Provision for unearned premium Sundry receivables 9,008,450

Commission income unearned 139,602,689 Premiums due but unpaid-unsecured 82,637,041
Unclaimed dividend 12,683,052 Amounts due from other
Others liabilities 249,031 insurers/reinsurers unsecured,
Paid up share capital 3,522,069 considered good 27,652,539
Retained earnings 92,462,868 Salvage recoveries accrued 6,402,630
Reserves 14,802,046 Advances to employees 356,939
Deferred taxation 22,397,304 Investments 151,023,979
Cash and other equivalents 984,743 Investment property 15,294,250
Current and other accounts 200,397 Leasehold improvements 2,135,563
Tracking devices 38,969,489 Software license 2,473,124
759,920 Capital work in progress 1,450,861

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Unit-8 Accounting for Insurance Companies

SOLUTION
B.T.E. Insurance Company Ltd.
Balance Sheet
As at 31st December, 2021
Share capital and reserves Cash and bank deposits Rupees
Authorized share capital Rupees
Cash and other equivalents 200,397
Current and other accounts 38,969,489
39,169,886
15,000,000 ordinary shares of Rs. 10 150,000,000
each
Advances to employees 356,939
Paid up share capital 92,462,868
Investments 151,023,979
Retained earnings 14,802,046
Investment property 15,294,250
Reserves 22,397,304
Deferred taxation 984,743
129,662,219
Deposit against issue of shares ----
Current assets-others
TOTAL EQUITY 129,662,219
Premiums due but unpaid-unsecured
Amounts due from other 82,637,041
Underwriting provisions
insurers/reinsurers unsecured,
Provision for outstanding claims 90,827,738
considered good 27,652,539
(including IBNR)
Salvage recoveries accrued 6,402,630
Provision for unearned premium 139,602,689
Accrued investment income 957,588
Commission income unearned 12,683,052
Total Underwriting provisions 243,113,479
Deferred Liabilities Reinsurance recoveries against
Staff compensated absences 2,753,291 outstanding claims-unsecured,
considered good 47,016,398
Creditors and Accruals
Premium received in advance 3,233,397 Deferred commission expense 9,722,651
Amounts due to other Prepayments 58,870,069
insurers/reinsurers 40,338,606 Sundry receivables 9,008,450
Accrued expenses 770,151 242,267,366
Taxation-provision less payments 1,048,496
Sundry creditors 38,803,288
84,193,938 Fixed assets
Tangible and intangible 2,356,023
Other Liabilities Furniture and fixtures
Unclaimed dividend 249,031 Computer and office equipment 3,720,442
Others 3,522,069 Motor vehicles 1,500,931
3,771,100 Tracking devices 759,920
Leasehold improvements 2,135,563
Total Liabilities 333,831,807 Software license 2,473,124
Capital work in progress 1,450,861
Total Equity and Liabilities 463,494,026 14,396,863

Contingencies and Commitments Total Assets 463,494,026

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Unit-8 Accounting for Insurance Companies

PROBLEM 12
Prepare the Balance Sheet As on December 31, 2021 from the following balances which
are extracted from the books of C.R.A. General Insurance Company. The company has
authorized share capital amounting Rs. 225,000,000 of Rs. 10 each. All amounts given
below are in thousand rupees
Staff retirement benefits Loan to employees 3,313
Provision for outstanding 2,599 Deposits maturing within 237,724
claims (including IBNR) 12 months 42,221
Premiums received in 1,197,061 Land and buildings 9,343
advance Furniture and fixtures 937,980
Provision for unearned 11,299 Reinsurance recoveries 5,017
premium against outstanding claims
Commission income 752,615 Accrued investment
unearned income 1,411,050
Paid-up share capital 45,815 Investments
Liabilities against assets 185,557 Motor vehicles
subject to finance lease Motor vehicles (Leased)
Unclaimed dividends 16,146 Taxation - payments less
Retained earnings 4,368 provision
Reserves 1,295,116 Deferred commission
Deferred taxation 174,577 expense
Amounts due to other 10,253
insurers / reinsurers Prepayments 29,588
Accrued expenses 237,295 Sundry receivables 21,516
Other creditors and 22,199 Cash and other 6,555
accruals 228,110 equivalents 76,833
Premiums due but unpaid 681,933 Current and other 274,367
Amounts due from other accounts 47,561
insurers/ reinsurers 149,038 Machinery and equipment 8,909
Salvage recoveries accrued 14,945 Computers and related 159,090
Premium and claim accessories 47,429
reserves retained by 3,488 Intangible asset - 7,841
cedents computer software 7,271

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Unit – 9

Accounting For Leases

Written by: Dr. Muhammad Munir Ahmad

Reviewed by: Prof. Dr. S.M. Amir Shah
Unit-9 Accounting for Leases

CONTENTS

Introduction .........................................................................................................311
Objectives .........................................................................................................311
9.1 Introduction & Definitions ..........................................................................312
9.1.1 Definition ........................................................................................312
9.1.2 Scope of IAS 17 ..............................................................................312
9.2 Important Terms OF IAS 17 .......................................................................312
9.3 Classification of Leases ..............................................................................315
9.3.1 Finance Lease ......................................................................315
9.3.2 Operating Lease...................................................................316
9.3.3 Criteria of Identification of Type of Lease .....................................316
9.4 Residual Value ............................................................................................318
9.4.1 Guaranteed Residual Value.............................................................318
9.4.2 Un-guaranteed Residual Value .......................................................319
9.5 Accounting for Leases by Lessee ...............................................................320
9.6 Bargain Purchase Option (BPO) .................................................................326
9.7 Accounting for Leases by Lessor ................................................................328
9.8 Operating Lease ..........................................................................................335
9.9 Sales and Lease Back ..................................................................................336
9.10 Miscellaneous Problems .............................................................................341

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Unit-9 Accounting for Leases
INTRODUCTION
This unit is based on the International Accounting Standard (IAS) 17, which
describes the concept of leasing, definition of important terms, its various types,
scope of the IAS 17 and accounting procedures of leasing form the view point of
lessee as well as the lessor in detail. Throughout the unit topic wise exercises with
solution and related problems are given for the understanding of the different
concepts of the leasing. At the end of the unit various problems are given for the
practice of the students.

OBJECTIVES
After reading this unit, you will be able:
a) To understand about the leasing, its scope, and various concepts of lease
accounting
b) To differentiate between operating lease and finance lease
c) To prepare the amortization schedule from the viewpoint of lessor and lessee
d) To record the transactions relating to lease accounting and presentation of
financial statements
e) To perform the accounting treatment of Bargain Purchase Option (BPO) and
residual value either guaranteed or un-guaranteed on the accounting
treatment.
f) To deal with the sales-leaseback arrangement and its accounting procedures.

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9.1 INTRODUCTION TO LEASING
The acquisition of assets - particularly expensive capital equipment - is a major
commitment for many businesses. How that acquisition is funded, requires careful
planning. Rather than pay for the asset outright using cash, it can often make sense
for businesses to look for ways of spreading the cost of acquiring an asset, to
coincide with the timing of the revenue generated by the business. The most
common source of long term and medium term finance for investment in capital
assets is leasing. Leasing is financial facility which allows a business to use an asset
over a fixed period, in return for regular payments. The business customer chooses
the equipment it requires and the finance company buys it on behalf of the business.

9.1.1 Definition
A lease is a contract between two parties, the lessee and the lessor for the hire of a
specific asset. The ownership is retained by the lessor (owner) but the rights of use
are transferred to lessee (Renter) for an agreed period of time in return of specified
rentals.

International Accounting Standard (IAS) 17 defines the leases as: “An agreement
whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time”.

Lessor: Lessor is referred as the owner of the asset, who transfers the rights to use
the assets.
Lessee: Lessee is that person to whom the asset is transferred for use in return of
rental payments.

9.1.2 Scope of the IAS 17

IAS 17 is applicable in accounting for all leases except the (i) Leases to explore
for or use minerals, oils, natural gas and similar non-generative resources (ii)
Licensing agreements for such items as motion picture films, video recordings,
plays, manuscripts, patents and copyrights and (iii) the contract of services that do
not transfer the right to use assets from one party to the other.

9.2 IMPORTANT TERMS OF IAS 17

IAS 17 defines the following some other important terms for the understanding of
the lease accounting:

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9.2.1 Lease term
The lease term is the non-cancelable period for which the lessee has contracted to
lease the asset together with any further terms of which the lessee has the option to
continue to lease the asset, with or without further payment, when at the inception
of the lease it is reasonably certain that the lease will exercise the option.

It is usually fixed non cancelable term. This period cannot be reduced but may be
extended if the lease contract contains the bargain renewal option. By exercising
this option, the lessee may renew the lease at a substantial lower rental than the
expected fair rate at the date the option becomes exercisable.

9.2.2 Inception of the lease

The inception of the lease is the earlier of the date of the lease agreement or the
date of commitment by the parties to the principal provision of the lease. As at this
date:
a. A lease is classified as either an operating or finance lease; and
b. In the case of finance lease the amounts to be recognised at the
commencement of the lease term are determined.

In other words, the data of inception of lease is the lease agreement date except that
the commitment to the principal provision of the lease has been made prior to the
lease agreement. In such case the date of commitment will be considered as the date
of inception of the lease.

9.2.3 Useful life

Useful life is the estimated remaining period, from the inception of the lease term,
over which the economic benefits associated with the leased assets are expected to
be consumed by the entity.

9.2.4 Economic life

Economic life is either:
a. The period over which an asset is expected to be economically usable by one
or more users; or
b. The number of production or similar units expected to be obtained from the
asset by one or more users.

9.2.5 Non cancelable lease

A non-cancelable lease is a lease that is cancelable only:
a. Upon the occurrence of some remote contingency
b. With the permission of lessor

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c. If the lessee enters into a new lease for the same or an equivalent asset with
the same lessor. or
d. Upon payment by the lessee of such an additional amount that, at inception
of the lease, continuation of the lease is reasonably certain.

Only the non cancelable leases may be considered as finance lease, if the lease is
cancelable and even meets all the criteria to be finance lease, it may not be
capitalized.

9.2.6 Initial direct costs

Incremental costs that are directly attributable to negotiating and arranging a lease,
except for such costs incurred by lessor. i.e. commissions, legal fees and relevant
internal costs etc.

9.2.7 Fair value

It is the price at which the assets can be sold to an unrelated party. Amount is usually
calculated cost less trade discount. Unrelated parties are entities which are not
subject to the significant influence over the operating or financial policies of
another entity.

9.2.8 Interest rate implicit in the lease

The discount rate that, at the inception of the lease, causes the aggregate present
value of:
a. The minimum lease payment
b. The unguaranteed residual value
to be equal to the sum of: (i) the fair value of the leased assets and (ii) any
initial direct costs

9.2.9 Lessees incremental borrowing rate

It is the rate of interest the lessee would have to pay on a similar lease or, if that is
not determinable, the rate that, at the inception of the lease, the lessee would incur
to borrow over a similar term, and with a similar security, the funds necessary to
purchase the asset.

9.2.10 Contingent rentals

Contingent rentals are not fixed per period, but depend upon future events and
therefore cannot be ascertained at the inception of lease. The rentals are based upon
any basis other than time period. i.e. rentals based on future sales volume, future
machine hours and future price indices.

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9.2.11 Minimum lease payments (MLP)
The payments over the lease term that the lessee is or can be required to make,
excluding contingent rent, costs for services and taxed to be paid by and be
reimbursable to the lessor, together with:
a. In the case of the lessee any amounts guaranteed by the lessee or by a party
related to the lessee
b. In the case of the lessor, any residual value guaranteed to the lessor by either
(i) the lessee (ii) a party related to the lessee (iii) an independent third party
financially capable of meeting this guarantee.

MLP = Down Payment + Lease Rentals + Guaranteed Residual Value or

Bargain Purchase Option

9.3 CLASSIFICATION OF LEASES

The objective of IAS 17 is to prescribe the appropriate accounting policies and
disclosure to apply in relation to leases for lessee and lessor. The classification of
leases adopted in this Standard is based on the extent to which risks and rewards
incidental to ownership of a leased asset lie with the lessor or the lessee.
Classification is made at the inception of the lease. Any changes or revision of the
agreement will be treated as a new agreement. However changes in estimates or
circumstances would not the cause of new classification of lease for the purpose of
accounting.

IAS 17 classifies the lease into broad categories: (i) finance lease (ii) operating
lease

9.3.1 Finance Lease

A lease is classified as a finance lease if it transfers substantially all the risks and
rewards incidental to ownership.

From the view point of lessor the finance lease may be further classified as (a)
Direct Finance Lease and (b) Sales type Lease

a. Direct Finance Lease

The lessor in a direct financing lease purchases an asset to accommodate the leasing
transaction and immediately leases it to the lessee. The purchased asset is on the
lessor’s books only momentarily. Conceptually, accounting for a direct financing
lease is similar to accounting for a disposal of an asset on credit. But rather than
reporting an account receivable, the lessor reports a lease receivable on the balance

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Unit-9 Accounting for Leases
sheet. No asset depreciation is taken by the lessor, and the lessor’s profit comes
entirely from interest.

b. Sales types Lease

Sales-type leases are used by manufacturers and distributors or dealers. It doesn’t
involve purchase for immediate lease. The manufacturer instead leases out the asset
directly from finished goods inventory, or the distributor leases the asset out of its
inventory accounts. Here the lessor’s profit comes partly through selling the asset
above cost and partly through interest.

9.3.2 Operating Lease

A lease is classified as an operating lease if it does not transfer substantially all the
risks and rewards incidental to ownership.

9.3.3 Criteria of identification of type of lease

Whether the lease is an operating lease or a finance lease is depends upon the
substance of the transactions rather than form of a contract. The main factor which
is considered is risk and rewards. However IAS 17 describes the following criterion
for the identification of lease, whether the lease is treated as finance or operating.
If the lease meets any one of the following criteria, it would be classified as finance
lease and if the lease doesn’t meet any one of the following criteria, then the lease
will be considered as operating lease:
i. The lease transfers ownership of the assets to the lessee at the end of the lease
term.
ii. The lessee has the option to purchase the asset at a price which is expected to
be sufficiently lower than the fair value at the date the option becomes
exercisable such that, at the inception of the lease, it is reasonably certain that
the option will be exercised.
iii. The lease term is for the major part of the economic life of the assets.
iv. At the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset.
v. The leased assets are of a specialized nature such that only the lessee can use
them without major modification being made.

Explanation
Criteria (i):
if the lease agreement contains that the ownership will be transferred by the end of
the lease term, the lease is classified as finance lease.

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Criteria (ii):
if the option is given to the lessee at the end of the lease term to purchase the leased
assets, which is known as Bargain Purchase Option (BPO), the lease is classified
as finance lease. The transfer of ownership is implied as the bargain purchase price
being significantly below the fair value, the lessee will exercise the option.

Criteria (iii):
if the lease term is major part of the useful life of the leased assets, it will be
capitalized. IAS 17 doesn’t define the “major part” however in generally if the lease
term is 75% or more of the asset’s economic life (useful life) is classified as finance
lease.

Criteria (iv):
if the present value of minimum lease payment (MLP) is greater than or equal to
substantially all of, the fair value the leased asset, net of grants and tax credits to
the lessor at the inception of lease, the lease should be classified as finance lease.
IAS 17 does not describe the term “substantially all” however generally, if the
present value of MLP is 90% or above of the fair value of the leased assets, the
lease will be classified as finance lease.

Criteria (v):
if the leased assets is designed as per the requirements of the lessee and is of the
specialized nature which cannot be used by other than lessee without major
modification, it will be categorized as finance lease.

Identification of Type of Lease

Example 01:
Sohrab Corporation leases an equipment on 1st January, 2021 that has fair value of
Rs. 8,000 from Barakat Corporation for five years. Interest rate implicit in the lease
is 12%. Useful life of equipment is 10 years. Annual rentals payable at the end of
each year are amounting Rs. 2,219.28.

You are required to identify the type of lease

Solution:
For the identification of type of lease, check the each of the criteria one by one in
the same order as mentioned in IAS 17, if the lease agreement meets any one of the
criteria, then the lease is classified as finance lease. But if the lease agreement
doesn’t meet any one of the five criterions then the lease will be classified as
operating lease.
i. There is no transfer of ownership, so criteria (i) doesn’t meet

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Unit-9 Accounting for Leases
ii. No bargain purchase option is given, so criteria (ii) is not applicable
iii. Lease term is not the major part of the economic life of the leased asset. It is
50% of the useful life of the assets (5/10 = 50%), so criteria (iii) doesn’t meet
iv. Present value of MLP is equal to fair value of the assets. This meets the
criteria (iv), so this is classified as finance lease. This is checked as:

Annual Rental payable: Rs. 2,219.28

Discount Rate: 12%
Lease term: 5 years
PVIFA: 3.605*
Present value of MLP: Rs. 8000 (Rs. 2,219.28 x 3.605)
1
1− (1+𝑖)𝑛
*PVIFA = where: i = interest rate (Discount Rate), n = lease term
𝑖
Now there is no need to check the criteria (v), as it has met the criteria (iv) and has
been classified as finance lease.

Problem 01
A lease was signed on 1st January, 2021 for 8 years. Annual rentals payable at the end
of each year were agreed Rs. 1,080. Useful life of the machine was 15 years and interest
rate implicit in the lease was 15%. Fair value of the machine was Rs. 5000.

Required:
Identify the type of lease

9.4 RESIDUAL VALUE

It is the estimated fair market value of the assets at the end of the useful life. From
the leasing point of view, the residual value may be (i) Guaranteed residual value
and (ii) un guaranteed residual value

9.4.1 Guaranteed Residual Value

Guaranteed Residual Value (GRV) is:

For Lessee: that part of residual value which is guaranteed by the lessee or by a
party related to the lessee (the amount of the guarantee being the maximum amount
that could, in any event, become payable).

For Lessor: that part of the residual value that is guaranteed by the lessee or by a
third party unrelated the lessor that is financially capable of discharging the
obligations under the guarantee.

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9.4.2 Unguaranteed Residual Value
Unguaranteed Residual Value (UGRV) is that portion of the residual value of the
leased asset, the realization of which by the lessor is not assured or is guaranteed
solely by a party related to the lessor.

Hint: Guaranteed Residual Value will be capitalized by the lessee, whereas

Unguaranteed Residual Value will not be added by the lessee while calculating
the MLP

Example 02
A lease was signed on 1st January, 2021 for 10 years. Annual rentals payable at the
end of each year were agreed Rs. 2,500. Useful life of the machine was 25 years
and interest rate implicit in the lease was 12%. Fair value of the machine was Rs.
15000. Residual value guaranteed by the lessee was Rs. 2000.

Required
Identify the type of lease

Solution
This lease agreement does not meet the first three criterions, so now check the
criteria (iv):
Annual Rental payable: Rs. 2,500
Discount Rate: 12%
Lease term: 10 years
PVIFA: 5.65
Present value of MLP:
Rs. 14,125 (Rs. 2,500 x 5.65)
Add: Present value of GRV Rs. 644 (Rs. 2000 x 0.322*)
-------------
Rs. 14,769
-------------
Fair value of assets Rs. 15,000

As the Present value of MLP is (Rs. 14,769/ Rs. 15,000) 98% of the fair value
of the assets, so it is classified as the finance lease.
1
*PVIF = (1+𝑖)𝑛 where: i = interest rate (Discount Rate), n = lease term

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Unit-9 Accounting for Leases
Problem 02:
M.N.K Co. Ltd leases a machine on 1st January, 2021 that has fair value of Rs.
18,000 from M.S.R Co. Ltd for five years. The incremental borrowing rate for
M.N.K Co. Ltd is 15%. Useful life of equipment is 10 years. Annual rentals payable
at the end of each year are amounting Rs. 5,000. Residual value guaranteed by the
lessee was Rs. 2,500.

9.5 ACCOUNTING FOR LEASES BY LESSEE

From the lessee’s point of view the following journal entries are passed:
1. Assets under finance lease (Dr)
Liability under finance lease (Cr)
To record the Capitalization of leased asset and raising of corresponding
liability at the inception of lease

2. Profit and loss account (Dr)

Accumulated depreciation (Cr)
To record the depreciation on the leased assets at the end of year.

3. Interest expenses (Dr)

Interest Payable (Cr)
To record the accrued expenses at the end of year

4. Interest Payable (Dr)

Liability under F.L (Dr)
Cash/Bank (Cr)
To record the lease payment

Example 03
Shah Corporation leases an equipment on 1st January, 2019 that has fair value of
Rs. 12,000 from Zain Corporation for four years. Interest rate implicit in the lease
is 15%. Useful life of equipment is 4 years. Annual rentals payable at the end of
each year are amounting Rs. 4,203.18. The lessee depreciates the asset using the
straight line method.

Required
i. Identify the type of lease.
ii. Prepare amortization schedule.
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Unit-9 Accounting for Leases
iii. Prepare journal entries for the first two years.
iv. Balance Sheet as at 31st December, 2019.

Solution
Req. (i) Identification of lease
➢ Does the lease transfer the ownership of the assets? NO
➢ Does the lease contain the Bargain Purchase Option? NO
➢ Is the lease term for a major Part of the asset’s economic life? YES
➢ Does the Present value of MLP greater than or substantially equal
to the asset’s fair value? YES

This lease contract meets the criteria (iii) and (iv), so it is classified as the finance
lease.

Present value of MLP is calculated as:

Annual Rental payable: Rs. 4,203.18
Discount Rate: 15%
Lease term: 4 years
PVIFA: 2.855
Present value of MLP: Rs. 12,000 (Rs. 4,203.18 x 2.855)

Req. (ii) Amortization Schedule

Balance at the Annual Installments Balance at the
Date
Beg. of Period Rentals Interest Principal End of Period

31/12/2019 12000.00 4203.18 1800.00 2403.18 9596.82

31/12/2020 9596.82 4203.18 1439.52 2763.66 6833.16

31/12/2021 6833.16 4203.18 1024.97 3178.21 3654.96

31/12/2022 3654.96 4203.18 548.24 3654.96 0.00

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Unit-9 Accounting for Leases
Req. (iii) Journal Entries
AMOUNT
DATE PARTICULARS
RUPEES.
Jan 1, Assets under finance lease 12,000
2019 Liability under finance lease 12,000
To record the Capitalization of leased asset and raising of corresponding
liability at the inception of lease
Dec 31, Interest Expenses 1,800.00
2019 Liability under Finance Lease 2,403.18
Cash 4203.18
To record the lease payment
Dec 31, Profit and loss account 3,000
2019 Accumulated depreciation 3,000
To record the depreciation on the leased assets at the end of
year.(12000/4)
Dec 31, Interest Expenses 1,439.92
2020 Liability under Finance Lease 2,763.66
Cash 4203.18
To record the lease payment
Dec 31, Profit and loss account 3,000
2020 Accumulated depreciation 3,000
To record the depreciation on the leased assets at the end of
year.(12000/4)

Req. (iv) Balance sheet, December 31, 2019

ASSETS Rs.
Assets under Finance Lease 12,000
Less: Accumulated Depreciation 3,000
9,000
LIABILITIES Rs.
Current Liabilities
Liability under finance lease 2,763.66
Long term Liabilities
Liability under finance lease 6,833.16
9,596.82

Problem 03:
Company A leases equipment for five (05) years, from Company B having the fair
market value of Rs. 150,000 on 1st January, 2020. Interest rate implicit in the lease
is 10%. Useful life of equipment is 10 years. Annual rentals payable at the end of
each year are amounting Rs. 39,569.62. Company A depreciates the asset using the
straight line method.

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Required:
i. Identify the type of lease.
ii. Prepare amortization schedule.
iii. Prepare journal entries for the first two years.
iv. Balance Sheet as at 31st December, 2021.

Hint: If ownership expected to be transferred at the end of lease term then

depreciate the leased assets over its useful life otherwise depreciate asset over
shorter of the lease term or its useful life.

Example 04
A lease was signed on 1st January, 2019 for 6 years. Annual rentals payable at the
beginning of each year were agreed Rs. 75,176.44. Useful life of the machine was
6 years and interest rate implicit in the lease was 20%. Fair value of the machine
was Rs. 300,000. The lessee depreciates the assets using the straight line method.

Required
i. Identify the type of lease.
ii. Prepare amortization schedule.
iii. Prepare journal entries for the first two years.
iv. Balance Sheet as at 31st December, 2019.

Req. (i) Identification of lease

This lease contract meets the criteria (iii) and (iv), so it is classified as the finance
lease.

Present value of MLP is calculated as:

Annual Rental payable: Rs. 75,176.44
Discount Rate: 20%
Lease term: 6 years
PVIFAD: 3.99*
Present value of MLP: Rs. 300,000 (Rs. 75,176.44 x 3.99)
1
1− (1+𝑖) 𝑛
*PVIFAD = x (1+ i); where: i = interest rate (Discount Rate), n = lease
𝑖
term

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Req. (ii) Amortization Schedule

Balance at the Installment Balance at the

Date Annual Rentals
Beg. Of Period Interest Principal End of Period

1/1/2019 300000.00 75176.44 0.00 75176.44 224823.56

1/1/2020 224823.56 75176.44 44964.71 30211.72 194611.84

1/1/2021 194611.84 75176.44 38922.37 36254.07 158357.77

1/1/2022 158357.77 75176.44 31671.55 43504.88 114852.89

1/1/2023 114852.89 75176.44 22970.58 52205.86 62647.03

1/1/2024 62647.03 75176.44 12529.41 62647.03 0.00

Req. (iii) Journal Entries

AMOUNT
DATE PARTICULARS
RUPEES.
Jan 1, 2019 Assets under finance lease 300,000
Liability under finance lease 300,000
To record the Capitalization of leased asset and raising of
corresponding liability at the inception of lease
Jan 1, 2019 Liability under Finance Lease 75,176.44
Cash 75,176.44
To record the lease payment
Dec 31, 2019 Interest Expenses 44,964.71
Interest Payable 44,964.71
To record the accrued interest for 2010
Dec 31, 2019 Profit and loss account 50,000
Accumulated depreciation 50,000
To record the depreciation on the leased assets at the end of
year.(300000/6)
Jan 1, 2020 Interest Payable 44,964.71
Liability under Finance Lease 30,211.72
Cash 75,176.44
To record the lease payment
Dec 31, 2020 Interest Expenses 38,922.37
Interest Payable 38,922.37
To record the accrued interest for 2011
Dec 31, 2020 Profit and loss account 50,000
Accumulated depreciation 50,000
To record the depreciation on the leased assets at the end of
year.(300000/6)

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Req. (iv) Balance sheet, December 31, 2019

ASSETS Rs.
Assets under Finance Lease 300,000
Less: Accumulated Depreciation 50,000
250,000
LIABILITIES Rs.
Current Liabilities
Interest Payable 44,964.71
Liability under finance lease 30,211.72
Long term Liabilities
Liability under finance lease 194,611.84
269,788.27

Problem 04
A lease was signed on 1st January, 2021 for 5 years. Annual rentals are payable at
the beginning of each year. Useful life of the machine was 5 years and interest rate
implicit in the lease was 16%. Fair value of the machine was Rs. 120,000. The
lessee depreciates the assets using the straight line method.

Required
i. Prepare journal entries for the first two years.
ii. Balance Sheet as at 31st December, 2022.

Hint: You may calculate the amount of annual rentals payable by dividing the
fair value of assets by PVIFA/PVIFAD.

Problem 05
A lease was signed on 1st April, 2018 for 8 years. Annual rentals payable at the
beginning of each year are amounted Rs. 102,242.20. Useful life of the equipment
was 10 years and interest rate implicit in the lease was 10%. Fair value of the
machine was Rs. 600,000. The lessee depreciates the assets using the straight line
method and closes its accounts at the end of each calendar year.

In the books of lessee, you are required to prepare the:

i. Lease amortization schedule
ii. Journal entries for the first two years.
iii. Interest expenses to be reported in profit and loss accounts for years ended
December 31, 2018 through 2021.
iv. Extracts from the Balance Sheet as at 31st December, 2019.

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9.6 BARGAIN PURCHASE OPTION (BPO)
This option is given to lessee by the lessor to purchase the leased assets at the end
of the lease term at the price, which is determined at the inception of lease. It is
actually the sale of residual value of the leased property at the bargain price to make
it assured that the lessee will take the benefit of the “bargain”.
9.6.1 Accounting Treatment:
The present value of the BPO will be included, while calculating the Present Value
of MLP. And if the useful life is greater than the lease term and BPO is given then
the depreciation will be calculated by using the useful life of the leased assets
instead of the lease term.
Example 05
A lease was signed on 1st January, 2019 for 6 years. Annual rentals payable at the
end of each year were agreed Rs. 12,071. Useful life of the machine was 10 years
and interest rate implicit in the lease was 5%. Fair value of the machine was Rs.
65,000. The lessee depreciates the assets using the straight line method. Lease also
contains the Bargain Purchase Option (BPO) of Rs. 5000.

Required
i. Identify the type of lease.
ii. Prepare amortization schedule.
iii. Prepare journal entries for the first two years.

Solution
Req. (i) Identification of lease
This lease agreement does not meet the first three criterions, so now check the
criteria (iv):
Annual Rental payable: Rs. 12,071
Discount Rate: 5%
Lease term: 6 years
PVIFA: 5.076
Present value of MLP:
Rs. 61,270 (Rs. 12,071 x 5.076)
Add: Present value of BPO Rs. 3,730 (Rs. 5000 x 0.746)
-------------
Rs. 65,000
-------------
Fair value of assets Rs. 65,000

As the Present value of MLP is equal to the fair value of the assets, so it is
classified as the finance lease.

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Req. (ii) Amortization Schedule:
Installments Balance at
Balance at the Beg. Annual
Date the End of
Of Period Rentals Interest Principal Period
31/12/2019 65000.00 12071.00 3250.00 8821.00 56179.00
31/12/2020 56179.00 12071.00 2808.95 9262.05 46916.95
31/12/2021 46916.95 12071.00 2345.85 9725.15 37191.80
31/12/2022 37191.80 12071.00 1859.59 10211.41 26980.39
31/12/2023 26980.39 12071.00 1349.02 10721.98 16258.41
31/12/2024 16258.41 12071.00 812.92 11258.08 5000.00
31/12/2024 5000.00 5000.00 0.00 5000.00 0.00

Req. (iii) Journal Entries

AMOUNT
DATE PARTICULARS
RUPEES.
Jan 1, Assets under finance lease 65,000
2019 Liability under finance lease 65,000
To record the Capitalization of leased asset and raising of corresponding
liability at the inception of lease
Dec 31, Interest Expenses 3,250.00
2019 Liability under Finance Lease 8,821.00
Cash 12,071.00
To record the lease payment
Dec 31, Profit and loss account 6,500
2019 Accumulated depreciation 6,500
To record the depreciation on the leased assets at the end of
year.(65000/10)
Dec 31, Interest Expenses 2,808.95
2020 Liability under Finance Lease 9,262.05
Cash 12,071.00
To record the lease payment
Dec 31, Profit and loss account 6,500
2020 Accumulated depreciation 6,500
To record the depreciation on the leased assets at the end of
year.(65000/10)

Problem 06
A lease was signed on 1st January, 2020 for 5 years. Annual rentals payable at the
beginning of each year were agreed Rs. 34,509. Useful life of the machine was 5
years and interest rate implicit in the lease was 12%. Fair value of the machine was
Rs. 145,000. The lessee depreciates the assets using the straight line method. Lease
also contains the Bargain Purchase Option (BPO) of Rs. 10,000.

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Unit-9 Accounting for Leases
Required
i. Identify the type of lease.
ii. Prepare amortization schedule.
iii. Prepare journal entries for the first two years.

Problem 07
From the following given particulars, you are required to determine the (i) annual
rental payments (ii) lease classification (iii) prepare the Amortization Schedule (iv)
Also pass the journal entries throughout the lease term in the books of lessee.
Annual Rentals are payable at the beginning of each year.
Lease signed on January 1, 2020
Lease Term 3 years
Fair value of the Assets at inception Rs. 24,000
Economic Life 5 years
Implicit Interest Rate 15%
Bargain Purchase Option Rs. 6,000
Depreciation method Straight Line

9.7 ACCOUNTING FOR LEASES BY LESSOR

As already discussed, that from the view point of the lessor the finance lease may
be (a) direct finance lease and (b) Sales type lease. For the understanding of the
accounting, for both types of leases by the Lessor, some important terms are
described below:

9.7.1 Gross investment in the lease

From the view point of the Lessor, Gross Investment (GI) is calculated by adding
the Unguaranteed Residual Value (UGRV) in the Minimum Lease Payment (MLP)
receivable by the lessor, which may be expressed as follows:
GI =MLP (for Lessor) + UGRV

9.7.2 Net Investment in the Lease

Net Investment is the gross investment in the lease, discounted at the interest rate
implicit in the lease. It may be calculated by deducting the Unearned Finance
Income (UFI) from the Gross Investment (GI) in the lease, which may be expressed
as: NI = GI - UFI

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9.7.3 Unearned Finance Income
Unearned Finance Income is calculated by taking the difference of Gross
Investment (GI) in the lease and the Present Value of the Gross Investment / Net
Investment. It may be calculated as:
UFI = GI - NI

9.7.4 Cost of goods sold:

In sales type of lease cost of goods sold is debited with historical cost or carrying
value plus initial direct costs, if any.

Journal Entries (Direct Finance Lease):

The following journal entries are passed in the books of the lessor:
1. Lease Payment Receivable (GI) (Dr)
Assets (Cr)
Unearned Finance Income (Cr)
To record the Finance Lease of assets at inception of lease

2. Cash / Bank (Dr)

Lease Payment Receivable (Cr)
To record the Finance lease installment Received
3. Unearned Finance Income (Dr)
Finance Income (Cr)
To record the recognition of interest income earned

Example 06
A lease was signed on 1st January, 2021 for 5 years. Annual rentals payable at the
beginning of each year were agreed Rs. 7,782.14. Useful life of the machine was 5
years and interest rate implicit in the lease was 15%. Fair value of the machine was
Rs. 30,000.

Required
In the books of lessor, you are required to:
i. Identify the type of lease.
ii. Determine the Gross Investment in the lease
iii. Unearned Finance Income
iv. Prepare amortization schedule.
v. Prepare journal entries for the first two years.
vi. Balance Sheet at December 31,2021

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Unit-9 Accounting for Leases
Req. (i) identify the type of lease
This lease meets the criteria (iii) and (iv), so this is classified as finance lease

Req. (ii) Gross Investment in the Lease:

As we know that: GI = MLP (for Lessor) + UGRV
GI = Rs. 38,910 (Rs. 7,782 x 5) + 0
= Rs. 38,910
Req. (iii) Unearned Finance Income
As we know that: UFI = GI – NI
= Rs. 38,910 – 30,000
= Rs. 8,910

Req. (iv) Amortization Schedule:

Installment
Balance at the Annual Balance at the
Date Investment
Beg. Of Period Rentals Interest End Of Period
Recovery

1/1/2021 30000.00 7782.14 0.00 7782.14 22217.86

1/1/2022 22217.86 7782.14 3332.68 4449.46 17768.40
1/1/2023 17768.40 7782.14 2665.26 5116.88 12651.52
1/1/2024 12651.52 7782.14 1897.73 5884.41 6767.11
1/1/2025 6767.11 7782.14 1015.03 6767.11 0.00

Req. (v) Journal Entries (Books of Lessor):

AMOUNT
DATE PARTICULARS
RUPEES.
Jan 1, 2021 Lease Payment Receivable 38,910
Machine 30,000
Unearned Finance Income 8,910
To record the Finance Lease of assets at inception of lease
Jan 1, 2021 Cash 7,782.14
Lease Payment Receivable 7,782.14
To record the receipt of the annual rental
Dec 31, 2021 Unearned Finance Income 3,332.68
Finance Income 3,332.68
To record the recognition of interest income earned
Jan 1, 2022 Cash 7,782.14
Lease Payment Receivable 7,782.14
To record the receipt of the annual rental
Dec 31, 2022 Unearned Finance Income 2,665.26
Finance Income 2,665.26
To record the recognition of interest income earned

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Unit-9 Accounting for Leases
Req. (vi) Extracts of Balance sheet December 31, 2021:

Current Assets: Rs.

Net Investment in Finance Lease 4,449.46
Interest Receivable 3,332.68
Non Current Assets:
Net Investment in Finance Lease 17,768.40
25,550.54

Problem 08
Adil Corporation signed a lease agreement with Usman Corporation for leasing
office equipment on 1st January, 2021 for 8 years. Adil Corporation is entitled to
get Rs. 11,928.26 annual rentals at the beginning of each year. Useful life of the
machine was 10 years and interest rate implicit in the lease was 10%. Fair value of
the Leased Assets was Rs. 70,000.

Required
In the books of Adil Corporation and Usman Corporation, you are required
to:
i. Prepare amortization schedule.
ii. Prepare journal entries for the first two years.
iii. Present the Balance Sheet Extracts as at December 31,2021

Problem 09
Jawad Corporation signed a lease agreement with Kamran Corporation for leasing
a Motor Car on 1st January, 2020 for 6 years. Annual rentals are payable at the end
of each year Amounting Rs. 36,002 by the Kamran Corporation. Useful life of
Motor Car is 6 years and interest rate implicit in the lease is 14%. Fair value of the
Leased Assets is Rs. 140,000.

Required: In the books of Jawad Corporation, you are required to:

i. Identify the type of lease.
ii. Determine the Gross Investment in the lease
iii. Determine the Unearned Finance Income
iv. Prepare amortization schedule.
v. Prepare journal entries for the first two years.
vi. Present the Balance Sheet Extracts as at December 31,2020 and 2021

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Problem 10
A lease was signed on 1st October, 2020 for 5 years. Annual rentals payable at the
beginning of year are amounted Rs. 72,448.94. Useful life of the equipment was 5
years and interest rate implicit in the lease was 20%. Fair value of the machine was
Rs. 260,000. Lessor closes its accounts at the end of each calendar year.

In the books of lessee, you are required to prepare the:

i. Lease amortization schedule
ii. Journal entries for the first two years.
iii. Interest Revenue to be reported in profit and loss accounts throughout the
lease term
iv. Extracts from the Balance Sheet as at 31st December, 2020 and 2021.

Journal Entries (Sales type lease)

Once it has been established that the lease is classified as finance lease, the next
step is to ascertain whether it is manufacturer or dealers lease, or direct finance
lease. If the fair value and costs are not equal, the lease will be classified as sales
type lease.

In case of sales type lease the only difference is recording the lease at the inception
of the lease; rest of the entries will be same as in direct finance lease. The following
journal entry will be passed, if lease is sales type lease in the books of lessor:

Lease Payment Receivable (Dr)

Cost of Goods Sold (Dr)
Sales Revenue (Cr)
Assets/Inventories (Cr)
Unearned Finance Income (Cr)
To record the Sales type Lease of assets at the inception of lease

Manufacturer and dealer lessor’s is required to recognize selling profit or loss in

the period, in accordance with the policy followed by the entity for outright sales,
if artificially low rates of interest are quoted, selling profit shall be restricted to that
which would apply if a market rate of interest were charged. Costs incurred by
manufacturer or dealer lessor’s in connection with negotiating and arranging lease
shall be recognized as an expense when the selling profit is recognized (i.e. initial
direct costs are to be expensed)

The sales revenue recognized at the commencement of the lease term by a

manufacturer or dealer lessor is the fair value of the asset, or, if lower, the present

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Unit-9 Accounting for Leases
value of the MLP accruing to the lessor, computing at a market rate of interest. The
costs of sales recognized at the commencement of the lease term is the cost, or
carrying amount if different, of the leased property less the present value of the
UGRV. The difference between the sales revenue and the cost of sale is the selling
profit, which is recognized in accordance with the entity’s policy for outright sales.

Example 07
Green & Company uses leasing as a secondary means of selling its products. The
company contracted with Lutz Corporation to lease a machine to be used by Lutz
as an operational asset. The retail market value of the asset at the inception of the
lease was Rs. 200,000; it cost Rs. 160,000 and is carried in its inventory at the value.
Payments of Rs. 44,925 are to be made by Lutz at the end of each of the five years
following inception of the lease. Green’s implicit interest rate is 4% per annum,
which is known by Lutz.

Required: In the books of Lessor:

i. Identify the type of lease
ii. Classify the lease showing how the Rs. 44,925 rental payment was computed?
iii. Prepare the amortization schedule
iv. Give Green’s journal entries at the inception of the lease and upon receipt of
the first payment.

Solution
Req (i) identify the type of lease
Lease is classified as finance lease as the Present value of the MLP is equal to the
fair value of the assets. It is further classified as sales type lease because the fair
value is greater than the cost of the leased asset.

Req (ii) Amount of Rentals Payment

Annual Rentals are calculated as:
Fair value of the assets: Rs. 200,000
Discount Rate: 4%
Lease term: 5 years
PVIFA: 4.452
Annual Rentals: Rs. 44,925 (Rs. 200,000 /4.452)

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Unit-9 Accounting for Leases
Req (iii) Amortization Schedule
Installment
Balance at the Balance at the
Date Annual Rentals
Beg. Of Period Interest Principal End Of Period

Year 1 200,000 44,925 8,000 36,925 163,075

Year 2 163,075 44,925 6,523 38,402 124,673
Year 3 124,673 44,925 4,987 39,938 84,735
Year 4 84,735 44,925 3,389 41,536 43,199
Year 5 43,199 44,925 1,726 43,199 0

Req (iv) Journal entries in the Books of Green & Co.

AMOUNT
DATE PARTICULARS
RUPEES.
Beg of Year 1 Lease Payment Receivable 224,625
Cost of Goods Sold 160,000
Sales Revenue 200,000
Inventories 160,000
Unearned Finance Income 24,625
To record the Sales type Lease of assets at the inception of lease
End of Year 1 Cash 44,925
Lease Payment Receivable 44,925
To record the receipt of the annual rental
End of Year 1 Unearned Finance Income 8,000
Interest Income 8,000
To record the recognition of interest income earned

Problem 11
Rex Corporation (lessor) and Lee company (Lessee) agreed to a noncancelable
lease. The following information is available regarding the lease terms and the
leased assets:
a. Rex’s cost of the leased asset was Rs. 40,000. The asset was new at lease
inception date.
b. Lease term is four years, beginning January 1, 2021. Lease payments are
made each January 1, beginning January 1, 2021
c. Estimated useful life of leased asset is four years. Estimated residual value at
end of lease is zero
d. Sales price of leased asset on January 1, 2021, was Rs. 46,000
e. Rex’s implicit interest rate is 15 percent on retail price (known to Lee)
f. Rex expects to collect all payments from Lee, and there are no material cost
uncertainties.

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Unit-9 Accounting for Leases
Required
i. What kind of lease is this to Rex? To Lee?
ii. Compute the annual lease payments
iii. Prepare an amortization schedule for the lease
iv. Give the journal entries for both parties on January 1, 2021, and December
31, 2021.
Problem 12
Solve the Problem 11 again, assuming that the estimated residual value at the end
of the lease term guaranteed by lessee is Rs. 5,000.
Hint: In the journal entry, at the inception of the lease to record the sales type of
lease, the present value of the Residual value will be deducted from the Cost of
goods sold and Sales revenue

9.8 OPERATING LEASE

A lease is classified as an operating lease if it does not transfer substantially all the
risks and rewards incidental to ownership.
If lease doesn’t meet any one of the criteria, described above for finance lease, the
lease will be classified as operating lease. The lease assets and the long term
liabilities for the rental payments will not be reported on the balance sheet in the
books of lessee and lessor both.
Only the entry passed for the operating lease to record the lease rental payments
will be as follows:
Books of Lessee Books of Lessor
Rent Expenses Cash / Bank
Cash / Bank Rent Revenue

Example 08
On January 01, 2021 Mr. Aqeel took possession of a Machine from Mr. Nouman
and enters into lease agreement for 10 years. Annual rentals are payable at the
beginning of each year amounting Rs. 12,000. Useful life of the machine is 15 years
and interest rate implicit in the lease was agreed 13%. Fair value of the machine
was Rs. 140,000.
You are required to identify the type of lease and Pass the necessary journal
entries in the books of lessor and lessee both to record the rental payment.

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Unit-9 Accounting for Leases
Solution
For the identification of type of lease, check the each of the criteria one by one in
the same order as mentioned in IAS 17, if the lease agreement meets any one of the
criteria, then the lease is classified as finance lease. But if the lease agreement
doesn’t meet any one of the five criterions then the lease will be classified as
operating lease.
v. There is no transfer of ownership, so criteria (i) doesn’t meet
vi. No bargain purchase option is given, so criteria (ii) is not applicable
vii. Lease term is not the major part of the economic life of the leased asset. It is
50% of the useful life of the assets (10/15 = 67%), so criteria (iii) doesn’t meet
viii. Present value of MLP is also not equal to or substantially all the fair value of
the assets. Present Value of Minimum lease payment is 53% of the fair value
of the assets. So This also doesn’t meet the criteria (iv), and
ix. The asset is not specialized nature designed for the lessee.

In this case the lease does not meet any one the criteria, so this would be classified
as Operating Lease from the view point of lessee and lessor both. Assets will not
be capitalized in both of the books however only the following entry will be passed
each year:

Date Books of Mr. Aqeel Books of Mr. Nouman

Jan 01, Rent Expenses 12,000 Cash 12,000
2021 Cash 12,000 Rent Revenue 12,000

Problem 13
Mr. Zulfiqar acquired a car from Shah Corporation on January 02, 2021 and enters
into lease agreement for 5 years. Annual rentals are payable at the end of each year
amounting Rs. 180,000. Useful life of the machine is 10 years and interest rate
implicit in the lease was agreed 15%. Fair value of the machine was Rs. 900,000.
You are required to identify the type of lease and Pass the necessary journal
entries in the books of lessor and lessee both to record the rental payment.

9.9 SALES AND LEASE BACK

As the term indicates, the owner of an asset in a sale-leaseback (SLB) arrangement

sells it to a leasing company or another party and immediately leases it back. The
asset itself never leaves the seller-lessee’s possession. Like the leasing in general,
from the lessee’s perspective, sale –leaseback transactions are essentially financing
transactions and, in some cases, off-balance sheet financing devices. In a sale and
leaseback transaction, one of the following situations may arise:

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Unit-9 Accounting for Leases
i. The lessee continues the use of the asset without interruption. Here the
transaction is effectively a mode of financing. The lessee is borrowing the
funds from the lessor to improve the liquidity. The lease is classified as
finance lease.
ii. The lessee gives up the right of use of asset sold to lessor. In this case the
transaction is a sale of asset to lessor. It is an operating lease.

The characteristics of a typical sale-leaseback arrangement may be diagrammed as

follows:

ACCOUNTING TREATMENT
The accounting treatment for the lessee or seller should be as follows, depending
on the type of lease involved:
a. In a sale and leaseback transaction which results in a finance lease, any
difference between the sale price and the previous carrying value of the asset
(which may be profit or loss) should not be recognized as income
immediately. It should be deferred and amortized in the financial statements
of the seller/lessee over the lease term.
b. if the leaseback is an operating lease:
i. Any profit or Loss should be recognized immediately.
ii. If the sale price is above fair value, the excess over fair value should be
deferred and amortized over the period over which the asset is expected
to be used.
iii. If the sale price is below fair value, any profit or loss should be
recognized immediately except that if the apparent loss is compensated
by future lease payments at below market price it should to that extent
be deferred and amortized over the period for which the asset is
expected to be used.

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Unit-9 Accounting for Leases
Example 09
On January 1, 2020 XYZ limited sold the equipment to ABC leasing Company for
Rs. 30,000 and simultaneously leased back for 6 years at an annual rental of Rs.
2000 payable at the beginning of each year. The book value of the asset at the
inception of the lease was Rs. 25,000 and the remaining useful life of the assets is
10 years. The fair market value of the asset is Rs. 30,000 also. Interest rate implicit
to the lease is 10%.

Required
i. Identify the type of lease
ii. Prepare the journal entries in the books of Lessee and Lessor.

Solution
Req (i) identification of lease
The sales and leaseback lease doesn’t satisfy any one of the criteria, so this would
be classified as operating lease.
i. There is no transfer of ownership, so criteria (i) doesn’t meet
ii. No bargain purchase option is given, so criteria (ii) is not applicable
iii. Lease term is not the major part of the economic life of the leased asset. It is
60% of the useful life of the assets (6/10 = 60%), so criteria (iii) doesn’t meet
iv. Present value of MLP is also not equal to or substantially all the fair value of
the assets. Present Value of Minimum lease payment is 32% of the fair value
of the assets. So this also doesn’t meet the criteria (iv), and

Present value of MLP is calculated as:

Annual Rental payable: Rs. 2,000
Discount Rate: 10%
Lease term: 6 years
PVIFAD: 4.79
Present value of MLP: Rs. 9,582 (Rs.2,000 x 4.79)

Req (ii) Journal entries

As discussed above, IAS 17 provides that if the leaseback is an operating lease, and
the rentals and the sale price are established at fair value, there has in effect been a
normal sale transaction and any profit and loss is normally recognized immediately.
However the following journal entries will be passed in the books of lessor and
lessee:

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Date Books of Lessee Books of Lessor
Jan 01, Cash Rs. 30,000 Asset Rs. 30,000
2020 Asset Rs. 25,000 Cash Rs. 30,000
Gain on Sale Rs. 5,000
To record the Sale of assets under the Sale- To record the purchase of assets under the
leaseback arrangement Sale-leaseback arrangement
Jan 01, Rent Expenses Rs. 2,000 Cash Rs. 2,000
2020 Cash Rs. 2,000 Rent Revenue Rs. 2,000
To record the payment of Annual Rental To record the Receipt of Annual Rental
Payment Payment
Dec 31, Depreciation Expenses Rs. 3,000
2020 Accumulated Dep. Rs. 3,000
To record the depreciation on the asset using
straight line method (30,000/10)

Example 10
On January 1, 2021 M.I.N. Company limited sold a warehouse to N.R.S leasing
Company for Rs. 800,000 and simultaneously leased back for 5 years at an annual
rental of Rs.198,150 payable at the beginning of each year. The book value of the
asset at the inception of the lease was Rs. 700,000 and the remaining useful life of
the assets is 10 years. The fair market value of the asset is Rs. 800,000 also. Interest
rate implicit to the lease is 12%.

Required
i. Identify the type of lease
ii. Prepare the Amortization Schedule
iii. Prepare the journal entries in the books of Lessee and Lessor.

Solution
Req. (i) Identification of lease
This lease meets the criteria (iv), because the Present value of the MLP is equal to
the fair value of the assets.

Present value of MLP is calculated as:

Annual Rental payable: Rs. 198,150
Discount Rate: 12%
Lease term: 5 years
PVIFAD: 4.0374
Present value of MLP: Rs. 800,000 (Rs. 198,150 x 4.0374)

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Req. (ii) Amortization Schedule
Balance at the Annual Installment Balance at the
Date
Beg. of Period Rentals Interest Principal End of Period
1/1/2021 800000 198150 0.00 198150 601850
1/1/2022 601850 198150 72222 125928 475922
1/1/2023 475922 198150 57111 141039 334883
1/1/2024 334883 198150 40186 157964 176919
1/1/2025 176919 198150 21230 176920 0.00

Req. (iii) Journal Entries

BOOKS OF LESSEE

Date Particulars Debit Credit

Rs. Rs.
Jan 01, Cash 800,000
2021 Asset 700,000
Deferred Gain 100,000
To record the Sale of assets under the Sale-leaseback
arrangement
Jan 01, Asset under finance lease 800,000
2021 Liability under finance lease 800,000
To record the asset under the direct finance lease at inception of
lease

Jan 01, Liability under F.L 198,150

2021 Cash 198,150
To record the payment of Annual Rental Payment
Dec 31, Depreciation Expenses 160,000
2021 Accumulated Dep. 160,000
To record the depreciation on the asset using straight line method
(800,000/5)
Dec 31, Interest Expenses 72,222
2021 Interest Payable 72,222
To record the accrual of interest expenses
Dec 31, Deferred Gain 20,000
2021 Profit on sale and Leaseback 20,000
To record the amortization of unearned income over the period of
lease

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BOOKS OF LESSOR

Date Particulars Debit Credit

Rs. Rs.
Jan 01, Asset 800,000
2021 Cash 800,000
To record the purchase of assets under the Sale-
leaseback arrangement
Jan 01, Lease Payment Receivable 990,750
2021 Asset 800,000
Unearned finance income 190,750
To record the Finance Lease of assets at inception of
lease
Jan 01, Cash 198,150
2021 Lease Payment Receivable 198,150
To record the Receipt of Annual Rental Payment
Dec 31, Unearned Finance Income 72,222
2021 Finance Income 72,222
To record the recognition of interest income earned

9.10 MISCELLANEOUS PROBLEMS

Problem 14
Lessor Marcy and lessee Lenox contract for the lease of a machine for five
payments of Rs. 7,000 each. The Rs. 7,000 payments are to be paid at the end of
each of five years. They also agree that at the time of the fifth payment, for an added
Rs. 6,000 bargain purchase option payment, Lenox can buy the property. The
interest rate is 4 percent per annum. The lease qualifies as a direct finance lease.

Required
i. Calculate the present value of the lease payments and prepare an amortization
schedule for the lease covering the five year term.
ii. Give the lessor’s entries at the inception of the lease and at the time of the
fifth payment if the lessee exercises the purchase option. Assume that it is a
direct finance lease.

Problem 15
The present value to a lessor of a lease, on which the lessee is obligated to make a
Rs. 40,000 payment at the end of each of the next three years and on which there is
an unguaranteed residual value of Rs. 8,000 at the end of the lease term, is Rs.
98,266 using the lessor’s implicit interest rate of 14 percent. The lease qualifies as
a direct financing lease.

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Required
i. Prepare an amortization schedule for the lessor covering the three-year lease
term.
ii. Compute the present value of a similar lease; assume that the lessor’s implicit
rate is 12 percent. Prepare an amortization schedule similar to the one required
in (i) above
iii. Assume, instead, that each of the three Rs. 40,000 annual payments is paid at
the beginning of each year, and that 8,000 residual value is expected at the
end of the lease term of three years. What is the present value of the lease
payments at 14 percent? Prepare the lessor’s amortization schedule for this
lease.

Problem 16
On January 1, 2019, ABC Company signed a lease contract with Abel Company,
The lease asset cost ABC Rs. 45,000 and had a normal selling price of Rs. 55,000.
Three annual payments, based on the selling price, are payable by Abel on January
1, beginning in 2009. The asset reverts to ABC at the end of the lease term,
December 31, 2021, and is estimated to have an unguaranteed residual value on
that date of Rs. 3,000. ABC’s implicit interest rate is 12 percent, which is known to
Abel.

Required
i. What type of lease is this for ABC?
ii. Compute the annual lease payments.
iii. Give the lessor’s entry on January 1, 2019
iv. Give the lessee’s entry on January 1, 2019
v. What amount will ABC show as its lease receivable balance on January 1,
2021, after receipt of the third and final lease payment?

Problem 17
M.S.R. Corporation leased an equipment on finance lease for 4 years. The lease
require 4 annual payments of Rs. 30,000 at the end of each year, interest rate is 5%
and a purchase option of Rs. 15,000 at the end of lease term, even though the
estimated residual value on that date is Rs. 5,000.

Required: Compute the amount to be capitalized by M.S.R Corporation.

Hint: where both bargain purchase option and residual values are given, BPO is
to be used to ascertain present value of MLP

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Problem 18
Safeer Corporation signed a lease agreement with Usman Corporation for leasing a
Motor Car on 1st January, 2018 for 5 years. Annual rentals are payable at the
beginning of each year Amounting Rs. 36,000 by the Usman Corporation. Useful
life of Motor Car is 8 years and interest rate implicit in the lease is 10%. Fair value
of the Leased Assets is Rs. 170,000. Residual Value is estimated at Rs. 20,000.

Required: Determine the present value of MLP and determine the type of lease
from the view point of lessor and lessee if (i) Residual Value is Guaranteed and (ii)
Residual Value is Un-Guaranteed.

Hint: Lessee will capitalize the amount of residual value only if guaranteed,
whereas the lessor will capitalize the residual value either guaranteed or un-
guaranteed or guaranteed by third party.

Problem 19
Rich Grocery owns the building it uses; it has a current carrying value on January
1, 2021, of Rs. 450,000, a 10-year remaining life, and no residual value. On this
date it was sold to investor lucky for Rs. 500,000 cash. Simultaneously, the two
parties executed a 10-year direct financing lease with a 12 percent implicit rate;
each annual payment is due on December 31(end of their accounting periods).

Required
i. Compute the annual payments to be made by Rich to Lucky
ii. Give the entries for the seller-lessee and Buyer-lessor for the first year of lease
term.

Problem 20
Copper leasing limited engaged in leasing of high cost sports equipment undertook
following transactions on June 01, 2019.
i. A speed boat of a famous brand ABC was given on 3 years lease to Mr.
Carbon at an annual lease rental of Rs. 215,365 payable at the end of each
year.
ii. A motor boat of XYZ make was leased to Ms. Chlorine at an annual rent of
Rs.1,040,886 payable at the end of each year for three years. The price
charged in case of outright sale price of this boat is Rs. 2,500,000.
iii. A water bike of XYZ make was leased to Mr. Sulphur at an annual rent of Rs.
98,763 payable at the end of each year. The agreed lease term is three years.
Outright sale price of this bike is Rs. 250,000.
iv. The following additional information is available:

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v. The company is also a sole dealer of XYZ make in the city and operates an
outlet for that purpose.
vi. At the above outlet 25% area is uses as company’s administrative office.
vii. Outlet’s rent and other maintenance expenditures are approximately Rs.
660,000 per month.
viii. Marketing staff is given a commission at 2% of price of goods whether they
are leased or sold outright.
ix. The company paid Rs. 3,770 to a local authority, for inspection of each unit.
x. Registration charges incurred by the company for each unit of speed boat,
motor, boat and water bike were Rs. 3,500 Rs. 22,500 and Rs. 2,000
respectively.
xi. Cost of speed boat, motor boat and water bike were Rs. 500,000 Rs. 2,400,000
and Rs. 230,000 respectively.
xii. The ownership is transferred to lessee at the end of the lease.
xiii. The company charges 9 % markup on leases of water bikes as against
prevailing market rate of 11%

Required
a. Compute gross investment in lease and unearned financial income in respect
of each lease.
b. Prepare all necessary journal entries on June 01, 2009 and on receipt of first
rental

Note: Present value of an annuity of Rs. 1 received at the end of the year for three
years are as follows:

Rate 8% 9% 10% 11% 12% 13% 14%

Present 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216
Value

Problem 21
The pure limited leased plant and machinery having fair value of Rs. 125,000 from
leasing corporation limited. The lease agreement contains a bargain purchase
option and requires 15 annual minimum lease payment of Rs. 15,000 payable at the
end of each year. The economic life of the plant and machinery is 20 years. Implicit
rate of leasing corporation limited is 8%.

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Required
a. Calculate present value of minimum lease payments payable in 15 years.
b. Prepare a statement showing repayment of principal and mark-up for the
first five years.
c. In the light of IAS-17, what are the criteria, which attract capitalization of
leased plant and machinery in above case?
d. In the absence of bargain purchase option, will the pure limited capitalize
the lased plant and machinery? Briefly explain reasons.

Problem 22
M.N Corporation a lessor, purchased a new machine for Rs 1,200,000 on December
31, 2020, which was delivered the same day (prior arrangement) to A. N. &
company, the lessee.
Following information relating to lease transaction is available:
i. The lease Asset has an estimated useful life of 5 years, which coincides with
the lease therm.
ii. At the end of lease term, Machine will revert to M. N. Corporation, at which
time it is expected to have a residual value of Rs 10,000. (None of which is
guaranteed by A. N. & Company).
iii. M. N. Corporation’s implicit interest rate is 8% which is known to A. N. &
Company.
iv. A. N. & Company’s incremental borrowing rate is 10% at December 31,
2020.
v. Lease rentals consist of five equal annual payments, the first of which was
paid on December 31, 2020.
vi. Both the lessor and the lease use calendar year as their accounts period and
depreciate all fixed assets on straight line basis.

Required
a. Compute the annual rental under the lease.
b. Compute the amounts of Gross Lease Rental receivable and unearned interest
revenue that M. N. Corporation should disclose at the inception of the lease
December 31, 2020.
c. What expense should A. N. & Company record for the year ended December
31, 2021

Problem 23
Qaseem Ahmed & Company and Ebad Company signed a lease agreement dated
January 1, 2021, that calls for Qaseem Ahmad & Co to lease equipment to Ebad

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and Company beginning January 1, 2021. The terms and provisions of the lease
agreement and other pertinent data as follows:
(a) The term of the lease is 5 years, and the lease agreement is non-cancelable,
requiring equal rental payments of Rs. 47,963 at the beginning of each year
(annuity due basis).
(b) The equipment has fair value at the inception of the lease of Rs. 200,000, an
estimated economic life of 5 years, and no residual value.
(b) The lease contain no renewal options, and the equipment revert to Lessor
Company the termination of the lease.
(c) Ebad Company's incremental borrowing rate is 11 % per year.
(d) Ebad Company's depreciates on straight-line basis similar equipment that it
owns.
(e) Qaseem Ahmad & Company sets the annual rental to 'earn a rate of return on
its investment of 10% per year, this fact is known "to Edab & Company.

Required
In light of IAS-17, state with the reasons:
(i) Which treatment will be accorded to Lease in the Books of Edab & Company.
(ii) Which rate would be used for capitalization of lease, in the books of Ebad &
Company in accordance with IAS-17.
(ii) Calculate the amount to be capitalized in the books of lessee by using present
value of annuity factor 4. 16986.
(iii) Prepare a lease Amortization Schedule in the Book of Ebad & Company,
showing amount of profit and reduction in principal. (Round-off the figure in
nearest).

Problem 24
Punjab carpets sold their plant and machinery to English Leasing on a sale and lease
back basis. The book value of the machinery was Rs. 600,000 and fair value Rs.
750,000. The sale price was agreed at Rs. 894,000. The lease back was for a period
of three years against a monthly rental of Rs 10,000.

Required
Prepare the relevant portion of Financial Statements of Punjab Carpets at the end
of first year after this arrangement.

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Problem 25
Lessor Company and Lessee Company signed a lease agreement on January 01,
2021; the first Installment is payable on inception of lease agreement.

Fair Value is Rs. 500,000

Term of lease 5 years
Lease payment on beginning of each year Rs.119,910/-

Depreciation on straight-line method. Interest rate applicable 10%

You are required to show the charge in the profit and loss account if the lease is
treated as Finance/ Operating Lease In the books of the Lessee over the lease term.

Problem 26
On January 31, 2019, Dawn Company leased a new machine from Zee Corp. The
following data relate to the lease transaction at inception of the lease:
Lease term 10 years
Annual rental payable at beginning each lease year. Rs.50,000
Useful life of machine. 15 years
Implicit interest rate. 10%
Present value of an annuity of 1 in advance for 10 periods at 10% 6.76
Present value of annuity of 1 in arrears for 10 periods at 10% 6.15
Fair value of the machine Rs 400,000
The lease has not renewal option, and the possession of the machine reverts to zee
when the lease terminates.

Required
Work out the lease liability Dawn Company should record at the inception of the
lease.

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BIBLIOGRAPHY

▪ Companies Act 2017

▪ Gripping International Financial Reporting Standards 2020 Edition Volume
1, LexisNexis.
▪ https://www.accaglobal.com/lk/en/student/exam-support-
resources/professional-exams-study-resources/strategic-business-
reporting/technical-articles/conceptual-framework.html
▪ https://www.cpdbox.com/ifrs-conceptual-framework-2018/
▪ https://www.iasplus.com/en/standards/ias/ias17
▪ https://www.iasplus.com/en/standards/other/framework
▪ https://www.ifrs.org/content/dam/ifrs/project/conceptual-framework/fact-
sheet-project-summary-and-feedback-statement/conceptual-framework-
project-summary.pdf
▪ https://www.ifrs.org/issued-standards/list-of-standards/conceptual-
framework/
▪ https://www.ifrs.org/issued-standards/list-of-standards/ias-17-leases/
▪ https://www.ifrs.org/issued-standards/list-of-standards/ias-27-separate-
financial-statements/
▪ Insurance Ordinance 2000, Amended up to November 2011
▪ Meigs, W. B., & Meigs, R. F. (1996). Accounting: the basis for business
decisions.
▪ Phillips, F., (2018). Fundamentals of Financial Accounting 6th edition
McGraw-Hill Higher Education
▪ The Banking Companies (Amendment) Act, 2011
▪ The Banking Companies Ordinance 1962
▪ Wild, J., Shaw, K., Chiappetta, B. (2010) Fundamentals Accounting
Principles 20th Edition McGraw- Hill/ Irwin

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