Corporate Financial Accounting-munotes

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CORPORATE FINANCIAL REPORTING
Unit Structure
1.1 Introduction
1.2 Developments of Financial Reporting Objectives
1.3 Basic Objectives of Financial Reporting
1.4 Indian Perspective in Financial Reporting
1.5 Qualitative Characteristics of Financial Reporting Information
1.6 ASI, Disclosure of Accounting Policies
1.7 Notes on Accounts in Corporate Annual Reports
1.8 Director's Report
1.9 Auditors Report
1.10 Exercise
1.1 INTRODUCTION
Today reporting by companies has to assume a high level of importance.
Formerly annual reports used to be less revealin g and reporting was not
timely and we not catering to requirement of various shareholder. More
was concealed than what was revealed. But today thanks to investor
awareness global standards used the effective functioning of regulatory
bodies corporate repor ting has become more revealing.
1.2 DEVELOPMENTS OF FINANCIAL REPORTIN G
OBJECTIVES
The subject of financial reporting objectives has been generally
recognized as very important in accounting area since a long time. Many
accounting and professional institutes a ll over the word have made
attempts to define the objective of financial statements and financial
reporting which are vital to the development of financial accounting
theory and practice. This section describes developments in this area at the
internationa l level, particularly USA and UK. It can be rightly said that
most of the attempts in the area of financial reporting objectives has been
made in USA and UK and accounting developments in these countries
have great impact on accounting developments and practices in other
countries of the world.
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2 Accounting Principles Board (APB) Statement No. 4
In USA, the APB Statement No. 4 “Basic Concepts and Accounting
Principles Underlying Financial Statements of Business Enterprises”,
(1970) was the first publication which published the objectives of
financial statements. These objectives may be summarized as follows:
1. The particular objectives of financial statements are to present fairly,
and in conformity with generally accepted accounting principles, financial
posit ion, results of operations, and other changes in financial position.
2. The general objectives of financial statements are
a) To provide reliable information about economic resources and
obligations a business enterprise in order (i) Evaluate its strengths and
weakness, (ii) Show its financing and investment, (iii) Evaluate its ability
to meet its commitments, and (iv) Show its resources base for growth;
b) To provide reliable information about changes in net resources
resulting from a business enterprise’s profit - directed activities in order (i)
Show to investors expected dividend return, (ii0 Show the operation’s
ability to pay creditors and suppliers, provide jobs for employees pay
taxes, and generate funds for expansion, (iii) Provide management with
information for planning and control, and
(iv) Show its long-term profitability;
c) To provide financial information useful for estimating the earning
potential of the firm;
d) To provide other needed information about changes in economic
resources and obligations; and
e) To disclose other information relevant to statement user’s needs.
3. The qualitative objectives of financial accounting are the following:
a) Relevance, which means selecting the information most likely to aid
users in their economic decisions.
b) Understandability, w hich implies not only that the selected information
must be intelligible but also that the users can understand it.
c) Verifiability, which implies that the accounting results may be corn
borated by independent measurers using the same measurement methods.
d) Neutrality, which implies that the accounting information is directed
towards the common needs of users rather than the particulars needs of
specific users.
e) Timeliness, which implies an early communication of information to
avoid delays in economic decision -making.
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3 f) Comparability, which implies that differences should not be the result
of different financial accounting treatments.
g) Completeness. Which implies that all the information that ‘reasonably’
fulfils the requirements of other qualitative objectives should be reported?
True blood Report
To develop objectives of financial statements, a Study Group was
appointed in 1971 by American Institute of Certified Public accountants
under the Chairmanship of Robert M. Trueblood. The Study Group
solicited the views of more than 5000 corporations, professional firms,
unions, public interest groups, national and international accounting
oragnisations and financial publications. The study group conducted more
than 50 interviews with executives from all sectors of the bu siness and
from government. To elicit the widest range of views, 35 meeting were
held with institutional and professional groups representing major
segments of the US economy.
The study group submitted its report to AICPA in October 1973. The
objectives de veloped in the study Group Report are as follows:
1. The basic of financial statements is to provide information useful for
making economic decisions.
2. An objective of financial statements is to serve, primarily, those
users who have limited authority, ability , or resources to obtain
information and who rely on financial statements as their principal source
of information about an enterprise’s economic activities.
3. An objective of financial statements is to provide information useful
to investors and creditors f or predicting, comparing and evaluating
potential cash flows to them in terms of amount, timing and related
uncertainty.
4. An objective of financial statements is to provide users with
information for predicting, comparing, and evaluating enterprise earning
power.
5. An objective of financial statements is to supply information useful
in judging management’s ability to utilize enterprise resources effectively
in achieving the primary enterprise goal.
6. An objective of financial statements is to provide factual and
interpretative information about transactions and other events which is
useful for predicting, comparing and evaluating enterprise earning power.
Basic underlying assumptions with respect to matters subject to
interpretation, evaluation, prediction, or estimation should be disclosed.
7. An objective is to provide a statement of financial position useful for
predicting, comparing and evaluating enterprise earning power. This
statement should provide information concerning enterprise transactions
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4 should also be reported when they differ significantly from historical
costs. Assets and liabilities should be grouped or segregated by the
relative uncertainty of the amount and timing of prosp ective realization of
liquidation.
8. An objective is to provide a statement of periodic earnings useful
for predicting, comparing and evaluating enterprise earning power. The
net result of completed earning cycles and enterprise activities resulting in
recog nizable progress towards completion of incomplete cycles should be
reported. Changes in values reflected in successive statements of financial
position should also be reported, but separately, since they differ in terms
of their certainty realization.
9. An objective is to provide a statement of financial activities useful
for predicting, comparing, and evaluating enterprise earning power. This
statements should report mainly on factual aspects of enterprise
transactions having or expected to have significant cash consequences.
This statement should report data that require minimal judgment and
interpretation by the compiler.
10. An objective of financial statements is to provide information useful
for the predictive process. Financial forecasts should be provided when
they will enhance the reliability of users’ predictions.
11. An objective of financial statements for governmental and non -
profit organizations is to provide information useful for evaluating the
effectiveness of management of resources in achieving the organization’s
goals. Performance measures should be qualified in terms of identified
goals.
12. An objective of financial statements is to report on those activities of
the enterprise affecting society which can be determined and described or
measured and whi ch are important to the role of the enterprise in its social
environment.
The twelve objectives recommended in the report seem to fall into five
tiers as described in Table 1 Tier I is the basic objective which underlies all
financial reporting. Tire II ob jectives identify the financial statement users
and their needs. Tier III objectives translate users’ needs in terms of
enterprise. Tire IV objectives describe information about the enterprise
which satisfied or is presumed to satisfy users’ needs. Tire V objectives
concern skeletal financial statements directed at communicating the
information identified by the objectives in Tire IV.
1.3 BASIC OBJECTIVES OF FINANCIAL REPROTING
Financial reporting should provide information to help present and
potential invest ors and creditors and other users in assessing the amounts,
timing, and uncertainty of prospective cash receipts from dividends or
interest and the proceeds from the sale, redemption, or maturity of
securities or loans. The prospects for those cash receipt s from dividends or
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5 securities or loans, the prospects for those cash receipts are affected by an
enterprise’s ability to generate enough cash to meet its obligations when
due and its othe r cash operating needs, to reinvest in operations, and to pay
cash dividends, and may also be affected by perceptions of investors and
creditors generally about that ability, which affect market prices of the
enterprise’s securities. Thus, financial report ing should provide
information to help investors, creditors, and others assess the amount,
timing and uncertainty of prospective net cash inflows to the related
enterprise (Para 37).
Financial reporting should provide information about the economic
resourc es of an enterprise, the claims to those resources (obligations of the
enterprise to transfer resources to other entities and owners’ equity) and
the effects of transactions, events, and circumstances that change
resources and claim to those resources (Para 40)
Financial reporting should provide information about an enterprise’s
financial performance during a period. Investors and creditors often use
Information about the past to help in assessing the prospects of an
enterprise. Thus, although investment and credit decisions reflect
investors’ and creditors’ expectations about future enterprise performance,
those expectations are commonly based at least partly on evaluations of
past enterprise performance (Para. 42)
The primary focus of financial reporting i s information about an enterprise
performance provided by measures of earning and its components (Para
43)
Financial reporting should provide information about how an enterprise
obtains and spends cash, about its borrowing and repayment of borrowing,
about its capital transactions, including cash dividends and other
distribution of enterprise resources to owners, and about other factors that
may affect an enterprise liquidity of solvency (Para 49).
Financial reporting should provide information about hoe management of
an enterprise has discharged its stewardship responsibility to owners
(stockholders) for the use of enterprise resources entrusted to it (Para
50).
Financial reporting should provide information that is useful to managers
and directors in makin g decisions in the interests of owners (Para 52).
Besides the above objectives, the FASB Concept No. 1 contains the
followings important highlights;
1. Financial reporting is not an end in itself but is intended to provide
information that is useful in making business and economic decisions.
2. The objectives of financial reporting are not immutable - they are
affected by the economic, legal, political and social environment in which
financial reporting takes place.
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6 3. The objectives are also affected by the charact eristics and limitations
of the kind of information that financial reporting can provide.
I. The information pertains to business enterprises rather than to
industries or the economy as a whole.
II. The information often results form approximate, rather than exact,
measures.
III. The information largely reflects the financial effects of transactions
and events that have already happened.
IV. The information is but one source of information needed by those
who make decisions about business enterprises.
V. The information is provided and used at a cost.
4. The objectives in this statement (Concept No. 1) are those of general
purpose external financial reporting by business enterprises.
a) The objective stem primarily from the needs external users who lack
the authority to prescribe th e information they want and must rely on
information management communicates to them.
b) The objective are directed toward the common interest of many users
in the ability of the enterprise favorable cash flows but are phrased using
investment and credit decisions as a reference to give them a focus. The
objectives are intended to be broad rather than narrow.
c) The objectives pertain to financial reporting and are not restricted to
financial statements.
5. Investors’ and ‘Creditors’ are used broadly and include not only
those who have or contemplate having a claim to enterprise resources but
also those who advise or represent them.
6. although investment and credit decisions reflect investor’s and
creditors expectations about future enterprise performance, those
expect ations are commonly based at least partly on valuations of past
enterprise performance.
7. The primary focus of financial reporting is information about
earnings and its components.
8. Information about enterprises earning based on accrual accounting
generally provides a better indication of an enterprise’s present and
continuing ability to generate favorable cash flows than information
limited to the financial effects of cash receipts and payments.
9. financial reporting is expected to provide information about an
enterprise’s financial performance during a period and about how
management of an enterprise has discharged its stewardship responsibility
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7 10. Financial accounting is not designed to measure directly the value of
a business enterprises, but the info rmation it provides may be helpful to
those who wish to estimate its value.
11. Investors, creditors, and others may use reported earnings and
information about the elements of financial statements in various ways to
assess the prospects for cash flows. They m ay with for example, to
evaluated management’s performance, estimate ‘earning power’, predict
future earnings, assess risk, or to confirm, change, or reject earlier
predictions or assessments. Although financial reporting should provide
basic information t o aid them, they do their own evaluating, estimating,
predicting, assessing, confirming, changing, or rejecting.
12. Management knows more about the enterprise and its affairs than
investors, creditors or other outsiders’ and accordingly can often increase
the usefulness of financial information by identifying certain events and
circumstances and explaining their financial effects on the enterprise.
1.4 INDIAN PERSPECTIVE IN FINANCIAL REPRTING
In India, the basic purpose of financial reporting (as per Indian Compan ies
Act. 1956) appears to provide shareholders of the company, financial
statement and other related information. In India, shareholders, especially
the existing shareholders, are the primary users of financial reporting.
However, there are other potential users also who are equally interested in
financial reporting information for making economic decisions. Therefore,
the purpose of financial reporting in India should be to serve not only
existing investors but prospective investors and creditors, and other
external users as well.
GENERAL PURPOSE FINANCIAL REPORTING
Generally speaking, the term ‘financial reporting’ is used to mean general
purpose external financial reporting. Often it is said that the purpose of
financial reporting is the preparation of ge neral purpose reports for
external users.
The users of financial statements include present and potential investors,
employees, lenders, suppliers, and other trade creditors, customers,
governments and their agencies and the public. They use financial
statements in order to satisfy some of their different needs for information.
These needs included the following:
a) Investor – The providers of risk capital and their advisors are
concerned with the risk inherent, and return, provided by their investment,
they need information to help them determine whether they should buy,
hold or sell. Shareholders are also interested in information which enables
them to assess the ability of the enterprise to pay dividends.
b) Employees – Employees and their representative groups are
interested in information about the stability and profitability of their
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8 assess the ability of the enterprise to provide remuneration, retirement
benefits and employment opportun ities.
c) Lenders – Lenders are interested in information them enables them
to determine whether their loans, and the interest attaching to them, will
be paid when due.
d) Suppliers and other trade creditors – Suppliers and other creditors
are interested in information that enable them to determine whether
amounts owing to them will be pain when due. Trade creditors are likely
to be interested in an enterprise over a shorter period than lenders unless
they are dependent upon the continuation of the enterprises as a major
customer.
e) Customers – Customer have an interest in information about the
continuance of an enterprise, especially when they have a long-term
involvement with, or are dependent on, the enterprise.
f) Governments and their agencies – Governments and t heir agencies
are interested in the allocation of resources and, therefore, the activities of
enterprises. They also require information in order to regulate the
activities of enterprises, determine taxation policies and as the basis for
national income and similar statistics.
g) Public – Enterprises affect members of the public in a variety of
ways. For example, enterprises may make a substantial contribution to the
local economy in many ways including the number of people they employ
and their patronage of local suppliers. Financial statements may assist the
public by providing information about the trends and recent developments
in the prosperity of the enterprise and the range of its activities.
While all of the information needs of these users cannot be met by
financial statements. There are needs which are common to all users. As
investors are providers or risk capital to the enterprise, the provision of
financial statements that meet their needs will also meet most of the needs
of other users that financi al statements can satisfy.
The management of an enterprise has the primary responsibility for the
preparation and presentation of the financial statements of the enterprise.
Management is also interested in the information contained in the financial
inform ation that helps it carry out its planning, decision -making and
control responsibilities. Management has the ability to determine the form
and content of such additional information order to meet its own needs.
The reporting of such information, however, i s beyond the scope of this
framework. Nevertheless, published financial statements are based on the
information used by management about the financial position,
performance and changes in financial position of the enterprise.
Management as user of informat ion is as interested in information about
assets, liabilities, earnings, and related elements as external users are, and
need, generally, the same kind of information about these elements as
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9 that is provided by external financial reporting. However, management’s
primary role in external financial reporting is that of communicating
information for use by others. For that reason, it has a direct interest in
the cost, adequacy, reliability, and understandability of external financial
reporting.
SPECIFIC PURPOSE REPORT
Financial reporting objectives in accounting literature so far has focused
on general purpose financial reporting which aims to satisfy the
information needs of all potential u sers. Company law provisions in
almost all countries of the world have consistently accepted the utility of
general purpose financial reporting. Due to this the separate (specific)
needs of specific users have been largely ignored on the assumption that
general purpose reports can satisfy the information needs of all external
users. However, a reasoning has also been made suggesting that the needs
of specific users may be better served by presenting specific purpose
reports to help them in their separately identifiable decision functions. For
instance, financial reports submitted to obtain credit or loans, or
government, or financial reports given to trade and industry may not
satisfy other users’ needs and expectations.
However, the proposal of specific purpose reports in company financial
reporting is criticized on some counts.
Firstly, the cost of the developing specialized reports to satisfy special
requirements of specific users may exceed the benefit when the company
financial reporting policy is determ ined in its totally. Secondly,
specialized needs of specific users cannot be ascertained with any degree
of certainty. Thirdly, issuing multiple reports about the financial results of
an enterprise can create confusion among various users. Multiple
reports increase the perceived complexity of the environment complexity
induce change in decision -makers’ cognitive processing capabilities and, in
turn, can decrease the effectiveness of decision -making by users. Fourthly,
multiple reports may not be desirable a nd practicable from the standpoint
of information economics.
To conclude, company financial reporting, in future, will continue to
adhere to general purpose reporting system to aid investors, creditors, and
other external users in their economic decisions. Meanwhile, in order to
achieve the objectives of financial reporting (though general purpose
reports0 there is a continuous
need to investigate many vital aspects relating general purpose financial
reports such as identifying information need of such user s, determining the
feasibility of providing general purpose information to meet theses needs,
determining the manner of reporting such information, and having a
feedback from the users regarding the use and relevance of general
purpose information.
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10 1.5 QUALIT ATIVE CHARACTERISTICS OF
FINANCIAL REPORTING INFORMATION
Qualitative characteristics or qualities necessary for information serve a
major supporting role in the decision usefulness, decision model approach
to accounting theory. Qualitative characteristics are the tributes that make
the information provided in financial statements useful of users.
Accounting information that is reported to facilitate economic decisions
should possess certain characteristics or normative standards. The
information must be useful in the formulation of objectives, the making of
decisions, or the direction and control of resources to accomplish
objectives. The utility of information lies in its ability to reduce
uncertainty about the actual state of affairs of a business enterpri se to the
user. The characteristics make information a desirable commodity and
guide the selection of preferred accounting policies and methods form
among available alternatives. These characteristics have been viewed as
a hierarchy or qualities with usefu lness for decision -making or most
importance. The hierarchy of informational qualities which has been
accepted by FASB (USA) in its Concept No. 2 Qualitative characteristics
of Accounting Information is displayed in Table 12.2
International Accounting Stan dards Committee (IASC) has recognized the
four principal qualitative characteristics of accounting information.
1.5.1 Understandability
1.5.2 Relevance
1.5.3 Reliability
1.5.4 Comparability
The other qualities suggested by IASC are materiality, faithful
representation, substance over form, neutrality, Prudence, completeness,
timeliness.
The qualitative characteristics that have been found possessing wider
acceptance and recognition accounting literature are as follows;
1. Relevance
Relevance is closely and directly related to the con cepts of useful
information. Relevance implies that all those items of information should
be reported that may aid the users in making decisions and / or predictions.
In general information that is given greater weight in decision -making is
more relevant. Specially, it is information’s capacity to make a difference
that identifies it as relevant to a decision. American Accounting
Association’s Committee to Prepare a Statement of Basic Accounting
Theory defines relevance as the primary standard and requires that
information must bear upon or be usefully associated with actions it is
designed to facilitate or results desired to be produced. Financial
Accounting Standards Board in its Concept No. 1 (Para 47, 1978)
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11 “Relevant Accounting information must be capable of making a difference
in a decision by helping users to form predictions about the outcomes of
past, present and future events or to confirm or correct exceptions”.
The question of relevance arises after identification and recognition in of
the purpose for which the information will be used. It means that
information relevant for one purpose may not be necessarily relevant for
other purposes. Information that is not relevant is useless because that will
not aid users in making decisions. The re levant information also reduces
decision -maker’s uncertainty about future acts. A necessary test of the
relevance of reportable data is the ability to predict events of interest to
statement users. To say that accounting information has predictive value is
not to say that it is itself a prediction. Predictive value here mans value as
an input into a predictive process, not value directly as a prediction.
In today’s complex financial accounting environment, a general purpose
report aims to fulfill the common needs of users so that information should
be relevant to all users. In judging relevance of general purpose
information, attention is focused on the common needs of user and specific
needs of particular users will not be considered in this relevance
infor mation for all possible users and which may command universal
relevance. However, this has been recognized a potentially satisfactory
solution.
To conclude, relevance is the dominant criterion in taking decisions
regarding information disclosure. It follow s that relevant information must
be reported. Relevance has been defined in accounting literature, but no
satisfactory set of relevant items of information has been suggested. In this
regard, an important task is to determine that needs of user (s) and the
items of information that are relevant to target user (s).
2. Reliability
Reliability is described as one of the two primary qualities relevance and
reliability that make accounting information useful for decision -making.
Reliable information is required to form judgment about the earning
potential and financial position of a business firm. Reliability differs from
item to item. Some items of information presented in an annual report
may be more reliable than others. For example, information regarding
plant a nd machinery may be less reliable than certain information about
current assets because of differences in uncertainty of realization.
Reliability is that quality which permits users of data to depend upon it
with confidence as representative of what it pur ports to represent
3. Understandability
Understandability is the quality of information that enables users to
perceive its significance. The benefits of information may be increased by
making it more understandable and hence useful to a wider circle of
users. Presenting information which can be understood only by
sophisticated users and not by others, creates a bias which is inconsistent
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12 should not only facilitate understanding but also avoi d wrong
interpretation of financial statement. Thus, understandable financial
accounting information presents data that can be understood by users of
the information and is expressed in a form and with terminology adopted
to user’s range of understanding. The Corporate Report observes:
“Understandability does not necessarily mean simplicity, or that
information must be presented in elementary terms, for that may not be
consistent with the proper description of complex economic activities. It
does mean that judgment needs to be applied in holding the balance
between the need to ensure that all material matters are disclosed and the
need to avoid confusing users by the provision of too much detail.
Understandability calls for the provision, in the clearest for m, of all the
information which the reasonably instructed reader can make use of and
the parallel presentation of the main features for the use of the less
sophisticated.”
Understandability of information is governed by a combination of user
characteristic s, and characteristics inherent in the information.
Understandability should be determined in terms of broad classes of users
(decision -makers) rather than particular user groups. Since company
financial reporting aims at general purpose external financial reporting, all
relevant users’ needs should be considered in deciding the
understandability of the information, and no decision should be based on
specific circumstances of individual decision -makers.
4. Comparability
Economic decision required making choice among possible courses of
actions. In making decision, the decision -maker will make comparisons
among alternatives, which is facilitated by financial information.
Comparability implies to have like things reported in a similar fashion and
unlike things re ported differently. Hendriksen defines comparability as
“the quality or state of having enough like characteristics to make
comparisons appropriate”. FASB (USA) defines comparability, “as the
quality or state of having certain characteristics in common, and
comparison is normally a quantitative assessment of the common
characteristics. Clearly, valid comparison is possible only if the
measurement used - the quantities or ratios - reliably represent the
characteristic that is the subject of comparison”.
Financ ial reports of different firms are not able to achieve comparability
because of differences in business operations of companies and also
because of the management’s viewpoints in respects of their transactions.
Also, because there are different accounting practices to describe basically
similar activities. Two corporate management may view the similar risk,
uncertainly, benefit or sacrifice in different fashions and, thus, this would
lead to different implications of financial statements. With information t hat
facilitates interpretation, users are able to compare and assess the results of
similar transactions and other events among enterprises.
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13 Efforts, therefore, should be directed towards developing accounting
standards to be applied in appropriate circum stances to facilitate
comparisons and interpretation of data: areas of difference in accounting
practices, which are not justified by difference in circumstances, should be
narrowed; selection of an accounting practice should be based on the
economic subst ance of an event or a transaction being measured and
reported; and a desire a produce a particular financial statement result
should not influence choice between accounting alternatives.
5. Consistency
Consistency of method over a period of time is a valuable quality that
makes accounting numbers more useful. Consistent use of accounting
principles from one accounting period to another enhances the utility of
financial statements to users by facilitating analysis and understanding of
comparative accounting dat a. It is relatively unimportant to the investor
what precise rules or conventions are adopted by a company in reporting
its earnings, if he knows what method is being followed and is assured that
it is followed consistently from year to year. Lack of consi stency produces
lack of comparability. The value of inter-company comparisons is
substantially reduced when material differences in income are caused by
variations in accounting practices.
The quality of consistency can be applied in different situation, e.g. use of
same accounting procedures by a single firm or accounting entity from
period to period, the use of similar measurement concepts and procedures
for related items within the statement of a firm for a single period, and the
use of same procedures b y different firms. If a change in accounting
practices or procedures is made, disclosure of the change and its effects
permits some comparability, although users can rarely make adjustments
that make the data completely comparable.
Although consistency in the use of accounting principles from one
accounting period to another is a desirable quality, but it, if pushed too
far, will prove a bottleneck for bringing about improvement in accounting
policies, practices, and procedures. No change to a preferred accounting
method can be developing without sacrificing consistency; there is no
way that accounting can develop without change. Users’ needs in
changing circumstances. When, it is found that current practices or
presentations being followed are not fulfillin g users’ purposes, a new
practice or procedure should be adopted. According to Backer, “different
accounting methods are needed to reflect different management objectives
and circumstances. The consensus of opinion among analysts interviewed
was that stand ards are desirable as guidelines to financial reporting, but
that management should be free to depart from these standards provided
methods used and their effects are clearly disclosed”.
Thus consistency and uniformity in accounting methods would not
neces sarily bring comparability. Instead of enforced uniformity,
accounting standards should be developed which would be best or
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14 followed unless there is a compelling reason why they will not provide a
correct and useful reflection of business operations and results. Also, full
disclosure should be made of the alternative method applied and,
whenever practical, of the monetary difference resulting from deviations
from the standard. To conclude, consistency is desirable, until a need arises
to improve practices, policies, and procedures.
6. Neutrality
Neutrality is also known as the quality of freedom from bias’ or
objectivity. Neutrality means that, formulating or implementing standards,
the primar y concern should be the relevance and reliability of the
information the results, not the effect that the new rule may have on a
particular interest or user (s). a natural choice between accounting
alternatives is free from bias towards a predetermined res ult. The
objectives of (general purpose) financial reporting serve many different
information users who have diverse interest, and no one predetermined
result it likely to suit all user’s interests and purposes. Therefore,
accounting facts and accounting practices should be impartially determined
and reported with no objective of purposeful bias toward any user or user
group. If there is no bias in selection of accounting information reported, it
cannot be said to favour one set of interests over another. I t may, in fact,
favour certain interests, but only because the information points that
way.
To say that information should be free from bias is not to say that
standards -setters or providers of information should not have a purpose in
mind for financial re porting. In fat, information must be purposeful.
Neutrality neither means ‘without purpose’ not does it mean that
accounting should be without influence on human behaviour. Accounting
information cannot avoid affecting behaviour, nor should it. If it were
otherwise, the information would be valueless -by definition, irrelevant
and- the effort to produce it would be futile. It is, above all, the
predetermination of a desired result, that is the negation of neutrality in
accounting. To be neutral, accounting i nformation must report economic
activity as faithfully as possible, without colouring the image it
communicates for the purpose of influencing behaviour in some particular
direction.
7. Materially
The concept of materiality permeates the entire field of accou nting and
auditing. The materiality concept implies that not all financial information
need or should be communicated in accounting reports -only material
information should be reported. Immaterial information may and probably
should be omitted. Information should be disclosed in the annual report
which is likely to influence economic decision of the users. Information
that meets this requirement is material.
Generally, the decision -makers (investor, accountant and manager) see
materiality in relation to act ual assets or income. Investors see materiality
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15 seems not to be material in business may turn out to the very important in
the investment market. It has been established that the effect on earning
was the primary Standard to evaluate materiality in a specific case.
Guidelines to test materiality are: amount of the item, trend of net income,
average net income for a series of years, assets liability, trends and ratios
establish meaningful analytical relationship of information contained in
annual reports. Almost always, the relative rather than the absolute size of
a judgment item determines whether it should
be considered material in a given situation. Losses from bad debts or
pilferage that could be shrugged off as routine by a large business may
threaten the continued existence of a small one. An error in inventory
valuation may be material in a small enterprise for which it cut earnings in
half, but immaterial in an enterprise for which it might make barely
perceptible ripple in the earnings.
8. Timeliness
Timeliness means having information available to decision - makers before
it loses its capacity to influence decisions. Timeliness is ancillary aspect
relevance. If information is either no t available when it is needed or
becomes available long after the reported events that it has no value for
future action, it lacks relevance and is of little or no use.
Clearly, there are degrees of timeliness. Some reports need to be prepared
quickly, say in case of takeover bid or strike. In some other contexts,
such as routine reports by a business firm of its annual results, a longer
delay in reporting information may materially affect the relevance and,
therefore, the usefulness of information. But in order to have gain in
relevance that comes with increased timeliness, it may involve sacrifices
of other desirable characteristics of information, and as a result there may
be an overall gain or loss in usefulness. For example, it may sometimes
be desirabl e to sacrifice precision for timeliness, for an approximation
produced quickly is often more useful than precise information that is
reported after a longer delay. It can be argued that if in the interest of
timeliness, the reliability of the information i s sacrificed to a material
degree; the usefulness of the information may be adversely affected.
9. Verifiability
The quality of verifiability contributes to the usefulness of accounting
information because the purpose of verification is to provide a significa nt
degree of assurance that accounting measures represent, what they purport
to represent. Verification does not guarantee the suitability of method used,
much less the correctness of the resulting measure. It does convey some
assurance that the measuremen t rule used, whatever it was, was applied
carefully and without personal bias on the part of the measurer. In this
process, verification implies and enhances consensus about measurements
of some particular phenomenon.
The Accounting Principles Board of USA defines verifiability as:
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16 be substantially duplicated by independent measurers using the same
measurement methods.”22
According to FASB, “Verifiability means no more than that severa l
measurers are likely to obtain the same measure. It is primarily a means to
attempting to cope with measurement problems stemming from the
uncertainty that surrounds accounting measures and is more successful in
coping with some measurement problems than others. Verification of
accounting information does not guarantee that the information has a high
degree of representational faithfulness and a measure with a high degree
of verifiability is not necessarily relevant to the decision for which it is
intende d to be useful.’
10. Conservatism
Conservatism is generally referred to as a convention that many
accountants believe to be appropriate in making accounting decisions.
There is a place for a convention, such as conservatism – meaning
prudence in financial acco unting and reporting, because business and
economic activities are surrounded by uncertainty, but it needs to be
applied with care. Conservatism in financial reporting should no longer
connote deliberate, consistent, understatement of net assets and profit s.
Conservatism is prudent reaction to uncertainty to try to ensure that
uncertainties and risks inherent in business situations are adequately
considered. Thus, if two estimates of amounts to be received or paid in the
future are about equally likely, con servatism dictates using the less
optimistic estimates. However, if two amounts are not equally likely,
conservatism does not necessarily dictate using the more pessimistic
amount rather than the more likely one. Conservatism no longer requires
deferring r ecognition of income beyond the time that adequate evidence of
is existence becomes available, or justifies recognizing losses before there
is adequate evidence that they have been incurred.
11. Substance over From (Economic Realism)
Economic realism is not us ually mentioned as a qualitative criterion in
accounting literature, but it is important to investors. It is a concept that
seems easy to understand but hard to define because perceptions of reality
differ. In essence, economic reality means an accurate me asurement, of
the business operations, that is, economic costs and benefits generated in
business activity. The definitional problem arises from cash v. accrual
accounting, or the principle of matching costs with revenues. Accrual
accounting is necessary for complex organizations, of course, but, where
accruals and estimates have a considerable degree of uncertainty as to
amount or timing, cash accounting would seem to come closer to
economic realism.
There have been tendencies in accounting for “the media to become the
message”, i.e. for accounting numbers to become the reality rather than the
underlying facts they represent. These may give the illusion of steady
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17 the facts about these fluctuations; if they find it useful to average
earnings, they can do so themselves. The objective should be “to tell it like
is”.25
The above mentioned characteristics (relevance, Materiality,
understandability, comparability, consistency, reliability, ne utrality,
economic realism) make financial reporting information useful to users.
These normative qualities of information are based largely upon the
common needs of users.
1.6 ASI, DISCLOSURE OF ACCOUNTING POLICIES
The institute of Chartered Accountants of In dia (ICAI) issued ASI titled
Disclosure of Accounting Policies’ in November 1979. This standard is
now mandatory and deals with the disclosure of significant accounting
policies followed in preparing and presenting Financial Statements.
In general accounti ng policies are not at present regularly and fully
disclosed in all financial statements. Many enterprises include in the
Notes on the Accounts, description of some of the significant policies.
Even among the few enterprises that presently include in their annual
reports a separate statement of accounting policies, considerable variation
exists. The statement of accounting policies forms part of the accounts in
some cases while in others it is given as supplementary information.
The purpose of this statemen t is to promote better understanding of
financial statements by establishing through an accounting standard the
disclosure of significant accounting policies and manner in which
accounting policies are disclosed in the financial statements. Such
disclosure would also facilitate a more meaningful comparison between
financial statements of different enterprises.
ASI contains explanations on following points: Fundamental
Accounting Assumptions
1. Certain fundamental accounting assumptions underline the
preparatio n and presentation of financial statement. They are usually not
specifically stated because their acceptance and use are assumed.
Disclosure is necessary if they are not followed.
The following have been generally accepted as fundamental accounting
assumpt ion;
a) Going Concern – The enterprise is normally viewed as a going
concern, that is, as continuing in operation for the foreseeable future. It is
assumed that the enterprise has neither the intention nor the necessity of
liquidation or of curtailing materia lly the scale of the operation.
b) Accrual – Revenues and costs are accrued, that is, recognized as they
are earned or incurred (and not as money is received or paid) and recorded
in the financial statement of the periods to which they relate. (The
considerat ions affecting the process or matching costs with revenues under
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18 2. Nature of Accounting Policies
a) The accounting policies refer to the specific accounting principle and
the methods of applying tho se principles adopted by the enterprise in the
preparation and presentation of financial statements.
b) There is no single list of accounting policies which are applicable to
all circumstances in which enterprises operate in a situation of diverse and
complex economic activity make alternative accounting principles and
methods of applying those principles acceptable. The choice of the
appropriate accounting principles and the methods of applying those
principles in the specific circumstances of each enterprise calls for
considerable judgement by the management of the enterprise.
c) The various statements of the institute of Chartered Accountants of
India combined with the efforts of government and other regularity
agencies and progressive particularly in the case of corporate enterprises.
While continuing efforts in this regard in future are likely to reduce the
number still further, the availability of alternative accounting principles
and methods of applying those principles is not likely to be eliminated
altoget her in view of the differing circumstances faced by the enterprises.
3. Areas in which deferring accounting policies are encountered
The following are examples of the areas in which different accounting
policies may be adopted different enterprises:
 Method of depreciation, depletion and amortization
 Treatment of expenditure during Construction
 Conversion of translation of foreign currency items
 Valuation of inventories
 Treatment of goodwill
 Valuation of investments
 Treatment of retirement benefits
 Recognition of profit on long-term contracts
 Valuation of fixed assets
 Treatment of contingent liabilities
The above list of example is not intended to be exhaustive.
4. Considerations in the Selection of Accounting policies
The primary consideration in the selection of accounting policies by an
enterprise is that the financial statements prepared and presented on the
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19 the state of affairs of the enterprise as at the balance sheet data and of the
profit or loss for the period ended on that date.
For this purpose, the major considerations governing the selection and
application of accounting policies are:
a) Prudence – In view of the uncertainty attached to future events,
profits are not anticipated but recognized only when realized though not
necessarily in cash. Provision is made for all known liabilities and losses
even though the amount cannot be determined with certainty and
represents only a best estimate in the light of available information.
b) Subst ance over Form – The accounting treatment and presentation
in financial statement of transactions and events should be governed by
their substance and not merely by the legal form.
c) Materiality – Financial statement should disclose all ‘material’
items, the knowledge of which might influence the decisions of the user of
the financial statements.
5. Disclosure of accounting Policies
(i) To ensure proper understanding of financial statement, it is
necessary that all significant accounting policies adopted in the preparation
and presentation of financial statements should be disclosed.
(ii) Such disclosure should form part of the financial statements.
(iii) It would be helpful to the reader of financial statement it they are all
disclosed as such is one place instead of being scattered over several
statements, schedules and notes.
(iv) Examples of matters in respect of which disclosure of accounting
policies adopted will be required are contained in point No. 3. This list of
examples is not, however, intended to be exhaustive.
(v) Any chan ge in an accounting policy which has a material effect
should be disclosed. The amount by which any item in the financial
statements is affected by such change should also be disclosed to the
extent as certainable. When such amount is not as certainable, wholly or
in part, the fact should be indicated. If a change is made in the accounting
policies which has no material effect on the financial statement for the
current periods, but which is reasonably expected to have a material effect
in later periods, the fact of such change should be appropriately disclosed
in the period in which the change is adopted.
(vi) Disclosure of accounting policies or of changes therein cannot
remedy a wrong or inappropriate treatment of the item in the accounts.
Accounting Standard i n ASI
(i) All significant accounting policies adopted in the preparation and
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20 (ii) The disclosure of the significant accounting policies as such should
form part of the financial statement and the significant accounting policies
should normally be disclosed in one place.
(iii) Any change in the accounting policies which has a material effect in
the current period or which is reasonably expected to have a material
effect in later periods should be disclosed. In the case of a change in
accounting policies which has a material effect in the current period, the
amount by which any item in the financial statements in affected by such
change should also be disclosed to the extent ascertainable. Where such
amount is not asc ertainable, wholly or in part, the fact should be indicated.
(iv) If the fundamental accounting assumptions, viz. Going concern,
consistency and accrual are following in financial statements, specific
disclosure is not required. If a fundamental accounting assumption is not
followed, the fact should be disclosed.
1.7 NOTES ON ACCOUNTS IN CORPORATE ANNUAL
REPORTS
One of the important developments today in corporate reporting under
schedules forming part of accounts and roles from part of accounts.
Accounts normall y consent of Balance Sheet and Profit & Loss Accounts
and cash flow statement schedules for main part of accounts includes
(a) Schedule A - Share capital
(b) Schedule B - Reserve & Surplus
(c) Schedule C - Secured Loan
(d) Schedule D - Unsecured Loan
(e) Schedule E - Fixed assets
(f) Schedule F - Investment
(g) Schedule G - Current assets loans and advances
(h) Schedule H - Current Liabilities and provisions
(i) Schedule I - Deferred revenue terms
(j) Schedule J - Contingent liability
(k) Schedule K - Sales and Service
(l) Schedule L - Clts Increase
(m) Sche dule M - Manufacturing, construction and Operating
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21 (o) Schedule O - Sales administrative and other expenses
(p) Schedule P - Investors & borrowers
(q) Schedule Q - Important accounting
Under Schedule Q viz significant accou nting polices the are follow:
1. Basic of accounting
2. Sales and service income
3. Research & Development
4. Retirement benefits
5. Fixed Assets
6. Losses
7. Deprecations
8. Investment
9. Investor
10. Security premium account
11. Borrowing costs
12. Interest
13. Employee
14. Deferred revenue expenditu re
15. Foreign currency transaction
16. Segment Reporting
17. Taxes on income
18. Accounting for Joint Ventures
Note forming part of accounts:
Under this a company the following are to the points of reporting by a
company
1. Allotment of equity shares
2. Shareholder currently shares
3. Secured redeemable non point (NCBS) / Debentures
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22 6. Progress /money,
7. Balance with the schedule
8. Segment Reporting
9. Of related parts / related partly
10. Loss
11. Deferred tax assets / liabilities
12. Auditor remuneration
13. Vale of
14. Expenditure in foreign currency
15. Lest of SSI to when if company once more for so day
16. Sales corporate
17. Investor
18. Purchase of goods
1.8 DIRECTOR'S REPORT: -
Director's report is a report submitted by the directors of a company to its
shareholders, appraisi ng them of the performance of the company under its
direction. It is an exercise of self -evaluation. Director's report expresses
the opinion of directors on the state of the company, explains performance
and the financial results, discusses company's plans for expansion,
diversification or modernization, tells about appropriation of profits, and
elaborates company's future prospects and plans for investments. It is a
synopsis of the company's activities during the year and during the interim
period between the date of the balance sheet and date of the annual
report. Director's report should take the investors into confidence by
providing useful insights into the activities of the business, more than
what the financial statements provide.
Director's report is valuable and if read intelligently, gives the investor
good sense of company's working, its problems and future prospects.
1.9 AUDITORS REPORT: -
Every company is subject to audit and an auditor makes a report to the
members of the company on its state of aff airs. It is a comment on
accounts and on balance sheet and profit and loss account and other
documents attached to the financial statements, which are laid in the
AGM. Auditors report to shareholders contains an opinion as to whether
the financial statemen ts present a true and fair view of the state of affairs
of the company, in case of a balance sheet and of profit or loss in case of
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23 are in agreement and whether there is any deviation from generally
accepted accounting principles. It indicates the areas to which
shareholders and investors must give due attention while assessing the
financial strength of the company whose securities are being considered
for investment.
1.10 EXERCISE
1. What do you mean by them accounting policy?
2. What is the remuneration of true blood report?
3. What are the primary objects of financial reporting?
4. Discuss the differ user of functional reporting?
5. What are the qualitative characteristics of financial reporting
informat ion?
6. What are the financial accounting
7. What are the areas in what different accounting plus are
accounted? Discuss
8. Discuss important consideration in relating of accounting p
9. What do you mean by role on accounts in a corporate report?
10. Discuss schedules forming part of company annual report. Make a
can study on a report?



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24 2
FINANCIAL REPORTING STANDARDS
AND INDIAN -AS

Unit Structure
2.1 Introduction
2.2 Meaning of IFRS
2.3 Objectives of IFRS
2.4 Scope of IFRS
2.5 List of IFRS
2.6 Challenges of IFRS
2.7 Convergence With IFRSs: Indian Perspective
2.8 Benefits of IFRS
2.9 Framework for the Preparation and Prese ntation of Financial
Statements
2.10 IFRS -1: First Time adoption of IFRS
2.11 Solved Problem
2.12 Introduction to Borrowing Cost
2.13 Meaning and Definition of Borrowing Cost
2.14 Introduction to Segment Reporting
2.15 Explanatory Notes
2.16 Theoretical Questions on the Standard
2.17 Introducti on to Earning per Share
2.18 Theory Questions
2.19 Accounting for Taxes on Income
2.1 INTRODUCTION
Accounting is the art and science of recording business transactions in
best possible manner with proper selection and adoption of accounting
policies and principles. Over the time it was felt necessary to ensure easy
comparability the enterprises should follow uniform accounting methods.
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25 profession of accountancy. The institute ensures professionalism and
prudence in preparation and presentation of financial statements by issuing
guidelines, accounting standards from time to time.
In today’s world of globalization business enterprises have become more
dependent on each other, across the nation and across the world. The
globalization has forced more and more countries to open their doors for
business expansion across borders and to foreign investments.
Traditionally companies raised funds from domestic capital markets and
financial institutions. The business was restricted to very few countries.
The rapid expansion of international trade and internationalization of
firms, the development of new communication technologies, and the
emergence of international competitive forces has made it extremely
necessary to have uniform and internationally acceptable accounting
standards. Now it has been realized that under this global business
scenario the business community is badly in need of a common accounting
language that should be spoken by all of them across the wor ld.
A financial reporting system supported by a strong governance, high
quality standards and firm regulatory framework is the key to economic
development. Indeed, sound financial reporting standards underline the
trust that investors place in financial re porting information and thus play
an important role in contributing to the economic development of a
country. Different countries have local accounting standards which spell
out the accounting treatment and disclose your requirements for preparing
of finan cial statements, some sort of compatibility or convergence is
necessary to enable all the stake holders to take appropriate economic
decisions. This is sought to be ensured through the International Financial
Reporting Systems (IFRS) adopted by Internation al Accounting Standards
Board (IASB). Most of the countries have started adopting IFRS or
making their local GAAP convergent with IFRS. Major stock exchanges
across the world today accept IFRS.
2.2 MEANING OF IFRS
 IFRSs are principle -based standards.
 The prin ciple -based standards have distinct advantage that the
transactions cannot be manipulated easily to achieve a particular
accounting.
 The Financial Accounting Standards Board (FASB), USA, is having a
convergence project with the IASB and is broadly adopting the
principle -based approach instead of rule-based approach.
 IFRSs lay down treatments based on the economic substance of
various events and transactions rather than their legal form.
 The application of this approach may result into events and
transaction s being presented in a manner different from their legal
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26  To illustrate, as per IAS 32, preference shares that provide for
mandatory redemption by the issuer are presented as a liability.
2.3 OBJECTIVES OF IFRS:
WHY IFRS?
A single set of accounting standa rds would enable internationally to
standardize training and assure better quality on a global screen, it would
also permit international capital to flow more freely, enabling companies
to develop consistent global practices on accounting problems. It woul d
be beneficial to regulators too, as a complexity associated with needing to
understand various reporting regimes would be reduced.
OBJECTIVES OF IFRS:
2.3.1 The main objective of IFRS is to develop in the public the interest of
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 help
participants in the world's capital markets and other users make econom ic
decisions.
2.3.2 To promote the use and rigorous application of those standards; in
fulfilling the objectives associated with it.
2.3.3 To take account of, as appropriate, the special needs of small and
medium -sized entities and emerging economies.
2.3.4 To bring about c onvergence of national accounting standards and
International Accounting standards and IFRS to high quality solutions.
2.4 SCOPE OF IFRS:
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. IFRSs apply to the general
purpose financial statements and other financial reporting by profit -
oriented entities -- those engaged in commercial, industrial, financial, and
similar activities, regardless of their legal form. Entities other than profit -
oriented business entities may also find IFRSs appropriate.
General purpose financial statements are intended to meet the comm on
needs of shareholders, creditors, employees, and the public at large for
information about an entity's financial position, performance, and cash
flows. Other financial reporting includes information provided outside
financial statements that assists in the interpretation of a complete set of
financial statements or improves users' ability to make efficient economic
decisions. IFRS apply to individual company and consolidated financial
statements. A complete set of financial statements includes a balance
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27 showing either all changes in equity or changes in equity other than those
arising from investments by and distributions to owners, a summary of
accounting policies, and explanatory notes.
If an IFRS allows both a 'benchmark' and an 'allowed alternative'
treatment, financial statements may be described as conforming to IFRS
whichever treatment is followed. In developing Standards, IASB intends
not to permit choices in accounting treatment. Furth er, IASB intends to
reconsider the choices in existing IASs with a view to reducing the
number of those choices. IFRS will present fundamental principles in bold
face type and other guidance in non -bold type (the 'black -letter'/'grey -letter'
distinction). Paragraphs of both types have equal authority. The
provision of IAS 1 that conformity with IAS requires compliance with
every applicable IAS and Interpretation requires compliance with all
IFRSs as well.
2.5 LIST OF IFRS:
 IFRS 1: First-time Adoption of Interna tional Financial Reporting
Standards
 IFRS 2: Share -based Payment
 IFRS 3: Business Combinations
 IFRS 4: Insurance Contracts
 IFRS 5: Non-current Assets Held for Sale and Discontinued
Operations
 IFRS 6: Exploration for and Evaluation of Mineral Resources
 IFRS 7: Financial Instruments: Disclosures
 IFRS 8: Operating Segments
 IFRS 9: Financial Instruments
International Accounting Standards (IAS)
IAS relates to standards on various aspects of accounting issues.
These are mainly relevant for maintenance of accounts as well as
disclosure of Information.
 IAS 1: Presentation of Financial Statements.
 IAS 2: Inventories
 IAS 7: Cash Flow Statements
 IAS 8: Accounting Policies, Changes in Accounting Estimates and
Errors
 IAS 10: Events After the Balance Sheet Date
 IAS 11: Construction Contracts
 IAS 12: Income Taxes
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28  IAS 17: Leases
 IAS 18: Revenue
 IAS 19: Employee Benefits
 IAS 20: Accounting for Government Grants and Disclosure of
Government Assistance
 IAS 21: The Effects of Chang es in Foreign Exchange Rates
 IAS 23: Borrowing Costs
 IAS 24: Related Party Disclosures
 IAS 26: Accounting and Reporting by Retirement Benefit Plans
 IAS 27: Consolidated Financial Statements
 IAS 28: Investments in Associates
 IAS 29: Financial Reporting in Hyperinflationary Economies
 IAS 31: Interests in Joint Ventures
 IAS 32: Financial Instruments: Presentation
 IAS 33: Earnings per Share
 IAS 34: Interim Financial Reporting
 IAS 36: Impairment of Assets
 IAS 37: Provisions, Contingent Liabilities and Contingent Assets
 IAS 38: Intangible Assets
 IAS 39: Financial Instruments: Recognition and Measurement
 IAS 40: Investment Property
 IAS 41: Agriculture
2.6 CHALLENGES OF IFRS
Economic Environment
 Some IFRSs require fair value approach to be followed, examples
include:
o IAS 39, Financia l Instruments: Recognition and Measurement
o IAS 41, Agriculture
 The markets of many economies such as India normally do not have
adequate depth and breadth for reliable determination of fair values.
 With a view to provide further guidance on the use of fair value
approach, the IASB is developing a document.
 Till date, no viable solution of objective fair value measures is
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29
SME concerns
SMEs face problems in implementing IFRSs because of:
 Scarcity of resources and expertise with the SMEs to achieve
compliance
 Cost of compliance not commensurate with the expected benefits
Keeping in view the difficulties faced by the SMEs, the IASB is
developing an IFRS for SMEs.
Training to Preparers
 Some IFRSs are complex.
 There is lack of adequate skills amongst the preparers and users of
Financial Statements to apply IFRSs.
 Proper implementation of such IFRSs requires extensive education
of preparers
Interpretation
 A large number of application issues arise while applying IFRSs.
 There is a need to have a forum which may address the application
issues in specific cases.
2.7 CONVERGENCE WITH IFRSS:
 Indian Accounting Standards (ASs) are formulated on the basis of the
IFRSs.
 While formulating ASs, the endeavor of the ICAI remains to converge
with the IFRSs.
 The ICAI has till date issued 29 ASs corresponding to IFRSs.
 Some recent ASs, issued by the ICAI, are totally at par with the
corresponding IFRSs, e.g., the Standards on ‘Impairment of Assets’
and ‘Construction Contracts’.
 While formulating Indian Accounti ng Standards, changes from the
corresponding IAS/ IFRS are made only in those cases where these are
unavoidable considering:
o Legal and/ or regulatory framework prevailing in the country.
o To reduce or eliminate the alternatives so as to ensure comparability .
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30 o Level of preparedness of various interest groups involved in
implementing the accounting standards.
2.8 BENEFITS OF IFRS
The forces of globalization prompt more and more countries to open their
doors to foreign investment and as businesses expand across borders the
need arises to recognize the benefits of having commonly accepted and
understood financial reporting standards. Following are some of the
benefits of adopting IFRS -
 Transparency and comparability
 Low cost of capital
 Eliminates need for multiple reporting
 True value of acquisition
 Cross border transaction
 Sets a benchmark
 Improvement in planning and forecasting
2.9 FRAMEWORK FOR THE PREPARATION AND
PRESENTATION OF FINANCIAL STATEMENTS:
This Framework sets out the concepts that underlie the preparation and
presentation of financial statements for external users. The Framework
deals with: The objective of financial statements; the qualitative
characteristics that determine the usefulness of information in financ ial
statement; The Definition, recognition and measurement of the elements
from which financial statements are constructed; and Concept of capital
and capital maintenance. The Objective of Financial statements is to
provide useful information to users of financial statements in making
economic decision. Financial Statements are prepared to provide
information on Financial Position, Operating Performance and changes in
financial position of an entity Financial Statements are normally prepared
on the assumpti on that entity is a going concern and will continue in
operation for the foreseeable future, and prepared on accrual basis of
accounting. The four Qualitative characteristics are Understandability,
relevance; reliability and comparability are the attribute s that make the
financial information useful to users. The elements directly related to the
measurement of financial position are assets, liabilities and equity. An item
that meets the definition of an element should be recognized if: it is
probable that a ny future economic benefit associated the item will flow to
or from the entity. The item has a cost or value that can be measured with
reliability. Measurement is the process of determining the monetary
amounts at which each element in the financial statem ents is to be
recognized and carried in the Balance Sheet and Income statement. The
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31 the capital that it seeks to maintain. It provides the linkage between the
concepts of capital and th e concepts of profit because it provides the point
of reference by which profit is measured.
2.10 IFRS -1: FIRST TIME ADOPTION OF IFRS
An entity shall prepare and present an opening IFRS statement of
financial position at the date of transition to IFRSs. This is the starting
point for its accounting under IFRSs. An entity shall prepare an opening
IFRS balance sheet at the date of transition to IFRSs. This is the starting
point for its accounting under IFRSs. An entity need not present its
opening IFRS balance sheet in its first IFRS financial statements. In
general, the IFRS requires an entity to comply with each IFRS effective at
the end of its first IFRS reporting period. In particular, the IFRS requires
an entity to do the following in the opening IFRS statem ent of financial
position that it prepares as a starting point for its accounting under IFRSs:
recognize all assets and liabilities whose recognition is required by IFRSs.
not to recognize items as assets or liabilities if IFRSs do not permit such
recognit ion; IFRS -1. IFRS -1 reclassify items that it recognized under
previous GAAP as one type of asset, liability or component of equity, but
are different type of asset, liability or component of equity under IFRSs.
Apply IFRSs in measuring all recognized asset s and liabilities. The IFRS
grants limited exemptions from these requirements in specified areas
where the cost of complying with them would be likely to exceed the
benefits to users of financial statements. The IFRS also prohibits
retrospective applicatio n of IFRSs in some areas; particularly where
retrospective application would require judgments by management about
past conditions after the outcome of a particular transaction is already
known. The IFRS requires disclosures that explain how the transition from
previous GAAP to IFRSs affected the entities reported financial position,
financial performance and cash flows.
OBJECTIVE OF THIS STANDARD: The objective of this IFRS is to
specify the financial reporting by an entity when it undertakes a share -
based payment transaction. In particular, it requires an entity to reflect in
its profit or loss and financial position the effects of share -based
payment transactions, including expenses associated with transactions in
which share options are granted to employ ees.
IFRS -2: SHARE -BASED PAYMENTS
The IFRS requires an entity to recognize share -based payment
transactions in its financial statements, including transactions with
employees or other parties to be settled in cash, other assets, or equity
instruments of the entity. There are no exceptions to the IFRS, other than
for transactions to which other Standards apply. This also applies to
transfers of equity instruments of the entity’s parent, or equity
instruments of another entity in the same group as the entity , to parties that
have supplied goods or services to the entity. This IFRS sets out
measurement principles and specific requirements for three types of share -
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32 transactions, in which the entity receives goods or services as consideration
for equity instruments of the entity (including shares or share options);
(b) cash-settled share -based payment transactions, in which the entity
acquires goods or services by incurring liabilities to the supplier of those
goods or services for amounts that are based on the price (or value) of the
entity’s shares or other equity instruments of the entity; and (c) transactions
in which the entity receives or acquires goods or services and the terms of
the arrangement provide either the entity or the supplier of those goods or
services with a choice of whether the entity settles the transaction in cash
or by issuing equity instruments.
The IFRS also sets out requirements if the terms and conditions of an
option or shar e grant are modified (e.g. an option is reprised) or if a grant is
cancelled, repurchased or replaced with another grant of equity
instruments. For example, irrespective of any modification, cancellation
or settlement of a grant of equity instruments to em ployees, the IFRS
generally requires the entity to recognize, as a minimum, the services
received measured at the grant date fair value of the equity instruments
granted. For cash - settled share -based payment transactions, the IFRS
requires an entity to me asure the goods or services acquired and the
liability incurred at the fair value of the liability. Until the liability is
settled, the entity is required to re measure the fair value of the liability at
each reporting date and at the date of settlement, w ith any changes in value
recognized in profit or loss for the period.
IFRS -3: BUSINESS COMBINATIONS:
The objective of the IFRS is to enhance the relevance, reliability and
comparability of the information that an entity provides in its financial
statement s about a business combination and its effects. It does that by
establishing principles and requirements for how an acquirer:
(a) Recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed and any non - control ling
interest in the acquire;
(b) Recognizes and measures the goodwill acquired in the business
combination or a gain from a bargain purchase.
(c) Determines what information to disclose to enable users of the
financial statements to evaluate the nature and financ ial effects of the
business combination.
Points: Core principle an acquirer of a business recognizes the assets
acquired and liabilities assumed at their acquisition -date fair values and
discloses information that enables users to evaluate the nature and financial
effects of the acquisition. Applying the acquisition method a business
combination must be accounted for by applying the acquisition method,
unless it is a combination involving entities or businesses under common
control. One of the parties to a business combination can always be
identified as the acquirer, being the entity that obtains control of the other
business (the acquiree). Formations of a joint venture or the acquisition of munotes.in

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33 an asset or a group of assets that does not constitute a business are not
business combinations.
IFRS -4: INSURANCE CONTRACTS:
The objective of this IFRS is to specify the financial reporting for
insurance contracts by any entity that issues such contracts (described in
this IFRS as an insurer) until the Board completes the second phase of its
project on insurance contracts. In particular, this IFRS requires: limited
improvements to accounting by insurers for insurance contracts. disclosure
that identifies and explains the amounts in an insurer’s financial
statements ari sing from insurance contracts and helps users of those
financial statements understand the amount, timing and uncertainty of
future cash flows from insurance contracts.
IFRS -5: NON -CURRENT ASSETS HELD FOR SALE AND
DISCONTINUED OPERATIONS:
The objective of this IFRS is to specify the accounting for assets held for
sale, and the presentation and disclosure of discontinued operations. In
particular, the IFRS requires: assets that meet the criteria to be classified
as held for sale to be measured at the lower of carrying amount and fair
value less costs to sell, and depreciation on such assets to cease; and assets
that meet the criteria to be classified as held for sale to be presented
separately in the statement of financial position and the results of
discont inued operations to be presented separately in the statement of
comprehensive income.
IFRS -6: EXPLORATION FOR AND EVALUATION OF
MINERALS:
The objective of this IFRS is to specify the financial reporting for the
exploration for and evaluation of mineral resources. POINTS:
Exploration and evaluation expenditures are expenditures incurred by an
entity in connection with the exploration for and evaluation of mineral
resources before the technical feasibility and commercial viability of
extracting a mineral resource are demonstrable. Exploration for and
evaluation of mineral resources is the search for mineral resources,
including minerals, oil, natural gas and similar non-regenerative resources
after the entity has obtained legal rights to explore in a specific area, as
well as the determination of the technical feasibility and commercial
viability of extracting the mineral resource. Exploration and evaluation
assets are exploration and evaluation expenditures recognized as assets in
accordance with the entity’s accounting policy.
FRS -7: FINANCIAL INSTRUMENTS DISCLOSURE:
The objective of this IFRS is to require entities to provide disclosures in
their financial statements that enable users to evaluate: the significance of
financial instruments for the entity’s financial position and performance;
and the nature and extent of risks arising from financial instruments to
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34 how the entity manages those risks. The qualitative disclosures describe
management’s objectives, policies and processes for managing those risks.
The quantitative disclosures provide information about the extent to which
the entity is exposed to risk, based on information provided internally to
the entity's key management personnel. Together, these disclosures
provide an overview of the entity's use of financial instruments and the
exposures to risks they create.
IFRS -8: OPERATING SEGMENTS:
This IFRS shall apply to:
(a) The separate or individual financial statements of an entity: whose
debt or equity instruments are traded in a public market (a domestic or
foreign stock exchange or an over -the-counter market, including local and
regional markets), or that files, or is in the process of filing, its financial
statements with a securi ties commission or other regulatory organization
for the purpose of issuing any class of instruments in a public market.
(b) The consolidated financial statements of a group with a parent:
whose debt or equity instruments are traded in a public market (a domes tic
or foreign stock exchange or an over-the-counter market, including local
and regional markets), or that files, or is in the process of filing, the
consolidated financial statements with a securities commission or other
regulatory organization for the purpose of issuing any class of instruments
in a public market. IFRS -8
IFRS - Indian Context
Convergence with IFRS has gained momentum in recent years all over the
World.
India is committed to adopt IFRS from 2011.
United States of America has announced its intention to adopt IFRS from
2014 and it also permits foreign private filers in the
U.S. Stock Exchanges to file IFRS compiled Financial Statement,
without requiring the presentation of reconciliation statement.
In this scenario of globalization, India ca nnot insulate itself from the
developments taking place worldwide. In India, so far as the ICAI is
concerned, its aim has always been to comply with the IFRS to the extent
possible with the objective to formulate sound financial reporting
standards. The IC AI, being a member of the International Federation of
Accountants (IFAC), considers the IFRS and tries to integrate them, to the
extent possible, in the light of the laws, customs, practices and business
environment prevailing in India. The Preface to the Statements of
Accounting Standards, issued by the ICAI, categorically recognizes the
same. Now, as the world globalizes, it has become imperative for India
also to make a formal strategy for convergence with IFRS with the
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35
In the present era of globalization and liberalization, the World has
become an economic village. The globalization of the business world and
the attendant structures and the regulations, which support it, as well as
the development of e-commerce make it imperative to have a single
globally accepted financial reporting system. A number of multinational
companies are establishing their businesses in various countries with
emerging economies and vice versa.
The entities in emerging economies are increasingly accessing the global
markets to fulfill their capital needs by getting their securities listed on the
stock exchanges outside their country. Capital markets are, thus, becoming
integrated consistent with this World -wide t rend. The use of different
accounting frameworks in different countries, which require inconsistent
treatment and presentation of the same underlying economic transactions,
creates confusion for users of financial statements. This confusion leads to
ineffi ciency in capital markets across the world. Therefore, increasing
complexity of business transactions and globalization of capital markets
call for a single set of high quality accounting standards. High standards
of financial reporting underpin the trus t investors place in financial and
non-financial information. Thus, the case for a single set of globally
accepted accounting standards has prompted many countries to pursue
convergence of national accounting standards with IFRS.
The paradigm shift in the economic environment in India during last
few years has led to increasing attention being devoted to accounting
standards as a means towards ensuring potent and transparent financial
reporting by any corporate.
ICAI, being a premier accounting body in the country, took upon itself the
leadership role by establishing ASB, more than twenty five years back, to
fall in line with the international and national expectations. Today,
accounting standards issued by the Institute have come a long way.
The ICAI as the accounting standard - setting body in the country has
always made efforts to formulate high quality Accounting Standards and
has been successful in doing so. Indian Accounting Standards have
withstood the test of time. As the world continues to globalize, discussion
on convergence of national accounting standards with International
Financial Reporting Standards (IFRS) has increased significantly.
At present, the ASB of ICAI formulates the AS based on IFRS. However,
these standards remain sensitive to local conditions, including the legal
and economic environment. Accordingly, AS issued by ICAI depart from
corresponding IFRS in order to ensure consistency with legal, regulatory
and economic environment of India.
Formation of IFRS Task Force by the Council of ICAI Recommendation
of the IFRS Task Force submitted to the Council Full adoption of IFRS
from accounting period commencing on or after 1 April 2011 Proposed to
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36 insurance compani es and large sized entities Involvement of various
regulators (MCA, RBI, IRDA, Tax authorities and SEBI)
Draft Schedule VI and Accounting Standard 1 (Exposure Draft) consistent
with IFRSs Convergence Strategy presented by Technical Directorate of
ICAI on 02.02.2009:
– ICAI has begun the process of issuing IFRS equivalent AS with
following proposed changes:
1. Removal of alternative treatments
2. Additional disclosures, where required
3. AS number will continue but IFRS number will be given in
parenthesis
4. IFRICs will be issued as appendices
– ICAI has constituted a Group in liaison with government &
regulatory authorities and this group has constituted separate core groups
to identify inconsistencies between IFRS and various relevant acts.
An entity:
i Whose equity or debt securities are listed or are in the process of
listing on any stock exchange, whether in India or outside India; or
ii Which is a bank (including a cooperative bank), financial institution,
a mutual fund, or an insurance entity; or
iii Whose turnover (excluding o ther income) exceeds rupees one
hundred crores in the immediately preceding accounting year; or
iv Which has public deposits and/or borrowings from banks and
financial institutions in excess of rupees twenty five crores at any
time during the immediately preceding accounting year; or
v Which is a holding or a subsidiary of an entity which is covered in
(i) to (iv) above
Transition to IFRS – Things to remember
First year of reporting:
Accounting period commencing on or after 1 April 2011 (Normally 1
April 2011 – 31 March 2012)
Date of adoption:
The first day of the first reporting financial year (1 April 2011)
Date of reporting:
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37 Comparative year:
Immediately preceding previous year (1 April 2010 – 31 March 2011)
Date of transition:
The beginning of the earliest period for which an entity presents full
comparative information (1 April 2010)
First time adoption of IFRS on the date of reporting envisages -
1. Restatement of opening balances as at 1 April 2010
2. Presentation of comparative financial statements for the year
2010 -11
3. Preparation and presentation of financial statements for the first
year of reporting 2011 -12
4. Explicit and unreserved statement of compliance with IFRS
All the above statements (as stated in 1 to 3 above) have to be drawn as
per the IFRS in force on the date of reporting.
2.11 INTRODUCTION TO BORROWING COST
Business enterprises borrow funds for acquiring, constructing, building,
fixed & other assets. These assets take time to make them usable or
saleable. Interest has to be paid on borrowed funds immediately from the
date of borrower. Also there are other costs associated with borrower. This
accounting standard aims at prescribing the treatment of borrowing cost.
2.12 MEANING AND DEFINI TION OF BORROWING
COST
Borrowing costs are defined as interest and other cost incurred associated
with borrowing of funds. These include following cost/charges:
1. Interest and commitment charge on borrowing.
2. Amortization of discounts or provision relating to borrowing.
3. Amortization of ancillary costs incurred in connection with
arrangement of borrower.
4. Finance charges when the assets are acquired under finance
leases.
5. Exchange difference arising from foreign currency borrowings to the
extent they are regarde d as an adjustment to interest costs.
This standard does not deal with cost of owners’ equity or preference
share capital.
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38 Qualifying assets:
An asset which takes substantial period of time to get ready for its
intended use or sale is called as qualifying asset.
Examples of qualifying assets:
1. Any tangible fixed asset which is in construction process or
acquired fixed asset which is not ready for use or sale.
e.g. plant and machinery
2. Any tangible asset which are in development stage or acquired but
not read y for use e.g. patents
3. Investment property
4. Inventories that require a substantial period to bring them into
saleable condition.
As per these accounting standard borrowing costs, which is directly
related to the acquisition, construction or production of qualifying assets
should be capitalized. Amount of borrowing cost eligible for capitalization
is equal to actual borrowing cost incurred during the period less any
income on temporary investment on borrowing account.
Conditions for capitalization of borrowin g cost:
1. The borrowing cost which is directly attributable to acquisition,
construction or production of qualifying asset is eligible for capitalization.
Directly attributable cost are those cost which could have been avoided if
the expenditure on the quali fying assets had not been made.
2. Qualifying asset will give future economic benefits to the enterprise.
Borrowing cost eligible for capitalization
a) Specific Borrowings
Amount of borrowing cost to be capitalized:
Actual borrowing cost incurred during the period… xx
Less:
Income on temporary investment out of borrowed amount… (xx)
Xx
b) General borrowings:
When the amount borrowed is generally used for acquisition of
qualif ying assets.
The borrowing cost to be capitalized should be decided by applying a
capitalization rate to the expenditure of that asset. The capitalization rate munotes.in

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39 should be weighted average cost of borrowing. The amount of borrowing
cost capitalized during a period shall not exceed the amount of borrowing
cost incurred during the period.
Commencement of capitalization of borrowing costs: Conditions:
Following 3 conditions must be fulfilled before the commencement of
capitalization of borrowing cost.
a) Activities which are essential to prepare the assets for its intended
use should be in progress.
b) Borrowing cost is incurred.
c) Expenditure for acquisition, construction or production of a
qualifying asset is being incurred.
This expenditure includes payment of cash, t ransfer of other assets or
assumption of interest bearing liabilities. Progress payment received and
grants received towards the cost incurred should be deducted from the
expenditure.
Suspension of capitalization of borrowing costs Capitalization of
borrow ing costs should be suspended during extended periods in which
active development is interrupted. However capitalization of borrowing
cost is not suspended when a temporary delay is a necessary part of the
process of getting an asset ready for its intended use or sale.
Cessation of capitalization:
1. Capitalization of borrowing cost should cease when all the activities
necessary to prepare the qualifying asset for its intended use or sale are
substantially completed. It means all relevant activities which are essential
for intended use or sale of qualifying assets should be completed.
2. Construction of the qualifying asset is carried on in parts/phase and
each part/phase can be used independently, required activities are
completed for such phase and it is ready for intended use or sale,
capitalization of borrowing cost for such part/phase will cease.
Disclosure in financial statements:
The financial statement should disclose:
1. The accounting policy adopted for borrowing cost
2. The amount of borrowing cost capitalized during the period
Substantial period:
The “substantial period” of time essentially depends upon the facts and
circumstances of each case. However, ordinarily a period of 12 months is
considered as substantial period of time. Sometimes a shorter or longer
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40 case. In deciding the period, time which an asset takes, technologically
and commercially to get it ready for its intended use or sale should be
considered.
Fees paid for payment of loan
The prepayment fees paid for liquidating high cost debt and availing low
cost debt in place of high cost debt cannot be capitalized because it is not a
borrowing cost as per AS16.
Exchange difference:
Borrowing cost may include exchange differences aris ing from foreign
currencies borrowings to the extent that they are regarded as an adjustment
to interest cost.
AS16 covers exchange difference on the amount of principal of the
foreign currency borrowings to the extent of differences between interest
on local currency borrowings and interest on foreign currency borrowings.
Illustrations
1. On 20 -04-2010, KIC Ltd. obtained loan from the bank for Rs. 25,
00,000 to be utilized as under: -
Construction of shed Rs.10,00,000
Purchase of Machinery Rs.7,50,000
Workin g Capital Rs.5,00,000
Advance for purchase ofTempo Rs.2,50,000

On 31stMarch, 2011, construction of shed was completed and machinery
installed. Delivery of Tempo was not received. Total interest charged by
the bank for the year ending 31stMarch, 2011 was Rs.4, 50,000. Show the
treatment of interest under AS 16.
SOLUTION: -
AS 16 provide that:
I ) A qualifying asset is an asset which takes a substantial period of time
to get ready for intended use or sale.
ii) Assets which are ready for their intended use or sale when
acquired are not qualifying assets.
iii) Borrowing cost that is directly attributable to acquisition,
construction or production of a qualifying asset should be capitalized as
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41
Account Spent on Qualifying
asset or not Interes t to
be capitalized Interest to be
charged to Profit
& Loss A/c.
Construction of Shed Yes
Purchase of Machinery No
Working Capital No
Advance for purchase of Tempo No

2. Yoga Ltd. obtained a term loan of Rs. 2320 lakhs for purchase of
machinery on 1 -4-2010. The loan was immediately utilized as Rs.1624
lakhs for purchase of machinery which was ready for use on 31 -3-2011,
Rs. 232 lakhs for advance payment to the supplier for additional
machinery and the balance 464 lakhs for financing working capit al. Total,
Interest on loan for the year ended 31st March ,2011 came to Rs.208.80
Lakhs
Calculate
i) Average borrowing rate
ii) Interest to be capitalized
iii) Interest to be shown as expenses.
Solution: -
(Rs. In lakhs)
i) Average borrowing rate = 208.80/2320 x100 = 9%
ii) Interest to be capitalized :9% of Rs.1624 Lakhs
146.16
iii) Interest to be considered as an expenses 9% of (232+ 464 )= 696
lakhs
62.64

208.80
3. Rani Ltd. borrowed Rs. 300 crores on 1 -4-2010 for construction of
boiler plant @11%p.a. The plant is expected to be completed in 4 years.
The weighted Average cost of capital is 13% p.a. The accountant of
Rani Ltd. capitalized interest of Rs.39 crores for the accounting period
ending on 31 -3-2011. Due to surplus fund out of Rs.300 crores in
income of Rs. 7.00crores was earned and credited to Profit & Loss A/c.
Comment on above with reference to AS 16. munotes.in

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42 SOLUTION :
As the company has borrowed Rs.300 crores for construction of a boiler
plant it is a specific borrowing as pe r AS 16. In case a specific borrowing
as per AS 16. In case a specific borrowing the total amount of borrowing
cost incurred during the period less any income on the temporary
investment on borrowed is to be capitalized. Interest to be capitalized is
33.00 less 7.00 =26 crores . The interest earned Rs.7.00 crores cannot be
shown as income. It should be deducted from interest cost incurred for the
purpose of capitalization.
2.13 INTRODUCTION TO SEGMENT REPORTING
‘Segment Reporting’, issued by the Council of the Institute of Chartered
Accountants of India. This standard comes into effect in respect of
accounting periods commencing on or after 1.4.2001 and is mandatory in
nature, from that date, in respect of the following:
(i) Enterprises whose equity or debt secu rities are listed on a recognized
stock exchange in India, and enterprises that are in the process of issuing
equity or debt securities that will be listed on a recognized stock exchange
in India as evidenced by the board of directors’ resolution in this regard.
(ii) All other commercial, industrial and business reporting enterprises,
whose turnover for the accounting period exceeds Rs. 50 crores
OBJECTIVE
The objective of this Statement is to establish principles for reporting
financial information, about the different types of product of and services
an services an enterprise produces and the different geographical areas
which it operates. Such information helps users of financial statements:
a) better understand the performance of the enterprise;
b) better assess the risks and returns of the enterprise; and
c) Make more informed judgments about the enterprise as a whole.
Many enterprises provide groups of products and services or operate in
geographical areas that are subject to differing rates of profitability, for
growth, future prospects, and risks. Information about different types of
products and services of an enterprise and its operations in different
geographical areas – often called segment information is relevant to
assessing the risks and return of a diversifi ed or multi -locational enterprise
but may be determinable from the aggregated data. Therefore, reporting of
segment information is widely regarded as necessary for meeting the needs
of users of financial statements.
SCOPE
1. The Statement should be applied in presenting general purpose
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43 2. The requirements of this Statement are also applicable in case of
consolidated financial statements.
3. An enterprise should comply with the requirements of this Statement
fully and not selectively.
4. If a singl e financial report contains both consolidated financial
statements and the separate financial statements of the parent, segment
information need be presented only on the basis of the consolidated
financial statements. In the context of reporting of segment information in
consolidated financial statements, the references in this statement to any
financial statement items should construed to be the relevant items as
appearing in the consolidated financial statements.
DEFINITIONS
The following terms are used i n this statement with the meanings
specified:
A business segment is a distinguishable component of an enterprise that
is engaged in providing an individual product or service or a group of
related products or services and that is subject to risks and retur ns that are
different from those of other business segments. Factors that should be
considered in determining whether products or services are related
include:
a) the nature of the products or services;
b) the nature of the production processes;
c) the type or class or customers for the products or services;
d) the methods used to customers for the products or provide the
services; and
e) If applicable, the nature of the regulatory environment, for
example, banking, insurance, or public utilities.
A geographical segment is a distinguishable component of an enterprise
that is engaged in providing products or services within a particular
economic environment. Factors that should be considered in identifying
geographical segments include:
a) similarity of economic and political conditions;
b) relationships between operations in different geographical areas;
c) proximity of operations;
d) special risks associated with operations in a particular area;
e) exchange control regulations; and
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44 A reportable segment is a business segment or a geographical segment
identified on the basis of foregoing definitions for which segment
information is required to be disclosed by this Statement.
Enterprise revenue is revenue from sales to external customers as
reported in the stat ement of profit and loss.
Segment revenue is the aggregate of
I. the portion of enterprise revenue that is directly attributable to a
segment.
II. the relevant portion of enterprise revenue that can be allocated on
a reasonable basis to the segment, and
III. revenue from transaction with other segments of the enterprise.
Segment revenue does not include:
a) extraordinary items as defined in AS 5, Net Profit or Loss for the
Period, Prior Period Items and Changes in Accounting Policies;
b) interest or dividend income, includin g interest earned on advances or
loans to other segments unless the operations of the segments are primarily
of a financial nature; and
c) Gains on sales of investments or on extinguishment of debt unless
the operations of the segment are primarily of a finan cial nature.
Segment expense is the aggregate of
I. the expense resulting from the operating activities of a segment that
is directly attributable to the segment, and
II. the relevant portion of enterprise expense that can be allocated on a
reasonable basis to th e segment, including expense relating to transactions
with other segments of the enterprise.
Segment expense does not include:
a) extraordinary items as defined in AS 5, Net Profit or Loss for the
Period, Prior Period Items and Changes in Accounting Policies;
b) interest expense, including interest incurred on advances or loans
from other segments, unless the operations of the segment are
primarily of a financial nature3;
c) losses on sales of investments or losses on extinguishment of debt
unless the operations of the segment are primarily of a financial
nature;
d) income tax expense; and
e) General administrative expenses, head -office expenses, and other
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45 as a whole. However, costs are sometimes incurred at the enterprise
level on behalf of a segment. Such costs are part of segment expense
if they relate to the operating activities of the segment and if they
can be directly attributed or allocated to the segment on a reasonable
basis.
Segment result is segment revenue less segment expense.
Segment assets are those operating assets that are employed by a
segment in its operating activities and the either are directly attributable to
the segment or can be allocated to the segment on a reasonable basis.
If the segment result of a segment includes interest or dividend income, its
segment assets include the related receivables, loans, investments, or other
interest or dividend generating assets.
Segment assets do not include income tax assets.
Segment assets are determined after deducting related allowances/
provisions that are reported as direct offsets in the balance sheet of the
enterprise.
Examples of segment assets include current assets that are used in the
operating activities of the segment and tangib le and intangible fixed
assets. If a particular item of depreciation or amortization is included in
segment expense, the related asset is also included in segment assets.
Segment assets do not include assets used for general enterprise or head -
office purpo ses. Segment assets include operating assets shared by two or
more segments if a reasonable basis for allocation exists. Segment assets
include goodwill that is directly attributable to a segment or that can be
located to a segment on a reasonable basis, and segment expense includes
related amortization of goodwill. If segment assets have been revalued
subsequent to acquisition, then the measurement of segment assets reflects
those revaluations.
Segment liabilities are those operating liabilities that resul t from the
operating activities of a segment and that either are directly attributable to
the segment or can be allocated to the segment on a reasonable basis.
If the segment result of a segment includes interest expense, its segment
liabilities include the related interest -bearing liabilities.
Segment liabilities do not include income tax liabilities.
Segment accounting policies are the accounting policies adopted for
preparing and presenting the financial statements of the enterprise as well
as those accounting policies that relate specifically to segment reporting.
Examples of segment liabilities include trade and other payables, accrued
liabilities, customer advance, product warranty, provision, and other
claims relating to the provision of goods and service. Segment liabilities
do not include borrowings and other liabilities that are incurred for
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46 operations are not primarily of a financial nature do not include
borrowings and simi lar liabilities because segment result represents an
operating, rather than a net -of-financing, profit or loss. Further, because
debt is often issued at the head -office level on an enterprise -wide basis,
it is often not possible to directly attribute, or r easonably allocate, the
interest -bearing liabilities to segments.
Business and Geographical Segments
Business and geographical segments of an enterprise for external
reporting purposes should be those organizational units for which
information is reported to the board of directors and to the chief executive
office for the purpose of evaluating the unit’s performance and for making
decision about future allocations of resources, except as provided in
paragraph 25.
If internal organizational and management st ructure of an enterprise and
its system of internal financial reporting to the board of directors and the
chief executive office are based neither on individual products or services
or groups or related products/services nor on geographical areas,
paragrap h 20(b) requires that the directors and management of the
enterprise should choose either business segments or geographical
segments as the primary segment reporting format of the enterprise based
on their assessment of which reflects the primary source of the risks and
returns of the enterprise, with the other as its secondary reporting format.
In that case, the directors and management of the enterprise should
determine its business segments and geographical segments for external
reporting purposes based on the factors in the definitions in paragraph 5 of
this Statement, rather than on the basis of its system of internal financial
reporting to the board of directors and chief executive officer, consistent
with the following:
a) if one or more of the segment r eported internally to the directors and
management is a business segment or a geographical segment based on the
factors in the definitions in paragraph 5 but others are not, sub -paragraph
(b) below should be applied only to those internal segments that do not
meet the definitions in paragraph 5 (that is, an internally reported segment
that meets the definition should not be further segmented);
b) for those segments reported internally to the directors and
management that do not satisfy the definitions in parag raph 5,
management of the enterprise should look to the next lower level of
internal segmentation that reports information along product and service
lines or geographical lines, as appropriate under the definitions in
paragraph5; and
c) if such an internally reported lower -level segment meets the
definition of business segment of geographical segment based on the
factors in paragraph 5, the criteria in paragraph 27 for identifying
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47 Reportable Segments
A business segment or geographical segment should be identified as a
reportable segment if:
a) its revenue from sales to external customers and from transactions
with other segments is 10 per cent more of the total revenue, external and
internal, of all segments; or
b) its segment result, whether profit or loss, is 10 per cent or more of –
I. the combined result of all segments in profit, or
II. the combined result of all segments in loss, whichever is greater in
absolute amount;
c) its segment result, whether profit or loss, is 10 per cent or more of –
I. the combined result of all segments in profit, or
II. the combined result of all segments in loss, whichever is greater in
absolute amount; its segment assets are 10 per cent or more of the total
assets of all segments.
d) A business seg ment or a geographical segment which is not a
reportable segment as per paragraph 27, may be designated as reportable
segment despite its size at the discretion of the management of the
enterprise. If that segment is not designated as a reportable segment, is
should be included as an unallocated reconciling item.
e) If total external revenue attributable to reportable segments
constitutes less than 75 per cent of the total enterprise revenue, additional
segments should be identified as reportable segments, eve n if they do not
meet the 10 per cent thresholds in paragraph 27, until at least 75 per cent
of total enterprise revenue is included in reportable segments.
f) The 10 per cent thresholds in this Statement are not intended to be a
guide for determining materia lity for any aspect of financial reporting
other than identifying reportable business and geographical segments.
g) A segment identified as a reportable segment in the immediately
preceding period because it satisfied the relevant 10 per cent thresholds
shoul d continue to be a reportable segment for the current period
notwithstanding that its revenue, result and assets all no longer meet the
10 per cent thresholds.
h) If a segment is identified as a reportable segment in the current
period because it satisfies th e relevant 10 per cent thresholds, preceding -
period segment data that is presented for comparative purposes should,
unless it is impracticable to do so, be restated to reflect the newly
reportable segment as a separate segment, even if that segment, did no t
satisfy the 10 per cent thresholds in the preceding period.
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48 Segment Accounting Policies
1. Segment information should be prepared in conformity with the
accounting policies adopted for preparing and presenting the financial
statement of the enterprise as a whole.
2. There is a presumption that the accounting policies that the directors
and management of an enterprise have chosen to use in preparing the
financial statements of the enterprise as a whole are those that the
directors and management believe are the most appropriate for external
reporting purposes. Since the purpose of segment information is to help
user of financial statements better understand and make more informed
judgements about the enterprise as a whole, this Statement requires the
use, in preparing segment information, of the accounting policies adopted
for preparing and presenting the financial statements of the enterprise as a
whole. That does not mean, however, that the enterprise accounting
policies are to be applied to reportable segments as if the segments were
separate stand -alone reporting entities. A detailed calculation done in
applying a particular accounting policy at the enterprise wide level may be
allocated to segments if there is a reasonable basis for doing so. Pension
calculat ions, for example, often are done for an enterprise as a whole, but
the enterprise -wide figures may be allocated to segments based on salary
and demographic data for the segments.
3. This Statement does not prohibit the disclosure of additional segment
inform ation that is prepared on a basis other than the accounting policies
adopted for the enterprise financial statements provided that (a) the
information is reported internally to the board of directors and the chief
executive officer for purposes of making d ecisions about allocating
resources to the segment and assessing its performance and (b) the basis of
measurement for this additional information is clearly described.
4. Assets and liabilities that relate jointly to two or more segments
should be allocated t o segments if, and only if, their related revenues and
expenses also are allocated to those segments.
5. The way in which asset, liability, revenue, and expense items are
allocated to segments depends on such factors as the nature of those
items, the activiti es conducted by the segment, and the relative autonomy
of the segment. It is not possible or appropriate to specify a single basis of
allocation that should be adopted by all enterprises; nor is it appropriate to
force allocation of enterprise asses, liabi lity, revenue, and expense items
that relate jointly to two or more segments, if the only basis of
making those allocations is arbitrary. At the same time, the definitions of
segment revenue, segment expense, segment assets, and segment liabilities
are int errelated, and the resulting allocations should be consistent.
Therefore, jointly used assets and liabilities are allocated to segments if,
and only if, their related revenues and expenses also are allocated to those
segments. For example, an asset is incl uded in segment assets it, and only
if, the related depreciation or amortization is included in segment
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49 Disclosure
Paragraphs 39-46 specify the disclosures required for reportable segments
for primary segment reporting format of an enterprise. Par agraphs 47 -51
identify the disclosures required for secondary reporting format of an
enterprise. Enterprises are encouraged to make all of the primary -segment
disclosures identified in paragraphs 39-46 for each reportable secondary
segment although paragra phs 47-51 require considerably less disclosure
on the secondary basis. Paragraphs 53-59 address several other segment
disclosure matters. Appendix III to this Statement illustrates the
application of these disclosure standards.
Primary Reporting Format
1. The disclosure requirements in paragraphs 40-46 should be applied to
each reportable segment based on primary reporting format of an
enterprise. An enterprise should disclose the following for each reportable
segment:
a) segment revenue, classified into segment revenue from sales to
external customers and segments revenue from transactions with other
segments;
b) segment result;
c) total carrying amount of segment assets;
d) total amount of segment liabilities;
e) total cost incurred during the period to acquire segment asse ts that
are expected to be used during more than one period (tangible and
intangible fixed assets);
f) total amount of expense included in the segment result for
depreciation and amortization in respect of segment assets for the period;
and
g) Total amount of significant non-cash expenses, other than
depreciation and amortization in respect of segment assets that were
included in segment expense and, therefore, deducted in measuring
segment result.
2. Paragraph 40 (b) requires an enterprise to report segment result. If
an enterprise can compute segment net profit or loss or some other measure
of segment profitability other than segment result, without arbitrary
allocations, reporting of such amount (s) in addition to segment result is
encouraged. If that measure is prepared on a basis other than the
accounting policies adopted for the financial statements of the enterprise,
the enterprise will include in its financial statements a clear description of
the basis of measurement.
3. An example of a measure of segment perfor mance above segment
result in the statement of profit and loss is gross margin on sales.
Examples of measures of segment performance below segment result in
the statement of profit and loss are profit or loss from ordinary activities
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50 4. Accounting Standard 5, ‘Net Profit or Loss for the Period, Prior
Items and changes in Accounting Policies’ requires that “when items of
income and expense within profit or loss from ordinary activities are of
such size, nature or incidence that their disclosure is relevant to explain
the performance of the enterprise for the period, the nature and amount of
such items should be disclosed separately”. Examples of such items
include write -downs of inventories, legislati ve changes having
retrospective application, litigation settlements, and reversal of provisions.
An enterprise is encouraged, but not required, to disclose the nature and
amount of any items of segment revenue and segment expense that are of
such size, nat ure, or incidence that their disclosure is relevant to explain
the performance of the segment for the period. Such disclosure is not
intended to change the classification of any such items of revenue of
expense form ordinary to extraordinary or to change the measurement of
such items. The disclosure. However, does change the level at which the
significance of such items is evaluated for disclosure purposes from the
enterprise level to the segment level.
5. An enterprise that reports the amount of cash flows ar ising from
operating, investing and financing activities of a segment need not
disclose depreciation and amortization expense and non - cash expenses of
such segment pursuant to sub -paragraphs (f) and (g) of paragraph 40.
6. AS 3, Cash Flow Statements; recomme nds that an enterprise present
a cash flow statement that separately reports cash flows from operating,
investing and financing activities. Disclosure of information regarding
operating, investing and financing cash flows of each reportable segment
is rele vant to understanding the enterprise’s overall financial position,
liquidity, and cash flows. Disclosure of segment cash flow is, therefore,
encouraged, though not required. An enterprise that provides segment cash
flow disclosures need not disclose deprec iation and amortization expense
and non -cash expenses pursuant to sub-paragraphs (f) and (g) of paragraph
40.
7. An enterprise should present a reconciliation between the
information disclosed for reportable segments and the aggregated
information in the ente rprise financial statements. In presenting the
reconciliation, segment revenue should be reconciled to enterprise
revenue; segment result should be reconciled enterprise net profit or loss;
segment assets should be reconciled to enterprise assets; and segm ent
liabilities should be reconciled to enterprise liabilities.
Secondary Segment Information
1. Paragraphs 39-46 identify the disclosure requirements to be applied
to each reportable segment based on primary reporting format of an
enterprise. Paragraphs 48-51 identify the disclosure requirements to be
applied to each reportable segment based on secondary reporting format of
an enterprise, as follows:
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51 a) if primary format of an enterprise is business segments, the required
secondary -format disclosures are identi fied in paragraph 48;
b) if primary format of an enterprise is geographical segments based on
location of assets (where the products of the enterprise are produced or
where its service reading operation are based. The required secondary -
format disclosures are identified in paragraphs 49 and 50;
c) if primary format of an enterprise is geographical segments based on
the location of its customers (where its products are sold or services are
rendered), the required secondary - format disclosures are identified in
paragraphs 49 and 51.
2. If primary format of an enterprise for reporting segment information
is business segments, it should also report the following information:
a) Segment revenue from external customers by geographical area
based on the geographical location o f its customers, for each geographical
segment whose revenue from sales to external customers is 10 per cent or
more of enterprise revenue;
b) The total carrying amount of segment assets by geographical
location of assets, for each geographical segment whose segment assets
are 10 per cent or more of the total assets of all geographical segment; and
c) The total cost incurred during the period to acquire segment assets
that the expected to be used during more than one period (tanglible and
intangible fixed assets) by geographical location of assets, for each
geographical segment whose segment assets are 10 per cent more of the
total assets are 10 per cent or more of the total assets of all geographical
segments.
3. If primary format of an enterprise for reporting segm ent information
is geographical segments (whether based on location of assets or location
or customers), it should also report the following segment information for
each business segment whose revenue from sales to external customers is
10 per cent or more of enterprise revenue or whose segment asserts are 10
per cent or more of enterprise revenue or whose segment assets are 10 per
cent or more of the total assets of all business segments:
a) segment revenue from external customers;
b) the total carrying amount of segment assets; and
c) the total cost incurred during the period to acquire segment assets
that are expected to be used during more than one period (tangible and
intangible fixed assets).
4. If primary format of an enterprise for reporting segment information
is geographical segments that are based on location of assets, and if the
location of its customers is different from the location of its assets, them
the enterprise should also report revenue from sales to external customers
for each customer - based geogr aphical segment whose revenue from sales
to external customers is 10 per cent or more of enterprise revenue. munotes.in

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52 5. If primary format of an enterprise for reporting segment information
is geographical segments that are based on location of customers, and if the
assets of the enterprise are located in different geographical areas from its
customers, then the enterprise should also report the following segment
information for each asset -based geographical segment whose revenue
from sales to external customers or seg ment assets are 10 per cent or more
to total enterprise amounts:
a) The total carrying amount of segment assets by geographical
location of the assets; and
b) The total cost incurred during the period to acquire segment assets
that are expected to be used during more than one period (tangible and
intangible fixed assets) by location of the assets.
Illustrative Segment Disclosures
Appendix III to this Statement presents an illustration of the disclosures
for primary and secondary formats that are required by this Statement.
Other disclosures
1. In measuring and reporting segment revenue from transactions with
other segments. Inter -segment transfers should be measured on the basis
that the enterprise actually used to price those transfers. The basis of
pricing inter -segment transfers and any change therein should be disclosed
in the financial statements.
2. Changes in accounting policies adopted for segment reporting that
have a material effect on segment information should be disclosed. Such
disclosure should include a de scription of the nature of the change, and
the financial effect of the change if it is reasonably determinable.
3. AS 5 requires that changes in accounting policies adopted by the
enterprise should be made only if required by statue, or for compliance
with an accounting standard or if it is considered that the change would
result in a more appropriate presentation of events or transactions in the
financial statements of the enterprise.
4. Changes in accounting policies adopted at the enterprise level that
affect segment information are dealt with in accordance with AS 5.
AS 5 requires that any change in an accounting policy which has a
material effect should be disclosed. The impact of , and the adjustments
resulting from, such change, if material, should be shown in the financial
statements of the period in which such change is made, to reflect the
effect of such change. Where the effect of such change is not ascertainable,
wholly or in part, the fact should be indicated. If a change is made in
accounting policies which has no material effect on the financial
statements for the current period but which is reasonably expected to have
a material effect in later periods, the fact of such change should be
appropriately disclosed in the period in which the change is adopted.
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53 5. Some changes in accounting policies relate specifically to segment
reporting. Examples include changes in identification of segments and
changes in the basis for allocating revenues and expenses to segments.
Such changes can have a significant impac t on the segment information
reported but will not change aggregate financial information reported for
the enterprise. To enable users to understand the impact of such changes,
this Statement requires the disclosure of the nature of the change and the
financial effect of the change, if reasonably determinable.
6. An enterprise should indicate the types of products and services
included in each reported business segment and indicate the
composition of each reported geographical segment, both primary and
seconda ry, if not otherwise disclosed in the financial statements.
7. To assess the impact of such matters as shifts I demand, changes in
the prices of inputs or other factors of production, and the development of
alternative products and processes on a business segment, it is necessary to
know the activities encompassed by the segment. Similarly, to assess the
impact of changes in the economic and political environment on the risks
and returns of a geographical segment, it is important to know the
composition of that geographical segment.
2.14 EXPLANATORY NOTES:
Objective:
The objective of this Statement is to establish principles for reporting
financial information, about the different types of products and services an
enterprise produces and the different geographi cal areas in which it
operates which facilitates meaningful reading and analysis of statement of
account of an enterprise.
Business Segment:
Business segments are distinguishable components of enterprise as to:
 Product or group of products or services or group of services
e.g. Tractors and Jeep as reported by Mahindra and Mahindra
 Production process e.g. Dry linker process and wet clinker process
in Cement.
 Type or class of customers’ e.g. corporate finance and Retail
Finance in case of Banking as reported in ICICI.
 Nature of regulatory policy if applicable. eg. Banking, insurance, or
public utilities.
Geographical Segment: Geographical segments are distinguishable
components of enterprise as to asset situation and customer situation.
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54 Primary format: as per the provision of AS-17 the Enterprise has to
present segment information under primary and secondary format.
The selection of Business or geographical segment as primary is based on
the risk and returns attached to it.
E.g. in case of manufacturing enterp rise the products manufactured may
have more risks and returns attached to it rather than the location of its
customers. In such case business segment in presented under primary
format.
Similarly in case of service sectors the area of customers or its asset base
may have more risks and returns attached to it rather than the type of
services provided by it.
1. Attention is specifically drawn to paragraph 4.3 of the Preface,
according to which accounting standards are intended to apply only to
material items.
2. Reference may be made to the section titled ‘Announcements of the
Council regarding status of various documents issued by the institute of
Chartered Accountants of India’ appearing at the beginning of this
Compendium for a detailed discussion on the implicat ions of the
mandatory status of an accounting standard.
3. See also General Clarification (GC) – 14/2002, issued by the
Accounting Standards Board, published elsewhere in this compendium.
4. The Council, at its 224th meeting, held on March 8 -10, 2002,
considered the matter relating to disclosure of corresponding previous year
figures in respect of segment reporting in the first year of application of
AS 17. The Council decided that in the first year of application of AS 17,
corresponding previous year figures in respect of segment reporting need
not be disclosed (See Chartered Accountant’, April 2002, pp. 1242).
E.g. software developers have risks and returns more directly related to
the countries it exports than the type of software it develops. In such case
geog raphical segment is presented under primary format.
Once primary format is selected the other segment is presented under
secondary format.
Steps involved in selection and disclosure of segment information as
required by segment reporting.
Step 1. Identify the Primary and Secondary segments as per the
provision of para 19.
The segments will either be Business segment (pare 5) or geographical
segment, which further could be customer wise or asset wise. (refer to
appendix I)
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55 Step 2. Identify the reportable segments as per the provision of para
27, the quantitative thresholds are the 10% limit i.e. either its
 Segment revenue (gross)/Total revenue of all segments (external
customers) is at least 10; or
 Segment assets/total assets of all segments is a least 10%
(excluding income tax asset); or
 Segment result (profit or loss)/ combined results of all segments of
all segments is at least 10%. (refer to para 5 for def of segment result)
Further it should be noted that if a segment has been a reportable segment
in last year it shall then be considered as reportable segment even though
it may fail to satisfy 10% criteria this year. Also in case a segment which
becomes reportable for first time this year then previous year data should
be disclosed to the extent possible (or practical)
Step 3. In case where the total revenue from external customer of the
reportable segments is less than 75% of total revenue of all segments
(external) then additional segments should be identified as reportable
segments, even if they do not meet the 10 per cent thresholds in paragraph
27, until at least 75 per cent of total enterprise revenue in included in
reportable segments. (Refer to Q1 provided in self -study.)
Step 4. Segment information should be prepared in conformity with the
accounti ng policies adopted for preparing and presenting the financial
statements of the enterprise as a whole.
Step 5. Disclosure Requirements
Primary Segment (Business Segment)
Particulars A B C Eliminations Total
Segments revenue
External
Domestic
Export
Inter segment
TOTAL REVENUE
Segment Results
Unallocated Co. exp. - - -
Profit before interest and
Tax
Interest Cost - - -
Profit before tax
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56 Segment assets (fixed +
current)
Unallocable assets - - -
Total assets
Segments Liabilities
Unallocable Liabilities
Total

SECONDARY
SEGMENTS
(Geog) Domestic Mid east America Europe Pacific
External Revenue
by location of
customers.
Carryin g Amount
of segments assets by
location
Cost incurred for
Acquisition of tangible and
intangible assets.

2.15 THEORETICAL QUESTIONS ON THE STANDARD
1. What do you mean by business segment and geographical
segment?
2. What are the quantitati ve thresholds for deciding reportable
segments?
3. What are the inclusions and exclusions of segment revenue?
2.16 INTRODUCTION TO EARNING PER SHARE
Accounting Standard (AS) 20, “Earnings Per Share’, issued by the
Council of the Institute of Chartered account s of India, come into effect in
respect of accounting periods commencing on or after 1 -4- 2001 and is
mandatory in nature, from that date, in respect of enterprises whose
equity shares or potential equity shares are listed on a recognized stock
exchange in India. An enterprise which has neither equity shares nor
potential equity shares which are so listed but which discloses earnings per
share, should calculate and disclose earnings per share in share in
accordance with this Standard from the aforesaid date 3. The following is
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57 OBJECTIVE
The objective of this Statement is to prescribe principles for the
determination and presentation of earnings per share, which will improve
comparison of performance among different enterp rises for the same
period and among different accounting periods for the same enterprise.
The focus of this Statement is on the denominator of the earnings per share
calculation. Even though earnings per share data has limitations because
of different acco unting policies used for determining ‘earnings’, a
consistently determined denominator enhances the quality of financial
reporting.
SCOPE
1. This Statement should be applied by enterprises whose equity shares
or potential equity shares are listed on a recogni zed stock exchange in
India. An enterprise which has neither equity shares nor potential equity
shares which are so listed but which discloses earnings per share should
calculate and disclose earnings per share in accordance with this
Statement.4
2. In consol idated financial statements, the information required by this
Statement should be presented on the basis of consolidated information.5
3. This Statement applies to enterprises whose equity or potential
equity shares are listed on a recognized stock exchange in India. An
enterprise, which has neither equity shares nor potential equity shares,
which are so listed is not required to disclose earnings per share. However,
comparability in financial reporting among enterprises is enhanced if such
an enterprise tat is required to disclose by any statute or chooses to
disclose earnings per share calculates earnings per share in accordance
with the principles laid down in this Statement. In the case of a parent
(holding enterprise), users of financial statements are usually concerned
with, and need to be informed about, the results of operations of both the
enterprise itself as well as of the group as a whole. Accordingly, in the
case of such enterprise, this Statement requires the presentation of
earnings per share information on the basis of consolidated financial
statements as well as individual financial statements of the parent. In
consolidate financial statements, such information is presented of the basis
of consolidate information.
DEFINITIONS
For the purpose of this Statement, the following terms are used with the
meanings specified:
An equity share is a share other than a preference share. Equity shares
participate in the net profit for the period only after preference shares. An
enterprise may have more than one class of equity shares. Equity shares of
the same class have the same rights to receive dividends.
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58 A preference share is a share carrying preferential rights to dividends
and repayment of capital.
A financial instrument is any contract that gives rise to both a financial
asset of one enterprise and a financial liability or equity shares of another
enterprise. For this purpose, a financial asset is any asset that is
a) Cash;
b) A contractual right to receive cash or another financial asset from
another enterpris e.
c) A contractual right to exchange financial instruments with another
enterprise under condition that are potentially favorable; or
d) An equity share of another enterprise.
A financial liability is any liability that is a contractual obligation to
deliver cash or another financial asset to another enterprise or to exchange
financial instruments with another enterprise under conditions that are
potentially unfavorable.
A potential equity share is a financial instrument or other contract that
entitles, or may e ntitle, its holder to equity shares.
Examples of potential equity shares are:
a) Debt instruments or preference shares, that are convertible into
equity shares;
b) Share warrants;
c) Options including employee stock option plans under which
employees of an enterpri se are entitled to receive equity shares as
part of their remuneration and other similar plans; and
d) Shares which would be issued upon the satisfaction of certain
conditions resulting from contractual arrangements (contingently
issuable shares), such as the acquisition of a business or other
assets, or shares issuable under a loan contract upon default of
payment of principal or interest, if the contract so provides.
PRESENTATIONS
An enterprise should present basic and diluted earnings per share on the
face of the statement of profit and loss for each class or equity shares that
has a different right to share in the net profit for the period. An enterprise
should present basic and diluted earnings per share with equal prominence
for all periods presented.
This Statement requires an enterprise present basic and diluted earnings
per share, even if the amounts disclosed are negative (a loss per share).
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59 MEASUREMENT
Basic Earnings per Share
1. Basic earnings per share should be calculated by dividing the net
profit or loss for the period attributable to equity shareholders by the
weighted average number for equity shares outstanding during the period.
2. For the purpose of calculating basic earnings per share, the net profit
or loss for the period attributable to equity shareholders should be the net
profit or loss for the period after deducting preference dividends and any
attributable tax thereto for the period.
3. All items of income and expense which are recognized in a period,
including tax expense and extraordinary items, are included in the
determination of the net profit or loss for the period unless an Accounting
Standard requires or permits otherwise (see Accounting Standard (AS) 5,
Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies). The amount of preference dividends and any
attributable tax thereto for the period is deducted from the net profit for
the period (or added to the net loss for the period) in order to calculate the
net profit or loss for the period attributable to equity shareholders.
4. The amount of preference dividends for the period that is deducted
from the net profit for the period is:
a) The amount of any preference dividends on non -cumulative
preference shares provided for in respect of the period; and
b) The full amo unt of the required preference dividends for cumulative
preference shares for the period, wither or not the dividends have been
provided for. The amount of preference dividends for the period does not
include the amount of any preference dividends for cumu lative preference
shares paid or declared during the current period in respect of previous
periods.
5. If an enterprise has more than one class of equity shares, net profit or
loss for the period is apportioned over the different classes of shares in
accordan ce with their dividend rights.
Per Share – Basic
1. For the purpose of calculating basic earnings per share, the number
of equity shares should be the weighted average number of equity shares
outstanding during the period.
2. The weighted average number of equit y shares outstanding during
the period reflects the fact that the amount of shareholders’ capital may
have varied during the period as a result of a larger or lesser number of
shares outstanding at the beginning of the period, adjusted by the number
of equity shares bought back or issued during the period multiplied by
the time-weighting factor. The time-weighting factor is the number of
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60 total number of days in the period; a reasonabl e approximation of the
weighted average is adequate in many circumstances.
Appendix illustrates the computation of weighted average number of
shares.
3. In most cases, shares are included in the weighted average number of
shares from the date the consideratio n is receivable, for example:
a) Equity shares issued in exchange for cash are included when cash in
receivable;
b) Equity shares issued as a result of the conversion of a debt
instrument to equity shares are included as to the date of conversion;
c) Equity shares issued in lieu of interest or principal on other financial
instruments are included as of the date interest cease to accrue;
d) Equity shares issued in exchange for the settlement of a liability of
the enterprise are included as of the date the settlement becomes
effective;
e) Equity shares issued as consideration for the acquisition of an asset
other than cash are include as of the date on which the
acquisitions in recognized; and
f) Equity shares issued for the rendering of services to the enterprise
are included as the services are rendered.
In these and other cases, the timing of the inclusion of equity shares is
determined by the specific terms and conditions attaching to their issue.
Due consideration should be given to the substance of any contract
associated with issue.
4. Equity shares issued as part of the consideration in an amalgamation
in the nature of purchase are included in the weighted number of shares as
of the date of the acquisition because the transferee incorporates the
results of the operations of the transferor into its statement of profit and
loss as from the date of acquisition. Equity shares issued during the
reporting period as part of the consideration in an amalgamation in the
nature of merger are included in the calculation of the weighted a verage
number of shares from the beginning of the reporting period because the
financial statements of the combined enterprise for the reporting period are
prepared as if the combined entity had exited from the beginning of the
reporting period. Therefore, the number of equity shares used for the
calculation of basic earnings per share in an amalgamation in the nature
of merger is the aggregate of the weighted average number of shares of the
combined enterprise, adjusted to equivalent shares of the enterpri se whose
are outstanding after the amalgamation.
5. Partly paid equity shares are treated as a fraction of an equity share
to the extent that they were entitled to participate in dividends
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61
Appendix II illustrates the computations in respect of partly paid equity
shares.
6. Where an enterprise has equity shares of different nominal values
but with the same divided rights, the number of equity shares is calculated
by converting all such equity shar es into equivalent number of shares of
the same nominal value.
7. Equity shares which are issuable upon the satisfaction of certain
conditions resulting from contractual arrangements (contingently issuable
shares) are considered outstanding, and included in the computation of
basic earnings per share from the date when all necessary conditions under
the contract have been satisfied.
8. The weighted average number of equity shares outstanding during the
period and for all periods presented should be adjusted for e vents, other
than the conversion of potential equity shares that have changes the
number of equity shares outstanding, without a corresponding change in
resources.
9. Equity shares may be issued, or the number of shares outstanding
may be reduced, without a c orresponding change in resources. Examples
include:
a) A bonus issue;
b) A bonus element in any other issue, for example a bonus element in
a rights issue to existing shareholders;
c) A share split; and
d) A reverse share split (consolidation of shares).
10. In case of a bonus issue or a share split, equity shares are issued to
existing shareholders for no additional consideration. Therefore, the
number of equity shares outstanding is increased without an increase in
resources. The number of equity shares outstanding befor e the event is
adjusted for the proportionate change in the number or equity shares
outstanding as if the event had occurred at the beginning of the earliest
period reported. For example, upon a two-for-one bonus issue, the
number of shares outstanding prior to the issue is multiplied by a factor a
three to obtain the new total number of shares, or by a factor of two to
obtain the number of additional shares.
Appendix III illustrates the computation of weighted average number of
equity shares in case of a b onus issue during the period.
11. The issue of equity shares at the time of exercise or conversion of
potential equity shares will not usually give rise to a bonus element, since
the potential equity shares will usually have been issued for full value,
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62 enterprise. In a right issue, on the other hand, the exercise price is often les
than the fair value of the shares. Therefore, a rights issue usually includes
a bonus element. The number of equ ity shares to be used in calculating
basic earnings per share for all periods prior to the rights issue is the
number of equity shares outstanding prior to the issue, multiplied by the
following factor:
Fair value per share immediately prior to the exercis e of rights Theoretical
ex-rights fair value per share
The theoretical ex -rights fair value per share is calculated by adding the
aggregate fair value of the shares immediately prior to the exercise of the
rights to the proceeds from the exercise of the rights, and dividing by the
number of shares outstanding after the exercise of the rights. Where the
rights themselves are to publicly trader separately from the shares prior to
the exercise date, fair value for the purposes of this calculation is
establishe d at the close of the last day on which the shares are traded
together with the rights.
Appendix IV illustrates the computation of weighted average number of
equity shares in case of a rights issue during the period.
Diluted Earnings Per Share
1. For the purpose of calculating diluted earning per share, the net
profit or loss for the period attributable or equity shareholders and the
weighted average number of shares outstanding during the period should
be adjusted for the effects of all dilutive potential equity shares.
2. In calculating diluted earnings per share, effect is given to all
dilutive potential equity shares that were outstanding during the period,
that is:
a) The net profit for the period attributable to equity shares is:
I. Increased by the amount of divi dends recognized in the period in
respect of the dilutive potential equity shares as adjusted for any
attributable change in tax expense for the period;
II. Increased by the amount of interest recognized in the period in
respect of the dilutive potential equit y shares as adjusted for any
attributable change in tax expense for the period; and
III. Adjusted for the after -tax amount of any other changes in expenses
or income that would result from the conversion of the dilutive potential
equity shares.
b) The weighted ave rage number of equity shares outstanding during the
period in increased by the weighted average number of additional equity
shares which would have been outstanding assuming the conversion of all
dilutive potential equity shares.
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63 3. For the purpose of this S tatement. Share application money pending
allotment or any advance share application money as at the balance sheet
date, which is not statutorily required to be kept separately and is being
utilized in the business of the enterprise, is treated in the same manner as
dilutive potential equity shares for the purpose of calculation of diluted
earnings per share.
Dilutive Potential Equity Share
1. Potential equity shares should be treated as dilutive when, and only
when, their conversion to equity shares would dec rease net profit per share
from continuing ordinary operations.
2. An enterprise used net profit form continuing ordinary activities as
“the control figure” that is used to establish whether potential equity
shares are dilutive or anti-dilutive. The net profi t from continuing ordinary
activities is the net profit from ordinary activities (as defined in AS 5)
after deducting preference dividends and any attributable tax thereto and
after excluding items relating to discontinued operations6.
3. Potential equity sha re are anti -dilutive when their conversion to
equity shares would increase earnings per share from continuing ordinary
activities or decrease loss per share from continuing ordinary activities.
The effects of anti -dilutive potential equity shares are ignor ed in
calculation diluted earnings per share.
4. In considering where potential equity shares are dilutive or anti -
dilutive, each issue or series of potential equity shares is considered
separately rather than in aggregate. The sequence in which potential equity
shares are considered may affect whether or not they are dilutive.
Therefore, in order to maximize the dilution of basic earnings per share,
each issue or series of potential equity share is calculated. Where the
earnings per incremental share is the least, the potential equity share is
considered most dilutive and vice-versa.
Appendix VII illustrates the manner of determining the order in which
dilutive securities should be included in the computation of weighted
average number of shares.
5. Potential eq uity shares are weighted for the period they were
outstanding. Potential equity shares that were cancelled or allowed to
lapse during the reporting period are included in the computation of
diluted earnings per share only for the portion of the period duri ng which
they were outstanding. Potential equity shares that have been converted
into equity shares during the reporting period are included in the
calculation of diluted earnings per share from the beginning of the period
to the date of conversion; from t he date of conversion, the resulting equity
shares are included in computing both basic and diluted earnings per
share.
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64 Restatement
1. If the number of equity or potential equity shares outstanding
increases as a result of a bonus issue or shares split or decreases as a result
of a reverse share split (consolidation of shares), the calculation of basic
and diluted earnings per share should be adjusted for all the periods
presented. If these changes occur after the balance sheet date but before
the date on whi ch the financial statements are approved by the board of
directors, the per share calculations for those financial statements and any
prior period financial statements are approved by the board of directors,
the per share calculations for those financial statements and any prior
period financial statement presented should be based on the new number of
shares. When per share calculation reflect such changes in the number of
shares, that fact should be disclosed.
2. An enterprise does not restate diluted earning s per share of any prior
presented for changes in the assumptions used or for the conversion of
potential equity shares into equity shares outstanding.
3. An enterprise is encouraged to provide a description of equity share
transaction or potential equity share transactions, other than bonus
issues, share splits and reverse share splits (consolidation or shares) which
occur after the balance sheet date when they are of such importance that
non-disclosure would affect the ability of the users of the financial
statements to make proper evaluations and decisions. Examples of such
transactions include:
a) The issue of shares for cash;
b) The issue of shares when the proceeds are used to repay debt or
preference shares outstanding at the balance sheet date;
c) The cancellati on of equity shares outstanding at the balance sheet
date;
d) The conversion or exercise of potential equity shares, outstanding
at the balance sheet date, into equity shares;
e) The issue of warrants, options or convertible securities; and
f) The satisfaction of conditions that would result in the issue of
contingently issuable shares.
4. Earnings per share amount are not adjusted for such transactions
occurring after the balance sheet date because such transactions do not
affect the amount of capital used to produce the net profit or loss for the
period.
Disclosure
1. In addition to disclosures as required by paragraphs 8, 9 and 44 of
this Statement, an enterprise should disclose the following:
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65 a) The amounts used as the numerators in calculating basic and diluted
earnings per share, and a reconciliation of those amounts to the net profit
or loss for the period;
b) The weighted average number of equity shares used as the
denominator in calculating basic and diluted earnings per share, and a
reconciliation of these denominators to each other; and
2. Contracts generating potential equity shares may incorporate terms
and conditions which affect the measurement of basic and diluted
earnings per share. These terms and conditions may determine whether
or not any potential equity shares are dilutive and, if so, the effect on the
weighted average number of shares outstanding and any consequent
adjustments to the net profit attributable to equity shareholders. Disclosure
of the terms and conditions of such contracts is encouraged by this
Statement.
3. If the enterprise discloses, in addition to basic and diluted earnings
per share, per share amounts using a reported component of net profit
other than net profit or loss for the period attributable to equity
shareholders, such amounts should be calculated using the weighted
average number of equity shares determined in accordance with this
Statement. If a component of net profit is used which is not reported as al
line item in the statement of profit and loss, a reconciliation should be
provided b etween the component used and a line item which is reported in
the statement of profit and loss. Basic and diluted per share amounts
should be disclosed with equal prominence.
4. An enterprise may wish to disclose more information than this
Statement requires . Such information may help the users to evaluate
the performance of the enterprise and may take the form the per share
amounts for various components of net profit, e.g. profit from ordinary
activities7. Such disclosures are encouraged. However, when such
amounts are disclosed, the denominators need to be calculated in
accordance with the Statement in order to ensure the comparability of the
per share amounts disclosed.
2.17 THEORY QUESTIONS
1. What do you mean by potential equity share?
2. How do you calculate Basic EPS if bonus shares are issued in that
year?
3. How do you calculate theoretical ex right price?
4. What are the disclosure requirements of this standard?


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66 2.18 ACCOUNTING FOR TAXES ON INCOME
Accounting standard (AS) 22, ‘Accounting for Taxes on Income’, issued
by the Council of the Institute of Chartered Accountants of India, comes
into effect in respect of accounting periods commencing on or after 1 -4-
2001. It is mandatory in nature for:
a) All the accounting periods commencing on or after 01.04.2001, in
respect of th e following:
i) Enterprises whose equity or debt securities are listed on a recognized
stock exchange in India and enterprises that are in the process of issuing
equity or debt securities that will be listed on a recognized stock exchange
in India as evidence d by the board of directors’ resolution in this regard.
ii) All the enterprises of group, if the parent present consolidated
financial statements and the Accounting Standard is mandatory in nature
in respect of any of the enterprises of that group in terms of (i) above.
b) All the accounting periods commencing on or after 01.04.2002, in
respect of companies not covered by (a) above.
c) All the accounting periods commencing on or after 01.04.2003, in
respect of all other enterprises.
The Guidance Note on Accounting fo r Taxes on Income, issued by the
Institute of Chartered Accountants of India in 1991, stands withdrawn
from 1.4.2001.
OBJECTIVE
The objective of this Statement is to prescribe accounting treatment for
taxes on income. Taxes on income are one of the signifi cant items in the
statement of profit and loss of an enterprise. In accordance with the
matching concept, taxes on income are accrued in the same period as the
revenue and expenses to which they relate. Matching of such taxes against
revenue to a period special problems arising from fact that I number of
cases, taxable income may be significantly different from the accounting
income. This divergence between taxable income and accounting income
arises due to two main reasons. Firstly, there are difference between items
of revenue and expenses as appearing in the statement of profit and loss
and the items which are considered as revenue, expenses or deductions for
tax, purposes. Secondly, there are differences between the amount in
respect of a particular item of revenue or expense as recognized in the
statement of profit and loss and the corresponding amount which is
recognized for the computation of taxable income.
SCOPE
1. This Statement should be applied in accounting for taxes on income.
This includes the det ermination of the amount of the expense or saving
related to taxes on income in respect of accounting period and the
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67 2. For the purpose of this Statement, taxes on income include all
domestic and forei gn taxes which are based on taxable income.
3. This Statement does not specify when, or how, an enterprise should
account for taxes that are payable on distribution of dividends and other
distributions made by the enterprise.
DEFINITIONS
For the purpose of th is Statement, the following terms are used with the
meaning specified:
Accounting income (loss) is the net profit or loss for a period, as reported
in the statement of profit and loss, before deducting income tax expense
or adding income tax saving.
Taxabl e income (tax loss) is the amount for the income (loss) for a
period, determined in accordance with the tax laws, based upon which
income tax payable (recoverable) is determined.
Tax expense (tax saving) is the aggregate of current tax and deferred tax
charged or credited to the statement of profit and loss for the period.
Current tax is the amount of income tax determined to be payable
recoverable) in respect of the taxable income (tax loss) for a period.
Deferred tax is the tax effect of timing difference s.
Timing differences are the differences between taxable income and
accounting income for a period that originate in one period and are
capable or reversal in one or more subsequent periods.
Permanent differences are the differences between taxable income and
accounting income for a period that originate in one period do not reverse
subsequently.
Taxable income is calculated in accordance with tax laws. In some
circumstances, the requirements of these laws to computer taxable income
differ from the account ing policies applied to determine accounting
income. The effect of this difference is that the taxable income and
accounting income may not be the same.
The differences between taxable and accounting income can be classified
into permanent differences and timing differences. Permanent differences
are those differences between taxable income and accounting income
which originate in one period and do not reverse subsequently. For
instance, if for the purpose of computing taxable income, the tax laws
allow onl y a part of an item of expenditure, the disallowed amount would
result in a permanent difference.
Timing differences are those differences between taxable, income and
accounting income for a period that originate in one period and are
capable of reversal i n one or more subsequent periods. Timing differences
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68 are included in taxable income do not coincide with the period in which
such items of revenue and expenses are included or considered in arriving
at accounting income. For example, machinery purchased for scientific
resear4ch related to business is fully allowed as deduction in the first year
for tax purposes whereas the same would be charged to the statement of
profit and loss as depre ciation over its useful life. The total depreciation
charged on the machinery for accounting purposes and the amount
allowed as deduction for tax purposes will ultimately be the same, but
periods over which the depreciation is charged and the deduction is
allowed will differ. Another example of timing difference is a situation
where, for the purpose of computing taxable income, tax laws allow
depreciation on the basis of the written down value method, whereas for
accounting purposes, straight line method is used. Some other examples of
timing differences arising under the Indian tax laws are given in Appendix
Unabsorbed depreciation and carry forward of losses which can be
set-off against future taxable income are also considered as timing
differences and result in deferred tax assets, subject to consideration of
prudence.
RECOGNITION
1. Tax expense for the period, comprising current tax and deferred tax,
should be included in the determination of the net profit or loss for the
period.
2. Taxes on income are consid ered to be an expense incurred by the
enterprise in earning income and are accrued in the period as the revenue
and expenses to which they relate. Such matching may result into timing
differences. The tax effects of timing differences are included in the tax
expense in the statement of profit and loss and as deferred tax assets
(subject to the consideration of prudence as set out in paragraphs 15 -18) or
as deferred tax liabilities, in the balance sheet.
3. An example of tax effect of a timing difference that r esults in a
deferred tax asset is an expense provided in the statement of profit and
loss but not allowed as a deduction under Section 43B of the Income -
tax Act, 1961.
This timing difference will reverse when the education of that expense is
allowed under Section 43B in subsequent year(s). an example of tax
effect of a timing difference resulting in a deferred tax liability is the
higher charge of depreciation allowable under the Income -tax Act, 1961.
compared to the depreciation provided in the statement of profit and loss.
In subsequent years, the differential will reverse when comparatively lower
depreciation will be allowed for tax purposes.
4. Permanent differences do not result in deferred tax assets or deferred
tab liabilities.
5. Deferred tax should be rec ognized for all the timing differences,
subject to the consideration of prudence in respect of deferred tax assets as
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69 6. This Statement requires recognition of deferred tax for all the timing
differences. This is based on the principle that the financial statements for
a period should recognize the tax effect, whether current or deferred, of all
the transactions occurring in that period.
7. Except in the situation stated in paragraph 17, deferred tax assets
should be recognized and ca rried forward only to the extent that there is a
reasonable certainty that sufficient future taxable income will be available
against which such deferred tax assets can be realized.
8. While recognizing the tax effect of timing differences, consideration
of prudence cannot be ignored. Therefore, deferred tax assets are
recognized and carried forward only to the extent that there is a reasonable
certainty of their realisation. This reasonable level of certainty would
normally be achieved by examining the past r ecord of the enterprise and
by making realistic estimates of profits of the future.
9. Where an enterprise has unabsorbed depreciation or carry forward of
losses under tax laws, deferred tax assets should be recognized only to the
extent that there is virtual certainty supported by convincing evidence that
sufficient future taxable income will be available against which such
deferred tax assets can be realized.
10. The existence of unabsorbed depreciation or carry forward of losses
under tax laws is strong evidenc e that future taxable income may not be
available. Therefore, when an enterprise has a history of recent losses,
the enterprise recognizes deferred tax assets only to the extent that it has
timing differences the reversal of which will result in sufficient income
or there is other convincing evidence that sufficient taxable income will be
available against which such deferred tax assets can be realized. In such
circumstances, the nature of the evidence supporting its recognition is
disclosed.
RE-ASSESSMENT OF UNRECOGNIZED DEFERRED TAX
ASSETS
At each balance sheet date, an enterprise re-assesses unrecognized
deferred tax assets. The enterprise recognizes previously unrecognized
deferred tax assets to the extent that it has become reasonably certain or
virtua lly certain, as the case may be (see paragraphs 15 to 18), that
sufficient future taxable income will be available against which such
deferred tax assets can be realized. For example, an improvement in
trading conditions may make it reasonably certain that the enterprise will
be able to generate sufficient taxable income in the future.
MEASUREMENT
Current tax should be measured at the amount expected to be paid to
(recovered from) the taxation authorities, using the applicable tax rates
and tax laws.
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70 Defer red tax assets and liabilities should be measured using the tax rates
and tax laws that have been enacted or substantively enacted by the
balance sheet date.
Deferred tax assets and liabilities are usually measured using the tax rates
and tax laws that hav e been enacted. However, certain announcements of
tax rates and tax laws by the government may have the substantive
effect of actual enactment. In these circumstances, deferred tax assets and
liabilities are measured using such announced tax rate and tax laws.
When different tax rates apply to different levels of taxable income,
deferred tax assets and liabilities are measured using average rates.
Deferred tax assets and liabilities should not be discounted to their
present value.
The reliable determination of deferred tax assets and liabilities on a
discounted basis requires detailed scheduling of the timing of the reversal
of each timing difference. In a number of cases such scheduling is
impracticable or highly complex. Therefore, it is inappropriate to r equire
discounting of deferred tax assets and liabilities. To permit, but not to
require, discounting would result in deferred tax assets and liabilities which
would not be comparable between enterprises. Therefore, this Statement
does not require or permi t the discounting of deferred tax assets and
liabilities.
REVIEW OF DEFERRED TAX ASSETS
The carrying amount of deferred tax assets should be reviewed at each
balance sheet date. An enterprise should write - down the carrying amount
of a deferred tax asset to the extent that it is no longer reasonably certain
or virtually certain, as the case may be (see paragraphs 15 to 18), that
sufficient future taxable income will be available against which deferred
tax asset can be realized. Any such write -down may be re versed to the
extent that is becomes reasonably certain or virtually certain, as the case
may be (see paragraphs 15 to 18), that sufficient future taxable, income
will e available.
PRESENTATION AND DISCLOSURE
1. An enterprise should offset assets and liabilit ies representing
current tax if the enterprise:
a. Has a legally enforceable to set recognized amounts; and
b. Intends to settle the asset and the liability on a net basis.
2. An enterprise will normally have a legally enforceable right to set
off an asset and liab ility representing current tax when they relate to
income taxes levied under the same governing taxation laws and the
taxation laws permit the enterprise to make or receive a single net
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71 3. An enterprise should offset deferred tax assets and deferred tax
liabilities if:
a) The enterprise has a legally enforceable right to set off assets against
liabilities representing current tax; and
b) The deferred tax assets and the deferred tax liabilities relate to taxes
on income levied by the same governing taxation laws.
4. Deferred tax assets and liabilities should be distinguished from assets
and liabilities representing current tax for the period. Deferred tax assets
and liabilities should be disclosed under a separate heading in the balance
sheet of the enterprise, separately from current assets and current
liabilities.
5. The break -up of deferred tax assets and deferred tax liabilities into
major components of the respective balance should be disclosed in the
notes to accounts.
6. The nature of the evidence supporting the recognition of deferred tax
assets should be disclosed, if an enterprise has unabsorbed depreciation or
carry forward of losses under tax laws.
TRANSITIONAL PROVISIONS
1. On the first occasion that the taxes on income are accounted for in
accordance with this Statement, the enterprise should recognize, in the
financial statement, the deferred tax balance that has accumulated prior to
the adoption of this Statement, as deferred tax asset/liability with a
corresponding credit/change to the revenue reserves, subject to the
consideration of prudence in case of deferred tax assets (see
paragraphs 15-18). The amount so credited/charged to the revenue
reserves should be the same as that which would have resulted if this
Statement has been in effect from the beginnin g.3
2. For the purpose of determining accumulated deferred tax in the
period in which this Statement is applied the first time, the opening
balanced of assets and liabilities for accounting purposes and for tax
purposes are compared and the differences, if an y, are determined. The tax
effects of these differences, if any, should be recognized as deferred tax
assets or liabilities, if these differences are timing differences. For
example, in the year in which an enterprise adopts this Statement, the
opening bal ance of a fixed asset is Rs. 100 for accounting purposes and
Rs. 60 for tax purposes. The difference is because the enterprise applies
written down value method of depreciation for calculating taxable income
whereas for a accounting purposes straight line method is used. This
difference will reverse in future when depreciation for tax purposes will be
lower as compared to the depreciation for a accounting purposes. In the
above case, assuming that enacted tax rate for the year is 40% and that
there are no o ther timing differences, deferred tax liability of Rs. 16 [(Rs.
100 – Rs. 60) x 40%] would be recognized. Another example is an
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72 the year of its incurrance but is allowable for tax pur poses over a period of
time. In this case, the asset representing that expenditure would have a
balance only for tax purposes but not for accounting purposes. The
difference between balance of the asset for tax purposes and the balance
(which is nil) for accounting purposes would be a timing difference which
will reverse in future when this expenditure would be allowed for tax
purposes. Therefore, a deferred tax asset would be recognized in respect of
this difference subject to the consideration of prudence (see paragraphs
15 – 18).









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73 3
VALUATION OF BUSINESS FOR
AMALGAMATION AND MERGER
Unit Structure :
3.1 Introduction
3.2 Need for valuation of Goodwill
3.3 Factors affecting Goodwill
3.4 Characteristics of Goodwill
3.5 Need for valuation of Goodwil l
3.6 Valuation of Assets
3.7 Future maintainable profit
3.8 Normal Rate of return
3.9 Capital Employed
3.10 Methods of valuation of Goodwill
3.11 Illustrations
3.1 INTRODUCTION
Goodwill means the reputation of a Business concer n which enables
businessmen to earn extra profit, as compared to other concern. Goodwill
means various advantages of reputation and connections of a business.
Mr. Kohler defines goodwill as “the current value of expected future
income in excess or normal r eturn on the investment in net tangible
assets:”
3.2 NEED FOR VALUATION
The need for valuation of goodwill depends on the form of a business
organisation. The circumstances in which the goodwill is valued are given
below



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74 Form of Business Organisation Need for valuation
Sole proprietor Partnership firm








Company


Sale of business
Conversion into partnership
Admission of partner
Retirement / Death of partner
Change in profit sharing ratio
Amalgamation of firm
Dissolution on account of sale of
business.
Conversion into Private / public
Limited company.
Mergers / Acquisitions of
business
Transfer of controlling block of
shares
Sale of Business
Conversion of one class of
shares into another.

3.3 FACTORS AFFECTING GOODWILL
A firm may earn mo re profits than other firms in the same type of industry
because of numerous factors some of which are stated below:

Sr.
No. Main Factors Sub factors
I Managerial and Human
Resource Factors  Superior Management team
 Superb Organisation
 Exclusive Training programmes for employees.
 Co-ordinal labour relationship.
 Discovery of talent.
 Experienced work force
 Long standing experience
II Product / Service
Factors  Secretor patent manufacturing
 Exclusive know -how
 Economies of scale of production  Foreign collabor ation
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75 III Marketing Factors  Effective advertisement
 Market dominance
 Favourable attitude of customers
 Adequate selling outlets
 Adequate service centres
 Established list of customers
 Exclusive selling arrangements
IV Physical facto rs  Strategic location
 Availability of raw material
 Exclusive infrastructural facilities  Adequate input availability
like power, man power etc.
V Fiscal Factors  Cost saving
 Cost of financing
 Tax exemptions / deduction
benefits
 Good credit rating
VI Other Factors  Good public image
 Favourable Government
regulations
 Good relationship with suppliers

3.4 CHARACTERISTICS OF GOODWILL :
1. It is an intangible or invisible asset.
2. It’s value is not fixed. It is subject to fluctuation due to internal as well
as exter nal factors in value.
3. It can not valued in isolation.
4. Its valuation is attached to the total value of the business.
5. It has value only on going concern basis.
6. It is either created internally or purchased from outside.
7. Because off Goodwill a firm is able to earn excess profits than the
other firms in the same class of business.
8. value of Goodwill may differ due to different method used. In
certain cases it is not transferable.

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76 3.5 NEED FOR VALUATION OF GOODWILL
In case of partnership firm the necessity o f valuating goodwill arises in
connection with the following. Whenever there is change in constitution
of the business and partnership deed.
1. When there is a change in the profit -sharing ratio among the
partners.
2. When a new partner is admitted.
3. When a partner retires or dies and
4. When the firm sells it is business to a company or is
amalgamated with another firm.
In case of joint stock company the necessity of valuation of goodwill
arises in the following circumstances: -
1) When the business of the company is taken over by another company.
e.g. amalgamations, absorptions, mergers.
2) When stock exchange quotations not being available, shares have to be
valued for taxation purpose e.g. wealth tax etc.
3) When large stock of shares of the company have to be bought or sold.
4) When the management wants to write back goodwill, which was
previously written off.
5) When the company is being taken over by the government.
3.6 VALUATION OF ASSETS
When Goodwill is be raised / valued, it is necessary to reval ue various
Assets as guidelines issued by I. C. A. I. some of these are stated below.
1. Fixed Assets
As 6 : Depreciation
As. 10 : Fixed Assets
As. 12 : Government Grants Received / receivable
for revenue expenses or capital
expenditure.
As. 16 : Borrowing Cost
As. 19 : Leases (Treatment of various types of lease
Assets in the books of lessce / lessor.
As. 22 : Accounting for Taxes on Income (e.g.
Deferred tax; assets and liabilities)
As. 26 : Intangible Assets
As. 28 : Impairment of Assets
As. 29 : Provisions, Contingent Liabilities and
contingent Assets.)
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77 3.7 DETERMINATION OF FUTURE MAINTAINABLE
PROFIT [F.M.P]
Determination of Future maintainable profit under normal circumstances is
most important and complicated task: F. M. P. is subject to evolution of
many factors such as capability of company’s management, future govt.
policies; general and economical trend etc. For determining F. M. P. non
operating expenses and incomes are not to be considered. It is decided on
the basis of average post Trading profits subject to certain changes that may
have effect on future earning of the business concerns.
1) Calculation of past average earnings :
In order to calcul ate F. M. P. the profit of the previous year can be
considered, if necessary. Such business profit should be making adjusted
to make it acceptable for averaging.
Average profit may be simple average or weighted average profit.
a) Simple average profit
.Total average profitNo of years
b) When profit shows increasing on depreciating tendency weighted
average profit should be calculated.
Weighted Average profit
/Total weightedprofits productsTotal weights
Calculation of F. M. P.
Particulars Rs. Rs.
Average Trading profit after tax
Add: Income Tax + X
X
....W P AT Tax Rate
ax Rate      

Average Profit before Tax
Add: Increase in profit in Future
i) Saving in expenses
ii) Additional income likely to earn in future
Less : i) Additional Exp. likely to incurred in future
ii) Income earned in past but not expected to
earn.
iii) Abnormal gain credited to profit & Loss A/c
F. M. P. before Tax
Less : Income Tax (Revised)
F. M. P. after Tax
X


X
X
(x)
X

XY
(X)
XX
X
X
X
X

X
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78 Note : Goodwill can be classified as
i) Purchased Goodwill
ii) Internet Goodwill
iii) Goodwill due to various associate with Govt. / political
parties etc.
3.8 NORMAL RATE OF RETU RN [N. R. R.]
The term N. R. R. means the rate of return that will satisfy an ordinary
investor in the industry concerned. NRR differs from industry to industry.
It is also depends upon business risk as well as financial risk in the
business.
If N. R. R. not given in the problem, it can be calculated as under. ....Dividendper equity shareinsimilar CoNRRMarket value per shareinsimilar company     
Note : N. R. R. may adjusted for various changes in the basis
satiation related to business concern
3.9 CAPITAL EMPLOYED
The goodwill of a business depends on the amount of capital employed
also. It is the present value of tangible trading assets minus all liabilities.
Non Trading assets such as investments in shares should be excluded.
Similarly intangible assets. Such as goodwill useless patents and Trade
marks should be excluded.
It is considered desirable to use average capital employed in place of
capital employed since capital employed as calculated from the balance
sheet will be on a certain date only
Average capital employed can be calculated as under : -
sin...2opening capital clo g capitalACE   
OR
12Opening capital of profit earned during the year          .
OR
1sin .2Clo g capital of the profit earned during the year         
Average Capital employed can be calculated from given Balance Sheet
on the particular date. It is calculated as under: munotes.in

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79 ASSETS SIDE APPROACH
Rs. Rs.
All tangible trading Assets at revised value X
Otherwise at book value recorded as will as
unrecorded assets (except goodwill, non trade investment,fictitious assets, differed revenue expenditure) X
X
XX
Less: Third parties liabilities payable re corded as well asunrecorded, e.g. debentures loans, current liabilitiesprovisions etc.
Tangible capital employed at the end of the year.
X
X

(X)
X
Less : Half of the profit earned during the year. (X)
Average capital employed XX

Note: Half of profit earned should be deducted only when profit was not
withdrawn.
Note : Capital employed represents the fair value of Net Tangible
Trading Assets used in the business for earning the profits.
i) Non trade investment should be excluded.
ii) Goodwill and fictit ious assets shown in the balance sheet should be
excluded.
iii) Unproductive assets should be excluded.
iv) Assets should taken at fair value to the business.
v) External recorded or unrecorded liabilities should considered at
amount payable. [i.e. premium payable on redemption of
debentures etc]
vi) Debenture redemption fund is not a liability.
vii) Works men profit shearing fund is liability.
viii) Works men compensation fund is liability to the extent actual amount
payable.
ix) Liabilities relating to non-trade assets should be excluded.


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80 LIABILITY SIDE APPROACH

Liability side approach may be adopted for deciding average capital
employed. It is adjusted owners fund (share holders fund). It can be
calculated as under:
Rs.
Paid up share capital (equity + Preference share - capital) xxx
Add: Reserves and surplus (accumulated profits) xxx
Add : Revaluation OR Profits xxx
xxx
Less : i) Revaluation loss X
ii) Fictitious assets X
iii) Non Trading Assets X
xxx
Trading capital employed at the end of the year xxx
Less : Half of the profit earned should be deducted only if
profit was not withdrawn (xx)
Average capital employed xxxx

3.10 METHODS OF VALUATION OF GOODWILL
 NO. OF YEARS PURCHASE OF SALES OR GROSS FEES
Under this method the purchaser usually professional firms, pays to the
vend or the amount of goodwill, calculated on the basis of net sales or fees
received during the particular period.
This method is very simple and suitable for valuation of goodwill of
professional firms. The period for gross fees received or net sales are
settled by agreement between buyer and vendor.
 NO. OF YEARS PURCHASED METHOD
Under this method net profit of past few years is worked out. Goodwill is
valued either by adding the profit of post three years or by considering
average trade net profit. ..Goodwill Averageadjusted Tradenet profit no of years purchase        

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81  NO. OF YEARS OF PURCHASE OF FUTURE
MAINTAINABLE PROFIT
Under this method the profits which are likely to be earned in future over
the certain period of time are first estimated. To arrive at Future
Maintainable Profits (F.M.P.) past profits over the years, after adjusting
non-recurring factors as well as expected future events which were not
there in the past are also considered. .. . . .Goodwill F M P No of years purchase    
 SUPER PROFIT METHOD
In this case the future maintainable profits of the firm are compared with
the normal profits of the firm super profit is the excess OR the profit
earned by firm over the normal profit earned by the concern.
Super profit is excess of F. M. P. over normal profit. Pr . . . .Super ofit F M P Normal profit      
Normal Profit
It is average profit earned by the similar concern in the industry. It is
decided on the basis of average capital employed and normal rate of return
expected by the investors on capital employed. 100NRRNormal profit AverageCapital Employed      
METHODS OF VALUATION OF GOODWILL UNDER SUPER
PROFIT
1) Purchase OR Super Profit Method
Goodwill = Super profit x no. of years purchase under this method the no.
of years of purchase will differ from industry to industry and from firm to
firm.
2) Capitalization of super profit
Under this method the amo unt of super profit is capitalized at the normal
rate of return. This method tries to find out the amount of capital required
for earning the super profit.
sup...er profitGoodwillNRR 
3) Sliding scale of valuation of super profit
This method is the variat ion of the purchased method. It is based on
assumption that the greater amount OR super profit, the more difficult it in
future to maintain. If the super profit is greater more possibility of
competition and therefore is difficult to maintain the same over the many
years.

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82 In this method the super profit is divided in two or three divisions / slide
each of this is multiplied by different no. of years purchase, descending
order from the first division.
E.g. If super profit is estimated Rs. 75,000 goodwill be calculated as
under:
Rs.
First Rs. 25,000 say three years purchases
(25,000 x 3) 75,000Second Rs. 25,000 for two years purchases
(25,000 x 2) 50,000Third Rs. 25,000 one years purchases
(25,000 x 1) 25,000Goodwill Rs. 1,50,000
3) Annuity method of Super Profit
Annuity takes into consideration time value money. Payment of Goodwill
is made immediately for Super Profit likely to be earned in future.
Goodwill in this case is the discounted value of the Super Profit.
Pr ReGoodwill Super ofit ferencetoannuitytable     
4) Capita lisation of F. M. P. method
Under this method, goodwill is the excess of capitalize & value of F. M. P.
over net tangible trading assets. Following are the steps to taken for
valuating Goodwill under this method.
Step 1 : Find out F.M.P.
Step 2 : 100.. . .. ....Capitalised valueof F M P F M PNRR       
Step 3 : net tangible Trading Assets
Total Tangible Trading Assets x
Less : Third parties liabilities payable (x)
Net tangible Trading Assets x
Step 4 : Goodwill
. . . an .Capitalized valueof F M p Net gibleTrading Assets         
Note : The value of Goodwill remains the same in case of capitalization
of super profit or capitalization of F. M. P. munotes.in

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83 3.11 ILLUSTRATIONS
Illustration 1:
Ashok & Co. decided to purchase the business Sonu & Co. on 31-12-
2010. Profits of Sonu & Co. for the last 6 year’s were :
Rs.
2005 10,000
2006 8,000
2007 12,000
2008 16,000
2009 25,000
2010 31,000
The following additional information about Sonu & Co. is also supplied :
a) A casual income of Rs. 3,000 was included in the profits of 2007
which can never be expected in future.
b) Profit of 2008 was reduced by Rs. 1,000 as a results of an
extraordinary loss by fire.
c) After acquisition of the business. Ashok & Co. has to pay insurance
premium amounting to Rs. 1,000 which was not paid by Sonu & Co.
d) Ashok the proprieto r of, Ashok & Co. was employed in a firm at a
monthly salary of Rs. 1,000 p.m. The business of Sonu & Co. was
managed by a salaried manager who was paid a monthly salary of Rs.
400. Now, Mr. Ashok decides to manage the firm after replacing the
manager.
Compute the value of goodwill on the basis of 3 years purchase
of the average profit for the last 4 years.
Solution : Statement showing adjusted profi t
Years 2007 (Rs.) 2008 (Rs.) 2009 (Rs.) 2010 (Rs.) Profits Adjustments
a) Casual income not
likely to be earn ed
b) Loss by fire 12,000(3,000)NIL16,000NIL1,00025,000NILNIL31,000NILNILAdjusted - Trading Profits 9,00017,00025,00031,000 9000 17000 25000 31000420500Average profits   munotes.in

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84







Therefore, Adjusted average profit = 12300
Therefore, Goodwill = Average Profit x 3
= 12300 x 3
= 36900
Illustration : 2
The year wise results of the earnings of Ashok & Co. as disclosed by her
profit and Loss Account are like this.
2006 Rs. 50,000 (Profit)
2007 Rs. 60,000 (Profit)
2008 Rs. 90,000 (Profit)
2009 Rs. 5,000 (Loss)
2010 Rs. 60,000 (Profit)

K Brothers are interested in purchasing the above business. Calculate the
amount of goodwill payable by K Brothers to Asha & Co. taking following
factors into consideration :
i) Goodwill is to be calculated at three years purchase of the average
profits of the previous five years.
ii) Asha & Co. earned Rs. 30,000 from adventure of speculative nature in
2008. Out of this gain. Rs. 10,000 were credited to her Profit & Loss
Account in that very year. No entry was made in the account for the
remaining gain.
iii) The machinery was destroyed by fire in 2005. Loss amounting to Rs
70,000 being terminal depreciation was set off against Profit & Loss
Account of 2009.
iv) Asha & Co. engaged the service of an expert who i s drawing a salary of Rs. Average Profits 20,500Less : Insurance Premium payable (1,000)Add : Salary of Managers not payable (400 p.m. x 12mths.) + 4,800Less : Cost of Services of Ashok (1000 p.m. x 12 mths) (12,000)F. M. P. 12,300munotes.in

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85 Rs. 2000 per month K. Being an expert himself, does not need the
service of that man. At present Mr. K is a manager in Q & Sons and is
drawing a salary of Rs. 1500 per month. After the purchase of above
business Mr. K has to resign fr om his employment.
Solution :
Calculation of Actual Average Profit
Profit Given (Rs.) Adjustment (Rs.) Adjusted Profit (Rs.) 2006 50,000NIL50,0002007 60,000NIL60,0002008 90,000-10,00080,0002009 -5,00070,00065,0002010 6,000NIL60,000 Total 3,15,0003.15.000Pr 630005Average ofit      24000exp87000Add Saleery erts nolonger required     
Less : Fair remuneration of K (18000) Actual average Profit 69000
Calculation of Goodwill 69,000 3 . 207000Rs 

Illustration : 3
The followin g is the Balance Sheet Sun Ltd. As on 31st December, 2010.
Liabilities Rs. Assets Rs.
Fully paid up capital 12000 1200000 Goodwill 40000 shares of Rs. 100 each Land & Bldg. 780000 General Reserve 160000 Plant &
Machinery 300000 Profit & Loss A/c 10000 0 10% Government
Securities Creditors 80000 (F.V. 50000) 60000 Bills Payable 40000 Debtors 220000 Bills Receivable 60000 Stock in trade 120000 1580000 1580000 munotes.in

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86
The company earned net profits for the past years as follows: (This
amounts include interest received from Government Securities).
2007 Rs. 100000
2008 Rs. 200000
2009 Rs. 300000
2010 Rs. 400000
The value of the goodwill should be computed at three years purchase of
the average super profit for four years. The normal rate of return on ca pital
employed in a similar business organisation is 12%.
Solutions :
a) Average Capital Employed = Assets at a realisable value –
Liabilities payable
Assets at Realisable value :
Land & Bldg. 780000
Plant & Machinery 300000
Debtors 220000
Bills Receivable 60000
Stock in trade 120000
1480000
Less : Liabilities payable
Creditors 80000
Bills Payable 40000
Capital Employed 1360000
b) Normal rate of return = 12 %
c) Normal Profit 1360000 12% 
163200
d) Average Past Profit = 100000 200000 300000 4000004
10000004
250000 5000( .@10% . .
245000Interest onGovtSecurities on FV     

e) Future maintainable profit = Average past Trading Profit = 245000
f) Super profit + FMP – Normal Profit
245000 16320081800 munotes.in

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87 Illustration : 4
Ascertain the value of goodwill of Bahts & Co. carrying on business as
retail traders from the following information
Balance Sheet as on 31st December, 2010
Liabilities Rs. Assets Rs
Paid up capital 2500 shares of Rs. 100 250000 Goodwill 25000 Each Land & Bldg. 110000 Profit & Loss A/c 56650 Plant &
Machinery 100000 Bank Overdraf t 58350 Stock 150000 Creditors 90500 Debtors 45000 Provision for
taxation 19500 Investment 45000 475000 475000
The company commenced operations in with a paid up capital of Rs.
250000. The profits earned before providing for taxation (at 50%) have
been as follows :
Rs.
2006 62000
2007 64000
2008 71000
2009 78000
2010 85000

Average dividend paid by the company is at 12½% which is taken as a
reasonable return expected on Capital invested in the business.
Goodwill is to be calculated with reference to Capitalisation of future
maintainable profits method.





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88 Solution :
a) Average Capital Employed = Assets at a realizable value –
Liabilities payable
Assets at Realised value
Land & Bldg. 110000
Plant & Machinery 100000
Stock 150000
Debtors 45000
Investment 45000 450000
Bank Overdraft 58350
Creditors 90500
Provision for taxation 19500 168350
Capital Employed 281650

b) Normal rate of returen = 12.5%
c) Avg. Past Profit = 62000 64000 71000 78000 85000 36000055
= 72000
d) Future maintainable Profit :
.P r
: 50%36000Ave Past ofit
Less Tax
FMPafterTax      
e) Capitalised value of maintainable profit.
1003600010013.5288000FMP
NRR

f) Value of Goodwill = Capitalised value of maintainable profi ts – Actual
Cap.Employed
= 288000 – 281650
= 6350



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89 Illustration : 5
The following is the Balance Sheet of Sarah Ltd. As on 31st December,
2010
Liabilities Rs. Assets Rs.
Paid up share capital 1000 shares ofRs. 200 each
Capital Reserve
General R eserve
Bank Loan
Profit & Loss A/c
Creditors
Bills Payable
Provision for taxation
200000
40000
60000
50000
20000
130000
40000
30000 Goodwill Land &Bldg. Plant & MachineryVehicles Stock in tradeDebtors
Investment 30000 170000 160000 70000 60000 50000 30000 570000 570000
On Der. 31, 2010 the asses were revalued as follows :
Land & Bldg. Rs. 200000 Plant & Machinery Rs. 150000 Vehicles Rs. 60000
The company earned profit after depreciation & taxation as follows :
2008 Rs 60000 2009 Rs. 70000 2010 Rs. 80000
The average of these profits are expected to be earned in future.
The valuation of goodwill should be based on two year’s purchase of the
annual super profit. It is considered that 10% is a reasonable return on
tangible capital.
You are required to value the goodwill.




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Corporate Financial
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90 Solution :
a)Average Capital Employed = Assets at a realisable value – Liabilities
payable
Assets at Realisable value : Rs.
Land & Bldg. 200000
Plant & Machinery 150000
Vehicles 60000
Stock 60000
Debtors 50000
Investment 30000
550000

Less : Liabilities
Creditors
130000
Bills Payable 40000
Tax Provision 30000
Bank Loan 50000 250000 Capital Employed 300000
b) Normal rate of return
c) Normal Profit
=
=
=
10%
300000 x 10%
30000

d) Average Past Profit = 60000 70000 80000 21000033
= 70000
e) Future Maintainable Profit = 70,000
f) Super Profit = F.M.P. – Normal Profit
= 70000 – 30000
= 40000
g) Value of Goodwill = Super Profit x No. of years purchase
= 40000 x 2
= 80000 munotes.in

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91 Illustration : 6
The net profits of a company before providing for taxation for the past five
years Rs. 40000, Rs, 41,000, Rs. 42500, Rs. 43000 & Rs. 43500. The
capital employed in the business is Rs. 400000 on which a reasonable rate
of return of 15% is expected. It is expected that the company will be able to
maintain it’s super profits for the next five years.
a) Calculate the value of goodwill of business on the basis of an
annuity of one rupee for five years at 15% interest as Rs. 4%.
b) How would your a nswer differ if goodwill is calculated by capitalising
the excess of the annual average distributable profits over the
reasonable return on capital employed on the basis of the same return
of 15%?
c) Calculate goodwill on 4 years purchase of super profit.
Solutions :
a) Avg. Capital Employed = Rs. 100000
b) NRR = 15%
c) Normal Profit = 1,00,000 15% .15000Rs 
d) Avg. Past Profit = 40,000 41,000 42,500 43,000 43,5005
= 42,000
e) F.M.P.
N.P.B.T. 42,000
Tax@40% 16,800
FMP after Tax 25,200
f) Super profit = 25200 – 15000 = 10200
g) Value of Goodwill = Super Profit x No. of years purchases.
= 10200 x 5 = 51000
Capitalion Method :
Capitalion value = 100FMPNRR
= 25200 10016800015
Value of Goodwill = 168000 -100000 = 68000
Value of Goodwill an annuity of Rs. 1 = 10200 x 4.10 = 41820

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92 Illustration : 7
The follo wing are particulars in respect of Maru Ltd.
i. Capital employed in the business is Rs. 4200000.
ii. A reasonable rate of return expected in a similar type of business is
10%.
iii. Net profit of the company after providing for depreciation & taxation
for the past four years were :
Rs. 400000, Rs. 420000, Rs. 460000 & Rs. 480000
iv. It is expected that the company will be able to maintain it’s super
profit for the next four years.
You are required to calculate the value of goodwill.
a) On the basis of annuity of super pr ofit method taking the present value
of an annuity of Re. 1 for four years at 7% interest as Rs. 3.39.
b) By capitalising the excess of the annual average distributable profits
over a reasonable return on capital employed on the basis of the return
of 7% .
Solution :
a) i) Capital Employed = Rs. 12,00,000
ii) NRR = 7%
iii) Standered Profit = 1200000 x 7% = 84000
iv) Avg. Past Profit = 100000 120000 160000 1800004
= 140000
v) FMP
Avg. Past Profit 140000
-140000
vi) Super Profit = FMP – Normal profit
= 140000 – 84000
= 56000
vii) Value of Goodwill
Pr100Super ofitGoodwillNRR 
560001007.8,00,000Rs
 munotes.in

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Valuation Of Business For Amalgamation And Merger
93 Illustration : 8
The following is the Balance Sheet of X Limited as on 31st March 2010.
Liabilities Rs. Assets Rs.
Share Capital Goodwill 1,25,000 5,000 shares of Ts.100 each
Reserve Fund 5,00,000 1,50,000 Land & Building
Less :
Depreciation 1,80,000 36,000 1,44,000 Workmen compensation Fund 25,000 Plant &
Machinery (at
cost) 2,40,000 Workmen Profit Sharing Fund 45,000 Less :
Depreciation 40,000 2,00,000 Profit & Loss Account
Cred itors 1,50,000 2,30,000 Invesrments (to provide
replacement of Plant &
Machinery) 1,00,000 Other Liabilities 1,00,000 Book Debts 3,60,000 Less : Provision 30,000 3,30,000 Stock 2,00,000 Cash at Bank 75,000 Preliminary Expenses 26,000 12,00,000 12,00,000
Further Information
1) The profits after tax @ 50% earned by the company for the three years
were as under :
Year ended 31st March 2008 Rs. 5,10,000
Year ended 31st March 2009 Rs. 7,73,000
Year ended 31st March 2010 Rs. 8,90,000
2) X Lt d. had been carrying on business for the past several years. The
company is to be taken over by another company. for this purpose you
are required to value Goodwill by “capitalization of maintainable profits
method”. For this purpose following additional information is available:
a) The new company expects to carry on business with its own board of
directors, without any addition. The fees paid by X Ltd. to its directors
amounted to Rs. 2,000 p.m.
b) The new company expects a large increase in volume of business and
therefore, will have to take an additional office for which it will have to
pay extra rent of Rs. 36000 p.a.
c) As on 31st March 2010 Land and Buildings were worth Rs. 4,00,000
whereas Plant and Machinery were worth only Rs. 1,80,000. There is
sufficient provision for doubtful debts. There is no fluctuation in the
values of investments and stocks.
d) Liability under Workmen Compensation Fund was only Rs. 10,000.
3) The expected rate of return on similar business may be taken at 15%.
4) The expected rate of Tax likely to be 40%. munotes.in

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Corporate Financial
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94 You are required to value Goodwill according to above instructions. All
your workings should form part of your answer. Consider average capital
employed the same as closing capital employed for your calculations.
[Consider weighted average profit]
Solution :
Future Maintainable Profits
Year N.P.A.T. Add Income Tax N.P.B.T. Weight Product
2007 -8 5,10,000 5,10,000 10,20,000 1 10,20,000
2008 -9 7,73,000 7,73,000 15,46,000 2 30,92,000
2009 -10 8,90,000 8,90,000 17,80,000 3 53,40,000
6 94,52 ,000
94,52,00015,75,3336Average profit beforetax    
Add : Expenses Not Payable in future (directors fees) 24,000
Less : Additional Expenses (extra Rent) (36,000)
Adjusted Profit (before tax) 15,63,333
Less : tax @ 40% [6,25,333]
Net Profit after tax, or Future Maintainable Profit 9,38,000
2) Capital Employed (Excluding Goodwill )
Particulars Rs. Rs.
Assets
Land & Building (Market Value) 6,00,000
Plant & Machinery (Market Value) 1,00,000
Investment (cost) (See note) 1,00,000
Debtors (Net) 3,30,000
Stock (cost) 2,00,000
Cash 75,000
(A) 14,05,000
Less: Liabilities :
Creditors 2,30,000
Other Liabilities 1,00,000
Workmen’s Compensation Fund (actual) 10,000
Workmen’s Profit sharing Fund 45,000
(B) (3,85,000)
Closing Capital employed as on 31-3-2002 (A-B) 10,20,000

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Valuation Of Business For Amalgamation And Merger
95 3) Expected Rate of Return = 15% (given)
4) Value of business by capitalization of Future Maintainable Profits at
15%.
100 9,38,000. . . 100 62,53,33315FMPNRR     
5) Goodwill = Value of business Less Capital Employed
= 6253333 – 1020000
= 52,33,333
Working Notes :
1) Investments are incl uded in capital employed because they are trading
investments meant for replacement of Plant and Machinery.
2) In the absence of information (regarding rate and method of
depreciation) no adjustment is made to Future Maintainable Profit for
depreciation on re valued Land & Building and Plant & Machinery.
Illustration : 9
Sandwitch, Pizza and Burger are partners in a firm sharing profits and
losses in the ratio of 5:2:1. The partnerships deed provides that in the event
of retirement or death of a partner goodwil l is to be valued at three years’
purchase of Weighted Average of Future Maintainable Profits over a
Period of four years, (the weights being four for the immediate year after
the event, three for the next year, two for the third year and one for the last
year) in excess of 12.5% of Capital Employed in the business at the time
of retirement/death. On 31st December, 2010 Pizza retired. The Balance
Sheet of the firm was as follows:
Liabilities Rs. Assets Rs.
Capitals Fixed Assets 5,00,000 Sandwitch 7,00,00 0 Net current assets 8,00,000 Pizza 3,50,000 Burger 2,50,000 13,00,000 13,00,000
Sales during the year ended 31st December 2001 totalled Rs. 1 crore
and were at a gross margin of 10%. The expenses amount to 30% of Gross
Profit. It is expected that sales will increase at 20% curmulative rate of
growth every year. Gross Profit margin percentage being reduced to 9%.
The expenses would continue to be at 30% of Gross Profit. Calculate
goodwill which is to be credited to Pizza.
(Apr. 2000, adapted) munotes.in

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Corporate Financial
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96 Solution :
1) Calculation of Future Maintainable Profits (FMO)
Particulars 2011
Rs. ‘000) 2012
Rs. (‘000) 2013 Rs. (‘000) 2014
Rs. (‘000) Sales (Increase by 20% 12,000 14,400,00 17,280,0
0 20,736,00
Gross Margin (9% on Sale)
Less : Expenses likely to 1,080 1,296,00 1,555,20 1,866,24
arise in future (30% ofGross Profit)
324 388,80 466.56 559.87
FMP
Weights (as given) 756 907.20 1,088,64 1,306.37
X 4 X 3 X 2 X 1
Weighted FMP (Products) 3024 2,721,60 2,177,28 1,306.37
3,024 2,721.60 2,177.28 1,306.37 9, 229.2510 10
.922,925Weighted FMPWeighted Averageof FMPTotal of Weights
Rs    
 
 

2) Capital Employed = Rs. 13,00,000
3) Normal profit = Capital Employed x Normal Rate of Return (given)
= 13,00,000 x 12.5%=1,62,500
4) Super Profit = FMP – Normal Prof it
= 922,925 – 162500 = 760425
5) Goodwill = Super Profit x no. of years purchased
= 760425 x 3 = 22,81,280
6) Goodwill to be credited to Pizza’s A/c
22281,280 .5703208Rs  
 munotes.in

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97 4
VALUATION OF SHARES AND BUSINESS
Unit Structure :
4.1 Introduction
4.2 Need for Valuation of Shares
4.3 Factors Affecting Share Valuation
4.4 Methods of Valuation of Shares
4.5 Valuation of Equity Shares Having Different paid up Value
4.6 Valuation of Shares before Bonus and after Issue of Bonus
Shares
4.7 Valuation of Equity Shares before right Issue and after right
Issue of Shares
4.8 Valuation of Equity Shares before Conversion of Debentures and
after Debentures Conversion into Equity Shares
4.9 Valuat ion of Share before Sub-Division and after Sub- Division
4.10 Valuation of Shares from Point of View of Minority / Majority
Shareholders
4.11 Valuation of Preference Share
4.12 Solved Problems on Valuation of Shares
4.13 Valuation of Business
4.14 Solved Problems on Valuation of Business
4.15 Key Points on Valuation of Goodwill, Shares and Business
4.16 Exercise on Valuation of Goodwill, Shares and Business
4.1 INTRODUCTION
Share means share in a public or private Ltd. company. The shares of the
private Ltd . Company are never quoted on stock Exchange. Also not all
the public companies shares are quoted on the stock exchange. It’s value
cannot be easily ascertained. A public company may either be widely held
or closely held. A closely held public company mean s a company having
very few share holders. Each shareholder owing a substantial part of
the share capital. A widely held public company means a company having
large number of share holders spread over the entire country thus, it has
innumerable share holde rs. Share of only such companies are quoted on munotes.in

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Corporate Financial
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98 one or more stock exchanges. The prices of such shares depend upon
various factors like demand and supply, market sentiments etc
4.2 NEED FOR VALUATION OF SHARES
Shares of a company are to be valued at differe nt occasions as follows:
a) When shares of one class are to be converted into shares of another
class.
b) When shareholders wants to take loan from financial institution
against the security of shares hold by him.
c) When shares are to be transferred, bought or sold
d) When the companies are amalgamated absorbed merged or
reconstructed.
e) When the Government wants to compensate the shareholders on
the nationalization or the company.
f) Whenever there is a death of a shareholder and the distribution of
shares held by him is to be made among the legal heir offices.
4.3 FACTORS AFFECTING SHARE VALUATION
Following factors affects on the share value:
1) Nature of business.
2) Market conditions as regards the companies doing the similar
business and existing competition.
3) Demand and supp ly of shares in recognized stock exchange.
4) Earning capacity of the company and growth prospectus.
5) Goodwill of the company.
6) Reputation of the management.
7) Anticipated legislature measures
8) General economic conditions and policies of the Government.
4.4 METHO DS OF VALUATION OF SHARES
Generally there are two types of shares:
a) Equity shares
b) Preference shares
Whenever there are preference shares and Equity shares, the Articles of
Association must be referred for the purpose of finding out the respective
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Financial Reporting
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99 Preference shareholders have priority as regards dividends and repayment
of Capital. At the same time if Preference shares are participating, there
value depends upon the share in supply as per Articles of Association. In
such circumstances the valuation of Preference share is also important.
Value of Equity shares depends upon whether they are quoted or
unquoted.
In case of quoted shares the value should be as per the quoted in the
recognized stock exchange.
Primarily following are the metho ds of valuation of shares.
a) Intrinsic value
b) Yield value Basic
c) Fair value
d) Earning Capacity method
e) Capitalization of maintainable profits.
 INTRINSIC VALUE :
This is also called as “Net Assets Value” or “NAV” of Liquidation value
or Breakup value or Asset Back ing value.
This method OR valuation is based on the assumption of liquidation of
company. Here it is assumed that the company going into liquidation in
near future. All the assets are sold and all the liabilities are paid of and
then the remaining surplus is distributed among the Equity shareholders.
Steps to find the intrinsic value.
Step No. 1 – Find out amount available to Equity Shareholders
All Assets at current market value including goodwill. non trade
investments but excluding fictitious assets.
Goodwill xxx
Land and Building xxx
Plant and Machinery xxx
Furniture and Fixtures xxx
Vehicles xx
Trade and non trade investments xxx
Stock xxx
Debtors and Bills Receivable xxx
Cash and Bank Balances xxx
Loans Advances and prepaid expenses xxx
xxx
Less : All liabilities at current values excluding
share capital and Reserves and Surplus
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Corporate Financial
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100 Debentures and Accrued Interest xxx
Long term loans xxx
Creditors and Bills payable xxx
Outstanding Expenses xxx
Proposed / unpaid Dividend xxx
Provision for Taxation xxx
Other liabilities payable xxx (xxx)
xxx
Less : Dues to Preference shareholders xxx
Paid Preference share Capital xxx
Arrears of dividend (if any) xxx
Premium payable on redemption (if any) xxx (xxx)
Amount available to Equity shareholders xxxx

Step No. II: Intrinsic Value per Equity share
If all the shares are fully paid up
.Amount available to equity shareholdersNo of equity shares   
Points to be remembered:
While calculating the net asset value the following points should be
remember ed.
1) only market value of the assets should be considered. If market value
is not given then the book value should be considered.
2) All assets recorded and unrecorded should be taken into account.
3) goodwill also should be considered as per instruction of the problems.
4) Non trading assets should be considered.
Merits of intrinsic Value method :
1) it is very sureful when the company is being liquidated.
2) It takes into account both types of Assets.
3) It is simple to use in valuation of different types of equity shares.
Demerits of Intrinsic Value Method :
1) It is difficult to estimate the realizable value of assets.
2) the assumption of liquidation is contradictory with the normal of
assumption of going concern principal.
3) The value of goodwill is very much subjective. munotes.in

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101  YIELD VALUE BASIS
This method of valuation is based on the assumption of going concern
principal. Here it is assumed that the company shall carry on business
profitability for many years to come. Therefore, value of shares is based
on the amount or profit that wo uld be available to Equity shareholders as
dividend.
Steps to calculate yield value:
a) Find out Future maintainable Profit (F. M. P.) Sameas in Goodwill Valuation
Add : back interest on Non-Trade Investment
Less :
i. Transfer to Reserve as required under law
ii. Preference Dividend
F. M. P. available to Equity shareholders



xxx
xxx
xxx
xxx
xxx


(xxx)
xxx
b) ... . . 100FMPFind out rate of F M PPaidup equity capital        
c) .. .....Rate of F M PYield Value Amt Paid per shareNRR       
ALTERNATIVELY
d) .. .. . . 100..FMPCapitalised value of F M PNRR       
e) .. ..Capitalized Value of F M PYield ValueNo of Equity shares   
 FAIR VALUE
This method takes into account both the above methods 2InterinsicValue Yield ValueFair Value    
 EARNING CAPACITY VALUE
Under this method, value of share is decided on earning capacity of
the company:


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Corporate Financial
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102 Steps to calculate Earning capacity
)a Earning Net profit tax Interest on long term loans           
)b Capital employed Net Worth Long Term loans         
OR Assets Short Term liabilitiesOR Fixed Assets Investment Working Capital        100)Earningc Rate of EarningCapital Employed    
)d Value per Equity Share  
..Rate of EarningPaidup value per Equity ShareNRR     
 CAPITALISATION OF F. M. P. METHOD
Under this method F. M. P. is capitalized at N. R. R. Steps to calculate
value pe r share
a) Calculate F. M. P. available to Equity share holders
b) Capitalized value of F. M. P.
.. ....FMPNRR 
c) Value per share
.. . Capitalized value of F M PPaidup amount per SharePaidup Equity Share Capital        
10.5 VALUATION OF EQUITY SHARES HAVING
DIFFERENT PAID UP VALUE
INTRINSIC VALUE:
A company may have Equity shares of same face value, but in some
cases shares may partly called up / paid up.
For purpose of valuation a notional call equal to unpaid / uncalled amount
on each category of equity shares, should be made to make all Equity
shares fully paid up. Notional call amount should be added to net Assets
available to equity shareholders. Total amount will be available to Equity
Shareholders. when all shares are fully paid up value of Equity shares can
be determine as under: munotes.in

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103 Net Assets available to Equity shares (As
calculated earlier)
Add : Unpaid share capital
Add national call on partly called up shares, to make
shares fully paid up
Net Assets available to Equity shareholders, when all shares are fully paid up

x x x


+x
xx
.Total AmountValue of full paid Equity sharesTotal No of Equity shares         
Value of partly paid up share
Value of fully paid share National call per share        
Value can be determined as under
[When no notional call is to be made]
Instrinsic value of an Equity Share
..Amt available to equity shareholdersPaidup amt of each class of Equity ShareTotal paidup Equity share capital             
YIELD VALUE
For calculating yield value of Equity Share having different paid up
value following procedure should be followed:
Step I Calculate F. M. P. i.e. profit available for Equity dividend.
Step II  Calculate Rate of F. M. P.
.. .FMP
Paidup Equity Capital 
.. ....Rate of F M PYield Value Paidup value per quity shareNRR       
SOLVED PROBLEMS Illustration : 1
From following as certain fair value of Equity share.
Particulars Rs.
5,000 Equity Shares of Rs. 100 each fully paid up 5,00, 000
3,000 Equity shares of Rs. 100 each Rs. 60 paid up 1,80,000
12,000 Equity shares of Rs. 100 each Rs. 40 paid up 4,80,000
11,60,000


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Corporate Financial
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104 Net Assets were valued at Rs. 44,50,000
Adjusted Average profit after Tax amounted to 49,30,000 and N. R.
R. is 20%.
Solution :
Statement showing Total amount available to Equity Shareholders.
Particulars Rs. Rs.
Net Assets valued (given) 44,50,000
Add : Notional call made
On 5000 Equity Share @ Rs. 40 each 2,00,000
On 12000 Equity Share @ Rs. 60 each 7,20,000 9,20,000
Total Amount 53,70,000
.Total AmountInstrinsicValue of Fully Paid up Equity shareTotal No Equity Shares       
53.70,000
20,000 
Value of partly paid Equity Share = value of fully paid share – Notional
call per share
Value of Equity Share Rs. 60 paid up = 268.50 40
228.50
Value of Equity Share Rs. 40 paid up 268.50 60
208.50
Value Yeild
1. F.M.P. = 30,60,000 given
2. .... .FMPRate of F M PPaidup Equity Share Capitl    
49,30,000100 425%11,60,000 
......Rate of F M PYield Value Paid amt per equity shareNRR    
425.212520Yield Value of fully paid Equity Share Rs          munotes.in

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105 425.60 .127520Yield Value of Equity Share Rs paid up Rs          
425.40 .85020Yield value Equity Share Rs paid up Rs          \ 2IntrinsicValue Yield ValueFair Value of Equity Share      
268.50 2125.2Value of full paid Equity Share Rs       
228.50 1275,. .2Value of Equity Share Rs paid up Rs        
208.50.402Value of Equity Share Rs paid up       
Particulars Intrinsic
Value Rs. Yield
Value Rs. Fair
Value Rs. a) Rs. 100 fully paid up Equity Share 268.50 21251196.75b) Rs. 100 Equity Share, 60 paid up 228.50 1275751.70c) Rs. 100 Equity Share Rs. 40 paid up 208.50 850529.25
4.6 VALUATION OF SHARES BEFORE BONUS AND
AFTER ISSUE OF BONUS SHARES
A prosperous company may issue bonus shares by capitalizing reserves.
Bonus shares allotted to existing Equity shares holders at free of cost.
Issue of Bonus Shares increases Equity Shares and Equity capital.
However Net Assets of the company remains at same amount, therefore
after bonus issue value of Equity share reduces.
Illustration : 2
A Ltd. had an issued capital of 50,000 Equity shares of Rs. 100 each,
Rs. 75 paid up. The General Reserve of the company stood at
Rs. 90,00,000.
Net Assets valued at Rs. 5,00,00,000.
It was resolved to use a part of General Reserve as under :
a) to make shares fully paid
b) to issue 25,000 bonus share of Rs. 100 each at par. Find out
intrinsic value of Equity share befor e Bonus and After Bonus
Issue. munotes.in

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106 Solution :
Equity Share Capital Rs. No. of Equity Shares




.
5,00,00,000.50,000
5,00,00,000.75,000Intrinsic value of Equity ShareNet Assets available to Equity shareholdersNo of Equity Shares
Before Bonous Rs
After Bonous Rs    
 
      
4.7 VALUATION OF EQUITY SHARES BEFORE RIGHT
ISSUE AND AFTER RIGHT ISSUE OF SHARES.
Right shares are issued to employees and / or to existing Equity
shareholders at particular amount. Right share price indirectly includes
bonus element also. After right shares issued number of Equity shares and
Equity share capital increases. N et Assets available to Equity shareholders
also increases by proceeds received on right shares issue.
Illustration : 3
ZA Ltd. had an issued capital of 40,000 Equity Shares of Rs. 10 Each fully
paid up. Company decided to issue right share at the rate 3 sh are for every
5 shares @ Rs. 250 each; entire amount payable on application. Net assets
before right issue was Rs. 170,00,000.
Assuming right issue was subscribed find intrinsic value of Equity Shares
Before right and after right.
Solution :
Before Rights After Rights
a) No. of Equity Shares 40,000 64,000
b) Equity Share Capital 4,00,000 6,40,000
c) Net Assets available to Equity
share holders [170,00,000
+ 60, 00,000]
1,70,00,000 2,30,00,000
Before Bonus After Bonus
37,50,000 75,00,000
50,000 75,000
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107 4.8 VALUATION OF EQUITY SHARES BEFORE
CONVERSION OF DEBENTURES AND AFTER
DEBENTURES CONVERSION INTO EQUITY
SHARES
If debentures are converted into Equity shares, it increases it Equity share
capital, number of Equity shares and Net worth. Since after conversion
debenture interest is not to be payable, it increase F. M. P. also.
Therefore it has impact on both net worth and F. M. P.
Illustration : 4
The following particulars are available from Balance Sheet of Ketan Ltd.
a) 60,000 Equity shares of Rs 10 each fully paid up.
b) 5,000 12% Debentures of Rs. 100 each.
c) Net Assets available to Equity shareholders be conversion of
Debentures, Rs. 1, 24,00,000.
d) Average net profit before tax Rs. 36, 00,000.
e) Income Tax rate @ 40%.
Debentures are redeemable @ 20% premium. Debentures are converable
into Equity share of Rs. 10 each priced at Rs. 50 N. R. R. = 15%
You are require to find out fair value of Equity share after conversion of
debenture; assuming all debentures exercise their right in favour of
conversion. Solution
.
12% 5,00,000
Pr @ 20% 1,00,000I Debenture holders claim
Debentures
emium payable on redemption
Total Claim     
      
    6,00,000
..
6,00,0001200050Claim of Debenture holdersII No of share issuedIssue of one equtity shareEquity Shares
        
   




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Accounting
108 III. F. M. P. After conversion Rs.
N. P. Before Tax 36,00,000
Add: saving in Debenture interest [ 5,00,000 x 12%] 60,000
M. P. B. T (after conversion) 36,60,000
Less Income Tax @ 40% 14,64,000
F. M. P. after conversion [No debenture payable] 21,96,00 0
. 1,24,00,000:IV Net Assets Before Conversion
Add Debentures no more payable
Net Assets after Conversion             
[. ]Amt available to Equity shareholders    .. .60,000
60,000 12,000 72,000
.V No of shares after debentures conversionissued to Debenture holdersEquity Capital Rs        
  
   
.
1,29,00,000179.1772,000Net Assets availablel to Equity ShareholdersIntrinsicValueNo of Equity Shares     
 
)
) . . . 21,96,000
.. .) . . . 100
21,96,000100 3057,20,000
.. .B Yield Value
iF M P
FMPii Rate of F M PPaidup Equity Capital
Rate of F M PYield ValueN 
     
    
   ....
30510 203.33 `15
2
179.17191.25`2Paidup amt per Equity shareRR
IntrinsicValue Yield ValueFair Value    
   
    
  
Note : In case of conversion of preference shares into Equity shares,
Income Tax benefit are not available while calculating
F. M. P.
I) F.M.P. = Average Profit after Tax – transfer reserve if any.
II) No. of Equity shares and Equity share capital share increased due to
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Financial Reporting
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109 4.9 VALUATION OF SHARE BEFORE SUB -DIVISION
AND AFTER SUB -DIVISION
In such c ase number of Equity shares only changes (i.e. increases) Equity
share capital remain at same amount. Net Assets also remain same. Value
of Equity shares can be calculated as usual.
4.10 VALUATIO OF SHARES FROM POINT OF VIEW
OF MINORITY / MAJORITY SHAREHOLDERS
Shareholders may be classed into two categories namely:
a) Minority Shareholders :
These shareholders holding smaller portion of share capital of the
company. Such shareholders are interested in the rate of dividend declared
by the company and appreciation in share - market value. However,
valuation of such shares is based on the dividend declared by the
company.
....Average Rate of dividendValue per share Amt paidper Equity ShareNRR          
a) Majority shareholders:
These shareholders are holding larger portion of share capital. Such
shareholders ar e interested in F. M. P. Therefore yield value of shares
should be preferred. However in case change in holding / transfer /
amalgamation etc. fair value or intrinsic value may be calculated.
4.11 VALUATION OF PREFERENCE SHARE :
Values of Preference share depen d upon type of preference shares, which
are stated in Articles of Association.
a) When Preference shares are non-participating (having priority)
In such case value of Preference Share will be equal to its paid up value
plus premium on redemption if any payabl e plus arrears of Preference
dividend if any.
. Pr
. Pr .IntrinsicValuepaid up pref capital Arrears of Dividend emium on redeem ption if payableNo of ef Shares             
 



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Corporate Financial
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110 b) When Preference shares are participating :
In such a case, Preference share holders get a share in surplus as per
provisions of Articles of association.
.
. Prpaidup pref share capital surplus Arrears of Dividendif anyIntrinsicNo of eference Shares          

c) When Preference share are having no Preference over Equity
Shares:
In such a case, the net assets to all shareholders should be divided between
Equity and Preference share holders in the ratio of their paid up capital
. PrNet Assets availabel to preference shareholdersIntrinsicValueNo of eference Shares      

4.12 SOLVED PROBLEMS ON VALUATION OF
SHARES
Illustration: 5
The following information made available:
Issued & paid up capital Rs.
10% Preference shares of Rs. 100 each 5, 00,000
Equity share capital (Rs. 10 each) 15, 00,000
Reserve & Surplus 20, 00,000
Preliminary Expenses 20,000

All fixed Assets (including Goodwill) were under valued by Rs.10,
20,000 current Assets were over valued by Rs. 1, 00,000.
You are required to value Preference share if,
a) When Preference share are non-participating
b) When Preference share are participating; having 10% share in surplus
c) When Preference shares are having no Preference over Equity shares :


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Financial Reporting
Standards and Indian -AS

111 Solution :
Statement showing Net Assets a surplus (Liability side Approach)


Valuation :
a) When Preference Share not participating intrinsic value
Pr .
.Paidup ef Share Capital Arrears of dividendNo of preference shares       
5,00,000.1005,000Rs each   
b) When Preference share participating, having 10% share in
surplus : .29,00,000 10% .29,00,000
.
.surplus available to pref share holdersRs
IntrinsicValue
Paidup pref Share Capital surplus rrears of dividendNo of preference shares       
 
      
  5,00,000 2,90,000 79,00,0005000 5,000 .158 Pr .Rs per eference share    Particulars Rs. Rs.
10% Preference share capita l (100 5,00,000
each)
Equity share capital 15,00,000
Reserves & Surplus 20,00,000
Revaluation profit on Fixed Assets 10,20,000
50,20,000
Less :
i) Preliminary Expenses
ii) Loss on revaluation on current
Assets 20,000
1,00,000 (1,20,000)
Net Assets 49,00,000
Less :
i) Preference Share capital 5,00,000
ii) Equity Share capital 15,00,000 (20,00,000)
Surplus on Liquidation 29,00,000
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Corporate Financial
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112 c) When Preference shares having no Preference over Equity
Shareholders :
in this case, net assets of the company required to divide in the ratio of
paid up share capital
Pr :
5,00,000 : 1,50,000eferences Share Capital Equity Share capital       1:3 
Pr herefore net assets available to eference shareholder     
149,00,000 12, 25,0004   Net Assets Availabel to preference shareholdersIntrinsicValueNo of preference share       
12, 25,0005000
. 245Rs 
Illustration : 6
Following is the summarized Balance Sheet of R. K. Ltd. as on 31-3-
2010.

Find out the value of net assets basis of Equity shares of P.K. Ltd. On
basis of the following information :
a) Goodwill is valued at Rs. 10,00,000, Machinery at Rs. 49,50,000,
Building at Rs. 20,00,000 & Vehicles at Rs. 50,000.
b) Current Assets & Current Liabilities are to be taken at Book Value.
c) Shares of T Ltd. are to be valued on the basis of Net Assets Shares of
T Ltd. Liabilities Rs. Assets Rs.
3,00,000 Equity Shares Goodwill 1,00,000
of Rs. 10 each fully paid 30,00,000 Building 9,00,000
Reserves 30,00,000 Machinery 40,00,000
Long Term Loan 20,00,000 Vehicles 1,00,000
Current Liabilities 54,00,000 Shares in subsidiary Ltd.

3000 Equity Shares of
Rs. 100 each (at cost) 3,00,000
Current Assets 8,00, 000
1,34,00,000 1,34,00,000munotes.in

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Financial Reporting
Standards and Indian -AS

113 Balance Sheet of T Ltd. as on 31.3.2010

Fixed Assets of T Ltd. revalued at Rs. 12,00,0002 -actual current
liabilities payable Rs. 6,00,000.
Solution :
Net Assets Basis :
1, 44,80,000.
1,44,80,000
3,00,000Net Assets available for Equity shareholder
Net Assets available for ESHinstrisicValueNo of equity Shares        
 Liabilities Rs. Assets Rs.
5000 Equity shares of Rs. 100 each
Reserves Current Liabilities
5,00,000
8,00,000
7,00,000 Fixed Assets
Current Assets 9,00,000
11,00,000
20,00,000 20,00,000
a) Goodwill 10,00,000
Machinery 49,50,000
Building 20,00,000
Vehicles 50,000
Current Assets 80,00,000
Equity Shares of T. Ltd. 10,20,000


Less : Liability
152,20,000
Long Term Loan 20,00,000
Current Liabilities 54,00,000 -(7,40,000)
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Corporate Financial
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114 )/ .12,00,00011,00,000a Net Assets value Equity share of T LtdFixed Assets
Current Assets
L        
 
: 6,00,00017,00,00017,00,000
5,000340ess Current Liabilities
Net Assets
Intrinsic Value  
 
  

) Re
340 3000
10,20,000b valuation of investmentEquity shares   

Illustration : 7
Z Ltd. has the following items appearing in it’s Balance Sheet as on 31st
March, 2010

1) The profit for the past three years ended 31st
March, 2008 Rs. 1,40,000
March, 2009 Rs. 3,25,000
March, 2010 Rs. 5,50,000
1) The profit shown above are after debiting
a) Goodwill @ Rs. 50,000 p.a.
b) Dividend on Prefer ence shares as applicable.
c) Dividend an Equity capital @ Rs. 10% in 2009 & @ Rs. 12% in 2010
2) The recent value of fixed assets revealed property is worth Rs.
5,00,000 & Machinery worth Rs. 25,00,000.
4) The investment are trade investment worth Rs. 2,50,00 0. Liabilities Rs. Assets Rs.
Shares Capital : Goodwill 3,50,000
Equity shares Rs. 10 10,00,000 Freehold property 4,50,000
10% Preference Shares Rs. 10 5,00,000 Plant & Machinery 12,50,000
Profit & Loss A/c 5,00,000 Investment 1,00,000
Bank Loan 10,00,000 Stock 5,00,000
Current Liabilities 1,50,000 Debtors 3,50,000
Bank & Cash 1,50,000
31,50,000 31,50,000
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115 Obsolete & worthless stock included above is Rs. 4,00,000. This can
also realize Rs. 50,000.
You are required to calculate –
a) F. M. P. applying weights.



b) Value Equity shares on basis of – capitalized value of F. M.
P. @ 8⅓%.
c) Intrinsic value of Equity shares.
Solution :
F. M. P.
2008
2009
2010
Add: Goodwill written off 50,000 50,000 50,000
Add : Equity share Dividend - 1,00,000 1,20,000
Net Profit (after dividend) 1,40,000 3,25,000 5,50,000
Weight 1,90,000
X 1 4,75,000
X 2 7,20,000 X 3 1,90,000 9,50,000 21,60,000
Pr).
33,00,000
6
5,50,000
) int
1Total oductsa Weighted AvgTotal of weights
FMPb Capitalised Value of ma ainable profitFMP after tax
NRR   

 
   
  00
5,50,000
183 ).
66,00,000. 6611,00,000c Values at Equity share on the basic of capitalized value ofCapital Value FMPFMPNo of Equity share
Rs share           
  

2008 - 1
2009 - 2
2010 - 3
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Corporate Financial
Accounting
116 d) Intrinsic Values :

..
26,00,000
1,00,00026Net Assets available to Equity Share holdersInstrisic valueNo of eq shares     
  Illustration : 8
A) Final Accounts of New Ltd. as on 31st March, 2011 revealed following
significant infor mation:
i) Share Capital (Fully paid-up)
Equity – 1,00,000 shares of Rs. 10 each.
12% Preference – 20,000 shares of Rs. 50 each.
ii) Reserve & surplus – Rs. 1,50,000
iii) Preliminary Expenses – Rs. 30,000
iv) The valuation of assets revealed that assets as per accounts are
undervalued by Rs. 2,50,000.
v) The average pre-tax profits of past three years was Rs. 5,00,000. Tax
applicable to @ 50%.
vi) It is anticipated that due to favourable market conditions, pre-tax
profit will increase by 20%.
vii) Equity shareholder s expect a return at 15%. Goodwill 3,50,000
Freehold property 5,00,000
Plant & Machinery 25,00,000
Investment 2,50,000
Stock (5,00,000
realisable) Debtors – 4,00,000 + 50,0001,50,000
3,50,000
Bank & Cash 1,50,000
42,50,000
Less Liabilities payable
Bank Loan 10,00,000
Current Liabilties 1,50,000 - 11,50,000 31,00,000Less : Preference Share Capital -5,00,000Net Assets available to Equity shareholders 26,00,000
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Financial Reporting
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117 Find the Fair Value of Shares :
A) Sem. Ltd. submits following information as on 31st March, 2011
i) Fixed assets (Tangible) Rs. 15,00,000
ii) Current assets Rs. 6,00,000
iii) Patent Rights Rs. 2,50,000
iv) Investment Rs. 1,00,000
v) Capital issues expenses Rs. 50,000
vi) Liabilities Rs. 4,00,000
vii) Capital comprise of 12,500 shares of Rs. 100 each fully paid.
It is ascertained that Patent Rights are valueless. Find Intrinsic Value
Solution :
A) Fair value of Equity shares of New ltd. as Intrinsic value
Step – 1 :
Equity shares 10,00,000
Preference shares 10,00,000
Reserves & surplus 1,50,000
Less : preliminary expenses - 30,000
Add : Assets undervalued 2,50,000
23,70,000
Less : Preference shares - 10,00,000
Net assets available for ESH 13,70,000

Step – 2 :
.
13,70,000
1,00,000
13.7
)Net Assets available for ESHIntrinsicValueNo of equity Shares
b Yield Value     






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118 Step – 3 :
Pr1001,80,00010010,00,00018Expected rate of dividendNet ofit available for ESH
Paid up Equity Capital      
 
Step – 3 :
/
18 101215
12 13.7) 12.852Expectedrate of Dividend Paidup value sharesYield valueNRR
c Fair Value        
 
      
B) Net Assets value of Sem Ltd.





.
18,00,000
12,500144Net Assest available for ESHIntrinsicValueNo of equity Shares     


Step. 1 : F. M. P. before tax 5,00,000 Increase 20% 1,00,000 6,00,000 (-) Tax 50% -3,00,000 F. M. P. after tax 3,00,000 (-) Preference Dividend -1,20,000 Net Profit are basic to Equity shareholder 1,80,000
Fixed Assets 15,00,000
Current Assets 6,00,000
Investments 1,00,000
22,00,000
Less : O/s Liabilities - 4,00,000 Net assets available for ESH 18,00,000 munotes.in

Page 119

Financial Reporting
Standards and Indian -AS

119 Illustration : 9
A Ltd. & K Ltd. propose to sell their business to a new company
being formed for that purposes.
The summarized Balanc e Sheet as on 31st December, 2011 & profits of the
companies for the past three years are as follows :
Liabilities A Ltd. K Ltd. Assets A Ltd. K Ltd. Ordinary shares
of 60,000 25,000 Freehold property 36.000 12.000
Rs. 1 each cost
Capital Reserve s NIL 15,000 Plant & Machinery at 32.000 18.000
cost less in dep.
General Reserves 39,000 12,000 Investment at cost NIL 10.000
Profit & Loss A/c 11,000 16,000 Stock in trade 11,100 8.950
Creditors 21,580 12,680 Debtors 8,800 6.400
Balance at Bank 43,680 25.330
1,31,580 80,680 1.31580 80.680
You are also given the following relevant information :
a) It is agreed :
i) That the properties & Plant and Machinery to be re-valued as
ii) follows :
A Ltd. K Ltd.
Rs. Rs.
Freehold property 44,800 14,400
Plant & Machinery 30,750 17,095

iii) That the value of stock be reduced by 10% & provision of 12½% be
made on debtors for b ad & doubtful debts.
iv) That goodwill be valued at two years purchase of the average annual
trading profits of the past 3 years, after deducting a standard profit of
10% on the net trading assets before revaluation or adjustment, on 31st
December, 2010.
b) Profi ts of K Ltd. include Rs. 600 income from the investment in each
of the three years. The market value of the investment as on 31st
December, 2011 was Rs. 10,000.

Net profit for the years ended A Ltd. Rs. K Ltd.
Rs.
31st December, 2009 17,45010,76031st December, 2010 19,34012,29031st December, 2011 21,47014,450munotes.in

Page 120

Corporate Financial
Accounting
120 You are required to prepare a statement how you would a arrive at the
intrinsic value per shar es to the nearest rupee of the ordinary share in (i) A
Ltd. ii) K Ltd.
Solutions : Valuation of Goodwill
Step – 1 :

Step – 2 :
Normal Rate of Return 10%
Step – 3 :
tan / Pr
) .1,10,000 10% 11,000
) . 58,000 5,800S dard Normal ofit Capital Employed NRRi A Ltd
ii K Ltd               
      
Step – 4 : Average Past Profit
17,450) . 19,4203
10,760 12, 290 14,450) . 11,9003
(600):int11,300i A Ltd
ii K Ltd
Less erest on investment     
        
   
Step – 5 :
.. .Pr . .19,420 11,300FMPAverage Past ofit A Ltd K Ltd       
   Capital Employed = Assets at realizable value – liabilities .
Assets at real value A Ltd. K Ltd
Freehold property 36,000 12,000
Plant & Machinery 32,000 18,000
Stock in trade 11,100 8,950
Debtors 8,800 6,400
Bank Balance 43,680 25,330
1,31,580 70,680
Less : Liabilities payable
Creditors
-21,580 - 12,680
Capital Employed 1,10,000 58,000
munotes.in

Page 121

Financial Reporting
Standards and Indian -AS

121 Step – 6 :
/ . . . tan Pr
. 19, 420 11,000 8, 420
. 11,300 5,800 5,500Super Excess profit F M P S dard ofitA Ltd
K Ltd              
    
Step – 7 :
. Pr
. 2 8,420 16,840
. 2 5,500 11,000Value of Goodwill No of years purchased Super ofitA Ltd
B Ltd             
    
B) Valuation of Shares :
Step – 1 :
Step – 2 :
.
1,32,180.60,000
2.203
78,000.25,0003.152Net Assets available for ESHIntrinsicValueNo of Equity Shares
A Ltd
K Ltd     
  

  



Intrinsic Value A Ltd. K Ltd
Freehold property 44,800 14,400
Plant & Machinery 30,750 17,095
Stock in trade 9,990 8,055
Debtors 7,700 5,600
Bank Balance 43,680 25,330
Investments NIL 10,000
Add : Goodwill 16,840 11,000

Less : Liabilities payable 1,53,760 91,480
Creditors - 21,580 -12,680
Net Assets available for Equity shareholders 1,32,180 78,800munotes.in

Page 122

Corporate Financial
Accounting
122 Illustration : 10
Vijay Ltd. furnishes the following information & request you to find
out–
i) Value of Goodwil l – on the basis of capitalization of F. M. P.
methods.
Liabilities Rs. Assets Rs.
Shares capital 10,000 10,00,000 Goodwill 2,50,000Shares of Rs. 100 each
General Reserves 3,00,000 Property 2,88,000Profit & Loss A/c 3,00,000 Equipments 4,00,000Workmen Fund for 1,40,000 Investment 2,00,000Compensation
Loans 2,00,000 Receivables 6,60,000Current Liabilities 4,60,000 Inventory 4,00,000 Bank & Cash 1,50,000 Capital Issues Expenses 52,000 24,00,000 24,00,000
Further Information :
a) The investments are earn marked to provide funds for
replacements as and when required.
b) The provision already deducted from are :
Depreciation on property Rs. 72,000
Depreciation on equipments Rs. 80,000
Bad Doubtful Debts Rs. 60,000

c) The property is worth Rs. 6,00,000 and equipments are worth Rs.
3,60,000, other assets are valued property.
d) The liability for workmen compensation is expected at Rs. 1,00,000.
e) The expected rate of return is @ 12%.
f) The profit of past three years (before tax @ 50%) have been –
Year ended on 31-3-2000 Rs. 5,60,000
31-3-1999 Rs. 5,46,000
31-3-1998 Rs. 6,20,000

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Financial Reporting
Standards and Indian -AS

123 g) The changes expected from ensuing year are : -
1) Increase rent for new office @ Rs. 18,000/ - p.a.
2) Increase in Directors Fees @ Rs. 24,000/ - p.a.
3) Reduction in publicity expenses @ Rs. 36,000/ - p.a.
h) For the purpose of valuation year end capital employed should
be considered.
Solution :
Step – 1 :
Capital Employed = Assets at realisable value –O/s liabilities.
Assets at real value
Property 6,00,000
Equipments 3,60,000
Investment 2,00,000
Receivables 6,60,000
Inventory 4,00,000
Cash & Bank 1,50,000
Less : Liabilities 23,70,000
Workmen Compensation Fund - 1,00,000
Loans - 2,00,000
Current Liabilities - 4,60,000 Capital Employed 16,10,000
Step – 2 : Re 12%Normal Rate of turn    
Step – 2 : 5,60,000 5,46,000 6, 20,000Pr3Average Past ofit    
 


munotes.in

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Corporate Financial
Accounting
124 Step – 4 :
F. M. P.
Average Past Profit 5,75,333
Less : Expenses to be incurred in future : Rent - 18,000
Less : Expenses to be incurred in future : directors Fees - 24,000
Add : Expenses no to incurred : Publicity / Expenses 36,000
F. M. P. before Tax 5,69,333
Less : Tax 50% - 2,84,667
F. M. P. after tax 2,84,666
Step – 5 :
int
100
2,84,66610012
23,72, 217Capitalized value of ma ainable profitFMP after tax
NRR     
 

Step – 6 : .23,72,217 16,10,000
7,62,217Value of Goodwill Capitalised value Average capital employed          

Illustration : 11
A shareholder of M Private Ltd. requests you to advise him about the fair
value of the Equity shares of the Company. the Company’s financial
position as on 31st December, 1997 is as under :
Liabilities Rs. Assets Rs.
Shares Capital : Fixed Assets (at cost)
20,000 6% Cum. Preference
Shares of Rs. 10 each 2,00,000
12,000 Equity Shares of Rs. 20 2,40,000 Goodwill 1,20,000
Each
Deb. Redemption Fund 40,000 Plant & Machinery 2,00,000
Profit & Loss A/c : Investment (at cost) 1,20,000
Bal. As on 1-1-1987 45,000 Current Assets
Profit for the year (before tax) 1,75,000 Stock 1,20,000
13,000
5% Debentures 2,00,000 Debtors 1,40,000
Creditors 1,67,000 Cash at Bank 1,52,000
Depreciation Fund (Plant etc.) 30,000 Land & Building 2,00,000
10,52,000 10,52,000munotes.in

Page 125

Financial Reporting
Standards and Indian -AS

125 The following information is relevant :
1) Goodwill is revalued at Rs. 1,45,000/ -.
2) Normal rate of return expected is 10%.
3) The share of the company are not freely transferable.
4) Investments are part of business assets.
5) Profit for the year as stated above are before annual transfer of Rs.
12,700 to Deb. Redemption Fund.
6) Income tax may be taken at 50% of the profit.
7) Dividend record of the company is not stable. Work out the fair value
of Equity shares as requested.
Work out the fair value of Equity shares as requested.
Solution :
A) IntrinsicValue :
B) Step – 1 :
Fixed Assets :
Goodwill 1,45,000
Land & Building 2,00,000
Plant & Machinery 2,00,000
Investment 1,20,000
Current Assets :
Stock 1,20,000
Debtors 1,40,000
Cash at bank 1,52,000 10,77,000







Less : liabilities
Debentures 2,00,000Creditors 1,67,000Depreciation Fund 30,000Provision for taxatior 65,000- 4,62,000
6,15,000
Less : Preference Share Capital - 2,00,000
Net Assets available for ESH 4,15,000munotes.in

Page 126

Corporate Financial
Accounting
126 Step – 2 :
.
4,15,000
1,20,00034.58 /Net Assets available for ESHIntrinsicValueNo of Equity SharesShare     
  
C) Yield Value
Step – 1 :
F. M. P. before tax 1,30,000
Less : Tax 50% - 65,000
F. M. P. after tax 65,000
Less : Appropriations
Dividend on Preference Shares - 12,000
Deb. Redemption Fund - 12,700
Net Profit available for ESH 40,300

Step – 2 :
..10040,0001002,40,000N P available for ESHExpected rate of DividendPaidup Equity Capital        
  
Step – 3 :
16.79 20
12
34.58 27.98
2Expectedrate of Dividend Paidup Equity CapitalYield ValueNRR
Fair value of Equity Shares       


     
 


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Financial Reporting
Standards and Indian -AS

127 Illustration: 11
A Ltd. presents the following Balance Sheet on 31st December, 2011.

It is observed that fixed assets are undervalued by Rs. 50,000.
The current assets are overvalued by Rs. 3,000. The assets are to be valued
properly.
It is proposed to issue fully paid shares by capitalization of General
Reserves in ratio of one share for three shares held. Find the value of
shares.
i) Before issue of bonus shares; and
ii) After issue of Bonus shares.
Value Per Fully Paid Equity Share (before Bonus Issue)
4,67,000.15.57. 30,000Net Assets for Equity ShareholdersRsNo of Equity Shares     
Value Per Fully Paid Equity Share (after Bonus Issue)
4,67,000.11.67. 40,000Net Assets for Equity ShareholdersRsNo of Equity Shares     
Note : No. of Bonus Shares Issued : ⅓ of 30,000 = 10,000 Total No. of Shares = 30,000 + 10,000 = 40,000 Shares. Liabilities Rs. Assets Rs.
Shares Capital (Rs. 10/- each) 3,00,000Assets 4,50,000
Reserves 1,20,000Current Assets 30,000
Loans 50,000
Current Liabilities 10,000
4,80,000 4,80,000
Solution :
A & Co. Ltd.
Valuation of Equity Shares (Net Assets Method)
Gross Assets Rs. Rs.
Fixed Assets (4,50,000 + 50,000) 5,00,000 Current Assets (30,000 – 3,000) 27,000
Less Loans
50,000 5,27,000 Less Current Liabilities 10,000 (60,000) Net Assets available to Equity Shareholders 4,67,000 munotes.in

Page 128

Corporate Financial
Accounting
128 Illustration : 12
O. M. Limited submits the following information as on 31st March,
2010.
Rs.
i) Fixed Assets (Tangibles) 15,00,000
ii) Current Assets 16,00,000
iii) Patent Rights 2,50,000
iv) Investments 1,00,000
v) Capital Issue Expe nses 10,000
vi) Liabilities 4,00,000
Capital Comprises of 25,000 shares of Rs. 100/- each fully paid. It is
ascertained that Patent Right are valueless. Ascertain the value of shares
on Asset Back ing method.
Oct 97, adapted)
Solution :
O. M. LIMITED (Y. E. 31-3-2010)
Valuation of Equity Shares (Net Assets Method)







.
.28,00,000.11225,000Net Assets for Equity ShareholdersValue Per Fully Paid Equity ShareNo of Equity Shares
RsRs        
   
Note : Patents being valueless and Capital Issue Expenses being an
intangible asset are ignored while computing net assets value.
Illustration : 13
From the following figures calculate value of a share of Rs. 10 on (i)
dividend basis, and the market expectation being 12% (N. R. R.) Gross Tangible Assets Rs..
Fixed Assets 15,00,000
Current Assets 16,00,000
Investment 1,00,000
32,00,000
Less : Liabilities 4,00,000
Net Assets available to Equity Shareholders 28,00,000 munotes.in

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Financial Reporting
Standards and Indian -AS

129 50,000 Equity Shares of Rs. 100 each were from 1st January 2006
Solution :
i) Value of share on dividend basis :
The div idend rate on the simple average is 65/4 or 161/4% . But since the
dividend has been rising it would be better to take the weighted average
which come to 17.6% thus :
Dividing 176 by 10, we get 17.6%
The value of the share on the basis of dividend (weighted average)
17.610 14.6712Average Rate of DividendFaceValueExpected Rate of Dividend             
ii) Pr ( . . )Weighted Average ofit F M P 
Pr ( . . )
Pr
25,60,0002,56,00010100.. ....Weighted Average ofit F M P
Total oduct
Total Weight
Capitalized value of F M PNRR 
 
       1002,56,000...NRR  .. ..Capitalized value of F M PValue of Equity ShareNo of Equity Share      
21,33,333.42.6750,000Rs  
Year ended
31st March Capital Employed
Rs. Profit
Rs. Dividend Weights
2008 5,00,000 80,000 12 1
2009 8,00,000 1,60,000 15 2
2010 10,00,000 2,20,000 18 3
2011 15,00,000 3,75,000 20 4
Year ended Rate Weight Product Profit Product
31st March (A x D)
2008 12 1 12 80,00 080,0002009 15 2 30 1,60,0003,20,0002010 18 3 54 2,20,0006,60,0002011 20 4 80 3,75,00015,00,000 10 176 25,60,000 munotes.in

Page 130

Corporate Financial
Accounting
130 Illustration : 14
Balance Sheet of Anand Ltd. as on 30-6-2010
Liabilities
Share Capital : Rs.
5,000 shares of Rs. 50 each 2,50,000
General reserve 1,40,000
Profit and Loss account 1,32,000
Sundry creditors 1,08,000
Income -tax Provision 80,000
7,10,000 Assets :
Land and buildings 1,90,000
Plant and Machinery 2,00,000
Patents and trade marks 25,000
Stock 50,000
Debtors 75,000
Bank balance 50,000
Preliminary expenses 10,000 7,10,000
The expert valuer valued the land abd buildings at Rs.
3,40,000; goodwill at Rs. 2,50,000; and plant and machinery at Rs.
1,80,000. out of the total debtors, it is found that debtors of Rs. 6,000
are bad. The profits of the company have been as follows :




The company follows the practice of transferring 25% of profits to general
reserve. Considered depreciation on Land / Building @ 5%, plant -
Machinery @ 15%. Similar type of companies earn at 12.5% of the value
of their shares. Ascertain the value of shares of the company under :
i) Intrinsic value method;
ii) Yield value method; and
iii) Fair value method.
iv) directors decided to issue right shares 1 share for every 5 shares of
Rs 50 each at Rs. 100. find fair value after right issue. Rs.
31-3-2008 1,20,00031-3-2009 1,75,00031-3-2010 1,55,000munotes.in

Page 131

Financial Reporting
Standards and Indian -AS

131 v) Anand Ltd.
Valuation of shares











7,28,000(). 50,000.145.60Net assetsIntrinsic value of shares each shareNo of shares
Rs        
  
ii) Yield value method Rs.
Total profit of last three years 4,50,000
Less : Bad debts (6,000)
4, 44,000 . 4, 44,0003RsAverage profit     1,48,000
Add. Decrease in depreciation on plant and 3,000
Machinery say @ 15% on Rs. 20,000
Less : Increase in depreciation on land and
building say @ 5% on Rs. 1,50,000 7,500
Average profit
Less : Transfer to reserve 1,43,500
@ 25% of Rs. 1,43,500 (33,875)
Profit available for dividend 1,07,625 i) Intrinsic value method
Asse ts
Rs.
Rs.
Land and Buildings 3,40,000
Goodwill 2,50,000
Plant and machinery 1,80,000
Patents and trade marks 25,000
Stock 50,000
Debtors less bad debts 69,000
Bank balance
10,000 9,24,000
Less : liabilities Sundry
creditors
1,08,000
Provision for tax
88,000 (1,96,000)
Net Assets 7,28,000
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Accounting
132
1,07,625. . . 100 43.05%2,50,000
.. .
43.055012.50172.20Rate of F M P
Yield value of each share
Rate of F M PPidup value of each shareNormalrate of return        
  
     
 

)
2
.145.60 172.20 317.60) .158.9022
)iii Fair value methodIntrnsic value Yield vluefair value of each share
Rsiv Rs
v Value of Equity share after Right Issue       
       
   

.
8, 28,000
6,000.138Net Asset available to Equity ShareholdersIntrinsic valueNo of Equity SharesRs      
 
.. .. . . 1001,07,625100 35.88%3,00,000Yield ValueFMPFMPPaidup Equity Capital     
   No. of
Shares Equity Share
Capital Rs. Net Asset Rs.
Before Right Issue
Add : Right share, 1 share for
every 5 shares of Rs. 50 each @ Rs.
100 5,000
1,0002,50,000
50,0007,28,000
1,00,000
After Right Issue 6,000 3,00,000 8,28,000
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133 .. .
...
35.885012.50
.143.52
2
138 143.52
2Yield Value
Rate of F M PPaidup value of a Equity ShareNRR
Rs
Intrinsiv Value Yield ValueFair Value      
 
 
    

= Rs. 140.78
Illustration : 15
Balance Sheet of AB Ltd. as on 31st March 2010

Land and buildings to be valued at Rs. 9,00,000. The company’s earnings
were as follows:
Year ended 31stMarch Profits before tax
(Rs.) Tax paid
(Rs.)
2006 3,00,000 80,000
2007 4,00,000 1,60,000
2008 1,00,000 Loss 40,000 (Strike)
2009 5,00,000 2,30,000
2010 5,50,000 3,00,000

The company paid managerial remuneration of Rs. 60,000 per annum
but it will become Rs. 1,00,000 in future. There has been no change in
capital employed. The company paid dividend of Rs. 9 per share and it will
maintain the same in future. The company propos es to build up a plant
rehabilitation reserve @ 15% of N. P. A. T. dividend rate in this type of Liabilities Rs. Assets Rs.
8,000 Equity Shares Land and Building 5,00,000
of Rs. 100 each 8,00,000Plant & Machinery 6,00,000
4,000, 9% 4,00,000Paten ts 2,00,000
Preference shares Sundry debtors 3,00,000
of Rs. 100 each W. I. P. and Stock 5,00,000
10% Debentures 2,00,000Bank Bal. 1,00,000
Reserves 4,00,000
Sundry Creditors 4,00,000
22,00,000 22,00,000
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134 company is fluctuating and the asset backing of an Equity share is about 1 -
½ times. The Equity shares with an average dividend of 10% sell at par.
(Tax rate is assumed to be 50%). Find yield value of Equity shares
Solution :
For calculating average maintainable profits in 2008 -09 not considered
because of low profits due to abnormal reason.







.1,51,00 100.1,51,000 10%10
15,10,000188.758,000RsRs capitalised at Rs
The value of Equity share will be               
Illustration : 16
Balance Sheet of Kaka Ltd. as on 31.12.2010 was as under: Year ended Profits before tax Weight Product
31st March (Rs.) Rs.
2006 3,00,000 1 3,00,0002007 4,00,000 2 8,00,0002008 - - -2009 5,00,000 3 15,00,0002010 5,50,000 4 22,00,000 10 48,00,000 Weighted average : (48,00,000/10) 4,80,000
Adjustment :
Less : Increase in managerial remuneration 40,000
4,40,000
Less : Tax @ 50% 2,20,000
Profit available for distribution 2,20,000
Less : Rehabilitation Reserve (15% estimated) 33,000
1,87,000
Less : dividend on Preference Shares 36,000
Profit available for distribution to Equity shareholders 1,51,000
Liabilities Rs. Assets Rs.
Equity share Capital (Rs. 10) Building 12,00,000
Rs. 10 paid up per share 8,00,000 Plant & Machinery 14,00,000
Rs. 5 paid up per share 7,00,000 Sundry Debtors 10,10,000
9% preference share Capital 4,00,000 Stock 2,50,000
(Rs. 100)
Reserve 13,00,000 Cash and Bank 40,000
Sundry Creditors 7,00,000
39,00,000 39,00,000munotes.in

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135 Profit and dividend in last three years were as under:

Land and buildings are worth Rs. 24,00,000. Managerial remuneration is
likely to go up by Rs. 40,000 p.a. Income tax may be provided at 40%.
Equity shares of companies in the same - industry with dividend rate of
10% are quoted at per. Kaka Ltd. is a going concern and it will call the
unpaid part of share capital very shortly.
Find the most appropriate value of an Equity share assuming that
a) Controlling interest is to be transferred.
b) Only a few shares are to be transferred.
Ignore goodwill value, depreciation adjustment for revaluation and the
need of transfer to General Reserve.
Solution
Future Maintaina ble Profits




56,80,000Pr 9,46,6676Weighted Average ofit     
Less : Increase in Managerial Remunerations (40,000)
Profit Before Tax 9,,06, 667
Less : Tax @ 40% (3,62,667)
Profit After Tax (5,44,000)
Less : Preference Dividend (36,000)
Profit for Equity Shareholders 5,08,000
(a) Valuation of Controlling Interest


Year Profit before tax Rs. Equity Dividend Weights
2010 10,20,000 20% 3
2009 9,50,000 16% 2
2008 7,20,000 15% 1
Year Profit Before Tax Weight Product
2010 10,20,000 3 30,60,000
2009 9,50,000 2 19,00,000
2008 7,20,000 1 7,20,000
6 56,80,000
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136 First Method Capitalisation of Maintainable Profit @ 10%
1005,08,000 .50,80,00010Capitalised Value Rs      : 1,40,000 5 70,00057,80,000Add Notional call on partly paid shares
All Fully paid shares after Notional call        
  
     80,000 1, 40,000.
57,80,000. 26.272,70,000
26.27 5shares
Value of Fully paid share Rs
Value of partly paid share 
 
         
           . 21.27Rs
Net Assets (after revaluation) Second Method – Net Assets Basis
(39,00,000 + Appropriation Building 12,000 = 51,00,000
Add : National call on shares 7,00,000 Less : Creditors 7,00,000 58,00,000 Less : Preference Share Capital 4,00,000 11,00,000 Assets for Equity Shareholders 47,00,000 47,00,000. 21.362, 20,00021.36 5.00 .16.36Value of Fully paid shares Rs
Value of Partly paid share Rs         
            
26.27 21.3623.822
21.27 16.36.18.822Fair value of fully paid share
Fair Value of Partly paid share Rs      
         
)
20 16 1517%3
1710 .1710
175 .8.5010b Valuation of Few Share
Average rate of dividendValue of Fully Paid Share Rs per shareValue of Partly Paid Share Rs          
          
         
Illustration : 17
The Final Accounts N Ltd. As on 31st March, 2010 revealed following
significa nt information :
i) Share Capital (Fully paid up ) -
Equity – 2,00,000 Shares of Rs. 10 each, 10% Preference 30,000
Shares of Rs. 100 each munotes.in

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137 ii) Reserve and Surplus – Rs. 7,50,000.
iii) Preliminary Expenses – Rs. 30,000.
iv) The valuation of assets revealed that assets as per accounts are
undervalued by Rs. 6,50,000.
v) The average pre-tax profits of past three years was Rs. 10,00,000.
Tax applicable to company is @ 40%.
vi) It is anticipated that due to favourable market condition, pretax
profit will increase by 20%.
vii) Equity shareholders expect a return at 15%. Find the FAIR VALUE
of Shares.
Solution :
1) Valuation of Shares
Rs. Rs.
i) Capital Employed :
20,00,000
30,00,000
7,20,00057,20,000 6,50,000 Equity Capital
10% Preference
Reserves and Surplus 7,50,000
Less : Preliminary expenses 30,000
Add : Appreciations
Net Assets

ii) Future Maintainable Profit :
Pre Tax Profit
Add : Expected to Increase

Less : Tax @ 40%
Less : Preference Dividend
Future Maintainable Profit 10,00,000 2,00,000 63,70,000
7,20,000
3,20,00012,00,000
4,80,000
4,20,000

iii) a) Intrinsic Value of Equity Shares
.,
63,70,000 30,00,000
2,00,000
33,70,000.16.852,00,000Net Assets for Equity SharesholdNo of Equity shares
Rs  

   munotes.in

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Corporate Financial
Accounting
138 ) ) 1004,20,00010020,00,00021%FMPb i Rate of FMPPaidup equity capital        
  )2110 .1415ii Yield value per shareRate of FMPFaceValue of one Equity ShareNRR
Yield Value Per Share Rs        
      
)2
16.85 14
2.15.43IntrinsicValue Yield Valueiii Fair ValueRs     
 
b) Gem Ltd. submits following information as on 31st
March, 2011.

Capital comprise of 12,500 shares of Rs. 100 each fully paid. It is
ascertained that Patent Rights are valueless.
Ascertain the value of Shares on asset backing method.
Solution :
Valuation of Shares on Assets Backing Method :
a) Total Value of Assets :
Fixed Assets Rs. 15,00,000 Rs. Current Assets 6,00,000
Investments 1,00,000 22,00,000 b) Less : Liabilities : (-) 4,00,000 Net Assets available to Equity Shareholders 18,00,000 c) Value Per Share :
Fixed Asset (Tangible) 15,00,000 Investment 1,00,000
Current Assets 6,00,000 Capital issues
Patent Right 2,50,000 Expenses 50,000
Liabilities 4,00,000
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139 .
18,00,000
12,500
.144 /Net Assets as aboveAssets Backing MetodNo of Equity SharesValueRs Equity Share     
 
   
Illustration : 18
Mrs. Tata intends to invest Rs. 10,35,000 in Equity shares of B Ltd. and
seeks your advice as to the maximum numbers of shares she can
purchased on fair value of the shares to be determined by you from
following informa tion is available :
1. Issued and paid up Capital
10% Preference shares of Rs. 100 each 12,00,000
Equity shares of Rs. 5 each 60,00,000 /
Reserves and surplus 92,00,000
2. Average Net Profit of the company is Rs. 29,00,000, after tax
@ 50%.
3. Expected normal yield is 12% in case of such Equity shares.
4. Net assets on revaluation are worth Rs. 5,20,000 more than
the amounts at which they are stated in the books.
5. Goodwill is to be calculated @ 3 years purchase of super
profits.
6. Revised tax rate likely to be 40%.
7. Compen sation payable to workers not accounted Rs. 50,000.
Solution :
1. Goodwill = Super purchase
= 9,09,000 x 3 = 27,28,800

2. F. M. P. Average profit after Tax 29,00,000
Add : Income Tax @ 50% 29,00,000
N. P. B. T. 48,00,000
Less : Inco me Tax @ 40% 19,20,000
F. M. P. 28,80,000


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Corporate Financial
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140 3. Average Capital employed 72,00,000
Share capital at the end of the year 92,00,000
Reserved and Surplus 5,20,000
Add : revaluation Profit 1,69,20,000
Less : Compensation payab le 50,000
1,68,70,000
Less : ½ of the profit earned (9,00,00 ½ ) (4,50,000)

A. C. E. during the year 1,64,20,000
. . . 12Pr . . . 1,64,20,000100 100Pr . . . Pr
28,80,000 19,70,400 9,09,600NRRNormal ofit AC E
Super ofit F M P Normal ofit          
        
  
ii) Valuation of Shares
a) Intrinsic Value
1. Amourn available to Equity Sh areholders

2..
1,83,98,800
12,00,000.15.33Amount available to Equity ShareholdersIntrinsicValueNo of Equity SharesRs      
 



Rs.
Net Assets at Market Value 1,68,70,000 Add : Goodwill 27,28,800 Net Assets available to shareholder 1,95,98,800 Less : Claims of Preference Shareholders 12,00,000 (Preference Share Capital)
Amount available to Equity Shareholders 1,83,98,800 munotes.in

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141 b) The Yield Value .1. . . .Pr 28,80,000: PrRs
FMP
Average ofit
Less eference Dividend 
  
  1012,00,000 (1, 20,000)100. . . 27,60,000FM P 
  
.. .2. . . 10027,60,000100 46%60,00,000FMPRate of M PPaidup Equity Capital         
  
.. .3....
46
12Rate of F M PYield Value Amount paid per Equity ShareNRR        
  )15.33 19.172217.25c Fair ValueIntrinsic Value Yield value       ). :10,35,000
17.25
60,000d No of shares to be aquiredInvestment
Fair Value     

Illustration : 19 (When Goodwill and Share Valuation asked)
The Balance Sheet of Ketan Ltd. as on 31-12-2010 was as under :
Liabilities Rs. Assets Rs.
Equity Share Capital : Goodwill 60,000 Share of Rs. 10 each 2,00,000 Fixed Assets 1,00,000
Shares of Rs. 5 each 1,00,000 Stock 1,20,000
General Reserve 40,000 Debtors 1,45,000
P L A/c 10,000 Cash 10,000 Gratuity Fund 15,000 Prepaid Expenses 2,000 Workmen’s P.F. 5,000 Preliminary Expenses 3,000 Depreciation Fund 10,000
Trade Creditors 25,000
Liabilities for Expenses 5,000
Bank Overdraft 30,000
4,40,000 4,40,000munotes.in

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Corporate Financial
Accounting
142 A shareholder holding 500 shares of Rs. 10 and 300 shares of Rs. 5 wants
to dispose of all the shares.
Dividends paid for last 3 years were 12%, 11%, & 12%.Normal
expectation is 10%
Fixed assets are worth Rs. 80,000. goodwill is to be increased to
the Average of book value and a calculation made at 4 years’ purchase of
average super profit for the last 3 years. Debtors are considered good
except for Rs. 3,000. Liabilities for expenses are no longer required. On
the other hand, there is a claim for bonus amounting to Rs. 10,000 and
it is likely to be paid for. Profit for three years after taxation were Rs.
35,000, Rs. 48,000 and Rs. 46,000.
Find out the break up value, market value & fair value of the above 2
types of shares.
Solution :
Goodwill is equal to the average of B. V. of goodwill and goodwill at
average super profit. .35,000
1, 29,000Pr 43,0003RsAverage ofit



     
Rs.
Average Profit 43,000 Less : i) Bad Debts 3,000
ii) Claim for Bonus 10,000 13,000 30,000 Add : Liability for Expenses no longer required + 5,000 F. M. P. 35,000 ...)P r . .100MR Rii Normal ofit C E    



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Financial Reporting
Standards and Indian -AS

143 A. C. E. :

Assumption :
It is assumed that profit is withdrawn from business. Therefore tangible
capital at the end of the year considered equal to average capital
employed during the year. . . . 2,69,000...Pr . . .100
102,69,000 26,900100Therefore AC ENRRNormal ofit A C E    
  
Pr . . . Pr
35,000 26,900 8,100
Pr 4)Super ofit F M P Normal ofit
Super ofitrevised Goodwill       
  
  
Re
2
60,000
2
92, 400
2
46,200Goodwill for valuation of sharesBook value of goodwill vised Goodwill       



Rs.
Tangible Trading Assets at Market Value
Fixed Assets 80,000 Stock 1,20,000 Debtors 1,45,000
Less : Bad Debts - 3,000 1,42,000 Cash 10,000 Prepaid Expenses 2,000 Total Assets 3,54,000 Less : Liabilities
Gratuity Fund 15,000
Workmen’s P. F. 5,000
Creditors 25,000
Bank Overdraft 30,000
Bonus Payable 10,000 85,000 Net Tangible Assets 2,69,000 munotes.in

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Corporate Financial
Accounting
144 1. Break Up Value (Intrinsic Value)

Rs.
i) Amount available to Equity Shareholders
Net Tangible Trading Asset 2,69,000 Add : Goodwill 46,200 Net Amount of Assets available to equity Shareholders 3,15,200
Note : The Net Assets available Rs. 3,15,200 should be distributed
between the 2 types of Equity shareholders in the proportion of
their paid up value. Pr :2,00,000:1,00,0002:1oportion 
210 3,15, 2003
2,10,133
.5Amount available to Rs Equity shareholders
Amount available to Rs shareholders          
 
     13,15, 2003
1,05,067  
 
).
2,10,133.10 10.5120,000
1,05,067.5 5.2520,000Amount available to Equity Shareholdersii Value of shareNo of equity shares
For Rs
For Rs share      
    
      2. ( )) . . . ( ) 35,000
.. .) . . . 10035,0001003,00,000Market Value Yield Valuei F M P as per I
FMPii Rate of F M PPaidup Equity capital           
  
11.67%
.. .)...
11.67.10 10 11.6710
11.67.5 5 5.8310Rate of F M Piii Market value Amount paidup per shareNRR
For Rs Share
For Rs Share        
      
       munotes.in

Page 145

Financial Reporting
Standards and Indian -AS

145 3.2
10.51 11.67.10 11.042
5.25 5.83.52Break up value Market valueFair Value
For Rs Share
Rs share       
     
   
Illustration : 20 (When Equity Shares of different paid up values are
given)
From the Balance Sheet of Machine Tools Company Limited as at 31st
March, 2011 the following figures have been extracted.
Rs.
Share capital
9% Preference Shares of Rs. 100 each 3,00,000 10,000 Equity Shares of Rs. 10 each Rs. 5.00 paid up 50,000 10,000 Equity Shares of Rs. 10 each Rs. 2.50 paid up 25,000 10,000 Equity Shares of Rs. 10 each fully paid up 1,00,000 4,75,000 Reserves and Surplus
General Reserve 2,00,000 Profit and A/c 50,000 7,25,000
On a revaluation of assets on 31st March, 2011 it was found that they had
appreciated by Rs. 75,000 over their value in the aggregate.
The articles of association of the company provide that in case of
liquidation, Preference shareholders would have a further claim to 10% of
the surplus assets if any.
You are required to determine the value each Equity share assuming that
liquidation of the company has to take place on 31st March, 2011 and that
the expenses of winding up are nil.



munotes.in

Page 146

Corporate Financial
Accounting
146

Solution :
1. Surplus Asset
Re
7,25,000
ReBook Value of Net Assets Paid up capital and serves and surplusvised Value of Net Assets Book Value Appreciation           
       
  
 

Revised value of Net Assets Less :
Preference Share Capital Rs.
8,00,000 (3,00,000) 5,00,000 Less : Equity Share Capital (50,000 + 25,000 + (1,75,000) 1,00,000)
Surplus 3,25,000 Less : Preference Sha reholders (10% of Surplus 32,500 Assets)
Surplus available to Equity Shareholders 2,92,500 Amount payable to Equity Shareholders
Towards Capital Rs. 1,75,000 Towards Surplus Rs. 2,92,500 Total amount available to Equity Shareholders Rs. 4,67,500 Total Paid up Capital Rs. 1,75,000 ...
4,67,500. . . 2.50 2.50 .6.681,75,000i e Value of share of Different paid up valueAmount availableAmt paidup per shareTotal Capital
i e for Rs Rs
Rs         
     
4,67,500.5.00 5.00 .13.361,75,000
4,67,500.10.00 10.00 . 26.711,75,000Rs
Rs Rs    
     


munotes.in

Page 147

Financial Reporting
Standards and Indian -AS

147 Alternatively, share can also be valued as follows :


Value of Fully Called – Up Rs. 10 Rs.
19.75
Partly Called –Up (Rs.5) 19.75 Less : Uncalled (Rs. 5. 00) (5.00) = 14.75 Value of Fully Called Up (Rs. 2.50) 19.75. Less : Uncalled (Rs. 7.50) 7.50 12.25 Illustration : 21
Below is given the Balance Sheet of Anand Ltd. as at 31st December
2010










Rs.
Called up Capital 1,75,000
Un-Called Capital
10,000 shares @ Rs. 5.00 50,000
10,000 shares @ Rs. 7.50 75,000
i.e. Total - 30,000 shares 3,00,000
Add : Surplus 2,92,500
Total Amount available to Equity shareholders 5,92,500
Value per Share 5,92,500 = 19.75
30,000
Liabilities Rs. Assets Rs.
Equity shares of Goodwill 20,00 0 Rs. 10 each 2,00,000 Machinery 1,10,000
Less : Calls in Land and Building 1,20,000
Arrear (Rs. 2 for final Furniture and Fixtures 60,000 call) 5,000 1,95,000 Vehicles 80,000 6% Preference Shares Investments 80,000 of Rs. 10 each 1,00,000 Stock in Trade 55,000 Less : Calls in Arrear Sundry Debtors 90,000 (Rs. 2 for final call 1,000 99,000 Cash at Bank 10,000 General Reserve 80,000 Preliminary Expenses 10,000 P & L A/c 16,000
Bank Loan 60,000
Sundry Creditors 1,55,000
Bills Payabl e 30,000
6,35,000 6,35,000 munotes.in

Page 148

Corporate Financial
Accounting
148 For the purpose of valuation of shares, Goodwill is to be considered
on the basis of 2 years’ purchase of the super profits based on
average profit of last 4 years. Profits are as follows :
2007 : Rs. 80,000; 2008 Rs. 90,000; 2009 Rs. 1,05,000; 2010
Rs. 1,10,000
In a similar business normal return on capital employed is 5%.
Fixed assets are worth 30% above their actual book value. Stock is
over-valued by Rs. 5,000. Debtors are to be reduced by Rs. 1.000.
All trade investments are to be valued at 10% below cost. Of the
investments, 10% are trade and the balance non -trade investments
were acquired on 1-1-2010 and the rest on 1-1-2008
A uniform rate of dividend of 10% is earned on all investments.
The following furthe r information is relevant :
i) In 2008 a new machinery costing Rs. 10,000 was purchased but
wrongly charged to revenue. (No rectification has yet been made for
above).
ii) In 2009, some old furniture (Book Value Rs. 5,000) was disposed of
for Rs. 3,000. You are r equire to value each fully paid and partly paid
Equity share. (Depreciation is charged on machinery @ 10% on reducing
balance system. Ignore Taxation and Dividend)
(M. U. Nov. 1995)
Solution
1. ./ 80,000: (8,000)(10% 80,000)RsInvestment as per B S
Less Trade Investment
of    
   
  72,000108,000100Non Trade Investments
Loss onValuation of Trade Investment 
   
       800(8,000 800) 7,200:5% 72,000 1 1Value of Trade Investment
Non Trade Investment
Less of acquired on     
         2009 3,6001 1 2008 68, 400Acquired on
     

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149 2.
Dr. Non – Trade Investmen t A/c

Rate of Interest on non-trading investment is also 10% interest. .1031 12 08 68, 400 6,840100
1031 12 09 72,000 7,200100
1031 12 10 7,200100Date Interest Rs     
    
    720
4. Machinery
i) Rs. 10,000 should be added to profit of 2008
ii) As machinery was charged to Profit and Loss Account i.e. to
revenue, no depreciation on it was provided.
iii) The profits reported in the problem are before providing for
depreciation on machinery of Rs. 10,000. while calculating F.
M. P. the errors is to be rectified and depreciation is to be provided
@ 10% p.a. on Reducing Balance Method. Date particulars Rs. Date particulars Rs. 2008 To Bank 68,400 2008 By Balance c/d 68,400
Jan. 1 Dec. 31
68,400 68,400
2009 2009
Jan. 1 To 68,400 Dec. 31 By Balance c/d 72,000
Balance
c/d
Jan. 1 To Bank 3,600 --
72,000 72,000
2010 2010
Jan. 1 To 72,000 Dec. 31 By Balance e/d 72,000
Balance
b/d
72,000 72,000
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150 Depreciation of Machinery
Rs. 2008 Cost of machinery 10,000 Less : Depreciation (10% of 10,000) 1,000 9,000 2009 Less : Depreciation (10% of 9,000) 900 8,100 2010 Less : Depreciation (10% of 8,100) 810 Written down Value to be considered 7,290
5. Loss on Sale of Furniture
(5,000 – 3,000 = 2,000)
Rs. 2,000 loss on sale of furniture is an abnormal loss which should
be added to the Profit of 2000 for d eciding F. M. P. Super Profit = F.
M. P. – Normal Profit.
iii) F. M. P.
2007
Rs. 2008
Rs. 2009 Rs. 2010 Rs.
Reported Profits 80,000 90,000 1,05,000 1,10,000 i) Over Valuation of Stock -5,000 ii) Reduction in Debtors -1000 iii) Loss on Revaluation of
Trade Investment -800 iv) Interest on Non -trade
Investment
-6,840 -7,200 -7,200 v) Machinery charged to
Revenue +
10,000
vi) Depreciation on Machinery - 1,000 -900 -810 vii) Loss on Sale of Furniture - + 2,000 - Trading Profits 80,000 92,16 0 98,900 95,190 munotes.in

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151 80,000 92,160 98,900 95,190Pr4
3,66,250
4
91,563Average Trading ofit     
 
 
...)P r100NRRii Normal ofit ACE      
Average Capital Employed

Less : Over
Valuation Debtors
Less : Reduction
Bank Balance

Less : Liabilities
Bank Loan
Sundry
Creditors
B/P
Tangible Trading Capital at the end of the year -5,000 50,000 90,000
-1,000 89,000 10,000 6,46,677 60,000
1,55,000
30,000 2,45,000 4,01,677 Rs.
Tangible Trading Assets
Machinery 1,10,000 Add: W.D.V. of Machine charged as Expense 7,290 1,17,290 Land & Building 1,20,000 Furniture & Fixtures 60,000 Vehicles 80,000 Book Value of All Fixed Assets 3,77,290
Add : 30% of Book Value 1,13,187
Revised Value 4,90,477 Trade Investment 7,200 Stock in Trade 55,000
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152 . . . 4,01,677Pr . . .100
54,01,677 20,083.85 20,084100
Pr . . . PrAC ENRRNormal ofit AC E
Super ofit F M P Nomial ofit      
   
   

Pr .
71, 479 2 1,42,958Goodwill Super ofit No of years purchase
     
   
Net Assets Value (Intrin sic Value)
Amount available to Equity Shareholders
Rs.
Net Tangible Trading Assets 4,01,677 Add: Goodwill 1,42,958 Non Trading Investments 72,000 Calls in Arrears : Equity 5,000 Preference 1,000 6,000 6,22,635 Less : Preference Share Capital 1,00,000 Amount available to Equity Shareholders 5,22,635
.
5,22,63526.1320,000Amount available to Equity ShareholdersNet AssetsValue of shareNo of Equity Shares
Value of partly paid share value of fully pai        
  
       
26.13 2.00d calls unpaid per share   
  
 


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153


Illustration 22 :
Find out fair value of each share of Ekar Ltd. from the following
information :
a) Balance sheet as on 31st December, 2007
Liabilities Rs. Asse ts Rs.
5,000 Equity shares 5,00,000 Fixed Assets 11,99,000 of Rs. 100 each fully
paid up
Reserves 8,00,000 Cash 70,000 Loans 4,00,000 Other current assets 6,00,100 Creditors 1,50,000 Preliminary Expenses 30,900 Workmen’s saving 50,000
Accou nts
19,00,000 19,00,000
b) Goodwill to be valued at 3 years purchases of super profits calculated
on the basis of weighted average profits of last 5 years.
c) In similar business, normal return on capital employed is 15%.
d) Profits for last 5 years, after tax are as follows;

e) i) Druning 2005 a heavy repairs was done to machinery for
Rs. 50,000, which was wrongly debited to Revenue. It is to be
capita lized for the purpose of goodwill and shares, valuation taking
depreciation @ 10% on W. D. V.
ii) In 2006, closing stock was overvalued by Rs. 2000.
iii) In 2008, there was fire which resulted in loss of Rs. 8,000, which was
debited to profit & Loss A/c.
iv) In 2007, the company have sold some fixed Assets resulting into
profit of Rs. 25,000, credited to P/L A/c. Year 2009 2008 2007 2006 2005
(Rs.) Rs.N.P.A.T. 2,61,000 2,35,000 3,21,000 2,10,000 2,40,000 munotes.in

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Accounting
154 v) Additional Rent of Rs. 6,000 p.a. will be payable.
vi) Directors fees paid upto now was Rs. 10,000 p.a. but hence forth it
will be Rs. 13,000 p.a.
f) Income Tax upto now was at the rate of 50%, but hence forth it
will be 40%
g) i) Fixed Assets are overvalued by 10%.
ii) Other Current Assets are undervalued by 15%.
h) N. R. R. for valuation of shares 10%.
i) Company has practice of transferring Rs. 15,000 to General Reserves
every year.
Solution :
A) Valuation of Goodwill :
Statement Showing adjusted profit

Particulars 2005 2006 2007 2008 2009
N. P. A. Tax 2,40,000 2,10,000 3,21,000 2,35,0002,61,000(A) Income Tax 2,40,000 2,10,000 3,21,000 2,35,000 2,61,000N. P. B. Tax 4,80,000 4,20,000 6,42,000 4,70,0005,22,000(+) Repairs
calpitazed 50,000 -- -- -- --
(-)
Depreciation (5,000) (4,500) (4,050) (3,645)(3,281)Over valuation of
stock on
31/12/06 -- (2,000) 2,000 -- --
(+) loss due to fire in 2008 -- -- -- 8,000 --
(-) abnormal gains -- -- (25,000) -- --
Adjusted profit
B.T. 5,25,000 4,13,500 6,14,950 4,74,3555,18,719(x) weight X 1 X 2 X 3 X 4 X 5
Product Rs. 5,25,000 8,27,000 18,44,850 18,97,42025,93,595munotes.in

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155 Working for depreciation :
Rs.
Repa irs capitalized in 2005 50,000
(-) Depn for 2005 (5,000)
WDV as on 31.12.05 45,000
(-) Depn for 2006 (4,500)
WDV as on 31.12.06 40,500
(-) Depn for 2007 (4,050)
WDV as on 31.12.07 36,450
(-) Depn for the year 2008 (3,645)
WDV as on 31.12.08 32,805
(-) Depn for the year 31.12.09 (3,281)
WDV as on 31.12.09 29,524

76,87,8655,12,52415Total of productsweighted average profit before taxTotal weights     
  
Weighted average profit = 5,12,524 (-) increase in exp. in future
Additional rent (6,000) Add. Directors fee payable (3,000) F.M.P. Before Tax 5,03,52 4 (-) Increase Tax @ 40% (2,01,410) F.M.P. after Tax 3,02,114
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156 Net Tangible Trading Assets :
10011,99,000110
Re ( 29,524
)Particulars
Fixed Assets
pairs WDV value of repairs
capatilised
Cash   
     
  70,000
100. . 6,00,000 7,06,0008518,95,524:Others C A
Less liabilities payable
Loan   
  
 

1,50,000' / 50,000 (6,00,000)tanCreditors
Workmen s sauing A c
Net gible trading assets 
 
   
 12,95,52431.12.2009as on   
Pr . .10012,95,524 15%NRRNormal ofit Avg Capital equp        
 

Pr . . . PrSuper ofit F M P Normal ofit    

sup 3Goodwill er profit years of purchase     

):
2
323.78 547.2
2`B Valuation of sharesIntrinsic value yield valueFair ValueFair value     

   munotes.in

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157 :.
16,18,879
5,000WNNet assets available to equity share holdersIntrinsic value of shareNo of equity shares      
 
  
Net asset available to Equity S. H. Rs.
Net tangible trading asset as calculated 12,95,524 (+) Goodwill 3,23,355 Net assets available to Equity share holders 16,18,879
Yield value :
FMP = Adjusted avg. profit – pref. dividend – statutory Preference to
Reserves 1002,87,1141005,00,000FMPFMPRate of FMPpaid up equity cap        
 

57.4210010Rate of FMPYield value paid up value of a equity shareNRR         
 







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158 4.13 VALUATION OF BUSINESS
Valuation of Business













Business valuation process involves multiple judgments. It uses to
estimate the economic value of the owne r’s interest in the Business. It is
the price vender of business willing to receive and purchaser of business
willing to pay. It not only shares valuation but also valuation of intangible
assets, anticipation of future earnings, analysis of company’s cash flows
etc. It also guide share holders to hold shares or purchase addition share or
sell part / all his shares. Valuation is used by financial market participant
to determine the price, to buy or to sell the business.
Some of the methods of business Valuat ion are as follows:
1. EARNING PER SHARE METHOD (E.P.S)

.. .P r
. Pr .Step I F M P ofit available for Equity Dividend
Adj Averege profit ef Dividend statutory transfer to reserves              
.... tan.. . .100sin . . . ( )...FMPStep II E P SNo of equity shares outs ding
Step III Value of total Equity share No of Equityshares E P SStep IV Bu ess Value Valuation of E P S Step IIINRR     
           
          
Goodwill
and other
intangible
Assets Tangible
Fixed
Assets Long
Term
Funds Adjusted
F.M.P. Capital
Employd N.R.R.
Intrinsic value Yield Value
Fair value of Equity shares
Plus
Valuation of Business i) Other Economical factor
and Business / Financial
Risk
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159
1. DIVIDEND CAPITALISATION METHOD
This method is based on dividend. Equity dividend paid / declared is
capitalized by using N.R.R.
Following steps should be followed :
Step 1 - Ascertain Equity Dividend per share
Step 2 - Determine N.R.R. N.R.R. for dividend yield approach should be
different than N.R.R. for goodwill valuation. It depends upon many
factors e.g. promoters total holding, whether sh ares are listed or unlisted.
Higher the promotes holding N.R.R. can be less, similarly higher the
unlisted co. shares N.R.R. should be higher, as high risk.
a) Earning yield approach
.... . . 100EPSNRRMarket price per share  
b) Dividend yield approach
.... . . 100EPSNRRMarket price per share   3 100...Dividend per shareStep Value per shareNRR           
Step 4 – Business Value
. tan .No of Equity shares outs ding value on calculated on above         
3. PRICE EARNING MULTIPLE APPROACH
Pr...Market price per shareice Earning RatioEPS    
Price Earning ratio shows price currently paid for each Rs. of currently
reported E.P.S. It is ma rket price based method. It is relationship between
per share & E.P.S.
Business valuation can be ascertain as follows:
Step I - Determine P.E. multiple applicable for similar size
companies in same type of indenty.
Step II - Compute E.P.S. of the company being
under consideration, As per As – 20
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160 Step IV - Business Valuation
= No. of outstanding Equity shares x Value determine in Step
III above.
2. BOOK VALUE METHOD
This is m arket based. Book value can be ascertained on the basis of
company’s book of accounts. Book value method represents relationship
between market price of the share and book value of the same.
Step 1:
..Net Assets available to Equity share holdersBook value per shareNo of equity shares       
In such valuation net assets appearing books of accounts or i.e. equal to
shareholders fund.
Step 2: Determine Book value multiple of the similar sized and type
company. Market value per shareBook Value per share  
Step 3: Value per share
.Book Value per share Book Value per multiple       
Step 4: Business Value
.( 3 )No of Equity shares Value per shares step         
5) DISCOUNTED CASH FLOW METHOD
Cash flow is that cash flow through out during the year. Cash flow is
defined as “Earnings before Interest on Long Term Loans, Depreciation,
but after Taxes”.
Cash flows = N.B.I. + Tax + Depre ciation + Amortization
Free cash flow represents the cash flow which are available for :
Expansion
1. Diversification
2. Withdrawal
Free cash flows represent the cash flow available from earning after
adjusting for:
1. Additional cash required for incremental worki ng capital needs.
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161 Normally this method is preferred by investment Bankers to value business
as the company’s value can be estimated by forecasting future
performance and measuring future surplus cash flow gene rated by the
company. The cash flows and cash deficient cash flows are discounted
back to present value and added together to get the valuation of business.
As per this method to ascertain value of business following produce
should be followed:
Step 1 - Ascertain Future cash flow for which projections can be made
with certainly.
Step 2 - Discount above future cash flow at cost of capital.
Step 3 - Take total of above discounted cash flow.
Step 4 - Decide the Terminal value for last year of projections. The
Terminal value is ascertained by capitalising the last year earning at
N.R.R.
Step 5 - Discount the terminal value @ rate of cost of capital.
Step 6 - Add all these values to estimate the company’s present
value , assuming co. is debt free.
a) Discounted cash flows X
b) Discounted Terminal value X
Value of Business
Step 7 - sin
. tanValue of Bu essValue per shareNo of shares outs ding    
4.14 SOLVED PROBLEMS ON VALUATION OF
BUSINESS
Illustration 23:
Following information is available from books of Ketan Ltd.
a) Free Cash Flows:
Year Rs. in Lakhs
2006 100
2007 150
2008 250
2009 400
2010 500

b) The company uses 60% debt. And 40% Equ ity for long term
financing. Debt. Is obtained at 12%. The tax rate is 40% cost
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162 c) Assets amounting 362 lakhs were not used in generation of
the cash flow.
d) The company expects a steady cash flow growth at 5%.
Using Discounted Cash flow techni que, you are required to calculate the
value of Business
Solution :
1) Weighted Average Cost
Sources
of
Capital Cost of
Capital Tax
Shiel
d Net
Cost of
Capital Proportio
n of
Capital Weighted
Cost
Equity 25 -- 25 X 40% = 10.00
Debt 12 0.4
0 7.20 X 60% = 4.32
W.A.C.C. 14.32

2) Present Value of cash flow :
Year Cash flow Rs.
Lakhs D.F.@
14.32% P.V. of Cash flow
Rs. in Lakhs
2006 100 0.8747 87.47
2007 150 0.7651 114.77
2008 250 0.6693 167.33
2009 400 0.5855 234.20
2010 500 0.5121 256.05
P.V. of Total Cash Flows 859.82

Discount factor is calculated by constant factor using calculate as
1002006114.32
2007
2008
2009
2010for yearfor yearfor yearfor yearfor year  
  
  
  
   500 1.05 5253. min0.11432 05 0.064328162.31 .Ter al value value
Lakhs       

  munotes.in

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163 4. . . min 8162.31 0.5121PV of Ter al Valuein lakhs          
5)
Value of Ketan Ltd. Rs. (in
lakhs)
P.V. of cash flow 859.82 + P.V. of Termin al cash flow 4180.00 + Value of non-operating asset 362.00 Value of Business 5401.82 Note : As net present value concept not covered in syllabus, we are of
opinion that discounted cash flow method should not be asked in
M. Com. Part I.
Illustration 24:
Following information from X Ltd. & Y Ltd., were available.
X Ltd. Y Ltd.
Earning after Tax Rs. 2,50,00,000 Rs. 12,00,000
No. of Equity Share 5,00,000 2,00,000
P.E. Ratio C Times 12 7

You are required if Y Ltd. is taken over by X Ltd.
i) Calculate marke t price of shares of X Ltd. & Y Ltd.
ii) Find out swap ratio based on market price.
iii) What would be E.P.S. of X Ltd. after take over Y Ltd.
iv) What would be the market value of the merged of Company?
Solution : ... . . . Pr 25,00,000 12,00,000.... 5,00,000 2,00,0X Ltd Y LtdN P AT eference DividendEPSNo of Equity Share       00. . . .50 . 6
Pr.....
Pr 12 50E P S Rs Rs
Market iceP E RatioEPS
Market ice    
  
      76.. . .. . .P E Ratio E P S Rs Rs        
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164 . 420.07. 6007 . 100 .Swap price based on market pricemarket price of Y Ltd
Market price of X LtdShares of X Ltd for every shares of Y Ltd            
            

).. . . .
7. . 2,00,000 14,000 .100. . 5,00,000 14,000 5,14,000.iii E P S of X Ltd after takes over Y Ltd
No of shares issued to Y Ltd shares
Total No of shares of X Ltd after takes over
Total Ear              
                
 2,50, 00,000 12,00,000 2,62,00,000. ning after takes over        
2,62,00,000... .5,14,000
Pr
12 50.97
611.64
..E P S After Take over Rs
Expected Market ice
After take over
Market value of X Ltd No of share market price pershare     
 
     

           
5,14,000 611.64
31,43,82,960 

Illustration : 25
Anand Ltd. is intending to acquire Raj Ltd. by waerger and following
information is available.
Anand
Ltd. Raj Ltd.
No. of Equity shares 5,00,000 1,00,000 No. of 10% Pref. share s of Rs. 100 each 1,00,000 50,000 Earning after Tax 60,00,000 22,00,000 M. V. per Equity Share 45 67.50
You are required :
i) Calculate E. P. S. for Anand Ltd. and Raj Ltd.
ii) Calculate E. P. S. after mager


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165 Solution :
....). . ..
60.00,000 10,00,000.. . .5,00,000
50,00,000.5,00,000N P AT preference DividendiE P SNo of Equity shares
Anand Ltd E P S
Rs per share
Ra   
    
   
22,00,000 5,00,000. . . . .151,00,000j Ltd E P S Rs per share      ) . . ..67.501,00,000 1,50,00045. 5,00,000 1,50,000 1,50,000 6,50,00050,00,000 15,00,000ii No of shares issued to Raj Ltd by Anand LtdTotal share of Anand Ltd
Earnings after takeover        
        
     65,00,000
65,00,000. . . .106,50,000E P S after merger Rs per share
         
Illustration 26 :
Z Ltd. Furnished to following information, Assets (including goodwill
17,50,000)
Rs.
Net Assets [including goodwill] 1,75,000
10% Preference Capital Rs. 10 each 4,00,000
Equity share capital Rs. 5 each 6,00, 000
Avg. Net profit after tax 12,50,000
Normal rate of return 12%

Information :
1) Intrinsic value
2) Fair Value
3) Director decided to allow one fully paid equity share at
bonus for every 3 shares held.
4) After boun issued offer was made for right share issue @ 1
share Rs. 25 per share for every 4 shares prices was fully
subscribed fair value before right and after right.


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166 5) Solution :
Particulars Nos. Rs.
Net Asset 17,50,000
(Less) Preference Capital 4,00,000 Net Asset available to Equity share holder 1,20,000 13,50,000
Add + : Bonus (1,20,000 ×⅓) 40,000 -- Net Asset 1,60,000 13,50,000
Add +: Right issue (1,60,000 ×¼) (40,000 40,000 10,00,000
× 25)
Net Assets 2,00,000 23,50,000

Yield Value
FMP Given 12,50,000 (Less) Preference dividend (4,00,000 x 10%) 40,000 FMP 12,10,000
1) 2IntrinsicValue Yeild ValueFair Value    
11.25 84.03247.64 / 
iii) Rate of NNRYeild Value Paidup value per shareNRR     
151.2521263.02%
3) Fair value before right and a fter right (but after bonus)
a) Before Rights
Fair value = 35.73
b)After Rights
i) 2Instrinsic value yeild valueFair Value    
11.75 50.42231.085
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167 ii) .Net asset available to equity share holderIntrinsicValueNo of equity shares      
23,50,0001,50,00011.75
iii) Yeild Value
i) FMP = 12,10,000
ii) 100FMPRate of FMPPaid up equity capital    
12,10,00010010,00,000121% 
iii) Rate of FMPYeild Value paid up value per shareNRR     
12151250.42
a) .Net Asset available to equity shareholderIntrinsicValueNo of equity shares      
13,50,0001,20,00011.25
b) Yeild Value
i) FMP = 12,10,000
ii) 100FMPRate of FMPPaid up equity share capital      
12,10,0001006,00,000201.67%
iii) Rate of FMPYeild Value paid up Amount per shareNRR      
201.6751284.03 munotes.in

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168 2) Valuati on of shares before bonus and after bonus
a) Fair value before bonus = 47.64
b) 2Intrinsic value yeild valueFair value after bonus      
8.44 63.02235.73
i) .( )net asset available to equity shareholderIntrinsic valueNo equity share After bonus      
13,50,0001,60,0008.44
ii) Yeild Value
i) FMP = 12,10,000
ii) 100FMPRate of FMPpaid up equity capital     
12,10,0001008,00,000151.25
Illustration 27:
Following Information were made available from Y Ltd.
Equity share capital (Rs. 25 each) 50,00,000
10% Preferen ce share capital (Rs. 100 each) 10,00,000
Net Asset 94,00,000
Net Profit after Tax 21,00,000

Information :
1. Preferencial were converted into Equity shares @ rate of 2 shares
for every 5 shares. NRR 15%
2. You are required to ascertain fair value before conversion and after
conversion.
Solution :
1. On Convrsion no. of Equity share issue 510,000 2 4,000 
2. Net asset available to Equity shareholder. munotes.in

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169
Particular No. Rs.
Before Conversion 94,00,000
(Less) Preference capital 10,00,000
Net Asset Before Conversion 2,00,000 84,00,000
3) After Conversion (2,00,000 + 4,000) 2,04,000 94,00,000
4) FMP Before Conversion 21,00,000
(Less) Preference dividend 1,00,000
FMP (Before Conversion) 2,00,000 20,00,000
5) After Conversion 2,04,000 21,00 ,000

a) fair value before conversion of Preference shares
2
42 66.67
254.335Intrinsic Value yeild value  

i) .Net Asset available equity shareholderIntrinsicValueNo of equity shares     
84,00,0002,00,00042
2) Yeild Value
i) FMP = 20,00,000
ii) Rate of FMP
20,00,00010050,00,00040%FMPFaceValue of preference sharespaidup equity capital    

iii) Rate of FMPYeild value Paidup Value per equity shareNRR      
40251566.67 munotes.in

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170 B) After Conversion
2Intrinsic value yeild valueFair Value    
46.08 68.03257.35
i) 2Net asset available to equity share holderIntrinsicValue     
94,00,0002,04,00046.08
2) Yeild Value
i) FMP = 21,00,000
ii) 100FMPRate of FMPpaidup equity share    
21,00,00010051,00,00041.18%

iii) Rate of FMPYeild Value paidup value per equity shareNRR      
41.18251568.63
Illustration : 28
Equity share capital (Rs. 25 each 50,00,000 10% Debentures (Rs. 100 each) 10,00,000 Net Assets 94,00,000 N.P.A.T. @ 40% 24,00,000 N.R.R. @ 12.50%



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171 Information :
Debentures are convertible into Equity shares @ rate of 3 for every 5
debentures.
You are required to ascertain after conversion of debentures.
Solution :
1) No. of Equity shares issued to debentures holders =
5 10,000 3
6,000Equity shares
  
2) Net Asset after conversion
Add + Debenture (as converted to Equity no liability)
Net Asset after conversion 94,00 ,000
10400000
10400000

3)
FMP
N.P.A.T. 2400000
Add + Income Tax 40240000060 1600000

FMP Before Tax 4000000
Add + Debenture Interest 100000
N.P.B.T. 4100000
(Less -) Tax @ 40% (1640000)
FMP 2460000

Intrinsic Value after c onversion
1) .Net asset available to equity shareholderIntrinsicValueNo of equity shares      
1040000020600050.49
2) Yeild value
i) FMP = 2460000
ii) 100FMPRate of FMPpaidup equity share capital     
2460000100515000047.77% munotes.in

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172 iii) / Rate of FMPYield Value paidup value per shareNRR     
47.772512.5095.54
iv) int2rinsicValue yield ValueFair value    
50.49 95.54273.015
4.15 KEY POINTS ON VALUATION OF GOODWILL,
SHARES AND BUSINESS
Goodwill : It is intangible fixed Asset, which can be broug ht and /
or sold along with business.
F.M.P. : It is Future maintainable Trading profit after income
tax, duty adjusted for possibilities of increases /
decreases in profit due to the certain changes.
Capital Employed : It is net tangible trading assets. It is excess of market
value of trading assets over external liabilities payable.
N.R.R. : It is normal rate of return excepted in same type of
industry.
Super Profit : It is excess of F. M. P. over normal profit earned.
Weighted Average Profit : W hen profit earned over no. of years shows
increasing or decreasing tendency, weighted average
profit should be preferred for ascertaining F.M.P.
Share : Share means share in share capital in a public or private
Ltd. Company.
Preference Share : Preference shares are those shares enjoys preferential
rights over Equity shareholders in respect of dividend
and repayment of capital.
Intrinsic Value of Shares : It is amount available to one share in liquidation
of company, after payment of external liabilities and
Preference share capital.
Yield Value of Share: It is value of Equity share based on profit available
to Equity share holder, by way of dividend.
Fair value : It is average of intrinsic value and yield value.
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173 4.16 EXERCISE ON VALUATION OF GOODWILL,
SHARES AND BUSINESS
Objective Questions :
I. Answer in Brief :
1. Define Goodwill
2. Explain F.M.P.
3. Capital Employed
4. N.R.R.
5. Capitalisation of F.M.P.
6. Capitalisation of Super profit
7. Intrinsic value of Equity share
8. Yield value of Equity share
9. Fair value of equity share.
10. Participating Preference share.
11. When to consider weighted average profits.
12. Explain valuation of Business.
II. Multiple choice Question :
1) Money value of the reputation of business concern.
a) patenad b) working capital
c) Goodwill d) know -how
2) Goodwill is
a) Current Assets b) intangible assets
c) Fictitious Assets d) Net Assets
3) While calculating capital employed following assets are included :
a) Fixed Assets b) Current Assets
c) Trade Investment d) All the above
4) While calculating super profit; following income included.
a) Operating Net Profit b) Income from trade investment
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174 5) Norma l profit depends on
a) Average capital employed b) N.R.R.
c) F. M. P. d) both a & b
6) Super profit is :
a) Excess of F.M.P. over normal profit b) F. M. P.
c) Excess of normal profit over F.M.P. d) none of the above
7) Intrinsic value of share is also known as,
a) Assets Backing value b) Yield value
c) Liquidation value d) both a and c
8) While calculating capital employed for valuation of share,
following assets are included.
a) Goodwill b) Fictitious Assets
c) Unrecorded Assets d) both a and b
9) Shares are to be valued on
a) wealth tax b) purchased of major shares
c) amalgamation d) All the above
10) Quoted share means
a) Reported in new paper b) Quoted by seller
c) held by promoters d) Listed on the stock exchange
11) Super profit is 13,20,000 N.R.R. 33⅓% Goodwill is valued by
capitalization of super profit is
a) 3,96,00 b) 39,60,000
c) 39,59,553 d) 60,39,000
12) Fair value of share is equal to
a) Net Assets b) Intrinsic value
c) Yield value d) None of the above
13) Calculate intrinsic value of share, if 10,000 Equity shares of Rs. 10
each are fully paid up and Net Asset of the companies valued of Rs.
12,40,000
a) Rs. 124 b) 2400
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175 14) If profit earned by the company for last 5 years Rs. 50,000, Rs. 60,000,
Rs. 90,000, Rs. 80,000; weight assigned, 1, 2, 3 & 4 respectively,
weighted average profit is
a) 70,000 b) 95,000
c) 50,000 d) Non of the abobe
15) Fixed Assets undervalued by 15% = Rs. 97,75,000. It market
value.
a) 1,11,24,1250 b) 1,15,00,000
c) 1,11,55,000 d) Non of the above
Theory Question :
1. What is goodwill?
2. Specify the circumstances when goodwill is valued?
3. Describe the factors which influence value of Goodwill?
4. State various method of valuation of Goodwill?
5. Explain valuation of shares in following circumstances.
a) Before Bonus and After Bonus
b) Before right issue of shares and after right issue.
c) Before conversion of Debentures and after conversion of
Debentures into shares.
d) Partly called shares and after converting partly paid into
fully paid up, by capitalizing reserves.
6. Explain dividend capitalization method for valuation of
business.
7. Write short notes on :
 Valuation of Preference shares.
 Fair value of share
 Price earning multiple approach method of business.
 Net assets by liabilities side approach.
 Valuation of goodwill by capitalization of F. M. P.
8. State limitation of intrinsic value of shares
9. How you value Equity shares when company have issued
participating Preference shares.
10. Give the formula for valuation of fair value of Equity share s.

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176 5
CONSOLIDATED FINANCIAL
STATEMENTS
Unit Structure :
5.1 Meaning
5.2 Consolidated Financial Statements
5.3 Difference between Standalone a nd Consolidated Financial
Statements
5.4 Advantages
5.5 Disadvantages
5.6 Steps to Prepare Financial Statements
5.7 Need to Prepare A Consolidated Financial Statement
5.8 AS. 21 – Consolidation of Financial Statement
5.9 Consolidation of Balance Sheet
5.10 Consolidated Profit And Loss Account
5.11 Foreign Subsidiaries
5.1 MEANING
Consolidated financial statement s are the financial statements of a
group of entities that are presented as being those of a single economic
entity. These statements are useful for reviewing the financial position
and results of an entire group of commonly -owned businesses.
Otherwise, re viewing the results of individual businesses within the
group does not give an indication of the financial health of the group
as a whole. The key entities used in the construction of consolidated
statements are:
 A group is a parent entity and all of its s ubsidiaries
 A subsidiary is an entity that is controlled by a parent company
Thus, consolidated financial statements are the combined financials for
a parent company and its subsidiaries. It is also possible to have
consolidated financial statements for a portion of a group of
companies, such as for a subsidiary and those other entities owned by
the subsidiary.
A parent company may have investments in many other entities, not all
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177 decision po int when deciding whether to include a subsidiary’s
financial statements is whether the parent has more than a 50%
ownership interest in the subsidiary. If so, then its results are included
in the consolidated statements. Also, if the parent company has
decision -making influence over another business, despite owning a
smaller share of the business, then it may also choose to consolidate.
When a parent has no decision -making influence and owns less than a
50% interest in another business, then it will not co nsolidate; instead,
it will use either the cost method or the equity method to record its
ownership interest.
Standalone Financials statement
Standalone financial statements are the financial statements of a single
company. These statements reflect the pos ition of assets and liabilities of
the holding company in isolation without considering the impact of the
assets and liabilities of its subsidiary companies. Standalone financial
statements reflect the financial performance of the holding company
irrespect ive of the financial performance of its subsidiaries. The reporting
of details of subsidiaries are not completely absent in the standalone
financial statements. The interest of the holding company in its
subsidiaries is reflected as investments in its standalone financial
statements. The receivables and payables from subsidiaries are also
reflected as assets and liabilities in the standalone balance sheet .
5.2 CONSOLIDATED FINANCIAL STATEMENTS
Consolidated financial statements are drawn up when the individual
financial statements of all subsidiary companies are combined with the
standalone financial statements of the holding company. Consolidated
financial statements reflect the financial performance and position of
assets and liabilities of the entire group as a whole. Preparation of
consolidated financial statements require adherence to consolidation rules.
Consolidation rules provide for elimination of all inter -company
transactions. For e.g.: a receivable from the subsidiary in the books of the
holding company will be reflected as a payable in the books of the
subsidiary an d both will be eliminated on consolidation. In order for a
company’s financial statement to qualify as a subsidiary for consolidation,
the holding company must hold more than 50% shareholding. Any lower
shareholding in any company will not qualify for cons olidation and will
continue to reflect as an investment even in the consolidated financial
statements of the holding company. In cases where a holding company
holds less than 100% of its subsidiary, it will still incorporate 100% of the
subsidiary’s balanc es and will compute an amount of minority interest
which represents its liability towards the minority shareholders of its
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178 5.3 DIFFERENCE BETWEEN STANDALONE AND
CONSOLIDATED FI NANCIAL STATEMENTS
The difference between standalone and consolidated financial statements
has been detailed below:
1. Meaning
 Standalone financial statements are the financial statements of one
company – in the case of a group, that of the holding company
without considering the financial statements of its subsidiary
companies.
 Consolidated financial statements are the combined financial
statements of the holding company with all its subsidiary companies.
2. Financial position reflected
 Standalone financia l statements do not reflect the financial condition of
the entire group but only of the single company whose financial
statements are prepared.
 Consolidated financial statements of a company by incorporating
financial statements of its subsidiaries reflect a more comprehensive
financial condition of the entire group of companies.
3. Reporting of subsidiary balances
 In standalone financial statements, all subsidiary transactions and
balances are reported such as inter -company sales and purchases and
inter-company receivable and payables, investment in subsidiaries etc.
 In consolidated financial statements, subsidiary transactions and
balances are not separately reported as they are knocked off against
each other on consolidation of inter -company transactions.
4. Reported by
 Standalone financial statements are prepared by all companies.
 Consolidated financial statements are only prepared by holding
companies that have one or more subsidiaries.
5. Balances pertaining to individual companies
 In standalone financi al statements, the incomes and expenses and asset
and liability balances of each individual can be identified.
 In consolidated financial statements, the transactions and balances of
indivi dual companies cannot be identified as they are all combined and
reported as a whole for the group.
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179 6. Reporting of equity
 Standalone financial statements only report its shareholders’ interest in
its balance sheet.
 Consolidated financial statements repor t both its shareholders’ interests
and the minority interest of its subsidiaries, where applicable.
7. Complexity
 Standalone financial statements are less complex to prepare.
 Consolidated financial statements involve adherence to prescribed
consolidation r ules and passing of several complex elimination entries
to eliminate inter -company transactions which makes its preparation
more complex.
8. Relevance to investors of a group
 Standalone financial statements do not reflect the financial condition of
the ent ire group. In reality, for investors of companies especially those
dependent on group transactions and group support, the financial
position of its group companies are also relevant and hence standalone
financial statements are less relevant in such cases.
 Consolidated financial statements are more relevant to investors to
gauge the financial condition of the group as a whole.
9. Relevance for tax compliances
 Standalone financial stateme nts are more relevant from the perspective
of tax compliances. Each company is a separate taxable entity and thus
its standalone financial statements are considered while undertaking tax
compliances.
 Consolidated financial statements are less relevant from a tax
compliance perspective.
It should be noted that while this is true in most tax jurisdictions,
several countries such as USA, Australia and France allow tax
consolidation for which consolidated financial statements become
relevant.
10. Order of prep aration
 Standalone financial statements of all group companies are prepared
first and form the basis of preparation of consolidated financial
statements.
 Consolidated financial statements are prepared subsequent to
preparation of standalone financial state ments.
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180 5.4 ADVANTAGES
Some of the advantages are:
 The financial health of the company can be judged with one glance. It
portrays the entire asset and liability of a company, which helps in
decision making by potential investors.
 It reduces burden of prepa ring separate financial statements for all
subsidiaries and also reduces carbon emission. Preparing separate
balance sheets and presenting hard copies of them require lot of papers
 It helps to promote transparency. In standalone financial statements, it
gets difficult to judge the health of subsidiaries of a parent. In
consolidated balance sheet it is all available in one statement.
 Cross sale effects are correctly accounted. It is a general mistake that
subsidiary records profit on sales for sales made to parent companies.
This is not correct.
5.5 DISADVANTAGES
Some of the disadvantages are:
 The poor performance of the parent company can be overshadowed by
the excellent performance of the subsidiary. Hence the true picture is
sugar coated and presented to f ool the audience.
 If too much cross transactions have happened between parent and
subsidiary and proper accounting is not followed, then it will present an
elevated sales, which is actually not true.
 As everything is combined, so proper analysis based on r atios is tough.
Ratios are helpful in comparison with peer companies. In consolidated
statements, there are no sector specific financials. As everything is
combined, sector specific analysis is difficult.
5.6 STEPS TO PREPARE FINANCIAL STATEMENTS
When gene rating a consolidated financial statement, related items such as
assets, liabilities, income, and expenses total together line by line from the
parent company’s financial statements and its subsidiaries. The flow of the
consolidation accounting procedure i s as follows;
 Loans Between Companies: Recording intercompany loans from
subsidiaries to the parent company, as if the parent business has to
combine the cash balances of its subsidiaries into an investment
account. In addition, allocate interest income co llected on consolidated
investments from the parent business to the subsidiaries.
 Charge for Business Overhead: Calculating and charging the amount
of the allocation. Just to the various subsidiaries if the parent firm
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181  Accounts Payable: Verify that all accounts payable recorded during
the period have been appropriately charged to the various subsidiaries
if the parent business has a consolidated payables operation.
 Expenses for Payroll: If the parent business is u sing a similar
paymaster system to pay all employees across the board, make sure that
payroll expense is properly assigned to all subsidiaries.
 Adjusting Entries: Record any adjustment entries required at the
subsidiary and corporate levels to accurately r ecord revenue and
expense transactions in the correct timeframe.
 Examine the balances of your asset, liability, and equity
accounts: Verify the accuracy of all asset, liability, and equity
accounting for both the subsidiaries and the corporate parent. Also ,
make any necessary adjustments.
 Examine the Financial Statements of Subsidiaries: Print and study
each subsidiary’s financial accounts, and look into any things that
appear to be strange or inaccurate. Make any necessary changes.
 Intercompany transaction s elimination: If any intercompany
transactions have occurred, reverse them at the parent company level to
remove their impact from the consolidated financial statements.
 Examine the financial statements of your parents: Print and analyze
the parent compan y’s financial accounts, and look into any items that
appear to be strange or inaccurate. Make any necessary changes.
 Income Tax Liability: Record an income tax liability if the company
made a profit. It’s possible that this will be necessary at the subsidi ary
level as well.
 Subsidiary Books Closing: Depending on the accounting software
used, it may be essential to access each subsidiary’s financial records
and mark them as closed. This prohibits any further transactions from
being recorded during the accoun ting period that is about to end.
 Close the Books of the Parent Company: Marking the parent’s
company’s accounting period as ‘closed’, to prevent any further
transactions from being reported in that period.
 Publish Financial Reports: The parent company’s financial
statements should be printed and distributed.



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182 5.7 NEED TO PREPARE A CONSOLIDATED
FINANCIAL STATEMENT
The major goal of these statements is to display the compan y’s financial
information in a systematic manner for the benefit of financial statement
users such as owners, creditors, and investors.
It contains extremely important information, which is as follows:
 The overall assets and liabilities under the parent’s control
 As well as the results of this control.
5.8 AS. 21 – CONSOLIDATION OF FINANCIAL
STATEMENT
AS. 21 come into effect in respect of accounting periods commencing on
or after 1st April i.e. for year ending 31st March 2002. The A.S. 21 is
applicable to all the enterprises that prepare consolidated financial
statement. It is mandatory for Listed companies and Banking companies.
As per AS 21, The Consolidated financial statements would include:
i) Profit & Loss A/c
ii) Balance sheet
iii) Cash flow statement
iv) Notes of Accounts except typical notes.
v) Segment reporting
AS 21 also desire various import terms, as well as treatment and same
while preparing consolidated financial statement. Consolidated financial
statements should be prepared for both domestic as well as foreig n
subsidiaries.
5.9 CONSOLIDATION OF BALANCE SHEET
A holding company is required to present to its shareholders consolidated
balance sheet of holding company and its subsidiaries. Consolidated
balance sheet is nothing but addicting of up or combining the b alance sheet
of holding and its subsidiary together. However assets and liabilities are
straight forward, i.e. added line to line and combination of share capital,
reserves, and accumulated losses are not directly added in consolidated
balance sheet.

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183 Preparation of consolidated balance sheet . The following points need
special attention while preparing consolidated balance sheet.
1) Share of holding company and share of minority (outside
shareholders).
2) Date of Balance sheet of holding company and that of vari ous
subsidiary companies must be same. If they are not so necessary
adjustment must be made before consolidation.
3) Date of Acquisition of control in subsidiary companies.
4) Inter company owing.
5) Revaluation of fixed assets as on date of acquisition, depreciati on,
adjustment on revaluation amount etc. which are discussed here in
after.
 COST OF CONTROL / GOODWILL / CAPITAL RESERVE :
The holding company acquires more than 50% of the shares of the
subsidiary company. such shares may be acquired at a market price. W hich
may be at a premium or at discount. This amount is reflected in the
balance sheet of holding company of the assets side as investment in the
shares of subsidiary company. This is the price paid for shares in net
assets of subsidiary company as on date of its acquisition. Net assets of
the subsidiary
company consist of share capital, accumulated profits and reserve after
adjustment, accumulated losses as on the date of acquisition. If the amount
paid by the holding company for the shares of subsidiary c ompany is more
than its proportionate share in the net asset of the subsidiary company as
on the date of acquisition, the difference is considered as goodwill.
If there is excess of proportionate share in net assets of subsidiary
company intrinsic of share s acquired and cost of shares acquired by
holding company there will be capital reserve in favour of holding
company.
It goodwill already exists in the balance sheet of holding company or both
the goodwill thus calculated, will be added up to the existing goodwill.
Capital Reserve will be deducted from Goodwill.
In short, net amount resulting from goodwill and capital Reserve will be
shown in the consolidated Balance sheet.
 MINORITY INTEREST :
The claim of outside shareholders in the subsidiary company has to be
assessed and shown as liability in the consolidated balance sheet. Minority
interest in the net assets of the company is nothing but the proportionate
share of aggregation of share capital, reserve surpluses funds etc.
proportionate share of all assets should be deducted from the minority
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184 Thus, minority interest is the share of outsider in the following.
1) Share in share capital in subsidiary.
2) Share in reserves (Both pre and post acquisition of subsidiary).
3) Share in accumulated losses should be deducted.
4) Proportionate share of profit or loss on revaluation of assets.
5) Preference share capital of subsidiary company held by outsiders and
dividend due on such share capital, if there are profits.
Minority interest means outsiders interest. It is tre ated as liability and
shown in consolidated. Balance sheet as current liability. This amount is
basically intrinsic value of shares held by minority.
 CAPITAL PROFITS AND REVENUE PROFITS :
The holding company may acquire the shares in the subsidiary company
either on the balance sheet date or any date earlier than balance sheet date.
All the profit earned by the subsidiary company till the date of acquisition
of shares by holding company have to be taken as capital profits for the
holding company.
Such reser ves loose their individual identity and considered as capital
profits. In case, the holding company acquired shares on a date other than
balance sheet date of subsidiary, the profits of subsidiary company will
have to be apportioned between capital
profits and Revenue profits from the point of view of the holding
company. Thus any profit earned by subsidiary company before the date of
acquisition is the capital profit, while any profit earned by subsidiary
company after the date of acquisition is Revenue pr ofits. While preparing
the consolidated balance sheet share in capital profits should be adjusted
with the cost of control and Revenue profits / Reserves should be merged
with the balances in the Reserve and surpluses of the holding company.
 ELIMINATION OF INVESTMENTS IN SHARES OF
SUBSIDIARY COMPANY :
Investment in shares in subsidiary company represents the cost paid by the
holding company to acquire the shares of the subsidiary company. The
investment in shares of the subsidiary company entitles the holdi ng
company to share the net assets of the subsidiary company. While
preparing consolidated balance sheet all the assets and liabilities of
subsidiary company have to be merged with those of the holding company
and therefore it is logical to eliminate inves tments of the holding company
in the shares of the subsidiary company. Share in net assets of the outside
shareholders should treat as the minority interest it is shown in the balance
sheet on the liability side of holding company.
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Consolidated Financial
Statements
185  MUTUAL OWING / INTER COMPANY TRANSACTIONS :
The holding company and the subsidiary company may have number of
inter company transactions in any one or more of the following matters.
1. Loan advanced by the holding company to the subsidiary company or
vice versa.
2. Bill of Exchange drawn by holding company on subsidiary company
or vice versa.
3. Sale or purchase of goods on credit by holding company form
subsidiary company or vice versa.
4. Debentures issued by one company may be held by the other.
As a result of these inter company transact ions, certain accounts appear in
the balance sheet of the holding company as well as the subsidiary
company. In the consolidated balance sheet all these common accounts
should be eliminated. For e.g.
1. S Ltd. has taken loan of Rs. 20,000 from H Ltd. then S l td. balance
sheet shows a liability of Rs. 20,000 while H Ltd. balance sheet shows
on assets of Rs. 20,000.
2. H Ltd. draws a bill of Rs. 50,000 on S Ltd., then H Ltd. books it will
show bills receivable Rs. 50,000 while S Ltd. books will show bills
payable Rs. 50,000.
3. S Ltd. issued debentures of Rs. 1,00,000 which are held by H Ltd. then
S Ltd. balance sheet will show a liability of Rs. 50,000 while H Ltd.
books will show an assets of Rs. 50,000.
All the above inter company transactions have to be eliminated while
preparing the consolidated balance sheet. These can be done by deducting
inter company transactions from the respective items on both sides of
balance sheet.
 UNREALIZED PROFIT:
The problem of unrealized profit arises in those cases where the companie s
of the same group have sold goods to each other at the profits and goods
still remain unsold at the end of the year company to whom the goods are
sold.
While preparing the consolidated balance sheet, unrealized profit has to be
eliminated from the consol idated balance sheet in the following manner.
1. Unrealised profits should be deducted from the current revenue profits
of the holding company.
2. The same should be deducted from the stock of the company
consolidated balance sheet. Minority shareholders will not be affected
in any way due to unrealized profits. munotes.in

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Corporate Financial
Accounting
186 For e.g.
The sock in trade of S Ltd. includes Rs. 60,000 in respect of goods
purchased from H Ltd. These goods have been sold by H Ltd. at a profit of
20% on invoice price.
Therefore, unrealized profit = 60, 000 20100 12, 000
Unrealized profit Rs. 12,000 should be deducted from closing stock in the
consolidated balance sheet and from Revenue profits i.e. from profit and
loss account.
 CONTINGENT LIABILITIES :
As 29 defines a contingent liabilities as:
A possibl e obligation that arises from past events and whose existence will
be confirmed only by occurrence or non -occurrence of one or more
uncertain future events not wholly within the control of the entity or a
present obligation that arises from the past events but not recognized /
provided.
Such contingent liability may be of two types.
a) External contingent liability.
b) Internal contingent liability.
Internal contingent liability relates in respect of transactions between
holding and subsidiary company and it will not be shown as foot note in
the consolidated balance sheet, as they appear as actual liability in the
consolidated balance sheet.
 REVALUATION OF ASSETS AND LIABILITIES :
The holding company may decide to revalue the assets and liabilities of
the subsidia ry company on the date of acquisition of share in the
subsidiary company. Any profit or loss on such revaluation is a capital
profit or loss.
Profit on revaluation of assets of the subsidiary company whether before
or after date of acquisition of shares by the holding company, the same
must be shared by the holding company, and the minority share holders in
proportion to their respective holding. The minority share holders share
should be added to the minority interest. But the holding company share
should be treated as capital profits and considered in cost of control.
Further readjustment for depreciation on increase in the value of assets
should be made in the profit and loss account in the subsidiary company.
And same should be deducted from the Revenue profits of the subsidiary
company.
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Consolidated Financial
Statements
187  PREFERENCE SHARES IN SUBSIDIARY COMPANY :
In case the subsidiary company has also Preference share capital, its
treatment on consolidation will be as follows:
a) Nominal value of non participating Preference share capital o f the
subsidiary company is held by the holding company should be
adjusted in cost of control against the cost of Preference shares.
b) Preference shares held by outsiders. Paid up value of such
Preference shares should be included in Minority interest.
 BONUS SHARES:
The issue of bonus shares by the subsidiary company will increase the
number of shares held by the holding company as well as by the minority
share holders without any additional cost. However ratio of holding will
not change. Issue of bonus share s may or may not affect the cost of
control depending upon whether such shares are issued out of capital
profits or revenue profits.
i) Issue of bonus shares out of pre acquisition profits (capital
profits) : In case the subsidiary company issues bonus shares out of capital
profits the cost of control remains unaffected in the consolidated balance
sheet on account of issue of bonus shares. As share capital increases by the
amount of bonus and capital profits decreases by the same amount. Hence,
there is not ef fect on cost of control when bonus shares are issued from pre
acquisition profits.
ii) Issue of bonus share of post acquisition profits (Revenue profits):
In this case, a part of revenue profits will get capitalised resulting decrease
in cost of control or increase in capital reserve.
Issue of bonus shares whether out of capital profits or revenue profits will
not affect on minority interest. Minority interest will remain unaffected.
 TREATMENT OF DIVIDEND :
i) Dividend paid
When subsidiary company pays dividend, the holding company will
naturally receive its due share. On receipt the holding company will debit
bank account. However account to be credited depends upon whether
dividend received out of pre-acquisition profit or out of post acquisition
profit. Dividend received by the holding company out of Pre -acquisition
profit should be credited to investment account. Only the dividend out of
post acquisition profit should be treated as Revenue income and
credited to profit and loss account.
ii) Proposed dividend :
In case the subsidiary company has proposed dividend on its shares
which is not accounted by the holding company for such dividend due on
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Corporate Financial
Accounting
188 Profit may be then analysed between capital Revenue in the usual
manner.
iii) Dividend payable :
In case subsidiary company has declared dividend and the holding
company taken credits for such dividend in its account, following
treatments should be given.
1. No adjustment in respect of such dividend should be done in the
subsidiary compa ny book.
2. In the holding company books dividend out of pre -acquisition profit
should be credited investment account. Dividend out of post acquisition
profit should be credited to profit and loss account.
3. In the consolidated Balance -sheet the amount of divid end payable by
the subsidiary company will be cancelled against the amount of dividend
receivable by the holding company. dividend payable to minorities may be
either included in the minority interest or be shown separately as liability
in the consolidated balance sheet.
iv) Intension to propose dividend:
In case subsidiary company as intension to propose dividend, such
proposed dividend given in adjustment may be completely ignored while
preparing the consolidated balance sheet.
Alternatively proposed dividend on share capital held by minority may be
deducted from minorities interest and shown separately liability in the
consolidated balance sheet.
 PRELIMINARY EXPENSES :
The preliminary expenses of subsidiary company may be taken as capital
loss or the amount m ay be added with the amount of preliminary expenses
of the holding company.
 PROVISION FOR TAXATION :
Any provision for taxation provided by the subsidiary company should be
taken to the consolidated balance sheet and be shown on the liability side.
 PURCHAS E OF SHARES IN INSTALLMENT :
A holding company may purchase shares of the subsidiary company in
installments. In such circumstances division of profit between pre and post
acquisition will depend upon the lots in which shares are purchased.
However, if sma ll purchases are made over the period of time then date of
purchase of shares which results in acquiring in controlling interest may
be taken as cut of line for division of profits between capital and Revenue.
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Consolidated Financial
Statements
189  SALE OF SHARES :
When a holding company dispo sed off a part of its holding in the
subsidiary company and the relationship of holding and subsidiary
company continues as it holds majority of shares of subsidiary. Sale of
shares by holding company may be treated as follows.
a) Profit or loss on sale of sh ares should be ascertained and it should be
adjusted while ascertaining goodwill or capital reserve. In brief, such loss
or gain on sale of share should be considered in cost of control.
b) The minority interest and cost of control should be ascertained on th e
basis of number of shares held by the holding company and the minority
on the date of consolidated balance sheet.
5.10 CONSOLIDATED PROFIT AND LOSS ACCOUNT
The consolidated profit and loss account of the holding company and its
subsidiaries are prepared to show the operating activities of the companies
comprising the groups. While preparing the consolidated profit and loss
account of the holding company and its subsidiary, the items appearing in
the profit and loss account of the holding company and the subsidiary
companies have to be aggregated.
But while doing so, the following adjustment have to be made.
1) Prepare profit and loss account in columnar form Amounts relating to
inter company transactions are entered in the adjustment column
against the respec tive items and are subtracted while entering amounts
in the total columns.
2) All inter company operating transactions are eliminated such as
purchase and sale of goods, interest on loans among the group
companies.
3) All inter company profits are adjusted.
4) Dividends received from the subsidiary company by the holding
company should be eliminated from both the sides of consolidated
profit and loss account.
5) Interest accrued and outstanding on Debenture of the subsidiary
company held by the holding company should be accounted by
holding and subsidiary company both and then its should be
eliminated.
6) Readjustment of Depreciation on Revaluation on fixed Assets at the
time of acquisition of shares by the holding company should be
adjusted in consolidated balance sheet and respective fixed assets and
in the consolidated profit and loss account.
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Corporate Financial
Accounting
190 7) The minority interest in the profit of subsidiary company should be
transferred minority interest account, in the proportion of total profit
after adjustment of revaluation of fixed Assets, but before adjusting
unrealized profit on stock.
8) The share of holding company in pre -acquisition profit should be
transferred to cost of control, in case shares are acquired during the
year.
9) Share of holding company in the past acquisition profi ts shall be
considered as revenue profits.
10) The balance in holding company columns will represents the total
profit or loss made or suffered by the group as a whole.
9) Group Consisting more than one subsidiaries: There are three
situations
a) A holding compa ny may have a number of subsidiaries without any
mutual holding between the subsidies. The following chart will clearly
show the position.




In this case, the holding company H Ltd. acquired shares of 7573, 4, 4of
the S 1 ltd, S 2 ltd. S 3 ltd respectively. And as such the investment account
of holding company will show investment in S 1 ltd. S 2 ltd, and S 3 ltd. The
calculation of cost of control, minority interest etc. of each company
should be done following the usual principles.
b) There may be change holding i.e. the holding company may hold shares
in a subsidiary company which is also holding company of its subsidiary
company, there may be different combinations which are shown by the
following chart.





⅓
H Ltd. 73
S1 Ltd. 54
S2 Ltd. 74
S3 Ltd.
⅓ ½
S1 Ltd. S Ltd. H Ltd. 1
53 52 H Ltd.
S1 Ltd. S Ltd. 2 3 5 32 H Ltd.
S1 Ltd. S Ltd. 3 25 1 3 munotes.in

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Consolidated Financial
Statements
191 There may be cross holding i.e. subsidiary company may have shares in
the holding company as well. However, according to company’s Act,
subsidiary company cannot acquires shares in its holding company after
becoming sub sidiary company, but it can continue to hold those shares in
the holding company, which were acquired before it became subsidiary
company.
Note: possibilities discuss, 2 and 3 above are at advanced level and
therefore not discussed in study material assumi ng such type of problem
should not to be asked in M.com level.
5.11 FOREIGN SUBSIDIARIES
Foreign subsidiaries companies final A/c should be consolidated along
with other subsidiary companies in the usual manner. The trial balance of
the subsidiary or balan ce sheet and profit and loss A/c of the foreign
subsidiary is the first converted into home currency.
The rules of conversion are the same as for foreign branches which
can be summarized as under.
a) Fixed Assets and fixed liabilities should be converted at the rate of
exchange prevailing as on date when such assets were purchased or
such liabilities are incurred or the payment was made if they are
acquired or raised after acquisitions of shares.
b) Floating assets and liabilities should be converted at the rate of
exchange prevailing on the last day of the accounting year.
c) Revenue items or net profit for the year should converted at the
average rate of exchange ruling during the period under review.
d) Opening stock should be converted at the rate of exchange at the
beginning of the year.
e) Share capital and Reserves of subsidiary company as on date of
acquisition, should be converted at the rate of exchange prevailing on
date of acquisition.
f) Any remittances for purchases of goods by subsidiary company from
holding company or vice-versa should be converted at the actual rates
prevailing on the date of purchase or date of receipt of remittances.
g) Fixed assets / Fixed liabilities as on date of acquisition which are
carried forward should be converted at the rate of exchang e
prevailing on date of acquisition of shares; if rate on date of
acquisition on fixed assets not given.
After converting the various items of trial balance a new trial balance
can be prepared, difference if any in the new trial balance should be
transfer red to exchange fluctuation account. Such difference may be
carried and shown in the Balance sheet either as an asset or as a
liability depending on whether balance debit or credit, alternatively
difference in exchange can be transferred to profits & loss account.
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Corporate Financial
Accounting
192 Illustration 1:
From the following Summary Balance Sheets of H. Ltd. and its subsidiary
S. Ltd. as at 31st march 2012 and the additional information provided
thereafter, prepare a Consolidated Balance Sheet of the two companies as
that date.
Liabilities H Ltd. ` S Ltd. ` Assets H Ltd. ` S Ltd. ` Share Capital :
Shares of ` 10 each
fully paid
General Reserve
Profit and Loss A/c
Creditors

10,00,000
3,10,000
1,50,000
2,30,000
16,90,000

2,00,000
-
40,000
69,000
3,09,000 Tangible Fixed Asse ts
70% Shares of S. Ltd.
at cost
Bank
Preliminary Expenses 11,62,000

1,42,000
3,86,000
-

16,90,000 1,80,000

-
1,24,000
5,000

3,09,000

H Ltd. acquired the shares of 31st December 2011.
On 1st April 2011 S Ltd.’s Profit and Loss Account showed a deb it balance
of ` 8,000.
On 31st March 2012 S Ltd. decided to revalue its Fixed Assets at
` 2,00,000.
(Oct. 2009. Adapted)
Solution :
Consolidated Balance Sheet of H. Ltd. and Its Subsidiary S Ltd. as on
31-03-2012
Particulars Note ` ` I. EQUITY AND LIABILITIES 1. Shareholder’s Funds a. Share Capital (1,00,000 Equity Shares of ` 10
each) ……. 10,00,000 b. Reserves and Surplus ……. 1 4,96,500 14,96,500
2. Minority Interest ……. 76,500
3. Current Liabilities Trade Payable ……. 2 2,99,000
Total 18,72,000
II. ASSETS
1. Non-current Assets `
Fixed Assets
- Tangible Assets ……. 3 13,62,000
2. Current Assets
Cash and Cash Equivalents ……. 4 5,10,000
Total …….. 18,72,000 munotes.in

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Consolidated Financial
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193
Notes to Ac counts H S Total
1. Reserves and Surplus .. .. .. ..
a. CapitalReserve (on Consolidation) .. .. .. .. 28,100
b. General Reserve .. .. .. .. 3,10,000
c. Surplus (1,50,000 + 8,400) .. .. .. .. 1,58,400
Total .. .. .. .. 4,96,500
2. Trade Payables
Creditors for Goods .. .. .. .. 2,30,000 69,000 2,99,000
3. Fixed Assets
Tangible Assets .. .. .. .. 11,62,000 2.00.000 13,62,000
4. Cash and Cash Equivalents
Bank .. .. .. .. 3,86,000 1,24,000 5,10,000


Working Notes :
1. Revenue Profit
Profit and Loss A/c
Particulars ` Particulars ` To balance b/d 8,000 By N. P. for the year 48,000 To Balance c/d 40,000 48,000 48,000
Profit upto 31 -12-11 = 948,000 36,00012 
Profit for next 3 months = 348,000 12,00012 
Revenue profit = ` 12,000
H Ltd.’s Shares = 12,000 70% ` 8,400
Minority Shares = 12,000 30% ` 3,600






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Corporate Financial
Accounting
194 2.
Capital Profit ` Appreciation in the value of Fixed Assets (2,00,000 – 1,80,000) 20,000
Current Year’s Profit till 31 -12-11 36,000
56,000
Less : Preliminary Expreses 5,000
Less : P/L A/c (Dr.) on 1 -4-11 8,000 13,000
43,000
H Ltd.’s Share = 43 ,000 x 70% = ` 30,100
Minority Share = 43,000 x 30% = ` 12,900

3. Co st of Control
Particulars `
Paid up value of 70% shares … … … … 1,40,000 Add : H Ltd. Share of Capital Profit … …. … … 30,100 … … … … 1,70,100 Less : Amount Paid for Acquiring Shares … … … … 1,42,000 Capital Reserve … … … … (28,100)
4. monirity In terest
Particulars ` Paid up value of 20% Shares … … … … … 60,000 30% of Reserve Profit … … … … … 3,600 30% of Capital Profits 12,500 Total … … … … … 76,500
Illustration 2 :
A Ltd. acquired 16,000 equity shares of ` 10 each in B. Ltd. on 1st july,
2012. The summary balance sheets of the two companies as on 31st
December, 2012 were as follows :
Liabilities A Ltd. B Ltd. Assets A Ltd. B Ltd.
Share Capital (` 10) 5,00,000 2,00,000 Land and Buldings 1,80,000 1,90,000
Reserves 24,000 1,00,000 Plant and Machinery 2,40,000 1,35,000
Profit and Loss A/c 57,200 82,000 Investment in B Ltd. 3,30,000 -
Bank Overdraft 1,00,000 - (at cost)
Bills payable 2,16,000 13,000 Stock 1,44,000 42,000
Sundry Creditors 69,800 20,000 Sundry Debtors 44,000 40,00 0
Bills Receivable 14,800 -
Cash 14,200 8,000
9,67,000 4,15,000 9,67,000 4,15,000
munotes.in