Accounting and Auditing (Financial Accounting) - III Notes | B.Com. (Accountancy) Semester 5 | Mumbai University | munotes

No new capital. Nobody subscribes to shares in a company whose Balance Sheet shows accumulated losses. Nor will a bank lend against assets it can see are overstated.

The share price collapses. Existing shareholders cannot sell out except at a heavy loss, so they are locked in.

The company drifts towards winding up. Not because it cannot trade, but because it cannot finance itself. This is the real cost. A business that is operationally sound can be killed by a Balance Sheet.

What reconstruction does about it

Reconstruction accepts what everyone already knows: the money is gone. It then puts that fact on paper.

The shareholders agree to give up part of their capital. A share of Rs 10 on which Rs 10 has been paid becomes a share of, say, Rs 4. Nothing is taken out of the company and nothing is paid in. What changes is the figure at which the capital is stated.

The amount given up is then used to write off what is not really there: the fictitious assets, the overvaluation, the accumulated loss.

The sacrifice by the shareholders equals the write-off of the assets. That single sentence is the whole of the accounting in Module I, and every worked scheme in this book is an application of it. The account in which the two meet is the Capital Reduction Account, worked in [The Capital Reduction Account: Opening It, Using It, Closing It].

Others may be asked to sacrifice too. Debenture-holders may accept a lower rate or fewer debentures; creditors may accept part payment; directors may waive fees owed to them. Each is a sacrifice, and each goes to the same account.

Reconstruction is not one thing

Two quite different things are called reconstruction, and MU's very next topic is the distinction:

• Internal reconstruction. The company survives. Its capital is rearranged inside the existing legal shell. No new company is formed and no liquidation occurs.
• External reconstruction. The company does not survive. It is wound up and a new company is formed to take over its business.

This module is about the first. The second belongs to Module II, where an external reconstruction is accounted for under AS 14 as an amalgamation in the nature of purchase: see [Amalgamation in the Nature of Purchase]. The full comparison is the next chapter, [Internal and External Reconstruction: the Distinction That Decides Everything].

Why the law is involved at all

A company cannot reduce its capital simply because its members would like to. Capital is the fund creditors look to, and reducing it touches people who are not in the room.

So every step of a reconstruction is authorised by a provision, and refused if the provision is not followed. Altering capital is s.61 of the Companies Act 2013. Varying the rights of a class of shareholders is s.48. Telling the Registrar is s.64. Reducing capital, the step that actually absorbs the losses, is s.66, and it requires the Tribunal's confirmation. Those are the "company law provisions" in MU's topic, and they are mapped in the next chapter but one.

In short

• A Balance Sheet can be arithmetically perfect and still describe a company that no longer exists, because losses sit on the assets side as though they were an asset, and assets are carried at figures nobody would pay.
• The consequences are practical: no dividend, no new capital, no exit for shareholders, and a slow drift to winding up.
• Reconstruction restates the capital downwards to match reality. Nothing leaves the company; a figure changes.
• Shareholders' sacrifice equals the write-off. That is the whole accounting of this module.
• Internal reconstruction keeps the company alive. External reconstruction replaces it.
• Every step needs a provision, because capital is the creditors' fund.

Answer in one sentence

What is internal reconstruction? A rearrangement of a company's share capital and liabilities, carried out within the existing company and with the consent of those who sacrifice, by which accumulated losses and overvalued assets are written off against a reduction in capital, so that the Balance Sheet again reflects the true position.

Why is a reconstruction needed? Because accumulated losses and overstated assets prevent a company from paying a dividend, raising fresh capital or offering its shareholders an exit, even though the business itself may be sound.

What is the Capital Reduction Account? The account through which every sacrifice made in a scheme of internal reconstruction is passed and against which every write-off is charged.

What the question will say

A question is internal when it says the company resolved to reduce its capital, that shares of Rs 10 are to be treated as shares of Rs 4, that a scheme of reconstruction was sanctioned, and then gives you a list of write-offs to make. There is one Balance Sheet at the start and one at the end.

A question is external when it says a new company was formed to take over the business, that the purchase consideration was so much, that the old company was wound up or went into liquidation, and that shares in the new company were issued to the old company's shareholders. There are two sets of books.

The phrase external reconstruction may not appear at all. "A new company, X Ltd., was formed to acquire the business of Y Ltd." is an external reconstruction whether or not it is called one.

A trap worth naming

Students see the word reconstruction and reach for the Capital Reduction Account. In an external reconstruction there is no Capital Reduction Account. The old company opens a Realisation Account, transfers its assets and liabilities to it, and the difference is a profit or loss on realisation. The new company records a purchase.

The reverse trap also exists: in an internal reconstruction there is no purchase consideration, no Realisation Account and no goodwill, because nothing has been bought.

In short

• One question separates them: is there a second company?
• Internal, one company, no liquidation, capital restated, Capital Reduction Account, Module I.
• External, two companies, the old one wound up, business purchased, Realisation Account and purchase consideration, AS 14, Module II.
• The question will tell you which, but often without using either name.
• The accounts opened are different, and using the wrong one loses the whole answer.

Answer in one sentence

Distinguish internal from external reconstruction. In an internal reconstruction the existing company continues and only the stated figures of its capital and liabilities are rearranged, under ss.48, 61, 64 and 66 of the Companies Act 2013, the sacrifices being collected in a Capital Reduction Account; in an external reconstruction the existing company is wound up and a newly formed company purchases its business for a consideration discharged mainly in shares, the transaction being an amalgamation accounted for under AS 14.

Is external reconstruction an amalgamation? Yes. A business passes from one company to another, so it falls within AS 14, and because the conditions of a merger are not satisfied it is accounted for as an amalgamation in the nature of purchase.

That is why an internal reconstruction almost always runs through s.66 and not s.61 alone: writing off accumulated losses means writing capital down, and only s.66 permits it.

Where s.48 fits

A reconstruction rarely treats every class alike. Equity shareholders may be asked to give up half their capital while preference shareholders give up their arrears of dividend. That is a variation of the rights of a class, and s.48 governs it: consent of three-fourths of that class, and a right for a dissenting minority holding at least ten per cent to apply to the Tribunal.

A scheme that ignores s.48 can be perfectly sound arithmetically and still fail.

Where s.64 fits

Section 64 is short and is asked as a short note. When a company alters its share capital under s.61, or a reduction takes effect, it must give notice to the Registrar within thirty days, along with an altered memorandum. The Registrar records it and alters the register.

It carries a penalty, and it is the step students omit when a question asks for the "procedure".

The four buy-back sections, in one line each

They are Module IV's, but the logic belongs here.

• s.67 states the rule: a company limited by shares shall not buy its own shares. Buy-back is the exception, not the starting point.
• s.68 creates the exception and fences it: out of three permitted sources only, within limits, on conditions.
• s.69 requires the amount by which capital is reduced on a buy-back out of profits to be transferred to a Capital Redemption Reserve, so the creditors' fund is preserved in substance even though shares have gone.
• s.70 forbids buy-back altogether in certain cases.

Read in that order they are one argument: capital may not be returned, unless, and even then something must be put back in its place.

In short

• Capital is fenced because it is the creditors' fund, not the members'.
• s.61 alterations do not reduce it, so members alone may make them; s.61(2) says the cancellation of unissued shares is not a reduction.
• s.66 does reduce it, so the Tribunal must confirm and creditors may be heard.
• s.48 governs a scheme that treats one class differently from another.
• s.64 requires notice to the Registrar within thirty days.
• ss.67 to 70 apply the same principle to buy-back: forbidden, then permitted on conditions, with a reserve created to replace what left.

Answer in one sentence

Which sections of the Companies Act 2013 govern internal reconstruction? Sections 48 (variation of class rights), 61 (alteration of share capital), 64 (notice to the Registrar) and 66 (reduction of share capital), the last requiring a special resolution and confirmation by the Tribunal.

Why does s.61 not require the Tribunal when s.66 does? Because an alteration under s.61 does not reduce the capital available to creditors, whereas a reduction under s.66 does, and s.61(2) expressly provides that cancelling unissued shares is not a reduction.

Authorised capital is the ceiling the memorandum sets on what the company may issue. Raising the ceiling issues nothing and receives nothing, so it produces no accounting entry at all. What changes is a figure disclosed in the notes to the Balance Sheet.

Students lose marks by passing an entry here. There is none. What there is, is a notice to the Registrar under s.64 within thirty days.

The condition inside s.61(1)(b)

Consolidation is the only one of the five that the Act fences further. The proviso to s.61(1)(b) requires that no consolidation and division which results in changes in the voting percentage of shareholders shall take effect unless it is approved by the Tribunal on an application made in the prescribed manner.

The reason is practical. Consolidating ten Rs 1 shares into one Rs 10 share is harmless if every holding divides by ten exactly. If a member holds 15 shares, it does not, and somebody's voting power moves. Where that happens the Tribunal must approve.

An answer on consolidation that does not mention this proviso is incomplete, and MU's own reading list carries the point.

The one thing s.61 never does

None of these five is a reduction of share capital. That is the whole reason they live in a different section from s.66 and do not need the Tribunal's confirmation or creditors' consent.

The Act says so expressly for the case that most looks like a reduction. Section 61(2) provides that the cancellation of shares under s.61(1)(e) shall not be deemed to be a reduction of share capital.

Read the two together and the logic is clear. Cancelling unissued shares removes capital that nobody ever subscribed and nobody ever paid for. No creditor ever had it to look to. So although the authorised capital figure falls, nothing that creditors relied on has gone.

Reducing capital that was subscribed is a different act, and it is s.66's.

Where s.61 sits in a reconstruction

A scheme of internal reconstruction usually uses s.61 and s.66 together, in that order.

Section 61 rearranges the shares into a convenient shape: a Rs 100 share may be sub-divided into ten Rs 10 shares so that the reduction can be applied evenly. Section 66 then writes the capital down.

That is why the two are examined together, and why a question that asks you to state the "legal provisions" of a scheme expects both, plus s.48 if a class is treated differently and s.64 for the notice.

In short

• s.61 needs authority in the articles and an ordinary resolution; no Tribunal, because nothing is reduced.
• Its five clauses are increase, consolidate, convert into stock, sub-divide, and cancel unissued shares.
• Increasing authorised capital produces no accounting entry.
• Consolidation that changes anyone's voting percentage needs the Tribunal's approval, under the proviso to s.61(1)(b).
• s.61(2) says cancelling unissued shares is not a reduction of capital, because nobody ever subscribed it.
• A reconstruction typically uses s.61 to reshape and s.66 to write down.

Answer in one sentence

What does section 61 permit? A limited company having a share capital may, if authorised by its articles, alter its capital by ordinary resolution in general meeting by increasing its authorised capital, consolidating shares into larger amounts, converting fully paid shares into stock and back, sub-dividing shares into smaller amounts, or cancelling shares not taken or agreed to be taken by any person.

Is cancellation under s.61(1)(e) a reduction of capital? No. Section 61(2) expressly provides that it shall not be deemed to be a reduction of share capital, because the shares cancelled were never subscribed and no creditor could have looked to them.

Does an increase of authorised capital require an accounting entry? No. Nothing is issued and nothing is received; only a figure disclosed in the notes changes, and notice must be given to the Registrar under s.64.

The journal entry.

The entry is passed at the paid-up figure, because that is what the Share Capital account carries in the books. The uncalled amount was never credited to Share Capital and so does not appear.

Where students lose the marks

Passing the entry at nominal value. The books carry Rs 6,00,000, not Rs 10,00,000. An entry for the nominal figure will not agree with the trial balance.

Forgetting the proportion. Turning a Rs 100 share with Rs 60 paid into six fully paid Rs 10 shares looks tidy and is wrong. It would extinguish the uncalled liability of Rs 4,00,000, which is a reduction of capital and needs s.66 and the Tribunal, not s.61.

Omitting the notice. Section 64 requires notice to the Registrar within thirty days, with an altered memorandum. A question asking for "the procedure" expects it.

In short

• Sub-division splits a share into smaller shares; the totals do not move.
• s.61(1)(d) requires the paid-to-unpaid proportion on each new share to be the same as on the old one.
• The journal entry is passed at the paid-up amount, not the nominal amount.
• It is not a reduction, so no Tribunal; but notice to the Registrar under s.64 within thirty days.
• Making partly paid shares fully paid by sub-division is a reduction in disguise and needs s.66.

Answer in one sentence

What is sub-division of shares? The splitting under s.61(1)(d) of a share into a larger number of shares of smaller face value, the total nominal and paid-up capital remaining unchanged and the proportion between paid and unpaid on each new share remaining the same as on the original share.

Is sub-division a reduction of capital? No. The aggregate capital is unaltered; only the denomination and the number of shares change, so an ordinary resolution under s.61 suffices and the Tribunal is not involved.

Note what the proviso does not say. It does not require the Tribunal whenever a fraction arises for somebody; it requires it where the consolidation results in changes in the voting percentage of shareholders. A scheme that deals with fractions so that nobody's percentage moves is outside it.

Consolidation in a reconstruction

Consolidation appears in schemes in a particular way. After a heavy reduction, a company may be left with a very large number of very small shares: a Rs 10 share written down to Rs 2 leaves five times as many rupees of nominal value spread over the same count. Consolidating them back into a workable denomination tidies the capital.

The order in a scheme is therefore often: sub-divide, reduce, consolidate. Each step is authorised by its own clause and the reduction alone needs s.66.

In short

• Consolidation merges shares into a larger denomination; the total does not move.
• The entry is passed at the paid-up figure, exactly as for sub-division.
• s.61(1)(b) alone carries a proviso: the Tribunal must approve a consolidation that changes anyone's voting percentage.
• The proviso bites where a holding does not divide exactly, because the odd shares must be dealt with somehow.
• Notice to the Registrar under s.64 within thirty days.

Answer in one sentence

What is consolidation of shares? The combination under s.61(1)(b) of a number of shares into a smaller number of shares of larger face value, the aggregate capital remaining unchanged.

When does consolidation require the approval of the Tribunal? When the consolidation and division results in changes in the voting percentage of shareholders; the proviso to s.61(1)(b) provides that such a consolidation shall not take effect unless the Tribunal approves it on an application made in the prescribed manner.

Note that the denomination has changed from Rs 10 to Rs 5 and the Act permits it: reconversion may be into shares of any denomination.

Why a company would bother

Historically, to make transfer easier, because stock could be transferred in odd amounts when shares could not. In modern practice, with shares held in dematerialised form and traded freely, the advantage has largely gone, and conversion into stock is uncommon.

It remains on the syllabus because it remains in the Act, and MU asks it.

In short

• Stock here is share capital held as an amount, not as units. It is not inventory.
• Only fully paid shares may be converted into stock, because stock cannot carry an unpaid liability.
• Stock cannot be issued directly; it arises only from conversion.
• Reconversion may be into shares of any denomination.
• The entry is a transfer between two capital accounts; no total changes.
• Notice to the Registrar under s.64 within thirty days.

Answer in one sentence

What is stock, and how does it differ from shares? Stock is fully paid share capital held as a single sum of money rather than as a number of shares; it has no face value, cannot be partly paid, is not numbered, cannot be issued directly, and may be transferred in any amount the articles permit.

Can partly paid shares be converted into stock? No. Section 61(1)(c) permits the conversion of fully paid-up shares only, because stock carries no unit on which an unpaid liability could rest.

What must actually be done

• An ordinary resolution in general meeting, the articles permitting.
• Alteration of the memorandum to state the reduced authorised capital.
• Notice to the Registrar under s.64 within thirty days, with the altered memorandum.

The distinction the examiner wants

In short

• Only unissued shares may be cancelled under this clause, and only if nobody has taken or agreed to take them.
• It reduces the authorised capital ceiling, not the issued or paid-up capital.
• s.61(2) says expressly that it is not a reduction of share capital.
• There is no journal entry. Only the note on authorised capital and the memorandum change.
• Ordinary resolution, no Tribunal, notice to the Registrar within thirty days.
• It is not the same thing as cancelling shares bought back under s.68(7).

Answer in one sentence

What is cancellation of unissued capital? The cancellation under s.61(1)(e) of shares which at the date of the resolution have not been taken or agreed to be taken by any person, and the corresponding diminution of the company's authorised share capital.

Why is it not treated as a reduction of capital? Because the shares cancelled were never subscribed or paid for, so no part of the fund available to creditors is touched; s.61(2) provides expressly that such cancellation shall not be deemed to be a reduction of share capital.

What entry is passed? None. The unissued shares were never carried in the Share Capital account, so only the authorised capital disclosed in the notes and the memorandum are altered.

Step 4 is the one that is left out.

In short

• s.64 requires notice to the Registrar within thirty days, with an altered memorandum.
• It is triggered by any s.61(1) alteration, by a Government order increasing authorised capital under s.62, and by redemption of redeemable preference shares.
• The penalty is Rs 500 per day while the default continues, capped at Rs 5,00,000 for the company and Rs 1,00,000 for an officer in default.
• A reduction under s.66 files instead under s.66(5): the Tribunal's order and an approved minute, within thirty days of receiving the order.

Answer in one sentence

What notice must be given to the Registrar on an alteration of share capital? Under s.64(1) the company must file a notice in the prescribed form with the Registrar within thirty days of the alteration, increase or redemption, together with an altered memorandum.

What is the penalty for failing to file? Under s.64(2) the company and every officer in default is liable to a penalty of five hundred rupees for each day the default continues, subject to a maximum of five lakh rupees for the company and one lakh rupees for an officer in default.

The application must be made within twenty-one days after the date on which the consent was given or the resolution was passed, and it may be made on behalf of the shareholders entitled to make it by one or more of their number appointed in writing.

Under s.48(3) the Tribunal's decision is binding on the shareholders, and under s.48(4) the company must file a copy of the order with the Registrar within thirty days.

The thresholds, together

Why it matters to a reconstruction

A scheme that asks equity shareholders to give up 60 per cent of their capital while preference shareholders give up three years of arrears is varying the rights of both classes. Each class must consent by three-fourths, at its own meeting; and because each variation affects the other class, the proviso applies both ways.

A scheme approved by a thumping majority at a single general meeting, with no class meetings, is not validly approved. The arithmetic in such a question may be perfect and the answer still incomplete if it does not say so.

In short

• s.48, not s.62. Section 62 is further issue of capital.
• Engaged only where capital is divided into classes and rights are varied.
• Consent: three-fourths of the issued shares of that class, in writing or by special resolution at a separate class meeting.
• Permitted only if the memorandum or articles provide for variation, or the terms of issue do not prohibit it.
• If another class is affected, three-fourths of that class as well.
• A dissenting ten per cent may apply to the Tribunal within twenty-one days; the variation is then suspended until confirmed.
• The Tribunal's decision binds the shareholders; the order is filed with the Registrar within thirty days.

Answer in one sentence

How may the rights attached to a class of shares be varied? With the consent in writing of the holders of not less than three-fourths of the issued shares of that class, or by a special resolution passed at a separate meeting of that class, provided the memorandum or articles allow such variation or, failing that, the terms of issue do not prohibit it.

What remedy has a dissenting shareholder? Holders of not less than ten per cent of the issued shares of the class who did not consent may apply to the Tribunal within twenty-one days to have the variation cancelled, and the variation does not take effect unless and until the Tribunal confirms it.

Satisfaction about creditors, under s.66(3). The Tribunal may make an order confirming the reduction if satisfied that the debt or claim of every creditor has been discharged, or determined, or secured, or his consent obtained.

The accounting-standards proviso, under s.66(3). No application for reduction shall be sanctioned unless the accounting treatment proposed by the company is in conformity with the accounting standards specified in s.133 or any other provision of the Act, and a certificate to that effect by the company's auditor has been filed with the Tribunal.

That proviso is why this paper puts law and accounting in one module. The scheme's entries are not merely good practice; the Tribunal may not sanction the reduction without an auditor's certificate that they conform to the standards.

After the order

Publication, s.66(4). The company publishes the order as the Tribunal directs.

Filing, s.66(5). The company delivers to the Registrar, within thirty days of receiving the copy of the order, a certified copy of the order and a minute approved by the Tribunal showing the amount of share capital, the number of shares into which it is divided, the amount of each share, and the amount deemed paid-up on each share. The Registrar registers it and issues a certificate.

Members' liability, s.66(7). A member, past or present, is not liable to any call or contribution exceeding the difference between the amount paid on the share, or the reduced amount deemed paid, and the amount of the share as fixed by the order.

The carve-out

Section 66(6): nothing in this section applies to buy-back of its own securities by a company under s.68.

A buy-back also returns capital to members, and it also reduces the capital. But it is governed entirely by ss.68 to 70 and needs no Tribunal confirmation. That is why Module IV is a separate topic and not an application of this one.

The procedure, in order

1. The articles must authorise the reduction; if not, alter them first.
2. Special resolution in general meeting.
3. Where a class's rights are varied, comply with s.48 as well.
4. Application to the Tribunal, with the auditor's certificate on accounting treatment.
5. Tribunal notice to the Central Government, Registrar, SEBI where listed, and creditors; three months for representations.
6. Order confirming the reduction.
7. Publication as directed.
8. File the order and the approved minute with the Registrar within thirty days; certificate issued.
9. Words "and reduced" may be required to be added to the name, if the Tribunal so directs.

In short

• s.66 is the only section that lets subscribed capital be written down, and every internal reconstruction uses it.
• Special resolution, and confirmation by the Tribunal.
• Three modes: reduce uncalled liability; cancel paid-up capital lost or unrepresented by available assets; pay off capital in excess of wants. Reconstruction uses the second.
• Barred outright if the company is in arrears on deposits or interest.
• Creditors are notified and heard; silence for three months is presumed consent.
• The Tribunal may not sanction unless the accounting treatment conforms to the accounting standards and the auditor certifies it.
• Order filed with the Registrar within thirty days, with the approved minute.
• Buy-back under s.68 is expressly outside this section.

Answer in one sentence

In what manner may a company reduce its share capital? By special resolution and subject to confirmation by the Tribunal, in any manner, and in particular by extinguishing or reducing liability on shares not fully paid, by cancelling paid-up capital which is lost or unrepresented by available assets, or by paying off paid-up capital in excess of the wants of the company.

What protection have creditors on a reduction of capital? The Tribunal must give them notice and consider their representations within three months, and may confirm the reduction only if satisfied that every creditor's debt or claim has been discharged, determined or secured, or his consent obtained.

Why must the auditor certify the accounting treatment? Because the proviso to s.66(3) forbids the Tribunal from sanctioning a reduction unless the proposed accounting treatment conforms to the accounting standards specified in s.133 and a certificate to that effect has been filed.

Step 5. Leave the balancing instruction until last. Instruction 8 says the balance goes to Capital Reserve. It cannot be obeyed until every other entry is posted, because it is the balance. A student who tries to compute it early will compute it wrong.

The checks to run before writing the answer out

Does every sacrifice have a matching reduction in a capital or liability account? A sacrifice by equity shareholders reduces Equity Share Capital. A sacrifice by creditors reduces Creditors.

Does every write-off correspond to something actually on the Balance Sheet? A scheme that writes off Rs 60,000 from plant needs plant on the Balance Sheet at more than Rs 60,000.

Does the Capital Reduction Account close? The sacrifices credited must at least equal the write-offs debited. Any surplus goes where the scheme says, usually Capital Reserve. A debit balance left in the account means an error, not a loss: the scheme was designed to absorb the write-offs.

Does the reconstructed Balance Sheet balance? If it does not, the error is upstream, and the fastest place to find it is the Capital Reduction Account.

What the question will not tell you

It will not tell you which section authorises each step. That is what the "legal provisions" half of MU's topic 3 wants, and the mapping is:

In short

• Turn the paragraph into a numbered list before posting anything.
• Mark each instruction as a sacrifice, a write-off, or a settlement; they behave differently.
• Arrears of preference dividend are usually not in the books, so forgoing them may produce no entry. Read the Balance Sheet.
• An asset handed to a creditor is a settlement, not a sacrifice; only the difference reaches Capital Reduction.
• Do the balancing instruction last, because it is the balance.
• A debit balance left in the Capital Reduction Account is an error, not a result.

Answer in one sentence

How should a scheme of reconstruction be approached? By listing the scheme's instructions separately, classifying each as a sacrifice by a class of stakeholders, a write-off of an asset or loss, or a settlement between existing book figures, posting the sacrifices and write-offs through the Capital Reduction Account, and computing any balancing transfer only after every other entry has been made.

The debenture liability is reduced by a separate entry, debiting Debentures and crediting Shares Surrendered, depending on how the scheme expresses the bargain.

Stage 2(b), where the balance is cancelled. The 4,000 shares nobody takes are cancelled, and the capital they represent is a sacrifice by the members who gave them up.

The Shares Surrendered Account must close. It received Rs 1,00,000 and has given out Rs 60,000 and Rs 40,000. Nothing is left in it. If a balance remains, an instruction in the scheme has not been carried out.

Surrender, forfeiture and cancellation compared

In short

• The Act has no section on surrender; it is a device, not a power.
• It is lawful only where the company could have forfeited the shares anyway, or as part of a reduction sanctioned under s.66.
• A surrender that returns capital outside s.66 is a reduction by the back door and is bad.
• Recorded through a temporary Shares Surrendered Account, which must close to nil.
• Re-issued shares go back to Share Capital; cancelled shares go to Capital Reduction.
• It is not forfeiture, and it is not the cancellation of unissued shares under s.61(1)(e).

Answer in one sentence

What is surrender of shares? The voluntary return by a shareholder of his shares to the company, which the Companies Act 2013 nowhere authorises as such and which is therefore lawful only where the company could lawfully have forfeited the shares, or where it forms part of a scheme of reduction of capital confirmed by the Tribunal under s.66.

How is a surrender recorded? By debiting Share Capital and crediting a temporary Shares Surrendered Account, which is then closed by crediting Share Capital with any shares re-issued and crediting Capital Reduction Account with the capital on any shares cancelled.

Step 1: compute each sacrifice

Show these as working notes. They earn marks of their own.

Step 2: compute each write-off

Step 3: the account itself

The account closes. Rs 4,10,000 was given up, Rs 3,70,000 was spent, and the surplus of Rs 40,000 becomes a Capital Reserve, which will appear on the liabilities side of the new Balance Sheet.

Why the surplus is a Capital Reserve and not a profit

The company has not earned it. It arises because its owners and its creditors agreed to accept less than they were entitled to. A gain of that kind is not available for distribution as dividend, so it is set aside as a capital reserve rather than credited to the Profit and Loss Account.

A student who transfers the surplus to Profit and Loss has undone the whole purpose of the scheme, which was to clear that account.

What the account is called

MU and most textbooks call it the Capital Reduction Account. Some call it the Reconstruction Account, and a few call it the Capital Reduction and Reconstruction Account. They are the same account. Use whichever name the question uses, and if the question gives none, use Capital Reduction Account and say so once.

In short

• Credit what stakeholders give up; debit what is written off.
• Sacrifices are designed to be at least equal to write-offs.
• A credit balance goes to Capital Reserve; a debit balance means an error.
• The surplus is a capital reserve, never a trading profit, and is not distributable.
• The account is temporary and never appears in the reconstructed Balance Sheet.
• Set the sacrifices and the write-offs out as numbered working notes; they are marked.

Answer in one sentence

What is the Capital Reduction Account? A temporary account opened to give effect to a scheme of internal reconstruction, to which every sacrifice by shareholders, debenture-holders and creditors is credited and against which every write-off of an asset, accumulated loss or newly recognised liability is debited, the surplus being transferred to Capital Reserve.

What does a debit balance on the account indicate? An error in the entries, because a scheme is framed so that the sacrifices at least equal the amounts to be written off.

A debenture-holder taking an asset in settlement. Suppose debenture-holders take the freehold property, book value Rs 2,50,000, in part satisfaction of their Rs 2,00,000 claim, the excess being paid to them in cash:

No part of this touches Capital Reduction, because nobody has sacrificed anything: an asset has been exchanged for a liability at book value. Only a difference between the two would reach the account.

A provision newly recognised. A claim against the company that the scheme requires to be provided for is a write-off, and joins entry 4:

The narration

Every entry carries one, and MU's markers give credit for it. A narration should say what was done, to how many shares or how much of a claim, and under whose authority. "Being shares reduced" earns less than "Being 60,000 equity shares of Rs 10 each reduced to Rs 4 each fully paid under the scheme sanctioned by the Tribunal".

Where a figure comes from a working note, cite the note in the narration, as above. That is what lets a marker follow the arithmetic without recomputing it.

In short

• Fill the credit side first: capital reductions, then forgiven liabilities.
• Write-offs go in one compound entry, not several.
• Close the account to Capital Reserve last.
• An asset handed over in settlement of a liability does not touch Capital Reduction unless there is a difference in value.
• Arrears of preference dividend produce an entry only if they are in the books.
• Narrate every entry and cite the working note the figure came from.

Answer in one sentence

Give the entry for a reduction of equity capital under a scheme. Debit the old Equity Share Capital Account with its full paid-up amount, credit the new Equity Share Capital Account with the reduced amount, and credit the difference to the Capital Reduction Account.

How is a creditor's sacrifice recorded? By debiting Sundry Creditors with the amount forgone and crediting Capital Reduction Account.

Step 3. Capital Reduction Account

Step 4. Reconstructed Balance Sheet

Balance Sheet of Ashwin Ltd. as at 31st March, after reconstruction

A second scheme, at the difficulty MU actually sets

Ashwin Ltd. above has six adjustments and every one of them is a straight reduction or write-off. A real paper is harder than that. MU's own TYBCom Financial Accounting paper of October 2024 set a reconstruction with eight adjustments, including a preference share conversion, an asset sold at a profit inside the scheme, arrears half waived and half paid in cash, and an asset handed to debenture-holders with fresh debentures for the balance.

None of those appears above, so here is a second scheme that carries all of them. Work Ashwin first; work this one until it is easy.

The Balance Sheet of Vikram Ltd. stood as follows.

The preference dividend is in arrears for two years. The following scheme was sanctioned. (1) The equity shares are to be reduced to Rs 4 each fully paid. (2) The 12 per cent cumulative preference shares are to be converted into an equal number of 10 per cent preference shares of Rs 70 each fully paid. (3) The investments are to be sold at a profit of 10 per cent. (4) The preference shareholders agreed to waive half the arrears of dividend, the remaining half being paid in cash. (5) The debenture-holders agreed to accept the plant and machinery at Rs 2,60,000 and 400 new 15 per cent debentures of Rs 100 each in full settlement of their claim. (6) The debenture-holders agreed to forgo half the outstanding interest, the balance being paid in cash. (7) Goodwill, the Discount on Issue of Shares and the debit balance of Profit and Loss are to be written off in full. (8) Any balance is to be transferred to Capital Reserve.

Working notes

On WN 4 and WN 5, which is the trap. The arrears of preference dividend are not in the books: a preference dividend is payable only when declared, so unpaid arrears are a contingent item disclosed by note. Waiving them therefore produces no entry at all. What does produce an entry is the half that is paid, and because the company is paying a sum it never owed in its books, the debit goes to the Capital Reduction Account. A student who credits Capital Reduction with the waived Rs 48,000 has invented a liability in order to forgive it.

On WN 6. The debenture-holders' claim is Rs 3,00,000. They take plant valued at Rs 2,60,000 and Rs 40,000 of new debentures, which settles it exactly. But the plant leaves the books at Rs 3,20,000, so Rs 60,000 of value has gone for nothing and that loss is a charge on Capital Reduction.

Journal entries

Capital Reduction Account

Balance Sheet after the scheme

Balance Sheet of Vikram Ltd. after reconstruction

The bank overdraft. It began at Rs 60,000, was reduced by the Rs 88,000 received for the investments, and increased by the Rs 48,000 of arrears and the Rs 18,000 of interest paid: Rs 60,000 less Rs 88,000 plus Rs 48,000 plus Rs 18,000 is Rs 38,000. A scheme that moves cash always moves the overdraft, and forgetting it is the commonest reason a reconstructed Balance Sheet does not balance.

Plant and Investments are gone from the assets because both left the company: one to the debenture-holders, one to a buyer.

The seven things this scheme teaches that Ashwin Ltd. does not

1. A preference share converted, not merely reduced: the class, the rate and the face value all change in one entry, and the sacrifice is the fall in face value.
2. An asset sold at a profit inside the scheme: the profit is a capital gain and is credited to Capital Reduction, not to Profit and Loss.
3. Arrears half waived and half paid: the waiver produces no entry and the payment is a debit to Capital Reduction.
4. An asset handed over in part settlement with fresh securities for the balance, and the shortfall between book value and agreed value charged to Capital Reduction.
5. A liability that IS in the books being partly forgiven and partly paid, which behaves quite differently from the arrears in point 3.
6. Discount on Issue of Shares written off, a fictitious asset Ashwin Ltd. did not carry.
7. Cash movements changing the bank overdraft, which must be tracked to the last rupee.

What has actually happened

The Balance Sheet total has fallen from Rs 11,00,000 to Rs 7,30,000, a fall of Rs 3,70,000, which is exactly the amount written off.

Nothing left the company. No cash was paid to anyone. The freehold property, the stock, the debtors and the bank balance are untouched, and the business trades on with the same assets it had the day before.

What has gone is the fiction: Rs 80,000 of goodwill nobody would buy, Rs 2,50,000 of accumulated loss masquerading as an asset, and Rs 40,000 of plant value that was not there. The capital has been written down to match, and the company now shows a small Capital Reserve instead of a large accumulated loss.

It can now pay a dividend out of the next year's profits, because there is no debit balance to absorb them first. That was the point of the whole exercise, and a closing sentence saying so is worth writing.

Marks to be sure of

• Show the working notes and number them. Cite the number in the narration.
• Balance the Capital Reduction Account and show its total. A debit balance means an error, not a loss.
• Do not transfer the surplus to Profit and Loss. It is a Capital Reserve.
• Carry forward every figure the scheme did not touch. Freehold, stock, debtors, cash and the debentures come across unchanged, and a Balance Sheet that omits them will not balance.
• State the authority once: reduction under s.66, confirmed by the Tribunal; any sub-division or consolidation under s.61; notice to the Registrar under s.66(5).

In short

• Working notes, journal, Capital Reduction Account, Balance Sheet. In that order.
• The fall in the Balance Sheet total equals the total written off.
• The reconstructed Balance Sheet must balance; if it does not, check the Capital Reduction Account first.
• Say at the end what the company has gained: a clean Balance Sheet and the ability to pay a dividend.

Answer in one sentence

Set out the order of a reconstruction answer. Numbered working notes computing each sacrifice and each write-off; the journal entries with narrations citing those notes; the Capital Reduction Account showing the sacrifices credited, the write-offs debited and the surplus carried to Capital Reserve; and the reconstructed Balance Sheet.

Pass the journal entries, prepare the Capital Reduction Account and draw the Balance Sheet after the scheme.

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Answers

Question 1

2,00,000 shares of Rs 10 each, Rs 7.50 paid on each. The old share was 75 per cent paid, so each new share must be 75 per cent paid, which s.61(1)(d) requires.

The entry is at the paid-up figure of Rs 15,00,000, not the nominal Rs 20,00,000. That is the mark most often lost here.

Question 2

Capital Reduction Account

Balance Sheet after the scheme

The check: the Balance Sheet fell from Rs 10,00,000 to Rs 7,20,000, a fall of Rs 2,80,000, which is exactly the total written off in WN 4.

Question 3

Capital Reduction Account

Balance Sheet after the scheme

The bank overdraft. Rs 50,000 at the start, less the Rs 72,000 received for the investments, plus the Rs 22,000 of arrears and Rs 8,250 of interest paid, is Rs 8,250.

Three marks students lose on this question. Crediting the Capital Reduction Account with the waived arrears, which are not in the books and so cannot be forgiven in the ledger. Forgetting the Rs 50,000 shortfall on the machinery. And leaving the bank overdraft at Rs 50,000.

In short

• Work the question before reading the answer; a solution read is not a solution learnt.
• Check the Capital Reduction Account first. If it does not close, nothing after it can be right.
• The fall in the Balance Sheet total equals the total written off, less any gain credited.
• Arrears of preference dividend: waiving produces no entry, paying is a debit to Capital Reduction.
• Track every rupee of cash through the bank balance or overdraft.

A company that takes over another's entire undertaking, the other being wound up, has made an amalgamation. There is one company left. That is AS 14.

Why an external reconstruction is inside AS 14

Module I ended with the point and it can now be made properly. In an external reconstruction the old company is wound up and a new company takes over its business. The transferor is dissolved. That is an amalgamation on paragraph 2's own test, and because the conditions for a merger will not be satisfied, it is accounted for by the purchase method.

So the two modules are joined: the same commercial event, called reconstruction in Module I's vocabulary and amalgamation in Module II's, and only the first kind, the internal one, escapes AS 14.

Why a standard is needed at all

Suppose Alpha Ltd. takes over Beta Ltd. Beta's plant stands in its books at Rs 1,80,000 and is worth Rs 1,60,000. Beta has a General Reserve of Rs 60,000 built up over years of trading.

Without a rule, Alpha could record the plant at Rs 1,80,000 or Rs 1,60,000. It could carry Beta's General Reserve into its own reserves or ignore it. It could show a goodwill figure or not. Each choice changes Alpha's reported profits for years afterwards, and none of them is obviously wrong.

AS 14 removes the choice. It sorts every amalgamation into one of two kinds, and each kind has one method with one answer.

In short

• Transferor: amalgamated into another, dissolved, books close. Transferee: the survivor.
• Paragraph 1: the standard deals with amalgamations and the resulting goodwill and reserves.
• Paragraph 2: it does not deal with acquisitions, and the test is that in an acquisition the acquired company is not dissolved and its separate entity continues to exist.
• Buying a majority of shares is an acquisition, not an amalgamation.
• External reconstruction is an amalgamation, and is accounted for by the purchase method.
• The standard exists to remove the choice about the figures at which a business arrives.

Answer in one sentence

What does AS 14 deal with? Accounting for amalgamations and the treatment of any resultant goodwill or reserves, principally in the case of companies.

How does an amalgamation differ from an acquisition? In an amalgamation the transferor company is dissolved and its undertaking passes to the transferee; in an acquisition the company whose shares or assets are purchased is not dissolved and its separate entity continues to exist, and AS 14 does not apply to it.

None of that is on this paper. Every question a student meets on this syllabus will have the transferee holding no shares in the transferor before the amalgamation. If a textbook chapter opens by asking how many shares the transferee already holds, it is answering a question MU has not set.

Read the module title on the syllabus page before an examination, because a carve-out is the kind of thing a University removes without announcement.

What "treatment under purchase method only" means

MU's third topic reads: Computation of Purchase Consideration and treatment under purchase method only.

Both methods are examinable as concepts: their principles, the conditions that decide between them, and the distinction. What is limited is the entries. A question asking you to pass the entries in the transferee's books will be a purchase-method question.

This book teaches both, and works both, because AS 14's paragraphs on pooling are part of the standard and a student asked to distinguish the methods must know how each behaves. But [The Purchase Method, Worked in the Transferee's Books] is the chapter this paper turns on.

In short

• Amalgamation, absorption and external reconstruction are one transaction with three trade names; AS 14 treats them alike.
• In scope: any transaction where the undertaking passes and the transferor is dissolved, under the Companies Act or any other statute applicable to companies.
• Out of scope: acquisitions, where the other company survives; and interest, dividends, rentals and leases.
• MU excludes intercompany holdings, so no question will have the transferee already holding shares in the transferor.
• MU limits treatment to the purchase method, so entries will be purchase-method entries; both methods remain examinable as concepts.

Answer in one sentence

Are absorption and external reconstruction different from amalgamation under AS 14? No. They are trade names for amalgamations in which, respectively, an existing company takes over another and a newly formed company takes over an existing one; AS 14 applies the same two methods to all of them.

What does AS 14 not apply to? Acquisitions, in which the company whose shares or assets are purchased is not dissolved and continues to exist, and matters governed by other standards such as the recognition of interest, dividends and rentals and the accounting for leases.

The four that are asked most

Reserve against provision, since the definition invites it

Why the definitions decide everything

The structure of the standard falls straight out of paragraph 3.

Definition (e) lists five conditions. Definition (f) says failing any one of them makes it a purchase. Paragraph 31 then says a merger is accounted for by pooling and paragraph 32 says a purchase is accounted for by the purchase method.

So the whole of Module II is: test the five conditions, pick the method, apply it. Everything else is arithmetic.

In short

• Transferor is amalgamated into the transferee. The transferee survives.
• A reserve is an appropriation, for any purpose other than depreciation, diminution in value or a known liability. A provision is a charge.
• Merger satisfies all five conditions; purchase fails any one. There is no third kind.
• Consideration is what goes to the shareholders of the transferor, in shares, securities, cash or other assets.
• Fair value is an arm's length exchange amount between knowledgeable willing parties.
• Pooling accounts for the amalgamation as if the businesses were simply continuing.

Answer in one sentence

Define reserve as AS 14 uses it. The portion of earnings, receipts or other surplus of an enterprise, whether capital or revenue, appropriated by the management for a general or specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability.

Define the consideration for an amalgamation. The aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company.

Define fair value. The amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm's length transaction.

(iii) The consideration for the amalgamation receivable by those equity shareholders of the transferor company who agree to become equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company, except that cash may be paid in respect of any fractional shares.

Wholly in equity shares. Not preference shares, not debentures, not cash, with the single exception of cash for fractional shares. A scheme that pays even a small part of the consideration in cash, other than for fractions, fails this condition and the amalgamation becomes a purchase.

(iv) The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company.

It is a test of intention. A scheme under which the transferee intends to close the business down and sell the assets fails it.

(v) No adjustment is intended to be made to the book values of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company, except to ensure uniformity of accounting policies.

Book values are carried across untouched. The only permitted change is to align accounting policies. A scheme that revalues the plant, however sensibly, fails this condition.

What paragraph 6 adds

Paragraph 6 records that others believe the substance of an amalgamation in the nature of merger is evidenced by meeting certain criteria. It is the standard acknowledging that the five conditions are a chosen test rather than the only conceivable one.

For an examination the point is simple: the five conditions in paragraph 29 are the test, and no argument about substance can substitute for them.

How to answer a question that gives you facts

Test them one at a time, in order, and say which condition each fact bears on.

All five: merger, and pooling of interests applies.

Change any one line, for example the consideration includes Rs 20,000 in cash to shareholders, and condition (iii) fails, so the amalgamation is in the nature of purchase even though the other four are satisfied.

Say which condition failed. A question asking you to classify an amalgamation is marked on the reasoning, not the label.

In short

• Paragraph 4: one category is a genuine pooling of businesses and shareholders; the other is an acquisition in substance.
• All five conditions must be satisfied for a merger.
• 90 per cent of face value of equity, excluding shares already held by the transferee or its subsidiaries or nominees.
• Consideration wholly in equity shares, cash permitted only for fractional shares.
• The business must be intended to be carried on.
• No adjustment to book values, except to align accounting policies.
• Name the condition that fails; that is where the marks are.

Answer in one sentence

State the conditions for an amalgamation in the nature of merger. All the assets and liabilities of the transferor become those of the transferee; shareholders holding not less than 90 per cent of the face value of the transferor's equity shares, excluding any already held by the transferee or its subsidiaries or their nominees, become equity shareholders of the transferee; the consideration to those who so agree is discharged wholly by the issue of equity shares, save cash for fractional shares; the transferor's business is intended to be carried on; and no adjustment is intended to the book values of the assets and liabilities except to ensure uniformity of accounting policies.

An external reconstruction is always a purchase

The point Module I made can now be given its reason.

In an external reconstruction the whole object is to escape accumulated losses and to restate assets at what they are worth. Condition (v) forbids exactly that. So an external reconstruction fails condition (v) by design, and is accounted for by the purchase method.

In short

• Purchase is the residual category: any one of the five conditions failing is enough.
• State the definition first; the features of the method are consequences, not the test.
• Paragraph 4's reasoning: the transferor's shareholders do not keep a proportionate stake, so something has been bought.
• Condition (iii), consideration not wholly in equity shares, fails most often; condition (v), revaluation of assets, next.
• An external reconstruction always fails condition (v) and is therefore always a purchase.
• The method that follows is paragraph 32's, worked in [The Purchase Method: Principles].

Answer in one sentence

What is an amalgamation in the nature of purchase? An amalgamation which does not satisfy any one or more of the five conditions specified for an amalgamation in the nature of merger, and which is accordingly accounted for under the purchase method.

Why is an external reconstruction accounted for as a purchase? Because its whole purpose is to restate the transferor's assets and clear its accumulated losses, which fails the condition that no adjustment be made to book values except to ensure uniformity of accounting policies.

Steps 1 and 2 take a minute and protect the other five.

A trap in the wording

Some questions describe the transaction as a "merger" in ordinary commercial language while the facts fail the conditions. The word in the question does not decide it. Paragraph 29 decides it, on the facts.

Equally, a question may call it a purchase while the facts satisfy all five conditions. Test the conditions; the label is not evidence.

In short

• The transferor is dissolved; the transferee survives. If there is a liquidator, that company is the transferor. A newly formed company is always the transferee.
• Classify against the five conditions before computing anything.
• Three fastest signals of a purchase: consideration not wholly in equity shares, assets taken at other than book values, or something left behind.
• The classification decides how assets are recorded, whether reserves come across, and whether the difference is goodwill or an adjustment in reserves.
• The word the question uses is not the test. Paragraph 29 is.

Answer in one sentence

How is the transferee company identified? It is the company into which the transferor is amalgamated: the survivor, whose books absorb the business, and never the company that goes into liquidation.

What is the first step in answering an amalgamation question? Identifying the transferor and transferee and classifying the amalgamation against the five conditions of paragraph 29, because the classification determines the values at which assets are recorded, the treatment of reserves, and whether the difference on consideration is goodwill or an adjustment in reserves.

So a share issued at a premium is counted at its issue price, not its face value. Fifty thousand shares of Rs 10 issued at Rs 12 are consideration of Rs 6,00,000, of which Rs 5,00,000 is share capital and Rs 1,00,000 is securities premium.

Paragraphs 14 and 15: what the consideration may consist of, and later adjustments

Paragraph 14 records that the consideration may consist of securities, cash or other assets, and that in determining it a fair value is placed on the various elements. It also notes that a valuation may be considered by the parties.

Paragraph 15 deals with a consideration that is not fixed at the outset. Many amalgamations recognise that adjustments may have to be made to the consideration in the light of one or more future events.

Paragraph 41 turns that into the rule: where the scheme provides for an adjustment contingent on future events, the additional payment should be included in the consideration if payment is probable and a reasonable estimate of the amount can be made. In all other cases the adjustment is recognised as soon as the amount is determinable.

That is a short-note question in its own right: contingent consideration under AS 14.

The test to apply to every item in a question

Ask one question of each: does this reach the shareholders of the transferor, in their character as shareholders?

In short

• Consideration is what goes to the shareholders of the transferor, and only that.
• Shares, other securities, cash and other assets all count.
• Debenture-holders, creditors and liquidation expenses do not count.
• Non-cash elements at fair value: securities at the value fixed by the statutory authorities, other assets at the market value of what is given up, and at net book value where market value cannot be reliably assessed.
• Shares issued at a premium count at issue price, split into capital and securities premium.
• Contingent consideration is included if payment is probable and reasonably estimable; otherwise when determinable.

Answer in one sentence

Define purchase consideration under AS 14. The aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company.

Are payments to debenture-holders part of the purchase consideration? No. Consideration is confined to what is given to the shareholders of the transferor company; amounts paid to or assumed for debenture-holders and creditors are liabilities taken over, not consideration.

At what value is a non-cash element included? At fair value: for securities, the value fixed by the statutory authorities may be taken; for other assets, the market value of the assets given up; and where that cannot be reliably assessed, their net book values.

Purchase consideration: Rs 5,15,000.

Notice what was not used

The General Reserve of Rs 60,000 and the Profit and Loss credit balance of Rs 40,000 never entered the computation. They are not liabilities. They belong to the shareholders, and the shareholders are being bought out; deducting them would be counting the same thing twice.

The equity share capital of Rs 4,00,000 likewise did not appear.

A student who deducts reserves arrives at Rs 4,15,000 and every later figure is wrong. This is the second commonest error in Module II after the consideration definition itself.

A cross-check worth doing

The net assets of a company always equal its shareholders' funds. On book values here:

Book assets Rs 6,80,000 less book liabilities Rs 1,80,000 is also Rs 5,00,000. The two agree, as they must.

The agreed values produce Rs 5,15,000 rather than Rs 5,00,000, a difference of Rs 15,000, which is the net effect of the revaluations: land up Rs 50,000, plant down Rs 20,000, stock down Rs 10,000, debtors down Rs 5,000.

That check takes thirty seconds and catches an arithmetic slip before it reaches the entries.

In short

• Agreed value of assets taken over, less agreed value of liabilities taken over.
• Exclude any asset not taken over, and exclude fictitious assets absolutely.
• Never deduct reserves or share capital. They are not liabilities.
• The result is the consideration only where the scheme says the price is the net assets; where the scheme fixes payments, the payments govern.
• Cross-check against shareholders' funds at book value, and reconcile the difference to the revaluations.

Answer in one sentence

How is purchase consideration computed under the net assets method? By taking the agreed values of all the assets taken over by the transferee, excluding any asset not taken over and all fictitious assets, and deducting the agreed values of the liabilities taken over, reserves and share capital being excluded because they are not liabilities.

Counting the shares at face value when they are issued at a premium is the third common error of this module.

The two methods on the same facts

Take the original terms, and set the two computations beside each other.

The difference of Rs 45,000 is what Alpha has paid over and above the value of what it received. Paragraph 37 says that excess is recognised as goodwill arising on amalgamation.

Had the consideration been less than the net assets, the difference would have been a Capital Reserve. Both are worked in [The Purchase Method: Principles].

Which method the question wants

On a share exchange ratio, compute the shares before the rupees. "Four shares in Alpha for every five held in Beta" on 40,000 Beta shares is 32,000 Alpha shares; at Rs 10 each that is Rs 3,20,000.

In short

• Add everything given to the shareholders, at fair value; discard everything else.
• Debentures taken over, creditors paid and liquidation expenses borne are not consideration.
• Shares issued at a premium count at issue price, split later into capital and premium.
• Where both methods are possible, the payments are the consideration and the net assets figure yields the goodwill.
• Consideration above net assets is goodwill; below is capital reserve.
• On an exchange ratio, find the number of shares first.

Answer in one sentence

How is purchase consideration computed under the net payments method? By aggregating, at fair value, everything the transferee agrees to issue or pay to the shareholders of the transferor company, and excluding amounts payable to debenture-holders and creditors and expenses of the liquidation.

What does the difference between the consideration and the net assets represent? Goodwill arising on amalgamation where the consideration exceeds the value of the net assets acquired, and a capital reserve where it is lower.

Why there is no goodwill under pooling

Goodwill arises when a price exceeds the value of what is bought. Under pooling nothing is bought and nothing is valued: the figures are simply added.

So pooling never produces goodwill and never produces a capital reserve on the amalgamation. If an answer under the pooling method shows goodwill, it has used the wrong method.

The two methods, on principle

In short

• Paragraph 31: a merger must be accounted for by pooling.
• Assets, liabilities and reserves at existing carrying amounts and in the same form.
• The transferor's Profit and Loss balance is aggregated with the transferee's or transferred to General Reserve.
• Conflicting accounting policies are made uniform, and the effect reported under AS 5.
• Paragraph 35: the difference between share capital issued and the transferor's share capital is adjusted in reserves.
• No goodwill, ever.

Answer in one sentence

State the principles of the pooling of interests method. The assets, liabilities and reserves of the transferor are recorded at their existing carrying amounts and in the same form; its Profit and Loss balance is aggregated with the transferee's or transferred to General Reserve; conflicting accounting policies are made uniform with the effect reported under AS 5; and the difference between the share capital issued together with any additional consideration and the transferor's share capital is adjusted in reserves.

Can goodwill arise under the pooling of interests method? No. Nothing is purchased and no asset is revalued, so no excess of consideration over net assets can arise; any difference on the capital is adjusted in reserves.

Reading entry 2

The General Reserve is credited with Rs 1,40,000, not Rs 60,000. It is Beta's own General Reserve of Rs 60,000 carried across under paragraph 33, plus the Rs 80,000 adjustment required by paragraph 35.

Beta's Profit and Loss credit balance of Rs 40,000 comes across intact, as paragraph 33 permits: aggregated with Alpha's own balance, or, if Alpha prefers, transferred to General Reserve.

No goodwill appears anywhere, and none can. Nothing was valued and nothing was bought.

What the same facts would produce under the purchase method

If any one condition had failed, the entries would look wholly different: assets and liabilities at fair values or existing carrying amounts, no General Reserve and no Profit and Loss carried across, and the difference between the consideration and the net assets recognised as goodwill or capital reserve.

That contrast is what a distinguish-between question is asking for, and it is worked in the next two chapters.

In short

• Classify first; all five conditions were satisfied, so pooling is compulsory.
• Assets, liabilities and reserves at existing carrying amounts.
• The transferor's General Reserve and Profit and Loss balance come across.
• Paragraph 35's difference is share capital issued less the transferor's share capital, adjusted in reserves. Here Rs 80,000, increasing General Reserve to Rs 1,40,000.
• No goodwill, no capital reserve on the amalgamation.

Answer in one sentence

How is the difference on capital treated under the pooling of interests method? The difference between the amount recorded as share capital issued, plus any additional consideration in cash or other assets, and the amount of the transferor's share capital is adjusted in reserves, increasing them where the capital issued is less and reducing them where it is more.

That is two different subtractions, and using the pooling one in a purchase question is a common and expensive error.

Why goodwill and not a loss

A student sometimes asks why paying more than the net assets are worth creates an asset rather than a loss.

Because the transferee did not pay too much. It paid for something the Balance Sheet does not carry: an established customer base, a trained workforce, a trading name, a location. Those are real and were bought, and goodwill is the accounting name for them in aggregate.

The standard does not let that sit as an asset for ever, which is why paragraph 38 requires it to be amortised: see [Goodwill Arising on Amalgamation and Its Amortisation].

A capital reserve, and what it means

Where the consideration is lower than the net assets, the transferee has bought at a bargain. Paragraph 37 makes that difference a Capital Reserve.

It is not a profit and it is not credited to the Profit and Loss Account, for the same reason the surplus on an internal reconstruction was not: the company has not earned it by trading.

In short

• Paragraph 32: a purchase must be accounted for by the purchase method.
• Paragraph 36: assets and liabilities at existing carrying amounts, or at fair values allocated from the consideration. The question decides which.
• Paragraph 36: the transferor's reserves, capital or revenue or on revaluation, are not carried over, except statutory reserves.
• Paragraph 37: consideration over net assets is goodwill; consideration under net assets is capital reserve.
• Paragraph 13: fair values may be influenced by the transferee's intentions for the asset.

Answer in one sentence

State the principles of the purchase method. The assets and liabilities of the transferor are incorporated at their existing carrying amounts, or the consideration is allocated to individual identifiable assets and liabilities at their fair values; the transferor's reserves other than statutory reserves are not included; and any excess of the consideration over the value of the net assets acquired is recognised as goodwill, any shortfall being treated as a capital reserve.

Are the transferor's reserves carried into the transferee's books under the purchase method? No. Reserves whether capital, revenue or arising on revaluation are excluded, the only exception being statutory reserves, which are recorded with a corresponding debit to an Amalgamation Adjustment Reserve under paragraph 39.

Working the closing figures

WN 12. Cash at bank.

The Balance Sheet

Balance Sheet of Alpha Ltd. after the amalgamation

What to notice, because each is a mark

The General Reserve is Rs 3,00,000, not Rs 3,60,000. It is Alpha's own. Beta's General Reserve of Rs 60,000 did not come across, because paragraph 36 excludes the transferor's reserves under the purchase method. A student who adds the two reserves together has used pooling.

The Profit and Loss balance is Rs 1,00,000, not Rs 1,40,000, for the same reason and by paragraph 22: Beta's credit balance lost its identity.

Equity capital rose by Rs 5,00,000, not by Rs 5,60,000. The shares issued are recorded at their face value; the Rs 60,000 of cash is not capital, and had the shares been issued at a premium the excess would sit in Securities Premium.

Beta's debentures appear, its share capital does not. Alpha assumed a liability; it did not take over Beta's capital.

Goodwill of Rs 45,000 stands as an asset, and under paragraph 38 it will be amortised to income over its useful life, not exceeding five years unless a longer period can be justified.

Cash fell by Rs 60,000 net, because Rs 80,000 came in with Beta and Rs 60,000 went out to Beta's shareholders. A Balance Sheet that forgets the cash paid will be out by exactly the cash element of the consideration.

What is not in entry 2, and why

Beta's General Reserve of Rs 60,000 does not appear. Paragraph 36 excludes the transferor's reserves.

Beta's Profit and Loss credit balance of Rs 40,000 does not appear. Same reason.

Beta's equity share capital of Rs 4,00,000 does not appear. Alpha did not take over Beta's capital; it bought Beta's business and issued capital of its own.

A student who brings any of those across has used pooling entries in a purchase question, and the entry will not balance.

Where a capital reserve would arise instead

Suppose Alpha had agreed to issue only 45,000 shares and pay no cash, so the consideration were Rs 4,50,000.

Entry 2 would then credit Capital Reserve Rs 65,000 in place of debiting Goodwill Rs 45,000, and it would still balance.

A question that produces a capital reserve is testing the same paragraph from the other side, and the commonest mistake is to record it as goodwill with a minus sign, or to credit it to the Profit and Loss Account. It is a capital reserve on the face of the Balance Sheet.

Where the shares are issued at a premium

If the 50,000 shares had been issued at Rs 12, the consideration would be Rs 6,60,000 as computed in [Computing Purchase Consideration: Net Payments Method, Worked]. Two things change:

• Goodwill becomes Rs 6,60,000 less Rs 5,15,000, which is Rs 1,45,000.
• Entry 3 splits: Equity Share Capital Rs 5,00,000 and Securities Premium Rs 1,00,000, with cash Rs 60,000.

In short

• Three entries: record the price, incorporate what was bought, discharge the price.
• Entry 2 is a single compound entry carrying the assets, the liabilities, the Business Purchase credit and the goodwill or capital reserve.
• The transferor's reserves, Profit and Loss balance and share capital never appear.
• Consideration over net assets is Goodwill debited; under net assets is Capital Reserve credited.
• Shares issued at a premium split into Share Capital and Securities Premium in entry 3, and raise the goodwill.

Answer in one sentence

Give the entry to incorporate the transferor's business under the purchase method. Debit each asset taken over at its agreed value and Goodwill with any excess of the consideration over the net assets, credit each liability taken over at its agreed value and the Business Purchase Account with the consideration, a capital reserve being credited instead where the consideration falls short of the net assets.

Paragraph 39: statutory reserves

Where the requirements of the relevant statute for recording the statutory reserves in the transferee's books are complied with, the statutory reserves of the transferor should be recorded in the financial statements of the transferee. The corresponding debit is given to a suitable account head, for example 'Amalgamation Adjustment Reserve', which should be presented as a separate line item. When the identity of the statutory reserves is no longer required to be maintained, both the reserves and that account should be reversed.

Why the debit is needed at all

Under the purchase method the transferee has already recorded everything it bought and paid for. Adding a reserve now would credit something with no debit to match it, and the Balance Sheet would not balance.

So a debit is created purely to hold the entry in place. It is not an asset in any real sense, which is why paragraph 39 requires it to be shown as a separate line item rather than buried among the assets, and why it is reversed the moment the statute stops requiring the reserve.

The entry, on a statutory reserve of Rs 25,000:

And on reversal, when the statute no longer requires it:

Where the scheme prescribes a different treatment

Paragraph 42 provides that where a scheme sanctioned under a statute prescribes the treatment to be given to the reserves, that treatment should be followed. Where it differs from what the standard would otherwise require, the first financial statements after the amalgamation must disclose a description of the treatment given and the reasons for it, the deviations from the standard, and the financial effect of the deviation.

So a statutory scheme can override the standard, but never silently.

In short

• Pooling: reserves keep their identity and come across in the same form.
• Purchase: reserves are not carried over, whether capital, revenue or on revaluation.
• The exception is statutory reserves, recorded against an Amalgamation Adjustment Reserve shown as a separate line item, both reversed when the statute no longer requires the reserve.
• Paragraph 21: under merger the Profit and Loss balance is aggregated or goes to General Reserve.
• Paragraph 22: under purchase it loses its identity, debit or credit.
• A scheme sanctioned under a statute may prescribe a different treatment, which must be followed and disclosed.

Answer in one sentence

How are the transferor's reserves treated under each method? Under the pooling of interests method they are recorded at their existing carrying amounts and in the same form, their identity being preserved; under the purchase method they are not included at all, except statutory reserves.

What is the Amalgamation Adjustment Reserve? The account debited when a statutory reserve of the transferor is recorded in the transferee's books under the purchase method, presented as a separate line item and reversed, together with the statutory reserve, when the identity of that reserve is no longer required to be maintained.

What becomes of the transferor's Profit and Loss balance? Under a merger it is aggregated with the transferee's balance or transferred to General Reserve; under a purchase it loses its identity, whether it is a debit or a credit balance.

Goodwill on amalgamation against goodwill generally

A student who has met goodwill elsewhere may be confused by the amortisation requirement, so the distinction is worth drawing.

Self-generated goodwill is never brought into the books. That is why Beta Ltd.'s own goodwill, had it carried any, would have been excluded from the net assets computation as a fictitious asset, while the goodwill Alpha recognises on buying Beta is a real asset in Alpha's books.

The capital reserve, for contrast

Where the consideration is less than the net assets, paragraph 37 gives a Capital Reserve.

A capital reserve is not amortised. There is nothing to write off; it is a credit balance among the reserves. Nor is it distributed as dividend, because it was not earned.

That asymmetry is examinable: goodwill is written off to income over not more than five years; a capital reserve simply stands.

In short

• Goodwill on amalgamation arises only under the purchase method, as consideration less net assets acquired.
• Paragraph 19: it is a payment made in anticipation of future income, and its useful life is estimated on a prudent basis.
• Paragraph 38: amortised to income on a systematic basis over its useful life, not exceeding five years unless a somewhat longer period can be justified.
• Five years is a ceiling, not a fixed term.
• Paragraph 20's factors justify the period chosen: life of the business or industry, obsolescence and demand, service life of key employees, competitors' expected actions, and legal or contractual provisions.
• A capital reserve is not amortised.

Answer in one sentence

How is goodwill arising on amalgamation treated? It is recognised as an asset and amortised to income on a systematic basis over its useful life, the amortisation period not exceeding five years unless a somewhat longer period can be justified.

Why is goodwill arising on amalgamation amortised? Because it represents a payment made in anticipation of future income, so it is written off against that income as it arises, its useful life being estimated on a prudent basis.

What factors determine the useful life of such goodwill? The foreseeable life of the business or industry; product obsolescence, changes in demand and other economic factors; the service life expectancies of key individuals or groups of employees; expected actions by competitors or potential competitors; and legal, regulatory or contractual provisions affecting the useful life.

Two halves, and both matter.

It is disclosed. A reader of accounts made up to 31 March is entitled to know that the company was amalgamated in May, before those accounts were issued.

It is not incorporated. The accounts report the position at the balance sheet date, and at that date the amalgamation had not happened.

Paragraph 27 adds a nuance that is asked: in certain circumstances the amalgamation may also provide additional information affecting the financial statements themselves, for instance by allowing the going concern assumption to be maintained.

That is the exception which proves the rule. A company that would otherwise not be a going concern, rescued by an amalgamation agreed after the year end, may prepare its accounts on a going concern basis. The amalgamation is still not incorporated, but it has changed the basis on which the accounts are drawn.

Paragraph 41: contingent consideration

Where the scheme provides for an adjustment to the consideration contingent on one or more future events, the amount of the additional payment should be included in the consideration if payment is probable and a reasonable estimate of the amount can be made. In all other cases the adjustment should be recognised as soon as the amount is determinable.

Note the link to disclosure: paragraph 45 requires a description of the consideration paid or contingently payable, so a contingent element that is not yet included in the figure must still be described.

Paragraph 42: where the scheme prescribes a different treatment of reserves

Dealt with in [Treatment of Reserves, and the Amalgamation Adjustment Account], and repeated here because it is a disclosure requirement. Where a statutory scheme prescribes a treatment of the transferor's reserves different from the standard's, the first financial statements must disclose a description of the treatment given and the reasons for it, the deviations from the standard, and the financial effect of the deviation.

In short

• All amalgamations: names and nature of business, effective date, method of accounting, particulars of the scheme.
• Pooling adds: description and number of shares issued with the percentage exchanged, and the difference and its treatment.
• Purchase adds: the consideration paid or contingently payable, and the difference and its treatment including the amortisation period of goodwill.
• All in the first financial statements following the amalgamation.
• After the balance sheet date: disclosed under AS 4, not incorporated; but it may allow the going concern assumption to be maintained.
• Contingent consideration is included if probable and reasonably estimable, otherwise recognised when determinable, and described in any event.

Answer in one sentence

What disclosures does AS 14 require for all amalgamations? In the first financial statements following the amalgamation: the names and general nature of business of the amalgamating companies, the effective date of the amalgamation for accounting purposes, the method of accounting used, and particulars of the scheme sanctioned under a statute.

How is an amalgamation effected after the balance sheet date treated? Disclosure is made in accordance with AS 4 but the amalgamation is not incorporated in the financial statements, although it may provide information affecting those statements, for instance by allowing the going concern assumption to be maintained.

What is excluded, and why.

The debentures of Rs 2,00,000 are a liability taken over, not a payment to shareholders. Paragraph 3(g) confines consideration to what is given to the shareholders of the transferor company, and debenture-holders are creditors.

The liquidation expenses of Rs 12,000 are an expense of winding up the transferor, not part of the price payable to its shareholders.

The shares count at Rs 12, not Rs 10. Paragraph 40 requires the non-cash element at fair value, and for securities the issue price fixed by the statutory authorities may be taken as fair value. Counting them at face value gives Rs 4,50,000 and an answer of Rs 6,00,000, which is wrong by Rs 90,000.

A student who adds everything arrives at Rs 9,02,000. That is the whole point of the question.

Question 3

WN 5. The difference.

The consideration is LESS than the net assets, so the difference is a Capital Reserve, not goodwill. It is credited on the face of the Balance Sheet and is never credited to the Profit and Loss Account, and it is never amortised.

The entries in P Ltd.'s books

Three things to check in your own answer.

Q Ltd.'s General Reserve of Rs 80,000 and Profit and Loss of Rs 40,000 do not appear anywhere. Paragraph 36 excludes the transferor's reserves under the purchase method, and paragraph 22 says its Profit and Loss balance loses its identity.

Entry 3 splits the consideration three ways. Rs 4,50,000 of share capital at face value, Rs 90,000 of securities premium, Rs 1,50,000 of cash. Crediting Share Capital with the whole Rs 5,40,000 is the common error.

The Capital Reserve is credited in entry 2, not entry 3. It arises on the acquisition of the net assets, not on the discharge of the price.

In short

• Classify first, and name the condition that fails.
• Consideration is what reaches the shareholders: not debentures taken over, not liquidation expenses.
• Shares issued at a premium count at issue price, and split into capital and premium when discharged.
• Consideration below net assets gives a Capital Reserve, which is never amortised and never credited to profit and loss.
• The transferor's reserves and Profit and Loss never cross into the transferee's books under the purchase method.

So investments divide by what they give the holder:

A debt investment gives a fixed return and a right to repayment. Debentures, bonds, government securities. The return is interest, and it accrues with time whether or not it is paid.

An equity investment gives a share in results and net assets. Equity shares. The return is a dividend, which arises only when declared.

That difference drives everything in [Interest, Dividends and Rentals: Pre- and Post-acquisition], because interest accrues day by day and a dividend does not.

Most investments represent financial rights, but some are tangible, such as certain investments in land or buildings.

Why a separate standard is needed

Three reasons, and a question asking "why is AS 13 necessary" wants them.

The carrying amount rule differs by intention. An investment the company means to sell soon is carried at the lower of cost and fair value; one it means to keep is carried at cost. No other asset is treated by reference to how long the owner means to hold it.

Income and capital must be separated. Part of what a buyer pays for an interest-bearing security is interest that has already accrued. Treating that as income would overstate profit and overstate the cost of the investment at the same time.

The gain on sale is not trading profit. It is the difference between the carrying amount and the net proceeds, and paragraph 34 sends it to the Profit and Loss Account as its own item.

In short

• An investment is held for income or gain, not for use in the business and not for sale in the ordinary course of trade.
• Purpose decides, not the nature of the asset: the same building may be plant or an investment property.
• Securities held for sale in the ordinary course of business are stock-in-trade, not investments.
• Investments may be a debt, giving interest that accrues with time, or a stake in results and net assets, giving a dividend that arises only when declared.
• Some have no physical existence; some, such as land and buildings, do.
• AS 13 exists because the carrying amount depends on intention, because income must be split from capital, and because the gain on disposal is its own item.

Answer in one sentence

What does AS 13 deal with? Accounting for investments in the financial statements of enterprises and the related disclosure requirements.

How does an investment differ from stock-in-trade? An investment is held for the income or capital appreciation it yields, whereas shares, debentures and other securities held for sale in the ordinary course of business are stock-in-trade and are disclosed under current assets, not as investments.

So AS 13 decides that it is an investment and that it must be disclosed as one; AS 10 decides the figure. That split is worked in [Investment Properties].

In short

• AS 13 covers recognition, cost, carrying amount, disposal and disclosure of investments.
• Excluded: the bases of recognition of interest, dividends and rentals, which are AS 9's; operating and finance leases; retirement benefit plans and life insurance enterprises; and mutual funds, venture capital funds, banks and public financial institutions.
• Exclusion (a) does not remove the pre-acquisition question, which paragraph 12 answers and which this module teaches.
• Investment properties are within AS 13 but measured under the cost model in AS 10.

Answer in one sentence

What does AS 13 not deal with? The bases of recognition of interest, dividends and rentals earned on investments, which are covered by AS 9; operating or finance leases; investments of retirement benefit plans and life insurance enterprises; and mutual funds, venture capital funds and the related asset management companies, banks and public financial institutions formed under a Central or State Act or so declared under the Companies Act.

If AS 9 governs the recognition of interest, why does AS 13 deal with pre-acquisition interest? Because AS 9 settles when interest becomes income, whereas AS 13 paragraph 12 settles whether a particular receipt is income at all or a recovery of part of the price paid for the investment.

Fair value and market value, which are not the same

Students use these interchangeably and the standard does not.

Fair value is the wider idea: what a knowledgeable willing buyer and seller would exchange it for at arm's length. Definition 3.5 says market value or net realisable value provides an evidence of fair value, which is the language of proof, not identity.

Market value is narrower and specific: the amount obtainable from a sale in an open market, net of the expenses necessarily to be incurred on or before disposal.

That deduction is the examinable part. A share quoted at Rs 250 with brokerage and duties of Rs 3 payable on sale has a market value of Rs 247, not Rs 250.

Paragraph 14 links the two: for investments for which an active market exists, market value generally provides the best evidence of fair value. Where there is no active market, fair value has to be estimated another way.

Investment property, and the word "substantially"

Definition 3.4 excludes land or buildings intended to be occupied substantially for use by, or in the operations of, the investing enterprise.

The word substantially does the work. A company that owns a building, lets four floors and uses one for its own offices, has not disqualified the building; a company that occupies most of it has. The test is not all-or-nothing.

In short

• Investments: held for dividends, interest, rentals, capital appreciation or other benefits. Stock-in-trade is excluded.
• Current: readily realisable by nature AND intended to be held not more than one year from the date of the investment. Both limbs.
• Long-term: anything else. Defined as the residue.
• The test is of intention at the date of investment, not of what actually happened.
• Fair value: arm's length exchange amount; market value or net realisable value is evidence of it.
• Market value: obtainable in an open market, net of expenses necessarily incurred on or before disposal.
• Investment property: land or buildings not intended to be occupied substantially by the enterprise.

Answer in one sentence

Define a current investment. An investment that is by its nature readily realisable and is intended to be held for not more than one year from the date on which it is made.

Define market value, and distinguish it from fair value. Market value is the amount obtainable from the sale of an investment in an open market, net of expenses necessarily to be incurred on or before disposal; fair value is the amount for which the asset could be exchanged between a knowledgeable willing buyer and seller in an arm's length transaction, of which market value or net realisable value provides evidence.

Define an investment property. An investment in land or buildings that are not intended to be occupied substantially for use by, or in the operations of, the investing enterprise.

The statute comes first. Where the Companies Act or another statute governing the enterprise prescribes a classification, that classification governs and paragraph 27's list does not apply. The list is a default.

Debt and equity, and why the difference matters later

The whole of [Interest, Dividends and Rentals: Pre- and Post-acquisition] rests on this, so it is worth stating now.

Interest accrues; a dividend is declared. That single line decides most of the computations in this module.

In short

• Paragraph 4: enterprises hold investments for diverse reasons, and for some the investments are the business.
• Paragraph 5: an investment may have no physical existence, or may be tangible; it may be a debt, excluding loans and trade debts, or a stake in results and net assets.
• Paragraph 6: where an active market exists, market value is generally the best evidence of fair value; where it does not, other means are used.
• Paragraph 27: classify as the governing statute requires; failing that, into Government or Trust securities; shares, debentures or bonds; investment properties; and others, specifying nature.
• Interest accrues with time; a dividend arises only on declaration.

Answer in one sentence

What forms may an investment take? It may have no physical existence and be represented by certificates, such as shares, or exist in physical form, such as buildings; and in nature it may be a debt other than a loan or trade debt, usually bearing interest, or a stake in the results and net assets of an enterprise.

How are investments further classified for disclosure? As specified by the statute governing the enterprise, and in the absence of any such requirement into Government or Trust securities, shares, debentures or bonds, investment properties, and others specifying their nature.

Two consequences follow that questions test.

A long-term investment does not become current merely because it now has less than a year to run. A ten-year debenture in its final months is still a long-term investment unless it is reclassified.

An investment sold sooner than intended was not a current investment all along. The classification was correct when made.

Why it matters

A misclassification therefore changes the carrying amount, the profit, and the disclosure. It is not a labelling exercise.

In short

• Paragraph 26: current and long-term investments are disclosed distinctly.
• Paragraph 8: long-term is the residue, and an investment is long-term even though it may be readily marketable.
• Both limbs of definition 3.2 must hold for a current investment: readily realisable by nature, and intended to be held not more than one year.
• The intention is tested at the date the investment is made, not later.
• A long-term investment does not become current by the passage of time; that requires a reclassification.
• Paragraph 7: current investments are in the nature of current assets, though commonly shown among investments.

Answer in one sentence

How are investments classified under AS 13? As current investments, being those readily realisable by nature and intended to be held for not more than one year from the date the investment is made, and as long term investments, being all others; and an enterprise should disclose the two distinctly in its financial statements.

Does a readily marketable investment have to be a current investment? No. Paragraph 8 provides that investments other than current investments are classified as long term investments even though they may be readily marketable, because the intention to hold for not more than a year is a separate and necessary condition.

What is not part of cost

Interest that had accrued before the purchase. Where the price paid includes interest already accrued, that part is not cost; it is a recovery of the price when the interest is received. Paragraph 12 governs, and it is worked in [Interest, Dividends and Rentals: Pre- and Post-acquisition].

Interest on money borrowed to buy the investment, which is a finance cost of the enterprise, not a charge of acquiring the asset.

In short

• Cost is the price plus acquisition charges: brokerage, fees and duties, the list being illustrative.
• Never charged to the Profit and Loss Account as an expense.
• Understating cost overstates the current expense now and the gain on disposal later.
• Charges on sale are deducted from the proceeds, not added to cost.
• Pre-acquisition interest included in the price is not cost; it is dealt with under paragraph 12.

Answer in one sentence

What is included in the cost of an investment? The purchase price together with acquisition charges such as brokerage, fees and duties.

How is brokerage on the sale of an investment treated? It is deducted in arriving at the net disposal proceeds, against which the carrying amount is set to determine the profit or loss on disposal, and is not charged separately to the Profit and Loss Account.

The investment stands at Rs 3,40,000, the capital at its par value, and the premium takes the difference.

Worked, acquisition in exchange for another asset

Gamma Ltd. acquired an investment by transferring a piece of land carried in its books at Rs 2,00,000. The land had a fair value of Rs 2,90,000 on the date of transfer. The fair value of the investment acquired could not be reliably established.

The fair value of the asset given up governs, because it is the more clearly evident of the two.

Note which fair value is used. Paragraph 29 puts the asset given up first and allows the investment acquired to be used only if it is more clearly evident. A student who reaches for the value of what was received, without asking which is better evidence, has not applied the paragraph.

Paragraph 27: the further classification

Once recorded, an investment must be shown under a heading. Paragraph 27 requires further classification of current and long-term investments as specified in the statute governing the enterprise; in the absence of a statutory requirement, the classification should disclose, where applicable, investments in:

• Government or Trust securities
• Shares, debentures or bonds
• Investment properties
• Others, specifying nature

The statute prevails where there is one; the list is the default.

In short

• Acquired by issuing securities: cost is the fair value of the securities issued, which the issue price fixed by statutory authorities may indicate.
• Fair value need not equal nominal or par value, and the difference is a securities premium.
• Acquired in exchange for another asset: cost is the fair value of the asset given up, or of the investment acquired if that is more clearly evident.
• Paragraph 27: classify as the statute requires, failing which into Government or Trust securities, shares debentures or bonds, investment properties, and others specifying nature.

Answer in one sentence

At what cost is an investment acquired by the issue of shares recorded? At the fair value of the securities issued, which in appropriate cases may be indicated by the issue price as determined by statutory authorities, and which may not necessarily equal their nominal or par value.

At what cost is an investment acquired in exchange for another asset recorded? By reference to the fair value of the asset given up, or alternatively by reference to the fair value of the investment acquired where that is more clearly evident.

Step 1. Find the accrued interest bought with the debentures.

The last interest date before purchase was 31 March. Interest has therefore accrued from 1 April to 31 July, four months.

Step 2. Split the price paid.

Step 3. The entry on purchase.

Step 4. The interest received on 30 September.

Of the Rs 6,000 received, Rs 4,000 is a recovery of the price paid and only Rs 2,000 is income.

The Interest on Debentures Account was debited with Rs 4,000 on purchase and is now credited with Rs 6,000, leaving a credit balance of Rs 2,000, which is the income of the period and is transferred to the Profit and Loss Account.

The pre-acquisition Rs 4,000 has cancelled itself out, exactly as it should: it was paid out and received back, and it never touched income.

The same purchase quoted ex-interest

The same debentures at Rs 100 each ex-interest.

Gamma would pay Rs 1,00,000 for the debentures and Rs 4,000 of accrued interest, Rs 1,04,000 in all. The entry and every later figure are identical. Only the wording of the question changed.

Where students lose the marks

Counting the months from the wrong date. Accrual runs from the last interest payment date, not from the start of the financial year and not from the date of issue.

Treating the whole receipt as income. That overstates profit by the pre-acquisition portion and leaves the investment carried too high.

Apportioning a dividend by time. A dividend does not accrue. Apportion it only where the question says it was declared out of pre-acquisition profits.

Forgetting that a cum-interest price is a single figure. In a cum-interest question the cash paid is the quoted price; do not add the accrued interest to it.

In short

• Paragraph 12: interest and dividends are generally income, but a receipt that is a recovery of cost is not.
• Interest accrued before acquisition and included in the price is deducted from cost when received.
• Accrual runs from the last interest date to the date of purchase.
• Cum-interest: price includes the interest, so subtract it to get cost. Ex-interest: price excludes it, so the price is the cost and the interest is paid on top. Cost is the same either way.
• Dividends are apportioned only where declared out of pre-acquisition profits, and the cost is reduced only where the dividend clearly represents a recovery of cost.

Answer in one sentence

How is interest accrued before the acquisition of an investment treated? The interest subsequently received is allocated between the pre-acquisition and post-acquisition periods, and the pre-acquisition portion, having been included in the price paid, is deducted from the cost of the investment rather than treated as income.

Distinguish cum-interest from ex-interest. A cum-interest price includes the interest accrued to the date of purchase, so the accrued interest is deducted from the price to arrive at cost; an ex-interest price excludes it, so the accrued interest is paid in addition and the quoted price is the cost.

Why are dividends not apportioned by time as interest is? Because interest accrues day by day whereas a dividend arises only when it is declared, so a dividend is treated as a recovery of cost only where it is declared out of pre-acquisition profits and clearly represents a recovery of part of the cost.

Worked, rights sold, the ordinary case

The same holding, but Gamma does not subscribe and sells the rights in the market for Rs 12,000. The shares were not acquired cum-right.

The carrying amount of the 2,000 shares stays at Rs 2,40,000.

Worked, the proviso

Gamma had acquired 2,000 shares in Delta on a cum-right basis at Rs 130 per share. Immediately after the shares became ex-right their market value was Rs 122.50 per share. Gamma sold the rights for Rs 15,000.

Step 1. Test whether the proviso applies.

The market value ex-right is below the cost, and the shares were acquired cum-right. Both conditions of the proviso are satisfied.

Step 2. Apply the proceeds against the carrying amount, down to market value.

Nothing goes to the Profit and Loss Account. The carrying amount is now Rs 2,45,000, equal to the market value.

Had the proceeds exceeded the amount needed to bring the carrying amount down to market value, the excess would go to profit and loss, because the paragraph permits the reduction only to the market value.

In short

• Subscribed: cost of the right shares is added to the carrying amount of the original holding. One account, one figure.
• Sold, ordinarily: proceeds go to the Profit and Loss Account and the carrying amount is unchanged.
• Sold, where the shares were bought cum-right and the ex-right market value is below cost: the proceeds are applied to reduce the carrying amount to market value.
• The reduction is capped by the proceeds and floored at market value.
• Lapsed rights produce no entry.

Answer in one sentence

How are right shares subscribed for treated? The cost of the right shares is added to the carrying amount of the original holding.

How are the proceeds of rights sold treated? They are taken to the profit and loss statement, except where the investments were acquired on a cum-right basis and their market value immediately after becoming ex-right is lower than the cost for which they were acquired, when it may be appropriate to apply the proceeds to reduce the carrying amount to the market value.