Month: July 2021

Management Notes

Capital and Revenue Profit/Reserves/Losses

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Capital Profit

The amount of profit earned by the business from the sale of its assets, shares, and debentures is capital profit. If assets are sold at a price more than their book values then the excess of book value is capital profit. Similarly, if the shares and debentures are issued at a price more than their face value, then the excess of face value or premium is capital profit. Such profit is not earned in the ordinary course of the business. It is not available for the distribution to shareholders as dividend. Such profits are transferred to capital reserve. It is used for meeting capital losses. It is shown on the liabilities side of balance sheet.

Capital Reserves

A capital reserve is an account on the balance sheet to prepare the company for any unforeseen events like inflation, instability, need to expand the business, or to get into a new and urgent project.

  • Since a company sells many assets and shares and can’t always make profits, it is used to mitigate any capital losses or any other long-term contingencies.
  • It works in quite a different way. When a company sells off its assets and makes a profit, a company can transfer the amount to capital reserve.
  • Another thing that is important is nature. It is not always received in the monetary value but it is always existent in the book of accounts of the business.
  • It has nothing to do with trading or operational activities of the business. It is created out of non-trading activities and thus it can never be an indicator of the operational efficiency of the business.

Capital Losses

Capital losses are losses realized on sale of fixed assets or when a company issues shares at a discount to the general public. These losses are not recurring and are not realized through the normal business activities of a company.

Revenue Profit

Revenue profit is the difference between revenue incomes and revenue expenses. It is earned in the ordinary course of the business. It results from the sale of goods and services at a price more than their cost price. Revenue profit is he outcome of regular transactions of the business. It is shown as gross profit and net profit in trading and profit and loss accounts. It is available for the distribution to shareholders as dividend or for creating reserve and fund for various purposes. It shows the efficiency of the business. In fact, earning revenue profit is the main objective of every business.

Revenue Reserves

Revenue reserve is created from the net profit generated from the company’s core operations. Companies create revenue reserves to quickly expand the business. It is one of the best resources for internal finance.

  • The rest of the profit is distributed to the shareholders as dividends. Sometimes, the whole profits are distributed as a dividend to the shareholders.
  • When a company earns a lot in a year and makes huge profits, a portion of the profits is set aside and reinvested in the business. This portion is called revenue reserve or in the common term “retained earnings”.
  • It helps a company become stronger from the inside out so that it can serve its shareholders for years to come.
  • A company can distribute a cash dividend or dividend in kinds. Revenue reserves can be distributed as a dividend in the form of an issue of bonus shares.

Types

General Reserve: The general reserves can be broadly described as the reserves that is formed for the purpose that is not yet finalized or the intended use is unknown at the moment.

Specific Reserve: The specific reserve can further be categorized as dividend equalization reserve, workmen compensation fund, debenture redemption reserve, and investment fluctuation fund. The specific reserves, on the other hand, is the revenue reserve fund that is established to meet specific business objectives. The proceeds can be used for redeeming debt and hence a reserve may form that would be termed as debenture redemption fund. The reserves may be created to meet intermittent fluctuations observed in the market value of the investments. Similarly, dividend reserves are created to distribute dividends for the time period when the business earns below expected results.

Revenue Losses

Revenue loss is the excess of operating expenditure over operating revenue. Revenue results from the business operations of an entity. It includes loss due to sale of goods or provision of services below cost and excess of operating expenses over gross profit.

The net losses accruing from day-to-day operating activities of the business essentially qualify as revenue losses. As they occur due to regular business transactions, revenue losses are recurring in nature.

The formula for revenue loss can be presented as follows:

Revenue losses = (Operating expenses) – (Operating incomes)

Management Notes

Capital Reserves, Objectives, Creation, Calculation

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Capital Reserve is a reserve created out of capital profits, which are not earned from the normal trading operations of a company. These profits may arise from the sale of fixed assets, revaluation of assets, premium on issue of shares or debentures, or profits prior to incorporation. Capital reserves are generally not available for distribution as dividends to shareholders because they are meant for specific purposes, such as writing off capital losses, issuing bonus shares, or meeting long-term obligations.

In the context of company consolidation, a capital reserve arises when the holding company acquires a subsidiary at a price less than its share of the net assets’ value. This surplus is credited to the consolidated balance sheet as a capital reserve. It reflects a favorable acquisition deal and strengthens the company’s financial position. As per the Companies Act, 2013, the use of capital reserve is restricted to purposes allowed by law, ensuring it is utilized in the company’s long-term interest.

Objectives of Capital Reserve:

  • Strengthening the Financial Position

One of the main objectives of maintaining a capital reserve is to strengthen the company’s overall financial position. Since capital reserve represents funds arising from capital profits and not available for dividend distribution, it serves as a cushion against future uncertainties. It enhances the company’s net worth and provides a sense of security to shareholders, creditors, and potential investors. This strengthened financial standing improves the company’s creditworthiness, enabling it to secure loans on favorable terms. In challenging economic conditions, capital reserves act as a stabilizing factor, ensuring that the company remains financially viable and operationally sustainable.

  • Meeting Future Capital Requirements

Capital reserves are preserved to meet the company’s long-term capital needs without relying heavily on external financing. These reserves can be used for specific purposes such as issuing bonus shares, funding expansion projects, replacing fixed assets, or redeeming preference shares and debentures. By using internally generated funds, the company can reduce dependence on borrowings, thereby lowering interest obligations and financial risk. This objective supports sustainable growth while maintaining shareholder value. It also provides flexibility in decision-making, as management can access these funds for strategic purposes when opportunities arise, without waiting for external capital arrangements.

  • Compliance with Legal Requirements

The Companies Act, 2013, and other relevant corporate laws require that certain capital profits must be transferred to a capital reserve and not distributed as dividends. This ensures that funds arising from non-operational or capital-related activities, such as share premium, profit on reissue of forfeited shares, or gains from asset revaluation, are preserved for capital purposes only. Compliance with these regulations safeguards creditors’ interests and maintains the company’s long-term solvency. By adhering to these legal requirements, the company avoids penalties, maintains its good corporate standing, and ensures transparency and accountability in its financial management practices.

  • Providing Funds for Bonus Share issue

Capital reserves are commonly used to issue bonus shares to existing shareholders. This process involves converting part of the reserves into share capital, rewarding shareholders without affecting cash flow. The objective is to capitalize profits for reinvestment in the business, enhance market perception, and increase the liquidity of shares. Issuing bonus shares from capital reserves boosts shareholder confidence and may lead to a rise in share prices due to improved investor sentiment. It also signals the company’s financial strength and long-term commitment to rewarding shareholders while retaining its operating funds for business activities.

  • Offsetting Capital Losses

Capital reserves serve the important objective of absorbing or offsetting capital losses, such as losses from the sale of fixed assets, investments, or other capital transactions. This prevents such losses from affecting the profit and loss account and the distributable profits of the company. By utilizing capital reserves for this purpose, the company can maintain a stable dividend policy and protect shareholder value. This approach ensures that operational performance is not overshadowed by one-time capital setbacks, thereby maintaining investor trust and the company’s overall financial health. It also aligns with prudent financial management practices.

  • Facilitating Business Expansion

A major objective of capital reserves is to facilitate business expansion and modernization plans. The reserve can be utilized for acquiring new assets, funding mergers or acquisitions, upgrading technology, or entering new markets. Since these funds come from capital-related gains, using them for strategic growth aligns with the purpose of their creation. This avoids the need for heavy borrowing and interest burdens, enabling more efficient capital structure management. By reinvesting capital reserves into growth projects, the company strengthens its competitive position, enhances operational capacity, and lays the foundation for sustainable long-term profitability.

Creation of Capital Reserve:

  • From Capital Profits

Capital reserves are primarily created from capital profits, which do not arise from the normal course of business. Examples include profits from the sale of fixed assets, revaluation surplus, profit on redemption of debentures, or premium received on issue of shares. These profits are transferred to the capital reserve account instead of the profit and loss account for distribution. This ensures that such gains are preserved for specific capital purposes, like issuing bonus shares, writing off capital losses, or funding expansion. This practice maintains the company’s financial stability and complies with the Companies Act, 2013 guidelines.

  • On Acquisition of Subsidiary at a Bargain Price

When a holding company acquires a subsidiary for a price less than its proportionate share of the subsidiary’s net assets, the difference is treated as a capital reserve. This occurs during consolidation, where the net assets’ fair value exceeds the purchase consideration. This surplus is not distributable as dividends and is credited to the capital reserve in the consolidated balance sheet. It represents a favorable purchase and strengthens the company’s capital base. Such creation of capital reserve is recognized under accounting standards to ensure transparency and proper reflection of financial strength after acquisition.

  • Premium on Issue of Shares or Debentures

When a company issues shares or debentures at a price above their nominal value, the extra amount received is termed as securities premium. As per the Companies Act, 2013, this premium is credited to the Securities Premium Account, which is a form of capital reserve. It can be used only for specified purposes such as issuing bonus shares, writing off preliminary expenses, or redeeming preference shares. This premium cannot be distributed as dividends because it originates from capital transactions, not revenue profits. Maintaining it as capital reserve ensures that such funds are preserved for long-term financial and strategic uses.

  • Profit on Reissue of Forfeited Shares

When a shareholder fails to pay due calls, their shares may be forfeited and later reissued. If the reissue price plus the amount already received exceeds the original issue price, the surplus is credited to the capital reserve. This profit is considered capital in nature and is not available for dividend distribution. It strengthens the company’s reserves, providing a cushion for capital purposes. This method is recognized under corporate accounting practices to differentiate between capital and revenue profits, ensuring that such gains are retained within the company for strategic and compliance-based uses.

  • Revaluation of Assets

When a company revalues its fixed assets and the new valuation exceeds the book value, the surplus is transferred to a revaluation reserve, which is treated as a type of capital reserve. This gain is unrealized and hence not distributable as dividends. The revaluation reserve can be used to offset any future reduction in asset value or for issuing bonus shares. This process reflects the current market value of assets, enhances the company’s net worth, and is useful in attracting investors or securing loans, while keeping the surplus for capital strengthening rather than operational spending.

Calculation of Capital Reserve:

Capital Reserve is a reserve created from capital profits. These profits are not earned from normal business operations. Capital reserve is shown on the liabilities side of the Balance Sheet and is generally not used for dividend.

Common Sources and Calculation

Source of Capital Profit Calculation
Issue of shares at premium Share issue price minus Face value
Sale of fixed asset Sale price minus Book value
Revaluation of assets Revalued amount minus Old value
Profit prior to incorporation Total profit before incorporation date
Forfeiture of shares Amount forfeited not refunded

Journal Entries for Capital Reserve

Particulars Debit Amount Credit Amount
1. Issue of shares at Premium – –
Bank A/c Dr Total amount received –
To Share Capital A/c Face value –
To Securities Premium A/c Premium amount –
Transfer of premium to capital reserve if allowed – –
Securities Premium A/c Dr Premium amount –
To Capital Reserve A/c Premium amount –
2. Sale of fixed Asset at Profit – –
Bank A/c Dr Sale price –
To Fixed Asset A/c Book value –
To Capital Reserve A/c Profit –
3. Revaluation of Asset Upward – –
Asset A/c Dr Increase in value –
To Capital Reserve A/c Increase in value –
4. Profit prior to incorporation – –
Profit and Loss A/c Dr Amount –
To Capital Reserve A/c Amount –
5. Forfeiture of Shares – –
Share Capital A c Dr Called up amount –
To Share Forfeiture A/c Amount forfeited –
Transfer to capital reserve – –
Share Forfeiture A/c Dr Amount –
To Capital Reserve A/c Amount
Management Notes

Debentures in Subsidiary Companies

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Debenture is a long-term financial instrument that represents a loan made by an investor to a borrower, typically a corporate entity. It is issued under a formal agreement, which stipulates the terms of the loan, including the interest rate, repayment schedule, and the rights and obligations of both the issuer and the debenture holder.

Debentures are usually Secured or Unsecured:

  • Secured Debentures:

These are backed by specific assets of the company, providing assurance to debenture holders that they can claim these assets in the event of default.

  • Unsecured Debentures:

These are not backed by any specific assets, making them riskier for investors.

Importance of Debentures in Subsidiary Companies:

Subsidiary companies are entities that are controlled by a parent company, typically holding a majority of shares.

  1. Capital Raising

Subsidiary companies often require funds for various purposes, such as expansion, acquisition of assets, or working capital. Issuing debentures provides a means of raising capital without diluting the ownership of the parent company. This is particularly advantageous for subsidiaries that may not have easy access to equity markets.

  1. Fixed Cost of Financing

Debentures typically carry a fixed interest rate, which allows subsidiary companies to predict their financing costs accurately. This predictability aids in financial planning and budgeting, enabling the subsidiary to manage its cash flows effectively.

  1. Flexibility in Financing

Debentures offer flexibility regarding maturity periods and repayment schedules. Subsidiary companies can structure their debenture issues to align with their cash flow needs, allowing for better financial management.

  1. Tax Benefits

Interest payments on debentures are tax-deductible, which can enhance the financial efficiency of subsidiary companies. This tax advantage makes debt financing more attractive compared to equity financing.

  1. Attraction of Diverse Investors

Issuing debentures can attract a wide range of investors, including institutional investors who prefer fixed-income securities. This diversification of the investor base can enhance the subsidiary’s financial stability and reputation in the market.

Regulatory Framework Governing Debentures in Subsidiary Companies:

In India, the issuance and management of debentures by subsidiary companies are regulated under the Companies Act, 2013, as well as the Securities and Exchange Board of India (SEBI) regulations. Key provisions are:

  1. Issuance of Debentures

Section 71 of the Companies Act governs the issue of debentures, stipulating that a company may issue debentures subject to the conditions specified in the act. Companies must pass a resolution to approve the issue of debentures, which may require obtaining consent from the shareholders in certain cases.

  1. Debenture Trust Deed

Debenture trust deed is a legal document that outlines the terms and conditions of the debenture issue, including the rights of debenture holders and the obligations of the issuing company. It must be executed in favor of a trustee representing the debenture holders to safeguard their interests.

  1. Redemption of Debentures

Companies are required to outline a clear redemption plan for debentures in their issuance documents, specifying the maturity period and repayment terms. Provisions for the creation of a debenture redemption reserve may also apply, which is a fund set aside for the repayment of debentures upon maturity.

  1. Interest Payments

Subsidiary companies must ensure timely payment of interest to debenture holders as stipulated in the debenture agreement. Failure to do so can lead to legal consequences and impact the company’s creditworthiness.

  1. Filing Requirements

Subsidiary companies must comply with filing requirements under the Companies Act, including submitting necessary forms to the Registrar of Companies (ROC) concerning the issuance of debentures.

  1. Regulations by SEBI

If the debentures are listed on stock exchanges, the subsidiary company must also comply with SEBI regulations, which impose additional disclosure and reporting requirements to protect investors’ interests.

Types of Debentures Suitable for Subsidiary Companies:

  1. Convertible Debentures

These debentures give holders the right to convert their debentures into equity shares of the company after a specified period. This option can be attractive to investors, as it allows them to participate in the company’s equity upside.

  1. Non-Convertible Debentures

These debentures cannot be converted into equity shares and typically offer higher interest rates compared to convertible debentures, compensating investors for the lack of conversion rights.

  1. Redeemable Debentures

These debentures are issued with a specified maturity date, at which point the company must repay the principal amount to the debenture holders. This type allows for better cash flow management.

  1. Irredeemable Debentures

Irredeemable debentures do not have a fixed redemption date and may remain outstanding indefinitely. They can provide a steady income stream for the issuing subsidiary but may be less attractive to investors due to their uncertain repayment timeline.

Management Notes

Holding Companies Legal requirements

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This law prevents companies that hold public utilities from using their profits to pay for unregulated business activities. Side endeavors must be separated from the holding company. Although some utility companies argue that PUHCA restricts competition and no longer applies, repealing this law would result in the creation of several large utility companies and eliminate industry competition. Many believe that reform of this law should only take place as part of a thorough restructuring.

This law was originally passed to counteract the unfair business practices of large utility holding companies in the 1920s and 1930s. These businesses created complex pyramid structures that held shares in many subsidiaries. For example, at one point three holding companies controlled most of the industry with more than 130 subsidiaries. This resulted in inflated rates, hidden charges and fees, and a lack of accountability.

As per Section 2(46) “holding company”, in relation to one or more other companies, means a company of which such companies are subsidiary companies.

As per Section 2(87) “subsidiary company” or “subsidiary”, in relation to any other company (that is to say the holding company), means a company in which the holding company:

(i) controls the composition of the Board of Directors; or

(ii) exercises or controls more than one-half of the total share capital either at its own or together with one or more of its subsidiary companies:

Provided that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed.

Explanation. For the purposes of this clause:

(a) A company shall be deemed to be a subsidiary company of the holding company even if the control referred to in sub-clause (i) or sub-clause (ii) is of another subsidiary company of the holding company;

(b) The composition of a company’s Board of Directors shall be deemed to be controlled by another company if that other company by exercise of some power exercisable by it at its discretion can appoint or remove all or a majority of the directors;

(c) The expression “company” includes anybody corporate;

(d) “Layer” in relation to a holding company means its subsidiary or subsidiaries;

Company Includes Body Corporate:

  • As per Sec 2(87) Company include a ‘Body Corporate’.
  • As per Sec 2(11) body corporate includes a ‘Company incorporate out of India’.

Thus, an Indian company in which more than 50% shares are held by a foreign body corporate will be a ‘Subsidiary Company’.

Structure of a Holding Company

A simple holding company owns all the stock shares of at least one subsidiary. The shares of the holding company are owned by trusts or individuals. The holding company and subsidiaries each act as independent entities, with separate finances and bank accounts. They must enter into agreements with one another for assets and real estate. Often, one subsidiary serves to manage the holding company’s operations.

The Internal Revenue Code defines a personal holding company under two classification systems, which must be fulfilled to constitute this entity. These include:

  • Personal Holding Company Income Test: The entity must possess at 60 percent or more of the adjusted ordinary gross income of the corporation in question for the associated tax year.
  • Stock Ownership Requirement: At least 50 percent of the outstanding stock of the corporation must be owned by fewer than six individuals at any point during the second half of the associated tax year.

Benefits of Holding Companies

The holding company can own and control several companies, thus spreading its risk across markets and industries.

Holding companies reduce risk for the companies whose stock they hold by stabilizing the investment, making it more valuable. This attracts more buyers.

Risk management is enhanced by dividing assets across two or more companies. This allows liability to be limited to a single subsidiary, if it gets sued for example.

A product line can be sold or transferred easily and confidentially, without revealing trade secrets.

Subsidiaries that are completely owned by a holding company can be treated as pass-through tax entities. This eliminates the need to file a corporate tax return while maintaining limited liability.

Intellectual property (IP) can be licensed to several subsidiaries for various purposes.

Management Notes

Inter Company Transactions

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An inter-company transactions list provides information on all transactions that have occurred between your company and your group entities.

Intercompany transactions arises when the unit of a legal entity has a transaction with another unit within the same entity. Many international companies take advantage of intercompany transfer pricing and other related party transactions to influence IC-DISC, promote improved intercompany transaction taxes, and effectively enhance efficiency within the company. Intercompany transactions can be essential to maximizing the allocation of income and deductions

An inter-company transactions list contains details of the transactions within your corporate group including payment of dividends, purchase and sale of assets (e.g. inventory or machinery) and any borrowing and lending.

Information that is covered:

  • Transaction Details: Nature and the type of a particular transaction entered
  • Dates: Start and end dates of each transaction
  • Parties Involved: Names of the group entities involved in each transaction
  • Transaction Value: The amount and status involved in each transaction
  • Documentation: Documents and agreements that provide the evidence of each transaction.

Examples of intercompany transactions:

  • Two subsidiaries
  • Two departments
  • Parent company and subsidiary
  • Two divisions

Importance

Intercompany transactions can help improve the flow of finances and assets greatly. Transfer pricing studies can help ensure intercompany transfer pricing falls within arm’s length pricing to help avoid unnecessary audits. Intercompany transactions accounting can help keep records for resolving tax disputes, especially in countries where the markets are new and there is little or no regulations governing related party transactions. Here are few areas affected by the use of intercompany transactions:

  • Sales and transfer of assets
  • Loan participation
  • Dividends
  • Transactions with member banks and affiliates
  • Insurance policies
  • Management and service fees

Pros of addressing Inter-Company Transactions

  • Facilitate transparency and provide real-time information on your inter-company transactions.
  • Create consolidated and accurate financial statements and avoid any misrepresentation of your company’s financial position.
  • Implement uniform accounting and treatment policies and procedures for inter-company transactions.
  • Comply with tax norms and regulations related to inter-company transactions across jurisdiction.
  • Mitigate any potential for disputes between your company and its entities as each transaction is documented.

Any transaction between affiliates of a company group requires elimination, including:

  • Unrealized gain in ending inventory due to intercompany sale of above-cost inventory not later sold to third parties prior to year-end.
  • Elimination of equity in company acquisitions: When one company acquires another company, only the acquirer’s share of the shareholders’ equity of the acquired company is eliminated through consolidation in the equity section of the consolidated financial statements.
  • Unrealized gain due to intercompany sales of fixed assets above net book value: Such sales are only internal transfers of assets and no gain or loss should be recognized.

Intercompany loans: When one group company makes a loan to another affiliated company, there are several items that have to be eliminated on both sides:

  • Loans receivable and loans payable;
  • Interest income and interest expense; and
  • Interest payable and interest receivable.

Elimination of intercompany profits: Any intercompany profit or loss on assets remaining within the group must be eliminated and only profits and losses from third-party transactions should be included in the consolidated statements.

Management Notes

Interim Dividend by Subsidiary Companies

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An interim dividend is a dividend payment made before a company’s annual general meeting (AGM) and the release of final financial statements. This declared dividend usually accompanies the company’s interim financial statements. The interim dividend is issued more frequently in the United Kingdom where dividends are often paid semi-annually. The interim dividend is typically the smaller of the two payments made to shareholders.

The holding company may receive interim dividend from the subsidiary company; if such an interim dividend is to be apportioned between pre-acquisition period and post-acquisition period, it should be assumed that the interim dividend has been earned evenly throughout the year.

Proposed Dividend:

On the liabilities side of the balance sheet of the subsidiary company, proposed dividend may appear. Unless the facts of the case point otherwise, it should be assumed that proposed dividend is out of post acquisition profits. Hence, holding company’s share of proposed dividend will be added to the holding company’s Profit and Loss Account whereas minority shareholders’ share will be added to minority interest.

Dividend received by the holding company from its subsidiary out of pre-acquisition profits is treated as capital receipt; the journal entry for its record being as follows:

Bank Dr.
To Shares in Subsidiary Company  
   

The following points will highlight the three steps for payment of interim dividend.

(a) First, total amount of interim dividend (i.e.,% of dividend on Subsidiary’s Co.’s Share Capital) should be added with the current profit;

(b) Deduct subsidiary’s share of interim dividend from Minority Interest.

(c) Deduct Holding Company s share of interim dividend from Profit and Loss Account of holding company in the liability side of the Consolidated Balance Sheet.

In the consolidated books, the following entry will be passed:

Finance Income……….Dr.

To, Retained Earnings

(Amount of dividend paid by the subsidiary company to its parent entity)

Current Tax……………..Dr.

To, Retained Earnings

Management Notes

Revaluation of Assets

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A revaluation of fixed assets is an action that may be required to accurately describe the true value of the capital goods a business owns. This should be distinguished from planned depreciation, where the recorded decline in value of an asset is tied to its age.

A company can account for changes in the market value of its various fixed assets by conducting a revaluation of the fixed assets. Revaluation of a fixed asset is the accounting process of increasing or decreasing the carrying value of a company’s fixed asset or group of fixed assets to account for any major changes in their fair market value.

Fixed assets are held by an enterprise for the purpose of producing goods or rendering services, as opposed to being held for resale for the normal course of business. An example, machines, buildings, patents or licenses can be fixed assets of a business.

The purpose of a revaluation is to bring into the books the fair market value of fixed assets. This may be helpful in order to decide whether to invest in another business. If a company wants to sell one of its assets, it is revalued in preparation for sales negotiations.

Reasons for revaluation

It is common to see companies revaluing their fixed assets. It is important to make a distinction between a ‘private‘ revaluation and a ‘public‘ revaluation which is carried out in the financial reports. The purposes are varied:

  • To show the true rate of return on capital employed.
  • To conserve adequate funds in the business for replacement of fixed assets at the end of their useful lives. Provision for depreciation based on historic cost will show inflated profits and lead to payment of excessive dividends.
  • To show the fair market value of assets which have considerably appreciated since their purchase such as land and buildings.
  • To negotiate fair price for the assets of the company before merger with or acquisition by another company.
  • To enable proper internal reconstruction, and external reconstruction.
  • To issue shares to existing shareholders (rights issue or follow-on offering).
  • To get fair market value of assets, in case of sale and leaseback transaction.
  • When the company intends to take a loan from banks/financial institutions by mortgaging its fixed assets. Proper revaluation of assets would enable the company to get a higher amount of loan.
  • Sale of an individual asset or group of assets.
  • In financial firms revaluation reserves are required for regulatory reasons. They are included when calculating a firm’s funds to give a fairer view of resources. Only a portion of the firm’s total funds (usually about 20%) can be loaned or in the hands of any one counterparty at any one time (large exposures restrictions).
  • To decrease the leverage ratio (the ratio of debt to equity).

Methods

Appraisal Method

In this method, the technical valuer does a detailed assessment of the assets to find out the market value. A complete assessment is required when the Co. is taking out an insurance policy for fixed assets. In this method, we should ensure that the fixed assets not over/undervalued.

  • Date of purchase of fixed assets for calculating the age of fixed assets.
  • Usage of Assets such as 8 hours, 16 hours, and 24 hours (Generally 1 Shift = 8 Hours).
  • Type of assets such as Land & Building, Plant & Machinery.
  • Repairs & Maintenance policy of the enterprise for fixed assets;
  • Availability of Spare Parts in the future.

Current Market Price Method

As per the prevailing market price of assets.

Plant and Machinery: Forgetting the fair market value of plant and machinery, we can take the help of the supplier.

Revaluation of the Land & Building: For getting the fair market value of the building, we can take the help of real estate values/ property dealers available in the market.

Indexation Method

In this method, the index does apply to the cost of assets to know the current cost. Index list issued by the statistical department.

Advantages

  • To negotiate a fair price for the assets of the entity before the merger with or takeover by another company.
  • If assets revalued on the upward side, this will increase the cash profit (Net Profit plus Depreciation) of the Entity.
  • The credit balance of revaluation reserve can be used for the replacement of fixed assets at the end of their useful lives.
  • Tax Benefit: It results in an increase in the value of assets; hence the amount of depreciation will increase and thereby resulting in income tax deductions.
  • To decrease the leverage ratio (Secured Loan to Capital).

Disadvantages

  • The total depreciation charged on fixed assets revaluation does not show a regular pattern.
  • The company could not revalue its fixed assets every year, or the cost of the fixed asset may not decline. In such a situation, depreciation could not be charged by the company.
  • The company does spend much amount on revaluation of fixed assets as this work takes assistance from technical experts, and an increase in expenses results in less profit.
Management Notes

Auditing Meaning, Definition, Evolution, Objectives, Importance

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An audit is an “independent examination of financial information of any entity, whether profit oriented or not, irrespective of its size or legal form when such an examination is conducted with a view to express an opinion thereon.” Auditing also attempts to ensure that the books of accounts are properly maintained by the concern as required by law. Auditors consider the propositions before them, obtain evidence, and evaluate the propositions in their auditing report.

Audits provide third-party assurance to various stakeholders that the subject matter is free from material misstatement. The term is most frequently applied to audits of the financial information relating to a legal person. Other commonly audited areas include: secretarial and compliance, internal controls, quality management, project management, water management, and energy conservation. As a result of an audit, stakeholders may evaluate and improve the effectiveness of risk management, control, and governance over the subject matter.

Auditing has been a safeguard measure since ancient times, and has since expanded to encompass so many areas in the public and corporate sectors that academics have started identifying an “Audit Society”.

Features of an Audit

  • The audit is always done by an independent authority or a body of persons with the necessary qualifications. They have to be independent so their views and opinions can be totally unbiased.
  • Auditing is a systematic process. It is a logical and scientific procedure to examine the accounts of an organization for their accuracy. There are rules and procedures to follow.
  • Once again, an audit is the examination of all the books of accounts and financial information of the company. So, it is essentially a verification of the final accounts of the organization, i.e., the profit and loss statement and the balance sheet at the end of the financial year.
  • To conduct the audit, we need the help of various sources of information. This includes vouchers, documents, certificates, questionnaires, explanations etc. He may scrutinize any other documents he sees fit like Memorandum of Association, Articles of Associations, vouchers, minute books, shareholders register etc.
  • Auditing is not only the review of the books of accounts but also the internal systems and internal control of the organization.
  • The auditor must completely satisfy himself with the accuracy and authenticity of the financial statements. Only then can he give the opinion that they are true and fair statements.

Evolution

During medieval times, when manual bookkeeping was prevalent, auditors in Britain used to hear the accounts read out for them and checked that the organization’s personnel were not negligent or fraudulent. In 1951, Moyer identified that the most important duty of the auditor was to detect fraud. Chatfield documented that early United States auditing was viewed mainly as verification of bookkeeping detail.

However, Auditing started assuming its present form in the eighteenth century when the Industrial Revolution gave rise to joint-stock companies characterised by the separation of ownership and management.

With the stakeholders now being the real owners of the company, Auditing increasingly became an essential instrument for checking the administrative activities of the company managers.

To ensure that the financial efforts of an organisation are fairly portrayed, the International Accounting Standards Committee have set out specific standard auditing and accounting practices to guide the day to day activities of Auditors and Accountants, respectively.

Objectives

  • To help the management executives in the effective discharge of their duties.
  • To improve the profitability of the organisation.
  • To help the management executives in the effective discharge of their responsibilities.
  • To ensure that the management is going to achieve the objectives.
  • To identify the level of achievement of the main objectives of the organisation.
  • To obtain or utilise the full efficiency of the management.
  • To suggest to the management the ways and means available to achieve the objectives.
  • To help the management to do efficient administration of the operations.
  • To identify the defects or irregularities of management executives.

Importance

  • It provides scope to the business to interact openly with the environment and maxmises the benefit of the environmental opportunities and controlling the effects of environmental threats.
  • It helps the management in improving its performance in execution of policies and in utilising resources.
  • Management Audit sets the policies and objectives right in view of changing environment, competitors’ strategies, changes in technology, consumers’ preferences etc.
  • It sets the direction of objectives policies and business definition.
  • It helps the management in improving its systems in view of developments or creations in management principles, techniques and approaches.
Management Notes

Procedure for issue of standards by AASB

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ICAI is the highest accounting body in the country. And the ASB is a committee of the ICAI. But to ensure maximum transparency and independence, the ASB is a completely independent body.

The ASB formulates all the accounting standards for the Indian companies. This process is fully transparent, very thorough and completely independent of any government involvement. While framing the standards the ASB will try and incorporate the IFRS and its principles in the Indian standards. While India does not plan to adopt the IFRS, this process will help the convergence of the two standards. So, the ASB will modify the IFRS to suit the laws, customs and common usage in the country.

The ASB is composed of various members. There are representatives of industries like the FICCI and ASSOCHAM. There are also certain government officials, a few academics, and regulators from various departments. The idea is to make the ASB as inclusive and representative as possible.

ICAI has issued 43 Engagement and Quality Control Standards (formerly known as Auditing and Assurance Standards) covering various topics relating to auditing and other engagements. All Chartered Accountants in India are required to adhere to all these standards. If a Chartered Accountant is found not to follow the said standards he is deemed guilty of professional misconduct. These standards are fully compatible with the International Standards on Auditing (ISA) issued by the IAASB of the IFAC except for two standards SA 600 and SA 299, where corresponding provisions do not exist in ISA.

Objectives and Functions of The Auditing and Assurance Standards Board (AASB)

The following are the objectives and Functions of the Auditing and Assurance Standards Board (AASB):

  1. To review the existing and emerging auditing practices worldwide and identify areas in which Standards on Quality Control, Engagement Standards and Statement on Auditing need to be developed.
  2. To formulate Engagement Standards, Standards on Quality Control and Statement on Auditing so that these may be issued under the authority of the Council of the Institute.
  3. To review the existing Standards and Statements on Auditing to assess their relevance in the changed conditions and to undertake their revision, if necessary.
  4. To develop guidance notes on issues arising out of any Standard, auditing issues pertaining to any specific industry or on generic issues, so that those may be issued under the authority of the Council of the Institute.
  5. To review the existing Guidance Notes to access their relevance in the changed circumstances and to undertake their revision, if necessary.
  6. To formulate General Clarifications, where necessary, on issues arising from Standards.
  7. To formulate and issue Technical Guides, Practice Manuals, Studies and other papers under its own authority for guidance of professional accountants in the cases felt appropriate by the Board.

Procedure for Formulation of Accounting Standards

  • At First, the ASB will identify areas where the formulation of accounting standards may be needed
  • Then the ASB will constitute study groups and panels to discuss and study the topic at hand. Such panels will prepare a draft of the standards. The draft normally includes the definition of important terms, the objective of the standard, its scope, measurement principles and the representation of said data in the financial statements.
  • The ASB then carries out deliberations of the said draft of the standard. If necessary, changes and revisions are made.
  • Then this preliminary draft is circulated to all concerned authorities. This will generally include the members of the ICAI, and any other concerned authority like the Department of Company Affairs (DCA), the SEBI, the CBDT, Standing Conference of Public Enterprises (SCPE), Comptroller and Auditor General of India etc. These members and departments are invited to give their comments.
  • Then the ASB arranges meetings with these representatives to discuss their views and concerns about the draft and its provisions
  • The exposure draft is then finalized and presented to the public for their review and comments
  • The comments by the public on the exposure draft will be reviewed. Then a final draft will be prepared for the review and consideration of the ICAI
  • The Council of the ICAI will then review and consider the final draft of the standard. If necessary they may suggest a few modifications.
  • Finally, the Accounting Standard is issued. In the case of standard for non-corporate entities, the ICAI will issue the standard. And if the relevant subject relates to a corporate entity the Central Government will issue the standard.
Management Notes

Standards of Auditing

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The standards on auditing, review, other assurance, quality control and related services are aimed towards delivery of high-quality audits by improving the quality of practice by professional accountants and ultimately increase public confidence in financial reporting.

(i) Standards on Quality Control (SQC): To be in applied in ensuring quality by firms that performs audits and Reviews of Historical Financial Information, and Other Assurance and Related Services Engagements. SQC requires that the firm should establish a system of quality control designed to provide it with reasonable assurance that the firm and its personnel comply with professional standards, regulatory, legal requirements, and that reports issued by the firm or engagement partner(s) are appropriate in the circumstances. SQC, therefore sets the tone for enhancing the quality of audit. [Number of Standards: 1]

(ii) Standards on Auditing (SAs): To be applied in the audit of historical financial information. [Number of Standards: 38]

(iii) Standards on Review Engagements (SREs): To be applied in the review of historical financial information. [Number of Standards: 2]

(iv) Standards on Assurance Engagements (SAEs): To be applied in assurance engagements, other than audits and reviews of historical financial information. [Number of Standards: 3]

(v) Standards on Related Services (SRSs): To be applied to engagements involving application of agreed- upon procedures to information, compilation engagements, and other related services engagements, as may be specified by the ICAI. [Number of Standards: 2]

Standards on Auditing

The Standards on Auditing (SAs) issued by ICAI are based on International Standards on Auditing (ISAs) issued by International Federations of Accountants (IFAC). These Standards are issued by the AASB under the authority of the council of the ICAI. Section 143 (2) of the Companies Act 2013 requires the auditor to ensure compliance with these standards on auditing

The standards on auditing have been divided into 38 standards presently grouped into 6 categories as detailed below.

  • 100-199: Introductory Matters (Nil Standard)
  • 200-299: General Principles & Responsibilities (9 Standards)
  • 300-499: Risk Assessment and Response to Assessed Risks (6 Standards)
  • 500-599: Audit Evidence (11 Standards)
  • 600-699: Using Work of Others (3 Standards)
  • 700-799: Audit Conclusions & Reporting (6 Standards)
  • 800-899: Specialised Areas (3 Standards)

Each Standard has a uniform structure which includes the following:

  • Introduction
  • Objective
  • Definitions
  • Requirements
  • Application and other explanatory material

The number given to SA is similar to the numbering system followed for International Standards on Auditing formulated by IAASB.

  • Standards on Assurance Engagements (SAEs) for assurance engagements other than the audits and reviews of financial information.
  • Standards on Review Engagements (SREs) for reviewing historical financial information.
  • Standards on Related Services (SRSs) for all engagements about the application of agreed procedures to information, compilation engagements, and other related services engagements.
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