Author: indiafreenotes

Management Notes

Salvage, Insurance Policy, Sum Assured, Under Insurance, Average Clause, Claim

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Salvage

There is difference between salvage value and scrap value. Suppose your car damaged from front. Damage occur to Bonnet, radiator and bumper. your insurer will pay for replacement of these items with new. Now these damage items have some value in market. Say a damaged radiator will fetch 400 in market and can be used for resale. So, this is salvage value of Radiator. But If Radiator is fully damaged by crushing it, it will lose its usability and fetch value of say 100. This is scrap value.

Same occur with fully damage cars. When cars damage occurs beyond repair. Settlement is done on net of salvage basis. These cars sold to salvage buyers with good value as they sell saved parts of car at value. But when these cars crushed so make it unusable then sold on scrap basis. Then value is as per old metal prices in market.

This is concept in India, where old things are recirculated and not might fit for insurance industry in developed countries.

Abandonment and salvage is a term that can surface fairly frequently in insurance contracts. When such a clause is present, it indicates that the insurer has the ability to rightfully claim an insured asset or piece of property that has been destroyed and subsequently abandoned by its owners.

For the insurer to salvage the item, the owner must first express an intent of abandonment in writing. Once that process is complete, the insurance company could choose to take full possession of the damaged property after paying out its insured value to the policyholder.

The selling value of the property can surpass the amount paid out on the claim, so salvage rights are sometimes legally contested by several parties.

Insurance Policy

In insurance, the insurance policy is a contract (generally a standard form contract) between the insurer and the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for an initial payment, known as the premium, the insurer promises to pay for loss caused by perils covered under the policy language.

Insurance contracts are designed to meet specific needs and thus have many features not found in many other types of contracts. Since insurance policies are standard forms, they feature boilerplate language which is similar across a wide variety of different types of insurance policies

Sum Assured

The sum assured is the guaranteed amount that the beneficiary of your life insurance policy will receive in case of your death. The sum assured is also known as the coverage or the cover of your insurance policy.

There are many different ways to calculate the sum assured for your life insurance policy. One of the most popular methods is Human Life Value or HLV. This method calculates sum assured based on your current and future expenses, present and future earnings, and age.

It helps you calculate your capitalized value based on current inflation. You can now find Human Life Value calculators online to know your HLV and select the right sum assured.

Sum insured, on the other hand, refers to the payable amount in case of an unforeseen event such as a medical emergency. It is a monetary benefit, unlike sum assured which is a maturity benefit.

Non-life insurance policies like motor insurance or health insurance provide protection as the sum insured. In short, it is the compensation payable to the policyholder in case of an injury/hospitalization or damage based on the concept of indemnity.

Sum Assured

Sum Insured
Sum assured is the value of life cover defined under life insurance policies. Sum insured is the value applicable to non-life insurance policies like car insurance.
Your Sum Assured is usually calculated by taking into account the economic value of your life (Human Life Value) which may actually go up in time for a person Sum Insured usually depreciates for assets. The essential difference is coverage for the creator of the asset vs the asset itself.

 
It is a pre-fixed amount that the insurer pays to the policyholder or nominee in case of a misfortune. It is a reimbursement/compensation based on the concept of indemnity against damage/loss.
Sum assured refers to the benefit availed by the insured person or beneficiary. One can choose to get maturity benefit under specific types of life insurance plans. There is no maturity benefit involved related to the sum insured.

Under Insurance

Condition of average (also called underinsurance in the U.S., or principle of average, subject to average, or pro rata condition of average in Commonwealth countries) is the insurance term used when calculating a payout against a claim where the policy undervalues the sum insured. In the event of partial loss, the amount paid against a claim will be in the same proportion as the value of the underinsurance.

Payout = Claim *(Sum Insured / Current Value)

Average Clause

This means that in case of loss the insured has to bear a part of the loss. The insurer will only bear rateable proportion of the loss. In other words, for the difference between the actual value of subject matter and the amount for which it is insured, the insured has to be his own insurer.

Ex.

Suppose a property worth Rs. 2,00,000 is insured for Rs. 1,50,000 and the fire policy contains the average clause. Now, if half the property is destroyed by fire, the insurer will pay only Rs. 75,000 which is calculated as per the following formula.

Insured amount (Rs.1,50,000) x Actual loss (Rs. 1,00,000) / Actual value of the property (Rs.2,00,000)

If three-fourths of the property is destroyed by fire, the insurer will pay Rs. 1,12,500. The entire amount of policy will become payable only when entire property is destroyed by fire.

Claim

An insurance claim is a formal request by a policyholder to an insurance company for coverage or compensation for a covered loss or policy event. The insurance company validates the claim (or denies the claim). If it is approved, the insurance company will issue payment to the insured or an approved interested party on behalf of the insured.

Insurance claims cover everything from death benefits on life insurance policies to routine and comprehensive medical exams. In some cases, a third-party is able to file claims on behalf of the insured person. However, in the majority of cases, only the persons listed on the policy is entitled to claim payments.

A paid insurance claim serves to indemnify a policyholder against financial loss. An individual or group pays premiums as consideration for the completion of an insurance contract between the insured party and an insurance carrier. The most common insurance claims involve costs for medical goods and services, physical damage, loss of life, and liability for the ownership of dwellings (homeowners, landlords, and renters) and liability resulting from the operation of automobiles.

For property and causality insurance policies, regardless of the scope of an accident or who was at fault, the number of insurance claims you file has a direct impact on the rate you pay to gain coverage (typically through installment payments called insurance premiums). The greater the number of claims that are filed by a policyholder, the greater the likelihood of a rate hike. In some cases, it’s possible if you file too many claims that the insurance company may decide to deny you coverage.

Types of Insurance Claims

Health Insurance Claims

Costs for surgical procedures or inpatient hospital stays remain prohibitively expensive. Individual or group health policies indemnify patients against financial burdens that may otherwise cause crippling financial damage. Health insurance claims filed with carriers by providers on behalf of policyholders require little effort from patients; the majority of medical are adjudicated electronically.

Policyholders must file paper claims when medical providers do not participate in electronic transmittals but charges result from rendered covered services. Ultimately, an insurance claim protects an individual from the prospect of large financial burdens resulting from an accident or illness.

Property and Casualty Claims

A house is typically one of the largest assets an individual will purchase in their lifetime. A claim filed for damage from covered perils is initially routed via the Internet to a representative of an insurer, commonly referred to as an agent or claims adjuster.

Unlike health insurance claims, the onus is on the policyholder to report damage of a deeded property they own. An adjuster, depending on the type of claim, inspects and assesses damage to property for payment to the insured. Upon verification of the damage, the adjuster initiates the process of compensating or reimbursing the insured.

Life Insurance Claims

Life insurance claims require the submission of a claim form, a death certificate, and oftentimes the original policy. The process, especially for large face value policies, may require in-depth examination by the carrier to ensure that the death of the insured did not fall under a contract exclusion, such as suicide (usually excluded for the first few years after policy inception) or death resulting from a criminal act.

Management Notes

Need and Bases of Apportionment of Common Expenses

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An apportionment is the separation of sales, expenditures, or income that are then distributed to different accounts, divisions, or subsidiaries. The term is used in particular for allocating profits to a company’s specific geographic areas, which affects the taxable income reported to various governments.

When all the items are collected properly under suitable account headings, the next step is allocation and apportionment of such expenses to cost centres. This is also known as departmentalisation of overhead. Departmentalisation of production overheads is the process of identifying production overhead expenses with different production/service departments or cost centres. It is done by means of allocation and apportionment of overheads among various departments.

For example, a multi-state entity’s overall revenue may be distributed to its state-level branches based on their individual revenues, headcount, asset base, or cash receipts.

An apportionment is the separation of sales, expenditures, or income that are then distributed to different accounts, divisions, or subsidiaries. The term is used in particular for allocating profits to a company’s specific geographic areas, which affects the taxable income reported to various governments.

For example, a multi-state entity’s overall revenue may be distributed to its state-level branches based on their individual revenues, headcount, asset base, or cash receipts.

Basis for Apportionment:

The basis used for apportionment of costs is the number of cost centres when the expenses are to be shared equitably between them. This happens when an overhead cannot be assigned directly to one specific cost centre.

Rent and business rates, for example, are sometimes paid by individual cost centres, and floor space is also used as a basis for apportionment to share costs between relevant cost centres.

The costs are proportionately assigned to different departments when the overhead belongs to various departments. In simple terms, the expenses which cannot be charged against a specific department are dispersed over multiple departments.

For example, the wages paid to the factory head, factory rent, electricity, etc. cannot be charged to a particular department, then these can be apportioned among several departments.

Following are the main bases of overhead apportionment utilised in manufacturing concerns:

(i) Direct Allocation

Overheads are directly allocated to various departments on the basis of expenses for each department respectively. Examples are: overtime premium of workers engaged in a particular department, power (when separate meters are available), jobbing repairs etc.

(ii) Direct Labour/Machine Hours

Under this basis, the overhead expenses are distributed to various departments in the ratio of total number of labour or machine hours worked in each department. Majority of general overhead items are apportioned on this basis.

(iii) Value of Materials Passing through Cost Centres

This basis is adopted for expenses associated with material such as material handling expenses.

(iv) Direct Wages

According to this basis, expenses are distributed amongst the departments in the ratio of direct wages bills of the various departments. This method is used only for those items of expenses which are booked with the amounts of wages, e.g., workers’ insurance, their contribution to provident fund, workers’ compensation etc.

(v) Number of Workers

The total number of workers working in each department is taken as a basis for apportioning overhead expenses amongst departments. Where the expenditure depends more on the number of employees than on wages bill or number of labour hours, this method is used. This method is used for the apportionment of certain expenses as welfare and recreation expenses, medical expenses, time keeping, supervision etc.

(vi) Floor Area of Departments

This basis is adopted for the apportionment of certain expenses like lighting and heating, rent, rates, taxes, maintenance on building, air conditioning, fire precaution services etc.

(vii) Capital Values

In this method, the capital values of certain assets like machinery and building are used as basis for the apportionment of certain expenses.

Examples are:

Rates, taxes, depreciation, maintenance, insurance charges of the building etc.

(viii) Light Points

This is used for apportioning lighting expenses.

(ix) Kilowatt Hours

This basis is used for the apportionment of power expenses.

(x) Technical Estimates

This basis of apportionment is used for the apportionment of those expenses for which it is difficult, to find out any other basis of apportionment. An assessment of the equitable proportion is carried out by technical experts. This is used for distributing lighting, electric power, works manager’s salary, internal transport, steam, water charges etc. when these are used for processes.

Principles of Apportionment of Overhead Costs:

The determination of a suitable basis is of primary importance and the following principles are useful guides to a cost accountant:

(i) Service or Use or Benefit Derived

If the service rendered by a particular item of expense to different departments can be measured, overhead can be conveniently apportioned on this basis. Thus, the cost of maintenance may be apportioned to different departments on the basis of machine hours or capital value of the machines, rent charges to be distributed according to the floor space occupied by each department.

(ii) Ability to Pay Method

Under this method, overhead should be distributed in proportion to the sales ability, income or profitability of the departments, territories, basis of products etc. Thus, jobs or products making higher profits take a higher share of the overhead expenses. This method is inequitable and is not generally advisable to relieve inefficient units at the cost of efficient units.

(iii) Efficiency Method

Under this method, the apportionment of expenses is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing thereby the inefficiency of the department.

(iv) Survey Method

In certain cases it may not be possible to measure exactly the extent of benefit wick the various departments receive as this may vary from period to period, a survey is made of the various factors involved and the share of overhead costs to be borne by each cost centre is determined.

Thus, the salaries of foreman serving two departments can be apportioned after a proper survey which may reveal that 30% of such salary should be apportioned to one department and 70% to the other department. The cost of lighting, when not metered, may similarly be apportioned on a survey of the number and wattage of light points and the hours of use in each cost centre.

Principles of apportionment of overhead expenses:

The guidelines or principles which facilitate in determining a suitable basis for apportionment of overheads are explained below:

  • Derived Benefit

According to this principle, the apportionment of common items of overheads should be based on the actual benefit received by the respective cost centers. This method is applicable when the actual benefits are measurable. e.g., rent can be apportioned on the basis of the floor area occupied by each department.

  • Potential Benefit

According to this principle, the apportionment of the common item of overheads should be based on potential benefits (i.e., benefits likely to be received). When the measurement of actual benefit is difficult or impossible or uneconomical this method is adopted. e.g., the cost of canteen can be apportioned on the basis of the number of employees in each department which is a potential benefit.

  • Ability to Pay

According to this principle, overheads should be apportioned on the basis of the saleability or income generating ability of respective departments. In other words, the departments which contribute more towards profit should get a higher proportion of overheads.

  • Efficiency Method

According to this principle, the apportionment of overheads is made on the basis of the production targets. If the target is higher, the unit cost reduces indicating higher efficiency. If the target is not achieved the unit cost goes up indicating inefficiency of the department.

  • Specific Criteria Method

According to this principle, apportionment of overhead expenses is made on the basis of specific criteria determined in a survey. Hence this method is also known as “Survey method”. When it is difficult to select a suitable basis in other methods, this method is adopted. e.g., while apportioning salary of the foreman, a careful survey is made to know how much time and attention is given by him to different departments. On the basis of the above survey, the apportionment is made.

Management Notes

Inter Departmental Transfers at Cost Price

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In organizations with multiple departments, goods and services are often transferred internally from one department to another. This is known as inter-departmental transfer. For example, in a textile company, the spinning department may transfer yarn to the weaving department, or in a retail business, the warehouse may transfer goods to sales departments. These transfers must be recorded properly to ensure accurate departmental accounts and correct profit calculation.

Inter-departmental transfers can happen at either cost price or selling price. When transfers occur at cost price, the transferring department records the value of the goods or services at the original cost it incurred, without adding any profit or markup. This method focuses purely on recovering the expense involved, making it simple and transparent. Recording at cost price ensures that no unrealized profits inflate the departmental accounts, helping management track true profitability.

Proper accounting treatment of inter-departmental transfers at cost price is essential to avoid overstatement or understatement of departmental profits, ensure fair performance evaluation, and maintain accurate consolidated accounts. Let’s explore the meaning, accounting treatment, significance, advantages, and limitations of inter-departmental transfers at cost price in detail

Inter-departmental transfers at cost price refer to the transfer of goods or services between departments within the same organization, where the transfer value is recorded at the actual cost incurred by the supplying department, without adding any profit margin.

For example, if the production department produces a product at ₹100 per unit and transfers it to the sales department, the entry is made at ₹100 per unit. No profit or loading is included in the transfer value.

Purposes of inter-departmental transfers at cost price:

The main purposes of inter-departmental transfers at cost price are:

  • To avoid artificial profits: Since no sale to an external party has occurred, no real profit has been realized. Recording the transfer at cost avoids inflating profits on paper.
  • To ensure fair departmental performance evaluation: By using cost price, each department’s results reflect their true operational performance without distortion from internal markups.
  • To maintain simplicity and transparency in accounts: Recording at cost simplifies bookkeeping and avoids complications arising from loading and adjustments.
  • To prepare accurate combined financial statements: The organization as a whole should not report profit on internal transfers, only on external sales.

Advantages of Inter-Departmental Transfers at Cost Price:

  • Simplicity in Accounting

One of the biggest advantages of inter-departmental transfers at cost price is the simplicity it brings to accounting records. Since the transfers are made without adding any profit or markup, there is no need to calculate or track loading adjustments or unrealized profits. This straightforward approach reduces the complexity of journal entries and ledger postings, making it easier for the accounting staff to maintain records. It also minimizes the chances of clerical errors, simplifying reconciliation between departments. As a result, the overall administrative burden is reduced, and the accounting process becomes more efficient and clear.

  • Avoidance of Unrealized Profits

Inter-departmental transfers at cost price ensure that profits are only recorded when they are actually realized, i.e., when goods or services are sold to external customers. This avoids inflating departmental profits artificially due to internal transfers. If transfers were made at selling price or with added profit, the supplying department’s profit would include internal, unrealized margins, which need to be adjusted later. By using cost price, the organization prevents overstatement of profits and maintains the integrity of financial statements. This promotes a realistic view of business performance, both at departmental and overall levels.

  • Fair Performance Evaluation

Recording inter-departmental transfers at cost price allows for fair and unbiased evaluation of each department’s performance. Departments are assessed based on their operational efficiency and cost management rather than the profit generated through internal transfers. This ensures that the receiving department is not unfairly burdened by internal markups and the supplying department is not artificially credited with profits not yet realized externally. By focusing on true operational results, management can identify which departments are performing well and which need improvement, allowing for accurate assessments and informed performance reviews across the organization.

  • Accurate Stock Valuation

When goods are transferred between departments at cost price, the value recorded in the receiving department’s stock is the actual cost, not an inflated figure with internal profit. This ensures that the closing stock is correctly valued in the departmental accounts. Accurate stock valuation is essential because it directly affects the calculation of departmental profits. If transfers were recorded at selling price, adjustments would be necessary to remove unrealized profit from the closing stock. Using cost price eliminates the need for such adjustments, simplifying the preparation of financial statements and ensuring accuracy.

  • Transparency Across Departments

Cost-based inter-departmental transfers promote transparency between departments by showing the true cost of resources and avoiding artificial internal profits. This fosters trust and cooperation between departments, as there is no perception of one department profiting at the expense of another. Transparency ensures that departments work collaboratively toward organizational goals rather than focusing on maximizing internal profits. It also provides clear visibility into cost flows, helping managers understand how resources move through the organization. This openness supports better decision-making and encourages a healthy organizational culture focused on efficiency and teamwork.

  • Easier Consolidation of Accounts

When departments transfer goods or services at cost price, the organization’s consolidated financial statements are easier to prepare. Since there are no internal profits included in departmental figures, there is no need to make complicated adjustments to eliminate unrealized profits during consolidation. This saves time and reduces the risk of errors in the final accounts. Easier consolidation improves the efficiency of the finance team, ensures compliance with accounting standards, and provides stakeholders with an accurate picture of the organization’s overall financial performance without distortions from internal transactions.

  • Supports Better Decision-Making

Recording inter-departmental transfers at cost price gives management access to clear, undistorted cost data. This helps in making informed decisions related to budgeting, pricing, cost control, and resource allocation. Managers can identify high-cost areas and explore opportunities to improve efficiency. Accurate cost data also enables better analysis of profitability, helping the organization decide whether to continue, expand, or restructure certain departments. Without the noise of internal profit margins, the management has a clearer understanding of the cost structure, allowing for strategic decisions that align with overall business objectives.

  • Reduces Internal Conflicts

Using cost price for inter-departmental transfers minimizes potential conflicts between departments. When goods or services are transferred without profit, no department feels overcharged or undervalued. This reduces disputes over pricing and performance, promoting harmony and cooperation. In contrast, transfer pricing with added profit can lead to disagreements, with supplying departments seeking higher prices and receiving departments feeling burdened. By standardizing transfers at cost, the organization creates a fair environment where departments focus on collective success rather than internal competition, leading to smoother operations and better overall morale.

Disadvantages of Inter-Departmental Transfers at Cost Price:

  • Understatement of Supplying Department’s Performance

When inter-departmental transfers are recorded at cost price, the supplying department’s performance may appear weaker because it does not reflect any internal profit. This can demotivate managers and staff in the supplying department, as their efforts to create value and efficiency may not be visible in their financial results. Even though they deliver high-quality goods or services, the lack of profit recognition in internal transfers means their contributions are undervalued. This underreporting may lead to less recognition, fewer incentives, and an inaccurate picture of the department’s actual capabilities and strengths.

  • Lack of Profit Accountability

By not including profit margins in inter-departmental transfers, departments may lose sight of profitability and become less disciplined in their operations. Without accountability for generating profits on internal transactions, departments may focus only on covering costs instead of seeking efficiency improvements or maximizing value. This can lead to complacency, as departments are not incentivized to work as profit centers. Over time, this mindset can reduce overall competitiveness and innovation within the organization, making it harder for management to push departments to operate at peak performance levels.

  • Difficulty in Assessing True Profit Potential

Transfers at cost price prevent management from seeing the potential profit margins that departments could generate if they operated independently or sold externally. This makes it challenging to evaluate the real commercial value or competitive strength of individual departments. Without internal pricing reflecting market-based values, the company misses opportunities to benchmark internal departments against external standards. This limits insights into whether departments are underpriced, overpriced, or underperforming relative to market potential, making strategic decisions about outsourcing, expansion, or restructuring more difficult for senior management.

  • Inefficiency in Cost Recovery

Transferring at cost price may sometimes result in incomplete recovery of certain indirect or hidden costs. Overheads like administrative charges, storage expenses, or depreciation might not be fully reflected when only direct cost is used. This creates gaps in cost recovery, leading to underfunded departments or inaccurate departmental budgets. Without considering a fair share of fixed and indirect costs, the supplying department may not break even, placing financial strain on specific units. Over time, these gaps can create inefficiencies across the organization and lead to distorted internal cost structures.

  • Absence of Competitive Pricing Pressure

When departments transfer goods or services internally at cost, they face no competitive pressure to price competitively or improve offerings. Without internal markups or profit accountability, departments may lack motivation to optimize operations, control costs, or innovate. If they know their output will automatically be accepted by the receiving department at cost, they may neglect quality improvements or efficiency efforts. This can create a sluggish internal system where departments operate in silos, missing out on the opportunity to simulate external market competition and foster a dynamic, performance-driven internal environment.

  • Misalignment with Market Realities

Cost-based transfers may misalign internal accounting with external market realities. While external sales must include profit margins to sustain the business, internal transfers at cost price ignore these commercial dynamics. As a result, the organization’s internal pricing and decision-making may become disconnected from real-world conditions, causing misjudgments in product costing, pricing strategies, and resource allocation. This misalignment can have strategic consequences, especially if the organization assumes departments are operating profitably based on cost figures, without fully considering what actual market conditions would demand.

  • Complex Managerial Control

Although cost price transfers simplify accounting, they complicate managerial control because profit responsibility is blurred. Without profit recognition in internal transfers, managers may struggle to track whether departmental outputs are contributing positively to the company’s bottom line. This makes it harder for management to set clear performance targets or measure departmental effectiveness beyond basic cost control. It can also make incentive structures more difficult to design, as linking rewards or bonuses to cost-only metrics may not adequately reflect the true value or efficiency of a department’s work.

  • Limited Financial Motivation

Inter-departmental transfers at cost reduce the financial motivation for departments to seek improvements or efficiencies, since no profit is recognized from internal operations. Supplying departments may see little reason to control costs aggressively, negotiate better supply terms, or invest in process improvements if the only focus is on breaking even. Similarly, receiving departments may not challenge the cost structures or push for more efficient internal sourcing. This lack of internal financial motivation can result in stagnation, where departments operate at status quo levels without striving for continuous improvement or innovation.

  • Transfer from One Department to another Department at Cost Price, i.e., Cost Based Transfer Price:

Under the circumstance, the supplying department should be credited at–cost and the receiving department should be debited at cost, i.e., by the same amount. The so-called cost price may be considered as actual cost or standard cost or marginal cost and, accordingly, transfer price is based on any of the above methods.

  • Transfer from One Department to another Department at Invoice Price/Provision for Un-realised Profit Market Based Transfer Price:

In this case, the Departmental Trading Account of the receiving department is debited and the issuing one credited. Now, if the entire goods of the receiving department is sold within the year, practically no problem arises since notional profit materializes into actuality. But problem arises in the cases where there is unsold stock (i.e., if the entire goods are not disposed off).

In this case, appropriate adjustment for the unsold stock is to be made in order to ascertain the correct profit or loss since the notional profit remains un-realised. (The method of calculation for provision of un-realised profit is simple in the case of a trading concern but the same is very complicated in the case of a manufacturing concern particularly when the latter is engaged in various continuous processes.)

Therefore, provision for both opening and closing stock is to be made. The former is credited and the latter is debited in Consolidated Profit and Loss Account. Alternatively, the net effect can be given to Consolidated Profit and Loss Account.

(i) For Opening Stock Reserve:

Opening Stock Reserve, A/c Dr.

To, General Price

(ii) For Closing Stock Reserve:

General P & L A/c Dr.

Management Notes

Meaning and Features of Departmental Undertaking

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Under departmental form of organisation, a public enterprise is run as a separate full-fledged ministry or as a major sub-division of a department of the Government.

For example, the Indian Railways are managed by the Ministry of Railways. Post and Telegraph services are run as a department, in the Ministry of Communication.

The Delhi Milk Scheme, All India Radio, Doordarshan are other examples of departmental undertakings.

Features of Departmental Undertaking:

The salient features of a departmental undertaking are as follows:

(i) Formation:

A departmental undertaking is established either as a separate full-fledged ministry or as a sub-division of a ministry (i.e. department) of the Government.

(ii) No Separate Entity:

A departmental undertaking does not have an independent entity distinct from the Government.

(iii) Ultimate Responsibility with the Minister:

The ultimate responsibility for the management of a departmental undertaking lies with the minister concerned; who is responsible to the Parliament or State Legislature for the affairs of the departmental undertaking. The minister, in turn, delegates his authority downwards to various other management levels, in the departmental undertaking.

(iv) Governmental Financing:

The departmental undertaking is financed through annual budget appropriations by the Parliament or the State Legislature. The revenues of the undertaking are paid into the treasury.

(v) Accounting and Audit etc. as Applicable to Government Departments:

The departmental undertaking is subject to the normal budgeting, accounting and audit procedures, which are applicable to Government departments.

(vi) Managed by Civil Servants:

The departmental undertaking is managed by civil servants, who are subject to same service conditions as applicable to civil servants of the Government.

(vii) Sovereign Immunity:

A departmental undertaking cannot be sued at all, without the consent of the Government.

Advantages of Departmental Undertaking:

Following are the advantages of the departmental undertaking:

(i) Easy Formation:

It is easy to set up a departmental undertaking. The departmental undertaking is created by an administrative decision of the Government, involving no legal formalities for its formation.

(ii) Direct and Control of Parliament or State Legislature:

The departmental undertaking is directly responsible to the Parliament or the State legislature through its overall head i.e. the minister concerned.

(iii) Secrecy Maintained:

The departmental undertaking can maintain secrecy of important policy matters; as the Government can withhold any information, in public interest.

(iv) Lesser Burden of Tax on Public:

Earnings of departmental undertaking are paid into Government treasury, resulting in lesser tax burden on the public.

(v) Instrument of Social Change:

Government can promote economic and social justice through departmental undertakings. Hence, a departmental undertaking can be used by the Government, as an instrument of social change.

(vi) Lesser Risk of Misuse of Public Money:

As the departmental undertaking is subject to budgeting, accounting and audit procedures of the government; the risk of misuse of public money is relatively less.

(vii) Guided by Rules and Regulations of the Ministry:

The officers of the departmental undertaking are under the direct administrative control of the ministry. They are guided by the rules and regulations of the ministry, framed with a focus on public welfare.

Limitations of Departmental Undertaking:

Following are the major limitations of the departmental undertaking:

(i) Read-Tape and Bureaucracy:

Departmental undertaking is run in a way other department of the Government are run. Its management and functioning are subject to excessive red-tap and bureaucracy. (Red-tape means unnecessary and complicated officials rules which prevent things from being done quickly). As a result, the departmental undertaking loses all flexibility desired of a business enterprise.

(ii) Incidence of Additional Taxation:

Losses incurred by a departmental enterprise are met out of the treasury. This very often necessitates additional taxation the burden of which falls on the common man.

(iii) Lack of Competition:

A departmental undertaking often enjoys monopoly in its field. As a result, it tends to become indifferent to the quality and price of its goods and services; and may not hesitate to exploit the society.

(iv) Casual Approach to Work:

As officers of a departmental undertaking are subject to frequent transfers; they develop a sense of casual approach to work. As a result, the operational efficiency of the undertaking suffers a lot.

(v) Political Influence:

A departmental undertaking is subject to excessive political influence. Its fate depends on the balance of power between the ruling party and the opposition. As such, a departmental undertaking becomes a political organisation rather than an economic or business organisation.

(vi) Lack of Professional Management and Fear of Criticism:

A departmental undertaking is managed by civil servants, who do not possess professional management skills. Moreover, these managers could not afford to be innovative, because of a fear of criticism by the minister or the Parliament.

(vii) Financial Dependence:

A departmental undertaking is financially dependent on the Government’s budgetary allocations. As such, it cannot have its own independent long range investment decisions, which may bring enormous prosperity to the undertaking.

Management Notes

Treatment of security premium

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Under Section 78 of the Act, Securities Premium Reserve may be used wholly or in part for:

(a) Issuing fully paid bonus shares to the members.

(b) Writing off preliminary expenses.

(c) Writing off the expenses of or the commission paid or discount allowed on any issue of shares or debentures of the company.

(d) Providing for the premium payable on the redemption of preference shares or debentures of the company.

(e) In purchasing its own shares i.e. Buy Back u/s 77 A

It is to be noted here that any utilization of the amount of premium except in any of the modes specified above, can only be done by way of reduction of capital and this will require the compliance of the provisions laid down in Section 100 of the Act.

Accounting Treatment:

Securities Premium Reserve may be demanded by company on application, allotment or calls.

In case it is received by the company on application, then the following treatment is followed:

(1) When Premium is received on application:

(i) Bank A/c ….Dr. (With the App. Money & Securities Premium)

To Share Application A/c

(ii) Share Application A/c ….Dr.

To Share Capital A/c

To Securities Premium Reserve A/c

(Being the application money transferred to share capital and securities premium account)

Note:

Students should note that Securities Premium Reserve Account is not credited when the application money is received. It is due to the reason that at the time of receiving the application money it is treated as deposit and the company is not certain whether the amount received would be accepted or rejected.

(2) When Premium is received on allotment:

Securities Premium Reserve Account is credited with Full Amount at the Time of Making the Allotment Due:

(i) Share Allotment A/c …Dr. (With the amount of allotment and Securities Premium)

To Share Capital A/c

To Securities Premium Reserve A/c

(ii) For Allotment (including premium) Received:

Bank A/c … Dr.

To Share Allotment A/c

It is important to note that surplus application money retained for allotment should first be applied towards the adjustment of nominal value of allotment money and the balance, if any, will be adjusted towards securities premium payable.

Management Notes

Meaning of purchase consideration, Methods of calculating Purchase consideration, Net Payment method, Net Asset method

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Purchase Consideration refers to the consideration payable by the purchasing company to the vendor company for taking over the assets and liabilities of Vendor Company.

If one company purchases another business as a going concern (that is, the business will continue to operate for eternity), it can pay for it using one or more of the following methods:

  • Cash: The entire amount is paid in cash. This is a rare scenario as the following two methods are more common.
  • Shares: The limited liability company offers some of its shares to the owners of the business that is being purchased.
  • Debentures: The limited liability company may offer some of its debentures to the owners of the business.

The following two things must be kept in mind when the price of the business is being determined:

  • The assets bought are stated at different values in the books of the limited company and the books of the selling business. This is because they are revalued to reflect their current worth in the market. This value is known as the fair value of the assets.

The price paid by the limited company for the business is known as the purchase consideration. In many cases, the purchase consideration is not the same as the net assets bought and the difference must be recorded in the books of account.

If the purchase consideration is greater than net assets, the difference is known as positive goodwill. However, if the purchase consideration is lower than the net assets, the difference is known as negative goodwill. The accounting treatment for each of these types of goodwill is different.

Accounting Standard–14 defines the term purchase consideration as the “aggregate of the shares and other securities issued and the payment made in the form of ach or other assets by the transferee company to the shareholders of the transferor company”. Although, purchase consideration refers to total payment made by purchasing company to the shareholders of Vendor Company, its calculation could be in different methods, as explained below:

  1. Lump sum method
  2. Net Assets method
  3. Net Payment Method

Lump sum Method:

Under this method purchase consideration will be paid in lump sum as per the valuation of purchasing companies’ valuation. E.g., if it is stated that A Ltd. takes over the business of B Ltd. for Rs.15, 00,000 here the sum of the Rs.15, 00,000 is the Purchase Consideration.

Net Assets Method:

(1) The value of goodwill will be ascertained.

(2) Fixed assets of the company, disclosed or undisclosed in Balance Sheet, are taken at their realisable values.

(3) Floating assets are to be taken at market value.

(4) Remember to exclude fictitious assets, such as Preliminary Expenses, Accumulated Losses etc.

(5) Provision for depreciation, bad debts provision etc. must be considered.

(6) Find out the external liabilities of the company payable to outsiders including contingent liabilities.

Under this method P.C. shall be computed as follows:

Particulars Rs.
Agreed value of assets taken over

Less: Agreed value of Liabilities taken over

 XXX

XXX
Purchase Consideration XXX

Net Payment Method:

Under this method P.C. should be calculated by aggregating total payments made by the purchasing company. E.g.: A Ltd. had taken over B Ltd. and for that it agreed to pay Rs.5, 00,000 in cash 4, 00,000 Equity Shares of Rs.10 each fully paid at an agreed value of Rs.15 per share then the P.C. will be ascertained as follows:

Particulars Rs.
Cash

4,00,000 E. Shares of Rs.10 each fully paid, at Rs.15 per share

 5,00,000

60,00,000
Purchase Consideration 65,00,000

Management Notes

Non-assumption of Trade Liabilities in the Books of Purchasing company

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Except for the Assumed Liabilities, the Buyer shall not be responsible for, assume, pay, perform, discharge, or accept any liabilities, debts or obligations of the Seller of any kind whatsoever, whether actual, contingent, accrued, known or unknown, including, without limitation, any relating to accounts payable, interest-bearing debt, notes to Affiliates or other related Persons, interest and termination penalties on indebtedness, taxes, employee compensation, severance, pension, profit-sharing, vacation, health insurance, disability insurance or other employee benefit plans and programs, worker’s compensation, breach or negligent performance of any contract, or breach of warranty relating thereto, liabilities resulting from breach of contract, torts (including, without limitation, product liability claims), illegal activity, unlawful employment or business practice, infringement of intellectual property rights, claim for environmental liability or remediation or any other liability or obligation whatsoever. All such non-assumed liabilities, debts and obligations shall remain the responsibility of the Seller which shall pay and discharge the same when and as due.

Assumption of a liability

In a sale of business transaction, it is common for the purchaser to assume certain existing or future obligations of the vendor to make payments to third parties.  As explained in the Draft Ruling:

The following types of liabilities are commonly assumed by a purchaser:

  • Trade creditors/accounts payable;
  • Product warranties;
  • Long service leave obligations of employees;
  • Environmental rehabilitation;
  • Rates;
  • Land tax;
  • Plant and equipment or property leases; and
  • Hire purchase obligations.

As the ATO identifies in the Draft Ruling, to determine the GST consequences, it is necessary to focus on the contractual arrangements entered into between the vendor and purchaser.  The focus is on what is agreed by the parties and the GST consequences that flow from this agreement.

Supply and consideration

It is a fundamental requirement of making a taxable supply that an entity makes a “supply” for “consideration”.  The essence of a sale of business transaction is that the vendor supplies certain assets of a business to a purchaser for consideration.  In circumstances where the purchaser assumes certain liabilities of the vendor as part of this transaction, a key issue is whether the purchaser’s assumption of a liability is simply part and parcel of the main transaction, or whether it has any separate GST implications.

It has been a concern of some tax advisers that, in agreeing to assume the vendor’s liability to third parties, the purchaser makes a supply to the vendor for consideration.  The basis for this concern is in the extremely wide definitions of “supply” and “consideration”.  Relevantly:

The definition of supply includes “an entry into, or release from, an obligation” to do anything and

The definition of consideration includes “any payment, or any act or forbearance, in connection with a supply of anything”.

Taken together, on one view, the line of analysis would be as follows:

  • In assuming, for example, the liability to pay trade creditors, the purchaser makes a supply constituted by the entry into an obligation the vendor; and
  • the vendor provides consideration for that supply equal to the amount required to be paid by the vendor in respect of the entitlements or, more typically, allowed by the vendor as an adjustment to the purchase price.

There are four general case law exceptions to the rule of buyer non-liability in asset transactions:

  • The buyer assumes the seller’s liabilities expressly or impliedly.
  • The transaction in substance constitutes a merger or consolidation of the buyer and seller (de facto merger).
  • The buyer is “a mere continuation” of the seller.
  • The intent of the transaction is to defraud the seller’s creditors.

The de facto merger theories are the most commonly cited by courts. Facts which support those theories include:

  • Continuity of management.
  • Same physical location.
  • Same general business operations.
  • Common equity ownership.
  • Assumption seller’s ordinary course business trade debt.
  • Seller’s dissolution following the sale.
Management Notes

Passing of Journal entries in the books of Vendor

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Journal is a book of original entry. All day-to-day transactions of business are recorded first in it in a chronological order with the help of vouchers like cash receipts, cash memos, invoices, etc. Journal is also called a ‘Day Book’. The process of recording business transactions in the journal is called ‘Journalising’ and the entries passed in this book are called ‘Journal Entries’.

The ruling of Journal is given below:

Journal: 

Date Particulars L. Dr. Cr.
    F. Amount Amount
      Rs Rs

The Journal consists of five columns. The first column is used for recording date of the transaction with year. In the second column i.e., ‘Particulars’, the journal entry is made by mentioning the two accounts affected by the transaction. The accounting entry is passed following the ‘Accounting Equation’ or ‘Dual Aspect Concept’.

The two accounts affected by the transaction are debited and credited by the same amount. The third column LP, i.e. Ledger Polio is used for writing the page number of the ledger on which the particular account appears. The fourth and fifth columns of journal are meant for writing respectively ‘Debit’ and ‘Credit’ amounts of the transaction.

The Journal consists of five columns. The first column is used for recording date of the transaction with year. In the second column i.e., ‘Particulars’, the journal entry is made by mentioning the two accounts affected by the transaction. The accounting entry is passed following the ‘Accounting Equation’ or ‘Dual Aspect Concept’.

The two accounts affected by the transaction are debited and credited by the same amount. The third column LP, i.e., Ledger Polio is used for writing the page number of the ledger on which the particular account appears. The fourth and fifth columns of journal are meant for writing respectively ‘Debit’ and ‘Credit’ amounts of the transaction.

Account

In simple words, an account is a summarised record of all transactions relating to a particular person, a thing or an item of income or expense. You will know more about the ruling of an account under the next context titled Ledger 32.6.

An account resembles the shape of the English alphabet ‘T’ as follows:

Name of the Account
Dr. Cr.

Classification or Types of Accounts:

All business transactions relate to three accounts, namely, (i) Personal Accounts, (ii) Real Accounts, and (iii) Nominal Accounts. When real and nominal accounts are taken together, these are called ‘Impersonal Accounts.”

(i) Personal Accounts:

Accounts relating to persons and organisations representing to persons are called ‘Personal Accounts.’ Examples are Chinmoy’s Account, Mazumdar’s Account, The State Bank of India Account, Tanmoy & Sons’ Account, Carnal Paper Mills’ Account, Salaries Outstanding Account, etc.

(ii) Real Accounts:

Accounts which are related to properties or assets are called ‘Real Accounts.’ They are called Real Accounts because they represent things of value owned by the business. Cash Account, Furniture Account, Building Account, etc. are the popular examples of Real Accounts.

(iii) Nominal Accounts:

Accounts relating to expenses, losses, incomes, gains, profits are called ‘Nominal Accounts.’ Examples of nominal accounts are Wages Account, Salaries Account, Commission Received Account, Interest Received Account, etc.

Rules for Debit and Credit:

The rules applicable for debiting and crediting the three types of accounts are summarised

Rules for Debit and Credit:

Accounts Debit Credit
Personal

Real

Nominal

 Receiver

What comes in

Expenses and Losses

 Giver

What goes out

Incomes and Gains

Management Notes

Preparation of Ledger Accounts in the Books of Vendor

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When a partnership firm is converted into a limited company, the firm transfers its assets and liabilities to the purchasing company. The vendor, i.e., the partnership firm, prepares certain ledger accounts to record the closure of its books.

  1. Realization Account: To record the sale of assets and liabilities.
  2. Purchasing Company Account: To record the purchase consideration receivable from the purchasing company.
  3. Partners’ Capital Account: To account for partners’ balances after transferring assets and liabilities.
  4. Bank Account: To record cash received and payments made during the process.

Steps in Preparing Ledger Accounts:

  • Realization Account

All assets except cash and fictitious assets (e.g., goodwill) are transferred to the realization account. Liabilities are also transferred here. The account is closed by transferring the net profit or loss to the partners’ capital accounts.

  • Purchasing Company Account

This account records the purchase consideration due from the purchasing company and its subsequent receipt in cash, shares, or debentures.

  • Partners’ Capital Account

The net profit or loss from the realization account is transferred here, along with any settlement made in cash or through shares and debentures.

  • Bank Account

Any cash received as part of the purchase consideration or payments made for expenses is recorded here.

Journal Entries:

Date Particulars Debit (₹) Credit (₹) Narration
1 Realization A/c Dr. ₹XX
To Sundry Assets A/c ₹XX (Being all assets except cash transferred to realization account)
2 Sundry Liabilities A/c Dr. ₹XX
To Realization A/c ₹XX (Being liabilities transferred to realization account)
3 Purchasing Company A/c Dr. ₹XX
To Realization A/c ₹XX (Being purchase consideration due from the purchasing company)
4 Bank A/c Dr. ₹XX
To Purchasing Company A/c ₹XX (Being cash received from purchasing company as part of purchase consideration)
5 Shares in Purchasing Company A/c Dr. ₹XX
Debentures in Purchasing Company A/c Dr. ₹XX
To Purchasing Company A/c ₹XX (Being shares and debentures received from purchasing company)
6 Realization A/c Dr. ₹XX
To Bank A/c ₹XX (Being realization expenses paid)
7 Realization A/c Dr. ₹XX
To Partners’ Capital A/c ₹XX (Being profit on realization transferred to partners’ capital account)
8 Partners’ Capital A/c Dr. ₹XX
To Bank A/c ₹XX
To Shares in Purchasing Company A/c ₹XX
To Debentures in Purchasing Company A/c ₹XX (Being settlement of partners’ capital accounts in cash, shares, and debentures)

Explanation of Journal Entries:

  • Transfer of Assets:

All assets (except cash) are transferred to the realization account at their book value.

  • Transfer of Liabilities:

All external liabilities are transferred to the realization account.

  • Purchase Consideration Receivable:

The purchase consideration receivable from the purchasing company is recorded by debiting the purchasing company account and crediting the realization account.

  • Receipt of Cash:

When cash is received from the purchasing company, it is debited to the bank account, and the purchasing company account is credited.

  • Receipt of Shares and Debentures:

If part of the purchase consideration is received in the form of shares and debentures, these accounts are debited, and the purchasing company account is credited.

  • Realization Expenses:

Any realization expenses paid by the firm are recorded by debiting the realization account and crediting the bank account.

  • Profit or Loss on Realization:

The profit or loss on realization is transferred to the partners’ capital accounts in their profit-sharing ratio.

  • Settlement of Partners’ Accounts:

The partners’ capital accounts are settled by transferring the balance to the bank account, shares, or debentures, depending on the mode of settlement.

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