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Management Notes

Indian Financial System Functions

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Encourage Savings:

Financial system promotes savings by providing a wide array of financial assets as stores of value aided by the services of financial markets and intermediaries of various kinds. For wealth holders, all this offers ample choice of portfolios with attractive combinations of income, safety and yield.

With financial progress and innovations in financial technology, the scope of portfolio choice has also improved. Therefore, it is widely held that the savings-income ratio is directly related to both financial assets and financial institutions. That is, financial progress generally insures larger savings out of the same level of real income.

As stores of value, financial assets command certain advantages over tangible assets (physical capital, inventories of goods, etc.) they are convenient to hold, or easily storable, more liquid, that is more easily encashable, more easily divisible, and less risky.

A very important property of financial assets is that they do not require regular management of the kind most tangible assets do. The financial assets have made possible the separation of ultimate ownership and management of tangible assets. The separation of savings from management has encouraged savings greatly.

Savings are done by households, businesses, and government. Following the official classification adopted by the Central Statistical Organization (CSO), Government of India, we reclassify savers into, household sector, domestic private corporate sector, and the public sector.

The household sector is defined to comprise individuals, non-Government, non-corporate entities in agriculture, trade and industry, and non-profit making organisations like trusts and charitable and religious institutions.

The public sector comprises Central and state governments, departmental and non departmental undertakings, the RBI, etc. The domestic private corporate sector comprises non-government public and private limited companies (whether financial or non-financial) and corrective institutions.

Of these three sectors, the dominant saver is the household sector, followed by the domestic private corporate sector. The contribution of the public sector to total net domestic savings is relatively small.

Risk Function

The financial markets provide protection against life, health, and income risks. These guarantees are accomplished through the sale of life, health insurance, and property insurance policies.

Mobilisation of Savings:

Financial system is a highly efficient mechanism for mobilising savings. In a fully-monetised economy this is done automatically when, in the first instance, the public holds its savings in the form of money. However, this is not the only way of instantaneous mobilisation of savings.

Other financial methods used are deductions at source of the contributions to provident fund and other savings schemes. More generally, mobilisation of savings taken place when savers move into financial assets, whether currency, bank deposits, post office savings deposits, life insurance policies, bill, bonds, equity shares, etc.

Transfer Function

A financial system provides a mechanism for the transfer of resources across geographic boundaries.

Allocation of Funds:

Another important function of a financial system is to arrange smooth, efficient, and socially equitable allocation of credit. With modem financial development and new financial assets, institutions and markets have come to be organised, which are replaying an increasingly important role in the provision of credit.

In the allocative functions of financial institutions lies their main source of power. By granting easy and cheap credit to particular firms, they can shift outward the resource constraint of these firms and make them grow faster.

On the other hand, by denying adequate credit on reasonable terms to other firms, financial institutions can restrict the growth or even normal working of these other firms substantially. Thus, the power of credit can be used highly discriminately to favour some and to hinder others.

Reformatory Functions

A financial system undertaking the functions of developing, introducing innovative financial assets/instruments services and practices and restructuring the existing assets, services, etc, to cater to the emerging needs of borrowers and investors.

Key Points

  • Issuing and gathering of deposits.
  • Supply of loans from the collected pool of money.
  • The undertaking of financial transactions.
  • Boosting the growth of stock markets and other financial markets.
  • Setting up the legal commercial substructure.
  • Provision of monetary and consultative services.
  • Permits portfolio adaptation for existing assets.
  • Allotment of chance and risk.
  • It forges a connection between depositors and investors.
  • Boosts depth and breadth of finances by increasing its horizon.
  • It is responsible for capital creation.
  • Adds time value to assets and money.
  • To set up an entire payment structure and system.
  • Allocate and dissipate the economic resources.
  • To maintain the economic stability in the country and the markets.
  • To create markets that can judge the investment performance.
Management Notes

Weaknesses of Indian Financial System

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In order to meet the growing requirements of the Government and the industries, many innovative financial instruments have been introduced. Besides, there has been a mushroom growth of financial intermediaries to meet the ever-growing financial requirements of different types of customers. Hence, the Indian financial system is more developed and integrated today than what it was 50 years ago. Yet, it suffers from some weaknesses as listed below:

Dominance of development banks in industrial finance:

The industrial financing in India today is largely through the financial institutions set up by the government. They get most of their funds from their sponsors. They act as distributive agencies only. Hence, they fail to mobilise the savings of the public. This stands in the way of growth of an efficient financial system in the country.

Lack of co-ordination among financial institutions:

There are a large number of financial intermediaries. Most of the financial institutions are owned by the government. At the same time, the government is also the controlling authority of these institutions. As there is multiplicity of institutions in the Indian financial system, there is lack of co-ordination in the working of these institutions.

Unhealthy financial practices:

The dominance of development banks has developed unhealthy financial practices among corporate customers. The development banks provide most of the funds in the form of term loans. So there is a predominance of debt in the financial structure of corporate enterprises. This predominance of debt capital has made the capital structure of the borrowing enterprises uneven and lopsided. When these enterprises face financial crisis, the financial institutions permit a greater use of debt than is warranted. This will make matters worse.

Inactive and erratic capital market:

In India, the corporate customers are able to raise finance through development banks. So, they need not go to capital market. Moreover, they do not resort to capital market because it is erratic and inactive. Investors too prefer investments in physical assets to investments in financial assets.

Monopolistic market structures:

In India some financial institutions are so large that they have created a monopolistic market structures in the financial system. For instance, the entire life insurance business is in the hands of LIC. The weakness of this large structure is that it could lead to inefficiency in their working or mismanagement. Ultimately, it would retard the development of the financial system of the country itself.

High Rate of Interest:

There is a possibility of the high-interest rate charged by several financial institutions in the financial system of our country. Various institutions due to their monopolistic structure in the market may charge high or unfair interest rates.

Other factors:

Apart from the above, there are some other factors which put obstacles to the growth of Indian financial system. Examples are:

a. Banks and Financial Institutions have high level of NPA.

b. Government burdened with high level of domestic debt.

c. Cooperative banks are labelled with scams.

d. Investors confidence reduced in the public sector undertaking etc., e. Financial illiteracy.

Management Notes

Profits Prior to Incorporation and Accounting Treatment

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Profit of a business for the period prior to the date company into existence is referred to as Pre-Incorporation profit. Hence prior period item are those item which is done before incorporation of the company. Profit prior to incorporation is the profit earned or loss suffered during the period before incorporation. It is a capital profit and not legally available for distribution as dividend because a company cannot earn a profit before it comes into existence.

Profit earned after incorporation is revenue profit, which is available for dividend. Profit of prior period and post period however divided separately because the prior period profit and loss hence always credited and charged from capital reserve A/c. Post period profit and loss thus credited and charged from Profit & Loss A/c.

When a running business is taken over from a date prior to its incorporation/commencement, the profit earned up to the date of incorporation/commencement (incorporation, in case of private company; and commencement, in case of public company) is known as ‘Pre-incorporation profit’.

The same is to be treated as capital profit since these are profits which have been earned before the company came into existence. In short, the profit earned after the date of purchase of business is called ‘Post-incorporation or Post-acquisition profit’ and the profit earned before the date of purchase of business is termed as ‘Pre-incorporation profit’.

Method of Computation of Profits/Loss Prior to Incorporation:

In order to ascertain the profit prior to incorporation a Profit and Loss Account is to be prepared at the date of incorporation. But in practice, the same set of books of accounts is maintained throughout the accounting year.

A Profit and Loss Account is prepared at the end of the year and thereafter the profits (or losses) between the two periods are allocated:

(i) From the date of purchase to the date of incorporation or pre-incorporation period;

(ii) From the date of incorporation to the closing of the accounting year or post-incorporation period.

Method of Accounting of Profit/Loss Prior to Incorporation:

Steps may be suggested for ascertaining profit or loss prior to incorporation:

Step I:

A Trading Account should be prepared at first for the whole period, i.e., between the date of purchase and the date of final accounts, in order to calculate the amount of gross profit.

Step II:

Calculate the following two ratios:

(i) Sales Ratio:

Amount of sales should be calculated for the pre-incorporation and post-incorporation periods.

(ii) Time Ratio:

It is calculated after considering the time period, i.e., one is required to calculate the period falling between the date of purchase and the date of incorporation and the period between the date of incorporation and the date of presenting final accounts.

Step III:

A statement should be prepared for calculating the amount of net profit before and after incorporation separately on the following principle:

(i) Gross Profit should be allocated for the two periods on the basis of sales ratio which will present the gross profit for the two separate periods, viz. pre-incorporation and post- incorporation.

(ii) Fixed Expenses or expenses incurred on the basis of time, viz., Rent, Salary, Depreciation, Interest, etc. should be allocated for the two periods on the basis of time ratio.

(iii) Variable Expenses or expenses connected with sales should be allocated for the two periods on the basis of sales ratio.

(iv) Certain expenses, viz., partners’ salary, directors’ salary, preliminary expenses, interest on debentures, etc. are not apportioned since they relate to a particular period. For example, partners’ salary is to be charged against pre-acquisition profit whereas directors’ remuneration, debenture interest, etc. are to be charged against post-acquisition profit.

List of Expenses: Allocated on the basis of Sales/Turnover:

(a) Gross Profit

(b) Selling Expenses

(c) Advertisement

(d) Carriage Outwards

(e) Godown Rent

(f) Discount Allowed

(g) Salesmen’s Salaries

(h) Commission to Salesmen

(i) Promotion Expenses for Sales

(j) Distributions Expenses (Variable Portions)

(k) Free Samples given

(l) Expenses incurred for After-Sale Service, etc.

(m) Delivery Van Expenses.

List of Expenses: Allocated on the basis of Time:

(a) Office and Administration Expenses

(b) Salaries to Office Staff

(c) Rent, Rates and Taxes

(d) Depreciation on Fixed Assets

(e) Printing and Stationery

(f) Insurance

(g) Audit Fees

(h) Miscellaneous Expenses

(i) Distribution Expenses (Fixed Portion)

(j) Travelling Expenses (General)

(k) Interest of Debenture

(l) General Expenses

(m) Expenses Fixed in Nature.

Application/Accounting Treatment of Profit/Loss Prior to Incorporation:

(a) Pre-incorporation Profit:

Since “Profit prior to Incorporation” is a Capital Profit the same should be written off against:

(i) Preliminary Expenses Account

(ii) Formation Expenses Account

(iii) Liquidation Expenses Account

(iv) Write down the value of Fixed Assets, if any

(v) Goodwill Account

(vi) Balance, if any, transferred to Capital Reserve.

(b) Pre-incorporation Loss:

Since “Pre-incorporation Loss” is a Capital Loss the same is adjusted against

(i) Any Capital Profit

(ii) Debited to Goodwill Account

(iii) Writing-off Fictitious Assets

(iv) Capital Reserve.

Basis of allocation of items between ‘pre’ and ‘post’ incorporation period

Time basis

Some type of expense and income which thus divided between pre- and post-period item on basis of time ratio.

For example: Depreciation, salary & wages, Rent and trade expenses etc.

Turnover basis

Some type of expense and income thus divided between pre- and post-period item on the basis of turnover.

Debtors & Creditors Suspense Accounts

  • A company taking over a running business may also agree to collect its debts as an agent for the vendor and may further undertake to pay the creditors on behalf of the vendors in such a case, the debtors and creditors of a vendors will include in the accounts for the company by debit or credit separate total accounts in the general ledger to distinguish them from the debtors and creditors of the business and contra entries will make in corresponding suspense account. Also details of debtors and creditors balance will thus kept in separate ledger.
  • The vendor hence treated as a creditors for the cash received by the purchasing company in respect of the debts due to the vendor, just as if he has himself collected cash from his debtors and remitted the proceeds to the purchasing company.
  • The vendor thus considers a debtor in respect of cash paid to his creditors by the purchasing company. The balance of cash collected, less paid, will represent the amount due to or by the vendor, arising from debtors and creditors balances which have taken over, subject to any collection expenses.
  • Balance in suspense account will be equal to the amount of debtor and creditors taken over remaining unadjusted at anytime.
Management Notes

Insolvency of a Partner

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An insolvent is a person unable to pay or settle his just debts. When a person or a partnership firm or Hindu undivided family is not able to meet its liabilities and is in financial difficulties, the Court intervenes, at the instance of the creditors or the debtor himself, and brings about a settlement whereby the debtor surrenders his entire property and obtains freedom from having to pay his debts. A joint stock company may also be insolvent but the necessary action in this respect is taken under the Companies Act the company has to be wound up and its assets realized and distributed in accordance with that Act.

  • Where a partner in a firm is adjudicated an insolvent, he ceases to be a partner on the date on which the order of adjudication is made, whether or not the firm is hereby dissolved.
  • Where under a contract between the partners the firm is not dissolved by the adjudication of a partner as an insolvent, the estate of a partner so adjudicated is not liable for any act of the firm and the firm is not liable for any act of the insolvent, done after the date on which the order of adjudication is made.

Individuals and Partnerships:

There is one chief difference between insolvency of individuals and partnership firms. In case of individuals, no distinction is made between private assets and business assets and similarly for liabilities.

In case of partnership, a distinction between firm’s liabilities and assets and private liabilities and assets of partners is made. Private assets must first be utilized for paying private liabilities. If there is a surplus, it is utilized to pay firm’s liabilities.

Firm’s assets must first be utilized to pay firm’s liabilities and, if there is a surplus, a partner can utilize his share of the surplus to pay his private liabilities. It should be noted that a minor partner is not liable to contribute to the assets of the firm out of his private estate. In his case, therefore, the firm’s creditors will not be able to look to his private estate for satisfaction of their claims. In other words, the private estate and private liabilities of a minor partner will be kept totally separate from those of the firm.

Accounts:

Statement of Affairs:

When a person or a firm is adjudicated as insolvent, he or the firm has to prepare a statement showing the financial position. The true financial position can be shown by preparing a sort of balance sheet. The only point to remember is that the “balance sheet” must show the assets at realizable value and not at book value. The purpose is to show how much money will be available for distribution among creditors and, therefore, for this purpose assets should be put down at the figure they are expected to fetch. All liabilities should be recorded. This can be done by setting down assets at their realizable value and the amount payable to creditors.

Preferential Creditors:

Out of the unsecured creditors, some have to be paid, under the law, before others. Such creditors are known as preferential.

By law, the following are the Preferential Creditors:

(a) All debts due to Government or local authority.

(b) The salary of any clerk in respect of services rendered to the insolvent during four months before the date of the presentation of the petition, not exceeding Rs 300 for each such clerk. (In case of the Provincial Insolvency Act, the maximum amount per clerk is Rs 20).

(c) The wages of any servant or labourer in respect of services rendered to the insolvent during four months before the date of the presentation for the petition not exceeding Rs 100 for each such labourer or servant (Rs 20 in case of Provincial Insolvency Act).

(d) Rent due to the landlord not exceeding one month’s rent. (Rent is not preferential under the Provincial Insolvency Act.)

Deferred Creditors:

In England some creditors are treated as deferred and cannot be paid till others are paid off.

Such creditors are:

(a) Loan from wife to husband or from husband to wife;

(b) Creditors whose rate of interest varies with profit; and

(c) Creditors for goodwill who take a share of profit.

Deficiency Account:

In addition to various statements (A, B, C, D, E, F and G) and the Statement of Affairs, the debtor must also prepare an account showing how the capital introduced by the proprietor came to be lost along with amounts belonging to creditors. In other words, the deficiency appearing in the statement of affairs must be explained. The method to prepare it is simple. On the left hand side is put the capital plus all that increases capital, viz., profit or interest on capital or salary to proprietor.

On the right hand side, losses and withdrawals (all that decreases capital) are put. In case of a sole trader, any surplus of household assets over household liabilities should be put on the left hand side. If household liabilities exceed household assets, the difference should be put on the right hand side. The difference between the right hand side and the left hand side is deficiency. It must agree with the figure appearing in the statement of affairs. The account must cover the period specified by the Official Receiver.

University of Mumbai BMS Notes

Capital Accounts (Fixed and Fluctuating)

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A Capital Account is a general ledger account which shows some of the special transactions like proprietor’s investment in his own business, the aggregate amount of earning, expenses of companies, etc. There are many more transactions which affect the Capital. Like: Interest on Capital, Interest on Drawings, Salaries to the Partners, Commission for the Partners, etc. These values are put in Profit and Loss Appropriation Account and at the same time credited or debited to their respective Capital Accounts.

In the case of Partnership Capital Account of all partnership maintained mandatory. In sole proprietorship, capital account of the sole proprietor is maintained and net profit or loss is transferred to his/her capital account. But in the case of a partnership firm, capital is contributed by all partners and capital account of every partner is maintained separately. Capital account partnership may be:

(1) Fixed Capital Account

In case of fixed capital account, balance of capital in the beginning of the year, fresh capital introduced during the current year is recorded credit site and permanent withdrawal of excess capital and closing balance of capital are recorded on debit site of the capital account. There is always a credit balance in the capital account of a partner, which is shown on equities site of balance sheet. Following is format of fixed capital account.

Under the fixed nature of capital, the capital of each partner remains constant from the start of partnership till at the end of it. No adjustments like interest on capital, partner’s salary/commission, Drawings and profit or loss earned during the operation is made.

To have record of all such adjustments each partner’s current account is opened, which is debited with Drawings, share of loss sustained during a period and credit is given for partner’s salary/commission, interest on capital and share of profit earned.

After all the adjustments have been made in the current A/c., it is balanced, if it shows debit balance it will be shown in the balance sheet on asset side and if it shows credit balance it will be shown on the liability side.

At the time of dissolution of the partnership, each partner’s current account balance is transferred to capital A/c. The credit balance of current account will be credited to capital account and debit balance of the current account will be debited to respective partners’ capital account.

Format of Fixed Capital Account

Partners’ Capital Account

Description

 Amount

Description

 Amount
Bank Account $$$$$ Balance b/d $$$$$
(Permanent withdrawl of excess capital) (Capital contributed till last year)
Balance c/d $$$$$ Bank Account $$$$$
(Balance of capital at the end of year) (Fresh Capital introduced by partner)
Total $$$$$ $$$$$$

To record, drawing made by a partner and his share in allocation of profit etc. an account known as Partner’s Current Account is opened. The format of Partner’s Current Account is as follows:

Partners’ Current Account

Description

 Amount

Description

 Amount
Bank b/d $$$$$ Balance b/d $$$$$
(In case of Debit opening balance) (In case of Credit opening balance)
Drawing Account Salary Account $$$$$
Interest on Drawing Account Interest on Capital Account $$$$$
Profit and Loss Appropriate Account Profit and Loss Appropriate Account $$$$$
(For Share of Loss) (For share of profit)
Balance c/d $$$$$ Balance c/d $$$$$
(In case of Credit closing balance) (In case of Debit closing balance)
Total $$$$$ $$$$$$

The closing balance of a partner’s current account is shown on equities side, in case of credit balance; and in case of debit balance, it is shown on assets side.

It may be noted that in case of fixed capital, the balance of capital account remains unchanged except when either fresh capital is introduced or the excess capital is permanently withdrawn. Moreover, the word ‘fixed’ is not prefixed to capital account of a partner because maintenance of partner’s current account implies that capitals are fixed.

(2) Fluctuating Capital Account

Under this method as is apparent from the name, capital of each partner goes on changing from time to time. Each partner will have his separate capital account, which will be credited by his initial investment and any additional capital introduced during the year will also be credited to his capital account.

All the adjustments, which result decrease in capital will be debited to partner’s capital, such as drawing made by each partner, interest on drawings and share of loss. On the other hand, adjustments resulting increase in capital will be credited to partner’s capital, like interest on capital, partners salary if any, partner’s share of profit etc.

Balance of each partner’s capital account will be shown in the balance sheet. Debit balance of partner’s capital account is shown on the asset side and credit balance is shown on the liability side.

If current accounts of partners are not maintained, the transactions relating to drawings by partners and their share in allocation of profit including interest on capital, interest on drawings, salary payable to partners, commission payable to partners etc. are recorded in partner’s capital account. In that case, the balance of capital account will fluctuate from year to year and capital accounts in the case are known as Fluctuating Capital Account. None-preparation of current accounts implies capital accounts are fluctuating. The Fluctuating Capital Account Format is given below:

Fluctuating Capital Account Format

Partners’ Current Account

Description

Amount

Description

 Amount
Balance b/d Balance b/d $$$$$
(In case of Debit opening balance) (In case of Credit opening balance)
Bank Account $$$$$ Bank Account $$$$$
(Permanent withdrawal of excess capital) (Fresh capital introduced by pertner)
Drawing Account Salary Account $$$$$
Interest on Drawing Account Interest on Capital Account $$$$$
Profit and Loss Appropriate Account Profit and Loss Appropriate Account $$$$$
(For Share of Loss) (For share of profit)
Balance c/d $$$$$ Balance c/d $$$$$
(In case of Credit closing balance) (In case of Debit closing balance)
Total $$$$$ $$$$$$

Generally, the closing balance of capital account is Credit and it is recorded on equities site of balance sheet. But if a partner’s capital account reveals a debit closing balance, is appears on asset site of balance sheet.

Management Notes

Retirement and Death of a Partner

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A partner may ascertain to either withdraw or retire from the enterprise due to certain reasons such as his bad health, his age, change in enterprise’s nature of a business, etc., In the Partnership at Will, a partner might retire at any time. Retirement leads to a reconstitution of an enterprise where the partners’ contribution ratio and the profit-sharing ratio change. The retiring partner is given his share of capital, revaluation profit or loss and goodwill.

Death or insolvency of a partner is the outcome in the reconstitution of an enterprise when the remaining partners desire to continue the enterprise. In case of bankruptcy or insolvency, all dues are paid to the bankrupt partner and partnership agreement is terminated as per the law a bankrupt is ineffectual to get into an agreement or a contract. In the case of decease, all dues are being paid to the legal successor of the deceased partner.

Treatment of Reserves, Accumulated Profits and Accumulated Losses in the Case of Death of a Partner

Reserves, Existing Goodwill, accumulated profits/losses appearing in the Balance Sheet of the firm at the time of death of a new partner belong to all partners including the retiring or deceased partner. Hence these should be distributed among all the partners in their old profit-sharing ratio.

Following Journal Entries Are Required to Be Passed:
(1) Distribution of Existing Goodwill  All Partners’ Capital A/c  Dr.

         To Goodwill A/c 
(2) Distribution of Reserves  Reserve fund/General Reserve A/c  Dr. 

     To All Partners’ Capital A/c 
(3) Distribution of Accumulated Losses  All Partners’ Capital A/c  Dr.

    To Profit & Loss A/c
(4) Distribution of Accumulated Profits  Profit & Loss A/c  Dr.

   To All Partners’ Capital A/c

The Retirement of an Existing Partner

A partner may decide to retire or withdraw from the firm due to reasons such as his age, his bad health, change in firm’s nature of a business, etc. In case of Partnership at Will, a partner may retire at any time. Retirement amounts to a reconstitution of a firm where the number of partners, their capital contribution ratio and also the profit sharing ratio changes. The retiring partner is paid his share of capital, goodwill and revaluation profit or loss.

For example, A, B, and C are partners in the firm sharing profits in the ratio of 3:2:1. A chooses to retire and B and C decide to share the future profits equally. This is a reconstitution of the firm where the number of partners and their profit-sharing ratio both have changed.

Death or Insolvency of a Partner:

Death or insolvency of a partner also results in the reconstitution of the firm when the remaining partners wish to continue the firm. In case of insolvency, all dues are paid to the insolvent partner and partnership agreement is aborted because as per the law an insolvent is incompetent to enter into a contract or an agreement.

In case of death, all dues are paid to the legal heir of the deceased partner.

The accounting treatment in the occurrence of death of a partner is:

  • Similar to that, when a partner retires and that in case of deceased partner his belonging is transferred to his legal enforcers and settled in a similar way as that of the partner who retires
  • However, there is one primary distinction, the retirement usually takes place during the closure of an accounting period or financial year, the death of a partner may take place any time
  • Therefore, in the case of a partner, his rights shall also incorporate his share of gains or loss, interest on drawings (if any), interest on capital from the last date of the Balance Sheet to the date of his death of these, the main issue associates to the computation of profit for a moderate period
  • Since, it is contemplated burdensome to close the books and outline final a/c, for the period, the dead partner’s share of profit may be computed on the ground of previous year’s gain (or aggregate of past few years) or on the base of sales
(a) Linking Death of a Partner with Retirement of a Partner
(a) Common accounting treatment in case of Retirement of a Partner and Death of a Partner: (Assuming retirement to be on the date of Balance Sheet)

  • Partners Capital Balance
  • Existing goodwill
  • Partner’s share in the present value of Firm’s Goodwill
  • Revaluation Profit or Loss
  • Reserves, Surplus and Fictitious Assets
  • Drawings made by the partner
  • Asset/Liability taken over by a partner
  • Partner’s Loan given on Assets side or Liabilities side
(b) Special accounting treatments required in case of Death of a Partner only:
  • Salary/Commission to a Partner
  • Interest on Capital
  • Interest on Drawings
  • Interest on Loan
  • Share in current year’s Profits
  • Accounting treatments at the time of Death of a Partner is an extension of the Retirement of a Partner. In the above-mentioned list, treatment of category ‘A’ items is exactly the same both for retirement & death. There will be no effect of date of death.
  • But for the treatment of category ‘B’ items date of death plays a very important role.

 
(B) Calculation of Category ‘b’ Items:
i. Salary to the deceased partner:
  • Monthly Salary x Time Period
  • Commission as per the agreement for this period only (if any).

# Time Period = Period from the date of last Balance Sheet to the date of Death

{This period can be in months, weeks or days.}
(B) Calculation of Category ‘b’ Items:
  • Capital Balance as per the last Balance Sheet x Rate of Int./100× Time Period/12
iii. Interest on Drawings
  • We’ll use the rules of Interest on Drawings learned earlier and of course, keep in mind the ‘Time Period’.
iv. Interest on Loan
  • Amount of Loan as per the last Balance Sheet x Rate of Int./100× Time Period/12
v. Share in Current Year’s Profits
  • To compute the deceased partner’s share in estimated profits there are following two approaches/basis:
  • Time Basis: Under this approach his profit share for the current year is computed on the basis of last year’s profit or last few years’ average profits.
  • Formula: Last Year’s Profit × Time Period/12 × Deceased Partner’s Share

Or

Average Profits × Time Period/12 × Deceased Partner’s Share

  • Turnover Basis– In this case, his profit share for the current year is estimated using last year’s sales and last year’s profits.
  • Formula: Step 1. Compute Profits % of last year: Last Year’s Profit/Last Year’s Sales × 100

Step 2. Firm’s estimated profit till the date of death: Current Year’s Sales up to the date of death × Profit %

Step 3. Decease Partner’s share

Firm’s Profit as per Step 2 × Deceased Partner’s ratio

University of Mumbai BMS Notes

Partnership Accounts

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There are several distinct transactions associated with a partnership that are not found in other types of business organization. These transactions are:

  • Contribution of funds. When a partner invests funds in a partnership, the transaction involves a debit to the cash account and a credit to a separate capital account. A capital account records the balance of the investments from and distributions to a partner. To avoid the commingling of information, it is customary to have a separate capital account for each partner.
  • Contribution of other than funds. When a partner invests some other asset in a partnership, the transaction involves a debit to whatever asset account most closely reflects the nature of the contribution, and a credit to the partner’s capital account. The valuation assigned to this transaction is the market value of the contributed asset.
  • Withdrawal of funds. When a partner extracts funds from a business, it involves a credit to the cash account and a debit to the partner’s capital account.
  • Withdrawal of assets. When a partner extracts asset other than cash from a business, it involves a credit to the account in which the asset was recorded, and a debit to the partner’s capital account.
  • Allocation of profit or loss. When a partnership closes its books for an accounting period, the net profit or loss for the period is summarized in a temporary equity account called the income summary account. This profit or loss is then allocated to the capital accounts of each partner based on their proportional ownership interests in the business. For example, if there is a profit in the income summary account, then the allocation is a debit to the income summary account and a credit to each capital account. Conversely, if there is a loss in the income summary account, then the allocation is a credit to the income summary account and a debit to each capital account.
  • Tax reporting. In the United States, a partnership must issue a Schedule K-1 to each of its partners at the end of its tax year. This schedule contains the amount of profit or loss allocated to each partner, and which the partners use in their reporting of personal income earned.

Capital Accounts of Partners:

A partnership organisation maintains accounts of its transactions in the same manner as a Sole Trader ship. Since partnership has two or more partners, separate capital account for each partner has to be maintained. Usually every partner contributes something in cash or in kind to provide funds for the running of a business. The amount of contribution is mutually settled and need not necessarily be equal.

The sum of the contributions represents the capital of the firm. The partnership deed usually mentions the method of maintaining capital accounts of partners. There are two methods by which capital accounts are maintained i.e., Fixed Capital and Fluctuating Capital.

Fluctuating Capital:

Fluctuating Capital is one which changes from year to year. There is only one account for each partner in case 6of fluctuating capital system. All entries relating to introduction of fresh capital, inter­est on capital, salary, commission, share of profit etc. are credited to the capital account and similarly capital account is debited with drawings, interest on drawing, losses etc.

All entries for all items are passed through his capital accounts; as such, the amounts of his capital at the end of the year will be different from what it was at the beginning of the year. The balance of the capital goes on fluctuating year after year and is known as Fluctuating Capital.

In the absence of the contract to the contrary, capital accounts are fluctuating. Partner’s drawings are, however, recorded in his Drawings Account which will be closed at the end of the year, by transferring to the capital accounts.

Loan Account:

Where advance is made by a partner, credit is given to him by opening his separate Loan Account and not through his capital account. In the absence of agreement to the contrary, the Partnership Act provides that interest at 6% p.a. shall be allowed on such loan, irrespective of profits. Interest on such advance or loan should be credited to Loan Account or Current Account.

Unless the Partnership Deed expressly lays down that the partners Capital Accounts shall be kept fixed, they are treated as fluctuating.

Fixed Capital:

When the partners agree to keep their capital at their original figures, year after year, they are said to have fixed capitals. They continue to appear at their original figures unless contribution is made by way of additional capital or refund is allowed of the surplus capital, if any. Under the fixed capital, separate CURRENT ACCOUNT of each partner is opened.

This current account will be cred­ited at the end of every year with his:

(a) Share of profits,

(b) Interest on capital and

(c) Salary or any other remuneration; and debited with his

(a) Drawings

(b) Interest on Drawings and

(c) Share of loss, if any.

The current account may show credit and debit balance at the end of the year. If they show Credit balances, they appear on the liability side of the Balance Sheet of the firm along with Fixed Capitals. If the Current Accounts show Debit balances, they appear on the asset side of the Balance Sheet.

A Debit Balance of the Current account implies that the concerned member has overdrawn his Current account and owes that amount to the firm. A Credit balance of the Current account represents the amount which a partner is entitled to draw but has not actually drawn.

In some cases, interest is allowed on the credit balance and charged to the debit balance; if so entries are passed through respective partners Current accounts.

Drawings:

The Partnership Deed may allow partners to withdraw money or goods from the business to meet their private requirements. The amount of withdrawals at each interval need not be equal. To avoid congestion entries in Capital or Current Account, in respect of withdrawals, a separate Drawing Ac­count is opened for each partner.

The amount drawn at each time is debited therein. At the closing date, the Drawings Account is closed by transferring it to Capital Account, if Capital Account is fluctuating, or to Current Account, if the Capital Account is fixed. But the Current Account is not transferred to Capital Account.

Interest on Drawings:

Interest on Drawings also depends upon the Partnership Deed. There are many cases, where Capitals bear interest but Drawings are not Chargeable with interest. Generally, Partnership Deed stipulates the maximum amount that each partner is permitted to withdraw, without paying interest.

If any partner exceeds the limit, he has to pay interest on Drawings. Where the withdrawals of the partners are unequal, partner’s accounts are equitably adjusted through the mechanism of interest on drawings.

To the firm it is an income and therefore the Capital or Current Accounts of the partners are debited and Interest on Drawing Account is credited. Interest on Drawings is a loss to the partners. To make calculation of the interest on Drawings, three things must be present – the interest rates the amount and the period. 

Interest on Capital:

Interest on Capital is usually allowed by an agreement between the partners. The Partnership Act is silent on this point that is, no interest on capital is allowed. Interest on capital is generally allowed on capitals so that the partner who contributes more than the proportionate capitals is properly com­pensated.

If partners contribute equal amounts of capital and share profits equally, no need arises for any interest to be allowed on capital. Where capital contributions are equal but the profit sharing ratios are unequal, a partner, with a lower share of profit, stands to lose. Besides, where capitals are unequal but profit sharing ratios are equal, a partner with large capital contribution is affected finan­cially.

Interest on capital tends to balance capital account equitably, without allowing any partner to enjoy an unfair advantage over the others. Interest on capital is a loss or expense to the firm and thus debited to Interest on capital account and finally transferred to Profit and Loss Appropriation Ac­count. And it is an income or gain to the partners and their Capital Account or Current Account is credited with the amount of interest.

Commission to Partners:

Under the partnership law all partners are supposed to devote their time to the affairs of the firm but in practice many partners may not devote any time and some of the partners may have to carry on the entire work of the firm. Thus, a percentage of profit is paid to a partner for the special work or service done. This commission may be payable before charging such commission or after charging such commission.

Profit and Loss Appropriation Account:

The Profit and Losses of the partnership are divisible equally or in any other manner agreed upon by the partners. In case of partnership accounting, it is usual that adjustments relating to Interest on Capital Interest on Drawings, Salary, Commission, Share of profits etc. to be made through the Profit and Loss Appropriation Account.

Management Notes

Admission of a Partner

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A business firm seeks new partners with business expansion being one of the driving motives. As per the Partnership Act, 1932, a new partner can be admitted into the firm with the consent of all the existing partners, unless otherwise agreed upon.

With the admission of a new partner, there is a reconstitution of the partnership firm and all the partners get into a new agreement for carrying out the business of the firm.

The following conditions led to the addition of a new partner:

  • When the firm is in an expansion mode and requires fresh capital.
  • When the new partners possess expertise, which can be beneficial for the business expansion of the firm.
  • When the partner in question is a person of reputation and adds goodwill to the firm.

The following adjustments need to be made at the time of admission of a new partner

  • Calculating the new profit-sharing ratio along with the sacrificing ratio.
  • Accounting for goodwill.
  • Revaluation of assets and liabilities.
  • Adjustment of capital as per new profit-sharing ratio.

With the admission of a new associate, the partnership enterprise is restructured and a new agreement is entered into; to carry on the trading concern of the enterprise. A newly added partner obtains 2 primary rights in the enterprise:

  • Right to share the assets of the partnership firm
  • Right to share the profits of the partnership firm

Treatment of Goodwill:

Depending upon the share of profits to be given to the new partner, either a sum of money will be directly paid by him to the old partners (through the firm or privately) or after recording new partner’s capital, new partner’s capital account will be debited with his share of goodwill, the credit being given to the old partners in the ratio of their sacrifice of future profits. The latter is an indirect method of payment for goodwill by the new partner. The payment is justified became the new partner will take a share of profits which comes out of the shares of other partners. The old partners must be compensated for such a loss.

The various possibilities as regards goodwill are:

(i) The new partner brings goodwill in cash which is left in the business.

(ii) The new partner brings goodwill in cash but the cash is withdrawn by the old partners.

(iii) The amount of goodwill is paid by the new partner to the old partners privately.

(iv) The new partner does not bring in cash for goodwill as such; but an adjustment entry is passed by which the new partner’s capital account is debited with his share of goodwill and the amount is credited to old partners’ capital accounts in the ratio of sacrifice. This entry reduces the capital of the new partner by the amount of his share of goodwill and results in payment for goodwill by the new partner to the old partners.

Revaluation of Assets and Liabilities:

When a new partner is admitted, it is natural that he should not benefit from any appreciation in the value of assets which has occurred (nor should he suffer because of any fall which has occurred up to the date of admission) in the value of assets. Similarly, for liabilities.

Therefore, assets and liabilities are revalued and the old partners are debited or credited with the net loss or profit, as the case may be, in the ratio in which they have been sharing profits and losses hitherto. Partners may agree that the change in the value of assets and liabilities is to be adopted and figures changed accordingly or that the assets and liabilities should continue to appear in the books of the firm at the old figures.

(i) Values to be altered in books. In this case, a Profit and Loss Adjustment Account (or Revaluation Account) is opened and the following steps should be taken

(a) If the values of assets increase, the particular assets should be debited and the Revaluation Account credited with the increases only.

(b) If the values of assets fall, the Revaluation Account should be debited and the particular assets credited with the fall in values.

Capitals of Partners to be Proportionate to Profit-Sharing Ratio:

It is often agreed on admission of a partner that the capitals of all partners should be in proportion to their respective shares in profits. The starting point may be the new partner’s capital or the new partner himself may be required to bring in capital equal to his share in the firm. If the new partner’s capital is given, one should find out the total capital of the firm on the basis of his share.

Adjustment of Capital and Change in Profit Sharing Ratio Among Existing Partners

Few significant points which require observation during the admission of a new partner are mentioned below:

  • Sacrificing ratio
  • New profit-sharing ratio
  • Revaluation of assets and Reassessment of liabilities
  • Valuation and adjustment of goodwill
  • Adjustment of partners’ capitals
  • Distribution of accumulated profits (reserves)
University of Mumbai BMS Notes

Fixed and Flexible exchange rate

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Functions of Foreign Exchange Market

  1. Transfer Function: Foreign exchange market transfers purchasing power between the countries involved in the transaction.

This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.

  1. Credit Function: Foreign exchange market provides credit for foreign trade.

Bills of exchange, with maturity period of three months, are generally used for international payments.

Thus, credit is required for this period to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.

  1. Hedging Functions: Hedging in an important function of foreign exchange market.

When exporter and importers enter into an agreement to sell and buy gods on some future date at the current prices and exchange rate, it is called hedging.

Fixed exchange rate system:

The system in which the foreign exchange rate is officially fixed by the government/monetary authority and not determined by markets forces.

Under fixed exchange rate system: Each country keeps the value of its currency fixed in terms of some external standard.

This external standard can be gold, silver, other precious metal, another country’s currency, or even some internationally agreed unit of account.

In earlier times, exchange rates of all major countries were fixed according to the Gold Standard.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.

Merits:

(i) It ensures stability in exchange rate which encourages foreign trade.

(ii) It contributes to the coordination of macro policies of countries in an interdependent world economy.

(iii) Fixed exchange rates prevents capital outflow.

(iv) It prevents speculation in foreign exchange market.

(v) Fixed exchange rates are more conductive to expansion of world trade because it prevents risk and uncertainty in transactions.

Demerits:

(i) There is a fear of devaluation in situation of excess demand.

Central Bank uses its reserves to maintain fixed exchange rate.

But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency.

If speculators believe the exchange rate cannot be held for log, they buy foreign exchange in massive amount causing deficit in BOP. This may lead to larger devaluation.

This is the main flaw of fixed exchange rate system.

(ii) Benefits of free markets are deprived.

(iii) There is always possibility of undervaluation or overvaluation.

Disadvantages of Fixed Exchange Rate

Developing economies commonly use a fixed rate structure to curb inflation and provide a stable system. A secure environment enables importers, exporters, and investors to plan without having to worry about currency movements.

A fixed-rate structure, however, limits the ability of a central bank to change interest rates as required for boosting economic growth. Often, a fixed rate system prevents market fluctuations when a currency is over or undervalued. Effective management of a fixed-rate system also needs a large pool of reserves, when it is under pressure, to support the currency.

An unsustainable official exchange rate can also trigger a parallel, unofficial, or dual exchange rate to grow. A large gap between official and unofficial rates will draw hard currency away from the central bank, which can result in shortages of forex and periodic devaluations. These can be more detrimental for an economy than the daily adjustment of a floating currency regime.

Flexible (fixating) Exchange Rate:

Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market. There is no official (govt.) Intervention. Here the value of a currency is left completely free to be determined by market forces of demand and supply of foreign exchange.

In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency’s value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value of which is instead specified in terms of material goods, another currency, or a set of currencies (the idea of the last being to reduce currency fluctuations).

In the modern world, most of the world’s currencies are floating, and include the most widely traded currencies: the United States dollar, the euro, the Swiss franc, the Indian rupee, the pound sterling, the Japanese yen, and the Australian dollar. However, even with floating currencies, central banks often participate in markets to attempt to influence the value of floating exchange rates. The Canadian dollar most closely resembles a pure floating currency because the Canadian national bank has not interfered with its price since it officially stopped doing so during 1998. The US dollar is a close second, with very little change of its foreign reserves. By contrast, Japan and the UK intervene to a greater extent, and India has medium-range intervention by its national bank, the Reserve Bank of India

Merits:

(i) Deficit or surplus in BOP is automatically corrected.

(ii) There is no need for government to hold any foreign reserve.

(iii) It helps in optimum resource allocation.

(iv) It frees the government from problem of balance of payment.

(v) Flexible exchange rate increases the efficiency in the economy by achieving best allocation of resources.

Demerits:

(i) It encourages speculation leading to fluctuation in exchange rate.

(ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between countries.

(iii) It generates inflationary pressure when prices of imports go up due to depreciation of the  currency caused by deficit in BOP.

(iv) It discourages investment and international trade.

Determination of Exchange Rate (Flexible Exchange Rate System)

Rate of exchange is determined by the interaction of then force of demand and supply.

let us understand the various sources of demand and supply of foreign exchange.

Demand for Foreign Exchange Demand (outflow) for foreign exchange arises due to the following reasons

  1. Import of Goods and Services: foreign exchange is demanded to make the payment for imports of goods and services.
  2. Tourism: When Indian tourists go abroad, they need to have foreign currency with them to meet their expenditure abroad. So, foreign exchange is needed to undertake foreign tour.
  1. Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
  2. Purchase of Assets in Foreign Countries: Foreign exchange in needed to make payment for the purchase of assets (like land, building, share, bonds etc.) in foreign countries.
  3. Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of the currency.
University of Mumbai BMS Notes

Managed flexibility in exchange rate

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Managed floating rate system refers to a system in which foreign exchange rate is determined by market force and central bank is a key participant to stabilize the currency in case of extreme, appreciation or depreciation.

Under Managed floating rate system, also called dirty floating, central banks to buy and sell foreign currencies in an attempt to moderate exchange rate movement whenever they feel that such actions are appropriate.

Against the two extremes of rigidly fixed and freely flexible exchange rates, a system of controlled or managed flexibility is suggested on practical considerations into the exchange rate regime.

The focus on intermediate regime between fixed and floating exchange rate is desirable for a prudency to eliminate the drawbacks and capture the advantages of both extreme systems.

Under the managed or controlled flexibility of exchange rate system, the scope of the range of flexibility around fixed par values is determined by the country as per its economic need and the prevailing trend in the international monetary system.

Managed floating exchange rate system is essentially based on the par value concept under the IMF guidelines.

Managing or controlling exchange rates requires the country to intervene in the foreign exchange market time to time in view of the emerging BOP disequilibrium.

Categories

  1. Adjustable Peg System:

Under the Bretton Woods System, the exchange rates of different currencies were pegged in terms of gold or the U.S. dollar at the rate of $ 35 per ounce of gold. The nations were allowed to change the par values of their currencies when faced with a ‘fundamental’ disequilibrium.

  1. Crawling Peg System:

The crawling peg system was popularised in mid-sixties by such prominent economists as William Fellner, J.H. Williamson, J. Black, J.E. Meade and C.J. Murphy. This system is a compromise between the extremes of freely fluctuating exchange rates and perfectly stable exchange rates. It was devised in order to avoid the disadvantage of relatively large changes in par values and possibly destabilising speculation associated with the system of adjustable peg.

In case of the Bretton Woods adjustable peg, sudden and large changes in exchange rates have to be made. These are clearly undesirable and should be avoided.

  1. Policy of Managed Floating:

The exchange rates may continue to fluctuate, even if speculation is stabilising, on account of the variations that take place in the real sectors of the economy. The fluctuations in exchange rate tend to have an adverse effect upon the flow of international trade and investments. The Smithsonian Agreement made on December 18, 1971 provided for the widening of margin of fluctuations from 1 percent on each side of the exchange parity to 2.25 percent on each side of the par value of exchange.

Clean and Dirty Float Systems:

In connection with a system of managed float, it may be pointed out that a distinction is sometimes made between a clean float and dirty float.

(i) Clean Float:

In case of clean float, the rate of exchange is allowed to be determined by the free market forces of demand and supply of foreign exchange. The exchange rate is permitted to move up and down. The foreign exchange market itself corrects the excess demand or excess supply conditions without the intervention of monetary authority. Thus, the policy of clean float is identical to the policy of freely fluctuating exchange rates.

(ii) Dirty Float:

In case of a dirty float, the exchange rate is sought to be determined by the market forces of demand and supply for foreign exchange. However, the monetary authority intervenes in the foreign exchange market through the pegging operations either to smoothen or to eliminate the fluctuations altogether. It means even the long term trend in exchange rate is manipulated by the monetary authority. Such a policy of managed float is understood as the policy of ‘dirty float’.

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