Chapter 1: Accounting for Partnership Firms

1.1 Fundamentals of Partnership

Partnership is an association of two or more persons who have agreed to share the profits of a business carried on by all or any of them acting for all.

Characteristics of Partnership:

• Two or more persons (Max: 50 as per Companies Act 2013).
• Agreement (Partnership Deed).
• Lawful Business.
• Sharing of Profits.
• Mutual Agency.

Provisions of Indian Partnership Act, 1932 (in absence of Partnership Deed)

• Profit Sharing Ratio: Equal.
• Interest on Capital: Not allowed.
• Interest on Drawings: Not charged.
• Salary/Commission: Not allowed.
• Interest on Partner’s Loan: \( 6\% \) p.a.

Fixed vs. Fluctuating Capital Accounts

1.2 Valuation of Goodwill

Goodwill is an intangible asset representing the good name and reputation of the firm.

Methods of Valuation:

1. Average Profit Method: \[ \text{Goodwill} = \text{Average Profits} \times \text{Number of Year’s Purchase} \]

2. Super Profit Method: \[ \text{Normal Profit} = \text{Capital Employed} \times \frac{\text{Normal Rate of Return}}{100} \] \[ \text{Super Profit} = \text{Average Profit} - \text{Normal Profit} \] \[ \text{Goodwill} = \text{Super Profit} \times \text{Number of Year’s Purchase} \]

3. Capitalisation Method (Super Profit): \[ \text{Goodwill} = \text{Super Profit} \times \frac{100}{\text{Normal Rate of Return}} \]

1.3 Reconstitution of Partnership Firm

Reconstitution implies a change in the existing agreement among partners, leading to a change in the relationship among partners but the firm continues.

Change in Profit Sharing Ratio

• Sacrificing Ratio: Ratio in which existing partners surrender their share in favor of another partner. \[ \text{Sacrificing Ratio} = \text{Old Ratio} - \text{New Ratio} \]
• Gaining Ratio: Ratio in which a partner acquires share from another partner. \[ \text{Gaining Ratio} = \text{New Ratio} - \text{Old Ratio} \]

Revaluation Account

When a new partner is admitted, or there is a change in the profit-sharing ratio, or during retirement/death, the assets and liabilities of the firm are revalued. The net gain or loss is transferred to the partners’ capital accounts in their old profit-sharing ratio.

Admission of a Partner

• Adjustment of Goodwill (AS 26).
• Revaluation of Assets and Reassessment of Liabilities.
• Adjustment of Reserves, Accumulated Profits, and Losses.

Retirement and Death of a Partner

• Identifying new profit sharing and gaining ratio.
• Ascertaining retreating/deceased partner’s share in goodwill and accumulated reserves.
• In case of death: calculation of profit till the date of death: \[ \text{Share of Profit} = \text{Estimated Profit} \times \frac{\text{Time from last balance sheet to death}}{12 \text{ months}} \times \text{Deceased Partner’s Share} \]
• Preparation of the deceased partner’s executor’s account.

1.4 Dissolution of Partnership Firm

Dissolution of the firm closes down the business permanently. Settlement of accounts includes the preparation of the Realisation Account, Partners’ Capital Accounts, and Cash/Bank Account.

Realisation Account: All assets are transferred to the debit side (excluding cash/bank) and all outside liabilities are transferred to the credit side. The proceeds from the sale of assets are credited, and payments of liabilities are debited.

Competency-Based Questions (CBQs)

Q1. A and B are partners without a partnership deed. A has advanced a loan of ₹ 50,000 to the firm, and he demands interest @ 10% p.a. Assess A’s claim in light of the Indian Partnership Act, 1932. Context: Real-world application of partnership fundamentals when the deed is silent.

Q2. The average profit of a firm is ₹ 80,000. Capital employed is ₹ 5,00,000 and the normal rate of return is 10%. Calculate the value of goodwill based on 3 years’ purchase of super profits. Context: Application of mathematical formulas to value intangible assets.

Q3. X and Y are partners sharing profits in the ratio 3:2. They admit Z into partnership for 1/4th share. Calculate the sacrificing ratio of X and Y. Context: Identifying mathematical shifts in sharing ratios during reconstitution.

Q4. On the date of dissolution of a firm, unrecorded typed writers valued at ₹ 5,000 were taken over by a partner, Q, at ₹ 4,000. Analyze how this transaction will be recorded in the Realisation Account. Context: Scenario-based assessment regarding dissolution and unrecorded assets.

Q5. Explain the treatment of the deceased partner’s share of profits from the beginning of the year until the date of death. Provide the necessary journal entry. Context: Application of conceptual rules regarding death of a partner.

Answers to CBQs

Ans 1. In the absence of a partnership deed, the provisions of the Indian Partnership Act, 1932 apply. According to the Act, interest on a partner’s loan is allowed at \( 6\% \) p.a., not 10%. Therefore, A’s claim is invalid, and he will only receive interest at \( 6\% \) p.a.

Ans 2.

• Capital Employed = ₹ 5,00,000
• Normal Rate of Return = 10%
• Normal Profit = \( 5,00,000 \times \frac{10}{100} = ₹ 50,000 \)
• Average Profit = ₹ 80,000
• Super Profit = Average Profit - Normal Profit = \( 80,000 - 50,000 = ₹ 30,000 \)
• Goodwill = Super Profit × 3 = \( 30,000 \times 3 = ₹ 90,000 \)

Ans 3. Z is admitted for 1/4th share. Since no information is given about how Z acquires his share, it is assumed X and Y sacrifice in their old ratio. Thus, the Sacrificing Ratio of X and Y = 3:2.

Ans 4. The typewriter is an unrecorded asset. When it is taken over by a partner, the firm receives value through a deduction in the partner’s capital. The journal entry is: Q’s Capital A/c Dr. 4,000 To Realisation A/c 4,000 In the Realisation Account, this will be recorded on the Credit side as “By Q’s Capital A/c - ₹ 4,000”.

Ans 5. The deceased partner is entitled to their share of profit up to the date of death. This is usually calculated linearly based on time or turnover. The journal entry is: Profit & Loss Suspense A/c Dr. To Deceased Partner’s Capital A/c (Being share of profit credited to the deceased partner)

Chapter 2: Accounting for Companies

2.1 Accounting for Share Capital

A company is an artificial person created by law, having separate entity with a perpetual succession and a common seal.

Classification of Share Capital

The share capital of a company is classified for accounting purposes as follows:

Issue and Forfeiture of Shares

• Issue at Premium: When shares are issued at a price higher than their face value. The premium is credited to Securities Premium Account.
• Calls in Arrears: Amount not paid by shareholders on calls.
• Forfeiture: If a shareholder fails to pay call money, the company can forfeit the shares. \[ \text{Amount Forfeited} = \text{Amount received on shares excluding premium} \]
• Re-issue: Forfeited shares can be re-issued. The maximum discount allowed on re-issue is the amount forfeited on those shares. \[ \text{Discount on Re-issue} \le \text{Amount Forfeited per Share} \] Any surplus in the Share Forfeiture account after re-issue is transferred to the Capital Reserve.

2.2 Accounting for Debentures

A debenture is a document issued by a company as evidence of a debt, acknowledging a loan.

Issue of Debentures

Debentures can be issued:

1. At Par: Issue Price = Face Value
2. At Premium: Issue Price > Face Value
3. At Discount: Issue Price < Face Value

Debentures as Collateral Security

When a company takes a loan from a bank and issues its own debentures to the bank as an additional or secondary security, it is known as issue of debentures as collateral security.

• The company will not pay interest on these debentures until it defaults on the principal loan.

Writing off Discount/Loss on Issue of Debentures

Discount or loss on issue of debentures is a capital loss. It must be written off in the year debentures are allotted:

1. First, from Securities Premium Account (if it exists).
2. Then, from Statement of Profit and Loss as a Financial Cost.

Competency-Based Questions (CBQs)

Q1. XY Ltd. forfeited 500 equity shares of ₹ 10 each (₹ 8 called up) for non-payment of first call of ₹ 3 per share. Out of these, 300 shares were re-issued for ₹ 7 per share as ₹ 8 paid up. Calculate the amount to be transferred to Capital Reserve. Context: High-level assessment of Forfeiture and Capital Reserve mathematical logic.

Q2. ABC Ltd. was formed with an authorized capital of ₹ 50,00,000 divided into 5,00,000 equity shares of ₹ 10 each. It invited applications for 2,00,000 shares. The amount was payable as ₹ 3 on application, ₹ 4 on allotment, and balance on first and final call. Applications were received for 2,50,000 shares (over-subscription). Pro-rata allotment was made. How much application money will be adjusted towards allotment? Context: Applying calculations for pro-rata over-subscription scenarios.

Q3. PQ Ltd. purchased a machine for ₹ 9,90,000. It paid the purchase consideration by issuing 11% Debentures of ₹ 100 each at a discount of 10%. Calculate the number of debentures issued. Context: Mathematical conversion of consideration into discounted debentures.

Q4. Explain the accounting treatment of “Debentures issued as Collateral Security” without opening a debenture suspense account. Context: Conceptual understanding of collateral security presentation in financial statements.

Q5. A company issued 10,000, 9% Debentures of ₹ 100 each at a discount of 5%, redeemable at a premium of 10% after 5 years. Determine the total Loss on Issue of Debentures and specify how it will be written off. Context: Identifying both discount and premium on redemption as a combined loss and its write-off order.

Answers to CBQs

Ans 1.

• Called up per share = ₹ 8
• Unpaid (First Call) = ₹ 3
• Paid up per share (Amount forfeited) = ₹ 8 - ₹ 3 = ₹ 5
• Total Forfeited Amount on 500 shares = \( 500 \times 5 = ₹ 2,500 \)
• Re-issue of 300 shares at ₹ 7 (Paid up ₹ 8): Discount = ₹ 1 per share.
• Amount forfeited on 300 shares = \( 300 \times 5 = ₹ 1,500 \)
• Less: Discount on re-issue = \( 300 \times 1 = ₹ 300 \)
• Transfer to Capital Reserve: \( 1,500 - 300 = ₹ 1,200 \).

Ans 2.

• Shares Applied = 2,50,000
• Shares Allotted = 2,00,000
• Application money received = \( 2,50,000 \times 3 = ₹ 7,50,000 \)
• Application money required = \( 2,00,000 \times 3 = ₹ 6,00,000 \)
• Excess application money to be adjusted on allotment = \( 7,50,000 - 6,00,000 = ₹ 1,50,000 \).

Ans 3.

• Purchase Consideration = ₹ 9,90,000
• Issue Price per Debenture = ₹ 100 - 10% Discount = ₹ 90
• Number of Debentures Issued = \( \frac{9,90,000}{90} = 11,000 \text{ debentures} \).

Ans 4. If no journal entry is passed for the issue of debentures as collateral security (Debenture Suspense Account not opened), then in the Balance Sheet of the company, the loan from the bank is shown under “Long-Term Borrowings”. A note is appended below the loan stating that it is secured by the issue of debentures as collateral security.

Ans 5.

• Total Face Value of Debentures = \( 10,000 \times 100 = ₹ 10,00,000 \)
• Discount on Issue (5%) = ₹ 50,000
• Premium on Redemption (10%) = ₹ 1,00,000
• Total Loss on Issue of Debentures: \( 50,000 + 1,00,000 = ₹ 1,50,000 \). This loss of ₹ 1,50,000 will be written off entirely in the year of allotment. It will first be written off from Securities Premium Account (if any balance exists), and the remaining balance will be written off from the Statement of Profit and Loss (Finance Cost).

Chapter 3: Analysis of Financial Statements

3.1 Financial Statements of a Company

Financial statements are the written records that convey the business activities and the financial performance of a company. For a company, they primarily include:

1. Balance Sheet: Showing the financial position on a particular date.
2. Statement of Profit and Loss: Showing the financial performance over a given period.
3. Cash Flow Statement: Discloses the cash flows during the period.

Format of Balance Sheet (Schedule III, Companies Act 2013)

The Balance Sheet of a company is presented in vertical format. Equities and Liabilities include:

1. Shareholders’ Funds (Share Capital, Reserves and Surplus)
2. Non-Current Liabilities (Long-term borrowings)
3. Current Liabilities (Trade payables, short-term borrowings)

Assets include:

1. Non-Current Assets (Property, Plant, and Equipment, Intangible assets)
2. Current Assets (Inventories, Trade receivables, Cash and cash equivalents)

3.2 Tools for Financial Statement Analysis

• Comparative Statements: Show absolute data, changes in absolute data, and percentage changes between multiple periods.
• Common Size Statements: Every item in the statement is shown as a percentage of a common base (e.g., Revenue from Operations for P&L, Total Assets for Balance Sheet).

3.3 Accounting Ratios

Accounting ratios represent the arithmetic relationship between two interconnected accounting figures.

1. Liquidity Ratios

• Current Ratio: Measures short-term ability to pay current liabilities. \[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
• Quick / Liquid Ratio: Measures immediate liquidity. \[ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \] (Where Quick Assets = Current Assets - Inventory - Prepaid Expenses)

2. Solvency Ratios

• Debt to Equity Ratio: \[ \text{Debt to Equity Ratio} = \frac{\text{Debt (Long-term Borrwings)}}{\text{Equity (Shareholders’ Funds)}} \]
• Interest Coverage Ratio: \[ \text{ICR} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-term Debt}} \]

3. Activity (Turnover) Ratios

• Inventory Turnover Ratio: \[ \text{ITR} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} \]
• Trade Receivables Turnover Ratio: \[ \text{TRTR} = \frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}} \]

4. Profitability Ratios

• Gross Profit Ratio: \[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Revenue from Operations (Net Sales)}} \times 100 \]
• Return on Investment (ROI): \[ \text{ROI} = \frac{\text{Net Profit before Interest, Tax, and Dividend}}{\text{Capital Employed}} \times 100 \]

Competency-Based Questions (CBQs)

Q1. Current Ratio is 2.5 : 1. Discuss the effect of “Purchasing goods on credit” on the current ratio. Context: Evaluating analytical skills on directional ratio changes resulting from transactions.

Q2. ABC Ltd. has a Current Ratio of 3:1 and a Quick Ratio of 1.2:1. If the Inventory is ₹ 1,80,000, calculate the Current Liabilities and Current Assets. Context: High-order calculation testing multiple interconnected algebraic constraints.

Q3. If the Operating Ratio of a company is 75%, what will be its Operating Profit Ratio? Why? Context: Relationship assessment between mutually exclusive percentage ratios.

Q4. A company has Debt of ₹ 10,00,000 and Shareholders’ Funds of ₹ 5,00,000. It raised a further loan of ₹ 2,00,000 from the bank. Calculate the new Debt to Equity Ratio. Context: Impact of structural capital changes on solvency.

Q5. Based on Schedule III of the Companies Act 2013, under which major head and sub-head would you present “Provision for Employee Benefits” and “Computer Software”? Context: Statutory classification of items under the prescribed balance sheet format.

Answers to CBQs

Ans 1. Current Ratio = 2.5 : 1 (e.g., CA = 2,50,000; CL = 1,00,000). Purchasing goods on credit will increase Current Assets (Inventory) and increase Current Liabilities (Creditors) by the same amount. Since the ratio is initially > 1, an equal increase in numerator and denominator will decrease the ratio. Therefore, the Current Ratio will decline.

Ans 2.

• Current Ratio (CR) = CA / CL = 3 / 1
• Quick Ratio (QR) = QA / CL = 1.2 / 1
• Assuming CL = \( x \)
• CA = \( 3x \)
• QA = \( 1.2x \)
• Inventory = CA - QA = \( 3x - 1.2x = 1.8x \)
• Given Inventory = ₹ 1,80,000
• \( 1.8x = 1,80,000 \Rightarrow x = 1,00,000 \)
• Current Liabilities: ₹ 1,00,000
• Current Assets: \( 3 \times 1,00,000 = ₹ 3,00,000 \)

Ans 3. Operating Ratio + Operating Profit Ratio = 100%. Therefore, Operating Profit Ratio = \( 100\% - 75\% = 25\% \). This is because operating costs and operating profit together constitute the total net revenue from operations (sales).

Ans 4.

• Old Debt = ₹ 10,00,000
• Old Equity = ₹ 5,00,000
• New Loan = ₹ 2,00,000
• New Debt = \( 10,00,000 + 2,00,000 = ₹ 12,00,000 \)
• Equity remains unchanged = ₹ 5,00,000
• New Debt to Equity Ratio = \( \frac{12,00,000}{5,00,000} = 2.4 : 1 \)

Ans 5.

• Provision for Employee Benefits: Major Head: Non-Current Liabilities Sub-head: Long-term Provisions
• Computer Software: Major Head: Non-Current Assets Sub-head: Property, Plant and Equipment and Intangible Assets (specifically Intangible Assets).

Chapter 4: Cash Flow Statement

4.1 Meaning and Objectives

A Cash Flow Statement is a statement that shows the flow of cash and cash equivalents during a specific period. It is designed to provide information about the historical changes in cash and cash equivalents of an enterprise.

Benefits of Cash Flow Statement:

• Helps in assessing the liquidity and solvency of an enterprise.
• Facilitates short-term financial planning.
• Helps in evaluating past cash flows against expected cash flows.

Cash and Cash Equivalents

• Cash: Comprises cash on hand and demand deposits with banks.
• Cash Equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value (e.g., Treasury bills, commercial papers).

4.2 Classification of Activities

As per AS-3 (Revised), cash flows are classified into three activities:

1. Operating Activities: The principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
2. Investing Activities: The acquisition and disposal of long-term assets and other investments not included in cash equivalents.
3. Financing Activities: Activities that result in changes in the size and composition of the owner’s capital and borrowings of the enterprise.

4.3 Preparation of Cash Flow Statement (Indirect Method)

The Indirect Method determines the cash flows from operating activities by adjusting net profit or loss for the effects of:

• Non-cash items (e.g., depreciation, amortization).
• Non-operating items (e.g., loss/gain on sale of fixed assets, interest paid/received, dividend received).
• Changes in Current Assets and Current Liabilities during the period.

Formula for Operating Cash Flow:

\[ \begin{array}{r l} & \text{Net Profit before Tax and Extraordinary Items} \\ + & \text{Non-cash and Non-operating Expenses (Depreciation, Loss on sale, etc.)} \\ - & \text{Non-operating Incomes (Interest/Dividend Received, Gain on sale, etc.)} \\ = & \textbf{Operating Profit before Working Capital Changes} \\ + & \text{Decrease in Current Assets and Increase in Current Liabilities} \\ - & \text{Increase in Current Assets and Decrease in Current Liabilities} \\ = & \text{Cash Generated from Operations} \\ - & \text{Income Tax Paid} \\ = & \textbf{Net Cash from Operating Activities} \end{array} \]

Important Adjustments

• Depreciation and Profit/Loss on Sale: A separate Fixed Asset Account must be prepared to identify hidden purchases or sales of machinery when accumulated depreciation is given.
• Proposed Dividend: The proposed dividend of the previous year is paid in the current year (Financing Activity Outflow), and added back to calculate Net Profit before Tax. The current year’s proposed dividend is ignored as per AS-4.
• Tax: Provision for Tax made during the year is added back; Tax paid during the year is deducted at the end of Operating Activities.

Competency-Based Questions (CBQs)

Q1. An enterprise deals in the trading of shares. How will you classify the “dividend received on shares” and “dividend paid on shares” in its Cash Flow Statement? Context: Testing classification differentiation based on the primary nature of the business.

Q2. From the following information, calculate Cash from Operating Activities:

• Operating Profit before Working Capital Changes: ₹ 1,50,000
• Trade Receivables increased by ₹ 40,000
• Inventory decreased by ₹ 20,000
• Trade Payables decreased by ₹ 10,000
• Outstanding Expenses increased by ₹ 5,000

Context: Numerical application of Working Capital changes in Indirect Method.

Q3. A company had a machine costing ₹ 50,000 with an accumulated depreciation of ₹ 20,000. It was sold for ₹ 35,000. Analyze the complete treatment of this transaction across the three activities of the Cash Flow Statement. Context: High-order integration of one transaction affecting multiple activities natively.

Q4. Explain why the Proposed Dividend of the current year is not considered while preparing the Cash Flow Statement as per the revised accounting standards. Context: Statutory understanding of Accounting Standard 4 and contingencies.

Q5. Based on the indirect method, evaluate why Depreciation and Amortization are added back to the Net Profit when calculating Cash Flow from Operating Activities. Context: Conceptual rationale behind the algebraic formulas of the Indirect Method.

Answers to CBQs

Ans 1. Since the enterprise is a financial/trading entity dealing in shares, its principal revenue-producing activity is investing in and selling shares.

• Dividend Received on shares trading is a primary revenue, so it is classified under Operating Activities.
• Dividend Paid on its own equity shares represents the cost of generating capital, so it is classified under Financing Activities (irrespective of whether it is a financial or non-financial enterprise).

Ans 2.

• Operating Profit before WC Changes = ₹ 1,50,000
• Less: Increase in Trade Receivables = (₹ 40,000) (outflow because cash is tied up in credit sales)
• Add: Decrease in Inventory = ₹ 20,000 (inflow because stock was sold)
• Less: Decrease in Trade Payables = (₹ 10,000) (outflow because cash was paid off)
• Add: Increase in Outstanding Expenses = ₹ 5,000 (inflow because expense occurred but cash was retained) Calculation: \( 1,50,000 - 40,000 + 20,000 - 10,000 + 5,000 = ₹ 1,25,000 \) Cash flow from Operating Activities = ₹ 1,25,000.

Ans 3. Cost of machine = ₹ 50,000. Accumulated depreciation = ₹ 20,000. Book Value = Cost - Accumulated Depreciation = \( 50,000 - 20,000 = ₹ 30,000 \). Sale Price = ₹ 35,000. Gain on sale = \( 35,000 - 30,000 = ₹ 5,000 \). Treatment in Cash Flow:

1. Operating Activities: The Gain on Sale (₹ 5,000) must be deducted from Net Profit because it is a non-operating income that already bloated the net profit.
2. Investing Activities: The actual cash received from the sale (₹ 35,000) will be shown as a Cash Inflow under Investing Activities.
3. No impact on Financing Activities.

Ans 4. According to AS-4 (Contingencies and Events Occurring After the Balance Sheet Date), the proposed dividend of the current year is a non-adjusting event as it is yet to be approved by shareholders in the Annual General Meeting. Since it is only a proposal and not a liability on the balance sheet date, it does not mandate a cash outflow and is ignored. Conversely, the previous year’s proposed dividend (which was approved) is treated as paid in the current year.

Ans 5. The Cash Flow Statement under the indirect method starts with Net Profit (derived from the Statement of Profit & Loss prepared on an accrual basis). In computing this Net Profit, non-cash charges like Depreciation and Amortization have been deducted, reducing the profit. However, these expenses did not result in an actual outflow of cash. Thus, to reach the “true cash” generated from operations, we must reverse this non-cash deduction by adding them back to the Net Profit.