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ADVANCED ACCOUNTING - II

ACG 102

YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITYDnyangangotri, Near Gangapur Dam, Nashik 422 222, Msharashtra

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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY

Vice-Chancellor : Dr. M. M. SalunkheDirector (I/C), School of Commerce & Management : Dr. Prakash DeshmukhState Level Advisory CommitteeDr. Pandit Palande Dr. Suhas Mahajan Dr. V. V. MorajkarHon. Vice Chancellor Ex-Professor Ex-ProfessorDr. B. R. Ambedkar University Ness Wadia College of Commerce B.Y.K. College, NashikMuaaffarpur, Bihar Pune

Dr. Mahesh Kulkarni Dr. J. F. Patil Dr. Ashutosh RaravikarEx-Professor Economist Kolhapur Director, EDMU,B.Y.K. College, Nashik Ministry of Finance

New Delhi

Dr. A. G. Gosavi Dr. Madhuri Sunil Deshpande Dr. Prakash DeshmukhProfessor Professor Director (I/C)Modern College, Shivaji Nagar, Pune Swami Ramanand Teerth Marathwada School of Commerce & Management

University, Nanded Y.C.M.O.U., Nashik

Dr. Parag Saraf Dr. S. V. Kuvalekar Dr. Surendra PatoleChartered Accountant Sangamner Associate Professor and Assistant ProfessorDist. AhmedNagar Associate Dean (Training)(Finance ) School of Commerce & Management

National Institute of Bank Management , Y.C.M.O.U., Nashik

PuneDr. Latika Ajitkumar AjbaniAssistant ProfessorSchool of Commerce & Management

Y.C.M.O.U., Nashik

Author Editor Instructional Technology Editing &Programme Co-ordinator

1) Dr. Suhas Mahajan Prof. V. V. Morajkar Dr. Latika Ajitkumar AjbaniResearch Guide, 10, Vidya Society, Shikhare Wadi, Assistant ProfessorNess Wadia College of Commerce, Nashik Road - 422 101. School of Commerce & ManagementPune - 411 001. Y.C.M.O.U., Nashik

2) Dr. Mahesh A. KulkarniResearch Guide,BYK College of Commerce,Nashik - 422 005.

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Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.(First edition developed under DEC development grant)First Publication : September 2015Type Setting : Omkar Computers and PrintersCover Print :Printed by :Publisher : Dr. Prakash Atkare, Registrar, Y.C.M.Open University, Nashik - 422 222.

CONTENTSTopic 1 Accounts of Holding CompaniesUnit 1 Meaning, Definition, Legal Conditions and Principles of Consolidation 1-221.0 Introduction 1.1 Unit Objectives 1.2 Meaning and Definitions 1.3 Legal Conditions for preparation of BalanceSheet of a Holding Co. 1.4 Principles of Consolidation 1.5 Financial year of the Holding Co. and its Subsidiary 1.6Illustrations 1.7 Summary 1.8 Key Terms 1.9 Questions and Exercises 1.10 Further Reading

Unit 2 Preparation of Consolidated Balance-sheet of Holding Company 23-462.0.Introduction 2.1 Unit Objectives 2.2 Preparation of Consolidated Balance Sheet of Holding Co. with oneSubsidiary only 2.2.1 Purpose 2.2.2 Advantages 2.2.3 Disadvantages 2.2.4 Procedure 2.3 Basic Rules for preparinga Consolidated Balance Sheet 2.4 Miscellaneous Adjustments 2.5 Illustrations 2.6 Summary 2.7 Key Terms 2.8Questions and Exercises 2.9 Further Reading

Unit 3 AS-21 and Preparation of Consolidated Financial Statements 47-743.0 Introduction 3.1 Unit Objectives 3.2 AS-21 and Preparation of Consolidated Financial Statements 3.2.1 Objectives3.2.2 Notable Terms 3.2.3 Format of Consolidated Financial Statement 3.3. Scope of Consolidated Financial Statement3.4 Consolidation Procedure 3.5 Unrealised Losses 3.6 Disclosure 3.7 Practical Examples related to AS-21 3.8.Illustrations 3.9. Summary 3.10. Key Terms 3.11. Questions and Exercises 3.12. Further Reading

Topic 2 Human Resource AccountingUnit 4 Meaning, Objectives and Measurements in Human Resources

Accounting 75-924.0 Introduction 4.1 Unit Objectives 4.2 Meaning and Concept of HRA 4.2.1 Objectives of HRA 4.4.2 Purposeof HRA 4.3 Need of HRA 4.4 Historical Development of HRA Concept 4.5 Importance in HRA 4.6 Measurementsin HR Accounting (A) Cost Approach. (a) Original or Historical Cost Approach. (b) Opportunity Cost Approach (c)Replacement Cost Approach (d) Adjusted Present Value 4.7 Illustrations 4.8 Summary 4.9 Key terms 4.10Questions and Exercise 4.11 Further Reading

Unit 5 Measurement in HRA - Economic Value Approach 93-1065.0 Introduction 5.1 Unit Objectives 5.2 Economic Value Approach 5.2.1 Lev and Schwart 2 Model 5.2.2Likert’s Behaviour Model 5.2.3 Flamholtz’s Model of Individual Value 5.2.4 Stochastic process with service Model5.2.5 Hekimian and Jones competitive Bidding Model 5.2.6 Hermanson’s unpurchased Goodwill Model 5.3 Other- Non-monetary Models 5.4 Illustrations 5.5 Summary 5.6 Key Terms 5.7 Questions and Exercises 5.8 FurtherReading

Unit 6 Human Resource Accounting In India 107-1166.0 Introduction 6.1 Unit Objectives 6.2 Human Resource Accounting in India 6.2.1 Frame work of CorporateReporting in India 6.3 Human Resource Valuation models selected by Indian Companies 6.4 General considerationin working of HRA concept by Indian companies 6.5 Usefulness of HRA practice 6.6 Problems in HR Accounting6.7 Summary 6.8 Key Terms 6.9 Questions and Exercises 6.10 Further Reading

Topic 3 Valuation of Goodwill and Valuation of SharesUnit 7 Meaning, Need, Valuation of Goodwill - Average Profit Method 117-1367.0 Introduction 7.1 Unit Objectives 7.2 Meaning and Definition of Goodwill 7.3 Need for Valuation of Goodwill 7.4Elements of Goodwill 7.4.1 Distinguishing Features of Goodwill 7.4.2 Type of Goodwill 7.5 Factory AffectingValuation of Goodwill 7.6 Methods of Valuation of Goodwill 7.6.1 Average profit Method 7.7 Illustrations 7.8 Summary7.9 Key Terms 7.10 Questions and Exercises 7.11 Further Reading

Unit 8 Valuation of Goodwill - Super Profit Method 137-1548.0 Introduction 8.1 Unit Objectives 8.2 Super Profit Method 8.3 Accounting Treatment 8.4 Calculation of AverageProfit, Super profit and Goodwill 8.5 Sliding -Scale Valuation of Super Profit 8.6 Illustrations 8.7 Summary 8.8 KeyTerms 8.9 Questions and Exercises 8.10 Further Reading

Unit 9 Valuation of Goodwill - Capitalisation and Annuity Methods 155-1669.0 Introduction 9.1 Unit Objectives 9.2 Capitalisation of Profit method 9.3 Annuity Method 9.4 Illustrations 9.5summary 9.6 Key Terms 9.7 Questions and Exercises 9.8 Further Reading

Unit 10 Valuation of Shares - Need, Methods of Valuation of Shares 167-18510.0 Introduction 10.1 Unit Objectives 10.2 Valuation of shares 10.2.1 Factors Affecting the value of shares 10.2.2Need for Valuation of Shares 10.3 Methods of Valuation of Shares 10.3.1 Asset - Backing Method 10.3.2 Yield-Basis Method (i) On Profit Basis (ii) On Dividend Basis 10.4 Illustrations 10.5 Summary 10.6 Key Terms 10.7Questions and Exercises 10.8 Further Reading

Unit 11 Valuation of Shares - Fair Value Method, Value of Right andPreference Shares 187-208

11.0 Introduction 11.1 Unit Objectives 11.2 Fair Value Method 11.3 Valuation of Right Shares 11.4 Valuation ofPreference Shares 11.5 Valuation of Bonus Shares 11.6 Illustrations 11.7 Summary 11.8 Key Terms 11.9 Questionsand Exercises 11.10 Further Reading

Topic 4 Hotel AccountingUnit 12 Visitor’s Ledger and Preparation of Final Accounts 209-21812.0 Introduction 12.1 Unit Objectives 12.2 Visitor’s Ledger 12.3 Preparation of Final Accounts 12.4 Illustrations12.5 Summary 12.7 Key Terms 12.8 Questions and Exercises 12.9 Further Reading

Unit 13 Introduction, Accounting Treatment in Hotel Accounting 219-22813.0 Introduction 13.1 Unit Objectives 13.2 Hotel Accounting 13.2.1 Type of Hotels and Restaurants 13.3 AccountingTreatment in Hotel Accounting 13.4 Fixation and Charging of Room Rate 13.4.1 Method for ascertaining Room-Rate 13.4.2 Calculation of Room Occupancy Rate 13.5 Illustrations 13.6 Summary 13.7 Key Terms 13.8 Questionsand Exercises 13.9 Further Reading

INTRODUCTION

This book of self - instructional material is based on the syllabus for thesubject Advanced Accounting (M.Com ACG 102), This book is written as per therevised syllabus prescribed for M.Com. Part I students of Yashwantrao ChavanMaharashtra Open University, Nashik from June, 2015. We do hope that thisbook will definitely help to meet the emmerging and growing requirements ofdistance education students of Advanced Accounting from the School ofCommerce. This book adopts a moderate and novel approach towards the studyof Advanced Accounting in view with the specific and upcoming requirements ofthe readers and practitioners of this subject.

All the topics included in the revised syllabus are explained in simple but aptlanguage. Equal stress is also given for neccessary basic accounting theory andwide variety of practical problems. Authors have taken appropriate care toincorporate basic accounting concepts, accounting control techniques and tabularrepresentation of classified accounting statements and reports. Proper emphasishas also being given on graphical presentation to simplify the accounting theoriesand modern practices. This book has been designed to serve as a self sufficienttext for M.Com students. Nevertheless, we do not rule out the possibility of certainshortcomings or misprints still remaining, we will be greatful to the reader if sucherrors are pointed out from time to time. Any criticism or valuable suggestions forfurther improvement of this book will be greatfully acknowledged and highlyappreciated.

The authors have also kept in mind the fact that the students concerned arethe distance education students, spread over a large territory, different environmentand do not have regular interaction with the teachers. Thereofore, authors havetaken ulmost efforts to simplify the matter without affecting scientific quality andprecision.

The editor and authors are greatful to the authorities of YCMOU for valuableguidence and whole hearted co-operation.

Editor Authors

Topic 1 Accounts of Holding Companies

Unit 1 Meaning, Definition, LegalConditions and Principles ofConsolidation

Unit 2 Preparation of ConsolidatedBalance-sheet of HoldingCompany

Unit 3 AS-21 and Preparation ofConsolidated Financial Statements

Meaning, Definition, LegalConditions & Principles ofConsolidation

Advanced Accounting - II

NOTES

Unit 1 Meaning, Definition, LegalConditions and Principles ofConsolidation

Structure

1.0 Introduction

1.1 Unit Objectives

1.2 Meaning and Definitions

1.3 Legal Conditions for preparation of Balance Sheet of a Holding Co.

1.4 Principles of Consolidation

1.5 Financial Year of the Holding Co. and its Subsidiary

1.6 Illustrations

1.7 Summary

1.8 Key Terms

1.9 Questions and Exercises

1.10 Further Reading

1.0 Introduction

A company may acquire either the whole or the majority of shares of anothercompany so as to have a controlling interest in such a company or companies.The controlling company is knows as the Holding Company and the companyso controlled is known as a Subsidiary and both together are knows as the Group.The purpose of getting control over another company may be to gain advantagessuch as elimination of competition, enjoying economies of large-scale production,ensuring a smooth supply of quality raw materials, getting an assured market forthe products of the company etc.

It also means that a company which has controlling interest by virtue ofacquisition of shares or otherwise is known as a Holding Company and thecompany whose shares have been acquired is known as a Subsidiary Company.Therefore, one of the common ways of acquiring a controlling interest is to acquiremore than half in nominal value of the equity shares of another company.

1



NOTES

1.1 Unit Objectives

After studying this unit you should be able to :

• Know the meaning of ‘Holding Company’ and ‘Subsidiary Company’.

• Identify the Legal conditions for preparation of Balance Sheet of a HoldingCo.

• Understand the Basic Principles of Consolidation.

• Understand the legal definition of a Holding and Subsidiary Company.

• Explain financial year of the Holding Company and its Subsidiary.

• Describe the right of Holding Company’s Representative and Members.

1.2 Meaning and Definition

There are two ways by which one company can gain control over othercompanies.

i) One way is to acquire all the assets and liabilities of the companiesconcerned thereby securing control by ownership of such assets and liabilities.This arrangements is termed as ‘Absorption’.

ii) Another way is to acquire all or the majority (50% and above) of thevoting shares of these companies. The company acquiring the shares is knownas Holding Company; the company whose shares have been acquired is knownas Subsidiary Company of the Holding Company.

Different ways of control over other Companies is shown in Figure 1.1 onnext page.

Legal Definition of a Holding Company and Subsidiary Company :

(1) Holding Company has been indirectly defined by section 4 of the CompaniesAct, 1956 in the context of the definition of the Subsidiary Co. According to thissection a company shall be deemed to be a subsidiary of another company onlyif :

a) that other company controls the composition of its Board of Directors, or

b) that other -

i) When the first mentioned company is an existing company in respectof which the holders of Preference Shares issued before thecommencement of this Act have the same voting rights in all respectsas the holders of Equity Shares, exercises or controls more than half ofthe total voting power of such company,

2

Fig. 1.1 : Different ways of control over other Companiesii) where the first mentioned company is any other company, holds more

than half in nominal value of its equity share capital, or

c) the first mentioned company is a subsidiary of any company which is thatother’s subsidiary.

Examples :a) B Co. Ltd. has a Share Capital of 1,00,000 divided into Shares of ` 10

each. Therefore, the number of Shares are 10,000. If A Co. Ltd. acquires6,000 Shares in B Co. Ltd., then A Co. Ltd. will be called the Holding Co.and B Co. Ltd. will be the Subsidiary of A Co. Ltd.

b) X Co. Ltd. purchased 4,000 shares in Y Co. Ltd. The share Capital of the YCo. Ltd. consists of 10,000 shares of `10 each. In this case, since theshare holdings of X Co. Ltd. is only 40%, the relationship of Holding Co.and Subsidiary Co. is not established.

c) F. Co. Ltd., is holding 5,000 Shares out of 10,000 shares of 10 each of QCo. Ltd., since the holding in nominal value is not more than 50%, again therelationship of Holding Co. and Subsidiary Co. is not established.

(2) For the purpose of sub- section (1), the composition of a company’sBoard of Directors shall be deemed to be controlled by another company if,but only if, that other company by the exercise of some power exercisable by it at

HH Co.Ltd.

invests inSSCo.Ltd.

Acquires

majoroty sharesof

SS Co.Ltd.

Recorded as StockAcquisition and

operates asSubsidiary

HH Co.Ltd.

invests inSSCo.Ltd.

Acquiresnet assets

ofSS Co.

Ltd.

Record asAbsorption

(SS Co. Ltd. willbe liquidated)



NOTES

3

its discretion without the consent or concurrence of any other person, can appointor remove the holders of all or a majority of the directorships; but for the purposesof this provision that other company shall be deemed to have power to appoint adirectorship with respect to which any of the following condition is satisfied, viz.

a) that a person cannot be appointed thereto without the exercise in thefavour by that other company of such a power as aforesaid;

b) that a person’s appointed thereto follows necessarily from his appointmentas director, managing agent, secretaries and treasurers, or manger, orto any other office or employment in, that other company; or

c) that the directorship is held by an individual nominated by that othercompany or a subsidiary thereof.

(3) In determining whether one company is a subsidiary of another -

a) any shares held or power exercisable by that other company in a fiduciarycapacity shall be treated as not or exercisable by it;

b) subject to the provisions of clauses c) and d), any shares held or powerexercisable :

i ) by any person as a nominee for that other company (except wherethat other is concerned only in a fiduciary capacity); or

ii) by, or a nominee for, a subsidiary of that other company, not being asubsidiary which is concerned only in a fiduciary capacity; shall betreated as held or exercisable by that other company;

c) any shares held or power exercisable by any person virtue of the provisionof any debentures of the first-mentioned company or of a trust deed forsecuring any issue of such debentures shall be disregarded.

d) any share held or power exercisable by, or a nominee for, that othercompany or its subsidiary (not being held or exercisable as mentionedin clause) (c) shall be treated as not held or exercisable as mentioned inordinary business of that other or its subsidiary, as the case may be,includes the lending of money and the shares are held or the power isexercisable as aforesaid by way of security only for the purposes of atransaction entered into in the ordinary course of that business.

(4) For the purposes of this Act, a company shall be deemed to be the HoldingCompany of another, if, but only if, that other is its Subsidiary.

(5) In this section, the expression “Company” includes any body corporate and the expression “Equity Share Capital” has the same meaning as sub-section(2) of Section 85.

(6) In the case of a body corporate which is incorporated in a country outsideIndia, a Subsidiary of Holding Co. of the body corporate under the law ofsuch country shall be deemed to be the Subsidiary of Holding Co. of thebody corporate within the meaning and for the purpose of this Act, also



NOTES

4

whether the requirement of this section are fulfilled or not.

(7) A private company, being a subsidiary of a body corporate incorporatedoutside India, which if incorporated in India, would be a public companywithin the meaning of this Act, shall be deemed for the purpose of this Actto be a subsidiary of a public company if the entire share capital in thatprivate company is not held by that body corporate whether alone or togetherwith one or more other bodies incorporated outside India.

1.3 Legal Conditions for preparation of BalanceSheet of a Holding Company

Section 212 of the Companies Act stipulate the conditions regarding themanner in which the Balance Sheet of the Holding Co. should be prepared. Theprovisions of the Section are given below :

(1) These shall be attached to the Balance Sheet of a Holding Companyhaving a subsidiary or subsidiaries at the end of the financial year asat which the Holding Co.’s Balance Sheet is made out, the followingdocument in respect of such subsidiary or of each such subsidiary, as thecase may be :

a) a copy of the Balance Sheet of the subsidiary;

b) a copy of its Profit and Loss Account;

c) a copy of the Report of its Board of Directors;

d) a copy of the Report of its Auditors;

e) a statement of the Holding Co.’s interest in the subsidiary as specifiedin sub-section (3);

f) the statement referred to in sun-section (5) if any; and

g) the report referred to in sub-section (6) if any.

(2) a) The Balance Sheet referred to in clause (a) of sub-section (1) shall bemade out in accordance with the financial year of the Holding Co.

i) as at the end of the financial year of the subsidiary, where suchfinancial year coincides with the financial year of the Holding Co.

ii) as at the end of the financial year of the subsidiary last before that ofthe Holding Co. where the financial year of the subsidiary does notcoincide with that of the Holding Co.

b) The Profit and Loss Account and the Report of the Board of Directorsand the Auditors, referred to in clauses b), c) and d) of sub-section (1),shall be made out, in accordance with the requirements of this Act forthe financial year of the subsidiary referred to in clause (a).



NOTES

5

c) Where the financial year of its subsidiary does not coincide with that ofits Holding Co., the financial year aforesaid of the subsidiary shall notend on a day which precedes the day on which the Holding Co.’s financialyear ends by more than six months.

d) Where the financial year of a subsidiary is shorter in durationthan thatof its Holding Co., references to the financial year of the subsidiary inclauses b), c) and a) shall be construed as references to two or morefinancial years of the subsidiary the duration of which, in the aggregate,is not less than the duration of the Holding Co.’s financial year.

(3) The statement referred to in clause (e) of sub-section (1) shallspecify

a) the extent of the Holding Co.’s interest in the subsidiary at the end offinancial year or of the last financial year of the subsidiary referred to insub-section (2);

b) the net aggregate amount, so far as it concerns members of the HoldingCo. and is not dealt with in the company’s accounts, of the subsidiaryprofits after deducting its losses or vice-versa.

i) for the financial year or years of the subsidiary aforesaid; and

ii) for the previous financial year of the subsidiary since it became theHolding Co.’s subsidiary;

c) the net aggregate amount of the profits of the subsidiary after deductingits losses or vice versa.

i) for the financial year or year of the subsidiary aforesaid ; and

ii) for the previous financial year of the subsidiary since it became theHolding Co.’s subsidiary;

so far as those profit are dealt with, or provision is made for those losses,in the company’s accounts.

4) Clauses (o) and (c) of sub-section (3) shall apply only to profits andlosses of the subsidiary which may properly be treated in the HoldingCo.’s accounts as revenue profits or losses, and the profits or lossesattributable to any shares in a subsidiary for the time being held by theHolding Co. or any other of its subsidiaries shall not (for that or any otherpurpose) be treated as aforesaid so faras they are profits or losses for theperiod before the date on or as from which the shares were acquired by thecompany or any of its subsidiaries, except that they may be in a proper casebe so treated where

a) the company is itself the subsidiary of another body corporate; and

b) the shares were acquired from that body corporate or a subsidiary ofit; and for the purpose of determining whether any profits or losses areto be treated as profits or losses for the said period, the profit or loss



NOTES

6

for any financial year of the subsidiary may , if it is not practicable toapportion it with reasonable accuracy by reference to the facts, betreated as accruing from day-to-day during that year and be apportionedaccordingly.

(5) Whether the financial year or years or a subsidiary referred to insub-section (2) do not coincide with the financial year of the HoldingCo., a statement containing information on the following matters shall alsobe attached to the Balance Sheet of the Holding Co. :

a) Whether there has been any, and if so , that change in the HoldingCo.’s interest in the subsidiary between the end of the financial year orof the last of the financial years of the subsidiary and the end of theHolding Co.’s financial year;

b) details on any material changes which have acquired between the endof the financial year or of the last of the financial years of the subsidiaryand the end of the Holding Co’s financial year in respect of -

i) the subsidiary’s fixed assets;

ii) its investments;

iii) the money lent by it;

iv) the money borrowed by it for any purpose other than that of meetingcurrent liabilities.

(6) If, for any reason, the Board of Directors of the Holding Co.’s is unableto obtain information on any of the matters required to be specified bysubsection (4) a report in writing to that effect shall be attached to theBalance Sheet of the Holding Co.

(7) The documents referred to in clauses (c), (f) and (g) of sub-section (1)shall be signed by the person by whom the Balance Sheet of the HoldingCo. is required to be signed.

(8) The Central Government may, on the application or with the consent of theBoard of Directors of the company, direct that in relation to any subsidiary,the provisions of this section shall not apply, or shall apply only to suchextent as may be specified in the direction.

(9) If any such person as is referred to in sub - section (6) of Section 209 failsto take all reasonable steps to comply with the provisions of this Section, heshall, in respect of each offence, be punishable with imprisonment for aterm which may extent to six months, or with a fine which may extend toone thousand rupees, or with both :

Provided that no person shall be sentenced to imprisonment for any suchoffence unless it was committed wilfully.



NOTES

7

1.4 Principles of Consolidation

The basic principles to be remembered in the preparation of a consolidatedBalance Sheet are as follows :

(1) The shares in the Subsidiary Co. held by the Holding Co. as investmentsrepresent the share of ownership of Holding Co. in the equity or net assetsof the Subsidiary Co. Therefore, while preparing the consolidated BalanceSheet, the investments of the Holding Co. in the subsidiary are replaced byproportionate net assets of the Subsidiary Co.

(2) Assets and liabilities of the Holding Co. and its subsidiary will be aggregatedwith the exception of the following :

a) The share capital of the Holding Co. alone will be considered inconsolidation and not aggregated with that of Subsidiary Co.

b) Investment in the Subsidiary Co. as appearing on the asset side ofthe Holding Co. balance will not be aggregated as the same hasbeen considered in the wording of the cost of control.

c) The Profit and Loss Account and reserves of the Subsidiary Co.will not be aggregated as they have been considered in working ofcost of control, minority interest and consolidated Profit and LossAccount.

(3) All the inter - company owing should be eliminated from both the sides ofthe consolidated Balance Sheet.

(4) The interest of minority shareholders will appear on the liabilities side of theconsolidated Balance Sheet.

(5) The cost of control or goodwill calculated will be shown on the asset sideof the Balance Sheet. If it is a capital reserve it will be shown on the liabilityside of the Balance Sheet.

(6) Consolidated Profit and Loss Account will consist of the Profit and LossAccount of Holding Co. along with its share in the revenue profits of theSubsidiary Co.

(7) Unrealised profit to the extent of Holding Co.’s share will be deducted fromthe figure of consolidated Profit and Loss Account and the figure of totalstock.



NOTES

8

1.5 Financial Year of the Holding Co. and itsSubsidiary

Section 213 of the Companies Act provides :

(1) Where it appears to the Central Government desirable for a Holding Co. ora Holding Co.’s subsidiary, to extent its financial year so that the subsidiary’sfinancial year may end with that of the Holding Co., and for that purpose topostpone the submission of the relevant accounts to a general meeting, theCentral Government may, on the application or with the consent of theBoard of Directors of the company whose financial year is to be extended,direct that in the case of that company, the submission of accounts to ageneral meeting, the holding of an an nual general meeting the making ofan annual return, shall not be required to be submitted, held or made, earlierthan the dates specified in the direction, notwithstanding anything to thecontrary in this Act or in any other Act for the time being in force.

(2) The Central Government shall, on the application of the Board of Directorsof a Holding Co. or a Holding Co.’s subsidiary exercise the powers conferredon that Government by sub-section (1) if it necessary to do so, in order tosecure that the end of the financial year of the subsidiary does not precedethe end of the holding company’s financial year by more than six months,where that is not the case at the commencement of this Act, or at the dateon which the relationship of the holding company and subsidiary comes intoexistence where that date is later than the commencement of this Act’.

Rights of Holding Co.’s Representatives and Members :

Section 214 of the Companies Act states :

(1) A Holding Co. may, by resolution, authorise representatives named in theresolution to inspect the books of account kept by any of its subsidiaries;and the books of accounts of any such subsidiary shall be open to inspectionby those representatives at any time during business hours`

(2) The rights conferred by Section 235 upon members or a company may beexercised, in respect of any subsidiary , by members of the Holding Co. asif they alone were members of the subsidiary.’

The Principles of Consolidation can be understood with the help of followingillustrations :



NOTES

9

Check Your Progress

i) What do you understandby the term ‘Holding‘Company’ and‘Subsidiary Company’ ?

ii) State the ‘Principles ofConsolidation’.

1.6 IllustrationsILLUSTRATION 1

A Ltd., acquired 16,000 Equity Shares of B Ltd., of 10 each on 31st March,2014. The summarised Balance Sheet of A Ltd., and B Ltd., as on that date wereas under :

Balance Sheet as on 31-3-2014

Liabilities A Ltd. B Ltd. Assets A Ltd. B Ltd.

` ` ` `

Share Capital : Land and Buildings 1,50,000 1,80,000

Equity Shares of Plant and Machinery 2,40,000 1,09,400

`10 each 5,00,000 2,00,000 Investment in shares

General Reserve 2,40,000 1,20,000 in B Ltd. (at cost) 3,40,000 -

Profit and Loss 57,200 36,000 Stock 1,20,000 36,000

Bank Overdraft 80,000 - Sundry Debtors 44,000 40,000

Bills Payable - 8,400 Bills Receivables 15,800 -(including 3,000 (including 3,000payable to A Ltd.) From B Ltd.)

Sundry Creditors 47,100 9,000 Cash at Bank 14,500 8,000

9,24,300 3,73,400 9,24,300 3,73,400

You are supplied with the following information :

i) The directors are advised that Land and Buildings of B Ltd., areundervalued by `20,000 and Plant and Machinery of B Ltd., areovervalued by ` 10,000. Their assets have to be adjusted accordingly.

ii) Sundry Creditors of A Ltd., include `12,000 due to B Ltd.

You are required to prepare the Consolidated Balance Sheet as at 31-3-2014alongwith necessary workings.

SOLUTION

Working Notes :

1) A Ltd., acquired Equity Shares of B Ltd., on 31st March, 2014.

2) Share of A Ltd., in B Ltd.

=Shares acquired by A Ltd. Shares issued by B Ltd.

=16,000 shares20,000 shares

= 4 5



NOTES

10

3) Statement of Capital Profit :

`

General Reserve on 31-3-2014 1,20,000

Add : Profit and Loss Account (Cr.) on 31-3-2014 36,000

Add : Undervaluation of Land and Buildings of B Ltd. (+) 20,000

1,76,000

Less :Overvaluation of Plant and Machinery of B Ltd. (-) 10,000

Capital Profit 1,66,000

Capital Profit

`1,66,000

A Ltd. Minority

(4/5) (1/5)

` 1,32,800 ` 33,200

(Goodwill)

Since the shares have been acquired on the date of Balance Sheet i.e31-3-2014, all profits shown in the Balance Sheet of B Ltd. as on that date are tobe treated as Capital Profits.

4) Statement of Minority Interest : `

Face Value of shares held by Minority

(4000 shares X ` 10) 40,000

Add : Capital Profit (+) 33,200

Minority Interest 73,200

5) Statement of Goodwill : `

Cost of shares acquired by A Ltd. 3,40,000

Less : Face Value of shares acquired

(16,000 shares x ` 10) (-) 1,60,000

1,80,000

Less : A Ltd.’s share in Capital Profit (-) 1,32,800

Goodwill 47,200



NOTES

11

Consolidated Balance Sheet of A Ltd., and its Subsidiary B ltd., as on 31-3-2014Liabilities ` ` Assets ` `

Share Capital : Goodwill 47,200• Equity Shares of 10 each 5,00,000 Land and Buildings 3,50,000Genral Reserve 2,40,000 A Ltd. 1,50,000Profit and Loss 57,200 B Ltd. 1,80,000Minority Interest 73,200 Add : Increase (+) 20,000 2,00,000Bank Overdraft 80,000 Plant and Machinery 3,39,400

A Ltd. 80,000 A Ltd. 2,40,000B Ltd. (+) NIL B Ltd. 1,09,400

Less : Decrease (-) 10,000 99,400Bills Payable 5,400 Bills Receivables 12,800

A Ltd. NIL A Ltd. 15,800B Ltd. (+) 8,400 B Ltd. (+) NIL

8,400 15,800Less : Inter-company owings (-) 3,000 Less : Inter-company owings (-) 3,000

Creditors 44,100 Debtors 72,000A Ltd. 47,100 A Ltd. 44,000B Ltd. (+) 9,000 B Ltd. (+) 40,000


Stock 1,56,000A Ltd. 1,20,000B Ltd. (+) 36,000

Cash at Bank 22,500A Ltd. 14,500B Ltd. (+) 8,000

9,99,900 9,99,900

ILLUSTRATION 2

On 1st October, 2013 S Ltd., purchased 5,500 shares of 10 each fully paidin W Ltd., for `20 each. At that time, it was estimated that the tangible assets andliabilities of W Ltd., might be taken at book valuation except the Buildings whichwere undervalued by `25,000.

Each Company prepares a Balance Sheet as on 31-3-2014 which can becondensed as follows :

Liabilities S Ltd. W Ltd. Assets S Ltd. W Ltd.

` ` ` `

Share Capital : 2,00,000 60,000 Buildings 1,50,000 65,000

• Shares of 10 each Sundry Assets 50,000 11,000

General Reserve on 50,000 6,000 Debtors 20,000 15,000

1-4-2013 Shares in W Ltd. 1,10,000 -

Creditors 15,000 5,000

Profit and Loss

Balance on 1-4-2013 25,000 8,000

Profit for the year 40,000 12,000

3,30,000 91,000 3,30,000 91,000

The debtors of S Ltd. included ` 5,000 due from W Ltd.Advanced Accounting - II12

Prepare a consolidated Balance Sheet as on 31-3-2014 showing yourworking notes clearly.

SOLUTION

Working Notes :

1) S Ltd., purchased 5,500 shares of W Ltd., on 1st October, 2013.

2) Share of S Ltd., in W Ltd. :

=Shares purchased by S Ltd. Shares issued by W Ltd.


=1112

3) Statement of Capital Profit : `

i) General Reserve on 1-4-2013 6,000

ii) Profit and Loss (Cr.) on 1-4-2013 8,000

iii) Profits earned from 1-4-2013 to 1-10-2013 6,0001/2 X (Profits for the year ` 12,000)

iv) Appreciation in the value of Buildings of W Ltd., being

undervaluation on 1-10-2013 (+) 25,000

Capital Profit 45,000

Capital Profit

` 45,000

S Ltd. Minority

(11/12) (1/12)

` 41,250 ` 3,750

(Goodwill)

4) Statement of Revenue Profit : `

Profits earned from 1-10-2013 to 31-3-2014 6,000

= 1/2 x (Profits for the year ` 12,000) (+)

Revenue Profit 6,000



NOTES

13

Revenue Profit

` 6,000

S Ltd. Minority

(11/12) (1/12)

`5,500 ` 500

(Consolidated Profit and Loss)


Face value of shares held by minority

(500 shares x `10) 5,000


8,750

Add : Revenue Profit (+) 500



Cost of shares purchased by S Ltd. 1,10,000

Less : Face value of shares purchased

(5,500 shares x ` 10) (-) 55,000

55,000

Less : S Ltd.s’ share in Capital Profit (-) 41,250

Goodwill 13,750

7) Statement of Consolidated Profit and Loss Account : `

Profit and Loss (Cr.) Balance on 1-4-2013 25,000

Add : Profits for the year 40,000

Add : S Ltd.s’ share in Revenue Profit (+) 5,500

Profit and Loss (Cr.) 70,500



NOTES

14

ILLUSTRATION 3

The Balance Sheet of S Ltd. and P Ltd. as on 31-3-2014 is as follows.


Liabilities S Ltd. P Ltd. Assets S Ltd. P Ltd.

` ` ` `

Share Capital : Goodwill 60,000 20,000

• Shares of 10 each 10,00,000 4,00,000 Machinery 7,32,000 2,72,000

General Reserve 1,50,000 - Stock 1,80,000 90,000

Profit and Loss 1,42,000 60,000 Debtors 2,95,000 1,23,000

Creditors 1,82,000 87,000 Cash 35,000 27,000

Bills Payable 20,000 - Investment :

24,000 Shares of

P Ltd. at Cost 1,92,000

Bills Receivable - 15,000

14,94,000 5,47,000 14,94,000 5,47,000

Other Information :

i) S Ltd., acquired the shares in P Ltd., on 1st October, 2013.

ii) The Profit and Loss Account of P Ltd., showed a debit balance of 20,000on 1-4-2013.

iii) Included in the stock of P Ltd., are goods of 20,000 which were suppliedby S Ltd., at cost plus 25 %.

iv) The bills payable in S Ltd., represented 15,000 issued in favour of P Ltd.

Prepare a Consolidated Balance Sheet as on 31-3-2014.

Advanced Accounting - II 15

Consolidated Balance Sheet of S Ltd., and its Subsidiary W Ltd., as on 31-3-2014Liabilities ` ` Assets ` `

Share Capital : 2,00,000 Goodwill 13,750• Shares of 10 each Buildings 2,40,000Genral Reserve as on 1-4-2013 50,000 S Ltd. 1,50,000Profit and Loss 70,500 W Ltd. 65,000Minority Interest 9,250 Add : Appreciation (+) 25,000 90,000Creditors 15,000 Debtors 30,000

S Ltd. 15,000 S Ltd. 20,000W Ltd. (+) 5,000 W Ltd. (+) 15,000


Sundry Assets 61,000S Ltd. 50,000W Ltd. (+) 11,000

3,44,750 3,44,750

SOLUTION

Working Notes :

1) S Ltd., acquired shares of P Ltd., on 1st October, 2013.

2) Share of S Ltd., in P Ltd. :

= Shares acquired by S Ltd.

Shares issued by P Ltd.


=35


i) General Reserve as on 1-4-2013 NIL

ii) Profit and Loss (Dr.) on 1-4-2013 i.e. Loss (-) 20,000

iii) Profits earned from 1-4-2013 to 1-10-2013 (+) 40,000

1 x General Reserve + Profit and Loss i.e. Profit

2 NIL `80,000)

Capital Profit 20,000Capital Profit

` 20,000

S Ltd. Minority

(3/5) (2/5)

` 12,000 `8,000

(Goodwill)


Profits earned from 1-10-2013 to 31-3-2014

=1

x General Reserve + Profit & Loss i.e. Profit2 NIL ` 80,000 (+) 40,000


Revenue Profit

` 40,000

S Ltd. Minority

(3/5) (2/5)

` 24,000 `16,000




NOTES

16

5) Statement of Minority Intrest : `

Face value of shares held by Minority

(16,000 shares x `10 1,60,000


1,68,000

Add : Revenue Profit (+) 16,000

Minority Intrest 1,84,000


Cost of shares acquired by S Ltd. 1,92,000

Less : Face value of acquired

(24,000 shares x ` 10) (-) 2,40,000

Capital Reserve 48,000

Add : S Ltd.’s share in Capital Profit * (+) 12,000


Add : Balance in Goodwill as per Balance Sheet

S Ltd. +

P Ltd.

`60.000 ` 20,000 (+) 80,000

Goodwill 20,000

* Note : This item is added and not deducted since the resulting figure (i.e. `1,92,000 - ` 2,40,000) is negative `48,000 which is capital reserve.

7) Calculation of Unrealised Profit :

S Ltd., supplied goods to P Ltd., for ` 20,000 at cost plus 25%

SP = CP + P

125 = 100 + 25

P =

25 =

1 x 20,000

SP 125 5

= ` 4,000 x 3

5

= ` 2,400

Hence, unrealised profit of ` 2,400 will be deducted from the Stock ofP Ltd. and from the Consolidated Profit and Loss of S Ltd., in the ConsolidatedBalance Sheet.



NOTES

17



NOTES

18

8) Statement of Consolidated Profit and Loss Account `

Profit and Loss (Cr.) 1,42,000

Add : S Ltd.’s share in Revenue Profit (+) 24,000

1,66,000

Less : Unrealised Profit (-) 2,400


Consolidated Balance Sheet of S Ltd., and its Subsidiary P Ltd.,

as on 31-3-2014Liabilities ` ` Assets ` `

Share Capital 10,00,000 Goodwill 20,000• Shares of 10 each Machinery 10,04,000Profit and Loss 1,63,600 S Ltd. 7,32,000General Reserve 1,50,000 P Ltd. (+) 2,72,000Creditors 2,69,000 Debtors 4,18,000

S Ltd. 1,82,000 S Ltd. 2,95,000P Ltd. (+) 87,000 P Ltd. (+) 1,23,000

Minority Interest 1,84,000 Bills Receivables NILBills Payble 5,000 S Ltd. NIL

S Ltd. 20,000 P Ltd. (+) 15,000P Ltd. (+) NIL 15,000

20,000 Less : Inter-Co.’sLess : Inter-Co.’s Owing(-) 15,000 Owings (-) 15,000

Stock 2,67,600S Ltd. 1,80,000P Ltd. (+) 90,000

2,70,000Less : Unrealised Profit (--) 2,400Cash 62,000

S Ltd. 35,000P Ltd. (+) 27,000

17,71,600 17,71,600

1.7 Summary

• A company may acquire either the whole or majority of shares of anothercompany so as to have a controlling interest in such a company or companies.The controlling company is known as the “Holding Company” and thecompany so controlled is known as a “Subsidiary” and both together areknown as the “Group”.

• There are two ways by which one company can gain control over othercompanies. One way is termed as “Absorption”. Another way is to acquire

all other majority (50% and above) of the voting share of these companies.

• Holding Company has been indirectly defined by Section 4 of the CompaniesAct, 1956 in the context of the definition of Subsidiary Company.

• Section 212 of the Companies Act,1956, stipulates the conditions regardingthe manner in which the Balance Sheet of the Holding Company should beprepared.

1.8 Key Terms

(1) Holding Company :

It is one which acquires all or working majority of the equity shares of anyother company with a view to control the operations of such other company calleda subsidiary.

(2) Subsidiary Company :

A company which is being controlled by another company (i.e. HoldingCompany) because of the latter having acquires majority of the shares or thepower to appoint majority of the directors of the former company.

(3) Absorption :

One way is to acquire all assets and labilities of the companies concernedthereby security control by ownership of such assets and liabilities. Thisarrangement is termed as “ Absorption”.


I - Objective Questions

(A) Multiple Choice Questions :

(1) Consolidations of financial statements helps to understand the financial ----- of the group as one business unit.

(a) strength

(b) solvency

(c) liquidity

(d) viability

(2) One of the common ways of acquiring a controlling interest is to purchasemore than ----- in nominal value of the equity shares of another company

(a) forty percent

(b) fifty percent



NOTES

19

(c) forty five percent

(d) forty nine percent

(3) The company is a subsidiary of any company which is that other company’s------

(a) holding

(b) parent

(c) subsidiary

(d) vendor

(4) A ----- is a parent and all its subsidiaries.

(a) firm

(b) vendor

(c) association

(d) group

Ans : (1-a), (2- b), (3-c), (4-d)

II - Long Answer Questions :

(1) Define ‘Holding Company’ Explain in brief the important points to be keptin mind while consolidating a Balance Sheet.

(2) Define the term i) a parent , ii) a subsidiary and iii) a group as per AS-21.

(3) Explain the legal conditions involved in determining whether one companyis a subsidiary of another.

(4) What do you understand by ‘Holding Company’ ? Explain the basic principlesof consolidation.

(5) What is ‘Holding Company’ ? How it differs from a Subsidiary Company?



NOTES

20

III - Practical Problems :

(1) The following are the summarised Balance Sheet of H Ltd. and S Ltd. ason 31st March, 2014

Balance Sheet as on 31st March, 2014

Liabilities H Ltd. S Ltd. Assets H Ltd. S Ltd.

C ` ` `

Share Capital 1,80,000 1,00,000 Buildings 50,000 40,000

Shares of 10 each Machinery 80,000 20,000

Creditors 40,000 20,000 Furniture 60,000 20,000

Bills Payable 20,000 10,000 Debtors 50,000 25,000

Bank Overdraft 20,000 - Investments 55,000 -

Profit and Loss 35,000 - Profit ans Loss - 25,000(8,000 Equity Sharesin S Ltd.

Profit ans Loss - 25,000

2,95,000 1,30,000 2,95,000 1,30,000

Additional Information :

i) Debtors include `10,000 due from S Ltd.

ii) H Ltd. acquired shares of S Ltd. on 1st April, 2013 when S Ltd. had a debitbalance of ` 40,000 in its Profit and Loss Account.

Prepare a Consolidated Balance-Sheet as on 31st March, 2014.


• Shukla M.C., Grewal T. S. and Gupta S.C. - Advanced Accounts - NewDelhi - S Chand & Co. Pvt.Ltd., 2013

• Sehgal Ashok - Taxman’s Fundamentals of Corporate Accounting - NewDelhi - Taxmann Publications Pvt. Ltd., - 2012



NOTES

21

Unit 2 Preparation of ConsolidatedBalance-Sheet of Holding Company

Structure

2.0. Introduction

2.1. Unit Objectives

2.2 Preparation of Consolidated Balance Sheet of Holding Co. with oneSubsidiary only

2.2.1 Purpose

2.2.2 Advantages

2.2.3 Disadvantages

2.2.4 Procedure

2.3 Basic Rules for preparing a Consolidated Balance Sheet

2.4 Miscellaneous Adjustments

2.5 Illustrations

2.6 Summary

2.7 Key Terms


2.9 Further Reading

2.0 Introduction

The financial position and operating results reported through the consolidatedstatement are portrayed from the standpoint of the interest of the members ofHolding Co.. In practice, users of the financial statements of a parent are usuallyconcerned with, and need to be inform about the financial position and results ofoperations of not only the enterprise itself ‘ but also of the group as a whole. Thisneed is served by providing the users separate financial statement of the parentand consolidated financial statements. which present financial information indetailed about the group as that of a single enterprise without regard to the legalboundaries of the separate legal entities.

Consolidated financial statements normally include consolidated BalanceSheet consolidated Profit and Loss and notes, other statements and explanatorymaterial that from an integral part thereof. The consolidated financial statementsare presented to the extend possible in the same format as that adopted by the

Preparation of ConsolidatedBalance-Sheet of HoldingCompany


NOTES

23

parent for its separate financial statements. Consolidated financial statements arepresented by a parent ( i.e by Holding Enterprise) to provide financial informationabout the economic activities of its group.

2.1 Unit Objectives

After this unit you should able to :

• Prepare Consolidated Balance Sheet of Holding Company with a SubsidiaryCompany.

• Understand the Basic Rules for preparing a Consolidated Balance Sheet.

• Calculate Minority Interest.

• Calculate Goodwill or Capital Reserve on consolidation.

• Understand various miscellaneous adjustments related to Consolidated

Balance Sheet.

• Acquainted with treatment of issue of bonus shares by the Subsidiary Co.

• Discuss the advantages and disadvantages of Consolidated FinancialStatement.

2.2 Preparation of Consolidated Balance Sheet ofHolding Co. with one Subsidiary only

2.2.1 Purpose

The purpose of a consolidated Balance Sheet and Profit and Loss Accountis to show the financial position and operating results of a group consisting of aHolding Co. and one or more subsidiaries. The consolidated statements are reportsof a notional accounting entity which subsist on the view that the holding andsubsidiary companies are to be treated as one economic unit. The financial positionand operating results, reported through the consolidated statements are portrayedfrom the standpoint of the interest of the members of Holding Co.

Shareholders of a Holding Co. hand over share capital to the directors ofthe company for carrying out an agreed business in the most efficient way.Directors, with a view to discharging their responsibilities fully, present detailedaccounts and reports. If the directors have invested a part of this capital inpurchasing, controlling shares in some other company, thus making that companya subsidiary company, it becomes obligatory to explain the position of the subsidiaryalso. Since the shareholders of the Holding Co. are interested in the SubsidiaryCo. only to the extent of the shares held in it, a full Balance Sheet of the Subsidiarymay not be of much interest to them. They are interested only to the extent they

NOTES

24



are entitled to the assets of Subsidiary Co. But many shareholders being laymenmay not be able to make out anything from separate Balance Sheets of the HoldingCo. and the Subsidiary Co.’s. Therefore, in order to enable them to understandtheir interest better, it is advisable to give the Consolidated Balance SCeet of thegroup.

2.2.1 Advantages :

The advantages of Consolidation of Financial Statements are as follows.

a) The Holding Co. with its subsidiary constitute one business units althoughthey function as separate legal entities. Hence, one Balance Sheet is desirablethrough consolidation.

b) The shareholders of Holding Co. get a complete and full disclosure of t heinterest of the Holding Co. in its subsidiary Co.

c) The shareholders get a better idea and picture of their investment in thesubsidiary which is represented by the net assets position of Subsidiary Co.,the investment item appearing on the assets side is represented by the netassets of the subsidiary to the extent of their interest in subsidiary.

d) It helps in judging the efficiency and performance of the group as a whole.

e) It helps to understand the financial strength of the group as a one businessunit.

2.2.2 Disadvantages :

The following are the main disadvantages of Consolidation of FinancialStatements :

a) Aggregating the results of Holding Co. and its subsidiary may concealimportant information from shareholders when the companies differ in respectto profitability, business risk and growth potential.

b) Consolidation may mislead the shareholders if the activities of the subsidiaryare very dissimilar from those of other companies within the group.

2.2.3 Procedure :

It becomes imperative for consolidation to arrive at the following figures topresent a Consolidated Balance Sheet disclosing the interest in the subsidiary.Hence, the following workings are necessary :

a) Determination of the share of the Holding Co. in subsidiary and the shareof minority in subsidiary

b) Analysis of profits of Subsidiary Co. into pre and post acquisition period.

c) Calculation of Minority Interest.

d) Calculation of Cost of Control.



NOTES

25

Check Your Progress

i) Explain the basic purposeof preparing aConsolidated BalanceSheet of Holding Co.

ii) How consolidation ofFinancial Statements isadvantageous to HoldingCo. ?

e) Calculation of Consolidated Profit and Loss Account.

f) Working of unrealised profit in unsold closing stock.

g) Elimination of inter company indebtedness.

h) Finally, the Consolidated Balance Sheet is prepared as per the rules ofconsolidation explained below.

2.3 Basic Rules for Preparing a ConsolidatedBalance Sheet

Rule 1 : Cancellation of Investment and Share Capital :

A Consolidated Balance Sheet can be prepared by simply combining all theassets and liabilities of the Holding Co. and its subsidiary. It will certainly balance,but it is not a consolidated Balance Sheet. This is because the inter-companybalance have first to be eliminated. The “Investment in Subsidiary Co.” by theHolding Co. should cancel out the share Capital of the Subsidiary Co. consider thefollowing example :

The simplest example is a case where the Holding Co. is holding all theshares of the subsidiary. Suppose, H Ltd. acquires all the shares of S Ltd. onApril 1, 2009 on which date the Balance Sheet of the two companies are asfollows :

Balance Sheet as on April 1, 2009


` ` ` `

Share Capital 10,00,000 2,00,000 Sundry Assets 10,00,000 2,50,000

(Share of 10 each) Investments 2,00,000 -

Creditors 2,00,000 50,000 (20,000 Shares of 10

each at cost)

12,00,000 2,50,000 12,00,000 2,50,000

Since, in the above example, all the shares of S. Ltd. are held by H Ltd., allthe assets and liabilities of S Ltd. belong only to the Holding Co. and the consolidatedBalance Sheet will be as follows :

Consolidated Balance Sheet of H Ltd. and S Ltd. as on April 1, 2009

Liabilities ` Assets `

Share Capital : 10,00,000 Sundry Assets :

Creditors : H Ltd. 10,00,000

H Ltd. 2,00,000 S Ltd. (+) 2,50,000 12,50,000

S Ltd. (+) 50,000 2,50,000

12,50,000 12,50,000

NOTES

26



Thus, in the above example, the investment in the Holding Co. is replacedby the assets and liabilities of the subsidiary; the Share Capital of S Ltd. beingcancelled against the Investments in H Ltd.

Rule 2 : Calculation of Minority Interest :

When the Holding Co. acquires all the shares of the Subsidiary Co., thelatter co. becomes a wholly owned subsidiary. In our previous example , S Ltd.is a wholly owned subsidiary of H Ltd. But when the Holding Co. acquires morethan half but less than all the shares of the Subsidiary Co., those shareholders whohave a minority share are referred to as Minority Shareholders. The interest ofthe Minority Shareholders, known as Minority Interest must be accountedseparately in the Consolidated Balance Sheet.

A minority interest is the proportion of the subsidiary company’s net assets/shareholders fund which belongs to the minority shareholders. Therefore, the valueof the minority interest is the portion of the share capital and reserves at the datewhen the Holding Co. acquires its controlling interest and the share of incomeafter acquisition.

The minority interest is calculated as follows :

`

Paid-up value of the shares held by outsiders ------

Add : (+) Proportionate share in the company’s profits and reserves ------

(+) Proportionate share in the increase in the value of the

assets of the subsidiary (+) ------

Less : (-) Proportionate share in the loss of the subsidiary, if any ------

(-) Proportionate share in the decrease in the value of assets

of the subsidiary (-) ------

Minority Interest ------

If preference shares are held by outsiders, the face value of such shareswith the dividend due thereon (if there are profits) will be included in the minorityinterest. If the Subsidiary Co. does not have any profit and the preference sharesare cumulative, then the dividend due will be shown by way of a note. Theproportionate share of the outsiders in the profits or losses will be shown by wayof a note. The proportionate share of the outsiders in the profits or losses will becalculated only with reference to the equity shares held by them since the profitand reserves, if any, belong only to the equity shareholders.

Rule 3 : Goodwill or Capital Reserve on Consolidation :

i) Goodwill on Consolidation :

If value of “Investment in Subsidiary” in the Holding Co.’s Balance Sheetis more than the book value of the net assets acquired, the difference represents,



NOTES

27

“Goodwill on Consolidation”. In this case, Investment in Subsidiary will notcancel out against the share capital of the subsidiary unless a goodwill equal tothe difference of the two items is shown on the assets side of the ConsolidatedBalance Sheet.

ii) Capital Reserve on Consolidation :

If the value of Investment in Subsidiary is less than the book value of thenet assets acquired, the difference represents Capital Reserve on Consolidation.In this case also, Investment in Subsidiary will not cancel out against the sharecapital of the subsidiary unless a capital reserve equal to the difference of the twoitems is shown on the liabilities of the Consolidated Balance Sheet.

To calculate goodwill or capital reserve, the value of the net assets acquiredby the Holding Co. in the Subsidiary Co. must be compared with the cost of theinvestment. This value can be ascertained by adding together with proportionateshare capital and reserve of the subsidiary.

Calculation of Cost of Control of Goodwill :

The shares acquired by the Holding Co. appear under the head “Investmentin Subsidiary Co.”, in the Balance Sheet of the Holding Co. This figure appears atthe cost at which it has been acquired or the purchase cost. This is therefore theprice actually paid for purchasing the share in the Subsidiary Co. This price ispaid against the nominal value of the shares as well as the profits or losses alreadyexisting in the Balance Sheet of the Subsidiary Co. on the date of acquisition.These profits or losses already existing in the Balance Sheet of the Subsidiary Co.are therefore known as pre-acquisition profits or losses. When the price paid ismore than the nominal value of the shares acquired and pre-acquisition profits (orlosses ) put together, then the differential amount represents the excess pricepaid and therefore called as Goodwill. If on the other hand, the price paid is lessthan the total of nominal value of shares and pre-acquisition profits or losses, thenthe total of nominal value of shares and pre- acquisition profits or losses, then theresulting figure is known as Capital Reserve. This is explained in the followingformat.

`

Investment in the Subsidiary Company ..........

(Cost of acquiring the shares or the price paid for shares)

Less : Nominal value of shares acquired ..........

Less : Pre-acquired profits (including reserves)

(Capital profits) (-)

Cost of Control or Goodwill (Capital Reserve)

1. If the figure work out to be negative, then the amount is known asCapital Reserve, since what has acquired is more than what has beenpaid for.

NOTES

28



2. Pre-acquisition losses are added instead of deducting those (shownabove) as in case of pre- acquisition profits.

Rule 4 : Pre-acquisition or Capital Profits :

The profits of the subsidiary may be divided into Capital Profit; and RevenueProfit . Profit existing , or earned by, the subsidiary company upon the date ofacquisition of shares by the Holding Company are Capital Profits or (pre-acquisitionprofits) and the Holding Company’s share or the same is to be calculated andshown separately under the heading ‘Capital Reserve’ or adjusted against thecost of control. The profits earned by the subsidiary company after the purchaseof shares by the Holding Company are Revenue Profits (or post-acquisitionprofits) and the holding company’s share of it is to be added to the profits of theHolding Company. The share in the capital profit and revenue profit of the minorityshareholders are added to the minority interest.

Any increase in the value of fixed assets of the Subsidiary Company whetherbefore or after the date of acquisition will also be treated as Capital Profit and ifthere is reduction in the value of fixed assets as on the date of acquisition, it mustbe treated as Capital Loss and deducted from the Capital Profits. But if the fall inthe value of the assets occurs after the date of acquisition, the loss is treated as anordinary revenue loss.

Thus, to decide whether profits or losses and reserve of the SubsidiaryCompany are Capital Profits or Revenue Profits, the date of purchase of sharesby the Holding Company is the deciding factor.

Similarly, the losses of the Subsidiary Company up to the date of acquisitionis treated as a Capital Loss and subsequent to the acquisition as a Revenue Loss.

Rule 5 : Cancellation of Inter-company Debts and Acceptances :

It is very common that member companies have business dealings not onlywith outsiders but also with each other. Inter-company transactions may lead tointer company debts and acceptances. At the time of consolidation, inter-companydebts and acceptances which are part of the group, are to be cancelled out asfollows :

(i) Debtors and Creditors : These relate to sale and purchases of goodson credit between the holding and subsidiary company. This results inthe mutual indebtedness in the form of debtors in the books of thecompany selling the goods and creditors in the Balance Sheet of thepurchasing company on credit basis. The amount of debtors and creditorsare eliminated by deducting the common owing amount from the totalof the debtors and creditors in the consolidated Balance Sheet.

(ii) Bill Receivable an Bill Payable : Bill of Exchange drawn by thecompany on another company appears as an assets in the BalanceSheet of the company drawing the bill whereas the same amount willappears as Bill Payable on the liabilities side in the Balance Sheet ofthe company accepting the bills. The mutual indebtedness is eliminated



NOTES

29

by deducting the common amount of bills. receivable and bills payablefrom the total of the bills receivable and total of bills payable in theconsolidated Balance Sheet.

Rule 6 : Cancellation of Inter- company Loans and Advances :

Usually, a Current Account is used to record inter-company loans andadvances. When a loan is provided by either of the companies to the other, acurrent account will exist between the Holding Co. and its subsidiary.

Inter company transactions refers to those transactions between the holdingand subsidiary with regard to loans given and taken or sales and purchases ofgoods effected between the two entities. Sale and purchase of goods on creditbasis result in debtors and creditors relationships between the two companies.Since it amounts to purchase and sale of goods by the same company or loansgiven or taken by the same company, the transactions deserve eliminations.

Rule 7 : Contingent Liability on Bill Discounted :

Contingent Liability is an uncertain liability which materialises on thehappening of a particular event. Till then it is not an actual liability and thereforecannot appear on the face of the Balance Sheet. However, it appears as a note atthe foot of the Balance Sheet.

If the company has discounted any of its bills receivable with its bankersand the transaction involved is between the company in the group and outsidethird party, it will appear as a note to the Balance Sheet of the company as acontingent liability to the extent of the bills discounted. But if the contingent liabilityis in respect of a transaction between the holding and subsidiary companies, it willdisappear from the footnote of individual company, Balance Sheet, as it appearsas actual liability in the consolidated Balance Sheet.

Rule 8 : Revaluation of Assets :

Certain assets may be revalued on the date of acquisition of shares by theHolding Co. Any such revaluation of the assets results in capital profit or capitallosses. If there is an increase in the value of asset, it results in capital profit. Ifthere is a decrease in the value of the asset, it results in capital loss. Theproportionate share of Holding Co. will be adjusted against the cost of controlthereby reducing or increasing the amount of goodwill or resulting in capital reserveas the case may be. The minority shareholders would be entitled to theirproportionate share in capital profits or capital reserves.

Further, for adjustment for depreciation on the increase or decrease in thevalue of assets should be made in the Profit and Loss Account of the subsidiary.It may be noted that for revaluation profit (due to increase in the value of theassets), higher depreciation provision will be necessary, on the other hand, forrevaluation loss (due to decrease in the value of assets ) excess depreciationprovisions should be written back.

NOTES

30



Rule 9 : Adjustment of Bank Balances :

Bank accounts may be held by the Holding Co. and its subsidiary at differentbanks. While some balances are favourable, others are overdrawn balances theyshould appear in the Consolidated Balance Sheet as assets and liabilitiesrespectively. It would be incorrect to adjust the overdraft balances against creditbalances for the purpose of the Consolidated Balance Sheet.

Rule 10 : Unrealised Profit on Fixed Assets :

A member company may transfer fixed assets or stock which becomesfixed assets of the transferee company at a profit . In this case, a similar problemarises as that seen in connection with trading stock transfer. At the time ofconsolidation, unrealised profits should be deducted from consolidated profit aswell as aggregate value of fixed assets.

2.4 Miscellaneous Adjustments

1) Unrealised Profit on Unsold Stock :

It is quite possible that the Holding Company can buy goods from theSubsidiary Company which sells it at costs plus certain margin of profits. Suchgoods purchased by the Holding Company may still remain in its closing stock asunsold as on the date of Balance Sheet. In such a case, it becomes necessary toeliminate the profit of the Subsidiary Company to the extent of the HoldingCompany’s share, since such profits have not yet been earned to the extent towhich it has been included in the closing stock. Therefore, a proportionate shareof the Holding Company’s profits included in the stock of the goods remainingunsold is elimination from the figure of closing stock of the Holding Companyalong with simultaneous elimination of such unrealised profits from the profit ofthe Subsidiary Company. It may be noted that the minority interest remainsunaffected in this regards, since for them profit has already been earned on thesale effected by the subsidiary to the Holding Company. It is only the share of theHolding Company in the profits of the subsidiary on such sale which matters,since the same has not been earned as long as it remains in the closing stock ofthe Holding Company as unsold.

Similarly, if the Holding Company has sold goods to the Subsidiary Companyand the closing stock of the Subsidiary Company still contains such goods asunsold stock, such elimination effects of profits is necessary. Since the HoldingCompany has not earned profits till the goods are sold by the subsidiary, theunrealised profits including in such goods to the extent lying in closing stock requireselimination. Such unralised profits to the extent of Holding Company share iseliminated both from the closing stock of Subsidiary Company as well as from theprofit of the Holding Company. Some authors have argued in favour of eliminationof the full provision of unrealized profits. However, as a matter of normal practiceand as per the standards prescribed by well known authors on the subject, it isconsidered prudent to eliminate only to the extent of Holding Company’s share.



NOTES

31

All problems solved in this book have, therefore, been given treatment accordingly.

For example, a Subsidiary Company may sell to the Holding Company goodsof the value of `30,000 on which the subsidiary has put a profit of 20% on theselling price and the entire goods may remain unsold at the date of consolidation.Supposing the Holding Company holds, 3,000 shares of the subsidiary’s 4,000shares, the stock reserve would be :

a) ` 30,000 x 1/5 x 3/4 = ` 4,500 (only to the extent of the HoldingCompany’s share).

b) ` 30,000 x 1/5 = ` 6,000

The modern practice is to create the whole of the unrealised profit as StockReserve without adjusting the share of the minority shareholders. The StockReserve is created whether the goods are sold by the Holding Company to theSubsidiary Company or vice-versa at a profit. The amount of unrealised profit(Stock Reserve) is deducted from the stock on the asset side and also from theProfit and Loss Account on the liability side of the consolidated Balance Sheet.Thus, stock will be shown at its true cost and the Profits and Loss Account willshow only realised profit.

2) Issue of Bonus Shares :

Treatment of issue of bonus shared by the subsidiary will depend upon thesource from which bonus shares are issued. Bonus shares may be issued out ofpre-acquisition profits or reserves or post acquisition profits or reserves.

i) Issue of bonus shares out of pre-acquisition profits : In this case,there will be no effect on the consolidated balance because whilecalculating the cost of control, the Holding Company’s shares in thepre- acquisition profit is reduced (because of capitalisation of profit)while on the other hand, the paid-up value of shares held increases. Sothe cost of control or goodwill will remain the same as it was before theissue of bonus shares.

ii) Issue of shares out of Post-acquisition Profits : If a subsidiarycompany issues bonus shares out of post - acquisition profit, it will havea direct effect on the Consolidated Balance Sheet. In such a situation,the Holding Company’s share of revenue profit in the SubsidiaryCompany will be reduced and the paid - up value of the shares held bythe Holding Company in its subsidiary will be increased because of theissue of bonus shares. This will reduce the value of goodwill or increasethe value of capital reserve. The portion of the bonus shares of theminority interest will be added to the minority interest, as before.

3) Preference Shares held by the Holding Company :

When preference shares are issued by a Subsidiary Company and are heldby the Holding Company (whether wholly or partly), it should be treated in thesame way as equity shares. If the Holding Company acquires the preferenceshares at par, the cost of investment of the Holding Company cancels out the

NOTES

32



shares shown on the Balance Sheet of the subsidiary. When the preference sharesare acquired at a premium or a discount, the balance is carried to goodwill orcapital reserve in the Consolidated Balance Sheet. The portion of the preferenceshares owned by the minority shareholders are added to minority interest.

4) Debentures of the Holding Company :

The debentures of the Holding Company will appear on the liability side ofthe Consolidated Balance Sheet, just like equity or preference share capital.Debentures issued either by the Holding Company or the subsidiary and held byothers should be cancelled out when they are acquired at par. When at par. Whenpart of the debenture are held by the minority shareholders, it should appear in theliability side of the Consolidated Balance Sheet. The holding company’s “ investmentin debentures in the subsidiary” will cancel out against the nominal value ofdebentures shown in the subsidiary company’s Balance Sheet.

If the debentures are acquired at a premium or at a discount, the differencebetween cost and nominal value is adjusted against goodwill or capital reserve inthe Balance Sheet.

5) Inter-company Dividends :

Holding Company owns majority of the shares of its subsidiary . When adividend is paid out of profit of the Subsidiary Company, the Holding Company islikely to receive a majority portion of it as a shareholders. It should be noted thatsuch dividend may be paid out of pre-acqusition profit or post-acquisition profit .

If any dividend received by the Holding Company from its subsidiary comeout of pre-acquisition profits, such dividend should be treated as a return on capitalto the Holding Company, since it transfers to the Holding Company part of the netassets in the Subsidiary Company that have been paid for. In this situation, thecorrect accounting treatment is to deduct such dividend from the cost of investmentin the subsidiary for calculating goodwill or capital reserve.

The procedure followed in the preparation of Consolidated Balance Sheetof Holding Company with one subsidiary only can be understood with the help offollowing illustrations :



NOTES

33

Check Your Progress

1. How would you treateinvestment in SubsidiaryCo. by Holding Co. andShare Capital ofSubsidiary Co. ?

2 . Explain the accountingadjustments to be madewhile computingMinority Interest.

3 . Define the term Goodwillon Consolidation andCapital Reserve onConsolidation.

4 . How Capital Profitsdiffers from RevenueProfits ?

5 . What are Inter-CompanyDebts and Acceptances ?

2.5 Illustrations

ILLUSTRATION 1

The following is the summarised Balance Sheet of H Ltd., and S Ltd., ason 31-3-0214


` ` ` `

Share Capital 2,00,000 50,000 Sundry Assets 1,80,000 1,20,000

Reserve as on 1-4-13 30,000 10,000 Share in S Ltd. 2,30,000 -

Profit and Loss Cash at Bank 20,000 10,000

(Balance as on 1-4-13) 60,000 30,000

Profits for the year 40,000 10,000

Creditors 1,00,000 30,000

4,30,000 1,30,000 4,30,000 1,30,000

H Ltd., acquired 80% of the shares in S Ltd., on 1st October, 2013. Includedin the assets of H Ltd., there is ` 30,000 Loan to S Ltd., shown as Creditors of SLtd. Sundry Assets of S Ltd., include Furniture and Fittings of ` 40,000 to berevalued at ` 50,000 being over depreciated as at 1-10-2013.

Prepare a Consolidated Balance Sheet of H Ltd., as at 31-3-2014

SOLUTION

Working Notes :

1) H Ltd., acquired 80% shares of S Ltd., on 1st October, 2013.

2) Share of H Ltd., in S Ltd. :

=Shares acquired by H Ltd. Shares issued by S Ltd.


=45


i) Reserves as on 1-4-2013 10,000

ii) Profit and Loss (Cr.) on 1-4-2013 30,000

iii) Profit earned from 1-4-2013 to 1-10-2013

1 Profits for the year2

x ` 10,000 5,000

iv) Appreciation in the value of Sundry Assets(i.e. Furniture and Fittings) of S Ltd., beingover depreciation on 1-10-2013 (+)10,000


NOTES

34



Capital Profit

` 55,000

H Ltd. Minority(4/5) (1/5)

` 44,000 ` 11,000(Goodwill)



1 Profits for the year2

x ` 10,000 (+) 5,000


Revenue Profit

` 5,000

H Ltd., Minority(4/5) (1/5)

` 4,000 ` 1,000(Consolidated Profit and Loss)


Face Value of shares held by Minority 10,000( 20% of ` 50,000 )

Add :Capital Profit (+) 11,000

21,000

Add :Revenue Profit (+) 1,000



Cost of shares acquired by H Ltd.. 2,30,000

Less : Face value of shares acquired (80 % of ` 50,000) (-) 40,000

1,90,000

Less : H Ltd.’s share in Capital Profit (-) 44,000

Goodwill 1,46,000



NOTES

35


Profit and Loss (Cr.) balance on 1-4-2013 60,000

Add : Profits for the year 40,000

Add : H Ltd.’s share in Revenue Profit (+) 4,000


Consolidated Balance Sheet of H Ltd., and its Subsidiary S Ltd.,as on 31-3-2014

Liabilities ` ` Assets ` `

Share Capital 2,00,000 Goodwill 1,46,000

Reserves as on

1-4-2013 30,000 Cash at Bank 30,000

Profit and Loss 1,04,000 H Ltd. 20,000

Minority Interest 22,000 S Ltd. (+) 10,000

Creditors 1,00,000 Sundry Assets 2,80,000

H Ltd. 1,00,000 H Ltd. 1,80,000

S Ltd. (+) 30,000 S Ltd. 1,20,000

1,30,000 Add : Appreciation in

Less: Inter- Furniture and Fittings

Company Loan (-) 30,000 (+)10,000 1,30,000

(+) 3,10,000

Less: Inter-

Company Loan (-) 30,000

4,56,000 4,56,000

ILLUSTRATION 2

A Ltd., holds 80% of the Equity Shares Capital of B Ltd., which wasacquired on 31st March, 2013 when the latter company had a credit balance onProfit and Loss Account of ` 15,000 and General Reserve of ` 20,000. Stockheld by A Ltd., include 5,000 for goods supplied by B Ltd., at a profit of 20% onthe selling price.

From the following Balance Sheet, prepare a consolidated Balance Sheetas on 31-3-2014.

NOTES

36





` ` ` `

Share Capital : Fixed Assets 2,45,500 23,000

Equity Shares Investments:

of 10 each 5,00,000 1,00,000 8,000 Shares

Capital Reserve 1,00,000 - of B Ltd. 1,20,000 -

General Reserve 1,20,000 30,000 Stock 4,14,000 1,23,000

Profit and Loss 40,000 10,000 Debtors 87,000 37,400

Creditors 1,49,700 36,000 Cash 64,500 -

Bills Payable 21,300 1,000

Bank Overdraft - 6,400

9,31,000 1,83,400 9,31,000 1,83,400

SOLUTION

Working Notes :

1) A Ltd., acquired 80% of Equity Shares of B Ltd., on 31st March, 2013

2) Shares of A Ltd., in B Ltd. :

=Shares acquired by A Ltd. Shares issued by B Ltd.


=45


i) Profit and Loss (Cr.) on 31-3-2013 15,000

ii) General Reserve on 31-3-2013 (+) 20,000


Capital Profit

` 35,000

A Ltd. Minority(4/5) (1/5)

` 28,000 ` 7,000(Goodwill)



NOTES

37


Profit earned from 31-3-2013 to 31-3-2014

(i) Profit and Loss i.e. Loss (-) 5,000

(ii) General Reserve (+) 10,000


Revenue Profit

` 5,000


` 4,000 ` 1,000



Face value of shares held by Minority(2,000 shares x ` 10) 20,000


27,000

Add :Revenue Profit (+) 1,000




Less :Face value of shares acquired

(8,000 shares x ` 10) (-) 80,000

40,000

Less : A Ltd’s share in Capital Profit (-) 28,000

Goodwill 12,000

This Goodwill of ` 12,000 is adjusted against Capital Reserve of ALtd. , in the consolidated Balance Sheet.

7) Calculation of Unerealised Profit :

B Ltd., supplied goods to A Ltd., for ` 5,000 at a profit of 20% onselling price.

SP = CP + P

100 = 80 + 20

P=

20=

1 x ` 5,000

SP 100 5

NOTES

38



= ` 1,000 x

4

5

= ` 800

Hence, unrealised profit of ` 800 will be deducted from the stock of ALtd., and from the Consolidated Profit and Loss Account of A Ltd., inConsolidated Balance Sheet.



Add :A Ltd’s share in Revenue Profit (+) 4,000

44,000

Less :Unrealised Profit (-) 800


Consolidated Balance Sheet of A Ltd., and its Subsidiary B Ltd.,as on 31-3-2014


Share Capital 5,00,000 Fixed Assets 2,68,500Equity Shares of A Ltd. 2,45,500

` 10 each B Ltd. (+) 23,000

Capital Reserve 1,00,000 88,000 5,36,200

Less:Goodwill Stock

adjusted (-) 12,000 A Ltd. 4,14,000

General Reserve 1,20,000 B Ltd. (+) 1,23,000

Profit and Loss 43,200 5,37,000

Creditors 1,85,700 Less: Unrealised

A Ltd. 1,49,700 Profit 800

B Ltd. (+) 36000 (-)Bills Payable 22,300 Debtors 1,24,400

A Ltd. 21,300 A Ltd. 87,000

B Ltd. (+) 1,000 B Ltd. (+) 37,400

Minority Interest 28,000 Cash 64,500

Bank Overdraft 6,400 A Ltd. 64,500

A Ltd. NIL B Ltd. (+) NIL

B Ltd. (+) 6,400

9,93,600 9,93,600



NOTES

39

ILLUSTRATION 3

H Ltd., acquired Equity Shares in S Ltd., as on 1st April, 2013. Their BalanceSheet as on 31-3-2014 was as follows :

Liability H Ltd. S Ltd. Assets H Ltd. S Ltd.

` ` ` `

Share Capital : 2,50,000 50,000 Land and Buildings 1,00,000 20,000

• Equity Shares of Plant and Machinery 1,50,000 30,000

`100 each, fully paid Investments :

General Reserve 50,000 20,000 400 Shares in S Ltd., 50,000 -

(as on 1-4-2013) (at cost)

Profit and Loss 70,000 25,000 Stock 40,000 25,000

Creditors 30,000 5,000 Debtors 30,000 15,000

Cash 30,000 10,000

4,00,000 1,00,000 4,00,000 1,00,000

Additional Information:

i) Sundry Debtors of H Ltd. , include ` 5,000 due from S Ltd.

ii) Stock of S Ltd., includes goods purchased from H Ltd., for ` 20,000on which H Ltd., made a profit of 25% on Sales.

iii) On 1-4-2008 the Profit and Loss of S Ltd., showed a credit balance of` 5,000.

Prepare a Consolidated Balance Sheet of H Ltd., and its Subsidiary S Ltd.,as on 31-3-2014

SOLUTION

Working Notes :

1) H Ltd., acquired Equity Shares of S Ltd., on 1st April ,2013.

2) Shares of H Ltd., in S Ltd :

=Shares acquired by H Ltd.Shares issued by S Ltd.

=400 shares500 shares

=45


(i) General Reserves as on 1-4-2013 20,000

(ii) Profit and Loss (Cr.) on 1-4-2013 i.e. Profit (+) 5,000


NOTES

40



Capital Profit

` 25,000


` 20,000 ` 5,000(Goodwill)



(i) General Reserve NIL

(ii) Profit and Loss i.e. Profit (+) 20,000


Revenue Profit

` 20,000





(100 shares x ` 100) 10,000

Add :Capital Profits (+) 5,000

15,000

Add :Revenue Profits (+) 4,000


6) Statement of Capital Reserve : `

Cost of shares acquired by S Ltd. 50,000

Less : Face value of shares acquired

(400 shares x ` 100) (-) 40,000

10,000

Less : H Ltd.’s share in Capital Profit (-) 20,000




NOTES

41

7) Calculation of Unralised Profit :

H Ltd., sold goods to S Ltd., for ` 20,000 at a Profit of 25% on Sales.

SP = CP + P100 = 75 + 25

P=

25 = 1

x ` 20,000SP 100 4

= ` 5,000 x 4 = ` 4,000 5

Hence, unrealised profit of ` 4,000 will be deducted from Stock of S Ltd.,and from the Consolidated Profit and Loss of H Ltd., in the ConsolidatedBalance Sheet.


Profit an d Loss (Cr.) 70,000

Add : H Ltd.’s shares in Revenue Profit (+) 16,000

86,000



Consolidated Balance Sheet of H Ltd. and its Subsidiary S Ltd.,as on 31-3-2014


Share Capital : Land and Buildings 1,20,000• Equity Shares of 2,50,000 H Ltd. 1,00,000`100 each, fully paid S Ltd. (+) 20,000Profit and Loss 82,000 Plant and Machinery 1,80,00Capital Reserve 10,000 H Ltd. 1,50,000General Reserve 50,000 S Ltd. (+) 30,000as on 1-4-2013 Stock 61,000Creditors 30,000 H Ltd. 40,000

H Ltd. 30,000 S Ltd. (+) 25,000S Ltd. (+) 5,000 65,000

35,000 Less: Unrealised Profit (-) 4,000Less: Inter-Co.’s Debtors 40,000owing (-) 5,000 H Ltd. 30,000Minority Interest 19,000 S Ltd. (+) 15,000

45,000Less: Inter-Co.’sowings (-) 5,000Cash 40,000

H Ltd. 30,000S Ltd. (+) 10,000

4,41,000 4,41,000

NOTES

42



2.6 Summary

• Consolidated financial statement normally include consolidated BalanceSheet. Consolidated Profit and Loss Account notes, other statements andexplanatory material that form an integral part therefor.

• The purpose of a consolidated Balance Sheet and Profit and Loss Accountis to show the financial position and operating result of a group consisting ofa Holding Co. and one or more subsidiaries.

• Basic Rules for preparing a Consolidated Balance Sheet :

Rule 1. Cancellation of Investment and Share Capital

Rule 2. Calculation of Minority Interest .

Rule 3. Goodwill or Capital Reserve on Consolidation

Rule 4. Pre-requisition or Capital Profit.

Rule 5. Cancellation of Inter company Debts and Acceptances

Rule 6. Cancellation of Inter - company Loans and Advances

Rule 7. Contingent Liability on Bills Discounted

Rule 8. Revaluation of Assets

Rule 9. Adjustment of Bank Balances

Rule 10. Unrealised Profit on Fixed Assets.

• Miscellaneous Adjustment :

(1) Unrealised Profit on Unsold Stock

(2) Issue of Bonus Shares

(3) Preferences Shares hold by the Holding Co.

(4) Debentures of Holding Co.

(5) Inter-company Dividends.

2.7 Key Terms

(1) Minority Interest :It is that part of the net results of the operations andof the net assets of a subsidiary attributable to interests which are notowned, directly or indirectly through subsidiary or subsidiaries by the parent.

(2) Capital Profit : Capital Profit are the pre-acquisition profits earned by theSubsidiary Company till the date of acquisition of shares by the HoldingCompany.

(3) Revenue Profit : Revenue profit are the post-acquisition profits earned



NOTES

43

by the Subsidiary Company in the post acquisition period.

(4) Capital Reserve : If the cost incurred by the Holding Co. is less than thebenefits derived by it, is treated as Capital Reserve.

(5) Goodwill : If the cost incurred by the Holding Company is more than thebenefit s derived by it, is treated as Goodwill.

(6) Consolidated Balance Sheet : It is a consolidated statement of the financialposition of the Holding as well as Subsidiary Companies.

(7) Gross Holding : A situation where the Holding and Subsidiary Companiesown shares in each others.

(8) Wholly - owned subsidiary : A subsidiary company whose all sharesowned by the Holding Company or companies of the same group.

(9) Partly - owned subsidiary : A subsidiary in which the Holding Companyor the group does not hold all the shares.



(A) Multiple Choice Questions

(1) Consolidation of financial statements may mislead the ......... if the activitiesof the subsidiary are very dissimilar from those of other companies withinthe group.

(a) Shareholders

(b) Customers

(c) Bankers

(d) Suppliers

(2) As per ......... consolidated financial statements are the financial statementsof a ‘group’ presented as those of a single enterprise.

(a) AS - 24

(b) AS-18

(c)AS-21

(d) AS -16

(3) Section 212 of the Companies Act,1956 requires that the published accountsof Holding Co. must be accompanies by ..............

(a) the recent Balance Sheet

(b) the Profit and Cost Account

NOTES

44



(c) the Board of Directors Report

(d) all of the above

(4) That part of the net results of operations and of the net assets of a subsidiaryattributable to interests which are owned, directly or indirectly throughsubsidiary by the parent is termed as -------

(a) Majority Interest

(b) Operational Interest

(c) Minority Interest

(d) Parential Interest

Ans : (1 - a) , (2 - c), (3 - d),(4 - c)

II - Long Answer Questions

(1) What are ‘Consolidated Financial Statement ?’ Explain in brief the need ofconsolidated financial statements.

(2) Explain in brief the advantages and disadvantages of consolidation offinancial statement .

(3) Explain the neccesary steps involved in the preparation of consolidatedfinancial statements.

(4) What is ‘ Minority Interest ?’ Explain the procedure for calculation of minorityinterest.

(5) How would you differentiate between Goodwill and Capital Reserve onConsolidation ?

(6) Write Short Notes on :

(a) Minority Interest

(b) Goodwill or Cost of Capital

(c) Inter Company Indebtedness

(d) Need of Consolidated Financial Statements

III - Practical Problems

(1) Prepare a Consolidated Balance Sheet with necessary working notes fromthe Balance Sheet of H Ltd. and S Ltd. and the additional information given belowas on 31st March, 2014



NOTES

45

Balance Sheet as on 31st March 2014


` ` ` `

Share Capital 5,00,000 3,00,000 Buildings 2,00,000 1,00,000

share of ` 100each Machinery 1,50,000 2,00,000

General Reserve 40,000 10,000 Investment 2,97,000 -

Profit and Loss 70,000 5,000 2,700shares in S Ltd.

Bills Payable 50,000 25,000 Stock 40,000 30,000

Creditors 1,40,000 60,000 Debtors 50,000 60,000

Bills Receivable 63,000 10,000

8,00,000 4,00,000 8,00,000 4,00,000


i) On the date of purchase of shares there was no balance in General Reserveand Profit and Loss Account showed a debit balance of `10,000 in thebooks of S Ltd.

ii) Debtors of S Ltd. include Rs. 40,000 due from H Ltd.

iii) Bills Payable of S Ltd. include ` 18,000 in favour of H Ltd. which hasdiscounted ` 3,000 of them .

2.9 Further Reading

• Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - NewDelhi - S. Chand and Co. Pvt. Ltd., 2013

• Sehgal Ashok - Taxman’s Fundamentals of Corporate Accounting - NewDelhi - Taxman Publications Pvt. Ltd., 2012.

NOTES

46



UNIT 3 AS-21 and preparation ofConsolidated Financial Statements

Structure

3.0 Introduction

3.1 Unit Objectives

3.2 AS-21 and preparation of Consolidated Financial Statements

3.2.1 Objectives

3.2.2 Notable Terms

3.2.3 Format of Consolidated Financial Statement

3.3. Scope of Consolidated Financial Statement

3.4 Consolidation Procedure

3.5 Unrealised Losses

3.6 Disclosure

3.7 Practical Examples related to AS-21

3.8 Illustrations

3.9 Summary

3.10 Key Terms



3.0. Introduction

AS-21 deals with the preparation of Consolidated Financial Statement withan intention to provide information about the activities of a group. This statementshould be applied in preparation and presentation of Consolidated FinancialStatements for a group (parent company and companies under its control referredas subsidiary companies) of enterprises under the control of a parent. In a parent’sseparate financial statements investments in subsidiaries should be accounted forin accordance with accounting standard (AS)13 Accounting for Investments.Consolidated Financial Statement normaly include Consolidated Balance Sheet,Consolidated Profit and Loss Account and related notes. The ConsolidatedFinancial Statements under AS-21 mean a complete set of financial statementseven if this means a repetition of notes already disclose in the individuals entityfinancial statement. AS 21 requires Consolidated Financial Statements to include

AS-21 & Preparation OfConsolidated FinancialStatements


NOTES

47

notes and other statements and explanatory material that form an integral partthereof. ICAI has issued ASI 15 on the subject of presentation and disclosure,which concentrated on certain principles should be observed in respect of notesand other explanatory material. It means, in the preparation of consolidated financialstatements, other mandatory accounting standards also apply in the same manneras they apply to separate financial statements.

In preparing consolidated financial statements, the financial statements ofthe parent and its subsidiaries should be combined on a line by line basis addingtogether like items of assets, liabilities, income and expenses. Further balancesand transactions among members of the group must be eliminated. The effect ofthis is to show transaction that have been communicated with outside parties only.

3.1 Unit Objectives

After studying this unit you should able to

• Understand how AS-21 deals with the preparation of Consolidated FinancialStatement.

• Interprete the various notable terms related to AS-21.

• Express the exceptions to AS-21.

• Discuss the terms “negative minority interest”

• Understand the accounting treatment for unrealised losses from inter grouptransactions.

• Give the practical examples related to AS-21.

3.2 AS-21 and preparation of ConsolidatedFinancial Statements

AS-21, deals with the preparation of Consolidated Financial Statementswith an intention to provide information about the activities of a group (ParentCompany and companies under its control referred to as Subsidiary Companies.)

3.2.1. Objectives :

The objectives of this statement is to present financial statement of a parentand its subsidiary as a single economic entity. In other words, the Holding Companyand its subsidiary are treated as one entity for the preparation of these ConsolidatedFinancial Statements. Consolidated Profit or Loss Account and ConsolidatedBalance Sheet are prepared for disclosing the total profit or loss of the group andtotal assets and liabilities of the group. As per this accounting standard, theconsolidated Balance Sheet if prepared should be prepared in the manner prescribedby this statement.

NOTES

48

AS-21 & Preparation OfConsolidated FinancialStatement


3.2.2. Notable Terms :

a) Parent :

A parent is an enterprise that has one or more subsidiaries.

b) Subsidiary :

A subsidiary is an enterprise that is controlled by another enterpriseknown as parent.

c) Control :

Control can be exercised directly or indirectly (through a subsidiary) bypurchasing more than 50% of the voting power of an enterprise or bycontrolling composition of board of directors or governing body. Generally,it is done by purchasing more than 50% of the equity shares (votingpower) of an enterprise.

3.2.3 Format of Consolidated Financial Statements :

These are prepared or presented in the same format as that followed bythe parent for preparation of its separate financial statements.

Application of other accounting standards in preparation of ConsolidatedFinancial Statements :

As per the accounting standard while preparing the Consolidated FinancialStatement, the other accounting standard shall apply in the same manner as theyapply in preparing the separate financial statements.

Accounting for investments made by parents in its subsidiary(ies) whilepreparing separate financial statements:

A parent should account for the investment in subsidiary(ies) in accordancewith AS-13, “Accounting for Investment”. As per AS-13, the investment madeby a parent in subsidiary(ies) should be recorded at cost.

Consolidated Financial Statements are no substitute for separate financialstatements :

Consolidated Financial Statements are not the substitute for separatefinancial statements of a parent and its subsidiary(ies). In other words, a parentand its subsidiary(ies), shall prepare separate financial statements as per governinglaw. The consolidated financial statement made by a parent is in addition to theseparate financial statements

.



NOTES

49

3.3. Scope of Consolidated Financial Statement

A parent, which is required to prepare the Consolidated Financial Statement,should consolidate the financial statement of all its subsidiary(ies), whether domesticor foreign.

Exceptions:

Consolidated Financial Statements are not required to be prepared even ifparent subsidiaries relationship exists when :

• a parent acquires the control (investment in subsidiary), which is intendedto be temporary as the investment (control) is to be disposed in the nearfuture.

• the subsidiary operates under severe long-term restrictions and due to thisits ability to transfer the funds to parent is significantly weakened.

Dissimilar activities of parent and the its subsidiaries cannot be the groundfor non-consolidation of financial statements.

3.4. Consolidation Procedure

In preparing Consolidated Financial Statements the financial statements(Balance Sheet and Profit and Loss Account) of the parent and its subsidiariesshould be combined or added on line by line basis by adding the like items ofassets, like items of liabilities, like items of income and expense.

• The Cost of Investment of parent in each subsidiary should be cancelledor eliminated with parent’s portion of equity of each subsidiary on thedate on which the investment was acquired in each subsidiary. Parentsportion of equity of means share of parent (holding), in equity sharecapital of subsidiary (+) share in reserve and surplus of the subsidiary onthe date of acquisition of share. In other words, parent’s portion of equityin each subsidiary(ies) on the date of acquisition is paid up share capitalheld by holding (+) Share of pre-acquisition profits.

• If cost of investment in a subsidiary exceeds the parent’s (holding) portionof equity i.e. paid up capital held by the holding plus share of pre-acquisitionprofit on the date of consolidation, the excess is Goodwill, and such goodwillarising due to consolidation procedure should be shown as an asset inconsolidated financial statement.

• When the cost of investment in subsidiary is less than the paid up equitycapital held by holding (parent) plus share of pre-acquisiton profits, thedifference is credited Capital Reserve and this capital reserve is shownin consolidated financial statement under the head ‘Reserve and Surplus’.

• Minority Interest should be calculated and shown in the consolidatedfinancial statements separately under separate heads. Minority interestmeans the portion of net assets of subsidiary on the date of consolidation

NOTES

50



Check Your Progress

1. What is AS-21 ?

2 . Define the terms -Parent, Subsidiary andControl as per AS-21.

3 . State the procedure ofconsolidation.

not controlled by the parent, itself or through its subsidiary. Minorityinterest = Paid up equity capital held by an outsider (outside the group)plus share of ‘reserve and surplus’ on the date of consolidation. Preferenceshare capital not held by parent or group is also shown along with minorityinterest.

• While calculating minority interest, share of minority in net profit ofconsolidated subsidiaries for the reporting period should be calculatedand charged against the consolidated profit consequently balance profitafter charging minority interest represents the parent (holding company)share in profit which he shown under the head ‘Reserves and Surplus’ inconsolidated Balance Sheet.

• Intra - Group Balances and transactions i.e. inter-company debtor orcreditors, inter-company purchase or sales and resulting unrealise profitshall be eliminated in full.

3.5. Unrealised Losses

Unrealised Losses from intra-group transactions should also be eliminatedif recoverable amount is more than the cost of transactions, e.g., if X Ltd. (holdingcompany), sells goods costing 5,00,000 to its subsidiary, Y Ltd. at 4,00,000 andon the date of consolidation. The goods are lying in stock of Y Ltd. This recoverableamount of stock is ` 5,50,000; as the recoverable amount is more than the cost ofthe transaction, the unrealised loss of 1,00,000 should be eliminated by addingto stock and adding to consolidated Period and Loss Account in consolidatedBalance Sheet.

It should be noted that if unrealised losses are on account of intra-groupsale or purchase of assets, the recoverable amount shall have the meaning asdescribed in accounting standard on ‘Impairment of Assets’.

Consolidation when different reporting Date :

Financial statement of parents and its subsidiary used for consolidation aregenerally of same date, however when reporting dates are different and it is notpractical to prepare the financial statement of subsidiary of the same date, thedifferent reporting date financial date financial statement can be consolidatedmaking adjustment for the effects of significant transactions that occur betweenthose dates and parent financial statements provided difference is not more thansix months. If parent and its subsidiaries are following different accounting policies,the consolidated financial statement should be prepared using uniform accountingpolicies, if it is not practicable, then the items in which different accounting havebeen followed should be disclosed.

Disposal of investment in a subsidiary :

The difference between the proceeds front the disposal of investments ina subsidiary and the carrying amount of its assets less liabilities as of the date ofdisposal is recognized in the consolidated statement of profit and loss on thedisposal of the investment in a subsidiary.



NOTES

51

Successive purchase of shares in a subsidiary by the parent :

If all enterprise purchases two or more the investment of other enterpriseand eventually obtains control of the other enterprise, the consolidated financialstatement is prepared from the date on which holding subsidiary relationship isestablished. Further, in such cases goodwill or capital reserve on consolidationshould be determined on a step by step basis, however if small investments aremade over a period of time, then the date of latest major investment which resultedin control, should be considered as date of investment for all successive purchasesand, accordingly calculation of goodwill/capital reserve should be made.

Minority interest is in Negative :

When minority interest comes in negative (minus), this should be adjustedagainst majority interest. In other words, negative minority interest will not shownin consolidated Balance Sheet. If the subsidiary subsequently reports profits, allsuch profits should be allocated to majority interest until minority share of lossespreviously absorbed by the majority has been recovered.

Arrears of Cumulative Preference Sheet of a subsidiary :

If the subsidiary has arrears of, cumulative preference shares which areheld outside the group, then the holding company share of profit is calculated aftercharging the arrear of cumulative preference dividend of a subsidiary, whetherdeclared or not.

3.6 Disclosure

Following disclosure should be made in Consolidated Financial Statements

• List of all subsidiaries.

• Proportion of ownership interest.

• Nature of relationship between parent and subsidiary whether direct controlor control through subsidiaries.

• Name of the subsidiary of which reporting dates are different.

• The fact for different accounting policies applied for preparation ofconsolidated financial statement.

• If consolidation of particular subsidiary has not been made as per the groundsallowed in accounting standards the reason for not consolidating should bedisclosed.

AS-21 also focuses on the following points :

• Interpretations issued by the ICAI.

• Transactional provisions.

• Significant differences among AS, IFRS/and US GAAP.

NOTES

52



Check Your Progress

1. Define the term‘Unrealised Losses’.

2 . What disclosures shouldbe made in ConsolidatedFinancial Statements ?

3.7 Practical Examples related to AS-21

EXAMPLE 1

What are the exceptions to AS-21 ?

ANSWER

AS-21 does not deals with :

i) Method of accounting for amalgamations and their effects onconsolidation, including goodwill arising on amalgamation (see AS-14,Accounting for Amalgamations);

ii) Accounting for investments in associates (at present governed byAS-23, Accounting for Investments in Associates in ConsolidatedFinancial Statements) and

iii) Accounting for investments in joint ventures (governed by AS - 27,Financial Reporting of Interests in Joint Ventures).

EXAMPLE 2

If A is holding 60% in B is holding 60% in C, will C be consolidated in Band ultimately in A ?

ANSWER

Consolidation is required when there is ownership of more than one-half ofvoting power directly or indirectly through subsidiaries. In this case though effectiveownership of , A is 36%, A is able to exercise more than one - half of the votingpower in C through its majority holding in B.E.g. of a resolution is put to votein C,A because of its control over B will be able to pass or veto that resolution .Hence, C will be consolidated in B, and consequently in A.

EXAMPLE 3

Parent Co. A owns 100% of subsidiary B and 49% of C. Subsidiary B inturn, owns 10% of C Parent Co. A controls C through direct and indirect ownershipand would therefore consolidate it.

ANSWER

Parent Co. A owns 51% of subsidiary B, which in turn owns 51% ofsubsidiary C. Again parent Co. A control subsidiary C and would consolidate it.On the other hand , if parent company A owned only 49% of B, Control wouldnot result. If company A does not control company B, company B’s investmentin company C is irrelevant to whether company A controls company C.

EXAMPLE 4

X Ltd. is Textile Manufacturing Co., it has purchased 75% equity sharesof Y Ltd., which is a Software Company. X Ltd, did not consolidate the accountsof Y Ltd., on the pretext that subsidiary business is entirely different and it does



NOTES

53

not make sense to consolidate the subsidiary Y Ltd., accounts. Comment.

ANSWER

Contention is not correct as per AS-21.

EXAMPLE 5

While consolidating the financial statement the Minority Interest wascalculated as minus ` 50,000. The accountant wants to show it in assets side ofconsolidated Balance Sheet.

Comment.

ANSWER

` 50,000 to be adjusted with Majority Interest.

3.8 Illustrations

The preparation of consolidated financial statements as per AS-21 can beunderstood with the help of following illustration :-

ILLUSTRATION 1

The following is the condensed Balance Sheet of A Ltd., and its SubsidiaryB Ltd., as on 31-3-2014.



` ` ` `

Share Capital: Fixed Assets 5,58,000 3,45,000

Sh. of 10 each 11,00,000 4,00,000 Stock 2,00,000 1,35,000

Share Premium 1,30,000 - Sundry Debtors 2,85,000 1,55,000

General Reserve - 1,00,000 Investments :

Profit and Loss 1,40,000 30,000 36,000 Shares in

Sundry Creditors 95,000 1,50,000 B Ltd., at cost 3.90,000 -

Cash at Bank 5,000 45,000

14,65,000 6,80,000 14,65,000 6,80,000

You are required to prepare a Consolidated Balance Sheet as on 31-3-2014with necessary workings, having regard to the following :

i) On the date, when A Ltd. acquired the Shares of B Ltd., the latterCompany had a General Reserve of `25,000 and a credit balance onProfit and Loss of `5,000.

ii) B Ltd. had purchased goods from A Ltd., of which ` 70,000 are still inStock A Ltd., sells to B Ltd., at cost plus 25%.

NOTES

54



SOLUTION

Working Notes :

1) It is assumed that A Ltd., acquired Shares of B Ltd. on 1st April, 2013.

2) Shares of A Ltd., in B Ltd.

=Shares acquired by A Ltd.Shares issued by B Ltd.


= 9 10


(i) General Reserve as on 1-4-2013 25,000

(ii) Profit and Loss (Cr.) on 1-4-2013 i.e. Profit (+) 5,000


Capital Profit

` 30,000


` 27,000 ` 3,000(Goodwill)4) Statement of Revenue Profit : `


(i) General Reserve 75,000

(ii) Profit and Loss (Cr.) i.e. profit (+) 25,000

Revenue Profit 1,00,000

Revenue Profit

` 1,00,000





NOTES

55



(4,000 shares x `10) 40,000


43,000






(36,000 shares x `10) (-) 3,60,000

30,000

Less : A Ltd.’s share in Capital Profit (-) 27,000

Goodwill 3,000


A Ltd., sold goods to B Ltd., for `70,000 at cost plus 25%

SP = CP + P

125 = 100 + 25

P=

25 = 1

x ` 70,000SP 125 5

= ` 14,000 x 9

= ` 12,600 10

Hence, Unrealised Profit of `12,600 will be deducted from Stock of BLtd., and from the Consolidated Profit and Loss of A Ltd., in the ConsolidatedBalance Sheet.

8) Statement of Consolidated Profit and Loss Account `


Add : A Ltd.’s share in Revenue Profit (+) 90,000

2,30,000



NOTES

56



Consolidated Balance Sheet of A Ltd. and its Subsidiary B Ltd., as on 31-3-2014


Share Capital : 11,00,000 Goodwill 3,000

• Sh. of `10 each Fixed Assets 9,30,000

Share Premium 1,30,000 A Ltd., 5,85,000

Profit and Loss 2,17,400 B Ltd., (+) 3,45,000

Minority Interest 53,000 Stock 3,22,400

Sundry Creditors 2,45,000 A Ltd., 2,00,000

A Ltd. 95,000 B Ltd., (+) 1,35,000

B Ltd. (+) 1,50,000 3,35,000

Less: Unrealised

Profit (-) 12,600

Sundry Debtors 4,40,000

A Ltd. 2,85,000

B Ltd. (+) 1,55,000

Cash at Bank 50,000

A Ltd. 5,000

B Ltd. (+) 45,000

17,45,400 17,45,400

ILLUSTRATION 2

The Balance Sheet of two companies as at 31-3-2014 is as follows.

Liabilities A Ltd. C Ltd. Assets A Ltd. C Ltd.

` ` ` `

Share Capital : Land and Buildings 2,00,000 1,50,000

Equity Shares of

` 10 each 10,00,000 5,00,000 Machinery 3,00,000 3,00,000

General Reserve 1,00,000 1,00,000 Stock 75,000 50,000

(as on 1-4-2013) Sundry Debtors 50,000 60,000

Profit and Loss 50,000 30,000 Investment at cost in

(as on 1-4-2013) the Shares of C Ltd. 5,00,000 -

Profit for the year Bills Receivable 10,000 5,000

(2013-2014) 60,000 40,000 Cash at Bank 1,55,000 1,60,000

Sundry Creditors 70,000 50,000


12,90,000 7,25,000 12,90,000 7,25,000


i) A Ltd. acquired 40,000 Equity Shares of C Ltd. on 1st April, 2013.



NOTES

57

ii) Bills Receivable of A Ltd., include ` 3,000 accepted by C Ltd.

iii) Sundry Debtors of A Ltd., include `10,000 due from C Ltd.

iv) Stock of C Ltd., includes goods purchased from A Ltd., for `30,000which were invoiced by A Ltd., at a profit of 25% on the invoice price.

Prepare a Consolidated Balance Sheet of A Ltd. and its Subsidiary C Ltd.as at 31-3-2014

SOLUTION

Calculation and Notes :

1) A Ltd. acquire Equity Shares of C Ltd., on 1st April, 2013.

2) Share of A Ltd., in C Ltd.

=Shares acquired by A Ltd. Shares issued by C Ltd.


=45


i) General Reserve on 1-4-2013 1,00,000

ii) Profit and Loss (Cr.) on 1-4-2013 i.e. Profit + 30,000

Capital Profit 1,30,000

Capital Profit

` 1,30,000


` 1,04,000 ` 26,000(Goodwill)4) Statement of Revenue Profit : `

Profits earned from 1-4-2013 to 31-3-2014 i.e. NIL

Profit for the year 2013-2014 i.e. Profit (+) 40,000


Revenue Profit

` 40,000


` 32,000 ` 8,000(Consolidated Profit and Loss Account)

NOTES

58




Face value of shares held by Minority 1,00,000

(10,000 shares x ` 10)


1,26,000


Minority Interest 1,34,000

6) Statement of Capital Reserve : `



(40,000 shares x ` 10) (-) 4,00,000

1,00,000

Less : A Ltd.’s share in Capital Profit (-) 1,04,000



A Ltd., invoiced goods to C Ltd., for 30,000 at a profit of 25% on theinvoice price.

SP = CP + P

100 = 75 + 25

P=

25=

1 x ` 30,000SP 100 4

= ` 7,500 x 4 = ` 6,000

5Hence, Unrealised Profit of 6,000 will be deducted from Stock of C Ltd.,

and from the Consolidated Profit and Loss of A Ltd., in Consolidated BalanceSheet.


Profit and Loss (Cr. ) on 1-4-2013 50,000

Add : Profit for the year 2013-2014 60,000

Add : A Ltd.’s share in Revenue Profit (+) 32,000

1,42,000

Less: Unrealised Profit (-) 6,000




NOTES

59

Consolidated Balance Sheet of A Ltd. and its Subsidiary C Ltd., as on 31-3-2014


Share Capital : 10,00,000 Land and Buildings 3,50,000

Equity Shares of A Ltd. 2,00,000

Rs.10 each C Ltd. (+) 1,50,000

Capital Reserve 4,000 Machinery 6,00,000

General Reserve 1,00,000 A Ltd. 3,00,000

on 1-4-2013 C Ltd. (+) 3,00,000

Profit and Loss 1,36,000 Sundry Debtors 1,00,000

Sundry Creditors 1,10,000 A Ltd. 50,000

A Ltd. 70,000 C Ltd. (+) 60,000

C Ltd. (+) 50,000 1,10,000

1,20,000 Less:Inter-Co.

Less: Inter-Co. owings (-) 10,000

owing (-) 10,000 Bills Receivable 12,000

Bills Payable 12,000 A Ltd. 10,000

A Ltd. 10,000 C Ltd. (+) 5,000

C Ltd. (+) 5,000 15,000

15,000 Less : Inter-Co. (-) 3,000

Less: Inter-Co. (-) 3,000 owings

owings Stock 1,19,000Minority Interest 1,34,000 A Ltd. 75,000

C Ltd. (+) 50,000

1,25,000

Less :Unrealised

Profit 6,000

Cash at Bank 3,15,000

A Ltd. 1,55,000

C Ltd. (+) 1,60,000

14,96,000 14,96,000

NOTES

60



ILLUSTRATION 3

From the following information, prepare a Consolidated Balance Sheet ofH Ltd., and its Subsidiary S Ltd., as at 31-3-2014 giving detailed working notes :


Liabilities H Ltd. S Ltd.

` `

Share Capital :

Equity Share of ` 10 each 4,00,000 2,00,000

General Reserve 2,00,000 60,000

Profit and Loss 1,00,000 40,000

6% Debentures - 1,00,000

Loan from H Ltd. - 10,000

Sundry Creditors 1,00,000 40,000


8,50,000 4,80,000

Assets H Ltd. S Ltd.

` `

Goodwill 1,00,000

Fixed Assets 2,00,000 2,50,000

Investments :

i) 16,000 Shares of 10 each in S Ltd., at cost 2,00,000 -

ii) 6% Debentures of S Ltd., (Face value 60,000) 60,000 -

iii) Government Securities - 50,000

Stock 1,00,000 40,000

Sundry Debtors 80,000 40,000

Bills Recevable 40,000 -

Bank Balance 60,000 1,00,000

Loans to S Ltd. 10,000 -

8,50,000 4,80,000


i) Sundry Creditors of H Ltd., include ` 20,000 due to S Ltd.

ii) The Closing Stock of H Ltd., includes stock worth 30,000 supplied byS Ltd., which had invoiced at cost plus 20% profit on cost.

iii) Bills Payable of S Ltd., include Rs.24,000 issued in favour of H Ltd.,which was discounted but yet matured ` 4,000 of them.

iv) H Ltd., acquired 16,000 Equity Shares in S Ltd., on 1st April, 2013 onwhich date the Balance Sheet of S Ltd., showed General Reserve at



NOTES

61

` 20,000 and Profit and Loss Account credit balance of ` 10,000.

v) H Ltd., revalued Fixed Assets of S Ltd., as on 1-4-2013 at ` 2,60,000.

SOLUTION

Working Notes :

1) H Ltd., acquired shares in S Ltd., on 1st April, 2013.

2) Share of H Ltd., in S Ltd. :

=Shares acquired by H Ltd.Shares issued by S Ltd.

= 16,000 shares

20,0000 shares

= 45


(i) General Reserves as on 1-4-2013 20,000

Add : Profit and Loss (Cr.) as on 1-4-2013 10,000

Add : Increase in value of Fixed Assets of S Ltd.,

as on 1-4-2013 (+) 10,000


Capital Profit

` 40,000


` 32,000 ` 8,000(Goodwill)



i) General Reserve 40,000

ii) Profit and Loss (Cr.) (+) 30,000


Revenue Profit

` 70,000



NOTES

62




Face value of shares held by Minority 40,000

(4,000 shares x ` 10 )

Add :Capital Profit 8,000




Cost of Shares acquired by H Ltd. 2,00,000


(16,000 Shares x `10) (-) 1,60,000

40,000

Less : H Ltd.’s share in Capital Profits (-) 32,000

8,000

Add : Goodwill as per Balance Sheet (-)1,00,000

(H Ltd., 1,00,000)

Goodwill 1,08,000


The Closing Stock of H Ltd., includes Stock worth ` 30,000 supplied by SLtd. invoice at cost plus 20%.

SP = CP + P

120 = 100 + 20

P=

20=

1x ` 30,000

SP 120 6

= ` 5,000 x4 = ` 4,0005

Therefore, 4,000 being unrealised profit will be deducted from the ClosingStock of S Ltd., and from the Consolidated Profit and Loss Account of H Ltd., inConsolidated Balance Sheet.


Profit and Loss as on 31-3-2014 1,00,000


1,56,000

Less : Unrelised Profit (-) 4,000




NOTES

63

Consolidated Balance Sheet of H Ltd., and its Subsidiary S Ltd.,as on 31-3-2014.


Share Capital : Goodwill 1,08,000

• Equity Shares of Fixed Assets

` 10 each 4,00,000 H Ltd. 2,00,000

General Reserve 2,00,000 S Ltd. (+) 2,60,000 4,60,000

Profit and Loss 1,52,000 Investments

6% Debentures (i) Government

S Ltd. 1,00,000 Securities 50,000

Less : held by H Ltd. (-) 60,000 40,000 (ii) 6% Debenture 60,000

Minority Interest 62,000 Less: Held by

Loan from H Ltd. 10,000 H Ltd. (-) 60,000 NIL

Less :Inter-Company 10,000 NIL Stockowings(-) H Ltd. 1,00,000

Sundry Creditors S Ltd. (+) 40,000

H Ltd. 1,00,000 1,40,000

S Ltd. (+) 40,000 Less: Unrealised

1,40,000 Profit (-) 4,000 1,36,000

Less : Inter-Company Sundry Debtorsowings (-) 20,000 1,20,000 H Ltd. 80,000

Bills Payable S Ltd. (+) 40,000

H Ltd. 50,000 1,20,000

S Ltd. (+) 30,000 Less:Inter -

80,000 Company owings(-) 20,000 1,00,000

Less: Inter-Company Bills Receivable

owings (-) 20,000 60,000 H Ltd. 40,000

Contingent Liability for - S Ltd. (+) NIL

Bills Recevable discount 40,000

by H Ltd., 4,000 Less :Inter -

Company owings (-) 20,000 20,000

Bank Balance

H Ltd. 60,000

S Ltd. (+) 1,00,000 1,60,000

Loan to S Ltd. 10,000

Less : Inter -

Company owings(-) 10,000 NIL

10,34,000 10,34,000

NOTES

64



ILLUSTRATION 4

The summerised Balance Sheet of H Ltd., and M Ltd., as on 31-3-2014were as follows :

Liabilities H Ltd. M Ltd. Assets H Ltd. M Ltd.

` ` ` `

Share Capital : 2,50,000 1,00,000 Premises 75,000 90,000

Equity Shares of Plant 1,20,000 54,700

` 100 each Investment 1,70,000 -

Capital Reserve - 60,000 (Sh. in M Ltd.,

at cost)

General Reserve 1,20,000 - Stock 70,000 18,000

Profit and Loss 28,600 18,000 Debtors 21,000 20,000

Bank Overdraft 50,000 - M Ltd.’s Current

Bills Payable - 4,200 Account 1,000 -

Creditors 23,550 4,000 Cash at Bank 7,250 4,000

H Ltd.’s Current A/C - 500 Bills Receivable 7,900 -

4,72,150 1,86,700 4,72,150 1,86,700

H Ltd., acquired 800 Equity Shares of `100 each in M Ltd., on

30th March, 2013.

i) Creditors of H Ltd., include ` 6,000 due to M Ltd.

ii) ` 1,500 of the bills are drawn by H Ltd., on M Ltd.

iii) The directors are advised that the Premises of M Ltd. are undervaluedby `10,000 and its Plant is overvalued by ` 5,000.

iv) A cheque for ` 500 sent by M Ltd., to H Ltd., on 30-3-2014 wasreceivable H Ltd., on 3-4-2014.

Prepare a Consolidated Balance Sheet on 31-3-2014.

SOLUTION

Working Notes :

1) H Ltd., acquired Equity Shares in M Ltd., on 30th June, 2013.

2) Share of H Ltd., in M Ltd. :

= Shares acquired by H Ltd.

Shares issued by M Ltd.

= 800 Shares1,000 Shares

=45



NOTES

65



Add : Profits earned from 1-4-2013 to 30-6-2013

3 Profits for the year 2013-2014 4,500

12 x

` 18,000

Add : Undervaluation of Premises of M Ltd. (+) 10,000

74,500

Less : Overvaluation of Plant of M Ltd. (-) 5,000


Capital Profit

` 69,500


` 55,600 ` 13,900(Goodwill)



9 x

Profits for the year 2013-201412 ` 18,000 (+) 13,500


Revenue Profit

` 13,500




Face Value of shares held by Minority

(200 Shares x ` 100) 20,000


33,900



NOTES

66




Cost of Shares acquired by H Ltd. 1,70,000


(800 shares x ` 100) (-) 80,000

90,000

Less : H Ltd.’s shares in Capital Profit (-) 55,600

Goodwill 34,400




Profit and Loss(Cr.) 39,400

Consolidated Balance Sheet of H Ltd., and its Subsidiary M Ltd.,as on 31-3-2014


Share Capital : 2,50,000 Goodwill 34,400• Equity Shares of Premises` 100 each H Ltd. 75,000General Reserve 1,20,000 M Ltd. 90,000Profit and Loss 39,400 Add :Minority Interest 36,600 Increase +10,000 1,00,000 1,75,000Bank Overdraft 50,000 Plant 1,20,000Bills Payable 2,700 H Ltd. 54,700 (+)

H Ltd. NIL M Ltd.(-)5,000 49,700 1,69,700M Ltd. (+) 4,200 Less: Decrease

4,200 Bills ReceivableLess :Inter - H Ltd. 7,900company owings (-) 1,500 M Ltd. (+) NILCreditors 21,550 7,900

H Ltd. 23,550 Less :Inter - Co.M Ltd. (+) 4,000 owings (-) 1,500 6,400

27,550 DebtorsLess : Inter - Co. H Ltd. 21,000owings (-) 6,000 M Ltd. (+) 20,000

41,000Less: Inter - Co.owings (-) 6,000 35,000Cash in Transit* 500Stock

H Ltd. 70,000M Ltd. (+) 18,000 88,000

Cash at BankH Ltd. 7,250M Ltd. (+) 4,000 11,250

5,20,250 5,20,250



NOTES

67

• N.B. : Cash in Transit represents ` 500 cheque sent by M Ltd., to HLtd., on 30-3-2014, but received by H Ltd., on 3-4-2014 i.e. after the date ofBalance Sheet as on 31-3-2014. Hence, shown as Cash in Transit as on the dateof Balance Sheet i.e. 31-3-2014. This reflects the difference in the Current AccountBalance of both the companies which gets squared off against each other.

3.9 Summary

• AS-21 deals with the preparation of consolidated financial statement withan intention to provide information about the activities of group.

• The objectives of this statement is to preset financial statement of a parentand its subsidiaries as a single economic entry.

• A parent and its subsidiary shall prepare separate financial statements asper governing law. The consolidated financial statement made by a parentis in addition to the separate financial statement.

• ‘Minority Interest’ should be calculated and shown in the consolidatedfinancial statements separately under separate heads.

• Unrealised Losses from intra-group transaction should also be eliminated ifrecoverable amount is more than the cost of transaction.

• When minority interest comes in negative (minus) this should be adjustedagainst majority interest .

• AS - 21 also focuses on the following points:

a) Interpretations issues by the ICAI

b) Transactional provisions

c) Significant differences among AS, IFRS/IAS and USGAAP.

3.10 Key Terms

(a) Parent : A parent is an enterprise that has one or moresubsidiaries (Also known as Holding Enterprise)

(b) Subsidiary : A subsidiary is an enterprise that is controlled by anotherenterprise known as parent.

(c) Control : Control can be exercise directly or indirectly (througha subsidiary) by purchasing more than 50% of thevoting power of an enterprise or by controllingcomposition of board of directors or governity body.

(d) Minority Interest : Minority Interest means the portion of net assets ofsubsidiary on the date of consolidation not controlled

NOTES

68



by the parent it self or through it subsidiary.

Minority Interest : Paid up equity capital held by an outsider (out side thegroup) plus share of reserves and surplus on the dateof consolidation (Are forever share capital not held byparent or group is also shown along with minorityinterest.)

(e) Consolidated Financial Statement : These statements are intended topresent financial information about a parent and itssubsidiaries as a single economic entity to shown theeconomic resources controlled by the group.


I. Objective Questions


(1) AS-21 deals with the preparation of consolidated financial statement withan intention to provide information about the activities of a ..........

(a) group

(b) association

(c) holding co.

(d) subsidiary co.

(2) The holding company and its subsidiary are treated as are.......for thepreparation of consolidated financial statement

(a) business

(b) entity

(c) organisation

(d) group

(3) A parent should account for the investment in subsidiary in accordancewith ..........

(a) AS - 21

(b) AS - 17

(c) AS - 13

(d) AS - 9

(4) When the cost of investment in subsidiary is less than the paid-up equitycapital held by holding plus share of pre-acquisition profits, the difference iscredited to ---------- Account.



NOTES

69

(a) Secret Reserve

(b) Revenue Reserve

(c)Investment fluctuation Reserve

(d) Capital Reserve

Ans : (1-a), (2-b), (3-c), (4-d)

II . Long Answer Questions

(1) What is AS-21? Explain the objective and scope of AS-21

(2) Explain in brief the application of other accounting standards in thepreparation of consolidated financial statements.

(3) While preparing a consolidated Balance Sheet how would you deals with

a) Arrears of cumulative preference share of a subsidiary

b) Minority interest is in negative

c) Successive purchase of shares in a subsidiary by the parent

(4) Define a ‘Subsidiary Company’ as per AS-21. How a subsidiary can becontrolled by a parent company.

(5) Write short notes on :

(a) Objective of Consolidated Financial Statements

(b) Consolidation Procedure

(c) Unrealised Losses

(d) Impairment of Assets

NOTES

70



III. Practical Problems :

1) The Balance Sheet of K Ltd., and P Ltd., as on 31-3-2014 were as under :

Liabilities K Ltd. P Ltd. Assets K Ltd. P Ltd.

` ` ` `

Share Capital : 2,00,000 50,000 Buildings 60,000 -

Shares of ` 10 each - Plant 2,00,000 -

Reserve Fund 30,000 10,000 Stock 40,000 85,000

Profit and Loss Debtors 10,000 30,000

Balance as on Bank 10,000 10,000

1-4-2013 40,000 20,000 3,000 shares in P Ltd. 65,000 -

Profit for the year Bills Receivable - 10,000

2013-2014 50,000 25,000

Creditors 30,000 30,000

Bank Overdraft 20,000 -

Bills Payable 15,000 -

3,85,000 1,35,000 3,85,000 1,35,000

K Ltd., purchased Shares of P Ltd. on 1st October, 2013 at a cost of` 65,000. The Bills Payable of K Ltd., included bills amounting to 10,000 drawnby P Ltd., and payable to P Ltd. The Debtors of P Ltd., included the debts duefrom K Ltd., in respect of goods supplied to them for `6,000.


2) The following are the Balance Sheet of M Ltd., as on 31-3-2014. M Ltd.,acquired the shares in N Ltd., at a cost of ` 2,10,000 on 1st April, 2013.

Liabilities M Ltd. N Ltd. Assets M Ltd. N Ltd.

` ` ` `

Share Capital : 7,00,000 90,000 Premises 3,30,000 56,000

Shares of ` 10each Plant 1,40,000 52,000

General Reserve 2,00,000 4,000 Shares inN Ltd. 2,10,000 -

(1-4-2013) (at cost)

Profit and Loss 1,80,000 72,000 Stock 1,24,000 36,000

Creditors 20,000 28,000 Debtors 70,000 28,000

Cash 1,26,000 22,000

11,00,000 1,94,000 11,00,000 1,94,000

The Creditors include ` 10,000 due to N Ltd., for purchases on which thelatter Company made a profit of ` 2,000. The stock includes ` 3,000 of theabove purchases from N Ltd.




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3) The following are the Balance Sheet of X Ltd., and Y Ltd., as on 31-3-2014.

Liabilities X Ltd. Y Ltd. Assets X Ltd. Y Ltd.

` ` ` `

Eq. Share Capital : Fixed Assets 7,00,000 3,00,000

Equity Shares of 10,00,000 4,00,000 Stock 1,80,000 80,000

` 100 each Debtors 1,20,000 60,000

General Reserve 2,00,000 - Investments -

Profit and Loss 1,90,000 - i) 6%Debentures

Creditors 1,20,000 90,000 in Y Ltd. 1,20,000 -

6% Debentures - 2,00,000 ii) 3,000 Shares

in Y Ltd. at cost 2,40,000 -

Cash 1,50,000 50,000

Profit and Loss - 2,00,000

15,10,000 6,90,000 15,10,000 6,90,000

X Ltd., acquired the Shares in Y Ltd., on 1st October, 2013. The Profit andLoss of Y Ltd., showed a debit balance of ` 3,00,000 on 1-4-2013. Creditors ofY Ltd., include ` 40,000 for goods supplied by X Ltd., made a profit of 4,000.Half of the goods were still in Stock on 31-3-2014.


4) S Ltd., acquired 8,000 Equity Shares of V Ltd., on1st April ,2013. The followingare the Balance Sheets of the two companies as at 31-3-2014.

Liabilities S Ltd. V Ltd. Assets S Ltd. V Ltd.

` ` ` `

Shares Capital 20,00,000 10,00,000 Buildings 5,00,000 3,00,000

Equity Shares of Machinery 5,00,000 6,00,000

` 100 each Stock 1,50,000 1,00,000

General Reserve Debtors 1,00,000 1,20,000

(1-4-2013) 4,00,000 2,00,000 Investments in

Profit and Loss 1,00,000 60,000 shares of V Ltd. 10,00,000 -

(1-4-2013) Bills Recevable 80,000 -

Profit for the year Cash and Bank 5,00,000 3,30,000

2013-2014 2,00,000 80,0000

Creditors 1,00,000 1,00,000


28,30,000 14,50,000 28,30,000 14,50,000

Other information is an follows :

i) Bills Recevable of S Ltd., includes ` 10,000 by V Ltd.

ii) Debtors of S Ltd., include ` 50,000 due from V Ltd.

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iii) Stock of V Ltd., includes goods purchased from S Ltd., for 60,000 whichwere invoiced by S Ltd., at a Profit of 25% on cost.

Prepare a Consolidated Balance Sheet of S Ltd., and its Subsidiary V Ltd.,as on 31-3-2014.

5) The Balance Sheet of A Ltd., and B Ltd., as on 31-3-2014 were as follows :


` ` ` `

Share Capital : 10,00,000 2,50,000 Goodwill 1,00,000 50,000

Equity Shares of Land 2,00,000 1,00,000

Rs10 each Plant 5,00,000 2,00,000

General Reserve 2,00,000 80,000 Stock 2,00,000 1,00,000

(1-4-2013) Investments 3,40,000 -

Profit and Loss 60,000 60,000 Bills Receivable 30,000 -

(1-4-2013) Cash at Bank 50,000 20,000

Profit for the year Debtors 2,40,000 70,000

ended 31-3-2014 1,50,000 50,000

Creditors 2,50,000 1,30,000

16,60,000 5,70,000 16,60,000 5,70,000

The following information is given :

A Ltd., acquired 15,000 Equity Shares of B Ltd., for 1,90,000 on 1st April, 2013.

Debtors of A Ltd., include `30,000 due from B Ltd.

Bills Receivable of B Ltd., include ` 10,000 due from A Ltd.

The Stock of B Ltd., Include goods purchased from A Ltd. of `10,000 whichincludes profit charged by A Ltd., at 25% on cost.




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73

Topic 2 Human Resource Accounting

Unit 4 Meaning, Objectives andMeasurements in HumanResources Accounting

Unit 5 Measurement in HRA - EconomicValue Approach

Unit 6 Human Resource Accounting In India

Unit 4 Meaning, Objectives and Measurementsin Human Resources Accounting

Structure

4.0 Introduction

4.1 Unit Objectives

4.2 Meaning and Concept of Human Resource Accouting

4.2.1 Objectives of Human Resource Accounting

4.4.2 Purpose of Human Resource Accounting

4.3 Need of Human Resource

4.4 Historical Development of Human Resource Accounting Concept

4.5 Importance in Human Resource Accounting

4.6 Measurements in Human Resource Accounting

(A) Cost Approach

(a) Original or Historical Cost Approach

(b) Opportunity Cost Approach

(c) Replacement Cost Approach

(d) Adjusted Present Value

4.7 Illustrations

4.8 Summary

4.9 Key terms

4.10 Questions and Exercise


4.0 Introduction

Human resources are the chest important assets of an organisation andtheir effective management is the key to its success. HRA (Human ResourceAccounting) means accounting for people as the organisational resource. HumanResource Accounting is the measurement of the cost and value of people toorganisation and involves measuring the costs incurred on recruitment selecting,living, training and developing employees and judging their economic value to theorganisation. Human Resource Accounting can be very useful in decision making.Human Resource Accounting can provide data pertaining to turnover cost, the

Meaning Objectives &Measurements In HumanResources Accounting


NOTES

75

cost of employee absence and its the process of recruitment and selection HumanResource Accounting can provide an estimate of the cost involves in the processof recruitments and selection or replacement of an employee.

Human Resource Accounting is a means of measuring the cost and valueof people. It is one of the modern developments in the area of accounting. Thougha good amount of research has been rapidly accumulated in the science of humanresource managing the measurement aspect of human resources is touched veryperipherally. The frame work of human resource accounting is concerned withthe efforts of the accounting research to prepare human resource investment andvalue analysis for managerial planning an control. It is acknowledged that humanResource Accounting will represent one of the major innovations in behavioralaspects of accounting and control system in the decades to come. Applyingaccounting tools and techniques to the area of human Resource management is achallenging responsibility.

4.1 Unit Objectives


• Understand the concept of Human Resource Accounting.

• Recognise the need for human resource accounting.

• Determine the importance of human resource accounting.

• Find out the different approaches and models for valuation of humanresources.

• Explain the meaning of certain key terms used in Human ResourceAccounting.

• Explain the Historical Development of Human Resource Accountingconcept.

4.2 Meaning and Concept of Human ResourceAccounting

According to Emch & Arnold F,

Human resource system in an organisation operates with production as thecentral processing function. The human resource input influence on the productionactivity result in actual human output. This is compared with the preplanned humanoutput and significant deviations are investigated and rectified through theadjustments of input factors. The effectiveness of human organisation dependsupon the continuous improvement of productive interaction between human inputsand production process. The greater the degree of productive interaction the greaterwill be the human recourse effectiveness and vice versa. As such, the relation

NOTES

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between human input and human output is vitally dependant on adaptation ofproduction planning and control to the planning and control of human inputs.

The behaviour of human resource inputs is to be adjusted for improving thequality of human resource output. In other words, the influence of human resourceinputs on production activity would result in a set of human resource outputvariables. These output variables are : (i) Magnitude resource investments, (ii)Efficiency of human resource investments, (iii) Magnitude of human resourcevalue and (iv) Relative efficiency of human resources.’

The American Accounting Association’s Committee on Human ResourceAccounting (1973) has defined Human Resource Accounting as “the processof identifying and measuring data about human resource and communicating thisinformation to interested parties”. Human Resource Accounting, thus, not onlyinvolves measurement of all the costs/investments associated with the recruitmentplacement, training and developments of employees, but also the quantification ofthe economic value of the people in an organisation.

Flamholtz (1971) too has offered a similar definition for Human ResourceAccounting. They define Human Resource Accounting as “the measurementsand reporting of the cost and value of people in organizational resources”.

Mr. Woodruff Jr. president of R.G. Barry Corporation, defines is as follows:

“Human resources accounting is an attempt to identify and report investmentsmade in human resources of an organisation that are presently not accounted forin conventional accounting practice. Basically it is an information system that tellsthe management what changes over time are accruing to the human resources ofthe business”.

In simple words, “Human resource accounting is the art of valuing recordingand presenting the worth of human resources in the books of accounts of anorganisation. Accordingly, human resources accounting is an information system.It involves measuring the costs incurred by business to recruit, select, train anddevelop personnel, evaluate their economic value, and report to management thechanges occurring in this asset management may use of this information forplanning, budgeting and control of human resources.

Thus, human resource accounting is primarily involved in measuring thevarious aspects related to human asses. Its basic purpose is to facilitate the effectivemanagement of human resources by providing information to acquiring, develop,retain, utilize, and evaluate human resources.

4.2.1. Objectives of Human Resource Accounting

The objectives of human resource accounting are as follows :

(i) To provide cost value date for managerial decisions regarding acquiring,developing, allocating and maintaining human resource so as attain costeffective organizational objectives.



NOTES

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(ii) To provide information for effectiveness of human resources utilization.

(iii) To provide information for determining the status of human asset whether itis conserved properly: it is appreciating or depleting.

(iv) To assist in the development of effective human resource Managementpractices by classifying the financial consequences of these practices.

(v) To Develope new measures of effective manpower utilisation & betterhuman resource planning.

4.2.2 Purposes of Human Resource Accounting

According to Likert (1971), Human Resource Accounting serves thefollowing purposes in an organisation:

(a) It furnishes cost/value information for making management decisions aboutacquiring allocating, developing and maintaining human resources in orderto attain cost-effectiveness.

(b) It allows management personnel to monitor effectively the use of humanresources;

(c) It provides a sound and effective basis of human asset control, that is,whether the asset is appreciated, depleted or conserved;

(d) It helps in the development of management principles by classifying thefinancial consequences of various practices.

Basically, Human Resource Accounting is a management tool which isdesigned to assist senior management in understanding the long term cost andbenefit implications of their HR decisions so that better business decisions can betaken.If such accounting is not done,then the management runs the risk of takingdecisions that may improve profits in the short run but may also have severerepercussions in future.

4.3 Need of Human Resource Accounting

Dr. Prubhakara rao, in his book “Human Resource Accounting” stated that

The human output can be recognised as the manual or mental, creative ortechnical services rendered by the employees. Very often the effectiveness ofhuman resource system would directly of indirectly interact with the effectivenessof the total system. Human Resource Accounting is the need the of the day tomeasure the human input/output behaviour and to provide useful information forhuman resource planning and control operations.

The basic premises underlying the theory of Human Resource Accountingare many. Among them the contemporary thoughts on human resource cost andvalue variables and their changes. Dominated the thinking of researchers from anumber of disciplines. In fact, the area is a multi-disciplinary one, demanding

NOTES

78



pragmatic and relevent thoughts from accounting as well as economics coupledwith the management of human resources.

The need of human resource accounting is felt because of the vitality ofmanpower as an asset of the modern enterprise. It is people who employ, plan,promote and produce to accomplish the organsational goals. The preponderanceof people as the most valuable assets, has been acknowledged since timesimmemorial. The organisational climate that provides an opportunity of makingthe fullest contribution of its people is said to be effective. Man is not a substituteof subordinate to the inanimate assets as well as advancements is productionmethods and systems. The so-called sophisticated and scientific work study,technological exacerbations and innovative adaptations as well as organisationalmanifestations can be antiproductive unless they are recognised to be a broad setof guidelines within which the individual literally performs his job.

The skills and abilities of human beings are included in the concept of fixedcapital by Adam Smith. He has attributed the variances in wage-rates to thecorresponding differences in the level of education and training of people. AlfredMarshall has also acknowledged that the investment in man is similar to investmentin plant and machinery, Schultz has stated that human capital may be accumulatedthrough imparting knowledge and skills and also through the experience on thejob. Schultz has argued that the human resource investments do not exactlyrepresent the value of human capital. Many scholars have opined that thecapitalisation of wage or salary may be an agreed basis for valuing people. Thurowhas added that when the value of marginal product is not equal to the earnings ofthe employees, the capitalisation of earnings stream method may not hold goodfor valuing people”

In addition to facilitating internal decision making processes, HumanResource Accounting also enables critical external decision makers, especiallythe investors in making realistic investment decisions. Investors make investmentdecisions based on the total worth of the organisation. Human Resource Accountingprovides the investors with a more complete and accurate account of theorganisation total worth, and therefore, enables better investment decisions.

Furthermore, in a business environment where corporate social responsibilityis rapidly gaining ground, Human Resource Accounting reflects the extent to whichorganisation contributes to society’s human capital by investing in its development.



NOTES

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Check Your Progress

1. What is Human ResourceAccounting’ ?

2 . State the basic objectivesof Human ResourceAccounting.

3 . What purposes are servedby Human ResourceAccounting according to‘Likert’ ?

4

5

1

2

3

1960-66

1980onw

ards

NOTES

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4.4 Historical Development of Human ResourceAccounting Concept

Developmentof

Human Resource Accounting

inFive Stages

The development of Human Resource Accounting as a systematic anddetailed academic activity, according to Eric G Falmholtz (1999) began in sixties.He divides the development into five stages. These are :

First stage (1960-66) : This makes the beginning of academic interest in thearea of HRA. However, the focus was primarily on deriving Human ResourceAccounting concepts from other studies like the economic theory of capitalpsychological theories of leadership effectiveness, the emerging concepts of humanresources as different from personnel or human relation; as well ad themeasurement of corporate goodwill.

Second stage (1966-71) : The focus here was more on developing and validatingdifferent models for Human Resource Accounting. These models covered bothcosts and the monetary and non-monetary value of HR. The aim was to developsome tools that would help the organisations in assessing and managing their humanresource/asset in a more realistic manner. One of the earliest studies here wasthat of Roger Hermanson, who as part of his Ph. D. studied the problem ofmeasuring the value of human assets as an element of goodwill. Inspired by hiswork, a number of research projects were undertaken by the researchers to developthe concepts and methods of accounting for human resource.

Third stage (1971-76) : This period was marked by a widespread interest in thefield of Human Resource Accounting leading to a rapid growth of research in thearea. The focus in most cases was on the issues of application of Human ResourceAccounting in business organisation. R.G. Barry experiments contributedsubstantially during this stage. (R.G. Barry Corporation : 1971)

Forth Stage (1976 - 1980) : This was a period of decline in the area of HRAprimarily because the complex issues that needed to be explored required muchdeeper empirical research than was needed for the earlier simple models. TheOrganisation, however, were not prepared such research. They found the idea ofHRA interesting but did not find much use in pumping in large sums or investinglot of time and energy in supporting the research.

Fifth Stage (1980 Onwards) : There was a sudden renewal of interest in thefield of Human Resource Accounting partly because most of developed economicshas shifted from manufacturing to service economics and realized the criticalityof human asset for their organisations. Since the survival, growth and profits ofthe organisations were perceived to be dependent more on the intellectual assetsof the companies more than on the physical assets, the need was felt to havemore accurate measures for HR costs, investments and value.

An important outcome of this renewed interest was that unlike the previousdecades, when the interests were mainly academic with some practical applications,from mid 90s the focus has been on greater application of Human ResourceAccounting to business management.

Different types of models to suit the specific requirements of the organisationshave been developed incorporating both the tangible and the intangible aspects.Also, larger number of organisations actually began to use Human ResourceAccounting as part of their managerial and financial accounting practice.

Today, human and intellectual capital are perceived to be the strategicresources and therefore, clear estimation of their value has gained significantimportance. The increased pressures for corporate governance and the corporatecode of conduct demanding transparency in accounting have further supportedthe need for developing methods of measuring human value.

4.5 Importance of Human Resource Accounting

Human Resource Accounting helps decision making process. It is moreuseful for internal decision making specially while discharging personnel function.Brummet and others observed that managerial decisions will be made differentlyif human resource accounting information is considered. A study conducted byFlamholtz to examine the effects of human resource cost data and value data onpersonnel allocation decision, revealed significant differences. The impact oflearning costs on productivity showed significant correlation proving the hypothesisthat learning cost is essentially an investment in Human Assets. For decisions onemployee turnover, positional replacement costs have been considered. Thepositional replacement costs consist of direct and indirect costs on acquisition,learning and human resource turnover. Woodruff argued that human resourceaccounting data has many applications in improving planning and controlling ofhuman resource investments.

The necessary investments needed to meet the expected human resource



NOTES

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requirements, the rate to return on such investments and the decisions relating toallocation of human resources for must profitable areas of operation, will be guidedby the information generated from a system of human resource accounting.Investment allocation decisions on human or non-human activities can be examinedin the light of relative efficiency. The decisions on employee turnover may beinvestigated with the help of turnover analysis provided by human resourceaccounting.

4.6 Measurements in Human Resource Accounting

The two main approaches usually employed for valuation of humanresources.

Two approaches for Valuation of Human Resources :

I) The cost approach which involves methods based on the costs incurredby the company, with regard to an employee.

II) The economic value approach which includes methods based on theeconomic value of the human resources and their contribution to thecompany’s gains. This approach looks at human resources as assetsand tries to identify the stream of benefits flowing from the asset.

(I) The Cost Approach : Cost is a sacrifice incurred to obtain some anticipatebenefit of service. All costs have two portions, viz, the expense and assetsportions. The expense portion is that which provides benefits during thecurrent accounting period, where as the asset portion is that which isexpected to give rise to benefits in the future.

1) Original or Historical Cost Approach :

Two types of costs are of special importance in Human ResourceAccounting. These are original or historical cost, and replacement cost. Thehistorical cost of human resources is the sacrifice that was made to acquire anddevelop the resource. These include the costs of recruiting, selection, hiring,placement, orientation, and on the job training. While some of the costs like salaries,for instance, are direct costs, other costs like the time spent by the supervisorsduring induction and training, are indirect costs.

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The Economic ValueApproach

2The CostApproach

1

MonetaryModels

NonMonetaryModels

CompositeModels

Original Cost Model :

The original cost model is proposed by Brummet and others to measure afirm’s investment in human resources. They argued that human resource costsare current sacrifices for obtaining future benefits and can be obviously treated asassets. They suggested. therefore, to capitalise firm’s expenditure on recruitment,selection, orientation, training and development of people and treat them as assetsfor the purposes of human resource accounting. The amounts so capitalised areto be shown in the Balance-sheet as human assets as distinguished from otherphysical assets. However, accounting practices of amortisation and write-off wouldusually apply to assets alike. This original cost model has been followed by R.G.Barry Corporation.

Historical cost is based on actual cost incurred on human resources. Sucha cost may be two types - acquisition cost and learning cost. Acquisition cost isthe expense incurred on recruitment, selection, and placement. While calculatingthe cost of recruitment and selection, entire cost is taken into consideration includinghose who are not selected. Learning cost involves expenses incurred on trainingand development. This method is very simple in its application but it does notdeflect the true value of human assets. For example, an experienced employeemay not require much training and, therefore, his value may appear to belowthough his real value is much mode than will is suggested by historical cost method.

2) Opportunity Cost Approach

Sometimes, opportunity cost method, that is, a calculation of what wouldhave been the returns if the money spent on HR was spent on something else, isalso used. However, this method is seen to be not as objective as desired. Henceits use is restricted to internal reporting and not external reporting.

It means that the opportunity cost is linked with scarcity. The value of anemployee is determined according to his alternative use. Human resources areevaluated under this method by making an estimate of their alternative use.

It has specifically excluded from its purview those employees who are notscarce or are not being bid by other department. This is likely to result in loweringmorale and productivity of the employees, who are not covered by the competitivebidding process.

Opportunity Cost Model :

Hekimian and Jones advanced an opportunity cost model to value theemployees. The computation of monetary value and allocation of people areconsidered as the central points of emphasis. They have suggested opportunitycost as the best means to value employees. They have relied upon the availabilityof alternatives to allocate people to the most promising economic activity. Toassess the opportunity cost of key employees they have suggested competitivebidding among investment centres. It us emphasised that this system would facilitatemore optional allocation of key employees and argued that it would also act as aquantitative base for planning and controlling the activities of personnel function.The only contention is that key employees are assigned with tasks, the contribution



NOTES

83

of which is much less than it would have been if they are employed in moredynamic jobs.

The Method roughly works as shown below. Suppose a division’s targetROI is 15%. It has capital base of 1,00,00,000 but its profit is only `13,00,000i.e., `2,00,000 short of the target. It is felt that if it can acquire the services of aparticular executive, its profits can improve by ` 90,000 i.e., the profit will be`15,90,000. ` 90,000 more than `15,00,000 `90,000 capitalised at 15% comesto ` 6,00,000. The division certainly may bid up to 6,00,000 for the services ofthe executive. Actually, the maximum bid may even be the capitalised value of` 2,90,000 the extra profit likely to be generated by the executive’s availability.The method can work for some of the people but, surely. quite a few people,specially those at the top, will not be available for the auction. It also ignorespeople that are not scarce.

Opportunity cost method is also known as competitive Bidding Method.Opportunity costs is determined by a process of competitive bidding in whichvarious division are departments bid for the services of various officers.

3) Replacement Cost Method :

The replacement cost of human resources is the cost that would have tobe incurred if present employees are to be replaced. For instance, if an employeewere to leave today, several costs of recruiting, selection, hiring, placement,orientation, and on the job training would have to be incurred in order to replacehim. Such costs have two dimensions-positional replacement costs or the costsincurred to replace the services rendered by an employee only to a particularposition; and personal replacement cost or the cost incurred to replace all theservices expected to be rendered by the employee at the various positions that hemight have occupied during his work like in the organisation.

Replacement Cost Model :

This approach was developed by Rensis Likert and Eric G-Flamholtz.

Since accountants first undertook the task of putting a value on humanresources, it was natural for them to first turn to the historical cost method whichhas been the traditional method of valuing physical or intangible assets for thepurpose of financial statements. In the case of human resources, cost wouldcomprise.

(i) the amount spent on processes leading upto selection and placement inposition;

(ii) the cost of formal training imparted to the selected people; and

(iii) the cost of informal training, the loss incurred because of the mistakescommitted, due to their being new on the job and becasue of the time takento reach the normal level of efficiency.

In cost accounting labour turnover cost has been computed in this manner.To compute a figure which is more up-to-date, one can imagine that everyone

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84



would leave and then arrive at the cost of replacing all members of the presentstrength.

Replacement cost is generally much higher than the historical cost. Forexample, Friedman has estimate that the replacement cost of an executive inmiddle management level is about 1.5 to 2 times the current salary paid in thatposition. Replacement cost is much better indicator of value of human assetsthough it may present certain operational problems. For example, true replacementof a person may not ne found easily with whose cost the valuation is done.

Standard Cost : Instead of using historical or replacement cost, manycompanies use standard cost for the valuation of human assets just as its used forphysical and financial assets. For using standard cost, employees of an organizationare categorized into different groups based on the hierarchical positions. Standardcost is fixed for each category of employees and their value is calculated. Thismethod is simple but does not take into account differences in employees put inthe same group. In many cases, these differences may be quite vital.

5) Adjusted Present Value Method :-

The method attempts to bring in the question of effectiveness but the ratioof ROI of the firm to the ROI of the industry, based on past performance, assumesthat there were no unusual or extraneous factors - that the performance wasentirely due to the efforts of the employees and executives of the firm. If the pastreturns on investment can be suitably adjusted to remove the effect of all factorsbeyond the firm’s control, the method may approximate to value somewhat.

Adjusted Present Value Model -

Hermanson has suggested that human resource must be reported as assetin the financial statements. He has proposed an Adjusted Present Value model toquantify the value of human capital of a company. The first stage is to computethe present value of future wage payments for five years. The next step is to findout the efficiency ratio.

Hermanson used efficiency ratio to adjust the discounted future wage stream.The equation is :

5(RF0) + 4(RE1) + 3(RF2) + 2(RF3) + (RF4)/15 (RF0) 4(RE1) 3(RF2) 2(RF3) (RF4)

Where RF indicates firm’s return, RE indicates economy’s rerurn.

This ratio is applied to adjust the present value of the future wage payments.The resultant figure is the value of human (Operational) assets. He categorised ahighly trained sales force as an example for ‘operational assets’ differentiatingthem from legally owned assets. Hermanson also suggested an entry to record histheory in the books of accounts.

If the efficiency ratio is one (1), the value of both credit and debit will besame as follows :



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Human Resources (Operational Assets ) Dr. xx

To Future Wages payable xx

But more than one (>1) efficiency ratio denotes excess worth and less thanone (<1) efficiency ratio indicates inefficiency. Then entry for a situationwhere the efficiency ratio is more than one will be :

Human Resources (Operational Assets) Dr. xx

To Future Wages payable xx

To Excess worth created by relatively

efficient human resources xx

The entry for less than one efficiency ratio will be :

Human Resources (Operational Assets ) Dr. xx

Reserve for Future Human Resource

Inefficiency Dr. xx

To Future Wages Payable xx

The amount of future wages payable represents a liability, while the HumanResources (or operational assets s. an assets in the Balance-sheet.

Alternatively, Hermanson also suggested unpurchased Goodwill Method tovalue Human Resources. Under this method, the superior earnings on physicaland financial assets are capitalised at normal rate or return to establish a case forHuman Assets for Balance - sheet purposes.

Adjusted present value model has two variables. One is the present valueof future wage payments for the next five years and the other is the efficiencyratio derived from the relative performance of the firm and the economy as awhole. The product of the present value of future wages and the efficiency ratiounfolds the relative efficiency of the firm’s resources in relation to the performanceof the economy’s total human resources.

The cost approach employed for education human resources can beunderstood with the help of following illustrations.

4.7. Illustrations

ILLUSTRATION 1

Escorts Ltd. Ernakulam employed seven skilled employers of the same agegroup with similar educational qualifications who expect to work for the period ofnear eighteen years. The costs incurred for the same were as under :

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Check Your Progress

1. Which are the differentsteps involved in thedevelopment of ‘HumanResource Accountingconcept’?

2 . Explain the importanceof Human ResourchAccounting.

3 . Explain the ‘CostApproach’ employed forvaluation of humanresources.

Recruitment : ` 12,000

Selection : ` 15,000

Training : ` 19,000

Orientation : ` 26,000

Calculate the value of human resource after a period of seven years as perHistorical Cost Method.SOLUTION

1) Calculation of Total Capital Investments made in Human Resource :

Capital = Recruitment + Selection + Training + OrientationInvested cost cost cost cost

= ` 12,000 + ` 15,000 + ` 19,000 + ` 26,000= ` 72,000

2) Calculation of total amortisation and written off amount over seven years :

Total Amortization = Total Capitalx

Specific Period of Valuation& Written off Amts Investment in Estimated Working period

Human Resourse

= ` 72,000 x7 years18 years

= ` 28,000

3) Calculation of Value of Human Resource :

Value of Human Total Capital Investments Amortization andResource = in Human Resource - Written off Amount

= 72,000 - ` 28,000= 44,000

4.8 Summary

• Human Resource Accounting is a means of measuring the cost and valueof people. It is one of the neoteric developments in the area of accounting.Though a good amount of research has been rapidly accumulated in thescience of human resource management, the measurement aspect of humanresources is touched very peripherally. Now the success of all organisationsis contingent on the quality of their Human Resource its knowledge, skills,competence, motivation and understanding of the organisational culture inknowledge-driven economics therefore, it is imperative that the humans berecognised as an integral part of the total worth of an organisation. However,in order to estimate and project the worth of the human capital, it is necessarythat some method of quantifying the worth of the knowledge, motivation,skills, and recruitment, selection, training etc. which are used to build andsupport these human aspects, is developed Human Resource Accounting(Human Resource Accounting) denotes just this process of quantification/measurement of the Human Resource.



NOTES

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• There are a number of human resource valuation models. Hermanson hasdeveloped Adjusted Present Value Model, to quantify the value of humancapital of a company. He has used a technique, called Efficiency Ratio toadjust the present value of future wage payments to arrive at the relativeefficiency of particular firm’s human assets compared to that of theeconomy’s human assets.

• Likert has established a relationship among causal, intervening and end -result variables for assessing the productive capabilities of humanorganisation and the associated changes over a period of time.

• Likert has linked the management system and the resultant influence on theefficiency of human resources in his model.

• Hekimian and Jones have advocated an Opportunity Cost model to valuethe firm’s important people and suggested competitive bidding amonginvestment centres to find out the monetary value.

• Flamholtz and other have concentrated on original cost model and arguedthat investment expenditure on human resource having future benefits maybe capitalised to establish a basis for the human assets. Lev and Schwartzhave considered compensation as a possible measure of employees’ valueto an undertaking.

• Historical Development of Human Resource Accounting concept : Thedevelopment of Human Resource Accounting as a systematic and detailseconomic activity, according to Eric G. Flamholtz began in sixties. He divideddevelopment in his 5 stages.

(i) First stage (1960-66) (ii) Second stage (1966-71), (iii) Third stage (1971-76), (iv) Forth stage (1976-80) & (v) stage Five 1980 onwords.

• The two main approaches usually employed for valuation of human resources(i) The cost Approach and (ii) The Economic value Approach.

(i) Cost approach which is involves methods buses on the costsincurred by the company, with regard to an employee.

(ii) The economic value approach which includes method buses onthe economic value of the human resources and their contributionto the company’s gains.

4.9 Key Terms

(1) Capitalization of compensation

The capitalisation method involves capitalizing a person’s salary and usingit as a surrogate measure of human value. This value may be ascertainedfor group as well as individuals. The value of the group is essentially theaggregate value of the individuals compromising the group.

NOTES

88



Capitalization of compensation method is not considered an ideal method ofgroup valuation because it ignores the possible effects of synergy. However,this method may be used to arrive at an approximation of a group value tothe firm.

(2) Replacement cost valuation

The replacement cost of group is defined as the sacrifice that would haveto be incurred today to recruit, select, hire, train and develop a substitutegroup capable of providing a set of services equivalent to that of a grouppresently employed.

This method involves considerable subjective estimates, which reduce itsvalidity and replicability.

(3) Original cost valuation

The original cost valuation method involves estimation of the original costof recruiting, selecting, hiring, training and developing a firm’s existing humanorganisation.

(4) Adjusted Present Value Method

In his book, “ Accounting for Human Assets.” Hermanson advocated thatearning for the next five years be estimated and than discounted, the resultingfigure being multiplied by an “Efficiency Factor” - the 5 years weightedaverage of the return on investment of the firm divided by a similar averageof the return on investment of the firm divided by a similar average for theconcerned industry [(REO)/ RFO)].

(5) Opportunity Cost Method

An interesting method advocated by Hekimain and Jones, called opportunitycost method, is that divisional heads may bid for the services to variouspeople whose services they may require and then include the bid price inthe investment base.

(6) Human Resource Accounting -

“The process of identifying and measuring data about human resourcesand communicating this information to interested parties”. Human ResourceAccounting, thus not only involves measurement of all the costs/investmentsassociated with the recruitment, placement, training and development ofemployees, but also the qualification of the economic value of the people inthe organisation.



(A) Multiple choice Questions



NOTES

89

(1) Accounting for people as the organisational resource is termed as ......

(a) Human Resource Accounting.

(b) Social Responsibility Accounting.

(c) Environmental Accounting.

(d) Financial Accounting.

(2) Human Resource Accounting provides cost/value information aboutacquiring, allocating, developing and maintaining human resources in orderto attain cost ........

(a) measurement

(b) allocation

(c) effectiveness

(d) classification

(3) The first attempt to value the human beings in monetary terms was madeby ....

(a) William Far

(b) Earnest Engle

(c) William Petty

(d) William Pyle

(4) For valuation of human resources the ............ approach follows the traditionalaccounting concept of matching cost with revenue.

(a) replacement cost

(b) opportunity cost

(c) standard cost

Ans - (1-a), (2-c), (3-c), (4-d)


(1) Define the term ‘Human Resource Accounting’. Explain in brief theobjectives of Human Resource Accounting.

(2) Explain the concept of ‘Human Resource Accounting’. State the purposesserved by human Resource Accounting.

(3) What is ‘Human Resource Accounting’? Explain the need of HumanResource Accounting.

(4) Explain in detail the historical development of ‘Human Resource Accounting’concept.

NOTES

90



(5) What do you understand by ‘Human Resource Accounting’? State theimportance of Human Resource Accounting.

(6) Briefly describe the following method employed for valuation of humanresources under cost approach.

(a) Original Cost Model

(b) Opportunity Cost Model

(c) Replacement Cost Model

(d) Adjusted Present Value Model

III) Practical Problems

1) Bokaro Ltd., Baroda employed ten skilled employees of the same age groupwith similar educational qualifications who except to work the period of next twentyyear. The costs incurred for the same were as under :

Recruitment - ` 32,000, Selection - 28,000, Training - ` 16,000 andOrientation - 24,000.

Calculate value of Human Resource after a period of eight years as perHistorical Cost Method.


• Shukla M. C., Grewal T.S. , and Gupta S.C. - Advanced Accounts - NewDelhi S. Chand & Co. Pvt. Ltd. - 2013

• Bapat varadraj and Raithatha mehul - Financial Accounting a managerialperspective - New Delhi - Tata Mcgraw Hill Education Pvt. Ltd. - 2012



NOTES

91

Unit 5 Measurement in Human ResourceAccounting - Economic ValueApproach

Structure

5.0 Introduction

5.1 Unit Objectives

5.2 Economic Value Approach

5.2.1 Lev and Schwart 2 Model

5.2.2 Likert’s Behaviour Model

5.2.3 Flamholtz’s Model of Individual Value

5.2.4 Stochastic process with service Model

5.2.5 Hekimian & Jones competitive Bidding Model

5.2.6 Hermanson’s unpurchased goodwill Model

5.3 Other - Non-monetary Models

5.4 Illustrations

5.5 Summary

5.6 Key Terms


5.8 Further Reading

5.0 Introduction

It has been widely accepted fact that success of any business house, to agreat extend depends upon the quality, calibre character and tallent of peopleworking in it. The importance of human asset as productive resources was ignoredby accounting authorities. But during 1960’s, as a result of various researchconducted by different experts in the field of accounting and finance a new branchof accounting known as “Human Resources Accounting” has come into being.

In the last unit (i.e. in unit) we have seen that the two main a approachesusually employes for valuation of human resources i.e. (i) The cost Approach and(ii) The Economic Value Approach. In this unit we are going discuss the economicvalue approach which includes methods based on the economic value of the humanresources and their contribution to company’s gains. On one hand, the cost approachwhich involves methods based on the costs incurred by the company, with regardto an employee. On the other hand, the economic value approach looks at humanresources as assets and tries to identify the stream of benefits flowing from theasset.

Measurement In HRA -Economic Value Approach


NOTES

93

5.1 Unit Objectives

After studying their unit your should able to :

• Understand the meaning and importance of “Economic Value Approach”.

• Discuss “Human Capital Model” developed by Lev and Schwartz.

• Explain “Likert’s Behaviour Model”.

• Classify “Human Variables” with the help of Likert’s Model.

• Discuss “Flamholtz Model of Individual Value”.

• Explain “three factors - (i) productivity (ii) transferability and (iii)promotability

• Explain “Service Rewards Model.”

• Discuss “ Competitive Bidding Model.”

• Know ‘Other Non-Monetary Methods for assessing the Economic Valueof HRS’.

5.2 Economic Value Approach

The value of an object in economic terms, is the present value of the servicesthat it expected to render in future. This may be the value of individuals groups orthe total human organisation. The methods for calculating the economic value ofindividuals may be classified into monetary, non - monetary methods and composmethods.

Human Resource Accounting models can be classified into three categories,viz. (i) Monetary models, (ii) Non-monetary models, and (iii) Composite models.The models that are constructed mainly with monetary variables are monetarymodels while those which are dominated by behavioral variables are called asnon-monetary models. The models which consider both monetary and behaviouralvariables may be known as composite models.

5.2.1 Lev and Schwartz Model

Lev and Schwartz developed a model which known as “Human CapitalModel.”

Lev and Schwartz have valued human capital in a different way. The valueof human capital is the present value of the future earning of people till retirement.A mathematical model was developed to quantify the value of human capital. Themodel considers employee compensation as the reasonable measure of individual’svalue to an organisation.

Lev and Schwartz advocate the estimation of future earning during the

NOTES

94



remaining working life of the employees, taking into account the possibility ofearly death and than arriving at the present value by discounting the estimatedearnings at the firm’s cost of capital. Replacement cost may be either (a) positionalreplacement cost or (b) personal replacement cost.

Where,

v * = the human capital value of a person x years old.

I x(t) = the person’s expected future annual earnings upto retirement.

r = a discount rate specific to the person.

T = retirement age.

The above equation ignores the possibility of death prior to retirement; butthat can be easily taken care of by visualising ‘t’ as the age at which the employeemay die, if that is before retirement. Mortality tables can help in this regard.

The method ignores the possibility of a person moving from one career toanother and the possibility of early exit. The most important defect of the methodis that it assumes remuneration of an employee as being equal to his value; further,the synergistic effect is totally ignored.

This method of accounting is basically oriented towards measuring changesin the employees ‘value rather than employers’ gain from the employees. Unlessthe employees’ payments are directly linked to employee productivity or thecompany performance, the changes in the value of employees will not reflect thechanges in the employees’ contribution.

The Lev and Schwartz model is the basic model employed by differentIndian companies.

The basic theme of Lev and Schwartz model is to compute the presentvalue of the future direct and indirect payments to their employees as a measureof their human resource value. While doing so, the common assumptions set bythe Indian companies are the pattern of employee compensation, normal careergrowth and weightage for efficiency. Moreover companies adapt this model totheir practical requirements by making necessary alterations. For instance, differentorganisations use different discount rates for ascertaining the present value forfuture cash flows.

According to D. Prabhakara Rao in his book ‘Human ResourceAccounting’,

“The human capital model is mainly dependant on present value of annualearning until retirement, adjusted with the death probability of the individual. Thismodel also invariably considers the value as its basis. But the model suffers fromthe main drawback that it does not consider the effect of employee mobilitybefore death on the earnings.”

Vx = T I (T) (t)

t = x (1 + r) t - x

x



NOTES

95

5.2.2 Likert’s Behaviour Model :

Likert developed a model to diagnose the changes in human organisationover a period of time. He has classified certain human variables into threecategories, viz, (i) Causal variables (ii) intervening variables, and (iii) End-resultvariables.

The interaction between causal and intervening variables has been shownto effect the job satisfaction, costs, productivity and earnings, the end-resultvariables. Some of the end-result variables are monetary in nature. Likertestablished a very concrete relationship between these variables and theorganisational performance. For assessing the change in value of the productivecapability of the human organisation form time to time, Likert designed a modelreflecting a good amount to numerical support. Managerial leadership determinesorganisational climate which in turn influence the subordinate satisfactions andsubsequently the total productive efficiency. Time lag of two years or more, oftenexist between a change in causal variables and the resultant changes in the end-result variables.

Likert identified four systems of Management, viz., (a) System I to representexploitative style of management, (b) System II for Benevolent style ofmanagement, (c) System III for Consultative style of management and (d) systemIV for participative Management style, Likert, R., The human Organisation : ItsManagement and Value, Mc Graw-Hill Kogakusha Ltd., Tokyo, 1967.

Likert observes that a firm in which the causal variables display thecharacteristics of participative management style will generate more effectiveintervening variables and consequently end-result variables and consequently moreeffective intervening variables and consequently more desirable end - result variable.He argues that the philosophy and practice of conventional accounting concentrateon a few end-result variables which are consistent with the exploitative type ofmanagement. He opines that by over-emphasising short-run profits and cost savingsthe present accounting system penalises managers who are making the greatestlong-run contribution to the organisation. For example, a manager can achieveapparent gains in production volume cost reduction and profitability by liquidatingthe human assets.

NOTES

96



Classifica-tion ofHuman

Variables

1

32

End-R

esult

Varia

ble

Intervening

Variables

Casual Variables

Although these human assets are as important to the future growth andsurvival of organisation as any physical assets, their loss is not immediatelynoticeable. Therefore, the existing accounting system will reflect the supposedgains of the system I manager, but fails to record the real costs that are incurred.However, the decrease in human assets will eventually be reflected in theaccounting reports as profits begin to fall.

In his book “Human Resource Accounting” D.Prabhakra Rao observedthat -

The behavioural model is dominated by the human actions and reactions.These are termed as the non-monetary variables. While the construction of themodel is based in non-monetary variables, the working of the model has vitalinfluence in the monetary variables also. The model implicity explains: (i) aninteraction of causal and intervening variables, the non-monetary measures inthemselves, and (ii) the interaction of the effect of non-monetary variables on themagnitude of manetary variables. It is stated that the monetary reflections mayinvolve time lags of two years of more. Likert thus emphasised the importance ofaccounting for the human resources on a continuing basis. Horngren acceptsLikert’s suggestion and opines that the major formal performance measurementsystem (the accounting system) is the best way to portray of results of the humanresource utilisation for the benefit of the organisation.

5.2.3 Flamholtz’s Model of Individual Value :

According to Flamholtz, the value of an individual is the present worth ofthe services that he is likely to render to the organisation in future. As ad individualmoves from one position to another, at the same level of at different levels, theprofile of the services provided by him is likely to change. The present cumulativevalue of all the possible services that may be rendered by him during his/ herassociation with the organisation, is the value of the individual.

Typically, this value is uncertain and has two dimensions. The first is theexpected conditional value of the individual. This is the amount that the organisationcould potentially realize from the services of an individual during his/her productiveservice life in the organization. It is composed of three factors which are shown infigure 5.1 as follows :

Fig. 5.1 : Elements of Conditional Value



NOTES

97

1 2

3

Prod

uctiv

ityor

Perfo

rman

ce

Transferability

Promotability

1) Productivity : Which involved in creation of goods and services to produceweather value. Productivity of performance (set of services that anindividual is expected to provide in his/her present position.)

2) Transferability : Which involved an activity to carry, remove or shift fromone position or place to another. Transferability (set of services that he/sheis expected to provide if any when he/she is in different position at the samelevel.)

3) Promotability : Which involved the qualities needs for advancing to ahigher position of rank. Promotability (set of services that are expectswhen an individual is in higher level positions.)

Flamholtz seeks to remove the defects of Lev and Schwartz model andvalue the human resources on the basis of their discounts earnings in the futuretaking in to account charges in their service status and the possibility of earlyretirement.

Productivity, transferability and promotability, these three factors depends,to a great extend on individual determinants activation level of the individual andorganisational determinants like opportunity to use these skills or roles and thereward system.

The another dimension of an individual value is the expected realizablevalue, which is a function of the expected conditional value, and the probabilitythat the individual will remain in the organisation of the duration of his/her productiveservice life. Since individuals are not owned by the organisation and are free toleave, ascertaining the probability of their turnover becomes important.

The interaction between the individual and organizational determinantsmentioned above, leads to job satisfaction. The higher is the level of job satisfaction,the lower is the probability of employee turnover. Therefore, higher is the expectedrealizable value.

5.2.4 Stochastic Process with Service Rewards Model :

Flamholtz developed a model for measuring a person’s value to theorganisation with the help of stochastic process. He has considered the movementof employees from one position to another position over a time period. He hasused statistical probability estimates to forecast the person’s association with aparticular position in each of the time period. He has established the value of anindividual. It is equal to the present value of future rewards adjusted with theprobability of mobility and separation.

The expected conditional value is computed with the following equation.

Where E (CV) is the expected conditional value; Ri is the positional value; P(Ri)

NOTES

98



E(CV) = n m - 1

Ri . P(Ri)

t = 1 i = 1

(1 + r)t

is the person’s probability to occupy the service state i, t is the time period; m isthe state of exit and (1+r)t is Discount Factor.

Finally the present value of future rewards is being adjusted with theprobability of separation. The resultant figure represents the expected realisablevalue of a person to the organisation. The equation for computing expectedrealisable value is given below.

Ref. Flamholtz, Eric, A Model for Human Resource Valuation : A StochasticProcess with Service Rewards, The Accounting Review, American Accounting,U.S.A., April 1971, pp. 253-67.

The Stochastic Process with Service Rewards model is called as a compositemodel of human resource accounting. It consists of both monetary and non-monetayvariables, for the monetary value of an individual depends upon many qualitative(non-monetary) variables. The models links the competence and activation levelsof employees with rewards system that affect productivity and work - satisfactionas well. The variables of promotability and organisational membership are alsoconsidered with the help of statistical probability estimates to determine therealisable value of an employee to the organisation.

Use of this model necessitates the following information :

1. The set of mutually exclusive states that an individual may occupy in thesystem during his/her career;

2. The value of each state, to the organisation;

3. Estimates of a person’s expected tenure in the organisation.

4. The probability that in future, the person will occupy each state for thespecified time.

5. The discount rate to be applied to the future cash flows.

A person’s expected conditional value and expected realizable value will beequal, if the person is certain to remain in the organisation, in the predeterminedset of states, throughout his expected service life.

The movement of progress of people through organizational ‘states’ or rolesis called a stochastic process. The Stochastic Rewards Model is a direct way ofmeasuring a person’s expected conditional value and expected realizable value. Itis based on the assumption that an individual generates value as he occupies andmoves along ogranizational roles, and renders service to the organisation. Itpresupposes that a person will move from one state in the organisation, to another,during a specified period of time. In this model, exit is also considered to be astate.

E (RV) = n m

Ri . P(Ri)

t = 1 i = 1

(1 + r)t



NOTES

99

The main drawback of his model, however, is the extent of informationrequired to make the necessary estimates of the values of the service states, theexpected tenure, and the probability that the individual will occupy the state forthe specified period of time. However, if this information can be made available,this model emerges as one of the most sophisticated models for determining thevalue if individuals.

5.2.5 Hekimian & Jones Competitive Bidding Model :

In this method, an internal market for labour is developed and the value ofthe employees is determined by the managers. Managers bid against each otherfor human resources already available within the organisation. The highest bidder‘Wins’ the resource. There is no criteria on which the bids are based. Rather, themanagers rely only on their judgement.

5.2.6 Hermanson’s Unpurchased Goodwill Model :

According to Hermanson, the unpurchased goodwill notion is based on thepremise that ‘the best available evidence of the present existence of un-ownedresources is the fact that a given firm earned a higher than normal rate of incomefor the most recent year. Here Hermanson is proposing that supernormal earningare an indication of resources not shown on the balance sheet, such as humanassets. Even though his method of valuing human resources is explicitly intendedfor use in a company’s published financial statements rather than for internalconsumption, this would necessarily involve forecasting future earnings andallocating any excess above normal expected earnings to human resources of theorganization. However, the assumptions would be subject to the uncertaintiesinvolved in any forecast of future events.

5.3 Other Non-Monetary Methods for assessingthe Economic Value of human resources :

There are some behavioral measurement techniques which can be used toassess the benefits gained from Human Resource of an organisation.

These techniques are as under :-

(i) Performance evaluation measures used in Human Resource Accountinginclude ratings, and rankings. Ratings reflect a person’s performance inrelation to a set of scales. They are scores assigned to characteristicspossessed by the individual. These characteristics include skills, judgment,knowledge, interpersonal skills, intelligence etc. Ranking is an ordinal formof rating in which the superiors rank their subordinates on one or moredimensions, mentioned above.

(ii) Assessment of potential determines a person’s capacity for promotion anddevelopment. It usually employs a trait approach inwhich the traits essentialfor a position are identified. The extent to which the person possesses thesetraits is then assessed.

NOTES

100



(iii) Attitude measurements are used to assess employees’ attitudes towardstheir job, pay, working conditions, etc. in order to determine their jobsatisfaction and dissatisfaction.

(iv) The skills or capability inventory is a simple listing the education.knowledge, experience and skills of the firm’s human resources.

(v) The results-oriented appraisals are based on the concrete performancetargets which are usually established by superior and subordinates jointly.This procedure has been known as MBO. CMBO management byobjectives.

The concept of individual value in Human Resource Accounting can beunderstood with the help of following illustrations.

5.4 Illustrations

ILLUSTRATION 1Aakruti Enterprises has started their business on 15th April, 2013 and

transacted the following transactions for the year ended 31st March, 2014.

a) Started business with initial capital amazing to 2,50,000.

b) The firm has purchased machinery worth ` 75,000 and Buildings`1,00,000 for cash.

c) The firm has utilised ` 50,000 as working capital.

d) During the year the total expenses incurred on recruitment, training anddevelopment of human resources amounted to ` 25,000

e) The value of human resources is assessed at ` 1,00,000.

You are required to prepare the Balance Sheet of the firm as on31st March, 2014 inclusive of Human Resource Accounting information attachedto the financial statements.

SOLUTION

In the books of Aakruti EnterpriseBalance-sheet as on 31st March, 2014

(inclusive of Human Resource Accounting information)Liabilities ` Assets `

Capital : Machinery 75,000

i) Cash 2,50,000 Buildings 1,00,000

ii) Human Assets 1,00,000 Current Assets 50,000

Human Assets :

i) Value of Individuals 1,00,000

ii) Value of Firm’s investment 25,000

3,50,000 3,50,000



NOTES

101

Check Your Progress

1. Define the term‘Economic Value’.

2 . How to classify ‘HumanVariables’ according to‘Likert’ ?

3 . State the elements ofConditional Valueaccording to ‘Flamholtz’.

4 . What is ‘StochasticProcess’ ?

5.5 Summary

• The Economic Value Approach : The economic value of human resourcesis the present worth of the services that they are likely to render in future.This may be the value of individuals, group of the total human organisation.The methods for calculating the economic value of individuals may beclassified into monetary and non-monetary methods.

• The Lev and Schwartz Model :

As mentioned earlier, the Lev and Schwartz model is the basic modelemployed by Indian organisations. According to this model, the value ofhuman capital embodied in a person who is ‘y’ years old, is the presentvalue of his/her future earning from employment and can be calculated byusing the following formula

E(Vy) Py ( t I) I (T) / (I R) t y

T Y T

Where E (V y) = expected value of a ‘y’ year old person’s human capital

T = the person’s retirement age

py (t) = probability of the person leaving the organisation

I (t) = expected earning of the person in period I

r = discount rate

• Expected Realizable Value :-

Expected realizable value is based on the assumption. That there is nodirect relationship between cost incurred on an individual and his value toorganization can be defined as the present worth of the set of future servicesthat he is expected to provide during the period he remains in the organization.Flamholtz has given the variables affecting an individual’s expected realizablevalue (IERV) : individual conditional values and his like hood of remainingin the ogranization. The former is a function of the individual’s abilities andactivation level. While the later is a function of such variables as jobsatisfaction, commitment, motivation, and other factors.

Likert’s Behaviour Model : Likert developed a model to diagnose the changesin human organisation over a period of time . He has classified certain humanvariables in to three categories, viz (i) causal variables, (ii) Interveating variablesand (iii) eco-result variables.

Flamholtz’s Model of Individual Value : According to Flamoltz, the value ofan individual is the present worth of the services that he is likely to render to theorganisation in future. The present cumulative value of all possible services thatmay be rendered by him during his/her association with the organisation, is thevalue of the individual.

Stochastic process with service Rewards Model : Flamholtz developed amodel for measuring a person’s value to the organisation with the help of stochastic

NOTES

102



process. He has established the value of an individual. It is equal to the presentvalue of future rewords adjusted with the probability of mobility and separation.

Hekimian and Jones competitive Bidding Model : In this model, an internalmarket for labour is developed and the value of the employees is determines bythe managers.

Hermanson is proposing that super normal earning are an indication of resourcesnot shown on the balance-sheet, such as human assets.

There are some behavioural measurement techniques which can be used to assesthe benefits gains from Human Resource of an organisation.

5.6 Key Terms

(1) Monetary and Non Monetary Models :- The models that are constructedmainly with monetary variables are monetary models while those whichare dominated by behavioural variables are called as non- monetary models.

(2) Composite Models :- The models which consider both monetary andbehavioural variables may be known as composite models.

(3) Likert has classifies human variables into three categories viz (i) causalvariables, (ii) Intervening variables and (iii) Eco-result variables.

(4) “Value of an Individual” is the present worth of the services that he islikely to render to the organisation in future.

(5) Expected Realisable Value” : Which is a function of the expectedconditioned value and the probability that the individual will remain in theorganisation for the duration of his / her productive service life.

(6) “Stochastic Process” - The movement of progress of people throughorganisational “states” or roles is called a stochastic process.

(7) MBO :- The result-oriented appraised are based on the concreteperformance targets which are usually established by superior andsubordinates jointly. This procedure has been known as MBO ( Managementby Objectives)




NOTES

103


A) Multiple choice Questions

(1) The complete disclosure of the value of human resource in the final accountsis made as a ...........

(a) part of final accounts

(b) legal obligation

(c) supportive information

(d) compulsory part

(2) Tax laws do not recognise human beings as ...........

(a) physical assets

(b) intangible assets

(c) wasting assets

(d) current assets

(3) Human capital Model has been developed by ............ in 1971.

(a) Hekimian and Jones

(b) Lev and schwartz

(c) Likert and Flamholtz

(d) David watson

(4) According to chakraborty the cost incurred for recruitment hiring, selection,development and training of each employee should be recorded separatelyand treated as ..................... .

(a) capital expenditure

(b) revenue expenditure

(c) deferred revenue expenditure

(d) accrued expenditure

Ans : (1 - c), (2 - a), (3 - b), (4 - d)


1) What is ‘Economic Value’ ? Classify the Human Resource Accountingmodels in different categories.

2) Define the concept of ‘Human Capital’. Explain the formula developed byLev and Schwartz for calculating the value of an employee.

NOTES

104



3) Classify human variables according to a model developed by Likert.

4) What is ‘Individual value’? Explain in brief the elements of ‘ConditionalValue’ according to Flamholtz.

5) What is ‘Stochastic Process’. Explain the composite model of humanresource accounting developed by Flamholtz.

6) Explain in brief the competitive Bidding model developed by Hekimian andJones.


1) From the following accounting data provided by Barua and co. for the yearended 31st March, 2014 prepare the Balance Sheet of the firm as on that dateinclusive of human resource accounting information attached to the financialstatements.

a) Started business with initial capital of 4,00,000 of which 1,00,000 wereborrowed from Dena Bank.

b) The firm has utilised ` 1,00,000 as circulating capital.

c) The firm has also purchased factory premises worth ` 1,25,000 andmachinery 1,00,000.

d) During the year the total expenses incurred on training, development andrecruitment of human resources amounted to ` 75,000.

e) The value of human resources is assessed of ` 1,00,000.

5.8 Further Reading

• Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts- NewDelhi : S. Chand & Co. Pvt. Ltd., 2013.

• Bapat Varadraj and Raitha tha Mehul - Financial Accounting A ManagerialPerspective - New Delhi - Tata Mc Graw Hill Education Pvt. Ltd. - 2012.



NOTES

105

Unit 6 Human Resource Accounting in India

Structure

6.0 Introduction

6.1 Unit Objectives

6.2 Human Resource Accounting in India

6.2.1 Frame work of corporate reporting in India

6.3 Human Resource valuation models selected by Indian Companies

6.4 General consideration in the working of Human Resource Accountingconcept by Indian companies

6.5 Usefulness of Human Resource Accounting practice

6.6 Problems in Human Resource Accounting

6.7 Summary

6.8 Key Terms



6.0 Introduction

In India, AS-26 does not allow Human Resource Assets to be recognised inthe balance sheet for the following reasons.

(a) Self generates intangibles such as human resource asset are notrecognised in the balance sheet.

(b) There is no control over future economic benefit in the case of HumanResource Asset. They can leave on organisation or may continue toremain in the organisation, but may not perform.

(c) The cost of Human Resource Assect can not be because reliably. Forexample salaries paid to office staff cannot be spilt with realiability intocurrent cost and those that would be provided benefit in future.

Under the constraints under which the financial statements are prepared asper the companies Law in India, there is no scope for showing any significantinformation about human resource is financial statements except the remunerationpaid to them and the human employees getting high rate of salaries andremuneration. However, there is nothing to prohibit the companies to attachinformation about the worth of human resources and the result of their performance

Human ResourceAccounting In India


NOTES

107

during the accounting period in notes or schedules.

In India, the concept of Human Resource Accounting is yet to gainmomentum. Bharat Heavy Electrical is a pioneer in this direction. few moreorganisation like Minerals and Metals Trading corporation of India, Oil & Naturalcost commission, southern petrochemical Indian’s corportion and Ney Lignitecorportion are adopted this concept. But the concept is adopted as additionalinformation.

6.1 Unit Objectives

After studying this unit you should be able to:

• Understand the framework of corporate reporting in India.

• Describe Human Resource Valuation Models selected by Indian companies.

• Discuss general consideration in the working of the Human ResourceAccounting concept by Indian companies.

• Illustrates Indian companies adopting Human Resource Accounting conceptin India.

• Discuss problem in Human Resource Accounting.

6.2 Human Resource Accounting in India

6.2.1 Framework of corporate reporting in India

In India corporate reporting has been mandatory and is governed by theframework enshrined in sections 209, 210, 211, 212, 213, and 617 of the CompaniesAct 1956. The statutory format for a balance sheet is prescribed in schedule VIof the said act. Where as rules for reporting on banking, insurance, and electricitycompanies are prescribed in the respective acts and laws and rules made thereunder. However, no specific legislation exists for extraction, plantation, oil, andgas and agribusiness companies. These companies are required to follow thegeneral principles as laid down in the Companies Act 1956 and to the extent thespecific law does not provide for, the provisions of company law prevail. Companylaw directs that the financial statements should give a “true and fair view” of theaffairs that the company. The overarching framework does not specify the nutsand bolts of corporate reporting and hence leaves greater scope for professionaljudgement to be applied in determining as to what constitutes a “true and fairview”. This has given rise to (a) statutory versus voluntary disclosures and (b)mandatory versus voluntary but creative reporting, Creative reporting may beclassified into two categories: (a) voluntary and creative and (b) highly creativebut forensic in character.

The Companies Act 1956 does not explicitly provide for the disclosure on

NOTES

108



human assets in the financial statements of companies. The Institute of CharteredAccountants of India has not issued an accounting standard for the measurementand reporting of the human resources of an organisation. Therefore, it is up to theorganisation to decide how much information, what information and in which formthey want to disclose voluntarily in their annual financial reports or elsewhere.However, accepting the arguments raised in favour of human resource accounting(Human Resource Accounting) many companies have voluntarily started valuationand disclosure regarding their human resources.

In India, human resource accounting has not been introduced so far as asystem. But its importance as a managerial tool has been recognised. The annualreports of some companies contain information regarding the manpower employed,manhours lost and the associated loss of production, the human resourceproductivity, etc. The monetary value of human resources has been reported byM/s. Bharat Heavy Electrical Limited.

M/s. Bharat Heavy Electrical Limited is engaged in world-wide business inthe area of Electrical / Mechanical Engineering equipment for the generation,transmission and the utilisation of energy. The company made it a point to puthuman resource development as one of the corporate objectives.

The company introduced a system of human asset reporting from 1974-75in the capacity of image-projection. The Lev and Schwartz. Human Capital modelis consulted for evaluating the human assets. The employees future earning areconsidered as a reasonable measure of the human asset value. The employees ofthe company are divided into six categories - (i) Executives, (ii) Supervisors, (iii)Supporting Technical Staff, (iv) Skilled Artisans, (v) Unskilled and semi-skilledworkers and (vi) Clerical Stall. The weighted average salary of the concernedgroup of employes is computed and the future earning of the employees of eachgroup are calculated depending on the general promotion policy. Finally, the annualearning are adjusted at 12 percent discount factor to determine the human capitalvalue. The computation of these values assume that pay-scales and the promotionpolicy are constant. The ratios of value of production per rupee of human assetand value added per rupee of human asset have been computed at 1.4 and 0.8respectively for the year 1978-79 as against 1.1 and 0.6 in 1974-75, the yearsystem’s inception. The increase in the ratios indicate the improvement in theefficiency level of the company’s human resources.

(Bharat Heavy Electrical Limited, Annual Reports, for the years 1974-75 and1978-79)



NOTES

109

6.3 Human Resource Valuation Models Selectedby Indian Companies

Companies like ACC, CCI, EIL, MRL, OIL, and PEC have adopted theeconomic valuation concept and accepted the model suggested by Lev and Schwartzwith refinements suggested by Flamholtz, Jaagi and Lau. Companies like CFSL,GTL, HPCL, HZL, IDPL, INFOSYS, KRL, MECON, MMTC, NTPC, ROLTA,SAIL, SATYAM, SPIC and STC have adopted the Lev and Schwartz model(1971) of economic value and have used an employee’s anticipated future earningsas a surrogate of his value, whereas a company like BHEL has developed its ownvaluation model considering the original model of Lev and Schwartz as a base.The model used by BHEL is as follows:

Human ResourceV = P x 12 x N x E x I/F

Where,

N = Number of employees in the grade

E = Efficiency factor

I = Imcremental factor, future expected increments

f = Discount factor, which is constant at 12 percent being a risk free rate ofreturn

Most of the Indian companies following the economic valuation methodconsidering human resources as a human capital. The charge in the discount ratewould a effect the human Resource value without a change in any other materialcondition of the business.

In order to evolute the quality of disclosure relates to profitability andefficiency made by each company, ratios were identified from the literatare surveyand the annual reports of the companies which have been following the humanresource accounting practices. As there is no compulsion by any statutroy bodiesregarding human resource accounting disclosure, different companies followdifferent practice for the valuation and reporting of human resources. Followingefficiency and profitability indicator ratio commonly discloses by the IndianCompanies

(i) Ratio of human resource value to the number of employees.

(ii) Ratio of Human Resource to fixed assets.

(iii) Ratio of turnover to Human Resources.

(iv) Ratio of turnover to total resources.

(v) Ratio of employee cost to Human Resources Value

(vi) Ratio of return on Human Resource Value

(vii) Ratio of value added to Human Resource Value.

NOTES

110



Check Your Progress

1. What is the Frameworkof corporate Reporting inIndia ?

2 . State the various ratioscomputed by IndianCompanies to indicateefficiency andprofitability.

(viii) Ratio of value added to total resources.

(ix) Ratio of net value added to total resources.

6.4 General Consideration in the Working ofHuman Resource Accounting Concept byIndian Companies

The following are the general considerations in the working of the HumanResource concept by the organisation in India.

(i) Only internal human organisation (employees) is considered. Externalorganisation like customers are not considered.

(ii) At categories of employees are includes. The value of employee’s potentialservices is considered.

(iii) Human Resource value is worked out - on the Lev and Schewartz model

(iv) A 12 percent discount rate is adopted.

(v) Employees are classified according to age and pay scales under sixcategories - executives, supervisors, supporting technical staff, skilledartisans, unskilled and semi skilled workers and clerical staff.

(vi) Weighted average is calculated for each group on information of total numberof employees at each incremental stage and in each grade

(vii) Future number of employees is worker out on the basis of general promotionpolicy.

(viii) Employee considerations include direct and indirect benefits.

6.5 Usefulness of Human Resource AccountingPractices

In favour of Human Resource Accounting, behavioural scientists as well asprofessionals made number of arguments such as following:

(i) Human Resource Accounting helps in decision making.

(ii) Human Resource Accounting provides input to the internal as well as externaldecision makers.

(iii) Human Resource Accounting works as a motivational factor to theemployees.

(iv) It helps in giving valuable information to the management of effectiveplanning and managing human resources.



NOTES

111

(v) It helps in measurement of standard cost of recruiting, selecting, hiring andtraining people and organization can select a person with highest expectedrealizable values.

(vi) Human resource accounting can change the attitude of managers completely,thereby, they would try to maximize the expected value of human resourcesand effective use of human resources in the organization.

(vii) It also provides necessary data to devise suitable promotion policy congenialwork environment and job satisfaction to the people.

Human Resource Accounting information, if property developed, will beuseful to managers at all levels regarding costs of turnover and inefficient utilizationof human resources. Such information will help managers to make better decisionsregarding personnel. Such information also helps these organization to understandthe costs involved in fulfilling social responsibilities such as training to the unemployedand retrenched personnel. Data could also be useful to investors to judge thefuture performances of enterprise.

6.6 Problems in Human Resource Accounting

The major operational problems involves in Human Resource Accounting are ofthe following type :-

(i) Human being cannot be owned like other assets. thus they cannot commandany value therefore subjective factor may play crucial role.

(ii) There is no well-set standard accounting practice for measuring the valueof human resources. In the case of financial accounting, there are certainspecified standards which every organization follows. However, in the caseof human resource accounting, there are on such standards.

Therefore, various organization that adopt human asset valuation use theirown models with the result, value of human assets of two organization maynot be comparable. models with tax laws do not recognise human being asasset. Assets depreciate in value for various reasons but human assetsappreciated in value because of experience efficiency etc.

(iii) The valuation of human assets is based on the assumption that the Employeesmay remain with the organization for certain specified period. However,this assumption may not hold in the today’s context because of increasedhuman resource mobility.

(iv) There is a possibility that human resource accounting may leas to thedehumanization in the organization if the valuation is not done correctly orresults of the valuation are not utilised properly. Hence salaries cannot bepredicted with precision and accuracy. If is difficult to obtain reliable datafor detemining the value derived by an organisation during the period aperson occupies a particular position.

NOTES

112



Check Your Progress

1. State the generalconsideratons in theworking of HumanResource AccountingConcept.

2 . How Human ResourceAccounting is useful inactual practices ?

3 . What are the majoroperational problemsinvolved in HumanResource Accounting ?

(v) There is also possibility that trade unions may oppose the use of humanresource accounting. They may want parity of wages/salaries and value ofemployees.

However many of these problems are of operational nature or of attitudinalnature. These may be overcome by developing suitable organizational climate andculture.

6.7 Summary

• In India the concept of Human Resource Accounting is yet to gainmomentum. There are a few organization. however, that do recognize thevalue of their human resources, and furnish the related information in theirannual reports. In India, some of these companies are : Infosys, BharatHeavy Electrical Ltd (BHEL) ; the steel Authority of India Ltd. (SAIL) theMinerals and Metals Trading Corporation of India Ltd, (MMTC), theSouthern petrochemicals Industries Corporation of India(SPIC), theAssociated Cement Companies Ltd, Madras Refineries Ltd., the HindustanZinc Ltd,. Engineers India Ltd, the Oil and Natural Gas Commission, OilIndia Ltd. the Cement Corporation of India Ltd. etc.

• Most of the Indian companies following the economic valuation methodconsidering human resources as a human capital. Some Indian companieslike BHEL has developed its own valuation model considering the originalmodel of ‘Lev & Schwartz” as a base.

• Human Resource Accounting information, if properly developed, will beuseful to managers at all levels regarding with of turnover and inefficientutilization of human resources.

• There are some operational problems involved in Human ResourceAccounting, however many of these problems are of attitudinal nature.these can solves by developing suitable organisational climate and culture.

6.8 Key Terms

(1) ‘BHEL’ valuation model : Human ResourceV = Px12xNxExI/F

Where, N = Number of employees in the grade

E = Efficiency Factor

I = Increments factor, future expected increments

F = Discount factor, which is at conduct 12% being a risk free rate ofreturn.

(2) ‘Lev and Schwartz’ model : The basic theme of Lev, Schwartz model isto compute the present value of the future direct and indirect payment to theiremployees as a measure of their human resource value.



NOTES

113




(1) In India AS-26 does not allow ---------- assets to be recognised in theBalance-sheet.

(a) Human Resource

(b) capital

(c) Non-wasting

(d) contingent

(2) The companies Act, 1956 does not explicity provide for the disclosure of ------ assets in the financial statements of companies.

(a) capital

(b) human

(c) wasting

(d) contingent

(3) Indian companies are generally following human resource accountingaccording to model as developed by -------------.

(a) Likert,

(b) Flamholtz,

(c) Hermanson,

(d) lev and schwartz

(4) Among all the corporate enterprise in India ------------- is the pioneer in thefield of human resource accounting since -1970.

(a) Bajaj Auto Ltd.

(b) Bharat Heavy Electrical Ltd.,

(c) Tata motors Ltd,

(d) Hindustan unilever Ltd.

Ans. (1 - a), (2 - b), ( 3 - d), ( 4 - b)


(1) What is Human Resource Assets? Why in India As 26- does not allowHuman Resource Assets to be recognised in the Balance Sheet.

NOTES

114



(2) State in brief the general considerations in the working of the human resourcesconcept by Indian companies.

(3) Explain in brief the usefulness of Human Resource accounting practicesfollowed in India.

(4) Explain the major problems involved in Human Resource Accountingpractices followed in India.

(5) “Conventional accounting practices in India ignore human resourcesaltogether”. Explain.

(6) Explain in brief the progress made by Indian companies so far in the field ofhuman resource accounting.


• Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - NewDelhi - S. Chand Co. Pvt. Ltd,. - 2013

• Bapat varadraj and Raithatha Mehul - Financial accounting - A managerialprospective - New Delhi - Tata Mc Graw Hill Education Pvt. Ltd,. 2012.



NOTES

115

Topic 3 Valuation of Goodwill and Shares

Unit 7 Meaning , Need, Valuation ofGoodwill - Average Profit Method

Unit 8 Valuation of Goodwill - Super ProfitMethod

Unit 9 Valuation of Goodwill - Capitalisationand Annuity Methods

Unit 10 Valuation of Shares - Need, Methodsof Valuation of Shares

Unit 11 Valuation of Shares - Fair ValueMethod, Value of Right andPreference Shares

Unit 7 Meaning , Need, Valuation ofGoodwill - Average Profit Method

Structure

7.0 Introduction

7.1 Unit Objectives

7.2 Meaning and Definition of Goodwill

7.3 Need for Valuation of Goodwill

7.4 Elements of Goodwill

7.4.1 Distinguishing Features of Goodwill

7.4.2 Type of Goodwill

7.5 Factory Affecting Valuation of Goodwill

7.6 Methods of valuation of Goodwill

7.6.1 Average profit Method

7.7 Illustrations

7.8 summary

7.9 Key Terms



7.0 Introduction

When a business is able to earn profits at a rate higher than that at which asimilar business earns, the former is said to possess goodwill. Every businessmantries to establish their goodwill because to enables them to earn more profit. Goodwillis a valuation asset if the concern is profitable, it is valueless if the concern is alosing concern. Goodwill refers to a measure of the capacity of a business to earnabove the normal profits. It is an attractive force which beings in customers.

Goodwill refers to a measure of the capacity of a business to earn abovenormal profits. It is the benefit and advantage of a good name, reputation andconnection of a business. It is the attractive force which brings in customers. It isthe one thing which distinguished an old and established business from a newbusiness at start. It is an intangible but a real asset.

Goodwill is a term used in accounting for intangible assets usually measured

Meaning, Need,Valuation of Goodwill -Average Profit Method


NOTES

117

by the difference between the price paid for a going concern and its book value.If a firm is sold with a “good name” or large set of customers or clients likely toremain after the sale, these are part of the firm’s goodwill. There are severalways by which an accountant can compute goodwill. Here, we will outline someof the various methods available for valuation of goodwill.

7.1 Unit Objectives

After studying this unit to should be able to :

• Understand the need of valuation of goodwill

• Recognise the factors that effect the value of goodwill

• Determine the elements of goodwill

• Explain various methods of valuation of goodwill

• Calculate valuation of goodwill as per average profit method.

7.2 Meaning and Definition of Goodwill

Meaning :

Goodwill is an asset which has countless definitions. Accountants,Economists, Engineers and the Counts have defined Goodwill in a number ofways from their respective angles. As such they have suggested different methodsfor its nature and valuation. No doubt, it is an intangible real asset and not afictitious one. ‘It is perhaps the most intangible of intangibles’.

Goodwill is a most valuable asset if the concern is profitable, on the otherhand, it is valueless if the concern is a losing one. Therefore, it can be stated thatGoodwill is the value of the representative firm, judged in respect of its earningcapacity. However, some of the definitions are discussed here under:

Definitions :

Prof. Dicksee : “ The present value of a firm’s anticipated excessearning”. When a man pays for goodwill, he pays for something which puts himin a position of being also to earn more than he would be able to do by his ownunaided efforts.

Goodwill is thus, the extra saleable value attached to a prosperous businessbeyond the intrinsic value of net assets.

From a different angle, goodwill may be viewed as a more or less permanentimpression created in the minds of the customers of a particular organisation whocontinue to patronise that organisation despite the high price of its products whichenables the organisation to earn super-profits. So goodwill is the outcome of animpression created in the mind of each customer. It can exist only among competitivebusinesses.

NOTES

118



Lord Lindley :

“ The term Goodwill can hardly be said to have any precise significance.It is generally used to denote the benefit arising from connection andreputation and its value is what can be got for the change of being able tokeep that connection and improve it. Upon the sale of an established businessits goodwill has a marketable value, whether the business is that of aprofessional man or any other person. But it is plain that goodwill has nomeaning except in connection with a continuing business, and the value ofthe goodwill of any business to a purchaser depends in some cases entirely,and in all very much, on the absence of competition on the part of those bywhom the business has been previously carried on”.

Wilson :

“Goodwill has been very ably divided into three types - cat, dog an rat- in view of the peculiar habits of these three animals. The cat tends to stickto the abode, cat goodwill is therefore that which will adhere to the businesswhich is being transferred and is the most valuable. The dog follows hismaster, dog goodwill is difficult to transfer and is correspondingly lessvaluable. The rat is a migrant, rat goodwill is practically valueless, as itrepresents those customers who have no specialities either to the business orits properties and who may be here today and gone tomorrow. Summed up,cat goodwill is adherent; dog personal and rat fugitive. Adherent goodwillis only valuable as attaching to the business; personal goodwill is unsaleable,fugitive goodwill in only valuable in that as one fugitive goes another mayarrive”.

In the word of Spicer and Pegler, “Goodwill may be said to be thatelement arising from the reputation, connection, or other advantagespossessed by a business which enables it to earn greater profits than thereturn normally to be expected on the capital represented by the net tangibleassets employed in the business”.

Goodwill may be described as the aggregate of those intangible attribute ofa business which contribute to its superior earning capacity over a normal returnon investment. It may arise from such attributes of a business as good reception,a favorable location, the ability and skill of its employees and management, natureof its products, etc.

Lord Machaghten :

‘What is goodwill ? It is a thing very easy to describe, very difficult todefine. It is the benefit and advantages of the good name, reputation in connectionwith a business. It is the attractive force which brings is customers. It is a thingwhich distinguishes an old established business from a new business at its firststart’.

Lord Eldon :

“Goodwill is nothing more than the probability that the old customerswill resort to the old place”.



NOTES

119

Hatfield :

“The value of business connections, the value of the probability thatpresent customers will continue to buy inspite of the allurements of competingdealers”.

Walton :

“The element of an established business which makes the business asa going concern worth more than its book value, that is, its net worth asshown by the books”.

Wildman :

“It is the influence that the proprietor or his organisation has uponthe purchasing public through which he is enabled to attract and retainpatronage”.

7.3 Need for Valuation of Goodwill

There are various circumstances when it may be necessary to value goodwill.Some of the circumstances are as under.

(1) In the of individuals, goodwill is valued for purpose of Estate Duty, DeathDuty, etc. on the death of a person.

(2) In the case of a sole trader, goodwill is valued at the time of selling thebusiness, to decide the purchase consideration.

(3) In the case of a partnership, when there is an admission, retirement, deathor amalgamation, or a change in profit sharing ratio takes place, valuationof goodwill become necessary.

(4) In the case of a company, when two or more companies amalgamate orone company absorbs another company, or one company wants to acquirecontrolling interest in another company of with the Government takes overthe business, valuation of goodwill becomes necessary.

7.4 Elements of Goodwill

R.H. Nelson suggests that goodwill generally consists of the followingelements:

(a) Customer lists;

(b) Organisation costs;

(c) Development costs;

(d) Trademarks, trade names and brands;

NOTES

120



Check Your Progress

1. What is ‘Goodwill’ ?

2 . Why it is necessary tovalue ‘Goodwill’ ?

3 . State the Elements ofGoodwill.

(e) Secret processes and formulae;

(f) patents;

(g) Copyrights;

(h) Licenses;

(i) Franchises; and

(j) Superior earning power.

7.4.1 Distinguishing Features of Goodwill

Following are the factors distinguishing goodwill from most of the otherassets.

(a) It is the earning power of the business.

(b) It is intangible in nature.

(c) It represents a non-physical value over and above the physical assets.

(d) It cannot have an existence separate from the business and therefore,cannot be realised separately.

(e) It is difficult to place a cost on goodwill as the value may fluctuate fromday-to-day as a result of internal and external circumstances, i.e.changing fortunes of the company’s business.

(f) The amount or value of the goodwill and the assessment of its actualexistence is highly dependent on the subjective judgement of the valuer.

7.4.2 Types of Goodwill

Generally, the types of goodwill can be shown as indicated in Figure 7.1

Fig. 7.1 : Types of Goodwill

a) Purchased Goodwill:

Purchased Goodwill arises when one business buys another and the purchaseconsideration paid is more than the value of the net tangible assets received. Itcan never exist in a new business except by purchase.

It is accepted practice to recognise only the purchased goodwill in the

Non-Purchased Goodwill

Types of GoodwillPurchased Goodwill



NOTES

121

accounting system.Therefore, goodwill should enter into the books of accounts ofa business only in connection with a valuation ascribed to it in the acquisition priceof a business. Purchased goodwill is recognised in financial statements. Mostly, itarises on an acquisition.

b) Non-Purchased or Inherent Goodwill:

Non-Purchased or inherent goodwill is referred to as internally generatedgoodwill and it arises when a business may over the years generate its owngoodwill. Inherent goodwill is never recognised in financial statements. It is notdemonstrated by a purchase consideration. It is internally generated.

7.5 The Various Factors affecting valuation ofgoodwill are shown belows in figure 7.2

Fig 7.2 Factors affecting valuation of goodwill

There are many other factors which are taken into consideration for valuationof goodwill. Those factors - internal and external-which contribute to the goodwillof a business and the important ones are listed below :

(A) Internal Factors :

1) If risk is less in a business, then the amount of goodwill will be more thanthose business in which risks are more.

2) If quality of goods manufactured is better, there will be more goodwill.

3) If more profits are made in a business, no doubt, goodwill increases.

4) If more profits can be derived by investing comparatively less capital, thenvalue of goodwill increases.

5) The better the relations between employer and employees more will begoodwill.

6) The profits of the past years play an important role in determination ofgoodwill.

7) If a firm has established reputations for a patent or trade - mark. it will havegoodwill due to it.

8) If the increasing trend of profits can be maintained in future, without risk,the amount of goodwill will be more.

NOTES

122



ExternalFactors

InternalFactors

Factors Affecting Valuation of Goodwill

A B

9) Some place are famous for certain products. If a business is carried on atthese place, goodwill is created. if it is located in a very prominent place itcan attract more customers.

10) If management expenses are less, comparing with the profits, goodwillincreases.

11) The efficient management may also help to increase the value of goodwillby increasing profits through proper planned production, distribution &services.

(B) External Factors :

1) If customers’ point of view is good about the business, goodwill will bemore and vice versa.

2) The position of the business in relation to its competitors is an importantfactor.

3) Popularity of products in terms of quality and effective after-sales-services.

4) Availability of raw materials is also one of the factors influencing the valueof goodwill.

5) If a business is enjoying political protection or it is expected to enjoy politicalprotection, the value of goodwill will be more.

6) Effective advertising to establish brand popularity.

7) Good industrial relations with other industries, as well as good labour relations.

8) Research and Development efforts.

9) Technical collaborations with established companies.

10) Customers’ favourable attitude and customer satisfaction.

11) Favourable money market condition help to increase the value of goodwill.

12) Effective government policies and peace and security in the country helpto increase the value of goodwill. Favourable Tax polices are also helping.

13) Time dimention is another important factor which influences the value ofgoodwill.



NOTES

123

7.6 Methods of Valuation of Goodwill

The Various Methods of valuation of Godwill are shown below in figure 7.3 -

Fig. 7.3 Methods of Valuation of Goodwill

7.6.1 Average Profit Method

This method takes into account the average profit for the last few yearsand fixes the value of the goodwill as so many years of purchase of this amount.

Formulae :

Total Profit Less Loss, if any(i) Average Profit =

Number of Years

(ii) Valuation of Goodwill = Average Profit x Number of Years purchase

Calculation of Average Profit :

Under this method, at first, average profit is calculated on the basis of thepast few years’ profits. At the time of calculating average profit, precaution must

Methods ofValuation of Goodwill

Super Profit Methods

Capitalisation Methods

Ann

uity

Met

hods

Avarage ProfitM

ethods

NOTES

124



be taken in respect of any abnormal items of profit or loss which may be based onsimple average or weighted average.

Valuation of Goodwill : After calculating average profit, it is multiplied bya number (3 or 4 i.e. three or four years), as agreed. The product will be the valueof the goodwill, ?If the weighted average profit is taken for the last four years, thelast year should be given a weightage of 4, the previous year a weightage of 3, theprior to that a weight of 2 and so on. To obtain the weighted average profit, theprofit of the year must be multiplied by its weightage and the grand total should bedivided by the aggregate number of weights.

Since goodwill figures rely on a series of estimates and assumptions,different weightings would produce different end results.

EXAMPLE

Ashoka Ltd. Ahmednagar agreed to purchase business of a sole trader. Forthat purpose, goodwill is to be valued at 3 year’s purchase of the average profitsof last 5 years.

Years `

2007 - 2008 80,000

2008 - 2009 90,000

2009 - 2010 72,000

2010 - 2011 92,000

2011 - 2012 1,00,000

Calculate the value if Goodwill by following Average Profit Method

ANSWER

Average profit =` 80,000 + 90,000 + 72,000 + 92,000 + 1,00,000

5 Years

=` 4,34,000

5Yeras

= ` 86,800

Goodwill = 3 Years purchase of average profit of last 5 years

= ` 86,800 x 3

= ` 2,60,400

ACCOUNTING TREATMENT

Average Profit Method involves two steps to follow in computation ofgoodwill



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125

(a) The profit for an agreed number of years preceding the valuation areaveraged so as to arrive at the average annual profit earned during the period.This will have to be adjusted in the light of future possibilities and the averagefuture maintainable profit determined.

If the profit have been fluctuating, a simple average is used. If profits showa steadily increasing or decreasing trend, appropriate weights are used givinggreater weightage for profits of the last years.

(b) The average future maintainable profit is multiplied by certain numberof years to find out the value of goodwill. The number of years selected for thispurpose are based on the expectation of the number of years’ benefit to be derivedin the future from the past association.

The Average Profit Method has the following advantages and limitations.

Advantages :

(i) This method is very simple for calculations.

(ii) The net profit earned in the past over the desired period forms the suitablebase for computation of goodwill.

(iii) Income-Tax department uses this method of valuation of goodwill becauseof its simplicity and universal applicability.

Limitations :

(i) The main disadvantage of this method of valuing goodwill is that any trendin the level of profitability is not reflected in the valuation of goodwill. If thesimple average is used, i.e. each year’s profits are given the same weightage,no discrimination is made between a business that has rising profits and onethat has falling profits. To overcome this,it is necessary to give moreweightage to the profits of recent years.

(ii) Difficulty of finding out the right number of years’ purchase of profits as itdepends on many factors and situations.

(iii) It does not consider the capital investment which has been made to earnthe profits.

(iv) This method relies upon historical data.

(v) It is not a scientific method.

The Average Profit Method of valuation of goodwill can be understoodwith the help of following illustrations.

NOTES

126



Check Your Progress

1. What are the important‘Features of Goodwill’ ?

2 . Differentiate betweenPurchased Goodwill andNon-Purchased Goodwill.

3 . State the internal andexternal factors affectingthe ‘Valuation ofGoodwill.’

4 . Explain the advantagesand limitations ofAverage Profit Method ofValuation of Goodwill.

7.7 Illustrations

ILLUSTRATION 1

Eastern India Ltd., Edalbad earned the following amount of profits:

Year Profit

`

2011 22,000

2012 23,500

2013 21,000

2014 25,500

It is decided to value Goodwill of the company at two years purchase of theaverage profits of the four years.

Calculate of the amount of Goodwill as per Average Profit Method.

SOLUTION

(a) Calculation of the Average profit :

Year Profit

`

2011 22,000

2012 23,500

2013 21,000

2014 25,500

Total 92,000

Average Profit = Total Profit

Number of Years

=` 92,000

4 Years

= ` 23,000

(b) Calculation of Goodwill of the firm :

Goodwill = 2 years’ purchase of Average Profit

= Average Profit x 2

= ` 23,000 x 2

= ` 46,000

Hence, Goodwill of the company is to be valued at ` 46,000



NOTES

127

ILLUSTRATION 2

Femina and Co., Faridabad wish to value Goodwill of their firm. They havedecided to value Goodwill as three years’ purchase of the average profit earnedby them in last five years. The profit earned are as under :

Year Profit/Loss

`

2010 32,000

2011 12,500 (Loss)

2012 27,800

2013 25,900

2014 35,300

Calculate the amount of Goodwill as per Average Profit Method.

SOLUTION

(a) Calculation of the Average profit:

Year Profit/Loss

`

2010 32,000

2011 12,000 (Loss)

2012 27,800

2013 25,900

2014 (+) 35,300

Total Profit 1,09,000

Average Profit = Total profit

Number of Years

=` 1,09,000

5 Years

= ` 21,800

(b) Calculation of the Goodwill :

Goodwill = 3 years’ purchase of Average profit

= ` 21,800 x 3

= ` 65,400

Hence, Goodwill of the film is to be valued of ` 65,400

NOTES

128



ILLUSTRATION 3

The partnership firm of M/s Gemini and Sons, Goregaon wishes to valuegoodwill of the firm. It is decided to use average profit method for this purposeand the basis to be used is two years’ purchase of the average profits for precedingfour years. The profit and losses for the last four years are as follows:

Year Profits/Loss

`

2011 8,700 (Loss)

2012 10,850

2013 14,380

2014 17,070

Calculate the amount of Goodwill as per Average Profit Method.

SOLUTION

(1) Calculation of the Average Profit :

Year Profit/Loss

`

2011 8,700 (Loss)

2012 10,850

2013 14,380

2014 (+) 17,070

Total Profit 33,600

Average Profit = Total Profit

Number of Years

=` 33,600

4 Years

= ` 8,400

(b) Calculation of Goodwill


= ` 8,400 x 2

= ` 16,800




NOTES

129

ILLUSTRATION 4

M/s Hira - panna and Co. Haridwar wish to find out the value of the Goodwillof the firm. Goodwill is decided to be valued at two years’ purchase of the averageprofit for last five years. The profits and losses of the five years as under:

`

Year ended 31st March, 2010 14,580


Year ended 31st March, 2012 8,350 (Loss)



Calculate the value of the Goodwill of the firm as per Average Profit Method.

SOLUTION

(1) Calculation of the Average profit:

Particulars Profits/Loss



Year ended 31st March, 2012 8,350 Loss

Year ended 31st March, 2013 (+) 9,460


Total Profit 39,710


Number of Years

=` 39,710

5 Years

= ` 7,942

(2) Calculation of the Goodwill :


= ` 27,942 x 2

= ` 15,884

Hence, Goodwill of the company is to be valued of ` 15,884

NOTES

130



ILLUSTRATION 5

A Partnership firm in which Mahesh, Suresh and Bhaegsh are the partners,has earned profits in the last five years as under:

Year Profit

`

2010 27,750

2011 32,225

2012 33,465

2013 28,640

2014 30,360

The partners have decided to value Goodwill at 3 years’ purchase of theaverage profit for last 5 years.

SOLUTION

(1) Calculation of Average profits:

Year Profit

`

2010 29,750

2011 32,225

2012 33,645

2013 28,640

2014 30,360



Number of Years

=` 1,54,440

5 Years

= ` 30,888

(2) Calculation of Goodwill of the firm:


= ` 30,888 x 3

= ` 92,664




NOTES

131

7.8 Summary

(1) Goodwill is the value of the reputation of a business in respect of profitsexpected in future over and above the normal level of profits earned byundertakings belonging to the same class of business.

(2) Goodwill is the term used in accounting for intangible assets, but not fictitious,usually measured by the difference between the price paid for a concernand its book value.

(3) In case of a partnership firm, when there is an admission, retirement, deathof a partner. amalgamation or sale of a firm, or a change in profit sharingratio takes place, valuation of Goodwill becomes necessary.

(4) Goodwill is the earning power of business with intangible nature.

(5) Purchased Goodwill and Inherent Goodwill are generally the two types ofGoodwill arises in a partnership.

(6) Average profit Method takes into account the average profit for the lastfew years and fixes the value of Goodwill as to many years of purchase ofthis amount.

7.9 Key Terms

(1) Goodwill : Goodwill is the extra saleable value attaches to a prosperousbusiness beyond the intrinsic value of net assets.

(2) Purchased Goodwill : Purchased Goodwill arises when one business buysanother and the purchase consideration paid is more than the value of thenet tangible assets received.

(3) Non-purchased or Inherent Goodwill : Non-purchased or inherentgoodwill is referred to as internally generated goodwill and it arises when abusiness may over the years generate its own goodwill.

(4) Average Profit =Total profit Less Loss, if any

Number of Years

(5) Valuation of Goodwill = Average profit x Number of Years purchase

(6) Average profit may be computed in the following manners :

(1) Simple Average; and

(2) Weighted Average

(1) Simple Average :

It is nothing but the simple average profit for the last few years.

NOTES

132



Average Profit =Total profit of all the years

Number of years

(2) Weighted Average :

Actual profit is being multiplied by the respective number of weights (say,1,2,3, and 4 ..........) in order to get the amount of product.

Average Profit =Total Product

No. of weights

(Note : Weighted average profit is considered when the trend of profits is raising.)



(A) Multiple choice Questions

(1) A measure of the capacity of a business to earn above normal

profits in accounting term is referred to as ------- .

(a) Goodwill

(b) Reputation

(c) Creditstandings

(d) Prestige

(2) Goodwill is an ----------- real assets and not a fictitious one.

(a) Intangible

(b) tangible

(c) wasting

(d) non-wasting

(3) In case of a sole trader goodwill is valued at the time of selling the businessto decide upon the ----------- .

(a) selling price

(b) inflated price

(c) purchase consideration

(d) loaded price

(4) Income - Tax department uses ------------ method of valuation of goodwillbecause of its simplicity and universal applicability



NOTES

133

(a) super profit

(b) capitalisation

(c) annuity

(d) average profit

Ans :- (1-a), (2 - b), (3 - c), (4 - d)


1) What is ‘Goodwill’ ? Explain the need for valuation of goodwill.

2) Define ‘Goodwill’. Explain in breif the elements of goodwill.

3) What do you understand by ‘Goodwill’? State the distinguishing features ofGoodwill.

4) What is ‘Goodwill’? Explain in brief the types of goodwill viz.

a) Purchased Goodwill and b) Inherent goodwill

5) Explain in brief the factors affecting the valuation of goodwill.

6) What is ‘Average profit’? State the advantages and limitations of Averageprofit method of valuation of Goodwill.


1) The profits of Aarohi Enterprises for the last four years are 27,500, 19,300.` 23,200 and 14,000 respectively. The goodwill of the firm is equal to two yearspurchase of the average profits for the last for years. Calculate the Goodwill asper Average profit method.

2) Goodwill of Bristol adn co. is to be valued at three times of the average profitsfor the last five years. The profits were .....

Year `

2010 20,400 profits

2011 11,700 profits

2012 6,900 profits

2013 8,700 profits

2014 19,700 profits

Find out the value of Goodwill as per Average profit method.

3) Goodwill of chandan Bros. is to be calculated as two years purchased of theaverage profits of last three years. The profits for the first year was ` 10,000.

NOTES

134



The profits for the second and third year was twice the profits of the previousyear.

Find out the value of Goodwill as per Average profit method.


• Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - NewDelhi - S. Chand & Co. Pvt. Ltd., 2013.

• Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - NewDelhi - Taxmann Publications Pvt. Ltd., 2012.



NOTES

135

Unit 8 Valuation of Goodwill - Super ProfitMethod

Structure

8.0 Introduction

8.1 Unit Objectives

8.2 Super Profit Method

8.3 Accounting treatment

8.4 Calculation of Average Profit, Super Profit and Goodwill

8.5 Sliding -Scale Valuation of Super Profit

8.6 Illustrations

8.7 Summary

8.8 Key Terms



8.0 Introduction

Goodwill, in general is recorded in the books only when some considerationin money or money’s worth has been paid for it. Whenever a business is acquiredfor a price (payable either in cash in shares or otherwise) which is in excess of thevalue of the net assets of the business taken over, the excess is termed as“goodwill”. In previous Unit, we have discussed various methods of valuation ofgoodwill. Another common method of valuation of goodwill is the “Super ProfitMethod”. Under this method, super profits is taken as the basis for calculatinggoodwill in place of average profit. Like average profit method, this value is alsocomputed by applying a general rule acceptable in the trade e.g. three or fouryears purchase of super profit.

Valuation of Goodwill -Super Profit Method


NOTES

137

8.1 Unit Objectives


• Understand the meaning of Average profit, Normal profit & super profit.

• Calculate Average profit, super profit and goodwill as per super profit method.

• Know the concept of Normal rate of Return.

• Ascertain ‘Average capital Employed”.

• Explain “Sliding -Scale valuation of super profit”.

8.2 Super Profit Method

Under this method, super profits is taken as the basis for calculating goodwillin place of average profit. Like the previous method, this value is also computedby applying a traditional rule acceptable in the trade, e.g. three or four years’purchase of super profit.

Strictly speaking, goodwill can be attached only to a business which is earningabove normal profits or super profits. If there are no anticipated excess earningsover normal earnings, there can be no goodwill. Such excess profit is known assuper profit and it is difference between the average profit earned by the businessand the normal profit based on the normal rate of return. For ascertaining thesuper profits the following information will be required.

(i) The estimated average future profits of the firm.

(ii) The normal rate of return on investment and

(iii) The fair value of average capital employed in the business.

These essentials are depicted in following figure. 8.1

Fig. 8.1 Essential of super profit method.

Normal Rate of Return

Esentials ofSuperprofit Method

Average maintainable profit

Capital Employed

3

1

2

NOTES

138



Formulae :

(i) Average Profit =Total Profit Less Loss, if any

Number of years

(ii) Normal Profit = Capital Employed x Normal Rate of Returns

(iii) Super Profit = Average Profit - Normal Profit.

(iv) Valuation of Goodwill = Super Profit x Number of years purchase.

8.3 Accounting Treatment

Normal Rate of Return : The normal rate of return refers to the rate ofearning which investors in general expect on their investments in a particular typeof industry. It varies depending upon general factors like the bank rate, generaleconomic conditions, political stability, etc. and specific factors like periodinvestment, risk attached to the investment, etc.

Average Capital Employed : The average capital employed in the businessmay be ascertained in the following ways:

(i) Asset Side Approach and

(ii) Liabilities side Approach.

(i) Asset Side Approach :

Assets (other than non-trading assets, goodwill and pastexpenses and losses) at market value, at the Balance Sheetdate. xxxLess :Liabilities to outsiders at revised values, if any

(-) xxxAverage Capital employed for the year. xxx

(ii) Liabilities Side Approach :

Add : • Equity Share Capital xxx

• Preference Share Capital xxx

• Reserves and Surplus xxx

• Profit on revaluation of assets and labilities (+) xxx

Less : * Goodwill (Book Value) xxx

* Losses and past expenses not yet written off xxx

* Loss on revaluation xxx (-) xxx

Capital employed at the end of the year xxx

Less : 1/2 of the profit (-) xxxAverage Capital employed for the year xxx



NOTES

139

In short, super profit is the excess of actual profit over the normal of anenterprise. A common method of valuation of goodwill is the super-profit method.A business unit may posses some advantages which enable it to make extra profitsover and above the amount that would be earned it the capital of the business wasinvested elsewhere with similar risks. These extra profits, generally expressed assuper profit, can be valued, and goodwill is the value of the few years’ purchaseof super profit.

8.4 Calculation of Average Profit, Super profit andGoodwill

For calculating goodwill, the different steps are as follows :

Step 1: Calculate capital employed (it is the total of shareholders equity pluslong-term debt or fixed assets plus net current assets).

Step 2: Calculate normal return by multiplying capital employed withnormal rate of return.

Step 3: Calculate average maintainable profit of the business.

Step 4: Calculate the difference between the average maintainable profitand normal return as calculated above.This difference is calledsuper profit (if it is positive).

Step 5: Multiply that super profit by the number of years’ purchase. Theproduct is the value of the goodwill.

EXAMPLE

The following particulars are available in respect of the business of Colgateand Co., Cochin.

(i) Capital employed - ` 50,000.

(ii) Trading profit (after tax) :

2009 - 10,000;

2010 - 17,200;

2011 - ` 2,000 (Loss); and

2012 - 21,000

(iii) Market rate of interest on investment - 8%.

(iv) Rate of risk return on capital invested in business - 2%.

(v) Remuneration from alternative employment of the proprietor (if not engagedin business) amount to ` 3,600 p.a.

You are required to compute the value of goodwill on the basis of three

NOTES

140



years purchase of super profit of the business calculated on the average profit ofthe last four years.

ANSWER

(1) Calculation of Average Profit :

Particulars `

2009 - Profit 10,000

2010 - Profit 17,200

2011 - Loss 2,000

2012 - Profit (+) 21,000

Total Profit 46.200

Average Profit = ` 46,200 11,550

4 Years

(2) Calculation of Super Profit :

Particulars `

Average Profit 11,550

Less : Remuneration from alternative employment (-) 3,600

Average Trading Profit 7,950

Less : Normal Profit @ 10% on ` 50,000 (-) 5,000

Super Profit 2,950

Goodwill = 3 Years purchase of super profit

= ` 2,950 x 3

= ` 8,850

EXAMPLE

The net profit of Dorabjee and Co., Dombivali after providing for taxationfor the past five years as under:

2007 - 08 - ` 80,000; 2008-09 - ` 85,000; 2009-10 ` 92,000; 2010-11 -` 1,05,000 and 2011-12 - ` 1,18,000. The capital employed in the business is` 8,00,000. The normal rate of return expected in this type of industry in 10%. Itis expected that the company will be able to maintain its super profit for the next5 years.

Calculate the value of goodwill on the five years’ purchase of super profitmethod.



NOTES

141

ANSWER

(1) Calculation of Average Profit and Super Profit:

Average Profit = Total Profits

Number of Years

`

Profit for 5 Years,

(` 80,000 + 85,000 + 92,000 + 1,05,000 + 1,18,000) 4,80,000

Average Profit (` 4,80,000/5) 96,000

Less : Normal Profit (` 8,00,000 x 10/100) (-) 80,000

Super Profit 16,000

2) Calculation of Goodwill as per Purchase of Super Profit Method:

Goodwill = Super Profit x 5 Years

= ` 16,000 x 5

= ` 80,000

8.5 Sliding -Scale Valuation of Super Profit

This method of valuation of goodwill is a slight variation of the purchase ofsuper profit method. It has been advocated by AE. Cutforth. It is based on thelogic that the greater is the amount of super profits, the more difficult it is tomaintain it. Higher profit will naturally attract competition and soon the firm’sability to make super profit is curtailed. Hence, instead of multiplying the wholesuper profit by a certain number of years, a grading scale is adopted. According toCulforth , super profit is divided into two or three divisions. Each of these bemultiplied by a different number of year’s purchase, in desceding order from thefirst division. Thus, for example, if super profit is estimated at 15,000, the goodwillwill be calculated as under:

First ` 5,000 at, say, 5 years purchase ` 25,000

Second ` 5,000 at, say 4 Years purchase ` 20,000

Third ` 5,000 at, say 3 Years purchase ` 15,000

Total value of goodwill ` 60,000

The super profit method of valuation of goodwill can be understood withthe help of following illustrations.

NOTES

142



Check Your Progress

1. What is ‘Super Profit’ ?

2 . Explain the essentials ofSuper Profit Mehtod ofvaluation of Goodwill.

3 . What is ‘Normal Rate ofReturn’ ?

4 . Define the term ‘Sliding-Scale Valuation of Profit’.



NOTES

143

ILLUSTRATION 1

Indian Chemicals Ltd., Indore has earned profits in the last four years asunder:

Year Profit

`

2011 9,200

2012 12,300

2013 14,700

2014 15,800

Investments made in the firm is ` 90,000. Other firms carrying on similarbusiness give a return @ 10% of the investment made in them.

It is decided to value the Goodwill of the firm on super profit basis usingfive years’ purchase of the average super profit method.

Calculate the amount of Goodwill of the firm.SOLUTION


Year Profit

`

2011 9,200

2012 12,300

2013 14,700

2014 (+) 15,800

Total Profit 52,000

Average Profit =

Total profit

Number of Years

=` 52,000

4 Years

= ` 13,000

(2) Calculation of Normal Profit :

Normal profit is 10% of the investments made.

Normal Profit = ` 90,000 x 10%

= ` 9,000


Super Profit = Average Profit - Normal Profit

= ` 13,000 - ` 9,000

= ` 4,000

(4) Calculation of Goodwill according to five years’ purchase of superprofit method :

Goodwill = Super Profit x Number of Years purchase

= ` 4,000 x 5 Years

= ` 20,000

Hence, Goodwill of the company is to be valued at ` 20,000.

ILLUSTRATION 2

M/s Jindal and Sons. Jamner have earned the following amount of profits inthe last five years.

Year Profit

`

2010 25,300

2011 28,560

2012 26,200

2013 29,440

2014 35,500

Investment made in the firm amounts to ` 1,20,000. Other firms carryingon similar business give return at 15% on the investment made in them.

Calculate the Goodwill of the firm on super profit basis using four years’purchase of the Super Profit Method.

SOLUTION


Year Profit `

2010 25,3002011 28,5602012 26,2002013 29,4402014 (+) 35,500 Total Profit 1,45,000

NOTES

144




Number of Years

=` 1,45,000

5 Years

= ` 29,000



Normal Profit = ` 1,20,000 x 15%

= ` 18,000



= ` 29,000 - 18,000

= ` 11,000

(4) Calculation of Goodwill according to four years’ purchase of superprofit method.


= ` 11,000 x 5 Years

= ` 55,000

Hence, Goodwill of the firm is to be valued at ` 55,000.

ILLUSTRATION 3

M/s Kirloskar Bros., Kalyan have earned the profits in the last four yearsas under.

Year Profit/Loss

`

2011 7,000 (Loss)

2012 32,000

2013 36,000

2014 47,000

Investment made in M/s Kirloskar Bros., ` 1,20,000. Other firm carryingon similar business give return at 18% on the amount of investment made in them.

You are required to calculate the Goodwill M/s Kirlsokar Bros. using threeyears’ purchase of the Super Profit Method.



NOTES

145

SOLUTION


Year Profit/Loss

`

2011 7,000 (Loss)

2012 32,000

2013 36,000

2014 (+) 47,000



Number of Years

=` 1,08,000

4 Years

= `27,000


Normal Profit = Normal profit is 18% of the

investments made.

= ` 1,20,000 x 18%

= ` 21,600


Average Super Profit = Average Profit - Normal Profit

= ` 27,000 - 21,600

= ` 5,400

(4) Calculation of Goodwill according to three years’ purchase of SuperProfit Method :


= ` 5,400 x 3 Years

= ` 16,200


NOTES

146



ILLUSTRATION 4

M/s Larson and Co., Lasagaon have earned following amount the profits inthe last five years.

2010 - 38,750; 2011 - 41,900; 2012 - 36,280;

2013 - 39,020; 2014 - 44,050.

Investment made in Larson and Co. amount to ` 3,25,000.

Other firms doing similar business earn a return of 10% on their investments.

Calculate the Goodwill of M/s Larson and Co. on super profit using fouryears’ purchase of the Super Profit Method.

SOLUTION


Year Profit

`

2010 38,750

2011 41,900

2012 36,280

2013 39,020

2014 (+) 44,050



Number of Years

=` 2,00,000

5 Years

= `40,000



Normal Profit = ` 3,25,000 x 10%

= ` 32,500


Super Profit = Average Profit - Normal Profit= ` 40,000 - 32,500= ` 7,500



NOTES

147

(4) Calculation of Goodwill according to four years’ purchase of SuperProfit :


= ` 7,500 x 4 Years

= `30,000


ILLUSTRATION 5

M/s Manik - Moti and Co., Malegaon, a partnership firm in which 60,000are invested has earned ` 14,200; ` 18,400 and ` 16,300 ad profits in the lastthree years. Other firms doing similar firms earn 16% returns on the amountinvested in them.

Reference to Annuity Table shown that the annuity of ` 1 for 3 years @16% is 2.246.

You are required to calculate Goodwill of the firm on super profit using twoyears’ purchase of the Super Profit Method.

SOLUTION


Year Profit

`

1st Year 14,200

2st Year 18,400

3st Year (+) 16,300

Total Profit 48,900


Number of Years

=` 48,900

3 Years

= `16,300



Normal profit = ` 60,000 x 16%

= ` 9,600

NOTES

148





= ` 16,300 - ` 9,600

= ` 6,700

(4) Calculation of Goodwill according to two years’ purchase of SuperProfit Method :


= ` 6,700 x 2 Years

= ` 13,400

Hence, Goodwill of the firm is to be valued at `13,400.

8.7 Summary

• A common method of valuation of goodwill is the “Super Profit Method”.Under this method, super profits is taken as the basis for calculating goodwillis place of average profit. For ascertaining the super profit the followinginformations in will be required.

(i) The estimated average future profit.

(ii) The Normal rate of return on investment &

(iii) The fair value of average capital employed in the business.

• For calculating goodwill as per super profit method following steps arefollows -

(1) Calculate capital employed.

(2) Calculate normal rate of return.

(3) Calculate average maintainable profit.

(4) Calculate difference between the average maintainable profit & normalreturn. This differences called “ Super Profit”.

(5) Multiply the super profit by number of years purchase. The product isthe value of the goodwill.

• Sliding Scale Valuation of Super Profit - It has been advocates by AE Cutforth.It is bused on the logic that the grater is the amount of super profits, themore difficult it is to maintain it. Here, super profit is divided in to two orthree division.



NOTES

149

8.8 Key Terms

(1) Capital Employed :

At the time of calculating the goodwill of a firm, It is very important toascertain the value of Capital employed, since the profit of a firm can be justifiedin terms of capital employed only. Capital employed may be computed with thehelp of the following :

Capital Employed = Fixed assets (at revalued figure but excluding non-tradingassets, like investment) + Current Assets(at market value)- Current Liabilities.

Alternatively, Capital Employed = Fixed Assets + Working Capital.

OR

Capital Employed = Share Capital + Reserve and Surplus + Long-term Debts -Preliminary Expenses, Discount on issue of Shares andDebentures.

Capital Employed may be divided into :

(a)Gross Capital Employed = Total Fixed Assets + Total Current Assets.

(b)Net Capital Employed = Total Fixed Assets + Total Current Assets -Total Current Liabilities (stated above).

(c)Proprietor’s Capital Employed = Total Fixed Assets + Total Current Assets -External Liabilities.

(Note : Usually, the term “Capital Employed” indicates Net Capital employed.)

(2) Average Capital Employed :

It is the modified version of capital employed. Average capital employedmay be computed by adding the closing capital employed with the opening capitalemployed and dividing the same by two:

Opening Capital Employed + Closing Capital EmployedAverage Capital Employed =

2

Alternatively : Average Capital Employed = Capital Employed - 1/2 Current Year’sProfit.

(3) Normal Rate of Return or Standard Rate of Return :

Valuation of goodwill is greatly affected by the rate of earning which isexpected by the investors from their investments - since normal level of profit isascertained from the above expectation of the said investors. The return whichsatisfies a general investor on his investment in business or industry is said to bethe Normal Rate of Return. It is also known as Average Rate of Return. NormalRate of Earnings, Yeild, Reasonable Rate of Return, Rate of General Expectations,Standard Rate of Return etc.

NOTES

150






(1) The difference between the average profit earned and the normal profitbased on the normal rate of return is termed as-----.

(a) super profit

(b) capital profit

(c) revenue profit

(d) maintainable profit

(2) The rate of earnings which investors in general expect on their investmentsin a particular type of industry is termed as ----- rate of return.

(a) average

(b) normal

(c) general

(d) super

(3) Sliding scale valuation of super profit method of valuation of goodwill hasbeen advocated by ------

(a) Spicer

(b) Dicksee

(c) Cutforth

(d) Wilson

(4) Capital Employed during the year = opening capital (+) 1/2 of ------ profit.

(a) Capital

(b) revenue

(c) super

(d) annual

Ans. : (1-a), (2-b), (3-c), (4-d)


(1) What is ‘super profit’? state the essentials of super profit method of valuationof goodwill.



NOTES

151

(2) Explain and illustrate the super profit method of valuation of goodwill.

(3) Define the term ‘Super Profit’, Explain the concepts of average profit andnormal profit in the computation of super profit.

(4) Explain in brief ‘sliding scale valuation of super profit’ method of valuationof goodwill.

(5) What is ‘super profit’? state the advantages and limitations of super profitmethod of valuation of goodwill.


(1) The following is the Balance sheet of Rakesh and Yogesh as on 31st March2012



Capitals: Machinery 50,000

• Rakesh 90,000 Buildings 41,000

• Yogesh 70,000 Furniture 10,000

General Reserve 44,000 Investments 30,000

Sundry Creditors 30,000 Stock 10,000

Bills Payable 8,000 Sundry Debtors 66,000

Cash at Bank 35,000

2,42,000 2,42,000

The net profit of the firm for last few years were as follows:

Year Profit`

2008-09 15,0002009-10 25,0002010-11 26,000

Ascertain the value of Goodwill at two years purchase of the super profitfor 3 years, taking the normal rate of return on capital employed as 10%.

(2) The present average net profit of M/s Pradip and Sudip before deductingpartners remuneration is 27,000 p.a. The capital employed in the businessby the partners were.

Pradip ` 1,00,000 and Sudip ` 50,000. The profit expected from thetotal capital invested is 10% p.a. The total remuneration of the partners isestimated to be ` 6,000 p.a. Find out the value of Goodwill on the basis oftwo years purchases of super profits.

(3) Calculate the value of Goodwill of M/s Pratik and Co.,Pune from the followinginformation :

NOTES

152



(a) Total capital employed in the business 4,00,000.

(b) Net profit of the firm for the three years were :

Year Profit`

2010 53,8002011 43,3502012 56,250

(c) Normal rate of return at 10%.

(d) Goodwill is to be valued at three years purchase of super profit.

(4) M/s Deshpande and Sons, Dapoli have earned following amount of profitsin the last 4 years :

2009 - 15,450; 2010 - 18,600; 2011 - 22,250;

2012 - 23,700.

Investments made in the firm is ` 1,60,000.

Other firms carrying on similar business earned 10% return on theirinvestments.

Calculate Goodwill of the firm according to two years’’ purchase of thesuper profit method.

(5) M/s Jay and Parajay, Jalgaon has given you the result of its working for last5 years as under :

2008 - 19,050 profit, 2009 - 4,800 loss, 2010 - 18,750 profit,2011 - 22,200 profit, 2012 - 25,200 profit.

Investments made in the firm is ` 75,000. Other firms engaged in similarbusiness show earnings @ 14% on amount invested in them.

Calculate the amount of Goodwill of the firm using three years’ purchase ofthe super profit method.

(6) Calculate the amount of Goodwill of M/s Ravi-shankar bros, Ranjangaon,from the following details provided to you :

(1) Profit earned by the firm in the firm in the last 3 years :

2010 - ` 48,900 ; 2011 - ` 56,400 ; 2012 - ` 44,700.

(2) Investment ,made in the firm amounted to ` 2,25,000.

(3) Rate of earnings of other firms carrying similar business is 20% oninvestment.

Goodwill to be calculated by using two years purchase of the super profitmethod.



NOTES

153

(7) M/s Pannalal and Keshavalal, Panchgani have earned profits and losses inthe last 5 years as follows :

Year Profit /Loss`

2008 40,820 Profit2009 44,150 Profit2010 6,300 Loss2011 32,700 Profit2012 38,130 Profit

Investments made in the firm is ` 1,50,000. Other firms carrying similarbusiness earn 15% profit on the amount invested in them.

Calculate Goodwill of M/s Pannalal & Keshavlal using three years purchaseof the super profit method.

(8) M/s Bhave, Surve and Co., Badalapur earned profits in the last 4 years asunder :

2009 - ` 52,390; 2010 - ` 64,830; 2011 - 78,080;

2012 - 72,600.

Investments made in the firm is ` 5,00,000. Other firms carrying onsimilar business earn profit @ 10% on their investment.

You are requested to calculate Goodwill of the firm using three yearspurchase of the super profit method.


• Shukla M.C., Grewal T.S. and Gupta S.C. - Advanced Accounts - NewDelhi - S. Chand & Co. Pvt. Ltd. - 2013.

• Bapat Varadraj and Raithatha Mehul - Financial Accounting : An ManagerialProspective - New Delhi - Tata Mc Graw Hill Education Pvt. Ltd. - 2012.

NOTES

154



Unit 9 Valuation of Goodwill - Capitalisationand Annuity Methods

Structure

9.0 Introduction

9.1 Unit Objectives

9.2 Capitalisation of Profit method

9.3 Annuity Method

9.4 Illustrations

9.5 Summary

9.6 Key Terms


9.8 Further Reading

9.0 Introduction

Goodwill arise only if a firm earns extra profits, which is called super profits.There are two factors relates to valuation of goodwill; (i) When one buys a business,he will be able to get profits in future only and is not concerned with the pastprofits at all. (ii) Goodwill is paid for the ability to earn super profits and not forordinary profits. Goodwill is the value of reputation of a firm in respect of profitsexpected in future over and above the normal profits The value of goodwill dependsupon such factors as nature of the business, reputation if the firm, location of thebusiness, pleasing sevice, superior quality of its product managerial efficiency etc.The excess over the normal profit, called super profit, is the tangible factor ofgoodwill. In last Unit, we have discussed super profit Method. In this unit we aregoing to learn the another inportant methods of valuation of goodwill i.e.capitalisation method and Annunity Method. In the capitalisation of profit method,the total value of the business is found out by capitalising the expected profits onthe basis of normal rate of return. The value of goodwill is the difference betweenthe value of the business so foundout and the actual capital employes in the business.On the other work, Annuity method is bused an the logic that the purchaser shouldpay for goodwill only the present value of super profits calculated at a proper rateof interest. It means, goodwill in case of annuity method is the discounted value ofthe total amount calculated as per purchase of super profit method.

Valuation of Goodwill -Capitalisation & AnnuityMethod


NOTES

155

9.1 Unit Objectives

After studying this unit you should be able to :-

• Understand the meaning of capitilisation of profit method.

• Ascertain value of goodwill as per capitalisation of super profit method.

• Calculate value of goodwill as per capitalisation of Average profit method.

• Understand the meaning and process of Annuity Method.

• Calculate value of goodwill as per annuity method.

9.2 Capitilisation of Profit Method

In this method the total value of the business house is found out by capitalisingthe expected average profits on the basis of normal rate of return. As per thismethod, the value of goodwill is the difference between the value of the businessso found out and the actual capital employed in the business. The Capitatisation ofProfit Method is further classified in to : (a) Capitalisation of Super profit and (b)Capitalisation of Average profit as shown below in figure 9.1

Fig. 9.1 : Classification of Capitatisation of Profit Method.

(a) Capitalisation of Super Profit

Under this method, it is estimated as to how much capital will be required toearn super profit at normal rate of profit. This capitalised value of super profit istreated as goodwill.

(b) Capitalisation of Average Profit

Under this method, the average annual profit is to be ascertained afterproviding for reasonable management remuneration. This profit should be capitalisedat the rate of reasonable return to find out the total value of the business. Now thevalue of goodwill will be the total value of the business minus its net assets. If,however the net asset is greater, there will be no goodwill but badwill.

CAPITALISED VALUE OF PROFIT = PROFIT (ADJUSTED)

NORMAL RATE OF RETURN X 100

VALUE OF GOODWILL = CAPITALISED VALUE OF PROFIT LESS NET TANGIBLE ASSETS

Capitalisation of Average Profit Method

Capitalisation of Profit Method

Capitalisation of Super Profit Method

NOTES

156



Under the Capitalisation method the average profit is capitalised in the basis ofnormal rate of return and than excess of this capitalised amount over the netassets of the firm is goodwill.

Goodwill = Average Profit x 100

Percentage of normal return - Net Asset

EXAMPLE The average profit if a firm is 9,000. The firm’s is 60,000 andthe normal return on business is expected at 10%. Calculate thegoodwill amount as per capitalisation method.

ANSWER Goodwill =

Average profit x 100

percentage of normal returns - Net Assets.

=(9,000 x 100 )

10 - ` 60,000

= 90,000 - 60,000

= ` 30,000

Alternatively : Super profit = ` 9,000 - 6,000 = ` 3,000

= Normal Return 10%

Capital value = 3,000/10% = 3,000 x 100/10 = ` 30,000

EXAMPLE

The net profits of a Company, after providing for taxation. for the past fiveyears are ` 42,000; ` 47,000; ` 45,000; ` 39,000 and ` 47,000. The capitalemployed in the business is ` 4,00,000 on which a reasonable rate of return of10% is expected, Calculate the goodwill under (a) Capitalisation of Average ProfitMethod and (b) Capitalisation of Super Profit Method.

SOLUTION

(a)Average Profit = Total profits of 5 years

5

= ` 42,000 + 47,000 + 45,000 + 39,000 + 47,000

5

= ` 2,20,000 = ` 44,000 5



NOTES

157

Capitalised value of the business at 10% = ` 44,000 x 100 = ` 4,40,000

10

Less : Capital employed (given) 4,00,000

Value of goodwill : 40,000

(b) Average Profit (as above ) 44,000

Less : Normal return on capital employed

(at 10% on ` 4,00,000) 40,000

Super Profit 4,000

The normal rate of return is 10%.

Hence Capital Value = ` 4,000

10%

= ` 4,000 x 100

10

= ` 40,000

9.3 Annuity Method

Annuity Method of super profit is bused on the logic that the purchasershould pay for goodwill only the resent value of super profits calculated at aproper rate of interest. Under this method goodwill is the discounted value of thetotal amount calculated as per purchase of super profit method.

The value of goodwill as per this method is calculated as follows -

Average Annual Super Profit x Annuity Rate

EXAMPLE

In ABC firm, average annual super profit ` 5,000, rate of Interest 10%.Supposed, goodwill is to be valued at 3 years, purchase of the average annualsuper profit reference will have to be made to the annuity table for finding out thepresent -value of one rupee paid annually for 3 years at 10% interest. Annuitytable shows the ` 2.48685 is the present-value of an annuity of ` 1 for threeyears.

ANSWER

The Value of Goodwill = ` 5,000 x 2,48685 = ` 12434 or

(say ) ` 12500.

NOTES

158



Formula of Annuity Method :

Under this method, Super - Profit(excess of actual profit over normal profit)is being considered as the value of annuity over a certain number of years and, forthis purpose, compound interest is calculated at a certain respective percentage.The present value of the said annuity will be the value of goodwill.

Value of Goodwill, V =

Where, V = Present value of Annuity

a = Annual Super Profit

n = Number of Years

i = Rate of Interest

EXAMPLE

From the following particulars, compute the value of Goodwill under ‘AnnuityMethod’ :

Super - Profit ` 10,000

Number of years over which Super-profit is to be paid 5

Rate percent per annum 5%

ANSWER

V =

Or, V = 10,000

05

Where, a = ` 10,000

1 = 5%, or .05

n = 5.

Or, V = ` 43,260 or, say, 43,300

The capitalisation of profit method and Annuity Method of valuation ofgoodwill can be understood with the help of following illustrations.

a (1 - 1 )i (1 + i)n

a (1 - 1 )i (1 + i)n

(1 - 1(1 +0.5)n

)



NOTES

159

Check Your Progress

1. Explain the term‘Capitalisation of Profit.’

2 . Differentiate betweencapitalisation of averageprofit and capitalisationof super profit.

9.4 Illustrations

ILLUSTATION 1

Prestige Ltd., Pune are selling their business to Howking Ltd., Haridwar.The net profits of prestage Ltd., Pune after providing for taxation. For the pastfive years are as follows.

Year Profits

`

2010 1,80,000

2011 2,05,000

2012 1,90,000

2013 1,95,000

2014 2,30,000

The value of the net tangible assets of the business at the proposed date ofsale amounted to ` 20,50,000 and a reasonable rate of return of 8% is expectedon capital invested.

Calculate the value of Goodwill as per capitalisation of Average profit Methodand capitalisation of super profit method.

SOLUTION

1) Calculation of Average Profits :-

Year Profits

`

2010 1,80,000

2011 2,05,000

2012 1,90,000

2013 1,95,000

2014 2,30,000


Average profit = Total Profits

Number of years

=` 10,00,000

5 Years

= ` 2,00,000

NOTES

160



(2) Calculation of Capitalised value of Profit :

Capitalised value=

Adjusted profitx 100

of Profit Normal Rate of Return

= ` 2,00,000 x 100

8

= ` 25,00,000

(3) Calculation of the value of Goodwill as per capitalisation of AverageProfit Method :- `

Capitalised value of profit 25,00,000

Less : net tangible Assets (-) 20,50,000

Value of Goodwill 4,50,000

Hence the Goodwill of the Company is to be valued at ` 4,50,000

1) Calculation of super profit :- `

Average profit 2,00,000

Less Normal Return on capital Employed

( 8% on ` 20,50,000) (-) 1,64,000

Super profit 36,000

2) Calculation of the value of Goodwill as per capitalisation of Super ProfitMethod :-

Capitalised Value=

Super Profitof Super Profit Rate of Return

=` 36,000

8%

= ` 36,000 x 100

8

= ` 4,50,000

Hence, Goodwill of the Company is to be valued at ` 4,50,000



NOTES

161

ILLUSTRATION 2

Rotex and Co. decides to purchase the business of Bata and Co. as on 31st

December, 2014. The profits of Bata and Co. for the last five years as follows.

Year Profit

`

2010 15,900

2011 17,800

2012 18,200

2013 16,800

2014 21,300

The value of the net tangible assets of Bata and Co. as on the date of saleamounted to ` 1,50,000 on which the normal rate of return is expected to be 8%.

Calculate the value of Goodwill of the business of Bata and co. as perAnnuity Method taking the present value of annuity of one rupee for five years @8% interest as ` 2.45.

SOLUTION

1) Calculation of Average Profit

Year Profit

`

2010 15,900

2011 17,800

2012 18,200

2013 16,800

2014 21,300

Total Profit 90,000

Average Profit = Total Profits

Number of years

=` 90,000

5 Years

= `18,000

NOTES

162



(2) Calculation of Super Profit : `


Less: Normal Return on Net

Tangible Assets (8% on ` 1,50,000) (-) 12,000

Super Profit 6,000

(3) Calculation of the value of Goodwill as per Annuity Method :-if ` 1 Annuity = ` 2.45 present value

` 6,000 = ?

= ` 6,000 x ` 2.45

1

= ` 14,700 .

Hence, Goodwill of the firm is to be valued of ` 14,700

9.5 Summary

• Capitalisation Method :- The average profit is capital on the basis ofnormal rate of return and the excess of this capitalises amount over the netassets of the firms is goodwill.

Goodwill = Average profit x 100Percentage of normal return - net Assets.

• The capitalisation of profit method of valuation of Goodwill is further classifyin to : (a) capitalisation of super Profit & (b) Capitalisation of AverageProfit Method.

• Under Annuity method of Super Profit goodwill is the discounted value ofthe total amount calculates as per purchase of super profit method.

Goodwill = Average Annual Super Profit x Annuity Rate



NOTES

163

9.8 Key - Terms

(1) Under capitalisation Method :-

Goodwill = Average profit x 100Percentage of normal return - net Assets.

(2) Annuity Method :-Goodwill = Average Super Profit x Annuity Rate

(3) Formula of Annuity Method = Value of goodwill =

Where v = Present Value of Annuity

a = Annual Super Profit

n = Number of years

i = Rate of Interest




(1) According to lord Linaley -------------- is the profit earned due to relationsand reputations.

(a) Goodwill

(b) Creditworthyness

(c) Prestige

(d) Value of Confidence

(2) The time value of money is considered basically under ------------ of valuationof Goodwill.

(a) Average Profit Method

(b) Annuity Method

(c) Super Profit Method

(d) capitalisation Method

(3) While calculating the value of Goodwill under --------- method, averagecapital investment is subtracted from the capitalised value of business.

(a) Annuity method

(b) Super Profit Method

a (1 - 1 )i (1 + i)n

NOTES

164



(c) Capitalisation Method

(d) Average Profit Method

(4) Goodwill, in case of professionals like cost are accountants charteredaccountants is usually valued on the basis of ------------- years purchase offees earned.

(a) two

(b) three

(c) four

(d) one

Ans: (1-a), (2 - b), ( 3 - c), ( 4 - d)


(1) What is ‘Capitalisation of Profit’? State the advantages and limitation ofcapitalisation of Average profit method of valuation of Goodwill.

(2) Explain the term ‘Capitalisation of Profit’ State the advantages and limitationsof capitalisation of super profit method of valuation of Goodwill.

(3) Differentiate clearly between capitalisation of Average profit method andcapitalisation of super profit method.

(4) Explain the advantages and limitations of Annuity method of valuation ofGoodwill.


(1) Bosco Enterprises provides the following accounting information four yearsended on 31st December, 2014.

Year Profit

`

2011 10,200

2012 13,700

2013 14,400

2014 9,700

The firm has average capital investment of ` 50,000. The rate of return oninvestment is 15% calculate the value of Goodwill as per capitalisation of Averageprofit Method and capitalisation of super profit method



NOTES

165

(2) Chirag and co. provides the annual results of their trading business carried outfor last four years ended on 31st December, 2014.

Year Profit

`

2011 36,900

2012 48,100

2013 59,200

2014 63,800

The normal rate of on investment is 10% p.a. The firm has average capitalinvestment of ` 3,00,000. The present value of an annuity of one rupee for fouryears @ 10% is ` 3.78.

You are required to calculate the value of Goodwill of the business of chiragand co. as per Annuity Method

9.8 Further Reading


• Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - NewDelhi - Taxmann publications Pvt. Ltd. - 2012.

NOTES

166



UNIT 10 Valuation of Shares - Need, Methodsof Valuation of Shares

Structure

10.0 Introduction

10.1 Unit Objectives

10.2 Valuation of shares

10.2.1 Factors Affecting the value of shares

10.2.2 Need for valuation of Shares

10.3 Methods of Valuation of Shares

10.3.1 Asset - Backing Method

10.3.2 Yield-Basis Method

(i) On Profit Basis

(ii) On Dividend Basis

10.4 Illustrations

10.5 Summary

10.6 Key Terms



10.0 Introduction

Generally shares quotes on a recognised stock exchange prices are takenas the basis for the valuation of those shares. However, the stock exchangequotation are not acceptable when a large block of company’s shares is involved.Actually the exchange price it determines on the interactions of demand and supplyof business cycles. In this regard, the council of the London stock exchange hasalso passed the following remark.

“The stock exchange may be linked to a scientific recording instrumentwhich registers, not its own actions and opinions but the actions and opinions ofprivate institutional investors all over the country and indeed the world. Theseactions and opinions are result of fear, guess work, intelligent or otherwise, goodor bad investment policy and many other considerations. The quotations that resultdefinitely do not represent valuation of a company by reference to its assets andits earning potential”.

Valuation of Shares -Need, Methods ofValuation of Shares


NOTES

167

In practice stock exchange quotations are not form a fair and equitable orrational basis for compensation. Therefore accountants of business houses arefrequently required to place a proper value on the shares in a company.

The shares of joint stock company quoted on the stock exchange have avalue different from the face value. The shares of private companies are notfreely purchased and sold to the public. Only the share of public limited companiesare freely transferable and hence their valuation is absolutely necessary. In thisunit we will also discuss some important methods for valuation of shares.


After studying this unit you should be able to:

• Understand factors affecting the value of shares.

• Explain in need for valuation of shares.

• Discuss various methods of valuation of shares.

• Explain Asset Backing Method of valuation of shares.

• Understand Yield Basis Method of valuation of shares

• Focus on profit Basis and Dividend Basis for calculation of yield.

10.2 Valuation of Shares

Share capital of a company is spilt up in to a large number of equal parts orunits each of part is called a “share”. e.g. the total capital of a company mayconsist of `1,00,000 divided in to 10,00,000 share or parts of ` 10 each.

According to section 2(46) of the companies Act 1956,

“ Share” means a share in the share capital of a company and includesstock except where a distraction between. stock and share is expressed or implied”.

A share is a fructional part of the : Capital of the company which forms thebasis of ownerships of certain rights and interests of a subscriber in the company.A share is the interest of a shareholder in a definite portion of the capital. Ifexpressed proprietory relationship between the company and the shareholder.

Equity capital is a term which denoted the capital contributed by owners ofthe company Different values are attached to equily share which are: (a) parvalue (b) Book value (c) Market value and (d) Issue price. In fact, all these pricesdoes not ... represent the true value of intrinsic value of the share. Under thecircumstances, the valuation of share may be only necessary even if the sameare quoted in the stock-Exchange. Practical in the case of Amalgamation orAbsorption valuation of share is because necessary.

NOTES

168



While valuing the share an accountant has to depend upon the followingassumptions:

(i) The purchaser of shares does not like to pay a higher price in comparisonwith the reasonable or market price of the shares.

(ii) The seller does not want to sell his shares due to his urgent need &

(iii) Sufficient number of buyers and sellers of the shares are available in themarket.

10.2.1 Factors affecting the Value of Shares

The value of a share is greatly affected by the economic, political andsocial factors such as:

(i) The nature of the company’s business;

(ii) The economic conditions of the country;

(iii) Other political and economic factor (e.g., possibility of nationalisation, exciseduty on goods produced etc.);

(iv) The demand and supply of shares;

(v) Proportion of liabilities and capital;

(vi) Rate of proposed dividend and past profit of the company;

(vii) Yield if other related shares of the Stock Exchange etc.

(viii) Dividend declared by company in the past,

(ix) Net tangible asset of the company

(xi) Restrictions on investment

(xii) Pease and security of company

(xii) Goodwill of the company

(xix) Capacity of Directors

(xx) Type of Management

10.2.2 Need for valuation of shares

The necessity for valuation of a share arises in the following circumstances:

(i) For Estate Duty and Wealth Tax purpose;

(ii) For Amalgamation and Absorption schemes;

(iii) For Gift Tax purposes;

(iv) For Nationalisation of companies compensation made to a company.

(v) In case of trust finance or investment trust companies.

(vi) For grunting loans on the basis of security of shares.

(vii) For discharge of debts and liabilities, in exceptional nature;

(viii) Purchasing shares for control;

(ix) For selling shares of a shareholder to a purchaser (Which are not quoted inthe stock Exchange) ;

(x) For the conversion of one class of share to another class.



NOTES

169

10.3 Methods of Valuation of shares

The Methods of Valuation of Shares are shown in figure 10.1 as follows :

Fig. 10.1 : Methods of Valuation of Shares.

(a) Asset Baking Method; (b) Yield Basis Method, & (c) Fair Value Method

10.3.1 Asset-Backing Method

Since the valuation is made on the basis of the assets of the company, it isknown as Asset-Basis or Asset-Backing Method. At the same time, the sharesare valued on the basis of real internal value of the assets of the company and thatis why the method is also termed Intrinsic Value Method or Real Value BasisMethod. This method may be made either (i) on a going \ continuing concernbasis; and (ii) break-up value basis.

Here the emphasis is on the safety of investment as the investors alwaysneed safety for their investments. Under this method, net assets of the companyare divided by the number of share to arrive at the net asset value of each share.The following points may be borne in mind:

NOTES

170



Methods ofValuation of shares

Fair Value Method; or,Average of Asset-Backing and Yield-basis Method

Yield-basis Method; or Market Value Method; or, Earning Capacity MethodProfit/Income Basis Method

Asset-backing Method; or Asset-Basis Method; or Intrinsic Value Method; or,Real Value Basis Method; or,Break-uo Value Method; or Net Asset Method; or Balance-sheet Method.

b c

a

(1) The value of goodwill will be ascertained.

(2) Fixed assets of the company, disclosed or undisclosed n Balance Sheet, aretaken at their realisable value.

(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 includingcontingent liabilities.

Thus the value of net asset is;

Total of realisable value of assets - Total of external liabilities = Net Assets(Intrinsic value of asset)

Total value of Equity shares = Net Assets - Preference share capital

Value of one Equity share =Net Assets - Preference share capital

Number of Equity shares

The following chart will make the above points clear :

Computation of Net Assets

Net Assets `

Fixed Assets (Market Value) xx

Investments (Market Value) xx

Current Assets (Market Value) xx

Goodwill, any (Market Value) xx

xx

Less :

Current Liabilities xx

Debentures xx

Pref. Share Capital (with arrear Dividend) xx ---

Net Assets /Funds available for Equity Shareholders xx

Intrinsic Value of each share = Funds available for equity shareholders

Number if Equity shares

Alternatively -

Net Assets = Share Capital + Reserves and surplus - Miscellaneous Expenditure+ Profit on Revaluation - Loss on Revaluation



NOTES

171

EXAMPLE

From the following information compute the ‘Intrinsic Value’ of an Equityshare of Sumana Ltd.

Balance Sheet as at 31.03.2013


1,000 Equity Share Land and Buildings 40,000

of ` 100 each fully Plant and Machinery 40,000

paid-up 1,00,000 Sundry Debtors 5,000

100, 6% Perference Share Stock 20,000

of ` 100 each, Cash at Bank 25,000

fully paid 10,000 Investment in

Reserves and Surplus 25,000 5% Govt. Securities 10,000

100, 5%Debentures Cash in hand 10,000

of ` 100each 10,000 Preliminary Expenses 5,000Sundry Creditors 10,000

1,55,000 1,55,000

(i) Fair return on capital employed in this type of business is around 10% p.a..

(ii) Goodwill is to be taken at 5 years’ purchase value of super profits.

(iii) Average of the profits (after deduction of preliminary expenses) for the lastseven years is ` 19,000. Preliminary expenses to the extent of ` 1,000has been written-off every year for the last seven years. Profit is more orless stable over years and the same trend is expected to be maintained inthe near future. Ignore tax.

ANSWER

1) Computation of Goodwill : `

Capital Employed: 40,000

Land and Building 40,000

Plant and Machinery 5,000

Sundry Debtors 20,000Stock 25,000

Cash at Bank 10,000

Cash in Bank 10,000

1,40,000

Less : Liabilities

5% Debentures 10.000

Creditors 10.000 20,000

Capital Employed: 1,20,000

Normal Profit 1,20,000 x 10

= 12,000 100

NOTES

172



Super Profit


Less : Non-trading income 500

Interest on Investment

@ 5% on 10,000 18,500


= ` 18,500 - 12,000 = 6,500

Value of Goodwill = 6,500 x 5 = 32,500

Computation of Intrinsic Value of Equity Share :

Total Assets (as above) 1,40,000

Add : Investment 10,000

Add : Goodwill 32,500

1,82,500

Less : Liabilities (as above) 20,000

1,62,500

Less : Preference Share Capital 10,000

Funds available to equity Shareholders: 1,52,500

Intrinsic Value of Equity Share =

1,52,500 = 152.50

1,000 sh.

10.3.1 Utility Asset - Backing Method

(i) This method highly applicable if liquidation takes place although the netrealisable value of the asset is to be taken into account. But the best methodis to prepare a statement of affairs supported by independent valuation ofdifferent fixed assets after making proper provision for cost of liquidation.

(ii) The permanent investors determine the value of share under this method atthe time of purchasing the share.

(iii) The method is particularly applicable when the share are valued at the timeof Amalgamation. Absorption and Liquidation of companies; and

(iv) This method is also applicable when shares are acquired for control motives.

10.3.2 Yield-Basis Method

Yield is the effective rate of return on investments which is invested by theinvestors. It is always expressed in terms of percentage. Since the valuation ofshares is made on the basis if Yield, it is called Yield-Basis Method. For example,an investor purchases one share of `100 each (face value and paid-up value) at` 150 from a stock Exchange on which he receives a return(dividend)@ 30%. Inthat case, yield of the said investor will be :



NOTES

173

Yield =30 x 100

= 20% 150

Practically, yield may also termed as: Expected Yield Normal Rate of Return/Earning, Rate of Fair Return, Rate of General Expectations, Estimated Rate forCapitalisation etc.

Yield may be calculated as under :

Yield = Normal Profit

x 100 Capital employed

Under Yield-Basis Method, valuation of shares is made on (i) Profit Basis;or on (ii) Dividend Basis.

(i) Profit Basis :

Under this method, at first, profit should be ascertained on the basis ofpast average profit. There after, capitalised value of profit is to be determined onthe basis of normal rate of return, and the same (capitalised value of profit) isdivided by the number of share in order to find out the value of each share. Thefollowing procedure may be adopted.

Capitalised Value of Profit = Profit

x 100Normal rate of return

Value of each Equity Share =Capitalised Value of Profit

Number of shares

NOTES

174



Yield-Basis Method

OnProdit Basis

OnDividend Basis

Profit Basis should be followed in thecase of Majority Holding.(The shareholders holding maximumnumber of shares.)

Dividend Basis should be followedin the case of Minority Holding.(The shareholders holding minimumnumber of shares.)

or, Value of each equity share = Profit

x100Normal rate of return x Number of Equity shares

1. Here, profit means and includes Future Maintainable Profit, i.e. the rate ofprofit which is expected in be earned in future. “ It is to be remembered that theanalysis of profit that is made in order to determine future annual maintainableprofit must seek a profit that is capable of distribution as dividend.” - Yorston,Smyth and Brown, Advance According.

The following principle should be kept in mind while ascertaining maintainableprofit.

(i) Average profit for the last few years should be taken as base.

(ii) Average profit should be properly adjusted such as:

(a) Proper depreciation on assets should be deducted;

(b) Appreciation in Fixed Assets should not be included whereasappreciation in current assets should, however, be included;

(c) Income from non-trading assets should be excluded.

(d) Non-recurring expenses, which may not be incurred in future, arenot to be included;

(e) Any casual income (Which is not expected in future) should not tobe included;

(f) provision should be made for taxation;

(g) If any reserve is created, the same should be deducted; and

(h) Preference dividend should always be deducted form profit.

EXAMPLE

Two companies, A Ltd. and B. Ltd,. are found to be exactly similar as totheir assets, reserve and liabilities except that their share capital structures aredifferent.

The Share Capital of A. Ltd is `11,00,000, divided into 10,000, 6%Preference Shares of `100 each and 10,000 Equity Share of `10 each.

The Share Capital of B. Ltd is also `11,00,000, divided into 1,000, 6%Preference Shares of `100 each and 1,00,000 Equity Share of `10 each.

The fair yield in respect of the Equity Share of this type of companies isascertained at 8%.

The profits of the two companies for 2013, and 2012 are found to be` 1,10,000 and 1,50,000, respectively.

Calculate the value of the Equity Share of each of these two companies on31.12.2012 on the basis of this information only. Ignore taxation.



NOTES

175

Check Your Progress

1. Explain the term‘Valuation of Shares’.

2 . What are the factorsaffecting Value of Shares ?

3 . Explain the need for‘Valuation of Shares’.

4 . What is ‘Asset BackingMethod’ ?

5 . Explain in brief ‘Yield BasisMethod’.

ANSWER

A. Valuation of Shares ` Valuation of Shares `

of A Ltd. of B Ltd.

Average profit of two years 1,30,000 Average profit 1,30,000

( 1,10,000 + 1,50,000) Less: Pref.Dividend

2 6% on 1,00,000 6,000

Less: Preference Dividend Maintainable profit: 1,24,000

6% on 10,00,000 60,000 Capitalised Value of profit:

Maintainable Profit 70,000

Capitalised Value of Profit

= 70,000

x 100` 1,24,000

x 100 8 8,75,000 8 = 15,50,000

Value of each Equity Share Value of each Equity Share

= 8,75,000

x 87.50 = 15,50,000

x 15.50 10,000 Equity Share 1,00,000 Equity Share

(ii) Dividend Basis

Valuation of shares may be made either (a) on the basis total amount of dividend,or (b) on basis of percentage or rate of dividend.

(a) On the basis of total amount of Dividend:

Capitalised Value of Profit =Divisible Profit i.e. Total amount of Dividend

x 100 Normal Rate of Return i.e. Yield

Value of each Equity Share =Capitalised Value of Profit

Number of Equity Shares

Or, Value of each Equity Share = Divisible Profit x 100

Normal Rate of Return x No. of Equity Share.

(b) On the basis of percentage or Rate of Dividend:

Value of each Equity Share

= Rate of Dividend

x Paid-up value of each Equity Share Normal Rate of Return x No. of Equity Share

When the Rate of Dividend is not given:

Rate of Dividend = Profit

Equity Share Capital (paid-up) x 100

NOTES

176



EXAMPLE

On December 31, 2012, the Balance Sheet of xyz Ltd,. Disclosed thefollowing position :


Share Capital 40,000 Equity 4,00,000 Fixed Assets 5,00,000

Shares of ` 10 each Current Assets 1,50,000

Reserves and Surplus 90,000 Goodwill 40,000

Profit and Loss Account 20,000

5% Debentures 1,00,000

Current Liabilities 80,000

6,90,000 6,90,000

The Net Profit for the three years were.

Year `

2010 51,1502011 50,3002012 53,800

On which 20% was placed to Reserve, this proportion being consideredreasonable in the industry in which the company is engaged and where a fairinvestment return may be taken at 10%.

Compute the value of the company’s share under yeild-basis method.

ANSWER 51,150 + ` 50,300 + ` 53,800 1,55,250

Average Profit = = = ` 51,7503 3

Less : Transfer to Reserve @ 20% = ` 10,350

Maintainable Profit = ` 41,400

Here, the rate ofdividend is not given, the same can be found out with the help ofthe following :

Rate of Dividend = Profit

x 100Paid up Equity Capital

= ` 41,400

x 100 = 10.35 % ` 4,00,000

Value of each Equity Shares

= Rate of Dividend

xPaid -up Value of each Equity

Normal Rate of Return Share



NOTES

177

=` 10.3

x ` 10 10

= ` 10.35

EXAMPLE

Form the following information supplied to you ascertain the value per shareof AMCO Ltd. on Dividend Basis.

1) 2,50,000 Equity Shares of ` 1 each fully paid-up .

2) The annual net earnings of the company normally amounts to ` 35,000.

3) The normal rate of return on paid-up value of Equity share capital is 7%.

ANSWER

1) Calculation of Rate of Dividend :

ProfitRate of Dividend = x 100

Paid-up Equity share Capital

35,000= x 100

2,50,000

= 14%

2) Calculation of value per Equity Share :

Value Per Equity Share = Rate of Dividend x Paid up value ofNormal Rate of Return each Equity Share 14

= x v 1 7

= ` 2

The Asset Backing Method and yield Basis Method of Valuation of sharescan be understood with the help of following illustrations.

NOTES

178



10.4 Illustrations

ILLUSTRATION 1

From the following information relating to Adwani Ltd., Ahmednagar,Compute the ‘Intrinsic Value’ of each Equity Share.

Balance Sheet as on 31st March 2014


Share Capital : Goodwill 35,000

Issued and Paid-up Capital Land and Buildings 95,000

• 20,000 Equity Shares of Plant and Machinery 1,35,000

` 10 each 2,00,000 Investments 55,000

• 13,000 Preference Share Stock in Trade 65,000

` 10 each 1,30,000 Trade Debtors 36,000

Reserve Fund 60,000 Cash in Hand 24,000

Trade Creditors 45,000 Underwriting Commission 15,000

Bills Payable 20,000

Taxation Provision 5,000

4,60,000 4,60,000

For the purpose of valuing the equity shares of the company, various assetswere revalued as under :

• Book Debts realised 100% of book value

• Stock-in-Trade realised at a profit of ` 15,000

• Investments - ` 60,000

• Goodwill - ` 50,000

• Land and Building - 1,10,000

• Plant and Machinery - 1,40,000

SOLUTION

1) Computation of Total Net Assets :

Total Assets `

• Goodwill 50,000

• Land and Buildings 1,10,000

• Plant and Machinery 1,40,000

• Investments 60,000

• Stock-in-Trade 80,000

• Trade Debtors 36,000

• Cash in hand (+) 24,000

5,00,000



NOTES

179

Less : Current Liabilities 70,000

• Trade Creditors 45,000

• Bills Payable 20,000

• Taxation Provision (+) 5,000

Total Net Assets 4,30,000

2) Computation of Funds available for equity shareholders :

`

Total Net Assets 4,30,000Less : Preference Share Capital (-) 1,30,000

Fund available for Equity Shareholders 3,00,000

3) Computation of Intrinsic Value of each Equity Share :

=Funds available for Equity Shareholders


= ` 3,00,000

20,000 Equity Shares

= ` 15

ILLUSTRATION 2

Bremain Ltd., Bareli issued 50,000 Equity Shares of 10 each fully called-up and paid-up respectively. The company has earned sizable amount of net profitduring the last five years which as follows:

Year Net Profit

`

2009 55,390

2010 57,820

2011 60,140

2012 61,280

2013 65,370

Of the profits so earned 20% was transferred to General Reserve, thisproportion being considered reasonable in the manufacturing industry in which thecompany is engaged and where a fair investment return may be taken at 10%.

You are required to compute the value of company’s Equity Share in theYield Basis Method under Dividend Basis and Profit Basis separately.

NOTES

180



(-)

Solution

1) Calculation of average expected future Profits:

Average Profit =` 55,390 + 57,820 + Rs.60,140 + 61,280 + 65,370

5

=` 3,00,000

5

= ` 60,000

2) Calculation of Maintainable Profit:

= Average Profit Less 20% of Transfer to General Reserves

= ` 60,000 - 20% of ` 60,000

= ` 60,000 - 12,000

= ` 48,000

3) Calculation of Rate of Dividend:

Rate of Dividend = Maintainable Profit

Equity Share Capital (paid-up) x 100

= ` 48,000

` 5,00,000 x 100 = 9.60 %

4) Calculation of value of each Equity Share under Yield Basis Method :

A) On Dividend Basis:

Value of each=

Rate of Dividendx

Paid up value of

Equity Share Normal Rate of Return each Equity Share

=9.60

x

` 10 10

= ` 9.60

B) On Profit Basis :

i) Calculation of Capitalised Value of Maintainable Profit :

Capitalised Value=

Profitx 100

of Profit Normal Rate of Return

=` 48,000

x 100 10

= ` 4,80,000



NOTES

181

ii) Calculation of value of each Equity Share :

Value of Capitalised Value of Profit

Equity Share=

Number of Equity Share

= ` 4,80,000


= ` 9.60

10.5 Summary

• The valuation of Shares may be broadly be classified as -

(i) Assets - backing method, (ii) Yield base method & (iii) Fair value method.

• Fair value method which is the mean of intrinsic value and yield value methodand the same provides a better indication about the value of shares than theother method.

• Profit Basis should be followed in the case of majority Holding and DividendBasis should be followed in the case of minority Holding.

• Since the valuation is made on the basis of the assets of the company, it isknown as Assets Basis or Assets-Backing method.

• Yield is the effective rate of return on investment of which is invested bythe investors. It is always expressed in terms of percentage. Since thevaluation of share is made on the basis of yield, it is called Yield - BasisMethod.

10.6 Key Terms (Valuation of Share)

(i) Future Maintainable Profit that is, the rate of profit which is expected tobe earned in future. “It is to be remembered that the analysis of profit thatis made in order to determine future annual maintainable profit must seek aprofit that is capable of distribution as dividend.”

(ii) Calculation of Expected Return :

Expected Return =Expected Profits

x 100Equity Capitals

(iii) Calculation of Yield value of Share :

Value of share =Expected Rate

x Paid up value of share Normal Rate

NOTES

182



(iv) Calculation of Rate of Earning

Rate of Earning = Profit earned

x 100Capital Employed

(v) Calculation of fair value

Fair value =Intrinsic Value + Yield value

2

(vi) Calculation of Capitalised value of profit

Capitalised value of profit = Profit

Normal Rate of Return x 100

(vii) Value of Right Share :

Value of Right=

Number of Right sharesx

(Market value

share Total Holdings (i.e. holding% + New) - Issue price)




(1) The need for valuation of shares arises in circumstances for assessmentsunder --------- .

(a) estate duty

(b) Wealth tax

(c) gift tax


(2) The value of share of a company is affected by -------------- backing of thecompany.

(a) current asset

(b) non- current asset

(c) net - asset

(d) gross - asset

(3) The value of an equity share based on net assets is known as -----------value of a share.

(a) current

(b) intrinsic



NOTES

183

(c) face

(d) market

(4) Under Balance-Sheet method of valuation of shares -------------- assetsare excluded as they have no realisable value.

(a) fictitious

(b) non - wasting

(c) fixed

(d) current

Ans :- (1 - d), (2 - c), (3 - b), (4 - a)

II - Long Answer Questions :

(1) What is ‘Valuation of Shares’? State the factors affecting the value ofshares.

(2) Define the term ‘Share’. Explain in brief the important assumptions whilemaking valuation of shares.

(3) Explain the term ‘Valuation of Shares’. What is the need for valuation of ashare?

(4) ‘The value of the share is greatly affected by the economic, political andsocial factors’ Discuss Valuation of share.

(5) Explain in brief the various methods of valuation of share.

(6) What is ‘Asset Backing Method’ of valuation of shares. State the entireprocedure for computation of a value of share under this method.

(7) Explain in brief the utility of Asset-Backing method of valuation of shares.

(8) What is ‘Yield Basis Method’? State the procedure for computation of avalue of share under profit Basis Method.

(9) How do you ascertain the value of a share under Dividend Basis Method.

III - Practical Problems :

(1) Calculate the value of each equity share. by Intrinsic value Method fromthe following accenting information made available by AMCO. Ltd,. as on 31st

March, 2014.

NOTES

184



Balance - Sheet as on 31st March, 2014.


3,000 Equity Shares of 3,00,000 Goodwill 32,000

of ` 100 each fully paid

3,000 8% preference shares 3,00,000 Buildings 1,67,000

of Rs.100 each fully paid machinery 3,05,000

Reserve fund 1,20,000 Investments 76,000

creditors 40,000 Stock in Trade 1,10,000

Bills payable 25,000 Debtors 90,000

Bank Overdraft 15,000 cash at Bank 10,000

under writers commission 10,000

8,00,000 8,00,000

The assets were revalued for the purpose of valuation of shares of thecompany as follows:

Goodwill - 72,000, Buildings - 2,27,000, machinery - 2,65,000, Investmentsof Book value, stock - ` 1,70,000, Debtors less ` 8,000.

(2) The issued capital of Bokaro Ltd., is ` 10,00,000 divided into 1,00,000Equity shares of ` 10 each. The net profits of the company for the last five yearswere as fallows:

Year Net Profit

`

2010 72,000

2011 97,000

2012 1,16,000

2013 1,41,000

2014 1,74,000

Every year 20% of the profits were transferred to General Reserve. Thenormal rate of return in respect of equily shares of this type of companies is 10%.

Calculate the value of the equity shares of Bokaro Ltd. by Yield BasisMethod.



• Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - NewDelhi - Taxmann publications Pvt. Ltd. - 2012.



NOTES

185

Unit 11 Valuation of Shares - Fair ValueMethod, Value of Right andPreference Shares

Structure

11.0 Introduction


11.2 Fair Value method

11.3 Valuation of Right Shares

11.4 Valuation of Preference Shares

11.5 Valuations of Bonus Shares

11.6 Illustrations

11.7 Summary

11.8 Key Terms



11.0 Introduction

A share in a company is one of the units in to which the total share capitalof a company is divided. Share are two types, (i) Preference share (ii) Equityshare. Preference share are those which carry the following preferential rightover other classes of shares: (a) a preferential right in respected of fixed dividend(b) a preferential right to repayment of capital in the event of a companies windingup.

In case of joint stock companies generally the shareholders are given thepre-emptive right either by their charter or by the Act applicable to them. Thispre-emptive right gives holders of equity shares the first option to purchase additionalissued of common stock. CAS per section 81 of the companies Act,1956)

Preference share valuation is generally on “Dividend Basis” according tothe following formula:

Paid-up value x Average maintainable dividend rate ÷ Normal Rate of Return

Value of right share will be the difference between the result that is obtainedand market value of shares.

Valuation of Shares -Fair Value Method, Value ofRight & Preference Shares


NOTES

187

A company may capitalise its profits or reserves by issuing fully paid bonusshare to existing members. The intrinsic value of each equity share will always beless after the bonus issue.

In this unit, we are going to discuss Fair value method of valuation if sharesvaluation of Right issue shares and preference share.


After studying this unit should be able to :

• Understand meaning of Right issue share and its valuation.

• Ascertain the value of preference share.

• Discuss the Fair value method of valuation of shares.

• Know the meaning of Bonus issues and its valuation.

11.2 Fair Value Method

Some Accountant prescribed the “Fair Value Method” as the mean ofIntrinsic value and Yield Value Method. The result from the same provides betterindication about the value of shares then the earlier two method. In short, FairValue Method is a combination of Intrinsic value method & Yield Method whichcalculate the ‘Mean’ of these two methods.

Fair Value =Intrinsic Value + Yield Value

2

EXAMPLE

The following is the Balance Sheet of X Co. Ltd as on 31.12.2012.


Share Capital : Goodwill 50,000

Equity Shares of ` 10 each 1,00,000 Buildings 1,50,000

12% Pref. Shares of Plant 1,00,000

` 100 each 1,00,000 Investment in 10% stock

General Reserve 60,000 (Market value of 52,000)

Profit and Loss 40,000 Normal Value 50,000 48,000

15% Debentures 1,00,000 Stock 60,000

creditors 80,000 Debtors 40,000

Cash 10,000

Preliminary Expenses 22,000

4,80,000 4,80,000

NOTES

188



Ascertain the value of each equity share under Fair Value Method on thebasis of the information given below.

Assets are revalued as follows :

Building 3,20,000, Plant 1,80,000; Stock 45,000 and Debtors 36,000.

Average profit of the company is ` 1,20,000 and 12 1/2% of profit istransferred to General Reserve. Rate of taxation being 50%. Normal dividendexpected on Equity Shares is 8% whereas fair return on capital employed is 10%.Goodwill may be valued at 3 year’s purchase of super profit.

ANSWER

Computation Goodwill :

Total Net Assets : `

Buildings 3,20,000

Plant 1,80,000

Stock 45,000

Debtors 36,000

Cash 10,000

5,91,000

Less : Current Liabilities :

Creditors 80,000

Capital Employed 5,11,000

Normal Profit ` 51,100

i.e. ` 5,11,000 x 10

100

Actual Profit

`

Average Profit 1,20,000

Less : Non-trading Income

(i.e. income from investment)

@ 10% on ` 50,000 (-) 5,000

1,15,000

Add : Debenture Interest (-) 15,000

1,30,000

Less :Preference Dividend @ 12 % of ` 1,00,000 (-) 12,000

1,18,000

Less :Taxation @ 50% of 1,18,000 (-) 59,000

59,000



NOTES

189

Less :Transfer to Reserve @ 12 1/2 % (-) 7,375

51,625

Super Profit = Actual Profit - Normal Profit

= ` 51,625 x ` - ` 51,000

= ` 525

Goodwill is to be valued at three years purchase of Super Profit.

Value of Goodwill = ` 525 x 3 = ` 1,600

Valuation of Shares :

Assets-Backing Method `

Sundry Assets (as above) 5,11,000

Add : Investments 48,000

Add : Goodwill 1,600

Funds available for Equity Shareholders 5,60,000

Intrinsic Value of Share =R 5,60,600

10,000

= ` 56.06

Yield - Basis :

Value of share = Rate of Dividend

Normal Rate of returnx Paid up value of each share

= 8

x ` 1010

= ` 8

Fair Value :

Fair value =Intrinsic Value + Yield Basis

2

=` 56.06 + ` 8.00

2

= ` 32.03

11.3 Valuation of Right Shares

On a right issue being made, the existing shareholders have the privilege ofeither applying for the share offering within a fixed period or to renounce theirright to apply for these shares in favour of some other person. He may sell thisright with or without selling his existing shareholding. The price of the shares may

NOTES

190



of two type viz. Cum-right price or ex-right price which is shown below in figure11.1 -

Fig 11.1 : Classification of Right Issue Price

i) The “Cum-right price” gives the buyer, besides the ownership of the sharesalready held, the right to apply for new shares offered by the company.

ii) The “ex-right price” gives the buyer only the ownership of the existingshares held by the seller and not the right to apply for additional sharesoffered by company.

Ex-right price is quoted either after the right shares have already beenallotted by the company or the time to apply for right share has already expired.

The Cum-right price is higher than the ex-right price of the share since theformer includes the value of the right also.

(i) Cum - right Price

The value of the right can be calculated by applying the following formula

R =M - S

N + I

Where; R = Value of one right

M = Cum - right market price of a share

S = Subscription price for a new share

N = Number of old shares required to purchase one new share.

EXAMPLE

X Ltd., has a share capital of 5,000 equity shares of `10 each, havingnumber price of ` 15 new share . The company wants to raise additional funds of` 12,000 old offers to existing sharesholders the right to apply for a new share at` 12 for every five shares held.

You are required to ascertain the value of right.

ANSWER

R =M - S

N + I



NOTES

191

Cum-Right Price Ex-Right Price

Right IssuePrice

` = ` 15 - ` 12

=` 3

` 5 + ` 1 ` 6 = ` 0.50

The value of one right is therefore ` 0.50

ii) Valuation of a share ex-right

The ex-right value of a share can be calculated by deducting the value ofright form the cum-right market price of the share.

Formula :-P =

MN + S

N + I

Where : P = The orefical market value of a share ex-right

M = Cum - Market price

N = Number of old shares entitling purchase of one new share

S = Subscription price for a new share.

EXAMPLE

In the Example given above, the ex-right value of a share would be asfollows -

` 14.50 (i.e. ` 15 - ` 0.50)

ANSWER

On the basis of the data given in the above example, the theoretical ex-rightvalue of a share will be as follows :

P =MN + S

N + I

P =` 15 x ` 5 + ` 12

= ` 75 + ` 12

= ` 14.50 5 + 1 6 Shares

Alternatively the value of right by this method also come to ` 0.50 (i.e. `15 - ` 14.50)

Value of Right Shares

According to Sec. 81 of the Compare Act, 1956, a company, if it so desirescan increase its share capital by issuing new shares. In that case, the existingshareholders must be given the priority of purchasing those shares according totheir paid-up value. Since the existing shareholders have got such right to purchasethe newly issued shares, they are called Right Shares.

In order to make a proper valuation of right relating to Right Shares, themarket value of the old holding and the total issue price of the new holdings mustbe added and the same must be divided by the total number of new and old

NOTES

192



holdings. Value of right will be the difference between the result that is obtainedand market value of shares. Hence,

Value of Right =

= Number of Right Shares

x (Market Value - Issue Price)Total Holdings (i.e. holdings = Old + New)

EXAMPLE

The face value of the Equity shares of a company is ` 10 and the currentmarket price ` 17. The company issues “Right” shares at the rate of 3 Equityshares for every 5 existing Equity shares held, the “Right” shares being priced at` 13.

Calculate the value of “Right”

ANSWER

Value of Right = Number of Right Shares

(x) (Market Value -

Total Shares (old + new holdings) Issue Price

Value of right = 3 shares

x ( ` 17 - `13) shares (5+3)

=3 shares

x ` 4 = ` 1.508 shares

Alternatively :

Market value of 5 existing holdings = ` 17 x 5 shares = ` 85

Add : Issue price of 3 new holdings = ` 13 x 3 shares = ` 39

Value of holding = ` 124

Value of each share = ` 124

= ` 15.50 8 shares

Value of Right = ` 17.00 - ` 15.50 = Rs. 1.50

11.4 Valuation of Preference Shares

i) In the case if Non-participating Preference Shares :

When Preference Shares are Non-Participating, they are to be treated asoutside creditors and, hence, the same will be deducted from the total net assets.Therefore, value of each preference share in this case will be only of its facevalue plus arrear dividend (if any).



NOTES

193

(ii) In the case of Participating Perference Shares:

When Preference Shares are Participating, they will take part in Surplus.The surplus will be distributed among the equity and preference shareholders inthe ratio of paid-up capital; therefore, value of each preference share will be of itsface value plus surplus (of each share), plus arrear dividend (if any). The surplusmay be computed as under:

`

Sundry Assets (at market value)Less : Current Liabilities (-) .

Less : Preference Share CapitalArrear Preference DividendOr, Proposed Prefeference Dividend

Less : Equity Share CapitalSurplus

Now the “Surplus” will be distributed between equity and perferenceshareholders in the ratio of their paid-up capital.

Value of each Equity Share = Face value of each equity share + Surplusof each equity share.

Value of each Preference Share = Face value of each equity share + Surplusof each equity share + Arrear Div. (if any)

11.5 Valuation of Bonus Shares

The company issues new shares to existing shareholders which is known“Bonus Shares - instead of paying a dividend in cash. After the bonus issue, therewill be increase in the number of equity shears without a correoponding increasein the available net assets to the equity shareholders. As a result, the intrinsicvalue of each equity share will always be less after be less after the bonus issue.

The other method of valuation of shares can be understood with the help offollowing illustrations.

NOTES

194



Check Your Progress

1. Explain ‘Fair ValueMethod’ of valuation ofshares.

2 . Differentiate between‘Cum-Right Price’ and ‘Ex-Right Price’.

3 . How would you make‘Valuation of Preferenceshares’ ?

4 . Explain in brief the‘Valuation of BonusShares’.

11.6 Illustrations

ILLUSTRATION 1

On 31st December, 2013 the Balance Sheet of Dolphin Ltd., Delhi disclosedthe financial position as follows :


Share Capital Goodwill 42,000

i) Issued and subscribed Business Premises 2,70,000

Capital: Machinery 2,20,000

• 40,000 Equity Shares of Furniture and Fixtures 18,000

` 10 each fully paid 4,00,000 Trade Debtors 2,75,000

Reserve 2,02,000 (all considered good)

Profit and Loss 1,08,000 Stock- in- trade 1,05,000

7% Debentures 1,00,000 Cash - in- Hand 20,000

Trade Creditors 90,000

Bills payable 50,000

9,50,000 9,50,000

The additional information as on 31st December, 2013 made available toyou which is as follows.

i) Assets were valued as follows. `

• Business Premises 1,95,000

• Machinery 1,35,000

• Furniture and Fixture 20,000

• Goodwill 50,00

• Stock - in - Trade 1,05,000

ii) The Net Profits for the last three years were as follows:

Year Net Profit

`

2011 1,13,000

2012 1,21,000

2013 1,26,000

Of which 20% were transfer to reserve, this proportion being consideredreasonable in the industry in which the company is engaged and where a fairreturn on investment may be taken at 20%.

You are required to calculate the valuation of each Equity Share separately,ingnoring taxation as per Fair Value Method.



NOTES

195

SOLUTION

A) Net Assets Method :

1) Calculation of Total Net Assets `

Total Assets

• Goodwill 50,000

• Business Premises 1,95,000

• Machinery 1,35,000

• Furniture and Fixture 20,000

• Trade Debtors 2,75,000

• Stock - in - Trade 1,05,000

• Cash-in-Hand (+) 20,000

8,00,000

Less :

• 7% Debentures 1,00,000

• Trade Creditors 90,000

• Bills Payable (+) 50,000 (-) 2,40,000


2) Calculation of funds available for Equity Shareholders:

`


Less : Preference Share Capital (-) NIL


3) Calculation of Intrinsic Value of each Equity Shareholders:


Number of Equity Shareholders

= ` 5,60,000

= ` 1440,000 Equity Shares

B) Yield Basis Method (on Profit Basis):

1) Calculation of Average Expected Future Profits :

Average Profit =` 1,13,000 + 1,21,000 + 1,26,000

3

=` 3,36,000

3

= ` 1,20,000

NOTES

196



2) Calculation of Maintainable Profit :

= Average Profit Less 20% Transfer to Reserve

= ` 1,20,000 - 20% of 1,20,000

= ` 1,20,000 - 24,000

= ` 96,000

3) Capitalised Value of Maintainable Profit:


Normal Rate of Returnx 100

=` 96,000

20 x 100

= ` 4,80,000

4) Calculation of Yield Value of each Equity Share :

Value of Equity Share =Capitalised value of Profit

Number if Equity Share

= ` 4,80,000


= ` 12

C) Fair Value Method :

1) Valuation of Shares as per Fair Value Method:

Valuation of each Equity Share =Intrinsic Value (+) Yield Value

2

=`14 + ` 12

2

=` 26

2

= ` 13



NOTES

197

ILLUSTRATION 2

Following is the Balance Sheet of Camin Ltd., Chennal as on 31st December,2013.


Share Capital Freeholds Premises 50,000

i) Issued and Subscribe Machinery 70,000

Capital Furniture 14,000

• 10,000 Equity Shares of Stock-in-Trade 20,000

` 10 each, fully paid 1,00,000 Book Debts 44,000

Reserve Fund 50,000 Bank Balance 26,000

Profit and Loss 16,000 Formation Expenses 2,000

Creditors 45,000


2,26,000 2,26,000

Additional Information:

i) Assets are valued as under: `

• Goodwill 44,000

• Freehold Premises 1,30,000

• Machinery Premises 72,000

• Furniture 24,000

• Stock -in- Trade 25,000

• Debtors 39,000

ii) The Profits of the company amounted to,

Year Profit

`

2011 45,000

2012 49,000

2013 50,000

iii) It is the practice of the company to transfer one-fourth of profit toReserve Fund.

iv) The fair Yield in respect of Equity Share of similar type of companies isascertained at 10%.

Find out the value of each Equity Share under Fair Value Method.

NOTES

198



SOLUTION

A) Intrinsic Value Method :

1) Computation of Total Net Assets :

Total Assets `

• Goodwill 44,000

• Freehold Premises 1,30,000

• Machinery 72,000

• Furniture 24,000

• Stock - in - Trade 25,000

• Debtors 39,000

• Bank Balance (+) 26,000

3,60,000

Less Current liabilities: 60,000

• Creditors 45,000

• Bills Payable (+) 15,000


2) Computation of funds available for Equity Shareholders:

`


Less : Preference Share Capital (+) NIL


3) Computation of Intrinisic Value of each Equity Share :


Number of Equity Shareholders

= ` 3,00,000


= ` 30


1) Computation of Average Expected Future Profits :

Average Profit =

` 45,000 + 49,000 + 50,000

3

=` 1,44,000

3

= ` 48,000



NOTES

199

(-)

2) Computation of Maintainable Profit :

= Average Profit Less one fourth transfer to Reserve Fund

= ` 48,000 - 1/4 of ` 48,000

= ` 48,000 - 12,000

= ` 36,000

3) Computation of Capitalised Value of Maintainable Profit :



=` 36,000

10 x 100

= ` 3,60,000

4) Computation of Yield Value of each Equity Share :

Value of Equity Share =Capitalised Value of Profit


= ` 3,60,000


= ` 36

C) Fair Value Method:

1) Valuation Share as per fair Value Method :

Value of each equity Share =Intrinsic Value + Yield Value

2

=` 30 + ` 36

2

=` 66

2= ` 33

NOTES

200



ILLUSTRATION 3

The Following is the Balance Sheet of Domino Ltd., Durgapur as on 31st

December, 2013.


Share Capital: Goodwill 18,000

• 30,000 Equity Shares of Freehold Premise 1,22,800

100 3,00,000 Plant and Machinery 1,80,000

Profit and Loss Account-2013 Motor Vehicles 57,900

Debentures 65,000 Trade Receivable 54,300

Trade Payable 50,000 Stock - in - Trade 41,600

Bills Payable 45,000 Bills Receivable 6,700

Income tax Payable 30,000 Cash at Bank 8,700

10,000 Preliminary Expenses 10,000

5,00,000 5,00,000

The following additional information are given to you :

i) The company’s prospects for 2014 are equally good.

ii) The profits for the past three years have shown as increase of ` 15,000annually.

iii) Goodwill is taken at ` 32,000.

iv) The value of Freehold Premises to be raised by ` 27,200 whereas MotorVehicles are to be reduced by ` 7900.

v) Plant and Machinery are worth 20% above their book values.

vi) Book Debts amounting to Rs.4,300 are totally bad and hence to be written-off.

vii) All other assets and liabilities are worth at their book value as shown in theBalance Sheet above.

viii) It is the practice of the company to transfer Rs.5,000 every year to GeneralReserve.

ix) Similar companies give a yield of 10% on the market value of shares.

x) Dhansukhlal desires to invest 34,655 in equity shares, seeks your valuableadvice as to the fair value of shares.

Determine the number of shares which he should purchase, separately.



NOTES

201

SOLUTION

A) Net Assets Method :

1) Calculation of Total Net Assets `

• Goodwill 32,000

• Free Premises 1,50,000


• Motor Vehicles 50,000

• Trade Receivable 5,000

• Bills Receivable 6,700

• Stock - in - Trade 41,600

• Cash at Bank (+) 8,700

5,55,000

Less : 1,35,000

• Debentures 50,000

• Trade Payable 45,000

• Bills Payable 30,000

• Income Tax Payable 10,000


2) Calculation on funds available for Equity Shareholders `


Less : Preference Share Capital NIL


3) Calculation of Intrinsic Value of each Equity Share :



= ` 4,20,000

3,000 Equity Shares

= ` 140


1) Calculation of Yearly Profits :

Profits for 2013 - ` 65,000 (as per Balance Sheet)

Profits for 2012 - ` 50,000 (` 15,000 less than for 2013)

Profits for 2011 - Rs.35,000 (` 15,000 less than for 2012)

NOTES

202



(-)

Average Profit =` 65,000 + 50,000 + 35,000

3

=` 1,50,000

3

= ` 50,000

2) Calculation of Maintainable Profit :

= ` 50,000 Less ` 5,000 Transfer to General Reserve

= ` 45,000

3) Calculation of Capitalised Value of Maintainable Profit :



= ` 45,000

10 x 100

= ` 4,50,000

4) Calculation of Yield Value of each Equity Share:

Value of Equity Share =Capitalised Value of Profit

Number of Equity Share

= 4,50,000

3,000 Equity Shares

= ` 150

C) Fair Value Method :

1) Valuation of Shares as per Fair Value Method:

Value of each Equity Share =Intrinsic Value + Yield Value

2

=`140 + 150

2

= ` 145

Valuable Advice :

Number of Equity Shares =Funds available to Invest in Equity share

to be purchased Fair value of Equity Share

=` 34,655

` 145

= ` 239 Equity Shares

Hence it is advisable that Dhansukhlal should invest the available funds of` 34,655 for purchasing 239 Equity Shares of Domino Ltd., Durtapur.



NOTES

203

11.7 Summary

• Fair Value Method :- Fair Value Method is a combination of Intrinsic valuemethod and Yield value method which calculate the “Mean” of these twomethods.

Fair value = Intrinsic value + Yield value

2

• The price of the shares may be of two type Viz. Cum-right price and ex-right price.

(i) Cum-right price give the buyer, besides the ownership of the sharesalready held, the right to apply for new shares offered by the co.

(ii) Ex-right price given the buyer only the ownership of the existing shareheld by the seller and not the right to apply for additional shares offeredthe co.

• Valuation of Preference Shares : Their valuation is generally on “DividendBasis” According to the formula:

Paid-up Value x Average maintainable dividend rate ÷ Normal rate of return

In case dividend on cumulative perference shares is in arrears the presentvalue of such value of a preference share calculated as above.

In case of Participating Perference Shares of companies in liquidationtheir share in the surplus assets remaining after payment to the equityshareholders is taken on to account.

11.8 Key Terms

(1) Preference Shares Valuation (Dividend Basis) :

= Paid up value x Average maintainable dividend rate ÷ Normal rate of return.

(2) Fair Value = Intrinisic value + Yield Value

2

(3) Valuation of Cum-right price R = M - S

N + 1

(4) Valuation of Ex-right Price P = MN + S

N + I

(5) Value of Right =

= Number of Right Shares

Total Holding (i.e. holding = old + New) x Market value - Issue price.

NOTES

204




I - Object Questions

A) Multiple choice Question

1) A simple average of net assets value and Yield value is termed as ---------value of a shares.

(a) Fair,

(b) intrinisic,

(c) earning,

(d) future.

(2) The value of a non participating preference share is equivalent to its -----value, provided there are sufficient net assets available to settle the amountpayable to preference shareholders.

(a) intrinsic,

(b) face,

(c) fair,

(d) future

(3) The ------------- givers the buyer, besides the ownership of the shares alreadyheld, the right to apply for new shares, offered by the company.

(a) ex-right price

(b) Selling price

(c) Cum- right price

(d) inflated price

(4) The ------------ gives the buyer only the ownership of the existing sharesheld by the seller and not the right to apply for additional shares by thecompany.

(a) Cum-right price

(b) loaded price

(c) invoice price

(d) ex- right price.

Ans :- (1 - a), (2 - b), (3 - c), (4 - d).



NOTES

205


1) What is ‘ Fair Value Method’ of Valuation of Shares? Explain in brief theprocedure involved in calculation of fair value of each equity share.

2) What is ‘Right Share’? Classify the right issue price.

3) What is ‘Cum - Right price’? How if differs from Ex- Right price?

4) Explain in brief the method of Valuation of Shares in case of participatingand non-participating preference shares.

5) How would you make the valuation of bonus shares?

6) Write Short notes on :

a) Fair Value Method of Valuation of Shares.

b) Value of Right Share

c) Valuation of preference Shares.

d) Valuation of Bonus Shares.


1) On 31st December, 2013 the Balance Sheet of Activa Ltd., Amarnathdisclosed the Following position:


Equity Share Capital: Goodwill 40,000

• 40,000 Equity Shares of Plant and Machinery 3,00,000

` 10 each 4,00,000 Land and Buildings 2,00,000

General Reserve 40,000 Sundry Debtors 80,000

Profit and Loss Account 15,000 Stock - in - Trade 70,000

10% Debentures 1,00,000 Cash at Hand 10,000

Sundry Creditors 85,000


7,00,000 7,00,000

Additional information:

a) Independent valuation made of fixed assets shows the details as follows:

`

• Goodwill 50,000


• Land and Buildings 1,00,000

b) The net profits for the last three years were : 2011 - ` 34,100. 2012 -` 42,600, 2013 - 47,300 of which 10% was transferred to General Reserve

NOTES

206



annually, this proportion being considered reasonable in the industry in whichthe company is engaged and where a fair investmentreturn may be takenas 10%.

Find out the value of each Equity Share under Fair Value Method.

2) The following financial details are available in relation to Bedaux Ltd.,Badalapur as on 31st December. 2013.

a) Share Capital comprises of

i) 450, 8% Preference Shares of `100 each fully paid-up and

ii) 4,500 Equity Shares of ` 10 each fully paid-up

b) Third Party Liabilities - 7,500

c) General Reserve - ` 3,500.

d) The average expected profit after taxation earned by the company- ` 8,500.

e) The normal profit earned on the market value of equity shares of thesame type of company is 9%.

f) 10% profit after tax of each year is transmitted to General Reserve.

g) Out of the total assets, assets amounting to ` 350 are fictitious.

You are require to calculate the value of each equity share as per fair valuemethod.

3) On 31st December, 2013 the Balance Sheet of Ekebana Ltd., Ellora showsthe financial position as Follows:


Share Capital: Plant and Machinery 1,15,000

• 20,000 Equity Shares of Land and Buildings 85,000

` 10 each fully paid-up 2,00,000 Motor Car 69,000

General Reserve Fund 45,000 Furniture 61,000

Profit and Loss Account 27,000 Patents 5,000

Debentures 1,00,000 Trade Debtors 90,000

Trade Creditors 67,000 Bills Receivable 50,000

Bank (Cr.) 11,000 Cash in Hand 25,000

Bills Payable 50,0005,00,000 5,00,000

The following additional information is also provided on 31st December, 2013.

a) The independent valuator valued the various assets as follows: Plant andmachinery 1,30,000, Land and Buildings 1,05,000. Motor Car 45,000,Furniture ` 37,000, Patents are worthless, Trade Debtors are estimated torealise 10 % less than the book value, Goodwill at ` 24,000.



NOTES

207

b) The net profit for the last three years indicates the financial performancesas follows:

Year Profit

`

2011 25,350

2012 30,630

2013 34,020

c) It is the practice of the company to transfer 20% of profit to General ReserveFund.

d) Similar companies give a yield of 10 % on the market value of equity share.

You are require to calculate the fair value of each Equity Share.



• Sehgal Ashok - Taxmann’s Fundamentals of Corporate Accounting - NewDelhi - Taxmann Publications Pvt. Ltd. - 2012.

NOTES

208



Topic 4 Hotel Accounting

Unit 12 Visitor’s Ledger and Preparation of FinalAccounts

Unit 13 Introduction, Accounting Treatment inHotel Accounting

Unit 12 Visitor’s Ledger and Preparation ofFinal Accounts

Structure

12.0 Introduction


12.2 Visitor’s Ledger

12.3 Preparation of Final Accounts

12.4 Illustrations

12.5 Summary

12.7 Key Terms



12.0 Introduction

Hotel industries are required to follows the double entry system for recordingtheir business activity. However, it will be advantageous for them to follow tabularsystem of book-keeping because most of their transactions are of regular anduniform type. This requires maintenance of proper columns in different books ofaccounts.

The following are the main books of accounts which a hotel may kept ontabular system.

(a) Cash Book : This book records all cash transaction of the hotel. This bookmay be maintained by having proper columns (as per the requirement of the hotel)both on the receipts and payments side.

(b) Purchase Book : It records all credit purchase.

(c) Sale Book : It records all credit sale, transactions. It may have separatecolumns for food, beverages drinks etc.

(d) Visitors or Guest Ledger : This ledger contains an account of each gueststaying in the hotel. It is also kept in a tabular analytical form so as to provideready information of different items or services provides to the visitors.

Visitor’s Ledger &Preparation Of Final Accounts


NOTES

209



• Understand the formats of visitor’s ledger

• Classify the item included in visitor’s ledger.

• Prepare visitor’s Ledger.

• Prepare final accounts of a hotel. (i.e. Profit and Loss A/c and BalanceSheet)

• Explain How and Why the visitor’s ledger is maintained by a hotel.

12.3 Visitor’s Ledger

Visitors (Guest) Ledger is the main record of hotel accounting. This willhelp them in maintaining accounts property.

In this visitors ledger every day’s transactions are maintained in a separatepage together with a column for each visitor. The room numbers are indicatedagainst each and every visitor. The amount brought down in each column indicatedthe balance due at the commencement of the day from the concerned visitor. Atthe time of settlement of the account, the amount receives from the visitor isrecorded as creditors it is observed that, there will be no balance in the accountwhich will be carried down in the next day’s page. On the other hand if there isany due at any date form a visitor, the same account is transferred to a personalledger.

While closing the visitor’s ledger the daily total of each heading both debitand credit sides are recorded in the total column on the right hand side of thevisitor’s ledger accounts. The same is transferred to a summary ledger of generalledger for the purpose of obtaining the periodically totals (say for monthly quarterly,or half yearly).

The items included in visitor’s ledger are depending on the services providedby the restaurant of hotel.

A format of visitor’s Ledger is as given below:-

NOTES

210





NOTES

211

Visi

tor’

s L

edge

rR

oom

No.

12

34

56

78

Roo

m N

o.N

ames

and

Add

ress

AB

CD

EF

GH

Nam

es a

nd A

ddre

ss`

``

``

``

``

Bala

nce

B/D

Bala

nce

B/D

Lodg

ing

and

Lodg

ing

and

Boar

ding

etc

.Bo

ardi

ng e

tc.

Bre

akfa

st/s

nack

sB

reak

fast

/sna

cks

Lunc

hes

Lunc

hes

Din

ners

Din

ners

Tea.

Cof

fee,

etc.

Tea.

Cof

fee,

etc

.W

ines

Win

esSp

irit

Spiri

tB

eer

Bee

rM

iner

als

Min

eral

sC

igar

ette

rs, C

igar

s, et

c.C

igar

ette

rs, C

igar

s, et

c.La

undr

yLa

undr

yC

arria

geC

arria

geSu

ndrie

s et

c.Su

ndrie

s et

c.To

tal `

Tota

l `C

redi

tsC

redi

tsC

ash

Cas

hA

llow

ance

sA

llow

ance

sPe

rson

al A

/cPe

rsno

nal A

/cBa

lanc

e C

/DBa

lanc

e C

/DTo

tal `

Tota

l `

Deb

its

T

otal

Deb

its

Visitors’ Ledger (Total Account)

Dr. Cr.

Particulars ` Particulars `

To Balance B/D *** By Cash - Debit Cash Book ***

To Lodging - Credit, Lodging *** By Allowance - Debit -

To Boarding etc. - Allowance ***

Boarding etc. A/c *** By Balance C/D. ***

*** ***

To Balance B/D. ***

12.4 Preparation of Final Accounts

Trading accounts is of maintained in the hotel accounting. Therefore itemsrelates to trading accounts are to be recording first (i.e. at the top) while preparingprofit and loss Account. The Profit and Loss Account shall set out the variousitems relating to the income and expenditure of the hotel industry arranged undermost convenient heads. The Balance-Sheet to be prepared at the end of stipulatedperiod (generally annually) in prescribed form. In practice all the accountingprinciples applicable to a hotel industry are the same as in the case of anycommercial organisation.

The concept of visitors Ledger and preparation of finals Accounts of HotelBusiness can be understood with the help of following illustrations.

12.5 Illustrations

ILLUSTRATION 1

From the following particulars pertaining to four rooms in a hotel draw up asuitable columunar ledger :

(i) Room rent for each room ` 5000 + 15% tax.

(ii) Room 1 : Breakfast ` 450 Laundry ` 500 Local Phone calls ` 150.

(iii) Room 2 : Lunch ` 850 S.T.D. Calls ` 1250 Wine ` 600 Previous day’soutstanding amount 1,2500

(iv) Room 3 : Private Taxi hired form hotel 4000 S.T.D. calls 35000 Dinner` 1250. Whisky ` 1,000 Deposited ` 3,5000 with the hotel.

(v) Room 4 : Opening due from the guest ` 5750 Laundry ` 300 Lunch `1200.

(vi) The guest in Room 3 is a regular visitor and is entitled to a discount of 20%on room rent.

All the foregoing transactions pertain to a single day.

NOTES

212



Check Your Progress

1. Explain the various booksof accounts to bemaintained under HotelAccounting.

2 . State the basic need ofmaintaining Visitors Ledgerunder Hotel Accounting.

3 . Explain the accounts andstatements prepared byHotel Business relating totheir Final Accounts.

SOLUTION

Visitors’ Ledger

Total

Particulars 1 2 3 4

` ` ` ` `

Balance B/D 18,250 - 12,500 - 5,750

Lodging 19,000 5,000 5,000 4,000 5,000

Tax on Lodging 3,000 750 750 750 750

Boarding 3,750 450 850 1,250 1,200

Loundry 800 500 - - 300

Telephones 4,900 150 1,250 3,500 -

Private Taxi 4,000 - - 4,000 -

Alcohonlic Drinks 1,600 - 600 1,000 -

Total Debits 55,300 6850 20,950 14,500 13,000

Credit Cash Received 35,000 - - 3,5000 -

Balance C/D 20,300 6850 20,950 (-) 20,500 13,000

Total 55,300 6850 20,950 14,500 13,000

* ` 5,000 Less 20% discount

ILLUSTRATION 2

The following are the balances from the ledger of Ameet Hotel on31st December 2012.

Particulars `

Share Capital 56,865

Freehold Premises 46,800

Furniture and Fittings 8,934

Glass and China 1,101

Linen 840

Cutlery and Plate 390

Rates, Taxes and Insurances 1,713

Salaries 2,400

Wages 4,304

Stock on 1.1.2012

Wines ` 1,239, Spirits 378, Beer 165,

Mineral Water ` 147, Cigars and Cigarettes 114,

Sundry Provisions and Stores 183, Coal 150



NOTES

213

Purchases

Meat ` 3,627, Fish and Poultry 3,960, Sundry Provisions

and Stores ` 5,220, Wines 1,881, Spirits 2,190,

Beers 1,152, Mineral Water 1,000,

Cigars and Cigarettes 240.

Laundry 951

Coal and Gas 2,160

Electric Light 1,128

General Expenses 1,710

Sales

Wines 3,870, Spirits 4,338, Beer 1,863,

Minerals ` 2,160, Cigars and Cigarettes 390.

Charges

Meals 23,829, Room 9,375, Fires in bedrooms 582,

Washing Charges 219.

Repairs, Renewals and Depreciations

Premises 348, Furniture and Fittings 660,

Glass and China 609, Linen 390, Cutlery

and Plate 207.

Cash Book - Debit Balances

Bank ` 8,148, In hand 219, Visitor’s Account

` 1,348, Sundry Creditors 2,569

Prepare Final Account for the year ended 31st December 2012.

Stock on 31-12-2012 : Wines 1,197, Spirits 333, Beers 174, Minerals` 357, Cigars and Cigarettes ` 69, Sundry Provisions and Stores ` 141, Coal` 99.

NOTES

214



SOLUTION

In the books of Ameet Hotel

Profit and Loss Account for the year ended 31st December, 2012.Dr. Cr.

Particulars ` ` Particulars ` `

To Materials Consumed By Sales

(opening + purchase - closing) • Wines 3,870

• Wines • Spirit 4,335

(1,239 + 1,881 - 1,197) 1,923 • Beers 1,863

• Spirits • Minerals 2,160

(378 + 2,190 - 333) 2,235 • Cigars and

• Beers Cigarettes (+) 390 12,618

(165 + 1,152 - 174) 1,143 By Charges

• Minerals • Meals 23,829

(147 + 1,050 - 357) 840 • Rooms 9,375

• Cigars and Cigarettes • Fires in

( 114 + 240 - 69) 285 Bedrooms 582

To Provision and Stores • Washing (+) 219

(183 + 5,220 - 141) 5,262 34,005

Meat 3,627

Fish and poultry (+) 3,960

To Wages 19,275

To Salaries 4,305

To Rent, Rates and

Insurance 1,713

To Laundry 951

To Coal and Gas :

(150 + 2,160 - 99) 2,211

To Electric Light 1,128

To General Expenses 1,710

To Repairs and Renewals

and Depreciation on :

• Freehold premises 348

• Furniture and Fitting 660

• Glass and China 609

• Linen 390

• Cutlery and Plated (-) 207 2,214

To Net Profit C/D 10,716

46,623 46,623



NOTES

215

In the books of Ameet Hotel

Balance Sheet as on 31st December 2012

Labilities ` Assets ` `

Share Capital : Fixed Assets :

Authorised, Issued and • Freehold Premises 46,800

Subscribed : 56,865 • Furniture and Fitting 8,934

Reserve and Surplus Current Assets :

Profit and Loss 10,716 Visitor’s A/c 1,345

Current Liabilities : Stocks :

Sundry Creditors 2,569 • Wines 1,197

• Spirits 333

• Beers 174

• Minerals 357

• Cigars and Cigarettes 69

• Provisions and Stores 141

• Coal (+) 99

2,370

Cash - at Bank 8,148

Cash - in - Hand 219

Glass and China 1,101

Linen 840

Cutlery and Plates 390

70,150 70,150

12.6 Summary

The main business of a hotel is to provide food and accomonodation. Thereare some big hotels who provide different type of service such as recreationentertain meats, business facilities, motals etc.

The accounting treatment in hotel industry will depend on the nature andside of a hotel and its requirement. The principal of accounting will be the same aslike other business activities.

An analytical Purchase Book, Cash Book and Sale Book may be maintainedfor recording business transactions. A Ledger column must also be made in cashBook for recording the disbursement made for visitors. Cash Book will incorporatetwo other ledgers Viz. visitors ledger and Personal Ledger.

While preparing final accounts, special attention must be made for adjustmententries relating meals, lunch, accommolation etc.

NOTES

216



12.7 Key Terms

(1) Visitors Ledger : This ledger contains an account of each guest staying inthe Hotel. The ledger is maintained in a loose leaf form. Separate sheetsare used for each day. It is kept in a tabular form so as to provide readyinformation of different items or services provided to the guests.

(2) Food staffs and Beverages (F & B) : are the two important items ofsales in a hotel.




(1) Hotel industries follows the ------- system for recording their businessactivities.

(a) double entry,

(b) Cash,

(c) Single entry,

(d) mixed-system

(2) The ledger kept in a tabular analytical form, on account of each guest stayingin the hotel, which provide ready information of different items or servicesprovided to them is termed as ---------

(a) analytical ledger,

(b) principal ledger,

(c) Visitors ledger,

(d) Debtors ledger

(3) The final accounts of hotel business includes -----------

(a) Trading Account , Profit and Loss Account and Balance - Sheet.

(b) Profit and Loss Account and Balance - Sheet.

(c) Trading Account and Balance - Sheet.

(d) Manufacturing Account, Profit and Loss Account and Balance-Sheet.

(4) An effective system of -------- is used by every hotel to check leakage ofrevenue wastage of materials or facilities

(a) internal audit,

(b) internal check,



NOTES

217

(c) internal control,

(d) internal verification.

Ans. : (1-a), (2-c), (3-b), (4-c).


(1) What is ‘Tabular System of Book-Keeping’ ? Explain in brief the importantbooks of accounts maintained under Hotel Accounting.

(2) What is ‘Visitors Ledger’? Explain the need of maintaining visitors ledgerby Hotel Business.

(3) Define the term ‘Visitors Ledger’. State the importance of visitors ledgeras a basic record in Hotel Accounting .

(4) What are ‘Final Accounts’ of Hotel Business ? Explain in brief the needand importance of preparing final accounts in Hotel Accounting.


(1) From the following particulars relating to five rooms in Hotel sadanandprepare a visitors ledger in columner form.

a) Room Rent for each room ` 5,500 (+) 12% Tax

b) Room 1 : Breakfast ` 390, Laundry ` 210, Local Phone Calls ` 100

c) Room 2 : Lunch ` 1280, STD Calls ` 550, Wine ` 900, Outstanding forprevious bill 270

d) Room 3 : Hiring for Taxi ` 720, Local Phone Calls ` 240, Dinner `1,240

e) Room 4 : Outstanding at the beginning 470, Laundry 230, Lunch 1,100

f) Room 5 : Breakfast ` 410, Laundry Rs.240, Lunch ` 1,400.

g) The guest in room 3 is regular visitor and is allowed to a discount of 8% onroom rent.



• Maheshwari S.N. and Maheshwari S.K. corporate Accounting - New Delhi- Vikas publications Pvt. Ltd. - 2013.

NOTES

218



Unit 13 Introduction, Accounting Treatmentin Hotel Accounting

Structure

13.0 Introduction


13.2 Hotel Accounting

13.2.1 Type of Hotels and Restaurants

13.3 Accounting Treatment in Hotel Accounting

13.4 Fixation and charging of Room Rate

13.4.1 Method for ascertaining Room-Rate

13.4.2 Calculation of Room Occupancy Rate

13.5 Illustrations

13.6 Summary

13.7 Key Terms



13.0 Introduction

The hotel business is basically a service industry. With the growth of tourism,the hotel business is becoming a highly profitable venture for the entrepreneurs.The accounting rules and principles to a hotel industry are the same as in the caseof any commercial organisation. In this regard, the provision of companies Act,1956 for maintenance of account are also applicable to a hotel company. Hotelindustry provided services like, accommodation, food and beverage professionaland technical services to customers. Hence, the accounting system and controldevices are to some extent different form those applicable to other commercialorganisations. It is therefore necessary to get familiar with certain special servicesand facilities concerning hotel business as discussed in this unit.

It may be noted that rent form rooms and sale of food and beverages (i.e.provide breakfast, lunch, dinner guests and visitors) are the primary source ofrevenue of a hotel. Other minor operating services like Telephone/fax services,business centre, health club facilities, guest loundry, and beauty parlors etc. whichearn revenue for a hotel.

Introduction, AccountingTreatment In Hotel Accounting


NOTES

219


After study this unit you should be able to.

• Understand the nature of a hotel business.

• Identify the different type of hotels and restaurants.

• Explain the accounting treatment for hotel business.

• Explain the important points for fixation of room rate.

• Determine Room occupancy rate.

13.2 Hotel Accounting

Restaurants and hotels provides their customers good services and valuefor money and potential business transaction for the former. They provide qualityfood to those who enjoy eating in these places. Today, restaurants and hotels havebecome an essential part of living. Not only in cities, but also in towns and in therural areas. Many hotels are emerging, particularly near bus stands, railway stationsand in the market places. But there are some big hotels who provide other comfortsrecreations, eutertainments, business facitilies, transport facilities, caterer servicesetc. Therefore, the scheme of accounting will depend on the nature and size of ahotel and its requirement although the principal of book keeping and accountingwill be the same.

Hotel Accounting is a particular system of accounting which accumulates,communicates and interpretes historical and projects economic data that are usefulfor the purpose of ascertaining the financial position and gaining results of arestaurant or hotel. The types of hotels and restaurants is equally important to theusers of internal services of the hotel and external parties. In hotel industry,accounting is nothing but an information of charging for various services providedby the hotel or restaurant.

NOTES

220



13.2.1 Types of Hotels and Restaurants :

1) Amruttulya Bhavan (Tea Stalls) :- Provides only tea, coffee, colddrinksetc. These hotels are the first in the various types of hotels.

2) Ordinary Hotels :- These hotels also serve tea coffee, cold drinks anddelicious snacks and are gaining financially to a large extent.

3) Udupi Hotels :- These hotels are found it cities and towns. They providesouth Indian snacks and other delicious eateries. These hotels are normallyrun by the Udipi community and who strongly advocate vegtarianisum.

4) Restaurants :- Restaurants have established them selves in cities, townsand on highway carrying to the demands of quality foods by people througha varied menu - from various Indian states and satisfying those whoappreciate social drinking. Restaurants are rates us 3 Star, and 5 star,depending or the quality of their services, by attracting tourists and highprofile corporate clients. Some restaurants and hotel provides different typesof services which are classified as under.

(i) Inn :- A loading house serving food and drinks to the travellers.

(ii) Hotel :- A Hotel for motorists, with room adjoining a parking area.

13.3. Accounting treatment in Hotel Accounting

A hotel may have different provisions for serving of refreshments or forserving of lunches and dinners including the arrangement of bar. Hotels may haveseparate sections for catering at different places on different social occasions.For this purpose, they maintained separate accounts for purchase of various typesof items and sales of various types of items.



NOTES

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Types ofRestaurants and Hotels

Amruttulya Bhavan (Tea Stalls)

Ordinary Hotels(Snanck Centres)

Restaurants

Udupi Hotels1

2

3

4

An analytical Purchase or Bought Book, Sales Book and Cash Book maybe maintained in Hotel Accounting.

(i) A purchase book have a separate column for each and every purchase andexpenses i.e. Column for Wine, Minerals, Groceries and Provisions, Cutlery,Glass, Plates, etc., Bedding and Lineus, Establishments, Furniture & Fixturesetc.

(ii) A ‘Ledger Column’ must be made in Cash Book for recording thedisbursement made for visitors, Cash Book will also incorporate two otherledgers viz, “Visitors Ledger” and “Personal Ledger”.

(iii) A Sales Book have a analysis column - such as Breakfast, Lunches andDinners, Bar, Cigarettes and cigurs etc., Carriages (If any) etc. The receiptside of Cash Book must have similar analysis columns which areincorporated in Sales Book.

(iv) Beside the above, the Stock Ledger has to be maintained in details so thatdirect control must be exercises regarding purchases, sales and otherconsumable items.

(v) Separate account have to be maintained for receipts like wines, Beer andSpirits etc. and payments made against these items, the balance being transferto Profit and Loss Account.

(vi) Proper Adjustments are also to be made for Meals, Loundry etc. betweenthe staff and the owner for ascertaining correct profit in Hotel Accounting.(Salaries and wages (for staff) and Drawing Account (for owner) will bedebited and particular account say, Loundry will be credited)

(vii) All kinds of transfer from one section to another section is to be maintainedsystematically.

(viii) Open working accounts for various sections of Bar, Accommodation,Restaurant, Lunch, Dinner etc. (When collection are made AccommodationAccount is credited on the other hand rates, taxes, repairs to building,depreciation on bedding, attendents, wages, proportionate establishmentcharges etc. are to be debited to Accommodation Account)

(ix) Cost and expenses relating to meat, eggs, fish, poultry, groceries provisionsetc. should be apportioned between Restaurants and Lunches and Dinners.

(x) It becomes necessary to prepare separate accounts for Internet connection,Billiards Room, Bunquet Hall, Laundry etc.

(xi) While preparing Final Accounts, special attention must be made for alladjustment entries, as well as closing entries relating to various types ofservices provided by the hotel. All relating expenses are to be apportinedamong the different sections in an appropriate manner and, consequentlythe same will be adjusted in Profit and Loss Account.

NOTES

222



13.4 Fixation and charging of Room Rate

While fixing room rate following points should be taken in to consideration

(a) Location of the Hotel.

(b) Availability of rooms in the hotel.

(c) Capital and Revenue Expenditure.

(d) Expected Rate of return on investments.

(e) Availability of various facilities and services attached.

(f) Location of the particular room.

(g) Occupancy Rate.

(h) Suitable season of tourists.

13.4.1 Method for ascertaining Room-Rate :

For calculating room-rate, normally the total estimated revenue expenditureplus estimated rate of return on investment is divided by the number of roomswhich are available for letting out purposes. The charges for single Room, DoubleRoom, South facing Room will be quite different than the other.

Room Occupancy Rate is calculated as :

Room Occupancy Rate= Number of Rooms occupied

x 100Number of Rooms available for letting out

(Note : Double Bedded Room is taken as two rooms.)

Double Occupancy Rate :

=Total number of Guests - Number of Rooms occupied

x100 Number of Rooms occupied

(Note : Number of beds should be taken instead of number of Rooms.) OR

Room

=Estimates cost of operation + Expected fair return on investment

rate No. of available Room that can be let out.

13.4.2 Calculation of Room Occupancy Rate :

Usually for a 24-hour stay one day’s charge is take n, i.e., the occupant isallowed to stay for 24 hours from the time of arrival to the time of departure. Theoccupant is to pay one day’s charge even if he stays for less than 24 hours. It isinteresting to note that check-out time is followed in some hotels which is usuallyfixed at 12 noon. For this, full charge is to be paid by the occupant from the timeof occupying the room to the check-out time which usually is less than 24 hours.



NOTES

223

Check Your Progress

1. State the types ofRestaurants and Hotelsrequiring appropriatesystem of HotelAccounting.

2 . State the important factorsto be considered whilefixing a room-rate.

3 . State the method ofcalculating RoomOccupancy Rate.

For Example, X occupied a room in a hotel at 7.00 a.m. in the morning on Mondaywhere check out time was fixed at 12.00 a.m.. He left the hotel on Tuesday at4.00 p.m. He should pay 3 days charges (i.e., from 7.00 a.m. to 12 a.m. on Monday+ 12 noon of Monday to 12 noon of Tuesday + 12 noon of Tuesday to 4 p.m. ofTuesday.)

The concept of room occupancy rate can be understood with the help offollowing illustrations.

13.5 Illustrations

ILLUSTRATION 1

A five - star hotel in Chennai has 320 lettable rooms on a particular day, 240rooms are occupied by 300 guests. Calculate Double Occupancy Rate.

SOLUTION

Double Occupancy Rate =Number of Guests - Number of Rooms Occupied

x100 Number of Rooms Occupied

=300 Guest - 240 Rooms

x 100 240 Rooms

= 60 Guest

x 100 240 Rooms

= 25%

ILLUSTRATION 2

A five - star hotel has 660 rooms in all, out of which 52 rooms are used foroperational purposes and 8 rooms are used by the departmental managers.

If 480 rooms are occupied by the guests on any day, calculate the roomoccupancy rate.

SOLUTION

Room Occupancy Rate = Number of Rooms occupied

x 100Number of rooms available for letting out

= 480 Rooms

x 100660 Rooms - 44 Rooms (52 Rooms - 8 Rooms)

=480 Rooms

x 100616 Rooms

= 78 %

NOTES

224



ILLUSTRATION 3

Mr. A arrives in Nagpur and check into a room in a five-star hotel at 4.p.m.on 1st June 2012 at ` 500 per day plus 10% for service charges on EuropeanPlan. Check out time in the hotel is 12 noon.

Calculate the amount payable by Mr. A in each of the following circumstance:

(i) If Mr. A checks out at 10 p.m. on the same day

(ii) If Mr. A checks out at 9 a.m. on 2nd June 2012

(iii) If Mr. A checks out at 6 p.m. on 2nd June 2012

(iv) If Mr. A checks out at 4 p.m. on 3rd June 2012

Show also the amount payable by Mr. A if the charges were leviable @` 500 for a stay of every 24 hours or part there of plus service charges at 10%

SOLUTION

Based on 12 Noon Check-out TimeParticulars Number of Rate Amount Tax@10% Total

AmountsDays ` ` ` payable

Check out at 10 p.m. 1 500 500 50 550

on the same day

`` ` ` 9 a.m. on 2nd June 1 500 500 50 550

`` `` ` 6 a.m. ` ` ` 2 500 1,000 100 1,100

`` `` ` 4 p.m. on 3rd June 3 500 1,500 150 1,650

Based on 24 Noon Check-out Time

Check out at 10 p.m. on the 1 500 500 50 550

same day

`` ` ` 9 a.m. on the same day 1 500 500 50 550

`` ` ` 6 p.m. on 2nd June 2 500 1,000 100 1,100

`` ` ` 4 p.m. on 3rd June 2 500 1,000 100 1,100

13.6 Summary

• Hotel business is basically a service industry. Hence the accounting systemis some extent different from those applicable to other type of businesses.

• Following services are provided by a hotel.

(i) Accommodation to customer.

(ii) Food & beverages.

(iii) Professional and technical services.

(iv) Other facilities like, shopping centre, beauty parlors, hair dressingsaloons etc.



NOTES

225

• Rent from rooms and sales of food and beverages are the primary sourcesof revenue of a hotel.

• Generally room rate is fixed taking into consideration the following importantfactors :

(i) Number of Rooms which can be hired out during a particular period.

(ii) The estimated cost of operation for the same period.

(iii) The expected fair return on the investment.

However the following additional factors which are important while fixingthe room rate by a hotel.

(i) Location of the hotel, (ii) Location of the room,(iii) Facilities provided in the room & (iv) occupancy rate.

13.7 Key Terms

i) Room Occupancy Rate = Name of Room Occupied

x 100Number of Rooms Available for letting out

ii) Double Occupancy Rate =No. of Guest - No. of Room Occupied

x 100 No. of Rooms Occupied

iii) Room Rate :- It is the rate at which a guest is to be charge for accommodationprovided to him by the hotel.



A) Multiple Choice Questions

(1) The hotel business is basically a --------------

(a) serving industry

(b) trading concern

(c) manufacturing organisation

(d) commercial enterprise

(2) The primary source of revenue for a Hotel Business is -----------

(a) rent from room - accommodations

(b) sale of food and beverages

(c) health club facilities

NOTES

226




(3) The compilation of various information of charging for various servicesprovided by the hotel is termed as -----------

(a) Services Accounting

(b) Hotel Accounting

(c) Business Accounting

(d) Corporate Accounting

(4) The percentage of beds occupied by the guests to the total beds available inthe hotel is termed as ---------------

(a) Single Occupancy Rate

(b) Double Occupancy Rate

(c) Bed Occupancy Rate

(d) Room Occupancy Rate

Ans. : (1 - a), (2 - d), (3 - b), (4 - c).


(1) What is ‘Hotel Accounting’? Explain the types of Hotels and Restaurants.

(2) Define ‘Hotel Accounting’. State the importance of Purchase Book, SalesBook and Cash Book maintained in Hotel Accounting.

(3) What is ‘Room Rate’ ? Explain in brief the important points to be consideredwhile fixing room-rate.

(4) What is ‘Room Occupancy Rate’? Explain the method for calculating Roomoccupancy Rate.


(1) Hotel Blue Diamond, a three star hotel in Pune has 500 lettable rooms, ofwhich 300 rooms are single bed rooms and 200 are double bed rooms. On26th January, 2014 200 single rooms and 100 double rooms are occupied bythe guests. Calculate the Bed Occupancy Rate for 26th January,2014.



NOTES

227


• Shukla M.C., Grewal T. S. and Gupta S. C. - Advanced Accounts - NewDelhi - S. Chand & Co. Pvt. Ltd. - 2013

• Maheshwari S. N. and Maheshwari S. K. - Corporate Accounting - NewDelhi - Vikas Publishing House Pvt. Ltd. - 2013

NOTES

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