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By going through these CBSE Class 12 Accountancy Notes Chapter 9 Analysis of Financial Statements, students can recall all the concepts quickly.

Analysis of Financial Statements Notes Class 12 Accountancy Chapter 9

Meaning of Financial Statement Analysis: The process of critical examination of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called the ‘Financial Statement Analysis’.

Basically, it is a study of the relationship among various financial facts and figures as given in a set of financial statements.

→ “Financial statement analysis is designed to indicate the strength and weaknesses of business undertaking through the establishment of certain crucial relationship by regrouping and analysis of figures contained in financial statements.” —J.N. Myres

→ “Financial statement analysis is a judgemental process which aims to estimate current and past financial position and the results of the operations of enterprises with the primary objective of determining the best possible estimated and predictions about future conditions.” —Bernstein

Thus, Analysis of Financial Statements is the process of identifying the financial strengths and weaknesses of the firm by properly establishing a relationship between the items of the Balance Sheet and Income Statement.

The term ‘Financial Analysis’ includes both ‘analysis and interpretation’. The term analysis means simplification of financial data by the methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data so simplified.

Significance of Financial Analysis: As we know that Financial Analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the Balance Sheet and the Profit and Loss Account.

It can be undertaken by the management of the firm, or by parties outside the firm like Creditors, Lenders, Investors, Unions, etc. The nature and technique used for analysis will differ depending on the interests of the analysis.

Financial Analysis is useful and significant to different users in the following way:
1. To The Finance Manager: Financial Analysis focuses on the facts and relationships related to managerial performance, corporate efficiency, financial strengths and weaknesses, and credit worthiness of the company. The Finance Manager has to make rational decisions for the firm, so he must be well equipped with the different tools for analysis. These tools help him in studying accounting data, so as to determine the continuity of the operating policies, the investment value of the business.

Credit rating and testing the efficiency of operations. The technique is equally important in the area of financial control, enabling the Finance Manager to make constant reviews of the actual financial operations of the firm as a whole and in part, to analyze the cause of major deviations, which result in corrective action wherever indicated.

2. To The Management: It is the responsibility of the management to see that the resources of the firm are used most efficiently and that the firm’s financial condition is sound.

Financial analysis helps the management in measuring the success or otherwise of the company’s operations, appraising the individual’s performance, and evaluating the system of internal control.

3. To The Trade Creditors: Trade Creditors are particularly interested in the firm’s ability to meet their claims over a very short period of time. Their analysis will, therefore, confine to the evaluation of the firm’s liquidity position.

4. To The Lenders: Lenders are mainly concerned with the firm’s long-term solvency and survival. They analyze the firm’s profitability over time, its ability to generate cash to be able to pay interest and repay principal, and the relationship between various sources of funds. They do analyze the historical financial statements as well as projected financial statements to make an analysis about its future solvency and profitability.

5. To The Investors: Investors who invested their money in the firm’s shares, are interested to know about the firm’s earnings. They mainly concentrate on the analysis of the firm’s present and future profitability. The investors evaluate the efficiency of the management and determine whether a change is needed or not. In large companies, the shareholder’s interest is limited to decide whether to buy, sell or hold the shares.

6. To The Labour Unions: They analyze the Financial Statements to assess whether the company is earning a fair rate of return on invested capital, whether it can presently afford a wage increase and whether it can absorb a wage increase through increased productivity or by rising the prices.

7. To the Economists, Government, etc.: The economists, researchers analyze the Financial Statements to study the present business and economic conditions. The Government agencies need financial analysis for price regulations, tax fixation, and another similar purpose.

Purpose or Objectives of Financial Statement Analysis: Financial Statement Analysis reveals important facts and relationships concerning the managerial performance and the efficiency of the firms. The main objectives of the analysis are to understand the information contained in financial statements with a view to knowing the weaknesses and strengths of the firms and making a forecast about the future prospects of the firm and thereby enabling the financial analysis to take different decisions regarding the operations of the firm.

The following are generally considered to be the objectives of analysis:

1. To find out the financial stability and soundness of the business enterprises.
2. To assess and evaluate the earning capacity of the business.
3. To estimate and evaluate the Fixed Assets, Stock, etc. of the concern.
4. To estimate and determine the possibilities of future growth of the business.
5. To assess and evaluate the firm’s capacity and ability to repay short-term and long-term loans.
6. To evaluate the administrative efficiency of the business enterprises.

Tools of Financial Analysis.

1. Comparative Statement Analysis.
2. Common Size Statement Analysis.
3. Trend Analysis.
4. Ratio Analysis.
5. Cash Flow Analysis.

1. Comparative Statement Analysis: Comparative statements compares financial numbers at two points of time and helps in deriving meaningful conclusions regarding the changes in financial positions and operating results and to enable the reader to understand the significance of such changes.

Such comparison of Financial Statements is accomplished by setting up a Balance Sheet and Profit and Loss Account side by side and studying the changes that have occurred in the individual figure therein from year to year and over the years. Thus, Comparative Statements are those which summarise and present relating data for a number of years incorporating therein the changes in individuals items of Financial Statements. This analysis is also known as Florizontal Analysis.

2. Common Size Statement Analysis: These Statements indicate the relationship of different items of Financial Statements with some common item by expressing each item as a percentage of the common item. The percent thus calculated can be easily compared with the corresponding percentages of some other firms, as the number is brought to a common base. This analysis is also known as ‘Vertical Analysis’.

3. Trend Analysis: It is a technique of studying several Financial Statements over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. Trend analysis is important because, with its long-run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising, or remaining relatively constant.

4. Ratio Analysis: Accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency, and efficiency of an enterprise through the techniques of ratio analysis.

5. Cash Flow Analysis: It refers to the analysis of the actual movement of cash in and out of an organization. Cash Flow Statements is prepared to project the manner in which the cash received has been utilized during an accounting year. It is a statement, which shows the sources of cash receipts and also the purposes for which payments are made. Thus, it summarises the causes for the changes in the cash position of a business enterprise between the dates of two Balance Sheets.

Comparative Financial Statements Analysis: Financial Statements include Income Statements (Trading and Profit and Loss A/c) and Position Statement (Balance Sheet). The study of financial statements with a view to indicating the trend of the profitability, efficiency, and financial soundness of the business is known as a comparison of financial statements.

Purpose:

1. To study the magnitude and direction of changes in the financial position and performance of the enterprise.
2. To ascertain the strengths and weaknesses of the enterprise in terms of liquidity, solvency, and profitability.

Importance:

1. Inter-period and/or inter-firm comparisons are very much facilitated by such comparative statements. t
2. With the help of Comparative Statements, weakness in the operating cycle, financial health, etc. can be identified and suitable remedial steps may be taken.
3. These statements highlight the trends in a number of accounting data relating to performance, efficiency, and financial position which are useful for future estimates.
4. The Profit and Loss A/c of a business show the result of operation while a Comparative Balance Sheet shows the effect of operations on its assets and liabilities. Thus, the Comparative Balance Sheet contains a connecting link between Balance Sheet and Profit and Loss A/c.

Comparative Balance Sheet: In the comparative balance sheet, the items and data of balance sheets prepared at two different dates are presented in such a way that the changes in each item between two dates are easily found out and determined.

→ “Comparative balance sheet is the study of the trend of the same item, group of items and computed items in two or more balance sheets of the same business enterprise on different dates.”—Prof. Foulkes.

Comparative Profit and Loss Account: A comparative income statement is prepared to show the net profit or loss for a number of years in comparative form. A comparative study of Income Statements for more than one period may enable us to have definite knowledge about the progress of the business concern.

Steps:
The following steps may be followed to prepare the comparative statements:
1. Draw a table with the five columns like;
Comparative Statement

2. List out absolute figures in rupees at two different points of time.
3. Find out the change in absolute figures by subtracting the first year from the second year and indicate the change as an increase (+) or decrease (-).
4. Calculate the Percentage change as:
\(\frac{\text { SecondyearabsoluteFigure }}{\text { First year absoluteFigure }}\) × 100 – 100

Common-Size Financial Statement Analysis: Common-Size Statement also known as a component percentage statement, is a financial tool for studying the key changes and trends in the financial position (Balance Sheet) and financial result (Profit and Loss A/c) of a company.

These figures reported are converted into percentages of some common base. For example, total assets may be chosen as a measured size for the Balance Sheet and sales may act as a measured size for Profit and Loss A/c.

These statements are known as common size statements because all the figures are converted into a common size.

Purpose: An analysis of the common size statement will help better to understand the important changes which have occurred in the enterprise over a period of time. This analysis constitutes a vertical study within one column of the comparative statement therefore, it is also called vertical analysis.

Importance: An analysis of common size statement is of immense use which comparing business enterprise which differs substantially in size as it provides an insight into the structure of financial statements.

Common Size Balance Sheet
In Common Size Balance Sheet, each item of assets is shown as a percentage of total assets and each item of liability is shown as a percentage of total liabilities. The total of the assets and that of liabilities is taken as 100 percent and each item, appearing on the assets side as well as liabilities side is shown as the proportion of the total of 100. It is known as the Percentage Balance Sheet.

Common Size Income Statement: Income Statements are reduced to common size by expressing each item as a percentage of net sales. Thus the common size Income Statement captures the relationship between sales and expenses.

Steps:
The following steps may be followed to prepare the common size statements:
1. Draw a table with the five columns.
Common Size Statements

2. List out absolute figures in rupees at two different points in time.
3. Choose a common base (as 100) for example, Sales revenue total may be taken as a base (100) in case of Profit and Loss A/c and total assets or total liabilities (100) in case of Balance Sheet.
4. Convert all items of Col. 2 and Col. 4 as a percentage of that total. Columns 3 and 5 portray these percentages.

The purpose of the common-size analysis is to know the importance of each item in the total. Hence, this analysis can be done for one year also.

Trend Analysis: The Financial Statements may be analyzed by computing trends emeries of information. Trend analysis determines the direction upwards or downwards and involves the computation of the percentage relationship that each item bears to the same item in the base year. In Trend Analysis, we would like to know the behavior of some item over the period, say during the last 5 years.

In other words, Comparative and Common Size Statements present the percentage of each item to the total sum. These percentages could be calculated for a number of successive years in order to understand the trend of the Financial Statement item and this analysis is called trend analysis.

The trend in general term signifies a Tendency. The review and appraisal of tendency in accounting data are nothing but trend analysis. It discloses the change in the financial and operating data between specific period and makes possible for the analyst to form an opinion as to whether favorable or unfavorable tendencies are reflected by the accounting data.

Purpose and Importance:
1. It helps in future forecasts of various items as the basis of data of the previous year.
2. In this method, mass complex accounting data are converted into % and presented in brief, so the direction of the business can be easily detected.
3. There is less chance of mistakes because changes in percentages can be compared to changes in absolute data.
4. It is a very easy method to calculate that even a layman can also use this method.

Procedure: Generally, the first or the last year is taken as the base year. The figure for the base year is taken as 100. The trend percentages are calculated in relation to this base year. Each year’s figure is divided by the base year figure.
Trend Percentage = \(\frac{\text { Present year value }}{\text { Base year value }}\) × 100

The base period should be carefully selected. The accounting procedures and conventions used for collecting data and preparation of Financial Statements should be similar, otherwise, the figures will not be compared.

Limitations of Financial Analysis
Though financial analysis is quite powerful in determining the financial strengths and weaknesses of a firm, the analysis is based on the information available in financial statements. As such, financial analysis also suffers from the serious limitations of financial statements.

Some other limitations of financial analysis are:

1. It does not consider price level changes.
2. It may be misleading an account of changes in accounting procedure followed by a firm.
3. It is just a study of interim reports.
4. Monetary information alone is considered in financial analysis while non-monetary factors are ignored.
5. The financial statements are prepared on the basis of ongoing concepts as such, it does not give an exact position.

By going through these CBSE Class 12 Accountancy Notes Chapter 8 Financial Statements of a Company, students can recall all the concepts quickly.

Financial Statements of a Company Notes Class 12 Accountancy Chapter 8

Financial Statements are the end products of the accounting process. They are prepared following the consistent accounting concept principles, procedures and also tire legal environment in which the business organization operates. These statements are the outcome of % the summarizing process of accounting and are, therefore the sources of information/on the basis of which conclusions are drawn about the profitability and the financial position of a business enterprise.

Meaning of Financial Statements: Financial Statements are the summarized statements of accounting data produced at the end of the accounting process by an enterprise through which it communicates accounting information to the external users as well as internal users.

These are the basic and formal means through which the corporate management communicates financial information to various users. External user includes investors, tax-authorities, government, employees, etc.

Financial information, which is the information relating to the financial position of any firm, when presented in a concise and capsule form, is known as the financial statement.

“Financial Statements are prepared for the purpose of presenting a periodical review or report on progress made by the management and deal with the status of investment in the business and the results achieved during the period under review.”

—American Institute of Certified Public Accountants (AICPA)
“The end product of financial accounting in a set of financial statements prepared by the accounts of a business enterprise that purport to reveal the financial position of the enterprise, the result of its recent activities and an analysis of what has been done with earnings.” -Smith and Assume

“The Finacial Statements provide a summary of accounts of a business enterprise, the balance sheet reflecting the assets, liabilities, and capital as on a. certain date and the income statement showing the results of operations during a certain period.”. -John N. Myer

“Financial Statement, essentially, are interim reports presented annually and reflect a division of the life of an enterprise into more or less arbitrary accounting period more frequently a year.” -Anthony

Thus, Financial Statements are the final product of accounting work done during the accounting period which shows the financial position and result of business activities for that accounting period. In other words, Financial Statements are the end products of the accounting process. It may be defined as the reports prepared for the purpose of presenting a periodical review of the performance and the financial position of a business enterprise. Financial statements are the indicators of profitability and financial soundness of a corporate sector.

Nature of Financial Statements:
Viewpoints of the Professional Bodies and Researchers about the nature of Financial Statements:
According to the American Institute of Certified Public Accountants

(AICPA), “Financial statements are prepared for the purpose of presenting a periodical review of the report on progress by the management and deal with the status of investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgments.”

In the words of the American Accounting Association, “Every corporate statement should be based on accounting principles, which are sufficiently uniform, objectives and well understood to justify opinion as to the condition and progress of the business enterprise. Its basic assumption was that the purpose of periodic financial statements of a corporation is to furnish information that is necessary for the formation of dependable judgments.”

According to John. N. Mayer, “The financial statements are composed of data which are the result of a combination of

1. Recorded facts concerning the business transactions;
2. Conventions adopted to facilitate the accounting technique;
3. Postulates or assumptions made; and
4. Personal judgments used in the application of the conventions and postulates.”

The following points explain the nature of financial statements:
1. Recorded Facts: The basis of recording transactions in financial statements is the original cost or historical cost. The assets purchased at different times and at different prices are put together and shown at cost price. The financial statements do not show current financial conditions, as they are based on original costs not on replacement costs.

2. Accounting Conventions: For preparing financial statements, certain accounting conventions are followed. For example, the convention of valuing inventory at cost or market price, whichever is lower, is followed. Small items like pencils, pens, postage, stamps, etc. although assets in nature but treated as expenditure in the year in which they are purchased. The Stationery is valued at cost. The use of accounting conventions makes financial statements comparable, simple and realistic.

3. Postulates: Financial Statements are prepared on certain basic \ assumptions known as postulates such as going concern postulates, money-measurement postulate, realization postulate, etc. Going concern postulates assumes that the enterprise is run for a long time. Money FC measurement postulate assumes that the value of money will remain the same in different periods.

4. Personal Judgements: Under more than one circumstance, facts and figures presented through financial statements are based on personal opinion, estimates, and judgment. For example, depreciation is calculated with a written-down method or at the original cost.

Provisions for doubtful debts are made on estimates and personal judgments. Personal opinion, judgments, and estimates are made while preparing the financial statements to avoid any possibility of overstatement of assets and liabilities, income, and expenditure, keeping in mind the, convention of conservation.

Thus, Financial Statements are the summarized reports of recorded facts and are prepared following the accounting concepts, conventions, and requirements of law.

Objectives of Financial Statements
1. To provide information about economic resources and obligations of a business: Financial Statements are prepared to provide adequate, accurate, reliable, and periodical information to investors and other external parties regarding economic resources and obligations of a business firm.

2. To provide information about the earning capacity of the business: Financial Statements are prepared to provide the information about the earning capacity of the business, which can be very useful and important for decision-making purposes for internal as well as external users. They provide very useful financial information, which can be utilized to predict, compare and evaluate the firm’s earning capacity.

3. To provide information about cash flows: Financial Statements can also provide vital information useful to investors and creditors for predicting, comparing and evaluating, potential cash flows in terms of amount, timing, and related uncertainties.

4. To judge the effectiveness of management: With the help of financial statements, we can judge the management’s ability to utilize the resources of a business effectively.

5. Information about activities of business affecting the society: They have to report the activities of the business organization affecting the society, which can be determined and described or measured and which are important in its social environment.

6. Meeting the informational needs of users: These statements have to disclose, to the extent possible, other information related to the financial statements that are relevant to the needs of users of these statements.

7. Disclosing accounting policies: These reports have to provide the significant policies, concepts followed in the process of accounting, and changes are taken up in them during the year to understand these statements in a better way.

8. To provide information about solvency: Solvency determined the ability of a business concern to meet its short-term debt such as creditors, bills payable and -bank overdraft, etc., and long-term debts such as debentures, bank loans, etc. The financial statements of the firm provide information regarding the solvency of the firm.

9. Helps in comparison: With the help of information provided by the financial statements, comparison between the different firms made easy.

Types of Financial Statements: Financial Statements generally includes:

1. Income Statement (or Profit & Loss Account)
2. Position Statement (or Balance Sheet)

The statement, which takes care of matching revenue receipts with revenue payments (of nominal nature) is known as Income Statement.

Items of capital nature that have potential uses and future obligations known as assets and liabilities. The statement which shown total assets and liabilities is known as the position statement (or Balance Sheet).

These two basic statements are required for external reporting and also for the internal needs of the management. These two basic statements are supported by a number of schedules, annexures, supplementing the data contained in the balance sheet and income statement.

1. Balance Sheet: It is a component of a financial statement that shows the balance of liabilities, equities, and assets of a business entity as on a particular date. The balance sheet is not an account. Balance of liabilities, equities, and assets are not closed by transferring to Balance Sheet, balance of those accounts are simply carried forward to the next accounting period.

The balance sheet displays the liabilities, equities, and assets position generally at the end of the accounting period. It is a sheet of the balance of ledger accounts that are still open after the transfer of all nominal accounts to the Income Statement. The balance of all the personal and real accounts are grouped as assets and liabilities. Liabilities are shown on the left side of the Balance Sheet and Assets on the right side.

According to the American Institute of Public Accountants, Balance\ Sheet is “A tabular statement of summary of balance (debits and credits) carried forward after an actual and constructive closing of books of accounts and kept according to principles of accounting.”

→ “A business form showing what is owed and what the proprietor is forth is called a Balance Sheet.” —Karlson exi

→ “The Balance Sheet is a statement prepared with a view to measure the ICT financial position of a business on a certain fixed date.”—J. R. Batliboi side

→ “The Balance Sheet is a statement at a particular date showing on one (he trader’s property and possession and on the other hand the liabilities.” -A. Palmer

It is the report about the properties owned by the enterprise and the claims of the creditors and owner against these properties. Thus, a Balance Sheet is a statement prepared with a view to measure the exact financial position of a business on a certain date.

2. Income Statement or Profit and Loss Account: It is the accounting report, which summarizes the revenues expenses, and incomes, and the difference between them for a specified accounting period. An income statement gives a mathematical interpretation of policies, expenses, knowledge, foresight, and aggressiveness of the management of a business from the point of view of income, expenses, gross profit, operating profit, and net profit or loss.

As per the accounting concept of income, profit or loss is the difference between the realized revenues of the period and the related expired costs. Income measurement is based on concepts like going concerned, accounting period, realization, matching, and objectives evidence, etc. Normally accrual basis of accounting is followed in income measurement.

Uses and Importance of Financial Statements
Financial Statements, which are prepared to depict true relevant, easily understandable, comparable, analytically represented, and promptly presented financial position, help the user in their economic decisions.

The main uses and importance of financial statements are following:
1. Provide Information to Shareholders: Financial statements provide information about the management performance to the shareholders. Shareholders are the suppliers of the basic capital to run the concern and as such, they are very much interested in the well-being of the business.

They are interested to know the profitability and prospects of future growth of the business. They come to know about the financial position and operating results of the business through these financial statements only.

2. Basis for Fiscal Policies of the Government: Financial Statement provides the basis for fiscal policies of the Government. Financial Statement provides useful information to various government departments like Income Tax, Sale Tax, Excise duty, etc to determine the tax liability of the concern. So, on the basis of financial statements, the government determines tax policy, import-export policy, industry policy, etc.

3. Basis for Dividend Policies: The dividend policies of the corporate sector are linked with the government regulation and financial performance of the undertaking. Hence, financial statements form the basis for dividend policies of companies.

4. Basis for Granting of Credit: Corporate undertaking has to borrow funds from banks and other financial institutions for different purposes. All financial institutions which provide loan to the corporate undertaking are interested to know the profit earning capacity of the business and its long term solvency. They make decisions based on the financial performance of the undertaking. Thus financial statements form the basis for granting credit.

5. Guide to the Value of the Investment Already Made: Shareholders of companies are interested in knowing the status, safety, and return on their investment. They may also need the information to make decisions about the continuation or discontinuation of their investment in the business. Financial statements provide information to the shareholder in taking such important decisions.

6. Basis for Prospective Investors: In addition to the existing investor there may be people who may be interested in investing money in the company. But before doing that they would be interested to know the long-term and short-term solvency as well as the profitability of the concern. Financial statements provide adequate information to such potential investors to enable them to take the necessary decisions.

7. Aids Government in Policy Framework: Financial statements help Government to assess the role of corporate undertaking in the economic development of the country. It also assesses the economic situation of the country from these statements in terms of industrial production, employment, etc. These statements enable the government to know whether a business is following various rules and regulations or not. These statements also form the basis for framing and amending various laws for the regulation of the business.

8. Aids Trade Associations in Helping their Members: Trade Associations can judge, on the basis of financial statements the profitability of the business enterprises. They can compute as to how much bonus and increase in their wages are possible from the profits of the business concern. Trade unions negotiate the wages and salaries with the company, the financial statements reveal the financial soundness of the company and thus provide the basis to the trade unions to go in for negotiations.

9. Helps Stock Exchanges: Financial Statements help the stock exchanges to understand the extent of transparency in reporting on financial performance and enable them to call for the required information to protect the interest of investors. The financial statements enable the stockbrokers to judge the financial position of different concerns and take decisions about the price to be quoted.

10. Helps Trade Creditors: Trade creditors and suppliers of goods are interested in knowing the short-term solvency of the business. They are interested to know whether the business firm will be making payment on time or not. Financial statements provide adequate information to them to take the necessary decisions.

Limitations of Financial Statements
Financial Statements suffer from the following limitations.
1. Do not reflect the current situation: Financial Statements are prepared on the basis of historical cost and do not throw light on the current and present position of the business. The purchasing power of money is changing, the value of assets and liabilities shown in the financial statement does not reflect the current market situation. It does not indicate the current position of the business.

2. Dividends out of Capital: Net profit is ascertained on the basis of historical cost. If profits are adjusted to changing price levels, it may lead to loss and consequently, dividends may be paid out of capital.

3. Incomplete Information: Financial statements do not include all of the relevant information necessary for evaluating the status, progress, and future prospects of a business enterprise. The Balance Sheet does not disclose information relating to the loss of markets and cessation of agreements that have a vital bearing on the enterprise.

4. Assets may not realize: Some of the assets may not realize the stated value if the liquidation is forced on the company. Assets shown in the balance sheet reflect the merely unexpired or unamortized cost.

5. Different accounting policies: Various concepts and conventions of accounting affect the value of assets and liabilities as shown in the Balance Sheet and profit as shown by the Profit and Loss Account. For example, different firms may adopt different methods of stock valuation.

6. No Qualitative Information: The financial statements do not reflect complete information about the firm. Only that information, which can be expressed in monetary terms, is given. Qualitative information is however ignored like industrial relations, industrial climate, labor relations, etc.

7. No free from Bias: Financial statements are prepared on the basis of certain established concepts and conventions yet they are greatly affected by personal bias and personal judgment of various factors.

8. Aggregate Information: Financial Statements show aggregate information but not specific information. Hence they may not satisfy the user in decision making unless modified suitably.

9. Interim reports: Financial Statements are merely interim reports, not final reports. Profit and Loss Account discloses only interim profits but not final profits. Final profits can be known only when an enterprise is liquidated, assets are sold and liabilities are paid off.

10. Affected by window-dressing: Some business firms have given too much attention to decorate their financial statements in such a way that they fulfilled all the legal requirements and show the sound financial position of the firm. In fact, these statements may be far from the truth.

Income Statement may be divided into three components

1. Trading Account → To show Gross Profit Earned or Gross Loss incurred.
2. Profit and Loss Account → To show Net Profit earned or Net Loss incurred.
3. Profit and Loss Appropriation Account → To show all appropriation from the current year and balance of profit or loss of last year and surplus or deficit at the end of the period.

Note: If the company is a manufacturing concern, apart from the above components manufacturing account is also required.

→ Trading Account: Trading Account is the first part of the financial statements. The trading account is designed to show the gross profit on the sale of goods. The trading account contains the transactions of the company relating to the commodities in which it deals, throughout the accounting period.

All expenses either related to purchasing of raw material or production are charged to the Trading A/c i.e. Debited to Trading A/c. It is prepared to find out Gross Profit or Gross Loss. If the sales are more than purchases and expenses the result is Gross Profit and vice versa. Its main components are sales, services rendered and cost of such sales or service rendered. A trading account provides the data for comparison, analysis, and planning for future growth.

Form of Trading Account
Trading Account of…………………. Co. Ltd.
for the year ended……………………..

→ Profit and Loss Account: The profit and Loss Account is the second part of the financial statement. The company is more interested in knowing its net income or net profit, which increases its equity. Net profit represents the excess of gross profit plus other revenue income over indirect expenses.

The indirect expenses are not shown in Trading Account. On the debit side of the Profit and Loss Account, the indirect expenses are shown whereas on the credit side revenue incomes. If the debit side is less than of credit side, it would be net profit and if the credit side is less than of debit side it would be a net loss.

“A Profit and Loss account is an account into which all gains and losses are collected in order to ascertain the excess of gain over the losses or vice-versa.” -Prof. Carter

Form of Profit & Loss Account
Profit & Loss Account of………… Co. Ltd.
for the year ended…………………………..

→ Profit and Loss Appropriation Account: The account which shows the disposition of profit is called the Profit and Loss Appropriation Account. The disposition of profit means the distribution of net profits by way of dividends, transfer of profits to various reserves, adjustment of arrears of depreciation, if any, bonus to shareholders, and so on.

Form of Profit and Loss Appropriation Account
Profit and Loss Appropriation Account of…………… Co. Ltd
for the year ending…………………………

Income statements may also be presented in vertical form with detailed data. Verticle form income statements are suitable for further analysis and providing suitable data for decision making.

Form of Vertical Income Statement
Income Statement of……………………. Co. Ltd.
for the year ending……………………..


Process for Preparation of Income Statement:
The following process is to be followed for the preparation of the income statement (in T form):

1. Preparation of trial balance on the basis of balances of all the accounts available in the ledgers of the concern.
2. Recording all the revenue receipts appearing on the credit side of tire trial balance on the credit side of income statement after making suitable adjustments for revenues received in advance or revenues realized but not received etc.
3. Recording all the revenue expenditure items that appeared on the debit side of the trial balance on the debit side of the income statement after making adjustments for outstanding, prepaid expenses, depreciation, provisions for bad debts, taxes, etc.
4. Recording non-operating incomes and gains on the credit side of the income statement.
5. Recording non-operating losses on the debit side of the income statement.
6. Finding the difference between totals of credit items and totals of debit items.
7. If the credit items are more than the debit items, it is known as net profit and vice versa.
8. In India, the accounting year for preparing financial statements for companies is 1st April to 31st March (same as that of the financial year of the Government).

→ Form and Contents of Balance Sheet: A balance Sheet is a component of a financial statement that shows balances of liabilities, equities, and assets of a business entity as on a particular date. It is prepared with a view to measure the exact financial position of a business on a certain fixed date. It is usually prepared in horizontal T form. The assets are shown on the right-hand side and capital and liabilities are shown on the left-hand side. These can be arranged either on:
(a) Liquidity basis or on
(b) Permanency basis

(a) Liquidity Basis: According to this method an asset that is most easily convertible into cash such as cash in hand is written first and then will follow those assets which are comparatively less easily convertible so that the least liquid assets such as Goodwill are shown last.

In the same way, those liabilities which are to be paid at the earliest will be written first, in other words, current liabilities are written, first of all, then fixed or long-term liabilities, and lastly the equity of the owner.

(b) Permanency Basis: This method is just opposite to the first method. Assets that are most difficult to be converted into cash such as Goodwill are written first and the assets which are most liquid such as cash in hand are written last.

Those liabilities which are to be paid last will be written first. The owner equity is written, first of all, then long-term liabilities, and lastly the current liabilities.

The Companies Act adopted the permanency approach form in the preparation of the balance sheet. The registered companies are required to follow Part I of Schedule VI of the Companies Act, 1956 recording assets and liabilities in the tire balance sheet in a particular order. According to section 211 (i) of the Companies Act, the balance sheet shall be prepared in prescribed format from time to time, depict the true and fair view of financial position, and follow general instructions for the preparation of the balance sheet under the heading notes at the end of that part.

This format is not applicable to Banking and Insurance Companies. These companies follow the formats prescribed by their respective legislation.

Horizontal Form Of Balance Sheet Schedule Vi, Part I (See Section 211)
A-Horizontal Form Of Balance Sheet Balance Sheet Of ……………………..
(Here enter the name of the company) as on (Here enter the date at which the balance sheet is made out)




Notes:
(a) Fixed assets are shown at original cost less total depreciation to date.
(b) Investments should be divided into two parts:

• Quoted, and
• unquoted. In the case of quoted investments market price must be disclosed.

(c) Contingent liabilities are not included in the total of the liability side. Following are the usual types of contingent liabilities:

1. Claim against the company not acknowledged as debt.
2. Uncalled liability on shares partly paid.
3. Arrears of fixed cumulative dividends.
4. The estimated amount of contracts remaining to be executed on capital account and not provided for, ‘
5. Other money for which the company is contingently liable.
   The Balance Sheet can be prepared in the abridged form also which is shown below:

Abridged Balance Sheet
Form of Balance Sheet (Horizontal Form),
Balance Sheet of ……………..Co. Ltd.
as on……………..

Note: A footnote to the Balance sheet may be added to show separately the contingent liabilities.

Vertical Form of Balance Sheet Form of Balance Sheet (Vertical Form)
Balance Sheet of………………….. CO. LTD.
as on…………………….

Note: Usually detail under each of the above items is given by way of a separate schedule. The number of the schedule incorporating the information is mentioned against the item in the column.

Explanation to Balance Sheet Items
Statutory Contents of Liabilities Side of Company’s Balance Sheet
1. Share Capital: It is the first item on the liabilities side of the balance sheet and shows details about the following:

1. Authorized Capital
2. Issued Capital
3. Subscribed Capital.
4. Called up Capital
5. Paid-up Capital

In terms of the number of shares of each kind along with the nominal value. If forfeited shares are reissued then this amount is added to the paid-up capital.

2. Reserves and Surplus: As per Schedule VI to the Companies Act, 1956, ‘Reserves and Surplus’ includes the following items:

1. Capital Reserves
2. Capital Redemption Reserves
3. Share Premium Account or Securities Premium
4. Other reserves
5. Surplus
6. Proposed Addition to reserves
7. Sinking fund

These reserves may be classified broadly as revenue and capital reserves.

3. Secured Loans: If any company given security for the loan by a mortgage or charge on all or any of its property, the loan will be called ‘Secured Loans’. It includes:

1. Debentures
2. Loans and Advances from Banks
3. Loans and Advances from subsidiaries
4. Other Loans and Advances if any

Information regarding the nature of security given for each secured loan should be given along with the respective loans.

4. Unsecured Loans: Loans and advances for which no security is given are shown under this heading. This include:

1. Fixed deposits
2. Loans and Advances from Subsidiary Companies
3. Loans and Advances from other sources.
4. Short-term loans from banks and others.

5. Current Liabilities and Provisions: Current Liabilities include:

1. Acceptances (or Bills Payable)
2. Sundry Creditors
3. Advance Payments
4. Un-expired Discounts
5. Unclaimed dividends
6. Accrued Interest but not paid
7. Other liability (if any)

Provisions include:

1. Provisions for taxation
2. Proposed Dividend
3. Provisions for Contingencies
4. Provision for provident fund
5. Provision for Pension
6. Provision for Insurance
7. Similar staff benefit schemes etc.
8. Other provisions

Statutory Contents of Assets Side of Company’s Balance Sheet 1. Fixed Assets: These are those assets that are used for a long time in business to earn profit. They are acquired with an intention of using them in the main activity of the concern but not for resale.

It includes:

• Goodwill
• Land and Building
• Leaseholds
• Plant and Machinery
• Furniture
• Railway Lines
• Patents etc.

These assets are shown at cost less depreciation till the date.

2. Investments: It includes

1. Investment in Government Securities
2. Investment in Trust securities
3. In shares, debentures, bonds, etc.
4. Investment in immovable property etc.

3. Current Assets, Loans, and Advances: Current Assets includes:

1. Inventories
2. Sundry Debtors
3. Cash and Bank Balances
4. Loose Tools
5. Accrued Interest

Loans and Advances include:

1. Loans and Advances to Subsidiary Company
2. Bills of Exchange
3. Balance with customs, port trust, etc.

4. Miscellaneous Expenditure: Expenditure, which is not debited to Profit and Loss Account fully and deferred for some years, is shown under this heading.

It includes:

1. Preliminary Expenses
2. Advertisement Expenditure
3. Discount on issue of shares and debenture etc.

5. Profit and Loss Account: If there is any debit balance in the Profit and Loss Account, it will be shown as the assets side of the Balance Sheet.

By going through these CBSE Class 12 Accountancy Notes Chapter 7 Issue and Redemption of Debentures, students can recall all the concepts quickly.

Issue and Redemption of Debentures Notes Class 12 Accountancy Chapter 7

In today’s growing business equity sources of financing only are not sufficient to meet the ever-growing needs of corporate expansion and growth. As a result, the companies turn to raise long-term funds by issuing debentures. Debt financing not only helps in reducing the cost of capital but also helps in designing the appropriate capital structure for the company.

Meaning of Debenture: The term, ‘debenture’ has been derived from the Latin word “debre” which means “to borrow”. Thus, it is a written document acknowledging a debt under the common seal of the company and containing a contract for the repayment of the principal sum at a specified date and for the payment of interest (usually half-yearly) at a fixed rate percent until the principal sum is repaid.

→ “Debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not.”- Section 2(12) of the Companies Act, 1956

→ “A debenture is a document given by a company as evidence of a debt to the holder usually arising out of a loan and most commonly secured by a charge.”- Topham

→ “Debenture is a document under company’s seal which provides for the repayment of a principal sum and interest thereon at regular intervals which is usually secured, by a fixed or floating charge on the company’s property and which acknowledges loan of-a company.” – E. Thomas

→ “Debenture means a document which either creates a debt or acknowledges it and any document which fulfills either of these conditions.” -Chitty J.

Bond: Bond, like debenture, is an acknowledgment of debt issued under the seal of a company and signed by an authorized signatory.

Charge: It means securing the loan by encumbering a specific part of assets towards the loan. It means, if the company fails to meet its obligation, the lender can secure his payment from the assets mortgaged or in case of winding up of the company from the official liquidator.

The Companies Act, 1956) requires that all the charges be registered with the Registrar of Companies. Section 125 (4) of the Companies Act, 1956 requires that a charge when created on the following be got registered:

For the purpose of securing any issue of debentures.

• On uncalled share capital of the company.
• On calls made but not paid.
• On any book debts of the company.
• On any immovable property, wherever situated, or any interest therein.
• On a ship or any share in the ship.
• On goodwill, on a patent or a license under a patent, on a trademark or on the copyright or a license under copyright.

Difference Between Share and Debenture:


Types of Debentures:
1. Security point of view
(a) Secured/Mortgage Debentures: Secured Debentures are those which are secured either on a particular asset or on all the assets of the company in general.

(b) Unsecured/Naked Debentures: Unsecured Debentures do not have a specific charge on the assets of the company.

2. Tenure point of view:
(a) Redeemable Debentures: Redeemable debentures are those that will be repaid by the company at the end of a specified period during the existence of the company.
(b) Irredeemable Debentures: Irredeemable debentures are those that are not repayable during the lifetime of the company.

3. Mode of Redemption point of view:
(a) Convertible Debentures: Convertible debentures are those the holder of which is given an option of
exchanging the amount of their debenture for equity shares after a specified period.

These are of two types:

1. Fully Convertible Debentures (FCD) are those debentures where the whole amount is to be converted into equity shares.
2. Partly Convertible Debentures (PCD) are those debentures where only a part of the amount of debenture is convertible into equity shares.

(b) Non-Convertible Debentures: The debentures which cannot be converted into shares or in any other securities are called non-convertible debentures.

4. Coupon Rate point of view:
(a) Zero Coupon Rate Debenture: These debentures do not carry a specific rate of interest.
(b) Specific Coupon Rate Debenture: These debentures are issued with a specified rate of interest, which may either be fixed and floating.

5. Registration point of view:
(a) Registered Debentures: Registered debentures are those which are payable to the persons whose name appears in the Register of Debenture holders. These can be transferred only by executing a transfer deed.
(b) Bearer Debentures: Bearer debentures are those which are payable to the bearer thereof. These can be transferred merely by delivery. Interest is paid to the persons who produced the interest coupon attached to such debenture.

Issue of Debentures: Debentures can be issued at par, at a premium, or at a discount. They can also be issued for consideration other than cash or as Collateral Security. Accounting treatment regarding the issue of debenture is done in the same manner as in the case of the issue of share. The only difference is that ‘Debenture’ in place of ‘Share’ and ‘Debenture A/e’ in place of ‘Share Capital A/c’ is substituted.

Issue of Debentures at Par: Debentures are said to have been issued at par when the issue price is equal to their face value.
1. If the debenture amount is received in one installment (lump sum).


Similar entries like e, f may be made for the second call and final call.

Issue of Debentures at a Discount: When the debentures are issued at less than the face value, it is said to be issued at discount. Discount on issue of debenture is a capital loss and is shown on the assets side of the Balance Sheet under the head “Miscellaneous Expenditure” till it is written off.

Accounting Treatment:
On the issue of debentures at a discount
Debenture Allotment A/c Dr.
Discount of Issue of Debenture A/c Dr.
To Debenture A/c

Issue of Debentures at Premium: A debenture is said to have been issued at a premium when the price charged is more than the face value of debenture. Premium on Issue of Debenture represents a capital receipt and should be transferred to Securities Premium A/c. It can be used for writing off capital losses and fictitious assets. This account is shown on the liabilities side of the Balance Sheet under the head of ‘Reserves & Surplus’.

Accounting Treatment:
On Issue of Debenture at Premium
Debenture Allotment A/c Dr.
To Debenture A/c To Securities Premium A/c

Over Subscription: When the number of debentures applied for is more than the number of debentures offered to the public, the issue is said to be oversubscribed. The excess money received on oversubscription may be retained for adjustment towards allotment and respective calls when the amount is payable in Instalments or excess money will be refunded.

Issue of Debentures for Consideration Other than Cash: When the company purchases some assets (including services) and instead of making the payment to the supplier in the form of cash, issues its fully paid debentures, such issue of debentures is called the Issue of Debentures for Consideration Other than Cash. Such debentures can be issued at par, a premium, or at a discount.

If the purchase consideration is greater than the value of the net assets acquired (i.e., the difference between the agreed value of the assets taken over and the agreed value of liabilities taken over), the difference is treated as a capital loss which should be debited to Goodwill A/c.

Or
If the amount of the purchase consideration is lower than the value of the net assets acquired, the difference is treated as a capital profit which should be credited to Capital Reserve A/c.

(b) On the issue of Debentures
1. At par
Vendor’s A/c Dr.
To Debentures A/c

2. At Premium
Vendor’s A/c Dr.
To Debentures A/c To Securities Premium A/c

3. At a Discount Vendor’s A/c
Discount on Issue of Debentures A/c

To Debentures A/c
No. of Debentures issued = \(\)\(\)

Issue Price of a Debenture:
Issue of Debentures as Collateral Security: When a company takes a loan from a bank or any other party and gives some additional security in the shape of debentures, the debentures are said to be issued as collateral security. In such a case, the lender has the absolute right over the debentures unless and until the loan is repaid. On repayment of the loan, the lender is legally bond to release the debenture forthwith.

In case the loan is not repaid by the company on the due date, the lender has the right to retain these debentures and realize them. The holder of such debentures is entitled to interest only on the amount of loan, but not on the debentures.

Debentures issued as collateral security can be dealt with in two ways in the books.
1. No accounting entry is required to be shown in the books at the time of issue of such debentures, but a footnote to the fact that the loan has been secured by the issue of debentures is appended.

2. If it is desired that such an issue of debentures is to be recorded in the books, the following entries are recorded:
(a) On the issue of Debentures as Collateral Security
Debentures Suspense A/c Dr.
To Debentures A/c

(b) On repayment of the loan
Debentures A/c Dr.

To Debentures Suspense A/c The net effect of the above two entries is nil.
Issue of Debentures From Condition of Redemption Point of View: Redemption of debentures means discharge of liability on account of debentures by repayment made to the debenture holders. Depending upon the terms and conditions of issue and redemption of debentures, there may be the following six cases:

Accounting Treatment:
Case 1: Issue at Par and Redemption at Par

Case 2: Issue at Discount and Redemption at Par

Case 3: Issue at Premium and Redemption at Par.

Case 4: Issue at Par and Redemption at Premium

Case 5: Issue at Discount and Redemption at Premium

Case 6: Issued at Premium and Redemption at Premium

Interest on Debentures: Interest on debentures is a charge against the profits of the company and is payable irrespective of the fact whether there are profits or not. It is calculated on the face value of the debenture. According to Income-tax Act, 1961, the company must deduct income tax at the prescribed rate from the gross amount of interest payable on debenture before the annual amount is paid to debenture holders. Accounting Treatment:
1. For Interest due

2. For Payment of Interest
Debentureholder A/c Dr.
To Bank A/c

3. On Closing of Debenture Interest A/c
Profit and Loss A/c Dr.
To Debenture Interest A/c

4. For Payment of Income Tax to Government
Income Tax Payable A/c Dr.
To Bank A/c

Writing off Discount/Loss on Issue of Debentures: The discount/ loss on the issue of debentures is a capital loss and therefore must be written off during the lifetime of debentures. The discount/loss on the issue of debentures is shown under the head “Miscellaneous Expenditure” on the assets side of the Balance Sheet. Section 78 of the Companies Act, 1956 permits the utilization of Securities Premium for writing off the discount/loss on the issue of the debenture.

Entry is following:
Security Premium A/c Dr.
To Discount/Loss on
Issue of Debenture A/c

In case there are no capital profits or if the capital profits are not adequate, the amount of such discount/loss can be written off by utilizing the revenue profits.

There are two methods, which can be used to write off the Discount/Loss on the issue of debentures:
(a) Fixed Installment Method: When the debentures are redeemed at the end of a specified period, the total amount of discount should be written off in equal installments of a fixed amount over the period.

(b) Fluctuating Installment Method: When debentures are repaid by annual drawings or installments, the discount is written off in the ratio of debentures outstanding before redemption. The amount of discount, in this method, goes on reducing every year as a greater amount is used in the initial years than the later years. This method is also known as the Reducing Instalment Method.

Section-II
Redemption of Debentures: Redemption of debentures means repayment of the loan due on debentures to debenture holders. According to Section 117 C (3) of the Companies Act 1956, the debentures should be redeemed in accordance with the terms and conditions of their issue/ offer documents. The date, the terms, and the conditions are generally stated in the debenture certificate itself or in the trust deed.

On the due date or happening of the circumstances so specified, the company becomes liable to pay the principal amount to the debenture holder. A company may purchase its own debenture which then stands canceled.

In other words, the redemption of debentures means repayment of the number of debentures by the company. There are three aspects that a company should bear in mind regarding redemption namely the time of redemption, the amount to pay, and the sources from which redemption will have to be carried out.

Methods of the Redemption of Debentures: The various methods of redemption of debentures are as under:

1. Payment in Lump-Sum
2. Payment in Instalments
3. Purchase in Open Market
4. Conversion of existing Debenture into Shares or New Debentures.

1. Payment in Lump Sum: It means debentures can be redeemed by paying the debenture holders in one lump sum at the expiry of the agreed time or earlier at the option of the company. In this case, the time of repayment is known in advance and thus the company can plan its financial resources accordingly.

2. Payment in Instalments: It means the redemption is made in annual installments. The amount of installment is worked out by dividing the total amount of debentures by the number of years it is to last. The number of debentures to be redeemed each year are selected by lottery. Thus, it is also known as drawing by lottery or draw of lots.

3. Purchase in Open Market: A company, if authorized by its Articles of Association, can purchase its own debenture in the open market. Debentures so purchased may be canceled and it means the debentures have been paid.

4. Conversion of Existing Debentures into Shares or New Debentures: It means the debenture holder can exchange their debenture either for shares or new debentures of the company and the debentures which carry such right are called convertible debentures.

Sources of funds for Redemption of Debentures: The redemption of debentures can be done either out of capital or out of profits.

(a) Redemption of Debenture out of Capital: In this case, profits of the company are not utilized for the redemption of debentures, so the assets of the company are reduced by the amount paid. Normally the profits are transferred to Debenture Redemption Reserve for redemption. In case no profits have been transferred to Debenture Redemption Reserve and debentures are redeemed on the due date, it is regarded as redemption out of the capital. It is, however, presumed that the company has adequate funds to redeem the debentures.

Accounting Treatment:
(a) If debentures are to be redeemed at par
1. On debentures becoming due
Debentures A/c Dr.
To Debenture- holder A/c

2. On Redemption Debentureholder A/c Dr.
To Bank A/c

(b) If debentures are to be redeemed at a premium
1. On debentures becoming due
Debentures A/c Dr.
Premium on Redemption of
Debenture A/c Dr.
To Debentureholder A/c

2. On Redemption Debentureholder A/c Dr.
To Bank A/c

(b) Redemption of Debentures out of Profits: Redemption of debentures out of profits means the amount equal to that utilized for repayment to debenture holders is transferred from Profit and Loss Appropriation A/c to a newly opened A/c called ‘Debenture Redemption Reserve A/c’ (DRR). The portion of the profits set aside may either be retained in the business or maybe invested.

The Companies Act (Amendment), 2000 has introduced Section 117 C which provides as under:
(a) Where company-issued debentures after the commencement of this act, it shall create a DRR for the redemption of such debentures, to which adequate amount shall be credited, from out of its profits every year until such debentures are redeemed.

(b) The amount credited to the DRR shall not be utilized by the company except for the purpose of the redemption of debentures.

SEBI’s Guidelines: Securities and Exchange Board of India (SEBI) has provided some guidelines for the redemption of debentures. The focal points of these guidelines are:

1. Every company shall create a venture Redemption Reserve in case of issue of debenture redeemable after a period of more than 18 months from the date of issue.
2. The creation of Debenture Redemption Reserve is obligatory only for non-convertible debentures and a non-convertible portion of partly convertible debentures.
3. A company shall create a Debenture Redemption Reserve equivalent to at least 50% of the amount of debenture issue before starting the redemption of the debenture.
4. Withdrawal from Debenture Redemption Reserve is permissible only after 10% of the debenture liability has already been reduced by the company.

Exemption: SEBI guidelines would not apply under the following situations:
(a) Infrastructure company (a company wholly Engaged in the business of developing, maintaining, and operating infrastructure facilities.)
(b) A company issuing debentures with a maturity period of not more than 18 months.

Clarifications regarding Debenture Redemption Reserve:
The Department of Company Affairs, Government of India, vide their circular No. 9/2002, dates 18.04.2002 has issued the following clarifications regarding the creation of Debenture Redemption Reserve (DRR):
(a) No DRR is required for debentures issued by All India Financial Institutions, by RBI and, Banking Companies for both public as well as privately placed debentures.
(b) No DRR is required in case of privately placed debentures.
(c) Section 117c will apply to debentures issued and pending to be redeemed and, therefore, DRR will also be created for debentures issued prior to 13.12.2000 and pending redemption.
(d) Section 117c will apply to the non-convertible portion of debentures issued whether they are fully or partly paid.

Journal Entries:

1. Debenture A/c To Debentureholders A/c
2. Debenture holder A/c To Bank A/c
3. Profit and Loss Appropriation A/c To Debenture Redemption Reserve A/c

DRR A/c appears on the liability side of the Balance Sheet, under the head “Reserves and Surplus”. The balance in DRR A/c increases with each redemption. When all the debentures are redeemed, the DRR A/c is closed by transferring its balance to General Reserve A/c.

Redemption by Purchase in the Open Market: A company, if authorized by its Articles of Association, can redeem its own debenture by purchasing them in the open market.

If a company purchases its own debenture for the purpose of immediate cancellation, the purchase and cancellation of such debenture are called, redemption by purchase in the open market.

Advantages:

1. A company can redeem the debentures at its convenience whenever it has surplus funds.
2. A company can save money by purchasing its own debenture when they are available in the market at discount.

Accounting Treatment:
(In case of Profits)
(a) On purchase of own debentures for immediate cancellation.
Debenture A/c Dr.
To Bank A/c
To Profit on Cancellation of Debenture A/c

(b) On transfer of Profit on Redemption
Profit on Cancellation of Debenture A/c Dr.
To Capital Reserve A/c

(In case of Loss)
(a) On purchase of own debenture for immediate cancellation.
Debenture A/c Dr.
Loss on Cancellation
of Debenture A/c Dr.
To Bank A/c

(b) On transfer of Loss on Redemption
Profit and Loss A/c Dr.
To Loss on Cancellation of Debenture A/c

Redemption by Conversion: Sometimes, at the time of issue of debentures, a company gives the convertible debenture holders the privilege that they can get their debentures converted into shares or new debentures after the expiry of a specified period. Whenever debenture is redeemed by conversion, the debenture holders have to.; apply for the same. The new shares or debentures may be issued at par, discount, or a premium.

No DRR is required in case of convertible debentures because no funds are required for redemption.
If debentures to be converted were issued at discount, the issue price of the share must be equal to the amount actually received from debentures. If this rule is not followed, it would be a violation of section 79 of the Companies Act, 1956.

Accounting Treatment:
(i) For the amount due to debenture holders
(a) If Redemption at par
Debentures A/c Dr.
To Debentureholder A/c
Or
If Redemption at a premium
Debentures A/c Dr.
Securities Premium A/c Dr.
To Debentureholder A/c

(b) For discharging obligation by issuing shares or debentures
Debentureholder A/c Dr.
To Equity Share Capital
Or
To Debentures A/c (New)

If the new shares/debentures are issued at a premium, the Securities Premium A/c is credited or new shares/debentures are issued at a discount, the Discount on Issue of Shares/Debentures A/c is debited in the above-mentioned entry (b).

Sinking Fund Method: The amount required for the redemption of debentures is generally large and the date of redemption is known to the company. Thus, it is prudent for a company to make arrangements to ensure the availability of adequate funds for the redemption of debenture at the end of the stipulated period for which debentures are issued. Hence, it is better for the company to set aside every year a part of divisible profits and to invest the same outside the business in marketable securities.

This is done by creating a Sinking Fund. The company adopts the method of Debenture Redemption Sinking Fund. An appropriate amount calculated by referring to Sinking Fund Factors, depending upon the interest rate on investments and the number of years for which investments are made, is set aside.

Debenture Redemption Sinking Fund A/c will be created every year to provide means for the redemption of debentures. The company sets aside every year a certain sum of money out of its profits and invests the same along with the interest that may be earned on an investment. The investment is sold when debentures fall due for redemption. The amount available from the sale of investment is utilized for the redemption of debentures.

Accounting Treatment:
I. At the end of First Year
(a) For setting aside the amount out of Profit

(b) For Investing the amount set aside

II. At the end of the second year and subsequent years other than the last year.
(a) For Receiving the Interest on Investments made

(b) For the transfer of Interest on Deb. Red. Fund Investment to DRF A/c
The interest of Deb. Red
Fund Investment A/c Dr.
To Debenture Redemption Fund A/c

(c) For Setting aside the number of profits
Profit and Loss Dr. [With the amount
Appropriation A/c of Profit set aside]
To Debenture Redemption FundA/c

(d) For Investing the amount set aside along with interest • received.
Deb. Red. Fund Investment A/c Dr.
ToBank A/c

III. At the end of last year
(a) For Receiving the Interest on Investment made
Bank A/c Dr.
To Interest on Deb. Red. Fund Investment A/c

(b) For the transfer of Interest on Deb. Red. Fund Investment to DRF A/c
Interest in Deb. Red.
Fund Investment A/c Dr.
To Deb. Red. Fund A/c

(c) For setting aside the number of profits
Profit & Loss
Appropriation A/c Dr.
To Deb. Red. Fund A/c

(d) For Realising the Investment made
Bank A/c Dr. [With the sale
To Deb. Red. Fund proceeds]
Investment A / c

(e) For the transfer of profit/loss on realization of Deb. Red. Fund Investments

(f) For the amount due to debenture holders
Debenture A/c Dr.
To Debentureholders A/c

(g) For redemption
Debenture holders A/c
To Bank A/c

(h) For the transfer of the balance, if any, Discount on Issue of Debentures A/c/Loss on Issue of Debenture A/c
Deb. Red. Fund. A/c Dr.
To Discount on Issue of Debentures A/c,
To Loss on Issue of Debentures A/c

1. For the transfer of an amount from the Deb. Red. Fund A/c to General Reserve:
(a) If some of the Debentures are redeemed

(b) If all the Debentures are redeemed