Yearly Archives: 2022

Chapter 4: Planning

Meaning:
• Deciding in advance what to do& how to do it. It is one of the basic managerial functions.
• It involves 2 aspects:
Setting of aims and objectives of the organization + Selecting and developing an appropriate course of action to achieve these objectives.
• Koontz and O‘Donnell – ―Planning is deciding in advance what to do, how to do, when to do, and who to do it. Planning bridges the gap from where we are to where we want to go. It makes it possible for things to occur which would not otherwise happen.
• Involves setting of objectives & developing an appropriate course of action to achieve these objectives
Importance of Planning
1. Planning provides directions: By stating in advance how the work is to be done planning provides direction for action. If there was no planning, employees would be working in different directions and the organization would not be able to achieve its goals efficiently.
2. Planning reduces the risk of uncertainity: Planning is an activity which enables a manager to look ahead, anticipate change, consider the impact of change and develop appropriate responses.
3. Planning reduces wasteful activities: Planning serves as the basis of coordinating the activities and efforts of different departments and individuals whereby useless and redundant activities are mentioned.
4. Planning promotes innovative ideas: Planning is the first function of management. Managers get the opportunity to develop new ideas and new ideas can take the shape of concrete plans.
5. Planning facilities decision making: Under planning targets are laid down. The manager has to evaluate each alternative and select the most viable option.
6. Planning establishes standards for controlling: Planning provides the standards against which the actual performance can be measured and evaluated. Control is blind without planning. Thus planning provides the basis for control.
Limitations of Planning
(A) Internal Limitations
1. Planning leads to rigidity: Planning discourages individual’s initiative &creativity. The managers do not make changes according to changing business environment. They stop taking or giving suggestions and new ideas. Thus detailed planning may create a rigid framework in the organization.
2. Planning may not work in dynamic environment: Planning is based on anticipation of future happenings and since future is uncertain and dynamic therefore, the future anticipations are not always true.
3. Planning involves huge costs: When plans are drawn up, huge cost is involved in their formulation.
4. Planning is time consuming: Sometimes plans to be drawn up take so much of time that there is not much time left for their implementation.
5. Planning does not guarantee success: The success of an enterprise is possible only when plans are properly drawn and implement. Sometimes managers depend on previously tried successful plans, but it is not always true that a plan which has worked before will work effectively again.
6. Planning reduces creativity: In planning, work is to be done as per pre-determined plans. It is decided in advance what is to be done, how it is to be done and who is going to do it. Moreover, planning is done by top management which leads to reduction of creativity of other levels of management.
(B) External Limitations
They are those limitations of planning which arises due to external factors over which an organization has no control.
1. Changes in Government policies way leads to failure of planning.
2. Natural calamities such as flood, earthquake etc. also adversely affect the success of planning.
3. Changes in the strategies of competitors also leads to failure of planning many times.
4. Regular technological changes may affect planning.
5. Changes in the Economic and Social Conditions also reduces the effectiveness of planning.
Planning Process
1. Setting Objectives:
– Objectives specify what the organization wants to achieve.
– Objectives can be set for the entire org. & stated to each dept. within the org. very clearly, to determine how all depts. would contribute towards overall objectives.
-Then these have to percolate down to all employees at all levels so that they understand how their actions contribute to achieving objectives.
– E.g. Objective could be to achieve sales, expansion of business etc.
2. Developing Premises:
– Plans are made on the basis of some assumptions.
– These assumptions, which provide the basis for planning, are called premises.
– All managers involved in planning should be familiar w/ them, cuz plans are expected to operate & reach their destination subject to these. They can be:
• Internal premises: Cost of products, capital, machinery, profitability etc.
• External premises: Changes in technology, population growth, competition, govt. policies etc
3. Identifying Alternative Courses Of Action:
– After setting the objectives, managers make a list of alternatives through which the org. can achieve its objectives as there can be many ways to achieve the objectives & managers must know all of them.
– E.g. Sales could be increased through any of the following ways:
• By enhancing advertising expenditure
• Appointing salesmen for door-to-door sales
• By offering discounts
• By adding more product lines.
4. Evaluating Alternative Courses Of Action
– Positive & negative aspects of each &every proposal need to be evaluated to determine their feasibility and consequences in the light of each objective to be achieved.
– E.g. In financial plans, risk-return trade-off are imp. Riskier the investment, higher the returns it is likely to give. To evaluate such proposals, detailed calc. of earnings, taxes, earnings per share etc. should be done.
5. Selecting The Best Alternative
– Real point of decision-making→ Best plan has to be adopted and implemented.
– The ideal plan = most feasible, profitable and with least negative consequences.
– Most plans may not be subjected to mathematical analysis. In such cases, subjectivity & manager‘s experience, judgment and intuition are important to select the most viable alternative.
– Sometimes a combination of plans may be selected instead of one best course.
6. Implementing The Plan
– Concerned with putting the plan into action.
– For implementing the plans, managers start organizing & assembling resources for it.
– E.g. If there is a plan to ↑ production, then more labour, more machinery will be reqd. This step would also involve organizing for more labour and purchase of machinery.
7. Follow Up Action
– This involves monitoring the plans and ensuring that activities are performed according to the schedule.
– Whenever there are deviations from plans, immediate action has to be taken to bring implementation according to the plan or make changes in the plan.
TYPES OF PLAN
Plan
A Plan is a specific action proposed to help the organization achieve its objectives. It is a document that outlines how goals are going to be met. The importance of developing plans is evident from the fact that there may be more than one means of reaching a particular goal. So with the help of logical plans, objectives of an organization could be achieved easily.
SINGLE USE PLAN
A Single use plan in a business refers to plan developed for a one-time project or event that has one specific objective. It applies to activities that do not reoccur or repeat. It is specifically designed to achieve a particular goal. Such plan is developed to meet the needs of a unique situation. The length of a single use plan differs greatly depending on the project in question, as a single event plan may only last one day while a single project may last one week or months. For example, an outline for an advertising campaign. After the campaign runs its course, the short term plan will lose its relevance except as a guide for creating future plans.
Types of Single Use Plan
1. Programme: A programme is a single use plan containing detailed statements about project outlining the objectives, policies, procedures, rules, tasks, physical and human resources required to implement any course of action.
2. Budget: A budget is a statement of expected result expressed in numerical terms for a definite period of time in the future.
STANDING PLANS
Standing plans are used over and over again because they focus on organizational situations that occur repeatedly. They are usually made once and retain their value over a period of years while undergoing revisions and updates. That is why they are also called repeated use plans. For example, Businessman plans to establish a new business Entrepreneur drafts business plan before opening the doors to their business, and they can use their plan to guide their efforts for years into the future.
Types of Standing Plans
1. Objectives: Objectives are defined as ends for the achievement of which an organization goes on working. They may be designed as the desired future position that the management would like to reach. The first and foremost step of the planning process is setting organizational objectives. Examples increasing sales by 10%, Getting 20% return on Investment etc. Objectives should be clear and achievable.
2. Strategy: Strategies refer to those plans which an organization prepares to face various situations, threats and opportunities. When the managers of an organization prepare a new strategy for the business it is called internal strategy and when some strategies are prepared to respond to the strategies of the competitors, then such strategies are called external strategies. Examples, selection of the medium of advertisement, selection of the channel of distribution etc.
3. Policy: Policies refers to the general guidelines which brings uniformity in decision-making for achievement of organizational objectives. They provide directions to the managers of an organization. They are flexible as they may be changed as per requirement. Example, selling goods on cash basis only, reserving some post for women in the organization.
4. Procedure: Procedures are those plans which determine the sequential steps to carry out some work/activity. They indicate which work is to be done in which sequence/way. They help in the performance of work. Procedures are guides to action. Example: Process adopted in the Selection of Employees.
5. Rule: Rules are specific statement that tell what is to be done and whatnot to be done in a specified situation. They help in indicating which points are to be kept in mind while performing task/work. Rules are rigid which ensure discipline in the organization. Example : ‘No smoking in the office premises’. Violation of rules may invite penalty.
6. Method: Methods are standardized ways or manners in which a particular task has to be performed. There may be many ways/method of completing a task but that method/way must be selected by which work can be done early at the minimum possible cost. Methods are flexible. Example, various methods of training are adopted by an organization to train its employees like apprenticeship training, vestibule training etc.

Basis of Difference	Single use plans	Standing Plans
1. Meaning	A single use plans in a business refers to plans developed for a one time project or event that has same objective.	A standing plans in a business refers to plans developed for using over and over again because they focus on organizational situations that occur repeatedly.
2. Objective	Single use plans is developed to carry out a course of action that is not likely to be repeated in future time.	Standing plans however is developed for activities that occur regularly over a period of time.
3. Scope	Single use plans generally encompass a narrow scope targeting a specific project or event.	Standing plans generally encompass a wider scope involving more than one department or business function.
4. Stability	Single use plans are discarded when the situation, project or event is occur.	Standing plans are relatively stable and used over and over again with necessary modifications or updations.
5. Example	Budget for Annual General Meeting of Shareholders.	Recruitment and selection procedure for a particular post in a company.

CHAPTER 2 Principles of Management class 12 Notes Business Studies

Principle
A principle is a fundamental statement of truth that provides guidance to thought and action.
Principles of Management
Principles of management are broad and general guidelines for managerial decision making and behavior (i.e. they guide the practice of management).
Nature of Principles of Management
The nature of principles of management can be described in the following points:
1. Universal applicability i.e. they can be applied in all types of organizations, business as well as non-business, small as well as large enterprises.
2. General Guidelines: They are general guidelines to action and decision making however they do not provide readymade solutions as the business environment is ever changing or dynamic.
3. Formed by practice and experimentation: They are developed after thorough research work on the basis of experiences of managers.
4. Flexible: Which can be adapted and modified by the practicing managers as per the demands of the situations as they are man-made principles.
5. Mainly Behavioural: Since the principles aim at influencing complex human behaviour they are behavioural in nature.
6. Cause and Effect relationship: They intend to establish relationship between cause & effect so that they can be used in similar situations.
7. Contingent: Their applicability depends upon the prevailing situation at a particular point of time. According to Terry, “Management principles are ‘capsules’ of selected management wisdom to be used carefully and discretely”.
Significance of the Principles of Management
The significance of principles of management can be derived from their utility which can be understood from the following points:
1. Providing managers with useful insights into reality: Management principles guide managers to take right decision at right time by improving their knowledge, ability and understanding of various managerial situations and circumstances.
2. Optimum utilization of resources and effective administration: Management principles facilitate optimum use of resources by coordinating
the physical, financial and human resources. They also help in better administration by discouraging personal prejudices and adopting an objective approach.
3. Scientific decisions: Decisions based on management principles tend to be more realistic, balanced and free from personal bias.
4. Meeting the changing environmental requirements: Management principles provide an effective and dynamic leadership and help the organization to implement the changes.
5. Fulfilling social responsibility: Principles of management not only help in achieving organizational goals but also guide managers in performing social responsibilities. Example : “Equity” and “Fair” remuneration.
6. Management training, education and research: Management principles are helpful in identifying the areas in which existing and future managers should be trained. They also provide the basis for future research.
Fayol’s Principles of Management
About Henry Fayol: Henry Fayol (1841-1925) got degree in Mining Engineering and joined French Mining Company in 1860 as an Engineer. He rose to the position of Managing Director in 1988. When the company was on the verge of bankruptcy. He accepted the challenge and by using rich and broad administrative experience, he turned the fortune of the company. For his contributions, he is well known as the “Father of General Management”.
Principles of Management developed by Fayol
1. Division of work: Work is divided in small tasks/job and each work is done by a trained specialist which leads to greater efficiency, specialization, increased productivity and reduction of unnecessary wastage and movements.
2. Authority and Responsibility: Authority means power to take decisions and responsibility means obligation to complete the job assigned on time. Authority and responsibility should go hand in hand. Mere responsibility without authority, makes an executive less interested in discharging his duties. Similarly giving authority without assigning responsibility makes him arrogant and there is fear of misuse of power.
3. Discipline: t is the obedience to organizational rules by the subordinates. Discipline requires good supervisors at all levels, clear and fair agreements and judicious application of penalties.
4. Unity of Command: t implies that every worker should receive orders and instructions from one superior only, otherwise it will create confusion, conflict, disturbance and overlapping of activities.

5. Unity of Direction: Each group of activities having the same objective must have one head and one plan. This ensures unity of action and coordination.

Difference between Unity of Command and Unity of Direction

Basis	Unity of Command	Unity of Direction
1.Meaning	It means that a subordinate should receive orders and instructions from one boss only.	It advocates ‘one head, and one plan‘ for a group of activities having the same objectives. The activities should be directed towards the common goals.
2.Scope	This principle is related to the functioning of personnel	This principle is related to the functioning of a department or the organization as a whole
3.Purpose	The main purpose of unity of command is to avoid confusion and fix up the responsibility of the employee.	The purpose of unity of direction is to direct the efforts of employees of one department in achieving the main objective of that department.
4.Results in	Systematic working and improved efficiency by removing confusion and chaotic conditions	Co-ordination within a particular department and overall; by preventing overlapping of various activities.

7. Remuneration of Employees: The overall pay and compensation should be, fair to both employees and the organization. The wages should encourage the workers to work more and better.6. Subordination of Individual Interest to General Interest: The interest of an organization should take priority over the interest of any one individual employee.
8. Centralization and Decentralization: Centralization means concentration of decisions making authority in few hands at top level. Decentralization means evenly distribution of power at every level of management. Both should be balanced as no organization can be completely centralized or completely decentralized.
9. Scalar Chain: The formal lines of authority between superiors and subordinates from the highest to the lowest ranks is known as scalar chain. This chain should not be violated but in emergency employees at same level can contact through Gang Plank by informing their immediate superiors.

10. Order: A place for everything and everyone and everything and everyone should be in its designated place. People & material must be in suitable places at appropriate time for maximum efficiency.
11. Equity: The working environment of any organization should be free from all forms of discrimination (religion, language, caste, sex, belief or Basis Unity of Command Unity of Direction nationality) and principles of justice and fair play should be followed. No worker should be unduly favoured or punished.
12. Stability of Personnel: After being selected and appointed by rigorous procedure, the selected person should be kept at the post for a minimum period decided to show results.
13. Initiative: Workers should be encouraged to develop and carry out their plan for improvements. Initiative means taking the first step with self-motivation. It is thinking out and executing the plan.
14. Espirit De Corps: Management should promote team spirit, unity and harmony among employees. Management should promote a team work.
Taylor’s Scientific Management
Fredrick Winslow Taylor (1856-1915) was a person who within a very short duration (1878-1884) rose from ranks of an ordinary apprentice to chief engineer in Midvale Steel Company, U.S.A. Taylor conducted a number of experiments and came to conclusion that workers were producing much less than the targeted standard task. Also, both the parties – Management and workers are hostile towards each other. He gave a number of suggestions to solve this problem and correctly propounded the theory of scientific management to emphasize the use of scientific approach in managing an enterprise instead of hit and trial method. For his contributions, he is well known as the “Father of the Scientific Management”. Scientific Management attempts to eliminate wastes to ensure maximum production at minimum cost.
Principles of Scientific Management
(1) Science, not rule of Thumb: There should be scientific study and analysis of each element of a job in order to replace the old rule of thumb approach or hit and miss method. We should be constantly experimenting to develop new techniques which make the work much simpler, easier and quicker.
(2) Harmony, Not discord: It implies that there should be mental revolution on part of managers and workers in order to respect each other’s role and eliminate any class conflict to realize organizational objectives.
(3) Cooperation not individualism: It is an extension of the Principle of Harmony not discord whereby constructive suggestions of workers should be adopted and they should not go on strike as both management and workers share responsibility and perform together.
(4) Development of each and every person to his or her greatest Efficiency and Prosperity: It implies development of competencies of all persons of an organization after their scientific selection and assigning work suited to their temperament and abilities. This will increase the productivity by utilizing the skills of the workers to the fullest possible extent.

1. Functional Foreman-ship: Functional foreman-ship is a technique in which planning and execution are separated. There are eight types of specialized, professionals, four each under planning and execution who keep a watch on all workers to extract optimum performance.
Planning Incharges:
1. Route Clerk to specify the exact sequence and route of production.
2. Instruction card clerk is responsible for drafting instructions for the workers.
3. Time and cost clerk to prepare time and cost sheet for the job.
4. Shop Disciplinarian to ensure discipline and enforcement of rules and regulations among the workers.
Production Incharges:
1. Gang boss is responsible for keeping tools and machines ready for operation.
2. Speed boss is responsible for timely and accurate completion of job.
3. Repair boss to ensure proper working conditions of tools and machines.
4. Inspector to check quality of work.
2. Standardization and Simplification of work: Standardization refers to developing standards for every business activity whereas Simplification refers to eliminating superfluous varieties of product or service. It results in savings of cost of labour, machines and tools. It leads to fuller utilization of equipment and increase in turnover.
3. Method Study: The objective of method study is to find out one best way of doing the job to maximize efficiency in the use of materials, machinery, manpower and capital.
(1) Which technique of scientific management is being violated here?
(Hint: Functional Foreman ship.)
(2) Write one consequence of this violation.
4. Motion Study: It is the science of eliminating wastefulness resulting from using unnecessary, ill-directed and inefficient motions by workers and machines to identify best method of work.
5 Time study: It determines the standard time taken to perform a well-defined job. The objective of time study is to determine the number of workers to be employed, frame suitable incentive schemes & determine labour costs.
6. Fatigue study: Fatigue study seeks to determine time and frequency of rest intervals in completing a task. The rest interval will enable workers to regain their lost stamina thereby avoiding accidents, rejections and industrial sickness.
7. Differential piece wage system: This system links wages and productivity. The standard output per day is established and two piece rates are used: higher for those who achieve upto and more than standard output i.e. efficient workers and lower for inefficient and slow workers. Thus, efficient workers will be rewarded & inefficient will be motivated to improve their performance.
For example: Standard task is 10 units. Rates are: Rs 50 per unit for producing 10 units or more and Rs 40 per unit for producing less than 10 units
Worker A produces 11 Units; he gets Rs 550 (11 units x 50 per unit)
Worker B produces 09 units; he gets Rs 360 (9 units x 40 per unit)
This difference of Rs 190 will motivate B to perform better.

Basis	Fayol	Taylor
1. Nature of Research	He developed the theory of Functional management or Management process.	He developed the concept of Scientific management.
2. Concern	His principles are concerned with management efficiency.	His principle and techniques are concerned with workers efficiency.
3. Level	He designed principles for top level of management.	He designed principles for lower level of management.
4. Focus	Improving overall administration by observing certain principles was his main focus.	For him increasing productivity through work simplification was main focus.
5. Personality	He developed the personality of a researcher and practioner and was called as ‘father of general management.	He developed the personality of scientist and was called as ‘father of scientific management
6. Major contribution	Hid main contribution was to produce a systematic theory of management with the help of fourteen principles of general management.	He provided a basis on accomplishment on production line with the help of scientific techniques and management.
7. Human element	He gave due emphasis to human elements by suggesting principles like equality, initiative, fair renumeration etc.	He ignored the human element and emphasized more on increasing productivity.
8. Rigidity and flexibility	His principles were flexible.	He was rigid in his approach and he felt that there should be no deviation from fixed standards.
9. Applicability	His principles are applicable to business as well as non-business organizations i.e. are applicable universally.	His principles are applicable to production and manufacturing i.e. are applicable to specific situations.
10. Unity of command	He strictly follow this principles i.e. one boss for one employee.	He did not follow this principle instead he insisted on minimum eight bosses.

8. Mental Revolution: It involves a complete change in mental outlook and attitude of workers and management towards one another from competition to cooperation. The management should create pleasant working conditions & workers should work with devotion and loyalty. Instead of fighting over distribution of profits, they must focus attention on increasing it

Class 12 Business Studies Revision Notes chapter 3

Meaning of Business Environment:

Business environment refers to forces and institutions outside the firm with which its members must deal to achieve the organisational purposes. Here
• Forces = economical, social, political, technological etc
• Institutions = suppliers, customers, competitors etc
It includes all those constraints and forces external to a business within which it operates. therefore,
• The firm must be aware of these external forces and institutions and
• The firm must be nagged keeping in mind these forces and institutions so that the organisational objectives are achieved. .

Features of Business Environment

1. Totality of external forces: Business environment is the sum total of all the forces/factors external to a business firm.
2. Specific and general forces: Business environment includes both specific and general forces. Specific forces include investors, competitors, customers etc. who influence business firm directly while general forces include social, political, economic, legal and technological conditions which affect a business firm indirectly.
3. Inter-relatedness: All the forces/factors of a business environment are closely interrelated. For example, increased awareness of health care has raised the demand for organic food and roasted snacks.
4. Dynamic: Business environment is dynamic in nature which keeps on changing with the change in technology, consumer’s fashion and tastes etc.
5. Uncertainty: Business environment is uncertain as it is difficult to predict the future environmental changes and their impact with full accuracy.
6. Complexity: Business environment is complex which is easy to understand in parts separately but it is difficult to understand in totality.
7. Relativity: Business environment is a relative concept whose impact differs from country to country, region to region and firm to firm. For example, a shift of preference from soft drinks to juices will be welcomed as an opportunity by juice making companies while a threat to soft drink manufacturers.

IMPORTANCE OF BUSINESS ENVIRONMENT

1. Identification of opportunities to get first mover advantage: Understanding of business environment helps an organization in identifying advantageous opportunities and getting their benefits prior to competitors, thus reaping the benefits of being a pioneer.
2. Identification of threats: Correct knowledge of business environment helps an organization to identify those threats which may adversely affect its operations. For example, Bajaj Auto made considerable improvements in its two wheelers when Honda & other companies entered the auto industry.

Helps in Improving performance: Correct analysis and continuous monitoring of business environment helps an organization in improving its performance.

Economic Environment in India

As a part of economic reforms, the Government of India announced New Economic Policy in July 1991 for taking out the country out of economic difficulty and speeding up the development of the country.
Main features of NEP, 1991 are as follows:
1. Only six industries were kept under licensing scheme.
2. The role of public sector was limited only to four industries.

The three main strategies adopted for the above may be defined as follows:

1. Globalisation:
• Integrating the economy of a country with the economies of other countries to facilitate freer flow of trade, capital, persons and technology across borders. It leads to the emergence of a cohesive global economy.
• Till 1991, the Government of India had followed a policy of strictly regulating imports in value and volume terms. These regulations were with respect to (a) licensing of imports, (b) tariff restrictions and (c) quantitative restrictions.
• NEP ‘91 advocated rapid advancement in technology and directed trade liberalization towards:
a. Import Liberalisation
b. Export promotion towards rationalization of the tariff structure and
c. Reforms w.r.t foreign exchange
2. Liberalisation:
= Liberalising the Indian business and industry from all unnecessary controls and restrictions. That is relaxing rules and regulations which restrict the growth of the private sector and allowing the private sector to take part in economic activities that were earlier reserved for the government sector. The steps taken for this were:
a. Abolishing licensing b. Freedom in deciding the scale of operations c. Removal of restrictions on movement of goods and services. d. Freedom in fixing prices.
e. Reduction in tax rates and unnecessary controls f. Simplifying procedures for import and exports g. Making it easy to attract foreign capital.
3. Privatization:
• Refers to the reduction of the role of the public sector in the economy of a country.
• Transfer of ownership and control from the private to the public sector (disinvestment) can be done by : a. Sale of all/some asses of the public sector enterprises. b. Leasing of public enterprises to the private sector. c. Transfer of management of the public enterprise to the private sector.
• To achieve privatization in India, the government redefined the role of the public sector and –
a. Adopted a policy of planned disinvestment of the public sector
b. Refer the loss making and sick units to the Board of Industrial and Financial Reconstruction (BIFR)

DIMENSIONS/COMPONENTS OF BUSINESS ENVIRONMENT

1. Economic Environment: It has immediate and direct economic impact on a business. Rate of interest, inflation rate, change in the income of people, monetary policy, price level etc. are some economic factors which could affect business firms. Economic environment may offer opportunities to a firm or it may put constraints.
2. Social Environment: It includes various social forces such as customs, beliefs, literacy rate, educational levels, lifestyle, values etc. Changes in social environment affect an organization in the long run. Example: Now a days people are paying more attention towards their health, as a result of which demand for mineral water, diet coke etc. has increased while demand of tobacco, fatty food products has decreased.
3. Technological Environment: It provides new and advance ways/techniques of production. A businessman must closely monitor the technological changes taking place in the industry as it helps in facing competition and improving quality of the product. For Example, Digital watches in place of traditional watches, artificial fabrics in place of traditional cotton and silk fabrics, booking of railway tickets on internet etc.
4. Political Environment: Changes in political situation also affect business organizations. Political stability builds confidence among business community while political instability and bad law & order situation may bring uncertainty in business activities. Ideology of the political party, attitude of government towards business, type of government-single party or coalition government affects the business Example: Bangalore and Hyderabad have become the most popular locations for IT due to supportive political climate.
5. Legal Environment: It constitutes the laws and legislations passed by the Government, administrative orders, court judgements, decisions of various commissions and agencies. Businessmen have to act according to various legislations and their knowledge is very necessary. Example: Advertisement of Alcoholic products is prohibited and it is compulsory to give statutory warning on advertisement of cigarettes.

MAJOR STEPS IN ECONOMIC FORMS

1. New Industrial Policy – Under this the industries have been freed to a large extend from licences and other controls. Efforts have been made to encourage foreign investment.
2. New Trade Policy – The Foreign trade has been freed from the unnecessary control. The age old restrictions have been eliminated.
3. Fiscal Reforms. The greatest problem confronting the Indian Govt. is excessive fiscal deficit.
(a) Fiscal Deficit – It means country is spending more than its income
(b) Gross Domestic Product (GDP) – It is the sum total of the financial value of all goods & services produced in a year in a country.
4. Monetary Reform – It is a sort of control policy through which the central bank controls the supply of money with a view to achieving objectives of general economic policy.
5. Capital Market Reforms- The Govt. has taken the following steps for the development of this market:
(1) SEBI has been established.
(2) The restriction in respect of interest on debentures has been lifted.
(3) Private Sector has been permitted to establish Mutual Fund.
6. Dismantling Price control – The govt. has taken steps to remove price control in many products especially in fertilizers, iron and steel, petro products. Restrictions on the import of these things have also been removed.

IMPACT OF GOVERNMENT POLICY CHANGES ON BUSINESS AND INDUSTRY

1. Increasing Competition: De-licencing and entry of foreign firms Indian market is increased the level of competition for Indian firms.
2. More Demanding Customers: Now customers are more aware and they keep maximum information of the market as the result of which now market is customer/buyer oriented, Now, products are produced keeping in mind the demands of the customers.
3. Rapid Changing Technological Environment: Rapid Technological advancement has changed/improved the production process as a result of which maximum production is possible at minimum cost but it leads to tough challenges in front of small firms.
4. Necessity for Change- After New Industrial. Policy the market forces (demand & supply) are changing at a very fast rate. Change in the various components of business environment has made it necessary for the business firms to modify their policies & operations from time to time.
5. Need for Developing Human Resources: The changing market conditions of today requires people with higher competence and greater commitment, hence there is a need for developing human resources which could increase their effectiveness and efficiency.
6. Market Orientation: Earlier selling concept was famous in the market now its place is taken by the marketing concept. Today firms produce those goods & services which are required by the customers. Marketing research, educational advertising, after sales services have become more significant.
7. Reduction in budgetary Support to Public Sector: The budgetary support given by the government to the public sector is reducing thus the public sector has to survive and grow by utilising their own resources efficiently.

Business Studies Class 12 Revision Notes Chapter 1 Nature and Significance of Management

Points to Remember

1. Management According to Marrie and Douglas,
“Management is the process by which a co-operative group directs actions of others toward common goals.”
Management is defined as the process of planning, organising and controlling an organisation’s operations in order to achieve the target efficiently and effectively. It is essential for all organisations.
2. Concepts of Management
(i) Traditional Concept Management is the art of getting things done through others.
(ii) Modern Concept Management is defined as the process (refers to the basic steps) to get the things done with the aim of achieving goals effectively and efficiently (effectiveness refers to achievement of task on time and efficiently implies optimum use of resources).
3. Characteristics of Management
(i) Management is a Goal Oriented Process Organisation’s existence is based on objectives and management is the process which unites the efforts of every individuals to achieve the goal.
(ii) Management is All Pervasive The use of management is not restricted, it is applicable in all organisations big or small, profit or non-profit making.
(iii) Management is Multidimensional It does not contain one activity, it is a complex activity including three main activities
(a) Management of house
(b) Management of people
(c) Management of operations
(iv) Management is a Continuous Process It is a never ending process. It consists of series of interrelated functions which performs continuously.
(v) Management is a Group Activity Organisation is a collection of many individuals, every individual contributes towards achieving the goal.
(vi) Management is an Intangible Force It cannot be seen or touched only it can be felt in the way the organisation functions.
4. Objectives of Management Objectives can be classified into organisational, social or personal
(i) Organisational Objectives
(a) Survival It exists for a long time in the competition market.
(b) Profit It provides a vital incentive for the continued successful operations.
(c) Growth Success of an organisation is measured by growth and expansion of activities.
(ii) Social Objectives Involves creation of benefit for society.
(iii) Personal Objectives Objectives of employees like good salary, promotion, social recognition, healthy working conditions.
5. Importance of Management
(i) Management Helps Achieving Group Goals It integrates the objective of individual along with organisational goal.
(ii) Management Increases Efficiency It increases productivity through better planning, organising, directing the activities of the organisation.
(iii) Management Creates a Dynamic Organisation Organisation have to survive in dynamic environment thus manager keep changes in the organisation to match environmental changes.
(iv) Management Helps in Achieving Personal Objectives Through motivation and leadership, management helps in achieving the personal objectives.
(v) Management Helps in the Development of Society It provides good quality products and services, creates employment, generate new technology in that sense it helps in the development of the society.
6. Management as an Art
Management as an art because it satisfies following points
(i) It is based on practice and creativity.
(ii) Lots of literature is present which gives the existence of theoretical knowledge.
7. Management as a Science
Management as a science because
(i) It is a systematised body of knowledge.
(ii) Its principles are based on experimentation.
8. Management as a Profession It does not meet the exact criterion of a profession, it does have some features of a profession.
9. Levels of Management
(i) Top Management It consists of senior most executives who are usually referred to as the Chairman, Chief Executive Officer, President and Vice President.
(ii) Middle Management They are usually division heads who are the link between top and lower level of management.
(iii) Operational Management They are usually the foremen and supervisors who actually carry on the work or perform the activities.
10. Functions of Management
(i) Planning It refers to deciding in advance what to do, how to do and developing a may of achieving goal efficiently and effectively.
(ii) Organising It refers to the assigning of duties, grouping tasks, establishing authority and allocating of resources required to carry out a specific plan.
(iii) Staffing It implies right people for the right job.
(iv) Directing It involves leading, influencing, motivating employees to perform the task assigned to them.
(v) Controlling It refers to the performance measurement and follow up actions that keep the actual performance on the path of plan.
11. Co-ordination—TheEssence of Management Co-ordination means binding together all the activities such as purchase, production, sales, finance to ensure continuity in the working of the organisation. It is considered as a separate function of management, in order to achieve harmony among individual, efforts towards the accomplishment of goods.
12. Characteristics of Co-ordination
(i) It integrates group efforts.
(ii) It ensures units of action.
(iii) It is a continuous process.
(iv) It is an all pervasive function.
(v) It is the responsibility of all managers.
13. Importance of Co-ordination
(i) Growth in Size When there is a growth in size, the number of people employed by the organisation also increases. Thus to integrate the efforts, co-ordination is needed.
(ii) Functional Differentiation In an organisation, there are separate department and different goals. The process of linking these activities is achieved by co-ordination.
(iii) Specialisation Modern organisation is characterised by a high degree of specialisation. Co-ordination is required among different specialists because of their different approaches, judgement etc.
14. Management in the Twenty-First Century Management in 21st century means the new ways, trends, ideas, techniques of doing business and makes it possible to think of the organisation as a ‘Global Organisation.’

Dissolution of a Partnership Firm Notes Class 12 Accountancy

The word Dissolution implies “the undoing or breaking of a bond tie”. In other words, dissolution implies that the existing state of arrangement is done away with. In terms of the partnership, dissolution means discontinuance of relationships amongst the partners.

But the dissolution of partnership and dissolution of a partnership firm are two different terms. As we know that the reconstitution of a partnership firm takes place on account of admission, retirement, or death of a partner. Here, the existing partnership is dissolved, but the firm may continue under the same name if the partners so decide. It means that it results in the dissolution of a partnership but not that of the firm.

The dissolution of a partnership does not lead to the dissolution of the firm since the two situations are different. In case of dissolution of the partnership, the firm continues, only the partnership relation is reconstituted, but in case of dissolution of the firm, not only partnership is dissolved but the firm also loses its existence, implying thereby that the firm ceases to operate as a partnership firm.

Dissolution of a Partnership:
If dissolution involves only the reconstitution of the firm and the business in partnership is continued in the same name after the dissolution of the partnership agreement, it is known as the ‘Dissolution of the Partnership’. It involves a change in the relationship between partners without affecting the continuity of business. Here, the firm is reconstituted without the dissolution of the Finn.

A partnership is dissolved by change of mutual contract in the following cases:

1. Change in the existing profit sharing ratio among partners.
2. Admission of a new partner.
3. Retirement of a partner.
4. Death of a partner (Section 42).
5. Insolvency of a partner.
6. Completion of the venture if the partnership is formed for that,
7. Expiry of the period of the partnership, if the partnership is for a specific period.
8. The merger of one partnership firm into another.

Dissolution of a Firm:
According to Section 39 of the Indian Partnership Act, 1932 dissolution of a partnership between all the partners of a firm is called the ‘dissolution of the firm’.

It refers to the winding up of the business in partnership. It involves a complete breakdown of relations among all the partners and is the dissolution of a partnership between all the partners of a firm. Here, in this situation, business is to be discontinued, it requires the realization of assets and settlement of liabilities.

Dissolution of a firm takes place in the following cases:
Dissolution by Agreement

1. All the partners give consent to it; or
2. As per the terms of the partnership agreement.

Compulsory Dissolution:

1. Where all the partners or all expect one partner, become insolvent or insane rendering them incompetent to sign a contract; or
2. When the business of the firm becomes illegal; or
3. When some event has taken place which makes it unlawful for the partner to catty on the business of the firm in partnership.

On the Happening of Certain Contingencies

Subject to contract between the partners, a firm is dissolved:

1. if constituted for a fixed term, by the expiry of that term; or
2. if constituted to carry out one or more ventures, by the completion thereof; or
3. where all the partners except one decided to retire from the firm; or
4. where all the partners or all except one partner dies; or
5. by the adjudication of a partner as an insolvent.

Dissolution by Notice:
In case of partnership at will, the firm may be dissolved if any of the partners give notice in writing to the other partners signifying his intention of seeking dissolution of the firm.

Dissolution by Court (Under Section 44):
At the suit of a partner, the court may order for dissolution of partnership firm on any of the following grounds:

1. If a partner becomes insane; or
2. When a partner becomes permanently incapable of performing his duties as a partner; or
3. When a partner is guilty of misconduct that is likely to adversely affect the business of the firm; or
4. When a partner deliberately and consistently commits a breach of agreements relating to the management of the firm; or
5. When the partner transfer whole of his interest in the firm to a third party; or
6. When the business of the firm cannot be carried on, except at a loss; or
7. When the court, on any ground, regards dissolution to be just and equitable.

Difference between Dissolution of Partnership and Dissolution of Firm:


Settlement of Accounts
In case of dissolution of a firm, the firm ceases to conduct business and has to settle its accounts. For this purpose, it disposes of all its assets for satisfying all the claims against it. Section 48 of the Partnership Act provides the following rules for the settlement of accounts between the partners:
(a) Treatment of Losses
Losses, including deficiencies of capital, shall be paid:

1. first out of profits,
2. next out of the capital of partners, and
3. lastly, if necessary, by the partners individually in their profits sharing ratio.

(b) Application of Assets
The assets of the firm, including any sum contributed by the partners to make up deficiencies’ of Capital, shall be applied in the following manner and order:

1. In paying the debts of the firm to the third parties;
2. In paying each partner proportionately what is due to him/ her from the firm for advances as distinguished from capital (i.e. partner’s loan);
3. In paying to each partner proportionately what is due to him on account of capital; and
4. The residue, if any, shall be divided among the partners in their profit-sharing ratio.

Thus, assets realized along with a contribution from the partner if required, are applied as follows:

1. To pay outside liabilities. Debts with fixed charges are paid first, followed by debts with floating charges and then unsecured debts. Such as creditors, loans, bank overdraft, bills payable, etc.
2. To pay loans and advances made by the partners to the firm (in case the balance amount is not adequate enough to pay off such loans and advances, they are to be paid proportionately).
3. To settle capital accounts of the partners.

Private Debts and Firm’s Debts:
Where both the debts of the firm and private debts of a partner co-exist, the following rules, as stated in Section 49 of the Indian Partnership Act, 1932, shall apply:
(a) The property of the firm shall be applied first in the payment of debts of the firm and then the surplus if any shall be divided among the partners as per their claims, which can be utilized for payment of their private liabilities.

(b) The private property of any partner shall be applied first in payment of his private debts and the surplus, in any, may be utilized for payment of the firm’s debts, in case the firm’s liabilities exceed the firm’s assets. In nutshell, private property shall be first used to settle private debts and business property shall be first used to settle business debts, and the surplus if any, can be transferred.

Accounting Treatment:
Dissolution of the firm involves the realization of assets and settlement of liabilities and capital accounts. For this purpose, the following accounts are opened in the firm’s books:

1. Realization Account.
2. Partner’s Loan Account
3. Partner’s Capital Account
4. Bank or Cash Account

1. Realization Account:
A realization Account is opened on the dissolution of a firm. It is a nominal account. It shows the net result of realization of assets and settlement of liabilities.

For this purpose, the balances of assets and liabilities appearing in the ledger books are transferred to the realization account. It also records realized value of recorded as well as unrecorded assets. Similarly, payment for liabilities and unrecords liabilities are also recorded in the realization account.

It also recorded the realization expenses. The balance in this account is termed as profit or loss on realization which is transferred to partner’s, capital accounts in their profit sharing ratio. As the dissolution of a firm involves winding up of partnership business and requires final closure of books, the following steps are followed to record dissolution of the partnership firm:

→ Journal Entries:
1. For transfer of Assets
Realization A/c Dr.
To Sundry Assets (Individually) A/c [With a book value of individual asset]

All assets transferred to the realization account at their book value and its corresponding provisions or reserve appearing on the balance sheet are also transferred to the credit side of the realization account. Balance of cash, bank, and fictitious assets are not transferred to realization account.

2. For transfer of liabilities
Book value of all outside liabilities recorded in the books is transferred to realization account along with provisions against various assets.

Liabilities A/c (Individually) Dr.
To Realisation A/c [With a book value of Liabilities]

Note:
Partner’s capital account, accumulated profits, general reserves, reserve fund, partner’s loan are not transferred to realization account.

3. For Sale of Assets (recorded or unrecorded)
Bank/Cash A/c Dr.
To Realisation A/c [With the amount actually realized]

4. For an asset taken over by a partner
Partner’s Capital A/c Dr.
To Realisation A/c [ With the agreed take over the price of the assets]

5. For payment of liabilities
Realization A/c Dr.
To Bank/Cash A/c [With the amount actually paid]

6. For a liability which a partner takes responsibility to discharge
Realization A/c Dr.
To Partner’s Capital A/c [With the agreed value of liability taken over]

7. For transfer of assets to settle liabilities
If assets are transferred to settle the liability account (full and final settlement), then no separate journal entry is passed to record settlement of liability by transfer of assets. But if there is a difference, then we have to pass entry.

For example: If the creditor accepts an asset only as part of the payment of his dues, the entry will be made for cash payment. Creditors to whom Rs. 4,000 was due accepts typewriter worth Rs. 3,000 and Rs. 1,000 paid in cash, the following entry shall be made for the payment of Rs. 1,000 only.

If a creditor accepts an asset whose value is more than the amount due to him, he will pay cash to the firm for the difference for which the entry will be:
Bank A/c Dr.
To Realisation A/c

8. For payment of realization expenses;
(a) Expenses paid by the firm:
Realization A/c Dr.
To Bank/Cash A/c

(b) Expenses paid by a partner on behalf of the firm:
Realization A/c Dr.
To Pa liner’s Capital A/c

(c) When a partner has agreed to undertake the dissolution work for an agreed remuneration bear the realization expenses:
1. If payment of realization expenses is made by the firm:
Partner’s Capital A/c Dr.
To Bank/Cash A/c

2. If the partner himself pays the realization expenses:
[No Entry]

3. For agreed remuneration to such partner:
Realization A/c Dr.
To Partner’s Capital A/c

9. For the realization of any unrecorded assets including goodwill
Bank/Cash A/c Dr.
To Realisation A/c

10. For settlement of any unrecorded liability
Realization A/c Dr.
To Bank A/c

11. For transfer of profit and loss on realization
(a) In case of profit
Realization A/c Dr.
To Partner’s Capital A/c (Individually)

(b) In case of loss
Partner’s Capital A/c (Individually) Dr.
To Realisation A/c

Important:

1. If nothing is mentioned regarding the sale value of intangible assets like goodwill, prepaid expenses, patents, etc., it is assumed that these are valueless.
2. If nothing is mentioned regarding the sale value of tangible assets in the question, it is assumed that these are realized at their book value shown in the Balance Sheet.

→ Accounting Treatment of Reserve and Provisions:
1. If there exists a special reserve against any assets, it should be transferred to the credit side of the Realisation Account.
Provision for Depreciation A/c Dr.
Provision for Bad and Doubtful Debts Dr.
Investment Fluctuation Fund A/c Dr.
Life Policy Fund A/c Dr.
To Realisation A/c

→ These are not to be paid.
(a) Undistributed profits
General Reserve A/c Dr.
Reserve Fund A/c Dr.
Profit and Loss A/c (Credit Balance) Dr.
Workmen Compensation Fund A/c Dr.
To Partner’s Capital A/c (Individually)

(b) Undistributed losses
Partner’s Capital A/c (Individually) Dr.
To Profit and Loss A/c (Debit Balance)
To Advertisement Expenses A/c

2. Partner’s Loan Account:
When all the outside liabilities are paid in full, afterward this loan will be paid.
Partner’s Loan A/c Dr.
To Bank/Cash A/c

3. Partner’s Capital Accounts: After all the adjustments.
(a) If capital account showed debit balance:
Bank/Cash A/c Dr.
To Partner’s Capital A/c (Individually)
(For deficit amount of capital brought in cash by the partner)

(b) If capital account showed credit balance:
Partner’s Capital A/c Dr.
To Bank/Cash A/c (For final payment made to a partner)

4. Bank/Cash Account:
On the debit side of this account, entries as opening balance, sale of assets, and cash brought in by partners are shown and on the credit side, entries as cash payment for liabilities, expenses, and amount paid to partners are shown. If all the entries are correctly recorded, this account balances, and hence all accounts are closed.

Format of Realisation Account
Answer:

Reconstitution of Partnership Firm: Retirement/Death of a Partner Notes Class 12 Accountancy

As we already knew that reconstitution of the partnership firm can also take place on the retirement of the partner or death of the partner. Here, the existing partnership deed comes to an end, and in its place, a new partnership deed comes into existence where remaining partners shall continue to do the business but on different terms and conditions. In both cases, i.e. on retirement or death of a partner, we are required to determine the sum due to the retiring partner or to the legal representatives of the deceased partner.

Retirement of a Partner:
A partner may retire from the partnership firm:

1. with the consent of all other partners;
   or
2. in case of retirement at will i.e. (partnership at will);
   or
3. by giving notice in writing to all other partners by the retiring partner.

On retirement, the old partnership comes to an end arid a new one between the remaining partner1 comes into existence. However the partnership firm as such continues.

Amount due to Retiring Partner:

1. Credit Balance of his Capital Account;
2. Credit Balance of his Current Account (if any);
3. His share of goodwill, accumulated profits, reserves etc.;
4. His share in the profit on revaluation of assets and liabilities;
5. His share of profit, interest on capital up to the date of retirement;
6. Any salary/commission due to him.

The following deductions (if any) made from his share:

1. Debit balance of the his-current account (if any);
2. His share of Goodwill to be written off, accumulated losses;
3. His share of loss on revaluation of assets and liabilities;
4. His share of loss, drawing and interest on drawings up to the date of retirement.

The various accounting aspects involved in retirement or death are as follows:

1. New profit sharing ratio
2. Gaining ratio
3. Goodwill Treatment
4. Accumulated profit and losses -Distribution
5. Profit and Loss till the date of retirement or death
6. Adjustment of Capital
7. Settlement of the amount due to retired /deceased partner.

New Profit Sharing Ratio:
The new profit sharing ratio is the ratio in which the remaining partners will share future profits after the retirement or death of any partners. In other words, the new profit sharing ratio of each remaining partner will be the sum total of his old share of profits in the firm and the portion of the retiring partner’s share of the profit acquired.

New Share of Partner = Old share + Acquired share from retiring/deceased partner.

(a) Nothing is mention about the new profit sharing ratio at the time of retirement:
If nothing is stated about the future ratio of the remaining partner, then their old ratio is considered as their new ratio. In other words, in the absence of any information regarding the profit-sharing ratio in which the remaining partner acquire the share of the retiring/deceased partner, then it is assumed that they will acquire it in the old profit sharing ratio and so the share the future profits in their old ratio.

For example, Kapil, Anu and Priti are partners in firm sharing profits and losses in the ratio 5: 3: 2. If Anu retires, then the new profit sharing ratio of Kapil and Priti will be 5: 2.

(b) Remaining partners acquire the share of retiring/deceased partner in the specified ratio:
If the remaining partners acquire the share of retiring/deceased partner in a specified ratio, other than their old ratio, then there is a need to compute a new profit sharing ratio among them. The new profit sharing ratio is equal to the sum total of their old ratio and the share acquired from the retiring/deceased partner.

For example, Kapil, Anu and Priti are partners in firm sharing profits and losses in the ratio 5: 3: 2. If Anu retires from the firm and her share was acquired by Kapil and Priti in the ratio 2: 1. In that case, the new share of profit will be calculated as follows:

New share of remaining partner = Old share + Acquired share from the outgoing partner.

(c) Remaining partners may agree on a particular new profit sharing ratio:
If the remaining partners decide a particular profit sharing ratio to share the future profits of the firm, in such a case the ratio so specified will be the new profit sharing ratio.

Gaining Ratio:
The ratio in which the continuing partners acquire the share of the retiring /deceased partner is called the gaining ratio.
(a) If nothing is mention in agreement:
If nothing is mention in the agreement about the gaining ratio, then it is assumed that the remaining partners acquire the share of the retiring/deceased partner in their old profit sharing ratio. In that case, the gaining ratio of the remaining partners will be the same as their old profit sharing ratio and there is no need to compute the gaining ratio.

(b) If a new profit sharing ratio is given:
If the new profit sharing ratio is given of the remaining partners then we have to compute the gaining ratio. In this case, the gaining ratio is calculated by deducting the old ratio from the new ratio.
Gaining ratio = New ratio – Old ratio

For example X, Y and Z are partners in a firm, sharing profits and losses in ratio 5:3:2. Y retires from the firm and X and Z decide to share future profits and losses in the ratio 7: 3. The gaining ratio will be calculated as follows:

Treatment of Goodwill:
The outgoing partner is entitled to his share of goodwill at the time of retirement/death because the goodwill has been earned by the firm with the efforts of all the existing partners. Therefore, goodwill is valued as per the agreement, at the time of retirement/death.

Due to the retirement/death of any partner, the continuing partners make again because the future profit will be shared only between the continuing partners. Therefore, the continuing partners should compensate the retiring/deceased partner for his share of goodwill in the gaining ratio.

The accounting treatment for goodwill depends upon whether the goodwill already appears in the books of the firm or not.

When Goodwill does not Appear in the Books:
When Goodwill does not appear in the books of the firm, there are four following ways to compensate the retiring partner for his share of goodwill:
(a) Goodwill is raised at its full value and retained in the books:
Goodwill A/c Dr.
To All Partner’s Capital AJc’s
(including retiring/deceased partner)
(For the goodwill raised at its full value and credited to capital A/c’s of a ’1 partners in their old profit sharing ratio)
The full value of goodwill will appear in the new balance sheet.

(b) Goodwill is raised at its full value and written off immediately:
If it is decided that the goodwill will not appear in the balance sheet of the reconstituted firm, then the following journal entries are required:
1. Goodwill A/c Dr.
To All Partner’s Capital A/c’s (For raising of Goodwill and credited to all partners capital A/c’s in their old profit sharing ratio)

2. Continuing Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For written off goodwill between continuing partners in their new profit sharing ratio)

(c) Goodwill is raised to the extent of retired/deceased partner’s share and written off immediately:
1. Goodwill A/c Dr.
To Retiring/Deceased Partner’s Capital A/c (For the goodwill raised by share of outgoing partner)

2. Continuing Partner’s Capital AJc’s Dr.
To Goodwill A/c
(For the goodwill written off between the continuing partners in their gaining ratio)

(d) No Goodwill account is raised at all in the firm’s books:
If the outgoing partner’s share of goodwill is adjusted in the capital accounts of the continuing partners without opening a goodwill account, the following entry will be required:

Continuing Partner’s Capital A/c’s Dr.
To Outgoing Partner’s Capital A/c (For the share of outgoing partner in the goodwill adjusted through capital accounts in the gaining ratio)

The following example clears the above accounting treatment of Goodwill at the time of retirement/death:
Ram, Shyam and Mohan are partners in firm sharing profits and losses in the ratio of 5: 3: 2. Shyam retires. The goodwill of the firm is valued at Rs. 1,40,000 and the remaining partner’s Ram and Mohan continue to share profits in the ratio of 5:2. The following journal entries passed under various alternatives shall be as follows:

If goodwill is raised at full value and retained in books:

If goodwill is raised at full value and written off immediately:


If goodwill is raised to the extent of retiring partner’s share and written off immediately:

No goodwill account is raised at all in the firm’s books:

When Goodwill is already appearing in the books:
(a) If the value of goodwill appearing is equal to the current value of goodwill of the firm:
Normally, no adjustment is required if both the amounts are the same. Because goodwill stands credited in the accounts of all the partners including the retiring one.

(b) If the book value of goodwill is lower than its present value:
If the book value is less than the present value, the difference will be debited to the goodwill account and credited to the old partner’s capital accounts in their old profit sharing ratio.
Goodwill A/c Dr.
To All Partner’s Capital A/c’s (individually)
(For goodwill raised to its present value)

(c) If the book value of goodwill is more than the agreed or present value:
If the book value of goodwill is more than the present value, the difference will be debited to All partner’s capital accounts in their old profit sharing ratio and credited to the goodwill account.
All Partner’s Capital A/c’s (individually) Dr.
To Goodwill A/c
(For goodwill brought down to its present value)

Alternatively,
1. First, write off the existing goodwill that appears in the books:
All Partner’s Capital A/c’s (individually) Dr.
To Goodwill A/c
(For write off goodwill to all partners in old profit sharing ratio)

2. Adjust retiring partner’s share of goodwill through capital A/c’s
Remaining Partner’s Capital A/c’s Dr.
To Retiring/deceased Partner’s Capital A/c
(For goodwill share of retiring/deceased partner adjusted to remaining partner’s Capital A/c’s in their gaining ratio)

Hidden Goodwill:
If the firm has agreed to settle the retiring/deceased partner by paying him a lump sum, then the amount paid to him in excess of what is due to him based on the capital accounts balance after making all adjustments like accumulated profits and losses and revaluation profit or loss etc. shall be treated as his share of goodwill known as hidden goodwill.

Revaluation of Assets and Liabilities:
The retiring /deceased partner must be given a share of all profits that have arisen till his retirement/death and is made to bear his share of losses that have occurred till that period. This necessitates the revaluation of assets and liabilities. At the time of retirement/death of a partner, there may be some assets and liabilities which may not have been shown at their present values.

Not only that, there may be some unrecorded assets and liabilities which need to be brought into books. For this purpose, a revaluation account is opened, for the revaluation of assets and liabilities on the date of retirement/death of the partner. The journal entries to be passed for this purpose are as follows:

1. For increase in the value of assets:
Asset(s) AIc (individually) Dr.
To Revaluation A/c (For increase in the value of assets)

2. For decrease in the value of assets:
Revaluation A/c Dr.
To Assets A/c’s (individually)
(For decrease in the value of assets)

3. For increase in the number of liabilities:
Revaluation A/c Dr.
To Liabilities A/c’s (individually)
(for an increase in liabilities)

4. For decrease in the number of liabilities:
Liabilities A/c’s (individually) Dr.
To Revaluation A/c (For decrease in the liabilities)

5. For an unrecorded asset:
Assets A/c Dr.
To Revaluation A/c
(For unrecorded assets brought into books)

6. For an unrecorded liability:
Revaluation A/c Dr.
To Liability A/c
(For an unrecorded liability brought into books)

7. For the sale of an unrecorded asset:
Cash A/c Dr.
To Revaluation A/c (For the sale of unrecorded assets)

8. For payment of an unrecorded liability:
Revaluation A/c Dr.
To Cash A/c
(For the payment of an unrecorded*liability)

9. For-profit on revaluation:
Revaluation A/c Dr.
To All Partner’s Capital A/c’s (individually)
(For the distribution of profit on revaluation to all partners in their old profit sharing ratio)
Or

10. For Loss on revaluation:
All Partner’s Capital A/c’s (individually) Dr.
To Revaluation A/c
(For the distribution of losses on revaluation to all partners in their old profit sharing ratio)

Reserves and Accumulated Profits and Losses:
The retiring/deceased partner is also entitled to his/her share in the accumulated profits, general reserve, workmen compensation fund 1 etc. and is also liable to share the accumulated losses.

For this purpose the following journal entries are required:
1. For Transferring accumulated profits, General Reserves etc.
To All Partner’s Capital A/c’s (individually)
(For accumulated profits are transferred to all partner’s Capital A/c’s in their old profit sharing ratio)

2. For transfer of accumulated losses:
All Partner’s Capital A/c’s (individually) Dr.
To Profit and Loss A/c To Any Accumulated Loss A/c (For accumulated losses transferred to all partner’s Capital A/c’s in their old profit sharing ratio)

Settlement of Amount Due to Retiring Partner:
The retiring partner is entitled to the amount due to him. It is settled as per the terms of the partnership deed i.e. in lump sum immediately or in various instalments with or without interest as agreed or partly in cash immediately and partly in instalments.

In absence of any agreement, Section 37 of the Indian Partnership Act, 1932 is applicable, according to this, the retiring partner has an option to receive either interest 6% p.a. till the payment of his/her amount due or such share of profits which has been earned with his/her money i.e. based on the capital ratio. The necessary journal entries are as follows:
1. If payment (full) is made in cash:
Retiring Partner’s Capital A/c Dr.
To Cash/Bank A/c
(For the amount paid to retire partner)

2. If the amount due to retiring partner’s treated as loan:
Retiring Partner’s Capital A/c Dr.
To Retiring Partner’s Loan A/c (For the amount due to retiring partner transferred to his loan account)

3. When the amount due to retiring partner is partly paid in cash and the remaining amount treated as loan:
Retiring Partner’s Capital A/c Dr. (Total Amount Due)
To Cash/Bank A/c. (Amount paid)
To Retiring Partner’s Loaij A/c (Amount of loan) (For the amount due to retiring, partner; partly paid in cash and remaining transferred to his loan account)

4. When loan account is settled by paying in instalment includes principal and interest:
(a) For interest due on loan:
Interest on Loan A/c Dr.
To Retiring Partner’s Loan A/c
(For the interest due on the loan of retiring partner)

(b) For payment of instalment of the loan with interest:
Retiring Partner’s Loan A/c Dr.
To Cash/Bank A/c
(For the amount paid (Instalment + Interest) to retiring
partner)
These entries i.e. (a) and (b) repeated till the loan is paid off.

Adjustment of Partner’s Capital:
At the time of retirement or death of a partner, the remaining partners may decide to adjust their capital contribution in their new profit sharing ratio. The adjustment of the remaining partner’s capitals may involve any one of the following cases:
1. When the total capital of a new firm is specified.
Steps:
(a) Compute the new capitals of the remaining partners by dividing total capital in their new profit sharing ratio.

(b) Calculate the amount of adjusted old capital of the remaining partners after all adjustments regarding goodwill, accumulated profit and losses, profit or loss on revaluation etc.

(c) Find out the surplus or deficiency, as the case may be, in each
of the remaining partner’s capital account by comparing the new capital and the adjusted capital. ‘

(d) Adjust the surplus by paying cash to the concerned partner or by crediting his Current Account as agreed. Adjust the deficiency by asking the concerned partner to pay cash or by debiting his current account.

Journal Entries:
For excess capital withdrawn by the remaining partners:
Partner’s Capital A/c’s (individually) Dr.
To Cash/Bank A/c.

For the amount of capital to be brought in by the partners:
Cash/Bank A/c Dr.
To Partner’s Capital AJc’s (individually)
If the adjustment is made through the current account:

For excess capital:
Partner’s Capital A/c’s (individually) Dr.
To Partner’s Current A/c’s (individually)

For short capital:
Partner’s Current A/c’s /individually) Dr.
To Partner’s Capital A/c’s (individually)

2. When the total capital of the new firm is not specified:
Calculate the total capital of the new firm which will be equal to the aggregate of the adjusted old capitals of the continuing partners after all adjustments like goodwill, accumulated profits and losses, profit and losses on revaluation etc.
After calculating the total capital of the new firm, follow the same steps as discussed in case 1.

3. When the amount payable to retiring partner will be contributed by continuing partners in such a way that their capitals are adjusted proportionately to their new profit sharing ratio:

Calculate the total capital of the reconstituted firm by adding the adjusted old capitals of remaining partners and the cash to be brought in by continuing partners in order to make payment to the retiring/ deceased partner.
Then follow the same step we discussed in case 1.

Death of a Partner:
The accounting treatment in the event of the death of a partner is the same as that in the case of the retirement of a partner. Here, his claim is transferred to his executor’s account and settled in the same manner as that of the retired partner.

The only major difference between the retirement and death of a partner is that retirement normally takes place at the end of the accounting period whereas death may occur on any day. Therefore, in case of death, his claim shall also include his share of profit or loss, interest on capital, interest on drawings (if any), from the beginning of the year to the date of death.

Calculation of profit for the intervening period:
Share of profit of a deceased partner

Share of deceased partner = Profit of the firm till the date of death × Deceased partner share

Accounting Treatment of Outgoing Partner’s Share in Profit:
1. Through Profit and Loss Suspense Account
In case of Profit:
Profit and Loss Suspense A/c Dr.
To Deceased Partner’s Capital A/c (Share of profit for the intervening period)

In case of Loss:
Deceased Partner’s Capital A/c Dr.
To Profit and Loss Suspense A/c (Share of loss for the intervening period)

2. Through Capital Transfer In case of Profit:
Remaining Partner’s Capital A/c’s Dr.
To Deceased Partner’s Capital A/c In case of Loss:
Deceased Partner’s Capital A/c Dr.

To Remaining Partner’s Capital A/c’s The executors of deceased partner are entitled to the following:

1. The credit balance of deceased partner’s capital account;
2. His share of goodwill;
3. His share of profit till the date of death;
4. His share of profit on revaluation of assets and liabilities;
5. His share of accumulated profits and reserves;
6. His interest on capital if partnership deed provides till the date of death;
7. His share of Joint Life Policy (if any);
8. His salary and commission due (if any);

The following deduction has to made from above.

1. His drawings, interest in drawings till the date of death;
2. His share of loss till the date of death;
3. His share of loss on revaluation of assets and liabilities. ,
4. His share of the reduction in the value of goodwill (if any).

Payment to the executors:
1. When payment is made in full Executor’s A/c Dr.
To Bank A/c.

2. When payment is made in instalment The executor’s are entitled to interest when the payment is made in instalment. If the deed is silent about this, then 6% p.a. should be given as per Section 37 of the Indian Partnership Act, 1932.

When interest is due
Interest A/c Dr.
To Executor’s A/c

When instalment paid along with interest
Executor’s A/c Dr.
To Cash/Bank A/c

Reconstitution of Partnership Firm: Admission of a Partner Notes Class 12 Accountancy

As we know that Partnership is an agreement between the partners or members of the firm for sharing profits and losses of the business carried on by all or any of them acting for all. Any change in this agreement amounts to the reconstitution of the partnership firm.

A change in the agreement brings to an end the existing agreement and a new agreement comes into existence. This new agreement changes the relationship among the members or partners of the partnership firm. Hence, whenever there is a change in the partnership agreement, the firm continues but it amounts to the reconstitution of the partnership firm.

Modes of Reconstitution of the Partnership Firm:
Reconstitution of partnership firm usually takes place in any of the following situations:

1. At the time of admission of a new partner;
2. Change in the profit-sharing ratio of existing partners;
3.  At the time of retirement of an existing partner;
4. At the time of death of a partner;
5. The amalgamation of two partnership firms.

Admission of a New Partner:
When a business enterprise requires additional capital or managerial help or both for the growth and expansion of the business it may admit a new partner to supplement its existing resources. So, admission of a new partner is required for the following reasons:

1. Requirement of more capital for the expansion of the business.
2. Need of a competent and experienced person for the efficient running of the business.
3. To increase the goodwill of the business by taking a reputed and renowned person into the partnership.
4. To encourage a capable employee by taking him into the partnership.

According to Sec. 31, Indian Partnership Act, 1932, a new partner can be admitted into the firm only with the consent of all the existing partners unless otherwise agreed upon. Admission of a new partner means reconstitution of the firm. It is so because the existing agreement comes to an end and a new agreement comes into effect.

A newly admitted partner acquire s two main rights in the firm:

1. Right to share m the assets of the partnership firm, and
2. Right to share in the profits of the partnership firm.

Section 31, Indian Partnership Act, 1932, further specifies that the new partner is not liable for any debts incurred by the firm before he became a partner. New partner, however, will become liable if:

1. the reconstituted firm assumes the liabilities to pay the debt; and
2. the creditors have agreed to accept the reconstituted firm as their debtors and discharge the old firm from liability.

A new partner brings an agreed amount of capital either in cash or in-kind and he also contributes some additional amount known as premium or goodwill. This is done primarily to compensate the existing partners for the loss of their share in the profits of the firms.

Adjustment at the Time of Admission of a New Partner:

1. New profit sharing ratio;
2. Sacrificing ratio;
3. Valuation and adjustment of goodwill;
4. Revaluation of assets and liabilities;
5. Distribution of accumulated profits or losses or reserves; and
6. Adjustment of partners capitals.

New Profit Sharing Ratio:
The ratio in which all partners including new partner share the future profits is called the new profit sharing ratio. In other words, on the admission of a new partner, the old partners sacrifice a share of their profits in favour of the new partner. On admission of a new partner, the profit-sharing ratio among the old partners will change keeping in view their respective contribution to the profit-sharing ratio of the incoming partner. Hence, there is a need to ascertain the new profit sharing ratio among all the partners.

The new partner may acquire his share from the old partners in any of the following situations:
1. If only the ratio of the new partner is given, then in the absence of any other agreement or information, it is assumed that the old partners will continue to share the remaining profits in the old ratio.
Example: X, Y.and Z are partners sharing profits in the ratio 3:2:1 respectively. A is admitted in the firm as a new partner with 16th share. Find the new profit sharing ratio.
Answer:
Let total profit = 1
A’s share = 16th
Remaining Profit = 1 – 16 = 56
Old partners share this remaining profit in the old profit sharing

= 15:10:5:636
= 15: 10: 5: 6

2. If the new partner acquires his share of profit from the old partners equally. In that case, the new profit sharing ratio of the old partner will be calculated by deducting the sacrifice made by them from their existing share of profit.

Example: Varun and Daksh are partners sharing profits and losses in the ratio 5:3. They admit Dhruv as a partner for 14th share, which he acquires equally from Varun and Daksh. Calculate the new profit sharing ratio.
Answer:
Dhruv1s share = 14
Share acquired by Dhruv from Varun = 14×12=18
Share acquired by Dhruv from Daksh = 14×12=18

3. In the new partner acquire his share of profit from the old partners in a particular ratio. In that case, the new profit sharing ratio of the old partners will be calculated by deducting the sacrifice made by them from their existing share of profit.

Example: Noni and Pony are partners, sharing profits in the ratio of 7:5. They admit Tony as new partner for 16th share which he takes 124th from Noni and 18th from Pony. Calculate the new profit sharing ratio.
Answer:

4. If the old partners surrender a particular fraction of their share in favour of the new partner. In that case, the new partner’s share is calculated by adding the surrendered portion of the share by the old partners. Old partners’ share is calculated by deducting the surrendered portion from their old ratio.

Example: Anu and Priti are partners in firm sharing profits in the ratio of 5:3. Anu surrenders 120th of her share and Priti surrenders 124th of her share in favour of Kapil, a new partner. Calculate the new profit sharing ratio.
Answer:
Anu’s share = 58

5. If the new partner acquires his share of profit from only one partner. In that case, the new profit sharing ratio of the old partner will be calculated by deducting the sacrifice made by one partner from his existing ratio.

Example: Akshay and Anshul are partners in a firm sharing profits in a 4: 1 ratio. They admitted Shikha as a new partner for 14 share in the profits, which she acquired wholly from Akshay. Calculate the new profit sharing ratio.
Answer:
Akhay’s share = 45

Sacrificing Ratio:
The ratio in which the old partners have agreed to sacrifice their shares in profit in favour of a new partner is called the sacrificing ratio. This ratio is calculated by taking out the difference between the old profit sharing ratio and the new profit sharing ratio.

Sacrificing Ratio = Old Ratio – New Ratio

Goodwill:
Goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits earned by other similar firms belonging to the same industry. In other words, a well-established business develops an advantage of good name, reputation and wide business connections. This helps the business to earn more profits as compared to newly set-up business. This advantage in monetary terms called ‘Goodwill’. It arises only if a firm is able to earn higher profits than normal.

“Goodwill is nothing more than the probability that old customers will resort to the old place.” – Lord Eldon

“The term goodwill is generally used to denote the benefit arising from connections and reputation.” -Lord Lindley

“Goodwill is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connections of a business. It is the attractive force that brings in customers. It is one thing which distinguishes an old-established business from a new business at its first start.” -Lord Macnaghten

“Goodwill may be said to be that element arising from the reputation, connections or other advantages possessed by a business which enable it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business.” – Spicer and Pegler

“When a man pays for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts.” -Dicksee

Thus, goodwill can be defined as “the present value of a firm’s anticipated excess earnings “or as” the capitalised value attached to the differential profits capacity of a business.”

Characteristics of Goodwill:

1. Goodwill is an intangible asset but not a fictitious asset;
2. It is a valuable asset. Its value is dependent on the subjective judgement of the valuer.
3. It helps in earning higher profits than normal.
4. It is very difficult to place an exact value on goodwill. It is fluctuating from time to time due to changing circumstances of the business.
5. Goodwill is an attractive force that brings in customers to the old place of business.
6. Goodwill comes into existence due to various factors.

Factors Affecting the Value of Goodwill:
1. Nature of business: Company produces high value-added products or having stable demand in the market. Such a company will have more goodwill and is able to earn more profits.

2. Location: If a business is located in a favourable place, it will attract more customers and therefore will have more goodwill.

3. Efficient Management: Efficient Management brings high productivity and cost efficiency to the business which enables it to earn higher profits and thus more goodwill.

4. Market Situation: A firm under monopoly or limited competition enjoys high profits which leads to a higher value of goodwill.

5. Special Advantages: A firm enjoys a higher value of goodwill if it has special advantages like import licences, low rate and assured supply of power, long-term contracts for sale and for purchase, patents, trademarks etc.

6. Quality of Products: If the quality of products of the firm is good and regular, then it has more goodwill.

Need for Valuation of Goodwill:

1. At the time of sale of a business;
2. Change in the profit-sharing ratio amongst the existing partners;
3. Admission of a new partner.
4. Retirement of a partner;
5. Death of a partner;
6. Dissolution of a firm;
7. The amalgamation of the partnership firm.

Methods of Valuation of Goodwill:
Goodwill is an intangible asset, so it is very difficult to calculate its exact value. There are various methods for the valuation of goodwill in the partnership, but the value of goodwill may differ in different methods. The method by which the value of goodwill is to be calculated may be specifically decided among all the partners.

The methods followed for valuing goodwill are:

1. Average Profit Method
2. Super Profit Method
3. Capitalisation Method.

1. Average Profit Method:
Goodwill is calculated on the basis of the number of past years profits. In this method, the goodwill is valued at an agreed number of ‘years’ purchase of the average profits of the past few years.

Steps:

1. Find the total profit of the past given years.
2. Add ail Abnormal Losses like loss from fire or theft etc. and any Normal Income if not added before to the total profit of past given year.
3. Then, subtract, Abnormal Income (income from speculation or lottery etc.), Normal Expenses (if not deducted), Income from investment (if not related to general activities of business) and remuneration of the proprietor (if not given), if any, from the total profit of past given years.
4. After this, calculate the actual average profit by dividing the total profit by a number of years.
5. Then multiply Average Profit by the numbers of year purchases to find out the value of goodwill.

In other words:

Actual Average Profit =  Total Profit  No. of Years 

Goodwill = Actual Average Profit × No. of Years Purchased
→ Weighted Average Profit Method
Sometimes, if there exists an increasing or decreasing trend, it is considered to be better to give a higher weightage to the profits to the recent years than those of the earlier years. This method is an extension of the average profit method.

Steps:

1. Multiply each year’s profit to the weights assigned to each year respectively.
2. Find the total of the product.
3. Divide this product by total weights for ascertaining average profits.
4. Average profits then multiplied with No. of years purchased to find the value of Goodwill.

2. Super Profit Method:
Under this method, goodwill is valued on the basis of excess profits earned by a firm in comparison to average profits earned by other firms. When a similar type of firm gets a return as a certain percentage of the capital employed, it is called ‘normal return’. The excess of actual profit over the normal profit is called ‘Super Profits’. To find out the value of goodwill, Super profit is multiplied by the agreed number of year’s purchase.

Steps:

1. Calculate Actual Average Profit i.e. [ Total Profit  No. of Years ]
2. Calculate Normal Profit i.e.
   =  Capital Employed × NormalRate of Return 100
   [Capital Employed = Total Assets – Outside Liabilities]
3. Find Out Super Profits
   Super Profits = Actual Average Profit – Normal Profit
4. Calculate the Value of Goodwill
   = Super profit × No. of years purchased

3. Capitalisation Methods:
(a) by capitalizing the average profits
(b) by capitalizing the super profits.

(a) Capitalisation of Actual Average Profit Method:
Steps:

1. Calculate actual average profit: [ Total Profit  No. of Years ]
2. Capitalize the average profit on the basis of the normal rate of return:
   The capitalised value of actual average profit
   = Actual Average Profit × 100 Normal Rate of Return 
3. Find out the actual capital employed:
   Actual Capital Employed = Total Assets at their current value other than [Goodwill, Fictitious assets and non-trade investments] – Outside Liabilities.
4. Compute the value of Goodwill:
   Goodwill = Capitalised value of actual average profit – Actual Capital Employed.

(b) Capitalisation of Super Profit Method:
Steps:

1. Calculate Actual Capital Employed [same as above].
2. Calculate Super Profit [same as under Super Profit Method].
3. Multiply the Super Profit by the required rate of return multiplier:
   Goodwill = Super Profit × 100 Normal Rate of Return 

Treatment of Goodwill:
To compensate old partners for the loss (sacrifice) of their share in profits, the incoming partner, who acquire his share of profit from the old partners brings in some additional amount termed as a share of goodwill.
Goodwill, at the time of admission, can be treated in two ways:

1. Premium Method
2. Revaluation Method.

1. Premium Method:
The premium method is followed when the incoming partner pays his share of goodwill in cash. From the accounting point of view, the following are the different situations related to the treatment of goodwill:

(a) Goodwill (Premium) paid privately (directly to old partners)
[No entry is required]

(b) Goodwill (Premium) brought in cash through the firm
1. Cash A/c or Bank A/c Dr.
To Goodwill A/c
(For the amount of Goodwill brought by new partner)

2. Goodwill A/c Dr.
To Old Partner’s Capital A/c
(For the amount of Goodwill distributed among the old partners in their sacrificing ratio)

Alternatively:
1. Cash A/c or Bank A/c Dr.
To New Partner’s Capital A/c (For the amount of Goodwill brought b> a new partner)

2. New Partner’s Capital A/c Dr.
To Old Partner’s Capital A/c’s (For the amount of Goodwill distributed among the old partners in their sacrificing ratio)

3. If old partners withdrew goodwill (in full or in part) (if any)
Old Partner’s Capital A/c’s Dr.
To Cash A/c or Bank A/c
(For the amount of goodwill withdrawn by the old partners)

When goodwill already exists in books:
If the goodwill already exists in the books of firms and the incoming partner brings his share of goodwill in cash, then the goodwill appearing in the books will have to be written off.

Old Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For Goodwill written-off in old ratio)

After the admission of the partner, all partners may decide to maintain the Goodwill Account in the books of accounts.
Goodwill A/c Dr.
To All Partner’s Capital A/c’s (For Goodwill raised in the new firm after admission of a new partner in new profit sharing ratio)

2. Revaluation Method:
If the incoming partner does not bring in his share of goodwill in cash, then this method is followed. In this case, the goodwill account is raised in the books of accounts. When goodwill account is to be raised in the books there are two possibilities:
(a) No goodwill appears in books at the time of admission.
(b) Goodwill already exists in books at the time of admission,

(a) No goodwill appears in the books:
Goodwill A/c Dr.
To Old Partner’s Capital A/c’s (For Goodwill raised at full value in the old ratio)
If the incoming partner brings in a part of his share of goodwill. In that case, after distributing the amount brought in for goodwill among the old partners in their sacrificing ratio, the goodwill account is raised in the books of accounts based on the portion of premium not brought by the incoming partner.
Example: X and Y are partners sharing profits in the ratio of 3: 2.

They admit Z as a new partner. 14th share. The sacrificing ratio of X and Y is 2: 1. Z brings Rs. 12,000 as goodwill out of his share of Rs. 18,000. No goodwill account appears in the books of the firm.
Answer: Journal

(b) When goodwill already exists in the books
1. When the value of goodwill appearing in books is equal to the agreed value:
[No Entry is Required]

2. If the value of goodwill appearing in the books is less than the agreed value:
Goodwill A/c Dr.
To Old Partner’s Capital A/c’s (For Goodwill is raised to its agreed value)

3. If the value of goodwill appearing in the books is more than the agreed value:
Old Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For Goodwill brought down to its agreed value)

→ If partners, after raising Goodwill in the books and making necessary adjustments decide that the goodwill should not appear in the firm’s balance sheet, then it has to be written off.
All Partners’ Capital A/c’s Dr.
To Goodwill A/c (For Goodwill written off)

→ Sometimes, the partners may decide not to show goodwill account anywhere in books.
New Partner’s Capital A/c Dr.
To Old Partner’s Capital A/c (For adjustment for New Partner’s Share of Goodwill)

Hidden or Inferred Goodwill:
1. To find out the total capital of the firm by new partner’s capital and his share of profit.
Example: New partner’s capital for 14th share is Rs. 80,000, the entire capital of the new firm will be
80,000 × 41 = Rs. 3,20,000

2. To ascertain the existing total capital of the firm: We will have to ascertain the existing total capital of the new firm by adding the capital (of all partners, including new partner’s capital after adjustments, if any excluding goodwill)
→ If assets and liabilities are given:
Capital = Assets (at revalued figures) – Liabilities (at revalued figures)

3. Goodwill = Capital from (1) – Capital from (2)
Generally, this method is used, when the incoming partner does not bring his share of goodwill in cash. Here, we find out the total goodwill of the firm. After that, we can find out the new partner’s share of goodwill and treat accordingly.

Adjustment for Accumulated (Undistributed) Profits and Losses:
1. For Undistributed Profits, Reserves etc.
(For distribution of accumulated profits and reserves to old partners in old profit sharing ratio)
General Reserves A/c Dr.
Reserve fund A/c Dr.
Profit and Loss A/c Dr.
Workmen’s Compensation Fund A/c Dr.
To Old Partner’s Capital A/c’s
(For distribution of accumulated profits and reserves to old partners in old profit sharing ratio)

2. For Undistributed Losses:
Old Partner’s Capital A/c’s Dr.
To Profit and Loss A/c
(For distribution of accumulated losses to old partners in old profit sharing ratio)

Revaluation of Assets and Reassessment of Liabilities: Revaluation of Assets and Reassessment of Liabilities is done with the help of ‘Revaluation Account’ or ‘Profit and Loss Adjustment Account’.

The journal entries recorded for revaluation of assets and reassessment of liabilities are following:
1. For increase in the value of an Assets
Assets A/c Dr.
To Revaluation A/c (Gain)

2. For decrease in the value of an Assets
Revaluation A/c Dr.
To Assets A/c (Loss)

3. For appreciation in the amount of Liability
Revaluation A/c Dr.
To Liability A/c (Loss)

4. For reduction in the amount of a Liability
Liability A/c Dr.
To Revaluation A/c (Gain)

5. For recording an unrecorded Assets
Unrecorded Assets A/c Dr.
To Revaluation A/c (Gain)

6. For recording an unrecorded Liability
Revaluation A/c Dr.
To Unrecorded Liability A/c (Loss)

7. For the sale of unrecorded Assets
Cash A/c or Bank A/c Dr.
To Revaluation A/c (Gain)

8. For payment of unrecorded Liability
Revaluation A/c Dr.
To Cash A/c or Bank A/c (Loss)

9. For transfer of gain on Revaluation if the credit balance
Revaluation A/c Dr.
To Old Partner’s Capital A/c’s (Old Ratio)

10. For transfer of loss on Revaluation if debit balance
Old Partner’s Capital A/c’s Dr.
To Revaluation A/c (Old Ratio)

Adjustment of Capitals:
1. When the new partner brings in proportionate capital OR On the basis of the old partner’s capital.
(a) Calculate the adjusted capital of old partners (after all adjustments)

(b) Total capital of the firm
= Combined Adjusted Capital × Reciprocal proportion of the share of old partners

(c) New Partner’s Capital
= Total Capital × Proportion of share of a new partner.

2. On the basis of the new partner’s capital:
(a) Total Capital of the firm = New Partner’s Capital × Reciprocal proportion of his share.
(b) Distribute Total Capital in New Profit Sharing Ratio.
(c) Calculate adjusted capital of old partners.
(d) Calculate the difference between New Capital and Adjusted Capital.

1. If the debit side of the Capital Account is bigger then it means he has excess capital
   Partner’s ( capital Accounts Dr.
   To Cash A /c or Bank A/c or Current A/c
2. If the credit side is bigger then it means that he has short capital
   Cash A/c or Bank A/c or Current A/c Dr.
   To Partner’s Capital A/cs

Change in Profit Sharing Ratio among the Existing Partners:
Sometimes the existing partners of the firm may decide to change their profit sharing ratio. In such a case, some partner will gain in future profits and some will lose. Here the gaining partners should compensate the losing partners unless otherwise agreed upon. In such a situation, first of all, the loss and gain in the value of goodwill (if any) will have to adjust.
1. Goodwill A/c Dr.
To Partner’s Capital A/c’s (For raising the amount of Goodwill in old ratio)

2. Partner’s Capital A/c’s Dr.
To Goodwill A/c
(For writing off the amount of Goodwill in New Profit sharing ratio)

Alternatively:
Gaining Partner’s Capital A/c’s Dr.
To Losing Partner’s Capital A/c’s (For adjustment due to change in profit sharing ratio)

Accounting for Partnership: Basic Concepts Notes Class 12 Accountancy

Due to the limitation of sole-tradership regarding limited capital, limited managerial abilities, the low scale of business, involves more risk due to unlimited liability, tie need of partnership arises. A partnership is a relation of mutual trust and faith. There are certain peculiarities in ” the accounts of partnership firm than those are prepared in the sole tradership firm. The main peculiarities regarding the accounting of partnership firms are maintenance of the capital accounts of partners, distribution of profits to the partners, etc.

Meaning of Partnership:
The partnership is an agreement written/oral between two or more persons who have agreed to do some lawful business and to share profit ! or loss arising from the business.

According to the Indian Partnership Act, 1932, Section 4
“Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.”

In partnership, two or more persons join hands to set up a business and share its profit and losses.

Persons who have entered into a partnership with one another are called individually partners and collectively ‘a firm’, and the name under which their business is carried on is called the ‘firm name’. A partnership firm is not a separate legal entity apart from the partners constituting it.

There must be a minimum of two persons to form a partnership firm, according to the Indian Partnership Act, 1932, but it does not specify the maximum number of partners. In this issue Section 11 of the Companies Act, 1956 limits the number of partners to 10 for a partnership carrying on banking business and 20 for a partnership carrying on any other type of business.

Features of Partnership
1. Two or More Persons: There must be a minimum of two persons to form a partnership firm, according to the Indian Partnership Act, 1932, but it does not specify the maximum number of partners. In this issue Section 11 of the Indian Companies Act, 1956 limits the number of partners to 10 (ten) for a partnership carrying on banking business and 20 (twenty) for a partnership carrying on any other type of business.

2. Agreement: Partnership comes into existence on account of an agreement among the partners, and not from status or operations of law. The agreement becomes the basis of the relationship between the partners. It may be written or oral. It may be for a fixed period or for a particular venture or at will.

3. Business: A partnership can be formed for the purpose of carrying on some lawful business with the intention of earning profits. Mere co-ownership of a property does not amount to a partnership.

4. Mutual Agency: The partnership business may be carried on by all the partners or any of them acting for all. This statement means that every partner is entitled to participate in the conduct of the affairs of its business and there exists a relationship of mutual agency between all the partners.

Partners are agents as well as principals for all other partners. Each partner can bind other partners by his acts and also is bound by the acts of other partners with regard to the business of the firm. Relationship of the mutual agency is so important feature of partnership that one can say that there would be no partnership if this feature is absent,

5. Sharing of Profit: The agreement between the partners must be to share the profits (or losses). Though the definition of partnership, according to Partnership Act, describes the partnership as the relationship between people who agree to share the profits of a business, the sharing of loss is implied. If some persons join hands for the purpose of some charitable activity, it will not be termed as a partnership.

6. Liability of Partnership: The liability of partnership is unlimited. Each partner is liable jointly with all the other partners and also individually to the third party for all the acts of the firm done while he is a partner.

Partnership Deed:
A partnership is formed by an agreement, it is essential that there must be some terms and conditions agreed upon by all the partners. These terms and conditions or Agreements may be written or oral. Though the Partnership Act does not expressly require that there should be an agreement in writing. But in order to avoid all misunderstandings and disputes, it is always the best course to have a written agreement duly signed and registered under the Act.

A document in writing which contains the terms of agreement for the partnership is called ‘Partnership Deed’. This document contains the details about all the aspects affecting the relationship between the partners including the objectives of the business, the contribution of capital by each partner, ratio in which the profit and losses will be shared by the partners, and entitlement of partners to interest on capital, interest on the loan, etc. The clauses of the partnership deed can be altered with the consent of all the partners.

Contents of Partnership Deed:

1. Names and Addresses of the firm and its main business.
2. Names and Addresses of all partners.
3. Amount of capital contributed or to be contributed by each partner.
4. The accounting period of the firm.
5. Date of commencement of partnership firm.
6. Rules regarding operations of a bank account.
7. Profit and loss sharing ratio.
8. Duration of partnership, if any.
9. Rate of interest on capital, loan, drawings, etc.
10. Salaries, commissions, etc., if payable to any partner(s).
11. The rights, duties, and liabilities of each partner.
12. Mode of auditor’s appointment, if any.
13. Rules to be followed in case of admission, retirement, death of a partner.
14. Rules to be followed in case of insolvency of one or more partners.
15. Settlement of accounts on the dissolution of the firm.
16. Rules for the settlement of disputes among the partners.
17. Safe custody of the books of accounts and other documents of the firm.
18. Any other matter relating to the conduct of business.

Provisions Relevant for (Affecting) Accounting of Partnership:
Normally, the partnership deed covers all matters relating to the mutual relationship of partners amongst themselves. But if the partnership silent on certain matters, or in the absence of any deed, the provisions of the Indian Partnership Act, 1932 shall apply.

The important provisions affecting partnership accounts are:

1. Profit-Sharing Ratio: In absence of deed or agreement, according to the act, the profit-sharing ratio is equal i.e. the profit and loss of the firm are to be shared equally by the partners, irrespective of their capital contribution in the firm.
2. Interest on Capital: No interest on capital shall be allowed to the partners. In case the deed provides for payment of interest on capital but does not specify the rate, the interest will be paid at the rate of 6% p.a., only from the profits of the firm. It is not payable if the firm incurs losses during the period.
3. Interest on Drawings: No interest is to be charged on drawings.
4. Interest on Loan, Advances: If any partner, apart from his capital, provides a loan to the firm, he is entitled to get interested at the rate of 6% per annum. Such interest shall be paid even if there a losses to the firm.
5. Remuneration to Partners: No partner is entitled to any salary or commission for participating in the business of the firm.

Apart from the above, the Indian Partnership Act specifies that subject to a contract between the partners:

• If a partner derives any profit for himself/herself from any transaction of the firm or from the use of the property or business connection of the firm or the firm name, he/ she shall account for the profit and pay it to the firm
• If a partner carries on any business of the same nature as and competing with that of the firm, he/she shall account for and pay to the firm, all profit made by him/her in that business.

Maintenance of Capital Accounts of Partners:
There are two methods by which the capital accounts of partners are maintained. They are the following:
(a) Fixed Capital Method
(b) Fluctuating Capital Method

(a) Fixed Capital Method: Under the fixed capital method, the capitals of the partner shall remain fixed or unaltered unless some additional capital is introduced or some amount of capital is withdrawn with the consent of all the partners.

In this method, two accounts for each partner are to be maintained:

1. Capital Account
2. Current Account.

1. Capital Account: This account is credited with the amount of capital introduced by the partner. This account will continue to show the same balance from year to year unless some amount of capital is introduced or withdrawn. This account always appears on the liabilities side in the balance sheet.

2. Current Account: All entries relating to drawings, interest on capital, interest on drawings, salary or commission, the share of profit or loss, etc. are made in this account. This account is debited with drawings, interest on drawings, the share of loss, etc. and credited with the interest on capital, salary, commission, the share of profit, etc. The balance of this account will fluctuate from year to year. If it has a credit balance then it will appear on the liabilities side of the Balance Sheet and if it has a debit balance then it will appear on the assets side of the Balance Sheet.

The format of the Capital Account and Current account are as follows:


(b) Fluctuating Capital Method: Under this method, only one account i.e. Capital Account is maintained for each partner. All the entries relating to the interest on capital, salary, commission to partners, the share of profit and loss, drawings, interest on drawings, etc. are directly recorded in the capital accounts of the partners. The balance of this account fluctuates from year to year. The format of Fluctuating Capital Account is as follows:

Partner’s Capital Account

Difference between Fixed and Fluctuating Capital Accounts


Profit and Loss Appropriation Account:
In partnership, net profit after adjustment of partner’s interest on capital, salary, and commission to partner’s, interest on drawings, etc. is distributed among the partners in the agreed profit sharing ratio. For this purpose, a separate account is prepared called Profit and Loss Appropriation Account.

It is merely an extension of the Profit and Loss Account. All adjustments in respect of partner’s commission and salary, interest on capital and on drawings, etc. are made through this account. It starts with the net profit/net loss as per the Profit and Loss Account is transferred to this account.

Journal Entries relating to Profit and Loss Appropriation Account:
1. Transfer of Net Profit/Net Loss as per Profit and Loss Account to Profit and Loss Appropriation Account:
(a) If Profit:
Profit and Loss A/c Dr.
To Profit and Loss App. A/c

(b) If Loss:
Profit and Loss App. A/c Dr.
To Profit and Loss A/c

2. Interest on Capital:
(a) For crediting interest on capital to partner’s Capital/Current
Account:
Interest on Capital A/c Dr.
To Partner’s Capital A/c or Current A/c (Individually)

(b) For transferring interest on Capital to Profit and Loss Appropriation A/c:
Profit and Loss App. A/c Dr
To Interest on Capital A/c OR

Only one entry may be passed in place of the above two entries:
Profit and Loss Appropriation A/c Dr.
To Partner’s Capital/Current A/c (Individually)

3. Interest on Drawings:
(a) For charging interest on drawings to partner’s Capital/ Current A/c:
Partners Capital/Current A/c (Individually) Dr.
To Interest on Drawings A/c

(b) For transferring interest on drawings to Profit and Loss Appropriation Account:
Interest on Drawings A/c Dr.
To Profit and Loss Appropriation A/c OR

Only one entry may be passed in place of the above two entries:
Partner’s Capital/Current A/c (Individually) Dr.
To Profit and Loss Appropriation A/c

4. Salary to Partner(s):
(a) For crediting partner’s salary’ to partner’s Capital/Current A/c:
Salary to Partner A/c Dr.
To Partner’s Capital /Current A/c (Individually)

(b) For transferring partner’s salary to Profit and Loss Appropriation A/c:
Profit and Loss Appropriation A/c Dr.
To Salary to Partner A/c OR

Only one entry may be passed in place of the above two entries:
Profit and Loss Appropriation A/c Dr.
To Partner’s Capital/Current A/c (Individually)

5. Commission to Partner(s):
(a) For crediting partner’s commission to partner’s Capital/ Current A/c:
Commission to Partner A/c Dr.
To Partner’s Capital/Current A/c (Individually)

(b) For transferring partner’s commission to Profit and Loss Appropriation A/c:
Profit and Loss Appropriation A/c Dr.
To Commission to Partner A/c OR

Only one entry may be passed in place of the above two entries:
Profit and Loss Appropriation A/c Dr.
To Partner’s Capital/Current A/c (Individually)

6. Share of Profit/Loss after adjustments:
(a) If Profit
Profit and Loss Appropriation A/c Dr.
To partner’s Capital/Current A/c (Individually)
OR
(b) If Loss:
Partner’s Capital/Current A/c (Individually) Dr. To Profit and Loss Appropriation A/c
Format of Profit and Loss Appropriation Account is given below:
Profit and Loss Appropriation Account

Interest on Capital:
Interest on Capital is generally provided for in two situations:

1. When the partners contribute unequal amounts of capital but share profits equally.
2. When the capital contribution is the same but profit sharing is unequal.
   Interest on Capital = Amount of Capital ×  Rate 100 × Time

When there are both addition and withdrawal of capital by the partners during the financial year, the interest on capital can be calculated as:
1. On the opening balance of Capital A/c, interest is calculated for the whole year.
If the closing balance of the Capital A/c is given then we have to find the opening balance of Capital A/c:
Closing Capital + Drawings during the year + Interest on Drawing – Share of Profits – Salary to Partner – Commission
to Partner – Additional Capital = Opening Capital

2. On the additional capital brought in by any partner during the year, interest is calculated from the date of introduction of additional capital to the last day of the financial year

3. On the amount of capital withdrawn (other than usual drawings) during the year interest for the period from the date of withdrawal to the last day of the financial year is calculated and deducted from the total of the interest calculated under points (1) and (2) above.
Or
Drawing has been made then the amount deducted from the capital and interest is calculated on the balance amount.

The interest on capital is allowed only when there is profit during the financial year. No interest will be allowed on capital if the firm has incurred a net loss during the year. If the profit of the firm is less than the amount due to the partners as interest on capital, the payment of interest will be restricted to the number of profits. In other words, profit will be distributed in the ratio of interest on capital of each partner.

Interest on Drawings:
Drawings is the amount withdrawn, in cash or in-kind, for personal use by the partner(s). Interest on drawings is calculated with reference to the date of withdrawal.

The calculation of interest on drawings under different situations is shown as under:
(a) When Fixed Amount is Withdrawn Every Month/Quarter:
If the equal amount is withdrawn at equal intervals of times, interest on the drawing can be calculated by Monthly/Quarterly Drawing Methods. While calculating the time period, attention must be paid to whether the fixed amount was withdrawn on the first day (beginning) of the month, at the last day (end) of the month, middle of the month, at the beginning of the Quarter or at the end of Quarter. Depending upon the time period the interest on drawings can be calculated as follows:

When drawings are made:
1. At the beginning of each month of the financial year:
Interest on Drawings = Interest on Drawings = Total Drawings ×  Rate 100×61/212
Here, time period is 612 months.

2. At the middle of each month of the financial year
Interest on Drawings = Total Drawings ×  Rate 100×612
Here, time period is 6 months.

3. At the and of each month of the financial year:
Interest on Drawings = Total Drawings ×  Rate 100×51/212
Here, time period is 512 months.

4. At the beginning of the eaclr quarter of the financial year:
Interest on Drawings = Total Drawings ×  Rate 100×71/212
Here, time period is 712 months.

5. At the end of each quarter of the financial year:
Interest on Drawings = Total Drawings ×  Rate 100×41/212
Here, time period is 412 months.

(b) When Varying Amounts are Withdrawn at Different Intervals: When the partners withdraw different amounts of money at different time intervals, the interest is calculated using the production method. In this method, each amount of drawing is multiplied by the number of days/months (from the date of drawings to the last date of the financial year) to find out the product and then all the products are totaled. Here, the total product and interest for 1 month at the given rate are calculated.

Interest on Drawings = Total Drawings ×  Rate 100×112
or
1365

(c) When Dates of Withdrawal are Not Specified: When the total amount withdrawn is given but the dates of withdrawals are not specified, then it is assumed that the amount was withdrawn evenly throughout the year. Here, the time period is taken 6 months.
Interest on Drawings = Total Drawings ×  Rate 100×612

Guarantee of Profit to a Partner:
Sometimes a partner may be guaranteed a minimum amount of profit by one or some or by all the partners in the existing profit sharing ratio or some other agreed ratio. The minimum guaranteed amount shall be paid to a partner when his share of profit as per the profit-sharing ratio is less than the guaranteed amount.

The following steps may be followed in this case:

1. Calculate the share of profit of the partner who has been guaranteed a minimum amount of profit as per profit sharing ratio. If this amount is more than or equal to the amount guaranteed, no adjustment is required.
2. If the share of profit of that partner is less than the guaranteed amount, then we have to find out the difference between the guaranteed amount and the share of profit of that partner.
3. Then, we add this difference to the share of the profit of the partner and deduct the difference from the share of profit of other partners or partner who has guaranteed the amount in the agreed ratio.

Past Adjustments:
Sometimes, after making of final accounts and the distribution of profits among the partners, a few omissions or errors in the recording of transactions or the preparation of summary statements are found. These errors or omissions need adjustments for correction of their impact.

This error or omissions may relate to:

1. Interest on capital may have omitted or have been wrongly treated.
2. Interest in drawings may have been omitted.
3. Salary or commission payable has been omitted in the capital account of the partner.
4. The profit-sharing ratio has been changed from the past.
5. Interest in the partner’s loan has been omitted.

Instead of altering old accounts, necessary adjustments can be made either by:
(a) through ‘Profit and Loss Adjustment Account’
Or
(b) directly in the capital account of the concerned partners.

(a) Profit and Loss Adjustment Account:
1. For omission of Interest on Capital, Salaries to partner(s), Commission to partner, etc.
Profit and Loss Adjustment Account Dr.
To Partner’s Capital/Current A/c (Individually)

2. For omission of Interest on drawings etc
Partner’s Capital/Current A/c Dr.
To Profit and Loss Adjustment Account

3. Calculate the difference or balance of the Profit and Loss Adjustment Account and transfer it to the Capital/Current Accounts of partners in the profit-sharing ratio.
(a) If Profit (Credit balance):
Profit and Loss Adjustment A/c Dr.
To Partner’s Capital/Current A/c (Individually)
OR

(b) If Loss (Debit balance):
Partner’s Capital/Current A/c (Individually) Dr.
To Profit and Loss Adjustment A/c (b) Adjustment through a single entry or directly in the capital account of the concerned partner(s):

In this case, the following steps should be taken:

1. Calculate amount which should have been credited to each partner’s Capital/Current Account by way of (Interest on Capital + Salaries to Partner(s) + Commission to Partner(s) – Interest on Drawings etc.)
2. Distribute the amount calculated in step (1) in the current profit sharing ratio.
3. Calculate the difference between the above two steps for each partner (1) – (2)
   (-) Excess or (+) Short

Pass the following Journal entry:
Excess having Partner’s Capital A/c Dr.
To Short Partner’s Capital A/c

Accounting for Not for Profit Organisation Notes Class 12 Accountancy

There are certain institution or organization which are set-up not to earn a profit, but for providing service to its members and the public in general. The main aim of this institution or organization is rendering service to its members and the public, but not the profit as in the case of business. Such organization includes schools, hospitals, clubs, charitable institutions, religious organizations, trade unions, welfare societies, consumer-cooperatives, literary societies, etc.

These organizations or institutions are managed by a group of people known as trustees who are fully accountable to their members and the society for the utilization of funds and the objectives of the organization. So, they have to maintain proper accounts and financial statements in the form of the Receipt and Payment Account, Income and Expenditure Account, and the Balance Sheet. This financial statement helps them to keep track of their income and expenditure as well as fulfill the legal requirements for maintaining records.

Meaning of Not-For-Profit Organisation:
All trading and business organizations are profit organizations since their main objective is to earn profit. Not-For-Profit Organisations are those organizations whose main aim/objective is to rendering service to their members or the society at large and not the earning of profits.

These organizations refer to the organizations that are set up for the welfare of the society, as charitable institutions, which run without a profit motive. Their main aim is to provide services to its members or the society at large. The funds, raised by such organizations are represented as capital funds or general funds. The main source; of their income usually are subscriptions from their members, donations, grants, income from investment, etc.

These organization keeps the accounting records to meet the statutory requirements and controlling utilization of their funds. They usually prepare them at the end of the financial year to ascertain their income and expenditure and the financial position of the organization and submit them to the statutory authority i.e. Registrar of Societies.

Characteristics of Not-For-Profit Organisation:
1. Service Motive: The main motive of these organizations is service motive. They provide service either free of cost or at a nominal cost and not to earn profit. These are formed for rendering service to a specific group or society at large such as education, health care, recreation, sports, and so on without any consideration of caste, creed, and color.

2. Organisation: Not-For-Profit Organisations are organized as charitable trusts or societies. The subscribers to such trust or societies are called its members.

3. Management: The affairs of Not-For-Profit Organisations are normally managed by a managing committee or executive committee. These committees are elected by their members or subscribers.

4. Source of Income: The main source of income of these organizations are:

1. Subscriptions from members
2. Life-membership fees
3. Endowment fund
4. Donations
5. Legacies
6. Grant-in-aid
7. Income from investments etc.

5. Capital Fund or General Fund: The funds raised by Not-For-Profit Organisations through various sources are credited to capital funds or general funds.

6. Surplus Added to Capital Fund: The surplus generated in the form of excess income over expenditure is simply added to the capital fund or general fund. It is not distributed amongst the members as in trading or business organization.

7. Goodwill: The Not-For-Profit Organisation earn their reputation or goodwill on the basis of their contribution to the welfare of the society rather than on the customers’ satisfaction or owner’s satisfaction.

8. Accounting Records: The accounting records of these organizations are totally different from the trading or business organization. They are not prepared financial statements like Trading Account and Profit and Loss Account, instead, they prepare Receipts and Payment Account and Income and Expenditure Account. The preparation of the Balance Sheet is the same in both organizations.

9. Statutory Requirement: The accounting information provided by such organizations is meant for the present and potential contributors to meet the statutory requirements.

Accounting Records of Not-For-Profit Organisations:
As we know that Not-For-Profit Organisations are not engaged in any trading or business activity normally. Their main source of income is subscriptions/donations, financial assistance or grant from the government, etc. Most of their transactions are in form of cash or through the bank. These organizations are required by law to keep proper accounting records and keep proper control over the utilization of their funds.

For maintaining accounting records these organizations usually keep a cash book to record all receipts and payments and maintain ledger accounts of all income, expenses, assets, and liabilities. In addition, they maintain a stock register to keep records of all fixed assets and consumables.

In place of the capital account, they maintain a capital fund or general fund that goes on increases due to surpluses, life membership fees, donations, legacies, etc. received from year to year.

Final Accounts or Financial Statements of Not-For-Profit Organisations:
As they are non-profit making entities, so they are not required to make Trading and Profit and Loss Account but instead of these accounts to know whether the income during the year was enough to meet the expenses or not they prepare:

1. Receipts and Payment Account,
2. Income and Expenditure Account, and
3. Balance Sheet.

For the preparation of these financial statements, the general principles of accounting are fully applicable. The statements provide the necessary financial information to members, donors, and to the Registrar of Societies.

Along with all these, Not-For-Profit organizations also prepare a trial balance for checking the accuracy of ledger accounts. The trial balance also facilitates the preparation of an accurate Receipt and Payment Account as well as the Income and Expenditure Account and the Balance Sheet.

Receipts and Payment Account:
A Receipts and Payments Account is a summary of cash A transactions. It is prepared at the end of the accounting period from the cash receipts journal and cash payment journals.

“Receipts and Payment Account is nothing more than a summary of the cash book (Cash and Bank transactions) over a certain period, analyzed and classified under the suitable heading. It is the form of account most commonly adopted by the treasurers of societies, clubs, associations, etc. When preparing the results of the year’s working.” – William Pickles

In ‘other words, the Receipt and Payment Account simply is a summary of cash and bank transactions under various heads. On the debit side, it begins with an opening balance of cash and bank and records all the items of receipts irrespective of whether they are of capital or revenue nature or whether they pertain to the current or past or future accounting periods.

The payments are recorded on the credit side without making any distinction between items of revenue and capital nature and whether they belong to the current or past or future accounting period(s). It may be noted that this account does not show any non-cash item like depreciation.

At the end of the period, this account is balanced to ascertain the balance of cash in hand or cash at the bank. The annual totals of various items of receipts and payments are found from their respective accounts in the ledger or from the cash book and are then entered in the Receipts and Payment Account.

Salient Features of Receipts and Payment Account:
1. Real Account: It is a real account, so the rule of a real account i.e. ‘Debit what comes in and credit what goes out, is followed. Thus receipts are recorded on the Debit side and the payments are recorded on the Credit side.

2. Summary of the Cash Book: It is a summary of the cash book. Its form is similar to cash book (without discount and bank column) with debit and credit sides.

3. Shows amount irrespective of period: It shows the total amount of all receipts and payments irrespective of the period to which they pertain.

4. No distinction between nature (Capital or Revenue nature): It includes all receipts and payments whether they are of capital nature or of revenue nature.

5. No distinction between the mode of the transaction (Cash or Bank): No distinction is made in receipts/payments made in cash or through the bank. With the exception of the opening and closing balances, the total amount of each receipt and payment is shown in this account.

6. Do not show non-cash items: Non-cash items like depreciation, outstanding expenses, accrued income, etc. are not shown in this account.

7. Opening and closing balances: The opening and closing balance in its respective mean cash in hand or cash at a bank in the j beginning and at the end. The balance of receipts and payment account must be debit being cash in hand or cash at the bank unless there is a bank overdraft.

8. Does not reflect net income or net loss: Thir account does not tell us whether the current income exceeds the current expenditure or vice versa or in other words, it does not give any information of net 1 income or a net loss.

Steps in the prepare ion of Receipt and Payment Account:
1. Put the opening balance of cash in hand and cash at the bank at the beginning on the Receipt side. If there is a bank overdraft at the beginning, but the same in the Payment side of the account.

2. Enter the total amounts of all receipts (either cash or cheque) in the Receipt side (Dr. side) irrespective of their nature, (whether capital or revenue) and whether they pertain to past, present, and future periods.

3. Enter the total amounts of all payments (either cash or cheque) in the Payment side (Cr. side) irrespective of their nature (whether capital or revenue) and whether they pertain to past, present, and future periods.

4. Do not enter the non-cash item like depreciation, outstanding expenses, accrued income, etc.

5. Find out the difference between the total debit side and the total credit side of the tired account and enter the same on the credit side as the closing balance of cash or bank balances.

But, if the total of credit side is more than of debit side, show the difference on the debit as bank overdraft and close the account.

Examples of Important Receipts and Payments Items:

Format of Receipts and Payments A/c:


There will be either of the two amounts i.e. cash at a bank or bank overdraft, not both.

Limitations of Receipts and Payments Account:

1. It does not show expenses and incomes on an accrual basis.
2. It does not show whether the organization is able to meet its day-to-day expenses out of its income.

Income and Expenditure Account:
It is a nominal account of the Not-For-Profit Organisation equivalent to the profit and loss account of the trading concerns. The terms profit is substituted by the words excess of income over expenditure (surplus) and the loss is expressed as an excess of expenditure over income (deficit).

It reveals the surplus or deficit arising out of the organization’s activities during an accounting period. This account is prepared on an accrual basis and includes only items of revenue nature. All the revenue items relating to the current period are shown in this account, the expenses and losses on the expenditure side (debit side), and incomes and gains on the income side (credit side) of the account. It shows the net operating result in the form of surplus or deficit, which is transferred to the capital fund shown in the balance sheet.

Salient Features of Income and Expenditure Account:
1. Nominal Account: It is a nominal account, therefore the rule of nominal account i.e. “Debit all expenses and losses and credit all incomes and gains” is followed.

2. Ignore Items of Capital Nature: In this account, only items of revenue nature are to be considered and all the items of capital nature should be ignored.

3. Prepare from Receipt and Payment Account: It is generally
prepared from a given Receipts and Payments Account and other information after making necessary adjustments.

4. No Opening and Closing Balances: In this account, no opening and closing balances of cash and bank are recorded.

5. Same as Profit and Loss Account: This account is prepared in the same manner in which a Profit and Loss Account is prepared, considering, all adjustments relating to the current year.

6. Exclude Past and Future Items: It excludes all the items of j income and expenditure which do not pertain to the current period.

7. End-balance of this Account: The end balance of the Income and Expenditure Account, which may be either ‘excess of income over expenditures’ or ‘excess of expenditure over income’ would be added to or deducted from, as the case may be, tire capital fund, on the liabilities side of the Balance Sheet.

Steps in the Preparation of Income Expenditure Account:

1. From the Receipts and Payments, the Account excludes the opening and closing balance of cash and bank as they are not an income.
2. Exclude the items of capital nature as these are to be shown in the balance sheet.
3. Take out the revenue receipts only for the current year to be shown on the income side of the Income and Expenditure Account. These are adjusted by excluded the amounts relating to the preceding and the succeeding periods and including the amounts relating to the current year not yet received.
4. Take out the revenue payments only for the current year to be shown on the expenditure side of the Income and Expenditure Account. These are adjusted by excluded the amounts relating to the preceding and the succeeding periods and including the amounts relating to the current year not yet paid,
5. Make the adjustments of non-cash items like:
   (a) Depreciation on fixed assets.
   (b) Provision for doubtful debts, if required.
   (c) Profit or Loss on sale of fixed assets etc.

For determining the surplus/deficit for the current year.

So, we can also prepare the Income and Expenditure Account with the help of the following methods after considering Receipt and Payment Account and information given:

Income and Expenditure Account for the year ended.

Format of Income and Expenditure Account Income and Expenditure Account for the year” ended.


The distinction between Income and Expenditure Account and Receipt and Payment Account


Balance Sheet:
Not-For-Profit organizations prepare a Balance Sheet at the end of an accounting period to ascertain the financial position of the organization. The preparation of their Balance Sheet is the same as that of the business or trading entities. It is prepared in the usual way showing assets on the ‘right-hand side’ and the liabilities on the ‘left-hand side. However, the term capital is not to be found.

Instead, there will be a capital fund or a general fund, or an accumulated fund, and the surplus or deficit as per Income and Expenditure Account shall be added to or deducted from this fund. Some capitalized items like legacies, entrance fees, and life membership fees directly (added) in the capital fund.

Sometimes it becomes necessary to prepare a Balance Sheet at the beginning of the year in order to find out the opening balance of the capital/general fund.

Steps in the Preparation of Balance Sheet:
1. Find out the Capital fund as per the Opening Balance Sheet and add surplus from the Income and Expenditure Account. Then, add capitalized items like legacies, entrance fees, and life membership fees, etc. received during the year.

2. Put all the fixed assets (from the opening balance sheet) with additions (from Receipts and Payments Account) after charging depreciation (as per Income and Expenditure Account), on the assets side of the balance sheet.

3. Compare items on the receipts side of the Receipts and Payments Account with the income side of the Income and Expenditure Account to find out the amounts of:
(a) Subscription due but not yet received,
(b) Income received in advance,
(c) Sale of fixed assets made during the year,
(d) Items to be capitalized etc.

4. Compare items on the payment side of the Receipts and Payments Account with the expenditure side of the Income and Expenditure Account to find out the amount of:
(a) Outstanding Expenses,
(b) Prepaid Expenses,
(c) Purchases of a fixed asset during the year,
(d) Depreciation on fixed assets,
(e) Stock of consumable items like stationery in hand,
(f) Closing balance of cash in hand and cash at bank etc.

Format of Balance Sheet:
Balance Sheet of……………………
as on…………………….

Some Important items relating to Not-For-Profit Organisations:
1. Subscription: It is the amount paid by the members of the organization periodically so that their membership is not canceled. This is the main source of income of Not-For-Profit Organisations.

Treatment:

1. The total amount of subscriptions received during the accounting period is shown on the receipt side (Dr. side) of the Receipt and Payment Account.
2. Subscription related to the current period shown in the income side (Cr. side) of Income and Expenditure Account. The amount of subscription to be shown in the Income and Expenditure Account is calculated as follows :
   Table Showing Calculation of Subscriptions
   
   or
   Subscription Account
   
3. Subscription Outstanding at the end of the year is shown on the assets side of the Balance Sheet and subscription received in advance in the current year for the next year is shown on ‘ the liabilities side of the Balance Sheet.

2. Donations: It is a type of gift in cash or in property received from some person, firm, or company. The donation can be for specific purposes or for general purposes. Both the donation received appears on the receipts side of the Receipts and Payments Account.
1. Specific Donations: If the amount received as the donation is for a specific purpose such as a donation for extension of the existing building, donation for the library, for construction of new computer laboratory, etc., it is capitalized and is shown in the liabilities side of Balance Sheet.

2. General Donations: Such donations are to be utilized to promote the general purpose of the organization. It is of two types:
(a) General Donation of Big Amount: It is shown on the liability side of the Balance Sheet because it is non-recurring in nature as the donations of huge amounts cannot be expected every year.
(b) General Donation of Small Amount: These are treated as revenue receipts as it is a regular source of income hence, it is taken to the income side of the Income and Expenditure Account of the current year.

3. Legacies: It is in the nature of a gift, received in cash or in the property as per the will of a deceased person. It is not treated as an income because it is not of recurring nature. Such receipts come very rarely and therefore it is of a capital nature and is shown on the liabilities side of the Balance §heet. It appears on the receipt side of the Receipts and Payments Account and is directly added to Capital Fund in the Balance Sheet. However, legacies of the small amount may be treated as income and show on the income side of the Income and Expenditure Account.

4. Life Membership Fees: In order to become a member of an organization for the whole of the life, some members pay the fee in lump sum i.e. once in their lifetime. It is a receipt of non-recurring nature since the members will not be required to pay the fees regularly. It is shown on the receipt side of the Receipt and Payment Account and added to the Capital Fund in the Balance Sheet. It should not be credited to the Income and Expenditure Account.

5. Entrance Fees: The entrance fee also known as the Admission Fee is paid only once the member at the time of becoming a member.
1. In the case of organizations like clubs and some charitable institutions, where the membership is limited and the amount of Entrance Fees is quite large. It is treated as a non-¬recurring item and added directly to Capital Fund in the Balance Sheet and also shows in the receipt side of the Receipt and Payment Account.

2. For some organizations like educational institutions the entrance fee is a regular income and the amount is quite small. So it is treated as the recurring item and shown in the income side of the Income and Expenditure Account. It is also shown on the receipt side by the Receipt and Payment Account.

From the examination point of view, if there is no specific instruction about Entrance Fees, it should be treated as Capital Receipt and directly added to Capital Fund in the Balance Sheet.

6. Sale of Old Assets: Receipt from the sale of the old asset appears in the receipt side of Receipt and Payment Account. Only the profit or loss on the sale of a fixed asset is credited or debited, as the case may be, to the Income and Expenditure Account. In the Balance Sheet, the book value of the asset sold should be deducted from the relevant asset.

7. Sale of Periodicals: Receipts from the sale of periodicals shown in the receipt side of Receipt and Payment Account. It is an item of recurring nature and shown in the income side of the Income and Expenditure Account.

8. Sale of Sports Materials: The sale of sports materials like old bats, old nets, etc. is a regular feature with any sports club. It is treated as revenue income on the assumption that their book value is zero. It is therefore shown in the income side of the Income and Expenditure Account. It is also shown on the receipt side of the Receipt and Payment Account.

9. Payment of Honorarium: It is the payment made to a person for his specific services rendered by him, not as a regular employee. This is an item of expense and is shown in the ‘debit or expenditure side’ of the Income and Expenditure Account.

10. Endowment Fund: “It is a fund arising from a bequest or gift, the income of which is devoted for a specific purpose. – Eric L. Kohler

Thus, Endowment Fund is a capital receipt and is shown on the liabilities side of the Balance Sheet.

11. Government Grant: Some organizations like schools, colleges, public hospitals, etc. depend upon Government grants for their activities.

It is shown on the receipt side of the Receipt and Payment Account:

1. The tie maintenance grant is a recurring grant. It is treated as a revenue receipt and shown on the income side of the Income and Expenditure Account.
2. Grants such as building grants are treated as capital receipts and transferred to the building fund account.
   Cash subsidy: Some Not-For-Profit Organisations receive cash subsidies from the Government or Government agencies. This subsidy is also treated as revenue income for the year in which it is received.

12. Special Funds: Not-For-Profit Organisation creates some special funds for a specific purpose such as ‘prize funds’, ‘match fund’ and ‘sports fund’ etc. The number of such hands is invested in securities and the income earned on such investment is added to the respective fund, not credited to the Income and Expenditure Account. Similarly, the expenses incurred on such a specific purpose are also deducted from the fund.

13. Stationery (or some consumable items): Expenses incurred on Stationery (or some consumable items) are charged to the Income and Expenditure Account.

If the opening or closing stock of stationery is given, then the amount of stationery consumed during the year will be shown in the Income and Expenditure Account and the closing stock in the Balance Sheet.

The calculation for Expenses for the Current Year

Total Amount Paid shown in Payment side of Receipt and Payment Account. Outstanding expenses at the end of the current year shown in the Liabilities side of the Balance Sheet and prepaid at the end shown in the Assets side of the Balance Sheet.

The calculation for Income for the Current Year

Total Amount Received shown in Receipt side of Receipt and Payment Account. Accrued income at the end of the current year shown in assets side of Balance Sheet and Income received in advance at the end of the current year shown in the liabilities side of Balance Sheet

Cash Flow Statement Notes Class 12 Accountancy Chapter 6

The Income Statement and the Balance Sheet (Position Statement) are the two important and basic financial statements prepared by every business enterprise. Income Statement shows the profit or loss incurred by the enterprise for the accounting period and the Balance Sheet discloses the financial condition or position at a particular date. But many of those who study these statements are, for different reasons, also interested in knowing the inflow and outflow of cash.

Hence, many companies presented along with the final accounts, a statement called ‘Cash Flow Statement’ which shows inflows and outflows of the cash and cash equivalent. In June 1995, the Securities and Exchange Board of India, (SEBI) amended clause 32 of the Listing Agreement requiring every listed company to give along with its balance sheet and profit and loss account, a Cash Flow Statement prepared in the prescribed format showing separately cash flows from operating activities, investing activities and financing activities.

Meaning of Cash Flow Statement
A Cash Flow Statement is a statement that shows inflow (receipts) and outflow (payments) of cash and its equivalents in an enterprise during a specified period of time. Accounting Standard (AS-3) Revised issued by the Institute of Chartered Accountant of India on Cash Flow Statement in March 1997 has defined Cash Flow Statement as “a statement which shows inflows (receipts) and outflows (payment) of cash and its equivalents in an enterprise during a specified period of time.” According to the revised accounting standard 3, an enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented.

The terms, Cash, Cash Equivalents, and Cash Flows explained below:
Cash: It comprises cash in hand and demand deposits with banks.

Cash Equivalents: They are short term highly liquid investments that are readily convertible into cash and which are subject to an insignificant risk of change in value. An investment normally qualifies as a cash equivalent only when it has a short maturity, of say three months or less from the date of acquisition. Cash equivalent is held for the purpose of meeting short-term cash commitments rather than for investment or another purpose.

Cash Flows are inflows and outflows of cash and cash equivalents. An inflow increases the total cash and cash equivalents at the disposal of the enterprise whereas an outflow decreases them.

As per AS 3, Cash Flows exclude movements between items that constitute cash or cash equivalents because these components are part of the cash management of an enterprise rather than part of its operating, investing, or financing activities.

Objectives of Cash Flow Statement
The basic objective of the Cash Flow Statement is to highlight the change in the cash position including the sources from which cash was obtained by the enterprise and specific uses to which cash was applied.

The Cash Flow Statement serves a number of objectives which are following:
1. Depict Inflows and Outflows of Cash: The cash Flow Statement gives information about cash inflows and cash outflows of an enterprise during a particular period from operating activities, investing activities, and financing activities. It is an effective tool for managing cash.

2. Cash Flow information helps in Planning: Cash Flow Statements provide information for planning for short-range cash needs of the enterprise. It helps in the formulation of financial policies.

3. Helping in understanding the Liquidity of the Enterprise: Cash Flow Statement helps the enterprise to assess whether it would meet its current obligations or not. It also helps the lending institutions like banks etc to ascertain the liquidity of the enterprise.

4. Help in preparing Cash Budget: A cash Flow Statement helps the management of the firm in preparing a Cash Budget.

5. Analysis Management of Cash: CashFlow Statement reveals good and bad points relating to the management of Cash.

According to AS-3 (Revised) the objectives of the Cash How Statement are as follows: ” Information about the cash flow of an enterprise is useful in providing users of financial statements with a basis of assessing the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize these cash flows.

The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation. The statement deals with the provision of information about the historical changes in cash and cash equivalent of an enterprise by means of a cash flow statement which classifies cash flows during the period from operating, investing and financing activities.”

Advantages of Cash Flow Statement
A Cash Flow Statement is a useful financial statement and provides the following benefits:
(a) It enables the management to identify the magnitude and directions of changes in cash.
(b) It enables the users to evaluate the changes in the economic resources of an enterprise.
(c) It enables the users to evaluate the changes in financial structure. ‘
(d) It enables the users to evaluate the changes in net assets of enterprises.
(e) It enables the users to evaluate the enterprise’s ability to alter the amounts and timings of cash flows in order to adapt to changing circumstances and opportunities.
(f) It is useful in assessing the ability of the enterprise to generate Cash and Cash Equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises.
(g) As a tool of planning, the Projected Cash Flow Statement enables the management to plan its future investments, operating, and financial activities such as repayment of long-term loans and interest thereon, modernization or expansion of the plant, payment of cash dividend, etc.
(h) It helps in efficient cash management. The management can know the adequacy or otherwise of cash and can plan for the effective use of surplus cash or can make the necessary arrangement in case of inadequacy of Cash.
(i) It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.

Classification of Cash Flows
A Cash Flow Statement shows the inflow and outflow of cash and cash equivalents from various activities of a company during a specific period. As per AS-3, these activities can be classified into three categories which are following:

1. Operating activities
2. Investing activities
3. Financing activities

1. Operating Activities: Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. Cash flows from operating activities generally result from the transactions and other events that enter into the determination of net profit or loss.

The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise to pay dividends, repay loans and make investments without resources to extent source of financing. Examples of Cash Flows from operating activities are:

Cash Inflows from Operating Activities:

1. Cash receipts from the sale of goods and rendering of services.
2. Cash receipts from royalties, fees, commissions, and other revenues.
3. Cash receipts relating to future contracts, forward contracts, option contracts, and swap contracts when the contracts are held for dealing or trading purpose.
4. Cash receipts as income tax refunds unless they can be specifically identified with financing and investing activities.

Cash Outflows from Operating Activities:

1. Cash payments to suppliers of goods and services.
2. Cash payments to and on behalf of employees for wages, salaries, etc.
3. Cash payments of income tax unless they can be specified as financing or investing activities.
4. Cash payments for future contracts, forward contracts, etc.
5. Cash Payments for interest etc.

2. Investing Activities: As per AS-3 investing activities are the acquisition and disposal of long-term assets (such as land, building, plant, machinery, etc.) and other investment not included in cash equivalents. It is important to make a separate disclosure of cash flows arising from investing activities because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Cash Inflows from Investing Activities:

1. Cash receipts from disposal of fixed assets.
2. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interest in joint ventures other than cash equivalents.
3. Cash receipts from the repayment of advances and loans made to third, parties (other than advances and loans of the financial enterprise.)
4. Interest received in cash from loans and advances.
5. Dividend received from investment in other enterprises.

Cash Outflows from Investing Activities:

1. Cash payments to acquire fixed assets.
2. Cash payment, relating to capitalized research and development costs.
3. Cash payment, to acquire shares, warrants, etc. other than cash equivalent.
4. Cash advances and loans made to a third party (other than advances and loans made by a financial enterprise wherein it is operating activities.)

3. Financing Activities: As per AS-3, financing activities are activities that result in changes in the size and composition of the owner’s capital (including preference share capital in the case of a company) and borrowings of the enterprise. The separate disclosure of cash flows from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.

Cash Inflows from Financing Activities:

1. Cash proceeds from issuing shares or other similar instruments.
2. Cash proceeds from issuing debentures, loans, bonds, and other short or long-term borrowings.

Cash Outflows from Financing Activities:

1. Cash repayments of the amounts borrowed.
2. Payment of dividend, Interest, etc.
3. Redemption of Preference Shares.

Classification of Business Activities as per AS-3, showing Inflow and Outflow of Cash.



Treatment of Important Items:
1. Extraordinary Items: Extraordinary items are not the regular phenomenon for example loss due to theft or fire or flood, winning of a lawsuit, or a lottery. They are non-recurring in nature and hence cash flow associated with extraordinary items is disclosed separately as arising from operating, investing, or financing activities in the cash flow statement, to enable users to understand their nature and effect on the present and future cash flows of the enterprise.

2. Interest and Dividend: Treatment of cash flows from interest and dividends can be described under two heads which are the followings:
1. In the case of a financial enterprise (whose main business is lending and borrowing), cash flows arising from interest paid and interest and dividend received are classified as cash flows from operating activities, while dividend paid is classified as a financing activity.

2. In the case of a non-financial enterprise, cash flows arising from interest and dividends paid should be classified as cash flows from financing activities while interest and dividend received should be classified as cash flows from investing activities.

3. Taxes on Income and Gains: Taxes may be income tax, capital gains tax, dividend tax, etc. As per AS-3, cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.

This clearly implies that:

1. Tax on Operating Profit i.e. Income Tax should be classified as operating cash flows.
2. Dividend tax i.e. tax on the amount distributed as a dividend to shareholders should be classified as financing activity along with dividend paid.
3. Capital Gains Tax i.e. tax on capital profits like tax paid on the sale of fixed assets should be classified under investing activities.
4. Non-Cash Transactions: As per AS-3, investing and financing transactions which do not involve inflow or outflow of cash or cash; equivalent, are excluded from the cash flow statement. But significant such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.

Examples of the non-cash transaction are:

1. Acquisition of fixed assets by the issue of share or on Credit.
2. Redemption of debenture by conversion into equity share.
3. Acquisition of an enterprise by means of an issue of share. s

Preparation of Cash Flow Statement: (Main Heads Only):

Cash Flows from Operating Activities:
Operating activities are the main source of revenue and expenditure in an enterprise. Therefore, the ascertainment of cash flows from operating activities is of prime importance.

As per AS-3, an enterprise should report cash flows from -N * operating activities using either by.
Direct Method
or
Indirect Method
In Direct Method, major classes of gross cash receipts and gross cash payments, are disclosed.
or
In the Indirect Method, net profit or loss is adjusted for the effects of

1. Transactions of a non-cash nature.
2. any deferrals or accruals of past/future operating cash receipts.
3. Items of income or expenses associated with investing or financing cash flows.

Direct Method:
As we know that items are recorded on an accrual basis in profit and loss accounts therefore certain adjustments are made to convert them into cash bases.

These adjustments are discussed below:
1. Cash Inflow from Sales: Total Sales include Cash Sale and Credit Sale both. Cash sales is a cash inflow, but in the case of credit sales, cash receipts from Debtors are calculated as follows:

Cash receipts from Customers = Credit Sales + Opening Debtors and Bills Receivable: Closing Debtors and Bills Receivable – Bad Debts – Discount Allowed – Sales Returns.

2. Cash Outflow from Purchases: Total Purchases include both cash purchases and credit purchases. Cash purchases are cash outflow, but in the case of credit purchases, cash paid to the suppliers is calculated as follows:

Cash paid to Suppliers = Credit Purchases + Opening Creditors and Bills Payable – Closing Creditors and Bills Payable – Discount received – Purchases Returns.

Purchases = Cost of Goods Sold – Opening Stock + Closing Stock

3. Cash Outflow on Expenses Incurred: The figures of expenses given in the Profit and Loss Account have to be adjusted to find out cash outflow. The amount outstanding and the amount paid in advance have to be adjusted for this purpose.
Cash Paid for Expenses = Expenses as given in Profit & Loss A/c – Prepaid Expenses in the beginning and Outstanding Exp. at the end + Prepaid Expenses at the end and Outstanding Expenses in the beginning.

However, the following items are not to be considered:
1. All non-cash items are ignored as no cash is involved in them. Examples are:
(a) Depreciation
(b) Discount on issue of Shares written off
(c) Goodwill written off.
(d) Preliminary Expenses are written off
(e) Discount on issue of Debenture written off
(f) Patents and Copyright wrote off
(g) Underwriting commission written off.

2. Appropriations of transfer to different reserves and provisions like to General Reserve, Provision for Taxation, and Proposed Dividend should be ignored.

3. Items that are classified as investing or financing activities like profit or loss on sale of fixed assets, interest received, the dividend paid, etc. are also ignored.

Cash Flows From Operating Activities (Direct Method)

Indirect Method:
In this method, net profit or loss is adjusted for the effects of transactions of a non-cash nature flow. In other words, Net profit or loss is adjusted for items that affected net profit but did not affect cash.

As per AS-3, (Revised), under the indirect method, net cash flow from operating activities is determined by adjusting net profit or loss for the effects of:
1. Non-cash items are to be added back. Non-cash items like
(a) Depreciation
(b) Goodwill has written off
(c) Patents and Copyrights are written off
(d) Appropriation to General Reserve
(e) Interim dividend
(f) Deferred taxes etc.

2. All other items for which the cash effects are investing or financing cash flows. The treatment of such items depends upon their nature. All investing and financing incomes are to be deducted from the number of net profits while all such expenses are to be added back.

3. Changes in current assets and liabilities during the period. An increase in current assets and a decrease in current liabilities are to be deducted while the increase in current liabilities and a decrease in current assets are to be added up.

Cash Flows from Operating Activities (Indirect Method)

Cash Flow from Investing Activities:
Investing activities are the acquisition and disposal of long terms assets and other investments not included in cash equivalent. Accordingly, cash inflow and outflow relating to fixed assets, shares, and debentures of other enterprises, advances, and loans to third parties and their repayments are shown separately under Investing activities in the Cash Flow Statement.

It is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Cash Flow from Investing Activities

Cash Flows from Financing Activities:
The Financing Activities of an enterprise are those activities that result in a change in size and composition of owners capital and borrowing of the enterprise. It includes separate disclosure of proceeds from the issue of shares or other similar instruments, issue of debentures, loans, bonds, other short-term or long-term borrowings, and repayment of amounts borrowed. It is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings to the enterprise.)

Cash Flow from Financing Activities

Format for Cash Flow Statement (As Per AS-3 (Revised))
1. Direct Method
Cash Flow Statement for the year ended………….



2. Indirect Method
Cash Flow Statement for the year ended…………