Author Archives: Swati

Short Answer Type Question:

Q.1 Define Partnership Deed

ANSWER: Partnership Deed is a written agreement among the partners of a partnership firm. It includes agreement on profit sharing ratio, salaries, commission of partners, interest provided on partner’s capital and drawings and interest on loan given or taken by the partners, etc. Generally following details are included in a partnership deed.

1. Objective of business of the firm

2. Name and address of the firm

3. Name and address of all partners

4. Profit and loss sharing ratio

5. Contribution to capital by each partner

6. Rights, types of roles and duties of partners

7. Duration of partnership

8. Rate of interest on capital, drawings and loans

9. Salaries, commission, if payable to partners.

10. Rules regarding admission, retirement, death and dissolution of the firm, etc.

Q.2 Why it is considered desirable to make the partnership agreement in writing.

ANSWER: Partnership agreement may be oral or written. It is not compulsory to form partnership agreement in writing under the Partnership Act, 1932. However, written partnership deed is desirable than oral agreement as it helps in avoiding disputes and misunderstandings among the partners. Also, it helps in settling disputes (as the case may be) among the partners, as written partnership deed can be referred to anytime. If written partnership deed is duly signed and registered under Partnership Act, then it can be used as evidence in the court of law.

Q.3 List the items which may be debited or credited in the capital accounts of the partners when:

(i) Capitals are fixed

(ii) Capitals are fluctuating

ANSWER:

(i)When Capitals are fixed

The following items are credited in the Partner’s Capital Account when capital accounts are fixed.

(a) Opening balance of capital

(b) Additional capital introduced during an accounting year

The following items are debited in the Partner’s Capital Account when capital accounts are fixed.

(a) Part of capital withdrawn

(b) Closing balance of capital

(ii) When Capitals are fluctuating

The following items are credited in the Partner’s Capital Account when capital accounts are fluctuating.

(a) Opening balance of capital.

(b) Additional capital introduced during an accounting year

(c) Salaries to the partners

(d) Interest on capital

(e) Share of profit

(f) Commission and bonus to the partners

The following items are debited in the Partner’s Capital Account when capital accounts are fluctuating.

(a) Drawings made during the accounting period

(b) Interest on drawings.

(c) Share of loss.

(d) Closing balance of capital.

Q.4 Why is Profit and Loss Adjustment Account prepared? Explain.

ANSWER: The Profit and Loss Adjustment Account is prepared because of the following two reasons.

1. To record omitted items and rectify errors if any– After the preparation of Profit and Loss Account and Balance Sheet, if any error or omission is noticed, then these errors or omissions are adjusted by opening Profit and Loss Adjustment Account in the subsequent accounting period without altering old Profit and Loss Account.

2. To distribute profit or loss between the partners– Sometimes, besides adjusting the items and rectifying errors, this account is also used for distribution of profit (or loss) among the partners. In this situation, this account acts as a substitute for Profit and Loss Appropriation Account. The main rationale to prepare the Profit and Loss Adjustment Account is to ascertain true profit or loss.

Q.5 Give two circumstances under which the fixed capitals of partners may change.

ANSWER: The following are the two circumstances under which the fixed capitals of partner may change.

(i) If any additional capital is introduced by the partner during the year.

(ii) If any part of capital is permanently withdrawn by the partner from the firm.

Q.6 If a fixed amount is withdrawn on the first day of every quarter, for what period

the interest on total amount withdrawn will be calculated?

ANSWER: If a fixed amount is withdrawn on the first day of every quarter, then the interest is calculated on the amount withdrawn for a period of seven and half () months.

Example:

If a partner withdraws Rs 5,000 in the beginning of each quarter and the interest is charged @ 10% on the drawings, then interest on drawings is calculated as:

Total drawings made by the partner during the whole year are Rs 20,000, i.e. Rs 5000× 4.

Interest on drawings 

Q.7 In the absence of partnership deed, specify the rules relating to the following:

(i) Sharing of profits and losses.

(ii) Interest on partner’s capital.

(iii) Interest on Partner’s drawings.

(iv) Interest on Partner’s loan

(v) Salary to a partner.

ANSWER: (i) Sharing of profits and losses: If the partnership deed is silent on sharing of profit or losses among the partners of a firm, then according to the Partnership Act of 1932, profits and losses are to be shared equally by all the partners of the firm.

(ii) Interest on partner’s capital: If the partnership deed is silent on interest on partner’s capital, then according to the Partnership Act of 1932, no interest on capital should be given to the partners of the firm.

(iii) Interest on partner’s drawings: If the partnership deed is silent on interest on partner’s drawings, then according to the Partnership Act of 1932, no interest on drawing should be charged from the partners of the firm for the amount of capital withdrawn in form of drawings.

(iv) Interest on partner’s loan: If the partnership deed is silent on interest on partner’s loan, then according to the Partnership Act of 1932, the partners are entitled for 6% p.a. interest on the loan forwarded by them to the firm.

(v) Salary to a partner: If the partnership deed is silent on salary to a partner, then according to the Partnership Act of 1932, no salary should be given to any partner.

Long Answer Type Questions:

Q.1 What is partnership? What are its chief characteristics? Explain.
  ANSWER: According to the Section 4 of the Partnership Act, 1932
Partnership is an agreement between two or more persons who have agreed to share profits or losses of a business that will be carried by all or any one of them acting for all.
Person who joined their hands to set up the business are called ‘partners individually and ‘firm’ collectively and the name under which they carry out their business is termed as ‘firm name’.
The following are the important characteristics of partnership
(i) Two or More Persons
In order to form partnership, there should be at least two person coming together for a common goal In other words, the minimum number of partners in a firm can be two. There is however, a limit on their maximum number, if a firm is engaged in the banking business, it can have a maximum of ten partners while in case of any other business, the maximum number of partners can be twenty.
(ii) Partnership Deed
A partnership deed is an agreement among the partners which contains all the terms of the partnership. It generally contains the details about all the aspects affecting the relationship between the partners including the objective of business, contribution of capital by each partner, ratio in which the profits and the losses will be shared by the partners and entitlement of partners to interest on capital, interest on loan, etc.
(iii) Business
One of the important characteristics of a partnership is that it is formed to carry out a legal business. Partnership in case of illegal business is not valid.
(iv) Sharing of Profit
In case of a partnership the partners are suppose to share profit or loss on an agreed ratio or as per the provisions of the Partnership Act, 1932, as per which they will share profit equally.
(v) Liability
In the case of a partnership liability of partners are unlimited. If there is any obligation against the third party the partner will have to pay it out of his personal property.

Q.2 Discuss the main provisions of the Indian Partnership Act, 1932 that are relevant to partnership accounts if there is no partnership deed.
ANSWER: It is always suggested that there must be a partnership deed among the partners before getting into any partnership venture. But sometimes a partnership is started without signing any such document. In this case the rules of partnership will be applicable as per the provisions of the Indian Partnership Act, 1932. The following are the provisions that are relevant to the partnership accounts in absence of partnership deed.
(i) Profit Sharing Ratio When a partnership deed is not made or even if it is made and silent on sharing of profit or losses among the partners of a firm, then according to the Partnership Act 1932, profits and losses are to be shared equally among all the partner of the firm.
(ii) Interest on Capital When there is absence of partnership deed or the partnership deed is silent on the issue related to interest on partner’s capital, then according to the Partnership Act 1932, no interest on partners’ capital will be provided. However, if they mutually agree on this issue than they are free to give interest on capital out of the profit of the firm.
(iii)Interest on Drawings  there is no partnership Peed the issue ‘elated h die interest on drawing will be handled according to the provisions Partnership Act. 1932 According sc which no Interest on drawing will be charge loan the orders on withdraw in the form of drawings.
(iv) Interest on Partner’s Loan When there is no partnership deed among the partners or the partnership deed is silent on interest on partner’s loan then according to the Partnership Act, 1932. the partners are entitled for 6% pa interest on the loan forwarded by them to the firm
(v) Salary to Partner When partnership deed is not there or it is silent on the issue related to salary to a partner, then as per the rules of the partnership Act. 1932. no partner will be entitled to any salary.

Q.3 Explain why it is considered better to make a partnership agreement in writing.
ANSWER:  As per Partnership Act. 1932, it is not necessary that a partnership agreement must be in writing but still it is always suggested that it should be in written form. Because today there are very good relationship among the partners but in future there may be any dispute regarding any Issue a written partnership agreement will help in avoiding dusputes and misunderstandings among the partners.
In this way a written partnership deed is more desirable than the ora agreements. A written partnership agreement ensures the smooth functioning of the business of the partnership firm It aiso helps in settling the disputes among the partners. Moreover a duly signed and registered partnership deed can be used as evidence in the court of law. Therefore, it s desirable to form partnership deed in writing because of the moots associated with written documents over its oral counterparts.

Q.4 Illustrate how interest on drawings will be calculated under various situations.
ANSWER: When a partner withdraws any amount, either in cash or in any other form, from the firm for his/her personal use, then it is termed as drawings. The interest charged by the firm on the amount of drawings is termed as interest on drawings. The method of calculating interest on drawings depends on the information available for time and frequency of the drawings made by the partner. The following different situations of drawings made illustrate the calculation of interest charged on drawings.
Situation I When ail the information regarding amount, date and rate of interest on drawings is given
When a partner withdrew Rs 10,000 on July 01 and interest on drawings is charged at 12% pa and the firm closed its books on December 31 every year then interest on drawings amount to Rs 600.

Situation(II) When information regarding amount, rate of interest on drawings is given
Case I Sometimes amount and rate of interest on drawings (per annum) is given but date is not mentioned
in this case when the details regarding the amount of drawings and rate of interest on drawings (pa) is given but the date of drawings is not given then interest will be charged on average basis and the period of drawings will be taken as 6 months

Case II Sometimes the amount and rate of is interest on drawings is given but the date and per anum rate of interest is not mentioned.
In this case when the date and the rate of interest aim given but per annum is not specified, then annual interest is charged.
e.g., If a partner withdrewRs 10 000 and interest rate is 12%, then the interest on drawings amounts to Rs.12,000.

Situation III When a fixed amount is withdrawn at regular interval
Case I Sometimes a fixed amount is withdrawn at the beginning of each month and the rate of interest is given then the interest is calculated for 6 5 months.
e.g.. If a partner withdraws Rs1,000 in the beginning of every month and the rate of interest is 12% pa, then the interest on drawings amount to RS 780.

Case II Sometimes a fixed amount is withdrawn at the end of each month and the rate of interest is given then the interest is calculated for 5.5 months.
e.g.. if a partner withdraws Rs 1.000 at the end of each month arid rate of interest is 12% pa then the interest on drawings amount to Rs 660.

Case III Sometimes a fixed amount is withdrawn at the mid of each month and the rate of interest is given then the interest is calculated for 6 months.
e g. if a partner.withdraws Rs.1,000 on 15th of every month and the rate of in’crest is 12% pa then the interest on drawings amount to Rs 720.

Case IV If a fixed amount is withdrawn in the beginning of every quarter then the interest is calculated for 7.5 months.
e.g.. If a partner withdraws Rs.5,000 in the beginning of every quarter and the rate of interest is 12% pa then the interest on drawings amount to Rs 1,800.

Case V If a fixed amount is withdrawn at the end of every quarter, then the interest is calculated for 4.5 months.
e.g., If a partner withdraws Rs. 5,000 at the end of every quarter and the rate of interest is 12% pa then the interest on drawings amounts to Rs. 900

Situation IV When different amount is at different intervals
When different amount is withdrawn by a partner at different dates then the interest is calculated by product method. The period of drawings is calculated from the date of withdrawal to the last date of the accounting year,
e.g., A partner withdraws?6,000 on March 01, Rs.4,000 on June 01, Rs.5,000 on Aug 30 and Rs.2,000 on Nov 30 and the rate of interest on drawings is 12% pa. The firm closes its book on December 31.

Q.5 How will you deal with a change in profit sharing ratio among existing partners? Take imaginary figures to illustrate your answer.
ANSWER:  Change in the profit sharing ratio occurs only in case of the admission, retirement or death of a partner or sometimes due to the general agreement among the partners in which they may decide to change the profit sharing ratio. There may be number of issues that should be considered during the change in the profit sharing ratio such as goodwill, reserves and accumulated profits, profit or loss on the revaluation of assets and liabilities and adjustment of capital, etc.
As far as the issue related to general reserve is concerned it is basically the accumulated profits (if any) and profit (or loss) on revaluation of assets and liabilities and should be distributed in the partner’s capital account in partners old profit sharing ratio.
Sometimes the existing partners may decide to change the profit sharing ratio then some partners gain at the cost of other partners. In other words one partner gain and other one sacrifice equal to the gain. In that case the former should compensate the latter. Therefore, the gaining partner’s capital account’s are debited to the extent of their gain and sacrificing partner’s capital accounts are credited to the extent of their sacrifice .The following journal entry is passed

Example Ram. Mohan and Shyam are partners in a firm sharing profit and loss in 3 2 :1 ratio. They decide to share profit and loss equally in future. On dm: date, the books of the firm showsRs.2.40.000 as general reserve, profit on ^evaluation of Plant and Machinery Rs.60.000. The following adjustment entry is passed through the capital accounts without affecting the books of accounts.

Hence, in the above example. Shyam gains at the cost of Ram. so the Ram needs to be compensated by Shyam with the amount of Rs.50.000. The following adjustment entry is passed.

Short Answer Type question:

Q.1 State the meaning of ‘Not-for-Profit’ Organisations.

ANSWER: Not-for-Profit Organisations (NPO) are set up with the prime objective of providing services and not to earn profit thereby enhancing the welfare of society. Such organisations include schools, hospitals, trade unions, religious organisations, etc. The person/s or the groups of individuals who govern and manage the working of an NPO are known as trustees. NPO’s main sources of income are donations, subscriptions, life membership fees, grants etc. As these organisations are not set up with profit motive, they do not prepare Trading and Profit and Loss Account. Instead, they maintain Receipt and Payments Account, Income and Expenditure Account and Balance Sheet. 

Q.2 State the meaning of Receipt and Payment Account.

ANSWER: Receipts and Payments Account is a summary of the Cash Book. All cash receipts are recorded on the Receipts side (i.e. Debit side) and all cash payments are recorded on the Payments side (i.e. Credit side) of Receipts and Payments Account. It is prepared on the basis of cash and bank transactions recorded in the Cash Book. It begins with the opening balance of cash and bank and ends with the closing balances of cash and bank (balancing figure) at the end of the accounting period. It records all cash and bank transactions both of capital and revenue nature. It not only records the cash and bank transactions relating to the current accounting period, but also the cash and bank receipts (or payments) received during the current accounting period that may be related to the previous or next accounting period.

This account only helps us to ascertain the closing balance of the cash and bank and helps in assessing the cash position of an NPO.

Q.3 State the meaning of Income and Expenditure Account.

ANSWER: Income and Expenditure Account (I&E) is similar to the Profit and Loss Account in the sense that while the former is prepared to ascertain surplus or deficit during an accounting period, the latter is prepared to ascertain net profit or net loss incurred during an accounting period. I&E Account is a nominal account and is prepared on the accrual basis. It records all transactions of revenue nature that are related to the current accounting period (whether outstanding or prepaid) for which the books are maintained. All expenses and losses are recorded on the debit side (Expenditure side) and all income and gains are recorded on the credit side (Income side) of I&E Account. The closing balance or the balancing figure of I&E Account is termed as surplus (or deficit), if the sum total of the Income side exceeds (is lesser than) the sum total of the Expenditure side.

Q.4 What are the features of Receipt and Payment Account?

ANSWER: The following are the features of Receipt and Payment Account:

1. Nature: It is a Real Account. It is a summarised version of Cash Book.

2. Nature of Transactions: It records only cash and bank transactions. Transactions other than cash and bank like depreciation, loss/ profit on sale of assets, etc. are not recorded in this account.

3. No distinction between Capital and Revenue items: It records all cash and bank receipts and payments of both capital and revenue nature.

4. Opening and closing balance: It begins with the opening balance of cash and bank and ends with the closing balance of the cash and bank (balancing figure) at the end of the accounting period.

5. Purpose: It reveals the cash position of an organisation. It helps to ascertain the total amount paid and received during an accounting period.

Q.5 What steps are taken to prepare Income and Expenditure Account from a Receipt and Payment Account?

ANSWER: The following steps are taken to prepare Income and Expenditure Account (I&E) from Receipts and Payment Account (R&P).

Step 1: All the revenue expenditures paid for the current accounting period are transferred from the Payments side of R&P to the Expenditure side of I&E.

Step 2: All the revenue receipts for the current accounting period are transferred from the Receipts side of R&P to the Income side of I&E.

Step 3: Expenses outstanding for the current period and expenses paid in advance (prepaid expenses) for the current period in the preceding accounting periods are to be added (adjusted) to their related expenses in the Step 1.

Step 4: Income outstanding (accrued income) for the current period and income received in advance for the current period in the preceding accounting periods are to be added (adjusted) to their related incomes in Step 2.

Step 5: Non-cash items like depreciation, appreciation for the current accounting period are to be adjusted in the I&E.

Step 6: After adjusting all the revenue items for the current accounting period, the Income and the Expenditure sides are totaled. If the sum total of the Income side exceeds (or is lesser than) the sum total of the Expenditure side, then the balancing figure is termed as surplus (or deficit).

Q.6 What is subscription? How is it calculated?

ANSWER: Subscription is the main source of income for an NPO besides entrance fees, donations, grants, etc. Subscriptions refer to the amount of money paid by the members on periodic basis for keeping their membership with the organisation alive. It is paid monthly, quarterly, half yearly or annually by the members.

It is shown in the debit side of the Receipt and Payment Account with the total amount received during the year that may be related to the current period and to the previous and next accounting period.

While calculating subscription for the current period, advance subscription received for the current period in the previous period and outstanding subscription for the current period are added to the subscription received during the current period. Whereas, on the other hand, advance subscription received for the next accounting period during the current period and outstanding subscription for the preceding period are deducted from the subscription received during the current period.

Calculation of Subscription

Subscription received during the year		***
Add: Subscription received (in advance) during previous year for current year	***
Add: Subscription outstanding at the end of the year	***
		***
Less: Subscription received in advance for the next year	***
Less: Subscription outstanding for the previous year	***	***
## Subscription shown in Income and Expenditure Account		***

## This subscription is related to the current accounting period and is shown in the Income side of the Income and Expenditure Account.

Q.7 What is Capital Fund? How is it calculated?

ANSWER: Capital fund is the excess of NPOs’ assets over its liabilities. In other words, the excess of assets over the liabilities for a profit earning organisation is termed as capital and the same for an NPO is termed as capital fund. Any surplus or deficit ascertained from Income and Expenditure account is added to (deducted from) the capital fund. It is also termed as Accumulated Fund.

Calculation of Capital Fund

Capital Fund at the beginning of the year		**
Add: Surplus from Income and Expenditure Account	**
Add: Subscription Amount (Capitalised amount)	**
Add: Life membership fee.	**	**
Less: Deficit from Income and Expenditure Account		**
Capital Fund at the end of the year		***

Long Answer Type Question.

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Q.1 Explain the statement: “Receipt and Payment Account is a summarised version of Cash Book”.

ANSWER: A receipts and payments account (R & P Account) is a summary of actual cash receipts and payments that is extracted from the cash book over a certain time period. All the cash received is recorded on the Receipts and all cash payments are recorded in Payments side of the R & P Account. All the cash and bank transactions are recorded in Cash Book and this book is created on the basis of all these transaction. All cash and bank transactions that are of revenue and capital nature gets recorded. It records all transactions i.e. bank receipts and cash receipts.

This account helps in determining the closing balance of bank and cash receipts and thereby assess cash position of a Not-for-profit organisation or NPO.

Here are some similarities between Cash Book and Receipts and Payments Account:

1. Both are real accounts.

2. Only transactions of cash and bank are recorded

3. There is no distinction between Revenue and Capital Items

4. Helps in assessing the cash position of an organisation

5. Starts with an opening balance consisting of cash and bank and concludes with closing balance of cash and bank.

Therefore, it can be said that Receipt and Payments Account is a summarised version of cash book.

Q.2 “Income and Expenditure Account of a Not-for-Profit Organisation is akin to Profit and Loss Account of a business concern”. Explain the statement.

ANSWER: The account containing all expenses and losses for current accounting period prepared by a Not-for-profit organisation is called as Income and Expenditure (I & E) account, while a similar account prepared by profit earning organisation is called as Profit and Loss Account (P & L).

Here are some of the similarities between I & E and P & L accounts:

1. Accrual basis is followed for the preparation of both accounts.

2. Expenses and losses are recorded on Expenditure (debit) side and gains and income are recorded on Income (credit) side.

3. Records only revenue items related to current accounting period.

4. Both exhibit nature similar to nominal accounts

Therefore, it can be said that from the above statements that Income and Expenditure account of a Not-for-Profit Organisation is akin to Profit and Loss Account of a business concern.

Q.3 Distinguish between Receipts and Payments Account and Income and Expenditure Account.

ANSWER:

Basis of Comparison	Receipts and Payments Account	Income and Expenditure Account
Nature	Contains bank and cash transaction summary.	Contains summary of income and expenses of current year
Revenue and Capital	Both revenue and capital transactions are recorded	Only revenue transactions are recorded
Debit Side	Records cash and bank receipts are recorded	Records expenses and losses incurred for the current accounting year
Credit side	Records payments received in form of cash and cheques	Records incomes and gains during the current accounting year
Account Type	Real Account	Nominal Account
Accounting Period	Records receipts and payments made during the year which may be related to current, previous or next accounting year	Records only the expenditure and income made during the current accounting year
Object	Shows the cash position of NPO	Shows the net results in terms of deficits or surplus
Depreciation	Non-cash items like depreciation is not included	Includes non-cash items like depreciation, bad-debts for determining net profit or loss.
Adjustment	Before preparing financial statements the Payments and Receipts received during the year can be adjusted.	Cash and non-cash transactions can be adjusted
System	Cash basis	Accrual Basis

Q.4 Explain the basic features of Income and Expenditure Account and of Receipt and Payment Account.

ANSWER: Income and Expenditure account is similar to the P & L account (Profit and Loss Account). In an income and expenditure account surplus and deficit is determined during the accounting period while in a P& L account the net profit or loss is determined during an accounting period. It is a nominal account and records transactions that are of revenue nature. The closing balance is called deficit or surplus based.

Basic Features of I & E Account are:

1. It is a nominal account

2. Prepared on the basis of R & P (Receipt and Payment Account). All revenue items irrespective of income or expenditure get transferred.

3. Transactions that are of capital nature are not included in the account.

4. It is similar to P & L account

5. Records only current accounting year items and excludes any other transactions

6. Items like prepaid expenses, depreciation, income received in advance can be adjusted.

7. Balancing figure is expressed as surplus or deficit based on the status of expenses and income.

A receipts and payments account is a summary of actual cash receipts and payments that is extracted from the cash book over a certain time period. All the cash received is recorded on the Receipts and all cash payments are recorded in Payments side of the Receipts and Payments Account. This account is prepared on the basis of all the cash and bank transactions that are recorded in Cash Book. It records all cash and bank transactions that are of revenue and capital nature. It records all transactions i.e. bank receipts and cash receipts.

This account helps in determining the closing balance of bank and cash receipts and thereby assess cash position of an NPO.

Basic Features of R & P Account are:

1. It is a real account also known as summarised version of Cash Book

2. It records only bank and cash transactions.

3. Non-cash transactions like depreciation is not recorded

4. It begins with an opening balance of cash and bank and ends with closing balance of cash and bank.

5. Helps in assessing the cash position of an organisation

6. It does not distinguish between capital and revenue items

Q.5 Show the treatment of the following items by a Not-for-Profit Organisation

ANSWER:

(i)	Annual subscription
(ii)	Specific donation
(iii)	Sale of fixed assets
(iv)	Sale of old periodicals
(v)	Sale of sports materials
(vi)	Life membership fee

i) Annual Subscription

1. Subscriptions that are obtained during an accounting year (it may be related to current, previous or upcoming year) are reflected on the debit side of R & P Account.

2. Subscriptions related to the present year whether yet to be received or already received reflects on the credit side of I & E account (Income and Expenditure)

3. Advance subscriptions received for the following year are reflected on Liabilities side of balance sheet.

4. Subscriptions which are due but yet to be received are shown on Assets part of Balance Sheet.

5. Subscriptions that are due but yet to receive are reflected on asset side of balance sheet.

ii) Specific donation

1. Specific donation amount is reflected on Debit side of R & P Accounts.

2. Specific donation amount is shown on Liabilities side of Balance Sheet. Because it is used for that specific purpose for which it is received.

iii) Sale of fixed assets

1. Amount received recorded on debit side of R & P Account.

2. Profit/Loss is credited/debited to I & E Account.

3. Book value of asset deducted from the respective asset on Asset side of Balance Sheet

iv) Sale of old periodicals

1. Amount received reflects on the debit side of R & P Account.

2. Sale of old periodical is counted as revenue receipts, hence reflects on credit side of I & E Account.

v) Sale of sport Materials

1. Amount received is debited to R & P Account

2. Sport material sale is revenue earned, hence reflects on credit side of I & E Account.

vi) Life Membership Fees

1. It is considered as a receipt for a NPO. Hence, debited to R & P Account

2. It is one-time fee and hence treated as Capital receipts, hence, added to Capital Fund on liabilities side of Balance Sheet

Q.6 Show the treatment of items of Income and Expenditure Account when there is a specific fund for those items.

ANSWER: A NPO (Not-for-Profit organisation) has different sources of receipts in the form of subscriptions, donations, government grants etc. Of these some receipts are general while some are specific. Specific receipts are used only for the purpose for which it is received while general receipts can be used for any purpose. The specific receipts are not considered as revenue income for the Not-for-Profit organisation and therefore are reflected in I & E account.

In a way, specific receipts are considered as liabilities to the Not-for-Profit organisation as these amounts are received for specific purpose and cannot be used elsewhere. These are reflected in Liabilities side of Balance Sheet, until and unless it is completely used for the purpose it was received. If such amount is invested in the form of shares or debentures, then it is known as funds such as prize funds, match funds etc. The interest earned on such investment are not credited to I & E Account, instead it is credited to the respective fund account.

Similarly, any expense that is incurred for such funds gets debited from respective fund account. Such funds are shown in the liabilities side of Balance Sheet. If the expenses exceed the receipts of the fund, the difference gets reflected in I & E Account.

Treatment for items received for specific purpose

(Tournament/Match/Prize, etc.) Fund Account
Dr.	Cr.
Date	Particulars	L.F.	Amount	Date	Particulars	L.F.	Amount
	Expenses (expenses incurred like, match expenses, tournament expenses)				Balance b/d
					Incomes (Income or interest earned on funds invested in the form of donation, interests, dividends, etc.)
	Balance c/d (see explanation)		(a)		Income and Expenditure A/c (see explanation)		(b)

Explanation (a)

When receipts are more than expenses meant for specific purpose, that time the difference between receipts and expenses is shown on balance sheet in the liabilities side.

Balance Sheet
Specific Fund (i.e. Tournament, Match, Prize Fund, etc.)		Tournament Fund Investment

Explanation (b)

When expenses are more than receipts meant for specific purpose, that time the difference between expenses and receipts is shown in I & E account at the expenditure side.

Income and Expenditure A/c
Expenditure	Amount	Income	Amount
Expenses (I.e. Tournament, Match, Prize Expenses etc. except capital expenditure like, i.e.  expenses on construction of building)

Q.7 What is Receipt and Payment Account? How is it different from Income and Expenditure Account?

ANSWER: A receipts and payments account is a summary of actual cash receipts and payments that is extracted from the cash book over a certain time period. All the cash received is recorded on the Receipts and all cash payments are recorded in Payments side of the Receipts and Payments Account. This account is prepared on the basis of all the cash and bank transactions that are recorded in Cash Book. It records all cash and bank transactions that are of revenue and capital nature. It records all transactions i.e. bank receipts and cash receipts.

This account helps in determining the closing balance of bank and cash receipts and thereby assess cash position of an NPO.

Basis of Comparison	Receipts and Payments Account	Income and Expenditure Account
Nature	Contains bank and cash transaction summary.	Contains summary of income and expenses of current year
Revenue and Capital	Both revenue and capital transactions are recorded	Only revenue transactions are recorded
Debit Side	Records cash and bank receipts are recorded	Records expenses and losses incurred for the current accounting period
Credit side	Records payments received in form of cash and cheques	Records incomes and gains during the current accounting period
Account Type	Real Account	Nominal Account
Accounting Period	Records receipts and payments made during the year which may be related to current, previous or next accounting year	Records only the expenditure and income made during the current accounting year
Object	Shows the cash position of NPO	Shows the net results in terms of deficits or surplus
Depreciation	Non-cash items like depreciation is not included	Includes non-cash items like depreciation, bad-debts for determining net profit or loss.
Adjustment	Before preparing financial statements the Payments and Receipts received during the year can be adjusted.	Cash and non-cash transactions can be adjusted
System	Cash basis	Accrual Basis

Short Answer Type Question:

Q.1 What is a Cash Flow Statement?

ANSWER: A Cash Flow Statement is a statement showing inflows and outflows of cash and cash equivalents from operating, investing and financing activities of a company during a particular period. It explains the reasons of receipts and payments in cash and change in cash balances during an accounting year in a company.

Q.2 How are the various activities classified (as per AS-3 revised) while preparing cash flow statement?

ANSWER: As per the Revised Accounting Standard 3 (AS-3), preparation of Cash Flow Statement for each period is mandatory. AS-3 also specifies the classification of all inflows and outflows basically under the following heads:

1. Cash Flow from Operating Activities

2. Cash Flow from Investing Activities

3. Cash Flow from Financing Activities

Q.3 State the uses of cash flow statement?

ANSWER: The uses of cash flow statement are as follows:

1. It is useful for short term financial planning about inflows and outflow of cash.

2. It helps in analysing the reason for the change in cash and cash equivalent balances of a company

3. It assists in determining and assessing liquidity and solvency positions of a company.

4. It enables to analyse and study the trends of receipts and payments of cash from various activities of a company and thereby helps in drafting various policy measures and short term planning.

5. It enables the segregation of cash flows from operating, investing and financing activities of the business separately.

6. It assists in making decision about distribution of profit with reference to the availability of cash.

Q.4 What are the objectives of preparing cash flow statement?

ANSWER: The important objectives for preparing Cash Flow Statement are as follows:

1. The most important objective that is fulfilled by preparing Cash Flow Statement is to ascertain the gross inflows and outflows of cash and cash equivalents from various activities.

2. Secondly, Cash Flow Statement helps in analysing various reasons responsible for change in the cash balances during an accounting year.

3. This statement helps in analysing and understanding the liquidity and solvency of a company , thereby, depicting the true liquidity position to the creditors and the investors.

4. Cash Flow Statement also helps in ascertaining the requirement and availability of cash in near future.

Q.5 State the meaning of the terms: Cash Equivalents, Cash flows.

ANSWER: Cash equivalents are short term, highly liquid investments that are easily convertible into cash and which are subject to an insignificant risk of change in value. In other words, cash equivalents are held for the purpose of meeting short term cash commitments rather than for investment or any other purpose. An investment held for short-term maturity, say three months can be regarded as cash equivalent. Some examples of cash equivalents are treasury bills, commercial papers, etc. On the other hand, cash flows are inflows and outflows of cash and cash equivalents. A cash inflow results in increase in the total cash balance and a cash outflow results in decrease in the total cash balance.

Q.6 Prepare a format of cash flow from operating activities under indirect method.

ANSWER: The format of cash flow from operating activities under Indirect method is as follows:  

Indirect Method
Cash Flow from Operating Activities:
Net Profit before tax and extraordinary items		***
	Add:	Non-Cash Expenses and Non-Operating Expenses
		Depreciation	**
		Goodwill	**
		Interest paid	**
		Loss on sale of fixed assets	**
		Foreign exchange	**	**
	Less:	Non Operating Incomes.
		Dividend received	**
		Profit on sale of fixed assets	**
		Interest received	**	**
Operating profit before working capital changes		***
	Add: Decrease in Current Assets	***
		Increase in Current Liabilities	***	***
	Less: Increase in Current Assets	***
		Decrease in Current Liabilities	***	***
Cash generated from Operating Activities		***
Income tax paid		***
Cash Flow before Extraordinary Items		***
	Add/Less: Extra ordinary Items		***
Net Cash Flow from Operating Activities		***

Note: Preparation of Cash Flow Statement using Direct Method has been excluded from the prescribed syllabus. The format is given since the question has not specified the method explicitly. Students can refer to the direct method for the knowledge purpose.

Q.7 State clearly what would constitute the operating activities for each of the follow in the following of enterprises:

(i) Hotel

(ii) Film production house

(iii) Financial enterprise

(iv) Media enterprise

(v) Steel manufacturing unit

(vi) Software development business unit.

ANSWER:

(i) Hotels

1. Receipts from sale of goods to customer.

2. Payment of wages and salaries, electricity, food items and other items used in accommodation.

(ii) Film Production House:

1. Receipts from selling film rights of a film to the distributors.

2. Payment to the staff, actors, actresses, directors, etc.

(ii) Financial Enterprises:

1. Receipts from repayment of loans, interest incomes from investments, etc.

2. Repayment of loans, recovery expenditure for recover of loans etc, salaries of employees.

(iv) Media Enterprises:

1. Receipts from advertisements.

2. Payments to staff, reporters, photographers, etc.

(v) Steel Manufacturing Unit:

1. Receipts from sale of steel sheets, steel castings, steel rods, etc.

2. Payment for iron, coal, salaries to staff, etc.

(vi) Software Development Business Unit:

1. Receipts from sale of software and renewal of licenses.

2. Payment of salaries to their employees, etc.

“Q.8 The nature/type of enterprise can change altogether the category into which a particular activity may be classified.” Do you agree? Illustrate your answer.

ANSWER: Yes, the nature or type of an enterprise can change the category into which a particular activity may be classified. This can be better understood with the help of an example of two firms. One engaged in financial services and the other engaged in manufacturing services. For the firm that is engaged in financial services, interests received or paid are classified under operating activities whereas for the firm that is engaged in manufacturing business, interests paid are classified under financing activities and interest received as investing activities. Therefore, the classification of activities depends on the nature and type of enterprise.

LONG ANSWER TYPE QUESTIONS:

Q.1 Describe the procedure to prepare cash flow statement.
  ANSWER: The procedure for preparing cash flow statement is as follows
Step 1 First of all cash flows from operating activities is ascertain.
Step 2 After that cash flows from investing activities is ascertain.
Step 3 The third step is to ascertain the cash flows from financing activities.
Step 4 Sum up the total of all the three steps and ascertain net increase or decrease.
Step 5 Write the opening balance of cash and cash equivalents and deduct it from the amount ascertained in Step 4. The resulting figure arrived is the closing balance of cash and cash equivalents.
There are two methods viz Direct Method and Indirect Method for the preparation of cash flow statement. The main difference in direct and indirect method is to calculate the cash flow from operating activities. Computation of rest of the two activities will remain same. Here are the Proforma of cash flow statement from both the methods.

Q.2 Describe “Direct” and “Indirect” method of ascertaining cash flow from operating activities.
Answer
Computation of Cash Flow From Operating Activities
The first section of cash flow statement, known as cash flow from operating activities, can be prepared by two methods known as direct method and indirect method.
(i) Direct Method :In the direct method format, each line of the operating activities section represents a sum of all cheques or deposits in a particular category, e.g., the operating activities section would include such items as cash received from customers; cash paid to suppliers; cash paid for interest; cash paid for wages; cash paid for research and development; cash paid for selling, general, and administrative costs; and any other relevant summary lines.
Direct Method Format: Cash flow from operating activities is calculated by direct method as follows

(ii) Indirect Method: In indirect method, the net income figure from the income statement is used to calculate the amount of net cash flow from operating activities. Since income statement is prepared on accrual basis in which revenue is recognised when earned and not when received therefore net income does not represent the net cash flow from operating activities and is necessary to adjust EBIT for those items which effect net income although no actual cash has been paid or received against them.
Indirect Method :Following is the indirect method formula which is used to calculate cash flow from operating activities

Q.3 Explain the major cash inflows and outflows from investing activities.
ANSWER: Cash Flows from Investing Activities: The next step in building cash flow statement is to look at money a company spent on new capital investments. If a company capitalizes an investment, then that outflow of money does not show up on the income statement. That’s because accounting rules allow the company to depreciate (expense) the cost of the investment over time.
From a practical standpoint, if a company purchase an asset such as new plant equipment or machinery, then they most likely paid for that asset in cash. When monpy leaves a company, we have an outflow of cash that we need to show in our statement.
Example In this example, let’s say ‘X’ Company purchased a new computer system for Rs. 15,00,000 along with an assembly line machine for Rs. 20,00,000. These were the only two capital investments made by ‘X’ Company for the year. In this example, the company was also required to buy a new Machinery worth Rs. 5,00,000 into a special decommissioning fund.
Normally, a company might show one line item for the capital investments and label that line item as additions to plant. In this example, we are going to show these items separately

In the above example, we saw that the company made investment in fixed assets and used Rs.40,00,000.

Q.4 Explain the major Cash inflows and outflows from financing activities.
ANSWER:
Cash Flows from Financing Activities :The final category of adjustments we need to address on a statement of cash flows is money raised by financing activities. As was the case with cash from operations, we can have both positive and negative adjustments to cash flow depending on the financing activities the company is engaged during the year.

Typical adjustments appearing here include changes in long and short term debt (issuing and redemption), issuing of preferred stock, issuing of common stock, retirement of stock, and stock dividends paid in cash.
Example In our example, ‘X’ Company decided to raise Rs. 2,50,000 by issuing common stock. They also issued around Rs.5,00,000 in preference share, and redeemed around Rs. 3,00,000 in long term debt. Finally, they paid a cash

In this example, ‘X’ Company used less money in their financing activities than they generated during the year.

Short Answer Type Question:

Q.1 What do you mean by Ratio Analysis?

ANSWER: Ratio Analysis is a technique of financial analysis. It describes the relationship between various items of Balance Sheet and Income Statements. It helps us in ascertaining profitability, operational efficiency, solvency, etc. of a firm. It may be expressed as a fraction, proportion, percentage and in times. It enables budgetary controls by assessing qualitative relationship among different financial variables. Ratio Analysis provides vital information to various accounting users regarding the financial position and viability and performance of a firm. It also lays down the basic framework for decision making and policy designing by management.

Q.2 What are the various types of ratios?

ANSWER: Accounting ratios are classified in the following two ways.

I. Traditional Classification

II. Functional Classification

I. Traditional Classification: This classification is based on the financial statements, i.e. Profit and Loss Account and Balance Sheet. The Traditional Classification further bifurcates accounting ratios on the basis of the accounts to which the elements of a ratio belong. On the basis of accounts of financial statements, the Traditional Classification bifurcate accounting ratios as:

a. Income Statement Ratios: These are those ratios whose all the elements belong only to the Trading and Profit and Loss Account, like Gross Profit Ratio, etc.

b. Balance Sheet Ratios: These are those ratios whose all the elements belong only to the Balance Sheet, like Current Ratio, Debt Equity Ratio, etc.

c. Composite Ratios: These are those ratios whose elements belong both to the Trading and Profit and Loss Account as well as to the Balance Sheet, like Debtors Turnover Ratio, etc.

II. Functional Classification: This classification reflects the functional need and the purpose of calculating ratio. The basic rationale to compute ratio is to ascertain liquidity, solvency, financial performance and profitability of a business. Consequently, the Functional Classification classifies various accounting ratios as:

a. Liquidity Ratio: These ratios are calculated to determine short term solvency.

b. Solvency Ratio: These ratios are calculated to determine long term solvency.

c. Activity Ratio: These ratios are calculated for measuring the operational efficiency and efficacy of the operations. These ratios relate to sales or cost of goods sold.

d. Profitability Ratio: These ratios are calculated to assess the financial performance and the financial viability of the business.

Q.3 What relationships will be established to study:

a. Inventory Turnover

b. Trade Receivables Turnover

c. Trade Payables Turnover

d. Working Capital Turnover

ANSWER:

a. Inventory Turnover Ratio: This ratio is computed to determine the efficiency with which the stock is used. This ratio is based on the relationship between cost of goods sold and average stock kept during the year.

b. Debtors Turnover Ratio or Trade Receivables Turnover Ratio: This ratio is computed to determine the rate at which the amount is collected from the debtors. It establishes the relationship between net credit sales and average accounts receivables.

c. Trade Payables Turnover Ratio: This ratio is known as Creditors Turnover Ratio. It is computed to determine the rate at which the amount is paid to the creditors. It establishes the relationship between net credit purchases and average accounts payables.

d. Working Capital Turnover Ratio: This ratio is computed to determine how efficiently the working capital is utilised in making sales. It establishes the relationship between net sales and working capital.

Q.4 The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they become due. What are the ratios used for this purpose?

ANSWER: The liquidity of a business firm is measured by its ability to pay its long term obligations. The long term obligations include payments of principal amount on the due date and payments of interests on the regular basis. Long term solvency of any business can be calculated on the basis of the following ratios.

a. Debt-Equity Ratio– It depicts the relationship between the borrowed fund and owner’s funds. The lower the debt-equity ratio higher will be the degree of security to the lenders. A low debt-equity ratio implies that the company can easily meet its long term obligations.

b. Total Assets to Debt Ratio- It shows the relationship between the total assets and the long term loans. A high Total Assets to Debt Ratio implies that more assets are financed by the owner’s fund and the company can easily meet its long-term obligations. Thus, a higher ratio implies more security to the lenders.

c. Interest Coverage Ratio– This ratio depicts the relationship between amount of profit utilised for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

Q.5 The average age of inventory is viewed as the average length of time inventory is held by the firm for which explain with reasons.

ANSWER: Inventory Turnover Ratio: This ratio is computed to determine the efficiency with which the stock is used. This ratio is based on the relationship between cost of goods sold and average stock kept during the year.

It shows the rate with which the stock is turned into sales or the number of times the stock in turned into sales during the year. In other words, this ratio reveals the average length of time for which the inventory is held by the firm.

LONG ANSWER TYPE QUESTIONS:

Q.1 Who are the users of financial ratio analysis? Explain the significance of ratio analysis to them.
  ANSWER: Financial ratios help their users to take various managerial decisions. In this context there are four categories of users who are interested in financial ratios. These are the management, investors, long term creditors and short term creditors. The significance of ratios to the above mentioned users is as follows
(i) Management :Management calculate ratios for taking various managerial decisions. Management is always interested in future growth of the organisation. In this regard management design various policy measures and draft future plans. Management wish to know how effectively the resources are being utilised conseguently, they are interested in Activity Ratios and Profitability Ratios like Net Profit Ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratios, etc. ‘
(ii) Equity Investors :The prime concern of investors before investing in shares is to ensure the security of their principle and return on investment. It is a well known fact that the security of the funds is directly related to the profitability and operational efficiency of the business. In this way they are interested in knowing Earnings per Share, Return on Investment and Return on Equity.
(iii) Long Term Creditors: Long term creditors are those creditors who provide funds for more than one year, so they are interested in long term solvency of the firm and in assessing the ability of the firm to pay interest on time. In this way they are interested in calculating Long term Solvency Ratios like, Debt-Equity Ratio, Proprietory Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio, etc.
(iv) Short Term Creditors :Short term creditors are those creditors who provide financial assistance through short term credit (Generally less than one year). That’s why short-term creditors are interested in timely payment of their debts in short run. In this way they are always interested in Liquidity Ratios like, Current Ratio, Quick Ratios etc. These ratios reveal the current financial position of the business. It is always observed that short term obligations are paid through current assest.

Q.2 What are liquidity ratios? Discuss the importance of current and liquid ratio.
ANSWER:  Liquidity ratios are calculated to determine the short-term solvency of the business. Analysis of current position of liquid funds determines* the ability of the business to pay the amount due as per commitment to stakeholders. Included in this category are current ratio, Quick ratio and Cash Fund Ratios.

Current Ratio/Working Capital Ratio: This ratio establish relationship between current assets and current liabilities. The standard for this ratio is 2 : 1. It means a ratio 2 : 1 is considered favourable. It is calculated by dividing the total of the current assets by total of the current liabilities. The formula for the current ratio is as follows
Current Ratio = Current Assets/Current Liabilities Or
Current Assets : Current Liabilities
Importance of Current Ratio Current Ratio Provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. However, it must be interpreted carefully because window-dressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilisation or improper utilisation of resources.
Liquid/Acid Test/Quick Ratio This ratio establishes relationship between Quick assets and Current liabilities. Quick assets are those assets which can get converted into cash easily in case of emergency. Out of current assets it is believed that stock, and prepaid expenses are not possible to convert in cash quickly. The standard for this ratio is 1:1. It means if quick assets are just equal to the current liabilities they will be considered favourable with the view point of company’s credibility. The formula for the quick ratio is as follows

Importance of Current Ratio: Current Ratio Provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. However, it must be interpreted carefully because window-dressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilisation or improper utilisation of resources.
Liquid/Acid Test/Quick Ratio:This ratio establishes relationship between Quick assets and Current liabilities. Quick assets are those assets which can get converted into cash easily in case of emergency. Out of current assets it is believed that stock, and prepaid expenses are not possible to convert in cash quickly. The standard for this ratio is 1:1. It means if quick assets are just equal to the current liabilities they will be considered favourable with the view point of company’s credibility. The formula for the quick ratio is as follows

Importance of Quick Ratio :It helps in determining whether a firm has sufficient funds if it has to pay all its current liabilities immediately. Because of exclusion of non-liquid current assets, it is considered better than current ratio as a measure of liquidity position of the business. Standard for liquid ratio is 1:1. Sometimes quick ratio is calculated on the basis of quick liability instead of current liabilities. Quick liabilities are calculated by ignoring bank overdraft, if any. It means to get the figure of quick liabilities from current liabilities; bank overdraft is deducted from current liabilities.

Q.3 How would you study the solvency position of the firm?
ANSWER: The solvency position of any firm is determined and measured with the help of solvency ratios. In this way we can say that the ratios which throw light on the debt servicing ability of the businesses in the long run are known as solvency ratios. Solvency of a concern can be measured in two ways first to check the security of Debt and second is to check the security of return on Debt. For calculating the security of debt we calculate Debt-Equity Ratio, Proprietory Ratio, Fixed Assets – Proprietory Fund Ratio, etc. And for calculating Security of Return on Debt we calculate Interest Coverage Ratio. A brief description of the above mentioned ratios is as follows

Debt Equity Ratio :Debt Equity Ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds. It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.

Proprietory Ratio/ Total Assets to Debt Ratio: Total assets to Debt Ratio or Proprietory Ratio are a variant of the debt equity ratio. It is also known as equity ratio or net worth to total assets ratio. This ratio relates the shareholder’s funds to total assets. Proprietory/Equity Ratio indicates the long-term or future solvency position of the business. Formula of Proprietary/Equity Ratio

Shareholder’s funds include equity share capital plus all reserves and surpluses items. Total assets include all assets, including Goodwill. Some authors exclude goodwill from total assets. In that case the total shareholder’s funds are to be divided by total tangible assets. The total liabilities may also be used as the denominator in the above formula.

Fixed Assets to Proprietor’s Fund Ratio: Fixed Assets to Proprietor’s Fund Ratio establish a relationship between fixed assets and shareholders’ funds. The purpose of this ratio is to indicate the percentage of the owner’s funds invested in fixed assets. The formula for calculating this ratio is as follows

The fixed assets are considered at their book value and the proprietor’s funds consist of the same items as internal equities in the case of debt equity ratio.

Interest Coverage Ratio :This ratio deals only with servicing of return on loan as interest. This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

Q.4 What are important profitability ratios? How are they worked out? ‘
ANSWER:  Profitability Ratios Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most Important and popular profitability ratios are as under
Gross Profit Ratio: Gross Profit Ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales. The basic components for the calculation of gross profit ratio are gross profit and net sales. Net sales mean sales minus sales returns.

Gross profit would be the difference between net sales and cost of goods sold. Cost of goods sold in the case of a trading concern would be equal to opening stock plus purchase, minus closing stock plus all direct expenses relating to purchases. In the case of manufacturing concern, it would be equal to the sum of the cost of raw materials, wages, direct expenses and all manufacturing expenses. In other words, generally the expenses charged to profit and loss account or operating expenses are excluded from the calculation of cost of goods sold.
Following formula is used to calculate gross profit ratios

Net Profit Ratio :Net Profit Ratio is the ratio of net profit to net sales. It is expressed as percentage. The two basic components of the net profit ratio are the net profit and sales. The net profits are obtained after deducting income-tax and, generally, non-operating expenses and incomes are excluded from the net profits for calculating this ratio. Thus, incomes such as interest on investments outside the business, profit on sales of fixed assets and losses on sales of fixed assets, etc are excluded.

Operating Profit Ratio :Operating Profit Ratio is the ratio of operating profit to net sales. There are many non operating expenses and incomes included in the profit and loss account which has nothing to do with the operations of the business such as loss by fire, loss by theft etc. On the other had in credit side of the P&L account, there are so many incomes
which can be considered as operating incomes such as dividend, bank interest, rent etc. In this way net profit ratio will not tell the truth about the profit of the organisation. Hence operating profit ratio will be helpful in that case. The formula for calculating operating ratio is as follows

Operating Ratio :Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is generally expressed in percentage, Operating ratio measures the cost of operations per dollar of sales. This is closely related to the ratio of operating profit to net sales. The two basic components for the calculation of operating ratio are operating cost (cost of goods sold plus operating expenses) and net sales. Operating expenses normally include (a) administrative and office expenses and (b) selling and distribution expenses. The formula for calculating the operating ratio is as follows

Q.5 Financial ratio analysis are conducted by four groups of analysts : managers, equity investors, long term creditors and short term creditors. What is the primary emphasis of each of these groups in evaluating ratios?
ANSWER:  This is very much true that the financial ratio analysis is conducted by four groups of analysts : managers, equity investors, long term creditors and short term creditors. The primary emphasis of each of these groups in evaluating these ratios are as follows
(i) Management: Management calculate ratios for taking various managerial decisions. Management is always interested in future growth of the organisation. In this regard management design various policy measures and draft future plans. Management wish to know how effectively the resources are being utilised Consequently, they are interested in Activity Ratios and Profitability Ratios like Net Profit Ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratios, etc.
(ii) Equity Investors: The prime concern of investors before investing in shares is to ensure the security of their principle and return on investment. It is a well known fact that the security of the funds is directly related to the profitability and operational efficiency of the business. In this way they are interested in knowing Earnings per Share, Return on Investment and Return on Equity.
(iii) Long Term Creditors: Long term creditors are those creditors who provide funds for more than one year, so they are interested in long term solvency of the firm and in assessing the ability of the firm to pay interest on time. In this way they are interested in calculating Long term Solvency Ratios like, Debt-Equity Ratio, Proprietory Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio, etc.
(iv) Short Term Creditors: Short term creditors are those creditors who provide financial assistance through short term credit (Generally less than one year). That’s why short term creditors are interested in timely payment of their debts in short run. In this way, they are always interested in Liquidity Ratios like, Current Ratio, Quick Ratios etc. These ratios reveal the current financial position of the business. It is always observed that short term obligations are paid through current assest.

Q.6 The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall liquidity. Explain.
ANSWER:  The above mentioned statement is true. There are two different ways to measure the liquidity of a firm first through current ratio of the firm and second through quick ratio of the firm. The second one is considered the more refine form of measuring the liquidity of the firm.
The current ratio ‘explains the relationship between current assets and current liabilities. If current assets are quite capable to pay the current liability the liquidity of the concerned firm will be considered good. But here generally one question arises there are certain assets which cannot be converted into cash quickly such as stock and prepaid expenses.
As far as the matter of prepaid expenses is concerned it’s ok but what about the stock if we measure the liquidity on the basis of conversion of current assets in cash there are many firms where conversion of stock is not possible into cash frequently say e.g., heavy machinery manufacturing companies, locomotive companies, etc. This is because, the heavy stocks like machinery, heavy tools etc. cannot be easily sold off. In this case it is always advisable to follow the current ratio for measuring the liquidity of a firm.

But on the other hand, in case of those firms where the stock can be easily realised or sold off consideration of stock should be avoided and to measure the liquidity of that firm Quick ratio should be calculated, e.g., the inventories of a service sector company are very liquid as there are no stocks kept for sale, so in that case liquid ratio must be followed for measuring the liquidity of the firm.
We can understand from the above mentioned statement in the light of another example where stock contribute the major portion in current assets in that case to find out the liquidity of that firm stock cannot be avoided to measure the liquidity of the firm. On the other hand where stock contributes a reasonably less amount it can be avoided and liquidity of that firm can be measured with the help of quick ratio. On the other hand where there is a lot of fluctuation in the price of stock it is always advisable to compute quick ratio and avoid the stock figure because it will reduce the authenticity of liquidity measure.

Short Answer Type Question:

Q.1 List the techniques of Financial Statement Analysis.

ANSWER: The following are the commonly used techniques of Financial Statement analysis :

1.   Comparative Financial Statements

2.   Common Size Financial Statements

3.   Trend Analysis

4.   Ratio Analysis

5.   Cash Flow Statement

6.   Fund Flow Statement

The above listed techniques can be classified on the following basis:

A. On the basis of Comparison

      1.   Inter-firm Comparison

            a) Comparative Statement (Balance Sheet, Profit and Loss Account)

            b) Common size Statement (of the same period)

            c) Ratio of two or more Competitive Firms (of the same period)

            d) Cash Flow Statement of two or more Competitive firms

            e) Polygon, Bar Diagram

      2.   Intra-firm Comparison

            a) Comparative Statement (Balance Sheet, Profit and Loss Account)

            b) Common size Statement (of the same period)

            c) Ratio of two or more Competitive Firms (of the same period)

            d) Cash Flow Statement of two or more Competitive firms

            e) Polygon, Bar Diagram

      3.   Horizontal Comparison

      4.   Vertical Comparison

B. On the basis of Time

      1.   Inter-period Comparison

            a) Comparative statement (two or more periods)

            b) Cash Flow statement (two or more period) etc.

      2. Cross Sectional (Intra-period) Comparison

            a) Common size statement

            b) Ratio Analysis

C. Horizontal Analysis

      1.   Time series

      2.   Bar Diagram

      3.   Polygon

      4.   Comparative statement

      5.   Ratio Analysis

D. Vertical Analysis

      1.   Common size statement

      2.   Pie Diagram

Q.2 Distinguish between Vertical and Horizontal Analysis of financial data.

ANSWER:

Basis of Difference	Horizontal Analysis	Vertical Analysis
Meaning	It refers to the comparison of an item of the financial statement of one period or periods to its corresponding item of the base accounting period.	It refers to the comparison of itemitems of the financial statement to the common item of the same accounting period.
Purpose	Its purpose is to determine the change in an item during an accounting period. The change in the item is expressed either in absolute figures or in percentage or in both terms.	Its purpose is to determine the proportion of item/items to the common item of the same accounting period. The change in the item is expressed either in ratio or in percentage terms.
Usefulness	It indicates growth or decline of the item.	It helps in predicting and determining the future relative proportion of an item to the common item.

Q.3 State the meaning of Analysis and Interpretation.

ANSWER: Analysis and Interpretation refers to a systematic and critical examination of the financial statements. It not only establishes cause and effect relationship among the various items of the financial statements but also presents the financial data in a proper manner. The main purpose of Analysis and Interpretation is to present the financial data in such a manner that is easily understandable and self explanatory. This not only helps the accounting users to assess the financial performance of the business over a period of time but also enables them in decision making and policy and financial designing process.

Country Man Ltd Comparative statement as on March 31, 2010 and 2011
Particular	2009–10	2010–11	AbsoluteChange	% Change
Sales	1,00,000	1,50,000	50,000	50
Less: Cost of Goods Sold	60,000	78,000	18,000	30
Gross Profit	40,000	72,000	32,000	80
Less: Operating Expenses:
Office and Administrative Exp.	8,000	10,000	2,000	25
Selling and Distribution Exp.	5,000	6,000	1,000	20
Operating Profit	27,000	56,000	29,000	107.4
Add: Other Income	3,000	4,800	1,800	60
Less: Non-operating Expenses	4,000	4,800	800	20
Profit Before Interest and Tax	26,000	56,000	30,000	115.38
Interest	2,000	1,800	(200)	(10)
Profit before Tax	24,000	54,200	30,200	125.83
Less: 50% Income Tax	12,000	27,100	15,100	125.83
	12,000	27,100	15,100	125.83

Interpretation:

1. Sales of the company have increased by 50% during the year 2010−11 whereas the cost of goods sold has also increased but at a lesser rate. From this, we can infer that the company has followed an efficient sales strategy consequent of which the gross profit of the company has increased by 80% compared to the previous year (2009-10).

2. In 2010−11, operating expenses have also increased but on the contrary operating profit has increased at a higher rate than the rate of operating expenses.

3. Profit before interest and tax has also increased by 115.38% during these two years. This indicates the improvement in the operating efficiency of the company.

Q.4 State the importance of Financial Analysis?

ANSWER: Financial Analysis has great importance to various accounting users on various matters. Income Statements, Balance Sheets and other financial data provides information about expenses and sources of income, profit or loss and also helps in assessing the financial position of a business. These financial data are not useful until they are analysed. There are various tools and methods such as Ratio Analysis, Cash Flow Statements that make the financial data to cater varying needs of various accounting users.

The following are the reasons that advocate in favour of Financial Analysis:

1. It helps in evaluating the profit earning capacity and financial feasibility of a business.

2. It helps in assessing the long-term solvency of the business.

3. It helps in evaluating the relative financial status of a firm in comparison to other competitive firms.

4. It assists management in decision making process, drafting various plans and also in establishing an effective controlling system.

Q.5 What are Comparative Financial Statements?

ANSWER: Those financial statements that enable intra-firm and inter-firm comparisons of financial statements over a period of time are called Comparative Financial Statements. In other words, these statements help the accounting users to evaluate and assess the financial progress in the relative terms. These statements express the absolute figures, absolute change and the percentage change in the financial items over a period of time. Comparative Financial Statements present the financial data in such a manner that is easily understandable and can be analysed without any ambiguity. If the accounting policies and practices for the treatment of the items are same over the period of study, only then the Comparative Financial Statements enable meaningful comparisons.

The following are the two Comparative Financial Statements that are commonly prepared:

1. Comparative Balance Sheet

2. Comparative Income Statements

Q.6 What do you mean by Common Size Statements?

ANSWER: These statements depict the relationship between various items of financial statements and some common items (like Net Sales and the Total of Balance Sheet) in percentage terms. In other words, various items of Trading and Profit and Loss Account such as Cost of Goods Sold, Non-Operating Incomes and Expenses are expressed in terms of percentage of Net Sales. On the other hand, different items of Balance Sheet such as Fixed Assets, Current Assets, Share Capital etc. are expressed in terms of percentage of Total of Balance Sheet. These percentage figures are easily comparable with that of the previous years’ (i.e. inter-firm comparison) and with that of the figures of other firms in the same industry (i.e. inter-firm comparison) as well.

The analyses based on these statements are commonly known as Vertical Analysis.

The following are commonly prepared Common Size Statements.

1. Common Size Balance Sheet

2. Common Size Income Statements

LONG ANSWER TYPE QUESTIONS

Q.1 Describe the different techniques of financial analysis and explain the limitations of financial analysis.
  ANSWER: The most commonly used techniques of financial analysis are as follows
(i) Comparative Statements: These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. The financial data will be comparative only when same accounting principles are used in preparing these statements. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’.
(ii) Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with some common item by expressing each item as a percentage of the common item. The percentage thus calculated can be easily compared with the results corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. This analysis is also known as ‘Vertical analysis’.
(iii) Trend Analysis :It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good management is found. .
(iv) Ratio Analysis :It describes the significant relationship which exists between various items of a balance sheet and a profit and loss account of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements.
(v) Cash Flow Analysis :It refers to the analysis of actual movement of cash into and out of an organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow.
Limitations of Financial Analysis
The following are the limitations of Financial Analysis
(i) Ignorance of Price Level Changes :Financial statement is based on historical cost method and fails to capture the change in price level. The figures of different years are taken on nominal values and not in real terms (i.e., not taking price change into considerations).
(ii) Misleading and Wrong information: The financial analysis fails to reveal the change in the accounting procedures and practices. Consequently, they may provide wrong and misleading information.
(iii) Fail to Provide Final Picture: The financial analysis presents only the interim report and thereby provides incomplete information. They fail to provide the final and holistic picture.
(iv) Consider Only Monetary Aspect: This is one of the limitations of financial analysis that it reveals only the monetary aspects. Only those items are considered here which can be measured in term of money and fail to disclose managerial efficiency, growth prospects, and other non-operational efficiency of a business.
(v) Non-Reliable Conclusions :Conclusion base on financial analysis may be non reliable because financial statement are based on certain concepts and conventions.
(vi) Involves Personal Biasness: The financial analysis reflects the personal biasness and personal value judgments of the accountants and clerks involved. There are different techniques used by different personnel for charging depreciation (original cost or written-down value method) and also for inventory valuation. The use of different techniques by different people reduces the effectiveness of the financial analysis.
(vii) Unsuitable for Comparisons :Due to the involvement of personal value judgment, personal biasness and use of different techniques by different accountant, various types of comparisons such as inter-firm and intra-firm comparisons may not be possible and reliable.

Q.2 Explain the usefulness of trend percentages in interpretation of financial performance of a company.
ANSWER:  The Trend Analysis presents each financial item in percentage terms for each year. These Trend Analysis not only help the accounting users to assess the financial performance of the business but also assist them to form an opinion about various tendencies and predict the future trend of the business.

Usefulness and Importance of Trend Analysis:
The following are the various importance of Trend Analysis
(i) Assists in Forecasting: The trends provided by Trend Analysis help the accounting users to forecast the future trend of the business.
(ii) Percentage Terms: The trends are expressed in percentage terms. Analysing the percentage figures is easy and also less time consuming.
(iii) User Friendly: As the trends are expressed in percentage figures, so it is the most popular financial analysis to analyse the financial performance and operational efficiency of the company. In other words, one needs not to have an in-depth and sophisticated knowledge of accounting in order to analyse these percentage trends.
(iv) Presents a Broader Picture :The trend analysis presents a broader picture about the financial performance, viability and operational efficiency of a business. Generally, companies prefer to present their financial data for a period of 5 or 10 years in forms of percentage trends.

Q.3 What is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement.
ANSWER: The following are the importance of Comparative Statements.
(i) Make Presentation Simpler : Comparative statements presents the financial data in a simpler form. On the other hand, an year-wise data of the same items are presented side-by-side, which not only makes the presentation clear but also enables easy comparisons (both intra-firm and inter-firm) conclusive.
(ii) Help in Drawing Conclusion: The presentation of comparative statement is so effective that it helps the analyst to draw conclusion quickly and easily and that too without any ambiguity.
(iii) Help in Forecasting :The management may analyse the trend and forecast and draft various future plans and policy measures, with the help of comparative statement:
(iv) Help in Detection of Problems :The comparative analysis not only enables the management in locating the problems but also helps them to put various budgetary controls and corrective measures to check whether the current performance is aligned with that of the ” planned targets. With the help of the comparison of the financial data of two or more years, the financial management can easily detect the problems.

Q.4 What do you understand by analysis and interpretation of financial statements? Discuss their importance.
ANSWER:  Financial Analysis has great importance to various accounting users on various matters. Income Statements, Balance Sheets and other financial data‘provide information about expenses and sources of income, profit or loss and also helps in assessing the financial position of a business.
These financial data are not useful until they are analysed. There are various tools and methods such as Ratio Analysis, Cash Flow Statements that make the financial data to cater varying needs of various accounting users.
The following are the reasons that advocate in favour of Financial Analysis
(i) It helps in evaluating the profit earning capacity and financial feasibility of a business.
(ii) It helps in assessing the long-term solvency of the business.
(iii) It helps in evaluating the relative financial status of a firm in comparison to other competitive firms.
(iv) It assists management in decision making process, drafting various plans and also in establishing an effective controlling system.

Q.5 Explain how common size statements are prepared giving an example.
ANSWER:  Common size statements can be classified into two broad categories
(i) Common Size Income Statements
(ii) Common Size Balance Sheet
Common Size Statement is prepared in a columnar form for analysis. In a Common Size Statement, each item of the financial statements is compared to a common item. The analyses based on these statements are commonly known as Vertical Analysis.
The following are the columns prepared in a Common Size Statement
(a) Particulars Column:This column shows the various financial items under their respective heads.
(b) Amount Columns :These columns depict the amount of each item, sub-totals and the gross total of a particular year.
(c) Percentage or Ratio Columns :These columns show the proportion of each item to the common item either in terms of percentage or ratio.
The Common Size Statements can be presented in the following two ways.
Method 1 Percentage column is shown beside the amount column of the year to which percentage column belongs.

Method 2 Amount columns are shown first and their percentage columns are shown after the amount columns.

Example :From the following information provided by Alfa Limited Prepare the Common Size Statements.

Short Answer Type Question:

Q.1 State the meaning of financial statements?

ANSWER: Financial statements of a company present a true and fair picture of the results of a company’s operations to the various users of an accounting information. Financial Statements are the end products of the accounting process. These are the annual formal statements that are prepared by various enterprises or organisations for a particular accounting period. 
Quoting the words of the American Institute of Certified Public Accountants (AICPA), “Financial statements are prepared for the purpose of presenting a periodical review or report on progress made by the management and deal with the status of investment in the business and the results achieved during the period under review.”

Q.2 What are limitations of financial statements?

ANSWER: The limitations of the financial statements are as follows:

1. Historical Data- The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects. Thus, it can be concluded that financial statements reflect the data and information of historical nature.
2. Ignorance of Qualitative Aspects- Financial statements do not reveal the qualitative aspects of a transaction. The qualitative aspects such as colour, size and brand position in the market, employees’ qualities and capabilities are not disclosed by the financial statements. These statements record only those transactions that are quantitative in nature and can be expressed in the monetary terms.
3. Biased- Financial statements are based on the personal judgments regarding the use of methods of recording. For example, the choice of practice in the valuation of inventory, method of depreciation, amount of provisions, etc. are based on the personal value judgments, which may differ from person to person. Thus, the financial statements reflect the personal value judgments of the concerned accountants and experts.
4. Inter-firm Comparison- Usually, it is difficult to compare the financial statements of two companies (either in the same business or in different businesses). This is basically because of the difference in the methods and practices followed by them in preparing their respective financial statements.
5. Window Dressing- The possibility of window dressing is highly probable. This might be because of the motive of the company to overstate or understate its assets and liabilities to attract more investors or to reduce taxable profit. For example, Satyam showed high fixed deposits in the Assets side of its Balance Sheet for better liquidity that gave false and misleading signals to the investors.
6. Difficulty in Forecasting- Since the financial statements is based on the historical data, so they fail to reflect the effect of inflation. This drawback makes the forecasting difficult.

Q.3 List any three objectives of financial statements?

ANSWER: The financial statements are basically the accounts that are prepared for providing the true financial information to the internal as well as external users. These statements lay the base for the decision making process and policy designing by different users. The following are the various objectives for preparing financial statements. 

1. To Provide Information about Economic Resources- Financial statements provide adequate, accurate, reliable and periodical information about the employment of economic resources. It also specifies the obligation of a business to its external users who do not have the powers or authority to access the information directly.
2. To Ascertain the Financial Position- These statements help to reveal the true financial position of an enterprise. In other words, it discloses the performance and position of an organisation in terms of their profitability, solvency, liquidity, financial viability, etc.
3. To Ascertain the Earning Capacity- These statements are prepared with an objective of providing useful information to compare, predict and evaluate the earning capacity of a business firm. Thus, it helps in ascertaining the earning capacity of firms.

Q.4 State the importance of financial statements to
   (i) shareholders
   (ii) creditors
   (iii) government
   (iv) investors

ANSWER: Importance of financial statements to its various users is given below.
(i) Shareholders– They are interested in assessing the profitability and viability of the capital invested by them in the business. The financial statements prepared by the business concerns enable them to have sufficient information to assess the financial performance and financial health of the business.
(ii) Creditors– These are those individuals and organisations to whom a business owes money on account of credit purchases of goods and services. Hence, the creditors require information about the credit worthiness and liquidity position of the business.
(iii) Government– It needs information to determine various macroeconomic variables such as national income, GDP, industrial growth, etc. The accounting information assist the government in the formulation of various policies measures and to address various economic problems such as unemployment, poverty, etc
(iv) Investors– These are the parties who have invested or are planning to invest in the business of an enterprise. Hence, in order to assess the viability and prospects of their investments, they need information about the profitability and solvency position of the business.

Q.5 How will you disclose the following items in the Balance Sheet of a company:

(i) Loose Tools

(ii) Uncalled liability on partly paid-up shares

(iii) Debentures Redemption Reserve

(iv) Mastheads and publishing titles

(v) 10% debentures

(vi) Proposed dividends

(vii) Share forfeited account

(viii) Capital Redemption Reserve

(ix) Mining Rights

(x) Work-in-progress

ANSWER:

Disclosure of various items in the Balance Sheet of a company is given below. 

Items	Main Head	Sub-Head
(i)	Loose Tools	Current Assets	Inventories
(ii)	Uncalled liability on partly paid-up shares	Contingent Liability and Capital Commitments	Capital Commitments
(iii)	Debentures Redemption Reserve	Shareholders’ Funds	Reserve and surplus
(iv)	Mastheads and publishing titles	Non-Current Assets	Fixed Assets – Intangible assets
(v)	10% debentures	Non-Current Liabilities	Long-Term Borrowings
(vi)	Proposed dividend	Current Liabilities	Short-Term Provisions
(vii)	Share forfeited account	Shareholders’ Funds	Subscribed Capital (to be added)
(viii)	Capital Redemption Reserve	Shareholders’ Funds	Reserve and surplus
(ix)	Mining Rights	Non-Current Assets	Fixed Assets – Intangible assets
(x)	Work-in-progress	Current Assets	Inventories

LONG ANSWER TYPE QUESTIONS:

Q.1 Explain how financial statements are useful to the various parties who are interested in the affairs of an undertaking?
ANSWER: The various parties interested in financial statements directly or indirectly can be categorised in two broad categories
(i) Internal Parties: The following are the internal parties directly related to the company and interested in financial statements.
(a) Owner :The owner/s is/are interested in the profit earned or loss incurred during an accounting period. They are interested in assessing the profitability and viability of the capital invested by them in the business.
(b) Management: Management interested in financial statements for drafting various policies measures, facilitating planning and decision making process.
(c) Employees and Workers: The employee and workers are interested in financial statement for knowing about the timely payment of wages and salaries, bonus and appropriate increment in their wages and salaries. Financial statement enables them to know about the figure of profit earned during the year.
(ii) External Parties :There are various external parties who are interested in financial statements for a number of reasons.

The following are the various external parties.
(a) Creditors: Creditors are always interested in financial statement to gather information about credit worthiness of the business.
(b) Investors and Potential Investors: Persons who are willing to invest in any organisation always wish to know about the profitability and solvency of the business concern. Hence, in order to assess the viability and prospectus of their investment, creditors need information about profitability and solvency of the business.
(c) Consumers: The survival and growth of any organisation largely depends upon the Goodwill earned in the heart of the customers. In this regards if the Business has transparent financial records it help in assisting the customers to know the correct cost of production and accordingly assess the degree of reasonability of the price charged by the business.
(d) Banks/Financial Institutions: Banks and financial institutions provide finance in the form of loans and advances to various businesses. Thus, they need information regarding liquidity, creditworthiness, solvency and profitability to advance loans.
(e) Tax Authorities: They need information about sales, revenues, profit and taxable income in order to determine and levy various types of tax on the business.
(f) Government :It needs information to determine national income, GDP, industrial growth, etc. The accounting information assist the government in the formulation of various policies measures and to address various economic problems like employment, poverty etc.
(g) Researchers :Various research institutes like NGOs and other independent research institutions undertake various research projects and the accounting information facilitates their research work.

Q.2 Financial statements reflect a combination of recorded facts, accounting conventions and personal judgements. Discuss.
ANSWER:  The financial statements not only help in presenting the true and real financial position of the company but they also help in taking managerial decisions. The nature of the financial statements depends upon the following aspects like recorded facts, conventions, concepts and personal judgement.
(i) Recorded Facts: The items recorded in the financial statements reflect their original cost i.e., the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects.
(ii) Accounting Conventions: The preparation of financial statements is based on some accounting conventions like, Prudence Convention, Materiality Convention, Matching Concept, etc. The adherence to such accounting conventions makes financial statements easy to understand, comparable and reflects the true and fair financial position of the company. Besides the above while preparing financial statements, certain concepts are adhered to. The nature of these concepts is reflected in the nature of the financial statements.
(iii) Personal Judgements: The nature of financial statement largely depends upon the personal value judgements. Personal judgements are attached to different practices of recording transactions in the financial statements, e.g., recording stock either at market value or at the cost requires value judgement depending upon the personal judgement. Thus, personal judgements help in determining the nature of the financial statements.

Q.3 Explain the process of preparing income statement and balance sheet.
ANSWER: The process of preparing income statement is explained below
(i) First of all a Trial Balance is prepared on the basis of the balances of various accounts in the ledger.
(ii) After that trading account is prepared by recording Opening Stock, Purchases, Manufacturing Expenses and other direct expenses on the debit side.
(iii) On the other hand sales and closing stock is recorded on the credit side of the trading account.
(iv) After that the balancing figure of trading account is determined by totalling both the sides, if the credit side exceeds the debit side, then the balancing figure is termed as gross profit, but if the debit side exceeds the credit side, then the balancing figure is termed as gross loss.
(v) Carry forward the Gross Profit (Gross Loss) to the credit (debit) side of the Profit and Loss Account.
(vi) After that all the operating and non-operating revenue expenditures with their relevant adjustments are recorded on the debit side of the profit and loss account. Record all current year’s operating and non operating revenue incomes with their relevant adjustments on the credit side of the profit and loss account.
(vii) Ascertain the balancing figure by totalling both the sides of the profit and loss* account. If the credit exceeds the debit side, then the balancing figure is termed as net profit, but if the debit side exceeds the credit side, then the balancing figure is termed as net loss.

The process of preparing Balance Sheet is given below
(i) First of all match the total of both the side of trail balance. If there is any difference in the debit side of trail balance it will be posted in assets side of balance sheet and if there is any difference in credit side of balance sheet it will be posted in the liabilities side of the balance sheet.
(ii) Record all the debit balances of real and personal accounts on the left hand side (i.e., Assets side) of the balance sheet after making all adjustments for provision and other related items.
(iii) Record all the credit balances of real and personal accounts on the right hand side (i.e., Liabilities side) of the balance sheet after making all adjustments for interest and outstanding items.
(iv) Add Net Profit to the opening capital and deduct Net Loss, if any from the opening capital.
(v) Acertain the total of two sides, which must be equal.

Short Answer Type Question:

Q.1 What is meant by a Debenture?

ANSWER: The word Debenture is derived from a Latin word ‘debere’ which means to borrow. A debenture is issued in the form of a certificate under the seal of a company and containing a contract for the repayment of the principal sum after a fixed period of time and payment of interest at regular intervals, generally half yearly. Debentures are issued by a company for acquiring long-term borrowings.

Q.2 What does a Bearer Debenture mean?

ANSWER: When a company does not maintain any record of the debenture holders and the debenture is transferable mere by delivery, then the type of the debenture held by the holders is termed as Bearer Debenture. Interests on such debentures are paid to the persons who produce the interest coupons that are attached with these debentures in a specified bank.

Q.3 State the meaning of ‘Debentures issued as a Collateral Security’.

ANSWER: The term collateral security means additional or secondary security in addition to the primary security. Sometimes, when a company takes loan from a financial institution, then besides the primary security, the company may issue debenture for additional security (as collateral security). The lender who receives debenture as collateral security is not entitled for interest on these debentures. If any default is made by the company in paying back the principal amount (i.e. the loan amount) or interest on the loan, then the lender has the full right to recover his/her dues from the sale of primary security. But, if the primary security is not sufficient to recover the amount of the debt, then the debentures issued as collateral may be used for recovery of the remaining amount.

Q.4 What is meant by ‘Issue of debentures for Consideration other than Cash’?

ANSWER: If a company purchases assets from its suppliers or vendors, then instead of paying them in cash the company issues debentures to them. This is known as issue of debenture for consideration other than cash. The issue of debenture for consideration other than cash serves the purpose of both the vendor as well as of the purchaser (company). From the purchaser’s point of view, purchasing an asset against the issue of debentures requires no additional cost for raising loans or arranging funds immediately. On the other hand, the vendor gets interest on the amount of debentures received. In this case, payment is deferred by issue of debentures and interest is paid for time lag payment.  Debentures may be issued at par, premium or discount to the vendor.

Accounting treatment for Issue of Debentures for Consideration other than Cash

1. For purchase of Assets:

Assets A/c	Dr.
	To Vendor A/c
(Asset Purchased)

2. For Issue of Debentures

a. If debentures are issued at Par:

Vendor A/c	Dr.
	To Debentures A/c
(Debenture issued to Vendor at par )

b. If debentures are issued at Premium

Vendor A/c	Dr.
	To Debentures A/cTo Securities Premium A/c
(Debenture issued to Vendor at premium)

c) If debentures are issued at Discount

Vendor A/c	Dr.
Discount on Issue of Debentures	Dr.
	To Debentures A/c
(Debenture issued to Vendor at discount )

Q.5 What is meant by ‘Issue of debenture at discount and redeemable at premium?

ANSWER: When debentures are issued below its par value (or the face value) but are redeemed at price higher than its par value, then it is termed as issue of debenture at discount and redeemable at premium. The difference between the issue price and the redemption price is treated as loss on issue of debenture.

Example:

A 10% debenture of Rs 1,000 is issued at 5% discount and is redeemed at 10% premium.

Bank A/c	Dr.	950
Discount on Issue of Debenture A/c	Dr.	50
Loss on Issue of Debenture A/c	Dr.	100
	To Debenture A/c			1,000
	To Debenture Redemption Premium A/c			100
(Debenture issued)

Total loss = Payment made at redemption – Amount received on issue of debenture

1,100 – 950 = Rs 150

Q.6 What is ‘Capital Reserve’?

ANSWER: Capital Reserve is a reserve that is created out of capital profits i.e. gains or profits arising from other than the normal activities of business operations i.e. activities other than sale or purchase of goods and services. This reserve is utilised to meet future capital losses, if any, and to issue bonus shares. It cannot be distributed as dividend among the share holders. The Capital Reserve is generated out of the following activities:

i. Premium on issue of shares.

ii. Premium on issue of debentures.

iii. Profit on redemption of debentures.

iv. Profit on sale of fixed assets.

v. Profit on reissue of forfeited shares.

vi. Profit prior to incorporation, etc.

Q.7 What is meant by an ‘Irredeemable Debenture’?

ANSWER: Irredeemable Debentures are those debentures that are not repayable or redeemable by a company during its life time. These are repayable only at the time of winding up of the company. These are also known as Perpetual Debentures that means debentures having indefinite life. In India, now days, no company can issue irredeemable debentures.

Q.8 What is a ‘Convertible Debenture’?

ANSWER: Convertible Debentures are those debentures that can be converted into equity shares after a specified period of time. These are of following two types:

i. Fully Convertible Debentures: When the whole amount of a debenture is convertible into equity shares worth of equivalent amount, then these debentures are called Fully Convertible Debentures. There is no need to maintain Debenture Redemption Reserves for such debentures.

ii. Partly Convertible Debentures: When only a part of the amount of a debenture is convertible into equity share, then these debentures are called Partly Convertible Debentures. In this regards, the Debenture Redemption Reserve is maintained only for the non-convertible part of the debenture.

Q.9 What is meant by ‘Mortgaged Debentures’?

ANSWER: Mortgaged Debentures are those debentures that are secured against asset/s of a company. These are also known as secured debentures. If the debentures are secured against a particular asset, then it is called fixed charge whereas, if the debentures are secured against all the assets of a company, then it is called floating charge. In case the company fails to pay back the principal amount of debenture or fails to meet its interest obligations on the due date, then the debenture holders have the right to sell the mortgage asset in order to realise their amount due to the company.

Q.10 What is discount on issue of debentures?

ANSWER: When the debentures are issued at a price below its par value or face value, then it is said that the debentures are issued at discount. The difference between the issue price and the face value of the debenture is regarded as a capital loss.
As per the Revised Schedule VI of the Companies Act, Discount on Issue of Debentures is shown in the Notes to Accounts:

1. With the amount that is to be written off within 12 months from the date of Balance Sheet – Shown under Other Current Assets

2. With the amount that is to be written off after 12 months from the date of Balance Sheet – Shown under Other Non-Current Assets

Q.11What is meant by ‘Premium on Redemption of Debentures’?

ANSWER: When the debentures are redeemed at a price more than its face value or the par value, then it is said that the debentures are redeemed at premium. The difference between the redeemed price and the par value is regarded as a capital loss and this loss is written off till the redemption of the debentures. The Premium on Redemption of Debenture is shown in the Notes to Accounts under the sub-head of ‘Other Long-term Liabilities’. The final balance is shown under the main head of ‘Non-Current Liabilities’ on the Equity and Liabilities side of the Company’s Balance Sheet.

Accounting Treatment for Premium on Redemption on Debentures:

1. At the time of the Issue of Debenture:

Bank/Debenture Allotment A/c	Dr.
Loss on Issue of Debenture A/c	Dr.
	To Debenture A/c
	To Premium on Redemption
(Debenture issued with the term of redemption at premium)

2. At the time of Redemption of Debentures:

Debenture A/c	Dr.
Premium on Redemption A/c	Dr.
	To Debentureholder A/c
(Amount of debentures due to debentureholders)

Q.12 How are debentures different from shares? Give two points.

ANSWER:

Basis of Comparisons	Debentures	Shares
1. Meaning	Debentures are a part of loan, therefore, the debenture holders are the creditors of a company.	Shares form a part of capital, hence, share holders are the owner of a company.
2. Voting Rights	These do not carry any voting rights for their holders.	These carry voting rights for their holders.

Q.13 Name the head under which ‘discount on issue of debentures’ appears in the Balance Sheet of a company.

ANSWER: Discount on Issue of Debentures is regarded as a capital loss. As per the Revised Schedule VI of the Companies Act, Discount on Issue of Debentures is shown in the Notes to Accounts:

1. With the amount that is to be written off within 12 months from the date of Balance Sheet – Shown under Other Current Assets

2. With the amount that is to be written off after 12 months from the date of Balance Sheet – Shown under Other Non-Current Assets

Q.14 What is meant by redemption of debentures?

ANSWER: Redemption of debenture means repayment of debentures by the company to the debenture holders. In other words, it implies the discharge of liabilities by repaying the amount due to the debenture holders as per the terms and conditions determined at the time of issue of debentures. Debentures may be redeemable at par, premium or discount, but, nowa days, these are mostly redeemable at par or premium. The redemption can be done out of profits or from the fresh issue of debentures or shares. Redemption of debentures may be done by the following methods:

1. In lump sum at the time of maturity,

2. In instalments by draw of lots at the end of each year,

3. By purchase in open market whenever price is below its face value,

4. By converting debentures into shares or new debentures.

Q.15 Can the company purchase its own debentures?

ANSWER: Yes, a company can purchase its own debentures provided it is authorised by its Article of Association. As per the Company Act, if a company is authorised by its Article of Association, only then it may purchase its own debentures from the open market. The main purposes of such purchase are as follows:

1. For immediate cancellation of debenture liability, if the interest rate on its debenture is higher than the market rate of interest.

2. A company may also purchase its own debentures with the motive of investment and sell them at higher price in future and thereby earn profit.

Q.16 What is meant by redemption of debentures by conversion?

ANSWER: When a debenture holder can convert his/her debentures into shares or new debentures after the expiry of a specified period of time, then it is known as redemption of debentures by conversion. As the company do not need to pay any funds for the redemption, so there is no need to maintain the Debenture Redemption Reserve (DRR). The new shares or debentures may be issued at par, premium or at discount.

Q.17 How would you deal with ‘Premium on Redemption of Debentures’?

ANSWER: When the debentures are redeemed at a price more than its face value or the par value, then it is said that the debentures are redeemed at premium. The difference between the redeemed price and the par value is regarded as a capital loss and this loss is written off till the redemption of the debentures. The Premium on Redemption of Debenture is shown in the Notes to Accounts under the sub-head of ‘Other Long-term Liabilities’. The final balance is shown under the main head of ‘Non-Current Liabilities’ on the Equity and Liabilities side of the Company’s Balance Sheet.

Accounting Treatment for Premium on Redemption on Debentures:

1. At the time of the Issue of Debenture:

Bank/Debenture Allotment A/c	Dr.
Loss on issue of Debenture A/c	Dr.
	To Debenture A/c
	To Premium on Redemption
(Debenture issued with the term of redemption atpremium)

2. At the time of Redemption of Debentures:

Debenture A/c	Dr.
Premium on Redemption A/c	Dr.
	To Debenture Holder A/c
(Amount of debentures due to debenture holders)

Q.18 What is meant by ‘Redemption out of Capital?

ANSWER: When debentures are redeemed out of capital and no profits are utilised for redemption, then such redemption is termed as redemption out of capital. In such a situation, no profits are transferred to the Debenture Redemption Reserve.

As per the guideline laid down by Securities and Exchange Board of India (SEBI) and the Section 117C of Company Act of 1956, the creation of Debenture Redemption Reserve is mandatory (DRR). Therefore, it is not possible to redeem debentures purely out of capital, as it reduces the value of assets. The following companies are exempted from the creation of DRR.

1. Infrastructure companies (i.e. those companies that are engaged in the business of developing, maintaining and operating infrastructure facilities)

2. A Company that issues debentures with a maturity up to 18 months

The following are the necessary Journal entries that need to be passed, in case the debentures are redeemed out of capital.

a. If  debentures are redeemed out of capital at Par

Debenture A/c	Dr.
	To Debenture holder A/c
(Amount of debentures due to debenture holders)

Debenture holder A/c	Dr.
	To Bank A/c
(Amount of debentures paid to debenture holders)

b. If  debentures are redeemed out of capital at Premium

Debenture A/c	Dr.
Premium on Redemption A/c	Dr.
	To Debenture holder A/c
(Amount of debentures due to debenture holders)

Debenture holder A/c	Dr.
	To Bank A/c
(Amount of debentures paid to debenture holders)

Q.19 What is meant by redemption of debentures by ‘Purchase in the Open Market’?

ANSWER: According to the Company Act, if a company is authorised by its Article of Association, only then it may purchase its own debentures from the open market. The main purpose of such purchase is as follows:

1. For immediate cancellation of debenture liability, if the interest rate on its debenture is higher than the market rate of interest.

2. A company may also purchase its own debentures with the motive of investment and sell them at higher price in future and thereby earn profit.

Q.20 Under which head is the ‘Debenture Redemption Reserve’ shown in the Balance Sheet?

ANSWER: As per the Revised  Schedule VI, Debenture Redemption Reserve (DRR) is shown in the Notes to Accounts of Reserve and Surplus. The final balance after adding DRR, is shown as the sub-head ‘Reserves and Surplus’ under the main head of Shareholders’ Funds on the Equity and Liabilities side of the Company’s Balance Sheet. 

Long Answer Type Question:

Q.1 What is meant by a debenture? Explain the different types of debentures?
ANSWER: Debenture: The word ‘Debenture’ has been derived from a Latin w’ord ‘Debere’ which means to borrow. Debenture is a written instrument acknowledging a debt under the common seal of the company. It contains a contract for repayment of principal after a specified period or at intervals or at the option of the company and for payment of interest at a fixed rate payable usually either half-yearly or yearly on fixed dates.
According, to Section 2(12) of The Companies Act, 1956 ‘Debenture’ includes Debenture Stock, Bonds and any other securities of a company whether constituting a charge on the assets of the company or not. There are various types of Debentures.
(i) From Security Point of View :From security point of view debentures can be classified into two broad categories naked or simple debentures and Mortgaged debentures.
(a) Naked or Simple Debentures :Naked or Simple Debentures are those debentures which do not carry any security in respect of repayment of interest or the principal. The general solvency of the company is the only security for the holders of simple debentures.
(b) Mortgaged Debentures: Mortgaged Debentures are the debentures which are secured by a charge on the asset or properties of the company. The debenture holders have the right to recover their principal amount as well as unpaid interest out of the assets mortgaged by the company.

In case of mortgage debentures, a company may prefer to appoint trustees who will hold the property given by way of security in trust for the benefits of debentures holders.

(ii) From Permanence Point of View the debentures may be Redeemable or Irredeemable debentures.
(a) Redeemable Debentures Redeemable debentures provide for the payment of principal amount on the expiry of certain period. Redeemable debentures can be reissued even after they have been redeemed until they have been cancelled.
(b) Irredeemable Debentures Irredeemable Debentures are retained as a part of the permanent capital structure during the life time of the company. Such debt becomes due for payment only when the company goes into liquidation or when the payment of interest is not made regularly.

The company has the option of cancelling its liability to the debenture holders at any time by giving due notice to them.

(iii) From Priority Point of View :From this point of view the debentures may be First and Second debentures.
(a) First Debentures :First Debentures are those debentures which are paid first before any payment is made to another type of debentures.
(b) Second Debentures: Second Debentures are those debentures which are paid after making the payment of first debentures.
(iv) From Recording Point of View :From recording point of view debentures can be classified into two categories bearer and registered debentures.
(a) Bearer Debentures :Bearer Debentures are transferable per bearer without endorsement and they are just like bearer cheques or government currency notes. They are treated as negotiable instrument and transferable by mere delivery. It is not necessary that transfer of such debentures should be registered with the company. The interest is paid to the holder irrespective of identity.
(b) Registered Debentures: Registered debentures are made out in the name of a particular person who is registered by the company as a holder and are transferable in the same way as shares.
The payment of interest and repayment of capital is made to those whose name are registered with the company and duly entered in the register of debenture holders.
(v) From Conversion Point of View: From conversion point of view debentures may be convertible or non-convertible.
(a) Convertible Debentures :Convertible debenture holders are given an option to convert them into equity or preference shares at a stated rate of exchange after a certain period. Convertible debentures are very popular these days with the companies as it provides them a major source of permanent working capital. It also provides safety, liquidity, capital appreciation and assured return to the investors.
(b) Non-Convertible Debentures: Non-convertible debentures are not convertible into equity or preference shares afterwards.

Q.2 Distinguish between a debenture and a share. Why debenture is known as loan capital? Explain.

Q.3 Describe the meaning of ‘Debenture Issued as Collateral Securities’. What accounting treatment is given to the issue of debentures in the books of accounts?
  ANSWER: When a company takes a loan, it has to give some security, it may do so by giving debentures to the party from whom loan is takes. If on the due date principal is paid back by the Company and interest is also paid, the loan-giver will return the debentures to the Company and then they will be cancelled by the Company,

If the Company makes a default, the bank may either keep the debenture and become debenture-holder or sell them and realise money. This type of issue by the Company is called Issue of Debenture as Collateral Security.

When debentures are issued by the company, they are not really alive and no accounting entry is made in the books of the Company for it. Only a note is given in the balance sheet for it as under

If an accounting record for these debentures is to be made Debentures Suspense A/c is debited and deoentures A/c credited, debentures are shown in the liability side and balance of debentures Suspense A/c is shown in the assets side of the Balance Sheet. When debt is paid off by the Company, Debentures A/c is debited and Debentures Suspense A/c is credited.

Q.4 How is ‘Discount on Issue of Debentures’ treated in the books of accounts? How will you deal with the ‘Discount on issue of debentures’ when the debentures are to be redeemed in instalments?
ANSWER:  When the debentures are issued at a price below its par value or face value, then it is said that the debentures are issued at discount. The difference between the issue price and the face value of the debenture is regarded as a capital loss. This loss is written off every year till the debentures are redeemed.

The loss on the issue of debenture is shown on the Assets side of the Balance Sheet under the heading of Miscellaneous Expenditures.

Accounting Treatment for Discount on Issue of Debentures:
At the time of issue of debentures at discount

At the time of writing off the discount on issue of debentures at the end of each year

(i) Fixed Instalment Method/Equal Instalment Method : This method is used when debentures are redeemable in lump sum after a specified period of time. In this case an equal amount of discount (loss) is written off in equal instalments over the life of the debenture. The formula for calculating amount of discount written off every year is given below

(ii) Fluctuating Instalment Method/Variable Instalment Method/ Proportion Method: When debentures are repaid by annuaLdrawings or in instalments, the discount should be written-off in the ratio of
debentures outstanding as at the end of each accounting year. The amount of discount, under this method, goes on reducing every year and so this method may also be known as Reducing Instalment Method. –

e.g., if a company has issued 10% debentures of Rs. 12,00,000 at 5% discount redeemable annually by Rs. 2,40,000 each year. The total amount of discount on Rs.12,00,000 debentures @ 5% is Rs. 60,000, i.e., (12,00,000 x 5/100 =Rs. 60,000). The amount of discount to be written off every year is calculated as

Hence, the amount of the total discount of’ 60,000 will be written off in the ratio of ,5 : 4 : 3 : 2 :1 i.e.,’ 20,000,’ 16,000,’ 12,000,’ 8,000 and 4,000 respectively.

Q.5 Explain the different terms for the issue of debentures with reference to their redemption.
ANSWER: Debentures can be issued at par, at premium and at discount in the same way they can be redeem at par and at premium. Debentures can never be redeemed at discount. The following are the six situation under which debentures can be issued to their redemption.
(i) Issue at Par and Redeemable at Par: When the debentures are issued and are redeemed at their face value, then the following Journal entry is passed.

(ii) Issue at Premium and Redeemable at Par When the debentures are issued at premium and redeemable at par, then the following Journal entry is passed. As premium is a gain for a company so it is credited in the Journal entry.

(iv)Issue at Discount and Redeemable at Par When the debentures are issued at discount and redeemable at par, then the following Journal entry is passed. As discount is a loss for a company so it is debited in the Journal entry.

(v) Issue at Premium and Redeemable at Premium When debentures are issued at par and redeemable at premium, then the following Journal entry is passed. In such case, the company did not suffer any loss at the time of issue but there will be loss at the time of redemption.

(vi) Issue at Discount and Redemption at Premium When the debentures are issued at discount and redeemable at premium, then the following Journal entry is passed.

Q.6 Differentiate between redemption of debentures out of capital and out of profits.
ANSWER:  Debentures can be redeemed out of capital and out of profits. The following are the difference between these two methods.
Redemption of Debentures Out of Capital: This is the situation where debentures are redeemed out of capital and no profits are utilised for redemption of the debentures, such redemption is termed as redemption out of capital. In this situation, no profits are required to be transferred to the Debenture Redemption Reserve (DRR).
Here it is to be remembered that no company can redeem its debenture purely out of capital because as per the guideline laid down by Securities and Exchange Board of India (SEBI) and the Section 117C of Company Act of 1956, before starting any redemption process a company is required to create a DRR equal to 50% of the debentures issued).
Therefore, it is not possible to redeem debentures purely out of capital, as it reduces the value of assets. There are exceptions in the following case
(i) Infrastructure companies (i.e., those companies that are engaged in the business of developing, maintaining and operating infrastructure facilities)
(ii) A Company that issues debentures with a maturity up to 18 months.
(iii) In case of convertible debentures and convertible portion of partly convertible debentures.
Redemption of Debenture Out of Profits:When debentures are redeemed out of profit then no capital is utilised for redemption. Before redeeming the debentures profits are transferred to DRR from Profit and Loss Appropriation Account. The creation of DRR is mandatory as per the guidelines laid down by Securities and Exchange Board of India (SEBI).

SEBI mandates transferring amount equal to 50% of debentures issued to DRR before redeeming debentures. As transfer of amount (profits) to the DRR from Profit and Loss Appropriation Account reduces the amount of profit available for distribution of dividend, so this redemption process is known as redemption out of profit.

DRR is shown under the head of Reserves and Surpluses on the Liabilities side of the Balance Sheet. DRR account is closed by transferring it to General Reserve only when all the debentures are redeemed.

Q.7 Explain the guidelines of SEBI for creating Debenture Redemption Reserve.
ANSWER:  Securities and Exchange Board of India (SEBI) have provided some guidelines for redemption of debentures. The focal points of these guidelines are *
(i) Every company shall create Debenture Redemption Reserve in case of issue of debenture redeemable after a period of more than 18 months from the date of issue.
(ii) The creation of Debenture Redemption Reserve is obligatory only for non-convertible debentures and non-convertible portion of partly convertible debentures.
(iii) A company shall create Debenture Redemption Reserve equivalent to at least 50% of the amount of debenture issue before starting the redemption of debenture.
(iv) Withdrawal from Debenture Redemption Reserve is permissible only after 10% of the debenture liability has already been reduced by the company.

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

Q.8 Describe the steps for creating Sinking Fund for redemption of debentures.
ANSWER:  The steps involved in creation of Sinking Fund on redemption of Debenture are
(i) Calculate the amount of profit to be set-aside annually with the help of sinking fund table.
(ii) Set aside the amount of profit at the end of each year and credit to Debenture Redemption Fund (DRF) Account.
(iii) Purchase the investments of the equivalent amount at the end of first year and debit Debenture Redemption Fund Investment (DRFI) Account.
(iv) Receive interest on investment at the end of each subsequent year.
(v) Purchase the investments equivalent to the fixed amount of profit set aside and the interest earned every year except last year (year of redemption).
(vi) Receive interest on investment for the last year.
(vii) Set aside the fixed amount of profit for the last year.
(viii) Encash the investments at the end of the year of redemption.
(ix) Transfer the profit/loss on sale of investments reflected in the balance of Debenture Redemption Fund Investment Account to Debenture Redemption Fund Account.
(x) Make payment to debenture holders.
(xi) Transfer Debenture Redemption Fund A/c balance to General Reserve.

Q.9 Can a company purchase its own debentures in the open market? Explain.
  ANSWER: Securities and Exchange Board of India (SEBI) have provided some guidelines for redemption of Yes, a company, if authorised by its Articles of Association, can purchase its own debentures in the open market. The main purposes of such purchase may be as follows
(i) A company may purchase its own debenture for immediate cancellation for reducing the debenture liability especially in case when the interest rate on its debenture is higher than the market rate of interest.
(ii) A company may also purchase its own debentures with the motive of investment and sell them at higher price in future and thereby earn profit.

When a company purchase its own debenture,in the open market it can happen in either of the two ways first debentures may be purchased at premium for cancellation and debenture may be purchase at discount for cancellation. The following will be the accounting treatment in both situation.

(i) If Debentures are Purchased at Discount for Cancellation :When the company purchase its own debentures at discount for cancellation, then the following Journal entries are recorded.

Q.10 What is meant by conversion of debentures? Describe the method of such a conversion.
ANSWER: The debentures can also be redeemed by converting them into shares or new debentures. If debenture holders find that the offer is beneficial to them they may convert his/her debentures into shares or new debentures after the expiry of a specified period of time, then this whole process is known as redemption of debentures by conversion.
It is worth mentioning here that in such a case no Debenture Redemption Reserve is required because no funds are required for redemption.
If a debenture holder exercises the conversion option, then the issue price of shares must be equal to or less than the amount .actually received from debentures. The accounting treatment in that case will be as follows:

Short Answer Type Question:

Q.1What is public company?

ANSWER: A public company is defined as a company that offers a part of its ownership in the form of shares, debentures, bonds, securities to the general public through stock market. There must be atleast seven members to form a public company. As per the section 3 (1) (iv) of Companies Act 1956, public company means a company which:

a) is not a private company,

b) has a minimum paid up capital of Rs 5,00,000 or such higher paid up capital, as may be prescribed,

c) is a private company, being a subsidiary of a company which is not a private company.

A public company should not be mistakenly understood as a publicly-owned company, as the latter is exclusively owned and controlled by the government. A public company issues its share to general public without any restriction on maximum number of persons. A public company can be segmented into two types:

1. Listed Company– A Company whose shares are listed and traded in the stock exchange like, Tata Motors, Reliance, etc.

2. Unlisted Company– A Company whose shares are not listed in the stock exchange and thereby these shares cannot be traded in the stock exchange.

Q.2 What is private limited company?

ANSWER: Private limited company is a company that is limited by shares or by guarantee by its members. A private limited company is defined as a company that has a minimum paid up share capital of Rs 1,00,000. As defined by the Section 3 (1) (iii) of Companies Act 1956, private limited company is defined by the following characteristics:

a) It restricts the right to transfer its shares.

b) There must be atleast two and a maximum of 50 members (excluding current and former employees) to form a private company.

c) It cannot invite application from the general public to subscribe its shares, or debentures.

d) It cannot invite or accept deposits from persons other than its members, Directors and their relatives.

Unlike public company, a private company cannot issue its shares or debentures to general public at large as shares of these companies are not traded in the stock exchange, for example, Coca-Cola India Private limited, etc.

Q.3 When can shares be Forfeited?

ANSWER: When a shareholder fails to pay the allotment money or any subsequent calls, then the company informs the shareholder by giving him/her a proper notice.If even after the notice, the shareholder fails to pay the due money, then the company forfeits the shares allotted to him/her.

Q.4 What is meant by Calls-in-Arrears?

ANSWER: When shareholder fails to pay all the instalments in due time, then company expects the shareholder to pay the outstanding amount in the later stages (or calls). Such amount of money that is being paid at the later stages is termed as Calls-in-Arrears.

Q.5 What do you mean by a listed company?

ANSWER: Those public companies whose shares are listed and can be traded in a recognised stock exchange for public trading like, Tata Motors, Reliance, etc are called Listed Company. These companies are also called Quota Companies. The listing of securities (shares) helps the investor to determine the increase/decrease in value of their investment in a concerned listed company. This provides ample indication to the potential investors about the goodwill of the company and facilitates them to take various investment decisions and also to assess the viability of their investment in a company.

Q.6 What are the uses of securities premium?

ANSWER: As per the Section 78 of the Companies Act of 1956, the amount of securities premium can be used by the company for the following activities:

1. For paying up un issued shares of the company to be issued to members (shareholders) of the company as fully paid bonus share,

2. For writing off the preliminary expenses of the company,

3. For writing off the expenses of, or the commission paid or discount allowed on, any issue of shares or debentures of the company,

4. For paying up the premium that is to be payable on redemption of preference shares or debentures of the company.

5. Further, as per the Section 77A, the securities premium amount can also be utilised by the company to Buy-back its own shares.

Q.7 What is meant by Calls-in-Advance?

ANSWER: Calls-in-Advance refers to a situation when a shareholder pays the whole amount or a part of the amount of shares before it become due, i.e. before the company calls for it. 
So, the amount of money that is being paid in advance at the earlier stages is termed as Calls-in-Advance.

Q.8 Write a brief note on ‘Minimum Subscription’.

ANSWER: When shares are issued to the general public, the minimum amount that must be subscribed by the public so that the company can allot shares to the applicants is termed as Minimum Subscription. As per the Company Act of 1956, the Minimum Subscription of share cannot be less than 90% of the issued amount. If the Minimum Subscription is not received, the company cannot allot shares to its applicants and it shall immediately refund the entire application amount received to the public.

Long Answer Type Question:

Q.1 What is meant by the word ‘Company’? Describe i characteristics.
ANSWER: According to Section 3 (1) (i) of the Company Act of 195 “Company means a company formed and registered under this Act or £ existing company.”

In general, a company is an artificial person, created by law that has separate legal entity, perpetual succession, and common seal and t limited liability. It is a voluntary association of person who together contribu in the capital of the company to do business.

Generally, the capital of a company is divided into small parts known shares, the ownership of which is transferable subject to certain terms s conditions.
Characteristics of Company
(i) Incorporated Association A company comes into existence through the operation of law. Therefore, its incorporation under the Companies Act is must. Without such registration, no company can come into existence. Being created by law, it is regarded as an artificial legal person.
(ii) Separate Legal Entity A company has a separate legal entity, which is not affected by changes in the membership. Therefore being a separate entity, a company can contract, sue and be used in its corporate name and capacity.
(iii) Artificial Person A company is an artificial and juristic person that is created by law.
(iv) Limited Liability Every shareholder of accompany has limited liability. His liability is limited to the extent of the unpaid value of the shares held by him. If such shares are fully paid up, he is subject to no further liability.
(v) Perpetual Existence The existence of company is not affected by the death, retirement, and insolvency of its members. That is, the life of a company remains unaffected by the life and the tenure of its members in the company. The life of a company is infinite until it is properly wound up as per the Companies Act.
(vi) Common Seal The company is not a natural person and has no physical existence. Hence, it cannot put its signature. Thus, the common seal acts as an official signature of a company that validates the official documents.
(vii) Maintenance of Books A limited company is required by law to keep a prescribed set of account books and any failure in this regard attracts penalties.

Q.2 Explain in brief the main categories in which the share capital of a company is divided.
ANSWER: Share capital of a company can be divided into the following categories
(i) Authorised Capital It refers to that amount which is laid down in clause of the memorandum of association of the company. This i maximum amount with which company is registered and to raise from the public by the issue of shares. The therefore, called the registered or nominal or authorised capital of company.
(ii) Issued Capital The authorised capital which is offered to the public for subscription including shares offered to the vendors for subscription other than cash is called the issued capital.
(iii) Subscribed Capital It is the portion of issued capital which has been subscribed to by the public i.e., applied for and allotted by the company. Thus, face value of allotted shares is known as subscribed capital.
(iv) Called-up Capital The portion of the subscribed capital which the shareholders are called upon to pay is termed as called up capital of the company. The company usually does not require a shareholder to pay in one lot, the full value of the shares he has subscribed for. He is generally required to pay it by instalments. The balance of subscribed capital which has not been called-up represents uncalled capital.
(v) Paid-up Capital The amount of called-up capital which has been actually paid by the shareholders is called as paid-up capital and the amounts yet due from the shareholders are called as calls-in-arrears.
(vi) Reserve Capital Sometimes a company by means of special resolution decides that certain portion of its uncalled capital shall not be called-up during its existence and it would be available as an additional security to its creditors in the event of its liquidation. Such a portion of uncalled capital is termed as reserve capital.

Q.3 What do you mean by the term ‘share? Discuss the type of shares, which can be issued under the Companies Act, 1956 as amended to date.
ANSWER:  The capital of a company is divided into a number of equal parts. Each part is called a share. A company may divide its capital into shares of ? 10, ? 50, ^100 or any suitable amount, but it is always preferable to have shares of small denomination in order to bring them within the reach of small investor.
According to Lord Lindley, “The portion of capital to which each member is entitled to his share”. In this way, share is proportionate part of the share capital and forms ownership in a company.
According to Companies Act, 1956 there are two types of shares
(i) Preference Share Preference Share is one which carries the following two rights
(a) They have a right to receive dividend at a fixed rate before any dividend is paid on the equity shares
(b) On the winding up of the company, they have right to return of capital before the capital returned on equity shares.
However, not with standing the above two conditions, a holder of the preference share may have a right to share fully or to a limited extent in the surplus of the company as specified in the Memorandum or Articles* of the company.
(ii) Equity Share Under Indian Companies Act 1956, ‘an equity share is share which is not preference share’. Thus, this share does not carry any preferential right or in other words, equity share is one which is entitled to dividend and repayment of capital after the claim of preference shares is satisfied. Usually the equity shareholders control the affairs of the company and hence right to all the profits after the preference dividend has been paid.

Q.4 Discuss the process for the allotment of shares of a company in case of over subscription.
ANSWER:  When shares are issued to the public for subscription through the prospectus by well managed and financially strong companies, it may happen that the total number of applications received for shares exceeds the number of shares offered by the company to the public, such situation is called the situation of over-subscription. A company can opt for any of the three alternatives to allot shares in case of over-subscription of shares.
(i) Excess Applications are Refused and Money received on Excess Applications is Returned to the Applicants

(ii) If the Applicant are made Partially Allotment (or Pro-rata Basis) In case of over-subscription, when a company allots shares rateable to all the applicants, it is called as pro-rata allotment.
In such a case, the main problem is what to do with the excess amount received on application. Practically, it will be quite irrational to refund the excess money first and then ask the allottee applicants to pay the allotment money.

In practice, generally excess application money receive on these shares is adjusted towards the amount due on allotment or call. For this purpose the entry is made as follows
Pro-rata and Refund of Money In case of over-subscription, the director can adopt a combination of the above two alternatives i.e., they can accept full allotment to some applications, a pro-rata allotment to others and no allotment to the rest.

Q.5 What is a ‘Preference Share’? Describe the different types of preference shares.
ANSWER:  Preference share is one which carries the following two rights
(i) They have a right to receive dividend at a fixed rate before any dividend is paid on the equity shares.
(iii) On the winding up of the company, they have right to return of capital before of the capital returned on equity shares.
However, not with standing the above two conditions, a holder of the preference share may have a right to share fully or to a limited extent in the surplus of the company as specified in the Memorandum or Articles of the Company.
Preference shares can be of various types which are as follows
(i) Cumulative Preference Shares If there are no profits in one year and the arrears of dividends are to be carried forward and paid out of the profits of subsequent years, the preference share is said to be cumulative. It is noted that the company should pay dividend out of profits only.
(ii) Non-Cumulative Preference Shares If unpaid dividend lapses, the share is said to be non-cumulative preference share. It means when a preference shareholder receives dividend only in case of profit and is not entitled any right to recover the arrears of dividend, then the type of preference shares held by the shareholder is known as non-cumulative preference shares.
(iii) Redeemable Preference Shares When shares are repaid after some specified time in accordance with the terms of issue they are called redeemable preference shares.
(iv) Non-Redeemable Preference Shares These are the preference shares, which do not carry with them the arrangement regarding redemption. According to Section 80 (54), no company limited by shares shall issue irredeemable preference shares or preference shares redeemable after the expiry of 20 years from the date of issue.
(v) Participating Preference Shares When a preference shareholder enjoys the right to participate in the surplus profit (in addition to the fixed rate of dividend) that is left after the payment of dividend to the equity shareholders, the type of shares held by the shareholder is known as participating preference shares.
(vi) Non-Participating Preference Shares When a preference shareholder receives only a fixed rate of dividend every year and do not enjoy the additional participation in the surplus profit, then the type of shares held by the shareholder is known as non-participating preference shares.
(vii) Convertible Preference Shares These shares give the right to the holder to get them converted into equity shares at their option according to the terms and conditions of their issue.
(viii) Non-Convertible Preference Shares When the holder of a preference share has not been conferred the right to get his holding converted into equity share, it is called non-convertible preference shares. Preference shares are non-convertible unless otherwise stated.

Q.6 Describe the provisions of law relating to ‘Calls-in- Arrears’ and ‘Calls in Advance’
ANSWER:  Calls-in-Arrears The portion of called up capital which is not paid by the shareholder within a specified time is known as calls-in-arrears. In other words, when a shareholder fails to pay the amount due on allotment or any subsequent calls, then it is termed as call-in-arrears.
The company is authorised by its Article of Association to charge interest at a specified rate on the amount of call-in-arrears from the due date till the date of payment. If the Article of Association is silent in this regard, then Table A shall be applicable that is interest at 5% pa is charged.
It is deducted from the called-up share capital on the liabilities side of the Company’s Balance Sheet. The company can also forfeit the shares on account of non-payment of the calls money after giving proper notice to shareholders.
Calls in Advanqe It means calls not due but paid by the shareholder in advance. Thus, the amount of future calls is received in advance by the company.
In other words, when a shareholder pays the whole amount or a part of the amount in advance, i.e., before the company calls, then it is termed as calls in advance. The company is authorised by its Article of Association to pay interest at the specified rate on call in advance from the date of payment till the date of call made.
If the Article of Association is silent in this regard, then the Table A shall be applicable that is, interest at 6% pa is provided. It is shown under the heading of current liabilities on the liabilities side of the Company’s Balance Sheet.

Q.7 Explain the terms ‘Over-subscription’ and ‘Under-subscription’. How are they dealt with in accounting records?
ANSWER: When shares are issued to the public for subscription through the prospectus by well managed and financially strong companies, it may happen that the total number of applications received for shares exceeds the number of shares offered by the company to the public, such situation is called the situation of over-subscription. A company can opt for any of the three alternatives to allot shares in case of over-subscription of shares.
(i) Excess Applications are Refused and Money Received on Excess Applications is Returned to the Applicants

(ii) If the Applicant are made Partially Allotment (or Pro-rata Basis) In case of over-subscription, when a company allots shares rateable to all the applicants, it is called as pro-rata allotment. In such a case the main problem is what to do with the excess amount received on application.
Practically, it will be quite irrational to refund the excess money first and then ask the allottee applicants to pay the allotment money.
In practice, generally excess application money receive on these shares is adjusted towards the amount due on allotment or call. For this purpose the entry is made as follows

(iii) Pro-rata and Refund of Money In case of over-subscription, the director can adopt a combination of the above two alternatives i.e., they ,can accept full allotment to some applications, a pro-rata allotment to others and no allotment to the rest.

Under-Subscription: In case when share are issued by the company and the number of shares applied by the public is lesser than the number of shares issued this is called the situation of under-subscription.
As per the Comprise Act, the minimum subscription is 90% of the shares issued by the company. This implies that the company can allot shares to the applicants provided if applications for 90% of the issued shares are received. Otherwise, the company should refund the entire application amount received.
In this regard, necessary journal entry is passed only after receiving and refunding of the application. In this case, normal entries are made as the adjustment is not needed for any excess.

Q.8 Describe the purposes for which a company can use ‘Securities Premium Account.
ANSWER:  Securities premium account can be used only for the following four purposes as laid down by Section 78 of the Companies Act 1956
(i) To issue fully paid bonus shares to an extent not exceeding unissued share capital of the company.
(ii) To write-off preliminary expenses of the company.
(iii) To write-off the expenses of, or commission paid, or discount allowed on any of the shares or debentures of the company.
(iv) To pay premium on the redemption of preference shares or debentures of the company.

Q.9 State clearly the conditions under which a company can issue shares at a discount.
ANSWER:  In normal condition as a general rule, a company cannot ordinarily issue shares at a discount. It can do so only in cases such as ‘reissue of forfeited shares’ and in accordance with the provisions of Section 79 of the Companies Act. According to Section 79 of the Companies Act, 1932, a company is permitted to issue shares, at a discount provided the following conditions ara satisfied
(i) The issue of shares at a discount is authorised by an ordinary resolution passed by the company at its general meeting and sanctioned by the Company Law Board now Central Government.
(ii) The resolution must specify the maximum rate of discount at which the shares are to be issued but the rate of discount must not exceed 10 per cent of the nominal value of shares. The rate of discount can be more than 10 per cent if the government is convinced that a higher rate is called-for under special circumstances of a case.
(iii) At least one year must have elapsed since the date on which the company became entitled to commence the business.
(iv) The shares are of a class which has already been issued. •
(v) The shares issued within two months from the date of receiving sanction for the same from the government or within such extended period as the government may allow.
(vi) If the offer prospectus at the date of issue must mention particulars of the discount allowed on the issue of shares.

Q.10 Explain the term ‘Forfeiture of Shares’ and give the accounting treatment on forfeiture.
ANSWER:  If a shareholder fails to pay the allotment money and or any call money on his shares as called upon by the directors, his shares may be forfeited by the directors, if they are so authorised by the Articles of Association. This is known as forfeiture of shares.
As per the Table A of the Company Act, the procedure of forfeiting shares is mentioned below.
(i) A notice is sent to default shareholder stating him/her to pay calls-in-arrears along with the interest accrued on the outstanding calls money within a period of 14 days of the receipt of notice, otherwise, the shares will be forfeited.
(ii) If the shareholder does not pay the amount, then the company has the right to forfeit his/her share by passing a resolution.
(iii) A notice of that resolution is send to the default shareholder and a public notice of the same is published in a daily newspaper.
(iv) The name of the shareholder is removed from the register of members (i.e., shareholders).

Accounting Treatment for Forfeiture of Shares
(i) Forfeiture of Shares that were Issued at Par

(ii) Forfeiture of Shares that were Issued at Premium
(a) Sometimes forfeited shares would have been issued at premium in that case if amount of premium is received than premium received is not shown.

(b) Sometimes forfeited shares would have been issued at premium in that case if amount of premium is not received than premium not received is shown.

(iii) Forfeiture of shares that were issued at discount Sometimes forfeited shares would have been issued at discount in that case amount of discount will always be shown.

Short Answer Type Question:

Q.1 Discuss the formalities involved in getting an export licence.
ANSWER: The formalities involved in getting an export license are:

→ Opening a bank account in any bank authorised by the Reserve Bank of India (RBI) and getting an account number.
→ Obtaining Import Export Code (IEC) number from the Directorate General Foreign Trade (DGFT) or Regional Import Export Licensing Authority.
→ Registering with appropriate export promotion council.
→ Registering with Export Credit and Guarantee Corporation (ECGC) in order to safeguard against risks of non payments.

Q.2 Why is it necessary to get registered with an export promotion council?
ANSWER: It is necessary for firm to register with an export promotion council and obtain the registration-cum-membership certificate (RCMC). This enables the firm to take advantage of the benefits made available to export firms by the government. Export promotion councils carry out various promotional activities to create demand for domestically manufactured products in the international market. By joining appropriate export promotion council a firm can get support in the form of continuous promotion of its products.

Q.3 What is IEC number?

ANSWER: IEC number stands for Importer Exporter Code number is an unique number granted by the Directorate General for Foreign Trade (DGFT) to an import/export firm depending upon the firm’s credibility. It is needed to be filled in various export/import documents.

Q.4 What is pre-shipment finance?
ANSWER: Pre-shipment finance is the finance that the exporter needs for procuring raw materials and other components, processing and packing of goods and transportation of goods to the port of shipment.
Q.5 Why is it necessary for an export firm to go in for pre-shipment inspection?
ANSWER: Pre-shipment inspection is a compulsory step for inspection of certain products by a competent agency as designated by the government. The government has passed Export Quality Control andInspection Act, 1963 for this purpose. and has authorised some agencies to act as inspection agencies. If the product to be exported comes under such a category, the exporter needs to contact the Export Inspection Agency (EIA) or the other designated agency for obtaining inspection certificate.

Q.6 Discuss the procedure related to excise clearance of goods.
ANSWER: As per the Central Excise Tariff Act, excise duty is payable on the materials used in manufacturing goods. The exporter, therefore, has to apply to the concerned Excise Commissioner in the region with
an invoice. If the Excise Commissioner is satisfied, he may issue the excise clearance. But in many cases the government exempts payment of excise duty or later on refunds the excise duty paid. This is done in order to encourage exports. The refund of excise duty is known as duty drawback.

Q.7 Explain briefly the process of customs clearance of export goods.
ANSWER: The goods must be cleared from the customs before these can be loaded on the ship. For obtaining customs clearance, the exporter prepares the shipping bill that contains particulars of the goods being exported, the name of the vessel, the port at which goods are to be discharged, country of final destination, exporter’s name and address, etc. Five copies of the shipping bill along with the following documents are then submitted to the Customs Appraiser at the Customs House:• Export order
• Letter of credit
• Commercial invoice
• Certificate of origin
• Certificate of inspection, if necessary
• Marine insurance policy
After submission of these documents the superintendent of the concerned port trust is approached for carting order and after obtaining it, the Cargo is physically moved into the port area and stored in shed.

Q.8 What is bill of lading? How does it differ from bill of entry?
ANSWER: Bill of lading is a document wherein a shipping company gives its official receipt of the goods put on board its vessel and at the same time gives an undertaking to carry them to the port of destination.

It differ from bill of entry in following manner:

Bill of lading	Bill of entry
It is required at the time of an export transaction.	It is required at the time of an import transaction.
It is issued by the shipping company as a token of acceptance that the goods have been put on board in its vessel.	It is a form supplied by the customs office and filled by the importer once the goods are received.

Q.9 What is shipping bill?
ANSWER: The shipping bill is the main document on the basis of which customs office grants permission for the export. It contains particulars of the goods being exported, the name of the vessel, the port at which goods are to be discharged, country of final destination, exporter’s name and address, etc.
Q.10 Explain the meaning of mate’s receipt.
ANSWER: A mate receipt is a receipt issued by the commanding officer of the ship when the cargo is loaded on board, and contains the information about the name of the vessel, berth, date of shipment, description of packages, marks and numbers, condition of the cargo at the time of receipt on board the ship, etc.
Q.11 What is a letter of credit? Why does an exporter need this document?
ANSWER: A letter of credit is a guarantee issued by the importer’s bank that it will honour up to a certain amount the payment of export bills to the bank of the exporter. An exporter need this document as it is the most appropriate and secure method of payment adopted to settle international transactions.
Q.12 Discuss the process involved in securing payment for exports.
ANSWER: After the shipment of goods, the exporter informs the importer about the shipment of goods. The exporter sends the documents like certified copy of invoice, bill of lading, packing list, etc. needed by the importer to claim the title of goods on their arrival at his/her country and getting them customs cleared. These documents are sent through exporter’s banker with the instruction that these may be delivered to the importer after acceptance of the bill of exchange. The exporter’s bank receives the payment through the importer’s bank and is credited to the exporter’s account. The exporter can get immediate payment from his/ her bank on the submission of documents by signing a letter of indemnity. After receiving the payment for exports, the exporter needs to get a bank certificate of payment which states that the necessary documents relating to the particular export consignment have been presented to the importer for payment and the payment has been received in accordance with the exchange control regulations.

Q.13 Differentiate between the following
(i) Sight and usance drafts
(ii) Bill of lading and airway bill
(iii) Pre-shipment and post-shipment finance

ANSWER:

(i) Sight and usance drafts

Sight drafts	Usance drafts
Documents are handed over to the importer once he or she agrees to sign the draft.	Documents are handed over to the importer after the acceptance of the bill of exchange.
Payment is made at the time of issuing the draft.	Payment is made on the expiry of a specified period.

(ii) Bill of lading and airway bill

Bill of lading	Airway bill
Issued by shipping companies.	Issued by airline companies.
Goods are sent by ship.	Goods are sent by air.

(iii) Pre-shipment and post-shipment finance

Pre-shipment finance	Post-shipment finance
Credit is obtained before the shipment of goods.	Credit is obtained after the shipment of goods.
Used for purchasing raw materials to undertake production activities, packaging of goods and transporting goods to the port of shipment.	Used for financing activities from the date of receiving credit till payment is received from the importer.

Q.14 Explain the meaning of the following documents used in connection with import transactions
(i) trade enquiry (ii) Import licence (iii) Shipment of advice
(iv) Import general manifest (v) Bill of entry
ANSWER:
(i) trade enquiry: A trade enquiry is a written request by the importer to the exporter for supply of information regarding the price and various terms and conditions on which the importer is ready to exports goods.

(ii) Import licence: It is a licence which permits the import of goods that cannot be imported freely. In India, for obtaining an import licence, an importer requires an IEC (Importer Expert Code) number, which is obtained after the importer’s registration with the Directorate General for Foreign Trade (DGFT) or the Regional Import Export Licensing Authority.

(iii) Shipment of advice: The shipment advice is a document that the exporter sends to the importer informing him that the shipment of goods has been made. Shipment of advice contains invoice number, bill of lading/airways bill number and date, name of the vessel with date, the port of export, description of goods and quantity, band the date of sailing of the vessel.

(iv) Import general manifest: Import general manifest is a document that contains the details of the imported good. It is the document on the basis of which unloading of cargo takes place.

(v) Bill of entry: It is a form filled by the importer for assessment of custom import duty. It contains information such as the name and address of the importer, name of the ship in which the goods were transported and number of packages. The importer fills in the bill form and returns it to the customs office.

Q.15 List out major affiliated bodies of the World Bank

ANSWER: The major affiliated bodies of the world bank are:
• International Bank for Reconstruction and Development (IBRD)
• International Financial Corporation (IFC)
• International Development Association (IDA)
• Multilateral Investment Guarantee Agency (MIGA)
• International Centre for Settlement of Investment Disputes (ICSID)

Q.16Write short notes on the following
(i) UNCTAD
(ii) MIGA
(iii) World Bank
(iv) ITPO
(v) IMF

ANSWER: (i) UNCTAD: The United Nation Conference on Trade and Development was established in 1964 with the objective of integrating the developing countries with the world economy through discussions. It undertakes activities such as collecting research and data for policy making and extending technical assistance to the less developed countries as per their requirements.
(ii) MIGA: The Multinational Investment Guarantee Agency, or MIGA , was established in April 1988 with the objective of encouraging foreign direct investment in the less developed countries. It aims at insuring investors against political and non-commercial risks, providing advisory services, etc.
(iii) World Bank: It is earlier known as International Bank for Reconstruction and Development (IBRD) setup to assist the reconstruction of war -affected countries and to facilitate the development of the under-developed nations of the world. Now, the world bank turned its attention to
the development of underdeveloped nations. Apart from investing in infrastructure development, agriculture, health and industry, the World Bank is significantly involved in programmes to remove poverty, increasing the income of the poor and providing technological support.

(iv) ITPO: Indian Trade Promotion Organisation was setup on 1st January 1992 under the Companies Act 1956. Its main objective is to maintain close interactions among traders, industry and the government. In order to fulfil this objective, the ITPO organises trade fairs and exhibitions within and outside the country, thereby helping export firms to interact with international trade bodies.

(v) IMF: International Monetary Fund (IMF) came into existence in 1945 has its headquarters located in Washington DC. It aims at facilitating a system of international payments and adjustments in exchange rates among national currencies in order to bring about balanced growth at the international level and increase the levels of employment and income.

Long Answer Type Question:

Q.1 Rekha Garments has received an order to export 2000 men’s trousers to Swift Imports Ltd. located in Australia. Discuss the procedure that Rekha Garments would need to go through for executing the export order.
Answer:  Rekha Garments will have to adopt the following procedures given below to execute the export order.

• As the exporter, it should first assess the credit worthiness of the importer. Swift Imports, through an enquiry. It should then ask for a letter of credit from the importer’s bank, guaranteeing to honour a draft of a specified amount drawn on it by the exporter.
• Once Rekha Garments is assured that it will be paid for the goods, it will need to register itself and secure an Importer Exporter Code number in order to obtain an export license.
• After obtaining the license, it should acquire pre-shipment finance from a bank in order to purchase raw materials to undertake production and packaging.
• With the finance made available, Rekha Garments can procure the raw materials and other inputs required and start the production process.
• After the goods are produced, Rekha Garments must get them inspected before exporting them. For this inspection, it must contact the Export Inspection Agency (EIA) or another designated agency and obtain a certificate of inspection.
• The exporter then needs to secure excise clearance, for which it must submit an invoice to the regional excise commissioner. The excise commissioner then examines the invoice and, if satisfied, issues the excise clearance to the exporter.
• Once the excise clearance is received, Rekha Garments needs a certificate of origin, which specifies the country in which the goods are being produced. It allows the importer to claim tariff concessions and other exemptions, if any.
• The next step is for the exporter to submit an application to a shipping company for booking shipping space in a vessel. In the application, it must provide details such as the type of goods to be shipped and the port of destination. After the application is received, the shipping company will issue a shipping order to the captain of its ship to inform him or her that the specified goods will be received on board after the customs clearance.
• The goods are then properly packed and labelled with Ml the necessary information such as the importer’s name, port of destination, and gross and net weight of the goods.
• Once the goods are ready for export, Rekha Garments must insure the goods against perils of the sea or any related damage.
• It must then secure customs clearance before loading the goods on the ship. For getting customs clearance, the exporter must submit the necessary documents to the customs appraiser at Customs House.
• After customs clearance, a mate’s receipt will be issued by the captain or commanding officer of the ship to the exporter as evidence that the cargo has been loaded on the ship.
• Later, a bill of lading will have to be obtained from the shipping company as a token of acceptance that the goods have been put on board in its vessel.
• After the goods are shipped, an invoice will have to be prepared by the exporter, which will include the quantity of goods sent and the amount to be paid by the importer.
• The exporter then needs to send a set of documents to the banker, which is to be handed over to the importer on acceptance of a bill of exchange. After receiving the bill of exchange, the importer, Swift Imports, will instruct its bank to transfer money to the exporter’s bank account.
• Last, the exporter would be required to collect a bank certificate of payment, which will state that the necessary documents, along with the bill of exchange, have been presented to the importer for payment, and that the payment has been received in accordance with the exchange control regulations.

Q.2 Your firm is planning to import textile machinery from Canada. Describe the procedure involved in importing.
Answer:  In order to import textile machinery from Canada, the firm will have to take the following steps:

• The firm (the importer) should first make an enquiry about the price of the machinery, terms and conditions on which the selected Canadian exporter is willing to supply the goods and such related information. It should then send the trade enquiry to the exporter. On receipt of the trade enquiry, the exporter will prepare a quotation and send it to the importer.
• The importer must find out whether the goods to be imported are subject to import licensing. If needed, it must secure an import license.
• The firm must then convert domestic currency into foreign currency to make payment to the exporter. This is done by submitting an application to a bank in the prescribed form along with documents.
• Once the import license is obtained, the importer can place an order with the exporter specifying the price, quantity and quality of the goods required.
• The importer will be required to send a letter of credit to the Canadian exporter. This letter is obtained from the importer’s bank and acts as a bank guarantee that a draft of a specified amount drawn on it by the exporter will be honoured.
• The next step is for the importer to arrange for finance in order to make payment to the exporter on the arrival of the goods. This is necessary to avoid penalties on account of any delay in payment.
• Once the goods are shipped, the exporter will send a shipment advice to the importer. This document is proof of dispatch of the goods and contains information about the bill of lading, name of the vessel with date, port of export, description of goods, etc.
• The importer must then prepare a bill of exchange that is to be handed over to the exporter’s banker in exchange for the export documents. After this is done, the importer is required to instruct its bank to transfer money to the exporter’s bank account.
• An import general manifest will be issued by the person in charge of the carrier (ship or airliner) in which the goods are being imported. This is done in order to inform the officer in charge at the dock or the airport about the arrival of the goods. This document contains information about the goods being imported, and it is on the basis of this document that unloading of the cargo will take place.
• Once the goods arrive at the port, the importer must get customs clearance, which in turn requires a delivery order, a port duty dues receipt and a bill of entry.

Q.3 Discuss the principal documents used in exporting.
Answer:  The following documents are required for an export transaction:

• Export Invoice: It is a seller’s bill which contains information about the quantity of goods, total value of goods, number and marks of packaging, name of the ship, etc.
• Packing List: It includes information related to the goods that are packed, such as the number of items packed in one package, details of goods contained in one package, etc.
• Certificate of Origin: Certificate of Origin specifies the country in which the goods being exported were produced. It allows the importer to claim tariff concessions and other exemptions.
• Certificate of Inspection: Certificate of Inspection is proof that the goods being exported are of good quality. The exporter contacts the Export Inspection Agency (EIA) or another designated agency and obtains the certificate of inspection after getting the goods inspected.
• Mate’s Receipt: It is a receipt issued by the captain or commanding officer of a ship to an exporter as evidence that the exporter’s cargo has been loaded on the ship. It contains information about the name of the vessel, berth, date of shipment, condition of the cargo when the goods were loaded, description of packages of the cargo, number of packages, marks on the packages, etc.
• Shipping Bill: It contains information regarding the specifications of the goods for export, such as the name of the vessel, port at which the goods are to be discharged, country of final destination and exporter’s name and address. This document forms an essential part of an export transaction as it is on the basis of this document that customs grants clearance to the export.
• Bill of Lading: Bill of lading is an essential document required for an export transaction. It is issued by the shipping company concerned as a token of acceptance that the goods have been put on board in its vessel. A bill of lading is an undertaking signed by the shipping company to transfer the goods to the port of destination. Bills of Lading are freely transferable.
• Airway Bill: It is issued by an airline as a token of acceptance that the goods for export have been put on board its aircraft.
• Marine Insurance Policy: Marine Insurance Policy is an insurance contract under which the insurance company concerned, in return for a premium, agrees to pay an exporter a specified amount in case of loss of goods or damage caused during transport by sea.
• Cart Ticket: Also known as a cart chit or a gate pass is prepared by an exporter and includes information about the exporter’s cargo.
• Letter of Credit: Letter of Credit is issued by the bank of an importer guaranteeing to honour a draft of a specified amount drawn on it by the exporter. A letter of credit enables the exporter to assess the creditworthiness of the importer and is the most appropriate and secure method of payment for settling international transactions.
• Bill of Exchange: Bill .of Exchange indicates the amount that an importer must pay to the bearer of the bill. On receiving a bill of exchange, the importer instructs its bank to transfer the amount to the exporter’s bank account.
• Bank Certificate of Payment: Bank Certificate of Payment indicates that the necessary documents, along with the bill of exchange, have been presented to the importer, and that payment from the importer has been received in accordance with the exchange control regulations.

Q.4 List and explain various incentives and schemes that the government has evolved for promoting the country’s foreign trade.
Answer:  The following are some of the schemes and incentives adopted by the government to promote exports:

• Duty Drawback Scheme: Under the duty drawback scheme, exporters are either exempted from payment of excise duties or are refunded a certain percentage of the excise duty paid earlier. In case where inputs are used for export production, the custom duties paid on import of raw material and machines are refunded.
• Export Manufacturing under the Bond Scheme: This bond scheme enables exporters to undertake production of goods meant for exports without paying excise or other duties. In order to avail themselves of this scheme, exporters must sign an undertaking that the goods produced are meant only for exports and not for domestic consumption.
• Exemptions from Payment of Sales Tax: The goods that are meant for imports are not subjected to sales tax. The income earned by exporters (only those who run 100 per cent export-oriented units or units in export processing zones and special economic zones) from the export of goods is exempted from payment of income tax.
• Advance License Scheme: Advance License Scheme allows exporters to use inputs (those that are domestically produced or imported) without the payment of any duties. In addition, the scheme exempts exporters from paying custom duties in cases where the imported inputs are used for manufacturing goods meant for exports.
• Export Promotion Capital Goods (EPCG) Scheme: The EPCG Scheme promotes the import of goods for the production of export goods. Under the scheme, exporters are allowed to import goods at concessional rates of custom duties. However, to avail themselves of this scheme, exporters must fulfill certain export obligations stated under the scheme. ‘
• Scheme of Recognizing Export House, Trading House and Superstar Trading House: This scheme aims at facilitating well-established trading houses to market their products globally. Under the scheme, selected exporting firms are given the status of export house, trading house and star trading house by the government. This status is given on the basis of the past export performances of export firms.

Q.5 Identify various organizations that have been set up in the country by the government for promoting country’s foreign trade.
Answer:  In order to promote foreign trade, the Government has set up the following institutions:

• Indian Institute of Foreign Trade (IIFT): Established in 1963 under the Societies Registration Act, the IIFT is an autonomous body responsible for the management of the country’s foreign trade. It is also a deemed university that provides training
  in international trade, conducts research in areas of international business and disseminates data related to international trade.
• Export Inspection Council (EIC): The EIC was established by the Government of India under Section 3 of the Export Quality Control and Inspection Act, 1963, with the objective of promoting exports through quality control and pre-shipment inspections. According to this act, all goods that are meant for exports (except some commodities) must pass through the EIC for quality inspection.
• Indian Institute of Packaging (IIP): The IIP is a training and research institute established in 1966 by the joint efforts of the Ministry of Commerce of the Government of India, Indian Packaging Industry and Allied Industries. The institute caters to the packaging needs of domestic manufacturers and exporters.
• Indian Trade Promotion Organisation (ITPO): The ITPO was formed on January 1, 1992, under the Companies Act, 1956. Its main objective is to maintain close interactions among traders, industry and the government. In order to fulfill this objective, the ITPO organizes trade fairs and exhibitions within and outside the country, thereby helping export firms to interact with international trade bodies.
• Department of Commerce: The Department of Commerce is the apex body in the Ministry of Commerce of the Government of India and is responsible for formulating policies related to foreign trade as well as evolving import and export policies for the country. It is responsible for all matters related to the country’s external trade.
• Export Promotion Councils (EPCs): Registered under the Companies Act or the Societies Registration Act, EPCs are non-profit organizations that are responsible for promoting the exports of particular products. However, the product promoted by a particular EPC must fall under its jurisdiction.

Q.6 What is World Bank? Discuss its various objectives and role of its affiliated agencies.
Answer:  The World Bank is an International Financial Institution that was established in 1944 at the Bretton Woods Conference.
The following are some of the main objectives behind the setting up of the World Bank:

1. To facilitate the task of reconstruction of the war-affected European countries.
2. To focus on the development of underdeveloped nations of the world.
3. To encourage investments in infrastructure development, agriculture, health and industry;
4. To eradicate poverty, increase the income of the poor and provide technological support.

The following are some of the affiliates of the World Bank:

1.  MIGA: MIGA, or the Multinational Investment Guarantee Agency, was established in April 1988 with the objective of encouraging foreign direct investments in the less developed nations of the world. It also aims at insuring investors against political and non-commercial risks and providing advisory services.
2. IFC: The IFC, or the International Finance Corporation, was formed in 1956 as a separate legal entity to provide finance to the private sector in developing nations. Although the IFC is an affiliate of the World Bank, it has its own funding, besides functions that are managed independently.
3. IDA: The IDA, or the International Development Association, was established in 1960 with the affiliation to the World Bank. The basic objective of the association is to provide loans and grants on a soft-loan basis to the less developed member countries—it aims at providing loans at concessional rates to the member countries
   whose per capita income is very low. It is because of this objective that the IDA is also known as the World Bank’s soft-loan window.

Q.7 What is IMF? Discuss its .various objectives and functions.
Answer:  The IMF, or the International Monetary Fund, came into existence in 1945 with the objective of establishing a healthy and orderly monetary system. It aimed at facilitating a system of international payments and taking care of the adjustments in exchange rates among national currencies. It is one of the three international institutions—the other two being the World Bank and the International Trade Organization—that were created for facilitating and monitoring the economic development of the world.
Objectives of the IMF

1. To aid the balanced growth of international trade and market, thereby promoting the growth of employment and income;
2. To promote international monetary cooperation among the member countries;
3. To facilitate the orderly exchange of goods between the member countries;
4. To facilitate international payments with respect to the exchange transactions between the member countries.

Functions of the IMF

1. Providing short-term credit to member countries;
2. Maintaining stability in the exchange rate of the member countries;
3. Fixing and altering the value of a country’s currency whenever required, to facilitate the adjustment of exchange rate of member countries;
4. Collecting the currencies of member countries so as to allow them to borrow the currency of other nations;
5. Lending foreign currency to member nations and facilitating international payments with respect to the exchange transactions between member countries.

Q.8 Write a detailed note on features, structure, objectives and functioning of WTO.
Answer:  Features of the WTO (World Trade Organisation):

1. It governs trade in goods, services and intellectual property rights among the member countries.
2. It is a body created by an international treaty with the approval of the governments and legislatures of the member states.
3. The decisions of the WTO are made by the governments of the member nations on the basis of consensus.

Structure of the WTO
On January 1, 1995, the General Agreement on Tariffs and Trade (GATT) was transformed into the WTO to facilitate international trade among the member countries. The WTO was made much more powerful than GATT, by removing tariff and non-tariff barriers between the member nations. It is a permanent body created by an international treaty and represents the implementation of the original proposal of the ITO.
Objectives of the WTO

1. Reducing tariff and other non-trade barriers imposed by different nations;
2. Ensuring sustainable development by optimally using the world resources;
3. Developing a more integrated, feasible and stable trading system.

Functions of the WTO

1. Providing an environment to the member countries such that they can put forward their grievances before the WTO without any hesitation;
2. Resolving trade disputes among member nations;
3. Eliminating discriminations in trade relations by laying down a commonly accepted code of conduct;
4. Creating better understanding between member countries by consulting with the IMF, the World Bank and other affiliates.

Short Answer Type Question:

Q.1 Differentiate between international trade and international business.
ANSWER:

International trade	International business
International trade refers to the exchange of goods and services across the international boundaries of countries.	International business not only includes movement of capital, of goods and services, but also of capital, personnel, technology and intellectual property like patents, trademarks, know-how and copyrights.
International trade means movements of goods only.	Business transaction that takes place between two or more countries is known as international business.
International trade is a narrow term.	International business is much broader than international trade.

Q.2 Discuss any three advantages of international business.
ANSWER: Three advantages of international business are:
→ Earning of foreign exchange: International business helps a country to earn foreign exchange which it can later use for meeting its imports of capital goods, technology, petroleum products and fertilisers, pharmaceutical products and a host of other consumer products which otherwise might not be available domestically.
→ More efficient use of resources: International business allows a country to produce what a country can produce more efficiently and trade the surplus production so generated with other countries to procure what they can produce more efficiently.

→ Improving growth prospects and employment potentials: International business encourages many countries, especially the developing ones to produce on a larger scale which not only helps in improving their growth prospects, but also created opportunities for employment of people living in these countries.

Q.3 What is the major reason underlying trade between nations?

ANSWER: The major reason underlying trade between nations are:
→ Unequal distribution of natural resources among different nations.
→ Availability of various factors of production such as labour, capital and raw materials that are required for producing different goods and services differ among nations.
→ Labour productivity and production costs differ among nations due to various socio-economic, geographical and political reasons.

Q.4 Discuss as to why nations trade.

ANSWER: The nations cannot produce equally well or cheaply all that they need because of the unequal distribution of natural resources and various other factors such as labour productivity and production costs. Therefore, some countries are in an advantageous position in producing select goods and services which other countries cannot produce that effectively and efficiently, and vice-versa and procuring the rest through trade with other countries which the other countries can produce at lower costs.

Q.5 Enumerate limitations of contract manufacturing.
ANSWER: The limitations of contract manufacturing are:

→ Local firms might not adhere to production design and quality standards, thus causing serious product quality problems to the international firm.

→  Local manufacturer in the foreign country loses his control over the manufacturing process because goods are produced strictly as per the terms and specifications of the contract.

The profitability of local firm producing under contract manufacturing is low as it is not free to sell the contracted output as per its will. It has to sell the goods to the international company at prices agreed upon under the contract which may be lower than the open market prices.
Q.6 Why is it said that licensing is an easier way to expand globally?
ANSWER: Licensing is an easier way to expand globally because:

→ Under the licensing system, it is the licensor who sets up the business unit and invests his/her own money in the business and the licensor has to virtually make no investments abroad. Therefore, it is considered a less expensive mode of entering into international business.

→ Since the business in the foreign country is managed by the licensee who is a local person, there are lower risks of business takeovers or government interventions.

→ Licensee being a local person has greater market knowledge and contacts which can prove quite helpful to the licensor in successfully conducting its marketing operations.
Q.7 Differentiate between contract manufacturing and setting up wholly owned production subsidiary abroad.

ANSWER:

Contract manufacturing	Wholly owned production subsidiary
A firm enters into a contract with one or a few local manufacturers in foreign countries to get certain components or goods produced as per its specifications.	The parent company acquires full control over the foreign company by making 100 per cent investment in its equity capital.
The firm has limited control over the local manufacturer.	The parent company has full control over its operations in another country through the subsidiary.
There is no or little investment in the foreign countries	The parent company buys up the entire equity of the firm abroad and makes this firm its subsidiary.

Q.8 Distinguish between licensing and franchising.
ANSWER:

Licensing	Franchising
The licensor grants licence to a foreign company (licensee) to produce and sell goods under the licensor’s logo and trademarks for a fee.	The franchiser grants a foreign firm (franchisee) the right to operate a business using a common brand name for an initial or a regular fee.
Operations are related to production and marketing of goods.	Operations are related to the services business.
Less stringent rules and regulations	Strict rules and regulations

Q.9 List major items of India’s exports.
ANSWER: The major items of India’s exports are Tea, Basmati rice, Spices, Leather and leather products and Semi-precious stones.
Q.10 What are the major items that are exported from India?

Answer:
The major items that  are exported from India are tea, pearls, precious and semi-precious stones,medicinal and pharmaceutical products, rice, spices, iron ore and concentrates, leather and leather manufactures, textile yarns fabrics, garments and tobacco. It also holds the distinct position of being the largest exporter in the world in select commodities such as basmati rice, tea, and ayurvedic products
Q.11 List the major countries with whom India trades.
ANSWER: The major countries with whom India trades are USA, UK, Belgium, Germany, Japan, Switzerland, Hong Kong, UAE, China, Singapore and Malaysia.

Long Answer Type Question:

Q.1 What is international business? How is it different from domestic business?
Answer:  International business refers to business which is carried on in two or more nations. It means carrying on business activities beyond national boundaries. These activities normally include the transaction of economic resources such as goods, capital, services (comprising technology, skilled labour, and transportation, etc.), and international production. It refers to that business activity that takes place beyond the geographical limits of a country. Production may either involve production of physical goods or provision of services like banking, finance, insurance, construction, trading, and so on. Thus, international business includes not only international trade of goods and services but also foreign investment, especially foreign direct investment.
Differences between International Business and Domestic Business are summarised below:

Q.2“International business is more than international trade”. Comment.
Answer:  It is rightly said that international business is more than international trade. The scope of international business is much wider than international trade. International trade means exports and imports of goods which is an important component of international business but international business includes much more than this. International trade in services like travel and tourism, transportation, communication, banking, warehousing, distribution and advertising is a part of international business. International business also includes foreign direct investments, contract manufacturing, and setting up wholly owned subsidiaries etc. which are not included in international trade. It is clear from the diagram given below:

Q.3 What benefits do firms derive by entering into international business?
Answer:  The trade between two or more nations is termed as foreign trade or international trade. It involves exchange of goods and services between the trades of two countries. Foreign trade consists of import trade, export trade and entrepot trade. In the early stages of human civilization, production was confined as per consumption. Human wants were limited. Nowadays, human wants are increasing and as such no man was considered to be self-dependent. Like this no country can live in isolation and claimed the status to be self-sufficient. Because of this reason countries have trade relationships with each other. The primary objective of foreign trade is to increase foreign trade and increase the standard of living of its people. There is an increasing demand for foreign trade because of the following reasons:

1. The natural resources are unevenly distributed.
2. The presence of specialisation and division of labour.
3. Different countries have difference in economic growth rate.
4. The presence of the theory of comparative cost.
   The following are some of the advantages of foreign trade:

1. Optimum use of Resources: Foreign trade helps in the optimum use of natural resources and avoids wastages of resources.
2. Stable Price: It ensures the presence of stable price by avoiding wide fluctuations in prices. It tries to equalise the world price.
3. Availability of all types of goods: It enables a country to import those goods which it cannot produce.
4. Increased Standard of living: It ensures more production to meet the demand of the people of different countries. By increased production, it becomes possible to increase income and the standard of living of its people. It also increases the standard of living by increasing more employment opportunities.
5. Large Scale production: It ensures large production because the production is carried on to meet the demand of its people as well as world market. Large scale production also ensures a great deal of internal economies which reduces the cost of production.

Q.4 In what ways is exporting a better way of entering into international markets than setting up wholly owned subsidiaries abroad.
Answer:  Exporting is a better way of entering into international markets than setting up wholly owned subsidiaries abroad in following ways:

1. Easiest Way: It is easy to enter international markets through exports as compared to wholly owned subsidiaries.
2. Less Involving: It is less involving as compared to establishing a wholly owned subsidiary because firms need not invest that much time and money.
3. Zero risk of Foreign Investment: Exporting does not require much of investment in foreign countries. Therefore, foreign investments risks are low as compared to when a firm starts its wholly owned subsidiary in foreign country.
4. Less Costly: In a wholly owned subsidiary, 100% equity investment is to be made by foreign company. Therefore, small and medium size producers can’t think of this mode of entering into international business.
5. Risk of Profit and Loss: In wholly owned subsidiary, 100% equity capital is contributed by foreign company alone. Therefore, it alone has to bear the risk of losses.
6. Government Intervention: Some countries are averse to setting up of 100% wholly owned subsidiaries by foreign companies. This form of business operations is subject to high degree of political risks.

Q.5 Discuss briefly the factors that govern the choice of mode of entry into international business.
Answer:  Following factors govern the choice of mode of entry into international business,

1. Ease of entry: First and foremost factor that determines the choice of mode of entry into international business is ease of entry. A businessman wants to adopt such mode of entry into international business which is easy and less formalities requiring. Exporting, importing, licensing and franchising are better ways from this perspective.
2. Cost: Second determining factor is cost involved. For example, very less cost is involved in exporting, importing, licensing, franchising and contract manufacturing as compared to joint ventures and setting wholly owned subsidiaries.
3. Control over production: If the foreign company or producer wants full control over production activities in local country, he will prefer franchising, wholly owned subsidiary or joint venture with majority share holding. If it is not so important, he will prefer exporting, importing, contract manufacturing licensing etc.
4. Sharing of Technology: If the company has no problem in sharing of technology then it may choose joint venture or franchising. But if it does not want to share its technology and trade secrets, it will prefer wholly owned subsidiary or exporting,
5. Risk Involved: If a firm is ready to take risk, it may choose wholly owned subsidiary or joint ventures but if it is willing to minimize its loss then it should choose exporting, licensing, franchising or contract manufacturing.

Q.6 Discuss the major trends in India’s foreign trade. Also list the major products that India trades with other countries.
Answer:  India is 10th largest economy in the world. It is the second fastest growing economy, next only to China. But India’s performance in international business is not very good. India’s share in world trade in 2003 was just 0.8%. In absolute terms, there has been significant increase in imports as well as exports. Total exports have increased from 606 crores in 1950-51 to Rs. 2, 93,367 crores in 2003-04 while imports have increased from 608 crores in 1950-51 to 3, 59,108 crores in 2003-04. Exports increased 480 times while imports increased 590 times indicating that there is adverse balance of trade. India’s major trading partners are USA, UK, Germany, Japan, Belgium, Hong Kong, UAE, China, Switzerland, Singapore and Malaysia.
India’s major items of exports include: Textiles, garments, gems and jewellery, engineering products and chemicals, agriculture and allied products.
India’s major items of imports include: Crude oil and petroleum products, capital goods, electronic goods, pearls, precious and semi precious stones, gold, silver and chemicals.
Before 1991, promotion of import substitution and discouraging of exports was government strategy. Imports consisted of machinery, equipment and intermediates in production, petroleum and petroleum-products. After green revolution, imports of fertilizer too increased.
Before 1991, India’s exports consisted of agricultural products like tea, raw cotton with the diversifying industrial structure, promoted by import substitution, exports of manufactures were growing. During 1986-91, external trade formed only 13.40 % of the GDP. During the 1990-2000, this share is rising continuously.
India’s foreign trade has grown to exports of $250 billion and imports of $380 billion in 2010-11. The ratio of exports plus imports to GDP has grown from 13.40 % during 1985-90 to almost three times that, being 37.7 % in 2010-11. On adding services it becomes from 22.9 % in the 1990s to 49.0 % in 2010-11.
Leading role has been played by ‘invisibles’ which includes both services, mainly software services, export of which has grown to $59 billion in 2010-11. It has decreased the current account deficit from $130 billion to $44. This deficit was compensated by capital account surplus of $59 billion in that year.
But it is only because of IT services and we are still lacking in manufacturing exports which can generate a large volume of employment. We have not done as well as China and Malaysia have done.

Q.7 What is invisible trade? Discuss salient aspects of India’s trade in services.
Answer:  Trade in services is called invisible trade. Since services are invisible, export and import of services has been named as invisible trade. In absolute terms, there has been significant increase in India’s foreign trade in services. Export and import of foreign travel, transportation and insurance has largely increased during last four decades. There has been a change in composition of services exports. Software and other miscellaneous services have emerged as the main categories of India’s export of services. Share of travel and transportation has declined to 29.6% in 2003-04 from 64.3% in 1995-96 while the share of software exports has increased from 10.2% in 1995-96 to 49% in 2003-04.

The composition of India’s external trade has been changing. During 1950s and 60s exports were mainly of primary goods. Over time, the role of engineering goods has been increasing. Overall manufactured goods constitute 66 % of total exports, of which engineering goods are 27%. Textiles and textile products, garments and leather products make around 10 % of India’s exports.
In nutshell, we can say that the role of the external or internationally traded goods sector has been growing steadily in Indian economy. At present imports and exports together account for upto 49 % of India’s GDP which was 18% in 1990s. In India there is greater share of exports of services which are IT software services, called IT- enabled services (ITES). It contributed more than 20% of India’s export earnings. India accounts for about 45% of the world’s BPO services. The major Indian IT companies, TCS, Infosys and Wipro, initiated and perfected the Global Services Delivery (GSD) model. It is because India has a vast pool of software engineers and an even bigger pool of English-knowing staff. With growing competition in the market for such services, Indian companies have moved from BPO to Knowledge Process Outsourcing (KPO), which involves providing services for R and D and to high-end consulting.