A statutory reserve is any reserve that has to be maintained by an Act or law. When it comes to insurance, a statutory reserve is a reserve that an insurance company is legally bound to maintain to ensure that the company is able to meet its policy obligations. In India, as per the Banking RegulatioRead more
A statutory reserve is any reserve that has to be maintained by an Act or law. When it comes to insurance, a statutory reserve is a reserve that an insurance company is legally bound to maintain to ensure that the company is able to meet its policy obligations. In India, as per the Banking Regulations Act, every banking company has to maintain at least 25% of its net profits as statutory reserves.
The companies are required to maintain such reserves to guarantee the availability of cash when it is required by the customer. Common examples of statutory reserves are Cash reserve ratio (CSR), Statutory Liquidity Ratio (SLR).
Treatment
Statutory reserves are shown in the Profit and Loss account under the head “appropriations”.
It is also shown under the head Reserves and Surplus (Schedule 2) in the Balance Sheet.
Method
Rule-Based Approach – The company calculates the amount required by using standard formulas. However, since they are pre-determined formulas, it does not cover all risk determining factors.
Principle-based approach – This method is used to protect customers and ensure that the company stays solvent. They hold a higher amount of reserves than required after predicting all possible risks.
Statutory reserves are different from general reserves as general reserves are maintained voluntarily by the company. A company that does not follow statutory requirements will face financial penalties. These reserves are mostly maintained in the form of cash.
Maintenance of reserves gives confidence to investors that their money is secure. However, funds from these reserves can be used only for specific purposes. They should also maintain such reserves whether or not they earn profits.
The correct option is Option (b) at a particular point of time. A balance sheet discloses the financial position of an entity at a particular point of time. The particular point of time is generally the last date of an accounting year. Most of the business concerns follow an accounting year ending oRead more
The correct option is Option (b) at a particular point of time.
A balance sheet discloses the financial position of an entity at a particular point of time. The particular point of time is generally the last date of an accounting year. Most of the business concerns follow an accounting year ending on 31st March and prepare their balance sheet as at 31st March.
By financial position, it means the value of assets and liabilities of the entity. As an entity may enter into monetary transactions every day, the values of the assets and liabilities may also vary every day. Hence, to prepare the balance sheet of an entity, a particular point of time is to be chosen which is generally the last date of an accounting year
Option (a) for a given period of time is incorrect.
It is because the values of assets and liabilities of concern may differ daily, a balance sheet cannot be prepared to disclose the financial position of an entity for a given period of time.
The statement of profit or loss is prepared for a given period of time as it discloses the overall performance of an entity for a given period of time.
Option (c) after a fixed date is also incorrect.
The phrase, “after a fixed date” does not indicate a particular point of time. It may mean any day after a fixed date. For example, if there is an instruction to prepare a balance sheet that discloses the financial position of a concern after 30th March, it may mean 31st March, 1st April or any day thereafter.
As we know that a balance can be prepared for a particular point of time, this option seems wrong.
Option (d) None of these is incorrect too as Option (b) is the correct one.
Accumulated profit is the amount of profit left after the payment of dividends to the shareholders. It is also known as retained earnings. It is the profit that is not distributed as dividends to shareholders, hence called retained earnings. This accumulated profit is an important source of internalRead more
Accumulated profit is the amount of profit left after the payment of dividends to the shareholders. It is also known as retained earnings. It is the profit that is not distributed as dividends to shareholders, hence called retained earnings. This accumulated profit is an important source of internal finance for a company. Accumulated profit or retained earnings can be ascertained using the following formula:
Accumulated profit = Opening balance of accumulated profit + Net Profit/Loss (loss being in the negative figure) – Dividend paid
Accumulated profit can be put to the following uses:
To reinvest into the business in form of capital assets or working capital.
To repay the debt of the company.
To pay dividends in future.
To set off the net loss made by the company.
Accumulated profit and reserves are often considered the same. But in substance, they are not. The reserves are actually part of the accumulated profit, but the converse is not true. They are created by transferring amounts from the accumulated profit. While reserves are created for purpose of strengthening the financial foundation of a firm, the accumulated profit’s main purpose is to make reinvest in the business to increase its growth.
The amount of accumulated profits depends upon the retention ratio and dividend payout ratio of a company. The retention ratio is the opposite of the dividend payout ratio.
The formula of dividend pay-out ratio = Dividend payable/Net Income
And retention ratio = 1 – (Dividend payable/Net Income)
If the retention ratio is more than the dividend payout ratio, the accumulated profit remains positive.
Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders. Therefore the cost of retained earnings is similar to theRead more
Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders.
Therefore the cost of retained earnings is similar to the cost of equity without tax and flotation cost. Hence, it can be calculated as
Kr = Ke (1 – t) (1 – f),
Kr = Cost of retained earnings
Ke = Cost of equity
t = tax rate
f = flotation cost
Here, flotation cost means the cost of issuing shares.
EXAMPLE
If cost of equity of a company was 10%, tax rate was 30% and flotation cost was 5%, then
cost of retained earnings = 10% x (1 – 0.30)(1 – 0.05) = 6.65%.
From the above example and formula, it is clear that the cost of retained earnings would always be less than or equal to the cost of equity since retained earnings do not involve flotation costs or tax.
A company usually acquires funds from various sources of finance rather than a single source. Therefore the cost of capital of the company will be the weighted average cost of capital (WACC) of each individual source of finance. The cost of retained earnings is thus an important factor in calculating the overall cost of capital.
Another important factor of WACC is the cost of equity. The cost of equity is sometimes interchanged with the cost of retained earnings. However, they are not the same.
Capital Redemption Reserve is a statutory reserve, which means it is mandatory for a company to create such reserve when it decides to redeem its preference shares. Capital Redemption Reserve cannot be utilised for any purpose other than the issue of bonus shares. Now let’s understand the reason behRead more
Capital Redemption Reserve is a statutory reserve, which means it is mandatory for a company to create such reserve when it decides to redeem its preference shares. Capital Redemption Reserve cannot be utilised for any purpose other than the issue of bonus shares.
Now let’s understand the reason behind it.
We know preference shares are those shares that carry some preferential rights:
Dividend at a fixed rate
Right to get repaid before equity shareholders in event of winding up of the company
Other rights as specified in the Articles of Associations.
Also, unlike equity shares, preference shares are redeemable i.e. repaid after a period of time (which cannot be more than 20 years).
Generally, the creditors of a company have the right to be repaid first. So, in event of redemption of preference shares, the preference shareholders are repaid before creditors and the total capital of the company will but the total debt of the company is unaffected.
The gap between the debt and equity of the company will further widen and this will also increase the debt-equity ratio of the company. It will be perceived to be a risky scenario by the creditors and lenders of the company because the
So to protect the creditor and lender, Section 55 of the Companies Act comes to rescue.
Section 55 of the Companies Act ensure that the creditors and lenders of a company do not find themselves in a riskier situation when the company decides to redeem its preference shares by making it mandatory for a company to either
issue new shares to fund the redemption of preference shares
OR
create a capital redemption reserve if it uses profits for redemption
OR
a combination of both
This will fill up the void created by the redemption of preference shares and the debt-equity ratio will remain unaffected. Keeping an amount aside in Capital Redemption Reserve ensures that such amount will not be used for dividend distribution and capital will be restored because it can be only used to issue bonus shares.
In this way the debt-equity ratio remains the same, the interest of the creditors and lenders secured.
Bonus shares are fully paid shares that are issued to existing shareholders at no cost.
Let’s take a numerical example for further understanding:
ABC Ltd wants to redeem its 1,000 9% Preference shares at a face value of Rs 100 per share. It has decided to issue 8,000 equity shares @Rs 10 per share and use the profit and reserves to fund the deficit.
The journal entries will be as follows:
Working note: Rs
9% preference shares due for redemption (1,000 x 10) – 1,00,000
Less: Amount of new shares issued (8,000 x 10) – 80,000
Amount to be transferred to CRR 20,000
Hence, the reduction of total capital by Rs 1,00,000 due to the redemption of preference shares is reversed by issuing equity shares of Rs 80,000 and creating a Capital Redemption Reserve of Rs 20,000.
The correct option is (d) None of these. AS-3(Revised) deals with the preparation and presentation of cash flow statements. A cash flow statement is a statement that summarises the movement of cash and cash equivalents of an enterprise in an accounting year. It helps the stakeholder to know: the amoRead more
The correct option is (d) None of these.
AS-3(Revised) deals with the preparation and presentation of cash flow statements. A cash flow statement is a statement that summarises the movement of cash and cash equivalents of an enterprise in an accounting year. It helps the stakeholder to know:
the amount of cash generated by operating activities,
amount of cash invested in various assets or sale of assets,
the types of finance source utilised by an enterprise and
the net cash flow of the business.
Provision for depreciation is actually a charge on profit, i.e. it will be deducted even if there is loss. Also, there is nothing mentioned in the AS-3(revised) from which we can consider the provision for tax as an appropriation of profit.
Generally, the cash flow statement is prepared as per the ‘indirect method’ by most enterprises.
As per the indirect method, the computation starts from Net Profit before tax and extraordinary items. To calculate this, we have to take the current year’s profit and add the current year’s provision for tax to it.
The reason behind it is that we need to obtain the cash flow from operations and the provision for tax is a non-cash item that has reduced the net profit. So, we have to add it back to the current year’s profit.
Option (A) Current Liabilities is wrong.
Though the provision for tax is classified as a current liabilities in the balance sheet, it is not considered as a current liability when making adjustments for changes in working capital while preparing cash flow statement.
Option (B) as appropriation of profit is wrong.
An appropriation of profit is an item for which an amount is put aside when there is profit. For example, transfer to reserves. But the provision for tax is a charge on profit.
Option (C) either (A) or (B) is also wrong because both the options are incorrect as discussed above.
When a partnership firm decides to admit a new partner into their firm, the old partners have to forego a part of their share for the new partner. Therefore, sacrificing Ratio is the proportion in which the existing partners of a company give up a part of their share for the new partner. The partnerRead more
When a partnership firm decides to admit a new partner into their firm, the old partners have to forego a part of their share for the new partner. Therefore, sacrificing Ratio is the proportion in which the existing partners of a company give up a part of their share for the new partner. The partners can choose to forego their shares equally or in an agreed proportion.
Before admission of the new partner, the existing partners would be sharing their profits in the old ratio. Upon admission, the profit-sharing ratio would change to accommodate the new partner. This would give rise to the new ratio. Hence Sacrificing ratio formula can be calculated as: Sacrificing Ratio = Old Ratio – New Ratio
To further understand the formula, let’s say Bruce and Barry are sharing a pizza of 6 slices equally (3 slices each). They decide to share their pizza with Arthur such that they all get equal slices (2 slices each). Hence, we can use the formula to calculate their sacrifice as follows:
Bruce’s sacrifice = 3 – 2 = 1 slice
Barry’s sacrifice = 3 – 2 = 1 slice
Therefore, their sacrificing ratio = 1:1. In this same way, we can solve various problems to calculate the sacrifice of partners during a change in their profit sharing ratio.
For example, Joshua and Edwin are partners, sharing profits in the ratio 7:3. They admit Adam into their partnership such that the new profit-sharing ratio is 5:2:3. Therefore, their sacrificing ratio can be calculated as:
Joshua’s sacrifice = old share – new share = 7/10 – 5/10 = 2/10
Edwin’s sacrifice = old share – new share = 3/10 – 2/10 = 1/10
Hence, sacrificing ratio of Joshua and Edwin is 2:1. Once the denominators are equal, we ignore them and only consider numerators while showing sacrificing ratio.
What is a statutory reserve?
A statutory reserve is any reserve that has to be maintained by an Act or law. When it comes to insurance, a statutory reserve is a reserve that an insurance company is legally bound to maintain to ensure that the company is able to meet its policy obligations. In India, as per the Banking RegulatioRead more
A statutory reserve is any reserve that has to be maintained by an Act or law. When it comes to insurance, a statutory reserve is a reserve that an insurance company is legally bound to maintain to ensure that the company is able to meet its policy obligations. In India, as per the Banking Regulations Act, every banking company has to maintain at least 25% of its net profits as statutory reserves.
The companies are required to maintain such reserves to guarantee the availability of cash when it is required by the customer. Common examples of statutory reserves are Cash reserve ratio (CSR), Statutory Liquidity Ratio (SLR).
Treatment
Method
Rule-Based Approach – The company calculates the amount required by using standard formulas. However, since they are pre-determined formulas, it does not cover all risk determining factors.
Principle-based approach – This method is used to protect customers and ensure that the company stays solvent. They hold a higher amount of reserves than required after predicting all possible risks.
Statutory reserves are different from general reserves as general reserves are maintained voluntarily by the company. A company that does not follow statutory requirements will face financial penalties. These reserves are mostly maintained in the form of cash.
Maintenance of reserves gives confidence to investors that their money is secure. However, funds from these reserves can be used only for specific purposes. They should also maintain such reserves whether or not they earn profits.
See lessBalance Sheet discloses the financial position of a business
The correct option is Option (b) at a particular point of time. A balance sheet discloses the financial position of an entity at a particular point of time. The particular point of time is generally the last date of an accounting year. Most of the business concerns follow an accounting year ending oRead more
The correct option is Option (b) at a particular point of time.
A balance sheet discloses the financial position of an entity at a particular point of time. The particular point of time is generally the last date of an accounting year. Most of the business concerns follow an accounting year ending on 31st March and prepare their balance sheet as at 31st March.
By financial position, it means the value of assets and liabilities of the entity. As an entity may enter into monetary transactions every day, the values of the assets and liabilities may also vary every day. Hence, to prepare the balance sheet of an entity, a particular point of time is to be chosen which is generally the last date of an accounting year
Option (a) for a given period of time is incorrect.
It is because the values of assets and liabilities of concern may differ daily, a balance sheet cannot be prepared to disclose the financial position of an entity for a given period of time.
The statement of profit or loss is prepared for a given period of time as it discloses the overall performance of an entity for a given period of time.
Option (c) after a fixed date is also incorrect.
The phrase, “after a fixed date” does not indicate a particular point of time. It may mean any day after a fixed date. For example, if there is an instruction to prepare a balance sheet that discloses the financial position of a concern after 30th March, it may mean 31st March, 1st April or any day thereafter.
As we know that a balance can be prepared for a particular point of time, this option seems wrong.
Option (d) None of these is incorrect too as Option (b) is the correct one.
See lessWhat is accumulated profit meaning?
Accumulated profit is the amount of profit left after the payment of dividends to the shareholders. It is also known as retained earnings. It is the profit that is not distributed as dividends to shareholders, hence called retained earnings. This accumulated profit is an important source of internalRead more
Accumulated profit is the amount of profit left after the payment of dividends to the shareholders. It is also known as retained earnings. It is the profit that is not distributed as dividends to shareholders, hence called retained earnings. This accumulated profit is an important source of internal finance for a company. Accumulated profit or retained earnings can be ascertained using the following formula:
Accumulated profit = Opening balance of accumulated profit + Net Profit/Loss (loss being in the negative figure) – Dividend paid
Accumulated profit can be put to the following uses:
Accumulated profit and reserves are often considered the same. But in substance, they are not. The reserves are actually part of the accumulated profit, but the converse is not true. They are created by transferring amounts from the accumulated profit. While reserves are created for purpose of strengthening the financial foundation of a firm, the accumulated profit’s main purpose is to make reinvest in the business to increase its growth.
The amount of accumulated profits depends upon the retention ratio and dividend payout ratio of a company. The retention ratio is the opposite of the dividend payout ratio.
The formula of dividend pay-out ratio = Dividend payable/Net Income
And retention ratio = 1 – (Dividend payable/Net Income)
If the retention ratio is more than the dividend payout ratio, the accumulated profit remains positive.
See lessWhat is cost of retained earnings?
Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders. Therefore the cost of retained earnings is similar to theRead more
Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders.
Therefore the cost of retained earnings is similar to the cost of equity without tax and flotation cost. Hence, it can be calculated as
Kr = Ke (1 – t) (1 – f),
Kr = Cost of retained earnings
Ke = Cost of equity
t = tax rate
f = flotation cost
Here, flotation cost means the cost of issuing shares.
EXAMPLE
If cost of equity of a company was 10%, tax rate was 30% and flotation cost was 5%, then
cost of retained earnings = 10% x (1 – 0.30)(1 – 0.05) = 6.65%.
From the above example and formula, it is clear that the cost of retained earnings would always be less than or equal to the cost of equity since retained earnings do not involve flotation costs or tax.
A company usually acquires funds from various sources of finance rather than a single source. Therefore the cost of capital of the company will be the weighted average cost of capital (WACC) of each individual source of finance. The cost of retained earnings is thus an important factor in calculating the overall cost of capital.
Another important factor of WACC is the cost of equity. The cost of equity is sometimes interchanged with the cost of retained earnings. However, they are not the same.
See lessWhat is a capital redemption reserve account?
Capital Redemption Reserve is a statutory reserve, which means it is mandatory for a company to create such reserve when it decides to redeem its preference shares. Capital Redemption Reserve cannot be utilised for any purpose other than the issue of bonus shares. Now let’s understand the reason behRead more
Capital Redemption Reserve is a statutory reserve, which means it is mandatory for a company to create such reserve when it decides to redeem its preference shares. Capital Redemption Reserve cannot be utilised for any purpose other than the issue of bonus shares.
Now let’s understand the reason behind it.
We know preference shares are those shares that carry some preferential rights:
Also, unlike equity shares, preference shares are redeemable i.e. repaid after a period of time (which cannot be more than 20 years).
Generally, the creditors of a company have the right to be repaid first. So, in event of redemption of preference shares, the preference shareholders are repaid before creditors and the total capital of the company will but the total debt of the company is unaffected.
The gap between the debt and equity of the company will further widen and this will also increase the debt-equity ratio of the company. It will be perceived to be a risky scenario by the creditors and lenders of the company because the
So to protect the creditor and lender, Section 55 of the Companies Act comes to rescue.
Section 55 of the Companies Act ensure that the creditors and lenders of a company do not find themselves in a riskier situation when the company decides to redeem its preference shares by making it mandatory for a company to either
OR
OR
This will fill up the void created by the redemption of preference shares and the debt-equity ratio will remain unaffected. Keeping an amount aside in Capital Redemption Reserve ensures that such amount will not be used for dividend distribution and capital will be restored because it can be only used to issue bonus shares.
In this way the debt-equity ratio remains the same, the interest of the creditors and lenders secured.
Bonus shares are fully paid shares that are issued to existing shareholders at no cost.
Let’s take a numerical example for further understanding:
ABC Ltd wants to redeem its 1,000 9% Preference shares at a face value of Rs 100 per share. It has decided to issue 8,000 equity shares @Rs 10 per share and use the profit and reserves to fund the deficit.
The journal entries will be as follows:
Working note: Rs
9% preference shares due for redemption (1,000 x 10) – 1,00,000
Less: Amount of new shares issued (8,000 x 10) – 80,000
Amount to be transferred to CRR 20,000
Hence, the reduction of total capital by Rs 1,00,000 due to the redemption of preference shares is reversed by issuing equity shares of Rs 80,000 and creating a Capital Redemption Reserve of Rs 20,000.
See lessAs per accounting standard AS3 provision for taxation should be treated as?
The correct option is (d) None of these. AS-3(Revised) deals with the preparation and presentation of cash flow statements. A cash flow statement is a statement that summarises the movement of cash and cash equivalents of an enterprise in an accounting year. It helps the stakeholder to know: the amoRead more
The correct option is (d) None of these.
AS-3(Revised) deals with the preparation and presentation of cash flow statements. A cash flow statement is a statement that summarises the movement of cash and cash equivalents of an enterprise in an accounting year. It helps the stakeholder to know:
Provision for depreciation is actually a charge on profit, i.e. it will be deducted even if there is loss. Also, there is nothing mentioned in the AS-3(revised) from which we can consider the provision for tax as an appropriation of profit.
Generally, the cash flow statement is prepared as per the ‘indirect method’ by most enterprises.
As per the indirect method, the computation starts from Net Profit before tax and extraordinary items. To calculate this, we have to take the current year’s profit and add the current year’s provision for tax to it.
The reason behind it is that we need to obtain the cash flow from operations and the provision for tax is a non-cash item that has reduced the net profit. So, we have to add it back to the current year’s profit.
Option (A) Current Liabilities is wrong.
Though the provision for tax is classified as a current liabilities in the balance sheet, it is not considered as a current liability when making adjustments for changes in working capital while preparing cash flow statement.
Option (B) as appropriation of profit is wrong.
An appropriation of profit is an item for which an amount is put aside when there is profit. For example, transfer to reserves. But the provision for tax is a charge on profit.
Option (C) either (A) or (B) is also wrong because both the options are incorrect as discussed above.
See lessWhat is sacrificing ratio formula?
When a partnership firm decides to admit a new partner into their firm, the old partners have to forego a part of their share for the new partner. Therefore, sacrificing Ratio is the proportion in which the existing partners of a company give up a part of their share for the new partner. The partnerRead more
When a partnership firm decides to admit a new partner into their firm, the old partners have to forego a part of their share for the new partner. Therefore, sacrificing Ratio is the proportion in which the existing partners of a company give up a part of their share for the new partner. The partners can choose to forego their shares equally or in an agreed proportion.
Before admission of the new partner, the existing partners would be sharing their profits in the old ratio. Upon admission, the profit-sharing ratio would change to accommodate the new partner. This would give rise to the new ratio. Hence Sacrificing ratio formula can be calculated as:
Sacrificing Ratio = Old Ratio – New Ratio
To further understand the formula, let’s say Bruce and Barry are sharing a pizza of 6 slices equally (3 slices each). They decide to share their pizza with Arthur such that they all get equal slices (2 slices each). Hence, we can use the formula to calculate their sacrifice as follows:
Bruce’s sacrifice = 3 – 2 = 1 slice
Barry’s sacrifice = 3 – 2 = 1 slice
Therefore, their sacrificing ratio = 1:1. In this same way, we can solve various problems to calculate the sacrifice of partners during a change in their profit sharing ratio.
For example, Joshua and Edwin are partners, sharing profits in the ratio 7:3. They admit Adam into their partnership such that the new profit-sharing ratio is 5:2:3. Therefore, their sacrificing ratio can be calculated as:
Joshua’s sacrifice = old share – new share = 7/10 – 5/10 = 2/10
Edwin’s sacrifice = old share – new share = 3/10 – 2/10 = 1/10
Hence, sacrificing ratio of Joshua and Edwin is 2:1. Once the denominators are equal, we ignore them and only consider numerators while showing sacrificing ratio.
See less