AFM Unit II
AFM Unit II
AFM Unit II
A company is an artificial person created by law having perpetual succession and a common
seal.
The distinctive features of the company form of organization are as follows:
1. Separate legal existence:
A company has a distinct legal entity independent of its members. It can own property, make
contracts and file suits in its own name. Shareholders are not the joint owners of the company's
property.
A shareholder cannot be held liable for the acts of the company. Similarly, members of the
company are not its agents.
There can be contracts between a company and its members. A creditor of the company is not a
creditor of its members.
The separate legal entity of a company was recognised in the famous case of Salomon, v.
Salomon and Co. Ltd. The facts of the case were as follows:
Salomon formed a company which acquired his own shoe business. He took all the shares except
six shares which he distributed among his wife, daughter and four sons.
Salomon also purchased some debentures of the company which gave him a charge over its
assets. At the time of winding up, the company's assets were not sufficient enough to pay its
debts.
The creditors of the company (other than Salomon) argued that their debts should be cleared
before paying Salomon for his debentures because Salomon and the company was one and the
same person.
The Court decided that after incorporation, Salomon and Co. had an identity separate from
Salomon even though he owned virtually all the shares in the company.
2. Perpetual succession:
Perpetual succession means continued existence. A company is a creation of the law and only the
law can bring an end to its existence. Its life does not depend on the life of its members.
The death, insolvency or lunacy of members does not affect the life of a company. It continues to
exits even if all its members die. Members may come and go but the company goes on until it is
wound up.
3. Limited liability:
As a company has a separate legal entity, its members cannot be held liable for the debts of the
company. The liability of every member is limited to the nominal value of the shares bought by
him or to the amount of guarantee given by him.
For instance, if a member has 50 shares of Rs. 10 each, his liability is limited to Rs 500. Even if
the assets of the company are insufficient to satisfy fully the claims of the creditors, no member
can be called to pay anything more than what is due from him.
However, if the members of the company so desire, they may form a company with unlimited
liability.
4. Transferability of shares:
The capital of a company is divided into parts. Each part is called a share. These shares are
generally transferable.
A shareholder is free to withdraw his membership from the company by transferring his shares.
However, in actual practice some restrictions are placed on the transfer of shares.
5. Common seal:
Being an artificial entity, a company cannot act and sign itself. Therefore, it acts through human
beings. All the acts of the company are authorised by its common seal.
The name of the company is engraved on its common seal. The common seal is affixed on all
important documents as a token of the Company's approval.
The common seal is the official signature of the company. Any document which does not bear
the common seal of the company is not binding on the company.
6. Separation of ownership and control:
Members have no right to participate directly in the day-to-day management of a company. They
elect their representatives, called directors, who manage the company's affairs on behalf of the
members.
Thus, the ownership of a company is distributed among the shareholders while management is
vested in the board of directors. The management of a company is delegated and centralised.
7. Voluntary association:
A joint stock company is a voluntary association of certain persons formed to carry out a
particular purpose in common. Members of a company can join it and leave it at their own free
will.
8. Artificial legal person:
A company is an artificial person created by law. It exists only in contemplation of law. It is
competent to enter into contracts and to own property in its own name. But it does not take birth
like a natural person and it has no physical body of a natural human being.
9. Corporate finance:
The share capital of a company is generally divided into a large number of shares of small value.
These shares are purchased by a large number of people from different walks of life.
10. Statutory regulation and control:
Government exercises control through company law over the management of joint stock
companies. A company is required to comply with several legal formalities and to file several
documents with the Registrar of Companies.
STATUTORY BOOKS:
Statutory Books are the official records kept by the company relating to all legal and statutory
matters. A company's statutory books are usually kept at the registered office of the company.
All the registered company must have the statutory books for the reference or during the time of
the inspection.
The word “statue” means law.
Statutory books are usually a bound book or ring binder contained in a boxed register, but with
the increased use of technology they can also exist in electronic format Only.Every Company is
required to keep the following statutory registers, and to provide access to them.
Most companies keep the statutory registers in a single bound book or loose-leaf binder, but they
may be kept in any form, such as a computer record.
IMPORTANCE OF STATUTORY BOOKS
As part of a company sale process, the buyer's solicitors will request the statutory books and, at
this stage, if they have not been properly kept they will require them to be reconstituted.
If there are any gaps that cannot be remedied the buyers may also require protection in the
purchase agreement whereby the seller will undertake to indemnify the buyer for any loss they
suffer as a result of the books not having been properly maintained.
The index must be convenient to use and allow a shareholder’s entry in the register to be
readily found.
Exercise period: the employees are given a time period, called exercise period, within which
they are required to exercise the option. The date on which employees exercise this option is
known as exercise date.
Two ways in which a company can set up an ESOP:
(a) Create a trust (Special Purpose Vehicle): depending on the number of options given to
the employees, the company will issue shares or options to the trust. The trust would need
fund to buy these shares. For this, the company can either give soft loans from its own
fund or the trust can raise loans through other sources to meet its financial requirement.
The company can act as guarantee to the lender of the trust. With the funds so raised, the
trust then acquires shares/options required. The trust repays its loans as and when the
employees purchase the options offered and when they exercise their options by paying
the exercise price.
(b) Give options directly to employees: the selection of the employees is based on
performance of the employee, indicated by annual performance appraisal, minimum
period of service, present and potential contribution of the employees, and such other
factors deemed to be relevant for the success of the company.
Different types of ESOPs:
Employee Stock Option Scheme(ESOS): under this scheme, the company grants an option
to its employees to acquire shares at a future date at predetermined price. Eligible employees
are free to acquire shares on vesting within the exercise period. Employees are free to dispose
of the shares subject to lock in period if any.
Employee Stock purchase plan(ESPP): This is generally used in listed companies, wherein
the employees are given right to acquire shares of the company immediately, not a future
date as in ESOS, at a price lower than the prevailing market price. Shares issued by listed
companies under ESPP will be subject to lock in period as a result the employee cannot sell
the shares and/or the employee has to continue with the employer for a certain number of
years.
Share Appreciation Rights(SAR)/ Phantom Rights: under this scheme, no shares are
offered or allotted to the employee. The employee is given the appreciation in the value of
money between the two specified dates as an incentive or performance of the company as a
whole, as reflected in its share value.
Rules and Regulations:
Companies Act: issue of stock options require approval of shareholders by way of a special
resolution. This is not applicable for private companies who can issue stock options without
share holder approval but approval by board of directors.
Income tax issues:
For employees: Till recently, the difference the cost of the share to the employees and market
value on the date on which an employee got the share would be taxed as pre requisite in addition
to capital gains tax payable by the employee on sale of those shares. However with the recent
announcement the pre requisite has been removed.
For the company: As per the SEBI, the company should have separate account for ESOP and
treat them same as the expense.
Advantages of ESOPs:
1. Takeover protection
2. Financing advantages
3. Deduction of dividends paid
4. Non recognition of capital gain
5. Deferral of taxation
6. Exemptions from the prohibited transaction rules
7. Marketability of stock
Takeover protection:
An ESOP can provide some protection against an unwelcome takeover attempt. This is
more likely to be an advantage for a publicly traded company, especially in the banking industry.
A take over offer often presents a conflict for the ESOP fiduciaries. They are typically top
managers of the target company, and they’ll have to resolve conflicts between their personal
interests as officers and employees of the company, their fiduciary responsibility to the ESOP
participants and beneficiaries.
Financing advantages:
When a corporation repays a conventional loan, the interest payments are deductible but
the principal payments aren’t. By contrast, when a corporation borrows money to buy stock for
an ESOP, both interest and principal payments are deductible, within limits, as contributions to a
qualified plan. This significantly reduces the corporation’s after tax costs.
Deduction for Dividends paid:
A c corporation can claim deductions for:
1. Dividends that are paid to an ESOP and are used to repay a securities acquisition loan.
2. Dividends that are paid directly to ESOP participants or their beneficiaries, or to an
ESOP, which distributes them to participants or beneficiaries within 90 days after the end
of plan year.
Non recognition of capital gain:
Taxation of gain on the shares sold to the ESOP is deferred by reinvesting the sales
proceeds in qualifying replacement property. Time limits do apply.
Deferral of taxation:
If corporation stock is held by an ESOP, then the ESOP’s proportionate share of the
corporate income isn’t currently taxed, within the corporation, to finance current operations and
future growth, or be paid to the ESOP.
Marketability of stock:
For a closely held corporation, the ESOP provides a market for shareholders who wish to
sell all or part of their stock. Because of the ESOP’s tax advantages, this can be preferable to a
stock redemption by the corporation.
Disadvantages of ESOPs:
1. Equity dilution
2. Valuation problems
3. Cost of operating the ESOP
4. Voting rights
5. Employer cash flow issues
6. Employee Risk
Equity Dilution: Adoption of an ESOP reduces the percentage ownership of at least some of
their shareholders.
Valuation problems: In any transaction with a disqualified person or party in interest, an ESOP
may not pay than adequate consideration, which is the fair market value of assest as determined
by the trustee or fiduciary, on a purchase of stock. An ESOP may not receive less than adequate
consideration on a sale of stock.
Cost of operating the stock:A valuation of corporate stock is required in connection with any
purchase or sale of stock. Generally the valuation must be updated at least annually. Adequate
appraisals can be costly.
Voting rights: The participants must be given the right to vote the employer securities allocated
to their accounts.
Employer cash flow issues: If the ESOP is leveraged, the ESOP debt may absorb much of the
corporation’s available credit. This can make it difficult for the corporation to borrow funds
needed for operations and growth. If the corporation becomes less profitable, it may be unable to
service the ESOP debt, despite the favourable tax treatment of ESOP loan repayments.A big
problem for most small ESOP employers is the repurchase obligation. As employees leave for
the company, or otherwise become entitled to ESOP distribution, they have the right to require
the employer to repurchase stock, which isn’t readily tradable, as its fair market value.
Employee risk:It may be necessary to reduce or eliminate contributions to other retirement plans
when an ESOP is adopted, to enable the employer to pay the cost of the ESOP. Employees may
not like the situation, particularly when other investments are doing well.
Buy back of securities.
Buy back of securities means repurchase by a company of its own shares or other specified
securities( employee’s stock option or other securities as may be notified by the central govt
from time to time) out of : (i) its free reserves (ii) the securities premium account (iii) the
proceeds of any shares or other specified securities, provided that no buy back of any kind shares
or other specified securities shall be made out of the proceeds of an earlier issue of the same kind
of shares or same kind of other specified securities.
Till oct 31 1998, Indian companies were not allowed to buy their own shares from the open
market. However the companies(Amendment) Act 1999, has introduced section 77A& 77B in
the companies Act 1956 permitting companies to buy back their securities from the open market
for cancellation. The buy back of securities would result in reduction of share capital. The
companies Act have introduced a lot of restrictions for capital reduction, as it would affect the
interest of creditors. Buy back of shares may be done at par or at premium or discount.
The company may resort to Buy back of its own securities due to the following important
reasons:
1. when the prevailing market rate of its own shares is much lower than its true value, Buy
back may improve the value of the company over all.
2. Buy back reduces the number of outstanding shares, which will improve the earnings per
share.
3. Buy back of shares enables a company to frustrate “ hostile take over bids”
4. Buy back of shares facilitates a company to restructure its capital by utilizing its cash
surplus. A company need not pay corporate dividend tax on buy back.
1. The Buy back should be authorized by the Articles of Association of the company. If
Articles is silent necessary amendments will have to be made.
2. A special resolution has to be passed in general body meeting of the company to
authorize the Buy back.
3. The Buy back should not exceed 25% of the paid up capital and free reserves of the
company concerned.
4. The ratio of the debt owed by the company is not more than twice the capital and its free
reserves after such Buy back.
5. All the shares or other specified securities should be fully paid up.
6. The Buy back of the shares or other specified securities listed in any recognized stock
exchange is in accordance with the regulations made by the SEBI in this behalf.
7. The Buy back in respect of share or other specified securities is in accordance with the
guide lines as may be specified.
8. Every Buy back should be completed with in 12 months from the date of passing the
special resolution.
9. The Buy back may be : (a). from the existing security holders on a proportionate basis or
(b) from the open market.(c) by purchasing the securities issued to the employees of the
company pursuant to a scheme of stock option or sweat equity.
10. where a company Buy back its own securities, it shall extinguish and physically destroy
the securities so bought back with in 7 days of the last date of completion of Buy back.
11. After the completion of the Buy back, a company can not issue the same kind of shares or
securities for a period of 24 months.
12. Loans from bank of financial institutions should not be used for the purpose of Buy back.
13. A company, which has failed to file annual returns and to prepare annual accounts or to
give correct accounts, is also not permitted to Buy back shares
A running business may be acquired by another company. A public limited company has to get
certificate of Incorporation and Certificate of commencement of business. Only after getting the
certificate of Incorporation that the company comes into existence.. But it should be noted here
that a public limited company cannot commence its business till the certificate of
commencement of business is obtained. The new company is entitled to all profits earned after
the purchase or conversion of business till the date of incorporation. Such profit is referred to as
“Profit prior to Incorporation”.
1. Sales ratio: All expenses associated with sales are to be allocated in the ratio of the sales.
Gross profit is to be allocated on the basis of sales ratio.
Ex: Earnings outwards, Discount allowed, Commission to salesman, sales promotion expenses,
bad debts etc.
2. Weighted sales ratio: In case sales are not uniform throughout the accounting year,
weightage should be given to the trends observed in the sales. Adjustments have to be made
based on the charge in trend. The resultant is due to weighted sales ratio.
3. Time ratio: Time ratio is the ratio f period prior incorporation and post incorporation in an
accounting period. Ex: salaries, rent, interest, depreciation, bank charges,stationery postage, etc.
4. Weighted time ratio: In case of any changes made to the number of employees, weightage
should be given to such changes by arriving at the time ratio. Also, when some expenses are
incurred specifically pertaining to a part of the accounting period, separate ratio has to be
ascertained.
Various Items and Their Bases for apportionment are shown in the following:
The main purpose of preparing this account is to know the net result of business carried out for a
particular period of time. That is to know exactly how much is profit earned or loss incurred.
Profit and Loss Account takes into consideration all those expenses and incomes which are
indirectly connected to carrying out business transactions. It takes into account all Indirect
Expenses, which includes office, administrative, selling and distribution expenses and non-
operating expenses. Also it includes non-operating incomes like commission received discount
received, dividend received interest received, rent received, etc., non operating expenses, and
losses are compared with non-operating incomes or gains made during an accounting period.
Thus, this account shows the net result of the entire business operation.
Format for Profit and loss Account
The following table gives the various adjustments which normally appear in final accounts
problems along with their respective adjustments entries. It also indicates how the adjustments be
dealt with in final accounts.
Adjustments Adjustment Trading A/c P&L A/C Balance Sheet
Entry
Closing Stock Closing stock a/c Shown on Shown on
Dr credit side ********* Asset side
To Trading A/c
Expenses out Particular It is added to the particular The outstanding
standing expense expense account shown on expense is shown
A/c ….Dr the debit side of Trading on
To outstanding A/c or Profit and Loss A/c, as the The liability side.
Expenses A/c case may be
Income outstanding Outstanding Added to particular income Outstanding
Income A/c… Dr account on the credit side of income is shown on
To Particular Trading A/c or Profit and the asset
Income A/c Loss A/c as the case may be side
Prepaid Prepaid expense Deducted from particular Shown on the asset
expenses/expense A/c…. Dr expense on the debit side of side
paid in To Particular Trading A/c and P&L A/c,
advance/unexpired expense A/c as the case may be
expense
Interest on Capital A/c…Dr Shown on Deducted from
drawings To Drawings A/c ************** the credit capital
side on the liability side
Income received Particular Income Deducted Shown on the
in advance A/c…..Dr ************* from the liability
To Income relevant side
received in income on
advance the credit side
Interest on capital Interest on capital Shown on Added to capital on
A/c ….Dr ************ the debit the liability side
To Capital A/c side
Depreciation on Depreciation A/c Depreciation Depreciation
Asset ….Dr *********** shown on deducted
To Asset A/c the debit from the gross
side value
of asset
Goods taken by Drawings Deducted Deducted from
the owner A/c Dr FromPurchases *********** capital
To Purchases A/c on the debit on the liability side
Goods distributed Advertisement Deducted Shown as
as free sample A/c….Dr From Purchases Advertisement **********
To Purchases A/c on the debit side on the debit
side
Further Bad debts Bad debts A/c Dr Bad debts Deducted from
incurred To Debtors A/c ********** shown on debtors on the asset
the debit side
side
Provision for bad P&LA/c…Dr PBD shown Deducted
debts [PBD] To PBD A/c ************ on the debit from
side Debtors on
the asset
side
Bad debts (a) Cash A/c…Dr Bad debts Added to cash
recovered To Bad Debts ********** recovered is balance on the
recovery A/c shown on Asset
(b)Bad debts credit side side
Recovery
A/c…Dr
To profit &loss
A/C
Provision for P&LA/c…..Dr Provision Deducted from
discount on Drs To Provision for ************ for discount Debtors on the
discount on debtors asset
shown on side
debit side
Balance Sheet is a statement showing the list of assets and liabilities of a business as on a
particular period of time. It is prepared to know the financial position of a business unit. in a
balance sheet all the items of assets and liabilities are arranged according to the order of
liquidity. A Balance Sheet has two sides – Assets (right hand side) andLiabilities (left hand side).
Accounts which has debit balances are shown on the AssetSide and accounts which has credit
balances are shown on the Liabilities side.
BALANCE SHEET AS ON ………
LIABILITIES Rs Rs ASSETS Rs Rs
Bills Payable Cash in hand
Sundry Creditors Cash at bank
Outstanding expenses Sundry Debtors
Income received in advance Less: Bad debt
Bank overdraft Less: Provision for Bad debts
Loan from Bank Closing stock
Debenture Bills receivables
Capital Prepaid expenses
Add; Net profit Accrued income
Add: Interest on capital Short term investments
Less: Drawings Machinery
Less: Net loss Less: Depreciation
Less: interest on Drawings Building
Less: Depreciation
Furniture
Less: Depreciation
Goodwill
It is also called a statement of financial position, a balance sheet shows what your company owns
and what it owes through the date listed.
a. To determine if working capital is enough: The balance sheet is used to determine if the
business has enough working capital to sustain its operations. Working capital is the
difference of current assets less current liabilities. IT measure if the company still has
enough current resources after deducting its due loan or obligations. If the result of
computation is positive, that means the company is still doing okay. On the other hand, if
the computation becomes negative, that means the company is in trouble. There high risk
of bankruptcy or inability to continue operating.
b. To know the business net worth: Net worth is defined as the true value of an entity. IT
shows how rich or poor it is. It is computed by the difference of total assets less total
liabilities.
c. To see if the company can sustain future operations: By looking at the balance sheet, you
can determine if the company can sustain future operations. To do this, look at the value
of its noncurrent assets such as property, plant and equipment. IF the total is higher than
the current assets, it means the company has plans to sustain future operations. On the
other hand, if the amount is already lower than the current assets, it can be an indication
of inability to sustain future operations.
d. To identify if there possible issuance of dividend: Most business owners are interested to
know if when they will receive returns from their investment. Such returns can be in the
form of dividends. Dividends are issued if the company is profiting and has high amount
of retained earnings.
Explain the difference between a trial balance and a balance sheet.
TRIAL BALANCE BALANCE SHEET
1.It is prepared to verify the arithmetical It is prepared to disclose the true financial
accuracy of books of accounts position of the business
2. IT is prepared with balances of all the ledger IT is prepared with the balances of assets and
accounts. liabilities accounts.
3.It is not a part of final accounts It is an important part of final accounts
4.IT is prepared before the preparation of final It is prepared after the preparation of trading
accounts and profit and loss account
5. It may be prepared a number of time in an It is generally prepared once at the end of the
accounting year. accounting year.
6. Generally, it includes opening stock but not It always includes closing stock but not
closing stock. opening stock
7. There is no rule for arranging the ledger Assets and liabilities must be shown in it
balance in it. according to the rule of marshaling.
8.It is not required to be filed to anybody It must be filed with the registrar of companies
if the business is a company.
9. Auditor needs not to sign it. Auditor must sign it.