What are Contingent Liabilities?

These are the liabilities the obligations of which depend on the occurrence and non occurrence of one or more future events. Means, the liabilities are yet to be finalized. It is waiting for some future events to be happened.

Suppose, a decision of a court case is about to come, if the decision is your against, you are going to pay some amount as penalty. Perhaps, the decision can be of your favor; you are not sure about it. This is the situation of your contingent liability; the occurrence of your liability depends upon the decision of judge. So till the decision come, you have to recognize it as contingent liability in your books of accounts.

Remember! The word “contingent” means “unpredictable” therefore, the liabilities which we cannot predict whether it is going to be actualized or not. If we can predict, it is no more a contingent liability it will be regarded as a pure liability.

Similarly, Banks give guarantee on the behalf of its customers. So if the customer fails to pay the amount, the bank has to pay. Here banks cannot recognize it as liability as it is not confirmed that customers will not pay the amount so it is a contingent liability for banks because it depends on the future activities of the customers. Banks has to show this contingent liability in the foot notes of its annual report at the end of its accounting year. In the next year, if customers pay all their dues, the bank gets free from its contingent liability but if they fail to pay, bank has to recognize it as liability in the year it is cleared that customer is insolvent.

This was about company, now take it practically. Suppose, your dad promised you to buy an I-phone for you if you get 1^st rank in your upcoming examination.  Now from your father’s point of view, the obligation to give you I-phone depends on your getting 1^st rank in exam. The liability of your father arises only if you got 1^st rank. If you do not get it, there will be no liability so until the results come out it’s a contingent liability for your dad.

It is very important point to be seen carefully in annual report at the time of analyzing a company by investor because this is the point where all the books are cooks by the management of the company.

Last, liabilities are recorded in the balance sheet but contingent liabilities are recorded in the footnotes of the annual report.

Hope now you have understood this concept very well. If any questions regarding this topic, write me in comment box below.

Who are Underwriters?

Underwriters are the commission agents who give guarantee to the public limited company that in case public failed to subscribe its shares; they would purchase the rest of the shares.

Thus, the issuing company gets assured that its shares are not going to under subscribed.

First of all, the word “subscribes” means money given by the public in exchange of shares.

Suppose, XLTD wants to expand its business and intent to raise its capital from public by issuing 10000 equity shares @100 each to public but they have doubt whether shares were fully subscribed by the public or not. In case public does not subscribe its shares fully, the company will fail to get its intended money and its plan will not be implemented. To overcome from this worry, the company appoints underwriters who for a commission, takes all the responsibility of issuing shares and being fully subscribed. Now in this case, if public subscribes only 8000 shares, the rest 2000 shares were purchased by the underwriters. Thus, the company got its 8000*100=800000 plus 2000*100=200000 which makes total 1000000. Ofcourse, the company has to pay commission to the underwriters for this guarantee.

What is Prospectus?

It is a document issued by the public limited company at the time of raising money from public, either as shares or debentures. The thing is that, nobody is going to invest his money in the company without looking at proper records and profit earning ability of that company. That is why, company issued prospectus which says everything about the company like its preceding five year balance sheet, profit and loss statement,  name and address of the company and their directors, qualification of the directors, name and address of the signatories of the memorandum of association and shares held by them, etc and many more important things.

After reading this, if the public are tempted to invest their money they will apply accordingly.

Actually, company act also requires the public limited company to issue its prospectus at the time of raising its capital from public so that the general public gets full information about the company. 

What are preliminary Expenses?

1.       These are the expenses incurred at the time of formation of a company. The following are the expenses:

1.       Expenses relating to drafting and printing documents in relation to the registration of a company.

2.       Stamp duty on authorized capital. Registration fees.

3.       Cost of common seal and preliminary books.

4.       Expenses relating to the drafting, printing and issuing of prospectus.

5.       Commission payable to underwriters of shares etc.

“Security premium account” is used to write off this preliminary expense.  Some companies write it off over the years in profit and loss account. The portion which is yet to be written off will be shown as “miscellaneous expenditure” on the asset side of the Balance Sheet.

Ok! but reader wants to know is it only about company not for partnership business?

The answer is there is no such provision in partnership act regarding preliminary expenses. I think it’s because the preliminary expense of partnership is very minimum in comparison to company.

Is there any accounting standard relating to preliminary expenses?

Yes! AS 26 –intangible assets also deals with preliminary expenses.

If you have any other questions regarding this topic please write me in the comment box below.

Single Entry System of Accounting.

This system of accounting is followed by those who are not trained enough for double entry system although they are engaging in business activities and concern to find out their profits.

First of all, I want to add that the word “single entry” should not be understood as "one entry accounting". It is a combination of double entry, single entry and even no entry.

The main idea behind this concept is to not record expense and income transactions. We only have to compare opening capital with closing capital to determine our profit.

Suppose you started business with cash 100000 rupees in the beginning of the year on 1^st Jan 2014.

And during the year you made some transactions which brought the following balances on 31^st Dec 2014:

Machine—40000 rupees; Stock—20000; debtors – 30000; Bank balance—60000; cash in hand—20000.

Creditors—50000.  Thus the total closing capital balances are – 120000.

Thus, the profit for the year is 120000(-) 100000=20000.

What I have done is just deduct opening capital from closing capital to find out the profit.

This system explains that if you are incurring any expenses, your cash gets reduced so no need to maintain the recording of expenses and income. On the other hand, if you are incurring any expenses on credit your creditor appears on the liability side of the balance sheet. So you have just seen that in every situation your balance sheet value gets affected by the transactions, that is why, the system appeals us to use only balance sheet value in determining profits.

To conclude, I must say that the chances of misappropriation, miscalculation, and fraud increases too much as there is not trial balance to check the error.

That is how I explained single entry system of accounting. If you have any doubt regarding this topic, please write me in the comment box below. 

What is Double Entry System of Accounting?

The most important and backbone of the Accounting is this double entry concept according to which, every transaction has double effect.  Your debit must be equal to credit. If we are purchasing any material on cash, we are debiting purchase a/c and crediting Cash a/c. In the asset side of Balance sheet, the cash gets reduced and stock appears with the same amount. Thus, your balance sheet gets equal.  The idea is at any point of time your assets must be equal to liabilities+ capital.

 Here comes the Equation:   Assets= Liabilities + capital

The concept reduces the mathematical error to greater extent as it allows us to prepare trail balance and we can check easily the effect of transaction in balance sheet. The concept gets preferred over Single Entry System.

Now take an example to see how things get easy under double entry accounting.

You introduce cash Rs 500000 into the business.

                                          Cash (debit) 500000

                                          To capital (credit) 500000

Cash is an item of asset so your asset gets increased and capital on the other hand also gets increased with the same amount and here your balance sheet gets matched. The equation will be:

                                            ASSET= Liabilities + Capital

                                            500000= Liabilities + 500000

Purchasing goods on credit valued 10000:

Here your asset got increased because stocks are coming in for 10000 Rupees and your liabilities also gets increased with the same amount as you have to pay to creditor.

                                           Asset= Liabilities + Capital

                                           510000=10000+500000

In this way the double entry accounting makes our accounting easy.

Hope you like it. If you have any questions regarding this topic, feel free to write me in comment box.

What is Securities Premium Account? and what are its utilizations?

1.   Here “Securities” means shares, debentures, bond etc. Listen! There is a difference between share premium and security premium. If I am saying share premium, it means I’m taking only equity and preference shares and on the other hand, security premium contains bonds and debentures also apart from shares. So security concept is a broad concept than share concept. Now, “Premium” means amount more than the face value of securities. Face value may be of 100, 10, 5, or even 1 Rupees/dollar.

If the company issues the securities more than face value, the excess of the amount over face value will be treated as premium and this premium is a reserve which is shown in balance sheet under the head “Reserve and Surplus” with the name “Security Premium Account” 

Suppose, a limited company with a face value of Rs10 issues 100000shares at a premium of Rs2. The journal entry would be:

Bank a/c      debit 1200000 (money received)

  To Equity Share Capital a/c 1000000(face value)

  To Security Premium a/c 200000(excess of the amount over face value)

The same rule will be applied for debentures and bonds.

But the question is why any company is going to issue its shares in premium?  

The answer is the management of that company believes that his company is doing good business and worth more than its face value. 

Is it profitable for the company? 

Yes! Definitely, the company is getting cash more than its face value so it’s a good sign for the company.

Is it profitable for the company if it issues debentures at a premium?

 Again the answer is Yes, Sure! Because, the company is getting more money than the money it will have to pay at the time of redemption of debentures.

Curious readers never stops to ask questions, their last question is –

What if company redeems its debentures at premium?

 Answer is –loss for the company because that company has to pay more than what it took at the time of issue of debentures. And the amount credited in the security premium account (if any) will be utilized first, to cover up this loss. (see point 4 below)

Now learn some more utilization of security premium account.

Utilization of security premium account-:

Sec 78 of the company act 1956, directs us to utilize the security premium account for the following purposes:

1.       Issuing fully paid bonus shares.

2.       Writing off Preliminary Expenses.

3.       Writing off the expense of or the commission paid or discount allowed on any issue of shares or debentures of the company.

4.       Providing for the premium payable on the redemption of preference shares or debentures of the company.

5.       In purchasing its own shares that is, Buy Back u/s 77A.

This was how I explained the above concept, hope you like it.If you have any question regarding this topic please feel free to ask in below mention comment box. 

What is Capital Reserve? and its utilization?

Capital Reserve is the reserve which is created out of capital profit. It is not ordinarily distributed as dividend to shareholders. The concept is if we generate profit from an extra-ordinary transaction we kept it as capital reserve to safeguard against any capital losses if arise in future.

The following are some examples of capital profits which should be credited to capital reserve:

1.    Profit on repayment of debentures. That is, redeem the debentures at discount.

2.    Profit on revaluation of assets.

3.    Profit earned through forfeiture and re-issue of shares. For detail knowledge of forfeiture please click here

4.    Profit earned prior to incorporation, and

5.    Profit on the acquisition of business etc.

Utilization of Capital Reserves: (The intention is to reduce capital losses)

a)    For issuing bonus shares.

b)    In writing off preliminary expenses.

c)    In writing off commission or expense or discounts etc on shares or debentures.

d)    For providing premium on the redemption of redeemable preference shares or debentures.

This was the short description of capital Reserve. If you have any questions, feel free to write me in the comment box below.