Financial Reporting Vol. 2

FINAL COURSE STUDY MATERIAL

PAPER

1

Financial ReportingVolume 2

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge and skills in the subject. Students should also supplement their study by reference to the recommended text book(s). In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material.

The Institute of Chartered Accountants of India

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Published by Dr. T.P. Ghosh, Director of Studies, ICAI, C-1, Sector-1, NOIDA-201301Typeset and designed at Board of Studies, The Institute of Chartered Accountants of India.

PREFACEThe paper of Financial Reporting in the Final Course concentrates on understanding of the crucial aspects of preparing and analyzing financial statements. Students are expected to acquire advanced knowledge in this paper. The importance of the subject of financial reporting is growing over the years due to various factors like liberalization, flow of cross-border capital, emergence of global corporations and movement towards better corporate governance practices. Standardization of accounting policies and financial reporting norms are significant aspects that make the subject more interesting in the recent years. Various new Accounting Standards, Guidance Notes and Accounting Standards Interpretations have been formulated by the Institute of Chartered Accountants of India keeping in mind the growing importance of financial reporting in corporate scenario. The students are required to develop understanding of the Accounting Standards, Accounting Standards Interpretations and the relevant Guidance notes and should gain ability to apply the provisions contained therein under the given practical situations. The last decade has witnessed a sea change in the global economic scenario. The emergence of transnational corporations in search of money, not only for fuelling growth, but to sustain ongoing activities has necessitated raising of capital from all parts of the world. When an enterprise decides to raise capital from the foreign markets, the rules and regulations of that country will apply and the enterprise should be able to understand the differences between the rules governing financial reporting in the foreign country as compared to that of its own country. Thus translations and re-instatements of financial statements are of great significance. Therefore, chapter based on overview of Indian Accounting Standards, International Accounting Standards/International Financial Reporting Standard and US GAAPs has also been introduced in the Final Course curriculum. The book is divided into two volumes for ease of handling by the students. Volume 1 contains Chapters 1 7 and Volume 2 contains Chapters 8 10. Appendices containing text of Accounting Standards, Guidance Notes and Accounting Standards Interpretations have also been included in Volume 2. Care has been taken to present the chapters in the same sequence as prescribed in the syllabus to facilitate easy understanding by the students. Small illustrations have been incorporated in each chapter/unit to explain the concepts/principles covered in the chapter/unit. Another helpful feature is the addition of self-examination questions which will help the students in preparing for the Final Course Examination. Students are advised to practise the practical problems thoroughly. They are also advised to update themselves with the latest changes in the area of financial reporting. For this they may refer to academic updates in the monthly journal The Chartered Accountant and the Students Newsletter published by the Board of Studies, financial newspapers, SEBI and Corporate Law Journal , published financial statements of companies etc. The concerned Faculty members of Board of Studies of Accounting have put their best efforts in making this study material lucid and student friendly. The Board has also received valuable inputs from CA. Yash Arya, Dr. Satyajit Dhar, CA. Prasun Rakshit, Dr. S. K. Chowdhry for which the Board is thankful to them. In case students have any suggestions to make this study material more helpful, they are welcome to write to the Director of Studies, The Institute of Chartered Accountants of India, C-I, Sector-I, Noida-201 301.

VOLUME 2CONTENTSNote : Chapters 1 7 of Financial Reporting are available in Volume 1. CHAPTER 8 FINANCIAL REPORTING FOR FINANCIAL INSTITUTIONS Unit 1: Mutual Funds 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 Introduction .................................................................................................. 8.1 Organisation of Mutual funds ........................................................................ 8.1 Mutual Fund Schemes ................................................................................... 8.3 Evaluation of Mutual Funds ............................................................................ 8.3 Valuation of Portfolio ..................................................................................... 8.5 Annual Reporting........................................................................................... 8.5 Accounting Policies ....................................................................................... 8.6 Contents of Balance Sheet and Revenue Account ........................................... 8.9 Making investments to market ...................................................................... 8.12 Disposal of investments ............................................................................... 8.13 Recognition of dividend income .................................................................... 8.15 Cost of Investments ..................................................................................... 8.14 Date of recording of transactions.................................................................. 8.15 Dividend Equalisation .................................................................................. 8.16 Introduction ................................................................................................. 8.19 Definition of NBFC....................................................................................... 8.19 Registration and Regulation of NBFC ........................................................... 8.19 Minimum Net owned fund ............................................................................. 8.20 Types of NBFC regulated by RBI .................................................................. 8.20 Public Deposits ........................................................................................... 8.22 Liquid Asset Requirements .......................................................................... 8.23 Prudential Accounting Norms ....................................................................... 8.23

Unit 2: Non-Banking Finance Company

i

2.9 2.10 2.11 2.12 2.13 2.14 2.15 2.16 2.17 3.1 3.2 3.3 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 4.15 4.16 4.17

Income Recognition ..................................................................................... 8.24 Accounting for Investments .......................................................................... 8.24 Asset Classification ..................................................................................... 8.25 Non-Performing Asset.................................................................................. 8.26 Provisioning Requirements .......................................................................... 8.26 Disclosures in the Balance-Sheet ................................................................. 8.28 Requirements as to Capital Adequacy .......................................................... 8.28 Asset Liability Management ......................................................................... 8.29 NBFC Prudential Norms (RBI) Direction, 1998 .............................................. 8.30 Introduction ................................................................................................. 8.41 Capital Adequacy Requirement .................................................................... 8.41 Maintenance of Books of Account, Records .................................................. 8.42 Introduction ................................................................................................. 8.45 Stock Brokers.............................................................................................. 8.46 Maintenance of Proper Books of Account, Records ....................................... 8.47 Presentation of Books of Account and Records ............................................. 8.49 Boards Right to Inspect............................................................................... 8.50 Procedure for Inspection .............................................................................. 8.50 Obligations of Stock Broker on Inspection by the Board................................. 8.50 Submission of Report to the Board ............................................................... 8.51 Action on Inspection or Investigation Report ................................................. 8.51 Appointment of Auditor ................................................................................ 8.51 Regulation of Transactions between Clients and Brokers............................... 8.51 Member Broker to keep Accounts ................................................................. 8.51 Obligation to pay Money into Clients Accounts .............................................. 8.51 Accounts for Clients Securities .................................................................... 8.52 Payment and Delivery of Securities .............................................................. 8.53 Margin ........................................................................................................ 8.53 Closing Out ................................................................................................. 8.53

Unit 3: Merchant Bankers

Unit 4: Stock and Commodity Market Intermediaries

ii

CHAPTER 9 VALUATION Unit 1: Concept of Valuation 1.1 1.2 1.3 1.4 1.5 1.6 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 Introduction .................................................................................................. 9.1 Concept of Valuation ..................................................................................... 9.2 Need for Valuation......................................................................................... 9.2 Bases of Valuation......................................................................................... 9.3 Types of Value .............................................................................................. 9.4 Approaches of Valuation ................................................................................ 9.6 Introduction ................................................................................................... 9.7 Meaning of Original Cost ............................................................................... 9.7 Change in Original Cost ................................................................................. 9.9 Change of Original Cost -Improvements, Revaluation, Impairment ................... 9.9 Valuation Approaches .................................................................................. 9.10 Net Valuation .............................................................................................. 9.10 Disposal and Retirement .............................................................................. 9.10 Depreciation................................................................................................ 9.11 Definition of Intangibles ............................................................................... 9.17 Recognition ................................................................................................. 9.17 Definition of goodwill ................................................................................... 9.18 Nature and Types of Goodwill ...................................................................... 9.19 Factors Contributing to Goodwill................................................................... 9.20 Relevant Provisions of the Accounting Standards.......................................... 9.21 Valuation of Goodwill ................................................................................... 9.22 Determination of Capital Employed............................................................... 9.24 Future Maintainable profit ............................................................................ 9.28 Normal Rate of Return ................................................................................. 9.32 Brand Valuation........................................................................................... 9.35 Identification of brands as an Asset .............................................................. 9.36 Objectives of Corporate Branding ................................................................. 9.37

Unit 2: Valuation of Tangible Fixed Assets

Unit 3: Valuation of Intangibles

iii

3.14 3.15 3.16 3.17 3.18 3.19 4.1 4.2 4.3 4.4 4.5 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11

Corporate Brand Accounting ........................................................................ 9.37 Objectives of Brand Accounting.................................................................... 9.38 Difficulties in Brand Accounting .................................................................... 9.39 Valuation of Brands ..................................................................................... 9.40 Human Resources as a Brand ...................................................................... 9.45 Corporate Brand Strength ............................................................................ 9.47 Introduction ................................................................................................. 9.49 Base of Valuation ........................................................................................ 9.49 Carrying Value ............................................................................................ 9.49 Leases ........................................................................................................ 9.49 Provisions ................................................................................................... 9.50 Introduction ................................................................................................. 9.51 Purposes of Valuation.................................................................................. 9.51 Relevance of Valuation ................................................................................ 9.51 Limitation of Stock Exchange Price as a Basis for Valuation .......................... 9.52 Methods ...................................................................................................... 9.53 Statutory Valuation ...................................................................................... 9.60 Valuation of Preference Shares .................................................................... 9.67 Miscellaneous Problems for Practice ............................................................ 9.67 Introduction ................................................................................................. 9.76 Need for Valuation of Business .................................................................... 9.76 Valuation Approaches .................................................................................. 9.76 Valuation Methods ....................................................................................... 9.76 Book Value ................................................................................................. 9.78 Fair Value ................................................................................................... 9.79 Earning Based Valuation of Business ........................................................... 9.80 Market Value Model ..................................................................................... 9.80 Valuation of Investments.............................................................................. 9.80 Valuation of Current Assets, Loans and Advances ........................................ 9.81 Value of Control of the Business .................................................................. 9.87

Unit 4: Valuation of Liabilities......................................................................................

Unit 5: Valuation of Shares ..........................................................................................

Unit 6: Valuation of Business.......................................................................................

iv

CHAPTER 10 - DEVELOPMENTS IN FINANCIAL REPORTING Unit 1: Value Added Statement 1.1 1.2 1.3 1.4 1.5 1.6 1.7 2.1 2.2 2.3 2.4 2.5 3.1 3.2 3.3 3.4 4.1 4.2 5.1 5.2 5.3 5.4 6.1 6.2 Historical Background .................................................................................. 10.1 Definitions................................................................................................... 10.1 Reporting Value Added ................................................................................ 10.3 Necessity of preparing VA Statements .......................................................... 10.3 Value Added Statement ............................................................................... 10.5 Limitations of VA ......................................................................................... 10.7 Interpretation of VA ....................................................................................10.12 Introduction ................................................................................................10.15 Cost of Capital ...........................................................................................10.15 Capital Asset Pricing Model ........................................................................10.16 Beta...........................................................................................................10.16 Equity Risk Premium ..................................................................................10.17 Introduction ................................................................................................10.21 Relationship between EVA and Market Value Added ....................................10.21 Benefits of Market Value Added ..................................................................10.22 Limitations of Market Value Added ..............................................................10.24 Introduction ................................................................................................10.25 Implications................................................................................................10.25 Introduction ................................................................................................10.26 Models of HRA ...........................................................................................10.26 Implications of Human Capital Reporting .....................................................10.30 HRA in India...............................................................................................10.31 Introduction ................................................................................................10.35 Primary Purpose of Financial Statements ....................................................10.35

Unit 2: Economic Value Added

Unit 3: Market Value Added

Unit 4: Shareholders Value Added ..............................................................................

Unit 5: Human Resource Reporting

Unit 6: Inflation Accounting

v

6.3 6.4 6.5 6.6 6.7 6.8

Limitations of Historical Cost based Accounts ..............................................10.36 Need for Inflation Accounting ......................................................................10.36 Current Purchasing Power Method ..............................................................10.36 Current Cost Accounting .............................................................................10.39 Evaluation of CCA ......................................................................................10.46 Miscellaneous Illustrations ..........................................................................10.46

APPENDICES APPENDIX I .................................................................................................... I.1 I.412 APPENDIX II ...................................................................................................II.1 II.53 APPENDIX III .............................................................................................. III.1 III.204

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8FINANCIAL REPORTING FOR FINANCIAL INSTITUTIONSUNIT 1 MUTUAL FUNDS1.1 INTRODUCTION Mutual funds are trusts, which pool resources from large number of investors through issue of units under specified schemes. The funds raised are invested in capital market instruments such as shares, debentures and bonds and money-market instruments, such as commercial papers, certificates of deposits and treasury bonds. The fund earns income from these investments by way of dividends, interests and capital gains. The income from investments, less specified expenses for managing the funds, are distributed among unit holders in proportion of number of units held. The investments are made under expert guidance to allow unit holders to earn highest possible return for lowest possible risk. Risk reduction is achieved through planned diversification of investment portfolio and also by judicious use of various hedging techniques. The selection investments for a scheme should be within the investment objectives and other parameters set for the scheme. 1.2 ORGANISATION OF MUTUAL FUNDS In India, mutual funds are regulated by SEBI (Mutual Funds) Regulations, 1996. According to the SEBI (Mutual Funds) Regulations, 1996, a mutual fund means a fund established in the form of a trust to raise monies through the sale of units to the public under one or more schemes for investing in securities including money market instruments. The management of mutual fund comprises of a sponsor, trustee company and an Asset Management Company (AMC). Typically, a mutual fund is promoted by a sponsor who appoints trustee, asset management company and custodian. A mutual fund should be registered with SEBI. Asset management company means a company formed and registered under the Companies Act, 1956 and approved as such by the Securities and Exchange Board of India to manage the

8.2

Financial Reporting

funds of a mutual fund. Unit means the interest of the unitholders in a scheme, which consists of each unit representing one undivided share in the assets of a scheme; Money market instruments includes commercial papers, commercial bills, treasury bills, Government Securities having an unexpired maturity up to one year, call or notice money, certificate of deposit, usance bills, and any other like instruments as specified by the Reserve Bank of India from time to time; A mutual fund invests the money received from investors in instruments which are in line with the objectives of the respective schemes. Regular expenses like custodial fee, cost of dividend warrants, registrars fee, asset management fee, etc., are borne by the respective schemes. Balance every thing is given back to the investors in full. In a mutual fund, the resources of many investors are pooled to create a diversified port folio of securities. After collecting the funds from investors, daily operations are managed by experts and professional fund managers. They take investment decisions regarding what, how much, when and where to invest and disinvest so as to get maximum return as well as higher capital appreciation. The purchase and repurchase price of mutual funds are generally fixed and also vary in stock exchanges if the security is quoted on the basis of its net asset value (NAV). The investment pattern of mutual funds is governed partly by Government guidelines and partly by nature and objective of mutual fund. A mutual fund shall be constituted in the form of a trust and the instrument of trust shall be in the form of a deed, duly registered under the provisions of the Indian Registration Act, 1908 (16 of 1908), executed by the sponsor in favour of the trustees named in such an instrument. Under regulation 50, every asset management company for each scheme shall keep and maintain proper books of account, records and documents, for each scheme so as to explain its transactions and to disclose at any point of time the financial position of each scheme and in particular give a true and fair view of the state of affairs of the fund and intimate to the Board the place where such books of account, records and documents are maintained. The mutual funds are set up as registered trusts. Any body corporate, if approved by SEBI can sponsor such trusts. The sponsor appoints the trustees. The trustees hold assets of the trust for the benefit of unit holders. The sponsor, or if the trust deed permits, the trustees, appoint an Asset Management Company (AMC) for creation and maintenance of investment portfolios under different schemes. The AMC is a company formed and registered under the Companies Act 1956. It must obtain approval from the SEBI to act as AMC. The AMC acts under broad superintendence of the board of trustees. The trustees have the duty to monitor actions of the AMC to ensure compliance with the SEBI regulations. The AMC may charge the mutual fund with Investment Management and Advisory Fees subject to prescribed ceiling. The fees to be paid to the AMC must be disclosed fully in the offer

Financial Reporting for Financial Institutions

8.3

document. In addition to the fees, the AMC may recover prescribed expenses from the Mutual Fund. 1.3 MUTUAL FUND SCHEMES In terms of investment objectives, mutual fund schemes can be classified as the growth funds and income funds. The growth funds invest major parts of their corpus in equity instruments and hence are exposed to comparatively higher risks. These schemes are expected to provide higher return in form of dividends and capital appreciation. Income funds invest in fixed income debt instruments, e.g. corporate debentures, Government securities and money market instruments and hence are also called the debt funds. They provide steady flow of comparatively lower return for lower risks. Depending on the type of entry and exit routes available, the mutual fund schemes can be classified as open ended and close ended. The open-ended schemes permit entry by subscription or exit by sale of units on a continuous basis. The mutual fund announces daily sale and repurchase prices of units for the purpose. The numbers of units outstanding under these schemes keep on changing. The sale and repurchase prices announced by a mutual fund are based on Net Asst Value (NAV) and hence are called the NAV related prices. (The NAV per unit is the value of net assets of a mutual fund scheme divided by the total number of units outstanding.) The close-ended funds have fixed maturity periods e.g. 5-7 years. These schemes are kept open for subscription only during a specified period at the time of launch of the scheme. To provide liquidity, the units are however listed on stock exchanges. 1.4 EVALUATION OF MUTUAL FUNDS Mutual funds sell their shares to public and redeem them at current net Assets Value (NAV) which is calculated as under

Total market value of all MF holdings - All MF liabilities Unit sizeThe net asset value of a mutual fund scheme is basically the per unit market value of all the assets of the scheme. To illustrate this better, a simple example will help. Scheme name Scheme size Face value of units No. of units : : : : XYZ Rs. 50,00,00,000 (Rupees Fifty crores) Rs. 10 5,00,00,000

Scheme size Face value of units

8.4

Financial Reporting : In shares

Investments Market value of shares

Rs. 75,00,00,000 (Rupees seventy five crores) = = =

Market value of investments No. of unitsRs. 75,00,00,000 5,00,00,000

Rs. 15

Thus, each unit of Rs. 10 is worth Rs. 15. Simply stated, NAV is the value of the assets of each unit of the scheme, or even simpler value of one unit of the scheme. Thus, if the NAV is more than the face value (Rs. 10), it means your money has appreciated and vice versa. NAV also includes dividends, interest accruals and reduction of liabilities and expenses, besides market value of investments.The Net Asset Value (NAV) is the value of net assets under a mutual fund scheme. The NAV per unit is NAV of the scheme divided by number of units outstanding. NAV of a scheme keep on changing with change in market value of portfolio under the scheme. The day of valuation of NAV is called the valuation day. Illustration 1 A mutual fund raised Rs. 100 lakh on April 1, 2006 by issue of 10 lakh units at Rs. 10 per unit. The fund invested in several capital market instruments to build a portfolio of Rs. 90 lakh. The initial expenses amounted to Rs. 7 lakh. During April 2006, the fund sold certain securities of cost 38 lakh for Rs. 40 lakh and purchased certain other securities for Rs. 28.2 lakh. The fund management expenses for the month amounted to Rs. 4.5 lakh of which Rs. 25,000 was in arrears. The dividend earned was Rs. 1.2 lakh. 75% of the realised earnings were distributed. The market value of the portfolio on 30/04/06 was Rs. 101.90 lakh. Determine NAV per unit. Solution Rs. lakh Opening bank (100 90 7) Add: Proceeds from sale of securities Add: Dividend received Deduct: Cost of securities purchased 28.20 3.00 40.00 1.20 44.20 Rs. Lakh Rs. lakh

Financial Reporting for Financial Institutions Fund management expenses paid (4.50 0.25) Capital gains distributed = 75% of (40.00 38.00) Dividend distributed = 75% of 1.20 Closing bank Closing market value of portfolio Less: Arrears of expenses Closing net assets Number of units (Lakh) Closing NAV (Rs.) 1.5 VALUATION OF PORTFOLIO 4.25 1.50 0.90 34.85

8.5

9.35 101.90 111.25 0.25 111.00 10.0 11.10

Market value of portfolio has a direct bearing on the NAV and consequently on portfolio performance. The market value of portfolio is the aggregate market value of different investments. Marker value of a traded security is the last closing price quoted in a stock exchange immediately before the valuation day. In case, a security is traded in more than one stock exchange, the price quoted in an exchange where the security is mostly traded is taken as market value of the security. Non-traded securities, i.e. securities not traded in a period of 30 days prior to the valuation day, should be valued in the spirit of good faith subject to SEBI regulations. For example, a non-traded debt instrument can be valued by discounting cash flows by YTM of a comparable debt instrument as increased for lack of liquidity. The discounting rate for non-traded government securities should the prevailing market rate. 1.6 ANNUAL REPORTING Every mutual fund or the asset management company is required to prepare in respect of each financial year an annual report and annual statement of accounts of the schemes and the fund as specified in Eleventh Schedule. As per Regulation 51 the financial year for all the schemes shall end as of March 31st of each year. The schemewise Annual Report of a mutual fund or an abridged summary thereof shall be published through an advertisement [and an abridged schemewise annual report shall be mailed to all unitholders] as soon as may be but not later than six months from the date of closure of the relevant accounts year. According to Eleventh Schedule, the annual report shall contain (i) Report of the board of Trustees on the operations of the various schemes of the fund and

8.6

Financial Reporting the fund as a whole during the year and the future outlook of the fund;

(ii)

Balance Sheet and Revenue Account in accordance with paras 2, 3 and 4, respectively of this Schedule;

(iii) Auditors Report in accordance with paragraph 5 of this Schedule; (iv) Brief statement of the Board of Trustees on the following aspects, namely:(a) Liabilities and responsibilities of the Trustees and the Settlor; (b) Investment objective of each scheme; (c) Basis and policy of investment underlying the scheme; (d) If the scheme permits investment partly or wholly in shares, bonds, debentures and other Scrips or securities whose value can fluctuate, a statement on the following lines : The price and redemption value of the units, and income from them, can go up as well as down with the fluctuations in the market value of its underlying investments; (e) Comments of the Trustees on the performance of the scheme, with full justification. (v) Statement giving relevant perspective historical per unit statistics in accordance with paragraph 6 of this Schedule; (vi) Statement on the following lines : On written request, present and prospective unitholder/investors can obtain copy of the trust deed, the annual report [at a price] and the text of the relevant scheme. 1.7 ACCOUNTING POLICIES The annual report of a mutual fund consists of (a) Balance Sheet (b) Revenue Account (c) Report of the Board of Trustees (d) Auditors Report and (e) Statement of the Board of Trustees on specified matters. As per regulation 50(3) of SEBI (Mutual Funds) Regulations, 1996, the Asset Management Companies are required to follow the accounting policies and standards specified in the Ninth Schedule of the Regulations. The requirements of the said schedule are as below: Following accounting policies shall be followed by Mutual Funds for the preparation of accounts : (i) The realised gains or losses on sale or redemption of investment, as well as unrealised appreciation or depreciation shall be recognised in all financial statements. For the purpose of all financial statements, all investments shall be marked to market and investments shall be carried out in the balance sheet at market value. However, till necessary guidance notes are issued by the Institute of Chartered Accountants of India to their members , in the above matter, investments may be continued to be valued at cost, with the market value shown separately and the reconciliation statement for the

Financial Reporting for Financial Institutions changes in investments valued in the two different ways shall be provided.

8.7

Where the financial statement are prepared on a marked to market basis, there need not be a separate provision for depreciation. Since unrealised gain arising out of the appreciation on investments cannot be distributed, provision has to be made for its exclusion and for calculating distributable income. (ii) Non-traded investments shall be valued in good faith in accordance with the norms specified in Seventh Schedule.

(iii) For quoted shares, the dividend income earned by the scheme shall be recognised, not on the date the dividend is declared, but on the date the share is quoted on an exdividend basis. For investments in shares which are not quoted on the stock exchanges, the dividend income must be recognised on the date of declaration. (iv) In respect of all interest-bearing investments, income shall be accrued on a day to day basis as it is earned. Therefore when such investments are purchased, interest paid for the period from the last interest due date upto the date of purchase, shall not be treated as a cost of purchase, but shall be treated to Interest Recoverable Account. Similarly, interest received at the time of sale for the period from the last interest due date upto the date of sale must not be treated as an addition to sale value but shall be credited to Interest Recoverable Account. (v) In determining the holding cost of investments and the gains or loss on sale of investments, the average cost method shall be followed. (vi) Transactions for purchase or sale of investments shall be recognised as of the trade date and not as of the settlement date, so that the effect of all investments traded during a financial year are recorded and reflected in the financial statements for that year. Where investment transactions take place outside the stock market, for example, acquisitions through private placement or purchases or sales through private treaty, the transaction shall be recorded, in the event of a purchase, as of the date on which the scheme obtains in enforceable obligation to pay the price or, in the event of a sale, when the scheme obtains an enforceable right to collect the proceeds of sale or an enforceable obligation to deliver the instruments sold. (vii) Bonus shares to which the scheme becomes entitled shall be recognised only when the original shares on which the bonus entitlement accrues are traded on the stock exchange on an ex-bonus basis. Similarly, rights entitlements shall be recognised only when the original shares on which the right entitlement accrues are traded on the stock exchange on an ex-rights basis. (viii) Where income receivable on investments has been accrued and has not been received for a period of 12 months beyond the due date, provision shall be made by debit to the revenue account for the income so accrued and no further accrual of income should be

8.8

Financial Reporting made in respect of such investment.

(ix) When the units of an open-ended scheme* are sold, the difference between the sale price and the face value of the unit, if positive, shall be credited to Reserves and if negative is debited to reserve, the face value being credited to Capital Account. Similarly, when units of an open-ended scheme are repurchased, the difference between the purchase price and face value of the unit, if positive should be debited to reserves and, if negative, should be credited to reserves, the face value being debited to the capital account. (x) (a) In the case of an open-ended scheme, when units are sold an appropriate part of the sale proceeds shall be credited to an Equalisation Account and when units are repurchased an appropriate amount shall be debited to Equalisation Account. The net balance on this Account should be credited or debited to the revenue account. The balance on equalisation account debited or credited to the Revenue Account shall not decrease or increase the net income of the fund but is only an adjustment to the distributable surplus. It shall, therefore, be reflected in the Revenue Account only after the net income of the fund is determined. (b) The Trustees of the Board of the Trustee Company may, if necessary, transfer a portion of the distributable profits to a dividend equalisation reserve. Such a transfer would be independent of the requirement to operate an Equalisation Account as provided in (x)(a). (xi) In a close-ended scheme** which provide to the unitholders the option for an early redemption or repurchase their own units, the par value of the unit shall be 1[debited] to Capital Account and the difference between the purchase price and the par value, if positive, should be debited to reserves and, if negative, should be credited to reserves. A proportionate part of the unamortized initial issue expenses shall also be transferred to the reserves so that the balance carried forward on that account is proportional to the number of units remaining outstanding. (xii) The cost of investments acquired or purchased shall [inter alia] include brokerage, stamp charges and any charge customarily included in the brokers bought note. In respect of privately placed debt instruments any front-end discount offered shall be reduced from the cost of the investment. (xiii) Underwriting commission shall be recognised as revenue only when there is no development on the scheme. Where there is development on the scheme, the full underwriting commission received and not merely the portion applicable to the devolvement shall be reduced from the cost of the investment.


8.9

1.8 CONTENTS OF BALANCE SHEET AND REVENUE ACCOUNT Contents of Balance Sheet (i) The Balance Sheet shall give schemewise particulars of its assets and liabilities. These particulars shall contain information enumerated in Annexures 1A and 1B hereto. It shall also disclose, inter alia, accounting policies relating to valuation of investments and other important areas. If investments are carried at costs or written down cost, their aggregate market value shall be stated separately in respect of each type of investment, such as equity shares, preference shares, convertible debentures listed on recognised stock exchange, nonconvertible debentures or bonds further differentiating between those listed on recognised stock exchange and those privately placed.

(ii)

(iii) The Balance Sheet shall disclose under each type of investment the aggregate carrying value and market value of non-performing investments. An investment shall be regarded as non-performing if it has provided no returns in the form of dividend or interest for more than 2 years as at the end of the accounting year of the mutual fund. However, disclosure of such non-performing investments shall not be necessary if all investments are valued at marked to market. (iv) The Balance Sheet shall indicate the extent of provision made in the Revenue Account for the depreciation/loss in the value of non-performing investments. However, if the investments are valued at marked to market, provisions for depreciation shall not be necessary. (v) The Balance Sheet shall disclose the per-unit net asset value (NAV) as at the end of the accounting year. (vi) As in case of companies, the Balance Sheet shall give against each item, the corresponding figures as at the end of the preceding accounting year. (vii) The notes to the balance sheet should disclose the following information regarding investments :(a) all investments shall be grouped under the major classification given in the balance sheet; (b) under each major classification, the total value of investments falling under each major industry group (which constitutes not less than 5% of the total investment in the major classification) shall be disclosed together with the percentage thereof in relation to the total investment within the classification; (c) full schemewise portfolio of investments of a mutual fund : Provided that a mutual fund may publish particulars of its full portfolio in the

8.10

Financial Reporting advertisements of abridged annual report or full annual reports in newspapers; (d) a full list of investments of the scheme shall be made available for inspection with the Asset Management Company; (e) the basis on which management fees have been paid to the Asset Management Company and the computation thereof; (f) if brokerage, custodial fees or any other payment for services are paid to or payable to any entity in which the Asset Management Company or its major shareholders have a substantial interest (being not less than 10% of the equity capital), the amounts debited to the revenue account or amounts treated as cost of investments in respect of such services shall be separately disclosed together with details of the interest of the Asset Management Company or its major shareholders;

(g) aggregate value of purchases and sales of investments during the year and expressed as a percentage of average weekly net asset value; (h) where the non-traded investments which have been valued in good faith exceed 5% of the NAV at the end of the year, the aggregate value of such investments; and (i) movement in unit capital should be stated. An example of the manner in which the movement in unit capital may be disclosed is given below : No. of units Balance as on 1st April, 1994 Units sold during the year Units repurchased during the year (j) 1250,00,000 127,50,000 (15,40,000) 1362,10,000 (Rs. in lakhs) 12,500.00 1,275.00 (154.00) 13,621.00

the name of the company including the amount of investment made in each company of the group by each scheme and the aggregate investments made by all schemes in the group companies of the sponsor;

(k) if the investments are marked to market, the total income of the scheme shall include unrealised depreciation or appreciation on investment. There should be disclosure and unrealised appreciation deducted before arriving at the distributable income in the following manner, e.g. Net income as per Revenue Account Add:Balance of undistributed income as at 1st April, 1994 brought forward Less:Unrealised appreciation on investments As on 31st March, 1995 Rs. in lakh 100 20 30 Rs. in lakh

120

Financial Reporting for Financial Institutions As on 1st April, 1994 Less:Distributed to unitholders Transfer to reserve 15

8.11

105 (15) 80 5 (85) 20 (viii) Provisions for doubtful deposits, doubtful debts and for doubtful outstandings and accrued income shall not be included under provisions on the liability side of the balance sheet, but shall be shown as a deduction from the aggregate value of the relevant asset. (ix) Disclosure shall be made of all contingent liabilities showing separately underwriting commitments, uncalled liability on partly paid shares and other commitments with specifying details. Contents of Revenue Account (i) The Revenue Account shall give schemewise particulars of the income, expenditure and surplus of the mutual fund. These particulars shall contain information enumerated in Annexure 2 of this Schedule. If profit on sale of investments shown in the Revenue Account includes profit/loss on inter-scheme transfer of investments within the same mutual fund the aggregate of such profit recognised as realised, shall be disclosed separately without being clubbed with the profit/loss on sale of investments to third parties.

(ii)

(iii) Unprovided depreciation in value of investments representing the difference between their aggregate market value and their carrying cost shall be disclosed by way of a note forming part of the Revenue Account. Conversely, unrealised profit on investment representing the difference between their aggregate market value and carrying cost, shall be disclosed by way of note to accounts. The Revenue Account shall indicate the appropriation of surplus by way of transfer to reserves and dividend distributed. However, if investments are marked to market, depreciation may not be provided. (iv) The Revenue Account shall indicate the appropriation of surplus by way of transfer to reserves and dividend distributed. (v) The following disclosures shall also be made in the revenue accounts: (a) provision for aggregate value of doubtful deposits, debts and outstanding and accrued income; (b) profit or loss in sale and redemption of investment may be shown on a net basis; (c) custodian and registrar fees; (d) total income and expenditure expressed as a percentage of average net assets, calculated on a weekly basis.

8.12

Financial Reporting

1.9 MARKING INVESTMENTS TO MARKET For the purposes of the financial statements, mutual funds shall mark all investments to market and carry investments in the balance sheet at market value. However, since the unrealized gain arising out of appreciation on investments cannot be distributed, provision has to be made for exclusion of this item when arriving at distributable income. Clause 2(i) of Eleventh Schedule of the regulations provides that in carrying investments at market values, the asset management companies should follow the Guidance Note issued by the Institute of Chartered Accountants of India. As per paragraph 10 of the Guidance Note on Accounting for Investments in the Financial Statements of Mutual Funds, issued by the Institute of Chartered Accountants of India, while marking investments to market on balance sheet date, the excess of cost of acquisition over market value of securities on valuation day is treated as depreciation (unrealized loss). Likewise, the excess of market value of securities on valuation day over cost of acquisition is treated as appreciation, which is unrealized gain. The provision for depreciation in the value of investments is created in the books by debiting the Revenue Account. The provision so created is shown as a deduction from the value of investments in the balance sheet. However, unrealised appreciations are directly transferred to the Unrealised Appreciation Reserve, (i.e., without routing it through the Revenue Account) with the corresponding debit to the Investments Account. The Guidance Note recommends reversal of the Unrealised Appreciation Reserve at the beginning of the next accounting year. Paragraph 11 of the Guidance Note recommends that the gross value of depreciation on investments should be reflected in the Revenue Account rather than the same being netted off with the appreciation in the value of other investments. In other words, depreciation/appreciation on investments should be worked out on an individual investment basis or by category of investment basis, but not on an overall (or global) basis for the entire investment portfolio. Illustration 2 The investment portfolio for a mutual fund scheme includes 10,000 shares of A Ltd. and 8,000 shares of B Ltd. acquired on 30/10/2005. The cost of A Ltd. shares is Rs. 20 while that of B Ltd. shares is Rs. 30. The market values of these shares at the end of 2005-06 were Rs. 19 and Rs. 32 respectively. Show important accounting entries in books of the fund in the accounting year 2005-06. Solution Investment in A Ltd. shares Investment in B Ltd. shares To Bank Rs. 000 200 240 Rs. 000 440


8.13

Revenue A/c To Provision for Depreciation Investment in B Ltd. shares To Unrealised Appreciation Reserve 1.10 DISPOSAL OF INVESTMENTS

10 10 16 16

The profit/loss arising on the disposal of investment is the difference between the selling price and the cost. The profit arising on disposal of investment is recognised fully in the Revenue Account. The loss on disposal of investment is recognised fully in the revenue account, if the investments are sold in the same year in which they are purchased. However, if an investment is sold in any year subsequent to year of purchase, loss on disposal is charged first against provision for depreciation to the extent of balance available, and the balance of loss, if any, should be charged directly to the Revenue Account. Illustration 3 In the previous example, suppose that shares of both of the companies were disposed off on 31/05/06 realizing Rs. 18.50 per A Ltd. shares and Rs. 33.50 per B Ltd. shares. Show important accounting entries in books of the fund in the accounting year 2006-07 Solution Rs. 000 Unrealised Appreciation Reserve To Investment in B Ltd. shares Bank Loss on disposal of Investment To Investment in A Ltd. shares Provision for Depreciation Revenue A/c To Loss on disposal of Investment Bank To Investment in B Ltd. shares To Profit on disposal of investments Profit in disposal of Investments To Revenue A/c 28 28 268 240 28 10 5 15 185 15 200 16 16 Rs. 000

8.14

Financial Reporting

1.11 RECOGNITION OF DIVIDEND INCOME Dividend income earned by a scheme should be recognized, not on the date the dividend is declared, but on the date the share is quoted on an ex-dividend basis. For investments, which are not quoted on the stock exchange, dividend income must be recognized on the date of declaration. Where income receivable on investments has accrued but has not been received for the period specified in the SEBI guidelines, the income accrued should be debited to Revenue A/c as provision. Bonus shares to which the scheme becomes entitled should be recognized only when the original shares on which the bonus the bonus entitlement accrues are traded on the stock exchange on an ex-bonus basis. Similarly, rights entitlements should be recognized only when the original shares on which the right entitlement accrues are traded on the stock exchange on an ex-rights basis. 1.12 COST OF INVESTMENTS The cost of investments acquired or purchased should include brokerage, stamp charges and any charge customarily included in the brokers bought note. In respect of privately placed debt instruments any front end discount offered should be deducted from the cost of the investment. In respect of all interest bearing investments, income must be accrued on a day-to-day basis as it is earned. Therefore, when such investments are purchased, interest paid for the period from the last interest due date upto the date of purchase must not be treated as a cost of purchase but must be debited to Interest Recoverable Account. Similarly interest received at the time of sale for the period from the last interest due date upto the date of sale must not be treated as an addition to sale value but must be credited to Interest Recoverable Account. In determining the holding cost of investments and the gains or loss on sale of investments, the average cost method must be followed. Illustration 2 A fund purchased 10,000 debentures of a company on June 1, 2006 for 10.7 lakh and further 5,000 debentures on November 1, 2006 for Rs. 5.45 lakh. The debentures carry fixed annual coupon of 12%, payable on Every 31 March and 30 September. On February 28, 2007 the fund sold 6,000 of these debentures for Rs. 6.78 lakh. Nominal value per debenture is Rs. 100. Show Investment in Debentures A/c in books of the fund.

Financial Reporting for Financial Institutions Solution Investment in Debentures A/cRs. Lakh June 2006 Nov. 2006 1, 1, To Bank To Bank To Interest Recoverable (Note 3) To Profit on disposal (Note 4) 10.70 5.45 0.30 0.12 16.57 June 2006 Nov. 2006 Feb. 2007 1, 1, 28, By Interest Recoverable (Note 1) By Interest Recoverable (Note 2) By Bank By Balance c/d

8.15

Rs. Lakh 0.20 0.05 6.78 9.54 16.57

Feb. 28, 2007 Feb. 28, 2007

March 31, 2007

1.13 DATE OF RECOGNITION OF TRANSACTIONS Transaction for purchase or sale of investments should be recognized as of the trade date and not as of the settlement date, so that the effect of all investments traded during a financial year are recorded and reflected in the financial statements for that year. Where investment transactions take place outside the stock market, for example, acquisitions through private placement or purchases or sales through private treaty, the transaction should be recorded in the event of a purchase, as of the date on which the scheme obtains in enforceable obligation to pay the price or, in the event of a sale, when the scheme obtains an enforceable right to collect the proceeds of sale or an enforceable obligation to deliver the instruments sold. (a) When in the case of an open ended scheme units are sold, the difference between the sale price and the face value of the unit, if positive, should be credited to reserves and if negative be debited to reserves, the face value being credited to Capital Account. Similarly, when in respect of such a scheme, units are repurchased, the difference between the purchase price and face value of the unit, if positive should be debited to reserves and, if negative, should be credited to reserves, the face value being debited to the capital account. (b) In the case of an open ended scheme, when units are sold an appropriate part of the sale proceeds should be credited to an Equalisation Account and when units are repurchased an appropriate amount should be debited to Equalisation Account. The net balance on this account should be credited or debited to the Revenue Account. The balance on the Equalisation Account debited or credited to the Revenue Account should not decease or increase the net income of the fund but is only an adjustment to the distributable surplus. It should, therefore, be reflected in the Revenue Account only after

8.16

Financial Reporting the net income of the fund is determined.

(c) In a close ended scheme which provide to the unit holders the option for an early redemption or repurchase their own units, the par value of the unit has to be debited to Capital Account and the difference between the purchase price and the par value, if positive, should be credited to reserves and, if negative, should be debited to reserves. A proportionate part of the unamortized initial issue expenses should also be transferred to the reserves so that the balance carried forward on that account is proportional to the number of units remaining outstanding. (d) Underwriting commission should be recognized as revenue only when there is no devolvement on the scheme. Where there is devolvement on the scheme, the full underwriting commission received and not merely the portion applicable to the devolvement should be reduced from the cost of the investment. 1.14 DIVIDEND EQUALISATION New investors are not entitled to any share of the income of a mutual fund scheme which arose before they bought their units. However, at the end of each distribution period the fund management allocates the same amount from the income of the fund to each unit. To compensate for this an equalisation payment is added to the cost of new units. This is the amount of income that has arisen up to the date of purchase of the unit. Because these payments are included in the amount available for distribution they are effectively repaid to the purchaser. The purchaser's dividend voucher at the end of the first distribution period should show the amount of the returned equalisation payment. Illustration 2 On April 1, 2006 a mutual fund scheme had 9 lakh units of face value Rs. 10 outstanding. The scheme earned Rs. Rs. 81 lakh in 2006-07, out of which Rs. 45 lakh was earned in first halfyear. 1 lakh units were sold on 30/09/06 at NAV Rs. 60. Show important accounting entries for sale of units and distribution of dividend at the end of 2006-07. Solution Allocation of earnings Old unit holders (9 lakh units) Rs. Lakh First half-year (Rs. 5.00/ unit ) Second half-year (Rs. 3.60 / unit) 45.0 32.4 New unit holders (1 lakh units) Rs. lakh Nil 3.6 Total earning Rs. Lakh 45 36

Financial Reporting for Financial Institutions 77.4 Add: Equalisation payment recovered Total available for distribution Note: Equalisation payment = Rs. 45 lakh / 9 lakh = Rs.5 per unit. 3.6

8.17 81.0 5.0 86.0

Distribution of earning per unit Old unit holders Rs. Dividend distributed Less: Equalisation payment Net distributed income Date 30/09/06 Bank To Unit Capital To Reserves To Dividend Equalisation 31/03/07 Dividend Equalisation To Revenue A/c 31/03/07 Revenue A/c 86 5 5 Rs. lakh 65 10 50 5 8.60 Rs. lakh 1 lakh x Rs. 65 1 lakh x Rs. 10 1 lakh x Rs. 50 1 lakh x Rs. 5 8.60 New unit holders Rs. 8.60 5.00 3.60

To Bank 86 10 lakh x Rs. 8.60 Reference: Students are advised to refer the Guidance Note issued by ICAI on Accounting for Investments in the Financial Statements of Mutual Funds Self -examination Questions 1. Define the following terms in the context of a mutual fund: (a) Asset management company. (b) Unit. (c) Money market instruments. 2. What do you mean by Open-ended scheme and Close-ended scheme ?

8.18 3. 4.

Financial Reporting What should be the minimum components of an annual report of a mutual fund? The following particulars are available for a scheme of a mutual fund. Calculate current asset value (NAV) of each unit of the scheme. Scheme size In shares Investments Market value of shares Rs. 10,00,000 Rs. 10 In shares Rs. 25,00,000

5.

Prudential XYZ Mutual Funds have introduced a scheme ABC Premier. Its major details are as follows: Scheme Name Scheme Size Face value of units Investments : : : : ABC Premier Rs.1,00,00,00,000 (Rupees One hundred crores) Rs.20 in shares Rs.1,50,00,00,000 (Rupees One hundred and fifty crores)

Market value of Shares :

Computed the net assets value per unit of ABC Premier. Is there an appreciation of the value invested in units of ABC Premier.


8.19

UNIT 2 NON-BANKING FINANCE COMPANY2.1 INTRODUCTION A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956, engaged in the business of providing loans and advances, acquisition of shares, debentures and other securities, leasing, hire-purchase, insurance business and chit business. The term NBFC does not include any institution whose principal business is that of agriculture activity, industrial activity or sale/purchase/construction of immovable property. Non Banking Financial Companies (NBFC) play a crucial role in broadening access to financial services, enhancing competition and diversification of the financial sector. They are increasingly being recognised as complementary to the banking system, capable of absorbing shocks and spreading risks at times of financial distress. Simplified sanction procedures, orientation towards customers, attractive rates of return on deposits and flexibility and timeliness in meeting the credit needs of specified sectors (like equipment leasing and hire purchase), are some of the factors that enhanced the attractiveness of NBFCs. 2.2 DEFINITION OF NBFC Section 45I(f) of Reserve Bank of India (Amendment) Act, 1997 defines a non-banking financial company as: (i) (ii) A financial institution which is a company; A non banking institution which is a company with principal business of receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any manner;

(iii) Such other non-banking institution or class of such institutions, as the Reserve Bank with the previous approval of the Central Government may specify by notification in the Official Gazette. For purposes of RBI Directions relating to Acceptance of Public Deposits, non-banking financial company means only the non-banking institution which is a Loan company,Investment company, Hire purchase finance company, Equipment leasing company and Mutual benefit financial company. 2.3 REGISTRATION AND REGULATION OF NBFC Under Section 45IA of the Reserve Bank of India (Amendment) Act, 1997, no non-banking financial company is allowed to commence or carry on the business of a non-banking financial institution without obtaining a certificate of registration issued by the Reserve Bank of India.

8.20

Financial Reporting

A company incorporated under the Companies Act, 1956 and desirous of commencing business of non-banking financial institution as defined under Section 45IA of the RBI Act, 1934 can apply to Reserve Bank of India in prescribed form along with necessary documents for registration. The RBI issues Certificate of Registration after satisfying itself that the conditions as enumerated in Section 45-IA of the RBI Act, 1934 are satisfied. Functions of Non-Banking Financial Companies are similar to banks. However there are a few differences: (a) A NBFC cannot accept demand deposits; (b) Non-Banking Financial Companies do not take part in the payment and settlement system and hence cannot issue cheques to its customers; and (c) Deposit Insurance and Credit Guarantee Corporation (DICGC) does not insure the NBFC deposits. The Reserve Bank of India has issued directions to non-banking financial companies on acceptance of public deposits, prudential norms like capital adequacy, income recognition, asset classification, provision for bad and doubtful debts, risk exposure norms and other measures to monitor the financial solvency and reporting by NBFCs. Directions were also issued to auditors to report non-compliance with the RBI Act and regulations to the Reserve Bank, Board of Directors and shareholders. 2.4 MINIMUM NET OWNED FUND The minimum net owned fund of a registered NBFC is Rs 200 lakh. The term net owned fund (NOF) is given in the explanation to Section 45-IA of the Reserve Bank of India Act, 1934. As per the definition: Owned Fund = Aggregate of the paid-up equity capital + Free reserves as disclosed in the latest balance sheet of the company Accumulated balance of loss Deferred revenue expenditure Other intangible assets. Net Owned Fund = Owned Fund Investments in shares of subsidiaries/ companies in same group/Other NBFC. Book value of debentures, bonds, outstanding loans and advances made to and deposits with subsidiaries and companies in the same group (to the extent such sum exceeds 10% of owned fund) 2.5 TYPES OF NBFC REGULATED BY RBI Depending on the type of business, non-banking financial companies regulated by the Reserve Bank of India, have been classified as: (a) Equipment leasing company; (b) Hire-purchase company;

Financial Reporting for Financial Institutions (c) Loan company; (d) Investment company; (e) Residuary Non-Banking Company. (f) Mutual benefit financial company (MBFC) i.e. Nidhi Company (g) Mutual Benefit Company (MBC), i.e., potential Nidhi Company (h) Miscellaneous non-banking company (MNBC), i.e., Chit Fund Company

8.21

The first four types of companies may be further classified into those accepting deposits and those not accepting deposits. Equipment Leasing Company is a financial institution with principal business of offering equipment on leases. Hire Purchase Company is a financial institution with principal business of offering assets under hire purchase schemes. Loan company is a financial institution with principal business of providing finance whether by making loans or advances or otherwise for any activity other than its own but does not include an equipment leasing company or a hire-purchase finance company. Investment Company is a financial institution with principal business of acquisition of securities. Residuary Non-Banking Company is a class of NBFC, which is a company with principal business of receiving of deposits, under any scheme or arrangement or in any other manner. In addition to liquid assets as prescribed, these companies are required to maintain investments as per directions of RBI. Mutual benefit financial company (MBFC) i.e. Nidhi Company is any company which is notified by the Central Government under Section 620A of the Companies Act1956. Mutual Benefit Company (MBC), i.e., potential Nidhi Company, is a company, which works on the lines of a Nidhi company, but has not yet been so declared by the Central Government. Minimum Net Owned Fund of a MBC is Rs.10 lakh. A company treated as MBC, must be one, which has applied to the Reserve Bank for Certificate of Registration and also to Department of Company Affairs (DCA) for declaration as Nidhi Company, which has not contravened direction/ regulation of Reserve Bank/DCA. Miscellaneous non-banking company (MNBC), i.e., Chit Fund Company is a company, which enters into an agreement with a specified number of subscribers that every one of them shall subscribe a certain sum in instalments over a definite period and that every one of such subscribers shall in turn, as determined by lot or by auction or by tender or in such manner as may be provided for in the arrangement, be entitled to a prize amount.

8.22

Financial Reporting

2.6 PUBLIC DEPOSITS (a) No mutual benefit financial company mutual benefit company can accept or renew any public deposit except from its shareholders. Such deposits shall not be in the nature of current account (b) All NBFCs are not entitled to accept public deposits. Only those NBFCs holding a valid Certificate of Registration with authorization to accept Public Deposits can accept/hold public deposits. The NBFCs accepting public deposits should have minimum stipulated Net Owned Fund and comply with the Directions issued by the Reserve Bank. (c) The ability of a NBFC to raise public deposits depends on its credit rating, Capital to Risk Asset Ratio (CRAR). A NBFC with credit rating lower than investment grade is not allowed to accept public deposits. A NBFC with credit rating of investment grade and above, can accept public deposits subject to specified maximum ceiling. The ceiling depends on the rating, CRAR and the nature of business. (Minimum credit rating for investment grade is adequate safety, such as A for CRISIL). The norms are as below: Equipment Leasing and Hire Purchase Companies maintaining Capital to Risk Asset Ratio (CRAR) of 15% without credit rating can raise public deposits to the extent of 1.5 times of net owned fund or Rs. 10 crores, whichever is less. Equipment Leasing and Hire Purchase Companies maintaining Capital to Risk Asset Ratio (CRAR) of 12% with minimum investment grade credit rating can raise public deposits to the extent of 4 times of net owned fund. Loan companies and Investment Companies maintaining Capital to Risk Asset Ratio (CRAR) of 15% with minimum investment grade credit rating can raise public deposits to the extent of 1.5 times of net owned fund. There is no ceiling on maximum deposits that residuary non-banking company can raise. However, such companies have to ensure that the amounts deposited and investments made by the company are not less than the aggregate amount of liabilities to the depositors. To secure the interests of depositor, residuary nonbanking companies are required to invest in a portfolio comprising of highly liquid and secured instruments viz. Central/State Government securities, fixed deposit/certificates of deposits of scheduled commercial banks, units of Mutual Funds, etc. If rating of a NBFC is downgraded to below minimum investment grade rating, it must stop accepting further public deposit and report the position within 15 working days to the RBI. The amount of public deposit already accepted must also be reduced within three years from the date of such downgrading of credit rating, nil or to the permissible level.


8.23

The maximum interest that a NBFC can pay on its deposits is restricted to 14% per annum. The maximum frequency of compounding is month. The rate of brokerage that a NBFC can pay for collecting deposits is 2%. The maximum re-imbursement of actual expenses allowed is 0.5% of deposits collected. The NBFCs are allowed to accept/renew public deposits for a minimum period of 12 months and maximum period of 60 months. They cannot accept deposits repayable on demand. NBFCs cannot offer gifts/incentives or any other additional benefit to the depositors. Public deposits are unsecured. The deposits with NBFCs are neither insured nor the RBI guarantees their repayments. The non-banking financial companies accepting public deposits are required to file annual returns and financial statements with the Reserve Bank of India.

2.7 LIQUID ASSET REQUIREMENTS Section 45-IB of the Reserve Bank of India Act requires non-banking financial companies accepting public deposits to maintain liquid assets at the minimum level of 15% of public deposits outstanding as on the last working day of the second preceding quarter. Of this minimum level, not less than 10% must be invested in approved securities i.e. in Government securities or Government guaranteed bonds. The liquid assets in form of investments in approved securities must be maintained in dematerialised form only. The remaining 5% of minimum liquid assets can be invested in unencumbered term deposits with any scheduled commercial bank. The liquid assets maintained as above are utilised for payment of claims of depositors. However, the deposits being unsecured, the depositors do not have any direct claim on liquid assets. 2.8 PRUDENTIAL ACCOUNTING NORMS In order to ensure that NBFCs function on sound and healthy lines, the Reserve Bank issued its Non-banking Financial Companies Prudential Norms Directions in January 1998. All NBFCs, accepting public deposits and residuary non-banking companies are required to comply the norms. They are also to comply with the Accounting Standards and Guidance Notes issued by the Institute of Chartered Accountants of India, so far as these are not inconsistent with the prudential norms directions of the Reserve Bank of India. The provisions of the prudential norm directions regarding capital adequacy and credit concentration does not apply to (i) a loan company; (ii) an investment company; (iii) a hire purchase finance company; and (iv) an equipment leasing company, unless they accept/hold public deposit.

8.24

Financial Reporting

An investment company not accepting public deposits need not comply with the prudential norms, provided it holds investments in the securities of its group/holding/subsidiary companies and book value of such holding is not less than 90% of its total assets and if it does not trade in such securities. Prudential norms directions prescribe principles of income recognition, asset classification, provisioning, capital adequacy and disclosures. 2.9 INCOME RECOGNITION (a) The income recognition shall be based on recognised accounting principles. (b) Income on non-performing assets (NPA) shall be recognised only when it is actually realised. (c) Income relating to hire purchase asset, where instalments are overdue for more than 12 months, shall be recognised only when the hire charge is actually received. (d) Income relating to leased asset, where lease rentals are overdue for more than 12 months, shall be recognised only when the lease rental is actually received. (e) Income from dividend on shares of corporate bodies and units of mutual funds shall be taken into account on cash basis. However, income from dividend on shares of corporate bodies may be taken into account on accrual basis when such dividend has been declared by the corporate body in its annual general meeting and the NBFC's right to receive payment is established. (f) Income from bonds and debentures of corporate bodies and from Government securities/bonds may be taken into account on accrual basis:, provided that the interest rate on these instruments is pre-determined and that interest is serviced regularly and is not in arrears.

(g) Income on securities of corporate bodies or public sector undertakings, the payment of interest and repayment of principal of which have been guaranteed by Central Government or a State Government may be taken into account on accrual basis. 2.10 ACCOUNTING FOR INVESTMENTS (a) Investments in securities shall be classified into current investments and long-term investments. Current investment means an investment, which is by its nature readily realisable and is intended to be held for not more than one year from the date on which such investment is made. An investment, other than current investment is long-term investment. (b) Current investments shall be valued at cost or market value whichever is lower. Each category of such investments shall be valued scrip-wise and depreciation or appreciation be aggregated under each category. Net depreciation, if any, for each category of


8.25

investments shall be provided for or charged to profit and loss account. Net appreciation, if any, shall be ignored. The depreciation in one category of investments shall not be set off against appreciation in another category. (c) A long term quoted investment shall be valued in accordance with the accounting standards issued by ICAI. (d) Unquoted equity shares shall be valued at cost or break up value, whichever is lower. However, NBFCs can substitute fair value for the break-up value of the shares if considered necessary. In case of non-availability of balance sheet for two years, such shares shall be valued at one rupee only. (e) Unquoted preference shares are to be valued at lower of cost and or face value. Investments in unquoted Government securities or Government guaranteed bonds shall be valued at carrying cost. Investments in units of mutual funds shall be valued at market rates, or if such market rate is not available, at the net asset value declared by the mutual fund in respect of each particular scheme. Commercial papers and treasury bills shall be valued at carrying cost. 2.11 ASSET CLASSIFICATION Every NBFC shall, after taking into account the degree of well defined credit weaknesses and extent of dependence on collateral security for realisation, classify its lease/hire purchase assets, loans and advances and any other forms of credit into the following classes namely, (a) Standard assets; (b) Sub-standard assets; (c) Doubtful assets; and (d) Loss assets. Standard asset means an asset in respect of which, no default in repayment of principal or payment of interest is perceived and which does not disclose any problem nor carry more than normal risk attached to the business. Sub-standard asset means (i) an asset, which has been classified as non-performing asset for a period of not exceeding two years (ii) an asset, where the terms of the agreement regarding interest and/or principal have been renegotiated or rescheduled after commencement of operations, until the expiry of one year of satisfactory performance under the renegotiated or rescheduled terms. Doubtful asset means (i) a term loan or (ii) a lease asset or (iii) a hire purchase asset or (iv) any other asset, which remains a substandard asset for a period exceeding two years.

8.26

Financial Reporting

Loss asset means (i) an asset which has been identified as loss asset by the NBFC or its internal or external auditor or by the Reserve Bank during the inspection of the NBFC, to the extent it is not written off by the NBFC; and (ii) an asset which is adversely affected by a potential threat of non-recoverability due to either erosion in the value of security or non availability of security or due to any fraudulent act or omission on the part of the borrower. The class of assets referred to above shall not be upgraded merely as a result of rescheduling, unless it satisfies the conditions required for the upgrdation. 2.12 NON-PERFORMING ASSET (NPA) Non-performing asset (NPA) means: Any asset, in respect of which, interest has remained past due for six months. (a) A term loan inclusive of unpaid interest, when the instalment is overdue for more than six months or on which interest amount remained past due for six months. (b) A bill, which remains overdue for six months. (c) The interest in respect of a debt or the income on a receivable under the head `Other Current Assets' in the nature of short term loans/advances, which facility remained over due for a period of six months. (d) Any dues on account of sale of assets or services rendered or reimbursement of expenses incurred, which remained overdue for a period of six months. (e) The lease rental and hire purchase instalment, which has become overdue for a period of more than twelve months. (f) Balance outstanding under the credit facilities (including accrued interest) made available to the borrower/beneficiary in the same capacity, when any of the credit facilities to the same borrower becomes non-performing asset.

2.13 PROVISIONING REQUIREMENTS Every NBFC shall, after taking into account the time lag between an account becoming doubtful of recovery, its recognition as such, the realisation of the security and the erosion over time in the value of security charged, make provision against sub-standard assets, doubtful assets and loss assets as provided hereunder :Loans, advances and other credit facilities including bills purchased and discounted The provisioning requirement in respect of loans, advances and other credit facilities including bills purchased and discounted shall be as under :

Financial Reporting for Financial Institutions Loss Assets

8.27

The entire asset shall be written off. If the assets are permitted to remain in the books for any reason, 100% of the outstanding should be provided for. Doubtful Assets (a) 100% provision to the extent to which the advance is not covered by the realisable value of the security to which the NBFC has a valid recourse shall be made. The realisable value is to be estimated on a realistic basis. (b) In addition to item (a) above, depending upon the period for which the asset has remained doubtful, provision to the provision to the extent of 20% to 50% of the secured portion (i.e. estimated realisable value of the outstanding) shall be made on the following basis : Period for which the asset has been considered as doubtful Upto one year One to three years More than three years Sub-standard asset A general provision of 10% of total outstanding shall be made. Lease and hire purchase assets The provisioning requirements in respect of the lease and hire purchase assets shall be as under:Where any amount of lease rental or hire charges are overdue upto 12 Nil months Where any amount is overdue for more than 12 months but upto 24 months a) Entire amount of overdue taken to the credit of profit and loss account in earlier year shall be provided for; and b) in addition, provision shall be made at not less than 10% of the net book value. (a) entire amount of overdue taken to the credit of profit and loss account earlier shall be provided for, and % of provision 20 30 50

Where any amount is overdue for more than 24 months but upto 36 months

8.28

Financial Reporting (b) in addition, provision shall be made at not less than 50% of the net book value (a) entire amount of overdue taken to the credit of profit and loss account earlier shall be provided for, and (b) in addition, provision shall be equivalent to unprovided balance of net book value (i.e.100% )

Where any amount is overdue for more than 36 months

2.14 DISCLOSURE IN THE BALANCE SHEET (a) Every NBFC shall, separately disclose in its balance sheet the provisions made as per requirements above without netting them from the income or against the value of assets. (b) The provisions shall be distinctly indicated under separate heads of accounts as provisions for bad and doubtful debts and provisions for depreciation in investments. (c) Such provisions shall not be appropriated from the general provisions and loss reserves held, if any, by the NBFC. (d) Such provisions for each year shall be debited to the profit and loss account. The excess of provisions, if any, held under the heads general Provisions and loss reserves may be written back without making adjustment against them. 2.15 REQUIREMENT AS TO CAPITAL ADEQUACY Every NBFC shall, maintain a minimum capital ratio consisting of Tier I and Tier II capital which shall not be less than 12% of its aggregate risk-weighted assets. The total of Tier II capital, at any point of time, shall not exceed 100% of Tier I capital. Tier-I Capital" means owned fund as reduced by investment in shares of other NBFCs and in shares, debenture, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, 10% of the owned fund; Tier-II capital" includes the following :(a) Preference shares. (b) Revaluation reserves at discounted rate of 55%. (c) General provisions and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth percent of risk weighted assets.

Financial Reporting for Financial Institutions (d) Hybrid debt and (e) Subordinated debt

8.29

Subordinated debt means a fully paid up capital instrument, which is unsecured and is subordinated to the claims of other creditors and is free from restrictive clauses and is not redeemable at the instance of the holder or without the consent of the supervisory authority of the NBFC. The book value of such instrument shall be subjected to discounting as provided hereunder: Remaining maturity of the instrument (a) Upto one year (b) More than one year but upto two years (c) More than two years but upto three years (d) More than three years but upto four years (e) More than four years but upto five years 2.16 ASSET-LIABILITY MANAGEMENT (ALM) ALM is a risk management tool that helps a bank/NBFC to manage its liquidity risk and interest rate risk. This is a powerful tool that helps banks/NBFCs plan long term financial, funding, and capital strategy using present value analysis. With ALM, a bank/NBFC can model interest income and expenses for analysis and re-price assets and liabilities. Based on ALM position, banks/NBFCs can also model effect of competitive pricing to create innovative and imaginative new banking products. ALM also helps regulatory compliance for banks/NBFCs by through appropriate investment / disinvestment decisions to maintain the required statutory liquidity ratio (SLR), credit reserve ratio (CRR) and other ratios as per Reserve Bank of India (RBI) guidelines. ALM involves the analysis of Structural Liquidity Gap Analysis, Interest Rate Gap Analysis, Net Interest Income (NII) Analysis, Net Interest Margin (NIM) Analysis, Tolerance Analysis, Cost to Close Analysis, Duration Gap Analysis, Trend Analysis, Comparative Analysis, Present Value Analysis, Forward Analysis and Scenario Analysis The Reserve Bank of India has announced its ALM guidelines for NBFCs for effective risk management. As per the guidelines, all NBFCs with asset size of Rs.100 crore or above or with public deposits of Rs.20 crore or above, as per their balance sheet as on March 31, 2001, were required to implement the ALM system within March 31, 2002. They were also required to constitute an ALM Committee (ALCO), under the charge of Chief Executive Officer or other Senior Executive and other specialist members, for formalising ALM systems and to install a supervisory framework for its maintenance. The NBFCs covered under the system are required to submit half-yearly ALM return comprising of statements on structural liquidity, short-term dynamic liquidity and interest rate sensitivity, to the Reserve Bank of India. The Rate of discounting 100% 80% 60% 40% 20%

8.30

Financial Reporting

Chit Funds and Nidhi companies are outside the scope of the ALM guidelines. 2.17 NON-BANKING FINANCIAL COMPANIES PRUDENTIAL NORMS (RESERVE BANK) DIRECTIONS, 1998 Notification NO. DFC. 119/DG(SPT) - 98 Dated January 31, 1998 The Reserve Bank of India, having considered it necessary in the public interest, and being satisfied that, for the purpose of enabling the Bank to regulate the credit system to the advantage of the country, is necessary to issue the directions relating to the prudential norms as set out below hereby, in exercise of the powers conferred by section 45JA of the Reserve Bank of India Act, 1934 (2 of 1934), and of all the powers enabling it in this behalf, and in supersession of the earlier directions contained in Notification No. DFC. 115/DG(SPT)/98, dated January 2, 1998, gives to every non-banking financial company the directions hereinafter specified. Short title, commencement and applicability of the directions 1. (1) These directions shall be known as the Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions, 1998. (2) These directions shall come into force with immediate effect. (3) (i) All the provisions of these directions save as provided for in clauses (ii) and (iii) hereinafter, shall apply to (a) a non-banking financial company (referred to in these directions as NBFC), except a mutual benefit financial company, 1[and a mutual benefit company] as defined in the Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 1998, which is having a net owned fund (referred to in these directions as NOF) of rupees twenty-five lakhs and above and accepting/holding public deposit; (b) a residuary non-banking company (referred to in these directions as RNBC), as defined in the Residuary Non-Banking Companies (Reserve Bank) Directions, 1987. (ii) The provisions of paragraphs 10 and 12 of these directions shall not apply to

Financial Reporting Vol. 2

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