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PRIME / ME32 / FINAL 1

PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL – FINANCIAL REPORTING

QUESTION PAPER

FLRT

No. of Pages: 6 Total Marks: 100 No of Questions: 7 Time Allowed: 3 Hrs

Question No.1 is compulsory. Answer any five from the rest 1. (a) Profit after tax attributable to equity shareholders in 2009-10 = `81,000

Number of ordinary shares = 27,000 The company issued 15% `1,00,000 convertible debentures on 30/09/09. The debentures are convertible into 6,000 ordinary shares after 5 years. Tax rate = 40%

Compute basic and diluted EPS.

(b) A company obtained term loan `650 lakh on 01/04/2009 for modernization and development of its

factory. Buildings worth `120 lakh were completed and Plant and Machinery worth `350 lakh were installed by 31/03/2010. A sum of `70 lakh has been advanced for assets the installation of which has already commenced and is expected to be completed in the following year. `110 lakh has been utilized for working capital requirements. Interest paid on the loan of `650 lakh during the year 2009-10 amounted to `58.50 lakh.

How should the interest amount be treated in the Accounts of the Company?

(c) P Ltd. has a subsidiary A Inc. in USA. P Ltd. has advanced $ 10,000 to A Inc. on 01/03/2010 as

part of a long-term arrangement. The loan is not repayable in foreseeable future. The exchange rates on 01/03/2010 and 31/03/2010 were `48/$ and `48.50/$ respectively.

Show accounting entries in the books of the company to record the transactions.

(d) J Ltd. purchased machinery from K Ltd. on 30/09/2009. The price was `431.2 lakh after charging

10% excise duty and giving a trade discount of 2% on the quoted price. The whole of excise duty is admissible as CENVAT credit. Transport charges were 0.25% on the quoted price and installation charges come to 1% on the quoted price.

Expenditure incurred on the trial run `1,00,000 consisted of cost of materials `55,000, wages `30,000 and overheads `15,000.

A loan of `400 lakh was taken from the bank on which interest at 12% per annum was to be paid. The machine was ready for use on 01/12/2010. However, it was actually put to use only on 01/01/2011.


Find out the cost of the machine. (4x5=20 Marks)

2. AX Ltd. and BX Ltd. amalgamated on and from 1st January 2010. A new Company ABX Ltd. was

formed to take over the businesses of the existing companies.

Balance Sheet as on 31-12-2009

Liabilities AX Ltd. ‘000 `

BX Ltd. ‘000 `

Assets AX Ltd. ‘000 `

BX Ltd. ‘000 `

Share Capital Sundry Fixed Assets 85,00 75,00 Equity Shares of Rs10 each

60,00

70,00

Investments 10,50 5,50

General Reserve 15,00 20,00 Stock 12,50 27,50 P & L A/c 10,00 5,00 Debtors 18,00 40,00 Investment Allowance Reserve

5,00

1,00 Cash & Bank 4,50 4,00

Export Profit Reserve

50 1,00

12% Debentures 30,00 40,00 Sundry Creditors 10,00 15,00 Total 130,50 152,00 Total 130,50 152,00

ABX Ltd. issued requisite number of shares to discharge the claims of the equity shareholders of the transferor companies.

Prepare a note showing purchase consideration and discharge thereof and draft the Balance Sheet of ABX Ltd (16 Marks)

3. Ram and Shyam have been carrying on same business independently. Due to competition in the

market, they decided to amalgamate and form a new company called Shiva Ltd.

Following is the Balance Sheet of Ram and Shyam as at 31.3.2010: Liabilities Ram

` Shyam

` Assets Ram

` Shyam

` Capital 7,75,000 8,55,000 Plant & Machinery 4,85,000 6,14,000 Current liabilities 6,23,500 5,57,600 Building 7,50,000 6,40.000 Current assets 1,63,500 1,58,600 13,98,500 14,12,600 13,98,500 14,12,600

Following are the additional information: (i) The authorized capital of the new company will be `25,00,000 dividend into 1,00,000 equity shares

of `25 each.


(ii) Liabilities of Ram included `50,000 due to Shyam for the purchases made. Shyam made a profit of 20% on sale to Ram.

(iii) Ram has goods purchased from Shyam , cost to him `10,000. This is included in the Current asset of Ram as at 31st March, 2010.

(iv) The assets of Ram and Shyam are to be revalued as under: Ram

` Shyam

` Plant and machinery 5,25,000 6,75,000 Building 7,75,000 6,48,000

(v) The purchase consideration is to be discharged as under:

(a) Issue 24,000 equity shares of `25 each fully paid up in the proportion of their profitability in the preceding 2 years.

(b) Profits for the preceding 2 years are given below:

Ram `

Shyam `

1st year 2,62,800 2,75,125 2nd year 2,12,200 2,49,875 Total 4,75,000 5,25,000

(c) Issue 12% preference shares of `10 each fully paid up at par to provide income equivalent

to 8% return on capital employed in the business as on 31.3.2010 after revaluation of assets of Ram and Shyam respectively.

You are required to:

(i) Compute the amount of equity and preference shares issued to Ram and Shyam. (ii) Prepare the Balance Sheet of Shiva Ltd. immediately after amalgamation (16 marks)

4. (a) Balance Sheet of Sound Ltd. as at 31st March 2010 is given below:

Liabilities ` Assets ` Share Capital: 6000 Equity Shares of `100 each fully paid up

6,00,000 Fixed Assets: Building Machinery

1,50,000 2,20,000

Reserves & Surplus: Profit and Loss Account

50,000

Current Assets, Loans and Advances:

Current Liabilities and Provisions: Stock 3,00,000 Bank overdraft 10,000 Sundry Debtors 1,60,000 Creditors 60,000 Bank 60,000 Provision for Taxation 1,10,000 Proposed Dividend 60,000 8,90,000 8,90,000


The net profits of the company after deducting usual working expenses but before providing for taxation were as under:

On 31st March, 2010, building was revalued at `2,00,000 and machinery `2,50,000. Sundry Debtors, on the same date, included `10,000 as irrecoverable. Having regard to nature of the business, a 10% return, on net tangible capital invested, is considered reasonable. You are required: To value the company’s share ex-dividend. Valuation of goodwill may be based on three year’s purchase of annual super profits. Depreciation on Building -2%, Machinery- 10%. The income-tax rate is to be assumed at 50%. All working should form part of your answer. (8 Marks)

(b) Mr. Anil buys a stock option of ABC Co. Ltd in July, 2009 with strike price on 30-07-2009 of `250 to

be expired on 30-08-2010. The premium is `20 per unit and the market lot is 100. The margin to be paid is `120 per unit. Show the accounting treatment in the books of buyer when: (i) The option is settled by delivery of the asset, and (ii) The option is settled in cash and the index price is `260 per unit. (4 Marks)

(c) P Limited is considering the acquisition of R Limited. The financial data at the time of acquisition

being: P Limited R Limited Net profit after tax (`in Lakhs) 60 12 Number of shares (Lakhs) 12 5 Earning per share (`) 5 2.40 Market Price per share (`) 150 48 Price earning ratio 30 20

It is expected that the net profit after tax of the two companies would continue to be `72 lakhs even after the amalgamation. Explain the effect on, EPS of the merged company under each of the following situations: (i) P Ltd. offers to pay `60 per share to the shareholders of R Ltd. (ii) P Ltd. offers to Pay `78 per share to the share holders of R Ltd. The amount in both the cases is to be paid in the form of shares of P Ltd

(4 Marks) 5. (a) The following information is available of a concern: calculate E.V.A:

Year ` 2007-08 2,00,000 2008-09 2,40,000 2009-10 2,20,000

Debt capital 12% `2,000 crores Equity capital `500 crores Reserves and surplus `7,500 crores


(8 Marks)

(b) Alpha Ltd., commenced its business on 1st April, 2009. 2,00,000 equity shares of `10 each at par and 12.5% debentures of the aggregate value of `2,00,000 were issued and fully taken up. The proceeds were utilized as under:

` Fixtures and equipments (estimated life 10years, no scrap values) 16,00,000 Goods Purchased for Resale at `200 per Unit 6,00,000

The goods were entirely sold by 31st January, 2010 at a profit of 40% on selling price.

(i) Collections from debtors outstanding on 31st March, 2010 amounted to `60, 000 goods sold were replaced at a cost of `7, 20,000 the number of units purchased being the same as before. A payment of `40, 000 to a supplier was outstanding as on 31st March, 2010.

(ii) The replaced goods remained entirely in stock on 31st March, 2010. (iii) Replacement cost s at 31st March, 2010 was considered to be `280 per unit.

(iv) Replacement cost of fixtures and equipment (depreciation on straight line basis) was `20,00,000 as at 31st March, 2010.

Draft the Profit and Loss Account and the Balance Sheet on replacement cost (entry value) basis and on historical cost basis. (8 Marks)

6. (a) Uniway Ltd., have recognized contract revenue on a contract awarded in the financial year 2009-10

The target date of completion is 5 years. The contract provides for incentives for early completion at the rate of `1,000 per day subject to a maximum of `3,00,000. The company has included this amount in contract revenue (in the first year of contract) on the ground that based on the previous experience in similar contracts, it is confident of completing the contract in 4 years. The company’s past track record shows that company was able to complete such contracts well in time and earn incentives. Comment on the company’s accounting policies. (4 Marks)

(b) A company has a scheme for payment of settlement allowance to retiring employees. Under the

scheme, retiring employees are entitled to reimbursement of certain travel expenses for class they are entitled to as per company rule and to a lump-sum payment to cover expenses on food and stay during the travel. Alternatively employees can claim lump sum amount equal to one month pay last drawn.

Capital employed `10,000 crores Risk-free rate 9% Beta factor 1.05% Market rate returns 19% Equity (market) risk premium 10% Operating profit after tax 30% Tax rate 30%


The company’s contentions in this matter are: (i) Settlement allowance does not depend upon the length of service of the employees, it is

restricted to employee’s eligibility under the Travel rule of the company or where opinion for lump-sum payment is exercised, equal to the last pay drawn.

(ii) Since it is not related to the length of the service of the employees, it is accounted for on claim basis.

State whether the contention of the company are correct as per relevant accounting standard. Give reason in support of your answer. (4 Marks)

(c) Venus Ltd. has an asset, which is carried in the balance sheet on 31.3.2005 at `500 Lakhs. As at that date the value in use is `400 Lakhs and the net selling price is `375 lakhs.

From the above data: (i) Calculate impairment loss. (ii) Prepare journal entries for adjustment of impairment loss (iii) Show how impairment loss will be shown in the balance sheet. (4 Marks)

(d) P Ltd. has 60% voting right in Q Ltd. Q Ltd has 20% voting right in R Ltd. Also P Ltd directly enjoys

voting right of 14% in R Ltd. R Ltd. is a listed company and regularly supplies goods to P Ltd. The management of R Ltd. has not disclosed its relationship with P Ltd. How would you assess the situation from the view point of AS-18 on a related party disclosures?

(4 Marks)

7. (a) Explain significant differences and similarities between Indian Accounting Standards, IAS/IFRS and US GAAPs on the issues of (i) Changes in accounting policies (ii) Inventories (4 Marks)

(b) Write short notes on: (i) Market Value Added (ii) Open ended and close ended schemes of mutual funds (iii) Embedded derivatives (3x4=12 Marks)


PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL – FINANCIAL REPORTING

SUGGESTED ANSWERS

1. (a) ` PAT attributable to equity shareholders 81,000 Add: Post-tax interest saved + 15,000 (1- 0.4) x ½ (Note 1) 4,500 PAT attributable to equity shareholders (After conversion) 85,500 Number of shares outstanding before conversion 27,000 Add: Potential equity = ½ of 6,000 3,000 30,000 Basic EPS (`81,000/27,000) 3.00 Diluted EPS (`85,500/30,000) 2.85

Note 1: The profit for 2009-10 is after interest on debentures for half year Note 2: The deemed date of conversion is 30/09/09. Hence, 6,000 shares issuable on conversion are equivalent of 3,000 shares.

(b) Average rate of interest = (58.5/650) x 100 = 9%

A qualifying asset is one, which necessarily takes substantial period of time to get ready for intended use or sale. As per ASI 1, unless a longer or shorter period can be justified on the basis of facts and circumstances, a period of twelve months should ordinarily be considered a substantial period. Assuming that construction commenced on 01/04/2009, the Buildings and Machinery are qualifying assets.

The construction of asset not yet completed is also taken to be a qualifying asset.i.e., an asset necessarily taking substantial period of time for getting ready for intended use. Also, since installation has already commenced, it appears the asset satisfies all three conditions of Paragraph 14. `lakh `lakh Building 10.8 9% of 120 Plant & Machinery 31.5 9% of 350 Capital work-in-progress 6.3 9% of 70 Profit & Loss A/c 9.9 9% of 110 To Interest 58.5


(c) Books of A Ltd. ` 000 ` 000 01/03/10 Loan to A Inc. 480 $ 10,000 x Rs. 48 To Bank 480 31/03/10 Loan to A Inc. 5 $ 10,000 x Rs.0.50 To Exchange Gain 5 31/03/10 Exchange Gain 5 To FCTR 5

Note: A Inc., being a subsidiary, is a non-integral foreign operation of P Ltd. Since the Loan to A Inc. is not repayable in foreseeable future, the same should be treated as part of investment of P Ltd. in A inc. The exchange gain in respect of the loan has been transferred to Foreign Currency Translation Reserve (FCTR) as per paragraph 15 of the standard.

(d) Quoted Price Quoted Price Q Less: Trade Discount 0.02Q 0.98Q Add: Excise duty (0.10 x 0.98Q) 0.098Q Price Paid 1.078Q

Price Paid = 1.078Q = 431.2 Quoted Price = Q = 400

Cost of Machinery `lakh `lakh Quoted Price 400 Less: Trade Discount(2%) 8 Purchase Price 392

Costs capitalized Transport costs (0.25% of 400) 1 Installation costs (1% of 400) 4 Trial Run 1 6 398 Borrowing costs capitalized Interest (01/10/2009 to 01/12/2010) 56 Total cost 454


2. (Assumption: Amalgamation is in the nature of merger) Working Notes: (1) Purchase Consideration AX Ltd.

` 000 BX Ltd. ` 000

Assets taken over: Sundry fixed assets 85,00 75,00 Investments 10,50 5,50 Stock 12,50 27,50 Debtors 18,00 40,00 Cash & Bank 4,50 4,00 130,50 152,00 Less: Sundry Liabilities 12% Debentures 30,00 40,00 Sundry Creditors 10,00 40,00 15,00 55,00 Net Assets taken over 90,50 97,00 Less: Reserves and Surplus: General Reserve 15,00 20,00 P & L A/c 10,00 5,00 Investment Allowance Reserve 5,00 1,00 Export Profit Reserve 50 30,50 1,00 27,00 Purchase Consideration 60,00 70,00

AX Ltd.

` 000 BX Ltd. ` 000

Discharge of purchase consideration: 130,00 x 90,50 = 6,27,500 * Equity shares of `10 each 187,50

62,75

130,00 x 97,00 = 6,72,500 Equity shares of `10 each 187,50

67,25

Balance Sheet of ABX Ltd. as on 1.1.2010 Liabilities Amount

` 000 Assets Amount

` 000 Share Captial Sundry Fixed Assets 160,00 Equity Shares of `10 each 130,00 Investments 16,00 General Reserve 35,00 Stock 40,00 P & L A/c 15,00 Debtors 58,00 Investment Allowance Reserve 6,00 Cash & Bank 8,50 Export Profit Reserve 1,50 12% Debentures 70,00 (Assumed that new debentures were issued in exchange of the old series)


Sundry Creditors 25,00 Total 282,50 Total 282,50

Assumption: Amalgamation is in the nature of Purchase Balance Sheet of ABX Ltd. as on 1.1.2010

Liabilities Amount ` 000

Assets Amount ` 000

Share Capital Equity shares of `10 each 187,50 Sundry Fixed Assets 160,00 Investment Allowance Reserve 6,00 Investments 16,00 Export Project Reserve 1,50 Stock 40,00 12% Debentures 70,00 Debtors 58,00 Sundry Creditors 25,00 Cash & bank 8,50 Amalgamation Adjustment Account 7,50 Total 290,00 Total 290,00

Note:

1) Shares are issued by ABX Ltd. on the basis of net assets acquired of AX Ltd. and BX Ltd. Hence there is no goodwill.

2) Discharge of Purchase consideration: AX Ltd.

` 000 BX Ltd. ` 000

905,00 Equity Shares of `10 each 90,50 970,00 Equity Shares of `10 each 97,00

3) The statutory reserves of AX Ltd. and BX Ltd. are shown in the balance sheet of ABX Ltd. with a

corresponding debit in Amalgamation Adjustment Account. The total purchase consideration is to be discharged by ABX Ltd. in such a way that the rights of the shareholders of AX Ltd. and BX Ltd. remain unaltered in the future profits of ABX Ltd.

3.

(i) Calculation of amount of equity shares issued to Ram and Shyam

Profits of Ram `

Shyam `

I Year 2,62,800 2,75,125 II Year 2,12,200 2,49,875 Total 4,75,000 5,25,000


No. of shares to be issued = 24,000 equity shares in the proportion of the preceding 2 year’s profitability.

Ram Shyam 24,000 x 475/1000 11,400 equity shares 24,000 x 525/1000 12,600 equity shares

Calculation of amount of 12% Preference shares issued to Ram and Shyam

Ram `

Shyam `

Capital employed (Refer working note 1) 8,40,000 9,24,000 8% return on capital employed 67,200 73,920 12% Preference shares to be issued [67,200 x 100/12] [73,920 x 100/12]

5,60,000

6,16,000

Total Purchase Consideration

Ram `

Shyam `

Equity shares 2,85,000 3,15,000 12% Preference Shares 5,60,000 6,16,000 Total 8,45,000 9,31,000

(ii) Balance Sheet of Shiva Ltd. (after amalgamation)

Liabilities ` Assets ` Authorised share capital: Fixed assets: 1,00,000 Equity shares of `25 each 25,00,000 Goodwill (W.N.1) 14,000 Issued and subscribed share capital: Plant and Machinery 12,00,000 24,000 Equity shares of `.25 each 6,00,000 Building 14,23,000 1,17,600 12% Preference shares of `10 each (All of the equity and preference shares have been issued for consideration other than cash)

11,76,000 Current Assets (W.N.2) 2,70,100

Current Liabilities (W.N.3) 11,31,100 Total 29,07,100 Total 29,07,100


Working Notes:

1. Goodwill

Ram `

Shyam `

Plant and machinery 5,25,000 6,75,000 Building 7,75,000 6,48,000 Current assets 1,63,500 1,58,600 14,63,500 14,81,600 Less: Current liabilities 6,23,500 5,57,600 Net assets (capital employed) 8,40,000 9,24,000 Less: Purchase consideration 8,45,000 9,31,000 Goodwill 5,000 7,000 Total purchased goodwill 12,000 Add: Unrealised profit of Rs.10,000 @ 20% =`2,000 is adjusted from current assets and from goodwill (since P & L A/c is not given)

2,000

Total Goodwill 14,000

2. Current Assets

Ram `

Shyam `

Balances before amalgamation 1,63,500 1,58,600 Less: Liabilities of Ram due to Shyam - 50,000 Less: Unrealised Profit on stock i.e. `10,000 x 20% 2,000 Total 1,61,500 1,08,600 Grand Total 2,70,100

3. Current Liabilities

Ram `

Shyam `

Balances before amalgamation 6,23,500 5,57,600 Less: Liabilities of Ram due to Shyam 50,000 - Total 5,73,500 5,57,600 Grand Total 11,31,100


4. (a) Valuation of shares

Valuation of other net assets (W.N.1) 7,80,000 Goodwill (W.N.3) 85,000 8,65,000 Less: Proposed dividend 60,000 8,05,000

Value per share = 8,05,000/6,000

= `134.17

Working Notes:

1. Average capital employed ` Assets as per revaluation: Building 2,00,000 Machinery 2,50,000 Stock 3,00,000 Sundry debtors 1,50,000 Bank 60,000 9,60,000 Less Liabilities: Bank Overdraft

Creditors Provision for taxation 1,80,000 7,80,000

2. Super profits

Profits: 2006-07 2007-08 2008-09

2,00,000 2,40,000 2,20,000

6,60,000 Less: Bad debts _10,000 6,50,000 Average profits 2,16,667 Less: Depreciation on Revaluation of assets Building 2% on `50,000 1,000 Machinery 10% on `30,000 3,000

4,000

2,12,667 Less: Income-tax @ 50% 1,06,333 Maintainable profit 1,06,334


Normal return on capital employed @ 10% on `7,80,000

78,000

Super profit 28,334 Note 1: Adjustment should have been made for ½ of the profits after tax; however in this case as advance tax has not been paid, no adjustment is required.

3.Valuation of Goodwill On the basis of 3 yrs purchase of super profits (`28334×3) = 85,000

Alternative Working Notes: Opening capital employed: Equity

6,00,000

Reserves and surplus: Revaluation: Building Machinery Debtors

50,000 30,000 (10,000)

6,70,000 Closing Capital Employed: Equity 6,00,000 Reserves & Surplus- Revaluation 70,000 Profit before tax (as advance tax has not been paid)

2,20,000

8,90,000

Average capital employed = ` 15,60,000/2 = ` 7,80,000

(b) Accounting entries in the books of buyer

At the time of inception: ` ` Stock option premium account Dr. To Bank account (Being premium paid to buy a stock option)

2,000 2,000

Deposit for margin money account Dr. To Bank account (Being margin money paid on stock option)

12,000 12,000

At the time of settlement: (i) Option is settled by delivery of asset Shares of ABC Co. Ltd. Account Dr. To Deposit for margin money account To Bank account (Being option exercised and shares acquired Rs.12000 margin money

25,000 12,000 13,000


adjusted and the balance amount was paid) Profit and loss account Dr. To Stock option premium account (Being the premium transferred to profit and loss account on exercise of option)

2,000 2,000

(ii) Option is settled in cash Profit and loss account Dr. To Stock option premium account (Being the premium transferred to profit and loss account)

2,000

2,000

Bank account (`100×10) Dr. To Profit and loss account (Being profit on exercise of option)

1,000 1,000

Bank account Dr. To Deposit for margin money account (Being margin on equity stock option received back on exercise of option)

12,000 12,000

(c) (i) In this case, P Ltd. offers to pay `60 per share.

The share exchange ratio would be 60/150= 0.4

It means, P Ltd would give 0.4 shares for every one share of R Ltd. In other words, P Ltd. would give 2 shares for 5 shares of R Ltd. The total number of shares to be issued by P Ltd. to R Ltd.

= 5,00,000×.04 = 2,00,000 shares Or

[5,00,000×2/3 = 200,000 shares]

Total number of shares of P Ltd. after acquisition of R Ltd. = 12,00,000 + 2,00,000 = 14,00,000 shares

Calculation of E.P.S of the amalgamated company = Total Net Profit Interest and Tax / Total Number of shares = `72,00,000/14,00,000 = `5.14 per share

After amalgamation, the EPS of P Ltd., will improve from `5 to `5.14 Whereas EPS of the former share holders of R Ltd. would reduce from present 2.40 per share to 5.14×0.4 = `2.056 per after merger.

(ii) In this case, P Ltd. offers `78 per share to the shareholders of R Ltd.

The Exchange Ratio would be 78/150 = 0.52 shares of P Ltd. for each share of R Ltd. In other words, P Ltd would give 52 shares for per 100 shares of R Ltd. So, P Ltd would issue

5,00,000×0.52 = 2,60,000 shares to share holders of R Ltd. E.P.S of the merged company

= `72,00,000/12,00,000+2,60,000 =`4.93

After Merger, there is a dilution in the E.P.S., of P Ltd. from 5 to 4.93.


After Merger E.P.S of former shareholders of R Ltd. =4.93 × 0.52 = 2.56 There is a gain of Re.0.16 in E.P.S of merged company in comparison to E.P.S of R Ltd. of `2.40 before merger.

Comments: Initial increase in and decrease in earnings per share possible in both cases of Merger. Generally, the dilution in E.P.S will occur wherever the Price Earning Ratio of acquired company calculated on the basis of price paid exceed the P/E ratio of acquired company and vice-versa. Situation (i) The Price offered by P Ltd. per share of R Ltd. is Rs.60 and E.P.S of R Ltd. is 2.4, which would become the earnings of P Ltd. after merger. Price Earning (P/E) Ratio of P Ltd. after merger = 60/2.40 = 25. It is lower than the P/E Ratio of P Ltd. before merger i.e., 30, the E.P.S. of P Ltd. after merger increases to `5.14. Situation (ii) The Price Earnings (P/E) ratio offered for merger is 78/2.4 = 32.5 which is higher than P/E Ratio of P Ltd. before Merger. Hence, the E.P.S of P Ltd after merger would get diluted. 5. (a) E.V.A = NOPAT – COCE

NOPAT = Net Operating Profit after tax COCE = Cost of Capital Employed

COCE = Weighted Cost of Capital × Average Capital Employed = WACC × Capital Employed

Debt Capital `2,000 crores Equity capital 500+7,500 `8,000 crores Capital Employed 2,000+8,000 =

`10,000crores Debt to capital employed 2,000/10,000 = 0.20 Equity to capital employed 8,000/10,000 = 0.80

Debt cost before tax 12% Less: Tax(30% of 12%) 3.6% Debt cost after tax 8.4%

According to Capital Asset Pricing Model (CAPM) Cost of Equity Capital = Risk Free Rate + Beta × Equity Risk premium

Or = Risk free rate + Beta(Market rate – risk free rate) = 9+1.05 × (19-9)


= 9+1.05 × 10 = 19.5% WACC = Equity to CE × Cost of Equity + Debt to CE × Cost of debt = 0.8 × 19.5% + 0.20× 8.40% = 15.60% + 1.68% = 17.28% COCE = WACC × Capital Employed = 17.28% × 10,000crores = 17.28 crores E.V.A = NPAT - COCE = `2, 100 – `1,728 = 372 crores

(b) Profit and Loss Account for the year ended 31st March, 1997

Historical Cost Basis `

Replacement Cost Basis `

Sales 10,00,000 10,00,000 Cost of Sales

6,00,000 7,20,000

Gross Profit 4,00,000 2,80,000 Depreciation 1,60,000 1,80,000 2,40,000 1,00,000 Debenture Interest

25,000 25,000

Net profit 2,15,000 75,000

Balance Sheet of Alpha Limited as at 31st March, 1997 Historical Cost

Basis `

Replacement Cost Basis

` Liabilities Equity Share Capital 20,00,000 20,00,000 Profit and Loss Account 2,15,000 75,000 Replacement Reserve ‐ 6,20,000 12.5% Debentures 2,00,000 2,00,000 Creditors 40,000 40,000 24,55,000 29,35,000 Assets Fixtures and Equipment 14,40,000 18,00,000 Stock 7,20,000 8,40,000 Debtors 60,000 60,000 Cash and Bank 2,35,000 2,35,000 24,55,000 29,35,000


Working Notes: (i) Replacement cost of sales has been calculated on the basis of replacement cost at the date of

sale[3,000 units×`240= Rs.7,20,000]. (ii) Under replacement cost basis, depreciation has been calculated on the average basis [10% of

(`16,00,000 + `20,00,000/2) = `1,80,000) = 1,80,000] (iii) Fixtures and Equipment at net current replacement cost:

` Gross replacement cost 20,00,000 Less: Depreciation (10% of `20,00,000) 2,00,000 18,00,000

(iv) Replacement Reserve = Realised holding gains + Unrealised holding gains Realised holding gains

` Unrealised holding gains `

Stocks: Sold [replacement cost at the date of sale – historical cost = 7,20,000-600000]

1,20,000

Unsold [Closing Stock ×(closing rate - rate at the date of purchase) = 3000×(280-240)

1,20,000

Fixtures and Equipments: Depreciation (180000-160000)

20,000

Net book value at year end (1800000 – 1440000)

3,60,000

1,40,000 4,80,000

(v) Cash and Bank

Sales 10,00,000 Less: Outstanding 60,000 9,40,000 Payment for purchases(720000-40000) 6,80,000 2,60,000 Debenture interest 25,000 2,35,000


6. (a) The Company’s accounting policy is not in accordance with AS 7 (Revised) “Construction Contracts”. Past track record is not the criteria for recognition of incentive payments receivable for early completion of contract. According to AS 7 (Revised) incentives payments can be included in contract revenue only when

‐ the contract is sufficiently advanced that it is probable that the specified performance standards will be met or exceeded; and

‐ the amount of the incentive payment can be measured reliably. The contract is not sufficiently advanced as it is in the first year and its normal time is 4-5 years. Hence, the recognition criteria are not met and it is inappropriate to include inventive payments receivable in the current year is part of contract revenue.

(b) The present case falls under the category of defined benefit scheme under Para49 of AS

15(Revised) “Employee Benefits”. The said para encompasses cases where payment promised to be made to an employee at or near retirement presents significant difficulties in the determination of periodic charge to the statement of profit and loss. The contention of the Company that the settlement allowance will be accounted for on claim basis is not correct even if company’s obligation under the scheme is uncertain an requires estimation. In estimating the obligation, assumptions may need to be made regarding future conditions and events, which are largely outside the company’s control. Thus,

(i) Settlement allowance payable by the company is a defined retirement benefit, covered by As-15(Revised) “Employee Benefits”.

(ii) A provision should be made every year in the accounts for the accruing liability on account of settlement allowance. The amount of provision should be calculated according to actuarial valuation.

(iii) Where, however, the amount of provision so determined is not material, the company can follow some other method of accounting for settlement allowances.

(c) (i) Impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount.

Thus, Impairment loss = Carried amount – Recoverable amount = `500 lakhs – `400 lakhs = `100 lakhs Recoverable amount is higher of asset’s net selling price `375 lakhs and its value in use `400 lakhs. Recoverable amount = `400 lakhs

(ii) Journal Entries:

Particulars

Dr. Amount

`in lakhs

Cr. Amount

`in lakhs (i) Impairment loss account To Asset account (Being the journal entry to transfer impairment loss to the profit and loss)

100 100


(ii) Profit and loss account To impairment loss account (Being the journal entry to transfer impairment loss to the profit and loss account)

100 100

(iii) Balance sheet of Venus Ltd. as on 31.3.2005

`in lakhs Assets Less Depreciation 500 Less: Impairment loss 100 400

(d) P Ltd. has direct economic interest in R Ltd to the extent of 14% and through Q Ltd. in which it is the majority shareholders, it has further control of 12% in R Ltd. (60% of Q Ltd’s 20%). These two taken together (14%+12%) make the total control of 26%. Para 10 of AS-18 ‘Related Party Disclosures’, defines related party as one that has at any time during the reporting period, the ability to control the other party or exercise significant influence over the other party in making financial and/ or operating decisions.

Here, control is defined as ownership directly or indirectly of more than one-half of the voting power of an enterprise; and significant influence is defined as participation in the financial and/or operating policy decisions of an enterprise but not control of those policies.

In the present case, control of P Ltd. in R Ltd. directly and through Q Ltd., does not go beyond 26%. However, as per para 12 of AS-18, significant influence may be exercised as an investing party (P Ltd.) holds, directly or indirectly through intermediaries 20% or more of the voting power of R Ltd. As R Ltd. is a listed company and regularly supplies goods to P Ltd. therefore, related party disclosures, as per AS-18, is required.

7. (1)

Indian Accounting Standards

IFRS/IAS US GAAPs

Changes in accounting policy

In the year of change, the effect of change is included in income statement of that year and also the impact of change is disclosed.

Retrospective effect of the change in accounting policy is accounted. Also comparative figures are restated; where the effect of period(s) not presented is adjusted against opening retained earnings.

Similar to IFRS from the date of adoption of FAS 154.


Inventories Carried at lower of cost and net realizable value. FIFO or weighted average method is used to determine cost. LIFO method is however, prohibited.

Carried at lower of cost and net realizable value. For cost determination, FIFO or weighted average method is used. LIFO basis of valuation is prohibited. Reversal is required for subsequent increase in value of previous write-downs.

Similar to IFRS;however use of LIFO is permitted. Reversal of write-down is prohibited.

(2) (i) Market Value Added is the market value of capital employed in the firm less the book value

of capital employed. Market value added is calculated by summing up the paid up value of equity and preference share capital, Retained earnings, long term and short term debts and subtracting this sum from the market value of equity and debt. Market value added measures cumulatively the performance of corporate entity. A High market value added means that the company has created substantial wealth for shareholders. On the other hand negative MVA means that the value of management’s actions and investments are less than the value of the capital contributed to the company by the capital market or that the wealth and value has been destroyed.

(ii) Open ended funds can issue and redeem units any time during the life of the scheme while

close ended funds cannot issue new units except in case of bonus or rights issue. Hence, until capital of open ended funds can fluctuate on daily basis while that is not the case for close ended schemes. New investors can join the scheme by directly applying to the mutual fund at applicable net asset value related prices in case of open ended schemes while that is not the case in close ended schemes. New investors can buy the units from secondary market only.

(iii) An embedded derivative is a component of a hybrid(combined) instrument that also

includes a non-derivative host contract, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative should be separated from the host contract and accounted for as a derivative if (i) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract and (ii) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative. However, a derivative that is embedded in a financial asset or financial liability at fair value through profit or loss need not be separated.


PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL – STRATEGIC FINANCIAL MANAGEMENT

QUESTION PAPER

SCFT No. of Pages: 4 Total Marks: 100 No of Questions: 7 Time Allowed: 3 Hrs

Question No.1 is compulsory

Attempt any FIVE questions from the remaining SIX questions 1. (a) Following information is given in respect of two stocks X and Y Year Return on X % Return on Y % 2009 12 14 2010 15 20

Determine (i) The expected return on a portfolio containing X and Y in the proportion of 40% and 60%

respectively (ii) The standard deviation of return from each of the two stocks (iii) The covariance of returns from the two stocks (iv) Correlation coefficient between the returns of the two stocks (v) The risk of a portfolio containing X and Y in the proportion of 40% and 60%

(5 Marks)

(b) A has `1,00,000 to invest in a portfolio containing stocks X and stock Y and a risk free asset. He must invest all of his money. His goal is to create a portfolio that has an expected return of 12.5% and that has only 80% of the risk of the overall market. If X has an expected return of 28% and a beta of 1.6. Y has an expected return of 16% and has a beta of 1.2. The risk free rate is 7%. How much money will A invest in stock X? (5 Marks)

(c) The following information is given: Stock price – `88 Risk free rate = 3 %. In 3 months time the

stock could either go up to `95 or down to `82. The strike price is `90. Compute the value of put option using risk neutral probability. (5 Marks)

(d) Calculate the arbitrage gains possible on `10,00,000 from the middle rates given below

assuming there are no transaction costs? `76.2000 = £ 1 in London `46.6000 = $ 1 in Delhi $ 1.5820 00 = = £ 1 in New York (5 Marks) 2. (a) Kumar is planning to buy a computer, the cost of which is `60,000. The effective life of the

computer is 5 years and the resale value of the computer at the end of 5 years is `3,333 subject to a commission of 10% there on, and taxes applicable. He wants to buy the same either by borrowing `60,000 from bankers at 15% per annum or by lease. The principal amount of loan is repayable in five equal instalments of `12,000 at the end of each year.


Depreciation on computer is on straight line basis, spread over its life. Tax rate is 40% and after tax cost of capital is 9%. He wants to know the lease rentals to be paid annually, which will match the loan option. Lease rentals as also interest on loan will also be paid at the end of the year. Determine the quantum of annual, equated lease rentals, for which Kumar would be indifferent as between lease and borrow option. (12 Marks)

(b) The United States $ is selling in India at `45.50. If the interest rate for a six months borrowing

in India is 8% per annum and the corresponding rate in USA is 2% (i) Do you expect US $ to be at a premium or at discount in the Indian forward market (ii) What is the expected 6 months forward rate for United States Dollar in India (iii) What is the rate of forward premium or discount? (4 Marks)

3. (a) FDC Ltd is planning to acquire ELF Ltd. The following information is given FDC Ltd ELF Ltd

Total current earnings `100 million `100 million Number of shares outstanding 20 million 10 million Market price share `30 `60 P/E 6 6

(i) What is the minimum exchange ratio acceptable to the shareholders of ELF Ltd if the PE ratio of the combined entity is 6 and there is a synergy benefit of 10%

(ii) Assuming there is no synergy find the exchange ratio so that shareholders of ELF Ltd would not be at a loss. (12 Marks)

(b) A sold Hong Kong dollar 1,00,00,000 value spot to his customer `5.70 & covered himself in

London market on the same day, when the exchange rates were : US $ 1 = HK $ 7.5880 and 7.5920 Local inter bank market rates for US $ were Spot US $ 1 = `42.70 and 42.85. Calculate cover rate and ascertain the profit or loss in the transaction ignoring brokerage (4Marks)

4. (a) Genies Ltd wants to acquire Smart Ltd. The balance sheet of Smart Ltd as on 31st December 2010 is as follows. Liabilities ` Assets `

Equity share capital 6,00,000 Cash 20,000 (60,000 shares) Retained earnings 2,00,000 Debtors 30,000 12% debentures 2,00,000 Inventories 1,70,000 Creditors and other liabilities 3,20,000 Plant & equipments 11,00,000 ________ _________

13,20,000 13,20,000 ________ _________

Share holders of Smart Ltd will get one share in Genies Ltd for every two shares at current price of Genies Ltd of `15 . External liabilities are expected to be settled at `3,00,000. Debenture holders


will get 13% convertible debentures in the purchasing company for the same amount. Debtors and inventories are expected to realise at `1,80,000. Genies Ltd has decided to operate the business of Smart Ltd as a separate division which is expected to give cash flows after tax to the extent of `3,00,000 per year for 6 years. Genesis Ltd has planned that, after six years, this division would be emerged and disposed of `1,00,000. Company’s cost of capital is 14%. Make a report about advising the company Genesis Ltd about the financial feasibility of the acquisition. Present value of `1 for six years @ 14% : 0.8772 , 0.7695, 0.6750, 0.5921, 0.5194 and 0.4556 (8 Marks)

(b) In the context of CAPM, (i) what is the expected return of security j if it has the following

characteristics and if the following information holds for the market portfolio? Standard Deviation, security 0.20 Standard Deviation, market portfolio 0.15 Expected return, Market portfolio 0.13 Correlation between possible returns for Security j and the market portfolio 0.80 Risk free rate 0.07 (i) What would happen to the required return if the standard deviation for the security were

higher? (ii) What would happen if the correlation coefficient were less? (iii) What is the functional relationship between the required return for a security and market

risk? (8 Marks)

5. (a) The balance sheet of M Ltd shows that its shares have a par value of `8. The paid up capital is A `20 lacs. The share premium shows `16 lacs and the retained earnings are `84 lacs. The current market price is `60. What will happen to equity account and to the number of shares outstanding and to the market price in each of the following situations? Consider each situation independently and discuss. (i) If there is a 1:5 bonus issue (ii) If there is a 2:1 stock split (iii) If there is a 1:2 reverse split (8 Marks)

(b) Mr P on 1.7.2007 during the initial offer of some mutual fund invested in 10,000 units having a

face value of `10 for each unit. On 31.3.2008 the dividend operated by the MF was 10% and P found that his annualized yield was 153.33%. On 31.12.2009, 20% dividend was given. On 31.3.2010 Mr.P redeemed all his balance of 11,296.11 units when his annualized yield was 73.52%. What are the NAVs as on 31.3.2008, 31.12.2009 and 31.03.2010. P was in dividend reinvestment plan. (8 Marks)

6. (a) Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity. Both

the bonds have a face value of `1,000 and coupon rate of 8% (with annual interest payments) and both are selling at par. If the yields of bot the bonds fall to 6%, whether the price of bond will increase or decrease? What percentage of this increase/decrease comes from a change in


the present value of bond’s principal amount and what percentage of this increase/decrease comes from a change in the present value of bond’s interest payments? (8 Marks)

(b) A company earns `12 lacs after tax and pays out 60% of its profits as dividends and both

earnings and dividends are expected to grow at a constant rate of 6%. The number of shares outstanding is `1.2 lacs. Its price earning multiple is 6. The company can invest its retained earnings in projects that give an IRR of 15%. Compute (i) Compute the theoretical market price using Walter’s model? (ii) Is the company’s pay out practice in synchronise with the maximizing the wealth of the

shareholders (iii) If the answer to (ii) above is “No” what payout would you suggest? (iv) Is the Walter’s model very different from the all or nothing approach? (8 Marks)

7. Answer any four of the following (i) Differentiate between Debt factoring and Invoice Discounting (ii) Assumptions in Capital Asset Pricing Model (iii) How is a stock market index calculated? Indicate any two important stock market indices. (iv) Write a note on Cross Border Leasing: (v) Limitations of Credit rating (4x4=16 Marks)

ANNUITY TABLE

Qn. No.2 (a) Year

1 0.9174 2 0.8417 3 0.7722 4 0.7084 5 0.6499

_______ 3.8896 _______

INTEREST TABLE

Qn. No.6 (a) 6% ‐ 5 yrs cumulative 4.212 ‐ 5th yr 0.747 6% ‐ 20 yrs cumulative 11.47 ‐ 20th yr 0.312 8% ‐ 5 yrs cumulative 3.993 ‐ 5th yr 0.681 8% ‐ 20 yrs cumulative 9.82


‐ 20th yr 0.214

PRIME ACADEMY 32nd SESSION MODEL EXAM - FINAL – STRATEGIC FINANCIAL MANAGEMENT

SUGGESTED ANSWERS 1 (a)

(i) The expected return of the portfolio X and Y E (X) = (12 +15)/2 = 13.5% E(Y) = (14 + 20)/s = 17%

(ii) Stock X Variance = 0.5 (12 – 13.5)2 + 0.5 (15 – 13.5)2 = 0.5 x 2.25 + 0.5 x 2.25 = 2.25 Standard deviation = √ 2.25 = 1.5

Stock Y Variance = 0.5 ( 14 – 17) 2 + 0.5 (20 – 17) 2

= 0.5 x 9 + 0.5 x 9 = 9 Standard deviation = √ 9 = 3

(iii) Covariance of stocks X and Y Cov XY = 0.5( 12 – 13.5)(14 – 17) + 0.5 (15 – 13.5) (20 – 17)

= 0.5 x (-1.5) (-3) + 0.5 x 1.5 x 3 = 2.25 + 2.25 = 4.50

Correlation of coefficient = Cov XY / σ X σ Y = 4.5 /1.5 x 3 = 1 (iv) Portfolio risk

σ p = √ Wx 2 σ x 2 + Wy 2 x σ y 2 + 2 W x x Wy ( σ x σ y Cor xy ) = √ (0.4) 2 (1.5) 2 + (0.6) 2 (3) 2 + 2 (0.4) (0.6) (1.5) (3) (1) = √ 0.36 + 3.24 + 2.16 =√ 5.76 = 2.4%

(b) Let Wx – Weight of X and Wy – weight of Y

Given 0.125 = Wx x 0.28 + Wy x 0.16+ (1 – Wx – Wy)x0.07 0.80 = Wx x 1.6 + Wy x 1.2 + (1 – Wx – Wy) x 0

Solving this equation Wx = -0.015 and Wy = 0.740 and Wr = 0.315 This indicates that amount of stock X has to be sold short in the market

= -0.015 x (Rs.1,00,000) = (Rs.1,500)

(c) Current stock price :`88 Risk free rate: 3 % 3 month risk free rate = 0.03 x 3 / 12 = 0.0075 Stock value in 3 months, using a 3% risk free rate : 88 x 1.0075 = `88.66 Let y represent the probability that stock will be `95 after 3 months. Therefore, we can say that (1-y) is the probability that the stock would be `82 after 3 months. Solving for the probabilities of an up or down in the price: 95 x y + ( 1 – y) x 82 = 88.66

y = 0.5123 ( 1 – y) = 0.4877


If the stock goes up to `95, the put value will be 0 (Because we would not exercise put). If the stock goes down to `82, the put will have a value of `90 -82 = `8 (by exercising) The expected payoff of the put is = 0.5123 x 0 + 0.4877 x 8 = `3.90.

Discounting this back to the present we obtain the current put price of `3.87

(d) Beginning with `10 lakhs , we can purchase dollars in Delhi to get $ 21,459 (10,00,000/46.60). Using this we purchase pounds in New York to get £ 13,564 (21,459/1.582). Now we sell these pounds in London at `.76.20 per pound to get `10,33,577, thereby making arbitrage gains of `33,577 on an investment of `10 lakhs.

2. (a) Interest payable and the tax shield

Principle at the Interest at 15% Tax shield at Repayment Beginning of years thereon for one 40% amount `

1 to 5 year 60,000 9,000 3,600 21,000 48,000 7,200 2,880 19,200 36,000 5,400 2,160 17,400 24,000 3,600 1,440 15,600 12,000 1,800 720 13,800

Depreciation on straight line basis for `60,000 annually `12,000 Tax shield 40% = `4,800 Resale value of computer `3,333 Less: 10% commission 333 Inflow 3,000 Book value Nil Taxable gain 3,000 Tax 1,200 Inflow 1,800

Out flow under loan option

Year 2 3 4 5 Total

Principle & interest 21,000 19,200 17,400 15,600 13,800 87,000 Tax shield on depren. (4,800) (4,800) (4,800) (4,800) (4,800) (24,000) Tax shield on interest (3,600) (2,880) (2,160 (1,440) (720) (10,800) Receipts for resale (1,800) (1,800) Net cash outflows 12,600 11,520 10,440 9,360 6,480 50,400 Discount @ 9% 0.9174 0.8417 0.7722 0.7084 0.6499 3.8897 Present value 11,559 9,696 8,062 6,631 4,211 40,159

Computation of lease rentals, applying equated cost analysis Present value of total outflows `40,159 Cumulative P.V factor 3.8897


Equated annual pre tax outflow 10,324 Tax adjustment at 0.4 0.60 Pre tax out flow 17,207

When annual lease rentals payable at year end stand at `17,207,the net tax adjusted cash outflows would be the same for both loan and lease options. At a level of `17,207 Kumar would be indifferent

(b) (i) Under the given circumstances US $ is expected to quote at a premium in India as the

interest rate is higher in India (ii) Calculation of forward rate:

Interest rate parity equation of 1 + r h = F 1+ r f S Where r h is the home currency (Rs.) and r f is the foreign currency ($). S is the spot rate and F is the forward rate 1 + (0.08/2) = F 1+ (0.02/2) 45.50 F = Rs.46.85 Rate of premium = F – S x 12/n S = 46.85 – 45.50 x 12/6 45.50 = 5.93% 3. (a) (i) Total earning of the combined entity = (100 + 100) x 1.1 = 220 million

PE of the combined entity = 6 Total number of shares of combined entity = 220 / 6 = 36.67 million shares Existing number of shares = 20 million Number of shares to be issued to ELF Ltd = 16.67 million Exchange ratio = 16.67/10 = 1.67 i.e 5 shares of FDC Ltd for every 3 shares of ELF Ltd

(ii) Present EPS of FDC Ltd = 100/20 = `5

Present EPS of ELF ltd = 100/10 = 10 Exchange ratio should be 10 shares of FDC Ltd for every 5 shares of ELF Ltd i.e 2 shares of FDC Ltd for every share of ELF Ltd Shares to be issued to ELF Ltd 10 x 2/1 = 20 million shares Total number of shares of FDC Ltd = 20 + 20 = 40 million shares EPS after merger =200 million / 40 million = `5 Total earnings available to share holders of ELF Ltd 20 million x 5 = `100 million This is equal to earnings prior merger for ELF Ltd Therefore exchange ratio on the basis of Earnings per share is recommended.


(b) HK $ = 10 million Hong Kong dollar sold to customer : `5.70 Calculation of Cover rate: Given HK $ / $ quote and `/ $ quote We need to `/HK $ quote. We need to find only the Ask rate of `/HK $ quote, because we cover the sell with a buy. Therefore we need a buy rate. i.e ask side of quote. Ask (`/HK $ ) = Ask (`/$) x Ask ($/HK $)

= 42.85 x 1/Bid (HK $/$) =42.85 x 1/7.5880 = `5.65.

Therefore the sell rate is `5.70 and buy rate is `5.65. There is a gain of `0.05 x 10 million = `5 lakhs 4. (a) Cost of acquisition

Equity share capital 60,000 x `15 = `4,50,000 2

13% convertible debentures = 2,00,000 Cash (3,00,000 – 1,80,000 – 20,000) = 1,00,000 Total consideration 7,50,000

________ Calculation of NPV Year Cash in Flow P.V factor @ 14% Present value

1 3,00,000 0.8772 2,63,160 2 3,00,000 0.7695 2,30,850 3 3,00,000 0.6750 2,02,500 4 3,00,000 0.5921 1,77,630 5 3,00,000 0.5194 1,55,820 6 3,00,000 0.4556 1,36,680 6 (salvage) 1,00,000 0.4556 45,560 Total P.V of cash flow 12,12,200 Less : Cost of acquisition 7,50,000 NPV 4,62,200 Since NPV is positive , it is suggested to acquire Smart Ltd .

(b) (i) For CAPM model , the expected return is given by

R j = R f + R m – R j (ῥ jm σ j σ m ) σ2 m

Given σ j = 0.20 σ m = 0.15 ῥ jm = 0.80 Rm = 0.13 Rf = 0.07 Substituting R j = 0.07 + 0.06/(0.15x0.15) (0.8x 0.2 x 0.15) = 13.4%

(ii) If σ j were higher , the expected return would increase (iii) If ῥ jm were lower, the expected return would decrease


(iv) If σ m were higher, the expected return would decrease & if σ m were lower the expected return would increase. Therefore the required return for a security is inversely proportional to market risk

a. (a)

(i) Bonus issue Current number of shares = 20,00,000 / 8 = 2,50,000 Number of bonus shares to be issued = 2,50,000 / 5 = 50,000 A sum of `50,000 x `8 = `4,00,000 will be transferred from retained earnings to equity share capital No. Of shares outstanding = current shares + Bonus shares = 2,50,000 + 50,000 = 3,00,000 The new price of shares = S x P0

N + S = 2,50,000 x 60/ 3,00,000 = Rs.50 per share a. A 2 : 1 stock split means 2 shares will be issued for one share held New number of shares = 2,50,000 x 2 = 5,00,000

Since it is only a stock split there will be no change in equity account. Face value will drop to `8 x ½ = `4

The new price of shares = S x P0 = 2,50,000 x 60 / 5,00,000 = `30 N + S

(iii) Reverse split A 1:2 reverse split means one share will be issued for every two shares held Number of shares = 2,50,000 / 2 = 1,25,000 Since it is only a stock split there will be no change in equity account. Face value will drop to `8 x 2 = `16 The new price of shares = S x P0 = 2,50,000 x 60 / 1,25,000 = `120

N + S

(b) Annualized yield = Closing NAV – Opening NAV x 12 x 100 Original NAV n Where n is the number of months. Here n = 9 months period between 1.7.2007 and 31.3.2008 153.33 = NAV 31.3.2008 – 10 x 12 x 100 10 x 9 Solving NAV as on 31.3.2008 = `21.50.

10% dividend was declared on 31.3.2008 and 10000 units at 10% works out to `1000 and this `1,000 reinvested at `21.50 gives 465.11 units and the total units as on 31.3.2008 is 10465.11 units. Further payment of 20% dividend was declared on 31.12.2009 means `.20,930.22 (10465.11 x 2) in such a way that total units would be equal to 11,296.11 units (final balance). i.e 11,296.11 – 10465.11 = 831 units was issued on 31.12.2009. If 831 units were issued for `20,930.22, the NAV as on 31.12.2009 should have been

= 20,930.22/ 831 = `25.1868. Given annualized yield as on 31.32010 = 73.52. Using the above


formula 73.52 = NAV as on 31.3.2010 - 25.1868 x 12 x 100 25.1868 x 3 (months)

Solving this the closing NAV as on 31.3.2010 should be `29.8161

6. (a) If the yield of the bond falls the price will always increase. The following calculation show this. IF yield falls to 6% price of 5 year bond `80 (PVIFA 6%, 5 years) + `1000 (PVIF 6 %, 5 years) = 80 x 4.212 + 1000 x 0.747

= `336.96 + Rs.747 = `1,083.96 Increase in 5 years bond price = `83.96 Current price of 20 year bond = `80 (PVIFA 6%,20) + Rs.1000 (PVIF 6%, 20)

= `80 x 11.47 + 1000 (0.312) = `1,229.60 So increase in bond price is `229.60

Price increase due to change in PV of principle 5 Year bond = `1000 (PVIF 6%, 5 yrs) – `1000 (PVIF 8%, 5 yrs)

= 1000 x 0.747 – 1000 x 0.681 = `66 % change in price due to change in PV of principle = (66/83.96) x 100 = 78.6%

20 Year bond = Rs.1000 (PVIF 6%,20 yrs) – `1000(PVIF 8%, 20yrs)

= 1000 x0.312 – 1000 x 0.214 = `98 % increase in price due to change in PV of principle =( 98/229.6) x 100 = 42.68% Price increase due to change in PV of interest 5 Year bond = `80 (PVIF 6%, 5 yrs) – `80(PVIFA 8%, 5 yrs) = 80 x 4.212 – 80 x 3.993

= `336.96 – `319.44 = `17.52 % change in price due to change in PV of interest = (17.52/83.96) x 100 = 20.86%

20 Year bond = `80 (PVIF 6%, 20 yrs) – `80(PVIFA 8%, 20 yrs) = 80 x 11.47 – 80 x 9.82

= `917.60 – `785.60 = `132 % change in price due to change in PV of interest = (132/229.6) x 100 = 57.49%

(b) (i) Earnings per share = Earnings after tax Number of shares outstanding = 12,00,000 / 1,20,000 = `10

DPS = EPS x payout ratio = 10 x 0.60 = `6 P0 = EPS x PE = 10 x 6 = 60 D1 = `6 x 0.06 = `6.36 P0 = D1

Ke - g 60 = 6.36 ( Ke – 0.06)

Ke = 6.36/60 + 0.06 Ke = 16.66 % Theoretical market price using Walter’s model

= (D1 / Ke) + (r/Ke) (EPS – DPS) K e


= 6 / 16.67 + (15/16.67) ( 10 – 6) 16.67 = (6 + 3.5992)/ 16.67 = `57.58

(ii) Since R < Ke the answer in “No” (iii) Optimal pay out for a declining firm is 100% (iv) Walter’s model is not different from “all or nothing” approach because in deriving the formula for

Walter’s model, it is assumed that all earnings are either distributed or retained 7.

(i) Factoring involves the outright sale of a company’s debtors to a factor on a continuous basis who will charge for the administration of the sales ledger, the acceptance of the bad debt risk and the advance of finance. Factor offer services such as Sales ledger accounting, Credit insurance and provision of finance. A company need not use all three services. Generally, the factor will collect the client’s debts. However, the used confidential invoice factoring is sometimes more popular with the company as the customer is unaware that a factor has intervened the transaction. Factoring completely relieves a company of its financial administration burden. Invoice discounting is where a company can convert an invoice into cash by discounting it through a financial institution or bank. The company sends invoices to bank or financial institution and if accepted they will make payment to the company a proportion often 75 % of the invoice value. A promissory note for this amount is normally supplied by the company which means that on a specified date the repayment must be made even if the debtor has not made the payment. The company will continue to collect the debts as agents for financial institution or banks. Unlike factoring, the company has to devote its time and energy in collecting the debts. In invoice discounting, company continues to be responsible for the defaults in repayment. Factoring provides a company access to finance on the security of its book debts which maynot be available from other sources

(ii)

- Market is perfect. This means that all assets are marketable and that there are no transactions costs or taxes. - Risk free rate. There is a single risk free rate of return and invstors can freely borrow or invest at such risk free rate. - Homogeneous expectations – Investors have homogeneous expectations about return. - Time period – Forecasts are for one time period only. - Rational investors – All investors are rational - Divisible – All stocks are infinitely divisible, and it will be possible for investors to invest in a fraction of stock.. - Diversification – Investors hold well diversified portfolios

(iii) ‐ A base year along with a basket of shares is set. ‐ The shares included in the index are those shares which are traded regularly in high volumes ‐ The changes in the market price of these shares is calculated on a daily basis.


‐ In case the trading in any share stops or comes down then its gets excluded and another company’s shares replace it.

‐ Steps involved in calculation of index on a particular date : Market capitalisation of all the shares in the basket of index is calculated. Total market capitalisation of all the shares in the basket are calculated by adding the individual market capitalisation. Computing index of next day requires the index value and the total market capitalisation of the previous day and is computed as followa: Index Value = Index on previous day x Total market capitalisation for current day Total market capitalisation of the previous day

‐ Indices may also be calculated using the price weighted method. Here the share price of the constituent companies form the weights. However all equity indices world-wide are calculated using the market capitalisation weighted method.

Each stock exchanges has a flagship indices like Nifty of NSE, Sensex of BSE. There are other indices like Nifty Junior, BSE Midcap etc

(iv) Cross border leasing is a leasing agreement where lessor and lessee are situated in two different countries having different set of taxation rules. This raises significant additional issues relating to tax avoidance and tax shelters. This has been widely used in some European countries, to arbitrage the difference in the tax laws of two different countries. This form of finance have been in practice for financing infrastructure project such as rail and air transport, telecommunications etc in emerging countries. These projects normally have predictable revenue streams. The major objective of this cross border leasing is to reduce the overall cost of financing through the utilisation by the lessor of tax depreciation allowances to reduce its taxable income. The tax savings are passed through to the lessee as a lower cost of finance. The basis requisites for this sort of financing are relatively high tax rates in the lessor’s country, liberal depreciation rules and either very flexible or very formalistic rules governing tax ownership.

(v) Though credit rating is a very important indicator for prudence but it suffers from certain limitations and some of them are:: Conflict of interest. The rating agency collects fees from the entity which it rates leading to a conflict of interest and obligation. Industry specific rather than Company specific.- Downgrades are linked to industry rather than company performance. Rating agencies give importance to macro aspects and not to micro ones. Rating changes – With fast changing economic scenario, ratings given to instruments can change over a period of time and they have to be kept under constant watch. Rating downgrades may not be timely enough to keep investors educated over such matters. Basis of rating – Ratings are based on point of time concept rather than on period of time concept thus do not provide a dynamic assessment. Since rating is mandatory it is carried out without carrying out cost benefit analysis. Corporate governance issues associated with credit rating such as a rating agency getting most of their revenues from a single corporate group, greater transparency in the process such as disclosure of assumptions leading to a specific to a rating


PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL - ADVANCED AUDITING AND PROFESSIONAL ETHICS

QUESTION PAPER

ADPS No. of Pages: 3 Total Marks: 100 No of Questions: 7 Time Allowed: 3 Hrs

Question No 1 is compulsory. Answer any five from the rest.

1. (a) A public limited company i.e. ‘the Indian company’ whose shares are listed on the Bombay Stock Exchange in engaged in the business of manufacture and sale of electrical and electronic items. During the financial year 2009-10 the company acquired a company in Singapore carrying on similar business. The Singapore company’s shares were acquired through a subsidiary of the Indian company in Malaysia.

The acquisition was completed in May 2009, and the Indian company has incurred the following expenses up to May 2009, for the acquisition of the Singapore company.

S.No Expenses incurred Amount in ` Lakh

1 Travelling Expenses 200 2 Legal Expenses 100 3 Due Diligence Expenses 100 4 Other Expenses 50

TOTAL 450

The Indian company remitted an amount of US$ “x” to its subsidiary in the Malaysia for acquiring the shares. The Malaysian subsidiary actually incurred only US$”y” for the acquisition of the shares of the Singapore company and remitted back the balance US$(x-y) to the Indian Company. On account of this excess money refunded, the Indian company has incurred an exchange loss of Indian ` 200 lakh (approx)

Requirement: 1. Whether the amount of expenditure incurred by the Indian company can be treated as part of the

cost of investment 2. Whether the exchange loss incurred by the Indian company on account of sending and receiving

back excess US$ from its Malaysian subsidiary can be treated as part of the cost of investment. As a statutory Auditor of a Public committed company, how would you deal with the following situation?

(b) S Ltd a listed company, incurred heavy losses for the year ended 31st March 2010 and the

industry in which it was functioning was not expected to perform better in the next few years. While finalising the accounts, the CFO of the company decided to create a Deferred Tax Asset for the tax benefits that would arise in future years for the losses.


(c) As at the beginning of the year, the company has a capital of ` 2.50 crores, free reserves of ` 0.50 crores and Revaluation Reserve of ` 4.50 crores. In the relevant year under audit the company has incurred a loss of ` 4 crores. The company proposes to adjust the loss with the Revaluation Reserve.

(d) A company had subscribed to shares of associate companies amounting to ` 5 crores. These associate companies have incurred substantial losses and have been referred to BIFR for being declared as sick companies. The company does not want to make any provision for the fall in the value of the investments. (20 Marks)

2. (a) The auditor of a Government Company was asked to deposit a percentage of the audit fee (for

recovering administrative and other expensers) to the State Treasury by a prescribed challan within a prescribed time of the receipt of audit fee. Comment if he is guilty of professional misconduct for sharing his fees.

(b) X a Chartered Accountant in practice enters into partnership with a practicing Chartered

Accountant of a foreign professional body for sharing the fee of their partnership within India. Is he guilty of professional misconduct?

(c) B, a Chartered Accountant in practice is a partner in 3 firms. While printing personal letter heads,

b gave the names of all the firms in which he is a partner. Is he guilty of professional misconduct?

(d) A is the auditor of Z Ltd which has a turnover of ` 45 crores. During the year, the company offers

A an assignment of management consultancy within the meaning of Section 2(2)(iv) of the CA Act 1949. The total remuneration including Audit fee is ` 50 lakhs (` 30 lakhs towards management consultancy). A seeks your advise on accepting the assignment. (16 Marks)

3. (a) State the reasons for the following procedural requirements, in terms of internal control

(i) The gateman of a cinema house is required to tear each ticket presented for admission into two and hand over the stub to the patron.

(ii) After the chief accountant signing the disbursement cheques, they are listed and the supporting data are retained in the Accounts Department but the cheques are passed on to the Mailing Department for onward transmission.

(iii) The copy of the “Goods Received Note” passed on to the quality inspector for Quality Report does not contain the names and particulars of the supplier.

(iv) Department Attendance Registers are maintained in the factory even though the workers while entering the factory are to punch their respective clock-cards.

(v) In a bank no director, officer or employee is entitled to act on behalf of a customer in relating with any transaction with the bank.

(vi) The driver of each vehicle is to maintain a log book showing details of trips and petrol purchased. The log book is presented to the Office manager once a week for verification.

(b) Discuss some problems that will be encountered in an EDP system in implementation of

internal control. (16 Marks) 4. (a) An American company engaged in the business of manufacturing and distribution of industrial

gases, is interested in acquiring a listed Indian Company having a major market share of the industrial gas business in India, request you to conduct a “Due Diligence“of this Indian Company


and submit your Report. List out the contents of your Due Diligence Review Report that you will submit to your USA based client.

(b) Your firm has been appointed a Central Statutory Auditor of a Nationalised Bank. Then bank

follows financial year as accounting year. State your view on the following issues which were brought to your notice by your Audit Manager. (i) The bank has recognised on accrual basis income from dividends on securities and Units of

Mutual Funds held by it as at the end of the financial year. The dividends on securities and units of Mutual funds were declared after the end of the financial year.

(ii) In case of all such advances which have been classified as non-performing for the first time during the current financial year, only the last date of financial year has been reckoned as the date of account becoming non-performing. (16 Marks)

5. (a) As the statutory auditor of B Ltd to whom CARO 2003 is applicable, how would you report in

the following situations? (i) The company has stood guarantee to its sister concern, whose financial condition was not

healthy for a sum of ` 20 lakhs borrowed from a bank. (ii) Physical verification of only 50% (in value) of items of inventory has been conducted by the

Company. The balance 50% will be conducted in the next year due to lack of time and resources.

(iii) Accumulated losses of the company are 55% of its networth and it is incurring continuous cash losses since last 2 years.

(b) You have been asked by a company to compile financial statements for the purpose of obtaining

a loan from a Bank. Draft a report to be given to the Management for the same. (16 Marks)

6. (a) As a tax auditor, which are the accounting ratios required to be mentioned in the report in case

of manufacturing entities? Explain in detail any one ratio and how does it help the tax auditor in his analytical review.

(b) What are the steps involved in the Audit of Reinsurance ceded? (16 Marks)

7. Write a short note on the following. Answer any four

(a) Rolling Settlements. (b) Propriety Audit. (c) Solutions for resolving behavioural problems in Management Audit. (d) Haphazard Sampling (e) True and Fair cost of production. (4x4=16 Marks)


PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL - ADVANCED AUDITING AND PROFESSIONAL ETHICS

SUGGESTED ANSWERS

1. (a) AS-13, Accounting for Investments, states that the cost of an investment includes acquisition

charges such as brokerage fees and duties. Keeping in view the nature of the items of acquisition charges mentioned in AS 13, the cost of acquisition should include only those direct charges which are incurred on acquisition of investment, i.e. the expenses, without the incurrence of which, the transaction could not have taken place such as share transfer fees, stamp duty, registration fees, and duties and levies by regulatory agencies and stock exchanges. The expenses incurred before the acquisition, even though directly attributable to acquisition should not be added to the cost of acquisition of shares as these do not represent the worth of the shares acquired. • Keeping in view the above principles, in the present case, travelling cost and due diligence

cost should not form part of the cost of acquisition; rather, these should be expensed in the period in which these are incurred. The legal costs and ‘other expenses’ should form part of the cost of investment only if and only to the extent these costs meet the considerations for inclusion in the cost of investment as stated above.

• The exchange loss incurred by the Indian company on account of sending and receiving back excess US$ from its Malaysian subsidiary cannot be treated as part of the cost of the investment as these expenses do not represent the worth of the shares acquired.

(b) AS-22 on Accounting for Taxes on Income, requires that deferred tax should be recognized for all

timing differences, subject to the considerations of prudence in respect of deferred tax assets. The standard further states that where an enterprise has unabsorbed depreciation or carry forward of losses under the tax laws, deferred tax assets should be recognized only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realized. In this context, virtual certainty supported by convincing evidence would mean that there is a reasonable certainty that the carry forward losses would be recouped in the future years. In the instant case, looking to the fact that the industry in which the company was functioning was not expected to perform well in the next few years, getting virtual certainty and convincing evidence for the same would be almost impossible. Hence, in the absence of virtual certainty for offset of the losses in future years, creating a deferred asset would not be possible for the company. The statutory auditor would therefore have to qualify his report by stating that deferred tax assets have been created though there is no virtual certainty for getting the said benefit in income tax. He would also have to mention the amount by which the loss for the year has been understated and the amount by which the reserves are overstated.


(c) Adjustment of Loss against Revaluation Reserve: AS-10, on Accounting for Fixed Assets, states that an increase in net book value of fixed assets is normally credited to owner’s interest and under heading Reevaluation Reserves except the, to the extent that such increase is related to and not grater than a decrease arising on revaluation previously recorded as a charge to the profit and loss statement, it may credited tot eh profit and loss statement. A decrease in net book value arising on revaluation off fixed asset should be charged directly to the profit and loss statement except that to the extent that such a decrease is related to an increase which was previously recorded as, credit to revaluation reserve and which has not been subsequently reversed or utilized, It may be charged directly to that account. The Guidance Note on Treatment of Reserve created on Revaluation of Fixed Assets states that where the value of fixed assets is written up in the books of account of a company, the corresponding credit appearing as revaluation reserve does not represent a realized gain and is, therefore, not available for distribution as dividend. Similarly, accumulated losses and the depreciation on the acquisition cost (including arrears of depreciation) should not be adjusted against revaluation reserve since this would amount to setting off actual losses against unrealized gains.

The auditor should explain to the management that accumulated losses cannot be adjusted against the revaluation reserve created on revaluation of the fixed assets. In case the company in question does so, the balance sheet of the company will not reflect a true and fair view of the state of affairs of the company keeping in view the magnitude of the amount involved, ie., accumulated losses amount to ` 4 crores and share capital and reserves amount to ` 3 crores (excluding revaluation reserve). If the management does not agree with the opinion of the auditor, the auditor may even issue an adverse report.

(d) AS-13, on Accounting for investments, requires investments to be classified as long term and

current investments distinctly in its financial statements. The investments in shares of associate companies can very well be considered as trade investments since they would not be intended to be liquidated within a period of one year from its acquisition. Hence they would be classified as long term investments. AS-13 states long-term investments should be carried in the financial statements at cost. However, provision for diminution shall be made to recognize a decline, other than temporary, in the value of the investments, such reduction being determined and made for each investment individually. In the instant case, these associate companies have incurred substantial losses and have been referred to BIFR for being declared as sick companies. The net worth of these companies would have been wiped out resulting in a fall in the value of the investments. Therefore, such fall cannot be merely temporary as the companies could take a long time to turn around (if at all) and again have positive net worth. The auditor would therefore have to qualify his report by saying that no provision for diminution for all in the value of investments as required by AS 13 has been made and to that extent the profits and reserves have been overstated.

2. (a) In respect of the government Audit, the institute has come across certain circulars/orders issued

by the Registrar various State Co-operative Societies wherein it has been mentioned that certain amount of audit fee is payable to the concerned State Govt. and auditor has to deposit a percentage of his audit fee in the state Treasury by a prescribed challan within a prescribed time of the receipt of Audit fee. In view of the above, the Council considered the issue and while noting


that the Government is asking auditors to deposit such percentage of their audit fee for recovering the administrative and other expenses incurred in the process, the Council decided that as such there is no bar in the Code of Ethics to accept such there is no bar in the Code of Ethics to accept such assignment wherein a percentage of professional fees is deducted by the government to meet the administrative and other expenditure.

(b) Clause (4) of Part-I of First Schedule to the CA Act, permits partnership between members of the

institute and the members of the RECOGNIZED foreign professional bodies which are recognized by the Council or by the Central Government. In this case if the other member is from a recongnized professional body then X is not guilty.

(c) Advertisement of professional attainments: Clause 7 of Part I of the First Schedule to the

Chartered Accountants Act, 1949 prohibits advertising of professional attainments or services of a member. It also restrains a member from using any designation or expression other than that of a Chartered Accountant in documents through which the professional attainments of the member would come to the notice of the public. Even a member is not permitted to specify the date of setting up of practice or establishment of firm. However, there is no prohibition for printing names of all the three firms on the personal letterheads in which a member holding Certificate of Practice is a partner. Thus B is not guilty of any misconduct under the Chartered Accountants Act, 1949.

(d) Appointment as statutory auditor of a PSUs’ / Govt. company / companies / listed company /

companies and other public company / companies: In exercise of the powers conferred by clause (ii) of part II of the second schedule to the CA Act, 1949, the Council of ICAI specifies that a member of the institute in practice shall be deemed to be guilty of professional misconduct if he accepts the appointment as a statutory auditor of a PSUs’ / Govt company/companies/listed company/companies and other public company/companies having a turnover of ` 50 crores or more in a year and accepts any other works or assignments or services in regard to same undertakings on a remuneration which in total exceeds the fee payable for carrying out the statutory audit of the same undertaking. Since the turnover of the company is less than ` 50 crore this clause does not apply to this situation and hence he can accept the special assignment (management consultancy).

3. (a)

(i) The pass collected by the gate man can be checked against total sale of ticket as per the counter foils of ticked books. Any presentation of unauthorized tickets will be known; also the patrons will carry with them the evidence of their authorized entry into the exhibition hall by retaining the stub.

(ii) It provides an independent record with the Accounts Department about daily issue and actual forwarding of cheques.

(iii) The quality inspector should not know the supplying party in the interest of an objective quality inspection.

(iv) It records actual attendance to the work and also helps to keep check on wastage of time in reaching his work spot.

(v) It avoids conflict of interest


(vi) It enables exercise of control over tips and consumption of control; also unauthorized trips or excessive consumption of petrol may be known at an early date.

(b) Problems in implementation of internal control in EDP systems: The internal controls over

computer processing, which help tot achieve the overall objectives of internal control, include both manual procedures and procedures designed into computer programs. Such manual and computer control procedures comprise the overall controls affecting the EDP environment (general EDP controls) and the specific controls over the accounting applications (EDP application controls). The following problems normally arise in implementation of internal control in an EDP system:

1. Separation of duties: In a manual system, separate individuals are responsible for initiating

transactions, recording them and the custody of the assets. This separation of duties helps in preventing or detecting errors and other irregularities. In the EDP environment, this traditional segregation of duties may not always apply. For eg. A program may reconcile a vendor invoice against a receiving document and print a cheque for the amount owed to a creditor. Thus, the program is performing functions that in a manual systems would be considered incompatible.

2. Delegation of authority and responsibility: Normally a clear line of authority and

responsibility is essential aspect of control in any system. In a computer system, however, delegating authority and responsibility may prove difficult because some resources, are shared among multiple users. When multiple users have access to the same data, it is not always easy to trace or find out who is responsible for any corruption of the data and for identifying and correcting errors. Some organizations have attempted to overcome these problems by designating a single user as the owner of date. This user assumes ultimate responsibility for the integrity of the data.

3. Competent and trustworthy personnel: A good EDP system requires competent and

trustworthy personnel for its flawless operation. Highly skilled personnel are needed to develop, modify, maintain and operate the computer systems. Getting competent and trustworthy personnel for working in the EDP environment is, however, difficult as well-trained and experienced people in this field are normally in short supply.

4. System of authorizations: Any good system of internal control has a system of authorizations

at various levels. General authorizations establish policies for the organization to follow; for eg. A fixed price list is issued for personnel to use when products are sold. Specific authorizations apply to individual transactions; for eg. Acquisitions of major capital assets may have to be approved by the board of directors. In a manual system, auditors can evaluate the adequacy of procedures for authorization by examining the work of employees. In a computer system, however, the procedures are often embedded within a computer program. In such a case when evaluating the adequacy of authorization procedure, auditors will not only have to examine the work of the employees but also find out the veracity of program processing.


5. Adequate documents and records: In a manual, adequate documents and records are necessary to provide an audit trail of the various activities within the system. In a computer system, however, documents may not be used to support the initiation, execution and recording of some transaction. There would be therefore no visible audit trail to trace a transaction. This absence of a visible audit trail will not hinder the auditor’s work if systems are designed to maintain a record of all events and there is a means of accessing these records. The auditor therefore needs to find out whether the computer system environment provides for such a record of the events and also enables access to the records.

6. Physical control over assets and records: Physical control over access to their assets and

records is critical in both manual systems as well as computer systems. In computer systems, however, there is a concentration of the data processing assets and records of an organization. This means that in such an environment, if any fraud is to be perpetrated, the person does not have to go to long distances but only have access to the computer systems. Hence it is important that a good EDP environment restricts access to the data processing assets and records.

7. Adequate management supervision: In a manual system, the management supervision of

employee activities is relatively simple because the managers, and employees are often at the same physical location. In computer systems, however, the employees handling the data processing may be remotely located. Supervisory controls must therefore be built into the computer system to compensate for the controls that usually can be exercised through observation and inquiry.

8. Comparing recorded accountability with assets: In any good system, the data and their

assets that the data purports to represent should be compared to determine the completeness and accuracy of the data. In a manual system, there is normally an independent staff to prepare the basic data for such comparison. In a computer system, however, programmes are used to prepare this data. Therefore, care must be taken that there are no unauthorized modifications to this programs or to any of the data files database programs use otherwise the irregularity may not be discovered.

4. (a) Due Diligence - Key Areas: The American company engaged in the business of manufacturing

and distribution of industrial gases wishing to acquire a listed Indian company has commissioned the Due Diligence Audit to assess the strengths and weaknesses of this company. It is quite important for the acquirer to assess the proposal from different angles and specifically as per terms of the assignment and also see whether proposed merger would create operational synergies. On the other hand, financial due diligence review would be performed after the commercial valuation. Accordingly, while a preliminary review might be performed during initial stages of the restructuring exercise and may in fact, be performed simultaneously with the commercial evaluation, at a later stage, financial due diligence may be performed on the books of account and other information directly pertaining to the financial matters of the entity. In addition, a legal due diligence may be required where legal aspects of functioning of the entities are reviewed; for example, the legal aspects of property owned by the entity or compliance with various statutory requirements under various laws. Like other due


diligence exercises, environmental and personnel due diligence are also carried out in order to establish whether various propositions with regard to environment and personnel of the enterprise under review are appropriate. In any case, it is quite important to look behind the veil of initial information provided by the company and to assess the benefits and costs of the proposed acquisition/merger by inquiring into all relevant aspects of the past, present and future of the business to be acquired. Some of the significant key areas which shall be covered under the review are as under:

• Historical Background • Significant Accounting Policies • Review of Financial Statements • Cash Flow • Financial Projections • Human Resources • Statutory Compliance

Contents of a Due Diligence Report: Briefly, the contents of a due diligence report can be discussed

under: • Terms of reference and scope of verification • Objective of due diligence • Brief history of the company including shareholding pattern • Assessment of management structure • Assessment of financial liabilities with special emphasis on Interlocking investments and

financial obligations with group/associates companies, amounts receivables subject to litigation, any other likely liability which is not provided for in the books of account.

• Assessment of valuation of assets including comments on properties, terms of leases, lien and encumbrances including status of charges, liens, mortgages, assets and properties of the company.

• Assessment of operating results • Assessment of taxation and statutory liabilities • Assessment of possible liabilities on account of litigation and legal proceedings against

the company and suggestion on ways and means including affidavits, indemnities, to be executed to cover unforeseen and undetected contingent liabilities.

• Assessment of net worth. • Suggestions on various aspects to be taken care of before and after the proposed merger

/ acquisition. • Status of franchises, license and patents. • Finally, an executive summary may be prepared highlighting the significant areas.

(b)

(i) It is not a prudent practice to treat dividend on shares of corporate bodies and units of mutual funds as income unless these are actually received. Accordingly, income from dividend on shares of corporate bodies and units of mutual funds should be booked on cash basis. In respect of income from government securities and bonds and debentures of corporate bodies, where interest rates on these instruments are pre-determined, income could be booked on accrual basis, provided interest is serviced regularly and as such is not in arrears. It was further, however, clarified that banks may book income on


accrual basis on securities of corporate bodies/public sector undertakings in respect of which the payment of interest and repayment of principal have been guaranteed by the central government or a State government. Banks may book income from dividend on shares of corporate bodies on accrual basis, provided dividend on the shares has been declared by the corporate body in its annual general meeting and the owner’s right to receive payment is established. This is also in accordance with AS 9 as well. In the instant case, the recognition of income by the bank on accrual basis is not in order.

(ii) It is wrong to take the Balance sheet date for purposes of classification. In this context, it

is important to note the concept of past due. An amount should be considered as past due when it remains outstanding for 30 days beyond due date. For eg. If any SSI loan mount, the repayment of term loan installment falls due for payment on December 31 and is not paid; the amount would become past due if it remains unpaid for 30 days beyond that date. In case of terms loans, if interest or installment of principal is in arrears for any two quarters out of four quarters although default may not be continuously for two quarters during the year by applying past due test, it should be classified as non-performing asset and from that date provision should be made. In the case of other advances, outstanding in the last two quarters would be enough to classify the amount as such non-performing asset if no transaction appears in the last two quarters.

As per RBI circular dated January 29, 1997, if the account of the borrowers have been regularized before the balance sheet date by repayment of overdue amounts through genuine sources and not by sanction of additional facilities, the account need not be treated as NPA in spite of payment of interest and installment were in arrear for two quarters. Bank should, however, ensure that the account remains in order subsequently and a solitary credit entry made in the account on or before the balance sheet date which extinguished the overdue amount of interest or instalment of principal is not reckoned as the sole criterion for treating the account as a standard asset.

It has been further clarified that in respect of accounts where there are potential threats of recovery on account of erosion in the value of security or non-availability of security and existence of other factors such as frauds committed by borrowers, it will not be prudent for banks to classify them first as sub-standard and then as doubtful after expiry of two years from the date of account has became NPA. It should be straight way classified as doubtful asset or loss asset, as appropriate, irrespective of the period for which it has remained as NPA.

5. (a)

(i) Para 4(XV) of CARO, 2003 requires the auditor to state in his report whether the company has given any guarantee for loans taken by others from bank or financial institutions, the terms and condition whereof are prejudicial to the interests of the company. The auditor should examine the Memorandum of Association to determine whether the company has the power to give guarantee. The auditor should also examine the minute book and register of guarantee to ascertain whether guarantee has been issued under the sanction of competent authority. The auditor should also verify compliance with requirements of section 295 and 372A of the Companies Act, 1956. It should also be ensured that the guarantee given is shown as contingent liability.


In determining whether the guarantee is prejudicial to the interest of the company, the auditor should consider financial standing of the party, nature of security offered, etc. in this case, since financial condition of the company on behalf of whom guarantee is given is not so good, the auditor may consider expressing an opinion that the terms and conditions on which the company has given guarantees for loans taken by the sister concern, ie. M/s B Ltd., is prejudicial to the interests of the company.

(ii) Para 4(ii) (a) of CARO, 2003 requires the auditor to state in his report whether physical

verification of inventory has been conducted at reasonable interval by the management. Physical verification of inventory is the responsibility of the management which should verify all material items at least once in a year and more often in appropriate cases. The auditor in order to satisfy himself about verification at reasonable intervals should examine the adequacy of evidence and record of verification. In the given case, the above requirement of CARO, 2003 has not been fulfilled as such and the auditor should point out the specific areas where he believes the procedure of inventory verification is not reasonable. He may consider the impact on financial statement and report accordingly.

(iii) Para 4(X) of CARO, 2003 requires the auditor to state in his report in respect of a company which

is in existence for more than 5 years from the date of registration: • Whether the accumulated losses at the end of the year are more than 50% of its net worth

and • Whether it has incurred cash losses during the current year and the immediately preceding

financial year. In the instant case, since the company is covered by the above requirements, there are symptoms of potential sickness and thus, auditor should report the same. It is, however, to be assumed that the company is in existence for more than 5 years.

(b) Draft of a Report of an Engagement to Compile Financial Statements – SRS 4410 To…..

On the basis of the accounting records and other information and explanations provided to us by the management, we have complied, the unaudited balance sheet of …………..(name of the entity) as at March 31, XXXX and the related profit and loss account and the cash flow statement for the period then ended. The management of the ……………(name of the entity) is responsible for:3 (i) Completeness and accuracy of the underlying data and complete disclosure of all material

and relevant information to the accountant. (ii) Maintaining adequate accounting and other records and internal controls and selecting and

applying appropriate accounting policies; (iii) Preparation and presentation of financial statements in accordance with the applicable laws

and regulations, if any. (iv) Establishing controls to safeguard the assets of the entity and preventing and detecting

frauds or other irregularities. (v) Establishing controls for ensuring that the activities of the entity are carried out in

accordance with the applicable laws and regulations and preventing and detecting any non compliance.

The compilation engagement was carried out by us in accordance with the standard on Related Services (SRS) 4410, engagements to compile financial information issued by the ICAI.


The balance sheet and profit and loss account are in agreement with the books of account. We have not audited or reviewed these financial statements and accordingly express no opinion thereon.

For XYZ & Co., Chartered Accountants ………………………….. (Name of the accountant and membership number) Signature

Designation

6. (a) The ratios which are to be calculate for manufacturing entities are: • Gross profit / Turnover • Net profit / Turnover • Stock-in-trade / Turnover • Material consumed / Finished goods provided

Ratio analysis constitutes a substantive auditing procedure designed to obtain evidence as to the completeness accuracy and validity of the data produced by the accounting system. Such assessment is necessary in organization having large volumes of transactions and in the organization following mechanised accounting system where it is not possible to check each and every transaction. It has the merit of bringing to focus the abnormal deviations and unexpected variations which the normal routine checking in auditing may fall to reveal. Ratios highlight only symptoms and that too as of a particular day and the auditor should study these symptoms properly, correlate them and reach definite conclusions or identify areas for further enquiries. The auditor should by relating sales with the net profit, various items of direct and indirect costs and gross profit gather information about the profitability and operating efficiency of an enterprise variations in any of these ratios in a particular year should be inquired by the auditor. The fall in the gross profit ratio and profitability ratio should alert the auditor who should ask the management for the reasons thereof and which should be carefully examined by him. The auditor should by relating sales with the net profit, various items of direct and indirect cost and gross profit gather information about the profitability and operating efficiency of an enterprise variations in any of these ratios in a particular year should be inquired by the auditor. The fall in the gross profit ratio and profitability ratio should alert the auditor who should ask the management for the reasons thereof and which should be carefully examined by you.

These ratios have to be given for the business as a whole and not product wise. While calculating these ratios, the tax auditor should assign a meaning to the terms used in the above ratios having due regard to the generally accepted accounting principles. All the ratios mentioned in the clause are to be calculated in terms of value only. The relationship of stock-in-trade to turnover over a period of time would reveal whether the entity has been accumulating stocks or there is a decline in the same. The auditor may obtain data for about 7-10 years, compute ratio of stock-in-trade /turnover and plot it on a graph paper over a period of time. This may give rise to several possibilities such as parallel horizontal lines, vertical rising line or a vertical falling line. A study of this relationship would reveal whether stocks are being accumulated or they are dwindling over a period. Such information would provide an input to tax auditor as to whether figures of either stock or turnover are being manipulated. Sometimes, while studying the relationship, it may show sudden decline or increase at a point of time which reflect that there is definitely something wrong with the figures of stock. Therefore, a close examination of such ratios helps the tax auditor to focus on major deviations and consequently reasons for the same.


(b) (i) Evaluate internal control system in the area of reinsurance ceded to ensure determination of

correct amount for reinsurance ceded, proper valuation of assets and liabilities arising out of reinsurance transaction and adherence to legal provisions and regulations.

(ii) Ascertain whether adequate guidelines and procedures are established with respect to obtaining reinsurance.

(iii) Reconcile reinsurance underwriting returns received from various units with the figures of premium, claims paid and outstanding claims for the company as a whole.

(iv) Examine whether commission on reinsurance ceded is as per the terms of the agreement with the re-insurers.

(v) Examine the computation of profit commission for automatic treaty arrangements in the light of the periodic accounts rendered and in relation to outstanding loss pertaining to the treaty.

(vi) Examine whether loss recoveries have been claimed and accounted on a regular basis. (vii) Examine whether outstanding losses recoverable have been confirmed by re-insurers (viii) Examine whether remittances to foreign re-insurers are as per foreign exchange regulations. (ix) Examine whether confirmations have been obtained regarding balances with re-insurers. (x) Review individual accounts of re-insurers to evaluate whether any provision/write off or write

back is required. 7. (a) A rolling settlement is one in which a transaction outstanding at the end of the day have to be

settled with X number of business days from the transaction date. If a transaction is entered on Monday on T+2 rolling settlement, it will be settled on Wednesday when pay in or payout take place. SEBI has mandated most of the scrips to be settled exclusively on rolling settlement basis. Value at Risk (VaR) based margin approach has been adopted for transactions done in Compulsory Rolling Settlement. In the VaR system of margin percentage for a scrip. If a member fails to deliver the shares sold in rolling settlement, the exchange conducts an auction session to meet the shortfall credited by non-delivery of shares. If the price/close out price is less than the sale price, the difference is credited to Investor’s Education and Protection Fund. If the sale price is less than the auction price / close out price, the difference is payable by the defaulters.

(b) General principles to be confirmed by propriety

(i) The expenditure is not prima facie more than the occasion demands and that every official exercises the same degree of vigilance in respect of expenditure as a person of ordinary prudence.

(ii) That the authority exercises its powers of sanctioning expenditure which will not result in any benefit directly or indirectly to such authority.

(iii) That the funds are not utilised for the benefit of a particular person or group of persons and (iv) That, apart from the agreed remuneration or reward, no other revenue is kept open to

indirectly benefit the management personnel, employees or others.

(c) Solutions to behavioural problems: (i) To demonstrate that audit is part of an overall programme of review for protective and

constructive benefit.


(ii) To demonstrate the objective of review is to provide maximum service in all feasible managerial dimensions.

(iii) To demonstrate the review will be with minimum interference with regular operation. (iv) The responsible officers will be involved in the process of review of the findings and

recommendation before the audit report is formally released.

It is essential to create an atmosphere of trust and friendliness so that audit reports will be understood in their proper perspective. Finally it needs hardly any emphasis that there should be right management culture, enlightened auditees and auditors of the right caliber. May be to expect a combination at all times of all the three is asking for the impossible. But, a concerted effort by the management, auditors and auditees to achieve more acceptable climate would go a long way to achieve the goals.

(d) In haphazard selection, the auditor selects the sample without following a structured technique.

Although not structured technique is used, the auditor would nonetheless void any conscious bias or predictability for eg. Avoiding difficult to locate items or always choosing or avoiding the first or last entries on a page and thus attempt to ensure that all items in the population have a chance of selection. Haphazard selection is not appropriate when using statistical sampling. Haphazard selection of sample, may be an acceptable alternatives to random selection of sample, provided the auditor attempts to draw a representative sample from the entire population with no intention to either include or exclude specific units. When the auditor uses this method, care needs to be taken to guard against making a selection that is biased, for eg. Towards items which are easily located, as they may not be representative.

(e) True and Fair cost of Production

A cost auditor checks the cost accounting records to verify that the cost statement are properly drawn up as per the records and that they present a true and air view of the cost of production and marketing of various products dealt with by the undertaking. The Cost Audit (Report) Rules, 1996 as amended in 2001, prescribe the rules regarding the cost audit report. The prescribed format of the report contains assertions regarding whether cost accounting records have been properly kept so as to give a true and fair view of the cost of production / processing / manufacturing / mining activities and marketing of the product under reference. It may be noted that unlike in the case of audit of financial statements, the cost auditor does not have to state whether the cost statements reflect a true and fair view. In any case, the true and fair concept is known to us in the context of financial accounts. Based on that knowledge, it may be assumed that the following are the relevant considerations in determining whether the cost of production determined is true and fair.

(i) Determination of cost following the generally accepted cost accounting principles (ii) Application of the costing system appropriate to the product. (iii) Materiality (iv) Consistency in the application of costing system and cost accounting principles (v) Maintenance of cost records and preparation of cost statements in the prescribed form and

having the prescribed contents. (vi) Elimination of material prior-period adjustments (vii) Abnormal wastes and losses and other unusual transactions being ignored in determination

of cost.


PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL – CORPORATE AND ALLIED LAWS

QUESTION PAPER

CEAS No. of Pages: 4 Total Marks: 100 No of Questions: 7 Time Allowed: 3 Hrs

Question No.1 is compulsory. Answer any 5 from the rest 1.

(a) The Articles of Association of DEN Ltd mentioned in it that Mr. X and Mr. Y will act as Director of the company from the date of incorporation. The company was incorporated on 2nd January, 2007. The articles also provided that the directors will have to obtain qualification shares within 1 month from the date of appointment as Director. Mr. X purchased the shares of the company on 28th February, 2007 and Mr. Y purchased on 28th March, 2007, thus violating the provisions contained in the articles. Having regard to the provisions of the companies Act. Examine the validity of the appointments of Mr. X and Mr. Y as directors. (5 Marks)

(b) The Board meeting of MURARI Ltd. was held on 10th May, 2008 at Chennai at 11 a.m. At the time of starting the board meeting the numbers of the directors present were 7. The total numbers of directors were 10. The board transacted ten items in the board meeting. At 12 noon after the completion of four items in the agenda 4 directors left the meeting. Examine the validity of these transactions explaining the relevant provisions of the Companies Act, 1956.

(5 Marks)

(c) RSQ Ltd is holding 33% of the paid up equity capital of Coya stock exchange. The company appoints LMN Ltd as its proxy who is not a member of the Coya stock exchange to attend the vote at the meeting of the stock exchange. Examine whether the Coya stock exchange can restrict the appointment of LMN Ltd. as proxy for RSQ Ltd. and further restrict, the voting rights of RSQ Ltd. In the Coya stock exchange.

(5 Marks)

(d) Park Airways Limited appointed Mr. Santhosh as its auditor in the Annual General Meeting held on 30th September, 2010. Initially, he accepted the appointment. But he resigned from his office on 31st October, 2010 for personal reason. The Board of Directors seeks your advice for filing up the vacancy by appointment of Mr. Robert as auditor. Advise.

Also suggest the procedure to be adopted in case Mr. Robert is proposed to be removed from his office before the expiry of his term.

(5 Marks)


2. (a) Mr. BALARAM desires to draw foreign exchange for the following purpose:

(i) Payment related to ‘call back services’ of telephones (ii) USD 1, 20,000 for studies abroad on the basis of estimates given by the foreign

university. (iii) USD 25,000 for sending a cultural troup on a tour of Europe. (iv) USD 20,000 to make donation to a charitable trust situated in South Africa.

Advise him, whether he can get foreign exchange and if so, under what conditions. (8 Marks)

(b) (i) MSS Private Ltd is a company in which there are eight shareholders. Can a member

holding less than one-tenth of the issued share capital of the company apply to the Company law Board for relief against oppression and mismanagement?

(ii) It is alleged by said member that the directors of the Company have misused their position in making certain inter-corporate deposits which are against the interests of the company. Will the Company Law Board entertain application containing such allegation in the case of a private ltd company?

(8 Marks) 3.

(a) Mr. PAT is a member of PRAM Ltd. He obtains an order against the company for redressal of his grievances against the company. But the company fails to redress the grievances of DB within the time fixed by the SEBI. The board thereafter imposed penalty upon the company U/s 15C of the SEBI Act. PRAM Ltd. seeks your advice whether it has any remedy against the order of SEBI. Advise.

(8 Marks)

(b) Explain the meaning of the word ‘Statute’ and discuss the need for interpretation of any statute citing an example in the case of holding the Annual General Meeting of a company where more than one prescribed time is given in the Companies Act, 1956.

(8 Marks) 4.

(a) A public Company has been declaring dividend at the rate of 20% on equity shares during the last five years. The company has not made adequate profits during the year ended 31st March, 2010, but it has got adequate reserves which can be utilized for maintaining the rate of dividend at 20%. Advice the company as to how it should go about if it wants to declare dividend at the rate of 20% for the year 2009- 10. Would your answer be different if the company utilized only the profits made in the previous years and retained in the profit and loss account for the purpose of payment of dividend at the rate of 20% for the year 2009-2010?

(8 Marks) (b) Mr. Nanokar holding 3% shares in DELIGHT Ltd., become a director of this company on

1.5.2000. The company, prior to his appointment as director, had commenced transactions with LINK Ltd. In the next Board Meeting to be held on 10-5-2000, the Board proposes to discuss about price revisions sought for by LINK Ltd. Briefly explain:


(i) Whether Mr. Nanokar should make a disclosure of interest in LINK Ltd., assuming that the company is going to have transactions with LINK Ltd. On a continuous basis: if yes when and how? When should it be renewed?

(ii) Can he vote in the price revision resolution in the Board Meeting? You are informed that Mr. Nanokar holds 1.5%of the share capital of LINK Ltd and that his wife holds another 3% of the share capital of Link Ltd.

(8 Marks) 5.

(a) Analyse and Advise with reference to the provisions of the Companies Act, 1956, the following situations.

(i) The Articles of a company want to fix the quorum for the Board Meeting. (ii) There are 9 directors in a company and out of which 2 offices of the directors have

fallen vacant. What will be the quorum for the board meeting? (iii) There are15 directors in a company and during discussion of a particular item, 13 of

the directors are said to be “interested”. What shall be quorum of the meeting? (iv) Continuing with above situation, what will be your advice, when all the 15 directors are

said to be interested in the concerned resolution? (v) What are the situations, when interested directors will be counted for the purpose of

counting quorum for the meetings of the board? (8 Marks) (b) PRASHANT Limited, a private company, has been converted into a Public company under

provision of the Companies Act, 1956. The company proposes to constitute an audit committee. Taking into account the provisions of the Companies Act, 1956 draft a board resolution covering the following matters:

(i) Member of the audit committee. (ii) Chairman of the audit committee. (iii) Quorum for meeting of the said committee. (iv) Any two functions of the said committee.

(8 Marks) 6.

(a) Advise the Board of Directors of a Public company about their powers in respect of the following proposals explaining the relevant provisions of the Companies Act, 1956:

(i) Donation of Rs. 5,00,000 to a hospital established exclusively for the benefit of employees. (ii) Buy- back of shares of the company for the first time upto 9% of the paid-up equity share

capital. (iii) Delegating to the managing director of the company the power to invest surplus funds of

the company in the shares of some companies. (8 Marks)


(b) Mr. Stanes, a Chartered Accountant is a director in PSR Ltd. The company proposed to appoint/ engage the firm Strong & Co. in which Mr. Stanes is a partner in one or more of the following capacities

(i) Consultants on regular retainer basis. (ii) Authorized representatives to appear before tribunals.

Discuss whether the provisions of Section 314 of the companies Act are attached in the above situations

(8 Marks)

7. (a) The High Court at Chennai appointed the official liquidator as the liquidator of Impex Electrical

Company Limited. Some of the creditors have brought to the notice of the liquidator that though the company is in liquidation for the past several years, nothing worthwhile has been done to speed up the winding up and no documents have been filed to indicate the progress of liquidation. Examine in this connection the nature and periodicity of returns required to be field by the Liquidator in terms of the provisions contained in the Companies Act.

(8 Marks) (b) Mr. ALAGO is a director in a bank. The Reserve Bank of India terminates him on the ground

that his conduct is detrimental to the interests of the depositors. Decide, whether the Reserve Bank of India can do so under the Banking Regulation Act, 1949. Can the Reserve Bank of India appoint additional director in a bank under the said Act?

(8 Marks)


PRIME ACADEMY 32ND SESSION MODEL EXAM - FINAL – CORPORATE AND ALLIED LAWS

SUGGESTED ANSWERS

1. (a) Without prejudice to the restrictions imposed by Section 266, it shall be the duty of every director

who is require by the articles of the company to hold a specified share qualification and whom is not already qualified in that respect, to obtain his qualification within two months after his appointment as director [Section 270(1)]

So it becomes incumbent on the part of every director to hold qualification shares within the time specified and if he does not hold the same at the time of his appointment as director he must acquire them within two months after his appointment as director. Any provision made in the article of the company requiring a person proposed for directorship to hold qualification share either before appointment or within the shorter than two month after his appointment will be void.

Here the provision in the article of association to hold shares within one month shall be void. Keeping the above provision in consideration the appointment of Mr. X will be valid as he acquired the share before the expiry of two months. As far the appointment of Mr. Y is concerned he has failed to acquire the share within two month period. As per section of 283(1)(a) the office of director shall become vacant if he fails to obtain the shares within the time specified in section 270(1) therefore Mr. Y shall have to vacate his office. Here the date of incorporation is taken as the date of appointment.

(b) Section 287 of the Companies Act, 1956 provides for the quorum for meeting. The quorum for a

meeting of the Board of Directors of a company shall be one third of its total strength (any fraction contained in the said one third being rounded off as one), or two directors, whichever is higher. Where at any time the number of interested directors exceeds or it’s equal to two thirds of the total strength, the number of remaining directors, that is to say, the number of directors who are not interested present at the meeting being not less than two shall be the quorum during such time. In this case, the quorum is 4 (i.e. 1/3rd of 10=3 1/3 rounded off as 4). Hence, the quorum was present at the time of commencement of meeting.

As a rule, in the case of a meeting of the Board of Directors, the meeting cannot transact any business, unless a quorum is present at the time of transacting the business. It is not enough that a quorum was present at the commencement of the business.

The quorum of the Board is required at every state of the meeting and unless a quorum is present at every state, the business transacted is void. (Balakrishna vs. Balu Subudhi AIR 1949 Pat 184). In the given situation, four items were transacted with the quorum and thus they are valid. Six items were transacted after 4 Directors left the meeting resulting in the reduction of quorum as only 3 Directors were present as against the required quorum of 4 Directors. Such six transactions are void.

(c) Section 7(a) of the securities( Contracts) Regulation Act, 1956 provides that a recognized stock

exchange is empowered to amend rules to provide for all or any of the following matters: (i) Restrictions of voting right to members only.


(ii) Regulations of voting rights by specifying that each member is entitled to one vote only irrespective of number of shares held.

(iii) Restrictions on right of members to appoint proxy. As such Coya stock exchange can restrict the appointment of LMN Ltd., as proxy, if rules of the exchange so provide. If it is not so provided rules may be amended and after getting approval of the Central Government regarding amendment, it can restrict appointment of proxies. Coya stock exchange can also restrict the voting rights of RSQ Ltd. As proxy if rules of the exchange so provide. If it is not so provided, rules may be amended and after getting approval of Central Government regarding amendment, it can restrict appointment of proxies.

Coya stock exchange can also restrict the voting rights of RSQ Ltd.

(d) Under section 224(6) of the Companies Act, 1956, the Board may fill any casual vacancy in the

office of an auditor. However, where such vacancy is caused by resignation of an auditor, the vacancy shall be filled by the company in general meeting. Thus , in the present case, the company may convene an Extraordinary General Meeting to appoint Mr. Robert as its auditor consequent upon the resignation by Mr. Santhosh.

In term of section 224(7) of the Act, 1956 Mr. Robert may be removed from office before the expiry of his term only by the Company in General Meeting after obtaining previous approval of the Central Government.

2.

(a) Current Account Transactions: The Central Government in consultation with RBI framed Regulation known as Foreign

Exchange Management (Current Account Transaction) Regulation, 2000. Under these regulations certain transactions are prohibited, certain transactions require Central Government approval and certain transactions require RBI approval.

(i) Payment related to ‘call back services’ of telephone is totally prohibited under schedule 1

of Foreign Exchange Management (Current Account Transaction) Regulations. (ii) Remittance of Foreign Exchange of studies abroad:

This is a schedule III transaction. Foreign exchange may be released for studies abroad up to a limit of USD 1, 00,000 or the estimates from the institution abroad, whichever is higher. Above this limit RBI’s approval is required. In this case USD 1, 20,000 is required on the basis of estimates of the institutions abroad. Hence no permission from RBI is required.

(iii) Cultural troup:

This is a schedule II transaction. Irrespective of the amount involved prior approval of Central Government, Ministry of HRD (Dept. of Education and culture) is required. However no permission is required in case of remittance out of Resident Foreign Currency (RFC) Account or (Exchange Earner’s Foreign Currency) EEFC Account.


(iv) Making donation exceeding USD 10,000 per annum per beneficiary require Reserve Bank of India’s prior approval. Therefore BALARAM can draw USD 20,000 to make donation after taking prior approval form Reserve Bank of India.

(b) (i) Under Section 399 (1) (a) of the Companies Act, 1956, in the case of a company having

share capital, the following members(s) have the right to apply to the Company Law Board under Section 397 or 398:

(i) Not less than 100 members of the company or not less than one-tenth of the total number of members, whichever is less ; or

(ii) (ii) Any member or members holding not less than one-tenth of the issued share capital of the company provided the applicant (s) have paid all the calls and other sums due on the shares.

In the given case, since there are eight shareholders. As per (i) above, 10% of 8 i.e. 1 satisfies the condition. Therefore a single member can present a petition to the Company Law Board regardless of the fact that he holds less than one-tenth of the company’s share capital.

(ii) As regards the proprietary rights in inter corporate loans by a private company; they are not closely regulated by Company Law as in the case of public companies. Though the Board of Directors are the best to judge and to take a commercial decision in this regard, if it is mala fide, it should be looked into. Therefore the Company Law Board can look into the allegation lodged by the member.

3.

(a) Section 15C of Securities Exchange Board of India Act, 1992 lays down that if any listed company are any person who is registered as an intermediary, after having been called upon by the board in writing to redress the grievances of investors, fails to redress such grievances within the time specified by the board, such company are intermediary shall be liable to a penalty of one lakh rupees of each day during which such failure continues or one crore rupees, whichever is less.

PRAM Limited was penalized under the provision of above- mentioned section. Now two remedies are available to PRAM Limited in this matter:

(i) Appeal to the Securities Appellate Tribunal: Section 15T of the SEBI Act, 1992 provides that

any person aggrieved by an order of the board made, on and after the commencement of the security laws (second amendment) Act 1999, under this Act or the rules or regulations made the under may prefer an appeal to a Securities Appellate Tribunal having jurisdiction in the matter.

Such appeal shall be filed within a period of 45 days from the date on which a copy of the order made by the board is received and it shall be in such form and be accompanied by such fee as may be prescribed. However the tribunal may entertain an appeal after the expiry of the said period of 45 days if it is satisfied that there was sufficient cause for not filling it within the said period.

The tribunal may, after giving the parties and opportunity of being heard, pass such orders as it thinks fit, confirming, modifying or setting aside the order appealed against.


(ii) Appeal to the Supreme Court: Section 15Z of the SEBI Act, 1992 provides that any person aggrieved by any decision are an order of the Securities Appellate Tribunal may file an appeal to the Supreme Court within 60 days from the date of communication of the decision or an order to him on any question of law arising out of such order the Supreme Court may, if it is satisfied that the Appellate was prevented by sufficient cause from filing the appeal within the said period, allow it to be filed within a further period not exceeding 60 days.

(b) The word ’Statute’ generally means the laws and regulations of every sort without considering

from which source they emanate. It has been defined as the written will of the legislature solemnly expressed according to the forms necessary to constitute it the law of the State. Normally, the term denotes an Act enacted by the legislative authority (e.g. Parliament of India)

Even though the laws are drafted by legal experts, yet they are expressed in language and no language is so perfect as to leave no ambiguities. Since a statute is an edict of the legislature, many time the intent of the legislature has to be gathered not only from the language but the surrounding circumstances that prevailed when the law was enacted. Further if any provision is opened to two interpretations, the court has to choose that interpretation which represents the time intention of the legislature.

In the case of holding an annual general meeting of a company three different periods have been given as stated.

(i) The meeting should be held in every calendar year( section 166(1)) (ii) The gap between the two meetings should not be more than 15 months. (Section

166(1)) (iii) The meeting should be held with 6 months from the close of the financial year of the

company (section 210(3))

The above said three requirements are cumulative and separate. Failure to comply with any of them constitutes an offence. Therefore to give effect to all the provisions, they are to be interpreted harmoniously.

4. (a) As per rule 2 of the Companies (Declaration of Dividend out of Reserves) Rules, 1975 dividend

may be declared by a company for any year out of the accumulated profits earned by it previous years and transferred by it to the reserves subject to certain conditions. One of the conditions is that the rate of dividend shall not exceed the average of the rates at which dividend was declared by it in 5 years immediately preceding that year or 10% of its paid-up capital which ever is less. As the proposed dividend exceeds 10%, it is necessary to seek the approval of the Central Government as required under section 205A (3) and only after obtaining the approval of the Central Government, the company may declare dividend at rate of 20% for year 2009-10, even if the other conditions relating to the amount that can be drawn from the reserves and minimum balance in the reserve are fulfilled. However, the credit balance, if any, carried in the profit and loss account will be available for declaration of dividend without any restriction. Hence in such a case dividend may be declared at the rate of 20% for 2009-10 without approval of the central Government.


(b) DELIGHT LTD entered into certain transactions (arrangement/contract) with LINK LTD. In which Mr. Nanokar is interested before his appointment as a director in Delight Ltd. The issue is whether Mr. Nanakar should disclose his interest in LINK LTD. Section 299(2) (b) of the Companies Act, 1956 applies to a case of contract or arrangement in which a person was concerned or interested before he becomes a director and also to a case of a contract or arrangement in which he becomes concerned or interest after he becomes a director. The words ‘becomes concerned or interested’ occurring in the provision denotes a present state of thing. In the case of a person who was actually concerned or interested in the contract or arrangement, the liability for disclosure arises the moment he accepts office as director (M.O Varghese v. Thomas Stephen &Co Ltd. (1970)40CC1131 Kerala )

Further, in this case, the Board proposes to discuss in the Board Meeting to be held on 10-5-2000 the price revision sought by Link Ltd.

In view of the above, Mr. Nanokar should make a disclosure of his interest in the first meeting to be held on 10-5-2000 after he became a director. Such disclosure may be made be general notice under section 299(3) to the effect that he is a member or a director of a specified body corporate. Such notice is valid only for the financial year in which it is given and therefore, it should be renewed in the last month of every year, where necessary. Another issue is whether Mr. Nanokar can vote in the price revision resolution in the Board Meeting. As per section 300(1), no director of a company shall, as a director, take any part in the discussion of, or vote on, any contract or arrangement entered into, or to be entered into, by or on behalf of the company, if he is in any way, whether directly or indirectly, concerned or interested in the contract or arrangement. As per sub-section(2) the provision of sub-section(1) shall not apply to any contract or arrangement entered into or to be entered into with a public company, in which the interest of the director aforesaid consists solely in his being a member holding not more than two percent of its paid-up share capital. In the given case, Mr. Nanokar is holding 1.5% of the share capital of A Ltd., and his wife is holding another 3% in the share capital of A Ltd. [The word solely is used in section 300(2) (d)]. Hence Mr. Nanokar should not participate and vote in the Board Meeting to be held on 10-5-2000.

5.

(a) A quorum is the prescribed minimum number of qualified persons authorised to transact the business at a meeting. In relation to a Board meeting quorum implies fully qualified and disinterested directors who must be present at the meeting so as to enable the Board of which they are the constituents to legally transact the business threat. In view of Section 287 which has fixed the quorum of the Board meeting, the Articles of Association of the company cannot fix the quorum for the Board meeting.

(b) Accordingly such a quorum is one third of the total strength of Board (any fraction contained in

the said one third being rounded off as one) or two directors whichever is higher. The total strength is to be derived after deducting the number of directors whose offices are vacant. Therefore, the Quorum = 1/3 (of the total strength vacancies). Where total number of directors are 9 and 2 offices of the directors have fallen vacant, we find: 1/3 of (9-2) = 1/3 of 7 = 21/3 directors. If the fraction of 3rd were to be rounded off as one then 3, i.e. 2+1 directors would constitute the quorum for the Board meetings. If at any time the number of the remaining


directors exceeds or is equal to two thirds of the total strength, the number of the remaining directors who are non-interested but present at the meeting, not being less than two shall constitute the quorum.

(c) For example, there are in all 15 directors and the Board meeting commences with all the 15

directors. During the currency of meeting, an item comes up for discussion in respect of which 13 happen to be “interested” directors. In this case, in spite of the excess of the interest directors being more than two-thirds, the prescribed minimum number of non-interested directors constituting quorum, namely 2, 2 present at the meeting are to transact the particular item of business.

(d) If all the 15 directors cited in the above illustration are equally interested in that particular item of

business and time is so vital that but for a decision thereon, the business of the company will be greatly hampered. How to resolve this impasse? The Act has not made any direct provision to take with such a situation, but the Article 848 of Table A of Schedule 1 of the Act, provides a remedy. According to the said article, the Board may, whenever it thinks fit, call an extraordinary general meeting. By invoking this Article, the Board should get the aforesaid impasse resolved by the shareholders at the general meeting. Since according to Section 173(1) (b), all business in the case of any other meeting than the annual general meeting is to be deemed special, by virtue of sub-section (2) the notice of the extraordinary meeting must annex to it a statement setting out all the material facts concerning the item of business, including, in particular, the nature of the concern or interest there in of every director.

(e) The interested directors are excluded from the computation of the quorum under Section 300(1). However, in the terms of Section 300(2), the interested directors can be counted for the purpose of quorum in the following cases, namely – (a) where the company is a private company which is neither a subsidiary nor a holding company of a public company; (b) where the company is a private company which is a subsidiary of a public company, in respect of any contract or arrangement thereof; (c) where there is any contract of indemnity against any loss which the directors or any one or more of them may suffer by reason of becoming or being sureties or surety for the company; (d) in respect of any contract or arrangement entered or to be entered into with a public company, or a private company, which is a subsidiary of a public company in which the director’s interest consist solely (i) in his being a director holding shares of such number or value as to be just enough and not more than enough to qualify him for appointment as director or (ii) in his being a member holding not more than 20% of the paid-up share capital of the company; (e) where it is a public company in respect of which the Central government has, through a notification in the official Gazette, waived the necessity to comply with the requirements of Section 300(1) on considerations of establishing or promoting any industry, business or trade in the public interest.


(b) AUDIT COMMITTEE- BOARD’S RESOLUTION: “Resolved that pursuant to section 292A of the companies Act, 1956 an Audit Committee consisting of the following directors be and is hereby constituted. 1. Mr. --------- Nominee of IDBI 2. Mr.----------Nominee of ICICI 3. Mr.---------Nominee of the SBI 4. Mr.------- 5. Mr. --------Managing Director. Further resolved that the chairman of the Audit Committee shall be elected by its members from amongst themselves.

Further resolved that the quorum for the meeting of the Audit committee shall be 1/3 rd of the total number of members or two directors (other than the Managing Director) whichever is higher.

Further resolved that the Audit Committee shall have the authority to investigate into any matter that may be prescribed under Section 292A of the companies Act, 1956 and any other matter that may be referred to it by the board from time to time.

Further resolved that the Audit Committee shall conduct discussion with the auditors periodically about internal control systems, the scope of audit including the observations of auditors.

Further resolved that the Audit Committee shall review the quarterly and annual financial statements and submit the same to the board with its recommendations if any”.

6. (a) (i) Donation to a hospital run exclusively for the benefit of employees of the company: The limit

of 5% of average net profits during the last 3 financial years is applicable only to contributions to charitable and other funds not directly relating to the business of the company or the welfare of the employees (Section 293(1)(e), Companies Act, 1956). Hence the Board is empowered to make the proposed donation to the hospital.

(ii) Section 292 has been amended by Companies (Amendment) Act, 2001 to facilitate buy back

of shares up to 10% of the total paid-up equity capital and free reserves (Section 292((i) (aa)). Hence special resolution in general meeting of the company is not required. Hence the proposed buy back of shares is in order provided other conditions laid down on section 77A are fulfilled.

(iii) Section 292 of the Companies Act, 1956, empowers the Board of Directors to delegate to

M.D. the power to invest in general terms. But Section 372A (2) provides that no investment shall be made, unless it is sanctioned by a resolution passed at a meeting of the Board with the consent of all the directors present. Section 372A does not provide for delegation. Hence the proposed delegation of power to invest to the M.D. is not in order.

(b) Apparently the prohibition under sub-section (1) & (1B) of the section 314 of the Companies

Act, 1956 is not applicable to remuneration/ compensation given to consent persons (i.e. directors) for the services of a professional nature rendered by them to the company in their


professional capacity such as advocate, chartered accountant, solicitor etc. however prohibition will apply to them if they bind themselves on regular retainer ship basis. Therefore,

(i) Chartered Accountants appointed by a company on a regular retainer basis as advisers,

consultants, internal auditors, etc., also hold the position or place of consultant or advisor and accordingly such appointments are hit by the restrictive provisions of Sub sections(1) and (1B) of section 314.

(ii) Based on the above analogy as contained above the bare engagement of a Chartered

Accountant in a particular case and the payment to him of his professional fees in that case would not attract the provisions of Sub-sections (1) and (1B) of section 314 of the companies Act. Engaging a person in his professional capacity for performing a particular function, say, for attending to a particular case or for undertaking a particular assignment of consultancy, or rendering advice on a specific matter, would not by itself constitute appointment to an office or place of profit in or under the company. But if the terms of engagement of a Chartered Accountant or that he should attend to all the tax cases or Act as advisor in all connected matters, whether generally or in a particular city or town, then even though he may be paid on a case by case basis, it would amount to appointment to a “place of profit” under the company.

7.

(a) According to Section 462 (1) of the Companies Act, 1956 read with Rule 298 of the companies (Court) Rules the official liquidator is file the accounts of M/s Impex Electrical Company Ltd., with the Court twice a year, one made upto 31st March and the second up to 30th September within 3 months of closing the accounts. The accounts should be drawn up in Form No 144 of the Rules.

Further according to Rule 302, the accounts should be audited by a Chartered Accountant appointed by the Court or if the Court so directs by the Examiner of the Local Fund Accounts of the State concerned. A copy of the accounts so filed by the official liquidator with the court is open to inspection by any creditor, contributory or any person interested.

Where the winding up is not concluded within one year after commencement, the official liquidator is required within 2 months after the expiry of the year and thereafter until the winding is concluded, once every year to file his statement in the prescribed form No. 148(Rule 311) in Court. A copy thereof shall also be filed with the registrar (Rule 511).

(b) Appointment of Additional Director in a Bank by the RBI: Under Section 36AA of the

Banking Regulations Act, 1949, RBI can terminate any Chairman, Director, Chief Executive, other officials or any employee of the bank where it considers desirable to do so particularly when RBI is of the opinion that conduct of such persons is detrimental to the interest of the depositors or for securing proper management of the banking company. Before such termination, concerned person should be given opportunity to be heard of. Such terminated officials can make appeal to the Central Govt. within 30 days from the date of communication of such termination order. The decision of the Central Government cannot be called into question. In case an order is issued pursuant to this section the concerned person shall cease to hold his office for a period of not exceeding 5 years as may be specified in the order.


Contravention of the above provision shall be punishable with a fine, which may extent to Rs. 250 per day.

Any such order shall be valid for a period not exceeding three years or such further periods of not exceeding three years at a time as RBI may specify. Under Section 36AB, RBI is empowered to appoint additional Directors for the banking company with effect from the date to be specified in the order, in the interest of the bank or that of depositors. Such additional directors shall hold office for a period not exceeding three years or such further periods not exceeding three years at a time.

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