IC 26 LIFE INSURANCE

FINANCE

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 IC-26

LIFE INSURANCE FINANCE

Acknowledgement:
This course based on revised syllabus has been prepared with the assistance of
N. K. Mittal
R.B. L. Vaish

We also acknowledge Get Through Guides, Pune for their contribution in

preparing the study material.

INSURANCE INSTITUTE OF INDIA

G- Block, Plot No. C-46,
Near Dhirubhai Ambani International School,
Bandra Kurla Complex,
Bandra (E), Mumbai – 400 051.
 LIFE INSURANCE FINANCE

IC-26

Revised Edition - 2010

All Rights Reserved

This Course is the copyright of the Insurance Institute of India. In no
circumstances may any part of the course be reproduced.

The course is purely meant for the purpose of study of the subject by students
appearing for the examinations of Insurance Institute of India and is based on
prevailing best industry practices. It is not intended to give interpretations or
solutions in case of disputes or matters involving legal arguments.

Published by Sharad Shrivastva, Secretary-General, Insurance Institute of India,

“G” Block, Plot No. C-46, Bandra – Kurla Complex, Bandra (E) Mumbai 400051
and printed at ……..
 PREFACE

This course is designed for the use of candidates appearing for the Associateship
Examination (Life Branch) of Insurance Institute of India.

The course primarily deals with the Principles of Accounts, Life Insurance
Accounting procedures, budgetary control and Application of financial
management and financial analysis for life insurance business. . During last one
decade insurance sector has been liberalized and around two dozen private life
insurance companies are operating in market. To regulate these life insurance
companies Central govt. has appointed IRDA as regulator. For bringing
uniformity among all insurers including govt. run LIC, IRDA has prescribed
uniform accounting system and regulation of investment and other financial
aspect. This study material has been revised after considering IRDA’s regulation
on accounts, investment and other financial matters which is equally applicable
on all life insurance companies, be private or govt. run. In addition to these
global changes has also been considered wherever considered necessary.

The earlier part of this course deals with Principles of Elementary Book-Keeping,
Principles relating to Life Insurance Account such as Accounting of Premium,
Accounting of Policy Payments and Expenses of Management- leading to
Finalization of Accounts and other relevant Topics namely Audit and Budget
with special reference to accounting in LIC of India.

The latter portion of the course deals with important aspects of Accounts and
Finance and the emerging trends with which the candidates should be familiar
viz., New concepts in Accounting like Human Resource Accounting,
Significance of Accounting standards, Techniques of Financial Analysis and
Application of Financial Management concepts and Accounting Standard
applicable on life insurance industry.. The course also introduces candidates to
Income Tax., Antimony laundering act and compliance with IFRS.

Although the course covers the syllabus prescribed for the examination, it is
desirable that candidates should read additional material such as Accounting &
Financial Text Books, office manuals and operating instructions, insurance
magazines, law journals etc. This will enrich their knowledge of the subject.

The candidates are recommended to collect and study specimen forms used in
offices (e.g. proposal, policy claim forms etc. and other forms relevant to the
subject). This will provide a practical basis for their studies.
The candidates may also avail of Oral Tuition service whenever arranged by the
Associated Institutes and the Postal Tuition Service provided by the Institute.
These supplementary aids will help the students to improve their performance in
the examination.

The course should also prove useful to the general reader who desires to have
knowledge of the subject covered.

To enhance the learning and to make it rich, each chapter in the study text has
specific learning outcomes listed at the beginning of the chapter and a summary
at the end of the chapter followed by self-test questions and answers. Within the
study text there are a number of features like case studies, extensive use of
examples, diagrams, tables, MCQs, tips etc. to add life to learning and to make it
interesting for the candidate.

To supplement the study text, key notes have been provided. Key notes include
topics presented in the same order as the study text and aid revision by giving
clear, visual emphasis to key points. Key notes are quite handy as they are
portable and concise, ideal for last minute revision on the move.
 CONTENTS

Chapter No. Title Page No.

1 Elementary principles of accounts 1
Life insurance business : Important types of
2 123
insurance policies
3 Accounting procedure : Premium accounting 167
4 Accounting procedure : Disbursements 203
Accounting procedure : Expenses of
5 245
management
6 Investments 264
Final Accounts : Revenue account and balance
7 284
sheet
8 Budget and budgetary control 388
9 Innovative concepts in accounting 413
Accounting Standards applicable to life
10 431
insurance companies
11 Financial analysis 476
12 Financial management environment in India 514
Application of financial management concepts
13 535
in insurance industry
14 Taxation (current scenario) 546
Anti-Money Laundering Guidelines and
15 584
PMLAACT
Compliance with IFRS (involving broader
16 609
concepts)
 1

CHAPTER 1

ELEMENTARY PRINCIPLES OF ACCOUNTS

Chapter Introduction
Business Transactions involve the exchange of value either in the form of money
or goods or services measured in terms of money. Book keeping or accounting is
the systematic recording of transactions with a view to ascertaining the financial
position of the business. Accounts of all recognised business concerns are
maintained in what is known as Double Entry Book Keeping system. According
to this system, every business transaction has a twofold financial aspect, which
means that it affects two accounts; one account is debited and another is credited
with the like amount. This is the fundamental principle of double entry book
keeping.

Book keeping has been defined as “the art of recording business transactions with
a view to having a permanent record of them and of showing their effect on
wealth”. It is a science which records pecuniary transactions (i.e. transactions in
money or money’s worth) in such a manner that a trader is able to ascertain:

1. The nature and value of his assets, including the amount owing to him by
sundry debtors.
2. The amount of his liabilities including the amount owing by him to his
creditors.
3. Whether he has made a profit or loss during a given period and how the
amount he has gained or lost is made up.
4. Whether he is solvent or insolvent and the amount of his capital or
deficiency.

This chapter will give you an insight into the various stages of the accounting
process.
 2

a) Explain the accounting process.

b) Understand and apply the concept of double-entry accounting.
c) Learn about journalising accounting entries.
d) Understand and illustrate the posting of journal entries into ledger
accounts.
e) Preparing a trial balance.
f) Understand the accounting equation.
g) Preparation of final accounts.
h) Explain the difference between capital and revenue items.
i) Classify expenditure as capital or revenue expenditure.
j) Profit and loss account.
k) Preparation of Receipts and Payments account and Income and
Expenditure account.
l) Calculate the charge for depreciation.
m) Preparing bank reconciliation statements.
 3

1. Explain the accounting process.

[Learning Outcome a]
The accountant will be responsible for accounting of business transactions and
reporting them to external users.

Accounting is the process of recording and reporting of financial transactions

including the origination of the transaction, its recognition, processing and
summarisation in the financial statements.
The New York State Society of CPAs

During the accounting process, accountants identify record and analyse the
financial dealings of a company. At the end of each period, accountants use the
information they have collected to prepare financial statements. Thus financial
reporting is the process of preparing and presenting the financial statements.

Diagram 1: Accounting process

 4

1.1 Data sources

A data source is evidence that proves the occurrence of a transaction or

event. In accounting, all transactions or events are recorded on the basis of a data
source.

John purchased a car. The evidence of this transaction is an invoice issued by the
car dealer. An invoice contains the seller’s name, description of goods, buyer’s
name and date and amount of transaction. For the above transaction, the invoice
issued by the car dealer is a data source.

The source documents of the various transactions of an entity can be categorised

as follows:

Transaction Source document

Purchases of goods
Sales of goods
Returns of purchased goods
Returns of sold goods
Provision of services
Purchases of assets
Sales of assets
Cash receipts
Supplier’s invoice
Entity’s sales invoice
Debit note raised by the entity and credit note
issued by the seller accepting the return
Debit note raised by the customer and credit
note raised by the entity accepting the return
Entity’s sales invoice
Supplier’s invoice
Entity’s sales invoice
Receipts issued by the entity for cash sales

For every transaction of an entity, there has to be some kind of proof or data
source. This is the first step in the accounting process i.e. identifying
transactions.

Which of the following pairs do not show the transaction and its related source
document on the basis of which the transaction is recorded in the books of
accounts?

A Purchase of goods – supplier’s invoice

B Goods returned – credit note issued by seller
C Sale of goods – entity’s invoice
D Sale of asset – cheque received from the purchaser
 5

2. Understand and apply the concept of double-entry

accounting.
[Learning Outcome b]
2.1 Introduction
Every transaction involves two operations and two persons; a receipt and a
disbursement of either money or money’s worth and a receiver and a giver.

For example if a car is purchased for Rs.600, 000 on cash basis;

 the two operations are purchase of car and payment of cash
 a car is received and cash is disbursed
 the transaction is valued in monetary terms i.e. Rs.600,000; and
 the purchaser is the receiver of the car and the seller of the car is the giver

The twofold aspect is recognised as a distinguished feature of the Double Entry

system.

Accountants often say ‘every debit entry has a corresponding credit entry’.
Under the double-entry book-keeping system, all transactions are recorded by
giving two accounting effects - debit and credit. Debit is traditionally shown as
a positive figure and credit as a negative figure.

2.2 Nature of accounts and rules of accounting

The decision on the account which is to be either debited or credited depends on
the nature of the account and the accounting rule applicable to it.

Diagram 2: Nature of accounts and rules of accounting

 6

The above mentioned rules are to be rigidly followed under all circumstances.

The following examples will facilitate your understanding of the above concepts
and rules:

Example on nature of accounts

Classify the following items into personal, real or nominal accounts:

1. Capital
2. Purchases
3. Sales
4. Drawings
5. Rent paid
6. Grand Insurers
7. Bank of India
8. Cash
9. Bank balance
10. Outstanding salary
11. Commission received
12. Furniture and fixtures
13. Sushant
14. Jaycee

Answer

 Personal accounts: 1, 4, 6, 7, 10, 13 and 14

 Real accounts: 8, 9 and 12

 Nominal accounts: 2, 3, 5 and 11

 7

Here is an example on the rules of accounting.

Consider the following transaction:

a) Grand Insurers purchased a motor car for Rs.600, 000 on credit from
Mr. Shaan.

Identify the two

Step 1 elements of the Motor car account Shaan account
transaction
Classify the account
Step 2 as real, personal or Real account Personal account
nominal
Identify the Credit the giver
Debit what
Step 3 applicable of the benefit
comes in
accounting rules
Identify the account
Debit motor car Credit Shaan
Step 4 to be debited and
account account
credited

b) Paid Cash to Mr. Shaan Rs. 600,000 (from whom the motor car was
purchased on credit earlier)

Identify the two

Step 1 elements of the Shaan account Cash account
transaction
Classify the account
Step 2 as real, personal or Personal account Real account
nominal
Debit the Credit what goes
Identify the
receiver of the out
Step 3 applicable
benefit
accounting rules
Identify the account
Credit cash Debit Shaan
Step 4 to be debited and
account account
credited
 8

c) Grand insurers paid a rent of Rs.100, 000 to Zebra Ltd.

Identify the two

Step 1 elements of the Rent account Cash account
transaction
Classify the account
Step 2 as real, personal or Nominal account Real account
nominal
Identify the
Debit expenses Credit what goes
Step 3 applicable
and losses) out
accounting rules
Identify the account
Debit rent Credit Shaan
Step 4 to be debited and
account account
credited

d) Grand insurers received a commission of Rs. 50,000 from Delta Ltd.

Identify the two

Commission
Step 1 elements of the Cash account
account
transaction
Classify the account
Step 2 as real, personal or Real account Nominal account
nominal
Identify the
Debit what Credit incomes
Step 3 applicable
comes in and gains
accounting rules
Identify the account Credit
Debit cash
Step 4 to be debited and commission
account
credited account
 9

The above example can be summarised as follows:

If the car is purchased on credit terms:

Accounting entries in purchaser’s Accounting entries in seller’s books

books
At the time of purchase: say on 1 a) At the time of sale: 1 April
April 2011 2011

 Debit: Car account with  Debit: Purchaser’s account with

Rs.600,000, being its value; and Rs.600,000

 Credit: Seller’s account with like  Credit: Sales (Car) account with
amount (the value of the car). Rs.600,000

At the time of payment: say on 1 b) At the time of receiving the

May 2011 money: 1 May 2011

 Debit: Seller’s account with  Debit: Cash account with

Rs.600,000; and Rs.600,000

 Credit: Cash account with like  Credit: Purchaser’s account with

amount (as parting with the Rs.600,000
money).

If the payment is made at the time of sale, it would not be necessary to open
personal accounts in either the purchaser’s or vendor’s books and the transactions
would be recorded by entries in the Car and Cash Accounts as under:

Accounting entries in purchaser’s Accounting entries in seller’s books

books
At the time of purchase: say on 1 c) At the time of sale: 1 April
April 2011 2011

Debit: Car account with Rs.600,000 Debit: Cash account with Rs.600,000
Credit: Cash account with Credit: Sales account (Car A/c.) with
Rs.600,000 Rs.600,000
 10

Selva Stores sold its computer for Rs. 25,000 on credit to Ganesh.

Identify the option containing the element of the transaction which is to be

debited and credited.

Element debited Element credited

A Computer account Selva stores account
B Ganesh account Sales account
C Selva stores account Sales account
D Ganesh account Computer account

3. Learn about journalising accounting entries.

[Learning Outcome c]
A journal is the book of prime entry wherein accounting transactions are
recorded. A journal contains a chronological record of transactions.

The entries are arranged so as to indicate clearly the respective accounts debited
and credited. The rectification entries as well as the closing entries are passed
through the journal.

3.1 Proforma of a journal

The following is the proforma of a journal:

Date Particulars Folio Debits Credits

(Heads of Accounts and (Amount (Amount
narration) in Rs.) in Rs.)
1.4.2011 Car account Dr 600,000
To Cash account 600,000
Being a car acquired for
cash

Debit is abbreviated as Dr while credit is abbreviated as Cr

 11

In the journal entry given above, why is the car account debited and not the
cash account? This is because all journal entries have to follow the principles
of double-entry book-keeping (which are explained earlier).

1. The ‘Particulars’ column contains:

a) The names of the two principal ledger heads of accounts affected. i.e.

 the account head which is to be debited is entered on the left hand side.
This is succeeded by the abbreviation Dr at the right hand corner of this
line (in the particulars column)

 the line below will have to be indented and begins with the word ‘To’
followed a few spaces away by the account head which is to be credited

b) A brief description of the transaction (called a narration) is usually written on

the line below the credit.

2. Folio refers to the page number of the account in the Ledger.

3. Remember that each journal entry will contain items which are to be debited
and items which are to be credited. The total of the debit items should always
be equal to the total of the credit items.

Lead Way Co is setting up a small retail outlet.

The following transactions took place during the month of September 2011:

1.9.2011 Rent paid by cheque Rs. 5,000

5.9.2011 Received cheque from Bina Rs.500
14.9.2011 Sold goods to Lal Bros on credit for Rs.20,000.

Write the double-entry journal entries for the above transactions.

 12

Answer

Date Particulars Folio Debits Credits

(Heads of Accounts and narration) (Amt in (Amt in
Rs.) Rs.)
1.9.2011 Rent account Dr 5,000
To Bank 5,000
(Being rent paid)

5.9.2011 Bank account Dr 500

To Bina 500
(Being cheque received from Bina)

Lal Bros Dr
14.9.2011 To Sales 20,000
(Being goods sold on credit) 20,000

A general principle is that any transaction which cannot be recorded in the

following books of original entry has to be recorded in the journal.

a) Sales day book

b) Purchases day book
c) Sales returns day book
d) Purchases returns day book
e) Cash book
f) Petty cash book

For example, depreciation is a non-cash expense which cannot be recorded in the

sales day book, the sales returns day book, the purchases day book, the purchases
returns day book or the cash / bank book. Hence, it is recorded in the journal.
 13

The following balances appeared in the books of Chetna Book Stall as on 1st
January 2004:

Bank Rs.77, 000, Stock Rs. 80,000, Furniture Rs. 10,000, Debtors Rs. 33,000 and
Creditors Rs. 90,000.

The journal entry to record the above stated transaction is:

A Bank account Dr 77,000

Stock account Dr 80,000
Furniture account Dr 60,000
Debtors account Dr 33,000
To Creditors 90,000
To Capital account 160,000

B Capital account Dr 160,000

Creditors account Dr 90,000
To Bank account 77,000
To Stock account 80,000
To Furniture account 60,000
To Debtors account 33.000

C Bank account Dr 77,000

Stock account Dr 80,000
Furniture account Dr 60,000
Creditors account Dr 90,000
To Debtors 33,000
To Capital account 274,000

D Capital account Dr 254,000

Debtors account Dr 33,000
To Bank account 77,000
To Stock account 80,000
To Furniture account 60,000
To Debtors account 70.000
 14

4. Understand and illustrate the posting of journal entries

into ledger accounts.
[Learning Outcome d]

Ledger is a book containing accounts. An account is a record that is used to

collect and store information related to an individual element of the financial
statements.

It is the principal book as well as the book of final entries. It contains, in a series
of classified and summarized accounts, a permanent record of all the trader’s
transactions under various Heads of Accounts.

4.1 Principal ledger

1. Format of a ledger

Name of account

Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
(Rs.) (Rs.)
To (name XXX By (name XXX
of account of account
credited in debited in
journal) journal)

a) Name of account:

Every ledger account has a unique name.

The left hand side is called the debit side and the right hand side is called the
credit side.
 15

b) Date column:

Contains the date of the transaction

c) Particulars (on the debit side of the ledger):

This column will contain the names of accounts which are credited in the journal.
Each account name will be preceded by the word ‘To’.

d) Particulars (on the credit side of the ledger):

This column will contain the names of accounts which are debited in the journal.
Each account name will be preceded by the word ‘By’.

e) Folio (journal folio):

In this column, the page number of the journal (or any other subsidiary book like
cash book) from where the entry is transferred, is entered.

f) Amount:

The amount relating to the item debited / credited will be recorded in this
column.

Let us take up the above stated example to understand how entries are made
in the ledger.
 16

Transaction of General Stores:

1.4.2011 Goods purchased on credit from Ibrahim and Sons Rs. 8,000

Step 1: Journal entry

1.4.2011 Purchases account Dr 8,000

To Ibrahim and Sons 8,000
(Being goods purchased on credit)

Step 2: Let us post the journal entry in the ledger:

To record the above entry, Lead Way has to open two ledger accounts:

 Purchase account and

 Ibrahim and Sons account

Purchase account
Dr Cr
Date Particulars Folio Amt Date Particulars Folio Amt
(Rs.) (Rs.)

To Ibrahim 8,000
1.4.2011 and Sons

Ibrahim and Sons

Dr Cr
Date Particulars Folio Amt Date Particulars Folio Amt
(Rs.) (Rs.)
1.4.2011 By 8,000
Purchases

Journal entries are to be posted to the Principal Ledger twice. The amount
appearing against the account head in the Debit column of the journal is posted to
the debit side of the account in Principal Ledger and amount appearing against
the account head in the credit column of the journal is posted to the credit side of
the account in the Principal Ledger.
 17

By maintaining a ledger account you have all the transactions with the same
person or purpose in one place. This is an easy form that can be used to answer
day-to-day queries such as the amount of sales made to a customer in a month or
the balance outstanding from any customer etc.

Since final accounts relating to an accounting period are based primarily on

ledger accounts, utmost accuracy has to be ensured when posting to different
accounts, casting accounts and balancing accounts.

Besides journal and principal ledger, we have a number of subsidiary or primary

books, the most important being the cash book. Others are the purchase book,
sales book etc.

4.2 Cash book

The cash book is a book of prime entry of a special kind as it is also a part of the
ledger system. The cash book is meant to record all cash transactions, whatever
may be their nature.

Cash or bank columns serve the purpose of cash or bank accounts, often in a
ledger account. There is no need to post the transactions again in cash or bank
accounts. These columns are balanced just like a ledger account and the closing
balances are taken to the trial balance. The steps to record transactions in the cash
book are as follows:
 The receipts side of the cash book is used to record entries which debit the
cash account or the bank account;
 The payments side is used to record entries which credit either the cash
account or the bank account;
 However, once the transaction is entered into the cash book, the second
effect to the respective ledger account is also given.

Diagram 3: Cash Book

 18

In a modern business, transactions with or through the bank are even more
numerous than strictly cash transactions. Therefore, each side has two columns –
one to record cash transactions and the other to record bank transactions –
payments into the bank being entered on the left hand side and payments out of
the bank being entered on the right hand side.
Sometimes cash may be deposited in the bank and at other times, cash may be
withdrawn for use in the office. In this case, entries for both the transactions will
appear in the cash book itself, in the appropriate columns. These are called
contra transactions.
Cash deposited Cash withdrawn
Cash deposited into the bank is Cash withdrawn from the bank is
recorded as a payment in the cash recorded as a payment in the bank
column, and as a receipt in the bank column and as a receipt in the cash
column. column.
Bank account Dr X Cash account Dr X
To Cash account To Cr Bank account X
X

These contra transactions do not have to be posted into any ledger accounts since
both debit (receipt) and credit (payment) effects have already been given in the
cash and bank columns of the cash book, which itself is also a ledger account.
Proforma of the cash book is given below:

Date Particu L.F. Disc Ca Ba Date Particu L.F. Disc Ca Ban

lars ount sh nk lars ount sh k
To By
(name (name
of of
account account
credited debited
in in
journal) journal)

Analytical columns
Certain additional analytical columns are drawn on either side of a cash book
according to the accounting and reporting needs of each entity. These columns
are totalled, and not balanced. The totals are used for the purpose of summary
postings into ledger accounts e.g. discount allowed, discount received, etc.
Cash discount usually arises when payment is made before a specified date, e.g.
the supplier may offer a discount of 2% if the payment is made within a month.
 19

Sometimes, cash discount is received from creditors also. These are therefore
shown in a columnar cash book for convenience.
Discount allowed by a trader to a customer on the receipt of cash represents a
loss. Discount received by a trader on payment represents a gain.
If analytical columns are maintained, instead of individual entries, only the totals
are recorded to the respective ledger accounts. For example, if columns are
maintained for discount allowed, the totals of these columns will be recorded in
the accounts receivable and cash sales ledger account. Individual transactions of
accounts receivable are posted in the personal ledgers, which are not part of the
double entry system.
It may be noted that the cash book is a subsidiary book, and at the same time,
serves as a ledger in respect of cash and bank transactions. Hence, no separate
Cash/Bank Accounts are kept in the ledger. But even in cash/bank transactions,
there must be another aspect (usually one that does not involve cash or bank).
Ledger posting should be made in respect of these other aspects of accounts. No
ledger posting would be necessary for the cash/bank aspects. The rule for posting
non-cash/non-bank transactions is that the entry appearing on the debit side of the
cash / bank account is posted to the credit side of the Principal Ledger account
and vice versa.

It can be seen that only the bank and cash columns are balanced in order to arrive
at a balance which is to be incorporated into the trial balance. These accounts
serve the purpose of being ledger accounts. Other analytical columns do not
function as ledger accounts. They simply give totals which can be posted to the
individual ledger accounts.

Record the following transactions in the cash book:

 1 Nov 2011: Deposited cash in the bank Rs.5,000

 7 Nov 2011: Paid trade payables through cheque Rs.2,000, discount received
Rs.200
 8 Nov 2011: Cash received deposited in the bank Rs.1,000
 14 Nov 2011: Cheque received from trade receivables Rs.2,000, discount
allowed Rs.200
 16 Nov 2011: Received from trade receivables Rs.7,000, discount allowed
Rs.700
 24 Nov 2011: Cash withdrawn from the bank Rs.2,000
 20

Cash Book

Discount Discount
Date Receipts LF Cash Bank Date Payments LF Cash Bank
allowed received
Rs. Rs. Rs. Rs. Rs. Rs.
Bank
Balance
1 Nov 1 Nov account c 5,000
b/f
(contra)
Cash
Trade
1 Nov account 5,000 2,000 200
7 Nov payable
(contra) c
Cash Bank
8 Nov account 1,000 account 1,000
8 Nov
(contra) c (contra) c
Cash
Trade
14 Nov 2,000 200 24 Nov account 2,000
receivable c
(contra)
Trade
16 Nov 7,000 700
receivable
Bank
Balance
24 Nov account 2,000 3,000 4,000
c/f
(contra) c
9,000 8,000 *900 9,000 8,000 *200
Balance
3,000 4,000
b/f
 21

*These columns need not be balanced.

They are only to be totalled and posted to the respective ledger accounts.

Discount allowed Dr Rs.900

To Debtors Rs. 900
(being discount allowed)

Journal entry to record discount received

Trade payables Dr Rs.200
To Discount received Rs. 200
(being discount received)

Discount allowed, being an expense, is always debited.

Discount received, being an income, is always credited.

Given below is a comprehensive example containing all the matters explained

above.

1 January 2011: Kapur commenced business with cash of Rs.5, 000.

2 January 2011: Purchased 500 bags of cement from India Cement Co. Ltd. for
Rs.2, 000
4 January 2011: Sold 300 bags of cement to Pal Construction and Co. for Rs.1,
400
6 January 2011: Paid India Cements Rs.1, 200 on account
7 January 2011: Received cash Rs. 1,400 from Pal Construction and Co.
7 January 2011: Sold 150 bags of cement to M/s. Desai and Co. for Rs.950
10 January 2011: Paid sundry expenses Rs.120

Write Kapur’s Books of Accounts and ascertain his financial position on 10 th

January. The 50 unsold bags of cement were valued at cost: Rs.200.

Answer to illustration

The transactions recorded in the Journal, Cash Book and Principal Ledger are set
out below.
 22

Journal

Date Journal Folio Dr Cr

2 -1-11 Purchase A/c Dr 2,000
To India Cements Ltd. 2,000
(Being purchase of 500
bags of cement)
4 -1-11 Pal Construction Co. Dr 1,400
To Sales account 1,400
(Being sale of 300 bags of
cement)
7 -1-11 Desai and Co. Dr 950
To Sales account 950
(Being sale of 150 bags of
cement)

Cash Book

Dr Cr
L. Amount L. Amount
Date Particulars Date Particulars
F. (Rs.) F. (Rs.)
1-1-11 To Kapur’s 5,000.00 6-1-11 By India 1,200.00
Capital A/c. Cements
A/c.

7-1-11 To Pal 1,400.00 10-1-11 By Sundry 120.00

Const- Expenses
ruction and A/c.
Co
31-1-11 By Balance 5,080.00
c/d
Total 6,400.00 Total 6,400.00
1-2-11 To Balance 5,080.00
b/d
 23

Principal Ledger

Capital Account

Dr Cr
Date Particulars Amount Date Particulars Amount
(Rs.) (Rs.)
31-1-11 To Balance 5,000.00 1-1-11 By Cash 5,000.00
c/d

Total 5,000.00 Total 5,000.00

1-2-11 By Balance 5,000.00
b/d

Purchase Account

2-1-11 To India 2,000.00

Cements
Total 2,000.00

Sales Account

4-1-11 By Pal 1,400.00

Construction
7-1-11 By Desai and 950.00
Co.
Total 2,350.00
 24

India Cements Co

6-1-11 To Cash A/c. 1,200.00 2-1-11 By Purchase 2,000.00

A/c.
31-1-11 To Balance c/d 800.00
Total 20,00.00 Total 2,000.00
1-2-11 By Balance b/d 800.00

Pal Construction Co

4-1-11 To Sales 1400.00 7-1-11 By Cash A/c. 1400.00

Total 1400.00 Total 1400.00

M/s. Desai and Co.

7-1-11 To Sales 950.00 31-1-91 By Balance c/d 950.00

Total 950.00 Total 950.00

1-2-11 To Balance 950.00
b/d

Sundry Expenses A/c

10-1-11 To Cash 120.00

Total 120.00
 25

Which of the following options contains the journal entry for the following
transaction?

S V Enterprises received cash Rs. 24,700 on 2 Jan 2011, from Om Enterprises in

full settlement of its account of Rs. 25,000.

Option Date Journal Folio Dr Cr

A 2 -1-11 Cash account Dr 24,700
Discount allowed Dr 300
To Om Enterprises 25,000
(Being cash
Rs.24,700 received
from in full
settlement of Rs.
25,000)
B 2 -1-11 Om Enterprises Dr 25,000
To Cash account 24,700
To Discount 300
Allowed
(Being cash
Rs.24,700 received
from in full
settlement of Rs.
25,000)
C 2 -1-11 S V Enterprises Dr 24,700
Discount allowed Dr 300
To Om Enterprises 25,000
(Being cash
Rs.24,700 received
from in full
settlement of Rs.
25,000)
D 2 -1-11 Cash account Dr 24,700
Discount allowed Dr 300
To S V Enterprises 25,000
(Being cash
Rs.24,700 received
from in full
settlement of Rs.
25,000)
 26

5. Preparing a trial balance

[Learning Outcome e]

A trial balance is the summary of all the ledger account balances at a particular
point in time.

Under the double entry system of accounting, every debit has a corresponding
credit and vice-versa. This means that the total of the debit balances of all
accounts in the ledger must be equal to the total of all credit balances.

The trial balance is simply a list of all the ledger accounts and their respective
balances as at a specified point of time e.g. as at 31 December 2009.

5.1 Proforma of trial balance

Trial balance as at

Debit Credit
Rs. Rs.
Cash X
Inventory X
Payables X
Share capital X
Retained earnings X
Other accounts X
Total X X

Although it has debit and credit columns, the trial balance is a statement, not a
ledger account. It is prepared periodically, usually at the end of every reporting
period. Note that the trial balance is not a part of the financial statements.
 27

5.2 Purpose of a trial balance

After preparing all the required ledger accounts, a trial balance is prepared to
list, at one place, the balances of all the ledger accounts. This helps the
accountant to check the arithmetic accuracy of accounting.

When preparing a trial balance, the debit and credit balances for each ledger
account are totalled. If the totals of the debit column and the credit column of the
trial balance do not tally, we know at once that there is some error in the ledger
balance.

The fact that the trial balance agrees is a preliminary assurance that there are no
mathematical / arithmetic errors in the preparation of the accounts.

Checking for mathematical / arithmetical accuracy is the primary purpose of the

trial balance. However, because a trial balance presents the ledger account
balances in a readily available format, it is often used to prepare the financial
statements.

A trial balance is prepared in order to:

1. Confirm the arithmetical accuracy of the ledger accounts
2. Help to locate errors
3. Provide a basis for preparing the financial statements

5.3 Steps involved in the preparation of a trial balance

1. Balance all the ledger accounts in the general ledger.

2. Calculate the totals of the balances in the debtors and creditors ledger
accounts. (A single consolidated figure will be taken for total debtors /
creditors in the trial balance - not all individual ledger accounts).

3. Prepare a trial balance.

 Write the names of all accounts one after the other.
 All credit balances are written in the credit column of the trial balance –
against the name of the respective accounts.
 All debit balances are written in the debit column of the trial balance –
against the name of the respective accounts.
 Total both the columns.
 The two totals should be equal.
 28

Continuing the earlier example of Kapur

Trial balance as at 31 st Jan 2011

Name of the Account Dr Cr

Rs. Rs.
Capital account 5000
Cash in Hand 5080
Purchases 2000
Sales - 2350
Creditors 800
Pal Constructions - -
Debtors 950 -
Sundry Expenses 120
8150 8150

5.4 Relationship of the trial balance with the accounting cycle

The entire accounting exercise is summarised below:

1. Transactions are identified and recorded in day books (journal, sales book,
purchase book, cash book, etc.).

2. Transactions are recorded from day books to ledger accounts.

3. A trial balance is prepared from the ledger accounts. It is a list of the

balances of all ledger accounts where total debits = total credits.

4. A trial balance contains

 Ledger balances that affect the Profit and loss account – balance of
expense accounts and income accounts

 Ledger balances that affect the Balance Sheet– balance of asset accounts
and liability accounts
 29

5. Balances that affect the profit and loss account are recorded in it and profit
earned or loss incurred during the period is determined.

6. Balances that affect the Balance Sheet along with the profit or loss
determined by the Profit and loss account are recorded in it.

7. The asset and liability side of the Balance Sheet is totaled. The total of the
assets side should be equal to the total of the liabilities side.

Prepare a trial balance from the following details:

Rs. Rs.
Sales 50,000 Accrued expenses 6,300
Purchases 30,000 Expenses 12,000
Bad debts 2,000 Discount received 600
Depreciation 3,500 Inventory: 01/01/2009 6,000
Accumulated depreciation 10,500 Loss on sale of asset 500
Amortisation of intangible
Rent received 3,500 asset 300
Petty cash 500 Intangible assets 3,000
Cash at bank 35,000 Share premium account 6,000
Provision for bad debts
Share capital 12,900 01/01/2009 3,000
Provision for bad debts
Inventory:31/12/2009 7,000 31/12/2009 4,000
 30

6. Understand the accounting equation

[Learning Outcome f]
The balance sheet shows the financial condition / position of an organisation on a
specific date in regards to what it owns and what it owes. Therefore, the main
elements in a balance sheet are its:

1. Assets (everything the entity owns or controls), e.g. cash, machinery,

inventory

2. Liabilities (everything the entity owes to third parties) e.g. amounts

payable to vendors and

3. Equity (everything the entity owes to the owners / shareholders including

the initial capital contributed by the owners and the profits generated by
the business).

The accounting equation is the fundamental relationship between the above

mentioned three concepts. The equation implies that the assets of the entity are
equal to the amounts owed to the creditors and the owners of the entity.

Assets = Liabilities + Capital

John has saved Rs.50,000. He is interested in starting a business selling glass

under the name M/s Elite Traders.

On 1 Jan 2012 he introduced Rs.50,000 into the business.

On the same day he bought glass worth Rs.15,000 and a shop for Rs.30,000. All
the glass was sold during the same month for Rs.20,000.

These transactions can be shown at the end of the month as follows

 31

These transactions can be shown at the end of the month as follows:

Table 1

Purchases Sales
Sr. Cash Capital Shop Debit Credit
Transaction account account
no. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
John
Cash Capital
1 introduced 50,000 (50,000)
(↑asset) (↑liability)
capital
John Purchases
Cash
2 purchased (15,000) 15,000 account
(↓asset)
glasses (↑expenses)
John
Shop Cash
3 purchased (30,000) 30,000
(↑asset) (↓asset)
shop
John sold Cash Sales
4 20,000
glasses (20,000) (↑asset) (↑income)
Balance 25,000 (50,000) 30,000 15,000 (20,000)
 32

You can clearly see that:

Debits = Credits
(25,000 + 30,000+15,000) = (50,000 + 20,000) (figures in brackets)
Rs.70,000 = Rs.70,000

The financial statements of M/s Elite Traders will be as follows:

Note:

The steps related to recording the transactions and preparation of a trial balance,
Profit and loss account and BALANCE SHEET are explained in greater detail
later in this book. Here, a simple example is given to explain the accounting
equation.

M/s Elite Traders M/s Elite Traders

Profit and loss account Balance sheet as at 1 January 2012

Rs. Rs.

Sales 20,000 Assets

Less: Purchases (15,000) Shop 30,000

Profit 5,000 Cash in hand 25,000

Total 55,000

Capital and liabilities

Capital of John* 50,000

Profit from business** 5,000

Total 55,000

*Capital is the liability of the business

**Profit is a liability of the business to the owner
 33

In accounting, every transaction is debited in one account and credited in

another account. This means that for every amount that is debited the same
amount is credited elsewhere. Therefore the total of all debit amounts and all
credit amounts are equal.

Debits = Credits

The assets have a debit balance and liabilities have a credit balance. The total
debits are always equal to total credits hence; in the balance sheet, total assets
are equal to total liabilities (owed to outsiders and to owners). Therefore, the
two sides of the balance sheet always balance.

The accounting equation is:

Assets = Capital + Liabilities

Dr = Cr

Profit is the net result of all incomes and expenses and is added to capital.
Incomes / expenses are not considered individually in the accounting

Applying this to M/s Elite Traders: Rs.30,000 + Rs.25,000 = Rs.50,000 +

Rs.5,000

The above formula can be presented in a number of ways:

Capital = total assets – liabilities

Liabilities = total assets – capital

All are mathematically the same. The most commonly used presentation is:

Assets = Capital + Liabilities

 34

Diagram 4: Relationship of trial balance and financial statements

The liabilities of a business are Rs. 30,000, and the capital of the proprietor is
Rs.70, 000. The total assets are:

A Rs.70,000
B Rs. 100,000
C Rs. 40,000
D Rs. 30,000
 35

7. Preparation of final accounts

[Learning Outcome g]
The final accounts of an entity contain two main components; trading and profit
and loss account and balance sheet. P&L account and Balance sheet together
constitute the final accounts.

7.1 Trading and profit and loss account

This account helps to determine the amount of profit or loss made during the
year. This statement shows the transactions of a business for a period of time (say
one year).

7.2 Balance sheet

This statement helps to determine the financial position of the entity i.e. the
position of assets and liabilities as at the end of a period. It is a statement of the
amount owed and owned by the entity.

7.3 Steps for preparing the trading and profit and loss account and
balance sheet

Step 1: Prepare the trial balance

Step 2: Transfer the balances of nominal accounts from the ledger to the
“Trading and Profit and Loss” account or ‘Income and Expenditure account or
Revenue account. For this:

 accounts of expenses and losses are shown on the debit side;

 accounts of gains and incomes are shown on the credit side; and
 the result showing the net profit or loss is arrived at.

Step 3: Transfer the net profit / loss (arrived at in step 2) to the balance sheet. If
the P/L account shows a loss, then it is shown on the asset side. If, on the other
hand, the P/L account shows a profit, then it is shown on the liability side.

Step 4: Transfer the balances of other accounts (personal and real) that are not
closed from the trial balance to the Balance Sheet. For this, the credit balances of
the accounts should be shown on the left hand side of the Balance Sheet (i.e. the
side known as capital and liabilities) and the debit balances should be shown on
the right hand side (which is known as property and assets).
 36

Step 5: The two sides of the Balance Sheet are totalled and tallied.
P/L- Profit and Loss account
B/S- Balance Sheet

7.4 Errors disclosed by the trial balance

An error is a mistake which is committed accidentally. If done intentionally, it
becomes fraud.
While recording the transactions in the books of accounts, it is quite likely that
some mistake may be committed. Errors may happen at any of the following
stages.
1. At the recording stage 2. At the posting stage
a) Errors of principle a) Errors of omission
b) Errors of omission b) Error of commission
c) Errors of commission  Posting to wrong
account
 Posting on the wrong side
 Posting of wrong amount
3. At the balancing stage 4. At the preparation of the trial
a) Wrong totalling balance
b) Wrong balancing a) Errors of omission
b) Errors of commission
 Taking the wrong amount
 Taking the wrong account
 Taking the account to the wrong side
The trial balance is prepared to check the arithmetical accuracy of the accounts.
If the trial balance does not balance, it implies that there are arithmetical errors in
the accounts which require detection and correction. Even if the trial balance
agrees, there may still be errors.
From the point of view of correction, errors are classified into two types:
Diagram 5: Types of errors
 37

1. Casting error

The term casting means adding up. This error affects the agreement of a trial
balance. This error can be an error of overcasting or an error of undercasting.

Overcasting means summing (i.e. arithmetically adding) the totals to more than
what they are and undercasting means summing (i.e. arithmetically adding) the
total to less than what they are.

Under casting - Margaret sold goods to 3 different customers of Rs.10,000,

Rs.25,000 and Rs.15,000 respectively in July 2009. She entered the 3 amounts
correctly in the sales day book. However, when she totalled the month’s sales,
she came to Rs.40,000 instead of Rs.50,000. Margaret undercast the sales day
book by Rs.10,000.

Overcasting - Continuing the previous example of Margaret, the following

month, exactly the same value of goods was bought by customers. Although she
correctly entered the figures individually in the sales day book, when she totalled
the month’s sales, she came to Rs.60,000 instead of Rs.50,000. Margaret
overcast the sales day book by Rs.10,000.

2. Posting error

This error occurs while posting a transaction from the books of prime entry to the
ledgers. This can be:

 Posting with wrong amount

 Omission to post either credit or debit entry
 Posting to wrong side of correct ledger

Here, the posting of the journal entry should have been Rs.500, but was
incorrectly posted as Rs.200.
 38

Posting with wrong amount

Let us see how the following journal is incorrectly posted:

ICC Ltd Journal entry

Opening balance of AAL account is Rs.5,000
31/12/2009 Bad debts account Dr Rs.500
To AAL account Rs.500
(Being bad debts written off)

Here, the posting of the journal entry should have been Rs.500, but was
incorrectly posted as Rs.200.

ICC Ltd
Dr Bad debts account Cr
Date Rs. Date Rs.
31-Dec AAL account 200
Profit and loss
31-Dec account 200
Total 200 Total 200

Receivables ledger
Dr AAL account Cr
Date Rs. Date Rs.
1-Dec Balance b/f 5,000 31-Dec Bad debts 500
31-Dec Balance c/f 4,500
Total 5,000 Total 5,000

The most common form for posting the wrong amount is a transposition error.
 39

Omission to post either credit or debit entry

Let us see how the posting of the following journal is wrongly omitted.

ICC Ltd Journal entry

31/12/2009 Bad debts account Dr Rs.500
To AAL account Rs.500
(Being bad debts written off)

The ledger should have been posted with Rs.500. An error was made, and
this amount was omitted and posted with zero.

Dr Bad debts account Cr

Date Rs. Date Rs.
31/12/2009 AAL account 0
Profit and
31/12/2009 loss account 0
Total 0 Total 0

Dr AAL account Cr
Date Rs. Date Rs.
1/12/2009 Balance b/f 5,000 31/12/2009 Bad debts 500
31/12/2009 Balance c/f 4,500
Total 5,000 Total 5,000

Posting on the wrong side of the correct account:

Let us see how the posting of the following journal is made to the wrong side
of the correct account.

ICC Ltd Journal entry

31 Dec2009 Bad debts account Dr Rs.500
To AAL account Rs.500
(Being bad debts written off)

The AAL account should have been on the debit side, and not on the credit
side.
 40

Dr Bad debts account Cr

Date Rs. Date Rs.
31 Dec Profit and loss account 500 31 Dec AAL account 500

Total 500 Total 500

Dr AAL account Cr
Date Rs. Date Rs.
1 Dec Balance b/f 5,000 31 Dec Bad debts 500
31 Dec Balance c/f 4,500
Total 5,000 Total 5,000

7.5 Figures incorrectly carried over to the trial balance

If the balance of a ledger account is incorrectly recorded in the trial balance,

this will also result in the trial balance not balancing.

Continuing the previous example of the AAL account

The bad debt account is correctly posted from the journal with Rs.500. While
taking the balance of the bad debt accounts to the trial balance, it is incorrectly
carried over from Rs.500 to Rs.900.

Dr Bad debts account Cr

Date Rs. Date Rs.
31Dec AAL account 500
31 Dec Profit and loss account 500
Total 500 Total 500

Trial balance as at 31 December 2009

Debit Credit
Rs. Rs.

Bad debts (Note1) 900 -

Note 1: it should have been Rs.500 and not Rs.900. The trial balance will not
balance and there will be a difference of Rs.400.
 41

Transposition error

Under this type of error, a transaction is recorded in the books of prime /

original entry with the figures in the wrong sequence.

A sale to Alan for Rs.5,100 is recorded as Rs.1,500 in the Alan-receivable

account, and as Rs.5,100 in the sales account. The error is the transposition of the
numbers 1 and 5. As a result, the totals of the debit and credit balances in trial
balance will not agree.

Samuel purchased raw materials from Sam for Rs.5,200. He debited the purchase
account with Rs.2,500 and credited Sam’s account with Rs.5,200.
Has any error been committed by Samuel? If yes, what is the error?

Diagram 6: Errors- highlighted by trail balance

 42

7.6 Errors that cannot be highlighted by preparing a trial balance

The main purpose of the trial balance is to ensure that double entry book keeping
has been followed correctly and that debits = credits. If using a manual system, it
is possible to post just one side of the entry or even to write in an incorrect
amount. The trial balance will highlight this if it occurs, as debits ≠ credits.

While it is simple to identify that an error has been made, there is often a long
and difficult task of cross checking balances to find out where the error is! We
will discuss this in more detail in the next Learning Outcome.

When the totals of debits and credits are equal in a trial balance, this does not
assure the correctness of accounting. There may still be errors, which do not
create a difference in the debit and credit totals of a trial balance. These errors
distort the financial statements, but the trial balance total of debits and credits is
equal. These errors are difficult to detect compared to those errors that affect the
agreement of the trial balance.

1. Error of omission to record

Under this type of error, a transaction is completely omitted in the financial

records.

ICC Ltd sold goods to Alan for Rs.1,200 but omitted to record the transaction in
both the sales day book and the debtors ledger. Since both the accounting effects
(i.e. the credit in the sales account and the debit in the debtors ledger) of the
transaction are not recorded there cannot be a difference in the trial balance.

2. Error of commission

These are basically the clerical errors committed at the time of recording and / or
posting the transactions. This includes errors such as the recording of a
transaction to the wrong account or recording a transaction with the wrong
amount.
 43

ICC Ltd sold goods to Alan for Rs.1,200 and recorded this in the sales day book.
However instead of debiting the amount to Alan’s account, it was debited to
Peter’s account. This error will not affect the agreement of the trial balance
because whether Alan’s account is debited or Peter’s account is debited – the
posting has gone to the debit side of the account. The credit effect has been
correctly taken and so the trial balance will agree.

3. Error of principle

Errors of principle are errors resulting from the violation of generally

accepted accounting principles.

Tick-tick Ltd is a pharmaceutical company. It purchased a car for

Rs.10,000. The payment was made by cheque. The transaction was recorded
as follows:

Purchases account (profit and loss account) Dr Rs.10,000

To Bank account (balance sheet) Rs.10,000

The purchases account is debited as opposed to the asset account

As a result, the company’s profits and assets will be reported with a Rs.10,000
deficit. .

The trial balance will still balance as one account has been debited with the right
amount (it does not matter that the account head is wrong) and one account has
been credited with the right amount. Hence this error cannot be detected by
preparing a trial balance.

4. Compensating error

Under this type of error, two errors are committed, in such a way that the total
debits remain equal to the total credits in the trial balance.
 44

Goods sold to Jay for Rs.1,000 were recorded in the sales day book correctly but
were not recorded in Jay-receivables account. At the same time goods purchased
from Bob for Rs.1,000 were recorded in the purchase day book but not recorded
in Bob’s payables account.
The two accounting entries were as follows:
Purchases account Dr Rs.1,000
To Sales account Rs.1,000
The ultimate effect of the above error is that the debit in the first entry falls short
by Rs.1,000 and the credit in the second entry falls short by Rs.1,000. Therefore,
the two errors will compensate each other and the trial balance will agree in the
terms of debit and credit totals.

5. Errors of prime entry

Under this type of error, the error is committed while recording the transaction
from the source document to the books of prime entry.

A sales invoice of Rs.1,400 was recorded as Rs.1,600 in the sales day book and
posted to the receivables ledger account as Rs.1,600. This error will not result in
any disagreement in the trial balance totals.

6. Complete reversal of entry

Under this type of error a transaction is recorded in exactly the reverse manner.

Red Ltd sold goods to John for Rs.1,600.

The correct accounting entry should have been:
John account Dr Rs.1,600
To Sales account Rs.1,600
The wrong accounting entry recorded:
Sales account Dr Rs.1,600
To John account Rs.1,600
The trial balance will still balance so this error cannot be detected by
preparing a trial balance.
 45

Diagram 7: Errors- not highlighted by trail balance

Steps to discover errors

Step 1: Check the totals of the trial balance.

Step 2: Confirm that the cash and bank balances are duly included.

Step 3: Ascertain whether the trial balance itself or the subsidiary books contain
an item which is half the amount of the difference and, if so, whether that item
has been posted to the wrong side of the ledger account or inserted in the wrong
column of the trial balance.

Step 4: If the difference is divisible by 9, it means the figure has reversed, for
example, 342 has been posted as 432. Then check such figures.

Step 5: If these steps are unsuccessful, it may then be necessary to follow the
steps given below.

1) See that the ledger balances are correctly brought down, both at the
beginning and at the end of the period and that the closing balances are
correctly entered in the trial balance.

2) Check the additions of the subsidiary books, and of the ledger accounts.

3) Verify the postings of the individual items and the periodic or monthly totals
of purchases, sales, discounts and the like.
 46

Where exercises are worked under examination conditions and candidates are
unable to make the totals of either the trial balance or the Balance Sheet agree,
methods similar to those given above should be adopted to discover the cause of
the disagreement. Badly-formed figures and the misplacement of figures such as
the units figure being placed under the tens (or the tens figure being placed under
the hundreds) are usual causes of error. Thoughtful attention should be given to
this feature of postings into principal ledger.

Match the type of errors to the following transactions:

Sr. Transaction Type of

No. error
1 The sales book has an arithmetical totalling error of Rs. a. Omission
3,000.
2 Goods returned by Gina worth Rs.2,500 were not b. Casting
entered.
3 Cash received for commission Rs.72,735 was posted to c. Principle
the commission account as Rs. 72,375.
4 Purchase of machinery for Rs.60,000 has been entered d. Posting
in the purchases book.

8. Explain the difference between capital and revenue

items.
Classify expenditure as capital or revenue expenditure
[Learning Outcomes h and i]
We have already discussed:
 the method of recording transactions in the books of accounts
 the preparation of the trial balance
This is followed by the preparation of the profit and loss account and the balance
sheet.
In order to prepare the profit and loss account, we need to group together the
various heads of incomes and expenses. However, it will be inappropriate to treat
money spent on the acquisition of a plot of land as an expense (plot of land is an
asset) or to treat salaries paid as an asset (it is an expense).
 47

Capital transactions mean transactions involved in the purchase, acquisition, sale

or disposal of assets which have a useful life of at least more than one year.
Revenue transactions, on the other hand, relate to the income and expenses
connected with the normal day to day operations of the business. One must
therefore be clear in one’s mind regarding the nature of an item of expenditure or
income, that is to say one must be able to distinguish between capital expenditure
and revenue expenditure.
Diagram 8: Classification of items / transactions

8.1 Capital items

These are those items which affect the balance sheet.
Capital items are of two types: capital expenditure and capital receipt.
1. Capital expenditure
Capital expenditure is the expenditure which improves the earning capacity of
an asset so that the asset works more efficiently or lasts longer. This benefit can
be expected to last for more than one accounting period.

Nature of expense Example

Computers, vehicles, building,
1. Purchase of non-current assets
land, plant and machinery
Cost of bringing the non-current asset
2. carriage inward
into the entity
Legal and professional cost spent on Stamp duty, registration fees,
3.
purchasing non-current assets solicitor’s fees, architect’s fees.
Cost needed to make these non-
4. Installation charges
current assets ready for use
Improvement to existing non-current Fitting of air conditioner in
5.
assets vehicles
 48

Capital expenditure increases the value of a non-current asset. This means that
the working capacity and the life of the asset are increased. This results in long
lasting benefits to the entity.

Capitalisation of expenditure: When expenses are recorded in the books of

accounts as an increase in the cost of a non-current asset, it is known as
capitalisation of expenditure.

On 2 January 2006, Diana purchased land worth Rs. 900,000 from Jack. She paid
Rs.50,000 stamp duty on the purchase price. This amount of Rs. 50,000 is
included in the cost of the land bringing the total cost of the land purchased to
Rs. 950,000. In Diana’s accounts, the cost of the land will be recorded as
Rs.950,000.

2. Capital receipt

 When an item of capital expenditure is sold, the receipt thus generated is

called a capital receipt.

 Therefore, capital receipt is income which is earned from activities that are
not ordinary activities / regular operations of an entity i.e. it is not income
realised by the sale of the merchandise of the entity.

 A capital receipt decreases the value of a non-current asset.

Capital receipt
1. Sale of non-current asset
2. Receipt of share capital or capital
3. Receipt of loans and debentures
4. Premium received on issue of shares
 49

8.2 Revenue items

These are those items which affect the profit and loss account.

Revenue items consist of two types: revenue expenditure and revenue receipt.
3

1. Revenue expenditure

Revenue expenditure is that expenditure which is incurred to maintain the

existing capacity of an asset so that it can do its daily work. It is a regular
expenditure incurred from time to time in the ordinary course of the business.

‘Maintaining’ the existing capacity of the asset means keeping the asset in a
proper working condition so that the productivity of the asset is not reduced.
Revenue expenditure provides benefit of a current nature i.e. the benefit arising
out of revenue expenses expires in the same accounting period.

Mack purchased computers for Rs.1,500 and computer stationery for Rs.50.
These two expenditures will benefit Mack for different periods. The computers
will give benefit of an enduring nature i.e. benefit for a longer duration whereas
the expenditure on computer stationery will give benefit of a comparatively short
duration. Hence:

 purchase of computers Rs.1,500 will be treated as capital expenditure; and

 purchase of computer stationery Rs.50 will be treated as revenue

expenditure.

2. Revenue receipt

 A revenue receipt is a regular receipt i.e. these transactions are regularly

entered into in an entity in the ordinary course of the entity’s activities.

 Revenue receipts are a result of sale of the merchandise of the entity and
other revenue items like rent received or commission received.

Michael gave his building on rent to Sam. The monthly rent received is Rs.5,000.
Therefore, the amount received by Michael is Rs.5,000 is his revenue receipt.
 50

The chart given below shows why Better Plc classified the expenses it incurred
as capital or revenue expenses.

Nature of expense Classification Reason

Capital Machinery will be used in
Cost of machinery
expenditure business for long term.
Costs can be directly attributed
to bringing the asset to its
Cost of installing the Capital
intended location and condition.
machinery expenditure
This allows the asset to be used
as intended.
It is expenditure of a regular
Consumables (spare Revenue
nature – it helps the machine do
parts) for machinery expenditure
its daily work.
Revenue Expenditure incurred to maintain
Repairs to machinery
expenditure its existing capacity.
Electricity cost for Revenue It is expenditure of a regular
machinery expenditure nature.

Disclosure of capital and revenue expenditure in the financial statement

Profit and loss account Balance sheet

Rs. Rs. Rs.
Non-current
Income X assets X
Less: Expenses (X)
Total
Capital and
liability
Total

Revenue receipt and Capital expenses

expenses will come here will come here
 51

Diagram 9: Capital items

Diagram 10: Revenue items

Diagram 11: Difference between Capital expenditure & Revenue

expenditure
 52

8.3 Deferred revenue expenditure

Certain expenditure may seem to be of a definite revenue nature, but the benefit
in such cases may be available for a period of two years or more. For example,
expenses over a publicity campaign initiated on a massive scale, preliminary
expenses and research and development expenses. These expenses will increase
the sales over the next few years. Such expenditure is known as deferred revenue
expenditure.

Accounting treatment:

The amount of deferred revenue expenditure is written off over the probable
useful life of the expenses incurred. Therefore, deferred revenue expenditure is
written off over a period of two or more years and not wholly in the year in
which it was incurred.

Capital receipt Revenue receipt

Not a regular business income
Benefits for a long term
E.g. Sale of fixed asset
Has no bearing on the profits of the
entity
A regular revenue income
Benefits for a short term
E.g. Sale of goods, commission
received, miscellaneous income such
as sale of old newspapers or packing
cases
Has a direct relationship with the
profits of the entity

8.4 The Trading Account

Ascertaining the net profit or loss is done in two stages:

1. finding out the gross profit or loss; and then

2. finding out the net profit or loss.

Gross profit = Net sales - Cost of goods sold.

Net sales = Gross sales - Returns from customers

Cost of goods sold involves adjustment for inventory on hand at the beginning
and at the end of the accounting period.

Net profit = Gross Profit + / - Adjustment for all other income and expenses.
 53

For a trading setup:

Cost of sales = Opening stock + purchases – closing stock - any other expense
(incurred to bring the purchased goods to the firm’s shop or otherwise to make
the goods ready for sale). For example, freight on goods purchased, customs
duty, octroi duty, etc.

For a manufacturing set-up:

Cost of sales = opening stock + purchase of raw materials – closing stock - any
other expense (incurred up to the time the goods are made ready for sale). For
example, wages paid to workmen, fuel and power used to run the machinery,
carriage on purchase etc. In short, all expenses incurred in the factory or
workshops are debited to the trading account.

Format of a trading account:

Dr Trading account Cr
Amounts Amounts
Particulars Particulars
(Rs.) (Rs.)
Opening Stock X Sales X
Purchase X Less Returns X
Less Returns X
Carriage / Freight on
X Closing Stock X
purchases
Gross loss
Wages X X
(if Dr side > Cr side)
Fuel and power X
Lighting (factory) X
Rent and rates X
Gross profit
X
(if Cr side > Dr side)
Total XX Total XX

If the percentage of profit to sale varies widely from year to year, the reasons
should be investigated.
 54

A fall in the percentage of gross profit to sales is mainly due to:

 higher expenses; or
 lower income

This can arise due to:

1. High material costs: an unduly high price might have been paid for
purchases.

2. Wastages: the materials might not have been properly used i.e. there could
have been wastages or pilferages.

3. Inefficient manufacturing processes: there might have been inefficiency in

the manufacturing process so the output per worker went down, resulting in
higher expenditure in respect of wages, fuel, power etc. per unit of output.

4. Reduction in price of finished goods: prices of finished goods might have

dropped or sales may have reduced due to competition.

5. Improper inventory valuation: the closing inventory might not have been
properly taken or its valuation might be wrong.

Fill in the blanks.

A Comp Plc is a manufacturer of computers. During 2006, the company

purchased machinery for Rs.100,000. This purchase price is a
expenditure.

Comp Plc sold computers for Rs.200,000. This is a receipt

because it is part of the regular income. The company sold one of its vehicles
for Rs.50,000; this is a receipt because it is a sale of a non-
current asset.

B Suzy is a sole trader dealing in furniture. A dressing table was sold by Suzy
for Rs.20,000; the amount received for this sale is a receipt. She
also sold a computer used in her showroom for Rs.5,000. This is a
receipt because it is a sale of a non-current asset.
 55

9. Profit and loss account

[Learning Outcome j]
Steps to prepare the profit and loss account

Step 1: Start with the credit from the Trading account in respect of gross profit or
debit in case of gross loss.

Step 2: Transfer to the debit side of the profit and loss account, all the expenses
or losses which have not been debited to the Trading account. For example rent
paid, salary paid, etc.

Step 3: Transfer to the credit side of the profit and loss account any income
(which have not been credit to the Trading account besides the gross profit). For
example interest received, profit on sale of asset etc.

9.1 Expenses that appear in profit and loss account

If one understands the word “expense” there will be no difficulty in deciding

which items in the trial balance will appear in the Profit and Loss account.

Expense = All monies spent on various accounts for earning the income of
the business

In other words Revenue Expenditure and losses will be debited to the Profit and
Loss account.

The following points, however, should be noted,

Details Accounting treatment Explanation

Drawings Debit drawings to capital Drawings are not
account expenses

Income tax (In Debit income tax paid to Income tax is merely
respect of firms ) drawings account government’s share of a
person’s income
 56

Deferred revenue  Debit a portion of Each year’s Profit and

expenses deferred revenue Loss account is charged
expenses (proportionate only with expenses that
for the year) to the P and can fairly be attributed
L account of that year to that year
 Amounts not written off
will be c / f as an asset in
the Balance Sheet under
the heading ‘Deferred
Revenue Expenditure’
Expenses have  Debit a portion The Profit and Loss
been paid in (proportionate for the account is charged only
advance like year) of the nominal with expenses that can
telephones, rent, accounts to the P and L fairly be attributed to
insurance premium account that year
etc  Amount paid in advance
may be c / f as an asset in
the Balance Sheet under
the heading “Prepaid
Expenses A/c.”
 This entry is reversed at
the beginning of the next
financial year
Outstanding  Debit a portion (relating The Profit and Loss
liabilities in respect to the year) of the account is charged only
of nominal nominal accounts to the with expenses that can
accounts like P and L account fairly be attributed to
salaries, wages,  Amount outstanding may that year
rent, etc be c / f as a liability in
the Balance Sheet under
the heading “Outstanding
Expenses A/c.”
 This entry is reversed at
the beginning of the next
financial year
 57

Outstanding expenses

Pallore Co obtained a loan of Rs. 10 lakhs from a bank on 1 January 2007 at an

agreed interest rate of 9%. The dates of interest payment are 30 June and 31
December every year. The financial year ending is on 31 March 2007. Payment
of interest is made every 6 months at the end of June and December.

Calculate the accrual adjustments.

Whether the interest is due or not, the accrual continues every day. Interest for
the period 1 January 2007 to 30 June 2007 is due on 30 June 2007. The reporting
date for Pallore Co is 31 March 2007 and it falls in between the interest
repayment period.

Interest for the period 1 January 2007 to 31 March 2007 is not due for payment
on reporting date, but still it has accrued. Therefore the amount of interest
outstanding which needs to be recognised is Rs.10, 00,000 x 9% x 3/12 = Rs.
22,500.

Diagram 12: Accrual adjustment

 58

The journal entry made is

Interest on loan (Expense) Dr Rs.22,500

To Interest accrued on term Rs.22,500
loan (Liability)
(Being recording of interest
accrued on loan)

Interest expense account (Year 2006-07)

Dr Cr
Rs. Rs.

Interest accrued on term 22,500 Transferred to profit and loss 22,500

loan account
22,500 22,500
Outstanding expense is
added to expenses here

Note: the interest accrued during 2006-07 is transferred to the profit and loss
account even if there is no payment of interest. This is achieved by the accrual
adjustment.

Interest accrued on term loan (liability) account (extract)

(Year 2006-07)
Dr Cr
Rs. Rs.
Interest expense 22,500

Outstanding
expense recorded as
a liability
 59

1. Presentation in the financial statements

The interest expense will be added to the interest cost under finance costs in the
profit and loss account.

The interest accrued on the loan is shown in the balance sheet under current
liabilities.

Profit and loss account (extract) Balance sheet (extract)

For the year ended 31 March 2007 as at 31 March 2007
Rs. Rs. Rs.
Assets
Income X Non-current assets X
Less: Expenses Current assets X
Interest accrued 22,500 Total X
Other expenses X Capital X
Non-current
liabilities X
Current liabilities
Interest accrued on
term loan 22,500
Net profit X Total X

2. Impact on profit and net assets

As you have now learnt, accrued interest has two effects:

 increase in expense = reduction in profit for the current period
 creation / increase in liability = reduction in net assets

3. Reversal of accrual

At the beginning of the next year, the journal entry is reversed. This is known as
reversal of accrual. In the example considered above, the entry to be made in the
next year is:

Interest accrued on term loan (Liability) Dr Rs.22,500

To Cash (payments) Rs.22,500
(Being the reversal of entry taken for
accrued interest in the last year)
 60

Interest expense account (extract) (Year 2007-08)

Dr Cr
Rs. Rs.
Transferred to
Cash
30/06/2007 22,500 01/04/2007 profit and loss 90,000
(payments)
account
Cash
31/12/2007 45,000
(payments)
Interest
31/03/2008 accrued on 22,500
term loan
90,000 90,000
Interest accrued on term loan (liability) account (extract) (Year 2007-08)
Dr Cr
Rs. Rs.
Cash 01/04/2007 Balance b/f 22,500
30/06/2007 22,500
(payments)

Interest expense
31/03/2008 Balance c/d 22,500 31/032008 (Jan 2008 to 22,500
March 2008)
45,000 45,000

Impact on profit and net assets

The reversal of last year’s provision amount ensures that out of Rs.45,000 paid
on 30 June 2007 only half (the part related to the period from 1 April 2007 to 30
June 2007)is transferred to the profit and loss account (income and expense).

Selection Ltd has taken a loan from Chartered Bank on 1 October 2010. Interest
is due on a six monthly timeline i.e. on 31 March, and 30 September. Each
interest instalments is Rs.6, 000. According to the local laws, Selection prepares
its financial statements to the year ended 30 June. What is the amount of accrued
interest that Selection would show in its financial statement for the year ended 30
June 2011?
A Rs.4,000
B Rs.12,000
C Rs.6,000
D Rs.3,000
 61

Prepaid expenses

An insurance policy for fire and similar risks is obtained for the year from 1
November 2006 by paying a premium of Rs.24,000 for the full year in advance.
The reporting period is 31 December 2006.

Of the total premium paid of Rs.24,000, the premium accrued up to the end of the
reporting period is: 24,000 x (2/12) months = 4,000.

The part which relates to the current financial year is added to the insurance
expense account (in this case, two months: November and December 2006) and
the part which relates to the next financial year is carried forward as an asset –
‘prepaid expenses’. (in this case 10 months from January to October 2007).

The premium for the remaining 10 months, i.e., 24,000/12 x 10 = 20,000 accrues
in the next financial year i.e. it is paid in order to cover the fire and other risks for
the period 1 January 2007 to 31 October 2007.

1. The journal entry made is:

When the payment was made, the accountant would have recorded the following
entry:

Insurance expense (expense) Dr Rs.24,000

To Cash (asset) Rs.24,000
(Being payment of insurance premium
recorded)

Now, at the end of the year, having determined that Rs.20,000 is a pre-payment,
the following entry is made:

Prepaid insurance (asset) Dr Rs.20,000

To Insurance expense (expense) Rs.20,000
(Being prepaid insurance recorded)
 62

Insurance expense account (Year 2006)

Dr Cr
Rs. Rs.
Transferred to profit and loss
X 4,000
account (balancing figure)
Cash ( payments) 24,000
Prepaid insurance** 20,000
24,000 24,000
** Prepaid expense is shown here as a reduction from expense

The adjustment for prepaid insurance leads to an amount of Rs.4,000 i.e. the
amount of expense accrued. This amount is transferred to the profit and loss
account.

Pre-paid insurance (asset) account

Dr Cr
Rs. Rs.
Insurance expense** 20,000

** Prepaid expense is recorded here as an asset

2. Presentation in the financial statements

The insurance expense in the profit and loss account will be reduced by
Rs.20,000.

The prepaid insurance of Rs.20,000 is recognised as a current asset in the balance

sheet.

Profit and loss account for the year Balance sheet

ended 31 December 2007 as at 31 December 2007
Rs. Rs. Rs.
Assets
Income X Non-current assets X
Less: Expenses Current assets X
Insurance expenses 24,000 Pre-paid expenses 20,000
Less: Pre-paid (20,000) 4000 Total X

Capital and liabilities X

Net profit X
X Total X
 63

3. Impact on profit and net assets

Expenses prepaid for the year would have two effects:
 Decrease in expense = Increase in profit for the current period
 Creation / Increase in asset = Increase in net assets
The impact on the next year’s profit and net assets is the opposite of this.
4. At the beginning of the next year, the journal entry is reversed.
In the example considered above, the entry would be:
Insurance expense Dr Rs.20,000
To Prepaid insurance (asset) Rs.20,000
(Being the entry to transfer prepaid
insurance to insurance expense), i.e. the
reversal of last year’s entry
The ledger accounts would appear as:
Insurance expense account (Year 2007)
Dr Cr
Rs. Rs.
Prepaid insurance (last
year’s prepaid expense Transferred to profit and loss
20,000 X
transferred to expense account (including 20,000)
account)**
Cash ( payments) X
X X
** This indicates addition to insurance expense
This reversal of prepaid adjustment enables us to correctly show Rs.20,000 as an
expense of 2007, since the expense has actually accrued during this period, even
though it was paid in 2006.
Prepaid insurance (asset) account (Year 2007)
Dr Cr
Rs. Rs.
Insurance expense (last
year’s prepaid expense
Balance b/f 20,000 20,000
transferred to insurance
expense account)
Closing balance -
20,000 20,000
 64

Accrued income (outstanding income)

Moksh had business premises that were lying vacant. He rented it out for an
agreed rent of Rs.400 per month with effect from 1 April 2006.

The following rents were received by Moksh

Period Rent received on Amount

1 April 2006 to 31 December 2006 (9 months) 1 January 2007 Rs.3,600
1 January 2007 to March 2008 (15 months) 1 April 2008 Rs.6,000

The reporting period of Moksh is 31 March each year.

The rent for the 9 month’s period from 1 April 2007 to 31 December 2007 must
be accounted as an expense.P/L

Rent for the 3 months from January 2007 to March 2007 had accrued even
though it had not actually been received by Moksh. Moksh needs to record an
amount of Rs.1,200 (Rs.400 x 3) in his accounts as rent receivable for the year
2006-2007.

1. The journal entry

Rs. Rs.
Cash Dr 3,600
To Rent income 3,600
(Being rent received)

Rent receivable (B/S) Dr 1,200

To Rent income (P/L) 1,200
(Being rent receivable recorded)
 65

A proforma expense account

Rent (income) account (Year 2006-07)

Dr Cr
Rs. Rs.
Cash ( receipts) 3,600
Transferred to P/L (balancing
4,800
figure)
Income accrued
1,200
(outstanding)**
4,800 4,800
** Accrued income is added to income

Rent receivable (asset) account (Year 2006-07)

Dr Cr
Rs. Rs.
Rent income** 1,200

** Accrued income is recorded as an asset

2. Presentation in the financial statements

The rent receivable is shown as a current asset in the B/S.

The rent income of Rs.1,200 is added to the figure of rent income appearing in
the P/L.

3. Impact on profit and net assets

Accrued income would lead to an increase in income. Hence the following two
effects are noticed:

 increase in income = increase in profit for the current period

 creation / increase in asset = increase in net assets

The effect on the profit and the net assets in the next year, when the entries are
reversed, is the opposite of this.
 66

At the beginning of next year, the journal entry is reversed.

Rent income (P/L) Dr Rs.1,200

To Rent receivable (B/S) Rs.1,200
(Being the entry to transfer rent receivable
account to rent income account), i.e. the
reversal of last year’s entry no. .

The ledger accounts would appear as:

Rent (income) account (Year 2007-08)

Dr Cr
Rs. Rs.
Income accrued (outstanding) 1,200 Cash ( receipts) 6,000
Transferred to P/L (balancing
4,800
figure)**

6,000 6,000

** Opening balance of accrued income is reduced from income received

Reversal of accrual adjustment ensures that Rs.1, 200 received during 2007-08
but relating to 2006-07 is not shown as an income of 2007-08.

Rent receivable (asset) account (Year 2007-08)

Dr Cr
Rs. Rs.
Balance b/f 1,200 Rent income account 1,200
Closing balance ** -
1,200 1,200

** Accrued income is transferred to rent (income) account

 67

Income received in advance

A firm of lawyers received Rs.10,000 on 24 March 2007 as fees for a case that it
was handling and booked the same as revenue for the period. This amount
covered 2 court hearings requiring approximately similar time and effort. Up to
the end of the reporting period on 31 March 2007, only 1 hearing was complete.
The second hearing took place on 30 April 2007.

At the reporting date only half of the work was complete and therefore only half
of the fees must to be accounted.

Since, the fees for both the hearings was received in advance, it must be
accounted in the following manner:

 half of the fees i.e. Rs.10,000/2 = Rs.5,000 is treated as a revenue in 2007

and
 the remaining amount is treated as income received in advance

1. The journal entry

Cash Dr Rs.10,000
To Professional fees Rs.10,000
(Being cash received)

Professional fees (P/L) Dr Rs.5,000

To Professional fees received in advance Rs.5,000
(B/S)
(Being adjustment for fees received in
advance recorded)

Professional fees (income) account (Year 2006-07)

Dr Cr
Rs. Rs.
Transferred to P/L
5,000
(balancing figure)
Fees received in advance** 5,000 Cash ( receipts) 10,000

10,000 10,000
** Fees received in advance shown here as a reduction from income
 68

Professional fees received in advance (liability) account (Year 2006-07)

Dr Cr
Rs. Rs.
Professional fees** 5,000

X
** Fees received in advance recorded here as a liability

2. Presentation in the financial statements

The income from professional fees in the P/L is reduced by Rs.5,000.

The fees received in advance are shown as a current liability in the B/S.

3. Impact on profit and net assets

Income received in advance would lead to an increase in income. Hence the

following two effects are noticed:
 increase in expenses = decrease in profit for the current period
 creation / increase in liability = decrease in net assets

The effect on the profit and the net assets in the next year, when the entries are
reversed, is the opposite of this.

4. At the beginning of next year, the journal entry is reversed.

In the example considered above, the entry would be:

Professional fees received in advance (B/S) Dr Rs.5,000

To Professional fees (P/L) Rs.5,000
(Being reversal of fees received in current
year, in order to record income in the
current year)

The ledger accounts would appear as:

Professional fees (income) account (Year 2007-08)

Dr Cr
Rs. Rs.
Professional fees received in
P/L (balancing figure) 5,000 5,000
advance **

5,000 5,000
** Transferred from professional fees received in advance account
 69

Transfer of the amount received last year but pertaining to the current year (2007
- 2008) to this account enables us to show the income earned in the current year
(Rs.5,000) as current year’s income.

Professional fees received in advance (liability) account (Year 2007-08)

Dr Cr
Rs. Rs.
Professional fees
(opening balance
5,000 Balance b/f 5,000
transferred to professional
fees account)
Closing balance -
5,000 5,000

Diagram 13: Impact on profit and net assets

 70

9.2 The following is a list of the usual expenses which appear on the
profit and loss account

 Salaries: of Office Staff, of Selling Staff, of Proprietor.

 Rents and Rates: of office building; and of shops and godowns.
 Insurance: Premiums paid.
 Advertising and Publicity.
 Freight charges on Sales.
 Bad Debts or Provision for Bad Debts.
 Travelling Expenses and Motor Car Expenses.
 Royalties.
 Selling Commission and Cash Discounts.
 Lighting (except factory).
 Repairs or Provision for Repairs,
 Depreciation and Loss on sale of asset.
 Telephone, Postage and Telegram charges.
 Stationery and Printing.
 Bank charges.
 Interest Paid.
 Audit Fee.
 Loss by fire etc.

9.3 The items usually found on the credit side of the Profit and Loss
account are:
 Cash Discount Received or Commissions earned.
 Interest and Dividend and Rents received.
 Amount previously written off recovered.
 Profit on sale of assets etc. etc.

9.4 Determination of profit or loss

If Income > Expenses; organisation has made a profit

If Expenses > Income; organisation has incurred a loss

Profit = Income – Expenses Loss = Expenses – Income

 71

Diagram 14: When profit is earned

Diagram 15: When a loss is incurred

9.5 Balance sheet

Important matters relating to a balance sheet:

 It is prepared as on a certain date and not for a period: the balance sheet
shows the financial position on the date on which it is prepared and not on
any other day.

 The total of all assets must be equal to the total of all liabilities, including
capital. Since capital is nothing but the difference between assets and
liabilities to the outsiders, it is easy to understand why the two sides of the
Balance Sheet should agree.

Diagram 16: Composition of a balance sheet

 72

 A balance sheet can be prepared only after the Trading account and the
Profit and Loss account are prepared.
 The Balance Sheet must reflect the true financial position of a business.
Hence, it must be drawn up very carefully.
 The balance of the Profit and Loss account included therein should be
carefully arrived at.
 Both these statements, viz. Profit and Loss account and Balance Sheet
are interdependent. If any item of expense or income is omitted or over or
under stated, it will not only affect the accuracy of the net profit or loss but
will also equally affect the correctness of the Balance Sheet.

Likewise, if any asset or liability has been omitted from the Balance Sheet or is
over or under valued, not only would this affect the correctness of the Balance
Sheet but it would also falsify the net resultant profit or loss as disclosed by the
Profit and Loss account.

9.6 Arrangement of Assets and Liabilities

Assets can be presented in a Balance Sheet in the following ways:

 in the order of liquidity;

 in the order of the degree of ease with which they can be converted into cash;
or
 in the order of permanence i.e. in the order of the desire to keep them in use.

Various assets are grouped in these two orders below:

In the order of liquidity In the order of permanence

Cash in Hand Goodwill
Cash in Bank Patents
Sundry Debtors Furniture
Stock of finished goods Machinery
Stock of Raw Materials Prepaid Expenses
Stock of Partly Finished Goods Stock of Partly Finished Goods
Machinery Stock of Raw Materials
Furniture Stock of Finished Goods
Patents Sundry Debtors
Good Will Cash in Bank
Prepaid Expenses Cash in Hand

Liabilities can also be grouped in either of the two ways:

 in the order of urgency of payment; or
 in the reverse order (reverse of the above).
 73

Apart from the joint stock companies, which have to follow the form prescribed
by the Companies Act, liabilities are generally shown in the order of the urgency
of payment. That is why sundry creditors and promissory notes given are shown
first; then come loan creditors as they have given an undertaking to wait for a
definite period. The capital comes last.

It must, however, be borne in mind that whatever system or order is followed on

the assets side, the same order should be followed on the liabilities side in the
Balance Sheet. In other words, if we start with fixed assets and follow them with
the floating assets, we have to likewise start first with fixed liabilities, followed
by floating liabilities.

Order prescribed by the Life Insurance Corporation (LIC) of India

 The Insurance Act recommends starting with fixed assets followed by

floating assets, i.e. in the order of difficulty of realisation. Similarly, fixed
liabilities are stated first and are followed by floating liabilities i.e. in the
order of lower urgency of payment. The above order is followed by the Life
Insurance Corporation of India.

 Joint stock companies have to follow the form prescribed by the Companies
Act.

 In a partnership, usually the assets are shown in the natural order of their
realisability and the liabilities in the order in which they are payable.

 Banks usually prefer to state their assets in order of their realisability. Thus,
the most liquid assets are set out first and are followed by assets which are
more difficult to realise .Liabilities are also shown similarly

Mr. G. Kapadia and Mr. C. Desai are in partnership. Profits are divided as 3/5 to
Kapadia and 2/5 to Desai. Interest at 5 per cent is to be credited on capital
accounts, but no interest is charged on drawings. Desai’s account is to be credited
at the close of the year with Rs. 3,000 as a partnership salary.

The Trial Balance extracted from the books as at 31 st December 2011 is given
hereinafter.
 74

Trial balance

Ledger account Rs. Rs.

G. Kapadia – Capital account 1,50,000
C. Desai – Capital account 50,000
Partner’s drawings – (Kapadia Rs.500 and
Desai Rs.400 per month) 10,800
Loan account (W.R.Patel) 20,000
Machinery and Plant 85,400
Office Furniture 5,400
Sundry Debtors 108,600
Sundry Creditors 11,920
Purchases 1,68,940
Sales 3,54,110
Returns Inwards 1,420
Returns Outwards 3,240
Rent and rates (Office Rs.2,100; Warehouse
Rs.5,820) 7,920
Advertising 12,680
Cash at Bank 11,020
Cash in hand 180
Bills receivable 9,860
Bills payable 21,040
Stock (1st January, 1991) 38,960
Warehouse wages 42,870
Office salaries 18,940
Warehouse room Sublet 1,200
Carriage (inwards Rs.6,620; outwards 15,580
Rs.8,960)
Travellers Salaries and Commission 32,410
Interest account 720
Bad debts 3,010
Motor Lorries 28,600
Showroom Fittings 8,200
Total 6,11,510 6,11,510

When preparing these accounts, the following points are to be taken into
consideration:
 75

a) Depreciation must be provided as follows:

Machinery and Plant 10 per cent

Office Furniture 5 per cent

b) The following valuations were made on 31 st December 1991:

Stock Rs. 44,580

Showroom Fittings Rs. 7,600
Motor Lorries Rs. 24,310

c) No entry has been made with regard to C.Desai’s Salary.

d) Interest at 5 per cent on the loan account for the half year to 31 st December
had accrued due, but no entries had been made.

e) No provision has been made for warehouse wages of Rs.320 and office
salaries Rs.900, which had accrued due on 31 st December.

f) A provision for bad debts equal to 5 per cent on the sundry debtors is to be
set up.

Required:

Prepare a Trading and Profit and Loss account for the year ended 31st December
2011 and a Balance Sheet as at that date.

Solution

Journal entries for adjustments

Rs. Rs.
Dec.31 Stock account Dr 44,580
To Trading account 44,580
(Being value of closing stock)
 76

Dec.31 Interest account Dr 500

(6 months interest at 5% p.a. on loan
Rs.20,000)
Warehouse Wages Dr 320
Office Salaries Dr 900
To Outstanding Expenses 1,720
(Being amount accrued but not paid)

Dec.31 Profit and Loss account Dr 5,430

To Provisions for Bad and Doubtful 5,430
Debts
(Being provision at 5% on sundry
debtors Rs.1,08,600)

Dec.31 Depreciation account Dr 13,700

To Machinery and Plant 8,540
(10% on Rs.85,400)
To Office Furniture 270
(5% on Rs.5,400)
To Showroom Fittings 600
To Motor Lorries 4,290
(Being reduction in value)

Dec.31 Profit and Loss Appropriation account Dr 3,000

To C.Desai 3,000
(Being partnership salary for year)

Dec.31 Profit and Loss Appropriation account 10,000

To Interest on Capital 10,000
G.Kapadia 7,500
C.Desai 2,500
(Being interest on capital at 5%)
 77

Trading Account for the year ended 31 st December, 2011

Dr Cr
Rs. Rs. Rs. Rs.
st
To Stock at 1
38,960 By Sales 3,54,110
Jan
Returns
To Purchases 1,68,940 1,420 352,690
Inwards

Less : Returns
3,240 165,700
Outwards

To Warehouse
5,820
Rent and Rates

Less : Sub-let 1,200 4,620

To Warehouse 42,870

Wages
320 43,190
Outstanding

To Inward
6,620
Carriage
To Gross Profit By Stock at
138,180 44,580
c/d 31st Dec.
397,270 397,270
 78

Profit and loss account for the year ended 31 st December, 2011
Dr Cr
Rs. Rs. Rs. Rs.
To Office Rent and 2,100 By Gross 1,38,180
Rates Profit b/d
To Office Salaries 18,940
To Outstanding
Salaries 900 19,840
To Advertising 12,680
To Travellers Salaries
and Commission 32,410
To Outward Carriage 8,960
To Interest 720
To Interest on Loan 500 1,220
To Bad Debts 3,010
To Provision for Bad
Debts (5% on 5,430
Rs.1,08,600)
To Depreciation
Machinery and
Plant 8,540
Office Furniture 270
Showroom Fittings 600
Motor Lorries 4,290 13,700
To Net Profit 38,830
1,38,180 1,38,180

Profit and loss appropriation account for the year ended 31 st December,
2011
Dr Cr
Rs. Rs. Rs. Rs.
To Partnership Salary By Net Profit 38,830
C.Desai 3,000
Interest on Capital
G.Kapadia 7,500
C.Desai 2,500 10,000
To Division of balance of
Profits
G.Kapadia 3/5ths 15,500
C.Desai 2/5ths 10,330 25,830
38,830 38,830
 79

Balance sheet as at 31ST December, 2011

Liabilities Rs. Rs. Assets Rs. Rs.
Current Liabilities : Fixed Assets
Sundry Creditors 11,920 Machinery and Plant 85,400
Bills Payable 21,040 Less : Depreciation 8,540 76,860

Loan account ( W.R.Patel) 20,000 52,960 Office Furniture 5,400

Outstanding Expenses
Less : Depreciation 270 5,130
account:
Interest Outstanding 500 Showroom fittings 8,200
Warehouse Wages 320 Less : Depreciation 600 7,600
Office Salaries 900 1,720 Motor Lorries 28,600
Capital Accounts : Less : Depreciation 4,290 24,310
Kapadia A/c.

Balance As at 1st Jan. 1991 1,50,000 Current Assets

Add : Interest on Capital 7,500 Stock in Trade 44,580

Add : Profits 15,500 Sundry Debtors : 1,08,600

Less : Provision for Bad and

1,73,000 5,430 1,03,170
Doubtful Debts

Less : Drawings 6,000 1,67,000

 80

Desai A/c. Bills Receivable 9,860

Balance As at 1st Jan. 1991 50,000 Cash at Bank 11,020

Add : Partnership Salary 3,000 Cash in hand 180 11,200

Add : Interest on Capital 2,500
Add : Profits 10,330
65,830
Less : Drawings 4,800 61,030
Total 2,82,710 Total 2,82,710
 81

10.Preparation of Receipts and Payments account and

Income and Expenditure account
[Learning Outcome k]
So far we have studied the accounting system followed by commercial
institutions; the financial statements of commercial institutions are prepared on
the basis of an accrual system of accounting. In the accruals system, items are
recognised as assets, liabilities, incomes and expenses on the date they satisfy
the recognition criteria mentioned in their definitions. Therefore, the actual
date of payment of cash is immaterial for the purpose of recognition.

However, not-for-profit organisations like clubs, charitable institutions, etc.

where the object of the enterprise is of supplying a want and not that of profit
making generally adopt the cash system of accounting. Under the cash system of
accounting entities prepare a receipt and payment account.

Receipt and Payment account

The Receipts and Payments account is the simplified form in which the treasurer
of a non-trading institution can render an account of his stewardship.

The account consists of a classified summary of:

 The balances of cash in hand at the You must include the

beginning: this account starts with the balance of all bank
opening balance of cash in hand, and accounts
cash in bank accounts. and all cash books

 The actual cash receipts for a particular period: cash receipts are added
separately for each head of account and disclosed on the receipts side of the
Receipts and Payments account. For example, total subscriptions received
during the period will be shown as subscriptions received.

 The actual cash payments for a particular period: cash payments are
added separately for each head of account and disclosed on the receipts side
of the Receipts and Payments account. For example, total salary paid during
the period will be shown as salary payment.

 The balances of cash in hand at the end of the period: this account ends
with the closing balance of cash in hand, and cash in bank accounts.
 82

Therefore, amounts reported in this statement are confined to cash received and
paid during the period without consideration to any outstanding receipts or
payments.

As this kind of account is a condensed summary of the cash book:

 the receipts (including receipts of subscriptions relating to the earlier

accounting period) are set out on the debit side;

 the payments (including payment of outstanding expenses) are set out on the
credit side; and

 the balance of the cash on hand is carried forward to the next financial
period.

Furthermore, all receipts and payments, whether on account of capital or revenue,

are included in this account.

Therefore, this account does not necessarily reveal the actual income and expense
for the period it purports to cover.

Format of Receipt and Payment account:

Receipt and Payment account

Dr Cr
Receipts Amount Payments Amount
(Rs.) (Rs.)
To Cash in hand XXX By Salaries XXX

By Balance c/d XXX

Total XXX Total XXX
 83

Meera’s General Hospital

Receipt and Payment account for the period ending 31 March 2011
Dr Cr
Amount Amount
Receipts Payments
(Rs.) (Rs.)
To Cash in hand (1.4.2010) 1,005 By Salaries 9,840

To Bank balance on 29,145 By Laundry and domestic 5700

1.4.2010 help
To Subscriptions 16,750 By Rent, rates and taxes 3,000

To Government grant 15,000 By Surgical equipments 30,000

To Donation for building 23,400 By Car expenses 12,600

fund
To Fees from non-members 4050 By Drugs and incidental 10,050
exp.
To Interest 570 By Balance c/d 18630

Total 899,920 Total 899,920

Income and Expenditure account

On the other hand, it is the objective of an Income and Expenditure account to

ascertain and show the actual income and expenditure for the period covered by
the account, and thus reveal the surplus or deficit.

In other words, the purpose of this account as employed by non-trading concerns

is exactly the same as that of the Profit and Loss account of a commercial
undertaking. Therefore, this account includes the whole of the income and
expenditure pertaining to the period covered irrespective of whether actually
received or paid or not. It is precisely a Revenue account and includes revenue
items only.

The formation of an Income and Expenditure account being in essence as that of

Profit and Loss account, it follows that:
 84

 the income will appear on the credit side; and

 the outgoings properly chargeable against the income will appear on the debit
side of the account.
Furthermore, since all accrued income and outstanding liabilities have been taken
into account, it also follows that the account must be combined with the Balance
Sheet in order to disclose the financial position at the end of the period.

Balance of the Income and Expenditure account = Surplus / deficit for the period
Accounting treatment of surplus / deficit for the period

 Add surplus for the period to “capital” or “accumulated surplus” found in the
Balance Sheet.
 Deduct deficit for the period from the “capital” or “accumulated surplus”
found in the Balance Sheet.
The distinction between the two forms of accounts is set out below:

Receipt and Payment account Income and Expenditure account

This account is simply a summary of This account, like the Profit and Loss
the cash transactions analyzed under account, forms an integral part of the
suitable headings accounts in a system of double entry
book-keeping.
All receipts and payments, whether It is only a revenue account and
on account of capital or revenue, are includes revenue items only.
included in this account.

Amounts reported here are confined This account includes the whole of
to cash received and paid during the the income and expenditure
period without consideration to any pertaining to the period covered,
outstanding receipts or payments. irrespective of whether actually
received or paid or not.

A receipt and payment account is precisely a revenue account, and includes

revenue items only.
A True
B False
 85

11.Calculate the charge for depreciation

[Learning Outcome l]
11.1 Depreciation is the systematic allocation of the depreciable
amount of an asset over its useful life.

Non-current assets are acquired at a cost. However, it would be incorrect to

charge the entire cost in the first year itself. The asset is going to help generate
income for many years.

The matching principle requires that the expenses be recognised in the year in
which the revenue is recognised (cost is matched with the relevant revenue). If
the revenue from an asset is going to be earned over a number of years then its
cost should also be allocated over the same number of years. Hence, it is logical
to charge the cost of an asset to revenue over the useful life of the asset.

Physical wear and tear and obsolescence also result in the depreciating value of
an asset.

Like material costs, the depreciation on non-current assets is matched with the
sales revenue.

Provision for depreciation is over and above the amount spent for repairs and
renewals necessary to maintain these assets in their state of original efficiency.

In order to correctly determine depreciation, three estimates have to be made.

These are:

1. Useful life of the assets: useful life The life of the asset and
is the period over which the asset is the salvage value would
expected to be available for an depend upon the technical
entity’s use estimate.

2. Salvage value at the end of the useful life: salvage value is the value which
the entity expects to realise from the disposal of the asset at the end of its
useful life; and

3. The method of depreciation: there are various methods of depreciating an

asset. The important ones are discussed below.
 86

1. Straight-line method

Under this method, depreciation is charged uniformly over the life of the asset.

Cost of the asset - Estimated residual value

Depreciation =
Estimated life of the asset

This method results in a constant charge over the useful life of the asset. The
asset’s residual value does not change and depreciation is calculated as a fixed
amount every year or a fixed percentage of the original cost.

Tapra Ltd bought machinery on 01 January 2004 for Rs.260,000. It incurred

transportation and installation expenses of Rs.20,000 in connection with the
machinery. Tapra Ltd expects the useful life of the asset to be 6 years. The
estimated realisable value after 6 years is expected to be Rs.10,000.

Calculate the depreciation for six years.

Answer

Cost of the asset - Estimated residual value

=Depreciation =
Estimated life of the asset
Rs. 260,000 + Rs. 20,000 - Rs. 10,000 = Rs.45,000
6
The carrying values at the end of each year will be as follows:

1st year 280,000 - 45,000 Rs.235,000

2nd year 235,000 - 45,000 Rs.190,000
3rd year 190,000 - 45,000 Rs.145,000
4th year 145,000 - 45,000 Rs.100,000
5th year 100,000 - 45,000 Rs.55,000
6th year 55,000 - 45,000 Rs.10,000

The carrying value at the end of the asset’s useful life is equal to the disposal or
realisable value.
 87

If the depreciation rate is applied as a percentage, it will be applied to the

original cost, and not to the carried down value net of depreciation.

E.g. it may be stated that depreciation is to be charged at 16.07% of the original

cost, on a straight line basis.

The amount of depreciation each year would be calculated as 280,000 x 16.07%

= 45,000

2. Diminishing balance method

Under this method, depreciation is charged as a percentage of the written down

or book value of the asset i.e. cost minus accumulated depreciation. This is also
known as the reducing balance method. This method results in a decreasing
charge over the useful life of the asset.

Depreciation = (Cost – Accumulated depreciation) x Depreciation rate

KPL Inc purchased machinery for Rs10,000 on 1 January 2004. Its expected life
is 4 years and the residual disposal value is Rs1,296. KPL charges depreciation at
40% using the reducing balance method. Calculate the depreciation amount for 4
years.

Answer

Calculation of the depreciation amount

Year Particulars Calculation Depreciation Carrying

value
1st year Depreciation = 10,000 x 40% = Rs. 4,000
Carrying value = 10,000 - 4,000 = Rs. 6,000
nd
2 year Depreciation = 6,000 x 40% = Rs. 2,400
Carrying value = 6,000 - 2,400 = Rs. 3,600
3rd year Depreciation = 3,600 x 40% = Rs. 1,440
Carrying value = 3,600 - 1,440 = Rs. 2,160
4th year Depreciation = 2,160 x 40% = Rs. 864
Carrying value = 2,160 – 864 = Rs. 1,296

The depreciation charged in this method keeps reducing every year. In this case it
was Rs 4,000 in the first year, which gradually reduced to Rs864.
 88

Under the diminishing balance method of depreciation, the carrying value at the
end of the useful life is equal to the disposal or realisable value.

3. Sum of the years’ digit method

The sum of the years of the life of asset is taken to be the denominator. The
numerator each year will be the digits taken in the reverse order.

Remaining useful life of asset x (Cost of the asset - Estimated residual value)
Depreciation =
Sum of years of life of asset

Continuing the earlier example of KPL

The useful life of the asset is four years.

Therefore depreciation will be as follows:

Year Particulars Calculation Depreciation Carrying

value
1st year Depreciation = 8,704 x 40% = Rs.3,482
Carrying value =10,000 - 3,482 = Rs.6,518
2nd year Depreciation = 8,704 x 30% = Rs.2,612
Carrying value = 6,518 - 2,612 = Rs.3,906
3rd year Depreciation = 8,704 x 20% = Rs.1,740
Carrying value = 3,906 – 1,740 = Rs.2,166
4th year Depreciation = 8,704 x 10% = Rs.870
Carrying value = 2,166 – 870 = Rs.1,296

The diminishing balance method and the sum of the years’ digit methods are
known as accelerated method of depreciation for they charge heavier amounts in
the earlier years.

The repairs to the asset will be much less in the earlier years when compared to
the later years. If the above two methods are adopted, the sum total of
depreciation and repairs will be more or less a constant charge over the life of the
asset.
 89

4. Annuity method

The annuity method takes into consideration the interest lost by the owner - the
interest that could have been earned if the amount would have been invested in
interest earning securities. Therefore, under the annuity method, the cost of the
asset and the interest at a given rate is written down every year by fixed amount.
This annual amount is determined with the help of annuity tables.

The asset is debited with the amount of interest on the diminishing value of the
asset and the amount of depreciation is ascertained with reference to the present
value of the capital investment or the original cost of the asset, usually with the
help of the Logarithmic Table. A formula can also be used to ascertain the
present value. This method is useful for long term leases.

A lease was acquired with a premium of Rs. 2,00,000 on 01.04.2006 for 4 years.
Depreciation under annuity system at 5% p.a. interest is charged. Rupee 1 is the
present value of 0.282012 payable over 4 years @ 5% p.a.

Prepare Lease account.

Lease account
Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2006 To Bank 200,000 31.03.2007 By Depreciation 56,402
A/c
31.03.2007 To Interest 10,000 31.03.2007 By Balance c/d 153,598
210,000 210,000
01.04.2007 To Balance b/d 153,598 31.03.2008 By Depreciation 56,402
A/c
31.03.2007 To Interest 7,680 31.03.2008 By Balance c/d 104,876
161,278 161,278
01.04.2008 To Balance b/d 104,876 31.03.2009 By Depreciation 56,402
A/c
31.03.2009 To Interest 5,244 31.03.2009 By Balance c/d 53,718
110,120 110,120
01.04.2009 To Balance b/d 53,718 31.03.2010 By Depreciation 56,402
31.03.2010 To Interest 2,684
56,402 56,402
 90

Workings

W1 Interest (Rate: 5% p.a.)

1st year on Rs. 2,00,000 = 200000 x 5/100 = Rs. 10,000

2nd year on Rs. 1,53,598= 153598 x 5/100 = Rs. 7,680 rounded off (r/off)
3rd year on Rs. 1,04,876= 104876 x 5/100 = Rs. 5,244 r/off
4th year on Rs. 53,718= 53718 x 5/100 = Rs. 2,684

Rs. 2,686 has been r/off to balance the lease account as the amount of
annual depreciation is Rs. 56,402 and the opening balance is Rs. 53,718 in
the 4th year

W2 Annual depreciation

Present Value: Re.1 and Annual Depreciation: 0.282012

Hence, if present value is Rs. 2,00,000, then annual depreciation is:

= Rs. 2,00,000 x 0.282012
= Rs. 56,402 r/off.

5. Sinking fund method

This is the method of providing for depreciation by means of fixed periodic

charges aggregated with compound interest to equal the cost of the asset.
Usually, amounts equal to depreciation will be invested in interest bearing
securities outside the business. The invested amount will accumulate at
compound interest to a sum required to replace the original asset by the new one,
at the time when it is required to be discarded, without disturbing the financial
condition of the business in any way.
 91

PQR Company Ltd obtained a machine for Rs. 3,00,000 with its useful life of 4
years on 01.04.2006. Replacement was to be done after 4 years by setting up a
depreciation fund, and an annual investment of Rs.70,647 would be required to
earn interest @ 4% p.a.

Prepare necessary ledger accounts assuming that the depreciation fund

investment realised Rs. 2,20,800 at the end of four years.

In the books of PQR Company Ltd

Machine account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.04.2006 To Bank A/c 3,00,000 31.03.2007 By Balance c/d 3,00,000

3,00,000 3,00,000

01.04.2007 To Balance b/d 3,00,000 31.03.2008 By Balance c/d 3,00,000

3,00,000 3,00,000

01.04.2008 To Balance b/d 3,00,000 31.03.2009 By Balance c/d 3,00,000

3,00,000 3,00,000

01.04.2009 To Balance b/d 3,00,000 31.03.2010 By Depreciation 3,00,268

Fund account
31.03.2010 To Profit and 268
Loss A/c
3,00,268 3,00,268
 92

Depreciation Fund Account

Dr Cr
Date Particulars Rs. Date Particulars Rs.

31.03.2007 To Balance c/d 70,647 31.03.2007 By Depreciation 70,647

A/c
70,647 70,647

01.04.2007 By Balance b/d 70,647

31.03.2008 By Depreciation 70,647

A/c
31.03.2008 To Balance c/d 1,44,120 31.03.2008 By Interest A/c 2,826

1,44,120 1,44,120

01.04.2008 By Balance b/d 1,44,120

31.03.2009 By Depreciation 70,647

A/c
31.03.2009 To Balance c/d 2,20,532 31.03.2009 By Interest A/c 5,765

2,20,532 2,20,532

01.04.2009 By Balance b/d 2,20,532

31.03.2010 By Depreciation 70,647

A/c
31.03.2010 By Interest A/c 8,821
31.03.2010 To Machine 3,00,268 31.03.2010 By Depreciation 268
A/c Investment A/c
3,00,268 3,00,268
 93

Depreciation Fund Investment Account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.03.2007 To Bank A/c 70,647 31.03.2007 By Balance c/dc 70,647

70,467 70,467
01.04.2007 To Balance b/d 70,647 31.03.2008 By Balance c/d 1,44,120

31.03.2008 To Bank A/c 73,473

(70,647 + 2,826)
1,44,120 1,44,120
01.04.2009 To Balance b/d 1,44,120 31.03.2009 By Balance c/d 2,20,532

31.03.2009 To Bank A/c 76,412

(70,647 + 5,765)
2,20,532 2,20,532
01.04.2010 To Balance b/d 2,20,532 31.03.2010 By Bank A/c 2,20,800

31.03.2010 To Depreciation 268

Fund A/c
2,20,800 2,20,800

6. Insurance policy method

This method is similar to the sinking fund method. Under this method, premiums
are paid on a policy taken out with an insurance company. When the policy
matures, funds become available for replacement of the asset.

The policy is made usually for a period equal to the useful life of the asset and
for a sum assured that is expected to provide enough funds for the replacement of
the asset. If annual interest is to be accounted for, the surrender value of the
policy at the particular year-end is referred to. This method is usually adopted in
the case of vehicles due to the uncertainty of their useful lives.
 94

Journal entries under this method are as follows:

For the first year and subsequent years:

Insurance Policy account Dr X

To Bank account X
(Being premium paid at the beginning of the year)

Profit and Loss account Dr X

To Depreciation fund account X
(Being depreciation equal to premium charged)

For the last year:

Bank account Dr X
To Insurance Policy account X
(Being amount of the policy received on maturity)

Insurance Policy account Dr X

To Depreciation fund account X
(Being transfer of the excess amount received over
the total premiums)

Depreciation fund account Dr X

To Asset account X
(Being depreciation fund account closed and
transferred to asset account)

Bank account Dr X
To Asset account X
(Being sale of scrap, if any)
 95

Shyam Ltd took a building worth Rs. 80,000 on lease for four years, starting
from 01 January 2010. Shyam Ltd has decided to make a provision for
replacement of the lease by means of an insurance policy purchased for an annual
premium of Rs. 18,300.

Prepare the necessary accounts.

Leasehold Building Account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.01.2010 To Bank A/c 80,000 31.12.2010 By Balance c/d 80,000
80,000 80,000
01.01.2011 To Balance b/d 80,000 31.12.2011 By Balance c/d 80,000
80,000 80,000
01.01.2012 To Balance b/d 80,000 31.12.2012 By Balance c/d 80,000
80,000 80,000
01.01.2013 To Balance b/d 80,000 31.12.2013 By Depreciation 80,000
fund A/c
80,000 80,000

Depreciation Fund Account

Dr Cr
Date Particulars Rs. Date Particulars Rs.
31.12.2010 To Balance c/d 18,300 31.12.2010 By Depreciation 18,300
A/c
18,300 18,300
01.01.2011 By Balance b/d 18,300
31.12.2011 To Balance c/d 36,600 31.12.2011 By Depreciation 18,300
A/c
36,600 36,600
01.01.2012 By Balance b/d 36,600
31.12.2012 To Balance c/d 54,900 31.12.2012 By Depreciation 18,300
A/c
54,900 54,900
01.01.2013 By Balance b/d 54,900
31.12.2013 By Depreciation 18,300
A/c
31.12.2013 To Building A/c 80,000 31.12.2013 By Depreciation 6,800
fund policy A/c
80,000 80,000
 96

Depreciation Fund Policy A/c

Dr Cr
Date Particulars Rs. Date Particulars Rs.
01.01.2010 To Bank A/c 18,300 31.12.2010 By Balance c/d 18,300
18,300 18,300
01.01.2011 To Balance b/d 18,300
To Bank A/c 18,300 31.12.2011 By Balance c/d 36,600
36,600 36,600
01.01.2012 To Balance b/d 36,600
To Bank A/c 18,300 31.12.2012 By Balance c/d 54,900
54,900 54,900
01.01.2013 To Balance b/d 54,900
To Bank A/c 18,300
To Depreciation 6,800 31.12.2013 By Bank A/c 80,000
fund A/c
80,000 80,000

Comparison between the sinking fund method and the insurance policy method:

Sinking fund method Insurance policy method

Annual investments are made at the Annual premium is paid at the
end of the year. beginning of the year.
The amount to be received on The amount to be received on
maturity is not certain as it depends maturity is certain.
upon the nature of the investments
made and the market conditions.

7. Production hour method

The method of providing for depreciation by means of fixed rate per hour of
production calculated by dividing the value of the asset by the estimated number
of working hours of its life.

At the end of each year, assets are revalued and diminution in value is written off
as depreciation.

Broadly, the importance of charging depreciation on fixed assets may be looked

from two angles – depreciation as an element of cost and depreciation as a
provision for future replacement. Whatever be the method used, the amount of
 97

depreciation is treated as an expense for the accounting period. Depreciation is

either written off the asset (i.e. reducing the asset value) or accumulated and
shown as a cumulative total as provision for depreciation. The total provision for
depreciation is shown as a deduction from the asset account in the Balance Sheet
or shown as provision for depreciation on the Liabilities side. In Life Insurance
Accounts, all assets for which depreciation is provided are to be shown at gross
Book Value less depreciation on the Assets side of the Balance sheet. However,
in the case of House Property, depreciation is treated as ‘Reserve for House
Property’ and shown on Liabilities side.

11.2 Provision and reserve

Provisions are liabilities of uncertain timing or amount.

Provision refers to any amount written off or retained by way of providing for
depreciation, renewals or diminution in values of assets or retained by way of
providing for any known liability the amount of which cannot be determined with
substantial accuracy (e.g. provision for unexpired risk).

Reserve is a sum set aside out of the profits for some purposes which may or may
not subsequently be brought back into profit and loss account and allocated in
some other manner. Any excess provision may be treated as reserve.

In addition to depreciation, entries for provision for bad and doubtful debts and
provision for depreciation in the value of investment, if any, will have to be
made.

Accounting entries

1. In the year in which the allowance is created:

Bad and doubtful debts expense account Dr X
To Provision for doubtful debts X
(Being a provision made against doubtful debts)
The doubtful debts expense is an expense account in the profit and loss account.
It usually forms a part of the bad debt expense account. The provision for
doubtful debts is a separate account which is presented as a reduction from the
debtors account in the balance sheet.
 98

2. In subsequent years, when a debt actually becomes bad:

The accounting entry is:

Provision for Bad debts Dr X

To Debtors account X
(Being entry to record bad debts)

Shivam Corporation purchased machinery worth Rs. 50,000 on 1 January 2001

and incurred an installation charge of Rs. 10,000. The depreciation is calculated
at 10% on a straight line basis. On 30 June 2003, the machinery was sold for Rs.
42,500.

If the depreciation is calculated using the written down value method, the book
value of the machinery on 30 June 2003 will be more by:

A Rs. 1,170
B Rs. 3,000
C Rs. 2,500
D Rs. 2,430

12. Preparing bank reconciliation statements

[Learning Outcome m]
When a person opens and operates a current or savings account with any
commercial bank, he is supplied periodically with a statement showing where his
account stands - in the form of a pass book. This pass book contains a copy of the
customer’s account maintained in the bank’s ledger. This pass book is set out in
such a manner that the balance of an account can be immediately referred to by
the customer after each transaction. It is quite obvious that the balance shown by
the pass book of a customer as on a particular date should agree with the bank
balance as shown by the cash book maintained by him.
 99

12.1 Reasons for disagreement of balance in cash book and bank

pass book

However, in actual practice, the two balances rarely agree for the following
reasons:

1. Cheques not credited

When cheques are received from clients, they are immediately deposited with the
bank and debited in the bank column of the cash book. But the bank does not
credit the customer’s account until the bank gets the cheque realized, especially
when it is drawn on another bank. In the meantime, therefore, the cash book will
show a higher balance than that shown by the pass book.

2. Cheques not presented

When cheques are issued to clients, they are immediately entered and credited
in the bank column of the cash book. But the bank does not make an entry in the
pass book as long as the cheques are not actually presented for payment, and are
paid. During this time lag, the cash book will show a lower balance than that
shown by the pass book.

3. Entries in the pass book not recorded in the books of account:

These refer to items which are entered in the pass book only with no
corresponding entries appearing in the cash book and vice versa. Some of them
are given below such as:

a) Bank charges and interest on overdraft:

The bank usually charges the customers for the services it renders to them. These
charges are known as bank charges. These bank charges, and sometimes, interest
on overdraft are entered in the pass book only. These are entered in the cash book
either on receipt of intimation from the bank or after the receipt of the pass book
by the customer. Until such time, the cash book will show a higher balance than
that of the pass book.
 100

Sonia had issued a cheque of Rs. 20,000 to Sham. The cheque was dishonoured
due to insufficient balance in her account. For dishonour of cheque, the bank
charged her Rs. 200.

Sonia had no information about these bank charges until she got the bank
statement. So there was no entry in the cash book. This resulted in a difference of
Rs. 200 between the balance in the bank statement and in the cash book.

b) Direct credit and bank interest:

Whenever deposits are made directly into the bank account of a trader by his
debtors without the knowledge of the former, they are credited to the account of
that trader by the bank. This may also result in a difference between the cash
book balance and the pass book balance; the cash book will show a lower balance
than that of the pass book.

Furthermore, the bank is usually entrusted with the task of collection of interest
on securities or dividends on shares or proceeds of bills of exchange or
promissory notes on maturity on behalf of the customers. The bank credits the
customer’s account the moment the proceeds are collected whilst the customer
debits the bank account only after the receipt of information from the bank to that
effect. The bank may have also credited periodic interest on the customer’s
current and/or savings account, which will be known only after the receipt of the
pass book. During this time lag; the cash book will show a lower balance than
that of the pass book.

c) Standing order:

At times, a bank is also instructed by the customers to make recurring payments

like rents, taxes, insurance premium electricity charges, etc. on their behalf. Once
these payments are made by the bank, they are debited to the customer’s accounts
straightaway. But the customer on his part will credit the bank account only after
the receipt of the pass book or intimation from the bank to that effect. In the
meantime, therefore, the cash book will show a higher balance than that of the
pass book.
 101

d) Cheques dishonoured

Sometimes, entries may be passed in the pass book by the bank for dishonored
bills or cheques and these may not find place in the cash book until the receipt of
the pass book by the customer from the bank. Accordingly, the cash book will
show a higher balance than the pass book during this period.

Madhav deposited a cheque received from one of his customers of Rs. 50,000.
The cheque was dishonoured by the bank because there was insufficient balance
in the customer’s account. This fact was not known to Madhav.

This resulted in a difference between the cash book and bank statement. Madhav
had shown this withdrawal but there was no corresponding entry in the bank
book.

e) Errors

There may be differences between the cash book and bank statement because of
errors committed either by the entity’s personnel or the bank’s personnel. Errors
may be in the nature of calculation mistakes, or they may be made while
recording a transaction. Some of the reasons for errors are as follows:

A clerical error on the part of a bank may also result in a difference between the
cash book balance and the pass book balance. For instance, the bank may credit
or debit the account of one customer wrongly for another.

A careless omission on the part of a customer in not depositing the cheque with
the bank for collection after entering it in the cash book or depositing it with the
bank without entering in the cash book may also result in a difference between
the cash book balance and the pass book balance.

Any mistake in casting and carry forward of the total as well as erroneous
balancing of the cash book or pass book may also result in a difference between
the cash book balance and the pass book balance.
 102

12.2 Rectification of errors:

All errors and omissions in the cash book are first rectified to determine the
correct balance according to the cash book. We then prepare bank reconciliation
statement.

Let us understand how to determine the correct cash book balance with the
following example:

On 30 June 2009, Superb Inc discovered a difference between the cash book and
the bank statement. The accountant of the company was unable to explain the
difference. The details of the balances are as follows:

On 30 June 2009, the balance in the cash book was Rs.900 (debit) and in the
bank statement was Rs. 1,000 (credit).
After verification, it was found that the difference was because of the following
transactions:

a) The cash book was understated by Rs. 50.

b) Cheques deposited but not credited by the bank amounted to Rs. 300.
c) Cheques issued but not presented amounted to Rs. 450.
d) Cheques issued of Rs. 50 wrongly recorded on receipt side of cash book.

The only error in the cash book is that it is understated by Rs. 50 and issued
cheque is debited instead of credited. Hence, we will first correct this error.
The correction in the cash book is made as follows:

Cash Book

Dr Cr
Date Receipts Rs. Date Payments Rs.
Cheque wrongly
Balance b/d 900 recorded on receipt side 100
(50x2)*
Understated
50 Balance c/d 850
figure (a)
Total 950 Total 950
 103

The revised balance of the cash book is Rs. 850.

*The amount has been deducted twice: first for the reversal of the previous
wrong entry on receipt side, and later for the correct recording of the entry for
cheque issued.

Items b) and c) are not errors. They are items of timing differences which will
appear in the bank reconciliation statement.

12.3 Bank reconciliation statement

A statement is prepared to reconcile the difference that exists between the cash
book and the pass book. This statement is known as Bank Reconciliation
Statement.

Diagram 17: Bank reconciliation

For preparation of bank reconciliation statement, entries appearing in bank

column of the cash book are compared with those appearing in the pass
book. More precisely, the entries appearing on the debit side of the cash
book will be compared with entries appearing on the credit side (deposit
column) of the pass book and vice versa.

It should be remembered that entries appearing both in the cash book and the
pass book will cause no difference at all and hence, have to be ignored.
 104

One of the balances will be taken up as the starting point and is adjusted
considering how the balance would have changed if the same entries were made
in the two books. This enables the management of business concerns to check
accuracy of the entries made in the cash book and also to keep track of cheques
either sent to the bank for collection and remaining unclear or issued to the
clients by the customer and remaining unpresented, for an unreasonably long
period. Ultimately, the management can ascertain the cause for delay and take
timely action.

Preparation of a bank reconciliation statement

Take the Cash Book Balance or Pass Book Balance as the starting point and then
check what has been done or has not been done in the other Book. For instance if
we take the Pass Book Balance as the starting Point, we would check up
carefully, what has been done or not done in the Cash Book and ascertain if the
entries passed in the Cash Book are also passed in the Pass Book and also if the
entries not finding a place in the Cash Book are removed from the Pass Book.
Step 1:
Compare the debit side of the cash book with the deposits column of the pass
book, item by item. Note down the following:
 cheques deposited into the bank account (appearing in the cash book) which
are not credited by the bank
 interest credited by the bank for which there is no corresponding entry in the
cash book
 Cheques dishonoured (not recorded in cash book)
 direct credits by customers (appearing in pass book) for which there is no
corresponding entry in the cash book
Step 2:
Compare the credit side of the cash book with the withdrawals column of the
pass book. Note down the following:
 cheques issued during the period which have not been presented for payment
 bank charges debited by the bank for which there is no corresponding entry
in the cash book
 Standing order payments (appearing in pass book) for which there is no
corresponding entry in the cash book
 interest debited by the bank for which there is no corresponding entry in the
cash book
Step 3:
Fill up the proforma of the bank reconciliation statement.
 105

The following proforma can be used to reconcile the balances of cash book
and bank statement.

Let us see the proforma of the same in two different ways.

1. When we move from cash book balance to bank statement balance.

2. When we move from bank statement balance to cash book balance.

Proforma of bank reconciliation statement when we move from cash book

balance to bank statement balance

Bank Reconciliation Statement

Rs
Balance according to cash book X
Add: Cheque issued but not presented X
Add: Bank interest X
Add: Direct credit by customers X
X
Less: Standing order (X)
Less: Cheques deposited in bank but not credited (X)
Less: Cheques dishonoured (not recorded in cash book) (X)
Less: Bank charges (X)
Balance according to bank statement X

Proforma of bank reconciliation statement when we move from bank statement

balance to cash book balance

Bank Reconciliation Statement

Rs
Balance according to bank statement X
Add: Cheques deposited in bank but not credited X
Add: Bank charges X
Add: Cheques dishonoured X
Add: Standing order X
X
Less: Cheque issued but not presented (X)
Less: Direct credit by customers (X)
Less: Bank interest (X)
Balance according to cash book X
 106

The method of comparison of entries in the Cash Book with those found in the
Pass Book will be clear from the following:

Cash book (Bank Column Only)

Date DEBIT Amount Date CREDIT Amount
Particulars Rs. Particulars Rs.
2011 2011
July 1 To Cash 8,000 July 3 By Dulles 1,400
July 2 To Morris 400 July 10 By Brown 1,200
July 5 To Jones 600 July 12 By Cash 900
July 9 To Allen 500 July 20 By Hawking 700
July 15 To Cash 800 July 25 By Greig 1,200
July 20 To Compton 400 July 29 By Fraser 600
July 26 To Parker 300 July 31 By Balance 5,600
c/d
July 31 To Evans 600
11,600 11,600

M/s. Red and White Ltd, New Delhi in Current account with Indian Bank
Ltd, New Delhi

Dr Cr Dr Balance
Date Particulars Withdrawal Deposits Cr Rs.
Rs.
2011
July 1 By Cash 8,000 Cr 8,000
4 By Cheque Morris 400 Cr 8,400
4 To Bank Charges 2 Cr 8,398
5 To Dulles 1,400 Cr 6,998
8 By Cheque Jones 600 Cr 7,598
10 To Brown 1,200 Cr 6,398
11 By Cheque Allen 500 Cr 6,898
12 To Self 900 Cr 5,998
15 By Self 800 Cr 6,798
24 By Cheque Compton 400 Cr 7,198
24 To Bank Charges 3 Cr 7,195
26 To Hawkins 700 Cr 6,495
31 By Interest 500 Cr 6,995
 107

Step 1:

The cash book shows a balance of Rs. 5,600 whereas the pass book shows a
balance of Rs. 6,995. If one compares the debit side of the cash book with the
deposits column of the pass book, item by item, one will find that the following
cheques deposited into the bank were not credited by the bank till 31st July 2011:

 Cheque received from Parker:................... Rs. 300

 Cheque received from Evans: ……….. Rs. 600

Had these cheques been credited in the pass book, the pass book balance would
be showing Rs. 7,895, i.e. Rs. 6,995 plus Rs. 900.

Step 2:

While comparing the credit side of the cash book with the withdrawals column of
the pass book, one will find that the following cheques issued during the month
of July, 1991 have not been presented for payment till 31 st July, 2011.

 Cheque issued to Greig: ……… Rs. 1,200

 Cheque issued to Fraser: ……… Rs. 600

Had these cheques been presented for payment, the pass book balance would
have been reduced to Rs. 6,095 i.e. Rs. 7,895 minus Rs. 1,800.

Furthermore, one finds that the bank has credited a sum of Rs. 500 for interest
collected. There is no corresponding entry in the cash book. Had the pass book
ignored this item temporarily, the balance at the bank as per the pass book would
have been Rs. 5,595 (Rs. 6,095 – Rs. 500). Then again, the pass book shows a
debit of Rs. 5 as bank charges on different dates for which there is no
corresponding entry in the cash book. Had the pass book ignored this item, the
balance shown by the pass book would have been higher, viz., Rs. 5,600 (Rs.
5,595 + Rs. 5) which agrees with the cash book balance.

Summing up the above, a bank reconciliation statement can be prepared in the

following way.
 108

Bank Reconciliation Statement as on 31 ST July 2011

Rs. Rs.
Bank Balance as per Pass Book. 6,995
Add: Cheques Paid in but not yet credited :
Parker 300
Evans 600
900
Bank Charges Debited in the Pass Book 5 905
Less: Cheques issued but not yet presented 7,900
Greig 1,200
Fraser 600
1,800
Interest collected and entered in the Pass
Book 500 2,300
But not in Cash Book
Bank Balance as per Cash Book 5,600

The above example can also be worked out taking the Cash Book Balance as the
starting point, as shown below.

Bank Reconciliation Statement as on 31ST July 2011

Rs. Rs.
Bank Balance as per Cash Book 5600
Add : Cheques issued but not yet presented :
Greig 1,200
Fraser 600

Interest collected and entered in the Pass

Book 500 2300
But not in the Cash Book
7,900
Less : Cheques paid in but not yet credited
Parker 300
Evans 600
900
Bank charges debited in the Pass Book 5 905
6,995

Note: bank balances can be either favourable or unfavourable in the cash

book and the bank statement
 109

 The cash book shows a debit balance when the receipt (debit) side of the
cash book exceeds the payment (credit) side of cash book. This balance is
also known as a favourable balance.

 Similarly, when the payment side of cash book exceeds the receipt side of
cash book, the balance is known as an unfavourable balance. This balance
is also called an overdraft balance in the cash book.

 The bank statement has a credit balance or a favourable balance when the
credit side of the bank statement is higher than the debit side.

 In the same manner when the debit side of bank statement is greater than the
credit side of the bank statement, it shows a debit balance or an
unfavourable balance. This balance is also known as an overdraft balance.

If you are given a question in which there is an overdraft balance in the bank
statement, it is advisable to highlight the negative balance by putting brackets
around the figure.

The bank statement of Euro Cleaners for the month of Jan 2012 shows an
overdraft balance of Rs. 35,000.The cash book showed a balance of Rs. 24,200.
A comparison of the bank statement with the cash book indicated the following
discrepancies:

 Cheques deposited but not cleared Rs. Rs. 48,600

 Cheques not yet presented Rs.37,800

The bank reconciliation would be as follows:

Bank statement balance (35,000)

Outstanding lodgements 48,600
Unpresented cheques (37,800)
Balance as per cash book 24,200
 110

On 31st March 1991, the Pass book of Mr. V. Shanmugham showed a credit
balance of Rs.9,250. A comparison of the pass book and the cash book revealed
the following:
Rs.
(1) Cheques deposited but not yet cleared by 31st March, 2011 1,500

(2) Cheques issued by Shanmugham but not presented for payment 2,000
before 31st March, 2011

(3) Insurance premium paid by the bank on behalf of Shanmugham 240

but not recorded in the cash book.

(4) Bank commission not yet recorded in the cash book. 10

(5) Interest on bonds collected by the bank on behalf of Shanmugham 500

not yet recorded in the cash book.

From the above particulars, prepare a bank reconciliation statement as on 31 st

March, 1991.

Rs. Rs.

Bank Balance as per Pass Book 9,250

Add : Cheques deposited but not cleared 1,500
Insurance premium paid by the Bank but not 240
recorded in the Cash Book.
Bank Commission charged in the Pass Book 10
but not entered in the Cash Book. 1,750
Less : Cheques issued but not yet presented for 2,000 11,000
payment :
Interest on bonds collected by the bank and not 500
credited in the cash book. 2,500
Bank balance as per Cash Book. 8,500
 111

12.4 Cheques cancelled account

Ordinarily, cheques are valid only for a period of six months. However, in certain
organisations like the LIC, this validity period is restricted to 3 months.
(a) After the end of the validity period, the cheques that are not presented to the
bank as per the pass book are cancelled by recording the following entry:
Bank account Dr X
To Cheques cancelled account X
(Being cheques numbered xxx dated xxx cancelled due to lapse of the
validity period)
All such cancelled cheques have to be recorded in the credit column of the
cheques cancelled register.
(b) If within the validity period, the person approaches the organisation stating
that he has not received the cheque, he will be asked to give an indemnity
bond before a fresh cheque is issued.
In such cases, contra entries are passed debiting and crediting the bank
account.
(c) Generally, no cheque which is cancelled after the validity period is honoured
by the bankers.
Whenever a party approaches the organisation for fresh payment, a fresh
cheque will be drawn. The accounting entry would be:
Cheques Cancelled account Dr X
To Bank account X
All such payments are to be recorded in the debit column of the cheque
cancelled register and a contra remark is made against the original credit item
to avoid duplicate payment.

Which of the following does not cause a difference between the cash book
and the bank statement?
A Interest on bank overdraft debited in the bank account
B Cheques received and entered in the cash book, but not yet paid into the bank
for collection
C Cheques issued and presented for payment
D A customer directly deposited a certain amount into the bank
 112

Summary

 Accounting is the process of recording and reporting of financial transactions

including the origination of the transaction, its recognition, processing and
summarisation in the financial statements.

 Under the double-entry book-keeping system, all transactions are recorded by

giving two accounting effects - debit and credit.

 Rules of accounting

Nature of account Rule of accounting

Personal accounts Debit the receiver of benefits
Credit the giver of benefits
Real accounts Debit what comes in
Credit what goes out
Nominal account Debit expenses and losses


Credit incomes and gains


 A journal is the book of prime entry wherein accounting transactions are

recorded. All journal entries have to follow the principles of double-entry
book-keeping.

 A ledger is the principal book as well as the book of final entries. It contains,
in a series of classified and summarised accounts, a permanent record of all
the trader’s transactions under various Heads of Accounts.

 Journal entries are to be posted to the Principal Ledger twice. The amount
appearing against the account head in the Debit column of the journal is
posted to the debit side of the account in Principal Ledger and amount
appearing against the account head in the credit column of the journal is
posted to the credit side of the account in the Principal Ledger.

 The cash book is a book of prime entry of a special kind as it is also a part of
the ledger system. The cash book is meant to record all cash transactions,
whatever may be their nature.

 A trial balance is the summary of all the ledger account balances at a

particular point in time. A trial balance is prepared to list, at one place, the
balances of all the ledger accounts. This helps the accountant to check the
arithmetic accuracy of accounting.
 113

 The accounting equation is the fundamental relationship between the

following three concepts: Assets = Liabilities + Capital

 Steps for preparing the trading and profit and loss account and
balance sheet

Step 1: Prepare the trial balance

Step 2: Transfer the balances of nominal accounts from the ledger to the
“Trading and Profit and Loss” account.

Step 3: Transfer the net profit / loss (arrived at in step 2) to the balance sheet.

Step 4: Transfer the balances of other accounts (personal and real) that are
not closed from the trial balance to the Balance Sheet.

Step 5: The two sides of the Balance Sheet are totaled and tallied.

 Capital transactions mean transactions involved in the purchase, acquisition,

sale or disposal of assets which have a useful life of at least more than one
year. Capital expenditure is the expenditure which improves the earning
capacity of an asset so that the asset works more efficiently or lasts longer.
Capital receipt is income which is earned from activities that are not ordinary
activities / regular operations of an entity

 Revenue transactions, relate to the income and expenses connected with the
normal day to day operations of the business. Revenue expenditure is that
expenditure which is incurred to maintain the existing capacity of an asset so
that it can do its daily work. A revenue receipt is a regular receipt i.e. these
transactions are regularly entered into in an entity in the ordinary course of
the entity’s activities.

 Presentation of financial statements:

 Interest expenses are added to the interest cost under finance costs in the
profit and loss account.
 Interest accrued on the loan is shown in the balance sheet under current
liabilities.
 Prepaid expenses are recognised as a current asset in the balance sheet.
 Rent receivable is shown as a current asset in the balance sheet.
 Income received in advance is shown as a current liability in the B/S.
 114

 The Balance Sheet must reflect the true financial position of a business.A
balance sheet is prepared as on a certain date and not for a period. The total
of all assets must be equal to the total of all liabilities, including capital.

 Depreciation is the systematic allocation of the depreciable amount of an

asset over its useful life. There are various methods of depreciating an asset.

 A statement is prepared to reconcile the difference that exists between the

cash book and the pass book. This statement is known as Bank
Reconciliation Statement.

 If you are given a question in which there is an overdraft balance in the bank
statement, it is advisable to highlight the negative balance by putting brackets
around the figure.

Answers to Test Yourself

Answer to TY 1

The correct option is D.

Except for the sale of the asset, all the others are correct pairs of a transaction
matched with its source documents. The source document for the sale of the asset
is an invoice issued by the entity to the purchaser, and not the cheque received
from the purchaser.

Answer to TY 2

The correct option is D.

Step 1 Identify the two elements Ganesh Computer

of the transaction account account
Step 2 Classify the account as real, Personal Real account
personal or nominal account
Step 3 Identify the applicable Debit the Credit what
accounting rules receiver of comes goes out
the benefit
Step 4 Identify the account to be Debit Ganesh Credit Computer
debited and credited account account
 115

Answer to TY 3

The correct option is A.

Step 1 Identify the six Bank Stock Furniture Debtors Creditors Capital
elements of the account account account account account account
transaction

Step 2 Classify the Real Real Real Personal Personal Personal

account as real, account account account account account account
personal or
nominal

Step 3 Identify the Debit what comes in Debit the Credit the giver of the
applicable receiver of benefit
accounting rules the benefit

Step 4 Identify the Debit bank Debit stock Debit Debit Credit Credit
account to be account by account by furniture debtors creditor capital
debited and Rs. 77,000 Rs. 80,000 account by account by account by account by
credited Rs. 60,000 Rs. 33,000 Rs. 90,000 Rs. 160,000
 116

Answer to TY 4
The correct option is A.
Step 1 Identify the three Cash Discount Om
elements of the allowed Enterprises
transaction
Step 2 Classify the Real account Nominal Personal
account as real, account account
personal or nominal
Step 3 Identify the Debit what Debit Credit the
applicable comes in expenses and giver of the
accounting rules losses benefit

Step 4 Identify the account Debit cash Debit discount Credit Om

to be debited and account by allowed by Rs. Enterprises
credited Rs. 24,700 300 by Rs. 25,000
Answer to TY 5
Trial balance as at 31st December 2009

Debit Credit
Rs Rs
Sales 50,000
Purchases 30,000
Bad debts 2,000
Depreciation 3,500
Accumulated depreciation 10,500
Rent received 3,500
Petty cash 500
Cash at bank 35,000
Share capital 12,900
Share premium account 6,000
Provision for bad debts 01/01/2009 3,000
Accrued expenses 6,300
Expenses 12,000
Discount received 600
Inventory: 01/01/2009 6,000
Loss on sale of asset 500
Amortisation of intangible asset 300
Intangible assets 3,000
Total 92,800 92,800
 117

Closing inventory is not a part of the trial balance. It is directly taken to the P/L
and B/S.

Provision for bad debts at the year end is also not a part of the trial balance

Answer to TY 6

The correct option is B.

Assets = Liabilities + Capital

Assets = 30,000 + 70,000 = Rs.100,00

Answer to TY 7

1:b, 2:a, 3:d, 4:c

Answer to TY 8
(a) capital, revenue, capital
(b) revenue, capital

Answer to TY 9
The correct option is D.

Two instalments of Rs.6,000 in a year amounts to the yearly interest expense of

Rs.12,000. Hence, the monthly interest charge would be Rs.1,000.

The last installment of Rs.6,000 made on 31 March 2011 would include the
period from 1 October 2010 to 31 March 2011. The next installment of Rs.6,000
to be made on 30 September 2011 would include the period from 1 April 2011 to
30 September 2011. This installment would be made in the next accounting
period. Hence, the amount of interest accrued would be equal to 3 months
interest charge (from 1 April 2011 to 30 June 2011) Rs.3,000. This is the amount
of interest that has accrued, but has not been paid.

Answer to TY 10
The correct option is B.

All receipts and payments, whether on account of capital or revenue, are included
in the receipt and payment account.
 118

Answer to TY 11
The correct option is A.

Difference = Rs. 46,170 – Rs. 45,000 = Rs. 1,170

SLM WDV
Method Method
Purchase price on 01 January 2001 50,000 50,000

Add: Installation cost 10,000 10,000

Cost of the machinery on 01 January 2001 60,000 60,000

Less: Depreciation on 31 December 2001 6,000 6,000

Book value of the machinery on 01 January 2002 54,000 54,000

Less: Depreciation on 31 December 2002 6,000 5,400

Book value of the machinery on 01 January 2003 48,000 48,600

Less: Depreciation on 30 June 2003 (6 months) 3,000 2,430

45,000 46,170

Answer to TY 12

The correct option is C.

Cheques issued but not presented for payment will cause a difference between
the cash book balance and the bank statement balance.
 119

Self-Examination Questions
Question 1
Which of the following options contains the journal entry for the following
transaction?

Oxy Beauty, who owed Shazia Enterprises Rs. 10,000, is declared insolvent.
Shazia Enterprises recovered 25 paise in a rupee from them on 15th July, 2011.

A Cash account Dr 7,500

Bad debts Dr 2,500
To Oxy Beauty 10,000

B Cash account Dr 2,500

Bad debts Dr 7,500
To Oxy Beauty 10,000

C Oxy Beauty Dr 10,000

To Cash account 2,500
To Bad debts 7,500

D Oxy Beauty Dr 10,000

To Cash account 7,500
To Bad debts 2,500

Question 2

Parmar Group of Industries, which has a calendar year accounting period,

purchased a new machine for Rs. 1,20,000 on April 1, 2006. At that time, Parmar
Group of Industries expected to use the machine for nine years and then sell it for
Rs. 12,000. The machine was sold for Rs. 66,000 on 30 September 2011.

Assuming straight-line depreciation, no depreciation in the year of acquisition,

and a full year of depreciation in the year of withdrawal, the gain to be
recognised at the time of sale would be:

A Rs. 12,000
B Rs. 9,000
C Rs. 6,000
D NIL
 120

Question 3

Milltone paid Rs. 24,000 as insurance on 1 January 2007. The insurance for a
year is Rs16,000. Therefore, in its balance sheet as on 31 December 2007, the
company adjusted Rs8,000 as prepaid insurance. In 2008:

A Rs8,000 will be debited to prepaid insurance account and credited to

insurance expense account
B Rs8,000 will be credited to prepaid insurance account and debited to
insurance expense account
C Rs8,000 will be treated as an asset
D Rs8,000 will be treated as a liability

Question 4

Which of the following is an asset?

(i) Expense accrued

(ii) Expense prepaid
(iii) Income accrued
(iv) Income prepaid

A (i)
B (iii)
C (i) and (iv)
D (ii) and (iii)

Question 5
Receivables outstanding at the beginning of the year were Rs. 10,000. During the
year, the following transactions occurred:
 Credit sales Rs. 7,00,000
 Cash sales Rs. 1,00,000
 Prompt payment discounts given Rs. 3,000
 Payment Rs. 6,00,000
What is the closing balance of receivables in the closing trial balance?

A Rs.107,000
B Rs 207,000
C Rs 210,000
D Rs 710,000
 121

Answers to Self-Examination Questions

Answer to SEQ 1
The correct option is B.

Step 1 Identify the three Cash Bad debts Oxy Beauty

elements of the
transaction
Step 2 Classify the Real account Nominal Personal
account as real, account account
personal or nominal
Step 3 Identify the Debit what Debit Credit the
applicable comes in expenses and giver of the
accounting rules losses benefit
Step 4 Identify the account Debit cash Debit bad Credit Oxy
to be debited and account by debt expenses Beauty by
credited Rs. 2,500 by Rs. 7,500 Rs. 10,000

Answer to SEQ 2
The correct option is C.
Profit on sale of machinery
SLM Method
Purchase price on 01 April 2006 1,20,000
Less: Depreciation on 31 December 2006 NIL
Book value of the machinery on 01 January 2007 1,20,000
Less: Depreciation on 31 December 2007 12,000
Book value of the machinery on 01 January 2008 1,08,000
Less: Depreciation on 31 December 2007 12,000
Book value of the machinery on 01 January 2009 96,000
Less: Depreciation on 31 December 2009 12,000
Book value of the machinery on 01 January 2010 84,000
Less: Depreciation on 31 December 2010 12,000
Book value of the machinery on 01 January 2011 72,000
Less: Depreciation on 30 September 2011 12,000
Book value of the machinery on 30 September 2011 60,000
Selling price of machinery 66,000
Profit on sale of machinery 6,000
W1 Annual Depreciation = (Rs. 1,20,000 – Rs. 12,000)/9 years = Rs.12,000
 122

Answer to SEQ 3

The correct option is B.

At the beginning of the accounting year, on 1 January 2008, Rs8,000 will be

credited to the prepaid insurance account and debited to the insurance expense
account. This is to reverse the adjustment for prepaid insurance made at the end
of 2007

Answer to SEQ 4

The correct option is D.

Prepaid expenses and accrued income

Answer to SEQ 5

The correct option is A.

Receivables account
Rs. Rs.
Balance b/d 10,000 Discount received 3,000
Credit sales 700,000 Payment received 600,000
Balance c/f 107,000
Total 710,000 710,000
 123

CHAPTER 2

LIFE INSURANCE BUSINESS: IMPORTANT

TYPES OF INSURANCE POLICIES

Chapter Introduction
This chapter aims to provide you with an understanding of the life insurance
business. You will also learn about the different regulatory bodies and their
guidelines towards insurance investment and audit. The chapter also deals with
basic concepts related to life insurance business and particulars of different
insurance plans.

a) Learn about the various components of life insurance business.

b) Understand the regulatory requirements related to insurance investment
account and audit.
c) Understand the basic concepts of life insurance policies.
d) Learn about the features of various insurance plans.
 124

1. Learn about the various components of life insurance

business.
[Learning Outcome a]
1.1 History of life insurance business in India

In India, Life insurance business commenced in 1818, with the establishment of

Oriental life insurance company in Calcutta. However, for many years, insurance
business in India was dominated by foreign companies. The Indian Life
Insurance Companies Act 1912 was the first statutory measure that was
introduced for regulating life insurance business in India.

In the year 1956, an ordinance was issued by the Government of India for
nationalising the life insurance sector in India. Life Insurance Corporation (LIC)
came into existence in the same year, through the merger of 154 Indian insurers,
16 non-Indian insurers and 75 Provident Societies. LIC dominated the insurance
business in India till 1990s, when insurance sector was reopened for private
sector.

1.2 Introduction to insurance

Over the years, life insurance products have become quite popular because apart
from regular savings, an individual gets additional benefit in the form of
substitution of financial loss to the family due to the individual’s untimely death.

Insurance policies provide protection against ‘loss of income’ due to untimely

death of the main earning member of the family.

Insurance policies also offer a variety of savings schemes, in which an individual

can save for his future expenses such as child’s education, child’s marriage, and
his own post retirement expenses.

Life insurance

Life insurance is a contract between an insurer and a policyholder, in which the

insurer promises to pay a certain amount of predetermined money to the insured
or his beneficiary, if a certain event occurs.
 125

Based on above definition, the main features of life insurance can be summed up
as follows:

a) Life insurance is a contract

Life insurance is a contract between two parties: the Insurer and the
Policyholder.

 Insurer: Life Insurance Company is referred to as the insurer.

 Policyholder: Policyholder is the person who purchases the life insurance
policy and agrees to pay a certain premium to the insurance company for a
fixed period for availing life insurance cover of a predetermined amount
(sum assured).

b) Occurrence of a certain event

The entire life insurance contract is based on the occurrence of a certain event.
This event could be premature death of the life insured, disability due to sickness
or accident, loss of employment etc. The event against which the insurer provides
protection to the insured has to be clearly mentioned in the policy document.

Diagram 1: Contract between insurer and policyholder

 126

c) Payment is made if a certain event occurs

In the contract, the life insurance company agrees to make a payment of a

predetermined amount (sum assured) if a certain event occurs. Some of the
events, when an insurer will have to pay the sum assured and other benefits, are
as follows:

 Death of the life insured: In the event of the unexpected death of the life
insured, the insurance company will have to pay the sum assured (along with
other benefits) to the beneficiaries of the life insured.
 Maturity of the policy: If the life insured survives the policy term, then on
maturity of the policy , either a lump sum payment or regular payment of a
certain amount at periodic intervals have to be made to the policyholder.
 Specific date at periodic intervals: The policyholder can also choose to
receive a certain amount of money at periodic intervals.

d) Predetermined sum assured

The sum assured that the insurance company agrees to pay on the happening of a
certain event is predetermined, and its calculation is based on the age, lifestyle,
income, mortality risk etc. of the individual.

e) Premium payment

The policyholder has to pay a certain amount of money known as premium to the
insurer for availing life insurance cover of a certain amount. These premiums
have to be paid at periodic intervals - monthly, quarterly, or annually for a fixed
period.

1.3 Life insurance Vs. other saving schemes

Life Insurance is superior to other forms of saving since its advantages are in the
form of:
 Protection,
 Aid to thrift,
 Protection against creditors,
 Liquidity,
 Tax relief,
 Cash estate and
 Money when you need it.
 127

These advantages outweigh the ones available in other kinds of savings such as
Bank Deposits, Unit Trust of India, Public Provident Fund, and Post Office
Savings etc.

Unlike other savings plans, it provides full protection against the risk of death. In
cases of death, the full sum assured is made available under a Life Insurance
Policy whereas under other saving schemes, the total accumulated savings alone
will be available.

1.4 Difference between life insurance and other forms of insurance

One important difference between Life Insurance and other forms of insurance is
with respect to the ‘term’ of insurance.

In other forms of insurance viz. Fire, Marine, Miscellaneous, etc. the contract is
for a short period, usually for one year, and is renewable at the end of that period.
As against this, in Life Insurance, it is usually for a long period extending over a
number of years as the contingency insured against (i.e. the hazard of death) is
bound to happen, the uncertainty only being as to when it will happen. The risk
of death increases further with the age of the life insured.

If, therefore, the life insurance contract were to run for one year only and were to
be renewable year after year by mutual consent, the insurer will have to reassess
the risk and charge a higher premium commensurate with the increased risk due
to higher age. Thus, as the need for life insurance would increase with age, so
would the cost; and the latter would become prohibitive at advanced ages when
the need for insurance would be the greatest. To overcome this difficulty, life
insurance contracts usually run for a long period and a uniform or level annual
premium is charged to cover an increasing risk.

1.5 Life insurance contract

A contract of insurance is a contract of ‘utmost good faith’, technically known

as Uberrima Fides.

The doctrine of disclosing all material facts is embodied in this important

principle, which applies to all forms of insurance. The proposer, who is one of
the parties to the contract, is presumed to have means of knowledge, which are
not accessible to the insurer, who is the other party to the contract. Therefore, the
proposer is bound to tell the insurer everything affecting the judgement of the
insurer no matter how unimportant it may seem to him.
 128

In all contracts of insurance, the proposer is bound to make full disclosure of all
material facts and not merely those which he thinks material. Misrepresentation,
non-disclosure or fraud in any document leading to acceptance of the risk
automatically discharges the Insurer from all liabilities under the contract.

For issue of life insurance policy, the following requirements have to be

fulfilled

a) The proposer has to make a proposal with consideration of payment of first

premium in the form of Deposit.

b) The Insurer has to accept the proposal mentioning the precise terms on which
the proposal has been accepted.

c) The proposer has to carry out the terms of the acceptance letter; only then the
policy can be issued.

Diagram 2: Requirements for issue of life insurance policy

The financial aspect of Life Insurance is based on the Actuarial Principles which
are the most important and complicated ones. We will discuss them in detail in
the following sessions.
 129

1.6 Measurement of risk and law of large numbers

Insurance has been described as the institution which eliminates risk and which
substitutes certainty for uncertainty.

a) Measurement of risk

Risk in life insurance refers to the unceratinity related to a certain event, which, if
occurred, might result into occurrence of loss.

In life insurance business, it is important for insurers to correctly predict the risk,
as it helps them in determining the cost of insurance. The greater the degree of
accuracy with which this can be done, the more scientific will be the basis of life
insurance.

If insurers correctly predict the number of insurance claims that they will have to
pay in the next year, then they can also correctly determine the cost of insurance.

b) Law of large numbers

Concept of insurance is based on the law of large numbers.

According to the law of large numbers, the larger the group for the past data, the
more accurate will be the future estimate of losses.

Risk can be measured with the help of the Law of Averages, which operates only
when we are dealing with large numbers.

Insurance companies can gather data for past claims that have been paid over a
certain period, which can help them in making an estimate of the probability that
a person will die at a certain age. This concept can be further understood by way
of the following example:
 130

Let us assume that 10,000 healthy male persons all aged 40 having similar
prospects of long life, form an association (pool) for sharing losses in case of
their premature deaths.

There is a small chance that any one of these may die during the next year; but if
he dies, the loss of his earning power might prove disastrous to his family or his
business.

As it is not easy to estimate the financial value of the loss, let us assume for
simplicity that a sum of Rs.5,000 will suffice to meet the business or family
needs of any one of them who happens to die.

If on the basis of the past experience of a large number of similar lives, it is

found that 10 persons out of every 1000 die during the year following the age 40,
then the rate of mortality will be = 10/1000 = 100.

This means, on an average 100 people would die out of an association of 10,000
people and in respect of each of these deaths; a sum of Rs.5000 will have to be
provided. The total claims to be paid during the following year will, therefore, be
Rs.5,00,000. When these are shared among the 10,000 members, each person
will have to pay a sum of Rs.50 on an average.

Thus, here an uncertain loss of Rs.5000 which would be suffered by a few has
been replaced by a certain payment of Rs.50 to be made by every member, the
payment representing the cost of one year’s life Insurance at age 40 for Rs.5,000.

In this way, the risk of loss is eliminated by payment, on the part of a large
number of people, of a definite amount by way of premium, which is arrived at
by the application of the Theory of Probability and the Law of Averages.

The ‘uncertainty’ of loss can be converted into a “certain” amount of premium

payment as explained above only if we can calculate the amount of premium
with some degree of accuracy. This would depend upon the ability of insurers to
measure the probable risk of occurrence of death, in other words, upon the
confidence with which the future losses could be predicted.

For this purpose, the risk is measured on the basis of past experience under the
assumption that, under similar conditions, the future experience will closely
approximate to the past experience.
 131

1.7 Premium

For life insurers, premium is the cost of insurance, and for policyholders, it is the
money that they have to pay to avail certain amount of insurance cover.

a) Cost associated with premium

Insurance companies are basically concerned with recovering two kinds of cost:
Mortality charges and Expenses.

i) Mortality charges: mortality charges are the ones that are used for providing
death benefit cover to the insured. Mortality charges are based on age and the
risk associated with the life insured.

Insurance companies maintain mortality tables based on their past data, which are
used for determining premium to be charged for a life insured.

Mortality tables

Mortality tables are tables that consist of probability that a person would die
before his next birthday.

The mortality tables are based on the past data of insurance companies’
experience with insured lives.

Morbidity tables contain data on sickness rate of individuals. The Tables are also
based on the experience of the general population.

The tabular rates or premium of the LIC are calculated on quarterly basis for
Rupees One Thousand Sum Assured. Where the frequency of the payment of
premium is less or the sum assured under a policy is large, the expenses incurred
are comparatively low and accordingly, some rebates are allowed on the tabular
premium.

ii) Expenses: the various expenses that an insurance company might incur
during a policy term are: administrative expenses, salaries, expenses for
managing the policy etc. The insurance company has to ensure that the
premium collected should help them in meeting these expenses over the
years.
 132

b) Investment element associated with premium

Interest: the yield obtained by investing the fund and the rate of interest assumed
in premium calculations occupy an important place in the financial aspect of a
life insurance contract.

The Insurer gets huge funds in his possession to be utilized for getting maximum
yield. Collective investment of these large amounts under the expert advice
rendered by finance and investment experts enables the Insurer to secure a much
better yield, considering the degree of security provided, than would be possible
for an individual to do.

The individual policy holder is saved the trouble, inconvenience and risk of loss
of capital involved if he himself was to undertake investment of small funds. At
the same time, he gets the benefits of the better yield earned by the Insurer in the
form of a higher interest rate assumed in premium calculation or larger bonuses
at the time of periodical valuations.

The premium rates will vary according to the rates of interest assumed in the
premium calculations; the higher the rate of interest assumed, the smaller the
premium rates work out to and vice versa.

c) Gross Vs. Net premium

While calculating premium, insurance companies first give priority to mortality

charges. Once the mortality charges are calculated, other expenses are loaded
into the premiums.

i) Net premium: net premium is also known as ‘pure premium’. Net premium
includes :

 mortality charges and

 interest

Net premium does not take into account:

 expenses of management
 the possibility that the rates of mortality assumed will not be experienced
in practice,
 the possibility that the rates of interest earned will be less than those
assumed and the need for providing profits for the with-profits
policyholders
 133

Net premium covers only probable losses that the company might have to incur
due to occurrence of a certain unfavourable death, such as death of a life insured.
To cover these items, the net premiums are loaded and the premiums with these
“loadings” are usually known as “office” premiums.

ii) Gross premium: gross premiums are also known as office premiums. This is
the premium amount which is communicated to the policyholder. This is
calculated by loading expenses in the net premium.

It is essential that an appropriate allowance be made for expenses while

calculating office premiums. As the premiums are receivable over a long term, it
is important to estimate and forecast the future expenses as accurately as
possible, on the basis of past experience. It is equally important to maintain
stringent economy and to watch closely that the expenses do not exceed the
provision or loading made in that respect in the office premiums.

iii) Level premium

In level premium, the amount of premium remains the same over the entire
policy term.

In life insurance, the cost of life insurance increases with age of the insured, and
the challenge with the insurer is to determine the premium that should be charged
which enables them to meet different expenses that may arise during the policy
term.

As the premium remains the same over the entire policy term, a higher premium
amount is collected in the initial years to cover the cost of insurance. The balance
is accumulated to form a fund which could be drawn upon to meet a part of the
heavy cost of insurance cover during later years, when the premium actually
received would be insufficient to cover that cost of insurance.

Thus the uniform premium method and long term nature of life insurance
contract give rise to funds, which are not utilized immediately to pay claims.

They are however, placed to the credit of policy-holders as the Life insurance
Fund to meet future obligations and are invested by the insurer so as to yield the
maximum rate of interest consistent with optimum security.
 134

The premiums to be charged to the policyholders are usually level in amount

throughout the duration of the policies. On the other hand, the expenses incurred
are not level in their incidence as when a policy is affected there are heavy initial
expenses in respect of:

 large quantum of first year’s commission,

 medical fees,
 policy stamps and
 development and underwriting expenses

While at the time of renewal, the expenses are much lighter and consist of

 smaller commission on renewal premiums and

 expenses in connection with servicing of business

This incidence of expenses has a bearing on the surrender value allowed to the
policyholders, which is discussed later on.

Ramesh is an investment banker who had purchased life insurance polices 10

years back. Under the policy, his premium amount had remained the same over
the years and will also not change in future.

Which of the following types of premium is being charged by the insurance

company?
A Gross premium
B Level premium
C Net premium
D Increasing premium
 135

2. Understand the regulatory requirements related to

insurance investment account and audit
[Learning Outcome b]
2.1 Insurance Regulatory and Development Authority Act 1999

The Government of India constituted an authority called the Insurance

Regulatory & Development Authority (IRDA) under the Insurance Regulatory
and Development Authority Act, 1999 (IRDA Act) to regulate insurance business
of the life insurers, non-life insurers and reinsurers. IRDA regulates both
government as well as private insurers. The Government has given certain
powers and functions to the authority to discharge.

Powers and functions of the Authority

Following are the powers and functions of the IRDA:

a) issue to the applicant a certificate of registration, renew, modify, withdraw,

suspend or cancel such registration;
b) protection of the interests of the policy holders in matters concerning
assigning of policy, nomination by policy holders, insurable interest,
settlement of insurance claim, surrender value of policy and other terms and
conditions of contracts of insurance;
c) specifying requisite qualifications, code of conduct and practical training for
intermediary or insurance intermediaries and agents;
d) specifying the code of conduct for surveyors and loss assessors;
e) promoting efficiency in the conduct of insurance business;
f) promoting and regulating professional organisation connected with the
insurance and re-insurance business;
g) levying fees and other charges for carrying out the purpose of this Act;
h) calling for information from, undertaking inspection of, conducting enquiries
and investigations including audit of the insurers, intermediaries, insurance
intermediaries and other organisations connected with the insurance
business;
i) control and regulation of the rates, advantages, terms and conditions that may
be offered by insurers in respect of general insurance business not so
controlled and regulated by the Tariff Advisory Committee under section
64U of the Insurance Act, 1938 (4 of 1938);
j) specifying the form and manner in which books of account shall be
maintained and statement of accounts shall be rendered by insurers and other
insurance intermediaries;
 136

k) regulating investment of funds by insurance companies;

l) regulating maintenance of margin of solvency;
m) adjudication of disputes between insurers and intermediaries or insurance
intermediaries;
n) supervising the functioning of the Tariff Advisory Committee;
o) specifying the percentage of premium income of the insurer to finance
schemes for promoting and regulating professional organisations referred to
in clause (f);
p) specifying the percentage of life insurance business and general insurance
business to be undertaken by the insurer in the rural or social sector; and
q) exercising such other powers as may be prescribed

The Central Government has made certain amendments in the Insurance Act
1938 through the IRDA Regulations in 2000 (which have become the first
schedule of the IRDA Act) and the Life Insurance Act 1956 (this has become the
2nd Schedule of the IRDA Act). This amended Act will be applicable to Life
Insurers.

2.2 Investment accounts and audit

1. Investments accounts

Over the years, IRDA has issued several regulations for the purpose of regulating
investment.

IRDA (Investment Regulation) 2000 dt.14.08.2000

IRDA (Investment) (Amendment) Regulations dt.31.05.2001
IRDA (Investment) (Amendment) Regulations 2002 dt.30.03.2002
IRDA (Investment) (Amendment) Regulations 2004 dt.01.01.2004
IRDA (Investment) (Amendment) Regulations 2008 dt.22.08.2008

IRDA has also issued The Insurance Regulatory and Development Authority
(Preparation of Financial Statements and Auditor’s report of Insurance
companies) Regulation 2002, Authority, for the purpose of preparation of
financial statements, Management report and auditor’s report. Regulation has
been divided into the following parts:
 137

Part I Accounting principles for preparation of financial statements

Part II Disclosure forming part of financial statements
Part III General instructions for preparation of financial statement
Part IV Contents of Management Report
Part V Preparation of financial statement
 Revenue Account (Policy holders Account will be prepared in
Form A-RA) Profit & Loss Account (Shareholders Account)
will be prepared in Form A-PL) and Balance Sheet in Form A-
BS.
 Separate Accounts will be kept for:
a) Participating and Non-participating policies
b) Linked, Non-Linked and Health Insurance
c) Business within India and outside India

In addition to the above, the Insurer shall prepare separate Receipts

and Payment Account in accordance with Direct Methods Prescribed
in AS-3- “Cash Flow Statements” issued by the ICAI. (Note- Further
Details have been given in Chapter ‘final Accounts’).

2. Audit

As per section 12 of the Insurance Act 1938, all insurance companies must be
audited annually by the auditors. There are three types of audits: Statutory Audit,
Internal Audit and Concurrent Audit. Accounts of every insurance company shall
be audited by auditors who are duly qualified to act as auditors of companies.

Furthermore, The Insurance Regulatory and Development Authority (Preparation

of Financial Statements and Auditors report of Insurance companies) Regulation
2002 provides that the authority may issue separate guidelines in matters related
to appointment, continuance, removal of auditors of an insurance company.
These guidelines can also be related to qualifications, experience of auditors,
their rotation, period of appointment etc.

IRDA has issued circular re. 36/7/F&A/EMPL/74/JUH/05 DT.25/7/2005which

gives guidelines for the appointment of Statutory Auditors of Insurance
Companies, which are as follows:
 138

a) Eligibility Condition

i) Auditor of an insurance company shall be a firm;

ii) The firm should have been established and should be in continuous practice
for a period of 15 years or more;

iii)
(a) It should have

 a minimum of five partners of whom at least two should have been in

practice as partners in an audit firm for a minimum period of 10 years and
 at least two other partners have been in continuous practice in the audit firm
as their partner or had been in employment earlier with that firm for a
minimum period of five years;

(b) Alternatively,

 it could be a firm which has at least seven Chartered Accountants including

not less than two as partners who have been in continuous practice as
partners in the firm for a minimum period of 10 years and
 at least three Chartered Accountants, either partners or as employees, had
been in continuous partnership/employment with the audit firm for a
minimum period of five years and
 At least two partners of the firm shall be Fellow members of the Institute and
had been in continuous practice for five years after enrolment as Fellows.

iv) In both the cases mentioned in 3 (a) and 3(b) above, at least one partner or
paid Chartered Accountant of the firm should have CISA/ISA or any other
equivalent qualification

b) Limitation on auditors for insurance companies

One audit firm would not be permitted to carry out more than two statutory audits
of insurance companies (Life/Nonlife/Reinsurer).
 139

c) Rotation of Joint Auditors

i) Each insurance company will have two auditors on a joint audit.

ii) One of the Joint Auditor may have a term of 5 years and the other 4 years in
the first instance. Thereafter, the maximum duration for which the auditor
could be retained would be for a period of 5 years.

iii) There will be a cooling period of two years. An audit firm which completes a
tenure of five/four years as the case may be, at the first instance, in respect of
an insurance company should not accept statutory audit assignment of that
Insurance company in the next two years. However, audit firm may accept
statutory audit of any other insurance company subject to the compliance of
maximum two statutory audits.

LIC has also to follow up above mentioned guidelines. However LIC has to
obtain approval of the central government as per section 25 of LIC Act. Central
Government will fix the remuneration of statutory auditors.

d) Appointment of internal auditors

All private life insurance companies have to appoint internal auditors as per
companies Act. However LIC has to appoint Internal Auditors who are full time
employees of corporation to audit accounts of all offices of corporation as per
regulation 46 of LIC Regulations 1956.

A summary of the reports of the auditors shall be placed before the Executive
Committee as soon as possible after the close of each financial year.

Further Regulation 47 states that every office of the corporation shall be

inspected at least once a year. A summary of the report of the Inspecting officer
shall be placed before Executive Committee.

e) Appointment of concurrent auditors

In addition to above, each insurer will appoint concurrent auditor who will not be
Statutory or Internal Auditor of the company. Such concurrent auditor will do
investment audit. The auditor shall comment on such review and its impact on
the investment operations, systems and process in their report to be placed before
Board Audit Committee. Concurrent auditor should be Chartered Accountant and
well experienced
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2.3 Accounting for life insurance

Section 2 (11) of the Insurance Act 1938 defines life Insurance business as “The
business of effecting contracts of insurance upon human life including any
contract whereby the payment of money is assured on death (except death by
accident only) or happening of a contingency dependent on human life and any
contract which is subject to payment of premium for a term dependent on human
life and shall be deemed to include:

a) the granting of a disability and double or triple indemnity accident benefits,

if so provided in the contract of insurance;

b) the granting of annuity upon human life; and

c) the granting of superannuation allowance and annuities payable out of any

fund applicable solely to the relief and maintenance of persons engaged or
who have been engaged in any particular profession, trade or employment or
of the dependents of such persons.

The function of insurance is to provide for the pooling of risks among many
persons who are exposed to similar risks. The primary purpose of life insurance
is to provide financial assistance.

As per the Insurance Act 1938, a maximum of how many statutory audits can be
conducted by one audit firm for a certain life insurance company?

A Not more than one statutory audit

B Not more than two statutory audit
C Not more than three statutory audit
D Not more than five statutory audit
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3. Understand the basic concepts of life insurance policies.

[Learning Outcome c]
3.1 Life insurance polices

Life Insurance policies are mainly of two types namely:

a) Whole life Policies: in whole life policies, the sum assured is paid on the
death of the insured and the insured has to pay the premiums throughout his
life.

b) Endowment policies: in Endowment policies, insurance cover is provided

for fixed period and the sum assured is paid on the expiry of such period or
death whichever is earlier and the payment of premiums stops when the
policy becomes a claim.

Some of the important terms related to life insurance policies:

Premiums Premium is the amount paid by a policyholder to an insurance

company, as consideration for securing the insurance contract.
This is the main source of income for the insurance company.
Sum Sum assured is the face value for which the policy is issued. This
Assured is the amount that the insurance company has to pay to insured
(or his beneficiary) in case of occurrence of a certain event.
Policy Policy is the document evidencing the contract.
Insured The person whose life has been insured
Insurer The party ( insurance company) who promises to pay the claim
amount
Claim Claim arises when the policy money becomes payable either due
to maturity of the policy in case of endowment or death under
endowment and whole life provided the policies are in force.
With With profit policies are entitled to participate in the surplus
profit (returns earned by insurance companies on investment made).
policy
Without Without profit policies are not so entitled to participate in the
profit surplus (returns earned by insurance companies on investment
polices made).
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Annuity Annuity may be defined as a contract whereby the insurance

company agrees to pay a certain sum of money periodically to
the other party during the latter’s life time or for a certain period
in consideration of a lump sum paid in advance. The purchaser
of the annuity is called the annuitant.
Lapse If the premiums are discontinued before the contract period, the
policy contract is cancelled. In such circumstances, the policy is
said to lapse. But usually the contract provides that if certain
minimum numbers of premiums are paid, the policy will not
lapse but will continue to remain in force for a reduced sum
assured called the paid up value. When the policy becomes paid-
up, the sum assured gets reduced in proportion to the premiums
paid to the premiums payable.
Surrender Surrender value is calculated as a specified percentage of the
value paid up amount, increasing with the duration the policy is kept in
force.
Loan A policyholder can ask for a loan on the policy dependent upon
the surrender value of the policy or he may also surrender the
policy and get cash.
Discount In the last year of the policy the policyholder can discount his
policy at a specified rate of discount.
Inadequate When the amounts paid by the policyholder cannot be
premiums straightaway credited to premium accounts due to reasons like
inadequate premiums or premiums not paid in continuity the
amounts are temporarily kept in deposit to be either adjusted
towards premiums or refunded to policyholder.
Days of When premiums are not paid within days of grace (15 days for
grace monthly and 30 days for other modes) interest for late payment
of premiums is charged.
'X' charge Where policy premiums are short due to variation in exchange
rates, or due to alteration in policy conditions or interest on late
payment of premium received and on policy loans, interest not
received in full at settlement, ’X’ charge, subject to certain limits
is created on the policy. 'X' charge means the dues are treated as
a charge on the policy, and will be recovered from the claim if
not paid earlier.
Interest, The insurance company also receives interest, dividends and
dividends rents from the investments.
and rents
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3.2 Reserve: Life insurance fund

As discussed earlier under the section of level premium, insurance companies

accumulate funds from the level premiums that they collect for an increasing
risk. The accumulated value of all the premiums received under a policy plus
interest thereon less the cost of meeting the risk already covered (i.e. contribution
towards claims paid) and expenses incurred is technically called the “reserve” or
the policy value.

Reserve is the amount the insurer must have in hand to meet the liability under
the policy that future premiums will not cover.

Reserve = Accumulated value of all the premiums received under a policy

+ Interest – Cost of meeting the risk already covered –
Expenses incurred.

The life insurance fund is the sum of the reserve held on all the policies in the
books of an Insurer.

Each year, the life insurance fund is increased by the actual premiums received
and the interest earned on investments and is depleted by the actual claims paid
and expenses incurred.
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Diagram 3: Life insurance fund

3.3 Surrender value

The reserves created under the level premium system enable the insurer to pay
cash up to the amount of the reserve held under a policy in case an assured
desires to surrender all his rights under the policy. This cash value is known as
the surrender value of the policy.

Apart from expenses, a portion of the premiums paid has already been absorbed
by the cost of the life insurance cover given, for although a claim may not
actually have arisen under a particular policy, claims under other policies have
been paid and this has been possible by drawing upon the funds accumulated
under all the policies in the same class.

In practice, however, the surrender value payable is always less than the reserve
value. This is mainly due to two reasons:
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a) Possibility of adverse selection:

There is the possibility of adverse selection – the possibility that persons who
withdraw are in a better state of health and represent lesser risks than the average.
It is unlikely that any man who is in bad health and anticipates an early death
would voluntarily surrender his policy; on the contrary such a man would try his
utmost to keep the contract in force. Therefore, the effect of withdrawals is
generally to upset the mortality assumptions and affect adversely the rate of
mortality amongst the balance of the lives assured.

b) Heavy initial expenses:

The heavy initial expenses which are spread over all the premiums receivable
need to be recovered. Due to this, generally it is possible to pay any surrender
value only if premiums for at least two complete years are received.

3.4 Paid up value

If the policyholder, instead of surrendering his rights under a policy, desires to

discontinue payment of further premiums, the policy can be converted into a
paid-up one for a reduced sum assured – also as a result of the above-stated
accumulation of reserves.

The paid-up value may be considered the deferred payment of the surrender
value and the surrender value as the discounted value of the paid-up amount.

The paid-up value is generally determined on a proportionate basis taking into

account:
 Number of premiums paid and
 Number of premiums further payable.

3.5 Actuarial Valuation

Scale of premium that is adopted by an insurance company is dependent on

assumptions made by the actuary w.r.t.:
 the future course of mortality,
 interest and
 expenses
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The actual experience of the insurer may, and often does, differ from the basis
used in the scale of premiums. The margin which is normally provided in the
loadings is, under ordinary circumstances, sufficient to meet temporary
fluctuations.

Hence an insurer has to ensure that:

a) It maintains solvency at all times:

The profit or loss of an Insurer depends upon whether the actual experience is
favourable or otherwise in comparison with the assumption made in the scale of
premiums. This can truly be determined only after the last policy has exited as a
claim.

In the meantime, an Insurer has always to be careful to see that whatever be the
future experience, he would be able to meet his financial obligation. In other
words, for the solvent functioning of an Insurer, the assets in the Life insurance
fund must at any time be adequate to meet the future liabilities under the policies
issued by him.

b) Form fresh estimates of policy liabilities:

If the experience regarding mortality, interest and expenses does not exactly
conform to the initial assumptions, the reserves or policy liabilities calculated on
the assumptions made in the premiums may be found to be too small or too large.
The Insurers, therefore, have to form fresh estimates, at intervals specified either
by Government or by the Insurers themselves of the amount of policy liabilities
in the light of fresh and more up-to-date experience regarding the three basic
factors involved.

c) Compare future liabilities of insurer with its assets:

The mere sizes of the Insurer’s assets or the rate at which they are growing are no
indication of its financial strength. What actually matters is whether the size of
the assets is adequate to meet the liabilities. It is, therefore, necessary to estimate
from time to time the Insurer’s policy liabilities and to compare them with the
assets. This is the purpose of the actuarial valuation.
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Process of Actuarial Valuation

Process of Actuarial valuation involves the following steps:

1. The actuary determines the present value of the future premiums receivable.
2. The actuary determines the present value of future claims payable.
3. Calculate net liability. The difference between the present value of future
claims and the present value of future premiums is known as the net liability.

Diagram 4: Process of Actuarial valuation

i) This net liability is compared to the Life Fund.

ii) If the Life Fund is more than the net liability, the difference is the surplus but
if the net liability is more, there is deficit. This is known as actuarial
valuation.

iii) Valuation surplus can arise if:

 the mortality experience is more favourable that assumed.

 the net rate of interest earned is greater than that assured.
 the expenses of the business are less than the provisions made

Valuation surplus can also arise as a result of ‘loadings’ made in ‘with profits’
polices for bonus additions.

It is from this surplus that the bonuses are distributed to “with profits”
policyholders.
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Out of the surplus, the actuary provides for various reserves and funds and the
balance is available for distribution (95% to the policyholders and 5% to the
Government on the initial capital of Rs. 5 crores contributed by the Government).

The amount allocated to policyholders is called Bonus. Bonuses are of three

types:

a) Cash Bonuses
b) Bonuses in reduction of premiums and
c) Reversionary Bonuses.

The first two types of bonuses are self-explanatory. The third type of bonus is the
bonus that is added to the sum assured and paid at the time of claim. Once a
policy becomes paid-up, it is not entitled to future bonuses.

Which of the following is considered to be the main source of income for

insurance companies?

A Sum assured
B Claim amount
C Premium
D Interest
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4. Learn about the features of various insurance plans.

[Learning Outcome d]
The various plans that are offered by the erstwhile insurance companies and the
Life Insurance Corporation after nationalisation are given below in detail. The
majority of these plans are offered on both the “with profits” and “without
profits” basis.

For better understanding and appreciation of these life insurance plans, passing
references are also made to some schemes of Life insurance under which
previous insurers had issued policies; such policies will require servicing for
some years in future.

4.1 Whole life insurance plan

a) Whole life insurance plan with premiums payable throughout life

This is the purest form of permanent contract. Whole life insurance provides a
larger amount of “life cover” than any other permanent type of life insurance and
it is, therefore, the most inexpensive form of permanent protection for
dependents.

Main features of this plan are:

 Premiums are payable throughout the lifetime of the life assured

 The sum assured is payable only on death of the life assured.
 The element of protection for dependents is the dominating element
 Provision for old age is totally absent.
Whole life insurance has the disadvantage that premiums continue in old age
when the ability to pay them may be lessened by contraction of income.
To obviate this difficulty the LIC limits the maximum number of premiums that
are payable either till age 80 or till 35 annual premiums are paid whichever is
later.

A person aged 30 has to pay premiums for a maximum period of 50 years if he

survives this period, while a person aged 50 will have to pay premiums for a
maximum period of 35 years (i.e. not till age 80 but also beyond if he survives
beyond age 80).
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b) Whole life insurance plan with limited premiums

This insurance provides for payment of the sum assured at death but the
premiums are limited to a predetermined maximum number and include single
payment insurance.

Under this type of policy, it can be arranged that premiums cease at retirement
age so that the difficulties of maintaining the premiums in old age are removed.
When the premiums cease, the policy becomes fully paid-up.

“With profits” policies continue to participate in profits till the claim arises even
though the premiums have ceased .

4.2 Endowment insurance plans

This is undoubtedly the most popular form of life insurance plan at the present
time. This type of policy is really a combination of life insurance and investment.
Under this class of contract, the sum assured is payable at the expiration of a
fixed term of years or at death, shall that occur previously.

This plan is an ideal combination of both family protection and the savings
elements and answers most of the problems of the insuring public, especially
persons with families. It provides cover for a family during the selected term,
normally corresponding to the active years of the bread winner in service or in
business. Its other advantage is the compulsion to save during working years, the
accumulated saving being available on retirement.

In the case of policies running for long term, the insurance element predominates
while in the case of insurance maturing at the end of comparatively shorter terms
the actual cost of the life insurance is very small the bulk of the premium being
required for the investment portion.

4.3 Joint life endowment insurance plan

Under this plan, two lives are simultaneously insured and the sum assured is
payable on the expiry of the term or/on the death of one of the assured lives
during the endowment period.
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Main features of this plan are:

 The premiums are payable throughout the endowment period or till the prior
death of either of the lives assured.
 one payment of the sum assured is envisaged even though two lives are
insured;
 two payments on two deaths are not contemplated as the first death will
determine the contract

4.4 Term insurance plan

Term insurance plan is the oldest form of insurance plan available in the market.

Main features of this plan are:

 In term insurance the sum assured is payable only in the event of death of the
life assured occurring within a defined period, the insurance coming to an
end should the life assured survive that period.
 The policies can be issued for any period from a few months to a number of
years.
 Premiums are usually payable throughout the policy or till the prior death of
the life assured though sometimes they are limited to a shorter period or even
to a single payment.
 It is pure life insurance without any element of investment and is thus the
cheapest form of life insurance cover.

Additions with term insurance:

Some insurance companies returns premium collected with term insurance in

case of survival of policyholders when policy matures, or gives nominal bonus
(predetermined) like Bima Kiran issued by LIC.

Some companies also offer optional benefits such as:

 Critical illness benefit (CI)

 Accidental Death Benefit (ADB)
 Accelerated Sum Assured Benefit
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4.5 Convertible whole life insurance plan

This plan is essentially a whole life insurance with the option to convert after 5
years from commencement, into endowment insurance effective from inception.

This plan is suitable for a young man earning a modest income for the time being
but with good prospects of higher income after a short period. The objective is to
provide maximum insurance protection at minimum immediate cost and at the
same time to offer a flexible contract which can be altered to an endowment
insurance at the end of 5 years from the commencement of the policy by which
time it is expected that there would be a rise in his income which would enable
him to pay the larger premium payable after conversion.

If the conversion option is not exercised, the policy would continue as whole life
insurance plan.

The policy issued by the LIC under this plan is a limited payment life insurance
with premiums ceasing at age 70, in case the option is not exercised.

4.6 Policies under MWP Act

Section 6 of the Married Women’s Property Act ( MWP Act), 1874 provides that
“a policy of insurance effected by any married man on his own life, and
expressed on the face of it to be for the benefit of his wife or of his wife and
children or any of them, shall ensure and be deemed to be a trust for a benefit of
his wife or of wife and children or any of them, according to the interests so
expressed, and shall not, so long as any object of the trust remains, be subject to
the control of the husband, or to his creditors, or form part of his estate”.

A policy taken out under the Act is entirely different from a gift so far as the
incidence of Estate Duty is concerned.

The function of the trustees under the Act is to receive, on claim arising, the
policy moneys and carry out the object of the trust, subject to the prevailing rules
in respect of Estate Duty. Where the beneficiaries are all minors, the trustees will
hold the amount for the benefit of the minors.
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4.7 Money back policies

This plan is suitable for those who, besides providing for their old age and
family, need lump sum benefit at periodic intervals.

Main features of this plan are:

 The sum assured is paid in suitable installments.

 The dependents are guaranteed the benefit of the full sum assured protection
in the event of the death of the assured, irrespective of the installments that
might have been paid, throughout the period of insurance.
 The policy is available for various terms like 12 years, 15 years, 20 years, 25
years etc. to suit one’s best convenience.
 No loan is granted under this plan.

4.8 Children’s policies

Children’s policies issued by the LIC are:

a) Fixed Term (Marriage) Endowment Policy

Under this plan the life assured is either the parent or the guardian. The sum
assured is payable only on the expiry of the selected term whether the life assured
is alive or dead.

The premiums are payable throughout the selected term or till the death of the
life assured should it occur earlier. This insurance can be utilised to provide for
the marriage of a daughter, or “start-in-life” capital amount for a son.

b) Educational Annuity Policy

It is similar to the fixed term (marriage) Endowment; the difference being that
instead of paying the benefit in a lump-sum, the benefit or the sum assured is
payable in half-yearly installments for 5 years.

These installments can be used to meet higher educational expenses of a child.

Insurance under Fixed Term Endowment and Educational Annuity Policy is
useful in cases where definite financial needs of the future can be anticipated
(such as marriage or education of children) as the benefits are payable only at the
end of the stipulated period.
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Both these plans are issued by the LIC under “without profits” scheme only.
They can be “with profits” also and such policies have been taken over by the
LIC. In case of death of the child another child can be substituted to receive the
policy benefits.

c) Children’s Deferred Insurance

Form of insurance has as its object the provision of future life insurance for the
child at a substantially lower rate of premium. Here the child is the life assured,
the parent or guardian being the proposer. The following points should be noted:

1. The actual life insurance commences at age 18 to 22; the contract being a
form of pure endowment in the meantime, i.e. during the deferment period
involving no death risk.
2. The contract is affected by the parent, but the intention is that it should be
vested in the child on his attaining a selected age between 18 and 22.
3. If the child dies before the vesting age, the premiums are returned without
interest.
4. By payment of an additional premium during the deferment period, the
proposer (parent) can secure the benefit of cessation of premiums from the
date of his death to the end of the deferment period. Of course, medical
examination of the proposer will be necessary in such a case.
5. In case of death of the Proposer (parent) unless No. (iv) above is applicable
premium must be continued by someone else till the Deferred Date.
6. There is a cash option available at the vesting age should the policy be
discontinued.
7. After the vesting age, the insurance s may be under limited payment life or
endowment insurance plan
8. No evidence of health is required at the vesting age; this ensures that life
insurance cover can be obtained whatever the state of health of the child may
then be.
9. Medical Examination of the child is required if the deferment period is less
than 10 years.
10. The life insurance cover available at the vesting age will be at a very low
rate of premium.
11. During the deferment period the control over the policy is exercised by the
Proposer (parent).
12. It is obligatory on the life assured (child) to adopt the policy in writing after
attaining majority but before the Deferred Date. On such adoption, the policy
will be deemed to be a contract between the insurer and the life assured
(child) as the absolute owner.
13. Loans are not granted during the deferment period.
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14. The policy participates in profits only from the deferred date.
15. One contract is issued to cover both the stages of the policy viz. the first
stage from the date of commencement of the policy to the deferred date
and the second stage from the deferred date to the date of claim.

4.9 Annuities/pension plans

An annuity is a periodical payment made, in exchange for purchase money

(capital payment), for the remainder of the life time of a named life or for a
specified period irrespective of the duration of human life. The annuities do not
participate in the profits of the Insurer.

There are various types of annuity, dependent upon the duration of life or
otherwise and these are discussed below.

a) Annuity certain

Payment of a purchase price provides an annuity for a definite period of years

irrespective of the duration of life. Each payment includes interest and the return
of a portion of the purchase price. Under the settlement options, payment of sum
assured by installment over a selected period of years is offered. This is merely
an annuity certain, the sum assured payable on claim being utilized as purchase
price of such an annuity.

b) Immediate life annuity

In return for the purchase price, periodical payments of a specified amount are
made during the subsequent life time of an annuitant. Such a contract can be
looked upon as just the opposite of a whole life insurance which provides a
capital sum on the death of the life assured in consideration of payments of
premiums during his lifetime.

Under the immediate life annuity the payments depend on the continued
existence of the annuitant; and it is not necessary for evidence of the state of
health of the annuitant to be obtained.

No medical examination is required for such contract. It is presumed that an

annuitant must be in sound state of health at the time of purchase, as otherwise
the annuity would not be purchased. This is technically known as “self-selection”
by the annuitants.
 156

c) Guranteed annuity

The guarantee may take one of several forms for example:-

i) The annuity may continue for fixed number of years whether the annuitant is
alive or dead. If he survives the period, payments continue thereafter until
death. Such annuities are issued by the Corporation.

ii) If the whole of the purchase price has not been paid out in the annuity
payments at the date of the annuitant’s death the balance of such purchase
money will be returned in one lump sum or by installments.

d) Deferred annuity

A deferred annuity is one in which the annuity payments start after a fixed
number of years and then continue in the same manner as under immediate life
annuity or guaranteed annuity. The consideration is either a lump sum payment
in the beginning or yearly (half-yearly, quarterly or monthly) premiums during
the deferment period. At the end of the period of deferment, a cash option can be
taken in lieu of the annuity. In the event of death of the annuitant before the
annuity commences the premiums are returned without interest.

Jeevan Akshay

This is an immediate annuity policy (with profits), where under, in return for a
lump sum consideration called purchase price, the proposer will have the option
to secure either –

i) a full pension, starting from the next month after payment of consideration
and lasting till an annuitant survives. The guaranteed Insurance sum (GIS)
together with Bonus is paid to the beneficiary on the death of an annuitant.

ii) a reduced pension with a survival benefit of 30% of the guaranteed insurance
sum at the end of 7 years from the commencement of the policy and return of
the guaranteed insurance sum along with bonus as reduced by survival
benefit, on death of an annuitant. The same pension amount will continue
even after payment of the survival benefit.

The policy is issued only to the persons aged 50 and above.

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Jeevan Dhara

This is a with profit deferred annuity plan which provides monthly pension after
the vesting date during the life time of an annuitant and also allows for return of a
lump sum called Guaranteed Insurance Value Element (GIVE) along with a
terminal bonus on death.

The premiums can be paid by way of consideration in lump sum at the

commencement or by way of annual or semi-annual installments during the
deferment period. The policy is issued for deferment period ranging from 2 to 35
years and for vesting ages 50 years and onwards subject to the condition that the
age at entry is not less than 18 years.

The bonus under the plan accrues at two stages

i) at the end of the deferment period and

ii) at the time of death after vesting, and both payable along with GIVES
amount on death.

Accounting procedure in the insurance industry is different for each kind of plan.

4.10 Unit Linked Insurance Plans ( ULIPs)

Unit Linked Insurance Plan contains both

 Investment
 Insurance

Hence policy holders get benefit of Investment as well as Insurance plan. Salient
features of this product are as follows

1. This plan is two in one i.e. it contains both Life Insurance and Investment
2. Generally, this plan is for longer period say for 10 to 15 yrs.
3. It has 5 year lock in period.
4. This plan gives multiple choices to policy holders in terms of return such as
growth, Balance, debt or gilt plan which gives varied return as per risk
appetite
5. Premium payment may be yearly, half yearly, quarterly or monthly.
Policyholders have a choice to make lump sum payment which is called
Single Premium.
6. Investment of ULIP is kept separate from other investment of Life Insurance
Plan.
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7. From Premium Insurance premium and charges for expenses (discussed in

subsequent chapter) are deducted and balance premium is used to allocate
units to policy holders. Value of units is declared every day which is called
NAV (Net Asset Value).
8. Accounting of unit linked insurance plan is kept separately (discussed in
subsequent chapters)
9. At the time of maturity, NAV of outstanding units are paid and in case of
death, sum assured is paid in addition to NAV of outstanding units and in
case of surrender NAV of outstanding units are paid after deduction of
appropriate charges.
10. Tax benefits are available u/s Section 80C.

Some unit linked insurance plans are:

 Samriddhi Plus
 Endowment Plus
 Bima Plus
 Future Plus

11. Insurer does not carry any risk of market fluctuation. The loss or profit on the
investment has to be borne by the policyholder.

Unit linked pension plans

IRDA has allowed the insurance companies to issue unit linked Pension Plan,
where most of the features resemble the unit linked plan.

i) In unit linked pension plan, at the time of maturity, NAV of outstanding units
are converted into corpus for the purchase of Annuity, so that Annuity
payment can be made out of corpus.
ii) 1/3rd of corpus can be commuted by the insured.
iii) Unit linked pension plan may or may not have life cover.

Some of unit linked pension plans are

 Market Plus
 Market Plus I
 Pension Plus
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4.11 Health insurance plans

Health Insurance Plan is quite different from Mediclaim which is offered by

General Insurance Companies. Main features of Health Insurance plan are as
follows:

a) This plan is usually for a longer period, say 10 years.

b) Premium is directly linked to the sum assured. However, this plan will not
have level premium and will increase with the age of the insured.

c) Health Plan is for making payment in case of treatment of critical illness and
Hospitalization. Under Mediclaim, reimbursement is restricted to expenditure
incurred by the policy holder irrespective of S.A (however, subject to
maximum of SA). A Health Insurance Plan payment is linked to the sum
assured irrespective of the expenditure incurred by the policyholder.
Premium can be paid yearly, half yearly, quarterly and monthly.

d) In this plan, the following benefits are available.

 Hospital Cash Benefit
 Major Surgical Benefit
 Domiciliary Treatment Benefit
 Benefit at the end of the Policy Term
 Death Benefit

e) Health Insurance can cover family members also.

f) Generally, health insurance is a unit linked plan, where after deduction of

premium for health insurance and other charges to cover expenses, balance
premium is converted to purchase units by way of investment.

g) Units can be reimbursed during illness or at the time of death - or can be

redeemed at the time of compulsory surrender.

h) Premium received under health insurance plan is invested separately.

i) Similarly, separate accounts are kept for health insurance plans.

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Some unit linked pension plans are:

 Health Plus plan,
 Health Protection Plan
These have been launched by LIC of India.

4.12 Micro insurance plans

Generally, due to higher sum assured or higher premium, economically backward

persons were not in a position to purchase life insurance which can protect them
from the risk of death and illness.
Now IRDA has allowed Life Insurers to launch policies for these people which is
called micro insurance policies. Salient features of micro insurance policies are
as follows:
a) These types of policies are generally term insurance policies with or without
return of premium or Endowment Insurance or Health Insurance.
b) Generally, Sum Assured for insurance is kept at a lower level; Minimum
Sum Assured is Rs. 5000/- and Maximum Sum Assured, Rs. 30000/- (except
Rs. 50000/- in case of Term Insurance).
c) Term of cover is for minimum 5years and maximum 15 years (except for
Health Insurance where it is 1year (min) and 7years (max).
d) Premium is kept very low, say, Rs.100.
e) Premium is collected weekly or monthly unlike other normal life insurance
policies.
f) This type of plan is sold by an NGO or an institution which deals in micro
insurance.

4.13 Group and superannuation schemes

Under Group Insurance Schemes, the principles involved are more or less the
same as in the case of Life Insurance, but the scheme is taken for a group of
persons employed in an undertaking.
In this scheme, the contract of life insurance can be summed up as an
undertaking to pay specified amounts of money on the happening of certain
contingencies in exchange for a previously agreed series of payments called
premiums.
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This contract is between an employer and the Insurance Company, the

contingencies being either the death of the employee in service or survival up to
the retirement date. In the latter event, the employer would possibly want some
pension to be given for the post retirement life time of the employee. To offer
cover of death risk, the system is to cover risk year by year. The employer is
asked to pay the premiums in advance, and if death occurs, the insurer pays the
claim.
The Group Insurance portfolio is employer-employee oriented i.e. Organisation
Sector. This is because the employers feel the need to give insurance as one of
the employee benefits. Also, the group has the capacity to pay the premiums
regularly. There are different types of group insurance schemes. The main
schemes are given below:
a) Group Superannuation Scheme
Under this scheme, a monthly pension is provided to the retired employee. The
employee will have the option to choose any one of the types of pensions given
below :
i) A pension payable throughout the employee’s lifetime;
ii) A pension payable during his lifetime but also guaranteed for a specific
minimum number of years (5, 10 or 15). If he dies during the guaranteed
period, the pension will continue to be paid to his beneficiary for the
remaining part of the period;
iii) A pension payable during the joint lifetime of the employee and spouse and
continued thereafter during the lifetime of the survivor.
The employee may commute a portion of the pension for a lump sum to the
extent permitted by the Income Tax Rules, 1962. It is possible that in the case of
employees receiving gratuity, one fourth of the pension can be commuted and in
other cases one third of the pension can be commuted. This is meant to enable the
retiring employees to meet their special lump sum requirements which may arise
on retirement from service.
In the event of cessation of service or death of the member while in service prior
to superannuation age, the moneys standing to the credit of the employee would
be utilised to provide a pension to him or to his beneficiary as the case may be.
A superannuation scheme has to be approved by the Income Tax Commissioner
as per the Income-tax Act 1961, so that the contributions towards the scheme are
allowed as deductions in computing the profits of the employer. For this, an
irrevocable Trust Fund needs to be set up. The Trust offers complete protection
to the employees in respect of tax and service benefit.
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b) Group Insurance Scheme

Under this scheme, the insurer will insure all the employees of the undertaking
with the condition that the sum assured is payable on the death of the employee
while in service.
Premiums towards the scheme will be paid by the employer and will get the
benefit of tax as deductible expenditure and the same will not be treated as
perquisites in the hands of the employee.
c) Group Gratuity Scheme
The amount of gratuity payable depends on the:
 salary of the employee and
 the number of years of service completed by him
Since liability keeps on increasing at completion of every year of service, it has
been found necessary for the employers to create a fund so that liability in respect
of these payments is met from the proceeds of the Fund.
As per provisions of Gratuity Act 1972, gratuity is payable to an employee on
termination of employment after he has been in continuous service for not less
than five years
 on his superannuation or
 on his retirement or resignation or
 on his death or disablement due to accident or disease.
The gratuity scheme has to be approved by the Income Tax Commissioner under
the Income Tax Act 1961, for which a trust Fund is set up for the purpose. The
gratuity liability is funded by introducing a Group Gratuity scheme with the
insurers.
The employer will have to pay premium, and investment of these contributions
will be the responsibility of the insurer; this will relieve the employer of the
problems of investments. The insurer will be making the payments to the
employees as and when the various contingencies of payment arise.

In , the sum assured is payable only in the event of death of the

life assured occurring within a defined period.
A Whole life insurance plan
B Term insurance plan
C Endowment insurance plan
D Money back plan
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Summary
 In India, Life insurance business commenced in 1818, with the establishment
of Oriental life insurance company in Calcutta.
 Life insurance is a contract between an insurer and a policyholder, in which
the insurer promises to pay a certain amount of predetermined money to the
insured or his beneficiary, if a certain event occurs.
 One important difference between Life Insurance and other forms of
insurance is with respect to the ‘term’ of insurance.
 A contract of insurance is a contract of ‘utmost good faith’. The proposer,
who is one of the parties to the contract, is presumed to have means of
knowledge, which are not accessible to the insurer, who is the other party to
the contract.
 In life insurance business, it is important for insurers to correctly predict the
risk, as it helps them in determining the cost of insurance. The greater the
degree of accuracy with which this can be done, the more scientific will be
the basis of life insurance.
 Risk can be measured with the help of the Law of Averages which operates
only when we are dealing with large numbers.
 For life insurers, premium is the cost of insurance, and for policyholders, it is
the money that they have to pay to avail certain amount of insurance cover.
 The mortality tables are based on the past data of the insurance companies’
experience with the insured.
 Net premium is also known as ‘pure premium’. Net premium includes:
mortality charges and interest.
 Gross premiums are also known as office premiums. This is the premium
which is communicated to the policyholder. This is calculated by loading
expenses in the net premium.
 In level premium, the amount of premium remains the same over the entire
policy term.
 The Government of India constituted an Authority called the Insurance
Regulatory & Development Authority (IRDA) under the Insurance
Regulatory and Development Authority Act, 1999 (IRDA Act) to regulate
insurance business of the life insurers, non-life insurers and reinsurers. IRDA
regulates both government as well as private insurers.
 As per section 12 of the Insurance Act 1938, all insurance companies must be
audited annually by the auditors. There are three types of audits: Statutory
Audit, Internal Audit and Concurrent Audit.
 Accounts of every insurance company shall be audited by auditors who are
duly qualified to act as auditors of companies.
 Reserve is the amount the insurer must have in hand to meet the liability
under the policy that future premiums will not cover.
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 Scale of premium that is adopted by an insurance company is dependent on

assumptions made by the actuary w.r.t. the future course of mortality, interest
and expenses.

Answers to Test Yourself

Answer to TY 1
The correct answer is B.
Level premium is being charged by the insurance company.

Answer to TY 2
The correct answer is B.
As per the Insurance Act, 1938, one audit firm would not be permitted to carry
out more than two statutory audits of insurance companies.

Answer to TY 3
The correct answer is C.
Premium is considered to be the main source of income for insurance companies.

Answer to TY 4
The correct answer is B.
In term insurance plan, the sum assured is payable only in the event of death of
the life assured occurring within a defined period.

Self-Examination Questions
Question 1
Which of the following is taken into account while calculating Net premium?
A Mortality charges
B Expenses of management
C Possibility that the rates of mortality assumed will not be experienced in
practice
D Possibility that the rates of interest earned will be less than those assumed
and the need for providing profits for the with-profits policyholders
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Question 2

Which of the following is incorrect?

A Auditor of an insurance company shall be a firm

B The Auditing firm should have been established and should have been in
continuous practice for a period of 10 years or more
C The Auditing firm should have a minimum of five partners
D The Auditing firm could be a firm which has at least seven Chartered
Accountants

Question 3

Which of the following is correct?

A Reserve = Accumulated value of all the premiums received under a policy -
Interest + Cost of meeting the risk already covered- Expenses incurred.
B Reserve = Accumulated value of all the premiums received under a policy -
Interest – Cost of meeting the risk already covered+ Expenses incurred
C Reserve = Accumulated value of all the premiums received under a policy +
Interest + Cost of meeting the risk already covered-+Expenses incurred
D Reserve = Accumulated value of all the premiums received under a policy +
Interest – Cost of meeting the risk already covered- Expenses incurred

Question 4
is a periodical payment made, in exchange for purchase money
(capital payment), for the remainder of the life time of a named life or for a
specified period, irrespective of the duration of human life.
A Insurance
B Premium
C Annuity
D Claim

Question 5
Which of the following is also known as pure premium?
A Gross premium
B Net premium
C Office premium
D Level premium
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Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is A.

Mortality charges are taken into account while calculating Net premium.

Answer to SEQ 2

The correct answer is B.

The Auditing firm should have been established and should have been in
continuous practice for a period of 15 years or more.

Answer to SEQ 3

The correct answer is D.

Reserve = Accumulated value of all the premiums received under a policy +

Interest – Cost of meeting the risk already covered- Expenses incurred.

Answer to SEQ 4

The correct answer is C.

An annuity is a periodical payment made, in exchange for purchase money

(capital payment), for the remainder of the life time of a named life or for a
specified period, irrespective of the duration of human life.

Answer to SEQ 5

The correct answer is B.

Net premium is also known as pure premium.

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CHAPTER 3

ACCOUNTING PROCEDURE – PREMIUM

ACCOUNTING

Chapter Introduction
This chapter aims to provide you with an understanding of the life insurance
accounting process for premiums received by insurance companies with respect
to different policies. You will also learn about the different types of books of
accounts that are maintained by insurance companies for reconciliation,
classification and posting to control accounts. In addition, this chapter discusses
the accounting process for premium received by insurance companies for ULIPs.

a) Understand the accounting process for premium.

b) Learn about books of accounts that are used for reconciliation,
classification and posting to control accounts.
c) Understand the accounting process for premium related to ULIPs.
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1. Understand the accounting process for premium.

[Learning Outcome a]
In this chapter, we will discuss the procedure adopted for the Accounting of
Premium. For the purpose of understanding, we will take the procedure as
adopted by the Life Insurance Corporation and its various offices.

In addition to this, IRDA has issued IRDA (Manner of Receipt of Premium)

Regulation, 2002, the content of which is given briefly to understand how
premium can be collected.

1.1 Methods of premium payment

The proposer/policyholder can choose to pay premium through any of the

following methods:

a) Cash (up to Rs 50,000)

b) Banking negotiable instrument such as

 Cheques
 Demand Draft,
 Pay Order,
 Bankers Cheque.

c) Postal Money orders

d) Bank Guarantee or Cash Deposit

e) Internet Banking or E-Transfer

f) Direct Credits via standing instructions of proposer or the policy holder or

the life insured through Bank transfer

g) Any other method of payment as approved by IRDA.

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Diagram 1: Methods of premium payment

Risk will commence immediately in case of payment of cash. In all other cases,
the risk commences only after the receipt of premium by the insurer.

1.2 Types of premiums

For a life insurance company, premium is the principal source of income.
Premiums can be classified as:
 First Premium
 First Year Premium
 Renewal Premium

Diagram 2: Classification of Premium

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It is important to understand the difference between first premium and first year
premium as the Insurance Act allows higher allowance for expenses of
management for first premiums and first year’s premiums.

First premium

First premium represents the first installment premium whether monthly,

quarterly, half-yearly or yearly.

First year’s premium

First year’s premium is the premium relating to the first year of the policy,
including the first installment.

Rahul Vyas is a 30 year old individual who has purchased an insurance plan on
6th June 2010. He has chosen to pay Rs 1500 per month for paying the premium.
Hence, his first premium will be equal to his first instalment of Rs 1500, whereas
his first year’s premium will be equal to the sum total of all the premiums that he
will pay monthly in his first year, including his first instalment.

Renewal premium

Premiums paid in subsequent years during the policy term are known as renewal
premiums.

Based on the type of life insurance plan offered by insurance companies,

premiums can also be classified as:
 Single premium
 SSS premium
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a) Single Premium

In single premium life insurance plans, the policyholder has to pay a single lump
sum amount as premium to the insurance company and gets a life insurance
cover for his whole life.

Advantages of single premium

 Policyholder does not have to worry about arranging the funds for paying
premium every year.
 Policyholders who do not have a regular source of income can choose single
premium option, if they have a lump sum amount available with them.
 Policyholder does not have to remember due dates for premium payment
every year.
 The advantage to insurance company is that it gets an upfront payment at the
time of accepting the risk.

“Jeevan Vriddhi” is a single premium non linked insurance plan that has been
recently launched by LIC in the market. Main features of this policy are:

 The plan will provide risk cover of 5 times the premium that will be paid to
the policyholder.
 Loan on policy can be taken after one year.
 Policy term is fixed for 10 years.
 Minimum age of entry is 8 years.
 Minimum sum assured is Rs 1,50,000.
 Minimum premium under the policy is Rs 30,000 (increases in multiples of
Rs 1000).
 In case the life insured dies during the policy term, the basic sum assured ( 5
times the single premium paid, excluding extra premium , if any) will be paid
to his nominees or beneficiaries.

b) Salary Saving Scheme (SSS) Premium

In Salary Savings Scheme or SSS, policies are group insurance plans in which
the insurance company signs a contract with the employer for providing
insurance to its employees.

In this scheme, the employer deducts the premium from the employee’s salary
and passes it on to the insurance company.
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The main features of this policy are:

 Employer has to ensure that the employee signs an authority letter to the
employer, which authorises him to deduct a certain amount from his salary
towards payment of the premium.
 Premium is calculated on a yearly basis and the figure is then divided by 12
to arrive at the amount that will be deducted monthly from the employee’s
salary.
 The advantage of this scheme to the insurance company is that it is able to
cover a large number of individuals as a group for providing insurance cover.
Also, as the premiums are being paid by the employer, chances of a policy
lapsing is low.
 Advantage to policyholder in SSS is that he can avail hassle free insurance
cover and does not have to remember premium due dates.

1.3 Accounting entries for first year premium

As discussed above, the first year premium includes all the installments that will
be collected in the first year from the policyholder/proposer.

The process of collecting and recording first year premium is as follows:

1. Collection of advance deposit

Insurance agents generally collect an advance deposit from the proposers along
with the proposal form which is equivalent to the first installment premium.

Advance deposit is a minimum amount that needs to be paid by the proposer

along with the proposal form.

This advance deposit has to be submitted by the insurance agent at the insurance
company office along with the proposal form.
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Diagram 3: Process of insurance premium

Once the underwriter decides to accept the risk, the insurance company then
forwards a letter of acceptance to the proposer along with the details of the
premium amount that he needs to deposit to the insurance company within a
specific period.

2. Proposal deposit account / Suspense account

The amount deposited by insurance agents cannot be appropriated towards

premium account by insurance companies. Instead, insurance companies
maintain a proposal deposit account or suspense account for such advance
deposits.

These advance deposists are kept in the Proposal Deposit Account /Suspense
account till the underwriter takes a deciosn regarding accpetance or rejection of
the risk.

Once the underwriter decides to accept the proposal, this deposit is then taken out
of the suspense account and credited to premium account.
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Cash Book/Adjustment Book entries will be as follows

Date Amount
Cash or Bank A/c Dr.
To Proposal Deposit A/c
(Being record amount received towards proposal
deposit)

3. Is the deposit amount equal to the first premium that needs to be paid by
the proposer?

The deposit amounts collected may either be in excess of the required first
premium or less than the required first premium.
i) Deposit amount is less than the required premium
 If the amount falls short of Re 1 the shortfall is not collected from the
policyholder but debited to Short Remittance Account.
Cash Book/Adjustment Book entries will be as follows
Date Amount
Proposal Deposit A/c Dr.
Short Remittances Account Dr.
To First Premium A/c
(Being record amount adjusted towards first premiums
by debiting proposal deposit and shortfall to Short
Remittance)

 If the shortfall is more than the permissible limits of Short Remittance, the
balance amount is collected from the proposer and credited to proposal
deposit.
Cash Book/Adjustment Book entries will be as follows:
Date Amount
Cash or Bank A/c Dr.
To Proposal Deposit A/c
(Being record amount received towards proposal
deposit)
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The two deposit amounts (the advance deposit collected earlier and the shortfall
amount) are then linked and adjusted towards first premium by debiting proposal
deposit.
ii) Deposit amount is more than required premium
 If the excess of proposal deposit is up to Rs 10, it is credited to “Short
Remittance Account”.
Cash Book/Adjustment Book entries will be as follows:
Date Amount
Proposal Deposit A/c Dr.
To First Premium A/c
To Short Remittance A/c
(To record amount adjusted towards first premium and
crediting the excess to short remittance)

 If the excess of more than Rs 10, it is refunded to the policyholder.

Cash Book/Adjustment Book entries will be as follows:
Date Amount
Proposal Deposit A/c. Dr.
To First Premium A/c.
To Cash/Bank A/c.
(Being record amount adjusted towards first premium
and refund of the excess amount).

4. Collection of subsequent instalements of first year premiums

The subsequent instalments of first year’s premium when received is credited to
“Other First Year’s Premium” .
Cash Book/Adjustment Book entry to record the transactions is as follows:
Date Amount
Cash/Bank A/c. Dr.
To Other First Year’s Premium A/c.
(Being record receipt of other first year’s premium).
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Accounting entries in case of subsequent premiums are insufficient to cover

the required instalments

a) When subsequent premiums are insufficient to cover the required instalments

or paid without interest then the amounts are credited to ‘Policy Deposit
Account’.

Cash Book/Adjustment Book entry to record the transactions is as follows:

Date Amount
Cash/Bank A/c. Dr.
To Policy Deposit A/c.
(Being record amount kept in policy deposit)

b) On receipt of the late fees or balance premiums, the policy deposit is adjusted
towards premiums.

Cash Book/Adjustment Book entry to record the transactions is as follows:

Date Amount
Policy Deposit A/c. Dr.
To Renewal Premium A/c.
To Interest on Premiums A/c
(Being record amounts adjusted from policy deposit
towards renewal premium and late fees).

c) When interest on late payment is not received or when there is shortfall in

premiums due to foreign exchange rates, premiums are adjusted by creating
“X” charge on the policy.

Where, however, the premiums are short, an entry is passed debiting “X”
charge on premiums and crediting premiums as follows for the purpose of
premium control.
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Cash Book/Adjustment Book entry to record the transactions is as follows:

Date Amount
Cash / Bank A/c. Dr.
“X” charge on Premiums A/c. Dr.
To Renewal Premium A/c.
(Being record adjustment of short premiums by
debiting “X” charge account).

 When an “X” charge is created under a policy, it must be recovered from the
first available payment made to a policyholder, such as Loan, Survival
Benefit, Surrender Value, Claim, Refund of Deposit or Refund of Premium
due to any reason.

 If there is no payment due to the policyholder, “X” charge amount must be

indicated in the Notice to the policyholder for paying it along with the next
premium as and when it falls due.

d) When subsequent premiums are paid in advance by the policyholder, the

insurance company allows a discount to the policyholders. The premiums so
collected are credited to the Discounted Value of Premium Deposits.

Cash Book/Adjustment Book entry to record the transactions is as follows:

Date Amount
Cash / Bank A/c. Dr.
To Discounted value of premium deposits A/c.
(Being record discounted value of premium deposits)

Interest will be added to these deposits annually and, as and when premiums fall
due, they will be adjusted from the discounted value of premium deposits.
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Cash Book/Adjustment Book entry to record the transactions is as follows:

Date Amount
Interest Sundries A/c. Dr.
To Discounted value of premium deposits A/c.
(Being record interest due on discounted value of
premium deposits).

Date Amount
Discounted value of Premium Deposits A/c.
Dr.
To Renewal Premium A/c.
(Being record premiums appropriated on due dates
from Discounted value of premium Deposits).

5. If the proposal is rejected by underwriters

In case the proposal is rejected by underwriters due to high risk associated with
the life insured, the advance deposit needs to be refunded to the proposer.

Cash Book/Adjustment Book entries will be as follows:

Date Amount
Proposal Deposit A/c. Dr.
To Cash/Bank A/c.
(Being refund of proposal deposit when proposal is
declined).

1.4 Accounting entries for renewal premium

Renewal Premiums are received from policyholders if they relate to individual

policies or from employers (Paying Authorities) in respect of salary Savings
Scheme Policies.

Remittances towards premiums are received in Cash, Cheque or through

collecting banks and post offices.
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The following entry records receipts of premiums from individual

policyholders.

Date Amount
Cash/Bank A/c. Dr.
To Renewal Premium A/c.
(Being record amount received towards Renewal
Premium).

 In case of Renewal Premium, the allowable shortfall or excess that could be

taken to Short Remittance Account is Rupee one or 1% of the renewal
premiums, whichever is less.

 In case where the deposits received are in excess of the permissible “Short
Remittance” limits after adjustment, they are refunded to proponents.

 If the proposal is declined then also the entire amount of proposal deposit is
refunded.

1.5 Accounting entries for Single premium

The proposal deposit towards Single Premium is credited to Single Premium A/c
by debiting Proposal Deposit A/c as shown below. Lump sum premium received
under any plan other than Annuity is credited to ‘Single Premium’ (S.P.).

Cash Book/Adjustment Book entries will be as follows:

Date Amount
Proposal Deposit A/c. Dr.
To Single Premium A/c.
(Being record adjustment of proposal deposit towards
Single Premium)
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Cash Book/Adjustment Book entries for Premium payment towards annuity

The proposal deposit towards Consideration for Annuities is credited to

consideration for Annuities Granted A/c by debiting Proposal Deposit A/c as
shown below. Lump sum premium received for Annuity is credited to
‘Consideration for Annuities Granted’ (C.A.G.) Account .

Date Amount
Proposal Deposit A/c. Dr.
To Consideration for Annuities Granted A/c.
(Being record adjustment of proposal deposit towards
Consideration for Annuities Granted)

We will also discuss accounting for premium of ULIP Scheme separately.

1.6 Accounting entries for SSS

When the premiums are received from employers by insurance companies in

respect of SSS Policies, the amounts are initially credited to a deposit account
called the “SSS Collection Account”.

Cash Book/Adjustment Book entries will be as follows

Date Amount
Cash/Bank A/c. Dr.
To SSS Collection A/c.
(Being record amounts received from paying
authorities).

Subsequently, the software program gives the break-up of “Other First Year” and
“Renewal Premium”.
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Cash Book/Adjustment Book entries will be as follows

Date Amount
SSS Collection A/c. Dr.
To “Other First Year Premium” A/c.
To “Renewal Premium”.
To SSS Deposits (Policy),
(Being record appropriation of SSS collection to
“Other First Year” and Renewal Premiums and
Deposit).

1.7 Accounting entries for deposits written back

Proposal Deposits which are outstanding for two years and more and Policy
Deposits which are outstanding for four years and more from the date of
collection, as at 31 st March are written back to Revenue Account.

Cash Book/Adjustment Book entry for proposal deposist will be as follows

Date Amount
Proposal Deposit Dr.
To old Outstanding and Unclaimed Deposits
Written Back Account
(Being the entry for writing back old and outstanding
deposits)

Cash Book / Adjustment Book entry for policy deposist will be as follows

Date Amount
Policy Deposit Dr.
To old Outstanding and Unclaimed Deposits
Written Back Account
(Being the entry for writing back old and outstanding
deposits)
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All deposits written back must be listed with full particulars in the prescribed
Registers/Schedules to be maintained for this purpose. Whenever a policyholder
claims these deposits after they are written back, the amounts can be
adjusted/refunded to the party after due and proper examination and after
checking the genuineness of the party’s claim. A counter remark is to be taken
against the original credit entry in the Register / Schedule to avoid duplicate
payment / adjustment.

Cash Book/Adjustment Book entry for refund will be as follows

Date Amount
Old outstanding and Unclaimed Deposits
Written back paid during the year Account
Dr.
To Bank Account
(First Year or Other First Year or Renewal Premium)

Cash Book/Adjustment Book entry for Adjustment will be as follows

Date Amount
Old outstanding and Unclaimed Deposits
Written back paid during the year Account Dr.
To Premium etc. Account
(First Year or Other First Year or Renewal Premium)

1.8 Accounting entries for reinsurance

a) Reinsurance ceded

There is a maximum limit of insurance that an insurance company can carry on a

single life, which is known as limit of issue. There is, however, a maximum
amount of risk which will be retained which is known as “limit of retention”.

The difference between limit of issue and limit of retention will be ceded to the
reinsurance companies. When reinsurance is ceded, premiums will be debited
and Bank account will be credited.
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Cash Book/Adjustment Book entry for reinsurance that is ceded will be as

follows

Date Amount
Reinsurance Premium Ceded – First Year A/c Dr.
Reinsurance Premium Ceded – Renewal Premium A/c.
Dr.
To Bank A/c.
(Being record insurance premiums ceded)

b) Reinsurance accepted

When the company accepts reinsurance from other Life Insurance Companies,
the reinsurance premiums are received by the company.

Cash Book/Adjustment Book entry for reinsurance that is accepted will be

as follows

Date Amount
Bank Account Dr.
To Premium on Reinsurance Accepted – First Year
A/c
To Premium on Reinsurance Accepted – Renewal
A/c.
(Being record reinsurance premiums accepted)

1.9 Accounting entries for Outstanding premiums

During the financial year, premiums are accounted for on cash basis. At the end
of the financial year, the outstanding premiums are provided for in the accounts
for Revenue Account and Balance Sheet purposes.
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Premiums which have fallen due on policies but have not been paid, the days of
grace for payment which have not expired and the earlier premiums not in arrears
are treated as outstanding premiums.

Under the Insurance Act, two methods are allowed for provision of outstanding
premiums.

a) Method 1: the total outstanding premiums are set out above without
deduction of commission (commission shown as expense).

Cash Book/Adjustment Book entries to record the transaction of

outstanding premiums:

Date Amount
Outstanding Premiums – First Year
Dr.
Outstanding Premiums – Renewal
Dr.
To First Years' Premium
To Renewal Premium
(Being record outstanding premiums of first year and
renewal)

b) Method 2: On a net basis under which the outstanding Premiums less the
Commission payable on the outstanding premium are provided.

Cash Book/Adjustment Book entries to record the transaction of

outstanding commission on outstanding premium:

Date Amount
First year Commission Dr.
Renewal Commission Dr.
To outstanding Commission (First Year)
To outstanding Commission (Renewal)
(Being record outstanding commission on outstanding
premium)

The first method is more popular among insurance companies.

 185

1.10 Accouting entries for dishonoured cheques

Amounts appropriated towards premiums or deposits require reversal when those

amounts are received by cheques and the cheques are subsequently dishonoured.

In this case, Premium Account or Deposit Account will be debited and Bank
Account will be credited.

Cash Book/Adjustment Book entries will be as follows:

Date Amount
First Premium A/c. Dr.
Or
Other First Year Premium A/c. Dr.
Or
Renewal Premium A/c. Dr.
Or
Proposal Deposit A/c. Dr.
Or
Policy Deposit A/c. Dr.
To Bank A/c.
(To record dishonour of cheque).

In which of the following accounts does the insurance company record the
advance deposits received by the proposer for the purchase of the policy?

A Proposal deposit account

B Suspense account
C Premium account
D Either A or B
 186

2. Learn about books of accounts that are used for

reconciliation, classification and posting to control
accounts.
[Learning Outcome b]
2.1 Control on premiums
In insurance companies, the accounting entries are recorded on cash basis during
a financial year. Henceforth, no accounting entry is passed to record premiums
that are due!
Now-a-days, premium receipts are generated through the computer system, in
which the premium paid is automatically updated in the policy record. At the
end of the year, the list of unpaid premium is generated i.e. premium due whose
grace period is not expired and this is provided as ‘Outstanding Premium’ in
the account books.
a) Statistical control
The average first premium and the average first year’s premium per Rs. 1,000
Sum Assured are worked out and compared to those of earlier years to study the
sales mix. If the average first premium is declining, it may indicate shift towards
longer duration policies or policies having low premium or change in the mode.
b) Conservation ratio
The renewal premium of a year is related to the total premium of the preceding
year to give a conservation ratio. If there are large exits in the policies, this ratio
will show a declining trend.

2.2 Books of accounts maintained to control accounts

Insurance companies have to maintain two types of books: Statutory books and
Subsidiary books.
1. Statutory books
a) Register of policies
Under Section 14(a) of the Insurance Act, it is obligatory to maintain a Register
of Policies, which records, in respect of every policy issued by the insurer:
 the name and address of the policy-holder,
 the date when the policy was effected and
 any transfer assignment or nomination of which the insurer has received
notice.
 187

b) Register of claims

Under Section 14(a) of the Insurance Act, it is obligatory to maintain a Register

of claims, which records, for every claim made together, details regarding:

 the date of the claim,

 the name and address of the claimant and
 the date on which the claim was discharged, or, in the case of a claim which
is rejected, the date of rejection and the grounds therefor

2. Subsidiary books

For reconciliation, classification and posting to control accounts, the following

primary books of accounts are used:

a) Deposit Cash Book

b) Deposit Adjustment Book
c) Premium Cash Book
d) Cash Paid Book

In addition to the above, individual sub-ledgers in the software for each

policyholder known as policy-ledgers are maintained by the insurance company
which contain the running account of each policyholder.

Under Section 14(a) of the Insurance Act, it is obligatory to maintain a Register

of Policies which records, in respect of every policy issued by the insurer, the
name and address of the policy-holder, the date when the policy was effected and
any transfer assignment or nomination of which the insurer has received notice.

a) Deposit cash book

The insurance company receives a deposit either for a new proposal or towards
the existing policy. These deposits can be received by the insurance company via
different modes of payment such as cash, cheque, demand draft, pay order etc.
The insurance company has to maintain a record of all such deposits received on
a daily basis in a deposit cash book.
 188

Consider the follwoing example

Following is the list of deposits that a branch office of ABC insurance company
has received in a day.

Payment made Mode of Policy/proposal number Amount

towards payment
Policy Deposit By Cash Policy No. 05793788 Rs. 500/-
New Proposal By Cheque Proposal No. 11212922 Rs. 700/-
New Proposal By Cash Proposal No. 11213922 Rs. 80/-
Policy Deposit By Cheque Policy No. 06802468 Rs. 150/-

Accounting entries for Deposit cash book for above entries will be as follows

Sr. Cash Cheque B.O.C. Proposal / Proposal Policy

No. Dr. Dr. No. Policy No. Amount Deposit
Cr Cr
1 500 09267922 05793788 500

2 700 09268922 11212922 700

3 80 09269922 11213922 80
4 150 09270922 06802468 150
Total 580 850 780 650

b) Deposit Adjustment book

i) An insurance company needs to make the following entries in the Deposit

adjustment books:
ii) Amount received towards renewal premium from policyholder, including
interest payment.
iii) Amount recieved towards loan taken under a policy
iv) Amount recieved towards interest on loan taken under a policy etc.
v) These entries have to be recorded in the Deposit Adjustment Book on a daily
basis by the insurance company.
 189

Consider the following example:

The following adjustments for the Deposit have been made in the Branch office
of ABC insurance company in a day.

S. No BOC No.
1 Rs.400/- paid towards 350/- Renewal Premium, 50/- 12345914
interest on premium Pol.No.06135790
2 Rs.510/- paid towards loan under policy No.07890124 11355914
3 Rs.1,100/- paid towards loan (Rs.1000/-) + Loan Interest 10489914
(Rs.100/-) Policy No.07090345

The above entries will be made as under

Branch Deposit Adjustment Book for the period ending .

S. Policy B.O.C. Deposit Renewal Int. on Loan Loan

No. No. No. A/c. Premium Premium A/c. Int.
Dr. Cr. Cr. Cr. A/c.
Cr.
1 06135790 12345914 400 350 50

2 07890124 11355914 510 510

3 07090345 10489914 1100 1000 100

Total 2010 350 50 1510 100

c) Premium cash book (Income)

The main source of income for an insurance company is premium. Apart from
premium, an insurance company also recieves income from repayment of loan
interest, agent’s license fee, via sales of diaries, calenders etc.

The insurance company has to maintain a record of all such reciepts of income in
Premium etc cash book on a daily basis.
 190

Consider the following example

The following collections have been made at the Branch office of ABC
insurance company in a day.

S. no Particulars Policy no Amount

1 Year’s Renewal Premium (Cash) 08123567 Rs. 200.00
2 Renewal Premium with X-charge 07154680 Rs.150.00 (5.00
(Cheque) X charge)
3 Renewal Premium with late fee 09253612 Rs.515.00
(Cheque) (15.00 Late Fee)
4 Repayment towards loan 07201357 Rs.1000.00
(Cheque)
5 Repayment towards loan interest 01579357 Rs. 95.00
(Cash)
6 Towards Agents Licence Fee Ag. Code Rs. 15.00
(Cash) 6581912
7 Towards Saleable literature Rs. 250.00
(Diaries / Calendars) (Cash)

The entries in the Premium cash book will appear as under :

 191

Br. No. 912Premium etc. cash book

15-12-2010
DEBIT
CREDIT
Misc.
F.Y. Misc.
Sr. Name Misc A/c Renewal Int. on. Loan Misc.
Policy no. Cash Chq Prem Loan A/c.
no. Initials amt Code Prem. Prem. Int. amt
. Code
No.
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
1 2 3 4 5 6 7 8 9 10 11 12 13 14

i 08123567 ABC 200 200

ii 07154680 PQR 150 5 3951 155

iii 09253612 XYZ 515 500 15

iv 07201357 RST 1000 1000

v 01579357 STU 95 95

vi 6581912 TUV 15 15
(Ag. Code)
vii - WZY 250 250
560 1665 5 200 655 15 1000 95 265
 192

d) Branch cash paid book

In Branch Offices, there are two Cash Paid Books that have to be maintained:

 Cash Paid Book: For recording all payments related to management

expenses including commission to Agents and others
 Cash Outgo Book: For recording disbursement of all policy payments such
as Claims, Survival benefits, Surrenders, Loans, etc.

Consider the follwoing example

(For illustration purpose all entries are recorded in one Branch cash paid Book

The following are some of the payments made at Branch Office 916 of Life
Insurance Corporation of India, on day : 31-12-2010

1. Loan of Rs.2,000 paid on Policy No. 07891234 by Cheque.

2. Maturity Claim of Rs.10,000 paid on Policy No.12347890 by Cheque.
3. Death Claim of Rs.15,000 paid on Policy No.02468024 by Cheque.
4. Surrender Value of Rs.7,000 paid under Policy 07256357 by Cheque.
5. Commission of Rs.400.00 paid by Cash to Ag. Code 58621916.
6. Stationery worth Rs.300.00 purchased by cash.
 193

Branch 916 Cash Paid Book 31.1210

Dr Cr

Voucher Surrender Outstanding Bank

Policy Salary
No Loan Claim by Claim by Commn. Printing Cash Cheque
Agent No & Stny
Maturity Death
Paid Paid

1001 07891234 2,000 2,000

1002 012347890 10,000 10,000

1003 02468024 15,000 15,000

1004 07256357 7,000 7,000
1005 58621916 400 400
Bombay
1006 300 300
Sty.Co.
2,000 7,000 10,000 15,000 400 300 700 34,000
 194

Which of the following will not be recorded in the premium etc. cash book?

A Agent’s license fee

B Repayment of loan interest
C Amount of claims paid
D Premium received by the company

3. Understand the accounting process for premium related

to ULIPs.
[Learning Outcome c]
3.1 Introduction to ULIPs

ULIP stands for Unit linked insurance plans.

ULIPs are market linked insurance plans, in which policyholders are alloted units
on the basis of their premium, and NAV is declared on a daily
basis.

Main features of ULIPs

a) In Unit Linked Policies, the policyholder can pay premium via

 Cash
 Local Cheques
 Pay order
 Draft Payable at par at the place where the premium is received.

Generally, Insurance Companies don’t accept outstation cheques / outstation

demand drafts in case of ULIPs, because in unit linked policies, NAV is given of
the same day if premium is collected before 3pm and if premium is collected
after 3pm; then NAV is given of the next day.

Generally, outstation cheques are realised late and usually, banks levy collection
charges. For the insurers, it becomes very difficult to know when a cheque has
been realized. Hence, insurers avoid Outstation Cheques / Drafts.
 195

b) For mode of payment, policyholders can choose among:

 Yearly instalments,
 half yearly instalments,
 quarterly instalments
 monthly instalments or
 single instalment

3.2 Accounting entries for premium received for ULIPs

In case of ULIPs, the insurance company has to record the following entries.

1. On receipt of cash/cheque

a) Receipt of application money

When a proposer purchases a ULIP policy, he needs to submit proposal deposit

or application money to the insurance company along with the application form.

This entry is recorded as follows:

Date Amount
Bank Account Dr.
To Premium Deposit (Proposal) / Application Money.

b) Receipt of first premium

Submission of application money does not implicate that the insurance company
will provide insurance cover to the proposer. Once the application form is
received by the insurance company, the underwriter assesses the risk and then
takes the decision regarding acceptance/rejection of risk.

If the underwriter decides to accept the risk, then a letter is sent to the proposer
along with details of the premium amount that he needs to submit within the
stipulated period.
Once the insurance company receives the first premium/single premium, the
following entry will be recorded:

Date Amount
Premium Deposit (Proposal) / Application Money Dr.
To First Premium Received
To Single Premium Receipt
 196

c) Receipt of subsequent premium:

On Receipt of subsequent premium, the following entry has to be passed.

Date Amount
Bank A/c Dr.
To First Year Premium / Renewal Premium

2. Allocation of premium

Premium received on unit linked policies contains 2 parts:

a) Unit Fund – It consists of
i) unit capital (i.e. unit at face value) and
ii) unit capital premium account
b) Non-Unit Fund- It consists of
Premium allocation charges.
Date Amount
First / First Year / Renewal Premium / Single Premium
Allocated Dr.
To Unit Capital A/c
To Unit Capital Premium A/c
(If NAV is more than Rs.10/ F.V)

Unit Capital Premium Account Dr.

(If NAV is less than Rs.10/FV)

To Premium Allocation Charges

Premium allocation charges

The insurance company collects the following charges from the policyholder:
 Mortality charges: For providing insurance cover to the policyholder under
ULIP policy, the insurance company deducts mortality charges as insurance
premium. Mortality charges depend upon the sum assured under the Basic
Plan.
Furthermore, the charge will also depend on the underwriting decision at
entry or subsequent revival of policy e.g. sometimes due to health hazard or
occupational hazard some extras are levied.
 197

 Accident benefit charges: Insurer will deduct accidental benefit charges if

chosen by the policy holder.

 Policy administration charges: To cover expenses incurred on policy

preparation and other administration charges, policy administration charges
will be recovered.

In a nutshell, the following entry will be passed.

Date Amount
Premium Allocation Charges Dr
To Mortality Charges
To Accident Benefit Charges
To Policy Administration Charges
To Service Tax on risk cover
To Education cess on service tax on risk covers

In case of health insurance, the below mentioned charges will be recovered every
month by cancelling the unit (This entry will substitute the above mentioned
entry).

Hospital cash benefit and major surgical benefit shall depend upon the individual
age near birthday of each of the members covered as at the policy anniversary.
Furthermore, the charges will also depend on whether the person covered is
standard or Non-Standard life as per the underwriting decision.

Date Amount
Premium Allocation Charges Dr.
Repurchase of unit capital account for recovery of charges
Dr.
Repurchase of unit capital premium account for recovery
of charges Dr.
(If NAV is more than Face value charges)
To Repurchase of unit Capital Premium account for
recovery of charges
(If NAV is less than face value)
To Hospital Cash benefit charges
To Major Surgical benefit charges
To Policy Administration charges
To Service Tax and Education cess on Service Tax on
health cover
 198

Dishonour of cheques

There can be two cases relating to dishonour of cheques:

 If the cheque is dishonoured, the following entry shall be passed if the

amount paid by the proponent is still held as Deposit / Application money:

Date Amount
Proposal Deposit (Premium) / Application Money Dr.
To Bank A/c

 When a proposal has resulted into a policy, and subsequently a cheque has
been dishonoured, the following entry will be passed

Date Amount
FYRP / Renewal Premium Received Dr.
To Bank A/c

Entry passed under the heading Allocation of Premium and Premium Allocation
charges will be reversed. To clarify, the following entry will be passed:

Date Amount
Unit Capital A/c Dr.
Unit Capital Premium A/c Dr.
(If NAV is more than Rs.10/ Face value)
To Unit Capital Premium A/c
(If NAV is less than Rs.10/ Face value)
Premium Allocation Charges Dr.
Sundry adjustment charges Dr.

A similar entry has to be passed in the case of health insurance.

In the case of ULIPs, if the cheque is dishonoured and the amount paid by the
proposer is still held as application money, then:

A Proposal deposit account will be debited

B Bank account will be debited
C Proposal deposit account will be credited
D Bank account will be credited
 199

Summary
 First premium represents the first instalment premium whether monthly,
quarterly, half-yearly or yearly.
 First year’s premium are premiums relating to first year of the policy,
including the first instalment.
 Premiums paid in subsequent years during the policy term are known as
renewal premiums.
 In single premium life insurance plans, the policyholder has to pay a single
lump sum amount as premium to the insurance company and gets a life
insurance cover for his whole life.
 In Salary Savings Scheme or SSS, policies are group insurance plans in
which, the insurance company signs a contract with the employer for
providing insurance to its employees.
 Advance deposit is a minimum amount that needs to be paid by the proposer
along with the proposal form. This advance deposit has to be submitted by
the insurance agent at the insurance company office along with the proposal
form.
 The advance deposits are recorded in the Proposal Deposit Account
/Suspense account till the underwriter takes the decision regarding
acceptance or rejection of the risk. Once the underwriter decides to accept
the proposal, this deposit is then taken out of suspense account and credited
to premium accounts.
 During the financial year, premiums are accounted for on cash basis. At the
end of the financial year, the outstanding premiums are provided for in the
accounts for Revenue Account and Balance Sheet purposes.
 Amounts appropriated towards premiums or deposits require reversal when
those amounts are received by cheques and the cheques are subsequently
dishonoured.
 Insurance companies have to maintain two types of books: Statutory books
and Subsidiary books.
 For reconciliation, classification and posting to control accounts, the
following primary books of accounts are used: Deposit Cash Book, Deposit
Adjustment Book, Premium etc. Cash Book, Cash Paid Book.
 In Unit Linked Policies, policyholder can pay premium via Cash, Local
Cheques, Pay order or Draft Payable at par at the place where the premium is
received.
 Insurance Companies don’t accept outstation cheques / outstation demand
drafts in the case of ULIPs, because in unit linked policies, NAV is given of
the same day if premium is collected before 3pm and if premium is collected
after 3pm; then NAV is given of the next day.
 200

Answers to Test Yourself

Answer to TY 1

The correct answer is D.

The insurance company records the advance deposits received by the proposer
for the purchase of the policy in either the proposal deposit account or the
suspense account.

Answer to TY 2

The correct answer is C.

Amount of claims paid will not be recorded in the premium etc cash book.

Answer to TY 3

The correct answer is A.

In the case of ULIPs, if the cheque is dishonoured and the amount paid by the
proposer is still held as application money, then the proposal deposit account will
be debited.

Self Examination Questions

Question 1

If the initial deposit amount paid by the proposer of the policy falls short of Re 1,
then the

A Shortfall is collected in cash by the insurance company

B Shortfall is collected by cheque by the insurance company
C Shortfall is not collected and debited to Short remittance account
D Shortfall is adjusted towards next premium instalment
 201

Question 2

Which of the following entries will be recorded in the cash paid book?

A Management expenses
B Survival benefits
C Loans
D Surrenders

Question 3

Non unit fund consists of

A Unit capital
B Unit capital premium account
C Premium allocation charges
D Unit allocation charges

Question 4

In the case of ULIPs, which of the following will not be accepted by the
insurance companies for premium?

A Cash
B Local cheques
C Outstation cheques
D Pay order

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is C.

If the initial deposit amount paid by the proposer of the policy falls short of Re 1,
then the shortfall is not collected and is debited to Short remittance account.
 202

Answer to SEQ 2

The correct answer is A.

Management expenses will be recorded in the cash paid book.

Answer to SEQ 3

The correct answer is C.

Non unit fund consists of premium allocation charges.

Answer to SEQ 4

The correct answer is C.

Outstation cheques will not be accepted by the insurance companies for

premium.
 203

CHAPTER 4

ACCOUNTING PROCEDURES -
DISBURSEMENTS

Chapter Introduction
This chapter aims to provide you with an understanding of the accounting
process for loans that are taken against life insurance policies. You will also learn
about the accounting process for claim payments for life insurance policies,
ULIPs, Unit linked health policies and Unit linked pension plans.

a) Learn about accounting process for loans against policies.

b) Learn about accounting process for claim payments.
c) Learn about accounting process for claim payments for ULIPs.
d) Learn about accounting process for Unit linked health policies.
e) Learn about accounting process for Unit linked pension plans
 204

1. Learn about the accounting process for loans against

policies.
[Learning Outcome a]
1.1 Introduction to loan against policy

One of the biggest advantage of buying life insurance policies , is that the
policyholder can avail loan against these policies, when need arises!

Loan against policy

In Loan Against Policy ( LAP), , policyholder can apply for loan against his
insurance policy. The loan amount depends upon the surrender value of the life
insurance policy.

When a request for loan against insurance policy is received, the status of the
policy is reviewed by insurance comapny to ascertain that
 the policy is in force and
 that there is sufficient surrender value, which is acquired generally three
years after a policy is taken.

Insurance company generally provide loan upto

 90% of the surrender value ( subject to conditions) or
 85% in case of paid up policies ( subject to conditions).

Main features of Loan aganist policy are :

 When an insurance company provides loan to policyholder against his

insurance policy, policy needs to be ‘absolutely assigned’ to the insurance
company as a security for repayment of the loan.
 When loan is approved, unpaid due premiums are deducted from the loan and
balance is paid.
 Policyholder has to pay interest for the loan.
 Interest dues are compoundable , i.e. in case the policyholder defaults in the
interest payment , then interest is added to the principal amount for
calulating further interest that is due.
 205

 In case the total debt exceeds the surrender value of the policy, insurance
company can terminate the policy.
 The policy holder is entitled to get additional loans subsequently, if the
increase in surrender value of the policy permits such additional loan.
 If the insurance policy gets matured before the loan is repaid by policyholder,
then insurancec company can deduct the loan amount from maturity amount.

1.2 Accounting procedures for Loan against insurance policies

The total of loans disbursed and collections are posted to general ledger control
accounts.

Policy Loan ledger sheets must be prepared for every loan and would contain
following details:
 the amount of loan disbursed interest due and paid and
 policy loan repayments.

Process of loan disbursal against polices and their accounting entries

a) Disbursal of loan against insurance policy

Loan against policies are shown as assets in the Balance Sheet of Insurance
Company. However, loans against policies are not handled by the Investment
Department even though these are in fact investments.

As already discussed above, in loan against an insurance policy, loan amount is

calculated based on the surrender value of the policy. Loan against policy is
given to a policyholder on his assigning the policy in favour of Insurance
Company and executing necessary loan agreement.

When a request for policy loan is received, the status of the policy must be
reviewed to ascertain that the policy is in force and that there is sufficient
surrender value, which is acquired generally three years after a policy is taken.
When loan is approved, unpaid due premiums are deducted from the loan and
balance is paid.
 206

Accounting entry for loan amount that is disbursed will be as follows

Date Particulars Amount Amount

Policy Loan Account Dr.
To Renewal Premiums
To Bank.
(Being the entry to record the policy loan
disbursed after deduction of the unpaid due
premium)

b) Repayment of interest on loan against policy

Policyholder has to to pay interest against the loan amount that has been taken
by him on time, other wise interest gets compounded.

Hence premiums are computed on the assumption that the reserves will be
continually invested at fixed rates of interest.

The due dates of interest payment are half yearly coinciding with the policy
anniversary. Broken period interest from the date of loan to the next half yearly
will be due if the loan is taken in between.

Systematic repayments are required to be made by the policyholder and interest

need not be paid if the policy has sufficient surrender value to cover policy loan
and interest.

Accounting entry for repayment of interest on loan against policywill be as

follows

Date Particulars Amount Amount

Cash/Bank Dr.
To Interest on policy loan
(To record receipts of half yearly or broken
period policy loan interest)
 207

c) Repayment of loan against policy.

Policyholder can choose the repay the loan against policy during the policy term.

Accounting entry for repayment of loan against policywill be as follows:

Date Particulars Amount Amount

Cash/Bank Dr.
To Policy Loan A/c.
(To record repayment of policy loans)

d) Foreclosure of loan against policy

Foreclosure action is taken in case of lapsed policies ,where interest and loan
amount exceed the surrender value of the policy.

Lapsed policies

Lapsed policies under which policyholder has failed to pay premiums to keep it
in force.

As per present practice, if two half-yearly installments of interest on Policy Loan

are not paid under lapsed policies, foreclosure action is taken, after intimating to
the policyholder.

Foreclosure action

Foreclosure action means surrendering the policy to recover loan and interest
dues.

There can be following cases of foreclosure:

 In case the Surrender Value is more than the Policy loan amount and Interest
dues, the balance is refunded to the policyholder.
 208

Accounting entry for foreclosure will be as follows:

Date Particulars Amount Amount

Surrenders A/c. Dr.
To Policy Loan interest
To Policy Loan
(To record foreclosure of policy loan when the
total of policy loan and policy loan interest
exceed surrender values in the case of lapsed
policies)

 If policyholder does not claim the refund, the same is credited to ‘Surrender
Value Unclaimed A/c.’

Accounting entry will be as follows:

Date Particulars Amount Amount

Surrender A/c. Dr.
To Policy Loan Interest
To Policy Loan
To Bank/Surrender Value Unclaimed
(To record foreclosure of Policy Loan and
outstanding interest thereon and for payment
of residual surrender value or for residual
surrender value credited to unclaimed
surrender account)

 Amounts lying for more than three years in ‘Surrender Value Unclaimed
A/c.’ are written back as at the year end to ‘Old Outstanding and Unclaimed

Amounts Written Back A/c.’ and a Register/Schedule is maintained giving

full details. Whenever Policyholder claims the amount, these amounts are
refunded to them after due and proper examination and after confirming
genuineness of the party’s claim and after making a remark in the
Register/Schedule.
 209

Accounting entry will be as follows:

Date Particulars Amount Amount

Surrender Value Unclaimed A/c.
Dr
To old Outstanding and unclaimed
Amounts written Back A/c.
(To record writing back of unclaimed
surrender value)

e) To record outstanding and accruing interest due on policy loans

As at the close of the financial year, the outstanding and accrued interest due on
policy loans are brought into books by means of the following entries :

Accounting entry will be as follows:

Date Particulars Amount Amount

Interest on Policy Loans – Outstanding Dr.
Interest on Policy Loans – Accrued Dr.
To Interest on Policy Loans
(To record outstanding and accruing interest
calculated according to individual policy loan
ledger)

It should be remembered that these are only adjustment entries and would be
reversed during the next year.

Total of loans disbursed and collected are posted into by

accountants in case of loans against insurance policies?

A General journal
B General ledger control accounts
C Policy loan ledger sheets
D Bank account
 210

2. Learn about accounting process for claim payments

[Learning Outcome b]
2.1 Introduction to claim payments

Claims are policy benefits payable according to the terms of policy contract.

There can be following claims that are payable by insurance companies :

Diagram 1: Types of claim payments

a) Death claims: Death claims are payments of the insured amount of the
policies in the event of the death of the policy holders together with bonus
additions in the case of with-profit policies.

b) Maturity claims: Maturity claims are payments made to the surviving

policyholders on the expiry of the terms of the policies, together with bonus
in case of with profits policies.

c) Survival benefit: Under Anticipated Endowment Assurance and Money

Back policies, survival benefit is payable at fixed periodic intervals.

d) Surrender value payments: The policyholder may terminate the policy

during its currency and claim cash surrender value of the policy. These
payments are known as surrenders.

e) Annuity payments: Annuity contracts are purchased by the annuitant to

provide an income to the annuitant beginning at a stated age.
 211

 Under single premium immediate annuity, the annuity payments begin

immediately.
 Under deferred plans the annuity payments are deferred to future date.
 This contract may also provide for the return of premiums in case the
annuitant dies before the annuity payments begin.

2.2 Claim process and their accounting entries

Accounting entries for each type of claim payments, can be divided in 2 steps:

a) Creation of liability: This involves initial process carried out by insurance

companies, when they recieve intimation about life assured’s death.

 Death claims: In case of death claim, as soon as insurance company

recieves notice of life death of life insured, it is customary to treat the
policy amount as a claim and enter it in the Death claims intimation
register.

 Maturity claims: In the case of maturity claims Insurance Company will

initiate the transaction by sending claim discharge forms.

 Annuity payments: In the case of annuity payments as well, Insurance

Company will initiate the transaction by sending claim discharge forms.

Accounting process

Insurance companies follows ‘Netting of claims method’ for recording

accounting entries w.r.t claim payments.

Netting of claims method

Under this method, as soon as a claim arises, the total amount payable less all
deductions i.e. policy loan, interest on policy loan, due premiums etc. is treated
as an outstanding claim.
 212

Accounting entries in case of Netting of claims method will be as follows:

Date Particulars Amount Amount

Claims by Death / Maturity / Survival
Benefit Dr.
(Gross amount of Sum Assured, Vested
Bonus, Interim Bonus, and Terminal
Bonus)
To Premiums ( For
To Policy loans Recoveries)
To Interest on Policy loans
To Outstanding death / Maturity
Claims
(including Survival benefit) account
(Net Amount)
(To record liability on claims by netting of
claim amount).

b) Payment of claims: This will include the process followed by insurance

companies for disbursing the claim payments.

There can be following claim payments by insurance companies, which needs to

be recorded in books of accounts :

Outstanding Death claim

Accouting entry will be as follows:

Date Particulars Amount Amount

Outstanding Death Dr.
(including Survival Benefit) Paid Account
To Bank A/c.
(To record payment of net outstanding claim)
 213

Outstanding Death claim

Accounting entry will be as follows:

Date Particulars Amount Amount

Outstanding Maturity Claims Dr.
(including Survival Benefit) Paid Account
To Bank A/c.
(To record payment of net outstanding claim)

Annuity payments

Accounting entry will be as follows:

Date Particulars Amount Amount

Annuities A/c. Dr.
To Bank A/c.
(To record annuity payments)

Surrender payments

Accounting entry will be as follows:

Date Particulars Amount Amount

Surrenders A/c. Dr.
To Bank A/c.
(To record Surrender payments)

2.3 Writing back of old and outstanding claims

There can be cases, where some claim payment remain outstanding for more than
a year due to various reasons such as

 address of claimant not traceable

 discharge forms not received etc.

Such outstanding claims over five years or so are written back to revenue
account.
 214

Accounting entries for such transactions are recorded at the end of the year
as follows:

Date Particulars Amount Amount

Old Claims by Death / Maturity Outstanding and
Unclaimed Written Back Account Dr.
To Old Claims by Death / Maturity
Outstanding and Unclaimed Written Back
Account
(To record writing back of Old Outstanding
Claims).

The Claims Written Back are treated as income and shown in the revenue
account of Insurance Company. Whenever payments are made out of these
Written back amounts, such payments are made after noting down the particulars
in the record of such written back amounts.

Accounting entries for such transactions will be as follows:

Date Particulars Amount Amount

Old claims by Death / Maturity Outstanding and
Unclaimed Written Back Paid during the year
A/c. Dr.
To Bank Account
(To record payment of Written Back Death /
Maturity Claims)

A Register / Schedule is maintained giving full details of amounts written back

under “Old Claims by Death / Maturity Outstanding and Unclaimed Written
Back Account.

Whenever a claim is made either

 by the claimant (in case of Death claim) or

 policyholder (in the case of Maturity claim),

these amounts are refunded after due and proper examination and after
confirming genuineness of the party claiming the amounts and after making a
remark in the Register / Schedule.
 215

2.4 Repudiation of a death claim

When Death Claims are repudiated or rejected by insurance company, the

original debit entry passed is reversed in the following manner for the net amount

Date Particulars Amount Amount

Repudiated Claims by Death A/c. Dr.
To claims by Death A/c.
(To record claims that have been rejected by
insurance company).

Some important guidelines to remember while recording accounting entry

 The Claim Account Codes for ordinary policies are different from the
Account Codes for Pension and Group Schemes.
 While creating liability for net amount of claims payable, the heads of
Account which are credited are different from those which are debited while
making claim payment, or while taking writing back action or repudiating
claim.
 At the year end, all debit entries for liquidation of claims under both account
heads are set off against credit entries passed at the time of creating liability
and the balance amount of outstanding claims is to be arrived at.
 The balance amount of outstanding claims will be shown as liability in the
Balance Sheet, separately under Death / Maturity heads.
 For ULIP policies, there is different procedure for claim payment as
discussed later on.

are payments made to the surviving policyholders on the expiry

of the terms of the policies.

A Death claims
B Maturity claims
C Surrender value payments
D Annuity payments
 216

3. Learn about accounting process for claim payments for

ULIPs
[Learning Outcome c]
3.1 Introduction

In this session we will discuss about accounting process related to claim

payments for Unit linked policies

There can be following kinds of claim payments in ULIP

 Death claim
 Maturity claim
 Surrender value /partial withdrawal payment

Diagram 2: Types of claim payment in ULIP

The claim process for accounting purpose can be segregated in 2 steps as

discussed above:
a) Creation of liability
b) Payment of claim.

Let us discuss accounting entries for each of these claim payments in case of
ULIP in detail.
 217

3.2 Accounting entry for death claim for ULIP

Death claim payment will involve following steps

a) Creation of liability

In case of death of the policyholder when the cover is in full force, the nominee/
legal heir shall be eligible to get – ‘higher of sum assured or the fund value of
the unit held in policyholder’s unit account as at the date of booking the
liability’.

Hence there can be following 3 cases in case of death claim payment:

i) Fund value of units is higher

In this case, claim payment will be made from unit fund. When the fund value of
the unit is higher than sum assured, no liability will be payable from the Non-
Unit Fund.

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs. 10/- Face Value)
To Repurchase of unit capital premium
account
(If NAV is less than Rs.10/- Face value)
To Claim outstanding on death unit fund

ii) Sum assured value is higher than fund value of units

In this case, claim payment will be made from both unit fund and non-unit fund.
 218

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10/- Face Value)
To Repurchase of unit capital premium
account
(If NAV is less than Rs.10/-Face Value)
To Claim outstanding on death unit fund

iii) There is excess of sum assured over the fund value of units as on the date
of booking liability.
Accounting entry will be as follows:
Date Particulars Amount Amount
Claims by death Dr
Claim by accidental Death Dr.
(If Death is due to accident and policyholder
has opted for accidental cover)
To Claim outstanding on death - Non Unit
Fund
To Claim outstanding on accidental death –
Non Unit Fund

b) Payment of claim
After receipt of papers (Discharge Form + Death Certificate + Policy Documents)
etc. from nominee / legal heir, payment will be made and following entry will be
recorded.

Date Particulars Amount Amount

Claim outstanding on death paid (unit fund) Dr.
Claim outstanding on death paid –Non unit fund
Dr
Claim outstanding on accidental death paid –
Non unit fund Dr.
To Bank A/c
 219

3.3 Accounting entry for maturity claim for ULIP

Maturity claim payment involves following steps:

a) Creation of liability

Liability of benefit or claim payment on maturity in case of ULIP is created as

follows:

Date Particulars Amount Amount

Repurchase of unit capital A/c Dr.
Repurchase of unit capital premium A/c Dr.
(If NAV is more than Rs.10/- (Face Value)
ToRepurchase of unit capital premium A/c
(If NAV is less than Rs.10/- (Face Value)
To Claim outstanding on maturity – unit
Fund

It is important to note that on maturity, no claim payment will be made from non-
unit fund (Insurance Amount)

b) Payment of claim

Once, Insurance Company receives all the papers (discharge form and policy
bond) from policyholder, payment will be made to policyholder.

Accounting entry will be as follows:

Date Particulars Amount Amount

Claim outstanding on maturity paid–unitfund Dr
To Bank A/c

3.4 Accounting entry for Surrender/Partial withdrawals for ULIP

Policyholder can surrender his policy after 5years under ULIP Plans. If a
policyholder surrenders his policy, policy cannot be reinstated.
 220

a) Creation of liability

There can be following cases:

Policyholder chooses to surrender the policy after completion of 5 years.

If the policyholder chooses to surrender the policy after 5 years, then following
accounting entry will be recorded:

Date Particulars Amount Amount

Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10/- Face Value)
To Repurchase of unit capital premium
account.
(If NAV is less than Rs. 10/- FV)
To outstanding surrenders

Policyholder chooses to surrender the policy before the completion of 5

years.

If the policy holder wants to discontinue his policy before completion of 5yrs of
policy, be can discontinue his policy, but no amount be payable before
completion of 5yrs.
Also, no charges shall be recovered thereafter by canceling the policyholder’s
units. The payment will be made only after 5yrs from the date of commencement
of the policy at NAV as on the date of application of surrender.
Accounting entry will be as follows:
Date Particulars Amount Amount
Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10/- Face Value)
To Repurchase of unit capital premium
account .
(If NAV is less than Rs.10/-Face Value)
ToDiscontinued charges
To Deferred Surrender Value A/c
 221

Policyholder chooses to make partial withdrawal

Policyholder if wish can withdraw his units in parts after completion of 5yrs.
Following entry shall be passed on partial withdrawal.

Date Particulars Amount Amount

Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10/- Face Value)
To Repurchase of unit premium account
(If NAV is less than Rs.10/-FV)
To Outstanding partial withdrawals

b) Payment of surrender value

There can be following cases:

Payment of surrender value after completion of 5 years.

Accounting entry will be as follows:

Date Particulars Amount Amount

Outstanding Surrenders paid Dr.
To Bank account

Payment of surrender value before completion of 5 th policy anniversary

As discussed above, payment will be made only after completion of 5 years the
date of commencement of the policy at NAV as on the date of application of
surrender.

Accounting entry will be as follows:

Date Particulars Amount Amount

Deferred surrender value A/c paid Dr.
To Bank A/c.
 222

Payment of partial withdrawal

Accounting entry will be as follows

Date Particulars Amount Amount

Outstanding partial withdrawal paid Dr.
To Bank A/c

In which of the following cases, will the death claim payment be made from unit
fund only and non –unit fund will not be touched?

A Fund value of units is higher than sum assured

B Sum assured value is higher than fund value
C There is excess of sum assured over the fund value of units as on the date of
booking liability
D There is excess of fund value of units over

4. Learn about accounting process for unit linked health

policies
[Learning Outcome d]
4.1 Introduction

In this session we will discuss about accounting process related to claim

payments for unit linked health policies. In case of unit linked health policies,
there can be following claims payments:

 Claim payment on maturity

 Claim payment in case of death before maturity
 Claim payment in case of hospitalization.
 223

Diagram 3: Types of claim payment in unit linked health policies

Accounting entry for each type of claim payment will involve:

 Creation of liability
 Payment of claim.

4.2 Accounting entry for claim payment in case of death before

maturity:
a) Creation of liability: Since purpose of health policy is to provide health
benefit to policyholder and his family, hence no sum assured is payable to the
nominee or legal heir by insurance company.
However, fund value has been paid to nominee / legal heir by insurance company
in case of death before maturity.
Accounting entry will be as follows:
Date Particulars Amount Amount
Repurchase of unit capital for death Dr.
Repurchase of unit capital premium account for
death Dr.
(If NAV is more than Rs. 10/- Face Value)
To Repurchase of unit capital premium A/c
for death
(If NAV is less than Rs.10/- Face Value)
To Outstanding claim on death – unit fund
 224

b) Claim payment

Once insurance company receives all the relevant papers from nominee / legal
heir, it releases the claim amount (fund value).

Accounting entry will be as follows:

Date Particulars Amount Amount

Outstanding claim on death paid (unit fund) Dr.
To Bank A/c

4.3 Accounting entry for claim payment on maturity

a) Creation of liability: in case of claim payment on, liability will be booked

after cancellation of units.

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital A/c Maturity Dr.
Repurchase of unit capital premium A/c Dr.
(If NAV is more than Rs.10/- Face Value)
ToRepurchase of unit capital premium A/c
(If NAV is less than Rs.10/- Face Value)
To Outstanding claims on maturity unit fund

b) Claim payment: once insurance company receives all the relevant papers
from nominee / legal heir, it releases the claim amount.

Accounting entry will be as follows:

Date Particulars Amount Amount

Outstanding claim on maturity paid(unit fund)Dr
To Bank A/c
 225

4.4 Accounting entry for claim payment in case of hospitalisation

In case of hospitalisation, there can be following kinds of claim payments:

a) ICU Hospitalisation
b) Major Surgery benefit
c) Domiciliary Treatment benefit

a) ICU hospitalisation

Creation of liability- In case, life assured has to be hospitalized in ICU for

treatment, then benefits will be paid as per insurance value by the insurance
company.

Accounting entry will be as follows:

Date Particulars Amount

Claim by Health Insurance – Hospitalisation Benefits
for ICU Dr.
To Outstanding claim on hospitalization benefits – for
ICU

Claim payment- Accounting entry in case of ICU hospitalisation benefit and non
-ICU benefit will remain same.

Accounting entry will be as follows:

Date Particulars Amount

Outstanding claims on Hospitalisation Benefits- For other
than ICU Dr.
To Bank A/c

b) Major surgery benefit

Creation of liability: Insurance companies also provide benefit for some major
surgeries in case of Unit linked hospitalisation benefits.
 226

Accounting entry will be as follows:

Date Particulars Amount Amount

Claim by Health Insurance – Major Surgery
Benefits Dr.
To Outstanding claim on major surgical
Benefits

Claim payment

Accounting entry will be as follows:

Date Particulars Amount Amount

Outstanding claims on major surgical paid Dr.
To Bank A/c

c) Domiciliary treatment benefit

Creation of liability- Insurance companies make payment for Domiciliary

Treatment also. But this payment is made out of unit fund .

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital for DTB Dr.
Repurchase of unit capital premium A/c Dr.
(If NAV is more than Rs.10/- Face Value)
To Repurchase of unit capital premium A/c
(If NAV is less than Rs.10/- Face Value)
To Outstanding claims on Domiciliary
Treatment Benefit
 227

Claim payment

Accounting entry will be as follows:

Date Particulars Amount Amount

Outstanding claims on Domiciliary Treatment
Benefit Paid Dr.
To Bank A/c

In claim payment under hospitalisation, payment is made out

of unit fund only.

A Major surgery benefit

B ICU treatment benefit
C Domiciliary treatment benefit
D Hospitalisation benefit

5. Learn about accounting process for unit linked pension

plans
[Learning Outcome e]
5.1 Accounting process for unit linked pension plans

It is important to discuss the accounting process followed by insurance

companies in case in unit linked pension plans separately as , these policies are
totally different from other policies in terms of their feature that are offered by
insurance companies.

Claim payment process in case of unit linked pension plans is also different as
compared to other unit linked policies, due to the different features associated
with the pension plan.
 228

Main features of unit linked pension plan are as follows:

 The purpose of pension plan is to provide long term benefit (annuity) after
maturity (deferment period) of policy.
 In pension plan, insurance company does not provide a lump sum
payment to policyholder as it does in case of other policies. However, in
some cases option is given to policyholders to commute 1/3 rd of his fund at
the end of deferment period (maturity).
 It should be noted that pension plans cannot be surrendered.
 Since Pension plan is socially oriented plan, hence to protect policyholder’s
interest and corpus in case of deficiency, policyholders are paid Guaranteed
Maturity Value.

In case of annuity payments, there can be following 2 cases:

a) Policyholder’s fund value is higher than guaranteed maturity value.

b) Guaranteed maturity value exceeds policyholder’s fund

Let us discuss both these cases in detail

a) Policyholder’s fund value is higher than guaranteed maturity value.

In this policyholder can choose to opt for:

i. Full annuity payment without any commutation

Creation of liability: If policyholder opts for full annuity payment

without any commutation, then accounting entry will be as follows for
creation of liability
Date Particulars Amount Amount
Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10/- Face Value )
To Repurchase of unit capital premium
account
(If NAV is less than Rs.10/- Face Value)
To Claim outstanding on vesting – unit fund
 229

Claim payment

Accounting entry will be as follows

Date Particulars Amount Amount

Claims outstanding on vesting for Annuity – unit
fund Dr.
To Bank A/c

Payment of annuity through other life insurance companies

IRDA allows policyholders to opt for annuity from other insurance companies. In
such case the, existing insurance companies will issue cheque in the name of
other insurance company.

Accounting entry will be as follows:

Date Particulars Amount Amount

Claims outstanding on vesting for Annuity – unit
fund Dr.
To Bank A/c

If the policyholder chooses to continue with the same insurance company for
annuity, then accounting entry will be as follows:

Date Particulars Amount Amount

Insurance company – unit fund Dr.
To Life Business current A/c

Corresponding entry shall be passed in life / Annuity books by crediting Annuity

fund and debiting Unit linked Current Account.
 230

If policyholder chooses to continue with LIC for his annuity, then accounting
entry will be

Date Particulars Amount Amount

LIC – unit fund Dr.
To Life Business current A/c

ii. Commute up to maximum of 1/3rd of policyholder’s fund and balance as

annuity.

Creation of liability

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital account Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10/- Face Value
Repurchase of unit )
To Capital premium account
(If NAV is less than Rs.10/- Face Value)

Claim outstanding on vesting paid – unit

Fund Dr.
To Claim outstanding on vesting – unit fund
To Claim outstanding on vesting for
commutation
To Claim outstanding on vesting for Annuity

Claim payment

There will be 2 separate accounting entries- payment of commutation

value and payment of annuity
 231

Accounting entry for payment of commutation value will be as

follows:

Date Particulars Amount Amount

Claim outstanding on vesting for commutation
paid Dr.
To Bank A/c

Accounting entry for payment of annuity will be as follows:

Date Particulars Amount Amount

Claim outstanding on vesting for Annuity
paid Dr.
To Life Business current A/c

b) Guaranteed maturity value exceeds policyholder’s fund value.

In this policyholder can choose to opt for

iii. Full annuity payment without any commutation

Creation of liability

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10 Face Value)
Guaranteed Maturity Benefits Dr.
To Claims outstanding on vesting – unit fund
To Repurchase of unit capital premium
account
(If NAV is less than Rs.10 Face Value)
 232

Claim payment

Accounting entry will be as follows:

Date Particulars Amount Amount

Claim outstanding on vesting for annuity/unit
fund Dr.
To Bank

iv. Commute up to maximum of 1/3 rd of policyholder’s fund and balance

as annuity.

Creation of liability

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of unit capital Dr.
Repurchase of unit capital premium account Dr.
(If NAV is more than Rs.10 Face Value)
Guaranteed Maturity Benefits Dr.
To Claims outstanding on vesting – unit fund
To Repurchase of unit capital premium
account
(If NAV is less than Rs.10 Face Value)

Claim payment

In this insurance company will have to make payment for commutation and for
payment of annuity.

Accounting entry for payment of commutation will be as follows:

Date Particulars Amount Amount

Claim outstanding on vesting for commutation
paid Dr.
To Bank
 233

Accounting entry for payment of annuity will be as follows:

Date Particulars Amount Amount

Claims outstanding on vesting for Annuity paid
Unit Fund Dr.
To Life Business Current Account

5.2 Accounting entry for claim payment in case of death of life insured
before vesting

In case of death of the policyholder, the Policyholder’s Fund Value as at the date
of booking the liability shall be payable to the nominee. It is optional for the
nominee either to take the benefit
a) in lump sum
b) in form of annuity
c) Partially as lump sum and balance as annuity.

a) If Nominee opts for lump sum payment

Accounting entry will be as follows:

Date Particulars Amount Amount

Repurchase of Unit Capital account Dr.
Repurchase of Unit Capital Premium account Dr.
(If NAV is more than Rs.10/- F.V)
To Claims outstanding on death- unit Fund
To Repurchase of Unit Capital Premium
account
(If NAV is less than Rs.10/- F.V.)

b) If Nominee opts for annuity

Creation of liability
 234

Accounting entry will be as follows:

Date Particulars Amount Amount

Claims outstanding on death paid –
Unit Fund Dr.
To Claims outstanding on death for Annuity
– Unit Fund

Claim payment

Accounting entry will be as follows:

Date Particulars Amount Amount

Claims outstanding on death for Annuity paid-
Unit Fund Dr.
To Life Business current account
Corresponding entry shall be passed in Life /
Annuity books by crediting Premium and
debiting Unit linked Current account)

c) If Nominee opts for partially as lump sum and balance as annuity

Transfer of liability

In this case, liability will be created by transferring it to a lump sum amount and
annuity.

Accounting entry will be as follows:

Date Particulars Amount Amount

Claims outstanding on death paid –
Unit Fund Dr.
To Claims outstanding on death for Lump
sum
To Claims outstanding on death for Annuity
 235

Claim payment

Accounting entry for payment of lump sum will be as follows:

Date Particulars Amount Amount

Claims outstanding on death for Lump sum
paid Dr.
To Bank

Note - Readers may note that above mentioned accounting treatment has been
given for simple unit linked policies (Insurance / Pension / Health), because now
insurers are issuing these products along with riders for which there can be
different accounting treatment.

5.3 Books of accounts to be maintained for claim payments

Section 14(6) of Insurance Act states that every insurer shall maintain a register
or record of claims in which shall be entered
 every claim made together with the date of claim and name and address of
the claimant and
 the date on which the claim was discharged or
 In case of a claim which is repudiated the date of repudiation and grounds
thereof.

Performa of claims intimation registers both for maturity and death claims and
surrenders are as follows
 236

a) Intimation register – Maturity claims for the month of

Claim Policy Table Short Sum Agent PAYMENTS (DEBIT ACCOUNTS)

Intimatio Number Name of Ass- ’s Sum Antic Incre BONUS Disa Other A/c. Total
n number Term Life ured Code Assure ipated ases bility Acco Code
Date of Assured in d In VE IN Bene unts
Commen Mode ‘000 B.O. Instal Sum ST TE fit
Month cement Name Code Anticip lment Assur ED RI Insta
and year Address ated I/II/Fi ed M llme
Date of and Title install nal Rs. Rs. nts Rs. P
Maturity of ment Rs.
Claimant P
Rs. Rs.
 237

DEDUCTIONS (CREDIT ACCOUNTS) Net Amount

Payable
Loan Renewal Interest Other Account Total Credit Date Initials Date of Remark
Principal Interest Premium On Accounts Code Deductions Outstand of Payme Payme s
Account Premium ing Intim nt nt
Including Claims ation Passed Cheque
AP by by No.
Maturity Name
Rs. P. Rs. P. Rs. P. Rs. P. Rs. P. Rs. P. Account of
Bank
Rs. P.
 238

Intimation register – Death claims for the month of

Claim Polic Table B.O. (DEBIT

Intimation y Code Name ACCOUNTS)
number Num Term Date Address Sum Increase Increase BONUS Other Acco Total
ber Dev. Off. And And Assur To Sum s Head unt
Mode Code Cause Title of ed Assured To Sum VE IN of Code
Date of Date Of Claimant for Assured ST TE Accou
Intimation of Ag. Code Death Double (others) ED RI nt
Risk ME. Accident M
Code Benefit Rs. Rs.
Nam Rs. P.
e of Rs. P.
Life
Assu
red
 239

CREDIT ACCOUNTS
Reduction LOAN Other Accoun Total Net Admitt Initial Payme Cheque No. REM
in Sum Accoun t Amoun ed s of nt Date and ARKS
Assured ts Code t Rejecte Asst / passed Bank on
(State Princip Interest Payable d Sup by. which
reason in al With Per. drawn
Remarks Date
Col.) and
Ground
for
Rejecti
on

Rs. Rs. P. Rs. P. Rs. P. Rs. P.

 240

b) Register of Surrenders

MONTH……………
Sr. Policy D.O.C. Sum Table Surren Other Ac Total
No. Number Date of assured der Accou co
Initials of Lapse Term value nts un
Life Due Premium includi t
Assured month installme Mode ng Co
of first nt cash de Rs. Ps.
unpaid value
premiu Rs. P. of
m bonus

Rs.Ps.

………………….
………………….
Month…………..

DEDUCTIONS PAYMENTS
Pol Int on Due Other Acco Net Initial Initial Che
icy Pol.L Month Accou unt Amt s of of que Rem
Lo oan of int. nts Code Rs. P. Asst / Comp No. arks.
an. Install S.H. etent Dat
ment Author e
ity

Which of the following insurance policies cannot be surrendered by

policyholder?

A ULIP
B Unit linked health policies
C Unit linked pension plans
D Endowment plans
 241

Summary
 In Loan Against Policy (LAP), policyholder can apply for loan against his
insurance policy. The loan amount depends upon the surrender value of the
life insurance policy.
 When an insurance company provides loan to policyholder against his
insurance policy, policy needs to be ‘absolutely assigned’ to the insurance
company as a security for repayment of the loan.
 The total of loans disbursed and collections are posted to general ledger
control accounts.
 Policy Loan ledger sheets must be prepared for every loan and would contain
following details: the amount of loan disbursed interest due and paid and
policy loan repayments.
 Death claims are payments of the insured amount of the policies in the event
of the death of the policy holders together with bonus additions in the case of
with-profit policies
 Maturity claims are payments made to the surviving policyholders on the
expiry of the terms of the policies, together with bonus in case of with profits
policies.
 The policyholder may terminate the policy during its currency and claim cash
surrender value of the policy. These payments are known as surrenders.
 Under single premium immediate annuity, the annuity payments begin
immediately, whereas Under deferred plans the annuity payments are
deferred to future date.
 In case of death claim, as soon as insurance company recieves notice of life
death of life insured, it is customary to treat the policy amount as a claim and
enter it in the death claims intimation register
 In the case of maturity and annuity claims Insurance Company will initiate
the transaction by sending claim discharge forms.
 Outstanding claims over five years or so are written back to revenue account.
The Claims Written Back are treated as income and shown in the revenue
account of Insurance Company
 In case of death of the policyholder when the cover is in full force, the
nominee/ legal heir shall be eligible to get – ‘higher of sum assured or the
fund value of the unit held in policyholder’s unit account as at the date of
booking the liability’.
 In case of unit liked health policy no sum assured is payable to the nominee
or legal heir by insurance company. However, fund value has been paid to
nominee / legal heir by insurance company in case of death before maturity.
 The purpose of pension plan is to provide long term benefit (annuity) after
maturity (deferment period) of policy.
 242

Answers to Test Yourself

Answer to TY 1

The correct answer is B.

Total of loans disbursed and collected are posted in General ledger control
accounts by accountants in case of loans against insurance policies.

Answer to TY 2

The correct answer is B.

Maturity claims are payments made to the surviving policyholders on the expiry
of the terms of the policies.

Answer to TY 3

The correct answer is A.

If Fund value of units is higher than sum assured the death claim payment will be
made only from unit fund only and non –unit fund will not be touched

Answer to TY 4

The correct answer is C.

In domiciliary treatment benefit, claim payment under hospitalisation, is made

out of unit fund only.

Answer to TY 5

The correct answer is C.

Unit linked pension plans cannot be surrendered by policyholder.

 243

Self Examination Questions

Question 1

are shown as assets in the Balance Sheet of Insurance Company.

A Loan against policies

B Claim payments
C Premium amount
D Survival benefit

Question 2

What would happen to such claim payment that remains outstanding for more 5
years?

A Such claims are debited to outstanding maturity claims account

B Such claims are credited to bank account
C Such claims are written back to revenue accounts
D Such claims are treated as expense and written back to expense account

Question 3
In case of death claim payment, if sum assured value is higher than fund value of
units, then claim payment will be made from .
A Only unit funds
B Only non-unit funds
C Either unit funds or non-unit funds
D Both unit and non-unit funds

Question 4
Which of the following is true for Unit linked health policies?
A In case of death of life assured before maturity, no sum assured is payable to
the nominee or legal heir by insurance company.
B In case of death of life assured before maturity, sum assured is payable to the
nominee or legal heir by insurance company.
C In case of death of life assured before maturity , sum assured and fund value
is payable to the nominee or legal heir by insurance company
D In case of death of life assured before maturity, no fund value is payable to
the nominee or legal heir by insurance company
 244

Question 5
In unit linked pension plans amount of fund value can be commuted by
policyholder at maturity.
A Full lump sum amount
B ½ of his fund
C 1/3 of his fund
D No amount can be withdrawn in pension plans at maturity

Answers to Self-Examination Questions

Answer to SEQ 1
The correct option is A.
Loan against policies are shown as assets in the Balance Sheet of Insurance
Company.

Answer to SEQ 2
The correct answer is C.
Such claim payment that remain outstanding for more 5 years, are written back to
revenue accounts.

Answer to SEQ 3
The correct answer is D.
In case of death claim payment, if sum assured value is higher than fund value of
units, then claim payment will be made from both unit and non-unit funds.
Answer to SEQ 4
The correct answer is A.
For unit linked health policies, In case of death of life assured before maturity ,
no sum assured is payable to the nominee or legal heir by insurance company
Answer to SEQ 5
The correct answer is C.
In unit linked pension plans 1/3 rd amount of fund value can be commuted by
policyholder at maturity.
 245

CHAPTER 5

ACCOUNTING PROCEDURE: EXPENSES OF

MANAGEMENT

Chapter Introduction
This chapter aims to provide you with an understanding of how the accounting is
done for commission payments made and other expenses of management
incurred by a life insurance company.

a) Understand the accounting process for commission payments.

b) Understand the accounting process for other expenses of management.
 246

1. Understand the accounting process for commission

payments.
[Learning Outcome a]
1.1 Expenses of management

In any insurance company the management expenses form an important part of

the revenue account after the policy expenditure. Expenses of management
means all charges wherever incurred whether directly or indirectly and includes

a) Commission payments of all kinds

b) Other expenses of management
(Section 40-B of Insurance Act, 1938)

The following items are included under the expenses of management:

1. Commission including gratuity and term assurance to agents

2. Salaries including gratuity and corporation’s contribution to provident fund
3. Travelling expenses
4. Auditor’s remuneration
5. Fees to members of the corporation
6. Medical fees
7. Law charges
8. Advertisements
9. Printing and stationery, public relation and publicity expenses
10. Postage, telegram, M.O. charges and receipt stamps
11. Policy stamps
12. Bank charges
13. Telephone charges
14. Electricity charges
15. Tabulating machine – rental and maintenance
16. Carriage and freight etc. including packing material
17. Repairs to furniture
18. Staff medical, recreation and other expenses
19. Miscellaneous expenses
20. Rents
21. Depreciation

We shall deal with some of the important aspects of accounting of expenses of

management.
 247

Diagram 1: Expenses of management

 248

1.2 Commission

The objectives of commission accounting can be conveniently dealt with under

the following heads.

a) To calculate accurately the commission payable on the premiums received

and tabulates them agent wise and check agency license particulars before
release of commission. Commission payment is classified under
 first year commission,
 bonus commission and
 renewal commission

This classification is necessary to identify the expenses relating to first year

business and also to prepare the expense ratios.

b) To maintain accounts both for the amounts due to and recoverable from the
agents.

c) To submit returns to Income-Tax Department on tax deducted from the

commission payments and paying the deducted tax amount to Income-Tax
Authorities.

The following entries are necessary to record the various aspects of commission
transactions listed above:

1. Commission on first premium, first year’s renewal premium, renewal

premium and bonus commission

i) Commission on first premium

Wherever an agent introduces / brings a new business proposal and where the
same is accepted and preserved, first premium commission is paid to him.
This commission is paid to him as a percentage of first premium received
from the proposer / policyholder. This is called commission on first
premium

ii) Commission on first year’s renewal premium and renewal premium

Subsequently when the policyholder starts remitting the first year’s renewal
and subsequent premiums, a percentage of the first year’s renewal premium
and subsequent renewal premium is also paid to the agent known as
commission on first year’s renewal premium and renewal premium.
 249

iii) Bonus commission

The percentage of commission payable is dependent on the table and term of the
policy issued. Normally, the higher rate of percentage of commission is payable
on the premiums relating to the first policy year than those of the subsequent
years. Also the agent may be paid a percentage of first year’s commission as
bonus commission, subject to certain conditions being fulfilled by an agent.

Commission on First Premium A/c Dr.

Commission on First Year’s Renewal Premium A/c Dr.
Commission on Renewal Premium A/c Dr.
Bonus Commission to Agents A/c Dr.
To Income-Tax Deducted
To Bank
(To record first year premium commission, renewal premium
commission and bonus commission paid to agent after deduction of
income tax)

Commission on single premium and group and superannuation policy will be

debited to their respective heads and the bank account will be credited.

2. Commission paid on reinsurance accepted

Commission on Reinsurance Accepted A/c Dr.

To Income-Tax Deducted
To Bank
(To record commission paid on reinsurance premium accepted and tax
deducted)

3. Payment of tax deducted to Income-Tax Authorities

When the tax deducted at source is subsequently paid to the authorities the
Income-Tax Deducted Account will be debited and bank will be credited.

Income-Tax Deducted A/c Dr.

To Bank
(To record commission paid on reinsurance premium accepted and tax
deducted)
 250

4. Year-end outstanding commission payable

At the end of the year, the outstanding commission payable to agents will have to
be brought into account.

First Year Commission A/c Dr.

Bonus Commission A/c Dr.
Renewal Commission A/c Dr.
To First Year Commission Outstanding
To Bonus Commission Outstanding
To Renewal Commission Outstanding
(Being provision for outstanding commission)

5. Commission payable on outstanding premiums

In addition, the commission payable on outstanding premiums shall be taken into

account. There are two methods permissible under the Insurance Act to calculate
outstanding commission.

 Under the first method, various commission accounts are debited and their
outstanding amounts credited as indicated above.
 The other method is to provide the outstanding premiums only for the net
amount i.e. premium less commission.

Generally, the first method is followed.

6. Stipends paid to Career Agents

After nationalisation of life insurance industry, importance has been given to a

special category of full time agents, known as Career Agents. During the first
two years, these agents are given training and paid stipends and they are also
allowed to retain the commission due to them. The amounts of stipends paid are
debited to ‘Stipends to Career Agents’. The entry to record the transaction will
be:

Stipends to Career Agents A/c Dr.

To Bank
(To record stipends paid to Career Agents)
 251

The payment of commission is based on the provisions of the Insurance Act,

1938 as amended from time to time. In 1972 a major amendment was made to the
Act by bringing in Agents Regulations by which all agents appointed after 1 st
May 1972 are to be fully governed by these regulations. The regulation stipulates
the conditions for appointment, rates of commission, rates of bonus commission
as well as confirmation of agents.

1.3 Payment of commission at branch end

a) Independent accounting unit: Under reorganised system of working of LIC

offices, each branch office is an independent accounting unit and prepares its
own trial balance at the end of each month.

b) Calculation of commission: The entire job of payment of commission is

carried out at branch level. The commission job is mechanised as each
branch office is having in-built machine support or is provided such support
by the divisional office. The commission bills as well as cash books for
 first premium,
 bonus and
 renewal commission
are generated on the computer

c) Deductions: The deductions by way of recovery of excess commission paid,

towards advances and Income-tax etc. are also controlled on computer and
net commission payable is worked out. For this purpose, the necessary inputs
are provided to the data processing department. In some cases, even the
cheques for the net amount of commission are prepared on computer.

Special instructions register

All the branch offices are required to maintain a special instructions register to
note down important information regarding stoppage of commission due to
 death of an agent,
 prohibitory order,
 attachment of commission or
 any other reason
 252

Diagram 2: Stoppage of commission

As soon as the monthly / fortnightly commission bills, cash books and cheques
are generated by data processing department, the sales section in the branch
office has to scrutinize the bills with the entries in the cash book and has also to
tally the amount of the bill with the net amount payable as shown in the cash
book and cheques printed by the data processing department. Thereafter the
branch office is required to scrutinize the bills with the entries in the special
instructions register to ensure that before the payment is made, the necessary
action with regard to stoppage of commission, correction in the bill / cheque etc.
as noted in the register is carried out.
Control over commission payment
Since the entire job is decentralised to branch office and divisional office does
not get any return for vouching the commission payments, test checking of about
5-10% of first premium commission, renewal commission and bonus commission
bills settled by branches has to be carried out by manager (sales) or any other
official from the controlling divisional office, during Periodic Quality Control
Visits. Such sample checking is to be done with a view to ascertaining whether
there are any glaring mistakes in preparation of printed bills as well as manually
prepared bills with regard to eligibility as per agents register, rates of commission
particularly in respect of policies under excepted tables where commission rates
are far less and recoveries in respect of cheque dishonored advices, medical fees,
and other advances, have also to be checked.
 253

Gratuity and term assurance

Agents are eligible to receive gratuity depending upon the number of qualified
years and age and also to receive term assurance benefit in case the agent dies
while the agency is in force.

Incentives to Development Officers

For procuring more and more insurance business, incentives are given to
Development Officers in the form of bonus commission. These are generally
given to those Development Officers whose cost ratio does not exceed a certain
limit, say 20%. The other eligibility conditions besides cost ratio are
 improvement in quantum of business,
 conservation of first year’s premium income,
 strengthening agency organisation and
 spreading insurance cover to larger number of lives

The Development Officers will also earn increased conveyance allowance

depending upon all the above factors. There are also disincentives for those who
do not adhere to the norms stated above. These disincentives include reduction in
remuneration including termination of services due to uneconomical cost ratio.

Wherever an agent introduces / brings a new business proposal and where the
same is accepted and preserved, first premium commission is paid to him. What
will be the accounting entry passed for this transaction?

A Bank A/c will be debited and Commission on First Premium A/c will be
credited.
B Commission on First Premium A/c will be debited and Bank A/c will be
credited.
C Commission on First Premium A/c and Bank A/c will be debited.
D Commission on First Premium A/c and Bank A/c will be credited
 254

2. Understand the accounting process for expenses of

management
[Learning Outcome b]
2.1 Other Expenses of Management

Some of the important expenses of management and the method of accounting

these expenses by an insurance company are dealt with below.

1. Policy stamps

Purchase of stamps: Policy stamps affixed on policy are charged to this

account. Usually bulk purchase of policy stamps is made.

Policy Stamps A/c Dr.

To Cash / Bank
(Being the amount of policy stamps purchased)

Accounting entry for year-end stock of policy stamps

Stamps on hand (Policy stamps) A/c Dr.

To Policy Stamps
(Being the year-end stock of policy stamps)

Since all the policies pertaining to the year may not be issued during the said
year, it is necessary to provide for outstanding expenses relating to policy
stamps required to be affixed on the unissued policies, by passing following
accounting entry:

Policy Stamps A/c Dr.

To Other Outstanding Expenses
(To provide for amount of Policy Stamps required to be affixed on the
unissued policies of the year)
 255

2. Company’s contribution to Provident Fund

Some companies contribute towards Provident Fund an amount equal to

employee’s contribution. Corporation’s contribution to Provident Fund is debited
when the Provident Fund deductions of the employee are paid to concerned
authorities.

Corporation’s Contribution to Staff P.F. A/c Dr.

Provident Fund Deductions A/c Dr.
To Bank
(To record payment of Corporation’s contribution to Provident Fund
with employees deductions)

3. Printing and stationery

During the year all purchases of stationery (including data processing cards /
running stationery) are debited to this expenses account.

Printing and Stationery A/c Dr.

To Bank
(Being expenses on Printing and Stationery)

Accounting entry for year-end stock of printed forms and stationery

Stock of Printed Forms and Stationery A/c Dr.

To Printing and Stationery
(To transfer stock of printed forms and stationery at the year-end)

4. Postage, Telegram and Receipt Stamps

During the year all expenses incurred related to postage, telegram and receipt
stamps are debited to this expenses account.

Postage, Telegram and Receipt Stamps A/c Dr.

To Cash / Bank
(To record expenses on Postage, Telegram and Receipt Stamps)
 256

Accounting entry for year-end stock of postage, telegram and receipt stamps
including franking machine balances

Stamps on Hand (Postage, Receipt & Other Stamps) A/c Dr.

To Postage, Telegram and Receipt Stamps
(To record year-end balance of Stamps on hand)

5. Depreciation

As per accounting practice adopted by LIC, depreciation is provided under

“Straight Line” method on Gross Book Value of Assets. The depreciation on
furniture, office equipment and vehicles etc. is written off the asset.

Depreciation on furniture, office equipment, vehicle etc. A/c Dr.

To Appropriate Asset A/c
(Being depreciation provision made for appropriate asset)

The depreciation on house property is credited to a reserve account.

Depreciation transferred to Reserve for House Property A/c Dr.

To Reserve (Provision) for House Property A/c
(Being depreciation provision made on house property)

2.2 Expenses of management on unit linked plans

There are two types of expenses of management which are related to unit linked
plans (insurance pension and health).
1. Direct expenses
2. Indirect expenses

Diagram 3: Expenses of management on unit linked plans

 257

1. Direct expenses: These are expenses which are incurred on unit linked
business. These expenses include:

a) Commission: It is paid by insurers to agents for procurement of unit linked

business. Commission is paid on:
i) First premium
ii) Other first year premium
iii) Renewal premium
iv) Single premium

b) Incentive payment to other marketing officials: Sometimes incentive is

also paid to other marketing officials who help in procurement of business.

c) Policy Expenses: These include policy stamps on policy bond.

d) Medical expenses: These include expenditure incurred on medical tests for

proposer / policyholder who proposes to purchase unit linked policy.

e) Advertisement and publicity: These are directly related to ULIP products

where advertisements are only for ULIP products.

f) Fund management expenses (FMC): These include expenditure incurred

by insurer at the time of management of investment funds such as sale and
purchase of securities etc.

Amortisation of expenses

Direct expenses such as advertisement, promotional expenses of the policy etc.

which are of one time in nature are amortised over a number of years.
Proportionate amount is charged to the fund every year. If the units under the
policy are redeemed before the full recovery of the amortised amount, the
balance is recovered from the redemption proceeds.

2. Indirect expenses: In addition to direct expenditure, insurer has to spend

some money on insurance business as whole which cannot be allocated on
unit linked business directly. These expenses are called indirect expenses and
the expenditure is allocated among following business:

a) Conventional insurance business

b) Pension business
c) Unit linked business
 258

The expenditure is allocated as per business done in each category. Further some
expenses are allocated for unit linked business among various unit linked
products. These expenses are as follows:

 Employee remuneration and welfare benefits such as salaries, bonus, leave

encashment, corporation contribution to EPF etc.
 Rent, rate and taxes
 Repairs and maintenance
 Printing and stationary
 Legal and professional charges
 Auditor’s fees
 Communication expenses such as internet, telephone, postage etc.
 Receipt stamps
 Training expenses
 Other miscellaneous expenses

Diagram 4: ULIP indirect expenses

 259

Accounting Entry

1. Direct expenses

For direct expenses, following entry will be passed

Commission / Medical expenses / Fund management expenses / Other Dr.

direct expenses A/c
To Bank A/c
(Being direct expenses incurred)

2. Indirect expenses

For indirect expenses, following entries will be passed

At the time of allocation

Salaries / Rent / Printing / Other indirect expenses A/c Dr.

To Life Current A/c
(Being indirect expenses allocated)

At the time of payment

Life Current A/c Dr.

To Bank A/c
(Being indirect expenses paid)

The fund management expenses incurred by a life insurance company will be

classified as which of the following?

A Direct expenses on a traditional policy

B Indirect expenses on a traditional policy
C Direct expenses on a unit linked policy
D Indirect expenses on a unit linked policy
 260

Summary
 Expenses of management include commission payments of all kinds and
other expenses of management.
 Some of the expenses of management are salaries, travelling expenses,
auditor’s remuneration, medical fees, advertisements, telephone charges,
electricity charges, rent, depreciation, other miscellaneous expenses etc.
 Commission payment is classified as:
 Commission on first premium
 Commission on first year’s renewal premium
 Commission on renewal premium
 Bonus commission
 When the commission is paid to the agent, it is recorded by debiting the
respective commission account and crediting the bank account.
 Under reorganised system of working of LIC offices, each branch office is an
independent accounting unit and prepares its own trial balance at the end of
each month.
 LIC agents are eligible to receive gratuity depending upon the number of
qualified years and age and also to receive term assurance benefit in case the
agent dies while the agency is in force.
 While recording other expenses of management (policy stamp, contribution
to staff PF, printing, postage), the respective expense account is debited and
the bank account is credited.
 The expenses of management which are related to unit linked plans are
classified as direct expenses and indirect expenses.
 Direct expenses incurred on unit linked business include commission,
incentives, policy expenses, medical expenses, advertisement and publicity,
fund management expenses etc.
 Direct expenses such as advertisement, promotional expenses of the policy
etc. which are of one time in nature are amortised over a number of years.
 Indirect expenses incurred on unit linked business include employee
remuneration and welfare benefits, rent, repairs and maintenance, printing
and stationery, auditor’s fees, communication expenses, receipt stamps,
training expenses and other miscellaneous expenses.
 261

Answers to Test Yourself

Answer to TY 1

The correct answer is B.

Wherever an agent introduces / brings a new business proposal and where the
same is accepted and preserved, first premium commission is paid to him.
Following accounting entry will be passed:

Commission on First Premium A/c will be debited and Bank A/c will be credited.

Answer to TY 2

The correct answer is C.

The fund management expenses incurred by a life insurance company will be

classified as direct expenses on a unit linked policy.

Self-Examination Questions
Question 1

At the time of payment of commission to agents, TDS is deducted. When the tax
deducted at source is subsequently paid to the authorities, what is the accounting
entry that is passed?
A Income-Tax Deducted A/c will be debited and Bank A/c will be credited
B Bank A/c will be debited and Income-Tax Deducted A/c will be credited
C Income-Tax Deducted A/c and Bank A/c will be debited
D Income-Tax Deducted A/c and Bank A/c will be credited

Question 2
of the Insurance Act, 1938 specifies limitations on expenses of
management in life insurance business.
A Section 40A
B Section 40B
C Section 40C
D Section 40D
 262

Question 3

As per accounting practice adopted by LIC which of the below is true with
regards to depreciation?

A Depreciation is provided under “Reducing Balance” method on Gross Book

Value of Assets
B Depreciation is provided under “Reducing Balance” method on Net Book
Value of Assets
C Depreciation is provided under “Straight Line” method on Gross Book Value
of Assets.
D Depreciation is provided under “Straight Line” method on Net Book Value
of Assets

Question 4

Direct expenses such as advertisement, promotional expenses of the policy etc.

which are of one time in nature are?

A Adjusted in the 1st year itself

B Amortised over the first 3 years of the policy
C Adjusted at the time of maturity or death claim
D Amortised over a number of years

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is A.

When the tax deducted at source is subsequently paid to the authorities, the
Income-Tax Deducted Account will be debited and Bank A/c will be credited.

Answer to SEQ 2

The correct answer is B.

Section 40B of the Insurance Act, 1938 specifies limitations on expenses of

management in life insurance business.
 263

Answer to SEQ 3

The correct answer is C.

As per accounting practice adopted by LIC, depreciation is provided under

“Straight Line” method on Gross Book Value of Assets.

Answer to SEQ 4

The correct answer is D.

Direct expenses such as advertisement which are of one time in nature are
amortised over a number of years.
 264

CHAPTER 6

INVESTMENTS

Chapter Introduction
This chapter aims to provide you with an understanding of the regulations issued
by IRDA for life insurance companies for the investment of premium collect by
them. The chapter also explains the regulator’s guidelines regarding asset
classification, non-performing assets, provisioning of loss on account of loans
and income recognition

a) Learn about investment regulations issued by IRDA

b) Learn about guidelines pertaining to asset classification, non-performing
assets, provisioning and income recognition.
 265

1. Learn about investment regulations issued by IRDA

[Learning Outcome a]
1.1 Need for investment guidelines

Every life insurance company has to invest its surplus in the manner as approved
by competent authorities (IRDA) so that they can
 earn interest and profit on their investment to enable them to give returns in
the form of bonus to those policyholders who are participating in profit
 cover shortfall arising due to death claims and
 cover expenditure of its operations

Diagram 1: Investment of surplus

Most of the life insurance companies including Life Insurance Corporation (LIC)
of India are having centralised investment department (sometimes called treasury
also) to look after investment of funds, monitoring and accounting.
After coming into existence, Insurance Regulatory and Development Authority
(IRDA) have issued regulations to control investment of insurance companies.
IRDA does not want that life insurance companies recklessly invest hard earned
money of policyholders who have placed their trust in the insurance companies.
At the same time insurance companies should be able to earn adequate return for
policyholders to fulfill their aspirations.
IRDA issued regulations for investment for the first time in 2000 which is called
as Insurance Regulatory and Development Authority (Investment) Regulations
2000. After that IRDA has made several amendments and latest amendments
have been made in 2008 which is called Insurance Regulatory and Development
Authority (Investment) (fourth Amendment) Regulations 2008.
 266

1.2 What shall constitute an investment asset?

IRDA has defined investment assets vide regulation 2ba. Investment assets mean
all investments made out of

a) Shareholder funds representing solvency margin, non-unit reserves of unit

linked business, participating and non-participating funds of policyholders
b) Policyholders funds of pension and general annuity fund at carrying value
and
c) Policyholders unit reserves of unit linked business at their market value

1.3 Regulation 3 of the Insurance Regulatory and Development

Authority (Investment) Regulations 2000

Controlled Fund: As per the explanation for Section 27A of Insurance Act,
Authority has determined that assets relating to
 pension business,
 annuity business and
 all categories of unit linked business
shall not form part of controlled fund for the purpose of that section

Explanation: In this section, ‘controlled fund’ means all the funds of the insurer
appertaining to its life insurance business, capital redemption insurance business
and annuity certain business, but does not include any fund or portion thereof in
respect of which the Controller is satisfied that such fund or portion thereof, as
the case may be, is regulated by the law of any county outside India or in respect
of which the Controller is satisfied that it would not be in the interest of the
insurer to apply the provisions of this Section.

1.4 Approved securities

Approved securities

a) Government securities and other securities charged on the revenues of the

Central Government or Government of a State or guaranteed fully as regards
principal and interest by Central Government or Government of any State;

b) Debentures or other securities for money issued under the authority of any
Central Act or Act of a State Legislature by or on behalf of a Port Trust or
Municipal Corporation or City Improvement Trust in any Presidency town;
 267

c) Shares of a Corporation established by law and guaranteed fully by the

Central Government or the Government of a State as to the repayment of the
principal and the payment of the dividend;

d) Securities issued or guaranteed fully as regards principal and interest by the

Government of any Part B State and specified as approved securities for the
purposes of this Act by the Central Government by the notification in the
official gazette; and

e) Subject to the limitations contained in the provision hereto, securities

guaranteed fully as regards principal and interest by a provisional
Government in Pakistan of charged on the revenue of any part of that
Dominion and debentures or other securities for money issued by or on
behalf of the trustees of the Port of Karachi; provided that securities or
debentures specified in item (v) shall be recognised as approved securities
only for such purpose and such period and subject to such conditions as may
be prescribed.

1.5 Rule 10-B: Assets deemed to be approved investments

Rule 10-B states assets deemed to be approved investments. For the purpose of
Sub-section (1) of Section 27 of the Act, the following assets shall be deemed to
be assets invested or kept invested in approved investments specified in Sub-
section (1) of Section 27-A of the Act:

a) Interest, dividend and rents (outstanding and accrued),

b) Cash in hand and with banks (other than banks in liquidation) in current and
collection accounts;
c) Bills receivable;
d) Value of furniture, fittings, machinery, stationery and library but not
exceeding Rs. 10,000 or one percent of the sum referred to in Sub-section (1)
of Section 27 of the Act, whichever is greater;
e) Value of motor cars but not exceeding Rs. 20,000 or one-half percent of the
sum referred to in Sub-section (1) of Section 27 of the Act, whichever is
greater;
f) Stamps on hand;
g) Amount of Income-tax directed by the Income-tax authority to be refunded;
h) Temporary advances granted to chief, special and insurance agents to the
extent permitted under clause (b) of Sub-section (3) of Section 27 of the Act.
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1.6 Guidelines for investment of funds

The IRDA (Investment) Regulations were issued for the first time in 2000. In
2008 IRDA made some amendments and released the Insurance Regulatory and
Development Authority (Investment) (Fourth Amendment) Regulations, 2008.

1. Life insurance business

Every insurer carrying on the business of life insurance shall invest and all times
keep invested his investment assets other than funds relating to pension and
general annuity business and all categories of unit linked business in following
manner.

No Type of Investment Percentage

Not less than 25% of
i) Government securities
the fund
Government securities or other approved Not less than 50% of
ii)
securities (including (i) above) the fund
Investment as specified in Section 27A of
Insurance Act, 1938 and Schedule I of these
Regulations, subject to Exposure / Prudential
Norms specified in Regulation 5:

a) Approved investments and other

investments (Out of ‘(iii)a’ ‘other Not exceeding
investment’ specified under 27A (2) of the 35% of the fund
Act, shall not exceed 15% of the fund)

b) Investment in housing and infrastructure by

way of subscription or purchase of:
iii)
1. Bonds / debentures of HUDCO and
National Housing Bank
2. Bonds / debentures of housing finance
companies (HFCs) either duly accredited by Not less than 15% of
National Housing Bank, for house building the fund [(iii) b and c
activities, or duly guaranteed by taken together]
Government or carrying current rating of
not less than ‘AA’ by a credit rating agency
registered under SEBI (Credit Rating
Agencies) Regulations, 1999
3. Asset backed securities with underlying
housing loans, satisfying the norms
 269

specified in the guidelines issued under

these regulations.

c) Investment in infrastructure:
(Explanation: Subscription or purchase of bonds
/ debentures, equity and asset backed securities
with underlying infrastructure assets would
qualify for the purpose of this requirement.
‘Infrastructure facility’ shall have the meaning
as given in clause (h) of Regulation 2 of
Insurance Regulatory and Development
Authority (Registration of Indian Insurance
Companies) Amendment Regulations, 2008)
Here infrastructure facility means
1. A road highway, bridge, airport, port,
railway unloading BOLT, road transport
system, water supply project, irrigation
project, industrial parks, water treatment
system, solid waste management system,
sanitation system
2. Generation or distribution or transmission of
power
3. Telecommunication
4. Project for housing
5. Any other public facility which may be
notified by IRDA

2. Pension and general annuity business

Every insurer shall invest and at all times keep invested funds belonging to
pension and general annuity business in the following manner

No. Type of investment Percentage

i) Government securities Not less than 20% of the fund
Government securities or other Not less than 40% of the fund
ii)
approved securities (including (i)) above
Balance has to be invested in approved
investments as specified in Schedule I Not exceeding 60% of the
iii)
subject to exposure / prudential norms fund
specified in Regulation 5
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Note: For the purposes of this sub-regulation no investment which falls under
‘Other Investments’ as specified under Section 27A (2) of Insurance Act 1938
shall be made. However, funds pertaining to Group Insurance Business, except
One Year Renewable Pure Group Term Assurance Business (OYRGTA) shall
form part of Pension and General Annuity Fund. OYRGTA funds shall follow
the pattern of investment of life insurance business.
3. Investment pattern for Unit Linked Insurance Business
Unit Linked Insurance Plan (ULIP) is a unique product which gained popularity
during last one decade after constitution of IRDA. In these kinds of policies,
policyholder seeks to get profit / gain from policy according to their risk appetite
along with life insurance benefit. Generally, insurers give several fund options in
one plan to policyholders to maximise their return. Popular fund options are as
follows:
Balanced Money
Equity Fund Debt Fund
Fund Market Fund
This fund This fund invests major This fund This fund
invests major portion of the money in invests in a invests money
portion of the Government securities mix of equity mainly in
money in (e.g. Government Bonds), and debt instruments
equity and Corporate Bonds, Fixed instruments. such as
equity related Deposits etc. In these The Treasury Bills,
instruments. funds, it is expected that proportion of Certificates of
the income, being interest equity and Deposit,
on securities and bonds, debt Commercial
will be steady and almost component Paper etc.
guaranteed, but there may may vary from
not be much capital fund to fund
appreciation.
This fund is This fund is for those This fund is This fund is for
for those investors who don’t want for those those investors
investors who to take high risk and are investors who who want to
are willing to satisfied with lesser but are willing to preserve their
take high risk guaranteed returns. take moderate capital and are
and are risk and are satisfied with
looking for looking for lesser returns.
high returns. moderate
returns.
Sometimes Sometimes also called as Sometimes also
also called as bond funds called as liquid
growth funds funds.
 271

As per IRDA regulations, every insurer shall invest and at all times keep invested
his segregated fund of unit linked business as per pattern of investment offered to
and approved by policyholders where the units are linked to categories of assets
which are both marketable and easily realisable. However, the total investment in
Other Investments as specified under Section 27A (2) of Insurance Act, 1938
category shall at no time exceed 25% of such fund(s).

Exposure / prudential norms

As stated earlier, every policyholder put his hard earned money in insurance to
secure his future and to gain from his investment. At the same time, it is the
endeavour of every insurance company to maximise return for its policyholders
so that they may be able to keep premium at lower side and at the same time, stay
competitive.

However, sometimes to give higher returns, insurance companies may get

tempted to invest in those companies where risk is very high and chances of
failure are more.

After liberalisation, the insurance business has been opened up to private

companies. Lot of the insurance companies have been promoted by existing
companies / banks such as HDFC, ICICI Bank, Bank of Baroda, Canara Bank,
Bajaj Group, Kotak Group, SBI, Tata Group etc.

There are chances that these insurance companies may also invest in group
companies. For example HDFC Life in HDFC or HDFC Bank, ICICI Prudential
in ICICI Bank or Reliance Life in Reliance group companies.

To keep exposure in group companies within limit, IRDA has set exposure /
prudential norms for life (unit linked business) business for both:

a) approved investment as per Insurance Act, 1938; Schedule I of these

regulation and

b) other investments as permitted under 27A (2) and 27B (3) of the Insurance
Act, 1938
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As per the explanation for Section 27A of Insurance Act, Authority has
determined that assets relating to shall not form part of controlled
fund.

A Pension business
B Annuity business
C All categories of unit linked business
D All of the above

2. Learn about guidelines pertaining to asset classification,

non-performing assets, provisioning and income
recognition
[Learning Outcome b]
We are aware that every investment, be it in

 real estate,
 debt market,
 equity market or
 loan to companies
carries some kind of diminution risk. However the degree of risk may be varying.
In case of debt, risk is less than risk in case of equities.

Insurance regulator IRDA has issued guidelines regarding asset classification,

non-performing assets, provisioning of loss on account of loans and income
recognition.

2.1 Classification of assets

IRDA has mandated insurers to classify their loan / advances into four categories
for the determination of minimum provisions of loss on account of loans and
advances.
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Diagram 2: Classification of assets

Classification of assets into these categories shall be done taking into account the
ability of the borrower to repay and the extent of value and realisability of
security. Provisioning is done as per classification of assets as follows.

i. Standard assets

Standard asset is one which does not disclose any problem and which does not
carry more than normal risk attached to the business. Such types of assets are not
considered as non-performing assets.

ii. Sub-standard assets

Sub-standard asset is one which has been classified as non-performing asset

(NPA) for a period not exceeding 12 months

An asset which has been treated as a NPA on 1 st April 2011 would be treated as a
sub-standard asset only up to 31st March 2012.
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iii. Doubtful assets

A doubtful asset is one which has remained as NPA for a period exceeding 12
months.

A loan facility to a borrower which is treated as NPA on 1st April 2010 would be
treated as doubtful from 1 st April 2011.

iv. Loss assets

A loss asset is one where loss has been identified by the insurer or its internal or
statutory auditors or by IRDA but the amount has not been written off wholly. In
other words, such an asset is considered un-collectible and as such its
continuance as a bankable asset is not warranted although there may be some
salvage or recovery value.

2.2 Non–performing asset (NPA)

An asset is classified as an NPA if the interest and / or installment and / or

installment of principal remain overdue for more than 90 days (i.e. one quarter)

2.3 Provisioning for loans and advances

i. Standard assets

As a prudent policy, IRDA has asked insurers to make general provision on

standard assets of a minimum of 0.40 percent of the value of the asset.

ii. Sub-standard assets

A general provision of 10% of total value outstanding remaining sub-standard is

required to be made.

iii. Doubtful assets

 100% provision of the extent to which asset is not covered by the realisable
value of the security to which insurer has a valid recourse and the realisable
value is estimated on realistic basis.
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 Over and above the first point, depending upon the period for which asset has
remained doubtful, 20% to 100% provision of the secured portion (i.e.
estimated realisable value of the outstanding) should be made on following
basis:

Period for which the asset has been % of provision as doubtful

considered
Up to one year 20%
One to three years 30%
More than three years 100%

iv. Loss assets

The entire asset should be written off. If the assets are to remain in the books due
to any reason, 100% of the outstanding should be provided.

2.4 Income recognition

Income in respect of any asset classified as NPA shall not be recognised unless
realised. However, any adjustment towards overdue interest against any
fresh/additional loan shall not be considered as realised.

2.5 Functioning of the investment committee

a) Constitution of investment committee
To keep check over investment activities of insurance companies on whether
they are investing as per regulation or not, IRDA has mandated certain steps. One
of the steps is constitution of an investment committee by every insurance
company.
Main function of the investment committee is to take decision regarding
investment keeping in view the exposure norms / prudential norms and
investment criteria laid down by IRDA. The investment committee decisions
shall be recorded and be open for inspection by officers of the Authority.
b) Composition of the investment committee
Members of investment committee should consist of
 Minimum two Non-executive Directors of the insurer,
 Chief Executive Officer,
 Chief of Investment Division and
 Appointed Actuary (if employed)
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Diagram 3: Composition of investment committee

2.6 Investment policy

To document the basis of investment decision and to bring about uniformity and
transparency of investment decision every insurer shall draw up annually an
investment policy (fund wise in case of unit linked insurance business) and place
the same before its Board of Directors for its approval.

a) Investment policy compliance

While framing such policy, the Board shall ensure compliance with the
following:

 Issues relating to liquidity, prudential norms, exposure limits, stop loss limits
including securities trading, management of all investment risks,
management of assets liabilities, scope of internal or concurrent audit of
investments and investment statistics and all other internal controls of
investment operations, the provisions of the Insurance Act, 1938 and
Insurance Regulatory and Development Authority (Investment) Regulations,
2000, guidelines and circulars made thereunder.

 Ensuring adequate return of policyholders and shareholder funds consistent

with the protection, safety and liquidity of such fund(s).
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 The funds of the insurer shall be invested and continued to be invested in

equity shares, equity related investments and debt investments rated by a
credit rating agency registered under SEBI (Credit Rating Agencies)
Regulations, 1999. The Board shall lay down clear norms for investing in
‘Other Investments’ as specified under Section 27A(2) and 27B(3) of the
Insurance Act, 1938 by the investment committee, taking into account the
safety and liquidity of the policyholders’ funds and protection of their
interest.

b) Investment policy implementation

The investment policy as approved by the Board shall be implemented by

investment committee. The committee shall keep the Board informed on
quarterly basis about its activities and fund(s) performance.

c) Investment policy review

The Board shall review the investment policy and its implementation on a half-
yearly basis or at such short intervals as it may decide and make such
modification to the investment policy as is necessary to bring it in line with the
investment provisions laid down in the Act and Regulations made there under,
keeping in mind protection of policyholders’ interest and pattern of investment
laid down in these Regulations or in terms of the agreement entered into with the
policyholders in the case of unit linked insurance business.

d) Investment policy audit

The details of the investment policy or its review as periodically decided by the
Board shall be made available to the internal or concurrent Auditor. The auditor
shall comment on such review and its impact on the investment operations,
systems and processes in their report to be placed before the Board Audit
Committee.

e) Segregation of investment function and operations

IRDA has mandated that the insurer shall clearly segregate the functions and
operations of front, mid and back office. This shall ensure proper internal control
of investment functions and operations.

 Front Office: This is called operation department, where all kind of

investment decisions are taken keeping in mind IRDA regulation and advice
from mid office.
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 Mid Office: Here, risk assessment of investment decisions is done. Mid

office informs front office about risk associated with the investment decision.
Lot of research is also done here.

 Back Office: Here accounts of investment are kept in addition to regular

accounts. Compliance part is also looked after by back office. Back office
will arrange appointment of concurrent auditor who will be practicing firm of
Chartered Accountants. Concurrent auditors shall comment on the review of
investment policy and its impact on the investment operations, systems and
process in their report to be placed before the audit committee.

2.7 Accounting for investments

The accounting for investments includes purchase and sale of investments,

collection of interest, dividends, rent etc.

The cost and sale price of the investment is net i.e., after adjustment for
commission and brokerage.

The insurers act as underwriters and brokers and therefore, they are entitled to
underwriting commission and brokerage on new issues underwritten. The
insurers underwrite and subscribe to the shares for themselves, subject to
allotment, whereas other underwriters do not necessarily subscribe but take over
only the balance of shares which are not subscribed by the public. The
underwriting commission and brokerage received is reduced from the purchase
price and the net amount is taken as the book value.

The following are the entries recorded when loans are advanced, investments
purchased and house property purchased etc.

a) When loan is advanced

Loan A/c Dr.

To Bank A/c
(Being loan advanced)
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b) When securities are purchased

Securities A/c Dr.

To Bank A/c
(Being securities (shares, debentures, bonds etc.) purchased)

c) When house property is purchased

House property A/c Dr.

To Bank A/c
(Being house property purchased)

d) Income from investment may be collected, earned, accrued or outstanding.

When rent, interest or dividends etc. are realised the following journal entries
are recorded

Bank A/c Dr.

Tax Deducted at Source (TDS) A/c
To Rent / Interest / Dividend A/c
(Being rent / interest / dividend realised)

As per IRDA guidelines for provisioning for loans for sub-standard assets a
general provision of of total value outstanding remaining sub-standard
is required to be made.

A 5%
B 10%
C 25%
D 40%
E 50%
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Summary
 Life insurance companies invest surplus premium to earn interest and profit,
cover shortfall arising due to death claims and cover expenditure of its
operations.
 The IRDA issued called Insurance Regulatory and Development Authority
(Investment) (fourth Amendment) Regulations in 2008.
 Investment assets mean all investments made out of
 Shareholder funds, non-unit reserves of unit linked business,
participating and non-participating funds of policyholders
 Policyholders funds of pension and general annuity fund at carrying
value and
 Policyholders unit reserves of unit linked business at their market value
 Every life insurer shall invest not less than 25% of its surplus / investible
sum in Government securities
 Every life insurer shall invest not less than 50% of its surplus / investible
sum in Government securities or other approved securities (including above
25%).
 Every life insurer shall invest not exceeding 35% of its surplus / investible
sum in specified approved investments and other investments.
 Every life insurer shall invest not exceeding 15% of its surplus / investible
sum in housing and infrastructure.
 Every insurer shall invest and at all times keep invested not less than 20%
funds belonging to pension and general annuity business in Government
securities.
 Every insurer shall invest and at all times keep invested not less than 40%
funds belonging to pension and general annuity business in Government
securities and other approved securities (including above 20%).
 Every insurer shall invest and at all times keep invested not exceeding 60%
funds belonging to pension and general annuity business in specified
approved securities.
 As per IRDA regulations, every insurer shall invest and at all times keep
invested his segregated fund of unit linked business as per pattern of
investment offered to and approved by policyholders where the units are
linked to categories of assets which are both marketable and easily realisable.
 IRDA has mandated insurers to classify their loan / advances into four
categories: standard assets, sub-standard assets, doubtful assets and loss
assets.
 An asset is classified as an NPA if the interest and / or installment and / or
installment of principal remain overdue for more than 90 days (i.e. one
quarter).
 281

 Main function of the investment committee is to take decision regarding

investment keeping in view the exposure norms / prudential norms and
investment criteria laid down by IRDA.
 To document the basis of investment decision and to bring about uniformity
and transparency of investment decision every insurer shall draw up annually
an investment policy.
 IRDA has mandated that the insurer shall clearly segregate the functions and
operations of front, mid and back office.

Answers to Test Yourself

Answer to TY 1

The correct answer is D.

As per the explanation for Section 27A of Insurance Act, Authority has
determined that assets relating to pension business, annuity business and all
categories of unit linked business shall not form part of controlled fund.

Answer to TY 2

The correct answer is B.

As per IRDA guidelines for provisioning for loans for sub-standard assets a
general provision of 10% of total value outstanding remaining sub-standard is
required to be made.

Self-Examination Questions
Question 1

As per IRDA investment guidelines insurers are required to invest not less than
of their investible funds in housing and infrastructure.

A 5%
B 10%
C 12.5%
D 15%
 282

Question 2

Every insurer shall invest and at all times keep invested not less than of the
investible funds belonging to pension and general annuity business in
Government Securities.

A 5%
B 10%
C 15%
D 20%

Question 3

In a ULIP a growth fund invests majority of it funds in

A Equities
B Government Securities
C Commercial Paper
D Mix of equities and debt

Question 4

Sub-standard asset is one which has been classified as non-performing asset

(NPA) for a period not exceeding .

A 6 months
B 12 months
C 18 months
D 24 months

Question 5

As per IRDA Regulations, the investment committee of an insurer should consist

of a minimum of Non-executive Directors.

A Four
B Three
C Two
D One
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Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is D.

As per IRDA investment guidelines insurers are required to invest not less than
15% of their investible funds in housing and infrastructure.

Answer to SEQ 2

The correct answer is D.

Every insurer shall invest and at all times keep invested not less than 20% of the
investible funds belonging to pension and general annuity business in
Government Securities.

Answer to SEQ 3

The correct answer is A.

In a ULIP a growth fund invests majority of it funds in equities.

Answer to SEQ 4

The correct answer is B.

Sub-standard asset is one which has been classified as non-performing asset

(NPA) for a period not exceeding 12 months.

Answer to SEQ 5

The correct answer is C.

As per IRDA Regulations, the investment committee of an insurer should consist

of a minimum of two Non-executive Directors.
 284

CHAPTER 7

FINAL ACCOUNTS, REVENUE ACCOUNT AND

BALANCE SHEET

Chapter Introduction
Every insurance company has to prepare their final accounts as per the IRDA
(Preparation of Financial Statement and Auditor’s Report of Insurance
Companies) Regulation 2002. IRDA has mandated that an insurer carrying on
life insurance business after the commencement of this regulation shall comply
with the requirement of Schedule A. In this chapter, we will be learning various
parts of Schedule A and its applicability in accounting for life insurance
companies.

a) Discuss the accounting principles for preparation of financial statements.

b) Explain the various disclosure requirements which form a part of the
financial statements.
c) List out the general instructions for preparation of financial statements.
d) Understanding the meaning of the term ‘management report’ and list out
its contents.
e) Explain the method of preparation of financial statements.
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1. Discuss the accounting principles for preparation of

financial statements.
[Learning Outcome a]
1.1 Accounts for life insurance companies —An Introduction

Post 2002, the financial statements and audit reports of insurance companies are
to be prepared strictly as per the IRDA (Preparation of financial statements and
auditor’s report of Insurance Companies) Regulations, 2002. Following are the
relevant provisions of the said schedule:

 an insurer carrying on life insurance business shall comply with the

provisions of Schedule ‘A’ to prepare its financial statements.

 an insurer carrying on general insurance business shall comply with the

provisions of Schedule ‘B’ to prepare its financial statements.

Every life insurance company has to prepare the following accounts:

1. Revenue Account (Policyholders - technical account) as per Form A-RA.

2. Profit and Loss Account (Shareholder’s account-non technical) account as
per Form A-PL.
3. Balance sheet as per Form A-BS.
4. Receipt and payment A/c (cash flow statement).

As per the IRDA regulations, separate financial statements i.e. Revenue account
and Balance Sheet are required to be prepared for participating and non-
participating policies and linked and non-linked business. Furthermore, for non-
linked business, separate statements are required for ordinary life, general
annuity, pension and health insurance.

It is to be noted that Schedule A consists of 5 parts, each expressed in a roman

number. These five parts state and explain various regulations that are required to
be followed while preparing the financial statements of life insurance companies.

We will now see each such part in detail.

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1.2 PART – I of IRDA (Preparation of financial statements and

auditor’s report of insurance companies) Regulations, 2002

Accounting principles for preparation of financial statements

Accounting principles are the fundamental rules of accounting to be followed for

smoothly facilitating the preparation, presentation and disclosure of financial
statements. Insurance, being a sensitive area, requires some special principles to
be followed when it comes to accounting. Following are some of the principles
that have been included in Part I:-

Diagram 1: Part I – Accounting principles for preparation of financial

statements

a) Applicability of Accounting Standards

Every life insurance company shall have to follow the accounting standards
issued by the ICAI while preparing its financial statements, except that:

 Cash Flow Statement: AS 3 (Receipt and Payment account) needs to be

prepared under Direct Method.

 Segment Reporting: (AS-17) shall apply to all insurers irrespective of

listing and turnover requirement mentioned in AS-17.
 287

b) Premiums

Premium shall be recognised as income when due for linked business, the due
date for payment may be taken as the date when associated units are created.

c) Acquisition costs

Acquisition costs are those that vary with and mainly related to the acquisition of
new and renewal insurance costs. Examples of these costs are commission to
agents, policy stamps etc. Acquisition cost shall be expensed in the period in
which they are incurred.

XYZ Ltd., an insurance company, pays Rs.10 crores to its authorized agents and
Rs.5 crores for policy stamps. Both these expenses form the acquisition costs for
XYZ Ltd.

d) Claim costs
Cost of claim shall comprise the policy benefit amount. These include maturity
claims, death claims, surrender, annuity etc. and specific settlement costs such as
claim investigation expenses panel interest etc.
e) Actuarial valuation liability for life policies
 It is to be remembered that any premium received by an insurer is not its
income as such. Rather, the company is creating liabilities against policies.
 The estimation of liability against life policies shall be determined by
Appointed Actuary (Chief Actuary) of the insurer. This exercise is done
every year.
 Surplus valuation is also declared on the basis of Actuarial Valuation.
 Actuarial assumptions are to be disclosed by way of notes to the accounts.
 The liability is calculated in such a manner that, together with future
premium payments and investment income, the insurer can meet all future
claims (including bonus entitlements to policyholders) and expenses.

Actuary is a professional who uses specialised mathematical knowledge for the

purpose of valuation of insurance policies. Remember that premiums received by
an insurer form the part of its future liability as well. Valuing that liability today
is the job of an actuary.
 288

f) Valuation of investments
Following are the different classes of investments for which a life insurance
company has to undergo a valuation exercise in every period.
Diagram 2: Valuation of investments

i) Real Estate-Investment Property

These include assets like land, building and other fixed assets qualifying to be a
property for investment from the perspective of an insurer. Following are the
steps in the valuation exercise of real estate assets:
 The value of investment property shall be determined at historical cost,
subject to revaluation at least once in every three years. The change in the
carrying amount of investment property shall be taken to Revaluation
Reserve. Gains/ Losses arising due to change in the carrying amount of real
estate shall be taken to equity under ‘Revaluation Reserve’.
 The profit on sale of investment or loss on sale of investment as the case may
be shall include accumulated changes in the carrying amount previously
recognized in equity under the heading ‘Revaluation Reserve’ in respect
of a particular property and being recycled to the relevant Revenue Account
or Profit and Loss account on sale of that property.
 The basis for revaluation shall be disclosed in the notes to accounts.
 No bonus can be distributed to policyholders out of Revaluation Reserve
without direction from IRDA.
 289

An impairment loss shall be recognized as expenses in the Revenue / Profit &

Loss Account immediately unless the asset is carried at the revalued amount.
Any impairment loss of a revalued asset shall be treated as ‘revaluation decrease’
of that asset and if the impairment loss exceeds the corresponding revaluation
reserve, such excess shall be recognized as expense in the revenue/profit and loss
account.

ii) Debt Securities

Debt securities including government securities and redeemable preference

shares shall be considered as held to maturity securities and shall be measured at
historical cost subject to amortisation.

iii) Equity Securities and Derivation Instruments that are traded in active
markets

Equity shares or other derivative instruments (financial instruments which derive

its value from the changes in the value of an underlying asset) may either be
listed or actively traded on the stock exchange or they may be unlisted.
Following are the valuation steps for equity and derivative instruments which are
listed and actively traded.

 Listed equity securities and derivative instruments that are traded in active
markets shall be measured at fair value on the balance sheet date. For the
purpose of calculation of fair value, the lowest of the last quoted closing
price at the stock exchange where the securities are listed shall be taken. The
insurer must also assess on each balance sheet date, whether or not there is
any impairment in the value of the listed securities.

 Unrealized gains/losses arising due to change in the value of listed equity

shares and derivative instruments shall be taken to equity under the head
‘Fair Value Change Accounts’.

 The profit/loss on sale of investments shall include accumulated changes in

the fair value previously recognized in equity under the heading ‘Fair Value
Change Accounts’ in respect of a particular security and being recycled to
the Relevant Revenue Account or Profit & Loss Account on actual sale of
that listed security.
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 The insurer shall assess on each balance sheet date whether any
impairment occurred. An impairment loss shall be recognized as an
expense in Revenue/ Profit & Loss Account to the extent of the difference
between the re-measured fair value of the security / investment and its
acquisition on cost as reduced by any previous impairment loss recognized as
expense in Revenue/ Profit & Loss Account.

 Any reversal of impairment loss earlier recognized in Revenue/ Profit & Loss
Account shall be recognized in Revenue/ Profit & Loss Account.

iv) Unlisted and other than actively / traded equity securities and derivative
instruments

 Unlisted equity securities and derivatives & listed equity securities &
derivatives which are not activity traded shall be measured at historical cost.

 However, if there is any diminution in the value of such instrument, proper

provision should be made in each case.

 The provision so made shall be reversed in the subsequent periods, if

estimates based on external evidence show an increase in the value of the
investment over its carrying amount.

 The increased carrying amount of the investment due to reversal of the

provision shall not exceed the historical cost.

Comparative analysis between valuation of listed securities and unlisted

securities

Particulars Listed securities Unlisted securities

Valuation At fair value At historical cost
Shown in a special account
Unrealised
titled “Fair value changes No such question arises
gains/losses
account” under the equity
In case of diminution in
Assessment is made at each
Provisioning/Impai the value of
balance sheet date for
rment investments, proper
impairment losses.
provisioning is made.
 291

X Ltd, an insurance company, purchased 1000 equity shares of ABC Ltd on 1 Jan
2011 for Rs.450,000. The value of the investments would be recorded at Rs.
450,000.

i) On 31 March 2011, the lowest quoted closing price on the exchange was Rs.
500.

Since the shares are listed and the lowest quoted closing price is available, that
price itself will be the fair value. The value of such shares on the date of balance
sheet will be 1,000 shares x Rs. 500 per share = Rs. 5,00,000.

The increase in the value of the shares due to fair value increase is Rs.50,000.
This will involve a creation of Fair Value Change Account. The unrealized gain
arising due to change in the value of listed equity shares shall be taken to equity
under the head ‘Fair Value Change Accounts’.

The journal entry would be:

Investment Account Dr. Rs.50,000

To Fair Value Change Account Rs.50,000
(Being revaluation of investments on reporting date)

ii) On 8th April 2011 the shares were sold for Rs. 522,000

The profit/loss on sale of investments shall include accumulated changes in the

fair value previously recognised in equity under the heading ‘Fair Value Change
Accounts’ in respect of a particular security and being recycled to the relevant
Revenue Account or Profit & Loss Account on actual sale of that listed security.

The journal entry would be:

Cash account Dr. Rs.522,000

Fair Value Change Account Dr. Rs.50,000
To Investment Rs.500,000
To Profit on sale of shares Rs.72,000
(Being entry to record sale of investments)
 292

g) Loans

Loans shall be measured at historical cost subject to impairment provision.

Proper reserve should be created on the basis of guidelines issued by RBI that
apply to companies and financial institutions, and impairment provision shall be
made strictly as per RBI guidelines.

h) Linked business

The accounting principles used for valuation of investment are to be consistent

with principles detailed above. A separate set of financial statements for each
segregated fund of the linked business shall be prepared.
This term is defined below

Segregated Funds

Practically speaking, different classes of policyholders have different goals and

objectives behind taking an insurance policy. Hence, it is prudent to maintain a
separate fund for every such class of policyholders. Such separation is done since
the risk bearing for every class is different. Since investment income from the
finds and the associated risks accrue directly to the policyholders, the assets for
each such funds are separately maintained. Such assets are not subject to claims
that arise out of any other business of the insurer.

i) Funds for future appropriation

The funds for future appropriation shall be presented separately. The funds for
future appropriation represent all funds, the allocation of which either to the
policy holder or shareholders has not been determined by the end of the financial
year.

Every year, an estimation of liability against life policies needs to be determined

by:
A A Practicing Chartered Accountant
B The Chairman of IRDA
C Appointed Actuary
D Attorney General of India
 293

2. Explain the various disclosure requirements which form

a part of the financial statements.
[Learning Outcome b]
2.1 PART – II of IRDA (Preparation of financial statements and
auditor’s report of insurance companies) Regulations, 2002
Disclosures forming part of the financial statements:
Disclosure requirements form the central core of accounting excellence.
Preparation of financial statements does not achieve its intended purpose unless
appropriate and reasonable disclosures are made at the right place. Following are
the areas where the disclosure requirement attains special importance.

a) Segment Reporting
b) Revenue Account
c) Managerial remuneration
d) Related party transactions
e) Transfer of securities to policyholder’s account
f) Guidelines for recognition of claims
g) Bank reconciliation as at 31 st March
h) Provision for ‘free look’ period
i) Catastrophe reserve
j) Investments of policyholders and shareholders
k) Social sector business
l) Preliminary expenses.
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Diagram 3: Requirements of disclosures

Now, we will see the disclosure requirements for each of the above items, in
detail

a) Segment Reporting

 As per the IRDA Regulations, separate financial statements - Revenue

Account and Balance Sheet, are required to be prepared for participating and
non-participating policies, and linked and non-linked business.

 For non-linked business, separate statements are required for ordinary life,
general annuity, pension and health insurance.

 The Authority requires the segments to be reported on the basis of line of

business, and on the basis of business within and outside India. Other
geographical connotations are not perceived by the Authority.

 Insurers can lay down accounting policies in line with the Accounting
Standard -17 and the Regulations issued by the Authority in this regard, and
consistently follow the same.

 Separate Balance Sheets need to be prepared for each business segment

 295

b) Revenue Account

In case of deficit in the Revenue Account, where the deficit is made up through a
transfer from the Profit and Loss Account, as “Transfer from the Shareholders’
account”, it shall be depicted as under:

In the Revenue Account the following modification is made:

After the Row:

“Surplus/(Deficit) (D) = (A)-(B)-(C)’’

Insert another Row as below:

Amount transferred from Policy holders Account (Technical Account)

c) Managerial remuneration

Applicability of sections 198, 349 and 350 of the Companies Act:

Relevant applicable extract from the above sections:

‘Other than the sections which have been specifically made inapplicable to the
insurance companies, all other sections are applicable to insurers. Further, the
managerial remuneration is to be decided by the said Authority.’
d) Related party transactions
All related party transactions as required by the Accounting Standard (AS – 18)
are required to be disclosed.
e) Transfer of securities to policyholder’s account
 All securities are required to be transferred to the policy holders Account at
market price or cost price, whichever is lower.
 In respect of debt securities, the transfers are to be carried out at the net
amortized cost.
f) Guidelines for recognition of claims
The date for recognition of claims is the date of intimation of death/ date of
maturity.
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g) Bank reconciliation as at 31st March

Each insurer is required to prepare Bank reconciliation as at 31 st Mar
h) Catastrophe reserve
No reserves have been prescribed by the IRDA till now.
i) Investments of policyholders and shareholders
All insurers are required to maintain separate investment accounts for the
shareholders and the policy holders and the income/ losses accrued / capital
gains/losses on the investments is to be credited /debited to the Revenue
Account/ Profit & Loss Account, as the case may be.

j) Social sector business

 Point C (4) of Part II of the IRDA regulations requires the percentage of

business sector- wise to be given, along with the total business and rural
business.
 Moreover, the social sector business underwritten by the insurer should also
be furnished, indicating the gross premium underwritten, no. of policies
issued and No. of lives covered (both actual and percentages).
k) Preliminary expenses
 The insurers are required to deduct the preliminary expenses from the paid up
equity share capital as indicated in Schedule 5 of the Regulations
Submission of Accounts to IRDA
 IRDA has mandated that life insurer should prepare its accounts on quarterly
basis in addition to Annual Accounts and submit to IRDA by the following
dates.
June By 15th Aug
Sept By 15th Nov
Dec By 15th Feb of next year
Mar Annual closing Audited By 30th Sept

Students must note that there should be a limited review for quarterly accounts
by the statutory auditors and full audit review for Annual Accounts in the month
of March.
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All securities are required to be transferred to the policy holders Account at:

A Cost price
B Cost price or market price, whichever is higher
C Market Price
D Cost price or market price, whichever is lower

3. List out the general instructions for preparation of

financial statements.
[Learning Outcome c]
3.1 PART – III: General instructions for preparation of financial
statements

The said IRDA regulations have given certain instructions while preparing the
financial statements of the insurer. The main intention behind issuing these
instructions is to enhance the overall quality of disclosures and bring about
uniformity with respect to certain specific issues affecting the financial
statements of an insurance company.

Point number 4 has been classified as (I) and (II). The entire point has been
given under the tag “Important”. This point holds special importance when
it comes to understanding the meaning and requirements of certain specific
terms.

Following are the general instructions issued under the regulations:

i) The corresponding amounts for the immediately preceding financial year for
all items shown in the Balance Sheet, Revenue Account, Profit and Loss
Account and Receipts and Payments Account shall be given.

ii) The figures in the financial statements may be rounded off to the nearest
thousand.

iii) Interest, dividends and rentals receivable in connection with an investment

should be stated at gross amount, the amount of income tax deducted at
source should be included under 'advance taxes paid' and taxes deducted at
source
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(I) For the purposes of financial statements, unless the context otherwise
requires:
a) The expression ‘provision’ shall, subject to (II) below mean any amount
written off or retained by way of providing for depreciation, renewals or
diminution in value of assets, or retained by way of providing for any known
liability or loss of which the amount cannot be determined with substantial
accuracy;
b) The expression ‘reserve’ shall not, subject to as aforesaid, include any
amount written off or retained by way of providing for depreciation, renewals
or diminution in value of assets or retained by way of providing for any
known liability or loss;
c) The expression ‘capital reserve’ shall not include any amount regarded as
free for distribution through the profit and loss account; and the expression
‘revenue reserve’ shall mean any reserve other than a capital reserve;
d) The expression "liability" shall include all liabilities in respect of expenditure
contracted for and all disputed or contingent liabilities.
(II) Where:
a) any amount written off or retained by way of providing for depreciation,
renewals or diminution in value of assets, or
b) any amount retained by way of providing for any known liability or loss, is in
excess of the amount which in the opinion of the directors is reasonably
necessary for the purpose, the excess shall be treated as a reserve and not
provision.

iv) The company shall make provisions for damages under lawsuits where the
management is of the opinion that the award may go against the insurer.
v) Extent of risk retained and re-insured shall be separately disclosed.
vi) Any debit balance of the Profit and Loss Account shall be shown as
deduction from uncommitted reserves and the balance, if any, shall be shown
separately.
 299

The debit balance in profit and loss account has to be shown as

to/from

A Addition , committed reserves

B Reduction, committed reserves
C Addition , general reserves
D Reduction, uncommitted reserves

4. Understanding the meaning of the term ‘management

report’ and list out its contents.
[Learning Outcome d]
It is to be remembered that the management (board of directors, promoters etc.)
of an insurance company are ultimately responsible for its financial statements.
There are certain specific issues with respect to the insurance company which can
be best understood by the management itself. The auditor/accountant will have to
rely on the declarations/representations made by the management with respect to
such specific issues. A management report lists out those issues where the
management has to give certain representations, declarations or certifications.
The main purpose of this report is to assure the readers of the financial statements
about the business and financial prudence observed by the management while
carrying out the business of the insurance company.

4.1 Part – IV: Contents of Management Report

There shall be attached to the financial statements, a management report

containing, inter alia, the following duly authenticated by the management:

i) Confirmation regarding the continued validity of the registration granted by

the Authority;

ii) Certification that all the dues payable to the statutory authorities have been
duly paid;

iii) Confirmation to the effect that the shareholding pattern and any transfer of
shares during the year is in accordance with the statutory or regulatory
requirements;
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iv) Declaration that the management has not directly or indirectly invested
outside India the funds of the holders of policies issued in India;

v) Confirmation that the required solvency margins have been maintained;

vi) Certification to the effect that the values of all the assets have been reviewed
on the date of the Balance Sheet and that in his (insurer’s) belief the assets
set forth in the Balance sheets are shown in the aggregate at amounts not
exceeding their realisable or market value under the several headings

Headings

“Loans”, “Investments”, “Agents balances”, “Outstanding Premiums”, “Interest,

Dividends and Rents outstanding”, “Interest, Dividends and Rents accruing but
not due”, “Amounts due from other persons or Bodies carrying on insurance
business”, “ Sundry Debtors”, “ Bills Receivable”, “ Cash” and the several items
specified under “Other Accounts”

vii) Certification to the effect that no part of the life insurance fund has been
directly or indirectly applied in contravention of the provisions of the
Insurance Act, 1938 (4 of 1938) relating to the application and investment of
the life insurance funds;

viii) Disclosure with regard to the overall risk exposure and strategy adopted to
mitigate the same;

ix) Operations in other countries, if any, with a separate statement giving the
management’s estimate of country risk and exposure risk and the hedging
strategy adopted;

x) Ageing of claims indicating the trends in average claim settlement time

during the preceding five years;

xi) Certification to the effect as to how the values, as shown in the balance sheet,
of the investments and stocks and shares have been arrived at, and how the
market value thereof has been ascertained for the purpose of comparison with
the values so shown;

xii) Review of asset quality and performance of investment in terms of portfolios,

i.e. separately in terms of real estate, loans, investments, etc.
 301

xiii) A responsibility statement indicating therein that:

 in the preparation of financial statements, the applicable accounting

standards, principles and policies have been followed along with proper
explanations relating to material departures, if any;

 the management has adopted accounting policies and applied them

consistently and made judgments and estimates that are reasonable and
prudent so as to give a true and fair view of the state of affairs of the
company at the end of the financial year and of the operating profit or loss
and of the profit or loss of the company for the year;

 the management has taken proper and sufficient care for the maintenance of
adequate accounting records in accordance with the applicable provisions of
the Insurance Act 1938 (4 of 1938) / Companies Act, 1956 (1 of 1956), for
safeguarding the assets of the company and for preventing and detecting
fraud and other irregularities;

 the management has prepared the financial statements on a going concern

basis;

 the management has ensured that an internal audit system commensurate

with the size and nature of the business exists and is operating effectively.

xiv) A schedule of payments, which have been made to individuals, firms,

companies and organizations in which the directors of the insurer are
interested.

The management of an insurance company, in its report, has to certify that:

A The company is a profit making venture.

B The company has an internal audit system which is commensurate with its
size
C The remuneration of the directors is regularly paid.
D The chairman of the company is an expert in the area of ‘insurance’
 302

5. Explain the method of preparation of financial

statements.
[Learning Outcome e]
This is the last part of the said regulations. The most striking feature of this part
is the format provided for the financial statements of the life insurance business.
Certain explanations and practical examples have also been provided in the end
for better understanding.

5.1 Part V – Preparation of the financial statements

i) An insurer shall prepare the Revenue Account [Policyholders’ Account],

Profit and Loss Account [Shareholders’ Account] and the Balance Sheet in
Form A-RA, Form A-PL and Form A-BS, as prescribed in this Part, or as
near thereto as the circumstances permit.

Provided that an insurer shall prepare Revenue Account and Balance Sheet for
the under mentioned businesses separately and to that extent the application of
AS 17 shall stand modified:-

a) Participating policies and Non-participating policies;

b)
Linked business [As defined in regulation 2 (i) of the IRDA (Registration of
Indian Insurance Companies) Regulations, 2000]
Non-Linked business separately for Ordinary Life, General Annuity,
pensions and Health Insurance; Business within India and business outside
India.

ii) An insurer shall prepare separate Receipts and Payments Account in

accordance with the Direct Method prescribed in AS 3 – “Cash Flow
Statement” issued by the ICAI.

Now, we will see the formats of the financial statements as given in Part V
 303

FORM A-RA

Name of the Insurer:

Registration No. and Date of Registration with the IRDA

REVENUE ACCOUNT FOR THE YEAR ENDED 31 ST MARCH, 20 .

Policyholders’ Account (Technical Account)

Particulars Schedule Current Previous

Year Year
(Rs.’000) (Rs.’000).
Premiums earned – net
(a) Premium 1
(b) Reinsurance ceded
(c) Reinsurance accepted-

Income from Investments

(a) Interest, Dividends & Rent – Gross
(b) Profit on sale/redemption of investments
(c) (Loss on sale/ redemption of investments)
(d) Transfer/Gain on revaluation/change in fair value*
Other Income (to be specified)

TOTAL (A)
 304

Commission 2

Operating Expenses related to Insurance Business 3

Other Expenses (to be specified)

Provisions (other than taxation)

(a) For diminution in the value of investments (Net)
(b) Others (to be specified)

TOTAL (B)

Benefits Paid (Net) 4

Interim Bonuses Paid
Change in valuation of liability against life policies in force
(a) Gross**
(b) (Amount ceded in Reinsurance)
(c) Amount accepted in Reinsurance
TOTAL (C)

SURPLUS/ (DEFICIT) (D) =(A)-(B)-(C)

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APPROPRIATIONS

Transfer to Shareholders’ Account

Transfer to Other Reserves (to be specified)
Transfer to Funds for Future Appropriations

TOTAL (D)

Notes:

* Represents the deemed realised gain as per norms specified by the Authority.
** Represents Mathematical Reserves after allocation of bonus

The total surplus shall be disclosed separately with the following details:

(a) Interim Bonuses Paid:

(b) Allocation of Bonus to policyholders:
(c) Surplus shown in the Revenue Account:
(d) Total Surplus: ((a)+(b)+(c)):
 306

FORM A-PL

Name of the Insurer:

Registration No. and Date of Registration with the IRDA

PROFIT & LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH, 20 .

Shareholders’ Account (Non-technical Account)

Particulars Schedule Current Previous

Year Year
(Rs.’000). (Rs.’000).
Balance brought forward from /transferred to the Policyholders
Account (Technical Account)

Income From Investments

(a) Interest, Dividends & Rent – Gross
(b) Profit on sale/redemption of investments
(c) (Loss on sale/ redemption of investments)
Other Income (To be specified)
TOTAL (A)

Expense other than those directly related to the insurance business

Provisions (Other than taxation)

(a) For diminution in the value of investments (Net)
(b) Others (to be specified)
 307

TOTAL (B)

Profit/ (Loss) before tax

Provision for Taxation
Profit / (Loss) after tax

APPROPRIATIONS
(a) Brought forward Reserve/Surplus from the Balance Sheet
(b) Interim dividends paid during the year
(c) Proposed final dividend
(d) Dividend distribution on tax
(e) Transfer to reserves/ other accounts (to be specified)
Profit carried forward to the Balance Sheet

Notes:

a) In case of premiums, less reinsurance in respect of any segment of insurance business of total premium earned, the
same shall be disclosed separately.
b) Premium income received from business concluded in and outside India shall be separately disclosed.
c) Reinsurance premiums whether on business ceded or accepted are to be brought into account gross (i.e. before
deducting commissions) under the head reinsurance premiums.
d) Claims incurred shall comprise claims paid, settlement costs wherever applicable and change in the outstanding
provision for claims at the year-end
e) Items of expenses and income in excess of one percent of the total premiums (less reinsurance) or Rs.5,00,000
whichever is higher, shall be shown as a separate line item.
f) Fees and expenses connected with claims shall be included in claims.
g) Under the sub-head "Others” shall be included items like foreign exchange gains or losses and other items.
 308

h) Interest, dividends and rentals receivable in connection with an investment should be stated as gross amount, the
amount of income tax deducted at source being included under 'advance taxes paid and taxes deducted at source”.
i) Income from rent shall include only the realised rent. It shall not include any notional rent.

FORM A-BS

Name of the Insurer:

Registration No. and Date of Registration with the IRDA

BALANCE SHEET AS AT 31 ST MARCH, 20

Schedule Current Previous

Year Year
(Rs.’000). (Rs.’000).
Sources of funds

Shareholders’ funds:

Share capital 5
Reserves and surplus 6
Credit/[debit] fair value change account
Sub-Total

Borrowings 7
 309

Policyholders’ funds:
Credit/[debit] fair value change account
Policy liabilities
Insurance reserves

Provision for linked liabilities

Sub-Total
Funds for future appropriations
Total
Application of funds
Investments
Shareholders’ 8
Policyholders’ 8A

Assets held to cover linked liabilities

Loans 9

Fixed assets 10

Current assets
Cash and Bank Balances 11
Advances and Other Assets 12
Sub-Total (A)
 310

Current liabilities 13
Provisions 14
Sub-Total (B)

Net current assets (C) = (A – B)

Miscellaneous expenditure (to the extent not written off or 15

adjusted)

Debit balance in profit & loss account (Shareholders’

Account)
Total

Contingent Liabilities

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. Partly paid-up investments
2. Claims, other than against policies, not acknowledged as
debts by the company
3. Underwriting commitments outstanding
4. Guarantees given by or on behalf of the Company
5. Statutory demands/ liabilities in dispute, not provided for
6. Reinsurance obligations
7. Others (to be specified)
Total
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Schedules forming part of Financial Statements

Schedule – 1
Premium

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1 First year premiums
2 Renewal Premiums
3 Single Premiums

Total Premium

Premium Income from business written :

1 In India
2 Outside India
Total Premium (Net)

Notes:

Reinsurance premiums whether on business ceded or accepted are to be brought into account, before deducting
commission, under the head of reinsurance premiums.
 312

Schedule- 2

Commission expenses

Particulars Current Year Previous Year

(Rs.’000) (Rs.’000)
Commission paid
Direct – First year premiums
- Renewal premiums
- Single premiums

Add: Commission on Re-insurance Accepted

Less: Commission on Re-insurance Ceded

Net Commission

Note:

The profit/ commission, if any, are to be combined with the Re-insurance accepted or Re-insurance ceded figures.
 313

Schedule – 3

Operating expenses related to Insurance Business

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. Employees’ remuneration & welfare benefits
2. Travel, conveyance and vehicle running expenses
3. Rents, rates & taxes
4. Repairs
5. Printing & stationery
6. Communication expenses
7. Legal & professional charges
8. Medical fees
9. Auditors' fees, expenses etc
a) as auditor
b) as adviser or in any other capacity, in respect of
i) Taxation matters
ii) Insurance matters
iii) Management services; and
c) in any other capacity
10. Advertisement and publicity
11. Interest & Bank Charges
12. Others (to be specified)
13. Depreciation
Total
 314

Notes:
a) Items of expenses in excess of one percent of the net premium or Rs.5,00,000 whichever is higher, shall be shown as a
separate line item.
b) Under the sub-head "Others", `Operating Expenses (Insurance Business)' shall include items like foreign exchange
gains or losses and other items.
SCHEDULE – 4
BENEFITS PAID [NET]
Particulars Current Year Previous Year
(Rs.’000). (Rs.’000).
1. Insurance Claims
(a) Claims by Death,
(b) Claims by Maturity,
(c) Annuities/Pensions in payment,
(d) Other benefits, specify
2. (Amount ceded in reinsurance) :
(a) Claims by Death,
(b) Claims by Maturity,
(c) Annuities/Pensions in payment,
(d) Other benefits, specify
3. Amount accepted in reinsurance :
(a) Claims by Death,
(b) Claims by Maturity,
(c) Annuities/Pensions in payment,
(d) Other benefits, specify
Total
 315

Benefits paid to claimants:

1 In India
2 Outside India
Total Benefits paid (Net)

Notes:

a) Claims include claims settlement costs, wherever applicable.

b) The legal and other fees and expenses shall also form part of the claims cost, wherever applicable.

Schedule – 5

Share capital

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. Authorised Capital
Equity Shares of Rs..... each
2. Issued Capital
Equity Shares of Rs...... each
3. Subscribed Capital
Equity Shares of Rs...... each
4. Called-up Capital
Equity Shares of Rs...... each
5. Less : Calls unpaid
Add : Shares forfeited (Amount originally paid up)
 316

Less: Par value of Equity Shares bought back

Less : Preliminary Expenses
Expenses including commission or brokerage on
Underwriting or subscription of shares
TOTAL

Notes:

(i) Particulars of the different classes of capital should be separately stated.

(ii) The amount capitalised on account of issue of bonus shares should be disclosed.
(iii) In case any part of the capital is held by a holding company, the same should be separately disclosed.

Schedule – 5a
Pattern of shareholding

[As certified by the Management]

Shareholder Current Year Previous Year

Number of % of Number of % of
Shares Holding Shares Holding
Promoters
 Indian
 Foreign
Others
Total
 317

Schedule – 6

Reserves and surplus

Particulars Current Year Previous Year

(Rs.’000) (Rs.’000)
1. Capital Reserve
2. Capital Redemption Reserve
3 Share Premium
4. Revaluation Reserve
5. General Reserves
Less: Debit balance in Profit and Loss Account, if any
Less: Amount utilized for Buy-back
6. Catastrophe Reserve
7. Other Reserves (to be specified)
8. Balance of profit in Profit and Loss Account
Total

Note:

Additions to and deductions from the reserves should be disclosed under each of the specified heads.
 318

Schedule - 7

Borrowings

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. Debentures/ Bonds
2. Fixed Deposits
3. Banks
4. Financial Institutions
5. Other entities carrying on insurance business
6. Others (to be specified)
Total

Notes:
a) The extent to which the borrowings are secured shall be separately disclosed stating the nature of the security under
each sub-head.

b) Amounts due within 12 months from the date of Balance Sheet should be shown separately
 319

Schedule- 8

Investments-shareholders

Particulars Current Year Previous Year

(Rs.’000) (Rs.’000)
Long term investments

1. Government securities and Government guaranteed bonds

including Treasury Bills

2. Other Approved Securities

3. Other Investments

(a) Shares
(aa) Equity
(bb) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/ Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
 320

Short term investments

1. Government securities and Government guaranteed bonds
including Treasury Bills
2. Other Approved Securities
3. Other Investments
(a) Shares
(aa) Equity
(bb) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/ Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate

Total
Investments
1 In India
2 Outside India
Total

Note:

Refer notes under Schedule 8A

 321

Schedule- 8A

Investments-policyholders

Particulars Current Year Previous Year

(Rs.’000) (Rs.’000)
Long term investments
1. Government securities and Government guaranteed bonds
including Treasury Bills
2. Other Approved Securities
3. (a) Shares
(aa) Equity
(bb) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/ Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
4. Investments in Infrastructure and Social Sector
5. Other than Approved Investments
Short term investments
1. Government securities and Government guaranteed bonds
including Treasury Bills
2. Other Approved Securities
 322

3. (a) Shares
(aa) Equity
(bb) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/ Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
4. Investments in Infrastructure and Social Sector
5. Other than Approved Investments
Total

Investments
1 In India
2 Outside India
Total

Notes (applicable to Schedules 8 and 8A):

a) Investments in subsidiary/holding companies, joint ventures and associates shall be separately disclosed, at cost.

i) Holding company and subsidiary shall be construed as defined in the Companies Act, 1956:
ii) Joint Venture is a contractual arrangement whereby two or more parties undertake an economic activity, which is
subject to joint control.
iii) Joint control - is the contractually agreed sharing of power to govern the financial and operating policies of an
economic activity to obtain benefits from it.
 323

iv) Associate - is an enterprise in which the company has significant influence and which is neither a subsidiary nor a
joint venture of the company.
v) Significant influence (for the purpose of this schedule) -means participation in the financial and operating policy
decisions of a company, but not control of those policies. Significant influence may be exercised in several ways,
for example, by representation on the board of directors, participation in the policy making process, material inter-
company transactions, interchange of managerial personnel or dependence on technical information. Significant
influence may be gained by share ownership, statute or agreement. As regards share ownership, if an investor
holds, directly or indirectly through subsidiaries, 20 percent or more of the voting power of the investee, it is
presumed that the investor does have significant influence, unless it can be clearly demonstrated that this is not the
case. Conversely, if the investor holds, directly or indirectly through subsidiaries, less than 20 percent of the
voting power of the investee, it is presumed that the investor does not have significant influence, unless such
influence is clearly demonstrated. A substantial or majority ownership by another investor does not necessarily
preclude an investor from having significant influence.
b) Aggregate amount of company's investments other than listed equity securities and derivative instruments and also the
market value thereof shall be disclosed.
c) Investments made out of Catastrophe reserve should be shown separately
d) Debt securities will be considered as “held to maturity” securities and will be measured at historical costs subject to
amortisation
e) Investment Property means a property [land or building or part of a building or both] held to earn rental income or for
capital appreciation or for both, rather than for use in services or for administrative purposes.
 324

Schedule - 9

Loans

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. Security-wise classification
Secured
(a) On mortgage of property
(aa) In India
(bb) Outside India
(b) On Shares, Bonds, Govt. Securities, etc.
(c) Others (to be specified)
Unsecured
(a) Loans against policies
(b) Others (to be specified)
Total
2. Borrower-wise classification
(a) Central and State Governments
(b) Banks and Financial Institutions
(c) Subsidiaries
(d) Companies
(e) Loans against policies
(f) Others (to be specified)
Total
3. Performance-wise classification
 325

(a) Loans classified as standard

(aa) In India
(bb) Outside India
(b) Non-standard loans less provisions
(aa) In India
(bb) Outside India
Total
4. Maturity-wise classification
(a) Short Term
(b) Long Term
Total

Notes:

a) Short-term loans shall include those, which are repayable within 12 months from the date of balance sheet. Long term
loans shall be the loans other than short-term loans.
b) Provisions against non-performing loans shall be shown separately.
c) The nature of the security in case of all long term secured loans shall be specified in each case. Secured loans for the
purposes of this schedule, means loans secured wholly or partly against an asset of the company.
d) Loans considered doubtful and the amount of provision created against such loans shall be disclosed.
 326

Schedule - 10
Fixed assets
(Rs.’000)
Particulars Cost/ Gross Block Depreciation Net Block
Opening Additions Deductions Closing Upto For On Sales/ To As at Previous
Last The Adjustments Date year Year
Year Year end
Goodwill
Intangibles
(specify)
Land-Freehold
Leasehold Property
Buildings
Furniture &
Fittings
Information
Technology
Equipment
Vehicles
Office Equipment
Others (Specify
nature)
Total
Previous year
Note:
Assets included in land, property and building above exclude Investment Properties as defined in note (e) to Schedule 8.
 327

Schedule- 11

Cash and bank balances

Particulars Current Year Previous Year
(Rs.’000). (Rs.’000).
1. Cash (including cheques, drafts and stamps)
2. Bank Balances
(c) Deposit Accounts
(aa) Short-term (due within 12 months of the date
of Balance Sheet)
(bb) Others
(d) Current Accounts
(e) Others (to be specified)
3. Money at Call and Short Notice
(a) With Banks
(b) With other Institutions
4. Others (to be specified)
Total
Balances with non-scheduled banks included in 2 and 3
above

Cash & bank balances

1 In India
2 Outside India
Total

Note: Bank balance may include remittances in transit. If so, the nature and amount should be separately stated.
 328

Schedule – 12

Advances and other assets

Particulars Current Year Previous Year

(Rs.’000) (Rs.’000)
Advances
1. Reserve deposits with ceding companies
2. Advances to ceding companies
3. Application money for investments
4. Prepayments
5. Advances to Officers/ Directors
6. Advance tax paid and taxes deducted at source
7. Others (to be specified)
Total (A)
Other assets
1. Income accrued on investments
2. Outstanding Premiums
3. Agents’ Balances
4. Foreign Agencies’ Balances
5. Due from other entities carrying on insurance business
6. Due from subsidiaries/ holding company
 329

7. Reinsurance claims/balances receivable

8. Deposit with Reserve Bank of India [Pursuant to section 7
of Insurance Act, 1938]
9. Others (to be specified)
Total (B)
Total (A+B)

Notes:

(a) The items under the above heads shall not be shown net of provisions for doubtful amounts. The amount of provision
against each head should be shown separately.
(b) The term ‘officer’ should conform to the definition of the word ‘officer’ under the Companies Act, 1956.
 330

Schedule – 13

Current liabilities

Particulars Current Year Previous Year

(Rs.’000) (Rs.’000)
1. Agents’ Balances
2. Balances due to other insurance companies
3. Advances from Treaty Companies
4. Deposits held on re-insurance ceded
5. Premiums received in advance
6. Sundry creditors
7. Due to subsidiaries/ holding company
8 Claims Outstanding
9 Annuities Due
10. Due to Officers/ Directors
11. Others (to be specified)
Total
 331

Schedule – 14

Provisions

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. For taxation (less payments and taxes deducted at source)
2. For proposed dividends
3. For dividend distribution tax
4. Bonus payable to the Policyholders
5. Others (to be specified)

Total
 332

Schedule – 15

Miscellaneous expenditure

(To the extent not written off or adjusted)

Particulars Current Year Previous Year

(Rs.’000). (Rs.’000).
1. Discount Allowed in issue of shares/ debentures
2. Others (to be specified)
Total

Notes:

a) No item shall be included under the head “Miscellaneous Expenditure” and carried forward unless:
 some benefit from the expenditure can reasonably be expected to be received in future, and
 the amount of such benefit is reasonably determinable.

b) The amount to be carried forward in respect of any item included under the head “Miscellaneous Expenditure” shall
not exceed the expected future revenue/other benefits related to the expenditure.
 333

Now, we will see some salient features pertaining to finalization of accounts:

Assets
1. Verification of cash, cheques etc.
 The Auditors will be verifying cash on hand as at close of the accounting
year. Arrangement should, therefore, be made for smooth verification of cash
on hand.
 Cash on hand includes Currency Notes, Coins, Cheques, Demand Drafts, Pay
orders, Postal orders, Policy stamps, Policy Loan Endorsement Stamps etc.
 All such cash will be verified by the Auditors.
An analysis of cash on hand should be written up in the form given herein below:
Statement of analysis of Cash on hand as on ………………..
Cash on hand No. Rs.
I (a) Currency Notes :
(b) Cheques, Drafts, Indian Postal Orders, etc. on hand
as per pay in slips
II (a) Imprest Cash
(b) Petty Cash
(c) Mobile Van Imprest Cash
III (a) Receipt Stamps
(b) Postage Stamps including Money order forms etc.
on hand.
(c) Balance of Franking Machine
IV Policy Stamps
V Policy Loan Endorsement Stamps
VI Agents Licence Fee Stamps
VII Stock of Non-Judicial Stamps
Grand total Rs.
I certify that the balance of Cash, Cheques etc. Receipt Stamps, Postage
Stamps including Franking Machine Balance, Policy Stamps, Policy Loan
Endorsement Stamps with the Office at the close of the Business on
………………. is Rs. (in words) as above.
Cashier (Sign)
Officer in charge (Sign) Accountant(Sign)
Dated : ………………… Auditors.
Simple Steps in verification of cash
 334

Diagram 4: Steps in verification of cash

 335

2. Certificate of bank balances and reconciliation

Following steps are to be followed under this procedure

Diagram 5: Procedure for certificate of bank balances & reconciliation

After the above three steps, reconciliation with the corresponding balances in the
principal ledger account should be made.

There should be no attempt to reconcile Bank Accounts by transferring any un-

reconciled balances to “Suspense Account”.

X Ltd., an insurance company, has a bank account with the State Bank of India
(SBI). The insurance company has to obtain a certificate of balance from the
bank. Let’s say the certificate shows a balance of Rs. 10 crores. The actual
balance as per the books of account is, say, Rs. 9.99 crores. Hence, there is a
difference of Rs. 1,00,000, which must be mandatorily reconciled. The balance of
Rs. 1,00,000 must not be allowed to remain in the suspense account.
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3. Printing and stationary stock etc.

a) The following procedure with regard to the physical verification of

Stationery, Publicity Material, Building materials etc. should be adopted

b) There should be a physical stock checking of stock on hand of:-

 Printed forms and Stationery,

 Other Stationery,
 Publicity material remaining unused,
 Saleable Literature and Publicity materials,
 Stock of Building materials.

c) Saleable items should be valued at the sale price. All non-saleable and other
items like printed forms, books, stationery, etc. should be valued at original
cost price. Obsolete items which are no longer in vogue should be listed
separately and should not be valued for the purpose of closing of Accounts.
In the case of obsolete or unusable Building Materials (if any), the value (less
scrap value realized, if any) will be required to be written off under sanction
of competent authority.

d) Accounts Department should take steps to get all the inventories in time and
verify that they are correct and have been prepared and are in agreement with
the books of account as well as stock records.

4. Verification of furniture etc.

Physical Verification of Furniture, Fixtures, Office Equipments and Library
Books etc., should be done as at the close of the year.

The above inventory should be as per the Proforma given hereunder:-

 Serial No.
 Distinctive Number allotted.
 Description.
 Location (Office, Room & Place).
 Date of purchase.
 Purchase Price.
 Remarks.
 337

Office Services Department should compare the inventory with the last year’s
inventory, and reconcile all additions or depletions on account of purchase, sale
or other reasons with the corresponding entries in the books of accounts and
certify the same as to the additions or depletions during the year.

5. Motor cars (Hire purchase schemes)

 A list of vehicles classified into Motor Cars, Motor Cycles, Scooters showing
the name of the Officials, designations, Place and amount advanced and
recovered should be prepared. A certificate, as per the specimen given below,
should be obtained from the officer concerned.

 One certificate in every case should be attached to the list of vehicles.

Certificate for Conveyance

This is to certify that the total amount outstanding against my name as at

……………in respect of Motor
………………..model………………..Registration No. ........................... given to
me was Rs……………

This is to further certify that the above conveyance was in my possession and
was in good running condition as at .................... and was duly registered in the
name of the Company.

Against the above amount of Rs…… Outstanding in my name as at .............. a

sum of Rs.……was lying with the company under ................... Deposit Account.

Place:……
(Signature)
Date :
(Designation)

6. Company’s motor car

A certificate should be obtained from the officers who have been supplied with
the Company’s Motor Cars as per specimen given below :
 338

Certificate for Conveyance

This is to certify that Motor Car Model ………….Registration No. …………

supplied to me by the Company was in my possession and was in good running
condition as on …………….

Place:
(Signature)
Date :
(Designation)

Following are the broad guidelines for year-end provisions and preparation
of schedules for important items of Assets and Liabilities

7. Loans on policies

i) Schedule of policy loans as at the close of the year should be extracted from
the loan ledgers. If the work relating to Policy loan accounting is
mechanized, the schedule of outstanding Policy loans will be extracted on a
computer. However, the said schedule is to be scrutinized in conjunction with
the Loan Ledgers or Policy Loan dockets so as to establish one to one
correspondence between the schedule and other subsidiary records.

ii) The schedule should be drawn up so as to produce separate totals of new

loans granted during the year and loans repaid during the year. The specimen
form is given below:

Debits Credits
Outstanding Loans Other Loans Other Outstanding
As on 1st advanced debits (C) repaid credits (E) as on 31st
April (A) during the during the March
year (B) year (D) (F = A +B
+C – D –E)

iii) The totals of each column of the schedule should be tallied with the
corresponding figures extracted from the Principal Ledger.
 339

X Ltd, an insurance company, gives regular loans to its policyholders, against

their insurance policies. Suppose the amount of loans outstanding in the last year
was Rs. 1 crore. Fresh advances made in the current year are Rs. 50 lakhs, and
repayments received of earlier loans are Rs. 25 lakhs. The statement of loans
against policies will appear as follows:

Debits Credits
Outstanding Loans Other Loans Other Outstanding
As on 1st advanced debits (C) repaid credits (E) as on 31st
April (A) during the during the March
year (B) year (D) (F = A +B
+C – D –E)
100,00,000 50,00,000 Nil 25,00,000 Nil 125,00,000

8. Outstanding premiums

This account is used only at the time of the closing of accounts and entries made
are reversed in the next financial year. Premiums which satisfy the following
conditions should alone be treated as outstanding premiums:

a) Premium is due in the last month of the accounting year.

b) Days of grace have not expired by the last day of the accounting year.
c) All installments of premiums prior to those due in the last month of the
accounting year have been received.
d) The premium due in the last month of the accounting year has not been
received / or adjusted in the financial year.
9. Interest on policy loan outstanding and accruing
These Accounts are used only at the time of closing of Accounts.
Outstanding interest and accruing interest at the year end are worked out as per
actual interest calculated by IT Department:
Debit: Interest on policy loan outstanding
Debit: Interest on policy loan accruing but not due
Credit: Interest on policy loan

The above entries are reversed in the next financial year.

 340

10. Sundry debtors

In all cases where amounts become due to the company from any persons on
account of goods supplied, or where the services rendered to the customer are in
excess, or a less payment has been received, the sundry debtors account should
be debited.

The schedule of sundry debtors should include all the items grouped as sundry
debtors and advance. However, those debtors which are specifically shown
separately in the balance sheet need not be shown again in the schedule.

Proper analysis should be given in the schedule under different heads of account.
The account of identical nature falling under one head say Sundry Deposits or
Advances should be grouped together and shown as a separate item. The

Proforma for this schedule is generally as follows :

Particulars of Sundry Debtors including advances and deposits as at ……………

Amount
Sr. Particulars Rs.

1. Advance for purchase of cycles

2. Advance against Travelling Expenses
3. Advance for purchase of House Properties
4. Advance to Agents
5. Advance to Building contractors
6. Contractors' Security Deposit Investments
7. Other Security Deposit Investments
8. Excess refund (or adjustment) of Deposits
9. Electricity Charges recoverable
10. Festival Advance to employees
11. Fixed Deposit other than with Banks
12. Legal Charges recoverable
13. Inter Office Collection
14. Rent Deposit recoverable
15. Telephone Deposits
16. Telegram Deposits
 341

17. Sundry Deposits recoverable

18. Salary Suspense Account
19. Development Officers' Balances
20. Prepaid Expenses
21. Other items to be specified
22 Other Sundry Debtors as per statement attached

Total :

Particulars of Other Sundry Debtors referred to in Statement of

Sundry Debtors as at ……………….

Amount of
reserve
Name provided if
Sr. Amt Outstanding
of the Description considered Remark
No Rs. since (date)
Debtor doubtful of
recovery
Rs.
1.
2.
3.

Total

11. Development officers’ balance

Advances to development officers are regularly given by the insurance

companies. Following are the steps to verify the same for the purpose of
finalisation:

 Advance to development officers for purchase of various assets should be

included in this account.
 From the items appearing in this account, correct schedule as at the close of
the accounting year should be prepared tallying with the Principal Ledger.
 Confirmation from the development officers against whom balances are
shown should be obtained.
 342

12. Advances for purchase of cycles

 The above relates to advances made to employees.
 Schedule showing the position at the close of the accounting year should
be prepared and tallied with the ledger balance.
 Confirmation of the balances should be obtained from the employees
concerned.
13. Salary suspense account advance payment of salary
The schedule showing salaries paid in advance should be prepared. The
subsequent adjustments made should be marked in the schedule.
14. Advance against travelling expenses
Many times, the insurance companies provide funds to their employees as
advance towards travelling expenses. Following are the steps of verifying the
same for the purpose of finalisation:
 The schedule, showing the items of travelling expenses which are
unadjusted, should be prepared and tallied with the balance in the Principal
Ledger.
 All efforts should be made to adjust the advance before the accounts are
closed.
 The adjustments made subsequently should be marked in the schedule as
“subsequent adjustements”.
 Explanatory note should be added where the adjustments have not been made
before the accounts are closed.
 Provision for travelling expenses should be made in the accounts as
outstanding expenses for an amount equal to the total amount appearing as
outstanding in the above Accounts as at the close of the accounting year.
This should be reversed in the next year.
 Care should be taken to see that the bills settled subsequently and accounted
for as outstanding expenses are not included in this provision.
15. Telephone deposits
For obtaining the telephone connection, some funds need to be deposited with the
concerned department. The said deposit can be verified using the following steps
for finalisation:
 In case of payments made for OYT (Own Your Telephones) telephones,
1/20th of the original payment should be debited to the telephone expenses
account, and the telephone deposits account should be correspondingly
credited in the books.
 A schedule should be prepared and tallied with the balance in the Principal
Ledger.
 343

16. Sundry deposits (recoverable)

Any other sundry deposits should be verified using the following steps for the
purpose of finalisation:

 Schedules should be prepared and tallied with the balance in the Principal
Ledger.
 Confirmation of the deposit should be obtained from the parties concerned to
the effect that they hold the amount in deposit as at the close of the
accounting year.

17. Prepaid expenses

For prepaid expenses for the part of the current assets, the following steps are
laid down to verify the same for finalisation:

 This account is used only at the time of the closing of accounts and the
entries are reversed in the next financial year.
 Expenses incurred during one financial year, the benefit of which is spread
over to next financial year, should be brought into account by debiting this
account and crediting the appropriate expense account e.g. Telephone rental,
motor and fire insurance premium etc.

18. Advance to agents

All advances (interest bearing and non-interest bearing) to agents should be

adjusted towards commission earned by them, and should figure in the schedule.

19. Deferred expenditure

Certain expenses which would provide benefits over a period of time should be
recognised on ‘deferred’ (postponing) basis. Following are the typical expenses
which are deferred:
 Transportation charges of machines purchased by the company should be
added to the cost of machines.
 Importation and transportation charges incurred on machines which have
been acquired on rental basis should appear under this account and should be
written off to revenue over a period of years. The amount so written off
should be debited to carriage and freight.
 344

20. Sundry advances

Sundry advances refer to the loans or advances given for reasons other than those
mentioned above. Following aspects need to be verified before finalizing the
same:
 Schedules of Sundry Advances given and repayment of the same should be
prepared and tallied with the balance in the Principal Ledger.
 Every effort should be made to clear the items under the head “Sundry
Advances” before the year ends.
 Dates of adjustments subsequent to the close of the accounting year should
be marked in the Schedules and an explanatory note should be given in
respect of items remaining unadjusted for more than a month.
Liabilities
21. Outstanding claims
 All Maturity Claims in respect of which the date of maturity is the last day of
the accounting year say 31st March or earlier should be included in the
maturity Claims Intimation Register.
 Intimations of Death Claims received subsequent to the close of the
accounting year, and relating to deaths which took place on or before the last
date of the accounting year, should be included in the Death Claim
Intimation Register for March.
 A schedule of outstanding claims should be extracted from the Death Claims
and Maturity Claims Intimation registers after a complete check of the entries
relating to the payments is made.
 The totals of the schedules should be tallied in the following manner:

Students should note that the following calculation forms the core for
calculations of claims outstanding as on the date of the balance sheet. The format
presented must be learnt as it is.
No. Amt
Claims outstanding at the beginning of the year (Net)
Add: Claims Intimated during the year (Gross)
Less: Net claims paid during the year
Less: Amount adjusted for netting of claims
Less: Claims written Back during the year
Less: Claims repudiated during the year
Claims outstanding at the end of the year (Net)
 345

22. Sundry creditors

The Schedule should include all items under different heads of Account other
than those shown separately in the Printed Accounts. The accounts of identical
nature falling under one head, say outstanding commission on first year’s
premium and renewal premium, salaries etc. should appear separately in the
schedule of Sundry Creditors. The Proforma of the Schedule is given hereunder:

Particulars of Sundry Creditors including Outstanding and Accruing

expenses as at ………………..

Amount
Sr.No. Particulars
Rs.
Outstanding Expenses :
(a) Commission First year
(b) Commission Renewal
(c) Bonus Commission to Agents
(d) Bonus Commission to Dev. Officers
(e) Allowances to Agents other than Commission
(f) Salary, D.A. & House Rent Allowance etc.
(g) Travelling Expenses
(h) Telephone Charges
(i) Electricity Charges
1.
(j) Medical Fees
(k) Rents of other Offices occupied by the Corporation
(l) Postage and Telegrams
(m) Stationery & Printing
(n) Law Charges
(o) A.M.C Charges
(p) Tabulating Machines Rental & Maintenance
(q) Motor Car Expenses under various schemes
(r) Policy Stamps
(s) Other items to be specified.
2. Salaries unpaid
3. Income-tax on Salaries
4. Co-operative Society Deductions
5. Insurance Premium Deductions
6. Motor Car Deposit Deductions under various schemes
7. Licence Fee Deductions
8. Other Deductions from Salaries
9. Interest on Staff Security Deposit
 346

10. Rent Deposit Repayable

11. Cheques Cancelled Account
12. Agents Balances
Earnest Money and Retention Money received from
13.
Contractors
14. Agents' Licence Fee Stamps Recovery Account
15. Loan Bond Stamp Recovery Account
16. Security Deposits from Contractors
17. Other Sundry Deposit
18. Other Items to be specified
19 Other Sundry Creditors as per Statement attached

Particulars of Other Sundry Creditors referred to in Statement of Sundry

Creditors as at ……………

Outstanding
Name of the Amount
Sr.No. since Remarks
Creditor Rs.
(date)
1.
2.
3.
4.
5.

Total

Outstanding expenses

 Proper provision should be made for all expenditure relating to the year
ending which remains unpaid on that date.

 The procedure recommended is that in respect of all payments made

subsequent to close of the accounting year say 31st March, the vouchers
relating to the expenditure of the previous year should be rubber
stamped “outstanding”. For this purpose the payments made up to 30 th
April are to be scrutinized.
 347

 Notwithstanding this, all known expenses relating to previous year which

might not have been paid before 30 th April should be taken under this
head of Account, e.g. if the goods have been already delivered during the
accounting year but the bills are not received for some reason or other, the
provision should be made as outstanding expenses even though the bills are
not settled till close of the accounting year.

 As far as possible, payment vouchers in respect of expenses relating to the

previous accounting year should be prepared separately. Simultaneously
with the payment, a rough schedule relating to the outstanding
expenditure should be filled, giving alongside the date of payment. Just
before the schedule is closed and the entry relating to Outstanding Expenses
Account is taken to the Books, the entry should be made in the Schedule for
all outstanding bills on hand which relate to the previous financial year or
which include expenditure chargeable to the previous financial year, but not
paid.

Any expenses for which bills have not been paid as disclosed by the Register or
other records should also be included in the outstanding expenses for which the
above entry is made.

Outstanding accounts and bills of capital nature

Schedule should be prepared on the same lines, as mentioned above, for such
bills as for outstanding expenses, but the credit will be to “Provision for
outstanding Accounts and Bills of Capital nature” Account and not to
outstanding expenses account.

Such bills should be brought into the accounts only if the relevant assets have
been delivered on or before the close of the accounting year and taken in stock.

Outstanding commission

The following items should be taken into account whilst providing for
outstanding commission (First year, Renewal and Bonus).
 348

a) All commission bills prepared prior to the last date of the accounting year
which remained unpaid by that date:
 A detailed schedule of all such bills pending should be prepared, taking care
to include bills that might be paid in the next accounting year but before the
preparation of the schedule.
 Where bills remained unpaid because the eligibility of the agent to receive
commission has not been determined, the bills should be included in the
schedule but where the bills have remained unpaid because the agent was not
eligible to receive commission, only the bills in respect of which the agency
was likely to continue and the commission was likely to be paid should be
included.
b) Commission bills prepared subsequent to the close of the accounting year but
relating to premiums received and adjusted prior to close of the accounting
year:
 Special effort should be made to prepare these bills and make payment as
soon as possible and at the same time to prepare a schedule which will be
entered simultaneously with the bills being prepared and before payment is
made.
 The schedule will be closed when all the bills relating to premiums adjusted
up to and including the last date of the accounting year have been prepared.
c) Bonus Commission Bills for Agents whose agency year ended on or before
the last date of the Accounting year:
These Bills will be dealt with in the same manner as the commission bills
referred to in (a) and (b) above.

Further, estimated provision for outstanding bonus commission to Agents in

respect of 1st year’s premium income from closing of the Agency year till the end
of the accounting year should be made.

A schedule should be prepared for all agents who are qualified for Bonus
Commission in the accounting year and provision should be made for such bonus
commission on the premium income from the close of the agency year to the end
of the accounting year at the rate of bonus commission earned by the agent for
the Agency year which ended during the financial year.
 349

d) Commission on Outstanding Premiums:

Commission should be provided on the outstanding premiums in the following

manner :

 First Year’s commission ............................................. 20%

 Bonus Commission ………………………………. 8%
 Renewal Commission ……………………………. 5%
However some insurance companies are calculating commission through
system, hence they can take commission on actual basis.

23. Unpaid salary account

A Schedule should be prepared and if there are any items more than a month old
as at the close of the accounting year, necessary Explanatory Note should be
added to the Schedule.

24. Cheque cancelled account

 Before finalizing the schedule, it should be ensured that the Bank

reconciliation for the month of March is done, so that all cheques issued
up to end of December, which are not encashed till March end, are
cancelled as stale cheques and entered in this schedule.
 Necessary action should be taken to clear off as many items as possible.
Proper schedule duly reconciled should be prepared.

25. Amounts due to the trustees of staff provident fund and pension fund

 Under the above heading the amounts realized from the staff being their
contributions towards the Provident Fund, Additional Provident Fund, P.F.
Loan Deduction, P.F. Loan Interest Deduction and Pension Fund Deductions
not handed over to the trustees of the Provident Fund or Pension Fund should
be included.
 The provision for Company’s Contribution to Provident and Pension Fund
should be included under this head and not under outstanding expenses.
 350

26. Contingent liability

 The liability should be shown in respect of all pending suits filed against the
Company and for which no liability has been provided in the Books of
Account, by way of a foot-note below the Balance Sheet.
 As far as the contingent liability in respect of claims is concerned, it arises
out of repudiated claims for which the claimants have taken legal action
against the Company in the Court of Law.
 Only net amount of claims payable after deducting the recovery of dues from
Sum Assured and Bonus is to be noted as a contingent liability.

Contingent Liability may have also to be indicated in respect of (a) uncalled

capital on investments and (b) account of underwriting of shares and debentures.
This is done in the consolidated Balance Sheet prepared by the Central Office of
LIC.

Extract from the annual accounts of LIC for the year 2010-11, relating to
‘contingent liabilities’ appearing in the notes to accounts
Claims
The claims settled and remaining outstanding for a period of more than 6 months
as on the balance sheet date:(As certified by the Management).

Number Amount
(in lacs)
Current Previous Current Year Previous Year
Year Year
Claims by 4222 3062 1687 1446
death
Claims by 611226 509074 68035 49951
maturity

A liability against all pending suits in the court of law must:

A Be shown as a current liability.
B Be shown as a disclosure in auditor’s report.
C Be shown as a footnote to the balance sheet (contingent liability)
D Not be shown anywhere.
 351

The first step in the reconciliation of bank balances as per books with the bank
balances as per bank statement is:

A Obtaining certificate of balances from all the banks that have the insurer’s
account.
B Clearing stale cheques.
C Writing off old balances
D Not to be shown anywhere.

Which of the following statements is true with respect to finalization and

verification of ‘cash balance’?

A Supplementary cash book must not be incorporated in the main cash book.
B Imprest cash system should be followed for huge cash balances
C Imprest cash system should be followed for small cash balances.
D Stamp records fall under ‘cash’ records

One of the peculiar features in case of finalizing and verifying the expenses is
that:

A The amount of expense should tally with the amount in the principal ledger
B The amount of expense needs reconciliation with the amount in the principal
ledger.
C The amount of expense should tall with the amount of revenue
D The amount of expense need not tally with the amount in the principal
ledger.

Importation and transportation charges of machines purchased by the company

should be:

A Deducted from the cost of machines

B Added to the cost of machines
C Shown as an expense
D Shown as a deduction from revenue.
 352

From the following balances as at 31 st March 2008 given in the books of National
Life Assurance Co. Ltd. Prepare Profit and Loss account and Balance Sheet as on
that date.

Particulars ‘000 Particulars ‘000

Life Assurance fund as on

34,00,000 Agent's Balances 18000
1st April 2007
Annuities paid (in India Advances to ceding
81750 47000
72,500) companies
General Reserve 2,25,000 Due from re-insurers 38500
Deposit with Reserve
Bank:
- Government securities
2,10,000
- Indian Government Due to re-insurers 47500
securities 10,90,000
- Foreign Government 75,000
securities
Loan on company's policies 2,10,000 Sundry Creditors 1800

Leasehold buildings 63300 Premiums : First Year 5,90,000

Securities on which interest
is guaranteed by the 4,50,000 Premiums : Renewal 1,20,000
government
Stocks of shares of
companies incorporated in 14,50,000 Reinsurance accepted 50000
India
Share Capital (20,000
20,00,000 Reinsurance ceded 70000
shares @ Rs. 100 each)
Interim bonus to
Mortgages in India 14,32,500 22500
policyholders
 353

Commission :
- On Direct : First Year
40,500
Cash with Bankers on - Renewal
Current Account 40,500 - On Reinsurance 2,000
12,000
accepted
4,000
- On Reinsurance ceded
Cash with Bankers on
Deposit (short-term) 20000 Claims
account
--By death (In India
Cash in hand 7000 2,00,000
1,30,000)
State Government --By maturity (In India
7,25,000 2,20,000
securities 1,40,000)
Furniture and Fixtures 39000 Bank Loan 21750
Outstanding premiums 66000 Salaries 30400
Auditor's fees 5000
Law charges 3400
Rent paid 3600
Other management
750
expenses
Travelling expenses 1950
Interest and rents
1,95,000
received (gross)
Proposed dividend @
10%

Transfer the surplus amount if any to Life Fund for the year ended 31 st March
2008. Dividend at the rate of 5% was also proposed.
 354

Solution

In the books of National Assurance Co. Ltd

Form A-RA
Revenue Account for the year ended 31 st March 2008
Policyholder’s account (Technical account)
Particulars Schedule Current Previous
Year Year
(Rs.'000) (Rs.'000)
Premiums earned - net
(a) Premium 1 7,10,000
(b) Re-insurance ceded (70,000)
(c) Re-insurance accepted 50,000
6,90,000

Income from investments

(a) Interest, Dividends & Rent - Gross 2,16,000
(b) Profit on sale redemption on
---
investments
(c) Loss on sale redemption on
---
investments
(d) Transfer/gain on revaluation change
in
(e) fair value* ---
Other income (to be specified) ---
Total (A) 9,06,000
Commission 2 50,500
Operating expenses related to insurance
business 3 45,500
Other Expenses (to be specified) ---
Provisions (other than taxation)
(a) For diminution in value of
---
investments
(b) Others (to be specified) ---
Total (B) 96,000
Benefits Paid (Net) 4 5,01,750
Interim Bonuses paid 22,500
 355

Change in valuation of liabilities against

life policies in force
(a) Gross ** ---
(b) Amount ceded in re-insurance ---
( c) Amount accepted in reinsurance ---
Total (C) 5,24,250
Surplus/ (Deficit) (D)= [(A) - (B) - (D)] 2,85,750
Appropriations :
Transfer to Shareholder's funds ---
Transfer to Other Reserves (to be
specified) ---
Transfer to funds for future
appropriations 1,85,750
Total (D) 1,85,750

Form A – PL
Profit and Loss Account for the year ended 31 st March 2008
Shareholder’s Account (Non-technical Account)

Particulars Schedule Current Previous

Year Year
(Rs.'000) (Rs.'000)
Balance brought forward from/transferred
2,85,750
to the policyholder's account (technicalA/c)
Income from investments
(a) Interest, Dividends & Rent - Gross ---
(b) Profit on sale/redemption of
investments ---
(c) (Loss on sale/redemption of
---
investments)
Other income (to be specified) ---
Total (A) ---
Expense other than those directly related
to the insurance business ---
Provisions (other than taxation)
(a) For diminution in the value of
---
investments
 356

(b) Other (to be specified) ---

Total (B) ---
Profit/Loss before tax 2,85,750
Provision for taxation ---
Profit/Loss after tax 2,85,750
Appropriations:
(a) Brought forward from the balance
---
sheet
(b) Interim dividends paid during the year ---
( c) Proposed final dividend 1,00,000
(d) Dividend distribution on tax ---
(e) Transfer to reserves/other accounts 85,750
Profit carried forward to balance sheet 1,85,750

Notes:

 In case of premiums less reinsurance in respect of any segment of insurance

business of total premium earned, the same shall be disclosed separately.
 Premium income received from business concluded in and outside India shall
be separately disclosed.
 Re-insurance premiums whether on business ceded or accepted are to be
brought into account gross (i.e before deducting commissions) under the
head re-insurance premiums.
 Claims incurred shall comprise claims paid, settlement costs wherever
applicable and change in the outstanding provision for claims at the year-end.
 Items of expenses and incomes, in excess of one percent of the total
premiums (less re-insurance) or Rs. 5,00,000 whichever is higher, shall be
shown as a separate line item.
 Fees and expenses connected with claims shall be included in claims.
 Under the sub-head “Others” shall be included items like foreign exchange
gains or losses and other items.
 Interest, dividends and rentals receivables in connection with the investment
should be stated as gross amount, the amount of income tax deducted at
source being included under advance taxes paid and taxes deducted at source.
 Income from rent shall include only the realized rent. It shall not include any
notional rent.
 357

Form A – BS
Balance Sheet As On 31st March 2008
Shareholder’s Account (Non-technical Account)

Particulars Schedule Current Previous

Year Year
(Rs.'000) (Rs.'000)
(A) Sources of funds
Shareholder's Funds
Share Capital 5 20,00,000
Reserves and Surpluses 6 38,10,750
Credit/(Debit) Fair value change account
Sub-total 58,10,750
Borrowings 7 69,250
Policyholder's funds ---
Credit/(Debit) Fair value change account ---
Policy liabilities ---
Insurance reserves ---
Provision for linked liabilities ---
Sub-total 69,250
Funds for future appropriations ---
Total 58,80,000

(B)Application of funds

Investments 8 40,00,000
(Shareholder's and Policyholder's)

Assets held to cover linked liabilities

Loans 9 16,42,500
Fixed Assets 10 1,02,300
Current Assets
Cash and bank balances 11 67,500
Advances and other assets 12 1,69,500
Sub-total (A) 2,37,000
 358

Current Liabilities 13 1,800

Provisions 14 1,00,000
Sub-total (B) 1,01,800
Net Current Assets ( C) = (A) - (B) 1,35,200
Miscellaneous Expenditure
(to the extent not written off or adjusted) ---
Debit balance in Profit and loss A/c
(Shareholder's account) ---
Total 58,80,000

Schedules forming part of financial statements

Schedule 1

Premium

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. First Year Premiums 5,90,000

2. Renewal Premiums 1,20,000
3. Single Premiums ---
Total Premiums 7,10,000

Notes:

Reinsurance premiums whether on business ceded or accepted are to be brought

into account, before deducting commission, under the head re-insurance
premiums.
 359

Schedule 2

Commission Expenses

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)
Commission paid
Direct - First year premium 40,500
- Renewal premiums 2,000
- Single premiums ---
Add: Commission on re-insurance accepted 12,000
Less: Commission on re-insurance ceded (4,000)
Net Commission 50,500

Notes:

The profit/commission, if any, is to be combined with the reinsurance accepted or

reinsurance ceded.

Schedule 3

Operating expenses related to insurance business

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. Employees remuneration and welfare

30,400
benefits
2. Travel, conveyance and vehicle running
1,950
exp.
3. Rent, rates and taxes 3,600
4. Repairs ---
5. Printing and Stationery ---
6. Communication expenses ---
7. Legal and professional charges 3,400
 360

8. Medical fees ---

9. Auditor's fees, expenses etc 5,400
(a) as auditor
(b) as advisor or in any other capacity, in
respect of
(i) Taxation matters
(ii) Insurance matters
(iii) Management services, and
(c) in any other capacity
10. Advertisement and publicity ---
11. Interest and Bank charges ---
12. Others (to be specified) 750
13. Depreciation ---
Total 45,500

Notes:

 Items of expenses in excess of one percent of the net premium or Rs.

5,00,000, whichever is higher, shall be shown as a separate line item.
 Under the sub-head “others”, operating expenses (insurance business) shall
include items like foreign exchange gains or losses and other items.

Schedule 4
Benefits Paid (Net)

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)
1. Insurance Claims
(a) Claims by Death 2,00,000
(b) Claims by maturity 2,20,000
(c) Annuities/Pensions in payment 81,750
(d) Other benefits, specify ---

2. (Amount ceded in reinsurance)

(a) Claims by Death ---
 361

(b) Claims by maturity ---

(c) Annuities/Pensions in payment ---
(d) Other benefits, specify ---

3. Amount accepted in reinsurance

(a) Claims by Death ---
(b) Claims by maturity ---
(c) Annuities/Pensions in payment ---
(d) Other benefits, specify ---

Total 5,01,750

Benefits paid to claimants

1. In India 3,42,500
2. Outside India 1,59,250
Total Benefits paid (Net) 5,01,750

Notes:

 Claims include claims settlement costs, wherever applicable.

 The legal and other fees and expenses shall also form part of the claims costs,
wherever applicable.

Schedule 5

Share Capital

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. Authorised Capital
Equity Shares of Rs. ...... Each

2. Issued Capital
Equity Shares of Rs. ...... Each
 362

3. Subscribed Capital
Equity Shares of Rs. ...... Each 20,00,000

4. Called - up Capital
Equity Shares of Rs. ...... Each

5. Less : Calls Unpaid

Add : Shares forfeited (amount originally paid
up)
Less: Par Value of equity shares bought back
Less: Preliminary expenses
Expenses including commission
Underwriting or subscription of shares

Total 20,00,000

Notes:

 Particulars of the different classes of capital should be separately stated.

 The amount capitalised on account of issue of bonus shares should be
disclosed.
 In case any part of the capital is held by a holding company, the same should
be separately disclosed.
 363

Schedule 5A

Pattern of Shareholding (As certified by the management)

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)
No. of % of No. of % of
Shares holding Shares holding

Promoters
----Indian
----Foreign
Others

Total

Schedule 6
Reserves and Surpluses

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. Capital reserve
2. Capital redemption reserve
3. Share premium
4. Revaluation reserve
5. General reserve 2,25,000 2,25,000
Less: Debit balance in profit and loss A/c
Less: Amount utilised for buy back
6. Catastrophe Reserve
7. Other reserves (to be specified) Life fund 35,85,750 34,00,000
8. Balance of profit in profit and loss A/c --- ---
Total 38,10,750 36,25,000
 364

Notes:

Additions to and deductions from the reserves should be disclosed under each of
the specified heads.

Schedule 7
Borrowings

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. Debentures/Bonds ---
2. Fixed Deposits ---
3. Banks 21,750
4. Financial institutions ---
5. Other entities carrying on insurance business 47,500
6. Others (to be specified) ---
Total 71,050

Notes:

 The extent to which the borrowings are secured shall be separately disclosed
stating the nature of the security under each sub-head.
 Amounts due within 12 months from the date of Balance Sheet should be
shown separately.
 365

Schedule 8
Investments

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

Deposit with the RBI 2,10,000

Indian government securities 10,90,000
State government securities 7,25,000
Foreign government securities 75,000
Securities guaranteed by the government 4,50,000
Stock and shares of companies incorporated
in India 14,50,000
Total 40,00,000

Note:

The classification of investments as desired by schedule 8 and 8A of the format

can’t be done due to non-availability, of formation of shareholder’s and
policyholder’s investments. Therefore, investments are shown as follows
(included as total figure in the balance sheet)
 366

Schedule 9
Loans

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. Security-wise classification
Secured
(a) On mortgage of property
(aa) In India 14,32,500
(bb) Outside India ---
(b) On Shares, bonds, Govt. securities etc. ---
Unsecured
(a) Loans against policies 2,10,000
(b) Others to be specified ---
Total 16,42,500

2. Borrower-wise classification
(a) Central and State government ---
(b) Bank and financial institutions ---
(c) Subsidiaries ---
(d) Companies ---
(e) Loans against policies ---
(f) Others to be specified ---
Total

3. Performance-wise classification
(a) Loans classified as standard
(aa) In India
(bb) Outside India
(b) Non-standard loans less provisions
(aa) In India
(bb) Outside India
Total
 367

4. Maturity-wise classification
(a) Short-term
(b) Long-term
Total 16,42,500

Notes:

 Short-term loans shall include those that are repayable within 12 months
from the date of balance sheet. Long term loans shall be the loans other than
the short term loans.
 Provisions against non-performing loans shall be shown separately.
 The nature of the security in case of all long term secured loans shall be
specified in each case. Secured loans for the purposes of his schedule, means
loans secured wholly or partly against an asset of the company.
 Loans considered doubtful and the amount of provision created against such
loans shall be disclosed.

Schedule 10
Fixed Assets

Particulars Gross Block/ Depreciation Net block

Cost
(Rs.'000) (Rs.'000) (Rs.'000)

Goodwill
Intangibles (specify)
Land-freehold
Leasehold property 63,300
Buildings
Furniture and fittings 39,000
Information technology
Equipment
Vehicles
Office equipment
Others (specify nature)
Total 1,02,300
 368

Notes

Assets included in land, property and building above exclude investment

properties as defined in note (e) to Schedule 8

Schedule 11
Cash and bank balances

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

1. Cash (including cheques, drafts and stamps) 7,000

2. Bank balances
(a) Deposit accounts
(aa) Short-term (due within 12 months of the
20,000
date of balance sheet)
(bb) Others

(b) Current accounts 40,500

(c) Others (to be specified)

3. Money at call and short notice

(a) with banks
(b) with other institutions

4. Others (to be specified)

Total 67,500
 369

Schedule 12
Advances and other assets

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

Agents balances 18,000

Outstanding premiums 66,000
Advances to ceding companies 47,000
Due from reinsurers 38,500
Total 169,500

Schedule 13
Current Liabilities

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

Sundry Creditors 1,800

Schedule 14
Provisions

Particulars Current Previous

Year Year
(Rs.'000) (Rs.'000)

Proposed Dividend 1,00,000

 370

From the following balances appearing in the books of Alpha Life Insurance Co.
Ltd. prepare the Trial balance as at 31 st March 2010.

Amount
Sl.No. Head of Account
(in hundred Rs.)

1. L.I. Fund at the beginning of the year 5,00,000

2 Premium Deposits 11,500
3. Building Depreciation Account 3,000
4. Commission Paid 2,505
5. Income-Tax paid 4,500
6. Expenses of management 31,000
7. Sundry Creditors 3,500
8. Loans on Policies 32,500
9. Dues from Agents 1,000
10. Contingency Reserve 1,500
11. Taxation Provision 3,000
12. Interests, Dividends & Rents 18,000
13. Registration & Other Fees 20
14. Advance Payment of Income-Tax 500
15. Refunds of Income tax 600
16. Furniture & Office Equipment Depreciation 400
Reserve A/c.
17. Sundry Deposits 1,000
18. Printing & Stationery Expenses 770
19. Loans on Mortgages 1,500
20. Consideration for Annuities granted 20
21. House Property at Cost 54,000
22. Cash & Stamps on hand 300
23. Claims paid during the year :
Death Claims 22,000
Maturities 15,000
24. Furniture & Office equipment at cost 2,500
25. Sundry Debtors 500
26. Income tax on Int., Div & Rents 5,000
27. Cash with Banks on Current A/c. 13,500
28. Surrenders 400
29. Investments 5,20,000
 371

30. O/s Claims at the beginning of the year :

Death 9,000
Maturity 6,000
31. Premiums 1,50,000
32. Sundry Deposits with Electric Co. 5
33. Annuities Paid 60

Solution:

Trial Balance of Alpha Insurance Co.Ltd. as at 31 st March, 2010

Credit
Sr No. Head of Account Debit
Rs. In Hundreds
1. Life Insurance Fund as at 1.4.1990 * 5,00,000 ( R)
2. Premium Deposits 11,500 (BS)
3. Building Depreciation Account 3,000 (BS)
4. Commission paid 2,505 ( R)
5. Income-tax paid 4,500 ( R)
6. Management Expenses 31,000 ( R)
7. Sundry Creditors 3,500 (BS)
8. Loans on Policies 32,500 (BS)
9. Dues from Agents 1,000 (BS)
10. Contingency Reserve 1,500 (BS)
11. Taxation Provision (Reserve) 3,000 (BS)
12. Interest, Dividends & Rents 18,000 ( R)
13. Registration & Other Fees 20 ( R)
14. Advance payment of Income-tax 500 (BS)
15. Refunds of Income-tax 600 ( R)
16. Furniture & Office Equipments reserve 400 (BS)
17. Sundry Deposits 1,000 (BS)
18. Printing & Stationery Expenses 770 ( R)
19. Loans on Mortgages 1,500 (BS)
20. Consideration for annuities granted 20 ( R)
21. House Property at cost 54,000 (BS)
22. Cash & Stamps on hand 300 (BS)
23. Annuities paid 60 ( R)
24. Death Claims paid 22,000 ( R)
25. Maturity claims paid 15,000 ( R)
26. Furniture & Office equipments at cost 2,500 (BS)
 372

27. Sundry debtors 500 (BS)

Income tax on Interest, Dividends
28. 5,000 ( R)
&Rents
29. Cash with banks on Current Account 13,500 (BS)
30. Surrenders 400 ( R)
520,000
31. Investments
(BS)
Outstanding Claims at the beginning of
32.
the year :
Death 9,000 (BS)
Maturity 6,000 (BS)
33. Premiums 1,50,000 ( R)
34. Sundry Deposits with Electric Co. 5 (BS)

Total 7,07,540 7,07,540

*The Closing balance of this head of account will find a place both in the
Revenue Account and in the Balance Sheet of the Company

Write the Journal Entries in respect of the following annual closing entries as at
31st March2010 :

Rs.

i) Renewal premium outstanding 20,28,000

Commission thereon 65,000
ii) Expenses Outstanding 60,000
iii) Prepaid Expenses 15,000
iv) Int., Div & Rents O/S 30,000
v) Int., Div & Rents Accruing 3,50,000
vi) Depreciation on Buildings. 45,000
vii) Depreciation on Furniture 15,000
viii) Provision for Taxation 1,10,000
 373

Solution:

Journal
Date J.V. Particulars L.F. Debit Credit
No. No. Rs. Rs.

31.3.10 (i) (a) Renewal Premium (B/S) 20,28,000

Outstanding Dr. (Asset)
20,28,000
To Renewal Premium (R) (Income)

(Being the entry for making

necessary provision for
renewal premium outstanding
as at 31st March 91)

(b) Renewal Commission A/c. (R) 65,000

Dr. (Outgo)
To Outstanding Renewal 65,000
Commission (BS) (Liability)

(Being the entry for providing

commission on the outstanding
Renewal Premiums as at 31st
March2010)

(ii) Management Expenses (R) 60,000

Dr. (Outgo)
To Outstanding Expenses 60,000
(BS) (liability)
(Being the entry for providing
for the outstanding expenses
for which payments have not
been made till 31st March 91)
 374

(iii) Prepaid Expenses (B/S) 15,000

Dr. (Asset)
To Management Expenses 15,000
(R) (To be
(Being the entry for deducted
appropriating a portion of the from
Management Expenses Management
pertaining to the succeeding Exp. In
financial year) Outgo)

(iv) Interest, Dividends & Rents (B/S) 30,000

(v) O/S Dr. (Asset)
3,50,000
Interest, Dividends & Rents (B/S) (Asset)
Accruing Dr. 3,80,000
(Income)
To Interest, Dividends & Rents (R)

(Being the entry for making

provision for Int., Div & Rents
O/S & accrued as at 31st March
91 – not received up to 31.3.
2010)

(vi) Depreciation transferred to (R) 45,000

(vii) Reserve for Building Dr. (outgo)
Depreciation on furniture 15,000
(R) (outgo)
To Reserve for Building Dr. 45,000
(Liability)
To Furniture (B/S) 15,000
(To be
(Being the entry for providing (B/S) deducted
Depreciation on Buildings and from the
Furniture for the financial year relevant
2009-10) Asset A/c. in
the Balance
Sheet)
 375

(viii) Income-tax Provision (R) 1,10,000

Dr. (Outgo)
To Provision for Income-tax 1,10,000
(B/S) (Liability)
(Being the entry for IT
Provision for the financial year
2009-10)

From the following balances appearing in the Principal Ledger of Sunny Life
Insurance Co.Ltd., as at 31 st March 11, prepare the Trial Balance as at 31st March
11

Amount
Sr.
Head of Account (Rupees in
No.
Lakhs)

1. Share Capital 500

2. General Reserve 41
3. Reserve for bad & doubtful debts 589
4. Reserve for House Property 1,718
5. Investment Reserve 5,285
6. L I Fund as at 1.4.90 5,81,809
7. Amount due to other Ins. Cos. 12
8. Sundry Creditors 23,878
9. Premium and other Deposits 4,310
10. Loans on Policies 2,72,474
11. Investments 3,72,627
12. House Property at cost 7,050
13. Agents’ Balances dues to the co. 401
14. Sundry Debtors 9,871
15. Cash & Bank balances 17,005
16. Furniture and fittings 1,431
17. Prepaid expenses 55
18. Claims by Death 6,869
19. Claims by Maturity 17,845
20. Annuities paid 492
21. Surrenders 4,858
22. Management Expenses 23,200
23. U K & Other Taxes 3,195
 376

24. Loss on realization of assets 298

25. First Year’s Premium 14,879
26. Renewal Premium 68,840
27. Single Premium 2,903
28. Consideration for Annuities granted 2,112
29. Interest, Dividends & Rents 30,437
30. Outstanding claims written back 166
31. Outstanding Deposits written back 99
32. Sundry receipts 49
33. Exchange (credit) 44

Solution

Trial Balance of Sunny Life Ins.Co.Ltd., as at 31 st March,2011

Sl.No. Head of Account Debit Credit
Rs. In Lakhs

1. Share Capital 500

2. General Reserve 41
3. Reserve for Bad & Doubtful Debts 589
4. Reserve for House Property 1,718
5. Investment Reserve 5,285
6. Life Assurance Fund as at 1.4.90 5,81,809
7. Amount due to other Insurance Cos. 12
8. Sundry Creditors 23,878
9. Premiums & Other Deposits 4,310
10. Loans – Policies 2,72,474
11. Investments 3,72,627
12. House Property at Cost 7,050
13. Dues from Agents 401
14. Sundry Debtors 9,871
15. Cash and Bank Balances 17,005
16. Furniture & Fittings 1,431
17. Prepaid Expenses 55
18. Claims by Death 6,869
19. Claims by Maturity 17,845
20. Annuities Paid 492
21. Surrenders 4,858
22. Management Expenses 23,200
23. UK & Other Taxes 3,195
 377

24. Loss on realization of assets 298

25. First Year Premium 14,879
26. Renewal Premium 68,840
27. Single Premium 2,903
28. Consideration for annuities granted 2,112
29. Interest, Dividends & Rents 30,437
30. Outstanding Claims written back 166
31. Outstanding Deposits written back 99
32. Sundry Receipts 49
33. Exchange 44

Total 7,37,671 7,37,671

Write the adjustment/journal entries in respect of the following closing entries as

31st March 11 in the books of Sunny Life Insurance Co. Ltd

1. Provide for Reserve for Doubtful Debts in respect of sundry debtors Rs. 21
lakhs
2. Provide 2% as reserve for House Property.
3. Annuities due and unpaid amount to Rs. 15 lakhs.
4. Premiums outstanding in respect of renewal premiums Rs. 7753 lakhs.
5. Interest, Dividend & Rents accruing but not due as at 31 st March 91
amounted to Rs. 11200 lakhs.
6. Interest, Dividend & Rents outstanding as at 31 st March 11 Rs. 7500 lakhs.
7. Outstanding Management Expenses amount to Rs. 200 lakhs
8. Repudiated claims which are not recognised as liability Rs. 400 lakhs.

Solution:
Journal entries in the books of Sunny Life
Insurance Co. Ltd.
(Amt in Rs.)
Sr.
Particular Debit Credit
No
i) Transfer To Reserve For Bad & 21,00,000
Doubtful Debts … (Revenue) ….. (outgo)
To Reserve for Bad & Doubtful 21, 00,000
Debts (B/S) (Liability)
(Being the entry for making provision for Bad & Doubtful debts as at 31.3.11).
 378

ii) Depreciation transferred to Reserve for 1,41, 00,000

H.P. (Revenue) … (outgo)
To Reserve for House 1,41, 00,000
Property………..
(B/S)……….Liability………
(Being the entry for providing for Depreciation in respect of House Property as at
31.3.11)

iii) Annuities paid 15,00,000

account…………(Revenue)……………. (outgo)
To Annuities due & Unpaid 15,00,000
A/c………… (B/S)……….. (Liability)
(Being the entry for making necessary provision in the books in respect of
Annuities due & unpaid as at 31-3-11)

iv) Outstanding Premium 77,53,00,000

A/c……..(B/S)…….. (Asset)
To Renewal Premium 77,53,00,000
A/c… ..... (Revenue)…… (Income)
(Being the entry for providing for Renewal Premium due but not received as at
31.3.11)

v) Interest, Dividends & rents accruing 1,12,00,00,000

………(B/S)………. (Asset)
Interest, Dividends & Rents outstanding 75, 00, 00,000
………. (B/S)………. (Asset)
To Interest Dividends & 1,87,00,00,000
Rents……. (Revenue)…….. (Income)
(Being the entry for making provision in respect of the above mentioned two
items in the books as at 31-3-11)

vi) Management Expenses…… 2,00,00,000

(Revenue)…….. (outgo)
To Outstanding Expenses…….. 2,00,00,000
(B/S)………. (Liability)
(Being the entry for making provision as at 31-3-91 in respect of expenses
pertaining to the financial year 1990-91 but paid after 31-3-11)

vii) No entry shall be passed in respect of this item. However, a note shall be
made after the Balance Sheet under the heading “Contingent Liability”.
 379

From the following Trial balance of Mr. Santosh as at 31-12-2010 prepare Final
Accounts after making the necessary adjustments. Also give the closing and
adjusting entries.

Trial Balance
(Amount in Rs)
Debit Credit

Capital account - Santosh 30,000

Drawing account - Santosh 2,600
Plant and Machinery 12,000
Stock on 1-1-2010 5,000
Purchases 35,000
Sales 50,000
Return Inwards 2,000
Return Outwards 1,000
Sundry Debtors 8,000
Sundry Creditors 6,000
Carriage Inwards 500
Carriage Outwards 500
Wages 3,000
Salaries 2,000
Factory Rent 200
Office Rent 500
Insurance 500
Discount received 600
Discount allowed 300
Furniture 2,000
Bad debts 400
Commission 300
Building 8,000
Bills payable 2,000
Bills receivable 6,000
Cash on hand 200
Cash at bank 600

89,600 89,600
 380

Adjustments

a) Closing stock Rs.20,000.

b) Prepaid Insurance Rs.200.
c) Outstanding wages Rs.300, Salary Rs.200.
d) Interest on capital 5%.
e) Additional bad debts Rs.400.
f) Reserve for doubtful debt at 5% and Reserve for discount on debtors at 5%.
g) Reserve for discount on creditors at 2%.
h) Interest on drawing account at 6% for 6 months only.
i) Commission earned but not received Rs.200.
j) Rent Outstanding (office) Rs.400.
k) Depreciation is to be provided 10% on furniture, and plant and machinery.
l) Appreciation on building at 10%.

Solution

Mr. Santosh's
Trading Accountfor the year ended 31-12-2010
Dr. Cr.
Particulars Rs. Rs. Particulars Rs. Rs.

To Opening stock 5,000 By Sales 50,000

Less : Return
To Purchases 35,000 2,000 48,000
Inwards
Less : Return
1,000 34,000
Outwards
To Carriage 500
Inwards
To Wages 3,000
Add : Outstanding 300 3,300
To Factory Rent 200 By Closing Stock 20,000
To Gross Profit 25,000
(transferred to
Profit & Loss
A/c.)

68,000 68,000
 381

Profit and Loss Account for the year ended 31-12-2010

Particulars Rs. Rs. Particulars Rs. Rs.

To Carriage 500 By Gross Profit 25,000

Outward b/d
To Salaries 2,000 By Discount
Add : Outstanding 200 2,200 Received 600
To Office Rent 500 By Reserve for
Add : Outstanding 400 900 Discount 120
on creditors
To Insurance 500 By Interest on 78
Less : Prepaid 200 300 Drawing
To Discount 300 By Outstanding
allowed Commission 200
To Bad debts 400 By Appreciation
Add : Additional 400 800 on Building 10% 800
To Reserve for
doubtful debts 380
To Commission 300
To Interest on 1500
Capital
To Reserve for
Discount on 361
Debtors
To Depreciation
on Plant & 1,200
Machinery 200 1,400
Furniture
To Net Profit 17,857

26,798 26,798
 382

Mr. Santosh's
Balance Sheet as on 31-12-2010
Liabilities Rs. Rs. Assets Rs. Rs.

Capital 30,000 Plant & Machinery 12,000

Add: Interest on
capital (5%) 1,500 Less: Depreciation
Add : Net Profit 17,857 (10%) 1,200 10,800
49,357
Less : Drawing Sundry Debtors 8,000
2600 Less : Additional
Add : Interest on 2,678 46,679 Bad Debts 400
Drawing 6%
78
7,600
Sundry Creditors 6,000 Less: Reserve for
Less : Reserve for 120 5,880 Doubtful Debts 380
Discount (5%)
Bills Payable 2,000 7,220
Outstanding
Expenses 300
Wages 200 Less : Res. for
Salaries 400 900 Discount on 361 6859
Rent Debtors 5%
Furniture 2,000
Less : Depreciation 200 1,800
10%
Building 8,000
Add : Appreciation 800 8,800
10%
Bills Receivable 6,000
Cash on Hand 200
Cash at Bank 600
Prepaid Insurance 200
Outstanding 200
Commission
Closing Stock 20,000

55,459 55,459
 383

Summary
 Every life insurance company has to prepare Revenue Account as per Form
A-RA., Profit and Loss Account as per Form A-PL., Balance sheet as per
Form A-BS., and Receipt and payment A/c.
 Every life insurance company shall have to follow the accounting standards
issued by the ICAI while preparing its financial statements.
 It is to be remembered that any premium received by an insurer is not its
income as such. Rather, the company is creating liabilities against policies.
 The value of investment property shall be determined at historical cost,
subject to revaluation at least once in every three years.
 Debt securities shall be considered as held to maturity securities and shall be
measured at historical cost subject to amortization.
 Loans shall be measured at historical cost subject to impairment provision.
 Preparation of financial statements does not achieve its intended purpose
unless appropriate and reasonable disclosures are made at the right place.
 Insurers can lay down accounting policies in line with the Accounting
Standard -17 and the Regulations issued by the Authority.
 No catastrophe reserves have been prescribed by the IRDA till now.
 The insurers are required to deduct the preliminary expenses from the paid
up equity share capital as indicated in Schedule 5 of the Regulations
 The expression "liability" shall include all liabilities in respect of expenditure
contracted for and all disputed or contingent liabilities.
 Any debit balance of the Profit and Loss Account shall be shown as
deduction from uncommitted reserves and the balance, if any, shall be shown
separately.
 The main purpose of the management report is to assure the readers of the
financial statements about the business and financial prudence observed by
the management while carrying out the business of the insurance company.
 The auditors will be verifying cash on hand as at close of the accounting
year.
 There should be no attempt to reconcile Bank Accounts by transferring any
un-reconciled balances to “Suspense Account”.
 There should be a physical stock checking of stock on hand of printed forms
and Stationery, other Stationery, publicity material remaining unused,
saleable Literature and Publicity materials, stock of Building materials.
 Schedule of policy loans as at the close of the year should be extracted from
the loan ledgers.
 The schedule showing salaries paid in advance should be prepared.
 384

 All advances (interest bearing and non-interest bearing) to agents should be

adjusted towards commission earned by them, and should figure in the
schedule.
 Outstanding accounts and bills of capital nature should be brought into the
accounts only if the relevant assets have been delivered on or before the close
of the accounting year and taken in stock.
 Only net amount of claims payable after deducting the recovery of dues from
Sum Assured and Bonus is to be noted as a contingent liability.

Answers to Test Yourself

Answer to TY 1

The correct answer is C.

The liability on policies has to be determined by the appointed actuary. Actuary
is a professional who uses certain mathematical and statistical techniques to
determine the value of the said liability.

Answer to TY 2

The correct answer is D.

All the securities are transferred to policyholders account at cost or market price,
whichever is lower. This is in line with the principle of conservatism. It prohibits
from booking unrealized profits in the books of accounts.

Answer to TY 3

The correct answer is D.

The debit balance in Profit and loss account (which means a loss) has to be
adjusted by reduction from any uncommitted reserve.

Answer to TY 4

The correct answer is B.

Management’s report has to certify than an internal audit system is in place,

which is commensurate with the size of the company.
 385

Answer to TY 5

The correct answer is C.

A liability with respect to pending suits in the courts should be shown as a

contingent liability and should be disclosed as a foot note to the balance sheet.

Answer to TY 6

The correct answer is A.

The first step in the reconciliation of bank balances as per books with the bank
balances as per bank statement is obtaining a certificate of balances from all the
banks having the insurer’s account. Without this step, the process of
reconciliation cannot commence.

Answer to TY 7

The correct answer is C.

It is true that imprest cash system should be followed for small cash balances.
Supplementary cash book must be incorporated in the main cash book. Stamp
records fall under ‘cash’ records only.

Answer to TY 8

The correct answer is A.

One of the peculiar features in case of finalizing and verifying the expenses is
that the amount of expense should tally with the amount in principal ledger. If it
does not tally, there is some error in the accounting procedure.

Answer to TY 9

The correct answer is B.

Importation and transportation charges of machines purchased by the company

should be added to the cost of machines. This is because it is treated as a
‘deferred’ expenditure and hence capitalized.
 386

Self Examination Questions

Question 1
No bonus can be paid to policyholders out of:
A Free Reserve
B Revaluation Reserve
C General Reserve
D Profit & Loss Account
Question 2
Premium income received from business concluded in and outside India should:
A Not be disclosed
B Be clubbed together before disclosure.
C Be separately disclosed
D Be recognized but not disclosed.
Question 3
Income from rent should include:
A Only realized rent.
B Only notional rent.
C Both, realized and notional rent.
D Neither realized nor notional rent.
Question 4
First year’s commission on outstanding premium is:
A 8%
B 15%
C 10%
D 20%
Question 5
The vouchers relating to the expenditure of the previous year should be rubber
stamped as:
A Prepaid
B Outstanding
C Paid.
D Not paid.
 387

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

Revaluation reserve cannot be utilized for payment of bonus to policyholders,

since that would imply distribution of funds out of unrealized profits.

Answer to SEQ 2

The correct answer is C.

The premium received from business concluded in and outside India should be
separately disclosed. Other options are not right with respect to such premium
incomes.

Answer to SEQ 3

The correct answer is A.

Income from rent includes only the rent which has been actually realized. It must
not include the notional rent.

Answer to SEQ 4

The correct answer is D.

First year’s commission on outstanding premium is at the rate of 20%.

Answer to SEQ 5

The correct answer is B.

The vouchers relating to the expenditure of the previous year should be rubber
stamped as “Outstanding”.
 388

CHAPTER 8

BUDGET AND BUDGETARY CONTROL

Chapter Introduction
This chapter aims to provide an understanding of budgeting. Planning an optimal
budget requires realistic forecasts, proper analysis of available historical data and
the ability to make smart estimates. Budgets help the organisation to forecast
what will be the future financial result if certain strategies or changes are
implemented.

a) What is a budget?
b) Explain the types of budgets.
c) Explain how budgeting is done in an insurance company.
d) Describe budgeting activity and performance budget.
e) Explain performance review and financial ratios.
 389

1. What is a budget?
[Learning Outcome a]
1.1 Budget

A budget is a basic instrument of planning. It involves mere calculations of facts

and figures to project financial outcome in the future. For any organization, a
budget is an essential tool for financial management of the business.

Budget is a measurable statement of a definite period of time, which includes

planned revenues, expenses, assets, liabilities and cash flows for a company.

Normally, it is prepared at the start of the financial period, which translates as

long term objectives to be achieved in a definite period. It is a useful yardstick to
measure the achievements at the end of each period and also to monitor the
progress.

 A budget is prepared and approved before the start of the accounting period
(known as the budget period).

The budget for the year 2012 needs to be prepared before the start of 2012, i.e. by
the end of year 2011.

 It is all about planning for the future period and controlling the activities
(and in turn the costs) of an organisation by pursuing management policies.

 It is a quantitative / financial statement with an action plan. In other words,

it is a business plan, normally expressed in monetary terms.

 A budget includes statements showing income, expenditure, cash flow and

the capital to be employed.
 390

1.2 Budgetary Control

A budgetary control system is a means of monitoring revenue and costs and

thereby exercising control in an entity by developing budgets and comparing
budgeted figures with actual results.

1. Budgetary control consists of the following:

a) Determine the objective to be achieved. The objective may be to have bigger

profits, better financial position or better presence in the market.

b) Identify the steps necessary in order to achieve the objectives and work out a
detail course of action with exact planning.

c) There should be an actual conversion of the course of action into quantitative

and monetary terms. This means preparation of budget should actually take
place.

d) Time to time comparison of the actual budget should be done in order to

remove any failings, depletions or losses and set it on track to achieve good
outcomes.

XYZ Ltd has given the reponsibilty to Ram to prepare a budget for the company,
keeping in mind the shortcomings they faced in their last budget, which need to
be ovecome, resulting in better profits and improved financial performance.

2. Objectives and advantages of Budgetary Control

a) The objectives of budgetary control are as follows:

i) To design and control income and expenditure of a business and trading

operations.

ii) To forecast the capital expenditure of the business.

iii) To plan and control the outflow on research and development.

 391

iv) Make arrangements for the financing of operations so as to have enough

working capital as and when required.

v) Understand the actual profitability of the organisation and how the business
might perform if certain policies or changes are made.

Thus, budgetary control mainly has three different purposes:

 forecast of income and expenditure (and thereby profitability)

 instrument for decision making
 means to monitor business performance

b) The advantages of budgetary control are:

i) Minimize all losses and wastages to have better and much improved
efficiency.

ii) Provide motivation to achieve organisational goals and set targets on which
the performance of the people will be judged.

iii) Better planning and control of the work so there is no delay in execution.

iv) To keep a check on the amount of the expenditure that has been budgeted. If
the expenditure crosses the budgeted amount, it should be analyzed even
before it’s incurred.

v) Appropriate classification of the actual work that all the people have to do.
There should be no overlapping and no work should be left unfinished.

The budget should clearly classify work to be done by lower level of

manangment (e.g. foreman) and the top management (e.g. departmental heads)
which give effective control on the business.

vi) Comparison of actual and budgeted performance which will show where
supervision is needed.
 392

Diagram 1: Advantages of budgets

3. Requirements of a sound budgetary system

Before embarking on the budgeting exercise, certain important requirements are

to be looked at. These are:

a) Objectives to be achieved must be determined and should be in respect of

growth and profitability.

b) The period of budget must be fixed. Usually, a budget is drawn for a year.

c) Factors that usually affect the working of the organisation must be identified.
Normally, sales are a limiting factor, but sometimes other factors like capital,
problems with labour or raw materials also have an impact on the working of
an organisation.

d) Before the budget is implemented, all people at the management levels

should be consulted, and their approval is necessary.

e) Budget should be flexible and it should be in a way that can be molded into a
new budget with further changes to it. It should adapt quickly if the actual
business conditions differ from what was expected.
 393

f) A proper person must be appointed as ‘Budgetary Controller’ or just as

controller or management accountant, whose duty will be to:

 Draw budgets in time and do necessary change if required.

 Compare the actual and budgeted performances and identify any shortfall
or losses.

The actual performance of the drawn budget is monitored by the budgetary

controller or management accountant. Any discrepancy has to be reported to the
higher officials.

What are the three basic purposes of budgetary control?

2. Explain the types of budgets.

[Learning Outcome b]
A budget, as discussed earlier, is a complete, proper plan that estimates the
possible expenses and income for an organization during a specific period.
Different organisations have different types of budgets. In the case of
manufacturing business accounting, a series of budgets are prepared and used by
the management. Some budgets are small, used just for quick reference, whereas
some are detailed, and need proper action and study.

2.1 The main types of budgets are as follows:

1. Sales budget

The sales department is responsible for making the sales budgets which includes
the various products, periods and areas. With the help of past trends, facts and
figures, the sales budget is estimated for the future.

The contribution of all the members of the organisation is necessary as the sales
forecasting is the initial stage, and involves:

 People accountable for leading the entire budgeting and planning and with
leadership, direction, and correctness to the expected forecast.
 394

 Introduction of new products and improvement in the existing products

needs help from the production and the policy departments.

 Finally, the approval and support of top executives for the plan.

The sales budget is very important while planning; any inaccuracy in this has a
huge impact financially. Hence, proper steps should be taken to develop the sales
budget. The sales budget is expressed in terms of number of units and expected
revenue.

Following is an example of Sales budget for ABC Co.

Quarter
1 2 3 4

Budgeted Sales of
10,000 40,000 25,000 60,000
boxes

Selling price per box Rs.25 Rs.25 Rs.25 Rs.25

Expected total
250,000 10,00,000 6,25,000 15,00,000
sales

2. Production budget

After the sales budget has been drawn by the sales department, the production
budget is prepared. It specifies the needed quantity of units that has to be
manufactured in each budget period so that the products are available for sale.
While deciding the production budget, inventory levels in each budget period are
crucial and hence, inventories must be calculated and added carefully. There
should be no unnecessary inventory held, and at the same time, there should be
no shortfall.
 395

Continuing the above example of ABC Co, below is an example of the

production budget.

Quarter
1 2 3 4

Budgeted Sales 10,000 40,000 25,000 60,000

(+) Desired inventory

needed (15% of the next
quarter sales) 6,000 3,750 9,000 5,000*
Total 16,000 43,750 34,000 65,000
(-) Beginning inventory
of finished goods ** 1,500 6,000 3,750 9,000
Required production 17,500 37,750 30,250 56,000
*Assume to be 5,000 units
**beginning inventory in each quarter is the same as the prior quarter's
ending inventory

3. Purchase and Materials Budget

When the required quantity of sales is determined, the purchase department

comes up with the purchase and material budget after the production budget has
been prepared. The volume of material required is determined by the output
budget i.e. the sales budget.

To determine the minimum and maximum stock level, Last in First out (LIFO) or
First in first out (FIFO) methods are used by an organisation.

The budget helps to maintain the minimum and maximum stock needed from
time to time so that the material is available and the production does not stop.
It is necessary to have a complete list of required materials to produce one unit of
finished product. Purchase budgets are a part of decision making and thus, very
important in deciding the level of inventory.
 396

Continuing the above example of ABC Co, below is the purchase and material
budget

Quarter
1 2 3 4

Required production 17,500 37,750 30,250 56,000

Raw material needed for each

Rs.15 Rs.15 Rs.15 Rs.15
box

Production needed 2,62,500 5,66,250 4,53,750 8,40,000

(+) Desired inventory needed
(5% of the next quarter 28,312 22,687 42,000 40,000*
needs)
Total 2,90,812 5,88,937 4,95,750 8,80,000
(-) Beginning inventory of
13,125 28,312 22,687 42,000
finished goods **
Raw materials to be
2,77,687 5,60,625 4,73,063 8,38,000
purchased
Cost of Raw Material (Rs.) 0.20 0.20 0.20 0.20
Cost of Raw Material
55,537 1,12,125 94,613 1,67,600
Purchased
*Assume to be 40,000 units
**beginning inventory in each quarter is the same as the prior
quarter's ending inventory
 397

4. Work Expense or Labour Budget

Labour budget is prepared from the production budget. Labour is classified as

direct or indirect, and labour budget considers direct labour. It determines the
available labour time for the budgeted production. Inconsistent labour strategies
lead to uncertainty, little confidence, and waste.

The time and motion study department helps to determine how much labour is
needed to produce one unit of output. Apart from labour, various other expenses
of production are divided into the following categories:

 Fixed Expenses
 Variable Expense
 Semi-Variable Expense

Continuing the above example of ABC Co, below is the work expense and labour
budget
Quarter
1 2 3 4

Required production 17,500 37,750 30,250 56,000

Direct labour hours per

0.30 0.30 0.30 0.30
box (Rs.)

Total labours hours

5,250 11,325 9,075 16,800
needed

Direct labour cost per

12 12 12 12
hour (Rs.)
Total Direct Labour
63,000 1,35,900 1,08,900 2,01,600
Cost
 398

5. Office and Administrative Budget

Other expenses that are not a part of the manufacturing expenses are included
under the office and administrative budget. All work expenses and office
expenses that cannot be added to the manufacturing expense are included here.

6. Development and Research Budget

Apart from the existing products for sale, there should be a budget that estimates
the cost for research of new products and development of existing products. New
and improved methods of production must be used.

7. Capital Budget

To have an exact estimate of production, it’s important to have a list of

requirements of machine time for the production of one unit of output. If the
management thinks that the present capacity is not sufficient and they need to
increase the production, new plant and machinery will need to be purchased or
some work will need to be outsourced. To decide this, management needs to
prepare a capital budget keeping in mind the required production.

8. Cash Budget

Cash budget is the most important budget for the management. Cash budget is a
comprehensive statement showing how the cash funds will be generated and how
they will be spent. It is prepared after all the functional budgets are ready. Cash
budget shows the inflows and outflows of cash in the organisation.

The four important parts of the cash budget are:

 receipts (i.e. collection/cash inflow)

 payouts (i.e. payments/cash outflow)
 cash surplus or deficit
 financing

Cash sales, other receipts, dividend, interest income or disposal of asset are all
examples of cash inflows.

Cash purchases, other payments, management expenses, tax payment, dividend

payment, purchase of capital asset etc. are examples of cash outflows.
 399

After all, the operational activity of cash inflows and outflows is done if there is
any cash surplus or deficit it should be reported to the management. The
management then should take a decision if any additional working capital is
required in case of deficit or if there is any surplus of cash, the management
should decide if investments are to be made or how to maintain the extra cash.

9. Master Budget

The master budget is a summary of all the budgets of an organisation strategy

which gives targets for sales, manufacture, distribution and financing activities.
It’s a detailed statement of all the activities of the organisation describing how it
will perform in future, with steps to achieve all the goals.

The five main parts are:

 Operating Budget
 Capital Budget
 Expenditure Budget
 Cash Budget
 Projected financial position.

Diagram 2: Types of budget

 400

2.2 Budget review and Flexible budget

1. Budget review

The budget that has been prepared needs to be reviewed constantly to check and
be sure that there are no discrepancies or any other shortfall which may lead to
deviation in the budget. The budget loses its importance, and it is of no use if its
not been reviewed. Review, control and comparison is sine-qua-non of budgeting
excerise.

2. Flexible Budget

Normally a fixed budget or static budget is inflexible as its based on one level of
activity and a particular set of strict conditions which do not change and are not
helpful for contol. But a flexible budget is opposite to this; the word flexible
itself means elastic. A flexible budget is designed in a such way that it can adapt
to any condtions and provide information for different levels of activty.

It is prepared when it is difficult for an organisation to make a firm decision or

forcast the future. This is not because of the firm’s lack of management policy
but due to circumstances that are beyond the control of management.

Diagram 3: Flexible budget

 401

In a flexible budgeting system, it is necessary to have budgets:

 that quickly adapt and change to suit the conditions

 analysis of the behaviour costs and expenses to have a rock solid flexible
budget
 where fixed expenses do not change with any moderate changes in output or
sales
 where appropriate study of all expenses is carried out that might have an
impact on the budget if changes are done
 to suit actual conditions

What two methods are used by an organisation to maintain the minimum and
maximum level of inventory?

A LIFO and FIFO

B Weighted Average Cost and LIFO
C FIFO and Weighted Average Cost
D None of the Above

3. Explain how budgeting is done in an insurance company.

[Learning Outcome c]
We have already studied budgets and why they are necessary. Manufacturing
entities normally are required to make a budget as they are involved with
production of goods. But in case of the insurance industry, which does not
manufacture any product, the main concern is to sell insurance, which is their
business.

3.1 Budgeting in an insurance company

In an insurance company, budgeting is restricted to New business, Revenue and

Expenditure (source of income is the premium and main outflow is claims,
commission to agents and management expenses) and Capital Asset. For an
insurance company, control is applied to management expenses as related to
premium of income. Under LIC, Branch offices are concerned with preparation
of estimates of New Business which can be procured and premium generated
from it. The Head office is concerned with preparation of Revenue and Capital
budgets.
 402

The role of Branch office at the base has undergone a sea change after the
reorganisation of offices in LIC. A Branch office is now treated as:
a) Growth Center
b) Profit Center
c) Single window Servicing Center

A Branch office is like a full-fledged Accounting Unit; hence the performance of

the Branch office is considered not only from the angle of total business but also
from the viewpoint of contribution made by the Branch office.

Main objectives of a Branch office are:

 to give agreed level of contribution from business
 to give satisfactory level of service to policy holders at reasonable cost

Thus, the Branch office is concerned with the increase in the profit by increase in
the level and mix of business, keeping the cost of administration at a specific
level. For this, a ‘Planning and Performance Budgeting’, a detailed budget, has
been introduced in LIC.

3.2 Planning and Performance Budgeting

Planning means looking in advance and marking out upcoming developments

that are to be followed. It involves selecting Enterprise Objectives, Department
Goals, Performance Targets and ways to achieve the targets in the given
timeframe. The main aim of LIC is to make life insurance accessible easily and
to everyone, specifically to people from rural areas and to give cover at rational
cost to the socially and economically backward class.

Thus we can say that to achieve these objectives, a short tem plan as well as a
long term plan of growth is essential. The long term plan is typically of 3 years
and involves preparation of profile of the Branch office whereas the short term
plan is a Performance budget of 1 year only. A Performance budget is like the
Master Budget.

3.3 Socio-economic profile

To assess the likely growth of New business, the Divisional Office will help
branch offices to make a profile showing:
 403

Diagram 4: Socio-economic profile

While planning for the budgeting, the preparation of the profile of the Branch
office is a long term plan of and short term plan of for the
performance budget.

A 2.5 years and 1.5years

B 1.5 years and 2 years
C 3 years and 1 year
D 1 year and 3 years
 404

4. Describe budgeting activity and performance budget.

[Learning Outcome d]
4.1 Budgeting Activity

i) Before the commencement of the financial year, the Chairman of LIC will
issue guidelines 2-3 mths in advance. He will analyze the overall economic
situations and trends, specifying corporate goals to be achieved in all key
areas like New Business, Premium Income, Claims Operation, Clearance of
Policy Deposits etc.

ii) On the basis of the above guidelines, each Zonal Office will frame its own
guidelines to correspond to circumstances in various Divisional /Branch
offices in its jurisdiction.

iii) When Branches have prepared their performance budget, they will submit it
to the Divisional Office. The divisional office will then analyze the budget
and hold a discussion with each Branch Manager. After the budget is agreed
upon by all, then the Budget for the Divisional Office will be prepared.

iv) The Divisional Office in turn will discuss their budget with the Zonal Office,
and after the Zonal Budgets are completed by the Central office, the
Divisional Office will be informed of the approved budgets.

Budgets prepared under this are expected to have much better and superior
degree of participation and commitment on the part of concerned employees and
will have a favourable motivational influence in organisation.

4.2 Performance Budget

We have already studied that the Branch office prepares a short term budget of 1
year, called the performance budget. The performance budget can be divided into
four main parts:
 The Growth Budget
 The Finance Budget
 Customer Service Budget
 Capital Budget
 405

Diagram 5: Performance Budget

 406

4.3 Divisional Office Budget

Under the restructured system of working, the Divisional office does not have a
source of income other than the income earned by way of interest on mortgage
loan and rent. Thus, the budget of the divisional office is mainly an Expenditure
Budget whereas the Finance budget is prepared with Income, Expenditure, and
customer services in a combined, collective proposal.

The consolidated budget is then discussed with the Zonal Authorities and the
same strategy is planned for the entire zone; the budget is then finalized for all.

The Chairman of LIC will issue guidelines in advance.

A 3-4 months
B 1-2 months
C 2-3 months
D 2-4 months

5. Explain performance review and financial ratios.

[Learning Outcome e]

5.1 Performance Review

A Budget is prepared to plan and forecast the strategy for an organisation. Thus,
a budget is prepared with all details and figures to achieve goals that are put
before the organisation. After the budget is prepared and approved by the person
responsible, it is broken down into monthly targets, and thus, is a ‘live’
document.

This live document is monitored to see whether it is on the right path and there
are no discrepancies in it. If the budget is not reviewed, it loses its importance.
Hence, actual comparisons with the budgeted figures are necessary. All Branches
and divisional offices are required to send observation report in the form of
monthly and quarterly reports (as per the Report Format) to the controlling
Divisional and Zonal Offices.
 407

After the re-organised set-up, the Branch Office is an operating unit and the
Divisional Office is the controlling office.

The Divisional offices have to evaluate any variations between the actual and
targeted figures by classifying them into margianl, fairly large or very wide.They
also have to find the resasons for the lack of performance and adopt corrective
measure.

5.2 Critical Financial Ratios

Financial ratios express the relationship between two accounting figures in

quantitative terms. The ratios help to bring close facts to light and recognize the
financial strengths and weaknesses. Thus the ratios are used to compare
performance between two units, in accordance with statutory limits wherever
relevant, with fixed targets. Performance of a branch can be easily reviewed by
comparing the critical ratios.

The different types of ratios that are required by the branch office while
preparing budget targets are as follows:

i) Average First Premium per thousand = Sum assured

ii) Average First Year Premium per thousand = Sum assured

 408

iii) Renewal Expense Ratio.

The Statutory Limit for the above Expense ratio is 15%

iv) Overall Expense Ratio.

v) Conservation Ratio of Renewal Premium.

The good Conservative Ratio varies between 96% to 98%.

vi) Percentage of Maturity Claims outstanding (including Survival Benefit)

to Claims due (Numbers only).
 409

vii) Percentage of Death Claims outstanding to Claims intimated (Numbers

Only)

viii) Percentage of Outstanding Deposits

5.3 Management Information through budget.

The idea of the Budget and Review is to accomplish the objectives agreed to by
each unit. A Monthly Report in the Reporting Format to Zonal Office and Central
Office is submitted by Divisional Offices on the basis of performance. This
report is like management information to the Zonal Office and Central Office.

The success of any business depends on the participation of all those who are
responsible for it. For an insurance company, to achieve the desired goal, every
member of the Supervisory Staff, other staff-members and Managers must
participate in the preparation of budgets and control of operations.

The Statutory Limit of Expense Ratio is .

A 15%
B 10%
C 20%
D 25%
 410

Summary

 Budget is a basic instrument of planning. It is based on simple calculations of

facts and figures.
 Evaluation of the actual budget should be done in order to remove any
shortcomings.
 Period of budget is fixed and is prepared for 1 year.
 Budgetary Controller controls and manages the budget on timely basis.
 Sales budget is expressed in terms of number of units and expected
revenue.
 Maintaining of inventory levels in each budget period are essential.
 Cash budget shows the inflows and outflows of cash in the
organization, and hence is an important budget for the organisation.
 Master budget gives out a complete list of aims of the organisation.
 Fixed budget or static budget is inflexible as it is based on one level of
activity.
 Flexible budget is elastic and based on different levels of activity.
 LIC has introduced ‘Planning and Performance Budgeting’.
 Statutory Limit for Renewal Expense ratio is 15%.
 Conservative Ratio varies between 96% and 98%.
 Divisional Offices have to submit Monthly Report to Zonal and Central
Offices.

Answers to Test Yourself

Answer to TY 1
The three main purposes of budgetary control are:
i) forecast of income and expenditure
ii) tool for decision making
iii) monitoring business performance
Answer to TY 2

The correct option is A.

The two methods used by an organisation to maintain the minimum and

maximum level of invetory are LIFO and FIFO.
 411

Answer to TY 3

The correct option is C.

Answer to TY 4

The correct option is C.

Answer to TY 5

The correct option is A.

Self-Examination Questions
Question 1

Under the re-organised set-up, the Branch office is the controlling office.

A True
B False

Question 2

The budget prepared by the Divisional office is mainly .

A Income Budget
B Growth Budget
C Expenditure Budget
D Capital Budget
 412

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

After the re-organised set-up, the Divisional office is the Controlling office and
the Branch office is the Operating office.

Answer to SEQ 2

The correct option is C.

There is no source of income for the Divisional office other than the income
earned by way of Interest on mortgage loan and rent. Thus, the budget of the
divisional office is mainly an Expenditure Budget.
 413

CHAPTER 9

INNOVATIVE CONCEPTS IN FINANCIAL

REPORTING

Chapter Introduction
This chapter aims to provide you with an understanding of the concept of value
added statement and its advantages and limitations. The chapter also discusses
the concept of human resource accounting and the different models of human
resource accounting.

a) Learn about value added statement.

b) Learn about human resource accounting.
 414

1. Learn about value added statement.

[Learning Outcome a]
1.1 Value Added Statement
Value added statement is considerably old and this is not a statement in itself.
Rather it is a part of financial statement which gives value to financial reporting.
Companies prepare value added statement as supplementary financial statement
in their annual report.

Value Added Statement is a supplementary financial statement that shows how

much value (wealth) a reporting entity has been able to create during a specified
period, through the utilisation of its capacity, capital, management, human
resources and other resources. The statement also shows how this value created is
distributed to different stakeholders involved.

In economic terms, value added is the market price of the output of an enterprise
less the price of the goods and services acquired by transfer from other firms.
Value added can provide a useful measure in the gauging performance of the
reporting entity.

1.2 Gross Value Added (GVA)

GVA is arrived at by deducting from sales revenue the cost of all materials and
services which were brought in from outside suppliers.
In simple terms
Value added (VA) = Value of output – Value of input
We arrive at Gross Value Added from following formula

R  S  B  Dep  W  I  T  DIV ..................... (1)

R = Retained profit
S = Sales revenue
B = Bought in cost of materials and services
Dep = Annual depreciation charges
W = Annual wage cost
I = Interest payable for the year
T = Annual corporate tax
Div = Total dividend payable for the year
 415

Rearranging the equation (1) we get GVA as below

S  B  R  Dep  W  I  T  DIV..................... (2)
However, if we see practically, GVA includes many other things. This includes
any direct income, investment income and extra ordinary incomes in addition to
sales revenue. After inclusion of above items we get following equation.
(S  Di)  B  Inv  EI  R  Dep  W  T  I  DIV
Where
Di = Direct income
Inv = Investment Income
EI = Extra Ordinary Income

Net Value Added (NVA)

NVA can be defined as GVA less depreciation.

Rearranging the equation (1) we can get NVA as below

[NVA  S  B  Dep  R  W  I  T  Dw]

Infosys: Value Added Statement

The following extract has been taken from the Infosys Annual Report 2009-10
Value Added Statement
In Rs. Crore
2010 2009 Growth %

Value-added
Income 22,742 21,693 4.8
Less: Operating expenses
excluding personnel costs
Software development and
business process 1,461 1,656
management expenses
 416

Selling and marketing

250 272
expenses
General and administration
1,085 1,165
expenses
2,796 3,093
Value-added from
19,946 18,600 7.2
operations
Other income (including
991 473
exceptional items)
Total value-added 20,937 19,073 9.8
Distribution of value-added
Human resources
Salaries and bonus 12,085 57.7 11,405 59.8 6
Providers of capital
Dividend 1,434 6.8 1,345 7.1 6.6
Minority interest – – – – –
Interest on debt – – – – –
1,434 6.8 1,345 7.1 6.6
Taxes
Corporate income taxes 1,681 8 919 4.8 82.9
Dividend tax 240 1.1 228 1.2 5.3
1,921 9.2 1,147 6 67.5
Income retained in business
Depreciation 905 4.3 761 4 18.9
Retained in business 4,592 21.9 4,415 23.1 4
5,497 26.3 5,176 27.1 6.2
Total 20,937 100 19,073 100 9.8

Note: The figures above are based on the consolidated Indian GAAP financial
statements.
 417

1.3 Advantages of Value Added (VA) Statement

Some of the advantages of VA statement are as follows:

a) Improves attitude of employees: Reporting on VA improves the attitude of

employees towards their companies, because the VA statement reflects a
broader view of the company’s objectives and responsibilities.

b) Productivity linked bonus scheme: Company can declare productivity

linked bonus scheme based on VA. The employees may be given
productivity bonus on the basis of VA / Pay will ratio.

c) Diagnostic and predictive tools: VA based ratios (e.g. VA / Payroll,

Taxation / VA, VA / Sales etc.) are useful diagnostic and predictive tools.
Trends in VA ratio’s comparison with other companies and international
comparison may be useful.

d) VA provides a very good measure of the size and importance of a

company.

e) Contribution to national income: VA statement links a company’s

financial accounts to national income. A company’s VA indicates the
company’s contribution to national income.

f) Basic conceptual foundation: VA statement is built on basic conceptual

foundation which is currently accepted in balance sheets and income
statements. Concepts such as going concern, matching, consistency and
substance over form are equally applicable to VA Statement.
 418

Diagram 1: Advantages of VA statement

1.4 Limitation of Value Added Statement

Following are the limitations of value added statement

a) Value added statement is non-standardised.

b) Value added statement cannot substitute the traditional income statement (i.e.
Profit and Loss A/c)
c) Value added statement shows the application of VA to several interested
groups (like employees, Government, shareholders etc.), however opponents
of VA statement says that since shareholders are the ultimate risk takers
more weightage should be given to shareholders which is not possible in VA
statement.
 419

Which of the following statement is correct with respect to calculation of net

value added?

A NVA = S + B + Dep = R – W – I – T – DW
B NVA = S – B – Dep = R – W – I – T – DW
C NVA = S – B – Dep = R + W + I + T + DW
D NVA = S + B + Dep = R + W + I + T + DW

2. Learn about human resource accounting.

[Learning Outcome b]
2.1 Human Resource Accounting

Human being is considered to be achievement of productivity, technology and

money. Human resource reporting is an attempt to
 identify,
 quantify and
 report
investment made in human resources of an organisation that are not presently
accounted for under conventional accounting practice.

American Accounting Association has defined human resource accounting as

“the process of identifying and measuring data about human resources and
communicating this information to interested parties”.

The necessity of human resource reporting arose mainly as a result of the

growing concern for human relation management in industry since sixties. The
treatment of human resources as asset is desirable with a view to ensuring
comparability and completeness of financial statements and more efficient
allocation of funds as well as providing more useful information to management
for decision making process.
 420

2.2 Models of Human Resources Accounting

Few models have been suggested for the purpose of valuation of human assets.

Diagram 2: Models of Human Resource Accounting

1. Cost based models

a) Capitalisation of historical costs

R. Likert and his associates at R. G. Barry Corporation in Ohio, Columbia

developed this model in 1967. The method involves capitalising all costs related
with making an employee ready for providing service i.e. recruitment, training
development etc. The sum of such costs for all the employees of the enterprise is
taken to represent the total value of human resources. The value is amortised
annually over the expected length of service of the individual employees. The
unamortised cost is shown as investment in human assets. If an employee leaves
the firm before the expected service life period, the net asset value to that extent
is charged to current revenue.

This model is simple and easy to understand and satisfy the basic principles of
matching cost and revenue.
 421

Disadvantages

 This model failed to provide reasonable value to human assets. It capitalises

only training and development costs incurred and ignores the future expected
cost to be incurred for their maintenance.

 This model distorts the value of highly skilled human resources. Skilled
employees require less training and therefore, will be valued at lesser cost.
Thus this model distorts the value of highly skilled human resources.

Generally, this model has not found favour with industry.

b) Replacement cost (Flamholtz Model – 1973)

Replacement cost indicates the value of sacrifice that an enterprise has to make to
replace its human resources by the identical one. Flamholtz has mentioned two
different concepts:

 Individual replacement cost

The individual replacement cost refers the cost that would have to be incurred to
replace an individual by substitute who can provide the same set of services as
that of the individual being replaced.

 Positional replacement cost

The positional replacement cost refers to the cost of replacing the set of services
required of any incumbent in a defined position. Thus, the positional replacement
cost takes into account the position in the organisation currently held by an
employee and also future position expected to be held by him.

However, determination of replacement cost of an employee is subjective and it

is often impossible. To find out an exact replacement is very difficult. The exit of
a top management person may substantially change the human asset value.
 422

2. Economic value models

a) Opportunity cost (Hekimian and Jones Model)

This model uses the opportunity cost i.e. if we put employee in alternative use, as
a basis for estimating the value of human resources, what will be value. In this
model, managers must bid for any scarce employee. A human asset, therefore,
will have a value only if it is a scare resource i.e. when its employment in one
division denies it to another division.

In this method the major drawback is circumstances in which managers may like
to bid for an employee would be rare.

b) Discounted wages and salaries approach (Lev and Schwartz Model –

1971)

This model was conceived by Lev and Schwartz in 1971. This model involves
determining the value of human resources as the present value of estimated future
earnings of employees (in the form of wages, salaries etc.) discounted by the rate
of return on investment (cost of capital).

c) Present value of future services approach (Flamholtz Model – 1971)

According to Flamholtz, an individual represents value to an organisation

because he is capable of rendering future services. Theoretically, therefore, his
value to an organisation is equal to the present worth of his expected future
services. There are two concepts of an individual’s value.

 Expected conditional value:

This is the amount an organisation can potentially realise from an individual if he

maintains organisational membership during the entire period of his productive
service life.

 Expected realisable value:

Since an individual may not stay in the organisation throughout the period of his
productive service life, another measure of value i.e. expected realisable value,
has to be worked out. This is the amount actually expected to be derived taking
into account the person’s likelihood of turnover.
 423

Valuation on group basis (Jaggi and Lau Model – 1974)

Jaggi and Lau proposed that proper valuation of human resources is not possible
unless the contributions of individuals as a group are taken into consideration. A
group refers to homogeneous employees whether working in the same
department or division of the organisation or not. An individual’s expected
service tenure in the organisation is difficult to predict but on a group basis, it is
relatively easy to estimate the percentage of people in a group likely to leave the
organisation in future. This model attempts to calculate the present value of all
existing employees in each rank.

2.3 Importance of Human Resource Accounting (HRA)

HRA makes a systematic and scientific attempt to measure the value of human
resource of an enterprise and presents the information in the financial statements
in order to communicate the change in the value of human resources.

Major objectives of introducing HRA systems are

1) To help the management in analysing investment in human resources and

thereby
 designing appropriate systems of recruitment,
 training and development and
 improving its decision-making in these areas of human resource
management

2) To evaluate whether the human resources are being properly utilised and
allocated and

3) To evaluate returns from the human assets

 424

Diagram 3: Objectives of HRA

2.4 HRA in India

Leading public sector units like OIL, BHEL, NTPC, MMTC, SAIL etc. have
started reporting ‘Human Resources’ in their Annual Reports as additional
information from late seventies or early eighties. Thus Indian companies adopted
the model of Human Resource Valuation propounded by Lev and Schwartz
(1971) with some modification because the Indian companies focused their
attention on the present value of employee earning as a measure of human
capital.

Infosys: Human Resource Valuation

The below extract has been taken from the Infosys Annual Report 2009-10

A fundamental dichotomy in accounting practices is between human and non-

human capital. As a standard practice, non-human capital is considered as assets
and reported in the financial statements, whereas human capital is mostly ignored
by accountants. The definition of wealth as a source of income inevitably leads to
the recognition of human capital as one of the several forms of wealth such as
money, securities and physical capital.

We have used the Lev and Schwartz model to compute the value of human
resources. The evaluation is based on the present value of future earnings of
employees and on the following assumptions:
 425

a) Employee compensation includes all direct and indirect benefits earned both
in India and overseas
b) The incremental earnings based on group / age have been considered
c) The future earnings have been discounted at the cost of capital of 10.60%
(previous year – 12.18%).

in Rs. crore, unless stated otherwise

2010 2009
Employees (no.)
Software professionals 1,06,864 97,349
Support 6,932 7,501
Total 1,13,796 1,04,850
Value of human resources
Software professionals 1,06,173 95,600
Support 7,114 6,533
Total 1,13,287 1,02,133
Total income 22,742 21,693
Total employee cost 12,085 11,405
Value-added 20,937 19,073
Net profits excluding exceptional items 6,218 5,988
Ratios
Value of human resources per employee 1 0.97
Total income / human resources value (ratio) 0.2 0.21
Employee cost / human resources value (%) 10.7 11.2
Value-added / human resources value (ratio) 0.18 0.19
Return on human resources value (%) 5.5 5.9
 426

Inflation Accounting

Inflation accounting is an accounting system that adjusts values for changes in

purchasing power. The system of inflation accounting should be such that with
minor modification, it will field the necessary information to moderate proper
management. It replaces conventional accounting system which works on
historical cost and does not take inflation into account.

Why inflation accounting required

As mentioned above, historical cost based accounts do not take inflation into
account. In hyper inflationary situation, profit of a company will be on higher
side if assets are purchased at lower cost and recorded on historical cost which is
not true, as replacement cost of assets will be much higher. Similarly historical
based accounting reflects assets at their historical cost instead of current cost. It
results in under-statement of net worth of an enterprise.

Inflation Accounting, therefore becomes necessary to enable the financial

statement maintain their utility. It is an attempt to account for the price level
changes and adjust the financial statement accordingly.

In India, Inflation Accounting has been used in a limited way. Only recently,
IRDA has come out with regulation that each life insurer should revalue its assets
once in 3 years to bring it near to current cost. However, this measure also does
not reflect inflation fully. The rate of inflation has been changing very fast and
presently it is rising day by day. Hence, according to experts, it is not considered
desirable to take cognizance of inflationary factors in accounting under the
present circumstances.

of human resource accounting indicates the value of sacrifice that

an enterprise has to make to replace its human resources by the identical one.

A Flamholtz Model (1973)

B Lev and Schwartz Model (1971)
C Jaggi and Lau Model (1974)
D Hekimian and Jones Model
 427

Summary
 Value Added Statement is a supplementary financial statement that shows
how much value (wealth) a reporting entity has been able to create during a
specified period, through the utilisation of its capacity, capital, management,
human resources and other resources.
 Gross Value Added is arrived from the following formula
R = S – B – Dep – W – I – T – Div
 Net Value Added can be defined as Gross Value Added less depreciation.
 Some of the advantages of VA statement are as follows:
 Improves attitude of employees
 Productivity linked bonus scheme
 Diagnostic and predictive tools
 Measure of the size and importance of a company
 Contribution to national income
 Basic conceptual foundation
 Limitation of Value Added Statement
 It is non-standardised
 It cannot substitute the traditional income statement
 Giving more weightage to shareholders in VA statement is not possible
 Human resource reporting is an attempt to identify, quantify and report
investment made in human resources of an organisation that are not presently
accounted for under conventional accounting practice.
 American Accounting Association has defined human resource accounting as
“the process of identifying and measuring data about human resources and
communicating this information to interested parties”.
 Cost based models of HRA include:
 Capitalisation of historical costs
 Replacement cost
 Economic value models of HRA include:
 Opportunity cost
 Discounted wages and salaries approach
 Flamholtz model
 Jaggi and Lau model
 Inflation accounting is an accounting system that adjusts values for changes
in purchasing power.
 Inflation accounting is an attempt to account for the price level changes and
adjust the financial statement accordingly.
 IRDA has issued regulation that each life insurer should revalue its assets
once in 3 years to bring it near to current cost.
 428

Answers to Test Yourself

Answer to TY 1

The correct answer is C.

Net value added is calculated as follows
NVA = S – B – Dep = R + W + I + T + DW

Answer to TY 2

The correct answer is A.

Flamholtz Model (1973) of human resource accounting indicates the value of
sacrifice that an enterprise has to make to replace its human resources by the
identical one.

Self-Examination Questions
Question 1

Value added statement shows wealth created by a reporting entity through the
utilisation of its .

A Capital and human resources

B Human resources
C Other resources
D Capacity, capital, management, human resources and other resources

Question 2

Net value added can be defined as gross value added less

A Investment income
B Depreciation
C Extra ordinary income
D Total dividend payable for the year
 429

Question 3

Which of the following statement is correct with respect to value added

statement?

A Value added statement is standardised

B Value added statement cannot substitute the traditional income statement (i.e.
Profit and Loss A/c)
C Shareholders are given maximum weightage in value added statement over
other interested groups like employees, Government etc.
D Value added statement is non-standardised and can substitute the traditional
income statement (i.e. Profit and Loss A/c)

Question 4

Which of the following HRA model classified as a cost based model?

A Capitalisation of Historical Costs

B Opportunity Cost
C Discounted Wages and Salaries Approach
D Jaggi and Lau Model

Question 5

The Hekimian and Jones Model of HRA is known as

A Discounted wages and salaries approach model

B Present value of future services approach model
C Opportunity cost model
D Replacement cost model
 430

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is D.

Value added statement shows wealth created by a reporting entity through the
utilisation of its capacity, capital, management, human resources and other
resources.

Answer to SEQ 2

The correct answer is B.

Net value added can be defined as gross value added less depreciation.

Answer to SEQ 3

The correct answer is B.

Value added statement cannot substitute the traditional income statement (i.e.
Profit and Loss A/c).

Answer to SEQ 4

The correct answer is A.

Capitalisation of Historical Costs Model and Replacement Cost Model are

classified as Cost Based Models of HRA.

Opportunity Cost, Discounted Wages and Salaries Approach, Flamholtz Model,

Jaggi and Lau Model are classified as Economic Value Models of HRA.

Answer to SEQ 5

The correct answer is C.

The Hekimian and Jones Model of HRA is known as opportunity cost model.
 431

CHAPTER 10

ACCOUNTING STANDARDS
(APPLICABLE TO LIFE INSURANCE
COMPANIES)

Chapter Introduction
As with any profession, people who practice accountancy are expected to possess
certain expertise. Under this assumption, society accepts advice from
professional accountants in good faith and acts on this advice.
The main area in which this faith is evident is the reliance on financial statements
prepared by professional accountants. Readers should be able to accept them
without question and in turn base their decisions on them.

There has to be some mechanism to ensure that accounting work is performed

according to set principles and standards. Furthermore, an assurance is needed
that the assumed professional expertise does actually exist and is applied to the
work in hand. This is achieved by means of setting up accounting standards.

Accounting Standards are standards which are applicable to prescribed entities to

standardize their accounting procedure so that accounts of entities become
comparable with other entities engaged in similar lines of business and lay down
the principles on which accounting should be based.

This chapter aims to provide you with an understanding of the objectives of

accounting standards and the regulatory bodies which formulate the standards.
Furthermore, you will also get to know the basic contents of the accounting
standards which are applicable to insurance companies. An understanding of this
will facilitate your understanding of financial statements.

a) Explain the meaning and objectives of accounting.

b) Discuss the features of various accounting standards which are applicable
to life insurance companies.
 432

Following is an extract of the ‘significant accounting policies and notes forming

part of financial statements’ as on 31st march 2011 of United India Insurance Co.

Significant accounting policies

Accounting convention:
The Balance Sheet, the Profit and Loss Account, Revenue Accounts, Schedules
and Cash Flow Statement are drawn in accordance with the provisions of Section
11 (1A) of the Insurance Act, 1938, read with provisions of Sub-section (5) of
Section 227 of the Companies Act, 1956 and the Insurance Regulatory and
Development Authority (IRDA) Act, 1999 along with the instructions issued by
IRDA from time to time. The said statements are prepared on historical cost
convention and on accrual basis of accounting, comply with the Accounting
Standards referred to in Section 211(3C) of the Companies Act, 1956 to the
extent applicable, and also with the Insurance Regulatory and Development
Authority (Preparation of Financial Statements and Auditor's Report of Insurance
Companies) Regulations 2002, and conform to the practices prevailing in the
General Insurance Industry in India except as otherwise stated

This study guide will discuss the basic contents of the accounting standards and
the terminologies like ‘historical cost convention’, ‘accrual basis of
accounting’.

1. Explain the meaning and objectives of accounting.

[Learning Outcome a]
1.1 Concept of accounting standards
As all of us know that earlier each entity used to prepare its accounts as per its
suitability and preference. Some entities were using accrued method, some were
using cash method and some were using hybrid method. Every entity was using a
different method for different heads of income and expenditure. For example,
some entities were using W.D.V. method for depreciation and some were using
straight line method. Similarly, entities were using different methods for booking
expenses. However earlier, business used to be at a local level and ownership
used to be at proprietary level. There used to be a single line of business. Slowly
time has changed; each business is expanding its wings. Now, a number of
businesses are entering into foreign territories. For example, every big business
establishment like Tata, Birla, Reliance, Bharti, Jindal etc. has a business interest
outside India also.
 433

Moreover, now business establishments are diversifying into a number of

businesses. For example, earlier Reliance used to be dealing in textile, now they
have diversified into a number of businesses like Petrochemical, Retail, Finance
etc. Similarly, banks are entering into other businesses like Mutual Fund,
Insurance etc. As stated above, earlier businesses were controlled by family
members only, there was no public involved e.g. Birlas, Singhania, Modi etc.
Now, all big business establishments are issuing shares to public and ownership
in these businesses is quite diversified. However, Management has become more
professional and to some extent, transparent also.

Now, people want better reporting from these companies since it involves
their money and they wish to compare results with other entities.

Hence, the Apex Accounting body in India - the Institute of Chartered

Accountants of India - has taken the initiative in this regard to standardise
the Accounting procedure. Before detailing how ICAI took steps to standardize
accounts and how it is applicable to insurance companies, we should understand
what Accounting Standards are.

1.2 Objectives of Accounting Standards

Accounting Standards are standards which are applicable to prescribed entities to

standardize their accounting procedure so that accounts of entities become
comparable with other entities engaged in similar line of business and lay down
the principles on which accounting should be based.

Diagram 1: Objectives of accounting standards

 434

The Institute of Chartered Accountants of India has set up an Accounting

Standard Board to formulate Accounting Standards.

Keeping in view different kinds of requirements of business, the Accounting

Standard and Board (ASB) has consulted business bodies such as FICCI,
ASSOCHAM, CII and other business groups and come out with 32 Accounting
Standards which suited Indian conditions. It should be kept in mind that all
standards are not applicable on different kind of business. For example, some
standards are applicable to the manufacturing industry, while some standards are
applicable to the service industry. In the service industry also, some standards are
applicable to the Banking Industry and some are applicable to the Insurance
Industry.

For insurance companies, compliance with accounting standards issued by ICAI

is:

A Recommendatory
B Mandatory
C Not applicable since IRDA can issue their own accounting standards
D Approved by the IRDA

2. Discuss the features of various accounting standards

which are applicable to life insurance companies.
[Learning Outcome b]
2.1 List of accounting standards

The Institute of Chartered Accountants of India has so far issued 32 Accounting

Standards. In earlier years, most of the Accounting Standards became mandatory
so far as the corporate entities were concerned. Later on, the Institute has by
various notifications and pronouncements, clarified that some of these accounting
standards have also become mandatory so far as the non-corporate entities are
concerned.
 435
Given below is a list of 32 Accounting Standards issued by the Institute of
Chartered Accountants of India
AS
A S Title
No.
1 Disclosure of Accounting Policies
2 Valuation of Inventories
3 Cash Flow Statements
4 Contingencies and Events Occurring
after the Balance Sheet Date (Stands
withdrawn pursuant to AS 29 except
those relating to impairment of assets
not covered by any other AS)
5 Net Profit or Loss for the Period,
Prior Period Items and Changes in
Accounting Policies
6 Depreciation Accounting
7 Construction Contracts
8 Accounting for Research and
Development
9 Revenue Recognition
10 Accounting for Fixed Assets
11 The Effects of Changes in Foreign
Exchange Rates
12 Accounting for Government Grants
13 Accounting for Investments
14 Accounting for Amalgamations
15 Accounting for Retirement Benefits
16 Borrowing Costs
17 Segment Reporting
18 Related Party Disclosures
Applicability
Mandatory for all companies
Mandatory for all companies
Mandatory for specified
companies but encouraged for
others. Direct method is
adopted for General
Insurance Companies as per
IRDA regulations.
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Stands withdrawn pursuant to
AS 26
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
Mandatory for all companies
other than General Insurers.
Mandatory for all companies.
Mandatory for all companies
Mandatory for all companies
Mandatory for specified
companies including general
insurance companies.
Mandatory for listed/specified
companies.
 436

19 Leases Mandatory for all companies

subject to exclusion of certain
paragraphs in respect of
specified companies.
20 Earnings Per Share All companies are required to
calculate and disclose EPS as
per guidelines.
21 Consolidated Financial Statements Mandatory pursuant to
requirement of any statute/
regulation or in the cases of
voluntary preparation.
22 Accounting for Taxes on Income Mandatory for listed/specified
companies.
23 Accounting for Investments in Mandatory pursuant to
Associates in Consolidated Financial requirement of any statute/
Statements regulation or in cases of
voluntary preparation.
24 Discontinuing Operations Mandatory for listed/specified
companies.
25 Interim Financial Reporting Mandatory for listed/specified
companies.
26 Intangible Assets Mandatory for listed/specified
companies.
27 Financial Reporting of Interests in Mandatory pursuant to
Joint Ventures requirement of any statute/
regulation or in cases of
voluntary preparation.
28 Impairment of Assets Mandatory for all companies
with variation of meaning of a
term in respect of specified
companies.
29 Provisions, Contingent Liabilities Mandatory for all companies
and Contingent Assets subject to exclusion of certain
paragraph(s) in respect of
specified companies.
30 Financial Instrument; Recognition Mandatory for all entities w.e.f
and Measurement 01.04.11
31 Financial Instruments; Presentation Same as above
32 Financial Instruments; Disclosures Same as above
 437

Now we will discuss the Accounting Standards which are broadly applicable to
the Life Insurance Industry. The Accounting Standards are discussed in detail
below along with its implications for financial statements.

2.2 Accounting Standard 1- Disclosure Of Accounting Policies

Accounting policy refers to the specific accounting principles and the method of
applying those principles adopted by enterprises in the preparation and
presentation of financial statement. Accounting policy adopted by one enterprise
may be different from other enterprise. For example, some enterprise adopts
WDV Method of depreciation and some enterprise adopts straight line method of
depreciation.

a) Accounting assumptions

While formulating Accounting policies for the preparation and presentation of

Financial Statements, there are certain fundamental accounting assumptions
which are as follows:

i) Going concern concept

The enterprise is normally viewed as a going concern, that is, as continuing in

operation for the foreseeable future. It is assumed that the enterprise has neither
the intention nor the necessity of liquidation or closure or of curtailing materially
the scale of operations. Normal accounting concepts, accounting principles and
accounting policies are based on Going Concern Concept.

The going concern concept assumes that an entity:

 will continue its operations for at least the next 12 months

 does not have any intention or need to close down its operations 
 does not have any intention or need to curtail materially, the scale of its
operations

Due to an outdated production method, the demand for a product is reduced and
therefore the company has to reduce its production substantially. This affects the
going concern assumption.
 438

The difference in accounting for an entity which is a going concern and that
which is not a going concern:
The value for an asset which
has to be sold forcibly

Going concern Not a going concern

Financial statements Financial statements
Valuation Valuation
Assets Normal value Assets Disposal value
Liabilities Normal value Liabilities Settlement value

Normal accounting bases e.g. The value of a liability which

fair value, historical cost, etc. has to be settled immediately

Under which of the following conditions is ICC LLC deemed to be a going

concern?

A The company deals in a chemical product. Environmental authorities have

issued the company a notice to discontinue production. The company has
taken the case to a court of law but the lawyer has recommended
withdrawing the case because it is too weak.
B There was an intensive attack by enemies of the country. In this attack the
company’s plant was heavily damaged. This damage cannot be repaired in
the near future.
C The company is facing heavy competition which may result in decline of
revenue.

ii) Accrual Concept

Section 209 of the Companies Act has been amended so as to provide that proper
books of accounts shall not be deemed to have been maintained by a company, if
the same are not maintained on accrual basis.

The term “Accrual” has been explained in the Accounting Standard I – (AS-1) as
under:
 439

Revenues and costs are accrued, that is recognised as they are earned or incurred
[and not as money is received or paid] and recorded in the financial statements of
the periods to which they relate.
AS – 1

The Guidance Note on Terms used in Financial Statements issued by the

Accounting Standards Board of the ICAI explains “Accrual basis of Accounting
as under:

“Accrual Basis of Accounting is the method of recording transactions by which

revenues, costs, assets and liabilities are reflected in the Accounts in the period in
which they accrue. The Accrual Basis of Accounting includes considerations
relating to deferrals, allocations, depreciation and amortisation. This basis is also
referred to as Mercantile Basis of Accounting.”

The financial statements should be prepared on the basis of an accrual system of

accounting. In the accruals system, items are recognised as assets, liabilities,
incomes and expenses on the date they satisfy the recognition criteria
mentioned in their definitions. The actual date of payment of cash is
immaterial for the purpose of recognition.
The following examples will further explain the accruals concept.

Almond Inc purchased goods on 5 December 2006, but paid the supplier on 8
February 2007. Here, Almond Inc became the owner of the goods on 5 December
2006 even though the payment was made later. Hence the purchase transaction
should be recorded on 5 December 2006.
 440

Under the accruals system, all the elements of the profit and loss and the balance
sheet are recognised as follows:

Diagram 2: Recognising elements in the financial statements (Note that the

timing of actual payment is immaterial)

iii) Consistency concept

Under this concept, it is assumed that Accounting Policies are consistent from
one period to another.

According to this concept, an accounting policy once adopted in one accounting

period should be consistently followed in the subsequent accounting periods.

Until 2005, ICC Plc followed the reducing balance method (RBM) for charging
depreciation on assets. However, in 2006, the company calculated depreciation
according to the straight line method (SLM). Here, ICC Plc has not followed the
principle of consistency.
 441

A new method of preparing the financial statements can be used if:

 the new method is more appropriate
 the new method is prescribed by a standard or interpretation issued by
the ASB

Red Co valued its inventory under the last in first out method (LIFO) until 2004.
But IAS 2: Inventories does not permit the LIFO method of inventory valuation
and is applicable to the accounting periods in 2005. Therefore the company has
to follow a different method for valuing inventory from 200 5.

Part II of Schedule VI to the companies Act, 1956 recognises consistency

concept and requires disclosure of the fact of any change in method of
accounting along with its effect on the profit earned or loss sustained during the
accounting period.
iv) Qualitative characteristics
Qualitative characteristics refer to the attributes that financial statements
should possess. One has to keep a balance between all the characteristics.
These characteristics (explained below) make the financial statements more
accurate and acceptable.
v) Prudence
The concept of prudence implies that the profit should not be over-stated but
all anticipated losses should be recognised. The implication of this is that all
anticipated losses should be recognised and recorded immediately. But profits
should be recognised and recorded in the books of account only when realised
(this need not necessarily be in cash).

Let us imagine that Keira Co makes cakes. Shali bought a cake and ate it. She is
now in a hospital suffering from food poisoning and all tests indicate that the
cake from Keira Co is to blame.
Shali decides to take legal action against Keira Co and demands payment of her
hospital bill from Keira Co. The lawyers have told Keira that it is virtually
certain that Keira will lose the case. In this situation, it would make sense for
Keira Co to put an additional legal expense in the financial statements, to cover
the potential cost of losing the legal case. Therefore, including the potential expense
of the legal case in the financial statements is the application of the prudence concept.
 442

vi) Substance over Form

The accounting treatment and presentation in the financial statement of
transaction and events should be governed by their substance and not merely by
the legal form. At this stage, the term substance over form must be understood as
giving importance to the real nature of the transaction rather than how it is made
to appear. Substance over form would play a significant role while evaluating
financial transactions and disclosures. As an accountant, one must critically
analyse a transaction and present the reality of the transaction in the financial
statements. Transactions and other events should be accounted for and presented
in accordance with their substance and economic reality, and not merely their
legal form. Faithful representation of any transaction is only possible if it is
accounted for according to its substance and economic reality and not according
to its legal form.

BBG Inc provided domestic staff to its directors. BBG Inc pays Rs. 1,000
directly to the staff. In the legal sense, these domestic personnel are employees of
BBG Inc but they are actually working for the directors. Hence, the wages paid to
the domestic staff should be treated as payments to the directors and not as
company expenses.

BBG Inc
Profit and Loss A/c - 1 Profit and Loss A/c - 2
Legal form accounted for Substance accounted for
Rs. Rs.
Sales 50,000 Sales 50,000
Cost of goods sold (30,000) Cost of goods sold (30,000)
Gross profit 20,000 Gross profit 20,000
Expenses Expenses
(including wages paid
to domestic staff) (11,000) (10,000)
Directors’ fees
(including wages paid
Directors’ fees (5,000) to domestic staff) (6,000)
Profit 4,000 Profit 4,000

vii) Materiality
Financial Statements should disclose all material claims. Materiality means
relative importance. Material items are important items that the users of the
financial statements must know. The financial statements should show all the
material items separately.
 443

The concept of materiality relates to the time, efforts and the cost of accounting
in relation to the usefulness of the data generated. Materiality requires that only
those items which have a bearing on the determination of financial position and
computation of profit and loss during the accounting period should be recorded
and disclosed in the financial statements.

Gemini Plc is a large manufacturing firm. The total of the company’s debtors for
the year 2008 is Rs. 950,000. One of the company’s stationery providers to
whom Rs. 100 was given as advance, closed his business. It was clear that the
company would not be able to recover the advance. Here, considering the
company’s scale of operations, Rs. 100 is not a material amount. Hence, Gemini
Plc need not adjust the total debtors amount immediately. The financial
statements would still be fair.

Let’s consider another example.

Gemini Enterprises was penalised by the sales tax authorities for non-compliance
with tax rules. The penalty amount was Rs. 20,000. However, Gemini Enterprises
included this amount of penalty under miscellaneous expenses which amounted
to Rs. 50,000 excluding the penalty. Hence miscellaneous expenses inclusive of
penalty are Rs. 70,000 (Rs. 50,000 + Rs. 20,000).
Here, penalty forms 28.5% of miscellaneous expenses. Hence it is a material item
and must be disclosed separately.
Gemini Enterprises
SOCI
Materiality followed Materiality not followed
Rs. Rs.
Sales 10,00,000 Sales 10,00,000
Cost of goods sold (6,00,000) Cost of goods sold (6,00,000)
Gross profit 4,00,000 Gross profit 4,00,000
Expenses Expenses
Miscellaneous expenses (50,000) Miscellaneous expenses (70,000)
Penalty (20,000)
Profit 3,30,000 Profit 3,30,000
Payment of a penalty is a material item hence
should be deducted from miscellaneous
expenses and disclosed separately
 444

b) Disclosure of accounting policies

Disclosure is a part of the financial statement and normally it is shown in the

notes to accounts. Similarly, if there is any change in accounting policy it should
be disclosed in the notes to accounts.

However, it should be kept in mind that accounting policy should be in

consonance of sound accounting principle and simple disclosure of accounting
policy cannot remedy a wrong or inappropriate treatment.

If any fundament accounting assumption is not followed the fact should be

disclosed.

Every enterprise including Life Insurance Companies has to adopt AS1 and has
to disclose its accounting policy at appropriate place preferably in the notes of
accounts.

Following is an extract of the accounting policy of United India Insurance

Co. for the year 2010-11 relating to depreciation:

Depreciation:

 Depreciation on fixed assets (except Software considered under intangible

assets), is charged on written down value method at the higher of the rates
specified in the Income Tax Rules, 1962and those specified in Schedule XIV
to the Companies Act, 1956.

 Depreciation is provided at 50% of the applicable rates on additions to fixed

assets held for less than 180 days. No depreciation is provided on assets sold,
discarded or destroyed during the year.

 Depreciation is provided on Land and Building as a whole where separate

costs are not ascertainable.

 Assets whose actual cost does not exceed five thousand rupees are written off
in the year of acquisition, by retaining 1 per asset as book value.

 Cost of Lease Hold properties have been amortised over the period of Lease.
 445

2.3 Accounting standard 3 - Cash flow statements

Cash Flow Statement is additional information to user of financial statement in

addition to Balance Sheet, Profit & Loss Account and Revenue Accounts.

Cash Flow Statement (or Receipt & Payment accounts) exhibits the flow of
incoming and outgoing cash and assesses the ability of the company to generate
cash and cash equivalents and ability to utilize the cash and cash equivalents
generated. It also assesses the liquidity and solvency of the company.

All life Insurance Companies (whether listed or unlisted) have to prepare cash
flow statement using Direct Method called Receipt and Payment Account

In Direct Method, gross receipts and gross payments are disclosed

Cash Flow Statement has to be prepared for operating, Investing and Financing
Activities.

Before we move further, we should understand the terms which are used in a
Cash Flow Statement.

 Cash comprises cash on hand and demand deposit with Banks

 Cash equivalents are short terms deposits, highly liquid investment that are
readily convertible into known amount of cash and which are subject to an
insignificant risk of change in value.
 Cash flows are inflows and outflows of cash and cash equivalents
 Operating activities are the principal revenue producing activities of the
enterprise.
 Investing activities are the acquisition and disposal of long term assets and
other investments which are not included in cash equivalent.

Financing activities are activities that result in changes in the size and
composition of owner’s capital (including preference share capital) and
borrowing of company.

Cash flows from operating activities are primarily derived from the principal
revenue generating activities of the enterprise.
 446

a) Cash inflow from operating activities is

 Receipt of premium from policy holders (premium includes proposal deposit,

FY premium, renewal premium, single premium etc.)
 Repayment of policy loan from policy holders.
 Other income generated through policy holders such as interest on policy
loans, interest on delayed payment of premium etc.
 Claim receipt from reinsures

b) Cash outflow from operating activities

 Payment to policy holders such as Maturity claim, Death claim, Surrender,

Annuity payments, Loan Payment etc.
 Salary and other establishment expenses.
 Purchase of capital assets for general use.
 Payment to intermediaries for processing business and allied expenses.

c) Cash flow from investing activities

 Purchase and sale of properties which has been kept for long period
 Cash payment to acquire share, warrant, debentures etc. and sale of share,
warrant debenture etc.
 Loan to companies and its repayment
 Receipt of dividend, interest from above activities

d) Cash flow from financing activities

 Cash proceeds from issuing shares or other similar instruments

 Cash proceeds and payment of borrowing.
 447

Padmaja Ltd provides you the following information. Prepare a cash flow
statement using the direct method:
Particulars Amount
Sales for the year Rs. 50,00,000 (All sales in cash) 50,00,000
Cash paid to suppliers during the year 30,00,000
Selling and Administrative expenses paid in cash 2,00,000
Tax paid during the year 1,00,000
Cost of new Plant acquired and paid 4,00,000
Payment of Dividend 1,50,000
Opening cash balance 80,000
Closing cash balance 12,30,000

Cash flow statement for the period (direct method)

Particulars Amount Amount

A. Cash flow from operating activities

Cash from sales of goods 50,00,000
Less:- Payments to suppliers (30,00,000)
Less:- Selling and Admin Expenses (2,00,000)
Less:- Payment of tax (1,00,000)
Net cash flow from operating activities 17,00,000
B. Cash from investing activities
Purchase of plant (4,00,000)
Net cash flow from investing activities (4,00,000)

C. Cash from financing activities

Payment of dividend (1,50,000)
Net cash flow from financing activities (1,50,000)
D. Net Increase/(Decrease) in cash
(A)+(B)+(C) (Figures in brackets indicate 11,50,000
negative figures)
E. Opening balance of cash and cash
80,000
equivalents
F. Closing Balance of cash and cash equivalents 12,30,000
 448

2.4 Accounting standard 5 - Net profit or loss for the period, prior
period items and changes in accounting policies

The objective of this statement is to prescribe the classification and disclosure of

certain items in the statement of profit & loss so that all enterprises (including
life insurance) companies prepare and present such a statement on a uniform
bases. This enhances the comparability of the financial statement of an enterprise
over time and with the financial statement of other enterprise.

This standard should be applied in presenting profit or loss from:

i) ordinary activities,
ii) extraordinary items and
iii) prior period items in the statement of profit and loss, in accounting for
changes in the accounting estimate, and in disclosure of changes.

i) Extra ordinary items

Extra ordinary items are those items of incomes and expenses which are clearly
distinct from the ordinary activities of the business. They are not expected to
recur in the future periods.

Example of extra ordinary items is loss due to theft, fire, etc.

ii) Ordinary activities

Ordinary activities are those activities which are carried out by a business entity
as a part of its business operations and include any incidental activities
undertaken to further the main ordinary activity.

For example, in case of Life Insurance Companies, Insurance is the main

business and collection of premium, payment of claim etc. are the ordinary
activities.
iii) Prior period items

Prior period items are those items of incomes or expenses which arise in the
current period owing to errors or omissions in the preparation of the financial
statements of one or more prior periods.
 449

The term prior period items as defined in this statement refer only to income or
expenses which arise in the current period as a result of errors or omissions in the
preparation of the financial statement of one or more prior periods.

Example of prior period items are non-provision of commission or other

expenses.

However, term does not include other adjustments necessitated by circumstances

which though related to prior periods, are determined in the current period e.g.
arrears payable to workers as a result of revision of wages with retrospective
effect during the current period.

Disclosure of prior period is required for income tax purpose as expenses of prior
period are disallowed by income tax department.

iv) Accounting policies

Accounting policies are the specific accounting principles and the methods of
applying those principles adopted by an enterprise in the preparation and
presentation of financial statements.

Users should be able to compare the financial statement of an enterprise over a

period of time to identify trends in its financial position, performance and cash
flows. Hence, the same accounting policies are normally adopted for similar
events or transaction in each period.

As per AS – 1, only material items should be considered for designing and

disclosing the accounting policies.

Suppose there are two insurance companies, A Ltd and B Ltd. It may happen that
both these companies adopt different accounting policies for a given financial
item. It may also happen that the policies followed by these companies are
different for different accounting periods. If this happens, different users of the
financial statements of these companies will evaluate the companies differently.
However, if meaningful and consistent conclusions are to be drawn then a proper
disclosure of significant accounting policies of both these companies is a must.
 450

Diagram 3: Areas where different accounting policies may be followed by

different companies

v) Change in accounting policies

Accounting policy should be changed only if:

 required by statute or
 for compliance with an accounting standard or if change would result in
appropriate presentation of the financial statement.

Accounting for change in accounting policy

Any change in an accounting policy which has a material effect should be

disclosed. The impact of, and the adjustments resulting from, such change, if
material, should be shown in the financial statements of the period in which such
change is made, to reflect the effect of such change.

A change in method of depreciation if required by statute is an example of a

change in accounting policy.
 451

The Daily Press Ltd was incorporated on 1 January 2009. The draft statement of
financial position for the year ended 2010 and 2009 is given below:
2010 2009
Rs. Rs.
Property, plant and equipment 434 358
Research and development 17 17
Other assets 1,349 1,350
Total assets 1,800 1,725

Share capital 150 150

Retained earnings
Year ended 2009 75 75
Year ended 2010 75
Liabilities 1,500 1,500
Total equity and liabilities 1,800 1,725
The following information is relevant:
a) During 2009, the company had capitalised Research and Development costs.
However during 2010, the company realised that the expense did not meet
the requirements of research and development.
Required:
Redraft the statements of financial position after making the relevant changes.
This change in accounting policy should be applied retrospectively as follows
(the tax implications as a consequence of this challenge have been ignored for the
purposes of this illustration):
2010 2009
Rs. Rs.
Property, plant and equipment 434 358
Research and development * - -
Other assets 1,349 1,350
Total assets 1,783 1,708

Share capital 150 150

Retained earnings
Year ended 2009 (W1) 58 58
Year ended 2010 75
Liabilities 1,500 1,500
Total equity and liabilities 1,783 1,708
 452

Workings

W1 Adjustment re-capitalised borrowing cost

2009
Rs.
Retained earnings as given 75
Less: R & D expenses (17)
Balance c/f 58

* Research and development (R & D) expenses have been expensed and

therefore the R & D expenses shown in the statement of financial position for
2009 and 2010 becomes nil.

vi) Accounting estimates are items in the financial statements which cannot be
measured with precision. In such cases an entity has to make a judgement to
estimate the value of these elements.
For example: Bad debts, inventory obsolescence (inventory that is slow moving
or difficult to sell), the useful lives of, or expected pattern of consumption of, the
future economic benefits in depreciable assets etc.

All items of income and expenses, which are recognised in a period, should be
included in the determination of net profit or loss for the period unless an
Accounting Standard requires or permits otherwise.

vii) Disclosure requirements:

 Extraordinary items should be disclosed in the statement of profit and loss, as
a part of net profit or loss for the period. The nature and the amount of each
extraordinary item should be separately disclosed in the statement of profit
and loss in a manner that its impact on current profit or loss can be perceived.
 The nature and amount of prior period items should be separately disclosed
in the statement of profit and loss in a manner that their impact on the current
profit or loss can be perceived.
 The nature and amount of a change in an accounting estimate, which has a
material effect in the current period or which is expected to have a material
effect in subsequent periods, should be disclosed. If it is impracticable to
quantify the amount, this fact should be disclosed.
 453

 Any change in an accounting policy, which has a material effect should be

disclosed. The impact of, and the adjustments resulting from such change, if
material, should be shown in the financial statements of the period in which
such change is made, to reflect the effect of such change.

Akanksha Ltd received Rs.10,00,000 as compensation from a party against

whom litigation was filed by the company around 5 years back. This
compensation was received in the year 2010-11 and Akanksha Ltd. clubbed this
amount as a part of its net profit. Is this treatment valid?
Solution: No. This treatment is invalid as per AS – 5.

The said compensation received by the company is an extra-ordinary item,

since it is distinct from the normal activities and is expected to be non-
recurring. It needs to be separately disclosed in the Profit and Loss Account.

Diagram 4: Essence of AS 5
 454

2.5 Accounting Standard 6 depreciation accounting

This Accounting Standard deals with depreciation and Depreciable Assets.

Depreciable amount is the historical cost of a depreciable asset less the

estimated residual value.

Depreciation is a measure of wearing out, consumption or other loss of value of

a depreciable asset, arising from use, effluxion of time or obsolescence through
technology and market changes. It is charged as a fair proportion of the
depreciable amount in each accounting period during the expected useful life of
an asset. Depreciation includes amortization of assets whose useful life is
predetermined.

Depreciable assets are assets which

i) are expected to be used during more than one accounting period; and
ii) have a limited useful life; and
iii) are held by an enterprise for use in the production or supply of goods and
services, for rental to others, or for administrative purposes and not for the
purpose of sale in the ordinary course of business.

Useful life is either (a) the period over which a depreciable asset is expected to
be used by the enterprise or (b) number of production units expected to be
obtained from the use of asset by the enterprise.

Depreciable amount of depreciable asset should be allocated on systematic basis

to each accounting year over useful life of assets.

Basis for providing depreciation must be consistently followed and disclosed. For
example if any insurance company is adopting Written down Method (WDV) it
should disclose that it is adopting WDV Method.

The depreciation method selected should be applied consistently from period to

period.
 455

A change from one method of providing depreciation to another should be made

only if:
 the adoption of the new method is required by statute or
 for compliance with an accounting standard or
 if it is considered that the change would result in a more appropriate
preparation or presentation of the financial statements of the enterprise.

When such a change in the method of depreciation is made, depreciation should

be recalculated in accordance with the new method from the date of the asset
coming into use. The deficiency or surplus arising from retrospective
computation of depreciation in accordance with new method should be adjusted
in the accounts in the year in which the method of depreciation is changed. Such
a change should be treated as a change in accounting policy and its effect should
be quantified and disclosed.

As mentioned earlier, change in method of changing depreciation is a change in

accounting policy and be qualified and disclosed.

On revaluation of assets (Life Insurance Companies revalues its Investment

property once in three year) depreciation should be based on revalued amount
over balance useful life. Material impact on Depreciation should be disclosed.

Depreciation Method used should be disclosed. If rates applied are different from
the rates specified in the governing statute, then the rates and useful life should
also be disclosed.

This standard deals with depreciation accounting and applies to all depreciable
assets, except to certain specified items to which special considerations will
apply. Different accounting policies for depreciation are adopted by different
enterprises. Disclosure of accounting policy for depreciation followed by an
enterprise is to be made.

 Where the depreciable assets are revalued, the provisions for depreciation
should be based on the revalued amount and on the estimate of the remaining
useful lives of such assets. In case the revaluation has a material effect on the
amount of depreciation, the same should be disclosed separately in the year
in which revaluation is carried out.
 If any depreciable asset is disposed of, discarded, demolished or
destroyed, the net surplus or deficiency, if material, should be disclosed
separately.
 456

Disclosure requirements:

Details of disclosure Disclosed in

Historical cost, total depreciation and Profit and Loss A/c and
accumulated depreciation for each class of asset Balance Sheet
Depreciation methods and rates Profit and Loss A/c,
Balance Sheet and notes to
accounts
Effect of change in depreciation method Profit and Loss A/c and
notes to accounts
Depreciation amount in case of revaluation of Profit and Loss A/c and
assets notes to accounts
Net Surplus or deficiency in case any Profit and Loss A/c
depreciable is sold off or discarded

2.6 Accounting Standard 10 - Accounting for fixed assets

Accounting Standard 10 defines Fixed Assets as follows

Fixed Asset is an asset held with the intention of being used for the purpose of
producing or providing goods or services and is not held for sale in the normal
course of business.

Fair market value is the price that would be agreed to in an open and
unrestricted market between knowledgeable and willing parties dealing at arm’s
length who are fully informed and are not under any compulsion to transact.

Gross book value of a fixed asset is its historical cost or other amount
substituted for historical cost in the books of account or financial statements.
When this amount is shown net of accumulated depreciation, it is termed as net
book value.

The standard does not deal with:

 Forests, plantations and other natural resources

 Wasting assets like mineral rights and expenditure on explorations of oil,
natural gas etc.
 Expenditure on real estate development
 Livestock (Domesticated animals)
 457

Capitalisation

Cost of fixed assets should include purchase price (including import duties and
other non-refundable taxes and levies) and directly attributable costs of bringing
asset to its working condition for the intended use. Trade discounts and rebate are
deducted for calculating purchase price. Self constructed assets are to be
capitalized at cost that are specifically related to the asset and those which are
allocable to the specific asset

Daffodils Perfumeries Enterprise purchased a machine for Rs. 135,000. It spent

Rs. 4,000 on freight and Rs. 3,500 on installation. It spent materials worth Rs.
3,000 and wages Rs. 1,200 on the trial run. Owing to low capacity utilisation, it
incurred initial losses of Rs. 10,000 for the first year. It spent Rs. 7,000 on
launching the new product.

The cost of the machinery is to be calculated as below:

Details Rs.
Purchase price 135,000
Freight 4,000
Installation 3,500
Trial run costs 4,200
Total 146,200

Administration and other general overhead expenses are usually excluded from
the cost of fixed assets because they do not relate to a specific fixed asset.
Therefore office rent is not considered in the cost of the machinery.

Revaluation

Revaluation if any should be of class of assets and not an individual asset.

Basis of revaluation should be disclosed

Increase in value on revaluation is credited to Revaluation Reserve while the

decrease should be charged to Profit & Loss A/c.
 458

Accounting for the revaluation adjustment

There are two possibilities:

a) either an asset’s carrying amount is increased

b) or an asset’s carrying amount is decreased

a) If an asset’s carrying amount is increased

The increase should be recognised in Revaluation Reserve. However, if there was

a revaluation decrease of the same asset earlier (which was recognised in the
profit and loss account), then the increase should be recognised in the profit and
loss account to the extent that it reverses a revaluation decrease.

The carrying value of machine B is Rs.80,000. It is revalued at Rs.88,000. On the

previous revaluation, its value was decreased by Rs.5,000. Show the accounting
adjustments.

Answer

Increase in the value is Rs.8,000 (88,000 – 80,000).

The previous reduction of Rs.5,000 must have been recognised in the profit and
loss account. The following entry should now be made:

Machine Dr. Rs.8,000

To Profit and loss account Rs.5,000
To Revaluation reserve Rs.3,000

b) If an asset’s carrying amount is decreased

The decrease should be recognised in the profit and loss account. However, if
there is a balance in the revaluation reserve in respect of that asset (which had
resulted from a revaluation performed earlier), such a decrease is recognised in
revaluation reserve account.

The decrease recognised in revaluation reserve account reduces the amount

accumulated in equity under the heading of revaluation reserve.
 459

The carrying value of machine A is Rs.60,000. It is revalued at Rs.50,000. On the

previous revaluation, its value was increased by Rs.7,000 (the amount in the
revaluation reserve).

Answer

The revaluation decrease for A is Rs.10,000 (60,000 – 50,000). The credit

balance in revaluation reserve against this asset is Rs.7,000. The following entry
should be made:

Other revaluation reserve Rs.7,000

Profit and loss account on revaluations Rs.3,000
To Machinery Rs.10,000
Being revaluation decrease transferred to machinery account

Other points

 Profit & Loss on disposal of asset should be recognised in profit & loss
statement.

 Assets should be written off when there is no utility value.

Disclosure requirements

Details of disclosure Disclosed in

Gross and net book values of fixed assets along with
Balance Sheet
additions and deletions thereto
Any expenditure incurred in order to make the fixed asset
Balance Sheet
usable and occurring in the course of construction
Revalued amounts substituted for historical costs of fixed
assets, the method adopted to compute the revalued
amounts, the nature of indices used, the year of any
Balance Sheet
appraisal made and whether an external valuer was
involved in case where fixed assets are stated at revalued
amounts.
 460

2.7 Accounting standard 15 - Employee benefits

Following are some of the categories of employee benefits:

 Short-term employee benefits such as wages, salaries and social security

contributions (e.g., contribution to an insurance company by an employer to
pay for medical care of its employees), compensated absences or paid annual
leave, profit sharing and bonuses (if payable within twelve months of the end
of the period) and non-monetary benefits (such as medical care, housing, cars
and free or subsidised goods or services) for current employees;

 Post-employment benefits such as gratuity, pension, other retirement

benefits, post-employment life insurance and post-employment medical care;

 Other long-term employee benefits, including long-service leave or

sabbatical leave, jubilee or other long-service benefits, long-term disability
benefits and if they are not payable wholly within twelve months after the
end of the period, profit-sharing, bonuses and deferred compensation; and
 Termination benefits.

Following are various aspects with respect to recognition and measurement

 This Standard requires an enterprise to recognise the undiscounted amount of
short-term employee benefits when an employee has rendered service in
exchange for those benefits. Such benefits expected to be paid should be
shown as a liability after adjustment for paid amount. Amount paid in excess
should be shown as an asset as prepaid expense.
 Post-employment benefit plans are classified as either ‘defined contribution
plans’ or ‘defined benefit plans’. Under defined contribution plans, the
enterprise’s obligation is limited to the amount that it agrees to contribute to
the fund and in consequence, actuarial risk (that benefits will be less than
expected) and investment risk (that assets invested will be insufficient to
meet expected benefits) fall on the employee.
 The Standard requires that when an employee has rendered service to an
enterprise for a period, the enterprise should recognise the contribution
payable to a defined contribution plan in exchange for that service as a
liability after adjustment for paid amount. Amount paid in excess should be
shown as an asset as prepaid expense. Alternatively, it may be recognised as
an expense unless another AS requires or permits the inclusion of the
contribution in the cost of an asset.
 461

 All other post-employment benefit plans are defined benefit plans. Defined
benefit plans may be unfunded, or they may be wholly or partly funded.
Under these plans, i) the enterprise’s obligation is to provide the agreed
benefits to current and former employees and ii) actuarial risk (that benefits
will be less than expected) and investment risk (that assets invested will be
insufficient to meet expected benefits) fall on the enterprise.

Diagram 5: Post employment benefit plans

Following are the principles of accounting used and determination of value

of Defined Benefit plans:
It is a complex process in view of the necessity of actuarial assumptions.
For accounting and determination of value the enterprise should do the
following:

 To account not only for its legal obligation under the formal terms, but also
for any other obligation that arises from the enterprise’s informal practices.
 To determine the present value of defined benefit obligations and the fair
value of any plan assets with sufficient regularity so that the amounts
recognised in the financial statements do not differ materially from the
amounts that would be determined at the balance sheet date.
 462

 To use Projected Unit Credit Method to measure its obligations and related
costs

 To attribute benefit to periods of service under the plan’s benefit formula,

unless an employee’s service in later years will lead to a materially higher
level of benefit than in earlier years.

 To use unbiased and mutually compatible actuarial assumptions about

demographic assumptions (such as mortality, employee turnover) and
financial assumptions (such as discount rate, future salary and benefit levels.)
Financial assumptions should be based on market expectations, at the balance
sheet date for the period over which the obligations are to be settled;

 To determine the discount rate by reference to market yields at the balance

sheet date on government bonds of a currency and terms consistent with the
currency and estimated term of the post-employment benefit obligations;

 To deduct the fair value of any plan assets from the present value of the
defined benefit obligation at the balance sheet date. Certain reimbursement
rights that do not qualify as plan assets are treated in the same way as plan
assets except that they are presented as a separate asset rather than as a
deduction from the obligation;

 To limit the carrying amount of a defined benefit asset so that it does not
exceed the present value of any economic benefit available in the form of
refunds from the plan or reductions in future contributions to the plan;

 To recognise past service cost as an expense on a straight-line basis over the

average period until the benefits become vested. To the extent that the
benefits are already vested immediately following the introduction of, or
changes to, a defined benefit plan, an enterprise should recognize past service
cost immediately;

 To recognize gains or losses on the curtailment or settlement of a defined

benefit plan when the curtailment or settlement occurs;

 To recognise immediately actuarial gains and losses in the statement of profit

and loss as income or expense.
 463

Diagram 6: Determination of PV of DBO & current service cost

Digram 7: Accounting for DBP

 464

Disclosure requirements
Details of disclosure Disclosed in
Amount of Long-term employee benefits Profit and Loss A/c
Amount of defined contribution plans Profit and Loss A/c
Describing the accounting policy
Amount of defined benefit plans
used and a general description
2.8 Accounting Standard 17 - segment reporting
Accounting Standard 17: Segment Reporting, defines segment in following
terms:
Standard has divided segment as follows
a) Business Segment
b) Geographical Segment
a) Business Segment
It is a distinguishable component of an enterprise providing a product or service
or group of products or services that is subject to risks and returns that are
different from other business segments.
Factors that should be considered in determining whether products or services are
related include:
 the nature of the products or services;
 the nature of the production processes;
 the type or class of customers for the products or services;
 the methods used to distribute the products or provide the services; and
 if applicable, the nature of the regulatory environment, for example, banking,
insurance, or public utilities.
b) Geographical Segment
It is distinguishable component of an enterprise providing products or services in
a particular economic environment that is subject to risks and returns that are
different from components operating in other economic environments.
Factors that should be considered in identifying geographical segments include:
 similarity of economic and political conditions;
 relationships between operations in different geographical areas;
 proximity of operations;
 special risks associated with operations in a particular area;
 exchange control regulations; and
 the underlying currency risks
 465

All Insurance companies have to report on segmental basis which is based on

business segment. For example unit linked Insurance Plans, Pension Plan; Health
Insurance Plans constitute different segments.
Business and geographical segments of an enterprise for external reporting
purposes should be those organisational units for which information is reported
to the board of directors and to the chief executive officer for the purpose of
evaluating the unit’s performance and for making decisions about future
allocations of resources
Diagram 8: Business and operating segment

Diagram 9: Reportable segment

 466

If there is reportable segment in the preceding period (as per criteria), same shall
be considered as reportable segment in the current year.

Under primary reporting format for each reportable segment the enterprise should
report external and internal segment revenue. Segment result, amount of segment
assets and liabilities, cost of fixed assets acquired, depreciation, amortization of
assets and other non-cash expense.

Saturn Ltd has identified the following segments: (All amounts in Rs.‘000)

Iron Cement Steel Aluminiu Copper Limestone Total

Segment
revenue

External
25 2 6 20 23 23 99
sales

Inter-
segment 12 6 8 2 1 29
sales
Total
37 8 14 22 23 24 128
revenue
Segment
result
9 16 (3) (1) 6 8 35
(profit /
loss)

Segment
81 51 16 16 27 5 196
assets
 467

Using the quantitative threshold mentioned above, reportable segments can be

identified as follows:

Calculate which segments are reportable based on 10% of revenue

The revenue threshold is 12.8. Segments Iron, Steel, Aluminium,
Step 1 Copper and Limestone have revenue from sales to external customers
and from transactions with other segments of more than 10% of the total
revenue (external and internal), of all segments (W1)
Calculate which segments are reportable based on 10% of combined
profit / loss
The threshold is 3.9. (Segments Iron, Cement, Copper and Limestone
Step 2 have segment results, whether profit or loss, at 10% or more of the
combined profit of all segments in profit or the combined loss of all
segments in loss, whichever is the greater in absolute amount (W2, W3
and W4)
Calculate which segments are reportable based on 10% of total
assets
Step 3
The asset threshold is 19.6. Segments Iron, Cement and Copper have
assets which are 10% or more of the total assets of all segments (W5)

Therefore segments Iron, Cement, Steel, Aluminium, Copper and Limestone are
reportable segments.

Workings

Iron Cement Steel Aluminium Copper Limestone Total

W1 Segment revenue
External sales 25 2 6 20 23 23 99
Inter-segment sales 12 6 8 2 1 29
Total revenue 37 8 14 22 23 24 128
Segment result
W2 9 16 (3) (1) 6 8 35
(profit / loss)
Combined result of
W3 all segments in 9 16 6 8 39
profit
Combined result of
W4 3 1 (4)
all segments in loss
W5 Segment assets 81 51 16 16 27 5 196
 468

2.9 Accounting Standard 18 - Related party disclosures

Accounting Standard 18: Related Party Disclosures defines Related Party and
Related Party Disclosures as follows:

This standard is applied in reporting related party relationship and transactions

between a reporting enterprise and its related parties. The requirements of these
statements apply to the financial statements of each reporting enterprise as also to
consolidate financial statement presented by a holding company.

Related party transaction is a transfer of resources or obligation between related

parties regardless of whether or not a price is charged

Following are treated as related parties

a) Enterprises that directly or indirectly control (through subsidiaries) or are

controlled in respect of which reporting enterprise is an associate or a joint
venture for example LICHFL is Associate of LIC of India.

b) Associates, Joint ventures of the reporting entity: Investing party or venture

in respect of which reporting enterprise is an associate or a joint venture

c) Individuals owning voting power giving control or significant influence.

d) Key management personnel and their relatives.

Here, Key management personnel are those persons who have the authority and
responsibility for planning directing and controlling the activities of the reporting
enterprise. Relative means spouse, son, daughter, brother, sister, father and
mother.

Para 3 of this accounting standard specifies certain relationships, which are

termed to be ‘related parties’. The related party relationships between various
enterprises are determined on the following basis

 Control aspect
 Associate/Joint Venture
 Ownership
 Key management personnel & (e) Significant influence
 469

Diagram 10: Related party relationship

Remember, while determining whether a party is related or not, substance of the

relationship should be considered and not merely the legal form. This means that
to become a related party, the party should be in a position to influence the
decision making power of the reporting entity.

Relative in relation to an individual means the spouse, son, daughter, brother,

sister, father and mother, who may be expected to influence, or be influenced by
that individuals in his dealings with the reporting enterprise.

Related party is a party which has the ability to control the other party or
exercise significant influence over the other party in making financial and/or
operating decisions.

Related party transaction is a transfer of resources or obligations between

related parties, regardless of whether or not a price is charged.

Control means (a) direct or indirect ownership of more than 50% voting power
of an enterprise (b) control of the composition of the board of directors or any
corresponding governing authority in an enterprise, or (c) a substantial interest in
voting power and the power to direct, by statute or agreement, the financial and
operating policies of an enterprise
 470

Significant influence means participation or authority to participate in the

financial and operating decisions of an enterprise, but not the control of those
policies. Significant influence is presumed to exist if the holding of voting power
is 20% or more.

Key management personnel include those persons who have the authority and
responsibility for planning, directing and controlling the activities of the
reporting enterprise.

Following examples list out the transactions which may occur with the
related parties

 Purchase or Sale of goods

 Purchase or Sale of Fixed Assets
 Rendering or receiving of services
 Agency arrangements
 Leasing or Hire purchase arrangements
 Transfer of research and development
 License Agreements
 Finance including loans/ equity contributions
 Guarantees and collaterals
 Management contracts including for deputation of employees.

Following are not considered to be related parties

 Common directors of two or more companies

 Economic dependence on a single customer or supplier
 Participation in decision making by trade unions, government departments
etc.
 471

Disclosure requirements

Details of disclosure Disclosed in

The name of the transacting related party Notes to accounts
Description of the relationship between the parties Notes to accounts
Description of the nature of transactions Notes to accounts
Any other elements necessary for an understanding of
Notes to accounts
financial statements
Amount or appropriate proportion of outstanding items
or provisions of doubtful debts due from such related Notes to accounts
parties at balance sheet date
Volume of the transaction Notes to accounts
Outstanding amounts and bad debts written off
Notes to accounts
Or written back

is used for preparing cash flow statements of an insurance company.

A Percentage of completion method.

B Historical cost method
C Direct method
D Indirect method

Summary
 The Apex accounting body in India, the Institute of Chartered Accountants of
India, has taken the initiative in regard to standardising the Accounting
procedure.
 Accounting Standards are standards which are applicable to prescribed
entities to standardize their accounting procedure so that accounts of entities
become comparable with other entities engaged in similar line of business
and lay down the principles on which accounting should be based.
 The Institute of Chartered Accountants of India has so far issued 32
Accounting Standards.
 Accounting policy refers to the specific accounting principles and the method
of applying those principles adopted by enterprises in the preparation and
presentation of financial statements.
 Accounting policy adopted by one enterprise may be different from another
enterprise.
 472

 While formulating Accounting policies for the preparation and presentation

of Financial Statements, there are certain fundamental accounting
assumptions which are going concern concept, accrual concept, consistency
concept, qualitative characteristics, prudence, substance over form, and
materiality.
 As per the IRDA regulations on accounts and audit, every insurance
company must mandatorily prepare a cash flow statement by using the Direct
Method called the Receipt and Payment Account.
 Basis for providing depreciation must be consistently followed and disclosed.
 Accounting Standard 10 defines Fixed Assets. Fixed Asset is an asset held
with the intention of being used for the purpose of producing or providing
goods or services and is not held for sale in the normal course of business.
Therefore it does not deal with forests, plantations and other natural
resources, wasting assets, livestock, expenditure on explorations of oil,
natural gas and real estate development.
 Revaluation if any should be of class of assets and not an individual asset.
 Accounting standard 15 defines employee benefits. Some of the categories of
employee benefits are short-term employee benefits, post-employment
benefits, other long-term employee benefits and termination benefits.
 Accounting standard 17 which is segment reporting defines segment in terms
of business segment and geographical segment.
 Accounting standard 18 defines related party disclosures. This standard is
applied in reporting related party relationship and transactions between a
reporting enterprise and its related parties.

Answers to Test Yourself

Answer to TY 1
The correct answer is B.
Accounting standards issued by the ICAI are mandatory for insurance
companies.
Answer to TY 2
The correct option is C.
A Not a going concern: because there is a high probability of the company
being unable to continue as its only product can no longer be manufactured.
B Not a going concern: because there is no scope for rehabilitation.
C A going concern: competition and a decline in revenue is a part and parcel
of business.
 473

Answer to TY 3

The correct answer is C.

There are basically two methods of preparing cash flow statements, (a) Direct, &
(b) Indirect. Out of these, the direct method is specifically used in the case of
accounting for insurance companies.

Self Examination Questions

Question 1

An accrual system of accounting prescribes:

A Recording the substance of the transaction and ignoring the form

B Recording all expenses when the payment is made
C Recording assets when they are controlled
D Overstating the expenses

Question 2

Following is one of the important purposes of accounting standards:

A Helping government to take punitive action.

B Helping users of financial statements to compare different companies
C To establish financial supremacy of a nation.
D To hold as evidence against the company in court.

Question 3

Following is one of the fundamental accounting assumptions as per Accounting

Standard – 1.

A Prudence
B Substance over form
C Materiality
D Consistency
 474

Question 4
Which of the following is true with regard to a change in accounting policy?
A As a rule of thumb, all changes in accounting policies should be applied
retrospectively
B In the current year, the comparative figures of the previous year should be
adjusted to reflect the change. If this is not possible, the opening balance of
profit and loss should be adjusted as if the new policy had been applied since
the beginning
C As a rule of thumb, all changes in accounting policies should be applied
going forward only and no retrospective changes are required
D None of the above

Question 5
Which of the following items would require estimation?
(i) Bad-debts
(ii) Litigation settlement
(iii) Fair value of financial assets or liabilities
(iv) Disposal of investment

A All of the above

B Only (i)
C (i) and (iii)
D (i), (ii) and (iii)

Answers to Self-Examination Questions

Answer to SEQ 1
The correct option is C.

Recording the substance of the transaction comes under the concept ‘substance
over form’. According to the accrual system of accounting, expenses should be
recorded in the financial statements when there is a decrease in the economic
benefits whereas assets should be recorded when economic benefits will flow to
the entity.
 475

Answer to SEQ 2
The correct answer is B.
Comparability of financial statements of different companies is an important
purpose of accounting standards.

Answer to SEQ 3

The correct option is D.

Prudence, substance over form and materiality are considerations for designing
accounting policies for an organization whereas going concern, consistency and
accrual are fundamental accounting assumptions.
.
Answer to SEQ 4

The correct option is B.

In the case of a change in accounting policy, in the current year, comparative

figures of the previous year should be adjusted to reflect the change. If this is not
possible, the opening balance of profit and loss should be adjusted as if the new
policy had been applied since the beginning.

Answer to SEQ 5

The correct option is C.

The following are some examples of items that require estimation:

 Bad debts
 Inventory obsolescence (inventory that is slow moving or difficult to sell)
 The fair value of financial assets or financial liabilities
 The useful lives of, or expected pattern of consumption of, the future
economic benefits in depreciable assets
 476

CHAPTER 11

FINANCIAL ANALYSIS

Chapter Introduction
This chapter aims to provide an understanding as to why Financial Analysis is
needed for a life insurance company. You will also learn about the different tools
and techniques used for the analysis and the types of ratios used for calculation.

a) Financial Statements and the users of financial statements.

b) Analysis of financial statements and tools and techniques of financial
statements.
c) Usefulness of financial ratios and quantitative ratios.
d) Ratio analysis for the life insurance sector.
e) Fund flow statement and cash flow statement.
 477

1. Financial Statements and the users of financial

statements.
[Learning Outcome a]
The basic purpose of accounting is to give reliable information for the purpose of
decision making. All the financial data collected is finally converted into
financial statements which are then further evaluated by applying analytical
skills.

1.1 Financial Statements

In India, when we speak of financial statements it’s popularly known as ‘Balance

Sheet and Profit and Loss Account’. But each country has different names and
regulations for financial statements - e.g. in the USA, public owned companies
have to prepare four statements:

1. The statement of earnings

2. The statement of financial position
3. Cash flow statement
4. Statement of change in share owners’ equity.

Whereas Indian companies prepare:

1. Annual Report
2. Directors Report
3. Auditors Report
4. Balance Sheet (B/S)
5. Profit and loss Account (P/L)
6. And schedules forming a part of the B/S and P/L

1.2 Different Users of Financial Statements

The main purpose of the Financial Statements is to aid in decision making. The
traditional view is that financial statements are prepared for the proprietors. But
from the last few years, this view has changed and financial statements have
become more user friendly. The users of financial statements can be divided into
two types:
 478

 Internal Users: consist of managers, employees and people related to the

organisation.

 External Users: consist of shareholders, investors, customers, the

government and other agencies.

The main users of financial statements are:

1. Shareholders, Investors and Security Analysts

They are the most important users of the financial statements. They can be
anyone - from a small individual investor to large companies or institutions like
nationalized banks or investment companies. They are the people who, after
studying the financial statements, select shares for buying and selling or retaining
at the correct time.

2. Managers and Employees

In order to monitor the growth of the company and its profitability, managers and
employees need financial statements. They use the statements to forecast future
salary with increase in perquisites, welfare activities and retirement benefits.
Thus, financial statement variables like Earnings Before Interest and Tax (EBIT)
and Profit after tax are very important. Users are also interested in knowing the
solvency position of the business, its abilities to meet challenges in future and the
growth prospects of the company.

3. Lenders/Other Suppliers

Lenders and suppliers study the financial strength of the company before giving
any loans. The financial statements provide information to lenders about the
liquidity, leverage and profitability of the company before determining the
amount of loan to be given. They require a security for the principal amount and
its repayment with interest.

4. Customers

Customers are the people to whom the company sells and maintains relations that
go on for years. The customer’s business feasibility may be dependent on the
feasibility of the business concern. Thus, customers are also interested in the
financial statements for their analysis.
 479

5. Government / Regulatory Agency

Last but not the least, the government needs financial statements to get an idea of
the collection of revenue through taxes and encourage balanced regional
development.
Other interested parties include Academics, Environmental Protection
Organisations and Consumer Protection Organisations. Thus, it can be seen that
each user has a different purpose for the use of financial statements. The
information contained in the financial statements is reliable, and thus, can be
used for analysing.

is an external user who needs financial statements to know the

liquidity, leverage and profitability of the company.
A The customer
B The shareholder
C The lender
D The Government

2. Analysis of Financial Statements and Tools and

Techniques of Financial Statements.
[Learning Outcome b]
2.1 Analysis of Financial Statements

Analysis means detailed study of the financial statements which involves careful
reading of the financial information contained and coming up with explanations
based on certain conclusions. This analysis and explanations are used by the
proprietor or by any other user group. The main aim of the financial statements is
to help the user in decision making.

Before the analysis of the financial statements, there are 3 important things that
must be known:
 The purpose of the user
 Part of financial statements or a particular portion to be analyzed
 Method or technique to be used for analysis
The analysis may involve study of some comparable concerns at a particular time
i.e. Financial Year 1998-1999 or it may study only one particular firm over a
period of day 5 or 10 years, or it may cover both.
 480

The IRDA has suggested that all Life Insurers must prepare financial statements in following manner for five years:

Summary of Financial Statements Annexure I (Rs. In lakhs)

Sr no Particulars
Policyholders’ A/c
1 Gross premium income
2 Net premium income #
3 Income from investments (Net) @
4 Other income (Pl. specify)
5 Total income
6 Commissions
7 Brokerage
8 Operating Expenses related to insurance business
9 Total Expenses
10 Payment to policy holders*
11 Increase in actuarial liability
12 Surplus/Deficit from operations
SHAREHOLDERS’A/c
13 Total income under Shareholders’ Account
14 Profit/ (loss) before tax
15 Provisions for tax
16 Profit / loss after tax
17 Profit / loss carried to Balance Sheet
 481

Miscellaneous
(A) Policyholders’ account: Total funds
Total investments
Yield on investments (%)
18 (B) Shareholders’ account:
Total funds
Total investments
Yield on investments (%)
19 Yield on total investments
20 Paid up equity capital
21 Net worth
22 Total Assets
23 Earnings per share (Rs.)
24 Book value per share (Rs.)

# Net of reinsurance
@ Net of losses
* Inclusive of interim bonuses, if any
 482

2.2 Tools and Techniques of Financial Analysis

Financial Statements contain many figures which cannot give any clear idea
about the financial position of the enterprise. It is the relation of a particular
figure to other figures or the change in figures from one period to another that is
important. To understand this relation and the changes, tools of financial analysis
are used. Following are the most commonly used techniques:

1. Horizontal Analysis

Generally Accepted Accounting Principle (GAAP) needs presentation of

comparative financial statements that shows the current year’s and past years’
financial information. The most common way of studying such kind of
statements is the horizontal analysis, which begins with calculation of the
absolute amount changes and percentage changes from the previous to the
current year.

The percentage change is computed as below:

Comparative Balance Sheets with Horizontal Analysis

ABC Ltd.
Consolidated Balance Sheets
As at 31st March 2010 and as at 31st March, 2009

Rs. [in lakhs] Increase [Decrease]

2010 2009 Amount Percentage
Assets
Current Assets
Cash and Bank Balances 965 755 210 27.8
Investments 216 937 [721] [76.9]
Sundry Debtors 1382 1087 295 27.1
Inventories 1507 580 927 159.8
Prepaid Expenditure 268 199 69 34.7
Total Current Assets 4338 3558 780 21.9
 483

Land and Buildings 405 256 149 58.2

Plant and Machinery 578 516 62 12.0
Other Fixed Assets 604 567 37 6.5
1587 1339 248 18.5
Less Depreciation [753] [673] [80] 11.9
Net Fixed Assets 834 666 168 25.2
Total Assets 5172 4224 948 22.4

Capital Liabilities and

Current Liabilities
Sundry Creditors 823 184 639 347.3
Provisions for Expenses 1692 1242 450 36.2
Total Current Liabilities 2515 1426 1089 76.4
Secured loans 631 611 20 3.3
Share Capital 282 282 - -
Reserves 1744 1905 [161] [8.5]
Total Shareholders’ Equity 2026 2187 [161] [7.4]
Total Liabilities and
5172 4224 948 22.4
Shareholders ‘Equity

The Base Year in any set of data is always the first year being studied. For
example, from 2009 to 2010, ABC Ltd’s total assets increased by Rs.948 lakhs,
from Rs.4, 224 lakhs to Rs.5, 172 lakhs, or by 22.4 percent, computed as follows:

On further study of the comparative balance sheet, following information shows

the changes from 2009 to 2010.

 Total Assets increased by 22.4% with a large increase of 159.8% in

inventories.
 There was a decrease in investment of 76.9%.
 Increase in current liabilities by 76.4% was more than 3 times the percentage
increase in current assets of 21.9%.
 Sundry Creditors increased by 347.3 %, which is a large increase.
 Total shareholders’ equity increased by 7.4%.
 484

Likewise, horizontal analysis can be used for comparison of Income Statement of

ABC Ltd for 2010 and 2009 which will give us separate components of income –
like sales and other incomes and different expenses. Thus horizontal analysis
gives us a better idea about the position of ABC Ltd. from different viewpoints.

2. Trend Analysis

Trend analysis is slightly different from horizontal analysis, in which percentage

changes are calculated for successive years instead of only two years. In the long
run, trend analysis is crucial because it shows the basic changes in the nature of
business. The method of trend analysis is used to evaluate data on various key
indicators for five or more years of a firm.

The percentage change is computed as below:

Data of Domestic and International net sales of ABC Ltd. together with a trend
analysis is given below:

ABC LTD.
Domestic and International Net Sales
Trend Analysis

Net Sales
[Rupees in lakhs] 2010 2009 2008 2007 2006

Domestic 4,388 3,885 3,485 3,241 3,401

International 3,589 3,201 2,824 2,317 1,883

Trend Analysis
[in percentages]

Domestic Net Sales 129 114 103 95 100

International Net Sales 191 170 150 123 100
 485

Trend analysis uses the index number to show changes in related items over a
period of time. Two things are needed for calculating the index numbers i.e. base
year for the purpose of conversion and the index year with which to compare.

Let us calculate the Domestic Net Sales taking 2006 as the base year and 2010 as
the index year:

Thus, an index number of 129.00 means that the 2010 sales are 129.00% more
than the 2006 sales - or they are 1.290 times the 2006 sales.

From the above, we can study the following things:

 ABC Ltd’s International Sales have been rising more quickly as compared to
the Domestic Sales.
 Domestic Sales have hardly grown from 2006 to 2008 apart from a rise in
2010.
 International Sales on the other hand have been rising substantially in every
year.
 The above changes can be presented graphically also by taking ‘years’ on the
‘X’ axis and ‘percentage changes’ on the ‘Y’ axis.

Diagram 1: Shortcomings of Trend Analysis

 486

3. Vertical Analysis

In vertical analysis, percentages are used in order to show the connection

between different parts to the total in a single statement. The ‘Total Figure’ in the
statement is considered equal to 100% and then each factor of percentage is then
compared with the total. Such a statement of various percentages is called
‘Common – Size Statement’.

In other words, a common size statement normally is a financial statement

containing monetary data expressing percent to total. In common size all
elements of the Profit and Loss account are expressed as a percentage of total
revenue, and in the Balance Sheet all elements are expressed as a percentage of
total assets or liabilities.

ABC Ltd.
Common Size Balance Sheets as at 31st March2010 and as at 31st March2009

2010 2009
Assets
Current Assets 83.9% 84.2%
Net Fixed Assets 16.1% 15.8%
Total Assets 100.00% 100.00%

Liabilities
Current liabilities 48.6% 33.8%
Secured loans 12.2% 14.5%
Total Liabilities 60.8% 48.3%

Total Shareholders’ Equity 39.2% 51.7%

Total Liabilities and Shareholders’ Equity 100.00% 100.00%

Vertical Analysis is more useful for comparing certain important elements in the
operation of business. It is also useful for identifying significant changes in the
elements from one year to the next year in comparative common-size statements.

The above example shows that:

 the composition of assets of ABC Ltd. had no significant changes
 current liabilities have shown an increase from 33.8% to 48.6%
 there has been a decrease in the shareholders’ equity - to 39.2%
 487

Similarly, the common size statement can be used to draw a Profit and loss
account for each different item of expense and income. This can be presented
graphically in a pie-chart form also, and is mostly used for comparison between
companies.

4. Ratio Analysis
A ratio is the arithmetical relation between any two figures. Generally, a financial
ratio shows the inter relation between a number of items of financial information.
For example, suppose there is a direct relation between gross profit and sales
figures. Due to change in the ratio of gross profit to sales, there might be a
possibility that it would show that the business condition has changed or there
has been wrong accounting. So, in order to be accurate, there must be a study of
the basic data.
Ratios are indicators useful for:
 evaluation of a company’s financial position and operations
 making comparisons with results of previous years or with other companies
 highlighting areas that need further investigation
 analytical review
 general understanding of the company and its environment
A ratio determined using at least one financial variable can be called a financial
ratio. Also, if both numerator and denominator are financial variables or if one is
a financial variable and the other is a non-financial variable, then still it is called
a financial ratio.

Two variables from P/L Statement (Profit and Loss Ratio)

Two variables from Balance Sheet Statement (Balance Sheet Ratio)

One variable from the Profit and Loss Statement and other from the Balance
Sheet (Mixed Ratio)
 488

The above examples of ratios can be described on the basis of classification, but
normally, financial ratios are often classified according to their usage. It is
already seen that different users have different objectives, and some financial
ratios are often worked out to meet the objectives of each user group.

Hence, from the viewpoint of usage, we can have the following categories of
ratios:

i. Cash position
ii. Liquidity
iii. Working Capital /Cash flow
iv. Capital Structure or Structural Ratios
v. Profitability
vi. Debt Services Coverage
vii. Turnover

Annexure ‘A’ given in chapter 13 contains a list of different ratios that can be
worked out. But the main aim of ratios is to be used for interpretation and to
uncover new aspects of working for that business organisation.

2.3 Liquidity Ratio

Liquidity means the ability to convert any asset to cash within a short time
for pay out of short term liabilities. The inability to pay short term liabilities
affects its credibility as well as credit rating. It leads to commercial bankruptcy if
there is continuous default which eventually leads to sickness and dissolution.
Mostly, short term creditors and lenders are interested in knowing the liquidity
position of their financial stake.

Traditionally, two ratios are used to highlight the business liquidity.

1. Current Ratio

This ratio indicates whether the current assets will be able to generate
sufficient cash to pay off the current liabilities as and when they fall due.

Current assets
Current ratio =
Current liabilities
 489

The current ratio mainly gives an idea of the company’s ability to pay back its
current liabilities i.e. short-term debt and payables with its current assets i.e.
cash, inventory and receivables.
The higher the current ratio, the more capable the company is of paying its
obligations. This is because a high current ratio depicts that the company has
more current assets as compared to its current liabilities.

Furthermore, a ratio less than 1 suggests that the company would be unable to
pay off its obligations if they fall due at that point.

The current ratio can give an idea of the efficiency of a company’s operating
cycle or its ability to turn its products into cash.

Current Assets

Cash and Bank balances + Inventories + Disposable Investments + Sundry

Debtors + Loans and Advances + Receivables Accruals

Current Liabilities

Creditors for goods and services + short term loan + outstanding expenses +
provision for taxation + bank overdraft + cash credit + proposed dividend +
unclaimed dividend

2. Quick Ratio / Acid Test Ratio

This ratio illustrates how the company’s liquid current assets can cover its current
liabilities. Since stocks or inventory are the least liquid of the current assets, they
are excluded.

Quick assets (Current assets - Inventory)

Quick ratio =
Quick liabilities (Current liabilities - Bank overdraft)

Ratios that are ideal for a company depend upon the industry in which the
company operates. Generally a current ratio of 2:1 is considered to be
reasonable. If inventories can be quickly converted into cash then a lower
current ratio of around 1 is acceptable.

Some business sectors successfully operate with current ratios of less than one.
 490

Similarly, a quick ratio of 1:1 is considered to be reasonable; however, it

again depends on the business sector concerned.

Acid test ratio i.e. quick ratio is a precise test that indicates whether a firm has
enough short-term assets to cover its immediate liabilities without selling
inventory.

Quick Assets mean – Current Assets less Inventories

Quick Liabilities mean – Current Liabilities less Bank overdraft less cash credit.

The following information is extracted from the financial statements of Ram Ltd.

20Y0 Rs
Accounts receivables 54,000
Accounts payables 14,000
Inventories 30,000
Property, plant and equipment 79,000
Bank overdraft 12,000
Cash 10,000
Short-term loan 7,600

Current assets Rs54,000  Rs30,000  Rs10,000

Current ratio = =
Current liabilities Rs14,000  Rs12,000  Rs7,600
Rs94,000
= = 2.79: 1
Rs33,600

Quick assets (Current assets - Inventory)

Quick ratio =
Quick liabilities (Current liabilities - Bank overdraft)

Rs94,000 - Rs30,000 Rs64,000

= = = 2.96: 1
Rs33,600 - Rs12,000 Rs21,600
 491

2.4 Capital Structure Ratio

Capital structure ratios normally focus on the long term solvency position of the
business and one of the important ratios among this is Debt- Equity Ratio.

Debt Equity ratio means long term borrowed funds whereas equity refers to
owners’ equity i.e. share capital, preference share capital and reserves.

Diagram 2: Debt Equity Ratio

2.5 Profitability Ratios

The objective of profitability is to earn a satisfactory income for the company so

that the investors and shareholders continue to provide capital. A company’s
profitability is also closely linked to its liquidity because earnings ultimately
produce cash flow.
 492

1. Return on Capital Employed (ROCE)

Profit before interest and tax (PBIT) or operating profit

100
Capitalemployeed (shareholders' funds plus mediumand long term debt)

This ratio measures the percentage return to the company on the funds it had
employed, and is a good indication of the profitability of the organization. It is
also a useful overall measure of the capability of the management.

MICO Co’s accountant provides the following details:

The financial goal of the company for 2008: ROCE of 10% (minimum)

The actual figures are as follows:

Profit before interest and tax Rs.480

Sales revenue Rs.8,000
Average capital employed (Equity + long- Rs.5,647
term debt)

The previous year’s (2007) ratios were:

ROCE 9%
Operating profit margin 5%
Asset turnover ratio 1.8

The ROCE for 2008 are:

PBIT
ROCE 
Capital Emlpoyed
480
 x 100
5647
= 8.50%
 493

2. Earnings per Share Ratio (EPS)

This ratio falls under the category of Investor’s Ratios

Profit after taxLess Dividendon PrefernceShare

EPS  100
Numberof EquityShare

EPS data is frequently used to determine exchange ratio in cases of corporate

merger.

Particulars Rs
Profits after interest and taxes 500,000
Preference dividend 40,000
Ordinary share capital of Rs. 1 each 100,000

Calculate the earnings per share (EPS)

Profit after tax LessDividendon PrefernceShare

EPS  100
Number of EquityShare

EPS = Rs.4, 60,000 (WN1) / 1, 00,000 shares (WN2)

EPS = Rs.4.6 per share

Working Note 1

Profit available for distribution to ordinary shareholders

= Profit after interest and tax – Preference dividend

= Rs.5, 00,000 - Rs.40, 000
= Rs.4, 60,000

Working Note 2

No. of ordinary shares = Total ordinary share capital /Face value per share

= Rs.1, 00,000 / Rs.1

= 1, 00,000 shares
 494

3. Debt Service Coverage Ratio (DSCR)

Lenders are interested in knowing the debt service coverage to judge the firm’s
ability to pay off the current interest and the installment towards repayment of
loan.

If EBIT = Rs.5.90 lakhs, Interest = Rs.50, 000.00 and Installment = Rs.5 lakhs.

4. Turnover ratios

The turnover ratio indicates the effectiveness of the management to manage

funds and activities such as stock, collection of receivables and cash.

If sales = Rs.800 lakhs, Net Fixed Assets = Rs.175 lakhs and Current Assets =
Rs.195 lakhs,

Thus we can say that for every 1 rupee of asset, the sale generated is Rs.2.16. A
higher ratio indicates that more revenue is generated per rupee of investment in
assets.
 495

Vertical analysis data can be presented graphically in the form of

A Bar Diagram
B Pie Chart
C Column Diagram
D None of the above

3. Usefulness of Financial Ratios and Quantitative Ratios.

[Learning Outcome c]

3.1 Financial Ratios

We have already studied a number of ratios that are used for analysis and each
and every ratio used for calculation has its own significance. Let’s look at the
basic uses of financial ratios.

1. For predicting insolvency on the basis of financial ratio

Long term solvency can be calculated with the help of financial ratios. When we
say long term solvency, it means the ability of the company to survive for many
years. The idea for the use of long term solvency analysis is to point out clearly
well in advance whether a company is on the road to bankruptcy.

Studies have shown that financial ratios can predict, up to 5 years in advance,
that a company may fail. Fall in profitability and liquidity ratios are the two
possible signs of business failure. Similarly, we also have indicators like debt to
equity ratio and interest coverage ratio which show whether the business is on the
road to failure.

A very good deal of work has been done in the USA to predict as to how
corporate insolvency takes place by using financial ratios. These empirical
studies are of the following types:
 496

 Univariate Approaches: to find out the predictive ability of an individual

 Multi variate Approaches: several ratios are considered simultaneously to
predict corporate insolvency.

Owing to widespread sick industries in India, these studies are being proved to be
more useful. For the monitoring of sick industries (special provision) Act 1985
has been introduced. According to the Act, Board for Industrial and Financial
Reconstructions (BIFR) has been developed to find necessary diagnostics and
remedial measures.

2. Financial Ratios for Budgeting

Ratios are of great help in planning a budget for an organisation. This is because
a budget is an estimate of the present activity, based on the past activity
experience with an aim of improving. It can be used for measuring the actual
performance as against the budget activity or targets.

Ratios are useful to auditors while conducting audits as:

 They can know by interpreting and comparing ratios whether there has been
wrong accounting.
 Help in assessing performance of the unit being audited.
 Minimises routine checking.
 Helps in presenting final results.

3.2 Limitations of Ratio Analysis

Although ratio analysis is a widely used technique for evaluating the financial
performance of an enterprise, it is not free from limitations. Some of the
limitations are:

1. Changes in the price level affect the validity of comparison since historical
cost values may be substantially different from true values.

2. Differences in situations are difficult to eliminate.

3. Seasonal factors may influence financial data.

 497

4. Short term changes may affect ratios adversely.

5. Many businesses have diversified product lines. In such cases, ratios

calculated on the basis of aggregate data cannot be used for inter-firm
comparisons.

6. A firm may make year-end adjustments in order to present a good picture

regarding popularly used financial ratios, like current ratio or debt equity
ratio. Such window-dressing can change the character of financial ratios.

7. Differences in accounting policies and accounting periods make the

accounting data and the financial ratios of two firms non-comparable.

8. There is no standard set of ratios against which a firm’s ratios can be

compared.

Despite various limitations, financial ratios do serve a useful purpose. Ratio

analysis is an important tool for management as well as external end-users of
financial statements. Ratios should only serve as a guide for taking corrective
action and not as a substitute for judgement. In other words, financial ratios
provide clues and not conclusions; financial ratios are tools in the hands of
experts because there is no standard ready-made interpretation of financial ratios.

3.3 Quantitative ratios

1. Financial ratios continuously change with the variations in the price levels; in
a dynamic economy, the price levels rarely remain constant. This is one of
the most important drawbacks of the financial ratios.

2. A quantitative ratio reflects some basic input-output relationships and

changes only if the methods of operation, technology, degree of automation,
products mix etc. has been changed.

3. A standard input-output ratio can be established to show a relation between

raw materials of a specific quality.
 498

solvency can be calculated with the help of financial ratios to know the
ability of the company to survive.

A Short term
B Long term
C Cash
D None of the above

4. Ratio Analysis in the Life Insurance Sector.

[Learning Outcome d]
Some of the ratios used in LIC have been discussed and a reference to other
ratios has been made in chapter 7 on “Final Accounts, Revenue Accounts and
Balance Sheet.” All important formulae for most of the ratios have been given
under “Important statistics relating to Final Audited Accounts for 3 years ended"
in that chapter.

 Ratios are calculated for two or more than two years and then they are
compared with other units.

 Even the corporate ratios are interpreted and based on the indications
received, and corrective action is taken.

 Sometimes some of the ratios are calculated monthly for observing the trend
of movement in various indices, and for taking remedial action promptly.

Discussion on some of the ratios follows:

1. Average First Premium Per 1000 Sum Assured

 Fall in the ratio indicates that either large number of policies have been
issued under long term plans or more policies have been issued in the
quarterly or half-yearly mode
 In order to improve the ratio, product-mix has to be changed
 Part wise study will have to be undertaken for taking necessary action.
 499

2. Average First Year Premium Per 1000 Sum Assured

 Fall in this ratio indicates lapse of new business. Steps should, therefore, be
taken for conservation of New Business.

3. Conservation Ratio (CR)

 Preferably Conservation Ratio should be near 100%.

 If the C.R. is showing a downward trend, say from 98% to 97% or below, it
indicates lapse of new business.

4. Renewal Expense Ratio (RER)

 RER is a statutory ratio. It should not exceed 15%.

 It indicates cost of managing Renewal Business.
 If RER of current year exceeds RER of previous year, the likely reasons
could be:
a) Low First Year Premium
b) High management expenses and
c) High lapses

5. Overall Expense Ratio (OER)

 It indicates overall operational efficiency of the unit.

 If OER of current year exceeds OER of previous year, it indicates either or
all of the following:
a) Lapse of business lending to decrease in premium or under provision of
outstanding premium.
b) Increase in deposits and in unadjusted salary savings scheme collections.
c) Excess provision of expenses or higher management expenses
 500

6. Percentage of Outstanding Deposits to Total Premium

(Deposits and Premium of both life insurance and pension groups schemes
business – Ratio can be calculated separately for Life and Pension and Group
Schemes)

 Deposit, as long as it remains unadjusted, it is a liability of the organization.

 Above consolidated ratio [i.e. for Life and Pension and Group Schemes
together] has to be 1.5% or less.
 If the ratio exceeds 1.5%, there should be a concerted effort to adjust deposits
on a priority basis.
 Unadjusted deposits mean that liability has not been converted into income
of that office.

7. Percentage of Outstanding Claims to Total Claims Payable

 For death claims, the ratio has to be below 5%

 For maturity claims, it has to be 1% or less
 The lower the ratio, higher the claims settlement and the higher the
customer satisfaction.
8. Percentage of Outstanding First Year Premium to F.Y.P And
Percentage of Outstanding Renewal Premium to Renewal Premium.
These ratios calculated at year-end indicate whether accounting is done
correctly and whether outstanding provisions are made correctly.
9. Percentage of Outstanding First Year Commission to F.Y.Com. and
Percentage of outstanding Renewal Commission to Renewal Commission
These ratios calculated at year-end indicate whether:
i. accounting is done correctly
ii. outstanding provisions are made correctly and
iii. commission bills are being settled promptly.
10. Percentage of F.Y.Com to F.Y.Premium

This ratio should generally be in the vicinity of 25%.

 501

11. Percentage of Renewal Commission to Renewal Premium

This ratio should generally be in the vicinity of 5%.

Ratios higher than those stated above may indicate that excess provision is made
in the current year or an under provision was made in the previous year.

Thus, we saw that ratios play an important role in life insurance. Ratios help:

i. In assessing the performance of the unit.

ii. In knowing whether wrong accounting is done. And
iii. In knowing areas where to probe.

IRDA has also prescribed following ratios for Life Insurers:

1. New Business Premium Growth (Segment)

2. Net Retention Ratio

3. Ratio Of Expenses of Management

4. Commission Ratio
 502

5. Ratio of policyholders’ liabilities to shareholders’ funds.

6. Growth rate of shareholders fund.

7. Ratio of surplus to policyholders’ liability

8. Change in Net Worth

9. Profit after Tax / Total Income

Prefered Conservative Ratio (CR) should be near and Renewal Expense

Ratio (RER) should not exceed .

A 90%; 25%
B 60%; 35%
C 100%; 15%
D None of the above
 503

5. Fund flow statement and Cash flow Statement.

[Learning Outcome d]
5.1 Funds Flow Statement

The financial statements of a business indicate assets, liabilities and capital on

a particular date and also the profit or loss during a period. Sometimes there is a
possibility that there is enough profit in the business and the financial position is
also good and but there may be deficiency of cash or of working capital in
business. Financial statements cannot show how and where the cash is being
used. Thus a statement is prepared to know the sources and applications of funds
- from where Working Capital comes and where it is utilized.

Thus a statement of changes in financial position is a funds flow statement which

shows the flow of funds during the period represented by the two dates.

In a fund flow statement:

 The sales and other revenues are inflows of funds and, therefore, the sources
of funds and various expenses are outflows.
 Profit being an excess of revenue over expenses, is a source of fund, whereas
loss is an application of fund.
 Funds are sometimes interpreted as cash.
 The most common way to define ‘funds’: as being equal to working capital
that is current assets less current liabilities.

Diagram 3: Fund flow statements

 504

Following are the Sources of Funds and Application of funds.

Sources of funds:
 An increase in liabilities
 An increase in owners’ equity and / or
 A decrease in assets.
Application or uses of funds:
 A decrease in liabilities
 A decrease in owners’ equity and / or
 An increase in assets.

Funds flow statements are prepared on the basis of financial data. Given below
are comparative balance sheets as at 31 st March, 1997 and as at 31st March, 1998
of PQR Ltd. The third column shows the change in respective items.
[Rs. In
Particulars 31.3. 2009 31.3.2010 Lakhs]
Net Change
Share Capital 1,000 1,000 -
Reserve Fund 3,140 3,250 + 110
Other Reserves 5,090 8,180 + 3,090
Long Term Loans 6,030 11,820 +5,790
Short Term Loans 2,000 1,600 - 400
Current Liabilities and 10,490 11,160 + 670
Provisions
Total 27,750 37,010 +9,260
[Rs. In
Particulars 31.3. 2009 31.3. 2010 Lakhs]
Net Change
Fixed Assets 16,420 26,220
Less : Depreciation 7,510 8,670
Net Fixed Assets 8,910 17,550 +8,640
Stock 5,600 7,450 +1,850
Debtors 10,090 5,960 -4,130
Cash and Bank balances 1,850 2,950 +1,100
Investments 1,300 3,100 +1,800
Total 27,750 37,010 +9,260
The above statement showing ‘net changes’ in different items of balance sheet is
presented below in the form of “Sources and Application of Funds”.
 505

Statement of Sources and Application of Funds

Sources [Rs. In Application [Rs. In

Lakhs] Lakhs]
Increase in Reserve 110 Increase in Net Fixed 8640
Assets
Increase in other Increase in current
reserves 3090 assets
Increase in long term Stock 1850
loan 5790 Cash and Bank Balances 1100
Increase in current Investments 1800
liabilities and provisions 670
Decrease in current Decrease in short term
assets loan 400
Debtors 4130
13790 13790

On the basis of the above statement, a statement of net change in working capital
can be worked out, as shown below:
i)

[Rs. In
Change in Current Assets
Lakhs]
Increase in Stock 1850
Increase in Cash and Bank Balances 1100
Increase in Investments 1800
Total Increase 4750
Less : Decrease in Debtors 4130
Net addition to current assets 620
……A
ii)
Change in Current Liabilities [Rs. In
Lakhs]
Increase in current liabilities and provisions 670
Less : Decrease in short term loan 400
Net increase in current liabilities 270
.……B
iii) Net Change [Increase] in working capital i.e. [A-B] = 350

The above statements were derived from the data given in the balance sheets.
 506

5.2 Cash flow statements

In contrast to fund flow statement, cash flow statements are prepared to explain
the cash movements between two points of time.

The Institute of Chartered Accountants of India [ICAI] has recently issued

revised Accounting standard AS-3 on “Cash Flow Statements”. This standard
supersedes AS-3 issued by ICAI in June 1981 on “changes in Financial
Position”.

A gist of AS-3 is given below

i) In the initial years, AS-3 will be recommendatory in nature, and the standard
is recommended for use by companies listed on a recognized stock exchange
and other commercial, industrial and business enterprises in the public and
private sectors

ii) The statement deals with the provision of information about the historical
changes in cash and cash equivalents of an enterprise by means of a cash
flow statement which classifies cash flows during the period from operating,
investing and financing activities.

iii) An enterprise should prepare a cash flow statement and should present it for
each period for which financial statements are presented.

iv) A cash flow statement when used in conjunction with the rest of the financial
statements provides information that enables users to evaluate the changes in
net assets of an enterprise, its financial structure [including its liquidity and
solvency] and its ability to affect the amounts and timing of cash flows in
order to adopt to changing circumstances and opportunities.

v) Terms used in AS-3 are having following meanings :

 Cash comprises cash on hand and demand deposits with banks.

 Cash equivalents are short term, highly liquid investments that are
readily convertible into known amounts of cash and which are subject to
an insignificant risk of changes in value.
 Cash flows are inflows and outflows of cash and cash equivalents.
 507

 Operating activities are the principal revenue producing activities of the

enterprise and other activities that are not investing or financing
activities.

 Investing activities are the acquisition and disposal of long term assets
and other investments not included in cash equivalents.

 Financing activities are activities that result in changes in the size and
composition of the owners’ capital [including preference share capital in
the case of a company] and borrowings of the enterprise.

vi) The cash flow statement should report cash flows during the period classified
as operating, investing and financing activities.

vii) An enterprise should report cash flows from operating activities using either

 The direct method whereby major classes of gross cash receipts and
gross cash payments are disclosed, or

 The indirect method, whereby net profit or loss is adjusted for the effects
of transactions of a non-cash nature, any deferrals or accruals of past or
future operating cash receipts or payments, and items of income or
expense associated with investing or financing cash flows.

viii) An enterprise should report separately major classes of gross cash receipts
and gross cash payments arising from investing and financing activities
subject to certain exceptions under which they are reported on net basis.

ix) The cash flows associated with extra-ordinary items should be classified as
arising from operating, investing or financing activities as appropriate and
separately disclosed.

x) Cash flows arising from transactions in a foreign currency should be

recorded in an enterprise’s reporting currency by applying to the foreign
currency amount, the exchange rate between the reporting currency and the
foreign currency at the date of the cash flow.

xi) Cash flows arising from taxes on income should be separately disclosed and
should be classified as cash flows from operating activities unless they can be
specifically identified with financing and investing activities.
 508

5.3 Purpose and usefulness of cash-flow statements

The statement of cash flows show the effect on cash of a company’s
operating, investing and financing activities for an accounting period.
i) It explains the net increase or decrease in cash during the accounting
period.
ii) The main purpose of cash flow statement is to provide information
about an enterprise’s cash receipts and cash payments during an
accounting period.
iii) The statement also provides information about operating, investing
and financing activities during the accounting period.
If cash flow exceeds what is needed for operations and for expansion the
firm will not have to borrow additional funds for expansion. The excess
cash flow will be available to reduce the concern’s debt and improve its
financial position by lowering its debt to equity ratio, which position is
important to management from the point of view of liquidity of the firm.
The cash flow statement is useful internally to management and externally
to investors and creditors. Management uses the statement to assess the
liquidity of the business, to determine dividend policy, and to evaluate the
effects of major policy decisions involving investment and financing.
Investors and creditors find the statement useful in assessing the concern’s
ability to manage cash flows, to generate positive cash flows in future to
pay its liabilities and to pay dividends and interest.

The cash flow statement is useful to management and

to investors and creditors.
A Externally; Internally
B Internally; Externally
C For a short period; for a long period
D None of the above
 509

Summary

 The users of financial statements can be divided into internal and external
users.
 The main aim of the financial statements is to help in decision making for the
user.
 Horizontal analysis gives us a better idea about working of organisation from
different viewpoints.
 In the long run, Trend analysis is crucial because it shows the basic changes
in the nature of business.
 A common size statement normally is a financial statement containing
monetary data expressing percent to total.
 Financial ratios show the inter relation between number of items of financial
information.
 Ratios are used for making comparison with results in previous years or with
other companies.
 A ratio determined using at least one financial variable can be called a
financial ratio.
 The inability to pay short term liabilities affects the credibility as well as
credit rating of the organisation.
 The current ratio can give an idea of the efficiency of a company’s operating
cycle or its ability to turn its products into cash.
 Univariate helps to find out the predictive ability of an individual.
 Multi-variate considers that several ratios are simultaneously needed to
predict corporate insolvency
 Ratios should only serve as a guide for taking corrective action and not as a
substitute for judgement.
 A standard input- output ratio can be established to show relation between
raw materials of a specific quality.
 Profit being an excess of revenue over expenses, is a source of fund, whereas
loss is an application of fund.
 The cash flow statement should report cash flows during the period,
classified as operating, investing and financing activities.
 510

Answers to Test Yourself

Answer to TY 1

The correct option is C.

Answer to TY 2

The correct option is B.

Vertical analysis data can be presented in the form of a pie chart.

Answer to TY 3

The correct option is B.

Long term solvency means the ability of the company to survive for many years.

Answer to TY 4

The correct option is C.

The prefered CR ratio must be near 100% and RER should be 15%.

Answer to TY 5

The correct option is B.

Cash flow statement is useful internally to management to assess the liquidity

of the business and externally to investors to generate positive cash flows in
future to pay its liabilities.
 511

Self-Examination Questions
Question 1

When ‘Total Figure’ in a statement is equal to 100% of each factor of percentage,

such a statement is called a .

A Zero sized statement

B Complete sized statement
C Common size statement
D None of the above

Question 2

Following is an extract of financial statements of Amco Ltd.

2010 Rs
Accounts receivables 64,000
Accounts payables 24,000
Inventories 40,000
Property, plant and equipment 79,000
Bank overdraft 6,000
Cash 20,000
Short-term loan 9,600

What is the curent ratio ?

A 3.10
B 3.13
C 3.03
D 2.75

Question 3

Use the above data of Amco Ltd. and calculate the quick ratio.

A 2.50
B 2.96
C 2.05
D 3.14
 512

Question 4

If EBIT = Rs.6.90 lakhs, Interest = Rs.60, 000.00 and Installment = Rs.5 lakhs:

Calculate the Debt Service Coverage Ratio.

A 1.23
B 1.56
C 1.26
D None of the above.

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is C.

The ‘Total Figure’ in the statement is considered equal to 100% and then each
factor of percentage is compared with the total; this is called a Common Size
Statement.

Answer to SEQ 2

The correct option is B.

Current assets
Current ratio =
Current liabilities

Rs64,000  Rs40,000  Rs20,000

=
Rs24,000  Rs6,000  Rs9,600
Rs1,24,000
=
Rs39,600
=3.13
 513

Answer to SEQ 3

The correct option is A.

Quick assets (Current assets - Inventory)

Quick ratio = Quick liabilities (Current liabilities - Bank overdraft)

Rs1,24,000 - Rs40,000

Rs39,600 - Rs6,000
Rs84,000

Rs33,600

=2.50: 1

Answer to SEQ 4

The correct option is A.

 514

CHAPTER 12

FINANCIAL MANAGEMENT ENVIRONMENT

IN INDIA

Chapter Introduction
This chapter aims to provide you with an understanding of the liberalisation of
the insurance sector and finance sector in India. The chapter also explains the
Indian financial system and its components: capital market, money market,
insurance market, mutual funds and banking system.

a) Learn about the liberalisation of insurance sector and finance sector.

b) Understand the Indian financial system.
 515

1. Learn about the liberalisation of the insurance sector

and finance sector.
[Learning Outcome a]
1.1 Liberalisation of the insurance sector

After the liberalisation of the insurance sector in 1999, in addition to the public
sector life insurer - Life Insurance Corporation (LIC) of India - 23 more life
insurers have entered into life insurance business (as on March 2012). IRDA has
been set up to regulate and oversee the business of the insurance sector. Before
liberalisation, Life Insurance Corporation (LIC) was allowed to procure business
through traditional plans like:
 Endowment plans,
 Term insurance plans,
 Money back plans etc.

Disposable premium for investment was not much and investment of insurance
premium was regulated through the Insurance Act, which mandated that more
than 75% of premium investment should be in Government Securities.

After liberalisation, IRDA has allowed all life insurers (including LIC) to come
out with new and innovative products with freedom to invest according to
objectives of the products. Some of the innovative products include:
 unit linked insurance plans where the premium (after deducting charges) is
invested in funds as per options given by policyholders
 health insurance plans
 pension plans
 micro insurance plans etc.

IRDA has laid down premium investment guidelines based on which the
insurance companies can invest the premium collected from policyholders.

1.2 Liberalisation of finance sector

Along with the liberalisation of the insurance market, our capital market has also
been liberalised after 1991. Before 1991, only few instruments were available for
investment and choices were limited. Hence, there was little scope of financial
management which may give better return to all stakeholders (including
policyholders).
 516

1.3 Pre-liberalisation era

Before we discuss various financial instruments, let us understand the journey

from a mixed economy mode to the liberalisation policy.
 Government’s role: The Government plays a leading role in giving shape to
the financial policy in order to achieve growth in industry, agriculture and
trade and commerce.
 Mixed economy model: Post Independence, in 1947, the political leaders
who were greatly influenced by ideas of socialism and democracy adopted a
model of mixed economy for the economic development of the country.
 The public sector was supposed to play a leading role in developing the
infrastructure for basic industries like iron and steel, power, machinery etc.
and the private sector was assigned the role of developing other industries.
 Co-operative sector and small scale sector were also allowed to develop in
the specified areas.
 A model of mixed economy resulted into slow growth. 

Apart from various other factors, some of the public sector units became sick and
the huge investment in certain undertakings did not bring adequate returns. In
many cases, losses were incurred owing to various reasons such as:
 labour unrest,
 strikes,
 inefficient work force,
 absence of professional management etc.

Diagram 1: Reasons for PSUs not doing well

 517

In respect of the private sector, a number of protection measures like subsidies

and incentives were required to be given by the Government.

1.4 Establishment of Planning Commission

The model of economic development adopted strategies through the process of

planning. Immediately after independence, the Planning Commission was
established as an independent body and it was assigned the role of preparing five
year plans. The achievements through the plans were on a moderate scale in
various areas.

1.5 Post-liberalisation era

 In recent times, many changes have taken place in the world in respect of the
strategies for economic development.
 Owing to a revolution in communication, the world has come closer and
furtherance of global trade and commerce through liberalisation in policies
has been accepted in principle by developing countries, including India.
 Post 1991, reforms have been introduced and the Government of India has
adopted a policy of liberalisation and invited foreign capital for speedy
development of industries and removed a large number of restrictions on
foreign investments.
 Financial management concepts have been greatly influenced as a result of
the competitive environment in industries, trade and commerce.

The Planning Commission has been assigned the job of preparing

A Annual plans
B Three year plans
C Five year plans
D Seven year plans
 518

2. Understand the Indian financial system.

[Learning Outcome b]
In this section, we will discuss the Indian financial system in general and how the
insurance sector contributes to our financial system.

2.1 Role of financial institutions

 To run a business; every enterprise requires money. In the case of

infrastructure projects and large industries; the amount of initial capital
required is huge.
 At the time of Independence, the Government of India established most of
the core industries, where huge capital was required. For example SAIL,
BHEL, ONGC, NTPC etc. were set up.
 Very few private players like TATA, etc. were allowed to enter the core
industries area. The Tatas set up TATA Steel.
 To provide long term funds for Government projects and private projects, the
Government established financial institutions like IDBI (now IDBI Bank),
IFCI, LIC, GIC, UTI (now UTI Mutual Fund) and ICICI (now ICICI Bank).
 In the early stage of independence, every private player had to obtain a
licence from the Government for setting up an industry. Getting a license was
a very tedious and a time consuming job for industrialists. This in turn
retarded industrial growth.
 At the same time, Government industries were not making much progress as
there were no incentives to perform. Hence, industrial growth was minimal.
 In 1991, the Government took a decision to deregulate the ‘Licence Raj’ in
order to boost industrial growth.
 All developmental financial institutions like IFCI, IDBI, ICICI and LIC have
given a boost to industrial growth by providing capital and loans to the
private sector.

Financial System in India

The structure of the financial system in India is as follows:

 Capital Market
 Money Market
 Insurance Market
 Mutual Funds
 Banking System
 519

Diagram 2: Financial System in India

2.2 Capital Market

Capital market is a place where companies (privately owned or Government

owned) can raise money (capital). This is done by offering equity shares
(fractional ownership in the company). Money can be raised for capital
expenditure, meeting working capital requirements, acquisitions or for any other
purpose. Companies can raise funds in the following ways:

a) Primary Market

 IPO and FPO

When the company offers shares to the public for the first time, it is known as
Initial Public Offering (IPO). Subsequent offer/s made by the company to the
public is known as Follow-on Public Offering (FPO).

 Primary Market

Shares offered by the company through the IPO route or FPO route are in the
primary market.
 520

 Fixed Price Option and Book Building Process

In the IPO and FPO method of offering shares, companies sell equity or bonds to
the public through a fixed price option or book building process. In a fixed price
option, shares are issued at a fixed price. In a book building process, a specified
price band is determined by the issuer. Final issue price is decided on the basis of
bids received at various levels within the price band.

 Insurance companies’ participation

All insurance companies are allowed to participate in the primary market. Over
the last few decades, LIC has been an active player in the primary market and has
participated in many IPOs and FPOs.

 Share allotment

After the ‘issue closing date’, the allotment of shares is finalised, and the over-
subscription money is refunded.

 Trading of shares

On the listing date, the trading of shares starts on the stock exchange. The
Bombay Stock Exchange and the National Stock Exchange are the two primary
stock exchanges in India. After listing, buying and selling of shares happens
through the stock exchange. This is known as the secondary market.

b) Secondary Market

 Trading

Once shares / bonds are allotted to investors, trading in these securities happens
through the exchange i.e. sale and purchase happens through stock exchanges.

 BSE and NSE

Earlier, there used to be a number of stock exchanges. However, after the

introduction of screen based trading, only two stock exchanges i.e. National
Stock Exchange of India (NSE) and Bombay Stock Exchange are more active.
 521

 Brokers:

Sale and purchase of shares / bonds are allowed only through registered
intermediaries or members. These intermediaries or members are known as
brokers.

 Taxation:

Securities Transactions Tax (STT) is payable on the sale and purchase of shares.
No long term capital gain tax is payable where shares are held for more than 12
months.

Securities and Exchange Board of India (SEBI)

i) Regulator:

SEBI is the capital market regulator in India. SEBI, along with its members,
works towards orderly growth of the capital markets and ensures the smooth
functioning of the capital markets. SEBI also plays the role of a watchdog.

ii) Dematerialisation:

Since its establishment, SEBI has introduced a lot of reform measures from time
to time. SEBI has mandated that no company will be allowed to issue shares in
physical form and all shares should be in demat (electronic) form only. All
investors including institutional investors shall have a demat account before
applying for allotment of shares / bonds through the primary market or sale /
purchase of shares / bonds through stock exchanges.

iii) Depositories:

Shares / Bonds can be held in demat form with the authorised depositories. SEBI
has authorised two depositories that can hold securities in demat form for demat
account holders. These are:
 National Securities Depository Ltd. (NSDL) and
 Central Securities Depository Ltd. (CSDL)
 522

iv) Avoiding fraud:

Purpose of demat is that shares / bonds should be purchased / sold in a

transparent manner only and there should not be any kind of creation of black
market / grey market. Dematerialisation also ensures that frauds / scams which
were taking place in case of physical holding of securities are avoided.

v) All insurance companies including LIC are active participants in the

secondary market.

Private placement of securities

Sometimes companies do not wish to raise money by issuing shares / bonds to

the public. They may issue shares through private placement to:
 Promoters,
 Foreign institutional investors (FII),
 Domestic institutional investors (DII),
 Anchor investors,
 Private equity (PE) investors etc.

Diagram 3: Private placement

Some companies prefer the private placement route because they don’t need to
spend a large amount for marketing the issue. All insurance companies are
allowed to purchase shares / bonds through private placement. Now companies
can also go abroad for raising capital through ADR (American Depository
Receipts) / GDR (Global Depository Receipts) / FCCB (Foreign Currency
Convertible Bonds) and list their shares on foreign stock exchanges.
Life Insurance Companies can also raise capital through markets subject to
guidelines issued by IRDA and SEBI.
 523

2.3 Money Market

Insurance companies collect premium at the branch level and, after meeting all
expenses, transfer surplus funds to their head office for investment. Insurance
companies cannot immediately invest their surplus funds into stock markets or
lend it to companies / industries. Hence, in the short term, they invest their
money in money market instruments.
Money market securities are instruments with maturity of not more than one
year. Some of these instruments include:
a) Certificate of deposit issued by companies
b) Commercial papers issued by companies
c) Repo and reverse repo by RBI
d) Treasury bills by RBI
e) Call, notice money through RBI
f) Collateralised borrowing and lending obligation (CBLO)
g) Fixed deposits

Diagram 4: Money Market Securities

Generally, insurance companies put their immediate money in this account. Its
maturity can be as short as one day. This is like call and notice money. Presently,
RBI does not permit insurance companies to participate in call and notice money
directly.
 524

2.4 Insurance Market

a) Pre-liberalisation insurance market

Insurance provides risk cover to an individual against uncertainties in life like

untimely death. Most of the life insurance plans sold by the LIC during the pre-
liberalisation era came with a savings component. These plans are known as
participating plans (endowment plans or money back plans). In these plans, the
premium after deducting expenses was invested by LIC on behalf of the insured.
The returns earned from these investments were shared with the contributing
policyholders in the form of bonuses.

b) Post-liberalisation insurance market

Now, after liberalisation of the economy and the insurance sector, while LIC and
private insurance companies continue to offer the above mentioned participating
plans, a lot has changed. Insurance companies have innovated and have come out
with a variety of investment plans that give the investor a lot of investment
options to choose from, based on his risk profile. For example:

 in unit linked insurance plans (ULIP), the insured gets the option to
participate in the growth of capital markets
 in pension plans he can get regular income (annuity) during his retirement
years
 in health plans he can get himself covered against medical emergencies like
hospitalisation
 in riders he has a lot of options to choose from based on his requirement

Premium collected by insurance companies invested in Government securities is

directed towards building infrastructure like roads, railways, airports, ports, core
industries, rural development schemes etc.
 525

2.5 Mutual Funds

Introduction to mutual funds

A mutual fund is a professional collective investment scheme that pools money

from investors with a common objective; to invest it in stocks, bonds, money
market instruments and any other securities as notified by SEBI. The returns
earned are shared with the investors.

Investor classes

In India, mutual funds industry is regulated by SEBI. Mutual funds collect money
from various classes of investors like
 Individuals,
 High net worth individuals,
 Companies
 Institutions etc.

Types of schemes

Mutual fund houses float various schemes to cater to the requirements of

different groups of people. Generally, mutual funds offer the following types of
schemes to their investors:

a) Equity Schemes:

These schemes invest a major portion of their money in equities and equity
related securities

b) Debt Schemes:

These schemes invest a major portion of their money in fixed income securities
like bonds, debentures, fixed deposits etc.

c) Balanced Schemes:

These schemes invest a major portion of their money in a mix of equities and
debt instruments.
 526

d) Gilt Schemes:

These schemes invest a major portion of their money in Government securities

(G-secs) like Treasury Bills and / or Long Dated Securities.

e) Money Market Schemes:

These schemes invest a major portion of their money in short term securities with
maturities of less than a year.

Diagram 5: Types of schemes offered by MFs

Open ended and close ended funds

a) Open ended funds

In this scheme, the investor can purchase units from or sell units to the fund
house at any time at the prevailing net asset value (NAV).

Net Asset Value (NAV) =

Current Market Value of fund’s holding – Fund’s liabilities
Number of fund’s units outstanding

NAV is calculated every day in case of open ended schemes.

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b) Close ended funds

This scheme is open for subscription for a short period and has a fixed maturity
period of say 3 years or 5 years etc. Generally, units are sold at face value and
units are redeemed at NAV at the end of the maturity period. After closure of the
subscription period, the scheme units are listed on the stock exchange for trading.
Units can be bought and sold through the stock exchange. If an investor wants to
redeem the unit/s before the maturity period, he may have to pay a penalty called
the exit load.

Generally, insurance companies invest their surplus amount in money market

funds. The money market instruments comprise fixed income securities with a
short time to maturity (less than a year) and high credit quality. Investors often
use money market funds as a substitute to a bank savings account. IRDA has laid
down guidelines for investment of premium in various securities with prescribed
limits.

2.6 Banking System in India

Banks play a major role in channeling savings from the general public (who have
surplus investible funds) to the Government / companies who need funds for
developmental projects. In India, the banking system plays a major role in
meeting the short term, medium term and long term financial needs of the
industry. The Reserve Bank of India (RBI) is the banking regulator and has the
responsibility to ensure smooth functioning of the banking sector. The banking
system can be classified as follows.

Diagram 6: Classification of Banking System

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a) Nationalised Banks

In these banks, the Government of India is the majority shareholder (more than
51% shareholding). These banks are also known as PSU banks. Examples of
nationalised banks include:
 State Bank of India and its subsidiaries
 Punjab National Bank
 Bank of India
 Bank of Baroda
 Andhra Bank
 Bank of India etc.

b) Private Banks

In these banks, majority of the shareholding is with private individuals or

corporate entities. Examples of private banks include:
 ICICI Bank
 HDFC Bank
 Axis Bank
 Kotak Mahindra Bank
 Yes Bank
 Indusind Bank etc.

c) Foreign Banks

These banks are headquartered outside India and have operations in India.
Examples of foreign banks include:
 Standard Chartered Bank
 HSBC Bank
 Citibank
 Royal Bank of Scotland
 Barclays Bank
 Bank of America

d) Co-operative Banks

These banks are established by groups of people and are registered with the
Registrar of co-operative societies. Examples of co-operative banks include:
 Saraswat Co-operative Bank
 Rupee Co-operative Bank
 Cosmos Co-operative Bank
 Ratnakar Co-operative Bank
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 Karad Co-operative Bank

 Pune District Co-operative Bank

e) Regional Rural Banks

These banks have been set up with an objective to ensure sufficient institutional
credit for agriculture and other rural sectors. The RRBs are jointly owned by the
Government of India, the concerned State Government and the Sponsor Banks.
They collect money from the people in the form of deposits and lend them to
farmers for agricultural and allied activities. Examples of regional rural banks
include:
 Chhatisgarh Gramin Bank
 Haryana Gramin Bank
 Parvatiya Gramin Bank
 Pragathi Gramin Bank
 Sharda Gramin Bank
 Manipur Rural Bank

f) National Bank for Agricultural and Rural Development (NABARD)

NABARD is set up as an apex Development Bank with a mandate for facilitating

credit flow for promotion and development of agriculture, small-scale industries,
cottage and village industries, handicrafts and other rural crafts. It also has the
mandate to support all other allied economic activities in rural areas, promote
integrated and sustainable rural development and secure prosperity of rural areas.

g) National Housing Bank (NHB)

NHB is the regulator for housing finance companies (HFCs) in India. NHB
controls the activities of HFCs like HDFC, LIC Housing Finance, Dewan
Housing Finance etc. and also provides them with low cost finance. Its basic
function is to operate as a principal agency to promote housing finance
institutions both at local and regional levels and to provide financial and other
support to such institutions and for matters connected therewith or incidental
thereto.
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Primary functions of banks:

Banks primarily perform two functions:

 Collecting deposits:

Banks collect money through Current Accounts, Saving Accounts (Demand

Deposits) and Fixed Deposits, Recurring Deposits (Time Deposits).

 Giving loans:

These deposits are lent in the form of loans to corporates (business loans,
working capital loans, overdraft, equipment financing loans term loan etc.) and to
individuals (personal loan, housing loan and education loan, vehicle loan etc.).
They also sell third party products like insurance and mutual funds to boost their
fee income.

The financial management function plays a very important role in every sector of
the economy and a professional finance manager can play a vital role in this era
of cut throat competition where the policyholder is the king. The finance
manager has to be very vigilant, efficient, opportunistic and enterprising to pick
up best deals and at the same time, enforce financial discipline. Insurance
companies through their professional finance managers can make best use of
scarce resources available at their disposal and help in bringing the required
speedy economic development.

The licence raj was deregulated in .

A 1981
B 1991
C 2001
D 1971
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Summary
 Today, there are 24 life insurance companies (including LIC) doing life
insurance business in India.
 Post-Independence in 1947, the political leaders who were greatly influenced
by ideas of socialism and democracy adopted a model of mixed economy for
the economic development of the country.
 Immediately after independence, the Planning Commission was established
and it was assigned the role of preparing five year plans.
 At the time of Independence, the Government of India established most of
the core industries, where huge capital was required. For example SAIL,
BHEL, ONGC, NTPC etc. were set up.
 In 1991, the Government took a decision to deregulate the Licence Raj to
boost industrial growth.
 Following is the structure of the financial system in India: capital market,
money market, insurance market, mutual funds, banking system.
 Capital market is a place where companies (privately owned or Government
owned) can raise money (capital).
 When a company issues shares for the first time, it is done through the IPO
process in the primary market.
 Once the shares are listed, the trading (buying and selling) of shares happens
through the secondary market.
 The BSE and the NSE are the two active stock exchanges in India.
 SEBI is the stock market regulator in India.
 NSDL and CSDL are SEBI authorised depositories.
 Money market securities are instruments with maturity of not more than one
year.
 A mutual fund is a professional collective investment scheme that pools
money from investors with a common objective; to invest it in stocks, bonds,
money market instruments and any other securities as notified by SEBI.
 Investment schemes offered by mutual funds include: equity schemes, debt
schemes, balanced schemes, gilt schemes, money market schemes etc.
 Banks play a major role in channeling savings from the general public (who
have surplus investible funds) to the Government / companies who need
funds for developmental projects.
 The Reserve Bank of India (RBI) is the banking regulator and has the
responsibility to ensure smooth functioning of the banking sector.
 The banking system in India includes: national banks, private banks, foreign
banks, co-operative banks, regional rural banks etc.
 532

Answers to Test Yourself

Answer to TY 1

The correct answer is C.

The Planning Commission has been assigned the job of preparing five year plans.

Answer to TY 2

The correct answer is B.

The licence raj was deregulated in 1991.

Self-Examination Questions
Question 1

The trading of shares of listed companies happens in the .

A Primary Market
B Secondary Market
C Intermediary Market
D Post Listing Market

Question 2

In an Initial Public Offering (IPO), the process of distributing shares to applicants

is known as

A Allotment of shares
B Allocation of shares
C Provisioning of shares
D Handing out of shares
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Question 3

Money market securities are instruments with maturity of not more than .

A 3 months
B 6 months
C 1 year
D 3 years

Question 4

In which of the following insurance plans does the insured get the option to
participate in the growth of capital markets?

A Endowment Assurance Plan

B Money Back Plan
C Term Insurance Plan
D Unit Linked Insurance Plan

Question 5

Which of the following plays a significant role in meeting the credit needs of
agriculture?

A NABARD
B NHB
C NIA
D SIDBI
 534

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

The trading of shares of listed companies happens in the secondary market.

Answer to SEQ 2

The correct answer is A.

In an Initial Public Offering (IPO), the process of distributing shares to applicants

is known as allotment of shares.

Answer to SEQ 3

The correct answer is C.

Money market securities are instruments with maturity of not more than one
year.

Answer to SEQ 4

The correct answer is D.

In a unit linked insurance plan (ULIP), the insured get the option to participate in
the growth of capital markets.

Answer to SEQ 5

The correct answer is A.

NABARD plays a significant role in meeting the credit needs of agriculture.

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CHAPTER 13

APPLICATION OF FINANCIAL MANAGEMENT

CONCEPTS IN INSURANCE INDUSTRY

Chapter Introduction
This chapter aims to provide an understanding about the different concepts of
financial management and their application to the insurance industry. You will
learn how the insurance industry applies these concepts to perform better and
provide the best returns to policyholders.

a) Financial Management and the Insurance Industry.

b) Financial Management concepts and application.
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1. Financial Management and the Insurance Industry.

[Learning Outcome a]
The Indian insurance industry is growing stronger due to modern and much
improved liberalization of the economy brought about by key changes e.g. the
domination of the government ended with the introduction of the Insurance
Regulatory and Development Authority (IRDA) Bill and with the allowing of
participation of foreign players into the market (with some parameters on direct
foreign ownership).

Due to increase in competition among the players in the insurance industry to

perform better and at the same time to provide attractive returns to stakeholders,
financial management concepts and their application were introduced.

With the introduction of foregin players in the insurace industry who develop
innovative products, perform better marketing of products and ensure strong
distribution skills, private companies are attracting more Indian customers as
compared to the government ones.

As cut-throat competition is present among insurance companies, financial

concepts need to be applied to get the best possible returns for the policy holders
and stakeholders. To achieve this, the insurer has to make optimal use of the
financial assets available with them. There should not be any idle financial asset
(like cash) at any level, be it a branch, regional office, or head office. If any
financial asset is idle and unused, it should be invested promptly to get returns
from it.

The introduction of foreign companies in the insurance industry has:

A Given rise to new products

B Increased the level of competition
C Provided attractive rate of interest
D All of the above
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2. Financial Management concepts and application.

[Learning Outcome b]
In order to be competent and perform to the optimum level, the insurance
industry applies financial management concepts. These are applied to the overall
working of the business.

2.1 Types of concepts and their application

1. Solvency Margin

Solvency is the capacity of an organisation’s assets to cover its liabilities, i.e. to

pay its debts. It is different from liquidity.

Solvency for an insurance company relates to the payment of claims. It directly

depends on the financial strength of the company and whether it has sufficent
reserves to meet the obligations together with enough capital as security, if the
needs arises.
 The amount of asset that exceeds the liability is the shareholders’ fund.
 Different methods used for valuation of assets and liabilities are given in the
insurance regulations.
 The compulsory minimum solvency margin must be maintained all the time.

In order to determine the solvency margin, insurers need to follow some basic
principles of cash management called Safety/Profitabilty/ Liquidity (SPL).

Diagram 1: SPL (Safety/Profitabilty/ Liquidity)

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2. Risk Management

Risk management in insurance is a kind of policy bought by individuals or

organizations in an effort to minimize any likely damages - which can be
infrastructure-based or financial. Damages can also be either internal or external.

The main purpose of insurance is to protect policyholders from unforeseen

calamities like natural death or death due to accident by giving them death claim,
claim on accident and maturity claim. The insurer must create a reserve for the
policyholders to meet the liability at any given point of time. Thus, with the use
of financial management tools, risk can be ascertained and measures to mitigate
the risk can be taken.

A ship carrying valuable goods can sink, or the goods might get damaged in
transit. To manage this risk, an insurance policy can be taken to protect the goods
or to recover the damage.

The life insurance company invests the premium received from the policyholders
in various classes of assets like:
 Real estate
 Capital Market Operations
 Loan to policy holders

Normally, when the life insurance company makes investments, it is exposed to

two types of risk:
 Underwriting risk
 Asset risk

Here, we will study asset risk as a financial management tool.

a) Asset Risk

As life insurers hold investments in various assets, they are subject to different
types of asset risk.
 539

Diagram 2: Types of Asset risk

b) Realization risk

When the asset value is dependent on the performance and operation of the
business, the insurer anticipates the return on investment, which includes the cash
rate to compensate for the realization of additional risk. In a life insurance
company, the insurer has to analyze the risk and must be able to separate the
return from the investment.

The insurer has to mitigate the risk involved with the investment. Normally, the
Life Insurance Companies offer products that are hybrid in nature, like:

i) Insurance

ii) Investment
 540

 The insurance company must be able to separate the insurance portion from
the investment products.

 The life insurance premium is calculated on the actual valuation, and it

should be a sound investment even though the return is low, like in the case
of government bonds.

 In regards to the investment part, the insurance company is improving and

developing much better products where the investment objective is different.

The capital protection plan objective is to protect capital so that the investment is
safe and secure. Thus, the risk varies according to the nature of the product.

 We have seen that concentration risk involves putting all money in one asset,
thus the insurer has to be careful with the investment and must keep
sufficient funds in cash or equivalents like call money or short term FD.

 The insurer must estimate the portfolio to avoid market risk and should
reshuffle any assets where he sees any shrinkage in the asset.

 The insurer must obtain credit rating for those companies where it decides to
put money so as to avoid any credit risk.

 Finally, the insurer must recover the assets from the debtors as and when
due.

3. Asset Liability Management (ALM)

ALM is one of the most important management techniques used by Life

Insurance Companies. Generally, the contracts that are entered by the insurance
company are long term in nature, and thus, it’s a long term liability for the
insurance company that has to be paid out in the future. The insurance company
should have sufficient long term assets to pay out its liabilities.

What is ALM?

In order to maintain a favourable ratio between assets and liabilities,

organisations use the technique of ALM. ALM is used for sound decision making
and taking actions with respect to assets and liabilities. The objective of ALM is
 541

to manage risk rather than to eliminate it with a certain structure which includes
self-imposed limits.

ALM is very important and vital for proper management of finances in order to
enable the organisation to meet its future needs of cash flow and capital. The
insurer must have sufficient long term assets to meet its long term liabilities. For
insurance companies, the ALM focal point is to match the liability to the asset,
with the primary goal of minimising interest risk.

The main objective of ALM can be classified into two parts:

 Liquidity
 Interest rate risk management

ALM helps the insurer to maintain a good balance for effective competition and
to meet legitimate objectives for growth, profit and risk. It helps to forecast
changes in economic value over a range of likely and adverse scenarios.

Insurers should have prior knowledge of sufficient assets that must be available
to match liabilities for new businesses.

The value of future cash flows must be in such a manner that it is consistent with
the market prices and should take into consideration the distribution of future
asset and liability cash flows to decide the exposure of ALM risk.

4. Cash Management

The operations of the life insurance company are spread all over and are multi-
level e.g. Branch office, Regional office and Head office. Collection of premium
is done at the lowest level i.e. the branch or business center. After the premium is
collected, it is sent to the head office. Some insurance companies have given the
Branch office power to make payments to policyholders and manage expenses at
their level, whereas some have centralized their power at the head office.

Some insurance companies have decentralized the payment at the Branch Office
Level, after they have assessed the need for payment of expenses (to
policyholders and others). After allocating funds for this, if there is any surplus, it
should be transferred to the higher office as soon as possible. In some branches,
they have the facility for only collections and not payments. Accordingly, the
total deposits with the bank must be reported to the controlling office on a daily
basis. After the controlling office has been reported about the cash, it is then
 542

transferred immediately. The funds should not remain idle in the bank account as
no interest will be earned on them.

Transfer of all surplus funds should be made within the minimum possible time
and the funds must be available to insurance companies for investment on real
time basis. Funds are usually transferred thorough RTGS or Net Banking.

5. Capital Management

In order to have better returns, the insurance company must make optimal
utilization of its capital.

Financial Ratios in Life Insurance Industry

Accounting Ratios

a) Average Sum Assured per policy (individual)

b) Percentage of SSS Sum Assured to total Sum Assured (individual)
c) Percentage of Medical Sum Assured to Total Sum Assured
d) Average Medical Fees per 1000 Medical Sum Assured
e) Average policy stamps( individual) per 1000 sum assured (individual)
f) Average first premium per 1000Aum Assured (individual)
g) Average F.Y.P. per 1000 Sum Assured (individual)
h) Conservation Ratio
i) Renewal Expense Ratio
j) Overall Expense Ratio
k) Percentage of First Year Commission (individual) to First Year Premium
(individual)
l) Percentage of Renewal Commission (individual) to Renewal Premium
(individual)
m) Cost of printing and stationery per in force policy
n) Cost of postage, telegram and M.O. commission per in force policy
o) Cost of telephone charges per force policy percentage of Surplus Fund to
total premium.
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Asset Liability Management for an organisation means to have sufficient

against its .

A Short term assets; Long term liabilities

B Long term assets; Short term liabilities
C Long term assets; Long term liabilities
D Long term liabilities; Long term assets

Summary
 Financial concepts are used by insurance companies to get attractive returns
for the policy holders in the face of tough competition.
 Due to introduction of foreign companies in the industry, there has been
increase in competition.
 Solvency and liquidity are two different things. Solvency means the ability of
an organisation to cover its liabilities with the use of the organisation’s
assets. Liquidity refers to the cash flow in an organisation.
 Risk management refers to minimising the likely damages.
 ALM is used for sound decision making and taking actions with respect to
assets and liabilities.
 ALM helps to forecast changes regarding economic value.
 RTGS or Net Banking methods are used for transfer of funds collected by the
controlling office.
 The insurance company must make optimal utilisation of its capital.
 544

Answers to Test Yourself

Answer to TY 1
The correct option is B.

The introduction of foreign companies in the inurance industry has given new
products, and policyholders are provided with attractive rates of interest which
has increased the level of competion.

Answer to TY 2

The correct option is C.

ALM is to have sufficent long term assets to cover up long term liablities with a
primary objective to minimize risk.

Self-Examination Questions
Question 1

When the asset value is dependent on the performance and operation of the
business, and the rate of investment includes the cash rate to compensate for the
additional risk, this is called

A Concentration Risk
B Market Risk
C Realization Risk
D Liquidity Risk

Question 2

is the capacity of an organiation to cover its liabilties by its assets.

A Liquidity
B Solvency
C Asset Liabilty Management
D None of the above
 545

Question 3

risk means losses due to exposure to only a certain amount of

investement where the insurer puts all his money in one kind of asset.

A Credit
B Capital
C Market
D Concentration

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is A.

Answer to SEQ 2

The correct option is B.

Answer to SEQ 3

The correct option is C.

 546

CHAPTER 14

TAXATION (CURRENT SCENARIO)

Chapter Introduction
Taxes form an important source of revenue to the Government. This is a major
source of revenue generation. The Government has to fund various activities of
development and for this purpose it requires revenue which is generated through
taxation.

This chapter aims to provide you with an understanding of the taxation process.

a) Explain the objectives and canons of taxation.

b) Explain the salient features of income tax on companies carrying on life
insurance business.
c) Explain the salient features of income tax on salaries.
d) Explain the method of calculation of salary for the purpose of tax
deduction at source.
e) Discuss the applicability of tax deduction account number (T.A.N) and
permanent account number (PAN).
f) Discuss the features of income from house property.
g) Discuss the provisions of advance tax, tax audits and service tax
applicable to life insurance business.
 547

1. Explain the objectives and canons of taxation.

[Learning outcome a]

1.1 Definition of tax

A levy charged by the government on a product, income or activity.

Taxes are of two types; direct tax and indirect tax.

a) Direct tax

If tax is levied directly or on personal income or on corporate income then it is a

direct tax. Income tax and wealth tax are examples of direct taxes.

b) Indirect tax

If tax is levied on the price of goods or service, then it is called indirect tax.
Service tax, value added tax etc. are examples of indirect taxes.

1.2 Objectives of levying taxes

Following are the objectives of levying taxes:

 To finance planned and unplanned expenditure of the government.

 To finance the salaries of government staff and employment generation
 Rationalisation of terms and conditions of the economic system.

1.3 Canons of Taxations

The Father of Economics, Adam Smith, has laid down the following four basic
principles in order to build a good taxation system:

a) Equitable

This principle aims at equality and social justice to people. There should be equal
treatment of similarly situated tax payers i.e. taxes levied should be directly
proportional to the income.
 548

b) Certainty

According to this principle, there should be certainty in respect of:

 the amount of taxes which the tax payer has to pay

 the time when the tax is payable by the tax payer
 the form in which tax is to be paid to the government

In short, there should be consistency and stability in the prediction of tax payer’s
bills and amount of revenue collected over time.

c) Convenience

Taxes should be readily and easily assessed, collected and administered. Under
this principle, the convenience of the tax payer must be taken into account while
deciding the mode and timing of payment of taxes.

d) Economical

This principle requires that the tax administration is economical i.e. cost of tax
collection should be lower than the amount of tax collected. In short, compliance
and administration of taxes should be minimal in terms of cost.

Additional features

The above mentioned canons of taxation are also considered the original canons
of taxation. In view of the increased complexities in governance, modern
economists have come up with additional criteria which should also be complied
with while devising a tax system.

a) Adequacy

A tax should have the ability to produce sufficient and desirable amount of
revenue to the taxing authority i.e. the tax system should have the ability to yield
enough revenue without resorting to deficit financing. This is also called the
canon of productivity.
 549

b) Achievement of Social and Economic effect

The tax system should be elastic, i.e. the tax system should be capable of
reallocating resources to achieve various specific social and economic objectives.

For example, during a liquidity crunch when the government needs more income,
the taxation system should be elastic enough to generate additional income
through increase in the tax rates.

c) Neutrality

The tax system should not encourage inefficient allocation of resources by being
so extreme that tax payers make counterproductive economic decisions.

d) Simplicity

The tax system should be simple to understand and administer as it would

otherwise cause ambiguity in interpretations and thereby cause disputes.

e) Diversity

Tax revenues should be collected from various sources rather than from one
source. This is because diversified sources of revenue would ensure that the
government is not dependent heavily on one source.
 550

Diagram 1: Cannons of taxation

The objectives of taxation exclude:

A Financing planned and non-planned expenditure of government.

B Financing salaries of staff of government and employment generation
C Ensuring economical tax administration
D Rationalisation of terms and conditions of economic system
 551

2. Explain the salient features of income tax on companies

carrying on life insurance business.
[Learning Outcome b]
Income Tax is a charge on income, and it is applicable on individual, HUF and
companies including companies carrying on life insurance business.

In this learning outcome, we will discuss the features of Income Tax with respect
to companies carrying on life insurance business.

2.1 Income tax on companies carrying on life insurance business

Income Tax on life insurance companies is not considered a normal business

income. Tax on insurance companies is calculated in accordance with the
provisions of Section 44 read with the First Schedule of the Income tax 1961.

Section 44 provides that profits and gains of any business of an insurance

company shall be computed in accordance with the rules contained in the First
Schedule.

Part A of First Schedules deals with life insurance business.

1. Separate computation of profits and gains from life insurance business

Rule 1 of Section 115 B says that Profit and Gains of life insurance business shall
be computed separately from profit and gains of any other business.

2. Special rate of taxation

Profits and gains of life insurance business will be taxed at the special rate of
12.5% as per section 115B. Both policy holders’ and shareholders’ profit should
be taxed at 12.5%, as combined results represent profits from life insurance
business.

Profits and gains from ‘Other than life insurance business’ would be taxed at the
normal tax rate.
 552

3. Method of determining profits and gains from life insurance business

Rule 2 says that Profit and Gain shall be taken to be the annual average of the
surplus which is calculated by adjusting the surplus or deficit disclosed by the
actuarial valuation made in accordance with the Insurance Act 1938 (4 of 1938)
in respect of the last inter valuation period ending before the commencement of
the assessment year, so as to exclude from it any surplus or deficit included
therein which was made in any earlier inter-valuation period.

In short, life insurance business is taxed at 12.5% of valuation surplus as

determined by actuaries.

2.2 Income-Tax (I-Tax) Assessment Of Insurance Business

Section 44 of the I-Tax Act 1961 [under Chapter IV D – “Profits and Gains
of Business or Profession] exempts an insurance business of any kind from the
operation of the sections dealing with specified heads of income as well as those
of section 199 which deals with credits for tax deducted at source, and provides
that the profits and gains of such a business, from all sources, are to be computed
in accordance with the Rules contained in the First Schedule to the I-Tax Act
1961. The principle is applicable even to mutual associations and co-operative
societies carrying on insurance business.

1. Section 44 of the I-Tax Act 1961 is quoted below

Insurance Business

Notwithstanding anything to the contrary contained in the provisions of this Act

relating to the computation of income chargeable under the head “Interest on
Securities”, “Income from House Property”, “Capital gains” or “Income from
other sources”, or in Section 199 or in Sections 28 to 43B, the profits and gains
of any business of insurance, including any such business carried on by a mutual
insurance company or by a co-operative society, shall be computed in accordance
with the rules contained in the First Schedule”.

In the First Schedule, Part A deals with life insurance business, and Part B deals
with other insurance business.
 553

2. Part A of First Schedule to I. Tax Act 1961 states as under:

a) Profits of life insurance business to be computed separately.

In the case of a person who carries on or at any time in the previous years carried
on life insurance business, the profits and gains of such person from that business
shall be computed separately from his profits and gains from any other business.

b) Computation of profits of life insurance business

The profits and gains of life insurance business shall be taken to be the annual
average of the surplus arrived at by adjusting the surplus or deficit disclosed by
the actuarial valuation made in accordance with the Insurance Act, 1938 [4 of
1938], in respect of the last inter-valuation period ending before the
commencement of the assessment year, so as to exclude from it any surplus or
deficit included therein which was made in any earlier inter-valuation period.

c) Adjustment of tax paid by deduction at source

Where for any year an assessment of the profits of life insurance business is
made in accordance with the annual average of a surplus disclosed by a valuation
for an inter-valuation period exceeding twelve months, then in computing the
income-tax payable for that year, credit shall not be given in accordance with
section 199 for the income-tax paid in the previous year, but credit shall be given
for the annual average of the income-tax paid by deduction at source from
interest on securities or otherwise during such period”.

d) Tax on profits and gains of life insurance business

Section 115B of the Income Tax Act 1961 which deals with tax on profits and
gains of life insurance business is quoted below :-

115B. [(1)] Where the total income of an assessee includes any profits and gains
from life insurance business, the income-tax payable shall be the aggregate of –

i) the amount of income-tax calculated on the amount of profits and gains of

the life insurance business included in the total income, at the rate of twelve
and one-half per cent; and

ii) the amount of income-tax with which the assessee would have been
chargeable had the total income of the assessee been reduced by the amount
of profits and gains of the life insurance business.
 554

[(2)] Notwithstanding anything contained in Sub-section (1) or in any other law

for the time being in force or any instrument having the force of law, the assessee
shall, in addition to the payment of income-tax computed under sub-section(1),
deposit, during [the previous years relevant to the assessment years commencing
on the 1st day of April, 1989 and the 1st day of April, 1990], an amount equal to
thirty-three and one-third per cent of the amount of income-tax computed under
clause (i) of sub-section (1), in such social security fund (hereafter in this sub-
section referred to as the security fund), as the Central Government may by
notification in the Official Gazette, specify in this behalf :

Provided that where the assessee makes during the said previous [years] any
deposit of an amount of not less than two and one-half per cent of the profits and
gains of the life insurance business in the security fund, the amount of income-
tax payable by the assessee under the said clause (i) shall be reduced by an
amount equal to two and one-half percent of such profits and gains and,
accordingly, the deposit of thirty-three and one-third per cent required to be made
under this sub-section shall be calculated on the income-tax as so reduced.

e) Exemption from deduction at source

Section 43A of Life Insurance Act, 1956 states -- "Notwithstanding anything

contained in Section 193 or 194 of Income Tax Act 1961 [43 of 1961] no
deduction of Income Tax shall be made on any interest or dividend payable to the
corporation in respect of any securities or shares owned by it or in which it has
full beneficial interest."
 555

Diagram 2: Features of profits of life insurance business

Profits and gains of life insurance business are taxed at the rate of as per
section 115B.

A 10%
B 12.5%
C 8%
D 12%
 556

3. Explain the salient features of income tax on salaries.

[Learning Outcome c]
3.1 Income Tax on salaries

1. Introduction

Every employer, including insurance companies, is liable to deduct tax from

salaries.

Section 192 of Income Tax Act 1961 (IT Act) provides that every person
responsible for paying any income which is chargeable under the head ‘Salary’
shall deduct income tax on the estimated income of the assessees under the head
salary. The deduction has to be made at the time of payment of salary and
average rate of income tax has to be applied for deduction of tax. It should be
kept in mind that income tax will be deducted only when the estimated salary
exceeds the maximum amount not chargeable to tax.

2. Bodies liable to deduct tax and circumstances when applicable

Income Tax law requires the deduction of tax when

a) Payment is made by the employer to an employee.

b) Payment is in the nature of salary and
c) The income under the head salaries is above the maximum amount not
chargeable to tax.

Persons responsible for making

Details of entities payment under the head salaries
and for deduction of tax
Central / State Government / PSU like The designated drawing and
LIC disbursing officer.
Private and Public Companies like The Company itself as also the
Other Life Insurers principal officer thereof

3. Timing for deduction of taxes

Section 192 casts the responsibility on the employer of tax deduction at

source (TDS) at the time of actual payment of salary to an employee. Thus,
when advance salary and arrears of salary have been paid, the employer has to
take the same into account while computing the tax deductible.
 557

4. Rate of deduction of tax

According to Section 192, the employer is required to deduct tax at source on the
amount payable at the average rate of income tax. This is to be computed on the
basis of rates in force for the financial year in which payment is made.

For Financial year 2012 - 13 (AY 2013-14) the same is as follows

Individual only

Where total income
(i) does not exceed
Rs.200,000/-
Where the total income
(ii) exceeds Rs.200,000/- but
does exceed Rs.500000/-
Where the total income
exceeds Rs.500000/- but
(iii)
does not exceed
Rs.10,00,000/-
Where the total income
(iv)
exceeds Rs.10,00,000/-
Resident
Resident Indians up individual of the
to 60 years of age age of eighty
years or above
Nil Nil
10% of the amt in
Nil
excess of Rs.200,000/-
Rs.30000/- + 20% of
20% of the amt in
the total amount by
excess of
which total income
Rs.500,000/-
exceeds Rs.500000/-
Rs.1,00,000 +
Rs.1,30,000 + 30% of
30% of the amount
the amount by which
by which total
total income exceeds
income exceeds
Rs.10,00,000/-
Rs.10,00,000/-

Note

For senior citizens of more than 60 years but less than 80 years of age, the
threshold limit is Rs.250000.

In addition to the above, ‘Education cess @2% and secondary and Higher
Education cess @1% on income tax shall be chargeable.
 558

5. Payment of tax by employer on non-monetary perquisite

With effect from 1.6.2002, employers have the option of paying tax on the non-
monetary perquisite (discussed later) given to an employee. Section 192(1A) and
section 192(1B) of the Income Tax Act enable the employer to make payment at
his option of the entire tax or a part of the tax due on non-monetary perks on
behalf of the employee.

6. Deposit of tax in government account

According to section 200 of the IT Act, the person responsible for deduction of
tax from the payment made to an employee is also required to deposit the tax so
deducted in a Government Account within the prescribed time and in the manner
prescribed vide Rule 30.

7. Time limit for deposit

Payment of tax deducted at source (TDS) has to be normally made within a week
of the last day of the month in which the deduction is made.

However, vide Rule 30(1) (ii) (b), Assessing officials can in special case with
prior approval of Joint CIT allow payment of TDS quarterly i.e. 15 th June, 15th
Sept, 15th Dec and 15th Mar.

8. Mode of payment of TDS

It should be kept in mind that payment can be made through internet (e-TDS) /
Cheque / Debit / Credit Card / Demand Draft or through Cash.

In case of payment made by cheque, the date of encashment of the cheque will be
the date of payment of tax.

9. Issue of TDS certificate

Every person deducting tax at source is required as per Section 203 to furnish a
certificate to the payee to the effect that tax has been deducted along with certain
other particulars. The certificate, usually called the TDS certificate, has to be
furnished within a period of one month from the end of the relevant
financial year.
 559

In case of employees receiving salary income, the certificate has to be issued in

Form No.16 amended by CBDT’s notification No.S.O.1062 dtd.4.10.2002.In
certificate 16, the employer should quote the permanent account no.(PAN) of the
employee, along with the TAN (Tax deduction account no.).

10. Quarterly statement of TDS

With effect from 1.4.2005, every employer responsible for deducting tax is
required to file quarterly statements of TDS for quarters ending on 30 th June, 30th
Sept, 31st Dec and 31st March in each financial year which is to be delivered to
the prescribed authority [Director General of Income Tax (System)] or the
persons authorized by such authority (NSDL).

The normal rate of tax is applicable against payment of salary.

Timelines for filing quarterly statements of TDS through Form 24Q

Period of deduction of TDS Due date for filing statement

Quarter ending on 30th June 15th July
Quarter ending on 30th Sept 15th Oct
Quarter ending on 31st Dec 15th Jan
Quarter ending on 31st March On or before the 15th June

In quarterly statement of TDS, the deductor has to quote his TAN and PAN
numbers. In addition to this, the employer should mention the PAN of all
employees compulsorily.

Lately, all corporate employers have to furnish their return through electronic
media.

Tax on non-monetary perquisites are payable by:

A The employer
B The employee
C Neither the employer nor the employee
D Either the employer or the employee
 560

4. Explain the method of calculation of salary for the

purpose of tax deduction at source.
[Learning outcome d]
In this learning outcome, we will study the calculation of salary income. Every
employer has to deduct tax from salaries of the employee (Section 192 of Income
Tax Act 1961), so here we will see how to calculate salary income, so that proper
tax may be deducted.

Following is a proforma of the computation of taxable income for individuals

drawing salaried income:

Amounts Discussed in para

Salary remuneration XX 4.1
Add: valuation of taxable non-monetary XX 4.2
perquisites
Total salary income XX
Income from other sources like house XX 5.1
property , capital income
Total Income XX
Less: Section 10 deductions XX 4.3
Net income XX
Less: Deductions eligible u/s 80 XX 4.4
Taxable income XX

4.1 Meaning of salary

Salary is said to be the remuneration received by accruing to an individual for
service rendered as a result of an express or implied contract.

The meaning of salary provided by section 17(1) includes:

 Wages
 Annuity or Pension
 Gratuity
 Fees, Commission, Perquisites or Profit in lien of Salary
 Advance Salary
 Contribution of employer to Recognised provident fund in excess of
prescribed limit.
 Leave encashment.
 Compensation as a result of variation of service connected.
Please note, this is not exhaustive list.
 561

4.2 Non-monetary perquisites

As mentioned above, salary includes perquisites also. Perquisites are generally

benefits given to employees which may not give monetary value to the employee.
However, in providing perquisites, some costs are involved for the employer.
Hence, the taxable value of perquisites in the hands of the employee is
normally taken as its cost to the employer. However, there are specific rules
for valuation of certain perquisites laid down in Rule 3 of IT Rules, which have
been revised by CBDT notification dated 25.09.2001.

Valuation of residential accommodation for non-government

1.
employees (includes PSU employees)
Where
population
(a) Value of taxable perquisite
as per 2001
census is:
Less than 10 7.5% of salary
lakhs
Between 10 10% of salary
lakhs and 25
lakhs
Exceeds 25 15% of salary
lakhs
If employee Perquisite computed under (a) above
has paid any Less: Rent paid by employee
(b)
rent to
employer
Where  Actual amount of lease rent paid / payable by the
employer has employer; or
(c) taken house  15% of salary whichever is lower as reduced by the
on rent / lease rent, if any, actually paid by the employee.
If employer Perquisite computed under (a) above
has provided Add: 10% of the cost of furniture / hire charges of
(d) furniture furniture
Less: Rent on furniture (if any) paid by employee
 562

2. Perquisite of motor car provided by employer

Where the motor car is owned or hired by the employer and is used:
Exclusively Nil
(a) for official
duties
Exclusively Actual expenditure incurred by employer for running,
for personal maintenance
purpose Add: Normal wear and tear of motor car
(b)
Add: Remuneration to chauffer (if paid)
Less: Any amount charged from the employee for
such use
For official as cubic
well as capacity of
Value of perquisite
personal engine of
purpose motor car
Expenses are Expenses are
fully met by fully met by
employee employer
Rs. 1,800 per
(c) Rs. 600 per month
month (plus Rs.
1.6 liters or (plus Rs. 900 per
900 per month if
less month if chauffer
chauffer is
is provided
provided
Rs.2,400 per
exceeds 1.6 Rs.900 per month
month (plus Rs.
liters (plus Rs. 900 per
900 per month if
month if chauffer
chauffer is
is provided)
provided)
 563

3. Interest free / Concessional loans

Interest payable at prescribed rate**
Less: Interest (if any) actually paid by employee.

**Prescribed interest rate = rate charged by State Bank of

India as on the 1st Day of financial year in respect of loans
of the same types and for same purpose advanced by it to
general public.

However loan up to Rs. 20000, loans for medical

treatment are exempt
4. Value of free meals
Expenditure incurred by employer
Less: Amount paid by employee

However it will not be treated as perks if non-alcoholic

drinks and food is served during working hours.
5. Gift if it is more than Rs.5000/-
6. Provision of medical facilities (Section 17 (2)
Any amount paid by employer towards medical
reimbursement is exempt up to Rs.15000/-

The following examples will facilitate your understanding of the above

mentioned perquisites:

1. Ram is the manager of Zeta Insurance Co, drawing a salary of Rs.944,500

per annum. He is provided a rent free accommodation (owned by Zeta) in
Mumbai.

The valuation of the perquisite is 15% x 944,500 = Rs. 141,675

2. Furthermore, Ram was provided with household appliances costing Rs.

36,000 as well as an air conditioner for which Zeta paid hire charges of Rs.
5,000 per annum.

The valuation of the perquisite is as follows:

15% x 944,500 = Rs. 141,675 + 10% x 36,000 + 5,000 = Rs.150,275
 564

3. If Ram is provided with a house which is leased by Zeta at rent of Rs.

300,000 per annum.

Valuation of the perquisite = Rs. 141,675

(.e. lower of Actual lease rent [Rs. 300,000] or 15% x 944,500 = Rs.
141,675)

4. Ram is provided with a motor car owned by the company. Ram uses the car
exclusively for personal use. The cubic capacity of its engine is 1.3. During
2010-11, the company incurred an expenditure of Rs. 45,000 on its running
as well as maintenance. Furthermore, the company paid a remuneration of
Rs. 2,000 per month to his driver. Ram paid the company Rs. 12,000 for the
use of the car.

The value of the perquisite = Rs. 57,000

[Actual expenditure incurred by employer for running, maintenance (Rs.

45,000)
Add: Normal wear and tear of motor car (Nil)
Add: Remuneration to chauffer (if paid) (Rs. 24,000)
Less: Any amount charged from the employee for such use (Rs. 12,000)]

5. If the car was used for both personal as well as official use; the value of the
perquisite would be Rs. 32,400 [(Rs. 1800 + Rs. 900) x 12].

Tip: Amounts recovered from Ram must not be considered in this

computation.

6. Ram took a housing loan of Rs. 100,000 from the company on 1 April 2010.
The loan was taken for four years. The interest paid to the company was Rs.
6,000.

Note: The prescribed rate for such loans is 8%.

The taxable value of the perquisite = Rs. 2,000 [i.e. interest payable at the
prescribed rate (Rs. 100,000 x 8%) Less: interest (if any) actually paid by the
employee (Rs. 6000)]
 565

4.3 Exemption from salary income

Section 10 of the IT Act provides certain exemptions from income

Salaries generally include various other receipts besides the perquisites

mentioned above in order to meet the specific requirements of employees. These
are referred to as allowances and discussed below:

Details of exemption Amount of exemption

Fully exempt subject to following condition:

 Travel is within India

Leave travel
1  Only for two journeys in block of 4 calendar
concession
years.
 Travel should be subject to economy airfare
or AC 1st class fare
Exempt u/s 10 (13A) to following extent.

Provided expenditure on rent is actually

incurred, the amount of exemption granted is the
least of.

House Rent  HRA received

2 Allowance u/s
10(13A)  Rent paid less 10% of salary

 40% of salary (50% in case of Mumbai,

Chennai, Calcutta and Delhi).

Salary for computing this allowance would

include Bonus + Dearness Allowance
Allowances exempt  Allowance granted to meet cost of travel on
u/s 10(14) tour or transfer
3  Allowance granted to meet conveyance
expenditure for official purpose.
 Uniform allowance
 566

Examples relating to house rent allowance

Rent
50% paid
Resident Basic HRA Rent HRA
of HRA less
of salary paid paid exempt
salary 10% of
salary
A Kolkatta 25,000 6,000 7,500 12500 6,000 5000 5000
B Goa 37,000 4,500 4,400 14800 4,500 700 700

4.4 Deductions under chapter VI A in respect of payments

From the above mentioned salary, employees are entitled to get deductions under
various sections. Brief detail is given below.

Amount of
Section Details
deduction
 Life Insurance Premium- Self, Spouse
and Children
 Deferred Annuity- Self, Spouse and
Children
 Contribution to Recognized Provident
Fund, Public Provident Fund
 Deposit into selected post office
scheme such as NSS, NSC, and CTD
etc.
 Repayment of Housing loan
80C,
 Tuition Fees.
80CCC and Rs. 1,00,000/-
 Fixed Deposit of scheduled bank if it
80CCD
is more than 5years
 Contribution of ULIP OF LIC Mutual
Fund and investment in ELSS
schemes of Mutual Fund
 Payment of Premium for annuity plan
of LIC or any other insurer (80 CCC)
 Deposit made by Central Government
servant in his pension account to the
extent of 10% of his pension
80CCD.
This deduction is allowed for the payment
80D
of Mediclaim Insurance to General
 567

Insurance Companies/ any other insurance

company.

 for self, spouse and children Up to Rs.15000/-.

 for parents Up to Rs. 15000/-
 for parents who are senior citizens Up to Rs. 20,000
Deduction in respect of maintenance maximum
80DD including medical treatment of a exemption allowed
dependant who is a person with disability. is Rs.50000/-
Deduction in respect of medical treatment Actual amount paid
Section
etc. of such disease or ailment as may be or Rs. 4000 0/-
80DDB
specified in the IT Rules whichever is less-
Deduction for interest paid on loan taken
for pursuing Higher Education.

Loan can be taken by the tax payer for

pursuing his own education or education Actual amount paid
80E
of his spouse / child. as interest

The deduction is available for a maximum

period of eight years or till the principal
amount along with the loan is liquidated.
Payment of donation: I f it is paid through
employer then employer will deduct
amount of donation from salary

The list of approved donations include:

 the National Defence Fund set up by 100%
the Central Government; or
 the Prime Minister’s National
Relief Fund; or 
80G  the Prime Minister’s Armenia
Earthquake Relief Fund; or
 an approved university or any
educational institution or]

Donations to other institutions like:

 the Jawaharlal Nehru Memorial

Fund; or
 the Prime Minister’s Drought 50%
 568

Relief Fund; or
 the National Children’s Fund; or
 the Indira Gandhi Memorial Trust,
or
 the Rajiv Gandhi Foundation,

The following examples illustrate the applicability of the Sec 80 E deduction:

Situation Date of Loan Loan Who has Deduction Deduction

loan taken taken paid the available available
taken by for interest / to father to son
for amount
higher of
educatio interest
n u/s
80E
1 1/4/2009 Father Son Father / 25,000 nil
Rs.25,000
2 1/4/2009 Father Son Father / 25,000 nil
Rs.25,000
Son /
30,000
3 1/4/2009 Son Father Father / Nil Nil
Rs.25,000
Son /
30,000
4 1/4/2009 Son Son Father / Nil 30,000
Rs.25,000
Son /
30,000

Loan can be taken by the tax payer for pursuing his own education or education
of his spouse / child.
 569

4.5 Relief from income tax

If an employee gets salary for more than 12 months then to take tax rate benefit,
he can claim relief u/s 89 of the Income Tax Act. Employer will take cognizance
of it and give relief from tax while deducting tax at source.

Finally, from the Assessment year 2011-12, if the employee has income from
salary and tax has been deducted from salary as per rules and no tax is payable by
him / refundable to him, he need not file an income tax return.

Sham is the manager of Beta Insurers. His salary for the year 2011-12 was Rs.
820,000 per annum. He is provided with a house which is leased by Zeta at a rent
of Rs. 120,000 per annum. What is the value of the taxable perquisite?

A 123,000
B 120,000
C 82,000
D 61,500

5. Discuss the applicability of tax deduction account

number (T.A.N) and permanent account number (PAN)
[Learning Outcome e]
5.1 Tax deduction account number (TAN)

TAN is a unique number allotted to the deductor of tax at source for the purpose
of identification of every deductor.

1. Who shall apply for TAN

According to Section 203A, every person deducting tax at source is required to

apply to the assessing officer for allotment of TAN. The application has to be
made in duplicate in form 49B within one month from the end of the month in
which tax was deducted at source (Rule 114A). Such application has to be either
furnished to the Assessing Officer (AO) specifically assigned the function of
allotment of TAN by the CCIT/CIT or in any other case to the Assessing Officer
(AO) having jurisdiction to assess the applicant.
 570

2. Responsibility to quote TAN

Section 203A (2) casts a statutory responsibility on the deductor to quote TAN
in the following places once it has been allotted:

 In all challans for the payment of any sum in accordance with the provisions
of Section 200

 In all certificates issued pertaining to deduction of tax in accordance with the

provisions of Section 203

 In all quarterly statements submitted in accordance with the provisions of sub

section (3) of section 200

 In all returns filed pertaining to deduction of tax at source in accordance with

the provisions of Section 206.

 In all other documents pertaining to such transactions as may be prescribed in

the interest of revenue.

3. Quoting of PAN by employer / deductor

With effect from 1.6.2001, the deductor of tax at source is required as per section
139A (5B) to quote the PAN of the person from whose income TDS has been
deducted in:

 Statement furnished u/s 192(2C) (statement of particulars of profit in lieu of

salary)
 Certificate furnished u/s 203 (TDS Certificate)
 Annual return of TDS prepared and delivered u/s 206.
 Quarterly statements submitted in accordance with the provisions of sub
section (3) of section 200

5.2 Permanent account number (PAN)

Under section 139 A of the Act, every person if his total income or the total
income of any person in respect of which he is assessable under the Act during
any previous year exceeded the amount which is not chargeable to tax, and who
has not been allotted a permanent account number (PAN), shall apply to the
Assessing Officer for the allotment of Permanent Account Number.
 571

The PAN should be quoted in all challans, returns, correspondence and

documents pertaining to income tax. Now if the tax is deposited without PAN, its
credit will not be given, so due care should be taken to obtain the PAN, and
mention it in all the documents related to Income Tax.

Diagram 3: Difference between TAN and PAN

Which of the following statements is true?

A A permanent account number is a unique number allotted to a person whose

total income < the amount not chargeable to tax
B A permanent account number is a unique number allotted to a person whose
total income = the amount not chargeable to tax
C A permanent account number is a unique number allotted to a person whose
total income > the amount not chargeable to tax
D A permanent account number is a unique number allotted to the deductor of
tax at source for the purpose of identification of every deductor
 572

6. Discuss the features of income from house property.

[Learning Outcome f]
Section 22 to 27 of the Income Tax Act deal with income under the head
‘Income from House Property’.
Income from house property is perhaps the only income that is charged to tax on
notional basis. The charge is not because of receipt of any income, but is on the
inherent potential of house property to generate income. Hence it is the annual
value of a building and land appurtenant thereto, which is charged to tax as
income from house property. Annual value is the amount for which the
property might reasonably be expected to be let from year to year.
Income from house property
Meaning: the It is the annual value of a building and land.
only income that
is charged to tax Annual value = amount for which the property might
on notional basis. reasonably be expected to be let from year to year.
If house property Income from house property = nil
is not let out
When the Income from house property =
property is let Annual value i.e. Rent received / receivable, whichever is
out, more
Less:
1. Municipal taxes
2. Repairs and collection charges of rent- 1/4th of the
annual value or rent.
3. Insurance premium paid to insure the property
4. Annual Charge
5. Ground rent
6. Interest on borrowed capital,
7. Land revenue
8. Vacancy allowance
9. Unrealisable rent
Note: interest on borrowed capital for acquisition of self
occupied property is deductible up to Rs. 1.50 lakhs
When property is To compute income from house property;
self-occupied Annual value is taken at nil value. However, interest on
borrowed capital is allowed as a deduction.
Income from house property = Nil Less: Interest on
borrowed capital
 573

Jasmine owns a house property which is used by him throughout the previous
year 2010-11 for his residence.
The annual value of the property is Rs. 1,50,000.
Expenses incurred are as follows:
Repairs: Rs. 2,000, municipal taxes: Rs. 20,000, insurance Rs. 3,000, interest on
borrowed capital Rs. 1,50,000.
Compute the income from house property.
A Nil
B (Rs. 150,000)
C (Rs.25,000)
D (Rs.175,000)

7. Discuss the provisions of advance tax, tax audits and

service tax applicable to life insurance business.
[Learning outcome g]
7.1 Payment of advance tax
LIC is required to pay advance tax as per Section 211 of the Income-tax Act
1961, which deals with installments of advance-tax and due dates. The schedule
of advance-tax payment is given below:
Diagram 4: Advance tax
 574

7.2 Tax audit

Section 44AB of the Income-tax Act, 1961 deals with “Audit of accounts of
certain persons carrying on business or profession”.

The Finance Act 1984 has made a provision in the Income-tax Act 1961, in the
form of Section 44AB, making it obligatory for a person carrying on business to
get his accounts audited with effect from the Assessment year 1985-86 before the
‘specified date’ by an accountant if the total sales turnover or gross receipts in
business for the accounting year or years relevant to the Assessment year 1985-
86 or any subsequent Assessment year exceed or exceeds Rs. 40 lakhs.(Rs100
Lakhs with effect from A.Y. 2013-14) A person carrying on profession is also
required to get his accounts audited before the “specified date” if his gross
receipts in profession for an accounting year or years relevant to any of the
aforesaid assessment years exceed Rs. 10 lakhs.(Rs. 25Lakhs with effect from
A.Y. 2013-14) Such persons should also obtain before the ‘specified date’ a
report of the audit in the prescribed form. For this purpose, the Central Board of
Direct Taxes has prescribed under Rule 6G, Forms 3C A – 3 CE containing
forms of audit report and particulars to be furnished therewith.

In cases where the accounts of a person are required to be audited by or under

any other law before the specified date, it will be sufficient if the person gets his
accounts audited under such other law before the specified date and also obtains
before the said date, the report of audit in the prescribed form, in addition to the
report of audit required under such other law.

The expression “specified date” is November 30 and October 31 of the

assessment year in the case of a corporate and non-corporate assesses
respectively.

The provisions of Section 44AB of the Income-tax Act, 1961 are applicable to
All Life Insurance Companies including Life Insurance Corporation of India
 575

Diagram 5: Tax audit

7.3 Service tax

Service tax has been introduced for the first time in the year 1994-95 by the then
Finance Minister (Now Prime Minister) Dr. Manmohan Singh. One of the
purposes of levying service tax was to generate a new avenue of taxation and to
bring more people in the service tax net.

It will not be out of place to mention that Service Tax is a part of the Finance
Act; Chapter V of Finance Act 1994 deals with the imposition of service tax.

For the first time in 2002, Service Tax was imposed on Insurance Auxiliary
Service concerning life insurance – detailed discussion is given in the following
paragraphs.

Similarly, Service Tax was imposed on Life Insurance Service vide Finance
(No.2) Act with effect from 10 th Sept 2004.
 576

Details of service tax on the above 2 services are given below:

1. Service tax on life insurance auxiliary services

a) Date of introduction 16.8.2002

b) Service Tax has to be paid on taxable service; hence it is very important for
us to know what is meant by a taxable service.

Taxable service means any service provided or to be provided to a policyholder

or any person or insurer, and includes reinsurance by an actuary or intermediary
or insurance intermediary or insurance agent in relation to insurance auxiliary
services concerning life insurance business.

Hence, from the above we can see that service providers are insurance agents,
actuaries and insurance consultants. In the case of insurance consultants, the
service is provided mainly to insurance companies (insurers), while in the case of
insurance agents, the service is provided to both the insurer and the policyholder.
Service tax is liable to be paid by the insurance auxiliary service provider, except
in the case of insurance agents. Insurance agents normally do not charge the
policy holder. Hence, there cannot be any service tax on nil payment service.
However, agents provide service on behalf of insurance companies, and they get
commission on a periodic basis. In the case of an insurance agent, it has been
provided in the service tax rules that the concerned insurance company who has
appointed the agent will be liable to pay service tax.

In simple words, we can say that Life Insurance Companies are liable to pay
service tax on commission (including other remuneration to agents); this is called
input service tax.

Details Applicable for services rendered

up to 31/ 3/ 2012 from 1 / 4/ 2012
Rate of service tax 10% 12%
Education cess @ 2% 0.2% 0.24%
Secondary and Higher 0.1% 0.12%
Education cess @ 1%
Total 10.3% 12.36%
 577

2. Service tax on Life Insurance Services

Date of introduction 10 th Sept 2004

Service tax is payable on taxable service.

Here, Taxable service means any service provided or to be provided to a

policyholder or any person by an insurer including reinsurer carrying on life
insurance business in relation to risk cover in life insurance.
(Section 65 (105) (2x) of Finance Act 1994

Hence, we can say that - that portion of service which pertains to the risk element
is liable to service tax. This levy will not be applicable to such premium of the
existing policies which were paid before the new levy comes into force.

Details Applicable for services rendered

up to 31/ 3/ 2012 from 1 / 4/ 2012
Rate of service tax 10% 12%
Education cess @ 2% 0.2% 0.24%
Secondary and Higher 0.1% 0.12%
Education cess @ 1%
Total 10.3% 12.36%

However, option has been given to life insurers that in case of composite policies
risk plus saving) they can pay 1% (now Increased to 1.5% from financial 2011-
12) of total premium towards discharge of service tax liability.

However, it shall not be applicable in case an insurance policy is towards risk

only or where the premium gives details of risk premium and other premium
separately. In these cases, normal rate of service tax will be applicable.

Now, w.e.f 1.4.2011, a unit linked insurance plan has also been brought under the
net of service tax. Earlier, only mortality rates and fund management charges
were taxed. Now policy allocation charges and administration charges on ULIP
would also come under the service tax net.’

The service tax shall be paid to the credit of the Central Government:

i) By the 6th day of the month, if tax is paid electronically through internet
banking, it has been provided that the assessee who has paid service tax of
Rs.50 lakh in the current financial year shall deposit the service tax liable to
be paid by him electronically, through internet banking.
 578

ii) In other cases, by the 5 th of the month following the calendar month in which
payment is received.

However, service tax for the month of March has to be paid by 31 st March.

Service tax on life insurance services are called output services and are allowed
to take credit against input services like service tax on payment to Insurance
Agents and service tax paid on other services like service tax on telephone,
mobile bills etc.

Hence, a Life Insurance Company should keep proper record of service tax
payable on out front services and service tax paid on input services.

Diagram 6: Service Tax

 579

The quantum of the four installments of advance tax is as follows:

Option Installment 1 Installment 2 Installment 3 Installment 4

25% of 25% of 25% of 25% of
A
advance tax advance tax advance tax advance tax
10% of 25% of 25% of 40% of
B
advance tax advance tax advance tax advance tax
15% of 30% of 30% of 25% of
C
advance tax advance tax advance tax advance tax
15% of 25% of 25% of 35% of
D
advance tax advance tax advance tax advance tax

Summary
 The Father of Economics, Adam Smith, has laid down the four basic
principles which would help to build a good taxation system.
 Income Tax on life insurance companies is not considered a normal business
income. Calculation of tax on insurance companies is done in accordance
with the provisions of Section 44 read with the First Schedule of the Income
tax 1961.
 Profits and gains of life insurance business will be taxed at the special rate of
12.5% as per section 115B.
 Payment of tax deducted at source (TDS) has to be normally made within a
week of the last day of the month in which the deduction is made.
 The TDS certificate has to be furnished within a period of one month
from the end of the relevant financial year.
 If an employee has income from salary and tax has been deducted from
salary as per the rules and no tax is payable by him / refundable to him, then
he need not file an income tax return.
 Life insurance companies are liable to pay service tax on commission
(including other remuneration to agents), and it is called input service tax.
 Service tax on life insurance services are called output services and are
allowed to take credit against input services like service tax on payment to
Insurance agents and service tax paid on other services like service tax on
telephone, mobile bills
 A life insurance company should keep proper record of service tax payable
on out front services and service tax paid on input services.
 580

Answers to Test Yourself

Answer to TY 1

The correct option is C.

Ensuring economical tax administration is a canon of taxation.

The other options contain valid objectives of taxation.

Answer to TY 2

The correct option is B.

Profits and gains of life insurance business will be taxed at the special rate of
12.5% as per section 115B.

Answer to TY 3

The correct option is D.

With effect from 1.6.2002, employers have the option of paying tax on the non-
monetary perquisite given to employees.

Answer to TY 4

The correct option is B.

Valuation of the perquisite = Rs. 120,000

(i.e. lower of Actual lease rent [Rs. 120,000] or 15% x 820,000 = Rs. 123,000)

Answer to TY 5

The correct option is C.

 581

Answer to TY 6

The correct option is B.

Annual value Nil

Less: Municipal taxes Nil
Repairs Nil
Insurance Nil
Interest on borrowed capital Rs. 1,50,000
Property income (Rs. 150,000)

Answer to TY 7

The correct option is C.

Self-Examination Questions
Question 1

The four basic principles of taxation are:

A Adequacy, equitable, convenience, neutrality

B Equitable, certainty, convenience, economical
C Achievement of social and economic effect, neutrality, simplicity, diversity
D Convenience, economical, neutrality, simplicity

Question 2

Tax revenues should be collected from various sources rather than from one
source. This relates to which canon of taxation?

A Adequacy
B Neutrality
C Simplicity
D Diversity
 582

Question 3

The deduction of Income Tax made on any interest or dividend payable to the life
insurance corporation in respect of any securities or shares owned by it is at the
rate of:

A 5%
B 7.5%
C 12.5%
D 0%

Question 4

Swanand has taken a loan of Rs. 70,000 for higher studies for his wife on
1.10.2011. On 31.3.2012, he has repaid Rs. 20,000 (which includes Rs.3,000
towards interest). Furthermore, his son has repaid Rs.10,000 (which includes an
interest of Rs.1,000) on the same date.

The deduction available as deduction u/s 80E is:

Options Swanand Swanand’s son

A Rs. 20,000 Rs. 10,000
B Rs. 3,000 Rs. 1,000
C Rs. 3,000 Nil
D Nil Rs. 1,000

Question 5

Grand insurers will have to get a tax audit conducted on its business if:

A The total sales of the business exceed Rs. 60 lakhs

B The total sales of the business exceed Rs. 50lakhs
C The gross receipts of the business exceed Rs. 50 lakhs
D The gross receipts of the business exceed Rs. 75 lakhs
 583

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

The other options contain additional features of a taxation system.

Answer to SEQ 2

The correct option is D.

Answer to SEQ 3

The correct option is D.

No deduction of Income Tax shall be made on any interest or dividend payable to

the corporation in respect of any securities or shares owned by it or in which it
has full beneficial interest.

Answer to SEQ 4

The correct option is C.

Under section 80E, Swanand can claim a deduction for interest paid on loan
taken for pursuing Higher Education. Loan can be taken by the tax payer for
pursuing his own education or education of his spouse / child. The deduction is
available for a maximum period of eight years or till the principal amount along
with the interest is liquidated.

Answer to SEQ 5

The correct option is A.

According to the provisions of Section 44AB of the Income-tax Act, 1961, which
are applicable to all Life Insurance Companies, tax audit is applicable where the
total sales turnover for an accounting year exceeds Rs.60 lakhs.However for
financial year 2012-13, limit is Rs. 1 Crore.
 584

CHAPTER 15

ANTI MONEY LAUNDERING GUIDELINES

AND PMLAACT

Chapter Introduction
This chapter aims to provide an understanding of the Anti Money Laundering
Guidelines and the PMLAACT. You will also learn about the insurance
regulation regarding Know Your Customers, reporting obligation for insurance
companies and the customer identification procedure.

a) Meaning of money laundering.

b) Know Your Customer (KYC).
c) Source of funds and their use.
d) Reporting obligation by government of India under FIU- India.
e) Appointment of Principal Compliance Officer.
 585

1. Meaning of Money Laundering.

[Learning Outcome a]
The insurance industry, like the banking and financial services industry, relies
seriously on the perception that it functions within the framework of highly
professional, ethical and legal standards. A reputation for integrity is one of the
most important features of a financial institution. Money laundering poses a risk
to the entire financial system. Anti-money laundering guidelines prevent the anti-
social elements from routing funds through illegal channels for use against public
interest. The Prevention of Money Laundering Act (PMLA), 2002 brought into
force with effect from 1st July 2005, is applicable to all the financial institutions
which include insurance institutions.

1.1 What is Money Laundering?

Money laundering means bringing illegally obtained money into the mainstream,
legal economy. Money launderers, from dishonest traders to terrorists, aim to
deposit their illegally-obtained money in financial institutions and banks. The
goal of a large number of criminal acts is to generate income which can be used
for illegal purposes, causing harm to society, which enables the criminals to
enjoy the illegitimate income without jeopardising their source. Sales of illegal
arms, smuggling, embezzlement and insider trading can produce large gains and
create the incentive to “legitimise” the illegitimate gains made through money
laundering.

Money laundering is the act of changing the appearance of money that comes
from illegitimate sources so that it appears to be legitimate money.

The word money laundering has two aspects: MONEY + LAUNDREING. The
laundry is a place where dirty clothes are taken to be washed. Similarly, money
laundering is also the process by which dirty money / black money / illegal
money is converted into legal money. To put it more precisely, we can say that
money laundering is a process where illegal or ‘dirty’ money is put through a
cycle of transactions, so that it comes out ‘cleansed’ at the other end as ‘legal’ or
‘clean’ money.
 586

Anil obtained money from smuggling. In order to clean this money, he went to an
antiques shop and bought an antique piece of furniture for Rs.1,20,000 in cash.
He then sold this piece of furniture for Rs. 1,00,000 (being quite prepared to
suffer the apparent loss of Rs. 20,000). This time, Anil asked for a cheque that
could then be paid innocently into a bank account, making the money look
legitimate.

1.2 Stages of money laundering

The process of money laundering can be broadly classified into three stages viz.
placement, layering and integration:

 Placement – physically placing bulk cash proceeds

 Layering – separating the proceeds from criminal activity from their origins,
through layers of complex financial transactions
 Integration – providing an apparently legitimate explanation for the illegal
proceeds

i) Placement

This is generally the first stage. In this stage, the launderer inserts the illegitimate
money into a legitimate financial institution through purchase of art, jewellery, or
a series of monetary instruments (cheques, money orders) etc. This is also often
done by depositing cash in the bank.

This is commonly done in the following ways:

 The introduction of illegal money into the financial system can be done by
breaking up large amounts of money into less conspicuous smaller sums that
are then deposited directly into a bank account.

 Another method of placement is by purchasing a series of monetary

instruments (cheques, money orders, etc.) that are then collected and
deposited into accounts at another location.

 Techniques like “smurfing”, where small amount deposits are made every
day in various financial institutions, in such a way that it does not attract
attention of legal / enforcement authorities.
 587

ii) Layering

While transferring funds, instead of ‘straight’ transfers from one point to another,
a complex series of transfers are made. This is called ‘layering’ of transactions.
One transaction forms a layer upon another, ultimately concealing the source of
funds, the nature of funds and their ownership.

After the funds have entered the financial system, the launderer engages in a
series of conversions or movements of the funds to separate them from their
source. The funds might be channelled through the purchase and sales of
investment instruments, or electronically transferred through a series of accounts
at various banks across the globe. Layering involves moving the money through
various financial transactions to change its form and make it difficult to follow.
Layering may involve:

 several bank-to-bank transfers

 wire transfers between different accounts in different names in different
countries
 making deposits and withdrawals to continually vary the amount of money in
the accounts
 purchasing expensive products to change the form of the money

The recent case of money laundering that alleged illegal gratification of about Rs.
550 crore related to the 2G spectrum allocation scam involved a lot of people
without any explanation given for it. This clearly shows how big is the process of
money laundeing.

From the below, which is one of the stages of money laundering?

A Smurfing
B Shell companies
C Integration
D None of the above
 588

2. Know Your Customers (KYC).

[Learning Outcome b]
Before we know about KYC, it is important to know that all rigours of the KYC
process are meant to weed the bad, illegitimate customers out and to protect the
good, legitimate ones. It is important for the financial institutions to give more
focus on business, develop a good customer relationship and become aware of
the clients’ needs.

Knowing a customer is a basic need of insurance companies. Detailed

information to build up a customer profile has been collected to serve purposes
like:
 To satisfy legal requirements for better customer relationship
 To become aware of customer needs and to provide required services

2.1 KYC Process

The KYC process involves identifying, validating and verifying the customer’s
information so as to ensure that the customer is genuine and legitimate and does
not have any fraudulent intentions. The KYC process involves collecting the
customer’s photograph, identification proof and address proof and verifying the
same.

The insurance companies have to collect and verify the following proofs in
compliance with the KYC requirements for individuals and others:
1. Photographs
2. Proof of Identity
3. Proof of Residence

(Refer to detailed documents required for proof of residence and identity given in
Annexure I)

2.2 What are KYC norms?

1. Insurance companies should take reasonable efforts to determine the true

identity of all customers requesting for services, especially the persons who
fund/pay for an insurance contract, as beneficial owner.

2. Effective and proper measures should be taken in order to obtain mandatory

details for accurate identification of new customers.
 589

3. To take all necessary steps to identify the beneficial owner and all measures
to verify their satisfaction so as to establish who the beneficial owner is.

4. Customer information should be collected from all relevant sources,

including from agents.

5. Customer should be suitably identified and should not be a fictitious person.

Contracts should not be anonymous.

6. Insurers are advised to maintain an updated list of designated

individuals/entities in electronic form and run a thorough check on the given
parameters on a regular basis to verify whether the designated individuals/
entities are holding any insurance policies with the company.

2.3 When is KYC needed?

Insurers have to monitor all the KYC norms for their customers. KYC is needed
for both the new customers as well as for existing customers. Such data is used to
monitor the policy for possible abuse or illegal use. This is one of the objectives
of KYC. KYC deficiencies can lead to various business and legal risks. If an
insurance company gets unknowingly used for money laundering, such
involvement can lead to substantial risk and loss of reputation of the company.

1. Knowing New Customers

When a new contract is issued to new customer, KYC should be done before the
issue of the new insurance contract. This requirement should be complied with in
all life insurance contracts as specified.

In case of no face to face business which includes Tele calling, Internet

Marketing, Logging in of business or payment of premiums/lump sums at
branches, collection of documentation should be completed for premiums
exceeding one lakh per person per annum within 15 days of issue of policy.

2. Knowing Existing Customers

KYC in the case of existing customers should be carried out based on the limits
fixed for new ones on all contracts/relevant transactions in the case of the
existing polices.
The AML/CFT requirements will not be applied to the existing customers paying
premiums less than Rs. one lakh per annum. But KYC norms are compulsory to
those policy holders who pay premium of Rs. one lac or more per annum.
 590

3. KYC on On-going basis

With the verification of identity of the customer at the time of initial issuance of
contract which includes obtaining a recent photograph, KYC should be carried
out at the claim payout stage and when any further top-up payments are
inconsistent with the customer’s known profile. Any change which is
inconsistent with the normal and expected activity of the customer should attract
the attention of the insurer for further ongoing KYC processes and action should
be considered as necessary.

2.4 KYC and Risk Profile

KYC norms are to be applied in a risk based approach. Risk assessment

comprises understanding the risks in customer profile and product profile. They
are important to decide the extent of caution to be exercised in case of each
proposal. It can be divided into two categories:

1. Customer Profile:

Customer’s risk profile can be categorised into high risk and low risk customers.

 Low risk customers are individuals and entities whose identities and source
of funds can be verified easily e.g. salaried employees, people belonging to
lower income group, Government departments and Government owned
companies and Regulators and statutory bodies etc.

 High risk customer includes customers who carry an inherently higher than
average risk to the insurance company e.g. Non-residents, High net worth
individuals, Firms with sleeping partners , trusts, charities etc.

2. Product profile:

Vulnerable products like single premium products, ULIPs, policy features like
top-ups, partial withdrawals, and free-look period etc. are high risks in product
profiles. Vulnerable areas like frequent free-look cancellations, assignments by
policyholder to a third party not related to him will have to attract more attention
and detailed checks from AML perspective.
 591

Diagram 1: KYC and Risk Profile

Out of the below, which is an example of a low risk customer?

A Non-residents
B High net worth individuals
C Companies having close family shareholding or beneficial ownership
D None of the above

3. Source of funds and its use.

[Learning Outcome c]
The main cause of many evil activities like corruption, black marketing,
smuggling, drug trafficking, tax evasion etc. is money. When a nation is more
developed, the standard of living of the people is also higher. More money is
required to satisfy needs and at some point of time, it does not matter what the
source of money Is, i.e. black or white money. At this point, the system of money
laundering enters and then grows.
Hence, it is important to know for the insurance company the source of funds of
its customers. It is necessary that the insurer should ascertain the reasonability of
the insurance value being purchased by a customer.

1. Verification of source of funds at the time of purchase.

The insurance company must verify the following things:

a) Customer’s source of funds, his estimated net worth etc., should be

documented properly

b) The advisor and/or employee shall obtain income proofs as in Annexure III,
to establish his need for insurance cover.
 592

c) Proposal form may also have questionnaires/declarations on sources of funds,

and details of bank accounts.

d) Large single premiums should be backed by documentation, to establish

source of funds.

The insurer must see that mere documentation of income proofs, however, does
not constitute establishing ‘source of funds’. Insurers should take appropriate
measures commensurate with the assessed risk of a customer and product profile
as part of their due diligence measures which may include:
 conducting independent enquiries on the details collected /provided by the
customer where required
 referring to a trustworthy database: public or other, etc.

2. Verification at the time of redemption/surrender

In life insurance business, no payments must be allowed to third parties except in

cases like superannuation/gratuity accumulations and payments to legal heirs in
case of death benefits. All payments should be made after due verification of the
bonafide beneficiary through:
 account payee cheques, or
 electronic payment methods such as ECS, NEFT, systems approved by the
Reserve Bank of India

Every insurance company provides its customers a period within which they can
get back to the insurer with questions regarding their Life Insurance Policy,
which is called Free look Period.

The feature of free look period is highly prone to misuse by launderers. They
place criminal proceeds into a contract and then take them back within the free-
look period on the pretext of not being happy with terms and conditions of the
policy. The money comes out of the insurance company and therefore, loses its
original identity and appears to come from a legitimate source.

Free look cancellation means the customer the has right to terminate the policy
without any further charges or fines when the necessary questions are not
answered reasonably or a Life Insurance Policy has been missold or if he does
not agree with the Terms and conditions as mentioned in the Policy Documents.
 593

The advantages of free look cancellation are:

 Nothing is charged except for the mortality charge for those 15 days
and medical charges and stamp duty charges are only deducted.
 A mere simple transaction as Free look Cancellation is a simple
process.
 The normal cancellation terms and conditions and deductions of the
Life Insurance Policy are not applicable for Free look cancellation.

The insurer needs to give special attention especially where clients do free look
cancellation more than once.

A customer has a right to cancel his Life Insurance Policy when his questions
are not answered or the policy is missold to him. This is called:

A Free look right

B Free look period
C Free look cancellation
D Free look duty

4. Reporting obligations by the Government of India under

FIU-India.
[Learning Outcome d]
The Government of India has set up a Financial Intelligence Unit – INDIA (FIU-
India) to track possible money laundering attempts. It is a central agency to
receive, process, analyse and disseminate reports of specified transactions.
Financial institutions are entrusted with a statutory duty to make a disclosure to
the authorized officer, viz., Director; FIU-IND regarding certain transactions
which come to their notice. The FIU- India office is located at Delhi. Financial
Intelligence Unit – India (FIU-IND) was set up by the Government of India vide
O.M. dated 18th November 2004. The insurance company has to follow reporting
obligations set by the Government of India. Lists of reports have to be followed
that are called by the FIU- India to keep a possible check on money laundering.
 594

4.1 Following are reports are asked by FIU- India:

1. Suspicious Transactions Reports

 Suspicious activity monitoring programme should be used by the company

and the products it sells.

 Special attention should be paid to all complex, unusually large transactions

and all unusual patterns which have no apparent economic or visible lawful
purpose.

 Insurance companies should report the suspicious transactions immediately

on identification.

 Reports should include attempted transactions, whether or not made in cash,

irrespective of the monetary value involved.

 Directors, officers and employees (permanent and temporary) shall be

prohibited from disclosing the Suspicious Transactions Report or any other
related information of a policyholder/prospect being reported or provided to
the FIU-IND.

2. Monitoring and Reporting of Cash Transactions

In order to confirm that the premium is paid out of clear, recognizable source of
funds, the insurance company is advised not to accept premiums in cash above
Rs. 50, 000. They are further advised to accept the remittance of lower cash
transactions.

 Premium/proposal deposits beyond Rs. 50,000 should be remitted only

through cheques, demand drafts, credit cards or any other banking channels.

 For integrally related transactions, premium amounts greater than Rs.50, 000
in a calendar month should be examined more closely for possible angles of
money laundering.

 Insurance companies have to report integrally connected cash transactions

above Rs.10 lakh per month to FIU-IND by the 15th of the next succeeding
month.
 595

 Splitting of the insurance policies/issue of number of policies to one or more

entities facilitating individuals to defeat the spirit of the AML/CF guidelines
should be avoided.

3. Reporting of receipts by Non-Profit Organisations

Receipts involving transactions of a non-profit organisation (either in the form of

assignments and/or in the form of top-up remittances): the insurance company
should report to the FIU-IND if the value is more than Rs.10 lakhs by the 15 th
day of the next succeeding month.

4. Reporting of Counterfeit Currency/Forged Bank notes

All cash transactions where forged or fake currency notes or bank notes have
been used as genuine and where any forgery of a valuable security or a document
has taken place facilitating the transactions should be reported within 7 days of
identification to FIU-IND.

Diagram 2: Reporting Obligation

 596

4.2 Record keeping requirements

An effective AML programme envisages proper audit trail through appropriate

record keeping. The obligations vest on the insurance companies to retain records
of all transactions, especially those related to customer correspondence. The
requirements are as follows.

 Records can be in electronic form.

 Records of transactions reported to FIU will have to be retained for 10 years
beginning from the date of occurrence of transaction.
 Records of customer identification date will have to be retained for a period
of 10 years after the relationship with the customer has ended.
 In situations where the records relate to ongoing investigations, or
transactions which have been the subject of a disclosure, they should be
retained until it is confirmed that the case has been closed.

Records are to be retained in such a way that they should be easily accessible.

Cash transactions where fake currency notes or bank notes have been used as
genuine or where any forgery of a valuable security has taken place have to be
reported to FIU-India within .

A 7 days
B 6 days
C 17 days
D 3 days

5. Appointment of Principal Compliance Officer.

[Learning Outcome e]
5.1 Who is a Principal Compliance Officer?

A Principal Compliance Officer is a professional employed by a financial group

working in a variety of fields and for numerous customers to ensure that there is
no conflict of interest and all obligations and regulations are fulfilled with.

He owes a responsibility to act with honesty, requires trustworthiness and being

authentic and truthful. Deception and subordination of principles are
inconsistent with integrity.
 597

a) Appointment

Companies should appoint a Principal Compliance Officer (PCO) under

AML/CFT rules, at senior level and preferably not below the Head
(Audit/Compliance)/Chief Risk Officer. The name of the principal compliance
officer should be communicated to IRDA and FIU immediately.

b) Rights and Responsibilities

 The Principal Compliance Officer should ensure that the Board approved
AML/CFT programme is being implemented effectively, including
monitoring compliance by the company’s insurance agents with their
obligations under the programme.

 He /She should ensure that employees and agents of the insurance company
have appropriate resources and are well trained to address questions
regarding the application of the programme in light of specific facts.

 He /She should be able to act independently and report to senior

management.

 He /She and staff assisting in execution of AML/CFT guidelines should have

timely access to customer identification data, other KYC information and
records.

5.2 Recruitment and Training of employees/agents

There is a possibility of misuse of insurance sector when launderers plan to
become part of the system as employees / agents. The role of employees / agents
who deal with customers face to face is vital towards effective compliance with
AML / CFT programme especially because they are in a position to access
information of customers which may provide leads on suspicious activity.

 Insurance companies should therefore have adequate screening procedures

when hiring employees / agents.

 They should, therefore, be properly trained on AML / CFT to bring about

awareness emphasizing on possible misuse of the financial system by
launderers.

 The committee monitoring the agents should monitor sales practices

followed by agents and ensure that if any unfair practice is being reported
then action is taken after due investigation.
 598

 Periodic risk management reviews should be conducted to ensure company's

strict adherence to laid down process and strong ethical and control
environment.

Diagram 3: Following training requirements are considered essential based

on the class of employees:
 599

5.3 Internal Control/Audit

Insurance companies’ internal audit/inspection departments should verify on a
regular basis, compliance with policies, procedures and controls relating to
money laundering activities. The reports should specifically comment on the
robustness of the internal policies and processes in this regard and make
constructive suggestions where necessary, to strengthen the policy and
implementation aspects. Exception reporting under AML/CFT policy should be
done to the Audit Committee of the Board.

The principal compliance officer owes a reponsibilty to act

with , and .

A Honesty, trust, truthfulness

B Deception, fraud, dishonesty
C Honesty, deception, trust
D Inconsistency, fairness, equality.

Summary

 Money laundering is the act of changing the appearance of money that comes
from illegitimate sources so that it appears to be legitimate money.
 The progress of money laundering can broadly be classified into three stages
viz. placement, layering and integration.
 KYC process is meant to weed the bad customers out and to protect the good
ones.
 Implementation of KYC should not mean denial of insurance services to the
public.
 AML / CFT guidelines place the responsibility of a robust programme on the
insurance companies for guarding against insurance products being used to
launder unlawfully derived funds or to finance terrorist acts.
 Records of transactions reported to FIU will have to be retained for 10 years
beginning from the date of occurrence of transaction.
 Records of training imparted to staff in the various categories detailed above
should be maintained.
 600

Answers to Test Yourself

Answer to TY 1

The correct answer is C.

Integration is a stage of money laundering.

Answer to TY 2

The correct answer is D.

Non-residents, high net worth individuals, companies having close family

shareholding or beneficial ownership are examples of high risk customers.

Answer to TY 3

The correct answer is C.

Free look cancellation means the customer has the right to terminate the policy
without any further charges or fine.

Answer to TY 4

The correct answer is A.

The transactions should be reported within 7 days of identification to FIU-IND.

Answer to TY 5

The correct answer is A.

A responsibility to act with honesty requires trust and being authentic and
truthful.
 601

Self-Examination Questions

Question 1

In which year was the Financial Intelligence Unit (FIU) set up in Delhi?

A 1999
B 2002
C 2004
D 2006

Question 2

Records of customer identification date will have to be retained for a period of:

A 10 years
B 15 years
C 11 years
D 20 years

Question 3

Cash transactions above Rs.10 lakh per month have to be reported to FIU-IND by
the insurance company by .

A 15th of each month

B 15th of next following month
C Every 15 days
D 15th of every quarter

Question 4

Which of the below options is an indicator of suspicious transactions?

A Unreasonable requests for free-look cancellations

B Insurance policies with premiums that exceed the client’s apparent means
C Overpayment of premium with request for refund of amount overpaid
D All the above
 602

Question 5

What is layering in money laundering?

A Smuggling bulk cash

B Depositing amounts in small denominations
C Disguising source of initial deposit through multiple transactions
D None of the above

Question 6

The technique of making numerous deposits of small amounts is called

A Integration
B Smurfing
C Layering
D None of the above

Answers to Self-Examination Questions

Answer to SEQ 1

The correct answer is C.

Financial Intelligence Unit (FIU) was set up in 2004.

Answer to SEQ 2

The correct answer is A.

Records of customer identification have to be retained for a period of 10 years.

Answer to SEQ 3

The correct answer is B.

Insurance companies have to report integrally connected cash transactions above

Rs.10 lakh per month to FIU-IND by the 15th of the next succeeding month.
 603

Answer to SEQ 4

The correct answer is D.

The indicators of suspicious transactions include:

 Unreasonable requests for free-look cancellations

 Insurance policies with premiums that exceed the client’s apparent means
 Overpayment of premium with request for refund of amount overpaid.

Answer to SEQ 5

The correct answer is C.

Layering in money laundering means disguising the source of initial deposit

through multiple transactions.

Answer to SEQ 6

The correct answer is B.

The technique of making numerous deposits of small amounts is called smurfing.

 604

ANNEXURE I

CUSTOMER IDENTIFICATION PROCEDURE

Documents that may be obtained from customers

A. Insurance contracts with individuals

Features Documents
Legal name and any other names used i. Passport
ii. PAN Card
iii. Driving License
iv. Voters identity card
v. Letter from a recognized
vi. Personal identification and
certification of the employees of
the insurer for identity of the
prospective policyholder.

Public authority (as defined under section 2 (h) of the Right to Information Act,
2005) or Public Servant (as defined in section 2 ( c) of the “The Prevention of
Corruption Act 1988”) verifying the identity and residence of the customer.
 605

Features Documents
Proof of residence i. Telephone bill pertaining to any
kind of telephone connection like
mobile, landline wireless etc
provided it is not older than six
months from the date of insurance
contract.
ii. Bank Account statement wherein
his Permanent/Present residential
address is available provided it is
not older than six months as on the
date of acceptance.
iii. Letter from any recognized public
authority
iv. Electricity Bill
v. Ration Card
vi. Valid lease agreement along with
rent receipt which is not more than
three months old as a residence
proof
vii. Employer’s certificate as a proof of
residence (certificates of employers
who have in place systematic
procedures for recruitment along
with maintenance of mandatory
records of its employees are
generally reliable.)
Proof of both identity and residence Written confirmation from the banks
regarding identification and proof of
residence
 606

B. Insurance contracts with companies

Features
Name of the Company
i. Principal place of business
ii. Mailing address of the company
iii. Telephone/fax number
Documents
i. Certificate of incorporation and
Memorandum and Articles of
Association
ii. Resolution of the Board of
Directors to open an account and
identification of those who have
authority to operate the account.
iii. Power of Attorney granted to its
managers, officers or employees to
transact business on its behalf.
iv. Copy of PAN allotment letter

C. Insurance contracts with partnership firms

Features Documents
i. Legal name, i. Registration Certificate if registered
ii. address, ii. Partnership deed
iii. name of all partners and their iii. Power of Attorney granted to a
addresses, partner or an employee of the firm
iv. telephone numbers of the firm and to transact business on its behalf
partners iv. Any officially valid document
identifying the partners and the
persons holding the Power of
Attorney and their addresses
 607

D. Insurance contracts with trusts and foundations

Features
i. Names of trustees, settlers,
beneficiaries and signatories
ii. Names and address of the founder,
the managers/directors and the
beneficiaries.
iii. Telephone/Fax numbers of the Trusts
and Foundations and trustees,
settlers, beneficiaries and signatories.
Documents
i. Certificate of Registration if
registered. Power of Attorney
granted to transact business on its
behalf
ii. Any officially valid document to
identify the trustees, settlers,
beneficiaries and those holding
Power of Attorney,
founders/managers/directors and
their addresses
iii. Resolution of the managing body of
the foundation/ association

ANNEXURE II

VULNERABLE PRODUCTS

i. Unit link products which provide for withdrawals and unlimited top-up
premiums
ii. Single Premium products, where the money is invested in lump sum and
surrendered at the earliest opportunity
iii. Free look cancellations - especially the big ticket cases

Note: The list is only illustrative and not exhaustive.

ANNEXURE III

INCOME PROOFS STANDARD INCOME PROOF

i. Income Tax Assessment orders/Income Tax Returns

ii. Employer’s certificate
iii. Audited Company Accounts
iv. Audited firm accounts and partnership deed
 608

NON STANDARD INCOME PROOFS

i. Chartered Accountant’s Certificate

ii. Agricultural Income Certificate
iii. Agricultural land details and Income assessments
iv. Bank cash flows statement and Pass Book

Note: The list is only illustrative and not exhaustive

ANNEXURE IV
ILLUSTRATIVE LIST OF SUSPICIOUS TRANSACTIONS

i. Customer insisting on anonymity, reluctance to provide identifying

information, or providing minimal, seemingly fictitious information

ii. Cash based suspicious transactions for payment of premium and top ups over
and above Rs. 5 lakhs per person per month. It should also consider multiple
DDs each denominated for less than ` Rs. 50,000/-

iii. Frequent free look surrenders by customers;

iv. Assignments to unrelated parties without valid consideration;

v. Request for a purchase of policy in amount considered beyond his apparent

need;

vi. Policy from a place where he does not reside or is employed;

vii. Unusual terminating of policies and refunds;

viii. Frequent request for change in addresses

ix. Borrowing the maximum amount against a policy soon after buying it

x. Inflated or totally fraudulent claims e.g. by arson or other means causing a

fraudulent claim to be made to recover part of the invested illegitimate funds

xi. Overpayment of premiums with a request for a refund of the amount

overpaid.

Note: The list is only illustrative and not exhaustive

 609

CHAPTER 16

COMPLIANCE WITH IFRS (INVOLVING

BROADER CONCEPTS)

Chapter Introduction
This chapter aims to provide you with an understanding of the implementation of
IFRS 4 for insurance companies. You will also learn about the key features of
IFRS 4 with respect to an insurance contract.

a) Understand the importance of IFRS.

b) Learn about the key features of IFRS.
 610

1. Understand the importance of IFRS.

[Learning Outcome a]
1.1 Introduction to IFRS

As per the directives issued by the Ministry of Corporate Affairs, all insurance
companies are required to apply International Financial Reporting Standards
(IFRS), w.e.f. 1st April 2012. Presently, Indian Insurance Companies prepare
their accounts as per IRDA (Preparation of financial statements and auditor’s
report) Regulations 2000.

IFRS

The International Accounting Standard Council (IASC) has developed uniform

international financial reporting standards that are termed International Financial
Reporting Standards or IFRS.

International Financial Reporting Standards (IFRS) has been prepared by the

International Accounting Standard Council (IASC) and approved by the
International Accounting Standard Board (IASB).

The Institute of Chartered Accountants of India (ICAI) has also issued Indian
Standards which are in convergence with IFRS, and is actively promoting IFRS.
It has recently issued an exposure draft of the new Accounting standard AS39, “
Insurance Contracts”, along the lines of IFRS 4 (phase I). All listed entities,
including banks and insurance companies, are required to adopt IFRS.

The insurance contract project of IASB has been split into 2 phases:

Phase I:

This phase was concluded in 2004, when IFRS 4 for insurance contracts was
published by IASB. At the end of this phase, it was decided to retain many of the
existing international insurance contract accounting practices.

It is important to note that IFRS 4 has been issued as a short term means to fill
the gap in IFRSs.
 611

Phase II:

An exposure draft on phase II was launched by IASB on 30 th July 2010, with an

aim for implementing a single, consistent recognition and measurement standard
for insurance contracts internationally. This phase is expected to be implemented
by 2013.

1.2 Need of IFRS

With recent globalization, a large number of Indian companies are increasingly

investing in foreign markets. Also, the companies try to raise capital for their
expansion and other activities from these international markets.

This makes it necessary for Indian companies to follow an international standard

of accounting practices that is accepted globally by all stock exchanges.

To have uniformity with other countries, India has agreed to adopt International
Standards for preparing financial statements. In view of these international
developments, the Indian Ministry of Corporate Affairs has also committed to
comply with the IFRS provisions by 2012.

1.3 Objective of IFRS 4 standard

The main objective of IFRS 4 is to specify accounting for insurance contracts

issued by insurers. It also specifies accounting for reinsurance contracts issued
or held by an entity.

In particular, IFRS 4 requires:

a) Limited improvements to accounting by insurers for insurance contracts.

b) Disclosure that identifies and explains the amounts in an insurer’s financial

statements arising from insurance contracts and helps users of those financial
statements to understand the amount, timing and uncertainty of future cash
flows from insurance contracts.

1.4 Definition of Insurance Contract

As per IFSR 4, an insurance contract is a contract under which one party (the
insurer) accepts significant insurance risk from another party (the policyholder)
by agreeing to compensate the policy holder if a specified uncertain future event
(the insured event) adversely affects the policy holder.
 612

1.5 Scope of IFRS 4

a) IFRS 4 applies to all insurance contracts (including reinsurance contracts that

an entity issues and reinsurance contracts that it holds, except for specified
contracts covered by other IFRS).
b) It does not apply to other assets and liabilities of an insurer, such as financial
assets and financial liabilities within the scope of IAS 39(Financial
Instruments: Recognition and Measurement.).
c) IFRS 4 does not address accounting by policyholders.
d) IFRS 4 exempts an insurer temporarily from some requirements of other
IFRSs including the requirement to consider the framework in selecting
accounting policies from insurance contracts. However, IFRS 4:
 Prohibits provisions for possible claims under contracts that are not in
existence at the reporting date.
 Requires a test for the adequacy of recognised insurance liabilities and an
impairment test for reinsurance assets.
 Requires an insurer to keep insurance liabilities in its balance sheet until
they are discharged or cancelled or expire and to present insurance
liabilities without offsetting them against related reinsurance assets.
e) IFRS 4 permits an insurer to change its accounting policies for insurance
contracts.
f) IFRS 4 requires disclosure to help users understand:
 the amounts in the insurer’s financial statement that arise from insurance
contracts
 the amount, timing and uncertainty of future cash flows from insurance
contracts

What is the main objective of IFRS 4?

A To specify financial risk that can be accepted by insurers

B To specify accounting for insurance contracts issued by insurers.
C To exempt certain risk from the purview of certain insurers
D To define insurance risk for reinsurance
 613

2. Learn about the key features of IFRS 4.

[Learning Outcome b]
2.1 Key features of IFRS 4
Key features of IFRS 4 can be summed up as follows:

a) Compliance with IFRS 4

To make accounts comparable, the financial statements for 2012-13 of all listed
insurance companies will have to be prepared in compliance with IFRS 4
Insurance Contracts.

b) Better disclosure and greater transparency

With the adoption of IFRS 4 Insurance Contracts, the financial statements will be
more transparent and comparable across the world. It is also believed by various
accounting bodies and regulators that it will bring enhanced disclosure and
greater consistency in insurance accounting.

IFRS 4 requires disclosures with respect to:

 Information that helps users understand the amount in financial statements of
insurers that arises from insurance contract.
 Information that helps users to evaluate the nature and extent of risks arising
from insurance contracts.

c) Fair value accounting

Objective of this new IFRS is to move towards fair value accounting (i.e.
recording both assets and liabilities at the “amount for which an asset could be
exchanged or a liability settled) in place of historical accounting.

Under IFRS 4, if an insurer changes its accounting policies for insurance

liabilities, it may reclassify a few or all of its financial assets at ‘fair value
through profit or loss”.

Under IFRS 4, all assets and any profits or losses flowing through the revenue
account may be allowed under fair value measurement. Fair value can be
measured reliably if:
 The variability is in the range of reasonable fair value estimates and is not
significant for the estimate
 The probabilities of the various estimates within the range can be reasonably
assessed and used in estimating fair value
 614

d) Defining insurance contracts in crisp and precise manner

IFRs 4 requires insurance contracts to be defined in a crisp and precise manner so

that it is easy to understand for all stakeholders involved

e) Substance of economic transactions

Definition of Insurance contracts has focused on the substance of economic

transactions rather than legal form and has helped to standardize the treatment of
insurance contracts across industries.

f) Separation between investment and insurance

IFRS 4 separates investment and insurance components of a contract to account

for embedded derivatives at fair value with movements in this value being
recorded in the income statement.

g) Treatment of investment

In this standard, the investment assets of insurance companies will have to be

categorized as one of the following:

 Held to maturity (HTM): Debt instruments which the entity intends to hold
to maturity.
 Available for sale (AFS): Investment marked to market with changes
recorded in reserves.
 Held for trading: Marked to market with changes recorded in the income
statement
 Loans and receivables: Non derivative financial assets.

h) Available for sale (AFS)

Given the nature of insurance company liabilities, most investments are liable to
be categorised as ‘available for sale’ with the associated volatility in
shareholders’ equity.

It should be noted that IFRS 4 (Insurance Contract) is a technical and very

complex reporting standard which requires actuarial interpretation. Here, we
have given only the salient points of IFRS 4 for the understanding of students. It
is also possible that there can be some changes in IFRS 4 to suit local conditions.
 615

Diagram 1: Key features of IFRS 4

 616

Under IFRS, debt instruments, which the entity intends to hold to maturity, are
categorised as:

A Held to maturity
B Available for sale
C Held for trading
D Loans and receivables

Summary
 As per the directives issued by the Ministry of Corporate Affairs, all
insurance companies are required to apply International Financial Reporting
Standards (IFRS), w.e.f. 1st April 2012.
 International Financial Reporting Standards (IFRS) has been prepared by the
International Accounting Standard Council (IASC).
 The main objective of IFRS 4 is to specify accounting for insurance contracts
issued by insurers. It also specifies accounting for reinsurance contracts
issued or held by an entity.
 As per IFSR 4, an insurance contract is a contract under which one party (the
insurer) accepts significant insurance risk from another party (the
policyholder) by agreeing to compensate the policy holder if a specified
uncertain future event (the insured event) adversely affects the policy holder.
 With the adoption of IFRS 4 Insurance Contracts, the financial statements
will be more transparent and comparable across world.
 Under IFRS 4, if an insurer changes its accounting policies for insurance
liabilities, it may reclassify a few or all of its financial assets as at ‘fair value
through profit or loss”.
 617

Answers to Test Yourself

Answer to TY 1

The correct answer is B.

Main objective of IFRS 4 is to specify accounting for insurance contracts issued

by insurers.

Answer to TY 2

The correct answer is A.

Under IFRS, debt instruments which the entity intends to hold to maturity are
categorised as held to maturity.

Self Examination Questions

Question 1

International Financial Reporting Standards (IFRS) has been prepared by

A IRDA
B ICAI
C IASC
D IASB

Question 2

Under IFRS 4, if an insurer changes its accounting policies for insurance

liabilities, it may reclassify a few or all of its financial assets as at

A Present value at a profit

B Historical cost at profit or loss
C Fair value through profit or loss.
D Economical value through profit or loss
 618

Question 3

IFRS 4 separates investment and insurance components of a contract to account

for embedded derivatives at fair value with movements in this value being
recorded in the .

A Revenue statement
B Income statement
C Profit and loss statement
D Balance sheet

Question 4

Which of the following is categorised under loans and receivables under IFRS?

A Debt instruments
B Equity
C Non derivative financial assets
D Investment products

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is C.

International Financial Reporting Standards (IFRS) has been prepared by IASC.

Answer to SEQ 2

The correct answer is C.

Under IFRS 4, if an insurer changes its accounting policies for insurance

liabilities, it may reclassify a few or all of its financial assets as at fair value
through profit or loss.
 619

Answer to SEQ 3

The correct answer is B.

IFRS 4 separates investment and insurance components of a contract to account

for embedded derivatives at fair value with movements in this value being
recorded in the income statement.

Answer to SEQ 4

The correct answer is C.

Non derivative financial assets are categorised under loans and receivables under
IFRS.