RETURNS ON FINANCIAL SOURCES

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Advance Financial Accounting (FIN-611)

LESSON # 24

RETURNS ON FINANCIAL SOURCES

Company style of business entity obtains finances from two sources; Owners' Capital

and Lenders' Capital. Both of the financers are paid in terms of returns on their

respective capitals. Return on owners' capital is known as dividend and return on

lenders' capital is known as interest/markup.

Dividends

Company style of business entity does not allow its owners (shareholders) to draw

cash or non cash resources from the entity like sole proprietorship and partnership

business organizations. As a replacement for drawings the shareholders are paid

dividends.

Dividend is the return on finances received from the equity participants (ordinary

shareholders). Dividends may be paid after declaration of the current year's profits

and may also be paid during the accounting year as interim dividend based on

expectation of the profits.

Declaration of dividends depends upon the availability of profits where as payment of

dividends depends upon the availability of cash resources. So, in order to pay

dividends, the company must have sufficient distributable profits as well as cash

resources. Therefore, it is only the board of directors who takes decision that how

much dividends should be paid to the shareholders. Although the decision of

dividends is taken by the directors but it is formally approved by the shareholder in

the annual general meeting after they have gone through the annual report.

Calculation of dividends

Amount of dividend can be determined in either of the two ways:

1. As a percentage of the amount of issued and paid-up share capital

2. As rupees/paisa per number of issued and paid-up share capital

Example:

Ordinary share capital of a company is 100,000 number of ordinary share of Rs. 10

each and dividend is paid to shareholders either; as 7% of the ordinary share capital

issued or as Paisa 50 per share.

If dividend is paid as a percentage

The amount of dividend is Rs. 1,000,000 x 7%

= Rs. 70,000

If dividend is paid as paisa per share

The amount of dividend is 100,000 x 0.50

= Rs. 50,000

113

Advance Financial Accounting (FIN-611)

Accounting for dividends

For dividends paid (interim dividends and previous year's proposed dividends)

Dividends a/c

Bank a/c

Debit to the dividend a/c is recognized as a decrease in equity (retained earnings) and

is presented in the statement of changes in equity.

Credit to bank a/c is recognized as a decrease in cash resources kept in the bank.

For dividends proposed by the directors

Where directors of an entity propose dividends after the balance sheet date (closing

date of the year), such dividends are not recognized as a liability and so are not

recognized as a decrease in equity. This is so because such proposed dividends do not

meet the criterion of a present obligation to be a liability. Such dividends are disclosed

in the notes in accordance with the requirements of IAS 1 and IAS 10.

Example:

Pleasure Co. Ltd paid Rs. 55,000 during the year ending on December 31, 2009 as

interim equity dividends.

On March 21st, 2010, directors of the company proposed and declared final equity

dividends of Rs. 135,000 in addition to the already paid.

Presentation:

Statement of changes in equity

For the year ended 31-12-2009

(Extract)

Rupees

Opening balances (retained profits)

???????

Dividend paid

(55,000)

Balance Sheet

As on 31-12-2009

(Extract)

Rupees

Current Assets

Bank balance (decreases by Rs. 55,000)

???????

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Advance Financial Accounting (FIN-611)

Notes

For the year ended 31-12-2009

(Extract)

Proposed Dividends

Dividends proposed for the year is Rs. 135,000.

Interest on Debentures/Loan notes

Debentures, loan notes, loan bonds, or loan stocks are the lenders' capital. These are

the long term loans and have charge on the non-current assets of the entity through a

trust. Money against these loan certificates is collected from the general public.

Against the capital money received, the company pays interest to the lenders.

A company style of business entity also receives money from the financial institutions

as loan. This loan is also a long term loan and is subject to interest on it. This loan is

secured against non-current assets or inventories of the entity either through

mortgage, pledge, or hypothecation.

Interest on these sources of finance is calculated on the amount due for the period

(time) dues. It means that if the loan was of Rs. 200,000 and an installment of Rs.

50,000 has been paid, the interest will be calculated on the amount due i.e. Rs. 150,000.

It further means that if the loan was taken on 1st of October, 2009 and the accounting

year ends on 31st of December, 2009, the interest will be calculated for the three (3)

months i.e. October, November, & December.

Calculation of interest/markup

Basic Scenario

Rupees

5% Debentures

opening balance 1-1-09

25,000

Issued during the year

20,000

Closing balance 31-12-09

45,000

Scenario I

If the fresh issue of 5% Debentures took place on January 1st, 2009

Interest on debentures 5% of Rs. 25,000 for full year

1,250

Interest on debentures 5% of Rs. 20,000 for full year

1,000

Financial charges for the year

2,250

115

Advance Financial Accounting (FIN-611)

Scenario II

If the fresh issue of 5% Debentures took place on July 1st, 2009

Interest on debentures 5% of Rs. 25,000 for full year 1,250

Interest on debentures 5% of Rs. 20,000 for six months

500

Financial charges for the year

1,750

Changed Scenario

Rupees

5% Debentures

opening balance 1-1-09

25,000

Redemption during the year

15,000

Closing balance 31-12-09

10,000

Scenario III

If the redemption of 5% Debentures took place on January 1st, 2009

Interest on debentures 5% of Rs. 10,000 for full year

500

Financial charges for the year

500

Scenario IV

If the redemption of 5% Debentures took place on July 1st, 2009

Interest on debentures 5% of Rs. 10,000 for full year

500

Interest on debentures 5% of Rs. 15,000 for six months

375

Financial charges for the year

875

Scenario V

If the redemption of 5% Debentures took place on December 31st, 2009

Interest on debentures 5% of Rs. 25,000 for full year

1,250

Financial charges for the year

1,250

Accounting for Interest/markup

For the amount of interest/markup paid during the year

Financial charges a/c

Bank a/c

Debit to the financial charges a/c is recognized as an expense in the incomes statement

and is presented as deduction form operating profits before charging income tax.

Credit to bank a/c is recognized as a decrease in cash resources kept in the bank.

116

Advance Financial Accounting (FIN-611)

For the amount of interest/markup due on balance sheet date

Financial charges a/c

Accrued/owing financial charges a/c

Debit to the financial charges a/c is included in the interest/markup paid and then

recognized as an expense in the incomes statement. Total financial charges, paid and

due, are presented as deduction form operating profits before charging income tax.

Credit to accrued/owing financial charges a/c is recognized as a current liability in

balance sheet, as it meets all the criteria to be a liability.

Example:

Pleasure Co. Ltd paid Rs. 25,000 during the year ending on December 31, 2009 as

interest on loan. On closing date Rs. 10,000 interest on loan is still due.

Presentation:

Income Statement

For the year ended 31-12-2009

(Extract)

Profit from operations

*****

Other incomes

*****

Financial charges

35,000

Profit before tax

*****

Income tax

(****)

Profit after tax

*****

Balance Sheet

As on 31-12-2009

(Extract)

Rupees

Current Assets

Bank balance (decreases by Rs. 25,000)

???????

Current Liabilities

Interest accrued/owing

10,000

Income Tax Expense

Income tax expense is a charge on the realized profits earned by an entity. This is

calculated in accordance with the Income Tax Ordinance 2001 and its accounting

treatments are set out in IAS 12.

117

Advance Financial Accounting (FIN-611)

Income tax expense for the year comprises of:

Current tax, and

Deferred tax

1) Current tax

Current tax is the income tax on current year's taxable profits that is levied by the

income tax authorities. The income tax authorities come to know the profits of an

entity when the income tax return is submitted. Income tax return for the year is

prepared by the tax accountant of the entity after the financial statements have been

approved and published, obviously in these financial statements the current year's

income tax expense is calculated on estimated bases. Such estimated amount of

income tax is known as provision for income tax. Hence, in the income statement, the

income tax expense representing current tax will be an estimated amount with an

adjustment of the difference between actual and estimated amount of previous year's

income tax expense.

Example:

Years

2007

2008

2009

Rupees

Profit before tax

50,000

60,000

40,000

Income Tax rate

40%

Provision for tax

20,000

24,000

16,000

Actual Tax levied

22,000

23,000

Accounting Entries

For the year 2007

Income tax expense a/c

20,000

Provision for tax a/c

20,000

It is assumed that the year 2007 is first year of the business and for the profits of the

year 2007 the estimated amount of the income tax expense is worked out as Rs. 20,000.

Debit to the income tax expense a/c is subtracted from the profit before tax. Whereas,

credit to provisions for tax a/c is recognized as a current liability, because the entity

has a present obligation to pay tax in future against current year's profits.

For the year 2008

Provision for tax a/c

20,000

Income Tax expense a/c

2,000

Bank a/c

22,000

118

Advance Financial Accounting (FIN-611)

Income tax expense a/c

24,000

Provision for tax a/c

24,000

Income statement a/c

26,000

Income tax expense a/c

26,000

Obligation against the previous year's income tax expense is settled in the current

year. Amount of income tax paid in excess to the previous years' estimated (provision

for) income tax is charged to the current year's income statement as a part of current

year's income tax expense.

In the above case Rs. 22,000 income tax was paid against the provision for income tax

Rs. 20,000 created last year, the excessive amount of income tax paid during the

current year for the previous year is Rs. 2,000 known as under-provision. This Rs.

2,000 (under-provision) is closed into the income statement for the current year along

with the current year's provision of Rs. 24,000 as an expense. So, the total amount of

income tax expense for the year 2008 is Rs. 26,000.

For the year 2009

Provision for tax a/c

24,000

Income Tax expense a/c

1,000

Bank a/c

23,000

Income tax expense a/c

16,000

Provision for tax a/c

16,000

Income statement a/c

15,000

Income tax expense a/c

15,000

When the amount of income tax paid in the current year is lesser than the previous

years' estimated (provision for) income tax the difference is known as over provision,

which is subtracted from the current year's provision for income tax as an adjustment.

In the above case Rs. 23,000 income tax was paid against the provision for income tax

Rs. 24,000 created last year, the lesser amount of income tax paid is Rs. 1,000. This

under-provision of Rs. 1,000 is subtracted form the current year's provision for income

tax of Rs. 16,000 and the balance of Rs. 15,000 is closed into the income statement for

the current year as an expense.

Working in support of the above accounting:

2007

2008

2009

Rupees

Income Statement

Provision for current year's tax

20,000

24,000

16,000

119

Advance Financial Accounting (FIN-611)

Add Under provision

2,000

Less Over provision

(1,000)

Income tax expense for the year

20,000

26,000

15,000

Balance Sheet

Current Liabilities

Provision for income tax

20,000

24,000

16,000

Deferred tax

Deferred tax is an accounting adjustment that is used to match the tax effects with

accounting profits.

Accounting entries

For creating provision for deferred tax

Income tax expense a/c

Deferred tax liability a/c

For increasing the provision for deferred tax

Income tax expense a/c

Deferred tax liability a/c

For decreasing the provision for deferred tax

Deferred tax liability a/c

Income tax expense a/c

Presentation in Financial Statements

Balance Sheet

As on 31-12-2009

(Extract)

Liabilities

Non-Current Liabilities

Deferred tax liability

****

Current Liabilities

Provision for income tax

****

120

Advance Financial Accounting (FIN-611)

Income Statement

For the year ended 31-12-2009

(Extract)

Profit before tax

****

Income tax expense

Current tax

Provision for current year's tax

***

Add under-provision

***

Less over-provision

(***)

****

Deferred tax

Deferred tax liability increased by

****

Deferred tax liability decreased by

(***)

(****)

Profit after tax

****

Solved Problem:

Q.1:

Amjad Ltd. is preparing its accounts for 20X2. A summarized trial balance is noted

below:

Rs. 000

Profits before tax and dividends

1,036

Total assets

2,292

Sundry current liabilities

241

Income tax

Provision for deferred tax

200

Long-term loan

Ordinary shares

100

693

Opening retained earnings

_____

2,317

Notes:

a. No dividends have been paid or proposed.

b. Last year's income tax was settled at Rs. 238,000. The under provision is noted

on the trial balance.

c. The provision for deferred tax should be adjusted to a closing balance of Rs.

33,000.

Required:

Prepare an income statement, statement of changes in equity and balance sheet with

for Amjad Ltd. for 20X2.

121

Advance Financial Accounting (FIN-611)

Solution:

Amjad Ltd.: Income Statement for 20X2

Rs. 000

Profit before tax

1,036

Taxation

(Note 1)

(364)

Profit after tax

672

Amjad Ltd.: Statement of changes in equity (extract)

Rs. 000

Opening retained earnings

693

Profit for the year

672

Closing retained earnings

1,365

Balance Sheet for 20X2

Rs. 000

Total Assets

2,292

Equity and Liabilities

Equity

Ordinary shares

100

Retained earnings

1,365

1,465

Non-Current Liabilities

Deferred tax (Note 2)

Long-term loan

200

233

Current Liabilities

Sundry

241

Income tax

353

594

2,292

Note 1 Tax Charge

Rs. 000

Income tax charge on the profits for the year at XX %

353

Under (over) provision for tax in previous years

Deferred tax charge (credit)

(14)

364

Note 2 Provision for deferred tax

Rs. 000

Opening provision

Charge (credit) for the year

(14)

Closing provision

33_

122

Advance Financial Accounting (FIN-611)

Practice Questions:

Q 1:

TAXATION X LTD

X Ltd. is preparing its accounts for the year ended 31 December 20X6. The deferred tax

account as at 31 December 20X5 was Rs. 50,000. A provision of Rs. 70,000 for deferred

tax will be required at the year-end. The current income tax charge provision for the

year is Rs. 60,000. Prepare the relevant extracts from the income statement, balance

sheet and the notes to the accounts.

Solution:

TAXATION X LTD

Extract from the income statement

For the year ended 31 December 20X6

Rs.

Taxation

Income tax at X%

60,000

Deferred taxation

20,000

Tax charge

80,000

Extract from balance sheet

As at 31 December 20X6

Rs.

Non-current liabilities

Deferred taxation (Note 1)

70,000

Current liabilities

Income tax

60,000

Notes to the accounts

Deferred taxation

Rs.

Balance brought forward

50,000

Transfer from income statement

20,000

Balance carried forward

70,000

Q 2:

TAXATION UNITED LTD

An extract from the trial balance of United Ltd. as at 31 December 20X8 shows:

The tax provision for the year is estimated at Rs. 170,000.

The income tax rate is 30%.

A provision for deferred taxation of Rs. 45,000 will be required at the year-end.

The directors are not proposing a final dividend.

123

Advance Financial Accounting (FIN-611)

Required

Prepare the figures to appear in the income statement and statement of changes in

equity.

Solution:

TAXATION UNITED LTD

Income statement

For the year ended 31 December 20X8

Rs.

Revenues

1,500,000

Expenses

(950,000)

Profit from operations

550,000

Investment income

8,000

Profit before tax

558,000

Taxation (Note 1)

(187,500)

Profit for the financial year

370,500

Statement of changes in equity

Rs.

Opening retained earnings

650,000

Profit for the financial year

370,500

Dividends

22,500

Closing retained earnings

998,000

Note 1 Taxation

Rs.

On profits of the year

170,000

Under-provision in prior year (1)

2,500

Deferred taxation (2)

15,000

187,500

Notes

1. The trial balance shows an under provision in last year's income statement for

tax of Rs. 2,500 (22,500 20,000). This is accounted for by increasing this year's

tax charge by Rs. 2,500.

2. The double entry for the transfer to deferred taxation for the year is:

Dr.

Tax charge in the income statement

Rs. 15,000

Cr.

Deferred taxation provision in the balance sheet

Rs. 15,000

124

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