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SYMBIOSIS INSTITUTE OF

INTERNATIONAL BUSINESS [SIIB]


Constituent of Symbiosis International University
Accredited by NAAC with ‘A’ Grade

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IB-11-13-Pre-Induction – Introduction to Finance
INDEX

MODULE – 4 – Introduction To Finance And Accounting

Sr. No. Content Page No.


1 Instructions 3
2 Financial System – An Introduction 4-25

3 Introductory Finance Concepts 26-30

4 Accounting Concepts – An Introduction 31-65

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1. Instructions

Students are required to go through the study material provided.


On the first day of induction, you will be required to compulsorily give a quiz based on the
topics given in the study material.
The marks of the quiz will be part of your grades for the subjects in the first semester.
Kindly go through the material carefully.

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2. FINANCIAL SYSTEM – AN INTRODUCTION
FINANCIAL SYSTEM

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlinked institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy.

The financial system is concerned about money, credit and finance - the three terms are
intimately related yet are somewhat different from each other.

Indian financial system consists of a variety of institutions, markets, instruments and


financial regulators related in a systematic manner – provides the principal means by which
savings are transformed into investments. Financial system deals with financial assets.

Financial assets : They represent claims against the future income and wealth of others.
Financial liabilities, the counterparts of financial assets, represent promises to pay some
portion of prospective income and wealth to others. The important financial assets and
liabilities in our economy are money, demand deposit, short-term debt, intermediate-term
debt, long-term debt, and equity stock.

Financial market: A financial market is a market for creation and exchange of financial
assets. In financial market trading of financial assets take place, facilitating transfer of
economic resources from lenders to ultimate borrowers. There are varieties of financial
instruments that are created and traded on these markets. The financial markets can be
classified in several ways viz. |Primary market and Secondary market, Capital Market and
money market, etc. These two markets are interdependent and inseparable segments.

Constituents of Financial System

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Financial Institutions or Financial Intermediaries: These are business firms that produce
specialized financial products like loans, insurance, pensions, etc. They act as mobilisers and
depositors of savings and provide various financial services to the community. There are
many types of financial intermediaries that coexist in any economy. They are broadly
classified as banking intermediaries and non-banking intermediaries. There are also
regulatory institutions to provide policy framework and to supervise/ monitor the operations
of the players in the financial markets.

The financial system provides a payment mechanism, enables the pooling of funds, facilitates
the management of uncertainty, generates information for decentralized decision making, and
helps in dealing with informational asymmetry.

Payment System
Depository financial intermediaries such as banks are the pivot of the payment system. Credit
card companies play a supplementary role.

Pooling of Funds
– Financial markets and intermediaries facilitate the pooling of the household savings for
financing business. Transfer funds from those who have surplus to those who need funds to
invest
– Transfer funds in such a way as to redistribute the unavoidable risk
– To facilitate the transfer efficiently, we need a sound financial system

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Transfer of Resources
The financial system facilitates the efficient life-cycle allocations of household consumption, the
efficient allocation of physical capital to its most productive use, and the efficient separation of
ownership from management.

Risk Management
A well-developed financial system offers a variety of instruments that enable economic agents to
pool, price, and exchange risk. The three basic methods of managing risk are: hedging,
diversification, and insurance.

Price Information for Decentralized Decision Making


Interest rates and security prices are used by households in their consumption-saving-investment
decisions and by firms in their investment and financing decisions

The purpose of financial system in any economy is to gather and allocate funds in the most
efficient manner. This involves flow of funds from surplus to deficit economic units. Financial
Markets in which funds are transferred from people who have an excess of available funds to
people who have a shortage

Financial markets play a very pivotal role in allocating resources in the economy by performing
three important functions as they:

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Facilitate Price Discovery
The continual interaction among numerous buyers and sellers who participate in financial
markets helps in establishing the prices of financial assets.

Provide Liquidity
Thanks to the liquidity provided by financial markets, it is possible for companies (and other
entities) to raise long-term funds from investors with short-term horizons

Reduce the Costs of Transacting


Financial markets considerably reduce the following costs of transacting
• Search cost
• Information cost

Financial Markets is a place where buyers and sellers of securities can enter into transactions to
purchase and sell ordinary shares, Government Securities, debentures, preference shares, etc.
Further, it performs an important role of enabling corporates, entrepreneurs to raise resources for
their companies and business ventures through public issues. Transfer of resources from those
having idle resources (investors) to others who have a need for them (corporates) is most
efficiently achieved through the securities market. They provide channels for reallocation of
savings to investments and entrepreneurship. Savings are linked to investments by a variety of
intermediaries, through a range of financial products, called ‘Securities’. One can invest in
Shares, Government Securities, Derivative products, Units of Mutual Funds etc., are some of the
securities investors in the securities market can invest in.

The financial market essentially has three categories of participants, namely, the issuers of
securities, investors in securities and the intermediaries, such as merchant bankers, brokers etc.
While the corporates and government raise resources from the securities market to meet their
obligations, it is households that invest their savings in the securities market.

Participants in the Financial Market: The financial market essentially has three categories of
participants, namely, the issuers of securities, investors in securities and the intermediaries, such
as merchant bankers, brokers etc. While the corporate and government raise resources from the
securities market to meet their obligations, it is households that invest their savings in the
securities market.

The securities market has two interdependent segments: the primary (new issues) market and the
secondary market. The primary market provides the channel for sale of new securities while the
secondary market deals in securities previously issued.

There are different ways of classifying financial markets. The important bases for classification
are: type of financial claims, maturity of claims, new issues versus outstanding issues, timing of
delivery, and nature of organizational structure.

Financial markets can be classified by the type of financial claims. i.e. Debt Markets and
Equity Markets. Debt markets enable corporations and governments to borrow to finance their

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activities. Determination of interest rates takes place in this market. It is the financial market for
fixed claim and the equity market is the financial market for residual claims (equity instruments)

Equity Markets is a place where buyers and sellers of securities can enter into transactions to
purchase and sell ordinary shares, preference shares. Further, it performs an important role of
enabling corporates, entrepreneurs to raise resources for their companies and business ventures
through public issues. Transfer of resources from those having idle resources (investors) to
others who have a need for them (corporates) is most efficiently achieved through the securities
market.

Debt instrument represents a contract whereby one party lends money to another on pre-
determined terms with regards to rate and periodicity of interest, repayment of principal amount
by the borrower to the lender. In Indian securities markets, the term ‘bond’ is used for debt
instruments issued by the Central and State governments and public sector organizations and the
term ‘debenture’ is used for instruments issued by private corporate sector.

Features of debt instruments: Each debt instrument has three features: Maturity, coupon and
principal.

Maturity: Maturity of a bond refers to the date, on which the bond matures, which is the date on
which the borrower has agreed to repay the principal.

Term-to-Maturity refers to the number of years remaining for the bond to mature. The Term-to-
Maturity changes every day, from date of issue of the bond until its maturity. The term to
maturity of a bond can be calculated on any date, as the distance between such a date and the
date of maturity. It is also called the term or the tenure of the bond.

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Coupon: Coupon refers to the periodic interest payments that are made by the borrower (who is
also the issuer of the bond) to the lender (the subscriber of the bond). Coupon rate is the rate at
which interest is paid, and is usually represented as a percentage of the par value of a bond.

Principal: Principal is the amount that has been borrowed, and is also called the par value or face
value of the bond. The coupon is the product of the principal and the coupon rate. The name of
the bond itself conveys the key features of a bond. For example, a GS CG2008 11.40% bond
refers to a Central Government bond maturing in the year 2008 and paying a coupon of 11.40%.
Since Central Government bonds have a face value of Rs.100 and normally pay coupon semi-
annually, this bond will pay Rs. 5.70 as six- monthly coupon, until maturity.

Interest is the amount paid by the borrower (the company) to the lender (the debenture-holder)
for borrowing the amount for a specific period of time. The interest may be paid annual, semi-
annually, quarterly or monthly and is paid usually on the face value (the value printed on the
bond certificate) of the bond.

There are three main segments in the debt markets in India, viz., (1) Government Securities, (2)
Public Sector Units (PSU) bonds, and (3) Corporate securities. The market for Government
Securities comprises the Centre, State and State-sponsored securities. In the recent past, local
bodies such as municipalities have also begun to tap the debt markets for funds. Some of the
PSU bonds are tax free, while most bonds including government securities are not tax-free.
Corporate bond markets comprise of commercial paper and bonds. These bonds typically are
structured to suit the requirements of investors and the issuing corporate, and include a variety of
tailor- made features with respect to interest payments and redemption.

Given the large size of the trades, Debt market is predominantly a wholesale market, with
dominant institutional investor participation. The investors in the debt markets are mainly banks,
financial institutions, mutual funds, provident funds, insurance companies and corporates.

Most Bond/Debenture issues are rated by specialized credit rating agencies. Credit rating
agencies in India are CRISIL, CARE, ICRA and Fitch. The yield on a bond varies inversely with
its credit (safety) rating. The safer the instrument, the lower is the rate of interest offered.

You may subscribe to issues made by the government/corporates in the primary market.
Alternatively, you may purchase the same from the secondary market through the stock
exchanges.

A second way is to classify financial markets by the maturity of claims. A money market is a
financial market for debt securities with maturities of less than one year (short-term). The New
York money market is the world’s largest. The money market facilitates short term financing
and assures the liquidity of short term financial assets. The money market is significant for
indicating changes in short term interest rates, monetary policy and availability of short term
credit and is a main place for central bank activities.

The focus of money market is on providing a means by which the participants, individuals,
institutions and Government are able to rapidly adjust their actual liquidity position. It is a

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medium through which holders of temporary cash surpluses meet the requirements of those with
temporary cash deficits. Hence an institution with temporary excess of investible funds is able to
invest in the money market for a short period of time and get return on them. Similarly
individuals, institutions and government with temporary problem of liquidity can raise funds in
the money market for a short period of time. Money market meets the working capital
requirements of industry, trade and commerce.

The money market assures borrowers that they can obtain short term funds quickly and it assures
lenders that they can convert their short term financial assets into cash. Reserve Bank of India,
The Central bank, which is responsible for regulating and controlling the money supply in
economy, conducts most of its operations through money market. The risk of capital losses and
risk of default are minimum in the money market. Capital losses are minimized because the
money market instruments are short term in nature and change in interest rates does not affect
their prices very much as the assured maturity is discounted over a short period of time. The risk
of default or credit risk is low because money market instruments are mostly the liabilities of the
government, central bank and commercial banks.

The money market comprise specialised sub markets and it consists of central bank, commercial
banks, cooperative banks, discount houses, acceptance houses, bill market, bullion market and in
some cases even insurance companies. The central bank occupies a pivotal position in money
market. Its function is not only that of monitoring of the monetary system but also of a
promotional and development banker.

Money Market provides various kinds of instruments that suit the needs of various investors viz.
call money, Repos, Treasury Bills and commercial bills.

Capital markets are the financial markets for long-term debt and corporate stocks. The New
York Stock Exchange, Bombay Stock Exchange (BSE), National Stock exchange (NSE) are the
examples of a capital market. Traditionally cut off between short term and long term has been
one year – though this dividing line is arbitrary but widely accepted. The primary purpose of
capital market is to direct the flow of savings into long term investments. The demand for long
term funds is from individuals, institutions, government, local authorities and corporate sector
and are met through the issue of shares, debentures and bonds. Apart from raising funds directly
from savers, the deficit units obtain long term funds from financial institutions. On the supply
side are individuals (household sector), institutions, banks and financial institutions.

Capital market plays a vital role in the financial system. Savings and investment are important
for economic development and growth of an economy, which depends upon the rate of long term
investment and capital formation in a country. The capital market plays a vital role in mobilizing
the savings and making them available to the enterprising investors. An active capital market,
through its price mechanism, allocates the scarce financial resources to the most productive uses
at a low cost. Usually the cost of capital is comparatively low for the large and efficient
companies as their securities are subject to lesser risk and their shares command a premium in
the market whereas the companies with poor performance may have to issue securities at a
discount to raise additional funds.

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Third way to classify financial markets is based on whether the claims represent new issues or
outstanding issues. Primary markets are the markets in which newly issued securities are sold for
the first time. Secondary markets are where securities are resold after initial issue in the primary
market.

Primary Market: The primary market provides the channel for sale of new securities. Primary
market provides opportunity to issuers of securities; Government as well as corporates, to raise
resources to meet their requirements of investment and/or discharge some obligation. They may
issue the securities at face value, or at a discount/premium and these securities may take a variety
of forms such as equity, debt etc. They may issue the securities in domestic market and/or
international market.

Primarily, issues can be classified as a Public, Rights or Preferential issues (also known as
private placements). While public and rights issues involve a detailed procedure, private
placements or preferential issues are relatively simpler. The classification of issues is illustrated
below:

Initial Public Offering (IPO) is when an unlisted company makes either a fresh issue of
securities or an offer for sale of its existing securities or both for the first time to the public. This
paves way for listing and trading of the issuer’s securities.

A follow on public offering (Further Issue) is when an already listed company makes either a
fresh issue of securities to the public or an offer for sale to the public, through an offer document.

Rights Issue is when a listed company which proposes to issue fresh securities to its existing
shareholders as on a record date. The rights are normally offered in a particular ratio to the
number of securities held prior to the issue. This route is best suited for companies who would
like to raise capital without diluting stake of its existing shareholders.

A Preferential issue is an issue of shares or of convertible securities by listed companies to a


select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights
issue nor a public issue. This is a faster way for a company to raise equity capital. The issuer
company has to comply with the Companies Act and the requirements contained in preferential
allotment in SEBI guidelines which inter-alia include pricing, disclosures in notice etc.

Difference between public issue and private placement: When an issue is not made to only a
select set of people but is open to the general public and any other investor at large, it is a public
issue. But if the issue is made to a select set of people, it is called private placement. As per
Companies Act, 1956, an issue becomes public if it results in allotment to 50 persons or more.
This means an issue can be privately placed where an allotment is made to less than 50 persons.

Initial Public Offer (IPO): An Initial Public Offer (IPO) is the selling of securities to the public
in the primary market. It is when an unlisted company makes either a fresh issue of securities or
an offer for sale of its existing securities or both for the first time to the public. This paves way
for listing and trading of the issuer’s securities. The sale of securities can be either through book
building or through normal public issue.

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Secondary market: Secondary market refers to a market where securities are traded after being
initially offered to the public in the primary market and/or listed on the Stock Exchange.
Majority of the trading is done in the secondary market. Secondary market comprises of equity
markets and the debt markets.

Role of the Secondary Market: For the general investor, the secondary market provides an
efficient platform for trading of his securities. For the management of the company, Secondary
equity markets serve as a monitoring and control conduit—by facilitating value-enhancing
control activities, enabling implementation of incentive-based management contracts, and
aggregating information (via price discovery) that guides management decisions.

Difference between the Primary Market and the Secondary Market


In the primary market, securities are offered to public for subscription for the purpose of raising
capital or fund. Secondary market is an equity trading venue in which already existing/pre-issued
securities are traded among investors. Secondary market could be either auction or dealer
market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part
of the dealer market.

Fourth way to classify financial markets is by the timing of delivery. A cash or spot market is
one where the payment and delivery occurs immediately. Most of the trades in government
securities in OTC market in India are spot trades. The organized markets do not provide facility
for spot trades. Closest to the spot market is the cash market where settlement takes place after
some time. Trades taking place over a trading cycle are settled together after certain time. E.g.
if an organized market follows T+2 settlement cycle, the transaction has taken place on Monday
(T) will be settled after 2 days.

Markets where securities are traded for future delivery and payments are known as deferred
delivery markets. Derivative products are traded in this market. Derivatives are claims whose
value depends on what happens to the value of the underlying asset. The underlying asset can be
a commodity, index, share foreign exchange or anything. The basic financial derivative products
are Forward or Futures and options. Their values depend on what happens to the prices of other
assets, say IBM stock, and Japanese yen. hence, the value of a derivative security is derived from
the value of an underlying real asset. Derivative contracts may be traded on an exchange or they
may be sold directly over the counter by the issuer. Forward markets or futures market where
the delivery occurs at a predetermined time in future.

Forwards: A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts, such as futures
of the Nifty index.

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Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the
underlying at a stated date and at a stated price. While a buyer of an option pays the premium
and buys the right to exercise his option, the writer of an option is the one who receives the
option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options:

‘Calls’ give the buyer the right but not the obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future dates.
‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying asset
at a given price on or before a given future date. Presently, at NSE futures and options are traded
on the Nifty, CNX IT, BANK Nifty and 116 single stocks.

Warrants: Options generally have lives of up to one year. The majority of options traded on
exchanges have maximum maturity of nine months. Longer dated options are called Warrants
and are generally traded over-the counter.

At the time of buying an option contract, the buyer has to pay premium. The premium is the
price for acquiring the right to buy or sell. It is price paid by the option buyer to the option seller
for acquiring the right to buy or sell. Option premiums are always paid up front.

Commodity Exchange: A Commodity Exchange is an association, or a company of any other


body corporate organizing futures trading in commodities. In a wider sense, it is taken to include
any organized market place where trade is routed through one mechanism, allowing effective
competition among buyers and among sellers – this would include auction-type exchanges, but
not wholesale markets, where trade is localized, but effectively takes place through many non-
related individual transactions between different permutations of buyers and sellers.

Commodity: FCRA Forward Contracts (Regulation) Act, 1952 defines “goods” as “every kind
of movable property other than actionable claims, money and securities”. Futures’ trading is
organized in such goods or commodities as are permitted by the Central Government. At present,
all goods and products of agricultural (including plantation), mineral and fossil origin are
allowed for futures trading under the auspices of the commodity exchanges recognized under the
FCRA.

Commodity derivatives market: Commodity derivatives market trade contracts for which the
underlying asset is commodity. It can be an agricultural commodity like wheat, soybeans,
rapeseed, cotton, etc. or precious metals like gold, silver, etc.

Difference between Commodity and Financial derivatives: The basic concept of a derivative
contract remains the same whether the underlying happens to be a commodity or a financial
asset. However there are some features which are very peculiar to commodity derivative
markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the
case of physical settlement, financial assets are not bulky and do not need special facility for
storage. Due to the bulky nature of the underlying assets, physical settlement in commodity
derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset

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does not really exist as far as financial underlyings are concerned. However in the case of
commodities, the quality of the asset underlying a contract can vary at times.

Fourth way to classify financial markets is by the nature of its organizational structure i.e.
exchange traded market and Over the Counter (OTC) market. In exchange traded markets like
the share market operated by licensed exchanges. All the procedures are standardized and
exchange acts as counter party for every trade, thus counter party risk is centralized. Operations
are regulated by regulator (like SEBI in India) and the exchange’s self-regulatory organization.
Exchanges specify limits on positions and leverages.

OTC markets run by investment institutions and banks and conducted by traders via telephones,
and counter party risk is decentralized with individual institutions. Regulation is through
national legal system, banking supervision and market surveillance. No formal centralized limits
on individual positions, leverage or margining.

We can as well classify financial markets in several other ways: Wholesale and Retail market, in
wholesale markets the size and volume of transaction is huge also quotes are competitive. In
retail markets size and volume of transactions is small and quotes differ according to size of
transaction.

Private placement markets and Public markets. In private placement markets, transactions are
worked out directly between two parties and structured in any manner that appeals to them.
Bank loans and private placements of debt with insurance companies are examples of private
placement market transactions. In public markets, standardized contracts are traded on organized
exchanges. Securities that are issued in public markets, such as common stock and corporate
bonds, are ultimately held by a large number of individuals. Private market securities are more
tailor-made but less liquid, whereas public market securities are more liquid but subject to
greater standardization.

Financial Intermediaries:

Financial Intermediaries that stands between the lender-savers and borrower-spenders and help
transfer funds from one to another. Financial intermediaries are business organizations that
receive funds in one form and repackage them for the use of those who need funds. Through
financial intermediation, resources are allocated more effectively, and the real output of the
economy is thereby increased.

Financial intermediaries are firms that provide services and products that customers may not be
able to get more efficiently by themselves in financial markets. E.g. Mutual Funds. The major
financial intermediaries in India are commercial banks, developmental financial institutions,
insurance companies, mutual funds, non-banking financial companies, and merchant banks.
Financial intermediaries seem to offer several advantages like return with diversification, lower
transaction cost, economies of scale, confidentiality, and signaling benefit.

Important products offered by Financial Intermediaries include Savings / Current Accounts,


Loans, Mortgages, Mutual Fund Schemes, Insurance Contracts, etc.

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There are many types of financial intermediaries that coexist in any economy. These
intermediaries essentially purchase financial claims with one set of characteristics from deficit
units and sell financial claims with different characteristics to surplus units.

Deposit institutions offer savings, current and time deposit facilities and use the funds to provide
consumer, business and mortgage loans. The deposits collected are highly liquid and can be
withdrawn with no or short notice. The deposits up to Rs. 1 lakh are generally covered by
deposit insurance. They participate in the payment mechanism of the economy and their deposit
liabilities constitute major part of nation’s money supply. Commercial Banks Scheduled/
Private, Cooperative Banks, Regional Rural Banks come under this category of institutions.

Banks: The banking system of India consists of the Reserve Bank of India, commercial banks
and cooperative banks. It is characterized by excessive concentration of business in a small
number of big banks. All these banks accept deposits and give loans.

Commercial banks liabilities include several types of deposits and non-deposit funds as well as
equity capital provided by the owners. They accept savings, current and time deposits of varied
maturities. Non deposit liabilities include borrowings and a wide array of instruments such as
inter bank borrowings, repo transactions etc. these firms are highly leveraged firms. The ratio of
outsider’s liability to share holders’ funds in commercial banks is the highest in the financial
sector.

Their assets are wide varieties of loans viz. consumer, commercial and real estate loans, business
loans being the major asset in bank balance sheets. Banks are also major investors of
government and industrial securities. In most of the countries money available with the banking
system is subject to regulation. Regulations prescribe for the investment in high quality papers
such as government securities and highly rated corporate papers. Credit or default risk is the
major risk factor of commercial banks.

Commercial Banks are of the following types scheduled, nonscheduled. Indian, foreign, public
sector, private sector and regional rural banks. The share of nonscheduled banks has declined
and it has become nil now. The commercial banking activity is mainly constituted by the
Scheduled Commercial Banks (SCBs). Among the SCBs Indian scheduled banks (excluding
regional rural banks) belonging to both public and private sector account for more than 90% of
business. The proportion of time deposit to total deposits has significantly increased accounting
for 55 – 60% of total deposits. Banks have diversified into many areas such as merchant
banking, mutual funds, venture capital, equipment leasing, hire purchase credit, housing finance,
credit cards, securities trading, etc.

Contractual Savings Institutions: They obtained funds under long term contractual
arrangements and invest funds in capital market instruments, government securities and real
estate. They receive steady flow of funds from contractual commitments and liquidity is not a
problem in the management of these institutions. Insurance Companies: Life Insurance / Non-
Life Insurance Cos. And Pension Funds come under this category. These companies collect
premium by issuing policies and the premium collected after the payment of expenses are

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invested largely in short term money market instruments and to a small extent in long term
capital market instruments.

Non-Banking Financial Institutions: Some institutions are not direct intermediaries in the
financial markets. These institutions do the loan business but their resources are not directly
obtained from the savers. They are generally set up by the government to provide financial
assistance for specific purposes, sectors and regions thereby meet the credit needs of certain
borrowers. Institutions like IDFC, IFC, NHB, and NABARD in India are examples.

Other Institutions: There are several types of financial intermediaries operate in an economy.
Examples of them are Mutual Funds, Housing Finance Companies, Non-Banking financial
companies (NBFCs).

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act,
1956 and is engaged in the business of loans and advances, acquisition of shares/stock/bonds/
debentures/securities issued by Government or local authority or other securities of like
marketable nature, leasing, hire-purchase, insurance business, chit business but does not include
any institution whose principal business is that of agriculture activity, industrial activity,
sale/purchase/construction of immovable property.

NBFCs are similar to banking institutions as they collect deposits from small investors and
generally lend for commercial purposes. They generally engage themselves in the activities like
leasing, hire purchase, factoring, venture capital financing.

NBFCs are doing functions akin to that of banks; however there are a few differences:
(i) a NBFC cannot accept demand deposits;
(ii) it is not a part of the payment and settlement system and as such cannot issue cheese to its
customers; and
(iii)Deposit insurance facility of DICGC is not available for NBFC depositors unlike in case
of banks.

In terms of Section 45-IA of the RBI Act, 1934, it is mandatory that every NBFC should be
registered with RBI to commence or carry on any business of non-banking financial institution as
defined in clause (a) of Section 45 I of the RBI Act, 1934.

However, to obviate dual regulation, certain category of NBFCs which are regulated by other
regulators are exempted from the requirement of registration with RBI viz. Venture Capital
Fund/Merchant Banking companies/Stock broking companies registered with SEBI, Insurance
Company holding a valid Certificate of Registration issued by IRDA, Niche companies as
notified under Section 620A of the Companies Act, 1956, Chit companies as defined in clause
(b) of Section 2 of the Chit Funds Act, 1982 or Housing Finance Companies regulated by
National Housing Bank.

The NBFCs that are registered with RBI are:


(i) Equipment leasing company; (ii) hire-purchase company; (iii) loan company; and
(iv) investment company.

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With effect from December 6, 2006 the above NBFCs registered with RBI have been reclassified
as
(i) Asset Finance Company (AFC)
(ii) Investment Company (IC)
(iii)Loan Company (LC)

AFC would be defined as any company which is a financial institution carrying on as its
principal business the financing of physical assets supporting productive / economic activity,
such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling
equipments, moving on own power and general purpose industrial machines. Principal business
for this purpose is defined as aggregate of financing real/physical assets supporting economic
activity and income arising therefrom is not less than 60% of its total assets and total income
respectively.

Some of the important intermediaries operating in the financial markets include;


• Banks : Commercial Banks Scheduled/ Private, Cooperative Banks, Regional Rural Banks
• NBFCs
• Developmental Financial Institutions – SFC, SIDC, SIDBI
• Insurance Companies : Life Insurance / Non Life Insurance Cos.
• Pension Funds
• Post Office Savings Bank
• NABARD
• National Housing Bank
• Mutual Funds
• Investment Bankers
• Financial Advisers
• Portfolio Managers
• Stock Exchanges
• Merchant Bankers
• Underwriters
• Registrars
• Depositories
• Custodians
• Venture Capital Firms
• Information Services

Though the markets are different, there may be a few intermediaries offering their services in
more than one market e.g. Underwriter. However, the services offered by them vary from one
market to another.

Over the years, the roles of domestic and the international financial institutions (IFIs) have been
changing. For many of the IFIs, recent projects in the Europe and Central Asia (ECA) region are
heavily concentrated in the financial sector. The World Bank’s private arm, the International
Finance Corporation (IFC), along with the European Bank for Reconstruction and Development
(EBRD) and Asian Development Bank (ADB), have prioritized private sector development,
notably in the areas of finance, energy, and small and medium sized enterprises (SMEs).

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The projects often decentralize lending by filtering IFI assistance through financial
intermediaries (FIs), which then distribute funds to various projects, companies, or other banks

Stock Exchange
The Securities Contract (Regulation) Act, 1956 [SCRA] defines ‘Stock Exchange’ as anybody of
individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or
controlling the business of buying, selling or dealing in securities. Stock exchange could be a
regional stock exchange whose area of operation/jurisdiction is specified at the time of its
recognition or national exchanges, which are permitted to have nationwide trading since
inception. NSE was incorporated as a national stock exchange.

Intermediary Market Role

Stock Exchange Capital Market Secondary Market to securities

Investment Bankers Capital & Credit Market Corporate advisory services, Issue of
securities
Underwriters Capital & Money Subscribe to unsubscribed portion of
Market securities
Registrars, Depositories, Capital Market Issue securities to the investors on
Custodians behalf of the company and handle share
transfer activity
Primary Dealers Satellite Money Market Market making in government securities
Dealers

Forex Dealers Forex Market Ensure exchange in currencies

Financial Regulators: Fourth component of financial system is law and regulations. As a


maker and enforcer of laws in a society, the government has the responsibility for regulating the
financial system. Financial system constantly deals with other people’s property so it is
responsibility of financial system to make sure that the wealth of people is protected, that the
financial contracts are honoured by counterparties so that the events of default are minimized,
that small investors given services that they have been promised, that investors are made aware
of their rights and so on. This role is performed by the specialized institutions known as
financial regulators. In India there are three major regulatory arms of the Government of India
are the Reserve Bank of India (RBI) , the Securities and Exchange Board of India (SEBI) and the
Insurance Regulatory and Development Authority.

Reserve Bank of India (RBI) :

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The RBI is the central bank of the economy and guides, monitors, regulates, controls and
promotes the financial system in the country. The main functions of the RBI are

• Formulation and conduct of monetary policy, which refers to the use of techniques of monetary
control at the disposal of the central bank
• Promoting the country’s banking and financial structure, thereby helping savings mobilization and
proper allocation of funds to desired sectors
• Maintaining stable payment system for smooth financial transaction.
• To act as banker to the government by providing all banking services like deposit acceptance,
withdrawals, transfer of funds and management of public debt. RBI also acts as bankers’ bank by
providing credit facility to commercial as well as cooperative banks in times of need.
• To develop a sound banking system in the country, RBI has powers to supervise and control the
banking institutions.
• Monopoly of issuing currency notes (other than one rupee notes and coins and coins of smaller
denominations) against the security of gold coins and gold bullion and foreign securities.
• Management of rupee exchange rate and foreign exchange reserves

Securities Exchange Board of India (SEBI)

The absence of conditions of perfect competition in the securities market makes the role of the
Regulator extremely important. The regulator ensures that the market participants behave in a
desired manner so that securities market continues to be a major source of finance for corporate
and government and the interest of investors are protected. The responsibility for regulating the
securities market is shared by Department of Economic Affairs (DEA), Department of Company
Affairs (DCA), Reserve Bank of India (RBI) and Securities and Exchange Board of India
(SEBI).

Role of SEBI: The Securities and Exchange Board of India (SEBI) is the regulatory authority in
India established under Section 3 of SEBI Act, 1992. SEBI Act, 1992 provides for establishment
of Securities and Exchange Board of India (SEBI) with statutory powers for (a) protecting the
interests of investors in securities (b) promoting the development of the securities market and (c)
regulating the securities market. Its regulatory jurisdiction extends over corporates in the
issuance of capital and transfer of securities, in addition to all intermediaries and persons
associated with securities market. SEBI has been obligated to perform the aforesaid functions by
such measures as it thinks fit. In particular, it has powers for:

• Regulating the business in stock exchanges and any other securities markets
• Registering and regulating the working of stock brokers, sub–brokers etc.
• Promoting and regulating self-regulatory organizations
• Prohibiting fraudulent and unfair trade practices
• Calling for information from, undertaking inspection, conducting inquiries and audits of the stock
exchanges, intermediaries, self – regulatory organizations, mutual funds and other persons
associated with the securities market.

The Insurance Regulatory and Development Authority (IRDA):

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IRDA is a national agency of the Government of India, based in Hyderabad. It was formed by an
act of Indian Parliament known as IRDA Act 1999, which was amended in 2002 to incorporate
some emerging requirements. Mission of IRDA as stated in the act is "to protect the interests of
the policyholders, to regulate, promote and ensure orderly growth of the insurance industry and
for matters connected therewith or incidental thereto.

The law of India has following expectations from IRDA...

1. To protect the interest of and secure fair treatment to policyholders.


2. To bring about speedy and orderly growth of the insurance industry (including annuity
and superannuation payments), for the benefit of the common man, and to provide long
term funds for accelerating growth of the economy.
3. To set, promote, monitor and enforce high standards of integrity, financial soundness, fair
dealing and competence of those it regulates.
4. To ensure that insurance customers receive precise, clear and correct information about
products and services and make them aware of their responsibilities and duties in this
regard.
5. To ensure speedy settlement of genuine claims, to prevent insurance frauds and other
malpractices and put in place effective grievance redressal machinery.
6. To promote fairness, transparency and orderly conduct in financial markets dealing with
insurance and build a reliable management information system to enforce high standards
of financial soundness amongst market players.
7. To take action where such standards are inadequate or ineffectively enforced.
8. To bring about optimum amount of self-regulation in day to day working of the industry
consistent with the requirements of prudential regulation.

Duties, Powers and Functions of IRDA

Section 14 of IRDA Act, 1999 lays down the duties, powers and functions of IRDA
1. Subject to the provisions of this Act and any other law for the time being in force, the
Authority shall have the duty to regulate, promote and ensure orderly growth of the insurance
business and re-insurance business.

2. Without prejudice to the generality of the provisions contained in sub-section (1), the powers
and functions of the Authority shall include,
1. issue to the applicant a certificate of registration, renew, modify, withdraw, suspend or
cancel such registration;

2. 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;
3. specifying requisite qualifications, code of conduct and practical training for
intermediary or insurance intermediaries and agents;

4. specifying the code of conduct for surveyors and loss assessors;

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5. promoting efficiency in the conduct of insurance business;

6. promoting and regulating professional organizations connected with the insurance and
re-insurance business;

7. levying fees and other charges for carrying out the purposes of this Act;

8. calling for information from, undertaking inspection of, conducting enquiries and
investigations including audit of the insurers, intermediaries, insurance intermediaries
and other organizations connected with the insurance business;

9. 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);

10. 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;

11. regulating investment of funds by insurance companies;

12. regulating maintenance of margin of solvency;

13. adjudication of disputes between insurers and intermediaries or insurance


intermediaries;

14. supervising the functioning of the Tariff Advisory Committee;

15. specifying the percentage of premium income of the insurer to finance schemes for
promoting and regulating professional organizations referred to in clause (f);

16. specifying the percentage of life insurance business and general insurance business to
be undertaken by the insurer in the rural or social sector; and

17. exercising such other powers as may be prescribed from time to time,

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Mutual Funds: These are funds operated by an investment company which raises money from
the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated
set of objectives. It is a substitute for those who are unable to invest directly in equities or debt
because of resource, time or knowledge constraints. Benefits include professional money
management, buying in small amounts and diversification. Mutual fund units are issued and
redeemed by the Fund Management Company based on the fund's net asset value (NAV), which
is determined at the end of each trading session. NAV is calculated as the value of all the shares
held by the fund, minus expenses, divided by the number of units issued. Mutual Funds are
usually long term investment vehicle though there some categories of mutual funds, such as
money market mutual funds which are short term instruments

Securities Exchange Board of India (SEBI) is the regulatory body for all the mutual funds. All
the mutual funds must get registered with SEBI.

Benefits of investing in Mutual Funds: There are several benefits from investing in a Mutual
Fund:
1. Small investments: Mutual funds help you to reap the benefit of returns by a portfolio spread across
a wide spectrum of companies with small investments.

2. Professional Fund Management: Professionals having considerable expertise, experience and


resources manage the pool of money collected by a mutual fund. They thoroughly analyze the
markets and economy to pick good investment opportunities.

3. Spreading Risk: An investor with limited funds might be able to invest in only one or two
stocks/bonds, thus increasing his or her risk. However, a mutual fund will spread its risk by investing
a number of sound stocks or bonds. A fund normally invests in companies across a wide range of
industries, so the risk is diversified.

4. Transparency: Mutual Funds regularly provide investors with information on the value of their
investments. Mutual Funds also provide complete portfolio disclosure of the investments made by
various schemes and also the proportion invested in each asset type. Choice: The large amount of
Mutual Funds offer the investor a wide variety to choose from. An investor can pick up a scheme
depending upon his risk/ return profile.

5. Regulations: All the mutual funds are registered with SEBI and they function within the provisions
of strict regulation designed to protect the interests of the investor.

Net Asset Value: NAV or Net Asset Value of the fund is the cumulative market value of the
assets of the fund net of its liabilities. NAV per unit is simply the net value of assets divided by
the number of units outstanding. Buying and selling into funds is done on the basis of NAV-
related prices. The NAV of a mutual fund are required to be published in newspapers. The NAV
of an open end scheme should be disclosed on a daily basis and the NAV of a close end scheme
should be disclosed at least on a weekly basis

Entry/Exit Load: A Load is a charge, which the mutual fund may collect on entry and/or exit
from a fund. A load is levied to cover the up-front cost incurred by the mutual fund for selling

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the fund. It also covers one time processing costs. Some funds do not charge any entry or exit
load. These funds are referred to as ‘No Load Fund’. Funds usually charge an entry load ranging
between 1.00% and 2.00%. Exit loads vary between 0.25% and 2.00%.

For e.g. Let us assume an investor invests Rs. 10,000/- and the current NAV is Rs.13/-. If the
entry load levied is 1.00%, the price at which the investor invests is Rs.13.13 per unit. The
investor receives 10000/13.13 = 761.6146 units. (Note that units are allotted to an investor based
on the amount invested and not on the basis of no. of units purchased). Let us now assume that
the same investor decides to redeem his 761.6146 units. Let us also assume that the NAV is Rs
15/- and the exit load is 0.50%. Therefore the redemption price per unit works out to Rs. 14.925.
The investor therefore receives 761.6146 x 14.925 = Rs.11367.10.

Risks involved in investing in Mutual Funds

Mutual Funds do not provide assured returns. Their returns are linked to their performance. They
invest in shares, debentures, bonds etc. All these investments involve an element of risk. The unit
value may vary depending upon the performance of the company and if a company defaults in
payment of interest/principal on their debentures/bonds the performance of the fund may get
affected. Besides incase there is a sudden downturn in an industry or the government comes up
with new a regulation which affects a particular industry or company the fund can again be
adversely affected. All these factors influence the performance of Mutual Funds.

Some of the Risk to which Mutual Funds are exposed to is given below:

Market risk : If the overall stock or bond markets fall on account of overall economic factors,
the value of stock or bond holdings in the fund's portfolio can drop, thereby impacting the fund
performance.

Non-market risk: Bad news about an individual company can pull down its stock price, which
can negatively affect fund holdings. This risk can be reduced by having a diversified portfolio
that consists of a wide variety of stocks drawn from different industries.

Interest rate risk: Bond prices and interest rates move in opposite directions. When interest
rates rise, bond prices fall and this decline in underlying securities affects the fund negatively.

Credit risk: Bonds are debt obligations. So when the funds invest in corporate bonds, they run
the risk of the corporate defaulting on their interest and principal payment obligations and when
that risk crystallizes, it leads to a fall in the value of the bond causing the NAV of the fund to
take a beating.

Different types of Mutual funds: Mutual funds are classified in the following manner:

(a) On the basis of Objective Equity Funds/ Growth Funds : Funds that invest in equity
shares are called equity funds. They carry the principal objective of capital appreciation of the
investment over the medium to long-term. They are best suited for investors who are seeking

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capital appreciation. There are different types of equity funds such as Diversified funds, Sector
specific funds and Index based funds.

Diversified funds: These funds invest in companies spread across sectors. These funds are
generally meant for risk-averse investors who want a diversified portfolio across sectors.

Sector funds: These funds invest primarily in equity shares of companies in a particular
business sector or industry. These funds are targeted at investors who are bullish or fancy the
prospects of a particular sector.

Index funds: These funds invest in the same pattern as popular market indices like S&P CNX
Nifty or CNX Midcap 200. The money collected from the investors is invested only in the
stocks, which represent the index. For e.g. a Nifty index fund will invest only in the Nifty 50
stocks. The objective of such funds is not to beat the market but to give a return equivalent to the
market returns.

Tax Saving Funds : These funds offer tax benefits to investors under the Income Tax Act.
Opportunities provided under this scheme are in the form of tax rebates under the Income Tax
act.

Debt/Income Funds : These funds invest predominantly in high-rated fixed-income-bearing


instruments like bonds, debentures, government securities, commercial paper and other money
market instruments. They are best suited for the medium to long-term investors who are averse to
risk and seek capital preservation. They provide a regular income to the investor.

Liquid Funds/Money Market Funds : These funds invest in highly liquid money market
instruments. The period of investment could be as short as a day. They provide easy liquidity.
They have emerged as an alternative for savings and short-term fixed deposit accounts with
comparatively higher returns. These funds are ideal for corporate, institutional investors and
business houses that invest their funds for very short periods.

Gilt Funds : These funds invest in Central and State Government securities. Since they are
Government backed bonds they give a secured return and also ensure safety of the principal
amount. They are best suited for the medium to long-term investors who are averse to risk.

Balanced Funds : These funds invest both in equity shares and fixed-income-bearing
instruments (debt) in some proportion. They provide a steady return and reduce the volatility of
the fund while providing some upside for capital appreciation. They are ideal for medium to
long-term investors who are willing to take moderate risks.

b) On the basis of Flexibility

Open-ended Funds
These funds do not have a fixed date of redemption. Generally they are open for subscription and
redemption throughout the year. Their prices are linked to the daily net asset value (NAV). From
the investors' perspective, they are much more liquid than closed-ended funds.

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Close-ended Funds
These funds are open initially for entry during the Initial Public Offering (IPO) and thereafter
closed for entry as well as exit. These funds have a fixed date of redemption. One of the
characteristics of the close-ended schemes is that they are generally traded at a discount to NAV;
but the discount narrows as maturity nears. These funds are open for subscription only once and
can be redeemed only on the fixed date of redemption. The units of these funds are listed on
stock exchanges (with certain exceptions), are tradable and the subscribers to the fund would be
able to exit from the fund at any time through the secondary market.

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3. Introductory Finance Concepts
3.1 Different Types Of Capital In A Limited Company

Nominal, Authorised or Registered capital:


This is the sum stated in the memorandum of association of a company limited by shares as the
capital of the company with which it is registered. It is the maximum amount which the
company is authorised to raise by issuing shares. This is the capital on which it had paid the
prescribed fee at the time of registration, hence also called Registered capital. As and when this
is increased, fees for such increase will have to be paid to the Registrar in accordance with the
provisions in the Companies’ Act. This is divided into shares of uniform denominations. The
amount of nominal capital is fixed on the basis of the projections of fund requirements of the
company for its business activities.

Issued capital: It is part of the authorised or nominal capital which the company issues for the
time being for public subscription and allotment. This is computed at face value or nominal
value.

Subscribed capital: It is that portion of the issued capital at face value which has been
subscribed or taken up by the subscribers of shares in the company. It is clear that the entire
issued capital may or may not be subscribed.

Called up capital: It is that portion of the subscribed capital which has been called up or
demanded on the shares by the company e.g., where Rs.5 has been called up on each of 100000
shares of a nominal value of Rs.10/- each, the called up capital is Rs.5lacs.
Uncalled capital: It is the total amount not yet called up or demanded by the company on the
shares subscribed, which the shareholders are liable to pay as and when called up, e.g., in the
above case, uncalled capital is Rs.5lacs.

Paid-up capital: It is that part of the total called up amount which is actually paid by the
shareholders e.g., out of Rs.5lacs, called up, only 4.5lacs get paid by the subscribers, the paid up
capital is Rs.4.5lacs.

Unpaid capital: It is the total of the called up capital remaining unpaid, determined by the
difference between the called up capital and paid-up capital.

Reserve capital: It is that part of the uncalled capital of a company which the company has
decided by special resolution not to call excepting in the event of the company being wound up
and thereafter that portion of the share capital shall not be capable of being called up except in
that event and for that purpose only.

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Merits and demerits of “limited companies”
Merits:
1. It is a well structured form of organisation;
2. It is a perpetual entity and change in the management does not affect the continuity of the
entity, unlike in the case of partnership firms;
3. The level of acceptability in the market of a limited company is quite high with widely held
public limited companies commanding the highest degree of acceptability. Hence they have
wider access to resources starting from a private limited company with the widely held public
limited company having the maximum resources;
4. The shareholders have limited liability and they are not held personally responsible for any
loss of the company. Their liability is limited to the value of their share investment in the
company.

Demerits:
1. The formation of a limited company is far more complex with requirement of registration and
other legal formalities to be gone through;
2. The companies are subject to a number of statutes, like The Companies’ Act, The Income-
Tax Act for compulsory audit, SEBI rules and guidelines for raising equity from the public as
in the case of widely held companies, legal clearance for mergers and acquisitions etc. and
their administration is far more complex than that of partnership firms;
3. In case of large public limited companies, the ownership is not exclusive, but shared with a
lot of other investors;
4. Private limited companies are comparable with partnership firms from the point of view of
control and administration and their shareholders do not enjoy “limited liability” on the
losses of the company, at least in the case of bank borrowing. The banks, in order to tie the
owners up, obtain the personal guarantees of the owners as collateral security for loans given
by them;

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4. Accounting Concepts – An Introduction

4.1 Finance & Accounts Functions & Business Enterprises

Functions of Accounts Department that does Financial Accounting


1. Maintenance of Accounts strictly in accordance with the Accounting Principles,
following Accounting Rules as per prescribed Accounting system and observing
Accounting standards as well GAAP depending upon the country of operations.
2. Control over amounts receivable, amounts payable, bank accounts, cash on hand etc.
3. Preparation of budgets, both revenue and capital, with the objectives of allocation of
resources, control and monitoring of expenses
4. Compliance with payment of Advance Tax as per the Rules and Regulations in this
behalf
5. Thorough understanding of Income Tax Rules and Regulations with a view to minimize
tax payable by the enterprise
6. Maintenance of Financial Management Information System (popularly known as MIS)
that is a review of performance of key financial parameters vis-à-vis the estimates – this
is an important tool in taking corrective action in time and hence forms an integral part of
decision-making process
7. Being responsible for the process of “Audits” of various kinds – Internal Audit, Statutory
Audit, Tax Audit etc.

Differences among proprietorship and partnership firms on one hand and limited
companies on the other hand in respect of Financial Accounting process/system

Parameter Sole proprietorship Partnership firms Limited companies


firms

Accounting system – No compulsion. The No compulsion under Under the provisions


Accrual or Cash firm can choose either The Partnership Act. of The Companies’
of them but once The firm can choose Act, it is compulsory
decided, will have to either of them but to adopt the Accrual
stick with it once decided, will basis of Accounting.
have to stick with it No choice

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Cash transactions and If cash system is If cash system is The enterprise has to
credit transactions adopted, credit adopted, credit account for both cash
transactions will be transactions will be and credit transactions
ignored ignored

Final audited No specific formats No specific formats Specific formats as


statements – per Schedule VI of the
presentation in Companies’ Act
specific formats

Components of P&L Trading and Profit & Trading and Profit & Profit & Loss and
Statement Loss components Loss components Profit & Loss
Appropriation
components

Retained profit in Transferred to the Transferred to the Transferred to


business capital of the owner capital accounts of the Reserves & surplus as
(Profit After Tax as thereby increasing the owners thereby share capital of the
reduced by profit investment of the increasing their owners cannot be
withdrawn from owner in the firm. investment in the firm altered by retained
business or distributed profits in business
in the form of
dividend)

Distribution of 100% Done Done Cannot be done.


profit to the owners’ Dividend is only after
capital transferring certain
minimum amount to
the General Reserve
that depends upon the
percentage of
Dividend on Capital
Share capital

Statutory audit of Not compulsory. Tax Not compulsory. Tax Compulsory under the
Accounts audit compulsory in audit compulsory in provisions of the
case turnover is case turnover is Companies’ Act,
beyond beyond besides Tax audit

Depreciation on fixed Not compulsory in the Not compulsory in the Compulsory in terms
assets other than land books of accounts – books of accounts – of the Companies’
claimed in the Income claimed in the Income Act – Schedule XIV
Tax returns Tax returns and the rates are

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different from The
Income Tax
provisions

Difference between finance function and accounts function

Financial Accounting Functions Corresponding Finance Functions

Maintenance of Accounts – strict compliance Financial planning and Resources


with statutory provisions as per ICAI mobilization. Adequate resources in time and
guidelines, Accounting Standards, GAAP in a cost-effective way. More of market
(India) provisions, Income Tax Act provisions orientation than statute-orientation
etc.

Responsible for budgets – both revenue and Cash management – stand-by arrangements,
capital both in case of excess and deficit

Tax compliance and tax planning besides audit Responsible for treasury management –
largely, liquidity management, risk
management and investment management

Management Information System & Reports Strategic Financial Management initiatives like
for Finance expansion, diversification etc.

Finance and accounts functions may be integrated in an organisation. This means that one
department handles both. In most of the small and medium size units in India, the functions will
be integrated. A business enterprise will require a full-fledged finance department only when the
functions listed above are predominant functions impacting business in a big way. If the finance
functions are not predominant functions, Accounts department looks after Finance also. Constant
requirement of funds, surplus for investment etc, could be some of the factors influencing the
need for a full-fledged Finance department.

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4.2

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4.4 Basic Accounting Terms

Asset The property of the business entity such as land, building, stocks etc.
Usually split into current assets, i.e., working capital assets and long-term
assets, i.e., fixed assets.

Balance Sheet A summary picture of what the business owns, i.e., assets and what it
owes, i.e., liabilities as on a particular date. Usually balance sheet is
prepared at the end of one year. However it can be prepared as at the end
of every month also.

Capital Normally means permanent or long-term funds of the business –


introduced by the owners of the enterprise and/or borrowed in the form of
long-term loans from banks and financial institutions. In the case of a
limited company, the owners’ capital is called share capital. The
borrowings are called debt capital.

Cash flow This usually means a statement showing all cash inflow, i.e., cash receipts
and cash outflow, i.e., cash expenditure. The statement is prepared at least
for a period of one month with the objective of monitoring cash flows in
the business and managing liquidity.

Creditors Persons to whom the business enterprise owes money due to goods or
services supplied by them or for expenses.

Current asset Working capital assets which enable a business enterprise to achieve what
is known as sales revenue by the process of turn-over of the current assets.
Current assets constantly change form from cash back to cash through the
activity of the firm, i.e., trading or manufacturing or service.

Current liability Debt of the business enterprise which is to be settled within a period of 12
months. They are also called short-term liabilities or working capital
liabilities, like creditors, accrued expenses etc.

Debt Money owed to external agencies, like loans, creditors etc. This is
classified into short-term, medium-term/long-term etc. depending upon the
period of repayment as well as the purpose for which it has been incurred.
If it is for fixed asset, it is medium to long-term and if it is for working
capital, it is short-term.

Debtors The money that is owned by the business and owed to it by the customers
to whom it has sold goods or supplied services on credit basis.

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Depreciation A charge against business income to enable a business enterprise to keep a
certain % of the value of a fixed asset every year with a view to replace it
at the required time. It is a book or non-cash expense but is recognised as
a business expense by the revenue authorities.

Dividend Return to a shareholder in a limited company on its equity investment paid


by the company out of its taxed profits every year and is often referred to
as profit distributed to share holders.

Equity Money brought in by the owners in the case of a limited company. It is


permanent investment in the company and is paid back to the owners only
upon liquidation of the company.

Fixed assets Long-term business assets, like land, building, machinery, vehicles etc.
which act as catalysts in the activity of the enterprise but do not form a
part of the finished goods of the manufacturing company or stocks in trade
in the case of a trading enterprise. They are subject to wear and tear and
hence require replacement after some time. Hence, the business enterprise
claims depreciation on these assets and charges the amount to its revenue
income.

Gearing Same as leverage. A measure of external debt in relation to the capital of


the owners of the enterprise. The higher the gearing, the greater the risk
and vice-versa.

Inventory Comprises materials like raw materials, consumables/ machinery spares


and packing material, work-in-progress and finished goods. Together with
bills receivables, form bulk of current or working capital assets.

Insolvent A business enterprise is considered insolvent when it is not able to pay its
liabilities in full from the proceeds of its assets.

Liability Amount owed by the business enterprise to outside agencies, which have
provided resources either in the form of money, as in the case of bank over
draft or goods as in case of creditors or services as in the case of accrued
expenses.

Loss Excess of expenditure over income in a particular accounting period.

Net current Difference between current assets and current liabilities. This
Asset is called as Net working capital.

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Net Fixed assets Gross fixed assets (purchase price) as diminished by depreciation
(cumulative).

Overdraft A credit facility by which a customer of the bank can draw up to a pre
determined limit against some tangible security like inventory or
receivables or mortgage.

Payables Also known as bills payables or money owed by the enterprise to various
creditors.

Profit An excess of sales revenue over expenditure.

Profit and loss A detailed and consolidated statement of all income and expenditure
Statement prepared at the end of a specific period, like month, quarter, half-year and
year. However, the revenue authorities are insistent on yearly statements
and the other statements are meant for management purposes.

Receivables Also known as sundry debtors or bills receivables or book debts.


Represent money owed to the enterprise by debtors.

Reserves or Accumulated profits retained in business over a period of time.


Retained This is net of profit distributed in the form of dividend.
Earnings

Returns Either purchase returns or sales returns representing goods returned on


purchases or sales due to defects which stand adjusted either in the
amounts due from us or due to us or by replenishment of stocks with
quality goods. Purchase return is also called return outward and sales
return is also called return inward.

Shareholders’ Share capital plus all kinds of reserves representing profit


Funds retained in business over a period of time.

Solvent Means that the business enterprise is able to meet its liabilities with all its
assets.

Working capital Gross working capital = Total current assets


Net working capital = Total current assets (-) total current liabilities.

Difference between cash and fund – Cash means “money” and does not include credit or kind.
Fund includes every thing like credit or kind. For example, a supplier supplies material on
credit for which payment is not made immediately. Till the payment is made by us, the supplier
has given us money’s worth of goods. Similarly services would also be provided. Thus fund

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could mean, either “physical cash” or “credit” for supply of goods or services. Hence, at times,
the term “fund” also refers to money or money’s worth (OR) cash or kind.

Another example is in case capital is brought into an enterprise in a form, other than cash; say in
the form of land or building or machinery or vehicle. This is also fund but would not fall under
the category of cash.

Components of cash flow statement – Cash management is usually done on the basis of cash
inflow and cash outflow. The cash receipts and cash expenditure are reflected in a statement
called “cash flow statement”. This statement can be prepared at a predetermined frequency, say
every day, every week, every fortnight or every month. Usually it is not prepared at a frequency,
which is less than a month. It has revenue receipts, revenue expenditure, capital receipts and
capital expenditure unlike profit and loss account, which has only revenue items of income and
expenditure. The details of revenue receipts/revenue expenditure and cash receipts/cash
expenditure are given in the following points.

Medium and long - term liability – Any liability, which is not due within a period of 12 months
but due within a period of 5-7 years like debenture or term loan, is called a medium-term
liability. In case the liability is due beyond 7/10 years like deep discounted bond, then it is called
long–term liability.

Revenue Receipt – Receipt from operations unlike capital receipt like sale of a capital equipment
etc. Usually a period of 12 months is taken as the period in which revenue receipt should occur.

Revenue Expenditure – Expenditure for operations unlike capital expenditure like purchase of
machinery etc. Usually a period of 12 months is taken as the period in which revenue
expenditure should occur.

Concept of ‘Profit’ as distinct from ‘Income’ – If the revenue receipts are higher in value than
revenue expenditure, the business enterprise is said to be in ‘Profit’; otherwise it is in ‘loss’.
Income or revenue is the result of activity of the business enterprise, be it manufacturing, trading
or services, while profit is the measure of financial performance for the year of the business
enterprise. Profit is the end result of revenues for the year. While revenues occur throughout the
financial year (1st April to 31st March in India), profit is determined at the end of the year.

Capital Receipt – Receipt from owner in the form of capital or loans from lenders which need
not be repaid within 12 months. Generally all sources, which go in for purchase of capital assets,
are called capital receipts.

Capital Expenditure – Expenditure towards purchase of capital assets or repayment of an earlier


capital receipt.

Opportunity cost and opportunity gain – A phenomenon arising out of comparison between
returns on alternative investment opportunities available to an investor.

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For example an investor gets return of 13% p.a. in bank deposits, while he can get 18% in
shares, the opportunity cost of investing in bank deposits vis-à-vis the investment in shares is
18% - 13% = 5%. As against this, the investment in shares fetches an opportunity gain of
5% p.a. Thus opportunity cost and gain are relative terms and absolutely dynamic, as the
returns even in the case of same investment vary from time to time.
Opportunity cost or gain is a dynamic concept and not static one. Further it is a product of
time and holds good only for a short period. It is always determined for a pair of alternative
investment opportunities.

Pre-tax expenditure and post-tax allocation – All operating expenses like interest, wages salaries
etc. are pre-tax expenditure as they are met out of income of an organisation and not out of
profits. As opposed to this, profits distributed to owners of the company are out of taxed profits
and hence they are referred to as post tax allocation. For example, dividend is a post tax
allocation. This can be appreciated by keeping in mind three stages of income profit and profit
allocation in a business.

⇒ Stage 1 – income from operations and other income like dividend etc.

⇒ Stage 2 – determination of profit for a given period after setting off all the operating
expenditure – pre-tax expenditure, against income for the same period and payment of tax on
the same.

⇒ Stage 3 – Distribution of profit after tax (some portion) among the owners of the company in
the form of dividend – post-tax allocation, while keeping the balance portion in the business
itself in the form of reserves.

Difference between liquidity and profitability – While liquidity means availability of cash to
meet all the liabilities, it need not indicate profitability of operations. An enterprise can be liquid
because its position of cash is comfortable, i.e., the cash inflow is greater than cash out flow
because of owner’s capital as well as other borrowed funds, whereas, its operations need not be
profitable, i.e., expenses could be more than income. On the contrary, an enterprise can be
profitable but because of delay in realisation of sale bills, it could be in cash crisis.
Thus liquidity and profitability are two independent phenomena and mostly move in opposite
direction. Example, current assets. The level of current assets does indicate the level of liquidity
available with an enterprise and in case it is too high the profitability does dip in due to the cost
of carrying a high level of current assets and vice-versa.

Broad break-up of operating expenditure in a manufacturing unit –

⇒ Expenses relating to production –

a) Expenses on material – raw material, packing material, consumable stores and machinery
spares;

b) Wages paid to workers including employer’s contribution to Provident Fund, bonus, ex-
gratia, uniform and other incidental expenses etc.

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c) Expenses for manufacturing like depreciation on fixed assets used in factory, repairs and
maintenance on fixed assets used in factory, salaries paid to factory personnel, utilities like
power, water and fuel etc.

⇒ Expenses relating to administration – General and administrative expenses like salaries


paid to administrative personnel, other administrative expenses, a host of them like printing
and stationary etc.

⇒ Expenses relating to sales – Selling expenses, both direct and indirect.

⇒ Finance expenses – Interest, commission, brokerage, discount and others.

Note: In the case of a trading unit, there will be no manufacturing expenses and hence
manufacturing expenses would be absent. However, material would be replaced by trading
stocks and further, if the trading unit repacks the material before selling in the market,
packing expenses would also be incurred and this has to be included.

Similarly, in the case of a unit extending services, be it in finance or any other field, the unit
will not incur any expenditure on account of materials at all. Hence, in the case of a service
unit, the expenses would only be general and administrative expenses, besides selling
expenses, if any, and of course, financial expenses towards loans taken etc.

A sample of “Profit and Loss” Account (Rupees in Lacs)

Income from operations 100


Operating expenses:
Salaries 30
Repairs and maintenance 3
Depreciation 10
Office and general expenses 10
Marketing expenses
Including Commission 7
Interest and other
Charges 10
Total expenses 70
Profit before tax 30
Tax say at 35% 10.5
Profit after tax 19.5
Dividend 7.5
Profit retained in
Business 12.0
(Retained earnings)

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Learning Points:

 Interest is charged to income before determining the profit of the organisation. Once the
profit of the organisation is determined, tax is paid at the stipulated rate and the dividend is
paid only after this. Thus, dividend is profit allocation.

Opportunity cost

Suppose there are two alternative investments available to us, say one in bank deposit and the
other in shares. While the bank gives a rate of interest of 12% p.a., the return on shares is 18%
p.a.

This means that if we were to invest in shares, we would gain 6% p.a. in comparison with the
return on bank deposit. This is known as the opportunity gain for investment in shares, in
comparison with investment in bank deposits. Similarly, investment in bank deposit would
entail a loss of 6% p.a. in comparison with investment in shares. This is known as the
opportunity cost for investment in bank deposit in comparison with investment in shares.

Thus, for every pair of alternative investment opportunities, there exists an opportunity gain or
opportunity cost, depending upon the respective rates of return. Two investments give the same
rate of return rarely and in case the rate of return is the same, there is neither an opportunity cost
nor an opportunity gain. It should be noted that the concept of opportunity cost or gain is a
dynamic concept and not static one. It keeps on varying from time to time in accordance with
the changes in the rates of return for the same investment under consideration and is exclusive
for a pair of alternative investment opportunities at a given time.

It is seen from the above that the opportunity cost for cash on hand is the highest at any time, as
idle cash does not earn any interest. Any investment of this cash would fetch some return and
hence in comparison with any investment, cash suffers from opportunity cost. It would also be
noted that generally, the rate of return increases with the increase in risk associated with a
business.
This is so, as with higher risk, investors would be attracted only when the return is higher in
comparison with a less risky investment. This leads to the economic maxim “Risk and
Return go together”.

Secondly, while abundant cash would increase the liquidity of the enterprise, the cost is also high
for holding high level of cash. Hence, the second economic maxim, “Liquidity and
Profitability are inversely related to each other”.

Importance of “Depreciation”

The fixed assets employed in business are subject to “wear and tear”. This requires
replacement on a regular basis, as the enterprise should not suffer for want of proper asset for
production, at a future date. Hence, it is only prudent that a certain sum, as per the rules every
year, is set aside from the business income in the form of “depreciation”, so that when the time

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comes for replacement of a fixed asset, you will have created sufficient “cushion” in the
business through the amount of “depreciation” ploughed back.

The importance of “depreciation” does not rest there. By claiming depreciation, we are
reducing the profit for the year and thereby tax.

As there is no “cash out flow” involved in depreciation, the entire funds are available with the
enterprise. Thus, depreciation is at once a “business expense” and a “fund”.

Learning Points:

 Depreciation is at once an expense and a fund (resource).


 In the SLM the value of the asset can reduce to “zero”, while in the WDV, this would not
happen.

Revenue receipt/expenditure and Capital receipt/expenditure

Revenue receipt is defined as an “inflow”, which is recurring like sales revenue, dividend income
etc. It is also referred to as “revenue income”. Revenue expenditure is also recurring and hence
all the operating expenditure is revenue expenditure. Revenue receipt and revenue expenditure
decide the profit for the year, whereas, capital receipt is outside the purview of the profit and loss
account.

Then, what is a capital receipt?

Any inflow of a capital nature, like increase in capital of the owners, fresh loans taken from
outside etc. is a capital receipt. The sources for capital receipts are as under:

Share capital
Term loan
Debentures
Fixed deposits for more than 12 months
Unsecured loans from relatives, friends and promoters etc.

What is a capital expenditure?

Purchase of any fixed asset


Repayment of any earlier capital receipt like term loan, debenture etc.

While operating expenditure can be met from operating income, capital expenditure can be met
only out of capital receipts and not out of revenue income.

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In this connection, it should be noted that profit and depreciation are taken as capital receipt even
though profit arises out of the excess of revenue income over revenue expenditure and
depreciation is an operating expenditure. Once income tax is paid on the profits, the residual
amount with depreciation added back, known as “internal accruals” constitutes capital receipt
and forms the major source for repayment of term loans or debentures.

Learning points:

 Revenue income is meant for meeting revenue expenditure and not capital expenditure.
 Capital receipt is necessary to meet capital expenditure and if revenue receipt is used for
meeting capital expenditure, there will be liquidity problem. However, capital receipt like
capital from the owners, debentures, retained earnings, depreciation etc. can be used for
revenue expenditure.
 Depreciation as an expense is a part of the profit and loss account. Similarly, profit after tax
also forms part of the profit and loss account. However, once profit is taxed and retained in
business, it is reflected under “reserves” as a capital receipt. This is so, as profit retained in
business belongs to the equity shareholders. Similarly, depreciation is claimed on all fixed
assets, excluding land, and hence, as a fund, is treated as a capital receipt.

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