Regular Study - Basic Accounting Terms
The understanding of the subject becomes easy when one has the knowledge of a few
important terms of accounting. Let us go through some of them.
Transactions
Transactions are those activities of a business, which involve transfer of money or goods or
services between two persons or two accounts. For example, purchase of goods, sale of
goods, borrowing from bank, lending of money, salaries paid, rent paid, commission
received and dividend received. Transactions are of two types, namely, cash and credit
transactions.
Cash Transaction is one where cash receipt or payment is involved in the transaction. For
example, When You buys goods from a seller paying the price of goods by cash
immediately, it is a cash transaction.
Credit Transaction is one where cash is not involved immediately but will be paid or
received later. In the above example, if You, do not pay cash immediately but promises to
pay later, it is credit transaction.
Proprietor
A person who owns a business is called its proprietor. He contributes capital to the business
with the intention of earning profit.
Capital
It is the amount invested by the proprietor/s in the business. This amount is increased by the
amount of profits earned and the amount of additional capital introduced. It is decreased by
the amount of losses incurred and the amounts withdrawn. For example, if Mr. Ram starts
business with Rs.10,00,000, his capital would be Rs.10,00,000.
Assets
Assets are the properties of every description belonging to the business. Cash in hand, plant
and machinery, furniture and fittings, bank balance, debtors, bills receivable, stock of
goods, investments, Goodwill are examples for assets. Assets can be classified into tangible
and intangible.
Tangible Assets: These assets are those having physical existence. It can be seen and
touched. For example, plant & machinery, cash, etc.
Intangible Assets: Intangible assets are those assets having no physical existence but their
possession gives rise to some rights and benefits to the owner. It cannot be seen and
touched. Goodwill, patents, trademarks are some of the examples.
Liabilities
Liabilities refer to the financial obligations of a business. These denote the amounts which a
business owes to others, e.g., loans from banks or other persons, creditors for goods
supplied, bills payable, outstanding expenses, bank overdraft etc.
Drawings
It is the amount of cash or value of goods withdrawn from the business by the proprietor for
his personal use. It is deducted from the capital.
Debtors
A person (individual or firm) who receives a benefit without giving money or money’s
worth immediately, but liable to pay in future or in due course of time is a debtor. The
debtors are shown as an asset in the balance sheet. For example, Mr. Ravi bought goods on
credit from Mr. Ram for Rs.10,000. Mr. Ravi is a debtor to Mr. Ram till he pays the value
of the goods.
Creditors
A person who gives a benefit without receiving money or money’s worth immediately but
to claim in future, is a creditor. The creditors are shown as a liability in the balance sheet. In
the above example Mr. Ram is a creditor to Mr. Ravi till he receive the value of the goods.
Purchases
Purchases refers to the amount of goods bought by a business for resale or for use in the
production. Goods purchased for cash are called cash purchases. If it is purchased on
credit, it is called as credit purchases. Total purchases include both cash and credit
purchases.
Purchases Return or Returns Outward
When goods are returned to the suppliers due to defective quality or not as per the terms of
purchase, it is called as purchases return. To find net purchases, purchases return is
deducted from the total purchases.
Sales
Sales refers to the amount of goods sold that are already bought or manufactured by the
business. When goods are sold for cash, they are cash sales but if goods are sold and
payment is not received at the time of sale, it is credit sales. Total sales includes both cash
and credit sales.
Sales Return or Returns Inward
When goods are returned from the customers due to defective quality or not as per the terms
of sale, it is called sales return or returns inward. To find out net sales, sales return is
deducted from total sales.
Stock
Stock includes goods unsold on a particular date. Stock may be opening and closing stock.
The term opening stock means goods unsold in the beginning of the accounting period.
Whereas the term closing stock includes goods unsold at the end of the accounting period.
For example, if 5,000 units purchased @ Rs. 30 per unit remain unsold, the closing stock is
Rs. 1,50,000. This will be opening stock of the subsequent year.
Revenue
Revenue means the amount receivable or realised from sale of goods and earnings from
interest, dividend, commission, etc.
Expense
It is the amount spent in order to produce and sell the goods and services. For example,
purchase of raw materials, payment of salaries, wages, etc.
Income
Income is the difference between revenue and expense.
Voucher
It is a written document in support of a transaction. It is a proof that a particular transaction
has taken place for the value stated in the voucher. It may be in the form of cash receipt,
invoice, cash memo, bank pay-in-slip etc. Voucher is necessary to audit the accounts.
Invoice
Invoice is a business document which is prepared when one sell goods to another. The
statement is prepared by the seller of goods. It contains the information relating to name and
address of the seller and the buyer, the date of sale and the clear description of goods with
quantity and price.
Receipt
Receipt is an acknowledgement for cash received. It is issued to the party paying cash.
Receipts form the basis for entries in cash book.
Account
Account is a summary of relevant business transactions at one place relating to a person,
asset, expense or revenue named in the heading. An account is a brief history of financial
transactions of a particular person or item. An account has two sides called debit side and
credit side.
Regular Study - Classification of Accounts
Classification of Accounts
Transactions can be divided into three categories.
i. Transactions relating to individuals and firms
ii. Transactions relating to properties, goods or cash
iii. Transactions relating to expenses or losses and incomes or gains.
Therefore, accounts can also be classified into Personal, Real and Nominal. The
classification may be illustrated as follows
Personal Accounts:
Accounts recording transactions relating to individuals or firms or company are known as
personal accounts. Personal accounts may further be classified as:
(i) Natural Person’s personal accounts: The accounts recording transactions relating to
individual human beings e.g., Anand’s a/c, Ramesh’s a/c, Pankaj a/c are classified as natural
persons’ personal accounts.
(ii) Artificial Persons’ Personal accounts: The accounts recording transactions relating to
limited companies, bank, firm, institution, club, etc., Delhi Cloth Mill; M/s Sahoo & Sahoo;
Hans Raj College; Gymkhana Club are classified as artificial persons’ personal accounts.
(iii) Representative Personal Accounts: The accounts recording transactions relating to
the expenses and incomes are classified as nominal accounts. But in certain cases (due to
the matching concept of accounting) the amount, on a particular date, is payable to the
individuals or recoverable from individuals. Such amount (i) relates to the particular head of
expenditure or income and (ii) represent persons to whom it is payable or from whom it is
recoverable. Such accounts are classified as representative personal accounts e.g., “wages
outstanding account”, pre-paid Insurance account, etc.
The proprietor being an individual his capital account and his drawings account are
also personal accounts.
Impersonal Accounts
All those accounts which are not personal accounts. This is further divided into two types
viz. Real and Nominal accounts.
i. Real Accounts: Accounts relating to properties and assets which are owned by the
business concern. Real accounts include tangible and intangible accounts. For example,
Land, Building, Goodwill, Purchases, etc.
ii. Nominal Accounts: These accounts do not have any existence, form or shape. They
relate to incomes and expenses and gains and losses of a business concern. For example,
Salary Account, Dividend Account, etc.
Rules of debit and credit (classification based)
1. Personal accounts : Debit the receiver - Credit the giver (supplier)
2. Real accounts : Debit what comes in - Credit what goes out
3. Nominal accounts : Debit expenses and losses - Credit incomes and gains
Regular Study - Process of Accounting
Accounting is “the process of identifying, measuring and communicating economic
information to permit informed judgements and decision by users of the information”.
Process of Accounting
The process of accounting as per the above definition is given below:
In order to accomplish its main objective of communicating information to the users,
accounting embraces the following functions.
i. Identifying: Identifying the business transactions from the source documents.
ii. Recording: The next function of accounting is to keep a systematic record of all business
transactions, which are identified in an orderly manner, soon after their occurrence in the
journal or subsidiary books.
iii. Classifying: This is concerned with the classification of the recorded business
transactions so as to group the transactions of similar type at one place. i.e., in ledger
accounts. In order to verify the arithmetical accuracy of the accounts, trial balance is
prepared.
iv. Summarising : The classified information available from the trial balance are used to
prepare profit and loss account and balance sheet in a manner useful to the users of
accounting information.
v. Analysing: It establishes the relationship between the items of the profit and loss account
and the balance sheet. The purpose of analysing is to identify the financial strength and
weakness of the business. It provides the basis for interpretation.
vi. Interpreting: It is concerned with explaining the meaning and significance of the
relationship so established by the analysis. Interpretation should be useful to the users, so as
to enable them to take correct decisions.
vii. Communicating: The results obtained from the summarised, analysed and interpreted
information are communicated to the interested parties.
Regular Study - Objective of accounting
Objective of accounting may differ from business to business depending upon their specific
requirements. We discuss in this section the general objectives of accounting.
Keeping systematic record
It is very difficult to remember all the business transactions that take place. Accounting
serves this purpose of record keeping by promptly recording all the business transactions in
the books of account.
To ascertain the results of the operation
Accounting helps in ascertaining result i.e., profit earned or loss suffered in business during
a particular period. For this purpose, a business entity prepares either a Trading and Profit
and Loss account or an Income and Expenditure account which shows the profit or loss of
the business by matching the items of revenue and expenditure of the some period.
To ascertain the financial position of the business
In addition to profit, a businessman must know his financial position i.e., availability of
cash, position of assets and liabilities etc. This helps the businessman to know his financial
strength. Financial statements are barometers of health of a business entity.
To portray the liquidity position
Financial reporting should provide information about how an enterprise obtains and spends
cash, about its borrowing and repayment of borrowing, about its capital transactions, cash
dividends and other distributions of resources by the enterprise to owners and about other
factors that may affect an enterprise’s liquidity and solvency.
To protect business properties
Accounting provides upto date information about the various assets that the firm possesses
and the liabilities the firm owes, so that nobody can claim a payment which is not due to
him.
To facilitate rational decision – making
Accounting records and financial statements provide financial information which help the
business in making rational decisions about the steps to be taken in respect of various
aspects of business.
To satisfy the requirements of law
Entities such as companies, societies, public trusts are compulsorily required to maintain
accounts as per the law governing their operations such as the Companies Act, Societies
Act, Public Trust Act etc. Maintenance of accounts is also compulsory under the Sales Tax
Act and Income Tax Act.
Regular Study - Steps/Phases of Accounting Cycle
When complete sequence of accounting procedure is done which happens frequently and
repeated in same directions during an accounting period, the same is called an accounting
cycle.
Steps/Phases of Accounting Cycle
The steps or phases of accounting cycle can be developed as under:
a) The opening balances of accounts from the balance sheet & day to day business
transaction of the accounting year are first recorded in a book known as journal.
b) Periodically these transactions are transferred to concerned accounts known as ledger
accounts.
c) At the end of every accounting year these accounts are balanced & the trial balance is
prepared.
d) Then the final accounts such as trading & profit & loss accounts are prepared.
e) Finally, a balance sheet is made which gives the financial position of the business at the
end of the period.
Regular Study - Basic Assumptions
Business Entity Concept
This concept explains that the business is distinct from the proprietor. Thus, the transactions of
business
only are to be recorded in the books of business.
For example, Mr A starts a new business in the name and style of M/s Independent Trading
Company and introduced a capital of Rs 2,00,000 in cash. It means the cash balance of M/s
Independent Trading Company will increase by a sum of Rs 2,00,000/-. At the same time, the
liability of M/s Independent Trading Company in the form of capital will also increase. It means
M/s Independent Trading Company is liable to pay Rs 2,00,000 to Mr A.
Going Concern Concept
This concept assumes that the business has a perpetual succession or continued existence.
For example, a business unit makes investments in the form of fixed assets and we book only
depreciation of the assets in our profit & loss account; not the difference of acquisition cost of
assets less net realizable value of the assets. The reason is simple; we assume that we will use
these assets and earn profit in the future while using them. Similarly, we treat deferred revenue
expenditure and prepaid expenditure. The concept of going concern does not work in the
following cases:
If a unit is declared sick (unused or unusable unit).
When a company is going to liquidate and a liquidator is appointed for the same.
When a business unit is passing through severe financial crisis and going to wind up.
Money Measurement Concept
According to this concept only those transactions which are expressed in money terms are to be
recorded in accounting books.
Example
Determine and book the value of stock of the following items:
Shirts Rs 5,000/-
Pants Rs 7,500/-
Coats 500 pieces
Jackets 1000 pieces
Value of Stock = ?
Here, if we want to book the value of stock in our accounting record, we need the value of coats
and jackets in terms of money. Now if we conclude that the values of coats and jackets are Rs
2,000 and Rs 15,000 respectively, then we can easily book the value of stock as Rs 29,500 (as a
result of 5000+7500+2000+15000) in our books. We need to keep quantitative records
separately.
The Accounting Period Concept
Businesses are living, continuous organisms. The splitting of the continuous stream of business
events into time periods is thus somewhat arbitrary. There is no significant change just because
one accounting period ends and a new one begins. This results into the most difficult problem of
accounting of how to measure the net income for an accounting period. One has to be careful in
recognizing revenue and expenses for a particular accounting period. Subsequent section on
accounting procedures will explain how one goes about it in practice.
The Accrual Concept
The accrual concept is based on recognition of both cash and credit transactions. In case of a
cash transaction, owner’s equity is instantly affected as cash either is received or paid. In a
credit transaction, however, a mere obligation towards or by the business is created. When
credit transactions exist (which is generally the case), revenues are not the same as cash receipts
and expenses are not same as cash paid during the period.
Today’s accounting systems based on accrual concept are called as Accrual system or
mercantile system of accounting.
Regular Study - Basic Concepts of Accounting
These concepts guide how business transactions are reported. On the basis of the four
assumptions the following concepts (principles) of accounting have been developed.
Dual Aspect Concept
Dual aspect principle is the basis for Double Entry System of book-keeping. All business
transactions recorded in accounts have two aspects - receiving benefit and giving benefit.
For example, when a business acquires an asset (receiving of benefit) it must pay cash
(giving of benefit).
For example, if we buy some stock, then it will have two effects:
the value of stock will increase (get benefit for the same amount), and
it will increase our liability in the form of creditors.
Transaction Effect
Purchase of Stock for Rs
25,000
Stock will increase by Rs 25,000 (Increase in debit balance)
Cash will decrease by Rs 25,000 (Decrease in debit balance)
Or
Creditor will increase by Rs 25,000 (Increase in credit balance)
Revenue Realisation Concept
According to this concept, revenue is considered as the income earned on the date when it is
realised. Unearned or unrealised revenue should not be taken into account. The realisation
concept is vital for determining income pertaining to an accounting period. It avoids the
possibility of inflating incomes and profits.
Historical Cost Concept
Under this concept, assets are recorded at the price paid to acquire them and this cost is the
basis for all subsequent accounting for the asset. For example, if a piece of land is
purchased for Rs.5,00,000 and its market value is Rs.8,00,000 at the time of preparing final
accounts the land value is recorded only for Rs.5,00,000. Thus, the balance sheet does not
indicate the price at which the asset could be sold for.
Matching Concept
Matching the revenues earned during an accounting period with the cost associated with the
period to ascertain the result of the business concern is called the matching concept. It is the
basis for finding accurate profit for a period which can be safely distributed to the owners.
Full Disclosure Concept
Accounting statements should disclose fully and completely all the significant information.
Based on this, decisions can be taken by various interested parties. It involves proper
classification and explanations of accounting information which are published in the
financial statements.
Verifiable and Objective Evidence Concept
This principle requires that each recorded business transactions in the books of accounts
should have an adequate evidence to support it.
For example, cash receipt for payments made. The documentary evidence of transactions
should be free from any bias. As accounting records are based on documentary evidence
which are capable of verification, it is universally acceptable.
Regular Study - Modifying Principles
The Concept of Materiality
The materiality could be related to information, amount, procedure and nature. Error in
description of an asset or wrong classification between capital and revenue would lead to
materiality of information. Say, If postal stamps of ` 500 remain unused at the end of
accounting period, the same may not be considered for recognizing as inventory on account
of materiality of amount. Certain accounting treatments depend upon procedures laid down
by accounting standards. Some transactions are by nature material irrespective of the
amount involved. e.g. audit fees, loan to directors.
Consistency Concept
This Concept says that the Accounting practices should not change or must remain
unchanged over a period of several years.
Conservatism Concept
Conservatism concept states that when alternative valuations are possible, One should select
the alternative which fairly represents economic substance of transactions but when such
choice is not clear select the alternative that is least likely to overstate net assets and net
income.
It provides for all known expenses and losses by best estimates if amount is not known with
certainty, but does not recognizes revenues and gains on the basis of anticipation.
Timeliness Concept
Under this principle, every transaction must be recorded in proper time. Normally, when the
transaction is made, the same must be recorded in the proper books of accounts. In short,
transaction should be recorded date-wise in the books. Delay in recording such transaction
may lead to manipulation, misplacement of vouchers, misappropriation etc. of cash and
goods. This principle is followed particularly while verifying day to day cash balance.
Principle of timeliness is also followed by banks, i.e. every bank verifies the cash balance
with their cash book and within the day, the same must be completed.
Industry Practice
As that are different types of industries, each industry has its own characteristics and
features. There may be seasonal industries also. Every industry follows the principles and
assumption of accounting to perform their own activities. Some of them follow the
principles, concepts and conventions in a modified way. The accounting practice which has
always prevailed in the industry is followed by it. e.g Electric supply companies, Insurance
companies maintain their accounts in a specific manner.
Insurance companies prepare Revenue Account just to ascertain the profit/loss of the
company and not Profit and Loss Account. Similarly, non trading organizations prepare
Income and Expenditure Account to find out Surplus or Deficit.
Regular Study - Single Entry System
Business transactions are recorded in two different ways, one is double entry system and
another one is single entry system.
All business transactions are has two aspects namely Debit and Credit, If these two aspects
of a transaction are recorded, which system is known as the Double entry system.
The term single entry is vaguely used to refer to any method of maintaining accounts which
does not conform to strict principles of double entry system, under single entry method only
one aspect of a transaction is recorded, it may be debit without a corresponding credit and
vice versa. This system is not based on any scientific system therefore it cannot be termed
as a system, It is incomplete and unsatisfactory system and it is clear that accurate
information of the operations of the business is entirely lacking.
SALIENT FEATURES OF SINGLE ENTRY SYSTEM
Some features of single entry system.
i) The system is suitable for sole trader, partnership firms and professionals.
ii) In this system, usually personal accounts are fully written and cash book is also
maintained and ignore all other accounts.
iii) This system does not follow uniformity .It is highly flexible accounting to the
capabilities of individuals maintaining the records.
iv)This system needs very few numbers of account books and it gives only partial
information.
v) When preparing cash book under this system both personal and business transactions are
recorded.
vi) In this system to know the total purchases and sales, one has to depend on original
vouchers.
DEFECTS OF SINGLE ENTRY SYSTEM
Some of the defects of single entry system.
i) It is not a scientific method of accounting.
ii) Frauds can be committed easily
iii) It is difficult to ascertain the value of the business
iv) It is very difficult to say whether the business is making progress or working at a loss
v) The Trading and profit and loss account and balance sheet cannot be prepared in a
scientific manner
vi) The trading results of one period cannot be compared with those of the other period.
vii) Impersonal accounts such as sales account, purchases account as well as assets account
are not available.
METHODS OF ASCERTAINMENT OF PROFIT OR LOSS UNDER SINGLE
ENTRY SYSTEM:
There are two methods of ascertaining profit or loss under the single entry system, they are:
(a) Comparison method (or) Net worth Method (or) statement of affair method (b)
Conversion Method.
Comparison method (or) statement of affair method
Under this method the profit or loss is ascertained by comparing the capital at the beginning
with the capital at the end of the period. The closing capital is taken; drawings should be
added to this; from this total the additional capital if any introduced should be subtracted;
from this total the opening capital should be subtracted. The answer so obtained will be the
profit or loss (before adjustment) earned during the year.
Conversion Method
The process of collecting, computing and recording missing information along with the
available data in the incomplete books of a business is called “conversion method”. Once
the books are “converted”, all future transactions can be recorded as per “double entry
system”. Conversion to double entry system enables a business to avoid the harassment of
taxation authorities and ensures better management of the business.
Procedure for conversion
The following are the steps to be followed for conversion of incomplete records to complete
record system (Double entry system)
1. A statement of affairs at the beginning of the year should be prepared. The balance in the
statement represents opening capital.
2. Single or double column cash book should be prepared to find out missing items like
opening cash, closing cash, cash sales, cash purchase, additional capital and drawings etc.
Any shortage on the debit side can be cash sales or additional capital introduced or opening
cash. Shortage on the credit site can be cash purchase or drawings or sundry expenses or
closing cash balance.
3. Impersonal accounts like total debtors account ,total creditors account , Bills receivables
account and Bills payable account should be prepared .preparation of these accounts can
help in finding any missing items like opening or closing debtors, opening or closing
creditors, credit sales and credit purchases
4. Appropriate journal entry should be passed in respect of assets and liabilities included in
the opening statement of affairs.
5. Real and nominal accounts must be written from the information recorded in the cash
book, total debtors account, total creditors account, etc. The double effect of every entry
must be posted to the ledger, opening new accounts wherever necessary.
6. From all the accounts balance in the ledger and any other additional details trading
account, profit and loss account and balance sheet must be prepared.
Regular Study - Double Entry System
There are numerous transactions in a business concern. Each transaction, when closely
analysed, reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect” or
“expenses/loss aspect”. This is termed as the “Debit aspect”. The other aspect will be “giving
aspect” or “outgoing aspect” or “income/gain aspect”. This is termed as the “Credit aspect”.
These two aspects namely “Debit aspect” and “Credit aspect” form the basis of Double Entry
System. The double entry system is so named since it records both the aspects of a transaction.
In short, the basic principle of this system is, for every debit, there must be a corresponding
credit of equal amount and for every credit, there must be a corresponding debit of equal
amount.
According to J.R.Batliboi “Every business transaction has a two-fold effect and that it affects
two accounts in opposite directions and if a complete record were to be made of each such
transaction, it would be necessary to debit one account and credit another account. It is this
recording of the two fold effect of every transaction that has given rise to the term Double Entry
System”.
Features of Double Entry System
i. Every business transaction affects two accounts.
ii. Each transaction has two aspects, i.e., debit and credit.
iii. It is based upon accounting assumptions concepts and principles.
iv. Helps in preparing trial balance which is a test of arithmetical accuracy in accounting.
v. Preparation of final accounts with the help of trial balance.
Approaches of Recording
There are two approaches for recording a transaction.
I. Accounting Equation Approach
II. Traditional Approach
I. Accounting Equation Approach
This approach is also called as the American Approach. Under this method transactions are
recorded based on the accounting equation, i.e.,
Assets = Liabilities + Capital
II. Traditional Approach
This approach is also called as the British Approach. Recording of business transactions under
this method are formed on the basis of the existence of two aspects (debit and credit) in each of
the transactions. All the business transactions are recorded in the books of accounts under the
‘Double Entry System’.
Advantages
The advantages of this system are as follows:
i. Scientific system: This is the only scientific system of recording business transactions. It
helps to attain the objectives of accounting.
ii. Complete record of transactions: This system maintains a complete record of all business
transactions.
iii. A check on the accuracy of accounts: By the use of this system the accuracy of the
accounting work can be established by the preparation of trial balance.
iv. Ascertainment of profit or loss: The profit earned or loss occurred during a period can be
ascertained by the preparation of profit and loss account.
v. Knowledge of the financial position : The financial position of the concern can be
ascertained at the end of each period through the preparation of balance sheet.
vi. Full details for control: This system permits accounts to be kept in a very detailed form,
and thereby provides sufficient information for the purpose of control.
vii. Comparative study : The results of one year may be compared with those of previous
years and the reasons for change may be ascertained.
viii. Helps in decision making: The management may be able to obtain sufficient information
for its work, especially for making decisions. Weaknesses can be detected and remedial
measures may be applied.
ix. Detection of fraud: The systematic and scientific recording of business transactions on the
basis of this system minimizes the chances of fraud.
Regular Study - Differences between Single entry system and Double entry
system
Differences between Single entry system and Double entry system
Single entry system Double entry system
1 Personal account and cash account
alone are maintained.
Personal account, real account and nominal
accounts are maintained properly.
2 It involves less clerical labour. It involves more clerical labour.
3 Only one aspect of a transaction is
recorded.
Two aspect of a transaction are recorded.
4 There may be debit without a
corresponding credit and vice versa.
For every debit there is a corresponding
equal credit.
5 Trading account, Profit and loss
account and Balance sheet cannot be
prepared as it has incomplete record.
They can be prepared.
6 It is an imperfect way of bookkeeping. It is a perfect and scientific system.
7 Approximate net profit can be
indirectly calculated.
Accurate net profit can be calculated
directly.
8 As the ledger does not contain all
accounts, trial balance cannot be
prepared.
To test the arithmetical accuracy a trial
balance can be prepared.
9 Tax authorities do not accept it as such Tax authorities accept this method.
10 Internal check is not possible It is possible in this system.
11 Balance sheet cannot prepare. So,
financial position is difficult to ascertain.
Reliable financial position can be found
through balance sheet.
12 The Accounting records are not
acceptable as evidence.
In case of disputes, accounting records can
be produced in courts of law
13 It is suitable for small businessmen It is suitable for any type of businessmen.
Regular Study - Types of Transactions
There are 2 types of Transaction
1. Capital
2. Revenue
The concepts of capital and revenue are of fundamental importance to the correct
determination of accounting profit for a period and recognition of business assets at the end
of that period.
• Capital Transactions:
Transactions having long-term effect are known as capital transactions.
• Revenue Transactions:
Transactions having short-term effect are known as revenue transactions.
• Capital Expenditure
Capital expenditure can be defined as expenditure incurred on the purchase, alteration or
improvement of fixed assets. For example, the purchase of a car to be use to deliver goods is
capital expenditure. Included in capital expenditure are such costs as:
• Delivery of fixed assets;
• Installation of fixed assets;
• Improvement (but not repair) of fixed assets;
• Legal costs of buying property;
• Demolition costs;
• Architects fees;
• Revenue Expenditures
Revenue expenditure is expenditure incurred in the running / management of the business.
For example, the cost of petrol or diesel for cars is revenue expenditure. Other revenue
expenditure:
• Maintenance of Fixed Assets;
• Administration of the business;
• Selling and distribution expenses.
Capitalized Expenditure
Expenditure connected with the purchase of fixed asset are called capitalized expenditure
e.g. wages paid for the installation of machinery.
The Treatments of Capital and Revenue Expenditures
Capital expenditures are shown in the Balance Sheet Assets Side while Revenue
Expenditures are shown in the Trading and Profit And Loss Account debit side.
Revenue Receipts
Amount received against revenue income are called revenue receipt.
Capital Receipts
Amount received against capital income are called capital receipts.
Capital Profits
Capital profit which is earned on the sale of the fixed assets.
Revenue Profit
The profit which is earned during the ordinary course of business is called revenue profit.
Capital Loss
The loss suffered by a company on the sale of fixed assets.
Revenue Loss
The loss suffered by the business in the ordinary course of business is called revenue loss.
Rules for Determining Capital Expenditure
An expenditure can be recognised as capital if it is incurred for the following purposes :
• An expenditure incurred for the purpose of acquiring long term assets (useful life is at
least more than one accounting period) for use in business to earn profits and not meant for
resale, will be treated as a capital expenditure. For example, if a second hand motor car
dealer buys a piece of furniture with a view to use it in business; it will be a capital
expenditure. But if he buys second hand motor cars, for re-sale, then it will be a revenue
expenditure because he deals in second hand motor cars.
• When an expenditure is incurred to improve the present condition of a machine or putting
an old asset into working condition, it is recognised as a capital expenditure. The
expenditure is capitalized and added to the cost of the asset. Likewise, any expenditure
incurred to put an asset into working condition is also a capital expenditure.
• For example, if one buys a machine for ` 5,00,000 and pays ` 20,000 as transportation
charges and ` 40,000 as installation charges, the total cost of the machine comes upto `
5,60,000. Similarly, if a building is purchased for ` 1,00,000 and ` 5,000 is spent on
registration and stamp duty, the capital expenditure on the building stands at ` 1,05,000.
• If an expenditure is incurred, to increase earning capacity of a business will be considered
as of capital nature. For example, expenditure incurred for shifting ‘the ‘factory for easy
supply of raw materials. Here, the cost of such shifting will be a capital expenditure.
• Preliminary expenses incurred before the commencement of business is considered capital
expenditure. For example, legal charges paid for drafting the memorandum and articles of
association of a company or brokerage paid to brokers, or commission paid to underwriters
for raising capital.
• Thus, one useful way of recognising an expenditure as capital is to see that the business
will own something which qualifies as an asset at the end of the accounting period.
Some examples of capital expenditure:
(i) Purchase of land, building, machinery or furniture
(ii) Cost of leasehold land and building
(iii) Cost of purchased goodwill
(iv) Preliminary expenditures
(v) Cost of additions or extensions to existing assets
(vi) Cost of overhauling second-hand machines
(vii) Expenditure on putting an asset into working condition and
(viii) Cost incurred for increasing the earning capacity of a business.
Rules for Determining Revenue Expenditure
Any expenditure which cannot be recognised as capital expenditure can be termed as
revenue expenditure. A revenue expenditure temporarily influences only the profit earning
capacity of the business. An expenditure is recognised as revenue when it is incurred for the
following purposes :
Expenditure for day-to-day conduct of the business, the benefits of which last less than one
year.
Examples are wages of workmen, interest on borrowed capital, rent, selling expenses, and
so on.
Expenditure on consumable items, on goods and services for resale either in their original or
improved form. Examples are purchases of raw materials, office stationery, and the like. At
the end of the year, there may be some revenue items (stock, stationery, etc.) still in hand.
These are generally passed over to the next year though they were acquired in the previous
year.
Expenditures incurred for maintaining fixed assets in working order.
For example, repairs, renewals and depreciation.
Some examples of revenue expenditure
(i) Salaries and wages paid to the employees;
(ii) Rent and rates for the factory or office premises;
(iii) Depreciation on plant and machinery;
(iv) Consumable stores;
(v) Inventory of raw materials, work-in-progress and finished goods;
(vi) Insurance premium;
(vii) Taxes and legal expenses; and
(viii) Miscellaneous expenses.
Deferred Revenue Expenditures
Deferred revenue expenditures represent certain types of assets whose usefulness does not
expire in the year of their occurrence but generally expires in the near future. These type of
expenditures are carried forward and are written off in future accounting periods.
Sometimes, we make some revenue expenditure but it eventually becomes a capital asset
(generally of an intangible nature). If one undertake substantial repairs to the existing
building, the deterioration of the premises may be avoided. We may engage our own
employees to do that work and pay them at prevailing wage-rate, which is of a revenue
nature. If this expenditure is treated as a revenue expenditure and the current year’s-profit is
charged with these expenses, we are making the current year to absorb the entire expenses,
though the benefit of which will be enjoyed for a number of accounting years. To overcome
this difficulty, the entire expenditure is capitalised and is added to the asset account.
Another example is an insurance policy. A business can pay insurance premium in advance,
say, for a 3 year period. The right does not expire in the accounting period in which it is
paid but will expire within a fairly short period of time (3 years). Only a portion of the total
premium paid should be treated as a revenue expenditure (portion pertaining to the current
period) and the balance should be carried forward as an asset to be written off in subsequent
years.
Regular Study - Types of Transactions - Illustrations
Illustration1.
State whether the following are capital, revenue or deferred revenue expenditure.
(i) Carriage of 7,500 spent on machinery purchased and installed.
(ii) Heavy advertising costs of 20,000 spent on the launching of a company’s new product.
(iii) 200 paid for servicing the company vehicle, including ` 50 paid for changing the oil.
(iv) Construction of basement costing 1,95,000 at the factory premises.
Solution :
(i) Carriage of 7,500 paid for machinery purchased and installed should be treated as a
Capital Expenditure.
(ii) Advertising expenses for launching a new product of the company should be treated as a
Revenue Expenditure. (As per AS-26)
(iii) 200 paid for servicing and oil change should be treated as a Revenue Expenditure.
(iv) Construction cost of basement should be treated as a Capital Expenditure.
Illustration 2.
State whether the following are capital or revenue expenditure.
(i) Paid a bill of 10,000 of Mr. Kumar, who was engaged as the erection engineer to set up a
new automatic machine costing 20,000 at the new factory site.
(ii) Incurred 26,000 expenditure on varied advertisement campaigns under taken yearly, on
a regular basis, during the peak festival season.
(iii) In accordance with the long-term plan of providing a well- equipped Labour Welfare
Centre, spent 90,000 being the budgeted allocation for the year.
Solution :
(i) Expenses incurred for erecting a new machine should be treated as a Capital
Expenditure.
(ii) Advertisement expenses during peak festival season should be treated as a Revenue
Expenditure.
(iii) Expenses incurred for Labour Welfare Centre should be treated as a Capital
Expenditure.
Illustration 3.
Classify the following items as capital or revenue expenditure :
(i) An extension of railway tracks in the factory area;
(ii) Wages paid to machine operators;
(iii) Installation costs of new production machine;
(iv) Materials for extension to foremen’s offices in the factory;
(v) Rent paid for the factory;
(vi) Payment for computer time to operate a new stores control system,
(vii) Wages paid to own employees for building the foremen’s offices.
Solution :
(i) Expenses incurred for extension of railway tracks in the factory area should be treated as
a Capital Expenditure because it will yield benefit for more than one accounting period.
(ii) Wages paid to machine operators should be treated as a Revenue Expenditure as it will
yield benefit for the current period only.
(iii) Installation costs of new production machine should be treated as a Capital Expenditure
because it will benefit the business for more than one accounting period.
(iv) Materials for extension to foremen’s offices in the factory should be treated as a Capital
Expenditure because it will benefit the business for more than one accounting period.
(v) Rent paid for the factory should be treated as a Revenue Expenditure because it will
benefit only the current period.
(vi) Payment for computer time to operate a new stores control system should be treated as
Revenue Expenditure because it has been incurred to carry on the normal business.
(vii) Wages paid for building foremen’s offices should be treated as a Capital Expenditure
because it will benefit the business for more than one accounting period.
Illustration 4.
For each of the cases numbered below, indicate whether the income/expenditure is capital
or revenue.
(i) Payment of wages to one’s own employees for building a new office extension.
(ii) Regular hiring of computer time for the preparation of the firm’s accounts.
(iii) The purchase of a new computer for use in the business.
(iv) The use of motor vehicle, hired for five years, but paid at every six months.
Solution :
(i) Payment of wages for building a new office extension should be treated as a Capital
Expenditure.
(ii) Computer hire charges should be treated as a Revenue Expenditure.
(iii) Purchase of computer for use in the business should be treated as a Capital Expenditure.
(iv) Hire charges of motor vehicle should be treated as a Revenue Expenditure.
Illustration 5.
State with reasons whether the following are capital or revenue expenditure :
(i) Freight and cartage on the new machine 150, and erection charges 500.
(ii) Fixtures of the book value of 2,500 sold off at 1,600 and new fixtures of the value of
4,000 were acquired. Cartage on purchase 100.
(iii) A sum of 400 was spent on painting the factory.
(iv) 8,200 spent on repairs before using a second hand car purchased recently, to put it in
usable condition.
Solution :
(i) Freight and cartage totaling 650 should be treated as a Capital Expenditure because it
will benefit the business for more than one accounting year.
(ii) Loss on sale of fixtures (2,500 – 1,600) = 900 should be treated as a Capital Loss. The
cost of new fixtures and carriage thereon should be treated as a Capital Expenditure because
the fixture will be used for a long period. So (4,000+1,000)the cost of new fixture will be
4,100.
(iii) Painting of the factory should be treated as a Revenue Expenditure because it has been
incurred to maintain the factory building.
(iii) Repairing cost of second hand car should be treated as a Capital Expenditure because it
will benefit the business for more than one accounting year.
Illustration 6.
State the nature (capital or revenue) of the following expenditure which were incurred by
Vedanta & Co. during the year ended 30th June, 2016 :
(i) 350 was spent on repairing a second hand machine which was purchased on 8th May,
2016 and 200 was paid on carriage and freight in connection with its acquisition.
(ii) A sum of 30,000 was paid as compensation to two employees who were retrenched.
(iii) 150 was paid in connection with carriage on goods purchased.
(iv) 20,000 customs duty is paid on import of a machinery for modernisation of the factory
production during the current year and ` 6,000 is paid on import duty for purchase of raw
materials.
(v) 18,000 interest had accrued during the year on term loan obtained and utilised for the
construction of factory building and purchase of machineries; however, the production has
not commenced till the last date of the accounting year.
Solution :
(i) Repairing and carriage totaling 550 for second hand machine should be treated as a
Capital Expenditure.
(ii) Compensation paid to employees shall be treated as a Revenue Expenditure.
(iii) Carriage paid for goods purchased should be treated as a Revenue Expenditure.
(iv) Customs duty paid on import of machinery to be treated as a Capital Expenditure.
However, import
duty paid for raw materials should be treated as a Revenue Expenditure.
(v) Interest paid during pre-construction period to be treated as a Capital Expenditure.
Illustration 7.
State with reasons whether the following items relating to Parvati Sugar Mill Ltd. are capital
or revenue :
(i) 50,000 received from issue of shares including ` 10,000 by way of premium.
(ii) Purchased agricultural land for the mill for ` 60,000 and ` 500 was paid for land revenue.
(iii) 5,000 paid as contribution to PWD for improving roads of sugar producing area.
(iv) 40,000 paid for excise duty on sugar manufactured.
(v) 70,000 spent for constructing railway siding.
Solution :
(i) 40,000 (50,000 – 10,000) received from issue of shares will be treated as a Capital
Receipt. The premium of 10,000 should be treated as a Capital Profit.
(ii) Cost of land 60,000 to be treated as Capital Expenditure and land revenue of 500 to be
treated as Revenue Expenditure.
(iii) Contribution paid to PWD should be treated as a Revenue Expenditure.
(iv) Excise duty of 40,000 should be treated as a Revenue Expenditure.
(v) 70,000 spent for constructing railway siding to be treated as a Capital Expenditure.
Illustration 8.
State with reasons whether the following are Capital Expenditure or Revenue Expenditure :
(i) Expenses incurred in connection with obtaining a licence for starting the factory were
10,000.
(ii) 1,000 paid for removal of stock to a new site.
(iii) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get full efficiency.
(iv) 2,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site
belonged to the Plaintiff. The suit was not successful.
(v) 10,000 were spent on advertising the introduction of a new product in the market, the
benefit of which will be effective during four years.
(vi) A factory shed was constructed at a cost of 1,00,000. A sum of 5,000 had been incurred
for the construction of the temporary huts for storing building materials.
Solution :
(i) 10,000 incurred in connection with obtaining a license for starting the factory is a Capital
Expenditure. It is incurred for acquiring a right to carry on business for a long period.
(ii) 1,000 incurred for removal of stock to a new site is treated as a Revenue Expenditure
because it is not enhancing the value of the asset and it is also required for starting the
business on the new site.
(iii) 5,000 incurred for changing Rings and Pistons of an engine is a Revenue Expenditure
because, the change of rings and piston will restore the efficiency of the engine only and it
will not add anything to the capacity of the engine.
(iv) 2,000 incurred for defending the title to the firm’s assets is a Revenue Expenditure.
(v) 10,000 incurred on advertising is to be treated as a Revenue Expenditure (As per AS-
26).
(vi) Cost of construction of Factory shed of 1,00,000 is a Capital Expenditure, similarly cost
of construction of small huts for storing building materials is also a Capital Expenditure.
Illustration 9.
State clearly how you would deal with the following in the books of a Company :
(i) The redecoration expenses 6,000.
(ii) The installation of a new Coffee-making Machine for 10,000.
(iii) The building of an extension of the club dressing room for 15,000.
(iv) The purchase of Snacks & food stuff 2,000.
(v) The purchase of V.C.R. and T.V. for the use in the club lounge for 15,000.
Solution :
(i) The redecoration expenses of 6,000 shall be treated as a Deferred Revenue Expenditure.
(ii) The installation of a new Coffee - Making Machine is a Capital Expenditure because it
is the acquisition of an asset.
(iii) 15,000 spent for the extension of club dressing room is a Capital Expenditure because it
creates an asset of a permanent nature.
(iv) The purchase of snacks & food stuff of 2,000 is a Revenue Expenditure.
(v) The purchase of V.C.R. and T.V. for 15,000 is a Capital Expenditure, because it is the
acquisition of assets.
Regular Study - Accounting Equation
The source document is the origin of a transaction and it initiates the accounting process,
whose starting point is the accounting equation.
Accounting equation is based on dual aspect concept (Debit and Credit). It emphasizes on
the fact that every transaction has a two sided effect i.e., on the assets and claims on assets.
Always the total claims (those of outsiders and of the proprietors) will be equal to the total
assets of the business concern. The claims are also known as equities, are of two types: i.)
Owners equity (Capital); ii.) Outsiders’ equity (Liabilities).
Assets = Equities
Assets = Capital + Liabilities (A = C+L)
Capital = Assets – Liabilities (C = A–L)
Liabilities = Assets – Capital (L = A–C)
Effect of Transactions on Accounting Equation :
Illustration 1
If the capital of a business is Rs.3,00,000 and other liabilities are Rs.2,00,000, calculate the
total assets of the business.
Solution
Assets = Capital + Liabilities
Capital + Liabilities = Assets
Rs. 3,00,000 + Rs.2,00,000 = Rs.5,00,000
Illustration 2
If the total assets of a business are Rs.3,60,000 and capital is Rs.2,00,000, calculate
liabilities.
Solution
Assets = Capital + Liabilities
Liabilities = Assets – Capital
Assets – Capital = Liabilities
Rs. 3,60,000 – Rs. 2,00,000 = Rs. 1,60,000
Illustration 3
If the total assets of a business are Rs.4,50,000 and outside liabilities are Rs.2,50,000,
calculate the capital.
Solution:
Capital = Assets – Liabilities
Assets – Liabilities = Capital
Rs. 4,50,000 – Rs. 2,50,000 = Rs.2,00,000
Illustration – 4
Transaction 1: Murugan started business with Rs.50,000 as capital.
The business unit has received assets totalling Rs.50,000 in the form of cash and the claims
against the firm are also Rs.50,000 in the form of capital. The transaction can be expressed
in the form of an accounting equation as follows:
Assets = Capital + Liabilities
Cash = Capital + Liabilities
Rs. 50,000 = Rs. 50,000 + 0
Transaction 2: Murugan purchased furniture for cash Rs.5,000.
The cash is reduced by Rs,5,000 but a new asset (furniture) of the same amount has been
acquired. This transaction decreases one asset (cash) and at the same time increases the
other asset (furniture) with the same amount, leaving the total of the assets of the business
unchanged. The accounting equation now is as follows:
Assets = Capital + Liabilities
Cash + Furniture = Capital + Liabilities
Transaction 1 50,000 + 0 = 50,000 + 0
Transaction 2 (–) 5,000 + 5,000 = 0 + 0
Equation 45,000 + 5,000 = 50,000 + 0
Transaction 3: He purchased goods for cash Rs.30,000.
As a result, cash balance is reduced by the goods purchased, leaving the total of the assets
unchanged.
Assets = Capital +Liabilities
Cash + Furniture + Stock = Capital +Liabilities
(Goods)
Transaction 1&2 45,000 + 5,000 + 0 = 50,000 + 0
Transaction 3 (–) 30,000 + 0 + 30,000 = 0 + 0
Equation 15,000 + 5,000 + 30,000 = 50,000 + 0
Transaction 4: He purchased goods on credit for Rs.20,000.
The above transaction will increase the value of stock on the assets side and will create a
liability in the form of creditors.
Assets = Capital +Liabilities
Cash + Furniture + Stock = Capital +Creditors
Transaction 1-3 15,000 + 5,000 + 30,000 = 50,000 + 0
Transaction 4 0 + 0 + 20,000 = 0 + 20,000
Equation 15,000 + 5,000 + 50,000 = 50,000 + 20,000
Transaction 5: Goods costing Rs.25,000 sold on credit for Rs.35,000.
The above transaction will give rise to a new asset in the form of Debtors to the extent of
Rs.35,000. But the stock of goods will be reduced by Rs.25,000 i.e., the cost of goods sold.
The net increase of Rs.10,000 is the amount of revenue which will be added to the capital.
Assets = Capital + Liabilities
Cash + Furniture + Stock + Debtors = Capital + Creditors
+
Revenue
Transaction 1-4 15,000 + 5,000 + 50,000 + 0 = 50,000 + 20,000
Transaction 5 0 + 0 +(-)25,000 + 35,000 = 10,000 + 0
Equation 15,000 + 5,000 + 25,000 + 35,000 = 60,000 + 20,000
Transaction 6: Rent paid Rs.3,000.
It reduces cash and the rent is an expense, it results in a loss which decreases the capital.
Assets = Capital + Liabilities
Cash + Furniture + Stock + Debtors = Capital + Creditors
Transaction 1-5 15,000 + 5,000 + 25,000 + 35,000 = 60,000 + 20,000
Transaction 6 – 3,000 + 0 + 0 + 0 = –3,000 + 0
Equation 12,000 + 5,000 + 25,000 + 35,000 = 57,000 + 20,000
77,000 = 77,000
From the above transactions, it may be concluded that every transaction has a double effect
and in each case - Assets = Capital + Liabilities, i.e., ‘Accounting equation is true in all
cases’. The last equation appearing in the books of Mr.Murugan may also be presented in
the form of a statement called Balance Sheet.
Regular Study - Journal
The books in which a transaction is recorded for the first time from a source document are
called Books of Original Entry or Prime Entry. Journal is one of the books of original entry
in which transactions are originally recorded in a chronological (day-to-day) order
according to the principles of Double Entry System.
Journal is a date-wise record of all the transactions with details of the accounts debited and
credited and the amount of each transaction.
Format - Journal
Date Particulars L.F. Debit Amount
Rs.
Credit Amount
Rs.
Explanation:
1. Date : In the first column, the date of the transaction is entered. The year and the month
is written only once, till they change. The sequence of the dates and months should be
strictly maintained.
2. Particulars : Each transaction affects two accounts, out of which one account is debited
and the other account is credited. The name of the account to be debited is written first, very
near to the line of particulars column and the word Dr. is also written at the end of the
particulars column. In the second line, the name of the account to be credited is written,
starts with the word ‘To’, a few space away from the margin in the particulars column to the
make it distinct from the debit account.
3. Narration : After each entry, a brief explanation of the transaction together with
necessary details is given in the particulars column with in brackets called narration. The
words ‘For’ or ‘Being’ are used before starting to write down narration. Now, it is not
necessary to use the word ‘For’ or ‘Being’.
4. Ledger Folio (L.F): All entries from the journal are later posted into the ledger accounts.
The page number or folio number of the Ledger, where the posting has been made from the
Journal is recorded
in the L.F column of the Journal. Till such time, this column remains blank.
5. Debit Amount : In this column, the amount of the account being debited is written.
6. Credit Amount : In this column, the amount of the account being credited is written.
Steps in Journalising
The process of analysing the business transactions under the heads of debit and credit and
recording them in the Journal is called Journalising. An entry made in the journal is called
a ‘Journal Entry’.
Step 1 - Determine the two accounts which are involved in the transaction.
Step 2 - Classify the above two accounts under Personal, Real or Nominal.
Step 3 - Find out the rules of debit and credit for the above two accounts.
Step 4 - Identify which account is to be debited and which account is to be credited.
Step 5 - Record the date of transaction in the date column. The year and month is written
once, till they change. The sequence of the dates and months should be strictly maintained.
Step 6 - Enter the name of the account to be debited in the particulars column very close to
the left and side of the particulars column followed by the abbreviation Dr. in the same line.
Against this, the mount to be debited is written in the debit amount column in the same line.
Step 7 - Write the name of the account to be credited in the second line starts with the word
‘To’ a few space away from the margin in the particulars column. Against this, the amount
to be credited is written in the credit amount column in the same line.
Step 8 - Write the narration within brackets in the next line in the particulars column.
Step 9 - Draw a line across the entire particulars column to separate one journal entry from
the other.
Regular Study - Ledger
A Ledger is a book which contains all the accounts whether personal, real or nominal, which are
first entered in journal or special purpose subsidiary books.
According to L.C. Cropper, ‘the book which contains a classified and permanent record of all
the transactions of a business is called the Ledger’.
Format – Ledger
Name of Account
Dr.
Cr.
Date
Particulars J.F Amount
Rs. P.
Date Particulars J.F Amount
Rs. P.
Year
Month
Date
To (Name of
Credit Account
in Journal)
Year
Month
Date
To (Name of
Debit Account
in Journal)
Explanation:
i. Each ledger account is divided into two parts. The left hand side is known as the debit side and
the right hand side is known as the credit side. The words ‘Dr.’ and ‘Cr.’ are used to denote
Debit and Credit.
ii. The name of the account is mentioned in the top (middle) of the account.
iii. The date of the transaction is recorded in the date column.
iv. The word ‘To’ is used before the accounts which appear on the debit side of an account in the
particulars column. Similarly, the word ‘By’ is used before the accounts which appear on the
credit side of an account in the particulars column.
v. The name of the other account which is affected by the transaction is written either in the debit
side or credit side in the particulars column.
vi. The page number of the Journal or Subsidiary Book from where that particular entry is
transferred, is entered in the Journal Folio (J.F) column.
vii. The amount pertaining to this account is entered in the amount column.
Regular Study - Balancing an Account
Balance is the difference between the total debits and the total credits of an account. When
posting is done, many accounts may have entries on their debit side as well as credit side.
The net result of such debits and credits in an account is the balance.
Balancing means the writing of the difference between the amount columns of the two
sides in the lighter (smaller total) side, so that the grand totals of the two sides become
equal.
Significance of balancing
There are three possibilities while balancing an account during a given period. It may be a
debit balance or a credit balance or a nil balance depending upon the debit total and the
credit total.
i. Debit Balance : The excess of debit total over the credit total is called the debit balance.
When there is only debit entries in an account, the amount itself is the balance of that
account, i.e., the debit balance. It is first recorded on the credit side, above the total. Then it
is entered on the debit side, below the total, as the first item for the next period.
ii. Credit Balance : The excess of credit total over the debit total is called the credit
balance. When there is only credit entries in an account, the amount itself is the balance of
that account i.e., the credit balance. It is first written in the debit side, as the last item, above
the total. Then it is recorded on the credit side, below the total, as the first item for the next
period.
iii. Nil Balance : When the total of debits and credits are equal, it is closed by merely
writing the total on both the sides. It indicates the equality of benefits received and given by
that account.
Balancing of different accounts
Balancing is done periodically, i.e., weekly, monthly, quarterly, half-yearly or yearly,
depending on the requirements of the business.
i. Personal Accounts : These accounts are generally balanced regularly to know the
amounts due to the persons (creditors) or due from the persons (debtors).
ii. Real Accounts : These accounts are generally balanced at the end of the financial year,
when final accounts are being prepared. However, cash account is frequently balanced to
know the cash on hand.
A debit balance in an asset account indicated the value of the asset owned by the business.
Assets accounts always show debit balances.
iii.Nominal Accounts : These accounts are in fact, not to be balanced as they are to be
closed by transfer to final accounts. A debit balance in a nominal account indicates that it is
an expense or loss. A credit balance in a nominal account indicates that it is an income or
gain.
All such balances in personal and real accounts are shown in the Balance Sheet and the
balances in nominal accounts are taken to the Profit and Loss Account.
Procedure for Balancing
While balancing an account, the following steps are involved:
Step 1 - Total the amount column of the debit side and the credit side separately and then
ascertain the difference of both the columns.
Step 2 - If the debit side total exceeds the credit side total, put such difference on the
amount column of the credit side, write the date on which balancing is being done in the
date column and the words “By Balance c/d” (c/d means carried down) in the particulars
column.
OR
If the credit side total exceeds the debit side total, put such difference on the amount column
of the debit side, write the date on which balancing is being done in the date column and the
words “To Balance c/d” in the particulars column.
Step 3 - Total again both the amount columns, put the total on both the sides and draw a line
above and a line below the totals.
Step 4 - Enter the date of the beginning of the next period in the date column and bring
down the debit balance on the debit side along with the words “To Balance b/d” (b/d
means brought down) in the particulars column and the credit balance on the credit side
along with the words “By balance b/d” in the particulars column.
Note: In the place of c/d and b/d, the words c/f or c/o (carried forward or carried over) and
b/f or b/o (brought forward or brought over) may also be used. When the balance is carried
down in the same page, the words c/d and b/d are used, while balance is carried over to the
next page, the term c/o and b/o are used. When balance is carried forward to some other
page either in same book or some other book, the abbreviations c/f (carried forward) and b/f
(brought forward) are used.
Regular Study - Distinction between Journal and Ledger
Books of original entry (Journal) and Ledger can be distinguished as follows:
Basis of
Distinction
Journal Ledger
1. Book It is the book of prime entry. It is the main book of account.
2. Stage Recording of entries in these books is
the first stage.
Recording of entries in the ledger
is the second stage.
3. Process The process of recording entries in
these books is called “Journalising”.
The process of recording entries
in the ledger is called “Posting”.
4.Transactions Transactions relating to a person or
property or expense are spread over.
Transactions relating to a
particular account are found
together on a particular page.
5. Net effect The final position of a particular
account cannot be found.
The final position of a particular
account can be ascertained just at
a glance.
6. Next Stage Entries are transferred to the ledger. From the Ledger, first the Trial
Balance is
drawn and then final accounts are
prepared.
7. Tax authorities Do not rely upon these Rely on the ledger for books
assessment purpose.
Regular Study - Trial balance
Trial balance is a statement prepared with the balances or total of debits and credits of all the
accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the name
indicates it is prepared to check the ledger balances. If the total of the debit and credit amount
columns of the trail balance are equal, it is assumed that the posting to the ledger in terms of debit
and credit amounts is accurate. The agreement of a trail balance ensure arithmetical accuracy only,
A concern can prepare trail balance at any time, but its preparation as on the closing date of an
accounting year is compulsory.
According to M.S. Gosav (The Substance of Accountancy) “Trail balance is a statement containing
the balances of all ledger accounts, as at any given date, arranged in the form of debit and credit
columns placed side by side and prepared with the object of checking the arithmetical accuracy of
ledger postings”.
OBJECTIVES OF PREPARING A TRAIL BALANCE
Trial balance is prepared to check arithmetic accuracy.
(i) It gives the balances of all the accounts of the ledger. The balance of any account can be found
from a glance from the trail balance without going through the pages of the ledger.
(ii) It is a check on the accuracy of posting. If the trail balance agrees, it proves that both the aspects
of each transaction are recorded and that the books are arithmetically accurate.
(iii) It facilitates the preparation of profit and loss account and the balance sheet.
(iv) Important conclusions can be derived by comparing the balances of two or more than two years
with the help of trail balances of those years.
FEATURES OF TRIAL BALANCES
(i) A trial balance is prepared as on a specified date.
(ii) It contains a list of all ledger accounts including cash account.
(iii) It may be prepared with the balances or totals of Ledger accounts.
(iv) Total of the debit and credit amount columns of the trial balance must tally.
(v) It the debit and credit amounts are equal, we assume that ledger accounts are arithmetically
accurate.
(vi) Difference in the debit and credit columns points out that some mistakes have been committed.
(vii) Tallying of trail balance is not a conclusive proof of accuracy of accounts.
LIMITATIONS OF TRAIL BALANCE
(i) The trail balance can be prepared only in those concerns where double entry system of bookkeeping
is adopted. This system is too costly.
(ii) A trail balance is not a conclusive proof of the arithmetical accuracy of the books of account. It
the trail balance agrees, it does not mean that now there are absolutely no errors in books. On the
other hand, some errors are not disclosed by the trail balance.
(iii) It the trail balance is wrong, the subsequent preparation of Trading, P&L Account and Balance
Sheet will not reflect the true picture of the concern.
METHODS OF PREPARING TRAIL BALANCE
A trail balance refers to a list of the ledger balances as on a particular date. It can be prepared in the
two manners. In this section we present the important methods of preparing Trial balance
Total method
According to this method, debit total and credit total of each account of ledger are recorded in the
trail balance.
Balance Method
According to this method, only balance of each account of ledger is recorded in trail balance. Some
accounts may have debit balance and the other may have credit balance. All these debit and credit
balances are recorded in it. This method is widely used.
Note: Accounts of all assets, expenses, losses and drawings are debit balances. Accounts of
incomes, gains, liabilities and capital are credit balances
Regular Study - Basel III
Basel III Capital Regulations are being implemented in India with effect from April 1, 2013 in a phased
manner.
I request all of you to go through the Amended Master Circular - Basel III (01 July 2015) here :
"https://rbidocs.rbi.org.in/rdocs/notification/PDFs/58BS09C403D06BC14726AB61783180628D39.PDF"
Revised Framework for Leverage Ratio for Implementation of Basel III Capital Regulations in India can
be better explained under the following headings.
Rationale and Objective
Definition, Minimum Requirement and Scope of Application of the Leverage Ratio
Capital Measure
Exposure Measure
Transitional arrangements
Disclosure requirements
They can be better understood in detail by going through "http://icmai.in/upload/pd/RBI-Circular-
09012015.pdf". We can also discuss in details if members wants to.
Just a recollection of Basel III developments till now :
Basel III released in December, 2010 is the third in the series of Basel Accords. These accords deal with
risk management aspects for the banking sector. In a nut shell we can say that Basel III is the global
regulatory standard (agreed upon by the members of the Basel Committee on Banking Supervision) on
bank capital adequacy, stress testing and market liquidity risk. (Basel I and Basel II are the earlier
versions of the same, and were less stringent)
According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of reform
measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation,
supervision and risk management of the banking sector".
Thus, we can say that Basel III is only a continuation of effort initiated by the Basel Committee on
Banking Supervision to enhance the banking regulatory framework under Basel I and Basel II. This
latest Accord now seeks to improve the banking sector's ability to deal with financial and economic
stress, improve risk management and strengthen the banks' transparency.
Objectives / aims of the Basel III measures
Basel III measures aim to:
→ improve the banking sector's ability to absorb shocks arising from financial and economic stress,
whatever the source
→ improve risk management and governance
→ strengthen banks' transparency and disclosures.
Thus we can say that Basel III guidelines are aimed at to improve the ability of banks to withstand
periods of economic and financial stress as the new guidelines are more stringent than the earlier
requirements for capital and liquidity in the banking sector.
How Does Basel III Requirements Will Affect Indian Banks :
The Basel III which is to be implemented by banks in India as per the guidelines issued by RBI from
time to time, will be challenging task not only for the banks but also for GOI. It is estimated that Indian
banks will be required to rais Rs 6,00,000 crores in external capital in next nine years or so i.e. by 2020
(The estimates vary from organisation to organisation). Expansion of capital to this extent will affect the
returns on the equity of these banks specially public sector banks. However, only consolation for Indian
banks is the fact that historically they have maintained their core and overall capital well in excess of the
regulatory minimum.
The basic structure of Basel III remains unchanged with three mutually reinforcing pillars.
Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) :
Maintaining capital calculated through credit, market and operational risk areas.
Pillar 2 : Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral
risks that banks face.
Pillar 3: Market Discipline : Increasing the disclosures that banks must provide to increase the
transparency of banks
Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II
(a) Better Capital Quality : One of the key elements of Basel 3 is the introduction of much stricter
definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will
mean that banks will be stronger, allowing them to better withstand periods of stress.
(b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required
to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to
ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of
financial and economic stress.
(c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical
buffer has been introduced with the objective to increase capital requirements in good times and decrease
the same in bad times. The buffer will slow banking activity when it overheats and will encourage
lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of
common equity or other fully loss-absorbing capital.
(d) Minimum Common Equity and Tier 1 Capital Requirements : The minimum requirement for
common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to
4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only
common equity but also other qualifying financial instruments, will also increase from the current
minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8%
level, yet the required total capital will increase to 10.5% when combined with the conservation buffer.
(e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets
fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio
to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not riskweighted).
This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3%
leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A
new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015
and 2018, respectively.
(g) Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework,
systemically important banks will be expected to have loss-absorbing capability beyond the Basel III
requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.
-----------------------------------------
Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking
Supervision, to strengthen the regulation, supervision and risk of the banking sector.
The Basel Committee is the primary global standard-setter for the prudential regulation of banks and
provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the
regulation, supervision and practices of banks worldwide with the purpose of enhancing financial
stability.
The Committee reports to the Group of Governors and Heads of Supervision (GHOS). The Committee
seeks the endorsement of GHOS for its major decisions and its work programme.
The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, European
Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico,
the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the
United Kingdom and the United States.
The Basel III reform measures aim to:
Improve the banking sector's ability to absorb shocks arising from financial and economic stress,
whatever the source
Improve risk management and governance
Strengthen banks' transparency and disclosures.
The reforms target:
a. Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking
institutions to periods of stress.
b. Macroprudential, system wide risks that can build up across the banking sector as well as the
procyclical amplification of these risks over time.
These two approaches to supervision are complementary as greater resilience at the individual bank level
reduces the risk of system wide shocks.
From 1993 to 2008 the total assets of a sample of what we call global systemically important banks saw a
twelve-fold increase (increasing from $2.6 trillion to just over $30 trillion). But the capital funding these
assets only increased seven-fold, (from $125 billion to $890 billion). Put differently, the average risk
weight declined from 70% to below 40%.
The problem was that this reduction did not represent a genuine reduction in risk in the banking system.
One of the main reasons the economic and financial crisis became so severe was that the banking sectors
of many countries had built up excessive on and off-balance sheet leverage. This was accompanied by a
gradual erosion of the level and quality of the capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor
could it cope with the reintermediation of large off-balance sheet exposures that had built up in the
shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of
systemic institutions through an array of complex transactions.
During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of
many banking institutions. The weaknesses in the banking sector were rapidly transmitted to the rest of
the financial system and the real economy, resulting in a massive contraction of liquidity and credit
availability.
Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and
guarantees, exposing taxpayers to large losses.
The effect on banks, financial systems and economies at the epicentre of the crisis was immediate.
However, the crisis also spread to a wider circle of countries around the globe. For these countries the
transmission channels were less direct, resulting from a severe contraction in global liquidity, crossborder
credit availability and demand for exports.
Given the scope and speed with which the recent and previous crises have been transmitted around the
globe as well as the unpredictable nature of future crises, it is critical that all countries raise the resilience
of their banking sectors to both internal and external shocks.
The G20 Leaders at the Seoul Summit endorsed the Basel III framework and the Financial Stability
Board’s (FSB) policy framework for reducing the moral hazard of systemically important financial
institutions (SIFIs), including the work processes and timelines set out in the report submitted to the
Summit.
SIFIs are financial institutions whose disorderly failure, because of their size, complexity and systemic
interconnectedness, would cause significant disruption to the wider financial system and economic
activity.
We read in the final G20 Communique:
"We endorsed the landmark agreement reached by the Basel Committee on the new bank capital and
liquidity framework, which increases the resilience of the global banking system by raising the quality,
quantity and international consistency of bank capital and liquidity, constrains the build-up of leverage
and maturity mismatches, and introduces capital buffers above the minimum requirements that can be
drawn upon in bad times.
The framework includes an internationally harmonized leverage ratio to serve as a backstop to the riskbased
capital measures.
With this, we have achieved far-reaching reform of the global banking system.
The new standards will markedly reduce banks' incentive to take excessive risks, lower the likelihood
and severity of future crises, and enable banks to withstand - without extraordinary government support -
stresses of a magnitude associated with the recent financial crisis.
This will result in a banking system that can better support stable economic growth.
We are committed to adopt and implement fully these standards within the agreed timeframe that is
consistent with economic recovery and financial stability.
The new framework will be translated into our national laws and regulations, and will be implemented
starting on January 1, 2013 and fully phased in by January 1, 2019."
To ensure visibility of the implementation of reforms, the Basel Committee has been regularly publishing
information about members’ adoption of Basel III to keep all stakeholders and the markets informed, and
to maintain peer pressure where necessary.
It is especially important that jurisdictions that are home to global systemically important banks (G-SIBs)
make every effort to issue final regulations at the earliest possible opportunity.
But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for: full, timely
and consistent implementation of Basel III. In response to this call, in 2012 the Committee initiated what
has become known as the Regulatory Consistency Assessment Programme (RCAP).
The regular progress reports are simply one part of this programme, which assesses domestic regulations’
compliance with the Basel standards, and examines the outcomes at individual banks.
The RCAP process will be fundamental to ensuring confidence in regulatory ratios and promoting a level
playing field for internationally-operating banks.
It is inevitable that, as the Committee begins to review aspects of the regulatory framework in far more
detail than it (or anyone else) has ever done in the past, there will be aspects of implementation that do
not meet the G20’s aspiration: full, timely and consistent.
The financial crisis identified that, like the standards themselves, implementation of global standards was
not as robust as it should have been.
This could be classed as a failure by global standard setters.
To some extent, the criticism can be justified – not enough has been done in the past to ensure global
agreements have been truly implemented by national authorities.
However, just as the Committee has been determined to revise the Basel framework to fix the problems
that emerged from the lessons of the crisis, the RCAP should be seen as demonstrating the Committee’s
determination to also find implementation problems and fix them.
------------------------------------------
Basel III is divided in two main areas:
Regulatory capital
Asset and liability management
AREA 1: Regulatory Capital
Banks shall progressively reach a minimum solvency ratio of 7% as of 2019:
Solvency ratio = (Regulatory Capital) / (Risk-Weighted Assets). [RWA = Risk-Weighted Assets]
The minimum requirement used to be 2% prior to Basel 3, with many national banking authorities
requiring much more leading to that most banks used to have a Tier 1 ratio exceeding 7%
According to the Basel III impact study, at the end of 2009, the average solvency ratio (Core Tier One)
of large banks was 11.1%
So, what is the problem, if banks already exceed the minimum solvency ratio set by Basel III? The devil
is in the details and here is where we find the problems caused to the corporate sector:
The definitions of the Regulatory Capital and the RWA have changed:
Calculated according to the Basel III definitions, the Core Tier One ratio would have been 5.7% instead
of 11.1% according to the old definitions
The 87 “large banks” who answered the impact study would have been short of €600bn of equity at the
end of 2009. New stress tests are disclosed regularly and the shortcomings differ, but they are still there.
This means that banks will either/or have to raise more capital or decrease its present lending, which will
create a crowding out of capital in the financial markets either way.
There are new definitions of core equity leading to that it is reduced with up to 40% for large banks
increased the crowding out effects even further. Major changes in the definition:
Some financial instruments are not any longer eligible as Regulatory Capital
Intangibles and deferred tax assets shall be deducted from the Regulatory Capital
There are changes in how RWA is calculated in average increasing it with 23%. Major changes include:
Sharp increase of RWA amounts from trading activities (stress tests on value at risk, securitisations…)
leading to many banks decreasing the trading leading to fewer banks quoting prices. This has already led
to reduced liquidity and increased costs and risks for corporates in managing its financial exposure from
import and export etc
This encourages particularly banks to perform their swaps through clearing houses
This may weight on complex derivatives businesses
Loan portfolios require being marked-to-market even though it is not required by accounting standards.
This increases pro-cyclicality
Basel III introduces a “Leverage Ratio” such that the amounts of assets and commitments should not
represent more than 33 times the Regulatory Capital, regardless of the level of their risk-weighting and of
the credit commitments being drawn down or not
The Financial Stability Board recommended in July 2011 that the 29 identified systemically important
financial institutions have a Core Tier 1 ratio increased between 1% and 2.5%. Of course these “SIFIs”
are the main large corporates’ banking counterparts. This provision has been “enacted” by the G20 in
November 2011.
The European Commission has added:
Minimum solvency ratio shall be 9% for the EU banks (instead of 7%)
The EU banks shall comply with this level in June 2012 (instead of 2019)
AREA 2: Assets and liabilities management
Banks will have to comply with two new ratios:
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
LCR: high-quality highly-liquid assets available must exceed the net cash outflows of the next 30 days:
High-quality highly-liquid assets:
Level 1 assets: Recognized at 100%: cash, sovereign debt of countries weighted at 0% (which include the
PIIGS as they are part of the Eurozone), deposit at central bank. Level 1 assets shall account for at least
60% of the “high-quality highly liquid assets”
Level 2A assets: Recognized at 85% and must not represent more than 40% of the assets: sovereign debt
weighted at 20% (countries rated below AA-), corporate bonds and covered bonds rated at least AALevel
2B assets (introduced Jan, 2013): non-financial corporate bonds rated between BBB- and A+, with
a hair cut of 50%; certain unencumbered equities, with a hair cut of 50%; and certain residential
mortgage-backed securities (RMBS), with a hair cut of 25%.
The Level 2B assets will not be eligible for more than 15% of the “high-quality highly liquid assets” and
a total level 2 assets will not be eligible for more than 40% of the “high-quality highly liquid assets”
Changes from January 2013 provide:
To some extent, lesser cost of carry for banks on “high-quality highly-liquid assets” but still limited
because of the 50% hair cut and 15% limitation
Improvement for the financing of investment graded companies (BBB and above) by banks through
bonds, which will remain in competition with residential mortgage-backed securities (RBMS) with lesser
hair cut and whose markets is restored with these new provisions
Level 1 assets remain at least 60% of the “high-quality highly-liquid assets”, which means that
concentration risks and cost of carry remain.
Net cash outflows = cash outflows – cash inflows
NSFR: long-term financial resources must exceed long-term commitments (long term = and more than 1
year):
Stable funding:
equity and any liability maturing after one year
90% of retail deposits
50% of deposits from non-financial corporates and public entities
Long-term uses:
5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach risk-weighting (see
comment above for LCR) with a residual maturity above 1 year
20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity above 1 year
50% of non-financial corporate or covered bonds at least rated between A- and A+ with a residual
maturity above 1 year
50% of loans to non-financial corporates or public sector
65% of residential mortgage with a residual maturity above 1 year
5% of undrawn credit and liquidity facilities
----------------------------------------
RBI Guidelines for Implementation of Basel III Guidelines
Back Ground for Basel III :
Earlier guidelines were known as Basel I and Basel II accords. Later on the committee was expanded to
include members from nearly 30 countries , including India. Inspite of implementation of Basel I and II
guidelines, the financial world saw the worst crisis in early 2008 and whole financial markets tumbled.
One of the major debacles was the fall of Lehman Brothers. One of the interesting comments on the
Balance Sheet of Lehman Brothers read : “Whatever was on the left-hand side (liabilities) was not right
and whatever was on the right-hand side (assets) was not left.” Thus, it became necessary to re-visit
Basel II and plug the loopholes and make Basel norms more stringent and wider in scope.
BCBS, through Basel III, put forward norms aimed at strengthening both sides of balance sheets of banks
viz.
(a) enhancing the quantum of common equity;
(b) improving the quality of capital base;
(c) creation of capital buffers to absorb shocks;
(d) improving liquidity of assets;
(e) optimising the leverage through Leverage Ratio;
(f) creating more space for banking supervision by regulators under Pillar II; and
(g) bringing further transparency and market discipline under Pillar III.
Thus, Basel III norms were released by BCBS and individual central banks were asked to implement
these in a phased manner. RBI (India's central bank) too issued draft guidelines in the initial stage and
then came up with the final guidelines.
Over View f the RBI Guidelines for Implementation of Basel III guidelines :
The final guidelines have been issued by Reserve Bank of India for implementation of Basel 3 guidelines
on 2nd May, 2012. Full detailed guidelines can be downloaded from RBI website, by clicking on the
following link : Implementation of Base III Guidelines. Major features of these guidelines are :
(a) These guidelines would become effective from January 1, 2013 in a phased manner. This means that
as at the close of business on January 1, 2013, banks must be able to declare or disclose capital ratios
computed under the amended guidelinesThe Basel III capital ratios will be fully implemented as on
March 31, 2018
(b) The capital requirements for the implementation of Basel III guidelines may be lower during the
initial periods and higher during the later years. Banks needs to keep this in view while Capital Planning;
(c) Guidelines on operational aspects of implementation of the Countercyclical Capital Buffer. Guidance
to banks on this will be issued in due course as RBI is still working on these. Moreover, some other
proposals viz. ‘Definition of Capital Disclosure Requirements’, ‘Capitalisation of Bank Exposures to
Central Counterparties’ etc., are also engaging the attention of the Basel Committee at present.
Therefore, the final proposals of the Basel
Committee on these aspects will be considered for implementation, to the extent applicable, in future.
(d) For the financial year ending March 31, 2013, banks will have to disclose the capital ratios computed
under the existing guidelines (Basel II) on capital adequacy as well as those computed under the Basel III
capital adequacy framework.
(e) The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8%
(international) prescribed by the Basel Committee of Total Risk Weighted assets. This has been decided
by Indian regulator as a matter of prudence. Thus, it requirement in this regard remained at the same
level. However, banks will need to raise more money than under Basel II as several items are excluded
under the new definition.
(f) of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs;
(g) In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international
standards require these to be only at 4.5%) banks are also required to maintain a Capital Conservation
Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. CCB is designed to
ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can
be drawn down as losses are incurred during a stressed period. In case such buffers have been drawn
down, the banks have to rebuild them through reduced discretionary distribution of earnings. This could
include reducing dividend payments, share buybacks and staff bonus.
(h) Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been raised to
7% under Basel III. Moreover, certain instruments, including some with the characteristics of debts, will
not be now included for arriving at Tier 1 capital;
(i) The new norms do not allow banks to use the consolidated capital of any insurance or non financial
subsidiaries for calculating capital adequacy.
(j) Leverage Ratio : Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3% under
Basel III). Leverage ratio has been introduced in Basel 3 to regulate banks which have huge trading
book and off balance sheet derivative positions. However, In India, most of banks do not have large
derivative activities so as to arrange enhanced cover for counterparty credit risk. Hence, the pressure on
banks should be minimal on this count.
(k) Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough
unencumbered liquid assets to cover expected net outflows during a 30-day stress period. In India, the
burden from LCR stipulation will depend on how much of CRR and SLR can be offset against LCR.
Under present guidelines, Indian banks already follow the norms set by RBI for the statutory liquidity
ratio (SLR) – and cash reserve ratio (CRR), which are liquidity buffers. The SLR is mainly government
securities while the CRR is mainly cash. Thus, for this aspect also Indian banks are better placed over
many of their overseas counterparts.
(l) Countercyclical Buffer: Economic activity moves in cycles and banking system is inherently procyclic.
During upswings, carried away by the boom, banks end up in excessive lending and unchecked
risk build-up, which carry the seeds of a disastrous downturn. The regulation to create additional capital
buffers to lend further would act as a break on unbridled bank-lending. The detailed guidelines for these
are likely to be issued by RBI only at a later stage.
On the day of release of these guidelines, analysts felt that India may need at least $30 billion (i.e. around
Rs 1.6 trillion) to $40 billion as capital over the next six years to comply with the new norms. It was also
felt that this would impose a heavy financial burden on the government, as it will need to infuse capital in
case it wants to continue its hold on these PS Banks. RBI Deputy Governor, Mr Anand Sinha viewed that
the implementation of Basel II may have a negative impact on India's growth story. In FY 2012-13,
Government of India is expected to provide Rs 15888 crores to recapitalize the banks. as to maintain
capital adequacy of 8% under old Basel II norms.
Some Major Developments after 2nd May 2012 (i.e. the date when RBI issued Basel III guidelines) :
(a) On 30th October 2012, RBI in its Second Quarter Review of Monetary Policy 2012-13 has declared
as follows :
(i) "Basel III Disclosure Requirements on Regulatory Capital Composition
The Basel Committee on Banking Supervision (BCBS) has finalised proposals on disclosure
requirements in respect of the composition of regulatory capital, aimed at improving transparency of
regulatory capital reporting as well as market discipline. As these disclosures have to be given effect by
national authorities by June 30, 2013, it has been decided:
to issue draft guidelines on composition of capital disclosure requirements by end-December 2012.
(ii) Banks’ Exposures to Central Counterparties (CCP)
The BCBS has also issued an interim framework for determining capital requirements for bank exposures
to CCPs. This framework is being introduced as an amendment to the existing Basel II capital adequacy
framework and is intended to create incentives to increase the use of CCPs. These standards will come
into effect on January 1, 2013. Accordingly, it has been decided:
to issue draft guidelines on capital requirements for bank exposures to central counterparties, based on
the interim framework of the BCBS, by mid-November 2012.
(iii) Core Principles for Effective Banking Supervision
The Basel Committee has issued a revised version of the Core Principles in September 2012 to reflect the
lessons learned during the recent global financial crisis. In this context, it is proposed:
to carry out a self-assessment of the existing regulatory and supervisory practices based on the revised
Core Principles and to initiate steps to further strengthen the regulatory and supervisory mechanism.
(b) On 7th November, 2012 : RBI has issued final guidelines in respect of Liquidity Risk Management
by Banks
On September 1, 2014 : RBI revised some of its rules governing instruments that qualify as bank capital
under Basel-III
Revised rules make instruments more attractive and broaden the base for AT-1 bonds to include retail
investors
Moodys says the amended rules will also allow banks to have a higher proportion of AT-1 in their Tier-1
capital
The major benefit is expected to accrue to public sector banks
Low capital levels are a key credit weakness for many Indian banks, particularly PSBs.
Regular Study - Telegraphic Transfer (TT) Buying/Selling Rate & Bills Buying/Selling
Rate
Understanding Telegraphic Transfer (TT) Buying/Selling Rate & Bills Buying/Selling Rate
TT Buying/Selling Rate & Bills Buying/Selling Rate are rather called as Merchant exchange rate.
Merchant rates are lower than the spot rate definitely and somewhat around the interbank rate
which is one of the lowest rate in the market. At merchant rate high volume export import
transaction take place, because the volume of transaction of the exporter importers may be
millions of dollar, and they get a comparable rate generally favourable to them. So, authorized
dealer those who are providing exchange rate to merchant compete among each other to give what
is called a low, lowest rate to the merchant. And the authorized dealers charge very low profit for
merchant transaction because the transaction is huge, any marginal level of profit can give them
huge amount of profit.
The types of merchant rates are telegraphic transfer rate, what you called TT rates, and bills rate.
There are two types of T Rates - one is called TT buying rate, another is called TT selling rate.
When as a customer, I go to a bank and ask to remit some money to a person in US, I purchase
what is called TT selling, I sale a TT. When as a exporter, I got export transaction in the form of
foreign currency, I want to convert the foreign currency into domestic currency, the rate applicable
to is called TT buying rate. So, TT selling rate is nothing but outward transaction, TT buying rate
nothing but inward remittances.
TT Buying Rate
If you want to convert the foreign currency into domestic money, you have to buy a TT, the TT
buying rate inward remittances applicable to them. Telegraphic transfer, money transfer, demand
draft, which are generally denominated in foreign currency converted into Indian currency or
domestic currency. So, we have to purchase what is called TT buying. Conversion of proceeds of
instrument, many export oriented instruments, many foreign bills, those who are denominated in
foreign currency converts into domestic currency through TT buying rate.
Similarly, if you want to cancel outward remittances, suppose you have booked a foreign DD,
foreign currency DD, but you want to convert into Indian currency or cancel it, then you have to
purchase what is called a TT buying rate. So, TT buying rates applicable to inward remittances,
foreign currency demand draft, foreign currency money transfer, conversion of proceeds of
foreign currency denominated instrument, cancellation of outward remittances in the form of DD,
TT, MT.
TT selling rate
If you want to send foreign currency to outside that is from domestic economy, the foreign
currencies are going outward to other country, then you have to sale a TT. So, if I want to send US
dollar to any US citizen in US, then I have to convert the domestic rupee into US dollar, that time
I have to sell a TT. So, all outward remittances transaction which are generally converted by
paying domestic money into foreign currency are called TT selling rate.
So, outward remittances, telegraphic transfer, money transfer, foreign currency denominates DD
that is demand draft, conversion of proceeds of instrument that is any instrument in domestic
money converted into a foreign currency, cancellation of inward remittances, if you want to
convert any foreign domestic DD, TT, MT into foreign currency, then TT selling rate applicable.
If you want to import something, then you have to sell TT. TT selling rate applicable to all
outward transaction in which any foreign currency purchased by paying domestic currency.
Bills Buying Rate/Bills Selling Rate
Bills are export import proceeds. Bills buying rate is nothing but inward remittances, bill selling
rate nothing but outward remittances. Foreign currency converted into domestic currency through
bills buying rate; domestic currency converted into foreign currency through bill selling rate. Here
bills are export import bill, and any other kind of foreign, foreign currency denominated
instruments.
TT/Bills Buying/Selling Examples:
1. Inflow of USD 200,000.00 by TT for credit to your exporter's account, being advance payment
for exports (credit received in Nostro statement received from New York correspondent). What
rate you will take to quote to the customer, if the market is 55.21/25?
Explanation :
It will be a purchase of USD from customer for which USD will have to be sold in the market. Say
when USD/Rs is being quoted as 55.21/25, meaning that market buys USD at Rs 55.21 and sells at
Rs 55. 25. We shall have to quote rate to the customer on the basis of market buying rate, i.e.
55.21, less our margin, as applicable, to arrive at the TT Buying Rate applicable for the customer
transaction.
2. Retirement of import bill for GBP 100,000.00 by TT Margin 0.20%, ignore cash
discount/premium, GBP/USD 1.3965/75, USD/INR 55.16/18. Compute Rate for Customer.
Explanation :
For retirement of import bill in GBP, we need to buy GBP, to buy GBP we need to give USD and
to get USD, we need to buy USD against Rupee, i.e. sell Rupee.
At the given rates, GBP can be bought at 1.3975 USD, while USD can be bought at 55.18. The
GBP/INR rate would be 77.1140. (1.3975 x 55.18), at which we can get GBP at market rates. Thus
the interbank rate for the transaction can be taken as 77.1140.
Add Margin 0.20% 0.1542.
Rate would be 77.1140 + 0.1542 = 77.2682 for effecting import payment. (Bill Selling Rate).
Regular Study - Letter of Credit (LC)
Letter Of Credit
A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and
for the correct amount. In the event that the buyer is unable to make payment on the purchase, the
bank will be required to cover the full or remaining amount of the purchase. Now in simple words,
If LC opened on your name as beneficiary, you will receive amount though the buyer’s bank
(opening bank) on the agreed time. All Letters of Credit for export import trade is handled under
the guidelines of Uniform Customs and Practice of Documentary Credit of International Chamber
of Commerce (UCP 600).
Letters of credit are often used in international transactions to ensure that payment will be
received. Due to the nature of international dealings including factors such as distance, differing
laws in each country and difficulty in knowing each party personally, the use of letters of credit
has become a very important aspect of international trade. The bank also acts on behalf of the
buyer (holder of letter of credit) by ensuring that the supplier will not be paid until the bank
receives a confirmation that the goods have been shipped.
There are various types of letters of credit like Revocable, Irrevocable, Confirmed, Unconfirmed,
Clean & Documentary, Fixed, Revolving, Transferable, Back to Back etc. Most common and safe
LC is Irrevocable Letter of Credit for both buyer and seller.
Procedures to get money under Letter of Credit at sight.
Opening a Letter of Credit at sight is common practice in the export business. Under sight LC, the
payment of export proceeds sent to seller’s bank by buyer’s bank immediately up on receipt of
original shipping documents as per the terms and conditions mentioned on LC.
Once after completion of export customs clearance procedures, the exporter prepares all required
documents as per the terms and conditions of letter of credit. These documents will be submitted
with exporter’s bank, along with the original LC. Bank verifies all documents and make sure, the
documentation is in order as per LC conditions. These documents will be sent to buyer’s bank and
in turn to the buyer after necessary approval in documentation by seller’s bank. Once the buyer’s
bank receives the documents, the export sales amount as per the said documents will be sent to
exporter’s bank. However, the documentation of each consignment must be as per the conditions
of LC at sight and the buyer’s bank has the right to reject payment on any violation of such
documentation. This is the procedures under letter of credit at sight.
How long is the Credit period under Letter of Credit:
The credit period of LC can be determined my mutually agreed terms and condition by buyer and
seller before sales takes place.
Some time, the foreign buyer may demand credit period of 30 days, 60 days, 90 days, 120 days
etc. However as per government regulation, the total period of credit should not exceed more than
180 days.
Normally the credit period is calculated from the date of shipment. The date of shipment is
determined on the basis of date of bill of lading or airway bill.
Who is a ‘prime banker’ ?
As per the details of assets and liabilities based on the annual financial report of each bank all over
the world, the authorities related to banking prepares prime bankers list. The prime banks are the
banks that hold strong financial background with sound assets and have been serving people with
best service. The prime banker’s data base are available with all major reputed banks all over
world. One can check this data with your bank or your bank may help you to whom to be
approached to get the said data.
So a Letter of Credit issued by a Prime Bank is safe for an exporter always.
How to check authenticity of letter of credit (LC)?
There are many banks all over world. Now days, after the introduction of globalization of trade, a
number of banks and financial institutions have been introduced all over world with least
restrictions within the country. Some of them have been working without any regulations by
government also. These banks work under Society’s Registration Act, but name as “Bank”. You
can approach your bank with the copy of letter of credit to verify the authenticity and check
whether the said LC has been opened by a prime bank.
We can classify mainly eight main parties involved in a Letter of Credit.
Applicant of Letter of Credit.
Applicant is the party who opens Letter of Credit. Normally, buyer of goods is the Applicant who
opens letter of credit. Letter of credit is opened as per his instruction and necessary payment is
arranged to open Letter of credit with his bank. The applicant arranges to open letter of credit with
his bank as per the terms and conditions of Purchase order and business contract between buyer
and seller. So Applicant is one of the major parties involved in a Letter of credit.
LC Issuing Bank
Issuing Bank is the bank who opens letter of credit. Letter of credit is created by issuing bank who
takes responsibility to pay amount on receipt of documents from supplier of goods (beneficiary
under LC).
Beneficiary party
Beneficiary of Letter of credit gets the benefit under Letter of credit. Beneficiary is the party under
letter of credit who receives amount under letter of credit. The LC is opened on Beneficiary
party’s favor. Beneficiary party under letter of credit submits all required documents with is bank
in accordance with the terms and conditions under LC.
Advising Bank
Advising bank, as a part of letter of credit takes responsibility to communicate with necessary
parties under letter of credit and other required authorities. The advising bank is the party who
sends documents under Letter of Credit to opening bank.
Confirming Bank
Confirming bank as a party of letter of credit confirms and guarantee to undertake the
responsibility of payment or negotiation acceptance under the credit.
Negotiating Bank
Negotiating Bank, who negotiates documents delivered to bank by beneficiary of LC. Negotiating
bank is the bank who verifies documents and confirms the terms and conditions under LC on
behalf of beneficiary to avoid discrepancies
Reimbursing Bank
Reimbursing bank is the party who authorized to honor the the reimbursement claim of
negotiation/ payment/ acceptance.
Second Beneficiary
Second beneficiary who represent the first beneficiary or original beneficiary in their absence,
where in the credits belongs to original beneficiary is transferable as per terms.
Some more notes for clear understanding of LC
Letters of credit used in international transactions are governed by the International Chamber of
Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and
definitions of the International Chamber of Commerce are binding on all parties. Domestic
collections in the United States are governed by the Uniform Commercial Code.
A commercial letter of credit is a contractual agreement between a bank, known as the issuing
bank, on behalf of one of its customers, authorizing another bank, known as the advising or
confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its
customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings
made under the credit. The beneficiary is normally the provider of goods and/or services.
Essentially, the issuing bank replaces the bank's customer as the payor.
Elements of a Letter of Credit
A payment undertaking given by a bank (issuing bank)
On behalf of a buyer (applicant)
To pay a seller (beneficiary) for a given amount of money
On presentation of specified documents representing the supply of goods
Within specified time limits
Documents must conform to terms and conditions set out in the letter of credit
Documents to be presented at a specified place
Letter of Credit Characteristics
Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the
beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed
freely from one party to another almost in the same way as money. To be negotiable, the letter of
credit must include an unconditional promise to pay, on demand or at a definite time. The
nominated bank becomes a holder in due course. As a holder in due course, the holder takes the
letter of credit for value, in good faith, without notice of any claims against it. A holder in due
course is treated favorably under the UCC.
The transaction is considered a straight negotiation if the issuing bank's payment obligation
extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is
referenced on its face by "we engage with you" or "available with ourselves". Under these
conditions the promise does not pass to a purchaser of the draft as a holder in due course.
Revocability
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be
revoked or modified for any reason, at any time by the issuing bank without notification. A
revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction
that involves a revocable letter of credit, it serves as the advising bank.
Once the documents have been presented and meet the terms and conditions in the letter of credit,
and the draft is honored, the letter of credit cannot be revoked. The revocable letter of credit is not
a commonly used instrument. It is generally used to provide guidelines for shipment. If a letter of
credit is revocable it would be referenced on its face.
The irrevocable letter of credit may not be revoked or amended without the agreement of the
issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit from the
issuing bank insures the beneficiary that if the required documents are presented and the terms and
conditions are complied with, payment will be made. If a letter of credit is irrevocable it is
referenced on its face.
Transfer and Assignment
The beneficiary has the right to transfer or assign the right to draw, under a credit only when the
credit states that it is transferable or assignable. Credits governed by the Uniform Commercial
Code (Domestic) maybe transferred an unlimited number of times. Under the Uniform Customs
Practice for Documentary Credits (International) the credit may be transferred only once.
However, even if the credit specifies that it is nontransferable or nonassignable, the beneficiary
may transfer their rights prior to performance of conditions of the credit.
Sight and Time Drafts
All letters of credit require the beneficiary to present a draft and specified documents in order to
receive payment. A draft is a written order by which the party creating it, orders another party to
pay money to a third party. A draft is also called a bill of exchange.
There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented for
payment. The bank is allowed a reasonable time to review the documents before making payment.
A time draft is not payable until the lapse of a particular time period stated on the draft. The bank
is required to accept the draft as soon as the documents comply with credit terms. The issuing
bank has a reasonable time to examine those documents. The issuing bank is obligated to accept
drafts and pay them at maturity.
Standby Letter of Credit
The standby letter of credit serves a different function than the commercial letter of credit. The
commercial letter of credit is the primary payment mechanism for a transaction. The standby letter
of credit serves as a secondary payment mechanism. A bank will issue a standby letter of credit on
behalf of a customer to provide assurances of his ability to perform under the terms of a contract
between the beneficiary. The parties involved with the transaction do not expect that the letter of
credit will ever be drawn upon.
The standby letter of credit assures the beneficiary of the performance of the customer's
obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of
invoices, with evidence that the customer has not performed its obligation. The bank is obligated
to make payment if the documents presented comply with the terms of the letter of credit.
Standby letters of credit are issued by banks to stand behind monetary obligations, to insure the
refund of advance payment, to
support performance and bid obligations, and to insure the completion of a sales contract. The
credit has an expiration date. The standby letter of credit is often used to guarantee performance or
to strengthen the credit worthiness of a customer. In the above example, the letter of credit is
issued by the bank and held by the supplier. The customer is provided open account terms. If
payments are made in accordance with the suppliers' terms, the letter of credit would not be drawn
on. The seller pursues the customer for payment directly. If the customer is unable to pay, the
seller presents a draft and copies of invoices to the bank for payment.
The domestic standby letter of credit is governed by the Uniform Commercial Code. Under these
provisions, the bank is given until the close of the third banking day after receipt of the documents
to honor the draft.
Procedures for Using the Tool
The following procedures include a flow of events that follow the decision to use a Commercial
Letter of Credit. Procedures required to execute a Standby Letter of Credit are less rigorous. The
standby credit is a domestic transaction. It does not require a correspondent bank (advising or
confirming). The documentation requirements are also less tedious.
Step-by-step process:
Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee
payment.
Buyer applies to his bank for a letter of credit in favor of the seller.
Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its
correspondent bank (advising or confirming). The correspondent bank is usually located in the
same geographical location as the seller (beneficiary).
Advising bank will authenticate the credit and forward the original credit to the seller
(beneficiary).
Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to
support the letter of credit.
Documentary requirements may vary greatly depending on the perceived risk involved in dealing
with a particular company.
Seller presents the required documents to the advising or confirming bank to be processed for
payment.
Advising or confirming bank examines the documents for compliance with the terms and
conditions of the letter of credit.
If the documents are correct, the advising or confirming bank will claim the funds by:
Debiting the account of the issuing bank.
Waiting until the issuing bank remits, after receiving the documents.
Reimburse on another bank as required in the credit.
Advising or confirming bank will forward the documents to the issuing bank.
Issuing bank will examine the documents for compliance. If they are in order, the issuing bank
will debit the buyer's account.
Issuing bank then forwards the documents to the buyer.
Standard Forms of Documentation
When making payment for product on behalf of its customer, the issuing bank must verify that all
documents and drafts conform precisely to the terms and conditions of the letter of credit.
Although the credit can require an array of documents, the most common documents that must
accompany the draft include:
Commercial Invoice
The billing for the goods and services. It includes a description of merchandise, price, FOB origin,
and name and address of buyer and seller. The buyer and seller information must correspond
exactly to the description in the letter of credit. Unless the letter of credit specifically states
otherwise, a generic description of the merchandise is usually acceptable in the other
accompanying documents.
Bill of Lading
A document evidencing the receipt of goods for shipment and issued by a freight carrier engaged
in the business of forwarding or transporting goods. The documents evidence control of goods.
They also serve as a receipt for the merchandise shipped and as evidence of the carrier's obligation
to transport the goods to their proper destination.
Warranty of Title
A warranty given by a seller to a buyer of goods that states that the title being conveyed is good
and that the transfer is rightful.
This is a method of certifying clear title to product transfer. It is generally issued to the purchaser
and issuing bank expressing an agreement to indemnify and hold both parties harmless.
Letter of Indemnity
Specifically indemnifies the purchaser against a certain stated circumstance. Indemnification is
generally used to guaranty that shipping documents will be provided in good order when available.
Common Defects in Documentation
About half of all drawings presented contain discrepancies. A discrepancy is an irregularity in the
documents that causes them to be in non-compliance to the letter of credit. Requirements set forth
in the letter of credit cannot be waived or altered by the issuing bank without the express consent
of the customer. The beneficiary should prepare and examine all documents carefully before
presentation to the paying bank to avoid any delay in receipt of payment. Commonly found
discrepancies between the letter of credit and supporting documents include:
Letter of Credit has expired prior to presentation of draft.
Bill of Lading evidences delivery prior to or after the date range stated in the credit.
Stale dated documents.
Changes included in the invoice not authorized in the credit.
Inconsistent description of goods.
Insurance document errors.
Invoice amount not equal to draft amount.
Ports of loading and destination not as specified in the credit.
Description of merchandise is not as stated in credit.
A document required by the credit is not presented.
Documents are inconsistent as to general information such as volume, quality, etc.
Names of documents not exact as described in the credit. Beneficiary information must be exact.
Invoice or statement is not signed as stipulated in the letter of credit.
When a discrepancy is detected by the negotiating bank, a correction to the document may be
allowed if it can be done quickly while remaining in the control of the bank. If time is not a factor,
the exporter should request that the negotiating bank return the documents for corrections.
If there is not enough time to make corrections, the exporter should request that the negotiating
bank send the documents to the issuing bank on an approval basis or notify the issuing bank by
wire, outline the discrepancies, and request authority to pay.
Payment cannot be made until all parties have agreed to jointly waive the discrepancy.
Tips for Exporters
Communicate with your customers in detail before they apply for letters of credit.
Consider whether a confirmed letter of credit is needed.
Ask for a copy of the application to be fax to you, so you can check for terms or conditions that
may cause you problems in compliance.
Upon first advice of the letter of credit, check that all its terms and conditions can be complied
with within the prescribed time limits.
Many presentations of documents run into problems with time-limits. You must be aware of at
least three time constraints - the expiration date of the credit, the latest shipping date and the
maximum time allowed between dispatch and presentation.
If the letter of credit calls for documents supplied by third parties, make reasonable allowance for
the time this may take to complete.
After dispatch of the goods, check all the documents both against the terms of the credit and
against each other for internal consistency.
Regular Study - Commercial Paper (CP)
Commercial Paper (CP)
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note.
It was introduced in India in 1990. It was introduced in India in 1990 with a view to enabling
highly rated corporate borrowers to diversify their sources of short-term borrowings and to
provide an additional instrument to investors. Subsequently, primary dealers and all-India
financial institutions were also permitted to issue CP to enable them to meet their short-term
funding requirements for their operations.
Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are eligible to
issue CP.
A corporate would be eligible to issue CP provided –
a. the tangible net worth of the company, as per the latest audited balance sheet, is not less than
Rs. 4 crore
b. company has been sanctioned working capital limit by bank/s or all-India financial institution/s;
and
c. the borrowal account of the company is classified as a Standard Asset by the financing bank/s/
institution/s.
All eligible participants shall obtain the credit rating for issuance of Commercial Paper either from
Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and
Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or
the FITCH Ratings India Pvt. Ltd. or such other credit rating agency (CRA) as may be specified
by the Reserve Bank of India from time to time, for the purpose.
Issue of CP – Credit enhancement, limits, etc.
a. CP shall be issued as a ‘stand alone’ product. Further, it would not be obligatory in any manner
on the part of the banks and FIs to provide stand-by facility to the issuers of CP.
b. Banks and FIs may, based on their commercial judgement, subject to the prudential norms as
applicable to them, with the specific approval of their respective Boards, choose to provide standby
assistance/credit, back-stop facility etc. by way of credit enhancement for a CP issue.
c. Non-bank entities (including corporates) may provide unconditional and irrevocable guarantee
for credit enhancement for CP issue provided:
1. the issuer fulfils the eligibility criteria prescribed for issuance of CP;
2. the guarantor has a credit rating at least one notch higher than the issuer given by an
approved CRA; and
3. the offer document for CP properly discloses the net worth of the guarantor company, the
names of the companies to which the guarantor has issued similar guarantees, the extent of
the guarantees offered by the guarantor company, and the conditions under which the
guarantee will be invoked.
d. The aggregate amount of CP that can be issued by an issuer shall at all times be within the limit
as approved by its Board of Directors or the quantum indicated by the CRA for the specified
rating, whichever is lower.
e. Banks and FIs shall have the flexibility to fix working capital limits, duly taking into account
the resource pattern of company’s financing, including CP.
f. An issue of CP by an FI shall be within the overall umbrella limit prescribed in the Master
Circular on Resource Raising Norms for FIs, issued by the Reserve Bank of India, Department of
Banking Operations and Development, as prescribed/ updated from time-to-time.
g. The total amount of CP proposed to be issued should be raised within a period of two weeks
from the date on which the issuer opens the issue for subscription. CP may be issued on a single
date or in parts on different dates provided that in the latter case, each CP shall have the same
maturity date.
h. Every issue of CP, and every renewal of a CP, shall be treated as a fresh issue.
Eligibility for Investment in CP
1. Individuals, banks, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, Non-Resident Indians and Foreign Institutional Investors (FIIs)
shall be eligible to invest in CP.
2. FIIs shall be eligible to invest in CPs subject to (i) such conditions as may be set for them
by Securities Exchange Board of India (SEBI) and (ii) compliance with the provisions of
the Foreign Exchange Management Act, 1999, the Foreign Exchange (Deposit)
Regulations, 2000 and the Foreign Exchange Management (Transfer or Issue of Security
by a Person Resident Outside India) Regulations, 2000, as amended from time to time.
Form of the Instrument, mode of issuance and redemption
1. CP shall be issued in the form of a promissory note (as specified in Schedule I to these
Guidelines) and held in physical form or in a dematerialized form through any of the
depositories approved by and registered with SEBI, provided that all RBI regulated entities
can deal in and hold CP only in dematerialised form through such depositories.
2. Fresh investments by all RBI-regulated entities shall be only in dematerialised form.
3. CP shall be issued in denominations of ` 5 lakh and multiples thereof. The amount invested
by a single investor should not be less than ` 5 lakh (face value).
4. CP shall be issued at a discount to face value as may be determined by the issuer.
5. No issuer shall have the issue of CP underwritten or co-accepted.
6. Options (call/put) are not permitted on CP.
Tenor
1. CP shall be issued for maturities between a minimum of 7 days and a maximum of up to
one year from the date of issue.
2. The maturity date of the CP shall not go beyond the date up to which the credit rating of
the issuer is valid.
Procedure for Issuance
1. Every issuer must appoint an IPA for issuance of CP.
2. The issuer should disclose to the potential investors, its latest financial position as per the
standard market practice.
3. After the exchange of confirmation of the deal between the investor and the issuer, the
issuer shall arrange for crediting the CP to the Demat account of the investor with the
depository through the IPA.
4. The issuer shall give to the investor a copy of IPA certificate to the effect that the issuer
has a valid agreement with the IPA and documents are in order (Schedule II).
Rating Requirement
Eligible participants/issuers shall obtain credit rating for issuance of CP from any one of the SEBI
registered CRAs. The minimum credit rating shall be ‘A3’ as per rating symbol and definition
prescribed by SEBI. The issuers shall ensure at the time of issuance of the CP that the rating so
obtained is current and has not fallen due for review.
Investment / Redemption
1. The investor in CP (primary subscriber) shall pay the discounted value of the CP to the
account of the issuer through the IPA.
2. The investor holding the CP in physical form shall, on maturity, present the instrument for
payment to the issuer through the IPA.
3. The holder of a CP in dematerialised form shall get the CP redeemed and receive payment
through the IPA.
The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of
Directors or the quantum indicated by the Credit Rating Agency for the specified rating,
whichever is lower.
As regards FIs, they can issue CP within the overall umbrella limit prescribed in the Master
Circular on Resource Raising Norms for FIs, issued by DBOD and updated from time-to-time.
The total amount of CP proposed to be issued should be raised within a period of two weeks from
the date on which the issuer opens the issue for subscription.
CP may be issued on a single date or in parts on different dates provided that in the latter case,
each CP shall have the same maturity date. Further, every issue of CP, including renewal, shall be
treated as a fresh issue.
Only a scheduled bank can act as an Issuing and Paying Agent (IPA) for issuance of CP.
Individuals, banking companies, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs) etc.
can invest in CPs. However, investment by FIIs would be within the limits set for them by
Securities and Exchange Board of India (SEBI) from time-to-time.
CP can be issued either in the form of a promissory note (Schedule I given in the Master Circular-
Guidelines for Issue of Commercial Paper dated July 1, 2011 and updated from time –to-time) or
in a dematerialised form through any of the depositories approved by and registered with SEBI.
Banks, FIs and PDs can hold CP only in dematerialised form.
CP will be issued at a discount to face value as may be determined by the issuer.
No issuer shall have the issue of Commercial Paper underwritten or co-accepted.
CPs are actively traded in the OTC market. Such transactions, however, are to be reported on the
FIMMDA reporting platform within 15 minutes of the trade for dissemination of trade information
to market participation thereby ensuring market transparency.
Mode of redemption
Initially the investor in CP is required to pay only the discounted value of the CP by means of a
crossed account payee cheque to the account of the issuer through IPA. On maturity of CP,
(a) when the CP is held in physical form, the holder of the CP shall present the instrument for
payment to the issuer through the IPA.
(b) when the CP is held in demat form, the holder of the CP will have to get it redeemed through
the depository and receive payment from the IPA.
CP being a `stand alone’ product, it would not be obligatory in any manner on the part of banks
and FIs to provide stand-by facility to the issuers of CP.
However, Banks and FIs have the flexibility to provide for a CP issue, credit enhancement by way
of stand-by assistance/credit backstop facility, etc., based on their commercial judgement and as
per terms prescribed by them. This will be subjected to prudential norms as applicable and subject
to specific approval of the Board.
Non-bank entities including corporates can provide unconditional and irrevocable guarantee for
credit enhancement for CP issue provided :
a. the issuer fulfils the eligibility criteria prescribed for issuance of CP;
b. the guarantor has a credit rating at least one notch higher than the issuer by an approved credit
rating agency and
c. the offer document for CP properly discloses: the networth of the guarantor company, the names
of the companies to which the guarantor has issued similar guarantees, the extent of the guarantees
offered by the guarantor company, and the conditions under which the guarantee will be invoked.
Procedure for Buyback of CP:
1. Issuers may buyback the CP, issued by them to the investors, before maturity.
2. Buyback of CP shall be through the secondary market and at prevailing market price.
3. The CP shall not be bought back before a minimum period of 7 days from the date of issue.
4. Issuer shall intimate the IPA of the buyback undertaken.
5. Buyback of CPs should be undertaken after taking approval from the Board of Directors.
Role and responsibilities of the Issuer/Issuing and Paying Agent and Credit Rating Agency.
Issuer:
a. Every issuer must appoint an IPA for issuance of CP.
b. The issuer should disclose to the potential investors its financial position as per the standard
market practice.
c. After the exchange of deal confirmation between the investor and the issuer, issuing company
shall issue physical certificates to the investor or arrange for crediting the CP to the investor's
account with a depository.
Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement
with the IPA and documents are in order (Schedule II given in the Master Circular-Guidelines for
Issue of Commercial Paper dated July 1, 2011 and updated from time –to-time).
Issuing and Paying Agent
a. IPA would ensure that issuer has the minimum credit rating as stipulated by the RBI and
amount mobilised through issuance of CP is within the quantum indicated by CRA for the
specified rating or as approved by its Board of Directors, whichever is lower.
b. IPA has to verify all the documents submitted by the issuer viz., copy of board resolution,
signatures of authorised executants (when CP in physical form) and issue a certificate that
documents are in order. It should also certify that it has a valid agreement with the issuer
(Schedule II given in the Master Circular-Guidelines for Issue of Commercial Paper dated July 1,
2011 and updated from time –to-time).
c. Certified copies of original documents verified by the IPA should be held in the custody of IPA.
Credit Rating Agency
a. Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of capital market
instruments shall be applicable to them (CRAs) for rating CP.
b. Further, the credit rating agencies have the discretion to determine the validity period of the
rating depending upon its perception about the strength of the issuer. Accordingly, CRA shall at
the time of rating, clearly indicate the date when the rating is due for review.
c. While the CRAs can decide the validity period of credit rating, CRAs would have to closely
monitor the rating assigned to issuers vis-a-vis their track record at regular intervals and would be
required to make its revision in the ratings public through its publications and website
Fixed Income Money Market and Derivatives Association of India (FIMMDA), may prescribe, in
consultation with the RBI, any standardised procedure and documentation for operational
flexibility and smooth functioning of CP market. Issuers / IPAs may refer to the detailed
guidelines issued by FIMMDA on July 5, 2001 in this regard, and updated from time-to-time.
Every CP issue should be reported to the Chief General Manager, Reserve Bank of India,
Financial Markets Department, Central Office, Fort, Mumbai through the Issuing and Paying
Agent (IPA) within three days from the date of completion of the issue, incorporating details as
per Schedule III given in the Master Circular-Guidelines for Issue of Commercial Paper dated July
1, 2011 and updated from time-to-time.
Regular Study - Facilities for Exporters and Importers
Facilities for Exporters and Importers
Highlights of the Foreign Trade Policy 2015-20:
Increase exports to $900 billion by 2019-20, from $466 billion in 2013-14
Raise India's share in world exports from 2% to 3.5%.
Merchandise Export from India Scheme (MEIS) and Service Exports from India Scheme (SEIS)
launched.
Higher level of rewards under MEIS for export items with High domestic content and value
addition.
Chapter-3 incentives extended to units located in SEZs.
Export obligation under EPCG scheme reduced to 75% to Promote domestic capital goods
manufacturing.
FTP to be aligned to Make in India, Digital India and Skills India initiatives.
Duty credit scrips made freely transferable and usable For payment of custom duty, excise duty
and service tax.
Export promotion mission to take on board state Governments
Unlike annual reviews, FTP will be reviewed after two-and-Half years.
Higher level of support for export of defence, farm Produce and eco-friendly products.
You can go through the full details here http://dgft.gov.in/exim/2000/ftp2015-20E.pdf
RBI controls Foreign Exchange
DGFT (Directorate General of Foreign Trade) controls Foreign Trade.
Exim Policy as framed in accordance with FEMA is implemented by DGFT.
DGFT functions under direct control of Ministry of Commerce and Industry.
It regulates Imports and Exports through EXIM Policy.
RBI keeps Forex Reserves, Finances Export trade and Regulates exchange control.
Receipts and Payments of Forex are also handled by RBI.
IEC – Importer Exporter Code
One has to apply for IEC to become eligible for Imports and Exports.
DGFT allots IEC to Exporters and Importers in accordance with RBI guidelines and FEMA
regulations. EXIM Policy is also considered before allotting IEC.
Export Declaration Form
All exports (physically or otherwise) shall be declared in the following Form.
GR form--- meant for exports made otherwise than by post.
PP Form---meant for exports by post parcel.
Softex form---meant for export of software.
SDF (Statutory Declaration Form)----replaced GR form in order to submit declaration
electronically.
SDF is submitted in duplicate with Custom Commissioned who puts its stamp and hands over the
same to exporter marked “Exchange Control Copy” for submission thereof to AD.
Exceptions
Trade Samples, Personal effects and Central Govt. goods.
Up to USD 25000 (value) – Goods or services as declared by exporter.
Gift items having value up to Rs. 5.00 lac.
Goods with value not exceeding USD 1000 value to Mynmar.
Goods imported free of cost for re-export.
Goods sent for testing.
The time norms for export trade are as under:
Submission of documents with “Exchange Control Copy” to AD within 21 days from date of
shipment.
Time period for realisation of Export proceeds is 12 M or 365 days from date of shipment.
No time limit for SEZ (Special economic zones) and SHE(Status Holder Exporters) and 100
EOUs.
After expiry of time lime limit, extension is sought by Exporter on ETX Form.
The AD can extend the period by 6M. However, reporting will be made to RBI on XOS Form on
half yearly basis in respect of all overdue bills.
Direct Dispatch of Shipping Documents
AD banks may handle direct dispatch of shipping documents provided export proceeds are up to
USD 1 Million and the exporter is regular customer of at least 6 months.
Prescribed Method of payment and Reduction in export proceeds
Exporter will receive payment though any of the following mode:
Bank Drafts, TC, Currency, FCNR/NRE deposits, International Credit Card. But the proceeds can
be in Indian Rupees from Nepal.
Export proceeds from ACU countries (Bangladesh, Burma, Mynmar, Iran, Pak, Srilanka, Nepal
and Maldivis can be settled in ACUEURO or USD. A separate Dollar/Euro account is maintained.
Exports may be allowed to reduce the export proceeds with the following:
Reduction in Invoice value on account of discount for pre-payment of Usance bills (maximum
25%)
Agency commission on exports.
Claims against exports.
Write off the unrecoverable export dues up to maximum limit of 10% of export value.
The proceeds of exports can be got deposited by exporter in any of the following account:
Overseas Foreign Currency account.
Diamond Dollar account.
EEFC (Exchange Earners Foreign Currency account)
DDA - Diamond Dollar Accounts
Diamond Dollar account can be opened by traders dealing in Rough and Polished diamond or
Diamond studded Jewellary with the following conditions:
With track record of 2 years.
Average Export turnover of 3 crore or above during preceding 3 licensing years.
DDA account can be opened by the exporter for transacting business in Foreign Exchange. An
exporter can have maximum 5 Diamond Dollar accounts.
EEFC Exchange Earners Foreign Currency accounts can be opened by exporters. 100% export
proceeds can be credited in the account which do not earn interest but this amount is repatriable
outside India for imports (Current Account transactions).
Pre-shipment Finance or Packing Credit
Packing credit has the following features:
Calculation of FOB value of order/LC amount or Domestic cost of production (whichever is
lower).
IEC allotted by DGFT.
Exporter should not be on the “Caution List” of RBI.
He should not be under “Specific Approval list” of ECGC.
There must be valid Export order or LC.
Account should be KYC compliance.
Liquidation of Pre-shipment credit
Out of proceeds of the bill.
Out of negotiation of export documents.
Out of balances held in EEFC account
Out of proceeds of Post Shipment credit.
Concessional rate of interest is allowed on Packing Credit up to 270 days. Previously, the period
was 180 days. Running facility can also be allowed to good customers.
Post Shipment Finance
Post shipment finance is made available to exporters on the following conditions:
IEC accompanied by prescribed declaration on GR/PP/Softex/SDF form must be submitted.
Documents must be submitted by exporter within 21 days of shipment.
Payment must be made in approved manner within 6 months.
Normal Transit Period is 25 days.
The margin is NIL normally. But in any case, it should not exceed 10% if LC is there otherwise it
can be up to 25%.
Types of Post Shipment Finance:
Export Bills Purchased for sights bills and Discounting for Usance bills.
Export bills negotiation.
Pre-shipment & Post-shipment Finance
Q. 1. Received order of USD 50000(CIF) to Australia on 1.1.2015 when USD/INR Bill Buying
Rate is 63.50. How much preshipment finance will be released considering profit margin of 10%
and Insurance and freight cost@ 12%.
Solution
FOB Value = CIF – Insurance and Freight – Profit (Calculation at Bill Buying Rate on 1.1.2015)
= 50000X63.5 = 3175000 – 381000(12%) – 279400(10% of 2794000) = 2514600
Pre-shipment Finance = FOB value -25%(Margin) = 2514600-628650=1885950.
Q. 2. What will be amount of Post-shipment Finance under Foreign Bill Purchased for USD 45000
when Bill Buying rate on 31.3.2015 (date of submission of Export documents) is 63.50
Solution
45000X63. 05 = 2857500 Ans.
Regular Study - NRI - NRE/NRO
NRI: (Non- resident Indian) definition: As per FEMA 1999
A person resident outside India who is a citizen of India i.e.
a) Indian Citizen who proceed abroad for employment or for carrying on any business or vocation
or for any other purpose in cirucumstances indicating indefinite period of stay outside India.
b) Indian Citizens working abroad on assignment with Foreign government, government agencies
or International MNC
c) Officials of Central and State Governments and Public Sector Undertaking deputed abroad on
assignments with Foreign Govt Agencies/ organization or posted to their own offices including
Indian Diplomatic Missions abroad.
NRI is a Person of Indian Nationality or Origin, who resides abroad for business or vocation or
employment, or intention of employment or vocation, and the period of stay abroad is indefinite.
And a person is of Indian origin if he has held an Indian passport, or he/she or any of his/hers
parents or grandparents was a citizen of India.
A spouse , who is a foreign citizen, of an India citizen or PIO, is also treated at a PIO, for the
purpose of opening of Bank Account, and other facilities granted for investments into India,
provided such accounts or investments are in the joint names of spouse.
NRE Accounts – Rupee and Foreign Currency Accounts
NRI has provided with various schemes to open Bank A/cs an invest in India.
1) Non Resident (External) Rupee Account (NRE);
2) Non- Resident (Ordinary) Rupee Account (NRO);
3)Foreign Currency (Non-Resident) Account (Banks) {FCNR(B)}
When resident becomes NRI, his/her domestic rupee account, has to be re-designated as an
NRO account.
For NRE – Rupee A/cs , w.e.f 15-3-2005 an attorney can withdraw for local payments or
remittance to the account holder himself through normal banking channels.
NRI wants to repatriate overseas earned money back to India and/or NRI wants to keep India based
earnings in India. NRI has the option of opening a Non Resident Rupee (NRE) account and/or a
Non Resident Ordinary Rupee (NRO) account. An NRO account can also be opened by a Person
of Indian Origin (PIO) and an Overseas citizen of India (OCI).
Similarities between NRE and NRO accounts:
Both accounts can be opened as Savings as well as current accounts and are Indian Rupee
accounts. One needs to maintain an average monthly balance of Rs 75000 in both NRE and NRO
accounts.
The Differences between NRE and NRO accounts:
Repatriation: Repatriation is defined as sending or bringing money back to the foreign country.
You can easily repatriate funds from an NRE account including the interest earned in that account.
However, RBI has made some restrictions on NRO accounts. You can remit only up to USD 1
million in a financial year (April to March). In addition, you will need a chartered accountant to
complete the paperwork for you.
Taxation Laws: NRE accounts are tax exempted. Therefore, income taxes, wealth taxes, and gift
taxes do not apply in India. Interest earned from these accounts is also exempt from taxes. But as
per Indian Income tax laws, NRO accounts are taxable; income taxes, wealth taxes, and gift taxes
do apply. Interest earned on an NRO account as also subject to taxation. However, reduced tax
benefit is availed under Double Taxation Avoidance Agreement (DTAA).
Deposit and Withdrawal of Funds: You can deposit funds from a foreign country (in foreign
currency) in both NRE and NRO accounts, but funds originating from India (in Indian rupees) can
only be deposited in an NRO account and cannot be deposited in an NRE account. Withdrawals
from both NRE and NRO accounts can only be made in INR.
Flow of Funds: In an NRE account, repatriation is allowed outside India in any currency.
Transfer: An NRE account allows you to transfer funds to another NRE account as well as to an
NRO account. You can transfer funds from an NRO to another NRO account, but you cannot
transfer funds from an NRO account to an NRE account.
Joint Accounts: Two NRIs can open both an NRE joint account or an NRO joint account.
However, you cannot open an NRE joint account with a resident Indian. This facility is available
only with an NRO joint account.
Motive or Purpose: An NRE account helps you transfer funds to India earned abroad and
maintain them. While NRO accounts helps maintain regular flow of income earned in the form of
rent, pensions, or dividends from India.
Effect of Exchange Rate Fluctuations: NRE accounts are exposed to two kinds of exchange loss,
namely day-to-day fluctuations in the value of INR and conversion loss. NRO accounts are not at
such risk.
Choose NRE accounts if you:
want to park your overseas earnings remitted to India converted to Indian Rupees;
want to maintain savings in Rupee but keep them liquid; want to make a joint account with another
NRI;
want Rupee savings to be freely repatriable
Choose NRO account if you:
want to park India based earnings in Rupees in India;
want account to deposit income earned in India such as rent, dividends etc;
want to open account with resident Indian (close relative).
Regular Study - Correspondent Banking
Correspondent Banking
A correspondent account is an account (often called a nostro or vostro account) established
by a banking institution to receive deposits from, make payments on behalf of, or handle
other financial transactions for another financial institution. Correspondent accounts are
established through bilateral agreements between the two banks.
Commonly, correspondent accounts are the accounts of foreign banks that require the ability
to pay and receive the domestic currency. The accounts allow them to pay others from the
account or receive money from others into the account. This allows the bank to offer various
services to their customers such as foreign exchange and foreign currency denominated loans
and deposits, despite their not having a bank licence for the foreign country in that country's
currency.
Such accounts are necessary for international trade that requires people and businesses to pay
for things in a currency other than their own. It is impractical to transport large amounts of
currency around the world and physically exchange domestic currency for the currency that a
customer/supplier demands. Instead, money is taken out of an account at a local bank (which
is in local currency) and an equivalent amount of money is put in the customer's or supplier's
account at their local bank (in a foreign currency). The money from the buyer's account goes
to an internal account of your bank. The money to the customer or supplier comes from an
account the buyer's local bank holds with a bank in the supplier's country—the buyer's bank's
correspondent account, at their correspondent bank.
A correspondent bank is a financial institution that provides services on behalf of another,
equal or unequal, financial institution. It bank can conduct business transactions, accept
deposits and gather documents on behalf of the other financial institution. Correspondent
banks are more likely to be used to conduct business in foreign countries, and act as a
domestic bank's agent abroad.
Correspondent banks are used by domestic banks in order to service transactions originating
in foreign countries, and act as a domestic bank's agent abroad. This is done because the
domestic bank may have limited access to foreign financial markets, and cannot service its
client accounts without opening up a branch in another country.
1. Corresponding Banking is the relationship between two banks which have mutual
accounts with each other, r one of them having account with the other.
2. Functions of Corresponding Banks:
A. Account Services
i. Clearing House Functions
ii. Collections
iii. Payments
iv. Overdraft and loan facility
v. Investment Services
B. Other Services
i. Letter of Credit Advising
ii. LC confirmation
iii. Bankers Acceptance
iv. Issuance of Guarantees – Bid-bond, Performance
v. Foreign Exchange services, including derivative products
vi. Custodial Services etc.
3. Types of Bank Accounts: The foreign account maintained by a Bank, with another bank
is classified as Nostro, Vostro, and Loro Accounts.
4. Nostro Account: “Our Account with you”. DLB maintains an US $ account with Bank of
Wachovia, New York is Nostro Account in the books of DLB, Mumbai.
5. Vostro Account: “Your account with us”. Say American Express Bank maintain a Indian
Rupee account with SBI is Vostro Account in the books of American Express bank
6. Loro Account: It refers to accounts of other banks i.e. His account with them. E.g. Citi
Bank referring to Rupee account of American Express Bank, with SBI Mumbai or some
other bank referring to the USD account of SBI, Mumbai with Citi Bank, New York.
7. Mirror Account: While a Bank maintains Nostro Account with a foreign Bank, (Mostly
in foreign currency), it has to keep an account of the same in its books. The mirror account is
maintained in two currencies, one in foreign currency and one in Home currency.
8. Electronic Modes of transmission/ payment gateways
SWIFT, CHIPS, CHAPPS, RTGS, NEFT
9. SWIFT: Society for Worldwide Interbank Financial Telecommunications.
10. SWIFT has introduced new system of authentication of messages between banks by use
of Relationship Management Application (RMA) also called as SWIFT BIC i.e.Bank
Identification Code.
11. CHIPS: (Clearing House Interbank Payment System) is a major payment system in
USA since 1970. It is established by New York Clearing House. Present membership is 48.
CHIPS are operative only in New York.
12. FEDWIRE: This is payment system of Federal Reserve Bank, operated all over the US
since 1918. Used for domestic payments.
13. All US banks maintain accounts with Federal Reserve Bank and are allotted an “ABA
number” to identify senders and receivers of payment
What Does ABA Transit Number Mean?
A unique number assigned by the American Bankers Association (ABA) that identifies a
specific federal or state chartered bank or savings institution. In order to qualify for an ABA
transit number, the financial institution must be eligible to hold an account at a Federal
Reserve Bank. ABA transit numbers are also known as ABA routing numbers, and are used
to identify which bank will facilitate the payment of the check.
14. CHAPS: Clearing House Automated Payments system is British Equivalent to CHIPS,
handling receipts and payments in LONDON
15. TARGET: Trans-European Automated Real Time Gross Settlement Express Transfer
System is a EURO payment system working in Europe. And facilitates fund transfers in Euro
Zone.
16. RTGS + and EBA: RTGS+ is Euro German Based hybrid Clearing System. RTGS+ has
60 participants.
17. EBA-Euro 1 is a cross Border Euro Payments
18. RTGS/NEFT in India: The RTGS system is managed by IDRBT- Hyderabad. Real
Time Gross Settlement takes place in RTGS. NEFT settlement takes place in batches.
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